symbol
stringclasses 685
values | quarter
int64 1
4
| year
int64 2.01k
2.03k
| date
stringdate 2005-10-13 14:45:00
2025-05-15 16:30:00
| content
stringlengths 0
245k
| structured_content
listlengths 0
369
| company_name
stringclasses 496
values | company_id
float64 18.7k
1.87B
⌀ |
|---|---|---|---|---|---|---|---|
MRK | 3 | 2,006 | 2006-10-20 09:00:00 | Operator: Good day everyone, and welcome to Merck’s third quarter 2006 earnings conference call. Today’s call is being recorded. At this time, I would like to turn the call over to Mr. Graeme Bell, Senior Director of Investor Relations with Merck. Please go ahead, sir.
Graeme Bell: Thank you, Cynthia, and good morning. Welcome to our call this morning to review our business results for the third quarter of 2006. I am Graham Bell, head of investor relations. Joining me on the call today are our CEO and President, Dick Clark, and Judy Lewent, our Executive Vice President and Chief Financial Officer. Before we get into the details, I would like to go over some logistics. On this call, we will review the results of the third quarter of 2006, released at 7:30 this morning. You can access the earnings press release and supporting material through the Merck website. This conference call is being webcast live and recorded for replay later today via phone, webcast, and podcast. As you begin to review the results, let me remind you that some of the statements made during this call may discuss certain subjects that may contain forward-looking statements as that term is defined in the Private Securities Litigation Act of 1995. These statements are based on management’s current expectations and involve risk and uncertainty, which may cause results to differ materially from those set forth in the statements. The forward-looking statements may include statements regarding the product development, product potential or financial performance. No forward-looking statement can be guaranteed and actual results may differ materially from those projected. Merck undertakes no obligation to publicly update any forward-looking statement, whether as a result of new information, future events, or otherwise. Forward-looking statements in this call should be evaluated together with the many uncertainties that affect Merck's business, particularly those mentioned in Merck's most recent 10-K, or on Form 10-Q, that are posted on our website. We will begin with some brief remarks from our senior management, and then open the call for questions. We expect the total call to last approximately an hour. With that, I will turn the call over and we will begin with remarks from our CEO and President, Mr. Dick Clark.
Richard T. Clark: Thank you, Graeme. Good morning, everyone, and thank you for joining us. I am pleased to report that Merck's strong performance in 2006 has continued right through the third quarter. Let me take a few moments to review the highlights of the quarter, which are led by the performance of Singulair, Vytorin and Zetia, our vaccines, as well as our ongoing cost management initiatives. It was another solid quarter for Merck. Our earnings per share for the quarter were $0.51, excluding restructuring charges. This figure includes reserving an additional $598 million in the third quarter solely for future Vioxx legal defense costs. It excludes an $0.08 net charge for activities associated with the global restructuring plan we announced in November of last year, which continues to unfold as expected. The Vioxx reserves are consistent with our commitment to defend these cases in a rigorous and responsible manner. We have both the financial strength and resolve to see our litigation strategy through. Including the impact of the restructuring charges, our reported EPS for the third quarter were $0.43. We are pleased to report that Vytorin and Zetia achieved combined global sales of more than $1 billion in the third quarter. Vaccine sales also realized strong growth, with Gardasil reaching $70 million in the quarter. Due to these strong results, we are raising our full-year 2006 guidance, and now anticipate an EPS range of $2.48 to $2.52, excluding restructuring charges. We anticipate our reported 2006 EPS range to be $2.18 to $2.25. Judy Lewent will provide more details on the financial performance and guidance in a moment. Our third quarter results reflect Merck's fundamental strengths and our determination to take full advantage of the opportunities that exist inside our company. We are establishing our credibility in delivering results our stockholders have every right to expect. As we announced last year, our business model is changing in many ways. We are concentrating on nine therapeutic areas based on scientific opportunity and value to our customers. We are focusing on research efforts on the most promising candidates, and reducing the time it takes to bring drugs to market. Our commercial model is becoming leaner, more nimble, more information- and value-driven, and much more cost-effective. By investing in these areas that will drive our growth by reducing cost base in a strategic and targeted way, and by continuing to provide patients with the innovative products they want and they need for their health, we expect to continue to see Merck progress towards the goals I expressed last December, to regain the leadership position we so long enjoyed. As I mentioned, our established products remain strong. I would like to take a moment to review the results of these products with you: The combined sales of Zetia and Vytorin topped $1 billion in the third quarter, the first time the combined sales of these products have exceeded that major milestone in one quarter. I should add that the strong growth of both of these products has been consistent through 2006. Global sales of Zetia reached $1.4 billion for the first nine months of the year. Also, for the first three quarters of the year, sales of Vytorin also reached $1.4 billion. As you know, Merck launched three new vaccines during the first three quarters of this year. To date, Gardasil has been approved in more than 30 countries, including the U.S., E.U., Australia, Brazil, and two countries in Africa. In fact, as recently as this week, SPMSD has launched Gardasil in the United Kingdom. It is validation of how well this vaccine has been received as a new standard of care. It is important to note that approximately 10,000 American women are diagnosed with cervical cancer every year, and an average of 10 women die each day from this disease. Being able to prevent cervical cancer is something all of us at Merck take pride in to provide those at risk of this terrible disease. Besides Gardasil, Merck launched two other important vaccines, Rotateq and Zostavax. These vaccines represent significant medical breakthroughs in protecting infants and children from Rotavirus B and adults from shingles. These three new vaccines and ProQuad have helped drive a 64% increase in vaccine sales for the quarter, compared to the same period a year ago. Before I turn it over to Judy, let me say that we are very pleased with the recent FDA approvals over the past two weeks of Januvia, our first-in-class drug to treat type 2 diabetes, and Zolinza, the first anti-cancer treatment approved for CTCL since 1999. Merck is delighted that the FDA approved Januvia on Monday, October 16th -- the first and only DPP-4 inhibitor available in the United States for the treatment of type 2 diabetes. Januvia has been approved as mono-therapy as well as add-on therapy to either the two other types of oral diabetes medications, metformin or TZDs, to improve blood sugar control in patients with type 2 diabetes when diet and exercise are not enough. Januvia is a potent and highly selective DPP-4 inhibitor. The recommended dose of Januvia is 100 milligrams once a day. Januvia provides powerful A1C reductions as mono-therapy patients with type 2 diabetes and poor blood sugar control. Also, Januvia has a significant complementary affect when added to metformin or TZDs. Januvia has an overall incidence of side effects comparable to placebo, and in phase III clinical programs, treatment with Januvia was not associated with weight gains or an increase of hypoglycemia. Regarding the launch of Januvia, we began taking orders from customers on Tuesday, began packaging product Wednesday, and shipped product to our distribution centers on Thursday. Our customers will begin to have their orders filled today. The FDA approval clearly demonstrates our ability to deliver on our strategy of providing physicians and patients with innovative medicines that meet unmet medical needs. We are prepared to ensure that Januvia reaches its full market potential. The Januvia approval letter this week marks the first new Merck medicine or vaccine approved for the United States in 2006. That is an extraordinary record of success. As I look back over the most recent quarters, and over the first three quarters of 2006, I believe the evidence is clear that the course we have embarked on last year is proving to be the right path for Merck. To restate, this approval of Januvia this week marks the fifth new Merck medicine or vaccine approved in the United States in 2006. Now, I am pleased to ask Judy to provide you with additional details about our strong third quarter. Judy.
Judy C. Lewent: Thank you, Dick, and good morning. As mentioned, we are pleased with the third quarter results. Our earnings in the quarter from ongoing operations reflects strong performance in a number of areas, particularly Singulair, vaccine, equity income, as well as the benefits of our ongoing cost management positions that are starting to have a positive effect on our bottom line. I will take the next few minutes to highlight the important underlying drivers of our performance, then I will discuss our full-year 2006 guidance and the elements we will change. To briefly summarize the quarterly performance, our in-line franchises and the recently launched vaccines exhibited strong growth. When taken together, their performance offset the financial effect of the loss of patent exclusivity for Zocor and Proscar in the U.S. We also saw strong performance of our partnerships and alliances, resulting in enhanced equity income and an upward move in interest income. These positive contributors were partially offset by an increase in the level of sales and marketing activity to support the recently approved vaccines and the imminent launch of Januvia. In the third quarter, we recorded revenues of $5.4 billion, and that is comparable to the same period last year, including in the aggregate, an overall 2% decrease from price, offset by 1% growth in volume and 1% positive impact of foreign exchange. For the quarter, strong global growth in Singulair, vaccines, and other promoted products were offset by those products losing exclusivity in the U.S., namely Zocor and Proscar. In the third quarter, the first full quarter following the loss of U.S. patent exclusivity, branded Zocor revenue in the U.S. was $152 million, representing an 80% decrease year over year. During the quarter, Merck recorded revenue associated with the Dr Reddy’s arrangement for Simvastatin of approximately $80 million, and please note that Merck records this revenue on the top-line as part of other revenue, not within branded Zocor. It remains unclear whether the whole 180-day exclusivity will be awarded to the first filer for Simvastatin. The issue of exclusivity is not yet decided and is pending the court’s decision. As you know, we have no influence over the outcome. Total sales of Merck's other promoted medicines and vaccines were $1.8 billion for the third quarter, representing growth of 15% as compared with the third quarter of 2005. A major contributing factor to the 15% growth in the other promoted medicines was the strong growth in our vaccines business, and that was up 64% compared to the base period. Part of the $555 million of revenue we recorded was driven by the uptake of Gardasil, Rotateq, Zostavax, and ProQuad, for which we collectively recorded $226 million in the quarter. To assist in your modeling, we are providing a breakdown of the new product revenues on our other financial disclosure. You will see the global sales for Rotateq in its second full quarter on the market reached $62 million. Regarding Gardasil, since FDA approval on June 8th, managed care plans representing over 90% of covered lives in the U.S. have made positive coverage decisions on the product, and U.S. sales of $70 million in the quarter. Also contributing to our top-line, our revenues from our alliances, primarily AstraZeneca LT. In the third quarter, revenue recorded by Merck from the company’s relationship with AZLT was $442 million, and that is flat compared to third quarter ’05, but keep in mind that there is inherent variability relating to this revenue, given that Merck is not actively managing these products. Our revenue recognition takes into account inventory levels at AZLT for PTI and non-PTI products, as well as their product shipments. Taking the third quarter revenue announced today and adding 50% of the revenues from the Merck/Schering-Plough, Merial, Sanofi Pasteur MSD, and Johnson & Johnson Merck joint ventures and partnerships, third quarter 2006 revenue would have been $6.3 billion. If you do the same adjustment in third quarter ’05, the growth rate from that baseline was 3%. Keep in mind the base period has a full quarter of branded Zocor sales. Year-to-date, that growth rate would be 5%. As we move into the next three lines on the income statement, recall that they include the consequences of FAS-123R, or expensing stock options, consistent with where payroll costs are incurred. For this third quarter of 2006, our total stock option expense was $42 million, and year-to-date, that expense has been $183 million. We remain on track and stock option expense is expected to be approximately $220 million in 2006. Moving down the P&L, materials and productions came in at $1.5 billion. The actual reported product gross margin in the quarter was 71.5%, but this includes restructuring costs of $200 million, primarily related to accelerated depreciation and asset impairment costs associated with Merck's global restructuring program announced in November, 2005. It also includes $5 million recorded in accordance with the adoption of FAS-123R. Excluding the restructuring costs, but including stock option expensing that will be an ongoing cost, PGM in the quarter was 75%, and just as in previous quarters, this result was affected by the final product mix. We are reaffirming our guidance for the full year of 76% to 78%, and keep in mind that we anticipate PGM rates after 2008 to return to pre-Zocor patent expiry levels. Turning to marketing and administrative, third quarter expense came in at $2.4 billion, and that is up 43% over the same period last year. Per our financial footnotes in the press release, this includes a $598 million charge related to increasing the legal defense reserve and $25 million recorded in accordance with the adoption of FAS-123R. Year-to-date, excluding the legal defense reserve charge taken in the third quarter, we showed 4% growth over the first nine months of 2005, reflecting an increase in activity to support the three recently approved vaccines and the imminent launch of Januvia, partially offset by reduced spending in support of Zocor. As you can appreciate, there are many factors affecting the marketing and administrative expenses, and during the quarter, we make decisions regarding the timing of commercial spending and reallocation of funds to initiatives scheduled throughout the year. Regarding the legal defense reserve charge, the company accrued legal defense costs expected to be incurred in connection with a lawsuit contingency when such costs are probable and reasonably estimable. As of December 31, 2005, the company had established reserves of $685 million solely for its future legal defense costs related to the Vioxx lawsuit and the Vioxx investigation. During the first nine months of 2006, the company spent $325 million in the aggregate in legal defense costs worldwide, related to Vioxx litigation. In the third quarter, the company recorded a charge of $598 million to increase the reserve solely for its future legal defense costs related to Vioxx, to $958 million at September 30, 2006. In increasing the reserve, the company considered the same factors that it considered when it previously established reserves for the Vioxx litigation, and management now believes it has a better estimate of the company’s expenses and can reasonably estimate such costs through 2008. Some of the significant factors considered in the establishment and ongoing review of the reserve for the Vioxx legal defense cost were as follows: Events such as scheduled trials that are expected to occur throughout 2007 and into 2008, and the inherent inability to predict the ultimate outcomes of such trials, limits the company’s ability to reasonably estimate its legal costs beyond the end of 2008. The company will continue to monitor its legal defense costs and review the adequacy of the associated reserves. The company has not established any reserve for any potential liability relating to the Vioxx lawsuit and the Vioxx investigation. Regarding research and development during the third quarter, expenses were $945 million. That is flat year over year, inclusive of the $11 million for stock option expense taken in the period. Merck continues its strategy of establishing strong, external alliances to complement our internal research, and for the first nine months of 2006, we have entered into 24 such transactions. Two recent examples of our commitment to strategic alliances are the Ambrilia Biopharma licensing agreement, in which Merck was granted the worldwide rights to Ambrilia’s HIV AIDS protease inhibitor program. In late September, Merck and FoxHollow Technologies announced that they will expand the scope of their existing strategic collaboration for atherosclerotic plaque analysis. At this time, we are in discussions with approximately 40 companies regarding potential transactions, and are actively monitoring the landscape for a range of targeted acquisitions that meet the company’s strategic needs. Moving on to restructuring, we continue to provide this breakout to assist in tracking the restructuring related expenses, and to ensure fair comparisons of the underlying business. This line captures all separation costs, and in accordance with GAAP accounting, it also includes asset related dismantling costs, demolition expenses, costs to relocate assets being put to alternative use, and any gains on facility sales. Remember, any accelerated depreciation associated with our global restructuring program is being reported in the respective line items, namely materials and production and R&D. So in our third quarter results, the total charges related to the global restructuring program were $50 million, and $200 million of accelerated depreciation and asset impairment costs included in the materials and production lines. The $50 million charge is for employee separation and other related costs associated with the approximately 500 positions eliminated, bringing the total to 3,900 to date in the global restructuring program, and we remain on track to eliminate 7,000 positions by the end of 2008. In reviewing equity income from affiliates, you will see $595 million in income related to the contribution from all our joint ventures -- AstraZeneca LT, Merck/Schering-Plough, Merial, Sanofi Pasteur MSD, and Johnson & Johnson Merck. Regarding the Merck/Schering-Plough partnership, the third quarter combined MSP cholesterol franchise global revenue, as reported by the Merck/Schering-Plough partnership, surpassed $1 billion. In the third quarter, revenues of Zetia and Vytorin were $502 million and $527 million respectively. Turning to other income within this line, interest income continues to come in at a higher level, as our portfolio benefits from the rising short-term rate environment. For the quarter, income before taxes was $1.2 billion. Taxes on income in the period were $290 million, and the reported tax rate was 23.6%, but this included a favorable 160 basis points associated with the restructuring charge. The underlying effective tax rate of 25.2% reflects in general the changes in foreign and domestic mix and currency fluctuations, and these elements change throughout the quarter. Moving down to net income and earnings per share, net income for the quarter was $941 million, down considerably when compared to the same period last year but recall that in this period, there was a $598 million legal defense charge. During the quarter, we spent $250 million in treasury stock, and now have $6.8 billion under the current authorization from the board, with no time limit. In summary, earnings per share for the third quarter were $0.51, excluding a net charge related to the global restructuring, and on a reported GAAP basis, EPS was $0.43. With that result, let me briefly turn to our guidance. Regarding 2006, continuing our previous practice, we provide detailed guidance for the full year and, as you will see in today’s release, we are raising our full-year 2006 range, and are raising several elements of our 2006 guidance. All the details of the guidance are provided to you in the release and, as stated, this guidance does not reflect the establishment of any reserves for any potential liability relating to the Vioxx litigations. In summary, we are raising our full-year 2006 EPS guidance to capture the fact that we had another solid quarter, and to reflect our strong, year-to-date performance. Our revised expectations are that EPS will now be in the range of $2.48 to $2.52, excluding the restructuring charges related to site closings and position eliminations, and we anticipate reported full-year 2006 EPS of $2.18 to $2.25. Now, regarding specific elements, we are increasing guidance on the following four items: As stated a moment ago, the company’s full-year 2006 EPS guidance is now anticipated to be in the range of $2.48 to $2.52, excluding restructuring charges, and reported 2006 EPS in the range of $2.18 to $2.25. I would also highlight that in 2006, the company remains on track to generate approximately $5 billion in free operating cash flow, after capital expenditures but before dividends and share repurchases. I also want to emphasize that we have the financial strength to support our dividends, and we remain fully committed to maintaining it at the current level, while at the same time, continuing to fully fund our investment priorities. In addition, as Dick noted, our strategy is on track. We remain committed to driving compound annual double-digit EPS growth, excluding restructuring cost, net tax charges, and the one-time gains associated with the AstraZeneca partnership and the establishment of any reserves for any potential liability related to the Vioxx litigation over the three- to five-year period, as well as adjusted compound annual revenue growth, including 50% of joint venture revenues of 4% to 6% through 2010 over our 2005 base. With that, I will turn the call back over to Graeme.
Graeme Bell: Thank you, Judy. We will now open the call to take your questions. We will take the questions in the order they were received and try to get through as many as we possibly can. At this point, I will turn the call back over to Cynthia, who will communicate instructions for our Q&A format, then introduce the first question.
Operator: (Operator Instructions) Your first question comes from David Risinger with Merrill Lynch.
David Risinger: With respect to government rebate reversals, a number of other drug companies have recorded government rebate reversals that have benefited the top-line. I may have missed it, but if you could comment on whether Merck recorded any such benefit in its top-line this quarter, and if not, why not? Then, with respect to Zostavax, I believe that there is upcoming reviews of Zostavax that could potentially accelerate market adoption of that product. If you could comment on that, and then finally, with respect to Gardasil, could you just characterize whether the up-take of Gardasil has been surprising on the upside in young girls, i.e., those aged 11 to 12, or whether Gardasil demand upside is more so being driven by the females between the ages of 16 and 26? Thank you.
Judy C. Lewent: I will take the first question. I believe you are referring to the TRICARE decision, and this is based on the September decision of the U.S. Court of Appeals to the federal circuit, where they determined that pharmaceutical companies do not owe rebates to the Department of Defense associated with TRICARE business for the period from the fourth quarter of 2004 to the third quarter of 2006. For Merck, this really generated minor third quarter 2006 discount rate favorability. That has been reflected in Merck's net sales, and there is also a minor pick-up in the net sales of Vytorin and Zetia, which were reported by Merck/Schering-Plough.
Richard T. Clark: Relating to your question about Gardasil, it is too early for us to be able to answer that question. We will have more data as the year progresses. With the Zostavax, we are pleased during the third quarter, sales of Zostavax reached $10 million, and there has really been extremely positive response from managed care organizations to Zostavax, and I think that was a major part of the up-tick. In addition, on October 25th of this year, ACIP, which develops written recommendations for the administration of vaccines, will vote to determine the recommendation for the use of Zostavax in the U.S. I think that will be another critical part of it, and Zostavax is on the agenda.
Graeme Bell: Thank you. Next question, please.
Operator: Your next question comes from Chris Schott with Banc of America.
Chris Schott: Thank you. Just two quick questions. First, on Gardasil, once we get through this initial launch stage, are you expecting seasonality with this vaccine, i.e. a strong summer season, as we see with Menactra vaccine, for example? Second, on Januvia, could you comment on the initial market you are targeting with this product launch? One of your competitors has highlighted they are initially targeting the heavy TZD prescribers as compared to [inaudible] users. Do you share this view? Any color there would be appreciated. Thank you.
Richard T. Clark: On Gardasil, I do not see any seasonality with a vaccine that type of that indication. Certainly what we are looking at with our Januvia launch strategy, it is something that is proprietary and it is really across the whole type 2 diabetes drug therapy.
Graeme Bell: Next question, please.
Operator: Your next question comes from Mario Corso with Summer Street Research.
Mario Corso: On Gardasil, could you comment on where the VFC process may be at this point, and what timing may look like? Then, in terms of the obesity drug, could you talk about how the mechanism or chemical structure might be different than the first generation molecule that is being developed? Thanks.
Richard T. Clark: On the issue with Gardasil, as you know, we received ACIP recommendations on June 29th, with supply to girls and women ages 9 to 26, which is very, very important. We are currently in negotiations and finalizing the CDC contract as we speak. What is also important to realize with that lobby, and then WR publication is currently pending. The American College of Obstetricians and Gynecologists, the American College of Health Associates, and the Society for Adolescent Medicine has already published their support for the vaccine, so I think that has been very, very important. Obviously, finalizing the CDC contract is important, and that is under discussion as we speak.
Judy C. Lewent: Regarding the obesity compound, it is way too early, as we noted, to really provide any insight into the profile of that product whatsoever.
Graeme Bell: Next question, please, Cynthia.
Operator: Your next question comes from Tim Anderson with Prudential.
Tim Anderson: Thank you. Back on the TRICARE decision, can I just clarify that is fully washed through the P&L, whether it occurred in this quarter or whether it might occur in future quarters, it is done for you guys? Then, on the general topic of sales, it seems like a few products came in ahead of where prescription trends would suggest. I did not see anything in your press release that talks about this, so I am wondering if there was anything else that may have boosted sales this quarter that we may not be seeing. A second question, on your obesity product, seeing as you had the CV1 receptor product, did you see any depression in your Phase II trail program?
Judy C. Lewent: First of all, the financial impact of TRICARE is fully reflected in the third quarter of 2006. It is completely taken account of and there is no impact in future periods. In terms of the sales trends, globally, recognized versus the ordinary prescription trend, there continues to be substantial growth in the un-audited channels, and that is really across all of the major product lines. That needs to be factored into the performance. Again, as noted in the answer to the prior question, on CV1, on the new anti-obesity compound, we really have nothing more to say than we put in the press release at this point in time.
Operator: (Operator Instructions) Your next question comes from James Kelly with Goldman Sachs.
James Kelly: Good morning. I have a question about the other products line. If we take a look at that line, and even if we adjust it for the vaccines, that line seems to have gone from a modest decline a year ago to good growth going to this year. I am wondering if there are any important factors about the business away from the big four products and the new launches that we should be considering here? Thank you.
Judy C. Lewent: It really just reflects the continuing contributions from supplies for supply sales for basically our joint venture relationships. Also, bear in mind my earlier comment that a major contributor there was the $80 million from our arrangement with Dr Reddy.
Graeme Bell: Next question, please.
Operator: Your next question comes from Jamie Rubin with Morgan Stanley.
Jamie Rubin: Thank you. Just a couple of Vioxx related questions. The next big Vioxx case in Atlantic City is early next year, which my understanding is it is eight consolidated cases, which -- I am not a lawyer, but I think that would put you in an impossible position. Could you discuss what your legal options are? Also, with respect to Judge Higbee to reverse your win on the Humeston case. Thirdly, on Gardasil, do not know if you spoke to this, but was there any stocking in the $70 million recorded this quarter? Thank you.
Judy C. Lewent: There is no stocking, apart from normal wholesale inventory provision. There is nothing unusual in that Gardasil number whatsoever. That reflects the up-tick of the product since its launch in June, in early June.
Richard T. Clark: The issue concerning Vioxx, certainly Merck is very concerned about the potential strategy of multiple cases, and our concern revolves around the fact that they involve different states, different period of ingestion, different risk factors, pre-existing conditions, et cetera, et cetera, so it makes it extremely very complex for a jury to understand all of that in a combined focus. Obviously we continue to work on convincing the judge that may not be the appropriate way to go. With regard to the whole issue around Vioxx and some of the other issues, we will appeal as appropriate.
Judy C. Lewent: I am going to come back to my earlier comment. I just want to clarify. Clearly the major place where we are shipping Gardasil is the physicians’ offices, so again, that is just based on the underlying demand.
Operator: Your next question comes from Stephen Scala with Cowen.
Stephen Scala: Thank you. I am intrigued by your legal strategy on Fosamax. You dropped the inequitable conduct suit, and then I believe you sued the generics over a process patent. I am wondering, what is the best case outcome here? Could generic Fosamax be substantially delayed by what I believe has been a recent suit?
Judy C. Lewent: We continue to expect that Fosamax is going to lose exclusivity in early ’08.
Graeme Bell: Thank you. Next question, please.
Operator: Your next question comes from [Seamus Fernandez] with Leerink Swann.
Seamus Fernandez: Thank you very much. Just a couple of questions here. I was hoping that you could discuss, should we be thinking about the payment from Dr Reddy’s as basically 100% gross profit margins? So, assuming that, it has basically contributed roughly $0.02 to earnings in the quarter? Then, second, could you just discuss, there was a news report about a manufacturing plant for cancer products in Germany. Was this for Zolinza or should we be thinking about it as something for other products? That is it. Thank you.
Judy C. Lewent: Based on our agreement with Dr Reddy’s, we do not comment on any specifics of our contractual arrangement there. Those are proprietary.
Richard T. Clark: Concerning the manufacturing plant in Germany, that is really not a Merck facility, or maybe it is the German Merck versus ours, but we do not have any plants or manufacturing facilities in Germany.
Operator: Your next question comes from Roopesh Patel with UBS.
Roopesh Patel: Thank you. I have a couple of questions. First, on gross margins, given that Merck has already recorded a significant erosion of Zocor and Proscar sales this quarter, would it be reasonable to assume that the gross margins recorded this quarter, notwithstanding the restructuring costs, should roughly be the forward run-rate? If not, what are the broad pushes and pulls that we should take into account? Separately, I was just wondering if you could also broadly comment on the sales force support behind Januvia’s launch. Have you increased the size of Merck's overall sales force? If not, is effort being diverted from any particular product? Thank you.
Richard T. Clark: Concerning the sales force, we really think about our launch for Januvia and other products as a very important part of proprietary information and certainly do not provide details on that. What I can reassure you is that we are providing the proper capabilities for promotion, as well as re-educating the physicians. We did announce earlier that, as a part of our plans of looking at a new operating model for marketing and sales, that we were going to take 1500 sales representatives and reallocate them to vaccines and other activities.
Judy C. Lewent: Regarding thinking about progression on product gross margins, I think you need to take a few things into consideration. Obviously in the second-half of 2006, you are seeing, as you noted, the impact of Zocor on the product mix. But as you also may recall, in our longer-term guidance, we had talked about our product gross margins returning to pre-Zocor patent expiry levels after 2008. That is a function of a lot of a lot of new product launches that we are talking about, and the major cost improvement initiatives that our supply strategy already has underway. I think you need to factor all of that in at this point in time.
Operator: (Operator Instructions) Your next question comes from Craig Baskin with Loomis, Sayles.
Craig Baskin: Thanks for taking my question. I was wondering on Gardasil, since the rate at which you are able to ship the product out to physicians is probably significantly greater than the rate at which the insurance companies might choose to reimburse the physician, I was wondering what sort of terms you were giving.
Richard T. Clark: We are not going to discuss terms with physicians. I can tell you this though -- as of today, managed care plans representing over 90% of the covered lives of girls and women from the age of 9 to 26 in the U.S., have added Gardasil to their respected formularies. I think that is a critical part, that we are up to 90%, which certainly was accelerated and it exceeded our expectation of where we would be on October 20th.
Operator: Your next question comes from Chris Shibutani with J.P. Morgan.
Chris Shibutani: Thanks very much. Two questions, if I may. On MK-524A, timelines are still apparently on track. Can you comment about when we can expect to see a little bit more data in regard to the profile? Can you also address where you are in terms of the formulation issues for the 524B? Secondly, a question on collaborations, 24 year-to-date. Obviously the rhythm and pace of these can vary. I believe the numbers have been higher in the past, 40 to 50 per year, which is a considerable step-up. Does this change in number reflect in any way your appetite or capacity to manage these, the quality of the deals you are seeing, or maybe the competitiveness or valuation that is out there, since everyone is obviously looking for in-licensing, et cetera? Thank you.
Judy C. Lewent: Relative to 524A, I will remind you that there will be papers presented at the American Heart Association, the week of November 13th. I think some of those have already been posted, so that is where those data are going to be discussed. In terms of the formulation, as you note, we have not stipulated a timetable on the product of 524B at this point in time.
Richard T. Clark: In relationship to the licensing deals that we have focused on, and 24 compared to the previous number, there really is no change in strategy. We are still very aggressive. We are still looking at the opportunity, and we will take advantage of each and every opportunity, so we are looking at quality and certainly not quantity.
Operator: Your next question comes from [Bob Yates] with Principle Capital.
Bob Yates: Thanks for taking my question. Just to follow on the questions on Vioxx, number one, it seems like there are more cases that came in this quarter. Could you comment if there was a statute of limitations which expired in certain states during the quarter? Secondly, Judy, you sort of bumped your reserve here to $950 million. Does that mean you expect you are going to spend most of those funds over 2007 and 2008?
Judy C. Lewent: Let me just address the process for the reserve. As you noted earlier, we continue to look at our ability to estimate, and part of that is a function of the progress in the litigation and our knowledge and visibility over a certain timetable. At this point, all of that reflects is our best estimate. We can establish and make a reasonable estimation only through the end of 2008, so it is really just part of our, you know, the horizon that we have in our ability to forecast with the right rigor that we need to update the reserve, but it really does not stipulate anything else about the timetable. It really was a progression of where this is going to go.
Graeme Bell: Cynthia, given the time, we will take one more question.
Operator: Your final question comes from Tim Anderson with Prudential.
Tim Anderson: Thank you. I just had a follow-up question, actually, two. Judy, you mentioned higher sales in un-audited channels. Why, I guess is the question? Is that a change in the strategy in terms of how you are contracting in those channels, or what exactly? Dick, at one point last year, you said Merck may actually get into the medical device business. This morning, you reference the FoxHollow collaboration. My question to you is whether medical devices, or anything else outside the traditional pharmaceutical space, are areas in which you would potentially consider building up presence in?
Judy C. Lewent: Just to the first question, there is no change in strategy there. It is really just un-audited picked up and the fact that we continue to work to contract our product in the unordered channels. There is nothing there. It just helps explain why from time to time you may see a slightly different trend in sales reported as opposed to the reported script track.
Richard T. Clark: I was just thinking about medical devices as a part of our strategy. We are certainly interested in the capabilities and technologies around medical devices diagnostics biomarkers when it helps us from a research standpoint, but not as a standalone business. To go back to a previous question concerning Vioxx, one of the reasons you saw such an increase in the third quarter of suits is September 30th was the two-year date since we voluntarily recalled Vioxx, and that is significant from the standpoint that approximately two-thirds of the states have a two-year limitation. Obviously that is where the limitation took place, on September 30th. There are obviously complexities around whether that can continue or not, but that is probably the major driver.
Graeme Bell: With that last question, it concludes this call. The information from today’s call, both the transcript and the replay, will be available on our website, and Mike and I will be available all day to take your calls. I would like to now turn the call back to Dick Clark for some concluding remarks.
Richard T. Clark: Thank you, Graeme, and thank you for tuning in and listening to our call today. Judy and I are very pleased to continue to speak directly with you every quarter, and as we stated, we are very pleased with the third quarter results. It exceeded consensus expectation, and we are certainly looking forward to updating you further on our progress at our annual business briefing that we will hold in White House Station on December 12th. We will be in touch to give you details on our meeting very soon. Thank you again. We appreciate your interest and participation. Operator, thank you very much, and that is the end of our call. Thank you.
Operator: Ladies and gentlemen, this concludes today’s Merck third quarter 2006 earnings conference call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day everyone, and welcome to Merck’s third quarter 2006 earnings conference call. Today’s call is being recorded. At this time, I would like to turn the call over to Mr. Graeme Bell, Senior Director of Investor Relations with Merck. Please go ahead, sir."
},
{
"speaker": "Graeme Bell",
"text": "Thank you, Cynthia, and good morning. Welcome to our call this morning to review our business results for the third quarter of 2006. I am Graham Bell, head of investor relations. Joining me on the call today are our CEO and President, Dick Clark, and Judy Lewent, our Executive Vice President and Chief Financial Officer. Before we get into the details, I would like to go over some logistics. On this call, we will review the results of the third quarter of 2006, released at 7:30 this morning. You can access the earnings press release and supporting material through the Merck website. This conference call is being webcast live and recorded for replay later today via phone, webcast, and podcast. As you begin to review the results, let me remind you that some of the statements made during this call may discuss certain subjects that may contain forward-looking statements as that term is defined in the Private Securities Litigation Act of 1995. These statements are based on management’s current expectations and involve risk and uncertainty, which may cause results to differ materially from those set forth in the statements. The forward-looking statements may include statements regarding the product development, product potential or financial performance. No forward-looking statement can be guaranteed and actual results may differ materially from those projected. Merck undertakes no obligation to publicly update any forward-looking statement, whether as a result of new information, future events, or otherwise. Forward-looking statements in this call should be evaluated together with the many uncertainties that affect Merck's business, particularly those mentioned in Merck's most recent 10-K, or on Form 10-Q, that are posted on our website. We will begin with some brief remarks from our senior management, and then open the call for questions. We expect the total call to last approximately an hour. With that, I will turn the call over and we will begin with remarks from our CEO and President, Mr. Dick Clark."
},
{
"speaker": "Richard T. Clark",
"text": "Thank you, Graeme. Good morning, everyone, and thank you for joining us. I am pleased to report that Merck's strong performance in 2006 has continued right through the third quarter. Let me take a few moments to review the highlights of the quarter, which are led by the performance of Singulair, Vytorin and Zetia, our vaccines, as well as our ongoing cost management initiatives. It was another solid quarter for Merck. Our earnings per share for the quarter were $0.51, excluding restructuring charges. This figure includes reserving an additional $598 million in the third quarter solely for future Vioxx legal defense costs. It excludes an $0.08 net charge for activities associated with the global restructuring plan we announced in November of last year, which continues to unfold as expected. The Vioxx reserves are consistent with our commitment to defend these cases in a rigorous and responsible manner. We have both the financial strength and resolve to see our litigation strategy through. Including the impact of the restructuring charges, our reported EPS for the third quarter were $0.43. We are pleased to report that Vytorin and Zetia achieved combined global sales of more than $1 billion in the third quarter. Vaccine sales also realized strong growth, with Gardasil reaching $70 million in the quarter. Due to these strong results, we are raising our full-year 2006 guidance, and now anticipate an EPS range of $2.48 to $2.52, excluding restructuring charges. We anticipate our reported 2006 EPS range to be $2.18 to $2.25. Judy Lewent will provide more details on the financial performance and guidance in a moment. Our third quarter results reflect Merck's fundamental strengths and our determination to take full advantage of the opportunities that exist inside our company. We are establishing our credibility in delivering results our stockholders have every right to expect. As we announced last year, our business model is changing in many ways. We are concentrating on nine therapeutic areas based on scientific opportunity and value to our customers. We are focusing on research efforts on the most promising candidates, and reducing the time it takes to bring drugs to market. Our commercial model is becoming leaner, more nimble, more information- and value-driven, and much more cost-effective. By investing in these areas that will drive our growth by reducing cost base in a strategic and targeted way, and by continuing to provide patients with the innovative products they want and they need for their health, we expect to continue to see Merck progress towards the goals I expressed last December, to regain the leadership position we so long enjoyed. As I mentioned, our established products remain strong. I would like to take a moment to review the results of these products with you: The combined sales of Zetia and Vytorin topped $1 billion in the third quarter, the first time the combined sales of these products have exceeded that major milestone in one quarter. I should add that the strong growth of both of these products has been consistent through 2006. Global sales of Zetia reached $1.4 billion for the first nine months of the year. Also, for the first three quarters of the year, sales of Vytorin also reached $1.4 billion. As you know, Merck launched three new vaccines during the first three quarters of this year. To date, Gardasil has been approved in more than 30 countries, including the U.S., E.U., Australia, Brazil, and two countries in Africa. In fact, as recently as this week, SPMSD has launched Gardasil in the United Kingdom. It is validation of how well this vaccine has been received as a new standard of care. It is important to note that approximately 10,000 American women are diagnosed with cervical cancer every year, and an average of 10 women die each day from this disease. Being able to prevent cervical cancer is something all of us at Merck take pride in to provide those at risk of this terrible disease. Besides Gardasil, Merck launched two other important vaccines, Rotateq and Zostavax. These vaccines represent significant medical breakthroughs in protecting infants and children from Rotavirus B and adults from shingles. These three new vaccines and ProQuad have helped drive a 64% increase in vaccine sales for the quarter, compared to the same period a year ago. Before I turn it over to Judy, let me say that we are very pleased with the recent FDA approvals over the past two weeks of Januvia, our first-in-class drug to treat type 2 diabetes, and Zolinza, the first anti-cancer treatment approved for CTCL since 1999. Merck is delighted that the FDA approved Januvia on Monday, October 16th -- the first and only DPP-4 inhibitor available in the United States for the treatment of type 2 diabetes. Januvia has been approved as mono-therapy as well as add-on therapy to either the two other types of oral diabetes medications, metformin or TZDs, to improve blood sugar control in patients with type 2 diabetes when diet and exercise are not enough. Januvia is a potent and highly selective DPP-4 inhibitor. The recommended dose of Januvia is 100 milligrams once a day. Januvia provides powerful A1C reductions as mono-therapy patients with type 2 diabetes and poor blood sugar control. Also, Januvia has a significant complementary affect when added to metformin or TZDs. Januvia has an overall incidence of side effects comparable to placebo, and in phase III clinical programs, treatment with Januvia was not associated with weight gains or an increase of hypoglycemia. Regarding the launch of Januvia, we began taking orders from customers on Tuesday, began packaging product Wednesday, and shipped product to our distribution centers on Thursday. Our customers will begin to have their orders filled today. The FDA approval clearly demonstrates our ability to deliver on our strategy of providing physicians and patients with innovative medicines that meet unmet medical needs. We are prepared to ensure that Januvia reaches its full market potential. The Januvia approval letter this week marks the first new Merck medicine or vaccine approved for the United States in 2006. That is an extraordinary record of success. As I look back over the most recent quarters, and over the first three quarters of 2006, I believe the evidence is clear that the course we have embarked on last year is proving to be the right path for Merck. To restate, this approval of Januvia this week marks the fifth new Merck medicine or vaccine approved in the United States in 2006. Now, I am pleased to ask Judy to provide you with additional details about our strong third quarter. Judy."
},
{
"speaker": "Judy C. Lewent",
"text": "Thank you, Dick, and good morning. As mentioned, we are pleased with the third quarter results. Our earnings in the quarter from ongoing operations reflects strong performance in a number of areas, particularly Singulair, vaccine, equity income, as well as the benefits of our ongoing cost management positions that are starting to have a positive effect on our bottom line. I will take the next few minutes to highlight the important underlying drivers of our performance, then I will discuss our full-year 2006 guidance and the elements we will change. To briefly summarize the quarterly performance, our in-line franchises and the recently launched vaccines exhibited strong growth. When taken together, their performance offset the financial effect of the loss of patent exclusivity for Zocor and Proscar in the U.S. We also saw strong performance of our partnerships and alliances, resulting in enhanced equity income and an upward move in interest income. These positive contributors were partially offset by an increase in the level of sales and marketing activity to support the recently approved vaccines and the imminent launch of Januvia. In the third quarter, we recorded revenues of $5.4 billion, and that is comparable to the same period last year, including in the aggregate, an overall 2% decrease from price, offset by 1% growth in volume and 1% positive impact of foreign exchange. For the quarter, strong global growth in Singulair, vaccines, and other promoted products were offset by those products losing exclusivity in the U.S., namely Zocor and Proscar. In the third quarter, the first full quarter following the loss of U.S. patent exclusivity, branded Zocor revenue in the U.S. was $152 million, representing an 80% decrease year over year. During the quarter, Merck recorded revenue associated with the Dr Reddy’s arrangement for Simvastatin of approximately $80 million, and please note that Merck records this revenue on the top-line as part of other revenue, not within branded Zocor. It remains unclear whether the whole 180-day exclusivity will be awarded to the first filer for Simvastatin. The issue of exclusivity is not yet decided and is pending the court’s decision. As you know, we have no influence over the outcome. Total sales of Merck's other promoted medicines and vaccines were $1.8 billion for the third quarter, representing growth of 15% as compared with the third quarter of 2005. A major contributing factor to the 15% growth in the other promoted medicines was the strong growth in our vaccines business, and that was up 64% compared to the base period. Part of the $555 million of revenue we recorded was driven by the uptake of Gardasil, Rotateq, Zostavax, and ProQuad, for which we collectively recorded $226 million in the quarter. To assist in your modeling, we are providing a breakdown of the new product revenues on our other financial disclosure. You will see the global sales for Rotateq in its second full quarter on the market reached $62 million. Regarding Gardasil, since FDA approval on June 8th, managed care plans representing over 90% of covered lives in the U.S. have made positive coverage decisions on the product, and U.S. sales of $70 million in the quarter. Also contributing to our top-line, our revenues from our alliances, primarily AstraZeneca LT. In the third quarter, revenue recorded by Merck from the company’s relationship with AZLT was $442 million, and that is flat compared to third quarter ’05, but keep in mind that there is inherent variability relating to this revenue, given that Merck is not actively managing these products. Our revenue recognition takes into account inventory levels at AZLT for PTI and non-PTI products, as well as their product shipments. Taking the third quarter revenue announced today and adding 50% of the revenues from the Merck/Schering-Plough, Merial, Sanofi Pasteur MSD, and Johnson & Johnson Merck joint ventures and partnerships, third quarter 2006 revenue would have been $6.3 billion. If you do the same adjustment in third quarter ’05, the growth rate from that baseline was 3%. Keep in mind the base period has a full quarter of branded Zocor sales. Year-to-date, that growth rate would be 5%. As we move into the next three lines on the income statement, recall that they include the consequences of FAS-123R, or expensing stock options, consistent with where payroll costs are incurred. For this third quarter of 2006, our total stock option expense was $42 million, and year-to-date, that expense has been $183 million. We remain on track and stock option expense is expected to be approximately $220 million in 2006. Moving down the P&L, materials and productions came in at $1.5 billion. The actual reported product gross margin in the quarter was 71.5%, but this includes restructuring costs of $200 million, primarily related to accelerated depreciation and asset impairment costs associated with Merck's global restructuring program announced in November, 2005. It also includes $5 million recorded in accordance with the adoption of FAS-123R. Excluding the restructuring costs, but including stock option expensing that will be an ongoing cost, PGM in the quarter was 75%, and just as in previous quarters, this result was affected by the final product mix. We are reaffirming our guidance for the full year of 76% to 78%, and keep in mind that we anticipate PGM rates after 2008 to return to pre-Zocor patent expiry levels. Turning to marketing and administrative, third quarter expense came in at $2.4 billion, and that is up 43% over the same period last year. Per our financial footnotes in the press release, this includes a $598 million charge related to increasing the legal defense reserve and $25 million recorded in accordance with the adoption of FAS-123R. Year-to-date, excluding the legal defense reserve charge taken in the third quarter, we showed 4% growth over the first nine months of 2005, reflecting an increase in activity to support the three recently approved vaccines and the imminent launch of Januvia, partially offset by reduced spending in support of Zocor. As you can appreciate, there are many factors affecting the marketing and administrative expenses, and during the quarter, we make decisions regarding the timing of commercial spending and reallocation of funds to initiatives scheduled throughout the year. Regarding the legal defense reserve charge, the company accrued legal defense costs expected to be incurred in connection with a lawsuit contingency when such costs are probable and reasonably estimable. As of December 31, 2005, the company had established reserves of $685 million solely for its future legal defense costs related to the Vioxx lawsuit and the Vioxx investigation. During the first nine months of 2006, the company spent $325 million in the aggregate in legal defense costs worldwide, related to Vioxx litigation. In the third quarter, the company recorded a charge of $598 million to increase the reserve solely for its future legal defense costs related to Vioxx, to $958 million at September 30, 2006. In increasing the reserve, the company considered the same factors that it considered when it previously established reserves for the Vioxx litigation, and management now believes it has a better estimate of the company’s expenses and can reasonably estimate such costs through 2008. Some of the significant factors considered in the establishment and ongoing review of the reserve for the Vioxx legal defense cost were as follows: Events such as scheduled trials that are expected to occur throughout 2007 and into 2008, and the inherent inability to predict the ultimate outcomes of such trials, limits the company’s ability to reasonably estimate its legal costs beyond the end of 2008. The company will continue to monitor its legal defense costs and review the adequacy of the associated reserves. The company has not established any reserve for any potential liability relating to the Vioxx lawsuit and the Vioxx investigation. Regarding research and development during the third quarter, expenses were $945 million. That is flat year over year, inclusive of the $11 million for stock option expense taken in the period. Merck continues its strategy of establishing strong, external alliances to complement our internal research, and for the first nine months of 2006, we have entered into 24 such transactions. Two recent examples of our commitment to strategic alliances are the Ambrilia Biopharma licensing agreement, in which Merck was granted the worldwide rights to Ambrilia’s HIV AIDS protease inhibitor program. In late September, Merck and FoxHollow Technologies announced that they will expand the scope of their existing strategic collaboration for atherosclerotic plaque analysis. At this time, we are in discussions with approximately 40 companies regarding potential transactions, and are actively monitoring the landscape for a range of targeted acquisitions that meet the company’s strategic needs. Moving on to restructuring, we continue to provide this breakout to assist in tracking the restructuring related expenses, and to ensure fair comparisons of the underlying business. This line captures all separation costs, and in accordance with GAAP accounting, it also includes asset related dismantling costs, demolition expenses, costs to relocate assets being put to alternative use, and any gains on facility sales. Remember, any accelerated depreciation associated with our global restructuring program is being reported in the respective line items, namely materials and production and R&D. So in our third quarter results, the total charges related to the global restructuring program were $50 million, and $200 million of accelerated depreciation and asset impairment costs included in the materials and production lines. The $50 million charge is for employee separation and other related costs associated with the approximately 500 positions eliminated, bringing the total to 3,900 to date in the global restructuring program, and we remain on track to eliminate 7,000 positions by the end of 2008. In reviewing equity income from affiliates, you will see $595 million in income related to the contribution from all our joint ventures -- AstraZeneca LT, Merck/Schering-Plough, Merial, Sanofi Pasteur MSD, and Johnson & Johnson Merck. Regarding the Merck/Schering-Plough partnership, the third quarter combined MSP cholesterol franchise global revenue, as reported by the Merck/Schering-Plough partnership, surpassed $1 billion. In the third quarter, revenues of Zetia and Vytorin were $502 million and $527 million respectively. Turning to other income within this line, interest income continues to come in at a higher level, as our portfolio benefits from the rising short-term rate environment. For the quarter, income before taxes was $1.2 billion. Taxes on income in the period were $290 million, and the reported tax rate was 23.6%, but this included a favorable 160 basis points associated with the restructuring charge. The underlying effective tax rate of 25.2% reflects in general the changes in foreign and domestic mix and currency fluctuations, and these elements change throughout the quarter. Moving down to net income and earnings per share, net income for the quarter was $941 million, down considerably when compared to the same period last year but recall that in this period, there was a $598 million legal defense charge. During the quarter, we spent $250 million in treasury stock, and now have $6.8 billion under the current authorization from the board, with no time limit. In summary, earnings per share for the third quarter were $0.51, excluding a net charge related to the global restructuring, and on a reported GAAP basis, EPS was $0.43. With that result, let me briefly turn to our guidance. Regarding 2006, continuing our previous practice, we provide detailed guidance for the full year and, as you will see in today’s release, we are raising our full-year 2006 range, and are raising several elements of our 2006 guidance. All the details of the guidance are provided to you in the release and, as stated, this guidance does not reflect the establishment of any reserves for any potential liability relating to the Vioxx litigations. In summary, we are raising our full-year 2006 EPS guidance to capture the fact that we had another solid quarter, and to reflect our strong, year-to-date performance. Our revised expectations are that EPS will now be in the range of $2.48 to $2.52, excluding the restructuring charges related to site closings and position eliminations, and we anticipate reported full-year 2006 EPS of $2.18 to $2.25. Now, regarding specific elements, we are increasing guidance on the following four items: As stated a moment ago, the company’s full-year 2006 EPS guidance is now anticipated to be in the range of $2.48 to $2.52, excluding restructuring charges, and reported 2006 EPS in the range of $2.18 to $2.25. I would also highlight that in 2006, the company remains on track to generate approximately $5 billion in free operating cash flow, after capital expenditures but before dividends and share repurchases. I also want to emphasize that we have the financial strength to support our dividends, and we remain fully committed to maintaining it at the current level, while at the same time, continuing to fully fund our investment priorities. In addition, as Dick noted, our strategy is on track. We remain committed to driving compound annual double-digit EPS growth, excluding restructuring cost, net tax charges, and the one-time gains associated with the AstraZeneca partnership and the establishment of any reserves for any potential liability related to the Vioxx litigation over the three- to five-year period, as well as adjusted compound annual revenue growth, including 50% of joint venture revenues of 4% to 6% through 2010 over our 2005 base. With that, I will turn the call back over to Graeme."
},
{
"speaker": "Graeme Bell",
"text": "Thank you, Judy. We will now open the call to take your questions. We will take the questions in the order they were received and try to get through as many as we possibly can. At this point, I will turn the call back over to Cynthia, who will communicate instructions for our Q&A format, then introduce the first question."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from David Risinger with Merrill Lynch."
},
{
"speaker": "David Risinger",
"text": "With respect to government rebate reversals, a number of other drug companies have recorded government rebate reversals that have benefited the top-line. I may have missed it, but if you could comment on whether Merck recorded any such benefit in its top-line this quarter, and if not, why not? Then, with respect to Zostavax, I believe that there is upcoming reviews of Zostavax that could potentially accelerate market adoption of that product. If you could comment on that, and then finally, with respect to Gardasil, could you just characterize whether the up-take of Gardasil has been surprising on the upside in young girls, i.e., those aged 11 to 12, or whether Gardasil demand upside is more so being driven by the females between the ages of 16 and 26? Thank you."
},
{
"speaker": "Judy C. Lewent",
"text": "I will take the first question. I believe you are referring to the TRICARE decision, and this is based on the September decision of the U.S. Court of Appeals to the federal circuit, where they determined that pharmaceutical companies do not owe rebates to the Department of Defense associated with TRICARE business for the period from the fourth quarter of 2004 to the third quarter of 2006. For Merck, this really generated minor third quarter 2006 discount rate favorability. That has been reflected in Merck's net sales, and there is also a minor pick-up in the net sales of Vytorin and Zetia, which were reported by Merck/Schering-Plough."
},
{
"speaker": "Richard T. Clark",
"text": "Relating to your question about Gardasil, it is too early for us to be able to answer that question. We will have more data as the year progresses. With the Zostavax, we are pleased during the third quarter, sales of Zostavax reached $10 million, and there has really been extremely positive response from managed care organizations to Zostavax, and I think that was a major part of the up-tick. In addition, on October 25th of this year, ACIP, which develops written recommendations for the administration of vaccines, will vote to determine the recommendation for the use of Zostavax in the U.S. I think that will be another critical part of it, and Zostavax is on the agenda."
},
{
"speaker": "Graeme Bell",
"text": "Thank you. Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from Chris Schott with Banc of America."
},
{
"speaker": "Chris Schott",
"text": "Thank you. Just two quick questions. First, on Gardasil, once we get through this initial launch stage, are you expecting seasonality with this vaccine, i.e. a strong summer season, as we see with Menactra vaccine, for example? Second, on Januvia, could you comment on the initial market you are targeting with this product launch? One of your competitors has highlighted they are initially targeting the heavy TZD prescribers as compared to [inaudible] users. Do you share this view? Any color there would be appreciated. Thank you."
},
{
"speaker": "Richard T. Clark",
"text": "On Gardasil, I do not see any seasonality with a vaccine that type of that indication. Certainly what we are looking at with our Januvia launch strategy, it is something that is proprietary and it is really across the whole type 2 diabetes drug therapy."
},
{
"speaker": "Graeme Bell",
"text": "Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mario Corso with Summer Street Research."
},
{
"speaker": "Mario Corso",
"text": "On Gardasil, could you comment on where the VFC process may be at this point, and what timing may look like? Then, in terms of the obesity drug, could you talk about how the mechanism or chemical structure might be different than the first generation molecule that is being developed? Thanks."
},
{
"speaker": "Richard T. Clark",
"text": "On the issue with Gardasil, as you know, we received ACIP recommendations on June 29th, with supply to girls and women ages 9 to 26, which is very, very important. We are currently in negotiations and finalizing the CDC contract as we speak. What is also important to realize with that lobby, and then WR publication is currently pending. The American College of Obstetricians and Gynecologists, the American College of Health Associates, and the Society for Adolescent Medicine has already published their support for the vaccine, so I think that has been very, very important. Obviously, finalizing the CDC contract is important, and that is under discussion as we speak."
},
{
"speaker": "Judy C. Lewent",
"text": "Regarding the obesity compound, it is way too early, as we noted, to really provide any insight into the profile of that product whatsoever."
},
{
"speaker": "Graeme Bell",
"text": "Next question, please, Cynthia."
},
{
"speaker": "Operator",
"text": "Your next question comes from Tim Anderson with Prudential."
},
{
"speaker": "Tim Anderson",
"text": "Thank you. Back on the TRICARE decision, can I just clarify that is fully washed through the P&L, whether it occurred in this quarter or whether it might occur in future quarters, it is done for you guys? Then, on the general topic of sales, it seems like a few products came in ahead of where prescription trends would suggest. I did not see anything in your press release that talks about this, so I am wondering if there was anything else that may have boosted sales this quarter that we may not be seeing. A second question, on your obesity product, seeing as you had the CV1 receptor product, did you see any depression in your Phase II trail program?"
},
{
"speaker": "Judy C. Lewent",
"text": "First of all, the financial impact of TRICARE is fully reflected in the third quarter of 2006. It is completely taken account of and there is no impact in future periods. In terms of the sales trends, globally, recognized versus the ordinary prescription trend, there continues to be substantial growth in the un-audited channels, and that is really across all of the major product lines. That needs to be factored into the performance. Again, as noted in the answer to the prior question, on CV1, on the new anti-obesity compound, we really have nothing more to say than we put in the press release at this point in time."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your next question comes from James Kelly with Goldman Sachs."
},
{
"speaker": "James Kelly",
"text": "Good morning. I have a question about the other products line. If we take a look at that line, and even if we adjust it for the vaccines, that line seems to have gone from a modest decline a year ago to good growth going to this year. I am wondering if there are any important factors about the business away from the big four products and the new launches that we should be considering here? Thank you."
},
{
"speaker": "Judy C. Lewent",
"text": "It really just reflects the continuing contributions from supplies for supply sales for basically our joint venture relationships. Also, bear in mind my earlier comment that a major contributor there was the $80 million from our arrangement with Dr Reddy."
},
{
"speaker": "Graeme Bell",
"text": "Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jamie Rubin with Morgan Stanley."
},
{
"speaker": "Jamie Rubin",
"text": "Thank you. Just a couple of Vioxx related questions. The next big Vioxx case in Atlantic City is early next year, which my understanding is it is eight consolidated cases, which -- I am not a lawyer, but I think that would put you in an impossible position. Could you discuss what your legal options are? Also, with respect to Judge Higbee to reverse your win on the Humeston case. Thirdly, on Gardasil, do not know if you spoke to this, but was there any stocking in the $70 million recorded this quarter? Thank you."
},
{
"speaker": "Judy C. Lewent",
"text": "There is no stocking, apart from normal wholesale inventory provision. There is nothing unusual in that Gardasil number whatsoever. That reflects the up-tick of the product since its launch in June, in early June."
},
{
"speaker": "Richard T. Clark",
"text": "The issue concerning Vioxx, certainly Merck is very concerned about the potential strategy of multiple cases, and our concern revolves around the fact that they involve different states, different period of ingestion, different risk factors, pre-existing conditions, et cetera, et cetera, so it makes it extremely very complex for a jury to understand all of that in a combined focus. Obviously we continue to work on convincing the judge that may not be the appropriate way to go. With regard to the whole issue around Vioxx and some of the other issues, we will appeal as appropriate."
},
{
"speaker": "Judy C. Lewent",
"text": "I am going to come back to my earlier comment. I just want to clarify. Clearly the major place where we are shipping Gardasil is the physicians’ offices, so again, that is just based on the underlying demand."
},
{
"speaker": "Operator",
"text": "Your next question comes from Stephen Scala with Cowen."
},
{
"speaker": "Stephen Scala",
"text": "Thank you. I am intrigued by your legal strategy on Fosamax. You dropped the inequitable conduct suit, and then I believe you sued the generics over a process patent. I am wondering, what is the best case outcome here? Could generic Fosamax be substantially delayed by what I believe has been a recent suit?"
},
{
"speaker": "Judy C. Lewent",
"text": "We continue to expect that Fosamax is going to lose exclusivity in early ’08."
},
{
"speaker": "Graeme Bell",
"text": "Thank you. Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from [Seamus Fernandez] with Leerink Swann."
},
{
"speaker": "Seamus Fernandez",
"text": "Thank you very much. Just a couple of questions here. I was hoping that you could discuss, should we be thinking about the payment from Dr Reddy’s as basically 100% gross profit margins? So, assuming that, it has basically contributed roughly $0.02 to earnings in the quarter? Then, second, could you just discuss, there was a news report about a manufacturing plant for cancer products in Germany. Was this for Zolinza or should we be thinking about it as something for other products? That is it. Thank you."
},
{
"speaker": "Judy C. Lewent",
"text": "Based on our agreement with Dr Reddy’s, we do not comment on any specifics of our contractual arrangement there. Those are proprietary."
},
{
"speaker": "Richard T. Clark",
"text": "Concerning the manufacturing plant in Germany, that is really not a Merck facility, or maybe it is the German Merck versus ours, but we do not have any plants or manufacturing facilities in Germany."
},
{
"speaker": "Operator",
"text": "Your next question comes from Roopesh Patel with UBS."
},
{
"speaker": "Roopesh Patel",
"text": "Thank you. I have a couple of questions. First, on gross margins, given that Merck has already recorded a significant erosion of Zocor and Proscar sales this quarter, would it be reasonable to assume that the gross margins recorded this quarter, notwithstanding the restructuring costs, should roughly be the forward run-rate? If not, what are the broad pushes and pulls that we should take into account? Separately, I was just wondering if you could also broadly comment on the sales force support behind Januvia’s launch. Have you increased the size of Merck's overall sales force? If not, is effort being diverted from any particular product? Thank you."
},
{
"speaker": "Richard T. Clark",
"text": "Concerning the sales force, we really think about our launch for Januvia and other products as a very important part of proprietary information and certainly do not provide details on that. What I can reassure you is that we are providing the proper capabilities for promotion, as well as re-educating the physicians. We did announce earlier that, as a part of our plans of looking at a new operating model for marketing and sales, that we were going to take 1500 sales representatives and reallocate them to vaccines and other activities."
},
{
"speaker": "Judy C. Lewent",
"text": "Regarding thinking about progression on product gross margins, I think you need to take a few things into consideration. Obviously in the second-half of 2006, you are seeing, as you noted, the impact of Zocor on the product mix. But as you also may recall, in our longer-term guidance, we had talked about our product gross margins returning to pre-Zocor patent expiry levels after 2008. That is a function of a lot of a lot of new product launches that we are talking about, and the major cost improvement initiatives that our supply strategy already has underway. I think you need to factor all of that in at this point in time."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your next question comes from Craig Baskin with Loomis, Sayles."
},
{
"speaker": "Craig Baskin",
"text": "Thanks for taking my question. I was wondering on Gardasil, since the rate at which you are able to ship the product out to physicians is probably significantly greater than the rate at which the insurance companies might choose to reimburse the physician, I was wondering what sort of terms you were giving."
},
{
"speaker": "Richard T. Clark",
"text": "We are not going to discuss terms with physicians. I can tell you this though -- as of today, managed care plans representing over 90% of the covered lives of girls and women from the age of 9 to 26 in the U.S., have added Gardasil to their respected formularies. I think that is a critical part, that we are up to 90%, which certainly was accelerated and it exceeded our expectation of where we would be on October 20th."
},
{
"speaker": "Operator",
"text": "Your next question comes from Chris Shibutani with J.P. Morgan."
},
{
"speaker": "Chris Shibutani",
"text": "Thanks very much. Two questions, if I may. On MK-524A, timelines are still apparently on track. Can you comment about when we can expect to see a little bit more data in regard to the profile? Can you also address where you are in terms of the formulation issues for the 524B? Secondly, a question on collaborations, 24 year-to-date. Obviously the rhythm and pace of these can vary. I believe the numbers have been higher in the past, 40 to 50 per year, which is a considerable step-up. Does this change in number reflect in any way your appetite or capacity to manage these, the quality of the deals you are seeing, or maybe the competitiveness or valuation that is out there, since everyone is obviously looking for in-licensing, et cetera? Thank you."
},
{
"speaker": "Judy C. Lewent",
"text": "Relative to 524A, I will remind you that there will be papers presented at the American Heart Association, the week of November 13th. I think some of those have already been posted, so that is where those data are going to be discussed. In terms of the formulation, as you note, we have not stipulated a timetable on the product of 524B at this point in time."
},
{
"speaker": "Richard T. Clark",
"text": "In relationship to the licensing deals that we have focused on, and 24 compared to the previous number, there really is no change in strategy. We are still very aggressive. We are still looking at the opportunity, and we will take advantage of each and every opportunity, so we are looking at quality and certainly not quantity."
},
{
"speaker": "Operator",
"text": "Your next question comes from [Bob Yates] with Principle Capital."
},
{
"speaker": "Bob Yates",
"text": "Thanks for taking my question. Just to follow on the questions on Vioxx, number one, it seems like there are more cases that came in this quarter. Could you comment if there was a statute of limitations which expired in certain states during the quarter? Secondly, Judy, you sort of bumped your reserve here to $950 million. Does that mean you expect you are going to spend most of those funds over 2007 and 2008?"
},
{
"speaker": "Judy C. Lewent",
"text": "Let me just address the process for the reserve. As you noted earlier, we continue to look at our ability to estimate, and part of that is a function of the progress in the litigation and our knowledge and visibility over a certain timetable. At this point, all of that reflects is our best estimate. We can establish and make a reasonable estimation only through the end of 2008, so it is really just part of our, you know, the horizon that we have in our ability to forecast with the right rigor that we need to update the reserve, but it really does not stipulate anything else about the timetable. It really was a progression of where this is going to go."
},
{
"speaker": "Graeme Bell",
"text": "Cynthia, given the time, we will take one more question."
},
{
"speaker": "Operator",
"text": "Your final question comes from Tim Anderson with Prudential."
},
{
"speaker": "Tim Anderson",
"text": "Thank you. I just had a follow-up question, actually, two. Judy, you mentioned higher sales in un-audited channels. Why, I guess is the question? Is that a change in the strategy in terms of how you are contracting in those channels, or what exactly? Dick, at one point last year, you said Merck may actually get into the medical device business. This morning, you reference the FoxHollow collaboration. My question to you is whether medical devices, or anything else outside the traditional pharmaceutical space, are areas in which you would potentially consider building up presence in?"
},
{
"speaker": "Judy C. Lewent",
"text": "Just to the first question, there is no change in strategy there. It is really just un-audited picked up and the fact that we continue to work to contract our product in the unordered channels. There is nothing there. It just helps explain why from time to time you may see a slightly different trend in sales reported as opposed to the reported script track."
},
{
"speaker": "Richard T. Clark",
"text": "I was just thinking about medical devices as a part of our strategy. We are certainly interested in the capabilities and technologies around medical devices diagnostics biomarkers when it helps us from a research standpoint, but not as a standalone business. To go back to a previous question concerning Vioxx, one of the reasons you saw such an increase in the third quarter of suits is September 30th was the two-year date since we voluntarily recalled Vioxx, and that is significant from the standpoint that approximately two-thirds of the states have a two-year limitation. Obviously that is where the limitation took place, on September 30th. There are obviously complexities around whether that can continue or not, but that is probably the major driver."
},
{
"speaker": "Graeme Bell",
"text": "With that last question, it concludes this call. The information from today’s call, both the transcript and the replay, will be available on our website, and Mike and I will be available all day to take your calls. I would like to now turn the call back to Dick Clark for some concluding remarks."
},
{
"speaker": "Richard T. Clark",
"text": "Thank you, Graeme, and thank you for tuning in and listening to our call today. Judy and I are very pleased to continue to speak directly with you every quarter, and as we stated, we are very pleased with the third quarter results. It exceeded consensus expectation, and we are certainly looking forward to updating you further on our progress at our annual business briefing that we will hold in White House Station on December 12th. We will be in touch to give you details on our meeting very soon. Thank you again. We appreciate your interest and participation. Operator, thank you very much, and that is the end of our call. Thank you."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today’s Merck third quarter 2006 earnings conference call. You may now disconnect."
}
] | null | null |
META | 4 | 2,018 | 2019-01-30 17:00:00 | Operator: Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook Fourth Quarter and Full Year 2018 Results Earnings Conference Call. [Operator Instructions]. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin.
Deborah Crawford: Thank you. Good afternoon, and welcome to Facebook's Fourth Quarter 2018 Earnings Conference Call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our quarterly report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I'd like to turn the call over to Mark.
Mark Zuckerberg: Thanks, Deborah, and thank you, all, for joining us today. Our community continues to grow, and our business delivered good results this quarter. There are now 2.7 billion people using Facebook, Instagram, WhatsApp or Messenger each month and more than 2 billion people who use at least one of our services every day. On our last call, I talked about our overall strategy as we faced some important opportunities and challenges. And today, I want to give you an update and talk about our priorities for 2019. For the past couple of years, most of our focus and energy has gone into addressing some of the biggest social issues around the future of the Internet, including election integrity, content governance, safety and security, data privacy and digital well-being. And these are all complex issues but we've made real progress. In many of these areas, we believe we built the most advanced systems in the world and, in many cases, more advanced than any other company or government. And in other areas, we have clear road maps now for our work ahead. Still, there's a lot more to do, and I expect it will take strong execution through 2019 and beyond before we get all our systems to the level that we need. But we've fundamentally changed how we run this company. We've changed how we build services to focus more on preventing harm. We've invested billions of dollars in security, which has affected our profitability. We've taken steps that reduced engagement in WhatsApp to stop misinformation and reduced viral videos in Facebook by more than 50 million hours a day to improve well-being. We've made significant progress and we're going to continue this work, but we're also going to allocate more of our energy to building new and inspiring ways to help people connect and build community. Going into 2019, we're focused on four priorities: first, continue making progress on the major social issues facing the Internet and our company; second, build new experiences that meaningfully improve people's lives today and set the stage for even bigger improvements in the future; third, keep building our business by supporting the millions of businesses, mostly small businesses, that rely on our services to grow and create jobs; then fourth, communicate more transparently about what we're doing and the role our services play in the world. And I want to take a minute talk about each of these. So first, continue making progress on the major social issues. The most important work here is to keep executing our road map to build systems that can proactively identify harmful content so we can act on it sooner. We just finished a year of very heavy investment to get these systems to a better place, and we've seen the results of that in recent elections, including the U.S. midterms and in our transparency reports, where we report what percent of violating content we identified proactively. We ended 2018 with more than 30,000 people working on safety and security, up from 10,000 people a couple of years ago. And this work will never be finished, but I now believe we've built some of the most advanced systems in the world for dealing with these issues. Now however, this raises a broader set of values questions about how to use these systems. One question is about who decides what speech is acceptable and what isn't. Right now, we have a deliberative process of consulting with experts around the world. But I've increasingly come to believe that we shouldn't be making so many of these decisions about content ourselves. In November, I wrote a note about a blueprint for a system of content governance and enforcement, which includes giving people the ability to appeal our internal content decisions to an independent body, and we're currently working with experts to design the system and we plan to start piloting it this half. Another important issue is the future of privacy and encryption. People really value the privacy that encrypted messaging brings and we've built the most secure global messaging service in the world. As people increasingly share more privately, we're working on making more of our products end-to-end encrypted by default and making more of our products ephemeral so your information doesn't stick around forever. And I'll discuss this more over the coming quarters. Our second priority for 2019 is that as we make progress on these social issues, we also need to deliver new experiences that meaningfully improve people's lives. Now, I'm not talking about the many day-to-day iterative improvements we make so that ranking gets a bit better or that things get a little faster, but I'm talking about major improvements to people's lives that whole communities recognize and say, "Wow, we're all doing something new on Facebook or on WhatsApp that we weren't doing before." The last experience like this was Stories, which continues to grow very quickly. For example, Instagram just passed 500 million daily actives on Stories. But the reality is, we've put most of our energy into security over the past 18 months, so that building new experiences wasn't the priority over that period. So this year, I think we're going to deliver several of these new experiences. Messaging is an area that's growing the most quickly. And this year, people are going to feel these apps becoming the center of their social experience in more ways. We're going to roll out Payments on WhatsApp in some more countries. Private sharing in Groups and Stories will become more central to the experience. We're going to onboard millions of more businesses that people can interact with. In Facebook, the way people experience groups and communities will continue to deepen. We're going to get to a point soon where people feel like Facebook is about as communities as it - is about communities as much as it's about your friends and family where almost everyone is in a group that's meaningful to them and that community is a central part of their experience. On Facebook, I also expect this to be the year where Watch becomes more mainstream. There are now 400 million people who use it every month, and people, on average, spend over 20 minutes on Watch daily. This means we're finding ways for video to grow outside of News Feed so it doesn't displace the social interactions that people primarily come to our services for. In Instagram, one of the areas I'm most excited about this year is commerce and shopping. There's a lot of natural activity happening here. And this year, I expect us to deliver some qualitatively new experiences around that. Longer term, I remain very focused on building technology that brings people together in new ways, including through AR and VR. I'm looking forward to Oculus Quest shipping this spring. The feedback there so far has been very positive. And I've also been positively surprised that Portal has done better than I expected it to. I love using it with my own family. But we never shipped Facebook-branded hardware before and a lot of people said this would be a difficult time to start. So I'm pleased that so many people are enjoying this experience of being able to feel closer to the people they care about even when they're physically far apart. Our third priority is to continue strong execution on our business. In the past couple of years, a lot of our business challenges have been self-imposed. The reality is that we've had a number of substantive issues that we needed to address, and the investments we made in safety, security, privacy and well-being both increased our costs and, in some cases, reduced our revenues. But as I said at the time, I believe that these investments are the right thing to do and will make our community and our business stronger over the long term. And what we've seen is that the fundamentals of the business remain strong. More than 90 million small businesses now use our products, the vast majority of them for free. And of those we surveyed, half tell us that they've been able to grow their businesses and hire more people since joining Facebook. This means they're using our services to create millions of jobs, and this is one of the most important contributions that we feel we can make to the world. And to put this in perspective, the U.S. economy added about 2.6 million jobs last year. Our last priority is to get out there more and make the case for the role our services play in the world. Right now, there's a lot of negativity about the impact of technology, and some of it's fair and some of it's misplaced. And we, in the tech industry overall, should be scrutinized heavily because we play a role in many people's lives. My approach here is to listen to the critique first, to work on addressing our issues, figure out what we believe are the most important principles to uphold and then go engage in the debate. And I feel like we've come out of 2018 not only making real progress on important issues but having a clear sense of what we believe are the right ways to move forward. Now, we're still going to make mistakes along the way, but we now have a clearer sense of the path ahead and we're ready to work with people to understand our role and move towards good outcomes, whether that's regulation on content or data, cooperation on shared threats, working openly to make sure AI best serves people, or just standing up for the kind of open and connected world that we all want to see. The Internet is a massive force for change and we're at the center of a lot of the debate that brings, but our core value to people and society remains the same. We offer a service free to everyone to help you stay connected with the people you care about, express what you're thinking and feeling, get help when you need it most, support the causes and ideas you believe in, start and grow businesses no matter where you are, and that makes a lot of good possible and we're committed to building technology that people can use to create positive change. As always, thank you for being on this journey with us. And now, here is Sheryl to talk about our business.
Sheryl Sandberg: Thanks, Mark, and hi, everyone. We had a strong fourth quarter and a good end to the year. Q4 mobile ad revenue was $15.5 billion, increasing 36% year-over-year and contributing approximately 93% of our total ad revenue. Full year mobile ad revenue grew 45% compared to 2017. 2018 was a challenging and important year for us. As Mark said, we made significant investments in safety and security and strengthened our defenses against election interference. We gave people tools to better control their information and set a new standard for transparency and ads. We have focused on making progress in these important areas while continuing to grow our community and our business. This quarter proved that we can do both. We know we still have a lot of hard work ahead of us. We need to continue to do better at anticipating the risks that come from connecting so many people, and we need to earn back people's trust not with words alone but with actions. Part of building trust is helping people better understand our business model. Protecting people's privacy and showing them relevant ads are not at odds. We don't sell your data and we don't tell advertisers who you are. What we do is allow advertisers to reach people interested in their products. The result is that people see more relevant ads and small businesses can reach people in ways that only big companies previously could. This business model keeps Facebook free so people all around the world can use it and levels the playing field for businesses of all sizes while protecting people's privacy. I'm excited to announce today that we have more than 7 million active advertisers across our services. From local shops to global brands, companies all over the world are growing and hiring because they can reach their customers on our platform. The opportunities we create for businesses drive our growth, which continues to be broad-based across regions, marketer segments and verticals. During the holidays, companies used our ads to help people discover deals and find gifts. We saw particular strength among advertisers that optimized for measurable objectives, like conversions or sales. For example, Bryan Anthonys an online jewelry store based in Austin, Texas, used our campaign budget optimization to bring in new customers and sales on Black Friday. The campaign was so successful that they tripled their holiday purchases and hired additional people to help pack and ship orders for the busy season. We're also helping advertisers keep up with shifts in how people use technology. People are creating more Stories and sending more messages, which means these are emerging areas of opportunity for marketers. Today, we're also announcing that 2 million advertisers are using Stories to reach customers across our family of apps. We're making it easier for advertisers to adopt their campaigns for Stories. In Q4, we expanded automatic placements, which converts feed ads into a format that works for Stories and delivers ads wherever they'll get the best results. Framebridge, a start-up that provides custom picture framing, recently used automatic placements to run ads across Instagram Stories, Facebook and Instagram feed. They ran short videos to show that their frames make great holiday gifts, and Instagram Stories generated over 25% of their new customer sales. As people increasingly use messaging apps, we're helping small businesses make that shift, too. In Q4, we launched ads in Messenger Stories, which means advertisers can now easily buy Stories ads across Facebook, Instagram and Messenger. Beyond Stories and messaging, we have an opportunity to connect people and businesses on new services like Marketplace. We're seeing good early results at Marketplace ads. In Q4, we worked on making ads more relevant to the products that people are looking for. For example, if someone is browsing furniture in Marketplace, we'll try to show them an ad for furniture or a related item. We plan to keep working on this to provide a better experience for people and more value to advertisers over time. As we build new ad products, we remain focused on improving the overall quality of our ads. Across all of our platforms and formats, we're investing in AI to make ads more relevant and effective. In Q4, we developed new AI ranking models to help people see ads they're more likely to be interested in. We're also using AI to identify and more quickly review ads that might violate our policies, which was particularly important during the U.S. midterm elections. Looking ahead, we see more opportunities to use AI to keep people safe on Facebook and help businesses grow. I want to close by saying thank you to the businesses around the world who are using our tools to create jobs and growth. Last month, I went to Facebook's Community Boost in my hometown of Miami, which was the 50th stop on our tour across the U.S. in 2018, offering digital skills training to small businesses and job seekers. I met entrepreneurs like Alex Kassab. He started Morelia Gourmet Paletas with friends just two years ago. He says that 60% of his new customers learned about their ice cream from Facebook and Instagram. And because of this growth, they've expanded to 12 locations and hired more than 35 people. Last week, I was in Europe and met with SMEs from across the continent who shared similar stories of growing their companies, hiring people and investing in their communities. These stories motivate us to keep improving so more people can succeed on our platform. I also want to thank our global team for their commitment to tackling our issues and making our products better every single day. As we come out of a challenging year and continue to face challenges ahead, I believe we're in a position to build on the progress we've made and better serve our community in 2019. I am grateful to all of you for your continued hard work and dedication. Now, here's Dave.
David Wehner: Thanks, Sheryl, and good afternoon, everyone. Q4 was a strong quarter wrapping up a good year for our business. Full year 2018 revenue grew 37% to $56 billion, and we generated over $15 billion of free cash flow. Let's begin with our community metrics. Daily active users on Facebook reached 1.52 billion, up 9% compared to 2017, led by growth in India, Indonesia and the Philippines. This number represents approximately 66% of the 2.32 billion monthly active users in Q4. MAUs grew 191 million or 9% compared to last year. Turning to our overall family metrics. Around 2.7 billion people worldwide used one of our applications in December, and on average, over 2 billion people were active daily. This is our best estimate of our de-duplicated audience across Facebook, Instagram, Messenger and WhatsApp. We believe these numbers better reflect the size of our community and the fact that many people are using more than one of our services. For the time being, we will continue to disclose both set of numbers. But over time, we expect family metrics will play the primary role in how we talk about our company and we will eventually phase out Facebook-only community metrics. Turning now to the financials. All comparisons are on a year-over-year basis unless otherwise noted. Q4 total revenue was $16.9 billion, up 30% or 33% on a constant currency basis. Had foreign exchange rates remained constant with Q4 '17, total revenue would have been approximately $348 million higher. Q4 total ad revenue was $16.6 billion, up 30% or 33% on a constant currency basis. In terms of regional ad revenue growth, Asia Pacific was strongest at 34%, followed by North America at 31% and Europe at 28%. Rest of World ad revenue grew 24% and was impacted by ongoing currency weakness and macroeconomic challenges. In Q4, the average price per ad decreased 2% and the number of ad impressions served on our services increased 34%. Impression growth was primarily driven by ads on Instagram, including both feed and Stories as well as Facebook mobile News Feed. The year-over-year decline in average price per ad reflects an ongoing mix shift towards product services and geographies that monetize at lower rates. Payments and other fees revenue was $274 million, up 42%. Sales of Oculus Go and the launch of Portal contributed to the revenue growth in the quarter. Turning now to expenses. Total expenses were $9.1 billion, up over $1 billion sequentially and up 62% compared to last year. In addition to continued investment in infrastructure, safety and security and innovation, expenses were also driven by seasonal factors, including marketing efforts, notably the promotion of Portal and Oculus Go. We ended the year with over 35,500 full-time employees, a 42% increase. Operating income was $7.8 billion, representing a 46% operating margin. Our Q4 tax rate was 14%. Net income was $6.9 billion or $2.38 per share. Full year capital expenditures for 2018 were $13.9 billion, driven by investments in data centers, servers, network infrastructure and office buildings. We generated $3.3 billion in free cash flow in Q4 and ended the year with approximately $41 billion in cash and investments. In Q4, we bought back approximately $3.5 billion of our Class A common stock and completed our prior repurchase authorization. In December, our Board of Directors authorized the repurchase of an additional $9 billion of stock. Turning now to the revenue outlook. In Q1, we expect our total revenue growth rate to decelerate by a mid-single-digit percentage on a constant currency basis compared to the Q4 rate. We also expect that our revenue growth rates will continue to decelerate sequentially throughout 2019 on a constant currency basis. Turning now to the expense outlook. On a full year basis, we continue to expect 2019 total expenses will grow approximately 40% to 50% compared to 2018. Our 2019 capital expenditure outlook is unchanged at $18 billion to $20 billion, driven primarily by our continued large investment in building data centers. Lastly, we expect that our 2019 tax rate will be a few percentage points higher than our 2018 rate. In conclusion, we are confident in our ability to continue to invest effectively in the key priorities that Mark outlined in his opening remarks: making progress on the major social issues facing the Internet, building new experiences that meaningfully improve people's lives, and growing our business by supporting the many businesses that rely on our services. With that, operator, let's open up the call for questions.
Operator: [Operator Instructions]. Your first question comes from the line of Brian Nowak from Morgan Stanley.
Brian Nowak: I have two, the first one for Dave. Last quarter, you talked about an expected sequential deceleration in 4Q rather, and I think it came in a little better than expected. Could you just talk to sort of which forms of media, whether it's News Feed or Stories or Instagram, kind of came in better than you thought it originally would a few months ago and what drove the upside? And then, Mark, you talked about the Instagram commerce opportunity. Maybe just talk us through sort of 1 or 2 of the key - what you think are the most important steps you have to cross throughout 2019 to really execute on this opportunity.
David Wehner: Sure. Thanks, Brian. I'll take the first part of your question. Yes, Q4 was very strong on revenues, so we're pleased with that. On the demand front, we continued to benefit from advertisers targeting on business results. So direct response was especially strong during the holiday season. And then on the supply front, we benefited from strong Instagram growth, which was aided by both growth in impressions on Instagram feed and on Stories. But I'd reiterate that we expect that we will see a deceleration of revenue growth in Q1.
Mark Zuckerberg: I'd like to talk about - a bit about commerce. When I think about it, just from the consumer side, increasing commerce on Instagram, Facebook and WhatsApp, I think, is one of the most exciting product opportunities that we have in all of these products and a big business opportunity as well. The big things that I think we want to make sure that we nail, in Instagram especially, are discovery. People are already doing a lot of commerce activity and are really interested in following brands, and I think making sure that, that works is - and does well is a big deal. But I think there's also a very big opportunity in basically enabling the transactions and making it so that the buying experience is good and that when you buy from someone - from a seller that you know that you can trust them, that you're going to have a good experience and in facilitating and making that go well. The work that we're going to do in Instagram also will go across the efforts in Marketplace and Facebook, the work - the rest of work that we're doing in Facebook and all the work that we're going to be doing in WhatsApp as well. So this is a big area that I'm personally very excited about and focused on.
Operator: Your next question comes from the line of Anthony DiClemente from Evercore.
Anthony DiClemente: Maybe, first, for Sheryl on Stories. Stories continues to grow very quickly. As you said, the number of advertising - advertisers using Stories are growing quickly. Can you give us a little bit more on the performance of the ads? Are you seeing improvements in conversion rates for those ads? Are the ads performance on Stories narrowing the gap with feed ads in terms of pricing or performance? And anything broadly on demand for those ad formats. And then one for Mark. I wonder if you could speak to the possibility of stitching together the messaging apps, WhatsApp, Instagram, Messenger. It would be great to hear what the rationale or potential commercial benefits might be to - or for potential integration of those properties.
Sheryl Sandberg: I'll take the Stories question. One of the challenges that marketers have is keeping up where consumers are. If you think about our history, people made the shift to mobile before marketers did, and I think one of the successes we've had is we made it easier for advertisers to move into a mobile environment. And just as we did that in mobile, now we're very focused on doing that in the new things that people are doing, and Stories is a big part of that, Messaging will be further out, but as important as well. So I think the fact that we've already gotten 2 million advertisers to move into Stories is because we've gotten better at making it easier. We launched our automatic placements and expanded it, which converts feed ads into a format that works for Stories and delivers the ads wherever they'll get the best results. So our goal is to make it as easy as possible for marketers to get to the format of Stories and then deliver the ads where they're going to get the best experience and the best ROI. Now right now, one of the interesting things about Stories is there's a benefit to being an early adopter. So the pricing is really attractive. And so we think the mix shift to Stories is a big opportunity for us and it's going to take time to continue to get advertisers in, but we're very happy with demand to date.
David Wehner: I would just - before we turn to Mark, I'd just layer in on the Stories front. When we look into 2019, we do expect to see a deceleration of revenue growth throughout the year. And while we have opportunities to grow impressions on Facebook and Instagram, that's less so in feed, where we already have healthy ad loads in - on both surfaces and more in Stories where we have lower CPMs. So - whereas in 2018, we benefited from strong impressions growth on Instagram in both feed and Stories. We'll be more reliant on Stories impression growth in 2019. And from a pricing perspective, there's - we've got to improve our ability to grow the number of advertisers using Stories and improve price there, but it's going to be more reliant on that in terms of revenue growth.
Mark Zuckerberg: All right. I can talk about messaging and the integration that we're thinking about, but first, we're really early in thinking through this. So there's a lot more that we need to figure out before we finalize the plans. And then, of course, this is going to be a long-term project that I think will probably be to whatever extent we end up doing it in - a 2020 thing or beyond. There are a few big reasons why I'm excited about this and think it'll be good for the user experience, which is the reason that we're doing it. I mean, part of the question was about a commercial benefit, but that really isn't the big focus here. The first reason that I'm excited about this is moving more to end-to-end encryption by default in more of our products. People really like this in WhatsApp. I think it's the direction that we should be going in with more things in the future. And I think if there's an opportunity to use the work that we've done with WhatsApp there, rather than doing it in different ways in the different messaging experiences, to have that really just - to have encryption work in a consistent way across the different things that we're doing. There are also a number of cases that we see where people tell us that they want to be able to message across the different services. So one example is a lot of people, hundreds of millions of people, are using Marketplace on Facebook now, and a lot of people are using that in countries where WhatsApp is the primary messaging app that they use. So we have these experiences today where we're building Marketplace and you go to message someone to buy something. And the link to basically do the messaging is over Messenger, but in that country, where people really want to be using it, is WhatsApp and we need to make it so that people can communicate across the different networks and graphs that they have or be able to do that integration better in order to facilitate more transactions and connections there. Another example is there are tens of millions of people, maybe more, but I'll go with that, who, on Android, use Messenger as not only their app for Facebook messaging but also for SMS, as their SMS client. And going back to the encryption point from before, we think that there's an opportunity to, when you're going to go message someone over a phone number network, have that primarily go over WhatsApp and be end-to-end encrypted rather than go over SMS where it's unencrypted and less secure. So I can give you a few more examples like that, but I guess the way that I'm thinking about this is that there's a handful of cases that people are telling us that they want to be able to integrate and communicate more easily across the networks. I think moving more towards end-to-end encryption and improving security there is the right direction to go in. There's a lot of questions there that we need to work through. So we're working through this in a deliberative way. And I wouldn't expect anything here to launch soon, but this is definitely something that we're thinking about and that I think will improve the user experience.
Operator: Your next question comes from the line of Eric Sheridan from UBS.
Eric Sheridan: Two, if I could. One, Mark, on Facebook Watch, what do you think are some of the things you're still trying to solve for on either the content side or the consumer engagement side to drive broader adoption of Watch and turning it into sort of the mechanism for customers that you're trying to solve for over the medium to long term? I'd love to understand how you see the opportunity and the challenge that's just in front of the company. And second, there was a fair bit of noise in the advertising community about the macro environment at the end of 2018 and maybe at the beginning of 2019 with things like Brexit and the government shutdown in the U.S. Are you seeing anything on the macro front in your own business either exiting 2018 or should start in this year?
David Wehner: Yes, I can...
Mark Zuckerberg: Take that first one and then I'll...
David Wehner: Yes, I can start on the macro environment, Eric. Obviously, we delivered strong results in Q4. As we look out into 2019 further, that's - the macro economy is certainly a potential headwind and risk to the business just given the sensitivity of the advertising business to a slowdown in growth. Obviously, we believe we've got the best advertising products out there in terms of being able to deliver measurable business results to clients. And so we think that does help us in that environment, but clearly, macroeconomics stands out there as a risk on top of other issues that we face, leading to a deceleration of revenue growth in 2019.
Mark Zuckerberg: I'll talk about Watch and video. So there, we've really had this dynamic over the last 12 to 18 months where we've limited the amount of video that we've shown in order to make sure - in News Feed, to make sure that it doesn't displace interactions, social interactions that people are having. And the big thing that unlocked a lot of growth in Watch is we basically were able to move a bunch of the video-watching behavior to a different tab, where people intentionally go to the tab because they want to watch a video and browse and see what's going on. And that has allowed us to really increase the amount of video that people are watching without getting in the way of the core mission of what we do, which is helping people interact. The two big things that we're really focused on now in Watch are, within the Watch tab, also just making sure that the consumption isn't all just passive consumption and making it so that there are more two-way interactions between viewers and the creators and that we can help build community around that, where we've built this great feature, Watch Party, that allows people to come together with their friends to watch different content and premiers. It's a new feature that allows people to basically take a video and stream it live for the first time when it comes out. So these are all things that make it so the video-watching experience isn't just about passive consumption but about interaction, and that's going to, I think, help really drive engagement as well. Then there's also the monetization side for creators, which is going to be really important for making it so that we have the content that people want to consume. And that's just a big thing that we're continuing to focus on. We think that the more money that creators can make through Watch, there will be a virtuous cycle there. And that's going to be really important for continuing to grow this as well. But right now, it looks like this is going in a good direction. It's still very early. We're still growing quickly but from a small base, but it's one of the things that I'm excited about for this year.
Operator: Our next question comes from the line of Doug Anmuth from JPMorgan.
Douglas Anmuth: One for Mark and one for Dave. Mark, it's been more than a year since you shifted to feeds for more friends and family and removed the passive videos, as you just talked about, and reported engagement numbers, obviously good. Are there any signs that the changes you made a year ago are now having a more positive impact on engagement in the core Facebook feed? And then, Dave, you talked 3 months ago about better aligning revenue and expenses in 2020. I was just curious if that's still your view at this point. What gives you the confidence you can do that? And what changes most from a spending perspective as you look toward 2020?
David Wehner: Yes, I can start on the expense front. We continue to have an outlook for expense growth in 2019 of 40% to 50% total expense growth. We did see headcount growth come down modestly in Q4 from Q3 to 42%. As we look out, we do expect that beyond 2018 - sorry, beyond 2019, we'll have expense growth more in line with revenue growth. But we do plan to continue to invest aggressively in the priority areas, including on the innovation side with AR/VR and AI and continuing to invest in the safety and security programs that we're undergoing. And then CapEx, we'll see continue to flow in through the P&L over time. And you already saw that pick up with the cost of revenue growth in Q4. And so we'll expect to see more of that flow through over time. So I would say, we do plan to continue to invest aggressively in the business going forward, and we are going to see, obviously, a margin impact from that in 2019.
Mark Zuckerberg: And I can talk a bit about meaningful social interactions, although I don't have any specific metrics to share on this. I mean, my own take of this, I think this has gone pretty well and has done what we had hoped, although we've made a number of changes. This is a long-term direction that we're going to continue making more ranking changes and building more products around, but I think that this is kind of reflected broadly in the numbers that you see on engagement and the growth in daily actives and how people are engaging across the family of apps. At the time, what I basically said was, that even though this might decrease time spent and we expected that it would, is we took out especially a bunch of watching of viral videos. We thought that helping people interact more was the unique thing that people come to our services for and that it would be good for the community and the business over the long term. And certainly, everything that we've seen since then suggests that, that is right.
Operator: Your next question comes from the line of Justin Post from Bank of America Merrill Lynch.
Justin Post: Great. A couple of questions. First, pretty rough press cycle in Q4. Did you see any impact in the U.S. and Europe on engagement or usage or people closing their accounts? It certainly doesn't seem evident in MAU numbers. But just anecdotally, did you see any impact or - on that? And then maybe to Sheryl, if we look at trailing 12 month monetization in the U.S. ARPU, it's about $110. And just how do you think about that long term? If you improve targeting, is there room to grow that significantly? Obviously, Instagram's a growth platform that's contributing to that there. But just how do you think about where ARPU is and where it could be very long term?
David Wehner: Justin, I can probably take both of those. In terms of our ability to continue to grow the advertising business, it's about working to develop the best products we can to enable advertisers to achieve their end business results. Targeting is obviously very important in that. One of the things I would point out is that from a pricing perspective, there are headwinds that we might face on targeting, given the overall privacy landscape in 2019. And so I think that is another factor that presents risk in our ability to continue to grow ARPU. So I would point that out as being an issue. As well, we're seeing a mix shift towards Stories. And that is going to be something that will contribute to a deceleration of our revenue growth. So that's another factor that's leading to deceleration of revenue growth in 2019. In terms of your first question, Justin, about the impact of the press cycle, I would just - I'd probably just let the numbers stand for themselves. We saw that we are growing in all regions albeit we're sort of bouncing around in the developed markets like the U.S. and Canada. In Q4, we saw better growth in Europe because we've come off of the GDPR - the first two quarters of GDPR. So we saw a little bit of a rebound there.
Sheryl Sandberg: I'll talk a little bit about long-term growth opportunities. David is, of course, right that the mix shift and pricing continues to be an issue. But I think over the very long term, which is how you framed your question, we have a lot of opportunity. If you look at what percentage of our ads are truly relevant to the people who are seeing them, I think we've done a lot better over the last couple of years, but we have a long way to go. And that means that for every ad we show, that ad can be better, better for people, show something they're more interested in. I also think the shift we're seeing towards people doing more measurable results, and this is important to understand. It's not just what people think of as direct response advertisers. It's some of the largest brands in the world really going for the results that they're looking for. That bodes very well for our business because we think we can do that very efficiently. And then when we have new opportunities that open up like Stories, even with some pressure on pricing, we think that gives us more inventory and more opportunity and more formats, and we haven't really even gotten started on future things like messaging. So over the very long run, I think we remain very optimistic about the growth opportunities we have.
Operator: Your next question comes from the line of Mark Mahaney from RBC Capital Markets.
Zachary Schwartzman: It's Zachary Schwartzman on for Mark. Mark, I have a question on data privacy as it relates to your 2019 goal of progressing major social issues. This is a topic that is important for the Internet ecosystem as a whole and not just Facebook, and it appears that regulators are struggling to come up with comprehensive reform that it's appropriate for all stakeholders involved. Facebook has invested a lot to improve data privacy, transparency and trust in the platform over the last year, but I wanted to hear your thoughts on the following. In your Facebook post at the end of 2018, you asked the question of whether we should decentralize authority through encryption or other means to put more power into the people's hands and that you plan to discuss these topics in the public domains. As the accumulation of data and micro targeting increases, so can the value of individual's data. Do you see a future where individuals are compensated for renting their data to Facebook and other tech companies? Will that be in the form of crypto through decentralized blockchains or other methods like a traffic acquisition cost? I know we're in early days and due to scalability and consumer adoption roadblocks, this isn't possible yet, but do you believe these technologies are real existential risk or perhaps even a solution to the current data privacy trust and control issues on the Internet?
Mark Zuckerberg: I mean, this is a really important question, one that we are spending a lot of time on, broadly thinking about. I do generally - I mean, I believe very strongly in trying to decentralize and put power in individual's hands. I mean, that's always been the first part of the mission of Facebook, is giving people the power to share, to connect, to come together and build communities, but give people the power has always been the primary and first thing that we have focused on. And one of the ways that we're talking about decentralization is through end-to-end encryption in messaging. I do think that there is a very broad sense, as you're saying, that - and greater awareness that having data stored for long periods of time with companies cannot only be an asset, and that it can help provide better services but can also be a liability in that there could be breaches or the data could be used in ways that weren't intended. And I think people broadly are starting to get that more, which is why things like encryption are so attractive to people and why features around ephemerality or keeping data less permanently are becoming increasingly important. So when you think about the types of products that we're building on messaging, where encryption is going to play a huge role, sharing with your friends, where Stories, which is ephemeral, is the main thing that's growing. I mean, these are really privacy-first products, and I think that, that's kind of the most important way that we're thinking about this whole space overall. I think that this is going to become increasingly important not just from the perspective of what does the privacy policy say but how is this deeply designed into the products that we're building. I mean, these are the products that are growing the quickest and these are differentiating parts of why they work and why people prefer them as opposed to other services. In terms of regulation overall, I think that, that's going to be very important. We - the basic - the principles behind GDPR in Europe, I think we're very important, and I think having that codified around the world would be a very positive step. And I mean, we're working with folks to enable that but I think that, that would be good for people everywhere to make sure that basically every person who uses an Internet service has the same protections no matter where they live.
Operator: Your next question comes from the line of Lloyd Walmsley from Deutsche Bank.
Lloyd Walmsley: Two if I can. First, Mark, it sounds like there's really a clear shift this year to more aggressive core product development. You talked about a lot of areas across Instagram commerce, Messaging, Payments in WhatsApp and many more. I guess, are there any that you would point out that could be a material contributor to revenue over the next 2 to 3 years and if - I guess, if there's, yes, any you would call out? And then, secondly, when you look at the Stories ad in adoption, is there any difference you're seeing between the more sophisticated advertisers and smaller advertisers either in terms of adoption or performance? And do you see any inhibitions to long-term success among smaller advertisers with the format? Or do you think they can compete effectively in the creative side?
David Wehner: Lloyd, I'll take - it's Dave. I'll take the first one in terms of material contributors to revenue. Look, I think on a lot of those fronts, it's very early. I'd say commerce broadly and e-commerce is an important vertical for our advertising business. So our success in building - continuing to build good advertising products for our e-commerce clients on the advertising side will be a more important contributor to revenue in the foreseeable future than the new area. So that's what I would focus on. I think those are still very small and we're very early in those being anything from a contribution point of view on revenue. And then I think you had a question on the Stories ad. I think Sheryl will take that.
Sheryl Sandberg: Yes, I can take that. So at 2 million advertisers in Stories, we're obviously seeing broad adoption and that means you have both. You have large advertisers and small advertisers. It's definitely the case that sometimes small advertisers or medium-sized advertisers can sometimes move the fastest. But one of the things we're most proud of, and Mark talked about it in his remarks as well, is that we take tools that were previously only available to large companies and make them available to small companies. And one of the things we've learned over the years is that the easier we make it for our advertisers, whether they're really big or really small, the more they'll adopt. So what - with the work we've done to "We'll take your pictures, we'll take your post and we'll create the story for you," we do automatic placements, I think that makes it easier. And I'll share one specific example of a medium-sized company. Cetaphil is a skin care brand. They ran video ads across IG - Instagram Stories, Instagram feed and Facebook, targeted to Canadian women aged 25 to 54, and they were measuring all the way through to sales and they saw almost a 7%, so 6.9% lift in store sales. So what we want to do is get marketers to use our tools, use the technology we have to do automatic placements, show people things they're interested in, so ads are a good experience, but really help them ring the cash registers so that they know their dollars or their pound or their euro are well spent, and that's what we're pushing to do.
Mark Zuckerberg: And I'll add one thing, which I think David has said this a couple of times, but I think it's worth emphasizing that while I'm excited about the road map that we have and it's going to be great over the long term, the growth of the business over the next year, a few quarters or the near term is going to be mostly based on the growth of Stories and the core News Feed work. And Stories is - we have a lot of work still to go there to make it - monetize at the same levels as News Feed. And I'm confident that we're going to get there, but I want to make sure that we're giving the right outlook on how we expect the near future to go.
Operator: Your next question comes from the line of Mark May from Citi.
Mark May: First, regarding Stories again. Given the size of the WhatsApp audience and the amount of status posts on that platform, just curious about your early learnings from testing status ads on WhatsApp and how optimistic are you that, that will become an interesting and meaningful opportunity going forward. And in terms of Stories on Facebook, from what we can gather, Stories consumption and impression volume on the core Facebook ad seems to maybe not be scaling as fast as some of it and maybe even that some of your comments last year suggested that, that in - if, in fact, that's true, do you - why do you think that, that is? And does that actually pose any sort of issue to your long-term growth plans for Stories, at least on that platform?
Sheryl Sandberg: Yes. So WhatsApp, we don't have ads in Stories. It's not available. Ads are something that's more of a future thing for WhatsApp. We remain very focused on the consumer experience there. We do have the WhatsApp Business app, which is helping businesses connect with consumers, and that's growing well but that monetization opportunity is not available.
David Wehner: Yes. And Stories on Facebook, clearly, Stories is a big success on Instagram. From an impression growth perspective, we're pleased with what we're seeing there, and we're optimistic on our ability to grow Stories on Facebook but it's much earlier on the Facebook platform. So we have to just continue to work to build that format on Facebook.
Mark Zuckerberg: Yes. And just to add quickly, I mean, Stories on Facebook is growing quickly. I think we're going to get to where we need to get to there. We started a little bit later, and some of the early execution, I think, wasn't as good as it needed to be. But I think we're doing good work there now and it's growing quite quickly. So I'm confident about where we're going to be there.
Operator: Your next question comes from the line of Ross Sandler from Barclays.
Ross Sandler: I guess, a question on Messenger. Any learnings from the monetization efforts at Messenger? You've got inbox ads that you've done. You just mentioned Stories ads are starting to enter Messenger. So I guess, what are you seeing there? And what are you most excited about as far as monetizing Messenger? And I guess, what might be applicable at some point in the future to WhatsApp? And then, Mark, you mentioned Payments in WhatsApp. We know that you guys have been working on that for a little while in the background, but any thoughts on how that's going to play out in terms of what geographic markets that might be available? And then - and kind of what do you see as the future opportunity in Payments?
Sheryl Sandberg: Our approach to monetization anywhere is always very cautious and we are very - moving very slowly on Messenger, where we remain primarily focused on consumer growth and engagement. Our real focus has been on the organic connections between businesses and consumers, where this is a really strong channel for customer service. We now have 10 billion messages being sent between people and businesses every month. And of course, that includes automated messages as well. We continue to make progress with monetization. We're starting to roll out Stories ads, but it is very early days and we think it will be a long road ahead. It's also probably worth noting that the experiences we had to date, moving from Facebook to Instagram, were more similar, that the Instagram feed is similar to the Facebook feed in terms of what you can do with advertising. And so Messenger and messaging services, if Stories is one click different from that, that's a few clicks different than that. So we're going to have some real work to do.
Operator: Your next question comes from the line of Colin Sebastian from Robert W. Baird.
Colin Sebastian: Mark, you mentioned Facebook Groups as one part of the community effort. And I wonder if you could expand on how you see Groups gaining a higher profile and how that extends to other apps potentially? And then, secondly, listening to the descriptions of the convergence of features and usage across the apps, such as in Stories and messages, I wonder how we should think about how that could impact usage and engagement if people are also converging their own use into 1 or 2 apps instead of the broad suite if that's something that we should keep an eye on.
Mark Zuckerberg: All right. So for Groups, the main thing that we're focused on is making it so that connecting with communities of people that you're interested in is going to be as central to the experience as connecting with friends and family. So it's not just a feature. It's going to become more of an organizing principle for more of the activity in the app. And friends and family is always going to be really central to what we do, but we just think that there's an opportunity now to do more and to make it so that people can also be a part of these meaningful communities. Hundreds of millions of people already tell us that the groups that they're a part of on Facebook or at least a few meaningful ones are the most important part of their social experience. There's a lot of data, sociological data outside, that shows that a physical group membership in the world off the Internet has been declining for decades. So I think that building groups is - it obviously cannot replace people getting together in person, and a lot of the most successful groups are successful because they facilitate people going and doing things together in person as well. But we think that this is a real human need and a sociological need and it's an important thing that people need to do. And I think it's going to be one of the next big areas that I'm really excited about the Facebook uptick. It's worth pointing out here that while Instagram doesn't have Groups, we also really focus on community and interest there, more around discovery and hashtags and explore, being able to really delve into your interests and interact with people who are interested in the same things that you are there, even if they're not your friends. So that's going to be an increasing part of that experience too. I think there might have been another question but I - no? All right.
Operator: Your next question comes from the line of Rich Greenfield from BTIG.
Richard Greenfield: If I think about kind of the San Francisco Valley kind of elitist community and even, I think, a good chunk of Wall Street, there's been this kind of ongoing narrative that nobody uses core Facebook blue anymore and really, time spent is all about Instagram. Your DAU numbers obviously give a good sense that people are touching Facebook still, core Facebook on a regular basis, but we don't really get any sense of engagement with Facebook versus your other apps. Is there anything you can do to give us some color or sense? I mean, you've talked about Marketplace before on the call, but any way of getting a sense of actual usage trends and what you're seeing in terms of core Facebook versus Instagram versus the communications apps, et cetera?
David Wehner: Rich, it's Dave. Look, I think the DAU trends that we're giving really do paint the picture broadly, which is stability in the developed markets, growth for Facebook blue in the developing markets. We're not giving an update on time spent. That's not our major focus. We pivoted to focus on meaningful social interactions and we've been pleased with the results of that effort broadly, but I think that DAU trends tell the story broadly.
Operator: Your last question comes from the line of John Blackledge from Cowen.
John Blackledge: For Mark, just curious if you're happy with the progress around the safety and security initiatives. And going forward, is there any kind of recurring metric or anything you can disclose to show progress that you guys might see internally but Facebook users and other constituents maybe don't see? And then just a quick one on pricing on Instagram Stories. Should we expect to see the pricing gap close between feed and Stories over the course of 2019?
David Wehner: John, I can real quickly take the pricing question first. The reality is pricing is a function of supply and demand and how demand grows versus supply. So while I do expect that we'll bring more advertisers to Stories and we'll bring more advertising formats to Stories and that will create more demand for Stories, we're also growing Stories inventory quickly. So those two things will balance out in price. Feed from a growth perspective on an impression front is more constrained given where we are with ad loads on Facebook and Instagram. So there'll be more pricing pressure there because there's already strong demand for feed products. So in terms of convergence, it's hard to say how those things will play out. We do think there's opportunities to improve the value of the Stories format that will translate into better price for Stories. But how it converges over time, there's a lot of different dynamics there.
Mark Zuckerberg: Yes. And on all the content and safety and security issues, there's more to do here but I'm proud of the work that we've done to get in front of a lot more of these issues. If you think about the journey that the company has really been on for the last couple of years, it's moving from reactively dealing with issues that our community flags. Perhaps if someone sees some content that's problematic, they used to tell us about it and then we'd go look at it to now, increasingly, we're building AI systems and we have tens of thousands of people who are doing more proactive review of content that could be potentially problematic. And we're prioritizing the different types of content that we think could create the most harm. So one of the things that we worked on earliest was removing terrorist propaganda. One of the things that we're proud of there is, there are now 99% of the ISIS and Al Qaeda content that we take down, our AI flags it, removes it before people see it. Another area that we really care about that's deeply important is self-harm, right? And that's an area where the goal isn't to take down the content, but if we see an area where - if we see something that a person might be thinking about hurting themselves, we now have thousands of people and technical tools that can flag this content to those people to - so we can actually go get first responders to go reach out to people. And I think in the last six months or a year alone, there have been hundreds, if not thousands, of cases where we're we've been able to get first responders to people when they needed help because of this approach of being more proactive on looking at the content. The same goes for things around election interference and more proactively looking for inauthentic behavior. And we've taken down a lot of effort by different nation states to harm or interfere in elections that way. So we're just going to go down the list of every basic type of bad content. And we do report this publicly, going back to your question. We issue a transparency report. It's our content enforcement report. Right now, we're doing it, I think it's every six months, but the goal is to get that to the cadence by, I think it's the end of this year, we're going to be doing it quarterly and doing calls to discuss the results just like we do for earnings because we think that this stuff is really important as well, at the same level there. So where I come to summarize where I think we are, coming into 2019 is, 2017 and 2018 were really - we had a lot of hard work to do, but we also needed to figure out what the road map was going to be going forward. And while we haven't solved all of the issues yet - you never solve all of the issues, but we certainly have a lot more to do on our road map. The way that I feel starting 2019 is that we have clear road maps for what we need to go do. And I think you're going to be able to look at these transparency reports as we issue them and see that we're continually making more progress, finding more of the content proactively, taking - getting better at taking it down, getting better at not distributing stuff that's borderline. And that's just some of the most important work that we're doing. It's also the first priority again for this year, is making - continuing to make progress on the big, substantive issues facing the Internet and our company because there's still a lot more to do here, and this is incredibly important. But I do feel like we've started to turn a corner and have a clear plan for what we need to do here now. So thanks for that question.
Deborah Crawford: Great. Thank you. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again.
Operator: Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines. | [
{
"speaker": "Operator",
"text": "Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook Fourth Quarter and Full Year 2018 Results Earnings Conference Call. [Operator Instructions]. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford",
"text": "Thank you. Good afternoon, and welcome to Facebook's Fourth Quarter 2018 Earnings Conference Call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our quarterly report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I'd like to turn the call over to Mark."
},
{
"speaker": "Mark Zuckerberg",
"text": "Thanks, Deborah, and thank you, all, for joining us today. Our community continues to grow, and our business delivered good results this quarter. There are now 2.7 billion people using Facebook, Instagram, WhatsApp or Messenger each month and more than 2 billion people who use at least one of our services every day. On our last call, I talked about our overall strategy as we faced some important opportunities and challenges. And today, I want to give you an update and talk about our priorities for 2019. For the past couple of years, most of our focus and energy has gone into addressing some of the biggest social issues around the future of the Internet, including election integrity, content governance, safety and security, data privacy and digital well-being. And these are all complex issues but we've made real progress. In many of these areas, we believe we built the most advanced systems in the world and, in many cases, more advanced than any other company or government. And in other areas, we have clear road maps now for our work ahead. Still, there's a lot more to do, and I expect it will take strong execution through 2019 and beyond before we get all our systems to the level that we need. But we've fundamentally changed how we run this company. We've changed how we build services to focus more on preventing harm. We've invested billions of dollars in security, which has affected our profitability. We've taken steps that reduced engagement in WhatsApp to stop misinformation and reduced viral videos in Facebook by more than 50 million hours a day to improve well-being. We've made significant progress and we're going to continue this work, but we're also going to allocate more of our energy to building new and inspiring ways to help people connect and build community. Going into 2019, we're focused on four priorities: first, continue making progress on the major social issues facing the Internet and our company; second, build new experiences that meaningfully improve people's lives today and set the stage for even bigger improvements in the future; third, keep building our business by supporting the millions of businesses, mostly small businesses, that rely on our services to grow and create jobs; then fourth, communicate more transparently about what we're doing and the role our services play in the world. And I want to take a minute talk about each of these. So first, continue making progress on the major social issues. The most important work here is to keep executing our road map to build systems that can proactively identify harmful content so we can act on it sooner. We just finished a year of very heavy investment to get these systems to a better place, and we've seen the results of that in recent elections, including the U.S. midterms and in our transparency reports, where we report what percent of violating content we identified proactively. We ended 2018 with more than 30,000 people working on safety and security, up from 10,000 people a couple of years ago. And this work will never be finished, but I now believe we've built some of the most advanced systems in the world for dealing with these issues. Now however, this raises a broader set of values questions about how to use these systems. One question is about who decides what speech is acceptable and what isn't. Right now, we have a deliberative process of consulting with experts around the world. But I've increasingly come to believe that we shouldn't be making so many of these decisions about content ourselves. In November, I wrote a note about a blueprint for a system of content governance and enforcement, which includes giving people the ability to appeal our internal content decisions to an independent body, and we're currently working with experts to design the system and we plan to start piloting it this half. Another important issue is the future of privacy and encryption. People really value the privacy that encrypted messaging brings and we've built the most secure global messaging service in the world. As people increasingly share more privately, we're working on making more of our products end-to-end encrypted by default and making more of our products ephemeral so your information doesn't stick around forever. And I'll discuss this more over the coming quarters. Our second priority for 2019 is that as we make progress on these social issues, we also need to deliver new experiences that meaningfully improve people's lives. Now, I'm not talking about the many day-to-day iterative improvements we make so that ranking gets a bit better or that things get a little faster, but I'm talking about major improvements to people's lives that whole communities recognize and say, \"Wow, we're all doing something new on Facebook or on WhatsApp that we weren't doing before.\" The last experience like this was Stories, which continues to grow very quickly. For example, Instagram just passed 500 million daily actives on Stories. But the reality is, we've put most of our energy into security over the past 18 months, so that building new experiences wasn't the priority over that period. So this year, I think we're going to deliver several of these new experiences. Messaging is an area that's growing the most quickly. And this year, people are going to feel these apps becoming the center of their social experience in more ways. We're going to roll out Payments on WhatsApp in some more countries. Private sharing in Groups and Stories will become more central to the experience. We're going to onboard millions of more businesses that people can interact with. In Facebook, the way people experience groups and communities will continue to deepen. We're going to get to a point soon where people feel like Facebook is about as communities as it - is about communities as much as it's about your friends and family where almost everyone is in a group that's meaningful to them and that community is a central part of their experience. On Facebook, I also expect this to be the year where Watch becomes more mainstream. There are now 400 million people who use it every month, and people, on average, spend over 20 minutes on Watch daily. This means we're finding ways for video to grow outside of News Feed so it doesn't displace the social interactions that people primarily come to our services for. In Instagram, one of the areas I'm most excited about this year is commerce and shopping. There's a lot of natural activity happening here. And this year, I expect us to deliver some qualitatively new experiences around that. Longer term, I remain very focused on building technology that brings people together in new ways, including through AR and VR. I'm looking forward to Oculus Quest shipping this spring. The feedback there so far has been very positive. And I've also been positively surprised that Portal has done better than I expected it to. I love using it with my own family. But we never shipped Facebook-branded hardware before and a lot of people said this would be a difficult time to start. So I'm pleased that so many people are enjoying this experience of being able to feel closer to the people they care about even when they're physically far apart. Our third priority is to continue strong execution on our business. In the past couple of years, a lot of our business challenges have been self-imposed. The reality is that we've had a number of substantive issues that we needed to address, and the investments we made in safety, security, privacy and well-being both increased our costs and, in some cases, reduced our revenues. But as I said at the time, I believe that these investments are the right thing to do and will make our community and our business stronger over the long term. And what we've seen is that the fundamentals of the business remain strong. More than 90 million small businesses now use our products, the vast majority of them for free. And of those we surveyed, half tell us that they've been able to grow their businesses and hire more people since joining Facebook. This means they're using our services to create millions of jobs, and this is one of the most important contributions that we feel we can make to the world. And to put this in perspective, the U.S. economy added about 2.6 million jobs last year. Our last priority is to get out there more and make the case for the role our services play in the world. Right now, there's a lot of negativity about the impact of technology, and some of it's fair and some of it's misplaced. And we, in the tech industry overall, should be scrutinized heavily because we play a role in many people's lives. My approach here is to listen to the critique first, to work on addressing our issues, figure out what we believe are the most important principles to uphold and then go engage in the debate. And I feel like we've come out of 2018 not only making real progress on important issues but having a clear sense of what we believe are the right ways to move forward. Now, we're still going to make mistakes along the way, but we now have a clearer sense of the path ahead and we're ready to work with people to understand our role and move towards good outcomes, whether that's regulation on content or data, cooperation on shared threats, working openly to make sure AI best serves people, or just standing up for the kind of open and connected world that we all want to see. The Internet is a massive force for change and we're at the center of a lot of the debate that brings, but our core value to people and society remains the same. We offer a service free to everyone to help you stay connected with the people you care about, express what you're thinking and feeling, get help when you need it most, support the causes and ideas you believe in, start and grow businesses no matter where you are, and that makes a lot of good possible and we're committed to building technology that people can use to create positive change. As always, thank you for being on this journey with us. And now, here is Sheryl to talk about our business."
},
{
"speaker": "Sheryl Sandberg",
"text": "Thanks, Mark, and hi, everyone. We had a strong fourth quarter and a good end to the year. Q4 mobile ad revenue was $15.5 billion, increasing 36% year-over-year and contributing approximately 93% of our total ad revenue. Full year mobile ad revenue grew 45% compared to 2017. 2018 was a challenging and important year for us. As Mark said, we made significant investments in safety and security and strengthened our defenses against election interference. We gave people tools to better control their information and set a new standard for transparency and ads. We have focused on making progress in these important areas while continuing to grow our community and our business. This quarter proved that we can do both. We know we still have a lot of hard work ahead of us. We need to continue to do better at anticipating the risks that come from connecting so many people, and we need to earn back people's trust not with words alone but with actions. Part of building trust is helping people better understand our business model. Protecting people's privacy and showing them relevant ads are not at odds. We don't sell your data and we don't tell advertisers who you are. What we do is allow advertisers to reach people interested in their products. The result is that people see more relevant ads and small businesses can reach people in ways that only big companies previously could. This business model keeps Facebook free so people all around the world can use it and levels the playing field for businesses of all sizes while protecting people's privacy. I'm excited to announce today that we have more than 7 million active advertisers across our services. From local shops to global brands, companies all over the world are growing and hiring because they can reach their customers on our platform. The opportunities we create for businesses drive our growth, which continues to be broad-based across regions, marketer segments and verticals. During the holidays, companies used our ads to help people discover deals and find gifts. We saw particular strength among advertisers that optimized for measurable objectives, like conversions or sales. For example, Bryan Anthonys an online jewelry store based in Austin, Texas, used our campaign budget optimization to bring in new customers and sales on Black Friday. The campaign was so successful that they tripled their holiday purchases and hired additional people to help pack and ship orders for the busy season. We're also helping advertisers keep up with shifts in how people use technology. People are creating more Stories and sending more messages, which means these are emerging areas of opportunity for marketers. Today, we're also announcing that 2 million advertisers are using Stories to reach customers across our family of apps. We're making it easier for advertisers to adopt their campaigns for Stories. In Q4, we expanded automatic placements, which converts feed ads into a format that works for Stories and delivers ads wherever they'll get the best results. Framebridge, a start-up that provides custom picture framing, recently used automatic placements to run ads across Instagram Stories, Facebook and Instagram feed. They ran short videos to show that their frames make great holiday gifts, and Instagram Stories generated over 25% of their new customer sales. As people increasingly use messaging apps, we're helping small businesses make that shift, too. In Q4, we launched ads in Messenger Stories, which means advertisers can now easily buy Stories ads across Facebook, Instagram and Messenger. Beyond Stories and messaging, we have an opportunity to connect people and businesses on new services like Marketplace. We're seeing good early results at Marketplace ads. In Q4, we worked on making ads more relevant to the products that people are looking for. For example, if someone is browsing furniture in Marketplace, we'll try to show them an ad for furniture or a related item. We plan to keep working on this to provide a better experience for people and more value to advertisers over time. As we build new ad products, we remain focused on improving the overall quality of our ads. Across all of our platforms and formats, we're investing in AI to make ads more relevant and effective. In Q4, we developed new AI ranking models to help people see ads they're more likely to be interested in. We're also using AI to identify and more quickly review ads that might violate our policies, which was particularly important during the U.S. midterm elections. Looking ahead, we see more opportunities to use AI to keep people safe on Facebook and help businesses grow. I want to close by saying thank you to the businesses around the world who are using our tools to create jobs and growth. Last month, I went to Facebook's Community Boost in my hometown of Miami, which was the 50th stop on our tour across the U.S. in 2018, offering digital skills training to small businesses and job seekers. I met entrepreneurs like Alex Kassab. He started Morelia Gourmet Paletas with friends just two years ago. He says that 60% of his new customers learned about their ice cream from Facebook and Instagram. And because of this growth, they've expanded to 12 locations and hired more than 35 people. Last week, I was in Europe and met with SMEs from across the continent who shared similar stories of growing their companies, hiring people and investing in their communities. These stories motivate us to keep improving so more people can succeed on our platform. I also want to thank our global team for their commitment to tackling our issues and making our products better every single day. As we come out of a challenging year and continue to face challenges ahead, I believe we're in a position to build on the progress we've made and better serve our community in 2019. I am grateful to all of you for your continued hard work and dedication. Now, here's Dave."
},
{
"speaker": "David Wehner",
"text": "Thanks, Sheryl, and good afternoon, everyone. Q4 was a strong quarter wrapping up a good year for our business. Full year 2018 revenue grew 37% to $56 billion, and we generated over $15 billion of free cash flow. Let's begin with our community metrics. Daily active users on Facebook reached 1.52 billion, up 9% compared to 2017, led by growth in India, Indonesia and the Philippines. This number represents approximately 66% of the 2.32 billion monthly active users in Q4. MAUs grew 191 million or 9% compared to last year. Turning to our overall family metrics. Around 2.7 billion people worldwide used one of our applications in December, and on average, over 2 billion people were active daily. This is our best estimate of our de-duplicated audience across Facebook, Instagram, Messenger and WhatsApp. We believe these numbers better reflect the size of our community and the fact that many people are using more than one of our services. For the time being, we will continue to disclose both set of numbers. But over time, we expect family metrics will play the primary role in how we talk about our company and we will eventually phase out Facebook-only community metrics. Turning now to the financials. All comparisons are on a year-over-year basis unless otherwise noted. Q4 total revenue was $16.9 billion, up 30% or 33% on a constant currency basis. Had foreign exchange rates remained constant with Q4 '17, total revenue would have been approximately $348 million higher. Q4 total ad revenue was $16.6 billion, up 30% or 33% on a constant currency basis. In terms of regional ad revenue growth, Asia Pacific was strongest at 34%, followed by North America at 31% and Europe at 28%. Rest of World ad revenue grew 24% and was impacted by ongoing currency weakness and macroeconomic challenges. In Q4, the average price per ad decreased 2% and the number of ad impressions served on our services increased 34%. Impression growth was primarily driven by ads on Instagram, including both feed and Stories as well as Facebook mobile News Feed. The year-over-year decline in average price per ad reflects an ongoing mix shift towards product services and geographies that monetize at lower rates. Payments and other fees revenue was $274 million, up 42%. Sales of Oculus Go and the launch of Portal contributed to the revenue growth in the quarter. Turning now to expenses. Total expenses were $9.1 billion, up over $1 billion sequentially and up 62% compared to last year. In addition to continued investment in infrastructure, safety and security and innovation, expenses were also driven by seasonal factors, including marketing efforts, notably the promotion of Portal and Oculus Go. We ended the year with over 35,500 full-time employees, a 42% increase. Operating income was $7.8 billion, representing a 46% operating margin. Our Q4 tax rate was 14%. Net income was $6.9 billion or $2.38 per share. Full year capital expenditures for 2018 were $13.9 billion, driven by investments in data centers, servers, network infrastructure and office buildings. We generated $3.3 billion in free cash flow in Q4 and ended the year with approximately $41 billion in cash and investments. In Q4, we bought back approximately $3.5 billion of our Class A common stock and completed our prior repurchase authorization. In December, our Board of Directors authorized the repurchase of an additional $9 billion of stock. Turning now to the revenue outlook. In Q1, we expect our total revenue growth rate to decelerate by a mid-single-digit percentage on a constant currency basis compared to the Q4 rate. We also expect that our revenue growth rates will continue to decelerate sequentially throughout 2019 on a constant currency basis. Turning now to the expense outlook. On a full year basis, we continue to expect 2019 total expenses will grow approximately 40% to 50% compared to 2018. Our 2019 capital expenditure outlook is unchanged at $18 billion to $20 billion, driven primarily by our continued large investment in building data centers. Lastly, we expect that our 2019 tax rate will be a few percentage points higher than our 2018 rate. In conclusion, we are confident in our ability to continue to invest effectively in the key priorities that Mark outlined in his opening remarks: making progress on the major social issues facing the Internet, building new experiences that meaningfully improve people's lives, and growing our business by supporting the many businesses that rely on our services. With that, operator, let's open up the call for questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. Your first question comes from the line of Brian Nowak from Morgan Stanley."
},
{
"speaker": "Brian Nowak",
"text": "I have two, the first one for Dave. Last quarter, you talked about an expected sequential deceleration in 4Q rather, and I think it came in a little better than expected. Could you just talk to sort of which forms of media, whether it's News Feed or Stories or Instagram, kind of came in better than you thought it originally would a few months ago and what drove the upside? And then, Mark, you talked about the Instagram commerce opportunity. Maybe just talk us through sort of 1 or 2 of the key - what you think are the most important steps you have to cross throughout 2019 to really execute on this opportunity."
},
{
"speaker": "David Wehner",
"text": "Sure. Thanks, Brian. I'll take the first part of your question. Yes, Q4 was very strong on revenues, so we're pleased with that. On the demand front, we continued to benefit from advertisers targeting on business results. So direct response was especially strong during the holiday season. And then on the supply front, we benefited from strong Instagram growth, which was aided by both growth in impressions on Instagram feed and on Stories. But I'd reiterate that we expect that we will see a deceleration of revenue growth in Q1."
},
{
"speaker": "Mark Zuckerberg",
"text": "I'd like to talk about - a bit about commerce. When I think about it, just from the consumer side, increasing commerce on Instagram, Facebook and WhatsApp, I think, is one of the most exciting product opportunities that we have in all of these products and a big business opportunity as well. The big things that I think we want to make sure that we nail, in Instagram especially, are discovery. People are already doing a lot of commerce activity and are really interested in following brands, and I think making sure that, that works is - and does well is a big deal. But I think there's also a very big opportunity in basically enabling the transactions and making it so that the buying experience is good and that when you buy from someone - from a seller that you know that you can trust them, that you're going to have a good experience and in facilitating and making that go well. The work that we're going to do in Instagram also will go across the efforts in Marketplace and Facebook, the work - the rest of work that we're doing in Facebook and all the work that we're going to be doing in WhatsApp as well. So this is a big area that I'm personally very excited about and focused on."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Anthony DiClemente from Evercore."
},
{
"speaker": "Anthony DiClemente",
"text": "Maybe, first, for Sheryl on Stories. Stories continues to grow very quickly. As you said, the number of advertising - advertisers using Stories are growing quickly. Can you give us a little bit more on the performance of the ads? Are you seeing improvements in conversion rates for those ads? Are the ads performance on Stories narrowing the gap with feed ads in terms of pricing or performance? And anything broadly on demand for those ad formats. And then one for Mark. I wonder if you could speak to the possibility of stitching together the messaging apps, WhatsApp, Instagram, Messenger. It would be great to hear what the rationale or potential commercial benefits might be to - or for potential integration of those properties."
},
{
"speaker": "Sheryl Sandberg",
"text": "I'll take the Stories question. One of the challenges that marketers have is keeping up where consumers are. If you think about our history, people made the shift to mobile before marketers did, and I think one of the successes we've had is we made it easier for advertisers to move into a mobile environment. And just as we did that in mobile, now we're very focused on doing that in the new things that people are doing, and Stories is a big part of that, Messaging will be further out, but as important as well. So I think the fact that we've already gotten 2 million advertisers to move into Stories is because we've gotten better at making it easier. We launched our automatic placements and expanded it, which converts feed ads into a format that works for Stories and delivers the ads wherever they'll get the best results. So our goal is to make it as easy as possible for marketers to get to the format of Stories and then deliver the ads where they're going to get the best experience and the best ROI. Now right now, one of the interesting things about Stories is there's a benefit to being an early adopter. So the pricing is really attractive. And so we think the mix shift to Stories is a big opportunity for us and it's going to take time to continue to get advertisers in, but we're very happy with demand to date."
},
{
"speaker": "David Wehner",
"text": "I would just - before we turn to Mark, I'd just layer in on the Stories front. When we look into 2019, we do expect to see a deceleration of revenue growth throughout the year. And while we have opportunities to grow impressions on Facebook and Instagram, that's less so in feed, where we already have healthy ad loads in - on both surfaces and more in Stories where we have lower CPMs. So - whereas in 2018, we benefited from strong impressions growth on Instagram in both feed and Stories. We'll be more reliant on Stories impression growth in 2019. And from a pricing perspective, there's - we've got to improve our ability to grow the number of advertisers using Stories and improve price there, but it's going to be more reliant on that in terms of revenue growth."
},
{
"speaker": "Mark Zuckerberg",
"text": "All right. I can talk about messaging and the integration that we're thinking about, but first, we're really early in thinking through this. So there's a lot more that we need to figure out before we finalize the plans. And then, of course, this is going to be a long-term project that I think will probably be to whatever extent we end up doing it in - a 2020 thing or beyond. There are a few big reasons why I'm excited about this and think it'll be good for the user experience, which is the reason that we're doing it. I mean, part of the question was about a commercial benefit, but that really isn't the big focus here. The first reason that I'm excited about this is moving more to end-to-end encryption by default in more of our products. People really like this in WhatsApp. I think it's the direction that we should be going in with more things in the future. And I think if there's an opportunity to use the work that we've done with WhatsApp there, rather than doing it in different ways in the different messaging experiences, to have that really just - to have encryption work in a consistent way across the different things that we're doing. There are also a number of cases that we see where people tell us that they want to be able to message across the different services. So one example is a lot of people, hundreds of millions of people, are using Marketplace on Facebook now, and a lot of people are using that in countries where WhatsApp is the primary messaging app that they use. So we have these experiences today where we're building Marketplace and you go to message someone to buy something. And the link to basically do the messaging is over Messenger, but in that country, where people really want to be using it, is WhatsApp and we need to make it so that people can communicate across the different networks and graphs that they have or be able to do that integration better in order to facilitate more transactions and connections there. Another example is there are tens of millions of people, maybe more, but I'll go with that, who, on Android, use Messenger as not only their app for Facebook messaging but also for SMS, as their SMS client. And going back to the encryption point from before, we think that there's an opportunity to, when you're going to go message someone over a phone number network, have that primarily go over WhatsApp and be end-to-end encrypted rather than go over SMS where it's unencrypted and less secure. So I can give you a few more examples like that, but I guess the way that I'm thinking about this is that there's a handful of cases that people are telling us that they want to be able to integrate and communicate more easily across the networks. I think moving more towards end-to-end encryption and improving security there is the right direction to go in. There's a lot of questions there that we need to work through. So we're working through this in a deliberative way. And I wouldn't expect anything here to launch soon, but this is definitely something that we're thinking about and that I think will improve the user experience."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Eric Sheridan from UBS."
},
{
"speaker": "Eric Sheridan",
"text": "Two, if I could. One, Mark, on Facebook Watch, what do you think are some of the things you're still trying to solve for on either the content side or the consumer engagement side to drive broader adoption of Watch and turning it into sort of the mechanism for customers that you're trying to solve for over the medium to long term? I'd love to understand how you see the opportunity and the challenge that's just in front of the company. And second, there was a fair bit of noise in the advertising community about the macro environment at the end of 2018 and maybe at the beginning of 2019 with things like Brexit and the government shutdown in the U.S. Are you seeing anything on the macro front in your own business either exiting 2018 or should start in this year?"
},
{
"speaker": "David Wehner",
"text": "Yes, I can..."
},
{
"speaker": "Mark Zuckerberg",
"text": "Take that first one and then I'll..."
},
{
"speaker": "David Wehner",
"text": "Yes, I can start on the macro environment, Eric. Obviously, we delivered strong results in Q4. As we look out into 2019 further, that's - the macro economy is certainly a potential headwind and risk to the business just given the sensitivity of the advertising business to a slowdown in growth. Obviously, we believe we've got the best advertising products out there in terms of being able to deliver measurable business results to clients. And so we think that does help us in that environment, but clearly, macroeconomics stands out there as a risk on top of other issues that we face, leading to a deceleration of revenue growth in 2019."
},
{
"speaker": "Mark Zuckerberg",
"text": "I'll talk about Watch and video. So there, we've really had this dynamic over the last 12 to 18 months where we've limited the amount of video that we've shown in order to make sure - in News Feed, to make sure that it doesn't displace interactions, social interactions that people are having. And the big thing that unlocked a lot of growth in Watch is we basically were able to move a bunch of the video-watching behavior to a different tab, where people intentionally go to the tab because they want to watch a video and browse and see what's going on. And that has allowed us to really increase the amount of video that people are watching without getting in the way of the core mission of what we do, which is helping people interact. The two big things that we're really focused on now in Watch are, within the Watch tab, also just making sure that the consumption isn't all just passive consumption and making it so that there are more two-way interactions between viewers and the creators and that we can help build community around that, where we've built this great feature, Watch Party, that allows people to come together with their friends to watch different content and premiers. It's a new feature that allows people to basically take a video and stream it live for the first time when it comes out. So these are all things that make it so the video-watching experience isn't just about passive consumption but about interaction, and that's going to, I think, help really drive engagement as well. Then there's also the monetization side for creators, which is going to be really important for making it so that we have the content that people want to consume. And that's just a big thing that we're continuing to focus on. We think that the more money that creators can make through Watch, there will be a virtuous cycle there. And that's going to be really important for continuing to grow this as well. But right now, it looks like this is going in a good direction. It's still very early. We're still growing quickly but from a small base, but it's one of the things that I'm excited about for this year."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Doug Anmuth from JPMorgan."
},
{
"speaker": "Douglas Anmuth",
"text": "One for Mark and one for Dave. Mark, it's been more than a year since you shifted to feeds for more friends and family and removed the passive videos, as you just talked about, and reported engagement numbers, obviously good. Are there any signs that the changes you made a year ago are now having a more positive impact on engagement in the core Facebook feed? And then, Dave, you talked 3 months ago about better aligning revenue and expenses in 2020. I was just curious if that's still your view at this point. What gives you the confidence you can do that? And what changes most from a spending perspective as you look toward 2020?"
},
{
"speaker": "David Wehner",
"text": "Yes, I can start on the expense front. We continue to have an outlook for expense growth in 2019 of 40% to 50% total expense growth. We did see headcount growth come down modestly in Q4 from Q3 to 42%. As we look out, we do expect that beyond 2018 - sorry, beyond 2019, we'll have expense growth more in line with revenue growth. But we do plan to continue to invest aggressively in the priority areas, including on the innovation side with AR/VR and AI and continuing to invest in the safety and security programs that we're undergoing. And then CapEx, we'll see continue to flow in through the P&L over time. And you already saw that pick up with the cost of revenue growth in Q4. And so we'll expect to see more of that flow through over time. So I would say, we do plan to continue to invest aggressively in the business going forward, and we are going to see, obviously, a margin impact from that in 2019."
},
{
"speaker": "Mark Zuckerberg",
"text": "And I can talk a bit about meaningful social interactions, although I don't have any specific metrics to share on this. I mean, my own take of this, I think this has gone pretty well and has done what we had hoped, although we've made a number of changes. This is a long-term direction that we're going to continue making more ranking changes and building more products around, but I think that this is kind of reflected broadly in the numbers that you see on engagement and the growth in daily actives and how people are engaging across the family of apps. At the time, what I basically said was, that even though this might decrease time spent and we expected that it would, is we took out especially a bunch of watching of viral videos. We thought that helping people interact more was the unique thing that people come to our services for and that it would be good for the community and the business over the long term. And certainly, everything that we've seen since then suggests that, that is right."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Justin Post from Bank of America Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "Great. A couple of questions. First, pretty rough press cycle in Q4. Did you see any impact in the U.S. and Europe on engagement or usage or people closing their accounts? It certainly doesn't seem evident in MAU numbers. But just anecdotally, did you see any impact or - on that? And then maybe to Sheryl, if we look at trailing 12 month monetization in the U.S. ARPU, it's about $110. And just how do you think about that long term? If you improve targeting, is there room to grow that significantly? Obviously, Instagram's a growth platform that's contributing to that there. But just how do you think about where ARPU is and where it could be very long term?"
},
{
"speaker": "David Wehner",
"text": "Justin, I can probably take both of those. In terms of our ability to continue to grow the advertising business, it's about working to develop the best products we can to enable advertisers to achieve their end business results. Targeting is obviously very important in that. One of the things I would point out is that from a pricing perspective, there are headwinds that we might face on targeting, given the overall privacy landscape in 2019. And so I think that is another factor that presents risk in our ability to continue to grow ARPU. So I would point that out as being an issue. As well, we're seeing a mix shift towards Stories. And that is going to be something that will contribute to a deceleration of our revenue growth. So that's another factor that's leading to deceleration of revenue growth in 2019. In terms of your first question, Justin, about the impact of the press cycle, I would just - I'd probably just let the numbers stand for themselves. We saw that we are growing in all regions albeit we're sort of bouncing around in the developed markets like the U.S. and Canada. In Q4, we saw better growth in Europe because we've come off of the GDPR - the first two quarters of GDPR. So we saw a little bit of a rebound there."
},
{
"speaker": "Sheryl Sandberg",
"text": "I'll talk a little bit about long-term growth opportunities. David is, of course, right that the mix shift and pricing continues to be an issue. But I think over the very long term, which is how you framed your question, we have a lot of opportunity. If you look at what percentage of our ads are truly relevant to the people who are seeing them, I think we've done a lot better over the last couple of years, but we have a long way to go. And that means that for every ad we show, that ad can be better, better for people, show something they're more interested in. I also think the shift we're seeing towards people doing more measurable results, and this is important to understand. It's not just what people think of as direct response advertisers. It's some of the largest brands in the world really going for the results that they're looking for. That bodes very well for our business because we think we can do that very efficiently. And then when we have new opportunities that open up like Stories, even with some pressure on pricing, we think that gives us more inventory and more opportunity and more formats, and we haven't really even gotten started on future things like messaging. So over the very long run, I think we remain very optimistic about the growth opportunities we have."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Mark Mahaney from RBC Capital Markets."
},
{
"speaker": "Zachary Schwartzman",
"text": "It's Zachary Schwartzman on for Mark. Mark, I have a question on data privacy as it relates to your 2019 goal of progressing major social issues. This is a topic that is important for the Internet ecosystem as a whole and not just Facebook, and it appears that regulators are struggling to come up with comprehensive reform that it's appropriate for all stakeholders involved. Facebook has invested a lot to improve data privacy, transparency and trust in the platform over the last year, but I wanted to hear your thoughts on the following. In your Facebook post at the end of 2018, you asked the question of whether we should decentralize authority through encryption or other means to put more power into the people's hands and that you plan to discuss these topics in the public domains. As the accumulation of data and micro targeting increases, so can the value of individual's data. Do you see a future where individuals are compensated for renting their data to Facebook and other tech companies? Will that be in the form of crypto through decentralized blockchains or other methods like a traffic acquisition cost? I know we're in early days and due to scalability and consumer adoption roadblocks, this isn't possible yet, but do you believe these technologies are real existential risk or perhaps even a solution to the current data privacy trust and control issues on the Internet?"
},
{
"speaker": "Mark Zuckerberg",
"text": "I mean, this is a really important question, one that we are spending a lot of time on, broadly thinking about. I do generally - I mean, I believe very strongly in trying to decentralize and put power in individual's hands. I mean, that's always been the first part of the mission of Facebook, is giving people the power to share, to connect, to come together and build communities, but give people the power has always been the primary and first thing that we have focused on. And one of the ways that we're talking about decentralization is through end-to-end encryption in messaging. I do think that there is a very broad sense, as you're saying, that - and greater awareness that having data stored for long periods of time with companies cannot only be an asset, and that it can help provide better services but can also be a liability in that there could be breaches or the data could be used in ways that weren't intended. And I think people broadly are starting to get that more, which is why things like encryption are so attractive to people and why features around ephemerality or keeping data less permanently are becoming increasingly important. So when you think about the types of products that we're building on messaging, where encryption is going to play a huge role, sharing with your friends, where Stories, which is ephemeral, is the main thing that's growing. I mean, these are really privacy-first products, and I think that, that's kind of the most important way that we're thinking about this whole space overall. I think that this is going to become increasingly important not just from the perspective of what does the privacy policy say but how is this deeply designed into the products that we're building. I mean, these are the products that are growing the quickest and these are differentiating parts of why they work and why people prefer them as opposed to other services. In terms of regulation overall, I think that, that's going to be very important. We - the basic - the principles behind GDPR in Europe, I think we're very important, and I think having that codified around the world would be a very positive step. And I mean, we're working with folks to enable that but I think that, that would be good for people everywhere to make sure that basically every person who uses an Internet service has the same protections no matter where they live."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Lloyd Walmsley from Deutsche Bank."
},
{
"speaker": "Lloyd Walmsley",
"text": "Two if I can. First, Mark, it sounds like there's really a clear shift this year to more aggressive core product development. You talked about a lot of areas across Instagram commerce, Messaging, Payments in WhatsApp and many more. I guess, are there any that you would point out that could be a material contributor to revenue over the next 2 to 3 years and if - I guess, if there's, yes, any you would call out? And then, secondly, when you look at the Stories ad in adoption, is there any difference you're seeing between the more sophisticated advertisers and smaller advertisers either in terms of adoption or performance? And do you see any inhibitions to long-term success among smaller advertisers with the format? Or do you think they can compete effectively in the creative side?"
},
{
"speaker": "David Wehner",
"text": "Lloyd, I'll take - it's Dave. I'll take the first one in terms of material contributors to revenue. Look, I think on a lot of those fronts, it's very early. I'd say commerce broadly and e-commerce is an important vertical for our advertising business. So our success in building - continuing to build good advertising products for our e-commerce clients on the advertising side will be a more important contributor to revenue in the foreseeable future than the new area. So that's what I would focus on. I think those are still very small and we're very early in those being anything from a contribution point of view on revenue. And then I think you had a question on the Stories ad. I think Sheryl will take that."
},
{
"speaker": "Sheryl Sandberg",
"text": "Yes, I can take that. So at 2 million advertisers in Stories, we're obviously seeing broad adoption and that means you have both. You have large advertisers and small advertisers. It's definitely the case that sometimes small advertisers or medium-sized advertisers can sometimes move the fastest. But one of the things we're most proud of, and Mark talked about it in his remarks as well, is that we take tools that were previously only available to large companies and make them available to small companies. And one of the things we've learned over the years is that the easier we make it for our advertisers, whether they're really big or really small, the more they'll adopt. So what - with the work we've done to \"We'll take your pictures, we'll take your post and we'll create the story for you,\" we do automatic placements, I think that makes it easier. And I'll share one specific example of a medium-sized company. Cetaphil is a skin care brand. They ran video ads across IG - Instagram Stories, Instagram feed and Facebook, targeted to Canadian women aged 25 to 54, and they were measuring all the way through to sales and they saw almost a 7%, so 6.9% lift in store sales. So what we want to do is get marketers to use our tools, use the technology we have to do automatic placements, show people things they're interested in, so ads are a good experience, but really help them ring the cash registers so that they know their dollars or their pound or their euro are well spent, and that's what we're pushing to do."
},
{
"speaker": "Mark Zuckerberg",
"text": "And I'll add one thing, which I think David has said this a couple of times, but I think it's worth emphasizing that while I'm excited about the road map that we have and it's going to be great over the long term, the growth of the business over the next year, a few quarters or the near term is going to be mostly based on the growth of Stories and the core News Feed work. And Stories is - we have a lot of work still to go there to make it - monetize at the same levels as News Feed. And I'm confident that we're going to get there, but I want to make sure that we're giving the right outlook on how we expect the near future to go."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Mark May from Citi."
},
{
"speaker": "Mark May",
"text": "First, regarding Stories again. Given the size of the WhatsApp audience and the amount of status posts on that platform, just curious about your early learnings from testing status ads on WhatsApp and how optimistic are you that, that will become an interesting and meaningful opportunity going forward. And in terms of Stories on Facebook, from what we can gather, Stories consumption and impression volume on the core Facebook ad seems to maybe not be scaling as fast as some of it and maybe even that some of your comments last year suggested that, that in - if, in fact, that's true, do you - why do you think that, that is? And does that actually pose any sort of issue to your long-term growth plans for Stories, at least on that platform?"
},
{
"speaker": "Sheryl Sandberg",
"text": "Yes. So WhatsApp, we don't have ads in Stories. It's not available. Ads are something that's more of a future thing for WhatsApp. We remain very focused on the consumer experience there. We do have the WhatsApp Business app, which is helping businesses connect with consumers, and that's growing well but that monetization opportunity is not available."
},
{
"speaker": "David Wehner",
"text": "Yes. And Stories on Facebook, clearly, Stories is a big success on Instagram. From an impression growth perspective, we're pleased with what we're seeing there, and we're optimistic on our ability to grow Stories on Facebook but it's much earlier on the Facebook platform. So we have to just continue to work to build that format on Facebook."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yes. And just to add quickly, I mean, Stories on Facebook is growing quickly. I think we're going to get to where we need to get to there. We started a little bit later, and some of the early execution, I think, wasn't as good as it needed to be. But I think we're doing good work there now and it's growing quite quickly. So I'm confident about where we're going to be there."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ross Sandler from Barclays."
},
{
"speaker": "Ross Sandler",
"text": "I guess, a question on Messenger. Any learnings from the monetization efforts at Messenger? You've got inbox ads that you've done. You just mentioned Stories ads are starting to enter Messenger. So I guess, what are you seeing there? And what are you most excited about as far as monetizing Messenger? And I guess, what might be applicable at some point in the future to WhatsApp? And then, Mark, you mentioned Payments in WhatsApp. We know that you guys have been working on that for a little while in the background, but any thoughts on how that's going to play out in terms of what geographic markets that might be available? And then - and kind of what do you see as the future opportunity in Payments?"
},
{
"speaker": "Sheryl Sandberg",
"text": "Our approach to monetization anywhere is always very cautious and we are very - moving very slowly on Messenger, where we remain primarily focused on consumer growth and engagement. Our real focus has been on the organic connections between businesses and consumers, where this is a really strong channel for customer service. We now have 10 billion messages being sent between people and businesses every month. And of course, that includes automated messages as well. We continue to make progress with monetization. We're starting to roll out Stories ads, but it is very early days and we think it will be a long road ahead. It's also probably worth noting that the experiences we had to date, moving from Facebook to Instagram, were more similar, that the Instagram feed is similar to the Facebook feed in terms of what you can do with advertising. And so Messenger and messaging services, if Stories is one click different from that, that's a few clicks different than that. So we're going to have some real work to do."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Colin Sebastian from Robert W. Baird."
},
{
"speaker": "Colin Sebastian",
"text": "Mark, you mentioned Facebook Groups as one part of the community effort. And I wonder if you could expand on how you see Groups gaining a higher profile and how that extends to other apps potentially? And then, secondly, listening to the descriptions of the convergence of features and usage across the apps, such as in Stories and messages, I wonder how we should think about how that could impact usage and engagement if people are also converging their own use into 1 or 2 apps instead of the broad suite if that's something that we should keep an eye on."
},
{
"speaker": "Mark Zuckerberg",
"text": "All right. So for Groups, the main thing that we're focused on is making it so that connecting with communities of people that you're interested in is going to be as central to the experience as connecting with friends and family. So it's not just a feature. It's going to become more of an organizing principle for more of the activity in the app. And friends and family is always going to be really central to what we do, but we just think that there's an opportunity now to do more and to make it so that people can also be a part of these meaningful communities. Hundreds of millions of people already tell us that the groups that they're a part of on Facebook or at least a few meaningful ones are the most important part of their social experience. There's a lot of data, sociological data outside, that shows that a physical group membership in the world off the Internet has been declining for decades. So I think that building groups is - it obviously cannot replace people getting together in person, and a lot of the most successful groups are successful because they facilitate people going and doing things together in person as well. But we think that this is a real human need and a sociological need and it's an important thing that people need to do. And I think it's going to be one of the next big areas that I'm really excited about the Facebook uptick. It's worth pointing out here that while Instagram doesn't have Groups, we also really focus on community and interest there, more around discovery and hashtags and explore, being able to really delve into your interests and interact with people who are interested in the same things that you are there, even if they're not your friends. So that's going to be an increasing part of that experience too. I think there might have been another question but I - no? All right."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Rich Greenfield from BTIG."
},
{
"speaker": "Richard Greenfield",
"text": "If I think about kind of the San Francisco Valley kind of elitist community and even, I think, a good chunk of Wall Street, there's been this kind of ongoing narrative that nobody uses core Facebook blue anymore and really, time spent is all about Instagram. Your DAU numbers obviously give a good sense that people are touching Facebook still, core Facebook on a regular basis, but we don't really get any sense of engagement with Facebook versus your other apps. Is there anything you can do to give us some color or sense? I mean, you've talked about Marketplace before on the call, but any way of getting a sense of actual usage trends and what you're seeing in terms of core Facebook versus Instagram versus the communications apps, et cetera?"
},
{
"speaker": "David Wehner",
"text": "Rich, it's Dave. Look, I think the DAU trends that we're giving really do paint the picture broadly, which is stability in the developed markets, growth for Facebook blue in the developing markets. We're not giving an update on time spent. That's not our major focus. We pivoted to focus on meaningful social interactions and we've been pleased with the results of that effort broadly, but I think that DAU trends tell the story broadly."
},
{
"speaker": "Operator",
"text": "Your last question comes from the line of John Blackledge from Cowen."
},
{
"speaker": "John Blackledge",
"text": "For Mark, just curious if you're happy with the progress around the safety and security initiatives. And going forward, is there any kind of recurring metric or anything you can disclose to show progress that you guys might see internally but Facebook users and other constituents maybe don't see? And then just a quick one on pricing on Instagram Stories. Should we expect to see the pricing gap close between feed and Stories over the course of 2019?"
},
{
"speaker": "David Wehner",
"text": "John, I can real quickly take the pricing question first. The reality is pricing is a function of supply and demand and how demand grows versus supply. So while I do expect that we'll bring more advertisers to Stories and we'll bring more advertising formats to Stories and that will create more demand for Stories, we're also growing Stories inventory quickly. So those two things will balance out in price. Feed from a growth perspective on an impression front is more constrained given where we are with ad loads on Facebook and Instagram. So there'll be more pricing pressure there because there's already strong demand for feed products. So in terms of convergence, it's hard to say how those things will play out. We do think there's opportunities to improve the value of the Stories format that will translate into better price for Stories. But how it converges over time, there's a lot of different dynamics there."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yes. And on all the content and safety and security issues, there's more to do here but I'm proud of the work that we've done to get in front of a lot more of these issues. If you think about the journey that the company has really been on for the last couple of years, it's moving from reactively dealing with issues that our community flags. Perhaps if someone sees some content that's problematic, they used to tell us about it and then we'd go look at it to now, increasingly, we're building AI systems and we have tens of thousands of people who are doing more proactive review of content that could be potentially problematic. And we're prioritizing the different types of content that we think could create the most harm. So one of the things that we worked on earliest was removing terrorist propaganda. One of the things that we're proud of there is, there are now 99% of the ISIS and Al Qaeda content that we take down, our AI flags it, removes it before people see it. Another area that we really care about that's deeply important is self-harm, right? And that's an area where the goal isn't to take down the content, but if we see an area where - if we see something that a person might be thinking about hurting themselves, we now have thousands of people and technical tools that can flag this content to those people to - so we can actually go get first responders to go reach out to people. And I think in the last six months or a year alone, there have been hundreds, if not thousands, of cases where we're we've been able to get first responders to people when they needed help because of this approach of being more proactive on looking at the content. The same goes for things around election interference and more proactively looking for inauthentic behavior. And we've taken down a lot of effort by different nation states to harm or interfere in elections that way. So we're just going to go down the list of every basic type of bad content. And we do report this publicly, going back to your question. We issue a transparency report. It's our content enforcement report. Right now, we're doing it, I think it's every six months, but the goal is to get that to the cadence by, I think it's the end of this year, we're going to be doing it quarterly and doing calls to discuss the results just like we do for earnings because we think that this stuff is really important as well, at the same level there. So where I come to summarize where I think we are, coming into 2019 is, 2017 and 2018 were really - we had a lot of hard work to do, but we also needed to figure out what the road map was going to be going forward. And while we haven't solved all of the issues yet - you never solve all of the issues, but we certainly have a lot more to do on our road map. The way that I feel starting 2019 is that we have clear road maps for what we need to go do. And I think you're going to be able to look at these transparency reports as we issue them and see that we're continually making more progress, finding more of the content proactively, taking - getting better at taking it down, getting better at not distributing stuff that's borderline. And that's just some of the most important work that we're doing. It's also the first priority again for this year, is making - continuing to make progress on the big, substantive issues facing the Internet and our company because there's still a lot more to do here, and this is incredibly important. But I do feel like we've started to turn a corner and have a clear plan for what we need to do here now. So thanks for that question."
},
{
"speaker": "Deborah Crawford",
"text": "Great. Thank you. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines."
}
] | null | null |
META | 3 | 2,018 | 2018-10-30 17:00:00 | Executives: Deborah Crawford - Facebook, Inc. Mark Elliot Zuckerberg - Facebook, Inc. Sheryl Kara Sandberg - Facebook, Inc. David M. Wehner - Facebook, Inc.
Analysts: Douglas T. Anmuth - JPMorgan Securities LLC Eric J. Sheridan - UBS Securities LLC Brian Nowak - Morgan Stanley & Co. LLC Justin Post - Bank of America Merrill Lynch Ross Sandler - Barclays Capital, Inc. Lloyd Walmsley - Deutsche Bank Securities, Inc. Brent Thill - Jefferies LLC Mark A. May - Citigroup Global Markets, Inc. Anthony DiClemente - Evercore Group LLC Heather Bellini - Goldman Sachs & Co. LLC Ralph Edward Schackart - William Blair & Co. LLC
Operator: Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook third quarter 2018 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin.
Deborah Crawford - Facebook, Inc.: Thank you. Good afternoon, and welcome to Facebook's third quarter 2018 earnings conference call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our Quarterly Report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I'd like to turn the call over to Mark.
Mark Elliot Zuckerberg - Facebook, Inc.: Thanks, Deborah, and thank you all for joining us today. We had a solid quarter, and our community and business continue to grow quickly. 2.3 billion people now use Facebook every month, and 1.5 billion every day. Revenue grew 33% year over year to $13.7 billion. Last quarter, for the first time, we also shared the number of people who use at least one of our apps each month. We believe this is a better way to measure our community over time because so many people use more than one of our apps. There are now more than 2.6 billion people using Facebook, WhatsApp, Instagram or Messenger each month, up from around 2.5 billion last quarter. But now, on average, more than 2 billion people use at least one of our services every day. Today, I want to talk about our strategy overall as we navigate challenges and opportunities on several fronts. For one, we're seeing the way people connect shifting to private messaging and stories. We have great products here that people love, but it will take some time for our business to catch up to our community growth. Two, we're seeing video grow dramatically across the ecosystem. And while Watch is now growing very quickly, we're well behind YouTube and still working to make this a unique people-centric experience. Three, we continue to face increased safety and security threats. We've significantly improved our systems here, but we have more to do. So let's start with messaging and stories. Public sharing will always be very important, but people increasingly want to share privately too, and that includes both just smaller audiences with messaging and ephemerally with stories. People feel more comfortable being themselves when they know their content will only be seen by a smaller group and when their content won't stick around forever. Messaging and stories make up the vast majority of growth in the sharing that we're seeing. On messaging specifically, we think we've built the best messaging apps in the world. People now send around 100 billion messages each day using our services that even our second most popular service, Messenger, has a higher daily message volume than SMS had globally at its peak. And this isn't just text. People share more photos, videos and links on WhatsApp and Messenger than they do on social networks. We are leading in most countries, but our biggest competitor by far is iMessage. And in important countries like the U.S., where the iPhone is strong, Apple bundled iMessage as a default texting app and it's still ahead. In countries where there's more competition between iOS and Android, like much of Europe, people tend to prefer our services. Now, it's worth noting that one of the main reasons people prefer our services, especially WhatsApp, is because of its stronger record on privacy. WhatsApp is completely end-to-end encrypted, does not store your messages and doesn't store the keys to your messages in China or anywhere else. And this is important because if our systems can't see your messages, then that means that governments and bad actors won't be able to access them through us either. Our roadmap focuses on continuing to make WhatsApp and Messenger even simpler, faster and adding basic utility features like payments. We found that every time we make our services faster and simpler, people communicate more. We'll also keep pushing our messaging services to be more private and secure, and we believe this will continue to be a competitive advantage for us. On the business side of messaging, our first step has been to enable people to connect with businesses organically in ways they find useful, and then the second step is to give businesses additional paid tools to increase those interactions. We're well into step one at this point, with more than 3 million accounts on WhatsApp Business. We'll begin step two with a couple of products, paid messaging and ads in Stories. And by making businesses pay to send messages, we believe it will make them more selective with what they send. Payments will make each of these services more useful for people and businesses, even though we don't plan to profit from it directly. I'll update with more progress on each of these efforts in the next few quarters. On Stories, we are even better-positioned. People now share more than 1 billion stories every day. We lead in almost every country. There are a couple of reasons we've focused on building Stories in all of our apps. First, I just think that this is the future. People want to share in ways that don't stick around permanently, and I want to make sure that we fully embrace this. Second, Stories is a medium like feeds that can feel very different in very different contexts. So just like most major social apps have feeds, including Pinterest, Twitter, or LinkedIn, but you wouldn't say that those services do the same things, I think many services will have Stories in the future too, but will serve different functions. Now, while this effort is going well, we're also working through a couple of challenges here. One is that while WhatsApp Status and Instagram Stories immediately took off and have been huge successes, Facebook Stories started off slower. It's now growing quickly and I think we'll be in a better position soon, but our effort to shift Facebook from News Feed first to Stories first hasn't been as smooth as I had hoped. But this is important for the Facebook community long term. Another challenge is that we're earlier in developing our ads products for Stories, so we don't make as much money from them yet as we do from feed ads. We're following our normal playbook here of building out the best consumer products first and focusing on succeeding there before ramping up ads. I'm optimistic that we'll get ads in Stories to perform as well as feed over time, and that the opportunity will be even bigger because it looks like Stories will be a bigger medium than feed has been. But I want to be up front that even assuming that we get to where we want to go from a feed-only world to a feed plus Stories world, it will take some time and our revenue growth may be slower during that period like it was while transitioning our products to mobile. Now, talking about messaging and Stories raises the question of what's the future of our feed product and the Facebook app overall. On feed specifically, people continue to use them heavily and we don't expect that to decrease. From a business perspective, feeds will drive the majority of our growth over the next couple of years, at least until Stories become an even bigger driver. On the Facebook app overall, what we see is that we are generally stable, although we may be close to saturated in developed countries while we continue to grow quickly in developing countries. For a few years, we saw a trend where people's time was increasing primarily because they were consuming more video and public content, even as they interacted with friends and family less. But people were telling us what they wanted was to interact with people more. So we didn't think that this trend was sustainable. We've made a number of changes this year to focus the product on meaningful social interactions, and those generally seem to be working. That means the trends in how people are interacting have improved, even though we've purposefully reduced time spent on things like lower-quality viral videos and news to achieve this. While there's a lot to do to improve News Feed, our roadmap for the Facebook app is very focused on a few priorities: Stories, which we've discussed; video, which I'll get to in a moment; and a much bigger focus on communities and groups. If the last 10 years have been about friends and family, then the next 10 years will be about your communities as well. When we say communities, we mean both helping people connect with people who share their interests, which is a major need in people's lives, and also building out specific services for bringing people closer together, like helping you find someone to date, or find a job, or buy and sell things, or grow your small business, or create an event, or start fundraisers, or bring together a group to volunteer. A lot of these services are growing quickly. Hundreds of millions of people now belong to meaningful communities that are a central part of their social support structure. Marketplace is now used by 800 million people and is emerging as one of the most popular places to buy vehicles online. On jobs, our new tool has helped people find more than 1 million jobs. On fundraisers, in the last year we've helped people raise more than $300 million for charities on their birthdays alone. And I'm looking forward to rolling out dating across the world soon too. These are services that generally benefit from having everyone you know connected on a single platform. And while people may not spend as much time on some of these tools as they do in News Feed, these are very high-value activities for our community. Now, we're seeing a similar dynamic in Instagram, where there's still a lot to improve in feed, but we're increasingly focused on other experiences as well. But in Instagram, instead of focusing on communities, we're very focused on helping you explore your interests. So this will take the form of IGTV, which I'll discuss more in a minute, plus new shopping experiences and really building out Explore. These areas have huge potential for serving our community and a lot of potential for businesses as well. For example, Explore is already about 20% of the time that people spend in Instagram. But unlike feed, we haven't built any ads experience for it yet, so that's an opportunity. Now, I want to discuss what we're seeing with video specifically, since it's such an important and growing area. Our efforts here have grown, but we've had challenges reconciling all this passive video consumption with what people uniquely want from us, which is meaningful social interaction. Video has grown a lot on our services, but as I mentioned earlier, we hit a dynamic where when it grows in feeds in Facebook and Instagram, it displaces some social interactions, and people tell us it makes the experience less valuable even though they're spending more time on it. So the solution to this has been building separate video experiences outside of our feeds with Watch on Facebook and IGTV on Instagram. And what we found is that when people seek out video experiences intentionally, they don't displace social interactions as much, and the quality of the experience is generally higher. We've also been able to build experiences that help creators build communities around their content, which fits our mission and our focus to encourage meaningful interactions. At this point, Watch has really hit its stride and it's growing incredibly quickly, about 3x in the last few months in the U.S. alone. IGTV is still earlier in its development, but I think we have a good sense of how to make it work as well. To be clear, these services are still well behind YouTube, which is our primary competitor in this space, but they're growing very quickly. Now, that said, beyond the mission challenges of video displacing social interactions, there is also a business challenge, which is that video monetizes significantly less well per minute than people interacting in feeds. So this means that even though we've made video more community-oriented and minimized displacement of social interactions, as video grows, it will still displace some other services where we'd probably make more money. From a mission and a business perspective, though, we still believe this is the right thing to do. Video is a critical part of the future. It's what our community wants as long as we can make it social, and I think will end up being a large part of our business as well. All right, next I want to talk about safety and security. So let me start by saying that last month, we had a serious security issue. Our teams did well to find and close the vulnerability quickly, but we have a long road ahead to prevent these kinds of attacks in the future. Over the last couple years, though, we've done a lot of work and made a lot of progress. We still have at least a year before our systems are at the level that we want, but they're getting better every day, and that's both technology and people. Our systems for proactively identifying harmful content are improving. Our systems for detecting interference in elections are a lot more mature now. The upcoming elections will be a real test of the protections we've put in place. With a community of more than 2 billion people, we will see all the good and bad that humanity can do. And we will never be perfect, but I'm proud of the work that we're doing here. We've reduced the incentives to spread misinformation. We're partnering more closely with governments and outside experts to improve security, including here in the U.S. And we set a new standard for transparency in advertising. This quarter alone, we've found and taken down foreign influence campaigns from Russia and Iran attempting to interfere in the U.S., UK, Middle East, and elsewhere, as well as groups in Brazil that have been active in their own country. We still have a lot of work to do in all of these areas that I've talked about. News Feed continues to be very important. We're building the best messaging and stories and community tools in the world. Our video services are getting better and growing quickly, and we still have a lot of work to do on safety. And we're also heavily investing in AR and VR, as well as hardware for bringing people closer together, like Portal for video presence and Oculus Quest, the all-in-one VR experience that delivers rift like quality with no wires attached. So with all of this ahead, I expect 2019 to be another year of significant investment. Dave will say more about this in a moment, but I want you to know that looking out beyond 2019, I know that we need to make sure our costs and revenue are better matched over time; and that's something that I'm focused on as well. So, overall, this has been an important year. It's been a tough year, but we've built products that I'm proud of and we've made a lot of progress on some of our hardest issues. As always, I appreciate your support. And thank you for being a part of this journey with us. And now, here is Sheryl.
Sheryl Kara Sandberg - Facebook, Inc.: Hi, everyone. It was another good quarter for our business, with ad revenue up 33% year over year. Our growth was broad-based across regions, marketer segments and verticals. Mobile ad revenue grew 40% to $12.5 billion, making up approximately 92% of our total ad revenue. Since Facebook launched its first ad products, we've been in the business of growing our clients' businesses, from the largest brands in the world, to the entrepreneur in her living room. Over 90 million businesses rely on Facebook pages to reach potential customers for free. In a global survey, half of small businesses with a presence on Facebook said that they are hiring because of growth they're able to achieve through our platform. More than 6 million advertisers are active across Facebook, Instagram and our other services. With more than 2 billion people using at least one of our services every day, we're the best place for these advertisers to show people ads that work. We know that our continued growth depends upon maintaining the trust of the people who use our services and earning our clients' business each and every day in a very competitive environment. Every time I meet with clients, I tell them that we want to be the best minute and the best dollar, euro or peso they spend. As we look ahead to 2019 and beyond, we're focused on continuing to build our clients' businesses and ours by helping advertisers reach consumers where they are and making ads better. First, helping advertisers connect with people where they are. Consumers often adopt new technologies before businesses do. Our competitive advantage is helping advertisers close that gap. We've done this before on desktop, mobile and News Feed. In the early days, we helped businesses deliver personalized marketing at scale on desktop. With the shift to mobile, we've helped companies large and small build their mobile presence. Now, we're doing it again with stories, messaging, Marketplace and Watch. Today, the primary way advertisers are reaching people on our services is through Facebook News Feed and Instagram Feed. Feed ads on Facebook and Instagram represent the majority of our revenue growth and the majority of opportunities for marketers to generate ROI. Quarter after quarter, we make improvements that help advertisers use feed ads to launch new products, find new customers, build awareness and increase sales, all in a highly efficient way. We're always working to enable more marketers to achieve their goals through mobile feed, and we see continued opportunity here going forward. At the same time, as Mark mentioned, more and more consumers are using stories and private messaging in addition to the time they spend in News Feed and Instagram Feed. Because our services share a common platform, advertisers can use the same tools to buy across all our ad services. Building on the strength of ads and Instagram Stories, we rolled out ads in Facebook Stories in Q3 and announced plans to introduce ads in WhatsApp Status next year. We know it's not enough to make a new format available. We also need to make it easy for advertisers to optimize their campaigns. In Q3, we improved how ads from News Feed look in Stories. This is important for advertisers like Pandora, which uses Facebook and Instagram to reach potential listeners. Previously, they would buy Instagram Story ad separately and develop unique creative each time. Now, with automatic placements, our technology converts their horizontal video and captions from Facebook into a design that looks native to the vertical Instagram Stories format. For Pandora, this resulted in a 10% lower cost per view than their stand-alone campaigns simply by checking a box in our ad tool. When it comes to messaging, we have an opportunity to help people and businesses connect in ways that are valuable for both. On Messenger, over 10 billion messages are sent between people and businesses every month. It's still early, but we're exploring how we can help advertisers reach people in Messenger through sponsored messages and inbox ads. For WhatsApp, we're growing our business ecosystem starting with the WhatsApp Business model app on Android. In August, we launched the WhatsApp Business API to help larger companies send useful information such as boarding passes or delivery confirmations. This paid messaging model will ensure that companies are selective about what they send and don't clutter people's chats. As always, people will be able to block any business they want with one tap. As we build the business on WhatsApp, we're determined to maintain the simple private user experience that people love. That's also true for Marketplace and Watch. Last year, we started allowing advertisers to extend their News Feed ads to Marketplace, helping businesses reach people where they already shop. In Q3, we expanded Marketplace ads to nearly 70 marketers. It's early days, but advertisers are seeing good results. With Facebook Watch, we've been working closely with advertisers to better fit their current planning and buying process for video. In Q3, we introduced a way for advertisers to buy video placements from a selection of the most engaging publishers, choose specific content categories they want their ads to play alongside, and pay only for ads that are watched to the end. Again, it's still early, but we're pleased with advertiser interest and results so far. We have a big opportunity to help our large and growing advertiser base expand to new platforms and formats to reach potential customers. Our service makes it possible for every business to access the same tools as the largest brands. We start by making it simple for small businesses to transition from using our consumer apps to using our business tools, and then we make it easy to run more sophisticated campaigns. This has been true every step of our journey so far, from online to mobile and now for messaging and stories. In the future, this will include opportunities with the new VR/AR platforms that we're creating as well. We're also focused on making ads better. One of the top things people tell us about our ads is that they want them to be relevant. We create value for people when we show ads they are likely to find useful, for advertisers when we deliver ads to the right audience, and for our own business by performing this match effectively. Our business model is and always has been to connect people and businesses with relevant marketing messages without sharing people's personal information. Protecting people's privacy is incredibly important because people and businesses will only use our services if they feel Facebook can be trusted and if sharing on our platform is safe. That's why we're making significant ongoing investments to better protect privacy and security. In Q3, we completed the shutdown of partner categories and tightened our standards for Custom Audiences. These changes help protect peoples' privacy and ensure that advertisers have more oversight of the information they use for advertising. We also continue to invest heavily in technology and people to remove bad content as quickly as possible and prevent it from going up in the first place, while giving advertisers more control over where their ads are placed. This quarter, we added more tools for advertisers to see where their ads might appear in Audience Network, Instant Articles and instream placements like Watch. They can block their ads from running in videos or articles from certain publishers or categories of content and review all of their placements at the end of each campaign. Making ads better also means increasing efficiency for advertisers. In Q3, we expanded campaign budget optimization so advertisers of all sizes can now set a single budget, and our system automatically finds the best opportunities across each of those segments. Improvements like this one add up and help businesses maximize the value they're gaining from our products over time. This is critical for small businesses that don't have large advertising budgets or expertise, and it's an important way we support economic growth and job creation around the world. As we wrap up the year, I want to thank our clients for their partnership and their continued feedback which helps us improve. And I also want to thank our teams at Facebook for helping these businesses reach their customers and grow. And now, here is Dave.
David M. Wehner - Facebook, Inc.: Thanks, Sheryl, and good afternoon, everyone. Let's start with our community metrics. Daily active users on Facebook reached 1.49 billion, up 9% compared to last year, led by growth in India, Indonesia and the Philippines. This number represents approximately 66% of the 2.27 billion monthly active users in Q3. MAUs were up 199 million or 10% compared to last year. Note that our Q3 2018 community metrics reflect an update to our calculation methodology. This resulted in the removal of the small percentage of accounts or approximately 15 million DAU and 9 million MAU worldwide. This change will modestly impact our year-over-year user growth rates until we lap it next year. Further details are included in the earnings slides on our IR website. Turning now to the financials, all comparisons are on a year-over-year basis, unless otherwise noted. Q3 revenue was $13.7 billion, up 33% or 34% on a constant currency basis. Had foreign exchange rates remained constant compared to last year, Q3 total revenue would have been $159 million higher. Q3 total ad revenue was $13.5 billion, up 33% or 35% on a constant currency basis. In terms of regional ad growth, Asia Pacific was strongest at 38%, followed by Europe and North America at 34% and 33%, respectively. Rest of world ad growth trailed at 26% due to both currency weakness and economic challenges in Latin America. Mobile ad revenue was $12.5 billion, up 40%, and represented approximately 92% of total ad revenue. In Q3, the average price per ad increased 7% and the number of ad impressions served across our services increased 25%, driven primarily by feed ads on Instagram and Facebook. Our impression growth in Q3 came primarily from product surfaces and geographies that monetize at relatively lower rates. For example, ads in Instagram Stories contributed to our impression growth this quarter, although these ads currently monetize at lower rates compared to feed ads. Payments and other fees revenue was $188 million, up 1%. Turning now to expenses. Total expenses were $7.9 billion, up 53%. We ended Q3 with approximately 33,600 full-time employees. That's up 45%. The majority of our new hires in the past year have been in technical functions. Operating income was $5.8 billion, representing a 42% operating margin. Our Q3 tax rate was 13%. This was lower than we expected because we did not take the one-time charge that we anticipated due to the Ninth Circuit Court withdrawing its decision in the Altera case. Net income was $5.1 billion or $1.76 per share. Capital expenditures were $3.3 billion, driven by investments in data centers, servers, network infrastructure and office facilities. In Q3, we generated $4.2 billion in free cash flow and ended the quarter with approximately $41.2 billion in cash and investments. In the third quarter, we bought back approximately $4.3 billion of our Class A common stock. Turning now to the revenue outlook, in Q4, we expect that our total revenue growth rate will decelerate by a mid to high single-digit percentage compared to our Q3 total revenue growth rate. Several factors are contributing to this deceleration. First, we expect more of our impression growth to continue to come from product services and geographies that monetize at lower rates. Second, we are seeing some impact from data privacy initiatives on pricing growth. And third, as we focus more of our product efforts on the growth of Stories, its more prominent placement on Facebook will displace some ad impression opportunities. Turning now to the expense outlook, we anticipate our full-year 2018 total expenses will grow approximately 50% to 55% versus our prior range of 50% to 60%. We anticipate that full-year 2018 capital expenditures will be approximately $14 billion to $14.5 billion compared to our prior estimate of $15 billion. Turning to tax, at current stock prices, we expect that our Q4 tax rate will be in the mid-teens. As a reminder, fluctuations in our stock price will impact our tax rate. I'd also like to share our initial outlook on 2019 operating expenses and CapEx. As Mark mentioned, we plan to continue to invest aggressively across the business and expect that full-year 2019 total expenses will grow 40% to 50% compared to full-year 2018. We also expect that full-year 2019 capital expenditures will be approximately $18 billion to $20 billion, driven by a continuation of our data center build strategy that seeks to put in place adequate capacity ahead of our needs. We anticipate that our full-year 2019 tax rate will be in the mid-teens. The third quarter marked a period of both solid revenue growth across the globe and heavy investment as we make progress on our mission to bring the world closer together. We are confident in our ability to improve the products that our community loves as well as to provide innovative new experiences in the near and long-term. And with that, Mike, let's open up the call for questions.
Operator: We will now open the lines for a question-and-answer session. Your first question comes from the line of Doug Anmuth from JPMorgan.
Douglas T. Anmuth - JPMorgan Securities LLC: Thanks for taking the questions. I just wanted to ask two. First for Mark, I was just hoping you could talk a little bit more about some of the challenges that you see for Stories within Facebook relative to their stronger adoption in Instagram and for WhatsApp Status. And then also, what if Stories don't gain traction on Facebook over time here? How do you think about that for the platform as well? And then, secondly, for Dave, just on OpEx for 2019, the 40% to 50% growth, should we think about that as still the same buckets of spend that you've been talking about over the last year or so, and does their prioritization change at all for next year? Thanks.
Mark Elliot Zuckerberg - Facebook, Inc.: Sure, so I can take the first part. I think a lot of this is really basic. When I say that we got started slower on Facebook, that starts with literally rolling out on Facebook a number of months after we had rolled out on either WhatsApp or Instagram. And then the initial version of what we shipped I just think wasn't as high-quality as where it needed to be. It wasn't as fast. There were bugs. And we've been working on dialing that in. I'm less worried at this point about it not working because we're starting to see it really take off. Certainly, with different groups of people, it's stronger on Instagram or WhatsApp or Facebook, but across all three at this point, it's growing. And as I said in my opening remarks, I think we're going to be a lot better positioned here in Facebook in the next year.
David M. Wehner - Facebook, Inc.: Hey, Doug. It's Dave. Just on the 2019 expense growth guide, a lot of that is consistent with what we've been talking about as our big investment areas. If you look at just head count growth in the past year, it's up 45%. So that compensation expense base that we're bringing into 2019 is really factoring into the overall growth guidance for the total expense guide, so that's a big factor there. In addition, we've been investing significantly in CapEx, and those investments are starting to flow through the P&L in terms of depreciation. And then I'd point to significant investment areas like AR/VR efforts, the content ecosystem around video, and the ongoing investment in safety and security.
Operator: Your next question comes from the line of Eric Sheridan from UBS.
Eric J. Sheridan - UBS Securities LLC: Thank you so much, maybe one for Sheryl. When you think about some of the friction points you're trying to solve for on either the creative side or the selling-through side with respect to video and Stories, maybe you could call out some of the conversations you're having with advertisers and how you see some of the moves Facebook can make to solve for those friction points looking out to 2019 and beyond. Thanks so much.
Sheryl Kara Sandberg - Facebook, Inc.: Thanks for the question. We have a very large and growing advertiser base, and that gives us we think a really strong position to get people into new formats. When you do that, a couple of things really matter. One is that the format of an ad really has to match the format of the consumer experience. So the right ad in News Feed is different than the right ad in an Instagram or a Facebook story is different than the right ad in Watch, which would be video-only. And so making these new formats of ads is actually hard for people and expensive. And so we're working hard on tools to make the formats easier, and I talked about one of those examples before. What's nice is that the same targeting, the same measurement systems really work. Because we are looking to show relevant ads to the right person at the right time, the systems we have that understand in a privacy-protected way what ads people are likely to be more interested in, those work, whether you're in Stories or Watch or Instagram Feed or News Feed. And the other thing is that our systems for measuring the effectiveness of ads, which help advertisers get all the way through to their ROI, which help them bid in our system, also work. And so we take the advertiser base, we take the systems we have for targeting and measuring ads, and then we help advertisers move to the new format. And I think that's the process we're on.
Operator: Your next question comes from the line of Brian Nowak from Morgan Stanley.
Brian Nowak - Morgan Stanley & Co. LLC: Thanks for taking my questions. I have two. The first one, last quarter, Dave, you made some comments about a multiyear margin outlook, and I appreciate the comment this quarter about engagement in the feed, et cetera. I was just curious when you thought about that margin outlook, how do you think about the one or two key drivers of News Feed monetization over the next few years, given you expect to be flat overall engagement? And then secondly on Watch, I'm wondering, Mark. Could you just talk about the key one to two steps you need to sort of clear in order to drive higher Watch and video engagement to sort of catch up with some of the competitors? Thanks.
David M. Wehner - Facebook, Inc.: Hey, Brian. It's Dave. In terms of what we're seeing as opportunities, I mean, we continue to see good growth opportunities for revenue across both Facebook and Instagram, including both feed and Stories. I think in terms of impression growth, you're going to have more opportunities in Stories, probably more opportunity on Instagram, but good revenue growth opportunities in both places. So that's obviously what we're looking for when we look forward. Beyond that, I don't have much to update on in terms of any more specific revenue outlook.
Mark Elliot Zuckerberg - Facebook, Inc.: And to the video questions, the biggest thing that we need to do is make sure that the video experience is people-centric and that we're helping creators build community and we're helping people interact with each other. Our journey with video has been a little bit funny, in that people really want to watch a lot of video. And to a large degree, we've had to limit its growth and we had to do the things so we can stop limiting it. The things that have caused us to limit it are, on the one hand, when we see passive consumption of video displacing social interactions, that's not something that we've wanted because we feel like that's what Facebook is. We build social products that help people interact. There are lots of places in the world that you can go to consume content, but we're the Internet service that people use to help connect with other people and we're not going to let passive consumption get in the way of that. So we needed to figure out a way so that video can grow, but people can also keep on interacting doing what they tell us that they uniquely want from Facebook. And now, I think we're starting to work through what the formula is going to be so we can take some of those rate limits off and let video grow at the rate it wants to. And I think that's a very exciting opportunity ahead, and that's one of the reasons that I'm very optimistic about the Watch growth that we've started to see recently up about 3x in the last few months in the U.S. alone.
Operator: Your next question comes from the line of Justin Post from Bank of America Merrill Lynch.
Justin Post - Bank of America Merrill Lynch: Thank you. Mark, first, on Facebook engagement. There are some questions about usage. And when you look at the engagement, do you see it stable? I think you mentioned that earlier. And does that include some of the changes you've made on video earlier in the year? And then, secondly, some usage may be moving over to Instagram. When you look at Facebook plus Instagram, how do you feel about how that usage is trending? Thank you.
Mark Elliot Zuckerberg - Facebook, Inc.: Sure. So I mean across the whole family of apps, I mean all of this engagement is growing quickly and we're very happy with how we're enabling people to share. As I said, the vast majority or the majority of the growth that we're seeing in sharing is coming from private messaging and story sharing. So that's kind of the big thing. The basic story that we've seen within the Facebook app is, over the last few years, the amount of time that people were spending in the app was increasing primarily because people were consuming more public content, like passive video consumption and news. But it was coming at the expense of people interacting with each other as much. So interactions were down. And we got a lot of feedback from people saying that's not what they wanted. We don't think that that's what we're uniquely here to do. It's not the mission of the company. So we felt like that was not sustainable. So we've made a lot of shift this year, which I've talked a lot about on a bunch of these calls, to encourage more meaningful social interactions instead. And we have seen that those changes have improved the trajectory of how people are interacting. Now, at the same time that we have intentionally reduced time spent on certain things, like lower-quality viral videos, some news, some passive content, but that's what I was talking about before when I said that now the trend – and you can kind of look at it in developed markets and developing. In developed markets, it is stable and we feel like we're pretty close to saturation in a lot of countries, like the U.S. And in developing countries, where a lot of people are still getting on the Internet, it continues to grow at a fast rate. And we think that there's a lot more connecting in community that people want there. So that's kind of what we're seeing overall. Across the whole family, I would say it's very positive. On Facebook overall, I feel like we have a handle on what the drivers of this are and we're kind of driving it to be what people tell us they want and what we think is going to be sustainable over time. That's the picture that we have.
Operator: Your next question comes from the line of Ross Sandler from Barclays.
Ross Sandler - Barclays Capital, Inc.: Great. Two questions. Dave, you mentioned 4Q revenue is going to have a mid to high-single digit deceleration. That's a tad better than what you stated 90 days ago. So just I know it's a small change, but I think folks on the line are looking for anything incremental in terms of what you're seeing. Has anything improved? And then, any initial read on what kind of deceleration we can expect to see in 2019, if at all, as you start turning on the ads on WhatsApp? And then, one for Sheryl. The shopping experience on Instagram, how do you compare, I guess, just the overall commercial intent on Instagram compared to Facebook? And what do you think that says about the long-term monetization potential for Instagram versus Facebook?
David M. Wehner - Facebook, Inc.: All right. Ross, I'll start off on that. I think the outlook that we're giving for Q4 deceleration is broadly consistent with the outlook that I gave last quarter with the benefit of a little bit more visibility. I'd just reiterate the points that I'd made in the earnings script around what's driving that deceleration. And as far as to how that plays into 2019, we're not providing a specific revenue outlook for 2019. We continue to see good growth opportunities across the platform on both Facebook and Instagram and feed and Stories. Those are going to be the drivers. I would characterize the launch of Status apps on WhatsApp as being a much smaller thing than a driver of 2019 revenue growth, and it's going to be more about Instagram and Facebook. The same factors that I discussed impacting Q4 growth will likely continue to play out to some extent in 2019, but we've got a lot of good growth opportunities for next year.
Sheryl Kara Sandberg - Facebook, Inc.: When you look at the Instagram Shopping experience, we're seeing some really nice growth. We have 90 million people tap to reveal product tags and posts every month to learn more about them, and we're putting real investments behind this. In Q3, we rolled out Shopping in Stories globally and began testing the Shopping Channel in Explore. And so, we think the opportunities are big. As you think about commercial intent in Facebook versus Instagram, there's so much activity on both. We think there's a lot of opportunity for people to have commercial intent, if not have it when they start, but develop it because they see things they're interested in, in both. Instagram can be more interest-based in some places than Facebook. So there are places in Instagram like Fashion or like Shopping that have very high signal, and that gives us I think a very strong opportunity there.
Operator: Your next question comes from the line of Lloyd Walmsley from Deutsche Bank.
Lloyd Walmsley - Deutsche Bank Securities, Inc.: Thank you. Two questions, if I can. First, just, Mark, your comments in prepared remarks on Stories having potential to be a bigger medium than News Feed suggests that the engagement is a net positive in terms of time spent or sessions per user. Is that the right way to interpret that as you see people engage in this they actually spend more time overall? And then, second question for Dave. Last quarter, you guided to kind of long-term operating margins in the mid-30s range. The guidance on OpEx for next year kind of implies we may already be there. Is that the right interpretation and should we expect it to be kind of stable beyond that based on some of the comments from Mark about recognizing that revenue and costs should be matched over the long-term? Any help you could give there would be great.
Mark Elliot Zuckerberg - Facebook, Inc.: So on Stories, I don't know if we've given any metrics on time spent or anything on that side. But what I can say is that all of the trends that we've seen suggests that in the not too distant future people will be sharing more into Stories than they will into feeds, and that the whole market across all of the Stories type of products will be bigger in a market where people are sharing more moments from their days into Stories-type products than into feed-type products. And this happened very quickly, right? I mean this whole trend is much newer than the trend with News Feed and feeds overall and it continues to grow incredibly quickly. So we just see that there is a lot of upside there. Now, on the flip side, I try to be very careful in my remarks to be clear that this is one of those situations where the community growth that we're seeing is outpacing the progress that we've made so far on developing the ads in that space. And I think we'll get there over time, where the performance for Stories ads will converge with what we have seen in feed. And I think that the opportunity will be bigger because there will be more in Stories – or more Stories overall than in feed. But I can't tell you just yet what that timeframe is going to look like, but I think we're well-positioned over the long-term because we're leading in Stories in basically every country.
David M. Wehner - Facebook, Inc.: And, Lloyd, on the margin question, as I mentioned, 2019 will be a big investment year. So I would expect us to have the biggest change in our margin structure to happen in 2019 and for it to moderate from there. It's hard to be too prescriptive about 2020 and beyond, but I think the biggest change will be 2019.
Operator: Your next question comes from the line of Brent Thill from Jefferies.
Brent Thill - Jefferies LLC: Thanks. Just on Europe, there's been a more pronounced deceleration. Just curious in terms of how you think about the stabilization there going forward in your model and maybe a little more color on the pricing.
David M. Wehner - Facebook, Inc.: Yeah. Hey, Brent. It's Dave. I think, I guess, if you're talking about DAU and MAU, Europe is stable on that front in terms of Facebook overall. The accounting methodology change did affect how Europe sequential growth rate came in, but really stable if you kind of take that aside. And we had some impact from GDPR over the last two quarters. So I think, from that perspective, it is broadly stable for Facebook there. European growth rate I think was healthy from a revenue point of view. So I think we're still seeing good growth in Europe on the revenue front, and a lot of the similar dynamics playing out in Europe as in the rest of the world where you see good impression growth opportunity, especially in areas like Instagram and Stories contributing to overall ability to drive revenue growth.
Operator: Your next question comes from the line of Mark May from Citi.
Mark A. May - Citigroup Global Markets, Inc.: Thanks for taking my questions. You seem confident that Stories will ultimately be a more effective canvas both for users and businesses and maybe even more so than the feed, but you also talked the transitional challenges. What specifically are those challenges? And since Instagram is further along with Stories, are there any things you're seeing with Instagram Stories monetization that gives you line of sight to reaching monetization parity, not only at Instagram, but also at core Facebook eventually? And then maybe just a second one. In addition to Stories, Mark also discussed how private messaging is also a growth use case. In private messaging, the company has, understandably so, been cautious on the monetization side. So just curious if you could discuss how optimistic you are about building a meaningful business around private messaging.
Sheryl Kara Sandberg - Facebook, Inc.: I can take those. When you think about the transition or people using feed versus Stories, there are a couple of things that are different. One is just the format. And again, we have a lot of experience at this. People had display ads or search ads before they really did Facebook ads, if you look back a decade. And teaching people here is what a Facebook ad looks like was a new format people had to understand. Then, as we moved into more photos with Instagram, more videos, a video ad on Facebook or Instagram is a very different thing if they perform well. They need to be natively social than a video ad that runs on TV. So Stories is a new format. It has multiple pictures, multiple screens, words and phrases intermixed in a different way. And so again, that's a new muscle for advertisers. I think we're getting people up the curve well this time. We've learned that we can't just rely on teaching our clients and teaching the ad agencies to do it, but helping them do that. And so some of the tools we've rolled out that I talked about where we can take your Facebook pictures and your posts and make it a story, that makes that process faster. I think when you think about the long-term monetization opportunities, it's really going to depend upon the time people spend. The amount of ads we would feel comfortable inserting into a consumer experience really depends upon how many different things you go through. So if you spend more time in Stories, they'll be need to be more engaging because there will be fewer ads in there. Now that may be possible because there's high, high, high engagement in Stories. So we're going to have to see the length and how quickly people scroll through them to see how many ad opportunities there are and to see how effective those ad opportunities are. Our business depends upon the amount of ads that we can share and the effectiveness of those ads, which drives up ROI and ultimately the price. When you think about messaging, if we've already made the transition in a big way to feed, if we are starting to see real success in Stories, messaging is in a much earlier stage. And what we're doing on Messenger and on WhatsApp are really making sure that businesses can connect with people, and then in the early stages of testing messaging. So we think paid messaging, as we've talked about. And WhatsApp is interesting because by virtue of paying, businesses are going to have to be careful about the content they send. You're not going to send a lot of things people don't want to see if you're paying for them. And so really focused on the consumer experience there and figuring out over time. The last thing I'll say is that I think these things are more connected than people realize, in the sense that we're already seeing some nice traction with click-to-Messenger ads. So one of the things advertisers are trying to do when they're in feed and ultimately when they're in Stories is drive to transactions and real engagement, one-on-one with a consumer is often part of that. So a click-to-Messenger ad takes advantage of having both of those platforms so that businesses can deepen their relationship with the consumer. And I think those experiences and the interaction between them, we're even in earlier days there, but I think we have a lot of opportunity to explore there.
David M. Wehner - Facebook, Inc.: And, Mark, this is Dave. I just wanted to add in. I think you asked about line of sight on monetization parity on Stories versus feed. It's obviously hard to say that because they're both dynamic, they're auctions, there's a lot going on. But I would say that at least in the near term, the impression growth opportunity is significant on Stories. Pricing will take time. So as we bring more formats to Stories and bring more advertisers to Stories, we can build up that demand and balance that out with supply. But I think in terms of it converging on feed from any pricing perspective, that's a journey that's going to take years, not quarters. So it's going to take time.
Operator: Your next question comes from the line of Anthony DiClemente from Evercore.
Anthony DiClemente - Evercore Group LLC: Thank you very much for taking my question. Just really one for Mark, which is, I don't think anyone has asked much about the security investments that Facebook is making. And when I talk to investors, people are curious whether it's one-off or recurring. And so as you think about 2019, the magnitude of the resources that the company plans to deploy to protect privacy, to protect security, it sounds like you're in or will be in, hopefully, a better position to ward off bad actors than you were prior to the 2016 election. But I just wonder. Do you look at this as an endless arms race, or is there some point in this investment where you might be able to get some better efficiencies on those investments, also relative to others in the industry who are making investments that don't seem quite as sizable as Facebook's? Thanks.
Mark Elliot Zuckerberg - Facebook, Inc.: This is a really important question. I do think that we are up against sophisticated adversaries who will continue to evolve. So there is a large element of this, which is an arms race. And when you're talking about security issues and some of the safety and content issues, these are not problems that we fix. They're problems that you manage over time and try to reduce and prevent issues from coming up, but there's no silver bullet where you do the thing and then you're done. That said, I do think that we were quite behind where we needed to be a couple of years ago. We started a roadmap, which we said was going to be about a three-year roadmap. I think that we have some confidence in that timeframe, which takes us through the end of about 2019, to get our systems to the level that we generally think that they should be at, where we're building AI systems that can flag content that might be problematic to a much larger security and review team that can manage the larger volume of stuff that our tools are flagging to them. We're judging our success by, go through all of the categories of harmful content and behavior, whether it's terrorism, or self-harm, or hate speech, or just any different kind of thing that you'd be worried about. We're judging our success by how proactive can we get, so what percent of the stuff that we're taking down are we identifying before other people identify it for us. We've started issuing transparency reports so we can be held publicly accountable on this. What we see internally is that generally every week and every quarter that goes by, we're getting better and better at this. But I anticipate that it will be about the end of next year when we feel like we're as dialed in as we would generally all like us to be. And even at that point, we're not going to be perfect because more than 2 billion people are communicating on the service. There are going to be things that our systems miss, no matter how well-tuned we are. But I think we're making progress. We've made a lot of progress in the last couple of years on content overall. Elections are a special case, an extremely important special case of the content and safety issues and security issues that we face. But across all of the different types of content issues of people trying to spread hate or incite violence. We are making progress, and I feel good about the progress that we're making. And I think we will continue investing more. But I do think that to some degree the last few years and next year are probably going to be the biggest growth in the investment in the security efforts that we'll see.
Operator: Your next question comes from the line of Heather Bellini from Goldman Sachs.
Heather Bellini - Goldman Sachs & Co. LLC: Great. Thank you. I just had two questions and I guess maybe you just touched on some of this, Mark. But the CapEx growth that you guys gave for next year, how far ahead should we think about you guys building out capacity? And can you help us think about the ongoing trend, in particular in light of your comments that you just made about how you'll feel about being more dialed in at the end of 2019? But how do we think about kind of that continued growth and CapEx number? And is there anything there that's a one-time item? And I guess the other question would just be related to Stories. And I guess, I'm just wondering, I know it's early days in terms of advertisers putting ad units in there at this point. But given that you've got the technology that converts to creative and kind of help people with that process of how to do a good Stories ad, how effective do you think that's been in terms of helping to drive their adoption of this ad unit thus far?
David M. Wehner - Facebook, Inc.: Heather, I'll take the first question regarding CapEx. So, yeah, we are investing ahead of user growth, given the long lead time in deploying data centers and network capacity. So we are building some capacity ahead of our immediate needs. So that is playing into it. But we're also making investments to support the core growth of the business. There's a lot of compute that goes behind, things like feed ranking and ads ranking. We think there is good ROI to putting more servers behind things like choosing the right ad for the right impression opportunity that we have. So we are putting more compute behind that. And then, I'd also make the comment that a lot of our growth is coming from markets in Asia, our top growth countries were India, Indonesia and the Philippines. So we're building capacity to serve that Asian peak and those users are at a lower ARPU. So that impacts the overall capital intensity. So we're continuing to invest and we're seeing increased CapEx in 2019, albeit at a much slower growth rate than we had in 2018.
Sheryl Kara Sandberg - Facebook, Inc.: I'll talk about Stories and I'll share a fun and, I think, important example. We know that when people are using more of the opportunities to reach consumers, their returns often go up. So the fun example is the Furbo Dog Camera. They're a Taiwanese company. They built this camera where you can see/talk and you can see and talk and toss dog treats to your dog when you're not at home. They ran a video ad campaign across Facebook and Instagram Stories and they targeted people with dog-related interests and used Custom Audiences to exclude people who had already purchased their product. By running across Facebook Stories and Instagram Stories, they drove 20% more leads than our other digital campaigns. So anecdotally, with our early, early adopters, we can see that we believe the increased opportunities here really work, and we have other examples like this. In terms of how early it is for adoption, it's super early. We just rolled out the ability to do this in August, and we have to drive awareness and drive people into trying it. And even when we make it super easy for people to get their ads into the right format, from the smallest mom-and-pop to the largest brands, people want to understand the creative of their ad and it needs to be in a format they feel comfortable. So as more people use Stories, we think they will increasingly feel comfortable in Stories. But we have a long road ahead of us even with tools that make it easy to drive awareness and adoption. We think once we do, the returns will be good.
Deborah Crawford - Facebook, Inc.: Operator, we are going to take one last question.
Operator: Your last question comes from the line of Ralph Schackart from William Blair.
Ralph Edward Schackart - William Blair & Co. LLC: Good afternoon. Maybe switching gears to feed, you talked about it being a major growth driver and a lot of opportunities for improvement. Can you maybe share some perspective on what those opportunities look like from both a user, as well as an advertiser? And then also, maybe just more longer-term, how can feed continue to be a strong growth driver? Thanks.
Sheryl Kara Sandberg - Facebook, Inc.: I can take that. When you think about feed, what people are doing is sharing. They're sharing in Instagram and Facebook. And that means there's, in many ways, almost limitless opportunity for consumers to do more. I think we've made some strong changes on Facebook in terms of meaningful social interactions, and I think the history of our ability to develop and iterate on consumer products shows that we can help people as they evolve, share the things they want to share, and have a very meaningful and important experience in feed as they're sharing. Feed is fundamentally about information being pushed to a consumer and us helping figure out what is most interesting and most engaging and I think, in many ways, positive for people. And I think the product teams, led by Mark, have done a great job of that over time and you're seeing the continued investment there. Along with that, goes the advertising opportunities. As there are more Stories and feed, as more people are engaged in Facebook and increasingly in Instagram, that gives us more opportunities just on the supply side of ads. On the demand side, all of the things we do to get more advertisers active in our system, means we'll have more ads to choose from, to make those ads more relevant, to measure the ROI of those ads so that people can then iterate and, again, make those more relevant. I think we've made real improvements there, but I think there's a lot more we can do. And one of the ways I talk to people about it is just ask what percentage of the ads do you see in your feed are as good as the very best posts you see from friends. And I think most people will honestly say that certainly compared to a few years ago, those ads are much more relevant to them, but not all of them. And you can see in that example, even in your own feed, the opportunities we have to improve, finding the right ad and giving it to the right person at the right time, which drives businesses all around the world and drives our business as well.
Deborah Crawford - Facebook, Inc.: Great. Thank you for joining us today. We appreciate your time. And we look forward to speaking with you again.
Operator: Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines. | [
{
"speaker": "Executives",
"text": "Deborah Crawford - Facebook, Inc. Mark Elliot Zuckerberg - Facebook, Inc. Sheryl Kara Sandberg - Facebook, Inc. David M. Wehner - Facebook, Inc."
},
{
"speaker": "Analysts",
"text": "Douglas T. Anmuth - JPMorgan Securities LLC Eric J. Sheridan - UBS Securities LLC Brian Nowak - Morgan Stanley & Co. LLC Justin Post - Bank of America Merrill Lynch Ross Sandler - Barclays Capital, Inc. Lloyd Walmsley - Deutsche Bank Securities, Inc. Brent Thill - Jefferies LLC Mark A. May - Citigroup Global Markets, Inc. Anthony DiClemente - Evercore Group LLC Heather Bellini - Goldman Sachs & Co. LLC Ralph Edward Schackart - William Blair & Co. LLC"
},
{
"speaker": "Operator",
"text": "Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook third quarter 2018 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford - Facebook, Inc.",
"text": "Thank you. Good afternoon, and welcome to Facebook's third quarter 2018 earnings conference call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our Quarterly Report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I'd like to turn the call over to Mark."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Thanks, Deborah, and thank you all for joining us today. We had a solid quarter, and our community and business continue to grow quickly. 2.3 billion people now use Facebook every month, and 1.5 billion every day. Revenue grew 33% year over year to $13.7 billion. Last quarter, for the first time, we also shared the number of people who use at least one of our apps each month. We believe this is a better way to measure our community over time because so many people use more than one of our apps. There are now more than 2.6 billion people using Facebook, WhatsApp, Instagram or Messenger each month, up from around 2.5 billion last quarter. But now, on average, more than 2 billion people use at least one of our services every day. Today, I want to talk about our strategy overall as we navigate challenges and opportunities on several fronts. For one, we're seeing the way people connect shifting to private messaging and stories. We have great products here that people love, but it will take some time for our business to catch up to our community growth. Two, we're seeing video grow dramatically across the ecosystem. And while Watch is now growing very quickly, we're well behind YouTube and still working to make this a unique people-centric experience. Three, we continue to face increased safety and security threats. We've significantly improved our systems here, but we have more to do. So let's start with messaging and stories. Public sharing will always be very important, but people increasingly want to share privately too, and that includes both just smaller audiences with messaging and ephemerally with stories. People feel more comfortable being themselves when they know their content will only be seen by a smaller group and when their content won't stick around forever. Messaging and stories make up the vast majority of growth in the sharing that we're seeing. On messaging specifically, we think we've built the best messaging apps in the world. People now send around 100 billion messages each day using our services that even our second most popular service, Messenger, has a higher daily message volume than SMS had globally at its peak. And this isn't just text. People share more photos, videos and links on WhatsApp and Messenger than they do on social networks. We are leading in most countries, but our biggest competitor by far is iMessage. And in important countries like the U.S., where the iPhone is strong, Apple bundled iMessage as a default texting app and it's still ahead. In countries where there's more competition between iOS and Android, like much of Europe, people tend to prefer our services. Now, it's worth noting that one of the main reasons people prefer our services, especially WhatsApp, is because of its stronger record on privacy. WhatsApp is completely end-to-end encrypted, does not store your messages and doesn't store the keys to your messages in China or anywhere else. And this is important because if our systems can't see your messages, then that means that governments and bad actors won't be able to access them through us either. Our roadmap focuses on continuing to make WhatsApp and Messenger even simpler, faster and adding basic utility features like payments. We found that every time we make our services faster and simpler, people communicate more. We'll also keep pushing our messaging services to be more private and secure, and we believe this will continue to be a competitive advantage for us. On the business side of messaging, our first step has been to enable people to connect with businesses organically in ways they find useful, and then the second step is to give businesses additional paid tools to increase those interactions. We're well into step one at this point, with more than 3 million accounts on WhatsApp Business. We'll begin step two with a couple of products, paid messaging and ads in Stories. And by making businesses pay to send messages, we believe it will make them more selective with what they send. Payments will make each of these services more useful for people and businesses, even though we don't plan to profit from it directly. I'll update with more progress on each of these efforts in the next few quarters. On Stories, we are even better-positioned. People now share more than 1 billion stories every day. We lead in almost every country. There are a couple of reasons we've focused on building Stories in all of our apps. First, I just think that this is the future. People want to share in ways that don't stick around permanently, and I want to make sure that we fully embrace this. Second, Stories is a medium like feeds that can feel very different in very different contexts. So just like most major social apps have feeds, including Pinterest, Twitter, or LinkedIn, but you wouldn't say that those services do the same things, I think many services will have Stories in the future too, but will serve different functions. Now, while this effort is going well, we're also working through a couple of challenges here. One is that while WhatsApp Status and Instagram Stories immediately took off and have been huge successes, Facebook Stories started off slower. It's now growing quickly and I think we'll be in a better position soon, but our effort to shift Facebook from News Feed first to Stories first hasn't been as smooth as I had hoped. But this is important for the Facebook community long term. Another challenge is that we're earlier in developing our ads products for Stories, so we don't make as much money from them yet as we do from feed ads. We're following our normal playbook here of building out the best consumer products first and focusing on succeeding there before ramping up ads. I'm optimistic that we'll get ads in Stories to perform as well as feed over time, and that the opportunity will be even bigger because it looks like Stories will be a bigger medium than feed has been. But I want to be up front that even assuming that we get to where we want to go from a feed-only world to a feed plus Stories world, it will take some time and our revenue growth may be slower during that period like it was while transitioning our products to mobile. Now, talking about messaging and Stories raises the question of what's the future of our feed product and the Facebook app overall. On feed specifically, people continue to use them heavily and we don't expect that to decrease. From a business perspective, feeds will drive the majority of our growth over the next couple of years, at least until Stories become an even bigger driver. On the Facebook app overall, what we see is that we are generally stable, although we may be close to saturated in developed countries while we continue to grow quickly in developing countries. For a few years, we saw a trend where people's time was increasing primarily because they were consuming more video and public content, even as they interacted with friends and family less. But people were telling us what they wanted was to interact with people more. So we didn't think that this trend was sustainable. We've made a number of changes this year to focus the product on meaningful social interactions, and those generally seem to be working. That means the trends in how people are interacting have improved, even though we've purposefully reduced time spent on things like lower-quality viral videos and news to achieve this. While there's a lot to do to improve News Feed, our roadmap for the Facebook app is very focused on a few priorities: Stories, which we've discussed; video, which I'll get to in a moment; and a much bigger focus on communities and groups. If the last 10 years have been about friends and family, then the next 10 years will be about your communities as well. When we say communities, we mean both helping people connect with people who share their interests, which is a major need in people's lives, and also building out specific services for bringing people closer together, like helping you find someone to date, or find a job, or buy and sell things, or grow your small business, or create an event, or start fundraisers, or bring together a group to volunteer. A lot of these services are growing quickly. Hundreds of millions of people now belong to meaningful communities that are a central part of their social support structure. Marketplace is now used by 800 million people and is emerging as one of the most popular places to buy vehicles online. On jobs, our new tool has helped people find more than 1 million jobs. On fundraisers, in the last year we've helped people raise more than $300 million for charities on their birthdays alone. And I'm looking forward to rolling out dating across the world soon too. These are services that generally benefit from having everyone you know connected on a single platform. And while people may not spend as much time on some of these tools as they do in News Feed, these are very high-value activities for our community. Now, we're seeing a similar dynamic in Instagram, where there's still a lot to improve in feed, but we're increasingly focused on other experiences as well. But in Instagram, instead of focusing on communities, we're very focused on helping you explore your interests. So this will take the form of IGTV, which I'll discuss more in a minute, plus new shopping experiences and really building out Explore. These areas have huge potential for serving our community and a lot of potential for businesses as well. For example, Explore is already about 20% of the time that people spend in Instagram. But unlike feed, we haven't built any ads experience for it yet, so that's an opportunity. Now, I want to discuss what we're seeing with video specifically, since it's such an important and growing area. Our efforts here have grown, but we've had challenges reconciling all this passive video consumption with what people uniquely want from us, which is meaningful social interaction. Video has grown a lot on our services, but as I mentioned earlier, we hit a dynamic where when it grows in feeds in Facebook and Instagram, it displaces some social interactions, and people tell us it makes the experience less valuable even though they're spending more time on it. So the solution to this has been building separate video experiences outside of our feeds with Watch on Facebook and IGTV on Instagram. And what we found is that when people seek out video experiences intentionally, they don't displace social interactions as much, and the quality of the experience is generally higher. We've also been able to build experiences that help creators build communities around their content, which fits our mission and our focus to encourage meaningful interactions. At this point, Watch has really hit its stride and it's growing incredibly quickly, about 3x in the last few months in the U.S. alone. IGTV is still earlier in its development, but I think we have a good sense of how to make it work as well. To be clear, these services are still well behind YouTube, which is our primary competitor in this space, but they're growing very quickly. Now, that said, beyond the mission challenges of video displacing social interactions, there is also a business challenge, which is that video monetizes significantly less well per minute than people interacting in feeds. So this means that even though we've made video more community-oriented and minimized displacement of social interactions, as video grows, it will still displace some other services where we'd probably make more money. From a mission and a business perspective, though, we still believe this is the right thing to do. Video is a critical part of the future. It's what our community wants as long as we can make it social, and I think will end up being a large part of our business as well. All right, next I want to talk about safety and security. So let me start by saying that last month, we had a serious security issue. Our teams did well to find and close the vulnerability quickly, but we have a long road ahead to prevent these kinds of attacks in the future. Over the last couple years, though, we've done a lot of work and made a lot of progress. We still have at least a year before our systems are at the level that we want, but they're getting better every day, and that's both technology and people. Our systems for proactively identifying harmful content are improving. Our systems for detecting interference in elections are a lot more mature now. The upcoming elections will be a real test of the protections we've put in place. With a community of more than 2 billion people, we will see all the good and bad that humanity can do. And we will never be perfect, but I'm proud of the work that we're doing here. We've reduced the incentives to spread misinformation. We're partnering more closely with governments and outside experts to improve security, including here in the U.S. And we set a new standard for transparency in advertising. This quarter alone, we've found and taken down foreign influence campaigns from Russia and Iran attempting to interfere in the U.S., UK, Middle East, and elsewhere, as well as groups in Brazil that have been active in their own country. We still have a lot of work to do in all of these areas that I've talked about. News Feed continues to be very important. We're building the best messaging and stories and community tools in the world. Our video services are getting better and growing quickly, and we still have a lot of work to do on safety. And we're also heavily investing in AR and VR, as well as hardware for bringing people closer together, like Portal for video presence and Oculus Quest, the all-in-one VR experience that delivers rift like quality with no wires attached. So with all of this ahead, I expect 2019 to be another year of significant investment. Dave will say more about this in a moment, but I want you to know that looking out beyond 2019, I know that we need to make sure our costs and revenue are better matched over time; and that's something that I'm focused on as well. So, overall, this has been an important year. It's been a tough year, but we've built products that I'm proud of and we've made a lot of progress on some of our hardest issues. As always, I appreciate your support. And thank you for being a part of this journey with us. And now, here is Sheryl."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "Hi, everyone. It was another good quarter for our business, with ad revenue up 33% year over year. Our growth was broad-based across regions, marketer segments and verticals. Mobile ad revenue grew 40% to $12.5 billion, making up approximately 92% of our total ad revenue. Since Facebook launched its first ad products, we've been in the business of growing our clients' businesses, from the largest brands in the world, to the entrepreneur in her living room. Over 90 million businesses rely on Facebook pages to reach potential customers for free. In a global survey, half of small businesses with a presence on Facebook said that they are hiring because of growth they're able to achieve through our platform. More than 6 million advertisers are active across Facebook, Instagram and our other services. With more than 2 billion people using at least one of our services every day, we're the best place for these advertisers to show people ads that work. We know that our continued growth depends upon maintaining the trust of the people who use our services and earning our clients' business each and every day in a very competitive environment. Every time I meet with clients, I tell them that we want to be the best minute and the best dollar, euro or peso they spend. As we look ahead to 2019 and beyond, we're focused on continuing to build our clients' businesses and ours by helping advertisers reach consumers where they are and making ads better. First, helping advertisers connect with people where they are. Consumers often adopt new technologies before businesses do. Our competitive advantage is helping advertisers close that gap. We've done this before on desktop, mobile and News Feed. In the early days, we helped businesses deliver personalized marketing at scale on desktop. With the shift to mobile, we've helped companies large and small build their mobile presence. Now, we're doing it again with stories, messaging, Marketplace and Watch. Today, the primary way advertisers are reaching people on our services is through Facebook News Feed and Instagram Feed. Feed ads on Facebook and Instagram represent the majority of our revenue growth and the majority of opportunities for marketers to generate ROI. Quarter after quarter, we make improvements that help advertisers use feed ads to launch new products, find new customers, build awareness and increase sales, all in a highly efficient way. We're always working to enable more marketers to achieve their goals through mobile feed, and we see continued opportunity here going forward. At the same time, as Mark mentioned, more and more consumers are using stories and private messaging in addition to the time they spend in News Feed and Instagram Feed. Because our services share a common platform, advertisers can use the same tools to buy across all our ad services. Building on the strength of ads and Instagram Stories, we rolled out ads in Facebook Stories in Q3 and announced plans to introduce ads in WhatsApp Status next year. We know it's not enough to make a new format available. We also need to make it easy for advertisers to optimize their campaigns. In Q3, we improved how ads from News Feed look in Stories. This is important for advertisers like Pandora, which uses Facebook and Instagram to reach potential listeners. Previously, they would buy Instagram Story ad separately and develop unique creative each time. Now, with automatic placements, our technology converts their horizontal video and captions from Facebook into a design that looks native to the vertical Instagram Stories format. For Pandora, this resulted in a 10% lower cost per view than their stand-alone campaigns simply by checking a box in our ad tool. When it comes to messaging, we have an opportunity to help people and businesses connect in ways that are valuable for both. On Messenger, over 10 billion messages are sent between people and businesses every month. It's still early, but we're exploring how we can help advertisers reach people in Messenger through sponsored messages and inbox ads. For WhatsApp, we're growing our business ecosystem starting with the WhatsApp Business model app on Android. In August, we launched the WhatsApp Business API to help larger companies send useful information such as boarding passes or delivery confirmations. This paid messaging model will ensure that companies are selective about what they send and don't clutter people's chats. As always, people will be able to block any business they want with one tap. As we build the business on WhatsApp, we're determined to maintain the simple private user experience that people love. That's also true for Marketplace and Watch. Last year, we started allowing advertisers to extend their News Feed ads to Marketplace, helping businesses reach people where they already shop. In Q3, we expanded Marketplace ads to nearly 70 marketers. It's early days, but advertisers are seeing good results. With Facebook Watch, we've been working closely with advertisers to better fit their current planning and buying process for video. In Q3, we introduced a way for advertisers to buy video placements from a selection of the most engaging publishers, choose specific content categories they want their ads to play alongside, and pay only for ads that are watched to the end. Again, it's still early, but we're pleased with advertiser interest and results so far. We have a big opportunity to help our large and growing advertiser base expand to new platforms and formats to reach potential customers. Our service makes it possible for every business to access the same tools as the largest brands. We start by making it simple for small businesses to transition from using our consumer apps to using our business tools, and then we make it easy to run more sophisticated campaigns. This has been true every step of our journey so far, from online to mobile and now for messaging and stories. In the future, this will include opportunities with the new VR/AR platforms that we're creating as well. We're also focused on making ads better. One of the top things people tell us about our ads is that they want them to be relevant. We create value for people when we show ads they are likely to find useful, for advertisers when we deliver ads to the right audience, and for our own business by performing this match effectively. Our business model is and always has been to connect people and businesses with relevant marketing messages without sharing people's personal information. Protecting people's privacy is incredibly important because people and businesses will only use our services if they feel Facebook can be trusted and if sharing on our platform is safe. That's why we're making significant ongoing investments to better protect privacy and security. In Q3, we completed the shutdown of partner categories and tightened our standards for Custom Audiences. These changes help protect peoples' privacy and ensure that advertisers have more oversight of the information they use for advertising. We also continue to invest heavily in technology and people to remove bad content as quickly as possible and prevent it from going up in the first place, while giving advertisers more control over where their ads are placed. This quarter, we added more tools for advertisers to see where their ads might appear in Audience Network, Instant Articles and instream placements like Watch. They can block their ads from running in videos or articles from certain publishers or categories of content and review all of their placements at the end of each campaign. Making ads better also means increasing efficiency for advertisers. In Q3, we expanded campaign budget optimization so advertisers of all sizes can now set a single budget, and our system automatically finds the best opportunities across each of those segments. Improvements like this one add up and help businesses maximize the value they're gaining from our products over time. This is critical for small businesses that don't have large advertising budgets or expertise, and it's an important way we support economic growth and job creation around the world. As we wrap up the year, I want to thank our clients for their partnership and their continued feedback which helps us improve. And I also want to thank our teams at Facebook for helping these businesses reach their customers and grow. And now, here is Dave."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Thanks, Sheryl, and good afternoon, everyone. Let's start with our community metrics. Daily active users on Facebook reached 1.49 billion, up 9% compared to last year, led by growth in India, Indonesia and the Philippines. This number represents approximately 66% of the 2.27 billion monthly active users in Q3. MAUs were up 199 million or 10% compared to last year. Note that our Q3 2018 community metrics reflect an update to our calculation methodology. This resulted in the removal of the small percentage of accounts or approximately 15 million DAU and 9 million MAU worldwide. This change will modestly impact our year-over-year user growth rates until we lap it next year. Further details are included in the earnings slides on our IR website. Turning now to the financials, all comparisons are on a year-over-year basis, unless otherwise noted. Q3 revenue was $13.7 billion, up 33% or 34% on a constant currency basis. Had foreign exchange rates remained constant compared to last year, Q3 total revenue would have been $159 million higher. Q3 total ad revenue was $13.5 billion, up 33% or 35% on a constant currency basis. In terms of regional ad growth, Asia Pacific was strongest at 38%, followed by Europe and North America at 34% and 33%, respectively. Rest of world ad growth trailed at 26% due to both currency weakness and economic challenges in Latin America. Mobile ad revenue was $12.5 billion, up 40%, and represented approximately 92% of total ad revenue. In Q3, the average price per ad increased 7% and the number of ad impressions served across our services increased 25%, driven primarily by feed ads on Instagram and Facebook. Our impression growth in Q3 came primarily from product surfaces and geographies that monetize at relatively lower rates. For example, ads in Instagram Stories contributed to our impression growth this quarter, although these ads currently monetize at lower rates compared to feed ads. Payments and other fees revenue was $188 million, up 1%. Turning now to expenses. Total expenses were $7.9 billion, up 53%. We ended Q3 with approximately 33,600 full-time employees. That's up 45%. The majority of our new hires in the past year have been in technical functions. Operating income was $5.8 billion, representing a 42% operating margin. Our Q3 tax rate was 13%. This was lower than we expected because we did not take the one-time charge that we anticipated due to the Ninth Circuit Court withdrawing its decision in the Altera case. Net income was $5.1 billion or $1.76 per share. Capital expenditures were $3.3 billion, driven by investments in data centers, servers, network infrastructure and office facilities. In Q3, we generated $4.2 billion in free cash flow and ended the quarter with approximately $41.2 billion in cash and investments. In the third quarter, we bought back approximately $4.3 billion of our Class A common stock. Turning now to the revenue outlook, in Q4, we expect that our total revenue growth rate will decelerate by a mid to high single-digit percentage compared to our Q3 total revenue growth rate. Several factors are contributing to this deceleration. First, we expect more of our impression growth to continue to come from product services and geographies that monetize at lower rates. Second, we are seeing some impact from data privacy initiatives on pricing growth. And third, as we focus more of our product efforts on the growth of Stories, its more prominent placement on Facebook will displace some ad impression opportunities. Turning now to the expense outlook, we anticipate our full-year 2018 total expenses will grow approximately 50% to 55% versus our prior range of 50% to 60%. We anticipate that full-year 2018 capital expenditures will be approximately $14 billion to $14.5 billion compared to our prior estimate of $15 billion. Turning to tax, at current stock prices, we expect that our Q4 tax rate will be in the mid-teens. As a reminder, fluctuations in our stock price will impact our tax rate. I'd also like to share our initial outlook on 2019 operating expenses and CapEx. As Mark mentioned, we plan to continue to invest aggressively across the business and expect that full-year 2019 total expenses will grow 40% to 50% compared to full-year 2018. We also expect that full-year 2019 capital expenditures will be approximately $18 billion to $20 billion, driven by a continuation of our data center build strategy that seeks to put in place adequate capacity ahead of our needs. We anticipate that our full-year 2019 tax rate will be in the mid-teens. The third quarter marked a period of both solid revenue growth across the globe and heavy investment as we make progress on our mission to bring the world closer together. We are confident in our ability to improve the products that our community loves as well as to provide innovative new experiences in the near and long-term. And with that, Mike, let's open up the call for questions."
},
{
"speaker": "Operator",
"text": "We will now open the lines for a question-and-answer session. Your first question comes from the line of Doug Anmuth from JPMorgan."
},
{
"speaker": "Douglas T. Anmuth - JPMorgan Securities LLC",
"text": "Thanks for taking the questions. I just wanted to ask two. First for Mark, I was just hoping you could talk a little bit more about some of the challenges that you see for Stories within Facebook relative to their stronger adoption in Instagram and for WhatsApp Status. And then also, what if Stories don't gain traction on Facebook over time here? How do you think about that for the platform as well? And then, secondly, for Dave, just on OpEx for 2019, the 40% to 50% growth, should we think about that as still the same buckets of spend that you've been talking about over the last year or so, and does their prioritization change at all for next year? Thanks."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Sure, so I can take the first part. I think a lot of this is really basic. When I say that we got started slower on Facebook, that starts with literally rolling out on Facebook a number of months after we had rolled out on either WhatsApp or Instagram. And then the initial version of what we shipped I just think wasn't as high-quality as where it needed to be. It wasn't as fast. There were bugs. And we've been working on dialing that in. I'm less worried at this point about it not working because we're starting to see it really take off. Certainly, with different groups of people, it's stronger on Instagram or WhatsApp or Facebook, but across all three at this point, it's growing. And as I said in my opening remarks, I think we're going to be a lot better positioned here in Facebook in the next year."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Hey, Doug. It's Dave. Just on the 2019 expense growth guide, a lot of that is consistent with what we've been talking about as our big investment areas. If you look at just head count growth in the past year, it's up 45%. So that compensation expense base that we're bringing into 2019 is really factoring into the overall growth guidance for the total expense guide, so that's a big factor there. In addition, we've been investing significantly in CapEx, and those investments are starting to flow through the P&L in terms of depreciation. And then I'd point to significant investment areas like AR/VR efforts, the content ecosystem around video, and the ongoing investment in safety and security."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Eric Sheridan from UBS."
},
{
"speaker": "Eric J. Sheridan - UBS Securities LLC",
"text": "Thank you so much, maybe one for Sheryl. When you think about some of the friction points you're trying to solve for on either the creative side or the selling-through side with respect to video and Stories, maybe you could call out some of the conversations you're having with advertisers and how you see some of the moves Facebook can make to solve for those friction points looking out to 2019 and beyond. Thanks so much."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "Thanks for the question. We have a very large and growing advertiser base, and that gives us we think a really strong position to get people into new formats. When you do that, a couple of things really matter. One is that the format of an ad really has to match the format of the consumer experience. So the right ad in News Feed is different than the right ad in an Instagram or a Facebook story is different than the right ad in Watch, which would be video-only. And so making these new formats of ads is actually hard for people and expensive. And so we're working hard on tools to make the formats easier, and I talked about one of those examples before. What's nice is that the same targeting, the same measurement systems really work. Because we are looking to show relevant ads to the right person at the right time, the systems we have that understand in a privacy-protected way what ads people are likely to be more interested in, those work, whether you're in Stories or Watch or Instagram Feed or News Feed. And the other thing is that our systems for measuring the effectiveness of ads, which help advertisers get all the way through to their ROI, which help them bid in our system, also work. And so we take the advertiser base, we take the systems we have for targeting and measuring ads, and then we help advertisers move to the new format. And I think that's the process we're on."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Brian Nowak from Morgan Stanley."
},
{
"speaker": "Brian Nowak - Morgan Stanley & Co. LLC",
"text": "Thanks for taking my questions. I have two. The first one, last quarter, Dave, you made some comments about a multiyear margin outlook, and I appreciate the comment this quarter about engagement in the feed, et cetera. I was just curious when you thought about that margin outlook, how do you think about the one or two key drivers of News Feed monetization over the next few years, given you expect to be flat overall engagement? And then secondly on Watch, I'm wondering, Mark. Could you just talk about the key one to two steps you need to sort of clear in order to drive higher Watch and video engagement to sort of catch up with some of the competitors? Thanks."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Hey, Brian. It's Dave. In terms of what we're seeing as opportunities, I mean, we continue to see good growth opportunities for revenue across both Facebook and Instagram, including both feed and Stories. I think in terms of impression growth, you're going to have more opportunities in Stories, probably more opportunity on Instagram, but good revenue growth opportunities in both places. So that's obviously what we're looking for when we look forward. Beyond that, I don't have much to update on in terms of any more specific revenue outlook."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "And to the video questions, the biggest thing that we need to do is make sure that the video experience is people-centric and that we're helping creators build community and we're helping people interact with each other. Our journey with video has been a little bit funny, in that people really want to watch a lot of video. And to a large degree, we've had to limit its growth and we had to do the things so we can stop limiting it. The things that have caused us to limit it are, on the one hand, when we see passive consumption of video displacing social interactions, that's not something that we've wanted because we feel like that's what Facebook is. We build social products that help people interact. There are lots of places in the world that you can go to consume content, but we're the Internet service that people use to help connect with other people and we're not going to let passive consumption get in the way of that. So we needed to figure out a way so that video can grow, but people can also keep on interacting doing what they tell us that they uniquely want from Facebook. And now, I think we're starting to work through what the formula is going to be so we can take some of those rate limits off and let video grow at the rate it wants to. And I think that's a very exciting opportunity ahead, and that's one of the reasons that I'm very optimistic about the Watch growth that we've started to see recently up about 3x in the last few months in the U.S. alone."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Justin Post from Bank of America Merrill Lynch."
},
{
"speaker": "Justin Post - Bank of America Merrill Lynch",
"text": "Thank you. Mark, first, on Facebook engagement. There are some questions about usage. And when you look at the engagement, do you see it stable? I think you mentioned that earlier. And does that include some of the changes you've made on video earlier in the year? And then, secondly, some usage may be moving over to Instagram. When you look at Facebook plus Instagram, how do you feel about how that usage is trending? Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Sure. So I mean across the whole family of apps, I mean all of this engagement is growing quickly and we're very happy with how we're enabling people to share. As I said, the vast majority or the majority of the growth that we're seeing in sharing is coming from private messaging and story sharing. So that's kind of the big thing. The basic story that we've seen within the Facebook app is, over the last few years, the amount of time that people were spending in the app was increasing primarily because people were consuming more public content, like passive video consumption and news. But it was coming at the expense of people interacting with each other as much. So interactions were down. And we got a lot of feedback from people saying that's not what they wanted. We don't think that that's what we're uniquely here to do. It's not the mission of the company. So we felt like that was not sustainable. So we've made a lot of shift this year, which I've talked a lot about on a bunch of these calls, to encourage more meaningful social interactions instead. And we have seen that those changes have improved the trajectory of how people are interacting. Now, at the same time that we have intentionally reduced time spent on certain things, like lower-quality viral videos, some news, some passive content, but that's what I was talking about before when I said that now the trend – and you can kind of look at it in developed markets and developing. In developed markets, it is stable and we feel like we're pretty close to saturation in a lot of countries, like the U.S. And in developing countries, where a lot of people are still getting on the Internet, it continues to grow at a fast rate. And we think that there's a lot more connecting in community that people want there. So that's kind of what we're seeing overall. Across the whole family, I would say it's very positive. On Facebook overall, I feel like we have a handle on what the drivers of this are and we're kind of driving it to be what people tell us they want and what we think is going to be sustainable over time. That's the picture that we have."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ross Sandler from Barclays."
},
{
"speaker": "Ross Sandler - Barclays Capital, Inc.",
"text": "Great. Two questions. Dave, you mentioned 4Q revenue is going to have a mid to high-single digit deceleration. That's a tad better than what you stated 90 days ago. So just I know it's a small change, but I think folks on the line are looking for anything incremental in terms of what you're seeing. Has anything improved? And then, any initial read on what kind of deceleration we can expect to see in 2019, if at all, as you start turning on the ads on WhatsApp? And then, one for Sheryl. The shopping experience on Instagram, how do you compare, I guess, just the overall commercial intent on Instagram compared to Facebook? And what do you think that says about the long-term monetization potential for Instagram versus Facebook?"
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "All right. Ross, I'll start off on that. I think the outlook that we're giving for Q4 deceleration is broadly consistent with the outlook that I gave last quarter with the benefit of a little bit more visibility. I'd just reiterate the points that I'd made in the earnings script around what's driving that deceleration. And as far as to how that plays into 2019, we're not providing a specific revenue outlook for 2019. We continue to see good growth opportunities across the platform on both Facebook and Instagram and feed and Stories. Those are going to be the drivers. I would characterize the launch of Status apps on WhatsApp as being a much smaller thing than a driver of 2019 revenue growth, and it's going to be more about Instagram and Facebook. The same factors that I discussed impacting Q4 growth will likely continue to play out to some extent in 2019, but we've got a lot of good growth opportunities for next year."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "When you look at the Instagram Shopping experience, we're seeing some really nice growth. We have 90 million people tap to reveal product tags and posts every month to learn more about them, and we're putting real investments behind this. In Q3, we rolled out Shopping in Stories globally and began testing the Shopping Channel in Explore. And so, we think the opportunities are big. As you think about commercial intent in Facebook versus Instagram, there's so much activity on both. We think there's a lot of opportunity for people to have commercial intent, if not have it when they start, but develop it because they see things they're interested in, in both. Instagram can be more interest-based in some places than Facebook. So there are places in Instagram like Fashion or like Shopping that have very high signal, and that gives us I think a very strong opportunity there."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Lloyd Walmsley from Deutsche Bank."
},
{
"speaker": "Lloyd Walmsley - Deutsche Bank Securities, Inc.",
"text": "Thank you. Two questions, if I can. First, just, Mark, your comments in prepared remarks on Stories having potential to be a bigger medium than News Feed suggests that the engagement is a net positive in terms of time spent or sessions per user. Is that the right way to interpret that as you see people engage in this they actually spend more time overall? And then, second question for Dave. Last quarter, you guided to kind of long-term operating margins in the mid-30s range. The guidance on OpEx for next year kind of implies we may already be there. Is that the right interpretation and should we expect it to be kind of stable beyond that based on some of the comments from Mark about recognizing that revenue and costs should be matched over the long-term? Any help you could give there would be great."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "So on Stories, I don't know if we've given any metrics on time spent or anything on that side. But what I can say is that all of the trends that we've seen suggests that in the not too distant future people will be sharing more into Stories than they will into feeds, and that the whole market across all of the Stories type of products will be bigger in a market where people are sharing more moments from their days into Stories-type products than into feed-type products. And this happened very quickly, right? I mean this whole trend is much newer than the trend with News Feed and feeds overall and it continues to grow incredibly quickly. So we just see that there is a lot of upside there. Now, on the flip side, I try to be very careful in my remarks to be clear that this is one of those situations where the community growth that we're seeing is outpacing the progress that we've made so far on developing the ads in that space. And I think we'll get there over time, where the performance for Stories ads will converge with what we have seen in feed. And I think that the opportunity will be bigger because there will be more in Stories – or more Stories overall than in feed. But I can't tell you just yet what that timeframe is going to look like, but I think we're well-positioned over the long-term because we're leading in Stories in basically every country."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "And, Lloyd, on the margin question, as I mentioned, 2019 will be a big investment year. So I would expect us to have the biggest change in our margin structure to happen in 2019 and for it to moderate from there. It's hard to be too prescriptive about 2020 and beyond, but I think the biggest change will be 2019."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Brent Thill from Jefferies."
},
{
"speaker": "Brent Thill - Jefferies LLC",
"text": "Thanks. Just on Europe, there's been a more pronounced deceleration. Just curious in terms of how you think about the stabilization there going forward in your model and maybe a little more color on the pricing."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Yeah. Hey, Brent. It's Dave. I think, I guess, if you're talking about DAU and MAU, Europe is stable on that front in terms of Facebook overall. The accounting methodology change did affect how Europe sequential growth rate came in, but really stable if you kind of take that aside. And we had some impact from GDPR over the last two quarters. So I think, from that perspective, it is broadly stable for Facebook there. European growth rate I think was healthy from a revenue point of view. So I think we're still seeing good growth in Europe on the revenue front, and a lot of the similar dynamics playing out in Europe as in the rest of the world where you see good impression growth opportunity, especially in areas like Instagram and Stories contributing to overall ability to drive revenue growth."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Mark May from Citi."
},
{
"speaker": "Mark A. May - Citigroup Global Markets, Inc.",
"text": "Thanks for taking my questions. You seem confident that Stories will ultimately be a more effective canvas both for users and businesses and maybe even more so than the feed, but you also talked the transitional challenges. What specifically are those challenges? And since Instagram is further along with Stories, are there any things you're seeing with Instagram Stories monetization that gives you line of sight to reaching monetization parity, not only at Instagram, but also at core Facebook eventually? And then maybe just a second one. In addition to Stories, Mark also discussed how private messaging is also a growth use case. In private messaging, the company has, understandably so, been cautious on the monetization side. So just curious if you could discuss how optimistic you are about building a meaningful business around private messaging."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "I can take those. When you think about the transition or people using feed versus Stories, there are a couple of things that are different. One is just the format. And again, we have a lot of experience at this. People had display ads or search ads before they really did Facebook ads, if you look back a decade. And teaching people here is what a Facebook ad looks like was a new format people had to understand. Then, as we moved into more photos with Instagram, more videos, a video ad on Facebook or Instagram is a very different thing if they perform well. They need to be natively social than a video ad that runs on TV. So Stories is a new format. It has multiple pictures, multiple screens, words and phrases intermixed in a different way. And so again, that's a new muscle for advertisers. I think we're getting people up the curve well this time. We've learned that we can't just rely on teaching our clients and teaching the ad agencies to do it, but helping them do that. And so some of the tools we've rolled out that I talked about where we can take your Facebook pictures and your posts and make it a story, that makes that process faster. I think when you think about the long-term monetization opportunities, it's really going to depend upon the time people spend. The amount of ads we would feel comfortable inserting into a consumer experience really depends upon how many different things you go through. So if you spend more time in Stories, they'll be need to be more engaging because there will be fewer ads in there. Now that may be possible because there's high, high, high engagement in Stories. So we're going to have to see the length and how quickly people scroll through them to see how many ad opportunities there are and to see how effective those ad opportunities are. Our business depends upon the amount of ads that we can share and the effectiveness of those ads, which drives up ROI and ultimately the price. When you think about messaging, if we've already made the transition in a big way to feed, if we are starting to see real success in Stories, messaging is in a much earlier stage. And what we're doing on Messenger and on WhatsApp are really making sure that businesses can connect with people, and then in the early stages of testing messaging. So we think paid messaging, as we've talked about. And WhatsApp is interesting because by virtue of paying, businesses are going to have to be careful about the content they send. You're not going to send a lot of things people don't want to see if you're paying for them. And so really focused on the consumer experience there and figuring out over time. The last thing I'll say is that I think these things are more connected than people realize, in the sense that we're already seeing some nice traction with click-to-Messenger ads. So one of the things advertisers are trying to do when they're in feed and ultimately when they're in Stories is drive to transactions and real engagement, one-on-one with a consumer is often part of that. So a click-to-Messenger ad takes advantage of having both of those platforms so that businesses can deepen their relationship with the consumer. And I think those experiences and the interaction between them, we're even in earlier days there, but I think we have a lot of opportunity to explore there."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "And, Mark, this is Dave. I just wanted to add in. I think you asked about line of sight on monetization parity on Stories versus feed. It's obviously hard to say that because they're both dynamic, they're auctions, there's a lot going on. But I would say that at least in the near term, the impression growth opportunity is significant on Stories. Pricing will take time. So as we bring more formats to Stories and bring more advertisers to Stories, we can build up that demand and balance that out with supply. But I think in terms of it converging on feed from any pricing perspective, that's a journey that's going to take years, not quarters. So it's going to take time."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Anthony DiClemente from Evercore."
},
{
"speaker": "Anthony DiClemente - Evercore Group LLC",
"text": "Thank you very much for taking my question. Just really one for Mark, which is, I don't think anyone has asked much about the security investments that Facebook is making. And when I talk to investors, people are curious whether it's one-off or recurring. And so as you think about 2019, the magnitude of the resources that the company plans to deploy to protect privacy, to protect security, it sounds like you're in or will be in, hopefully, a better position to ward off bad actors than you were prior to the 2016 election. But I just wonder. Do you look at this as an endless arms race, or is there some point in this investment where you might be able to get some better efficiencies on those investments, also relative to others in the industry who are making investments that don't seem quite as sizable as Facebook's? Thanks."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "This is a really important question. I do think that we are up against sophisticated adversaries who will continue to evolve. So there is a large element of this, which is an arms race. And when you're talking about security issues and some of the safety and content issues, these are not problems that we fix. They're problems that you manage over time and try to reduce and prevent issues from coming up, but there's no silver bullet where you do the thing and then you're done. That said, I do think that we were quite behind where we needed to be a couple of years ago. We started a roadmap, which we said was going to be about a three-year roadmap. I think that we have some confidence in that timeframe, which takes us through the end of about 2019, to get our systems to the level that we generally think that they should be at, where we're building AI systems that can flag content that might be problematic to a much larger security and review team that can manage the larger volume of stuff that our tools are flagging to them. We're judging our success by, go through all of the categories of harmful content and behavior, whether it's terrorism, or self-harm, or hate speech, or just any different kind of thing that you'd be worried about. We're judging our success by how proactive can we get, so what percent of the stuff that we're taking down are we identifying before other people identify it for us. We've started issuing transparency reports so we can be held publicly accountable on this. What we see internally is that generally every week and every quarter that goes by, we're getting better and better at this. But I anticipate that it will be about the end of next year when we feel like we're as dialed in as we would generally all like us to be. And even at that point, we're not going to be perfect because more than 2 billion people are communicating on the service. There are going to be things that our systems miss, no matter how well-tuned we are. But I think we're making progress. We've made a lot of progress in the last couple of years on content overall. Elections are a special case, an extremely important special case of the content and safety issues and security issues that we face. But across all of the different types of content issues of people trying to spread hate or incite violence. We are making progress, and I feel good about the progress that we're making. And I think we will continue investing more. But I do think that to some degree the last few years and next year are probably going to be the biggest growth in the investment in the security efforts that we'll see."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Heather Bellini from Goldman Sachs."
},
{
"speaker": "Heather Bellini - Goldman Sachs & Co. LLC",
"text": "Great. Thank you. I just had two questions and I guess maybe you just touched on some of this, Mark. But the CapEx growth that you guys gave for next year, how far ahead should we think about you guys building out capacity? And can you help us think about the ongoing trend, in particular in light of your comments that you just made about how you'll feel about being more dialed in at the end of 2019? But how do we think about kind of that continued growth and CapEx number? And is there anything there that's a one-time item? And I guess the other question would just be related to Stories. And I guess, I'm just wondering, I know it's early days in terms of advertisers putting ad units in there at this point. But given that you've got the technology that converts to creative and kind of help people with that process of how to do a good Stories ad, how effective do you think that's been in terms of helping to drive their adoption of this ad unit thus far?"
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Heather, I'll take the first question regarding CapEx. So, yeah, we are investing ahead of user growth, given the long lead time in deploying data centers and network capacity. So we are building some capacity ahead of our immediate needs. So that is playing into it. But we're also making investments to support the core growth of the business. There's a lot of compute that goes behind, things like feed ranking and ads ranking. We think there is good ROI to putting more servers behind things like choosing the right ad for the right impression opportunity that we have. So we are putting more compute behind that. And then, I'd also make the comment that a lot of our growth is coming from markets in Asia, our top growth countries were India, Indonesia and the Philippines. So we're building capacity to serve that Asian peak and those users are at a lower ARPU. So that impacts the overall capital intensity. So we're continuing to invest and we're seeing increased CapEx in 2019, albeit at a much slower growth rate than we had in 2018."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "I'll talk about Stories and I'll share a fun and, I think, important example. We know that when people are using more of the opportunities to reach consumers, their returns often go up. So the fun example is the Furbo Dog Camera. They're a Taiwanese company. They built this camera where you can see/talk and you can see and talk and toss dog treats to your dog when you're not at home. They ran a video ad campaign across Facebook and Instagram Stories and they targeted people with dog-related interests and used Custom Audiences to exclude people who had already purchased their product. By running across Facebook Stories and Instagram Stories, they drove 20% more leads than our other digital campaigns. So anecdotally, with our early, early adopters, we can see that we believe the increased opportunities here really work, and we have other examples like this. In terms of how early it is for adoption, it's super early. We just rolled out the ability to do this in August, and we have to drive awareness and drive people into trying it. And even when we make it super easy for people to get their ads into the right format, from the smallest mom-and-pop to the largest brands, people want to understand the creative of their ad and it needs to be in a format they feel comfortable. So as more people use Stories, we think they will increasingly feel comfortable in Stories. But we have a long road ahead of us even with tools that make it easy to drive awareness and adoption. We think once we do, the returns will be good."
},
{
"speaker": "Deborah Crawford - Facebook, Inc.",
"text": "Operator, we are going to take one last question."
},
{
"speaker": "Operator",
"text": "Your last question comes from the line of Ralph Schackart from William Blair."
},
{
"speaker": "Ralph Edward Schackart - William Blair & Co. LLC",
"text": "Good afternoon. Maybe switching gears to feed, you talked about it being a major growth driver and a lot of opportunities for improvement. Can you maybe share some perspective on what those opportunities look like from both a user, as well as an advertiser? And then also, maybe just more longer-term, how can feed continue to be a strong growth driver? Thanks."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "I can take that. When you think about feed, what people are doing is sharing. They're sharing in Instagram and Facebook. And that means there's, in many ways, almost limitless opportunity for consumers to do more. I think we've made some strong changes on Facebook in terms of meaningful social interactions, and I think the history of our ability to develop and iterate on consumer products shows that we can help people as they evolve, share the things they want to share, and have a very meaningful and important experience in feed as they're sharing. Feed is fundamentally about information being pushed to a consumer and us helping figure out what is most interesting and most engaging and I think, in many ways, positive for people. And I think the product teams, led by Mark, have done a great job of that over time and you're seeing the continued investment there. Along with that, goes the advertising opportunities. As there are more Stories and feed, as more people are engaged in Facebook and increasingly in Instagram, that gives us more opportunities just on the supply side of ads. On the demand side, all of the things we do to get more advertisers active in our system, means we'll have more ads to choose from, to make those ads more relevant, to measure the ROI of those ads so that people can then iterate and, again, make those more relevant. I think we've made real improvements there, but I think there's a lot more we can do. And one of the ways I talk to people about it is just ask what percentage of the ads do you see in your feed are as good as the very best posts you see from friends. And I think most people will honestly say that certainly compared to a few years ago, those ads are much more relevant to them, but not all of them. And you can see in that example, even in your own feed, the opportunities we have to improve, finding the right ad and giving it to the right person at the right time, which drives businesses all around the world and drives our business as well."
},
{
"speaker": "Deborah Crawford - Facebook, Inc.",
"text": "Great. Thank you for joining us today. We appreciate your time. And we look forward to speaking with you again."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines."
}
] | null | null |
META | 2 | 2,018 | 2018-07-25 17:00:00 | Executives: Deborah Crawford - Facebook, Inc. Mark Elliot Zuckerberg - Facebook, Inc. Sheryl Kara Sandberg - Facebook, Inc. David M. Wehner - Facebook, Inc.
Analysts: Brian Nowak - Morgan Stanley & Co. LLC Eric J. Sheridan - UBS Securities LLC Ross Sandler - Barclays Capital, Inc. Douglas T. Anmuth - JPMorgan Securities LLC Heather Bellini - Goldman Sachs & Co. LLC Mark Mahaney - RBC Capital Markets LLC John Blackledge - Cowen & Co. LLC Justin Post - Bank of America/Merrill Lynch Mark A. May - Citigroup Global Markets, Inc. Richard Greenfield - BTIG LLC Anthony DiClemente - Evercore Group LLC Peter C. Stabler - Wells Fargo Securities LLC Brent Thill - Jefferies LLC Colin Alan Sebastian - Robert W. Baird & Co., Inc.
Operator: Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook Second Quarter 2018 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin.
Deborah Crawford - Facebook, Inc.: Thank you. Good afternoon and welcome to Facebook second quarter 2018 earnings conference call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our Quarterly Report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I'd like to turn the call over to Mark.
Mark Elliot Zuckerberg - Facebook, Inc.: Thanks, Deborah, and thanks, everyone, for joining us today. We had another solid quarter. Revenue grew 42% year-over-year to $13.2 billion. And Facebook now has more than 2.2 billion monthly active with almost 1.5 billion actives using it every day. For the first time today, we're also releasing how many people use at least one of our apps, Facebook, WhatsApp, Instagram or Messenger, and that's 2.5 billion people each month. This number better reflects our community for a couple of reasons. First, it refers to individual people rather than active accounts, so it excludes when people have multiple active accounts on a single app. And second, it reflects that many people use more than one of our services. And Dave will explain this in a little more detail later. I want to start by talking about all the investments we've made over the last six months to improve safety, security and privacy across our services. This has been a lot of hard work and it's starting to pay off. We recently launched two important ad transparency tools: one to let anyone see the ads any page is running even if the ads aren't targeted to you; and the other an archive of ads with political or issue content that's starting in the U.S. ready for the midterm election. These ads are now labeled so you can clearly see who's paying for them and, within the archives, you can see the budget associated with each ad, how many people saw it, and search all ads with political or issue content that an advertiser has run for up to seven years. This level of transparency will mean increased accountability and responsibility for advertisers globally. Over the next 18 months, there are important elections beyond the U.S. in Brazil, India, and the EU, and these will all be real tests for Facebook. But I'm confident that we will get this right given our results during last year's French and German elections, the Alabama special election, as well as this month's presidential election in Mexico, where our systems found and removed thousands of fake account pages and groups that violated our policies. Of course, security is not a problem that you ever fully solve. We face sophisticated well-funded adversaries who are constantly evolving. But, during each election, we learn and improve too. We're also making progress in the fight against misinformation. We're getting rid of the financial incentives for spammers to create fake news, much of which is economically motivated. We stopped pages that repeatedly spread false information from buying ads. And we also use AI to prevent fake accounts that generate a lot of the problematic content from ever being created in the first place. Our investments in AI mean that we can now remove more bad content quickly because we don't have to wait until after it's reported. It frees our reviewers to work on cases where human expertise is needed to understand the context or nuance of a situation. In Q1, for example, almost 90% of graphic violence content that we removed or added a warning label to was identified using AI. This shift from reactive to proactive detection is a big change, and it will make Facebook safer for everyone. I also want to talk about privacy. GDPR was an important moment for our industry. We did see a decline in monthly actives in Europe, down by about 1 million people as a result. And at the same time, it was encouraging to see the vast majority of people affirm that they want us to use context, including from websites they visit, to make their ads more relevant and improve their overall product experience. Looking ahead, we will continue to invest heavily in security and privacy because we have a responsibility to keep people safe. But, as I've said on past calls, we're investing so much in security that it will significantly impact our profitability. We're starting to see that this quarter. But, in addition to this, we also have a responsibility to keep building services that bring people closer together in new ways as well. Now, in light of increased investment in security, we could choose to decrease our investment in new product areas, but we're not going to, because that wouldn't be the right way to serve our community and because we run this company for the long term not for the next quarter. And Dave will talk about this in a few minutes. Now, perhaps one of the most important things we've done this year to bring people closer together is to shift News Feed to encourage connection with friends and family over passive consumption of content. We've launched multiple changes over the last half to News Feed that encourage more interaction and engagement between people, and we plan to keep launching more like this. Now, of course, connecting isn't limited to News Feed. Now, there are more than 200 million people that are members of meaningful groups on Facebook, and these are communities that, upon joining, they become the most important part of your Facebook experience and a big part of your real world social infrastructure. These are groups for new parents, for people with rare diseases, for volunteering, for military families deployed to a new base and more. We believe there is a community for every one on Facebook. And these meaningful communities often spend online and offline and bring people together in person. We found that every great community has an engaged leader. But running a group can take a lot of time. So we have a road map to make this easier. That will enable more meaningful groups to get formed, which will help us to find relevant ones to recommend to you, and eventually achieve our five-year goal of helping 1 billion people be a part of meaningful communities. Now, since the 1970s, there has been this long decline in people joining physical groups around the world, and that has contributed to a broad feeling of loneliness and isolation. But if we can help 1 billion people be a part of something meaningful, then that can help reverse this trend. Talking about being a part of something meaningful, it's been inspiring to see how people are using our fundraising tools to make a difference. Last month, a campaign to raise $1,500 for undocumented children separated from their families at the border ended up going viral and raising more than $20 million from more than 0.5 million donors all around the world. This quarter, we added the ability for pages to create and donate to fundraisers for causes that they care about too. This quarter, we also reached a milestone with now more than 1 billion actives on Instagram. And this is a moment to reflect on how this acquisition has been an amazing success. When Instagram joined us the team had only 16 people. And since then, Kevin and the team have built Stories, Direct, and now IGTV. This has been a story of great innovation and product execution. And it's also a story of how effective the integration has been. We believe Instagram has been able to use Facebook's infrastructure to grow more than twice as quickly as it would have on its own. So a big congratulations to the Instagram team and to all the teams across our company that have contributed to this success. I'm really excited about video too. And this quarter, we launched IGTV. People are watching less TV, but more video, but most video is not yet optimized for mobile. IGTV will help solve that problem. It's designed specifically for mobile and makes watching long-form vertical video from creators easy. There's a stand-alone IGTV app, but you can also watch within the Instagram app, so that means the entire Instagram community has been able to use it from the start. We're also seeing Watch start to grow more quickly on Facebook too. Our teams are focused on building new experiences that help people connect and start conversation. We recently rolled out Watch Party to all groups, so you can watch and chat with friends at the same time. And we're seeing some real traction with some of the original program, from the talk show Red Table Talk, featuring Jada Pinkett Smith, to Skam, an interactive series that started in Norway and features a new style of storytelling where the characters have accounts on Facebook and Instagram, and key parts of the story are told not just through video, but through posts on their pages. Stories continue to be a big part of the future of sharing too, and they're growing quickly across WhatsApp, Instagram, Facebook and Messenger. While we started off just implementing the basic Stories format, we've now moved well beyond it, and have built lots of new features like polls, questions, and collaborative stories and groups and events. And we're also making progress developing Stories into a great format for ads. We've made the most progress here on Instagram, but this quarter, we started testing Stories ads on Facebook too. The other major trend we're seeing is the shift to more private messaging. There's a lot to build here. We've been testing payments on WhatsApp in India, and it gives people a really simple way to send money to each other and contribute to greater financial inclusion. And of the people who have tested this, feedback and usage have been very strong. All signs point to a lot of people wanting to use this when the government gives us the green light. And in the meantime, we've broadened our focus to building this for other countries so we can give more people this ability faster. Over the next five years, we're focused on building out the business ecosystem around messaging on WhatsApp and Messenger. More broadly, our strategy is to use Facebook's computing infrastructure, business platforms and security systems to serve people across all of our apps. For example, we made the decision a decade ago to build our own data centers, and we opened our first custom-built data center in 2011. Today, we have six data centers around the world, and we're working on building eight more. We're using AI systems in our global community operations team to fight spam, harassment, hate speech, and terrorism across all of our apps to keep people safe. And this is incredibly useful for apps like WhatsApp and Instagram as it helps us manage the challenges of hyper-growth there more effectively. Beyond apps and looking at the next 10 years, we're making a lot of progress with virtual reality. Our goal is to create that feeling of presence like you're right there with people you care about even if you might be halfway around the world. Oculus Go is off to a good start, and at $199, it's going to be how a lot of people experience virtual reality for the first time. Overall, this is a critical year for Facebook. We've made progress preventing abuse, forged ahead with new innovation, and are adapting our services to the new trends of messaging, Stories, videos and groups. As always, thank you for being a part of this journey, and I'm looking forward to making more progress together. And now, here is Sheryl to talk about our business.
Sheryl Kara Sandberg - Facebook, Inc.: Hi, everyone. It was a good second quarter with ad revenue growing 42% year-over-year. Mobile ad revenue was $11.9 billion, a 50% increase year-over-year, making up approximately 91% of total ad revenue. Our growth, again, was broad-based across regions, marketer segments and verticals. We are working to ensure that Facebook is a safe place for people and businesses. We've taken strong steps to address a number of issues, including election integrity, fake news and protecting people's information. One of the most important things we can do to affect change is to increase transparency because transparency leads to greater accountability. For example, when anyone can see any ad on Facebook, advertisers have to stand behind the ads they run. Transparency also allows us to get more input from our community and from experts around the world, so that we can find and fix problems. We wish we could find everything ourselves, but we never will, so we're building tools to make it easier for people to report issues to us. As Mark mentioned, this quarter, we took major steps to make advertising in pages more transparent. Now anyone can see all the ads a page is running across Facebook, Instagram, Messenger and Audience Network. You can also learn more about pages even if they don't advertise. You can see when a page was created and if they've changed their name. For political and issue ads, we're going even further. Advertisers placing ads with political content are now required to verify their identity and location. These ads will be labeled with a disclosure about who paid for them and saved in a searchable archive. The vast majority of ads on Facebook are run by legitimate organizations from small businesses looking for new customers to advocacy groups raising money for their causes. But we've seen that bad actors can misuse our products too, so we're erring on the side of transparency. We're being intentionally broad in our interpretation of political and issue ads. This includes ads for books about politicians and brand campaigns that touch on national issues. Given our commitment to transparency, we think it's important to apply this policy to more ads rather than fewer. These steps are just the start. We'll keep looking for ways to improve, and we hope these tools become standard across the industry. As we make these investments in transparency and accountability, we remain focused on our key priorities: helping businesses leverage the power of mobile, developing innovative ad products, and making our ads more relevant and effective. First: leveraging the power of mobile. For businesses, winning on mobile now means winning on video. Globally, people are creating and watching more video, especially on mobile devices. According to eMarketer, nearly a quarter of the world's population will watch video on a mobile phone this year. We see this trend toward video across all of our apps, from people sharing more video with their friends on Facebook, to watching more video from creators on Instagram, to having more video calls on WhatsApp and Messenger. Marketers are making more video of their own. We're seeing healthy growth in video ads among all advertiser segments. M&M's UK recently used mobile-optimized five-second video ads on Facebook and Instagram to introduce M&M's Mix, a bag of three kinds of M&M's in one. Their campaign worked, driving results not just for their new product but for the brand overall. Their sales increased by over 10% and 80% of that came from households that had not bought M&M's in the previous 26 weeks. Second: developing new ad products. We know that creating video can be more difficult for small businesses that have fewer resources, so we've launched new tools on Facebook to help anyone make videos that work well on mobile. Last quarter, we released Ads Animator, a simple way to create eye-catching video ads using photos and other content that's already on a company's Facebook page. We're also testing Video Creation Kit, which gives advertisers easy-to-use video templates for different marketing objectives. By learning what performs best across our platform, we can help other businesses succeed. We're also making it easier to run ads on Instagram and in Stories. Ads in Stories are an immersive engaging way for people to interact with businesses. When online retailer Overstock wanted to gain new customers and increase furniture sales, they ran video ads in Instagram Stories with a shop now button. They saw an 18% increase in return on ad spend and a 20% decrease in cost per acquisition. This quarter, we made it easier for more advertisers to adopt the Stories format. When an advertiser uploads video in a square or horizontal format for feed, we can automatically transform it into the full-screen vertical format of Stories. Third: making our ads more relevant and effective. We're building new products and improving existing ones to ensure advertisers can reach the right audience. For example, automatic placements help advertisers get better results by showing ads across our platform wherever they'll perform best and at the lowest cost. SumUp, a German payment start-up that helps small businesses accept debit and credit cards, switched from manual to automatic placements and increased sales by 34% in one week. Advertisers of all sizes want to know if their ads are working and how to make them better, but smaller businesses don't always have this capability. We're changing that. Last year, we introduced Test and Learn, a way for advertisers to run variations of their ads and measure the results in just a few steps. We started with tools for direct response advertisers to figure out what drives conversions. In Q2, we added a way for companies to understand the effect of their ads on brand perception. We plan to roll this out to all advertisers, big and small, so they can easily experiment with different strategies and find the ones that work best. As always, I'm grateful to our teams around the world. Their work over the past several months has helped millions of businesses grow and created new levels of transparency in advertising. I'd also like to thank our partners and the businesses of all sizes who turned to us to reach their customers and give us the feedback that helps make us better. Thank you. And now, here's Dave.
David M. Wehner - Facebook, Inc.: Thanks, Sheryl, and good afternoon, everyone. Let's start with our community metrics. Daily active users on Facebook reached 1.47 billion, up 11% compared to last year, led by growth in India, Indonesia and the Philippines. This number represents approximately 66% of the 2.23 billion monthly active users in Q2. MAUs were up 228 million or 11% compared to last year. It's worth noting that MAU and DAU in Europe were both down slightly quarter-over-quarter due to the GDPR roll out, consistent with the outlook we gave on the Q1 call. As Mark mentioned, we're also introducing a family-wide audience metric, 2.5 billion people worldwide used one of our applications in June. This is our best estimate of our de-duplicated audience across Facebook, Instagram, Messenger, and WhatsApp. We believe this number better reflects the size of our community and the fact that many people are using more than one of these services. Note that, for comparison purposes, Facebook MAU does count multiple accounts for a single user when such accounts exist, and we estimate those represent approximately 10% of our Facebook MAU as previously disclosed in the limitation of key metrics section in our SEC filings. The family audience metric only counts a single user in these instances. Turning now to the financials; all comparisons are on a year-over-year basis unless otherwise noted. Q2 total revenue was $13.2 billion, up 42% or 38% on a constant currency basis. Foreign exchange tailwinds contributed approximately $370 million of revenue in Q2. Q2 ad revenue was $13 billion, up 42% or 38% on a constant currency basis. In terms of ad revenue by region, Europe and Asia-Pacific both grew fastest at 47% each and benefited from foreign exchange tailwinds. I'd note that European ad revenue growth decelerated more quickly than other regions and was impacted primarily by reduced currency tailwinds and, to a lesser extent, the roll out of GDPR. Mobile ad revenue was $11.9 billion, up 50%, and represents approximately 91% of ad revenue. In Q2, the average price per ad increased 17% and the number of ad impressions served across our services increased 21%, driven primarily by ads in feed on Instagram and Facebook. Payments and other fees revenue was $193 million, up 23%. Turning now to expenses; total expenses were $7.4 billion, up 50%. We ended Q2 with over 30,000 full-time employees, up 47% compared to last year. Operating income was $5.9 billion, representing a 44% operating margin. Our effective tax rate in the quarter was 13%. Net income was $5.1 billion or $1.74 per share. Capital expenditures were $3.5 billion, driven by investments in data centers, servers, network infrastructure, and office facilities. In Q2, we generated $2.8 billion of free cash flow and ended the quarter with approximately $42 billion in cash and investments. And, in the second quarter, we bought back approximately $3.2 billion of our Class A common stock. Turning now to the revenue outlook; our total revenue growth rate decelerated approximately 7 percentage points in Q2 compared to Q1. Our total revenue growth rates will continue to decelerate in the second half of 2018, and we expect our revenue growth rates to decline by high-single digit percentages from prior quarters sequentially in both Q3 and Q4. There are several factors contributing to that deceleration. For example, we expect currency to be a slight headwind in the second half versus the tailwinds we have experienced over the last several quarters. We plan to grow and promote certain engaging experiences like Stories that currently have lower levels of monetization, and we are also giving people who use our services more choices around data privacy, which may have an impact on our revenue growth. Turning now to expenses; we continue to expect that full-year 2018 total expenses will grow in the range of 50% to 60% compared to last year. In addition to increases in core product development and infrastructure, this growth is driven by increasing investment in areas like safety and security, AR/VR, marketing, and content acquisition. Looking beyond 2018, we anticipate that total expense growth will exceed revenue growth in 2019. Over the next several years, we would anticipate that our operating margins will trend towards the mid-30s on a percentage basis. We expect full-year 2018 capital expenditures will be approximately $15 billion, driven by investments in data centers, servers, network infrastructure, and office facilities. We plan to continue to grow capital expenditures beyond 2018 to support global growth and our ongoing product needs. Turning now to tax; at current stock prices, we expect our full-year 2018 tax rate will be in the mid-teens, but that our Q3 tax rate will be 25% to 30% due to a one-time charge related to a recent court ruling in the IRS versus Altera case. As a reminder, fluctuations in our stock price will impact our tax price. In summary, our community and business growth remain solid. Our financial strength has enabled us to invest heavily to improve our ability to serve our global community through our family of apps as well as to prepare us for the future. With that, operator, let's open up the call for questions.
Operator: Your first question comes from the line of Brian Nowak from Morgan Stanley.
Brian Nowak - Morgan Stanley & Co. LLC: Thanks for taking my questions. Two. Just the first one on monetization of Facebook core versus Instagram; can you talk a little bit about how you think about monetization levels and the key drivers currently and, going forward, when we think about ad load, pricing and the importance of ad improvements across the two platforms over the next, call it, year or so? And the second one on Instagram TV, maybe just talk about how you look at – think about the core consumer offering, how it varies from Facebook Watch and, philosophically, how you think about investing in premium content or sports content across these two products. Thanks.
David M. Wehner - Facebook, Inc.: Brian, I'll take the first one. In terms of Facebook versus Instagram, they're obviously both contributing to revenue growth. Instagram is growing more quickly and making an increasing contribution to growth. And we've been pleased with how Instagram is growing. Facebook and Instagram are really one ads ecosystem. I think, from a supply perspective, both now from a feed perspective are at similar ad loads. Instagram has more heavy usage of Stories, so that's an area of continued growth opportunity because the effective levels of monetization in Stories are lower. On the demand side, we see a good traction across both platforms, and we're rolling out more ability for advertisers to leverage ads in Stories with more formats and the like. So that's, again, an important opportunity for growth is just continuing to build out more products on the demand side for Stories.
Mark Elliot Zuckerberg - Facebook, Inc.: And I can take the second part of the question about the – what we're trying to do with IGTV and Watch at the same time. The IGTV product approach is very focused on helping people connect with creators in a mobile-native vertical video format and helping people not only see content that they love from people that they want to follow, but build a community around those creators, which is what we see people are trying to do. And creators now uniquely have the ability to both reach a large audience and connect and engage the community through the social network on Instagram at the same time. With Watch, a lot of what we're trying to do is make it so the video content that's on Facebook and some of the content that we're acquiring through original programming that people can come together with their friends to watch that content through things like Watch Party and engage and build community that way. So there's a big space here in terms of helping people have real connections and interactions around video. These are two different takes on this. Overall, what you're going to see from us on video is not just try to optimize for overall watch time, but to optimize for building products that help bring people together and help facilitate real interactions between people.
Operator: Your next question comes from the line of Eric Sheridan from UBS.
Eric J. Sheridan - UBS Securities LLC: Thanks for taking the question. Maybe going back to the OpEx and your comments, Dave, looking out sort of medium to longer term, just wanted to understand if we can get a little bit more color on some of the drivers of that. How much of it could be video in support of where you want to take the business over the medium and long term versus things that maybe don't necessarily have a revenue component to them like the security and the protection of the ecosystem that the whole team has been talking about since the end of last year? Thanks so much.
David M. Wehner - Facebook, Inc.: Yeah, Eric, it's going to be a combination of those factors. I would say we're going to continue to invest in core product development and infrastructure. And so, you've seen that already in terms of the ramp that we have in capital expenditures. We're continuing to build out features and functionality for the community across a wide range of different products, whether it be the ad products that Sheryl talked about or IGTV and the like. In addition to those core developments, we're also making the significant long-term investments in safety and security. Those investments are in the billions of dollars per year. Those will have a negative impact on margins. We think that's the right thing to do for the business in terms of ensuring the community's safety and security and the durability of the franchise. So those are important investments from an ROI perspective, but they don't have, obviously, immediate translation into revenue dollars. Secondly, we're continuing to make big investments in innovation. Those, we believe, are attractive long-term investments. The things that I would point to are things like AI as well as our investments in AR and VR. Those are things that will play out – AI in the near-term, but the investments in AR and VR are really about building the next generation of computing, and that's got a longer-term return window. So, attractive investments we believe, but ones that will take longer-term to pay off, and those would have a dilutive effect on margins in the near-term. Those are the two factors that I would point to. In addition, on the CapEx side, we're continuing to invest heavily on capital expenditures, first, to just get ahead of user growth and engagement and then also to make sure that we've got the compute available to support the growth of a number of the key drivers of our business around feed ranking and ads ranking. So, I think those are the things that I would point to, all factoring into the margin guidance that I gave.
Operator: Your next question comes from the line of Ross Sandler from Barclays. Your next question is from the line of Ross Sandler from Barclays.
Ross Sandler - Barclays Capital, Inc.: Hi. Can you hear me?
Sheryl Kara Sandberg - Facebook, Inc.: Yes.
Ross Sandler - Barclays Capital, Inc.: Can you guys hear me?
David M. Wehner - Facebook, Inc.: Yes.
Sheryl Kara Sandberg - Facebook, Inc.: Yes.
Ross Sandler - Barclays Capital, Inc.: Okay. Sorry. Dave, I think you said that the quarter-on-quarter growth rates are going to be high-single digits lower than the prior-year quarter-on-quarter growth rates versus 3Q and 4Q. That would imply around a 20% year-on-year growth rate exiting fourth quarter. So just want to clarify, is that what you actually said? And if so, what's driving this fairly dramatic deceleration in revenue growth?
David M. Wehner - Facebook, Inc.: Ross, so, yes, so we grew at 42% in the current quarter and we would expect decel in the high-single digits for the next couple quarters. In terms of what is driving the deceleration, it's a combination of factors, and I think I outlined those in my commentary. First of all, there's the currency, which is going from being a tailwind to being a modest headwind, we expect. Secondly, we're going to be focusing on growing engaging new experiences like Stories and promoting those. And that's going to have a negative impact on revenue growth. And then, finally, we're giving people who use the services more choice around privacy, and that's coming both in terms of impacts that could be ongoing from things like GDPR as well as other product options that we're providing that could have an impact on revenue growth. So it's a combination of all those factors that is leading to the deceleration of revenue growth in the second half.
Operator: Your next question comes from the line of Doug Anmuth from JPMorgan.
Douglas T. Anmuth - JPMorgan Securities LLC: Great. Thanks for taking the question. A question for Mark. I was hoping you could talk about the company's focus on meaningful social interactions. Several months into some of those changes, do you think behavior on platform has shifted at all? And would you expect the improvements in the experience to ultimately drive a rebound in core Facebook engagement? Thanks.
Mark Elliot Zuckerberg - Facebook, Inc.: Sure. So, we've launched a number of changes that are focused towards trying to encourage more interaction at the expense of some passive consumption on the network. And we found that these have generally encouraged more interaction or positives, so we're going to keep on moving in this direction. We're doing this for a number of reasons. One is that we just started getting a lot of feedback from people in the community that they wanted Facebook to be more about connecting with people, which is really the core of what it's always been, less so about viral videos or news content and just passive consumption. So that's one. Another big driver is we've focused on trying to make sure that we understand the effects of using our services on people's well-being. That's important for all companies. And the research there is very clear that when people are using the Internet, and including our services, to interact with other people, that's associated with all the positive elements of well-being that you'd expect: feeling more connected, feeling less lonely, feeling happier, and long-term measures of health but when you're simply using the Internet to passively consume content that isn't necessarily associated with positive improvements to well-being. So, both because of the feedback that we were getting and the research, we felt like this was really the right direction to go in. We're seeing positive signs in terms of how it's encouraging people to interact more. Of the usage on the platform, we do think that that is the most valuable usage, but that's why we're going in that direction. And everything that we've seen so far suggests to us that we should continue moving in that direction more.
Operator: Your next question comes from the line of Heather Bellini from Goldman Sachs.
Heather Bellini - Goldman Sachs & Co. LLC: Great. Thank you. And, Mark, thank you for all the detailed commentary in the beginning. I was just wondering if you could share with us, as you look ahead over the next 12 to 24 months and you think of assets that you have that you aren't currently monetizing in material ways, which of those do you think about – when you think about kind of layering on the next leg of the stool, if you will, which one of those would you expect us or would you expect to see start to contribute in a more meaningful way over the next couple of years? How would you rank order those assets that are not currently being monetized in a significant way at this point? Thank you.
Sheryl Kara Sandberg - Facebook, Inc.: I'll take it. So, obviously, we started with ads in Facebook, and that was something we have grown and they continue to grow. The ads have expanded quite nicely to Instagram, and Instagram represents a very healthy part of the growth and we expect that to continue as well. When you think about things that are further out, I think you then start talking about our messaging apps. We are furthest ahead in Messenger, but it's still very early days. We're quite happy with consumer engagement with 1.3 billion monthly actives on the platform, and we continue to see a lot of organic connections between businesses and consumers on the messaging platform. We now have over 8 billion messages sent between people and businesses per month, which includes automated messages. We're being very slow and deliberate with monetization. It's still in early days. But I think we've launched some things that people are excited about and interested in like click-to-Messenger ads. We also have some early nice results we can share from clients. One of them recently was LEGO. They launched a Messenger bot to help with gift recommendations, and they created a click-to-Messenger ads that link to a LEGO bot which helped provide product and gift recommendations. They reached people over 25 years old in the U.S., UK, France and Germany, and targeted people who are interested in LEGO toys and shopping, and they found a 3.4 times higher return on ad spend for click-to-Messenger ads versus those that just linked to the LEGO website. And I share that case because it shows what we're excited about. We're excited about a new surface where businesses can interact with consumers, but also really a new functionality. If you go further out, you would then start thinking about WhatsApp. We are very focused there on the user experience, but we're also focused even earlier stages on growing our business ecosystem. The WhatsApp Business app has launched, and we now have more than 3 million people actively using it to test business solutions. So that's further out, but we think it has potential as well.
Operator: Your next question comes from the line of Mark Mahaney from RBC Capital Markets.
Mark Mahaney - RBC Capital Markets LLC: Two questions, please; a near term one and a long term one. The near term one is can you just comment on what you're seeing in terms of MAU recovery growth trends in Europe? You haven't – you gave us what turned out to be a pretty accurate read into the June quarter, so do you have a read into whether things have based out and started to improve again post GDPR implementation? And then, I know, Sheryl, you just talked about this, but can I just ask you to just maybe comment a little bit more on Facebook Messenger? I've just seen the ad units there. They seem to be – there seemed like there's been a pickup recently in implementation of ads there that seemed to me to be highly effective and reasonably well targeted. So any learnings just from those, the basic ad units that you put in there beyond the – kind of the business metrics you just reported on? Thank you.
David M. Wehner - Facebook, Inc.: Hey, Mark. It's Dave. On Europe, yeah, we don't have any update on trends. We had indicated in the first quarter that we would expect to see a decline. We're not providing any guidance on MAU and DAU in Europe on this call.
Sheryl Kara Sandberg - Facebook, Inc.: In terms of number two, we have an ad model where we're able to use the targeting capabilities for Facebook. But when we put ads into a new surface, we obviously learn and evolve. So, one example of some of the things that we're excited about, again, are the click-to-Messenger ads. That's something we can put in News Feed in Instagram and Messenger and it both grows the ecosystem and creates a new opportunity for interaction. We also have inbox ads where we're enabling advertisers to extend their reach to people in Messenger, which is still really early. And we're also in the early days of sponsored messages, which enable businesses to reengage people once a conversation has started. And so, when we think about the format of Messenger, we think about the direct correspondence between a person, either an existing or a potential client or with a business, and we think there are many times in kind of a life cycle of interacting with a business where that's a very attractive opportunity.
Operator: Your next question comes from the line of John Blackledge from Cowen.
John Blackledge - Cowen & Co. LLC: Great. Thanks. Mark or Sheryl, could you discuss your view about the importance of Instagram as a discovery platform for new and/or emerging brands and merchants? And then, over time, as these merchants and brands mature, how do you view Instagram's ability to monetize? And then just a quick one on North American ad revenue; it was a bit lower than we expected in the second quarter. Don't know if you guys have any color there. Thank you.
Sheryl Kara Sandberg - Facebook, Inc.: On the first, when we think about Instagram, we think we have a great opportunity; 25 million Instagram business profiles, 2 million advertisers. We're growing quite nicely across brand and DR. And with 1 billion active people on the platform, I think Instagram is definitely both a direct response opportunity but an opportunity for discovery. Part of it's the format. The format is so visually appealing and people are telling stories with pictures, so we see both anecdotally and in the data that this is a great place for people to become aware of a product in the first place. And we see a lot of small businesses really able to do things on the platform. I'll share a recent example. We just launched a shopping experience that was just expanded in Q2 to all consumers in an additional 45 countries. DefShop is an e-commerce fashion brand in Germany. They were an early tester for IG Shopping. And what they did in that test is tag each article of clothing. They had 56% more website visitors and a 64% increase in sales for tagged products. And I think a lot of those were discovered and purchased right through that advertising funnel.
David M. Wehner - Facebook, Inc.: John, its Dave. Just on the North American deceleration in ad revenue growth, kind of consistent with the trends we've seen, so nothing there notable. I would say we're pleased at the growth that we're seeing at the scale at which we're operating. When you look at the deceleration, the one that I called out was really Europe where you saw the currency impact as well as, to a lesser extent, GDPR causing sort of faster deceleration than in the other regions. I would say North America was more kind of within kind of what we're seeing across the rest of the business.
Operator: Your next question comes from the line of Justin Post from Bank of America/Merrill Lynch.
Justin Post - Bank of America/Merrill Lynch: Great. Thank you. The guidance for the deceleration might raise some questions just on Facebook engagement. So just wondering how you're seeing activity within just core Facebook right now? Is it growing at a healthy rate? And then, secondly, you have had a couple of months now with GDPR. Just wondering how you're thinking about how that will impact your ad targeting over the next year. Thank you.
David M. Wehner - Facebook, Inc.: Sure, Justin. I'll take that. So we're continuing to see good growth in the Facebook ecosystem with 11% DAU growth. And obviously, we've got broader family growth as well. In terms of, I guess, going to the GDPR question, we've talked about – oh, sorry. Sheryl, were you going to take the GDPR question?
Sheryl Kara Sandberg - Facebook, Inc.: Yeah, I can talk about GDPR. GDPR has not had a revenue impact, but we also recognize it wasn't fully rolled out this quarter. It was very encouraging for us to see that the vast majority of people affirmed that they want us to use information, including from the websites they visit, to make their ads more relevant. But, as we look further out, we recognize that there's still risk, and we're going to watch closely. Advertisers are still adapting to the changes, so it's early to know the longer-term impact. And things like GDPR and other privacy changes that may happen from us or may happen with regulation could make ads more relevant. One thing that we know that's not going to change is that advertisers are always looking for the highest ROI opportunity. And what's most important in winning budget is our relative performance in the industry, and we believe we'll continue to do very well on that.
Operator: Your next question...
David M. Wehner - Facebook, Inc.: I'll give a little bit more color – sorry. I wanted to give a little bit more color on some of the different regional trends we're seeing on Facebook DAU. U.S. and Canada, sort of consistent with past quarters, has been flat at about 185 million, and we would expect that to continue to bounce around. Europe, we saw the declines that we anticipated from GDPR. And I would say there, really, those impacts were purely due to the GDPR impact, not other engagement trends. So I would point to that. Otherwise, I think feeling good about Europe. Worldwide, we've got kind of different puts and takes. Indonesia had a SIM card registration requirement that caused a little bit of a headwind in APAC. And then rest of world, we saw some countries come back online like Ethiopia came back online. So some different puts and takes, but overall, still seeing regional growth across all regions with the exception of the U.S./Canada being flat.
Operator: Your next question comes from the line of Mark May from Citi.
Mark A. May - Citigroup Global Markets, Inc.: Thanks. Just following up on the comments, Sheryl mentioned that there's really no meaningful impact on GDPR to the ad business, at least as of now. But then, Dave, I think you mentioned that because you're giving people more control over their privacy and data that this is one of the reasons why you're expecting the meaningful decel in the second half; so just trying to recognize those two things. Maybe the questions have been too specific around the impact of GDPR and should be more broad around data and privacy? And I guess, ultimately, the question is what impact, if any, these greater controls that you're giving users having on ad revenue growth and monetization? Thanks.
David M. Wehner - Facebook, Inc.: Sure, Mark. Let me take that. So GDPR didn't have a significant impact in Q2, partially because of its implementation date. So you're just seeing effectively one month of it in terms of revenue. We do think that there will be some modest impact, and I don't want to overplay these factors, but you've got a couple of things going on. You've got the impact of the opt-outs. And while we're very pleased with the vast majority of people opting into the third-party data use, some did not. So that will have a small impact on revenue growth. And then we're seeing some impact from how advertisers are using their own data for targeting. So, again, that will have a modest impact on growth. And then in addition, we're continuing to focus our product development around putting privacy first and that's going to, we believe, have some impact on revenue growth. So it's really a combination of kind of how we're approaching privacy as well as GDPR and the like. So I think all of those factors together are one of the factors that we're talking about; the other being, obviously, the currency flip.
Operator: Your next question comes from the line of Rich Greenfield from BTIG.
Richard Greenfield - BTIG LLC: Hey. Thanks for taking the question. So I guess one of the things as you look at, you talked about the growth you're seeing in users overseas or basically everywhere but the U.S. and Canada. But when you look at ARPU, your ARPU outside, even in Europe, is still only a real tiny fraction of where you are in the U.S. and, obviously in Asia and rest of world, an infinitesimal fraction of where you are in the U.S. How does that factor into as you think about your long-term guidance that you just talked about, especially with margins moving towards the mid-30s, just given how early you are in those non-U.S. markets and how much headroom they have to grow as those ad markets mature. How do you have confidence that you, in that type of deceleration, when you look at how much upside there is in that ARPU?
David M. Wehner - Facebook, Inc.: Yeah, I guess you've got a couple of different factors going on there. You've got the opportunity, I think, for ARPU growth in those regions, and that's going to depend on the mix of countries in those regions and the GDP per capita in those countries as well as the relative size of the ad markets. And that correlates very strongly to our opportunity and our potential ARPU. And I think you've got upside growth potential in the long run in those markets. As it relates to margin profile, you also just have the factor that you're increasing growth – the increasing mix of the business is shifting towards Asia and towards what are currently lower ARPU markets. And so, while those are very attractive, we believe, to serve both in the near and in the long run, they're going to have a different impact on margin because the cost to support those users relative to the revenue they bring in does have an impact on margins in the medium-term.
Operator: Your next question comes from the line of Anthony DiClemente from Evercore.
Anthony DiClemente - Evercore Group LLC: Thank you. I have two; one for Sheryl and one for Mark. Sheryl, in Dave's comments and the comments about the business impact of engagement shifting to Stories versus feed products, if you could spell out for us I guess the specific reasons why Stories monetization is not as strong as feed today and in the context perhaps of what needs to happen in the future for Stories monetization to rebound to, let's say, parity to where feed is today and sort of get through that negative impact. And then, for Mark, I think perhaps Heather was getting at this in her question, but the company's investing so much into owned data centers. You talked about that I think in your prepared remarks. Are there ways to improve the return on investment of those investments in data center servers, network infrastructure? And what I'm thinking is in order to perhaps service third-parties to maybe just improve those returns in the way that other tech and Internet companies have in terms of investments in infrastructure. Thank you.
Sheryl Kara Sandberg - Facebook, Inc.: So, on Stories, we've seen great progress with Stories as a format for people to share on our platforms. We have 400 million people sharing with Instagram Stories, 450 million with WhatsApp Status. Facebook is newer, but we're seeing good progress there. The question is will this monetize at the same rate as News Feed? And we honestly don't know. We'll have to see what happens. There are good reasons to be very optimistic about the monetization. The opportunity, full-screen, authentic, very engaging, different format than feed, gives us an opportunity to grow. We also don't have all of our advertisers yet creating story ads. So, obviously, as more and more advertisers come in and do that, the more and the better ads we'll have. I think getting that ramp will take a while because Stories is a new format, and we definitely see that it takes a while for advertisers to adopt new formats. I think one of the other things we feel good about over the long run, not really the short run, is that since we have so many different places where you have Stories formats in Instagram and WhatsApp and Facebook, as volume increases of the opportunity, advertisers get more interested. But we won't know for a while if it's going to monetize at the same rate. We do feel very good about a new and very engaging opportunity for ads.
Operator: Your next question...
Mark Elliot Zuckerberg - Facebook, Inc.: And I can quickly answer the second part around data centers. I mean the quick answer is that we're not planning on going in to the cloud services. We're not planning on doing that. We have to build out all this capacity to serve our community. It's a very computationally and resource-intensive set of services that we provide and we need to build that out. We are very optimistic. I'm very optimistic about AI overall and being able to use more computing resources to be able to crunch more data to be able to rank News Feed and ads and search and friend suggestions, and all the important things that we use our AI systems to do in addition to the integrity and security work. Part of the advance in AI technology now allows us to use more compute to use all the data that's in the system to provide better results, so we certainly plan on doing that.
Operator: Your next question comes from the line of Peter Stabler from Wells Fargo Securities.
Peter C. Stabler - Wells Fargo Securities LLC: Thanks. One for Sheryl and then one for Dave. Sheryl, just on the SMB side, wondering if you could give us any color by region, if possible. And then secondly, on the go-to-market strategy, to what extent is Facebook dependent upon or leveraging resellers versus small businesses discovering the ad platform on their own? How key is that reseller channel for you on the small business side? And then, for Dave, given that you've given us some kind of relatively specific guidance on the revenue growth decel through the remainder of the year, I'm wondering if you could give us some color on what that embeds from an FX expectation at this point. Thank you very much.
Sheryl Kara Sandberg - Facebook, Inc.: So SMBs are very core to our business and, with over 80 million SMB pages that are using Facebook on a monthly basis, we know they're core to theirs. Our 6 million advertisers come from those pages, and so the fact that we have so much room to grow is exciting for us. We don't break this out by region, but we do see very strong SMB participation across the board and around the world, particularly as SMBs come online, the more. So, you can imagine that some of it goes with Internet penetration and Internet use. In terms of resellers, we think it's a big opportunity. We don't break that out either. But, obviously, some of our ads are sold directly and bought directly through our online interfaces. We also have third-parties that sell our ads and we welcome that as well.
David M. Wehner - Facebook, Inc.: Peter, its Dave. Just on the FX, we're just looking at current rates and just rolling those forward, not predicting what the rates will be, but rather looking at current rates and thus what the impact would be if rates stay the same on the second half.
Operator: Your next question comes from the line of Brent Thill from Jefferies.
Brent Thill - Jefferies LLC: Thanks. Dave, I want to go back to the magnitude of the deceleration. I think many investors are having a hard time reconciling that type of deceleration considering how good the advertiser feedback is on your platform. And I realize you've outlined FX and Stories and the other factors, but is there something that you're hearing now from advertisers that is giving you more confidence that they're seeing something different about what we're all hearing right now? It just seems like the magnitude is beyond anything we've seen, especially across a number of tech names we all cover.
David M. Wehner - Facebook, Inc.: Yeah. Brent, I'll take that. And if Sheryl wants to add color, she should step in as well. This is consistent – we consistently have seen over last eight quarters constant currency deceleration. So, there's a continuation of this trend. I don't think there's anything beyond that in the factors that I outlined. I would note we've been benefiting from continued growth across Instagram. Instagram ad load in feed is at the same level as Facebook, so that would be – that's certainly been helpful in our recent quarters. So I think when you look at the factors going forward, I would say we've got the currency impact, we've got some of the impacts around privacy and the like, but we continue to get good advertiser feedback on ROI. We continue to believe we're delivering great ROI for advertisers. So I don't think there's anything from the advertiser perspective that's necessarily playing out differently than expectations. Sheryl can add any color there.
Sheryl Kara Sandberg - Facebook, Inc.: Yeah, I'd add there. Even at decreasing growth rates, we are still growing and predicting growth at very healthy rates, and that's based on returning for advertisers. We're very focused on helping advertisers meet their ultimate goals, looking at their ROI, looking at the return they get on ringing the cash register, whether that cash register rings online or offline. And we hear from them and we continue to see in our results that we continue to deliver strong results. So we have a lot of opportunity ahead of us. We're going to continue investing in that opportunity. And what we're hearing from advertisers all over the world is that they want to continue to grow and invest with us as well.
Deborah Crawford - Facebook, Inc.: Operator, we have time for one last question.
Operator: The last question comes from the line of Colin Sebastian from Robert W. Baird.
Colin Alan Sebastian - Robert W. Baird & Co., Inc.: Great. Thanks. Just a couple of follow ups for me. First off, Dave, maybe I missed this, but what timeframe are you referring to in terms of getting down to the mid-30s operating margin? And does that outlook assume any meaningful contribution from any of the new areas of innovation that you highlighted on the call? Just trying to figure out how much of that might be more conservatism. And then, on the near-term trends and the midterm elections in the U.S., given the amount of scrutiny that will exist in your platform, how should we think about your level of preparation on one hand to manage content? And then, on the other hand, is this part of the potential impact on monetization revenue growth in the back half of the year that you're taking into consideration? Thanks.
David M. Wehner - Facebook, Inc.: Sure, Collin. Let me take a crack at that. So, in terms of the guidance, I've given guidance. This is several years, so more than two but less than many. So it's over a timeframe more than two years is our expectation. And then in terms of does that have any meaningful contribution from areas of innovation, we talked about some of the areas that we're investing in. Obviously, on the safety and security side, those are costs that are layering in that we think are the right thing to do for the business but don't necessarily have a revenue impact. So it certainly takes those into account. It also takes into account the ongoing investments we're making in the longer-term innovation work, which I don't think will necessarily have any meaningful revenue relative to the size of the business in those time frames. We're also investing in things like video, Watch and the like, which have the potential to condition tribute on the revenue side, but still relatively small in perspective of the overall business.
Mark Elliot Zuckerberg - Facebook, Inc.: All right. And I can take the question on the midterm elections. So, yes, the short answer is that we're much more confident that we're going to get this right for the elections in the 2018, which include the U.S. midterms, but also the elections in Brazil and upcoming elections in early-2019 in India and the EU. And the reason why we're confident that we can get this right is because there have been several elections since the 2016 ones that have had much better results, including the French presidential election, the German elections, the Alabama special election, and the Mexican election about a month ago. And in each of these – going back to 2016, we were – we have a very big security team that was focused on security around even the 2016 election and we found hacking and phishing attacks that the Russian government was trying to do, and we notified the right people about those. But 2016 was really the first time that we saw this kind of coordinated information operation. And since then, we've built the playbook out that has included building AI tools to identify thousands of fake accounts and groups and pages that violate the policies. It's included growing the security and content review teams to 20,000 people to be able to handle the volume of work that we need to do. And it includes a lot of the transparency work around advertising in general, but also the political and issue ads archive and verifying all advertisers who are trying to run political and issue ads. There are a number of other things that we're doing too, including creating an external program for independent academics to study how the impact of social media and how foreign governments try to interfere in elections. And that will have a longer-term impact as well. But the short answer here is we've been very focused on this. 2018 is a big year. And because of the successful results that we've seen in a number of elections recently, we feel like our road map and our level of preparation is much higher now than it has been. And we feel relatively confident going into these elections.
Deborah Crawford - Facebook, Inc.: Great. Thank you. Thank you for joining us today. We appreciate your time, and we look forward to speaking with you again.
Operator: Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines. | [
{
"speaker": "Executives",
"text": "Deborah Crawford - Facebook, Inc. Mark Elliot Zuckerberg - Facebook, Inc. Sheryl Kara Sandberg - Facebook, Inc. David M. Wehner - Facebook, Inc."
},
{
"speaker": "Analysts",
"text": "Brian Nowak - Morgan Stanley & Co. LLC Eric J. Sheridan - UBS Securities LLC Ross Sandler - Barclays Capital, Inc. Douglas T. Anmuth - JPMorgan Securities LLC Heather Bellini - Goldman Sachs & Co. LLC Mark Mahaney - RBC Capital Markets LLC John Blackledge - Cowen & Co. LLC Justin Post - Bank of America/Merrill Lynch Mark A. May - Citigroup Global Markets, Inc. Richard Greenfield - BTIG LLC Anthony DiClemente - Evercore Group LLC Peter C. Stabler - Wells Fargo Securities LLC Brent Thill - Jefferies LLC Colin Alan Sebastian - Robert W. Baird & Co., Inc."
},
{
"speaker": "Operator",
"text": "Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook Second Quarter 2018 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford - Facebook, Inc.",
"text": "Thank you. Good afternoon and welcome to Facebook second quarter 2018 earnings conference call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our Quarterly Report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I'd like to turn the call over to Mark."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Thanks, Deborah, and thanks, everyone, for joining us today. We had another solid quarter. Revenue grew 42% year-over-year to $13.2 billion. And Facebook now has more than 2.2 billion monthly active with almost 1.5 billion actives using it every day. For the first time today, we're also releasing how many people use at least one of our apps, Facebook, WhatsApp, Instagram or Messenger, and that's 2.5 billion people each month. This number better reflects our community for a couple of reasons. First, it refers to individual people rather than active accounts, so it excludes when people have multiple active accounts on a single app. And second, it reflects that many people use more than one of our services. And Dave will explain this in a little more detail later. I want to start by talking about all the investments we've made over the last six months to improve safety, security and privacy across our services. This has been a lot of hard work and it's starting to pay off. We recently launched two important ad transparency tools: one to let anyone see the ads any page is running even if the ads aren't targeted to you; and the other an archive of ads with political or issue content that's starting in the U.S. ready for the midterm election. These ads are now labeled so you can clearly see who's paying for them and, within the archives, you can see the budget associated with each ad, how many people saw it, and search all ads with political or issue content that an advertiser has run for up to seven years. This level of transparency will mean increased accountability and responsibility for advertisers globally. Over the next 18 months, there are important elections beyond the U.S. in Brazil, India, and the EU, and these will all be real tests for Facebook. But I'm confident that we will get this right given our results during last year's French and German elections, the Alabama special election, as well as this month's presidential election in Mexico, where our systems found and removed thousands of fake account pages and groups that violated our policies. Of course, security is not a problem that you ever fully solve. We face sophisticated well-funded adversaries who are constantly evolving. But, during each election, we learn and improve too. We're also making progress in the fight against misinformation. We're getting rid of the financial incentives for spammers to create fake news, much of which is economically motivated. We stopped pages that repeatedly spread false information from buying ads. And we also use AI to prevent fake accounts that generate a lot of the problematic content from ever being created in the first place. Our investments in AI mean that we can now remove more bad content quickly because we don't have to wait until after it's reported. It frees our reviewers to work on cases where human expertise is needed to understand the context or nuance of a situation. In Q1, for example, almost 90% of graphic violence content that we removed or added a warning label to was identified using AI. This shift from reactive to proactive detection is a big change, and it will make Facebook safer for everyone. I also want to talk about privacy. GDPR was an important moment for our industry. We did see a decline in monthly actives in Europe, down by about 1 million people as a result. And at the same time, it was encouraging to see the vast majority of people affirm that they want us to use context, including from websites they visit, to make their ads more relevant and improve their overall product experience. Looking ahead, we will continue to invest heavily in security and privacy because we have a responsibility to keep people safe. But, as I've said on past calls, we're investing so much in security that it will significantly impact our profitability. We're starting to see that this quarter. But, in addition to this, we also have a responsibility to keep building services that bring people closer together in new ways as well. Now, in light of increased investment in security, we could choose to decrease our investment in new product areas, but we're not going to, because that wouldn't be the right way to serve our community and because we run this company for the long term not for the next quarter. And Dave will talk about this in a few minutes. Now, perhaps one of the most important things we've done this year to bring people closer together is to shift News Feed to encourage connection with friends and family over passive consumption of content. We've launched multiple changes over the last half to News Feed that encourage more interaction and engagement between people, and we plan to keep launching more like this. Now, of course, connecting isn't limited to News Feed. Now, there are more than 200 million people that are members of meaningful groups on Facebook, and these are communities that, upon joining, they become the most important part of your Facebook experience and a big part of your real world social infrastructure. These are groups for new parents, for people with rare diseases, for volunteering, for military families deployed to a new base and more. We believe there is a community for every one on Facebook. And these meaningful communities often spend online and offline and bring people together in person. We found that every great community has an engaged leader. But running a group can take a lot of time. So we have a road map to make this easier. That will enable more meaningful groups to get formed, which will help us to find relevant ones to recommend to you, and eventually achieve our five-year goal of helping 1 billion people be a part of meaningful communities. Now, since the 1970s, there has been this long decline in people joining physical groups around the world, and that has contributed to a broad feeling of loneliness and isolation. But if we can help 1 billion people be a part of something meaningful, then that can help reverse this trend. Talking about being a part of something meaningful, it's been inspiring to see how people are using our fundraising tools to make a difference. Last month, a campaign to raise $1,500 for undocumented children separated from their families at the border ended up going viral and raising more than $20 million from more than 0.5 million donors all around the world. This quarter, we added the ability for pages to create and donate to fundraisers for causes that they care about too. This quarter, we also reached a milestone with now more than 1 billion actives on Instagram. And this is a moment to reflect on how this acquisition has been an amazing success. When Instagram joined us the team had only 16 people. And since then, Kevin and the team have built Stories, Direct, and now IGTV. This has been a story of great innovation and product execution. And it's also a story of how effective the integration has been. We believe Instagram has been able to use Facebook's infrastructure to grow more than twice as quickly as it would have on its own. So a big congratulations to the Instagram team and to all the teams across our company that have contributed to this success. I'm really excited about video too. And this quarter, we launched IGTV. People are watching less TV, but more video, but most video is not yet optimized for mobile. IGTV will help solve that problem. It's designed specifically for mobile and makes watching long-form vertical video from creators easy. There's a stand-alone IGTV app, but you can also watch within the Instagram app, so that means the entire Instagram community has been able to use it from the start. We're also seeing Watch start to grow more quickly on Facebook too. Our teams are focused on building new experiences that help people connect and start conversation. We recently rolled out Watch Party to all groups, so you can watch and chat with friends at the same time. And we're seeing some real traction with some of the original program, from the talk show Red Table Talk, featuring Jada Pinkett Smith, to Skam, an interactive series that started in Norway and features a new style of storytelling where the characters have accounts on Facebook and Instagram, and key parts of the story are told not just through video, but through posts on their pages. Stories continue to be a big part of the future of sharing too, and they're growing quickly across WhatsApp, Instagram, Facebook and Messenger. While we started off just implementing the basic Stories format, we've now moved well beyond it, and have built lots of new features like polls, questions, and collaborative stories and groups and events. And we're also making progress developing Stories into a great format for ads. We've made the most progress here on Instagram, but this quarter, we started testing Stories ads on Facebook too. The other major trend we're seeing is the shift to more private messaging. There's a lot to build here. We've been testing payments on WhatsApp in India, and it gives people a really simple way to send money to each other and contribute to greater financial inclusion. And of the people who have tested this, feedback and usage have been very strong. All signs point to a lot of people wanting to use this when the government gives us the green light. And in the meantime, we've broadened our focus to building this for other countries so we can give more people this ability faster. Over the next five years, we're focused on building out the business ecosystem around messaging on WhatsApp and Messenger. More broadly, our strategy is to use Facebook's computing infrastructure, business platforms and security systems to serve people across all of our apps. For example, we made the decision a decade ago to build our own data centers, and we opened our first custom-built data center in 2011. Today, we have six data centers around the world, and we're working on building eight more. We're using AI systems in our global community operations team to fight spam, harassment, hate speech, and terrorism across all of our apps to keep people safe. And this is incredibly useful for apps like WhatsApp and Instagram as it helps us manage the challenges of hyper-growth there more effectively. Beyond apps and looking at the next 10 years, we're making a lot of progress with virtual reality. Our goal is to create that feeling of presence like you're right there with people you care about even if you might be halfway around the world. Oculus Go is off to a good start, and at $199, it's going to be how a lot of people experience virtual reality for the first time. Overall, this is a critical year for Facebook. We've made progress preventing abuse, forged ahead with new innovation, and are adapting our services to the new trends of messaging, Stories, videos and groups. As always, thank you for being a part of this journey, and I'm looking forward to making more progress together. And now, here is Sheryl to talk about our business."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "Hi, everyone. It was a good second quarter with ad revenue growing 42% year-over-year. Mobile ad revenue was $11.9 billion, a 50% increase year-over-year, making up approximately 91% of total ad revenue. Our growth, again, was broad-based across regions, marketer segments and verticals. We are working to ensure that Facebook is a safe place for people and businesses. We've taken strong steps to address a number of issues, including election integrity, fake news and protecting people's information. One of the most important things we can do to affect change is to increase transparency because transparency leads to greater accountability. For example, when anyone can see any ad on Facebook, advertisers have to stand behind the ads they run. Transparency also allows us to get more input from our community and from experts around the world, so that we can find and fix problems. We wish we could find everything ourselves, but we never will, so we're building tools to make it easier for people to report issues to us. As Mark mentioned, this quarter, we took major steps to make advertising in pages more transparent. Now anyone can see all the ads a page is running across Facebook, Instagram, Messenger and Audience Network. You can also learn more about pages even if they don't advertise. You can see when a page was created and if they've changed their name. For political and issue ads, we're going even further. Advertisers placing ads with political content are now required to verify their identity and location. These ads will be labeled with a disclosure about who paid for them and saved in a searchable archive. The vast majority of ads on Facebook are run by legitimate organizations from small businesses looking for new customers to advocacy groups raising money for their causes. But we've seen that bad actors can misuse our products too, so we're erring on the side of transparency. We're being intentionally broad in our interpretation of political and issue ads. This includes ads for books about politicians and brand campaigns that touch on national issues. Given our commitment to transparency, we think it's important to apply this policy to more ads rather than fewer. These steps are just the start. We'll keep looking for ways to improve, and we hope these tools become standard across the industry. As we make these investments in transparency and accountability, we remain focused on our key priorities: helping businesses leverage the power of mobile, developing innovative ad products, and making our ads more relevant and effective. First: leveraging the power of mobile. For businesses, winning on mobile now means winning on video. Globally, people are creating and watching more video, especially on mobile devices. According to eMarketer, nearly a quarter of the world's population will watch video on a mobile phone this year. We see this trend toward video across all of our apps, from people sharing more video with their friends on Facebook, to watching more video from creators on Instagram, to having more video calls on WhatsApp and Messenger. Marketers are making more video of their own. We're seeing healthy growth in video ads among all advertiser segments. M&M's UK recently used mobile-optimized five-second video ads on Facebook and Instagram to introduce M&M's Mix, a bag of three kinds of M&M's in one. Their campaign worked, driving results not just for their new product but for the brand overall. Their sales increased by over 10% and 80% of that came from households that had not bought M&M's in the previous 26 weeks. Second: developing new ad products. We know that creating video can be more difficult for small businesses that have fewer resources, so we've launched new tools on Facebook to help anyone make videos that work well on mobile. Last quarter, we released Ads Animator, a simple way to create eye-catching video ads using photos and other content that's already on a company's Facebook page. We're also testing Video Creation Kit, which gives advertisers easy-to-use video templates for different marketing objectives. By learning what performs best across our platform, we can help other businesses succeed. We're also making it easier to run ads on Instagram and in Stories. Ads in Stories are an immersive engaging way for people to interact with businesses. When online retailer Overstock wanted to gain new customers and increase furniture sales, they ran video ads in Instagram Stories with a shop now button. They saw an 18% increase in return on ad spend and a 20% decrease in cost per acquisition. This quarter, we made it easier for more advertisers to adopt the Stories format. When an advertiser uploads video in a square or horizontal format for feed, we can automatically transform it into the full-screen vertical format of Stories. Third: making our ads more relevant and effective. We're building new products and improving existing ones to ensure advertisers can reach the right audience. For example, automatic placements help advertisers get better results by showing ads across our platform wherever they'll perform best and at the lowest cost. SumUp, a German payment start-up that helps small businesses accept debit and credit cards, switched from manual to automatic placements and increased sales by 34% in one week. Advertisers of all sizes want to know if their ads are working and how to make them better, but smaller businesses don't always have this capability. We're changing that. Last year, we introduced Test and Learn, a way for advertisers to run variations of their ads and measure the results in just a few steps. We started with tools for direct response advertisers to figure out what drives conversions. In Q2, we added a way for companies to understand the effect of their ads on brand perception. We plan to roll this out to all advertisers, big and small, so they can easily experiment with different strategies and find the ones that work best. As always, I'm grateful to our teams around the world. Their work over the past several months has helped millions of businesses grow and created new levels of transparency in advertising. I'd also like to thank our partners and the businesses of all sizes who turned to us to reach their customers and give us the feedback that helps make us better. Thank you. And now, here's Dave."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Thanks, Sheryl, and good afternoon, everyone. Let's start with our community metrics. Daily active users on Facebook reached 1.47 billion, up 11% compared to last year, led by growth in India, Indonesia and the Philippines. This number represents approximately 66% of the 2.23 billion monthly active users in Q2. MAUs were up 228 million or 11% compared to last year. It's worth noting that MAU and DAU in Europe were both down slightly quarter-over-quarter due to the GDPR roll out, consistent with the outlook we gave on the Q1 call. As Mark mentioned, we're also introducing a family-wide audience metric, 2.5 billion people worldwide used one of our applications in June. This is our best estimate of our de-duplicated audience across Facebook, Instagram, Messenger, and WhatsApp. We believe this number better reflects the size of our community and the fact that many people are using more than one of these services. Note that, for comparison purposes, Facebook MAU does count multiple accounts for a single user when such accounts exist, and we estimate those represent approximately 10% of our Facebook MAU as previously disclosed in the limitation of key metrics section in our SEC filings. The family audience metric only counts a single user in these instances. Turning now to the financials; all comparisons are on a year-over-year basis unless otherwise noted. Q2 total revenue was $13.2 billion, up 42% or 38% on a constant currency basis. Foreign exchange tailwinds contributed approximately $370 million of revenue in Q2. Q2 ad revenue was $13 billion, up 42% or 38% on a constant currency basis. In terms of ad revenue by region, Europe and Asia-Pacific both grew fastest at 47% each and benefited from foreign exchange tailwinds. I'd note that European ad revenue growth decelerated more quickly than other regions and was impacted primarily by reduced currency tailwinds and, to a lesser extent, the roll out of GDPR. Mobile ad revenue was $11.9 billion, up 50%, and represents approximately 91% of ad revenue. In Q2, the average price per ad increased 17% and the number of ad impressions served across our services increased 21%, driven primarily by ads in feed on Instagram and Facebook. Payments and other fees revenue was $193 million, up 23%. Turning now to expenses; total expenses were $7.4 billion, up 50%. We ended Q2 with over 30,000 full-time employees, up 47% compared to last year. Operating income was $5.9 billion, representing a 44% operating margin. Our effective tax rate in the quarter was 13%. Net income was $5.1 billion or $1.74 per share. Capital expenditures were $3.5 billion, driven by investments in data centers, servers, network infrastructure, and office facilities. In Q2, we generated $2.8 billion of free cash flow and ended the quarter with approximately $42 billion in cash and investments. And, in the second quarter, we bought back approximately $3.2 billion of our Class A common stock. Turning now to the revenue outlook; our total revenue growth rate decelerated approximately 7 percentage points in Q2 compared to Q1. Our total revenue growth rates will continue to decelerate in the second half of 2018, and we expect our revenue growth rates to decline by high-single digit percentages from prior quarters sequentially in both Q3 and Q4. There are several factors contributing to that deceleration. For example, we expect currency to be a slight headwind in the second half versus the tailwinds we have experienced over the last several quarters. We plan to grow and promote certain engaging experiences like Stories that currently have lower levels of monetization, and we are also giving people who use our services more choices around data privacy, which may have an impact on our revenue growth. Turning now to expenses; we continue to expect that full-year 2018 total expenses will grow in the range of 50% to 60% compared to last year. In addition to increases in core product development and infrastructure, this growth is driven by increasing investment in areas like safety and security, AR/VR, marketing, and content acquisition. Looking beyond 2018, we anticipate that total expense growth will exceed revenue growth in 2019. Over the next several years, we would anticipate that our operating margins will trend towards the mid-30s on a percentage basis. We expect full-year 2018 capital expenditures will be approximately $15 billion, driven by investments in data centers, servers, network infrastructure, and office facilities. We plan to continue to grow capital expenditures beyond 2018 to support global growth and our ongoing product needs. Turning now to tax; at current stock prices, we expect our full-year 2018 tax rate will be in the mid-teens, but that our Q3 tax rate will be 25% to 30% due to a one-time charge related to a recent court ruling in the IRS versus Altera case. As a reminder, fluctuations in our stock price will impact our tax price. In summary, our community and business growth remain solid. Our financial strength has enabled us to invest heavily to improve our ability to serve our global community through our family of apps as well as to prepare us for the future. With that, operator, let's open up the call for questions."
},
{
"speaker": "Operator",
"text": "Your first question comes from the line of Brian Nowak from Morgan Stanley."
},
{
"speaker": "Brian Nowak - Morgan Stanley & Co. LLC",
"text": "Thanks for taking my questions. Two. Just the first one on monetization of Facebook core versus Instagram; can you talk a little bit about how you think about monetization levels and the key drivers currently and, going forward, when we think about ad load, pricing and the importance of ad improvements across the two platforms over the next, call it, year or so? And the second one on Instagram TV, maybe just talk about how you look at – think about the core consumer offering, how it varies from Facebook Watch and, philosophically, how you think about investing in premium content or sports content across these two products. Thanks."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Brian, I'll take the first one. In terms of Facebook versus Instagram, they're obviously both contributing to revenue growth. Instagram is growing more quickly and making an increasing contribution to growth. And we've been pleased with how Instagram is growing. Facebook and Instagram are really one ads ecosystem. I think, from a supply perspective, both now from a feed perspective are at similar ad loads. Instagram has more heavy usage of Stories, so that's an area of continued growth opportunity because the effective levels of monetization in Stories are lower. On the demand side, we see a good traction across both platforms, and we're rolling out more ability for advertisers to leverage ads in Stories with more formats and the like. So that's, again, an important opportunity for growth is just continuing to build out more products on the demand side for Stories."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "And I can take the second part of the question about the – what we're trying to do with IGTV and Watch at the same time. The IGTV product approach is very focused on helping people connect with creators in a mobile-native vertical video format and helping people not only see content that they love from people that they want to follow, but build a community around those creators, which is what we see people are trying to do. And creators now uniquely have the ability to both reach a large audience and connect and engage the community through the social network on Instagram at the same time. With Watch, a lot of what we're trying to do is make it so the video content that's on Facebook and some of the content that we're acquiring through original programming that people can come together with their friends to watch that content through things like Watch Party and engage and build community that way. So there's a big space here in terms of helping people have real connections and interactions around video. These are two different takes on this. Overall, what you're going to see from us on video is not just try to optimize for overall watch time, but to optimize for building products that help bring people together and help facilitate real interactions between people."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Eric Sheridan from UBS."
},
{
"speaker": "Eric J. Sheridan - UBS Securities LLC",
"text": "Thanks for taking the question. Maybe going back to the OpEx and your comments, Dave, looking out sort of medium to longer term, just wanted to understand if we can get a little bit more color on some of the drivers of that. How much of it could be video in support of where you want to take the business over the medium and long term versus things that maybe don't necessarily have a revenue component to them like the security and the protection of the ecosystem that the whole team has been talking about since the end of last year? Thanks so much."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Yeah, Eric, it's going to be a combination of those factors. I would say we're going to continue to invest in core product development and infrastructure. And so, you've seen that already in terms of the ramp that we have in capital expenditures. We're continuing to build out features and functionality for the community across a wide range of different products, whether it be the ad products that Sheryl talked about or IGTV and the like. In addition to those core developments, we're also making the significant long-term investments in safety and security. Those investments are in the billions of dollars per year. Those will have a negative impact on margins. We think that's the right thing to do for the business in terms of ensuring the community's safety and security and the durability of the franchise. So those are important investments from an ROI perspective, but they don't have, obviously, immediate translation into revenue dollars. Secondly, we're continuing to make big investments in innovation. Those, we believe, are attractive long-term investments. The things that I would point to are things like AI as well as our investments in AR and VR. Those are things that will play out – AI in the near-term, but the investments in AR and VR are really about building the next generation of computing, and that's got a longer-term return window. So, attractive investments we believe, but ones that will take longer-term to pay off, and those would have a dilutive effect on margins in the near-term. Those are the two factors that I would point to. In addition, on the CapEx side, we're continuing to invest heavily on capital expenditures, first, to just get ahead of user growth and engagement and then also to make sure that we've got the compute available to support the growth of a number of the key drivers of our business around feed ranking and ads ranking. So, I think those are the things that I would point to, all factoring into the margin guidance that I gave."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ross Sandler from Barclays. Your next question is from the line of Ross Sandler from Barclays."
},
{
"speaker": "Ross Sandler - Barclays Capital, Inc.",
"text": "Hi. Can you hear me?"
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "Yes."
},
{
"speaker": "Ross Sandler - Barclays Capital, Inc.",
"text": "Can you guys hear me?"
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Yes."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "Yes."
},
{
"speaker": "Ross Sandler - Barclays Capital, Inc.",
"text": "Okay. Sorry. Dave, I think you said that the quarter-on-quarter growth rates are going to be high-single digits lower than the prior-year quarter-on-quarter growth rates versus 3Q and 4Q. That would imply around a 20% year-on-year growth rate exiting fourth quarter. So just want to clarify, is that what you actually said? And if so, what's driving this fairly dramatic deceleration in revenue growth?"
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Ross, so, yes, so we grew at 42% in the current quarter and we would expect decel in the high-single digits for the next couple quarters. In terms of what is driving the deceleration, it's a combination of factors, and I think I outlined those in my commentary. First of all, there's the currency, which is going from being a tailwind to being a modest headwind, we expect. Secondly, we're going to be focusing on growing engaging new experiences like Stories and promoting those. And that's going to have a negative impact on revenue growth. And then, finally, we're giving people who use the services more choice around privacy, and that's coming both in terms of impacts that could be ongoing from things like GDPR as well as other product options that we're providing that could have an impact on revenue growth. So it's a combination of all those factors that is leading to the deceleration of revenue growth in the second half."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Doug Anmuth from JPMorgan."
},
{
"speaker": "Douglas T. Anmuth - JPMorgan Securities LLC",
"text": "Great. Thanks for taking the question. A question for Mark. I was hoping you could talk about the company's focus on meaningful social interactions. Several months into some of those changes, do you think behavior on platform has shifted at all? And would you expect the improvements in the experience to ultimately drive a rebound in core Facebook engagement? Thanks."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Sure. So, we've launched a number of changes that are focused towards trying to encourage more interaction at the expense of some passive consumption on the network. And we found that these have generally encouraged more interaction or positives, so we're going to keep on moving in this direction. We're doing this for a number of reasons. One is that we just started getting a lot of feedback from people in the community that they wanted Facebook to be more about connecting with people, which is really the core of what it's always been, less so about viral videos or news content and just passive consumption. So that's one. Another big driver is we've focused on trying to make sure that we understand the effects of using our services on people's well-being. That's important for all companies. And the research there is very clear that when people are using the Internet, and including our services, to interact with other people, that's associated with all the positive elements of well-being that you'd expect: feeling more connected, feeling less lonely, feeling happier, and long-term measures of health but when you're simply using the Internet to passively consume content that isn't necessarily associated with positive improvements to well-being. So, both because of the feedback that we were getting and the research, we felt like this was really the right direction to go in. We're seeing positive signs in terms of how it's encouraging people to interact more. Of the usage on the platform, we do think that that is the most valuable usage, but that's why we're going in that direction. And everything that we've seen so far suggests to us that we should continue moving in that direction more."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Heather Bellini from Goldman Sachs."
},
{
"speaker": "Heather Bellini - Goldman Sachs & Co. LLC",
"text": "Great. Thank you. And, Mark, thank you for all the detailed commentary in the beginning. I was just wondering if you could share with us, as you look ahead over the next 12 to 24 months and you think of assets that you have that you aren't currently monetizing in material ways, which of those do you think about – when you think about kind of layering on the next leg of the stool, if you will, which one of those would you expect us or would you expect to see start to contribute in a more meaningful way over the next couple of years? How would you rank order those assets that are not currently being monetized in a significant way at this point? Thank you."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "I'll take it. So, obviously, we started with ads in Facebook, and that was something we have grown and they continue to grow. The ads have expanded quite nicely to Instagram, and Instagram represents a very healthy part of the growth and we expect that to continue as well. When you think about things that are further out, I think you then start talking about our messaging apps. We are furthest ahead in Messenger, but it's still very early days. We're quite happy with consumer engagement with 1.3 billion monthly actives on the platform, and we continue to see a lot of organic connections between businesses and consumers on the messaging platform. We now have over 8 billion messages sent between people and businesses per month, which includes automated messages. We're being very slow and deliberate with monetization. It's still in early days. But I think we've launched some things that people are excited about and interested in like click-to-Messenger ads. We also have some early nice results we can share from clients. One of them recently was LEGO. They launched a Messenger bot to help with gift recommendations, and they created a click-to-Messenger ads that link to a LEGO bot which helped provide product and gift recommendations. They reached people over 25 years old in the U.S., UK, France and Germany, and targeted people who are interested in LEGO toys and shopping, and they found a 3.4 times higher return on ad spend for click-to-Messenger ads versus those that just linked to the LEGO website. And I share that case because it shows what we're excited about. We're excited about a new surface where businesses can interact with consumers, but also really a new functionality. If you go further out, you would then start thinking about WhatsApp. We are very focused there on the user experience, but we're also focused even earlier stages on growing our business ecosystem. The WhatsApp Business app has launched, and we now have more than 3 million people actively using it to test business solutions. So that's further out, but we think it has potential as well."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Mark Mahaney from RBC Capital Markets."
},
{
"speaker": "Mark Mahaney - RBC Capital Markets LLC",
"text": "Two questions, please; a near term one and a long term one. The near term one is can you just comment on what you're seeing in terms of MAU recovery growth trends in Europe? You haven't – you gave us what turned out to be a pretty accurate read into the June quarter, so do you have a read into whether things have based out and started to improve again post GDPR implementation? And then, I know, Sheryl, you just talked about this, but can I just ask you to just maybe comment a little bit more on Facebook Messenger? I've just seen the ad units there. They seem to be – there seemed like there's been a pickup recently in implementation of ads there that seemed to me to be highly effective and reasonably well targeted. So any learnings just from those, the basic ad units that you put in there beyond the – kind of the business metrics you just reported on? Thank you."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Hey, Mark. It's Dave. On Europe, yeah, we don't have any update on trends. We had indicated in the first quarter that we would expect to see a decline. We're not providing any guidance on MAU and DAU in Europe on this call."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "In terms of number two, we have an ad model where we're able to use the targeting capabilities for Facebook. But when we put ads into a new surface, we obviously learn and evolve. So, one example of some of the things that we're excited about, again, are the click-to-Messenger ads. That's something we can put in News Feed in Instagram and Messenger and it both grows the ecosystem and creates a new opportunity for interaction. We also have inbox ads where we're enabling advertisers to extend their reach to people in Messenger, which is still really early. And we're also in the early days of sponsored messages, which enable businesses to reengage people once a conversation has started. And so, when we think about the format of Messenger, we think about the direct correspondence between a person, either an existing or a potential client or with a business, and we think there are many times in kind of a life cycle of interacting with a business where that's a very attractive opportunity."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of John Blackledge from Cowen."
},
{
"speaker": "John Blackledge - Cowen & Co. LLC",
"text": "Great. Thanks. Mark or Sheryl, could you discuss your view about the importance of Instagram as a discovery platform for new and/or emerging brands and merchants? And then, over time, as these merchants and brands mature, how do you view Instagram's ability to monetize? And then just a quick one on North American ad revenue; it was a bit lower than we expected in the second quarter. Don't know if you guys have any color there. Thank you."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "On the first, when we think about Instagram, we think we have a great opportunity; 25 million Instagram business profiles, 2 million advertisers. We're growing quite nicely across brand and DR. And with 1 billion active people on the platform, I think Instagram is definitely both a direct response opportunity but an opportunity for discovery. Part of it's the format. The format is so visually appealing and people are telling stories with pictures, so we see both anecdotally and in the data that this is a great place for people to become aware of a product in the first place. And we see a lot of small businesses really able to do things on the platform. I'll share a recent example. We just launched a shopping experience that was just expanded in Q2 to all consumers in an additional 45 countries. DefShop is an e-commerce fashion brand in Germany. They were an early tester for IG Shopping. And what they did in that test is tag each article of clothing. They had 56% more website visitors and a 64% increase in sales for tagged products. And I think a lot of those were discovered and purchased right through that advertising funnel."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "John, its Dave. Just on the North American deceleration in ad revenue growth, kind of consistent with the trends we've seen, so nothing there notable. I would say we're pleased at the growth that we're seeing at the scale at which we're operating. When you look at the deceleration, the one that I called out was really Europe where you saw the currency impact as well as, to a lesser extent, GDPR causing sort of faster deceleration than in the other regions. I would say North America was more kind of within kind of what we're seeing across the rest of the business."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Justin Post from Bank of America/Merrill Lynch."
},
{
"speaker": "Justin Post - Bank of America/Merrill Lynch",
"text": "Great. Thank you. The guidance for the deceleration might raise some questions just on Facebook engagement. So just wondering how you're seeing activity within just core Facebook right now? Is it growing at a healthy rate? And then, secondly, you have had a couple of months now with GDPR. Just wondering how you're thinking about how that will impact your ad targeting over the next year. Thank you."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Sure, Justin. I'll take that. So we're continuing to see good growth in the Facebook ecosystem with 11% DAU growth. And obviously, we've got broader family growth as well. In terms of, I guess, going to the GDPR question, we've talked about – oh, sorry. Sheryl, were you going to take the GDPR question?"
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "Yeah, I can talk about GDPR. GDPR has not had a revenue impact, but we also recognize it wasn't fully rolled out this quarter. It was very encouraging for us to see that the vast majority of people affirmed that they want us to use information, including from the websites they visit, to make their ads more relevant. But, as we look further out, we recognize that there's still risk, and we're going to watch closely. Advertisers are still adapting to the changes, so it's early to know the longer-term impact. And things like GDPR and other privacy changes that may happen from us or may happen with regulation could make ads more relevant. One thing that we know that's not going to change is that advertisers are always looking for the highest ROI opportunity. And what's most important in winning budget is our relative performance in the industry, and we believe we'll continue to do very well on that."
},
{
"speaker": "Operator",
"text": "Your next question..."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "I'll give a little bit more color – sorry. I wanted to give a little bit more color on some of the different regional trends we're seeing on Facebook DAU. U.S. and Canada, sort of consistent with past quarters, has been flat at about 185 million, and we would expect that to continue to bounce around. Europe, we saw the declines that we anticipated from GDPR. And I would say there, really, those impacts were purely due to the GDPR impact, not other engagement trends. So I would point to that. Otherwise, I think feeling good about Europe. Worldwide, we've got kind of different puts and takes. Indonesia had a SIM card registration requirement that caused a little bit of a headwind in APAC. And then rest of world, we saw some countries come back online like Ethiopia came back online. So some different puts and takes, but overall, still seeing regional growth across all regions with the exception of the U.S./Canada being flat."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Mark May from Citi."
},
{
"speaker": "Mark A. May - Citigroup Global Markets, Inc.",
"text": "Thanks. Just following up on the comments, Sheryl mentioned that there's really no meaningful impact on GDPR to the ad business, at least as of now. But then, Dave, I think you mentioned that because you're giving people more control over their privacy and data that this is one of the reasons why you're expecting the meaningful decel in the second half; so just trying to recognize those two things. Maybe the questions have been too specific around the impact of GDPR and should be more broad around data and privacy? And I guess, ultimately, the question is what impact, if any, these greater controls that you're giving users having on ad revenue growth and monetization? Thanks."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Sure, Mark. Let me take that. So GDPR didn't have a significant impact in Q2, partially because of its implementation date. So you're just seeing effectively one month of it in terms of revenue. We do think that there will be some modest impact, and I don't want to overplay these factors, but you've got a couple of things going on. You've got the impact of the opt-outs. And while we're very pleased with the vast majority of people opting into the third-party data use, some did not. So that will have a small impact on revenue growth. And then we're seeing some impact from how advertisers are using their own data for targeting. So, again, that will have a modest impact on growth. And then in addition, we're continuing to focus our product development around putting privacy first and that's going to, we believe, have some impact on revenue growth. So it's really a combination of kind of how we're approaching privacy as well as GDPR and the like. So I think all of those factors together are one of the factors that we're talking about; the other being, obviously, the currency flip."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Rich Greenfield from BTIG."
},
{
"speaker": "Richard Greenfield - BTIG LLC",
"text": "Hey. Thanks for taking the question. So I guess one of the things as you look at, you talked about the growth you're seeing in users overseas or basically everywhere but the U.S. and Canada. But when you look at ARPU, your ARPU outside, even in Europe, is still only a real tiny fraction of where you are in the U.S. and, obviously in Asia and rest of world, an infinitesimal fraction of where you are in the U.S. How does that factor into as you think about your long-term guidance that you just talked about, especially with margins moving towards the mid-30s, just given how early you are in those non-U.S. markets and how much headroom they have to grow as those ad markets mature. How do you have confidence that you, in that type of deceleration, when you look at how much upside there is in that ARPU?"
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Yeah, I guess you've got a couple of different factors going on there. You've got the opportunity, I think, for ARPU growth in those regions, and that's going to depend on the mix of countries in those regions and the GDP per capita in those countries as well as the relative size of the ad markets. And that correlates very strongly to our opportunity and our potential ARPU. And I think you've got upside growth potential in the long run in those markets. As it relates to margin profile, you also just have the factor that you're increasing growth – the increasing mix of the business is shifting towards Asia and towards what are currently lower ARPU markets. And so, while those are very attractive, we believe, to serve both in the near and in the long run, they're going to have a different impact on margin because the cost to support those users relative to the revenue they bring in does have an impact on margins in the medium-term."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Anthony DiClemente from Evercore."
},
{
"speaker": "Anthony DiClemente - Evercore Group LLC",
"text": "Thank you. I have two; one for Sheryl and one for Mark. Sheryl, in Dave's comments and the comments about the business impact of engagement shifting to Stories versus feed products, if you could spell out for us I guess the specific reasons why Stories monetization is not as strong as feed today and in the context perhaps of what needs to happen in the future for Stories monetization to rebound to, let's say, parity to where feed is today and sort of get through that negative impact. And then, for Mark, I think perhaps Heather was getting at this in her question, but the company's investing so much into owned data centers. You talked about that I think in your prepared remarks. Are there ways to improve the return on investment of those investments in data center servers, network infrastructure? And what I'm thinking is in order to perhaps service third-parties to maybe just improve those returns in the way that other tech and Internet companies have in terms of investments in infrastructure. Thank you."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "So, on Stories, we've seen great progress with Stories as a format for people to share on our platforms. We have 400 million people sharing with Instagram Stories, 450 million with WhatsApp Status. Facebook is newer, but we're seeing good progress there. The question is will this monetize at the same rate as News Feed? And we honestly don't know. We'll have to see what happens. There are good reasons to be very optimistic about the monetization. The opportunity, full-screen, authentic, very engaging, different format than feed, gives us an opportunity to grow. We also don't have all of our advertisers yet creating story ads. So, obviously, as more and more advertisers come in and do that, the more and the better ads we'll have. I think getting that ramp will take a while because Stories is a new format, and we definitely see that it takes a while for advertisers to adopt new formats. I think one of the other things we feel good about over the long run, not really the short run, is that since we have so many different places where you have Stories formats in Instagram and WhatsApp and Facebook, as volume increases of the opportunity, advertisers get more interested. But we won't know for a while if it's going to monetize at the same rate. We do feel very good about a new and very engaging opportunity for ads."
},
{
"speaker": "Operator",
"text": "Your next question..."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "And I can quickly answer the second part around data centers. I mean the quick answer is that we're not planning on going in to the cloud services. We're not planning on doing that. We have to build out all this capacity to serve our community. It's a very computationally and resource-intensive set of services that we provide and we need to build that out. We are very optimistic. I'm very optimistic about AI overall and being able to use more computing resources to be able to crunch more data to be able to rank News Feed and ads and search and friend suggestions, and all the important things that we use our AI systems to do in addition to the integrity and security work. Part of the advance in AI technology now allows us to use more compute to use all the data that's in the system to provide better results, so we certainly plan on doing that."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Peter Stabler from Wells Fargo Securities."
},
{
"speaker": "Peter C. Stabler - Wells Fargo Securities LLC",
"text": "Thanks. One for Sheryl and then one for Dave. Sheryl, just on the SMB side, wondering if you could give us any color by region, if possible. And then secondly, on the go-to-market strategy, to what extent is Facebook dependent upon or leveraging resellers versus small businesses discovering the ad platform on their own? How key is that reseller channel for you on the small business side? And then, for Dave, given that you've given us some kind of relatively specific guidance on the revenue growth decel through the remainder of the year, I'm wondering if you could give us some color on what that embeds from an FX expectation at this point. Thank you very much."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "So SMBs are very core to our business and, with over 80 million SMB pages that are using Facebook on a monthly basis, we know they're core to theirs. Our 6 million advertisers come from those pages, and so the fact that we have so much room to grow is exciting for us. We don't break this out by region, but we do see very strong SMB participation across the board and around the world, particularly as SMBs come online, the more. So, you can imagine that some of it goes with Internet penetration and Internet use. In terms of resellers, we think it's a big opportunity. We don't break that out either. But, obviously, some of our ads are sold directly and bought directly through our online interfaces. We also have third-parties that sell our ads and we welcome that as well."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Peter, its Dave. Just on the FX, we're just looking at current rates and just rolling those forward, not predicting what the rates will be, but rather looking at current rates and thus what the impact would be if rates stay the same on the second half."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Brent Thill from Jefferies."
},
{
"speaker": "Brent Thill - Jefferies LLC",
"text": "Thanks. Dave, I want to go back to the magnitude of the deceleration. I think many investors are having a hard time reconciling that type of deceleration considering how good the advertiser feedback is on your platform. And I realize you've outlined FX and Stories and the other factors, but is there something that you're hearing now from advertisers that is giving you more confidence that they're seeing something different about what we're all hearing right now? It just seems like the magnitude is beyond anything we've seen, especially across a number of tech names we all cover."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Yeah. Brent, I'll take that. And if Sheryl wants to add color, she should step in as well. This is consistent – we consistently have seen over last eight quarters constant currency deceleration. So, there's a continuation of this trend. I don't think there's anything beyond that in the factors that I outlined. I would note we've been benefiting from continued growth across Instagram. Instagram ad load in feed is at the same level as Facebook, so that would be – that's certainly been helpful in our recent quarters. So I think when you look at the factors going forward, I would say we've got the currency impact, we've got some of the impacts around privacy and the like, but we continue to get good advertiser feedback on ROI. We continue to believe we're delivering great ROI for advertisers. So I don't think there's anything from the advertiser perspective that's necessarily playing out differently than expectations. Sheryl can add any color there."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "Yeah, I'd add there. Even at decreasing growth rates, we are still growing and predicting growth at very healthy rates, and that's based on returning for advertisers. We're very focused on helping advertisers meet their ultimate goals, looking at their ROI, looking at the return they get on ringing the cash register, whether that cash register rings online or offline. And we hear from them and we continue to see in our results that we continue to deliver strong results. So we have a lot of opportunity ahead of us. We're going to continue investing in that opportunity. And what we're hearing from advertisers all over the world is that they want to continue to grow and invest with us as well."
},
{
"speaker": "Deborah Crawford - Facebook, Inc.",
"text": "Operator, we have time for one last question."
},
{
"speaker": "Operator",
"text": "The last question comes from the line of Colin Sebastian from Robert W. Baird."
},
{
"speaker": "Colin Alan Sebastian - Robert W. Baird & Co., Inc.",
"text": "Great. Thanks. Just a couple of follow ups for me. First off, Dave, maybe I missed this, but what timeframe are you referring to in terms of getting down to the mid-30s operating margin? And does that outlook assume any meaningful contribution from any of the new areas of innovation that you highlighted on the call? Just trying to figure out how much of that might be more conservatism. And then, on the near-term trends and the midterm elections in the U.S., given the amount of scrutiny that will exist in your platform, how should we think about your level of preparation on one hand to manage content? And then, on the other hand, is this part of the potential impact on monetization revenue growth in the back half of the year that you're taking into consideration? Thanks."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Sure, Collin. Let me take a crack at that. So, in terms of the guidance, I've given guidance. This is several years, so more than two but less than many. So it's over a timeframe more than two years is our expectation. And then in terms of does that have any meaningful contribution from areas of innovation, we talked about some of the areas that we're investing in. Obviously, on the safety and security side, those are costs that are layering in that we think are the right thing to do for the business but don't necessarily have a revenue impact. So it certainly takes those into account. It also takes into account the ongoing investments we're making in the longer-term innovation work, which I don't think will necessarily have any meaningful revenue relative to the size of the business in those time frames. We're also investing in things like video, Watch and the like, which have the potential to condition tribute on the revenue side, but still relatively small in perspective of the overall business."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "All right. And I can take the question on the midterm elections. So, yes, the short answer is that we're much more confident that we're going to get this right for the elections in the 2018, which include the U.S. midterms, but also the elections in Brazil and upcoming elections in early-2019 in India and the EU. And the reason why we're confident that we can get this right is because there have been several elections since the 2016 ones that have had much better results, including the French presidential election, the German elections, the Alabama special election, and the Mexican election about a month ago. And in each of these – going back to 2016, we were – we have a very big security team that was focused on security around even the 2016 election and we found hacking and phishing attacks that the Russian government was trying to do, and we notified the right people about those. But 2016 was really the first time that we saw this kind of coordinated information operation. And since then, we've built the playbook out that has included building AI tools to identify thousands of fake accounts and groups and pages that violate the policies. It's included growing the security and content review teams to 20,000 people to be able to handle the volume of work that we need to do. And it includes a lot of the transparency work around advertising in general, but also the political and issue ads archive and verifying all advertisers who are trying to run political and issue ads. There are a number of other things that we're doing too, including creating an external program for independent academics to study how the impact of social media and how foreign governments try to interfere in elections. And that will have a longer-term impact as well. But the short answer here is we've been very focused on this. 2018 is a big year. And because of the successful results that we've seen in a number of elections recently, we feel like our road map and our level of preparation is much higher now than it has been. And we feel relatively confident going into these elections."
},
{
"speaker": "Deborah Crawford - Facebook, Inc.",
"text": "Great. Thank you. Thank you for joining us today. We appreciate your time, and we look forward to speaking with you again."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines."
}
] | null | null |
META | 1 | 2,018 | 2018-04-25 17:00:00 | Executives: Deborah Crawford - Facebook, Inc. Mark Elliot Zuckerberg - Facebook, Inc. Sheryl Kara Sandberg - Facebook, Inc. David M. Wehner - Facebook, Inc.
Analysts: Douglas T. Anmuth - JPMorgan Securities LLC Mark A. May - Citi Investment Research Eric J. Sheridan - UBS Securities LLC Justin Post - Bank of America-Merrill Lynch Heather Bellini - Goldman Sachs & Co. LLC Ross Sandler - Barclays Capital, Inc. Anthony DiClemente - Evercore Group LLC John Blackledge - Cowen & Co. LLC Peter C. Stabler - Wells Fargo Securities LLC Brian Nowak - Morgan Stanley & Co. LLC Colin Alan Sebastian - Robert W. Baird & Co., Inc. Mark Mahaney - RBC Capital Markets LLC Richard Greenfield - BTIG LLC Youssef Squali - SunTrust Robinson Humphrey, Inc.
Operator: Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook First Quarter 2018 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there'll be a question-and-answer session. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin.
Deborah Crawford - Facebook, Inc.: Thank you. Good afternoon and welcome to Facebook's first quarter 2018 earnings conference call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I'd like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our Annual Report on Form 10-K filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I'd like to turn the call over to Mark.
Mark Elliot Zuckerberg - Facebook, Inc.: Thanks, Deborah, and thanks everyone for joining us today. Despite facing important challenges, our community and business are off to a strong start in 2018. More than 2.2 billion people now use Facebook every month, and more than 1.4 billion people use it every day. Our business grew 49% year-over-year to $12 billion. But as you know, we have important issues to address. For most of our existence, we've focused on all the good that connecting people can bring. But it's clear now we didn't do enough to prevent these tools from being used for harm as well, whether that's foreign interference in elections, fake news, hate speech, or app developers and data privacy. So now, we're going through every part of our relationship with people and making sure we're taking a broad enough view of our responsibility, not just to build tools, but to make sure those tools are used for good. This means continuing to invest heavily in safety, security and privacy. Some of this will come in the form of new technology. We're restricting that data developers can access. We're building advanced AI tools that have helped us detect and remove tens of thousands of fake accounts ahead of the elections in France, Germany and Alabama last year. We're investing more in people. We are doubling our team working on security and content review to more than 20,000 people by the end of this year, and this includes content reviewers with specific language skills to detect hate speech in places like Myanmar. We're also working to protect political discourse by making ads more transparent. We recently announced that from now on we will require everyone running political and issue ads or running a large page to be verified with a government ID. And we're also starting to roll out ads transparency tools that bring our ads to an even higher standard of transparency than TV or print ads. You'll be able to see who is running a political ad, who they're targeting, how much they're paying, and what other messages they're sending to different people. And we're going to get this done in time for the 2018 U.S. midterm as well as upcoming elections in Mexico, Brazil, India, Pakistan and more. We have a responsibility to keep our community safe and secure, and we're going to invest heavily to do that. At the same time, we also have a responsibility to keep moving forward and keep building tools that bring people together in meaningful new ways. That's what makes Facebook so important to so many people and that's our responsibility too. I'm proud that more than 2 billion people use our services to stay connected with the people that matter to them most. In just the last several months, we've seen the #metoo movement and the March for Our Lives, organized, at least in part, on Facebook. We've seen people come together after Hurricane Harvey to raise more than $20 million for relief, and we've seen more than 80 million small businesses use Facebook to grow and create jobs. That's why beyond the investments we're making to secure our platform, we're going to invest even more in building the experiences that bring people together on Facebook in the first place. Over the next three years, we're going to keep building Facebook to not only be a service that people love to use, but also one that's good for people and good for society. Last quarter, we shared our well-being research into the good and bad uses of technology that showed that when you use the internet to interact and build relationships that's correlated with greater long-term well-being and greater health and happiness over time. But when you're just passively watching videos or news online, that's not as positive. This quarter, we've continued shifting from passive consumption to encouraging meaningful interaction. It's still early, but we're starting to see some signs that this is working. Some types of sharing are increasing even as passive consumption of video is down. And at the same time, we're rolling out more interactive video features like Watch Party that let you watch video with your friend. This is something we can uniquely do and the feedback on it so far is great. Groups is also a major focus for us. This quarter, we announced that 200 million people are now members of meaningful groups on Facebook. Now we just need to keep doubling that for the next few years to reach our goal of helping 1 billion people belong to meaningful groups. As membership in physical groups continues declining as it has for decades, we hope helping people connect online will help strengthen our society's social fabric. Stories is also a big part of the future of video sharing, which is why we're all in on it across our family. Instagram was the first to really take off here, Facebook started slower, but is now growing quickly, too, and WhatsApp Status is by far the biggest of views products and continues to grow quickly. There's also a clear trend towards sharing with smaller groups, which is why messaging is so important. Between WhatsApp and Messenger, people now send almost 100 billion messages every day. They also do more than 3 billion minutes of video and voice calling every day, making us by far the largest network for video calling as well. Over the next five years, we're focused on building out the business ecosystems around our apps like Instagram, WhatsApp and Messenger. This quarter, we released WhatsApp Business, which lets small businesses create a presence and offers better tools for messaging. And in just a few months more than 3 million people are actively using WhatsApp Business. It's a hit and it's growing quickly. One of the interesting opportunities and challenges over the coming years will be making sure that ads are as good in Stories as they are in feeds. If we don't do this well, then as more sharing shifts to Stories, that could hurt our business. But there's real upside here, too, if we do a good job. And we're leading the way here with Instagram, and the results so far are promising both on product quality and business performance. Over the next 10 years, we're continuing to work on the long-term technology that we need to break down barriers and bring the world closer together. We continue to work on connectivity and our Internet.org efforts have now helped almost 100 million people get access to the Internet who may not have had it otherwise. AI is the most important technological trend right now and I'm optimistic that it can help us amplify the good that's happening on our services as well as proactively remove harmful content. For example, one thing that I'm proud of is our AI tools that help us take down ISIS and Al Qaeda related terror content, with 99% of that content being removed before any person flags it to us. We've also built AI tools that have flagged when people are posting thoughts about suicide. And these tools have helped us reach out to first responders to get over 1,000 people the help they need quickly. On the positive side, AI will help us understand the context of what people are sharing so we can help encourage more connection and conversations between people as well. And finally, we have some big moments for virtual reality coming up, and I'm excited to get Oculus Go in people's hands soon. Overall, 2018 is a year of important investment to keep people safe and also to keep building the experiences people expect from us. We are taking a broader view of our responsibility and investing to make sure our tools are used for good. And we also need to keep moving forward, building new tools to help people connect, build community and bring the world closer together. Thanks to all of you for being a part of this journey. I'm looking forward to making more progress together. Now, here's Sheryl to talk about our business.
Sheryl Kara Sandberg - Facebook, Inc.: Hi, everyone. Before going through our results, I want to take a minute to talk about ads and privacy. At Facebook, we have always built privacy protections into our ad system. We use the information you provide and that we receive from websites to target ads for advertisers, but we don't tell them who you are. We don't sell your information to advertisers or anyone else. We also believe that people should control their advertising experience. For every ad we show, there's an option to find out why you're seeing that ad and to turn off ads from that advertiser entirely. And you can opt out of being targeted based on certain information, like the websites you visit or your relationship status. Advertising and protecting people's information are not at odds. We do both. Targeted ads that respect people's privacy are better ads. They show people things that they're more likely to be interested in. We regularly hear from people who use Facebook that they prefer to see ads that are relevant to them and their lives. Effective advertising is also critical to helping businesses grow. This is especially important for small businesses who wouldn't otherwise be able to afford to buy broad reach media. As Mark shared, we now have more than 80 million small businesses around the world using Facebook pages and many of them are building their businesses on Facebook. Small businesses are the backbone of local communities and create the majority of jobs around the world and their growth creates millions of new jobs. We surveyed small businesses in 18 countries, and more than half of SMBs on Facebook say they've been able to hire more people due to growth in demand since joining our platform. Last month, I was in Houston for Facebook's Community Boost event. I met Patrice Farooq, who runs a small business called Cupcake Kitchen. After Hurricane Harvey damaged her business last year, she used Facebook to find new customers. Now more than half her business come from Facebook and she's getting ready to open a second store. We're proud of the ad model we've built. It ensures that people see more useful ads, allows millions of businesses to grow and enables us to provide a global service that's free for all to use. The fastest way to bridge the digital divide in the United States or around the world is by offering services free to any consumer regardless of their circumstance. Advertising supported businesses like Facebook equalize access and improve opportunity. At the same time, we know that people want control over how their information is used, and we want them to feel confident that the ads they're seeing are authentic. That's why we're building industry-leading transparency tools. This includes a way to see ads an advertiser is running, even if they aren't targeted to you. This new feature is live in Canada and will roll out in Ireland and the U.S. soon. In the coming months, GDPR will give us another opportunity to make sure people fully understand how their information is used by our services. It's an EU regulation, but as Mark said a few weeks ago, we're going to extend these controls to everyone who uses Facebook regardless of where in the world they live. Our commitment to you is that we will continue to improve our ads model by strengthening privacy and choice, while giving businesses of all sizes new and better tools to help them grow. With that, I'd like to turn to our results. It was a great quarter for our business. Q1 ad revenue grew 50% year-over-year. Mobile ad revenue was $10.7 billion, up 60% from last year and contributed approximately 91% of total ad revenue. Revenue growth was broad-based across regions, marketer segments and verticals. We continue to make progress on our three priorities: helping businesses leverage the power of mobile; developing new ad products; and making our ads more relevant and effective. First, leveraging the power of mobile. Advertisers recognize the importance of reaching their audience on mobile. During the Super Bowl this year, over 90% of national TV advertisers were also advertising on Facebook. This shows that the largest advertisers understand the value of broad-based campaigns with us. Take Tourism Australia. To get more Americans interested in visiting Australia, they ran ads on Facebook and Instagram in the week leading up to the game. On Super Bowl Sunday, they ran short video ads on Facebook before their big TV spot at halftime. This drove 22% incremental reach on top of TV and a 35 point lift in awareness. During the campaign, 50% of leads on the Tourism Australia site came from Facebook. Second, developing new ad products. Instagram Stories is changing how people share and express themselves. Advertisers are also finding creative ways to use the format. This quarter, we made carousel ads available in Stories so advertisers can share up to three images or videos per ad instead of just one. People can swipe up on the ads to visit the advertiser's website. We also announced a number of innovations to help retailers reach customers. We rolled out a more personalized shopping experience in News Feed. Now when people click on a collection ad, they'll see a full-screen catalog organized according to their interests. We also introduced a new way to reach people before they've shown interest in making a specific purchase. If someone is generally interested in furniture, a business can now run ads focused on different categories of their products, such as couches or tables, to inspire them to shop. And last, making our ads more relevant and effective. Our investments in measurement are helping advertisers of all sizes understand their results and make good investment decisions. We've heard from many of our advertisers that they want third-party verification to prove that we're helping them achieve their marketing goals. We were recently accredited by the Media Ratings Council for News Feed served ad impressions on desktop and mobile. We're working with them on accreditation in other areas as well. Going forward, we will continue to focus on these three priorities and ensure that people's privacy is protected on Facebook. I want to close by thanking our teams around the world for the work they do each and every day and each and every quarter to make our company and our services better. I'm also truly grateful to our partners who work with us to grow their businesses. Thanks, and now here's Dave.
David M. Wehner - Facebook, Inc.: Thanks, Sheryl, and good afternoon, everyone. Our community and business both showed solid growth in the first quarter. Let's start with our community metrics. Daily active users on Facebook reached 1.45 billion, up 13% compared to last year, led by user growth in India, Indonesia and Vietnam. This number represents approximately 66% of our 2.2 billion monthly active users in Q1. MAUs were up 260 million or 13% compared to last year. Turning now to the financials. All comparisons are on a year-over-year basis unless otherwise noted. Q1 total revenue was $12 billion, up 49% or 42% on a constant currency basis. Foreign exchange tailwinds contributed $536 million of revenue in Q1. Additionally, the adoption of ASC 606, the new revenue standard, resulted in approximately $130 million of incremental revenue in Q1 due to a change from net to gross accounting for our Instant Articles product. Q1 total ad revenue was $11.8 billion, up 50% or 43% on a constant currency basis. Mobile ad revenue was $10.7 billion, up 60%. In Q1, the average price per ad increased 39%, and the number of ad impressions served increased 8%, driven primarily by feed ads on Facebook and Instagram. Payments and other fees revenue was $171 million, down 2%. Turning to expenses, total expenses were $6.5 billion, up 39%. In Q1, we added over 2,600 employees, which was a record level of net new hires. We ended Q1 with over 27,700 full-time employees, up 48% compared to last year. We are focused on growing technical head count as well as a variety of other groups that support the business. Operating income was $5.4 billion, representing a 46% operating margin. Our effective tax rate was 11%. Net income was $5 billion or $1.69 per share. Capital expenditures were $2.8 billion, driven by investments in data centers, servers, network infrastructure and office facilities. In Q1, we generated $5 billion in free cash flow and ended the quarter with approximately $44 billion in cash and investments. In Q1, we bought back approximately $1.9 billion of our Class A common stock. Given our existing repurchase program is nearly fully executed, our Board of Directors has authorized the repurchase of up to an additional $9 billion of stock. Turning to our outlook, the changes that Mark and Sheryl described will, we believe, benefit our community and our business and will serve to strengthen Facebook overall. At the highest level, we believe that we can continue to build the great ads business while protecting people's privacy. That said, with regard to GDPR and other initiatives around data usage, while it's early and difficult to know the business implications in advance, we anticipate a couple of impacts. First, as you might expect, we believe that European MAU and DAU may be flat to slightly down sequentially in Q2 as a result of the GDPR rollout. Second, while we do not anticipate these changes will significantly impact advertising revenue, there is certainly the potential for some impact and we will be monitoring this closely. Importantly, GDPR affects the entire online advertising industry, so the Facebook specific impact is difficult to model in advance. In terms of our overall 2018 revenue outlook, we continue to anticipate revenue growth rates will decelerate on a constant currency basis throughout the year. On the expense side, we are tightening our initial expense guidance range. We now expect that full year 2018 total expenses will grow 50% to 60% compared to our prior range of 45% to 60%. This narrowed range reflects the significant investments we're making in areas like safety and security, content acquisition and our long-term innovation efforts. Turning to capital expenditures, we expect that our full year 2018 capital expenditures will be around $15 billion, at the high end of our prior range of $14 billion to $15 billion, driven by investments in data centers, servers, network infrastructure and office facilities. We also expect continued growth in capital expenditures beyond 2018 to support global growth and ongoing product improvements. Turning now to tax, at current stock prices, we expect that our Q2 and full year 2018 tax rate will be in the mid-teens. As a reminder, fluctuations in our stock price will impact our tax rate. In summary, our first quarter results demonstrated the growth in our business and global community remains strong. We have a lot of work ahead and are investing aggressively to enhance safety, security and privacy, while also focusing on our mission of giving people the power to build community and bring the world closer together. With that, operator, let's open up the call for questions.
Operator: We will now open the lines for a question-and-answer session. Your first question comes from the line of Doug Anmuth with JPMorgan.
Douglas T. Anmuth - JPMorgan Securities LLC: Great. Thanks for taking the question. One for Mark and one for Dave. Mark, so you focused on bringing people together and clearly have this massive platform with strong engagement, but can you talk about some of the business opportunities for Facebook on the platform away from advertising, and where you're most focused there? And then Dave, just on the OpEx, can you talk about kind of more specifically where some of the incremental costs would fall that take the previous low end of the range here off the table, given what you've seen over the last couple months? Thanks.
Mark Elliot Zuckerberg - Facebook, Inc.: I could take the first question. So we think that ads is a great business model that is aligned with our mission. We want to build a service that can help connect everyone around the world, so we want to offer that service for free and have it be affordable, and that's completely aligned with what we're trying to do. So even when we do other things, like we're running tests of payments, we have Marketplace which is growing and doing well, there may be other ways that we could think about making money from those, but in general our strategy is to offer those services at cost and make it so that businesses can bid what it is worth to them to run ads in the system. We think that that is both the most efficient way to run the business, it offers every business in the world the lowest prices that we can potentially offer, and it provides a great free service to people around the world. I know that a lot of people have had questions about the business model, and this is something that I just think we at Facebook are very proud of. And we think that it is the right way to build a service that connects everyone around the world.
David M. Wehner - Facebook, Inc.: Hey, Doug. It's Dave. So if you recall, it's very consistent with what we've been talking about the last couple of quarters which is the acceleration of expense growth is really driven by three factors. So it's the investments that we're making in safety and security, it's the content investments we're making to support Watch, and then finally it's the innovation initiatives around our longer term bets like AI, AR, VR and connectivity. So it's those three factors. If I had to point to what's really leading us to tighten the range, it's really the first factor which is the safety and security investments. Specifically, we're putting more behind that more quickly than we anticipated, and so that's where you're going to see it come up. If you look at the current results from this quarter, you'll see that our sales and marketing expense grew 51% in the quarter – one of the – year-over-year. One of the factors driving that is that's where we're categorizing our community operations investment and other operations teams that support the quality initiatives and the safety initiatives. So you're already seeing some of that getting picked up in the quarter and you'll see that carry through in the year.
Operator: Your next question comes from the line of Mark May with Citi.
Mark A. May - Citi Investment Research: Thank you. This question's probably aimed at Dave. You commented that you do not expect any significant, maybe some impact from the implementation of GDPR, yet you also voiced some uncertainty there. I guess the question is what gives you confidence in coming out now and saying that you expect no significant impact on the ad business, maybe some? And then maybe more for Mark, there have been some recent reports that imply that even some seemingly simple things that Facebook may not be proactively identifying or addressing have come up and I guess the question is, is it that it's not as simple as it may seem, or is it that these reports aren't accurate, this just has to do with some of the sensitive data like social security information being showing up online? Thank you.
David M. Wehner - Facebook, Inc.: Hey, Mark. It's Dave. So on GDPR, I think fundamentally we believe we can continue to build a great ads business while protecting the privacy of the people who use Facebook. As part of the rollout of GDPR, we're providing a lot of control to people around their ad settings and we're committed, as Sheryl and Mark mentioned, to providing those same controls worldwide. And while we don't expect these changes will significantly impact advertising revenue, there's certainly potential for some impact. Any change of the ability for us and our advertisers to use data can impact our optimization potential at the margin, which could impact our ability to drive price improvements in the long run. So we'll just have to watch how that plays out over time. I think it's important to note that GDPR is affecting the entire online advertising industry. And so what's really most important in winning budgets is our relative performance versus other opportunities presented to marketers. And that's why it will be important to watch kind of how this plays out at the industry level.
Sheryl Kara Sandberg - Facebook, Inc.: On the social security information, social security is not an input people put into Facebook and posts containing information like social security numbers or credit cards are not allowed on our site and we remove them as soon as we become aware of it. So we're continually working to improve these efforts and we encourage our community to report anything like this that they see, but that's not data that Facebook is collecting in any way.
Operator: Your next question comes from the line of Eric Sheridan with UBS.
Eric J. Sheridan - UBS Securities LLC: Thanks for taking the question, maybe two if I can. Mark, in the changes you talked about at the product level at the beginning part of the year, as you've started to make those changes and some of the content people see on the platform has evolved, what does that mean for engagement? What are you seeing in terms of the way people are using Facebook? I know it's early days, but curious if you've seen anything in terms of change of behavior. And then, Sheryl, we're starting to pick up from advertisers a lot of momentum and positive commentary on messaging platforms, especially Facebook Messenger. Wanted to know if you'd give us any color about your own conversations on the business side, on the messaging apps, WhatsApp, Facebook Messenger, and how investors should think about the opportunity there. Thanks.
Mark Elliot Zuckerberg - Facebook, Inc.: I can speak to the first point. So we made a number of changes and are still making changes to prioritize meaningful interactions between people over passive consumption of content. And that follows a lot of feedback directly from our community that people want Facebook to be more about friends and family and less about just content consumption. And it also follows the well-being research that we've done that suggests that when people use the Internet for interacting with people and building relationships, that is correlated with all of the positive measures of well-being that you just expect like longer term health and happiness, feeling more connected and less lonely, whereas just passively consuming content is not necessarily positive on those dimensions. So we've been rolling out a number of changes, both product changes and ranking the News Feed. As I said in my opening remarks, that has increased or we've observed increases in some types of sharing and interaction between people based on that. We've also observed some continued declines as we've done this and in the passive consumption of video, specifically. Overall, I'd say that these changes are doing what we expected that they would do and helping people to connect more and have more meaningful interactions. I think that that's the thing that people can uniquely do on Facebook that they can't do on other services that may be more about just consuming content. So we think that this is going in the direction of building a stronger community and a stronger business over the long term, and we're optimistic about what we're seeing here.
Sheryl Kara Sandberg - Facebook, Inc.: On Messenger, we continue to be primarily focused on consumer growth and engagement, and we're being slow and deliberate with monetization. It's worth noting this isn't a feed product, so there are some more unknowns here. But I think the potential is real and big and growing. We see a lot of organic connections between businesses and consumers, and our experience is that where are those – where we have those organic connections, that's very promising to turn that into monetization as well. We have over 18 million businesses now communicating with their customers through Messenger. We have 2 billion messages sent between people and businesses a month, which includes automated messages. And we're focused on launching new tools that help businesses use Messenger. For this quarter, we launched new quick replies for customers. We're seeing ads in inbox, which are now available to all advertisers. It's really early, but nice pick up and nice buzz there. And click to Messenger ads on Facebook are actually very promising as well because advertisers want to see a return for the money they spend. And when they have an ad and they can get a direct contact one to one with a customer, that's been something that people are really excited about. So early days, but I think a lot of potential here.
Operator: Your next question comes from the line of Justin Post with Bank of America Merrill Lynch.
Justin Post - Bank of America-Merrill Lynch: Thank you. I'd like to follow-up a little bit on usage just because of the comments last quarter. Any update to the time spent trends on Facebook post your changes? I guess, a second question is, do you think time spent on Facebook can start to grow again? And then third, when you look holistically at Instagram, which seems to be doing really well in third-party services, how do you think about the whole platform in total, Facebook plus Instagram? Thank you.
David M. Wehner - Facebook, Inc.: Yeah, so I'll take that. In terms of time spent on Facebook, we're not providing a specific update on that. I would note that Mark talked about some of the changes we're making to focus on connections over consumption. So we're seeing a decrease in certain types of time spent such as passive video consumption as a result of that and an increase in areas like sharing. So, we're not really optimizing the business on time spent, but rather the kind of quality of conversations and connections. So we're continuing to invest in that work, and we think it's the right thing for the Facebook community in the long run. And I think it's also good for overall engagement. For Instagram, that continues to perform very well, not providing kind of a separate breakout of that, but Instagram continues to grow nicely, both as a – both from an engagement perspective and a business perspective.
Operator: Your next question comes from the line of Heather Bellini with Goldman Sachs.
Heather Bellini - Goldman Sachs & Co. LLC: Great. Thank you very much. I was wondering if we could talk a little about Watch. I know it's early, but I was wondering if you could share with us your initial thoughts on how it's going versus your expectations? How you see it evolving over the next couple years? And ultimately, how would you define success for it as you look out? Thank you.
Mark Elliot Zuckerberg - Facebook, Inc.: So for Watch, the big thing that we're trying to do is help create new ways that people can connect, right? So it's very different from video and News Feed, the passive consumption that I'm talking about on response to some of the other questions because it's intentional, right? I mean, people go to it to watch specific content. And we're trying to make a different experience than what you might be able to get on YouTube or any of these other services by making it more about connecting with people in different ways. So a good example of this is what I talked about with Watch Party, where now people – groups of people can get together and can watch videos at the same time and you can interact around that. And we think that that's the kind of experience that we can uniquely build and that that's going to further our mission and just be a unique thing that we can add to the world. So what we're seeing so far is that a bunch of the content that has come onto Watch is good and is working and people watch it. We're continuing to treat the product to emphasize that kind of content more while building more of these social features. I'd say it's still pretty early overall in terms of the growth of this, but it's clearly an area that's important where I think we have something unique that we're going to bring to make this successful.
Operator: Your next question comes from the line of Ross Sandler with Barclays.
Ross Sandler - Barclays Capital, Inc.: Great. Just two questions. Dave, is the impression growth acceleration to 8% a function of easier comps or is it a function of some of the changes that Mark was talking about around the News Feed content that you put in in January? And then is the North America ad revenue growth acceleration being driven by that, that change on core Facebook? Or is it more coming from Instagram? Any color there on those two accelerating trends would be great. And then the last one is just a follow-up on the GDPR topic. Dave, you mentioned that MAUs and DAUs might be down a little bit in 2Q in Europe. Is that what you've seen already from these new screens that just came out with the new terms of service? Or is that just a guess of what you might see in the future? Thank you.
David M. Wehner - Facebook, Inc.: Sure. So I think I'll take all of those, Ross. So the impression growth acceleration, you've got a couple factors going on there. One of the factors is just that the desktop roll-off is just continuing. So as it gets smaller, it has less of a depressive effect on the overall impression growth number, because if you recall, desktop has quite a number of impressions per DAU, just given it's the right-hand column that has multiple impressions on each screen. So that's one of the reasons. And obviously, Instagram is continuing to grow nicely as well, so that's another contributing factor there. In terms of the North America revenue growth acceleration, one of the big factors there is really just also that's where you're picking up some of the accounting change from the Instant Articles going from net to gross, so that's contributing to that acceleration. Obviously, I'm very pleased with the strength of North American ad revenue and, overall, all the different regions, but that's a factor there, and IG is, obviously, contributing nicely to growth in North America and worldwide. Finally, on the GDPR trend, that's just based on what we're expecting given that you're having to bring people through these consent flows, and we have been modeling it and expect there would be a flat to down impact on MAU and DAU. It's very early in our rollout, but nothing inconsistent with what we've been modeling. So that's why we're giving that indication of what we expect.
Operator: Your next question comes from the line of Anthony DiClemente with Evercore ISI.
Anthony DiClemente - Evercore Group LLC: Thanks very much for taking my questions. I have two; one for Dave and one for Mark. Dave, will the privacy policy or the opt-in process differ in Europe versus other geographies post GDPR? Your prepared remarks suggested that those controls would extend to the rest of the world. And if that is the case, why wouldn't we also potentially see an impact to MAU and/or DAU outside of just Europe? And then Mark, just simple question, having watched most of your testimony on Capitol Hill, I just wonder what did you learn, or what surprised you the most personally from that experience? Thank you.
David M. Wehner - Facebook, Inc.: Do you want to take that, Sheryl?
Sheryl Kara Sandberg - Facebook, Inc.: Yeah. On the GDPR changes, so we just started rolling out the GDPR controls in Europe and we're going to make all the same controls and settings available every way, which gives people the same opportunities to make the same choices. It's not going to be exactly the same format. It's going to be localized instead for different parts of the world. And so we think some of the differences will come from that.
Mark Elliot Zuckerberg - Facebook, Inc.: And on the testimony, these are important issues and I think that that was an important moment to be able to go and hear what people were wondering about and just to have a public hearing of answering all of the questions around Cambridge Analytica and what we knew and all the steps that we're taking on data privacy and developers to make sure that this doesn't happen again and to lay out all the different things that we're doing. I mean, the hearings didn't just touch on that. They also touched on a number of the other issues that we face, including foreign interference in elections and that's something that we're incredibly focused on. 2018 is going to be an incredibly important year on this. There are big elections, not just the U.S. midterms, but the major elections upcoming in Mexico, in Brazil, in India, and Pakistan, and a number of other countries around the world. So this is important and it was an important moment for the company to hear the feedback and to show what we're doing. And now I think the important thing is that we execute on all the things that we need to do to make sure that we keep people safe.
Operator: Your next question comes from the line of Brian Nowak with Morgan Stanley. Brian Nowak, your line is open. Your next question comes from the line of John Blackledge with Cowen.
John Blackledge - Cowen & Co. LLC: Great. Thanks. Two questions. First, you posted another strong quarter for ad growth. Just wondering given the recent events, has there been any change in kind of advertisers' views about the platform, or concerns about ROI going forward? And then second on video, was there much investment in video content in the first quarter, or do you expect the bulk of the video content spend to hit kind of through the rest of the year, and what types of content will you be investing in?
Sheryl Kara Sandberg - Facebook, Inc.: To the first, in the immediate days of the concern, we heard from a handful of advertisers who paused spend, one of whom has already come back, and we haven't seen a meaningful trend or anything much since then. Advertisers ask the same questions as people are, that they want to make sure their and their customers' data is protected, and I think we are able to answer those questions in a compelling way. In terms of ROI on the platform, the ROI is really determined by the ability of advertisers to put the right ad in front of the right person in the right format. And I think we're seeing impressive growth in all of those areas. We have more advertisers using the ability to target their ads to the right person. We have more advertisers experimenting with different formats. Stories on Instagram are a very promising one, and we're seeing some nice experimentation there. And we have more advertisers really embracing the measurement that helps close the loop and helps make their ads more effective. So I think in terms of the ROI we are able to offer our marketers, the signs are strong, and we also continue to see there's a lot of room for improvement.
David M. Wehner - Facebook, Inc.: Yeah, John, on the video investment in the first quarter, it's clearly going to be more weighted towards the rest of the year, but we're already seeing the impact of some of that. So if you look at just the cost of revenue line where that's getting picked up, we saw cost of revenue grow 66% year-over-year. If you look at the gross margin, it dropped from 86% to 84%. There's really two kind main – two big factors in that compression there. One of those is the video content investment. The other is the move to gross versus net accounting on the Instant Articles product. So those are the two things that I'd point to as being drivers of that margin compression getting picked up in cost of revenue. So video is having an impact, but we grew expenses 39% year-over-year in the first quarter. We're obviously expecting faster growth in the back half – back three quarters of the year, so that's – video's going to be a component in driving that.
Operator: Your next question comes from the line of Peter Stabler with Wells Fargo Securities.
Peter C. Stabler - Wells Fargo Securities LLC: Thanks very much. A couple for Sheryl, if I may. A couple on GDPR. Do you think it's going to have any impact on your measurement capabilities? So that's one. And then secondly, if users elect to take the strictest possible approach to their data management, would their product experience change in any way on Facebook? I mean, we have a sense that their advertising experience might change, but in terms of their use of News Feed or any of your products, would the actual product functionality materially change for them? Thanks very much.
Sheryl Kara Sandberg - Facebook, Inc.: When you think about the way people have the choice to restrict data use, I think it would affect the product. There is lots of ways we use data to make the product better. It really depends what that would be. I don't think we have full visibility into what those changes would be over the long time. In terms of measurement capabilities, I don't think there's a direct thing we're exactly worried about right now. It's more what happens over the long time. The way we think about it, and Dave said this, is that the amount of uncertainty there is for us and all the other companies in the digital advertising industry is reasonably higher than it's been right now because we're in the process of rolling out GDPR. We're going to all know a lot more after we roll out, but the thing that won't change is that advertisers are going to look at the highest ROI opportunity. And what's most important in winning budgets is relative performance in the industry. And so we think that certainly we want to provide the best advertising, we certainly want to provide the best measurement, but our ability to do so as long as things happen across the industry, which is what's happening, I think we remain in a very strong position.
Operator: Your next question comes from the line of Brian Nowak with Morgan Stanley.
Brian Nowak - Morgan Stanley & Co. LLC: Thanks for taking my question. Sorry. Technological challenges. There's been a lot of good questions around core Facebook. Can you talk a little bit about Instagram, Mark, and how do you see the product evolving over the next 12 months? What are your visions for how it could continue to drive more engagement and maybe even higher quality connections on Instagram? And then second one on payments. Could you talk a little about philosophically how you think about the importance of enabling more frictionless payments to drive a higher quality advertising experience on Messenger and WhatsApp?
Mark Elliot Zuckerberg - Facebook, Inc.: Sure. So, on Instagram, there are a number of really exciting opportunities. The main focus is on helping people capture and share any moment that they want, and also the whole theme that we have around community plays out a little bit differently on Instagram. So for example, while there is no formal groups product on Instagram, people use Explore. More than 200 million people use Explore in order to see content that's interesting to them and interact with people beyond their friends and the people who are – who they follow directly. We launched hashtag following in December. That's a product that has done very well. I think now more than 100 million people follow different hashtags, which is a way that people can form ad hoc communities, and that – it all goes towards the overall mission that we have as a company of helping to build community and bring people closer together. Private sharing, both with Stories and direct messaging, are growing incredibly quickly on Instagram, and I think that those are both very exciting areas for development of products as well. You asked about payments in WhatsApp and Messenger, was that right?
Brian Nowak - Morgan Stanley & Co. LLC: Yes.
Mark Elliot Zuckerberg - Facebook, Inc.: So I think that this is going to be a really big opportunity. And again, like I said earlier, the point here isn't to charge for payments. It's that messaging can be a more transactional medium than feed. So I think what you're going to start to see are people interacting with pages, maybe follow a page on Facebook or Instagram. You see content from that page. You can click through or tap through to a message thread, and then you can either get customer support or complete a transaction or do a follow-on transaction. And that will be very valuable for businesses. So we view the payment in that context not as the goal, but as something that's helping the business and the person succeed at having the transaction or doing what they're trying to do. And that's going to make people's experience better, somebody can just do that online, and it's going to make businesses – it's going to make the experience of being on Facebook as a business more valuable because you can complete the transactions there. I'll add one more thing that I think is interesting on payments. I think this is probably different from what you're asking about, but I think it's cool. We've been running an experiment with mobile financial services in Messenger, and one of the things that we found in the Philippines, for example, is that people can buy access to data plans through Messenger. And because it allows the mobile carriers to not have to have the whole supply chain and sales and retail that they have otherwise, they're able to sell the data plans for on average about 10% less than they would be able to otherwise, which actually is allowing more people to get on the internet in the first place because they can now afford data plans. So it's an interesting example of how having payments in messaging can increase efficiency for businesses and how in this case that's contributing to our Internet.org and connectivity goals of helping more people access the internet who wouldn't have otherwise been able to. In other cases, it will be able to help people accomplish their goals with different businesses more easily.
Operator: Your next question comes from the line of Colin Sebastian with Robert Baird.
Colin Alan Sebastian - Robert W. Baird & Co., Inc.: Great. Thanks, and good afternoon. First off, related to the machine learning capabilities and more specifically how that's deployed into content filtering, I wonder if you can compare the ability of the machines to analyze content today versus six months or even a year ago? Meaning, is that ability improving at a rate where you have a higher degree of confidence in that reliability? And then secondly, wonder if you've been able to discern any impact to date on content publishers or apps that are utilizing Facebook for reach and engagement following the rollout of changes in access to APIs, login and other developer resources. Thank you.
Mark Elliot Zuckerberg - Facebook, Inc.: I could take the first one. So on AI, I think that there's a very big shift in how we're going to think about content moderation on the platform. And I mean, this goes back to the beginning of the service, right? So in 2004, when I was starting in my dorm room, for a number of reasons, it was just me, so we didn't have a lot of capacity to have thousands of people reviewing content. AI technology was not developed at the time. The only real logical way to run the service was to enable people to share what they wanted and then reactively, if people in the community saw something that was offensive or they thought was against the rules, they'd flag it for us. And we'd look at it and take things down that didn't belong. Now it is becoming increasingly possible, both because we can build the AI tools, but couple that with being able to hire thousands and thousands of people to do faster review of the content and look at something proactively. We're shifting over the next few years to a much more proactive model of moderation. Now, one of the things that I think is going to be interesting, and in some cases a little frustrating, is that AI tools lend themselves towards identifying certain content a lot more easily than others. So one area where I'm very proud that we're doing great work is around identifying terrorist content. And I mentioned this before that 99% of the ISIS and Al Qaeda related content that we take down, we're removing before any person flags it to us. And that's great, right? That's doing a good job. But if you look at areas like hate speech, which are just much more nuanced linguistically, it really depends on the local language, that's an area where I think it's going to take more years to be able to do something reasonably. So one of the pieces of criticism that I think we get that I think is fair is we're much better able to enforce our nudity policies, for example, than we are hate speech. And the reason for that is it's much easier to build an AI system that can detect a nipple than it is to determine what is linguistically hate speech. So this is something that I think we will make progress on and will get better on over time. These are not unsolvable problems, although it's worth calling out that our adversaries have all the same AI tools – or some of them, I think. I'd like to think that we're a little bit ahead. But we'll have a lot of the same tools as the field develops. But the combination of building AI and hiring what is going to be tens of thousands of people to work on these problems, I think will see us make very meaningful progress going forward.
Sheryl Kara Sandberg - Facebook, Inc.: To your second question, when we think about what's happening with developers, we are doing an audit of large developers and doing some investigation. We don't break out marketer segments, but mobile app install ads, which is where the revenue would come from developers, is a relatively small part of our advertising revenue. And our mobile app install ads help apps of all kinds, not those running on our platform. So we think the investigatory work we're doing into APIs, into the use, is very important, and we don't expect it to have an impact on revenue.
Operator: Your next question comes from the line of Mark Mahaney with RBC Capital Markets.
Mark Mahaney - RBC Capital Markets LLC: Okay. Two questions, please. David, could you just try to spell out a little bit more how GDPR could actually impact advertising revenue growth in the future, like, what's the doomsday scenario here? Is it just that it's clipped down because there would be a hit maybe near term to MAUs and DAUs? Or is there a reasonable scenario under which tracking or targeting would be impaired? Just spell out what the worst case scenario is. I'm kind of skeptical that there is one. But if there is one, please spell it out. And then, Mark, on Oculus, could you just give us a little bit of an update on your kind of long-term thinking about Oculus? There hasn't been a lot of focus on it. But Oculus Go is coming out. So maybe we all should take another – have another thought on it, like the opportunity you see there, where you think the product development is at this point? Are we years away from something mass marketable? Any commentary like that would be really helpful. Thank you.
David M. Wehner - Facebook, Inc.: So, Mark, on the first question, I don't know that we really see a doomsday scenario here. I think what we think is that depending on how people react to the controls and the ad settings, there could be some limitations to data usage. We believe that those will be relatively minor. But depending on how broadly the controls are adopted and set, there is a potential to impact targeting for our advertisers. Obviously, if they are less able to target effectively, they'll get a lower ROI on their advertising campaigns. They'll then bid differently into the auction. That ultimately will flow through into how we can realize price on the impressions that we're selling. So I think that's the mitigating issue that we could see, depending on how GDPR and our broader commitment to providing these same controls worldwide could play out. We think that there is a great case for not just our business, but also for the user experience on Facebook to have targeting because we think it's a better experience for the people who use Facebook to have targeted ads. We think we can do that in a privacy-protected way, and it's just a better experience. You get more relevant ads. And I think overall benefits not only the advertisers, but also the people who use Facebook. So I don't think we see a real doomsday scenario here. We see an opportunity to really make the case.
Operator: Your next question...
Mark Elliot Zuckerberg - Facebook, Inc.: And on virtual reality...
David M. Wehner - Facebook, Inc.: Mark has a second part of that question.
Mark Elliot Zuckerberg - Facebook, Inc.: So on virtual reality here, I think the big picture is that every 10 to 15 years or so there is a major new computing paradigm, right, whether that's DOS and then Windows and kind of desktop UI and then web browsers and now mobile phones and apps. So it strikes me as inevitable that that progression will continue. And each one gets to be more natural to interact with, more natural gestures for controlling, more immersive, more portable. So I think it strikes me as very likely that the next one is going to be around virtual and augmented reality. So we're investing a lot in this because, frankly, we haven't to date been a hardware company or an operating system company. And we think that we need to build up a lot of different muscles in order to be competitive and be able to succeed in that space and to be able to shape that space. One of my great regrets in how we've run the company so far is I feel like we didn't get to shape the way that mobile platforms developed as much as would be good because they were developed contemporaneously with Facebook early on, right. I mean, iOS and Android came out around 2007. We were really small company at that point. So that just wasn't a thing that we were working on. But now I think we're living in a world where – the way that I think about this is that people should really be at the center of how we design technology. It shouldn't be designed around apps. It should be designed around our relationships because that's what matters to people. And that's not the world we're on on mobile. So I really am very committed to this idea of making sure that the next platform reflects those values that Facebook stands for. I think this is going to be an exciting year. As you mentioned, Oculus Go is coming out. We have the prototype and the developer kit around the higher-end stand-alone coming out as well, and we're doing a number of other things that I think are going to be quite exciting over time as well. But that's how I think about the whole space. I don't know exactly when it's going to be a big deal. When we started talking about this, I said that I thought that this was going to be a 10-year journey before this was really a very mainstream, major platform. And I think the reality is Facebook needs to be investing before it is a big thing in order to build some of the muscles to be competitive. We're committed to doing that because I think that this is important for our mission.
Operator: Your next question comes from the line of Rich Greenfield with BTIG.
Richard Greenfield - BTIG LLC: Hi. Thanks for taking the question. When you think about the opportunities for the business broadly, you obviously are crushing it from an advertising standpoint when you look at any measure of growth. But wondering as you think about how you take this massive platform of users and engagement that you have across all your platforms, I'm thinking about if you look at like what Spotify has been able to achieve in music subscriptions, what Apple even has done in music subscriptions, what Netflix is doing in video, Amazon obviously now crossing 100 million subscribers. Like, is there other lines of business, other revenue streams that people should be thinking about that create substantial opportunities, and specifically subscription, and then maybe if you could just touch on from a commerce standpoint now that Instagram's starting to be such a big driver of commerce, how do you think about diversifying revenues versus essentially being almost pure advertising? Thanks so much.
Sheryl Kara Sandberg - Facebook, Inc.: We've certainly thought about lots of other forms of monetization, including subscriptions, and we'll always continue to consider everything. Ads for us is a very natural fit for our business, and we have a lot of runway ahead of us. We've done – obviously, we have 80 million now pages, so we have 80 million businesses using Facebook on a monthly basis, of which 6 million are advertisers. On Instagram, we have 25 million Instagram business profiles, of which 2 million are advertisers. So even if we just convert people who are advertising on Facebook into Instagram, that's a lot of a growth opportunity. Then you can start thinking about Messenger and some of the other platforms we have. What's I think interesting and strong about our potential business growth is that we're able to do this across these services. So as I mentioned before, running an ad that has a click to Messenger ad that goes into Messenger is just an early example of what's possible. And I think if you look at a large base of businesses who use us without paying, the growing base of businesses who do pay us and then the runway we have in services that are 1 billion plus (59:48) that we're really not monetizing, I think a strong focus on ads continues to be the best investment we can make. It's also very core to our mission. Ads gives us the ability to provide a free service to the world. And if your goal is to connect to everyone and make sure that people can all participate, that ads-based model makes a lot of sense and we're going to continue to invest very heavily there.
Deborah Crawford - Facebook, Inc.: Operator, we have time for one last question.
Operator: The last question comes from the line of Youssef Squali with SunTrust.
Youssef Squali - SunTrust Robinson Humphrey, Inc.: Thank you very much. I guess two quick questions for David. Growth in MAUs in rest of world was up about 11%; I think last year, it was up almost double that, 19% or so. Anything changed there that maybe could explain the slowdown? And I think we saw also a slighter – slightly lower growth in pricing as well. And then lastly, on the buyback, how much do you still have left on the old authorization to which we need to add the new $9 billion? And how do you look at it? Is it being (01:00:54) opportunistic, or do you have a timeline by which you guys are planning to complete the repurchase? Thank you.
David M. Wehner - Facebook, Inc.: Sure, Youssef. On the growth in MAUs in rest of world, we've had certain slowdowns. There was an internet shutdown in Ethiopia that contributed a little bit to that. So you've got some kind of one-time factors that do come into play there. So I think that's probably what I would point to. Nothing that notable to call out there. In terms of the share repurchase authorization, I would just say that we've just about gotten our way through that. We had about $2 billion left as of the end of the quarter. But we think it's – we asked the board and the board approved a $9 billion additional authorization. We look at it on two fronts: just offsetting the dilution from the share issuances that we have and then secondarily, to be opportunistic. And we think with the cash flow that we're generating, we have a strong financial position with which to fund that.
Deborah Crawford - Facebook, Inc.: Great. Thank you for joining us today. We appreciate your time, and we look forward to speaking with you again.
Operator: Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines. | [
{
"speaker": "Executives",
"text": "Deborah Crawford - Facebook, Inc. Mark Elliot Zuckerberg - Facebook, Inc. Sheryl Kara Sandberg - Facebook, Inc. David M. Wehner - Facebook, Inc."
},
{
"speaker": "Analysts",
"text": "Douglas T. Anmuth - JPMorgan Securities LLC Mark A. May - Citi Investment Research Eric J. Sheridan - UBS Securities LLC Justin Post - Bank of America-Merrill Lynch Heather Bellini - Goldman Sachs & Co. LLC Ross Sandler - Barclays Capital, Inc. Anthony DiClemente - Evercore Group LLC John Blackledge - Cowen & Co. LLC Peter C. Stabler - Wells Fargo Securities LLC Brian Nowak - Morgan Stanley & Co. LLC Colin Alan Sebastian - Robert W. Baird & Co., Inc. Mark Mahaney - RBC Capital Markets LLC Richard Greenfield - BTIG LLC Youssef Squali - SunTrust Robinson Humphrey, Inc."
},
{
"speaker": "Operator",
"text": "Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook First Quarter 2018 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there'll be a question-and-answer session. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford - Facebook, Inc.",
"text": "Thank you. Good afternoon and welcome to Facebook's first quarter 2018 earnings conference call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I'd like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our Annual Report on Form 10-K filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I'd like to turn the call over to Mark."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Thanks, Deborah, and thanks everyone for joining us today. Despite facing important challenges, our community and business are off to a strong start in 2018. More than 2.2 billion people now use Facebook every month, and more than 1.4 billion people use it every day. Our business grew 49% year-over-year to $12 billion. But as you know, we have important issues to address. For most of our existence, we've focused on all the good that connecting people can bring. But it's clear now we didn't do enough to prevent these tools from being used for harm as well, whether that's foreign interference in elections, fake news, hate speech, or app developers and data privacy. So now, we're going through every part of our relationship with people and making sure we're taking a broad enough view of our responsibility, not just to build tools, but to make sure those tools are used for good. This means continuing to invest heavily in safety, security and privacy. Some of this will come in the form of new technology. We're restricting that data developers can access. We're building advanced AI tools that have helped us detect and remove tens of thousands of fake accounts ahead of the elections in France, Germany and Alabama last year. We're investing more in people. We are doubling our team working on security and content review to more than 20,000 people by the end of this year, and this includes content reviewers with specific language skills to detect hate speech in places like Myanmar. We're also working to protect political discourse by making ads more transparent. We recently announced that from now on we will require everyone running political and issue ads or running a large page to be verified with a government ID. And we're also starting to roll out ads transparency tools that bring our ads to an even higher standard of transparency than TV or print ads. You'll be able to see who is running a political ad, who they're targeting, how much they're paying, and what other messages they're sending to different people. And we're going to get this done in time for the 2018 U.S. midterm as well as upcoming elections in Mexico, Brazil, India, Pakistan and more. We have a responsibility to keep our community safe and secure, and we're going to invest heavily to do that. At the same time, we also have a responsibility to keep moving forward and keep building tools that bring people together in meaningful new ways. That's what makes Facebook so important to so many people and that's our responsibility too. I'm proud that more than 2 billion people use our services to stay connected with the people that matter to them most. In just the last several months, we've seen the #metoo movement and the March for Our Lives, organized, at least in part, on Facebook. We've seen people come together after Hurricane Harvey to raise more than $20 million for relief, and we've seen more than 80 million small businesses use Facebook to grow and create jobs. That's why beyond the investments we're making to secure our platform, we're going to invest even more in building the experiences that bring people together on Facebook in the first place. Over the next three years, we're going to keep building Facebook to not only be a service that people love to use, but also one that's good for people and good for society. Last quarter, we shared our well-being research into the good and bad uses of technology that showed that when you use the internet to interact and build relationships that's correlated with greater long-term well-being and greater health and happiness over time. But when you're just passively watching videos or news online, that's not as positive. This quarter, we've continued shifting from passive consumption to encouraging meaningful interaction. It's still early, but we're starting to see some signs that this is working. Some types of sharing are increasing even as passive consumption of video is down. And at the same time, we're rolling out more interactive video features like Watch Party that let you watch video with your friend. This is something we can uniquely do and the feedback on it so far is great. Groups is also a major focus for us. This quarter, we announced that 200 million people are now members of meaningful groups on Facebook. Now we just need to keep doubling that for the next few years to reach our goal of helping 1 billion people belong to meaningful groups. As membership in physical groups continues declining as it has for decades, we hope helping people connect online will help strengthen our society's social fabric. Stories is also a big part of the future of video sharing, which is why we're all in on it across our family. Instagram was the first to really take off here, Facebook started slower, but is now growing quickly, too, and WhatsApp Status is by far the biggest of views products and continues to grow quickly. There's also a clear trend towards sharing with smaller groups, which is why messaging is so important. Between WhatsApp and Messenger, people now send almost 100 billion messages every day. They also do more than 3 billion minutes of video and voice calling every day, making us by far the largest network for video calling as well. Over the next five years, we're focused on building out the business ecosystems around our apps like Instagram, WhatsApp and Messenger. This quarter, we released WhatsApp Business, which lets small businesses create a presence and offers better tools for messaging. And in just a few months more than 3 million people are actively using WhatsApp Business. It's a hit and it's growing quickly. One of the interesting opportunities and challenges over the coming years will be making sure that ads are as good in Stories as they are in feeds. If we don't do this well, then as more sharing shifts to Stories, that could hurt our business. But there's real upside here, too, if we do a good job. And we're leading the way here with Instagram, and the results so far are promising both on product quality and business performance. Over the next 10 years, we're continuing to work on the long-term technology that we need to break down barriers and bring the world closer together. We continue to work on connectivity and our Internet.org efforts have now helped almost 100 million people get access to the Internet who may not have had it otherwise. AI is the most important technological trend right now and I'm optimistic that it can help us amplify the good that's happening on our services as well as proactively remove harmful content. For example, one thing that I'm proud of is our AI tools that help us take down ISIS and Al Qaeda related terror content, with 99% of that content being removed before any person flags it to us. We've also built AI tools that have flagged when people are posting thoughts about suicide. And these tools have helped us reach out to first responders to get over 1,000 people the help they need quickly. On the positive side, AI will help us understand the context of what people are sharing so we can help encourage more connection and conversations between people as well. And finally, we have some big moments for virtual reality coming up, and I'm excited to get Oculus Go in people's hands soon. Overall, 2018 is a year of important investment to keep people safe and also to keep building the experiences people expect from us. We are taking a broader view of our responsibility and investing to make sure our tools are used for good. And we also need to keep moving forward, building new tools to help people connect, build community and bring the world closer together. Thanks to all of you for being a part of this journey. I'm looking forward to making more progress together. Now, here's Sheryl to talk about our business."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "Hi, everyone. Before going through our results, I want to take a minute to talk about ads and privacy. At Facebook, we have always built privacy protections into our ad system. We use the information you provide and that we receive from websites to target ads for advertisers, but we don't tell them who you are. We don't sell your information to advertisers or anyone else. We also believe that people should control their advertising experience. For every ad we show, there's an option to find out why you're seeing that ad and to turn off ads from that advertiser entirely. And you can opt out of being targeted based on certain information, like the websites you visit or your relationship status. Advertising and protecting people's information are not at odds. We do both. Targeted ads that respect people's privacy are better ads. They show people things that they're more likely to be interested in. We regularly hear from people who use Facebook that they prefer to see ads that are relevant to them and their lives. Effective advertising is also critical to helping businesses grow. This is especially important for small businesses who wouldn't otherwise be able to afford to buy broad reach media. As Mark shared, we now have more than 80 million small businesses around the world using Facebook pages and many of them are building their businesses on Facebook. Small businesses are the backbone of local communities and create the majority of jobs around the world and their growth creates millions of new jobs. We surveyed small businesses in 18 countries, and more than half of SMBs on Facebook say they've been able to hire more people due to growth in demand since joining our platform. Last month, I was in Houston for Facebook's Community Boost event. I met Patrice Farooq, who runs a small business called Cupcake Kitchen. After Hurricane Harvey damaged her business last year, she used Facebook to find new customers. Now more than half her business come from Facebook and she's getting ready to open a second store. We're proud of the ad model we've built. It ensures that people see more useful ads, allows millions of businesses to grow and enables us to provide a global service that's free for all to use. The fastest way to bridge the digital divide in the United States or around the world is by offering services free to any consumer regardless of their circumstance. Advertising supported businesses like Facebook equalize access and improve opportunity. At the same time, we know that people want control over how their information is used, and we want them to feel confident that the ads they're seeing are authentic. That's why we're building industry-leading transparency tools. This includes a way to see ads an advertiser is running, even if they aren't targeted to you. This new feature is live in Canada and will roll out in Ireland and the U.S. soon. In the coming months, GDPR will give us another opportunity to make sure people fully understand how their information is used by our services. It's an EU regulation, but as Mark said a few weeks ago, we're going to extend these controls to everyone who uses Facebook regardless of where in the world they live. Our commitment to you is that we will continue to improve our ads model by strengthening privacy and choice, while giving businesses of all sizes new and better tools to help them grow. With that, I'd like to turn to our results. It was a great quarter for our business. Q1 ad revenue grew 50% year-over-year. Mobile ad revenue was $10.7 billion, up 60% from last year and contributed approximately 91% of total ad revenue. Revenue growth was broad-based across regions, marketer segments and verticals. We continue to make progress on our three priorities: helping businesses leverage the power of mobile; developing new ad products; and making our ads more relevant and effective. First, leveraging the power of mobile. Advertisers recognize the importance of reaching their audience on mobile. During the Super Bowl this year, over 90% of national TV advertisers were also advertising on Facebook. This shows that the largest advertisers understand the value of broad-based campaigns with us. Take Tourism Australia. To get more Americans interested in visiting Australia, they ran ads on Facebook and Instagram in the week leading up to the game. On Super Bowl Sunday, they ran short video ads on Facebook before their big TV spot at halftime. This drove 22% incremental reach on top of TV and a 35 point lift in awareness. During the campaign, 50% of leads on the Tourism Australia site came from Facebook. Second, developing new ad products. Instagram Stories is changing how people share and express themselves. Advertisers are also finding creative ways to use the format. This quarter, we made carousel ads available in Stories so advertisers can share up to three images or videos per ad instead of just one. People can swipe up on the ads to visit the advertiser's website. We also announced a number of innovations to help retailers reach customers. We rolled out a more personalized shopping experience in News Feed. Now when people click on a collection ad, they'll see a full-screen catalog organized according to their interests. We also introduced a new way to reach people before they've shown interest in making a specific purchase. If someone is generally interested in furniture, a business can now run ads focused on different categories of their products, such as couches or tables, to inspire them to shop. And last, making our ads more relevant and effective. Our investments in measurement are helping advertisers of all sizes understand their results and make good investment decisions. We've heard from many of our advertisers that they want third-party verification to prove that we're helping them achieve their marketing goals. We were recently accredited by the Media Ratings Council for News Feed served ad impressions on desktop and mobile. We're working with them on accreditation in other areas as well. Going forward, we will continue to focus on these three priorities and ensure that people's privacy is protected on Facebook. I want to close by thanking our teams around the world for the work they do each and every day and each and every quarter to make our company and our services better. I'm also truly grateful to our partners who work with us to grow their businesses. Thanks, and now here's Dave."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Thanks, Sheryl, and good afternoon, everyone. Our community and business both showed solid growth in the first quarter. Let's start with our community metrics. Daily active users on Facebook reached 1.45 billion, up 13% compared to last year, led by user growth in India, Indonesia and Vietnam. This number represents approximately 66% of our 2.2 billion monthly active users in Q1. MAUs were up 260 million or 13% compared to last year. Turning now to the financials. All comparisons are on a year-over-year basis unless otherwise noted. Q1 total revenue was $12 billion, up 49% or 42% on a constant currency basis. Foreign exchange tailwinds contributed $536 million of revenue in Q1. Additionally, the adoption of ASC 606, the new revenue standard, resulted in approximately $130 million of incremental revenue in Q1 due to a change from net to gross accounting for our Instant Articles product. Q1 total ad revenue was $11.8 billion, up 50% or 43% on a constant currency basis. Mobile ad revenue was $10.7 billion, up 60%. In Q1, the average price per ad increased 39%, and the number of ad impressions served increased 8%, driven primarily by feed ads on Facebook and Instagram. Payments and other fees revenue was $171 million, down 2%. Turning to expenses, total expenses were $6.5 billion, up 39%. In Q1, we added over 2,600 employees, which was a record level of net new hires. We ended Q1 with over 27,700 full-time employees, up 48% compared to last year. We are focused on growing technical head count as well as a variety of other groups that support the business. Operating income was $5.4 billion, representing a 46% operating margin. Our effective tax rate was 11%. Net income was $5 billion or $1.69 per share. Capital expenditures were $2.8 billion, driven by investments in data centers, servers, network infrastructure and office facilities. In Q1, we generated $5 billion in free cash flow and ended the quarter with approximately $44 billion in cash and investments. In Q1, we bought back approximately $1.9 billion of our Class A common stock. Given our existing repurchase program is nearly fully executed, our Board of Directors has authorized the repurchase of up to an additional $9 billion of stock. Turning to our outlook, the changes that Mark and Sheryl described will, we believe, benefit our community and our business and will serve to strengthen Facebook overall. At the highest level, we believe that we can continue to build the great ads business while protecting people's privacy. That said, with regard to GDPR and other initiatives around data usage, while it's early and difficult to know the business implications in advance, we anticipate a couple of impacts. First, as you might expect, we believe that European MAU and DAU may be flat to slightly down sequentially in Q2 as a result of the GDPR rollout. Second, while we do not anticipate these changes will significantly impact advertising revenue, there is certainly the potential for some impact and we will be monitoring this closely. Importantly, GDPR affects the entire online advertising industry, so the Facebook specific impact is difficult to model in advance. In terms of our overall 2018 revenue outlook, we continue to anticipate revenue growth rates will decelerate on a constant currency basis throughout the year. On the expense side, we are tightening our initial expense guidance range. We now expect that full year 2018 total expenses will grow 50% to 60% compared to our prior range of 45% to 60%. This narrowed range reflects the significant investments we're making in areas like safety and security, content acquisition and our long-term innovation efforts. Turning to capital expenditures, we expect that our full year 2018 capital expenditures will be around $15 billion, at the high end of our prior range of $14 billion to $15 billion, driven by investments in data centers, servers, network infrastructure and office facilities. We also expect continued growth in capital expenditures beyond 2018 to support global growth and ongoing product improvements. Turning now to tax, at current stock prices, we expect that our Q2 and full year 2018 tax rate will be in the mid-teens. As a reminder, fluctuations in our stock price will impact our tax rate. In summary, our first quarter results demonstrated the growth in our business and global community remains strong. We have a lot of work ahead and are investing aggressively to enhance safety, security and privacy, while also focusing on our mission of giving people the power to build community and bring the world closer together. With that, operator, let's open up the call for questions."
},
{
"speaker": "Operator",
"text": "We will now open the lines for a question-and-answer session. Your first question comes from the line of Doug Anmuth with JPMorgan."
},
{
"speaker": "Douglas T. Anmuth - JPMorgan Securities LLC",
"text": "Great. Thanks for taking the question. One for Mark and one for Dave. Mark, so you focused on bringing people together and clearly have this massive platform with strong engagement, but can you talk about some of the business opportunities for Facebook on the platform away from advertising, and where you're most focused there? And then Dave, just on the OpEx, can you talk about kind of more specifically where some of the incremental costs would fall that take the previous low end of the range here off the table, given what you've seen over the last couple months? Thanks."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "I could take the first question. So we think that ads is a great business model that is aligned with our mission. We want to build a service that can help connect everyone around the world, so we want to offer that service for free and have it be affordable, and that's completely aligned with what we're trying to do. So even when we do other things, like we're running tests of payments, we have Marketplace which is growing and doing well, there may be other ways that we could think about making money from those, but in general our strategy is to offer those services at cost and make it so that businesses can bid what it is worth to them to run ads in the system. We think that that is both the most efficient way to run the business, it offers every business in the world the lowest prices that we can potentially offer, and it provides a great free service to people around the world. I know that a lot of people have had questions about the business model, and this is something that I just think we at Facebook are very proud of. And we think that it is the right way to build a service that connects everyone around the world."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Hey, Doug. It's Dave. So if you recall, it's very consistent with what we've been talking about the last couple of quarters which is the acceleration of expense growth is really driven by three factors. So it's the investments that we're making in safety and security, it's the content investments we're making to support Watch, and then finally it's the innovation initiatives around our longer term bets like AI, AR, VR and connectivity. So it's those three factors. If I had to point to what's really leading us to tighten the range, it's really the first factor which is the safety and security investments. Specifically, we're putting more behind that more quickly than we anticipated, and so that's where you're going to see it come up. If you look at the current results from this quarter, you'll see that our sales and marketing expense grew 51% in the quarter – one of the – year-over-year. One of the factors driving that is that's where we're categorizing our community operations investment and other operations teams that support the quality initiatives and the safety initiatives. So you're already seeing some of that getting picked up in the quarter and you'll see that carry through in the year."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Mark May with Citi."
},
{
"speaker": "Mark A. May - Citi Investment Research",
"text": "Thank you. This question's probably aimed at Dave. You commented that you do not expect any significant, maybe some impact from the implementation of GDPR, yet you also voiced some uncertainty there. I guess the question is what gives you confidence in coming out now and saying that you expect no significant impact on the ad business, maybe some? And then maybe more for Mark, there have been some recent reports that imply that even some seemingly simple things that Facebook may not be proactively identifying or addressing have come up and I guess the question is, is it that it's not as simple as it may seem, or is it that these reports aren't accurate, this just has to do with some of the sensitive data like social security information being showing up online? Thank you."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Hey, Mark. It's Dave. So on GDPR, I think fundamentally we believe we can continue to build a great ads business while protecting the privacy of the people who use Facebook. As part of the rollout of GDPR, we're providing a lot of control to people around their ad settings and we're committed, as Sheryl and Mark mentioned, to providing those same controls worldwide. And while we don't expect these changes will significantly impact advertising revenue, there's certainly potential for some impact. Any change of the ability for us and our advertisers to use data can impact our optimization potential at the margin, which could impact our ability to drive price improvements in the long run. So we'll just have to watch how that plays out over time. I think it's important to note that GDPR is affecting the entire online advertising industry. And so what's really most important in winning budgets is our relative performance versus other opportunities presented to marketers. And that's why it will be important to watch kind of how this plays out at the industry level."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "On the social security information, social security is not an input people put into Facebook and posts containing information like social security numbers or credit cards are not allowed on our site and we remove them as soon as we become aware of it. So we're continually working to improve these efforts and we encourage our community to report anything like this that they see, but that's not data that Facebook is collecting in any way."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Eric Sheridan with UBS."
},
{
"speaker": "Eric J. Sheridan - UBS Securities LLC",
"text": "Thanks for taking the question, maybe two if I can. Mark, in the changes you talked about at the product level at the beginning part of the year, as you've started to make those changes and some of the content people see on the platform has evolved, what does that mean for engagement? What are you seeing in terms of the way people are using Facebook? I know it's early days, but curious if you've seen anything in terms of change of behavior. And then, Sheryl, we're starting to pick up from advertisers a lot of momentum and positive commentary on messaging platforms, especially Facebook Messenger. Wanted to know if you'd give us any color about your own conversations on the business side, on the messaging apps, WhatsApp, Facebook Messenger, and how investors should think about the opportunity there. Thanks."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "I can speak to the first point. So we made a number of changes and are still making changes to prioritize meaningful interactions between people over passive consumption of content. And that follows a lot of feedback directly from our community that people want Facebook to be more about friends and family and less about just content consumption. And it also follows the well-being research that we've done that suggests that when people use the Internet for interacting with people and building relationships, that is correlated with all of the positive measures of well-being that you just expect like longer term health and happiness, feeling more connected and less lonely, whereas just passively consuming content is not necessarily positive on those dimensions. So we've been rolling out a number of changes, both product changes and ranking the News Feed. As I said in my opening remarks, that has increased or we've observed increases in some types of sharing and interaction between people based on that. We've also observed some continued declines as we've done this and in the passive consumption of video, specifically. Overall, I'd say that these changes are doing what we expected that they would do and helping people to connect more and have more meaningful interactions. I think that that's the thing that people can uniquely do on Facebook that they can't do on other services that may be more about just consuming content. So we think that this is going in the direction of building a stronger community and a stronger business over the long term, and we're optimistic about what we're seeing here."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "On Messenger, we continue to be primarily focused on consumer growth and engagement, and we're being slow and deliberate with monetization. It's worth noting this isn't a feed product, so there are some more unknowns here. But I think the potential is real and big and growing. We see a lot of organic connections between businesses and consumers, and our experience is that where are those – where we have those organic connections, that's very promising to turn that into monetization as well. We have over 18 million businesses now communicating with their customers through Messenger. We have 2 billion messages sent between people and businesses a month, which includes automated messages. And we're focused on launching new tools that help businesses use Messenger. For this quarter, we launched new quick replies for customers. We're seeing ads in inbox, which are now available to all advertisers. It's really early, but nice pick up and nice buzz there. And click to Messenger ads on Facebook are actually very promising as well because advertisers want to see a return for the money they spend. And when they have an ad and they can get a direct contact one to one with a customer, that's been something that people are really excited about. So early days, but I think a lot of potential here."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Justin Post with Bank of America Merrill Lynch."
},
{
"speaker": "Justin Post - Bank of America-Merrill Lynch",
"text": "Thank you. I'd like to follow-up a little bit on usage just because of the comments last quarter. Any update to the time spent trends on Facebook post your changes? I guess, a second question is, do you think time spent on Facebook can start to grow again? And then third, when you look holistically at Instagram, which seems to be doing really well in third-party services, how do you think about the whole platform in total, Facebook plus Instagram? Thank you."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Yeah, so I'll take that. In terms of time spent on Facebook, we're not providing a specific update on that. I would note that Mark talked about some of the changes we're making to focus on connections over consumption. So we're seeing a decrease in certain types of time spent such as passive video consumption as a result of that and an increase in areas like sharing. So, we're not really optimizing the business on time spent, but rather the kind of quality of conversations and connections. So we're continuing to invest in that work, and we think it's the right thing for the Facebook community in the long run. And I think it's also good for overall engagement. For Instagram, that continues to perform very well, not providing kind of a separate breakout of that, but Instagram continues to grow nicely, both as a – both from an engagement perspective and a business perspective."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Heather Bellini with Goldman Sachs."
},
{
"speaker": "Heather Bellini - Goldman Sachs & Co. LLC",
"text": "Great. Thank you very much. I was wondering if we could talk a little about Watch. I know it's early, but I was wondering if you could share with us your initial thoughts on how it's going versus your expectations? How you see it evolving over the next couple years? And ultimately, how would you define success for it as you look out? Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "So for Watch, the big thing that we're trying to do is help create new ways that people can connect, right? So it's very different from video and News Feed, the passive consumption that I'm talking about on response to some of the other questions because it's intentional, right? I mean, people go to it to watch specific content. And we're trying to make a different experience than what you might be able to get on YouTube or any of these other services by making it more about connecting with people in different ways. So a good example of this is what I talked about with Watch Party, where now people – groups of people can get together and can watch videos at the same time and you can interact around that. And we think that that's the kind of experience that we can uniquely build and that that's going to further our mission and just be a unique thing that we can add to the world. So what we're seeing so far is that a bunch of the content that has come onto Watch is good and is working and people watch it. We're continuing to treat the product to emphasize that kind of content more while building more of these social features. I'd say it's still pretty early overall in terms of the growth of this, but it's clearly an area that's important where I think we have something unique that we're going to bring to make this successful."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ross Sandler with Barclays."
},
{
"speaker": "Ross Sandler - Barclays Capital, Inc.",
"text": "Great. Just two questions. Dave, is the impression growth acceleration to 8% a function of easier comps or is it a function of some of the changes that Mark was talking about around the News Feed content that you put in in January? And then is the North America ad revenue growth acceleration being driven by that, that change on core Facebook? Or is it more coming from Instagram? Any color there on those two accelerating trends would be great. And then the last one is just a follow-up on the GDPR topic. Dave, you mentioned that MAUs and DAUs might be down a little bit in 2Q in Europe. Is that what you've seen already from these new screens that just came out with the new terms of service? Or is that just a guess of what you might see in the future? Thank you."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Sure. So I think I'll take all of those, Ross. So the impression growth acceleration, you've got a couple factors going on there. One of the factors is just that the desktop roll-off is just continuing. So as it gets smaller, it has less of a depressive effect on the overall impression growth number, because if you recall, desktop has quite a number of impressions per DAU, just given it's the right-hand column that has multiple impressions on each screen. So that's one of the reasons. And obviously, Instagram is continuing to grow nicely as well, so that's another contributing factor there. In terms of the North America revenue growth acceleration, one of the big factors there is really just also that's where you're picking up some of the accounting change from the Instant Articles going from net to gross, so that's contributing to that acceleration. Obviously, I'm very pleased with the strength of North American ad revenue and, overall, all the different regions, but that's a factor there, and IG is, obviously, contributing nicely to growth in North America and worldwide. Finally, on the GDPR trend, that's just based on what we're expecting given that you're having to bring people through these consent flows, and we have been modeling it and expect there would be a flat to down impact on MAU and DAU. It's very early in our rollout, but nothing inconsistent with what we've been modeling. So that's why we're giving that indication of what we expect."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Anthony DiClemente with Evercore ISI."
},
{
"speaker": "Anthony DiClemente - Evercore Group LLC",
"text": "Thanks very much for taking my questions. I have two; one for Dave and one for Mark. Dave, will the privacy policy or the opt-in process differ in Europe versus other geographies post GDPR? Your prepared remarks suggested that those controls would extend to the rest of the world. And if that is the case, why wouldn't we also potentially see an impact to MAU and/or DAU outside of just Europe? And then Mark, just simple question, having watched most of your testimony on Capitol Hill, I just wonder what did you learn, or what surprised you the most personally from that experience? Thank you."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Do you want to take that, Sheryl?"
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "Yeah. On the GDPR changes, so we just started rolling out the GDPR controls in Europe and we're going to make all the same controls and settings available every way, which gives people the same opportunities to make the same choices. It's not going to be exactly the same format. It's going to be localized instead for different parts of the world. And so we think some of the differences will come from that."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "And on the testimony, these are important issues and I think that that was an important moment to be able to go and hear what people were wondering about and just to have a public hearing of answering all of the questions around Cambridge Analytica and what we knew and all the steps that we're taking on data privacy and developers to make sure that this doesn't happen again and to lay out all the different things that we're doing. I mean, the hearings didn't just touch on that. They also touched on a number of the other issues that we face, including foreign interference in elections and that's something that we're incredibly focused on. 2018 is going to be an incredibly important year on this. There are big elections, not just the U.S. midterms, but the major elections upcoming in Mexico, in Brazil, in India, and Pakistan, and a number of other countries around the world. So this is important and it was an important moment for the company to hear the feedback and to show what we're doing. And now I think the important thing is that we execute on all the things that we need to do to make sure that we keep people safe."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Brian Nowak with Morgan Stanley. Brian Nowak, your line is open. Your next question comes from the line of John Blackledge with Cowen."
},
{
"speaker": "John Blackledge - Cowen & Co. LLC",
"text": "Great. Thanks. Two questions. First, you posted another strong quarter for ad growth. Just wondering given the recent events, has there been any change in kind of advertisers' views about the platform, or concerns about ROI going forward? And then second on video, was there much investment in video content in the first quarter, or do you expect the bulk of the video content spend to hit kind of through the rest of the year, and what types of content will you be investing in?"
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "To the first, in the immediate days of the concern, we heard from a handful of advertisers who paused spend, one of whom has already come back, and we haven't seen a meaningful trend or anything much since then. Advertisers ask the same questions as people are, that they want to make sure their and their customers' data is protected, and I think we are able to answer those questions in a compelling way. In terms of ROI on the platform, the ROI is really determined by the ability of advertisers to put the right ad in front of the right person in the right format. And I think we're seeing impressive growth in all of those areas. We have more advertisers using the ability to target their ads to the right person. We have more advertisers experimenting with different formats. Stories on Instagram are a very promising one, and we're seeing some nice experimentation there. And we have more advertisers really embracing the measurement that helps close the loop and helps make their ads more effective. So I think in terms of the ROI we are able to offer our marketers, the signs are strong, and we also continue to see there's a lot of room for improvement."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Yeah, John, on the video investment in the first quarter, it's clearly going to be more weighted towards the rest of the year, but we're already seeing the impact of some of that. So if you look at just the cost of revenue line where that's getting picked up, we saw cost of revenue grow 66% year-over-year. If you look at the gross margin, it dropped from 86% to 84%. There's really two kind main – two big factors in that compression there. One of those is the video content investment. The other is the move to gross versus net accounting on the Instant Articles product. So those are the two things that I'd point to as being drivers of that margin compression getting picked up in cost of revenue. So video is having an impact, but we grew expenses 39% year-over-year in the first quarter. We're obviously expecting faster growth in the back half – back three quarters of the year, so that's – video's going to be a component in driving that."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Peter Stabler with Wells Fargo Securities."
},
{
"speaker": "Peter C. Stabler - Wells Fargo Securities LLC",
"text": "Thanks very much. A couple for Sheryl, if I may. A couple on GDPR. Do you think it's going to have any impact on your measurement capabilities? So that's one. And then secondly, if users elect to take the strictest possible approach to their data management, would their product experience change in any way on Facebook? I mean, we have a sense that their advertising experience might change, but in terms of their use of News Feed or any of your products, would the actual product functionality materially change for them? Thanks very much."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "When you think about the way people have the choice to restrict data use, I think it would affect the product. There is lots of ways we use data to make the product better. It really depends what that would be. I don't think we have full visibility into what those changes would be over the long time. In terms of measurement capabilities, I don't think there's a direct thing we're exactly worried about right now. It's more what happens over the long time. The way we think about it, and Dave said this, is that the amount of uncertainty there is for us and all the other companies in the digital advertising industry is reasonably higher than it's been right now because we're in the process of rolling out GDPR. We're going to all know a lot more after we roll out, but the thing that won't change is that advertisers are going to look at the highest ROI opportunity. And what's most important in winning budgets is relative performance in the industry. And so we think that certainly we want to provide the best advertising, we certainly want to provide the best measurement, but our ability to do so as long as things happen across the industry, which is what's happening, I think we remain in a very strong position."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Brian Nowak with Morgan Stanley."
},
{
"speaker": "Brian Nowak - Morgan Stanley & Co. LLC",
"text": "Thanks for taking my question. Sorry. Technological challenges. There's been a lot of good questions around core Facebook. Can you talk a little bit about Instagram, Mark, and how do you see the product evolving over the next 12 months? What are your visions for how it could continue to drive more engagement and maybe even higher quality connections on Instagram? And then second one on payments. Could you talk a little about philosophically how you think about the importance of enabling more frictionless payments to drive a higher quality advertising experience on Messenger and WhatsApp?"
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Sure. So, on Instagram, there are a number of really exciting opportunities. The main focus is on helping people capture and share any moment that they want, and also the whole theme that we have around community plays out a little bit differently on Instagram. So for example, while there is no formal groups product on Instagram, people use Explore. More than 200 million people use Explore in order to see content that's interesting to them and interact with people beyond their friends and the people who are – who they follow directly. We launched hashtag following in December. That's a product that has done very well. I think now more than 100 million people follow different hashtags, which is a way that people can form ad hoc communities, and that – it all goes towards the overall mission that we have as a company of helping to build community and bring people closer together. Private sharing, both with Stories and direct messaging, are growing incredibly quickly on Instagram, and I think that those are both very exciting areas for development of products as well. You asked about payments in WhatsApp and Messenger, was that right?"
},
{
"speaker": "Brian Nowak - Morgan Stanley & Co. LLC",
"text": "Yes."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "So I think that this is going to be a really big opportunity. And again, like I said earlier, the point here isn't to charge for payments. It's that messaging can be a more transactional medium than feed. So I think what you're going to start to see are people interacting with pages, maybe follow a page on Facebook or Instagram. You see content from that page. You can click through or tap through to a message thread, and then you can either get customer support or complete a transaction or do a follow-on transaction. And that will be very valuable for businesses. So we view the payment in that context not as the goal, but as something that's helping the business and the person succeed at having the transaction or doing what they're trying to do. And that's going to make people's experience better, somebody can just do that online, and it's going to make businesses – it's going to make the experience of being on Facebook as a business more valuable because you can complete the transactions there. I'll add one more thing that I think is interesting on payments. I think this is probably different from what you're asking about, but I think it's cool. We've been running an experiment with mobile financial services in Messenger, and one of the things that we found in the Philippines, for example, is that people can buy access to data plans through Messenger. And because it allows the mobile carriers to not have to have the whole supply chain and sales and retail that they have otherwise, they're able to sell the data plans for on average about 10% less than they would be able to otherwise, which actually is allowing more people to get on the internet in the first place because they can now afford data plans. So it's an interesting example of how having payments in messaging can increase efficiency for businesses and how in this case that's contributing to our Internet.org and connectivity goals of helping more people access the internet who wouldn't have otherwise been able to. In other cases, it will be able to help people accomplish their goals with different businesses more easily."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Colin Sebastian with Robert Baird."
},
{
"speaker": "Colin Alan Sebastian - Robert W. Baird & Co., Inc.",
"text": "Great. Thanks, and good afternoon. First off, related to the machine learning capabilities and more specifically how that's deployed into content filtering, I wonder if you can compare the ability of the machines to analyze content today versus six months or even a year ago? Meaning, is that ability improving at a rate where you have a higher degree of confidence in that reliability? And then secondly, wonder if you've been able to discern any impact to date on content publishers or apps that are utilizing Facebook for reach and engagement following the rollout of changes in access to APIs, login and other developer resources. Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "I could take the first one. So on AI, I think that there's a very big shift in how we're going to think about content moderation on the platform. And I mean, this goes back to the beginning of the service, right? So in 2004, when I was starting in my dorm room, for a number of reasons, it was just me, so we didn't have a lot of capacity to have thousands of people reviewing content. AI technology was not developed at the time. The only real logical way to run the service was to enable people to share what they wanted and then reactively, if people in the community saw something that was offensive or they thought was against the rules, they'd flag it for us. And we'd look at it and take things down that didn't belong. Now it is becoming increasingly possible, both because we can build the AI tools, but couple that with being able to hire thousands and thousands of people to do faster review of the content and look at something proactively. We're shifting over the next few years to a much more proactive model of moderation. Now, one of the things that I think is going to be interesting, and in some cases a little frustrating, is that AI tools lend themselves towards identifying certain content a lot more easily than others. So one area where I'm very proud that we're doing great work is around identifying terrorist content. And I mentioned this before that 99% of the ISIS and Al Qaeda related content that we take down, we're removing before any person flags it to us. And that's great, right? That's doing a good job. But if you look at areas like hate speech, which are just much more nuanced linguistically, it really depends on the local language, that's an area where I think it's going to take more years to be able to do something reasonably. So one of the pieces of criticism that I think we get that I think is fair is we're much better able to enforce our nudity policies, for example, than we are hate speech. And the reason for that is it's much easier to build an AI system that can detect a nipple than it is to determine what is linguistically hate speech. So this is something that I think we will make progress on and will get better on over time. These are not unsolvable problems, although it's worth calling out that our adversaries have all the same AI tools – or some of them, I think. I'd like to think that we're a little bit ahead. But we'll have a lot of the same tools as the field develops. But the combination of building AI and hiring what is going to be tens of thousands of people to work on these problems, I think will see us make very meaningful progress going forward."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "To your second question, when we think about what's happening with developers, we are doing an audit of large developers and doing some investigation. We don't break out marketer segments, but mobile app install ads, which is where the revenue would come from developers, is a relatively small part of our advertising revenue. And our mobile app install ads help apps of all kinds, not those running on our platform. So we think the investigatory work we're doing into APIs, into the use, is very important, and we don't expect it to have an impact on revenue."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Mark Mahaney with RBC Capital Markets."
},
{
"speaker": "Mark Mahaney - RBC Capital Markets LLC",
"text": "Okay. Two questions, please. David, could you just try to spell out a little bit more how GDPR could actually impact advertising revenue growth in the future, like, what's the doomsday scenario here? Is it just that it's clipped down because there would be a hit maybe near term to MAUs and DAUs? Or is there a reasonable scenario under which tracking or targeting would be impaired? Just spell out what the worst case scenario is. I'm kind of skeptical that there is one. But if there is one, please spell it out. And then, Mark, on Oculus, could you just give us a little bit of an update on your kind of long-term thinking about Oculus? There hasn't been a lot of focus on it. But Oculus Go is coming out. So maybe we all should take another – have another thought on it, like the opportunity you see there, where you think the product development is at this point? Are we years away from something mass marketable? Any commentary like that would be really helpful. Thank you."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "So, Mark, on the first question, I don't know that we really see a doomsday scenario here. I think what we think is that depending on how people react to the controls and the ad settings, there could be some limitations to data usage. We believe that those will be relatively minor. But depending on how broadly the controls are adopted and set, there is a potential to impact targeting for our advertisers. Obviously, if they are less able to target effectively, they'll get a lower ROI on their advertising campaigns. They'll then bid differently into the auction. That ultimately will flow through into how we can realize price on the impressions that we're selling. So I think that's the mitigating issue that we could see, depending on how GDPR and our broader commitment to providing these same controls worldwide could play out. We think that there is a great case for not just our business, but also for the user experience on Facebook to have targeting because we think it's a better experience for the people who use Facebook to have targeted ads. We think we can do that in a privacy-protected way, and it's just a better experience. You get more relevant ads. And I think overall benefits not only the advertisers, but also the people who use Facebook. So I don't think we see a real doomsday scenario here. We see an opportunity to really make the case."
},
{
"speaker": "Operator",
"text": "Your next question..."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "And on virtual reality..."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Mark has a second part of that question."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "So on virtual reality here, I think the big picture is that every 10 to 15 years or so there is a major new computing paradigm, right, whether that's DOS and then Windows and kind of desktop UI and then web browsers and now mobile phones and apps. So it strikes me as inevitable that that progression will continue. And each one gets to be more natural to interact with, more natural gestures for controlling, more immersive, more portable. So I think it strikes me as very likely that the next one is going to be around virtual and augmented reality. So we're investing a lot in this because, frankly, we haven't to date been a hardware company or an operating system company. And we think that we need to build up a lot of different muscles in order to be competitive and be able to succeed in that space and to be able to shape that space. One of my great regrets in how we've run the company so far is I feel like we didn't get to shape the way that mobile platforms developed as much as would be good because they were developed contemporaneously with Facebook early on, right. I mean, iOS and Android came out around 2007. We were really small company at that point. So that just wasn't a thing that we were working on. But now I think we're living in a world where – the way that I think about this is that people should really be at the center of how we design technology. It shouldn't be designed around apps. It should be designed around our relationships because that's what matters to people. And that's not the world we're on on mobile. So I really am very committed to this idea of making sure that the next platform reflects those values that Facebook stands for. I think this is going to be an exciting year. As you mentioned, Oculus Go is coming out. We have the prototype and the developer kit around the higher-end stand-alone coming out as well, and we're doing a number of other things that I think are going to be quite exciting over time as well. But that's how I think about the whole space. I don't know exactly when it's going to be a big deal. When we started talking about this, I said that I thought that this was going to be a 10-year journey before this was really a very mainstream, major platform. And I think the reality is Facebook needs to be investing before it is a big thing in order to build some of the muscles to be competitive. We're committed to doing that because I think that this is important for our mission."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Rich Greenfield with BTIG."
},
{
"speaker": "Richard Greenfield - BTIG LLC",
"text": "Hi. Thanks for taking the question. When you think about the opportunities for the business broadly, you obviously are crushing it from an advertising standpoint when you look at any measure of growth. But wondering as you think about how you take this massive platform of users and engagement that you have across all your platforms, I'm thinking about if you look at like what Spotify has been able to achieve in music subscriptions, what Apple even has done in music subscriptions, what Netflix is doing in video, Amazon obviously now crossing 100 million subscribers. Like, is there other lines of business, other revenue streams that people should be thinking about that create substantial opportunities, and specifically subscription, and then maybe if you could just touch on from a commerce standpoint now that Instagram's starting to be such a big driver of commerce, how do you think about diversifying revenues versus essentially being almost pure advertising? Thanks so much."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "We've certainly thought about lots of other forms of monetization, including subscriptions, and we'll always continue to consider everything. Ads for us is a very natural fit for our business, and we have a lot of runway ahead of us. We've done – obviously, we have 80 million now pages, so we have 80 million businesses using Facebook on a monthly basis, of which 6 million are advertisers. On Instagram, we have 25 million Instagram business profiles, of which 2 million are advertisers. So even if we just convert people who are advertising on Facebook into Instagram, that's a lot of a growth opportunity. Then you can start thinking about Messenger and some of the other platforms we have. What's I think interesting and strong about our potential business growth is that we're able to do this across these services. So as I mentioned before, running an ad that has a click to Messenger ad that goes into Messenger is just an early example of what's possible. And I think if you look at a large base of businesses who use us without paying, the growing base of businesses who do pay us and then the runway we have in services that are 1 billion plus (59:48) that we're really not monetizing, I think a strong focus on ads continues to be the best investment we can make. It's also very core to our mission. Ads gives us the ability to provide a free service to the world. And if your goal is to connect to everyone and make sure that people can all participate, that ads-based model makes a lot of sense and we're going to continue to invest very heavily there."
},
{
"speaker": "Deborah Crawford - Facebook, Inc.",
"text": "Operator, we have time for one last question."
},
{
"speaker": "Operator",
"text": "The last question comes from the line of Youssef Squali with SunTrust."
},
{
"speaker": "Youssef Squali - SunTrust Robinson Humphrey, Inc.",
"text": "Thank you very much. I guess two quick questions for David. Growth in MAUs in rest of world was up about 11%; I think last year, it was up almost double that, 19% or so. Anything changed there that maybe could explain the slowdown? And I think we saw also a slighter – slightly lower growth in pricing as well. And then lastly, on the buyback, how much do you still have left on the old authorization to which we need to add the new $9 billion? And how do you look at it? Is it being (01:00:54) opportunistic, or do you have a timeline by which you guys are planning to complete the repurchase? Thank you."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Sure, Youssef. On the growth in MAUs in rest of world, we've had certain slowdowns. There was an internet shutdown in Ethiopia that contributed a little bit to that. So you've got some kind of one-time factors that do come into play there. So I think that's probably what I would point to. Nothing that notable to call out there. In terms of the share repurchase authorization, I would just say that we've just about gotten our way through that. We had about $2 billion left as of the end of the quarter. But we think it's – we asked the board and the board approved a $9 billion additional authorization. We look at it on two fronts: just offsetting the dilution from the share issuances that we have and then secondarily, to be opportunistic. And we think with the cash flow that we're generating, we have a strong financial position with which to fund that."
},
{
"speaker": "Deborah Crawford - Facebook, Inc.",
"text": "Great. Thank you for joining us today. We appreciate your time, and we look forward to speaking with you again."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines."
}
] | null | null |
META | 4 | 2,019 | 2020-01-29 17:00:00 | Operator: Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook Fourth Quarter 2019 Earnings Conference Call. [Operator Instructions]. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin.
Deborah Crawford: Thank you. Good afternoon and welcome to Facebook's Fourth Quarter and Full Year 2019 Earnings Conference Call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our quarterly report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now I'd like to turn the call over to Mark.
Mark Zuckerberg: All right. Thanks, everyone, for joining us today. This was a good quarter for our community and our business and a strong end to the year. There are now around 2.9 billion people using Facebook, Instagram, WhatsApp or Messenger each month and around 2.3 billion people using at least one of our services daily. There are now more than 140 million small businesses that use our services to grow, and the vast majority of which use our services for free. Last year, I shared our four company priorities, and they're still our priorities in 2020: making progress on the major social issues, building qualitatively new product experiences, continuing to grow our business, and getting out there and communicating more transparently. Today, I'm going to focus mostly on the new product experiences we're building, but before I get to that, this is going to be another critical year for making progress on social issues. We're very focused on election integrity, and this is an area where I'm proud of the progress that we've made preventing foreign interference. We were behind in 2016, but after working to protect elections in countries across the world from the EU -- in the EU to India to Mexico to the U.S. midterms for the past few years, we think our systems are now more advanced than any other companies. And we're often alerting law enforcement and intelligence about threats that we identify. There's still going to be debate about what kinds of political speech should be allowed, especially as the 2020 elections heat up. But by any objective measure, our efforts in election integrity have made a lot of progress. This is also going to be a big year for our greater focus on privacy as well. As part of our FTC settlement, we committed to building privacy controls and auditing that will set a new standard for our industry, going beyond anything that's required by law today. We currently have more than 1,000 engineers working on privacy-related projects and helping to build out this program. Related to this, just yesterday, we announced that we're rolling out a Privacy Checkup tool to nearly 2 billion people, reminding them of the controls they have and making sure that they're set the way that they want them. We also introduced a new tool that notifies you anytime your account signs into a new service. So, it's going to take time, but over the next decade, I want us to build a reputation on privacy that's as strong as our reputation around building good, stable services. When it comes to these important social issues, I don't think the private companies should be making so many important decisions by themselves. I don't think that each service should have to individually decide what content or advertising is allowed during elections or what content is harmful overall. There should be a more democratic process for determining these rules and regulations. For these issues, it's not enough for us to just make principal decisions. The decisions also need to be seen as legitimate and reflecting what the community wants. And that's why I've called for clearer regulation for our industry. And until we get clearer rules or establish other mechanisms of governance, I expect that we and our whole industry will continue to face a very high level of scrutiny. So during this, our job is to keep doing what we think is right on the social issues and to stay focused on continuing to deliver product improvements and better experiences for our community. The product areas that I'm most focused on for the next chapter of our company are building out the private social platform and more intimate communities, enabling more commerce and payments and delivering the next computing platform. When I look at the Internet today, we all have this ability to connect with people, content, and opportunities coming from all around the world in ways that were unimaginable just a generation ago. And I grew up in a town of 10,000 people and making long distance calls anywhere outside the area was very expensive. Today, we all have access to billions of people, and that's made it easier to find people that are into the same things that you are. But as our networks and communities have gotten so large, we increasingly crave a sense of intimacy and privacy. So, delivering this experience is our focus. And across our services, the greatest growth in how people are communicating continues to come from private messaging, small groups, and disappearing stories where your data doesn't stick around forever. There's a lot more to do here. While the Facebook and Instagram apps have developed with lots of different ways to interact with the people you care about, our private communication apps are still pretty much just about texting, so we spent the last year building infrastructure to turn our private messaging apps, WhatsApp and Messenger into richer, private social platforms where you can hang out and be present with friends, find groups with your interest, engage with businesses more naturally. So, some of these are bigger projects like full end-to-end encryption, interoperability across the apps, or rewriting our apps for performance. And they're going to take a long time to see through. But we should start seeing more new experiences later this year, and this will all be built on a very strong privacy foundation. Commerce and payments is another area that will be important for the private social platform, but also across all of our apps, including Facebook and Instagram. Our goal here is to make sure that every individual, a small business entrepreneur out there has the same opportunity and access to the same type of sophisticated tools that historically only the big companies have had access to, so that's what we stand for putting power in individual's hands. One example that we've been working on is WhatsApp Payments where you're going to be able to send money as quickly and easily as sending a photo. We got approval to test this with 1 million people in India back in 2018. And when so many of the people kept using it week after week, we knew it was going to be big when we get to launch. I'm really excited about this, and I expect this to start rolling out in a number of countries and for us to make a lot of progress here in the next 6 months. Beyond WhatsApp Payments, we're working on several other efforts to help facilitate more commerce from Facebook Marketplace to Instagram Shopping, to our work on Facebook Pay or our work on Libra. This is such a big space, and it's important for empowering people. So we're taking a number of different approaches here, ranging from people buying and selling to each other directly to businesses setting up storefronts, to people engaging with businesses directly through messaging and a number of things on payments ranging from existing -- using existing national systems like India's UPI to creating new global systems. Having small businesses succeed is not only key to creating broad economic growth where everyone can support themselves, it's also important to maintaining healthy communities since small businesses are often where people come together. We see on our services all the time how small businesses that use our tools are often at the heart of their local communities. So this is a top priority for us on both fronts, for the social mission and the business. We've also been focusing on delivering the next computing platform with augmented and virtual reality. The defining characteristic of AR and VR is that they deliver the sense of presence, like you're right there with another person or in another place. And this is the Holy Grail of social experiences. And it's going to let us build things that we've only dreamed of for the last 15 years, like letting people interact as if they're in person together no matter where they are or letting people live wherever they want and hologram into work so they can access opportunities anywhere and don't have to move to a city or another country to find a job. So while full augmented reality is still a number of years away, we hit a real milestone for virtual reality with Quest. Sales are stronger than we expected, and people are buying and engaging with more content than we'd expected to. On Christmas Day, people bought almost $5 million worth of content in the Oculus store. And that's an outlier day, but still, this is real volume by any measure. And it shows the progress that this ecosystem is making. The experience also just keeps on getting better. Last quarter, we shipped hand tracking, which almost no one thought was going to be possible with the Quest hardware. And we shipped Oculus Link, so now you can run all of your Rift content from your PC on Quest. On the AR side, while we're working on the long-term hardware and operating system, it's worth noting that our Spark AR platform is the most widely used AR platform in the world with hundreds of millions of people interacting with effects every month. Artists are using this to create new face filters and other tools that are going viral across Instagram and Facebook. We're well positioned here overall, and we're going to keep developing this platform. So those are some of the bigger product initiatives that I'm excited about. And aside from these, we're also focused on communicating more clearly what we stand for. One critique of our approach for much of the last decade was that because we wanted to be liked, we didn't always communicate our views as clearly because we were worried about offending people. So this led to some positive but shallow sentiment towards us and towards the company. And my goal for this next decade isn't to be liked, but to be understood. Because in order to be trusted, people need to know what you stand for. So we're going to focus more on communicating our principles, whether that's standing up for giving people a voice against those who would censor people who don't agree with them, standing up for letting people build their own communities against those who say that the new types of communities forming on social media are dividing us, standing up for encryption against those who say that privacy mostly helps bad people, standing up for -- giving small businesses more opportunity and sophisticated tools against those who say that targeted advertising is a problem, or standing up for serving every person in the world against those who say that you have to pay a premium in order to really be served. These positions aren't always going to be popular, but I think it's important for us to take these debates head-on. I know that there are a lot of people who agree with these principles, and there are a whole lot more who are open to them and want to see these arguments get made. So expect more of that this year. This is going to be another important year. It's going to be an intense year with the election. Some of our long-term technology bets are going to start coming to fruition. We have strong business momentum, and we have to get out there and show what we stand for. As always, I'm grateful to all of you for your support and for being on this journey with us. And now I'm going to hand it over to Sheryl to talk about our business.
Sheryl Sandberg: Thanks, Mark, and hi, everyone. We had a good quarter across the board and a strong end to the year. Q4 ad revenue was $20.7 billion, increasing 25% year-over-year. Full year ad revenue grew 27% compared to 2018. We're focused on creating value over the long term for our community and for the 140 million businesses around the world who use our platform to connect with customers and grow. The majority use our free tools, but there are also more than 8 million businesses who advertise with us. This is because we help businesses create a mobile presence, increase sales, build the right relationships with customers and hire people. We will continue to focus on helping businesses use our free and paid tools to reach the people who matter the most. Throughout the holiday season, people used our apps to take advantage of the best deals and shop for the perfect gifts. We saw particular strength with e-commerce and online retailers who optimized for measurable objectives like website visits or sales. Pura Vida, a jewelry company based in San Diego, ran ads on Facebook and Instagram for a 50% off sale. In 9 days, they sold more than 300,000 bracelets, supporting more than 800 artisans around the world. People often adopt new technologies before businesses, and we try to make it as easy as possible for businesses to catch up. Stories is a great example. We recently announced 4 million advertisers are using Stories, up from 2 million this time last year. Bombas, a sock and apparel company, used Instagram Stories to show people wearing their stocks while ice-skating and gift wrapping. As a result, they saw a 60% increase in purchases from people under 35. In addition to helping businesses shift to new formats, we're also making it easier for people to shop directly on our apps. We launched Checkout on Instagram with a small closed beta in Q1 2019. We've fully been building the experience, and now hundreds of businesses in the U.S. are experimenting with Checkout. We're taking the time to get this right and growing fully so people and advertisers can benefit over the long term. We give small and growing businesses like Pura Vida and Bombas the same tools that previously only the biggest firms could access. Large companies can buy national TV spots and large billboards, but most small businesses can't. That's why small businesses benefit the most from targeted ads. We help them reach a more focused audience with the right message, and we do it while protecting people's privacy. This really matters because as Mark said, when businesses of all sizes succeed, they hire people and invest in their communities. Last week, we released a report with Copenhagen Economics. According to 7,000 companies surveyed across 15 EU countries, our apps helped businesses contribute about EUR 200 billion to the European economy just last year. Economists say this translates to more than 3 million new jobs last year alone. I announced these findings in London last week where I had the chance to meet with Naomi Roberts. Naomi started Flare Audio with her husband to improve the sound quality in everything from earplugs to loudspeakers. More than 75% of their sales come from Facebook and Instagram. This has enabled them to export to more than 180 countries and grow their business from 2 employees to 22. Stories like Naomi's are why we remain committed to helping small businesses reach customers and grow, but we know it's not enough. We also have to keep people safe and give them control over their experience on our apps, and we are. This month, we announced a number of improvements to our industry-leading ad transparency tools, including a new feature that gives people the option to see fewer political ads. We also updated our ads library to make it more transparent and easier to navigate. These updates help people understand who is trying to reach them, and we believe that this transparency is critical to empowering people and keeping them safe. We also want everyone to be in control of their privacy on Facebook. As Mark said, we are rolling out our updated Privacy Checkout -- Checkup tool to nearly 2 billion people around the world. With a few taps, people can control who sees what they share and how to keep their accounts secure. I want to close by saying how grateful I am to our partners around the world. Every day, they give us valuable feedback on how to improve our products so we can help them turn great ideas into revenue, jobs and economic empowerment. I also want to thank our teams around the world for working to solve tough challenges while still building great products that businesses use to grow, compete and hire. Thanks to your continued dedication, we are better prepared to serve the billions of people who count on us. Now here's Dave.
David Wehner: Thanks, Sheryl, and good afternoon, everyone. Q4 was a strong quarter and ended a good year for our business. Full year 2019 revenue grew 27% to $71 billion, and we generated over $18 billion in net income. Let's begin with our community metrics. In terms of family metrics, we estimate that approximately 2.3 billion people used at least one of our services on a daily basis in December and that approximately 2.9 billion people were active on a monthly basis. As a reminder, the family metrics are our best estimate of the deduplicated audience across Facebook, Instagram, Messenger and WhatsApp. We believe these numbers better reflect the size of our community and the fact that many people use more than one of our services. Beginning this quarter, we are including family metrics and related information in our SEC filings and the slide presentation on our investor website. Turning now to Facebook. We are pleased with the growth of the Facebook community in all regions this quarter. Daily active users reached 1.7 billion, up 9% compared to last year, led by growth in India, Indonesia and the Philippines. DAUs represented approximately 66% of the 2.5 billion monthly active users in December. MAUs grew 178 million or 8% compared to last year. We plan to continue to disclose Facebook-only community metrics through late 2020. Turning now to the financials. All comparisons are on a year-over-year basis unless otherwise noted. Q4 total revenue was $21.1 billion, up 25% or 26% on a constant currency basis. Had foreign exchange rates remained constant with Q4 of last year, total revenue would have been approximately $295 million higher. Q4 total ad revenue was $20.7 billion, up 25% or 26% on a constant currency basis. On a regional basis, ad revenue growth rates were strongest in Asia Pacific and Rest of World, which grew 33% and 28%, respectively. Europe and U.S. and Canada grew more slowly at 24% and 22%, respectively. In Q4, the total number of ad impressions served across our services increased 31%, and the average price per ad decreased 5%. Similar to last quarter, impression growth was driven primarily by Facebook News Feed, Instagram Stories and Instagram Feed. Facebook News Feed impression growth benefited largely from community growth and engagement trends on the Facebook app. The year-over-year decline in average price per ad was primarily driven by the ongoing mix shift towards ads on Stories and in geographies which monetized at lower rates. Other revenue was $346 million, up 26%. Year-over-year growth was driven by sales of Oculus Quest. Turning now to expenses. Total expenses were $12.2 billion in Q4, up 34%. Cost of revenue increased 25%, and the growth was driven primarily by depreciation related to our infrastructure spend. R&D grew 36% and was driven primarily by increased investments in core product as well as our innovation efforts particularly in AR/VR. Marketing and sales grew 23% and was driven primarily by consumer and growth marketing. Finally, G&A grew 87% largely driven by higher legal fees and settlements. This includes charges related to a $550 million settlement in principle we reached this month in connection with the Illinois Biometric Information Privacy Act litigation. We had over 9,300 net new hires in 2019 primarily in technical functions. We ended the year with approximately 45,000 full-time employees, up 26 compared to -- 26% compared to last year. Operating income was $8.9 billion, representing a 42% operating margin. Our tax rate was 20%. Net income was $7.3 billion or $2.56 per share. Full year capital expenditures were $15.7 billion, up 12%, driven by investments in data centers, servers, office buildings and network infrastructure. In 2019, we opened data centers in Nebraska, New Mexico and Denmark. These new data centers are supported by 100% renewable energy. We are committed to doing our part to help tackle the challenge of climate change. That's why we're working to minimize our energy emissions and water impact. Across the entire company, we are on track to meet our 2020 goal of supporting our global operations with 100% renewable energy and lowering our operational carbon emissions by 75% from 2017 levels. We ended the year with $54.9 billion of cash and investments. I would note that though we booked the expense in 2019, we have not paid the $5 billion FTC fine announced earlier this year as the agreement is still pending court approval. In the quarter, we repurchased approximately -- we repurchased $1.3 billion of our Class A common stock and had $4.9 billion remaining of our prior authorization as of December 31. Today, we announced a $10 billion increase in our stock repurchase program authorization. Turning now to the revenue outlook. We expect our year-over-year total reported revenue growth rate in Q1 to decelerate by a low to mid-single-digit percentage point as compared to our Q4 growth rate. Factors driving this deceleration include the maturity of our business as well as the increasing impact from global privacy regulation and other ad targeting-related headwinds. While we have experienced some modest impact from these headwinds to date, the majority of the impact lies in front of us. Turning now to expenses. We anticipate our 2020 total expenses will be in the range of $54 billion to $59 billion, unchanged from our prior outlook. Our 2020 capital expenditures outlook is also unchanged at $17 billion to $19 billion, driven by investments in data centers, servers, office facilities and our network infrastructure. Lastly, we expect our 2020 effective tax rate to be in the high teens. In summary, Q4 was a strong finish to 2019. We are pleased with the growth of our community and business as we continue to focus on our mission. And with that, operator, let's open up the call for questions.
Operator: [Operator Instructions]. Your first question comes from the line of Brian Nowak from Morgan Stanley.
Brian Nowak: I have two. Just the first one on Instagram Checkout, Instagram Commerce. I'm curious to hear about sort of early learnings of what you've learned from the hundreds of adopters and sort of what you think are the 1 or 2 key points of friction you really have to get over to build that business into a larger contributor over the next couple of years. And then, Dave, I guess to go back to your comment about the majority of the impact that lies ahead when you're thinking about ad targeting and privacy regulation, is there any more detail you can give us as sort of types of data or types of sort of breakage that you see as potential risk to the targeting and the efficacy of the ads going forward?
Sheryl Sandberg: So I'll take the first part of the question. So when you think about the shopping experience or the checkout experience on Instagram, these are still very early days, and we're working hard to improve the product and expand to more businesses. These require full integration. So our focus is making sure we get the right partners on board and consumers have a great experience all the way through. We expanded shopping to all -- shopping ads to all advertisers globally Q4, and we began testing checkout and shopping ads. And what you're going to see from us is very small steps to get more people in and make this deeper across the experience people have. But you are right that we are moving very slowly and very, very, very carefully because we want to make sure the entire experiences is right across the board before we go deeper and go broader.
David Wehner: Yes. Thanks, Brian. Yes, we are seeing headwinds in terms of targeting and measurement. But as I noted, the majority of that impact lies in front of us. Just as a reminder, we utilize signals from user activity on third-party website and services in order to deliver relevant and effective ads to our users. And in that regard, there are sort of three overlying factors that I'd point to, and I spoke to these on prior calls as well. First, the recent regulatory initiatives like GDPR and now CCPA have impacted, and we expect they'll continue to impact our ability to use such signals. Secondly, mobile operating systems and browser providers such as Apple and Google have announced product changes and future plans that will limit our ability to use those signals. And then finally, we've made our own product changes that gives users the ability to limit our use of such data signals to improve ads and other experiences. And there I'd point to something like the rollout of off-Facebook activity controls, and that's at 100% today. So, each of these factors limits our ability to target and measure the effectiveness of ads on our platform, and that can negatively impact our advertising revenue growth. Both Mark and Sheryl talked about the importance of ad targeting for small businesses. And I think it's important to note that the regulatory and platform changes will have a disproportionate impact on the ability of small businesses to use ads to grow and thrive.
Operator: Your next question comes from Ross Sandler from Barclays.
Ross Sandler: Great. Dave, can we talk about the growth rate in the fourth quarter, particularly in the U.S.? Was there anything that surprised you guys or any particular cohort of advertisers that slowed down? If we look at your growth rate from 3Q to 4Q in the U.S., I think it was the lowest since 2012 in the fourth quarter. So any color on what happened in the fourth quarter, or was this in line with your plan?
David Wehner: Yes, thanks. Thanks, Ross. No real surprises there. We are pleased with our Q4 results. We had a strong holiday season despite it being abbreviated. In terms of the North American numbers, we're seeing slower growth in our more mature markets. That's consistent with the outlook that we had going into the quarter. It's true in North America and our more developed markets within Europe, but I wouldn't say there's any real surprises there.
Operator: Your next question comes from the line of Heather Bellini from Goldman Sachs.
Heather Bellini: I just wanted to follow up on the Checkout on Instagram. And obviously you guys mentioned that you're rolling it out very slowly, which is understandable. I'm just wondering how much of this is due to the integration you need to have with the businesses' inventory system. And how are you going about the integration work that needs to be done to make the experience seamless, where you could kind of match inventory levels with what people are actually buying? And I guess the follow-up would be is there a benefit that you envision businesses getting from using this format versus one of your more traditional shopping ads?
Sheryl Sandberg: So, the integration you spoke of are the right ones we want. You want to be deeply integrated at a product level. It has to go all the way through for this to work from discovery, all the way through a pretty seamless checkout flow. And that's what we're working on, and that really takes time. You're also right that we are very focused on commerce ads on Facebook, that the great, great, great majority of activity is commerce ads on Facebook. We had a very strong holiday season. We continue to see growth across Facebook, across Instagram in people who are discovering products they're interested in, and we're continuing to make a lot of investments there.
Operator: Your next question comes from the line of Justin Post from Bank of America Merrill Lynch.
Justin Post: A couple of questions, first on the privacy commentary. Dave, has anything changed since third quarter when we're looking at less deceleration this year? Has there been incremental changes since then? And then secondly, on the expense outlook, I noticed headcount growth was around 26%. As far as getting to your headcount guide -- I mean to your expense guide, do you expect that growth to accelerate? And are there other kind of expense initiatives you'd call out for 2020?
David Wehner: Yes. Thanks, Justin. So I don't think anything has changed since Q3 in terms of our outlook on the headwinds that we have around ad signals. I think that's very consistent with what we've been talking about over the last several quarters. So I think we'll -- we continue to face those headwinds, and they will be more impactful as we move forward. In terms of the expense guide in 2020, I would say that obviously we plan to -- a large factor of our expense growth is driven off of headcount. And we're continuing to invest across the board in terms of our core R&D and innovation efforts in terms of headcount growth there. In addition, growth in infrastructure spend is our large increase in CapEx over the last several years, flows through the income statement as another driver of our expense growth as well. And there's other nonheadcount-related expenses that we expect to grow, including marketing and content investments.
Operator: Your next question comes from the line of Doug Anmuth from JPMorgan.
Douglas Anmuth: Mark, you have multiple payment initiatives across the family. You talked about WhatsApp Payments, Facebook Pay, potentially more over time around Libra and Calibra. Can you just talk about the importance of payments across the family? And how do you tie these together as you work towards interoperability?
Mark Zuckerberg: Yes. So we're doing a lot around commerce and payments because there are lots of different segments for what people are trying to do. In terms of buying and selling things, a lot of people want to buy and sell used goods. We have Facebook Marketplace for that. A lot of small businesses want to set up storefronts. We're enabling that through Instagram and Facebook and then increasingly through messaging as well. From the payments side, WhatsApp Payments will be a part of Facebook Pay. I mean we announced this program last year that basically we'll make it so if you pay for something in any of our apps, you only need to enter your credit card once, and then you can use that to have a more frictionless checkout experience across the other apps. So those two things tie in together. But we are taking multiple approaches on payments where things like what we're doing with Payments in WhatsApp or Facebook Pay overall are built on top of traditional payment infrastructure, whereas the longer-term work that we proposed around Libra that's now being handled by the independent Libra Foundation where we're working on a wallet that will work with Libra. That is more a proposal to make it so that some of the payment infrastructure around the world can be more efficient, especially for things like transferring money across borders. And if you think about it, a lot of the companies that do payments and such today are kind of national and/or in one country. And there aren't that many folks who have an incentive to make this work well across different places around the world. So that's some place where we thought that we could add. But overall, where -- a big focus for us is making sure that individuals and small businesses have access to the same kind of tools that historically only larger companies have had access to. Bigger companies are going to find ways to sell their things and measure the effectiveness of their ads and all that. A lot of the work that we end up doing goes towards making it easier for small businesses to be able to -- without a big technology shop, be able to use the same tools, get access to payments, set up storefronts easily, being able to measure the effectiveness of ads. And that's a lot of what we're focused on, and you heard Wehner talk about this a bit. A lot of the concerns that we have with some of the potential changes to the ecosystem we think will disproportionately hurt small businesses' ability to compete with larger companies.
Operator: Your next question comes from the line of Eric Sheridan from UBS.
Eric Sheridan: Maybe two, if I can. Mark, you had talked previously about trying to more tightly integrate the applications in the family under the Facebook umbrella. I wonder if we could get an update on the way you're thinking about branding the applications to the consumer as well as integrating them on the tech back end as you look out over the next couple of years. And then following up on the comment on messaging, I wondered if we can get an update on the way the team is thinking about the messaging component on a monetization front and thinking about some of the more interesting products you might use to monetize the messaging applications, both Facebook Messenger and WhatsApp as you look out over the next couple of years.
Mark Zuckerberg: Sure. So on integration, overall here's how I think about it. We're going to keep the brands, right, from all the apps. Of course, right, I mean these are large communities that people love and strongly associate with a specific app. So that's clearly going to stay. In terms of integration, all the apps are already very integrated today. We all run off of common infrastructure. We've tried to run the company in a way where we have -- we set up the infrastructure, and we set up the business models. That way, an engineer improving the efficiency of one system makes all of the apps better. And that's -- everything is already very tightly integrated kind of below the surface, in a way that people using these apps may not feel. But I think that the push for the next few years is we think that in running a company, I want to make it so it's not just the back end engineers when they improve something, it improves everything. We want to make it so that features that get built across Instagram or Facebook or WhatsApp and when people engage on those, it can also make your experience better across the other apps in the family, too. So that's kind of the philosophy behind why we're doing a number of things. Some of it is just we built up multiple technical stacks in some places that didn't need to exist. The voice calling stack on WhatsApp and Messenger, there's not a real reason why those need to be different. But we didn't standardize that layer historically, and that means that now we have to put twice as much work into making that good. If we got that to be integrated, then the same engineering effort could just make it better across everything at a faster rate. So there's going to be more work like that. I think some of it will start to be more visible across the apps. The apps will always continue to have their own identity and brand now because they -- people use them for somewhat different things, and that's really important.
Operator: Your next question comes from the line of Youssef Squali from SunTrust.
Youssef Squali: Okay. Great. I actually just have one question. Could you guys provide us any update around Facebook Dating? That is not one product that, Mark, you talked about. Any stats that you can share with us? Any plans to push into other geos? And would you bring it to Instagram as well?
Sheryl Sandberg: So before we answer that, I'm going to go back and answer the messaging monetization, second half of the last question, if that's okay, and then we'll take this one. On messaging, we are so really focused on this. And we think, in many ways, we're better positioned than anyone else in the industry to participate in the opportunity that should be there over the long run for businesses and consumers to connect on message. In terms of direct ads in messaging, we're taking that very slowly. We have a very slow rollout in Messenger. We don't have that rolled out in WhatsApp. Where we are seeing a lot of growth and really exciting metrics right now are click-to-messaging ads. These are one of the fastest-growing ad formats in our family, especially with SMBs in markets like APAC, but really across the board. And what happens is that from Facebook or Instagram Feed or from Facebook, Instagram or Messenger Stories, you can click-to-message a business on Messenger or WhatsApp. It's a really good way to drive engagement. It also really takes people further down the funnel from seeing an ad to having a direct connection with businesses, which consumers like and businesses like. We also think the ROI is very high here. So I'll share an example. Manulife from Vietnam is an insurance company. They use click-to-messaging ads to generate qualify leads. And compared to Facebook lead ads, which were already performing well, those ads had 2.4x more qualified leads and a 4x increase in sales. And so we think the combination of the discovery ads that we can do, clicking through the Messenger right now already shows the potential of how important messaging can be for businesses.
Mark Zuckerberg: Yes. And I could talk a little bit about the Dating experience. It's going well. I don't think we have any specific stats to share on this, but it's going well. And we -- I think we're already one of the top dating services, and we expect to continue growing. In terms of where we launched it, we launched a number of countries before bringing it to the U.S. And our product development approach is that we launch something, and then we get feedback. We try to test things before we launch them. But then there are some things that you can't learn until you have it out. And then we will kind of keep on iterating on it until -- in a number of countries, people who use it really like it and keep using it. And then we rolled it out to more countries. So we did that over the last year. We'll continue doing that in more places, but the U.S. was certainly one of the biggest places that we were focused on launching it. Overall, I mean the way that Dating fits into the strategy here is within the Facebook app, we think that News Feed is really central and that it's one of the only things that we think everyone who uses the app is really going to use on a daily basis. But there are different social utilities that even if not everyone wants to use them, hundreds of millions of people might find value in. So whether that's Marketplace for buying and selling things. Groups and communities, we think, is increasingly ubiquitous, but the tab there isn't going to be used by everyone. It's going to be used by hundreds of millions of people. Things like Watch or the News tab that we have started rolling out are not things that we expect everyone to use. But even if tens or hundreds of millions of people use them, then we're adding unique value that other folks might not be able to build, and we're making the app more valuable. So I kind of expect in a year or 2, the world that we're going to be in is people use Facebook, they're going to use News Feed, and then they're probably each going to have 2 or 3 other of these social utilities that they find valuable. And as we start building those, I think that that's some part of the story that you're seeing on why the Facebook app engagement has been strong recently is -- especially as we build more of these things that certainly is showing up in how people use the app.
Operator: Your next question comes from the line of Mark Mahaney from RBC.
Mark Mahaney: Okay. Two things, one, congrats on the carbon reduction goal, love that. Posted about it. Mark, you'd be happy to know that. But love to see more companies do that. The real question I have to do -- have has to do with the security of the platform in this election year. And so can you just talk about the confidence you have? And I know there's a lot of things you can't control, but I am sure that there's going to be a lot of controversy around the elections, or I assume that's going to be the case. There may well be bad actor interference as there was 4 years ago. To the extent you think that Facebook and its platforms are ready to handle that better prepared, is there anything you could do to talk more about that, quantify it whatever? Just how you were trying to hedge that risk, which I think is going to be a material risk this year.
Mark Zuckerberg: Yes. This is certainly something that we're extremely focused on. And I do think that there is going to be a lot that we need to be watching out for this year. Since -- in 2016, I think it's very fair to say that we were behind where we needed to be as with a lot of -- the rest of the industry and governments as well and expecting the kind of information operations that we now have seen. Now the good news is that since then, it's not like this is the first presidential election that we've had to play a part in defending the integrity of. There have been major elections across the world, and each time, we're able to see the tactics of the foreign adversaries evolve. Because we and others weren't really focused on that in 2016 as much, we've been able to improve at quite a fast rate. There are also good partnerships in place now across the industry, across law enforcement, the intelligence communities, not just in the U.S. but across other countries, too. So I think the systems are much more robust. And you can look at the results in other elections around the world where, for example, in the EU elections last year where a lot of people were very worried that there would be this kind of foreign interference. I actually had gone to the EU Parliament and testified about what we were going to do. And then I think the EU Parliament President after released a statement saying that we'd met our commitments and did the things that we said we were going to do, and it was a relatively clean election. So it's -- we're going to continue seeing the adversaries get more advanced. And I think certainly because this got a lot of attention, it's not just Russia at this point. We've seen similar types of attempts from Iran, China and some places, others as well. So there's more to kind of look out for there. But overall, I do feel confident about where we are. One of the things that I think we need to look out for, that the intelligence community has warned us about is some of the goal of some of these nation-state actors is not necessarily to interfere directly, but to just sow doubt about the legitimacy of an election. So even to the extent that we may not even see specific attacks, but if there's a big meme that there is widespread interference, that has the same effect in terms of kind of sowing doubt about things. So we're very focused on this and making sure that people know what we're doing, so that they can have confidence. And this is just -- this is really a top priority for us.
Operator: Your next question comes from the line of Colin Sebastian from Baird.
Colin Sebastian: Great. Two for me as well. Following up on the shopping commerce question, I wonder if the focus here includes expanding Marketplace across multiple services or if that seems like better as a distinct application. And then separately, curious on some of the newer visual apps such as Threads and Lasso, what are you seeing here in terms of usage or engagement? And are these features that ultimately fit within existing apps or also might be distinct from the current services?
Sheryl Sandberg: I can talk about Marketplace. Marketplace is growing nicely. It's now used by hundreds of millions of people every month. We also rolled out ads in Marketplace, which are available in 94 markets, which means advertisers can extend their News Feed ads to Marketplace. We're seeing a lot of interest, especially with retail and auto advertisers. It's very early, but we're seeing good results. So we believe this is a good opportunity we're going to continue to invest. But for the foreseeable future, even within this, ads remains the great focus.
Mark Zuckerberg: Yes. And I think you mentioned Threads and Reels and a couple of the apps that we've launched within Instagram. It's still early. I think there are some promising signs. We're figuring out the extent to which those should grow to be big, independent apps over time, or should be integrated into the core of the Instagram service or our other messaging apps. So we'll figure that over time, but those are certainly both important spaces to be in, visual messaging and kind of interest-based talent showing Stories-type functionality.
Operator: Your next question comes from the line of Kevin Rippey from Evercore ISI.
Kevin Rippey: Mark, this is really one for you. You described the new experiences that could be rolling out in the back half of the year. Could you just maybe provide a little more color on that and kind of what you're envisioning? It would be great to hear.
Mark Zuckerberg: Yes. I've been talking a lot about how we're trying to build out our private messaging apps into richer, private social platforms. And the idea there is that people want to interact in lots of different ways. And in Facebook and Instagram, you can interact with a lot of people you know or interested in connecting with them in a number of different ways. But our texting apps today are primarily still texting. So a lot of what we've been trying to do is make it so that we build out the infrastructure, so that way WhatsApp and Messenger and Instagram direct can evolve rather than being just places where you message folks. They can be places where you can hang out and feel more present with people, where you can connect to different groups in different ways, interact with businesses and do payments and commerce. And when we kicked off this big initiative, a lot of the stuff was long-term infrastructure that we needed to get started building. So we've now been -- we're now a year or so into -- starting to build out a lot of that. So I guess what I'm saying is I just expect some of this to land in this year. Not all of it, some of the stuff is longer term. For example, the work that we're doing on full end-to-end encryption, that's just -- that's a long-term project. We want to make sure we get the safety implications of that right. Already fully rolled out around WhatsApp. We're really committed to making sure that we nail the safety parts of that before fully rolling it out across Messenger and Instagram as well. So some parts of this will not land this year, but I expect a lot of this will start to land this year around this vision of building the private social platform.
Operator: Your next question comes from the line of Lloyd Walmsley from Deutsche Bank.
Lloyd Walmsley: So this is the second quarter in a row where you guys have called out core Facebook as the key driver of impression growth. So wondering if you can just elaborate a bit on what's driving that strength in core blue engagement, whether this is something you guys expect to continue. And I guess kind of as a follow-up related to that, there's been some press you plan a Super Bowl ad specific to the Facebook Groups product. So any updates on engagement around Groups or how the strength there is impacting the ad business? Any color you could share would be great.
David Wehner: Yes. Okay. So I'll take that, Lloyd. Yes. I mean we have -- we are pleased with the engagement that we're seeing on the Facebook app broadly. And as you'd mentioned, this has been a pretty consistent story over the last several quarters. So I don't think it's particularly a new story, but we're seeing that across the globe in all regions. And I'd say the character of the engagement growth is a little bit different by region. In the U.S. and Canada on Facebook, we're seeing strength in sort of nonvideo feed engagement. In other regions, we're seeing good strength in video. And then I'd say across all of our apps, we're seeing strong adoption of Stories and, on WhatsApp Status products around the world, and that continues to provide another way for people to connect and share. But specific to core Facebook, I think those are some of the drivers that I'd call out.
Operator: Your next question comes from the line of John Blackledge from Cowen.
John Blackledge: Two questions. How should we think about the video strategy on core Facebook? And any update on Watch users and engagement? And then on Instagram, there's been some discussion within the advertising community that Explore is an area for ad inventory expansion. Just any color on ad trends on the Explore tab.
Mark Zuckerberg: Yes. The video strategy is -- has been pretty consistent. We -- and it's consistent with the rest of what we're trying to do on creating these other tabs and social utilities as well. People watch a lot of video as part of News Feed. But what we also found was that just straight consuming a lot of video on News Feed was displacing some of the social interactions and connecting with people that was the real core of what people came to our services for. So basically, in order for -- to fully meet the needs that people have for video, we started creating a separate tab, Watch, and that's been growing quickly as well. You can think about the content acquisition that we do there as more along the lines of either marketing or bringing new people into the experience. It's -- we're not building out a subscription service or anything like that around this. So that's more just some good examples of content and anchor content to help create the community and get people into that experience.
Sheryl Sandberg: I can share a little bit about the Explore opportunity. So more than 50% of accounts on Instagram are using Explore every month. And as of Q3, ads were available to 100% of advertisers. We think it's a great opportunity to reach customers who are already in a discovery mindset. And the way it works is after you click on a post in the Explore grid, you enter a Feed-like experience where the ads show up.
Operator: Your next question comes from the line of Michael Nathanson from MoffettNathanson.
Michael Nathanson: I have two, one for Dave and one for Mark. So maybe for Dave, if you look at your slide deck, Page 4, what you see is just this amazing ARPU growth in the U.S. And just the size of the U.S. ARPU is so much larger than all these other markets, including Europe. I wonder when you look at the opportunity to try to drive market -- drive pricing in other markets, what are those gating factors? What are you looking for to -- or what should we look for to move pricing to be closer to where, I guess, ARPU closer to where the U.S. numbers are heading? And then for Mark, on payments, what are your initial markets that you're trying to target? And what impact do you all expect? And if you get payments right, what impact would that have on your other parts of the advertising business?
David Wehner: Sure, Michael. I'll take the first one. So this has been a pretty consistent question that's come up over the years. And I think the answer largely is the same as I've given on previous calls, which is the U.S. and Canada segment is really a pure-play developed market, which is U.S. and Canada is the 2 countries in that segment. Europe is a broader mix of countries. So you've got Eastern Europe, and you've got Turkey in there. So you've got just lower ad market per capita countries that are included in that segment. It's a much closer number if you were to look just pure-play at Western Europe. And then there's obviously different engagement levels, maturity of Instagram in those markets that also plays into it. I guess not for the Facebook-only stats, but I think you just get different dynamics based on the, really, characteristics of those countries. So that's really what's driven the difference in ARPUs, and you're also getting faster growth in general in the lower-ARPU countries both within Europe and within APAC. So that tends to also have a mitigating impact on ARPU because of the mix towards those lower-ARPU countries as the users grow there more quickly.
Mark Zuckerberg: Sure. And on payments, we're focused in different places with different products. For things like Instagram and even a lot of what we're doing on Facebook, it's a lot more developed countries. For WhatsApp, it's the biggest countries on WhatsApp. So that's countries like India and Mexico and Brazil and Indonesia, which will make up a large part of the community on WhatsApp. The way that we expect that this will work out is basically for people, it's just -- this is an important feature to be able to move your money around, pay friends and individuals as well as small businesses. From a small business perspective, being able to close the loop on ads and transactions, we think, is just going to make it so that it's more valuable to have a presence on our services, and buying ads is going to be more valuable. So click-to-messaging ads, which the ads run in Facebook and Instagram but then link you to WhatsApp or Messenger, is a product that's growing well. As you can complete more payments in WhatsApp and Messenger, you would expect it to be worth more for businesses to bid more there, which is why we're so far focused on making it so that the payments can be free or really as cheap as possible. Because we think that from a business perspective, we will get some of the value just by having the services be more valuable for businesses and the ad prices that they'll bid in the auction.
Operator: Your last question comes from the line of Brian Fitzgerald from Wells Fargo.
Brian Fitzgerald: Within the last few weeks, you brought several gaming streamers on board, the Disguised Toast, Corinna Kopf, ZeRo, and in December, you acquired Play Giga. So we want to hear a little bit more about Facebook Gaming and the opportunities there and maybe the strategic overlap with Oculus.
Mark Zuckerberg: Yes. I mean there are a couple of different things here. Over the long term, there surely will be in -- a connection between the work that we're doing in the Facebook app and Oculus, or there will be opportunities for that. But right now, we're developing them somewhat independently. I think within the Facebook app, you can think about this as a connection -- as an extension of the social utility strategy where we've talked about Dating on the call. We've talked about Watch. We've talked about Groups, News tab. Certainly, the Facebook Gaming effort for the people who are engaged in that. I mean there are a lot of communities that can get that -- people who really care about gaming. It has connections to the video and kind of live content services that we're building out. So this is going to be one of the increasing focuses for us or just the different ways that people want to interact and build communities. We're not just trying to build things that everyone is going to want to use. We think something like gaming, hundreds of millions of people are going to want to use it, and that's great.
Deborah Crawford: Great. Thank you for joining us today. We appreciate your time, and we look forward to speaking with you again.
Operator: Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines. | [
{
"speaker": "Operator",
"text": "Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook Fourth Quarter 2019 Earnings Conference Call. [Operator Instructions]. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford",
"text": "Thank you. Good afternoon and welcome to Facebook's Fourth Quarter and Full Year 2019 Earnings Conference Call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our quarterly report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now I'd like to turn the call over to Mark."
},
{
"speaker": "Mark Zuckerberg",
"text": "All right. Thanks, everyone, for joining us today. This was a good quarter for our community and our business and a strong end to the year. There are now around 2.9 billion people using Facebook, Instagram, WhatsApp or Messenger each month and around 2.3 billion people using at least one of our services daily. There are now more than 140 million small businesses that use our services to grow, and the vast majority of which use our services for free. Last year, I shared our four company priorities, and they're still our priorities in 2020: making progress on the major social issues, building qualitatively new product experiences, continuing to grow our business, and getting out there and communicating more transparently. Today, I'm going to focus mostly on the new product experiences we're building, but before I get to that, this is going to be another critical year for making progress on social issues. We're very focused on election integrity, and this is an area where I'm proud of the progress that we've made preventing foreign interference. We were behind in 2016, but after working to protect elections in countries across the world from the EU -- in the EU to India to Mexico to the U.S. midterms for the past few years, we think our systems are now more advanced than any other companies. And we're often alerting law enforcement and intelligence about threats that we identify. There's still going to be debate about what kinds of political speech should be allowed, especially as the 2020 elections heat up. But by any objective measure, our efforts in election integrity have made a lot of progress. This is also going to be a big year for our greater focus on privacy as well. As part of our FTC settlement, we committed to building privacy controls and auditing that will set a new standard for our industry, going beyond anything that's required by law today. We currently have more than 1,000 engineers working on privacy-related projects and helping to build out this program. Related to this, just yesterday, we announced that we're rolling out a Privacy Checkup tool to nearly 2 billion people, reminding them of the controls they have and making sure that they're set the way that they want them. We also introduced a new tool that notifies you anytime your account signs into a new service. So, it's going to take time, but over the next decade, I want us to build a reputation on privacy that's as strong as our reputation around building good, stable services. When it comes to these important social issues, I don't think the private companies should be making so many important decisions by themselves. I don't think that each service should have to individually decide what content or advertising is allowed during elections or what content is harmful overall. There should be a more democratic process for determining these rules and regulations. For these issues, it's not enough for us to just make principal decisions. The decisions also need to be seen as legitimate and reflecting what the community wants. And that's why I've called for clearer regulation for our industry. And until we get clearer rules or establish other mechanisms of governance, I expect that we and our whole industry will continue to face a very high level of scrutiny. So during this, our job is to keep doing what we think is right on the social issues and to stay focused on continuing to deliver product improvements and better experiences for our community. The product areas that I'm most focused on for the next chapter of our company are building out the private social platform and more intimate communities, enabling more commerce and payments and delivering the next computing platform. When I look at the Internet today, we all have this ability to connect with people, content, and opportunities coming from all around the world in ways that were unimaginable just a generation ago. And I grew up in a town of 10,000 people and making long distance calls anywhere outside the area was very expensive. Today, we all have access to billions of people, and that's made it easier to find people that are into the same things that you are. But as our networks and communities have gotten so large, we increasingly crave a sense of intimacy and privacy. So, delivering this experience is our focus. And across our services, the greatest growth in how people are communicating continues to come from private messaging, small groups, and disappearing stories where your data doesn't stick around forever. There's a lot more to do here. While the Facebook and Instagram apps have developed with lots of different ways to interact with the people you care about, our private communication apps are still pretty much just about texting, so we spent the last year building infrastructure to turn our private messaging apps, WhatsApp and Messenger into richer, private social platforms where you can hang out and be present with friends, find groups with your interest, engage with businesses more naturally. So, some of these are bigger projects like full end-to-end encryption, interoperability across the apps, or rewriting our apps for performance. And they're going to take a long time to see through. But we should start seeing more new experiences later this year, and this will all be built on a very strong privacy foundation. Commerce and payments is another area that will be important for the private social platform, but also across all of our apps, including Facebook and Instagram. Our goal here is to make sure that every individual, a small business entrepreneur out there has the same opportunity and access to the same type of sophisticated tools that historically only the big companies have had access to, so that's what we stand for putting power in individual's hands. One example that we've been working on is WhatsApp Payments where you're going to be able to send money as quickly and easily as sending a photo. We got approval to test this with 1 million people in India back in 2018. And when so many of the people kept using it week after week, we knew it was going to be big when we get to launch. I'm really excited about this, and I expect this to start rolling out in a number of countries and for us to make a lot of progress here in the next 6 months. Beyond WhatsApp Payments, we're working on several other efforts to help facilitate more commerce from Facebook Marketplace to Instagram Shopping, to our work on Facebook Pay or our work on Libra. This is such a big space, and it's important for empowering people. So we're taking a number of different approaches here, ranging from people buying and selling to each other directly to businesses setting up storefronts, to people engaging with businesses directly through messaging and a number of things on payments ranging from existing -- using existing national systems like India's UPI to creating new global systems. Having small businesses succeed is not only key to creating broad economic growth where everyone can support themselves, it's also important to maintaining healthy communities since small businesses are often where people come together. We see on our services all the time how small businesses that use our tools are often at the heart of their local communities. So this is a top priority for us on both fronts, for the social mission and the business. We've also been focusing on delivering the next computing platform with augmented and virtual reality. The defining characteristic of AR and VR is that they deliver the sense of presence, like you're right there with another person or in another place. And this is the Holy Grail of social experiences. And it's going to let us build things that we've only dreamed of for the last 15 years, like letting people interact as if they're in person together no matter where they are or letting people live wherever they want and hologram into work so they can access opportunities anywhere and don't have to move to a city or another country to find a job. So while full augmented reality is still a number of years away, we hit a real milestone for virtual reality with Quest. Sales are stronger than we expected, and people are buying and engaging with more content than we'd expected to. On Christmas Day, people bought almost $5 million worth of content in the Oculus store. And that's an outlier day, but still, this is real volume by any measure. And it shows the progress that this ecosystem is making. The experience also just keeps on getting better. Last quarter, we shipped hand tracking, which almost no one thought was going to be possible with the Quest hardware. And we shipped Oculus Link, so now you can run all of your Rift content from your PC on Quest. On the AR side, while we're working on the long-term hardware and operating system, it's worth noting that our Spark AR platform is the most widely used AR platform in the world with hundreds of millions of people interacting with effects every month. Artists are using this to create new face filters and other tools that are going viral across Instagram and Facebook. We're well positioned here overall, and we're going to keep developing this platform. So those are some of the bigger product initiatives that I'm excited about. And aside from these, we're also focused on communicating more clearly what we stand for. One critique of our approach for much of the last decade was that because we wanted to be liked, we didn't always communicate our views as clearly because we were worried about offending people. So this led to some positive but shallow sentiment towards us and towards the company. And my goal for this next decade isn't to be liked, but to be understood. Because in order to be trusted, people need to know what you stand for. So we're going to focus more on communicating our principles, whether that's standing up for giving people a voice against those who would censor people who don't agree with them, standing up for letting people build their own communities against those who say that the new types of communities forming on social media are dividing us, standing up for encryption against those who say that privacy mostly helps bad people, standing up for -- giving small businesses more opportunity and sophisticated tools against those who say that targeted advertising is a problem, or standing up for serving every person in the world against those who say that you have to pay a premium in order to really be served. These positions aren't always going to be popular, but I think it's important for us to take these debates head-on. I know that there are a lot of people who agree with these principles, and there are a whole lot more who are open to them and want to see these arguments get made. So expect more of that this year. This is going to be another important year. It's going to be an intense year with the election. Some of our long-term technology bets are going to start coming to fruition. We have strong business momentum, and we have to get out there and show what we stand for. As always, I'm grateful to all of you for your support and for being on this journey with us. And now I'm going to hand it over to Sheryl to talk about our business."
},
{
"speaker": "Sheryl Sandberg",
"text": "Thanks, Mark, and hi, everyone. We had a good quarter across the board and a strong end to the year. Q4 ad revenue was $20.7 billion, increasing 25% year-over-year. Full year ad revenue grew 27% compared to 2018. We're focused on creating value over the long term for our community and for the 140 million businesses around the world who use our platform to connect with customers and grow. The majority use our free tools, but there are also more than 8 million businesses who advertise with us. This is because we help businesses create a mobile presence, increase sales, build the right relationships with customers and hire people. We will continue to focus on helping businesses use our free and paid tools to reach the people who matter the most. Throughout the holiday season, people used our apps to take advantage of the best deals and shop for the perfect gifts. We saw particular strength with e-commerce and online retailers who optimized for measurable objectives like website visits or sales. Pura Vida, a jewelry company based in San Diego, ran ads on Facebook and Instagram for a 50% off sale. In 9 days, they sold more than 300,000 bracelets, supporting more than 800 artisans around the world. People often adopt new technologies before businesses, and we try to make it as easy as possible for businesses to catch up. Stories is a great example. We recently announced 4 million advertisers are using Stories, up from 2 million this time last year. Bombas, a sock and apparel company, used Instagram Stories to show people wearing their stocks while ice-skating and gift wrapping. As a result, they saw a 60% increase in purchases from people under 35. In addition to helping businesses shift to new formats, we're also making it easier for people to shop directly on our apps. We launched Checkout on Instagram with a small closed beta in Q1 2019. We've fully been building the experience, and now hundreds of businesses in the U.S. are experimenting with Checkout. We're taking the time to get this right and growing fully so people and advertisers can benefit over the long term. We give small and growing businesses like Pura Vida and Bombas the same tools that previously only the biggest firms could access. Large companies can buy national TV spots and large billboards, but most small businesses can't. That's why small businesses benefit the most from targeted ads. We help them reach a more focused audience with the right message, and we do it while protecting people's privacy. This really matters because as Mark said, when businesses of all sizes succeed, they hire people and invest in their communities. Last week, we released a report with Copenhagen Economics. According to 7,000 companies surveyed across 15 EU countries, our apps helped businesses contribute about EUR 200 billion to the European economy just last year. Economists say this translates to more than 3 million new jobs last year alone. I announced these findings in London last week where I had the chance to meet with Naomi Roberts. Naomi started Flare Audio with her husband to improve the sound quality in everything from earplugs to loudspeakers. More than 75% of their sales come from Facebook and Instagram. This has enabled them to export to more than 180 countries and grow their business from 2 employees to 22. Stories like Naomi's are why we remain committed to helping small businesses reach customers and grow, but we know it's not enough. We also have to keep people safe and give them control over their experience on our apps, and we are. This month, we announced a number of improvements to our industry-leading ad transparency tools, including a new feature that gives people the option to see fewer political ads. We also updated our ads library to make it more transparent and easier to navigate. These updates help people understand who is trying to reach them, and we believe that this transparency is critical to empowering people and keeping them safe. We also want everyone to be in control of their privacy on Facebook. As Mark said, we are rolling out our updated Privacy Checkout -- Checkup tool to nearly 2 billion people around the world. With a few taps, people can control who sees what they share and how to keep their accounts secure. I want to close by saying how grateful I am to our partners around the world. Every day, they give us valuable feedback on how to improve our products so we can help them turn great ideas into revenue, jobs and economic empowerment. I also want to thank our teams around the world for working to solve tough challenges while still building great products that businesses use to grow, compete and hire. Thanks to your continued dedication, we are better prepared to serve the billions of people who count on us. Now here's Dave."
},
{
"speaker": "David Wehner",
"text": "Thanks, Sheryl, and good afternoon, everyone. Q4 was a strong quarter and ended a good year for our business. Full year 2019 revenue grew 27% to $71 billion, and we generated over $18 billion in net income. Let's begin with our community metrics. In terms of family metrics, we estimate that approximately 2.3 billion people used at least one of our services on a daily basis in December and that approximately 2.9 billion people were active on a monthly basis. As a reminder, the family metrics are our best estimate of the deduplicated audience across Facebook, Instagram, Messenger and WhatsApp. We believe these numbers better reflect the size of our community and the fact that many people use more than one of our services. Beginning this quarter, we are including family metrics and related information in our SEC filings and the slide presentation on our investor website. Turning now to Facebook. We are pleased with the growth of the Facebook community in all regions this quarter. Daily active users reached 1.7 billion, up 9% compared to last year, led by growth in India, Indonesia and the Philippines. DAUs represented approximately 66% of the 2.5 billion monthly active users in December. MAUs grew 178 million or 8% compared to last year. We plan to continue to disclose Facebook-only community metrics through late 2020. Turning now to the financials. All comparisons are on a year-over-year basis unless otherwise noted. Q4 total revenue was $21.1 billion, up 25% or 26% on a constant currency basis. Had foreign exchange rates remained constant with Q4 of last year, total revenue would have been approximately $295 million higher. Q4 total ad revenue was $20.7 billion, up 25% or 26% on a constant currency basis. On a regional basis, ad revenue growth rates were strongest in Asia Pacific and Rest of World, which grew 33% and 28%, respectively. Europe and U.S. and Canada grew more slowly at 24% and 22%, respectively. In Q4, the total number of ad impressions served across our services increased 31%, and the average price per ad decreased 5%. Similar to last quarter, impression growth was driven primarily by Facebook News Feed, Instagram Stories and Instagram Feed. Facebook News Feed impression growth benefited largely from community growth and engagement trends on the Facebook app. The year-over-year decline in average price per ad was primarily driven by the ongoing mix shift towards ads on Stories and in geographies which monetized at lower rates. Other revenue was $346 million, up 26%. Year-over-year growth was driven by sales of Oculus Quest. Turning now to expenses. Total expenses were $12.2 billion in Q4, up 34%. Cost of revenue increased 25%, and the growth was driven primarily by depreciation related to our infrastructure spend. R&D grew 36% and was driven primarily by increased investments in core product as well as our innovation efforts particularly in AR/VR. Marketing and sales grew 23% and was driven primarily by consumer and growth marketing. Finally, G&A grew 87% largely driven by higher legal fees and settlements. This includes charges related to a $550 million settlement in principle we reached this month in connection with the Illinois Biometric Information Privacy Act litigation. We had over 9,300 net new hires in 2019 primarily in technical functions. We ended the year with approximately 45,000 full-time employees, up 26 compared to -- 26% compared to last year. Operating income was $8.9 billion, representing a 42% operating margin. Our tax rate was 20%. Net income was $7.3 billion or $2.56 per share. Full year capital expenditures were $15.7 billion, up 12%, driven by investments in data centers, servers, office buildings and network infrastructure. In 2019, we opened data centers in Nebraska, New Mexico and Denmark. These new data centers are supported by 100% renewable energy. We are committed to doing our part to help tackle the challenge of climate change. That's why we're working to minimize our energy emissions and water impact. Across the entire company, we are on track to meet our 2020 goal of supporting our global operations with 100% renewable energy and lowering our operational carbon emissions by 75% from 2017 levels. We ended the year with $54.9 billion of cash and investments. I would note that though we booked the expense in 2019, we have not paid the $5 billion FTC fine announced earlier this year as the agreement is still pending court approval. In the quarter, we repurchased approximately -- we repurchased $1.3 billion of our Class A common stock and had $4.9 billion remaining of our prior authorization as of December 31. Today, we announced a $10 billion increase in our stock repurchase program authorization. Turning now to the revenue outlook. We expect our year-over-year total reported revenue growth rate in Q1 to decelerate by a low to mid-single-digit percentage point as compared to our Q4 growth rate. Factors driving this deceleration include the maturity of our business as well as the increasing impact from global privacy regulation and other ad targeting-related headwinds. While we have experienced some modest impact from these headwinds to date, the majority of the impact lies in front of us. Turning now to expenses. We anticipate our 2020 total expenses will be in the range of $54 billion to $59 billion, unchanged from our prior outlook. Our 2020 capital expenditures outlook is also unchanged at $17 billion to $19 billion, driven by investments in data centers, servers, office facilities and our network infrastructure. Lastly, we expect our 2020 effective tax rate to be in the high teens. In summary, Q4 was a strong finish to 2019. We are pleased with the growth of our community and business as we continue to focus on our mission. And with that, operator, let's open up the call for questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. Your first question comes from the line of Brian Nowak from Morgan Stanley."
},
{
"speaker": "Brian Nowak",
"text": "I have two. Just the first one on Instagram Checkout, Instagram Commerce. I'm curious to hear about sort of early learnings of what you've learned from the hundreds of adopters and sort of what you think are the 1 or 2 key points of friction you really have to get over to build that business into a larger contributor over the next couple of years. And then, Dave, I guess to go back to your comment about the majority of the impact that lies ahead when you're thinking about ad targeting and privacy regulation, is there any more detail you can give us as sort of types of data or types of sort of breakage that you see as potential risk to the targeting and the efficacy of the ads going forward?"
},
{
"speaker": "Sheryl Sandberg",
"text": "So I'll take the first part of the question. So when you think about the shopping experience or the checkout experience on Instagram, these are still very early days, and we're working hard to improve the product and expand to more businesses. These require full integration. So our focus is making sure we get the right partners on board and consumers have a great experience all the way through. We expanded shopping to all -- shopping ads to all advertisers globally Q4, and we began testing checkout and shopping ads. And what you're going to see from us is very small steps to get more people in and make this deeper across the experience people have. But you are right that we are moving very slowly and very, very, very carefully because we want to make sure the entire experiences is right across the board before we go deeper and go broader."
},
{
"speaker": "David Wehner",
"text": "Yes. Thanks, Brian. Yes, we are seeing headwinds in terms of targeting and measurement. But as I noted, the majority of that impact lies in front of us. Just as a reminder, we utilize signals from user activity on third-party website and services in order to deliver relevant and effective ads to our users. And in that regard, there are sort of three overlying factors that I'd point to, and I spoke to these on prior calls as well. First, the recent regulatory initiatives like GDPR and now CCPA have impacted, and we expect they'll continue to impact our ability to use such signals. Secondly, mobile operating systems and browser providers such as Apple and Google have announced product changes and future plans that will limit our ability to use those signals. And then finally, we've made our own product changes that gives users the ability to limit our use of such data signals to improve ads and other experiences. And there I'd point to something like the rollout of off-Facebook activity controls, and that's at 100% today. So, each of these factors limits our ability to target and measure the effectiveness of ads on our platform, and that can negatively impact our advertising revenue growth. Both Mark and Sheryl talked about the importance of ad targeting for small businesses. And I think it's important to note that the regulatory and platform changes will have a disproportionate impact on the ability of small businesses to use ads to grow and thrive."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ross Sandler from Barclays."
},
{
"speaker": "Ross Sandler",
"text": "Great. Dave, can we talk about the growth rate in the fourth quarter, particularly in the U.S.? Was there anything that surprised you guys or any particular cohort of advertisers that slowed down? If we look at your growth rate from 3Q to 4Q in the U.S., I think it was the lowest since 2012 in the fourth quarter. So any color on what happened in the fourth quarter, or was this in line with your plan?"
},
{
"speaker": "David Wehner",
"text": "Yes, thanks. Thanks, Ross. No real surprises there. We are pleased with our Q4 results. We had a strong holiday season despite it being abbreviated. In terms of the North American numbers, we're seeing slower growth in our more mature markets. That's consistent with the outlook that we had going into the quarter. It's true in North America and our more developed markets within Europe, but I wouldn't say there's any real surprises there."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Heather Bellini from Goldman Sachs."
},
{
"speaker": "Heather Bellini",
"text": "I just wanted to follow up on the Checkout on Instagram. And obviously you guys mentioned that you're rolling it out very slowly, which is understandable. I'm just wondering how much of this is due to the integration you need to have with the businesses' inventory system. And how are you going about the integration work that needs to be done to make the experience seamless, where you could kind of match inventory levels with what people are actually buying? And I guess the follow-up would be is there a benefit that you envision businesses getting from using this format versus one of your more traditional shopping ads?"
},
{
"speaker": "Sheryl Sandberg",
"text": "So, the integration you spoke of are the right ones we want. You want to be deeply integrated at a product level. It has to go all the way through for this to work from discovery, all the way through a pretty seamless checkout flow. And that's what we're working on, and that really takes time. You're also right that we are very focused on commerce ads on Facebook, that the great, great, great majority of activity is commerce ads on Facebook. We had a very strong holiday season. We continue to see growth across Facebook, across Instagram in people who are discovering products they're interested in, and we're continuing to make a lot of investments there."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Justin Post from Bank of America Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "A couple of questions, first on the privacy commentary. Dave, has anything changed since third quarter when we're looking at less deceleration this year? Has there been incremental changes since then? And then secondly, on the expense outlook, I noticed headcount growth was around 26%. As far as getting to your headcount guide -- I mean to your expense guide, do you expect that growth to accelerate? And are there other kind of expense initiatives you'd call out for 2020?"
},
{
"speaker": "David Wehner",
"text": "Yes. Thanks, Justin. So I don't think anything has changed since Q3 in terms of our outlook on the headwinds that we have around ad signals. I think that's very consistent with what we've been talking about over the last several quarters. So I think we'll -- we continue to face those headwinds, and they will be more impactful as we move forward. In terms of the expense guide in 2020, I would say that obviously we plan to -- a large factor of our expense growth is driven off of headcount. And we're continuing to invest across the board in terms of our core R&D and innovation efforts in terms of headcount growth there. In addition, growth in infrastructure spend is our large increase in CapEx over the last several years, flows through the income statement as another driver of our expense growth as well. And there's other nonheadcount-related expenses that we expect to grow, including marketing and content investments."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Doug Anmuth from JPMorgan."
},
{
"speaker": "Douglas Anmuth",
"text": "Mark, you have multiple payment initiatives across the family. You talked about WhatsApp Payments, Facebook Pay, potentially more over time around Libra and Calibra. Can you just talk about the importance of payments across the family? And how do you tie these together as you work towards interoperability?"
},
{
"speaker": "Mark Zuckerberg",
"text": "Yes. So we're doing a lot around commerce and payments because there are lots of different segments for what people are trying to do. In terms of buying and selling things, a lot of people want to buy and sell used goods. We have Facebook Marketplace for that. A lot of small businesses want to set up storefronts. We're enabling that through Instagram and Facebook and then increasingly through messaging as well. From the payments side, WhatsApp Payments will be a part of Facebook Pay. I mean we announced this program last year that basically we'll make it so if you pay for something in any of our apps, you only need to enter your credit card once, and then you can use that to have a more frictionless checkout experience across the other apps. So those two things tie in together. But we are taking multiple approaches on payments where things like what we're doing with Payments in WhatsApp or Facebook Pay overall are built on top of traditional payment infrastructure, whereas the longer-term work that we proposed around Libra that's now being handled by the independent Libra Foundation where we're working on a wallet that will work with Libra. That is more a proposal to make it so that some of the payment infrastructure around the world can be more efficient, especially for things like transferring money across borders. And if you think about it, a lot of the companies that do payments and such today are kind of national and/or in one country. And there aren't that many folks who have an incentive to make this work well across different places around the world. So that's some place where we thought that we could add. But overall, where -- a big focus for us is making sure that individuals and small businesses have access to the same kind of tools that historically only larger companies have had access to. Bigger companies are going to find ways to sell their things and measure the effectiveness of their ads and all that. A lot of the work that we end up doing goes towards making it easier for small businesses to be able to -- without a big technology shop, be able to use the same tools, get access to payments, set up storefronts easily, being able to measure the effectiveness of ads. And that's a lot of what we're focused on, and you heard Wehner talk about this a bit. A lot of the concerns that we have with some of the potential changes to the ecosystem we think will disproportionately hurt small businesses' ability to compete with larger companies."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Eric Sheridan from UBS."
},
{
"speaker": "Eric Sheridan",
"text": "Maybe two, if I can. Mark, you had talked previously about trying to more tightly integrate the applications in the family under the Facebook umbrella. I wonder if we could get an update on the way you're thinking about branding the applications to the consumer as well as integrating them on the tech back end as you look out over the next couple of years. And then following up on the comment on messaging, I wondered if we can get an update on the way the team is thinking about the messaging component on a monetization front and thinking about some of the more interesting products you might use to monetize the messaging applications, both Facebook Messenger and WhatsApp as you look out over the next couple of years."
},
{
"speaker": "Mark Zuckerberg",
"text": "Sure. So on integration, overall here's how I think about it. We're going to keep the brands, right, from all the apps. Of course, right, I mean these are large communities that people love and strongly associate with a specific app. So that's clearly going to stay. In terms of integration, all the apps are already very integrated today. We all run off of common infrastructure. We've tried to run the company in a way where we have -- we set up the infrastructure, and we set up the business models. That way, an engineer improving the efficiency of one system makes all of the apps better. And that's -- everything is already very tightly integrated kind of below the surface, in a way that people using these apps may not feel. But I think that the push for the next few years is we think that in running a company, I want to make it so it's not just the back end engineers when they improve something, it improves everything. We want to make it so that features that get built across Instagram or Facebook or WhatsApp and when people engage on those, it can also make your experience better across the other apps in the family, too. So that's kind of the philosophy behind why we're doing a number of things. Some of it is just we built up multiple technical stacks in some places that didn't need to exist. The voice calling stack on WhatsApp and Messenger, there's not a real reason why those need to be different. But we didn't standardize that layer historically, and that means that now we have to put twice as much work into making that good. If we got that to be integrated, then the same engineering effort could just make it better across everything at a faster rate. So there's going to be more work like that. I think some of it will start to be more visible across the apps. The apps will always continue to have their own identity and brand now because they -- people use them for somewhat different things, and that's really important."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Youssef Squali from SunTrust."
},
{
"speaker": "Youssef Squali",
"text": "Okay. Great. I actually just have one question. Could you guys provide us any update around Facebook Dating? That is not one product that, Mark, you talked about. Any stats that you can share with us? Any plans to push into other geos? And would you bring it to Instagram as well?"
},
{
"speaker": "Sheryl Sandberg",
"text": "So before we answer that, I'm going to go back and answer the messaging monetization, second half of the last question, if that's okay, and then we'll take this one. On messaging, we are so really focused on this. And we think, in many ways, we're better positioned than anyone else in the industry to participate in the opportunity that should be there over the long run for businesses and consumers to connect on message. In terms of direct ads in messaging, we're taking that very slowly. We have a very slow rollout in Messenger. We don't have that rolled out in WhatsApp. Where we are seeing a lot of growth and really exciting metrics right now are click-to-messaging ads. These are one of the fastest-growing ad formats in our family, especially with SMBs in markets like APAC, but really across the board. And what happens is that from Facebook or Instagram Feed or from Facebook, Instagram or Messenger Stories, you can click-to-message a business on Messenger or WhatsApp. It's a really good way to drive engagement. It also really takes people further down the funnel from seeing an ad to having a direct connection with businesses, which consumers like and businesses like. We also think the ROI is very high here. So I'll share an example. Manulife from Vietnam is an insurance company. They use click-to-messaging ads to generate qualify leads. And compared to Facebook lead ads, which were already performing well, those ads had 2.4x more qualified leads and a 4x increase in sales. And so we think the combination of the discovery ads that we can do, clicking through the Messenger right now already shows the potential of how important messaging can be for businesses."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yes. And I could talk a little bit about the Dating experience. It's going well. I don't think we have any specific stats to share on this, but it's going well. And we -- I think we're already one of the top dating services, and we expect to continue growing. In terms of where we launched it, we launched a number of countries before bringing it to the U.S. And our product development approach is that we launch something, and then we get feedback. We try to test things before we launch them. But then there are some things that you can't learn until you have it out. And then we will kind of keep on iterating on it until -- in a number of countries, people who use it really like it and keep using it. And then we rolled it out to more countries. So we did that over the last year. We'll continue doing that in more places, but the U.S. was certainly one of the biggest places that we were focused on launching it. Overall, I mean the way that Dating fits into the strategy here is within the Facebook app, we think that News Feed is really central and that it's one of the only things that we think everyone who uses the app is really going to use on a daily basis. But there are different social utilities that even if not everyone wants to use them, hundreds of millions of people might find value in. So whether that's Marketplace for buying and selling things. Groups and communities, we think, is increasingly ubiquitous, but the tab there isn't going to be used by everyone. It's going to be used by hundreds of millions of people. Things like Watch or the News tab that we have started rolling out are not things that we expect everyone to use. But even if tens or hundreds of millions of people use them, then we're adding unique value that other folks might not be able to build, and we're making the app more valuable. So I kind of expect in a year or 2, the world that we're going to be in is people use Facebook, they're going to use News Feed, and then they're probably each going to have 2 or 3 other of these social utilities that they find valuable. And as we start building those, I think that that's some part of the story that you're seeing on why the Facebook app engagement has been strong recently is -- especially as we build more of these things that certainly is showing up in how people use the app."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Mark Mahaney from RBC."
},
{
"speaker": "Mark Mahaney",
"text": "Okay. Two things, one, congrats on the carbon reduction goal, love that. Posted about it. Mark, you'd be happy to know that. But love to see more companies do that. The real question I have to do -- have has to do with the security of the platform in this election year. And so can you just talk about the confidence you have? And I know there's a lot of things you can't control, but I am sure that there's going to be a lot of controversy around the elections, or I assume that's going to be the case. There may well be bad actor interference as there was 4 years ago. To the extent you think that Facebook and its platforms are ready to handle that better prepared, is there anything you could do to talk more about that, quantify it whatever? Just how you were trying to hedge that risk, which I think is going to be a material risk this year."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yes. This is certainly something that we're extremely focused on. And I do think that there is going to be a lot that we need to be watching out for this year. Since -- in 2016, I think it's very fair to say that we were behind where we needed to be as with a lot of -- the rest of the industry and governments as well and expecting the kind of information operations that we now have seen. Now the good news is that since then, it's not like this is the first presidential election that we've had to play a part in defending the integrity of. There have been major elections across the world, and each time, we're able to see the tactics of the foreign adversaries evolve. Because we and others weren't really focused on that in 2016 as much, we've been able to improve at quite a fast rate. There are also good partnerships in place now across the industry, across law enforcement, the intelligence communities, not just in the U.S. but across other countries, too. So I think the systems are much more robust. And you can look at the results in other elections around the world where, for example, in the EU elections last year where a lot of people were very worried that there would be this kind of foreign interference. I actually had gone to the EU Parliament and testified about what we were going to do. And then I think the EU Parliament President after released a statement saying that we'd met our commitments and did the things that we said we were going to do, and it was a relatively clean election. So it's -- we're going to continue seeing the adversaries get more advanced. And I think certainly because this got a lot of attention, it's not just Russia at this point. We've seen similar types of attempts from Iran, China and some places, others as well. So there's more to kind of look out for there. But overall, I do feel confident about where we are. One of the things that I think we need to look out for, that the intelligence community has warned us about is some of the goal of some of these nation-state actors is not necessarily to interfere directly, but to just sow doubt about the legitimacy of an election. So even to the extent that we may not even see specific attacks, but if there's a big meme that there is widespread interference, that has the same effect in terms of kind of sowing doubt about things. So we're very focused on this and making sure that people know what we're doing, so that they can have confidence. And this is just -- this is really a top priority for us."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Colin Sebastian from Baird."
},
{
"speaker": "Colin Sebastian",
"text": "Great. Two for me as well. Following up on the shopping commerce question, I wonder if the focus here includes expanding Marketplace across multiple services or if that seems like better as a distinct application. And then separately, curious on some of the newer visual apps such as Threads and Lasso, what are you seeing here in terms of usage or engagement? And are these features that ultimately fit within existing apps or also might be distinct from the current services?"
},
{
"speaker": "Sheryl Sandberg",
"text": "I can talk about Marketplace. Marketplace is growing nicely. It's now used by hundreds of millions of people every month. We also rolled out ads in Marketplace, which are available in 94 markets, which means advertisers can extend their News Feed ads to Marketplace. We're seeing a lot of interest, especially with retail and auto advertisers. It's very early, but we're seeing good results. So we believe this is a good opportunity we're going to continue to invest. But for the foreseeable future, even within this, ads remains the great focus."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yes. And I think you mentioned Threads and Reels and a couple of the apps that we've launched within Instagram. It's still early. I think there are some promising signs. We're figuring out the extent to which those should grow to be big, independent apps over time, or should be integrated into the core of the Instagram service or our other messaging apps. So we'll figure that over time, but those are certainly both important spaces to be in, visual messaging and kind of interest-based talent showing Stories-type functionality."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Kevin Rippey from Evercore ISI."
},
{
"speaker": "Kevin Rippey",
"text": "Mark, this is really one for you. You described the new experiences that could be rolling out in the back half of the year. Could you just maybe provide a little more color on that and kind of what you're envisioning? It would be great to hear."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yes. I've been talking a lot about how we're trying to build out our private messaging apps into richer, private social platforms. And the idea there is that people want to interact in lots of different ways. And in Facebook and Instagram, you can interact with a lot of people you know or interested in connecting with them in a number of different ways. But our texting apps today are primarily still texting. So a lot of what we've been trying to do is make it so that we build out the infrastructure, so that way WhatsApp and Messenger and Instagram direct can evolve rather than being just places where you message folks. They can be places where you can hang out and feel more present with people, where you can connect to different groups in different ways, interact with businesses and do payments and commerce. And when we kicked off this big initiative, a lot of the stuff was long-term infrastructure that we needed to get started building. So we've now been -- we're now a year or so into -- starting to build out a lot of that. So I guess what I'm saying is I just expect some of this to land in this year. Not all of it, some of the stuff is longer term. For example, the work that we're doing on full end-to-end encryption, that's just -- that's a long-term project. We want to make sure we get the safety implications of that right. Already fully rolled out around WhatsApp. We're really committed to making sure that we nail the safety parts of that before fully rolling it out across Messenger and Instagram as well. So some parts of this will not land this year, but I expect a lot of this will start to land this year around this vision of building the private social platform."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Lloyd Walmsley from Deutsche Bank."
},
{
"speaker": "Lloyd Walmsley",
"text": "So this is the second quarter in a row where you guys have called out core Facebook as the key driver of impression growth. So wondering if you can just elaborate a bit on what's driving that strength in core blue engagement, whether this is something you guys expect to continue. And I guess kind of as a follow-up related to that, there's been some press you plan a Super Bowl ad specific to the Facebook Groups product. So any updates on engagement around Groups or how the strength there is impacting the ad business? Any color you could share would be great."
},
{
"speaker": "David Wehner",
"text": "Yes. Okay. So I'll take that, Lloyd. Yes. I mean we have -- we are pleased with the engagement that we're seeing on the Facebook app broadly. And as you'd mentioned, this has been a pretty consistent story over the last several quarters. So I don't think it's particularly a new story, but we're seeing that across the globe in all regions. And I'd say the character of the engagement growth is a little bit different by region. In the U.S. and Canada on Facebook, we're seeing strength in sort of nonvideo feed engagement. In other regions, we're seeing good strength in video. And then I'd say across all of our apps, we're seeing strong adoption of Stories and, on WhatsApp Status products around the world, and that continues to provide another way for people to connect and share. But specific to core Facebook, I think those are some of the drivers that I'd call out."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of John Blackledge from Cowen."
},
{
"speaker": "John Blackledge",
"text": "Two questions. How should we think about the video strategy on core Facebook? And any update on Watch users and engagement? And then on Instagram, there's been some discussion within the advertising community that Explore is an area for ad inventory expansion. Just any color on ad trends on the Explore tab."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yes. The video strategy is -- has been pretty consistent. We -- and it's consistent with the rest of what we're trying to do on creating these other tabs and social utilities as well. People watch a lot of video as part of News Feed. But what we also found was that just straight consuming a lot of video on News Feed was displacing some of the social interactions and connecting with people that was the real core of what people came to our services for. So basically, in order for -- to fully meet the needs that people have for video, we started creating a separate tab, Watch, and that's been growing quickly as well. You can think about the content acquisition that we do there as more along the lines of either marketing or bringing new people into the experience. It's -- we're not building out a subscription service or anything like that around this. So that's more just some good examples of content and anchor content to help create the community and get people into that experience."
},
{
"speaker": "Sheryl Sandberg",
"text": "I can share a little bit about the Explore opportunity. So more than 50% of accounts on Instagram are using Explore every month. And as of Q3, ads were available to 100% of advertisers. We think it's a great opportunity to reach customers who are already in a discovery mindset. And the way it works is after you click on a post in the Explore grid, you enter a Feed-like experience where the ads show up."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Michael Nathanson from MoffettNathanson."
},
{
"speaker": "Michael Nathanson",
"text": "I have two, one for Dave and one for Mark. So maybe for Dave, if you look at your slide deck, Page 4, what you see is just this amazing ARPU growth in the U.S. And just the size of the U.S. ARPU is so much larger than all these other markets, including Europe. I wonder when you look at the opportunity to try to drive market -- drive pricing in other markets, what are those gating factors? What are you looking for to -- or what should we look for to move pricing to be closer to where, I guess, ARPU closer to where the U.S. numbers are heading? And then for Mark, on payments, what are your initial markets that you're trying to target? And what impact do you all expect? And if you get payments right, what impact would that have on your other parts of the advertising business?"
},
{
"speaker": "David Wehner",
"text": "Sure, Michael. I'll take the first one. So this has been a pretty consistent question that's come up over the years. And I think the answer largely is the same as I've given on previous calls, which is the U.S. and Canada segment is really a pure-play developed market, which is U.S. and Canada is the 2 countries in that segment. Europe is a broader mix of countries. So you've got Eastern Europe, and you've got Turkey in there. So you've got just lower ad market per capita countries that are included in that segment. It's a much closer number if you were to look just pure-play at Western Europe. And then there's obviously different engagement levels, maturity of Instagram in those markets that also plays into it. I guess not for the Facebook-only stats, but I think you just get different dynamics based on the, really, characteristics of those countries. So that's really what's driven the difference in ARPUs, and you're also getting faster growth in general in the lower-ARPU countries both within Europe and within APAC. So that tends to also have a mitigating impact on ARPU because of the mix towards those lower-ARPU countries as the users grow there more quickly."
},
{
"speaker": "Mark Zuckerberg",
"text": "Sure. And on payments, we're focused in different places with different products. For things like Instagram and even a lot of what we're doing on Facebook, it's a lot more developed countries. For WhatsApp, it's the biggest countries on WhatsApp. So that's countries like India and Mexico and Brazil and Indonesia, which will make up a large part of the community on WhatsApp. The way that we expect that this will work out is basically for people, it's just -- this is an important feature to be able to move your money around, pay friends and individuals as well as small businesses. From a small business perspective, being able to close the loop on ads and transactions, we think, is just going to make it so that it's more valuable to have a presence on our services, and buying ads is going to be more valuable. So click-to-messaging ads, which the ads run in Facebook and Instagram but then link you to WhatsApp or Messenger, is a product that's growing well. As you can complete more payments in WhatsApp and Messenger, you would expect it to be worth more for businesses to bid more there, which is why we're so far focused on making it so that the payments can be free or really as cheap as possible. Because we think that from a business perspective, we will get some of the value just by having the services be more valuable for businesses and the ad prices that they'll bid in the auction."
},
{
"speaker": "Operator",
"text": "Your last question comes from the line of Brian Fitzgerald from Wells Fargo."
},
{
"speaker": "Brian Fitzgerald",
"text": "Within the last few weeks, you brought several gaming streamers on board, the Disguised Toast, Corinna Kopf, ZeRo, and in December, you acquired Play Giga. So we want to hear a little bit more about Facebook Gaming and the opportunities there and maybe the strategic overlap with Oculus."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yes. I mean there are a couple of different things here. Over the long term, there surely will be in -- a connection between the work that we're doing in the Facebook app and Oculus, or there will be opportunities for that. But right now, we're developing them somewhat independently. I think within the Facebook app, you can think about this as a connection -- as an extension of the social utility strategy where we've talked about Dating on the call. We've talked about Watch. We've talked about Groups, News tab. Certainly, the Facebook Gaming effort for the people who are engaged in that. I mean there are a lot of communities that can get that -- people who really care about gaming. It has connections to the video and kind of live content services that we're building out. So this is going to be one of the increasing focuses for us or just the different ways that people want to interact and build communities. We're not just trying to build things that everyone is going to want to use. We think something like gaming, hundreds of millions of people are going to want to use it, and that's great."
},
{
"speaker": "Deborah Crawford",
"text": "Great. Thank you for joining us today. We appreciate your time, and we look forward to speaking with you again."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines."
}
] | null | null |
META | 3 | 2,019 | 2019-10-30 17:00:00 | Operator: Good afternoon, my name is Mike and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook Third Quarter 2019 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebooks’s Vice President and Investor Relations, you may begin.
Deborah Crawford: Thank you. Good afternoon and welcome to Facebook's third quarter 2019 earnings conference call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our quarterly report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these statements as a result of new information or future events. During this call we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I'd like to turn the call over to Mark.
Mark Zuckerberg: All right. Thanks, Deborah. Thank you all for joining us today. Before we get started, I want to talk about the announcement we just shared that Sue Desmond-Hellmann is going to be leaving our Board to focus on her health and other commitments. Sue has been a wonderful and thoughtful voice on our Board for six years and I'm deeply personally grateful for everything that she has done for this Company. This was a good quarter for our community and our business. There are now around 2.8 billion people using Facebook, Instagram, WhatsApp or Messenger each month and around 2.2 billion people using at least one of our services daily. The Facebook app had a particularly strong quarter, including in the US and Canada. We also recently released - now that we estimate that more than 140 million businesses, mostly small businesses are using our services each month to grow, create jobs and become social hubs in their communities. This has been a busy quarter on a lot of fronts. We launched a number of new exciting products like Facebook Dating in the US, which is doing quite well; Threads for Instagram, our camera first experience to share with your close friends, Facebook News, our dedicated product for news that we built in partnership with news publishers, and we introduced Horizon, a new social experience for VR. We also released hand-tracking technology for Oculus and Oculus Link. So your Quest is basically now a Rift too. We're making progress building out the private social platform across WhatsApp, Messenger and Instagram Direct, and we have multiple exciting initiatives around commerce and payments that we're moving forward from marketplace to Instagram Shopping to payments in WhatsApp and continuing our discussion on Libra. This has also been a busy quarter on the policy and social issues front. We formally entered into a settlement with the FTC to make structural changes and build a rigorous privacy program that will set a new standard for our industry. We're about a year out now from the 2020 elections and we just announced that the systems we've built are so advanced that we proactively identified and removed multiple foreign interference campaigns coming from Russia and Iran. And we found ourselves in the middle of the debate about what political speech is acceptable in the upcoming campaigns. But today I want to focus on talking about principles because from a business perspective it might be easier for us to choose a different path than the one that we're taking. So I want to make sure that everyone is clear about what we stand for and why we're making some of the decisions that we're making. Now I gave a speech a couple of weeks ago about the importance of standing for voice and free expression. I believe strongly and I believe that history supports that free expression has been important for driving progress in building more inclusive societies around the world. And at times of social tension, there's often been an urge to pull back on free expression and that we will be best served over the long term by resisting this urge and defending free expression. Today is certainly a historical moment of social tension and I view an important role of our Company as defending free expression. Now this has never been absolute and of course we take our responsibility to prevent harm very seriously too. I think we invest more in getting harmful content off our services than any other company in the world. Those who follow us closely know that we have more than 35,000 people working on safety and security, and that our budget for this work is billions of dollars a year, more than the whole revenue of our Company at the time of our IPO earlier this decade. And we're going to keep on investing more here. But while we work hard to remove content that can cause real danger, I think we also need to be careful about adopting more and more rules that restrict the way that people can speak and what they can say. Right now the content debate is about political ads, should we block political ads with false statements or should be block all political ads. Google, YouTube and most Internet platforms run these same ads. Most cable networks run these same ads and of course national broadcasters are required by law to run them by FCC regulations. And I think that there are good reasons for this. In a democracy, I don't think it's right for private companies to censor politicians or the news. And although I've considered whether we should not carry these ads in the past and I'll continue to do so, on balance so far I've thought that we should continue. Ads can be an important part of voice, especially for candidates and advocacy groups that the media might not otherwise cover, so that they can get their message into debates. And it's hard to define where to draw the line. Would we really want to block ads for important political issues like climate change or women's empowerment. Now instead I believe that the better approach is to work to increase transparency. Ads on Facebook are already more transparent than anywhere else. We have a political ads archive so anyone can scrutinize every ad that's run. You can see every message, who saw it, how much was spent, and that's something that no TV or print media does. Now since this is an earnings call, I want to talk about the business impact of all of this. Some people accuse us of allowing the speech because they think that all we care about is making money and that's wrong. I can assure you that from a business perspective the controversy that this creates far outweighs the very small percent of our business that these political ads make up. We estimate that these ads from politicians will be less than 0.5% of our revenue next year. That's not why we're doing this. To put this in perspective, the FTC finds that these same critics said, will it be enough to change our incentives was more than 10X bigger than this. So the reality is that we believe deeply that political speech is important and that's what's driving this. Now other people say that this policy is part of a broader pattern of us building a system that incentivizes inflammatory content to fuel our business. And again, to the contrary, I think that we've done more than any of the other major Internet platforms to try to build positive incentives into our systems. We don't let any of our newsfeed or Instagram feed teams set goals around increasing time spent on our services. We rank feeds to encourage meaningful social interactions, helping people connect with friends, family and their communities. We have real people come in and tell us what content they saw that was most meaningful to them and sport valuable discussions and then we build systems to try to surface that kind of content. We've taken many steps over the years to fight clickbait and polarization, and now we're even testing removing like counts in Instagram and Facebook. And we do this because we know that if we help people have meaningful interactions that they'll find our services more valuable and that's the key to building something sustainable and growing over time. Now last year, you'd probably remember that we made a series of changes that emphasized friends and family and reduced time spent on our services. The one change removed 50 million hours of viral video watching a day and we did this knowing that it would mean that people spend less time on our apps, which is not what you do if you're just prioritizing engagement over everything else. So I take getting these incentives right very seriously and we're willing to make huge sacrifices in the short term to do what we think is right and we'll be better over time. Now finally, some people say that this is just all a cynical political calculation and that we're acting in a way that we don't really believe because we're just trying to appear conservative. That's wrong too. Now we face a lot of criticism from both progressives and conservatives. And frankly if our goal, we're trying to make either side happy, then we're not doing a very good job because I'm pretty sure everyone is frustrated with us. Core values on voice and free expression are not partisans, but unfortunately in our current environment a lot of people look at every decision through the lens of whether it's going to help or hurt the candidate they want in winning their next election. Now a lot of people have told us, you've got to pick a side, or else both sides are just going to cause a lot of problems for you and sadly from a practical perspective, they may be right, but we can't make decisions that way. So over the next year of campaigns, we're going to be at the center of the debate, anytime there's content or policies on any of our services that people believe could advantage or disadvantage their side. This may lead to more investigations and the candidates are going to criticize us. I expect that this is going to be a very tough year. We try to do what we think is right but we're not going to get everything right. This is complex stuff and anyone you said that the answers are simple hasn't thought long enough about all the nuances and downstream challenges. I guess that some people are going to disagree with our decision. I guess that some people are going to think that these decisions may have a negative impact on things that they really care about. But I don't think anyone can say that we are not doing what we believe or that we haven't thought hard about these issues. I could be wrong, but my experience running this Company so far has been that if we do what we believe is right, even when it's unpopular for years at a time, then eventually it has worked out best for our community and for our business too. And there's a lot at stake here. We were at crossroad, not only in our own country, but in the future of the global Internet as well. China is building its own Internet and media ecosystem that's focused on very different values. And as these systems compete, the question of which nation's values will determine what speech has allowed for decades to come really puts into perspective the issues that we face today because while we may disagree on exactly where to draw the line on specific issues, we at least can disagree and that's what free expression is about. Voice and expression have been important for progress throughout history, they have been important in the fight for democracy worldwide. And I believe that voice and expression are an important part of the path forward today and that's why our Company will continue standing for these principles. As always, I'm grateful for all of your support in everything that we do and that's especially true today. In addition to these challenges, there are a lot of great things that are going on that I am incredibly proud of and excited about and I'm glad that our community and business trends continue heading in a good direction. I'm happy to talk about any of these things in the Q&A and now here is Sheryl to talk more about our business.
Sheryl Sandberg: Thanks, Mark, and hi everyone. It was a strong quarter for our business. Ad revenue grew 28% year-over-year and we saw strong performance in all regions and on both Facebook and Instagram. Mobile ad revenue was $16.4 billion, contributing approximately 94% of total ad revenue. We know we have a very important responsibility to keep people safe and continue innovating to help businesses of all sizes grow. We're working hard to demonstrate our commitment to the billions of people and the 140 million businesses who use our platforms every month. I want to start by talking about some of the protections we're putting in place to keep people safe. As Mark said, the 2020 elections are only a year away. We're continuing to invest in people and technology so that we can disrupt networks of bad actors, find and remove that content and stop fake accounts before people see them. We're also making political advertising on Facebook more transparent than anywhere else. In 2018, we started requiring ads about social issues, elections or politics to get authorized before running. And this quarter we strengthen those requirements to ask for even more information. Helping people understand who is trying to influence their vote without becoming arbiters of political truth ourselves is critical to empowering people and keeping them safe. We're also holding ourselves to a higher standard when it comes to protecting people from discrimination on Facebook. Earlier this year we reached an important settlement with the National Fair Housing Alliance, the ACLU, the Communication Workers of America and others to restrict targeting options for housing, employment and credit ads. Now advertisers in these areas are required to use a new buying process and by the end of the year people will be able to view all current housing ads in the United States. While these changes could have a small negative impact on our business in the short term, we believe they are the right thing to do for people and our business over the long term. At the same time, we're continuing to innovate to grow our business and help advertisers grow theirs. We did that by improving our ads products and creating new formats to help advertisers more easily reach their current and future customers. From the biggest brands in the world to the local barber, we are committed to leveling the playing field for businesses of all sizes. We give businesses free tools that previously only the largest companies could access. But we know this is not enough. We also need to ensure that small businesses have the digital skills to use those tools effectively. With the holiday shopping season approaching, we launched a series of holiday boot camp training sessions in 17 of our offices around the world from New York to Philippines. We also simplified business managers, our tool for managing campaigns to help businesses more easily create ads that align with their goals. We are continually making these basis point improvements to help advertisers save time and money and build their business. We're also focused on developing products to help businesses reach people where they are. Stories are a great example and we're continuing to see fast adoption across Facebook, Messenger, Instagram and WhatsApp. To make it easier for more businesses to create ads for the stories format, we recently launched customizable templates for Facebook, Instagram and Messenger. After uploading existing photos and videos, advertisers can choose from different layouts, color and text options. This helps businesses more easily create more engaging stories. Messaging is one of the fastest growing areas for online communication and especially between businesses and people. We've seen businesses use Messenger to reach customers, generate new leads and even sell cars. For example, French automaker Renault used a combination of Instagram stories and click to Messenger ads to drive sales of a limited edition vehicle, the Captur Tokyo. Facebook was their only advertising channel and over the span of 30 days, they sold 100 cars, 20 directly through Messenger. This quarter we added a click to Messenger feature in stories so businesses can grab some of the attention in stories and then continue the conversation. We also continue to build new formats that enable brands to interact with people in fun and engaging ways and make commerce more convenient. Earlier this year we launched polling stickers for ads and Instagram stories. In this quarter, we introduced our next wave of interactive advertising to help build even stronger connections between people and businesses. According to eMarketer, 63% of Internet users surveyed in the US say they've tried an augmented reality experience created by a brand. To help advertisers experiment with this, we launched a small beta test this quarter. As part of the test, we make up an Italian cosmetics brand, used their ads to give people an easy way to try on different shades of lipstick and they saw a 27% lift in purchases. While it is still very early days, we are making it easier for people to browse, discover, buy and sell across our platform. Take Facebook Marketplace as an example. We launched the commerce platform three years ago this month and we're now seeing millions of interactions between buyers and sellers every day. From furniture to used vehicles, people have an opportunity to discover the things they love and advertisers in nearly 100 regions have an opportunity to reach people where they shop. I want to close by saying how grateful I am to our partners around the world that continue to give us valuable feedback and how we can better deliver on our responsibilities and help them grow. I also want to thank the Facebook teams who are deeply committed to making progress on the major social issues facing the Internet and our Company and driving growth for businesses. Thanks everyone and here is Dave.
Dave Wehner: Thanks, Sheryl, and good afternoon everyone. Let me begin with our community metrics. We were pleased with the growth of the Facebook Community this quarter, daily active users reached 1.62 billion, up 9% compared to last year led by growth in India, Indonesia and the Philippines. This represents approximately 66% of the 2.45 billion monthly active users in September. MAUs grew 8% or 178 million compared to last year. We're pleased with the growth trends in all regions, including the US and Canada. In terms of our Family metrics, we continue to grow and estimate that on average around 2.2 billion people use at least one of our apps on a daily basis in September and around 2.8 billion were active on a monthly basis. As a reminder, the Family metrics are best estimate of our de-duplicated audience across Facebook, Instagram, Messenger and WhatsApp. We believe that these numbers better reflect the size of our community and the fact that many people are using more than one of our services. Over time, we anticipate Family metrics will play the primary role in our disclosures and how we talk about the Company. Turning now to the financials. All comparisons are on a year-over-year basis unless otherwise noted. Q3, total revenue was $17.7 billion, up 29% or 31% on a constant currency basis. As expected, we saw a deceleration in our constant currency revenue growth versus the second quarter. Had foreign exchange rates remained constant with the third quarter of 2018, total revenue would have been approximately $297 million higher. Q3 total ad revenue was $17.4 billion, up 28% or 31% on a constant currency basis. In terms of regional ad revenue growth, APAC and Rest of World were strongest and grew 35% and 34%, respectively. APAC got more of a revenue lift from our recent product optimizations while Rest of World benefited from favorable macroeconomic trends compared to the weaker environment in Q3 of last year. North America and Europe grew 27% and 24%, respectively. In Q3, the number of ad impressions served across our services increased 37% and the average price per ad decreased 6%. Impression growth was primarily driven by ads on Facebook News Feed, Instagram Stories and Instagram feed. The year-over-year decline in average price per ad was primarily driven by the ongoing mix shift towards geographies and Stories ads which monetize at lower rate. Payments and other fees revenue was $269 million, up 43%. This year-over-year growth was driven primarily by sales of new products, notably, Oculus Quest. Turning now to expenses, total expenses were $10.5 billion, up 32%. We ended Q3 with approximately 43,000 full-time employees, up 28%. Operating income was $7.2 billion, representing a 41% operating margin. Our Q3 tax rate was 17%. Net income was $6.1 billion or $2.12 per share. Capital expenditures were $3.7 billion driven by ongoing investments in data centers, servers, network infrastructure and office facilities. We generated $5.6 billion in free cash flow and ended the quarter with approximately $52.3 billion in cash and investments. In Q3, we bought back approximately $1.2 billion of our Class A common stock. Turning now to the revenue outlook. As I indicated on our second quarter call, we continue to expect a more pronounced deceleration of our revenue growth rate in Q4. We expect our Q4 reported revenue growth rate will decelerate by mid to high single-digit percentage compared to our Q3 rate. This deceleration is largely driven by the lapping of several successful product optimizations in Q4 of last year, as well as ad targeting related headwinds. Since these factors are largely unique to Q4, we would expect our revenue growth deceleration in 2020 versus the Q4 rate to be much less pronounced. Turning now to the 2019 expense outlook. Due to the FTC settlement announced earlier this year, we are providing our expense outlook on a dollar basis for additional clarity. We anticipate 2019 total expenses will be approximately $46 billion to $48 billion. As a reminder, this range includes $5 billion in accruals we recorded in the first half of 2019 related to our FTC settlement. We expect 2019 capital expenditures will be approximately $16 billion compared to our prior estimate of $16 billion to $18 billion. Our capital expenditures are driven primarily by our ongoing investments in data centers, servers and network infrastructure. Turning now to tax. We expect our Q4 tax rate will be in the range of 18% to 20%. I'd also like to share our initial outlook on 2020 expenses. We anticipate that our 2020 total expenses will be in the range of $54 billion to $59 billion. Our plan to re-accelerate headcount growth as well as growth in non-headcount related expenses like marketing factors into this guidance. We expect that 2020 capital expenditures will be approximately $17 billion to $19 billion driven by investments in data centers, servers, office facilities and our network infrastructure. Lastly, we anticipate our 2020 effective tax rate will be in the range of 18% to 20%. In summary, Q3 was a strong quarter for Facebook. We are pleased with the growth of our community and continued momentum in our ads business. At the same time, we continue to make investments in important areas like privacy, safety and innovation. With that, operator, let's open up the call for questions.
Operator: We will now open the lines for a question-and-answer session. [Operator Instructions] Your first question comes from the line of Doug Anmuth from JPMorgan.
Doug Anmuth: Thanks for taking the question. First off, Dave, can you just help us understand a little bit more on the 4Q on the revenue decel, just some of the product improvements from last year that you're lapping. And then also just how you're thinking about the ad targeting headwinds considering that they didn't seem to show up in the 3Q numbers that much. And then, Mark, can you just talk about Instagram Shopping. How that's ramping and how you're thinking about expanding that initiative as you're going deeper into 4Q here. Thanks.
Dave Wehner: Hey, Doug, it's Dave. Yes, on the Q4 outlook, we are lapping a few different product optimizations. We made a couple of those that I would cite as optimizations and how the ad auction operates, which can have an impact and also an increase in ad load on IG feed and stories. And so, as I noted, these are factors that are largely Q4 related. And given that we would expect that 2020 revenue deceleration to much less pronounced. And then in addition, in Q4, and over the longer term, we do continue to expect to face ad targeting related headwinds and uncertainties. And I just go back to the three factors that I cited in the past that the regulatory landscape is continuing to evolve. So for example, when GDPR came into effect, we saw a number of people who opted out on allowing us to use context from the apps and websites they visited for ad targeting. And then the second factor is just we're seeing proposed changes from the mobile platforms that are more oriented towards privacy which could affect targeting and measurement and make that more difficult. And then finally, we are rolling out our own product changes such as the recent launch of OSA that's our user control on what data stored on Facebook activity. So I'd say those three factors still factor in. And when it comes to this, I'd say the majority of the potential signal loss is still in front of us rather than behind us. So I think those headwinds are still real and out there and that factors into our outlook as well.
Sheryl Sandberg: I'll take the Instagram Shopping question. We think there is a big opportunity over the long run here because 90% -- more than 90% of Instagram users are following a business. But on the shopping product itself, it is still very early days and we're working to improve the product and it's quite small. We started testing in Q3 shopping ads, the idea that shoppers can tap on ad, see a product description page and can purchase from the business' mobile site. Again, we think interesting product, but very nascent. Our overall commerce efforts go across not just Instagram but Facebook and all of our properties, and our goal is to make it more convenient and accessible and secure for people and business to browse, discover, buy and sell. I think we have been and continue to be a great place for people to browse and discover. That continues to drive the great, great majority of our business and well for the foreseeable future. But as we can help people reduce friction and close that loop, we think that's a good opportunity for people and for our business.
Operator: Your next question comes from the line of Justin Post from Bank of America Merrill Lynch.
Justin Post: Great, thank you. Maybe one for Mark and one for Dave. First on Watch, with all the OTT launches, it's kind of interesting. Can you talk about your usage of the Watch tab and what your overall professional content strategy is and whether it could start contributing revenues going forward. And then Dave, you mentioned the headcount growth accelerating. Could you give us some of the areas where you'll be adding headcount next year. Thank you.
Mark Zuckerberg: I'm happy to talk about Watch for a little bit. I don't think we have any new status to share on this, but I mean overall we rolled out the tab for -- almost the first year we were really tuning it just to make sure that it would be retentive and very valuable for people. So they are in general -- the way we think about this stuff is, we try not to put something in front of a lot of people unless we're confident that they're going to find it useful and want to come back and use it multiple times and we can put a lot of things in front of people not to try it once, but we want to wait until things are kind of retentive and useful. So we got to there on Watch, it's growing well and that is -- so we're kind of still now focused on continuing to make it better and continuing to grow it. The premium content part of it, yes, I think the right way to think about this is almost as marketing to help people try out the tab for the first time. There are some good tent pole pieces of content that people really love that they come and they check out the product to experience that and then they stay for a lot of the other valuable content that's in there and that might not be talked about as much in the news. So, that's I think the right way to think about that.
Dave Wehner: Hey, Justin, it's Dave. On the 2020 expense outlook, that includes headcount growth and also other expense growth sort of around infrastructure is a big factor as well. We're seeing that large CapEx build over the last several years flowing through depreciation and cost of revenue. So that's a driver of the growth as well. We are planning to reaccelerate or accelerate hiring in 2020 and that's really going to be focused on the important priorities of the Company. So that includes our privacy, safety and security investments. So we are investing a lot in privacy related to building the products and also working on complying with the FTC settlement. And then we're continuing to invest heavily in our innovation investments. That includes building products around Facebook and Instagram and continuing to improve those but also in new developing areas like AR/VR. So those are big factors in growth. And then we are planning on growing non-headcount related expenses as well like marketing and ultimately that will depend on how the ROI of those investments play out over time.
Operator: Your next question comes from the line of Eric Sheridan from UBS.
Eric Sheridan: Thanks for taking the question. Maybe two, if I can. You gave us a little bit of color on Asia and Rest of World and why those had accelerated. Any additional color you could give on sort of the US and Europe or things you saw in the quarter that might have impacted the growth rates in those regions. And going to the Q4 guide, is there any color you can give us on how different regions of the world might be impacted against the mid to high single-digit deceleration of the levels of Q3 just so we have a better understanding of where you might be seeing some of those tougher comps or product optimizations play out on a global scale. Thanks so much.
Dave Wehner: Thanks, Eric. We're not breaking out specific regional impact, but let me give you some color around the acceleration in areas like Rest of World and APAC. APAC benefited from some of the product optimizations we did in the quarter. One thing that I would cite there, it's just how we manage ad load and balance some of our internal promotion units and sort of use it as internal house spend and the nature of the changes that we made in that had a more pronounced impact in some of the lower ARPU countries and unlocked more impression growth in those markets. So that was one of the factors. And then Brazil was particularly weak last Q3. So that had a good compare on a macroeconomic basis. In terms of the Q4 guide, not anything I would say specifically there. In the US, we will have a shorter holiday season, it's hard to know how that's going to play into it just given the late arrival of Thanksgiving, but I think overall the product optimizations that we're comping against in Q4 were global changes. So I think we're going to see the deceleration impact all regions.
Operator: Your next question comes from the line of Brian Nowak from Morgan Stanley.
Brian Nowak: Thanks for taking my question. I have two. The first on -- Mark, you mentioned Facebook app in particular had a strong quarter in the US and Canada. We can see it in the DAU numbers. We would be curious to hear about any specific products or changes or types of behavior you're seeing that really is driving the stronger engagement on Big Blue. And the second one, you have so many monetization I guess call them almost products to come. You talked about commerce and IGTV and Stories and Discover. Just as we sort of think about the timing of these, which one or two of those are you sort of most excited about to drive the business into 2020? Thanks.
Mark Zuckerberg: Yes, I can take the first one on the Facebook app. It's a bunch of different places in which I think we made improvements. I would say globally especially outside the US, we saw good improvements around -- engagement around video. In the US, I think it was less video and more core feed engagement. So it's a bunch of different factors and I think we're seeing good engagement from a bunch of cohorts in the US, which is good. But of course we are highly penetrated in the US and Canada. So we would expect that to bounce around. So I think we saw great growth this quarter. We are quite penetrated. In terms of monetization opportunities, I can speak to that and Mark can add color if you would like. Obviously -- and Sheryl would like to add color as well. So, Stories is obviously one of the big growing areas for us and continues to be a big driver. We're also seeing opportunities around Instagram Explore going into 2020. We're now monetizing with that product and more advertisers are buying from it and then Sheryl is going to jump in and I think give some additional color.
Sheryl Sandberg: Yes, I think in terms of our core advertising products and growth, it's worth really remembering that our core feed products for Facebook and Instagram are growing nicely and well. And we see a lot of opportunity to continue that growth. Definitely, Stories is a big part of the success. We've had I think a lot of success moving advertisers to where people already are. That's what happened with mobile ads. People weren't really doing mobile ads and we helped them get there. I think we've taken our experience on how to help advertisers migrate to the right places and been able to do that even more quickly in new formats like Stories. So of our more than 7 million advertisers, we already have 3 million advertising across Facebook, Instagram and Messenger Stories. And I think that's because we learned that we have to do a lot to help them move. So for example, advertisers can now buy Stories across Facebook, Instagram and Messenger all at once. We had automatic default templates which convert your feed ads into vertical Stories format and this quarter we just launched customizable templates, which help you save time and resources. So as we have to help advertisers move, we've learned how to make those investments in making the formats really easy, the measurement really easy, the buying really easy. Now, the mix to Stories is a big opportunity for us. Stories still does monetize at the same rate as a News Feed right now. So, we're keeping an eye on that. But the growth over the long run is pretty exciting. And I think our ability to help people migrate is something that we're able to prove out quarter over quarter.
Operator: Your next question comes from the line of Mark Mahaney from RBC Capital Markets.
Mark Mahaney: Mark, who would you want to add to the Board or what sort of voice would you want to add to the Board that would be particularly helpful for you in the Company now. And then, David, could you talk about that Stories monetization gap, to what extent it's closing the rate at which it's closing. Thank you.
Dave Wehner: I can take the Stories monetization gap first and give Mark the second. So on that, I think what we're continuing to see with Stories monetization is, that is a product that's experiencing a lot of impression growth. And whenever we have a product that's experiencing high impression growth that puts pressure on the auction in terms of price. And we've also seen good impression growth on the feed side as well. So if you noted in the commentary when I talked about the drivers of impression growth, I listed feed impressions from Facebook first. So I think that's also showing good growth. So I'd say overall not a big change in the gap there and overall the impression growth is really the story for Stories and will remain the story we think for the near future. So that will not be a price-driven revenue growth story, but rather an impression growth, revenue growth story.
Mark Zuckerberg: Yes, on Board members, there are a lot of great leaders who serve on our Board, who have served on our Board. It's been an incredible benefit running the Company. We face a very wide range of issues here from really hard technological problems to issues scaling large organizations to of course a lot of now major regulatory and social issues and having different people or different perspectives can help us navigate that and provide both advice and oversight to make sure that we're doing a good job is really important. And I just want to add one more time, Sue really did an amazing job on our Board and I'm sad to see her go and she has really helped shape a lot of what we do and I'm just incredibly grateful, perfect to mentioned it here.
Operator: Your next question comes from the line of Lloyd Walmsley from Deutsche Bank.
Lloyd Walmsley: Thanks. Two questions, if I can. First you mentioned a little bit earlier the OFA feature that you rolled out this quarter in just a few markets. So can you give us a sense of what you're seeing in terms of early user response to this, how it may be impacting targeting in those markets. And then secondly, you've disclosed on occasion kind of daily search query volumes, you're now expanding ad inventory more into search. So I'm wondering if you can give us an updated sense of query volumes and then how we should think about ad coverage ramping over time within search given a lot of the searches on the platform today are people searches and how we should think about that. Thanks.
Dave Wehner: Sure, I'll take those. In terms of the OFA roll out we initially launched that in August and we've been continuing to slowly roll that out globally and we'll be doing that over the next several months through the end of the year. And we're rolling it out globally on a percentage basis. We've seen a positive reception to having this feature as an option. It's too early to share adoption and we'll just have to see kind of over time how that gets picked up and how that gets adopted. But I think it's too early to really share much about it. In terms of search, we are showing ads in Marketplace in FB search results. But really the vast majority of searches on Facebook are for people, not topics related to retailer e-commerce. So, it's very early days. And from a revenue perspective, it's not material at this point.
Operator: Your next question comes from the line of Youssef Squali from SunTrust.
Youssef Squali: Thank you very much. Two questions from me as well. Mark, with GDPR now over a year old, how has it impacted your business relative to your own expectations and how does that inform your views about the potential impacts from CCPA in 2020. And then on VR, it seems like your vision has taken a bit longer than expected to materialize. Can you speak to the gating factors there and do you feel that now that Quest is at $400 and there seems to be a lot more content out there, we're going to see potentially an acceleration in adoption. Thank you.
Dave Wehner: Youssef, I'll take the question. I think it was about GDPR and how that's gone relative to expectations. We've seen adoptions around people who are opting out of allowing us to use context from the apps. And so I'd say that was largely within the range of expectations that we saw and it is having an impact and the people who are opting out are seeing less relevant ads. And obviously that will impact both, I think, the quality of the experience in terms of the ads they get and also the monetization for us. So I think that is kind of playing out as we expected. CCPA, I think is still a work in progress. So we're watching the developments on that closely. That's the California Consumer Privacy Act, and that has many similar provisions to GDPR, but it's a different line. We're going to have to watch how that evolves, but we do think that that's a factor that we're watching closely and we'll just have to see how that develops. I think, Mark, question was on Oculus.
Mark Zuckerberg: Sure. And then also just add something on privacy. I think it's very important that there is federal privacy legislation. GDPR encodes a lot of important principles and in order for businesses to be able to operate, especially starts to get started and keep the market competitive, you want to make sure that there aren't 50 different regulatory frameworks that companies need to follow. I mean, we could handle that if we needed to, we're a big company. But in terms of for the market overall, I just think it would be a lot better if we had a very clear set of rules at the federal level on privacy. So we'll continue to try to work with folks to try to do what we can to help there. On VR and AR, you're right. This is taking a bit longer than we thought. And I'm still optimistic, I think that the long-term vision and the reasons why I thought this -- we're going to be important and big are unchanged. So we're seeing a lot of people use these products and love them and because of that I think that we're still going to get there. Obviously, the fact that it's taking a little longer than we thought, it cuts both ways. On the one hand, that of course means that the future might be a few years further out and that it might be more expensive to develop because we'll be funding this for a bit longer until it gets there. But on the other hand, from our perspective, we're not a company that's traditionally done hardware or built operating systems or these kind of products. So every year that we get to practice and get better and build our brand around Oculus in terms of building the best products that we can in this space, I just think that we're going to be better off when this is really ready to be a completely mainstream thing with hundreds of millions of people using it. You're right that Quest is growing and doing quite well. We are selling them as fast as we can make them, the demand has been strong and the content is starting to pick up both on the AAA, really high quality side and some of the [indiscernible] stuff that I think is quite good. I'm very excited about what we're seeing and very optimistic about the future.
Operator: Your next question comes from the line of Ross Sandler from Barclays.
Ross Sandler: Great. So guys, just a question on the 2020 rev outlook, calling for a more modest deceleration. So, Dave, I guess what are some of the headwinds, tailwinds that you might see in 2020 that would cause the deceleration? Is this a function of lapping some of the impression acceleration you're seeing now in some of these innovations that you've had in '19 or is there things like the drawing on both the late stage VC funding market and some of those companies potentially coming back on their marketing plans. Is that a material factor? What are some of the other headwinds for next year? And then one housekeeping question is, the 4Q mid to high single-digit decel, is that referring to constant FX growth rate or is that reported US dollar growth rate that you're expecting the decel from? Thank you.
Dave Wehner: Yes, sure, Ross. It's a reported number that we're giving that on, on a mid to high-single digit deceleration from the reported growth rate. I don't think there should be a huge difference in them, but we're giving it on a reported basis. So in terms of the deceleration, we continue to expect deceleration into 2020, but it would be, we believe, more moderated and the reasons for that, that we expect the deceleration. We do continue to see these ad targeting related headwinds, which have been playing out slowly, but we think are still in front of us. The majority of potential signal loss on targeting is still in front of us. And that's the three factors that I cited, the regulatory landscape, potential platform changes and then the adoption of our own products like OFA that we're just rolling out now. So all of those will play into the potential deceleration of revenue growth in 2020. Obviously, we're lapping what's been good performance in 2019 where we've made a lot of product improvements and growing off a large base. So I think we are experiencing deceleration from that perspective. The specific sort of high level of deceleration going into Q4, we're signing the specific optimizations that we're lapping in Q4, which were more significant.
Operator: Your next question comes from the line of Heather Bellini from Goldman Sachs.
Heather Bellini: Great. I just wanted to go back to the opening remarks about the 35,000 people. I think you mentioned that you have working on safety and is that you're spending more, I think your budget for this area you said is more than it was back when you went public in 2012. So, maybe about $5 billion. I just was wondering if you could share with us your view on how much you're using, you talked about AI in the past being helpful here. How long does this have to be as resource-intensive from a people perspective or do you see the ability over time as with technologies like AI potentially helping you to get more leverage out of this existing budget, so maybe you don't have to continue to ramp it as quickly as your user base and engagement continues to grow. Thank you.
Mark Zuckerberg: Sure. So over time we may not have to ramp it as much, but I don't foresee any time in the near future that AI is going to make it to that if the cost comes down. In general what we have to do is we use computers and AI for what they're good for which is looking at a lot of content very quickly and making quick judgments. And we have teams of people doing what people are good for which is making nuanced human judgments. And so you build the computer system, in that way they can flag and get rid of some of the worst stuff, and so they can flag for human review, some of the stuff that's borderline and then there's just so much content flowing through the system that we do need a lot of people looking at this. And I don't think that's going to change anytime soon.
Dave Wehner: And Heather, I would add that when you're using systems to look at content, when you're using AI machine learning systems, it's a real benefit to have actual people looking and tagging that content, classifying it because it helps those machine learning algorithms be able to learn what they're looking at. So you actually have -- we do have actually ramped in people who are doing the tagging and classification. So there is actually expense related to AI that's on the human side in the near-and medium-term as well. So very much in line with what Mark said. Over time it's an opportunity to maybe slow down the growth, but it's not going to change the dynamics in the near term.
Operator: Your next question comes from the line of Colin Sebastian from Baird.
Colin Sebastian: Thank you. Mark, maybe a bigger picture question. I'm wondering how you think about the increase in scrutineer oversights impacting your or the Company's ability to explore new services, new markets and ultimately remain competitive or is that not really a factor at this point? And then on payments, related to the WhatsApp test, I'm just wondering how far off in the distance do you think we are from seeing a connected payments ecosystem across the family of apps and do the growing pains for Libra impact the timing of that. Thank you.
Mark Zuckerberg: Sure. So look, I think some of what you might be asking about are the antitrust questions that are out there in the investigations and I can talk a bit about this, if it's helpful. I mean, look, I think a lot of the antitrust questions that are out there that are going to be about our acquisition of Instagram, right. And some of that -- how that might affect other things that we do today, but -- so there's going to be a lot of scrutiny of that acquisition in particular. And so I think if it's helpful I'll go back to what it was like at the time there when we did that acquisition just to kind of lay out how we were thinking about this. And at the time of course in some way we considered Instagram to be a competitor, but we've always thought that the better way to target -- to think about Instagram was that it's complementary to Facebook and what we're doing. Back in 2012, people generally didn't think of Instagram as competing with our core service. We thought about Instagram in the context of this new mobile camera space that was complementary. If you remember, back then we were building the Facebook camera app. There were lots of different services. There is a camera plus VSCO Cam, Socialcam, Viddy, Snapseed. There were even apps like PAS [ph]. They were all in the same space. We thought that mobile photos we're going to be important. So we were competing there with things like Facebook camera, but we ultimately thought that we were going to do better work if we were building with Instagram. But if you remember at the time, Instagram was focused on helping people take photos, apply creative filters and share them publicly across different social networks including Facebook. It wasn't a full featured social network itself. It only had about 30 million people using it at the time. I mean, I remember specifically Kevin and I set a goal that we hope that one day Instagram might reach 100 million people. And I know that that seems quaint today compared to how well it's done. But remember that a lot of the other services that were Instagram's peers and were growing quickly at the time including startups with strong teams and very talented founders like Path don't really even exist today anymore. So look, I mean at the end of the day, the FTC makes its judgment on what we can do, the FTC had all this context when they made this decision in 2012. And the reality is, it ends up being a lot more complementary than I think we ever expected. Look, I mean, building services like this is hard, right. Instagram wouldn't be what it is today without Kevin and Mike who are just really incredible product leaders and of course did a lot of amazing work. But it also wouldn't be what it is without everything that we put into it and whether that's the infrastructure or our advertising model or spam and safety services and a lot more. And I know it can be really hard given how well things have gone to look back and remember what the world was like at the time that we made this acquisition. But our outlook was really different then and the outcome was not all guaranteed. So look, I mean I think for all the concern about whether there is enough competition, the space today continues to be incredibly competitive. We have different competitors in the space today like Snapchat, which shows that people are always building new ideas. And on mobile phones. Of course remember that both Apple and Google has built cameras and private photo sharing and photo management directly into their operating system. So I think that kind of gives you a picture of how we think about some of the scrutiny that's coming and just how we think about doing these things in general.
Dave Wehner: About commerce.
Colin Sebastian: Yes, sorry. Yes, how far off is a connected commerce -- payment ecosystem.
Mark Zuckerberg: Sure well, I mean we do a lot of stuff around commerce. I mean, we have Facebook Marketplace is probably the most advanced and hundreds of millions of people use that to buy and sell things. Instagram Shopping of course a lot earlier. But we're very optimistic about it. But we are optimistic on the timeframe of years, right not driving next quarter's business. And then in terms of payments, there's multiple approaches that we're taking there. We're of course working on payments in WhatsApp. We have our test going in India. It's the test really shows that a lot of people are going to want to use this product. We're very optimistic that we're going to able to launch to everyone in India soon, but of course will share more news when we have that. And we also differentiate between payment systems that are built on top of the existing financial infrastructure like what we're trying to do with WhatsApp payments or when we make payments in Instagram Shopping, and our work with something like Libra that is trying to build some new technological infrastructure for financial services. So they're working on different thing. If Libra works, then it will be able to make certain kind of payments whether they're micropayments or remittances across borders. We'll be able to be done much faster and much more affordably than it can happen today on top of existing rail. So I remain optimistic that we'll be able to do work there, but we're just working across a lot of different fronts here because this is a huge space. It's one of the areas that I am most excited and optimistic about for the years ahead. There's a lot to do, which is why we have a lot of different projects that we're trying to push forward here.
Sheryl Sandberg: Operator, we have time for one last question.
Operator: Your last question comes from the line of Michael Nathanson from Moffett Nathanson.
Michael Nathanson: Thanks. Let me as one of Mark, one of Dave. So, Mark, I mean, a couple of quarters ago we asked you about the embracing or maybe paying for news, and it looks like you've struck some deals with some publishers. Can you talk a bit about that pivot and what the rationale is and maybe how big is that vision for any news. And then for Dave, there's reports tonight about Cognizant who I guess [indiscernible] been the Facebook screeners, Head of AI is dropping a contract. Do you expect to bring that job in-house or is that a third-party outsourcing opportunity?
Mark Zuckerberg: Dave, do that and then I'll wrap on,
Dave Wehner: Yes. Thanks, Michael. No plans to bring that in-house. We obviously have a lot of people in-house who work with the third-parties on that front. But we have a wide variety of different partners beyond Cognizant who work with us. So there is no change in model planned on that front. But we continue to obviously invest heavily in that work and we'll continue to work with other partners in that space.
Mark Zuckerberg: All right, so on news, there are two things that I'm quite excited about here. One is just building a dedicated product space for high quality news. And the second is having a business partnership with news publishers that I think can be sustainable over the long term. So I'll talk a bit about both of them and why I think they are important. We'll start with the product, which is if you look at the Facebook app overall, for a lot of years the app was synonymous with News Feed, right, the main tab in the app and of course everyone who uses Facebook pretty much uses News Feed. And one of the questions that we had was, there are of course a lot of things that some people want to do, but not everyone and we weren't sure if we were going to be able to build a secondary tab in the app that could be meaningful even if most people didn't use them. But we started building things like Marketplace, that is a tab that and even if the majority of people on Facebook don't use it, it's still hundreds of millions of people are using it. So that's really, that's really valuable. And we built Watch. We're seeing a similar trend there. It took us a little while to really get it to work the way that we wanted, but now it's growing quickly, that's going to be hundreds of millions of people who are using it. We rolled out Facebook Dating. I don't know if that will be many hundreds of millions of people just because of the size of that market, but it's going be very useful for tens of millions of people around the world, maybe a hundred million or more. And we are of course doing this with groups and there will be opportunities to do this in other places, including with news. So I think in the future if this works out, what we're going to see is that how people use the Facebook app is going to be, they're going to keep on using News Feed, they are going to keep on sharing with friends and family, but the average person will also probably have one, two or three other apps or kind of secondary tabs that they use that are quite useful for them in connecting with their broader community on Facebook. But those things that each individual use, they're going to vary from person to person. So it's not going to be that everyone is using News Feed, they're going to have -- different people are going to care about different things, whether it's community, or marketplace marketplace for some or dating or news for others. And surely even though not everyone comes to Facebook, because they want high quality news , I believe that there are going to be, whether it's 10% or 20% at a floor who I think would really want something like this. And, we're going to work with the news publishers to make this very valuable and I'm optimistic that we can get there. So that's the kind of the product strategy on the Facebook side. Produce publishers, the thing that I'm excited about is, look, I do think that we have a responsibility to help work with newest publishers to fund high quality journalism. It's no secret that the Internet has disrupted the business model for journalism. And I think that that means that the major Internet platforms have a responsibility to form partnerships and help to fund this work. And the challenge that we've had historically. Is that when most of the usage of the Act was a News Feed. What our community told us is that they really wanted more content from friends and family and less other stuff, right. So less public video is less of other content besides friends and family. So even though we were talking to a lot of news publishers and we wanted to find a way to support and they of course wanted more distribution and some kind of financial relationship. It didn't really make a lot of sense in the past to pay for content to that a lot of our community was generally telling us that they want to see other stuff instead of that. But now with the dedicated news tab. We finally have a space where the business model forward really works for us to be in a long-term sustainable financial relationship with news publishers, where we can pay them for high quality content that can go in there that will be what would fuels the tab. It makes it a great product. And I think in doing so. This can be a long-term virtuous cycle and sustainable business model in way that we can help support journalism. And I'm really happy to do this.
Sheryl Sandberg: Great, thank you. Thank you all for joining us today. We appreciate your time and we look forward to speaking with you again.
Operator: Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines. | [
{
"speaker": "Operator",
"text": "Good afternoon, my name is Mike and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook Third Quarter 2019 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebooks’s Vice President and Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford",
"text": "Thank you. Good afternoon and welcome to Facebook's third quarter 2019 earnings conference call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our quarterly report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these statements as a result of new information or future events. During this call we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I'd like to turn the call over to Mark."
},
{
"speaker": "Mark Zuckerberg",
"text": "All right. Thanks, Deborah. Thank you all for joining us today. Before we get started, I want to talk about the announcement we just shared that Sue Desmond-Hellmann is going to be leaving our Board to focus on her health and other commitments. Sue has been a wonderful and thoughtful voice on our Board for six years and I'm deeply personally grateful for everything that she has done for this Company. This was a good quarter for our community and our business. There are now around 2.8 billion people using Facebook, Instagram, WhatsApp or Messenger each month and around 2.2 billion people using at least one of our services daily. The Facebook app had a particularly strong quarter, including in the US and Canada. We also recently released - now that we estimate that more than 140 million businesses, mostly small businesses are using our services each month to grow, create jobs and become social hubs in their communities. This has been a busy quarter on a lot of fronts. We launched a number of new exciting products like Facebook Dating in the US, which is doing quite well; Threads for Instagram, our camera first experience to share with your close friends, Facebook News, our dedicated product for news that we built in partnership with news publishers, and we introduced Horizon, a new social experience for VR. We also released hand-tracking technology for Oculus and Oculus Link. So your Quest is basically now a Rift too. We're making progress building out the private social platform across WhatsApp, Messenger and Instagram Direct, and we have multiple exciting initiatives around commerce and payments that we're moving forward from marketplace to Instagram Shopping to payments in WhatsApp and continuing our discussion on Libra. This has also been a busy quarter on the policy and social issues front. We formally entered into a settlement with the FTC to make structural changes and build a rigorous privacy program that will set a new standard for our industry. We're about a year out now from the 2020 elections and we just announced that the systems we've built are so advanced that we proactively identified and removed multiple foreign interference campaigns coming from Russia and Iran. And we found ourselves in the middle of the debate about what political speech is acceptable in the upcoming campaigns. But today I want to focus on talking about principles because from a business perspective it might be easier for us to choose a different path than the one that we're taking. So I want to make sure that everyone is clear about what we stand for and why we're making some of the decisions that we're making. Now I gave a speech a couple of weeks ago about the importance of standing for voice and free expression. I believe strongly and I believe that history supports that free expression has been important for driving progress in building more inclusive societies around the world. And at times of social tension, there's often been an urge to pull back on free expression and that we will be best served over the long term by resisting this urge and defending free expression. Today is certainly a historical moment of social tension and I view an important role of our Company as defending free expression. Now this has never been absolute and of course we take our responsibility to prevent harm very seriously too. I think we invest more in getting harmful content off our services than any other company in the world. Those who follow us closely know that we have more than 35,000 people working on safety and security, and that our budget for this work is billions of dollars a year, more than the whole revenue of our Company at the time of our IPO earlier this decade. And we're going to keep on investing more here. But while we work hard to remove content that can cause real danger, I think we also need to be careful about adopting more and more rules that restrict the way that people can speak and what they can say. Right now the content debate is about political ads, should we block political ads with false statements or should be block all political ads. Google, YouTube and most Internet platforms run these same ads. Most cable networks run these same ads and of course national broadcasters are required by law to run them by FCC regulations. And I think that there are good reasons for this. In a democracy, I don't think it's right for private companies to censor politicians or the news. And although I've considered whether we should not carry these ads in the past and I'll continue to do so, on balance so far I've thought that we should continue. Ads can be an important part of voice, especially for candidates and advocacy groups that the media might not otherwise cover, so that they can get their message into debates. And it's hard to define where to draw the line. Would we really want to block ads for important political issues like climate change or women's empowerment. Now instead I believe that the better approach is to work to increase transparency. Ads on Facebook are already more transparent than anywhere else. We have a political ads archive so anyone can scrutinize every ad that's run. You can see every message, who saw it, how much was spent, and that's something that no TV or print media does. Now since this is an earnings call, I want to talk about the business impact of all of this. Some people accuse us of allowing the speech because they think that all we care about is making money and that's wrong. I can assure you that from a business perspective the controversy that this creates far outweighs the very small percent of our business that these political ads make up. We estimate that these ads from politicians will be less than 0.5% of our revenue next year. That's not why we're doing this. To put this in perspective, the FTC finds that these same critics said, will it be enough to change our incentives was more than 10X bigger than this. So the reality is that we believe deeply that political speech is important and that's what's driving this. Now other people say that this policy is part of a broader pattern of us building a system that incentivizes inflammatory content to fuel our business. And again, to the contrary, I think that we've done more than any of the other major Internet platforms to try to build positive incentives into our systems. We don't let any of our newsfeed or Instagram feed teams set goals around increasing time spent on our services. We rank feeds to encourage meaningful social interactions, helping people connect with friends, family and their communities. We have real people come in and tell us what content they saw that was most meaningful to them and sport valuable discussions and then we build systems to try to surface that kind of content. We've taken many steps over the years to fight clickbait and polarization, and now we're even testing removing like counts in Instagram and Facebook. And we do this because we know that if we help people have meaningful interactions that they'll find our services more valuable and that's the key to building something sustainable and growing over time. Now last year, you'd probably remember that we made a series of changes that emphasized friends and family and reduced time spent on our services. The one change removed 50 million hours of viral video watching a day and we did this knowing that it would mean that people spend less time on our apps, which is not what you do if you're just prioritizing engagement over everything else. So I take getting these incentives right very seriously and we're willing to make huge sacrifices in the short term to do what we think is right and we'll be better over time. Now finally, some people say that this is just all a cynical political calculation and that we're acting in a way that we don't really believe because we're just trying to appear conservative. That's wrong too. Now we face a lot of criticism from both progressives and conservatives. And frankly if our goal, we're trying to make either side happy, then we're not doing a very good job because I'm pretty sure everyone is frustrated with us. Core values on voice and free expression are not partisans, but unfortunately in our current environment a lot of people look at every decision through the lens of whether it's going to help or hurt the candidate they want in winning their next election. Now a lot of people have told us, you've got to pick a side, or else both sides are just going to cause a lot of problems for you and sadly from a practical perspective, they may be right, but we can't make decisions that way. So over the next year of campaigns, we're going to be at the center of the debate, anytime there's content or policies on any of our services that people believe could advantage or disadvantage their side. This may lead to more investigations and the candidates are going to criticize us. I expect that this is going to be a very tough year. We try to do what we think is right but we're not going to get everything right. This is complex stuff and anyone you said that the answers are simple hasn't thought long enough about all the nuances and downstream challenges. I guess that some people are going to disagree with our decision. I guess that some people are going to think that these decisions may have a negative impact on things that they really care about. But I don't think anyone can say that we are not doing what we believe or that we haven't thought hard about these issues. I could be wrong, but my experience running this Company so far has been that if we do what we believe is right, even when it's unpopular for years at a time, then eventually it has worked out best for our community and for our business too. And there's a lot at stake here. We were at crossroad, not only in our own country, but in the future of the global Internet as well. China is building its own Internet and media ecosystem that's focused on very different values. And as these systems compete, the question of which nation's values will determine what speech has allowed for decades to come really puts into perspective the issues that we face today because while we may disagree on exactly where to draw the line on specific issues, we at least can disagree and that's what free expression is about. Voice and expression have been important for progress throughout history, they have been important in the fight for democracy worldwide. And I believe that voice and expression are an important part of the path forward today and that's why our Company will continue standing for these principles. As always, I'm grateful for all of your support in everything that we do and that's especially true today. In addition to these challenges, there are a lot of great things that are going on that I am incredibly proud of and excited about and I'm glad that our community and business trends continue heading in a good direction. I'm happy to talk about any of these things in the Q&A and now here is Sheryl to talk more about our business."
},
{
"speaker": "Sheryl Sandberg",
"text": "Thanks, Mark, and hi everyone. It was a strong quarter for our business. Ad revenue grew 28% year-over-year and we saw strong performance in all regions and on both Facebook and Instagram. Mobile ad revenue was $16.4 billion, contributing approximately 94% of total ad revenue. We know we have a very important responsibility to keep people safe and continue innovating to help businesses of all sizes grow. We're working hard to demonstrate our commitment to the billions of people and the 140 million businesses who use our platforms every month. I want to start by talking about some of the protections we're putting in place to keep people safe. As Mark said, the 2020 elections are only a year away. We're continuing to invest in people and technology so that we can disrupt networks of bad actors, find and remove that content and stop fake accounts before people see them. We're also making political advertising on Facebook more transparent than anywhere else. In 2018, we started requiring ads about social issues, elections or politics to get authorized before running. And this quarter we strengthen those requirements to ask for even more information. Helping people understand who is trying to influence their vote without becoming arbiters of political truth ourselves is critical to empowering people and keeping them safe. We're also holding ourselves to a higher standard when it comes to protecting people from discrimination on Facebook. Earlier this year we reached an important settlement with the National Fair Housing Alliance, the ACLU, the Communication Workers of America and others to restrict targeting options for housing, employment and credit ads. Now advertisers in these areas are required to use a new buying process and by the end of the year people will be able to view all current housing ads in the United States. While these changes could have a small negative impact on our business in the short term, we believe they are the right thing to do for people and our business over the long term. At the same time, we're continuing to innovate to grow our business and help advertisers grow theirs. We did that by improving our ads products and creating new formats to help advertisers more easily reach their current and future customers. From the biggest brands in the world to the local barber, we are committed to leveling the playing field for businesses of all sizes. We give businesses free tools that previously only the largest companies could access. But we know this is not enough. We also need to ensure that small businesses have the digital skills to use those tools effectively. With the holiday shopping season approaching, we launched a series of holiday boot camp training sessions in 17 of our offices around the world from New York to Philippines. We also simplified business managers, our tool for managing campaigns to help businesses more easily create ads that align with their goals. We are continually making these basis point improvements to help advertisers save time and money and build their business. We're also focused on developing products to help businesses reach people where they are. Stories are a great example and we're continuing to see fast adoption across Facebook, Messenger, Instagram and WhatsApp. To make it easier for more businesses to create ads for the stories format, we recently launched customizable templates for Facebook, Instagram and Messenger. After uploading existing photos and videos, advertisers can choose from different layouts, color and text options. This helps businesses more easily create more engaging stories. Messaging is one of the fastest growing areas for online communication and especially between businesses and people. We've seen businesses use Messenger to reach customers, generate new leads and even sell cars. For example, French automaker Renault used a combination of Instagram stories and click to Messenger ads to drive sales of a limited edition vehicle, the Captur Tokyo. Facebook was their only advertising channel and over the span of 30 days, they sold 100 cars, 20 directly through Messenger. This quarter we added a click to Messenger feature in stories so businesses can grab some of the attention in stories and then continue the conversation. We also continue to build new formats that enable brands to interact with people in fun and engaging ways and make commerce more convenient. Earlier this year we launched polling stickers for ads and Instagram stories. In this quarter, we introduced our next wave of interactive advertising to help build even stronger connections between people and businesses. According to eMarketer, 63% of Internet users surveyed in the US say they've tried an augmented reality experience created by a brand. To help advertisers experiment with this, we launched a small beta test this quarter. As part of the test, we make up an Italian cosmetics brand, used their ads to give people an easy way to try on different shades of lipstick and they saw a 27% lift in purchases. While it is still very early days, we are making it easier for people to browse, discover, buy and sell across our platform. Take Facebook Marketplace as an example. We launched the commerce platform three years ago this month and we're now seeing millions of interactions between buyers and sellers every day. From furniture to used vehicles, people have an opportunity to discover the things they love and advertisers in nearly 100 regions have an opportunity to reach people where they shop. I want to close by saying how grateful I am to our partners around the world that continue to give us valuable feedback and how we can better deliver on our responsibilities and help them grow. I also want to thank the Facebook teams who are deeply committed to making progress on the major social issues facing the Internet and our Company and driving growth for businesses. Thanks everyone and here is Dave."
},
{
"speaker": "Dave Wehner",
"text": "Thanks, Sheryl, and good afternoon everyone. Let me begin with our community metrics. We were pleased with the growth of the Facebook Community this quarter, daily active users reached 1.62 billion, up 9% compared to last year led by growth in India, Indonesia and the Philippines. This represents approximately 66% of the 2.45 billion monthly active users in September. MAUs grew 8% or 178 million compared to last year. We're pleased with the growth trends in all regions, including the US and Canada. In terms of our Family metrics, we continue to grow and estimate that on average around 2.2 billion people use at least one of our apps on a daily basis in September and around 2.8 billion were active on a monthly basis. As a reminder, the Family metrics are best estimate of our de-duplicated audience across Facebook, Instagram, Messenger and WhatsApp. We believe that these numbers better reflect the size of our community and the fact that many people are using more than one of our services. Over time, we anticipate Family metrics will play the primary role in our disclosures and how we talk about the Company. Turning now to the financials. All comparisons are on a year-over-year basis unless otherwise noted. Q3, total revenue was $17.7 billion, up 29% or 31% on a constant currency basis. As expected, we saw a deceleration in our constant currency revenue growth versus the second quarter. Had foreign exchange rates remained constant with the third quarter of 2018, total revenue would have been approximately $297 million higher. Q3 total ad revenue was $17.4 billion, up 28% or 31% on a constant currency basis. In terms of regional ad revenue growth, APAC and Rest of World were strongest and grew 35% and 34%, respectively. APAC got more of a revenue lift from our recent product optimizations while Rest of World benefited from favorable macroeconomic trends compared to the weaker environment in Q3 of last year. North America and Europe grew 27% and 24%, respectively. In Q3, the number of ad impressions served across our services increased 37% and the average price per ad decreased 6%. Impression growth was primarily driven by ads on Facebook News Feed, Instagram Stories and Instagram feed. The year-over-year decline in average price per ad was primarily driven by the ongoing mix shift towards geographies and Stories ads which monetize at lower rate. Payments and other fees revenue was $269 million, up 43%. This year-over-year growth was driven primarily by sales of new products, notably, Oculus Quest. Turning now to expenses, total expenses were $10.5 billion, up 32%. We ended Q3 with approximately 43,000 full-time employees, up 28%. Operating income was $7.2 billion, representing a 41% operating margin. Our Q3 tax rate was 17%. Net income was $6.1 billion or $2.12 per share. Capital expenditures were $3.7 billion driven by ongoing investments in data centers, servers, network infrastructure and office facilities. We generated $5.6 billion in free cash flow and ended the quarter with approximately $52.3 billion in cash and investments. In Q3, we bought back approximately $1.2 billion of our Class A common stock. Turning now to the revenue outlook. As I indicated on our second quarter call, we continue to expect a more pronounced deceleration of our revenue growth rate in Q4. We expect our Q4 reported revenue growth rate will decelerate by mid to high single-digit percentage compared to our Q3 rate. This deceleration is largely driven by the lapping of several successful product optimizations in Q4 of last year, as well as ad targeting related headwinds. Since these factors are largely unique to Q4, we would expect our revenue growth deceleration in 2020 versus the Q4 rate to be much less pronounced. Turning now to the 2019 expense outlook. Due to the FTC settlement announced earlier this year, we are providing our expense outlook on a dollar basis for additional clarity. We anticipate 2019 total expenses will be approximately $46 billion to $48 billion. As a reminder, this range includes $5 billion in accruals we recorded in the first half of 2019 related to our FTC settlement. We expect 2019 capital expenditures will be approximately $16 billion compared to our prior estimate of $16 billion to $18 billion. Our capital expenditures are driven primarily by our ongoing investments in data centers, servers and network infrastructure. Turning now to tax. We expect our Q4 tax rate will be in the range of 18% to 20%. I'd also like to share our initial outlook on 2020 expenses. We anticipate that our 2020 total expenses will be in the range of $54 billion to $59 billion. Our plan to re-accelerate headcount growth as well as growth in non-headcount related expenses like marketing factors into this guidance. We expect that 2020 capital expenditures will be approximately $17 billion to $19 billion driven by investments in data centers, servers, office facilities and our network infrastructure. Lastly, we anticipate our 2020 effective tax rate will be in the range of 18% to 20%. In summary, Q3 was a strong quarter for Facebook. We are pleased with the growth of our community and continued momentum in our ads business. At the same time, we continue to make investments in important areas like privacy, safety and innovation. With that, operator, let's open up the call for questions."
},
{
"speaker": "Operator",
"text": "We will now open the lines for a question-and-answer session. [Operator Instructions] Your first question comes from the line of Doug Anmuth from JPMorgan."
},
{
"speaker": "Doug Anmuth",
"text": "Thanks for taking the question. First off, Dave, can you just help us understand a little bit more on the 4Q on the revenue decel, just some of the product improvements from last year that you're lapping. And then also just how you're thinking about the ad targeting headwinds considering that they didn't seem to show up in the 3Q numbers that much. And then, Mark, can you just talk about Instagram Shopping. How that's ramping and how you're thinking about expanding that initiative as you're going deeper into 4Q here. Thanks."
},
{
"speaker": "Dave Wehner",
"text": "Hey, Doug, it's Dave. Yes, on the Q4 outlook, we are lapping a few different product optimizations. We made a couple of those that I would cite as optimizations and how the ad auction operates, which can have an impact and also an increase in ad load on IG feed and stories. And so, as I noted, these are factors that are largely Q4 related. And given that we would expect that 2020 revenue deceleration to much less pronounced. And then in addition, in Q4, and over the longer term, we do continue to expect to face ad targeting related headwinds and uncertainties. And I just go back to the three factors that I cited in the past that the regulatory landscape is continuing to evolve. So for example, when GDPR came into effect, we saw a number of people who opted out on allowing us to use context from the apps and websites they visited for ad targeting. And then the second factor is just we're seeing proposed changes from the mobile platforms that are more oriented towards privacy which could affect targeting and measurement and make that more difficult. And then finally, we are rolling out our own product changes such as the recent launch of OSA that's our user control on what data stored on Facebook activity. So I'd say those three factors still factor in. And when it comes to this, I'd say the majority of the potential signal loss is still in front of us rather than behind us. So I think those headwinds are still real and out there and that factors into our outlook as well."
},
{
"speaker": "Sheryl Sandberg",
"text": "I'll take the Instagram Shopping question. We think there is a big opportunity over the long run here because 90% -- more than 90% of Instagram users are following a business. But on the shopping product itself, it is still very early days and we're working to improve the product and it's quite small. We started testing in Q3 shopping ads, the idea that shoppers can tap on ad, see a product description page and can purchase from the business' mobile site. Again, we think interesting product, but very nascent. Our overall commerce efforts go across not just Instagram but Facebook and all of our properties, and our goal is to make it more convenient and accessible and secure for people and business to browse, discover, buy and sell. I think we have been and continue to be a great place for people to browse and discover. That continues to drive the great, great majority of our business and well for the foreseeable future. But as we can help people reduce friction and close that loop, we think that's a good opportunity for people and for our business."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Justin Post from Bank of America Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "Great, thank you. Maybe one for Mark and one for Dave. First on Watch, with all the OTT launches, it's kind of interesting. Can you talk about your usage of the Watch tab and what your overall professional content strategy is and whether it could start contributing revenues going forward. And then Dave, you mentioned the headcount growth accelerating. Could you give us some of the areas where you'll be adding headcount next year. Thank you."
},
{
"speaker": "Mark Zuckerberg",
"text": "I'm happy to talk about Watch for a little bit. I don't think we have any new status to share on this, but I mean overall we rolled out the tab for -- almost the first year we were really tuning it just to make sure that it would be retentive and very valuable for people. So they are in general -- the way we think about this stuff is, we try not to put something in front of a lot of people unless we're confident that they're going to find it useful and want to come back and use it multiple times and we can put a lot of things in front of people not to try it once, but we want to wait until things are kind of retentive and useful. So we got to there on Watch, it's growing well and that is -- so we're kind of still now focused on continuing to make it better and continuing to grow it. The premium content part of it, yes, I think the right way to think about this is almost as marketing to help people try out the tab for the first time. There are some good tent pole pieces of content that people really love that they come and they check out the product to experience that and then they stay for a lot of the other valuable content that's in there and that might not be talked about as much in the news. So, that's I think the right way to think about that."
},
{
"speaker": "Dave Wehner",
"text": "Hey, Justin, it's Dave. On the 2020 expense outlook, that includes headcount growth and also other expense growth sort of around infrastructure is a big factor as well. We're seeing that large CapEx build over the last several years flowing through depreciation and cost of revenue. So that's a driver of the growth as well. We are planning to reaccelerate or accelerate hiring in 2020 and that's really going to be focused on the important priorities of the Company. So that includes our privacy, safety and security investments. So we are investing a lot in privacy related to building the products and also working on complying with the FTC settlement. And then we're continuing to invest heavily in our innovation investments. That includes building products around Facebook and Instagram and continuing to improve those but also in new developing areas like AR/VR. So those are big factors in growth. And then we are planning on growing non-headcount related expenses as well like marketing and ultimately that will depend on how the ROI of those investments play out over time."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Eric Sheridan from UBS."
},
{
"speaker": "Eric Sheridan",
"text": "Thanks for taking the question. Maybe two, if I can. You gave us a little bit of color on Asia and Rest of World and why those had accelerated. Any additional color you could give on sort of the US and Europe or things you saw in the quarter that might have impacted the growth rates in those regions. And going to the Q4 guide, is there any color you can give us on how different regions of the world might be impacted against the mid to high single-digit deceleration of the levels of Q3 just so we have a better understanding of where you might be seeing some of those tougher comps or product optimizations play out on a global scale. Thanks so much."
},
{
"speaker": "Dave Wehner",
"text": "Thanks, Eric. We're not breaking out specific regional impact, but let me give you some color around the acceleration in areas like Rest of World and APAC. APAC benefited from some of the product optimizations we did in the quarter. One thing that I would cite there, it's just how we manage ad load and balance some of our internal promotion units and sort of use it as internal house spend and the nature of the changes that we made in that had a more pronounced impact in some of the lower ARPU countries and unlocked more impression growth in those markets. So that was one of the factors. And then Brazil was particularly weak last Q3. So that had a good compare on a macroeconomic basis. In terms of the Q4 guide, not anything I would say specifically there. In the US, we will have a shorter holiday season, it's hard to know how that's going to play into it just given the late arrival of Thanksgiving, but I think overall the product optimizations that we're comping against in Q4 were global changes. So I think we're going to see the deceleration impact all regions."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Brian Nowak from Morgan Stanley."
},
{
"speaker": "Brian Nowak",
"text": "Thanks for taking my question. I have two. The first on -- Mark, you mentioned Facebook app in particular had a strong quarter in the US and Canada. We can see it in the DAU numbers. We would be curious to hear about any specific products or changes or types of behavior you're seeing that really is driving the stronger engagement on Big Blue. And the second one, you have so many monetization I guess call them almost products to come. You talked about commerce and IGTV and Stories and Discover. Just as we sort of think about the timing of these, which one or two of those are you sort of most excited about to drive the business into 2020? Thanks."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yes, I can take the first one on the Facebook app. It's a bunch of different places in which I think we made improvements. I would say globally especially outside the US, we saw good improvements around -- engagement around video. In the US, I think it was less video and more core feed engagement. So it's a bunch of different factors and I think we're seeing good engagement from a bunch of cohorts in the US, which is good. But of course we are highly penetrated in the US and Canada. So we would expect that to bounce around. So I think we saw great growth this quarter. We are quite penetrated. In terms of monetization opportunities, I can speak to that and Mark can add color if you would like. Obviously -- and Sheryl would like to add color as well. So, Stories is obviously one of the big growing areas for us and continues to be a big driver. We're also seeing opportunities around Instagram Explore going into 2020. We're now monetizing with that product and more advertisers are buying from it and then Sheryl is going to jump in and I think give some additional color."
},
{
"speaker": "Sheryl Sandberg",
"text": "Yes, I think in terms of our core advertising products and growth, it's worth really remembering that our core feed products for Facebook and Instagram are growing nicely and well. And we see a lot of opportunity to continue that growth. Definitely, Stories is a big part of the success. We've had I think a lot of success moving advertisers to where people already are. That's what happened with mobile ads. People weren't really doing mobile ads and we helped them get there. I think we've taken our experience on how to help advertisers migrate to the right places and been able to do that even more quickly in new formats like Stories. So of our more than 7 million advertisers, we already have 3 million advertising across Facebook, Instagram and Messenger Stories. And I think that's because we learned that we have to do a lot to help them move. So for example, advertisers can now buy Stories across Facebook, Instagram and Messenger all at once. We had automatic default templates which convert your feed ads into vertical Stories format and this quarter we just launched customizable templates, which help you save time and resources. So as we have to help advertisers move, we've learned how to make those investments in making the formats really easy, the measurement really easy, the buying really easy. Now, the mix to Stories is a big opportunity for us. Stories still does monetize at the same rate as a News Feed right now. So, we're keeping an eye on that. But the growth over the long run is pretty exciting. And I think our ability to help people migrate is something that we're able to prove out quarter over quarter."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Mark Mahaney from RBC Capital Markets."
},
{
"speaker": "Mark Mahaney",
"text": "Mark, who would you want to add to the Board or what sort of voice would you want to add to the Board that would be particularly helpful for you in the Company now. And then, David, could you talk about that Stories monetization gap, to what extent it's closing the rate at which it's closing. Thank you."
},
{
"speaker": "Dave Wehner",
"text": "I can take the Stories monetization gap first and give Mark the second. So on that, I think what we're continuing to see with Stories monetization is, that is a product that's experiencing a lot of impression growth. And whenever we have a product that's experiencing high impression growth that puts pressure on the auction in terms of price. And we've also seen good impression growth on the feed side as well. So if you noted in the commentary when I talked about the drivers of impression growth, I listed feed impressions from Facebook first. So I think that's also showing good growth. So I'd say overall not a big change in the gap there and overall the impression growth is really the story for Stories and will remain the story we think for the near future. So that will not be a price-driven revenue growth story, but rather an impression growth, revenue growth story."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yes, on Board members, there are a lot of great leaders who serve on our Board, who have served on our Board. It's been an incredible benefit running the Company. We face a very wide range of issues here from really hard technological problems to issues scaling large organizations to of course a lot of now major regulatory and social issues and having different people or different perspectives can help us navigate that and provide both advice and oversight to make sure that we're doing a good job is really important. And I just want to add one more time, Sue really did an amazing job on our Board and I'm sad to see her go and she has really helped shape a lot of what we do and I'm just incredibly grateful, perfect to mentioned it here."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Lloyd Walmsley from Deutsche Bank."
},
{
"speaker": "Lloyd Walmsley",
"text": "Thanks. Two questions, if I can. First you mentioned a little bit earlier the OFA feature that you rolled out this quarter in just a few markets. So can you give us a sense of what you're seeing in terms of early user response to this, how it may be impacting targeting in those markets. And then secondly, you've disclosed on occasion kind of daily search query volumes, you're now expanding ad inventory more into search. So I'm wondering if you can give us an updated sense of query volumes and then how we should think about ad coverage ramping over time within search given a lot of the searches on the platform today are people searches and how we should think about that. Thanks."
},
{
"speaker": "Dave Wehner",
"text": "Sure, I'll take those. In terms of the OFA roll out we initially launched that in August and we've been continuing to slowly roll that out globally and we'll be doing that over the next several months through the end of the year. And we're rolling it out globally on a percentage basis. We've seen a positive reception to having this feature as an option. It's too early to share adoption and we'll just have to see kind of over time how that gets picked up and how that gets adopted. But I think it's too early to really share much about it. In terms of search, we are showing ads in Marketplace in FB search results. But really the vast majority of searches on Facebook are for people, not topics related to retailer e-commerce. So, it's very early days. And from a revenue perspective, it's not material at this point."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Youssef Squali from SunTrust."
},
{
"speaker": "Youssef Squali",
"text": "Thank you very much. Two questions from me as well. Mark, with GDPR now over a year old, how has it impacted your business relative to your own expectations and how does that inform your views about the potential impacts from CCPA in 2020. And then on VR, it seems like your vision has taken a bit longer than expected to materialize. Can you speak to the gating factors there and do you feel that now that Quest is at $400 and there seems to be a lot more content out there, we're going to see potentially an acceleration in adoption. Thank you."
},
{
"speaker": "Dave Wehner",
"text": "Youssef, I'll take the question. I think it was about GDPR and how that's gone relative to expectations. We've seen adoptions around people who are opting out of allowing us to use context from the apps. And so I'd say that was largely within the range of expectations that we saw and it is having an impact and the people who are opting out are seeing less relevant ads. And obviously that will impact both, I think, the quality of the experience in terms of the ads they get and also the monetization for us. So I think that is kind of playing out as we expected. CCPA, I think is still a work in progress. So we're watching the developments on that closely. That's the California Consumer Privacy Act, and that has many similar provisions to GDPR, but it's a different line. We're going to have to watch how that evolves, but we do think that that's a factor that we're watching closely and we'll just have to see how that develops. I think, Mark, question was on Oculus."
},
{
"speaker": "Mark Zuckerberg",
"text": "Sure. And then also just add something on privacy. I think it's very important that there is federal privacy legislation. GDPR encodes a lot of important principles and in order for businesses to be able to operate, especially starts to get started and keep the market competitive, you want to make sure that there aren't 50 different regulatory frameworks that companies need to follow. I mean, we could handle that if we needed to, we're a big company. But in terms of for the market overall, I just think it would be a lot better if we had a very clear set of rules at the federal level on privacy. So we'll continue to try to work with folks to try to do what we can to help there. On VR and AR, you're right. This is taking a bit longer than we thought. And I'm still optimistic, I think that the long-term vision and the reasons why I thought this -- we're going to be important and big are unchanged. So we're seeing a lot of people use these products and love them and because of that I think that we're still going to get there. Obviously, the fact that it's taking a little longer than we thought, it cuts both ways. On the one hand, that of course means that the future might be a few years further out and that it might be more expensive to develop because we'll be funding this for a bit longer until it gets there. But on the other hand, from our perspective, we're not a company that's traditionally done hardware or built operating systems or these kind of products. So every year that we get to practice and get better and build our brand around Oculus in terms of building the best products that we can in this space, I just think that we're going to be better off when this is really ready to be a completely mainstream thing with hundreds of millions of people using it. You're right that Quest is growing and doing quite well. We are selling them as fast as we can make them, the demand has been strong and the content is starting to pick up both on the AAA, really high quality side and some of the [indiscernible] stuff that I think is quite good. I'm very excited about what we're seeing and very optimistic about the future."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ross Sandler from Barclays."
},
{
"speaker": "Ross Sandler",
"text": "Great. So guys, just a question on the 2020 rev outlook, calling for a more modest deceleration. So, Dave, I guess what are some of the headwinds, tailwinds that you might see in 2020 that would cause the deceleration? Is this a function of lapping some of the impression acceleration you're seeing now in some of these innovations that you've had in '19 or is there things like the drawing on both the late stage VC funding market and some of those companies potentially coming back on their marketing plans. Is that a material factor? What are some of the other headwinds for next year? And then one housekeeping question is, the 4Q mid to high single-digit decel, is that referring to constant FX growth rate or is that reported US dollar growth rate that you're expecting the decel from? Thank you."
},
{
"speaker": "Dave Wehner",
"text": "Yes, sure, Ross. It's a reported number that we're giving that on, on a mid to high-single digit deceleration from the reported growth rate. I don't think there should be a huge difference in them, but we're giving it on a reported basis. So in terms of the deceleration, we continue to expect deceleration into 2020, but it would be, we believe, more moderated and the reasons for that, that we expect the deceleration. We do continue to see these ad targeting related headwinds, which have been playing out slowly, but we think are still in front of us. The majority of potential signal loss on targeting is still in front of us. And that's the three factors that I cited, the regulatory landscape, potential platform changes and then the adoption of our own products like OFA that we're just rolling out now. So all of those will play into the potential deceleration of revenue growth in 2020. Obviously, we're lapping what's been good performance in 2019 where we've made a lot of product improvements and growing off a large base. So I think we are experiencing deceleration from that perspective. The specific sort of high level of deceleration going into Q4, we're signing the specific optimizations that we're lapping in Q4, which were more significant."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Heather Bellini from Goldman Sachs."
},
{
"speaker": "Heather Bellini",
"text": "Great. I just wanted to go back to the opening remarks about the 35,000 people. I think you mentioned that you have working on safety and is that you're spending more, I think your budget for this area you said is more than it was back when you went public in 2012. So, maybe about $5 billion. I just was wondering if you could share with us your view on how much you're using, you talked about AI in the past being helpful here. How long does this have to be as resource-intensive from a people perspective or do you see the ability over time as with technologies like AI potentially helping you to get more leverage out of this existing budget, so maybe you don't have to continue to ramp it as quickly as your user base and engagement continues to grow. Thank you."
},
{
"speaker": "Mark Zuckerberg",
"text": "Sure. So over time we may not have to ramp it as much, but I don't foresee any time in the near future that AI is going to make it to that if the cost comes down. In general what we have to do is we use computers and AI for what they're good for which is looking at a lot of content very quickly and making quick judgments. And we have teams of people doing what people are good for which is making nuanced human judgments. And so you build the computer system, in that way they can flag and get rid of some of the worst stuff, and so they can flag for human review, some of the stuff that's borderline and then there's just so much content flowing through the system that we do need a lot of people looking at this. And I don't think that's going to change anytime soon."
},
{
"speaker": "Dave Wehner",
"text": "And Heather, I would add that when you're using systems to look at content, when you're using AI machine learning systems, it's a real benefit to have actual people looking and tagging that content, classifying it because it helps those machine learning algorithms be able to learn what they're looking at. So you actually have -- we do have actually ramped in people who are doing the tagging and classification. So there is actually expense related to AI that's on the human side in the near-and medium-term as well. So very much in line with what Mark said. Over time it's an opportunity to maybe slow down the growth, but it's not going to change the dynamics in the near term."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Colin Sebastian from Baird."
},
{
"speaker": "Colin Sebastian",
"text": "Thank you. Mark, maybe a bigger picture question. I'm wondering how you think about the increase in scrutineer oversights impacting your or the Company's ability to explore new services, new markets and ultimately remain competitive or is that not really a factor at this point? And then on payments, related to the WhatsApp test, I'm just wondering how far off in the distance do you think we are from seeing a connected payments ecosystem across the family of apps and do the growing pains for Libra impact the timing of that. Thank you."
},
{
"speaker": "Mark Zuckerberg",
"text": "Sure. So look, I think some of what you might be asking about are the antitrust questions that are out there in the investigations and I can talk a bit about this, if it's helpful. I mean, look, I think a lot of the antitrust questions that are out there that are going to be about our acquisition of Instagram, right. And some of that -- how that might affect other things that we do today, but -- so there's going to be a lot of scrutiny of that acquisition in particular. And so I think if it's helpful I'll go back to what it was like at the time there when we did that acquisition just to kind of lay out how we were thinking about this. And at the time of course in some way we considered Instagram to be a competitor, but we've always thought that the better way to target -- to think about Instagram was that it's complementary to Facebook and what we're doing. Back in 2012, people generally didn't think of Instagram as competing with our core service. We thought about Instagram in the context of this new mobile camera space that was complementary. If you remember, back then we were building the Facebook camera app. There were lots of different services. There is a camera plus VSCO Cam, Socialcam, Viddy, Snapseed. There were even apps like PAS [ph]. They were all in the same space. We thought that mobile photos we're going to be important. So we were competing there with things like Facebook camera, but we ultimately thought that we were going to do better work if we were building with Instagram. But if you remember at the time, Instagram was focused on helping people take photos, apply creative filters and share them publicly across different social networks including Facebook. It wasn't a full featured social network itself. It only had about 30 million people using it at the time. I mean, I remember specifically Kevin and I set a goal that we hope that one day Instagram might reach 100 million people. And I know that that seems quaint today compared to how well it's done. But remember that a lot of the other services that were Instagram's peers and were growing quickly at the time including startups with strong teams and very talented founders like Path don't really even exist today anymore. So look, I mean at the end of the day, the FTC makes its judgment on what we can do, the FTC had all this context when they made this decision in 2012. And the reality is, it ends up being a lot more complementary than I think we ever expected. Look, I mean, building services like this is hard, right. Instagram wouldn't be what it is today without Kevin and Mike who are just really incredible product leaders and of course did a lot of amazing work. But it also wouldn't be what it is without everything that we put into it and whether that's the infrastructure or our advertising model or spam and safety services and a lot more. And I know it can be really hard given how well things have gone to look back and remember what the world was like at the time that we made this acquisition. But our outlook was really different then and the outcome was not all guaranteed. So look, I mean I think for all the concern about whether there is enough competition, the space today continues to be incredibly competitive. We have different competitors in the space today like Snapchat, which shows that people are always building new ideas. And on mobile phones. Of course remember that both Apple and Google has built cameras and private photo sharing and photo management directly into their operating system. So I think that kind of gives you a picture of how we think about some of the scrutiny that's coming and just how we think about doing these things in general."
},
{
"speaker": "Dave Wehner",
"text": "About commerce."
},
{
"speaker": "Colin Sebastian",
"text": "Yes, sorry. Yes, how far off is a connected commerce -- payment ecosystem."
},
{
"speaker": "Mark Zuckerberg",
"text": "Sure well, I mean we do a lot of stuff around commerce. I mean, we have Facebook Marketplace is probably the most advanced and hundreds of millions of people use that to buy and sell things. Instagram Shopping of course a lot earlier. But we're very optimistic about it. But we are optimistic on the timeframe of years, right not driving next quarter's business. And then in terms of payments, there's multiple approaches that we're taking there. We're of course working on payments in WhatsApp. We have our test going in India. It's the test really shows that a lot of people are going to want to use this product. We're very optimistic that we're going to able to launch to everyone in India soon, but of course will share more news when we have that. And we also differentiate between payment systems that are built on top of the existing financial infrastructure like what we're trying to do with WhatsApp payments or when we make payments in Instagram Shopping, and our work with something like Libra that is trying to build some new technological infrastructure for financial services. So they're working on different thing. If Libra works, then it will be able to make certain kind of payments whether they're micropayments or remittances across borders. We'll be able to be done much faster and much more affordably than it can happen today on top of existing rail. So I remain optimistic that we'll be able to do work there, but we're just working across a lot of different fronts here because this is a huge space. It's one of the areas that I am most excited and optimistic about for the years ahead. There's a lot to do, which is why we have a lot of different projects that we're trying to push forward here."
},
{
"speaker": "Sheryl Sandberg",
"text": "Operator, we have time for one last question."
},
{
"speaker": "Operator",
"text": "Your last question comes from the line of Michael Nathanson from Moffett Nathanson."
},
{
"speaker": "Michael Nathanson",
"text": "Thanks. Let me as one of Mark, one of Dave. So, Mark, I mean, a couple of quarters ago we asked you about the embracing or maybe paying for news, and it looks like you've struck some deals with some publishers. Can you talk a bit about that pivot and what the rationale is and maybe how big is that vision for any news. And then for Dave, there's reports tonight about Cognizant who I guess [indiscernible] been the Facebook screeners, Head of AI is dropping a contract. Do you expect to bring that job in-house or is that a third-party outsourcing opportunity?"
},
{
"speaker": "Mark Zuckerberg",
"text": "Dave, do that and then I'll wrap on,"
},
{
"speaker": "Dave Wehner",
"text": "Yes. Thanks, Michael. No plans to bring that in-house. We obviously have a lot of people in-house who work with the third-parties on that front. But we have a wide variety of different partners beyond Cognizant who work with us. So there is no change in model planned on that front. But we continue to obviously invest heavily in that work and we'll continue to work with other partners in that space."
},
{
"speaker": "Mark Zuckerberg",
"text": "All right, so on news, there are two things that I'm quite excited about here. One is just building a dedicated product space for high quality news. And the second is having a business partnership with news publishers that I think can be sustainable over the long term. So I'll talk a bit about both of them and why I think they are important. We'll start with the product, which is if you look at the Facebook app overall, for a lot of years the app was synonymous with News Feed, right, the main tab in the app and of course everyone who uses Facebook pretty much uses News Feed. And one of the questions that we had was, there are of course a lot of things that some people want to do, but not everyone and we weren't sure if we were going to be able to build a secondary tab in the app that could be meaningful even if most people didn't use them. But we started building things like Marketplace, that is a tab that and even if the majority of people on Facebook don't use it, it's still hundreds of millions of people are using it. So that's really, that's really valuable. And we built Watch. We're seeing a similar trend there. It took us a little while to really get it to work the way that we wanted, but now it's growing quickly, that's going to be hundreds of millions of people who are using it. We rolled out Facebook Dating. I don't know if that will be many hundreds of millions of people just because of the size of that market, but it's going be very useful for tens of millions of people around the world, maybe a hundred million or more. And we are of course doing this with groups and there will be opportunities to do this in other places, including with news. So I think in the future if this works out, what we're going to see is that how people use the Facebook app is going to be, they're going to keep on using News Feed, they are going to keep on sharing with friends and family, but the average person will also probably have one, two or three other apps or kind of secondary tabs that they use that are quite useful for them in connecting with their broader community on Facebook. But those things that each individual use, they're going to vary from person to person. So it's not going to be that everyone is using News Feed, they're going to have -- different people are going to care about different things, whether it's community, or marketplace marketplace for some or dating or news for others. And surely even though not everyone comes to Facebook, because they want high quality news , I believe that there are going to be, whether it's 10% or 20% at a floor who I think would really want something like this. And, we're going to work with the news publishers to make this very valuable and I'm optimistic that we can get there. So that's the kind of the product strategy on the Facebook side. Produce publishers, the thing that I'm excited about is, look, I do think that we have a responsibility to help work with newest publishers to fund high quality journalism. It's no secret that the Internet has disrupted the business model for journalism. And I think that that means that the major Internet platforms have a responsibility to form partnerships and help to fund this work. And the challenge that we've had historically. Is that when most of the usage of the Act was a News Feed. What our community told us is that they really wanted more content from friends and family and less other stuff, right. So less public video is less of other content besides friends and family. So even though we were talking to a lot of news publishers and we wanted to find a way to support and they of course wanted more distribution and some kind of financial relationship. It didn't really make a lot of sense in the past to pay for content to that a lot of our community was generally telling us that they want to see other stuff instead of that. But now with the dedicated news tab. We finally have a space where the business model forward really works for us to be in a long-term sustainable financial relationship with news publishers, where we can pay them for high quality content that can go in there that will be what would fuels the tab. It makes it a great product. And I think in doing so. This can be a long-term virtuous cycle and sustainable business model in way that we can help support journalism. And I'm really happy to do this."
},
{
"speaker": "Sheryl Sandberg",
"text": "Great, thank you. Thank you all for joining us today. We appreciate your time and we look forward to speaking with you again."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines."
}
] | null | null |
META | 2 | 2,019 | 2019-07-24 17:00:00 | Operator: Good afternoon. My name is Mike and I will be your conference operator today. At this time I would like to welcome everyone to the Facebook Second Quarter 2019 Earnings Call. All lines have been placed on mute to prevent any background noise. [Operator Instructions] This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook’s Vice President of Investor Relations, you may begin.
Deborah Crawford: Thank you. Good afternoon and welcome to Facebook’s second quarter 2019 earnings conference call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward‐looking statements. Actual results may differ materially from those contemplated by these forward‐looking statements. Factors that could cause these results to differ materially are set forth in today’s press release, and in our quarterly report on form 10‐Q filed with the SEC. Any forward‐looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these statements as a result of new information or future events. During this call we may present both GAAP and non‐GAAP financial measures. A reconciliation of GAAP to non‐GAAP measures is included in today’s earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I’d like to turn the call over to Mark.
Mark Zuckerberg: Thanks Deborah, and thank you all for joining today. This was an important quarter for us. Our community and business continue to grow, and there are now more than 2.7 billion people using Facebook, Instagram, WhatsApp, or Messenger each month, and more than 2.1 billion people who use at least one of our services each day. We continue to focus on our four priorities for the year, making progress on the major social issues, building qualitatively new experiences, building our business, and communicating what we stand for more transparently. I’m going to focus on the first two priorities today, but first I want to talk about the recent news that we reached a settlement with the FTC over our privacy concerns. As part of this, we’ve agreed to pay a $5 billion fine, but even more importantly, we’re making some major changes to how we build our services and run this company. This will require investing a significant amount of our engineering resources in building tools to review our products in the ways we use data. It will also significantly increase our accountability by bringing the process for auditing our privacy controls more in line with how financial controls work at public companies with Sarbanes Oxley. We’ll have to certify quarterly that we’re meeting all our privacy commitments. And just as we have an audit committee of our Board overseeing our financial controls, we will now also have a new privacy committee of our board that will oversee our privacy program and work with an independent privacy auditor that will report to this new committee and to the FTC. We’re asking one of our most experienced leaders in product to take on the role of Chief Privacy Officer for Product, reporting to me and managing our privacy program. We’ll also be more rigorous in monitoring developers who access data through our platform. Together, we expect these changes will set a new standard for our industry. This is a major shift for us. We build services that billions of people trust every day to communicate with the people they care about. Privacy has always been important to the services we provide, and now it’s even more central to our future vision for social networking. It’s critical that we get this right, and we’re going to build it into all of our systems. It’s going to take time to do this properly, and I expect it will take us longer to ship new products, especially while we’re getting this up and running. I also expect that just as with the work we have been doing on safety and integrity, we’re going to continue to identify and fix issues as we develop our systems. But our goal is to build privacy protections that are as strong as the best services we provide, and this settlement gives us clear requirements moving forward. Now, turning to our company priorities, our top priority is making progress on the major social issues facing the internet, including privacy, and also elections, harmful content, data portability, and more. In all these areas, I’ve advocated that I believe the internet would benefit from governments setting clear rules. I don’t believe it’s sustainable for private companies to be making so many decisions on social issues without a robust democratic process. Either the right regulations will get put into place, or we expect frustration with our industry will continue to grow. This quarter I spent time in Europe talking with policymakers about how this could work. I met with President Macron to discuss a framework for harmful content. This is an area where I believe there could be an effective public process led by democratically elected governments in Europe, and perhaps in the U.S., a process for industry standards and self-regulation. But we’re not waiting for regulation to increase independent oversight. We just released our third transparency report, which shows the progress we’re making on many categories of harmful content, including hate speech and graphic violence. Those are the areas where we still need to do better, like bullying and harassment. I believe more companies should release transparency reports that enumerate the prevalence of harmful content on their services. This would help companies and governments design better systems for dealing with it. After next year, we’re going to publish these reports quarterly, so people can hold us accountable at the same cadence as these earnings calls. We’re also moving forward with our plans for an independent oversight board for decisions on content. I believe it’s important that people can appeal the decisions, and that we’re creating systems that are transparent and that people can trust. We’ve been working with experts on freedom of expression around the world, and we’ve gotten a lot of public input on how this could work, which we published in a report last month. We expect to form this oversight board by the end of this year. We also continue to invest heavily in protecting elections – including more advanced efforts to stop coordinated inauthentic behavior, new ads transparency tools, and more fact-checking partnerships. Our adversaries are continually getting more sophisticated, but recent elections in the EU and India show that our efforts are working. After the recent EU elections, the former President of the EU Parliament said that we met the commitments to fight election interference that I made in my testimony to the EU Parliament, and that’s thanks to our efforts the elections were much cleaner online. We’ll continue building on these efforts as we approach the 2020 U.S. elections to make sure that we stay ahead. Next, I know there’s a lot to discuss in terms of policy, but I also want to discuss our second priority – delivering qualitatively new experiences for our community. There are a few efforts here that I’m particularly excited about. The first is our privacy-focused vision for the future of social networking – starting with secure, private, and interoperable messaging. We’re very focused on delivering this over the next five years, building on the foundation we have with Messenger and WhatsApp. With Messenger, we’re rewriting the app from scratch to make it the fastest and most secure major messaging platform in the world, and we’re working towards making end-to-end encryption and reduced permanence, the default for all conversations. With that foundation, we’re starting to explore how a private social platform could become the center of your social experience, for example, by bringing together all of your ephemeral stories from your different apps into one place. We’re also building things like the ability to co-watch videos together. This shows how something like video chat, which is growing quickly as a basic way that we all communicate can become more of a platform for more ways we want to interact privately in the future. With WhatsApp, which already has incredibly strong privacy and performance, we’re more focused on building out all the ways you’d want to interact in this digital living room. WhatsApp Status is already the most popular ephemeral stories product in the world, and we continue to see good momentum there. With millions of small businesses using WhatsApp Business, we’re also building new tools like product catalogs that entrepreneurs around the world can use for free. This matters especially for the growing number of small businesses that don’t have a web presence or that use private messaging platforms like WhatsApp as their main way of interacting with customers. This connects to the next product area I’m very excited about, which is commerce and payments. These are huge and important spaces, and we have efforts in several major areas to deliver qualitatively better experiences than what exists today from Instagram Shopping to Facebook Marketplace to payments across our apps to the new Libra project that we announced with 27 other companies recently. These efforts are important both for our product experience and for our business. Once people have connected to their networks on social platforms, one of the biggest questions is how can we help them use those networks that they have created to create opportunity, and one of the best ways that we can do that is through commerce. Instagram Shopping will improve the experience of browsing and shopping from your favorite brands and creators, while also giving emerging creators a powerful new way to build a business and sustain their community. Facebook Marketplace gives people a way to buy and sell goods in a trusted network with real identities. Hundreds of millions of people are already using Marketplace monthly. We’re also building ways for people to interact with businesses through messaging like WhatsApp Business, because people don’t like having to call businesses and would rather engage asynchronously over messaging if possible. Payments is part of this that I’m particularly excited about. When I look at the kinds of private interactions we can make easier, payments may be the most important for the long term. We’re continuing to test payments on WhatsApp in India, and are close to launching in other countries as well. In the future, we’ll enable people to use the same payments account to send money to friends and businesses on WhatsApp, shop on Instagram, or make transactions on Facebook. Being able to send money as easily as you can send a photo will open up new opportunities for businesses. More broadly, I believe there’s an opportunity to help a lot more businesses access financial tools. Last month we announced that we were working with 27 other organizations to form the Libra Association. The association will create a new currency called Libra, which will be powered by blockchain technology. The Libra Association will be independent of Facebook or any other member, but we plan to support this currency across our services. The goal is to empower billions of people around the world, who use services like WhatsApp but might be excluded from banking services, with access to a safe, stable, and well-regulated cryptocurrency. There are a lot of possibilities here, and both Facebook and the association plan to work with regulators to help address their all of their concerns before Libra will be ready to launch. We worked with other prospective members of the association to release a white paper outlining the Libra concept in advance specifically so that we could address these important questions out in the open, and we’re committed to working with policymakers to get this right. The third product area I want to highlight where we’re focused on delivering a qualitatively better experience than what exists today is in the future computing platforms of augmented and virtual reality. This quarter, we shipped Oculus Quest, our first all-in-one headset with no wires and full freedom of movement. It has gotten great reviews and we’re selling them as fast as we can make them. More importantly, we’ve delivered an experience that people keep using week after week, and buying more content. There’s still a lot of work ahead to develop this ecosystem and deliver the future of VR and AR products that we dream of, but this is an important milestone. In a few years, we’ve improved the state of the art from the original Rift, which cost $600 and required to be tethered to a $1000 PC, to now Quest, which costs $400 all in, and is a superior experience in many ways. There’s going to be even more innovation over the next few years, and we now have the platform we’re going to build on going forward. The reason augmented and virtual reality will deliver a qualitatively better experience than traditional computing platforms is that they deliver the feeling of presence – that you’re actually there with another person or in another place. The feeling of presence is so important to social interactions and how we’re wired to interact as people. So even if it has taken longer than we expected to deliver this at scale, I continue to believe that this will be one of the most important contributions we make to the way we all use technology over the long term. That’s my update on our work on the major social issues we face and building new product experiences. We’ve made a lot of progress this quarter and a have a lot more ahead. Our business continues to perform well, and Sheryl is going to talk more about that in a minute. But this was also an important quarter because now we have a clearer path forward – not just in terms of product and business, but in terms of guidance from regulators, which sets clear expectations and gives us a foundation to build on. As always, thanks for being on this journey with us, and now here’s Sheryl.
Sheryl Sandberg: Thanks Mark, and hi everyone. It was a strong quarter for our business. Ad revenue grew 28% year-over-year and we saw strong growth across all regions and on both Facebook and Instagram. Mobile ad revenue was $15.6 billion, contributing approximately 94% of total ad revenue. As we’ve been discussing, we’re making significant investments in safety, security and privacy while continuing to grow our community and our business. We know we still have a lot of hard work ahead of us, but this quarter once again shows that we can do both. We are committed to earning back trust through the actions we take. In the lead up to elections around the world, we’re doing all we can to get ahead of threats and develop smarter technology. The European Parliament elections in May were an important test for us. We created an operation center in Dublin to bring our experts together and make decisions quickly. We also worked closely with third parties across the EU, including 21 fact-checking organizations. As Mark shared, these investments are starting to pay off and we remain committed to doing everything we can to stop bad actors. We are also focused on increasing transparency. At the end of June, we made our transparency tools available globally for ads about social issues, elections or politics. These tools show who paid for an ad, how much they spent, and who saw the ad. Helping people understand who’s trying to influence their vote will help us better defend against foreign interference and other abuse. We’re going to continue to make investments to protect our platform, because it’s the right thing to do and it’s good for our business over the long-term. At the same time, we are focused on growing our business by helping advertisers grow theirs. Consumers often adopt new technologies first and our competitive advantage is helping advertisers reach people, where they are. We helped businesses make the shift to mobile and now we are helping them shift to Stories, video and eventually messaging. We know that it’s not enough to make these new formats available. We also need to make it easy for advertisers to create effective ads. We do this by launching new ad products and by improving our existing ones to deliver more value for people and advertisers. One of our goals is to level the playing field for businesses of all sizes. We give small businesses free tools that previously only the largest companies could access. During National Small Business Week in May, we introduced Automated Ads to take the guesswork out of creating effective ads. Advertisers answer a few questions and get a customized marketing plan with up to six creative options, targeting suggestions and a recommended budget. We also launched new video editing tools to help SMBs quickly create eye-catching video with images they already have. Fernwood Fitness, a chain of women’s health clubs in Australia, used these tools to build a mobile-first campaign. They targeted women interested in fitness and as a result, nearly doubled their conversions to new memberships. We’re also focused on improving our existing ad products. We often get feedback from advertisers about how we can make small adjustments to our tools to better serve them. These basis point improvements allow us to create more value for businesses over time. For example, we first rolled out our Dynamic Ads format four years ago and since then, we have adapted the format to the needs of different verticals and surfaces. Frontier Airlines used Dynamic Ads to connect with travelers, who recently looked at flights online, but didn’t book. This contributed to a nearly 3.5% increase in ad-related bookings and a 2.5 times increase in ad-related revenue. This quarter, we launched our latest variation – Dynamic Ads in Instagram Stories – which show people ads for products they’ve already browsed on a retailer’s website or app. We’re constantly making incremental improvements to Facebook feed ads. This quarter, we improved how quickly we refresh the ads people see. In the past, these ads were pre-selected at the beginning of a feed session. Now, the ads are refreshed while people are scrolling through their feed. This means people get more relevant ads, which improves engagement and delivers a better return on investment for advertisers. In addition to improving our ad tools, we’re investing in new ways for people to discover products, engage with brands and shop on our platforms. On discovery – more than 50% of accounts on Instagram use Explore every month to discover photos and videos related to their interests. This quarter we started rolling out Ads in Explore on Instagram. This will give businesses a chance to reach new audiences in a place where they are already spending their time and learning about new products. On engagement, we’re making it easier for people to connect with the brands and influencers they love. Last month, we launched Branded Content Ads in Instagram, which allow businesses to promote Creators’ posts as feed ads. Brands like Old Navy, Sephora and Jack in the Box are reaching new audiences with these ads. Soon we’ll expand this option so that advertisers can do the same in Stories. On shopping, we’re building new ways for people to shop directly on our apps. We’re continuing our closed beta of Checkout on Instagram and we launched a new feature this quarter that enables Creators to tag products in their posts. This gives people an easy way to shop from their favorite Creators without leaving the app. It’s early days for shopping on Instagram, but we’re excited about this over the long run. I want to close by saying how grateful I am to our partners around the world. Every day, they give us valuable feedback on how to improve our products, so that we can help them grow their businesses. I also want to thank the Facebook teams, who drive that growth and are making progress on the major social issues facing the internet and our company. I am grateful for our teams’ tireless work and the commitment. Thanks everyone, and here’s Dave.
Dave Wehner: Thanks, Sheryl and good afternoon, everyone. Let’s begin with our community metrics. Facebook daily active users reached 1.59 billion, that’s up 8% compared to last year, led by growth in India, Indonesia and the Philippines. This represents approximately 66% of the 2.41 billion monthly active users in June. MAUs grew 180 million or 8% compared to last year. In terms of our Family metrics, we continue to grow and estimate that on average, more than 2.1 billion people used at least one of our apps on a daily basis in June and more than 2.7 billion people were active on a monthly basis. Turning now to the financials. All comparisons are on a year-over-year basis unless otherwise noted. Q2 total revenue was $16.9 billion, up 28% or 32% on a constant currency basis. Had foreign exchange rates remained constant with the second quarter of 2018, total revenue would have been approximately $574 million higher. Q2 total ad revenue was $16.6 billion, up 28% or 32% on a constant currency basis. In terms of regional ad revenue growth, North America and Asia-Pacific were strongest and both grew 30%, followed by Europe at 25%. Rest of World grew more slowly at 21% and was impacted by currency headwinds. In Q2, the average price per ad decreased 4% and the number of ad impressions served across our services increased 33%. Similar to last quarter, impression growth was primarily driven by ads on Instagram Stories, Instagram Feed, and Facebook News Feed. The year-over-year decline in average price per ad reflects an ongoing mix shift towards Stories ads and geographies that monetize at lower rates. Payments & Other Fees revenue was $262 million, up 36%. This year-over-year growth was primarily driven by sales of new products, notably Oculus Quest and Rift S. Turning now to expenses. Total expenses were $12.3 billion, up 66%. This includes an additional $2 billion expense accrued in connection with our $5 billion settlement with the Federal Trade Commission. Absent this charge, our total expense growth rate would have been 27 percentage points lower. We ended Q2 with approximately 39,700 full-time employees, up 31%. Operating income was $4.6 billion representing a 27% operating margin. Absent the FTC accrual, operating margin would have been approximately 12 percentage points higher. Our Q2 tax rate was 46% and was higher than expected due to the tax treatment of the FTC accrual and a court ruling in the IRS versus Altera case. In that case, the Ninth Circuit reversed a prior Tax Court decision addressing the tax treatment of certain share-based compensation expenses. We changed our treatment this quarter to reflect the Ninth Circuit opinion which resulted in a one-time income tax charge of $1.1 billion. Net income was $2.6 billion or $0.91 per share. Absent the impact of the FTC accrual and the Altera ruling, our EPS would have been approximately $1.08 higher. Capital expenditures were $3.8 billion, driven by investments in data centers, servers, office facilities, and network infrastructure. We generated $4.8 billion in free cash flow and ended the quarter with approximately $48.6 billion in cash and investments. In Q2, we bought back approximately $1.1 billion of our Class A common stock. Turning now to the revenue outlook. We executed well in Q2 with a number of optimizations and product wins, particularly with the Facebook app that fell in our favor and helped combat the overall trend of deceleration. However, we continue to expect that our constant currency revenue growth rates will decelerate sequentially going forward. We also expect more pronounced deceleration in the fourth quarter and into 2020, partially driven by ad targeting related headwinds and uncertainties. Turning now to the expense outlook. We anticipate full-year 2019 expenses to grow 53% to 61% compared to 2018. The $5 billion in accruals we recorded in the first half of 2019 related to the FTC settlement represents approximately 16 percentage points of this anticipated expense growth. Absent the $2B accrual, we recorded in Q2; our 2019 expense outlook is essentially unchanged from last quarter. I want to reiterate that our agreement with the FTC involves implementing a comprehensive expansion of our privacy program, including substantial management and board of directors’ oversight, stringent operational requirements and reporting obligations, and a process to regularly certify our compliance with the privacy program. These efforts will require significant investments in compliance processes, personnel, and technical infrastructure. In addition, these efforts will make some of our existing product development processes more difficult, time-consuming, and costly. We are lowering our 2019 capital expenditures outlook to $16 billion to $18 billion, down from our prior estimate of $17 billion to $19 billion. Our capital expenditures are driven primarily by our continued investment in data centers and servers. We expect our tax rate for the remaining quarters of 2019 to be approximately 16%. In summary, Q2 was another good quarter for Facebook. We’re pleased with the further growth of our community and business while we continue to make significant investments in privacy, safety and security. With that, operator, let’s open up the call for questions.
Operator: [Operator Instructions] Your first question comes from the line of Brian Nowak from Morgan Stanley.
Brian Nowak: Thanks for taking my question. I have two, the first one on the core Facebook app. I was wondering if you could tell us a little bit more about the impact on engagement as well as monetization from the redesign. Dave, I think you mentioned some optimization and product win. So, what are you seeing on the core app, I guess, now a big weight on engagement and monetization. And then can you talk to us a little bit more about some of the ad targeting headwinds that you foresee in 4Q and in 2020? Thanks.
Dave Wehner: Sure, Brian, it’s Dave. I think on the Facebook app, I just say the DAU trend paints the picture broadly for Facebook. We’re seeing stability in the developed markets and growth in the developing markets. And so, we’re continuing to see solid performance on Facebook, and we’re pleased with the engagement levels that we’re seeing overall on the Facebook app. So, I think the first half has been solid from that perspective. And then the second question was on the ad targeting related headwinds. So, we think of those in really three components. The first is regulatory as you think about things like GDPR and other impacts and how those will be rolling out globally. The second is platform changes as it relates to operating systems and a more of a focus on privacy from the operating systems and the impact that that can have on measurements and also on targeting. And then the third is our own product changes as we put privacy more front and center. So really, it’s the compounding of those three issues that are creating headwinds that we think are going to impact us, as we get later in the year and into 2020.
Operator: Your next question comes from Eric Sheridan from UBS.
Eric Sheridan: Thanks so much for taking the question. Maybe on a bigger, broader topic for everyone on video, how do you see video evolving as a consumption mechanism on all of your platforms and in terms of how users consume video what they’re attracted by? Second would be how that’s informing you investing in video content. How should we think about the investments going forward and how that might impact growth versus margins? And then third, the opportunities on the advertising side that video might present over the next three to five years? Thanks guys.
Sheryl Sandberg: So, I think video has been pretty important. It’s really followed technological change, if you think back even four years, you can’t really take a video, a lot of videos buffered on your phone. And now, you think about what people can do. They can consume video very easily on a phone. They can share video, they can take video. And so we’re seeing very – we’re seeing a lot of interest along a lot of consumer products. It’s also probably worth mentioning that video is within a bunch of our products. So, we certainly have video in feed and people can put video into stories and different places. And we also have the specific Watch place, where we’re looking at original content. I think to the second part of your question, which is how do we think about video content. Most of the content, people put up on Facebook video or other is user-generated, that’s also true of the watch content itself. We have made some investments there in creating a more dedicated place to watch video. So, while a lot of the content is still provided by people in a way that we’re not covering costs, we do have a strategy of investing in great content that really starts the flywheel growing – going and we’ve been pretty pleased, I mean it’s not the biggest effort anyone has, but we’ve had some hits from Tom and Time to Tom and Time to Red Table Talk ,sorry for your loss, and we’re seeing some really nice engagement numbers on these shows. And the best of them actually carry over into the Facebook community, because the best of the people creating those shows and starring in those shows are also engaging with Facebook, and I think the vision Mark laid out for this all along is that, we should do video in a pretty social way. When you think about video ads, video ads are pretty exciting, because it’s obviously a firm asset marketers have long loved. I think one of the challenges we’ve had is training the market that you can’t just take your TV ads and put them on video – I’m sorry, put them on mobile or put them into Facebook, because they don’t perform the same way. The best TV ad is 30 seconds, it builds slowly to a story, the product reveal is usually at the very end, the best mobile first ad or ad-on Facebook kind of gets to the main point or gets to the product in the first three seconds, captures your attention much more quickly. We sometimes talk about it as some stopping creative, where you actually want to stop and watch. I think the good news we have here is that mobile first video on Facebook right now is now over 50% of video revenue. So that shows real growth people understanding they need to do it differently, but we’ve still got a pretty long way to go, and we are seeing good results. I’ll share an example, McDonalds. McDonalds used mobile app video ads in Facebook and Instagram News Feed and Stories to launch a limited edition called the Big Mac range in the UK. They had a 16.5% lift in ad recall and then Nielsen’s study showed a nearly 20% incremental reach on Facebook versus TV. So, I think that shows that when video is done well, it can have a really big impact on companies large and small on our platform.
Dave Wehner: And then Eric, I think you asked about margin impact. I’d just say that the video content budget is already factored into the guidance that we’re providing on expenses.
Operator: Your next question comes from Ross Sandler from Barclays.
Ross Sandler: Hey, guys, can we just go back to the deceleration comment. So, we appreciate the color you just gave, Dave. But at the same time, you said that the impression growth in 2Q was driven by Instagram Stories, Instagram Feed and then Facebook Feed. And so if those are kind of the current drivers and we’re likely to continue to see those send in the future, what specifically do you see is slowing down in 4Q in 2020? Is that core Facebook, any additional color on like the surface that might slow down from some of these changes? Thanks a lot.
Dave Wehner: Sure. Ross, I mean if you remember we’re seeing good impression growth across Instagram Stories, Instagram Feed and Facebook Feed. So, we’re seeing good impression growth across all of those. We are seeing faster growth in impressions coming from Stories and then also coming from geographies that monetize at lower rates on things like Facebook News Feed. So even though we’re seeing good impression growth that’s impression growth it’s flowing through at a lower price point. Then, the way that growth was driven in the prior year. So that’s contributing to some of the deceleration, specifically as we look out into the remainder of 2019. When we get into Q4, we’re going to be similar to how we had good product wins in Q2. We also had several product optimizations in Q4 that contributed a strong performance that quarter. So, we’re going to have a tougher compare on that basis. So, just broadly, I think we expect the revenue deceleration trend that Q2 is not mark a reversal of that, but we expect to kind of return to constant currency revenue growth deceleration as you get into the remainder of 2019.
Operator: Your next question comes from Doug Anmuth from JPMorgan.
Doug Anmuth: Thanks for taking the question. One for Mark and one for Dave. First Mark, how are you thinking about the opposition that you’ve received so far around Libra? Because it changed your view of the timeframe at all in terms of rolling out the currency. And then second, Dave just, you talked about the higher demands of privacy. Can you just talk about how that could impact expense growth as you think about 2020, where in the past, you’ve talked about more moderate expense growth for next year? Thanks.
Mark Zuckerberg: Sure. So, on Libra and similar to our approach on some of the important social issues that we face around encryption and content regulation and things like that. We get that these are really important and sensitive spaces. So, our approach has been to try to have a very open dialog about this, right. If Facebook from a few years ago would have probably just showed up and tried to release a product on our own. And now, the approach on all of these fronts is to outline the ideas in the values that we think an eventual service should have. We’ve opened a period of, however, long it takes to address regulators and different experts and constituents questions about this and then figure out what the best way to move forward is and that’s certainly what we’re planning to do with Libra. So, we worked with the 27 other members of the association to publish the white paper to put the idea out there expecting that this is a very important and heavily regulated area and there were going to be a lot of questions. We’re going to have to work through that. So, I think we’re currently in the process of doing that. We are trying to provide a safe and stable and well-regulated product. So that’s always been the strategy and we’ll continue to engage it here.
Dave Wehner: And then Doug, you were asking about the impacts on expense growth. We’re not giving guidance, specifically on the 2020 expense outlook. But the privacy efforts do require significant investments obviously and compliance processes, people and then technical infrastructure and those are factored into the 2019 operating expense outlook. One of the impacts that I’d point to you is it’s also a reallocation of resources around privacy. So that will have an impact on our overall product development as well. So that’s something that I’d factor in both in terms of just the overall impact to the business, not purely just the expense side.
Operator: Your next question comes from Lloyd Walmsley from Deutsche Bank.
Lloyd Walmsley: Thanks. Two if I can. First, can you just talk to us about early learnings from the test of Instagram checkout and what some of the key hurdles are to kind of scaling that more broadly? And then secondly, on OpEx, it looked like you saw a fairly meaningful step up from Q1 to Q2 despite fairly limited head count growth. So, just wondering if there’s anything you would point to there that might explain why those are diverging a little bit in that quarter?
Sheryl Sandberg: I’ll talk about checkouts. So checkout is in, we talk a lot on this call about early stage things, this is earlier than that. We are in a very small closed beta with 23 brands, which for Facebook is about small as something could be. On – obviously, as I said, small, but there is working with the brands, we’re pretty excited by their feedback. We’re not in a rush to scale this quickly. We’re always focused on the consumer experience and we want to make sure we really get this right. I think the way to think about checkout is kind of in a larger picture of what we’re trying to do in terms of commerce and shopping on our services and apps across the board, which is, we obviously have a lot of consumer engagement in our products and that’s great. We obviously have felt some good and robust ad tools that are helping us grow our business quarter-after-quarter. If we can help people close the loop a little more, so they are looking more directly products, that makes our ads more valuable. If we can help people check out and pay for the products and even buy the products, it makes the consumer experience better. It also closes the loop on the data and measurement, we’re going to need going forward. So, we’re excited about these efforts for doing a lot across the board. All of them are in their early stages and we think about this primarily from a consumer and closing the loop point of view more than a monetization in and of itself point of view.
Dave Wehner: And then Lloyd, you were asking about the step-up on the cost side in Q2 versus Q1. A couple of things that I’d point to the cost of revenue was up 49% in Q2, and that’s really the flow-through of depreciation that you’re seeing from the big CapEx build cycle that we’ve been in and that’s starting to flow through in the cost profile of the business. And then if you look at the G&A line, obviously that was impacted by the accrual for the FTC settlement as well as some other legal expenses including the SEC settlement. So, you had some G&A expenses that were higher in the quarter as a result of that.
Operator: Your next question comes from Heather Bellini from Goldman Sachs.
Heather Bellini: Great, thank you so much. I wanted to follow up on two comments, one watch that Sherlyn was just talking about related to checkout. I’m just wondering if you could share what the feedback has been so far from the brands that are in the closed beta and how this has helped maybe some stats if they have them like how it helped maybe conversion for the brands that are doing it versus maybe the traditional way they were selling on Instagram. So, if you have anything you could share there and then Dave, just back to Ross’ comment related to the deceleration that you’re referencing. I mean in the past, you’ve given us a little bit more specificity, not too much, but you’ve said kind of mid-single digit or low-single digit decel. Just wondering if there is any other color you could provide us here for the back half in 2020 when you’re painting this at a high level? Thank you.
Sheryl Sandberg: Yes. on the check outs beta, it’s just really small and really early. We definitely hear that it decreases at friction in the shopping experience, but with 23 brands in a product, that’s just too small for us to take any real learnings. We are working with them on iterating the product experience for now.
Dave Wehner: And Heather on the deceleration, we’re simply guiding that we would expect that we would see constant currency revenue deceleration sequentially with that being more pronounced on a constant currency basis in Q4, again, due to the tougher comp for us in Q4 not giving specific quantitative guidance on that at this point.
Operator: Your next question comes from Justin Post from Bank of America Merrill Lynch.
Justin Post: Great, thank you. So Mark, from the outside, it’s really hard to tell what’s going on in the regulatory environment and status with regulators. I guess good news on the FTC settlement, but the new investigation has been started. I guess wonder if you could just give us high level to the extent you can. Is the company making progress with regulators both here and in Europe, and how you feel about that? And then, Dave, if you could talk about Europe since GDPR implementation. Has it really been a meaningful difference in your ad revenue growth rates there versus other regions? Thank you.
Mark Zuckerberg: Sure. So, I can talk about the regulatory picture overall. Over the last few years, we focused a lot on a number of major social issues everything from preventing election interference to reducing harmful content to protecting privacy. Now, I’m talking a lot about data portability. And on each of these, I think that there is work that we can do and that we certainly have a responsibility to really make sure that we perform well on them. But at the end of the day, when our systems are mature, there are still going to be trade-offs between important values that we all have something, I mean, on content between free expression and civil discourse and we’re moving hate and things like that. Those are hard questions that at some level, we’re always going to do the best that we can, but we think that having a more democratic process for setting with some of those norms are would be helpful. On privacy, there are really important questions about how you define what you want the system to be in terms of how much you’re locking down data versus are you making it portable for to enable competition and innovation and academic research and things like that. So, we believe that there needs to be a regulatory framework in place for each of the major issues that I just talked about. And my broader concern is that if that doesn’t get put in place, then frustration with the industry, I think, will continue to grow. And so we’re trying to do our part to help advocate for a good regulatory framework in each area and they will come in different forms. So in some places, we’ll – there will be laws passed and others might be working with regulators and having some structural rules imposed on us like with the FTC settlement; in other areas, it might be self-regulation like around, content and speech in the United States. That’s what I’d expect because of the, first amendment here is a strong protections on speech. So this is important overall, we’re very focused on it. I do think we are making progress on working through the issues and addressing them. We’re, I think, in a much stronger place in elections now. Our content systems are getting more mature, there’s a lot of more work to do in each of those. But I think we are making progress. And as said this is a global problem, not just these are global problem, not just American one. So working with folks across Europe and the other continents as well is important too.
Dave Wehner: Hey Justin, it’s Dave. As I noted in my comments. Europe is growing more slowly than North America and APAC. That said, we had a strong quarter and we’re pleased with results in currencies of factor in that delta as well. Overall, we did see Europe had a reacceleration of growth in Q2 versus Q1. And part of that is lapping the GDPR implementation. So, I think overall we’re kind of pleased with what we’re seeing around Europe, but it’s still growing more a little more slowly than North America and APAC.
Operator: Your next question comes from Mark May from Citi.
Mark May: Thanks for taking my questions. First, we’ve seen nice improvement in the rate of expense growth lately. And on the Q4 call, you said you expected in 2020 the expense growth will be more in line with revenue growth. Just curious if that is something that you still feel comfortable with? And then secondly in terms of WhatsApp and WhatsApp status specifically, what are your plans as it relates to ads on WhatsApp status? Have you tested here or have any plans to test? Thank you.
Dave Wehner: Yes. Thanks, Mark. So in terms of, in terms of our overall expense outlook. Our current outlook for 2019 does suggests that we’ll see margins come down this year versus 2018. Even if you were to set aside the $5 billion FTC accrual. We’re not providing specific guidance for 2020 or beyond. The investment priorities remain the same. In addition to the privacy investment priorities that we outlined today will continue to invest in key areas like core product infrastructure, innovation, video and content and safety and security over the long run. So we’re not at this point providing any more specific guidance on 2020.
Sheryl Sandberg: On WhatsApp Status ads are not available. We’re very focused for WhatsApp on the consumer experience. But I will take a minute to talk about Stories ads in general, because I think eventually depending on our ability to use data across platform that applies to WhatsApp it’s probably pretty important part of the story that’s going on with Facebook right now. So we do have Stories ads available across Facebook, Instagram and Messenger, and I think one of the most important things we learned as we were doing it transition to mobile is if we made it easy for our advertisers to place the ads, make sure they understood the measurement they were having and also make sure the ad format worked, businesses would move more quickly. Usually people move before businesses people move to mobile before businesses and we certainly saw the same with Stories. But I think one of the successes you are seeing we’re having right now is that we are helping people move to Stories more quickly because of the lessons we learned. So for example, automatic placements, what automatic placements do is they convert Feed ads into a Stories format and deliver the ads wherever they get their best results. And I think it’s product innovations like that that have gotten us to three million advertisers. So rather than across the three properties we have available Facebook, Instagram and Messenger. So rather than go to every advertiser both through our sales force and through our online tools where we sell and say we have a new format, you need to create the new format, you need to figure out the placement being able to just take what they are already doing like Feed ads, converted into Stories and place at anywhere helps us move people into these formats. It’s also a case of we have a lot of inventory on this. And so there is a real benefit right now to being an early adopter, the pricing is very attractive. And so we think the mix shift to Stories is the big opportunity for us and advertisers over time. I’ll say one more thing, which is that Stories don’t monetize right now at the same rate as News Feed. We’re optimistic about the growth over the long run, but we are as always very prudent and careful on the consumer experience.
Operator: Your next question comes from Mark Mahaney from RBC.
Mark Mahaney: Thanks. I just wanted to focus on WhatsApp and I know you’ve had WhatsApp payments in beta in India, you launched that last year. Could you just talk about the – if there are any particular factors that are causing a delay in that and maybe just takes a long time for a product like that to really gain traction, but is it consumer awareness of it is it regulatory push back is their technical hurdles and what does that tell you about the and maybe nothing, but what does that tell you about the ability to take that WhatsApp monetization or payments functionality embedded with WhatsApp and launched it in other markets. I said, I know you said you’re going to launch in other countries, but what are the lessons from India tell you about the pacing of that? Thank you.
Mark Zuckerberg: So it’s a regulatory approval question in India at this point and we had a license to roll it out as part of an initial test, the test went better than we even expected it would. I mean for a product that you would expect to need to be widely available to be useful, right, in order to – for someone to know that they can send money to someone else. Even a limited test the feedback was very positive. So, I’m quite confident that when we can roll this out broadly it’s going to be meaningfully valuable to the user experience. We’re also working beyond India, in a number of other countries and hope to have this rolled out to a large percentage of the people who use WhatsApp within the next year. So that’s the goal, we’re pushing forward on all of these issues and should have more to talk about soon.
Operator: Your next question comes from Michael Nathanson from Moffett Nathanson.
Michael Nathanson: Thanks. I have two, one for Sheryl and Dave and one for Mark. So Sheryl and Dave, you noted the growth I guess in Europe this time in acceleration. And can you talk a bit about maybe the regional development of Stories and either the embracing the advertising community or the user community by region. And then, for Mark on the answer on currency arguably Crypto is going to take a long time to you to get approval or to build a product. Do you see building a fiat currency wallet for Facebook and Instagram. I know it’s about WhatsApp but how does another title wallet non-crypto wallet develop if it takes a while for the other products to rollout meaning Crypto takes a while for approval. So does non-crypto fiat currency become an opportunity for you?
Dave Wehner: Hey, Michael, it’s Dave. I guess we’re not really providing detail on region. I would say Stories is today from an impression growth perspective really about Instagram Stories. So it maps where we’ve got good adoption of Instagram globally. So we’re certainly seeing good growth in places where Instagram is strong, including the U.S., so that’s been good to see. And as we continue to work on Facebook Stories, we’ll have more opportunity as well with Facebook and will map to the reasons where Facebook is stronger. So, I think we’re seeing good growth on Instagram. I think that will continue and continue to drive impression growth and then we hope to continue to make progress on Facebook where we’re seeing growth, but it’s off a smaller base.
Mark Zuckerberg: And on payments, I mean, the short answer is, yes. We’re very focused on payments with fiat currencies as well and making it so that when you pay in one service, whether it’s WhatsApp or in Instagram Shopping or in Marketplace your credentials can be shared and there’s a shared payment system across all those things. So that’s a – certainly a big area for investment. Overall these areas around commerce and payments, I think are one of the most exciting areas of product development for the next several years. I mean the way that we kind of see the products now is we’ve helped people map out and wire up their networks over the last several years, and now in each of these apps we have opportunities to help people get more value from the networks that they’ve created in some of that is going to be on the social side, especially around creating communities and groups and some of it is going to be more on the economic and opportunity side and there we’re doing a whole lot of projects. I know that Libra is the one that has gotten the most attention recently, but it’s really just one of a set of things everything from Instagram, Shopping which is going to help people connect to brands and emerging creators to Facebook marketplace, which is more consumer-to-consumer paying and buying and selling used goods to things like WhatsApp business, which is more about connecting with small businesses and then across the payment landscape, helping people do payments and existing currencies and also trying some newer approaches that can hopefully bring down the cost of doing payments around the world. We’re just very excited about all the – everything in this area and it’s one of the biggest areas that we’re focused on for the next several years.
Operator: Your next question comes from Ben Schachter from Macquarie.
Ben Schachter: Mark in 1Q, you mentioned specifically that GDPR had an impact on the business. I was just wondering if you can give an update on that? And then longer term on Facebook, you focused a few times now on buying and selling goods there. Just wondering if you can comment on how you think of services versus goods for example monetizing recommending a house painter versus selling a widget. And also can you talk about the timing of how marketplace might evolve? Thanks.
Mark Zuckerberg: Yes, I don’t know, Dave if you want to talk about the GDPR impact. And then I can end.
Dave Wehner: Yes, Ben. So, just in terms of GDPR I kind of address that earlier, we do see that having an impact in Europe that we did see a reacceleration in growth in Europe, as we have lapped the initial implementation of GDPR. So that’s promising, but we continue to see Europe growing just a bit slower than the rest of the regions. But overall, not a whole lot of additional color to provide there.
Mark Zuckerberg: Yes. And in Marketplace, we definitely are going to focus on some of the areas that you talked about including jobs is already a pretty meaningful focus where a lot of people do find jobs and business is less jobs through Facebook. I don’t want to, I don’t know what our last public status here. So I’m not going to attempt to site something but it’s meaningful. And the business model around this is probably not going to be charging for listings but advertising. And in order to promote things both in and what we’re doing on Instagram with shopping and in Facebook Marketplace and in the general approach to payments is providing as affordably as possible to improve the user experience and complete transactions which will of course make the tools more valuable for businesses overall and should make the ad prices go up. And that should be the primary thing that we’re focused on. Someone just handed me a piece of paper, which says that we have helped a million people find jobs. So there is the stat.
Operator: Your next question comes from Colin Sebastian from Baird.
Colin Sebastian: Great, thanks. A couple from me. First off, any update on the higher profile for groups in the Facebook app and any perspective on how that’s impacting engagements. And then Mark, the five-year timeline for the privacy focused vision. I guess, I wonder if we get a better sense for what the key milestones are along the way and why that’s a five-year outlook perhaps versus the shorter period? Thank you.
Mark Zuckerberg: Yes, I could take both of those. So in the Facebook app overall after helping people connect with friends and family, helping people connected with communities is the next most important social problem that we believe we can help address and that’s just going to be an area of increasing value in the product. That is going well since we started rolling that out after F8, I think Dave may have mentioned this earlier, but in case you didn’t just to emphasize this point I think part of the – our strong performance over the first half of this year, a meaningful part of our overperformance compared to what we had expected is because of strength and engagement in the Facebook app over that period. So that’s – it’s generally going well overall and we’re very optimistic about communities in particular going forward is one of the drivers of that. What was the second question?
Dave Wehner: The five-year.
Mark Zuckerberg: Right, okay. So on that’s on the privacy vision. So for the next year to two a lot of the work that we need to do is just about getting the architecture right. Right so establishing, we have to rewrite the networks on Messenger and on Instagram to be more client and server oriented to be end-to-end encrypted. We’re working on interoperability, that people will be able to choose to use between the services. These are pretty big technical projects. We want to make it so that the infrastructure that these services are built on is the most secure and most reliable and fastest and most widely available of any of the major messaging platforms out there, we think that that’s the foundation to build a successful private platform on. Then we need to do things like what we’re doing with WhatsApp business, which is building up the business ecosystem and that’s just something that our playbook on this but this is a multiyear journey where first we deliver the consumer product experience, then we create organic business experiences and then only as the last step, are we really able to ramp up having business that pay for things that are meaningful for them within that. So it’s not that you’re not going to see progress on that along the way, you’ll certainly see milestones every six months or 12 months. But before this is really the biggest driver of our business, I do think that that’s going to be a number of years.
Deborah Crawford: Great. Operator, we have time for one last question.
Operator: Your last question comes from Brent Thill from Jefferies.
Brent Thill: Thanks, Dave. I think a lot of us are having a hard time reconcile that the tougher comp in Q4. It was your easiest comp and you just accelerated your constant currency growth in the quarter. So I guess, just, is there any change in terms of the visibility or the contracts that you’re putting together that lead you to that, any other color. I think there is a number of questions, just trying to understand why you have such strong conviction in that decel?
Dave Wehner: Hey, Brent. So in terms of the outlook. Remember, we don’t have contracted revenue. We are constantly working from an auction perspective. So our forecasts are based on supply and demand and how we see the different product launches playing into that different optimizations that we make. So there’s a lot of granularity that goes into thinking about how revenue will progress that ultimately it’s going to depend on the supply and demand characteristics in that given quarter when we do that and we see that we expect constant currency deceleration. And when we get to Q4 we’re going to be lapping some particularly successful optimizations that we had in Q4 and that’s going to contribute to more of a decel in Q4 than we think we’ll see in Q3. So that’s the reason I’m characterizing the guidance the way I am.
Deborah Crawford: Great. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again.
Operator: Ladies and gentlemen, this concludes today’s conference call. Thank you for joining us. You may now disconnect your lines. | [
{
"speaker": "Operator",
"text": "Good afternoon. My name is Mike and I will be your conference operator today. At this time I would like to welcome everyone to the Facebook Second Quarter 2019 Earnings Call. All lines have been placed on mute to prevent any background noise. [Operator Instructions] This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook’s Vice President of Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford",
"text": "Thank you. Good afternoon and welcome to Facebook’s second quarter 2019 earnings conference call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward‐looking statements. Actual results may differ materially from those contemplated by these forward‐looking statements. Factors that could cause these results to differ materially are set forth in today’s press release, and in our quarterly report on form 10‐Q filed with the SEC. Any forward‐looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these statements as a result of new information or future events. During this call we may present both GAAP and non‐GAAP financial measures. A reconciliation of GAAP to non‐GAAP measures is included in today’s earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I’d like to turn the call over to Mark."
},
{
"speaker": "Mark Zuckerberg",
"text": "Thanks Deborah, and thank you all for joining today. This was an important quarter for us. Our community and business continue to grow, and there are now more than 2.7 billion people using Facebook, Instagram, WhatsApp, or Messenger each month, and more than 2.1 billion people who use at least one of our services each day. We continue to focus on our four priorities for the year, making progress on the major social issues, building qualitatively new experiences, building our business, and communicating what we stand for more transparently. I’m going to focus on the first two priorities today, but first I want to talk about the recent news that we reached a settlement with the FTC over our privacy concerns. As part of this, we’ve agreed to pay a $5 billion fine, but even more importantly, we’re making some major changes to how we build our services and run this company. This will require investing a significant amount of our engineering resources in building tools to review our products in the ways we use data. It will also significantly increase our accountability by bringing the process for auditing our privacy controls more in line with how financial controls work at public companies with Sarbanes Oxley. We’ll have to certify quarterly that we’re meeting all our privacy commitments. And just as we have an audit committee of our Board overseeing our financial controls, we will now also have a new privacy committee of our board that will oversee our privacy program and work with an independent privacy auditor that will report to this new committee and to the FTC. We’re asking one of our most experienced leaders in product to take on the role of Chief Privacy Officer for Product, reporting to me and managing our privacy program. We’ll also be more rigorous in monitoring developers who access data through our platform. Together, we expect these changes will set a new standard for our industry. This is a major shift for us. We build services that billions of people trust every day to communicate with the people they care about. Privacy has always been important to the services we provide, and now it’s even more central to our future vision for social networking. It’s critical that we get this right, and we’re going to build it into all of our systems. It’s going to take time to do this properly, and I expect it will take us longer to ship new products, especially while we’re getting this up and running. I also expect that just as with the work we have been doing on safety and integrity, we’re going to continue to identify and fix issues as we develop our systems. But our goal is to build privacy protections that are as strong as the best services we provide, and this settlement gives us clear requirements moving forward. Now, turning to our company priorities, our top priority is making progress on the major social issues facing the internet, including privacy, and also elections, harmful content, data portability, and more. In all these areas, I’ve advocated that I believe the internet would benefit from governments setting clear rules. I don’t believe it’s sustainable for private companies to be making so many decisions on social issues without a robust democratic process. Either the right regulations will get put into place, or we expect frustration with our industry will continue to grow. This quarter I spent time in Europe talking with policymakers about how this could work. I met with President Macron to discuss a framework for harmful content. This is an area where I believe there could be an effective public process led by democratically elected governments in Europe, and perhaps in the U.S., a process for industry standards and self-regulation. But we’re not waiting for regulation to increase independent oversight. We just released our third transparency report, which shows the progress we’re making on many categories of harmful content, including hate speech and graphic violence. Those are the areas where we still need to do better, like bullying and harassment. I believe more companies should release transparency reports that enumerate the prevalence of harmful content on their services. This would help companies and governments design better systems for dealing with it. After next year, we’re going to publish these reports quarterly, so people can hold us accountable at the same cadence as these earnings calls. We’re also moving forward with our plans for an independent oversight board for decisions on content. I believe it’s important that people can appeal the decisions, and that we’re creating systems that are transparent and that people can trust. We’ve been working with experts on freedom of expression around the world, and we’ve gotten a lot of public input on how this could work, which we published in a report last month. We expect to form this oversight board by the end of this year. We also continue to invest heavily in protecting elections – including more advanced efforts to stop coordinated inauthentic behavior, new ads transparency tools, and more fact-checking partnerships. Our adversaries are continually getting more sophisticated, but recent elections in the EU and India show that our efforts are working. After the recent EU elections, the former President of the EU Parliament said that we met the commitments to fight election interference that I made in my testimony to the EU Parliament, and that’s thanks to our efforts the elections were much cleaner online. We’ll continue building on these efforts as we approach the 2020 U.S. elections to make sure that we stay ahead. Next, I know there’s a lot to discuss in terms of policy, but I also want to discuss our second priority – delivering qualitatively new experiences for our community. There are a few efforts here that I’m particularly excited about. The first is our privacy-focused vision for the future of social networking – starting with secure, private, and interoperable messaging. We’re very focused on delivering this over the next five years, building on the foundation we have with Messenger and WhatsApp. With Messenger, we’re rewriting the app from scratch to make it the fastest and most secure major messaging platform in the world, and we’re working towards making end-to-end encryption and reduced permanence, the default for all conversations. With that foundation, we’re starting to explore how a private social platform could become the center of your social experience, for example, by bringing together all of your ephemeral stories from your different apps into one place. We’re also building things like the ability to co-watch videos together. This shows how something like video chat, which is growing quickly as a basic way that we all communicate can become more of a platform for more ways we want to interact privately in the future. With WhatsApp, which already has incredibly strong privacy and performance, we’re more focused on building out all the ways you’d want to interact in this digital living room. WhatsApp Status is already the most popular ephemeral stories product in the world, and we continue to see good momentum there. With millions of small businesses using WhatsApp Business, we’re also building new tools like product catalogs that entrepreneurs around the world can use for free. This matters especially for the growing number of small businesses that don’t have a web presence or that use private messaging platforms like WhatsApp as their main way of interacting with customers. This connects to the next product area I’m very excited about, which is commerce and payments. These are huge and important spaces, and we have efforts in several major areas to deliver qualitatively better experiences than what exists today from Instagram Shopping to Facebook Marketplace to payments across our apps to the new Libra project that we announced with 27 other companies recently. These efforts are important both for our product experience and for our business. Once people have connected to their networks on social platforms, one of the biggest questions is how can we help them use those networks that they have created to create opportunity, and one of the best ways that we can do that is through commerce. Instagram Shopping will improve the experience of browsing and shopping from your favorite brands and creators, while also giving emerging creators a powerful new way to build a business and sustain their community. Facebook Marketplace gives people a way to buy and sell goods in a trusted network with real identities. Hundreds of millions of people are already using Marketplace monthly. We’re also building ways for people to interact with businesses through messaging like WhatsApp Business, because people don’t like having to call businesses and would rather engage asynchronously over messaging if possible. Payments is part of this that I’m particularly excited about. When I look at the kinds of private interactions we can make easier, payments may be the most important for the long term. We’re continuing to test payments on WhatsApp in India, and are close to launching in other countries as well. In the future, we’ll enable people to use the same payments account to send money to friends and businesses on WhatsApp, shop on Instagram, or make transactions on Facebook. Being able to send money as easily as you can send a photo will open up new opportunities for businesses. More broadly, I believe there’s an opportunity to help a lot more businesses access financial tools. Last month we announced that we were working with 27 other organizations to form the Libra Association. The association will create a new currency called Libra, which will be powered by blockchain technology. The Libra Association will be independent of Facebook or any other member, but we plan to support this currency across our services. The goal is to empower billions of people around the world, who use services like WhatsApp but might be excluded from banking services, with access to a safe, stable, and well-regulated cryptocurrency. There are a lot of possibilities here, and both Facebook and the association plan to work with regulators to help address their all of their concerns before Libra will be ready to launch. We worked with other prospective members of the association to release a white paper outlining the Libra concept in advance specifically so that we could address these important questions out in the open, and we’re committed to working with policymakers to get this right. The third product area I want to highlight where we’re focused on delivering a qualitatively better experience than what exists today is in the future computing platforms of augmented and virtual reality. This quarter, we shipped Oculus Quest, our first all-in-one headset with no wires and full freedom of movement. It has gotten great reviews and we’re selling them as fast as we can make them. More importantly, we’ve delivered an experience that people keep using week after week, and buying more content. There’s still a lot of work ahead to develop this ecosystem and deliver the future of VR and AR products that we dream of, but this is an important milestone. In a few years, we’ve improved the state of the art from the original Rift, which cost $600 and required to be tethered to a $1000 PC, to now Quest, which costs $400 all in, and is a superior experience in many ways. There’s going to be even more innovation over the next few years, and we now have the platform we’re going to build on going forward. The reason augmented and virtual reality will deliver a qualitatively better experience than traditional computing platforms is that they deliver the feeling of presence – that you’re actually there with another person or in another place. The feeling of presence is so important to social interactions and how we’re wired to interact as people. So even if it has taken longer than we expected to deliver this at scale, I continue to believe that this will be one of the most important contributions we make to the way we all use technology over the long term. That’s my update on our work on the major social issues we face and building new product experiences. We’ve made a lot of progress this quarter and a have a lot more ahead. Our business continues to perform well, and Sheryl is going to talk more about that in a minute. But this was also an important quarter because now we have a clearer path forward – not just in terms of product and business, but in terms of guidance from regulators, which sets clear expectations and gives us a foundation to build on. As always, thanks for being on this journey with us, and now here’s Sheryl."
},
{
"speaker": "Sheryl Sandberg",
"text": "Thanks Mark, and hi everyone. It was a strong quarter for our business. Ad revenue grew 28% year-over-year and we saw strong growth across all regions and on both Facebook and Instagram. Mobile ad revenue was $15.6 billion, contributing approximately 94% of total ad revenue. As we’ve been discussing, we’re making significant investments in safety, security and privacy while continuing to grow our community and our business. We know we still have a lot of hard work ahead of us, but this quarter once again shows that we can do both. We are committed to earning back trust through the actions we take. In the lead up to elections around the world, we’re doing all we can to get ahead of threats and develop smarter technology. The European Parliament elections in May were an important test for us. We created an operation center in Dublin to bring our experts together and make decisions quickly. We also worked closely with third parties across the EU, including 21 fact-checking organizations. As Mark shared, these investments are starting to pay off and we remain committed to doing everything we can to stop bad actors. We are also focused on increasing transparency. At the end of June, we made our transparency tools available globally for ads about social issues, elections or politics. These tools show who paid for an ad, how much they spent, and who saw the ad. Helping people understand who’s trying to influence their vote will help us better defend against foreign interference and other abuse. We’re going to continue to make investments to protect our platform, because it’s the right thing to do and it’s good for our business over the long-term. At the same time, we are focused on growing our business by helping advertisers grow theirs. Consumers often adopt new technologies first and our competitive advantage is helping advertisers reach people, where they are. We helped businesses make the shift to mobile and now we are helping them shift to Stories, video and eventually messaging. We know that it’s not enough to make these new formats available. We also need to make it easy for advertisers to create effective ads. We do this by launching new ad products and by improving our existing ones to deliver more value for people and advertisers. One of our goals is to level the playing field for businesses of all sizes. We give small businesses free tools that previously only the largest companies could access. During National Small Business Week in May, we introduced Automated Ads to take the guesswork out of creating effective ads. Advertisers answer a few questions and get a customized marketing plan with up to six creative options, targeting suggestions and a recommended budget. We also launched new video editing tools to help SMBs quickly create eye-catching video with images they already have. Fernwood Fitness, a chain of women’s health clubs in Australia, used these tools to build a mobile-first campaign. They targeted women interested in fitness and as a result, nearly doubled their conversions to new memberships. We’re also focused on improving our existing ad products. We often get feedback from advertisers about how we can make small adjustments to our tools to better serve them. These basis point improvements allow us to create more value for businesses over time. For example, we first rolled out our Dynamic Ads format four years ago and since then, we have adapted the format to the needs of different verticals and surfaces. Frontier Airlines used Dynamic Ads to connect with travelers, who recently looked at flights online, but didn’t book. This contributed to a nearly 3.5% increase in ad-related bookings and a 2.5 times increase in ad-related revenue. This quarter, we launched our latest variation – Dynamic Ads in Instagram Stories – which show people ads for products they’ve already browsed on a retailer’s website or app. We’re constantly making incremental improvements to Facebook feed ads. This quarter, we improved how quickly we refresh the ads people see. In the past, these ads were pre-selected at the beginning of a feed session. Now, the ads are refreshed while people are scrolling through their feed. This means people get more relevant ads, which improves engagement and delivers a better return on investment for advertisers. In addition to improving our ad tools, we’re investing in new ways for people to discover products, engage with brands and shop on our platforms. On discovery – more than 50% of accounts on Instagram use Explore every month to discover photos and videos related to their interests. This quarter we started rolling out Ads in Explore on Instagram. This will give businesses a chance to reach new audiences in a place where they are already spending their time and learning about new products. On engagement, we’re making it easier for people to connect with the brands and influencers they love. Last month, we launched Branded Content Ads in Instagram, which allow businesses to promote Creators’ posts as feed ads. Brands like Old Navy, Sephora and Jack in the Box are reaching new audiences with these ads. Soon we’ll expand this option so that advertisers can do the same in Stories. On shopping, we’re building new ways for people to shop directly on our apps. We’re continuing our closed beta of Checkout on Instagram and we launched a new feature this quarter that enables Creators to tag products in their posts. This gives people an easy way to shop from their favorite Creators without leaving the app. It’s early days for shopping on Instagram, but we’re excited about this over the long run. I want to close by saying how grateful I am to our partners around the world. Every day, they give us valuable feedback on how to improve our products, so that we can help them grow their businesses. I also want to thank the Facebook teams, who drive that growth and are making progress on the major social issues facing the internet and our company. I am grateful for our teams’ tireless work and the commitment. Thanks everyone, and here’s Dave."
},
{
"speaker": "Dave Wehner",
"text": "Thanks, Sheryl and good afternoon, everyone. Let’s begin with our community metrics. Facebook daily active users reached 1.59 billion, that’s up 8% compared to last year, led by growth in India, Indonesia and the Philippines. This represents approximately 66% of the 2.41 billion monthly active users in June. MAUs grew 180 million or 8% compared to last year. In terms of our Family metrics, we continue to grow and estimate that on average, more than 2.1 billion people used at least one of our apps on a daily basis in June and more than 2.7 billion people were active on a monthly basis. Turning now to the financials. All comparisons are on a year-over-year basis unless otherwise noted. Q2 total revenue was $16.9 billion, up 28% or 32% on a constant currency basis. Had foreign exchange rates remained constant with the second quarter of 2018, total revenue would have been approximately $574 million higher. Q2 total ad revenue was $16.6 billion, up 28% or 32% on a constant currency basis. In terms of regional ad revenue growth, North America and Asia-Pacific were strongest and both grew 30%, followed by Europe at 25%. Rest of World grew more slowly at 21% and was impacted by currency headwinds. In Q2, the average price per ad decreased 4% and the number of ad impressions served across our services increased 33%. Similar to last quarter, impression growth was primarily driven by ads on Instagram Stories, Instagram Feed, and Facebook News Feed. The year-over-year decline in average price per ad reflects an ongoing mix shift towards Stories ads and geographies that monetize at lower rates. Payments & Other Fees revenue was $262 million, up 36%. This year-over-year growth was primarily driven by sales of new products, notably Oculus Quest and Rift S. Turning now to expenses. Total expenses were $12.3 billion, up 66%. This includes an additional $2 billion expense accrued in connection with our $5 billion settlement with the Federal Trade Commission. Absent this charge, our total expense growth rate would have been 27 percentage points lower. We ended Q2 with approximately 39,700 full-time employees, up 31%. Operating income was $4.6 billion representing a 27% operating margin. Absent the FTC accrual, operating margin would have been approximately 12 percentage points higher. Our Q2 tax rate was 46% and was higher than expected due to the tax treatment of the FTC accrual and a court ruling in the IRS versus Altera case. In that case, the Ninth Circuit reversed a prior Tax Court decision addressing the tax treatment of certain share-based compensation expenses. We changed our treatment this quarter to reflect the Ninth Circuit opinion which resulted in a one-time income tax charge of $1.1 billion. Net income was $2.6 billion or $0.91 per share. Absent the impact of the FTC accrual and the Altera ruling, our EPS would have been approximately $1.08 higher. Capital expenditures were $3.8 billion, driven by investments in data centers, servers, office facilities, and network infrastructure. We generated $4.8 billion in free cash flow and ended the quarter with approximately $48.6 billion in cash and investments. In Q2, we bought back approximately $1.1 billion of our Class A common stock. Turning now to the revenue outlook. We executed well in Q2 with a number of optimizations and product wins, particularly with the Facebook app that fell in our favor and helped combat the overall trend of deceleration. However, we continue to expect that our constant currency revenue growth rates will decelerate sequentially going forward. We also expect more pronounced deceleration in the fourth quarter and into 2020, partially driven by ad targeting related headwinds and uncertainties. Turning now to the expense outlook. We anticipate full-year 2019 expenses to grow 53% to 61% compared to 2018. The $5 billion in accruals we recorded in the first half of 2019 related to the FTC settlement represents approximately 16 percentage points of this anticipated expense growth. Absent the $2B accrual, we recorded in Q2; our 2019 expense outlook is essentially unchanged from last quarter. I want to reiterate that our agreement with the FTC involves implementing a comprehensive expansion of our privacy program, including substantial management and board of directors’ oversight, stringent operational requirements and reporting obligations, and a process to regularly certify our compliance with the privacy program. These efforts will require significant investments in compliance processes, personnel, and technical infrastructure. In addition, these efforts will make some of our existing product development processes more difficult, time-consuming, and costly. We are lowering our 2019 capital expenditures outlook to $16 billion to $18 billion, down from our prior estimate of $17 billion to $19 billion. Our capital expenditures are driven primarily by our continued investment in data centers and servers. We expect our tax rate for the remaining quarters of 2019 to be approximately 16%. In summary, Q2 was another good quarter for Facebook. We’re pleased with the further growth of our community and business while we continue to make significant investments in privacy, safety and security. With that, operator, let’s open up the call for questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Your first question comes from the line of Brian Nowak from Morgan Stanley."
},
{
"speaker": "Brian Nowak",
"text": "Thanks for taking my question. I have two, the first one on the core Facebook app. I was wondering if you could tell us a little bit more about the impact on engagement as well as monetization from the redesign. Dave, I think you mentioned some optimization and product win. So, what are you seeing on the core app, I guess, now a big weight on engagement and monetization. And then can you talk to us a little bit more about some of the ad targeting headwinds that you foresee in 4Q and in 2020? Thanks."
},
{
"speaker": "Dave Wehner",
"text": "Sure, Brian, it’s Dave. I think on the Facebook app, I just say the DAU trend paints the picture broadly for Facebook. We’re seeing stability in the developed markets and growth in the developing markets. And so, we’re continuing to see solid performance on Facebook, and we’re pleased with the engagement levels that we’re seeing overall on the Facebook app. So, I think the first half has been solid from that perspective. And then the second question was on the ad targeting related headwinds. So, we think of those in really three components. The first is regulatory as you think about things like GDPR and other impacts and how those will be rolling out globally. The second is platform changes as it relates to operating systems and a more of a focus on privacy from the operating systems and the impact that that can have on measurements and also on targeting. And then the third is our own product changes as we put privacy more front and center. So really, it’s the compounding of those three issues that are creating headwinds that we think are going to impact us, as we get later in the year and into 2020."
},
{
"speaker": "Operator",
"text": "Your next question comes from Eric Sheridan from UBS."
},
{
"speaker": "Eric Sheridan",
"text": "Thanks so much for taking the question. Maybe on a bigger, broader topic for everyone on video, how do you see video evolving as a consumption mechanism on all of your platforms and in terms of how users consume video what they’re attracted by? Second would be how that’s informing you investing in video content. How should we think about the investments going forward and how that might impact growth versus margins? And then third, the opportunities on the advertising side that video might present over the next three to five years? Thanks guys."
},
{
"speaker": "Sheryl Sandberg",
"text": "So, I think video has been pretty important. It’s really followed technological change, if you think back even four years, you can’t really take a video, a lot of videos buffered on your phone. And now, you think about what people can do. They can consume video very easily on a phone. They can share video, they can take video. And so we’re seeing very – we’re seeing a lot of interest along a lot of consumer products. It’s also probably worth mentioning that video is within a bunch of our products. So, we certainly have video in feed and people can put video into stories and different places. And we also have the specific Watch place, where we’re looking at original content. I think to the second part of your question, which is how do we think about video content. Most of the content, people put up on Facebook video or other is user-generated, that’s also true of the watch content itself. We have made some investments there in creating a more dedicated place to watch video. So, while a lot of the content is still provided by people in a way that we’re not covering costs, we do have a strategy of investing in great content that really starts the flywheel growing – going and we’ve been pretty pleased, I mean it’s not the biggest effort anyone has, but we’ve had some hits from Tom and Time to Tom and Time to Red Table Talk ,sorry for your loss, and we’re seeing some really nice engagement numbers on these shows. And the best of them actually carry over into the Facebook community, because the best of the people creating those shows and starring in those shows are also engaging with Facebook, and I think the vision Mark laid out for this all along is that, we should do video in a pretty social way. When you think about video ads, video ads are pretty exciting, because it’s obviously a firm asset marketers have long loved. I think one of the challenges we’ve had is training the market that you can’t just take your TV ads and put them on video – I’m sorry, put them on mobile or put them into Facebook, because they don’t perform the same way. The best TV ad is 30 seconds, it builds slowly to a story, the product reveal is usually at the very end, the best mobile first ad or ad-on Facebook kind of gets to the main point or gets to the product in the first three seconds, captures your attention much more quickly. We sometimes talk about it as some stopping creative, where you actually want to stop and watch. I think the good news we have here is that mobile first video on Facebook right now is now over 50% of video revenue. So that shows real growth people understanding they need to do it differently, but we’ve still got a pretty long way to go, and we are seeing good results. I’ll share an example, McDonalds. McDonalds used mobile app video ads in Facebook and Instagram News Feed and Stories to launch a limited edition called the Big Mac range in the UK. They had a 16.5% lift in ad recall and then Nielsen’s study showed a nearly 20% incremental reach on Facebook versus TV. So, I think that shows that when video is done well, it can have a really big impact on companies large and small on our platform."
},
{
"speaker": "Dave Wehner",
"text": "And then Eric, I think you asked about margin impact. I’d just say that the video content budget is already factored into the guidance that we’re providing on expenses."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ross Sandler from Barclays."
},
{
"speaker": "Ross Sandler",
"text": "Hey, guys, can we just go back to the deceleration comment. So, we appreciate the color you just gave, Dave. But at the same time, you said that the impression growth in 2Q was driven by Instagram Stories, Instagram Feed and then Facebook Feed. And so if those are kind of the current drivers and we’re likely to continue to see those send in the future, what specifically do you see is slowing down in 4Q in 2020? Is that core Facebook, any additional color on like the surface that might slow down from some of these changes? Thanks a lot."
},
{
"speaker": "Dave Wehner",
"text": "Sure. Ross, I mean if you remember we’re seeing good impression growth across Instagram Stories, Instagram Feed and Facebook Feed. So, we’re seeing good impression growth across all of those. We are seeing faster growth in impressions coming from Stories and then also coming from geographies that monetize at lower rates on things like Facebook News Feed. So even though we’re seeing good impression growth that’s impression growth it’s flowing through at a lower price point. Then, the way that growth was driven in the prior year. So that’s contributing to some of the deceleration, specifically as we look out into the remainder of 2019. When we get into Q4, we’re going to be similar to how we had good product wins in Q2. We also had several product optimizations in Q4 that contributed a strong performance that quarter. So, we’re going to have a tougher compare on that basis. So, just broadly, I think we expect the revenue deceleration trend that Q2 is not mark a reversal of that, but we expect to kind of return to constant currency revenue growth deceleration as you get into the remainder of 2019."
},
{
"speaker": "Operator",
"text": "Your next question comes from Doug Anmuth from JPMorgan."
},
{
"speaker": "Doug Anmuth",
"text": "Thanks for taking the question. One for Mark and one for Dave. First Mark, how are you thinking about the opposition that you’ve received so far around Libra? Because it changed your view of the timeframe at all in terms of rolling out the currency. And then second, Dave just, you talked about the higher demands of privacy. Can you just talk about how that could impact expense growth as you think about 2020, where in the past, you’ve talked about more moderate expense growth for next year? Thanks."
},
{
"speaker": "Mark Zuckerberg",
"text": "Sure. So, on Libra and similar to our approach on some of the important social issues that we face around encryption and content regulation and things like that. We get that these are really important and sensitive spaces. So, our approach has been to try to have a very open dialog about this, right. If Facebook from a few years ago would have probably just showed up and tried to release a product on our own. And now, the approach on all of these fronts is to outline the ideas in the values that we think an eventual service should have. We’ve opened a period of, however, long it takes to address regulators and different experts and constituents questions about this and then figure out what the best way to move forward is and that’s certainly what we’re planning to do with Libra. So, we worked with the 27 other members of the association to publish the white paper to put the idea out there expecting that this is a very important and heavily regulated area and there were going to be a lot of questions. We’re going to have to work through that. So, I think we’re currently in the process of doing that. We are trying to provide a safe and stable and well-regulated product. So that’s always been the strategy and we’ll continue to engage it here."
},
{
"speaker": "Dave Wehner",
"text": "And then Doug, you were asking about the impacts on expense growth. We’re not giving guidance, specifically on the 2020 expense outlook. But the privacy efforts do require significant investments obviously and compliance processes, people and then technical infrastructure and those are factored into the 2019 operating expense outlook. One of the impacts that I’d point to you is it’s also a reallocation of resources around privacy. So that will have an impact on our overall product development as well. So that’s something that I’d factor in both in terms of just the overall impact to the business, not purely just the expense side."
},
{
"speaker": "Operator",
"text": "Your next question comes from Lloyd Walmsley from Deutsche Bank."
},
{
"speaker": "Lloyd Walmsley",
"text": "Thanks. Two if I can. First, can you just talk to us about early learnings from the test of Instagram checkout and what some of the key hurdles are to kind of scaling that more broadly? And then secondly, on OpEx, it looked like you saw a fairly meaningful step up from Q1 to Q2 despite fairly limited head count growth. So, just wondering if there’s anything you would point to there that might explain why those are diverging a little bit in that quarter?"
},
{
"speaker": "Sheryl Sandberg",
"text": "I’ll talk about checkouts. So checkout is in, we talk a lot on this call about early stage things, this is earlier than that. We are in a very small closed beta with 23 brands, which for Facebook is about small as something could be. On – obviously, as I said, small, but there is working with the brands, we’re pretty excited by their feedback. We’re not in a rush to scale this quickly. We’re always focused on the consumer experience and we want to make sure we really get this right. I think the way to think about checkout is kind of in a larger picture of what we’re trying to do in terms of commerce and shopping on our services and apps across the board, which is, we obviously have a lot of consumer engagement in our products and that’s great. We obviously have felt some good and robust ad tools that are helping us grow our business quarter-after-quarter. If we can help people close the loop a little more, so they are looking more directly products, that makes our ads more valuable. If we can help people check out and pay for the products and even buy the products, it makes the consumer experience better. It also closes the loop on the data and measurement, we’re going to need going forward. So, we’re excited about these efforts for doing a lot across the board. All of them are in their early stages and we think about this primarily from a consumer and closing the loop point of view more than a monetization in and of itself point of view."
},
{
"speaker": "Dave Wehner",
"text": "And then Lloyd, you were asking about the step-up on the cost side in Q2 versus Q1. A couple of things that I’d point to the cost of revenue was up 49% in Q2, and that’s really the flow-through of depreciation that you’re seeing from the big CapEx build cycle that we’ve been in and that’s starting to flow through in the cost profile of the business. And then if you look at the G&A line, obviously that was impacted by the accrual for the FTC settlement as well as some other legal expenses including the SEC settlement. So, you had some G&A expenses that were higher in the quarter as a result of that."
},
{
"speaker": "Operator",
"text": "Your next question comes from Heather Bellini from Goldman Sachs."
},
{
"speaker": "Heather Bellini",
"text": "Great, thank you so much. I wanted to follow up on two comments, one watch that Sherlyn was just talking about related to checkout. I’m just wondering if you could share what the feedback has been so far from the brands that are in the closed beta and how this has helped maybe some stats if they have them like how it helped maybe conversion for the brands that are doing it versus maybe the traditional way they were selling on Instagram. So, if you have anything you could share there and then Dave, just back to Ross’ comment related to the deceleration that you’re referencing. I mean in the past, you’ve given us a little bit more specificity, not too much, but you’ve said kind of mid-single digit or low-single digit decel. Just wondering if there is any other color you could provide us here for the back half in 2020 when you’re painting this at a high level? Thank you."
},
{
"speaker": "Sheryl Sandberg",
"text": "Yes. on the check outs beta, it’s just really small and really early. We definitely hear that it decreases at friction in the shopping experience, but with 23 brands in a product, that’s just too small for us to take any real learnings. We are working with them on iterating the product experience for now."
},
{
"speaker": "Dave Wehner",
"text": "And Heather on the deceleration, we’re simply guiding that we would expect that we would see constant currency revenue deceleration sequentially with that being more pronounced on a constant currency basis in Q4, again, due to the tougher comp for us in Q4 not giving specific quantitative guidance on that at this point."
},
{
"speaker": "Operator",
"text": "Your next question comes from Justin Post from Bank of America Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "Great, thank you. So Mark, from the outside, it’s really hard to tell what’s going on in the regulatory environment and status with regulators. I guess good news on the FTC settlement, but the new investigation has been started. I guess wonder if you could just give us high level to the extent you can. Is the company making progress with regulators both here and in Europe, and how you feel about that? And then, Dave, if you could talk about Europe since GDPR implementation. Has it really been a meaningful difference in your ad revenue growth rates there versus other regions? Thank you."
},
{
"speaker": "Mark Zuckerberg",
"text": "Sure. So, I can talk about the regulatory picture overall. Over the last few years, we focused a lot on a number of major social issues everything from preventing election interference to reducing harmful content to protecting privacy. Now, I’m talking a lot about data portability. And on each of these, I think that there is work that we can do and that we certainly have a responsibility to really make sure that we perform well on them. But at the end of the day, when our systems are mature, there are still going to be trade-offs between important values that we all have something, I mean, on content between free expression and civil discourse and we’re moving hate and things like that. Those are hard questions that at some level, we’re always going to do the best that we can, but we think that having a more democratic process for setting with some of those norms are would be helpful. On privacy, there are really important questions about how you define what you want the system to be in terms of how much you’re locking down data versus are you making it portable for to enable competition and innovation and academic research and things like that. So, we believe that there needs to be a regulatory framework in place for each of the major issues that I just talked about. And my broader concern is that if that doesn’t get put in place, then frustration with the industry, I think, will continue to grow. And so we’re trying to do our part to help advocate for a good regulatory framework in each area and they will come in different forms. So in some places, we’ll – there will be laws passed and others might be working with regulators and having some structural rules imposed on us like with the FTC settlement; in other areas, it might be self-regulation like around, content and speech in the United States. That’s what I’d expect because of the, first amendment here is a strong protections on speech. So this is important overall, we’re very focused on it. I do think we are making progress on working through the issues and addressing them. We’re, I think, in a much stronger place in elections now. Our content systems are getting more mature, there’s a lot of more work to do in each of those. But I think we are making progress. And as said this is a global problem, not just these are global problem, not just American one. So working with folks across Europe and the other continents as well is important too."
},
{
"speaker": "Dave Wehner",
"text": "Hey Justin, it’s Dave. As I noted in my comments. Europe is growing more slowly than North America and APAC. That said, we had a strong quarter and we’re pleased with results in currencies of factor in that delta as well. Overall, we did see Europe had a reacceleration of growth in Q2 versus Q1. And part of that is lapping the GDPR implementation. So, I think overall we’re kind of pleased with what we’re seeing around Europe, but it’s still growing more a little more slowly than North America and APAC."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mark May from Citi."
},
{
"speaker": "Mark May",
"text": "Thanks for taking my questions. First, we’ve seen nice improvement in the rate of expense growth lately. And on the Q4 call, you said you expected in 2020 the expense growth will be more in line with revenue growth. Just curious if that is something that you still feel comfortable with? And then secondly in terms of WhatsApp and WhatsApp status specifically, what are your plans as it relates to ads on WhatsApp status? Have you tested here or have any plans to test? Thank you."
},
{
"speaker": "Dave Wehner",
"text": "Yes. Thanks, Mark. So in terms of, in terms of our overall expense outlook. Our current outlook for 2019 does suggests that we’ll see margins come down this year versus 2018. Even if you were to set aside the $5 billion FTC accrual. We’re not providing specific guidance for 2020 or beyond. The investment priorities remain the same. In addition to the privacy investment priorities that we outlined today will continue to invest in key areas like core product infrastructure, innovation, video and content and safety and security over the long run. So we’re not at this point providing any more specific guidance on 2020."
},
{
"speaker": "Sheryl Sandberg",
"text": "On WhatsApp Status ads are not available. We’re very focused for WhatsApp on the consumer experience. But I will take a minute to talk about Stories ads in general, because I think eventually depending on our ability to use data across platform that applies to WhatsApp it’s probably pretty important part of the story that’s going on with Facebook right now. So we do have Stories ads available across Facebook, Instagram and Messenger, and I think one of the most important things we learned as we were doing it transition to mobile is if we made it easy for our advertisers to place the ads, make sure they understood the measurement they were having and also make sure the ad format worked, businesses would move more quickly. Usually people move before businesses people move to mobile before businesses and we certainly saw the same with Stories. But I think one of the successes you are seeing we’re having right now is that we are helping people move to Stories more quickly because of the lessons we learned. So for example, automatic placements, what automatic placements do is they convert Feed ads into a Stories format and deliver the ads wherever they get their best results. And I think it’s product innovations like that that have gotten us to three million advertisers. So rather than across the three properties we have available Facebook, Instagram and Messenger. So rather than go to every advertiser both through our sales force and through our online tools where we sell and say we have a new format, you need to create the new format, you need to figure out the placement being able to just take what they are already doing like Feed ads, converted into Stories and place at anywhere helps us move people into these formats. It’s also a case of we have a lot of inventory on this. And so there is a real benefit right now to being an early adopter, the pricing is very attractive. And so we think the mix shift to Stories is the big opportunity for us and advertisers over time. I’ll say one more thing, which is that Stories don’t monetize right now at the same rate as News Feed. We’re optimistic about the growth over the long run, but we are as always very prudent and careful on the consumer experience."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mark Mahaney from RBC."
},
{
"speaker": "Mark Mahaney",
"text": "Thanks. I just wanted to focus on WhatsApp and I know you’ve had WhatsApp payments in beta in India, you launched that last year. Could you just talk about the – if there are any particular factors that are causing a delay in that and maybe just takes a long time for a product like that to really gain traction, but is it consumer awareness of it is it regulatory push back is their technical hurdles and what does that tell you about the and maybe nothing, but what does that tell you about the ability to take that WhatsApp monetization or payments functionality embedded with WhatsApp and launched it in other markets. I said, I know you said you’re going to launch in other countries, but what are the lessons from India tell you about the pacing of that? Thank you."
},
{
"speaker": "Mark Zuckerberg",
"text": "So it’s a regulatory approval question in India at this point and we had a license to roll it out as part of an initial test, the test went better than we even expected it would. I mean for a product that you would expect to need to be widely available to be useful, right, in order to – for someone to know that they can send money to someone else. Even a limited test the feedback was very positive. So, I’m quite confident that when we can roll this out broadly it’s going to be meaningfully valuable to the user experience. We’re also working beyond India, in a number of other countries and hope to have this rolled out to a large percentage of the people who use WhatsApp within the next year. So that’s the goal, we’re pushing forward on all of these issues and should have more to talk about soon."
},
{
"speaker": "Operator",
"text": "Your next question comes from Michael Nathanson from Moffett Nathanson."
},
{
"speaker": "Michael Nathanson",
"text": "Thanks. I have two, one for Sheryl and Dave and one for Mark. So Sheryl and Dave, you noted the growth I guess in Europe this time in acceleration. And can you talk a bit about maybe the regional development of Stories and either the embracing the advertising community or the user community by region. And then, for Mark on the answer on currency arguably Crypto is going to take a long time to you to get approval or to build a product. Do you see building a fiat currency wallet for Facebook and Instagram. I know it’s about WhatsApp but how does another title wallet non-crypto wallet develop if it takes a while for the other products to rollout meaning Crypto takes a while for approval. So does non-crypto fiat currency become an opportunity for you?"
},
{
"speaker": "Dave Wehner",
"text": "Hey, Michael, it’s Dave. I guess we’re not really providing detail on region. I would say Stories is today from an impression growth perspective really about Instagram Stories. So it maps where we’ve got good adoption of Instagram globally. So we’re certainly seeing good growth in places where Instagram is strong, including the U.S., so that’s been good to see. And as we continue to work on Facebook Stories, we’ll have more opportunity as well with Facebook and will map to the reasons where Facebook is stronger. So, I think we’re seeing good growth on Instagram. I think that will continue and continue to drive impression growth and then we hope to continue to make progress on Facebook where we’re seeing growth, but it’s off a smaller base."
},
{
"speaker": "Mark Zuckerberg",
"text": "And on payments, I mean, the short answer is, yes. We’re very focused on payments with fiat currencies as well and making it so that when you pay in one service, whether it’s WhatsApp or in Instagram Shopping or in Marketplace your credentials can be shared and there’s a shared payment system across all those things. So that’s a – certainly a big area for investment. Overall these areas around commerce and payments, I think are one of the most exciting areas of product development for the next several years. I mean the way that we kind of see the products now is we’ve helped people map out and wire up their networks over the last several years, and now in each of these apps we have opportunities to help people get more value from the networks that they’ve created in some of that is going to be on the social side, especially around creating communities and groups and some of it is going to be more on the economic and opportunity side and there we’re doing a whole lot of projects. I know that Libra is the one that has gotten the most attention recently, but it’s really just one of a set of things everything from Instagram, Shopping which is going to help people connect to brands and emerging creators to Facebook marketplace, which is more consumer-to-consumer paying and buying and selling used goods to things like WhatsApp business, which is more about connecting with small businesses and then across the payment landscape, helping people do payments and existing currencies and also trying some newer approaches that can hopefully bring down the cost of doing payments around the world. We’re just very excited about all the – everything in this area and it’s one of the biggest areas that we’re focused on for the next several years."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ben Schachter from Macquarie."
},
{
"speaker": "Ben Schachter",
"text": "Mark in 1Q, you mentioned specifically that GDPR had an impact on the business. I was just wondering if you can give an update on that? And then longer term on Facebook, you focused a few times now on buying and selling goods there. Just wondering if you can comment on how you think of services versus goods for example monetizing recommending a house painter versus selling a widget. And also can you talk about the timing of how marketplace might evolve? Thanks."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yes, I don’t know, Dave if you want to talk about the GDPR impact. And then I can end."
},
{
"speaker": "Dave Wehner",
"text": "Yes, Ben. So, just in terms of GDPR I kind of address that earlier, we do see that having an impact in Europe that we did see a reacceleration in growth in Europe, as we have lapped the initial implementation of GDPR. So that’s promising, but we continue to see Europe growing just a bit slower than the rest of the regions. But overall, not a whole lot of additional color to provide there."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yes. And in Marketplace, we definitely are going to focus on some of the areas that you talked about including jobs is already a pretty meaningful focus where a lot of people do find jobs and business is less jobs through Facebook. I don’t want to, I don’t know what our last public status here. So I’m not going to attempt to site something but it’s meaningful. And the business model around this is probably not going to be charging for listings but advertising. And in order to promote things both in and what we’re doing on Instagram with shopping and in Facebook Marketplace and in the general approach to payments is providing as affordably as possible to improve the user experience and complete transactions which will of course make the tools more valuable for businesses overall and should make the ad prices go up. And that should be the primary thing that we’re focused on. Someone just handed me a piece of paper, which says that we have helped a million people find jobs. So there is the stat."
},
{
"speaker": "Operator",
"text": "Your next question comes from Colin Sebastian from Baird."
},
{
"speaker": "Colin Sebastian",
"text": "Great, thanks. A couple from me. First off, any update on the higher profile for groups in the Facebook app and any perspective on how that’s impacting engagements. And then Mark, the five-year timeline for the privacy focused vision. I guess, I wonder if we get a better sense for what the key milestones are along the way and why that’s a five-year outlook perhaps versus the shorter period? Thank you."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yes, I could take both of those. So in the Facebook app overall after helping people connect with friends and family, helping people connected with communities is the next most important social problem that we believe we can help address and that’s just going to be an area of increasing value in the product. That is going well since we started rolling that out after F8, I think Dave may have mentioned this earlier, but in case you didn’t just to emphasize this point I think part of the – our strong performance over the first half of this year, a meaningful part of our overperformance compared to what we had expected is because of strength and engagement in the Facebook app over that period. So that’s – it’s generally going well overall and we’re very optimistic about communities in particular going forward is one of the drivers of that. What was the second question?"
},
{
"speaker": "Dave Wehner",
"text": "The five-year."
},
{
"speaker": "Mark Zuckerberg",
"text": "Right, okay. So on that’s on the privacy vision. So for the next year to two a lot of the work that we need to do is just about getting the architecture right. Right so establishing, we have to rewrite the networks on Messenger and on Instagram to be more client and server oriented to be end-to-end encrypted. We’re working on interoperability, that people will be able to choose to use between the services. These are pretty big technical projects. We want to make it so that the infrastructure that these services are built on is the most secure and most reliable and fastest and most widely available of any of the major messaging platforms out there, we think that that’s the foundation to build a successful private platform on. Then we need to do things like what we’re doing with WhatsApp business, which is building up the business ecosystem and that’s just something that our playbook on this but this is a multiyear journey where first we deliver the consumer product experience, then we create organic business experiences and then only as the last step, are we really able to ramp up having business that pay for things that are meaningful for them within that. So it’s not that you’re not going to see progress on that along the way, you’ll certainly see milestones every six months or 12 months. But before this is really the biggest driver of our business, I do think that that’s going to be a number of years."
},
{
"speaker": "Deborah Crawford",
"text": "Great. Operator, we have time for one last question."
},
{
"speaker": "Operator",
"text": "Your last question comes from Brent Thill from Jefferies."
},
{
"speaker": "Brent Thill",
"text": "Thanks, Dave. I think a lot of us are having a hard time reconcile that the tougher comp in Q4. It was your easiest comp and you just accelerated your constant currency growth in the quarter. So I guess, just, is there any change in terms of the visibility or the contracts that you’re putting together that lead you to that, any other color. I think there is a number of questions, just trying to understand why you have such strong conviction in that decel?"
},
{
"speaker": "Dave Wehner",
"text": "Hey, Brent. So in terms of the outlook. Remember, we don’t have contracted revenue. We are constantly working from an auction perspective. So our forecasts are based on supply and demand and how we see the different product launches playing into that different optimizations that we make. So there’s a lot of granularity that goes into thinking about how revenue will progress that ultimately it’s going to depend on the supply and demand characteristics in that given quarter when we do that and we see that we expect constant currency deceleration. And when we get to Q4 we’re going to be lapping some particularly successful optimizations that we had in Q4 and that’s going to contribute to more of a decel in Q4 than we think we’ll see in Q3. So that’s the reason I’m characterizing the guidance the way I am."
},
{
"speaker": "Deborah Crawford",
"text": "Great. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today’s conference call. Thank you for joining us. You may now disconnect your lines."
}
] | null | null |
META | 1 | 2,019 | 2019-04-24 16:00:00 | Operator: Good afternoon. My name is Mike and I will be your conference operator today. At this time I would like to welcome everyone to the Facebook First Quarter 2019 Earnings Call. All lines have been placed on mute to prevent any background noise. [Operator Instructions] This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook’s Vice President of Investor Relations, you may begin.
Deborah Crawford: Thank you. Good afternoon and welcome to Facebook’s first quarter 2019 earnings conference call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today’s press release, and in our annual report on Form 10-K filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these statements as a result of new information or future events. During this call we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today’s earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I’d like to turn the call over to Mark.
Mark Zuckerberg: Thanks Deborah, and thank you all for joining us today. This was a strong quarter, and our community and business continued to grow. There are now around 2.7 billion people using Facebook, Instagram, WhatsApp, or Messenger each month, and more than 2.1 billion people are using at least one every day. We’re continuing to see fast adoption of Stories with each of our three Stories experiences – Facebook and Messenger, Instagram, and WhatsApp – having more than half a billion daily actives. Since our last call, I’ve written about some major updates on the future of our services and how we’re thinking about some of the important social issues facing the Internet. So, I’ll focus my time today on these, starting with our privacy-focused vision for the future of social networking. The basic idea here is that in our lives, we all have public spaces like the town square and private spaces like our living rooms. In our digital lives, we also need both public and private spaces. For the last 15 years, Facebook and Instagram have become the digital equivalents of the town square where you can do almost anything you want with lots of people at once – stay in touch with your friends, meet new people, find communities that share your interests, start businesses, buy and sell things, and organize fundraisers for causes. They aren’t just tools for sharing one thing; they’re these whole rich platforms for lots of ways to interact in larger communities. Today, people increasingly want the intimacy of connecting privately as well, so I think there also needs to be a digital equivalent of the living room, a platform just as built out with all the ways that you’d want to interact privately. We already see that in messages, small groups, and Stories are by far the fastest growing areas of online communication. And we also know that people want additional tools for private interactions like payments and commerce. I expect the digital town squares like Facebook and Instagram will always be important and will only continue to grow in importance, but there’s a lot more to build there as well and I’m excited about that. But over time, I believe that there’s an even bigger opportunity with the digital living room to build a platform focused on privacy. We all need to communicate privately, and this service could be even more important in our lives. So, I think we should focus our efforts on building this privacy-focused platform. Our plan is to build this the way we’ve developed WhatsApp; focused on the most fundamental and private use case, messaging, make it as secure as possible with end-to-end encryption, and then build more ways for people to interact on top of that. And this privacy-focused platform will be built around several principles: Private interactions. You should have simple, intimate spaces where you have complete confidence that what you say and do is private. Encryption. Your private communications should be secure, and end-to-end encryption prevents anyone – including even us – from seeing what you share. Reducing permanence. You shouldn’t have to worry about what you share is going back to hurt you later, so we won’t keep around messages or Stories for longer than necessary. Safety. You should expect that we’ll do everything we can to keep you safe on our services within the bounds of an encrypted service. So we’re taking the time to get this right upfront before we ship this platform. Interoperability. You should be able to use any of our apps to reach your friends, and you should be able to communicate across our networks easily and securely. And finally, secure data storage. You should expect that we won’t store sensitive data in countries where it might be improperly accessed because of weak rule of law or governments that can forcibly get access to your data. So over the next few years, we’re going to rebuild more of our services around these ideas. There are a lot of open questions and real tradeoffs on important social issues, so we’re committed to working openly on this and consulting with experts and governments as we go. Now, I know one of the questions we’ve gotten frequently is about how this will affect our business. So, I’ll address that here. The reality is any impact is going to be longer term and we don’t know exactly how this will play out yet. But on some of the questions like whether encrypting content will hurt our business, I’m more confident that won’t be a significant issue. We don’t use the content of messages between people to target ads today, so encrypting that content won’t change what we do. It will strengthen people’s privacy without meaningfully affecting our business. Similarly, reducing the permanence of data may have some impact, but we’ve generally found that more recent data is more useful for recommendations anyway, so this is another step that should have a much bigger impact on strengthening people’s privacy than it will have on our business. Our stance on data localization is a risk. That is, if we get blocked in a major country, that will hurt our community and our business. But our principles on data localization aren’t new and this is always a risk. Some people have asked whether more use of private social platforms will replace the more public platforms. And our privacy road map applies to all our products, but we believe there needs to continue to be both the digital town square and the digital living room. As private platforms have grown, in some cases, we’ve seen some cannibalization of the more public platforms in countries like India, where WhatsApp is very popular, but the broader pattern across the world is that people want to use both private and public platforms . So, I believe building out this private social platform is a much greater opportunity than it is a risk. In thinking about the opportunity and impact to our business, by far the most important factor will be whether people choose to use our products and whether we can build the leading private social platforms in most countries. Now remember, we are not currently the leading messaging platform in either the United States, China, or Japan, which are the three largest economies in the world. Our apps aren’t in China, but innovating and succeeding in the other countries is going to be very important. People want a private social platform that is as strong on privacy as possible, so delivering this is both in the interest of our community and our business. As always, our first step is going to be to focus on building the services people want. We’re still in the early stages of developing this, and we’ll share more as our plans develop. The other piece I published in the last month was about the four areas of internet regulation I think would be most helpful around content, elections, privacy, and data portability. And the reason I wrote this is because I’ve spent most of the last couple of years focused on addressing the important social issues around the internet, and while I’m proud of the progress we’ve made, these are areas, where it doesn’t feel right for a private company to make such important policy decisions by ourselves. If the rules for the internet were being written from scratch today, I don’t think people would want private companies to be making so many decisions around speech, elections, and data privacy without a more robust democratic process. For harmful content, I think there should be a public process for determining what’s allowed and required for keeping harmful content to a minimum. That could be through government or industry, but having common standards is critical since people use so many different services to share content. For elections, there have long been laws defining what is political advertising, but we need to update those regulations to reflect today’s threats like the ways that foreign nation states try to interfere in elections now. Those threats are often not covered by today’s laws, and I think we’d be better off if companies didn’t define those policies themselves. For privacy, I believe it would be positive if more countries adopted regulation like GDPR as a common framework. At this point, realistically, most countries will adopt privacy regulation, and the most likely alternative to a global framework like GDPR is the fragmentation of the internet and more countries following the approach of authoritarian regimes adopting strict data localization policies, where governments can more easily access people’s data, and I’m highly concerned about that future. For data portability, if you have data in one service, you should be able to move it to another. But we need a common understanding of nuanced questions like what is your data and what is someone else’s. If I share my birthday with you, is that now your data that you should be able to bring to your calendar app, so it can remind you later? Or is that only my data? And if a platform like Facebook facilitates data portability and you’re bringing data to another app, whose responsibility is it if that app misuses your data? The absence of clear rules here discourages companies like ours from building tools to make it easier to move data between apps. These questions involve difficult tradeoffs. We can’t have complete free speech, but no hate. We can’t have complete privacy while also stopping every safety threat. We can’t tell platforms to keep everyone’s data private, but then expect a broad definition of data portability for research or competition. The values and equities at stake are too important and too conflicting for any company to balance them in a way that everyone will be comfortable with. So part of building trust will be deferring to a public process on how to make these tradeoffs. I understand that any regulation may hurt our business. But I think it’s necessary. Getting these issues right is more important than our interests. And I believe that regulation will help establish trust when people know that the right systems of governance and accountability are in place. So, over the long-term, I believe that that increase in the trustworthiness of the internet can have a much larger positive impact for our community and our business than any short-term hit that we’re going to take. Overall, this is an important time for Facebook. I’m excited about the direction we’re heading and looking forward to discussing how we should address some of these issues more directly. As always, thank you for being on this journey with us. And now here’s Sheryl to talk about our business.
Sheryl Sandberg: Thanks Mark, and hi everyone. We had a strong start to the year. Mobile ad revenue grew 30% year-over-year to $13.9 billion, making up approximately 93% of our total ad revenue. We had solid growth across all regions, and our revenue base continues to broaden as more businesses advertise with us. In Q1, our top 100 advertisers represented less than 20% of our total ad revenue, which means our advertiser base is more diverse compared to the same period last year. We’re making significant investments in safety and security while continuing to grow our community and our business. This quarter once again, shows that we can do both. As we prepare to build more services around our privacy roadmap, we’re changing the way we run the company. We are committed to earning back trust through the actions we take. A key part of earning back trust is increasing transparency. That starts with our products, which should be as easy to understand as they are to use. Last month, we updated our “Why am I seeing this ad?” feature to give people more context and control over the ads they see. We also introduced “Why am I seeing this post?” so people can learn more about what shows up in their News Feed and change their preferences to make their Facebook experience more personal. We are dramatically increasing transparency in our work on elections, where we’re focused on addressing known threats and anticipating new ones. We built up our defenses for the U.S. midterms, and we’re doing the same in other parts of the world. We’ve expanded our Ads Library to include all ads, not just electoral ads and we’ve made it easier to search for and report bad ads. Ahead of the European Parliament elections next month, anyone running political or issue ads in the EU is required to confirm their identity and location and include a “paid for by” disclosure. Making online ads more transparent helps people understand who’s trying to influence their vote, and helps us better defend against foreign interference. We’re also working hard to ensure that our ads don’t exclude or harm people. There’s a long history of discrimination in the areas of housing, employment, and credit, and we don’t want this happening on Facebook. In March, we announced industry-leading changes, anyone running ads in these categories in the U.S. will no longer be allowed to target by age, gender, or zip code. We’re also creating a new library, where people can search through active housing ads and report them. We expect these changes will affect some advertisers’ ability to run legitimate ads, but we believe this is the right tradeoff to better protect against discrimination. Going forward, we will continue making investments to increase transparency, protect our platform from interference, and help keep people safe. We’re doing this, because it’s the right thing to do for people, and because it’s good for our business over the long-term. At the same time, we are focused on continuing to grow our business by helping advertisers grow theirs. We offer the unique ability for advertisers to reach the right person with the right message at the right time, and for people to see ads that are truly relevant to them. We do this in a privacy-focused way that enables millions of businesses around the world to grow and hire. Facebook and Instagram Feed ads make up the bulk of our business today. We expect that to continue, but Stories are an increasingly important growth opportunity. We are helping advertisers keep up with the shift in how people are sharing, just as we did with mobile. We’re proud to announce that we now have 3 million advertisers using Stories Ads to reach customers across Instagram, Facebook, and Messenger. Now, we’ve learned it’s not enough to make a new format available. We also need to make it easy for advertisers to optimize their campaigns. And that’s what we’re doing with Stories. Last month, we introduced Interactive Stories Ads globally on Instagram. People and businesses already use interactive features to start conversations in their Stories and now advertisers can use polling stickers to stand out and drive results. When Dunkin’ promoted its donut fries with an interactive poll in their Stories ads, more than one in five people, who saw the ad voted, which increased engagement and drove 20% lower cost per video view. In addition to helping advertisers make the shift to new ads experiences, we’re making it easier for people to shop directly on our apps. We recently announced Checkout on Instagram, so when people find a product they love in a post or story, they can buy it without leaving the app. We launched with 23 brands in the U.S. including adidas and MAC. While this is a very small closed beta and we know this will take a long time to develop, we’re excited about this next step for shopping on Instagram. Commerce is a growing area for us, too. We’re seeing millions of interactions between buyers and sellers in Marketplace every day. Last quarter we expanded Marketplace ads to more countries and are seeing positive early results. For example, Succulents Box, an online subscription plant business, generates 18% of its total sales from their listings on Marketplace. As we continue to make ads and commerce better, we're focused on helping advertisers connect directly with people. In Q1, we launched Collaborative Ads, which give brands that don't have a direct-to-consumer channel a way to run e-commerce campaigns with retailers. Samsung recently tested Collaborative Ads with Fravega, an electronics retailer in Argentina. They targeted broad audiences who had viewed Samsung products on the retailer’s website, and the campaign resulted in a 21% lift in sales. I want to close by saying how grateful I am to our partners around the world. Every day, they give us valuable feedback on how to improve our products so that we can help them grow their businesses. I also want to thank the Facebook teams who drive that growth, while also making progress on the major social issues facing the internet and our company. I am grateful for my colleagues’ continued dedication and hard work. Thanks, and here’s Dave.
Dave Wehner: Thanks Sheryl and good afternoon everyone. Let’s begin with our community metrics. Facebook daily active users reached 1.56 billion, up 8% compared to last year, led by growth in India, Indonesia, and the Philippines. This represents approximately 66% of the 2.38 billion monthly active users in March. MAUs grew 179 million or 8% compared to last year. Turning to our Family metrics. We estimate that on average, over 2.1 billion people used at least one of our apps on a daily basis in March and around 2.7 billion people were active on a monthly basis. We believe these numbers better reflect the size of our community and the fact that many people are using more than one of our services. Turning now to the financials. All of the comparisons are on a year-over-year basis unless otherwise noted. Q1 total revenue was $15.1 billion, up 26% or 30% on a constant currency basis. Had foreign exchange rates remained constant with the first quarter of 2018, total revenue would have been approximately $503 million higher. Q1 total ad revenue was $14.9 billion, up 26% or 31% on a constant currency basis. In terms of regional ad revenue growth, U.S. and Canada was strongest at 30%, followed by Asia-Pacific at 28% and Rest of World at 23%. Europe grew more slowly at 21% and was impacted in part by currency headwinds. In Q1, the average price per ad decreased 4% and the number of ad impressions served across our services increased 32%. Impression growth was primarily driven by ads on Instagram Stories, Instagram Feed, and Facebook News Feed. The year-over-year decline in average price per ad reflects an ongoing mix shift towards Stories ads and geographies that monetize at lower rates. Payments and Other Fees revenue was $165 million, down 4% year-over-year and down 40% from Q4 which benefitted from holiday sales of Oculus and Portal. Turning now to expenses. Total expenses were $11.8 billion, up 80%. This includes a $3 billion accrual taken in connection with the inquiry of the Federal Trade Commission into our platform and user data practices. This matter remains unresolved, and we estimate that the associated range of loss is between $3 billion and $5 billion. Absent this accrual our total expense growth rate would have been 46 percentage points lower. We ended Q1 with approximately 37,700 full-time employees, up 36%. Operating income was $3.3 billion representing a 22% operating margin. Absent the accrual, operating margin would have been 20 percentage points higher. Our Q1 tax rate was 30% and was higher than the mid-teens guidance given the tax treatment of the accrual. Net income was $2.4 billion, or $0.85 per share. The accrual we recorded reduced EPS by approximately $1.04. Capital expenditures were $4 billion, driven by investments in data centers, servers, office facilities, and network infrastructure. We generated $5.3 billion in free cash flow and ended Q1 with approximately $45.2 billion in cash and investments. In Q1, we bought back approximately $521 million of our Class A common stock. Turning now to the revenue outlook. We continue to expect that our revenue growth rates will decelerate sequentially throughout 2019 on a constant currency basis. In addition, we anticipate ad targeting related headwinds will be more pronounced in the second half of 2019. Turning now to the expense outlook. We are adjusting our expense outlook which now includes the accrual we recorded in Q1. We now anticipate full-year 2019 total expenses to grow 47% to 55% compared to 2018, up from our prior guidance of 40% to 50% growth. The $3 billion accrual accounts for approximately 10 percentage points of the anticipated expense growth. But excluding the accrual, this revised outlook implies a modest adjustment in our guidance on 2019 core expense growth rate. Note that this does not change our longer-term outlook on the need to invest in core product, infrastructure, innovation, and safety and security, and the ultimate impact of those investments on our operating margin. We are updating our 2019 capital expenditures outlook to be $17 billion to $19 billion, down from our prior estimate of $18 billion to $20 billion. Our capital expenditures are driven primarily by our continued investment in data centers and servers. We expect our tax rate for the remaining quarters of 2019 to be in the mid-teens. In summary, Q1 was another good quarter for Facebook. We are pleased with our ability to grow our community and business while at the same time investing heavily for the future. With that, Mike, let’s open up the call for questions.
Operator: We will now open the lines for question-and-answer session. [Operator Instructions] Your first question comes from the line of Doug Anmuth from JPMorgan.
Doug Anmuth: Thanks for taking the question. Mark, can you maybe just talk a little bit more about the time frame for building out a privacy-focused social platform? Are we thinking about one year, three years, five years, and what’s the right way to think about that? And also how do you layer in additional services and functionality for users from there as you go along? And then one for Sheryl as well around Stories ads, you mentioned 3 million-plus advertisers, can you just talk about how the increased density there is translating into pricing relative to the feed? And your view over time, how Stories ads could monetize relative to feed ads? Thank you.
Mark Zuckerberg: Sure. For the time frame for this, I think that this is going to be a central focus for the company for the next five years or longer. Parts of this, we already have a strong foundation on, where WhatsApp and Messenger are strong around the world. But in a lot of the most important countries for this like that – like I mentioned in the United States and Japan, we are not the leading private communication service today. So there, the most important thing that we need to do is get the basics right and make sure that we are providing, hands down, without any question in anyone’s mind, the clear best service in those areas. So we’ll talk about both of these things over – a lot over the coming months and the plan – I’ll share a little bit more at F8 next week in terms of the product roadmap and what we expect to see on this. But some of the things we’re also going to intentionally take a longer period of time than we might have previously in order to get safety right. So when I first announced that we were going to be moving our private communication services to all be end-to-end encrypted, I was very clear that we’re planning on taking at least a year to go consult with experts and governments and law enforcements around the world to make sure that we have the right safety systems in place to make sure that we handle this really well, right? Because there are really important safety and content issues in messaging and if we don’t have the ability to see the content, we need to make sure we have different tools in place to handle that. And this is a different approach than we would’ve taken a few years ago, right? A few years ago, we probably would’ve rolled this out and tried to deal with issues as they came up with, but now part of our new approach of trying to be more proactive about social issues is trying to build in from the ground up, getting this right upfront. So the playbook is going to be work on getting the basics right, make sure that we have safety rights from the beginning. In countries where we already are the leading platform, there will be more ability to work on things like payments in the near term and build in additional ways that people want to interact privately. But in terms of when I expect this to be a real contributor to the business, I don’t think in the next couple of years that’s going to be a major driver. This is just a big focus for us which is why I’m talking about it now.
Dave Wehner: So Doug, it’s Dave. I’ll take the question on Stories. So we are seeing more of our impression growth coming from Stories, and when I outlined the factors driving impression growth, I listed Stories first. It was the largest contributor of year-over-year impression growth in the quarter. But those impressions are coming in at lower prices than we see in feed. So if anything, the mix shift on growth towards Stories is certainly in the near term a headwind on revenue growth. On pricing specifically, we’re seeing such strong impression growth that this supply growth keeps prices low and creates an opportunity for advertisers, and we’re seeing smart advertisers take advantage of that. Ultimately, we believe we can increase demand for Stories as we attract more advertisers and bring more effective direct response units to Stories. But this – and over time, that will play through to increased prices but this is going to take years, not quarters. So at least in the near term, we’re going to see a meaningful discount on prices on Stories.
Operator: Your next question comes from Brian Nowak from Morgan Stanley.
Brian Nowak: Thanks for taking my question; I have two. Just to go back to the story monetization point with the 3 million advertisers, could you just talk us through some of the main strategies you’ve used to really drive the Stories advertiser adoption? And then any clarity you can help us better understand what type of lifts you’re seeing in spend per advertiser as they start to spend on both News Feed and Stories? And then, Dave, just to come back to your comments about revenue for the year you mentioned the ad targeting headwinds would be more pronounced in the second half. Can you help us better understand why that is, the sort of changes to expect that would drive that? Thanks.
Sheryl Sandberg: Yes, this is Sheryl; I’ll take the Stories question. So one of the things we learned is that consumers usually move to new features, to new products, to new places before marketers, and it’s really up to us to help marketers move there quickly. We definitely saw that with mobile, that one of the barriers was convincing marketers that they needed to be with mobile. But then there was a second barrier which was just making it easier for them to do it. If you take your long TV ad or your 30-second TV spot and you just put it on mobile, it doesn’t perform as well as a mobile first ad, and that’s been something we’ve worked on. Now, we’re really applying that lesson to Stories. First, we need to convince marketers that people are using Stories, and I think having seen the mobile shift, their process – they’re getting that I think more quickly. But then we have to make it easy. So if you look at some of the tools and products I’ve talked about in the last couple of quarters, now you can – rather than us saying to you, go make a Stories ad you can just send us some pictures, some text, some very easy posts and we will create some Stories ads for you. So our process is, we have one sales team selling all of these products; I think that helps us a lot because they already have those relationships. And we’re doing all we can to make it very easy to adopt the format. We also want to make this as automated as possible. So the long run view should be that you can give us maybe simple pictures, maybe simple videos, maybe an ad you’ve produced, and we can do the placement for you, because we think over time our systems will do a better job deciding where your ads should be placed and even helping you target until you’re seeing us build tools in that direction as well. In terms of how much of its incremental, I’m sure not all of it is. There’s – definitely has to be some cannibalization for people who are doing feed ads as they get Stories. But we’ve seen that over time as we move people we’re able to get increasing shares, hopefully, of their budget but it’s our job to earn that. We tell marketers all over the world that we want to be the best dollar, the best minute, the best euro they spend and it’s up to us to prove that ROI and we’re going to continue to do that.
Dave Wehner: Hey, Brian, it’s Dave. We already talked about on the supply side the impact that Stories is having. And the supply growth really getting driven by Stories is coming through at lower prices, so that’s one of the factors that factors into the lower growth outlook for the second half. But on the demand side, want to specifically call out several factors that are contributing to ad targeting headwinds. The first is just the evolution of the regulatory landscape, and here I would point to regulations like GDPR. The number of people who have opted out on using context from the apps and websites they visit for ad targeting has continued to increase since the adoption of GDPR, so we’ve seen that come up both in Europe and around the world. That means those people are seeing less relevant ads and that’s an ad targeting headwind for our business. The second factor is just anticipated changes that mobile platforms will make that will make targeting and measurement more difficult. And the third is Facebook – our own product changes. For example, in the fall we plan to roll out our tool for seeing and clearing your off-Facebook browsing history. In addition, we’ve introduced restrictions on the use of certain targeting criteria from some ads. So we’re seeing a cumulative impact from all of these factors leading to – leading to what we expect to be targeting headwinds for the – for the back half of the year.
Operator: Your next question comes from Heather Bellini from Goldman Sachs.
Heather Bellini: Great. Thank you. I had two questions. The first one I guess, Mark, was given the focus on back-end integration that you’ve been talking about and a platform increasingly focused on privacy, I was wondering how you think about the incremental expenses, if any, to achieve this? And in particular, if I go back to your comments on your third quarter earnings call, you commented that over time, you knew there was a need to ensure that costs and revenue were better matched. Does any of your recent areas of focus change your timeframe associated with that to occur? And then I had a follow-up on IGTV and Watch. I was just wondering if you could share with us how these are performing versus your expectations and kind of what the differences are that you are seeing between the two? Thank you.
Dave Wehner: Heather, I can – I can take that. I mean in terms of the focus on privacy, the one thing that I would – I would sort of cite there, if anything the priority for messaging is clear, the focus on privacy and interoperability, and that means that monetization for messaging is a lower, near-term priority so that has some – has some impact on the outlook. And then when it comes to how we’re thinking about expense growth as we look beyond 2019, we’re not providing specific guidance but I’d note that we continue to invest aggressively across the business and there’s no change in our long-term outlook on the need to invest heavily in areas like safety and security, innovation in our core product and infrastructure and the ultimate impact that those will have on our operating margin. So, we’re still positioned to invest aggressively both in 2019 and beyond. On IGTV and Watch, do you want to – does anybody want to take that or...?
Mark Zuckerberg: Well if you were going to – you’re going to have to do the numbers and then I’ll do the color. Go for it with whatever you wanted to say and then I’ll jump in after. All right, we’ll – before we get to IGTV and Watch, I’ll just add on the cost point that this is something that I’m focused on personally. I care a lot about making sure that we want make the right investments in safety and innovation long-term, so I’m committed to doing that. But of course, I get that in running a company you don’t want to have costs growing at a much faster rate than your revenue for a long period of time. And that’s why I called that out last time exactly, because I care about making sure that we get that back more and more in line soon. On Watch, generally this is starting to go quite well. There’s – it’s early, but one of the big questions around Watch that we had early on was what is going to be people’s demand to go to a separate tab to have an experience that’s dedicated to interacting with people around a certain type of content? If you remember the reason why we got to this strategy, it was because people wanted to watch a lot of video, but we saw that passive consumption of video was displacing social interactions and News Feed. And when you think about what Facebook stands for in the world, and the really unique value that we can deliver to people, it’s primarily around helping people stay connected and have a meaningful interaction. So, it was really important to me, and I think to making – to the long term of what our product stands for it to make sure that News Feed is always about meaningful interaction. While people wanted to consume a lot of video and we thought that there were new ways that people could interact around that, we wanted to create a separate place, where people could go to do that. And one of the big open questions was to what extent, what percent of people are going to want to go and do this? And now it was more than 100 million people doing this, I think we’ve really proven as part of that hypothesis, that this is something that people are going to want to go do. That also not only with Watch, which is continuing to grow quickly, this also opens up opportunities around things – around doing this around areas like news, which I’ve recently started talking about. And I don’t have anything too specific to add today, we’re trying to take a very consultative approach to how we develop anything around news or any of the things that touch the big social issues and certainly, supporting journalism is up there as one of the really important things that we care about. So, we want to make sure we do this in a consultative away with a lot of folks in journalism and in the industry. But as Watch has grown, it has proven to us that that these sub-experiences as part of our different apps, similar with IGTV, can be quite successful. And that’s an optimistic sign for me for the future.
Operator: Your next question comes from Eric Sheridan from UBS.
Eric Sheridan: Thanks for taking the question. Maybe two if I can. Mark, for you, I guess as we read your statements and listened to you on the calls over the last sort of a year and a half, the end of 2017, I think investors are still trying to figure out the future business model and monetization path for Facebook as a company. Is it more media consumption and advertising driven or do you think you are in the process of a pivot towards more e-commerce? And we know there’s a privacy focus over all of that. But I’d love sort of your view on how you think about the puts and takes between an ad driven model and an e-commerce driven model or somewhere in between those two as you look out over the next three to five years? And I don’t know if this is best for Dave or not, but on the FTC, you threw out 3 billion to 5 billion, what sort of probability should we assume to that being the likely outcome within that range and how should we think about some of the changes if any that might happen to the business model if you were to settle with the FTC? Thanks so much, guys.
Dave Wehner: I can take for the FTC one first, Eric. Look, the accruals and accounting entry related to the ongoing settlement discussions that we’re having with the FTC. This matter’s not resolved, so the actual amount of payment remains uncertain. However, we’re estimating this range of loss to be $3 billion to $5 billion. Can’t really comment further as this is an ongoing matter. We booked at the low end of the range in accordance with the applicable accounting guidance. So, really not much more to add on that front.
Mark Zuckerberg: Sure. And in-between advertising and commerce, it’s really a continuous spectrum and they’re not two different things, right? Advertising is going to be the way that the revenue comes in for the foreseeable future, but what we expect is as we build out more commerce-related features around shopping, and Instagram and Marketplace and Facebook and certainly, the private social platform that we’re – that I’ve been talking about I think will lend itself to private interactions around payments and commerce and interacting with businesses in that way, I think what we’re going this is we’re going to build more tools for people to buy things directly through the platform. But I would expect that that will mostly come and affect the business through as those products that we build help businesses convert better, they’ll – it will be more valuable to them and therefore that’ll translate into higher bids for the advertising and that’ll be how we see it. Over the long-term, if Payments becomes a really important part of what we do, we can – we’ll have some options and choices about how we choose to – how to have the revenue flow to us in the future. But for the near-term, the way that we’re thinking about it is offering as many of these things at cost and for free as possible to deliver as much value to small businesses and businesses around the world. And I would imagine that that will come and contribute to our business through advertising in the way that it has historically.
Operator: Your next question comes from Justin Post from Bank of America Merrill Lynch.
Justin Post: Great. A couple of questions. Thank you. First, Dave, does your revenue outlook include any contemplated regulatory changes between now and the fall? And then second just kind of wondering if anything caused the expense forecast to go slightly down this year? And just maybe, if you could give us an update on the 35% long-term target margin you provided, I believe on the July call, last year? Thank you.
Dave Wehner: Thanks, Justin. On the revenue outlook, I’m not exactly sure what you’re getting at with the contemplated regulatory changes. But I did cite that one of the factors in the expected deceleration was the ongoing impact of the evolution of the regulatory landscape from things like GDPR and the number of people, who are opting out of using context from third-party apps and websites. That is going to we expect continue to increase. As well as we’re making our own product changes with things like tools for seeing and clearing your off-Facebook history and restricting use of some ad targeting. And some of that is in response to just the evolution of the regulatory landscape. So, I think it does factor into it. In terms of the expense guidance, we don’t have a specific update on a long-term margin target. But I would just note that we are not changing our overall philosophy of continuing to invest aggressively across the business in these important areas like safety, and security and innovation, which are going to play into continued expense growth both in 2019 and 2020. No real change in there; it’s more a question of pacing and better visibility on the pace of head count growth and investment in 2019. But the ultimate end outcome, I don’t think is changing on that front. We’re still expecting to continue to invest aggressively in the business, and that will have an impact on operating margins.
Operator: Your next question comes from Anthony DiClemente from Evercore.
Anthony DiClemente: Thank you for taking my questions. Maybe one for Sheryl and one for Dave. Sheryl, just on checkout, Instagram checkout, maybe talk specifically about the improvements that reduced friction can provide to marketers in terms of ROI on their ads, in terms of the benefits that are created from the reduced friction of buying a product without leaving the app? And then maybe for Dave, just noticed that the daily active users on Facebook in the U.S. and Canada were stable sequentially. So anything around that in terms of what does your revenue outlook kind of assume in terms of will there be continued stability there? Any color around what you're seeing in terms of its time spent or engagement on Facebook would be really helpful. Thank you.
Sheryl Sandberg: So in shopping in general, we do see a lot of interest in our apps and shopping. Instagram specifically where we launched checkout, 130 million Instagram accounts are tapping to reveal products or learn more about products in posts every month. So I think there is a real opportunity. We're excited about checkout but I really want to stress how early this is. This is a small closed beta with 23 brands and for us that's obviously a very small number. And it's not primarily a monetization product as your question assumes. Really, the benefit here is enabling a better experience for people, that when they're interested in a product they can learn more and checkout right there. Obviously, if people learn about things through our ads and then close the loop all the way to purchase, it's very strong for proving ROI, it also helps as a measure that return as well. We're excited about this kind of thing but this is as early as anything could be.
Dave Wehner: Yes, Anthony, on the DAU in the U.S. and Canada, yes, true, that was stable so in terms of the number of DAU quarter-over-quarter. And I think that broadly paints the right picture in terms of engagement as well. We're not providing a specific time spent update but I think it paints the picture well on the DAU front. In terms of the strength that we're seeing in the U.S. and Canada on the revenue front, obviously, Instagram is playing a big, big role there and the growth of impressions from Stories is factoring into it. And at the same time we're seeing continued pricing growth on feed, and that's true for both Facebook and Instagram. And there, we're relying on continuing to improve targeting. And so you've got – the risk there is of course the headwinds that we talked about on the ad targeting front and how that will play into U.S. growth as well.
Operator: Your next question comes from Mark May from Citi.
Mark May: Thank you. To Sheryl's earlier point about the evolution of Stories, the perception is the core Facebook user adoption of Stories format has been – hasn't been all that meaningful. How would you characterize the adoption on core Facebook? And if it is in fact relatively low, is that important for the company to address? And then secondly with impression growth of, I think you said, Dave, 32%, that's obviously significantly higher than the 8% growth in MAUs. What would you largely attribute that to? Is that a reflection of improving engagement or the ability to kind of increase ad loads globally? Thanks.
Sheryl Sandberg: So on Facebook Stories, we have 0.5 billion people using it daily, and we think that's pretty impressive growth; we're seeing real engagement. In ads in Stories, we rolled out globally about 1.5 years after launching Instagram so it's still early but we're definitely seeing a lot of value for businesses on Instagram, and we believe same on Facebook. To share one example, a local e-commerce jewelry brand called Lokai started donating 10% of their net profits to charitable partners. And they started running video ads in Facebook Stories and News Feed. And just the addition of Facebook Stories drove 26% more additions to their checkout cart. So I think we are seeing that – including on Facebook, including in ads even though it's earlier – the additional opportunity is big.
Dave Wehner: So Mark, it's Dave. So in the impression growth I sort of cited the drivers in order of impact, and I listed Instagram Stories first and then Instagram Feed. Stories it is the biggest individual driver of impression growth, and we talked about how that is coming through at lower prices. And there's some opportunity to increase – we were seeing increased engagement in Stories and there's some opportunity to increase load growing forward. On Instagram Feed, which was the second factor, we have seen some increase in ad load on Instagram on a year-over-year basis, but we expect that there'll be less significant growth opportunities going forward on Instagram Feed ad load. And then finally, you've got – you have Facebook Feed which we're still seeing impression growth and that's coming around the globe. And we're tending to see growth in – outside the U.S. and Canada. So that gives you some color on the sort of the type of impression growth that we're seeing.
Operator: Your next question comes from Ross Sandler from Barclays.
Ross Sandler: Great. Mark, so you mentioned payments and commerce a bunch of times in your March letter and also today. So I guess can you talk about how you see the strategy developing for payments and commerce on WhatsApp compared to maybe what you see broadly out there from other folks building these capabilities around messaging? And then what timeline should we expect to start to see some of this come out? And lastly any insights on what the blockchain team at Facebook is working on and how does that potentially tie into the overall payment strategy? Thanks.
Mark Zuckerberg: Sure. Across the – commerce and payments are an area that I'm quite focused on and optimistic about across all of our different services. So in Instagram and Facebook, you have shopping, and you have Marketplace and you have all the tens of millions of small businesses that use pages and a lot that use Instagram for sharing their inventory and being able to help people discover and pay. Through messaging specifically, I'm more optimistic because of the private nature of this space, right? It feels – when you're using a messaging service, that everything there is very intimate and private so it feels like a more natural space to be interacting with a business in a private way for doing transactions. So I think what we're going to end up seeing is building out Payments, which is going to end up being something that we do country-by-country – we have a test that is running in India for WhatsApp now, we're hoping to launch in several other countries at some point, but I don't want to put a timeframe on that here, but it's something that we're actively working on. And the goal would be to have something where you can do discovery through the broader town square-like platforms in Instagram and Facebook. And then you can complete the transactions and follow up with businesses individually and have an ongoing relationship through Messenger and WhatsApp. And it's – this is one of the things that I think will create a lot of value for people discovering and interacting with businesses. I don't know many people who like calling businesses to deal with issues that they have. I think being able to handle that through messaging is going to be a great experience. For businesses I think that this is going to help complete the loop and help them to actually sell more things which ultimately is what they care about when they're using the platform. So this is just a big opportunity, and one of the areas that I'm quite excited about.
Operator: Your next question comes from Lloyd Walmsley from Deutsche Bank.
Lloyd Walmsley: Thanks. Had a couple of related to the commerce topic. Know it's early on Instagram, but in the blog post you all alluded to opening up the platform more broadly. So wondering kind of what the timeline might be? And how easy will it be for smaller businesses to integrate here? And then I guess second one related to that would be, as you start to test this with checkout on Instagram, do you see any change from participating brands in their strategy around ad spend on the platform as part of those tests and kind of how that might evolve over time?
Dave Wehner: Yes. And Sheryl can add some color here but, Lloyd, it's Dave. I just want to make sure, I mean we've got a very small closed beta with 23 brands. It's very early days and it will take a while for this to have any impact. So I just – I think it's something we'll be watching and nurturing but it's going to take a while before Instagram Shopping has any meaningful impact on the business.
Sheryl Sandberg: And we haven't announced anything in terms of opening up the product more broadly so that people can buy sign up automatically which is where small businesses would come in. We're going to get feedback and expand in time. But with all of these things we're doing very small slowly, we have a lot of teams working on a lot of very important projects in ads, and this is one we're going to roll out very slowly and carefully.
Operator: Your next question comes from Michael Nathanson from MoffettNathanson.
Michael Nathanson: Thanks. I have one for Mark and one for Dave. Mark, I appreciate your call about regulating the Internet. You've been outspoken on that. I just wonder if you have any views on the EU copyright directive which YouTube has been critical of or the Australia law about violent material? And if those laws become more global, do you think the company is prepared operationally to protect the platform from those types of challenges by regulators?
Sheryl Sandberg: So we're working with policymakers to ensure that people can share and express themselves while still protecting copyright. In terms of the experience in Europe, some of the provisions could impact the user experience in Europe but we're going to continue to work with policymakers to try to get the balance right.
Operator: Your next question comes from Colin Sebastian from Baird.
Colin Sebastian: Great. Maybe a quick follow-up on the platform safety issue, maybe specifically with respect to broadcast. Wondering how close you are in terms of the ability to prevent harmful posts or videos from reaching users on a real-time basis? And how much of this can realistically be done today using AI versus more manual processes? And then secondly, Mark, just considering the fast adoption of voice interactions in interfaces online, how should we think about Facebook's strategy and competitive positioning as an opportunity to strengthen the connections that exist between the apps or would voice interaction being a distinct feature perhaps within the apps? Thank you.
Mark Zuckerberg: Sure. So on safety, I think given the volume of content that people share, if you want to have any hope of doing it in real time, the only hope is building AI systems that can either identify things and handle them proactively or at the very least, flag them for a lot of people who work for us who can then look at them rather than waiting for people in our community to flag those after they've already seen them. The reactive model of waiting for people in the community to flag them guarantees that by the time that we get to look at an issue someone has already seen that content, which is not the state that we want to be in. So the state that we're trying to get to and hold ourselves accountable to is where we have these transparency reports – right now every six months, but we want to get to quarterly on those soon. And in those transparency reports, we break down every category of harmful content, everything from terrorism, to hate speech, to bullying, to nudity. And in each one, we talk about the prevalence of the content that people see because we think what matters is the number of impressions or people who are seeing the content, not just – not if a lot of people are sharing something but no one sees it – but what is actually getting seen. One piece of content that gets seen by a lot of people is a big deal. And then in these reports, we also talk about and show what percent of the content we handle proactively and identify proactively. And our goal is to get that to be as high as possible. In areas like terrorism, for Al Qaeda and ISIS related content, now 99% of the content that we take down in the category our systems flag proactively before anyone sees it. That's what really good looks like. I don't know that in every category we're going to be able to get to 99%; certainly not in the next six months or a year. But my hope would be that we can get to 90-plus percent on most of these categories within the next couple of years. And that's I think the best hope for doing this. That's going to be a bit continued investment and something that we really care about getting right. The other question was about voice. Most of what we build – one of the things that’s different about Facebook and social products is more of it is about people interacting with each other than just people interacting with us, right? And so we’re certainly very focused on things like video calling and voice calling and ways that people can communicate with voice. We have worked on some voice products on Portal; that’s an important way that people interact. And having Portal out in the market has been very valuable in terms of seeing how people want to use that and for – so our teams can have a real target to shoot at and iterate on and continue improving week over week. That’s been a meaningful improvement. But in all of these different ways, voice and how people interact with each other and eventually building products that allow people to interface with our products through that, we’re quite focused on this.
Operator: Your next question comes from John Blackledge from Cowen.
John Blackledge: Great. Thanks. Could you provide some color on ad loads for Instagram Stories versus Instagram Feed at this point? And also any color on how conversion rates have trended on Stories ads and Instagram over the past year? And then other question, just on CapEx, the guide was brought – was brought down slightly. Just any callout out there and any view on longer-term CapEx on given the ramp the past couple years? Thank you.
Dave Wehner: Sure. I’ll take that, John. So on the ad load for Instagram Stories versus Instagram Feed. I mean it’s hard to compare Stories exactly to Feed, because there’s different characteristics of Stories versus Feed, because you have effectively rolls of video when people are posting lots of Stories, and the interstitials are in between the rolls. It’s a little bit different than Feed posts, so comparing apples and oranges a bit. But we do have opportunities we think to increase effective ad load on Stories, where Instagram Feed and Facebook Feed are – we think the opportunities are much more limited to increase ad load going forward. In terms of conversion rates, I’d probably just go back to the discussion that we had on pricing and the fact that we’ve got a lot of – we’ve got a lot of supply opportunity, and pricing is clearly lower on Stories than on Feed. Part of that is due to the fact that we don’t have as many direct response formats in Stories, so that reduces the opportunities for conversion opportunities on Stories. And as we are more effective at getting direct response into Stories, that should improve, so some opportunity there. On the CapEx guidance, this is really just about better visibility on how spend will come through. A big component of CapEx’s data center builds. Those are large complex projects, so the timing of that spend, we just get better visibility on as the year progresses, but no real change in outlook. We’re continuing to invest heavily in the business. The capital intensity of the business over the last several years had come up, and part of what is driving that are real changes in the business as it relates to our opportunity to deploy capital against things like ads targeting as well as the fact that we’ve seen the user base growth shift to regions like Asia and we’re now building our CapEx to what’s effectively an Asian peak and so that’s a lower ARPU user base. So that does have some impact on capital intensity and part of the driver, where we’re seeing kind of capital intensity increase over the – over the past several years.
Deborah Crawford: Operator, we’re going to take one last question.
Operator: The last question comes from Youssef Squali from SunTrust.
Youssef Squali: Great. Thank you very much. I actually just have one question around regulation. Mark, you’ve been obviously pushing for clearer rules of the road for you and for the other companies to play by. What have been the feedback so far from regulators? How long do you think it’ll take to come to some sort of resolution, especially considering that we’re going into this two-year election cycle? Thanks.
Mark Zuckerberg: Well, one of the things that I’ve been focused on is trying to help develop global frameworks where possible, but the challenge of course, with that is that except in a limited number of cases, regulation typically isn’t global; it’s national. So, I would expect that we’ll see different countries make progress on different timeframes. I had a recent trip, where I was in Berlin and Dublin, talking to a bunch of folks, who are policymakers or academics out there. And certainly, I think people are thinking about all of these issues. And certainly, Europe has led on areas like privacy regulation with GDPR, and is probably further along in thinking about how to think through issues around content regulation and safety as well. I think we’ll see different paces of people doing things in different countries around the world, but a lot of what we hope that we can – that we can contribute to this discussion is as much as possible have shared frameworks for how the industry should operate around the world.
Deborah Crawford: Great, thank you. And thank you for joining us today, we appreciate your time and we look forward to speaking with you again.
Operator: Ladies and gentlemen, this concludes today’s conference call. Thank you for joining us. You may now disconnect your lines. | [
{
"speaker": "Operator",
"text": "Good afternoon. My name is Mike and I will be your conference operator today. At this time I would like to welcome everyone to the Facebook First Quarter 2019 Earnings Call. All lines have been placed on mute to prevent any background noise. [Operator Instructions] This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook’s Vice President of Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford",
"text": "Thank you. Good afternoon and welcome to Facebook’s first quarter 2019 earnings conference call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today’s press release, and in our annual report on Form 10-K filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these statements as a result of new information or future events. During this call we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today’s earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I’d like to turn the call over to Mark."
},
{
"speaker": "Mark Zuckerberg",
"text": "Thanks Deborah, and thank you all for joining us today. This was a strong quarter, and our community and business continued to grow. There are now around 2.7 billion people using Facebook, Instagram, WhatsApp, or Messenger each month, and more than 2.1 billion people are using at least one every day. We’re continuing to see fast adoption of Stories with each of our three Stories experiences – Facebook and Messenger, Instagram, and WhatsApp – having more than half a billion daily actives. Since our last call, I’ve written about some major updates on the future of our services and how we’re thinking about some of the important social issues facing the Internet. So, I’ll focus my time today on these, starting with our privacy-focused vision for the future of social networking. The basic idea here is that in our lives, we all have public spaces like the town square and private spaces like our living rooms. In our digital lives, we also need both public and private spaces. For the last 15 years, Facebook and Instagram have become the digital equivalents of the town square where you can do almost anything you want with lots of people at once – stay in touch with your friends, meet new people, find communities that share your interests, start businesses, buy and sell things, and organize fundraisers for causes. They aren’t just tools for sharing one thing; they’re these whole rich platforms for lots of ways to interact in larger communities. Today, people increasingly want the intimacy of connecting privately as well, so I think there also needs to be a digital equivalent of the living room, a platform just as built out with all the ways that you’d want to interact privately. We already see that in messages, small groups, and Stories are by far the fastest growing areas of online communication. And we also know that people want additional tools for private interactions like payments and commerce. I expect the digital town squares like Facebook and Instagram will always be important and will only continue to grow in importance, but there’s a lot more to build there as well and I’m excited about that. But over time, I believe that there’s an even bigger opportunity with the digital living room to build a platform focused on privacy. We all need to communicate privately, and this service could be even more important in our lives. So, I think we should focus our efforts on building this privacy-focused platform. Our plan is to build this the way we’ve developed WhatsApp; focused on the most fundamental and private use case, messaging, make it as secure as possible with end-to-end encryption, and then build more ways for people to interact on top of that. And this privacy-focused platform will be built around several principles: Private interactions. You should have simple, intimate spaces where you have complete confidence that what you say and do is private. Encryption. Your private communications should be secure, and end-to-end encryption prevents anyone – including even us – from seeing what you share. Reducing permanence. You shouldn’t have to worry about what you share is going back to hurt you later, so we won’t keep around messages or Stories for longer than necessary. Safety. You should expect that we’ll do everything we can to keep you safe on our services within the bounds of an encrypted service. So we’re taking the time to get this right upfront before we ship this platform. Interoperability. You should be able to use any of our apps to reach your friends, and you should be able to communicate across our networks easily and securely. And finally, secure data storage. You should expect that we won’t store sensitive data in countries where it might be improperly accessed because of weak rule of law or governments that can forcibly get access to your data. So over the next few years, we’re going to rebuild more of our services around these ideas. There are a lot of open questions and real tradeoffs on important social issues, so we’re committed to working openly on this and consulting with experts and governments as we go. Now, I know one of the questions we’ve gotten frequently is about how this will affect our business. So, I’ll address that here. The reality is any impact is going to be longer term and we don’t know exactly how this will play out yet. But on some of the questions like whether encrypting content will hurt our business, I’m more confident that won’t be a significant issue. We don’t use the content of messages between people to target ads today, so encrypting that content won’t change what we do. It will strengthen people’s privacy without meaningfully affecting our business. Similarly, reducing the permanence of data may have some impact, but we’ve generally found that more recent data is more useful for recommendations anyway, so this is another step that should have a much bigger impact on strengthening people’s privacy than it will have on our business. Our stance on data localization is a risk. That is, if we get blocked in a major country, that will hurt our community and our business. But our principles on data localization aren’t new and this is always a risk. Some people have asked whether more use of private social platforms will replace the more public platforms. And our privacy road map applies to all our products, but we believe there needs to continue to be both the digital town square and the digital living room. As private platforms have grown, in some cases, we’ve seen some cannibalization of the more public platforms in countries like India, where WhatsApp is very popular, but the broader pattern across the world is that people want to use both private and public platforms . So, I believe building out this private social platform is a much greater opportunity than it is a risk. In thinking about the opportunity and impact to our business, by far the most important factor will be whether people choose to use our products and whether we can build the leading private social platforms in most countries. Now remember, we are not currently the leading messaging platform in either the United States, China, or Japan, which are the three largest economies in the world. Our apps aren’t in China, but innovating and succeeding in the other countries is going to be very important. People want a private social platform that is as strong on privacy as possible, so delivering this is both in the interest of our community and our business. As always, our first step is going to be to focus on building the services people want. We’re still in the early stages of developing this, and we’ll share more as our plans develop. The other piece I published in the last month was about the four areas of internet regulation I think would be most helpful around content, elections, privacy, and data portability. And the reason I wrote this is because I’ve spent most of the last couple of years focused on addressing the important social issues around the internet, and while I’m proud of the progress we’ve made, these are areas, where it doesn’t feel right for a private company to make such important policy decisions by ourselves. If the rules for the internet were being written from scratch today, I don’t think people would want private companies to be making so many decisions around speech, elections, and data privacy without a more robust democratic process. For harmful content, I think there should be a public process for determining what’s allowed and required for keeping harmful content to a minimum. That could be through government or industry, but having common standards is critical since people use so many different services to share content. For elections, there have long been laws defining what is political advertising, but we need to update those regulations to reflect today’s threats like the ways that foreign nation states try to interfere in elections now. Those threats are often not covered by today’s laws, and I think we’d be better off if companies didn’t define those policies themselves. For privacy, I believe it would be positive if more countries adopted regulation like GDPR as a common framework. At this point, realistically, most countries will adopt privacy regulation, and the most likely alternative to a global framework like GDPR is the fragmentation of the internet and more countries following the approach of authoritarian regimes adopting strict data localization policies, where governments can more easily access people’s data, and I’m highly concerned about that future. For data portability, if you have data in one service, you should be able to move it to another. But we need a common understanding of nuanced questions like what is your data and what is someone else’s. If I share my birthday with you, is that now your data that you should be able to bring to your calendar app, so it can remind you later? Or is that only my data? And if a platform like Facebook facilitates data portability and you’re bringing data to another app, whose responsibility is it if that app misuses your data? The absence of clear rules here discourages companies like ours from building tools to make it easier to move data between apps. These questions involve difficult tradeoffs. We can’t have complete free speech, but no hate. We can’t have complete privacy while also stopping every safety threat. We can’t tell platforms to keep everyone’s data private, but then expect a broad definition of data portability for research or competition. The values and equities at stake are too important and too conflicting for any company to balance them in a way that everyone will be comfortable with. So part of building trust will be deferring to a public process on how to make these tradeoffs. I understand that any regulation may hurt our business. But I think it’s necessary. Getting these issues right is more important than our interests. And I believe that regulation will help establish trust when people know that the right systems of governance and accountability are in place. So, over the long-term, I believe that that increase in the trustworthiness of the internet can have a much larger positive impact for our community and our business than any short-term hit that we’re going to take. Overall, this is an important time for Facebook. I’m excited about the direction we’re heading and looking forward to discussing how we should address some of these issues more directly. As always, thank you for being on this journey with us. And now here’s Sheryl to talk about our business."
},
{
"speaker": "Sheryl Sandberg",
"text": "Thanks Mark, and hi everyone. We had a strong start to the year. Mobile ad revenue grew 30% year-over-year to $13.9 billion, making up approximately 93% of our total ad revenue. We had solid growth across all regions, and our revenue base continues to broaden as more businesses advertise with us. In Q1, our top 100 advertisers represented less than 20% of our total ad revenue, which means our advertiser base is more diverse compared to the same period last year. We’re making significant investments in safety and security while continuing to grow our community and our business. This quarter once again, shows that we can do both. As we prepare to build more services around our privacy roadmap, we’re changing the way we run the company. We are committed to earning back trust through the actions we take. A key part of earning back trust is increasing transparency. That starts with our products, which should be as easy to understand as they are to use. Last month, we updated our “Why am I seeing this ad?” feature to give people more context and control over the ads they see. We also introduced “Why am I seeing this post?” so people can learn more about what shows up in their News Feed and change their preferences to make their Facebook experience more personal. We are dramatically increasing transparency in our work on elections, where we’re focused on addressing known threats and anticipating new ones. We built up our defenses for the U.S. midterms, and we’re doing the same in other parts of the world. We’ve expanded our Ads Library to include all ads, not just electoral ads and we’ve made it easier to search for and report bad ads. Ahead of the European Parliament elections next month, anyone running political or issue ads in the EU is required to confirm their identity and location and include a “paid for by” disclosure. Making online ads more transparent helps people understand who’s trying to influence their vote, and helps us better defend against foreign interference. We’re also working hard to ensure that our ads don’t exclude or harm people. There’s a long history of discrimination in the areas of housing, employment, and credit, and we don’t want this happening on Facebook. In March, we announced industry-leading changes, anyone running ads in these categories in the U.S. will no longer be allowed to target by age, gender, or zip code. We’re also creating a new library, where people can search through active housing ads and report them. We expect these changes will affect some advertisers’ ability to run legitimate ads, but we believe this is the right tradeoff to better protect against discrimination. Going forward, we will continue making investments to increase transparency, protect our platform from interference, and help keep people safe. We’re doing this, because it’s the right thing to do for people, and because it’s good for our business over the long-term. At the same time, we are focused on continuing to grow our business by helping advertisers grow theirs. We offer the unique ability for advertisers to reach the right person with the right message at the right time, and for people to see ads that are truly relevant to them. We do this in a privacy-focused way that enables millions of businesses around the world to grow and hire. Facebook and Instagram Feed ads make up the bulk of our business today. We expect that to continue, but Stories are an increasingly important growth opportunity. We are helping advertisers keep up with the shift in how people are sharing, just as we did with mobile. We’re proud to announce that we now have 3 million advertisers using Stories Ads to reach customers across Instagram, Facebook, and Messenger. Now, we’ve learned it’s not enough to make a new format available. We also need to make it easy for advertisers to optimize their campaigns. And that’s what we’re doing with Stories. Last month, we introduced Interactive Stories Ads globally on Instagram. People and businesses already use interactive features to start conversations in their Stories and now advertisers can use polling stickers to stand out and drive results. When Dunkin’ promoted its donut fries with an interactive poll in their Stories ads, more than one in five people, who saw the ad voted, which increased engagement and drove 20% lower cost per video view. In addition to helping advertisers make the shift to new ads experiences, we’re making it easier for people to shop directly on our apps. We recently announced Checkout on Instagram, so when people find a product they love in a post or story, they can buy it without leaving the app. We launched with 23 brands in the U.S. including adidas and MAC. While this is a very small closed beta and we know this will take a long time to develop, we’re excited about this next step for shopping on Instagram. Commerce is a growing area for us, too. We’re seeing millions of interactions between buyers and sellers in Marketplace every day. Last quarter we expanded Marketplace ads to more countries and are seeing positive early results. For example, Succulents Box, an online subscription plant business, generates 18% of its total sales from their listings on Marketplace. As we continue to make ads and commerce better, we're focused on helping advertisers connect directly with people. In Q1, we launched Collaborative Ads, which give brands that don't have a direct-to-consumer channel a way to run e-commerce campaigns with retailers. Samsung recently tested Collaborative Ads with Fravega, an electronics retailer in Argentina. They targeted broad audiences who had viewed Samsung products on the retailer’s website, and the campaign resulted in a 21% lift in sales. I want to close by saying how grateful I am to our partners around the world. Every day, they give us valuable feedback on how to improve our products so that we can help them grow their businesses. I also want to thank the Facebook teams who drive that growth, while also making progress on the major social issues facing the internet and our company. I am grateful for my colleagues’ continued dedication and hard work. Thanks, and here’s Dave."
},
{
"speaker": "Dave Wehner",
"text": "Thanks Sheryl and good afternoon everyone. Let’s begin with our community metrics. Facebook daily active users reached 1.56 billion, up 8% compared to last year, led by growth in India, Indonesia, and the Philippines. This represents approximately 66% of the 2.38 billion monthly active users in March. MAUs grew 179 million or 8% compared to last year. Turning to our Family metrics. We estimate that on average, over 2.1 billion people used at least one of our apps on a daily basis in March and around 2.7 billion people were active on a monthly basis. We believe these numbers better reflect the size of our community and the fact that many people are using more than one of our services. Turning now to the financials. All of the comparisons are on a year-over-year basis unless otherwise noted. Q1 total revenue was $15.1 billion, up 26% or 30% on a constant currency basis. Had foreign exchange rates remained constant with the first quarter of 2018, total revenue would have been approximately $503 million higher. Q1 total ad revenue was $14.9 billion, up 26% or 31% on a constant currency basis. In terms of regional ad revenue growth, U.S. and Canada was strongest at 30%, followed by Asia-Pacific at 28% and Rest of World at 23%. Europe grew more slowly at 21% and was impacted in part by currency headwinds. In Q1, the average price per ad decreased 4% and the number of ad impressions served across our services increased 32%. Impression growth was primarily driven by ads on Instagram Stories, Instagram Feed, and Facebook News Feed. The year-over-year decline in average price per ad reflects an ongoing mix shift towards Stories ads and geographies that monetize at lower rates. Payments and Other Fees revenue was $165 million, down 4% year-over-year and down 40% from Q4 which benefitted from holiday sales of Oculus and Portal. Turning now to expenses. Total expenses were $11.8 billion, up 80%. This includes a $3 billion accrual taken in connection with the inquiry of the Federal Trade Commission into our platform and user data practices. This matter remains unresolved, and we estimate that the associated range of loss is between $3 billion and $5 billion. Absent this accrual our total expense growth rate would have been 46 percentage points lower. We ended Q1 with approximately 37,700 full-time employees, up 36%. Operating income was $3.3 billion representing a 22% operating margin. Absent the accrual, operating margin would have been 20 percentage points higher. Our Q1 tax rate was 30% and was higher than the mid-teens guidance given the tax treatment of the accrual. Net income was $2.4 billion, or $0.85 per share. The accrual we recorded reduced EPS by approximately $1.04. Capital expenditures were $4 billion, driven by investments in data centers, servers, office facilities, and network infrastructure. We generated $5.3 billion in free cash flow and ended Q1 with approximately $45.2 billion in cash and investments. In Q1, we bought back approximately $521 million of our Class A common stock. Turning now to the revenue outlook. We continue to expect that our revenue growth rates will decelerate sequentially throughout 2019 on a constant currency basis. In addition, we anticipate ad targeting related headwinds will be more pronounced in the second half of 2019. Turning now to the expense outlook. We are adjusting our expense outlook which now includes the accrual we recorded in Q1. We now anticipate full-year 2019 total expenses to grow 47% to 55% compared to 2018, up from our prior guidance of 40% to 50% growth. The $3 billion accrual accounts for approximately 10 percentage points of the anticipated expense growth. But excluding the accrual, this revised outlook implies a modest adjustment in our guidance on 2019 core expense growth rate. Note that this does not change our longer-term outlook on the need to invest in core product, infrastructure, innovation, and safety and security, and the ultimate impact of those investments on our operating margin. We are updating our 2019 capital expenditures outlook to be $17 billion to $19 billion, down from our prior estimate of $18 billion to $20 billion. Our capital expenditures are driven primarily by our continued investment in data centers and servers. We expect our tax rate for the remaining quarters of 2019 to be in the mid-teens. In summary, Q1 was another good quarter for Facebook. We are pleased with our ability to grow our community and business while at the same time investing heavily for the future. With that, Mike, let’s open up the call for questions."
},
{
"speaker": "Operator",
"text": "We will now open the lines for question-and-answer session. [Operator Instructions] Your first question comes from the line of Doug Anmuth from JPMorgan."
},
{
"speaker": "Doug Anmuth",
"text": "Thanks for taking the question. Mark, can you maybe just talk a little bit more about the time frame for building out a privacy-focused social platform? Are we thinking about one year, three years, five years, and what’s the right way to think about that? And also how do you layer in additional services and functionality for users from there as you go along? And then one for Sheryl as well around Stories ads, you mentioned 3 million-plus advertisers, can you just talk about how the increased density there is translating into pricing relative to the feed? And your view over time, how Stories ads could monetize relative to feed ads? Thank you."
},
{
"speaker": "Mark Zuckerberg",
"text": "Sure. For the time frame for this, I think that this is going to be a central focus for the company for the next five years or longer. Parts of this, we already have a strong foundation on, where WhatsApp and Messenger are strong around the world. But in a lot of the most important countries for this like that – like I mentioned in the United States and Japan, we are not the leading private communication service today. So there, the most important thing that we need to do is get the basics right and make sure that we are providing, hands down, without any question in anyone’s mind, the clear best service in those areas. So we’ll talk about both of these things over – a lot over the coming months and the plan – I’ll share a little bit more at F8 next week in terms of the product roadmap and what we expect to see on this. But some of the things we’re also going to intentionally take a longer period of time than we might have previously in order to get safety right. So when I first announced that we were going to be moving our private communication services to all be end-to-end encrypted, I was very clear that we’re planning on taking at least a year to go consult with experts and governments and law enforcements around the world to make sure that we have the right safety systems in place to make sure that we handle this really well, right? Because there are really important safety and content issues in messaging and if we don’t have the ability to see the content, we need to make sure we have different tools in place to handle that. And this is a different approach than we would’ve taken a few years ago, right? A few years ago, we probably would’ve rolled this out and tried to deal with issues as they came up with, but now part of our new approach of trying to be more proactive about social issues is trying to build in from the ground up, getting this right upfront. So the playbook is going to be work on getting the basics right, make sure that we have safety rights from the beginning. In countries where we already are the leading platform, there will be more ability to work on things like payments in the near term and build in additional ways that people want to interact privately. But in terms of when I expect this to be a real contributor to the business, I don’t think in the next couple of years that’s going to be a major driver. This is just a big focus for us which is why I’m talking about it now."
},
{
"speaker": "Dave Wehner",
"text": "So Doug, it’s Dave. I’ll take the question on Stories. So we are seeing more of our impression growth coming from Stories, and when I outlined the factors driving impression growth, I listed Stories first. It was the largest contributor of year-over-year impression growth in the quarter. But those impressions are coming in at lower prices than we see in feed. So if anything, the mix shift on growth towards Stories is certainly in the near term a headwind on revenue growth. On pricing specifically, we’re seeing such strong impression growth that this supply growth keeps prices low and creates an opportunity for advertisers, and we’re seeing smart advertisers take advantage of that. Ultimately, we believe we can increase demand for Stories as we attract more advertisers and bring more effective direct response units to Stories. But this – and over time, that will play through to increased prices but this is going to take years, not quarters. So at least in the near term, we’re going to see a meaningful discount on prices on Stories."
},
{
"speaker": "Operator",
"text": "Your next question comes from Brian Nowak from Morgan Stanley."
},
{
"speaker": "Brian Nowak",
"text": "Thanks for taking my question; I have two. Just to go back to the story monetization point with the 3 million advertisers, could you just talk us through some of the main strategies you’ve used to really drive the Stories advertiser adoption? And then any clarity you can help us better understand what type of lifts you’re seeing in spend per advertiser as they start to spend on both News Feed and Stories? And then, Dave, just to come back to your comments about revenue for the year you mentioned the ad targeting headwinds would be more pronounced in the second half. Can you help us better understand why that is, the sort of changes to expect that would drive that? Thanks."
},
{
"speaker": "Sheryl Sandberg",
"text": "Yes, this is Sheryl; I’ll take the Stories question. So one of the things we learned is that consumers usually move to new features, to new products, to new places before marketers, and it’s really up to us to help marketers move there quickly. We definitely saw that with mobile, that one of the barriers was convincing marketers that they needed to be with mobile. But then there was a second barrier which was just making it easier for them to do it. If you take your long TV ad or your 30-second TV spot and you just put it on mobile, it doesn’t perform as well as a mobile first ad, and that’s been something we’ve worked on. Now, we’re really applying that lesson to Stories. First, we need to convince marketers that people are using Stories, and I think having seen the mobile shift, their process – they’re getting that I think more quickly. But then we have to make it easy. So if you look at some of the tools and products I’ve talked about in the last couple of quarters, now you can – rather than us saying to you, go make a Stories ad you can just send us some pictures, some text, some very easy posts and we will create some Stories ads for you. So our process is, we have one sales team selling all of these products; I think that helps us a lot because they already have those relationships. And we’re doing all we can to make it very easy to adopt the format. We also want to make this as automated as possible. So the long run view should be that you can give us maybe simple pictures, maybe simple videos, maybe an ad you’ve produced, and we can do the placement for you, because we think over time our systems will do a better job deciding where your ads should be placed and even helping you target until you’re seeing us build tools in that direction as well. In terms of how much of its incremental, I’m sure not all of it is. There’s – definitely has to be some cannibalization for people who are doing feed ads as they get Stories. But we’ve seen that over time as we move people we’re able to get increasing shares, hopefully, of their budget but it’s our job to earn that. We tell marketers all over the world that we want to be the best dollar, the best minute, the best euro they spend and it’s up to us to prove that ROI and we’re going to continue to do that."
},
{
"speaker": "Dave Wehner",
"text": "Hey, Brian, it’s Dave. We already talked about on the supply side the impact that Stories is having. And the supply growth really getting driven by Stories is coming through at lower prices, so that’s one of the factors that factors into the lower growth outlook for the second half. But on the demand side, want to specifically call out several factors that are contributing to ad targeting headwinds. The first is just the evolution of the regulatory landscape, and here I would point to regulations like GDPR. The number of people who have opted out on using context from the apps and websites they visit for ad targeting has continued to increase since the adoption of GDPR, so we’ve seen that come up both in Europe and around the world. That means those people are seeing less relevant ads and that’s an ad targeting headwind for our business. The second factor is just anticipated changes that mobile platforms will make that will make targeting and measurement more difficult. And the third is Facebook – our own product changes. For example, in the fall we plan to roll out our tool for seeing and clearing your off-Facebook browsing history. In addition, we’ve introduced restrictions on the use of certain targeting criteria from some ads. So we’re seeing a cumulative impact from all of these factors leading to – leading to what we expect to be targeting headwinds for the – for the back half of the year."
},
{
"speaker": "Operator",
"text": "Your next question comes from Heather Bellini from Goldman Sachs."
},
{
"speaker": "Heather Bellini",
"text": "Great. Thank you. I had two questions. The first one I guess, Mark, was given the focus on back-end integration that you’ve been talking about and a platform increasingly focused on privacy, I was wondering how you think about the incremental expenses, if any, to achieve this? And in particular, if I go back to your comments on your third quarter earnings call, you commented that over time, you knew there was a need to ensure that costs and revenue were better matched. Does any of your recent areas of focus change your timeframe associated with that to occur? And then I had a follow-up on IGTV and Watch. I was just wondering if you could share with us how these are performing versus your expectations and kind of what the differences are that you are seeing between the two? Thank you."
},
{
"speaker": "Dave Wehner",
"text": "Heather, I can – I can take that. I mean in terms of the focus on privacy, the one thing that I would – I would sort of cite there, if anything the priority for messaging is clear, the focus on privacy and interoperability, and that means that monetization for messaging is a lower, near-term priority so that has some – has some impact on the outlook. And then when it comes to how we’re thinking about expense growth as we look beyond 2019, we’re not providing specific guidance but I’d note that we continue to invest aggressively across the business and there’s no change in our long-term outlook on the need to invest heavily in areas like safety and security, innovation in our core product and infrastructure and the ultimate impact that those will have on our operating margin. So, we’re still positioned to invest aggressively both in 2019 and beyond. On IGTV and Watch, do you want to – does anybody want to take that or...?"
},
{
"speaker": "Mark Zuckerberg",
"text": "Well if you were going to – you’re going to have to do the numbers and then I’ll do the color. Go for it with whatever you wanted to say and then I’ll jump in after. All right, we’ll – before we get to IGTV and Watch, I’ll just add on the cost point that this is something that I’m focused on personally. I care a lot about making sure that we want make the right investments in safety and innovation long-term, so I’m committed to doing that. But of course, I get that in running a company you don’t want to have costs growing at a much faster rate than your revenue for a long period of time. And that’s why I called that out last time exactly, because I care about making sure that we get that back more and more in line soon. On Watch, generally this is starting to go quite well. There’s – it’s early, but one of the big questions around Watch that we had early on was what is going to be people’s demand to go to a separate tab to have an experience that’s dedicated to interacting with people around a certain type of content? If you remember the reason why we got to this strategy, it was because people wanted to watch a lot of video, but we saw that passive consumption of video was displacing social interactions and News Feed. And when you think about what Facebook stands for in the world, and the really unique value that we can deliver to people, it’s primarily around helping people stay connected and have a meaningful interaction. So, it was really important to me, and I think to making – to the long term of what our product stands for it to make sure that News Feed is always about meaningful interaction. While people wanted to consume a lot of video and we thought that there were new ways that people could interact around that, we wanted to create a separate place, where people could go to do that. And one of the big open questions was to what extent, what percent of people are going to want to go and do this? And now it was more than 100 million people doing this, I think we’ve really proven as part of that hypothesis, that this is something that people are going to want to go do. That also not only with Watch, which is continuing to grow quickly, this also opens up opportunities around things – around doing this around areas like news, which I’ve recently started talking about. And I don’t have anything too specific to add today, we’re trying to take a very consultative approach to how we develop anything around news or any of the things that touch the big social issues and certainly, supporting journalism is up there as one of the really important things that we care about. So, we want to make sure we do this in a consultative away with a lot of folks in journalism and in the industry. But as Watch has grown, it has proven to us that that these sub-experiences as part of our different apps, similar with IGTV, can be quite successful. And that’s an optimistic sign for me for the future."
},
{
"speaker": "Operator",
"text": "Your next question comes from Eric Sheridan from UBS."
},
{
"speaker": "Eric Sheridan",
"text": "Thanks for taking the question. Maybe two if I can. Mark, for you, I guess as we read your statements and listened to you on the calls over the last sort of a year and a half, the end of 2017, I think investors are still trying to figure out the future business model and monetization path for Facebook as a company. Is it more media consumption and advertising driven or do you think you are in the process of a pivot towards more e-commerce? And we know there’s a privacy focus over all of that. But I’d love sort of your view on how you think about the puts and takes between an ad driven model and an e-commerce driven model or somewhere in between those two as you look out over the next three to five years? And I don’t know if this is best for Dave or not, but on the FTC, you threw out 3 billion to 5 billion, what sort of probability should we assume to that being the likely outcome within that range and how should we think about some of the changes if any that might happen to the business model if you were to settle with the FTC? Thanks so much, guys."
},
{
"speaker": "Dave Wehner",
"text": "I can take for the FTC one first, Eric. Look, the accruals and accounting entry related to the ongoing settlement discussions that we’re having with the FTC. This matter’s not resolved, so the actual amount of payment remains uncertain. However, we’re estimating this range of loss to be $3 billion to $5 billion. Can’t really comment further as this is an ongoing matter. We booked at the low end of the range in accordance with the applicable accounting guidance. So, really not much more to add on that front."
},
{
"speaker": "Mark Zuckerberg",
"text": "Sure. And in-between advertising and commerce, it’s really a continuous spectrum and they’re not two different things, right? Advertising is going to be the way that the revenue comes in for the foreseeable future, but what we expect is as we build out more commerce-related features around shopping, and Instagram and Marketplace and Facebook and certainly, the private social platform that we’re – that I’ve been talking about I think will lend itself to private interactions around payments and commerce and interacting with businesses in that way, I think what we’re going this is we’re going to build more tools for people to buy things directly through the platform. But I would expect that that will mostly come and affect the business through as those products that we build help businesses convert better, they’ll – it will be more valuable to them and therefore that’ll translate into higher bids for the advertising and that’ll be how we see it. Over the long-term, if Payments becomes a really important part of what we do, we can – we’ll have some options and choices about how we choose to – how to have the revenue flow to us in the future. But for the near-term, the way that we’re thinking about it is offering as many of these things at cost and for free as possible to deliver as much value to small businesses and businesses around the world. And I would imagine that that will come and contribute to our business through advertising in the way that it has historically."
},
{
"speaker": "Operator",
"text": "Your next question comes from Justin Post from Bank of America Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "Great. A couple of questions. Thank you. First, Dave, does your revenue outlook include any contemplated regulatory changes between now and the fall? And then second just kind of wondering if anything caused the expense forecast to go slightly down this year? And just maybe, if you could give us an update on the 35% long-term target margin you provided, I believe on the July call, last year? Thank you."
},
{
"speaker": "Dave Wehner",
"text": "Thanks, Justin. On the revenue outlook, I’m not exactly sure what you’re getting at with the contemplated regulatory changes. But I did cite that one of the factors in the expected deceleration was the ongoing impact of the evolution of the regulatory landscape from things like GDPR and the number of people, who are opting out of using context from third-party apps and websites. That is going to we expect continue to increase. As well as we’re making our own product changes with things like tools for seeing and clearing your off-Facebook history and restricting use of some ad targeting. And some of that is in response to just the evolution of the regulatory landscape. So, I think it does factor into it. In terms of the expense guidance, we don’t have a specific update on a long-term margin target. But I would just note that we are not changing our overall philosophy of continuing to invest aggressively across the business in these important areas like safety, and security and innovation, which are going to play into continued expense growth both in 2019 and 2020. No real change in there; it’s more a question of pacing and better visibility on the pace of head count growth and investment in 2019. But the ultimate end outcome, I don’t think is changing on that front. We’re still expecting to continue to invest aggressively in the business, and that will have an impact on operating margins."
},
{
"speaker": "Operator",
"text": "Your next question comes from Anthony DiClemente from Evercore."
},
{
"speaker": "Anthony DiClemente",
"text": "Thank you for taking my questions. Maybe one for Sheryl and one for Dave. Sheryl, just on checkout, Instagram checkout, maybe talk specifically about the improvements that reduced friction can provide to marketers in terms of ROI on their ads, in terms of the benefits that are created from the reduced friction of buying a product without leaving the app? And then maybe for Dave, just noticed that the daily active users on Facebook in the U.S. and Canada were stable sequentially. So anything around that in terms of what does your revenue outlook kind of assume in terms of will there be continued stability there? Any color around what you're seeing in terms of its time spent or engagement on Facebook would be really helpful. Thank you."
},
{
"speaker": "Sheryl Sandberg",
"text": "So in shopping in general, we do see a lot of interest in our apps and shopping. Instagram specifically where we launched checkout, 130 million Instagram accounts are tapping to reveal products or learn more about products in posts every month. So I think there is a real opportunity. We're excited about checkout but I really want to stress how early this is. This is a small closed beta with 23 brands and for us that's obviously a very small number. And it's not primarily a monetization product as your question assumes. Really, the benefit here is enabling a better experience for people, that when they're interested in a product they can learn more and checkout right there. Obviously, if people learn about things through our ads and then close the loop all the way to purchase, it's very strong for proving ROI, it also helps as a measure that return as well. We're excited about this kind of thing but this is as early as anything could be."
},
{
"speaker": "Dave Wehner",
"text": "Yes, Anthony, on the DAU in the U.S. and Canada, yes, true, that was stable so in terms of the number of DAU quarter-over-quarter. And I think that broadly paints the right picture in terms of engagement as well. We're not providing a specific time spent update but I think it paints the picture well on the DAU front. In terms of the strength that we're seeing in the U.S. and Canada on the revenue front, obviously, Instagram is playing a big, big role there and the growth of impressions from Stories is factoring into it. And at the same time we're seeing continued pricing growth on feed, and that's true for both Facebook and Instagram. And there, we're relying on continuing to improve targeting. And so you've got – the risk there is of course the headwinds that we talked about on the ad targeting front and how that will play into U.S. growth as well."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mark May from Citi."
},
{
"speaker": "Mark May",
"text": "Thank you. To Sheryl's earlier point about the evolution of Stories, the perception is the core Facebook user adoption of Stories format has been – hasn't been all that meaningful. How would you characterize the adoption on core Facebook? And if it is in fact relatively low, is that important for the company to address? And then secondly with impression growth of, I think you said, Dave, 32%, that's obviously significantly higher than the 8% growth in MAUs. What would you largely attribute that to? Is that a reflection of improving engagement or the ability to kind of increase ad loads globally? Thanks."
},
{
"speaker": "Sheryl Sandberg",
"text": "So on Facebook Stories, we have 0.5 billion people using it daily, and we think that's pretty impressive growth; we're seeing real engagement. In ads in Stories, we rolled out globally about 1.5 years after launching Instagram so it's still early but we're definitely seeing a lot of value for businesses on Instagram, and we believe same on Facebook. To share one example, a local e-commerce jewelry brand called Lokai started donating 10% of their net profits to charitable partners. And they started running video ads in Facebook Stories and News Feed. And just the addition of Facebook Stories drove 26% more additions to their checkout cart. So I think we are seeing that – including on Facebook, including in ads even though it's earlier – the additional opportunity is big."
},
{
"speaker": "Dave Wehner",
"text": "So Mark, it's Dave. So in the impression growth I sort of cited the drivers in order of impact, and I listed Instagram Stories first and then Instagram Feed. Stories it is the biggest individual driver of impression growth, and we talked about how that is coming through at lower prices. And there's some opportunity to increase – we were seeing increased engagement in Stories and there's some opportunity to increase load growing forward. On Instagram Feed, which was the second factor, we have seen some increase in ad load on Instagram on a year-over-year basis, but we expect that there'll be less significant growth opportunities going forward on Instagram Feed ad load. And then finally, you've got – you have Facebook Feed which we're still seeing impression growth and that's coming around the globe. And we're tending to see growth in – outside the U.S. and Canada. So that gives you some color on the sort of the type of impression growth that we're seeing."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ross Sandler from Barclays."
},
{
"speaker": "Ross Sandler",
"text": "Great. Mark, so you mentioned payments and commerce a bunch of times in your March letter and also today. So I guess can you talk about how you see the strategy developing for payments and commerce on WhatsApp compared to maybe what you see broadly out there from other folks building these capabilities around messaging? And then what timeline should we expect to start to see some of this come out? And lastly any insights on what the blockchain team at Facebook is working on and how does that potentially tie into the overall payment strategy? Thanks."
},
{
"speaker": "Mark Zuckerberg",
"text": "Sure. Across the – commerce and payments are an area that I'm quite focused on and optimistic about across all of our different services. So in Instagram and Facebook, you have shopping, and you have Marketplace and you have all the tens of millions of small businesses that use pages and a lot that use Instagram for sharing their inventory and being able to help people discover and pay. Through messaging specifically, I'm more optimistic because of the private nature of this space, right? It feels – when you're using a messaging service, that everything there is very intimate and private so it feels like a more natural space to be interacting with a business in a private way for doing transactions. So I think what we're going to end up seeing is building out Payments, which is going to end up being something that we do country-by-country – we have a test that is running in India for WhatsApp now, we're hoping to launch in several other countries at some point, but I don't want to put a timeframe on that here, but it's something that we're actively working on. And the goal would be to have something where you can do discovery through the broader town square-like platforms in Instagram and Facebook. And then you can complete the transactions and follow up with businesses individually and have an ongoing relationship through Messenger and WhatsApp. And it's – this is one of the things that I think will create a lot of value for people discovering and interacting with businesses. I don't know many people who like calling businesses to deal with issues that they have. I think being able to handle that through messaging is going to be a great experience. For businesses I think that this is going to help complete the loop and help them to actually sell more things which ultimately is what they care about when they're using the platform. So this is just a big opportunity, and one of the areas that I'm quite excited about."
},
{
"speaker": "Operator",
"text": "Your next question comes from Lloyd Walmsley from Deutsche Bank."
},
{
"speaker": "Lloyd Walmsley",
"text": "Thanks. Had a couple of related to the commerce topic. Know it's early on Instagram, but in the blog post you all alluded to opening up the platform more broadly. So wondering kind of what the timeline might be? And how easy will it be for smaller businesses to integrate here? And then I guess second one related to that would be, as you start to test this with checkout on Instagram, do you see any change from participating brands in their strategy around ad spend on the platform as part of those tests and kind of how that might evolve over time?"
},
{
"speaker": "Dave Wehner",
"text": "Yes. And Sheryl can add some color here but, Lloyd, it's Dave. I just want to make sure, I mean we've got a very small closed beta with 23 brands. It's very early days and it will take a while for this to have any impact. So I just – I think it's something we'll be watching and nurturing but it's going to take a while before Instagram Shopping has any meaningful impact on the business."
},
{
"speaker": "Sheryl Sandberg",
"text": "And we haven't announced anything in terms of opening up the product more broadly so that people can buy sign up automatically which is where small businesses would come in. We're going to get feedback and expand in time. But with all of these things we're doing very small slowly, we have a lot of teams working on a lot of very important projects in ads, and this is one we're going to roll out very slowly and carefully."
},
{
"speaker": "Operator",
"text": "Your next question comes from Michael Nathanson from MoffettNathanson."
},
{
"speaker": "Michael Nathanson",
"text": "Thanks. I have one for Mark and one for Dave. Mark, I appreciate your call about regulating the Internet. You've been outspoken on that. I just wonder if you have any views on the EU copyright directive which YouTube has been critical of or the Australia law about violent material? And if those laws become more global, do you think the company is prepared operationally to protect the platform from those types of challenges by regulators?"
},
{
"speaker": "Sheryl Sandberg",
"text": "So we're working with policymakers to ensure that people can share and express themselves while still protecting copyright. In terms of the experience in Europe, some of the provisions could impact the user experience in Europe but we're going to continue to work with policymakers to try to get the balance right."
},
{
"speaker": "Operator",
"text": "Your next question comes from Colin Sebastian from Baird."
},
{
"speaker": "Colin Sebastian",
"text": "Great. Maybe a quick follow-up on the platform safety issue, maybe specifically with respect to broadcast. Wondering how close you are in terms of the ability to prevent harmful posts or videos from reaching users on a real-time basis? And how much of this can realistically be done today using AI versus more manual processes? And then secondly, Mark, just considering the fast adoption of voice interactions in interfaces online, how should we think about Facebook's strategy and competitive positioning as an opportunity to strengthen the connections that exist between the apps or would voice interaction being a distinct feature perhaps within the apps? Thank you."
},
{
"speaker": "Mark Zuckerberg",
"text": "Sure. So on safety, I think given the volume of content that people share, if you want to have any hope of doing it in real time, the only hope is building AI systems that can either identify things and handle them proactively or at the very least, flag them for a lot of people who work for us who can then look at them rather than waiting for people in our community to flag those after they've already seen them. The reactive model of waiting for people in the community to flag them guarantees that by the time that we get to look at an issue someone has already seen that content, which is not the state that we want to be in. So the state that we're trying to get to and hold ourselves accountable to is where we have these transparency reports – right now every six months, but we want to get to quarterly on those soon. And in those transparency reports, we break down every category of harmful content, everything from terrorism, to hate speech, to bullying, to nudity. And in each one, we talk about the prevalence of the content that people see because we think what matters is the number of impressions or people who are seeing the content, not just – not if a lot of people are sharing something but no one sees it – but what is actually getting seen. One piece of content that gets seen by a lot of people is a big deal. And then in these reports, we also talk about and show what percent of the content we handle proactively and identify proactively. And our goal is to get that to be as high as possible. In areas like terrorism, for Al Qaeda and ISIS related content, now 99% of the content that we take down in the category our systems flag proactively before anyone sees it. That's what really good looks like. I don't know that in every category we're going to be able to get to 99%; certainly not in the next six months or a year. But my hope would be that we can get to 90-plus percent on most of these categories within the next couple of years. And that's I think the best hope for doing this. That's going to be a bit continued investment and something that we really care about getting right. The other question was about voice. Most of what we build – one of the things that’s different about Facebook and social products is more of it is about people interacting with each other than just people interacting with us, right? And so we’re certainly very focused on things like video calling and voice calling and ways that people can communicate with voice. We have worked on some voice products on Portal; that’s an important way that people interact. And having Portal out in the market has been very valuable in terms of seeing how people want to use that and for – so our teams can have a real target to shoot at and iterate on and continue improving week over week. That’s been a meaningful improvement. But in all of these different ways, voice and how people interact with each other and eventually building products that allow people to interface with our products through that, we’re quite focused on this."
},
{
"speaker": "Operator",
"text": "Your next question comes from John Blackledge from Cowen."
},
{
"speaker": "John Blackledge",
"text": "Great. Thanks. Could you provide some color on ad loads for Instagram Stories versus Instagram Feed at this point? And also any color on how conversion rates have trended on Stories ads and Instagram over the past year? And then other question, just on CapEx, the guide was brought – was brought down slightly. Just any callout out there and any view on longer-term CapEx on given the ramp the past couple years? Thank you."
},
{
"speaker": "Dave Wehner",
"text": "Sure. I’ll take that, John. So on the ad load for Instagram Stories versus Instagram Feed. I mean it’s hard to compare Stories exactly to Feed, because there’s different characteristics of Stories versus Feed, because you have effectively rolls of video when people are posting lots of Stories, and the interstitials are in between the rolls. It’s a little bit different than Feed posts, so comparing apples and oranges a bit. But we do have opportunities we think to increase effective ad load on Stories, where Instagram Feed and Facebook Feed are – we think the opportunities are much more limited to increase ad load going forward. In terms of conversion rates, I’d probably just go back to the discussion that we had on pricing and the fact that we’ve got a lot of – we’ve got a lot of supply opportunity, and pricing is clearly lower on Stories than on Feed. Part of that is due to the fact that we don’t have as many direct response formats in Stories, so that reduces the opportunities for conversion opportunities on Stories. And as we are more effective at getting direct response into Stories, that should improve, so some opportunity there. On the CapEx guidance, this is really just about better visibility on how spend will come through. A big component of CapEx’s data center builds. Those are large complex projects, so the timing of that spend, we just get better visibility on as the year progresses, but no real change in outlook. We’re continuing to invest heavily in the business. The capital intensity of the business over the last several years had come up, and part of what is driving that are real changes in the business as it relates to our opportunity to deploy capital against things like ads targeting as well as the fact that we’ve seen the user base growth shift to regions like Asia and we’re now building our CapEx to what’s effectively an Asian peak and so that’s a lower ARPU user base. So that does have some impact on capital intensity and part of the driver, where we’re seeing kind of capital intensity increase over the – over the past several years."
},
{
"speaker": "Deborah Crawford",
"text": "Operator, we’re going to take one last question."
},
{
"speaker": "Operator",
"text": "The last question comes from Youssef Squali from SunTrust."
},
{
"speaker": "Youssef Squali",
"text": "Great. Thank you very much. I actually just have one question around regulation. Mark, you’ve been obviously pushing for clearer rules of the road for you and for the other companies to play by. What have been the feedback so far from regulators? How long do you think it’ll take to come to some sort of resolution, especially considering that we’re going into this two-year election cycle? Thanks."
},
{
"speaker": "Mark Zuckerberg",
"text": "Well, one of the things that I’ve been focused on is trying to help develop global frameworks where possible, but the challenge of course, with that is that except in a limited number of cases, regulation typically isn’t global; it’s national. So, I would expect that we’ll see different countries make progress on different timeframes. I had a recent trip, where I was in Berlin and Dublin, talking to a bunch of folks, who are policymakers or academics out there. And certainly, I think people are thinking about all of these issues. And certainly, Europe has led on areas like privacy regulation with GDPR, and is probably further along in thinking about how to think through issues around content regulation and safety as well. I think we’ll see different paces of people doing things in different countries around the world, but a lot of what we hope that we can – that we can contribute to this discussion is as much as possible have shared frameworks for how the industry should operate around the world."
},
{
"speaker": "Deborah Crawford",
"text": "Great, thank you. And thank you for joining us today, we appreciate your time and we look forward to speaking with you again."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today’s conference call. Thank you for joining us. You may now disconnect your lines."
}
] | null | null |
META | 4 | 2,017 | 2018-01-31 17:00:00 | Executives: Deborah Crawford - Vice President of Investor Relations Mark Zuckerberg - Chairman and Chief Executive Officer Sheryl Sandberg - Chief Operating Officer David Wehner - Chief Financial Officer
Analysts: Brian Nowak - Morgan Stanley & Co. LLC Douglas Anmuth - JPMorgan Securities LLC Heather Bellini - Goldman Sachs & Co. LLC Eric Sheridan - UBS Securities LLC Peter Stabler - Wells Fargo Securities LLC Justin Post - Bank of America Merrill Lynch Mark Mahaney - RBC Capital Markets LLC Ross Sandler - Barclays Capital, Inc. Brent Thill - Jefferies LLC Michael Nathanson - MoffettNathanson LLC John Blackledge - Cowen & Company Anthony DiClemente - Evercore ISI Mark May - Citigroup Inc.
Operator: Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook Fourth Quarter and Full-Year 2017 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations. You may begin.
Deborah Crawford: Thank you. Good afternoon and welcome to Facebook's fourth quarter and full-year 2017 earnings conference call. Joining me today to discuss our results are: Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our Quarterly Report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now I'd like to turn the call over to Mark.
Mark Zuckerberg: Thanks, Deborah, and thanks, everyone, for joining us today. 2017 was a strong year for Facebook in many ways. Our community continues to grow with more than 2.1 billion people now using Facebook every month and 1.4 billion people using it daily. Our business grew 47% year-over-year to $40 billion. I'm proud of the progress that our team has made, and the ways that Facebook is helping people around the world. Giving people a voice who didn't have one before, strengthening relationships by helping family and friends stay connected wherever they are, and enabling more than 70 million small businesses to grow and create jobs. But 2017 was also a hard year. The world feels anxious and divided and that played out on Facebook. We've seen abuse on our platform, including interference from nation states, the spread of news that is false, sensational and polarizing, and debate about the utility of social media. We have a responsibility to fully understand how our services are used and to do everything we can to amplify the good and prevent the harm. This is my personal challenge for 2018. One of the most important things we can do is make sure our services aren't just fun to use, but also good for people's well being and for society overall. So far this year, we've already announced a couple of important updates. The first is prioritizing meaningful social interactions over passive consumption of content. Research shows that strengthening our relationships improves our well being. When we use social media to connect with people that correlate to the long-term measures of well being that you'd expect like happiness and health. But passively watching videos or reading articles may not have those same effects. You can think about it this way. When you see a photo from a friend at News Feed, that's not just content that makes you smile or laugh, it's an opportunity to connect with that friend to reach out to them and to remind them that you care about each other. And that connection is deeply important to us as people. But when you see a video or a news articles, even if it's informative or entertaining, unless you start a conversation around it, you're not building a relationship. We've also gotten feedback from our community that these moments that lead us to connect to the unique experience that people want and expect from Facebook. But in the last couple of years, the ecosystem of public content like video, news, and post from businesses has grown massive to the point where it's starting to crowd out the personal connection that people value most. News and video will always be an important part of Facebook. But when people are spending so much time passively consuming public content that it starts taking away from the time people are connecting with each other, that's not good. So let me be clear, helping people connect is more important than maximizing the time they spend on Facebook. As a result of this update, you will now see more content from friends, family, and groups that lead you to interact with people and less public content that leads to more overall time spent. Now as I made clear announcing these changes, I expect the time people spend on Facebook and some measures of engagement will go down as a result. But I also expect the amount we actually interact with each other to go up over time. We are already starting to see this play out. On our last earnings call, I said that video done well can bring people together. But too often today, watching video is just a passive experience. To shift that balance, I saw that we were going to focus on videos that encourage meaningful social interaction, and in Q4, we updated our video recommendations to meet other quality changes to reflect these values. We estimate that these updates decrease time spent on Facebook by roughly 5% in the fourth quarter. To put that another way, we made changes that reduced time spent on Facebook by an estimated 50 million hours every day to make sure that people's time is well spent. That's how serious we are about this. Now we don't normally share time metrics because they're not the best way of understanding engagement. But this shows how committed we are to making sure that the time you spend on Facebook is valuable. Through this process, we've also got the sense of how some updates impact other metrics as well. For example, changes we made to improve quality in the fourth quarter contributed to a decline in people using Facebook daily in some country. By focusing on meaningful interactions, I expect the time we all spend on Facebook will be more valuable and I always believe that if we do the right and deliver deeper value, our community in our business will be stronger over the long-term. In this case, it intuitively makes sense. If people interact more that should lead to a stronger community, and we already know that time in News Feed interacting with people is more valuable than time passively consuming video or news. When you care about something, you're willing to see ads to experience it. But if you just come across a viral video then you're more likely to skip over it if you see an ad. So I want to be clear, the most important driver of our business has never been time spent by itself. It's the quality of the conversations and connection. And that's why I believe this focus on meaningful social interactions is the right one. The second update we announced is about making sure the information you see on Facebook comes from broadly trusted in high quality sources in order to counter misinformation and polarization. And the idea is this update will show more news from sources that are broadly trusted across the community and not only by those who read them directly. For example take the Wall Street Journal or The New York Times, even if you don't read them or if you don't agree with everything they write, most people have confidence that they're high quality journalists. On the flipside, there are blogs that have intense following, but are not widely trusted beyond to their core audience. We will show those publications somewhat less. Preventing false news hate speech and other abused is another important area of focus for us. In order to protect the security and integrity of our platform, we're investing in both people and technology. We now have around 14,000 people working across community ops, online ops, and our security efforts. That's almost double where we were a year-ago. We've also built new technology to detect suicidal posts that have helped first responders reach more than 100 people who needed help quickly and we've built AI systems to flag suspicious behavior around elections in real time and remove terrorists’ content. Thanks to our AI systems, 99% of the ISIS and Al Qaeda related terror content we take down is now removed before anyone even flagged with us. And in some cases before anyone sees it. We've also made progress demoting false news in News Feed, which typically reduces an article’s traffic by 80% and destroys the economic incentives that most spammers and trolls farmers have to generate these false articles in the first place. Finally, we’ve started rolling out a major ad transparent effort. We support Congress passing legislation to make all advertising more transparent. We're not going to wait for them to act. We've already begun launching a way for anyone to view the ad, a pages running on Facebook, Instagram and Messenger, even if they aren't in the intended audience. And we're testing this in Canada first with the goal of rolling it out in the U.S. this summer ahead of the mid-term election. As I said last quarter, I expect these investments on top of other investments we're making will significantly impact our profitability. But just like the changes we're making that will impact time spent these investments will help us build a stronger community over the long-term. Now building a stronger community also means delivering on our product roadmap for the next three, five and ten years. Over the next three years, we know video will continue to grow. So our job is to build a video experiences that help people connect with family, friends and group. That's why I'm excited about Watch as a place to connect with people who have similar interests and why we launch a product like Watch party, where friends can watch a show together. Another important shift that we're seeing across the industry is the growth of Stories. We expect Stories are on track to overtake posts and feeds as the most common way that people share across all social apps. That's because Stories is a better format for sharing multiple quick video clips throughout your day. The growth of Stories will have an impact on how we build products and think about our business, including Whatsapp and Instagram which are the number one and number two most used Stories product in the world. Beyond the video, we have a long roadmap working to help people connect in meaningful ways. Today, more people are using groups than ever. These include smaller groups of friends and family and also larger communities where people connect around shared interests. We are focused on helping more people find the right communities for them and giving group admins and leaders the new tools they need to run these groups and help them grow. The goal of the marketplace is to connect people through commerce. More than 700 million people each month now come to Facebook to buy and sell things. We've launched marketplace in 30 countries last year, including 11 countries in the last quarter alone. Over the next five years, we remained focused on building ecosystems around our services had lots of people already. In Messenger and WhatsApp, we are working to give businesses more ways to communicate with their customers. We launched a plugin for Messengers that people can chat live with companies on their websites, and now more than 2 billion messages are sent between businesses and customers every month. WhatsApp recently crossed 1.5 billion monthly active with people now sending more than 60 billion messages every day. A growing number of these messages are between people and companies, which is why we launched WhatsApp business. A new app designed specifically for small and medium businesses to connect with people they want to reach. Over the next 10 years, we are working on the foundational technologies needed to bring the world closer together. Our goal with AI is to understand the meaning of all the content on Facebook to help us build better services. In addition to making it easier to get people the help they need and remove harmful content, this will also help us show more content that encourages connection and conversation. And on the VR side, we are excited to get Oculus go into people's hands this year. Time Magazine named it one of the top inventions in 2017 and I can't wait for more people to use it. So 2017 was a good year in many ways, but it was also challenging and that's why our focus this year will be making sure that our services are not just fun, but also good for us. And I'm confident that we will rise to the challenge. Thanks to all of you for being part of this journey and I am looking forward to making more progress together. And now, you will here’s Sheryl talk about our business.
Sheryl Sandberg: Thanks Mark, and hi everyone. We had a strong fourth quarter and a great end to the year. Q4 ad revenue grew 48% year-over-year, mobile ad revenue was $11.4 billion, up 57% from last year, and contributed approximately 89% of total ad revenue in Q4. The full-year 2017 mobile ad revenue grew 56% compared to 2016 and was broad-based across regions, marketer segments, and vertical. We continue to make progress on our three priorities; helping businesses, leverage the power of mobile, developing new ad products, and making our ads more relevant and effective. Facebook and Instagram allow people and businesses connect and our especially meaningful platforms for small businesses. Globally 70 million businesses use Facebook. We surveyed small businesses in 18 countries and 57% of them are employing more people due to growth in demand since joining Facebook. Last week, I met Adam of Kings Barbers Club who started with two employees in Birmingham, England and now has 15 salons and 70 employees. I also met Domingo from Pescaria, a restaurant in Southern Italy that uses Facebook and Instagram to connect with customers. 80% of their diners and 70% of their revenues comes from Facebook. They opened their second restaurant and now employ more than 60 people. Like Adam and Domingo, small business owners are some of the most dedicated entrepreneurs and they are the heart of every economy and create the majority of new jobs throughout the world. As Mark said, we are taking strong action to maximize the good we do in communities. As part of this we are investing heavily in small businesses and in helping people gain digital skills. In November, we launched our community-based program which provides digital training for people in need of work and helps local businesses and non-profits get the most out of the Internet. During my trip last week, I announced that we are expanding the program to the EU. This year, we will visit more than 30 cities in the U.S. and Europe to work side by side with SMBs, start-ups and NGOs. Over 2 million people and businesses have already used our online and offline training, and by 2020 will have trained 1 million people and businesses across Europe alone. As people and businesses shift to mobile, Instagram continues to grow quickly. There are more than 2 million active advertisers on Instagram and we announced in November that more than 25 million businesses have profiles on Instagram up from 15 million in July. Instagram is a business as mobile visual shop and we're seeing more people seek out businesses there. About two-thirds of the visits to Instagram business profiles are from people who don't follow them and this is helping bring in new customers. Our second priority is developing innovative ad products, each year mobile advertising reaches new milestones during the holiday shopping season. A year-ago, we saw a mobile conversion action taken on a mobile website after viewing an ad on Facebook surpassed desktop conversions for the first time. In 2017 mobile conversions continue to accelerate. Data from 17 markets shows mobile accounted for 69% of online conversions on Black Friday and 64% on Cyber Monday. It also shows 80% of conversions on Singles' Day, a popular day for online shopping in China and increasingly other countries. Big shopping days like these are the kind of global events that Facebook and Instagram are uniquely positioned to support. During these events and throughout the year, businesses are using our innovative ad products like dynamic ads to connect and reconnect with shoppers. For example, Holiday Inn Express recently used dynamic ads for travel with our collection formats to advertise to people who search for hotels on their website, but hadn't yet booked. They ran ads with a video that showed a personalized selection of hotels for the city and dates people have looked up. This resulted in three times higher return on ad spend then their previous campaigns. In Q4 we also launched dynamic ads for auto, which allows dealers and manufacturers to show the right cars to the right audiences. As we expand and improve our ad products advertisers are increasingly developing mobile first ads rather than simply taking their TV creative and putting them online. Mobile first video was 50% of our video ad revenue this quarter up from 41% last quarter. We're seeing the short form videos work well and Instagram Stories were people can watch a full-screen vertical video and swipe up to quickly learn about a product or brand. 60% of these ads are viewed with sound on. Recently open table used Instagram Stories to advertise their reservation service to U.S. adults, who are frequent diners or are interested in dining. They combined food and restaurants footage of the book now button. Their ads reached 1.5 million people and achieved 33% lower costs per reservations and their other campaigns. We’re making it easier for any advertiser to try Stories ads as part of their other campaigns on our platform. Our third priority is making our ads more relevant and effective. Targeting makes advertising better more relevant to people and more effective for businesses. This is especially important for small businesses and they had limited budgets and need to make every dollar counts. Facebook give small businesses the same powerful tools that were previously only available to large advertisers. So they can reach the right people at the right time. For example, we're continuing to invest in value optimization, which helps advertisers show their ads to people who are likely to spend more with them. We've been gradually rolling this out to advertisers using web conversion dynamic ads and mobile app, install app. Their early results are promising over 2500 businesses have tried value optimization since June and many are putting more of their budgets toward it. We take our responsibility to prevent abuse of our ad system very seriously. And we're investing heavily in both people in technology to protect the integrity of our platform. In addition to rolling out the ad transparency tool in Canada that Mark mentioned, we've disabled the option that less advertisers exclude people and specific multicultural affinity segments until we can develop better safeguards against discrimination. We're also focused on improving ad quality and delivering a better experience for people who interact with marketers on our platform. This holiday, we took additional steps to penalize e-commerce advertisers, who created misleading or negative ads. In 2018, we will continue to focus on our same three priorities and do more to ensure the quality transparency and authenticity of ads in our platform. As part of our effort to be more transparent, last quarter we published our advertising principles, which have long guided our approach across all of our platforms. These principles are commitment to the people who use our services. They are we build for people first. We don't sell your data. You can control the ads you see. Advertising should be transparent. Advertising should be safe and civil. It should not divide or discriminate. Advertising should empower businesses big and small and we're always improving our advertising. As Mark said, 2017 was a challenging and important year for Facebook, a year where we committed to increasing our investment in the safety and security of our community, it was also a strong year for our business where our investments in helping our clients grow payoff. We will continue to make all of these investments in 2018 and in the coming years. I'm thankful to our partners around the world and to our employees who work so hard to make us better every day. Thanks. And now here's Dave.
David Wehner: Thanks Sheryl, and good afternoon, everyone. Q4 was a strong quarter for Facebook and a great end to the year. Full-year 2017 total revenue grew 47% over $40 billion and we generated over $17 billion of free cash flow. Let's begin with our community metrics. Overall our global community is strong and growing. Daily active users on Facebook in Q4 reached 1.4 billion, up 14% compared to last year, led by growth in markets like India, Indonesia and Brazil. This number represents approximately 66% of our 2.13 billion monthly active users in Q4. MAUs were up $269 million or 14% compared to last year. As Mark mentioned certain product quality changes impacted our DAU growth. In the U.S. and Canada, these changes contributed to a DAU decline of 700,000 compared to Q3. We don't see this is an ongoing trend, but we do anticipate that DAU in this region may fluctuate given the relatively high penetration level. We continue to see healthy growth across the Facebook family of apps including Instagram, WhatsApp and Messenger. Turning now to the financials, all comparisons are on a year-over-year basis unless otherwise noted. Q4 total revenue was $13 billion, up 44% or 47% on a constant currency basis. Foreign exchange tailwinds contributed $329 million of revenue in Q4. Q4 total ad revenue was $12.8 billion, up 48% or 44% on a constant currency basis. Mobile ad revenue was $11.4 billion, up 57%. In Q4 the average price per ad increased 43% and the number of ad impressions served increased 4%, driven primarily by feed ads on Facebook and Instagram. Payments and other fees revenues was $139 million, up 7%. Total expenses in Q4 were $5.6 billion up 32%. Headcount remains a primary driver of total expenses. In Q4 we added approximately 1,900 people and ended the year with over 25,000 employees, up 47% compared to last year. In 2017 we made significant investments in R&D and security. On the R&D side, we added more people in 2017 than we did in 2016 and 2015 combined. On the security side, as Mark mentioned, we have accelerated our efforts and at the end of the year had around 14,000 employees and contractors working across community operations, online operations and integrity efforts. We also continue to invest aggressively in key areas such as content and our long-term innovation efforts. Q4 stock-based compensation expenses were $814 million, which was down from the $831 million in Q4 of last year, due to a decline in deal related stock-based compensation expenses. As a reminder, we acquired Oculus and WhatsApp in 2014 and we expect the deal related SBC expenses to be substantially recognized by the end of 2018. Q4 operating income was $7.4 billion representing a 57% operating margin. Our effective tax rate was 43%. In Q4, we recorded net approximately $2.3 billion in one-time charges as a result of the 2017 Tax Cut & Jobs Act. That was largely driven by the mandatory transition tax based on the accumulated earnings from our foreign subsidiaries. Net income was $4.3 billion or $1.44 per share. Again the one-time charges related to the tax on accumulated earnings reduced EPS by approximately $0.77. Full-year 2017 capital expenditures were approximately $6.7 billion, driven by investments and servers, data center, offices facilities and network infrastructure. In 2017, we generated over $17 billion of free cash flow and ended the year with nearly $42 billion in cash and investments. In 2017, we brought back approximately $2 billion of our Class A common stock and had approximately $4 billion remaining in our current authorization as of December 31. We remain committed to repurchases of our stock to help manage dilution. Turning now to the revenue outlook. We believe we have good opportunities to grow the business across both Facebook and Instagram in 2018. We continue to improve the effectiveness of our ads which helps drive ROI for advertisers and demand for our ad products. On the supply side, we expect we will be able to continue to grow ad impressions at a modest space. In 2018, we expect constant currency ad revenue growth rates to decelerate consistent with the trends that we have seen over the past year. I would also note that in the first half of 2018, we will likely benefit from favorable exchange rate tailwinds due to the recent depreciation of the dollar. Moving on to expenses. We continue to expect full-year 2018 total expenses will grow approximately 45% to 60% compared to full-year 2017. Turning now to CapEx. We expect that our full-year 2018 capital expenditures will be in the range of $14 billion to $15 billion driven by increased investment in data centers, servers, office facilities and network infrastructure. We currently anticipate that our full-year 2018 tax rate will be in the mid-teens. In summary, 2017 was another good year for Facebook. We continue to grow our global community and deliver great results for our advertisers. Importantly, we accelerated our investments to make our products better and the community stronger as we push forward on our mission of giving people the power to build community and bring the world closer together. With that, Mike let's open up the call for questions.
Operator: We will now open the lines for a question-and-answer session. [Operator Instructions] Your first question comes from the line of Brian Nowak with Morgan Stanley.
Brian Nowak: Thanks for taking my questions. I have two. The first one, the quality changes that you mentioned that led to an impact on daily active users in North America. I guess any further detail on what those quality changes were and what makes you feel comfortable this isn't likely to continue? I think you may need to make further changes and cleanup throughout the course of the year? And then the second one, Mark, I thought your commentary on Stories engagement was really helpful. I'd be curious to hear about early learnings on monetization of the Stories format and any challenges you made to overcome to drive monetization through that consumption? Thanks.
David Wehner: On the quality changes on the impact on DAU in the U.S. and Canada, really no further I think elaboration on that. I would just say that we don't anticipate that that will be a continuing trend, but given the high penetration rates, we do think they'll be some fluctuation there. There's a lot of different effects that come from the different quality changes and focus on meaningful social interactions, but that's our expectation at this point.
Sheryl Sandberg: On story monetization, ads in Stories on Instagram is a small, but quickly growing part of our revenue. There are 300 million daily actives on Instagram alone, and the format is pretty exciting from a sales point of view because it has a lot of potential. Its full screen is authentic, it’s very engaging. So the opportunity in the future for us to combine the power of this new format with the targeting and measurement we offer, we think it’s going to be really powerful for both our business and the business of our clients. It's early days, but I'm pretty optimistic about this.
Operator: Your next question comes from the line of Doug Anmuth with JPMorgan.
Douglas Anmuth: Thanks for taking the question. First, Mark you made it pretty clear that driving meaningful social interactions is the Company's top priority this year, but can you talk a little bit about how the changes you're making impact advertising and maybe you can talk about how you're thinking about any changes around ad load or just overall impression volume? And then how the ads work in an environment of more friends and family content in an environment where you don't see as many business posts? And then secondly, can you talk about GDPR as well. I don't think you mentioned it, but just curious, I mean you put the blog post out the other day, but if you could talk about how you're preparing here, so that's a rollout over the next few months and whether you think that presents any risk to either engagement or monetization? Thanks.
David Wehner: Hey Doug, it’s Dave. I'll start off on the impact on the business. The biggest focus – the biggest impact of the focus on meaningful interactions as Mark mentioned will be in areas like passive video, where from a business perspective, we monetize less on a time spent basis. So if you think about it in terms of things like post views in News Feed, which drives impression growth that we think this will have less of an impact, and so that's sort of built in to what I had said about the business commentary when I commented on 2018 revenue outlook. We still believe we have an opportunity to grow impressions at a modest space year-over-year across the platform.
Sheryl Sandberg: When I think about the MSI changes, obviously any change that's beneficial for our community is good for the long run health of our business, because as Mark said, we care not just about time spent on Facebook, but time well spent. But even in the shorter-term all time spent on Facebook is not equal, because when people spend time viewing more posts because they're interacting with family and friends and they're not involved in longer post. We have actually more monetization opportunities. We're not doing this to be positive or negative for revenue. We're doing this because is the right thing for our community. But the impact that has on monetization is certainly not clearly negative. When you think about GDPR, the Facebook family of apps already applies the core principles in GDPR frame, which are transparency and control and we are building on this to make we’re ready to fully comply by May. We're going to continue to give people are personalized experience to be clear about how are using the data and give choices and we realize that this means that some users might opt out of our ads targeting tool. We also know that there may be a DAU impact for implications on European usage. But from the targeting, we're not forecasting a big impact here. There's some risk and more watching closely. Over the long run, we feel confident that we're very well placed to navigate the transition.
Operator: Your next question comes from the line of Heather Bellini with Goldman Sachs.
Heather Bellini: Great. Thank you. I had two questions. One, I was just wondering what the advertiser response is then to the lower engagement and also just the kind of I guess cleaning up of the News Feed if you will. What’s kind of there view on this and also can you share with us any metrics on Watch and I know it's really early, but anything that interesting from an engagement perspective here and kind of how do you think this could evolve? Thank you.
Sheryl Sandberg: On the DAU impact any Advertiser response our business is strong. We have over 184 million people using Facebook everyday in the U.S., which is considerably more than the Super Bowl every day on mobile alone. We also have – we think the best stability to target and make advertising relevant for businesses and people who see ads. We're continuing to build the products that allow businesses to get a higher return for the dollars they spend and allow people to see more relevant information in ads on our platform. So we're pleased with the growth and we believe that that delivering the strong quarter we have shows that. On Watch, it’s just early days. We have a dedicated place for people to watch and comment, where heavily focused on the social aspects of video viewing, but it’s too early to report any really findings.
Operator: Your next question comes from the line of Eric Sheridan with UBS Securities LLC
Eric Sheridan: Thanks for taking the question. Maybe following up on the team around engagement and the changes on product. First, how would be defining success? What will you be watching for in terms of either the time spent on the platform or the user growth on the platform or relative engagement to say that you've got the mix right and that people are seeing the right of content and have a healthy experience with Facebook over the next couple of years? That will be number one. And number two, Dave with respect to the OpEx and CapEx, given the incentive of the company to get a lot of things right on the security side and with repositioning products. Should we expect there to be a different cadence this year in terms of the investments the company might maybe more first half versus second half. Just one note there was any color there? Thank you so much.
Mark Zuckerberg: I can take the first point about meaningful social interaction. So the product directive that I've given to all of our teams is to shift from focusing on showing the most meaningful content to people to instead to now encouraging the most meaningful social interaction. So that will first take hold as the series of News Feed changes, but over time there are going to be new products that we build new interfaces that the team is designed with the goal of encouraging interactions between people. So the thing that we're going to be measuring is basically the number of interactions that people have on the platform and off because of what they're seeing that they report to us is as meaningful. One interesting thing that I think is worth being clear about in terms of how we develop News Feed. I think that there's this myth that we design News Feed in order to just optimize for time or for likes or comments or some signals like that. The reality is the way we've done this for years is we've had a panel, a survey of thousands of people who basically we asked what the most meaningful content is that they had seen on the platform or that they've seen off the platform and we design our systems in order to be able to get to that ground truth of what people – real people are telling us is that high quality experience. So now we're going to shift that that methodology a little bit to instead of just being focused on the content, now to be more focused on trying to measure and have people tell us what is creating the most meaningful interaction in their lives. We're not just on Facebook. It could be a message that you have on Messenger or Whatsapp. But it could also be that you see something on Facebook and have a conversation about that in the world with someone who's meaningful to you and the next to me that we need to understand that. But that's basically what where we're going to be moving all of these systems towards over the next period of time. And its not just can be one News Feed change that happens overnight. It will be a series of rollouts and then a number of product changes that go to the interface of the products and things that we launch within that as well.
David Wehner: And then Eric, you had a question about, how we might expect expense growth to progress through the year? There is no specific one item that's going to drive it. So we would expect expense growth to ramp throughout the year, largely due to the factors that we've talked about on prior calls in terms of what's driving the overall acceleration. There's the continued investment on the security front. We talked about that in both Mark's comments and my comments and we're continuing to ramp that investment. We are continuing to invest to support the video strategy on Watch. So we would expect that content investment to continue and ramp. And then finally we're continuing to invest in the long-term initiatives in areas like AR, VR, AI and connectivity. So across the board, we would expect expense growth ramp throughout the year.
Operator: Your next question comes from the line of Peter Stabler with Wells Fargo Securities.
Peter Stabler: Thank you. Two if I may, one for Dave and one for Sheryl. First of all for Sheryl, wondering if you could update us on the search opportunity given the rapid growth of product advertising on the platform. Is there an opportunity for Facebook to transition from more of a demand generation platform to demand fulfillment? And then for Dave, can you give us a sense of the timing of the changes to the News Feed? Is this of fully completed rollout were there different cohorts that saw it first? Was there any regional phasing or anything like that? Thank you.
David Wehner: Yes, Peter. I'll take the second part first. We began to make changes around a number of different quality initiatives in the fourth quarter, so that affected metrics that we've talked about including both the time spent and the DAU. But we continue to make changes to improve and to optimize around driving meaningful social interactions as Mark talked about. That's going to be an ongoing journey throughout the year. So there's no – I don't think we ever are going to declare that we are done making changes. So I'd expect we would continue to make changes and evolve.
Sheryl Sandberg: On the search opportunity, there's a growing number of searches on Facebook, but we're still a ways off from monetization. It's worth noting though that because of our ads targeting our ability to reach people multiple times. We do believe that some of our ad success is taking people from demand generation through demand fulfillment. So we have multiple clients who will show an ad, a video ad to everyone in the U.S. for example or to a big cohort of people and then they'll follow up with an ad that target on either Instagram or Facebook to people who engage with that first that then they can follow up with the next team and we are seeing as businesses are increasingly measuring your ad spend in terms of their real ROI for sales that even within our own platforms. We can move people down that marketing funnel from demand generation to demand fulfillment.
Operator: Your next question comes from the line of Justin Post with Bank of America Merrill Lynch.
Justin Post: Great, thank you. Dave, maybe you can talk a little bit about the sustainability of the pricing growth that you're seeing with advertising. Obviously your outlook for next year suggest decelerates modestly, but it's certainly a very high level and talk a little bit about that. And then maybe Mark or Dave, just talk about how the Watch tab is evolving? Are you seeing a lot of usage there? And how do you think about content in the Watch tab versions the News Feed? Thank you.
David Wehner: Yes. Sure, Justin on pricing growth, I think there we feel like we're making good progress in our goal of driving better outcomes in ROI for our advertisers through things like better targeting, better ad units, driving better conversion, and we think we're making good progress there, and the willingness of advertisers continue to grow budgets with us I think highlights our progress there. You remember they are optimizing at the end of the day for business results for a given dollar spent not the impression price that we're kind of nominally reporting here. So you can think of all of this work and Sheryl talked about the value optimization efforts as part of that as being an effort to improve the yield of the impressions that we have to drive downstream business results for advertising partners. And if we can drive those affectively that will translate into higher effective prices for our business. And as I mentioned, I think we believe we still have a lot of work to do to continue to improve that. So we think there's opportunities here.
Mark Zuckerberg: And for Watch, it's early, there are some promising signs, but in terms of how we think about this overall compared to News Feed. I would say it's really important to internalize that the News Feed video ecosystem and the Watch video ecosystem are almost completely separate things, right. So the Watch behaviors that we're building is one where people come intentionally to watch specific videos and to interact with the community around that. That's in contrast to what we worry is too passive consumption of an experience in News Feed today where people just happen to often see a video and maybe they'll watch it for a few minutes, but may not interactive around as much in News Feed. So we're still very optimistic long-term that Watch will be used for video that helps to bring people closer together and that will correlate with all the things that our community is telling us they want and that correlate with the measures of wellbeing that we think that social products can generate by helping people build relationships in terms of all the long-term measures of wellbeing that we care about like long-term happiness and health et cetera.
Operator: Your next question comes from the line of Mark Mahaney with RBC Capital Markets.
Mark Mahaney: Thanks. Two questions please. European advertising revenue growth or your ad revenue growth in Europe accelerated, is that just currency or anything else you would call out there? And then you talked about progress in moving away from kind of demand or creation towards demand fulfillment or including demand fulfillment. And I was wondering if you could give any more examples of that? And Sheryl, two years ago or so you mentioned Booking.com being on the platform. I still think those OTAs, based on our work, are still doing like 10x as much spend on Google. So there's a real opportunity versus Facebook. Are there other examples or any other evidence you can show or talk about that that companies are really finding the ability to do demand fulfillment on Facebook and what's caused that to change? Thanks a lot.
David Wehner: Let me just quickly hit on the constant currency question I think you had at the beginning Mark. The acceleration we saw from Q3 to Q4 was currency for Europe, but Europe continues to grow at a very healthy pace on a constant currency basis, so we're very pleased with the results both in constant currency terms and nominal terms. And then Sheryl.
Sheryl Sandberg: So to take the first question, the EU, the strength in Europe was driven by SMBs. We grew across the board with large companies too, but SMBs were really important for this. There are 18 million small businesses on Facebook in Europe, and I had a chance to meet a lot of them on my trip. But to mention just one which shows the point, a couple named Linda and Marius started a company called iELM. They’re a kids clothing retailer. They started in Sweden on Facebook. She was selling clothes in her living room and selling them. Facebook is driving about half their sales. They then opened a factory in Romania and moved back to Romania, where they're now employing 100 people and they're shipping across Sweden, Romania, Germany, and Austria. There's still a small business at 100 people, but they are a growing business and showing the power of how our work with SMBs is growing jobs. You're asking also for an example of a demand generation going all the way down to demand fulfillment. Here's another one from Europe. Gymshark is a fitness clothing brand based in the UK. They ran Facebook video ads and Instagram Story ads for their Black Friday Campaign and then they target with a look a like people who had previously purchased and custom audiences that people who started, but then complete the purchase. And they saw 9.3 times return of investment over the two week holiday period. What happens on our platform is often that people will start out during demand generation and then use the repeat opportunity to show people ads, moving down the funnel to demand fulfillment. If you use our targeting tools well, you can actually start out with demand fulfillment. So some of these examples I've shared on this call from holiday end to Gymshark are about people using the targeting tools to find the people who are interested in the products and then you can get closer and down the funnel to demand fulfillment.
Operator: Your next question comes from the line of Ross Sandler with Barclays.
Ross Sandler: Hey, guys, just two questions Mark, first on the topic of passive versus active consumption. Can you talk about what percent of the DAUs actively contribute today versus just moving back passive consumption? And how has that ratio maybe changed versus five years or 10 years ago based on some of the product changes that you had in News Feed? And then Dave just follow-up on pricing, so with the bunch of noise given the growth rates of desktop versus mobile, can you just talk about what pricing growth looks like in mobile like for like geography basis? Is that 20%, 30%, any color there would be helpful? Thank you.
David Wehner: Yes. Ross, I guess I'll take both. Yes, we don't break out the type of metric that you're talking about on the passive versus active consumption. So we don't have anything specifically to share there. In terms of breaking out pricing on a mobile basis. I mean I think overall that the trends reflect a generally what's happening on mobile, but there is still an overlay of a shift from desktop. But overall, we are seeing prices increase on mobile in region, so I think that's consistent with the reported trend.
Operator: Your next question comes from the line of Brent Thill with Jefferies LLC.
Brent Thill: Thank you. On Instagram I'm just curious if you give a little more color on the progress you're seeing, any metrics to help fill in what's happening there?
David Wehner: We continue to be pleased with the growth of Instagram both on a user basis and on a revenue basis. It continues to make an increasing contribution to the business. So we're very pleased with the Instagram result, nothing specifically to highlight from a metrics point of view.
Sheryl Sandberg: On the business side, I think we have both pleased with the results. We see a very big opportunity in front of us. We have 6 million advertisers on Facebook, which means we have a lot of opportunity on Instagram, where we only have 2 million advertisers to grow their engagement with us and their spend.
Operator: Your next question comes from the line of Michael Nathanson with MoffettNathanson.
Michael Nathanson: Thanks. I have one for Mark on news trustworthiness and then group on sports. So Mark, I realize you're taking great pains not to play the role of the news editor on your platform. You're asking users about trustworthiness, but I wonder does that pick up biases in our own stores of what we believe to be trustworthy and how do you get past that? And then would it make sense just simply you play the role of pipelining a new News Feed, maybe its own tab with news that we all believe – we believe to be trustworthy. So at some point you take a more active role in identifying the news that your platform believes to be real news and maybe create a new tab that ways. Is that ever something in your thinking?
Mark Zuckerberg: The value that we care about here is helping to build common ground. Right and helping to do our part to fight off news and polarization. So what we're doing. With this specific change which is one of a number of News Feed changes that are geared at improving the quality and trustworthiness of news on Facebook. What we basically ask people we don't want to assess by ourselves which sources are trustworthy. I think that's not a situation that our position that we're comfortable with ourselves. And I don't think personally that that's something that our community or our society wants us to do. So for all of the feedbacks that we get that we should take more of a view on that, I actually – I don't believe that that is the right thing broadly. What we try to do is get our community to tell us what matters to them, because we believe that we can get an accurate signal from the community then – people are smart. They know what they want and what's good and they can tell us that, if we can ask them in a simple enough way and get aggregate data. So what we're doing here is we basically are just asking people, if they're familiar with news sources and whether they trust them. And the effect of that is that it basically normalizes for – there are going to be people who read a given news source, who will probably trust it because they read it. But the question is that the people who don't read it, who are still familiar with it, do they think it's trustworthy, and that's the example that I gave before the Wall Street Journal or New York Times. A lot of people read those, a lot of people don't, but the people who don't still think that they're high quality journalism in general. And that's not true for a lot of the other stuff that's out there. And we've found that that's the reliable signal of content that helps to build common ground that is unlikely to be polarizing, that is unlikely to be false news, and what we're doing is helping to show that a little bit more. Again, we're not going to tell you that you can't share other stuff, right. You can share it on the platform. People can go to your profile. But in News Feed, we're going to just show that a little bit more to do what we view as our role is helping to build common ground, encounter some of these other forces in the world.
Michael Nathanson: Okay.
Sheryl Sandberg: On this sports answer, sports is one of the ways that people get together on Facebook and build community. We're excited to bring the UEFA Champions League Soccer and College Basketball to Facebook, and we're going to continue to experiment with developing many different forms of content for Facebook.
Operator: You next question is from the line of John Blackledge with Cowen.
John Blackledge: Great, thanks. Two questions, on marketplace with the expansion to 30 countries, just wondering how the business model evolves over time, does it kind of mirror Amazon’s third-party business or eBay’s marketplace business? And then just on ad units, on the mid-roll video ad units. Just wondering I know it's early, just any color on the ad demand and perhaps how you think about the impact to this ad unit for the next couple of years? Thank you.
Sheryl Sandberg: On marketplace, we're just going to continue to iterate on the ad test. We're pretty encouraged by what we've seen even though it's pretty early days. What we're excited about is that our business is helping people connect with things they want to buy. It's also important to note that commerce is a really important vertical in our ad business. So it's not just the commerce is being driven in ads in marketplace. But in a much bigger way, commerce discovering product all the way, through to sales is a big part of what's driving our ads business. On Ad Breaks for mid-roll video, early days pretty good result, more than 70% of Ad Break up to 15 seconds in length on Facebook and Audience Network are being viewed to completion. Most are being viewed with the sound on. But again it's very early for this.
Operator: Your next question is from the line of Anthony DiClemente with Evercore ISI.
Anthony DiClemente: Thanks for taking my questions. Sheryl, just hoping you could help us think about how marketing budgets grow as retail moves online. So investors we speak to ask the question about the addressable market for Facebook. Is the addressable market running out of opportunity as the platform gets larger? So do you believe the overall ad market or the TAM is possibly experiencing structural expansion, due to a shift in e-commerce overall? And then Mark, I wanted to ask about AI. Can you just talk about the broader applications of the technologies that you are investing into improve the user experience and safety on the platform. So I understand you're using AI to improve the quality of the experience and engagement, but should we be thinking about these investments as also enabling new features and products over time, whether it would be shipping hardware or custom chips or potentially AI as a service externally? Thanks.
David Wehner: Anthony, on the on the marketing budgets, we continue to think we've got great opportunities to grow in the large global advertising market. When you get sort of down to the micro level, you talked about e-commerce. E-commerce is and remains and was one of our strongest verticals in Q4, and we think we're doing an excellent job of building the right products for e-commerce retailers. And Sheryl talked about value optimization and that sort of work that we're doing, and so I think we've got continued opportunities with e-commerce going forward. So I think we're very well positioned in the e-commerce space. On AI?
Mark Zuckerberg: Yes. I can talk about AI. So machine learning is – the improvement there are by far the largest technological trends that we're seeing in the industry and across the business. And we really see it in three ways, right. The first and most tactical or just the optimization to everything that you see, right, from ranking in News Feeds, your ranking of ads or search, or improving our security systems, and that's driving a lot of the business and the quality improvement that we're seeing and that's really important. The second category, I would call qualitative changes and how we do business. So for example, for News Feed, historically all the content that's been a News Feed has been content that you're connected to, right. You become friends with someone or you follow a page and then their content can show up a News Feed, but long-term or not even long-term, right. Over the next several years as we develop an understanding of all of the content on Facebook that won’t be a constraint anymore. At some point, we're going to be able to just understand the meaning of all the content that hosted that you could potentially see and use that as candidates to potentially improve your experience and make it that you could see way more content that you might be able to today to – and of course, we'll do that to help encourage more social interaction. The way that this is improving the work that we're doing around security and integrity is also very fundamental. Today, that whole model is that people can post what they want and then a person can flag it, and then our systems will look at it. But increasingly as we move into the future, we're going to be able to proactively take down some negative content. I gave the example of the terrorism-related content and some things around suicidal post where if someone posts something that they're thinking about suicide. Now today, we don't have to wait for someone to report it a lot of the time. In the last few months, there have already been more than 100 instances where we've been able to reach out and get in touch with first responders that they can give you people the help that they need, and that's a big structural change in the way that we do business in terms of protecting the security and integrity of our community. The third major category is going to be completely new products and platforms. So there we talked about all the things that we're building around VR and AR and the ability to be present with anyone, anywhere. And certainly AI is going to be a big part of that both on the vision side and the voice side. And there are going to need to be big advances there, but that's really exciting. But I think in each of those three categories, the optimization, the upgrading how we do business, and really changing how that works in our products today, and then the new products. I would say that improvements in machine learning are the most important technological trends in the industry now by far.
Sheryl Sandberg: Operator, we have time for one last question.
Operator: Your last question comes from the line of Mark May with Citi.
Mark May: Thanks a lot. I just wanted to ask a follow-up question regarding Mark's comments that user engagement had declined by I think 50 million minutes in – daily hours in the quarter. I guess the question is how confident are you that that impact was due to News Feed changes that you made proactively versus some other factor outside your control, and if you are still fairly early in the process of making these quality improvements to the News Feed, do you expect for engagement declines to continue going forward? And just for Dave, I know you choose your words carefully, just want to clarify, you mentioned this year you expect constant currency ad revenue growth to decelerate consistent with trends that we've seen in the last year. I think your constant currency growth rate in 2017 declined by about 12 percentage points. Is that kind of what you're trying to lead us towards? Thanks.
David Wehner: I can take the second question first, Mark. I think what I am trying to say is that we do expect constant currency revenue growth to continue to decelerate consistent with steady deceleration that we've seen over the past year, so we do expect that trend to continue. I'm not putting specific percentages around it.
Mark Zuckerberg: So in Q4, we made a number of quality changes that were largely around video. We are going to continue to make quality changes now going forward around meaningful social interaction. And I do think that that is likely going to continue this trend of decreasing passive consumption, but if we do our jobs well, it should increase the number of meaningful interactions that people have. And we think that that's going to be positive, right. So we think it'll help make the community stronger over the long-term. I mean we think it'll be good for the business over the long-term, but this is what people are telling us is what they want on the product. It's the unique value that people expect from Facebook. You can go to a lot of places to consume content, but there aren't a lot of services where you can strengthen your relationships, that's what people want, so that's the right thing for us to focus on, and it also lines up with all the well being research that we've done which – and as you know, there have been a lot of debate over the last year about the utility of social media on the Internet, and we take this very seriously, right. It's our responsibility, too, to make sure that we understand everything that's going on on our platform. And one of the big takeaways from that is that time when people are engaging and building relationships, is good time and that correlates with all the aspect of long-term well being that you'd expect like happiness, and health, and feeling more connected and feeling less alone, and in all of the things that qualitatively matter in our lives. And we think that we can help drive that and improve people's lives by doing that, so we're absolutely going to go do that. End of Q&A
Sheryl Sandberg: Great. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again.
Operator: Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines. | [
{
"speaker": "Executives",
"text": "Deborah Crawford - Vice President of Investor Relations Mark Zuckerberg - Chairman and Chief Executive Officer Sheryl Sandberg - Chief Operating Officer David Wehner - Chief Financial Officer"
},
{
"speaker": "Analysts",
"text": "Brian Nowak - Morgan Stanley & Co. LLC Douglas Anmuth - JPMorgan Securities LLC Heather Bellini - Goldman Sachs & Co. LLC Eric Sheridan - UBS Securities LLC Peter Stabler - Wells Fargo Securities LLC Justin Post - Bank of America Merrill Lynch Mark Mahaney - RBC Capital Markets LLC Ross Sandler - Barclays Capital, Inc. Brent Thill - Jefferies LLC Michael Nathanson - MoffettNathanson LLC John Blackledge - Cowen & Company Anthony DiClemente - Evercore ISI Mark May - Citigroup Inc."
},
{
"speaker": "Operator",
"text": "Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook Fourth Quarter and Full-Year 2017 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations. You may begin."
},
{
"speaker": "Deborah Crawford",
"text": "Thank you. Good afternoon and welcome to Facebook's fourth quarter and full-year 2017 earnings conference call. Joining me today to discuss our results are: Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our Quarterly Report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now I'd like to turn the call over to Mark."
},
{
"speaker": "Mark Zuckerberg",
"text": "Thanks, Deborah, and thanks, everyone, for joining us today. 2017 was a strong year for Facebook in many ways. Our community continues to grow with more than 2.1 billion people now using Facebook every month and 1.4 billion people using it daily. Our business grew 47% year-over-year to $40 billion. I'm proud of the progress that our team has made, and the ways that Facebook is helping people around the world. Giving people a voice who didn't have one before, strengthening relationships by helping family and friends stay connected wherever they are, and enabling more than 70 million small businesses to grow and create jobs. But 2017 was also a hard year. The world feels anxious and divided and that played out on Facebook. We've seen abuse on our platform, including interference from nation states, the spread of news that is false, sensational and polarizing, and debate about the utility of social media. We have a responsibility to fully understand how our services are used and to do everything we can to amplify the good and prevent the harm. This is my personal challenge for 2018. One of the most important things we can do is make sure our services aren't just fun to use, but also good for people's well being and for society overall. So far this year, we've already announced a couple of important updates. The first is prioritizing meaningful social interactions over passive consumption of content. Research shows that strengthening our relationships improves our well being. When we use social media to connect with people that correlate to the long-term measures of well being that you'd expect like happiness and health. But passively watching videos or reading articles may not have those same effects. You can think about it this way. When you see a photo from a friend at News Feed, that's not just content that makes you smile or laugh, it's an opportunity to connect with that friend to reach out to them and to remind them that you care about each other. And that connection is deeply important to us as people. But when you see a video or a news articles, even if it's informative or entertaining, unless you start a conversation around it, you're not building a relationship. We've also gotten feedback from our community that these moments that lead us to connect to the unique experience that people want and expect from Facebook. But in the last couple of years, the ecosystem of public content like video, news, and post from businesses has grown massive to the point where it's starting to crowd out the personal connection that people value most. News and video will always be an important part of Facebook. But when people are spending so much time passively consuming public content that it starts taking away from the time people are connecting with each other, that's not good. So let me be clear, helping people connect is more important than maximizing the time they spend on Facebook. As a result of this update, you will now see more content from friends, family, and groups that lead you to interact with people and less public content that leads to more overall time spent. Now as I made clear announcing these changes, I expect the time people spend on Facebook and some measures of engagement will go down as a result. But I also expect the amount we actually interact with each other to go up over time. We are already starting to see this play out. On our last earnings call, I said that video done well can bring people together. But too often today, watching video is just a passive experience. To shift that balance, I saw that we were going to focus on videos that encourage meaningful social interaction, and in Q4, we updated our video recommendations to meet other quality changes to reflect these values. We estimate that these updates decrease time spent on Facebook by roughly 5% in the fourth quarter. To put that another way, we made changes that reduced time spent on Facebook by an estimated 50 million hours every day to make sure that people's time is well spent. That's how serious we are about this. Now we don't normally share time metrics because they're not the best way of understanding engagement. But this shows how committed we are to making sure that the time you spend on Facebook is valuable. Through this process, we've also got the sense of how some updates impact other metrics as well. For example, changes we made to improve quality in the fourth quarter contributed to a decline in people using Facebook daily in some country. By focusing on meaningful interactions, I expect the time we all spend on Facebook will be more valuable and I always believe that if we do the right and deliver deeper value, our community in our business will be stronger over the long-term. In this case, it intuitively makes sense. If people interact more that should lead to a stronger community, and we already know that time in News Feed interacting with people is more valuable than time passively consuming video or news. When you care about something, you're willing to see ads to experience it. But if you just come across a viral video then you're more likely to skip over it if you see an ad. So I want to be clear, the most important driver of our business has never been time spent by itself. It's the quality of the conversations and connection. And that's why I believe this focus on meaningful social interactions is the right one. The second update we announced is about making sure the information you see on Facebook comes from broadly trusted in high quality sources in order to counter misinformation and polarization. And the idea is this update will show more news from sources that are broadly trusted across the community and not only by those who read them directly. For example take the Wall Street Journal or The New York Times, even if you don't read them or if you don't agree with everything they write, most people have confidence that they're high quality journalists. On the flipside, there are blogs that have intense following, but are not widely trusted beyond to their core audience. We will show those publications somewhat less. Preventing false news hate speech and other abused is another important area of focus for us. In order to protect the security and integrity of our platform, we're investing in both people and technology. We now have around 14,000 people working across community ops, online ops, and our security efforts. That's almost double where we were a year-ago. We've also built new technology to detect suicidal posts that have helped first responders reach more than 100 people who needed help quickly and we've built AI systems to flag suspicious behavior around elections in real time and remove terrorists’ content. Thanks to our AI systems, 99% of the ISIS and Al Qaeda related terror content we take down is now removed before anyone even flagged with us. And in some cases before anyone sees it. We've also made progress demoting false news in News Feed, which typically reduces an article’s traffic by 80% and destroys the economic incentives that most spammers and trolls farmers have to generate these false articles in the first place. Finally, we’ve started rolling out a major ad transparent effort. We support Congress passing legislation to make all advertising more transparent. We're not going to wait for them to act. We've already begun launching a way for anyone to view the ad, a pages running on Facebook, Instagram and Messenger, even if they aren't in the intended audience. And we're testing this in Canada first with the goal of rolling it out in the U.S. this summer ahead of the mid-term election. As I said last quarter, I expect these investments on top of other investments we're making will significantly impact our profitability. But just like the changes we're making that will impact time spent these investments will help us build a stronger community over the long-term. Now building a stronger community also means delivering on our product roadmap for the next three, five and ten years. Over the next three years, we know video will continue to grow. So our job is to build a video experiences that help people connect with family, friends and group. That's why I'm excited about Watch as a place to connect with people who have similar interests and why we launch a product like Watch party, where friends can watch a show together. Another important shift that we're seeing across the industry is the growth of Stories. We expect Stories are on track to overtake posts and feeds as the most common way that people share across all social apps. That's because Stories is a better format for sharing multiple quick video clips throughout your day. The growth of Stories will have an impact on how we build products and think about our business, including Whatsapp and Instagram which are the number one and number two most used Stories product in the world. Beyond the video, we have a long roadmap working to help people connect in meaningful ways. Today, more people are using groups than ever. These include smaller groups of friends and family and also larger communities where people connect around shared interests. We are focused on helping more people find the right communities for them and giving group admins and leaders the new tools they need to run these groups and help them grow. The goal of the marketplace is to connect people through commerce. More than 700 million people each month now come to Facebook to buy and sell things. We've launched marketplace in 30 countries last year, including 11 countries in the last quarter alone. Over the next five years, we remained focused on building ecosystems around our services had lots of people already. In Messenger and WhatsApp, we are working to give businesses more ways to communicate with their customers. We launched a plugin for Messengers that people can chat live with companies on their websites, and now more than 2 billion messages are sent between businesses and customers every month. WhatsApp recently crossed 1.5 billion monthly active with people now sending more than 60 billion messages every day. A growing number of these messages are between people and companies, which is why we launched WhatsApp business. A new app designed specifically for small and medium businesses to connect with people they want to reach. Over the next 10 years, we are working on the foundational technologies needed to bring the world closer together. Our goal with AI is to understand the meaning of all the content on Facebook to help us build better services. In addition to making it easier to get people the help they need and remove harmful content, this will also help us show more content that encourages connection and conversation. And on the VR side, we are excited to get Oculus go into people's hands this year. Time Magazine named it one of the top inventions in 2017 and I can't wait for more people to use it. So 2017 was a good year in many ways, but it was also challenging and that's why our focus this year will be making sure that our services are not just fun, but also good for us. And I'm confident that we will rise to the challenge. Thanks to all of you for being part of this journey and I am looking forward to making more progress together. And now, you will here’s Sheryl talk about our business."
},
{
"speaker": "Sheryl Sandberg",
"text": "Thanks Mark, and hi everyone. We had a strong fourth quarter and a great end to the year. Q4 ad revenue grew 48% year-over-year, mobile ad revenue was $11.4 billion, up 57% from last year, and contributed approximately 89% of total ad revenue in Q4. The full-year 2017 mobile ad revenue grew 56% compared to 2016 and was broad-based across regions, marketer segments, and vertical. We continue to make progress on our three priorities; helping businesses, leverage the power of mobile, developing new ad products, and making our ads more relevant and effective. Facebook and Instagram allow people and businesses connect and our especially meaningful platforms for small businesses. Globally 70 million businesses use Facebook. We surveyed small businesses in 18 countries and 57% of them are employing more people due to growth in demand since joining Facebook. Last week, I met Adam of Kings Barbers Club who started with two employees in Birmingham, England and now has 15 salons and 70 employees. I also met Domingo from Pescaria, a restaurant in Southern Italy that uses Facebook and Instagram to connect with customers. 80% of their diners and 70% of their revenues comes from Facebook. They opened their second restaurant and now employ more than 60 people. Like Adam and Domingo, small business owners are some of the most dedicated entrepreneurs and they are the heart of every economy and create the majority of new jobs throughout the world. As Mark said, we are taking strong action to maximize the good we do in communities. As part of this we are investing heavily in small businesses and in helping people gain digital skills. In November, we launched our community-based program which provides digital training for people in need of work and helps local businesses and non-profits get the most out of the Internet. During my trip last week, I announced that we are expanding the program to the EU. This year, we will visit more than 30 cities in the U.S. and Europe to work side by side with SMBs, start-ups and NGOs. Over 2 million people and businesses have already used our online and offline training, and by 2020 will have trained 1 million people and businesses across Europe alone. As people and businesses shift to mobile, Instagram continues to grow quickly. There are more than 2 million active advertisers on Instagram and we announced in November that more than 25 million businesses have profiles on Instagram up from 15 million in July. Instagram is a business as mobile visual shop and we're seeing more people seek out businesses there. About two-thirds of the visits to Instagram business profiles are from people who don't follow them and this is helping bring in new customers. Our second priority is developing innovative ad products, each year mobile advertising reaches new milestones during the holiday shopping season. A year-ago, we saw a mobile conversion action taken on a mobile website after viewing an ad on Facebook surpassed desktop conversions for the first time. In 2017 mobile conversions continue to accelerate. Data from 17 markets shows mobile accounted for 69% of online conversions on Black Friday and 64% on Cyber Monday. It also shows 80% of conversions on Singles' Day, a popular day for online shopping in China and increasingly other countries. Big shopping days like these are the kind of global events that Facebook and Instagram are uniquely positioned to support. During these events and throughout the year, businesses are using our innovative ad products like dynamic ads to connect and reconnect with shoppers. For example, Holiday Inn Express recently used dynamic ads for travel with our collection formats to advertise to people who search for hotels on their website, but hadn't yet booked. They ran ads with a video that showed a personalized selection of hotels for the city and dates people have looked up. This resulted in three times higher return on ad spend then their previous campaigns. In Q4 we also launched dynamic ads for auto, which allows dealers and manufacturers to show the right cars to the right audiences. As we expand and improve our ad products advertisers are increasingly developing mobile first ads rather than simply taking their TV creative and putting them online. Mobile first video was 50% of our video ad revenue this quarter up from 41% last quarter. We're seeing the short form videos work well and Instagram Stories were people can watch a full-screen vertical video and swipe up to quickly learn about a product or brand. 60% of these ads are viewed with sound on. Recently open table used Instagram Stories to advertise their reservation service to U.S. adults, who are frequent diners or are interested in dining. They combined food and restaurants footage of the book now button. Their ads reached 1.5 million people and achieved 33% lower costs per reservations and their other campaigns. We’re making it easier for any advertiser to try Stories ads as part of their other campaigns on our platform. Our third priority is making our ads more relevant and effective. Targeting makes advertising better more relevant to people and more effective for businesses. This is especially important for small businesses and they had limited budgets and need to make every dollar counts. Facebook give small businesses the same powerful tools that were previously only available to large advertisers. So they can reach the right people at the right time. For example, we're continuing to invest in value optimization, which helps advertisers show their ads to people who are likely to spend more with them. We've been gradually rolling this out to advertisers using web conversion dynamic ads and mobile app, install app. Their early results are promising over 2500 businesses have tried value optimization since June and many are putting more of their budgets toward it. We take our responsibility to prevent abuse of our ad system very seriously. And we're investing heavily in both people in technology to protect the integrity of our platform. In addition to rolling out the ad transparency tool in Canada that Mark mentioned, we've disabled the option that less advertisers exclude people and specific multicultural affinity segments until we can develop better safeguards against discrimination. We're also focused on improving ad quality and delivering a better experience for people who interact with marketers on our platform. This holiday, we took additional steps to penalize e-commerce advertisers, who created misleading or negative ads. In 2018, we will continue to focus on our same three priorities and do more to ensure the quality transparency and authenticity of ads in our platform. As part of our effort to be more transparent, last quarter we published our advertising principles, which have long guided our approach across all of our platforms. These principles are commitment to the people who use our services. They are we build for people first. We don't sell your data. You can control the ads you see. Advertising should be transparent. Advertising should be safe and civil. It should not divide or discriminate. Advertising should empower businesses big and small and we're always improving our advertising. As Mark said, 2017 was a challenging and important year for Facebook, a year where we committed to increasing our investment in the safety and security of our community, it was also a strong year for our business where our investments in helping our clients grow payoff. We will continue to make all of these investments in 2018 and in the coming years. I'm thankful to our partners around the world and to our employees who work so hard to make us better every day. Thanks. And now here's Dave."
},
{
"speaker": "David Wehner",
"text": "Thanks Sheryl, and good afternoon, everyone. Q4 was a strong quarter for Facebook and a great end to the year. Full-year 2017 total revenue grew 47% over $40 billion and we generated over $17 billion of free cash flow. Let's begin with our community metrics. Overall our global community is strong and growing. Daily active users on Facebook in Q4 reached 1.4 billion, up 14% compared to last year, led by growth in markets like India, Indonesia and Brazil. This number represents approximately 66% of our 2.13 billion monthly active users in Q4. MAUs were up $269 million or 14% compared to last year. As Mark mentioned certain product quality changes impacted our DAU growth. In the U.S. and Canada, these changes contributed to a DAU decline of 700,000 compared to Q3. We don't see this is an ongoing trend, but we do anticipate that DAU in this region may fluctuate given the relatively high penetration level. We continue to see healthy growth across the Facebook family of apps including Instagram, WhatsApp and Messenger. Turning now to the financials, all comparisons are on a year-over-year basis unless otherwise noted. Q4 total revenue was $13 billion, up 44% or 47% on a constant currency basis. Foreign exchange tailwinds contributed $329 million of revenue in Q4. Q4 total ad revenue was $12.8 billion, up 48% or 44% on a constant currency basis. Mobile ad revenue was $11.4 billion, up 57%. In Q4 the average price per ad increased 43% and the number of ad impressions served increased 4%, driven primarily by feed ads on Facebook and Instagram. Payments and other fees revenues was $139 million, up 7%. Total expenses in Q4 were $5.6 billion up 32%. Headcount remains a primary driver of total expenses. In Q4 we added approximately 1,900 people and ended the year with over 25,000 employees, up 47% compared to last year. In 2017 we made significant investments in R&D and security. On the R&D side, we added more people in 2017 than we did in 2016 and 2015 combined. On the security side, as Mark mentioned, we have accelerated our efforts and at the end of the year had around 14,000 employees and contractors working across community operations, online operations and integrity efforts. We also continue to invest aggressively in key areas such as content and our long-term innovation efforts. Q4 stock-based compensation expenses were $814 million, which was down from the $831 million in Q4 of last year, due to a decline in deal related stock-based compensation expenses. As a reminder, we acquired Oculus and WhatsApp in 2014 and we expect the deal related SBC expenses to be substantially recognized by the end of 2018. Q4 operating income was $7.4 billion representing a 57% operating margin. Our effective tax rate was 43%. In Q4, we recorded net approximately $2.3 billion in one-time charges as a result of the 2017 Tax Cut & Jobs Act. That was largely driven by the mandatory transition tax based on the accumulated earnings from our foreign subsidiaries. Net income was $4.3 billion or $1.44 per share. Again the one-time charges related to the tax on accumulated earnings reduced EPS by approximately $0.77. Full-year 2017 capital expenditures were approximately $6.7 billion, driven by investments and servers, data center, offices facilities and network infrastructure. In 2017, we generated over $17 billion of free cash flow and ended the year with nearly $42 billion in cash and investments. In 2017, we brought back approximately $2 billion of our Class A common stock and had approximately $4 billion remaining in our current authorization as of December 31. We remain committed to repurchases of our stock to help manage dilution. Turning now to the revenue outlook. We believe we have good opportunities to grow the business across both Facebook and Instagram in 2018. We continue to improve the effectiveness of our ads which helps drive ROI for advertisers and demand for our ad products. On the supply side, we expect we will be able to continue to grow ad impressions at a modest space. In 2018, we expect constant currency ad revenue growth rates to decelerate consistent with the trends that we have seen over the past year. I would also note that in the first half of 2018, we will likely benefit from favorable exchange rate tailwinds due to the recent depreciation of the dollar. Moving on to expenses. We continue to expect full-year 2018 total expenses will grow approximately 45% to 60% compared to full-year 2017. Turning now to CapEx. We expect that our full-year 2018 capital expenditures will be in the range of $14 billion to $15 billion driven by increased investment in data centers, servers, office facilities and network infrastructure. We currently anticipate that our full-year 2018 tax rate will be in the mid-teens. In summary, 2017 was another good year for Facebook. We continue to grow our global community and deliver great results for our advertisers. Importantly, we accelerated our investments to make our products better and the community stronger as we push forward on our mission of giving people the power to build community and bring the world closer together. With that, Mike let's open up the call for questions."
},
{
"speaker": "Operator",
"text": "We will now open the lines for a question-and-answer session. [Operator Instructions] Your first question comes from the line of Brian Nowak with Morgan Stanley."
},
{
"speaker": "Brian Nowak",
"text": "Thanks for taking my questions. I have two. The first one, the quality changes that you mentioned that led to an impact on daily active users in North America. I guess any further detail on what those quality changes were and what makes you feel comfortable this isn't likely to continue? I think you may need to make further changes and cleanup throughout the course of the year? And then the second one, Mark, I thought your commentary on Stories engagement was really helpful. I'd be curious to hear about early learnings on monetization of the Stories format and any challenges you made to overcome to drive monetization through that consumption? Thanks."
},
{
"speaker": "David Wehner",
"text": "On the quality changes on the impact on DAU in the U.S. and Canada, really no further I think elaboration on that. I would just say that we don't anticipate that that will be a continuing trend, but given the high penetration rates, we do think they'll be some fluctuation there. There's a lot of different effects that come from the different quality changes and focus on meaningful social interactions, but that's our expectation at this point."
},
{
"speaker": "Sheryl Sandberg",
"text": "On story monetization, ads in Stories on Instagram is a small, but quickly growing part of our revenue. There are 300 million daily actives on Instagram alone, and the format is pretty exciting from a sales point of view because it has a lot of potential. Its full screen is authentic, it’s very engaging. So the opportunity in the future for us to combine the power of this new format with the targeting and measurement we offer, we think it’s going to be really powerful for both our business and the business of our clients. It's early days, but I'm pretty optimistic about this."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Doug Anmuth with JPMorgan."
},
{
"speaker": "Douglas Anmuth",
"text": "Thanks for taking the question. First, Mark you made it pretty clear that driving meaningful social interactions is the Company's top priority this year, but can you talk a little bit about how the changes you're making impact advertising and maybe you can talk about how you're thinking about any changes around ad load or just overall impression volume? And then how the ads work in an environment of more friends and family content in an environment where you don't see as many business posts? And then secondly, can you talk about GDPR as well. I don't think you mentioned it, but just curious, I mean you put the blog post out the other day, but if you could talk about how you're preparing here, so that's a rollout over the next few months and whether you think that presents any risk to either engagement or monetization? Thanks."
},
{
"speaker": "David Wehner",
"text": "Hey Doug, it’s Dave. I'll start off on the impact on the business. The biggest focus – the biggest impact of the focus on meaningful interactions as Mark mentioned will be in areas like passive video, where from a business perspective, we monetize less on a time spent basis. So if you think about it in terms of things like post views in News Feed, which drives impression growth that we think this will have less of an impact, and so that's sort of built in to what I had said about the business commentary when I commented on 2018 revenue outlook. We still believe we have an opportunity to grow impressions at a modest space year-over-year across the platform."
},
{
"speaker": "Sheryl Sandberg",
"text": "When I think about the MSI changes, obviously any change that's beneficial for our community is good for the long run health of our business, because as Mark said, we care not just about time spent on Facebook, but time well spent. But even in the shorter-term all time spent on Facebook is not equal, because when people spend time viewing more posts because they're interacting with family and friends and they're not involved in longer post. We have actually more monetization opportunities. We're not doing this to be positive or negative for revenue. We're doing this because is the right thing for our community. But the impact that has on monetization is certainly not clearly negative. When you think about GDPR, the Facebook family of apps already applies the core principles in GDPR frame, which are transparency and control and we are building on this to make we’re ready to fully comply by May. We're going to continue to give people are personalized experience to be clear about how are using the data and give choices and we realize that this means that some users might opt out of our ads targeting tool. We also know that there may be a DAU impact for implications on European usage. But from the targeting, we're not forecasting a big impact here. There's some risk and more watching closely. Over the long run, we feel confident that we're very well placed to navigate the transition."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Heather Bellini with Goldman Sachs."
},
{
"speaker": "Heather Bellini",
"text": "Great. Thank you. I had two questions. One, I was just wondering what the advertiser response is then to the lower engagement and also just the kind of I guess cleaning up of the News Feed if you will. What’s kind of there view on this and also can you share with us any metrics on Watch and I know it's really early, but anything that interesting from an engagement perspective here and kind of how do you think this could evolve? Thank you."
},
{
"speaker": "Sheryl Sandberg",
"text": "On the DAU impact any Advertiser response our business is strong. We have over 184 million people using Facebook everyday in the U.S., which is considerably more than the Super Bowl every day on mobile alone. We also have – we think the best stability to target and make advertising relevant for businesses and people who see ads. We're continuing to build the products that allow businesses to get a higher return for the dollars they spend and allow people to see more relevant information in ads on our platform. So we're pleased with the growth and we believe that that delivering the strong quarter we have shows that. On Watch, it’s just early days. We have a dedicated place for people to watch and comment, where heavily focused on the social aspects of video viewing, but it’s too early to report any really findings."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Eric Sheridan with UBS Securities LLC"
},
{
"speaker": "Eric Sheridan",
"text": "Thanks for taking the question. Maybe following up on the team around engagement and the changes on product. First, how would be defining success? What will you be watching for in terms of either the time spent on the platform or the user growth on the platform or relative engagement to say that you've got the mix right and that people are seeing the right of content and have a healthy experience with Facebook over the next couple of years? That will be number one. And number two, Dave with respect to the OpEx and CapEx, given the incentive of the company to get a lot of things right on the security side and with repositioning products. Should we expect there to be a different cadence this year in terms of the investments the company might maybe more first half versus second half. Just one note there was any color there? Thank you so much."
},
{
"speaker": "Mark Zuckerberg",
"text": "I can take the first point about meaningful social interaction. So the product directive that I've given to all of our teams is to shift from focusing on showing the most meaningful content to people to instead to now encouraging the most meaningful social interaction. So that will first take hold as the series of News Feed changes, but over time there are going to be new products that we build new interfaces that the team is designed with the goal of encouraging interactions between people. So the thing that we're going to be measuring is basically the number of interactions that people have on the platform and off because of what they're seeing that they report to us is as meaningful. One interesting thing that I think is worth being clear about in terms of how we develop News Feed. I think that there's this myth that we design News Feed in order to just optimize for time or for likes or comments or some signals like that. The reality is the way we've done this for years is we've had a panel, a survey of thousands of people who basically we asked what the most meaningful content is that they had seen on the platform or that they've seen off the platform and we design our systems in order to be able to get to that ground truth of what people – real people are telling us is that high quality experience. So now we're going to shift that that methodology a little bit to instead of just being focused on the content, now to be more focused on trying to measure and have people tell us what is creating the most meaningful interaction in their lives. We're not just on Facebook. It could be a message that you have on Messenger or Whatsapp. But it could also be that you see something on Facebook and have a conversation about that in the world with someone who's meaningful to you and the next to me that we need to understand that. But that's basically what where we're going to be moving all of these systems towards over the next period of time. And its not just can be one News Feed change that happens overnight. It will be a series of rollouts and then a number of product changes that go to the interface of the products and things that we launch within that as well."
},
{
"speaker": "David Wehner",
"text": "And then Eric, you had a question about, how we might expect expense growth to progress through the year? There is no specific one item that's going to drive it. So we would expect expense growth to ramp throughout the year, largely due to the factors that we've talked about on prior calls in terms of what's driving the overall acceleration. There's the continued investment on the security front. We talked about that in both Mark's comments and my comments and we're continuing to ramp that investment. We are continuing to invest to support the video strategy on Watch. So we would expect that content investment to continue and ramp. And then finally we're continuing to invest in the long-term initiatives in areas like AR, VR, AI and connectivity. So across the board, we would expect expense growth ramp throughout the year."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Peter Stabler with Wells Fargo Securities."
},
{
"speaker": "Peter Stabler",
"text": "Thank you. Two if I may, one for Dave and one for Sheryl. First of all for Sheryl, wondering if you could update us on the search opportunity given the rapid growth of product advertising on the platform. Is there an opportunity for Facebook to transition from more of a demand generation platform to demand fulfillment? And then for Dave, can you give us a sense of the timing of the changes to the News Feed? Is this of fully completed rollout were there different cohorts that saw it first? Was there any regional phasing or anything like that? Thank you."
},
{
"speaker": "David Wehner",
"text": "Yes, Peter. I'll take the second part first. We began to make changes around a number of different quality initiatives in the fourth quarter, so that affected metrics that we've talked about including both the time spent and the DAU. But we continue to make changes to improve and to optimize around driving meaningful social interactions as Mark talked about. That's going to be an ongoing journey throughout the year. So there's no – I don't think we ever are going to declare that we are done making changes. So I'd expect we would continue to make changes and evolve."
},
{
"speaker": "Sheryl Sandberg",
"text": "On the search opportunity, there's a growing number of searches on Facebook, but we're still a ways off from monetization. It's worth noting though that because of our ads targeting our ability to reach people multiple times. We do believe that some of our ad success is taking people from demand generation through demand fulfillment. So we have multiple clients who will show an ad, a video ad to everyone in the U.S. for example or to a big cohort of people and then they'll follow up with an ad that target on either Instagram or Facebook to people who engage with that first that then they can follow up with the next team and we are seeing as businesses are increasingly measuring your ad spend in terms of their real ROI for sales that even within our own platforms. We can move people down that marketing funnel from demand generation to demand fulfillment."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Justin Post with Bank of America Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "Great, thank you. Dave, maybe you can talk a little bit about the sustainability of the pricing growth that you're seeing with advertising. Obviously your outlook for next year suggest decelerates modestly, but it's certainly a very high level and talk a little bit about that. And then maybe Mark or Dave, just talk about how the Watch tab is evolving? Are you seeing a lot of usage there? And how do you think about content in the Watch tab versions the News Feed? Thank you."
},
{
"speaker": "David Wehner",
"text": "Yes. Sure, Justin on pricing growth, I think there we feel like we're making good progress in our goal of driving better outcomes in ROI for our advertisers through things like better targeting, better ad units, driving better conversion, and we think we're making good progress there, and the willingness of advertisers continue to grow budgets with us I think highlights our progress there. You remember they are optimizing at the end of the day for business results for a given dollar spent not the impression price that we're kind of nominally reporting here. So you can think of all of this work and Sheryl talked about the value optimization efforts as part of that as being an effort to improve the yield of the impressions that we have to drive downstream business results for advertising partners. And if we can drive those affectively that will translate into higher effective prices for our business. And as I mentioned, I think we believe we still have a lot of work to do to continue to improve that. So we think there's opportunities here."
},
{
"speaker": "Mark Zuckerberg",
"text": "And for Watch, it's early, there are some promising signs, but in terms of how we think about this overall compared to News Feed. I would say it's really important to internalize that the News Feed video ecosystem and the Watch video ecosystem are almost completely separate things, right. So the Watch behaviors that we're building is one where people come intentionally to watch specific videos and to interact with the community around that. That's in contrast to what we worry is too passive consumption of an experience in News Feed today where people just happen to often see a video and maybe they'll watch it for a few minutes, but may not interactive around as much in News Feed. So we're still very optimistic long-term that Watch will be used for video that helps to bring people closer together and that will correlate with all the things that our community is telling us they want and that correlate with the measures of wellbeing that we think that social products can generate by helping people build relationships in terms of all the long-term measures of wellbeing that we care about like long-term happiness and health et cetera."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Mark Mahaney with RBC Capital Markets."
},
{
"speaker": "Mark Mahaney",
"text": "Thanks. Two questions please. European advertising revenue growth or your ad revenue growth in Europe accelerated, is that just currency or anything else you would call out there? And then you talked about progress in moving away from kind of demand or creation towards demand fulfillment or including demand fulfillment. And I was wondering if you could give any more examples of that? And Sheryl, two years ago or so you mentioned Booking.com being on the platform. I still think those OTAs, based on our work, are still doing like 10x as much spend on Google. So there's a real opportunity versus Facebook. Are there other examples or any other evidence you can show or talk about that that companies are really finding the ability to do demand fulfillment on Facebook and what's caused that to change? Thanks a lot."
},
{
"speaker": "David Wehner",
"text": "Let me just quickly hit on the constant currency question I think you had at the beginning Mark. The acceleration we saw from Q3 to Q4 was currency for Europe, but Europe continues to grow at a very healthy pace on a constant currency basis, so we're very pleased with the results both in constant currency terms and nominal terms. And then Sheryl."
},
{
"speaker": "Sheryl Sandberg",
"text": "So to take the first question, the EU, the strength in Europe was driven by SMBs. We grew across the board with large companies too, but SMBs were really important for this. There are 18 million small businesses on Facebook in Europe, and I had a chance to meet a lot of them on my trip. But to mention just one which shows the point, a couple named Linda and Marius started a company called iELM. They’re a kids clothing retailer. They started in Sweden on Facebook. She was selling clothes in her living room and selling them. Facebook is driving about half their sales. They then opened a factory in Romania and moved back to Romania, where they're now employing 100 people and they're shipping across Sweden, Romania, Germany, and Austria. There's still a small business at 100 people, but they are a growing business and showing the power of how our work with SMBs is growing jobs. You're asking also for an example of a demand generation going all the way down to demand fulfillment. Here's another one from Europe. Gymshark is a fitness clothing brand based in the UK. They ran Facebook video ads and Instagram Story ads for their Black Friday Campaign and then they target with a look a like people who had previously purchased and custom audiences that people who started, but then complete the purchase. And they saw 9.3 times return of investment over the two week holiday period. What happens on our platform is often that people will start out during demand generation and then use the repeat opportunity to show people ads, moving down the funnel to demand fulfillment. If you use our targeting tools well, you can actually start out with demand fulfillment. So some of these examples I've shared on this call from holiday end to Gymshark are about people using the targeting tools to find the people who are interested in the products and then you can get closer and down the funnel to demand fulfillment."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ross Sandler with Barclays."
},
{
"speaker": "Ross Sandler",
"text": "Hey, guys, just two questions Mark, first on the topic of passive versus active consumption. Can you talk about what percent of the DAUs actively contribute today versus just moving back passive consumption? And how has that ratio maybe changed versus five years or 10 years ago based on some of the product changes that you had in News Feed? And then Dave just follow-up on pricing, so with the bunch of noise given the growth rates of desktop versus mobile, can you just talk about what pricing growth looks like in mobile like for like geography basis? Is that 20%, 30%, any color there would be helpful? Thank you."
},
{
"speaker": "David Wehner",
"text": "Yes. Ross, I guess I'll take both. Yes, we don't break out the type of metric that you're talking about on the passive versus active consumption. So we don't have anything specifically to share there. In terms of breaking out pricing on a mobile basis. I mean I think overall that the trends reflect a generally what's happening on mobile, but there is still an overlay of a shift from desktop. But overall, we are seeing prices increase on mobile in region, so I think that's consistent with the reported trend."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Brent Thill with Jefferies LLC."
},
{
"speaker": "Brent Thill",
"text": "Thank you. On Instagram I'm just curious if you give a little more color on the progress you're seeing, any metrics to help fill in what's happening there?"
},
{
"speaker": "David Wehner",
"text": "We continue to be pleased with the growth of Instagram both on a user basis and on a revenue basis. It continues to make an increasing contribution to the business. So we're very pleased with the Instagram result, nothing specifically to highlight from a metrics point of view."
},
{
"speaker": "Sheryl Sandberg",
"text": "On the business side, I think we have both pleased with the results. We see a very big opportunity in front of us. We have 6 million advertisers on Facebook, which means we have a lot of opportunity on Instagram, where we only have 2 million advertisers to grow their engagement with us and their spend."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Michael Nathanson with MoffettNathanson."
},
{
"speaker": "Michael Nathanson",
"text": "Thanks. I have one for Mark on news trustworthiness and then group on sports. So Mark, I realize you're taking great pains not to play the role of the news editor on your platform. You're asking users about trustworthiness, but I wonder does that pick up biases in our own stores of what we believe to be trustworthy and how do you get past that? And then would it make sense just simply you play the role of pipelining a new News Feed, maybe its own tab with news that we all believe – we believe to be trustworthy. So at some point you take a more active role in identifying the news that your platform believes to be real news and maybe create a new tab that ways. Is that ever something in your thinking?"
},
{
"speaker": "Mark Zuckerberg",
"text": "The value that we care about here is helping to build common ground. Right and helping to do our part to fight off news and polarization. So what we're doing. With this specific change which is one of a number of News Feed changes that are geared at improving the quality and trustworthiness of news on Facebook. What we basically ask people we don't want to assess by ourselves which sources are trustworthy. I think that's not a situation that our position that we're comfortable with ourselves. And I don't think personally that that's something that our community or our society wants us to do. So for all of the feedbacks that we get that we should take more of a view on that, I actually – I don't believe that that is the right thing broadly. What we try to do is get our community to tell us what matters to them, because we believe that we can get an accurate signal from the community then – people are smart. They know what they want and what's good and they can tell us that, if we can ask them in a simple enough way and get aggregate data. So what we're doing here is we basically are just asking people, if they're familiar with news sources and whether they trust them. And the effect of that is that it basically normalizes for – there are going to be people who read a given news source, who will probably trust it because they read it. But the question is that the people who don't read it, who are still familiar with it, do they think it's trustworthy, and that's the example that I gave before the Wall Street Journal or New York Times. A lot of people read those, a lot of people don't, but the people who don't still think that they're high quality journalism in general. And that's not true for a lot of the other stuff that's out there. And we've found that that's the reliable signal of content that helps to build common ground that is unlikely to be polarizing, that is unlikely to be false news, and what we're doing is helping to show that a little bit more. Again, we're not going to tell you that you can't share other stuff, right. You can share it on the platform. People can go to your profile. But in News Feed, we're going to just show that a little bit more to do what we view as our role is helping to build common ground, encounter some of these other forces in the world."
},
{
"speaker": "Michael Nathanson",
"text": "Okay."
},
{
"speaker": "Sheryl Sandberg",
"text": "On this sports answer, sports is one of the ways that people get together on Facebook and build community. We're excited to bring the UEFA Champions League Soccer and College Basketball to Facebook, and we're going to continue to experiment with developing many different forms of content for Facebook."
},
{
"speaker": "Operator",
"text": "You next question is from the line of John Blackledge with Cowen."
},
{
"speaker": "John Blackledge",
"text": "Great, thanks. Two questions, on marketplace with the expansion to 30 countries, just wondering how the business model evolves over time, does it kind of mirror Amazon’s third-party business or eBay’s marketplace business? And then just on ad units, on the mid-roll video ad units. Just wondering I know it's early, just any color on the ad demand and perhaps how you think about the impact to this ad unit for the next couple of years? Thank you."
},
{
"speaker": "Sheryl Sandberg",
"text": "On marketplace, we're just going to continue to iterate on the ad test. We're pretty encouraged by what we've seen even though it's pretty early days. What we're excited about is that our business is helping people connect with things they want to buy. It's also important to note that commerce is a really important vertical in our ad business. So it's not just the commerce is being driven in ads in marketplace. But in a much bigger way, commerce discovering product all the way, through to sales is a big part of what's driving our ads business. On Ad Breaks for mid-roll video, early days pretty good result, more than 70% of Ad Break up to 15 seconds in length on Facebook and Audience Network are being viewed to completion. Most are being viewed with the sound on. But again it's very early for this."
},
{
"speaker": "Operator",
"text": "Your next question is from the line of Anthony DiClemente with Evercore ISI."
},
{
"speaker": "Anthony DiClemente",
"text": "Thanks for taking my questions. Sheryl, just hoping you could help us think about how marketing budgets grow as retail moves online. So investors we speak to ask the question about the addressable market for Facebook. Is the addressable market running out of opportunity as the platform gets larger? So do you believe the overall ad market or the TAM is possibly experiencing structural expansion, due to a shift in e-commerce overall? And then Mark, I wanted to ask about AI. Can you just talk about the broader applications of the technologies that you are investing into improve the user experience and safety on the platform. So I understand you're using AI to improve the quality of the experience and engagement, but should we be thinking about these investments as also enabling new features and products over time, whether it would be shipping hardware or custom chips or potentially AI as a service externally? Thanks."
},
{
"speaker": "David Wehner",
"text": "Anthony, on the on the marketing budgets, we continue to think we've got great opportunities to grow in the large global advertising market. When you get sort of down to the micro level, you talked about e-commerce. E-commerce is and remains and was one of our strongest verticals in Q4, and we think we're doing an excellent job of building the right products for e-commerce retailers. And Sheryl talked about value optimization and that sort of work that we're doing, and so I think we've got continued opportunities with e-commerce going forward. So I think we're very well positioned in the e-commerce space. On AI?"
},
{
"speaker": "Mark Zuckerberg",
"text": "Yes. I can talk about AI. So machine learning is – the improvement there are by far the largest technological trends that we're seeing in the industry and across the business. And we really see it in three ways, right. The first and most tactical or just the optimization to everything that you see, right, from ranking in News Feeds, your ranking of ads or search, or improving our security systems, and that's driving a lot of the business and the quality improvement that we're seeing and that's really important. The second category, I would call qualitative changes and how we do business. So for example, for News Feed, historically all the content that's been a News Feed has been content that you're connected to, right. You become friends with someone or you follow a page and then their content can show up a News Feed, but long-term or not even long-term, right. Over the next several years as we develop an understanding of all of the content on Facebook that won’t be a constraint anymore. At some point, we're going to be able to just understand the meaning of all the content that hosted that you could potentially see and use that as candidates to potentially improve your experience and make it that you could see way more content that you might be able to today to – and of course, we'll do that to help encourage more social interaction. The way that this is improving the work that we're doing around security and integrity is also very fundamental. Today, that whole model is that people can post what they want and then a person can flag it, and then our systems will look at it. But increasingly as we move into the future, we're going to be able to proactively take down some negative content. I gave the example of the terrorism-related content and some things around suicidal post where if someone posts something that they're thinking about suicide. Now today, we don't have to wait for someone to report it a lot of the time. In the last few months, there have already been more than 100 instances where we've been able to reach out and get in touch with first responders that they can give you people the help that they need, and that's a big structural change in the way that we do business in terms of protecting the security and integrity of our community. The third major category is going to be completely new products and platforms. So there we talked about all the things that we're building around VR and AR and the ability to be present with anyone, anywhere. And certainly AI is going to be a big part of that both on the vision side and the voice side. And there are going to need to be big advances there, but that's really exciting. But I think in each of those three categories, the optimization, the upgrading how we do business, and really changing how that works in our products today, and then the new products. I would say that improvements in machine learning are the most important technological trends in the industry now by far."
},
{
"speaker": "Sheryl Sandberg",
"text": "Operator, we have time for one last question."
},
{
"speaker": "Operator",
"text": "Your last question comes from the line of Mark May with Citi."
},
{
"speaker": "Mark May",
"text": "Thanks a lot. I just wanted to ask a follow-up question regarding Mark's comments that user engagement had declined by I think 50 million minutes in – daily hours in the quarter. I guess the question is how confident are you that that impact was due to News Feed changes that you made proactively versus some other factor outside your control, and if you are still fairly early in the process of making these quality improvements to the News Feed, do you expect for engagement declines to continue going forward? And just for Dave, I know you choose your words carefully, just want to clarify, you mentioned this year you expect constant currency ad revenue growth to decelerate consistent with trends that we've seen in the last year. I think your constant currency growth rate in 2017 declined by about 12 percentage points. Is that kind of what you're trying to lead us towards? Thanks."
},
{
"speaker": "David Wehner",
"text": "I can take the second question first, Mark. I think what I am trying to say is that we do expect constant currency revenue growth to continue to decelerate consistent with steady deceleration that we've seen over the past year, so we do expect that trend to continue. I'm not putting specific percentages around it."
},
{
"speaker": "Mark Zuckerberg",
"text": "So in Q4, we made a number of quality changes that were largely around video. We are going to continue to make quality changes now going forward around meaningful social interaction. And I do think that that is likely going to continue this trend of decreasing passive consumption, but if we do our jobs well, it should increase the number of meaningful interactions that people have. And we think that that's going to be positive, right. So we think it'll help make the community stronger over the long-term. I mean we think it'll be good for the business over the long-term, but this is what people are telling us is what they want on the product. It's the unique value that people expect from Facebook. You can go to a lot of places to consume content, but there aren't a lot of services where you can strengthen your relationships, that's what people want, so that's the right thing for us to focus on, and it also lines up with all the well being research that we've done which – and as you know, there have been a lot of debate over the last year about the utility of social media on the Internet, and we take this very seriously, right. It's our responsibility, too, to make sure that we understand everything that's going on on our platform. And one of the big takeaways from that is that time when people are engaging and building relationships, is good time and that correlates with all the aspect of long-term well being that you'd expect like happiness, and health, and feeling more connected and feeling less alone, and in all of the things that qualitatively matter in our lives. And we think that we can help drive that and improve people's lives by doing that, so we're absolutely going to go do that. End of Q&A"
},
{
"speaker": "Sheryl Sandberg",
"text": "Great. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines."
}
] | null | null |
META | 3 | 2,017 | 2017-11-01 17:00:00 | Executives: Deborah Crawford - Facebook, Inc. Mark Elliot Zuckerberg - Facebook, Inc. Sheryl Kara Sandberg - Facebook, Inc. David M. Wehner - Facebook, Inc.
Analysts: Eric J. Sheridan - UBS Securities LLC Brian Nowak - Morgan Stanley & Co. LLC Mark A. May - Citigroup Global Markets, Inc. Douglas T. Anmuth - JPMorgan Securities LLC Heather Bellini - Goldman Sachs & Co. LLC Ken Sena - Wells Fargo Securities LLC Justin Post - Bank of America Merrill Lynch Ross Sandler - Barclays Capital, Inc. Richard Greenfield - BTIG LLC Brent Thill - Jefferies LLC Mark Mahaney - RBC Capital Markets LLC Colin Alan Sebastian - Robert W. Baird & Co., Inc. Youssef Squali - SunTrust Robinson Humphrey
Operator: Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook third quarter 2017 earnings call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin.
Deborah Crawford - Facebook, Inc.: Thank you, good afternoon and welcome to Facebook's third quarter 2017 earnings conference call. Joining me today to discuss our results are: Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our quarterly report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now I'd like to turn the call over to Mark.
Mark Elliot Zuckerberg - Facebook, Inc.: Thanks, Deborah, and thanks, everyone, for joining us today. Our community continues to grow, now with nearly 2.1 billion people using Facebook every month and nearly 1.4 billion people using it daily. Instagram also hit a big milestone this quarter, now with 500 million daily actives. And we saw good results in the business, where total revenue grew 47% year over year, and we had our first ever quarter with more than $10 billion in revenue. But none of that matters if our services are used in a way that doesn't bring people closer together, or if the foundation of our society is undermined by foreign interference. I've expressed how upset I am that the Russians tried to use our tools to sow mistrust. We built these tools to help people connect and to bring us closer together, and they used them to try to undermine our values. What they did is wrong, and we are not going to stand for it. Now for those who followed Facebook, you know that when we set our minds to something, we're going to do it. It may be harder than we realize up front. It may take longer and we won't be perfect, but we will get it done. We're bringing the same intensity to these security issues that we've brought to any adversary or challenge that we've faced. The first step is doing everything we can to help the U.S. government get a complete picture of what happened. We've testified in Congress over the past couple of days about the activity we found in last year's election. We're working with Congress on legislation to make advertising more transparent. I think this would be very good if it's done well. And even without legislation, we're already moving forward on our own to bring advertising on Facebook to an even higher standard of transparency than ads on TV or other media. That's because in traditional media, there's no way to see all the messages an advertiser is showing to different audiences. We're about to start rolling out a tool that lets you see all of the ads a page is running and also an archive of ads political advisers have run in the past. We're also working with other tech companies to help identify and respond to new threats because, as we've now seen, if there's a national security threat involving the Internet, it will affect many of the major tech companies, and we've announced a number of steps to help keep this kind of interference off our platform. This is part of a much bigger focus on protecting the security and integrity of our platform and the safety of our community. It goes beyond elections, and it means strengthening all of our systems to prevent abuse and harmful content. We're doing a lot here, with investments both in people and technology. Some of this is focused on finding bad actors and bad behavior. Some of this is focused on removing false news, hate speech, bullying, and other problematic content that we don't want in our community. We already have about 10,000 people working on safety and security, and we're planning to double that to 20,000 in the next year to better enforce our community standards and review ads. In many places, we're doubling or more our engineering efforts focused on security. And we're also building new AI to detect bad content and bad actors, just like we've done with terrorist propaganda. I am dead serious about this. And the reason I'm talking about this on our earnings call is that I've directed our teams to invest so much in security on top of the other investments we're making that it will significantly impact our profitability going forward, and I wanted our investors to hear that directly from me. I believe this will make our society stronger, and in doing so will be good for all of us over the long term. But I want to be clear about what our priority is. Protecting our community is more important than maximizing our profits. So security and the integrity of our services will be a major focus. Beyond this, our focus is on building community. I talked about this last quarter when we changed our mission to focus on building community to bring the world closer together, and that's more important now than ever. This gets into our roadmap for the next three, five, and ten years. Over the next three years, the biggest trend in our products will be the growth of video. This goes both for sharing, where we've seen Stories in Instagram and Status in WhatsApp grow very quickly, each with more than 300 million daily actives, and also for consuming video content. We recently launched the Watch tab, where you can discover shows, follow creators, connect with people watching an episode, and join groups with people with similar interests to build community. But as video grows, it's important to remember that Facebook is about bringing people closer together and enabling meaningful social interaction. It's not primarily about consuming content passively. Research shows that interacting with friends and family on social media tends to be more meaningful and can be good for our well-being, and that's time well spent. But when we just passively consume content, that may be less true. When done well, video brings us closer together. We've found that communities formed around video like TV shows or sport create a greater sense of belonging than many other kinds of communities. We found that live videos generate 10 times the number of interactions and comments as other videos. But too often right now, watching a video is just a passive consumption experience. Time spent is not a goal by itself. We want the time people spend on Facebook to encourage meaningful social interaction. So we're going to focus our products on all the ways to build community around the videos that people share and watch. That's something Facebook can uniquely do. Moving along, over the next five years, I expect us to make some good progress on several newer initiatives. In messaging, today already more than 20 million businesses are communicating with customers through Messenger. Now we're starting to test business features that make it easier for people to make the same kinds of connections with businesses through WhatsApp. We rolled out Marketplace to Canada and 17 countries across Europe, giving people the ability to discover, buy, and sell things in their local communities. Today, more than 550 million people are using Marketplace and buy-and-sell groups on Facebook to connect with other people for transactions. We're also seeing good progress with Workplace, helping companies connect their own teams internally through their own versions of Facebook. It's been less than a year since we launched Workplace, and today more than 30,000 companies are using it. This quarter, we welcomed on Walmart, the largest employer in the U.S. Over the next 10 years, we are working on the foundational technologies needed to bring the world closer together. I'm proud of the work we're doing with AI. We're now using machine learning in most of our integrity work to keep our community safe. When Hurricane Maria hit Puerto Rico, we used AI to look at satellite imagery and identify where people might live and need connectivity and other resources. Progress in AI can unlock a lot of opportunities. This quarter we opened a new AI research lab in Montreal, and we're building another lab in Paris as well. This quarter we held Oculus Connect and we announced Oculus Go, our first-ever all-in-one headset that's great for feeling like you're present with someone when you can't physically be together in person. It's great for playing games, watching movies, or hanging out with friends. And at $199, we think it's going to help us bring great virtual reality experiences to more people. It ships next year. At Connect, I also showed off our new Santa Cruz prototype, which is the first time any company has shown the full experience of positional tracking in a standalone headset and controllers. It's a major technical achievement, and I'm looking forward to getting this into developers' hands next year. In order to support our community's growth, we need to keep investing in our infrastructure. This quarter we broke ground on our New Albany [Ohio] data center, and we announced that we'll build our 11th major data center in Henrico County, Virginia. As always, all our new data centers are powered by 100% renewable energy. These long-term investments are important for our community's future. We can do a lot to help people connect through phones and computers, but so much more will be possible in a world where everyone has Internet access, where AI improves all our services, and where we can basically teleport anywhere or be with anyone anytime we want. With all the issues we've faced, it would be a lot to just invest in addressing those. But we know that we also have a responsibility to deliver these fundamental technical and scientific advances to fulfill the promise of bringing people closer together. So we're going to keep making significant investments looking ahead towards the future too. We've made some real progress this year. Across the board, we have a lot of work to deliver on our mission of bringing the world closer together, but we're committed to rising to the challenge and doing what we need to for our community. Thanks to all of you for being a part of this journey, and I'm looking forward to the road ahead. And now here's Sheryl to discuss our business.
Sheryl Kara Sandberg - Facebook, Inc.: Thanks, Mark, and hi, everyone. We had a strong third quarter, with growth across all regions, Marketer segments, and verticals. Ad revenue grew 49% year over year. Mobile ad revenue was $8.9 billion, a 57% year-over-year increase, making up approximately 88% of total ad revenue. We're continuing to build our business by focusing on our same three priorities: helping businesses leverage the power of mobile; developing new ad products; and making our ads more relevant and effective. Today, we're announcing that Facebook has over 6 million active advertisers, and we recently announced that Instagram has over 2 million advertisers. The vast majority of these are small and medium-sized businesses, which are a major source of innovation and create more than half of all new jobs globally. These businesses often have small ad budgets, so the ability to reach people more effectively is really valuable to them. A great example value is LoveBook, a small business in Michigan which lets you make personalized books for the people you love. During a recent campaign, they used Facebook ads to reach people getting ready to celebrate their first anniversary. They've grown so much from marketing on Facebook that they've been able to hire 10 new employees this year alone. We're proud of the role we are playing in enabling businesses like LoveBook to reach people on mobile, to grow, and to create jobs. One of our strongest areas this quarter was SMBs in Europe, with revenue growing more than 60% year over year. When I was Germany two months ago, I had a chance to meet Victor, one of the cofounders of Brooklyn Soap Company, which despite its name is based in Hamburg. Victor and his friends came up with the idea for their business while staying in a hostel in Brooklyn. Now they sell their grooming products in 38 countries using mobile video ads on Facebook and Instagram. As a result, their sales increased 62% over the last year. They're one of many small businesses using mobile to find new customers and grow across borders. Our second priority is developing innovative ad products. Video is exploding, and mobile video advertising is a big opportunity. Until recently, ads were only eligible for Ad Breaks if they also ran in News Feed. But in Q3, we gave advertisers the option to run ads in videos alone. We're seeing good early results, with more than 70% of Ad Breaks up to 15 seconds in length on Facebook and Audience Network viewed to completion, most with the sound on. As Mark said, Instagram Stories are growing well too. People and businesses are finding creative new ways to use full-screen vertical video in Stories. This quarter, we gave advertisers even more flexibility in the content, format, and reach of their ads in Stories. We're also seeing how immersive video and images can help people discover new products on Facebook. We added a new creative template to Collection Ads, which helps retailers bring their catalogs online. West Elm, a home décor company, recently used this template to promote its furniture and home accessories. They targeted people who already got their physical catalog and saw a 5.5% lift in purchases in store. Our third priority is making our ads more relevant and effective. In Q3, we introduced new tools powered by machine learning and automation to help businesses reach people more likely to spend with them. We also simplified the tools for creating ads, making it easier for businesses of all sizes to advertise with us. It's important for all businesses to reach the right audience, but it's especially important for small businesses that have limited budgets. Targeting allows them to show ads only to the people they want to reach. Neon Retro Arcade in L.A. is a great example. They advertise to people within 10 miles of their location who are interested in video games and comic books. Last year, they moved their entire ad budget to Facebook and Instagram, and their revenue was up 25%. Relevance and effectiveness are also about giving businesses more control over where their ads run. In Q3, we clarified which publishers and creators can include ads next to their content. This is good for creators who want guidance on how to earn money from their content on Facebook, and it's good for advertisers who want transparency and control to make the right decisions for their brands. We're also working to give advertisers more clarity on where their ads are shown so they can make more informed choices about where to run them in the future. I want to close by talking about what we're doing to protect our platform and help ensure that the ads and content people see on Facebook and Instagram are legitimate and authentic. When I was in Washington a few weeks ago, I made it clear that we are determined to do everything we can do to minimize abuse going forward. As Mark said, we're investing heavily in new technology and people to review ads and posts. This will enable us to look more closely at the content of the ads, targeting, and the advertiser who submits them, as well as tighten our ads policies, particularly for ads directed at social and political issues. We believe that ads are important to free expression and we will continue to accept ads on issues, but we will also do our part to elevate the quality of that discourse. Transparency helps everyone keep advertisers accountable for their messages. We're working with Congress on new requirements for online political advertising, but we are not waiting for legislation. We're building a tool now that will allow anyone to see the ads of pages running, even if those ads are not targeted to them. We will test it soon in Canada and then in the U.S. in the coming months. For ads related to U.S. federal elections, we'll start sharing even more information, including an archive of past ads, the total amount spent, and demographics about the people the ad reached. We're also going to require more thorough documentation from these advertisers and will label their ads so it's clear who paid for them. We believe these actions will set a new standard for transparency in online ads. Because the interference on our platform went beyond ads, we're also increasing transparency around organic content from pages. We're looking at ways to provide more information about who's behind a political or issue-based Facebook page. We believe this will make it harder for deceptive pages to gain large followings and make it easier for us to identify malicious activity. We are all committed to getting this right and to investing and strengthening our platform so we can better serve our community. We are also committed to continuing to help businesses all over the world attract customers, sell their products, and create jobs. As always, I'm grateful to all of our clients for their partnership and to our global Facebook teams for their hard work. Thank you, and now here's Dave.
David M. Wehner - Facebook, Inc.: Thanks, Sheryl, and good afternoon, everyone. Q3 was another great quarter for Facebook. We saw continued growth in engagement in our community as well as strong performance in our ads business. Let's begin with our community metrics. Daily active users in Q3 reached 1.37 billion, up 16% compared to last year. This number represents 66% of our 2.07 billion monthly active users in Q3. MAUs were up 284 million year over year or 16%. Our community growth was again driven by product improvements, promotional data plans, and internet.org. Note that in Q3 we began to lap the introduction of promotional data plans from mobile operators in markets like India. Before going to the financials, let me touch briefly on our ongoing effort to improve our user aspects. This quarter we implemented a new methodology to help identify duplicate accounts. As a result, we increased our estimates for duplicate accounts to approximately 10% of worldwide MAUs from our previously disclosed estimate of 6%. Duplicate accounts are those that we believe are used by the same person and represent real activity and engagement on Facebook. We have also increased our estimate for inauthentic accounts to approximately 2% to 3% of worldwide MAUs. Inauthentic accounts are largely those that are used for spam and other policy violating reasons. We continuously monitor and aggressively take down those accounts. These accounts tend to be less active and thus we believe impact DAU less than MAU. Now turning to the financials, all comparisons are on a year-over-year basis unless otherwise noted. Q3 total revenue was $10.3 billion, up 47% or 45% on a constant currency basis. Foreign exchange tailwinds contributed $128 million of revenue in Q3. Q3 total ad revenue was $10.1 billion, up 49%. On a constant currency basis, our ad revenue growth rate was 47%, down 2 percentage points compared to the growth in Q2. Ad revenue growth was strong globally, led by Europe and APAC with 56% and 54% growth respectively. Mobile ad revenue was $8.9 billion, up 57%. In Q3, the average price per ad increased 35%, and the number of ad impressions served increased 10%, driven primarily by Feed ads on Facebook and Instagram. I would note that compared to a year ago, price is a much more important driver of our ads revenue growth. Payments and other fees revenue was $186 million, down 5%. Total expenses were $5.2 billion, up 34%. Q3 was our biggest hiring quarter ever. We added over 2,500 people and ended the quarter with over 23,000 employees, up 47% compared to last year. Operating income was $5.1 billion, representing a 50% operating margin. Our tax rate in the third quarter was 10%. Excess tax benefits recognized from share-based compensation decreased our effective tax rate by 6 percentage points, a level that was driven by appreciation in our stock price. Net income was $4.7 billion or $1.59 per share. Year-to-date capital expenditures were approximately $4.5 billion, driven by investments in servers, data centers, office facilities, and network infrastructure. In Q3, we generated over $4.3 billion in free cash flow, and ended the quarter with over $38 billion in cash and investments. Year to date, we have bought back over $1 billion of our Class A common stock. Turning now to the revenue outlook, our ads business remains strong, but it's worth noting that in Q3, our year-over-year ads revenue growth rates decelerated for the fifth consecutive quarter on a constant currency basis, and we expect this trend to continue for the foreseeable future. Going forward, we also expect the growth in advertising revenue will increasingly be driven by price. This is a shift from prior years, when growth was primarily driven by increases in supply. Turning now to expenses, we anticipate that our full-year 2017 total expenses will grow approximately 35% to 40% versus our prior range of 40% to 45%. We anticipate that full-year 2017 capital expenditures will be approximately $7 billion. As mentioned previously, our tax rate will vary based on our stock price. At the current stock price, we would expect that the Q4 rate will be in the low teens. I also wanted to provide some comments on 2018 expenses and capital expenditures. Please recognize that these are preliminary estimates, as we have not yet finalized our 2018 budget. That said, it is shaping up to a be a significant investment year, and I wanted to provide initial guidance to align investors with our most current thinking. We expect full-year 2018 total expenses will grow approximately 45% to 60% compared to full-year 2017. We continued to invest aggressively across the business, but there are three important factors driving an acceleration in our expense growth rates from 2017 levels. First, as Mark outlined in his earlier comments, we are making sizable security investments in people and technology to strengthen our systems and prevent abuse. Secondly, we are investing aggressively in video content to support the Watch tab. Finally, we continue to invest in our long-term initiatives around augmented and virtual reality, AI, and connectivity. Given our expectation of continued deceleration in revenue growth rates, we expect these significant investments will be net negative on our operating margins. In addition, we expect to make substantial investments in our infrastructure to support growth and improve our products. As such, we expect full-year 2018 capital expenditures will roughly double from 2017 levels. We would also anticipate that the full-year 2018 tax rate will be in the mid-teens. In summary, Q3 was another strong quarter for Facebook across the board. We are excited about the opportunities we see ahead and will continue to make significant investments to support our growth and our mission. With that, Mike, let's open up the call for questions.
Operator: We will now open the lines for a question-and-answer session. Your first question comes from the line of Eric Sheridan, UBS.
Eric J. Sheridan - UBS Securities LLC: Thanks for taking the question. Maybe revisiting Mark's comments at the beginning of the call, I would love to get a better sense or granularity about what sort of video content you'd like to see on the platform that could drive a more active or interactive experience than passive. And then the second question would be, what does that mean in terms of the business model? Would there be licensing content, funding content that you have to do to build the sort of business you're aiming for over the medium to long term? Thank you.
Mark Elliot Zuckerberg - Facebook, Inc.: So the strategy here around helping people connect reflects more on what we do around the videos than some of the content itself. So hopefully, the experience on Facebook will not just be that you come and watch a video and you get informed, you feel entertained, and that's it. We think that the most valuable thing that people do are help build relationships with other people on the platform. So to the extent that video can serve as a touchstone for building community and helping facilitate interaction, then that's the thing that we feel like we can uniquely do. So we're going to continue investing heavily in video content for Watch that is centered around people, that is centered around the things that people want to talk and connect around, that give people a sense of pride and bring people together. But we're going to invest as much in just making sure that we build out the community features around that. And that I think is going to be the thing that differentiates this over time.
Operator: Your next question comes from Brian Nowak, Morgan Stanley.
Brian Nowak - Morgan Stanley & Co. LLC: Thanks for taking my questions. I have two. Just, Mark, to go back on your focus on community and video, I was wondering if you could share with us or help us understand what you're seeing in engagement trends or maybe time spent per user on the core Facebook platform, as you've had so many efforts focused on community and video. And then secondly for Sheryl, you made such good progress growing the advertising business across SMB in a lot of verticals. I wonder. If you step back, could you talk to any areas or any verticals where you really see the potential for material improvements or verticals you're having a hard time cracking into that you think can really be bigger drivers of ad revenue growth going forward?
David M. Wehner - Facebook, Inc.: So, Brian, just on engagement metrics, we're continuing to see good growth in DAU, as you saw in the 16% growth that we posted this quarter. In addition, we do continue to see time spent growth per DAU on the Facebook family and on Facebook.
Sheryl Kara Sandberg - Facebook, Inc.: For my part, when I think about our Marketer segment, we have SMBs; we have brand, direct response, and developers. We're seeing strong growth across. I think if you think about where the growth remains, it really is in increasing the relevance of the ads, because the ads I think are getting better in terms of reaching the right people at the right time. But I think there's still a lot more we can do. And as people really use our Custom Audiences, our targeting tools, the quality of the ads improve and the returns improve. And the more we – the better we get at measuring those returns, the better the ads get. And so I'll share just one example but one I really love, which is the Alameda County Fair, which is a local fairground in Pleasanton, California. I happened to meet this woman, Angel [Moore], who's running their marketing this year. And they use Facebook to target people within 25 miles of their fairgrounds age 20 to 51 who have specific interests in concerts, music festivals, and theme parks. And what they saw for season pass ticket sales for 2017 was a 50% increase compared to 2016, and they attribute that to Facebook. And that's really about finding the people that are interested. And if you look at the percentage of our ads business where people are using our most sophisticated approaches to finding the right audience, I think we still have a lot of opportunity for growth there, and that will improve both the quality of the ads people see but also the returns to marketers. And I think that will hit all of the verticals and all of the segments.
Operator: Your next question comes from Mark May, Citi.
Mark A. May - Citigroup Global Markets, Inc.: Thank you. I had two related questions on video. First on the OpEx guidance, one of the real consistencies of the business is OpEx growth. You've been growing that at $4 billion to $5 billion incremental spend per year, but the midpoint of your guidance is looking like a $14 billion increase next year. Is the differential there, the additional $6 billion to $7 billion, should we be thinking of that as the video content spend that you're setting aside possibly to spend next year? I'm just trying to understand where this significant increase would be coming from. And then related, the 35% increase in ad prices – would you say that that's predominantly being driven, the acceleration there, by the mix towards video, Ad Breaks, and other longer-form video ads? Thanks.
David M. Wehner - Facebook, Inc.: Sure, Mark. So on the acceleration of the growth rate in expenses from 2017 to 2018, I would really look at the growth rate that we grew at in 2017, apply that to the total expense base, and look at that growth in 2018. And then I would say the additional expense that leads to the acceleration is driven by three factors, not just one factor. And those three factors are the ones that I outlined in my commentary: number one, the substantial investment that Mark highlighted that we're making to just improve the security on our platform; two, the video content investments we're making for Watch tab; and then three, additional investments we're making in the long term initiatives like AR/VR, AI, and connectivity. And each of those are significant, so it's really the combination of those three factors that's driving the expense growth acceleration. And then on the 35% increases in ad prices, this is really being driven off of a couple things. One is just the auction dynamic, which as supply growth has slowed, then there's more competition, and you're seeing prices increase as demand continues to grow. But I think what is important here is we've been getting better and better at targeting as we optimize for real business results for advertisers, and we're better at converting the signals that we get from those advertisers into finding the right ad spots for them. And I think that's really what's allowing us to improve yield and effectively driving higher effective CPMs for us while still delivering business outcomes to them at attractive ROIs. So that's really what's driving it, not a shift to a different format like video. It's really about us getting better at targeting and working with especially people where we get those downstream signals like direct response advertisers.
Operator: Your next question comes from the line of Douglas Anmuth, JPMorgan.
Douglas T. Anmuth - JPMorgan Securities LLC: Thanks for taking the question. I wanted to hit on two topics. First just on the security comments, you talked about head count increasing from 10,000 to 20,000. I was hoping you could just help us understand. Is that 10,000 fully in the 23,000 head count that you have today, or is there a part of it that's not included in there, perhaps because it's not full time? And then just secondly, just going back to the ad pricing changes, Dave, just to clarify on that, it sounds like what you're saying is it's not that advertisers across the board are seeing that substantial of an increase in pricing, but that's more in output in your eCPM. Is that the right way to think about it? Thanks.
David M. Wehner - Facebook, Inc.: Right, Doug. So on the first one, the 10,000 number, that encompasses both employees at Facebook and also employees at partners, so it's not all Facebook employees. So that's a fully loaded number. So that's also in the OpEx guidance as well. But yes, you can't compare the 10,000 to the 23,000 directly. On the ad pricing, what you're seeing is that most of the advertising that we get isn't necessarily bid on an impression basis. You're getting people bidding for other actions and optimizing against other actions like a click to a website or a downstream e-commerce transaction, an app install. And our ability to optimize the inventory that we have against those downstream activities allows us to deliver those at still good prices while still seeing effective CPMs go up. You do have obviously people who are bidding on impressions if they're looking for a brand campaign or a reach campaign, but those aren't necessarily a part of the business that's driving up prices. It's more around just us doing a better job at being able to optimize campaigns for people who have downstream activities that we can do that for.
Operator: Your next question comes from the line of Heather Bellini, Goldman Sachs.
Heather Bellini - Goldman Sachs & Co. LLC: Great, thank you. I wanted to just ask a question about your content strategy, and I was wondering. How do you think about Facebook Watch in terms of Facebook-produced content versus the licensing of content that you might engage in? And I was wondering if there's a certain type of content that you think will be best suited to optimize the Watch experience. Thank you.
Mark Elliot Zuckerberg - Facebook, Inc.: I think it might be useful to talk a step back and first talk about why we're funding lighthouse content and Watch overall. So video is growing incredibly quickly on Facebook. And today, most of that is in News Feed. But most people who come to News Feed and who come to Facebook today in general are trying figure out – they're trying to see what's going on with their friends, see what's happening in the world. They're not coming necessarily to engage in a specific type of video or specific community around video. So the Watch tab is mainly – it's a way to give people a tool to do that. When they want to specifically come and engage around video or communities around that, they can go to the Watch tab. So the intent there is different. Now in order to build that up, we think it makes sense to first invest in a bunch of lighthouse content, some that we may produce or some that we may license, to get to your question. We're pretty agnostic on how that goes. We just want to start the flywheel going, so that way there's content and communities that are there that support this use case of people coming to Facebook specifically to engage in that. Long term, our hope is that the business here will primarily be through revenue shares of videos that normal creators and businesses put into the system rather than ones that we proactively go out and license ourselves. So that's a look at where we're trying to get on this. But first, we need to build this behavior where people want to come intentionally to engage with this content.
Operator: Your next question comes from the line of Ken Sena. Wells Fargo Securities.
Ken Sena - Wells Fargo Securities LLC: Hi, thank you. Just going back maybe to the investment and security comments, maybe could you provide a little more detail just on what that investment could look like and how we could think about that showing up in R&D, cost of revs, G&A, or maybe a combination, and then maybe any early thoughts on GDPR [General Data Protection Regulation] and potential impact there and maybe some of these transparency efforts if they could have possible benefit? Thank you.
David M. Wehner - Facebook, Inc.: So on the first part, Ken, you're going to see that show up in a variety of different line items that we don't have it specifically broken out. We're making substantial product and engineering investments. So as part of the overall hiring on R&D head count, there's going be a pretty significant allocation of that to some of the product-related security initiatives that we're doing. So that's going to show up in R&D. You're going to have some of the ads work that we're doing, the ads quality work showing up in the sales and marketing line, so you're going to see some there. And then you're going to also just have overall impact on G&A as well for things like policy-related expenses and the like. So I think you're going to see it impacting across the spectrum of our lines, but overall one of the significant factors driving the acceleration in growth rate.
Sheryl Kara Sandberg - Facebook, Inc.: On GDPR, the Facebook family of apps already applies the core principles in the framework because we built our services around transparency and control, and we're building on this to ensure that we comply in May of next year. It's too soon to tell whether this will impact the extent to which EU users opt out of certain services, but we're going to continue to give people personalized experience and be clear about how we're using the data. We believe that we'll be able to obtain consent for uses of the data across Europe and that people still expect the content and their ads to be relevant. And so we expect a good result here and we're going to do it very carefully and very seriously, as we always do.
Operator: Your next question comes from the line of Justin Post, Bank of America Merrill Lynch.
Justin Post - Bank of America Merrill Lynch: Great, two things. First, as you've integrated more video content into Facebook, are you seeing better time spent per user? Is that really showing up in more engagement on the site? And then secondly, it looks like you're running around $80 a year per user now in the U.S., quite, quite good improvement over the last couple years. Just thinking about benchmarking that versus other media categories or other things in traditional media, do you still think you have a lot of room ahead to grow that $80 over time? Thank you.
Mark Elliot Zuckerberg - Facebook, Inc.: I'll talk about video engagement, and then Dave can jump in on some of the stats. So one of the important points here that I tried to communicate in my comments up front is that connecting with friends and family and having those meaningful interactions is more important than just consuming content. So video is growing incredibly quickly, and that goes across both social content and more passive public consumption of content. And they create different dynamics in the system, and I think that's an important thing to understand. When your friend posts something and you get to engage with it, it might inform you and entertain you. But you also, if you interact with it, you're building a relationship with that person or you feel closer to that person, and that is a really important part of what social networking is supposed to do. Whereas when you engage with public content, you might get informed or be entertained, but it's not necessarily increasing social capital in the same way or building relationships between people. So we really differentiate what the core thing is that we're trying to do, which is help people connect with each other and build meaningful relationships. And that's why on a lot of these calls, I emphasize products like Instagram Stories or WhatsApp Status, which are very video-based products, but they're improving social interactions. And we're going to focus a lot more on helping people share videos of their moments in their lives. Because in a lot of ways, I think if you take a video of yourself and your family out trick-or-treating, that's more engaging than a photo and a better representation of that than writing it out in text. But overall, I would say not all time spent is created equal. That's why I tried to stress up front that time spent is not a goal by itself here. What we really want to go for is time well spent. And what the research that we found shows is that when you're actually engaging with people and having meaningful connections, that's time well spent, and that's the thing that we want to focus on. So out of this big video thing that's growing very quickly, I think that is the real opportunity and product area that we should be focused on more. And to the extent that there is going be a lot of public content, which there will be, a big part of the focus is going to be around building community and interactions around that content.
David M. Wehner - Facebook, Inc.: Justin, then your question on ARPU in the U.S., we do think that there are opportunities to continue to grow the business in the U.S. on a lot of different fronts. So we can continue to grow engagement on core Facebook, as well as there are opportunities with Instagram and the other services that we have that are not monetizing significantly today, so there are opportunities there. But most importantly, I would go back to the fact that we're getting better on the ad product side of being able to optimize our inventory for the advertisers in a way that will we think drive good pricing in the system for us and good outcomes for the advertisers. So we do think that that will lead to the potential for additional revenue growth in the U.S.
Operator: Your next question comes from the line of Ross Sandler, Barclays.
Ross Sandler - Barclays Capital, Inc.: Great, I had two questions for Mark. One, so, Mark, as you look to make changes around safety and security and ring-fence the fake news issue, do you think that will have any adverse impact on engagement, or is it just too small to even be material? And then a follow-up on the video consumption comment happening mostly in the Feed, is the deceleration you guys are seeing around impression growth right now a function of promoting video in the Feed versus what other things that might be in there? And I guess asked a different way, should we see impression growth revert back to view (43:52) growth at some point? And is that likely next year, or is that further off into the future? Thank you.
David M. Wehner - Facebook, Inc.: So I can take the second one, which is the question about impression growth. So there are a couple factors there. Certainly, this quarter we saw that ad load had a much less significant impact on impression growth. So overall, that story has played out as we thought, and that's one of the reasons you're seeing the impression growth come down. And then yes, I do think that there are less impressions when people are consuming video, so that also is a factor as more time is spent on videos. So I think you have both of those factors coming into play. In terms of how those play out going forward, hard to say. I would just point to our overall comments on just continued revenue growth deceleration. And I believe the first question was whether the security investments would have an adverse impact on engagement.
Mark Elliot Zuckerberg - Facebook, Inc.: Yes, and I can speak to that. Let me be clear on this, that people do not want false news or hate speech or bullying or any of the bad content that we're talking about. So to the extent that we can eradicate that from the platform, that will create a better product, which will also create a stronger long-term community and better business as well. So the reason why we haven't been able to get these things to the level that we want today is not because we somehow want them on the platform. It's that it's a really hard problem. And we're going to invest both in people and technology because we think that both are really important parts of the solution here, to go after all different parts of these problems. And that was what I tried to stress earlier on. We're going from 10,000 people working on safety and security to more than doubling that to 20,000. We're building – we're doubling – in some cases more – our engineering teams focused on security. We're building AI to go after more different areas of harmful content and finding fake accounts and other bad actors in the system. And I expect that all of these things will make our product better over the long term, but we will incur the expenses a lot sooner as we ramp up these efforts. And I also just think that going forward, we're going to be investing in these things at a much higher level because we realize that this is important, not only for our community and this company, but it's part of our responsibility to society overall.
Operator: Your next question comes from the line of Rich Greenfield, BTIG.
Richard Greenfield - BTIG LLC: Hi. Thanks for taking the question, a couple things. You talk about creators, I think, Mark, creating for the platform on their own without you having to invest. But I'm just trying to frame it in the sense of Hollywood. I look at what Apple is doing now and hiring a couple of Sony executives and doing a $5 million an episode buy of a Steven Spielberg show. I'm guess what I'm trying to understand – or I think a lot of investors are trying to understand is what type of content do you ultimately want? Because I don't think someone like Spielberg is going to work for an ad revenue share, no matter how good that advertising is. So how do you balance what type of content business you ultimately want to build? And then when you look at sports, which I also think about as being really relevant content that has a huge community around it, something like the NFL mobile rights I think come up next year. I'm wondering how important is that type of content? I know you were bidding on cricket rights overseas, but how important is sports in this mix?
Mark Elliot Zuckerberg - Facebook, Inc.: Well, I think the answer to that is we don't know all the answers around what kinds of content are going to work and are not, so we will probably experiment with a number of different things. I do think your point is right that not all kinds of content can be supported by ads, no matter how effective we make that. That said, the current model that we have for at least getting some of the lighthouse content onto the platform is to pay up front. And what we would like to transition that more to over time and what an increasing amount of the content is, is revenue shares for ads shown in the videos. And as we do better and better on the monetization there, that will support people with higher production costs and doing more premium production and bringing their content to the platform. And we've certainly found on the Internet and YouTube and in other places that there are whole industries around creators with different cost structures than traditional Hollywood folks who can produce very informative and engaging content that a lot of people like and enjoy and that builds communities and that helps people connect together in a way that definitely can be supported by this ad model. So I think the answer is we're going to try a bunch of things. That's a bunch of what the budget is. I'm very optimistic that a lot of this stuff will be able to be supported long term, but you're certainly right that not all of it will be able to be supported by ad models alone.
Operator: Your next question comes from the line of Brent Thill of Jefferies.
Brent Thill - Jefferies LLC: Thanks. On video, there's been a lot of questions about the ultimate profitability of this going forward. I was just curious if you could share your view. I know it's early, but what your thoughts are there.
David M. Wehner - Facebook, Inc.: I think – look, today we're talking about the additional investments we're making in terms of the lighthouse content on the Watch tab, so we are putting a substantial investment behind that. That clearly is going to have implications for margins along with the other big investments that we're making next year. And then even after we establish a flywheel here and get content being produced for ad revenue share, that's going have a different margin structure than core News Feed. So even going forward, there's going be revenue share back to the content creator, so it's going have a different margin structure than the core business.
Sheryl Kara Sandberg - Facebook, Inc.: I think it's worth adding that the ad inventory itself is really valuable for marketers and our clients and also works very well with our other ad products, so I'll share a recent one. Visa with SocialCode and BBDO created 10-second videos with text overlays showing people making digital payments. And they targeted millennials and early tech adopters. And they ran ads – one group for Facebook News Feed only, one group for Ad Breaks only, and one group for News Feed and Ad Breaks combined. And the best results combined the Ad Breaks and the News Feed. They had a seven times lower cost per video view compared to News Feed alone. And so one of the opportunities we have here is increasing inventory, and it's particularly good inventory for marketers because we're seeing nice adoption of video views and really nice impact from those sales. And it's also the case that our ad products work together. The ability to show something in News Feed and then show a video in Watch and then show something on Instagram and measure results across the full funnel we think are very worthy investments for the long-term health of the business.
Operator: Your next question comes from the line of Mark Mahaney, RBC Capital Markets. Mark Mahaney, your line is open.
Mark Mahaney - RBC Capital Markets LLC: Sorry about that, a comment and two questions. I think this incremental spend or this materially increased spend on security is highly unfortunate, but I think it makes eminent sense. I think most long-term investors realize that community maximization, including security, would lead to long-term profit maximization. So I think it makes eminent sense. Two quick questions, the Watch tab, is there any evidence or any data points you can give us to what kind of traction you're seeing with that so far? I was surprised by how many people are on the Marketplace. Any relevant data like that for Watch tab? And then secondly, of all the regions, Europe really stuck out to us as one that showed surprising acceleration. And I know you talked a little bit about that, Sheryl did, about the SMB pickup in traction there. Any other color for why Europe would have accelerated so much in terms of its revenue growth? Thank you.
David M. Wehner - Facebook, Inc.: Sure, let me I guess hit both of those and then Sheryl can add any color she'd like. On the Watch tab, I think it's just early. So I think it's too early to be talking about any stats there. In terms of Europe, one thing to note is that we did pick up currency advantages there. So it was 56% on a reported basis but 51% on a constant currency basis, still a healthy growth rate. I think it's a strong economy there. I think the team is executing well there, so I think you've got a variety of factors. As then as Sheryl commented in her prepared remarks, SMB has been particularly strong in Europe. And so I think that's one of the key drivers and one of the things we're really happy with.
Mark Elliot Zuckerberg - Facebook, Inc.: One clarification on your question two is that the 550 million people is across both Marketplace and buy-and-sell groups, not just the Marketplace tab. So that's the total amount of activity that we're seeing there across both of those things.
Operator: Your next question comes from the line of Colin Sebastian, Baird.
Colin Alan Sebastian - Robert W. Baird & Co., Inc.: Thanks for taking my question, first, a quick follow-up on safety and security. I guess I'm wondering why more of the AI and machine learning that you've built for product and the ad platform can't be utilized or cross-utilized to help mitigate some of the costs of adding people and technology to handle those issues. And then secondly, related to how much time younger people are spending or not spending on the Facebook apps, I wonder if you've looked at over the course of time the trend in usage as younger people hit different milestones in life such as graduating from college or getting a job and how their usage of the app changes over that timeframe, for example, if you're seeing a steady stream of the users come to Facebook once they hit those milestones. Any color on that would be interesting. Thank you.
Mark Elliot Zuckerberg - Facebook, Inc.: Sure, I'll speak to the safety and security investment, and then Dave can speak to the other question. So we need both technology and people for this. And the best articulation of this that I can make is that today, AI has different strengths than people do. So the AI tools that we've built can enable a system to look at millions of pieces of content and make rough assessments on them and figure out what to flag for people. But ultimately, if you want to get those high-quality judgments today on sensitive content and you want to do it quickly when the stakes are pretty high in terms of taking down content or leaving things up, and we take that extremely seriously, you want people to be looking at that. So earlier in the year, when we were working on problems like seeing issues when people were going live, there was this really serious issue around people with self-harm and in some cases suicide on Live, and we made an investment in AI tools and in dramatically increasing the staffing of the team that was working on that and brought the amount of time to review those Live videos down through a combination of those things to – I think it's under 10 minutes now. That might still be a conservative estimate, and we're continuing to work on that. So now what we're trying to do is just increase the SLAs that we have across all of these different types of content and security threats that we might see. So that way, through a combination of the AI tooling that we build and having people to look at these things, we can get it right faster for more of the types of content. And you're definitely right that a lot of the AI research that we do is applicable to multiple areas, but we still need to build those tools. So it takes a lot of engineering investment, and we will be prioritizing that, in some cases by adding people to teams and in other cases by trading off and doing more security work instead of other product work that we might have done, but this is really important and this is our priority.
David M. Wehner - Facebook, Inc.: I think on how people use our products in life stages, I would just – I would say generally, what we're trying to do is build a variety of different types of social products that can help in a variety of different use cases, so it can be one-on-one messaging with WhatsApp and Messenger. It could be sharing to Groups with Facebook. It could be the friends that you have on Instagram. So we're trying to make sure that we flesh out the full range of sharing experiences, and we think that has applicability across all the different life stages. And depending on the ages, people use the products differently, but not sharing any specific breakouts on that.
Deborah Crawford - Facebook, Inc.: Operator, we have time for one last question.
Operator: Your last question comes from the line of Youssef Squali, SunTrust.
Youssef Squali - SunTrust Robinson Humphrey: Thank you very much, just one question. You guys unbundled the video buy. Can you speak to pricing relative to that 35% average increase in ad pricing? Can you maybe just help us understand the disparity that exists today between pricing on the new video platform and the legacy video platform? Thank you.
David M. Wehner - Facebook, Inc.: So I'm not totally clear on what you mean by the new video platform and the legacy video platform, but I would just say that this is primarily driven by News Feed pricing, and then you have right-hand-column pricing as well, so you have impressions on Facebook News Feed, Instagram feed, as well as Facebook right-hand column. Ad Breaks are really a relatively small – a very small factor today. So the pricing is really about what is the pricing that you're seeing in the overall system primarily driven on the Feed-based products. So that's really what the driver is. And, again there, I would point to the comments that I made about getting better at targeting and driving towards good outcomes for advertisers as being the reason that we've been able to support higher prices.
Deborah Crawford - Facebook, Inc.: Great, thank you for joining us today. We appreciate your time, and we look forward to speaking with you again.
Operator: Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines. | [
{
"speaker": "Executives",
"text": "Deborah Crawford - Facebook, Inc. Mark Elliot Zuckerberg - Facebook, Inc. Sheryl Kara Sandberg - Facebook, Inc. David M. Wehner - Facebook, Inc."
},
{
"speaker": "Analysts",
"text": "Eric J. Sheridan - UBS Securities LLC Brian Nowak - Morgan Stanley & Co. LLC Mark A. May - Citigroup Global Markets, Inc. Douglas T. Anmuth - JPMorgan Securities LLC Heather Bellini - Goldman Sachs & Co. LLC Ken Sena - Wells Fargo Securities LLC Justin Post - Bank of America Merrill Lynch Ross Sandler - Barclays Capital, Inc. Richard Greenfield - BTIG LLC Brent Thill - Jefferies LLC Mark Mahaney - RBC Capital Markets LLC Colin Alan Sebastian - Robert W. Baird & Co., Inc. Youssef Squali - SunTrust Robinson Humphrey"
},
{
"speaker": "Operator",
"text": "Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook third quarter 2017 earnings call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford - Facebook, Inc.",
"text": "Thank you, good afternoon and welcome to Facebook's third quarter 2017 earnings conference call. Joining me today to discuss our results are: Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our quarterly report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now I'd like to turn the call over to Mark."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Thanks, Deborah, and thanks, everyone, for joining us today. Our community continues to grow, now with nearly 2.1 billion people using Facebook every month and nearly 1.4 billion people using it daily. Instagram also hit a big milestone this quarter, now with 500 million daily actives. And we saw good results in the business, where total revenue grew 47% year over year, and we had our first ever quarter with more than $10 billion in revenue. But none of that matters if our services are used in a way that doesn't bring people closer together, or if the foundation of our society is undermined by foreign interference. I've expressed how upset I am that the Russians tried to use our tools to sow mistrust. We built these tools to help people connect and to bring us closer together, and they used them to try to undermine our values. What they did is wrong, and we are not going to stand for it. Now for those who followed Facebook, you know that when we set our minds to something, we're going to do it. It may be harder than we realize up front. It may take longer and we won't be perfect, but we will get it done. We're bringing the same intensity to these security issues that we've brought to any adversary or challenge that we've faced. The first step is doing everything we can to help the U.S. government get a complete picture of what happened. We've testified in Congress over the past couple of days about the activity we found in last year's election. We're working with Congress on legislation to make advertising more transparent. I think this would be very good if it's done well. And even without legislation, we're already moving forward on our own to bring advertising on Facebook to an even higher standard of transparency than ads on TV or other media. That's because in traditional media, there's no way to see all the messages an advertiser is showing to different audiences. We're about to start rolling out a tool that lets you see all of the ads a page is running and also an archive of ads political advisers have run in the past. We're also working with other tech companies to help identify and respond to new threats because, as we've now seen, if there's a national security threat involving the Internet, it will affect many of the major tech companies, and we've announced a number of steps to help keep this kind of interference off our platform. This is part of a much bigger focus on protecting the security and integrity of our platform and the safety of our community. It goes beyond elections, and it means strengthening all of our systems to prevent abuse and harmful content. We're doing a lot here, with investments both in people and technology. Some of this is focused on finding bad actors and bad behavior. Some of this is focused on removing false news, hate speech, bullying, and other problematic content that we don't want in our community. We already have about 10,000 people working on safety and security, and we're planning to double that to 20,000 in the next year to better enforce our community standards and review ads. In many places, we're doubling or more our engineering efforts focused on security. And we're also building new AI to detect bad content and bad actors, just like we've done with terrorist propaganda. I am dead serious about this. And the reason I'm talking about this on our earnings call is that I've directed our teams to invest so much in security on top of the other investments we're making that it will significantly impact our profitability going forward, and I wanted our investors to hear that directly from me. I believe this will make our society stronger, and in doing so will be good for all of us over the long term. But I want to be clear about what our priority is. Protecting our community is more important than maximizing our profits. So security and the integrity of our services will be a major focus. Beyond this, our focus is on building community. I talked about this last quarter when we changed our mission to focus on building community to bring the world closer together, and that's more important now than ever. This gets into our roadmap for the next three, five, and ten years. Over the next three years, the biggest trend in our products will be the growth of video. This goes both for sharing, where we've seen Stories in Instagram and Status in WhatsApp grow very quickly, each with more than 300 million daily actives, and also for consuming video content. We recently launched the Watch tab, where you can discover shows, follow creators, connect with people watching an episode, and join groups with people with similar interests to build community. But as video grows, it's important to remember that Facebook is about bringing people closer together and enabling meaningful social interaction. It's not primarily about consuming content passively. Research shows that interacting with friends and family on social media tends to be more meaningful and can be good for our well-being, and that's time well spent. But when we just passively consume content, that may be less true. When done well, video brings us closer together. We've found that communities formed around video like TV shows or sport create a greater sense of belonging than many other kinds of communities. We found that live videos generate 10 times the number of interactions and comments as other videos. But too often right now, watching a video is just a passive consumption experience. Time spent is not a goal by itself. We want the time people spend on Facebook to encourage meaningful social interaction. So we're going to focus our products on all the ways to build community around the videos that people share and watch. That's something Facebook can uniquely do. Moving along, over the next five years, I expect us to make some good progress on several newer initiatives. In messaging, today already more than 20 million businesses are communicating with customers through Messenger. Now we're starting to test business features that make it easier for people to make the same kinds of connections with businesses through WhatsApp. We rolled out Marketplace to Canada and 17 countries across Europe, giving people the ability to discover, buy, and sell things in their local communities. Today, more than 550 million people are using Marketplace and buy-and-sell groups on Facebook to connect with other people for transactions. We're also seeing good progress with Workplace, helping companies connect their own teams internally through their own versions of Facebook. It's been less than a year since we launched Workplace, and today more than 30,000 companies are using it. This quarter, we welcomed on Walmart, the largest employer in the U.S. Over the next 10 years, we are working on the foundational technologies needed to bring the world closer together. I'm proud of the work we're doing with AI. We're now using machine learning in most of our integrity work to keep our community safe. When Hurricane Maria hit Puerto Rico, we used AI to look at satellite imagery and identify where people might live and need connectivity and other resources. Progress in AI can unlock a lot of opportunities. This quarter we opened a new AI research lab in Montreal, and we're building another lab in Paris as well. This quarter we held Oculus Connect and we announced Oculus Go, our first-ever all-in-one headset that's great for feeling like you're present with someone when you can't physically be together in person. It's great for playing games, watching movies, or hanging out with friends. And at $199, we think it's going to help us bring great virtual reality experiences to more people. It ships next year. At Connect, I also showed off our new Santa Cruz prototype, which is the first time any company has shown the full experience of positional tracking in a standalone headset and controllers. It's a major technical achievement, and I'm looking forward to getting this into developers' hands next year. In order to support our community's growth, we need to keep investing in our infrastructure. This quarter we broke ground on our New Albany [Ohio] data center, and we announced that we'll build our 11th major data center in Henrico County, Virginia. As always, all our new data centers are powered by 100% renewable energy. These long-term investments are important for our community's future. We can do a lot to help people connect through phones and computers, but so much more will be possible in a world where everyone has Internet access, where AI improves all our services, and where we can basically teleport anywhere or be with anyone anytime we want. With all the issues we've faced, it would be a lot to just invest in addressing those. But we know that we also have a responsibility to deliver these fundamental technical and scientific advances to fulfill the promise of bringing people closer together. So we're going to keep making significant investments looking ahead towards the future too. We've made some real progress this year. Across the board, we have a lot of work to deliver on our mission of bringing the world closer together, but we're committed to rising to the challenge and doing what we need to for our community. Thanks to all of you for being a part of this journey, and I'm looking forward to the road ahead. And now here's Sheryl to discuss our business."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "Thanks, Mark, and hi, everyone. We had a strong third quarter, with growth across all regions, Marketer segments, and verticals. Ad revenue grew 49% year over year. Mobile ad revenue was $8.9 billion, a 57% year-over-year increase, making up approximately 88% of total ad revenue. We're continuing to build our business by focusing on our same three priorities: helping businesses leverage the power of mobile; developing new ad products; and making our ads more relevant and effective. Today, we're announcing that Facebook has over 6 million active advertisers, and we recently announced that Instagram has over 2 million advertisers. The vast majority of these are small and medium-sized businesses, which are a major source of innovation and create more than half of all new jobs globally. These businesses often have small ad budgets, so the ability to reach people more effectively is really valuable to them. A great example value is LoveBook, a small business in Michigan which lets you make personalized books for the people you love. During a recent campaign, they used Facebook ads to reach people getting ready to celebrate their first anniversary. They've grown so much from marketing on Facebook that they've been able to hire 10 new employees this year alone. We're proud of the role we are playing in enabling businesses like LoveBook to reach people on mobile, to grow, and to create jobs. One of our strongest areas this quarter was SMBs in Europe, with revenue growing more than 60% year over year. When I was Germany two months ago, I had a chance to meet Victor, one of the cofounders of Brooklyn Soap Company, which despite its name is based in Hamburg. Victor and his friends came up with the idea for their business while staying in a hostel in Brooklyn. Now they sell their grooming products in 38 countries using mobile video ads on Facebook and Instagram. As a result, their sales increased 62% over the last year. They're one of many small businesses using mobile to find new customers and grow across borders. Our second priority is developing innovative ad products. Video is exploding, and mobile video advertising is a big opportunity. Until recently, ads were only eligible for Ad Breaks if they also ran in News Feed. But in Q3, we gave advertisers the option to run ads in videos alone. We're seeing good early results, with more than 70% of Ad Breaks up to 15 seconds in length on Facebook and Audience Network viewed to completion, most with the sound on. As Mark said, Instagram Stories are growing well too. People and businesses are finding creative new ways to use full-screen vertical video in Stories. This quarter, we gave advertisers even more flexibility in the content, format, and reach of their ads in Stories. We're also seeing how immersive video and images can help people discover new products on Facebook. We added a new creative template to Collection Ads, which helps retailers bring their catalogs online. West Elm, a home décor company, recently used this template to promote its furniture and home accessories. They targeted people who already got their physical catalog and saw a 5.5% lift in purchases in store. Our third priority is making our ads more relevant and effective. In Q3, we introduced new tools powered by machine learning and automation to help businesses reach people more likely to spend with them. We also simplified the tools for creating ads, making it easier for businesses of all sizes to advertise with us. It's important for all businesses to reach the right audience, but it's especially important for small businesses that have limited budgets. Targeting allows them to show ads only to the people they want to reach. Neon Retro Arcade in L.A. is a great example. They advertise to people within 10 miles of their location who are interested in video games and comic books. Last year, they moved their entire ad budget to Facebook and Instagram, and their revenue was up 25%. Relevance and effectiveness are also about giving businesses more control over where their ads run. In Q3, we clarified which publishers and creators can include ads next to their content. This is good for creators who want guidance on how to earn money from their content on Facebook, and it's good for advertisers who want transparency and control to make the right decisions for their brands. We're also working to give advertisers more clarity on where their ads are shown so they can make more informed choices about where to run them in the future. I want to close by talking about what we're doing to protect our platform and help ensure that the ads and content people see on Facebook and Instagram are legitimate and authentic. When I was in Washington a few weeks ago, I made it clear that we are determined to do everything we can do to minimize abuse going forward. As Mark said, we're investing heavily in new technology and people to review ads and posts. This will enable us to look more closely at the content of the ads, targeting, and the advertiser who submits them, as well as tighten our ads policies, particularly for ads directed at social and political issues. We believe that ads are important to free expression and we will continue to accept ads on issues, but we will also do our part to elevate the quality of that discourse. Transparency helps everyone keep advertisers accountable for their messages. We're working with Congress on new requirements for online political advertising, but we are not waiting for legislation. We're building a tool now that will allow anyone to see the ads of pages running, even if those ads are not targeted to them. We will test it soon in Canada and then in the U.S. in the coming months. For ads related to U.S. federal elections, we'll start sharing even more information, including an archive of past ads, the total amount spent, and demographics about the people the ad reached. We're also going to require more thorough documentation from these advertisers and will label their ads so it's clear who paid for them. We believe these actions will set a new standard for transparency in online ads. Because the interference on our platform went beyond ads, we're also increasing transparency around organic content from pages. We're looking at ways to provide more information about who's behind a political or issue-based Facebook page. We believe this will make it harder for deceptive pages to gain large followings and make it easier for us to identify malicious activity. We are all committed to getting this right and to investing and strengthening our platform so we can better serve our community. We are also committed to continuing to help businesses all over the world attract customers, sell their products, and create jobs. As always, I'm grateful to all of our clients for their partnership and to our global Facebook teams for their hard work. Thank you, and now here's Dave."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Thanks, Sheryl, and good afternoon, everyone. Q3 was another great quarter for Facebook. We saw continued growth in engagement in our community as well as strong performance in our ads business. Let's begin with our community metrics. Daily active users in Q3 reached 1.37 billion, up 16% compared to last year. This number represents 66% of our 2.07 billion monthly active users in Q3. MAUs were up 284 million year over year or 16%. Our community growth was again driven by product improvements, promotional data plans, and internet.org. Note that in Q3 we began to lap the introduction of promotional data plans from mobile operators in markets like India. Before going to the financials, let me touch briefly on our ongoing effort to improve our user aspects. This quarter we implemented a new methodology to help identify duplicate accounts. As a result, we increased our estimates for duplicate accounts to approximately 10% of worldwide MAUs from our previously disclosed estimate of 6%. Duplicate accounts are those that we believe are used by the same person and represent real activity and engagement on Facebook. We have also increased our estimate for inauthentic accounts to approximately 2% to 3% of worldwide MAUs. Inauthentic accounts are largely those that are used for spam and other policy violating reasons. We continuously monitor and aggressively take down those accounts. These accounts tend to be less active and thus we believe impact DAU less than MAU. Now turning to the financials, all comparisons are on a year-over-year basis unless otherwise noted. Q3 total revenue was $10.3 billion, up 47% or 45% on a constant currency basis. Foreign exchange tailwinds contributed $128 million of revenue in Q3. Q3 total ad revenue was $10.1 billion, up 49%. On a constant currency basis, our ad revenue growth rate was 47%, down 2 percentage points compared to the growth in Q2. Ad revenue growth was strong globally, led by Europe and APAC with 56% and 54% growth respectively. Mobile ad revenue was $8.9 billion, up 57%. In Q3, the average price per ad increased 35%, and the number of ad impressions served increased 10%, driven primarily by Feed ads on Facebook and Instagram. I would note that compared to a year ago, price is a much more important driver of our ads revenue growth. Payments and other fees revenue was $186 million, down 5%. Total expenses were $5.2 billion, up 34%. Q3 was our biggest hiring quarter ever. We added over 2,500 people and ended the quarter with over 23,000 employees, up 47% compared to last year. Operating income was $5.1 billion, representing a 50% operating margin. Our tax rate in the third quarter was 10%. Excess tax benefits recognized from share-based compensation decreased our effective tax rate by 6 percentage points, a level that was driven by appreciation in our stock price. Net income was $4.7 billion or $1.59 per share. Year-to-date capital expenditures were approximately $4.5 billion, driven by investments in servers, data centers, office facilities, and network infrastructure. In Q3, we generated over $4.3 billion in free cash flow, and ended the quarter with over $38 billion in cash and investments. Year to date, we have bought back over $1 billion of our Class A common stock. Turning now to the revenue outlook, our ads business remains strong, but it's worth noting that in Q3, our year-over-year ads revenue growth rates decelerated for the fifth consecutive quarter on a constant currency basis, and we expect this trend to continue for the foreseeable future. Going forward, we also expect the growth in advertising revenue will increasingly be driven by price. This is a shift from prior years, when growth was primarily driven by increases in supply. Turning now to expenses, we anticipate that our full-year 2017 total expenses will grow approximately 35% to 40% versus our prior range of 40% to 45%. We anticipate that full-year 2017 capital expenditures will be approximately $7 billion. As mentioned previously, our tax rate will vary based on our stock price. At the current stock price, we would expect that the Q4 rate will be in the low teens. I also wanted to provide some comments on 2018 expenses and capital expenditures. Please recognize that these are preliminary estimates, as we have not yet finalized our 2018 budget. That said, it is shaping up to a be a significant investment year, and I wanted to provide initial guidance to align investors with our most current thinking. We expect full-year 2018 total expenses will grow approximately 45% to 60% compared to full-year 2017. We continued to invest aggressively across the business, but there are three important factors driving an acceleration in our expense growth rates from 2017 levels. First, as Mark outlined in his earlier comments, we are making sizable security investments in people and technology to strengthen our systems and prevent abuse. Secondly, we are investing aggressively in video content to support the Watch tab. Finally, we continue to invest in our long-term initiatives around augmented and virtual reality, AI, and connectivity. Given our expectation of continued deceleration in revenue growth rates, we expect these significant investments will be net negative on our operating margins. In addition, we expect to make substantial investments in our infrastructure to support growth and improve our products. As such, we expect full-year 2018 capital expenditures will roughly double from 2017 levels. We would also anticipate that the full-year 2018 tax rate will be in the mid-teens. In summary, Q3 was another strong quarter for Facebook across the board. We are excited about the opportunities we see ahead and will continue to make significant investments to support our growth and our mission. With that, Mike, let's open up the call for questions."
},
{
"speaker": "Operator",
"text": "We will now open the lines for a question-and-answer session. Your first question comes from the line of Eric Sheridan, UBS."
},
{
"speaker": "Eric J. Sheridan - UBS Securities LLC",
"text": "Thanks for taking the question. Maybe revisiting Mark's comments at the beginning of the call, I would love to get a better sense or granularity about what sort of video content you'd like to see on the platform that could drive a more active or interactive experience than passive. And then the second question would be, what does that mean in terms of the business model? Would there be licensing content, funding content that you have to do to build the sort of business you're aiming for over the medium to long term? Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "So the strategy here around helping people connect reflects more on what we do around the videos than some of the content itself. So hopefully, the experience on Facebook will not just be that you come and watch a video and you get informed, you feel entertained, and that's it. We think that the most valuable thing that people do are help build relationships with other people on the platform. So to the extent that video can serve as a touchstone for building community and helping facilitate interaction, then that's the thing that we feel like we can uniquely do. So we're going to continue investing heavily in video content for Watch that is centered around people, that is centered around the things that people want to talk and connect around, that give people a sense of pride and bring people together. But we're going to invest as much in just making sure that we build out the community features around that. And that I think is going to be the thing that differentiates this over time."
},
{
"speaker": "Operator",
"text": "Your next question comes from Brian Nowak, Morgan Stanley."
},
{
"speaker": "Brian Nowak - Morgan Stanley & Co. LLC",
"text": "Thanks for taking my questions. I have two. Just, Mark, to go back on your focus on community and video, I was wondering if you could share with us or help us understand what you're seeing in engagement trends or maybe time spent per user on the core Facebook platform, as you've had so many efforts focused on community and video. And then secondly for Sheryl, you made such good progress growing the advertising business across SMB in a lot of verticals. I wonder. If you step back, could you talk to any areas or any verticals where you really see the potential for material improvements or verticals you're having a hard time cracking into that you think can really be bigger drivers of ad revenue growth going forward?"
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "So, Brian, just on engagement metrics, we're continuing to see good growth in DAU, as you saw in the 16% growth that we posted this quarter. In addition, we do continue to see time spent growth per DAU on the Facebook family and on Facebook."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "For my part, when I think about our Marketer segment, we have SMBs; we have brand, direct response, and developers. We're seeing strong growth across. I think if you think about where the growth remains, it really is in increasing the relevance of the ads, because the ads I think are getting better in terms of reaching the right people at the right time. But I think there's still a lot more we can do. And as people really use our Custom Audiences, our targeting tools, the quality of the ads improve and the returns improve. And the more we – the better we get at measuring those returns, the better the ads get. And so I'll share just one example but one I really love, which is the Alameda County Fair, which is a local fairground in Pleasanton, California. I happened to meet this woman, Angel [Moore], who's running their marketing this year. And they use Facebook to target people within 25 miles of their fairgrounds age 20 to 51 who have specific interests in concerts, music festivals, and theme parks. And what they saw for season pass ticket sales for 2017 was a 50% increase compared to 2016, and they attribute that to Facebook. And that's really about finding the people that are interested. And if you look at the percentage of our ads business where people are using our most sophisticated approaches to finding the right audience, I think we still have a lot of opportunity for growth there, and that will improve both the quality of the ads people see but also the returns to marketers. And I think that will hit all of the verticals and all of the segments."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mark May, Citi."
},
{
"speaker": "Mark A. May - Citigroup Global Markets, Inc.",
"text": "Thank you. I had two related questions on video. First on the OpEx guidance, one of the real consistencies of the business is OpEx growth. You've been growing that at $4 billion to $5 billion incremental spend per year, but the midpoint of your guidance is looking like a $14 billion increase next year. Is the differential there, the additional $6 billion to $7 billion, should we be thinking of that as the video content spend that you're setting aside possibly to spend next year? I'm just trying to understand where this significant increase would be coming from. And then related, the 35% increase in ad prices – would you say that that's predominantly being driven, the acceleration there, by the mix towards video, Ad Breaks, and other longer-form video ads? Thanks."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Sure, Mark. So on the acceleration of the growth rate in expenses from 2017 to 2018, I would really look at the growth rate that we grew at in 2017, apply that to the total expense base, and look at that growth in 2018. And then I would say the additional expense that leads to the acceleration is driven by three factors, not just one factor. And those three factors are the ones that I outlined in my commentary: number one, the substantial investment that Mark highlighted that we're making to just improve the security on our platform; two, the video content investments we're making for Watch tab; and then three, additional investments we're making in the long term initiatives like AR/VR, AI, and connectivity. And each of those are significant, so it's really the combination of those three factors that's driving the expense growth acceleration. And then on the 35% increases in ad prices, this is really being driven off of a couple things. One is just the auction dynamic, which as supply growth has slowed, then there's more competition, and you're seeing prices increase as demand continues to grow. But I think what is important here is we've been getting better and better at targeting as we optimize for real business results for advertisers, and we're better at converting the signals that we get from those advertisers into finding the right ad spots for them. And I think that's really what's allowing us to improve yield and effectively driving higher effective CPMs for us while still delivering business outcomes to them at attractive ROIs. So that's really what's driving it, not a shift to a different format like video. It's really about us getting better at targeting and working with especially people where we get those downstream signals like direct response advertisers."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Douglas Anmuth, JPMorgan."
},
{
"speaker": "Douglas T. Anmuth - JPMorgan Securities LLC",
"text": "Thanks for taking the question. I wanted to hit on two topics. First just on the security comments, you talked about head count increasing from 10,000 to 20,000. I was hoping you could just help us understand. Is that 10,000 fully in the 23,000 head count that you have today, or is there a part of it that's not included in there, perhaps because it's not full time? And then just secondly, just going back to the ad pricing changes, Dave, just to clarify on that, it sounds like what you're saying is it's not that advertisers across the board are seeing that substantial of an increase in pricing, but that's more in output in your eCPM. Is that the right way to think about it? Thanks."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Right, Doug. So on the first one, the 10,000 number, that encompasses both employees at Facebook and also employees at partners, so it's not all Facebook employees. So that's a fully loaded number. So that's also in the OpEx guidance as well. But yes, you can't compare the 10,000 to the 23,000 directly. On the ad pricing, what you're seeing is that most of the advertising that we get isn't necessarily bid on an impression basis. You're getting people bidding for other actions and optimizing against other actions like a click to a website or a downstream e-commerce transaction, an app install. And our ability to optimize the inventory that we have against those downstream activities allows us to deliver those at still good prices while still seeing effective CPMs go up. You do have obviously people who are bidding on impressions if they're looking for a brand campaign or a reach campaign, but those aren't necessarily a part of the business that's driving up prices. It's more around just us doing a better job at being able to optimize campaigns for people who have downstream activities that we can do that for."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Heather Bellini, Goldman Sachs."
},
{
"speaker": "Heather Bellini - Goldman Sachs & Co. LLC",
"text": "Great, thank you. I wanted to just ask a question about your content strategy, and I was wondering. How do you think about Facebook Watch in terms of Facebook-produced content versus the licensing of content that you might engage in? And I was wondering if there's a certain type of content that you think will be best suited to optimize the Watch experience. Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "I think it might be useful to talk a step back and first talk about why we're funding lighthouse content and Watch overall. So video is growing incredibly quickly on Facebook. And today, most of that is in News Feed. But most people who come to News Feed and who come to Facebook today in general are trying figure out – they're trying to see what's going on with their friends, see what's happening in the world. They're not coming necessarily to engage in a specific type of video or specific community around video. So the Watch tab is mainly – it's a way to give people a tool to do that. When they want to specifically come and engage around video or communities around that, they can go to the Watch tab. So the intent there is different. Now in order to build that up, we think it makes sense to first invest in a bunch of lighthouse content, some that we may produce or some that we may license, to get to your question. We're pretty agnostic on how that goes. We just want to start the flywheel going, so that way there's content and communities that are there that support this use case of people coming to Facebook specifically to engage in that. Long term, our hope is that the business here will primarily be through revenue shares of videos that normal creators and businesses put into the system rather than ones that we proactively go out and license ourselves. So that's a look at where we're trying to get on this. But first, we need to build this behavior where people want to come intentionally to engage with this content."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ken Sena. Wells Fargo Securities."
},
{
"speaker": "Ken Sena - Wells Fargo Securities LLC",
"text": "Hi, thank you. Just going back maybe to the investment and security comments, maybe could you provide a little more detail just on what that investment could look like and how we could think about that showing up in R&D, cost of revs, G&A, or maybe a combination, and then maybe any early thoughts on GDPR [General Data Protection Regulation] and potential impact there and maybe some of these transparency efforts if they could have possible benefit? Thank you."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "So on the first part, Ken, you're going to see that show up in a variety of different line items that we don't have it specifically broken out. We're making substantial product and engineering investments. So as part of the overall hiring on R&D head count, there's going be a pretty significant allocation of that to some of the product-related security initiatives that we're doing. So that's going to show up in R&D. You're going to have some of the ads work that we're doing, the ads quality work showing up in the sales and marketing line, so you're going to see some there. And then you're going to also just have overall impact on G&A as well for things like policy-related expenses and the like. So I think you're going to see it impacting across the spectrum of our lines, but overall one of the significant factors driving the acceleration in growth rate."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "On GDPR, the Facebook family of apps already applies the core principles in the framework because we built our services around transparency and control, and we're building on this to ensure that we comply in May of next year. It's too soon to tell whether this will impact the extent to which EU users opt out of certain services, but we're going to continue to give people personalized experience and be clear about how we're using the data. We believe that we'll be able to obtain consent for uses of the data across Europe and that people still expect the content and their ads to be relevant. And so we expect a good result here and we're going to do it very carefully and very seriously, as we always do."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Justin Post, Bank of America Merrill Lynch."
},
{
"speaker": "Justin Post - Bank of America Merrill Lynch",
"text": "Great, two things. First, as you've integrated more video content into Facebook, are you seeing better time spent per user? Is that really showing up in more engagement on the site? And then secondly, it looks like you're running around $80 a year per user now in the U.S., quite, quite good improvement over the last couple years. Just thinking about benchmarking that versus other media categories or other things in traditional media, do you still think you have a lot of room ahead to grow that $80 over time? Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "I'll talk about video engagement, and then Dave can jump in on some of the stats. So one of the important points here that I tried to communicate in my comments up front is that connecting with friends and family and having those meaningful interactions is more important than just consuming content. So video is growing incredibly quickly, and that goes across both social content and more passive public consumption of content. And they create different dynamics in the system, and I think that's an important thing to understand. When your friend posts something and you get to engage with it, it might inform you and entertain you. But you also, if you interact with it, you're building a relationship with that person or you feel closer to that person, and that is a really important part of what social networking is supposed to do. Whereas when you engage with public content, you might get informed or be entertained, but it's not necessarily increasing social capital in the same way or building relationships between people. So we really differentiate what the core thing is that we're trying to do, which is help people connect with each other and build meaningful relationships. And that's why on a lot of these calls, I emphasize products like Instagram Stories or WhatsApp Status, which are very video-based products, but they're improving social interactions. And we're going to focus a lot more on helping people share videos of their moments in their lives. Because in a lot of ways, I think if you take a video of yourself and your family out trick-or-treating, that's more engaging than a photo and a better representation of that than writing it out in text. But overall, I would say not all time spent is created equal. That's why I tried to stress up front that time spent is not a goal by itself here. What we really want to go for is time well spent. And what the research that we found shows is that when you're actually engaging with people and having meaningful connections, that's time well spent, and that's the thing that we want to focus on. So out of this big video thing that's growing very quickly, I think that is the real opportunity and product area that we should be focused on more. And to the extent that there is going be a lot of public content, which there will be, a big part of the focus is going to be around building community and interactions around that content."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Justin, then your question on ARPU in the U.S., we do think that there are opportunities to continue to grow the business in the U.S. on a lot of different fronts. So we can continue to grow engagement on core Facebook, as well as there are opportunities with Instagram and the other services that we have that are not monetizing significantly today, so there are opportunities there. But most importantly, I would go back to the fact that we're getting better on the ad product side of being able to optimize our inventory for the advertisers in a way that will we think drive good pricing in the system for us and good outcomes for the advertisers. So we do think that that will lead to the potential for additional revenue growth in the U.S."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ross Sandler, Barclays."
},
{
"speaker": "Ross Sandler - Barclays Capital, Inc.",
"text": "Great, I had two questions for Mark. One, so, Mark, as you look to make changes around safety and security and ring-fence the fake news issue, do you think that will have any adverse impact on engagement, or is it just too small to even be material? And then a follow-up on the video consumption comment happening mostly in the Feed, is the deceleration you guys are seeing around impression growth right now a function of promoting video in the Feed versus what other things that might be in there? And I guess asked a different way, should we see impression growth revert back to view (43:52) growth at some point? And is that likely next year, or is that further off into the future? Thank you."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "So I can take the second one, which is the question about impression growth. So there are a couple factors there. Certainly, this quarter we saw that ad load had a much less significant impact on impression growth. So overall, that story has played out as we thought, and that's one of the reasons you're seeing the impression growth come down. And then yes, I do think that there are less impressions when people are consuming video, so that also is a factor as more time is spent on videos. So I think you have both of those factors coming into play. In terms of how those play out going forward, hard to say. I would just point to our overall comments on just continued revenue growth deceleration. And I believe the first question was whether the security investments would have an adverse impact on engagement."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Yes, and I can speak to that. Let me be clear on this, that people do not want false news or hate speech or bullying or any of the bad content that we're talking about. So to the extent that we can eradicate that from the platform, that will create a better product, which will also create a stronger long-term community and better business as well. So the reason why we haven't been able to get these things to the level that we want today is not because we somehow want them on the platform. It's that it's a really hard problem. And we're going to invest both in people and technology because we think that both are really important parts of the solution here, to go after all different parts of these problems. And that was what I tried to stress earlier on. We're going from 10,000 people working on safety and security to more than doubling that to 20,000. We're building – we're doubling – in some cases more – our engineering teams focused on security. We're building AI to go after more different areas of harmful content and finding fake accounts and other bad actors in the system. And I expect that all of these things will make our product better over the long term, but we will incur the expenses a lot sooner as we ramp up these efforts. And I also just think that going forward, we're going to be investing in these things at a much higher level because we realize that this is important, not only for our community and this company, but it's part of our responsibility to society overall."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Rich Greenfield, BTIG."
},
{
"speaker": "Richard Greenfield - BTIG LLC",
"text": "Hi. Thanks for taking the question, a couple things. You talk about creators, I think, Mark, creating for the platform on their own without you having to invest. But I'm just trying to frame it in the sense of Hollywood. I look at what Apple is doing now and hiring a couple of Sony executives and doing a $5 million an episode buy of a Steven Spielberg show. I'm guess what I'm trying to understand – or I think a lot of investors are trying to understand is what type of content do you ultimately want? Because I don't think someone like Spielberg is going to work for an ad revenue share, no matter how good that advertising is. So how do you balance what type of content business you ultimately want to build? And then when you look at sports, which I also think about as being really relevant content that has a huge community around it, something like the NFL mobile rights I think come up next year. I'm wondering how important is that type of content? I know you were bidding on cricket rights overseas, but how important is sports in this mix?"
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Well, I think the answer to that is we don't know all the answers around what kinds of content are going to work and are not, so we will probably experiment with a number of different things. I do think your point is right that not all kinds of content can be supported by ads, no matter how effective we make that. That said, the current model that we have for at least getting some of the lighthouse content onto the platform is to pay up front. And what we would like to transition that more to over time and what an increasing amount of the content is, is revenue shares for ads shown in the videos. And as we do better and better on the monetization there, that will support people with higher production costs and doing more premium production and bringing their content to the platform. And we've certainly found on the Internet and YouTube and in other places that there are whole industries around creators with different cost structures than traditional Hollywood folks who can produce very informative and engaging content that a lot of people like and enjoy and that builds communities and that helps people connect together in a way that definitely can be supported by this ad model. So I think the answer is we're going to try a bunch of things. That's a bunch of what the budget is. I'm very optimistic that a lot of this stuff will be able to be supported long term, but you're certainly right that not all of it will be able to be supported by ad models alone."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Brent Thill of Jefferies."
},
{
"speaker": "Brent Thill - Jefferies LLC",
"text": "Thanks. On video, there's been a lot of questions about the ultimate profitability of this going forward. I was just curious if you could share your view. I know it's early, but what your thoughts are there."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "I think – look, today we're talking about the additional investments we're making in terms of the lighthouse content on the Watch tab, so we are putting a substantial investment behind that. That clearly is going to have implications for margins along with the other big investments that we're making next year. And then even after we establish a flywheel here and get content being produced for ad revenue share, that's going have a different margin structure than core News Feed. So even going forward, there's going be revenue share back to the content creator, so it's going have a different margin structure than the core business."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "I think it's worth adding that the ad inventory itself is really valuable for marketers and our clients and also works very well with our other ad products, so I'll share a recent one. Visa with SocialCode and BBDO created 10-second videos with text overlays showing people making digital payments. And they targeted millennials and early tech adopters. And they ran ads – one group for Facebook News Feed only, one group for Ad Breaks only, and one group for News Feed and Ad Breaks combined. And the best results combined the Ad Breaks and the News Feed. They had a seven times lower cost per video view compared to News Feed alone. And so one of the opportunities we have here is increasing inventory, and it's particularly good inventory for marketers because we're seeing nice adoption of video views and really nice impact from those sales. And it's also the case that our ad products work together. The ability to show something in News Feed and then show a video in Watch and then show something on Instagram and measure results across the full funnel we think are very worthy investments for the long-term health of the business."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Mark Mahaney, RBC Capital Markets. Mark Mahaney, your line is open."
},
{
"speaker": "Mark Mahaney - RBC Capital Markets LLC",
"text": "Sorry about that, a comment and two questions. I think this incremental spend or this materially increased spend on security is highly unfortunate, but I think it makes eminent sense. I think most long-term investors realize that community maximization, including security, would lead to long-term profit maximization. So I think it makes eminent sense. Two quick questions, the Watch tab, is there any evidence or any data points you can give us to what kind of traction you're seeing with that so far? I was surprised by how many people are on the Marketplace. Any relevant data like that for Watch tab? And then secondly, of all the regions, Europe really stuck out to us as one that showed surprising acceleration. And I know you talked a little bit about that, Sheryl did, about the SMB pickup in traction there. Any other color for why Europe would have accelerated so much in terms of its revenue growth? Thank you."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Sure, let me I guess hit both of those and then Sheryl can add any color she'd like. On the Watch tab, I think it's just early. So I think it's too early to be talking about any stats there. In terms of Europe, one thing to note is that we did pick up currency advantages there. So it was 56% on a reported basis but 51% on a constant currency basis, still a healthy growth rate. I think it's a strong economy there. I think the team is executing well there, so I think you've got a variety of factors. As then as Sheryl commented in her prepared remarks, SMB has been particularly strong in Europe. And so I think that's one of the key drivers and one of the things we're really happy with."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "One clarification on your question two is that the 550 million people is across both Marketplace and buy-and-sell groups, not just the Marketplace tab. So that's the total amount of activity that we're seeing there across both of those things."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Colin Sebastian, Baird."
},
{
"speaker": "Colin Alan Sebastian - Robert W. Baird & Co., Inc.",
"text": "Thanks for taking my question, first, a quick follow-up on safety and security. I guess I'm wondering why more of the AI and machine learning that you've built for product and the ad platform can't be utilized or cross-utilized to help mitigate some of the costs of adding people and technology to handle those issues. And then secondly, related to how much time younger people are spending or not spending on the Facebook apps, I wonder if you've looked at over the course of time the trend in usage as younger people hit different milestones in life such as graduating from college or getting a job and how their usage of the app changes over that timeframe, for example, if you're seeing a steady stream of the users come to Facebook once they hit those milestones. Any color on that would be interesting. Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Sure, I'll speak to the safety and security investment, and then Dave can speak to the other question. So we need both technology and people for this. And the best articulation of this that I can make is that today, AI has different strengths than people do. So the AI tools that we've built can enable a system to look at millions of pieces of content and make rough assessments on them and figure out what to flag for people. But ultimately, if you want to get those high-quality judgments today on sensitive content and you want to do it quickly when the stakes are pretty high in terms of taking down content or leaving things up, and we take that extremely seriously, you want people to be looking at that. So earlier in the year, when we were working on problems like seeing issues when people were going live, there was this really serious issue around people with self-harm and in some cases suicide on Live, and we made an investment in AI tools and in dramatically increasing the staffing of the team that was working on that and brought the amount of time to review those Live videos down through a combination of those things to – I think it's under 10 minutes now. That might still be a conservative estimate, and we're continuing to work on that. So now what we're trying to do is just increase the SLAs that we have across all of these different types of content and security threats that we might see. So that way, through a combination of the AI tooling that we build and having people to look at these things, we can get it right faster for more of the types of content. And you're definitely right that a lot of the AI research that we do is applicable to multiple areas, but we still need to build those tools. So it takes a lot of engineering investment, and we will be prioritizing that, in some cases by adding people to teams and in other cases by trading off and doing more security work instead of other product work that we might have done, but this is really important and this is our priority."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "I think on how people use our products in life stages, I would just – I would say generally, what we're trying to do is build a variety of different types of social products that can help in a variety of different use cases, so it can be one-on-one messaging with WhatsApp and Messenger. It could be sharing to Groups with Facebook. It could be the friends that you have on Instagram. So we're trying to make sure that we flesh out the full range of sharing experiences, and we think that has applicability across all the different life stages. And depending on the ages, people use the products differently, but not sharing any specific breakouts on that."
},
{
"speaker": "Deborah Crawford - Facebook, Inc.",
"text": "Operator, we have time for one last question."
},
{
"speaker": "Operator",
"text": "Your last question comes from the line of Youssef Squali, SunTrust."
},
{
"speaker": "Youssef Squali - SunTrust Robinson Humphrey",
"text": "Thank you very much, just one question. You guys unbundled the video buy. Can you speak to pricing relative to that 35% average increase in ad pricing? Can you maybe just help us understand the disparity that exists today between pricing on the new video platform and the legacy video platform? Thank you."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "So I'm not totally clear on what you mean by the new video platform and the legacy video platform, but I would just say that this is primarily driven by News Feed pricing, and then you have right-hand-column pricing as well, so you have impressions on Facebook News Feed, Instagram feed, as well as Facebook right-hand column. Ad Breaks are really a relatively small – a very small factor today. So the pricing is really about what is the pricing that you're seeing in the overall system primarily driven on the Feed-based products. So that's really what the driver is. And, again there, I would point to the comments that I made about getting better at targeting and driving towards good outcomes for advertisers as being the reason that we've been able to support higher prices."
},
{
"speaker": "Deborah Crawford - Facebook, Inc.",
"text": "Great, thank you for joining us today. We appreciate your time, and we look forward to speaking with you again."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines."
}
] | null | null |
META | 2 | 2,017 | 2017-07-26 17:00:00 | Executives: Deborah Crawford - Facebook, Inc. Mark Elliot Zuckerberg - Facebook, Inc. Sheryl Kara Sandberg - Facebook, Inc. David M. Wehner - Facebook, Inc.
Analysts: Brian Nowak - Morgan Stanley & Co. LLC Ralph Edward Schackart - William Blair & Co. LLC Heather Bellini - Goldman Sachs & Co. LLC Peter C. Stabler - Wells Fargo Securities LLC Douglas T. Anmuth - JPMorgan Securities LLC Ross Sandler - Barclays Capital, Inc. Justin Post - Bank of America Merrill Lynch Colin Alan Sebastian - Robert W. Baird & Co., Inc. Richard Greenfield - BTIG LLC Mark Mahaney - RBC Capital Markets LLC John Blackledge - Cowen and Company Mark A. May - Citigroup Global Markets, Inc. Michael B. Nathanson - MoffettNathanson LLC Rob J. Sanderson - MKM Partners LLC Brian W. Wieser - Pivotal Research Group LLC Lloyd Walmsley - Deutsche Bank Securities, Inc. Benjamin Schachter - Macquarie Capital (USA), Inc.
Operator: Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook second quarter 2017 earnings call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin.
Deborah Crawford - Facebook, Inc.: Thank you. Good afternoon and welcome to Facebook's second quarter 2017 earnings conference call. Joining me today to discuss our results are: Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our quarterly report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now I'd like to turn the call over to Mark.
Mark Elliot Zuckerberg - Facebook, Inc.: Thanks, Deborah, and thanks, everyone, for joining today. This quarter we reached an important milestone for our community. 2 billion people now use Facebook every month, and more than 1.3 billion people use it daily. We also saw good results on the business, with total revenue growing by 45% year over year to $9.3 billion, and advertising revenue up 47% to $9.2 billion. We're proud of the progress we're making, and it also comes with a responsibility to make sure that we have the most positive impact on the world that we can. That's why last month we updated Facebook's mission. For the past decade, we focused on making the world more open and connected. We have a lot more to do here to give people a voice and help everyone stay connected with their family and friends, but now I believe we have a responsibility to do even more. Our new mission is to bring the world closer together. A big part of this mission is building communities. Communities give us the sense that we're part of something bigger than ourselves, that we're not alone, and that we have something better ahead to work towards. Last month, we had our first-ever Facebook Community Summit to talk about our product roadmap, focused on building what we call meaningful communities. Meaningful communities on Facebook are groups that quickly become an important part of your social network experience and your real world support structure. And right now, over 100 million people are members of these groups, from new parents to people suffering from rare diseases. These groups often span online and offline and bring people together physically as well as over the Internet. Our goal is to help more than 1 billion people join meaningful communities. And part of this involves helping people discover the right groups, which is why we're building technology like AI to better understand people's interests and suggest groups that might be meaningful to them. And in the six months after we started working on this, we've already helped more than 50% more people join meaningful communities than had before them, so we have a lot more to do here. We also want to make it easier for people to build and lead communities. Last month, we launched new tools for group admins, making it easier for them to get Insights into who their members are, filter member requests, and remove bad actors and their content quickly to keep a positive and safe environment. Next, I want to give a quick update on what we're building over our three time horizons: making our existing services more useful now; building new ecosystems over the next five years around our products that a lot of people already use; and creating foundational technologies to achieve our mission over the next ten years. So we're pleased with the growth that we're seeing with Stories. Instagram Stories now has more than 250 million people using it daily, and WhatsApp Stories also now has more than 250 million people using it daily. We're always working to improve and give people more ways to share. And this quarter we added the ability to reply to Stories with a photo or video and share a replay of live video on Instagram. I am excited about how AI will improve people's experiences across our products. We're finding AI is both delivering consistent improvements to many of our systems, like News Feed, search, ads, security, and spam filtering and more. But more than just improving these existing experiences, I expect AI to change the way that we do business in some important ways. So for example, today to keep our community safe, we rely on people flagging content that might violate our community standards for us to review. In the future, AI will be able to help flag more of this content faster before people have even seen it. Now we've started using AI to fight terrorism and keep propaganda and extremist accounts off Facebook. We've even started experimenting with using AI to understand texts that might be used to promote terrorism. When it comes to News Feed, we currently mostly show you content from people and pages you're connected to. And we can write this better with algorithm improvements, but the really big improvement from AI will be when we can understand all the other content that's out there so we can help you discover much more of what matters to you beyond just what your friends are up to. On the business side, we're seeing a large shift in the way that marketing works. In the first wave of marketing, people would buy ads and media they thought their customers might watch like a TV show that had similar demographics, but they wouldn't know who saw their ads. The Internet gave people the power to target their messages to people who actually might be interested and to measure results much more precisely, and that was a big improvement. And now AI is taking this a step further. Now you can put a creative message out there, and AI can help you figure out who will be most interested. A lot of the time you don't even need to target now because AI can do it more precisely and better than we can manually. This makes the ads that you see more relevant for you and more efficient for businesses. Those are just a few of the reasons why I'm optimistic about how AI is going to improve our core services over the next few years. Over the next five years, we're going to build ecosystems around products that a lot of people are already using. We've talked about how video will continue to be a big focus and area of investment for us. It's growing quickly, and we're introducing new features to make the video experience even better. For example, in May we made the option to go live with someone else available to all profiles and pages on iOS. And we also launched closed caption to make Live more accessible. We're also working to build a business ecosystem around Messenger and WhatsApp. Messenger and WhatsApp both have large communities, and they're growing quickly, with 1 billion people now using WhatsApp daily. It is still early on the monetization side here, although we have started showing ads to a small number of people on Messenger. I want to see us move a little faster here, but I'm confident that we're going to get this right over the long term. Now finally, over the next 10 years, we're working on foundational technologies that are necessary to achieve our mission. In VR, we launched Live from Spaces, so you can go live with friends in different places. And we think that this has the potential to be a powerful tool to bring people together and help build community in some new ways. We're also working to help everyone in the world access the opportunities that come with the Internet. In May, we successfully flew Aquila, the solar powered plane that we're building to beam Internet to parts of the world that currently don't have access, and that was the second successful flight. These initiatives and other projects require a lot of ongoing aggressive investment in the infrastructure to serve our communities. Last quarter, our Fort Worth data center went live and is now serving traffic using 100% renewable energy, and we're also expanding our data centers in Los Lunas, New Mexico and Altoona, Iowa. This first half of 2017 has been an important period for Facebook. We've achieved some major milestones, delivered good business results, and set clear goals around building strong communities and bringing people and the world closer together, but we have a long way to go. So thanks to our community, our teams, and our partners for all being a part of this mission. I'm looking forward to making more progress together. And now here's Sheryl.
Sheryl Kara Sandberg - Facebook, Inc.: Thanks, Mark, and hi, everyone. We had a strong second quarter and a great first half of the year. Our business continues to deliver terrific results. Q2 ad revenue grew 47% year over year. Mobile ad revenue grew 53% year over year to $8 billion and is now 87% of total ad revenue. Our growth continues to be broad-based across regions, marketer segments, and verticals. Our goal is to build meaningful connections between people and businesses by focusing on our three key priorities: helping businesses leverage the power of mobile; developing innovative ad products; and making our ads more relevant and effective. Our first priority is helping businesses leverage the power of mobile. People are rapidly increasing the time they spend on mobile, and businesses know they need to be where consumers are. Given the size and engagement of our audiences, Facebook and Instagram are the best platforms to reach people and drive business results. We have over 70 million businesses on Facebook, and I'm excited to announce today that we now have more than 15 million business profiles on Instagram. Video is an important part of our mobile strategy. More video is being shared and watched on Facebook than ever before, and it's increasingly helping people and businesses connect. That's because video on Facebook is personal, so it's around connections, conversations, and communities. This is why it creates opportunities for businesses to reach people in new and creative ways. People consume content faster on their phones, and marketers are increasingly recognizing that this behavior is different from other media. This means that developing short-form snackable content is a big opportunity on mobile. We're working hard to help marketers adopt mobile-first video ad strategies for Facebook and Instagram. In a mobile environment, native mobile video ads typically outperform more traditional ads. For example, when Tropicana launched its probiotic juice, the company tested 6-second video ads against 15 and 30-second ads. The shorter ads resulted in higher brand metrics across the board, including a 16-point lift in brand awareness compared to a 6-point lift for the longer ads. Our second priority is developing innovative ad products. We're listening closely to feedback from marketers around the world to develop new ad formats and innovate on existing ones. Last quarter, I talked about how our Dynamic Ads help retailers and e-commerce companies promote their products across devices. Dynamic Ads show people the products that are most relevant to them based on actions they've taken, such as viewing items on a company's website. This quarter, we continued to improve Dynamic Ads and extended them to new verticals and categories. Delta Airlines used our new flight format to reach people who had searched for a flight but not yet booked one. Delta was able to run personalized ads based on the routes people viewed on their site and then bring people back to their booking page. This resulted in a 12.7 times return on ad spend. This quarter we also rolled out ads in Instagram Stories for all types of marketer objectives. As Mark described, Instagram Stories are growing incredibly well and are, therefore, a big opportunity for marketers. From driving brand awareness to increasing sales, businesses can now use full-screen Instagram Stories ads for any goal. For example, Ben & Jerry's created a brand awareness campaign using vertical video in Instagram Stories and saw a 14 point lift in ad recall and a 2 point lift in purchase intent for its new Pint Slices ice cream. Our third priority is making our ads more relevant and effective. This means better targeting and better measurement across Facebook, Instagram, and Audience Network. Marketers of all sizes are increasingly following our best practices, like optimizing their ads to drive real-world outcomes rather than focusing on proxy metrics such as page likes and video views. 53% of our revenue from SMBs is from campaigns that use these tools and strategies, up from 23% in the beginning of last year. This quarter, we also added new ways for marketers to improve their targeting and spend more efficiently. For example, we introduced value optimization, which helps businesses show ads to people who are most likely to spend based on previous purchase behavior. We also introduced value-based Lookalike Audiences, which use machine learning to help marketers reach people who are similar to their most valuable current customers. For example, California-based accessory company, Nomad, built a custom audience of people in the U.S. who bought something on their site, and then created a multi-country Lookalike Audience of people with similar characteristics. They targeted ads to their international audience across Facebook, Instagram, and Audience Network, resulting in a 2.7 times return on ad spend. We know that many marketers want to verify and compare results across platforms, and that's why we're focused on giving our clients more options for third-party measurement and verification. We now have 24 partners in our measurement system, including three partners measuring viewability, and we're in the process of adding two more viewability partners, DoubleVerify and Meetrics. As the first half of 2017 comes to a close, we feel good about the progress we're making. As marketers build more meaningful connections with people on mobile, we help them grow their businesses, which in turn grows ours. I continue to be grateful to our clients and partners all around the world and to our global team to make all of this possible. Thanks, and now here's Dave.
David M. Wehner - Facebook, Inc.: Thanks, Sheryl, and good afternoon, everyone. Echoing Mark and Sheryl's comments, Q2 was another strong quarter for Facebook. We continue to see strong growth and engagement in our global community as well as momentum in our mobile ads business. Let's begin with our community metrics. In June, 1.32 billion people visited Facebook on an average day, up 17% compared to last year. This number represents 66% of the 2.01 billion people that visited Facebook during the month of June, which was up 294 million or 17% compared to last year. Our community growth was again driven by product improvements on Android, our Internet.org effort, and ongoing third-party promotional data plans in markets like India. We will begin lapping the impact of these promotions in Q3 of this year. We're also pleased to see strong adoption and community growth across video, Instagram Stories, Messenger, and WhatsApp. While these products do not monetize at the same level as News Feed, they are providing new ways to build global communities. Turning now to the financials, all of our comparisons are on a year-over-year basis unless otherwise noted. Q2 total revenue was $9.3 billion, up 45%. Had foreign exchange rates remained constant with last year, total revenue would have been approximately $140 million greater, or up 47%. Q2 total ad revenue was $9.2 billion, up 47% or 49% on a constant currency basis. Ad revenue growth was strong globally. Rest of World and Asia-Pacific grew at 56% and 54% respectively, while the U.S. and Canada and Europe grew at 45% and 43% respectively. Mobile ad revenue was $8 billion, up 53%, and represented approximately 87% of ad revenue. Desktop ad revenue grew 17% despite an ongoing decline in desktop usage. Note that our Q2 desktop ad revenue benefited from our efforts to limit the impact of ad blocking technologies. In Q2, the average price per ad increased 24%, and the number of ad impressions increased 19%, primarily driven by mobile feed ads on Facebook and Instagram. Payments and other fees revenue was $157 million, down 20%. Total expenses were $4.9 billion, up 33%. We ended Q2 with over 20,000 employees, up 43% compared to last year. Our hiring growth rate increased for the third consecutive quarter, as we continued to invest in the many opportunities ahead. Q2 operating income was $4.4 billion, representing a 47% operating margin. Our tax rate was 13%. In the quarter, excess tax benefits recognized from share-based compensation decreased our effective tax rate by 6 percentage points. Net income was $3.9 billion or $1.32 per share. Q2 capital expenditures were $1.4 billion, driven by investments in servers, data centers, office facilities, and network infrastructure. We generated over $3.9 billion in free cash flow and ended the quarter with over $35 billion in cash and investments. Turning now to the outlook, growth engagement and advertising demand remain healthy, but there are certain factors that will impact revenue growth that are worth mentioning. As we have discussed before, we continue to expect that Facebook ad load will play a less significant factor driving advertising revenue growth going forward, and that desktop ad revenue growth rates will slow in the second half of 2017 when we begin to lap efforts to limit the impact of ad blockers. In addition, we expect that our strategic focus on driving engagement with mobile video may slow advertising impression growth, given the relatively fewer ad impressions in video relative to News Feed. I would also note that we do not see our early efforts in Messenger monetization offsetting the factors that I just mentioned. For these reasons, we continue to expect that our ad revenue growth rates will come down as the year progresses. We continue to expect full-year 2017 payments and other fees revenue to decline compared to full-year 2016. Turning now to the expense outlook, based on our updated view of the remainder of the year, we are tightening our initial expense guidance range. We expect that full year 2017 total GAAP expense growth will be approximately 40% to 45%, narrowed from our previous range of 40% to 50%. I would note that we expect to accelerate our head count growth rate in the second half of the year, as we remain solidly in investment mode. We also expect that our video content investments will contribute to operating expense growth in the second half of 2017. In terms of capital expenditures, we expect that full year 2017 CapEx will be in the lower end of the prior range of $7 billion to $7.5 billion. We are ramping our infrastructure investments to support global growth and anticipate more data center building activity in the second half of this year. For example, we recently broke ground on new buildings at our New Mexico and Iowa data centers. Turning now to tax, as I have previously noted, our tax rate will vary based on our stock price. At the current stock price, we would expect that our Q3 and full-year 2017 tax rates will both be similar to our Q2 rate. In summary, the first half of 2017 was a strong period for Facebook, both financially and in terms of growth and engagement of our community. We will continue to invest aggressively in the many opportunities we see ahead, as we make progress on our mission to give people the power to build community and bring the world closer together. With that, Mike, let's open up the call for questions.
Operator: Your first question comes from the line of Brian Nowak from Morgan Stanley.
Brian Nowak - Morgan Stanley & Co. LLC: Thanks for taking my question. I have one for Mark. Mark, the offerings on the core Facebook app have improved and changed a lot over the years from Groups, Live Video Search, et cetera. I'm curious to hear how you've noticed consumer behavior on the core product, the core Facebook app change as Instagram has grown. And how do you think about that evolving over the next three to five years? Thanks.
Mark Elliot Zuckerberg - Facebook, Inc.: So the main value proposition for the Facebook app is helping people share any type of content that they want with any audience that matters to them. So you can go from text to photo to video, from small groups to larger groups, from your friends to everyone in the world. And that's always been where the Facebook app has excelled. There have been different experiences that are more focused on specific things. But with a strong technological foundation supporting all of these different use cases, the Facebook app has always supported people using all of them. Now the biggest trend that we see in consumer behavior is definitely video. And there's a strong technological underpinning for that, which is that if you go back five years and you tried to watch a video on your phone, it would probably have to buffer for a minute or so before you'd actually get to watch it, which wasn't a good experience. And if you wanted to upload a video, whether it was a longer video like what you'd post to News Feed or a 10-second story like what you'd post in any of the apps, even that might take 30 seconds to upload, so it wasn't a good experience. So now as the technology on the network level improves to support that, what we're seeing is the ability to serve what is a large amount of demand for what's a very engaging type of content. And that demand flows across social content like we're seeing in Stories and Feed to clearly a huge amount of public content. Pages are engaging in this, and some of the trends that Dave just talked about for just a lot of video behavior across the platform.
Operator: Your next question comes from the line of Ralph Schackart from William Blair.
Ralph Edward Schackart - William Blair & Co. LLC: Good afternoon. Mark, in the prepared remarks you talked about Messenger and WhatsApp being on the early innings of monetization, and then you also talked about your desire to move faster on Messenger. Just curious what are the factors driving your willingness to move faster. And then how should we think about that both from a consumer and monetization experience? Thank you.
Mark Elliot Zuckerberg - Facebook, Inc.: On Messenger, there are two basic things that we're doing. One is we're starting to put some ads into the product just to see the basic parameters around how that performs, how people like the ads or don't, how they work for businesses, and just try to get an understanding of that. So we're starting to run that across the world. But as Dave said, even though we're starting to roll that out in a lot of places, the volume starts off pretty small. The biggest strategic thing that we really need to do in messaging right now is make it so that people organically interact with businesses and that that is a good interaction both for people and for the businesses. So here's one way to think about this. If you're a business and you have a higher ROI for interacting with a person in your messaging thread than you do on the mobile web or trying to get them to install an app, then that creates this positive feedback loop, where you're going to point your ads towards the Messenger thread. You're going to invest more of your engineering resources in building out the content and experience on the Messenger thread. So we're currently working on making it so that that is the highest ROI thing. I think we're making progress there. It's not that we're going to crack every market at once, but in sum I think we're definitely getting there. We're getting some positive feedback from the market. But once we start to achieve that in more and more verticals, I think that's going to start unlocking a lot of behavior, and a lot of businesses are going to want to push more interactions to happen there, which I think will really be the foundation for building that into a big business.
David M. Wehner - Facebook, Inc.: Ralph, it's Dave. I would just add that with messaging monetization, this is early and it's not a near-term overall Facebook growth driver. And much like Instagram in its early days, we're going to be cautious. But unlike Instagram, this isn't a feed product, so just there are more unknowns here.
Operator: Your next question comes from the line of Heather Bellini from Goldman Sachs.
Heather Bellini - Goldman Sachs & Co. LLC: Great, thank you. I was wondering. Sheryl talked a little bit about Instagram Stories. I was wondering if you could share with us the initial feedback from advertisers. Do they see it as similar to advertising in the IG feed, or are they using it to reach people in a different way, if you've noticed anything over the period that you've been doing it? Thank you.
Sheryl Kara Sandberg - Facebook, Inc.: So it's pretty early for ads in Stories. And I think the way people largely think about this is this is another way of using the Facebook ad system, including our targeting and measurement capabilities, to create ads that are great creative that can reach people. So the fully immersive format with the targeting and optimization of Facebook ads is a pretty unmatched opportunity. We also have a huge opportunity within Instagram. And obviously, the use of ads in Instagram is much, much bigger than the use of ads in Stories. The way we think about this is we're trying to help marketers reach their customers, both their existing and their new customers, effectively. And we think it's a combination of all these offerings that really are the strength of our business and explains why we can continue to grow. So within one interface, we're working with one sales rep. If you're a large company or a small company, you can buy Facebook. You can buy Instagram. You can buy Audience Network. You can buy the different ad formats within Facebook and Instagram. And that means that you have multiple targeting opportunities, multiple opportunities, and even opportunities to see who engages in an ad in one place and then reinvest to continue the conversation with those customers. So we think all of these things work together. And these new formats fit in really nicely with the ad system we built, which underlies all of the opportunity.
Operator: Your next question comes from the line of Peter Stabler from Wells Fargo.
Peter C. Stabler - Wells Fargo Securities LLC: Thanks, good afternoon, one for Sheryl, if I could. Sheryl, you guys have rolled out some initiatives designed to address specific advertising categories like Dynamic Travel Ads. Could we anticipate more efforts going forward to address categories that may be relatively underpenetrated by Facebook, Instagram, and Audience Network? I'm thinking about categories like financial services, auto, for example. Thanks.
Sheryl Kara Sandberg - Facebook, Inc.: So we're really happy that our growth has been really strong across our verticals, and that continues to be the case. Our top verticals are pretty consistent in e-commerce, CPG, entertainment, media, retail, and gaming. For the most part, when we build products, we build them to work for all verticals, and you see us do that. So being able to upload your catalog of products can be used no matter what your product lists are. We do build vertical-specific ad products when they are necessary, so Dynamic Ads for travel, for example, as you mentioned, being an example. I think the heaviest lifting of the work we do is really helping marketers in different verticals focus on the right metrics, which are the sales metrics, because for too long our industry has been focused on proxy metrics, how long someone viewed a video, even brand lift, measurements we care about, but these are all proxy metrics. What really matters is you see an ad and you buy a product. You see an ad and you drive a car off a lot. You see an ad and you order a service. And so there are very different processes with these different verticals in terms of helping them understand their own purchasing data so that we can connect our ads to their ultimate purchases. We believe that's one of the most important things that we've been very, very focused on, and we have a long way to go. And part of the results you see from us in different verticals are actually explained by the ability of us to help those marketers measure sales at the end of the day. The more that we can tie ad viewing to sales, the stronger our case is with our clients, and so we need to do a lot of work around the measurement with different verticals.
Operator: Your next question comes from the line of Doug Anmuth from JPMorgan.
Douglas T. Anmuth - JPMorgan Securities LLC: Great, thanks for taking the question, two, if I could. Mark, you visited many different parts of the country over the last several months. Just curious how you're applying what you've learned to Facebook and the broader platform. And then, Dave, can you just give some more color on how things have changed in terms of OpEx and CapEx, just given that you're coming down toward the lower end of the ranges? Thanks.
Mark Elliot Zuckerberg - Facebook, Inc.: So a lot of the themes around building community and bringing people closer together have been underscored by a lot of the experiences that I've had traveling around. And I've tried to write about them. I don't write about each visit that I make on Facebook. But it's been really striking to me when you talk to folks in a lot of different communities how important local institutions and their local communities are for supporting people there. And there's been a clearly documented trend across the world of declining membership in a lot of different kinds of communities. And I think that that's an important problem that is eating at the social fabric not only of our country but around the world that I hope that we can play a role in addressing. And that's not something that we can do directly, but I believe that we can empower people who want to build local communities and want to play a leadership role in their local community to have the tools that they need. And I think if we can do that, then you start bringing people together at a local level. And when people feel more comfortable in their lives at a local level, then I also think that that helps bring people and bring the world closer together at a global level too. So that all has been underscored by a lot of the visits and what I've seen as well as a lot of the research that we've done at Facebook, and it's all reflected in the new mission.
David M. Wehner - Facebook, Inc.: Doug, it's Dave. I don't think there's anything that's really fundamentally changed. We are tightening the range to 40% to 45% expense growth due to better visibility. We remain solidly in investment mode. And if anything, we're finding new opportunities to invest in. From the perspective of hiring growth, I'd really point to the fact that we've been consistently accelerating hiring so far in 2017, and I pointed to the fact that we expect to accelerate hiring in the back half of the year as well. And this quarter was the biggest recruiting quarter in terms of net hires ever for Facebook. We're continuing to invest in a number of key areas, hiring engineers to drive the three, five, and 10-year priorities. We're going to be investing in content to help build a platform for content producers to find an audience and monetize. We are also continuing to invest in areas like community operations and other areas. So, we remain solidly in investment mode from a total expense point of view. On CapEx, we still expect to be within the range of $7 billion to $7.5 billion, and we're investing aggressively in our data center footprint to support the global growth that we see. So, I think across the board, we're investing heavily. On head count, I would just point out that our payroll growth tends to lag head count growth, because head count is an end-of-period number, so the acceleration that we're seeing in 2017 will obviously play out in 2018 as well.
Operator: Your next question comes from the line of Ross Sandler from Barclays.
Ross Sandler - Barclays Capital, Inc.: Great, guys, a couple questions on the messaging apps. I think two years ago at F8, you talked about WhatsApp user base about really north of 1 billion sending out 50 billion messages a day, and Messenger was about 1 billion and 20 billion messages a day, so implying kind of like 2.5 times the engagement on WhatsApp compared to Messenger. Is that accurate? And where does that stand today? And then both of these messaging apps started in different geographies around the world. So, how does that impact your thinking around monetization ideas between Messenger and WhatsApp? Thanks.
David M. Wehner - Facebook, Inc.: Yeah. I don't think we're sharing detailed stats on engagement by messaging platform. They're obviously both critical platforms. Both have over 1.2 million monthly actives. And WhatsApp has demonstrated significant engagement with crossing 1 billion daily actives. So, I think that indicates the engagement that you have on that platform. There are different geographies where the messaging platforms are stronger. And depending on that, that shifts our priorities in different ways. But overall, from a monetization perspective, I think the strategy there is clear. We're focused on growing the user base, first and foremost. And then secondly, it's about building organic connections between businesses and consumers. And then third, it's about how do we build monetization around those relationships. And I think there, we're further along with Messenger than we are with WhatsApp. And so, I think you see us rolling out the global beta there with ads. So, I think we'll watch and learn from that. And as we learn things, we can apply them in other areas.
Operator: Your next question comes from the line of Justin Post from Bank of America Merrill Lynch.
Justin Post - Bank of America Merrill Lynch: Great. Thank you. Maybe a question for Mark. I know video is a priority for the company. To start with, any change in user trends or engagement as you've added video to Facebook? And then secondly, just how do you think about semi-professional or professional video for Facebook? Is that a good business, given all the content-sharing costs and the production costs when you compare it to your existing social business? And do you see it as cannibalistic or additive as far as usage? Thank you.
David M. Wehner - Facebook, Inc.: I can share a little bit about it, then Mark would want to jump in on any other color. I mean, I would say, as I mentioned, Justin, in my commentary, as people spend more time with video, and more time is going to video, that is going to have a limiting factor to how much time they spend in News Feed. And so, that's going to have an impact on impression rate growth. So there is, in that sense, a cannibalistic effect of sorts that happens there. But what Mark alluded to was video is where people – as networks improve and devices improve and our products improve, video is the most engaging experience that we can offer. And so, we're seeing consumers adopting that and we're building products for them. In terms of the types of content, I think we're looking at a wide variety of content from – of course, at the core is people sharing experiences in their lives. And that's at the base of what we offer in terms of bringing the world closer together. It's that community content. But then there's opportunities for semi-professional and professional content. And we're exploring things around the platform of making sure that we're a platform where professional content providers can come, find an audience, and then also monetize that audience.
Mark Elliot Zuckerberg - Facebook, Inc.: I think you pretty much got it.
Operator: Your next question comes from the line of Colin Sebastian from Robert Baird.
Colin Alan Sebastian - Robert W. Baird & Co., Inc.: Great. Thanks. Mark, I wanted to ask a question on conversational interfaces, and specifically if we should think of Facebook becoming integrated as the skill app or feature on platforms such as Alexa, or should we think of things like Oculus, Messenger, and perhaps even a dedicated device as part of Facebook's own alternative platform? And then, Dave, just hoping you can put a finer point on the timing around the reduction in ad load growth. Thank you.
Mark Elliot Zuckerberg - Facebook, Inc.: I mean, to the first question, we're going to build the services that we think are useful. Some of them are going to be platforms and some of them are going to be apps and different things on top of platforms that other folks build. But fundamentally, we're trying to serve our community the best we can, and we'll do that across all these platforms.
David M. Wehner - Facebook, Inc.: Yeah. And in terms of ad load growth, I pointed to the fact that we continue to expect that ad load will be a less significant factor in the remainder of 2017, and that's certainly the case. That starts in Q3, but there's a number of other factors that I also pointed to, including the desktop lapping some of the efforts we made on desktop in terms of unblocking or working against the ad blocking technologies. And so, that has a factor on desktop growth. And then of course, I talked about video and our focus on driving and serving the consumer demand for video, and that's also leading to potentially lower impression growth as well.
Operator: Your next question comes from the line of Rich Greenfield from BTIG.
Richard Greenfield - BTIG LLC: Hi. Thanks for taking the question. On one of your blogs, you put a post up basically detailing basically what people were doing during TV, and you showed a control group where Facebook usage was really constant. And then you did a group that was watching the TV show, and you saw huge spikes of Facebook usage during the television – during the ad breaks during the show. Wondering like, as you go talk to marketers, obviously, TV ratings are down a lot. How does that type of study – I realize it's just one TV show. But as you make the pitch of why are you not shifting dollars faster to Facebook, how does that type of research start to play into their thinking? And what's holding them back? Is it just the creative doing, or the embracing of 6-second ads? What's the block to getting more of that $70 billion of TV ad dollars to shift over faster? Thanks.
Sheryl Kara Sandberg - Facebook, Inc.: That was just one study, and I don't want to overstate its importance in how we sell ads. We make the case to our clients that consumers are moving to mobile and that they need to move to mobile. And not that mobile should replace all of their other advertising, but responsible marketers with great companies, large and small, still advertise on TV, and they advertise on mobile, and they advertise in other places. Our goal is to be the best dollar and the best minute anyone spends, and the case we make is that we want them to take advantage of the opportunity that is mobile and the opportunity for the targeting we offer and the measurement we offer. I think what has taken us time and continues to take us time is we need to convince marketers to make mobile-first video and other ad formats. We talk a lot about how the first TV ads were people reading their radio ads in front of microphones. And we're still in the case that when people go to put an ad on mobile, they often will take an ad that's really produced for TV and put it on mobile. And those work and they can work well, but they do not work as well as ads that are natively mobile, like the Tropicana example I shared in my earlier comments. Mobile ads when they're video are shorter. The brand comes in faster. They tell a story that doesn't evolve but really gets you to understand the brand and the offering really quickly. We talk about it as thumb-stopping creatives. And so the work that we have cut out for us is to help marketers and working with their agencies evolve the format of the ads so that they're optimized for mobile, optimized for Facebook, optimized for Instagram. I think we're making progress, but we have a long way to go there.
Operator: Your next question comes from the line of Mark Mahaney from RBC Capital Markets.
Mark Mahaney - RBC Capital Markets LLC: Great, thanks. Mark, you talked about maybe trying to accelerate a little bit the messaging monetization end. I'm wondering if there's anything more behind that statement. Is it that you were frustrated with the level that you had seen to date, or that you saw some opportunity that you thought you could accelerate the push towards I guess monetizing? And maybe big picture, I want to ask. I know the monetization is very early stages. It's barely even begun. There's very few platforms around the world that have got 1 billion users that are unmonetized, so you would think that there's a lot of opportunity there, but maybe not. And maybe people are making a mistake in trying to look at Asian assets and seeing what they've done there and thinking that you can do with your asset. So what's the upside? When you think about the real opportunity, what gets you excited about the ability to monetize those assets five years from now?
Mark Elliot Zuckerberg - Facebook, Inc.: Sure. So we're currently going through the process of figuring out what we want to invest in over the next year and doing our long-range planning, and this is certainly one of the areas where I think we want to be investing a lot more in and believe that there's a big opportunity and can accelerate all the effort. I do think, as you say, this is one of the rare times in business where you can look at messaging platforms that exist and see how they've successfully monetized in other parts of the world and have that be a floor. I think that over time, we should be able to do better, but that at least provides this existence proof that despite – regardless of what our internal logic is of what we're doing, that someone has done it. So that gives us some degree of confidence there in addition to our own execution on other things. But I feel there's a pretty clear playbook that we have here of first building up the consumer usage, then building up the organic person-to-business interaction, making sure it works for both people and businesses. And then once you have that, the quality of those interactions is really what contributes to the scale of how much you can grow. We've seen this in News Feed too. One of the factors that's contributed to ad load over time is the quality of the ads. If ad quality was low, we wouldn't be able to put as many ads in because people wouldn't want them. But in a lot of markets around the world, we see that ad quality is increasing at a very fast rate, and that makes it so that a lot of times people do ask for the content, which of course creates a very different dynamic. So we need to get to that in messaging. And because messaging really started from the place of people communicating one to one with each other and is now adding all these other uses, it's just a lot of investment and a lot of different functionality that needs to get added. But for all the reasons that I've said here around our own experience doing this in other contexts with Facebook and Instagram, proof points in the market of how it's worked, I think over the long term I'm pretty confident that we will get there, and it's our job to just go do that.
David M. Wehner - Facebook, Inc.: And I would just add. We don't know at what level that is. We've had more experience with feed-based products, so we know how those play out, and so this is in very much early days mode.
Operator: Your next question comes from the line of John Blackledge from Cowen.
John Blackledge - Cowen and Company: Great, thank you, two questions on the Messenger ads. I recognize that it's early days, but just wondering if you think those ads will be more complementary for core Facebook and Instagram advertisers, or perhaps serve a different advertiser base or different use cases versus core Facebook and Instagram. And then second question will be, at the high end of the OpEx guide, it implies 53% year-over-year OpEx growth in the back half of the year versus plus 36% in the first half. Just wondering if you can discuss other key drivers of the OpEx growth in the back half of the year aside from head count. Should we consider investment in video content the number two driver of OpEx growth in the back half of the year? Thank you.
Sheryl Kara Sandberg - Facebook, Inc.: On the Messenger ads, I think the way we think about it is, as Mark said, we have a lot of work to do to work on the format of that. This is not a feed-based product, and this is a messaging product. So it's a different consumer format, and we believe that the ad format should follow the consumer format, so it's really integrated as part of the experience. And that's where we have a lot of work to do. We do think that the advertiser base and the targeting and the measurement we offer once we figure out the format will be a very considerable advantage. We already have 5 million advertisers on Facebook, 1 million advertisers on Instagram. And one of the reasons we were able to scale into Instagram ads more quickly is because we were building off of the Facebook advertiser base. And similarly, the work we've done in Facebook and Instagram and Audience Network will help us expand to Messenger. But we really want to emphasize, especially since there are so many questions on Messenger monetization on this call, that we're going to be slow and deliberate. We are always looking at the long run. We do not manage this company quarter to quarter. We protect the consumer product and the consumer engagement. Messaging is really strategically important for the company and the long-term engagement with our users, and the organic feel of the engagement with businesses and consumers is where we will be focused. So it's early days this year, and it's going to continue to be early days for a while.
David M. Wehner - Facebook, Inc.: So on the OpEx guide, clearly the biggest driver there is going to be the accelerating head count growth. In addition, I mentioned video content as being a driver. And then also, we're just supporting the global growth of the platform. We continue to see growth in users. We continue to see growth in time spent per DAU across the Facebook family of apps and Facebook, and we're bringing more data centers online and the like towards that growth. So those will start hitting cost of revenue with depreciation. So there's going to be a variety of contributions to that growth. But like you mentioned, I would point to both head count, specifically in R&D. R&D head count grew 48% year over year in Q2, and that's what's going to be a key driver along with the content layering in.
Operator: Your next question comes from the line of Mark May from Citi.
Mark A. May - Citigroup Global Markets, Inc.: Thanks for taking my questions. Sheryl, in your prepared remarks about a case study, you discussed the benefits of shorter video ads. But I was hoping you could provide an update on the mid-roll Ad Breaks that you've now been testing for a few months and maybe what kind of progress that you're seeing in terms of completion rates. Are you at a point where Ad Breaks can start to roll out more broadly? And then, Dave, you mentioned that a greater focus on video could impact growth in ad impressions. But would you also assume that a greater focus on video ads could also drive improved ad pricing and yield on your available inventory? Thanks.
Sheryl Kara Sandberg - Facebook, Inc.: On Ad Breaks, we're currently really just testing the ability to put a short Ad Break in uploaded videos. We do it if a video is longer than 90 seconds or live videos are longer than 4 minutes. We're just in the process right now of expanding to more publishers in the United States, so it's really early. In terms of the metrics we're looking for, it's a great question. And obviously, we care that people view the ads, but the most important thing is tying those ads impressions, even if they're short views, all the way through to that same purchase data that we keep talking about. And so as we work on rolling out more Ad Breaks, and we are rolling out slowly, we're really focused on finding ways to help marketers measure the right things, and that's a very important focus for the company going forward.
David M. Wehner - Facebook, Inc.: Now, Mark, you were asking about video and its impact on pricing growth. I would probably step back and look at it from an overall system perspective. And so starting with the supply side, there's a variety of factors that will impact impression growth, and I mentioned slower ad growth and then increasing video watch time as being two of them. And given there's an auction that drives the pricing in how we run the business, there's always an interplay between supply growth and pricing growth. And so what we're really focused on is driving better ROI for our advertisers. And Sheryl alluded to it in her earlier commentary about if we get better at converting our impressions into things that are valuable for advertisers and we get more efficient in doing that, we'll be rewarded with better pricing and higher demand at better pricing as a result of that hard work. That doesn't necessarily specifically pertain just to video. It really is across the board. So if we're effective at continuing to do that, then that should benefit pricing growth. And if we can grow demand faster than we grow supply, then we're going to see that play through in price. And that's really the goal of a lot of the hard work that the ads team does to make our products better and more effective for advertisers.
Operator: Your next question comes from the line of Michael Nathanson from MoffettNathanson.
Michael B. Nathanson - MoffettNathanson LLC: Thank you. I have one for Dave and one for Sheryl. Dave, going back to your prepared comments, I think you mentioned there was 24% growth in pricing this quarter, in unit pricing. Can you help us explain or understand underlying that growth which products you're seeing the greatest inflation maybe quarter over quarter or year over year?
David M. Wehner - Facebook, Inc.: I would really just point to the overall dynamics of the system. And again, what we're seeing is with slower supply growth, that's going to play out to higher pricing. And again, are we effective? And we've been effective at delivering good return on investment for our advertisers and getting better at converting what we have as inventory into what they care about as outcomes. And that from a systemic point of view is what's playing through there. From a product perspective, as we get things like Dynamic Product Ads rolled out, those are incredibly valuable. As we connect more advertisers with those and bring more data into the system and we can get more of the impressions that are very highly targeted and very relevant, then we'll be rewarded with better pricing as we can expand that out into things like Lookalikes. We've talked a lot about it on this call. That basically takes some of that really good targeting and extends that into a much bigger audience, and then we can get more impressions at better value because we're really connecting that with end results that the advertisers value. So it's really all that type of work that we do to get the system better and better, and so we're constantly working to get better penetration of these key ad products. In terms of the supply side, obviously News Feed is incredibly valuable because it's very present for the consumer. And we've improved the quality of the ads in News Feed, and that's another driver from the supply side.
Operator: Your next question comes from the line of Rob Sanderson from MKM Partners.
Rob J. Sanderson - MKM Partners LLC: Yeah. Thank you. Good afternoon. It already feels like a call about Messenger monetization, so I'm almost reluctant to ask another, but just two things. Compared to what you saw in the early phases of testing News Feed ads, what can you say so far about users' responsiveness to ads in Messenger? And then second, obviously, there's a lot of momentum in the development of bots on the platform. And do you see this enabling of great organic interactions, as Mark put it, as a way to ultimately make Messenger a great ad platform, or do you think that enabling these other business services can lead to other monetization opportunities down the road, independent of advertising?
Sheryl Kara Sandberg - Facebook, Inc.: It's really too early to understand the impact of the ads on consumers because there aren't enough of them and they haven't been rolled out for long enough. In terms of the bots, what we really think about is our businesses and people making useful connections on both sides on Messenger or any platform. If the connection is useful for marketers, businesses, and useful for people, then it will grow. And we're open to automated bots being useful. We're open to other forms of things being useful. I think when you think about what bucket of spend that is in, which is a question we get, it really is both marketing spend and any other spend companies have where they're reaching their customers, of which if you think about marketing spend and customer service spend, marketing spend is way bigger, because marketing spend grows as you can grow sales. And customer service spend is something that people generally try to minimize. So, the way we think about it is we want to grow the organic connections, whether they're automated or whether they're personalized, and make sure that that is growing the business of our customers.
Operator: Your next question comes from the line of Brian Wieser from Pivotal Research.
Brian W. Wieser - Pivotal Research Group LLC: Thanks for taking the question. I was wondering if you could comment on how you think the European Commission's GDPR [General Data Protection Regulation] and related privacy initiatives will impact the business, either generally positively, negatively, and whether or not those policies around privacy might yet become global standards. I'm curious how you think that impacts both the consumer product as well as the advertising business. And maybe separately, I'm just curious if among those advertisers who have expressed particular concern around third-party tool access, we certainly heard from some who have said very publicly that they're going to reduce their spending. Obviously, others clearly are increasing their spending. But curious how far you've gone towards allaying those concerns and possibly regaining any lost spend.
Sheryl Kara Sandberg - Facebook, Inc.: When we think about any regulatory issue, GDPR or anything else, we respect local laws and regulations. And we have to work really closely with regulators to make sure they understand our business practices, understand how we contribute to economic growth in their countries, and understand the steps we take and continue to take to protect privacy. Certainly, regulation is always an area of focus that we work hard to make sure that we are explaining our business clearly and making sure regulators know the steps we take to protect privacy as well as making sure that we're in compliance. When you think about the metrics question you asked, how we think about what is – so what I think you're asking about is third-party verification. We're very interested in making sure that marketers can verify or measure outcomes through third-parties, and that's why we're working to actively expand those partnerships.
Operator: The next question is from the line of Lloyd Walmsley from Deutsche Bank.
Lloyd Walmsley - Deutsche Bank Securities, Inc.: Thanks for taking the question. Another one on Messenger. So, you guys have talked of building – the importance of building organic consumer-to-business interaction here. So wondering if you can share what sort of adoption you are seeing in those kind of interactions. And are there certain verticals or geos where it's really taking off? And then a second, if I can. We've talked a lot, obviously, already about ad impression growth and how it's set to slow in the second half. You're already seeing a big slowdown in impression growth in the first half. And yet, as you've noted, with supply growth slowing, pricing has gone up, as you've added a lot of ROA as to your customers. So wondering why should this phenomenon not continue to carry ad revenue growth in the second half?
Mark Elliot Zuckerberg - Facebook, Inc.: I'll take this. So, there have been a number of questions about Messenger. And in general, we're seeing – I'm happy with the rate of growth in the experiences that we're seeing on Messenger. But if there's one message here that I think is actually important to say, it's that we're trying to communicate that the pace of growing the Messenger business, it's a longer-term thing. I actually think over the next couple of years or few years, the much bigger driver of the business and determinant of how we do is going to be video, not Messenger. Messenger, I think, is a really important thing and WhatsApp over a three- to five-year period, and we're investing a lot in it. I think it's a huge opportunity. But as has been noted on the call, video is both at large scale and the economics are quite different from the current feed-based businesses that we have today, especially around how, with mid-roll ads and rev share around that, the margin structure will be different. So, I mean, one of the big questions that we're focused on as we build this out, we're very committed to building it out because it's what people in the community want. But one of the big things that we're really very focused on is making sure that we get this right so that even though this business will likely be – not likely, I think almost certainly will be a lower margin source of revenue than the current thing that we do, there's this big question of how incremental is that behavior going to be. And I'm just throwing this context out there because so many of the questions here today have been about Messenger, and I want to make sure on these calls that we do an accurate and a full job of conveying what we're actually thinking about as a business and what we think the outlook is going to be. And I think that those questions around video, which I'm optimistic about, but there are real questions there that we need to manage well, is going to be a much bigger driver of the business over the next two to three years likely even than the trajectory of what we're doing on Messenger and WhatsApp.
David M. Wehner - Facebook, Inc.: And, Lloyd, you asked about why the good work that we've done so far in basically providing value for advertisers is playing through into price. Look, that's not just happening. That's a bunch of hard work that goes into making our ads more targeted that makes the outcomes that advertisers get more valuable. We're going to continue to work to do that, and we're going to continue to invest in making improvements in the ad products, and we think there are great opportunities to continue to make improvements to ROI. But obviously, if you have rising prices, it's going to make that work against an upstream trend, so we need to continue to work hard to deliver more value for advertisers in the face of that. So we've got our work cut out for us, and we think we've got a great team working on those challenges.
Deborah Crawford - Facebook, Inc.: Operator, we're going to take one last question.
Operator: The last question comes from Ben Schachter from Macquarie.
Benjamin Schachter - Macquarie Capital (USA), Inc.: Thanks for taking the question. Mark, you stated that AR mixed reality could be the next computing platform. Obviously, this is way out in the future. But if that implies something so large, how do you think about allocating resources for that? How much are you willing to spend on it, and any new thoughts on how this all evolves? And then related to that, the next iPhone is coming out soon. Do you think that there will be capabilities there that will impact the AR evolution meaningfully? Thanks.
Mark Elliot Zuckerberg - Facebook, Inc.: This is certainly something that I'm really excited about long term. Not only does it have the possibility of being the next major computing platform, AR and VR together, but I think it has the possibility of being much more social and intuitive and natural than some of the devices that we have today, whether they're computers or phones. So that's why I'm really excited about that. When you think about AR glasses, the technology and science to build an experience that would be both comfortable to wear and something that people would actually want to wear out in public, that doesn't exist yet. So there's a lot of foundational work that needs to get done there. That's partially why I'm excited about doing the VR work because it doesn't have that constraint. You're not wearing VR out in public. But also recently, one of the things that we've seen is that there are a lot of AR experiences on mobile. So the work that we started talking about at F8 that we are releasing slowly over the course of the year is certainly one of the precursors for building out that ecosystem that I'm excited about. But look, if I was just saying that video is going to be the primary driver or one of the big drivers over the next few years and Messenger maybe after that, I think AR is quite far down the road. But when you're running an operation and serving people at this scale, I think you have a responsibility to invest in all these things that are downstream that could help shape and improve people's lives, because I don't think that there are that many other folks in the world who will. So I think that that's a thing that we take seriously, whether it's connectivity and making sure that people actually all around the world get to enjoy and benefit from the opportunities that the Internet has or the improvements that come from AI, or eventually upgrading the computing platforms that we all get to use. This stuff doesn't just happen automatically. And someone in the world needs to focus on building it, and we want to play a role in that.
Deborah Crawford - Facebook, Inc.: Great, thank you. Thank you for joining us today. We appreciate your time, and we look forward to speaking with you again.
Operator: Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines. | [
{
"speaker": "Executives",
"text": "Deborah Crawford - Facebook, Inc. Mark Elliot Zuckerberg - Facebook, Inc. Sheryl Kara Sandberg - Facebook, Inc. David M. Wehner - Facebook, Inc."
},
{
"speaker": "Analysts",
"text": "Brian Nowak - Morgan Stanley & Co. LLC Ralph Edward Schackart - William Blair & Co. LLC Heather Bellini - Goldman Sachs & Co. LLC Peter C. Stabler - Wells Fargo Securities LLC Douglas T. Anmuth - JPMorgan Securities LLC Ross Sandler - Barclays Capital, Inc. Justin Post - Bank of America Merrill Lynch Colin Alan Sebastian - Robert W. Baird & Co., Inc. Richard Greenfield - BTIG LLC Mark Mahaney - RBC Capital Markets LLC John Blackledge - Cowen and Company Mark A. May - Citigroup Global Markets, Inc. Michael B. Nathanson - MoffettNathanson LLC Rob J. Sanderson - MKM Partners LLC Brian W. Wieser - Pivotal Research Group LLC Lloyd Walmsley - Deutsche Bank Securities, Inc. Benjamin Schachter - Macquarie Capital (USA), Inc."
},
{
"speaker": "Operator",
"text": "Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook second quarter 2017 earnings call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford - Facebook, Inc.",
"text": "Thank you. Good afternoon and welcome to Facebook's second quarter 2017 earnings conference call. Joining me today to discuss our results are: Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our quarterly report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now I'd like to turn the call over to Mark."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Thanks, Deborah, and thanks, everyone, for joining today. This quarter we reached an important milestone for our community. 2 billion people now use Facebook every month, and more than 1.3 billion people use it daily. We also saw good results on the business, with total revenue growing by 45% year over year to $9.3 billion, and advertising revenue up 47% to $9.2 billion. We're proud of the progress we're making, and it also comes with a responsibility to make sure that we have the most positive impact on the world that we can. That's why last month we updated Facebook's mission. For the past decade, we focused on making the world more open and connected. We have a lot more to do here to give people a voice and help everyone stay connected with their family and friends, but now I believe we have a responsibility to do even more. Our new mission is to bring the world closer together. A big part of this mission is building communities. Communities give us the sense that we're part of something bigger than ourselves, that we're not alone, and that we have something better ahead to work towards. Last month, we had our first-ever Facebook Community Summit to talk about our product roadmap, focused on building what we call meaningful communities. Meaningful communities on Facebook are groups that quickly become an important part of your social network experience and your real world support structure. And right now, over 100 million people are members of these groups, from new parents to people suffering from rare diseases. These groups often span online and offline and bring people together physically as well as over the Internet. Our goal is to help more than 1 billion people join meaningful communities. And part of this involves helping people discover the right groups, which is why we're building technology like AI to better understand people's interests and suggest groups that might be meaningful to them. And in the six months after we started working on this, we've already helped more than 50% more people join meaningful communities than had before them, so we have a lot more to do here. We also want to make it easier for people to build and lead communities. Last month, we launched new tools for group admins, making it easier for them to get Insights into who their members are, filter member requests, and remove bad actors and their content quickly to keep a positive and safe environment. Next, I want to give a quick update on what we're building over our three time horizons: making our existing services more useful now; building new ecosystems over the next five years around our products that a lot of people already use; and creating foundational technologies to achieve our mission over the next ten years. So we're pleased with the growth that we're seeing with Stories. Instagram Stories now has more than 250 million people using it daily, and WhatsApp Stories also now has more than 250 million people using it daily. We're always working to improve and give people more ways to share. And this quarter we added the ability to reply to Stories with a photo or video and share a replay of live video on Instagram. I am excited about how AI will improve people's experiences across our products. We're finding AI is both delivering consistent improvements to many of our systems, like News Feed, search, ads, security, and spam filtering and more. But more than just improving these existing experiences, I expect AI to change the way that we do business in some important ways. So for example, today to keep our community safe, we rely on people flagging content that might violate our community standards for us to review. In the future, AI will be able to help flag more of this content faster before people have even seen it. Now we've started using AI to fight terrorism and keep propaganda and extremist accounts off Facebook. We've even started experimenting with using AI to understand texts that might be used to promote terrorism. When it comes to News Feed, we currently mostly show you content from people and pages you're connected to. And we can write this better with algorithm improvements, but the really big improvement from AI will be when we can understand all the other content that's out there so we can help you discover much more of what matters to you beyond just what your friends are up to. On the business side, we're seeing a large shift in the way that marketing works. In the first wave of marketing, people would buy ads and media they thought their customers might watch like a TV show that had similar demographics, but they wouldn't know who saw their ads. The Internet gave people the power to target their messages to people who actually might be interested and to measure results much more precisely, and that was a big improvement. And now AI is taking this a step further. Now you can put a creative message out there, and AI can help you figure out who will be most interested. A lot of the time you don't even need to target now because AI can do it more precisely and better than we can manually. This makes the ads that you see more relevant for you and more efficient for businesses. Those are just a few of the reasons why I'm optimistic about how AI is going to improve our core services over the next few years. Over the next five years, we're going to build ecosystems around products that a lot of people are already using. We've talked about how video will continue to be a big focus and area of investment for us. It's growing quickly, and we're introducing new features to make the video experience even better. For example, in May we made the option to go live with someone else available to all profiles and pages on iOS. And we also launched closed caption to make Live more accessible. We're also working to build a business ecosystem around Messenger and WhatsApp. Messenger and WhatsApp both have large communities, and they're growing quickly, with 1 billion people now using WhatsApp daily. It is still early on the monetization side here, although we have started showing ads to a small number of people on Messenger. I want to see us move a little faster here, but I'm confident that we're going to get this right over the long term. Now finally, over the next 10 years, we're working on foundational technologies that are necessary to achieve our mission. In VR, we launched Live from Spaces, so you can go live with friends in different places. And we think that this has the potential to be a powerful tool to bring people together and help build community in some new ways. We're also working to help everyone in the world access the opportunities that come with the Internet. In May, we successfully flew Aquila, the solar powered plane that we're building to beam Internet to parts of the world that currently don't have access, and that was the second successful flight. These initiatives and other projects require a lot of ongoing aggressive investment in the infrastructure to serve our communities. Last quarter, our Fort Worth data center went live and is now serving traffic using 100% renewable energy, and we're also expanding our data centers in Los Lunas, New Mexico and Altoona, Iowa. This first half of 2017 has been an important period for Facebook. We've achieved some major milestones, delivered good business results, and set clear goals around building strong communities and bringing people and the world closer together, but we have a long way to go. So thanks to our community, our teams, and our partners for all being a part of this mission. I'm looking forward to making more progress together. And now here's Sheryl."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "Thanks, Mark, and hi, everyone. We had a strong second quarter and a great first half of the year. Our business continues to deliver terrific results. Q2 ad revenue grew 47% year over year. Mobile ad revenue grew 53% year over year to $8 billion and is now 87% of total ad revenue. Our growth continues to be broad-based across regions, marketer segments, and verticals. Our goal is to build meaningful connections between people and businesses by focusing on our three key priorities: helping businesses leverage the power of mobile; developing innovative ad products; and making our ads more relevant and effective. Our first priority is helping businesses leverage the power of mobile. People are rapidly increasing the time they spend on mobile, and businesses know they need to be where consumers are. Given the size and engagement of our audiences, Facebook and Instagram are the best platforms to reach people and drive business results. We have over 70 million businesses on Facebook, and I'm excited to announce today that we now have more than 15 million business profiles on Instagram. Video is an important part of our mobile strategy. More video is being shared and watched on Facebook than ever before, and it's increasingly helping people and businesses connect. That's because video on Facebook is personal, so it's around connections, conversations, and communities. This is why it creates opportunities for businesses to reach people in new and creative ways. People consume content faster on their phones, and marketers are increasingly recognizing that this behavior is different from other media. This means that developing short-form snackable content is a big opportunity on mobile. We're working hard to help marketers adopt mobile-first video ad strategies for Facebook and Instagram. In a mobile environment, native mobile video ads typically outperform more traditional ads. For example, when Tropicana launched its probiotic juice, the company tested 6-second video ads against 15 and 30-second ads. The shorter ads resulted in higher brand metrics across the board, including a 16-point lift in brand awareness compared to a 6-point lift for the longer ads. Our second priority is developing innovative ad products. We're listening closely to feedback from marketers around the world to develop new ad formats and innovate on existing ones. Last quarter, I talked about how our Dynamic Ads help retailers and e-commerce companies promote their products across devices. Dynamic Ads show people the products that are most relevant to them based on actions they've taken, such as viewing items on a company's website. This quarter, we continued to improve Dynamic Ads and extended them to new verticals and categories. Delta Airlines used our new flight format to reach people who had searched for a flight but not yet booked one. Delta was able to run personalized ads based on the routes people viewed on their site and then bring people back to their booking page. This resulted in a 12.7 times return on ad spend. This quarter we also rolled out ads in Instagram Stories for all types of marketer objectives. As Mark described, Instagram Stories are growing incredibly well and are, therefore, a big opportunity for marketers. From driving brand awareness to increasing sales, businesses can now use full-screen Instagram Stories ads for any goal. For example, Ben & Jerry's created a brand awareness campaign using vertical video in Instagram Stories and saw a 14 point lift in ad recall and a 2 point lift in purchase intent for its new Pint Slices ice cream. Our third priority is making our ads more relevant and effective. This means better targeting and better measurement across Facebook, Instagram, and Audience Network. Marketers of all sizes are increasingly following our best practices, like optimizing their ads to drive real-world outcomes rather than focusing on proxy metrics such as page likes and video views. 53% of our revenue from SMBs is from campaigns that use these tools and strategies, up from 23% in the beginning of last year. This quarter, we also added new ways for marketers to improve their targeting and spend more efficiently. For example, we introduced value optimization, which helps businesses show ads to people who are most likely to spend based on previous purchase behavior. We also introduced value-based Lookalike Audiences, which use machine learning to help marketers reach people who are similar to their most valuable current customers. For example, California-based accessory company, Nomad, built a custom audience of people in the U.S. who bought something on their site, and then created a multi-country Lookalike Audience of people with similar characteristics. They targeted ads to their international audience across Facebook, Instagram, and Audience Network, resulting in a 2.7 times return on ad spend. We know that many marketers want to verify and compare results across platforms, and that's why we're focused on giving our clients more options for third-party measurement and verification. We now have 24 partners in our measurement system, including three partners measuring viewability, and we're in the process of adding two more viewability partners, DoubleVerify and Meetrics. As the first half of 2017 comes to a close, we feel good about the progress we're making. As marketers build more meaningful connections with people on mobile, we help them grow their businesses, which in turn grows ours. I continue to be grateful to our clients and partners all around the world and to our global team to make all of this possible. Thanks, and now here's Dave."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Thanks, Sheryl, and good afternoon, everyone. Echoing Mark and Sheryl's comments, Q2 was another strong quarter for Facebook. We continue to see strong growth and engagement in our global community as well as momentum in our mobile ads business. Let's begin with our community metrics. In June, 1.32 billion people visited Facebook on an average day, up 17% compared to last year. This number represents 66% of the 2.01 billion people that visited Facebook during the month of June, which was up 294 million or 17% compared to last year. Our community growth was again driven by product improvements on Android, our Internet.org effort, and ongoing third-party promotional data plans in markets like India. We will begin lapping the impact of these promotions in Q3 of this year. We're also pleased to see strong adoption and community growth across video, Instagram Stories, Messenger, and WhatsApp. While these products do not monetize at the same level as News Feed, they are providing new ways to build global communities. Turning now to the financials, all of our comparisons are on a year-over-year basis unless otherwise noted. Q2 total revenue was $9.3 billion, up 45%. Had foreign exchange rates remained constant with last year, total revenue would have been approximately $140 million greater, or up 47%. Q2 total ad revenue was $9.2 billion, up 47% or 49% on a constant currency basis. Ad revenue growth was strong globally. Rest of World and Asia-Pacific grew at 56% and 54% respectively, while the U.S. and Canada and Europe grew at 45% and 43% respectively. Mobile ad revenue was $8 billion, up 53%, and represented approximately 87% of ad revenue. Desktop ad revenue grew 17% despite an ongoing decline in desktop usage. Note that our Q2 desktop ad revenue benefited from our efforts to limit the impact of ad blocking technologies. In Q2, the average price per ad increased 24%, and the number of ad impressions increased 19%, primarily driven by mobile feed ads on Facebook and Instagram. Payments and other fees revenue was $157 million, down 20%. Total expenses were $4.9 billion, up 33%. We ended Q2 with over 20,000 employees, up 43% compared to last year. Our hiring growth rate increased for the third consecutive quarter, as we continued to invest in the many opportunities ahead. Q2 operating income was $4.4 billion, representing a 47% operating margin. Our tax rate was 13%. In the quarter, excess tax benefits recognized from share-based compensation decreased our effective tax rate by 6 percentage points. Net income was $3.9 billion or $1.32 per share. Q2 capital expenditures were $1.4 billion, driven by investments in servers, data centers, office facilities, and network infrastructure. We generated over $3.9 billion in free cash flow and ended the quarter with over $35 billion in cash and investments. Turning now to the outlook, growth engagement and advertising demand remain healthy, but there are certain factors that will impact revenue growth that are worth mentioning. As we have discussed before, we continue to expect that Facebook ad load will play a less significant factor driving advertising revenue growth going forward, and that desktop ad revenue growth rates will slow in the second half of 2017 when we begin to lap efforts to limit the impact of ad blockers. In addition, we expect that our strategic focus on driving engagement with mobile video may slow advertising impression growth, given the relatively fewer ad impressions in video relative to News Feed. I would also note that we do not see our early efforts in Messenger monetization offsetting the factors that I just mentioned. For these reasons, we continue to expect that our ad revenue growth rates will come down as the year progresses. We continue to expect full-year 2017 payments and other fees revenue to decline compared to full-year 2016. Turning now to the expense outlook, based on our updated view of the remainder of the year, we are tightening our initial expense guidance range. We expect that full year 2017 total GAAP expense growth will be approximately 40% to 45%, narrowed from our previous range of 40% to 50%. I would note that we expect to accelerate our head count growth rate in the second half of the year, as we remain solidly in investment mode. We also expect that our video content investments will contribute to operating expense growth in the second half of 2017. In terms of capital expenditures, we expect that full year 2017 CapEx will be in the lower end of the prior range of $7 billion to $7.5 billion. We are ramping our infrastructure investments to support global growth and anticipate more data center building activity in the second half of this year. For example, we recently broke ground on new buildings at our New Mexico and Iowa data centers. Turning now to tax, as I have previously noted, our tax rate will vary based on our stock price. At the current stock price, we would expect that our Q3 and full-year 2017 tax rates will both be similar to our Q2 rate. In summary, the first half of 2017 was a strong period for Facebook, both financially and in terms of growth and engagement of our community. We will continue to invest aggressively in the many opportunities we see ahead, as we make progress on our mission to give people the power to build community and bring the world closer together. With that, Mike, let's open up the call for questions."
},
{
"speaker": "Operator",
"text": "Your first question comes from the line of Brian Nowak from Morgan Stanley."
},
{
"speaker": "Brian Nowak - Morgan Stanley & Co. LLC",
"text": "Thanks for taking my question. I have one for Mark. Mark, the offerings on the core Facebook app have improved and changed a lot over the years from Groups, Live Video Search, et cetera. I'm curious to hear how you've noticed consumer behavior on the core product, the core Facebook app change as Instagram has grown. And how do you think about that evolving over the next three to five years? Thanks."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "So the main value proposition for the Facebook app is helping people share any type of content that they want with any audience that matters to them. So you can go from text to photo to video, from small groups to larger groups, from your friends to everyone in the world. And that's always been where the Facebook app has excelled. There have been different experiences that are more focused on specific things. But with a strong technological foundation supporting all of these different use cases, the Facebook app has always supported people using all of them. Now the biggest trend that we see in consumer behavior is definitely video. And there's a strong technological underpinning for that, which is that if you go back five years and you tried to watch a video on your phone, it would probably have to buffer for a minute or so before you'd actually get to watch it, which wasn't a good experience. And if you wanted to upload a video, whether it was a longer video like what you'd post to News Feed or a 10-second story like what you'd post in any of the apps, even that might take 30 seconds to upload, so it wasn't a good experience. So now as the technology on the network level improves to support that, what we're seeing is the ability to serve what is a large amount of demand for what's a very engaging type of content. And that demand flows across social content like we're seeing in Stories and Feed to clearly a huge amount of public content. Pages are engaging in this, and some of the trends that Dave just talked about for just a lot of video behavior across the platform."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ralph Schackart from William Blair."
},
{
"speaker": "Ralph Edward Schackart - William Blair & Co. LLC",
"text": "Good afternoon. Mark, in the prepared remarks you talked about Messenger and WhatsApp being on the early innings of monetization, and then you also talked about your desire to move faster on Messenger. Just curious what are the factors driving your willingness to move faster. And then how should we think about that both from a consumer and monetization experience? Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "On Messenger, there are two basic things that we're doing. One is we're starting to put some ads into the product just to see the basic parameters around how that performs, how people like the ads or don't, how they work for businesses, and just try to get an understanding of that. So we're starting to run that across the world. But as Dave said, even though we're starting to roll that out in a lot of places, the volume starts off pretty small. The biggest strategic thing that we really need to do in messaging right now is make it so that people organically interact with businesses and that that is a good interaction both for people and for the businesses. So here's one way to think about this. If you're a business and you have a higher ROI for interacting with a person in your messaging thread than you do on the mobile web or trying to get them to install an app, then that creates this positive feedback loop, where you're going to point your ads towards the Messenger thread. You're going to invest more of your engineering resources in building out the content and experience on the Messenger thread. So we're currently working on making it so that that is the highest ROI thing. I think we're making progress there. It's not that we're going to crack every market at once, but in sum I think we're definitely getting there. We're getting some positive feedback from the market. But once we start to achieve that in more and more verticals, I think that's going to start unlocking a lot of behavior, and a lot of businesses are going to want to push more interactions to happen there, which I think will really be the foundation for building that into a big business."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Ralph, it's Dave. I would just add that with messaging monetization, this is early and it's not a near-term overall Facebook growth driver. And much like Instagram in its early days, we're going to be cautious. But unlike Instagram, this isn't a feed product, so just there are more unknowns here."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Heather Bellini from Goldman Sachs."
},
{
"speaker": "Heather Bellini - Goldman Sachs & Co. LLC",
"text": "Great, thank you. I was wondering. Sheryl talked a little bit about Instagram Stories. I was wondering if you could share with us the initial feedback from advertisers. Do they see it as similar to advertising in the IG feed, or are they using it to reach people in a different way, if you've noticed anything over the period that you've been doing it? Thank you."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "So it's pretty early for ads in Stories. And I think the way people largely think about this is this is another way of using the Facebook ad system, including our targeting and measurement capabilities, to create ads that are great creative that can reach people. So the fully immersive format with the targeting and optimization of Facebook ads is a pretty unmatched opportunity. We also have a huge opportunity within Instagram. And obviously, the use of ads in Instagram is much, much bigger than the use of ads in Stories. The way we think about this is we're trying to help marketers reach their customers, both their existing and their new customers, effectively. And we think it's a combination of all these offerings that really are the strength of our business and explains why we can continue to grow. So within one interface, we're working with one sales rep. If you're a large company or a small company, you can buy Facebook. You can buy Instagram. You can buy Audience Network. You can buy the different ad formats within Facebook and Instagram. And that means that you have multiple targeting opportunities, multiple opportunities, and even opportunities to see who engages in an ad in one place and then reinvest to continue the conversation with those customers. So we think all of these things work together. And these new formats fit in really nicely with the ad system we built, which underlies all of the opportunity."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Peter Stabler from Wells Fargo."
},
{
"speaker": "Peter C. Stabler - Wells Fargo Securities LLC",
"text": "Thanks, good afternoon, one for Sheryl, if I could. Sheryl, you guys have rolled out some initiatives designed to address specific advertising categories like Dynamic Travel Ads. Could we anticipate more efforts going forward to address categories that may be relatively underpenetrated by Facebook, Instagram, and Audience Network? I'm thinking about categories like financial services, auto, for example. Thanks."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "So we're really happy that our growth has been really strong across our verticals, and that continues to be the case. Our top verticals are pretty consistent in e-commerce, CPG, entertainment, media, retail, and gaming. For the most part, when we build products, we build them to work for all verticals, and you see us do that. So being able to upload your catalog of products can be used no matter what your product lists are. We do build vertical-specific ad products when they are necessary, so Dynamic Ads for travel, for example, as you mentioned, being an example. I think the heaviest lifting of the work we do is really helping marketers in different verticals focus on the right metrics, which are the sales metrics, because for too long our industry has been focused on proxy metrics, how long someone viewed a video, even brand lift, measurements we care about, but these are all proxy metrics. What really matters is you see an ad and you buy a product. You see an ad and you drive a car off a lot. You see an ad and you order a service. And so there are very different processes with these different verticals in terms of helping them understand their own purchasing data so that we can connect our ads to their ultimate purchases. We believe that's one of the most important things that we've been very, very focused on, and we have a long way to go. And part of the results you see from us in different verticals are actually explained by the ability of us to help those marketers measure sales at the end of the day. The more that we can tie ad viewing to sales, the stronger our case is with our clients, and so we need to do a lot of work around the measurement with different verticals."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Doug Anmuth from JPMorgan."
},
{
"speaker": "Douglas T. Anmuth - JPMorgan Securities LLC",
"text": "Great, thanks for taking the question, two, if I could. Mark, you visited many different parts of the country over the last several months. Just curious how you're applying what you've learned to Facebook and the broader platform. And then, Dave, can you just give some more color on how things have changed in terms of OpEx and CapEx, just given that you're coming down toward the lower end of the ranges? Thanks."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "So a lot of the themes around building community and bringing people closer together have been underscored by a lot of the experiences that I've had traveling around. And I've tried to write about them. I don't write about each visit that I make on Facebook. But it's been really striking to me when you talk to folks in a lot of different communities how important local institutions and their local communities are for supporting people there. And there's been a clearly documented trend across the world of declining membership in a lot of different kinds of communities. And I think that that's an important problem that is eating at the social fabric not only of our country but around the world that I hope that we can play a role in addressing. And that's not something that we can do directly, but I believe that we can empower people who want to build local communities and want to play a leadership role in their local community to have the tools that they need. And I think if we can do that, then you start bringing people together at a local level. And when people feel more comfortable in their lives at a local level, then I also think that that helps bring people and bring the world closer together at a global level too. So that all has been underscored by a lot of the visits and what I've seen as well as a lot of the research that we've done at Facebook, and it's all reflected in the new mission."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Doug, it's Dave. I don't think there's anything that's really fundamentally changed. We are tightening the range to 40% to 45% expense growth due to better visibility. We remain solidly in investment mode. And if anything, we're finding new opportunities to invest in. From the perspective of hiring growth, I'd really point to the fact that we've been consistently accelerating hiring so far in 2017, and I pointed to the fact that we expect to accelerate hiring in the back half of the year as well. And this quarter was the biggest recruiting quarter in terms of net hires ever for Facebook. We're continuing to invest in a number of key areas, hiring engineers to drive the three, five, and 10-year priorities. We're going to be investing in content to help build a platform for content producers to find an audience and monetize. We are also continuing to invest in areas like community operations and other areas. So, we remain solidly in investment mode from a total expense point of view. On CapEx, we still expect to be within the range of $7 billion to $7.5 billion, and we're investing aggressively in our data center footprint to support the global growth that we see. So, I think across the board, we're investing heavily. On head count, I would just point out that our payroll growth tends to lag head count growth, because head count is an end-of-period number, so the acceleration that we're seeing in 2017 will obviously play out in 2018 as well."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ross Sandler from Barclays."
},
{
"speaker": "Ross Sandler - Barclays Capital, Inc.",
"text": "Great, guys, a couple questions on the messaging apps. I think two years ago at F8, you talked about WhatsApp user base about really north of 1 billion sending out 50 billion messages a day, and Messenger was about 1 billion and 20 billion messages a day, so implying kind of like 2.5 times the engagement on WhatsApp compared to Messenger. Is that accurate? And where does that stand today? And then both of these messaging apps started in different geographies around the world. So, how does that impact your thinking around monetization ideas between Messenger and WhatsApp? Thanks."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Yeah. I don't think we're sharing detailed stats on engagement by messaging platform. They're obviously both critical platforms. Both have over 1.2 million monthly actives. And WhatsApp has demonstrated significant engagement with crossing 1 billion daily actives. So, I think that indicates the engagement that you have on that platform. There are different geographies where the messaging platforms are stronger. And depending on that, that shifts our priorities in different ways. But overall, from a monetization perspective, I think the strategy there is clear. We're focused on growing the user base, first and foremost. And then secondly, it's about building organic connections between businesses and consumers. And then third, it's about how do we build monetization around those relationships. And I think there, we're further along with Messenger than we are with WhatsApp. And so, I think you see us rolling out the global beta there with ads. So, I think we'll watch and learn from that. And as we learn things, we can apply them in other areas."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Justin Post from Bank of America Merrill Lynch."
},
{
"speaker": "Justin Post - Bank of America Merrill Lynch",
"text": "Great. Thank you. Maybe a question for Mark. I know video is a priority for the company. To start with, any change in user trends or engagement as you've added video to Facebook? And then secondly, just how do you think about semi-professional or professional video for Facebook? Is that a good business, given all the content-sharing costs and the production costs when you compare it to your existing social business? And do you see it as cannibalistic or additive as far as usage? Thank you."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "I can share a little bit about it, then Mark would want to jump in on any other color. I mean, I would say, as I mentioned, Justin, in my commentary, as people spend more time with video, and more time is going to video, that is going to have a limiting factor to how much time they spend in News Feed. And so, that's going to have an impact on impression rate growth. So there is, in that sense, a cannibalistic effect of sorts that happens there. But what Mark alluded to was video is where people – as networks improve and devices improve and our products improve, video is the most engaging experience that we can offer. And so, we're seeing consumers adopting that and we're building products for them. In terms of the types of content, I think we're looking at a wide variety of content from – of course, at the core is people sharing experiences in their lives. And that's at the base of what we offer in terms of bringing the world closer together. It's that community content. But then there's opportunities for semi-professional and professional content. And we're exploring things around the platform of making sure that we're a platform where professional content providers can come, find an audience, and then also monetize that audience."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "I think you pretty much got it."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Colin Sebastian from Robert Baird."
},
{
"speaker": "Colin Alan Sebastian - Robert W. Baird & Co., Inc.",
"text": "Great. Thanks. Mark, I wanted to ask a question on conversational interfaces, and specifically if we should think of Facebook becoming integrated as the skill app or feature on platforms such as Alexa, or should we think of things like Oculus, Messenger, and perhaps even a dedicated device as part of Facebook's own alternative platform? And then, Dave, just hoping you can put a finer point on the timing around the reduction in ad load growth. Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "I mean, to the first question, we're going to build the services that we think are useful. Some of them are going to be platforms and some of them are going to be apps and different things on top of platforms that other folks build. But fundamentally, we're trying to serve our community the best we can, and we'll do that across all these platforms."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Yeah. And in terms of ad load growth, I pointed to the fact that we continue to expect that ad load will be a less significant factor in the remainder of 2017, and that's certainly the case. That starts in Q3, but there's a number of other factors that I also pointed to, including the desktop lapping some of the efforts we made on desktop in terms of unblocking or working against the ad blocking technologies. And so, that has a factor on desktop growth. And then of course, I talked about video and our focus on driving and serving the consumer demand for video, and that's also leading to potentially lower impression growth as well."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Rich Greenfield from BTIG."
},
{
"speaker": "Richard Greenfield - BTIG LLC",
"text": "Hi. Thanks for taking the question. On one of your blogs, you put a post up basically detailing basically what people were doing during TV, and you showed a control group where Facebook usage was really constant. And then you did a group that was watching the TV show, and you saw huge spikes of Facebook usage during the television – during the ad breaks during the show. Wondering like, as you go talk to marketers, obviously, TV ratings are down a lot. How does that type of study – I realize it's just one TV show. But as you make the pitch of why are you not shifting dollars faster to Facebook, how does that type of research start to play into their thinking? And what's holding them back? Is it just the creative doing, or the embracing of 6-second ads? What's the block to getting more of that $70 billion of TV ad dollars to shift over faster? Thanks."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "That was just one study, and I don't want to overstate its importance in how we sell ads. We make the case to our clients that consumers are moving to mobile and that they need to move to mobile. And not that mobile should replace all of their other advertising, but responsible marketers with great companies, large and small, still advertise on TV, and they advertise on mobile, and they advertise in other places. Our goal is to be the best dollar and the best minute anyone spends, and the case we make is that we want them to take advantage of the opportunity that is mobile and the opportunity for the targeting we offer and the measurement we offer. I think what has taken us time and continues to take us time is we need to convince marketers to make mobile-first video and other ad formats. We talk a lot about how the first TV ads were people reading their radio ads in front of microphones. And we're still in the case that when people go to put an ad on mobile, they often will take an ad that's really produced for TV and put it on mobile. And those work and they can work well, but they do not work as well as ads that are natively mobile, like the Tropicana example I shared in my earlier comments. Mobile ads when they're video are shorter. The brand comes in faster. They tell a story that doesn't evolve but really gets you to understand the brand and the offering really quickly. We talk about it as thumb-stopping creatives. And so the work that we have cut out for us is to help marketers and working with their agencies evolve the format of the ads so that they're optimized for mobile, optimized for Facebook, optimized for Instagram. I think we're making progress, but we have a long way to go there."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Mark Mahaney from RBC Capital Markets."
},
{
"speaker": "Mark Mahaney - RBC Capital Markets LLC",
"text": "Great, thanks. Mark, you talked about maybe trying to accelerate a little bit the messaging monetization end. I'm wondering if there's anything more behind that statement. Is it that you were frustrated with the level that you had seen to date, or that you saw some opportunity that you thought you could accelerate the push towards I guess monetizing? And maybe big picture, I want to ask. I know the monetization is very early stages. It's barely even begun. There's very few platforms around the world that have got 1 billion users that are unmonetized, so you would think that there's a lot of opportunity there, but maybe not. And maybe people are making a mistake in trying to look at Asian assets and seeing what they've done there and thinking that you can do with your asset. So what's the upside? When you think about the real opportunity, what gets you excited about the ability to monetize those assets five years from now?"
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Sure. So we're currently going through the process of figuring out what we want to invest in over the next year and doing our long-range planning, and this is certainly one of the areas where I think we want to be investing a lot more in and believe that there's a big opportunity and can accelerate all the effort. I do think, as you say, this is one of the rare times in business where you can look at messaging platforms that exist and see how they've successfully monetized in other parts of the world and have that be a floor. I think that over time, we should be able to do better, but that at least provides this existence proof that despite – regardless of what our internal logic is of what we're doing, that someone has done it. So that gives us some degree of confidence there in addition to our own execution on other things. But I feel there's a pretty clear playbook that we have here of first building up the consumer usage, then building up the organic person-to-business interaction, making sure it works for both people and businesses. And then once you have that, the quality of those interactions is really what contributes to the scale of how much you can grow. We've seen this in News Feed too. One of the factors that's contributed to ad load over time is the quality of the ads. If ad quality was low, we wouldn't be able to put as many ads in because people wouldn't want them. But in a lot of markets around the world, we see that ad quality is increasing at a very fast rate, and that makes it so that a lot of times people do ask for the content, which of course creates a very different dynamic. So we need to get to that in messaging. And because messaging really started from the place of people communicating one to one with each other and is now adding all these other uses, it's just a lot of investment and a lot of different functionality that needs to get added. But for all the reasons that I've said here around our own experience doing this in other contexts with Facebook and Instagram, proof points in the market of how it's worked, I think over the long term I'm pretty confident that we will get there, and it's our job to just go do that."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "And I would just add. We don't know at what level that is. We've had more experience with feed-based products, so we know how those play out, and so this is in very much early days mode."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of John Blackledge from Cowen."
},
{
"speaker": "John Blackledge - Cowen and Company",
"text": "Great, thank you, two questions on the Messenger ads. I recognize that it's early days, but just wondering if you think those ads will be more complementary for core Facebook and Instagram advertisers, or perhaps serve a different advertiser base or different use cases versus core Facebook and Instagram. And then second question will be, at the high end of the OpEx guide, it implies 53% year-over-year OpEx growth in the back half of the year versus plus 36% in the first half. Just wondering if you can discuss other key drivers of the OpEx growth in the back half of the year aside from head count. Should we consider investment in video content the number two driver of OpEx growth in the back half of the year? Thank you."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "On the Messenger ads, I think the way we think about it is, as Mark said, we have a lot of work to do to work on the format of that. This is not a feed-based product, and this is a messaging product. So it's a different consumer format, and we believe that the ad format should follow the consumer format, so it's really integrated as part of the experience. And that's where we have a lot of work to do. We do think that the advertiser base and the targeting and the measurement we offer once we figure out the format will be a very considerable advantage. We already have 5 million advertisers on Facebook, 1 million advertisers on Instagram. And one of the reasons we were able to scale into Instagram ads more quickly is because we were building off of the Facebook advertiser base. And similarly, the work we've done in Facebook and Instagram and Audience Network will help us expand to Messenger. But we really want to emphasize, especially since there are so many questions on Messenger monetization on this call, that we're going to be slow and deliberate. We are always looking at the long run. We do not manage this company quarter to quarter. We protect the consumer product and the consumer engagement. Messaging is really strategically important for the company and the long-term engagement with our users, and the organic feel of the engagement with businesses and consumers is where we will be focused. So it's early days this year, and it's going to continue to be early days for a while."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "So on the OpEx guide, clearly the biggest driver there is going to be the accelerating head count growth. In addition, I mentioned video content as being a driver. And then also, we're just supporting the global growth of the platform. We continue to see growth in users. We continue to see growth in time spent per DAU across the Facebook family of apps and Facebook, and we're bringing more data centers online and the like towards that growth. So those will start hitting cost of revenue with depreciation. So there's going to be a variety of contributions to that growth. But like you mentioned, I would point to both head count, specifically in R&D. R&D head count grew 48% year over year in Q2, and that's what's going to be a key driver along with the content layering in."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Mark May from Citi."
},
{
"speaker": "Mark A. May - Citigroup Global Markets, Inc.",
"text": "Thanks for taking my questions. Sheryl, in your prepared remarks about a case study, you discussed the benefits of shorter video ads. But I was hoping you could provide an update on the mid-roll Ad Breaks that you've now been testing for a few months and maybe what kind of progress that you're seeing in terms of completion rates. Are you at a point where Ad Breaks can start to roll out more broadly? And then, Dave, you mentioned that a greater focus on video could impact growth in ad impressions. But would you also assume that a greater focus on video ads could also drive improved ad pricing and yield on your available inventory? Thanks."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "On Ad Breaks, we're currently really just testing the ability to put a short Ad Break in uploaded videos. We do it if a video is longer than 90 seconds or live videos are longer than 4 minutes. We're just in the process right now of expanding to more publishers in the United States, so it's really early. In terms of the metrics we're looking for, it's a great question. And obviously, we care that people view the ads, but the most important thing is tying those ads impressions, even if they're short views, all the way through to that same purchase data that we keep talking about. And so as we work on rolling out more Ad Breaks, and we are rolling out slowly, we're really focused on finding ways to help marketers measure the right things, and that's a very important focus for the company going forward."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Now, Mark, you were asking about video and its impact on pricing growth. I would probably step back and look at it from an overall system perspective. And so starting with the supply side, there's a variety of factors that will impact impression growth, and I mentioned slower ad growth and then increasing video watch time as being two of them. And given there's an auction that drives the pricing in how we run the business, there's always an interplay between supply growth and pricing growth. And so what we're really focused on is driving better ROI for our advertisers. And Sheryl alluded to it in her earlier commentary about if we get better at converting our impressions into things that are valuable for advertisers and we get more efficient in doing that, we'll be rewarded with better pricing and higher demand at better pricing as a result of that hard work. That doesn't necessarily specifically pertain just to video. It really is across the board. So if we're effective at continuing to do that, then that should benefit pricing growth. And if we can grow demand faster than we grow supply, then we're going to see that play through in price. And that's really the goal of a lot of the hard work that the ads team does to make our products better and more effective for advertisers."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Michael Nathanson from MoffettNathanson."
},
{
"speaker": "Michael B. Nathanson - MoffettNathanson LLC",
"text": "Thank you. I have one for Dave and one for Sheryl. Dave, going back to your prepared comments, I think you mentioned there was 24% growth in pricing this quarter, in unit pricing. Can you help us explain or understand underlying that growth which products you're seeing the greatest inflation maybe quarter over quarter or year over year?"
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "I would really just point to the overall dynamics of the system. And again, what we're seeing is with slower supply growth, that's going to play out to higher pricing. And again, are we effective? And we've been effective at delivering good return on investment for our advertisers and getting better at converting what we have as inventory into what they care about as outcomes. And that from a systemic point of view is what's playing through there. From a product perspective, as we get things like Dynamic Product Ads rolled out, those are incredibly valuable. As we connect more advertisers with those and bring more data into the system and we can get more of the impressions that are very highly targeted and very relevant, then we'll be rewarded with better pricing as we can expand that out into things like Lookalikes. We've talked a lot about it on this call. That basically takes some of that really good targeting and extends that into a much bigger audience, and then we can get more impressions at better value because we're really connecting that with end results that the advertisers value. So it's really all that type of work that we do to get the system better and better, and so we're constantly working to get better penetration of these key ad products. In terms of the supply side, obviously News Feed is incredibly valuable because it's very present for the consumer. And we've improved the quality of the ads in News Feed, and that's another driver from the supply side."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Rob Sanderson from MKM Partners."
},
{
"speaker": "Rob J. Sanderson - MKM Partners LLC",
"text": "Yeah. Thank you. Good afternoon. It already feels like a call about Messenger monetization, so I'm almost reluctant to ask another, but just two things. Compared to what you saw in the early phases of testing News Feed ads, what can you say so far about users' responsiveness to ads in Messenger? And then second, obviously, there's a lot of momentum in the development of bots on the platform. And do you see this enabling of great organic interactions, as Mark put it, as a way to ultimately make Messenger a great ad platform, or do you think that enabling these other business services can lead to other monetization opportunities down the road, independent of advertising?"
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "It's really too early to understand the impact of the ads on consumers because there aren't enough of them and they haven't been rolled out for long enough. In terms of the bots, what we really think about is our businesses and people making useful connections on both sides on Messenger or any platform. If the connection is useful for marketers, businesses, and useful for people, then it will grow. And we're open to automated bots being useful. We're open to other forms of things being useful. I think when you think about what bucket of spend that is in, which is a question we get, it really is both marketing spend and any other spend companies have where they're reaching their customers, of which if you think about marketing spend and customer service spend, marketing spend is way bigger, because marketing spend grows as you can grow sales. And customer service spend is something that people generally try to minimize. So, the way we think about it is we want to grow the organic connections, whether they're automated or whether they're personalized, and make sure that that is growing the business of our customers."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Brian Wieser from Pivotal Research."
},
{
"speaker": "Brian W. Wieser - Pivotal Research Group LLC",
"text": "Thanks for taking the question. I was wondering if you could comment on how you think the European Commission's GDPR [General Data Protection Regulation] and related privacy initiatives will impact the business, either generally positively, negatively, and whether or not those policies around privacy might yet become global standards. I'm curious how you think that impacts both the consumer product as well as the advertising business. And maybe separately, I'm just curious if among those advertisers who have expressed particular concern around third-party tool access, we certainly heard from some who have said very publicly that they're going to reduce their spending. Obviously, others clearly are increasing their spending. But curious how far you've gone towards allaying those concerns and possibly regaining any lost spend."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "When we think about any regulatory issue, GDPR or anything else, we respect local laws and regulations. And we have to work really closely with regulators to make sure they understand our business practices, understand how we contribute to economic growth in their countries, and understand the steps we take and continue to take to protect privacy. Certainly, regulation is always an area of focus that we work hard to make sure that we are explaining our business clearly and making sure regulators know the steps we take to protect privacy as well as making sure that we're in compliance. When you think about the metrics question you asked, how we think about what is – so what I think you're asking about is third-party verification. We're very interested in making sure that marketers can verify or measure outcomes through third-parties, and that's why we're working to actively expand those partnerships."
},
{
"speaker": "Operator",
"text": "The next question is from the line of Lloyd Walmsley from Deutsche Bank."
},
{
"speaker": "Lloyd Walmsley - Deutsche Bank Securities, Inc.",
"text": "Thanks for taking the question. Another one on Messenger. So, you guys have talked of building – the importance of building organic consumer-to-business interaction here. So wondering if you can share what sort of adoption you are seeing in those kind of interactions. And are there certain verticals or geos where it's really taking off? And then a second, if I can. We've talked a lot, obviously, already about ad impression growth and how it's set to slow in the second half. You're already seeing a big slowdown in impression growth in the first half. And yet, as you've noted, with supply growth slowing, pricing has gone up, as you've added a lot of ROA as to your customers. So wondering why should this phenomenon not continue to carry ad revenue growth in the second half?"
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "I'll take this. So, there have been a number of questions about Messenger. And in general, we're seeing – I'm happy with the rate of growth in the experiences that we're seeing on Messenger. But if there's one message here that I think is actually important to say, it's that we're trying to communicate that the pace of growing the Messenger business, it's a longer-term thing. I actually think over the next couple of years or few years, the much bigger driver of the business and determinant of how we do is going to be video, not Messenger. Messenger, I think, is a really important thing and WhatsApp over a three- to five-year period, and we're investing a lot in it. I think it's a huge opportunity. But as has been noted on the call, video is both at large scale and the economics are quite different from the current feed-based businesses that we have today, especially around how, with mid-roll ads and rev share around that, the margin structure will be different. So, I mean, one of the big questions that we're focused on as we build this out, we're very committed to building it out because it's what people in the community want. But one of the big things that we're really very focused on is making sure that we get this right so that even though this business will likely be – not likely, I think almost certainly will be a lower margin source of revenue than the current thing that we do, there's this big question of how incremental is that behavior going to be. And I'm just throwing this context out there because so many of the questions here today have been about Messenger, and I want to make sure on these calls that we do an accurate and a full job of conveying what we're actually thinking about as a business and what we think the outlook is going to be. And I think that those questions around video, which I'm optimistic about, but there are real questions there that we need to manage well, is going to be a much bigger driver of the business over the next two to three years likely even than the trajectory of what we're doing on Messenger and WhatsApp."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "And, Lloyd, you asked about why the good work that we've done so far in basically providing value for advertisers is playing through into price. Look, that's not just happening. That's a bunch of hard work that goes into making our ads more targeted that makes the outcomes that advertisers get more valuable. We're going to continue to work to do that, and we're going to continue to invest in making improvements in the ad products, and we think there are great opportunities to continue to make improvements to ROI. But obviously, if you have rising prices, it's going to make that work against an upstream trend, so we need to continue to work hard to deliver more value for advertisers in the face of that. So we've got our work cut out for us, and we think we've got a great team working on those challenges."
},
{
"speaker": "Deborah Crawford - Facebook, Inc.",
"text": "Operator, we're going to take one last question."
},
{
"speaker": "Operator",
"text": "The last question comes from Ben Schachter from Macquarie."
},
{
"speaker": "Benjamin Schachter - Macquarie Capital (USA), Inc.",
"text": "Thanks for taking the question. Mark, you stated that AR mixed reality could be the next computing platform. Obviously, this is way out in the future. But if that implies something so large, how do you think about allocating resources for that? How much are you willing to spend on it, and any new thoughts on how this all evolves? And then related to that, the next iPhone is coming out soon. Do you think that there will be capabilities there that will impact the AR evolution meaningfully? Thanks."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "This is certainly something that I'm really excited about long term. Not only does it have the possibility of being the next major computing platform, AR and VR together, but I think it has the possibility of being much more social and intuitive and natural than some of the devices that we have today, whether they're computers or phones. So that's why I'm really excited about that. When you think about AR glasses, the technology and science to build an experience that would be both comfortable to wear and something that people would actually want to wear out in public, that doesn't exist yet. So there's a lot of foundational work that needs to get done there. That's partially why I'm excited about doing the VR work because it doesn't have that constraint. You're not wearing VR out in public. But also recently, one of the things that we've seen is that there are a lot of AR experiences on mobile. So the work that we started talking about at F8 that we are releasing slowly over the course of the year is certainly one of the precursors for building out that ecosystem that I'm excited about. But look, if I was just saying that video is going to be the primary driver or one of the big drivers over the next few years and Messenger maybe after that, I think AR is quite far down the road. But when you're running an operation and serving people at this scale, I think you have a responsibility to invest in all these things that are downstream that could help shape and improve people's lives, because I don't think that there are that many other folks in the world who will. So I think that that's a thing that we take seriously, whether it's connectivity and making sure that people actually all around the world get to enjoy and benefit from the opportunities that the Internet has or the improvements that come from AI, or eventually upgrading the computing platforms that we all get to use. This stuff doesn't just happen automatically. And someone in the world needs to focus on building it, and we want to play a role in that."
},
{
"speaker": "Deborah Crawford - Facebook, Inc.",
"text": "Great, thank you. Thank you for joining us today. We appreciate your time, and we look forward to speaking with you again."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines."
}
] | null | null |
META | 1 | 2,017 | 2017-05-03 17:00:00 | Executives: Deborah Crawford - Facebook, Inc. Mark Elliot Zuckerberg - Facebook, Inc. Sheryl Kara Sandberg - Facebook, Inc. David M. Wehner - Facebook, Inc.
Analysts: Eric J. Sheridan - UBS Securities LLC Douglas T. Anmuth - JPMorgan Securities LLC Brian Nowak - Morgan Stanley & Co. LLC Justin Post - Bank of America Merrill Lynch. Colin Alan Sebastian - Robert W. Baird & Co., Inc. John Blackledge - Cowen & Co. LLC Heather Bellini - Goldman Sachs & Co. Anthony DiClemente - Nomura Instinet Mark Mahaney - RBC Capital Markets LLC Ross Sandler - Barclays Capital, Inc. Mark A. May - Citigroup Global Markets, Inc. Michael B. Nathanson - MoffettNathanson LLC Peter C. Stabler - Wells Fargo Securities LLC
Operator: Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook first quarter 2017 earnings call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin.
Deborah Crawford - Facebook, Inc.: Thank you. Good afternoon and welcome to Facebook's first quarter 2017 earnings conference call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our Annual Report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now I'd like to turn the call over to Mark.
Mark Elliot Zuckerberg - Facebook, Inc.: Thanks, Deborah, and thanks, everyone, for joining today. We started the year off with a good quarter. Our community continues to grow, with more than 1.9 billion people now using Facebook every month and almost 1.3 billion people using it every day. Our ads business is doing well too. Total revenue grew by 49% year over year to $8 billion, and advertising revenue was up 51% to $7.9 billion. In my letter to our community back in February, I talked about how for the past decade Facebook has focused on connecting friends and family. Now with that foundation, our next focus will be building community. There's a lot to do here. Building a global community is bigger than any one organization, but we can help by developing social infrastructure for communities, for supporting us, for keeping us safe, for informing us, for civic engagement, and for including everyone. Building a global community that works for everyone starts with building millions of smaller supportive communities. This is especially important, since membership in many physical communities is declining. We recently found that more than 100 million people on Facebook are members of what we call very meaningful groups, like parenting or rare diseases, support groups that are an important part of their support structure. My hope is to help more than 1 billion people join meaningful groups to strengthen our social fabric over the next few years. To help build a safe community, we launched Community Help, a tool that allows people to give and get things like food, shelter, or transportation in the wake of a natural disaster. We also launched a new fundraising tool that allows people to raise money for themselves, a friend, or a cause that isn't already on Facebook. But it's clear we have more to do here. We're going to continue building new tools to keep people safe on our platform. Over the next year, we'll be adding 3,000 people to our Community Operations team around the world on top of the 4,500 we already have today to review the millions of reports we get every week and to improve the process for doing that quickly. To help build a more informed community, we make changes to our News Feed ranking to reduce the financial motivation to spread hoaxes. We're working with independent fact-checkers to give people more information on whether an article has been disputed. We launched an educational tool at the top of News Feed in 14 countries to help people spot false news. And we're beginning to test related articles that appear before you read an article, giving you easier access to more perspectives and information. We're also helping to build a more civically engaged community. In March we launched Town Hall to help people find and connect with their government representatives on a local, state, and federal level in the U.S. In just the first month, we created more than 1 million new connections between people and their representatives. We also rolled out a tool in France ahead of their election that allows candidates to share statements about where they stand on different policy issues. So these are some of the changes we've made to help people build stronger communities. Next I want to give a quick update on what we're building over our three time horizons, how we're making our core services more useful and engaging right now, how we're building ecosystems around products that a lot of people are already using over the next five years, and how we're investing in the technologies that will give more people a voice and make sharing more immersive over the next 10 years. This quarter we launched a set of new cameras. Photos and video are becoming more common than text, so the camera is becoming more central then the text box in all of our apps. In the Facebook app, you can now swipe right from News Feed to access our new camera with masks, frames, and filters. We've developed new computer vision tools that can apply the style of a painting to a photo or video, and we can do that in real time on your phone for the first time. This is part of making the camera the first augmented reality platform. We want to give developers the power to build all kinds of AR tools in the camera so more people can experience augmented reality on their phone. Creating the first open camera platform is a huge step forward, and we're excited to keep pushing augmented reality forward. We also expanded the Stories format to give people more new ways to share. Instagram Stories now has more than 200 million daily active people using it. And just a couple months after we launched it, WhatsApp Status has more than 175 million daily active people using it. More recently, we also rolled out Messenger Day and Facebook Stories, and we're going to keep putting video at the center of all these services. Over the next five years, we're going build ecosystems around our products that a lot of people are already using. I put live video in this category. Last month we announced that one in every five Facebook videos is a live broadcast. And over the past year, daily watch time for Facebook Live broadcasts has grown by more than four times. This year we also gave people the ability to go live in 360. Messenger is in this category too. And we just announced that 1.2 billion people use Messenger every month. At F8, we launched the second generation of our Messenger platform and introduced the Discover tab to make it easier to find the best experiences quickly. Finally, over the next 10 years, we're developing consumer use cases around technologies that are a big part of our future, but won't be a part of our business, a big part of the business for a while. On the connectivity side, in April we successfully simultaneously beamed 16 gigabits of data in each direction between a location on the ground and a Cessna aircraft circling more than 7 kilometers away. Eventually, we're going to use this technology along with Aquila, our solar powered plane that we're building, to beam Internet to parts of the world that currently don't have access. In virtual reality, we launched Facebook Spaces, the first social VR platform that lets you create your own avatar and hang out with your friends. And we also released the Facebook 360 app for Gear VR that makes it easier to discover and experience in 360 photos and videos. And we continue to ship RIFT and Touch to people everywhere and deliver a strong content ecosystem across both RIFT and Gear VR. As people share more video, as we explore more things like augmented reality, and as we build more tools to keep our community safe, we're going to keep investing aggressively in the infrastructure that we need to grow and serve our community. That's why we announced that our next two data centers will be built in Odense, Denmark and Papillion, Nebraska. We've made some good progress. We have a lot more to do to help build community and connect the world. I want to thank everyone in our community, our teams, our partners, and all of you for being a part of this journey with us. And now here's Sheryl.
Sheryl Kara Sandberg - Facebook, Inc.: Thanks, Mark, and hi, everyone. We had a strong first quarter and a great start to the year. Q1 ad revenue grew 51% year over year. Mobile ad revenue was $6.7 billion, up 58% year over year, and was approximately 85% of total ad revenue. Growth again this quarter was broad-based across regions, marketer segments, and verticals. Our goal is to build meaningful connections between businesses and people. We're doing this by focusing on three key priorities: helping businesses leverage the power of mobile; developing innovative ad products; and making our ads more relevant and effective. Our first priority is helping businesses leverage the power of mobile. More businesses around the world are shifting to marketing on mobile. Over 70 million businesses are now using Facebook Pages around the world on a monthly basis, and more and more of them are becoming advertisers. We also recently announced that over 5 million businesses are actively advertising on Facebook, including more than 1 million in emerging markets. Most of these advertisers start by using our free Pages product because it's easy to use. People are increasingly recognizing that the small screen is big. Our Creative Hub is providing tools that make it easier to create ads optimized for mobile, what we talk about as thumb stopping creative. Marketers can see previews of their ads across Facebook and Instagram before rolling them out and get tips to help drive business results. Our second priority is developing innovative ad products that help businesses make the most out of their campaigns. We continue to improve Dynamic Ads, which enable advertisers to promote their full range of products across all devices. Advertisers can now target Dynamic Ads to broad audiences and are seeing great results. Last week I visited home retailer Wayfair in Boston. They use Dynamic Ads to reach a large audience with personalized recommendations from their catalog of over 8 million items. By finding higher revenue customers at a lower cost, the campaign beat Wayfair's return on ad spend goal by more than 20%. We're also helping marketers use video to capture shoppers' attention. People are watching more video on Facebook than ever before, and it's changing how they connect with businesses. In a recent study Facebook commissioned with Kantar, 30% of mobile shoppers said video is the best way to discover new products. This quarter, we introduced a new ad format called Collection. Collection helps marketers tell stories on mobile by combining creative videos or photos of product images. Clicking on the products leads to an immersive shopping experience, driving purchase consideration and ultimately sales. For example, adidas, which is how you pronounce them at their headquarters, and its agency, iProspect, created a video highlighting the innovative future of a Z.N.E. road trip party. Using our Collection ad format, adidas featured four more items from their product catalog below the video. They saw a 5.3 times return on ad spend and a 1.8 times decrease in cost per conversion. It's still early for this new format, but it's a great example of how we can deliver innovative mobile experiences that work for advertisers and work for people. This quarter we also launched full-screen sound-on ads in Instagram Stories. Advertisers can now reach over 200 million daily actives on Stories to do everything from building brands to selling products. Our third priority is making our ads more relevant and effective. Measurement is critical. We recently introduced new and expanded verification partnerships and committed to audits with the Media Rating Council. Whether marketers are trying to get people to buy something on their website or in their store, we now have systems in place to help them measure results and third-party partnerships to verify those results. These are important steps as we continue to build the advertiser trough. Bud Light's NFL campaign is a great example. To promote the designs of their new team-specific cans, Bud Light took a national and regional approach. They ran video ads featuring the new cans to people ages 21 to 49 in the U.S. Then they also ran more targeted ads in each region featuring the two cans of the teams playing each other. Using Facebook polling and Oracle data cloud, they saw a 24-point lift in ad recall and a 4.4 times return on ad sales. We know marketers want to compare results across platforms and placements. Historically, we've enabled larger marketers to do this. In Q1 we started testing a set of advanced measurement tools that make it easier for marketers of all sizes to compare the effectiveness of Facebook, Instagram, and Audience Network alongside other publishers. We're off to a strong start in 2017. We're helping marketers leverage the power of mobile, developing innovative ad products, and delivering proven and measurable results. We're excited about the growing adoption of our platforms, and we're going to continue to invest in helping businesses and people connect. Thanks, and now here's Dave.
David M. Wehner - Facebook, Inc.: Thanks, Sheryl, and good afternoon, everyone. Q1 was a strong quarter for Facebook. We continued to see healthy growth in engagement trends across our community as well as broad-based growth in our ads business. Let's start with our community metrics. In March, 1.28 billion people visited Facebook on an average day, up 18% compared to last year. This daily number represented 66% of the 1.94 billion people that visited Facebook during the month of March, which was up 282 million or 17% compared to last year. Our community growth in Q1 was driven by product improvement, internet.org, and ongoing third-party promotional data plans in markets like India. Note that we do not control the timing or terms of these promotions. Before diving into the financials, I want to highlight that we are no longer reporting non-GAAP expenses, income, tax rate, or EPS. Given that stock is an important part of our compensation structure, we believe that investors should focus on our financial performance with stock-based compensation included. Turning now to the financials, all of our comparisons are on a year-over-year basis unless otherwise noted. Q1 total revenue was $8 billion, up 49%. Ad revenue was $7.9 billion, up 51%. Exchange rates did not affect our overall growth rate this quarter, as headwinds in certain currencies were offset by tailwinds in others. In terms of regional advertising growth, rest-of-world and Asia-Pacific were our strongest growers in percentage terms at 66% and 60% respectively. Both regions benefited from particularly strong advertiser demand. Europe and North America both grew at 47%. Mobile ad revenue was $6.7 billion, up 58%, and represented approximately 85% of ad revenue. Desktop ad revenue grew 22% despite a decline in desktop usage and was aided by our recent effort to limit the impact of ad blocking technologies, which we began in Q3 of last year. Our mobile ads business continued to be driven by healthy supply and demand in apps (15:41). In Q1, the average price per ad increased 14% and the total number of ad impressions served increased 32%, primarily driven by mobile feed ads. Payments and other fees revenue was $175 million, down 3%. Q1 total expenses were $4.7 billion, up 40%. In 2017, we have continued to accelerate our hiring efforts. We added over 1,700 employees in Q1, predominantly in technical and recruiting functions, and ended the quarter with approximately 18,800 employees, up 38% compared to last year. This marked an acceleration from the 34% growth rate in Q4. Q1 operating income was $3.3 billion, representing a 41% margin. Our tax rate was 10%, which reflects the adoption of ASU 2016-9 in the fourth quarter. Excluding this adoption, our tax rate would have been approximately 9 percentage points higher. Note that the new accounting guidance does not impact the cash taxes we pay but merely how the tax provision is presented under GAAP, whereby now excess tax benefits are flowing through the P&L and in this quarter positively impacted EPS. Net income was $3.1 billion or $1.04 per share. Q1 capital expenditures were approximately $1.3 billion, driven by investments in data centers, servers, office facilities, and network infrastructure. In Q1 we also broke ground on our ninth data center in Nebraska. We generated approximately $3.8 billion in free cash flow. In the first quarter, we repurchased $228 million of our Class A common stock and used $771 million in cash for taxes paid related to the net share settlement of equity awards. We ended the quarter with $32.3 billion in cash and investments. Turning now to the outlook, with regards to revenue, we continue to expect that our ad revenue growth rates will come down meaningfully over the course of 2017. We expect that ad loads will play a less significant factor in driving revenue growth after mid-2017. We also expect desktop ad revenue growth rates to slow in the third quarter when we begin to lap our efforts to limit the impact of ad blockers. We continue to expect that our full-year 2017 payments and other fees revenue will decline compared to full-year 2016. As a reminder, payments and other fees revenue is primarily generated from payments related to games played on personal computers. Turning to the expense outlook, we continue to expect that full-year 2017 GAAP expenses will grow 40% to 50% compared to full-year 2016. I would note that as we look into 2017 and beyond, there are going be a number of initiatives we believe are valuable to the community and to the company in the long term that are going be net negative on our operating margin. We are embarking on a significant ramp up in infrastructure supporting global growth, and we continue to expect that full-year 2017 capital expenditures will be in the range of $7 billion to $7.5 billion, which is up over 50% compared to last year. Turning now to tax, as we noted in the last call, under the new accounting guidance, our tax rate will vary based on our stock price. At current stock prices, we expect that our Q2 and full-year 2017 tax rates will both be in the mid-teens, so up from the first quarter rate. In summary, Q1 was a strong quarter and a great start to the year. Growth in the Facebook community remains strong. Engagement across our family of apps is healthy and growing, and advertiser demand from our growing base of marketers is robust. Importantly, we continue to invest aggressively to build our business and drive value for our community over the long term. With that, operator, let's open up the call for questions.
Operator: Your first question comes from the line of Eric Sheridan from UBS.
Eric J. Sheridan - UBS Securities LLC: Thanks for taking the question, maybe one thematic question on Instagram for Mark and Sheryl. I wanted to understand what you're seeing in terms of the development of the community on the user growth side, the engagement side, as well as on the monetization side with respect to breadth of advertisers and ad product evolution, what that means for Instagram's future and how it compares to maybe what you've learned growing the business on the Facebook side over the last couple years. Thanks so much.
David M. Wehner - Facebook, Inc.: Eric, why don't I take that and then Sheryl can augment with some additional color? So when you think about Instagram, we're seeing great growth there with the community. So this past quarter, we announced 700 million monthly actives, so that was a big announcement. And that's broad-based growth across the globe, so we're pleased with that. In terms of the development on the advertising side, we're not specifically breaking out Instagram revenue, as you know, because that's sold through the same Facebook ad interfaces, but we're seeing really good contribution and good growth there. And we're developing it across a wide variety of ad products, so VR is becoming a more significant part of the Instagram story, where it was originally more brand-focused. But we've expanded the product offerings on the Direct Response front, and we're continuing to bring more ad products to Instagram.
Sheryl Kara Sandberg - Facebook, Inc.: We're pretty excited about what's happening in the Instagram ad space because Facebook and Instagram are the two most important mobile ad platforms. And there's a special property with Instagram, which is that the increasing visualization of ads and the creative canvas it offers with the science behind the Facebook targeting and measurement system is really a pretty unusual combination. We're also seeing very broad adoption, including small customers. We are pretty excited to have 1 million advertisers and 8 million Instagram business profiles on the platform. To share one example, an online store in Brazil called Loja Nama, they sell decorative items and accessories. Their business owner, Joanna [Cariello], took photos of her products on her phone and then created ads with our Shop Now button. She targeted young audiences in Brazil who are interested in fashion, decoration, movies, and architecture. And during the period of her campaign, Instagram accounted for 79% of her sales. And I think what that shows is the power of the very sophisticated targeting we offer across our platforms along with really the ability to use very simple tools like a phone to create very sophisticated but visually compelling ads.
Operator: Your next question comes from the line of Douglas Anmuth from JPMorgan.
Douglas T. Anmuth - JPMorgan Securities LLC: Thanks for taking the question, one for Mark and then perhaps one for Sheryl or Dave. Mark, first just on the video strategy, I was hoping you could talk a little bit about how that's evolving in terms of the type of content that you're licensing and featuring within the Facebook Video tab, and then if you have any more clarity just on how the economics are going to work there around revenue share and gross margins. And then on ad revenue, the U.S. and Canada was very strong at 47% growth, but at the same time it also did decel a little bit more than we've seen in recent quarters. I was just wondering if there was anything else to call out there. Thank you.
David M. Wehner - Facebook, Inc.: Yes. Doug, why don't I take the decel question on the U.S. and Canada? I don't think there was anything particularly surprising about the deceleration in the growth in the U.S. and Canada. We've been talking about expecting a deceleration in ad revenue growth, and we saw that play out in the U.S. and Canada modestly. Obviously, we were particularly pleased that there was really strong demand that benefited regions like APAC and rest-of-world, so really broad-based strength in APAC. And then rest-of-world, we saw a rebound in Latin America, especially Brazil, so we're seeing some particular strength there. So I think that I think was a big highlight. On the content front, we're looking at investing in kick-starting an ecosystem for longer-form content on Facebook, and that involves us working with content providers to develop that content. In the long run, we expect to see a revenue share model on the platform. And obviously, we're going to be in an area where we're sharing revenue with content providers, so it's going to have a different margin profile than core Facebook News Feed from an expense profile perspective.
Mark Elliot Zuckerberg - Facebook, Inc.: I think you pretty much got that.
David M. Wehner - Facebook, Inc.: Okay.
Operator: Your next question comes from the line of Brian Nowak from Morgan Stanley.
Brian Nowak - Morgan Stanley & Co. LLC: Thanks for taking my questions. I have one for Mark on Messenger monetization. Can you just talk about some of the biggest trends you're monitoring and what you're most excited about as you think about ways to monetize Messenger over the next two or three years? And then on engagement, you continue to grow Instagram and Messenger user bases really healthily. I guess I'd be curious to hear, do you still continue to see rising time spent per user across all three of those platforms, even as the DAU base gets bigger? Thanks.
Mark Elliot Zuckerberg - Facebook, Inc.: Can you start with the stats, Wehner?
David M. Wehner - Facebook, Inc.: Sure. Yes, I can start with the stats, Mark. On the engagement front, we're seeing time spent growth per DAU across the Facebook family of apps, and that includes Facebook itself. Instagram has been strong, especially with Feed Ranking and Stories. We're not breaking out specific time spent stats on a quarterly basis on those. And then on the Messenger monetization front...?
Mark Elliot Zuckerberg - Facebook, Inc.: I can talk about the strategy. The first thing that we need to do on Messenger and WhatsApp is get a lot of businesses using it organically and build the behavior for people that they reach out to businesses for different things, like customer support or for getting news content, things that may not eventually be the big business use cases but establish the behavior of people interacting not only with their close friends, but also with businesses. In terms of making money on that, once we have that behavior, I think there are going to be a number of ways that we can amplify that. We're already experimenting with a couple. One is ads that actually display a News Feed, not in Messenger or WhatsApp, but that link to the ability to communicate with a business directly in Messenger or eventually WhatsApp. And that's great, it converts better for the businesses. They can have a better dialogue with the person and a persistent relationship. So that's one way that I think that this will be valuable. The other way is of course eventually showing paid content in Messenger, whether that's in the inbox or in relevant ways throughout the product. But the top priority right now is just building out the base of organic interaction between people and businesses that they want to interact with. And once we get that to a big base, then there are going to be a lot of opportunities to build a business, and the business will be proportional to the amount of that activity that people want to do organically.
Operator: Your next question comes from the line of Justin Post from Bank of America Merrill Lynch.
Justin Post - Bank of America Merrill Lynch.: Great, thank you, a couple things on advertising and modeling. When we think about Q1, can you help us at all think about how much the ad load growth is contributing and what drove the improvement in pricing in the quarter? And then, Dave, when you look out to the third quarter and you lap the ad blocking on desktop, are there more ad blocking you can do to help maintain that growth, or are there other drivers there for desktop that we can think about? Thank you.
David M. Wehner - Facebook, Inc.: Sure, Justin. I'm not breaking out specific drivers on the supply side. Supply growth was healthy, and we had contributions from users' time spent and ad load in the quarter. In terms of what drove the improvement in the pricing, it's strong demand, so that's playing through in the face of a little bit slower supply growth. And so you're seeing – of course, the auction drives pricing and there has been interplay between the supply growth and the pricing growth, and we're seeing the strong demand play through on the pricing side. When we get to lapping our efforts on desktop, I do think you're going to – you have a secular trend away from desktop. So that's going be an overall factor in desktop, our ability to grow and maintain the desktop business, so I think that's an underlying factor. We're always going be in a back-and-forth with ad blockers on the desktop side. So I think that's going to constantly be a thing that plays into the desktop revenue.
Operator: Your next question comes from the line of Colin Sebastian from Baird.
Colin Alan Sebastian - Robert W. Baird & Co., Inc.: Great, thanks. First off I guess is a follow-up on the earlier video question from Doug. Could you add some perspective on engagement trends with video content and video ads such as average viewing time and whether this mix is what is impacting impression growth? And then more broadly, if you can offer some perspective on how much of the video ad spending on Facebook applications are incremental to television budgets, or if there's any evidence you're seeing of a share shift. Thank you.
David M. Wehner - Facebook, Inc.: Sure, Colin. I'll take that first one. So impression growth was 32% in Q1, as I noted, and that was a bit slower than in previous quarters. Those of you who have been following us for a while know that periodically we make changes to the product that is going to impact some of the metrics. One of the things that I would call out in Q1 as a contributing factor on the impression growth side was our decision to rank longer-form video higher in News Feed. That means more time in video, and that does come at the expense of some impression growth in News Feed. So I think you do see some interplay there on the impression growth side due to our focus on video. And then Sheryl was going to follow up on the video ad spending.
Sheryl Kara Sandberg - Facebook, Inc.: On TV, we are definitely seeing people continue to advertise on TV and use us as a complement. So over time, we believe that the dollar shifts with eyeballs and we want to earn it from our clients and be the best dollar and the best minute they spend and help them measure across channels. I think increasingly, the question is not if you can do without TV, but it's if you can do without mobile. And we're working hard to help advertisers develop the video creative that really works for mobile because that really makes a really big difference. And we think the combination of the creative working for mobile but also the measurement and targeting we can do is a very powerful offer. To share one of my favorite new examples, Subway working with their agency 360i developed video ads and images for Facebook and Instagram to promote the limited time offer Reuben sandwich. And they used Audience Insights, targeting people ages 18 to 49 who purchase meat and cheese, and that's just pretty incredible targeting. Nowhere else I don't think you can actually target that way and people interested in fast food and encourage them to visit Subways. They then used Nielsen Brand Effects and were able to measure a 16-point lift in ad recall and a 5-point lift in intent to visit Subway. So it's a really unique combination of the power of creative that was designed for video for mobile with very specific targeting and very specific measurements.
Operator: Your next question comes from the line of John Blackledge from Cowen.
John Blackledge - Cowen & Co. LLC: Thanks, two questions. Mark, you mentioned adding 3,000 reviewers to content at Facebook. Could artificial intelligence be used over time to help solve some of the monitoring? And then just more broadly, how is AI being employed in the processes at the company now versus a couple years ago? And then second item would be, could newer ad units like mid-roll video help mitigate the decel from the lower ad load growth contribution in second half 2017? Thank you.
Mark Elliot Zuckerberg - Facebook, Inc.: I'll talk to the content and AI questions, and then someone else can talk about the ad piece. The short answer is yes. AI tools over time will be able to do a better job of flagging things for the set of people who are in the Community Ops teams that we can prioritize what we look at. A lot of what we're trying to do here is not just about getting content off Facebook. Last week there was this case where someone was using Facebook Live to broadcast – or was thinking about suicide. And we saw that video and actually didn't take it down and helped get in touch with law enforcement who used that live video to communicate with that person and help save their life. So a lot of what we're trying to do is not just about taking the content down, but also about helping people when they're in need on the platform, and we take that very, very seriously. Over time, the AI tools will get better. Right now there are certain things that AI can do in terms of understanding text and understanding what's in a photo and what's in a video. That will get better over time. That will take a period of years, though, to really reach the quality level that we want. So for a while, our strategy has been to just continue building as good tools as we can because no matter how many people we have on the team, we're never going to be able to look at everything. So that's going be a big challenge. But given the importance of this and how quickly live video is growing, we wanted to make sure that we doubled down on this and made sure we provided as safe of an experience for the community as we can, which is why we're almost doubling the size of the Community Ops team to focus on some of these issues around safety on live video. But over time for sure, more AI will do this, but this is over a period of years.
David M. Wehner - Facebook, Inc.: John, I think your question then was on Ad Breaks and then the mid-roll type of format. I think there we're testing the ability and are putting short Ad Breaks into longer-form live and on-demand videos. Tests are going well, but it's really early days to talk about that being a significant contributor, so we're working to continue to make those products better and continuing those tests, but it's early. On that front, we're focused on building out the best video experiences for our community and growing longer-form content as a priority. And Ad Breaks is going to allow us to have a monetization strategy with that longer-form content. But like I said, it's early.
Operator: Your next question comes from the line of Heather Bellini from Goldman Sachs.
Heather Bellini - Goldman Sachs & Co.: Great, thank you. I guess I had a question just related to Instagram and Facebook Stories. We've talked a lot about ad load growth over the last year, and Dave's been talking about the pending slowdown, which I think we're all expecting. But how do we think about these new applications or new ways to engage with the apps at the top of your phone, where you're starting to see ad insertion show up as well? Is that thought of as different than the general ad load comments that, Dave, you're making? I'm sorry to split hairs here, but I'm just trying to get a sense of how to think about when they're starting to show up in new places. And then I guess I just had a follow-up for Sheryl. And one question in particular was if there's any measurement metrics that advertisers are asking for now that if you could help them with, it would make them even more eager to shift their budgets over from TV and follow their eyeballs? Sorry, thank you.
David M. Wehner - Facebook, Inc.: So, Heather, on Stories, again, it's a pretty similar answer, I think, to Ad Breaks in the sense that it's early in terms of using the ads formats in Stories. We've certainly rolled those out. They are not in the ad load calculation per se. So it is different, as you said, from the ad load commentary that I've given. But obviously, it's very early on those products. And then, Sheryl, you had the question about measurement metrics.
Sheryl Kara Sandberg - Facebook, Inc.: Yes, we know that measurement is so critical, and we really want to measure core business results and focus on becoming the number one growth driver for our clients. We are continuing to constantly review our metrics. When we find bugs or errors, we're reporting them to our clients and addressing the issue and continuing with that analysis as we work through all of our metrics. We're also very focused on extending measurement partnerships and third-party verification. This last quarter we extended viewability measurement to the Audience Network, added another verification partner, DoubleVerify, for video and display measurement, and introduced our MMM [Marketing Mix Modeling] portal so that we can help people measure across all of the different platforms and compare the effectiveness of their ad spend no matter what their end goal is.
Operator: Your next question comes from the line of Anthony DiClemente from Nomura Instinet.
Anthony DiClemente - Nomura Instinet: Thank you very much. I have one for Mark and one for Sheryl. Mark, at F8 and in your comments today, you talked about making the camera central to the app, making the camera the first augmented reality platform. I know it's early, but can you maybe share with us your thoughts about the potential commercial application of augmented reality as you see it today? And then, Sheryl, there's been more lately about the use and effectiveness of influencer marketing on both Facebook and Instagram. How is Facebook thinking about sharing in the economics of when brands use celebrities or influencers to market their products using their Facebook posts? Is it by bringing more transactions onto the platform, building on the shopping experience on Facebook? How is Facebook going to share in those economics? Thank you.
Mark Elliot Zuckerberg - Facebook, Inc.: All right, I can start by talking about augmented reality. The big step forward that we announced at F8 is that there are lots of different apps that have cameras in them or that independent developers just build an app that has a single camera effect. But what we're basically saying is that there's so much innovation and so many different types of effects that people are creating that we don't want developers to have to build their own separate app and get to a huge scale in order to build some new kind of visual tool. So we built – we're making the cameras inside the whole family of apps into the first augmented reality platform, into an open platform, which is different from what any other app that has a camera has done before. It's going to open up a much greater diversity of use cases, not only making it so that use cases like facemasks or style transfers that we already have, you're now going to have thousands of options instead of just 10 or 20 at a time. But there are also going to be all these new kinds of things that we're not even building today that developers will be able to experiment with. One of the examples I showed at F8 was around using object recognition and computer vision to be able to point your camera at something and then tap on it and get a card of information and maybe even a buy button. So there are lots of different ways that over time this kind of content is going to both augment existing real-world objects and eventually replace them, which I think is going to be an interesting opportunity. maybe not on augmented reality on the phone but on glasses eventually. When you have that, I think we're going get to a point where things like TVs, you no longer need a physical TV. You'll get a $1 app that you can watch it screen on. And it will just be an interesting exercise to see how many of the things that we have that are physical things don't actually need to be physical in that world, and how much innovation that opens up for independent developers all around the world. A lot of people don't have a factory, so they can't build a TV. But think about how many kids and different developers around the world, kids sitting in dorm rooms and all these different places are going be able to create things that today they couldn't. So I hope this is going to create a pretty interesting economy. So a lot of that stuff is pretty far out, five, ten years. But we want to be pushing this forward. I think we're a little bit late to the trend initially around making cameras the center of how sharing works. But I do think at this point, we're pretty much ahead in terms of the technology that we're building, and making it an open platform I think is a big is a big step forward. A lot of people are using these products across our family of apps, and I would expect us to continue leading the way forward on this from this point on.
Sheryl Kara Sandberg - Facebook, Inc.: When you think about influencer marketing, we definitely see publishers interested in it, brands interested in it. And so we've worked on branded content, the ability to tag a sponsor and share posts and insights. And the financial arrangement remains between the sponsor and the publisher. It's early, but we're seeing some positive results with publishers of many different types bringing branded content to Facebook. In Q1, we opened this up to unverified pages so we could enable more people to take advantage of this kind of targeting. We see this in the broader context of better targeting. When you think about what really drives great performance for both people who are using Facebook but for marketers, it's well-targeted ads. And so influencer marketing is one way to get there, but we're focused on a very full range of ability to target well. We've been really pleased with the adoption of our targeting products from Custom Audiences to Lookalikes to Dynamic Ads, and we think all of these can improve the relevance of the ad by making ads more targeted, because when they're more targeted, they have higher returns for marketers and they're more enjoyable or relevant for people.
Operator: Your next question comes from the line of Mark Mahaney from RBC.
Mark Mahaney - RBC Capital Markets LLC: Great, thanks. First, I think it's a great move to go all-in GAAP in terms of reporting. Second, David, when you talked about the ads, your ad load commentary, I couldn't tell if there was a subtle shift there when you were saying that the ad load pressure would occur after the end of the year rather than in the second half of the year. And then third, this is for Sheryl and Mark. The recent stories about gender bias amongst engineers at Facebook, and I know you quickly responded to that and said if there were anything, there may be a rank bias, but in my mind it creates the opportunity potentially for Facebook to better tap into what is probably underappreciated female engineering talent in the Valley and across technology. How do you think about that as an opportunity for the company? Thank you.
David M. Wehner - Facebook, Inc.: I'll just real quickly address the ad load issue, Mark. Sorry if it wasn't clear, really no change in outlook there. We continue to expect that we'll see deceleration in ad revenue growth. And that's going to be particularly pronounced as we get into the second half of 2017 because ad load will be a less significant factor driving growth starting in the second half.
Sheryl Kara Sandberg - Facebook, Inc.: On the issue you raised with the Facebook female engineers, I'm really glad to have a chance to address this because this is an issue I take very seriously. On the specific report on this study, the study was conducted by a former employee with very incomplete data. When that study was shared with people internally, and we have that culture where people do studies and share things, and we're really glad because that helps surface issues, we immediately conducted our own research using the full data. And what we found is that the main reason code was sent back at different rates was not correlated with gender. It was correlated with level, and the fact that we have more male senior engineers was explaining it. If you compared male and female engineers at the same level, there was not this discrepancy. Then that leads to the obvious question is are you promoting men and women at the same rate and the broader question of are you paying men and women fairly. And we do a comprehensive look at that every single promotion and pay and performance cycle we have, which is six months. And we know that we're promoting men and women at the same rate as men. Now that said, our industry still has issues and we still have issues. We don't have enough senior female engineers. We don't have enough women going into computer science, and we take this very seriously, from the work we've done with LinkedIn to get CS&E Lean In circles all over college campuses, to encourage more women and under-represented minorities to come into our field. We've had a really nice program in extra internships where we're taking people who are not yet majoring in computer science but we think have the ability, and teaching them for a summer and seeing them return, to the work we're doing with our female engineers to make sure that all forms of bias are surfaced and eliminated. And we can continue to use the full talents of the population. Nothing is more important to us.
Operator: Your next question comes from the line Ross Sandler from Barclays.
Ross Sandler - Barclays Capital, Inc.: Hey, guys. Just had two questions on video. We know it's early, but what kind of traction do you see with the video tab that's in beta? And do you think longer term the video consumption is going to be in that dedicated tab, or will it stay in the News Feed based on what you're seeing right now? And then, Dave, just to follow up on your previous answers, so are the costs related to video ad rev share or licensing of video content, is that baked into your OpEx guidance for 2017, or is that something that will step up after this year? Thank you.
Mark Elliot Zuckerberg - Facebook, Inc.: I don't know if we have any public stats on the video tab, probably not. But in terms of the strategy, I can talk about that quickly. There were two basic use cases for checking in with Facebook and seeing what's going on in the world. What people do with News Feed a lot of the time is they have a few free minutes, or you want to sit down for maybe a longer session to see everything that's going on in the world. You don't have a specific intention to watch a specific type of content. You just want to check in and see what's going on in the world. There's this whole other use case around content, which is going to the app or sitting down at a TV because there's some content that you want to watch and you want to go directly to it. And that's what we're trying to do with the video tab, to make it so that all the different folks, whether they're pages that you follow or creators that you like, who you want to subscribe to and get the updates to what they're doing, that you have a place that you can go to with more intent to consume that content. The reason why it needs to be a different tab or at least a different service from News Feed is because people come to it with a different intent. I think you're going to start in the future getting people coming to Facebook for the News Feed use case of checking in and people coming with an intent to go to the video tab to watch a specific video. So that's what we're doing there. That's the strategy, and I guess we'll update on stats when we have them.
David M. Wehner - Facebook, Inc.: And, Ross, on the costs related to the video ad rev share, yes, our guidance on total cost is all-inclusive, so it includes all the R&D investments we're making. It includes the content. It includes things like the Community Operations investments that we talked about today in the announcement. But I would say that the nature of the types of video content deals that we're doing will make them more likely to show up after 2017. So there will be some content expense in 2017, but I think it will be something you will see step up after 2017.
Operator: Your next question comes from the line of Mark May from Citi.
Mark A. May - Citigroup Global Markets, Inc.: Thank you. Mark, in your prepared remarks, you talked about doing more to foster local communities and groups, and it would seem like one of the more interesting test cases here already is in Local Marketplaces. I was just wondering if you could talk to us a little bit about the kind of adoption and engagement that you've seen with Local Marketplaces and maybe anything that you've learned that you can apply to some of the newer initiatives that you're looking at? And then secondly, probably for Sheryl, for Ad Breaks to scale, it appears that content creators need to adapt their programming for this, and of course, users need to engage with the ads. So I guess the question is how are completion rates for Ad Breaks? I know it's early, but what are you seeing so far? And how would you characterize the willingness of content creators to adapt?
Mark Elliot Zuckerberg - Facebook, Inc.: I can talk about Marketplace Groups first. So I think your basic point is right, that the reason why we started working on Marketplace and the tab around that is because when we were exploring what the biggest use cases were of Groups, we uncovered that a very large number of people, hundreds of millions, use Groups to buy and sell different things. And so these whole communities have formed, which was somewhat surprising to us honestly, because we hadn't developed that product specifically for buying and selling. It was for group communication and that's what people were using it for. So we decided hey, we're going to put together a team that's going to invest in making this actually good for buying and selling and see how much we can grow that economy. So I don't know that we have any public stats on that yet, but that's an area that I'm certainly very excited about. And then in terms of local communities, one of the big trends in the world that we've seen is just that participation in all kinds of different physical communities, whether they're sports teams or some religious groups or different kinds of different things, have been declining a lot over the past several decades. And that I think is a big social issue that is eroding the social fabric of the whole society, not just our country, but around the world. And that's one where I look at that and I wonder if Facebook can play a role in helping to strengthen that. We look at – there are more than 1 billion people every month who use our Groups product. But if you think about your own use of the Groups product, you probably are a member of a bunch of different groups that you maybe check in on very infrequently. So that's very different from – there's a handful of people, around 100 million or a bit more, who are a member of what we call a very meaningful group. So that could be a parenting group or you're diagnosed with a rare disease, and you can now connect with people all around the world to share stories around that. These are groups that upon joining, they become one of the things that you spend the most time with on Facebook, one of the most important parts of your experience, and a really fundamental part of your real-world support structure. So we look that that and we ask the question of hey, if 100 million people are in those very meaningful groups today, can we get that to be 1 billion people over next several years? And if so, then that can help reverse some of the decline in community membership and help strengthen the social fabric, not only in our country, but around the world. So that's a big part of what we're focused on across a number of different initiatives.
Sheryl Kara Sandberg - Facebook, Inc.: And I'll talk a little bit about the Ad Break, what we're seeing. It's really early both in terms of testing the ads and getting any feedback from users, so people who use Facebook, so we don't have that data to share. But we're pleased that the test is active. We're pleased that it's going well and that we can do both live and uploaded videos. We think over time that marketers will follow where people are spending their time. And if the ads can be well-targeted, we think we'll be able to see engagement, and we already see that. When ads are really well targeted and taking full advantage of the kind of targeting we offer, so you're showing people something they want to see, we see engagement that we think is really critical. It's also worth noting that the metrics that really matter at the end are driving sales. And so any of the engagement with ad metrics, whether it's remembering an ad going back to – people have been measuring that for a long time too, how long a video ad is viewed, are only proxy metrics. What matters is the impact on sales. And so we think the better we can do at getting the measurement to what actually matters, which is the end behavior marketers are trying to drive, the more people will shift their focus to business metrics, the better it will be for the returns they get and ultimately our business.
Operator: Your next question comes from the line of Michael Nathanson from MoffettNathanson.
Michael B. Nathanson - MoffettNathanson LLC: Thanks. I have three philosophical questions on video for you guys. Anyone can grab them. The first is, it was interesting to see the NFL games go from Twitter to Amazon. I wonder. Do the NFL games fit with your video strategy, and why or why not? That's one. Two is, I know the model is revenue share, but a lot of the more traditional companies would like a license fee or the ability to sell their own inventory on your platform. Is that something you'd consider? And last but not least, the question about monetization, why is mid-roll optimal to pre-roll, and can you share anything about the testing of that concept?
Mark Elliot Zuckerberg - Facebook, Inc.: I can talk about sports. So in terms of experimenting with different content, I think we'll try a number of different things here. In terms of working with folks to produce all kinds of content, sports is probably something that we'll want to try at some point. But again, like Dave said before, the goal is going to be creating some anchor content initially that helps people learn that going to the video tab that that's a great destination where they can explore and come to Facebook with the intent to watch the videos that they want. And then the long-term goal is actually not to be paying for specific content like that, but doing a revenue share model once the whole economy around video on Facebook is built up. But we're working on that, and I think we'll probably look at different pieces of content like this around the world, but at this point don't feel like any specific one of them is a must-have for us.
David M. Wehner - Facebook, Inc.: And I think Mark touched on the question of business model here, and our focus really is on revenue share. We'll be investing to kick-start the ecosystem with content, so derisking it for some of our content partners to start off with, but the focus is really to build a rev-share model over time that's sustainable. That's the focus as opposed to other models. In terms of why mid-roll is preferable to pre-roll, Facebook is well suited for shorter-form content where we're ranking things to be longer-form as well. So we're ranking longer-form video, but that's still relatively short video views. And for that reason, we think mid-roll is a better user experience.
Deborah Crawford - Facebook, Inc.: Operator, I think we have time for one last question.
Operator: Your last question comes from the line of Peter Stabler from Wells Fargo.
Peter C. Stabler - Wells Fargo Securities LLC: Thanks very much, one for Sheryl. Sheryl, you talked a lot about the targeting advantage of Facebook, and you have a number of data signals and sources informing that. I'm wondering if you could talk about the relative importance of collecting signals on the platform versus off the platform, for instance, the behavior of Facebook users interacting with third-party websites. Is this the depth of your off-platform collection? Is this a significant competitive advantage for you? Thank you very much.
Sheryl Kara Sandberg - Facebook, Inc.: We think that targeting end measurement are significant competitive advantages for us. We're very focused on the privacy of what people do, wherever they do it, and using the information we have in a very responsible way. We believe that because people are sharing interests, because people are themselves their real identity on the Facebook platform, we have a significant advantage just in basic targeting itself. Just age and gender, we're 38% more accurate than broad-based targeting according to Nielsen in the U.S., and that's just age and gender. And then if you think about some of the key studies I shared, targeting people who purchase a certain item, targeting people who are interested in a certain item, we think that's very substantial. We also think that there's a real competitive advantage in focusing on business results, as we have. We're really working on shifting people to understanding what their real objectives are so that they can focus on driving businesses. At the end of the day, when you show an ad, you want to move a product off a lot, off a shelf, into a shopping cart, whether it's online or offline, and that's where our focus is and will continue to be.
Deborah Crawford - Facebook, Inc.: Great, thank you again, everybody, for joining us today. We appreciate your time, and we look forward to speaking with you again.
Operator: Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines. | [
{
"speaker": "Executives",
"text": "Deborah Crawford - Facebook, Inc. Mark Elliot Zuckerberg - Facebook, Inc. Sheryl Kara Sandberg - Facebook, Inc. David M. Wehner - Facebook, Inc."
},
{
"speaker": "Analysts",
"text": "Eric J. Sheridan - UBS Securities LLC Douglas T. Anmuth - JPMorgan Securities LLC Brian Nowak - Morgan Stanley & Co. LLC Justin Post - Bank of America Merrill Lynch. Colin Alan Sebastian - Robert W. Baird & Co., Inc. John Blackledge - Cowen & Co. LLC Heather Bellini - Goldman Sachs & Co. Anthony DiClemente - Nomura Instinet Mark Mahaney - RBC Capital Markets LLC Ross Sandler - Barclays Capital, Inc. Mark A. May - Citigroup Global Markets, Inc. Michael B. Nathanson - MoffettNathanson LLC Peter C. Stabler - Wells Fargo Securities LLC"
},
{
"speaker": "Operator",
"text": "Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook first quarter 2017 earnings call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford - Facebook, Inc.",
"text": "Thank you. Good afternoon and welcome to Facebook's first quarter 2017 earnings conference call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our Annual Report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now I'd like to turn the call over to Mark."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Thanks, Deborah, and thanks, everyone, for joining today. We started the year off with a good quarter. Our community continues to grow, with more than 1.9 billion people now using Facebook every month and almost 1.3 billion people using it every day. Our ads business is doing well too. Total revenue grew by 49% year over year to $8 billion, and advertising revenue was up 51% to $7.9 billion. In my letter to our community back in February, I talked about how for the past decade Facebook has focused on connecting friends and family. Now with that foundation, our next focus will be building community. There's a lot to do here. Building a global community is bigger than any one organization, but we can help by developing social infrastructure for communities, for supporting us, for keeping us safe, for informing us, for civic engagement, and for including everyone. Building a global community that works for everyone starts with building millions of smaller supportive communities. This is especially important, since membership in many physical communities is declining. We recently found that more than 100 million people on Facebook are members of what we call very meaningful groups, like parenting or rare diseases, support groups that are an important part of their support structure. My hope is to help more than 1 billion people join meaningful groups to strengthen our social fabric over the next few years. To help build a safe community, we launched Community Help, a tool that allows people to give and get things like food, shelter, or transportation in the wake of a natural disaster. We also launched a new fundraising tool that allows people to raise money for themselves, a friend, or a cause that isn't already on Facebook. But it's clear we have more to do here. We're going to continue building new tools to keep people safe on our platform. Over the next year, we'll be adding 3,000 people to our Community Operations team around the world on top of the 4,500 we already have today to review the millions of reports we get every week and to improve the process for doing that quickly. To help build a more informed community, we make changes to our News Feed ranking to reduce the financial motivation to spread hoaxes. We're working with independent fact-checkers to give people more information on whether an article has been disputed. We launched an educational tool at the top of News Feed in 14 countries to help people spot false news. And we're beginning to test related articles that appear before you read an article, giving you easier access to more perspectives and information. We're also helping to build a more civically engaged community. In March we launched Town Hall to help people find and connect with their government representatives on a local, state, and federal level in the U.S. In just the first month, we created more than 1 million new connections between people and their representatives. We also rolled out a tool in France ahead of their election that allows candidates to share statements about where they stand on different policy issues. So these are some of the changes we've made to help people build stronger communities. Next I want to give a quick update on what we're building over our three time horizons, how we're making our core services more useful and engaging right now, how we're building ecosystems around products that a lot of people are already using over the next five years, and how we're investing in the technologies that will give more people a voice and make sharing more immersive over the next 10 years. This quarter we launched a set of new cameras. Photos and video are becoming more common than text, so the camera is becoming more central then the text box in all of our apps. In the Facebook app, you can now swipe right from News Feed to access our new camera with masks, frames, and filters. We've developed new computer vision tools that can apply the style of a painting to a photo or video, and we can do that in real time on your phone for the first time. This is part of making the camera the first augmented reality platform. We want to give developers the power to build all kinds of AR tools in the camera so more people can experience augmented reality on their phone. Creating the first open camera platform is a huge step forward, and we're excited to keep pushing augmented reality forward. We also expanded the Stories format to give people more new ways to share. Instagram Stories now has more than 200 million daily active people using it. And just a couple months after we launched it, WhatsApp Status has more than 175 million daily active people using it. More recently, we also rolled out Messenger Day and Facebook Stories, and we're going to keep putting video at the center of all these services. Over the next five years, we're going build ecosystems around our products that a lot of people are already using. I put live video in this category. Last month we announced that one in every five Facebook videos is a live broadcast. And over the past year, daily watch time for Facebook Live broadcasts has grown by more than four times. This year we also gave people the ability to go live in 360. Messenger is in this category too. And we just announced that 1.2 billion people use Messenger every month. At F8, we launched the second generation of our Messenger platform and introduced the Discover tab to make it easier to find the best experiences quickly. Finally, over the next 10 years, we're developing consumer use cases around technologies that are a big part of our future, but won't be a part of our business, a big part of the business for a while. On the connectivity side, in April we successfully simultaneously beamed 16 gigabits of data in each direction between a location on the ground and a Cessna aircraft circling more than 7 kilometers away. Eventually, we're going to use this technology along with Aquila, our solar powered plane that we're building, to beam Internet to parts of the world that currently don't have access. In virtual reality, we launched Facebook Spaces, the first social VR platform that lets you create your own avatar and hang out with your friends. And we also released the Facebook 360 app for Gear VR that makes it easier to discover and experience in 360 photos and videos. And we continue to ship RIFT and Touch to people everywhere and deliver a strong content ecosystem across both RIFT and Gear VR. As people share more video, as we explore more things like augmented reality, and as we build more tools to keep our community safe, we're going to keep investing aggressively in the infrastructure that we need to grow and serve our community. That's why we announced that our next two data centers will be built in Odense, Denmark and Papillion, Nebraska. We've made some good progress. We have a lot more to do to help build community and connect the world. I want to thank everyone in our community, our teams, our partners, and all of you for being a part of this journey with us. And now here's Sheryl."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "Thanks, Mark, and hi, everyone. We had a strong first quarter and a great start to the year. Q1 ad revenue grew 51% year over year. Mobile ad revenue was $6.7 billion, up 58% year over year, and was approximately 85% of total ad revenue. Growth again this quarter was broad-based across regions, marketer segments, and verticals. Our goal is to build meaningful connections between businesses and people. We're doing this by focusing on three key priorities: helping businesses leverage the power of mobile; developing innovative ad products; and making our ads more relevant and effective. Our first priority is helping businesses leverage the power of mobile. More businesses around the world are shifting to marketing on mobile. Over 70 million businesses are now using Facebook Pages around the world on a monthly basis, and more and more of them are becoming advertisers. We also recently announced that over 5 million businesses are actively advertising on Facebook, including more than 1 million in emerging markets. Most of these advertisers start by using our free Pages product because it's easy to use. People are increasingly recognizing that the small screen is big. Our Creative Hub is providing tools that make it easier to create ads optimized for mobile, what we talk about as thumb stopping creative. Marketers can see previews of their ads across Facebook and Instagram before rolling them out and get tips to help drive business results. Our second priority is developing innovative ad products that help businesses make the most out of their campaigns. We continue to improve Dynamic Ads, which enable advertisers to promote their full range of products across all devices. Advertisers can now target Dynamic Ads to broad audiences and are seeing great results. Last week I visited home retailer Wayfair in Boston. They use Dynamic Ads to reach a large audience with personalized recommendations from their catalog of over 8 million items. By finding higher revenue customers at a lower cost, the campaign beat Wayfair's return on ad spend goal by more than 20%. We're also helping marketers use video to capture shoppers' attention. People are watching more video on Facebook than ever before, and it's changing how they connect with businesses. In a recent study Facebook commissioned with Kantar, 30% of mobile shoppers said video is the best way to discover new products. This quarter, we introduced a new ad format called Collection. Collection helps marketers tell stories on mobile by combining creative videos or photos of product images. Clicking on the products leads to an immersive shopping experience, driving purchase consideration and ultimately sales. For example, adidas, which is how you pronounce them at their headquarters, and its agency, iProspect, created a video highlighting the innovative future of a Z.N.E. road trip party. Using our Collection ad format, adidas featured four more items from their product catalog below the video. They saw a 5.3 times return on ad spend and a 1.8 times decrease in cost per conversion. It's still early for this new format, but it's a great example of how we can deliver innovative mobile experiences that work for advertisers and work for people. This quarter we also launched full-screen sound-on ads in Instagram Stories. Advertisers can now reach over 200 million daily actives on Stories to do everything from building brands to selling products. Our third priority is making our ads more relevant and effective. Measurement is critical. We recently introduced new and expanded verification partnerships and committed to audits with the Media Rating Council. Whether marketers are trying to get people to buy something on their website or in their store, we now have systems in place to help them measure results and third-party partnerships to verify those results. These are important steps as we continue to build the advertiser trough. Bud Light's NFL campaign is a great example. To promote the designs of their new team-specific cans, Bud Light took a national and regional approach. They ran video ads featuring the new cans to people ages 21 to 49 in the U.S. Then they also ran more targeted ads in each region featuring the two cans of the teams playing each other. Using Facebook polling and Oracle data cloud, they saw a 24-point lift in ad recall and a 4.4 times return on ad sales. We know marketers want to compare results across platforms and placements. Historically, we've enabled larger marketers to do this. In Q1 we started testing a set of advanced measurement tools that make it easier for marketers of all sizes to compare the effectiveness of Facebook, Instagram, and Audience Network alongside other publishers. We're off to a strong start in 2017. We're helping marketers leverage the power of mobile, developing innovative ad products, and delivering proven and measurable results. We're excited about the growing adoption of our platforms, and we're going to continue to invest in helping businesses and people connect. Thanks, and now here's Dave."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Thanks, Sheryl, and good afternoon, everyone. Q1 was a strong quarter for Facebook. We continued to see healthy growth in engagement trends across our community as well as broad-based growth in our ads business. Let's start with our community metrics. In March, 1.28 billion people visited Facebook on an average day, up 18% compared to last year. This daily number represented 66% of the 1.94 billion people that visited Facebook during the month of March, which was up 282 million or 17% compared to last year. Our community growth in Q1 was driven by product improvement, internet.org, and ongoing third-party promotional data plans in markets like India. Note that we do not control the timing or terms of these promotions. Before diving into the financials, I want to highlight that we are no longer reporting non-GAAP expenses, income, tax rate, or EPS. Given that stock is an important part of our compensation structure, we believe that investors should focus on our financial performance with stock-based compensation included. Turning now to the financials, all of our comparisons are on a year-over-year basis unless otherwise noted. Q1 total revenue was $8 billion, up 49%. Ad revenue was $7.9 billion, up 51%. Exchange rates did not affect our overall growth rate this quarter, as headwinds in certain currencies were offset by tailwinds in others. In terms of regional advertising growth, rest-of-world and Asia-Pacific were our strongest growers in percentage terms at 66% and 60% respectively. Both regions benefited from particularly strong advertiser demand. Europe and North America both grew at 47%. Mobile ad revenue was $6.7 billion, up 58%, and represented approximately 85% of ad revenue. Desktop ad revenue grew 22% despite a decline in desktop usage and was aided by our recent effort to limit the impact of ad blocking technologies, which we began in Q3 of last year. Our mobile ads business continued to be driven by healthy supply and demand in apps (15:41). In Q1, the average price per ad increased 14% and the total number of ad impressions served increased 32%, primarily driven by mobile feed ads. Payments and other fees revenue was $175 million, down 3%. Q1 total expenses were $4.7 billion, up 40%. In 2017, we have continued to accelerate our hiring efforts. We added over 1,700 employees in Q1, predominantly in technical and recruiting functions, and ended the quarter with approximately 18,800 employees, up 38% compared to last year. This marked an acceleration from the 34% growth rate in Q4. Q1 operating income was $3.3 billion, representing a 41% margin. Our tax rate was 10%, which reflects the adoption of ASU 2016-9 in the fourth quarter. Excluding this adoption, our tax rate would have been approximately 9 percentage points higher. Note that the new accounting guidance does not impact the cash taxes we pay but merely how the tax provision is presented under GAAP, whereby now excess tax benefits are flowing through the P&L and in this quarter positively impacted EPS. Net income was $3.1 billion or $1.04 per share. Q1 capital expenditures were approximately $1.3 billion, driven by investments in data centers, servers, office facilities, and network infrastructure. In Q1 we also broke ground on our ninth data center in Nebraska. We generated approximately $3.8 billion in free cash flow. In the first quarter, we repurchased $228 million of our Class A common stock and used $771 million in cash for taxes paid related to the net share settlement of equity awards. We ended the quarter with $32.3 billion in cash and investments. Turning now to the outlook, with regards to revenue, we continue to expect that our ad revenue growth rates will come down meaningfully over the course of 2017. We expect that ad loads will play a less significant factor in driving revenue growth after mid-2017. We also expect desktop ad revenue growth rates to slow in the third quarter when we begin to lap our efforts to limit the impact of ad blockers. We continue to expect that our full-year 2017 payments and other fees revenue will decline compared to full-year 2016. As a reminder, payments and other fees revenue is primarily generated from payments related to games played on personal computers. Turning to the expense outlook, we continue to expect that full-year 2017 GAAP expenses will grow 40% to 50% compared to full-year 2016. I would note that as we look into 2017 and beyond, there are going be a number of initiatives we believe are valuable to the community and to the company in the long term that are going be net negative on our operating margin. We are embarking on a significant ramp up in infrastructure supporting global growth, and we continue to expect that full-year 2017 capital expenditures will be in the range of $7 billion to $7.5 billion, which is up over 50% compared to last year. Turning now to tax, as we noted in the last call, under the new accounting guidance, our tax rate will vary based on our stock price. At current stock prices, we expect that our Q2 and full-year 2017 tax rates will both be in the mid-teens, so up from the first quarter rate. In summary, Q1 was a strong quarter and a great start to the year. Growth in the Facebook community remains strong. Engagement across our family of apps is healthy and growing, and advertiser demand from our growing base of marketers is robust. Importantly, we continue to invest aggressively to build our business and drive value for our community over the long term. With that, operator, let's open up the call for questions."
},
{
"speaker": "Operator",
"text": "Your first question comes from the line of Eric Sheridan from UBS."
},
{
"speaker": "Eric J. Sheridan - UBS Securities LLC",
"text": "Thanks for taking the question, maybe one thematic question on Instagram for Mark and Sheryl. I wanted to understand what you're seeing in terms of the development of the community on the user growth side, the engagement side, as well as on the monetization side with respect to breadth of advertisers and ad product evolution, what that means for Instagram's future and how it compares to maybe what you've learned growing the business on the Facebook side over the last couple years. Thanks so much."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Eric, why don't I take that and then Sheryl can augment with some additional color? So when you think about Instagram, we're seeing great growth there with the community. So this past quarter, we announced 700 million monthly actives, so that was a big announcement. And that's broad-based growth across the globe, so we're pleased with that. In terms of the development on the advertising side, we're not specifically breaking out Instagram revenue, as you know, because that's sold through the same Facebook ad interfaces, but we're seeing really good contribution and good growth there. And we're developing it across a wide variety of ad products, so VR is becoming a more significant part of the Instagram story, where it was originally more brand-focused. But we've expanded the product offerings on the Direct Response front, and we're continuing to bring more ad products to Instagram."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "We're pretty excited about what's happening in the Instagram ad space because Facebook and Instagram are the two most important mobile ad platforms. And there's a special property with Instagram, which is that the increasing visualization of ads and the creative canvas it offers with the science behind the Facebook targeting and measurement system is really a pretty unusual combination. We're also seeing very broad adoption, including small customers. We are pretty excited to have 1 million advertisers and 8 million Instagram business profiles on the platform. To share one example, an online store in Brazil called Loja Nama, they sell decorative items and accessories. Their business owner, Joanna [Cariello], took photos of her products on her phone and then created ads with our Shop Now button. She targeted young audiences in Brazil who are interested in fashion, decoration, movies, and architecture. And during the period of her campaign, Instagram accounted for 79% of her sales. And I think what that shows is the power of the very sophisticated targeting we offer across our platforms along with really the ability to use very simple tools like a phone to create very sophisticated but visually compelling ads."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Douglas Anmuth from JPMorgan."
},
{
"speaker": "Douglas T. Anmuth - JPMorgan Securities LLC",
"text": "Thanks for taking the question, one for Mark and then perhaps one for Sheryl or Dave. Mark, first just on the video strategy, I was hoping you could talk a little bit about how that's evolving in terms of the type of content that you're licensing and featuring within the Facebook Video tab, and then if you have any more clarity just on how the economics are going to work there around revenue share and gross margins. And then on ad revenue, the U.S. and Canada was very strong at 47% growth, but at the same time it also did decel a little bit more than we've seen in recent quarters. I was just wondering if there was anything else to call out there. Thank you."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Yes. Doug, why don't I take the decel question on the U.S. and Canada? I don't think there was anything particularly surprising about the deceleration in the growth in the U.S. and Canada. We've been talking about expecting a deceleration in ad revenue growth, and we saw that play out in the U.S. and Canada modestly. Obviously, we were particularly pleased that there was really strong demand that benefited regions like APAC and rest-of-world, so really broad-based strength in APAC. And then rest-of-world, we saw a rebound in Latin America, especially Brazil, so we're seeing some particular strength there. So I think that I think was a big highlight. On the content front, we're looking at investing in kick-starting an ecosystem for longer-form content on Facebook, and that involves us working with content providers to develop that content. In the long run, we expect to see a revenue share model on the platform. And obviously, we're going to be in an area where we're sharing revenue with content providers, so it's going to have a different margin profile than core Facebook News Feed from an expense profile perspective."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "I think you pretty much got that."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Okay."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Brian Nowak from Morgan Stanley."
},
{
"speaker": "Brian Nowak - Morgan Stanley & Co. LLC",
"text": "Thanks for taking my questions. I have one for Mark on Messenger monetization. Can you just talk about some of the biggest trends you're monitoring and what you're most excited about as you think about ways to monetize Messenger over the next two or three years? And then on engagement, you continue to grow Instagram and Messenger user bases really healthily. I guess I'd be curious to hear, do you still continue to see rising time spent per user across all three of those platforms, even as the DAU base gets bigger? Thanks."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Can you start with the stats, Wehner?"
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Sure. Yes, I can start with the stats, Mark. On the engagement front, we're seeing time spent growth per DAU across the Facebook family of apps, and that includes Facebook itself. Instagram has been strong, especially with Feed Ranking and Stories. We're not breaking out specific time spent stats on a quarterly basis on those. And then on the Messenger monetization front...?"
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "I can talk about the strategy. The first thing that we need to do on Messenger and WhatsApp is get a lot of businesses using it organically and build the behavior for people that they reach out to businesses for different things, like customer support or for getting news content, things that may not eventually be the big business use cases but establish the behavior of people interacting not only with their close friends, but also with businesses. In terms of making money on that, once we have that behavior, I think there are going to be a number of ways that we can amplify that. We're already experimenting with a couple. One is ads that actually display a News Feed, not in Messenger or WhatsApp, but that link to the ability to communicate with a business directly in Messenger or eventually WhatsApp. And that's great, it converts better for the businesses. They can have a better dialogue with the person and a persistent relationship. So that's one way that I think that this will be valuable. The other way is of course eventually showing paid content in Messenger, whether that's in the inbox or in relevant ways throughout the product. But the top priority right now is just building out the base of organic interaction between people and businesses that they want to interact with. And once we get that to a big base, then there are going to be a lot of opportunities to build a business, and the business will be proportional to the amount of that activity that people want to do organically."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Justin Post from Bank of America Merrill Lynch."
},
{
"speaker": "Justin Post - Bank of America Merrill Lynch.",
"text": "Great, thank you, a couple things on advertising and modeling. When we think about Q1, can you help us at all think about how much the ad load growth is contributing and what drove the improvement in pricing in the quarter? And then, Dave, when you look out to the third quarter and you lap the ad blocking on desktop, are there more ad blocking you can do to help maintain that growth, or are there other drivers there for desktop that we can think about? Thank you."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Sure, Justin. I'm not breaking out specific drivers on the supply side. Supply growth was healthy, and we had contributions from users' time spent and ad load in the quarter. In terms of what drove the improvement in the pricing, it's strong demand, so that's playing through in the face of a little bit slower supply growth. And so you're seeing – of course, the auction drives pricing and there has been interplay between the supply growth and the pricing growth, and we're seeing the strong demand play through on the pricing side. When we get to lapping our efforts on desktop, I do think you're going to – you have a secular trend away from desktop. So that's going be an overall factor in desktop, our ability to grow and maintain the desktop business, so I think that's an underlying factor. We're always going be in a back-and-forth with ad blockers on the desktop side. So I think that's going to constantly be a thing that plays into the desktop revenue."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Colin Sebastian from Baird."
},
{
"speaker": "Colin Alan Sebastian - Robert W. Baird & Co., Inc.",
"text": "Great, thanks. First off I guess is a follow-up on the earlier video question from Doug. Could you add some perspective on engagement trends with video content and video ads such as average viewing time and whether this mix is what is impacting impression growth? And then more broadly, if you can offer some perspective on how much of the video ad spending on Facebook applications are incremental to television budgets, or if there's any evidence you're seeing of a share shift. Thank you."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Sure, Colin. I'll take that first one. So impression growth was 32% in Q1, as I noted, and that was a bit slower than in previous quarters. Those of you who have been following us for a while know that periodically we make changes to the product that is going to impact some of the metrics. One of the things that I would call out in Q1 as a contributing factor on the impression growth side was our decision to rank longer-form video higher in News Feed. That means more time in video, and that does come at the expense of some impression growth in News Feed. So I think you do see some interplay there on the impression growth side due to our focus on video. And then Sheryl was going to follow up on the video ad spending."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "On TV, we are definitely seeing people continue to advertise on TV and use us as a complement. So over time, we believe that the dollar shifts with eyeballs and we want to earn it from our clients and be the best dollar and the best minute they spend and help them measure across channels. I think increasingly, the question is not if you can do without TV, but it's if you can do without mobile. And we're working hard to help advertisers develop the video creative that really works for mobile because that really makes a really big difference. And we think the combination of the creative working for mobile but also the measurement and targeting we can do is a very powerful offer. To share one of my favorite new examples, Subway working with their agency 360i developed video ads and images for Facebook and Instagram to promote the limited time offer Reuben sandwich. And they used Audience Insights, targeting people ages 18 to 49 who purchase meat and cheese, and that's just pretty incredible targeting. Nowhere else I don't think you can actually target that way and people interested in fast food and encourage them to visit Subways. They then used Nielsen Brand Effects and were able to measure a 16-point lift in ad recall and a 5-point lift in intent to visit Subway. So it's a really unique combination of the power of creative that was designed for video for mobile with very specific targeting and very specific measurements."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of John Blackledge from Cowen."
},
{
"speaker": "John Blackledge - Cowen & Co. LLC",
"text": "Thanks, two questions. Mark, you mentioned adding 3,000 reviewers to content at Facebook. Could artificial intelligence be used over time to help solve some of the monitoring? And then just more broadly, how is AI being employed in the processes at the company now versus a couple years ago? And then second item would be, could newer ad units like mid-roll video help mitigate the decel from the lower ad load growth contribution in second half 2017? Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "I'll talk to the content and AI questions, and then someone else can talk about the ad piece. The short answer is yes. AI tools over time will be able to do a better job of flagging things for the set of people who are in the Community Ops teams that we can prioritize what we look at. A lot of what we're trying to do here is not just about getting content off Facebook. Last week there was this case where someone was using Facebook Live to broadcast – or was thinking about suicide. And we saw that video and actually didn't take it down and helped get in touch with law enforcement who used that live video to communicate with that person and help save their life. So a lot of what we're trying to do is not just about taking the content down, but also about helping people when they're in need on the platform, and we take that very, very seriously. Over time, the AI tools will get better. Right now there are certain things that AI can do in terms of understanding text and understanding what's in a photo and what's in a video. That will get better over time. That will take a period of years, though, to really reach the quality level that we want. So for a while, our strategy has been to just continue building as good tools as we can because no matter how many people we have on the team, we're never going to be able to look at everything. So that's going be a big challenge. But given the importance of this and how quickly live video is growing, we wanted to make sure that we doubled down on this and made sure we provided as safe of an experience for the community as we can, which is why we're almost doubling the size of the Community Ops team to focus on some of these issues around safety on live video. But over time for sure, more AI will do this, but this is over a period of years."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "John, I think your question then was on Ad Breaks and then the mid-roll type of format. I think there we're testing the ability and are putting short Ad Breaks into longer-form live and on-demand videos. Tests are going well, but it's really early days to talk about that being a significant contributor, so we're working to continue to make those products better and continuing those tests, but it's early. On that front, we're focused on building out the best video experiences for our community and growing longer-form content as a priority. And Ad Breaks is going to allow us to have a monetization strategy with that longer-form content. But like I said, it's early."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Heather Bellini from Goldman Sachs."
},
{
"speaker": "Heather Bellini - Goldman Sachs & Co.",
"text": "Great, thank you. I guess I had a question just related to Instagram and Facebook Stories. We've talked a lot about ad load growth over the last year, and Dave's been talking about the pending slowdown, which I think we're all expecting. But how do we think about these new applications or new ways to engage with the apps at the top of your phone, where you're starting to see ad insertion show up as well? Is that thought of as different than the general ad load comments that, Dave, you're making? I'm sorry to split hairs here, but I'm just trying to get a sense of how to think about when they're starting to show up in new places. And then I guess I just had a follow-up for Sheryl. And one question in particular was if there's any measurement metrics that advertisers are asking for now that if you could help them with, it would make them even more eager to shift their budgets over from TV and follow their eyeballs? Sorry, thank you."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "So, Heather, on Stories, again, it's a pretty similar answer, I think, to Ad Breaks in the sense that it's early in terms of using the ads formats in Stories. We've certainly rolled those out. They are not in the ad load calculation per se. So it is different, as you said, from the ad load commentary that I've given. But obviously, it's very early on those products. And then, Sheryl, you had the question about measurement metrics."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "Yes, we know that measurement is so critical, and we really want to measure core business results and focus on becoming the number one growth driver for our clients. We are continuing to constantly review our metrics. When we find bugs or errors, we're reporting them to our clients and addressing the issue and continuing with that analysis as we work through all of our metrics. We're also very focused on extending measurement partnerships and third-party verification. This last quarter we extended viewability measurement to the Audience Network, added another verification partner, DoubleVerify, for video and display measurement, and introduced our MMM [Marketing Mix Modeling] portal so that we can help people measure across all of the different platforms and compare the effectiveness of their ad spend no matter what their end goal is."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Anthony DiClemente from Nomura Instinet."
},
{
"speaker": "Anthony DiClemente - Nomura Instinet",
"text": "Thank you very much. I have one for Mark and one for Sheryl. Mark, at F8 and in your comments today, you talked about making the camera central to the app, making the camera the first augmented reality platform. I know it's early, but can you maybe share with us your thoughts about the potential commercial application of augmented reality as you see it today? And then, Sheryl, there's been more lately about the use and effectiveness of influencer marketing on both Facebook and Instagram. How is Facebook thinking about sharing in the economics of when brands use celebrities or influencers to market their products using their Facebook posts? Is it by bringing more transactions onto the platform, building on the shopping experience on Facebook? How is Facebook going to share in those economics? Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "All right, I can start by talking about augmented reality. The big step forward that we announced at F8 is that there are lots of different apps that have cameras in them or that independent developers just build an app that has a single camera effect. But what we're basically saying is that there's so much innovation and so many different types of effects that people are creating that we don't want developers to have to build their own separate app and get to a huge scale in order to build some new kind of visual tool. So we built – we're making the cameras inside the whole family of apps into the first augmented reality platform, into an open platform, which is different from what any other app that has a camera has done before. It's going to open up a much greater diversity of use cases, not only making it so that use cases like facemasks or style transfers that we already have, you're now going to have thousands of options instead of just 10 or 20 at a time. But there are also going to be all these new kinds of things that we're not even building today that developers will be able to experiment with. One of the examples I showed at F8 was around using object recognition and computer vision to be able to point your camera at something and then tap on it and get a card of information and maybe even a buy button. So there are lots of different ways that over time this kind of content is going to both augment existing real-world objects and eventually replace them, which I think is going to be an interesting opportunity. maybe not on augmented reality on the phone but on glasses eventually. When you have that, I think we're going get to a point where things like TVs, you no longer need a physical TV. You'll get a $1 app that you can watch it screen on. And it will just be an interesting exercise to see how many of the things that we have that are physical things don't actually need to be physical in that world, and how much innovation that opens up for independent developers all around the world. A lot of people don't have a factory, so they can't build a TV. But think about how many kids and different developers around the world, kids sitting in dorm rooms and all these different places are going be able to create things that today they couldn't. So I hope this is going to create a pretty interesting economy. So a lot of that stuff is pretty far out, five, ten years. But we want to be pushing this forward. I think we're a little bit late to the trend initially around making cameras the center of how sharing works. But I do think at this point, we're pretty much ahead in terms of the technology that we're building, and making it an open platform I think is a big is a big step forward. A lot of people are using these products across our family of apps, and I would expect us to continue leading the way forward on this from this point on."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "When you think about influencer marketing, we definitely see publishers interested in it, brands interested in it. And so we've worked on branded content, the ability to tag a sponsor and share posts and insights. And the financial arrangement remains between the sponsor and the publisher. It's early, but we're seeing some positive results with publishers of many different types bringing branded content to Facebook. In Q1, we opened this up to unverified pages so we could enable more people to take advantage of this kind of targeting. We see this in the broader context of better targeting. When you think about what really drives great performance for both people who are using Facebook but for marketers, it's well-targeted ads. And so influencer marketing is one way to get there, but we're focused on a very full range of ability to target well. We've been really pleased with the adoption of our targeting products from Custom Audiences to Lookalikes to Dynamic Ads, and we think all of these can improve the relevance of the ad by making ads more targeted, because when they're more targeted, they have higher returns for marketers and they're more enjoyable or relevant for people."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Mark Mahaney from RBC."
},
{
"speaker": "Mark Mahaney - RBC Capital Markets LLC",
"text": "Great, thanks. First, I think it's a great move to go all-in GAAP in terms of reporting. Second, David, when you talked about the ads, your ad load commentary, I couldn't tell if there was a subtle shift there when you were saying that the ad load pressure would occur after the end of the year rather than in the second half of the year. And then third, this is for Sheryl and Mark. The recent stories about gender bias amongst engineers at Facebook, and I know you quickly responded to that and said if there were anything, there may be a rank bias, but in my mind it creates the opportunity potentially for Facebook to better tap into what is probably underappreciated female engineering talent in the Valley and across technology. How do you think about that as an opportunity for the company? Thank you."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "I'll just real quickly address the ad load issue, Mark. Sorry if it wasn't clear, really no change in outlook there. We continue to expect that we'll see deceleration in ad revenue growth. And that's going to be particularly pronounced as we get into the second half of 2017 because ad load will be a less significant factor driving growth starting in the second half."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "On the issue you raised with the Facebook female engineers, I'm really glad to have a chance to address this because this is an issue I take very seriously. On the specific report on this study, the study was conducted by a former employee with very incomplete data. When that study was shared with people internally, and we have that culture where people do studies and share things, and we're really glad because that helps surface issues, we immediately conducted our own research using the full data. And what we found is that the main reason code was sent back at different rates was not correlated with gender. It was correlated with level, and the fact that we have more male senior engineers was explaining it. If you compared male and female engineers at the same level, there was not this discrepancy. Then that leads to the obvious question is are you promoting men and women at the same rate and the broader question of are you paying men and women fairly. And we do a comprehensive look at that every single promotion and pay and performance cycle we have, which is six months. And we know that we're promoting men and women at the same rate as men. Now that said, our industry still has issues and we still have issues. We don't have enough senior female engineers. We don't have enough women going into computer science, and we take this very seriously, from the work we've done with LinkedIn to get CS&E Lean In circles all over college campuses, to encourage more women and under-represented minorities to come into our field. We've had a really nice program in extra internships where we're taking people who are not yet majoring in computer science but we think have the ability, and teaching them for a summer and seeing them return, to the work we're doing with our female engineers to make sure that all forms of bias are surfaced and eliminated. And we can continue to use the full talents of the population. Nothing is more important to us."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line Ross Sandler from Barclays."
},
{
"speaker": "Ross Sandler - Barclays Capital, Inc.",
"text": "Hey, guys. Just had two questions on video. We know it's early, but what kind of traction do you see with the video tab that's in beta? And do you think longer term the video consumption is going to be in that dedicated tab, or will it stay in the News Feed based on what you're seeing right now? And then, Dave, just to follow up on your previous answers, so are the costs related to video ad rev share or licensing of video content, is that baked into your OpEx guidance for 2017, or is that something that will step up after this year? Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "I don't know if we have any public stats on the video tab, probably not. But in terms of the strategy, I can talk about that quickly. There were two basic use cases for checking in with Facebook and seeing what's going on in the world. What people do with News Feed a lot of the time is they have a few free minutes, or you want to sit down for maybe a longer session to see everything that's going on in the world. You don't have a specific intention to watch a specific type of content. You just want to check in and see what's going on in the world. There's this whole other use case around content, which is going to the app or sitting down at a TV because there's some content that you want to watch and you want to go directly to it. And that's what we're trying to do with the video tab, to make it so that all the different folks, whether they're pages that you follow or creators that you like, who you want to subscribe to and get the updates to what they're doing, that you have a place that you can go to with more intent to consume that content. The reason why it needs to be a different tab or at least a different service from News Feed is because people come to it with a different intent. I think you're going to start in the future getting people coming to Facebook for the News Feed use case of checking in and people coming with an intent to go to the video tab to watch a specific video. So that's what we're doing there. That's the strategy, and I guess we'll update on stats when we have them."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "And, Ross, on the costs related to the video ad rev share, yes, our guidance on total cost is all-inclusive, so it includes all the R&D investments we're making. It includes the content. It includes things like the Community Operations investments that we talked about today in the announcement. But I would say that the nature of the types of video content deals that we're doing will make them more likely to show up after 2017. So there will be some content expense in 2017, but I think it will be something you will see step up after 2017."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Mark May from Citi."
},
{
"speaker": "Mark A. May - Citigroup Global Markets, Inc.",
"text": "Thank you. Mark, in your prepared remarks, you talked about doing more to foster local communities and groups, and it would seem like one of the more interesting test cases here already is in Local Marketplaces. I was just wondering if you could talk to us a little bit about the kind of adoption and engagement that you've seen with Local Marketplaces and maybe anything that you've learned that you can apply to some of the newer initiatives that you're looking at? And then secondly, probably for Sheryl, for Ad Breaks to scale, it appears that content creators need to adapt their programming for this, and of course, users need to engage with the ads. So I guess the question is how are completion rates for Ad Breaks? I know it's early, but what are you seeing so far? And how would you characterize the willingness of content creators to adapt?"
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "I can talk about Marketplace Groups first. So I think your basic point is right, that the reason why we started working on Marketplace and the tab around that is because when we were exploring what the biggest use cases were of Groups, we uncovered that a very large number of people, hundreds of millions, use Groups to buy and sell different things. And so these whole communities have formed, which was somewhat surprising to us honestly, because we hadn't developed that product specifically for buying and selling. It was for group communication and that's what people were using it for. So we decided hey, we're going to put together a team that's going to invest in making this actually good for buying and selling and see how much we can grow that economy. So I don't know that we have any public stats on that yet, but that's an area that I'm certainly very excited about. And then in terms of local communities, one of the big trends in the world that we've seen is just that participation in all kinds of different physical communities, whether they're sports teams or some religious groups or different kinds of different things, have been declining a lot over the past several decades. And that I think is a big social issue that is eroding the social fabric of the whole society, not just our country, but around the world. And that's one where I look at that and I wonder if Facebook can play a role in helping to strengthen that. We look at – there are more than 1 billion people every month who use our Groups product. But if you think about your own use of the Groups product, you probably are a member of a bunch of different groups that you maybe check in on very infrequently. So that's very different from – there's a handful of people, around 100 million or a bit more, who are a member of what we call a very meaningful group. So that could be a parenting group or you're diagnosed with a rare disease, and you can now connect with people all around the world to share stories around that. These are groups that upon joining, they become one of the things that you spend the most time with on Facebook, one of the most important parts of your experience, and a really fundamental part of your real-world support structure. So we look that that and we ask the question of hey, if 100 million people are in those very meaningful groups today, can we get that to be 1 billion people over next several years? And if so, then that can help reverse some of the decline in community membership and help strengthen the social fabric, not only in our country, but around the world. So that's a big part of what we're focused on across a number of different initiatives."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "And I'll talk a little bit about the Ad Break, what we're seeing. It's really early both in terms of testing the ads and getting any feedback from users, so people who use Facebook, so we don't have that data to share. But we're pleased that the test is active. We're pleased that it's going well and that we can do both live and uploaded videos. We think over time that marketers will follow where people are spending their time. And if the ads can be well-targeted, we think we'll be able to see engagement, and we already see that. When ads are really well targeted and taking full advantage of the kind of targeting we offer, so you're showing people something they want to see, we see engagement that we think is really critical. It's also worth noting that the metrics that really matter at the end are driving sales. And so any of the engagement with ad metrics, whether it's remembering an ad going back to – people have been measuring that for a long time too, how long a video ad is viewed, are only proxy metrics. What matters is the impact on sales. And so we think the better we can do at getting the measurement to what actually matters, which is the end behavior marketers are trying to drive, the more people will shift their focus to business metrics, the better it will be for the returns they get and ultimately our business."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Michael Nathanson from MoffettNathanson."
},
{
"speaker": "Michael B. Nathanson - MoffettNathanson LLC",
"text": "Thanks. I have three philosophical questions on video for you guys. Anyone can grab them. The first is, it was interesting to see the NFL games go from Twitter to Amazon. I wonder. Do the NFL games fit with your video strategy, and why or why not? That's one. Two is, I know the model is revenue share, but a lot of the more traditional companies would like a license fee or the ability to sell their own inventory on your platform. Is that something you'd consider? And last but not least, the question about monetization, why is mid-roll optimal to pre-roll, and can you share anything about the testing of that concept?"
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "I can talk about sports. So in terms of experimenting with different content, I think we'll try a number of different things here. In terms of working with folks to produce all kinds of content, sports is probably something that we'll want to try at some point. But again, like Dave said before, the goal is going to be creating some anchor content initially that helps people learn that going to the video tab that that's a great destination where they can explore and come to Facebook with the intent to watch the videos that they want. And then the long-term goal is actually not to be paying for specific content like that, but doing a revenue share model once the whole economy around video on Facebook is built up. But we're working on that, and I think we'll probably look at different pieces of content like this around the world, but at this point don't feel like any specific one of them is a must-have for us."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "And I think Mark touched on the question of business model here, and our focus really is on revenue share. We'll be investing to kick-start the ecosystem with content, so derisking it for some of our content partners to start off with, but the focus is really to build a rev-share model over time that's sustainable. That's the focus as opposed to other models. In terms of why mid-roll is preferable to pre-roll, Facebook is well suited for shorter-form content where we're ranking things to be longer-form as well. So we're ranking longer-form video, but that's still relatively short video views. And for that reason, we think mid-roll is a better user experience."
},
{
"speaker": "Deborah Crawford - Facebook, Inc.",
"text": "Operator, I think we have time for one last question."
},
{
"speaker": "Operator",
"text": "Your last question comes from the line of Peter Stabler from Wells Fargo."
},
{
"speaker": "Peter C. Stabler - Wells Fargo Securities LLC",
"text": "Thanks very much, one for Sheryl. Sheryl, you talked a lot about the targeting advantage of Facebook, and you have a number of data signals and sources informing that. I'm wondering if you could talk about the relative importance of collecting signals on the platform versus off the platform, for instance, the behavior of Facebook users interacting with third-party websites. Is this the depth of your off-platform collection? Is this a significant competitive advantage for you? Thank you very much."
},
{
"speaker": "Sheryl Kara Sandberg - Facebook, Inc.",
"text": "We think that targeting end measurement are significant competitive advantages for us. We're very focused on the privacy of what people do, wherever they do it, and using the information we have in a very responsible way. We believe that because people are sharing interests, because people are themselves their real identity on the Facebook platform, we have a significant advantage just in basic targeting itself. Just age and gender, we're 38% more accurate than broad-based targeting according to Nielsen in the U.S., and that's just age and gender. And then if you think about some of the key studies I shared, targeting people who purchase a certain item, targeting people who are interested in a certain item, we think that's very substantial. We also think that there's a real competitive advantage in focusing on business results, as we have. We're really working on shifting people to understanding what their real objectives are so that they can focus on driving businesses. At the end of the day, when you show an ad, you want to move a product off a lot, off a shelf, into a shopping cart, whether it's online or offline, and that's where our focus is and will continue to be."
},
{
"speaker": "Deborah Crawford - Facebook, Inc.",
"text": "Great, thank you again, everybody, for joining us today. We appreciate your time, and we look forward to speaking with you again."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines."
}
] | null | null |
META | 4 | 2,016 | 2017-02-01 17:00:00 | Executives: Deborah Crawford - Facebook, Inc. Mark Elliot Zuckerberg - Facebook, Inc. Sheryl K. Sandberg - Facebook, Inc. David M. Wehner - Facebook, Inc.
Analysts: Douglas T. Anmuth - JPMorgan Securities LLC Brian Nowak - Morgan Stanley & Co. LLC Eric J. Sheridan - UBS Securities LLC John Blackledge - Cowen & Co. LLC Mark A. May - Citigroup Global Markets, Inc. Justin Post - Bank of America Merrill Lynch Mark Mahaney - RBC Capital Markets LLC Heather Bellini - Goldman Sachs & Co. Peter C. Stabler - Wells Fargo Securities LLC Kenneth Sena - Evercore ISI Brian P. Fitzgerald - Jefferies & Company, Inc. Scott Devitt - Stifel, Nicolaus & Co., Inc. Anthony DiClemente, CFA - Nomura Instinet
Operator: Good afternoon. My name is Mike and I'll be your conference operator today. At this time, I would like to welcome everyone to the Facebook Fourth Quarter and Full Year 2016 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin.
Deborah Crawford - Facebook, Inc.: Thank you. Good afternoon and welcome to Facebook's fourth quarter and full year 2016 earnings conference call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our quarterly report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I'd like to turn the call over to Mark.
Mark Elliot Zuckerberg - Facebook, Inc.: Thanks, Deborah. And thanks, everyone, for joining today. This was another good quarter and a good end to 2016. Our community continues to grow, and now with nearly 1.9 billion people using Facebook every month and more than 1.2 billion people using it every day. We've seen continued growth and engagements on our platform, and our ads business is doing well, too. Total revenue grew by 51% year-over-year to $8.8 billion, and advertising revenue was up 53% to $8.6 billion. Facebook stands for connecting people and creating a global community. And, in 2016, more people than ever made their voices heard. We saw billions of conversations about everything from important elections to the Olympics to breaking news stories around the world. And more people are taking advantage of new tools to connect and share on our family of apps, especially with video. 2016 was also a year that reinforced the importance of connecting the world. Today is the five-year anniversary of the day we filed to go public. In our letter to potential shareholders, I wrote that there is a huge need and a huge opportunity to get everyone in the world connected, to give everyone a voice and to help transform society for the future. I believe that now more than ever. And as the largest global community, I see our responsibility as very important, and we will continue to focus on doing everything we can to bring the world closer together. I want to give you an update on our progress over our 3, 5 and 10-year time horizons, with a particular focus on what we're going to be doing over the next three years. I've said before that I see video as a megatrend on the same order as mobile. That's why we're going to keep putting video first across our family of apps and making it easier for people to capture and share video in new ways. To make it easier to find and watch videos, we've added a tab at the bottom of the Facebook app with top videos and recommendations. We've already rolled the tab out to everyone in the U.S., and we're planning to bring it to more countries soon. We're also improving live video as more people use it. New Year's Eve was our biggest live moment ever, with more people going live than at any other time since we launched the product. We're experimenting with Live 360 video, audio-only live for people with slower connections, and live face masks and more camera effects, and we'll have more updates soon. Finally, we're looking for ways to grow the ecosystem of video content on Facebook. We want people to think of Facebook as a place for interesting and relevant video content from professional creators as well as their friends. Last year we started to invest in more original video content to help seed the ecosystem, and we're planning to do more in 2017. We're also focused on building a more informed community. We see Facebook as a community, and ourselves, our role, as supporting that community. We don't write the news that you read, but we want to be a place where people can access information and have meaningful conversations, and this is a responsibility that we take very seriously. In the past, we've taken steps to reduce spam and clickbait, and now we're approaching misinformation and hoaxes the same way. In Q4, we started working with third-party fact-checkers in the U.S. to flag disputed stories and make them less likely to appear in News Feed. We've made it easier to report and identify misinformation and we're working to build stronger ties between Facebook and the news industry. Our primary goal here is to do the right thing for our community. If we can help people stay informed and make Facebook a better place to understand what's going on in the world, then we think that's going to make our community stronger and a more positive force for good in the world. So that's the three-year update. Over the next five years, we're going to keep building ecosystems around our apps that a lot of people are already using. Growth and engagement on Instagram have been strong. We announced in December that Instagram now has over 600 million monthly actives and recently passed 400 million daily actives. Instagram Stories reached 150 million daily actives just five months after the launch, and we've added new features like Boomerang and Live into Stories and I'm excited to see that continue to grow. Our messaging services are making good progress as well. In Q4, Messenger launched a new camera, group video chat for up to 50 people, and games. 400 million people now use voice and video chat on Messenger every month. WhatsApp is growing quickly, too. We recently reached 1.2 billion monthly actives and more than 50 billion messages are sent through WhatsApp every day. In the last quarter, we also added the ability to make video calls in the app. Over the next 10 years, we're going to continue to invest in these platforms and technologies that is going to give more people a voice and make sharing even more immersive. Through our efforts with Internet.org, we have now connected more than 50 million people to the Internet. And, in November, our Connectivity Lab set a world record by transmitting 20 gigabits per second over 13 kilometers using the same amount of power that it takes to light a single light bulb. Ultimately, this technology is going to make it into the solar-powered planes that we're building to beam Internet to parts of the world that aren't connected. On artificial intelligence, we developed a new technique called style transfer that uses AI to study a painting and then can take your photos and videos and draw them in that style in real time on your phone. And if you post on Facebook looking for a place to eat or suggestions for where to go, we can now use AI to understand the text of your post and understand what you're asking and surface (07:20) recommendations from the comments. We're still early in our 10-year plans for virtual reality, but we've made some good progress. In December, we shipped our Touch controllers, and the community response has been very positive. Samsung announced that they've now shipped more than 5 million Gear VRs. And we're bringing more social experiences to VR with apps like Oculus Rooms for Gear VR. We're going to keep making big investments in VR content, and I'm excited about what's coming in 2017, from new games to more immersive educational experiences. As I said in our call last quarter, we're going to continue to invest and hire aggressively to help improve our products, but also to build the infrastructure that will help us grow in the future. A few weeks ago, I visited our newest data center in Fort Worth, Texas. It's going to be the biggest data center we've built, powered by 100% renewable energy, and it's a great example of the investments that we're making to help us serve our community even better. So we've made some good progress, but we have a lot more to do to help bring the world together. I want to thank our community, our teams, our partners, and all of you for being a part of this journey with us. Now here's Sheryl.
Sheryl K. Sandberg - Facebook, Inc.: Thanks, Mark, and hi everyone. We had a strong fourth quarter capping off a great 2016. Q4 ad revenue grew 53%. Mobile ad revenue reached $7.2 billion, up 61% year-over-year, and was approximately 84% of total ad revenue. Our growth this quarter was broad-based across all regions, marketer segments, and verticals. We're really excited to announce today that 65 million businesses are using our free Pages product and 5 million are using Instagram Business profiles. More and more of these businesses are becoming advertisers with over 4 million advertising on Facebook and over 500,000 on Instagram. As a result, our revenue base is becoming more diverse. In Q4, our top 100 advertisers represented less than a quarter of our ad revenue, which is a decline from Q4 last year. We continue to focus on our three priorities: capitalizing on the shift to mobile, growing the number of marketers using our ad products, and making our ads more relevant and effective. First, capitalizing on the shift to mobile. In Q4, we saw consumers use mobile for more of their holiday shopping. comScore found that mobile drove over $1 billion in total Cyber Monday sales for the first time ever. Marketers are increasingly seeing mobile as the opportunity it is. In 2016, we saw more marketers prioritizing mobile and especially mobile video. People consume video differently on mobile, so the best marketers are optimizing their creative. For example, Hershey's used Facebook Live and Video ads for the launch of their Cookie Layer Crunch. They optimized their video ads to grab attention in the first few seconds and used captions for people who were viewing without sound. Nielsen Brand Effect measured an 11 point lift in brand awareness and a 20 point lift in ad recall. We are helping more businesses connect with more people on mobile, both on Facebook and off. Last month, we announced that advertisers can reach over 1 billion people a month on the Audience Network. Our second priority is growing the number of marketers using our ad products. It's clear that businesses of all sizes are using our platforms to reach customers. Two weeks ago, I visited Holzconnection, a family-run furniture maker in Berlin. When competition increased several years ago, the owner worried that he might have to close stores. His son joined the family business and convinced his father to market on Facebook. Holzconnection didn't change anything about their traditional craft, just the way they reached customers. Since then, they've opened five new locations both domestic and internationally. We want to help more small businesses grow, so we've invited companies including Holzconnection to participate in Small Business Councils around the world. We continue to invest in making our free and paid products easier to use, expanding our online tutorials and offering creative tools to businesses of all sizes. For example, the owners of Distinctive Gardens, a gardening center in Illinois, watched one of our online tutorials and then used their mobile phone to shoot a holiday-themed video. They sold out their holiday inventory. Our third priority is making our ads more relevant and effective. Our goal is to drive value for our clients. As we grow the diversity of businesses on our platform, we've invested in building ad products that meet a broad set of objectives, from building brands to moving products off shelves online and in-stores. To make our ad products as relevant and effective as possible, we're increasingly tailoring them by vertical. In 2016, we invested in Dynamic Ads, which allow advertisers to automatically promote products from their entire catalog. We expanded Dynamic Ads across Facebook, Instagram, and the Audience Network, and tailored them for verticals like travel and retail. Dynamic Ads for travel enable businesses to show ads based on dates and destinations people are interested in, while Dynamic Ads for retail show people the products available at nearby locations in real-time. Last month, we introduced Dynamic Ads for broad audiences to help businesses reach new customers based on their interests on Facebook and online behavior. We're going to continue to work on building effective ad products and proving the value they drive. We know that measurement is important to building advertiser trust. Last year, we discovered several metrics issues. And while no billable metrics were affected, we took action to fix the errors and reviewed all of our metrics. We also expanded our partnerships with third parties, given the important role they play in verification. We're going to continue to invest in measurement, including third-party partnerships, in the upcoming year. We believe our strong 2016 is because of the value we drove for businesses on our platforms. We're inspired by the entrepreneurs we work with, like the owners of Holzconnection and Distinctive Gardens, and we're grateful for the opportunity to help them reach customers, grow their businesses, and hire more people. With only a small fraction of the businesses on Facebook and Instagram advertising, we know we have a lot of opportunity and hard work ahead. In 2017, we'll stay focused on helping businesses of all sizes reach customers around the world and grow. Thanks. And now here's Dave.
David M. Wehner - Facebook, Inc.: Thanks, Sheryl, and good afternoon, everyone. 2016 was another year of strong, profitable growth, and we continued to invest in building our business for the long term. Full year 2016 revenue was $27.6 billion and grew 54% or 56% on a constant currency basis, and we generated over $10 billion in GAAP net income. Let's start with our community metrics. In December, 1.23 billion people used Facebook on an average day, up 189 million or 18% compared to last year. 1.86 billion people used Facebook during the month of December, up 269 million or 17% compared to last year. In addition to our ongoing Internet.org and Android product efforts, we benefited from an increase in third-party promotional free data plans in Asia and rest of the world. Mobile continues to drive our growth, with 1.15 billion people accessing Facebook on mobile on an average day in December, up 212 million or 23% compared to last year. Given that the vast majority of monthly and daily usage now occurs on mobile devices, my comments will focus on total MAU and DAU beginning next quarter. And we do not plan to include mobile and mobile-only usage breakdowns in our supplemental investor materials after this quarter. Turning now to the financials. My prepared remarks will focus on our GAAP results unless otherwise noted. As I have noted before, we focus on GAAP results because stock-based compensation plays an important role in how employees are compensated in our business and industry more broadly, and we view it as a real expense. Q4 total revenue was $8.8 billion, up 51%. Q4 ad revenue was $8.6 billion, up 53% or 54% on a constant currency basis. Mobile ad revenue was $7.2 billion, up 61%, and represented approximately 84% of total ad revenue. Desktop ad revenue grew 22%, despite a decline in desktop usage, helped by our efforts to limit the impact of ad blockers on advertisements served on personal computers. The same supply and demand factors we have discussed in the past continue to drive our mobile ads revenue. On the demand side, we continued to improve our targeting, measurement and ad formats to drive strong results for marketers. As Sheryl mentioned, these efforts are working for an increasingly broad set of advertisers. On the supply side, growth in users, time spent, and ad load also contributed to our strong results. In Q4, the average price per ad increased 3% and the total number of ad impressions served increased 49%, driven primarily by mobile feed ads on Facebook and Instagram. Payments and other fees revenue was $180 million, down 12%. Q4 total expenses were $4.2 billion, up 29%. We ended the year with approximately 17,000 employees, up 34% compared to last year and an increase from the 31% growth rate last quarter. Q4 operating income was $4.6 billion, representing a 52% margin. Our tax rate was 21%. Note that our tax rate reflects our early adoption of a new accounting standard ASU 2016-9. Under this standard, the tax benefit related to the difference between the vesting price and the grant price of RSUs is now reflected in our income tax provision, whereas previously it was reflected as an adjustment to equity. This is purely an accounting convention change and does not change the cash taxes we pay. Excluding the impact of this new standard, our Q4 GAAP tax rate would have been approximately 26% and in line with the guidance we provided on the Q3 call. Net income was $3.6 billion or $1.21 per share. Full year 2016 capital expenditures were approximately $4.5 billion, up 78%, as we continue to invest to support the rapid growth of the business around the world. Over the course of 2016, we expanded four of our existing data centers and began construction of four new data centers. In 2016, we generated over $11.6 billion in free cash flow and ended the year with $29.4 billion in cash and investments. Also note that the new accounting standard changed how we present operating cash flow and the free cash flow calculation. In the past, we treated the excess tax benefit as a financing cash flow item and thus was not included in either cash flow metric. Adoption of this standard also resulted in a retrospective adjustment to certain 2016 quarterly financial line items. For more detail on these adjustments, please refer to the supplemental earnings slides available on our investor website. Turning now to the outlook. First, on revenue, the outlook is unchanged. Consistent with my comments on the Q3 call, we continue to expect that our ad revenue growth rate will come down meaningfully in 2017. The factors driving this expectation remain the same. We also expect that our full year 2017 payments and other fees revenue will decline compared to full year 2016. Second, on expenses. Consistent with what I said last quarter, we expect that 2017 will be an aggressive investment year. We saw hiring growth accelerate in Q4, and we plan to accelerate hiring further in 2017 from the 34% growth rate. In addition to head count, we expect to increase investments in R&D, content, sales and marketing and other areas as we execute on our near, medium and long-term priorities. We expect that full year 2017 total GAAP expenses will grow 40% to 50% compared to the full year 2016. We anticipate that full year 2017 share-based compensation expenses will be in the range of $3.9 billion to $4.1 billion, approximately $1.3 billion of which is related to acquisitions, most notably WhatsApp. We also expect full year 2017 amortization expenses to be approximately $700 million to $800 million. Accordingly, on a non-GAAP basis, we would expect total expenses to grow approximately 47% to 57% compared to the full year 2016. We anticipate our expense growth rates will increase over the course of the year. We expect our full year 2017 capital expenditures will be in the range of $7 billion to $7.5 billion, as we fund the expansion of data center capacity and office facilities to support the continued rapid growth of our business. Turning now to tax. At current stock prices, we expect that our full year 2017 GAAP and non-GAAP tax rates will be one to two percentage points lower than our respective 2016 tax rates. Let me note two additional factors with the new standard. First, our tax rate will vary based on stock price. And secondly, we anticipate the tax rate will start to lower in Q1 and then trend up throughout the year. Before wrapping up, as a reminder, in the fourth quarter, our board of directors authorized a $6 billion stock repurchase program beginning in 2017 with no fixed expiration date. Our main priority is to invest aggressively to grow the business while maintaining a strong cash position. At this time, the company's strong balance sheet and financial performance puts us in a position to make opportunistic repurchases of our common stock from time to time to help offset the dilution incurred through equity issuance. To conclude, 2016 was a strong year for Facebook in terms of community growth, engagement, product innovation and the growth of our advertising business. We believe we have significant opportunities ahead of us as we invest in our mission to make the world more open and connected. With that, operator, let's open up the call for questions.
Operator: We will now open the lines for a question-and-answer session. Your first question comes from the line of Doug Anmuth from JPMorgan.
Douglas T. Anmuth - JPMorgan Securities LLC: Thanks for taking my question. Mark, it's been a couple of quarters that you've talked about video first. Can you just talk about the strategic importance of longer-form content? And then also how do you think about that in terms of distribution platforms both on the Facebook mobile app and then through other distribution formats as well? Thanks.
Mark Elliot Zuckerberg - Facebook, Inc.: We're focusing more on shorter-form content to start. So the thesis that we have now is that there were different parts of short-term content. There is the type of content that people will produce socially for friends. There's promotional content that businesses and celebrities and folks will produce. But there's also a whole class of premium content that the creators need to get paid a good amount in order to support the creation of that content, and we need to be able to support that with a business model, which we're working on through ads to fund that. So the biggest change that I think that we're going to see on the consumption in News Feed and in the tab over the next year or two is going to be much more video inventory and content coming in as we work through and make that business model start to really click for a lot of folks. Over the longer term, I think as that works, people will experiment with longer forms of video as well and all kinds of different things. But that, I think, is the primary focus for the foreseeable future.
David M. Wehner - Facebook, Inc.: Yeah. And Doug, I think you asked about platforms. I mean we've always been focused on a variety of – getting our services on a variety of platforms, but main focus is obviously on mobile.
Operator: Your next question comes from the line of Brian Nowak from Morgan Stanley.
Brian Nowak - Morgan Stanley & Co. LLC: Thanks for taking my questions. I have two. The first one Mark is on Instagram, the 400 million daily active users. Curious to be – hear (24:39) how you think about the core use of Instagram now and how it differs from core Facebook. And how do you think about that evolving over time and the monetization of Instagram evolving over time? And then the second one, just to go back to Doug's question on the content, I know Dave, you mentioned content spend as being part of the investment. Should we think about the content investment as being more driven on rev share or do you see yourselves going out and writing and doing licensing deals? Thanks so much.
David M. Wehner - Facebook, Inc.: I can start on that latter question. Our goal really is to kick-start an ecosystem of partner content in the video tab, for example, and our model is really oriented towards revenue share with creators. We are funding some feed content to get the ecosystem going, but the focus is on rev share. And then I think your question was on how the core use case between Facebook and Instagram differs.
Mark Elliot Zuckerberg - Facebook, Inc.: Yeah, I can take that one. There are a number of differences. I think a lot of this comes down to the graphs in the community that you have in the different places. Instagram is a follow model, right, so it's – they're not all bidirectional friendships. A larger portion of the content is public content. More of the content is visual, right. Facebook has a mix of text and news and links and visual content like photos and videos. And Instagram creates a pure experience that's focused on photos and videos. So all those good and subtle decisions that Kevin has made over the years add up to creating a different kind of community that what we're finding and that's great, is that it's really complementary to what people are doing on Facebook. And some of what we found is that as we encourage people to use both Facebook and Instagram, engagement on both can increase. So that is great. And that I think speaks to how you can build these different kinds of communities with different connections in a way that really is creating new value in people's lives.
Operator: Your next question comes from the line of Eric Sheridan from UBS.
Eric J. Sheridan - UBS Securities LLC: Thanks for taking the question. Maybe two, sticking on the same theme as what Doug and Brian just talked about. Sheryl, for you; would love to get a sense of how you think about some of the opportunities and challenges sitting ahead of the business now on monetizing all of the video that's being consumed on Facebook. And then maybe, Dave, for you. When we think about the P&L impacts of both monetizing video and investing in video, is there anything we should be thinking about or you want to call out in terms of gross versus net on either the revenue side or the revenue share side that could be leading to mix shift to incremental revenue growth but possibly lower margin revenue coming into the business? Thanks so much.
Sheryl K. Sandberg - Facebook, Inc.: On the video ad opportunity, we're seeing consumer video exploding on our platform, as Mark has talked about, and that really creates the opportunity for video ads in the feed. And a lot of this happens within the current News Feed product. People post videos. People consume News Feed stories. Those stories include video stories from consumers, and then we have an opportunity to serve ads. As consumer video has grown in News Feed, it's given us that opportunity for video ads because the format of the ads fits the format of what consumers are doing. And we're seeing a lot of great examples of people using ads in the feed across Instagram and News Feed. In terms of monetizing some of our newer attempts at products in News Feed such as Ad Break, those are really in early experimental stages, and for now, we're really focused primarily on our core business, our core ad products, of which video is one. One of the things that's really important in this is helping marketers understand that they need to optimize those video ads. An ad that works really well 30 seconds in other platforms and more traditional platforms can work on ours, but the ones that are optimized and use our targeting really perform better. And we're working hard with advertisers to help them see that. So to share one example, Motorola working with Ogilvy and Moto Mento (28:55) launched the Moto Z phone, and they did awareness boosting before they launched, targeting Android users and Verizon subscribers. And they optimized their video for the Facebook and Instagram mobile feeds. And then after they launched, they did purchasing ads and re-targeted people who had viewed those initial ads. That's just a great example of someone using video ads, optimizing a format, but also using the pretty unique targeting we can offer to drive sales. They measured that they had over a 3.5% lift in sales driven by the Facebook and Instagram video ads. And so we're pretty excited about the opportunity we have in our current business, and we're going to work client by client to get the video format of those ads right, get the targeting to be as good and as deep as it can be and make sure we're measuring all the way through to sales.
David M. Wehner - Facebook, Inc.: And Eric, you were asking about content and where that's going to get picked up in the P&L. There's no real simple answer in that. I would say in general where we're going to be, rev sharing with creators, that's going to be picked up in cost of revenue. So that's probably the simplest answer. But as we do arrangements to get the ecosystem going, some of that could get picked up in sales and marketing, and then we have content as well that's getting picked up in R&D for the efforts we're making with Oculus. So you're seeing some of those get spread across several different lines in the P&L, so it's not going to be a clean one spot where you're going to find it.
Eric J. Sheridan - UBS Securities LLC: Great. Thank you.
Operator: Your next question comes from the line of John Blackledge from Cowen.
John Blackledge - Cowen & Co. LLC: Great. Thanks. Just a couple of questions. With the strategic shift to video, how do you view the state of the digital/mobile video measurement? Any callout on improvements being done industry wide and within Facebook? And then just on video search, could you just comment on improvements in video search capabilities for users? Thank you.
David M. Wehner - Facebook, Inc.: Sheryl, do you want to take the question on video measurement and...
Sheryl K. Sandberg - Facebook, Inc.: Yeah.
David M. Wehner - Facebook, Inc.: ...how that's evolving?
Sheryl K. Sandberg - Facebook, Inc.: Yeah. So new platforms demand new measurement, and so people are measuring all kinds of different things from viewability to how many people see the ad to how long they run the ad. We're focused on all of these metrics and working hard with third parties and with our advertiser to get those metrics right. We really believe that at the end of the day what matters the most is all the way through to sales. What matters the most is the A/B test that these people saw ads on Facebook and Instagram, these people didn't, and here's the sales lift. And all of the other metrics, although important and we're working hard, are proxy metrics, and those metrics are going through a platform shift that we need to work on.
David M. Wehner - Facebook, Inc.: And then, Mark.
Mark Elliot Zuckerberg - Facebook, Inc.: And for video search – search is a big priority and a thing that we're working on across all of the different verticals, not just video but also all the posts on Facebook, all of the content that people are selling in Marketplace, the groups that people are joining and sharing and all the news content. And it's an area that we've been working on for a while. It's growing steadily and doing well, and we hope to have more updates on that soon.
Operator: Your next question comes from the line of Mark May from Citi.
Mark A. May - Citigroup Global Markets, Inc.: Thanks for taking my questions. I think the first one might be directed at Sheryl. Your reported pricing metric, I realize there's typically been noise in that. I think it's up 3% year-on-year. First of all, is that sort of representative for general pricing changes in the Marketplace? And do you think that there's still room for upside in pricing? And if so, where are some of the key areas where you see that coming from? And then another question on video. As you've begun to push more video content to users within the Facebook app itself, are you witnessing any meaningful changes in engagement, time spent with a typical Facebook app user? Thank you.
David M. Wehner - Facebook, Inc.: Mark, it's Dave. I can take those on the metrics. From the price-volume perspective, yeah, the price per ad increased modestly 3%. There's lots of different underlying metrics, but the overall kind of reported metric is really – continues to be driven by the mix shift away from right-hand column ads, which are lower price and lower value. And then, obviously impression growth is driven by the users' time spent in ad load. In terms of the opportunities for price, it's really just continuing to focus on making our ads better targeted, more relevant, improving all the different ways in which we can drive better outcomes for our advertisers and sort of meeting them with the results that they care about and delivering those results. We think there's – continue to be great opportunities to do that, and how the supply-demand dynamics play out will kind of impact the overall direction of price. And it's going to depend obviously also on regional mixes too, because some regions have obviously lower prices. I think the other question was on video. Video is one of the big drivers of engagement growth on Facebook. It's also helpful on Instagram where we're also seeing the benefit of ranking changes. So we continue to see good engagement and time spent growth across the Facebook family and on just Facebook, and video is a part of that story. So it's an important part of that story.
Operator: Your next question comes from the line of Justin Post from Bank of America Merrill Lynch.
Justin Post - Bank of America Merrill Lynch: Great. A couple things. First, we had a lot of political activity obviously in Q4. Did that contribute anything abnormally to revenues or users? Second question, and I know you'll be getting a lot of this over the next two or three months, but just any difference on trends – Millennials on the platform versus other cohorts or groups? Just thinking about how those are trending versus the other groups. And then finally, I think we've seen some ads on Messenger being tested in certain regions of the world. Any commentary on that would be helpful. Thank you.
Sheryl K. Sandberg - Facebook, Inc.: Yeah. I'll take a few of those. So on elections, we run a very large and diversified business. So there are these events that are obviously big like the U.S. elections, the World Cup, Super Bowl, but there are enough of these all around the world that no one event is that big for our business. Even last quarter, political spending even within the U.S. alone was not a top-10 vertical for us. When you think about ads in Messenger, we right now are really focused on consumer growth and engagement because we know that over time that creates the monetization opportunity. We're seeing a lot of organic connections between businesses and consumers. We're now per month at a billion messages sent between people and businesses, and we think that's very promising for our ability for people to use this platform to make those connections that will ultimately drive business opportunities. We're in the very early stages, some of those ads you're seeing of exploring how to build more of these connections. But right now, we're going to remain focused on user experience and the experimentation we're doing.
David M. Wehner - Facebook, Inc.: Yeah. And Justin, just adding to the question on elections, I'd also point out that our reported daily active and monthly active numbers reflect usage in December. So even for the U.S. that doesn't really pick up the election period just because of the way that we tabulate those results. On Millennials, we were really pleased – this was a fantastic quarter for overall growth of the Facebook community, our strongest absolute MAU and DAU additions year-over-year since being a public company, so really pleased with that. So within that context, we're not breaking out specific cohorts, but we remain a great place for advertisers to reach Millennials. And Instagram is obviously another great place to reach Millennials, and we continue to build our products to serve a wide variety of audiences, including Millennials as well.
Operator: Your next question comes from the line of Mark Mahaney from RBC Capital Markets.
Mark Mahaney - RBC Capital Markets LLC: David, I think you just talked about these pretty material increases in MAUs. Could I ask two questions? The Asia area MAU growth in particular – I think it was something like 44 million sequentially, that's the biggest that I think you've ever had. So could you just talk about was there some particular markets in particular region there that added to it? And then talking Asia, could you just comment, Mark, on China and how you think about it at long-term as a market opportunity and your level of optimism that Facebook can have a material presence in that market in 5 to 10 years? Thank you.
Mark Elliot Zuckerberg - Facebook, Inc.: Sure. So, Mark, Asia benefits probably more than any other region around the sort of three factors that I called out in my prepared remarks. And those are Internet.org efforts, Android product improvements that we've continued to make a big area like Android – Facebook Lite platform on Android has been a great grower for us. But then particularly in the fourth quarter, one of the callouts that we've seen, an increase in third-party promotional free data plans in places like India. So that clearly is having an impact in APAC and India was our strongest growth market. So that would be something that I would say is a little bit more unique this past quarter.
Operator: Your next question...
Mark Mahaney - RBC Capital Markets LLC: My (39:08) China question.
David M. Wehner - Facebook, Inc.: Yeah. Sorry. Mark's going to take China second (39:12).
Mark Elliot Zuckerberg - Facebook, Inc.: Sure. So as I've said a number of times before, our mission is to connect everyone in the world, and it's hard to do that over the long term if we don't find a way to serve more than a billion people who live in China. So that's certainly a thing that we're going to look out at over the long term. In the specific time horizon that you mentioned, I think it's really hard to predict how this will play out or what we will end up doing. But one of the big things that we need to think about here is, of course, we're only going to do this in a way that we're comfortable with over the long term. So this is something that we're going to continue engaging in and thinking about, how to move forward on, and long-term it's very important. But no news at all in the near-term.
Operator: Your next question comes from the line of Heather Bellini from Goldman Sachs.
Heather Bellini - Goldman Sachs & Co.: Great. Thank you for taking the questions. I had two. I was just wondering, Mark, you mentioned similar to how you referenced Facebook and Instagram being complementary, how do you think about WhatsApp and Messenger? And I'm wondering if there's different paths to monetization over time for each of these? And then my second question, I guess, might be for any of you. Just you, Dave, have mentioned expectations for slower growth in ad load on core Facebook in the second half of this year. How should we think about the potential for ad load growth on Instagram? Thank you.
Mark Elliot Zuckerberg - Facebook, Inc.: I'll take Messenger and WhatsApp and you can take ad load. So yes is the basic answer that Messenger and WhatsApp serve somewhat different utilities for people. WhatsApp really takes the place of SMS in a lot of the markets where it operates. The graph is based on phone numbers. You're as likely to text your barber or someone that you're going to transact with, who you would have a phone number with, as you would be a friend. Whereas on Facebook Messenger, the graph is your friends, and you're more likely to, say, wish an acquaintance happy birthday on Facebook Messenger than on WhatsApp or you might not have their phone number in the first place. So you can think about some overlap in the core use case, you might message your close friends and family on either. But what we found in general is that if you look at some of the markets that are strongest for both of them, they can each grow in those markets, and as messaging has become more affordable and more reliable for people, the volumes of messaging have just gone through the roof in terms of what people want to do. My understanding from looking at a bunch of analytics is that the peak of global SMS reached somewhere in the low 20 billion messages per day, and we already have many times more than that. Three times or more, more than that across WhatsApp and Messenger. And, of course, there are other messaging products in the world besides these as well. So we're pretty confident that this is going to keep on growing. I do think to your point that the monetization paths are going to be somewhat different, reflecting the differences in product philosophy. So Messenger is much more focused on being an expressive and rich environment that has lots of different types of content. Kind of more like Facebook to the Instagram example that we used before, whereas WhatsApp I think is a much more utilitarian experience with a much more stark UI where there's just not as much emphasis on having a lot of different ways to engage. So we did the experiment that you asked about before around ads and Messenger and different ways that businesses can interact and there's a lot of flexibility around how we can explore there, which is why I think you'll see more of that on the Messenger side than on the WhatsApp side in the near term. But giving businesses the opportunity to connect in WhatsApp and reach the people that they want and eventually have increasingly, hopefully, transactional interactions I think will be a really useful thing on that platform as well.
David M. Wehner - Facebook, Inc.: Heather, it's Dave. Just on Instagram versus Facebook and ad load, clearly the biggest driver of our business is core Facebook just in terms of sheer size and even sheer contribution to growth. Instagram is growing quicker on a percentage basis, but it's much smaller. The ad load opportunities are higher on Instagram because Instagram is at a lower ad load than Facebook, so there is an opportunity for us to continue to grow ad load on Instagram probably beyond – in a longer timeframe than there is on Facebook because of that disparity in terms of where they are today. But given the scale of Facebook and the importance of driving overall revenue, that's why I continue to express what our expectations are for advertising growth in 2017 and the reduction in the growth rate that we expect, given the potential to grow ad load on Facebook that we expect to come down in 2017.
Operator: Your next question comes from the line of Peter Stabler from Wells Fargo Securities.
Peter C. Stabler - Wells Fargo Securities LLC: Thanks very much. Two for Sheryl, if I could. First of all, Sheryl, when it comes to measurement, I'm curious if you could comment on what appear to be the really successful efforts you've had in linking on Facebook ad exposure to both offline and online sales of your customers. And, I guess, when we think across maybe your 1,000 largest clients, any chance you could give us a sense of what percentage are utilizing this level of kind of advanced measurement in terms of measuring actual sales lift and share gains? And then, secondly, just wondering if there's any color around the pretty recent rollout of buy buttons on Instagram? Thank you very much.
Sheryl K. Sandberg - Facebook, Inc.: Yeah. So when you think on measurement, your question gets to the heart of the matter, which is, there's a lot of conversations on what we measure. And when you see platform shifts, as you are in the ad market, from more traditional forms of media to display, to now mobile, we're seeing those metrics change, and there's obviously a lot of conversation and a lot of concern out there about what we're measuring. We think the answer to all of this is to remember that what really matters is going all the way through from the ad itself to the sale, whether that sale is online or offline. And we are working hard to work on the data in a privacy protected way to be able to do that. And we're making progress across verticals, across our large customers. I don't have the percentage of exactly how many customers are working on this type of measurement with us. It's certainly growing. It's certainly something we're working on vertical-by-vertical. But it has really important impacts, not just in their ability to serve the right ads to the right person at the right time, but also their ability to optimize their ads for our format. That once they understand what's really moving their product off shelves, online and off, that's where we get to the real work we need to do to optimize the ad and really work on the targeting. And so I remain very optimistic. We have a lot of hard work to do to get to all of our ad campaigns having that kind of measurement. That's going to take a long time. But the more we can do it, even in studies with each client, the better our ads get.
Operator: Your next question...
Sheryl K. Sandberg - Facebook, Inc.: Oh, buy button. Yeah, sorry. Just to address the buy button. The core of our business is really connecting people with what they care about. And so we're looking at getting the right message the right time. We've worked hard on products ads that get to products. So you've seen us work on dynamic ads, carousel ads, estimated store visits. Things that help our ad business sell products. You are seeing us take other steps like a buy button, like the Marketplace launch, which are really aimed at improving some of the experiences we think people are trying to have and already having in organic ways on Facebook. But the core of our focus is still very much focused on ads and how we can do ads at the product level.
Operator: Your next question comes from the line of Ken Sena from Evercore ISI.
Kenneth Sena - Evercore ISI: Thanks. Just on the OpEx for 2017, you mentioned R&D, content, sales, marketing. As we think about R&D and also the talent shortages that are in data science and engineering, not to mention the potentially getting worse around immigration, et cetera, how should we think about that potentially factoring in as we look out through 2017 and maybe a little bit further out? Thank you.
David M. Wehner - Facebook, Inc.: Sure, Ken. I mean, we obviously are focused on hiring top engineering talent. It's key to our 2017 goals and executing on our three, five, and 10-year roadmap, the one that Mark outlined. One thing that we're optimistic about is our ability to hire technical talent outside of the Bay Area as well as in the Bay Area. And that's because we've built up engineering locations in key areas like Seattle, London, New York, Boston, Tel Aviv. So we've got other markets in which we can recruit and grow engineering and other technical team. And that's really different from where we were a couple years ago. So that's an important part of the infrastructure that we've put in place in the last two years that we're pleased with.
Operator: Your next question comes from the line of Brian Fitzgerald from Jefferies.
Brian P. Fitzgerald - Jefferies & Company, Inc.: Thanks. Mark, on AI maybe. You mentioned improved recommendations and we've interacted with chatbots on Messenger. Maybe curious overall how you see artificial intelligence and machine learning processes impacting your business over time?
Mark Elliot Zuckerberg - Facebook, Inc.: Well, I think AI is going to be great for the experience that people have in our community. So there are a few types of systems here that we're working on around understanding content. One is around visual content and the other is about language. So, for visual content, we want to be able to look at a photo and understand what's in it, right, and whether that's something that you're going to be interested in, right? And similarly, we want to be able look at a video and watch it and understand whether that's something that you're going to be interested in. And you can imagine that today, we consider putting things in your News Feed that you're connected to in some way, right, that are from a friend or a page that you're following or that one of your friends likes. But there's no reason that we shouldn't be able to match you up with any of the millions of pieces of content that you might be interested in that gets shared on Facebook every day, except for the fact that we don't have the AI technology to know what those are about and if they match your interest today. So, a combination of being able to understand the text that people message, read the articles that people would want to look at, watch the videos, look at the photos, are going to be great, too. Another area where I'm really excited about this is our ability to keep the community safe, right? So there's an increasing focus on objectionable content, right, and a lot of unfortunate things, right, that people share on Facebook. And it's a minority of the content, but I'm really focused on making sure that our company gets faster at taking the bad stuff down. And we can do better with people, but ultimately the best thing that we can do is build AI systems that can watch a video and understand that it's going to be problematic and violate the policies of our community and that people aren't going to want to see it and then just not show it to people before bad experiences happen and things like violence gets spread through – violent content gets spread through the network. So I think it's both going to be – AI is both going to be great on showing people content that's really good and helping us enforce the community standards that we have to make sure that everyone has a good and fair experience.
Operator: Your next question comes from the line of Scott Devitt from Stifel.
Scott Devitt - Stifel, Nicolaus & Co., Inc.: Hi. Thanks. I have two questions for Mark. Wondering, Mark, if you could talk a bit more about the new video tab, just early engagement trends, user feedback, and really just how the product works in terms of categorization of content, user preference targeting, and maybe how the content flows into the tab versus being in the News Feed and, to the extent, that there's duplication there. And then separately, VR and AR continues to be in the 10-year vision for the business. Mark, I was wondering if you could provide some detail on what you think the friction points are that are keeping that from being on a more accelerated commercialization path. Thank you.
Mark Elliot Zuckerberg - Facebook, Inc.: So I'll take video first and then I can talk about VR as well. So, for the video tab, the goal that we have for the product experience is to make it so that when people want to watch videos or they want to keep up to date on what's going on with their favorite show or what's going on with the public figure that they want to follow, that they can come to Facebook and go to a place knowing that that's going to show them all the content that they're interested in. So that's a pretty different intent than how people come to Facebook today. Today, for the most part, people pull Facebook out when they have a few minutes, when they want to catch up and see what's going on in the world with their friends and in the news and everything that's going on. That's very different from saying, hey, I want to watch video content now. And that's what I think we're going to unlock with this tab. So, all of the content that is on Facebook is eligible to go in the tab. I mean, we're showing video content, not all the rest of it, but there isn't a concrete difference between what can be a News Feed and what can be here. It's just that the experience is designed to deliver on that promise of, you want to watch videos, you want to keep up with the content that you watch episodically week-over-week, this is going to the place where you go to do that. I do think that it's going to get a lot stronger once the business model really starts to click here, right? Because a lot of the best episodic content is professionally created, and those folks need to make a good amount of money in order to support their business model. So having mid-roll ads, we're committed to doing this in a way that's very good on the user experience, but that is going to enable the kind of content that I think is going to take us to the next level. The early trends are good, but I think this is really going to be an area that is proportional to the amount of quality content that is in the system, and the business model is really going to be the thing that enables that. All right. Sorry. I forgot about that for a second. All right. So VR and AR, what can accelerate that? I think that there are parts of this that are on a good trajectory and parts where we're a little behind where we would want to be. I think Samsung shipping 5 million Gear VRs. I mean, that's their product, not ours, but we build technology that powers it. I think that's quite a good result, right, and one that we're very happy with, and just shows how strong of a company Samsung is at being able to build these products and sell them through into the world. On the side of the products that we built, Rift and Touch were both a little delayed, so that was obviously somewhat of a disappointment. And if you want to accelerate development, obviously, we need to get our products in the market at a good pace. But in terms of the content development, I actually think that that's coming at a reasonable clip. Early on, there is this issue, which is that if you're a AAA game developer, until there's a certain volume of units in the field, you're not going to be able to make enough money to fund your game development just based off of people buying your content. So that's why we're investing so much capital in content to feed the ecosystem and solve this chicken and egg problem if you need the content in order to create the ecosystem. But I don't think that there is really a strategy to pull this in from 10 years to five, I just think it's going to be a 10-year thing. The analogy that I always use is the first smartphones came out in 2003, right, the BlackBerry and Palm Treo, and it took 10 years to get to 1 billion units. And, I mean, I don't know if there was something that folks could have done to make that happen fast, but I think that was pretty good. And, I mean, if we can be on a similar trajectory of anywhere near 10 years for VR and AR, then I would feel very good about that, and I feel like we're making the right bets now to plant the seeds for that. But I would ask for the patience of the investor community in doing that because we're going to invest a lot in this, and it's not going to return or be really profitable for us for quite a while.
Deborah Crawford - Facebook, Inc.: Operator, we have time for one last question.
Operator: Your last question comes from the line of Anthony DiClemente from Nomura Instinet.
Anthony DiClemente, CFA - Nomura Instinet: Thanks a lot for fitting me in. A couple for Mark. Mark, just on the theme of video, given the strong cash position that Facebook has, the cash on the balance sheet, the free cash flow generation of the company, are there any possible acquisitions out there that you think would or could supercharge your growth in the video space, in the original content space, given this evolution? And maybe along those lines, what do you think about live sports in terms of the video use case? Is that working on Facebook? You've experimented with NBA games on Facebook outside the U.S., NBA D-League on Facebook, so just wanted to get your thoughts on how those have gone. Thanks a lot.
David M. Wehner - Facebook, Inc.: So, Anthony, I can just take the first part of that at least, which is – look, our focus is on kick-starting the ecosystem here for the video tab that Mark talked about. We're looking at a wide range of content, and we're really working towards a revenue share model with creators. We're certainly going to be seeding content to get the ecosystem going, but that's not about doing big deals. So we're certainly looking at a variety of different types of content to look at.
Mark Elliot Zuckerberg - Facebook, Inc.: I mean, I think you got it.
David M. Wehner - Facebook, Inc.: Great.
Deborah Crawford - Facebook, Inc.: Great. Super. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again.
Operator: Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines. | [
{
"speaker": "Executives",
"text": "Deborah Crawford - Facebook, Inc. Mark Elliot Zuckerberg - Facebook, Inc. Sheryl K. Sandberg - Facebook, Inc. David M. Wehner - Facebook, Inc."
},
{
"speaker": "Analysts",
"text": "Douglas T. Anmuth - JPMorgan Securities LLC Brian Nowak - Morgan Stanley & Co. LLC Eric J. Sheridan - UBS Securities LLC John Blackledge - Cowen & Co. LLC Mark A. May - Citigroup Global Markets, Inc. Justin Post - Bank of America Merrill Lynch Mark Mahaney - RBC Capital Markets LLC Heather Bellini - Goldman Sachs & Co. Peter C. Stabler - Wells Fargo Securities LLC Kenneth Sena - Evercore ISI Brian P. Fitzgerald - Jefferies & Company, Inc. Scott Devitt - Stifel, Nicolaus & Co., Inc. Anthony DiClemente, CFA - Nomura Instinet"
},
{
"speaker": "Operator",
"text": "Good afternoon. My name is Mike and I'll be your conference operator today. At this time, I would like to welcome everyone to the Facebook Fourth Quarter and Full Year 2016 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford - Facebook, Inc.",
"text": "Thank you. Good afternoon and welcome to Facebook's fourth quarter and full year 2016 earnings conference call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our quarterly report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I'd like to turn the call over to Mark."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Thanks, Deborah. And thanks, everyone, for joining today. This was another good quarter and a good end to 2016. Our community continues to grow, and now with nearly 1.9 billion people using Facebook every month and more than 1.2 billion people using it every day. We've seen continued growth and engagements on our platform, and our ads business is doing well, too. Total revenue grew by 51% year-over-year to $8.8 billion, and advertising revenue was up 53% to $8.6 billion. Facebook stands for connecting people and creating a global community. And, in 2016, more people than ever made their voices heard. We saw billions of conversations about everything from important elections to the Olympics to breaking news stories around the world. And more people are taking advantage of new tools to connect and share on our family of apps, especially with video. 2016 was also a year that reinforced the importance of connecting the world. Today is the five-year anniversary of the day we filed to go public. In our letter to potential shareholders, I wrote that there is a huge need and a huge opportunity to get everyone in the world connected, to give everyone a voice and to help transform society for the future. I believe that now more than ever. And as the largest global community, I see our responsibility as very important, and we will continue to focus on doing everything we can to bring the world closer together. I want to give you an update on our progress over our 3, 5 and 10-year time horizons, with a particular focus on what we're going to be doing over the next three years. I've said before that I see video as a megatrend on the same order as mobile. That's why we're going to keep putting video first across our family of apps and making it easier for people to capture and share video in new ways. To make it easier to find and watch videos, we've added a tab at the bottom of the Facebook app with top videos and recommendations. We've already rolled the tab out to everyone in the U.S., and we're planning to bring it to more countries soon. We're also improving live video as more people use it. New Year's Eve was our biggest live moment ever, with more people going live than at any other time since we launched the product. We're experimenting with Live 360 video, audio-only live for people with slower connections, and live face masks and more camera effects, and we'll have more updates soon. Finally, we're looking for ways to grow the ecosystem of video content on Facebook. We want people to think of Facebook as a place for interesting and relevant video content from professional creators as well as their friends. Last year we started to invest in more original video content to help seed the ecosystem, and we're planning to do more in 2017. We're also focused on building a more informed community. We see Facebook as a community, and ourselves, our role, as supporting that community. We don't write the news that you read, but we want to be a place where people can access information and have meaningful conversations, and this is a responsibility that we take very seriously. In the past, we've taken steps to reduce spam and clickbait, and now we're approaching misinformation and hoaxes the same way. In Q4, we started working with third-party fact-checkers in the U.S. to flag disputed stories and make them less likely to appear in News Feed. We've made it easier to report and identify misinformation and we're working to build stronger ties between Facebook and the news industry. Our primary goal here is to do the right thing for our community. If we can help people stay informed and make Facebook a better place to understand what's going on in the world, then we think that's going to make our community stronger and a more positive force for good in the world. So that's the three-year update. Over the next five years, we're going to keep building ecosystems around our apps that a lot of people are already using. Growth and engagement on Instagram have been strong. We announced in December that Instagram now has over 600 million monthly actives and recently passed 400 million daily actives. Instagram Stories reached 150 million daily actives just five months after the launch, and we've added new features like Boomerang and Live into Stories and I'm excited to see that continue to grow. Our messaging services are making good progress as well. In Q4, Messenger launched a new camera, group video chat for up to 50 people, and games. 400 million people now use voice and video chat on Messenger every month. WhatsApp is growing quickly, too. We recently reached 1.2 billion monthly actives and more than 50 billion messages are sent through WhatsApp every day. In the last quarter, we also added the ability to make video calls in the app. Over the next 10 years, we're going to continue to invest in these platforms and technologies that is going to give more people a voice and make sharing even more immersive. Through our efforts with Internet.org, we have now connected more than 50 million people to the Internet. And, in November, our Connectivity Lab set a world record by transmitting 20 gigabits per second over 13 kilometers using the same amount of power that it takes to light a single light bulb. Ultimately, this technology is going to make it into the solar-powered planes that we're building to beam Internet to parts of the world that aren't connected. On artificial intelligence, we developed a new technique called style transfer that uses AI to study a painting and then can take your photos and videos and draw them in that style in real time on your phone. And if you post on Facebook looking for a place to eat or suggestions for where to go, we can now use AI to understand the text of your post and understand what you're asking and surface (07:20) recommendations from the comments. We're still early in our 10-year plans for virtual reality, but we've made some good progress. In December, we shipped our Touch controllers, and the community response has been very positive. Samsung announced that they've now shipped more than 5 million Gear VRs. And we're bringing more social experiences to VR with apps like Oculus Rooms for Gear VR. We're going to keep making big investments in VR content, and I'm excited about what's coming in 2017, from new games to more immersive educational experiences. As I said in our call last quarter, we're going to continue to invest and hire aggressively to help improve our products, but also to build the infrastructure that will help us grow in the future. A few weeks ago, I visited our newest data center in Fort Worth, Texas. It's going to be the biggest data center we've built, powered by 100% renewable energy, and it's a great example of the investments that we're making to help us serve our community even better. So we've made some good progress, but we have a lot more to do to help bring the world together. I want to thank our community, our teams, our partners, and all of you for being a part of this journey with us. Now here's Sheryl."
},
{
"speaker": "Sheryl K. Sandberg - Facebook, Inc.",
"text": "Thanks, Mark, and hi everyone. We had a strong fourth quarter capping off a great 2016. Q4 ad revenue grew 53%. Mobile ad revenue reached $7.2 billion, up 61% year-over-year, and was approximately 84% of total ad revenue. Our growth this quarter was broad-based across all regions, marketer segments, and verticals. We're really excited to announce today that 65 million businesses are using our free Pages product and 5 million are using Instagram Business profiles. More and more of these businesses are becoming advertisers with over 4 million advertising on Facebook and over 500,000 on Instagram. As a result, our revenue base is becoming more diverse. In Q4, our top 100 advertisers represented less than a quarter of our ad revenue, which is a decline from Q4 last year. We continue to focus on our three priorities: capitalizing on the shift to mobile, growing the number of marketers using our ad products, and making our ads more relevant and effective. First, capitalizing on the shift to mobile. In Q4, we saw consumers use mobile for more of their holiday shopping. comScore found that mobile drove over $1 billion in total Cyber Monday sales for the first time ever. Marketers are increasingly seeing mobile as the opportunity it is. In 2016, we saw more marketers prioritizing mobile and especially mobile video. People consume video differently on mobile, so the best marketers are optimizing their creative. For example, Hershey's used Facebook Live and Video ads for the launch of their Cookie Layer Crunch. They optimized their video ads to grab attention in the first few seconds and used captions for people who were viewing without sound. Nielsen Brand Effect measured an 11 point lift in brand awareness and a 20 point lift in ad recall. We are helping more businesses connect with more people on mobile, both on Facebook and off. Last month, we announced that advertisers can reach over 1 billion people a month on the Audience Network. Our second priority is growing the number of marketers using our ad products. It's clear that businesses of all sizes are using our platforms to reach customers. Two weeks ago, I visited Holzconnection, a family-run furniture maker in Berlin. When competition increased several years ago, the owner worried that he might have to close stores. His son joined the family business and convinced his father to market on Facebook. Holzconnection didn't change anything about their traditional craft, just the way they reached customers. Since then, they've opened five new locations both domestic and internationally. We want to help more small businesses grow, so we've invited companies including Holzconnection to participate in Small Business Councils around the world. We continue to invest in making our free and paid products easier to use, expanding our online tutorials and offering creative tools to businesses of all sizes. For example, the owners of Distinctive Gardens, a gardening center in Illinois, watched one of our online tutorials and then used their mobile phone to shoot a holiday-themed video. They sold out their holiday inventory. Our third priority is making our ads more relevant and effective. Our goal is to drive value for our clients. As we grow the diversity of businesses on our platform, we've invested in building ad products that meet a broad set of objectives, from building brands to moving products off shelves online and in-stores. To make our ad products as relevant and effective as possible, we're increasingly tailoring them by vertical. In 2016, we invested in Dynamic Ads, which allow advertisers to automatically promote products from their entire catalog. We expanded Dynamic Ads across Facebook, Instagram, and the Audience Network, and tailored them for verticals like travel and retail. Dynamic Ads for travel enable businesses to show ads based on dates and destinations people are interested in, while Dynamic Ads for retail show people the products available at nearby locations in real-time. Last month, we introduced Dynamic Ads for broad audiences to help businesses reach new customers based on their interests on Facebook and online behavior. We're going to continue to work on building effective ad products and proving the value they drive. We know that measurement is important to building advertiser trust. Last year, we discovered several metrics issues. And while no billable metrics were affected, we took action to fix the errors and reviewed all of our metrics. We also expanded our partnerships with third parties, given the important role they play in verification. We're going to continue to invest in measurement, including third-party partnerships, in the upcoming year. We believe our strong 2016 is because of the value we drove for businesses on our platforms. We're inspired by the entrepreneurs we work with, like the owners of Holzconnection and Distinctive Gardens, and we're grateful for the opportunity to help them reach customers, grow their businesses, and hire more people. With only a small fraction of the businesses on Facebook and Instagram advertising, we know we have a lot of opportunity and hard work ahead. In 2017, we'll stay focused on helping businesses of all sizes reach customers around the world and grow. Thanks. And now here's Dave."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Thanks, Sheryl, and good afternoon, everyone. 2016 was another year of strong, profitable growth, and we continued to invest in building our business for the long term. Full year 2016 revenue was $27.6 billion and grew 54% or 56% on a constant currency basis, and we generated over $10 billion in GAAP net income. Let's start with our community metrics. In December, 1.23 billion people used Facebook on an average day, up 189 million or 18% compared to last year. 1.86 billion people used Facebook during the month of December, up 269 million or 17% compared to last year. In addition to our ongoing Internet.org and Android product efforts, we benefited from an increase in third-party promotional free data plans in Asia and rest of the world. Mobile continues to drive our growth, with 1.15 billion people accessing Facebook on mobile on an average day in December, up 212 million or 23% compared to last year. Given that the vast majority of monthly and daily usage now occurs on mobile devices, my comments will focus on total MAU and DAU beginning next quarter. And we do not plan to include mobile and mobile-only usage breakdowns in our supplemental investor materials after this quarter. Turning now to the financials. My prepared remarks will focus on our GAAP results unless otherwise noted. As I have noted before, we focus on GAAP results because stock-based compensation plays an important role in how employees are compensated in our business and industry more broadly, and we view it as a real expense. Q4 total revenue was $8.8 billion, up 51%. Q4 ad revenue was $8.6 billion, up 53% or 54% on a constant currency basis. Mobile ad revenue was $7.2 billion, up 61%, and represented approximately 84% of total ad revenue. Desktop ad revenue grew 22%, despite a decline in desktop usage, helped by our efforts to limit the impact of ad blockers on advertisements served on personal computers. The same supply and demand factors we have discussed in the past continue to drive our mobile ads revenue. On the demand side, we continued to improve our targeting, measurement and ad formats to drive strong results for marketers. As Sheryl mentioned, these efforts are working for an increasingly broad set of advertisers. On the supply side, growth in users, time spent, and ad load also contributed to our strong results. In Q4, the average price per ad increased 3% and the total number of ad impressions served increased 49%, driven primarily by mobile feed ads on Facebook and Instagram. Payments and other fees revenue was $180 million, down 12%. Q4 total expenses were $4.2 billion, up 29%. We ended the year with approximately 17,000 employees, up 34% compared to last year and an increase from the 31% growth rate last quarter. Q4 operating income was $4.6 billion, representing a 52% margin. Our tax rate was 21%. Note that our tax rate reflects our early adoption of a new accounting standard ASU 2016-9. Under this standard, the tax benefit related to the difference between the vesting price and the grant price of RSUs is now reflected in our income tax provision, whereas previously it was reflected as an adjustment to equity. This is purely an accounting convention change and does not change the cash taxes we pay. Excluding the impact of this new standard, our Q4 GAAP tax rate would have been approximately 26% and in line with the guidance we provided on the Q3 call. Net income was $3.6 billion or $1.21 per share. Full year 2016 capital expenditures were approximately $4.5 billion, up 78%, as we continue to invest to support the rapid growth of the business around the world. Over the course of 2016, we expanded four of our existing data centers and began construction of four new data centers. In 2016, we generated over $11.6 billion in free cash flow and ended the year with $29.4 billion in cash and investments. Also note that the new accounting standard changed how we present operating cash flow and the free cash flow calculation. In the past, we treated the excess tax benefit as a financing cash flow item and thus was not included in either cash flow metric. Adoption of this standard also resulted in a retrospective adjustment to certain 2016 quarterly financial line items. For more detail on these adjustments, please refer to the supplemental earnings slides available on our investor website. Turning now to the outlook. First, on revenue, the outlook is unchanged. Consistent with my comments on the Q3 call, we continue to expect that our ad revenue growth rate will come down meaningfully in 2017. The factors driving this expectation remain the same. We also expect that our full year 2017 payments and other fees revenue will decline compared to full year 2016. Second, on expenses. Consistent with what I said last quarter, we expect that 2017 will be an aggressive investment year. We saw hiring growth accelerate in Q4, and we plan to accelerate hiring further in 2017 from the 34% growth rate. In addition to head count, we expect to increase investments in R&D, content, sales and marketing and other areas as we execute on our near, medium and long-term priorities. We expect that full year 2017 total GAAP expenses will grow 40% to 50% compared to the full year 2016. We anticipate that full year 2017 share-based compensation expenses will be in the range of $3.9 billion to $4.1 billion, approximately $1.3 billion of which is related to acquisitions, most notably WhatsApp. We also expect full year 2017 amortization expenses to be approximately $700 million to $800 million. Accordingly, on a non-GAAP basis, we would expect total expenses to grow approximately 47% to 57% compared to the full year 2016. We anticipate our expense growth rates will increase over the course of the year. We expect our full year 2017 capital expenditures will be in the range of $7 billion to $7.5 billion, as we fund the expansion of data center capacity and office facilities to support the continued rapid growth of our business. Turning now to tax. At current stock prices, we expect that our full year 2017 GAAP and non-GAAP tax rates will be one to two percentage points lower than our respective 2016 tax rates. Let me note two additional factors with the new standard. First, our tax rate will vary based on stock price. And secondly, we anticipate the tax rate will start to lower in Q1 and then trend up throughout the year. Before wrapping up, as a reminder, in the fourth quarter, our board of directors authorized a $6 billion stock repurchase program beginning in 2017 with no fixed expiration date. Our main priority is to invest aggressively to grow the business while maintaining a strong cash position. At this time, the company's strong balance sheet and financial performance puts us in a position to make opportunistic repurchases of our common stock from time to time to help offset the dilution incurred through equity issuance. To conclude, 2016 was a strong year for Facebook in terms of community growth, engagement, product innovation and the growth of our advertising business. We believe we have significant opportunities ahead of us as we invest in our mission to make the world more open and connected. With that, operator, let's open up the call for questions."
},
{
"speaker": "Operator",
"text": "We will now open the lines for a question-and-answer session. Your first question comes from the line of Doug Anmuth from JPMorgan."
},
{
"speaker": "Douglas T. Anmuth - JPMorgan Securities LLC",
"text": "Thanks for taking my question. Mark, it's been a couple of quarters that you've talked about video first. Can you just talk about the strategic importance of longer-form content? And then also how do you think about that in terms of distribution platforms both on the Facebook mobile app and then through other distribution formats as well? Thanks."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "We're focusing more on shorter-form content to start. So the thesis that we have now is that there were different parts of short-term content. There is the type of content that people will produce socially for friends. There's promotional content that businesses and celebrities and folks will produce. But there's also a whole class of premium content that the creators need to get paid a good amount in order to support the creation of that content, and we need to be able to support that with a business model, which we're working on through ads to fund that. So the biggest change that I think that we're going to see on the consumption in News Feed and in the tab over the next year or two is going to be much more video inventory and content coming in as we work through and make that business model start to really click for a lot of folks. Over the longer term, I think as that works, people will experiment with longer forms of video as well and all kinds of different things. But that, I think, is the primary focus for the foreseeable future."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Yeah. And Doug, I think you asked about platforms. I mean we've always been focused on a variety of – getting our services on a variety of platforms, but main focus is obviously on mobile."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Brian Nowak from Morgan Stanley."
},
{
"speaker": "Brian Nowak - Morgan Stanley & Co. LLC",
"text": "Thanks for taking my questions. I have two. The first one Mark is on Instagram, the 400 million daily active users. Curious to be – hear (24:39) how you think about the core use of Instagram now and how it differs from core Facebook. And how do you think about that evolving over time and the monetization of Instagram evolving over time? And then the second one, just to go back to Doug's question on the content, I know Dave, you mentioned content spend as being part of the investment. Should we think about the content investment as being more driven on rev share or do you see yourselves going out and writing and doing licensing deals? Thanks so much."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "I can start on that latter question. Our goal really is to kick-start an ecosystem of partner content in the video tab, for example, and our model is really oriented towards revenue share with creators. We are funding some feed content to get the ecosystem going, but the focus is on rev share. And then I think your question was on how the core use case between Facebook and Instagram differs."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Yeah, I can take that one. There are a number of differences. I think a lot of this comes down to the graphs in the community that you have in the different places. Instagram is a follow model, right, so it's – they're not all bidirectional friendships. A larger portion of the content is public content. More of the content is visual, right. Facebook has a mix of text and news and links and visual content like photos and videos. And Instagram creates a pure experience that's focused on photos and videos. So all those good and subtle decisions that Kevin has made over the years add up to creating a different kind of community that what we're finding and that's great, is that it's really complementary to what people are doing on Facebook. And some of what we found is that as we encourage people to use both Facebook and Instagram, engagement on both can increase. So that is great. And that I think speaks to how you can build these different kinds of communities with different connections in a way that really is creating new value in people's lives."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Eric Sheridan from UBS."
},
{
"speaker": "Eric J. Sheridan - UBS Securities LLC",
"text": "Thanks for taking the question. Maybe two, sticking on the same theme as what Doug and Brian just talked about. Sheryl, for you; would love to get a sense of how you think about some of the opportunities and challenges sitting ahead of the business now on monetizing all of the video that's being consumed on Facebook. And then maybe, Dave, for you. When we think about the P&L impacts of both monetizing video and investing in video, is there anything we should be thinking about or you want to call out in terms of gross versus net on either the revenue side or the revenue share side that could be leading to mix shift to incremental revenue growth but possibly lower margin revenue coming into the business? Thanks so much."
},
{
"speaker": "Sheryl K. Sandberg - Facebook, Inc.",
"text": "On the video ad opportunity, we're seeing consumer video exploding on our platform, as Mark has talked about, and that really creates the opportunity for video ads in the feed. And a lot of this happens within the current News Feed product. People post videos. People consume News Feed stories. Those stories include video stories from consumers, and then we have an opportunity to serve ads. As consumer video has grown in News Feed, it's given us that opportunity for video ads because the format of the ads fits the format of what consumers are doing. And we're seeing a lot of great examples of people using ads in the feed across Instagram and News Feed. In terms of monetizing some of our newer attempts at products in News Feed such as Ad Break, those are really in early experimental stages, and for now, we're really focused primarily on our core business, our core ad products, of which video is one. One of the things that's really important in this is helping marketers understand that they need to optimize those video ads. An ad that works really well 30 seconds in other platforms and more traditional platforms can work on ours, but the ones that are optimized and use our targeting really perform better. And we're working hard with advertisers to help them see that. So to share one example, Motorola working with Ogilvy and Moto Mento (28:55) launched the Moto Z phone, and they did awareness boosting before they launched, targeting Android users and Verizon subscribers. And they optimized their video for the Facebook and Instagram mobile feeds. And then after they launched, they did purchasing ads and re-targeted people who had viewed those initial ads. That's just a great example of someone using video ads, optimizing a format, but also using the pretty unique targeting we can offer to drive sales. They measured that they had over a 3.5% lift in sales driven by the Facebook and Instagram video ads. And so we're pretty excited about the opportunity we have in our current business, and we're going to work client by client to get the video format of those ads right, get the targeting to be as good and as deep as it can be and make sure we're measuring all the way through to sales."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "And Eric, you were asking about content and where that's going to get picked up in the P&L. There's no real simple answer in that. I would say in general where we're going to be, rev sharing with creators, that's going to be picked up in cost of revenue. So that's probably the simplest answer. But as we do arrangements to get the ecosystem going, some of that could get picked up in sales and marketing, and then we have content as well that's getting picked up in R&D for the efforts we're making with Oculus. So you're seeing some of those get spread across several different lines in the P&L, so it's not going to be a clean one spot where you're going to find it."
},
{
"speaker": "Eric J. Sheridan - UBS Securities LLC",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of John Blackledge from Cowen."
},
{
"speaker": "John Blackledge - Cowen & Co. LLC",
"text": "Great. Thanks. Just a couple of questions. With the strategic shift to video, how do you view the state of the digital/mobile video measurement? Any callout on improvements being done industry wide and within Facebook? And then just on video search, could you just comment on improvements in video search capabilities for users? Thank you."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Sheryl, do you want to take the question on video measurement and..."
},
{
"speaker": "Sheryl K. Sandberg - Facebook, Inc.",
"text": "Yeah."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "...how that's evolving?"
},
{
"speaker": "Sheryl K. Sandberg - Facebook, Inc.",
"text": "Yeah. So new platforms demand new measurement, and so people are measuring all kinds of different things from viewability to how many people see the ad to how long they run the ad. We're focused on all of these metrics and working hard with third parties and with our advertiser to get those metrics right. We really believe that at the end of the day what matters the most is all the way through to sales. What matters the most is the A/B test that these people saw ads on Facebook and Instagram, these people didn't, and here's the sales lift. And all of the other metrics, although important and we're working hard, are proxy metrics, and those metrics are going through a platform shift that we need to work on."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "And then, Mark."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "And for video search – search is a big priority and a thing that we're working on across all of the different verticals, not just video but also all the posts on Facebook, all of the content that people are selling in Marketplace, the groups that people are joining and sharing and all the news content. And it's an area that we've been working on for a while. It's growing steadily and doing well, and we hope to have more updates on that soon."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Mark May from Citi."
},
{
"speaker": "Mark A. May - Citigroup Global Markets, Inc.",
"text": "Thanks for taking my questions. I think the first one might be directed at Sheryl. Your reported pricing metric, I realize there's typically been noise in that. I think it's up 3% year-on-year. First of all, is that sort of representative for general pricing changes in the Marketplace? And do you think that there's still room for upside in pricing? And if so, where are some of the key areas where you see that coming from? And then another question on video. As you've begun to push more video content to users within the Facebook app itself, are you witnessing any meaningful changes in engagement, time spent with a typical Facebook app user? Thank you."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Mark, it's Dave. I can take those on the metrics. From the price-volume perspective, yeah, the price per ad increased modestly 3%. There's lots of different underlying metrics, but the overall kind of reported metric is really – continues to be driven by the mix shift away from right-hand column ads, which are lower price and lower value. And then, obviously impression growth is driven by the users' time spent in ad load. In terms of the opportunities for price, it's really just continuing to focus on making our ads better targeted, more relevant, improving all the different ways in which we can drive better outcomes for our advertisers and sort of meeting them with the results that they care about and delivering those results. We think there's – continue to be great opportunities to do that, and how the supply-demand dynamics play out will kind of impact the overall direction of price. And it's going to depend obviously also on regional mixes too, because some regions have obviously lower prices. I think the other question was on video. Video is one of the big drivers of engagement growth on Facebook. It's also helpful on Instagram where we're also seeing the benefit of ranking changes. So we continue to see good engagement and time spent growth across the Facebook family and on just Facebook, and video is a part of that story. So it's an important part of that story."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Justin Post from Bank of America Merrill Lynch."
},
{
"speaker": "Justin Post - Bank of America Merrill Lynch",
"text": "Great. A couple things. First, we had a lot of political activity obviously in Q4. Did that contribute anything abnormally to revenues or users? Second question, and I know you'll be getting a lot of this over the next two or three months, but just any difference on trends – Millennials on the platform versus other cohorts or groups? Just thinking about how those are trending versus the other groups. And then finally, I think we've seen some ads on Messenger being tested in certain regions of the world. Any commentary on that would be helpful. Thank you."
},
{
"speaker": "Sheryl K. Sandberg - Facebook, Inc.",
"text": "Yeah. I'll take a few of those. So on elections, we run a very large and diversified business. So there are these events that are obviously big like the U.S. elections, the World Cup, Super Bowl, but there are enough of these all around the world that no one event is that big for our business. Even last quarter, political spending even within the U.S. alone was not a top-10 vertical for us. When you think about ads in Messenger, we right now are really focused on consumer growth and engagement because we know that over time that creates the monetization opportunity. We're seeing a lot of organic connections between businesses and consumers. We're now per month at a billion messages sent between people and businesses, and we think that's very promising for our ability for people to use this platform to make those connections that will ultimately drive business opportunities. We're in the very early stages, some of those ads you're seeing of exploring how to build more of these connections. But right now, we're going to remain focused on user experience and the experimentation we're doing."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Yeah. And Justin, just adding to the question on elections, I'd also point out that our reported daily active and monthly active numbers reflect usage in December. So even for the U.S. that doesn't really pick up the election period just because of the way that we tabulate those results. On Millennials, we were really pleased – this was a fantastic quarter for overall growth of the Facebook community, our strongest absolute MAU and DAU additions year-over-year since being a public company, so really pleased with that. So within that context, we're not breaking out specific cohorts, but we remain a great place for advertisers to reach Millennials. And Instagram is obviously another great place to reach Millennials, and we continue to build our products to serve a wide variety of audiences, including Millennials as well."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Mark Mahaney from RBC Capital Markets."
},
{
"speaker": "Mark Mahaney - RBC Capital Markets LLC",
"text": "David, I think you just talked about these pretty material increases in MAUs. Could I ask two questions? The Asia area MAU growth in particular – I think it was something like 44 million sequentially, that's the biggest that I think you've ever had. So could you just talk about was there some particular markets in particular region there that added to it? And then talking Asia, could you just comment, Mark, on China and how you think about it at long-term as a market opportunity and your level of optimism that Facebook can have a material presence in that market in 5 to 10 years? Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Sure. So, Mark, Asia benefits probably more than any other region around the sort of three factors that I called out in my prepared remarks. And those are Internet.org efforts, Android product improvements that we've continued to make a big area like Android – Facebook Lite platform on Android has been a great grower for us. But then particularly in the fourth quarter, one of the callouts that we've seen, an increase in third-party promotional free data plans in places like India. So that clearly is having an impact in APAC and India was our strongest growth market. So that would be something that I would say is a little bit more unique this past quarter."
},
{
"speaker": "Operator",
"text": "Your next question..."
},
{
"speaker": "Mark Mahaney - RBC Capital Markets LLC",
"text": "My (39:08) China question."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Yeah. Sorry. Mark's going to take China second (39:12)."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Sure. So as I've said a number of times before, our mission is to connect everyone in the world, and it's hard to do that over the long term if we don't find a way to serve more than a billion people who live in China. So that's certainly a thing that we're going to look out at over the long term. In the specific time horizon that you mentioned, I think it's really hard to predict how this will play out or what we will end up doing. But one of the big things that we need to think about here is, of course, we're only going to do this in a way that we're comfortable with over the long term. So this is something that we're going to continue engaging in and thinking about, how to move forward on, and long-term it's very important. But no news at all in the near-term."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Heather Bellini from Goldman Sachs."
},
{
"speaker": "Heather Bellini - Goldman Sachs & Co.",
"text": "Great. Thank you for taking the questions. I had two. I was just wondering, Mark, you mentioned similar to how you referenced Facebook and Instagram being complementary, how do you think about WhatsApp and Messenger? And I'm wondering if there's different paths to monetization over time for each of these? And then my second question, I guess, might be for any of you. Just you, Dave, have mentioned expectations for slower growth in ad load on core Facebook in the second half of this year. How should we think about the potential for ad load growth on Instagram? Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "I'll take Messenger and WhatsApp and you can take ad load. So yes is the basic answer that Messenger and WhatsApp serve somewhat different utilities for people. WhatsApp really takes the place of SMS in a lot of the markets where it operates. The graph is based on phone numbers. You're as likely to text your barber or someone that you're going to transact with, who you would have a phone number with, as you would be a friend. Whereas on Facebook Messenger, the graph is your friends, and you're more likely to, say, wish an acquaintance happy birthday on Facebook Messenger than on WhatsApp or you might not have their phone number in the first place. So you can think about some overlap in the core use case, you might message your close friends and family on either. But what we found in general is that if you look at some of the markets that are strongest for both of them, they can each grow in those markets, and as messaging has become more affordable and more reliable for people, the volumes of messaging have just gone through the roof in terms of what people want to do. My understanding from looking at a bunch of analytics is that the peak of global SMS reached somewhere in the low 20 billion messages per day, and we already have many times more than that. Three times or more, more than that across WhatsApp and Messenger. And, of course, there are other messaging products in the world besides these as well. So we're pretty confident that this is going to keep on growing. I do think to your point that the monetization paths are going to be somewhat different, reflecting the differences in product philosophy. So Messenger is much more focused on being an expressive and rich environment that has lots of different types of content. Kind of more like Facebook to the Instagram example that we used before, whereas WhatsApp I think is a much more utilitarian experience with a much more stark UI where there's just not as much emphasis on having a lot of different ways to engage. So we did the experiment that you asked about before around ads and Messenger and different ways that businesses can interact and there's a lot of flexibility around how we can explore there, which is why I think you'll see more of that on the Messenger side than on the WhatsApp side in the near term. But giving businesses the opportunity to connect in WhatsApp and reach the people that they want and eventually have increasingly, hopefully, transactional interactions I think will be a really useful thing on that platform as well."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Heather, it's Dave. Just on Instagram versus Facebook and ad load, clearly the biggest driver of our business is core Facebook just in terms of sheer size and even sheer contribution to growth. Instagram is growing quicker on a percentage basis, but it's much smaller. The ad load opportunities are higher on Instagram because Instagram is at a lower ad load than Facebook, so there is an opportunity for us to continue to grow ad load on Instagram probably beyond – in a longer timeframe than there is on Facebook because of that disparity in terms of where they are today. But given the scale of Facebook and the importance of driving overall revenue, that's why I continue to express what our expectations are for advertising growth in 2017 and the reduction in the growth rate that we expect, given the potential to grow ad load on Facebook that we expect to come down in 2017."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Peter Stabler from Wells Fargo Securities."
},
{
"speaker": "Peter C. Stabler - Wells Fargo Securities LLC",
"text": "Thanks very much. Two for Sheryl, if I could. First of all, Sheryl, when it comes to measurement, I'm curious if you could comment on what appear to be the really successful efforts you've had in linking on Facebook ad exposure to both offline and online sales of your customers. And, I guess, when we think across maybe your 1,000 largest clients, any chance you could give us a sense of what percentage are utilizing this level of kind of advanced measurement in terms of measuring actual sales lift and share gains? And then, secondly, just wondering if there's any color around the pretty recent rollout of buy buttons on Instagram? Thank you very much."
},
{
"speaker": "Sheryl K. Sandberg - Facebook, Inc.",
"text": "Yeah. So when you think on measurement, your question gets to the heart of the matter, which is, there's a lot of conversations on what we measure. And when you see platform shifts, as you are in the ad market, from more traditional forms of media to display, to now mobile, we're seeing those metrics change, and there's obviously a lot of conversation and a lot of concern out there about what we're measuring. We think the answer to all of this is to remember that what really matters is going all the way through from the ad itself to the sale, whether that sale is online or offline. And we are working hard to work on the data in a privacy protected way to be able to do that. And we're making progress across verticals, across our large customers. I don't have the percentage of exactly how many customers are working on this type of measurement with us. It's certainly growing. It's certainly something we're working on vertical-by-vertical. But it has really important impacts, not just in their ability to serve the right ads to the right person at the right time, but also their ability to optimize their ads for our format. That once they understand what's really moving their product off shelves, online and off, that's where we get to the real work we need to do to optimize the ad and really work on the targeting. And so I remain very optimistic. We have a lot of hard work to do to get to all of our ad campaigns having that kind of measurement. That's going to take a long time. But the more we can do it, even in studies with each client, the better our ads get."
},
{
"speaker": "Operator",
"text": "Your next question..."
},
{
"speaker": "Sheryl K. Sandberg - Facebook, Inc.",
"text": "Oh, buy button. Yeah, sorry. Just to address the buy button. The core of our business is really connecting people with what they care about. And so we're looking at getting the right message the right time. We've worked hard on products ads that get to products. So you've seen us work on dynamic ads, carousel ads, estimated store visits. Things that help our ad business sell products. You are seeing us take other steps like a buy button, like the Marketplace launch, which are really aimed at improving some of the experiences we think people are trying to have and already having in organic ways on Facebook. But the core of our focus is still very much focused on ads and how we can do ads at the product level."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ken Sena from Evercore ISI."
},
{
"speaker": "Kenneth Sena - Evercore ISI",
"text": "Thanks. Just on the OpEx for 2017, you mentioned R&D, content, sales, marketing. As we think about R&D and also the talent shortages that are in data science and engineering, not to mention the potentially getting worse around immigration, et cetera, how should we think about that potentially factoring in as we look out through 2017 and maybe a little bit further out? Thank you."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Sure, Ken. I mean, we obviously are focused on hiring top engineering talent. It's key to our 2017 goals and executing on our three, five, and 10-year roadmap, the one that Mark outlined. One thing that we're optimistic about is our ability to hire technical talent outside of the Bay Area as well as in the Bay Area. And that's because we've built up engineering locations in key areas like Seattle, London, New York, Boston, Tel Aviv. So we've got other markets in which we can recruit and grow engineering and other technical team. And that's really different from where we were a couple years ago. So that's an important part of the infrastructure that we've put in place in the last two years that we're pleased with."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Brian Fitzgerald from Jefferies."
},
{
"speaker": "Brian P. Fitzgerald - Jefferies & Company, Inc.",
"text": "Thanks. Mark, on AI maybe. You mentioned improved recommendations and we've interacted with chatbots on Messenger. Maybe curious overall how you see artificial intelligence and machine learning processes impacting your business over time?"
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Well, I think AI is going to be great for the experience that people have in our community. So there are a few types of systems here that we're working on around understanding content. One is around visual content and the other is about language. So, for visual content, we want to be able to look at a photo and understand what's in it, right, and whether that's something that you're going to be interested in, right? And similarly, we want to be able look at a video and watch it and understand whether that's something that you're going to be interested in. And you can imagine that today, we consider putting things in your News Feed that you're connected to in some way, right, that are from a friend or a page that you're following or that one of your friends likes. But there's no reason that we shouldn't be able to match you up with any of the millions of pieces of content that you might be interested in that gets shared on Facebook every day, except for the fact that we don't have the AI technology to know what those are about and if they match your interest today. So, a combination of being able to understand the text that people message, read the articles that people would want to look at, watch the videos, look at the photos, are going to be great, too. Another area where I'm really excited about this is our ability to keep the community safe, right? So there's an increasing focus on objectionable content, right, and a lot of unfortunate things, right, that people share on Facebook. And it's a minority of the content, but I'm really focused on making sure that our company gets faster at taking the bad stuff down. And we can do better with people, but ultimately the best thing that we can do is build AI systems that can watch a video and understand that it's going to be problematic and violate the policies of our community and that people aren't going to want to see it and then just not show it to people before bad experiences happen and things like violence gets spread through – violent content gets spread through the network. So I think it's both going to be – AI is both going to be great on showing people content that's really good and helping us enforce the community standards that we have to make sure that everyone has a good and fair experience."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Scott Devitt from Stifel."
},
{
"speaker": "Scott Devitt - Stifel, Nicolaus & Co., Inc.",
"text": "Hi. Thanks. I have two questions for Mark. Wondering, Mark, if you could talk a bit more about the new video tab, just early engagement trends, user feedback, and really just how the product works in terms of categorization of content, user preference targeting, and maybe how the content flows into the tab versus being in the News Feed and, to the extent, that there's duplication there. And then separately, VR and AR continues to be in the 10-year vision for the business. Mark, I was wondering if you could provide some detail on what you think the friction points are that are keeping that from being on a more accelerated commercialization path. Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "So I'll take video first and then I can talk about VR as well. So, for the video tab, the goal that we have for the product experience is to make it so that when people want to watch videos or they want to keep up to date on what's going on with their favorite show or what's going on with the public figure that they want to follow, that they can come to Facebook and go to a place knowing that that's going to show them all the content that they're interested in. So that's a pretty different intent than how people come to Facebook today. Today, for the most part, people pull Facebook out when they have a few minutes, when they want to catch up and see what's going on in the world with their friends and in the news and everything that's going on. That's very different from saying, hey, I want to watch video content now. And that's what I think we're going to unlock with this tab. So, all of the content that is on Facebook is eligible to go in the tab. I mean, we're showing video content, not all the rest of it, but there isn't a concrete difference between what can be a News Feed and what can be here. It's just that the experience is designed to deliver on that promise of, you want to watch videos, you want to keep up with the content that you watch episodically week-over-week, this is going to the place where you go to do that. I do think that it's going to get a lot stronger once the business model really starts to click here, right? Because a lot of the best episodic content is professionally created, and those folks need to make a good amount of money in order to support their business model. So having mid-roll ads, we're committed to doing this in a way that's very good on the user experience, but that is going to enable the kind of content that I think is going to take us to the next level. The early trends are good, but I think this is really going to be an area that is proportional to the amount of quality content that is in the system, and the business model is really going to be the thing that enables that. All right. Sorry. I forgot about that for a second. All right. So VR and AR, what can accelerate that? I think that there are parts of this that are on a good trajectory and parts where we're a little behind where we would want to be. I think Samsung shipping 5 million Gear VRs. I mean, that's their product, not ours, but we build technology that powers it. I think that's quite a good result, right, and one that we're very happy with, and just shows how strong of a company Samsung is at being able to build these products and sell them through into the world. On the side of the products that we built, Rift and Touch were both a little delayed, so that was obviously somewhat of a disappointment. And if you want to accelerate development, obviously, we need to get our products in the market at a good pace. But in terms of the content development, I actually think that that's coming at a reasonable clip. Early on, there is this issue, which is that if you're a AAA game developer, until there's a certain volume of units in the field, you're not going to be able to make enough money to fund your game development just based off of people buying your content. So that's why we're investing so much capital in content to feed the ecosystem and solve this chicken and egg problem if you need the content in order to create the ecosystem. But I don't think that there is really a strategy to pull this in from 10 years to five, I just think it's going to be a 10-year thing. The analogy that I always use is the first smartphones came out in 2003, right, the BlackBerry and Palm Treo, and it took 10 years to get to 1 billion units. And, I mean, I don't know if there was something that folks could have done to make that happen fast, but I think that was pretty good. And, I mean, if we can be on a similar trajectory of anywhere near 10 years for VR and AR, then I would feel very good about that, and I feel like we're making the right bets now to plant the seeds for that. But I would ask for the patience of the investor community in doing that because we're going to invest a lot in this, and it's not going to return or be really profitable for us for quite a while."
},
{
"speaker": "Deborah Crawford - Facebook, Inc.",
"text": "Operator, we have time for one last question."
},
{
"speaker": "Operator",
"text": "Your last question comes from the line of Anthony DiClemente from Nomura Instinet."
},
{
"speaker": "Anthony DiClemente, CFA - Nomura Instinet",
"text": "Thanks a lot for fitting me in. A couple for Mark. Mark, just on the theme of video, given the strong cash position that Facebook has, the cash on the balance sheet, the free cash flow generation of the company, are there any possible acquisitions out there that you think would or could supercharge your growth in the video space, in the original content space, given this evolution? And maybe along those lines, what do you think about live sports in terms of the video use case? Is that working on Facebook? You've experimented with NBA games on Facebook outside the U.S., NBA D-League on Facebook, so just wanted to get your thoughts on how those have gone. Thanks a lot."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "So, Anthony, I can just take the first part of that at least, which is – look, our focus is on kick-starting the ecosystem here for the video tab that Mark talked about. We're looking at a wide range of content, and we're really working towards a revenue share model with creators. We're certainly going to be seeding content to get the ecosystem going, but that's not about doing big deals. So we're certainly looking at a variety of different types of content to look at."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "I mean, I think you got it."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Great."
},
{
"speaker": "Deborah Crawford - Facebook, Inc.",
"text": "Great. Super. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines."
}
] | null | null |
META | 3 | 2,016 | 2016-11-02 17:00:00 | Executives: Deborah Crawford - Facebook, Inc. Mark Elliot Zuckerberg - Facebook, Inc. Sheryl K. Sandberg - Facebook, Inc. David M. Wehner - Facebook, Inc.
Analysts: Brian Nowak - Morgan Stanley & Co. LLC Eric J. Sheridan - UBS Securities LLC Anthony DiClemente - Nomura Securities International, Inc. Mark A. May - Citigroup Global Markets, Inc. (Broker) Mark Mahaney - RBC Capital Markets LLC Douglas T. Anmuth - JPMorgan Securities LLC Ross Sandler - Deutsche Bank Securities, Inc. Heather Bellini - Goldman Sachs & Co. Peter C. Stabler - Wells Fargo Securities LLC Justin Post - Bank of America Merrill Lynch Brian P. Fitzgerald - Jefferies LLC Youssef Squali - Cantor Fitzgerald Securities John Blackledge - Cowen & Co. LLC
Operator: Good afternoon. My name is Chris, and I'll be your conference operator today. At this time, I would like to welcome everyone to the Facebook Third Quarter 2016 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin.
Deborah Crawford - Facebook, Inc.: Thank you. Good afternoon and welcome to Facebook's third quarter 2016 earnings conference call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our quarterly report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I'd like to turn the call over to Mark.
Mark Elliot Zuckerberg - Facebook, Inc.: Thanks, Deborah, and thanks, everyone, for joining today. We had another good quarter. Our community continues to grow around the world. We're pleased to see nearly 1.8 billion people now use Facebook every month and nearly 1.2 billion people use it every day. It's also great to see the continued growth and strength of engagement on our platform, and our ads growth is growing at a healthy rate as well. Total revenue grew by 56% year over year to $7 billion, and advertising revenue was up 59% to $6.8 billion. I want to start by talking about our work around putting video first across our apps. People are creating and sharing more video, and we think it's pretty clear that video is only going to become more important. So that's why we're prioritizing putting video first across our family of apps and taking steps to make it even easier for people to express themselves in richer ways. One way we're putting video first is through live video on Facebook. Since May, the number of people going live at any given moment has grown by four times. And people have gone live from all seven continents and also from outer space. Another recent example is Instagram Stories, which we launched in August. Instagram Stories is a lightweight way for people to share moments of their day through photos and videos that appear in a slide show format and disappear after 24 hours. Stories now has more than 100 million daily actives. We also improved the Explore tab in Instagram to include more videos and stories, and it has 100 million daily actives now as well. In addition to making it easy to share video, we also want to make it easier to capture video. In most social apps today, a text box is still the default way we share. Soon, we believe a camera will be the main way that we share. We're already testing this in our main Facebook app with a version that has a camera, directly just one swipe away from News Feed, with creative effects for your photos and videos. And in Messenger, we're testing new camera and video features. We'll be experimenting with even more visual messaging tools over the next few months as well. So those are a few examples of some of the things that we're doing to put video first across our family of apps. Now, I'll give you an update on our progress over our 3, 5, and 10-year time horizon. Over the next 3 years, we're focusing on making our core services more useful and engaging. The 2016 Summer Olympics were huge on Facebook, with more than 270 million people creating 1.5 billion interactions. Facebook helped bring the world together. And athletes, fans, and media went live throughout the games, including athletes who went live from the Olympic Village, and Michael Phelps, who even announced his retirement on our platform. This election season has also driven a lot of conversation, including on Facebook, where we've made it easier for voters and candidates to communicate with each other. In the first nine months of this year, 109 million people on Facebook in the U.S. generated over 5.3 billion posts, comments, and likes and shares related to the election. During the primaries and in September, we also added a Register to Vote link at the top of our Facebook app that we estimate helped more than 2 million people register to vote, some who were registering for the first time. Facebook really is the new town hall, and we're proud of the role that we've played in enabling dialogue and increasing civic engagement. That's the 3-year update. Over the next 5 years, we're going to keep building ecosystems around products that a lot of people already use every day. Instagram, Messenger, and WhatsApp each have large communities, but we have a lot more work to do on all of them. I think about our progress here in three phases. The first phase is building a great consumer experience and getting it to scale. The second phase is about enabling people to organically interact with businesses. And then the third phase is to give businesses tools to reach more people, and that's where we build our business. Right now, Instagram has moved into that third phase. Instagram has more than 500 million monthly actives and more than 300 million daily actives. We're making good progress helping businesses and marketers use Instagram in new ways, and Sheryl will talk more about that in a few minutes. Messenger is early in the second phase. We're helping businesses and consumers increasingly interact in richer ways. Today there are 33,000 bots live on Messenger. We also launched Messenger Lite, which is designed to make messaging fast and easy with a wide variety of Android phones and for people who are on slower networks as well. A lot of businesses use WhatsApp already, but we're going to really start working on the second phase in the next year. Right now, we're testing new camera features and we're continuing to keep features fast and reliable on multiple devices and every network condition. Finally, we're starting to build communities around completely new apps. This quarter, we launched Workplace to help make organizations more connected and productive. Workplace is a communications platform that uses features that people know, like News Feed, groups, and messages to help them collaborate and share at work the same way that they do everywhere else. Already, more than 1,000 organizations are using Workplace, including Starbucks, Royal Bank of Scotland, and Danone, and we're adding more all the time. We're also getting new services to scale in the core app. In October, we also launched the Marketplace tab to help people discover, buy, and sell things with people in their community. While we just launched Marketplace, many millions of people have been buying and selling things in Facebook for-sale groups for a while, and we think this is going to be an important tool going forward. Over the next 10 years, we're going to continue to invest in the platforms and technologies that will connect more people and more places and allow everyone in the world to have a voice. We focused our long-term innovation roadmap around three areas: connectivity initiatives that bring more people online; artificial intelligence; and virtual and augmented reality. On connectivity, through our efforts with internet.org, we've connected 40 million people, based on our best estimate. And we're making good progress with our Express Wifi program, which empowers entrepreneurs to build a business by providing their community with access to the Internet. On artificial intelligence, we're starting to see the impact that AI can have on enhancing people's experiences on Facebook and showing them more of what they care about. More than 40 teams at Facebook and more than 25% of our engineers are already using AI to power the products and services they build. We've made changes and improvements to our AI in order to filter out misleading clickbait stories from News Feed. And we're using AI to help find terrorist propaganda on Facebook. It's still early, but we think that AI will help improve the quality of what people see and can share on our platform. We also took some important steps forward on virtual reality to help people experience the world in richer and more immersive ways. At Oculus Connect, we announced that touch controllers for Rift will ship in early December with 35 games and experiences exclusively built for touch. And since we believe the next phase of VR is great software experiences, we're investing another $250 million in virtual reality content on top of the money that we've already invested. So this was a very busy third quarter, and 2016 is shaping up to be a year of important progress for Facebook. Our business is performing well. And while I'm happy about what we've accomplished, we're really just getting started. We want to continue to invest aggressively to accomplish our goals, which is why we're hiring, especially in engineering, which is going to be one of our top priorities going into 2017, and Dave will say more about this in his remarks. Everything we do is about opening the world to everyone and helping more people to connect and share. So I want to thank our entire community, all of our teams, our partners, and our shareholders for being a part of this journey with us. Now, here's Sheryl.
Sheryl K. Sandberg - Facebook, Inc.: Thanks, Mark, and hi, everyone. We had a great third quarter. Q3 ad revenue grew 59%. Mobile ad revenue reached $5.7 billion, up 70% year-over-year, and was approximately 84% of total ad revenue. Our growth was broad-based across all regions, marketer segments, and verticals. In Q3, we announced that we have over 4 million active advertisers on Facebook and over 500,000 active advertisers on Instagram. The number of advertisers on both platforms continues to grow quickly, and we're pleased to see more and more of them using the full range of our ad products. We continue to focus on our three priorities: capitalizing on the shift to mobile; growing the number of marketers using our ad products; and making our ads more relevant and effective. First, capitalizing on the shift to mobile, people have shifted to mobile, and we remain focused on helping businesses catch up. We know that marketing shifts take time. The first TV ads showed people standing in front of microphones reading their radio ads. Similarly, many of the first mobile video ads were TV ads dropped into mobile. Ads optimized for each platform often perform better, so marketers are increasingly tailoring their creative for mobile. We're excited to see the world's largest advertisers realize that the small screen is big. In September, P&G Chief Brand Officer, Marc Pritchard, GM CEO, Mary Barra, and I addressed the Adweek audience together. Marc described how P&G is creating mobile video ads designed to grab attention in the first few seconds. He shared the example of Tide. In a typical TV ad, they start with a clean dress or shirt, show it getting stained, and then cleaned it with Tide. On mobile, they need to communicate the product's value more quickly, so they start by showing Tide cleaning a stained garment. Mary shared GM's success with Facebook mobile video ads. In Q3, GM subsidiary, Holden, used carousel ads with video to maximize its sponsorship of Australia's premier rugby tournament. Holden created a video series about their support of the youth rugby. The ads generated an 8-point lift in brand favorability for the overall audience and a 15-point lift amongst their target audience of women over 35. For many small businesses, the shift to mobile means leveraging video for the very first time. Rather than needing a camera crew and production budget, anyone with a smartphone can shoot a video and share it on Facebook. In the past month alone, over 3 million small businesses have posted a video on Facebook, including organic posts and ads. Our second priority is growing the number of marketers using our ad products. We continue to focus on our advertiser pipeline. In Q2, we announced that over 60 million businesses use our free Facebook Pages product each month. And we introduced the Instagram equivalent, Business Profiles, which are being used by 1.5 million businesses. On past calls, I talked about product simplification as a driver of advertiser growth on Facebook. Now with the launch of Promoted Posts, we are seeing that on Instagram too. Like Boosted Posts on Facebook, Promoted Posts on Instagram are an easy way to start advertising, and we're pleased with the adoption. Over 85% of business pages are active on mobile, so we're making it easier for advertisers to manage campaigns from their phones. In Q3, we added a feature that shows marketers a preview of a potential ad in News Feed, just as their customers would see it. They can then run the ad with just a few taps from their mobile device. Making it easy to advertise from a mobile phone is especially important in emerging markets. For businesses operating in areas with weak network connections, we continue to build advertising tools into Facebook Lite, our low bandwidth app, and are making more of them available offline. Our third priority is making our ads more relevant and effective. Our goal is to be the number one driver of growth for our clients. In Q3, we introduced tools to help businesses find people around the world who look like their current customers and target the ones most likely to convert. For example, SA Company, an outdoor gear and apparel business started by a young man out of his parents' home, used international Lookalike targeting to reach customers in 32 countries and increase sales by 37%. We're focused on driving purchases online and in stores. In Q2, we launched Estimated Store Visits, which show advertisers how many people came to their store after seeing an ad. And this quarter, we made it possible for advertisers to optimize campaigns for in-store visits. We also expanded Dynamic Ads, a proven way to drive online sales for in-store retail objectives. Businesses can use Dynamic Ads for Retail to show people the products available at their closest location in real time and reach people likely to visit their stores. To prove the value we're driving for our partners, we continue to invest in measurements. This quarter we announced new third-party partnerships with Nielsen DataLogix, Visual IQ, and MarketShare to help our clients measure how Facebook ads drive business results. We're pleased with the value we're driving for our partners and remain focused on helping them make the shift to mobile. With only a small fraction of businesses on Facebook and Instagram advertising, we have a lot of opportunity in front of us. We also have a lot of hard work to do to help our partners around the world use mobile to drive their businesses. I want to thank our clients around the world for their partnership and congratulate our global teams on the results of their continued focus and dedication. Thanks, and now here's Dave.
David M. Wehner - Facebook, Inc.: Thanks, Sheryl, and good afternoon, everyone. Q3 was another strong quarter for Facebook. Total revenue grew 56% and exceeded $7 billion for the first time. And we delivered $2.4 billion in GAAP net income, up 166%. We saw healthy growth and engagement in our community as well as broad-based strength in our mobile ads business. Let's start with our community metrics. In September, 1.18 billion people used Facebook on an average day, up 172 million or 17% compared to last year. This daily number represents 66% of the 1.79 billion people that used Facebook in the month of September. Mobile continues to drive our growth, with 1.09 billion people accessing Facebook on mobile on an average day in September, up approximately 197 million or 22% compared to last year. Turning now to the financials, my comments today will focus on our GAAP financial metrics, and all of our comparisons are on a year-over-year basis unless otherwise noted. A reconciliation of our GAAP to non-GAAP financial metrics is included in our press release and earnings slides. Q3 total revenue was approximately $7 billion, up 56%. Q3 ad revenue was $6.8 billion, up 59%. Exchange rates did not impact our overall growth this quarter, as headwinds in certain currencies were offset by tailwinds in others. Asia-Pacific and North America were our fastest growing regions, with ad revenue growth rates of 64% and 62% respectively. Ad revenue grew at a rate of 50% or more in all regions in Q3. Mobile ad revenue was $5.7 billion, up 70% and representing approximately 84% of total ad revenue. On prior calls, we discussed the supply and demand factors that drive our mobile ads business. As Sheryl noted earlier, advertiser demand remained strong in Q3 across all geographies, verticals, and marketer segments. We also benefited from growth in users, time spent, and ad loads. It is worth noting that desktop ad revenue grew 18%, which is higher than growth rates in recent quarters, and was aided by our efforts to limit the impact of ad blockers on advertising served via web browsers. Our price/volume trends were similar to those we reported last quarter. The average price per ad increased 6% in Q3, while total ad impressions increased 50%. The reported increase in price continues to be driven by the ongoing mix shift towards mobile, where we show only higher priced feed ads. Impression growth was primarily driven by mobile feed ads on Facebook and Instagram. Payments and other fees revenue was $195 million, down 3%. Payments and other fees revenue is largely generated from games played on personal computers, which has declined as people spend less time on their PCs. Q3 total expenses were $3.9 billion, up 28%. This includes $839 million of share-based compensation expenses and related payroll taxes as well as $195 million of amortization of intangible assets. In Q3, we hired over 1,200 people and ended the quarter with approximately 15,700 employees, up 31% compared to last year. We remain committed to investing aggressively in hiring, including expanding our technical and recruiting teams globally. Q3 operating income was $3.1 billion, representing a 45% margin. Our tax rate was 25%. GAAP net income was $2.4 billion or $0.82 per share. Q3 capital expenditures were $1.1 billion. Year to date through September, capital expenditures were $3.2 billion, up 76%, driven by investments in data centers, servers, office buildings, and network infrastructure. In addition to our new data center projects in Texas and Ireland, we recently broke ground on our seventh data center facility in New Mexico, which we anticipate will come online in late 2018. We generated approximately $2.5 billion of free cash flow and ended the quarter with $26.1 billion in cash and investments. Turning now to the outlook for the remainder of 2016, first, some color on revenue. We continue to expect that revenue growth rates will decline in Q4 as we lap a strong fourth quarter in 2015. We also continue to expect that our total payments and other fees revenue in Q4 will be lower than it was in the fourth quarter of last year. Turning now to the 2016 expense outlook, based on our year-to-date results and our updated view of the remainder of the year, we are adjusting our expense guidance ranges. We now expect that full-year 2016 GAAP expense growth will be at the lower end of our prior range of 30% to 35%. We expect full-year 2016 amortization expenses to be approximately $700 million to $800 million and that full-year 2016 share-based compensation expenses to be approximately $3.2 billion to $3.3 billion. Accordingly, we anticipate that our total non-GAAP expenses, which exclude those share-based compensation and amortization expenses, will grow in the range of 40% to 45%, down from our prior range of 45% to 50%. We anticipate full-year capital expenditures to be approximately $4.5 billion, as we invest aggressively to support the rapid growth of the business. We expect that our Q4 and full-year 2016 tax rates will be in line with the year-to-date tax rates. I also wanted to provide some brief comments on 2017. First on revenue, as I mentioned last quarter, we continue to expect that ad load will play a less significant factor driving revenue growth after mid-2017. Over the past few years, we have averaged about 50% revenue growth in advertising. Ad load has been one of the three primary factors fueling that growth. With a much smaller contribution from this important factor going forward, we expect to see ad revenue growth rates come down meaningfully. Secondly on expenses, though it is premature to provide specific expense guidance, as Mark mentioned, we anticipate 2017 will be an aggressive investment year. Adding top engineering talent remains one of our key investment priorities as we continue to execute on our 3, 5, and 10-year roadmap. We will continue to invest in our ability to recruit top technology talent, both in the Bay Area and beyond. In addition, we expect to grow capital expenditures substantially, as we continue to fund the ongoing data center expansion effort that we have underway. Finally, I wanted to share some plans on the use of cash starting in 2017. Beginning in January, we intend to fund withholding taxes due on employee equity awards via net share settlement rather than our current approach of requiring employees to sell our shares of common stock to cover taxes upon vesting of such awards. We expect this change will increase our cash outflows and correspondingly result in less dilution. If we had used this approach in 2016, our cash outflows would have increased by approximately $1.8 billion in the year through September. To wrap things up, Q3 was another strong quarter for Facebook. Our results reflected the continued growth in engagement of our community around the world and the strength of our mobile ads business. With that, operator, let's open up the call for questions.
Operator: Thank you. Your first question comes from the line of Brian Nowak with Morgan Stanley. Your line is open.
Brian Nowak - Morgan Stanley & Co. LLC: Thanks for taking my questions, I have two. The first one, the past couple quarters you've given us a metric on the growth in time spent per user across the three big platforms. Any update at all on that around this quarter and what you're seeing? And then the second one, just on the Instagram Stories 100 million DAUs, any help at all on what the demographics or the age of those people look like? And how do you think about engagement of those users? Thanks.
David M. Wehner - Facebook, Inc.: I can take the first one, Brian, on the time spent metric. We're pleased with the growth in time spent per DAU that we're seeing across the Facebook family of apps. And that includes the Facebook mobile app, where we saw good year-over-year growth in time spent per DAU. Their video is making a big contribution to time spent growth, but we are not providing a specific stat on time spent growth on an ongoing basis.
Sheryl K. Sandberg - Facebook, Inc.: We're also not providing a specific breakdown of the DAU growth in Instagram Stories, but we're really excited about the engagement with the product and how it's growing across the board.
Operator: The next question is from Eric Sheridan with UBS. Your line is open.
Eric J. Sheridan - UBS Securities LLC: Thanks for taking the questions, maybe one for Sheryl and one for Dave. Sheryl, on local business and small business, as you continue to see success there, I wondered if we could get increased color on what you're seeing from an adoption curve on business pages. What are people looking for in terms of measurement attribution? What's Facebook delivering for those advertisers? Any color there would be very, very helpful. And then, Dave, as we try to digest some of the comments you made about ad load and revenue as we exit 2016, go to 2017, how should we also be thinking about the mix of ad units as you continue to see more e-commerce and video in the platform? And how should we be thinking about the pricing of ad units as that mix changes over time? Thanks so much, guys.
Sheryl K. Sandberg - Facebook, Inc.: On local, we think this is a really big opportunity, and you see this in the large base of existing businesses using Facebook and Instagram increasingly. There are 60 million small business pages up on Facebook and 1.5 million Instagram business profiles, which are the similar, the equivalent for Instagram. And the reason we think people are so active is it's just really expensive and hard to have your own mobile site or your own even webpage. Thirty-five percent of small businesses in the United States, which is the most developed market in many cases, don't even have a webpage of any kind. And it's cheaper and easier to build a webpage than it is to build a mobile app and get distribution or downloads. And so what's happening is that people are really using the Facebook business pages and increasingly the Instagram business profile as their mobile presence, and we think that's what's working. And then we're working hard to build products that work, in-store visits, and then to use simplified ad products that convert them over to advertising.
David M. Wehner - Facebook, Inc.: Eric, it's Dave. Just really reiterating what I said last quarter about our expectations on ad load going into mid-2017, it's been one of the key factors in terms of driving growth along with time spent – user growth and time spent growth and advertiser demand. So we continue to see good opportunities to grow time spent, continue to see good opportunities to grow users, and we continue to see good opportunities to grow advertiser demand. On that latter point, really the mix of ad units is part of what we're doing I think really well. We're developing a number of new ad products as well as enhancing the ad products that we have out in the market today. So we're taking what is a great mobile ad product on Facebook and Instagram and making it even better. And I think the investments that we're doing there will continue to enable us to drive advertiser demand. So those key factors will continue, we believe, to drive growth next year. So what I'm specifically talking about is ad load and our anticipation that it's going to be a less significant factor as we get into mid-2017.
Operator: The next question is from Anthony DiClemente with Nomura. Your line is open.
Anthony DiClemente - Nomura Securities International, Inc.: Good afternoon, thanks for taking my questions. For Mark, in terms of video and your broader media content strategy, just trying to think about your investment in Facebook Live, and then trying to frame that against investments in I guess non-live forms of video, such as maybe short form, prerecorded, professional content. So how do you weigh investing in live versus let's call it on-demand content? And maybe a related question would be, FOX Sports and Sports Illustrated are co-producing some original content for Facebook Live. I think they're doing a pregame show ahead of the big game tonight. So that seems like, in some ways, it's an entree into sports perhaps for Facebook. Could you give us an update on whether or not you see any advantage or any benefit in licensing sports content over time versus having one of the publishers do it on the Facebook platform? Thanks.
Mark Elliot Zuckerberg - Facebook, Inc.: Sure. So there was a lot in there, and I'll address most of it. The video-on-demand content is the vast majority of video that is both shared and consumed on Facebook, not live video, but live is growing very quickly. And part of the reason why we're investing in it is we see that video as a medium is not only in the future going to be about people producing content that looks like traditional content and then consuming it in a static rectangle video screen. So live video we think represents an example of something new, which is video which is a medium for doing something that's really interacting with other people. Whether you're a public figure that is using it to hold a town hall or interact with a lot of people at the same time, or you're hanging out with your friends by going live and you have 10 people who are just there with you chatting with you while you're doing something, going about throughout your day, it's not the kind of traditional video experience; it's actually a more social experience. I think 360 videos in another way are another example of this kind of interactive video experience, and my guess will be that we will see more different kinds of video media as time goes on. I think Stories is another example of this. We're seeing it with Instagram Stories and with Messenger and the initial test that we have with Messenger Day, where that is another interesting format for how you can put videos together. And I think that's going to be more and more. But to put that all in context, the majority of consumption today is video on demand. We are very interested in making sure that the business model that we have works for folks who produce content as their business to make sure they can make money from it, so that their best content comes on Facebook. So it's going to be a lot of growth in all of these things across all our family of apps.
Operator: The next question is from Mark May with Citi. Your line is open.
Mark A. May - Citigroup Global Markets, Inc. (Broker): Thanks a lot. I think the first one is for Mark. When you went mobile-only or started this concept, you had to tweak the app because it wasn't necessarily optimized for mobile. As now you begin to move to more of a video first approach, what needs to happen to the Facebook app both from a consumer-facing and from an ad tools perspective to make sure that you're optimized for video? What needs to change? And then I think the next question is for Dave. As the rate of growth in ad loads slows and also as you continue to enhance targeting and as more video advertisers come onto Facebook, would you expect that eCPMs will rise and offset part, if not all, of this impact of the ad loads slowing? Thanks.
Mark Elliot Zuckerberg - Facebook, Inc.: So I can talk about shifting to put video first across our whole family. There are two broad sets of improvements that I think we need to make. One are to the capture and sharing tools that we offer. So the example of that is the new camera that we're working on and all the creative tools around that. And then on the other hand, we also need to improve the infrastructure to deliver the best videos to people and do that quickly. So if you think about what is enabling video to become huge right now, it's that fundamentally the mobile networks are getting to a point where a large enough people around the world can have a good experience watching a video. If you go back a few years and you tried to load a video in News Feed, it might have to buffer for 30 seconds before you watched it, which wasn't a good enough experience for that to be the primary way that people shared. But now it loads instantly. You can take a video and upload it without having to take five minutes to do that, so it's a good experience. So we're very focused on creative tools. You can see that a little bit in the announcement and launch of Instagram Stories and what we're doing with Messenger and some of the additional tests on Facebook and the camera work that we're doing in WhatsApp. So this is across the whole family of apps. This is a big part of the product experience that we want to deliver. And then on the actual delivery of video side, it's just much more intensive technically. So there aren't that many companies that can do this at the scale that we're talking about, and this has been a big advantage for us. In rolling out things like Live, we've had this infrastructure that we've been building out for a decade all around the world, and that allowed us to build a product like Live where someone has to stream something live from their phone to potentially hundreds of thousands of people around the world. From a phone, that's a difficult scaling problem. So we've been able to build that up, not just because of the ongoing investment in technology and infrastructure here, but because we're building on this strong base. That goes not only for just being able to deliver the content, but being able to understand what it is so we can rank it in News Feed better and show people the right content. But all of these things are going to be part of a cohesive experience to get behind our community. And when people are ready and want video to be the primary way that they're sharing and consuming content, we're going to be there ready.
David M. Wehner - Facebook, Inc.: Mark, on ad load growth slowing and the impact on effective CPMs, I think when you look at our business, demand has been one of the key factors driving growth. So we've built up a large base of advertiser demand. We've got 4 million advertisers on Facebook; 0.5 million advertisers on Instagram. We continue to innovate on the products to make them more effective and make this a great gateway for businesses to come onto Facebook and come into mobile and spend. And we expect we've got a lot of great opportunities to continue to innovate on that front. But we've also been innovating over the past several years. So demand has been a big factor in what's been driving our growth to date. On top of that, we've grown users and time spent, and then we've also grown ad load. So I do think as we look into 2017, we do expect that as you get to mid-2017, ad load will be a less significant factor contributing. We'll continue to get benefits of being able to grow our revenue with advertiser demand and continuing to innovate there. But I do think that as we slow ad load growth, we're going to have a slowing in revenue as well. So that's our expectation, but obviously we're going to continue to work hard to innovate in the ad product space.
Operator: The next question is from Mark Mahaney with RBC Capital Markets. Your line is open.
Mark Mahaney - RBC Capital Markets LLC: Okay, two questions. A product question for Mark, in trying to – you're talking about some of these features and making the camera more of a central way of communicating on Facebook. How long do you think the iterations or the testing is going to go until, as an average user, I would notice that in my News Feed? Like I do see much more prevalence of live video, and it doesn't seem to me yet a perfect experience. But just in terms of other features and putting the camera at centerpiece, do you think this is something that's going to be obvious to people in the next year, couple of months? Just what's the timing of the innovations? And then real quickly, MAU growth seemed to accelerate in both Asia and rest of world. Any color on what would have caused that or any particular markets? Thank you.
David M. Wehner - Facebook, Inc.: I can take the MAU growth first, and then Mark can talk about camera. On the MAU front, we're seeing very strong overall growth in terms of the 240 million-plus MAUs that we added. If I was to point to – there's really no single driver, but I'll point to a few that contributed. And it also plays into the fact that we're seeing good growth in places like India, Mexico, Brazil, and others. First, we're improving our Android experiences, and we've talked about the impact that Facebook Lite has had on that, just making easier registration processes, just making Android – our lightweight Android app easier to use. Secondly, Mark talked about the internet.org efforts that we have. That's been a contributing factor to MAU growth. And then finally, we're seeing the introduction of low-priced data plans in markets like India and Mexico contributing. So there's no single factor, but those are all contributing factors in terms of MAU growth. And then, Mark, do you want to talk about the camera?
Mark Elliot Zuckerberg - Facebook, Inc.: Sure. So we already rolled out the first test of the new camera in Ireland. And we're a company that believes in testing things and getting feedback from our community before we roll it out broadly. We think we have a lot to learn. And the methodology of how we develop is we try to build things quickly. And rather than just relying on our own intuition, although we do rely on that a lot, we will try to put it out in the market and get feedback and then roll it out from there. So we rolled out what we believe is a good experience in Ireland. They were the first part of the community to get access to these new features. And then from there, we'll start to roll it out broadly across the world, hopefully sooner rather than later. Same thing on the Messenger side, as I mentioned, these products around my day, it's a similar video medium to Instagram Stories and a similar camera to what we're building in the Facebook app as well. And that we rolled out in a few countries as well. And similarly, based on the feedback that we're getting, I would expect that we'll be rolling that out pretty widely across the world soon as well.
Operator: The next question is from Douglas Anmuth with JPMorgan. Your line is open.
Douglas T. Anmuth - JPMorgan Securities LLC: Thanks for taking the questions. We're going to stick with video, one for Mark and then one for Sheryl. Mark, how do you think about, whether with video in terms of doing it on core Facebook itself or on a separate video app, some of the puts and takes there between those two? And then, Sheryl, can you just talk about with video, how you see marketers using Facebook more to complement TV and what it would take to shift dollars over in a bigger way going forward? Thanks.
Mark Elliot Zuckerberg - Facebook, Inc.: So in the main Facebook app, we're doing a number of different things. One is that video is naturally becoming a larger share of the content in News Feed because both people and pages are sharing more videos as a mix and people want to consume that content. So there's not really a question of whether that should be a separate app. This is what people want News Feed to be increasingly, so this is what it will become. There is a second experience called Video Home, which we started talking about earlier in the year. and we've rolled out again in a few markets, and those tests have gone well. So we're also hoping to roll that out pretty soon widely. And that's the new experience, which if you come to Facebook and you specifically want to watch some different kinds of videos or you want to see what videos a recent page that you follow has posted or the Presidential debate is on and you want to find a good place to go online to get that, you can go to Video Home and see that. That is a new experience that we're building, and building that as part of Facebook is a great way for people to see it and get exposure to it, and we'll see where that goes over time. I think it's a good experience inside Facebook, but we also have had examples over time, like Messenger for example, where we started it in Facebook and decided that in order to fulfill their potential, it needed to be its own experience over time. So we'll look at all those options, but for now I really think that Video Home is going to be a great experience, and I'm excited to roll that out.
Sheryl K. Sandberg - Facebook, Inc.: When we think about video ads and what platform they run on, we really believe that over time the dollars will shift with eyeballs, and our goal is to be the best dollar and the best minute people spend measured across channels. It's definitely true that most of our advertisers are advertising on TV and advertising with us on mobile, and they should be. And we've done studies that show with Nielsen that our ads can be a really big complement to TV, particularly enabling you to reach people who really aren't on TV and you can't reach. I think the power of what we're able to do really goes to the targeting. And what we're seeing is big brand advertisers, and this is actually particularly strong growth. This quarter was particularly strong for brand, are really recognizing that they can do big brand buys on our platform like they would do on TV, but make them much more targeted. So for example, Nestlé Purina PetCare did an ad campaign in Germany with ZenithOptimedia, and they defined five distinct cat owner personality types and created different creatives for each group. So that's a big brand thing. The cat food category is big and they want brand awareness. But rather than just run one ad, they were able to run five based on the interest base and personality targeting that really only we can do. And the results were amazing. They got an 89% increase in brand awareness and a 20% lift in sales. And so we think what we offer is the power of the broad reach of TV, but an ability to target much more efficiently.
Operator: The next question is from Ross Sandler with Deutsche Bank. Your line is open.
Ross Sandler - Deutsche Bank Securities, Inc.: Great, I just have one for Mark. Any update on the revenue ideas for Messenger that might be getting traction? I know it's still early days, but any early indications there? And based on the three phases you laid out earlier in the call, when can we expect Messenger to move into Phase 3? Thank you.
Mark Elliot Zuckerberg - Facebook, Inc.: So I'd say we're pretty early in Phase 2. Just to recap the framework that we have here, the strategy is there are three phases for that. We build and then build businesses around these apps. The first is build an experience and get it to scale, to build a community that can get to hundreds of millions or 1 billion people or more. The second phase is help people not only interact with the people they care about, but also the businesses and other public entities that they care about as well. And then the third phase is once there's good organic interaction between people and those businesses, give those businesses tools that they can pay for to reach more people and amplify those interactions. So I mentioned this stat earlier that we have about 33,000 bots that are live in Messenger, including experiences across a range of verticals, from news to e-commerce to local businesses and all kinds of different things, and we're seeing some early progress. I'd say we're still pretty early on in getting this to be widely rolled out. I think we're going to need many more than 33,000. And the number of people using them, I think it's still pretty early in terms of there are more than 1 billion people using Messenger, so we need to get that rolled out pretty widely. So I'm not sure that I have an answer for you just yet on exactly when we're going to move to the third phase. The one thing that I would say in terms of making money through Messenger is we're already driving results for businesses by letting them advertise in News Feed to open up threads in Messenger, which is different from the long-term vision that we have here around creating interactions that start in Messenger. I think that that will ultimately be most of the value that's generated. But in the near term, what we've found is that a lot of businesses are creating ads in News Feed that then they can follow up and do transactions with people in Messenger, and I think that's going to be pretty meaningful over the next few years.
Operator: The next question is from Heather Bellini with Goldman Sachs. Your line is open.
Heather Bellini - Goldman Sachs & Co.: Great, thank you. I just had a couple questions left. One, I was just wondering. Given your comments on the local and small business opportunity, I'm wondering what your view is on Facebook's potential role in the payment ecosystem and how that might evolve over time. And also, if you could, share with us how the rollout of Instagram Shopping, which people have started to talk about, how that might evolve over time as well. Thank you.
Sheryl K. Sandberg - Facebook, Inc.: In terms of payments, we really see payments as primarily a way to enforce the other activities we want to see on Facebook and Instagram. So payments enable advertisers to pay us. We are using payments in some of our other products in ways that enable some of the interactions we want to see. When we think about Instagram Shopping, it's very early tests, but it really follows the kinds of things we do in other areas of our products and services, like Messenger. What we see is that people in Instagram are using Instagram to browse for products and make those connections, and so we then make the product investments to make those a little bit easier. Similarly, to some of the things we've done in Messenger, some of the things we've done in Marketplace, we're watching for what is the organic activity between businesses and consumers, and then we're building products to enhance and enable that organic activity.
Operator: Your next question is from Peter Stabler with Wells Fargo Securities. Your line is open.
Peter C. Stabler - Wells Fargo Securities LLC: Good afternoon. Thanks for taking the question, one for Sheryl. Sheryl, you guys have talked about your top verticals as being e-commerce, CPG, entertainment media, and gaming. And despite your really significant growth, I can think of some categories where you've got some more considered purchases where you're probably punching below your weight in terms of share, so auto, telecom, travel, financial services. I'm wondering if you could talk a little bit about some of the unique challenges with those verticals and how you guys are attacking them. Thanks so much.
Sheryl K. Sandberg - Facebook, Inc.: You have our top verticals correct, and we see a lot of strong growth in those verticals. Our top verticals this time are e-commerce, CPG, retail, and entertainment media. We do see growth in the other verticals as well. You're right that historically it took us a longer time to break into some of these, particularly travel and auto were things that took us longer, but we are seeing some really nice traction. I talked about Mary Barra and what she and I did together in New York at Adweek, and we're seeing them not just use the platform for advertising but really use the platform. So earlier this year, they rolled out a car at CES on Facebook video rather than at a car show. And that was a big moment for us, I think, in the auto vertical. And we continue to work with them and lots of other partners. Measurement is really key there. The better we can do with dealers and with auto manufacturers at measuring all the way through the purchase, the better off we are. And I think they know that people are doing the research for autos and the purchases they make, which is a very long sales cycle on their mobile phone, and they want us to be part of that. Similarly with travel, this is a vertical that we are really investing in. We have rolled out different types of product ads that we think will help. So in Q2, we rolled out Dynamic Ads that were specifically focused on the travel vertical, and I'll share one example. Celebrity Cruises used these Dynamic Ads for travel on both Facebook and Instagram to increase their online bookings. They worked with one of our FMPs, StitcherAds, and they created custom audiences who viewed specific itineraries by date. So they look for people that at a certain date have used specific itineraries and then created Dynamic Ads which showed the available cruises and pricing and had a Book Now button. They saw a three times increase in their online bookings and I think those kind of results are made possible by more vertical-specific products, and we're going to continue to invest there.
Operator: The next question is from Justin Post with Bank of America Merrill Lynch. Your line is open.
Justin Post - Bank of America Merrill Lynch: Hi, thanks for taking my call. Dave, could you clarify a bit on investment year, what that means? Does that mean expenses growing faster than revenues? And then I think Mark mentioned $250 million on content for VR. Anything else in there that we should be thinking about? And then maybe one housekeeping, ad blocking, could you quantify how much that might have helped desktop revenues? Thank you.
David M. Wehner - Facebook, Inc.: Justin, just on investment year, I'm not giving specific commentary around revenue growth versus expense growth. What I wanted to provide was just some color around our thinking about investment going into 2017. Obviously, on the CapEx side, we've got a number of projects underway on the data center front. So clearly on that front, we've got a lot of projects that are going to need ongoing funding going into 2017, so that we've got good visibility on. In addition, while it's too early to give specifics, I want to give some directional color around expense growth. We've already invested in accelerating our recruiting efforts, so I wanted to highlight that. That's primarily around technology, technical recruiting, software engineering, and we have a lot of opportunities that we see to invest in the long-term growth of the business. And so that's our plan going into 2017. On ad blocking, in terms of the impact, I would just point out that this quarter we had 18% year-over-year desktop revenue growth. If you look at recent quarters, it was about half of that growth rate on a year-over-year basis. So that increment, that acceleration in desktop revenue growth is largely due to our efforts on reducing the impact of ad blocking. So that's what led to the acceleration of desktop revenue growth.
Operator: The next question is from Brian Fitzgerald with Jefferies. Your line is open.
Brian P. Fitzgerald - Jefferies LLC: Thanks. You've been tweaking the News Feed algorithm to prioritize friends and family, original content. We're curious what kind of impacts you're seeing there. And is it driving more engagement and more sharing of originals? Thanks.
Mark Elliot Zuckerberg - Facebook, Inc.: Sure. So News Feed is an ongoing work that we're always improving. What we basically are trying to do is work on over time adding more and more signals to the News Feed model to help us fully value what people in the community value about the different content that we show them. So what we realized was that the model that we had previously didn't fully capture the nuance in how people preferred certain content from friends and family. So we ran a bunch of qualitative studies and talked to a bunch of people and incorporated those signals into the model, and that has had the result that the people in our community who gave us that feedback and who we worked with on this, what we had expected in terms of both increasing the quality of the content that people see, and therefore also enabling people to share more with their friends and the people that they want. But one thing that I would clarify is that I think sometimes people – in your framing of your question, you asked if we had tweaked News Feed to do this or that. This is an ongoing iterative process. We're constantly learning about what our community wants, and we will constantly be trying to incorporate new information and signals into the models to help value all of the content in the system as accurately as possible. The biggest job that we have is to show people in the community what's going to be meaningful and important to them, and that is our goal in all of these changes.
Operator: The next question is from Youssef Squali with Cantor. Your line is open.
Youssef Squali - Cantor Fitzgerald Securities: Yes, thank you, two questions. About AI, can you help us understand your ambitions for MVO executed (53:39) in its current form? Does it have a place in the workplace, or internally maybe to enhance productivity, et cetera? And about the additional functionality you've added to Pages with the delivery and a few others, can you just help us understand what you're doing around discoverability? How will people actually find these services, and do you need tools for that? And maybe timing, how quickly can we see these tools being rolled out? Thank you.
Mark Elliot Zuckerberg - Facebook, Inc.: I did not fully understand the first question, so I'm going to talk about our AI work overall. In general, what we want to do is try to understand the content that people are sharing and that's out there for them to see as best as possible. So for example, that means being able to read and understand news articles or posts that people make or messages that a person might send to a business so we can help that business auto-reply to them and get information back to the person really quickly, or understand the content so we can better understand what might be interesting to a person and show it in News Feed. Similarly, aside from the conversational and linguistic understanding, there's a whole thread of the work that we're doing on visual understanding. So understanding photos, what's in photos, what's in videos, what people are doing. That allows us to not only do things around accessibility, to show somebody who is visually impaired to be able to read to them what might be in a video or a photo. But it also helps us rank News Feed better, so that way we can help understand what is in the content and show people more of what is going to be meaningful to them. It helps us identify content that might be offensive or graphic that might violate the policies of Facebook so we can flag that and review that better. So that's the main thread of the AI work we're doing is trying to understand conversational and linguistic context and computer vision, photographic and video signals to understand what's going on there. And that will apply across basically every product that we build at the company. And then of course, there's some deeper AI research that we're doing that feeds into those applications as well. That can apply to things like ranking for News Feed and search and ads and all of our systems more broadly.
David M. Wehner - Facebook, Inc.: On the discoverability of pages, a couple of things that I would point out there. First, we continue to invest in search. So obviously, that's a good way for people to discover interesting pages, interesting businesses around them, so search is one angle there. And then of course, ads, we've got 60 million businesses with pages. They manage those pages and then they can promote those pages via our easy-to-use ad products. We try to make it very easy for businesses to promote pages, promote posts and the like. So that's an important on-ramp to mobile advertising for a number of businesses around the world. Those are the two ways that I think of from enhancing discoverability of pages on Facebook.
Deborah Crawford - Facebook, Inc.: Operator, I think we have time for one last question.
Operator: Okay, the last question is from John Blackledge with Cowen & Company. Your line is open.
John Blackledge - Cowen & Co. LLC: Great, thanks. Just as it relates to video search, do you think that Facebook has the video content depth at this point for users to search for video content and be pleased with the experience? And then second for Mark, while Facebook embarks on its video first strategy, how should we think about Facebook also evolving into a transactional platform with the recent introduction of the Marketplace? Thank you.
Mark Elliot Zuckerberg - Facebook, Inc.: Sure, so search is an area that we've been working on for a while to improve. I don't know what the most recent public stat is on that. So I'm not going to say a stat, but it's grown a lot. So we're happy with that and we think that reflects that people are getting value from the search experience, which a lot of the growth comes from people searching for posts and content in the system, not just looking up people and pages in the system. So on search, there's that. And then of course, I think that search is often driven by what unique content is in a system and not just the ability to find it. So I think what people are going to search Facebook for are finding people and content that they know is on Facebook and that isn't in other places. And that I think is driving most of the volume today and I think can get us to be – we're already one of the largest search engines in the world, but to be even bigger on that front. You asked about transactions as well. And we've spent a lot of time on this call talking about putting video first. That has certainly been the biggest theme of the last quarter and is the biggest part of the product strategy for Facebook and Instagram and is a big part of the product strategy for Messenger and WhatsApp as well. In terms of transactions, one of the big things that we see happening in messaging long term is that it's a great channel for people to interact with a business one on one and either do transactions in a private space or get support, or for businesses to reach out with very personally tailored messages and have an ongoing engagement with a person. So that's something that we're very excited about building. And that is going to be the business that we hope to build on Messenger and WhatsApp over time. So we're looking forward to that. Marketplace I think is going to be a great example of this too. What we're seeing in pages and marketers on Facebook is they want to both get awareness and drive all the way down to generating transactions, and Marketplace I think is going to help people do that. We're starting with people being able to sell things and connect to other people who want to buy them, just like they've been doing in for-sale groups for many years, but we're excited to evolve this and grow it over time as well.
Deborah Crawford - Facebook, Inc.: So thank you for joining us today. We appreciate your time and we look forward to speaking with you again.
Operator: Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines. | [
{
"speaker": "Executives",
"text": "Deborah Crawford - Facebook, Inc. Mark Elliot Zuckerberg - Facebook, Inc. Sheryl K. Sandberg - Facebook, Inc. David M. Wehner - Facebook, Inc."
},
{
"speaker": "Analysts",
"text": "Brian Nowak - Morgan Stanley & Co. LLC Eric J. Sheridan - UBS Securities LLC Anthony DiClemente - Nomura Securities International, Inc. Mark A. May - Citigroup Global Markets, Inc. (Broker) Mark Mahaney - RBC Capital Markets LLC Douglas T. Anmuth - JPMorgan Securities LLC Ross Sandler - Deutsche Bank Securities, Inc. Heather Bellini - Goldman Sachs & Co. Peter C. Stabler - Wells Fargo Securities LLC Justin Post - Bank of America Merrill Lynch Brian P. Fitzgerald - Jefferies LLC Youssef Squali - Cantor Fitzgerald Securities John Blackledge - Cowen & Co. LLC"
},
{
"speaker": "Operator",
"text": "Good afternoon. My name is Chris, and I'll be your conference operator today. At this time, I would like to welcome everyone to the Facebook Third Quarter 2016 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford - Facebook, Inc.",
"text": "Thank you. Good afternoon and welcome to Facebook's third quarter 2016 earnings conference call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our quarterly report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I'd like to turn the call over to Mark."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Thanks, Deborah, and thanks, everyone, for joining today. We had another good quarter. Our community continues to grow around the world. We're pleased to see nearly 1.8 billion people now use Facebook every month and nearly 1.2 billion people use it every day. It's also great to see the continued growth and strength of engagement on our platform, and our ads growth is growing at a healthy rate as well. Total revenue grew by 56% year over year to $7 billion, and advertising revenue was up 59% to $6.8 billion. I want to start by talking about our work around putting video first across our apps. People are creating and sharing more video, and we think it's pretty clear that video is only going to become more important. So that's why we're prioritizing putting video first across our family of apps and taking steps to make it even easier for people to express themselves in richer ways. One way we're putting video first is through live video on Facebook. Since May, the number of people going live at any given moment has grown by four times. And people have gone live from all seven continents and also from outer space. Another recent example is Instagram Stories, which we launched in August. Instagram Stories is a lightweight way for people to share moments of their day through photos and videos that appear in a slide show format and disappear after 24 hours. Stories now has more than 100 million daily actives. We also improved the Explore tab in Instagram to include more videos and stories, and it has 100 million daily actives now as well. In addition to making it easy to share video, we also want to make it easier to capture video. In most social apps today, a text box is still the default way we share. Soon, we believe a camera will be the main way that we share. We're already testing this in our main Facebook app with a version that has a camera, directly just one swipe away from News Feed, with creative effects for your photos and videos. And in Messenger, we're testing new camera and video features. We'll be experimenting with even more visual messaging tools over the next few months as well. So those are a few examples of some of the things that we're doing to put video first across our family of apps. Now, I'll give you an update on our progress over our 3, 5, and 10-year time horizon. Over the next 3 years, we're focusing on making our core services more useful and engaging. The 2016 Summer Olympics were huge on Facebook, with more than 270 million people creating 1.5 billion interactions. Facebook helped bring the world together. And athletes, fans, and media went live throughout the games, including athletes who went live from the Olympic Village, and Michael Phelps, who even announced his retirement on our platform. This election season has also driven a lot of conversation, including on Facebook, where we've made it easier for voters and candidates to communicate with each other. In the first nine months of this year, 109 million people on Facebook in the U.S. generated over 5.3 billion posts, comments, and likes and shares related to the election. During the primaries and in September, we also added a Register to Vote link at the top of our Facebook app that we estimate helped more than 2 million people register to vote, some who were registering for the first time. Facebook really is the new town hall, and we're proud of the role that we've played in enabling dialogue and increasing civic engagement. That's the 3-year update. Over the next 5 years, we're going to keep building ecosystems around products that a lot of people already use every day. Instagram, Messenger, and WhatsApp each have large communities, but we have a lot more work to do on all of them. I think about our progress here in three phases. The first phase is building a great consumer experience and getting it to scale. The second phase is about enabling people to organically interact with businesses. And then the third phase is to give businesses tools to reach more people, and that's where we build our business. Right now, Instagram has moved into that third phase. Instagram has more than 500 million monthly actives and more than 300 million daily actives. We're making good progress helping businesses and marketers use Instagram in new ways, and Sheryl will talk more about that in a few minutes. Messenger is early in the second phase. We're helping businesses and consumers increasingly interact in richer ways. Today there are 33,000 bots live on Messenger. We also launched Messenger Lite, which is designed to make messaging fast and easy with a wide variety of Android phones and for people who are on slower networks as well. A lot of businesses use WhatsApp already, but we're going to really start working on the second phase in the next year. Right now, we're testing new camera features and we're continuing to keep features fast and reliable on multiple devices and every network condition. Finally, we're starting to build communities around completely new apps. This quarter, we launched Workplace to help make organizations more connected and productive. Workplace is a communications platform that uses features that people know, like News Feed, groups, and messages to help them collaborate and share at work the same way that they do everywhere else. Already, more than 1,000 organizations are using Workplace, including Starbucks, Royal Bank of Scotland, and Danone, and we're adding more all the time. We're also getting new services to scale in the core app. In October, we also launched the Marketplace tab to help people discover, buy, and sell things with people in their community. While we just launched Marketplace, many millions of people have been buying and selling things in Facebook for-sale groups for a while, and we think this is going to be an important tool going forward. Over the next 10 years, we're going to continue to invest in the platforms and technologies that will connect more people and more places and allow everyone in the world to have a voice. We focused our long-term innovation roadmap around three areas: connectivity initiatives that bring more people online; artificial intelligence; and virtual and augmented reality. On connectivity, through our efforts with internet.org, we've connected 40 million people, based on our best estimate. And we're making good progress with our Express Wifi program, which empowers entrepreneurs to build a business by providing their community with access to the Internet. On artificial intelligence, we're starting to see the impact that AI can have on enhancing people's experiences on Facebook and showing them more of what they care about. More than 40 teams at Facebook and more than 25% of our engineers are already using AI to power the products and services they build. We've made changes and improvements to our AI in order to filter out misleading clickbait stories from News Feed. And we're using AI to help find terrorist propaganda on Facebook. It's still early, but we think that AI will help improve the quality of what people see and can share on our platform. We also took some important steps forward on virtual reality to help people experience the world in richer and more immersive ways. At Oculus Connect, we announced that touch controllers for Rift will ship in early December with 35 games and experiences exclusively built for touch. And since we believe the next phase of VR is great software experiences, we're investing another $250 million in virtual reality content on top of the money that we've already invested. So this was a very busy third quarter, and 2016 is shaping up to be a year of important progress for Facebook. Our business is performing well. And while I'm happy about what we've accomplished, we're really just getting started. We want to continue to invest aggressively to accomplish our goals, which is why we're hiring, especially in engineering, which is going to be one of our top priorities going into 2017, and Dave will say more about this in his remarks. Everything we do is about opening the world to everyone and helping more people to connect and share. So I want to thank our entire community, all of our teams, our partners, and our shareholders for being a part of this journey with us. Now, here's Sheryl."
},
{
"speaker": "Sheryl K. Sandberg - Facebook, Inc.",
"text": "Thanks, Mark, and hi, everyone. We had a great third quarter. Q3 ad revenue grew 59%. Mobile ad revenue reached $5.7 billion, up 70% year-over-year, and was approximately 84% of total ad revenue. Our growth was broad-based across all regions, marketer segments, and verticals. In Q3, we announced that we have over 4 million active advertisers on Facebook and over 500,000 active advertisers on Instagram. The number of advertisers on both platforms continues to grow quickly, and we're pleased to see more and more of them using the full range of our ad products. We continue to focus on our three priorities: capitalizing on the shift to mobile; growing the number of marketers using our ad products; and making our ads more relevant and effective. First, capitalizing on the shift to mobile, people have shifted to mobile, and we remain focused on helping businesses catch up. We know that marketing shifts take time. The first TV ads showed people standing in front of microphones reading their radio ads. Similarly, many of the first mobile video ads were TV ads dropped into mobile. Ads optimized for each platform often perform better, so marketers are increasingly tailoring their creative for mobile. We're excited to see the world's largest advertisers realize that the small screen is big. In September, P&G Chief Brand Officer, Marc Pritchard, GM CEO, Mary Barra, and I addressed the Adweek audience together. Marc described how P&G is creating mobile video ads designed to grab attention in the first few seconds. He shared the example of Tide. In a typical TV ad, they start with a clean dress or shirt, show it getting stained, and then cleaned it with Tide. On mobile, they need to communicate the product's value more quickly, so they start by showing Tide cleaning a stained garment. Mary shared GM's success with Facebook mobile video ads. In Q3, GM subsidiary, Holden, used carousel ads with video to maximize its sponsorship of Australia's premier rugby tournament. Holden created a video series about their support of the youth rugby. The ads generated an 8-point lift in brand favorability for the overall audience and a 15-point lift amongst their target audience of women over 35. For many small businesses, the shift to mobile means leveraging video for the very first time. Rather than needing a camera crew and production budget, anyone with a smartphone can shoot a video and share it on Facebook. In the past month alone, over 3 million small businesses have posted a video on Facebook, including organic posts and ads. Our second priority is growing the number of marketers using our ad products. We continue to focus on our advertiser pipeline. In Q2, we announced that over 60 million businesses use our free Facebook Pages product each month. And we introduced the Instagram equivalent, Business Profiles, which are being used by 1.5 million businesses. On past calls, I talked about product simplification as a driver of advertiser growth on Facebook. Now with the launch of Promoted Posts, we are seeing that on Instagram too. Like Boosted Posts on Facebook, Promoted Posts on Instagram are an easy way to start advertising, and we're pleased with the adoption. Over 85% of business pages are active on mobile, so we're making it easier for advertisers to manage campaigns from their phones. In Q3, we added a feature that shows marketers a preview of a potential ad in News Feed, just as their customers would see it. They can then run the ad with just a few taps from their mobile device. Making it easy to advertise from a mobile phone is especially important in emerging markets. For businesses operating in areas with weak network connections, we continue to build advertising tools into Facebook Lite, our low bandwidth app, and are making more of them available offline. Our third priority is making our ads more relevant and effective. Our goal is to be the number one driver of growth for our clients. In Q3, we introduced tools to help businesses find people around the world who look like their current customers and target the ones most likely to convert. For example, SA Company, an outdoor gear and apparel business started by a young man out of his parents' home, used international Lookalike targeting to reach customers in 32 countries and increase sales by 37%. We're focused on driving purchases online and in stores. In Q2, we launched Estimated Store Visits, which show advertisers how many people came to their store after seeing an ad. And this quarter, we made it possible for advertisers to optimize campaigns for in-store visits. We also expanded Dynamic Ads, a proven way to drive online sales for in-store retail objectives. Businesses can use Dynamic Ads for Retail to show people the products available at their closest location in real time and reach people likely to visit their stores. To prove the value we're driving for our partners, we continue to invest in measurements. This quarter we announced new third-party partnerships with Nielsen DataLogix, Visual IQ, and MarketShare to help our clients measure how Facebook ads drive business results. We're pleased with the value we're driving for our partners and remain focused on helping them make the shift to mobile. With only a small fraction of businesses on Facebook and Instagram advertising, we have a lot of opportunity in front of us. We also have a lot of hard work to do to help our partners around the world use mobile to drive their businesses. I want to thank our clients around the world for their partnership and congratulate our global teams on the results of their continued focus and dedication. Thanks, and now here's Dave."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Thanks, Sheryl, and good afternoon, everyone. Q3 was another strong quarter for Facebook. Total revenue grew 56% and exceeded $7 billion for the first time. And we delivered $2.4 billion in GAAP net income, up 166%. We saw healthy growth and engagement in our community as well as broad-based strength in our mobile ads business. Let's start with our community metrics. In September, 1.18 billion people used Facebook on an average day, up 172 million or 17% compared to last year. This daily number represents 66% of the 1.79 billion people that used Facebook in the month of September. Mobile continues to drive our growth, with 1.09 billion people accessing Facebook on mobile on an average day in September, up approximately 197 million or 22% compared to last year. Turning now to the financials, my comments today will focus on our GAAP financial metrics, and all of our comparisons are on a year-over-year basis unless otherwise noted. A reconciliation of our GAAP to non-GAAP financial metrics is included in our press release and earnings slides. Q3 total revenue was approximately $7 billion, up 56%. Q3 ad revenue was $6.8 billion, up 59%. Exchange rates did not impact our overall growth this quarter, as headwinds in certain currencies were offset by tailwinds in others. Asia-Pacific and North America were our fastest growing regions, with ad revenue growth rates of 64% and 62% respectively. Ad revenue grew at a rate of 50% or more in all regions in Q3. Mobile ad revenue was $5.7 billion, up 70% and representing approximately 84% of total ad revenue. On prior calls, we discussed the supply and demand factors that drive our mobile ads business. As Sheryl noted earlier, advertiser demand remained strong in Q3 across all geographies, verticals, and marketer segments. We also benefited from growth in users, time spent, and ad loads. It is worth noting that desktop ad revenue grew 18%, which is higher than growth rates in recent quarters, and was aided by our efforts to limit the impact of ad blockers on advertising served via web browsers. Our price/volume trends were similar to those we reported last quarter. The average price per ad increased 6% in Q3, while total ad impressions increased 50%. The reported increase in price continues to be driven by the ongoing mix shift towards mobile, where we show only higher priced feed ads. Impression growth was primarily driven by mobile feed ads on Facebook and Instagram. Payments and other fees revenue was $195 million, down 3%. Payments and other fees revenue is largely generated from games played on personal computers, which has declined as people spend less time on their PCs. Q3 total expenses were $3.9 billion, up 28%. This includes $839 million of share-based compensation expenses and related payroll taxes as well as $195 million of amortization of intangible assets. In Q3, we hired over 1,200 people and ended the quarter with approximately 15,700 employees, up 31% compared to last year. We remain committed to investing aggressively in hiring, including expanding our technical and recruiting teams globally. Q3 operating income was $3.1 billion, representing a 45% margin. Our tax rate was 25%. GAAP net income was $2.4 billion or $0.82 per share. Q3 capital expenditures were $1.1 billion. Year to date through September, capital expenditures were $3.2 billion, up 76%, driven by investments in data centers, servers, office buildings, and network infrastructure. In addition to our new data center projects in Texas and Ireland, we recently broke ground on our seventh data center facility in New Mexico, which we anticipate will come online in late 2018. We generated approximately $2.5 billion of free cash flow and ended the quarter with $26.1 billion in cash and investments. Turning now to the outlook for the remainder of 2016, first, some color on revenue. We continue to expect that revenue growth rates will decline in Q4 as we lap a strong fourth quarter in 2015. We also continue to expect that our total payments and other fees revenue in Q4 will be lower than it was in the fourth quarter of last year. Turning now to the 2016 expense outlook, based on our year-to-date results and our updated view of the remainder of the year, we are adjusting our expense guidance ranges. We now expect that full-year 2016 GAAP expense growth will be at the lower end of our prior range of 30% to 35%. We expect full-year 2016 amortization expenses to be approximately $700 million to $800 million and that full-year 2016 share-based compensation expenses to be approximately $3.2 billion to $3.3 billion. Accordingly, we anticipate that our total non-GAAP expenses, which exclude those share-based compensation and amortization expenses, will grow in the range of 40% to 45%, down from our prior range of 45% to 50%. We anticipate full-year capital expenditures to be approximately $4.5 billion, as we invest aggressively to support the rapid growth of the business. We expect that our Q4 and full-year 2016 tax rates will be in line with the year-to-date tax rates. I also wanted to provide some brief comments on 2017. First on revenue, as I mentioned last quarter, we continue to expect that ad load will play a less significant factor driving revenue growth after mid-2017. Over the past few years, we have averaged about 50% revenue growth in advertising. Ad load has been one of the three primary factors fueling that growth. With a much smaller contribution from this important factor going forward, we expect to see ad revenue growth rates come down meaningfully. Secondly on expenses, though it is premature to provide specific expense guidance, as Mark mentioned, we anticipate 2017 will be an aggressive investment year. Adding top engineering talent remains one of our key investment priorities as we continue to execute on our 3, 5, and 10-year roadmap. We will continue to invest in our ability to recruit top technology talent, both in the Bay Area and beyond. In addition, we expect to grow capital expenditures substantially, as we continue to fund the ongoing data center expansion effort that we have underway. Finally, I wanted to share some plans on the use of cash starting in 2017. Beginning in January, we intend to fund withholding taxes due on employee equity awards via net share settlement rather than our current approach of requiring employees to sell our shares of common stock to cover taxes upon vesting of such awards. We expect this change will increase our cash outflows and correspondingly result in less dilution. If we had used this approach in 2016, our cash outflows would have increased by approximately $1.8 billion in the year through September. To wrap things up, Q3 was another strong quarter for Facebook. Our results reflected the continued growth in engagement of our community around the world and the strength of our mobile ads business. With that, operator, let's open up the call for questions."
},
{
"speaker": "Operator",
"text": "Thank you. Your first question comes from the line of Brian Nowak with Morgan Stanley. Your line is open."
},
{
"speaker": "Brian Nowak - Morgan Stanley & Co. LLC",
"text": "Thanks for taking my questions, I have two. The first one, the past couple quarters you've given us a metric on the growth in time spent per user across the three big platforms. Any update at all on that around this quarter and what you're seeing? And then the second one, just on the Instagram Stories 100 million DAUs, any help at all on what the demographics or the age of those people look like? And how do you think about engagement of those users? Thanks."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "I can take the first one, Brian, on the time spent metric. We're pleased with the growth in time spent per DAU that we're seeing across the Facebook family of apps. And that includes the Facebook mobile app, where we saw good year-over-year growth in time spent per DAU. Their video is making a big contribution to time spent growth, but we are not providing a specific stat on time spent growth on an ongoing basis."
},
{
"speaker": "Sheryl K. Sandberg - Facebook, Inc.",
"text": "We're also not providing a specific breakdown of the DAU growth in Instagram Stories, but we're really excited about the engagement with the product and how it's growing across the board."
},
{
"speaker": "Operator",
"text": "The next question is from Eric Sheridan with UBS. Your line is open."
},
{
"speaker": "Eric J. Sheridan - UBS Securities LLC",
"text": "Thanks for taking the questions, maybe one for Sheryl and one for Dave. Sheryl, on local business and small business, as you continue to see success there, I wondered if we could get increased color on what you're seeing from an adoption curve on business pages. What are people looking for in terms of measurement attribution? What's Facebook delivering for those advertisers? Any color there would be very, very helpful. And then, Dave, as we try to digest some of the comments you made about ad load and revenue as we exit 2016, go to 2017, how should we also be thinking about the mix of ad units as you continue to see more e-commerce and video in the platform? And how should we be thinking about the pricing of ad units as that mix changes over time? Thanks so much, guys."
},
{
"speaker": "Sheryl K. Sandberg - Facebook, Inc.",
"text": "On local, we think this is a really big opportunity, and you see this in the large base of existing businesses using Facebook and Instagram increasingly. There are 60 million small business pages up on Facebook and 1.5 million Instagram business profiles, which are the similar, the equivalent for Instagram. And the reason we think people are so active is it's just really expensive and hard to have your own mobile site or your own even webpage. Thirty-five percent of small businesses in the United States, which is the most developed market in many cases, don't even have a webpage of any kind. And it's cheaper and easier to build a webpage than it is to build a mobile app and get distribution or downloads. And so what's happening is that people are really using the Facebook business pages and increasingly the Instagram business profile as their mobile presence, and we think that's what's working. And then we're working hard to build products that work, in-store visits, and then to use simplified ad products that convert them over to advertising."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Eric, it's Dave. Just really reiterating what I said last quarter about our expectations on ad load going into mid-2017, it's been one of the key factors in terms of driving growth along with time spent – user growth and time spent growth and advertiser demand. So we continue to see good opportunities to grow time spent, continue to see good opportunities to grow users, and we continue to see good opportunities to grow advertiser demand. On that latter point, really the mix of ad units is part of what we're doing I think really well. We're developing a number of new ad products as well as enhancing the ad products that we have out in the market today. So we're taking what is a great mobile ad product on Facebook and Instagram and making it even better. And I think the investments that we're doing there will continue to enable us to drive advertiser demand. So those key factors will continue, we believe, to drive growth next year. So what I'm specifically talking about is ad load and our anticipation that it's going to be a less significant factor as we get into mid-2017."
},
{
"speaker": "Operator",
"text": "The next question is from Anthony DiClemente with Nomura. Your line is open."
},
{
"speaker": "Anthony DiClemente - Nomura Securities International, Inc.",
"text": "Good afternoon, thanks for taking my questions. For Mark, in terms of video and your broader media content strategy, just trying to think about your investment in Facebook Live, and then trying to frame that against investments in I guess non-live forms of video, such as maybe short form, prerecorded, professional content. So how do you weigh investing in live versus let's call it on-demand content? And maybe a related question would be, FOX Sports and Sports Illustrated are co-producing some original content for Facebook Live. I think they're doing a pregame show ahead of the big game tonight. So that seems like, in some ways, it's an entree into sports perhaps for Facebook. Could you give us an update on whether or not you see any advantage or any benefit in licensing sports content over time versus having one of the publishers do it on the Facebook platform? Thanks."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Sure. So there was a lot in there, and I'll address most of it. The video-on-demand content is the vast majority of video that is both shared and consumed on Facebook, not live video, but live is growing very quickly. And part of the reason why we're investing in it is we see that video as a medium is not only in the future going to be about people producing content that looks like traditional content and then consuming it in a static rectangle video screen. So live video we think represents an example of something new, which is video which is a medium for doing something that's really interacting with other people. Whether you're a public figure that is using it to hold a town hall or interact with a lot of people at the same time, or you're hanging out with your friends by going live and you have 10 people who are just there with you chatting with you while you're doing something, going about throughout your day, it's not the kind of traditional video experience; it's actually a more social experience. I think 360 videos in another way are another example of this kind of interactive video experience, and my guess will be that we will see more different kinds of video media as time goes on. I think Stories is another example of this. We're seeing it with Instagram Stories and with Messenger and the initial test that we have with Messenger Day, where that is another interesting format for how you can put videos together. And I think that's going to be more and more. But to put that all in context, the majority of consumption today is video on demand. We are very interested in making sure that the business model that we have works for folks who produce content as their business to make sure they can make money from it, so that their best content comes on Facebook. So it's going to be a lot of growth in all of these things across all our family of apps."
},
{
"speaker": "Operator",
"text": "The next question is from Mark May with Citi. Your line is open."
},
{
"speaker": "Mark A. May - Citigroup Global Markets, Inc. (Broker)",
"text": "Thanks a lot. I think the first one is for Mark. When you went mobile-only or started this concept, you had to tweak the app because it wasn't necessarily optimized for mobile. As now you begin to move to more of a video first approach, what needs to happen to the Facebook app both from a consumer-facing and from an ad tools perspective to make sure that you're optimized for video? What needs to change? And then I think the next question is for Dave. As the rate of growth in ad loads slows and also as you continue to enhance targeting and as more video advertisers come onto Facebook, would you expect that eCPMs will rise and offset part, if not all, of this impact of the ad loads slowing? Thanks."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "So I can talk about shifting to put video first across our whole family. There are two broad sets of improvements that I think we need to make. One are to the capture and sharing tools that we offer. So the example of that is the new camera that we're working on and all the creative tools around that. And then on the other hand, we also need to improve the infrastructure to deliver the best videos to people and do that quickly. So if you think about what is enabling video to become huge right now, it's that fundamentally the mobile networks are getting to a point where a large enough people around the world can have a good experience watching a video. If you go back a few years and you tried to load a video in News Feed, it might have to buffer for 30 seconds before you watched it, which wasn't a good enough experience for that to be the primary way that people shared. But now it loads instantly. You can take a video and upload it without having to take five minutes to do that, so it's a good experience. So we're very focused on creative tools. You can see that a little bit in the announcement and launch of Instagram Stories and what we're doing with Messenger and some of the additional tests on Facebook and the camera work that we're doing in WhatsApp. So this is across the whole family of apps. This is a big part of the product experience that we want to deliver. And then on the actual delivery of video side, it's just much more intensive technically. So there aren't that many companies that can do this at the scale that we're talking about, and this has been a big advantage for us. In rolling out things like Live, we've had this infrastructure that we've been building out for a decade all around the world, and that allowed us to build a product like Live where someone has to stream something live from their phone to potentially hundreds of thousands of people around the world. From a phone, that's a difficult scaling problem. So we've been able to build that up, not just because of the ongoing investment in technology and infrastructure here, but because we're building on this strong base. That goes not only for just being able to deliver the content, but being able to understand what it is so we can rank it in News Feed better and show people the right content. But all of these things are going to be part of a cohesive experience to get behind our community. And when people are ready and want video to be the primary way that they're sharing and consuming content, we're going to be there ready."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Mark, on ad load growth slowing and the impact on effective CPMs, I think when you look at our business, demand has been one of the key factors driving growth. So we've built up a large base of advertiser demand. We've got 4 million advertisers on Facebook; 0.5 million advertisers on Instagram. We continue to innovate on the products to make them more effective and make this a great gateway for businesses to come onto Facebook and come into mobile and spend. And we expect we've got a lot of great opportunities to continue to innovate on that front. But we've also been innovating over the past several years. So demand has been a big factor in what's been driving our growth to date. On top of that, we've grown users and time spent, and then we've also grown ad load. So I do think as we look into 2017, we do expect that as you get to mid-2017, ad load will be a less significant factor contributing. We'll continue to get benefits of being able to grow our revenue with advertiser demand and continuing to innovate there. But I do think that as we slow ad load growth, we're going to have a slowing in revenue as well. So that's our expectation, but obviously we're going to continue to work hard to innovate in the ad product space."
},
{
"speaker": "Operator",
"text": "The next question is from Mark Mahaney with RBC Capital Markets. Your line is open."
},
{
"speaker": "Mark Mahaney - RBC Capital Markets LLC",
"text": "Okay, two questions. A product question for Mark, in trying to – you're talking about some of these features and making the camera more of a central way of communicating on Facebook. How long do you think the iterations or the testing is going to go until, as an average user, I would notice that in my News Feed? Like I do see much more prevalence of live video, and it doesn't seem to me yet a perfect experience. But just in terms of other features and putting the camera at centerpiece, do you think this is something that's going to be obvious to people in the next year, couple of months? Just what's the timing of the innovations? And then real quickly, MAU growth seemed to accelerate in both Asia and rest of world. Any color on what would have caused that or any particular markets? Thank you."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "I can take the MAU growth first, and then Mark can talk about camera. On the MAU front, we're seeing very strong overall growth in terms of the 240 million-plus MAUs that we added. If I was to point to – there's really no single driver, but I'll point to a few that contributed. And it also plays into the fact that we're seeing good growth in places like India, Mexico, Brazil, and others. First, we're improving our Android experiences, and we've talked about the impact that Facebook Lite has had on that, just making easier registration processes, just making Android – our lightweight Android app easier to use. Secondly, Mark talked about the internet.org efforts that we have. That's been a contributing factor to MAU growth. And then finally, we're seeing the introduction of low-priced data plans in markets like India and Mexico contributing. So there's no single factor, but those are all contributing factors in terms of MAU growth. And then, Mark, do you want to talk about the camera?"
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Sure. So we already rolled out the first test of the new camera in Ireland. And we're a company that believes in testing things and getting feedback from our community before we roll it out broadly. We think we have a lot to learn. And the methodology of how we develop is we try to build things quickly. And rather than just relying on our own intuition, although we do rely on that a lot, we will try to put it out in the market and get feedback and then roll it out from there. So we rolled out what we believe is a good experience in Ireland. They were the first part of the community to get access to these new features. And then from there, we'll start to roll it out broadly across the world, hopefully sooner rather than later. Same thing on the Messenger side, as I mentioned, these products around my day, it's a similar video medium to Instagram Stories and a similar camera to what we're building in the Facebook app as well. And that we rolled out in a few countries as well. And similarly, based on the feedback that we're getting, I would expect that we'll be rolling that out pretty widely across the world soon as well."
},
{
"speaker": "Operator",
"text": "The next question is from Douglas Anmuth with JPMorgan. Your line is open."
},
{
"speaker": "Douglas T. Anmuth - JPMorgan Securities LLC",
"text": "Thanks for taking the questions. We're going to stick with video, one for Mark and then one for Sheryl. Mark, how do you think about, whether with video in terms of doing it on core Facebook itself or on a separate video app, some of the puts and takes there between those two? And then, Sheryl, can you just talk about with video, how you see marketers using Facebook more to complement TV and what it would take to shift dollars over in a bigger way going forward? Thanks."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "So in the main Facebook app, we're doing a number of different things. One is that video is naturally becoming a larger share of the content in News Feed because both people and pages are sharing more videos as a mix and people want to consume that content. So there's not really a question of whether that should be a separate app. This is what people want News Feed to be increasingly, so this is what it will become. There is a second experience called Video Home, which we started talking about earlier in the year. and we've rolled out again in a few markets, and those tests have gone well. So we're also hoping to roll that out pretty soon widely. And that's the new experience, which if you come to Facebook and you specifically want to watch some different kinds of videos or you want to see what videos a recent page that you follow has posted or the Presidential debate is on and you want to find a good place to go online to get that, you can go to Video Home and see that. That is a new experience that we're building, and building that as part of Facebook is a great way for people to see it and get exposure to it, and we'll see where that goes over time. I think it's a good experience inside Facebook, but we also have had examples over time, like Messenger for example, where we started it in Facebook and decided that in order to fulfill their potential, it needed to be its own experience over time. So we'll look at all those options, but for now I really think that Video Home is going to be a great experience, and I'm excited to roll that out."
},
{
"speaker": "Sheryl K. Sandberg - Facebook, Inc.",
"text": "When we think about video ads and what platform they run on, we really believe that over time the dollars will shift with eyeballs, and our goal is to be the best dollar and the best minute people spend measured across channels. It's definitely true that most of our advertisers are advertising on TV and advertising with us on mobile, and they should be. And we've done studies that show with Nielsen that our ads can be a really big complement to TV, particularly enabling you to reach people who really aren't on TV and you can't reach. I think the power of what we're able to do really goes to the targeting. And what we're seeing is big brand advertisers, and this is actually particularly strong growth. This quarter was particularly strong for brand, are really recognizing that they can do big brand buys on our platform like they would do on TV, but make them much more targeted. So for example, Nestlé Purina PetCare did an ad campaign in Germany with ZenithOptimedia, and they defined five distinct cat owner personality types and created different creatives for each group. So that's a big brand thing. The cat food category is big and they want brand awareness. But rather than just run one ad, they were able to run five based on the interest base and personality targeting that really only we can do. And the results were amazing. They got an 89% increase in brand awareness and a 20% lift in sales. And so we think what we offer is the power of the broad reach of TV, but an ability to target much more efficiently."
},
{
"speaker": "Operator",
"text": "The next question is from Ross Sandler with Deutsche Bank. Your line is open."
},
{
"speaker": "Ross Sandler - Deutsche Bank Securities, Inc.",
"text": "Great, I just have one for Mark. Any update on the revenue ideas for Messenger that might be getting traction? I know it's still early days, but any early indications there? And based on the three phases you laid out earlier in the call, when can we expect Messenger to move into Phase 3? Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "So I'd say we're pretty early in Phase 2. Just to recap the framework that we have here, the strategy is there are three phases for that. We build and then build businesses around these apps. The first is build an experience and get it to scale, to build a community that can get to hundreds of millions or 1 billion people or more. The second phase is help people not only interact with the people they care about, but also the businesses and other public entities that they care about as well. And then the third phase is once there's good organic interaction between people and those businesses, give those businesses tools that they can pay for to reach more people and amplify those interactions. So I mentioned this stat earlier that we have about 33,000 bots that are live in Messenger, including experiences across a range of verticals, from news to e-commerce to local businesses and all kinds of different things, and we're seeing some early progress. I'd say we're still pretty early on in getting this to be widely rolled out. I think we're going to need many more than 33,000. And the number of people using them, I think it's still pretty early in terms of there are more than 1 billion people using Messenger, so we need to get that rolled out pretty widely. So I'm not sure that I have an answer for you just yet on exactly when we're going to move to the third phase. The one thing that I would say in terms of making money through Messenger is we're already driving results for businesses by letting them advertise in News Feed to open up threads in Messenger, which is different from the long-term vision that we have here around creating interactions that start in Messenger. I think that that will ultimately be most of the value that's generated. But in the near term, what we've found is that a lot of businesses are creating ads in News Feed that then they can follow up and do transactions with people in Messenger, and I think that's going to be pretty meaningful over the next few years."
},
{
"speaker": "Operator",
"text": "The next question is from Heather Bellini with Goldman Sachs. Your line is open."
},
{
"speaker": "Heather Bellini - Goldman Sachs & Co.",
"text": "Great, thank you. I just had a couple questions left. One, I was just wondering. Given your comments on the local and small business opportunity, I'm wondering what your view is on Facebook's potential role in the payment ecosystem and how that might evolve over time. And also, if you could, share with us how the rollout of Instagram Shopping, which people have started to talk about, how that might evolve over time as well. Thank you."
},
{
"speaker": "Sheryl K. Sandberg - Facebook, Inc.",
"text": "In terms of payments, we really see payments as primarily a way to enforce the other activities we want to see on Facebook and Instagram. So payments enable advertisers to pay us. We are using payments in some of our other products in ways that enable some of the interactions we want to see. When we think about Instagram Shopping, it's very early tests, but it really follows the kinds of things we do in other areas of our products and services, like Messenger. What we see is that people in Instagram are using Instagram to browse for products and make those connections, and so we then make the product investments to make those a little bit easier. Similarly, to some of the things we've done in Messenger, some of the things we've done in Marketplace, we're watching for what is the organic activity between businesses and consumers, and then we're building products to enhance and enable that organic activity."
},
{
"speaker": "Operator",
"text": "Your next question is from Peter Stabler with Wells Fargo Securities. Your line is open."
},
{
"speaker": "Peter C. Stabler - Wells Fargo Securities LLC",
"text": "Good afternoon. Thanks for taking the question, one for Sheryl. Sheryl, you guys have talked about your top verticals as being e-commerce, CPG, entertainment media, and gaming. And despite your really significant growth, I can think of some categories where you've got some more considered purchases where you're probably punching below your weight in terms of share, so auto, telecom, travel, financial services. I'm wondering if you could talk a little bit about some of the unique challenges with those verticals and how you guys are attacking them. Thanks so much."
},
{
"speaker": "Sheryl K. Sandberg - Facebook, Inc.",
"text": "You have our top verticals correct, and we see a lot of strong growth in those verticals. Our top verticals this time are e-commerce, CPG, retail, and entertainment media. We do see growth in the other verticals as well. You're right that historically it took us a longer time to break into some of these, particularly travel and auto were things that took us longer, but we are seeing some really nice traction. I talked about Mary Barra and what she and I did together in New York at Adweek, and we're seeing them not just use the platform for advertising but really use the platform. So earlier this year, they rolled out a car at CES on Facebook video rather than at a car show. And that was a big moment for us, I think, in the auto vertical. And we continue to work with them and lots of other partners. Measurement is really key there. The better we can do with dealers and with auto manufacturers at measuring all the way through the purchase, the better off we are. And I think they know that people are doing the research for autos and the purchases they make, which is a very long sales cycle on their mobile phone, and they want us to be part of that. Similarly with travel, this is a vertical that we are really investing in. We have rolled out different types of product ads that we think will help. So in Q2, we rolled out Dynamic Ads that were specifically focused on the travel vertical, and I'll share one example. Celebrity Cruises used these Dynamic Ads for travel on both Facebook and Instagram to increase their online bookings. They worked with one of our FMPs, StitcherAds, and they created custom audiences who viewed specific itineraries by date. So they look for people that at a certain date have used specific itineraries and then created Dynamic Ads which showed the available cruises and pricing and had a Book Now button. They saw a three times increase in their online bookings and I think those kind of results are made possible by more vertical-specific products, and we're going to continue to invest there."
},
{
"speaker": "Operator",
"text": "The next question is from Justin Post with Bank of America Merrill Lynch. Your line is open."
},
{
"speaker": "Justin Post - Bank of America Merrill Lynch",
"text": "Hi, thanks for taking my call. Dave, could you clarify a bit on investment year, what that means? Does that mean expenses growing faster than revenues? And then I think Mark mentioned $250 million on content for VR. Anything else in there that we should be thinking about? And then maybe one housekeeping, ad blocking, could you quantify how much that might have helped desktop revenues? Thank you."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "Justin, just on investment year, I'm not giving specific commentary around revenue growth versus expense growth. What I wanted to provide was just some color around our thinking about investment going into 2017. Obviously, on the CapEx side, we've got a number of projects underway on the data center front. So clearly on that front, we've got a lot of projects that are going to need ongoing funding going into 2017, so that we've got good visibility on. In addition, while it's too early to give specifics, I want to give some directional color around expense growth. We've already invested in accelerating our recruiting efforts, so I wanted to highlight that. That's primarily around technology, technical recruiting, software engineering, and we have a lot of opportunities that we see to invest in the long-term growth of the business. And so that's our plan going into 2017. On ad blocking, in terms of the impact, I would just point out that this quarter we had 18% year-over-year desktop revenue growth. If you look at recent quarters, it was about half of that growth rate on a year-over-year basis. So that increment, that acceleration in desktop revenue growth is largely due to our efforts on reducing the impact of ad blocking. So that's what led to the acceleration of desktop revenue growth."
},
{
"speaker": "Operator",
"text": "The next question is from Brian Fitzgerald with Jefferies. Your line is open."
},
{
"speaker": "Brian P. Fitzgerald - Jefferies LLC",
"text": "Thanks. You've been tweaking the News Feed algorithm to prioritize friends and family, original content. We're curious what kind of impacts you're seeing there. And is it driving more engagement and more sharing of originals? Thanks."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Sure. So News Feed is an ongoing work that we're always improving. What we basically are trying to do is work on over time adding more and more signals to the News Feed model to help us fully value what people in the community value about the different content that we show them. So what we realized was that the model that we had previously didn't fully capture the nuance in how people preferred certain content from friends and family. So we ran a bunch of qualitative studies and talked to a bunch of people and incorporated those signals into the model, and that has had the result that the people in our community who gave us that feedback and who we worked with on this, what we had expected in terms of both increasing the quality of the content that people see, and therefore also enabling people to share more with their friends and the people that they want. But one thing that I would clarify is that I think sometimes people – in your framing of your question, you asked if we had tweaked News Feed to do this or that. This is an ongoing iterative process. We're constantly learning about what our community wants, and we will constantly be trying to incorporate new information and signals into the models to help value all of the content in the system as accurately as possible. The biggest job that we have is to show people in the community what's going to be meaningful and important to them, and that is our goal in all of these changes."
},
{
"speaker": "Operator",
"text": "The next question is from Youssef Squali with Cantor. Your line is open."
},
{
"speaker": "Youssef Squali - Cantor Fitzgerald Securities",
"text": "Yes, thank you, two questions. About AI, can you help us understand your ambitions for MVO executed (53:39) in its current form? Does it have a place in the workplace, or internally maybe to enhance productivity, et cetera? And about the additional functionality you've added to Pages with the delivery and a few others, can you just help us understand what you're doing around discoverability? How will people actually find these services, and do you need tools for that? And maybe timing, how quickly can we see these tools being rolled out? Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "I did not fully understand the first question, so I'm going to talk about our AI work overall. In general, what we want to do is try to understand the content that people are sharing and that's out there for them to see as best as possible. So for example, that means being able to read and understand news articles or posts that people make or messages that a person might send to a business so we can help that business auto-reply to them and get information back to the person really quickly, or understand the content so we can better understand what might be interesting to a person and show it in News Feed. Similarly, aside from the conversational and linguistic understanding, there's a whole thread of the work that we're doing on visual understanding. So understanding photos, what's in photos, what's in videos, what people are doing. That allows us to not only do things around accessibility, to show somebody who is visually impaired to be able to read to them what might be in a video or a photo. But it also helps us rank News Feed better, so that way we can help understand what is in the content and show people more of what is going to be meaningful to them. It helps us identify content that might be offensive or graphic that might violate the policies of Facebook so we can flag that and review that better. So that's the main thread of the AI work we're doing is trying to understand conversational and linguistic context and computer vision, photographic and video signals to understand what's going on there. And that will apply across basically every product that we build at the company. And then of course, there's some deeper AI research that we're doing that feeds into those applications as well. That can apply to things like ranking for News Feed and search and ads and all of our systems more broadly."
},
{
"speaker": "David M. Wehner - Facebook, Inc.",
"text": "On the discoverability of pages, a couple of things that I would point out there. First, we continue to invest in search. So obviously, that's a good way for people to discover interesting pages, interesting businesses around them, so search is one angle there. And then of course, ads, we've got 60 million businesses with pages. They manage those pages and then they can promote those pages via our easy-to-use ad products. We try to make it very easy for businesses to promote pages, promote posts and the like. So that's an important on-ramp to mobile advertising for a number of businesses around the world. Those are the two ways that I think of from enhancing discoverability of pages on Facebook."
},
{
"speaker": "Deborah Crawford - Facebook, Inc.",
"text": "Operator, I think we have time for one last question."
},
{
"speaker": "Operator",
"text": "Okay, the last question is from John Blackledge with Cowen & Company. Your line is open."
},
{
"speaker": "John Blackledge - Cowen & Co. LLC",
"text": "Great, thanks. Just as it relates to video search, do you think that Facebook has the video content depth at this point for users to search for video content and be pleased with the experience? And then second for Mark, while Facebook embarks on its video first strategy, how should we think about Facebook also evolving into a transactional platform with the recent introduction of the Marketplace? Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Facebook, Inc.",
"text": "Sure, so search is an area that we've been working on for a while to improve. I don't know what the most recent public stat is on that. So I'm not going to say a stat, but it's grown a lot. So we're happy with that and we think that reflects that people are getting value from the search experience, which a lot of the growth comes from people searching for posts and content in the system, not just looking up people and pages in the system. So on search, there's that. And then of course, I think that search is often driven by what unique content is in a system and not just the ability to find it. So I think what people are going to search Facebook for are finding people and content that they know is on Facebook and that isn't in other places. And that I think is driving most of the volume today and I think can get us to be – we're already one of the largest search engines in the world, but to be even bigger on that front. You asked about transactions as well. And we've spent a lot of time on this call talking about putting video first. That has certainly been the biggest theme of the last quarter and is the biggest part of the product strategy for Facebook and Instagram and is a big part of the product strategy for Messenger and WhatsApp as well. In terms of transactions, one of the big things that we see happening in messaging long term is that it's a great channel for people to interact with a business one on one and either do transactions in a private space or get support, or for businesses to reach out with very personally tailored messages and have an ongoing engagement with a person. So that's something that we're very excited about building. And that is going to be the business that we hope to build on Messenger and WhatsApp over time. So we're looking forward to that. Marketplace I think is going to be a great example of this too. What we're seeing in pages and marketers on Facebook is they want to both get awareness and drive all the way down to generating transactions, and Marketplace I think is going to help people do that. We're starting with people being able to sell things and connect to other people who want to buy them, just like they've been doing in for-sale groups for many years, but we're excited to evolve this and grow it over time as well."
},
{
"speaker": "Deborah Crawford - Facebook, Inc.",
"text": "So thank you for joining us today. We appreciate your time and we look forward to speaking with you again."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines."
}
] | null | null |
META | 2 | 2,016 | 2016-07-27 17:00:00 | Executives: Deborah Crawford - Director-Investor Relations Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer Sheryl K. Sandberg - Chief Operating Officer & Director David M. Wehner - Chief Financial Officer
Analysts: Eric J. Sheridan - UBS Securities LLC Douglas T. Anmuth - JPMorgan Securities LLC Brian Nowak - Morgan Stanley & Co. LLC Justin Post - Merrill Lynch, Pierce, Fenner & Smith, Inc. Anthony DiClemente - Nomura Securities International, Inc. Mark Mahaney - RBC Capital Markets LLC Heather Bellini - Goldman Sachs & Co. Carlos Kirjner-Neto - Sanford C. Bernstein & Co. LLC Ross Sandler - Deutsche Bank Securities, Inc. Benjamin Schachter - Macquarie Capital (USA), Inc. John Blackledge - Cowen & Co. LLC Mark A. May - Citigroup Global Markets, Inc. (Broker)
Operator: Good afternoon. My name is Chris, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the Facebook Second Quarter 2016 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin.
Deborah Crawford - Director-Investor Relations: Thank you. Good afternoon and welcome to Facebook's second quarter 2016 earnings conference call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our Quarterly Report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I'd like to turn the call over to Mark.
Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer: Thanks, Deborah, and thanks, everyone, for joining today. We had another good quarter and first half of the year. Our community continues to grow around the world. 1.7 billion people now use Facebook every month and 1.1 billion people use it every day. Our business is growing at a healthy rate as well. Total revenue grew by 59% year-over-year to $6.4 billion and advertising revenue was up 63% to $6.2 billion. Our results show our progress as we work to make the world more open and connected across our three-year, five-year, and ten-year horizons. Over the next three years, we're focused on continuing to build our community and help people share more of what matters to them. The next five years are about building our newer products into full ecosystems, developers and businesses. And over the next ten years, we're working to build new technologies to help everyone connect in new ways. I'll give an update on our progress across each of these areas. Starting with how we're working to deliver better experiences for our community and more ways for people to share and more of what they care with anyone they want. We continue to see excellent growth in our community. Over the past year, we've added over 200 million people using Facebook on a monthly basis. And in the second quarter, time spent per person increased double-digit percentages year-over-year across Facebook, Instagram and Messenger, and that doesn't even include WhatsApp yet. One of the biggest opportunities to grow our community is in developing countries where connectivity is less advanced than what we take for granted here at home. So, over the past couple of years, we've been making steady improvement throughout to make them work regardless of the device or connection that people are using. We've also built a lightweight version of our Android app called Facebook Lite that's tuned to work on 2G networks and is now used by more than 100 million. We're also working on new tools to help people express themselves and understand what's going on with the people they care about. Ten years ago, most of what we shared and consumed online was text. Now it's photos, and soon most of it will be video. We see a world that is video first with video at the heart of all of our apps and service. Over the past six months, we've been particularly focused on Live video. Live represents the new way to share what's happening in more immediate and creative ways. This quarter, Candace Payne's Chewbacca mask video was viewed almost 160 million times. Live is also changing the way we see politics, as news organization, delegates go live from the Republican and Democratic conventions, and we've seen in Minnesota and Dallas how Live can shine a light on important moments as they happen. This quarter we also launched 360 Photos. You don't need a special camera to take them. You just take a panorama or use the 360 cam or app on your phone and post it. And since we launched, more than 4 million 360 photos have been shared on Facebook with 1 million more being shared every week. We're making good progress on core services within the Facebook app, like search. A growing way that people use search is to find what people are saying about a topic across the more than 2.5 trillion posts in our network. Now people are doing more than 2 billion searches a day between looking up people, businesses, and other things that they care about. Continuous steady improvement in services like search are an important part of helping people connect and realizing our mission. We're also improving the experience for our community by building our business with more engaging ads. We've also emphasized the importance of measurements and value in driving real results for the businesses that use Facebook, and that means helping them create more relevant and engaging ads. Over the next five years, we're working hard to build ecosystems around some of our newer products. Instagram now has more than 500 million monthly active with more than 300 million daily. Now we're working to make that experience even more engaging. Recently, Instagram began to rank its feed because we know that people have a better experience when they see more of the stories they care about. We're already seeing a positive impact in terms of time spent and the amount of content that people are sharing. We've also introduced our advertising tools on Instagram and we're seeing marketers engage with people in creative and innovative ways. In the two years since we separated Messenger from the main Facebook app, which was a pretty controversial decision at the time, we've improved performance and given people new ways to express themselves. And now, for the first time, more than 1 billion people are using Messenger every month. I'm also happy with the updates we're making to WhatsApp, which also has a community of more than 1 billion people. This quarter, we launched new desktop apps, end-to-end encryption and millions of people are using WhatsApp's voice calling features. The scale we've achieved with our messaging services makes it clear that they are more than just a way to chat with friends. That's why we're also making it easier for people to connect in groups and businesses as well. We're going to keep focusing on this over the next several years. I'm also excited about the early progress we're making on our ten-year initiative. We're investing in new technologies to give more people a voice, including, of course, the 4 billion people around the world who aren't yet online. And we're helping more people take advantage of the opportunities that come with the internet. We're still early in our journey, lots of hard work ahead. But we're making good progress, like the first successful flight of Aquila, our solar powered aircraft that will beam Internet to places that have never been connected. Eventually, we're going to work with telecom operators and governments around the world to connect people on the outskirts of cities, rural areas, and disastrous zones where you can't get traditional connectivity today. We've also been making progress with our initiatives around artificial intelligence and virtual reality. This quarter, we announced DeepText, a deep learning based engine that can understand the context of several thousand posts per second across 20 different languages. This is a long-term project, but it also has some near-term benefits like helping show people more of what they want to see and filtering out less of what they don't want to see. We're also investing in new platforms to help people connect and share. We believe that virtual reality can help people share richer experiences and help everyone understand what's going on around the world. It's really early for us in VR, but we're hitting some important milestones. As of the second quarter, more than 1 million people a month are now using Oculus on mobile phones through our Gear VR partnership with Samsung. More than 300 apps are already available at the Oculus store for Gear VR. We filled all of our preorders for Oculus Rift and we're seeing increasing demand from retail stores planned for the holidays. While it's still early for augmented reality, we're doing AR research and are seeing lightweight versions of AR technology in mobile apps like MSQRD. So that's a recap of the progress that we're making in our ten-year plan. We have a saying at Facebook that our journey is only 1% done. And while I'm happy with our progress, we have a lot more work to do to grow our community and connect the whole world. That means making big investments and taking risks, focusing not just on what Facebook is but on what it can be. I want to thank everyone in our community, all of our teams, our partners and our shareholders for being a part of this journey with us. And now here's Sheryl.
Sheryl K. Sandberg - Chief Operating Officer & Director: Thanks, Mark, and hi, everyone. We had a great second quarter. Q2 ad revenue grew 63%. Mobile ad revenue reached $5.2 billion, up 81% year-over-year, and was approximately 84% of total ad revenue. Our growth was broad-based across verticals, marketer segments and regions. We're excited to announce that we now have 60 million monthly active business pages on Facebook. We also continue to grow the number of active advertisers on our platform. This shows that both our free and paid products are providing value to marketers of all sizes around the world. We continue to focus on our three priorities, capitalizing on the shift to mobile, growing the number of marketers using our ad products, and making our ads more relevant and effective. First, capitalizing on the shift to mobile. For 32 years, the advertising industry has gathered in (9:55) to celebrate creativity. People have shifted to mobile and marketers know they need to catch up. Mobile is no longer a nice to do, it's a must do, and we're working closely with marketers to help them make this transition. The best marketers understand that people watch video differently in mobile feeds. The goal is to create what we think of as thumb-stopping creative, videos that grab attention in the first few seconds even without sound. For example, to drive awareness for Sour Patch Kids Gum, Mondelez targeted teens with non-chocolate candy interests. Working with the VaynerMedia, Carat and the Facebook Creative Shop, they created punchy, ten-second looping videos tailored for Facebook and Instagram. The campaign helped the Sour Patch Kids portfolio beat sales benchmarks for the entire candy industry. We're excited to bring more relevant video ads to people both on and off Facebook. In May, we expanded Audience Network to include video for brand objectives. This means that advertisers can place video, brand video ads, not just on Facebook and Instagram, but across a network of apps and sites. Our second priority is growing the number of marketers using our ad products. Over a third of small businesses and medium businesses in the U.S. don't have a website and having a mobile presence is even more difficult and expensive. Creating a business page on Facebook is as easy as setting up a personal profile. This is why Facebook pages are the mobile solutions for many of the 60 million businesses using our products each month in the U.S. and around the world. We've made it easy for business owners to manage their Facebook page from their mobile device. Over 85% of active business pages use mobile, and 40% of active advertisers have created a Facebook ad on their mobile device. In Q2, we rolled out new tools to make it easier for businesses to promote posts and track performance directly from the Instagram app. We've worked hard to make becoming an advertiser as easy as possible for these businesses. With just a few steps and for as little as a few dollars, businesses can boost their posts to reach more people. Simplifying our ad products is key to advertiser acquisition. Over 80% of new advertisers in Q2 started with simplified products like boosted posts. Once these businesses begin advertising with us, we make it easy for them to take advantage of even our most sophisticated capabilities. For example, Lighting Etc., a third generation family-owned business used Facebook and Instagram ads to drive in-store sales. They targeted 25-year-old to 45-year-old homeowners interested in interior design living within 35 miles of their showroom in Fort Worth, Texas. It was striking to them that on Facebook, the size of our community meant that they could reach over 300,000 people even with such specific targeting. They've seen a 40% increase in revenue in 2016, and they attribute this increase to their ads on Facebook and Instagram. Our third priority is making our ads more effective and relevant. Our goal is to help our clients grow their businesses, whether it be moving products off shelves, driving online sales or building their brands. Our system constantly looks for the most efficient and effective way to drive these objectives. Businesses that want to build their brands need to reach a large audience with a compelling story, and they're seeing strong results from immersive formats like video and Canvas ads. Businesses working to acquire new customers need to reach high quality leads and convert them to actions. We introduced lead ads in Q1 to make it easy for people to fill out forms on mobile devices right from News Feed. In Q2, we made it possible for advertisers to retarget people who opened or completed a lead ad form. For example, Nissan Turkey and the SCM agency used lead ads to collect over 20,000 high quality leads from people interested in buying a new car. They then used retargeting to show relevant ads to people who had completed these lead ads and ultimately drove vehicle sales. The cost of a high quality lead was 9.3 times lower on Facebook than all other online media. Businesses selling products are getting search like ROI from dynamic ads. Dynamic ads allow advertisers to upload their product catalogs and target people with specific products in real-time. Over 300 million people see dynamic ads each month and over 2.5 billion unique products have been uploaded by marketers. In Q2, we expanded dynamic ads to Instagram and also launched dynamic ads for travel. For example, you can now advertise specific destinations and dates for hotel rooms. We're pleased with the value we're driving for our partners and the progress we're making across our three priorities. With only a small fraction of our 60 million business page is advertising, we have a lot of opportunity ahead. We also have a lot of hard work to do to help businesses make the shift to mobile and to drive results for our clients. I want to thank our clients around the world for their partnership and their ongoing input, which informs our product development. I also want to congratulate our global teams on the results of their hard work and thank them for their dedication to our mission. Thanks, everyone. And now here's Dave.
David M. Wehner - Chief Financial Officer: Thanks, Sheryl, and good afternoon, everyone. Q2 was another strong quarter for Facebook. Total revenue grew 59% to $6.4 billion and we generated over $2 billion in free cash flow. These results highlight the continued growth and engagement of our global community and the strength of our ads business as advertisers benefit from our increasingly broad and deep portfolio of targeting, creative and measurement tools. Let's start with our community metrics. This past quarter was our strongest in over three years in terms of absolute year-over-year growth of monthly and daily actives on Facebook. In June, 1.13 billion people used Facebook on an average day, up 17% compared to last year. This daily number represents 66% of 1.71 billion people who visited Facebook in the month of June. Mobile continues to drive our growth, with over 1 billion people accessing Facebook via mobile devices on an average day in June, up 22% compared to last year. The growth of our other services also continues to be strong. WhatsApp and Messenger now each have over 1 billion monthly actives and Instagram surpassed 500 million. Turning now to the financials. My comments today will focus on our GAAP financial metrics and all of our comparisons are on a year-over-year basis unless otherwise noted. A reconciliation of our GAAP to non-GAAP financial metrics is included in our press release and earnings slides. Total Q2 revenue was $6.4 billion, up 59%. Q2 ad revenue was $6.2 billion, up 63%. Exchange rates did not impact our overall revenue growth rate this quarter as headwinds in certain currencies were offset by tailwinds in others. U.S. and Canada, and Asia-Pacific were our fastest growing regions with advertising growth rates of 69% and 67% respectively. Mobile ad revenue was $5.2 billion, up 81%, and representing approximately 84% of total ad revenue. Let's turn to the supply and demand factors that continue to drive our growth. Advertiser demand was particularly strong in Q2 across a broad range of verticals and advertiser objectives. Additionally, supply side factors, including growth in users, time spent and ad load, all contributed to our Q2 revenue growth. In Q2, the average price per ad increased 9% while total ad impressions increased 49%. The reported increase in price was again driven by the continued mix shift towards mobile where we only show higher price News Feed ads compared to the mix of News Feed ads and lower priced right-hand column ads on personal computers. The 49% increase in total ad impressions was driven primarily by growth in ad impressions served in Facebook mobile News Feed where the majority of our ads are shown. Payments and other fees revenue was $197 million, down 8%. Remember that payments and other fees revenue largely generated from games played on personal computers, which has declined as people spend less time on their PCs. Q2 total expenses were $3.7 billion, up 33%, inclusive of $825 million of share-based compensation related expenses as well as $193 million of amortization of intangible assets. Q2 operating income was $2.7 billion, representing a 43% operating margin. We continue to be pleased with the profitable growth of the business while we invest for the long-term. We ended Q2 with approximately 14,500 employees, up 32% year-over-year. We added about 900 employees in the quarter, the majority of those in technical functions. We are seeing continued success with our efforts to hire top talent in a market that remains very competitive. Our Q2 tax rate was 26%. GAAP net income was approximately $2.1 billion or $0.71 per share. Q2 capital expenditures were $1 billion. Year-to-date capital expenditures totaled $2.1 billion, driven by investments in data centers, servers, office buildings, and network infrastructure. Facebook generated over $4 billion in free cash flow in the first half of 2016. And as of June 30, we had over $23 billion in cash and investment. Turning now to the outlook. First, some color on revenue. We have been pleased with the strength of our advertising revenue in the first half of 2016. As I discussed on our last call, while we expect the main drivers of our advertising revenue growth will continue throughout 2016, we will face tougher comparables as the year progresses, given the accelerating revenue growth rates we experienced in the second half of 2015. Consequently, we anticipate lower advertising revenue growth rates in each successive quarter in 2016. Additionally, we anticipate ad load on Facebook will continue to grow modestly over the next 12 months, and then will be a less significant factor driving revenue growth after mid-2017. Since ad load has been one of the important factors in our recent strong period of revenue growth, we expect the rate at which we are able to grow revenue will be impacted accordingly. Turning now to expenses. Based on our updated view of the remainder of the year, we are tightening our expense guidelines ranges. We expect that full year 2016 total GAAP expense growth will be approximately 30% to 35%, narrowed from our prior range of 30% to 40%. We expect full year 2016 amortization expenses to be approximately $700 million to $800 million, and full year 2016 stock-based compensation related expenses to be approximately $3.1 billion to $3.3 billion. Accordingly, we anticipate that our total non-GAAP expenses, which excludes stock-based compensation and amortization, will grow in the range of 45% to 50%, narrowed from our prior range of 45% to 55%. We anticipate full year 2016 capital expenditures will be approximately $4.5 billion as we invest to support the rapid growth of our business. Finally, we expect that our Q3 and full year 2016 tax rates will be similar to our Q2 rates. In summary, Q2 was another great quarter for Facebook, illustrated by the strong growth and engagement of our global community and continued broad-based strength of our ad business. We're pleased with the results, and we will continue to invest in order to best position Facebook for our long-term growth opportunities. With that, Chris, let's open up the call for questions.
Operator: Thank you. We will now open the lines for a question-and-answer session. [Operation Instructions] Your first question comes from the line of Eric Sheridan with UBS. Your line is open.
Eric J. Sheridan - UBS Securities LLC: Thanks for taking the questions. Maybe two. One on the video platform going forward and how you think about video as a distribution mechanism. How should we think about investments that need to be made in video on both technical infrastructure side as well as the sourcing of content type sort of broadened out the video offering over the next couple of years? And then maybe on the last comment on ad load, just wanted to go back to that for a minute in terms of what you're seeing on ad load by region, because we're seeing a widening gap in revenue per user between U.S. and Canada and the rest of the world. How much of that might be driven by ad load or ad products? Thank you so much.
David M. Wehner - Chief Financial Officer: Sure. I can take the question on video distribution as it relates to CapEx and the ad load question, and then maybe on the sourcing of content, I'll pass it back to Sheryl. So, on the video platform, clearly, from a investment perspective, you've seen us step up our CapEx this year pretty substantially. And that's baked into the guidance of $4.5 billion of CapEx which, if you recall, is at the high end of our prior range. We are investing across our infrastructure to prepare ourself for growth across all of our different services. And part of that investment is really to support video. That is definitely more taxing on the network and we're investing heavily on the network side. And as well, it does also impact our overall needs within the data center, servers and the like. So it's certainly an area that we're investing in heavily and we expect to be investing in heavily going forward, Eric. And then on the ad load question, ad load is not something that varies that dramatically by region. So you're really looking at a number of factors. Really what's driving that is just the dispersion of overall ad demand across region. And we're seeing really good strength across the globe on that front, but ad load is not a big driver of discrepancies in ARPU that you see. That's really something that maps very closely to the size of the mobile ad markets per population in those countries. So it's not an ad load question. And then I'll hand it over to Sheryl to talk about video from a content perspective.
Sheryl K. Sandberg - Chief Operating Officer & Director: When you think about what's happening on video on our platform, we're really excited by the production and consumption of video, and we're seeing the full range from people posting the things in their personal lives. The power of what a mobile phone can produce and distribute now is pretty incredible, when you compare it to just a few years ago, to some of the most sophisticated content producers in the world producing for us. We're experimenting across a wide variety of things. We're doing a partnership with the NBA to stream some U.S. Men's Olympic team games in the next couple of weeks. That said, our primary focus is on short form content, not long form content, and we're pretty excited to see the different forms of content people will create, both to share messages, to create new content and to engage audiences around the world.
Operator: The next question is from Douglas Anmuth with JPMorgan. Your line is open.
Douglas T. Anmuth - JPMorgan Securities LLC: Thanks for taking the questions. I just have two. First on engagement, obviously, the DAU and MAU numbers were strong. You gave the increase in the daily activity as well in the double-digits. But can you just give us some color on the user trends underneath that a little bit, and more specifically perhaps what you might be seeing in terms of younger users in different age demographics? And then secondly, just going back to the ad load, we have in the past heard some caution from you guys before in that area, and granted it was a few years ago and at a much earlier stage. But I guess my question is, if targeting continues to improve along with click-through-rate and then ultimately ROI, why does ad load have to become less of a factor going forward? Thanks.
David M. Wehner - Chief Financial Officer: Yeah, thanks. Thanks, Doug. On the DAU and MAU front, couple of things. One is DAU and MAU are up sequentially and year-over-year on all regions, and with trends that are largely consistent with past quarters. So, really good strong growth across the globe on a DAU to MAU ratio. We don't do specific break downs of those metrics by demographic. We're obviously pleased with our overall level of growth in engagement. On the teen front, younger users, we continue to be the best way to reach the largest global audience of teens and millennials. Teens remain very – remain engaged on Facebook. Clearly, how they've used our service has evolved over the years. And in addition to Facebook, they're using Instagram, Messenger and WhatsApp. So, from a teen perspective, that's some color there. On the ad load front, ad load is definitely up from where we were a few years ago. It has been an important driver of inventory growth. And really, I think one of the things that's enabled us to grow ad load has been improving the quality and the relevance of the ads, as you've mentioned. And we've been be able to do that without negatively impacting the user experience. We do expect that ad load will be a less significant factor driving overall growth, especially after mid-2017. The optimal ad load is really a mix of art and science. We've carefully tracked the impact of ads on the user experience over the last several years. We aren't seeing a cause for concern. We also want to be thoughtful about making sure that each person's overall feed experience has the right balance of organic and ad content. And that factors into how we think about ad load and where that might ultimately be. And that's really why we're talking about our expectation that as you get into mid-2017, ad load will not be a big factor in driving overall inventory growth. We still see the opportunity to grow inventory from the growth of people and engagement on Facebook, as well as our other services like Instagram. Instagram does have a lower ad load than Facebook.
Operator: The next question is from Brian Nowak with Morgan Stanley. Your line is open.
Brian Nowak - Morgan Stanley & Co. LLC: Thanks for taking my question today. I have two. The first one on the U.S. advertising, it was up particularly strong. Any specific ad category, branded, direct response, et cetera, or add unit like video that's driving this growth in the U.S.? And then the second one, just on Live video, recognizing it's very early with Live video, but any help at all on what percentage of your users are engaging with Live video and the type of uplift you're seeing on engagement? Thanks.
Sheryl K. Sandberg - Chief Operating Officer & Director: Our growth this quarter was very broad-based across all of the regions. We had especially strong growth in APAC and the U.S. and Canada, so that was part of the growth. In terms of our marketer segments from brands to direct response to SMBs to developers, the growth is really strong there as well. We're really excited today to announce that we have 60 million small business pages that are using Facebook on a monthly basis. And we're very focused on the opportunity to upsell them to advertising products. We think we have a good track record there. We're also seeing a lot of strength in brand. And I think that's because we have a combination of the creative and the story telling, so the art with the science of the targeting. And when people do that well together, you see great opportunities. So to share one example, Jack In The Box use our Canvas ads, which are very immersive ads. They're really good for a brand experience, to roll out a new menu item, their Double Jack burger. They worked with agencies Horizon, David & Goliath and Adaptly, and they targeted millennials on Facebook to create two different custom audience groups. One group was customers who had visited the restaurant web page or engaged with previous video ads. And the second group were people that hadn't engaged with them directly but were quick service restaurant purchasers. They had an average view rate of 23 seconds across those Canvas ads, so clearly people were really engaged in the brand experience of the ads, and they had a 13-point lift in add recall and a 9-point lift in purchase intent. And so I think what you're seeing is that across all of the objectives people have from brand marketers to direct response to SMBs to developers, as our ad products get more sophisticated, our targeting and measurements get better. They have an increased opportunity to grow, and that's why we think our growth to-date continues to be broad-based.
David M. Wehner - Chief Financial Officer: Yeah, and, Brian, I'll take the Live video question. It's hard to compete with the Double Jack burger. But in terms of Live video, it's really early. We're really excited about it in terms of it providing an authentic and real form of sharing for people, and we're really trying to give people the full range of tools to share what they care about with anyone that they want, and Live is really effective there. And we've seen experiences both in terms of a lighthearted like Candace Payne and also more serious, more serious issues around the U.S. and around the globe. So it's really an important part of what we're offering for people to share real experiences. Video as a whole is making a significant contribution to time spent growth. So, when we talk about the time spent per DAU growing worldwide across our family in double-digit percentages, video is making a contribution there more broadly.
Operator: The next question is from Justin Post with Merrill Lynch. Your line is open.
Justin Post - Merrill Lynch, Pierce, Fenner & Smith, Inc.: Yeah, I have a couple. First, Mark, maybe on core Facebook, there's been commentary out there that maybe there's less personal sharing. Just maybe comments on the direction of Facebook? What the activities are going on, how you feel about that? And then just about the ad loads, I mean how are you deciding how much ads to show? Could you hold back a bit and drive higher pricing? How are you balancing that? And why not hold back a little bit more now for longevity there? Thank you.
Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer: Sure. So I'll talk about sharing, and then I think Dave can probably talk about ad loads and pricing. So, the overall level of sharing is up on Facebook. And what we're seeing is that how people share is evolving as we move from desktop to mobile, right. So you can imagine more photos on people's mobile cameras, fewer long full photo albums, more ability to capture video, probably a little bit harder to type on mobile. So there's this evolution. The other thing that we see is that now people have tools to share more privately as well. So when you think about sharing on Facebook, you shouldn't just think about the kind of sharing that you see in News Feed, right. So sharing with all of your friends, sharing in groups on Facebook and public sharing, which are the trends that I was just talking about. But another area that's growing incredibly quickly is private messaging, right, where between Messenger and WhatsApp, I think we're around 60 billion messages a day, which I think is something like three times more than the peak of global SMS traffic. So that is something that's growing pretty quickly and that we're really excited about as well. And we're just going to continue working on giving people the best tools across the spectrum from private to public, and across the spectrum from text-based and simple communication to richer type of media like photos, videos, and then, eventually, more immersive forms like VR.
David M. Wehner - Chief Financial Officer: Yeah, and Justin, in terms of ad load, we've talked about the different factors that go into it, obviously, just in driving the overall business. Advertiser demand, that was particularly strong this period, and then also we matched that with supply. And the supply – the two big drivers are user and time spent and then ad load. And getting the balance and mix right is important, and clearly, how the pricing plays out is via the auction. And we've had a good balance of demand growth and supply growth, and that's led to our good strong financial results and our ability to deliver very strong ROI to advertisers. So we think we're in a good zone on the right ad load, and we do think there's opportunities to grow that modestly. But as we look forward into 2017, we think it'll be a less significant factor driving inventory growth. But we still think there's opportunities to drive inventory through user growth and time spent. I don't think we would think about necessarily dropping ad load to drive pricing. We're also very cognizant of providing good value to advertisers, and getting that balance right is important to driving overall ROI, as well as obviously providing better targeting and measurement tools for our advertisers.
Operator: The next question is from Anthony DiClemente with Nomura. Your line is open.
Anthony DiClemente - Nomura Securities International, Inc.: Great. Thank you for taking my questions. I have one for Mark and one for Sheryl. Mark, you mentioned search in your prepared remarks, two billion searches a day on Facebook. I also noticed you said you're making it easier for users to connect to businesses. How far away are you from commercial search on Facebook being viable? Why can't you do that today? And how big of an opportunity could commercial search be? And then, Sheryl, you mentioned the expansion of the Facebook Audience Network. Can you talk more about the revenue opportunity of bringing Facebook's targeting tools to other video publishers? How fast is Audience Network monetization growing? Is it accelerating, for example, and how do you see the revenue opportunity of expanding the Audience Network across the mobile web as well? Thank you.
Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer: I can take search. So when we talk about our strategy, I often talk about how when we develop new products we think about it in three phases. First, building a consumer use case; then, second, making it so that people can organically interact with businesses; and then third, on top of that, once there's a large volume of people interacting with businesses. Give businesses tools to reach more people and pay, and that's ultimately the business opportunity. So, I'd say, we're around the second phase of that in search now. You know, we have a pretty big navigational use case where people look up people and pages and groups that they want to get to and look at in search. One of the big growing use case is that we're investing a lot in is looking up the content in the ecosystem, and that is an area that we're very excited about, which helps people find more content. But certainly there's a reasonable amount of behavior in there which is looking for things that, over time, could be monetizable or commercial intent. And at some point we will probably want to work on that, but we're still in the phase of just making it easier for people to find all the content they want and connect with businesses organically.
Sheryl K. Sandberg - Chief Operating Officer & Director: On the Audience Network, we continue to invest in ad tech, and the Audience Network is a key part of our focus there. We don't break out revenue by our different platforms. But the opportunity to take not just video ads, but other ad formats we have, bring them to the rest of the web and other apps with our ability to target and measure, we think is a big one. And what we're starting to see is that people are using Facebook, Instagram and Audience Network to drive their objective in a cohesive way. So to share an example, Garmin launched the Fenix 3 Sapphire watch, and they did it with videos ads on Facebook that worked without sound. They targeted outdoor enthusiasts then retargeted people who viewed the Instagram videos with Carousel ads on Facebook that highlighted the product features. Then they extended those ads on Audience Network to maximize reach, and they used the Facebook Pixels to measure the incremental sales, and got to a 9.7 times return on ad sales. So that's a really good example of how you can take targeting and the ability to target across Audience Network, Facebook and Instagram and drive people all the way down the funnel. And we think more and more people will do that, particularly as we do a better job of combining the interfaces. So, for example, you can buy now in one interface on Facebook, Instagram and Audience Network.
David M. Wehner - Chief Financial Officer: And then, Anthony, just one thing to add on top of that, just the – we recognize the majority of our third-party advertising revenues of the Audience Network on a net rather than gross basis. So that will also minimize the impact that will have on the top line.
Operator: The next question is from Mark Mahaney with RBC Capital Markets. Your line is open.
Mark Mahaney - RBC Capital Markets LLC: Mark, when you see the what seems like phenomenal success of Pokémon Go, what are your reactions to that? And then, David, could you talk about the monetization ramp that you're seeing on the messaging platforms? I know it's still very early days. Anything in there that strike you as being particularly substantive for material yet? Thank you.
Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer: Well, I, like everyone else, am enjoying Pokémon Go. And the biggest thing that I think we can take away from this as we invest in augmented reality in addition to virtual reality, is that the phone is probably going to be the mainstream consumer platform that a lot of these AR features first become mainstream rather than glasses form factor that people will wear on their face. So I think we're seeing this in a number of places, whether it's location through Pokémon or some of the face filter activity. I referenced the MSQRD app that we acquired earlier in my remarks. That's a kind of a fun way to augment. You know, social experience that you're having with someone. I think that there's a big opportunity to build out that platform and a lot more functionality around that. And one of the big themes that we're talking about here is becoming video first, right, and as people look for richer and richer ways to express themselves just like people in the past just shared a lot of text and photos on Facebook, we think that in the future more of that is going to be video. And more of these augmented reality tools I think are going to be an important part of delivering that experience to making that fun to use and expressive as it can be.
David M. Wehner - Chief Financial Officer: And, Mark, we've talked about our strategy on how we go about monetizing the different apps in our portfolio, and we usually talk about it in terms of three phases. Phase one is really growing the user base and engagement. And we're really pleased with where we are with Messenger and WhatsApp in that perspective with it's over 1 billion monthly actives. The second phase is really working on buildings organic interactions between businesses and consumers; and then finally, the third phases is about building those commercial opportunities. With Messenger, we're really at the beginning of phase two. Messenger today has 1 billion organic interactions between businesses and consumers each month. But in terms of where we are in having in terms of actual monetization, incredibly early on that front. We're really in the – in that phase two where we're really talking about building those organic interactions.
Operator: The next question is from Heather Bellini with Goldman Sachs. Your line is open.
Heather Bellini - Goldman Sachs & Co.: Great. Thank you very much. I was wondering, and I guess this is a follow up on Anthony's question. Is there a way to think about maybe the percentage of your kind of top 100 customers, or however you want to define it, that might be using FAN as an ad on to their Facebook spending? I guess I'm wondering if you're seeing increasing leverage of FAN. And then the other question would just be political spending, obviously, wasn't a big driver for you guys in 2012, but it does seem like it is potentially a great opportunity in the back half of the year. I was just wondering if you could comment on that at all. Thank you.
Sheryl K. Sandberg - Chief Operating Officer & Director: On the political spending, our business is broad-based, not that no one event drives our business, we're pretty large and diversified. And while the political campaign, obviously, a lot a money is spend in ads. That's also true of an Olympics; it's true of a World Cup, it's also true of a Super Bowl. And so, with all of these events taking place around the world, there's no one event that we think drives a huge portion of revenue. That said, we are pleased by what's happened on Facebook for the elections cycle, not just on the paid side but actually on the organic side as well. We really see Facebook being embraced by politicians all over the world to get in touch with their constituents. And we're pleased with that. Every member of Congress right now has a Facebook presence. And we're seeing people like, one example is Elise Stefanik, the youngest person in the Congress. She made a pledge when she was elected that she would explain every vote she takes, and she explains every vote she takes on Facebook. With shorter explanations if they're not controversial but longer explanations. That's the kind of mission based work that we're happy about because it brings people closer to the people who are representing them. We don't break out how many advertisers are advertising on the Audience Network, but we're seeing solid and growing adoption of the Audience Network across the board, as we are with Instagram. And we think all of these platforms together really help give us the ability to serve our clients in a very leveraged way, and use the targeting and measurement capabilities we have invested in across multiple platforms.
Operator: The next question is from Carlos Kirjner with Bernstein. Your line is open.
Carlos Kirjner-Neto - Sanford C. Bernstein & Co. LLC: Hi. Thanks for taking my question. First, some people believe that much of what users see in their News Feed is driven by their behavior and preferences. And as a consequence, the stories they end up seeing are always, or almost always, in line with their existing views and preferences. Does this phenomenon in the end increase – does this phenomenon lead to increased adoption in use of Facebook creating more polarization of views and less effective communication, at least in some areas of people's lives? Mark, how do you think about this line of thought that because people see things that they are already in line with what they believe, communication is hindered? Second, when it comes to video ad formats, are you philosophically opposed to pre-rolls, and if yes, why? And if not, what is missing for you to adopt that? Thank you.
Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer: So we have studied the effect that you're talking about, and published the results of our research that show that Facebook is actually, and social media in general, are the most diverse forms of media that are out there. And basically what – the way to think about this is that, even if a lot of your friends come from the same kind of background or have the same political or religious beliefs, if you know a couple of hundred people, there's a good chance that even maybe a small percent, maybe 5% or 10% or 15% of them will have different viewpoints, which means that their perspectives are now going to be shown in your News Feed. And if you compare that to traditional media where people will typically pick a newspaper or a TV station that they want to watch and just get 100% of the view from that, people are actually getting exposed to much more different kinds of content through social media than they would have otherwise or have been in the past. So it's a good sounding theory, and I can get why people repeat it, but it's not true. So I think that that's something that if folks read the research that we put out there, then they'll see that. What was the other question?
Unknown Speaker: Pre-roll.
Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer: Oh, pre-roll. I can take that one too. So we don't think it would be a good experience in News Feed, right, because a lot of when people are finding videos on Facebook is you're scrolling through News Feed, you're looking at what story seems interesting to you, which is why we did the auto play videos so that rather than having to take an action, you can just start experiencing the video automatically and continue watching it if it's something that you're interested in. But if we started playing an ad in the middle of a feed before you got to the video, then that would really go against that. I think people just would watch a lot less of the organic videos that were posted because of that. But the important thing to keep in mind on this is we don't really – we don't need to do pre-roll because our model is not one where you come to Facebook to watch one piece of content, you come to look at a feed and putting the ads in between the stories is a much more effective way to do it and better for the user experience.
Operator: The next question is from Ross Sandler with Deutsche Bank. Your line is open.
Ross Sandler - Deutsche Bank Securities, Inc.: Great. I had two product related questions for Mark. So, Mark, you guys mentioned when you released the latest Instagram MAU crossing the 500 million mark, you give out the breakdown of U.S., international. It looks like U.S. has been around 100 million for about the past nine months. So is that just a pause along the growth path or is there something else that you're seeing that's causing that growth to stall out a bit in light of what you just said about engagement being up since you did the algorithm reranking? Any color there would be helpful. And then the second question is just any update on Messenger M and how do you see that product potentially impacting engagement monetization on Messenger? Thanks.
David M. Wehner - Chief Financial Officer: On any update on M, I can start with that one. Do you -
Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer: I was going to take that one.
David M. Wehner - Chief Financial Officer: Oh. You were going to take that one? On the Instagram MAU question, I don't think we're breaking out by region Instagram MAU. So, no, I don't think there's any update there that I'm aware of.
Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer: Okay. Yeah, so we just haven't updated that.
David M. Wehner - Chief Financial Officer: Yeah, all right.
Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer: Yeah, so for M, we've released the Messenger platform M bot in the last six months – F8 was the big announcement there. And I think since then, I think we've announced we have more than 10,000 bots in the system, which are basically making it so that different businesses can build automated ways to communicate with people. The way we think about this experience is that, qualitatively, I don't know a single person really who wants to call a business to get support or interact with it. Whether that's trying to get a reservation for a restaurant or getting customer support or calling to buy something. And those are slow interactions. They're synchronous. They consume your whole attention while you're doing them. And if we can make it so that you can have some of those interactions in an automated way where you fire off a text and then just get a response back quickly, but asynchronously so it doesn't take up your full attention, then I think that's going to be a much better experience that people really enjoy and like. So we're in the experimentation phase I think with the platform. We're seeing a lot of good ideas getting tried out. And I personally enjoy a lot of the different bots that people are using or making, especially the news one where you get these digests at the end of the day of different kinds of content. And between that and M, which is kind of our own internal bot that we're building, I think that this is going to be an interesting area to watch and encourage more interaction between people and businesses and messaging.
Operator: The next question is from Ben Schachter with Macquarie. Your line is open.
Benjamin Schachter - Macquarie Capital (USA), Inc.: Couple of questions for Mark. The first one, what are the lessons you're learning from seeing the growth of Snapchat and some of the other newer networks, particularly among young people? And obviously Facebook is continuing to do well but these things are growing. And then second, related to video, what are the key problems that you really think you need to solve for consumers and video producers and how is Facebook going to evolve to help solve those problems? Thanks.
Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer: Sure. And they're related. So, overall, people are spending more and more time on mobile, and that means that there are always more services that people use whether it's YouTube or there's some really interesting ones with younger folks, especially like musical.ly and live.ly that I think are pretty interesting as well, the Snapchat, which you mentioned. And part of why I think you see this is that there are just so many different ways that people want to share so many different kinds of content, ranging from text to photo to video, just richer and richer and more immersive content. And also there's a range from private one-on-one type sharing to small groups, all of your friends at once, large interface communities, and then ultimately fully public. And there are different apps that explore different regions of that space and do a good job with it, and offer ideas that I think the whole market needs to learn from. Right now, the big theme and strategy that we're executing is we're going to become video first. And what I mean by that is that there's this trend where ten years back, most of what you saw and shared online was text, and then we went through a phase where most of it is photos. And we really believed that, and call it five years, or whatever the period of time that it takes to get there, I think most of what people consume online is going to be video. And that means that there needs to be a whole range of new production tools and consumption experiences for enabling that. For production, I think that means that you need to get the camera experience, and the experience for capturing and uploading videos that you've captured to be much better in a more central part the of the experience. On consumption, there are innovations that we've had like auto play in feed, but what's the next version of that, that makes it so that people can have an even more native and default video experience when they're in News Feed, as well as private areas like Messenger and WhatsApp. So I think you're going to see this across all of our apps. More focused on producing this kind of content, and making it first class to consume as well, both in private and public context. And I think that that's just a big trend across the market, and one of the big things that if we get right, I think it's going to unlock a lot of sharing and opportunities.
David M. Wehner - Chief Financial Officer: And then just following up on Ross's question on Instagram in the U.S., because I think Ross, you were asking, we've provided some rough percentages around international and U.S., and I just wouldn't – I wouldn't – those are very approximate, and I wouldn't base any trending on that, on those percentages.
Operator: The next question is from John Blackledge with Cowen & Co. Your line is open.
John Blackledge - Cowen & Co. LLC: Great. Thanks. For Instant Articles, I think it went live globally for all publishers around the time of F8 in April. Just wondering if you can provide an update on the progress and how you see Instant Articles evolving over the next couple of years? And then maybe Dave, on the 49% year-over-year impression growth, how much of that was driven by ad loads? Thank you.
Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer: If I can take Instant Articles quickly. I think it's going well. It's a good user experience. People like it. The hypothesis when we rolled it out was that if we removed the latency, which is often 10 seconds to 15 seconds of opening up a web view from News Feed that more people would read news. I think the initial data suggests that that's probably true. So that's good. We're getting more partners on. And over the long-term, I think one of the big things that we need to do is see if we can not only make this good for engagement for our partners, but also a really positive business driver for them too. So that's something that I'm excited about, and we'll hopefully have more news on that coming up.
David M. Wehner - Chief Financial Officer: So, on the 49% year-over-year growth in impression, we're not providing a specific break down there. I would say that it's primarily driven by growth in Facebook mobile News Feed. We've talked about the drivers of supply being growth in DAU, growth in time spent per DAU and ad load, and obviously, we've given stats around rough stats around – we've given specific stats around DAU. We've talked about time spent per DAU being up double-digit. So I think you can make some assumptions around that. So that's probably the way to triangulate on that. I think we have time for one more question, Chris.
Operator: Certainly. The final question is from Mark May with Citi. Your line is open.
Mark A. May - Citigroup Global Markets, Inc. (Broker): Thanks a lot. I had two as well. You probably won't give specific revenue numbers, but just if you're – if you kind of, in aggregate, look at some of the non-Facebook app revenue streams, if it is FAN, Instagram, et cetera. Curious to get a sense of the traction and materiality of those. Would you expect, Dave, that in aggregate, those would become kind of material, meaning that sort of 10% plus threshold sometime this year? Just trying to get a ballpark sense of the level of traction and diversification of revenue outside the core Facebook app. And then along the lines of your commentary around ad load, how should we be thinking about, your MAUs are obviously very significant, DAU to MAU quite high. Do you continue to see that as being a primary driver of ad impression and ad revenue growth going forward as well? Thanks.
David M. Wehner - Chief Financial Officer: Yeah, thanks, Mark. Like you said, we're not specifically breaking out revenue numbers. One thing to just keep in mind is Instagram is known and operated property is represented gross in our revenue, so whereas as I mentioned the Audience Network is by and large going to be recognized net rather than gross. And so that is going to make it smaller in how it's going to appear in the revenue numbers. The overall growth is still being driven predominantly by Facebook. Instagram is clearly making a contribution and as is the Audience Network. In terms of ad load, as I said, it's been one of the factors driving supply, so it certainly has been helpful. But there's also DAU growth and time spent per DAU growth so time spent per person. And we continue to feel that there are opportunities to execute on those and to continue to grow inventory in that way. So that's where we would focus. You know, as we drive DAU faster than MAU, then that's going to increase that ratio, but we're really focused on driving DAU and time spent per person.
Deborah Crawford - Director-Investor Relations: Great. Thank you for joining us today. We appreciate your time, and we look forward to speaking with you again.
Operator: Ladies and gentlemen, this conclude today's conference call. Thank you for joining us. You may now disconnect your lines. | [
{
"speaker": "Executives",
"text": "Deborah Crawford - Director-Investor Relations Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer Sheryl K. Sandberg - Chief Operating Officer & Director David M. Wehner - Chief Financial Officer"
},
{
"speaker": "Analysts",
"text": "Eric J. Sheridan - UBS Securities LLC Douglas T. Anmuth - JPMorgan Securities LLC Brian Nowak - Morgan Stanley & Co. LLC Justin Post - Merrill Lynch, Pierce, Fenner & Smith, Inc. Anthony DiClemente - Nomura Securities International, Inc. Mark Mahaney - RBC Capital Markets LLC Heather Bellini - Goldman Sachs & Co. Carlos Kirjner-Neto - Sanford C. Bernstein & Co. LLC Ross Sandler - Deutsche Bank Securities, Inc. Benjamin Schachter - Macquarie Capital (USA), Inc. John Blackledge - Cowen & Co. LLC Mark A. May - Citigroup Global Markets, Inc. (Broker)"
},
{
"speaker": "Operator",
"text": "Good afternoon. My name is Chris, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the Facebook Second Quarter 2016 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford - Director-Investor Relations",
"text": "Thank you. Good afternoon and welcome to Facebook's second quarter 2016 earnings conference call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our Quarterly Report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I'd like to turn the call over to Mark."
},
{
"speaker": "Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer",
"text": "Thanks, Deborah, and thanks, everyone, for joining today. We had another good quarter and first half of the year. Our community continues to grow around the world. 1.7 billion people now use Facebook every month and 1.1 billion people use it every day. Our business is growing at a healthy rate as well. Total revenue grew by 59% year-over-year to $6.4 billion and advertising revenue was up 63% to $6.2 billion. Our results show our progress as we work to make the world more open and connected across our three-year, five-year, and ten-year horizons. Over the next three years, we're focused on continuing to build our community and help people share more of what matters to them. The next five years are about building our newer products into full ecosystems, developers and businesses. And over the next ten years, we're working to build new technologies to help everyone connect in new ways. I'll give an update on our progress across each of these areas. Starting with how we're working to deliver better experiences for our community and more ways for people to share and more of what they care with anyone they want. We continue to see excellent growth in our community. Over the past year, we've added over 200 million people using Facebook on a monthly basis. And in the second quarter, time spent per person increased double-digit percentages year-over-year across Facebook, Instagram and Messenger, and that doesn't even include WhatsApp yet. One of the biggest opportunities to grow our community is in developing countries where connectivity is less advanced than what we take for granted here at home. So, over the past couple of years, we've been making steady improvement throughout to make them work regardless of the device or connection that people are using. We've also built a lightweight version of our Android app called Facebook Lite that's tuned to work on 2G networks and is now used by more than 100 million. We're also working on new tools to help people express themselves and understand what's going on with the people they care about. Ten years ago, most of what we shared and consumed online was text. Now it's photos, and soon most of it will be video. We see a world that is video first with video at the heart of all of our apps and service. Over the past six months, we've been particularly focused on Live video. Live represents the new way to share what's happening in more immediate and creative ways. This quarter, Candace Payne's Chewbacca mask video was viewed almost 160 million times. Live is also changing the way we see politics, as news organization, delegates go live from the Republican and Democratic conventions, and we've seen in Minnesota and Dallas how Live can shine a light on important moments as they happen. This quarter we also launched 360 Photos. You don't need a special camera to take them. You just take a panorama or use the 360 cam or app on your phone and post it. And since we launched, more than 4 million 360 photos have been shared on Facebook with 1 million more being shared every week. We're making good progress on core services within the Facebook app, like search. A growing way that people use search is to find what people are saying about a topic across the more than 2.5 trillion posts in our network. Now people are doing more than 2 billion searches a day between looking up people, businesses, and other things that they care about. Continuous steady improvement in services like search are an important part of helping people connect and realizing our mission. We're also improving the experience for our community by building our business with more engaging ads. We've also emphasized the importance of measurements and value in driving real results for the businesses that use Facebook, and that means helping them create more relevant and engaging ads. Over the next five years, we're working hard to build ecosystems around some of our newer products. Instagram now has more than 500 million monthly active with more than 300 million daily. Now we're working to make that experience even more engaging. Recently, Instagram began to rank its feed because we know that people have a better experience when they see more of the stories they care about. We're already seeing a positive impact in terms of time spent and the amount of content that people are sharing. We've also introduced our advertising tools on Instagram and we're seeing marketers engage with people in creative and innovative ways. In the two years since we separated Messenger from the main Facebook app, which was a pretty controversial decision at the time, we've improved performance and given people new ways to express themselves. And now, for the first time, more than 1 billion people are using Messenger every month. I'm also happy with the updates we're making to WhatsApp, which also has a community of more than 1 billion people. This quarter, we launched new desktop apps, end-to-end encryption and millions of people are using WhatsApp's voice calling features. The scale we've achieved with our messaging services makes it clear that they are more than just a way to chat with friends. That's why we're also making it easier for people to connect in groups and businesses as well. We're going to keep focusing on this over the next several years. I'm also excited about the early progress we're making on our ten-year initiative. We're investing in new technologies to give more people a voice, including, of course, the 4 billion people around the world who aren't yet online. And we're helping more people take advantage of the opportunities that come with the internet. We're still early in our journey, lots of hard work ahead. But we're making good progress, like the first successful flight of Aquila, our solar powered aircraft that will beam Internet to places that have never been connected. Eventually, we're going to work with telecom operators and governments around the world to connect people on the outskirts of cities, rural areas, and disastrous zones where you can't get traditional connectivity today. We've also been making progress with our initiatives around artificial intelligence and virtual reality. This quarter, we announced DeepText, a deep learning based engine that can understand the context of several thousand posts per second across 20 different languages. This is a long-term project, but it also has some near-term benefits like helping show people more of what they want to see and filtering out less of what they don't want to see. We're also investing in new platforms to help people connect and share. We believe that virtual reality can help people share richer experiences and help everyone understand what's going on around the world. It's really early for us in VR, but we're hitting some important milestones. As of the second quarter, more than 1 million people a month are now using Oculus on mobile phones through our Gear VR partnership with Samsung. More than 300 apps are already available at the Oculus store for Gear VR. We filled all of our preorders for Oculus Rift and we're seeing increasing demand from retail stores planned for the holidays. While it's still early for augmented reality, we're doing AR research and are seeing lightweight versions of AR technology in mobile apps like MSQRD. So that's a recap of the progress that we're making in our ten-year plan. We have a saying at Facebook that our journey is only 1% done. And while I'm happy with our progress, we have a lot more work to do to grow our community and connect the whole world. That means making big investments and taking risks, focusing not just on what Facebook is but on what it can be. I want to thank everyone in our community, all of our teams, our partners and our shareholders for being a part of this journey with us. And now here's Sheryl."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "Thanks, Mark, and hi, everyone. We had a great second quarter. Q2 ad revenue grew 63%. Mobile ad revenue reached $5.2 billion, up 81% year-over-year, and was approximately 84% of total ad revenue. Our growth was broad-based across verticals, marketer segments and regions. We're excited to announce that we now have 60 million monthly active business pages on Facebook. We also continue to grow the number of active advertisers on our platform. This shows that both our free and paid products are providing value to marketers of all sizes around the world. We continue to focus on our three priorities, capitalizing on the shift to mobile, growing the number of marketers using our ad products, and making our ads more relevant and effective. First, capitalizing on the shift to mobile. For 32 years, the advertising industry has gathered in (9:55) to celebrate creativity. People have shifted to mobile and marketers know they need to catch up. Mobile is no longer a nice to do, it's a must do, and we're working closely with marketers to help them make this transition. The best marketers understand that people watch video differently in mobile feeds. The goal is to create what we think of as thumb-stopping creative, videos that grab attention in the first few seconds even without sound. For example, to drive awareness for Sour Patch Kids Gum, Mondelez targeted teens with non-chocolate candy interests. Working with the VaynerMedia, Carat and the Facebook Creative Shop, they created punchy, ten-second looping videos tailored for Facebook and Instagram. The campaign helped the Sour Patch Kids portfolio beat sales benchmarks for the entire candy industry. We're excited to bring more relevant video ads to people both on and off Facebook. In May, we expanded Audience Network to include video for brand objectives. This means that advertisers can place video, brand video ads, not just on Facebook and Instagram, but across a network of apps and sites. Our second priority is growing the number of marketers using our ad products. Over a third of small businesses and medium businesses in the U.S. don't have a website and having a mobile presence is even more difficult and expensive. Creating a business page on Facebook is as easy as setting up a personal profile. This is why Facebook pages are the mobile solutions for many of the 60 million businesses using our products each month in the U.S. and around the world. We've made it easy for business owners to manage their Facebook page from their mobile device. Over 85% of active business pages use mobile, and 40% of active advertisers have created a Facebook ad on their mobile device. In Q2, we rolled out new tools to make it easier for businesses to promote posts and track performance directly from the Instagram app. We've worked hard to make becoming an advertiser as easy as possible for these businesses. With just a few steps and for as little as a few dollars, businesses can boost their posts to reach more people. Simplifying our ad products is key to advertiser acquisition. Over 80% of new advertisers in Q2 started with simplified products like boosted posts. Once these businesses begin advertising with us, we make it easy for them to take advantage of even our most sophisticated capabilities. For example, Lighting Etc., a third generation family-owned business used Facebook and Instagram ads to drive in-store sales. They targeted 25-year-old to 45-year-old homeowners interested in interior design living within 35 miles of their showroom in Fort Worth, Texas. It was striking to them that on Facebook, the size of our community meant that they could reach over 300,000 people even with such specific targeting. They've seen a 40% increase in revenue in 2016, and they attribute this increase to their ads on Facebook and Instagram. Our third priority is making our ads more effective and relevant. Our goal is to help our clients grow their businesses, whether it be moving products off shelves, driving online sales or building their brands. Our system constantly looks for the most efficient and effective way to drive these objectives. Businesses that want to build their brands need to reach a large audience with a compelling story, and they're seeing strong results from immersive formats like video and Canvas ads. Businesses working to acquire new customers need to reach high quality leads and convert them to actions. We introduced lead ads in Q1 to make it easy for people to fill out forms on mobile devices right from News Feed. In Q2, we made it possible for advertisers to retarget people who opened or completed a lead ad form. For example, Nissan Turkey and the SCM agency used lead ads to collect over 20,000 high quality leads from people interested in buying a new car. They then used retargeting to show relevant ads to people who had completed these lead ads and ultimately drove vehicle sales. The cost of a high quality lead was 9.3 times lower on Facebook than all other online media. Businesses selling products are getting search like ROI from dynamic ads. Dynamic ads allow advertisers to upload their product catalogs and target people with specific products in real-time. Over 300 million people see dynamic ads each month and over 2.5 billion unique products have been uploaded by marketers. In Q2, we expanded dynamic ads to Instagram and also launched dynamic ads for travel. For example, you can now advertise specific destinations and dates for hotel rooms. We're pleased with the value we're driving for our partners and the progress we're making across our three priorities. With only a small fraction of our 60 million business page is advertising, we have a lot of opportunity ahead. We also have a lot of hard work to do to help businesses make the shift to mobile and to drive results for our clients. I want to thank our clients around the world for their partnership and their ongoing input, which informs our product development. I also want to congratulate our global teams on the results of their hard work and thank them for their dedication to our mission. Thanks, everyone. And now here's Dave."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Thanks, Sheryl, and good afternoon, everyone. Q2 was another strong quarter for Facebook. Total revenue grew 59% to $6.4 billion and we generated over $2 billion in free cash flow. These results highlight the continued growth and engagement of our global community and the strength of our ads business as advertisers benefit from our increasingly broad and deep portfolio of targeting, creative and measurement tools. Let's start with our community metrics. This past quarter was our strongest in over three years in terms of absolute year-over-year growth of monthly and daily actives on Facebook. In June, 1.13 billion people used Facebook on an average day, up 17% compared to last year. This daily number represents 66% of 1.71 billion people who visited Facebook in the month of June. Mobile continues to drive our growth, with over 1 billion people accessing Facebook via mobile devices on an average day in June, up 22% compared to last year. The growth of our other services also continues to be strong. WhatsApp and Messenger now each have over 1 billion monthly actives and Instagram surpassed 500 million. Turning now to the financials. My comments today will focus on our GAAP financial metrics and all of our comparisons are on a year-over-year basis unless otherwise noted. A reconciliation of our GAAP to non-GAAP financial metrics is included in our press release and earnings slides. Total Q2 revenue was $6.4 billion, up 59%. Q2 ad revenue was $6.2 billion, up 63%. Exchange rates did not impact our overall revenue growth rate this quarter as headwinds in certain currencies were offset by tailwinds in others. U.S. and Canada, and Asia-Pacific were our fastest growing regions with advertising growth rates of 69% and 67% respectively. Mobile ad revenue was $5.2 billion, up 81%, and representing approximately 84% of total ad revenue. Let's turn to the supply and demand factors that continue to drive our growth. Advertiser demand was particularly strong in Q2 across a broad range of verticals and advertiser objectives. Additionally, supply side factors, including growth in users, time spent and ad load, all contributed to our Q2 revenue growth. In Q2, the average price per ad increased 9% while total ad impressions increased 49%. The reported increase in price was again driven by the continued mix shift towards mobile where we only show higher price News Feed ads compared to the mix of News Feed ads and lower priced right-hand column ads on personal computers. The 49% increase in total ad impressions was driven primarily by growth in ad impressions served in Facebook mobile News Feed where the majority of our ads are shown. Payments and other fees revenue was $197 million, down 8%. Remember that payments and other fees revenue largely generated from games played on personal computers, which has declined as people spend less time on their PCs. Q2 total expenses were $3.7 billion, up 33%, inclusive of $825 million of share-based compensation related expenses as well as $193 million of amortization of intangible assets. Q2 operating income was $2.7 billion, representing a 43% operating margin. We continue to be pleased with the profitable growth of the business while we invest for the long-term. We ended Q2 with approximately 14,500 employees, up 32% year-over-year. We added about 900 employees in the quarter, the majority of those in technical functions. We are seeing continued success with our efforts to hire top talent in a market that remains very competitive. Our Q2 tax rate was 26%. GAAP net income was approximately $2.1 billion or $0.71 per share. Q2 capital expenditures were $1 billion. Year-to-date capital expenditures totaled $2.1 billion, driven by investments in data centers, servers, office buildings, and network infrastructure. Facebook generated over $4 billion in free cash flow in the first half of 2016. And as of June 30, we had over $23 billion in cash and investment. Turning now to the outlook. First, some color on revenue. We have been pleased with the strength of our advertising revenue in the first half of 2016. As I discussed on our last call, while we expect the main drivers of our advertising revenue growth will continue throughout 2016, we will face tougher comparables as the year progresses, given the accelerating revenue growth rates we experienced in the second half of 2015. Consequently, we anticipate lower advertising revenue growth rates in each successive quarter in 2016. Additionally, we anticipate ad load on Facebook will continue to grow modestly over the next 12 months, and then will be a less significant factor driving revenue growth after mid-2017. Since ad load has been one of the important factors in our recent strong period of revenue growth, we expect the rate at which we are able to grow revenue will be impacted accordingly. Turning now to expenses. Based on our updated view of the remainder of the year, we are tightening our expense guidelines ranges. We expect that full year 2016 total GAAP expense growth will be approximately 30% to 35%, narrowed from our prior range of 30% to 40%. We expect full year 2016 amortization expenses to be approximately $700 million to $800 million, and full year 2016 stock-based compensation related expenses to be approximately $3.1 billion to $3.3 billion. Accordingly, we anticipate that our total non-GAAP expenses, which excludes stock-based compensation and amortization, will grow in the range of 45% to 50%, narrowed from our prior range of 45% to 55%. We anticipate full year 2016 capital expenditures will be approximately $4.5 billion as we invest to support the rapid growth of our business. Finally, we expect that our Q3 and full year 2016 tax rates will be similar to our Q2 rates. In summary, Q2 was another great quarter for Facebook, illustrated by the strong growth and engagement of our global community and continued broad-based strength of our ad business. We're pleased with the results, and we will continue to invest in order to best position Facebook for our long-term growth opportunities. With that, Chris, let's open up the call for questions."
},
{
"speaker": "Operator",
"text": "Thank you. We will now open the lines for a question-and-answer session. [Operation Instructions] Your first question comes from the line of Eric Sheridan with UBS. Your line is open."
},
{
"speaker": "Eric J. Sheridan - UBS Securities LLC",
"text": "Thanks for taking the questions. Maybe two. One on the video platform going forward and how you think about video as a distribution mechanism. How should we think about investments that need to be made in video on both technical infrastructure side as well as the sourcing of content type sort of broadened out the video offering over the next couple of years? And then maybe on the last comment on ad load, just wanted to go back to that for a minute in terms of what you're seeing on ad load by region, because we're seeing a widening gap in revenue per user between U.S. and Canada and the rest of the world. How much of that might be driven by ad load or ad products? Thank you so much."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Sure. I can take the question on video distribution as it relates to CapEx and the ad load question, and then maybe on the sourcing of content, I'll pass it back to Sheryl. So, on the video platform, clearly, from a investment perspective, you've seen us step up our CapEx this year pretty substantially. And that's baked into the guidance of $4.5 billion of CapEx which, if you recall, is at the high end of our prior range. We are investing across our infrastructure to prepare ourself for growth across all of our different services. And part of that investment is really to support video. That is definitely more taxing on the network and we're investing heavily on the network side. And as well, it does also impact our overall needs within the data center, servers and the like. So it's certainly an area that we're investing in heavily and we expect to be investing in heavily going forward, Eric. And then on the ad load question, ad load is not something that varies that dramatically by region. So you're really looking at a number of factors. Really what's driving that is just the dispersion of overall ad demand across region. And we're seeing really good strength across the globe on that front, but ad load is not a big driver of discrepancies in ARPU that you see. That's really something that maps very closely to the size of the mobile ad markets per population in those countries. So it's not an ad load question. And then I'll hand it over to Sheryl to talk about video from a content perspective."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "When you think about what's happening on video on our platform, we're really excited by the production and consumption of video, and we're seeing the full range from people posting the things in their personal lives. The power of what a mobile phone can produce and distribute now is pretty incredible, when you compare it to just a few years ago, to some of the most sophisticated content producers in the world producing for us. We're experimenting across a wide variety of things. We're doing a partnership with the NBA to stream some U.S. Men's Olympic team games in the next couple of weeks. That said, our primary focus is on short form content, not long form content, and we're pretty excited to see the different forms of content people will create, both to share messages, to create new content and to engage audiences around the world."
},
{
"speaker": "Operator",
"text": "The next question is from Douglas Anmuth with JPMorgan. Your line is open."
},
{
"speaker": "Douglas T. Anmuth - JPMorgan Securities LLC",
"text": "Thanks for taking the questions. I just have two. First on engagement, obviously, the DAU and MAU numbers were strong. You gave the increase in the daily activity as well in the double-digits. But can you just give us some color on the user trends underneath that a little bit, and more specifically perhaps what you might be seeing in terms of younger users in different age demographics? And then secondly, just going back to the ad load, we have in the past heard some caution from you guys before in that area, and granted it was a few years ago and at a much earlier stage. But I guess my question is, if targeting continues to improve along with click-through-rate and then ultimately ROI, why does ad load have to become less of a factor going forward? Thanks."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Yeah, thanks. Thanks, Doug. On the DAU and MAU front, couple of things. One is DAU and MAU are up sequentially and year-over-year on all regions, and with trends that are largely consistent with past quarters. So, really good strong growth across the globe on a DAU to MAU ratio. We don't do specific break downs of those metrics by demographic. We're obviously pleased with our overall level of growth in engagement. On the teen front, younger users, we continue to be the best way to reach the largest global audience of teens and millennials. Teens remain very – remain engaged on Facebook. Clearly, how they've used our service has evolved over the years. And in addition to Facebook, they're using Instagram, Messenger and WhatsApp. So, from a teen perspective, that's some color there. On the ad load front, ad load is definitely up from where we were a few years ago. It has been an important driver of inventory growth. And really, I think one of the things that's enabled us to grow ad load has been improving the quality and the relevance of the ads, as you've mentioned. And we've been be able to do that without negatively impacting the user experience. We do expect that ad load will be a less significant factor driving overall growth, especially after mid-2017. The optimal ad load is really a mix of art and science. We've carefully tracked the impact of ads on the user experience over the last several years. We aren't seeing a cause for concern. We also want to be thoughtful about making sure that each person's overall feed experience has the right balance of organic and ad content. And that factors into how we think about ad load and where that might ultimately be. And that's really why we're talking about our expectation that as you get into mid-2017, ad load will not be a big factor in driving overall inventory growth. We still see the opportunity to grow inventory from the growth of people and engagement on Facebook, as well as our other services like Instagram. Instagram does have a lower ad load than Facebook."
},
{
"speaker": "Operator",
"text": "The next question is from Brian Nowak with Morgan Stanley. Your line is open."
},
{
"speaker": "Brian Nowak - Morgan Stanley & Co. LLC",
"text": "Thanks for taking my question today. I have two. The first one on the U.S. advertising, it was up particularly strong. Any specific ad category, branded, direct response, et cetera, or add unit like video that's driving this growth in the U.S.? And then the second one, just on Live video, recognizing it's very early with Live video, but any help at all on what percentage of your users are engaging with Live video and the type of uplift you're seeing on engagement? Thanks."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "Our growth this quarter was very broad-based across all of the regions. We had especially strong growth in APAC and the U.S. and Canada, so that was part of the growth. In terms of our marketer segments from brands to direct response to SMBs to developers, the growth is really strong there as well. We're really excited today to announce that we have 60 million small business pages that are using Facebook on a monthly basis. And we're very focused on the opportunity to upsell them to advertising products. We think we have a good track record there. We're also seeing a lot of strength in brand. And I think that's because we have a combination of the creative and the story telling, so the art with the science of the targeting. And when people do that well together, you see great opportunities. So to share one example, Jack In The Box use our Canvas ads, which are very immersive ads. They're really good for a brand experience, to roll out a new menu item, their Double Jack burger. They worked with agencies Horizon, David & Goliath and Adaptly, and they targeted millennials on Facebook to create two different custom audience groups. One group was customers who had visited the restaurant web page or engaged with previous video ads. And the second group were people that hadn't engaged with them directly but were quick service restaurant purchasers. They had an average view rate of 23 seconds across those Canvas ads, so clearly people were really engaged in the brand experience of the ads, and they had a 13-point lift in add recall and a 9-point lift in purchase intent. And so I think what you're seeing is that across all of the objectives people have from brand marketers to direct response to SMBs to developers, as our ad products get more sophisticated, our targeting and measurements get better. They have an increased opportunity to grow, and that's why we think our growth to-date continues to be broad-based."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Yeah, and, Brian, I'll take the Live video question. It's hard to compete with the Double Jack burger. But in terms of Live video, it's really early. We're really excited about it in terms of it providing an authentic and real form of sharing for people, and we're really trying to give people the full range of tools to share what they care about with anyone that they want, and Live is really effective there. And we've seen experiences both in terms of a lighthearted like Candace Payne and also more serious, more serious issues around the U.S. and around the globe. So it's really an important part of what we're offering for people to share real experiences. Video as a whole is making a significant contribution to time spent growth. So, when we talk about the time spent per DAU growing worldwide across our family in double-digit percentages, video is making a contribution there more broadly."
},
{
"speaker": "Operator",
"text": "The next question is from Justin Post with Merrill Lynch. Your line is open."
},
{
"speaker": "Justin Post - Merrill Lynch, Pierce, Fenner & Smith, Inc.",
"text": "Yeah, I have a couple. First, Mark, maybe on core Facebook, there's been commentary out there that maybe there's less personal sharing. Just maybe comments on the direction of Facebook? What the activities are going on, how you feel about that? And then just about the ad loads, I mean how are you deciding how much ads to show? Could you hold back a bit and drive higher pricing? How are you balancing that? And why not hold back a little bit more now for longevity there? Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer",
"text": "Sure. So I'll talk about sharing, and then I think Dave can probably talk about ad loads and pricing. So, the overall level of sharing is up on Facebook. And what we're seeing is that how people share is evolving as we move from desktop to mobile, right. So you can imagine more photos on people's mobile cameras, fewer long full photo albums, more ability to capture video, probably a little bit harder to type on mobile. So there's this evolution. The other thing that we see is that now people have tools to share more privately as well. So when you think about sharing on Facebook, you shouldn't just think about the kind of sharing that you see in News Feed, right. So sharing with all of your friends, sharing in groups on Facebook and public sharing, which are the trends that I was just talking about. But another area that's growing incredibly quickly is private messaging, right, where between Messenger and WhatsApp, I think we're around 60 billion messages a day, which I think is something like three times more than the peak of global SMS traffic. So that is something that's growing pretty quickly and that we're really excited about as well. And we're just going to continue working on giving people the best tools across the spectrum from private to public, and across the spectrum from text-based and simple communication to richer type of media like photos, videos, and then, eventually, more immersive forms like VR."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Yeah, and Justin, in terms of ad load, we've talked about the different factors that go into it, obviously, just in driving the overall business. Advertiser demand, that was particularly strong this period, and then also we matched that with supply. And the supply – the two big drivers are user and time spent and then ad load. And getting the balance and mix right is important, and clearly, how the pricing plays out is via the auction. And we've had a good balance of demand growth and supply growth, and that's led to our good strong financial results and our ability to deliver very strong ROI to advertisers. So we think we're in a good zone on the right ad load, and we do think there's opportunities to grow that modestly. But as we look forward into 2017, we think it'll be a less significant factor driving inventory growth. But we still think there's opportunities to drive inventory through user growth and time spent. I don't think we would think about necessarily dropping ad load to drive pricing. We're also very cognizant of providing good value to advertisers, and getting that balance right is important to driving overall ROI, as well as obviously providing better targeting and measurement tools for our advertisers."
},
{
"speaker": "Operator",
"text": "The next question is from Anthony DiClemente with Nomura. Your line is open."
},
{
"speaker": "Anthony DiClemente - Nomura Securities International, Inc.",
"text": "Great. Thank you for taking my questions. I have one for Mark and one for Sheryl. Mark, you mentioned search in your prepared remarks, two billion searches a day on Facebook. I also noticed you said you're making it easier for users to connect to businesses. How far away are you from commercial search on Facebook being viable? Why can't you do that today? And how big of an opportunity could commercial search be? And then, Sheryl, you mentioned the expansion of the Facebook Audience Network. Can you talk more about the revenue opportunity of bringing Facebook's targeting tools to other video publishers? How fast is Audience Network monetization growing? Is it accelerating, for example, and how do you see the revenue opportunity of expanding the Audience Network across the mobile web as well? Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer",
"text": "I can take search. So when we talk about our strategy, I often talk about how when we develop new products we think about it in three phases. First, building a consumer use case; then, second, making it so that people can organically interact with businesses; and then third, on top of that, once there's a large volume of people interacting with businesses. Give businesses tools to reach more people and pay, and that's ultimately the business opportunity. So, I'd say, we're around the second phase of that in search now. You know, we have a pretty big navigational use case where people look up people and pages and groups that they want to get to and look at in search. One of the big growing use case is that we're investing a lot in is looking up the content in the ecosystem, and that is an area that we're very excited about, which helps people find more content. But certainly there's a reasonable amount of behavior in there which is looking for things that, over time, could be monetizable or commercial intent. And at some point we will probably want to work on that, but we're still in the phase of just making it easier for people to find all the content they want and connect with businesses organically."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "On the Audience Network, we continue to invest in ad tech, and the Audience Network is a key part of our focus there. We don't break out revenue by our different platforms. But the opportunity to take not just video ads, but other ad formats we have, bring them to the rest of the web and other apps with our ability to target and measure, we think is a big one. And what we're starting to see is that people are using Facebook, Instagram and Audience Network to drive their objective in a cohesive way. So to share an example, Garmin launched the Fenix 3 Sapphire watch, and they did it with videos ads on Facebook that worked without sound. They targeted outdoor enthusiasts then retargeted people who viewed the Instagram videos with Carousel ads on Facebook that highlighted the product features. Then they extended those ads on Audience Network to maximize reach, and they used the Facebook Pixels to measure the incremental sales, and got to a 9.7 times return on ad sales. So that's a really good example of how you can take targeting and the ability to target across Audience Network, Facebook and Instagram and drive people all the way down the funnel. And we think more and more people will do that, particularly as we do a better job of combining the interfaces. So, for example, you can buy now in one interface on Facebook, Instagram and Audience Network."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "And then, Anthony, just one thing to add on top of that, just the – we recognize the majority of our third-party advertising revenues of the Audience Network on a net rather than gross basis. So that will also minimize the impact that will have on the top line."
},
{
"speaker": "Operator",
"text": "The next question is from Mark Mahaney with RBC Capital Markets. Your line is open."
},
{
"speaker": "Mark Mahaney - RBC Capital Markets LLC",
"text": "Mark, when you see the what seems like phenomenal success of Pokémon Go, what are your reactions to that? And then, David, could you talk about the monetization ramp that you're seeing on the messaging platforms? I know it's still very early days. Anything in there that strike you as being particularly substantive for material yet? Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer",
"text": "Well, I, like everyone else, am enjoying Pokémon Go. And the biggest thing that I think we can take away from this as we invest in augmented reality in addition to virtual reality, is that the phone is probably going to be the mainstream consumer platform that a lot of these AR features first become mainstream rather than glasses form factor that people will wear on their face. So I think we're seeing this in a number of places, whether it's location through Pokémon or some of the face filter activity. I referenced the MSQRD app that we acquired earlier in my remarks. That's a kind of a fun way to augment. You know, social experience that you're having with someone. I think that there's a big opportunity to build out that platform and a lot more functionality around that. And one of the big themes that we're talking about here is becoming video first, right, and as people look for richer and richer ways to express themselves just like people in the past just shared a lot of text and photos on Facebook, we think that in the future more of that is going to be video. And more of these augmented reality tools I think are going to be an important part of delivering that experience to making that fun to use and expressive as it can be."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "And, Mark, we've talked about our strategy on how we go about monetizing the different apps in our portfolio, and we usually talk about it in terms of three phases. Phase one is really growing the user base and engagement. And we're really pleased with where we are with Messenger and WhatsApp in that perspective with it's over 1 billion monthly actives. The second phase is really working on buildings organic interactions between businesses and consumers; and then finally, the third phases is about building those commercial opportunities. With Messenger, we're really at the beginning of phase two. Messenger today has 1 billion organic interactions between businesses and consumers each month. But in terms of where we are in having in terms of actual monetization, incredibly early on that front. We're really in the – in that phase two where we're really talking about building those organic interactions."
},
{
"speaker": "Operator",
"text": "The next question is from Heather Bellini with Goldman Sachs. Your line is open."
},
{
"speaker": "Heather Bellini - Goldman Sachs & Co.",
"text": "Great. Thank you very much. I was wondering, and I guess this is a follow up on Anthony's question. Is there a way to think about maybe the percentage of your kind of top 100 customers, or however you want to define it, that might be using FAN as an ad on to their Facebook spending? I guess I'm wondering if you're seeing increasing leverage of FAN. And then the other question would just be political spending, obviously, wasn't a big driver for you guys in 2012, but it does seem like it is potentially a great opportunity in the back half of the year. I was just wondering if you could comment on that at all. Thank you."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "On the political spending, our business is broad-based, not that no one event drives our business, we're pretty large and diversified. And while the political campaign, obviously, a lot a money is spend in ads. That's also true of an Olympics; it's true of a World Cup, it's also true of a Super Bowl. And so, with all of these events taking place around the world, there's no one event that we think drives a huge portion of revenue. That said, we are pleased by what's happened on Facebook for the elections cycle, not just on the paid side but actually on the organic side as well. We really see Facebook being embraced by politicians all over the world to get in touch with their constituents. And we're pleased with that. Every member of Congress right now has a Facebook presence. And we're seeing people like, one example is Elise Stefanik, the youngest person in the Congress. She made a pledge when she was elected that she would explain every vote she takes, and she explains every vote she takes on Facebook. With shorter explanations if they're not controversial but longer explanations. That's the kind of mission based work that we're happy about because it brings people closer to the people who are representing them. We don't break out how many advertisers are advertising on the Audience Network, but we're seeing solid and growing adoption of the Audience Network across the board, as we are with Instagram. And we think all of these platforms together really help give us the ability to serve our clients in a very leveraged way, and use the targeting and measurement capabilities we have invested in across multiple platforms."
},
{
"speaker": "Operator",
"text": "The next question is from Carlos Kirjner with Bernstein. Your line is open."
},
{
"speaker": "Carlos Kirjner-Neto - Sanford C. Bernstein & Co. LLC",
"text": "Hi. Thanks for taking my question. First, some people believe that much of what users see in their News Feed is driven by their behavior and preferences. And as a consequence, the stories they end up seeing are always, or almost always, in line with their existing views and preferences. Does this phenomenon in the end increase – does this phenomenon lead to increased adoption in use of Facebook creating more polarization of views and less effective communication, at least in some areas of people's lives? Mark, how do you think about this line of thought that because people see things that they are already in line with what they believe, communication is hindered? Second, when it comes to video ad formats, are you philosophically opposed to pre-rolls, and if yes, why? And if not, what is missing for you to adopt that? Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer",
"text": "So we have studied the effect that you're talking about, and published the results of our research that show that Facebook is actually, and social media in general, are the most diverse forms of media that are out there. And basically what – the way to think about this is that, even if a lot of your friends come from the same kind of background or have the same political or religious beliefs, if you know a couple of hundred people, there's a good chance that even maybe a small percent, maybe 5% or 10% or 15% of them will have different viewpoints, which means that their perspectives are now going to be shown in your News Feed. And if you compare that to traditional media where people will typically pick a newspaper or a TV station that they want to watch and just get 100% of the view from that, people are actually getting exposed to much more different kinds of content through social media than they would have otherwise or have been in the past. So it's a good sounding theory, and I can get why people repeat it, but it's not true. So I think that that's something that if folks read the research that we put out there, then they'll see that. What was the other question?"
},
{
"speaker": "Unknown Speaker",
"text": "Pre-roll."
},
{
"speaker": "Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer",
"text": "Oh, pre-roll. I can take that one too. So we don't think it would be a good experience in News Feed, right, because a lot of when people are finding videos on Facebook is you're scrolling through News Feed, you're looking at what story seems interesting to you, which is why we did the auto play videos so that rather than having to take an action, you can just start experiencing the video automatically and continue watching it if it's something that you're interested in. But if we started playing an ad in the middle of a feed before you got to the video, then that would really go against that. I think people just would watch a lot less of the organic videos that were posted because of that. But the important thing to keep in mind on this is we don't really – we don't need to do pre-roll because our model is not one where you come to Facebook to watch one piece of content, you come to look at a feed and putting the ads in between the stories is a much more effective way to do it and better for the user experience."
},
{
"speaker": "Operator",
"text": "The next question is from Ross Sandler with Deutsche Bank. Your line is open."
},
{
"speaker": "Ross Sandler - Deutsche Bank Securities, Inc.",
"text": "Great. I had two product related questions for Mark. So, Mark, you guys mentioned when you released the latest Instagram MAU crossing the 500 million mark, you give out the breakdown of U.S., international. It looks like U.S. has been around 100 million for about the past nine months. So is that just a pause along the growth path or is there something else that you're seeing that's causing that growth to stall out a bit in light of what you just said about engagement being up since you did the algorithm reranking? Any color there would be helpful. And then the second question is just any update on Messenger M and how do you see that product potentially impacting engagement monetization on Messenger? Thanks."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "On any update on M, I can start with that one. Do you -"
},
{
"speaker": "Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer",
"text": "I was going to take that one."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Oh. You were going to take that one? On the Instagram MAU question, I don't think we're breaking out by region Instagram MAU. So, no, I don't think there's any update there that I'm aware of."
},
{
"speaker": "Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer",
"text": "Okay. Yeah, so we just haven't updated that."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Yeah, all right."
},
{
"speaker": "Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer",
"text": "Yeah, so for M, we've released the Messenger platform M bot in the last six months – F8 was the big announcement there. And I think since then, I think we've announced we have more than 10,000 bots in the system, which are basically making it so that different businesses can build automated ways to communicate with people. The way we think about this experience is that, qualitatively, I don't know a single person really who wants to call a business to get support or interact with it. Whether that's trying to get a reservation for a restaurant or getting customer support or calling to buy something. And those are slow interactions. They're synchronous. They consume your whole attention while you're doing them. And if we can make it so that you can have some of those interactions in an automated way where you fire off a text and then just get a response back quickly, but asynchronously so it doesn't take up your full attention, then I think that's going to be a much better experience that people really enjoy and like. So we're in the experimentation phase I think with the platform. We're seeing a lot of good ideas getting tried out. And I personally enjoy a lot of the different bots that people are using or making, especially the news one where you get these digests at the end of the day of different kinds of content. And between that and M, which is kind of our own internal bot that we're building, I think that this is going to be an interesting area to watch and encourage more interaction between people and businesses and messaging."
},
{
"speaker": "Operator",
"text": "The next question is from Ben Schachter with Macquarie. Your line is open."
},
{
"speaker": "Benjamin Schachter - Macquarie Capital (USA), Inc.",
"text": "Couple of questions for Mark. The first one, what are the lessons you're learning from seeing the growth of Snapchat and some of the other newer networks, particularly among young people? And obviously Facebook is continuing to do well but these things are growing. And then second, related to video, what are the key problems that you really think you need to solve for consumers and video producers and how is Facebook going to evolve to help solve those problems? Thanks."
},
{
"speaker": "Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer",
"text": "Sure. And they're related. So, overall, people are spending more and more time on mobile, and that means that there are always more services that people use whether it's YouTube or there's some really interesting ones with younger folks, especially like musical.ly and live.ly that I think are pretty interesting as well, the Snapchat, which you mentioned. And part of why I think you see this is that there are just so many different ways that people want to share so many different kinds of content, ranging from text to photo to video, just richer and richer and more immersive content. And also there's a range from private one-on-one type sharing to small groups, all of your friends at once, large interface communities, and then ultimately fully public. And there are different apps that explore different regions of that space and do a good job with it, and offer ideas that I think the whole market needs to learn from. Right now, the big theme and strategy that we're executing is we're going to become video first. And what I mean by that is that there's this trend where ten years back, most of what you saw and shared online was text, and then we went through a phase where most of it is photos. And we really believed that, and call it five years, or whatever the period of time that it takes to get there, I think most of what people consume online is going to be video. And that means that there needs to be a whole range of new production tools and consumption experiences for enabling that. For production, I think that means that you need to get the camera experience, and the experience for capturing and uploading videos that you've captured to be much better in a more central part the of the experience. On consumption, there are innovations that we've had like auto play in feed, but what's the next version of that, that makes it so that people can have an even more native and default video experience when they're in News Feed, as well as private areas like Messenger and WhatsApp. So I think you're going to see this across all of our apps. More focused on producing this kind of content, and making it first class to consume as well, both in private and public context. And I think that that's just a big trend across the market, and one of the big things that if we get right, I think it's going to unlock a lot of sharing and opportunities."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "And then just following up on Ross's question on Instagram in the U.S., because I think Ross, you were asking, we've provided some rough percentages around international and U.S., and I just wouldn't – I wouldn't – those are very approximate, and I wouldn't base any trending on that, on those percentages."
},
{
"speaker": "Operator",
"text": "The next question is from John Blackledge with Cowen & Co. Your line is open."
},
{
"speaker": "John Blackledge - Cowen & Co. LLC",
"text": "Great. Thanks. For Instant Articles, I think it went live globally for all publishers around the time of F8 in April. Just wondering if you can provide an update on the progress and how you see Instant Articles evolving over the next couple of years? And then maybe Dave, on the 49% year-over-year impression growth, how much of that was driven by ad loads? Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer",
"text": "If I can take Instant Articles quickly. I think it's going well. It's a good user experience. People like it. The hypothesis when we rolled it out was that if we removed the latency, which is often 10 seconds to 15 seconds of opening up a web view from News Feed that more people would read news. I think the initial data suggests that that's probably true. So that's good. We're getting more partners on. And over the long-term, I think one of the big things that we need to do is see if we can not only make this good for engagement for our partners, but also a really positive business driver for them too. So that's something that I'm excited about, and we'll hopefully have more news on that coming up."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "So, on the 49% year-over-year growth in impression, we're not providing a specific break down there. I would say that it's primarily driven by growth in Facebook mobile News Feed. We've talked about the drivers of supply being growth in DAU, growth in time spent per DAU and ad load, and obviously, we've given stats around rough stats around – we've given specific stats around DAU. We've talked about time spent per DAU being up double-digit. So I think you can make some assumptions around that. So that's probably the way to triangulate on that. I think we have time for one more question, Chris."
},
{
"speaker": "Operator",
"text": "Certainly. The final question is from Mark May with Citi. Your line is open."
},
{
"speaker": "Mark A. May - Citigroup Global Markets, Inc. (Broker)",
"text": "Thanks a lot. I had two as well. You probably won't give specific revenue numbers, but just if you're – if you kind of, in aggregate, look at some of the non-Facebook app revenue streams, if it is FAN, Instagram, et cetera. Curious to get a sense of the traction and materiality of those. Would you expect, Dave, that in aggregate, those would become kind of material, meaning that sort of 10% plus threshold sometime this year? Just trying to get a ballpark sense of the level of traction and diversification of revenue outside the core Facebook app. And then along the lines of your commentary around ad load, how should we be thinking about, your MAUs are obviously very significant, DAU to MAU quite high. Do you continue to see that as being a primary driver of ad impression and ad revenue growth going forward as well? Thanks."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Yeah, thanks, Mark. Like you said, we're not specifically breaking out revenue numbers. One thing to just keep in mind is Instagram is known and operated property is represented gross in our revenue, so whereas as I mentioned the Audience Network is by and large going to be recognized net rather than gross. And so that is going to make it smaller in how it's going to appear in the revenue numbers. The overall growth is still being driven predominantly by Facebook. Instagram is clearly making a contribution and as is the Audience Network. In terms of ad load, as I said, it's been one of the factors driving supply, so it certainly has been helpful. But there's also DAU growth and time spent per DAU growth so time spent per person. And we continue to feel that there are opportunities to execute on those and to continue to grow inventory in that way. So that's where we would focus. You know, as we drive DAU faster than MAU, then that's going to increase that ratio, but we're really focused on driving DAU and time spent per person."
},
{
"speaker": "Deborah Crawford - Director-Investor Relations",
"text": "Great. Thank you for joining us today. We appreciate your time, and we look forward to speaking with you again."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this conclude today's conference call. Thank you for joining us. You may now disconnect your lines."
}
] | null | null |
META | 1 | 2,016 | 2016-04-27 21:15:00 | Executives: Deborah Crawford - Director-Investor Relations Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer Sheryl K. Sandberg - Chief Operating Officer & Director David M. Wehner - Chief Financial Officer
Analysts: Eric J. Sheridan - UBS Securities LLC Brian Nowak - Morgan Stanley & Co. LLC Douglas T. Anmuth - JPMorgan Securities LLC John Blackledge - Cowen & Co. LLC Heather Bellini - Goldman Sachs & Co. Justin Post - Bank of America Merrill Lynch Benjamin Schachter - Macquarie Capital (USA), Inc. Mark A. May - Citigroup Global Markets, Inc. (Broker) Benjamin C. Gaither - Robert W. Baird & Co., Inc. (Broker) Kenneth Sena - Evercore ISI Ross Sandler - Deutsche Bank Securities, Inc. Anthony DiClemente - Nomura Securities International, Inc.
Operator: Good afternoon. My name is Chris, and I will be your conference operator today. At this time, I'd like to welcome everyone to the Facebook first quarter 2016 earnings call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin.
Deborah Crawford - Director-Investor Relations: Thank you, good afternoon and welcome to Facebook's first quarter 2016 earnings conference call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release, our Annual Report on Form 10-K filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now I'd like to turn the call over to Mark.
Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer: Thanks, Deborah, and thanks, everyone, for joining today. We started 2016 off well. 1.65 billion people now use Facebook every month and 1.09 billion people use Facebook every day. In recent weeks, we're also consistently seeing more than 1 billion people using Facebook on mobile every day. We're also pleased with our business results. Total revenue this quarter grew by 52% year on year to $5.4 billion, and advertising revenue grew by 57% to $5.2 billion. I'll have more to say about these results in a minute, but first I want to talk about a proposal by our Board of Directors to reclassify Facebook stock. At F8, I talked about our mission and how the work we're doing to connect the world is more important today than it's ever been. I walked through our 10-year roadmap, focused on building the technology to give everyone in the world the power to share anything with anyone. Bringing people together and giving everyone a voice takes a long-term commitment, not just over the next few years but over the next few decades. We're focused on the long term, and that's the main reason for today's proposal. Facebook has always been a foundry-light company, so we can focus on our mission and build long-term value. This structure has served our shareholders well. Early on, we received some generous offers for companies trying to buy Facebook, and our structure helped us resist that pressure. More recently, we navigated a challenging transition to mobile. But because we were a controlled company, we were able to focus on improving the user and product experience of our apps first and then build a strong mobile business over time rather than being forced to do something shortsighted. And over the years, our structure has helped us make big bets on acquisitions like Instagram that were very controversial initially but were good decisions for our community and our business. Facebook has been built by a series of bold moves. And when I look out into the future, I see more bold moves ahead of us than behind us. We're focused not on what Facebook is, but on what it can be and on what it needs to be, and that means doing bold things. A lot of what we're building today in areas like connectivity, artificial intelligence, and virtual and augmented reality may not pay off for years, but they're important to our mission of connecting the world. And I'm committed to seeing this mission through and to leading Facebook there over the long term. Personally, there's another element to this. While helping to connect the world will always be the most important thing that I do, there are more global challenges that I also feel a responsibility to help solve to create a better world for my daughter and all future generations, things like: helping to cure all disease by the end of the century; upgrading our education system so it's personalized for each student; and protecting our environment from climate change. That's why Priscilla and I created the Chan Zuckerberg Initiative and committed to give 99% of our Facebook shares to advance human potential and promote equality. Today's board proposal will allow us to maintain and improve the voting structure that has served us well and allow me to fund the Chan Zuckerberg Initiative. In December, I also announced that I won't sell more than $1 billion worth of stock – Facebook shares per year over the next three years. That's still my commitment, and I'll update our shareholders on future plans beyond that. Dave will talk more about the mechanics of this proposal in his comments in just a few minutes. But before we get there, I want also share a few more thoughts on the progress we've made this quarter. As I said before, our roadmap has three horizons. Over the next three years, we're going to keep investing in our most developed ecosystem, the Facebook app and platform. Today, people around the world spend on average more than 50 minutes a day using Facebook, Instagram, and Messenger, and that doesn't even include WhatsApp yet. This growth isn't happening because we came up with just one or two big changes. Our team has just worked day after day on lots of improvements over a long period of time, and that progress continued in the first quarter. We launched Reactions to help people express themselves in more ways, and we improved our products to work on different mobile networks and devices all over the world. Sheryl will talk more about this in a minute, but now more than 3 million businesses are using our advertising products every month. We've expanded our measurement capabilities so more businesses can see the results they get from ads. And we've made it easier for small and medium businesses to use the same targeting tools and ad formats that our larger advertisers use. Over the next five years, we're going to build ecosystems around our products that are already being used by a lot of people. We're at the beginning of a golden age of online video. Video isn't just a single kind of content. We think it's a medium that allows people to interact in a lot of new ways. So that's why in addition to normal Internet video, we're also focusing on more interactive video experiences like Live and 360 video. I'm a big Game of Thrones fan, and the other week HBO and our Oculus team came out with a 360 video of the opening sequence of the show. And it's now the most watched 360 video on Facebook in any 24-hour period, with more than 12 million total views. Earlier this month, we opened up Live to everyone. Live is just one part of our overall video effort, but we think it has a lot of potential. Friends go Live because it's unfiltered and personal. Actors and news anchors go Live because they can reach bigger audiences in some cases than they can on even their own shows. And if we do a good job, we think it's something that people will associate with Facebook, with interacting with people and not just watching content. But it's also a very new and small part of all of the videos that we see on Facebook today. I'm also really excited about what we're building around messaging. Right now we have two of the top messaging apps in the world. Nine hundred million people use Messenger every month, and 1 billion people use WhatsApp every month. Between Messenger and WhatsApp, people send around 60 billion messages every day, and that's almost three times as many messages as SMS handled at its peak. Over the past couple of weeks, we've talked about steps we're taking to build messaging into a platform that developers and businesses can build on. We have Thoughts for Messenger that let you do things like order flowers or get news without leaving your Messenger thread. But this is all very early, and we're rolling these experiences out carefully and slowly over time. We're also very happy with the way that Instagram is growing, with more than 400 million actives and more than 200,000 businesses advertising every month. Now we're focused on making the user experience even more engaging. With more content on Instagram all the time, people are currently missing about 70% of what's in their feed. So that's why in the first quarter, we started rolling out Feed Ranking to help you see more of the posts that you care about. This is a long-term effort. But News Feed shows that ranking creates the best and most engaging experiences for our community. Over the next 10 years, we're going to keep investing in new technology to help everyone connect. As part of Internet.org, we're building an open source telco infrastructure project called TIP [Telecom Infra Project] to make it cheaper to operate mobile networks. Free Basics, which helps people access tools for education, health information, and communication for free, now features more than 600 services, and it has brought more than 25 million people online. That makes it one of the most successful connectivity initiatives in the world. We're also working to help people connect and share in a more natural and intuitive way. Artificial intelligence is a long-term effort for us, but we're already using it in lots of ways. Right now, our Moments app is using face recognition to help you share pictures with your friends. We're using AI to show the most relevant content in news feeds, filter spam and messaging, and even help blind people understand what's in their friends' photos by reading explanations of them aloud. Finally, we're building technology in virtual and augmented reality that can change the way that we all experience the world. Gear VR started shipping late last year, and the response so far has been great. There are now hundreds of apps built specifically for Gear, and people have watched more than 2 million hours of video on it. In Q1, we also started shipping Oculus Rift. We've got a lot of great content, with more than 50 games and apps built for Rift. And again, this is very early, and we don't expect VR to take off as a mainstream success right away. I really want to emphasize that. Most Rift early adopters are gamers and developers. But eventually, we believe that VR is going to be the next big computing platform, and we're making the investments necessary to lead the way there. So that's our update for the quarter. As always, everything we do is focused on our mission to make the world more open and connected. And to get there, we're building technology that brings people together and that helps everyone in the world share anything they want with anyone. It takes a long-term commitment and it won't happen overnight, but we're in a strong position, and I'm excited about what's next. So thank you to everyone in our community, to all of our teams, all of our partners, and all of our shareholders for everything you're doing to help connect the world. And now here's Sheryl.
Sheryl K. Sandberg - Chief Operating Officer & Director: Thanks, Mark, and hi, everyone. We had a great first quarter and a strong start to the year. Q1 ad revenue grew 57% or 63% on a constant currency basis. Mobile ad revenue reached $4.2 billion, up 75% year over year, and is now approximately 82% of total ad revenue. Our growth was strong across all verticals, marketer segments, and regions, particularly North America and APAC. We remain focused on driving our clients' businesses, moving their products off shelves both in stores and online. A big focus for us in 2016 is helping our clients understand the true business impact of their ads, especially on digital. We're pleased with the progress we made in Q1 across our three priorities: capitalizing on the shift to mobile; growing the number of marketers using our ad products; and making our ads more relevant and effective. First, capitalizing on the shift to mobile. Consumers have shifted to mobile, and businesses know they need to catch up. We hear from marketers that figuring out mobile today is like figuring out TV in its early days. But given where consumers spend their time, the question now is not if they should market on mobile, but how. One of the drivers of the consumer shift to mobile is video. People are sharing and creating nearly three times more video on Facebook than they were a year ago. And as of February, the time people spend watching videos on Instagram increased by more than 40% over the preceding six months. This presents a big opportunity for marketers. The best marketers understand that people watch video differently on mobile feed than on TV. They create ads that grab attention in the first few seconds, sometimes even without sound, what we now call thumb-stopping creative. For example, Nestlé took their TV ad for Natural Bliss coffee creamer and in less than a day edited it for mobile feed by creating a new opening and adding text overlays to relay their message without sound. They showed both the original TV ad and the mobile ad on Facebook. The original TV ad drove a four-point increase in ad recall. The mobile-optimized version, however, drove an even stronger 10-point increase in ad recall and a seven-point increase in product awareness. We want to help marketers optimize their video ads. For example, we know that on average, captioned videos increase view time by 12%, so we introduced Auto Captions to generate captions for video ads. In Q1 we introduced new ad formats like Canvas ads. Canvas ads showcase products by combining video images and call-to-action buttons. While it's still early, we're pleased with the results and are seeing adoption across many verticals. To motivate millennials to take on do-it-yourself projects, Lowe's and BBDO targeted 25 to 34-year-old homeowners with Canvas ads that let them see bathroom designs, discover the products in each design, and tap to purchase. The ads were so engaging that people spent an average of 28 seconds interacting with them, and Lowe's saw a 6.7 times return on AdSense. Our second priority is growing the number of marketers using our ad products. This quarter we announced that we have over 3 million active advertisers on Facebook and over 200,000 on Instagram. A significant number of these advertisers are small and medium businesses. These businesses use our platforms because it's easy and affordable for them to connect with their consumers on mobile. We're also making it easier for SMBs to use the same targeting tools and ad formats that our most sophisticated advertisers use. We're seeing even small businesses use products like Lead Ads, Slideshow, and Dynamic Product Ads. Our third priority is improving the relevance and effectiveness of our ads. Last year we introduced Conversion Lift to measure how Facebook and Instagram campaigns drive business objectives like sales. We've seen clients across verticals from retail to auto use Conversion Lift to measure and improve the return on their ad investments. Chase Bank used Conversion Lift to measure how effectively their Super Bowl ad drove credit card applications. They found that combining Facebook video ads with their TV ads drove 1.5 times more conversions than TV ads alone. In Q1 we expanded our Lift capabilities by testing Lift API, enabling more partners to measure the effectiveness of more of their campaigns. We're pleased with the value we're driving for our partners and the progress we're making across our three priorities. Helping marketers make the shift to mobile will take time. We have a lot of hard work ahead, and we'll continue to invest. I want to thank our clients around the world for their partnership and congratulate our global team on the results of their hard work. Thanks, everyone, and now here's Dave.
David M. Wehner - Chief Financial Officer: Thanks, Sheryl, and good afternoon, everyone. We're off to a great start in 2016, led by the ongoing growth and engagement of our community and continued momentum in our ads business. In Q1 we generated $5.4 billion in total revenue and delivered over $1.8 billion in free cash flow. Let's begin with our community metrics. In March, 1.09 billion people used Facebook on an average day, up 16% compared to last year. This daily number represents 66% of the 1.65 billion people who visited Facebook in the month of March. Mobile continues to drive our growth. Over 1.5 billion people accessed Facebook for mobile devices in March, up 21% from last year. Before diving into our quarterly financial results, I wanted to highlight that beginning this quarter, I will focus my prepared remarks on our GAAP results, and all financial metrics are GAAP unless otherwise noted. The primary difference between our GAAP non-GAAP metrics is stock-based compensation [SBC]. Stock-based compensation plays an important role in how we compensate our employees, and therefore we view it as a real expense to the business. We will continue to provide a reconciliation of GAAP to non-GAAP financial metrics in our press release and earnings slides. All of our comparisons are on a year-over-year basis unless otherwise noted. Q1 total revenue was $5.4 billion, up 52% or 58% on a constant currency basis. Ad revenue in Q1 was $5.2 billion, up 57% or 63% on a constant currency basis. This marked a slight decline from the 66% constant currency ad growth rate we experienced in Q4. In Q1 this year, we benefited from an additional day due to the leap year, which contributed approximately two percentage points to our year-over-year ad revenue growth rate. North America and Asia-Pacific were our fastest-growing regions, with advertising revenue growth of 64% and 62% respectively. Europe and rest of world grew advertising revenue more slowly, at 49% and 35% respectively, with the latter particularly impacted by foreign exchange headwinds. Setting aside currency headwinds, all regions exceeded 50% constant currency ad revenue growth. Mobile ad revenue was $4.2 billion, representing approximately 82% of total ad revenue. Mobile ad revenue grew 75%, driven by strength from Facebook's News Feed. Our mobile ads business continues to be driven by the combination of both supply-side and demand-side factors. On the supply side, we continue to see healthy growth in the number of people using Facebook, time spent across our products, and ad loads. On the demand side, we believe the investments we have made to improve our mobile advertising solutions are helping drive value for both people and marketers. We are seeing growth in both new customers as well as existing customers who are spending more with us on average compared to last year. In Q1, the average price per ad increased 5%, while total ad impressions increased 50%. The reported increase in price is being driven by the continued mix shift towards mobile, which contains higher priced News Feed ads rather than the mix we have on PCs of both News Feed ads and lower-priced right-hand column ads. The increase in impressions was driven by strong growth in mobile ad impressions and was offset partially by a decline in ad impressions delivered on personal computers, consistent with the ongoing declines in PC image. Total payments and other fees revenue was $181 million, down 20% compared to last year. This decline was mainly driven by a reduction in payments revenue related to games played on personal computers. Q1 total costs and expenses were $3.4 billion, up 29%. We ended the quarter with approximately 13,600 employees, up 35% compared to last year. Q1 operating income was $2 billion, representing a 37% operating margin. Our Q1 tax rate was 27%, down from our full-year 2015 tax rate of 40%. Our Q1 net income was approximately $1.5 billion, or $0.52 per-share. In Q1, capital expenditures were $1.1 billion, more than double compared to Q1 of last year. Server purchases and data center construction were the largest contributors to year-over-year growth. New builds in Texas and Ireland along with the expansion of existing facilities will nearly double our current data center footprint when completed. In addition to servers and data centers, investments in office facilities also contributed to the year-over-year growth. We ended the quarter with $20.6 billion in cash and investments. Turning now to the outlook, first, some color on revenue. We remain focused on creating value for the people and marketers who use our services. We expect that the main drivers of advertising revenue growth will continue throughout 2016, but we will face tougher comparables as the year progresses given the accelerating ad revenue growth we experienced throughout 2015. Payments and other fees revenues will continue to face headwinds throughout the year, given that the substantial majority of that revenue relates to payments from games played on personal computers. Even with the expected contribution from Oculus, we anticipate that our payments and other fees revenue for the full year 2016 will come in lower than the level in 2015. Next on to the expense outlook; our expense guidance remains unchanged. We expect that full-year 2016 total GAAP expense growth will be approximately 30% to 40%. We expect full-year 2016 amortization expenses to be approximately $700 million to $800 million, and full-year 2016 stock-based compensation expenses to be approximately $3.1 billion to $3.3 billion. If you take into account our GAAP expense guidance as well as our amortization and SBC guidance, you will see that our full-year 2016 total non-GAAP expense growth guidance range remains unchanged at 45% to 55%. We anticipate full-year 2016 capital expenditures to be at the high end of the $4 billion to $4.5 billion range we gave last quarter, as we invest to support the rapid growth of the business. We expect our Q2 and full-year 2016 tax rates to be similar to our Q1 rate. In summary, 2016 is off to a great start for Facebook. Our results reflect healthy growth and engagement in our community, strength in our ads business, and investments we're making to capitalize on the long-term opportunities we see ahead. Before going to questions, I wanted to touch briefly on the share reclassification that Mark discussed at the beginning of the call. As we disclosed in the proxy statement we filed today, our Board of Directors has approved a proposal for the reclassification of our capital stock that would involve the creation of a new class of publicly listed non-voting Class C capital stock. Pending stockholder approval, we intend to issue two Class C shares as a one-time stock dividend for each outstanding Class A and Class B share, resulting in a tripling of the pre-reclassification total shares outstanding. All stockholders would be treated equally. The net effect of this transaction would be to establish two publicly traded classes of Facebook stock, one representing the current Class A shares and the other representing the non-voting Class C shares. Since the Class C shares would have the same economic rights as the Class A and Class B shares, we would expect that after the payment of the stock dividend, the share price of the Class A common stock would generally reflect a three-for-one stock split. This will have no effect on the voting interest related to shares that investors currently hold. As Mark mentioned, this structure will allow for the preservation of the voting structure that has served the company well to date while allowing for Mark to fund the Chan Zuckerberg Initiative over the course of his lifetime. Importantly, as part of this proposal, the preservation of the multi-class capital structure would be generally predicated on Mark continuing to maintain an active leadership role at Facebook. Let me talk about next steps. The reclassification would be conditioned on approval by a majority of outstanding votes held by company stockholders, and we anticipate a vote on the matter at our annual meeting to be held on June 20 this year. A record date for this dividend would be determined at a later date. With that, Chris, let's open up the call for questions.
Operator: Your first question comes from the line of Eric Sheridan with UBS. Your line is open.
Eric J. Sheridan - UBS Securities LLC: Thank you so much. I wanted to come back to your comments on the small and medium-sized business opportunity at Facebook, maybe direct a few points to Sheryl to get some comment. I wanted to understand what some of the opportunities are to continue to demonstrate to those advertisers what the potential is for both Facebook and maybe even Instagram and Facebook Messenger long term as platforms to grow their businesses and also pointing out what some of the measurement tools and operating challenges are to bring people onto the platform. Thank you.
Sheryl K. Sandberg - Chief Operating Officer & Director: Thank you for the question. SMBs, or SMUs as they're called in different places around the world, we think are a very core competitive advantage for us. It's prohibitively expensive for most small businesses to reach people digitally. Thirty-five percent of small businesses in the United States, which is often the most advanced market, don't have a web presence at all. And setting up a mobile app, getting people to find and download a mobile app, can be even more expensive. And so what's happening is that SMBs are turning to Facebook pages as their mobile solution. They're free, they're easy to set up, and they already know how to do them because almost all of them are already Facebook users in the first place. And so the onboarding has been incredibly important and incredibly effective. We announced last year that we have over 50 million small business pages active on a monthly basis. Eighty percent of those are active on mobile. We then work on helping them use our ad products and upsell them to our paid ad products as well, and we announced this quarter that we hit 3 million active advertisers on Facebook and 200,000 on Instagram. What's interesting is that what you see is SMBs are able to use the pull of some of the biggest brands in the world. So over 2 million SMBs have posted a video, both paid and organic, in the last month. And that happens to be many times the number of SMBs that have shot or placed a TV commercial. In terms of measurement, your question is important because it's not just getting them to use our platforms to connect to consumers. It's getting them to be able to measure our results. And so we've worked hard to build measurement tools into the products, so that when you buy an ad, an SMB has a very easy interface and decide what their goals are. Are their goals measuring sales? Are their goals clicks to their website? Are their goals mobile app downloads? And then measuring all the way through from sharing that ad to the purchase. I continue and we continue to be very bullish on this channel because we have such a broad base of usage, because that usage is so active, and because we're very focused on investing in simplifying our products so that all SMBs can use them.
Operator: Your next question is from Brian Nowak with Morgan Stanley. Your line is open.
Brian Nowak - Morgan Stanley & Co. LLC: Thanks for taking my questions. I have two. The first one, Sheryl, you talked about video and increasing the overall video consumption. Can you talk about where you are on traction with video advertising and the adoption of video ad units and the impact of video in the quarter? And then secondly, just breaking down the advertising by cohort, could you talk to points of strength or weakness across direct response versus branded advertisers in the quarter? Thanks.
Sheryl K. Sandberg - Chief Operating Officer & Director: Sure, I'll take the second one first. Our growth was really broad-based, and we grew across all of our marketer segments this quarter. That's direct response, brands, SMBs, and developers. Our direct response business continues to be very strong. It's very ROI-focused, and we continue to invest and roll out products that help people. So for example, Lead Ads, where people can fill out forms on a mobile device, take their contact info from Facebook, we've rolled that out fully this quarter. And that enables people to use Facebook in a very direct to response way, and we'll continue to invest there. Video ads are really exciting. It's worth noting that video ads take place on another avenue, and receipts are not all of the revenue incrementals (28:55). But as consumer engagement with video has continued to grow, that creates more and more of an opportunity for video ads. Marketers have always loved video because it's a really compelling way to reach people. And now we can reach them on mobile all day with those kind of messages. Importantly, marketers have to adjust sometimes. While the 30-second ad does perform well in News Feed, we also see people understanding that some of the formats are different. Creating shorter ads, creating ads that can work even without sound, more personal ads has really mattered. One example is Toyota used Facebook for the launch of the RAV4 Hybrid with Saatchi in Los Angeles. They used a very broad video to drive brand awareness. They reached over 36 million people in a target demo within three days. Then, and this is where it gets even more interesting, they retargeted people who watched the video with over 500 personalized video ads which were optimized for Facebook and Instagram. So they were creating a direct response campaign to get people to take specific actions like requesting a quote and finding a specific dealer. We saw a 14-point lift in ad recall, a seven-point lift in message association. And right now, we're using the Lift tool to continue to measure their sales for the 30 and 60 days beyond the campaign to see what happens. And we're pretty excited about what that shows in terms of how video can be used in a really broad-based way but also a more personal way.
Operator: Your next question is from Douglas Anmuth with JPMorgan. Your line is open.
Douglas T. Anmuth - JPMorgan Securities LLC: Thanks for taking the questions. I have a couple for Mark around Messenger. Mark, I was hoping you could talk to us about how you expect to shift user behavior within Messenger to get users to focus more on businesses versus more personal communications and how you'll make users aware of the capabilities within the platform. And then just secondly, as more bots come on board here and businesses are engaging with Messenger, how do you envision bots and humans working together in terms of providing more customer service? Thanks.
Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer: Sure. So part of our playbook for building out these ecosystems at scale is we start with the person-to-person user base. So whether that's in messaging, it's people messaging their friends or groups and News Feed. Before that, it was people posting updates and seeing what was going on with their friends and the people that they care about. And then the next step is to create organic activity around public entities, so whether that's businesses, public figures like athletes and celebrities and types of folks that people want to interact with on these different platforms, and we did that on Facebook in News Feed group pages, and we're working on a number of different ways to do that in Messenger. One of those is bots. And one of the good things about bots that we've seen is that it can decrease the amount of time that you have to wait before you get a reply back from interacting with a message. So what we've seen – we've done some research on this. A lot of people every day in Facebook today are already messaging pages and businesses directly, and the businesses respond. But what we've actually also found is that through some of our AI research, we can look at the responses that businesses give to common questions and can confidently provide the right reply a lot of the time. And when we can do that, then that decreases the latency. And predictably, people want to do more of that activity. So that's one way that I think you're going to see bots work, between people who are actually driving the businesses directly will need to in some way train or answer questions for people, but we can build artificial intelligence that can learn from people how to automate a lot of that and make that experience a lot faster for people who want to interact with businesses and public figures. And of course then, after you start building out that segment of businesses and then public figures on the platform, then on top of that you have just a good amount of intent on these platforms to build a good business on top of that. That's stage three.
Operator: Your next question is from John Blackledge with Cowen & Company. Your line is open.
John Blackledge - Cowen & Co. LLC: Great, thank you, two questions. So Facebook just opened up Instant Articles globally to all publishers. I'm just wondering what you see as a publisher's benefit in joining Instant Articles. And how we should think about the monetization impact in 2016? And then second question, the ad revenue in APAC was much better than we thought, just any more color on the drivers there. Thank you.
Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer: So Instant Articles is all about the quality of the consumer experience. Right now for links that are not Instant Articles, it can be one of the slowest parts of the Facebook app. You're browsing through a News Feed, you tap on a link, if you're not on a good connection, the content isn't cached, it can take 10 or 20 seconds in some cases for that content to load. And people in our community, they don't know the difference about whether that content is coming from Facebook or a different place. They hold us accountable for making their experience quick, and we want to do everything we can to do that. So Instant Articles makes it so that any publisher around the world now can deliver a really great native experience instantly with no latency in loading it. And we're just seeing that people like to engage with that a lot more. So that's where we're most excited about there.
Sheryl K. Sandberg - Chief Operating Officer & Director: The APAC question, it has been growing really well for several quarters now, and we're seeing a lot of great adoption as people learn to use the products. One part of the business that I think has been really strong and is worth noting is we're working with marketers in China to help with their export business. So Air China is a good example. They're a popular airline in China, but they don't really have – they're not really as well-known overseas. And before working with us, they really only invested in traditional media. They had a goal of promoting their new flight routes, including one from Mumbai to Beijing, and their new aircraft. So they launched a campaign with us in 15 countries globally. They used reach and frequency and Carousel and video ad targeting. And for example, they would target in the U.S. age 18 and above frequent international travelers living in cities where they had routes or Indian expats living in the U.S. to promote new routes to Mumbai. They reached 30 million people globally, more than 95% on mobile. And here's the best part, they had a 73% sales lift in the United States. So our APAC business is robust, and I think the global nature of our business is part of driving that.
Operator: The next question is from Heather Bellini with Goldman Sachs. Your line is open.
Heather Bellini - Goldman Sachs & Co.: Great, thank you. I was just wondering if you could share with us. How do you see Instagram's ramp impacting Facebook's ad growth in 2016, or if there's any color you could share with us about how that's been ramping? And also, if you can, share with us how advertisers are viewing the platform. Are you finding that it's typically more additive to their Facebook spending, or are they funding it with existing Facebook budgets? Thank you.
Sheryl K. Sandberg - Chief Operating Officer & Director: Facebook and Instagram are the two most important mobile ad platforms out there. In the short run, some of the spend is incremental and some isn't. There are people who will have a social budget or a digital budget. And as they move to Instagram, some of that will come from Facebook. In the medium to long run, we believe we compare very favorably with any other spend we can do because we have this very broad reach on both platforms plus the ability to target very specifically. So what you're seeing in our results right now are very strong growth for Facebook and very strong growth for Instagram. We hit 3 million advertisers for Facebook. We hit 200,000 for Instagram, and often the platforms really work together.
Operator: The next question is from Justin Post with Merrill Lynch. Your line is open.
Justin Post - Bank of America Merrill Lynch: Thanks, a question for Mark. There have been some concerns about traffic to publishers and sharing levels on Facebook. I just wondered if you could talk about core Facebook engagement. What's really working? Are you concerned at all about that? And then when you think about the ad loads, are you comfortable with where they're at, is there still a lot of room to go? And then maybe last one, if you were to ever leave Facebook, what would happen to your voting shares? Thank you.
Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer: All right, let's talk about engagement first. So overall sharing is up across Facebook, and people are spending more time on Facebook and the whole family of apps. And that is not just the case for the aggregate of the growing community, but it's actually also the case on a per-person basis as well in terms of people sharing more and spending more time individually. Now one of the things that we see is that the way that we are sharing is always changing, and some of this is because of underlying technical transition. So on desktop, for example, it's easier to type, so we saw more text posts. On mobile, it's easier to take videos, so we see more videos. On desktop, people would have more commonly uploaded an album of photos that they took from their digital camera and downloaded onto their computer; whereas on mobile, the more common behavior is to take a single photo or a couple and just post those. So there are all these transitions. And that's our job, is to make it so that we build great tools that people – everyone around the world can share anything that they want with everyone. Now the other thing that's also true is that people want to share with lots of different kinds of audiences. So Facebook gives you the ability to share with all of your friends and publicly if you want and with groups. But we're also investing in things like Messenger and WhatsApp because a lot of people want to share increasingly messages privately one on one or with very small groups. So in addition to Messenger, which is at 900 million people a month, and WhatsApp, which is at more than 1 billion people a month, Facebook Groups is also at more than 1 billion people a month, which I think represents the increasing diversity of the different types of audiences that people want to share with. But ultimately, I think that humans have such a deep desire to express themselves and want to connect with the people around them that I think that all of these audiences and all of these different types of media should grow over time. And it's our job to basically make sure that we build good products and get rid of all the bugs and make it so the performance is fast, and all the basic stuff works, that way we get there. But in general, right now all the high-level trends look pretty positive on that. I think I'll kick it off to Dave to go through your questions about some of the technical pieces about the reclassification.
David M. Wehner - Chief Financial Officer: Sure. I guess, also, Justin, you had a question on ad load, so I'll do both the ad load and the question on the reclassification. So on ad load, it's definitely up from where we were couple of years ago. I think it's really worth emphasizing that what has enabled us to do that is just improving the quality and the relevance of the ads that we have, and that's enabled us to show more of them without harming the user experience at all. So that's been really key. Over time, we would expect that ad load growth will be a less significant factor driving overall revenue growth, but we remain confident that we've got opportunities to continue to grow supply through the continued growth in people and engagement on Facebook as well as on our other apps such as Instagram. On the question regarding what would happen to Mark's shares if he were to leave Facebook, I'd just refer that the new multi-class capital structure is generally dependent on Mark continuing to maintain an active leadership role at Facebook. And if you go into the proxy materials, it goes into more detail on how different things would play out under various other scenarios. So I would just refer you to those.
Operator: Your next question is from Ben Schachter with Macquarie. Your line is open.
Benjamin Schachter - Macquarie Capital (USA), Inc.: Mark, when you're thinking about acquisitions broadly, in what area do you think Facebook needs to buy versus build? Basically, where you need external help? And then on VR, just a few quick questions, any update on the shipping delay, how many units shipped in the quarter and expectations for the year? And then also on VR, understanding I know it's very, very early, but beyond games and entertainment, what verticals do you expect to be first to utilize VR and AR? Thanks.
Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer: So on the acquisition philosophy, I've talked about how I think the social ecosystem will play out on a number of these calls. The basic theory that we have is that there are a small number of services that are going to be ubiquitous utilities that 1 billion or 2 billion or more people are going to want to use. So that's core basic messaging, the core functionality around having your real identity and connecting with all of your real friends and family online. Those are things that we just think are just going to be ubiquitous. So we want to build those. At the same time, we also think that there are going to be many, many good businesses and different other social use cases where there are people doing good work and building different companies that we feel no need to own those things. So I think that people come up from time to time and suggest, should we buy this company or that. And what we look at are what are the things that we think are going to be ubiquitous tools, and who are the most talented people in the world to build this. And so when you think about something like virtual and augmented reality, that's how we thought about that. Those are going to be important platforms over time. It's very early obviously. It's going to take a long time to get there. And a lot of what we felt like we were buying there was a critical mass of the best people and the best technology to go do all the things that we needed to go do over the next 10 years to drive that home and turn that into a big platform. You asked a question about virtual and augmented reality. What are going to be the big use cases? For the first few years of virtual reality, I think gaming and video are going to be the big ones. The initial market that we look at are all the people who have Xboxes, PlayStations, and Wiis, the people who are excited to have an immersive media experience sitting in their living room for a long period of time, and that's a pretty big market. Even though that's not all of what we hope to eventually serve and that's not the full potential of these new platforms, I think that is one case where you can obviously deliver better and richer experiences than you can with the current generation of technology. Video is going really well. I shared a stat before in some of my comments that on Gear VR alone, we are now at more than 2 million hours of video have been watched on the platform, so that's really exciting. And that of course will be bolstered by the fact that these new 360 videos can not only be watched in VR, so in the headsets, but we're building tools so you can share them on News Feed and through our products elsewhere as well. So I think that's exciting. Over time there will be even more, but that I think should be enough to have some initial use. But again, I do want to really emphasize, this is early and it's going take a long time. And I know there's a lot of hype around this, and we're just focused on building this to be very good over the long term.
David M. Wehner - Chief Financial Officer: Then, Ben, you asked about shipping units. We did begin shipping units in the quarter. This is very small still. VR is still very early. It's not going to have a material impact on revenue in 2016, and I gave more color on that in my prepared remarks.
Operator: Your next question is from Mark May with Citi. Your line is open.
Mark A. May - Citigroup Global Markets, Inc. (Broker): Thanks a lot, first one for Sheryl, I think. I'm wondering if you could update us on the progress you're seeing with FAN [Facebook Audience Network]. You gave some metrics in Q4. It seemed like that advertisers were really adopting that platform and seeing a lot of additional reach. Maybe if you could, tell us how that's going. And then I think a couple more; on the tax rate, we saw it step down quite a bit in Q1, but you're guiding for flat sequentially. Should we think about that as a run rate, or are you still attempting to manage your tax rate down even further than where you saw it in Q1 and where you're expecting for Q2? And then on the OpEx guide, 41% non-GAAP growth in Q1, obviously below your range but you maintained the range. Why is that? Is that just purely a function of the comps as you head into the year, or are there some specific investment plans that you have? Thanks.
David M. Wehner - Chief Financial Officer: Sure, Mark. I can start with the detailed ones, the tax rate and the OpEx guide. So on the tax rate, the rate came in better than guidance in terms of the tax rate, but it's consistent with the long-term trend that I'd indicated. We do expect that that rate will be approximately the rate that will continue for the rest of the year. So for purposes of 2016 modeling, I would use the Q1 rate. On the OpEx guide, Q1 came in slightly below our annual expense growth guidance, but we do expect that investments in areas like video and Oculus will impact the remainder of the year more substantially, so that's why we're maintaining the annual OpEx growth guidance that we have. And then, Sheryl, did you want to speak about Audience Network?
Sheryl K. Sandberg - Chief Operating Officer & Director: Yes, Audience Network is important to us because we're making a strategic investment in ad tech, helping advertisers and publishers grow, so it's on and off Facebook. We think we're uniquely placed to bring people-based marketing to scale and solve the measurement problem, and the Audience Network is a place we're really focused because we feel like we're delivering value for advertisers and publishers, so we're investing behind the growth we've seen. We've seen a growth of native ads. Eighty-three percent of the overall inventory on the platform is native, and over 50% of our publishers are only using native ads. We have some great examples of Audience Networks really improving people's results. A recent one is eBay Vivanuncios, which is an online real estate destination working in Latin America and Mexico. When they were using a combination of Facebook, Instagram, and the Audience Network, they saw 57% lower cost per install with placement optimization and 59% more volume versus running on Facebook alone, which led to 6% incremental revenue. So compared to November a year before, the number of their app installs increased by 115%. So what we're seeing is the results we're able to deliver on Facebook and Instagram, a lot of our marketing partners want more. And our ability to do that is why we're investing in the Audience Network.
Operator: The next question is from Colin Sebastian with Robert W. Baird. Your line is open.
Benjamin C. Gaither - Robert W. Baird & Co., Inc. (Broker): Hi, this is actually Ben on for Colin. This one is for Mark. You had already talked about the AI and machine learning applications with respect to Messenger and bots, but I was wondering what are some of the more nascent initiatives where you're applying machine learning, or maybe where we might see those investments manifest themselves in the user experience over the next few years?
Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer: So the biggest thing that we're focused on with artificial intelligence is building computer services that have better perception than people, so the basic human senses like seeing, hearing, language, core things that we do. I think it's possible to get to the point in the next five to 10 years where we have computer systems that are better than people at each of those things. That doesn't mean that the computers will be thinking or be generally better, but that is useful for a number of things. So for example, I talked about earlier, we are building this Moments app, so that way you can take photos on your phone. And if you use this app, our face recognition can look at the photos that you take and suggest that you might want to share photos that you took with a friend in them with that person. So that way, all the photos that might be of you and your friends' camera rolls, they can share with you. Another example is just spam filtering and just making sure that we can actually read the content and understand what's interesting to you or not and not show that. One obvious thing I think over time is if you just look at the way that we rank News Feed, today we use some basic signals like who you're friends with and what pages you like as some of the most important things for figuring out what – out of all of the millions and millions of pieces of content that are on Facebook, what we're going to show and what are going to be the most interesting things to you. That's because today our systems can't actually understand what the content means. We don't actually look at the photo and deeply understand what's in it or look at the videos and understand what's in it or read the links that people share and understand what's in them, but in the future we'll be able to, I think in a five or 10-year period. So all of these millions and millions of pieces content that are out there, whether or not you've added someone as a friend or have liked a page, we'll be able to know a lot better what types of things are going to be interesting to you to produce a much better feed of content. So that's just a basic example of where having human-level perception broadly is going to yield better experiences in a lot of the things that people care about today.
Operator: The next question is from Ken Sena with Evercore. Your line is open.
Kenneth Sena - Evercore ISI: Hi. I have a high-level, longer-term question. For brands, we're seeing where promotion, transaction, and support capabilities for businesses are all deepening within Facebook. Therefore, should we be thinking about a longer-term transition from a platform that's basically all ad to something where more marketplace capability is offered, given that buyers and sellers are so known and so connected? And if so, can we think about Facebook starting to monetize maybe on a transaction basis or even through various customer support capabilities via the messaging tools, AI, et cetera, that you're beginning to offer businesses? So maybe if you could just provide a little bit of color on how you see that evolution, that would be great. Thank you.
Sheryl K. Sandberg - Chief Operating Officer & Director: You're right that people are increasingly using Facebook to discover products and services, and we're testing some ways like the Marketplace to make this easier. We're also testing some incremental features on pages, which enable businesses to drive purchases on a page or direct people directly to their website. These are really early, but we've had some positive feedback. Our focus, however, continues to be on our ad products because we think we can take people all the way from the top of the funnel, where they can really get a brand awareness or product awareness, and go all the way down to purchase, not necessarily because the purchase is happening on Facebook, but because we can work on the measurement systems to understand how the advertising, both at the top and lower down in the funnel is influencing those purchases. We've been really excited by what we've seen in the commerce vertical of our ad products. So products like dynamic product ads, Carousel ads are working really well for us. This quarter we launched Canvas ads, which are very fast-loading, immersive mobile ads. They're easy to build. You can use the self-service tool. You don't have to write any code. They are native format, so they decrease that initial drop-off you see when people click off to another site. It's very early days, but the average viewing time is over 30 seconds, which shows how immersive that is. I'll share one example of how ads are driving a small business on Facebook through ads, which is a company called Sparkle in Pink. They're a Utah-based SMB. They're selling girls' clothing. They did a Slideshow ad that included a Shop Now button, which enables you to take action on their site. They were able to increase sales by 9% a month. And more exciting for us, this was six times more efficient in terms of acquisition than any other digital media channel. And that shows how you can use our ad products to go all the way from awareness, measuring through to a sale and show how important our ads can be to commerce on our platform.
Operator: Your next question is from Ross Sandler with Deutsche Bank. Your line is open.
Ross Sandler - Deutsche Bank Securities, Inc.: Great, so I guess a question for Mark or Sheryl. So at F8, you showcased a bunch of new features for Messenger, including ads to promote your business inside of Messenger. So how should we think about the timing of those ad units coming on in Messenger? And can you use the same ad stack in the Facebook Power Editor that's used on core Facebook and Instagram to get ads up on Messenger? Can you walk us through that? And then the second question on messaging, so with WhatsApp crossing 1 billion users recently, how do you view the product roadmap today on WhatsApp versus what you showcased recently with Messenger? Is it a year behind, or is it further back than that? Any color there would be helpful. Thanks.
Sheryl K. Sandberg - Chief Operating Officer & Director: For Messenger and WhatsApp, our focus right now continues to be on growth and engagement. We are not rolling out any monetization products on WhatsApp right now, but we did start that process at F8 on Messenger. And what we're doing is following the organic activity that's happening on the Messenger platform. Businesses and consumers are using Messenger to connect to each other in a more personal, more immediate way. And we rolled out a platform beta, which gives new opportunities to build compelling experiences. Bots, very early but giving the opportunity for more personal interactions between businesses and mobile. The 10 received APIs (56:26), so that businesses could send immediate responses to common questions, including engaging images and call to action as well as texts. In terms of the timing, this is really early. We have a lot of opportunity to invest in advertising across our different platforms. And so we want to make sure we get this right as we focus on continued engagement. You're right that over time, when we make these investments, we are going to be able to rely on some of the core aspects of the ads infrastructure. Certainly, our long base of advertisers, some of the things we understand about how ads perform and the functionality will be an important part of the product offerings in the future, but those are not immediate by any stretch of the imagination.
Deborah Crawford - Director-Investor Relations: Operator, we have time for one last question.
Operator: Your last question is from Anthony DiClemente with Nomura. Your line is open.
Anthony DiClemente - Nomura Securities International, Inc.: Thanks a lot. I have one for Sheryl and one for Mark. Sheryl, there are many out there who might assume that this leg of excellent growth that Facebook is realizing might have come at the expense of TV advertising, but the TV ad world seems to be quite resilient here. And you actually talked a lot in your prepared remarks about how marketers benefit from running digital and TV campaigns in parallel. So I wonder if you could just comment on where your share gains are coming from, in your view. And then, Mark, on Live video, I realize it's a small part of overall video, but I wonder. Do you think multiple platforms can succeed in live streaming over time given the size of the market longer term, or do you think it's more of a network effect business where a vast majority of the traffic and economics will ultimately accrue to the leader in the live streaming space? Thank you.
Sheryl K. Sandberg - Chief Operating Officer & Director: We think our growth has been very broad-based, but dollars are shifting from all types of media formats to where consumers are spending their time. We tell our clients that we want to be the best dollar and the best minute they spend, and we want them to measure value. I don't think this means that all of our growth comes at the expense of any one channel, but it's broad-based. And often, TV and Facebook and Instagram can work really well together. I'll give a fun example from the Super Bowl. T-Mobile wanted to use their Super Bowl campaign to increase their brand awareness and increase their reach. So before the game, they targeted their 30-second Super Bowl ad that featured Drake to people with NFL and celebrity interests. It performed so well that they decided to run the 60-second version on Facebook and Instagram. That ad was so successful on Facebook and Instagram that they then ran the 60-second ad on TV instead of their 30-second ad. So as people invest, they can use these different platforms together, and we're pretty excited to see that progress.
Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer: And on Live video, the theme that I think is most important is just that there's so much that people want to express and share with the people around them that they don't have the tools to do today. And I think about this huge opportunity, not just in Live video, but in a lot of things that we're talking about. One interesting example recently that I touched on earlier is between Messenger and WhatsApp, we're around 60 billion messages a day. And SMS at its peak we think was around 20 billion messages a day. And just unlocking some of the friction that existed in SMS and improving the product a little bit and removing the small fee that was there has just unlocked a huge amount of expression. And we think that this is going to be the case in all different types of media and with all different audiences that a person would share it with. So in video, there are billions and billions of videos that are viewed every day on Facebook. Live is a very small part of it. The reason why we give disproportionate attention to it is because we're trying to help push forward new formats that are not just about consuming content but are really about interacting, so Live, 360 video, and there will be others in the future. And so yes, to answer your question, I do think that multiple products and companies can succeed in building these things. I also think that there are going to be a lot more interactive forms of video than just Live and 360 like we're talking about now. And I think that this extends not just to video but for all the different types of media and audiences that we're serving. So we're very excited about continuing to do our work to help unlock all the expression and connection that people want to do.
Deborah Crawford - Director-Investor Relations: Thank you for joining us today. We appreciate your time and we look forward to speaking with you again.
Operator: Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect. | [
{
"speaker": "Executives",
"text": "Deborah Crawford - Director-Investor Relations Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer Sheryl K. Sandberg - Chief Operating Officer & Director David M. Wehner - Chief Financial Officer"
},
{
"speaker": "Analysts",
"text": "Eric J. Sheridan - UBS Securities LLC Brian Nowak - Morgan Stanley & Co. LLC Douglas T. Anmuth - JPMorgan Securities LLC John Blackledge - Cowen & Co. LLC Heather Bellini - Goldman Sachs & Co. Justin Post - Bank of America Merrill Lynch Benjamin Schachter - Macquarie Capital (USA), Inc. Mark A. May - Citigroup Global Markets, Inc. (Broker) Benjamin C. Gaither - Robert W. Baird & Co., Inc. (Broker) Kenneth Sena - Evercore ISI Ross Sandler - Deutsche Bank Securities, Inc. Anthony DiClemente - Nomura Securities International, Inc."
},
{
"speaker": "Operator",
"text": "Good afternoon. My name is Chris, and I will be your conference operator today. At this time, I'd like to welcome everyone to the Facebook first quarter 2016 earnings call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford - Director-Investor Relations",
"text": "Thank you, good afternoon and welcome to Facebook's first quarter 2016 earnings conference call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release, our Annual Report on Form 10-K filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now I'd like to turn the call over to Mark."
},
{
"speaker": "Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer",
"text": "Thanks, Deborah, and thanks, everyone, for joining today. We started 2016 off well. 1.65 billion people now use Facebook every month and 1.09 billion people use Facebook every day. In recent weeks, we're also consistently seeing more than 1 billion people using Facebook on mobile every day. We're also pleased with our business results. Total revenue this quarter grew by 52% year on year to $5.4 billion, and advertising revenue grew by 57% to $5.2 billion. I'll have more to say about these results in a minute, but first I want to talk about a proposal by our Board of Directors to reclassify Facebook stock. At F8, I talked about our mission and how the work we're doing to connect the world is more important today than it's ever been. I walked through our 10-year roadmap, focused on building the technology to give everyone in the world the power to share anything with anyone. Bringing people together and giving everyone a voice takes a long-term commitment, not just over the next few years but over the next few decades. We're focused on the long term, and that's the main reason for today's proposal. Facebook has always been a foundry-light company, so we can focus on our mission and build long-term value. This structure has served our shareholders well. Early on, we received some generous offers for companies trying to buy Facebook, and our structure helped us resist that pressure. More recently, we navigated a challenging transition to mobile. But because we were a controlled company, we were able to focus on improving the user and product experience of our apps first and then build a strong mobile business over time rather than being forced to do something shortsighted. And over the years, our structure has helped us make big bets on acquisitions like Instagram that were very controversial initially but were good decisions for our community and our business. Facebook has been built by a series of bold moves. And when I look out into the future, I see more bold moves ahead of us than behind us. We're focused not on what Facebook is, but on what it can be and on what it needs to be, and that means doing bold things. A lot of what we're building today in areas like connectivity, artificial intelligence, and virtual and augmented reality may not pay off for years, but they're important to our mission of connecting the world. And I'm committed to seeing this mission through and to leading Facebook there over the long term. Personally, there's another element to this. While helping to connect the world will always be the most important thing that I do, there are more global challenges that I also feel a responsibility to help solve to create a better world for my daughter and all future generations, things like: helping to cure all disease by the end of the century; upgrading our education system so it's personalized for each student; and protecting our environment from climate change. That's why Priscilla and I created the Chan Zuckerberg Initiative and committed to give 99% of our Facebook shares to advance human potential and promote equality. Today's board proposal will allow us to maintain and improve the voting structure that has served us well and allow me to fund the Chan Zuckerberg Initiative. In December, I also announced that I won't sell more than $1 billion worth of stock – Facebook shares per year over the next three years. That's still my commitment, and I'll update our shareholders on future plans beyond that. Dave will talk more about the mechanics of this proposal in his comments in just a few minutes. But before we get there, I want also share a few more thoughts on the progress we've made this quarter. As I said before, our roadmap has three horizons. Over the next three years, we're going to keep investing in our most developed ecosystem, the Facebook app and platform. Today, people around the world spend on average more than 50 minutes a day using Facebook, Instagram, and Messenger, and that doesn't even include WhatsApp yet. This growth isn't happening because we came up with just one or two big changes. Our team has just worked day after day on lots of improvements over a long period of time, and that progress continued in the first quarter. We launched Reactions to help people express themselves in more ways, and we improved our products to work on different mobile networks and devices all over the world. Sheryl will talk more about this in a minute, but now more than 3 million businesses are using our advertising products every month. We've expanded our measurement capabilities so more businesses can see the results they get from ads. And we've made it easier for small and medium businesses to use the same targeting tools and ad formats that our larger advertisers use. Over the next five years, we're going to build ecosystems around our products that are already being used by a lot of people. We're at the beginning of a golden age of online video. Video isn't just a single kind of content. We think it's a medium that allows people to interact in a lot of new ways. So that's why in addition to normal Internet video, we're also focusing on more interactive video experiences like Live and 360 video. I'm a big Game of Thrones fan, and the other week HBO and our Oculus team came out with a 360 video of the opening sequence of the show. And it's now the most watched 360 video on Facebook in any 24-hour period, with more than 12 million total views. Earlier this month, we opened up Live to everyone. Live is just one part of our overall video effort, but we think it has a lot of potential. Friends go Live because it's unfiltered and personal. Actors and news anchors go Live because they can reach bigger audiences in some cases than they can on even their own shows. And if we do a good job, we think it's something that people will associate with Facebook, with interacting with people and not just watching content. But it's also a very new and small part of all of the videos that we see on Facebook today. I'm also really excited about what we're building around messaging. Right now we have two of the top messaging apps in the world. Nine hundred million people use Messenger every month, and 1 billion people use WhatsApp every month. Between Messenger and WhatsApp, people send around 60 billion messages every day, and that's almost three times as many messages as SMS handled at its peak. Over the past couple of weeks, we've talked about steps we're taking to build messaging into a platform that developers and businesses can build on. We have Thoughts for Messenger that let you do things like order flowers or get news without leaving your Messenger thread. But this is all very early, and we're rolling these experiences out carefully and slowly over time. We're also very happy with the way that Instagram is growing, with more than 400 million actives and more than 200,000 businesses advertising every month. Now we're focused on making the user experience even more engaging. With more content on Instagram all the time, people are currently missing about 70% of what's in their feed. So that's why in the first quarter, we started rolling out Feed Ranking to help you see more of the posts that you care about. This is a long-term effort. But News Feed shows that ranking creates the best and most engaging experiences for our community. Over the next 10 years, we're going to keep investing in new technology to help everyone connect. As part of Internet.org, we're building an open source telco infrastructure project called TIP [Telecom Infra Project] to make it cheaper to operate mobile networks. Free Basics, which helps people access tools for education, health information, and communication for free, now features more than 600 services, and it has brought more than 25 million people online. That makes it one of the most successful connectivity initiatives in the world. We're also working to help people connect and share in a more natural and intuitive way. Artificial intelligence is a long-term effort for us, but we're already using it in lots of ways. Right now, our Moments app is using face recognition to help you share pictures with your friends. We're using AI to show the most relevant content in news feeds, filter spam and messaging, and even help blind people understand what's in their friends' photos by reading explanations of them aloud. Finally, we're building technology in virtual and augmented reality that can change the way that we all experience the world. Gear VR started shipping late last year, and the response so far has been great. There are now hundreds of apps built specifically for Gear, and people have watched more than 2 million hours of video on it. In Q1, we also started shipping Oculus Rift. We've got a lot of great content, with more than 50 games and apps built for Rift. And again, this is very early, and we don't expect VR to take off as a mainstream success right away. I really want to emphasize that. Most Rift early adopters are gamers and developers. But eventually, we believe that VR is going to be the next big computing platform, and we're making the investments necessary to lead the way there. So that's our update for the quarter. As always, everything we do is focused on our mission to make the world more open and connected. And to get there, we're building technology that brings people together and that helps everyone in the world share anything they want with anyone. It takes a long-term commitment and it won't happen overnight, but we're in a strong position, and I'm excited about what's next. So thank you to everyone in our community, to all of our teams, all of our partners, and all of our shareholders for everything you're doing to help connect the world. And now here's Sheryl."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "Thanks, Mark, and hi, everyone. We had a great first quarter and a strong start to the year. Q1 ad revenue grew 57% or 63% on a constant currency basis. Mobile ad revenue reached $4.2 billion, up 75% year over year, and is now approximately 82% of total ad revenue. Our growth was strong across all verticals, marketer segments, and regions, particularly North America and APAC. We remain focused on driving our clients' businesses, moving their products off shelves both in stores and online. A big focus for us in 2016 is helping our clients understand the true business impact of their ads, especially on digital. We're pleased with the progress we made in Q1 across our three priorities: capitalizing on the shift to mobile; growing the number of marketers using our ad products; and making our ads more relevant and effective. First, capitalizing on the shift to mobile. Consumers have shifted to mobile, and businesses know they need to catch up. We hear from marketers that figuring out mobile today is like figuring out TV in its early days. But given where consumers spend their time, the question now is not if they should market on mobile, but how. One of the drivers of the consumer shift to mobile is video. People are sharing and creating nearly three times more video on Facebook than they were a year ago. And as of February, the time people spend watching videos on Instagram increased by more than 40% over the preceding six months. This presents a big opportunity for marketers. The best marketers understand that people watch video differently on mobile feed than on TV. They create ads that grab attention in the first few seconds, sometimes even without sound, what we now call thumb-stopping creative. For example, Nestlé took their TV ad for Natural Bliss coffee creamer and in less than a day edited it for mobile feed by creating a new opening and adding text overlays to relay their message without sound. They showed both the original TV ad and the mobile ad on Facebook. The original TV ad drove a four-point increase in ad recall. The mobile-optimized version, however, drove an even stronger 10-point increase in ad recall and a seven-point increase in product awareness. We want to help marketers optimize their video ads. For example, we know that on average, captioned videos increase view time by 12%, so we introduced Auto Captions to generate captions for video ads. In Q1 we introduced new ad formats like Canvas ads. Canvas ads showcase products by combining video images and call-to-action buttons. While it's still early, we're pleased with the results and are seeing adoption across many verticals. To motivate millennials to take on do-it-yourself projects, Lowe's and BBDO targeted 25 to 34-year-old homeowners with Canvas ads that let them see bathroom designs, discover the products in each design, and tap to purchase. The ads were so engaging that people spent an average of 28 seconds interacting with them, and Lowe's saw a 6.7 times return on AdSense. Our second priority is growing the number of marketers using our ad products. This quarter we announced that we have over 3 million active advertisers on Facebook and over 200,000 on Instagram. A significant number of these advertisers are small and medium businesses. These businesses use our platforms because it's easy and affordable for them to connect with their consumers on mobile. We're also making it easier for SMBs to use the same targeting tools and ad formats that our most sophisticated advertisers use. We're seeing even small businesses use products like Lead Ads, Slideshow, and Dynamic Product Ads. Our third priority is improving the relevance and effectiveness of our ads. Last year we introduced Conversion Lift to measure how Facebook and Instagram campaigns drive business objectives like sales. We've seen clients across verticals from retail to auto use Conversion Lift to measure and improve the return on their ad investments. Chase Bank used Conversion Lift to measure how effectively their Super Bowl ad drove credit card applications. They found that combining Facebook video ads with their TV ads drove 1.5 times more conversions than TV ads alone. In Q1 we expanded our Lift capabilities by testing Lift API, enabling more partners to measure the effectiveness of more of their campaigns. We're pleased with the value we're driving for our partners and the progress we're making across our three priorities. Helping marketers make the shift to mobile will take time. We have a lot of hard work ahead, and we'll continue to invest. I want to thank our clients around the world for their partnership and congratulate our global team on the results of their hard work. Thanks, everyone, and now here's Dave."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Thanks, Sheryl, and good afternoon, everyone. We're off to a great start in 2016, led by the ongoing growth and engagement of our community and continued momentum in our ads business. In Q1 we generated $5.4 billion in total revenue and delivered over $1.8 billion in free cash flow. Let's begin with our community metrics. In March, 1.09 billion people used Facebook on an average day, up 16% compared to last year. This daily number represents 66% of the 1.65 billion people who visited Facebook in the month of March. Mobile continues to drive our growth. Over 1.5 billion people accessed Facebook for mobile devices in March, up 21% from last year. Before diving into our quarterly financial results, I wanted to highlight that beginning this quarter, I will focus my prepared remarks on our GAAP results, and all financial metrics are GAAP unless otherwise noted. The primary difference between our GAAP non-GAAP metrics is stock-based compensation [SBC]. Stock-based compensation plays an important role in how we compensate our employees, and therefore we view it as a real expense to the business. We will continue to provide a reconciliation of GAAP to non-GAAP financial metrics in our press release and earnings slides. All of our comparisons are on a year-over-year basis unless otherwise noted. Q1 total revenue was $5.4 billion, up 52% or 58% on a constant currency basis. Ad revenue in Q1 was $5.2 billion, up 57% or 63% on a constant currency basis. This marked a slight decline from the 66% constant currency ad growth rate we experienced in Q4. In Q1 this year, we benefited from an additional day due to the leap year, which contributed approximately two percentage points to our year-over-year ad revenue growth rate. North America and Asia-Pacific were our fastest-growing regions, with advertising revenue growth of 64% and 62% respectively. Europe and rest of world grew advertising revenue more slowly, at 49% and 35% respectively, with the latter particularly impacted by foreign exchange headwinds. Setting aside currency headwinds, all regions exceeded 50% constant currency ad revenue growth. Mobile ad revenue was $4.2 billion, representing approximately 82% of total ad revenue. Mobile ad revenue grew 75%, driven by strength from Facebook's News Feed. Our mobile ads business continues to be driven by the combination of both supply-side and demand-side factors. On the supply side, we continue to see healthy growth in the number of people using Facebook, time spent across our products, and ad loads. On the demand side, we believe the investments we have made to improve our mobile advertising solutions are helping drive value for both people and marketers. We are seeing growth in both new customers as well as existing customers who are spending more with us on average compared to last year. In Q1, the average price per ad increased 5%, while total ad impressions increased 50%. The reported increase in price is being driven by the continued mix shift towards mobile, which contains higher priced News Feed ads rather than the mix we have on PCs of both News Feed ads and lower-priced right-hand column ads. The increase in impressions was driven by strong growth in mobile ad impressions and was offset partially by a decline in ad impressions delivered on personal computers, consistent with the ongoing declines in PC image. Total payments and other fees revenue was $181 million, down 20% compared to last year. This decline was mainly driven by a reduction in payments revenue related to games played on personal computers. Q1 total costs and expenses were $3.4 billion, up 29%. We ended the quarter with approximately 13,600 employees, up 35% compared to last year. Q1 operating income was $2 billion, representing a 37% operating margin. Our Q1 tax rate was 27%, down from our full-year 2015 tax rate of 40%. Our Q1 net income was approximately $1.5 billion, or $0.52 per-share. In Q1, capital expenditures were $1.1 billion, more than double compared to Q1 of last year. Server purchases and data center construction were the largest contributors to year-over-year growth. New builds in Texas and Ireland along with the expansion of existing facilities will nearly double our current data center footprint when completed. In addition to servers and data centers, investments in office facilities also contributed to the year-over-year growth. We ended the quarter with $20.6 billion in cash and investments. Turning now to the outlook, first, some color on revenue. We remain focused on creating value for the people and marketers who use our services. We expect that the main drivers of advertising revenue growth will continue throughout 2016, but we will face tougher comparables as the year progresses given the accelerating ad revenue growth we experienced throughout 2015. Payments and other fees revenues will continue to face headwinds throughout the year, given that the substantial majority of that revenue relates to payments from games played on personal computers. Even with the expected contribution from Oculus, we anticipate that our payments and other fees revenue for the full year 2016 will come in lower than the level in 2015. Next on to the expense outlook; our expense guidance remains unchanged. We expect that full-year 2016 total GAAP expense growth will be approximately 30% to 40%. We expect full-year 2016 amortization expenses to be approximately $700 million to $800 million, and full-year 2016 stock-based compensation expenses to be approximately $3.1 billion to $3.3 billion. If you take into account our GAAP expense guidance as well as our amortization and SBC guidance, you will see that our full-year 2016 total non-GAAP expense growth guidance range remains unchanged at 45% to 55%. We anticipate full-year 2016 capital expenditures to be at the high end of the $4 billion to $4.5 billion range we gave last quarter, as we invest to support the rapid growth of the business. We expect our Q2 and full-year 2016 tax rates to be similar to our Q1 rate. In summary, 2016 is off to a great start for Facebook. Our results reflect healthy growth and engagement in our community, strength in our ads business, and investments we're making to capitalize on the long-term opportunities we see ahead. Before going to questions, I wanted to touch briefly on the share reclassification that Mark discussed at the beginning of the call. As we disclosed in the proxy statement we filed today, our Board of Directors has approved a proposal for the reclassification of our capital stock that would involve the creation of a new class of publicly listed non-voting Class C capital stock. Pending stockholder approval, we intend to issue two Class C shares as a one-time stock dividend for each outstanding Class A and Class B share, resulting in a tripling of the pre-reclassification total shares outstanding. All stockholders would be treated equally. The net effect of this transaction would be to establish two publicly traded classes of Facebook stock, one representing the current Class A shares and the other representing the non-voting Class C shares. Since the Class C shares would have the same economic rights as the Class A and Class B shares, we would expect that after the payment of the stock dividend, the share price of the Class A common stock would generally reflect a three-for-one stock split. This will have no effect on the voting interest related to shares that investors currently hold. As Mark mentioned, this structure will allow for the preservation of the voting structure that has served the company well to date while allowing for Mark to fund the Chan Zuckerberg Initiative over the course of his lifetime. Importantly, as part of this proposal, the preservation of the multi-class capital structure would be generally predicated on Mark continuing to maintain an active leadership role at Facebook. Let me talk about next steps. The reclassification would be conditioned on approval by a majority of outstanding votes held by company stockholders, and we anticipate a vote on the matter at our annual meeting to be held on June 20 this year. A record date for this dividend would be determined at a later date. With that, Chris, let's open up the call for questions."
},
{
"speaker": "Operator",
"text": "Your first question comes from the line of Eric Sheridan with UBS. Your line is open."
},
{
"speaker": "Eric J. Sheridan - UBS Securities LLC",
"text": "Thank you so much. I wanted to come back to your comments on the small and medium-sized business opportunity at Facebook, maybe direct a few points to Sheryl to get some comment. I wanted to understand what some of the opportunities are to continue to demonstrate to those advertisers what the potential is for both Facebook and maybe even Instagram and Facebook Messenger long term as platforms to grow their businesses and also pointing out what some of the measurement tools and operating challenges are to bring people onto the platform. Thank you."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "Thank you for the question. SMBs, or SMUs as they're called in different places around the world, we think are a very core competitive advantage for us. It's prohibitively expensive for most small businesses to reach people digitally. Thirty-five percent of small businesses in the United States, which is often the most advanced market, don't have a web presence at all. And setting up a mobile app, getting people to find and download a mobile app, can be even more expensive. And so what's happening is that SMBs are turning to Facebook pages as their mobile solution. They're free, they're easy to set up, and they already know how to do them because almost all of them are already Facebook users in the first place. And so the onboarding has been incredibly important and incredibly effective. We announced last year that we have over 50 million small business pages active on a monthly basis. Eighty percent of those are active on mobile. We then work on helping them use our ad products and upsell them to our paid ad products as well, and we announced this quarter that we hit 3 million active advertisers on Facebook and 200,000 on Instagram. What's interesting is that what you see is SMBs are able to use the pull of some of the biggest brands in the world. So over 2 million SMBs have posted a video, both paid and organic, in the last month. And that happens to be many times the number of SMBs that have shot or placed a TV commercial. In terms of measurement, your question is important because it's not just getting them to use our platforms to connect to consumers. It's getting them to be able to measure our results. And so we've worked hard to build measurement tools into the products, so that when you buy an ad, an SMB has a very easy interface and decide what their goals are. Are their goals measuring sales? Are their goals clicks to their website? Are their goals mobile app downloads? And then measuring all the way through from sharing that ad to the purchase. I continue and we continue to be very bullish on this channel because we have such a broad base of usage, because that usage is so active, and because we're very focused on investing in simplifying our products so that all SMBs can use them."
},
{
"speaker": "Operator",
"text": "Your next question is from Brian Nowak with Morgan Stanley. Your line is open."
},
{
"speaker": "Brian Nowak - Morgan Stanley & Co. LLC",
"text": "Thanks for taking my questions. I have two. The first one, Sheryl, you talked about video and increasing the overall video consumption. Can you talk about where you are on traction with video advertising and the adoption of video ad units and the impact of video in the quarter? And then secondly, just breaking down the advertising by cohort, could you talk to points of strength or weakness across direct response versus branded advertisers in the quarter? Thanks."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "Sure, I'll take the second one first. Our growth was really broad-based, and we grew across all of our marketer segments this quarter. That's direct response, brands, SMBs, and developers. Our direct response business continues to be very strong. It's very ROI-focused, and we continue to invest and roll out products that help people. So for example, Lead Ads, where people can fill out forms on a mobile device, take their contact info from Facebook, we've rolled that out fully this quarter. And that enables people to use Facebook in a very direct to response way, and we'll continue to invest there. Video ads are really exciting. It's worth noting that video ads take place on another avenue, and receipts are not all of the revenue incrementals (28:55). But as consumer engagement with video has continued to grow, that creates more and more of an opportunity for video ads. Marketers have always loved video because it's a really compelling way to reach people. And now we can reach them on mobile all day with those kind of messages. Importantly, marketers have to adjust sometimes. While the 30-second ad does perform well in News Feed, we also see people understanding that some of the formats are different. Creating shorter ads, creating ads that can work even without sound, more personal ads has really mattered. One example is Toyota used Facebook for the launch of the RAV4 Hybrid with Saatchi in Los Angeles. They used a very broad video to drive brand awareness. They reached over 36 million people in a target demo within three days. Then, and this is where it gets even more interesting, they retargeted people who watched the video with over 500 personalized video ads which were optimized for Facebook and Instagram. So they were creating a direct response campaign to get people to take specific actions like requesting a quote and finding a specific dealer. We saw a 14-point lift in ad recall, a seven-point lift in message association. And right now, we're using the Lift tool to continue to measure their sales for the 30 and 60 days beyond the campaign to see what happens. And we're pretty excited about what that shows in terms of how video can be used in a really broad-based way but also a more personal way."
},
{
"speaker": "Operator",
"text": "Your next question is from Douglas Anmuth with JPMorgan. Your line is open."
},
{
"speaker": "Douglas T. Anmuth - JPMorgan Securities LLC",
"text": "Thanks for taking the questions. I have a couple for Mark around Messenger. Mark, I was hoping you could talk to us about how you expect to shift user behavior within Messenger to get users to focus more on businesses versus more personal communications and how you'll make users aware of the capabilities within the platform. And then just secondly, as more bots come on board here and businesses are engaging with Messenger, how do you envision bots and humans working together in terms of providing more customer service? Thanks."
},
{
"speaker": "Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer",
"text": "Sure. So part of our playbook for building out these ecosystems at scale is we start with the person-to-person user base. So whether that's in messaging, it's people messaging their friends or groups and News Feed. Before that, it was people posting updates and seeing what was going on with their friends and the people that they care about. And then the next step is to create organic activity around public entities, so whether that's businesses, public figures like athletes and celebrities and types of folks that people want to interact with on these different platforms, and we did that on Facebook in News Feed group pages, and we're working on a number of different ways to do that in Messenger. One of those is bots. And one of the good things about bots that we've seen is that it can decrease the amount of time that you have to wait before you get a reply back from interacting with a message. So what we've seen – we've done some research on this. A lot of people every day in Facebook today are already messaging pages and businesses directly, and the businesses respond. But what we've actually also found is that through some of our AI research, we can look at the responses that businesses give to common questions and can confidently provide the right reply a lot of the time. And when we can do that, then that decreases the latency. And predictably, people want to do more of that activity. So that's one way that I think you're going to see bots work, between people who are actually driving the businesses directly will need to in some way train or answer questions for people, but we can build artificial intelligence that can learn from people how to automate a lot of that and make that experience a lot faster for people who want to interact with businesses and public figures. And of course then, after you start building out that segment of businesses and then public figures on the platform, then on top of that you have just a good amount of intent on these platforms to build a good business on top of that. That's stage three."
},
{
"speaker": "Operator",
"text": "Your next question is from John Blackledge with Cowen & Company. Your line is open."
},
{
"speaker": "John Blackledge - Cowen & Co. LLC",
"text": "Great, thank you, two questions. So Facebook just opened up Instant Articles globally to all publishers. I'm just wondering what you see as a publisher's benefit in joining Instant Articles. And how we should think about the monetization impact in 2016? And then second question, the ad revenue in APAC was much better than we thought, just any more color on the drivers there. Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer",
"text": "So Instant Articles is all about the quality of the consumer experience. Right now for links that are not Instant Articles, it can be one of the slowest parts of the Facebook app. You're browsing through a News Feed, you tap on a link, if you're not on a good connection, the content isn't cached, it can take 10 or 20 seconds in some cases for that content to load. And people in our community, they don't know the difference about whether that content is coming from Facebook or a different place. They hold us accountable for making their experience quick, and we want to do everything we can to do that. So Instant Articles makes it so that any publisher around the world now can deliver a really great native experience instantly with no latency in loading it. And we're just seeing that people like to engage with that a lot more. So that's where we're most excited about there."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "The APAC question, it has been growing really well for several quarters now, and we're seeing a lot of great adoption as people learn to use the products. One part of the business that I think has been really strong and is worth noting is we're working with marketers in China to help with their export business. So Air China is a good example. They're a popular airline in China, but they don't really have – they're not really as well-known overseas. And before working with us, they really only invested in traditional media. They had a goal of promoting their new flight routes, including one from Mumbai to Beijing, and their new aircraft. So they launched a campaign with us in 15 countries globally. They used reach and frequency and Carousel and video ad targeting. And for example, they would target in the U.S. age 18 and above frequent international travelers living in cities where they had routes or Indian expats living in the U.S. to promote new routes to Mumbai. They reached 30 million people globally, more than 95% on mobile. And here's the best part, they had a 73% sales lift in the United States. So our APAC business is robust, and I think the global nature of our business is part of driving that."
},
{
"speaker": "Operator",
"text": "The next question is from Heather Bellini with Goldman Sachs. Your line is open."
},
{
"speaker": "Heather Bellini - Goldman Sachs & Co.",
"text": "Great, thank you. I was just wondering if you could share with us. How do you see Instagram's ramp impacting Facebook's ad growth in 2016, or if there's any color you could share with us about how that's been ramping? And also, if you can, share with us how advertisers are viewing the platform. Are you finding that it's typically more additive to their Facebook spending, or are they funding it with existing Facebook budgets? Thank you."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "Facebook and Instagram are the two most important mobile ad platforms out there. In the short run, some of the spend is incremental and some isn't. There are people who will have a social budget or a digital budget. And as they move to Instagram, some of that will come from Facebook. In the medium to long run, we believe we compare very favorably with any other spend we can do because we have this very broad reach on both platforms plus the ability to target very specifically. So what you're seeing in our results right now are very strong growth for Facebook and very strong growth for Instagram. We hit 3 million advertisers for Facebook. We hit 200,000 for Instagram, and often the platforms really work together."
},
{
"speaker": "Operator",
"text": "The next question is from Justin Post with Merrill Lynch. Your line is open."
},
{
"speaker": "Justin Post - Bank of America Merrill Lynch",
"text": "Thanks, a question for Mark. There have been some concerns about traffic to publishers and sharing levels on Facebook. I just wondered if you could talk about core Facebook engagement. What's really working? Are you concerned at all about that? And then when you think about the ad loads, are you comfortable with where they're at, is there still a lot of room to go? And then maybe last one, if you were to ever leave Facebook, what would happen to your voting shares? Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer",
"text": "All right, let's talk about engagement first. So overall sharing is up across Facebook, and people are spending more time on Facebook and the whole family of apps. And that is not just the case for the aggregate of the growing community, but it's actually also the case on a per-person basis as well in terms of people sharing more and spending more time individually. Now one of the things that we see is that the way that we are sharing is always changing, and some of this is because of underlying technical transition. So on desktop, for example, it's easier to type, so we saw more text posts. On mobile, it's easier to take videos, so we see more videos. On desktop, people would have more commonly uploaded an album of photos that they took from their digital camera and downloaded onto their computer; whereas on mobile, the more common behavior is to take a single photo or a couple and just post those. So there are all these transitions. And that's our job, is to make it so that we build great tools that people – everyone around the world can share anything that they want with everyone. Now the other thing that's also true is that people want to share with lots of different kinds of audiences. So Facebook gives you the ability to share with all of your friends and publicly if you want and with groups. But we're also investing in things like Messenger and WhatsApp because a lot of people want to share increasingly messages privately one on one or with very small groups. So in addition to Messenger, which is at 900 million people a month, and WhatsApp, which is at more than 1 billion people a month, Facebook Groups is also at more than 1 billion people a month, which I think represents the increasing diversity of the different types of audiences that people want to share with. But ultimately, I think that humans have such a deep desire to express themselves and want to connect with the people around them that I think that all of these audiences and all of these different types of media should grow over time. And it's our job to basically make sure that we build good products and get rid of all the bugs and make it so the performance is fast, and all the basic stuff works, that way we get there. But in general, right now all the high-level trends look pretty positive on that. I think I'll kick it off to Dave to go through your questions about some of the technical pieces about the reclassification."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Sure. I guess, also, Justin, you had a question on ad load, so I'll do both the ad load and the question on the reclassification. So on ad load, it's definitely up from where we were couple of years ago. I think it's really worth emphasizing that what has enabled us to do that is just improving the quality and the relevance of the ads that we have, and that's enabled us to show more of them without harming the user experience at all. So that's been really key. Over time, we would expect that ad load growth will be a less significant factor driving overall revenue growth, but we remain confident that we've got opportunities to continue to grow supply through the continued growth in people and engagement on Facebook as well as on our other apps such as Instagram. On the question regarding what would happen to Mark's shares if he were to leave Facebook, I'd just refer that the new multi-class capital structure is generally dependent on Mark continuing to maintain an active leadership role at Facebook. And if you go into the proxy materials, it goes into more detail on how different things would play out under various other scenarios. So I would just refer you to those."
},
{
"speaker": "Operator",
"text": "Your next question is from Ben Schachter with Macquarie. Your line is open."
},
{
"speaker": "Benjamin Schachter - Macquarie Capital (USA), Inc.",
"text": "Mark, when you're thinking about acquisitions broadly, in what area do you think Facebook needs to buy versus build? Basically, where you need external help? And then on VR, just a few quick questions, any update on the shipping delay, how many units shipped in the quarter and expectations for the year? And then also on VR, understanding I know it's very, very early, but beyond games and entertainment, what verticals do you expect to be first to utilize VR and AR? Thanks."
},
{
"speaker": "Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer",
"text": "So on the acquisition philosophy, I've talked about how I think the social ecosystem will play out on a number of these calls. The basic theory that we have is that there are a small number of services that are going to be ubiquitous utilities that 1 billion or 2 billion or more people are going to want to use. So that's core basic messaging, the core functionality around having your real identity and connecting with all of your real friends and family online. Those are things that we just think are just going to be ubiquitous. So we want to build those. At the same time, we also think that there are going to be many, many good businesses and different other social use cases where there are people doing good work and building different companies that we feel no need to own those things. So I think that people come up from time to time and suggest, should we buy this company or that. And what we look at are what are the things that we think are going to be ubiquitous tools, and who are the most talented people in the world to build this. And so when you think about something like virtual and augmented reality, that's how we thought about that. Those are going to be important platforms over time. It's very early obviously. It's going to take a long time to get there. And a lot of what we felt like we were buying there was a critical mass of the best people and the best technology to go do all the things that we needed to go do over the next 10 years to drive that home and turn that into a big platform. You asked a question about virtual and augmented reality. What are going to be the big use cases? For the first few years of virtual reality, I think gaming and video are going to be the big ones. The initial market that we look at are all the people who have Xboxes, PlayStations, and Wiis, the people who are excited to have an immersive media experience sitting in their living room for a long period of time, and that's a pretty big market. Even though that's not all of what we hope to eventually serve and that's not the full potential of these new platforms, I think that is one case where you can obviously deliver better and richer experiences than you can with the current generation of technology. Video is going really well. I shared a stat before in some of my comments that on Gear VR alone, we are now at more than 2 million hours of video have been watched on the platform, so that's really exciting. And that of course will be bolstered by the fact that these new 360 videos can not only be watched in VR, so in the headsets, but we're building tools so you can share them on News Feed and through our products elsewhere as well. So I think that's exciting. Over time there will be even more, but that I think should be enough to have some initial use. But again, I do want to really emphasize, this is early and it's going take a long time. And I know there's a lot of hype around this, and we're just focused on building this to be very good over the long term."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Then, Ben, you asked about shipping units. We did begin shipping units in the quarter. This is very small still. VR is still very early. It's not going to have a material impact on revenue in 2016, and I gave more color on that in my prepared remarks."
},
{
"speaker": "Operator",
"text": "Your next question is from Mark May with Citi. Your line is open."
},
{
"speaker": "Mark A. May - Citigroup Global Markets, Inc. (Broker)",
"text": "Thanks a lot, first one for Sheryl, I think. I'm wondering if you could update us on the progress you're seeing with FAN [Facebook Audience Network]. You gave some metrics in Q4. It seemed like that advertisers were really adopting that platform and seeing a lot of additional reach. Maybe if you could, tell us how that's going. And then I think a couple more; on the tax rate, we saw it step down quite a bit in Q1, but you're guiding for flat sequentially. Should we think about that as a run rate, or are you still attempting to manage your tax rate down even further than where you saw it in Q1 and where you're expecting for Q2? And then on the OpEx guide, 41% non-GAAP growth in Q1, obviously below your range but you maintained the range. Why is that? Is that just purely a function of the comps as you head into the year, or are there some specific investment plans that you have? Thanks."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Sure, Mark. I can start with the detailed ones, the tax rate and the OpEx guide. So on the tax rate, the rate came in better than guidance in terms of the tax rate, but it's consistent with the long-term trend that I'd indicated. We do expect that that rate will be approximately the rate that will continue for the rest of the year. So for purposes of 2016 modeling, I would use the Q1 rate. On the OpEx guide, Q1 came in slightly below our annual expense growth guidance, but we do expect that investments in areas like video and Oculus will impact the remainder of the year more substantially, so that's why we're maintaining the annual OpEx growth guidance that we have. And then, Sheryl, did you want to speak about Audience Network?"
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "Yes, Audience Network is important to us because we're making a strategic investment in ad tech, helping advertisers and publishers grow, so it's on and off Facebook. We think we're uniquely placed to bring people-based marketing to scale and solve the measurement problem, and the Audience Network is a place we're really focused because we feel like we're delivering value for advertisers and publishers, so we're investing behind the growth we've seen. We've seen a growth of native ads. Eighty-three percent of the overall inventory on the platform is native, and over 50% of our publishers are only using native ads. We have some great examples of Audience Networks really improving people's results. A recent one is eBay Vivanuncios, which is an online real estate destination working in Latin America and Mexico. When they were using a combination of Facebook, Instagram, and the Audience Network, they saw 57% lower cost per install with placement optimization and 59% more volume versus running on Facebook alone, which led to 6% incremental revenue. So compared to November a year before, the number of their app installs increased by 115%. So what we're seeing is the results we're able to deliver on Facebook and Instagram, a lot of our marketing partners want more. And our ability to do that is why we're investing in the Audience Network."
},
{
"speaker": "Operator",
"text": "The next question is from Colin Sebastian with Robert W. Baird. Your line is open."
},
{
"speaker": "Benjamin C. Gaither - Robert W. Baird & Co., Inc. (Broker)",
"text": "Hi, this is actually Ben on for Colin. This one is for Mark. You had already talked about the AI and machine learning applications with respect to Messenger and bots, but I was wondering what are some of the more nascent initiatives where you're applying machine learning, or maybe where we might see those investments manifest themselves in the user experience over the next few years?"
},
{
"speaker": "Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer",
"text": "So the biggest thing that we're focused on with artificial intelligence is building computer services that have better perception than people, so the basic human senses like seeing, hearing, language, core things that we do. I think it's possible to get to the point in the next five to 10 years where we have computer systems that are better than people at each of those things. That doesn't mean that the computers will be thinking or be generally better, but that is useful for a number of things. So for example, I talked about earlier, we are building this Moments app, so that way you can take photos on your phone. And if you use this app, our face recognition can look at the photos that you take and suggest that you might want to share photos that you took with a friend in them with that person. So that way, all the photos that might be of you and your friends' camera rolls, they can share with you. Another example is just spam filtering and just making sure that we can actually read the content and understand what's interesting to you or not and not show that. One obvious thing I think over time is if you just look at the way that we rank News Feed, today we use some basic signals like who you're friends with and what pages you like as some of the most important things for figuring out what – out of all of the millions and millions of pieces of content that are on Facebook, what we're going to show and what are going to be the most interesting things to you. That's because today our systems can't actually understand what the content means. We don't actually look at the photo and deeply understand what's in it or look at the videos and understand what's in it or read the links that people share and understand what's in them, but in the future we'll be able to, I think in a five or 10-year period. So all of these millions and millions of pieces content that are out there, whether or not you've added someone as a friend or have liked a page, we'll be able to know a lot better what types of things are going to be interesting to you to produce a much better feed of content. So that's just a basic example of where having human-level perception broadly is going to yield better experiences in a lot of the things that people care about today."
},
{
"speaker": "Operator",
"text": "The next question is from Ken Sena with Evercore. Your line is open."
},
{
"speaker": "Kenneth Sena - Evercore ISI",
"text": "Hi. I have a high-level, longer-term question. For brands, we're seeing where promotion, transaction, and support capabilities for businesses are all deepening within Facebook. Therefore, should we be thinking about a longer-term transition from a platform that's basically all ad to something where more marketplace capability is offered, given that buyers and sellers are so known and so connected? And if so, can we think about Facebook starting to monetize maybe on a transaction basis or even through various customer support capabilities via the messaging tools, AI, et cetera, that you're beginning to offer businesses? So maybe if you could just provide a little bit of color on how you see that evolution, that would be great. Thank you."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "You're right that people are increasingly using Facebook to discover products and services, and we're testing some ways like the Marketplace to make this easier. We're also testing some incremental features on pages, which enable businesses to drive purchases on a page or direct people directly to their website. These are really early, but we've had some positive feedback. Our focus, however, continues to be on our ad products because we think we can take people all the way from the top of the funnel, where they can really get a brand awareness or product awareness, and go all the way down to purchase, not necessarily because the purchase is happening on Facebook, but because we can work on the measurement systems to understand how the advertising, both at the top and lower down in the funnel is influencing those purchases. We've been really excited by what we've seen in the commerce vertical of our ad products. So products like dynamic product ads, Carousel ads are working really well for us. This quarter we launched Canvas ads, which are very fast-loading, immersive mobile ads. They're easy to build. You can use the self-service tool. You don't have to write any code. They are native format, so they decrease that initial drop-off you see when people click off to another site. It's very early days, but the average viewing time is over 30 seconds, which shows how immersive that is. I'll share one example of how ads are driving a small business on Facebook through ads, which is a company called Sparkle in Pink. They're a Utah-based SMB. They're selling girls' clothing. They did a Slideshow ad that included a Shop Now button, which enables you to take action on their site. They were able to increase sales by 9% a month. And more exciting for us, this was six times more efficient in terms of acquisition than any other digital media channel. And that shows how you can use our ad products to go all the way from awareness, measuring through to a sale and show how important our ads can be to commerce on our platform."
},
{
"speaker": "Operator",
"text": "Your next question is from Ross Sandler with Deutsche Bank. Your line is open."
},
{
"speaker": "Ross Sandler - Deutsche Bank Securities, Inc.",
"text": "Great, so I guess a question for Mark or Sheryl. So at F8, you showcased a bunch of new features for Messenger, including ads to promote your business inside of Messenger. So how should we think about the timing of those ad units coming on in Messenger? And can you use the same ad stack in the Facebook Power Editor that's used on core Facebook and Instagram to get ads up on Messenger? Can you walk us through that? And then the second question on messaging, so with WhatsApp crossing 1 billion users recently, how do you view the product roadmap today on WhatsApp versus what you showcased recently with Messenger? Is it a year behind, or is it further back than that? Any color there would be helpful. Thanks."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "For Messenger and WhatsApp, our focus right now continues to be on growth and engagement. We are not rolling out any monetization products on WhatsApp right now, but we did start that process at F8 on Messenger. And what we're doing is following the organic activity that's happening on the Messenger platform. Businesses and consumers are using Messenger to connect to each other in a more personal, more immediate way. And we rolled out a platform beta, which gives new opportunities to build compelling experiences. Bots, very early but giving the opportunity for more personal interactions between businesses and mobile. The 10 received APIs (56:26), so that businesses could send immediate responses to common questions, including engaging images and call to action as well as texts. In terms of the timing, this is really early. We have a lot of opportunity to invest in advertising across our different platforms. And so we want to make sure we get this right as we focus on continued engagement. You're right that over time, when we make these investments, we are going to be able to rely on some of the core aspects of the ads infrastructure. Certainly, our long base of advertisers, some of the things we understand about how ads perform and the functionality will be an important part of the product offerings in the future, but those are not immediate by any stretch of the imagination."
},
{
"speaker": "Deborah Crawford - Director-Investor Relations",
"text": "Operator, we have time for one last question."
},
{
"speaker": "Operator",
"text": "Your last question is from Anthony DiClemente with Nomura. Your line is open."
},
{
"speaker": "Anthony DiClemente - Nomura Securities International, Inc.",
"text": "Thanks a lot. I have one for Sheryl and one for Mark. Sheryl, there are many out there who might assume that this leg of excellent growth that Facebook is realizing might have come at the expense of TV advertising, but the TV ad world seems to be quite resilient here. And you actually talked a lot in your prepared remarks about how marketers benefit from running digital and TV campaigns in parallel. So I wonder if you could just comment on where your share gains are coming from, in your view. And then, Mark, on Live video, I realize it's a small part of overall video, but I wonder. Do you think multiple platforms can succeed in live streaming over time given the size of the market longer term, or do you think it's more of a network effect business where a vast majority of the traffic and economics will ultimately accrue to the leader in the live streaming space? Thank you."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "We think our growth has been very broad-based, but dollars are shifting from all types of media formats to where consumers are spending their time. We tell our clients that we want to be the best dollar and the best minute they spend, and we want them to measure value. I don't think this means that all of our growth comes at the expense of any one channel, but it's broad-based. And often, TV and Facebook and Instagram can work really well together. I'll give a fun example from the Super Bowl. T-Mobile wanted to use their Super Bowl campaign to increase their brand awareness and increase their reach. So before the game, they targeted their 30-second Super Bowl ad that featured Drake to people with NFL and celebrity interests. It performed so well that they decided to run the 60-second version on Facebook and Instagram. That ad was so successful on Facebook and Instagram that they then ran the 60-second ad on TV instead of their 30-second ad. So as people invest, they can use these different platforms together, and we're pretty excited to see that progress."
},
{
"speaker": "Mark Elliot Zuckerberg - Founder, Chairman & Chief Executive Officer",
"text": "And on Live video, the theme that I think is most important is just that there's so much that people want to express and share with the people around them that they don't have the tools to do today. And I think about this huge opportunity, not just in Live video, but in a lot of things that we're talking about. One interesting example recently that I touched on earlier is between Messenger and WhatsApp, we're around 60 billion messages a day. And SMS at its peak we think was around 20 billion messages a day. And just unlocking some of the friction that existed in SMS and improving the product a little bit and removing the small fee that was there has just unlocked a huge amount of expression. And we think that this is going to be the case in all different types of media and with all different audiences that a person would share it with. So in video, there are billions and billions of videos that are viewed every day on Facebook. Live is a very small part of it. The reason why we give disproportionate attention to it is because we're trying to help push forward new formats that are not just about consuming content but are really about interacting, so Live, 360 video, and there will be others in the future. And so yes, to answer your question, I do think that multiple products and companies can succeed in building these things. I also think that there are going to be a lot more interactive forms of video than just Live and 360 like we're talking about now. And I think that this extends not just to video but for all the different types of media and audiences that we're serving. So we're very excited about continuing to do our work to help unlock all the expression and connection that people want to do."
},
{
"speaker": "Deborah Crawford - Director-Investor Relations",
"text": "Thank you for joining us today. We appreciate your time and we look forward to speaking with you again."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect."
}
] | null | null |
META | 4 | 2,015 | 2016-01-27 17:00:00 | Executives: Deborah Crawford - Vice President, IR Mark Zuckerberg - CEO Sheryl Sandberg - COO Dave Wehner - CFO
Analysts: Douglas Anmuth - JP Morgan John Blackledge - Cowen & Company Eric Sheridan - UBS Heather Bellini - Goldman Sachs Ben Schachter - Macquarie Brian Nowak - Morgan Stanley Justin Post - Bank of America Merrill Lynch Anthony DiClemente - Nomura Carlos Karjner - Bernstein Michael Nathanson - Moffett Nathanson Mark Mahaney - RBC Capital Markets Paul Vogel - Barclays
Operator: Good afternoon. My name is Chris and I’ll be your conference operator today. At this time, I’d like to welcome everyone to the Facebook Fourth Quarter and Full-Year 2015 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook’s Vice President of Investor Relations, you may begin.
Deborah Crawford: Thank you. Good afternoon and welcome to Facebook’s fourth quarter and full-year 2015 earnings conference call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today’s press release, our annual report on Form 10-K and our most recent quarterly report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present, both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today’s earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I would like to turn the call over to Mark.
Mark Zuckerberg: Thanks, Deborah, and thanks everyone for joining us today. Overall Q4 was a strong quarter and a great end to the year. More than 1.59 billion people now use Facebook each month and 1.04 billion every day, a growth of nearly 200 million people monthly and a 148 million people daily this year. More than 1.44 billion people use Facebook on mobile devices. And when it comes to our business, we’re also pleased with our continued growth. Total revenue grew by 52% year-over-year to more than $5.8 billion and advertising revenue grew by 57% to reach more than $5.6 billion. But it’s important to consider not just our business results but also how we’re improving the lives of people and communities around the world. Next week Facebook celebrates its 12th birthday. And as I think about our progress and where we go from here, I’ve reflected on the diverse global moments that Facebook was involved in, in 2015. More than 950 million people received a notification that a friend or a loved one was safe in a crisis. Millions of people supported the people of Nepal after the earthquake and the people of France after the Paris attacks. More than 8 million people used 35,000 groups and pages on Facebook to support refugees. And people from all over the world connected around moments from Star Wars to the U.S. presidential election, from the Indian Super League to the Cricket World Cup. Seeing our global community connecting in all these ways shows the opportunities ahead as we connect the world but also the challenges. Even as the world has tended towards greater openness over time, in many communities we also see greater fear over what a connected world and more technological progress means for them. Addressing these concerns is essential for making progress on our mission. And we’re going to keep working to give as much voice as we can and advance the benefits of connectivity and bringing the world together. In 2016 and beyond, we’re going to continue doing that by serving our community, working to bring connectivity to billions of people who’re not yet connected, and building new technologies that give people more ways to express themselves. Now, let’s talk about how we’ve continued working to do that and let’s start with how we’re improving our existing products and businesses. Our strategy here is to deliver better more engaging experiences for our community and to give people better tools for sharing different types of content with the different groups of people that they care about. Video is an important part of the Facebook experience, and continuing to invest here is important for allowing people to share and consume some of the most engaging content. We’ve continued to make progress and now 100 million hours of video are watched daily on Facebook. We’ve been testing new experiences like suggested videos which enables people to discover more videos they might be interested in. We’re also exploring ways to give people a dedicated place on Facebook for when they just want to watch videos. With other parts of our core, we’ve continued to focus on improving the performance and quality of our products to better serve different communities on Facebook. And these efforts are paying off with growth in engagement for different products reaching an impressive scale. Now, more than 500 million people use events each month and more than a 123 million events were created on Facebook in 2015. For the first time, more than 1 billion people used groups in a single month on Facebook. It’s inspiring to see all the different communities using groups, from the small family and classroom and church groups to the large ones like the running challenge group that I started a few weeks ago that now has about a 100,000 members. To serve our entire global community, we’re optimizing our services for people in developing countries. We’ve improved Facebook Lite to offer better experience in low-bandwidth environments, improving load times and adding features like video. More than 80 million people now use Facebook Lite as of December. And when it comes to serving businesses, we’ve continued to focus on creating better ads and tools for our more than 2.5 million active advertisers. More than 50 million small businesses now use pages on Facebook and people post more than 2.5 billion comments on these pages each month. This is a good example of how the strength and engagement of our community is making Facebook more valuable for businesses every day. And Sheryl is going to talk more about this in a minute. Next, let’s talk about how we’re building our next generation of services. With Instagram, we’ve continued to drive the shift towards more visual content online. The community continues to grow. And back in September, we announced a new milestone of 400 million monthly actives. Over the last year, as the community has grown, we have focused on building engaging new experiences for the community including by improving search and by introducing Trending Content. We’ve also worked to develop new experiences to give people more options for creating and sharing different types of content. In March, we launched the layout app allowing people to easily combine images and in October the team also launched Boomerang, and app for making looping videos which reached number one in the App Store in more than 70 countries. We also introduced a new video channel on Instagram for people to watch moments from big events like New Year, so the college football championship as they have it. With Messenger and WhatsApp, we’ve continued to make progress with building these into valuable communication services for everyone in the world. More than 800 million people now use Messenger monthly and in 2015 we grew that number by almost a quarter of 1 billion while also increasing engagement. We continue to give people new ways to communicate by introducing video calling and new options for customizing conversations with fun things like colors and emojis and by using apps like -- using apps, the Messenger platform. We also worked to extend Messenger’s utility by adding payments, a new way to connect with businesses and by testing M, a digital assistant powered by AI. In this quarter we also began testing a transportation platform, allowing people to request an Uber ride through Messenger. More services will be coming to the platform soon, including airlines. WhatsApp ended the year with nearly 1 billion monthly actives. As WhatsApp has grown, we work to keep it fast, simple and reliable. And we’ve seen many communities come to depend on this as their main communication service. To serve these communities well, this month we announced that WhatsApp will now be free to everyone and will no longer charge the subscription fees that many people were charged after their first year. We think this is an important step towards creating and even more ubiquitous product without affecting our plans for building WhatsApp into important business in the coming years. Later this year, we’ll be testing new ways for people to use WhatsApp to communicate with businesses and organizations that they want to hear from. Finally, let’s talk about our work on new breakthrough technologies that can help connect more people to the internet and create transformative new experiences. In 2015, we made significant progress on our efforts to connect more people to the internet. We launched the first trials of Express WiFi, a product designed to help entrepreneurs bring their communities online. We launched Free Basics in 33 more countries, and we’ve now connected 19 million people. This year, we expect to hold our first test flight of Aquila, our first solar-powered aircraft designed to beam internet into communities from the sky. And we’re also working on new advances in lasers that can transfer large amounts of data faster and more efficiently than anything today. With our work in AI, we continue to make progress towards the new generation of computers that can see and understand. Over the last year, we published dozens of research papers including some of the leading work on image recognition and language understanding. To drive the entire AI community forward, we’ve also open-sourced software and a lot of new AI hardware platform. Achieving the scientific breakthroughs to build AI that makes a dramatic visible difference in people’s lives is going to take a long time. But already we’re seeing opportunities to serve our community. We recently built a prototype AI system that combines language and vision comprehension. You can show it an image that it’s never seen before and it can answer questions about that image. And we’ve even used AI to help blind people experience their friends’ photos and news feed by describing the scenes. With virtual reality, we’ve reached an important milestone. The Samsung Gear VR shipped over the holidays with our Oculus software and we’re pleased with the initial reaction. This month, we also opened pre-orders for Oculus headsets. This will be the world’s best VR experience and we’re excited to begin shipping to people in more than 20 countries before the end of March. More than 100 VR games and experiences are coming to Oculus this year. And later this year, we’ll also be shipping our Oculus Touch controllers to get your hands into virtual reality. These controllers will enhance the VR experience and allow people to communicate more naturally in VR through intuitive hand movements and gestures. This Oculus launch is shaping up to be a big moment for the gaming community. But over the long-term, VR has the potential to change the way that we live, work and communicate as well. The launch is an important step towards the future, and we’re really looking forward to seeing how people use it. So that’s how we’ve continued to make progress on our strategy. It’s been a strong quarter and we ended 2015 with a great foundation for our efforts going into 2016. Our strategy is working and we have many more opportunities ahead. So, we’re going to continue investing to deliver more great results over the long-term. On a more personal note, over the last few months with the new addition in my family, I’ve been reflecting a lot on the legacy that we want to pass on to the next generation. I’m excited about our progress and the chance to build something great for the future. If we continue to focus on solving the fundamental challenges facing the world and bringing the world closer together, we can leave a better world for the whole next generation. And that’s what I think about every day as we continue building Facebook. And I want to thank everyone in our community, our employees, our shareholders and our partners who are helping us on this journey. Thanks. And here’s Sheryl.
Sheryl Sandberg: Thanks, Mark, and hi everyone. We had a terrific fourth quarter capping off a great 2015. Q4 ad revenue grew 57% or 66% on a constant currency basis. Mobile ad revenue reached $4.5 billion, up 81% year-over-year and is now 80% of total ad revenue. Facebook and Instagram drive business results for our partners, helping their products off shelves online and off. As a result, we’re growing spend from our current clients and attracting new marketers to our platform. We saw strong growth across all verticals, marketer segments and regions. We’re also pleased with the growth we’re seeing in emerging markets and countries like China where businesses are advertising on Facebook and Instagram to reach people internationally. We continue to make progress on our three priorities, capitalizing on the shift to mobile; growing the number of marketers using our ad products; and making our ads more relevant and effective. First, capitalizing on the shift to mobile. Heading into 2016, it is clear that consumers have shifted to mobile and businesses know they need to catch up. Marketers now realize that if they want to reach their customers where they are, mobile is essential. Our conversations with clients have shifted from if they should market and mobile to how. With over 1.44 billion people using Facebook on mobile monthly and over 400 million monthly actives on Instagram, Facebook and Instagram have become the two most important mobile advertising platforms. We provide creative canvas powered by technology, a unique combination of art and science that marketers can use to deliver great creative with the highest quality targeting at unparalleled scale. The 2015 holiday season was a defining moment for mobile marketing and demonstrated the power of our mobile platform. According to comScore, total U.S. consumer spending on mobile in November and December was up 59% year-over-year. This holiday season, marketers turned to mobile more than ever before. To reach a large global audience for the launch of Halo 5, Microsoft Xbox used optimized for Facebook and Instagram. Working with our agencies and power media team from Dentsu Aegs Network, Eisenberg Group and twofifteenmccann, they understood that people watch video differently in mobile newsfeed than on TV. So they created videos to capture audience attention in the first three seconds even without sound. They drove over 380 million impressions and 49 million video views in key markets and increased purchases by 10 points in the U.S. Our second priority is growing a number marketers using our ad products. Last quarter we announced that we had over 2.5 million active advertisers and since then our growth has remained strong. This represents small fraction of the over 50 million small businesses now actively using pages. So we see a big opportunity to continue to grow the number of Facebook advertisers going forward. We’re also very pleased with the growth in advertiser adoption of Instagram and the positive results advertisers are seeing from their investments. 98 of the top 100 advertisers on Facebook also advertised on Instagram in Q4. Our third priority is improving the relevance and effectiveness of our ads. We shipped a lot of new ad products this past year. These products help deliver personalized marketing at scale and drive business for our clients. Leading up to Black Friday Shop Direct, the UK’s second largest online retailer teased upcoming sales with a cinemagraph video to build awareness. They then retargeted people who saw the video with one day only deals. On Black Friday, they used our carousel and DPA ads to promote products people had shown interest in. They saw 20 times return on ad spend from this campaign, helping them achieve their biggest Black Friday and their most successful sales day ever. To share just a few other product examples, in emerging markets we launched Slideshow a video like ad experience that works with lower connection speeds and feature phones. We introduced local awareness ads globally to help brick and mortar businesses reach people near their stores and started testing Canvas ads to help marketers showcase their products in a more immersive way. We continue to invest in ad tech and are especially pleased with the growth of our audience network. Measurement also remains a critical area of focus. Our measurement tools like Conversion Lift and the Facebook pixel prove to marketers that we’re driving business results and help make our ads more relevant. This year we saw more advertisers shift from proxy metrics like clicks to business results like digital and in store sales. Our results show that the investments we’ve made over the past few years are paying off and we see a lot of exciting opportunities ahead. We know we still have a lot of hard work to do and heading into the New Year, we will remain very focused on our top three priorities. I want to take this opportunity to thank our clients around the world for their partnership. Your investment and feedback is critical to making our products better. I also really want to thank the global Facebook teams for your extraordinary dedication to our partner success. Your hard work and execution is critical to helping us fulfill our mission. Thanks everyone and now here is Dave.
Dave Wehner: Thanks Sheryl and good afternoon everyone. Q4 was a strong quarter and wrapped up a phenomenal year for Facebook. Full year 2015 revenue was $17.9 billion, up 44% year-over-year or 53% on a constant currency basis. In 2015, we generated over $6 billion in free cash flow including $2.1 billion in Q4 while continuing to fund important investments for the future growth of the business. The strong growth and engagement of our community with consistent theme throughout 2015, and that continued in the fourth quarter. In December, 1.04 billion people used Facebook on an average day, an increase of 17% compared to last year. This daily number represented 65% of the 1.59 billion people who visited Facebook during the month of December. Mobile continued to drive the growth of our community. In December, 1.44 billion people accessed Facebook on mobile devices, an increase of 21% compared to last year and 90% of the people who have used Facebook on both a monthly and daily basis accessed us via mobile devices. Now turning to the financials. All of our comparisons are on a year-over-year basis unless otherwise noted. Additionally, our non-GAAP measures exclude stock-based compensation and the amortization of intangibles. In Q4, total revenue was $5.8 billion, up 52% or 60% on a constant currency basis. Q4 ad revenue was $5.6 billion, up over $2 billion from last year, year-over-year growth was 57% or 66% on a constant currency basis. The strengthening of the U.S. dollar continued to have an unfavorable impact on our revenue in the fourth quarter. Had exchange rates remained constant with Q4 2014 levels, our total revenue would have been approximately $320 million higher. U.S. and Canada and Asia Pacific continued to be our two strongest regions with ad revenue growth of 64% and 57% respectively. Our rest of world and Europe regions grew at 53% and 45% respectively, as they were more heavily impacted by currency headwinds. Mobile ad revenue was $4.5 billion, up 81% from last year and represented 80% of our advertising revenue. For perspective, three years ago the mobile percentage was just over 20%. Q4 tapped off a remarkably successful year for our mobile advertising business where we were able to combine strong growth in ad inventory supply with strong growth in advertiser demand. On the supply side, we grew the number of people using Facebook on mobile, time spent, and ad load. Our ongoing focus on ad quality and relevance enabled us to deliver a better overall mobile ads experience for our users while increasing the number of ads they see. In Q4, we also benefitted to a lesser extent from increases in ad inventory from Instagram and the Audience Network. On the demand side, we believe our efforts on targeting and measurement solution enabled marketers to achieve better business results at better values. This helped us drive strong growth from a broad array of advertisers including direct response in brand advertisers, large companies and SMBs and both existing and new advertisers. Turning now to the overall price volume metrics, in Q4 the average price per ad increased 21% while total ad impressions increased 29% on a year-over-year basis. It’s worth noting that this was the first quarter since Q3 2013 that total ad impressions increased on a year-over-year basis. This was driven by an increase in mobile ad impressions and was partially offset by a decline in ad impressions that were heard on personal computers, consistent with the ongoing declines in PC usage. The reported increase in price is being driven by the continued mix shift towards mobile which contains higher price newsfeed ads rather than the mix we have on PCs of both newsfeed ads and lower price right-hand column ads. Total payments and other fees revenue was $204 million, down 21% compared to last year. The decline was driven by reduction in payments revenue related to games played on personal computers. Turning now to expenses, Q4 total GAAP expenses were $3.3 billion, up 21%, and non-GAAP expenses were $2.3 billion, up 42%. Our year-over-year GAAP expense growth rate slowed this quarter as we lap the introduction of stock-based compensation charges associated with the WhatsApp transaction. Non-GAAP expenses were driven by increases in head count related costs, cost of revenue and marketing expenses. We ended the year with nearly 12,700 employees, up 38% compared to last year. Our GAAP operating income was approximately $2.6 billion, representing a 44% operating margin. Our non-GAAP operating income was $3.5 billion, representing a 60% operating margin. Our Q4 GAAP and non-GAAP tax rates were 39% and 36% respectively. Our Q4 GAAP net income was approximately $1.6 billion or $0.54 per share, and our non-GAAP net income was $2.3 billion or $0.79 per share. In the full year 2015, capital expenditures were $2.5 billion as we continued to invest in servers, data centers, network infrastructure, and office facilities to support the rapid growth of the business. We ended the year with over $18.4 billion in cash and investments. Turning now to the outlook, first some color on revenue. We expect the factors that drove the strong growth of our advertising business in 2015 will continue into 2016. However, we expect to continue to face foreign exchange headwinds especially early in the year as we will be lapping periods where the dollar was relatively weaker than it is today. More importantly -- sorry, more broadly, the overall macro-environment introduces the level of uncertainty around global growth and exchange rates that could impact our business in 2016. And we do expect to face tougher comparables as the year progresses, given the remarkably strong advertising performance in 2015. Turning now to expense guidance, 2016 will be another significant investment year for Facebook. In 2015, we continued investing heavily in the core. At the same time, we doubled our investment levels in our next generation services which includes WhatsApp, Instagram and Messenger and we tripled our investment levels in our long-term areas of focus which includes our connectivity efforts, Oculus and our AI investments. We will continue investing significantly in all of these areas in 2016. We expect the year-over-year growth rate for full year 2016 total GAAP expenses to be approximately 30% to 40%, and for full year 2016 total non-GAAP expenses to be approximately 45% to 55%. Note these ranges represent total operating expenses -- including cost of revenue. These ranges also include the cost of revenue impact of the expected shipments of Oculus Rift, so we expect that impact to be immaterial to our overall total expenses for the year. We anticipate our 2016 capital expenditures will be in the range of $4 billion to $4.5 billion. We recently announced that we will be -- begin building a new data center in Clonee, Ireland and that project is on top of the new data center being built in Fort Worth Texas. We expect our 2016 stock-based compensation to be in the range of $3.1 billion to $3.3 billion, approximately half of which is related to our prior acquisitions, most notably WhatsApp. We expect 2016 amortization expenses to be approximately $700 million to $800 million. And lastly, we anticipate that our Q1 and full year 2016 GAAP and non-GAAP tax rates to be in the low 30s on a percentage basis, down from our 2015 range. We expect our tax rates will decline further over time and resemble those for our global peers over the next several years. In addition in 2016, we expect for the first time to pay a significant amount of U.S. income tax on a cash basis. To conclude, 2015 was an outstanding year for Facebook. Our performance reflects the strong growth and engagement of our community, the momentum we’re seeing in our ads business, and significant progress we’re making on our mission to connect the world. With that Chris, we would like to open up the call for questions.
Operator: Thank you. And we will now open the line for question-and-answer session. [Operator Instructions] Your first question comes from the line of Douglas Anmuth with JP Morgan. Your line is open.
Douglas Anmuth: Thanks for taking my question. Two things I wanted to ask. First Mark, just on Messenger and WhatsApp, can you just talk more about the takeaway on the Messenger platform now that it’s been open for nearly a year to developers and how that’s informed your view on what you’re going to do with WhatsApp going forward? And then secondly Dave perhaps or Sheryl on the ad load, few years ago you talked about ad load at mid-single-digit levels and then more recently is up significantly since then. Do you still feel like there is still significant room to increase ad load here and how do you think about the theoretical ceiling there? Thanks.
Dave Wehner: I can start with the ad load question, Doug. So, ad load is definitely up significantly from where we were a couple of years ago. And as I mentioned, it’s one of the factors driving an increasing inventory. Really one thing to kind of think about here is that improving the quality and the relevance of the ads has enabled us to show more of them and without harming the experience, and our focus really remains on the experience. So, we’ll continue to monitor engagement and sentiment very carefully. I mentioned that we expect the factors that drove the performance in 2015 to continue to drive the performance in 2016. So, I think that’s the color I can give on ad loads.
Mark Zuckerberg: On Messenger, the platform efforts in 2015 focused on two things. One was expanding the different types of content that people could share in Messenger. And that diversity is going really well. And we see continued increase in video sharing and photos and stickers, and a lot of stuff that you would just call fun but that people really enjoy as different ways to express themselves. But in terms of the business, the more important piece is how people can interact with businesses through Messenger. And we started some early small tests around f8 last year where with some ecommerce services made it so that people who were buying things could follow up with the business and get customer support and buy more things. And we went through this process of integrating that and making sure that it’s integrated with all these system well. And I think everyone is really happy with that so far. So we started off pretty slowly, but that’s going to be some of the basis for how we look to make Messenger a business going forward. And we’re happy with the initial results. There is obviously a lot more there that we need to do and we’ll have more to talk about this year and beyond.
Operator: The next question is from John Blackledge with Cowen & Company. Your line is open.
John Blackledge : So, it was a phenomenal quarter and year for Facebook. And given we’re about a month into 2016, there is a lot of discussion around the global macro headwind. Just wondering how the business is trending thus far in the quarter or maybe by market U.S., Europe Asia-Pacific and Rest of World; and generally, just how Facebook is positioned if the global macro environment softens a bit? Thank you.
Dave Wehner: Yes, John, it’s Dave. Just on that question, we’re not commenting specifically on Q1. We didn’t see anything in Q4 that indicated broad-based macro weakness beyond of course the impact that FX was having, which was pretty significant. I mean we saw the impact in places like Brazil, where you’ve gotten in currency headwind of over 30%. So, you’re certainly seeing that impacted. And obviously those sort of global macroeconomic and currency factors will continue to impact us. We’re obviously benefiting from a strong secular shift to usage of mobile and we feel we’re very well positioned in that. We’re seeing more and more advertisers move to mobile; they realize that it’s no longer question of whether they need to be on mobile, but it’s really how they’re going to be on mobile, and we think we’ve got the best solution for that and we’re investing to make it even better. So, I think from a secular trend point of view, we’re very well-positioned, but obviously we’ll continue to monitor the macro conditions and currency.
Operator: The next question is from Eric Sheridan with UBS. Your line is open.
Eric Sheridan: Thanks for taking the question. Maybe just asking for more color on Instagram, it’s obviously still very early days on Instagram. But what are you seeing in terms of user engagement as you continue to move ad load up on the product? What advertiser adoption of the product is? I know you gave us a little bit of color during the prepared comments. And also pricing on the environment inside the platform, as you continue to rollout deeper with the advertising products? Thank you so much.
Sheryl Sandberg: When we introduce ads into feed and continue to increase the ad load, we monitor really carefully. We’re looking at user engagement on the platform, we also look at the quality of ads. And our basic belief is that if we have high quality ads, those create a good consumer experience and we can look at what consumers are doing, because we can understand how actively engaged they are on the platform. For Instagram, we don’t break out revenue. Instagram, and we’re pleased with the growth on Instagram. And as I mentioned, 98 of our top 100 advertisers in Facebook are now advertising on Instagram. It’s also the case that Facebook had remarkably strong growth as well. So, we’re seeing strong growth across those platforms. I think what’s exciting about those platforms is that they combine the art and the science of both a creative canvas that marketers are excited about and targeting. So to share another example from a holiday, Shutterfly did a Facebook and Instagram, both the brand and direct response holiday campaign on mobile. And what they did was just beautiful pictures but also targeting very specifically to women with specific interest, such as things like weddings and babies, and they saw a 6.4 times return on ad spend. We think that’s what’s possible when you combine the creative canvas we have using the technology and using the platform that we’ve created.
Operator: The next question is from Heather Bellini with Goldman Sachs. Your line is open.
Heather Bellini: I just had two quick questions. One, Sheryl, I just wanted to follow up on what you said about Facebook and Instagram, and the overlap in the advertisers. And I was wondering if you could share with us how you feel those advertisers view it; do they view it as an incremental platform or there has been some question about whether or not some advertisers might take their spending and just move it over to Instagram. I am just wondering if you see incremental spending as a result of opening up both platforms. And then the second question would just be to Mark. Just I was wondering -- I know you mentioned Oculus and the preorders. I was just wondering if you could give us your take on whether or not you’re happy with the initial launch of Oculus preorders. And also we obviously all know the big gaming impact. But I am just wondering from your perspective, as you look out what industries do you think are -- where this could be the most disruptive outside of gaming? Thank you.
Mark Zuckerberg: I will take the Oculus one first. Yes, I am happy. I don’t show much joy, but I am happy. It’s going to be gaming for the beginning. That’s the initial market. There are about -- I think it’s around 250 million people who have Xboxes, Play Station, or Wiis. That’s the initial marketer folks who we think are going to be most interested from the early VR experiences, especially at some of the higher price points. But overall, I mean the reason why we’re interested in this as the social company is that we think that this is going to be a new way that people interact. And if you tried out the Toybox demo with the hands, Oculus Touch, what you see is when you’re in virtual reality with another person and you can interact with the environment and use your hands, you can -- it’s not just about where you are and the fact that you can instantaneously teleport to another place, it’s just you can interact with people in all these different ways that would be very difficult in the rest of the world. So, we’re very excited about that. That’s going to be a big area of investment for us. And it is ultimately I think going to change the way that we communicate and live and work in addition to how we play games. But I think we’re off to a good start.
Sheryl Sandberg: On the Instagram question, certainly in the short-run, some of the spend is incremental and some of it isn’t. Some of our clients approached us where they have a social budget or Facebook budget and some of that moves to Instagram and some people, it’s incremental spend. In the medium to long-run however, we believe that we’re really well-positioned to take share from other platforms out there. We believe both Facebook and Instagram have this combination of an ability to do great creative with the best targeting in a most sophisticated measurement which shows businesses how we help them move products off shelves. And we want and we tell our clients we want to be the best dollar, the best euro, the best pound and the best minute you spend. And we really encourage them to measure their ROI and compare us to other platforms. We think that comparison bodes very well for our growth. We also think that continued consumer shift to mobile devices bodes well for our growth as well. That said, we have to continue to execute. We know this won’t be easy. We have to continue to build the right products. We have to continue to measure all the way through from seeing an ad impression to sell. And so it’s up to us to stay focused in the coming year and years.
Operator: The next question is from Ben Schachter with Macquarie. Your line is open.
Ben Schachter: You’ve had a lot of success with standalone apps, so should we expect to see you launching more such apps and could a standalone video app would be a part of that particularly for people who just want to watch a video? And then secondly on the virtual reality, another question. Can you just discuss the supply constraints in terms of how many units you can ship per month? And should we expect those shipments to accelerate into the holiday? And then also related to that, how are you going to work with retailers to show consumers the power of Oculus in store and in person? Thanks.
Mark Zuckerberg: So, on the apps question, the ones that have done the best are things that augment core Facebook functionality for large subsets of the community. So, for example, we have this Pages Manager App. There are 50 million businesses that have pages on Facebook. And while that is not a huge number compared to the size of the overall community of people, it’s a very large number of people and businesses. And giving a focused experience for the person who wants to run their business through Facebook and be communicating with their customers all day long, that’s just proven to be an incredibly engaging experience that drives content into the system and is good overall. We have introduced a number of things like that for public figures, for groups, messengers, probably been the most successful; it’s something that’s connected to the Facebook experience that now has more than 800 million people using it. So, I do think that there’re additional opportunities for this and we’ll continue looking at them.
Dave Wehner: Ben just following up on VR and supply constraints, so we have two products. You’ve got Gear VR and Samsung is really handling all of that from a hardware perspective, and obviously they’re well prepared on that front. With Rift, it’s really -- it’s early in the evolution of VR; it’s early to be talking about large volumes. So, at this point I don’t think we’re giving a lot of color around supply chain and that sort of thing. It’s not going to be material to our financials this year.
Operator: The next question is from Brian Nowak with Morgan Stanley. Your line is open.
Brian Nowak: I have two, the first one is to go back to some of the core Facebook advertising success. I wonder if you could talk about some of the Facebook video, ad, learning and kind of positive you have encountered and hurdles that you still encounter that could be holding back advertisers from moving further, video budgets out of the platform. And then the second one, we always see this gap between Asia and rest of world monetization versus North America and Europe. I was wondering if you just kind talk through some strategies and qualitative drivers you see over the next couple of years that are going increase the overall Asia and rest of world monetization even further?
Sheryl Sandberg: I think our approach to increasing monetization around the world is really the same. We need to build really compelling ad products with great formats that let marketers be creative and be convincing. I’ll share an example of something we did for an emerging market. I’ve mentioned briefly in my remarks, Slideshow, the Slideshow product is -- enables a video like experience which phone with lower connection speeds and feature phone by series of photos. So, Coca-Cola used that in Kenya and Nigeria. They took screenshots of a video ad they have produced for other markets, they uploaded them with text; and they reached 2 million people with a 10-point lift in ad awareness. So, the way we need to drive sales around the world is by understanding markets, launching things like click to missed call ads in India and making sure our products work for market but also being able to connect to those advertising metrics and business metrics around the world. Video ads are important on our platform and the most important thing that’s growing well there is consumer engagement with video is growing. We have 500 million people watching video a day. And the fact that so much video is being consumed on our platform gives us room for an ads business to grow because we want the formats to match. Marketers also really love video and it’s a really compelling way to reach people and video is contributing to our growth. It’s important to note that it’s not just large brand advertisers that are doing video but all of our market segments. Direct response, SMBs who have uploaded 1.5 million videos and have both organic and paid in the last month, and developers. The video ad spend is not all incremental of course because every time we put an ad in newsfeed, if it’s a video ad, it’s taking a place of an ad with another format. In terms of learnings, one of the most important learnings we have is that video formats are different on Facebook. There’re certainly people that are watching the whole 30-second video ad with sound, but there are some people that are doing at less, they’re watching shorter formats and they’re watching with sound. And one of the challenges we have in the market is convincing marketers and agencies and people that make the video to expand them with different formats. The good news is that we’re getting great results like the Halo 5 example I shared in my remarks that when people are willing to experiment, this is a pretty unique canvas. You can do short form with sound off, you can be longer firm with sound on and everything in between. And our ability to persuade marketers to experiment is going to be a major driver of how much we can do here.
Operator: The next question is from Justin Post with Bank of America Merrill Lynch. Your line is open.
Justin Post: I’ll ask couple of longer term questions. First, I know a year ago you gave us usage update and time spent, wondering if video or any other products are having a big impact on usage and if you can give us any metrics there. And then maybe one for Sheryl, we have you have at 8% of all media time spent. I’m just wondering if you think Facebook could monetize better than other forms of media based on time spent or maybe a little bit below. And then maybe one for Dave, 60% margins last quarter, obviously very strong. And just wondering what you think about the long-term, any comments on long-term margins?
Sheryl Sandberg: In terms of monetizing time spent, it’s certainly the case that consumers have shifted to mobile and businesses need to catch up. The exact [ph] percentage we can monetize that we’ll see, but we certainly think that we will continue to benefit from the consumer shift to mobile, because businesses are behind. If you ask even our largest clients, our largest clients, if they drew a pie chart of where their consumer spend their time and money and whether they spend their time, we’re still under-indexed. That said I’ll say it again, we’ve a lot of hard work to do. We really need to prove to clients particularly as they scale and we become a bigger part of their spent that we’re driving results. Other platforms, other forms of advertising like TV and other have very established metrics that people have believed for a very long time. We think our targeting can be better than any other platform. We also believe our ability to measure results can be deeper, but it’s up to us to prove and to prove that client-to-client. It’s also worth noting that we work really well with TV. It’s not always the choice of TV or Facebook, but often we can be a complement. We’ve done a bunch of work with Nielsen to measure what happens when marketers do big TV campaigns and do campaigns that are broadly, broadly targeted on Facebook. And we are able to increase the reach and increase brand favorability. So for the most part when people are doing big campaigns, they’re doing them across multiple platforms and we think that will continue.
Dave Wehner: Justin on time spent, there is no question that video is helping us on time spent and engagement. We’re not -- you won’t have any specific stats other than the hours per day -- or sorry time spent per day that Mark mentioned on video. So no updates on stats there other than that. In terms of our long-term margins, we’re not managing the business to a specific margin target in any year. We still think we’re early in investing in the business. And we’re really investing in new areas today where we see a long-term opportunity for revenue growth. That being said, we do think there is a lot of margin potential in this business, given the focus on advertising, but no target at this point.
Operator: The next question is from Anthony DiClemente with Nomura. Your line is open.
Anthony DiClemente: Thanks for the questions and good afternoon. It’s for Mark or Sheryl, I’m wondering what is your strategy for professional video content going forward. You talked a lot about video with bringing professional media content to Facebook, accelerate video engagement adoption. And then for Dave just kind of back to the quarter, you don’t break out Instagram revenue or financials. But wondering if the acceleration in the quarter, would you say -- was that driven more so by the step up in Instagram given the opening up of the API, the incremental Instagram ad load or was there a commensurate acceleration in the core of Facebook revenue? Thanks.
Sheryl Sandberg: In terms of video content, newsfeed is as interesting as the quality of the content in it. What we’re seeing is that users are generating a lot of really high quality content, often pretty short form that people are really happy to consume. And we believe that trend will continue because we’re at the very beginning with people really understanding the power of the smartphones and lot of people are walking around with particularly in developed market. We are working with publishers to try to make the content experience better inside of newsfeed. The best example of that is probably news with Instant Articles where we figured out that, it was the slowest upload experience you could have in newsfeed to link off to an outside article. So, we worked with publishers to upload more news articles natively to Facebook and we’re seeing great engagement from that. Similarly, we’ve had conversations with makers of Premium Content, I think they’re excited by the work they already do with us to use Facebook to distribute their content and we’re interested and doing more. It’s probably worth noting that much of the engagement and consumption we have is short form, not long form.
Dave Wehner: Yes, Anthony, it’s Dave. Instagram, we’re certainly very pleased with the performance of Instagram and it certainly made a contribution this quarter. But make no mistake, Facebook, core Facebook is really driving the top-line. And we’re very pleased with the strong performance that we had with Facebook itself in the quarter.
Operator: The next question is from Carlos Karjner with Bernstein. Your line is open.
Carlos Karjner: I have two quick questions. I’m interested in the plans to allow users to do other things beyond liking content. I think you call it Reactions; I call it adding more words to the Facebook graph. Can you talk about the rollout of this capability and whether this is something that you only see at Facebook.com or whether it’s going to be widespread across the web and other sites, much like the like button? And secondly, can you talk about thinking of the role of the different Facebook platforms in payments? I think that you will not do, because you don’t have or do not want to acquire [indiscernible] assets and what’s the boundary for what you could do vis-à-vis payments? Thank you.
Mark Zuckerberg: Sure. So Reactions is going to rollout on every platform. We’re testing it in a handful of countries to start just to make sure that we have the UI and interaction simple enough that people could express more of what they wanted without getting in their way, it is adding a little bit of complexity to something that is very simple, say just a one tap like button. But the philosophy behind it is that when you only have a like button, if you share a sad piece of content or something that makes you angry, people may not have the tool to react to it. And therefore over time the community feels less comfortable sharing that kind of content on Facebook. And we want people to be able to share all of the things that are meaningful to them not just the things that are happy and that people are going to like when they see it. And we think that that’s just really important to the mission of the company and we’ll increasing engagement and sharing and openness, and all of the things that we care about. And so far I think there are a few tweaks that we needed to make to reaction since initially testing it. But its’ going well and I think we plan to roll it out every where pretty soon, so that’s the game plan there. On payments, the basic strategy that we have is to make it especially in products like Messenger that where the business interaction maybe a bit more transactional, to take all the friction out of making the transactions that you need. So, we don’t view ourselves as a payments business, that’s not the type of company that we are. We’ll partner with everyone who does payment. We look at the stuff that Apple is doing with Apple Pay for example as a really neat innovation in the space that takes a lot of friction out of transactions as well. And our view is that the less friction, the better the user experience, the more people can easily interact with businesses that they care about. And ultimately for our business that will drive up the amount that businesses are willing to pay to advertise to send people into those interactions because they perform well. So it’s good for everyone but that’s how we think about that.
Operator: The next question is from Michael Nathanson with Moffett Nathanson. Your line is open.
Michael Nathanson: Following on Mark’s answer to the question about payments, I wonder Sheryl if you look at the fourth quarter, as you said as defining moment for marketers and with the friction of transactions again easier. Was there any type of shift in the marketers or verticals that move money to Facebook in the quarter? Do you see more retail let’s say or anything different in terms of the competition of who is buying in fourth quarter?
Sheryl Sandberg: Fourth quarter is a holiday quarter, so our top verticals were ecommerce, CPG and retail. Our growth is really broad-based, and I think it really shows how important the targeting can be. What we’ve definitely done over the last year and plan to invest even more in over the next year is worked hard on vertical specific targeting. So for example for the telecom industry being able to target existing consumers with new consumers with people who are -- their voice plan or data plan’s about to expire. With the auto industry, really important industry for growth for us, helping them figure out who their current customers are, who their potential customers are and where are the audience segments out there who have similar likes, interests, backgrounds, demographics to their current customers so that they can serve right ad to the right people. The kind of things we’re able to do with targeting and measurement apply across industries and obviously have to be industry and vertical specific and we’re working hard at that.
Operator: The next question is from Mark Mahaney with RBC Capital Markets. Your line is open.
Mark Mahaney: Two questions, Sheryl, could you just talk about political advertising and how you think about the attractiveness of -- and any anecdotes you have on Facebook as a platform for political campaign? And then Mark, the story is in 2012 with beginning of that year you realized just how powerful the movement was towards mobile devices and you turned to your engineers and said we need to generate $1 billion in revenue off of mobile devices. And I wonder if you’ve had that same had conversation with your engineers when you think about these two messaging platforms that you have that got a large number of users and clearly globally we’ve seen this massive shift of the words messaging, the interest is changed now, people have engaged with it. Do you feel like you’ve had or do you need to have that $1 billion conversation with your engineers about those two messaging platforms? Thanks.
Sheryl Sandberg: In terms of the election, it’s important to note that we’re large and diversified, so no one vertical drives our business. Yes, the 2016 election is a big deal in terms of ad spend but so is the World Cup, so Super Bowl every year, so are events like the Olympics. We are excited about the targeting we’re able to offer for our ad platform. We believe we have position that doesn’t exist on any other platforms. So for example, using Facebook and Instagram ads you can target by congressional district, you can target by interest, you can target by demographics or any combination of those. And we’re seeing politicians at all level really take advantage of that targeting. It’s also probably worth saying that we’re pretty excited about what’s happening with the elections organically on Facebook. Facebook is really the new town hall. And connecting the people who are running for office, both at the national and the local level with people directly has been really important. Every member of Congress in the United States is now on Facebook. We’re seeing some of them post every vote and explain why they’re doing votes. We’re seeing a bunch of that candidates for president get on Facebook themselves and interact taking questions from their potential voters directly. And we think that kind of direct engagement where people can hold their elected officials accountable and elected officials can speak directly to constituents is a really important part of our mission and we’re excited about the 2016 election and what’s happening there.
Mark Zuckerberg: Well, I’ll answer the other one. In terms of the story that you said, I think you have it wrong. I don’t know where you got that story from, I’ve never had a conversation with the team where we were behind on mobile and then I said we need to do this to make money. That’s not really how we operate. What happened is we realized that mobile was growing faster than desktop and that people were shifting their usage and that it was the more important thing for people’s consumer experience. And that’s when we made the shift, not in our business first but in how we develop products. And I told all of our product team and when they come in reviews really just coming with mobile. If you come in and you try to show me a desktop product, then I am going to kick you out; you have to come in and show me a mobile product. And that I think was just as a crude leadership tactic, somewhat effective and helping to motivate the organization to shift its energy towards focusing on mobile. But if you remember, we actually went through a pretty tough period because we went through this period where our mobile experience was not as good as we wanted it to be and we had no ads on mobile. And we actually prioritized making the mobile experience good before putting ad there. So there was a long time where people thought that our business might not be as good because we had no ads on mobile, and that was because we always prioritized the experience for people above, even if it’s going to be a painful thing for the company. So that’s how I think about messaging. We know that messaging is going to be increasingly important, that’s why we went out and hired David Marcus who is one of the best product leaders in the field to Messenger and why we bought WhatsApp, which the leading messaging product worldwide. And we have a formula for how we build these businesses. First, you build a great consumer experience that helps people share in a new way that’s really important. Then after that you can start to introduce organic ways that people can interact with businesses, so that in Facebook is pages, the businesses that people want to interact with, the public figures, the politicians, not necessary ads but organic interactions around not necessarily just your friends and families but more public figures and businesses. And then only once you have that ramped up to a good scale, can you really start dialing up advertising having that feel good and be a good part of your experience with good content because all those public figures and businesses are already participating in the platform at scale. So, you could expect to see that playbook in Instagram, we’re pretty far along in terms of having quite a mature pubic content. Ecosystem and ads are ramping well with good high quality ads because a lot of public figures and businesses are already investing in creating that kind of good content that goes in Instagram. And you’re going to see the same playbook in Messenger and WhatsApp. In terms of making it so there are organic businesses and public figures, there is a bit more of that on WhatsApp already in terms of businesses using it and our Messenger, we are catching on Messenger; we’ll do that on both. And once we have those ecosystems built out, we will build businesses around them. And that’s how we think about stuff and we’ll do that in all of our products and the different things that we do going forward.
Deborah Crawford: Operator, it looks like we have time for one last question.
Operator: Certainly, the final question is from Paul Vogel with Barclays. Your line is open.
Paul Vogel: Great, thanks. Just two questions, one on the Facebook Sports Stadium, I’m just wondering how you think about that in terms of how is going to be different from other offerings, what’s the big differentiating factor and how do you get folks to participate in that? And the second, so just on the margin side again. Do your revenue and cost line out geographically, so there is obviously a translation impact to the numbers, but is there any operating mismatch between revenue and cost that would either benefit or margins?
Sheryl K. Sandberg: On the Sports Stadium, this is an early test, but we’re pretty excited about it. We are the largest community of sports fans in the world; we have 650 million sports fans on our platform. And people are already using Facebook to share during real-time events. It’s an increasingly important use case for us. So this gives people to share, a place to share that one event and participate in it. I think what you will see from us is always a focus on driving users and driving engagement. This is one way to do it. We’ll see how it works; we’re pretty open to experimentation. So, we feel pretty confident that real-time sharing is an increasingly important part of the platform and one we’ll continue to invest in.
Dave Wehner: And Paul, it’s Dave. I think that question is really around sort of FX and how it relates on the revenue side versus the cost side. And on that front, we’re -- substantial majority of our expenses are U.S. dollar base. So certainly we see an impact to margins with FX headwind. So that’s just the reality of having most of our development resources for instance in the U.S. So beyond that, we don’t do geographic cost breakouts and allocations; it’s not how we run the business. But certainly from an FX point of view, FX headwinds have a dampening effect on margins.
Deborah Crawford: Alright. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again.
Operator: Ladies and gentlemen, this concludes today’s conference call. Thank you for joining us. You may now disconnect your lines. | [
{
"speaker": "Executives",
"text": "Deborah Crawford - Vice President, IR Mark Zuckerberg - CEO Sheryl Sandberg - COO Dave Wehner - CFO"
},
{
"speaker": "Analysts",
"text": "Douglas Anmuth - JP Morgan John Blackledge - Cowen & Company Eric Sheridan - UBS Heather Bellini - Goldman Sachs Ben Schachter - Macquarie Brian Nowak - Morgan Stanley Justin Post - Bank of America Merrill Lynch Anthony DiClemente - Nomura Carlos Karjner - Bernstein Michael Nathanson - Moffett Nathanson Mark Mahaney - RBC Capital Markets Paul Vogel - Barclays"
},
{
"speaker": "Operator",
"text": "Good afternoon. My name is Chris and I’ll be your conference operator today. At this time, I’d like to welcome everyone to the Facebook Fourth Quarter and Full-Year 2015 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook’s Vice President of Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford",
"text": "Thank you. Good afternoon and welcome to Facebook’s fourth quarter and full-year 2015 earnings conference call. Joining me today to discuss our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today’s press release, our annual report on Form 10-K and our most recent quarterly report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present, both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today’s earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I would like to turn the call over to Mark."
},
{
"speaker": "Mark Zuckerberg",
"text": "Thanks, Deborah, and thanks everyone for joining us today. Overall Q4 was a strong quarter and a great end to the year. More than 1.59 billion people now use Facebook each month and 1.04 billion every day, a growth of nearly 200 million people monthly and a 148 million people daily this year. More than 1.44 billion people use Facebook on mobile devices. And when it comes to our business, we’re also pleased with our continued growth. Total revenue grew by 52% year-over-year to more than $5.8 billion and advertising revenue grew by 57% to reach more than $5.6 billion. But it’s important to consider not just our business results but also how we’re improving the lives of people and communities around the world. Next week Facebook celebrates its 12th birthday. And as I think about our progress and where we go from here, I’ve reflected on the diverse global moments that Facebook was involved in, in 2015. More than 950 million people received a notification that a friend or a loved one was safe in a crisis. Millions of people supported the people of Nepal after the earthquake and the people of France after the Paris attacks. More than 8 million people used 35,000 groups and pages on Facebook to support refugees. And people from all over the world connected around moments from Star Wars to the U.S. presidential election, from the Indian Super League to the Cricket World Cup. Seeing our global community connecting in all these ways shows the opportunities ahead as we connect the world but also the challenges. Even as the world has tended towards greater openness over time, in many communities we also see greater fear over what a connected world and more technological progress means for them. Addressing these concerns is essential for making progress on our mission. And we’re going to keep working to give as much voice as we can and advance the benefits of connectivity and bringing the world together. In 2016 and beyond, we’re going to continue doing that by serving our community, working to bring connectivity to billions of people who’re not yet connected, and building new technologies that give people more ways to express themselves. Now, let’s talk about how we’ve continued working to do that and let’s start with how we’re improving our existing products and businesses. Our strategy here is to deliver better more engaging experiences for our community and to give people better tools for sharing different types of content with the different groups of people that they care about. Video is an important part of the Facebook experience, and continuing to invest here is important for allowing people to share and consume some of the most engaging content. We’ve continued to make progress and now 100 million hours of video are watched daily on Facebook. We’ve been testing new experiences like suggested videos which enables people to discover more videos they might be interested in. We’re also exploring ways to give people a dedicated place on Facebook for when they just want to watch videos. With other parts of our core, we’ve continued to focus on improving the performance and quality of our products to better serve different communities on Facebook. And these efforts are paying off with growth in engagement for different products reaching an impressive scale. Now, more than 500 million people use events each month and more than a 123 million events were created on Facebook in 2015. For the first time, more than 1 billion people used groups in a single month on Facebook. It’s inspiring to see all the different communities using groups, from the small family and classroom and church groups to the large ones like the running challenge group that I started a few weeks ago that now has about a 100,000 members. To serve our entire global community, we’re optimizing our services for people in developing countries. We’ve improved Facebook Lite to offer better experience in low-bandwidth environments, improving load times and adding features like video. More than 80 million people now use Facebook Lite as of December. And when it comes to serving businesses, we’ve continued to focus on creating better ads and tools for our more than 2.5 million active advertisers. More than 50 million small businesses now use pages on Facebook and people post more than 2.5 billion comments on these pages each month. This is a good example of how the strength and engagement of our community is making Facebook more valuable for businesses every day. And Sheryl is going to talk more about this in a minute. Next, let’s talk about how we’re building our next generation of services. With Instagram, we’ve continued to drive the shift towards more visual content online. The community continues to grow. And back in September, we announced a new milestone of 400 million monthly actives. Over the last year, as the community has grown, we have focused on building engaging new experiences for the community including by improving search and by introducing Trending Content. We’ve also worked to develop new experiences to give people more options for creating and sharing different types of content. In March, we launched the layout app allowing people to easily combine images and in October the team also launched Boomerang, and app for making looping videos which reached number one in the App Store in more than 70 countries. We also introduced a new video channel on Instagram for people to watch moments from big events like New Year, so the college football championship as they have it. With Messenger and WhatsApp, we’ve continued to make progress with building these into valuable communication services for everyone in the world. More than 800 million people now use Messenger monthly and in 2015 we grew that number by almost a quarter of 1 billion while also increasing engagement. We continue to give people new ways to communicate by introducing video calling and new options for customizing conversations with fun things like colors and emojis and by using apps like -- using apps, the Messenger platform. We also worked to extend Messenger’s utility by adding payments, a new way to connect with businesses and by testing M, a digital assistant powered by AI. In this quarter we also began testing a transportation platform, allowing people to request an Uber ride through Messenger. More services will be coming to the platform soon, including airlines. WhatsApp ended the year with nearly 1 billion monthly actives. As WhatsApp has grown, we work to keep it fast, simple and reliable. And we’ve seen many communities come to depend on this as their main communication service. To serve these communities well, this month we announced that WhatsApp will now be free to everyone and will no longer charge the subscription fees that many people were charged after their first year. We think this is an important step towards creating and even more ubiquitous product without affecting our plans for building WhatsApp into important business in the coming years. Later this year, we’ll be testing new ways for people to use WhatsApp to communicate with businesses and organizations that they want to hear from. Finally, let’s talk about our work on new breakthrough technologies that can help connect more people to the internet and create transformative new experiences. In 2015, we made significant progress on our efforts to connect more people to the internet. We launched the first trials of Express WiFi, a product designed to help entrepreneurs bring their communities online. We launched Free Basics in 33 more countries, and we’ve now connected 19 million people. This year, we expect to hold our first test flight of Aquila, our first solar-powered aircraft designed to beam internet into communities from the sky. And we’re also working on new advances in lasers that can transfer large amounts of data faster and more efficiently than anything today. With our work in AI, we continue to make progress towards the new generation of computers that can see and understand. Over the last year, we published dozens of research papers including some of the leading work on image recognition and language understanding. To drive the entire AI community forward, we’ve also open-sourced software and a lot of new AI hardware platform. Achieving the scientific breakthroughs to build AI that makes a dramatic visible difference in people’s lives is going to take a long time. But already we’re seeing opportunities to serve our community. We recently built a prototype AI system that combines language and vision comprehension. You can show it an image that it’s never seen before and it can answer questions about that image. And we’ve even used AI to help blind people experience their friends’ photos and news feed by describing the scenes. With virtual reality, we’ve reached an important milestone. The Samsung Gear VR shipped over the holidays with our Oculus software and we’re pleased with the initial reaction. This month, we also opened pre-orders for Oculus headsets. This will be the world’s best VR experience and we’re excited to begin shipping to people in more than 20 countries before the end of March. More than 100 VR games and experiences are coming to Oculus this year. And later this year, we’ll also be shipping our Oculus Touch controllers to get your hands into virtual reality. These controllers will enhance the VR experience and allow people to communicate more naturally in VR through intuitive hand movements and gestures. This Oculus launch is shaping up to be a big moment for the gaming community. But over the long-term, VR has the potential to change the way that we live, work and communicate as well. The launch is an important step towards the future, and we’re really looking forward to seeing how people use it. So that’s how we’ve continued to make progress on our strategy. It’s been a strong quarter and we ended 2015 with a great foundation for our efforts going into 2016. Our strategy is working and we have many more opportunities ahead. So, we’re going to continue investing to deliver more great results over the long-term. On a more personal note, over the last few months with the new addition in my family, I’ve been reflecting a lot on the legacy that we want to pass on to the next generation. I’m excited about our progress and the chance to build something great for the future. If we continue to focus on solving the fundamental challenges facing the world and bringing the world closer together, we can leave a better world for the whole next generation. And that’s what I think about every day as we continue building Facebook. And I want to thank everyone in our community, our employees, our shareholders and our partners who are helping us on this journey. Thanks. And here’s Sheryl."
},
{
"speaker": "Sheryl Sandberg",
"text": "Thanks, Mark, and hi everyone. We had a terrific fourth quarter capping off a great 2015. Q4 ad revenue grew 57% or 66% on a constant currency basis. Mobile ad revenue reached $4.5 billion, up 81% year-over-year and is now 80% of total ad revenue. Facebook and Instagram drive business results for our partners, helping their products off shelves online and off. As a result, we’re growing spend from our current clients and attracting new marketers to our platform. We saw strong growth across all verticals, marketer segments and regions. We’re also pleased with the growth we’re seeing in emerging markets and countries like China where businesses are advertising on Facebook and Instagram to reach people internationally. We continue to make progress on our three priorities, capitalizing on the shift to mobile; growing the number of marketers using our ad products; and making our ads more relevant and effective. First, capitalizing on the shift to mobile. Heading into 2016, it is clear that consumers have shifted to mobile and businesses know they need to catch up. Marketers now realize that if they want to reach their customers where they are, mobile is essential. Our conversations with clients have shifted from if they should market and mobile to how. With over 1.44 billion people using Facebook on mobile monthly and over 400 million monthly actives on Instagram, Facebook and Instagram have become the two most important mobile advertising platforms. We provide creative canvas powered by technology, a unique combination of art and science that marketers can use to deliver great creative with the highest quality targeting at unparalleled scale. The 2015 holiday season was a defining moment for mobile marketing and demonstrated the power of our mobile platform. According to comScore, total U.S. consumer spending on mobile in November and December was up 59% year-over-year. This holiday season, marketers turned to mobile more than ever before. To reach a large global audience for the launch of Halo 5, Microsoft Xbox used optimized for Facebook and Instagram. Working with our agencies and power media team from Dentsu Aegs Network, Eisenberg Group and twofifteenmccann, they understood that people watch video differently in mobile newsfeed than on TV. So they created videos to capture audience attention in the first three seconds even without sound. They drove over 380 million impressions and 49 million video views in key markets and increased purchases by 10 points in the U.S. Our second priority is growing a number marketers using our ad products. Last quarter we announced that we had over 2.5 million active advertisers and since then our growth has remained strong. This represents small fraction of the over 50 million small businesses now actively using pages. So we see a big opportunity to continue to grow the number of Facebook advertisers going forward. We’re also very pleased with the growth in advertiser adoption of Instagram and the positive results advertisers are seeing from their investments. 98 of the top 100 advertisers on Facebook also advertised on Instagram in Q4. Our third priority is improving the relevance and effectiveness of our ads. We shipped a lot of new ad products this past year. These products help deliver personalized marketing at scale and drive business for our clients. Leading up to Black Friday Shop Direct, the UK’s second largest online retailer teased upcoming sales with a cinemagraph video to build awareness. They then retargeted people who saw the video with one day only deals. On Black Friday, they used our carousel and DPA ads to promote products people had shown interest in. They saw 20 times return on ad spend from this campaign, helping them achieve their biggest Black Friday and their most successful sales day ever. To share just a few other product examples, in emerging markets we launched Slideshow a video like ad experience that works with lower connection speeds and feature phones. We introduced local awareness ads globally to help brick and mortar businesses reach people near their stores and started testing Canvas ads to help marketers showcase their products in a more immersive way. We continue to invest in ad tech and are especially pleased with the growth of our audience network. Measurement also remains a critical area of focus. Our measurement tools like Conversion Lift and the Facebook pixel prove to marketers that we’re driving business results and help make our ads more relevant. This year we saw more advertisers shift from proxy metrics like clicks to business results like digital and in store sales. Our results show that the investments we’ve made over the past few years are paying off and we see a lot of exciting opportunities ahead. We know we still have a lot of hard work to do and heading into the New Year, we will remain very focused on our top three priorities. I want to take this opportunity to thank our clients around the world for their partnership. Your investment and feedback is critical to making our products better. I also really want to thank the global Facebook teams for your extraordinary dedication to our partner success. Your hard work and execution is critical to helping us fulfill our mission. Thanks everyone and now here is Dave."
},
{
"speaker": "Dave Wehner",
"text": "Thanks Sheryl and good afternoon everyone. Q4 was a strong quarter and wrapped up a phenomenal year for Facebook. Full year 2015 revenue was $17.9 billion, up 44% year-over-year or 53% on a constant currency basis. In 2015, we generated over $6 billion in free cash flow including $2.1 billion in Q4 while continuing to fund important investments for the future growth of the business. The strong growth and engagement of our community with consistent theme throughout 2015, and that continued in the fourth quarter. In December, 1.04 billion people used Facebook on an average day, an increase of 17% compared to last year. This daily number represented 65% of the 1.59 billion people who visited Facebook during the month of December. Mobile continued to drive the growth of our community. In December, 1.44 billion people accessed Facebook on mobile devices, an increase of 21% compared to last year and 90% of the people who have used Facebook on both a monthly and daily basis accessed us via mobile devices. Now turning to the financials. All of our comparisons are on a year-over-year basis unless otherwise noted. Additionally, our non-GAAP measures exclude stock-based compensation and the amortization of intangibles. In Q4, total revenue was $5.8 billion, up 52% or 60% on a constant currency basis. Q4 ad revenue was $5.6 billion, up over $2 billion from last year, year-over-year growth was 57% or 66% on a constant currency basis. The strengthening of the U.S. dollar continued to have an unfavorable impact on our revenue in the fourth quarter. Had exchange rates remained constant with Q4 2014 levels, our total revenue would have been approximately $320 million higher. U.S. and Canada and Asia Pacific continued to be our two strongest regions with ad revenue growth of 64% and 57% respectively. Our rest of world and Europe regions grew at 53% and 45% respectively, as they were more heavily impacted by currency headwinds. Mobile ad revenue was $4.5 billion, up 81% from last year and represented 80% of our advertising revenue. For perspective, three years ago the mobile percentage was just over 20%. Q4 tapped off a remarkably successful year for our mobile advertising business where we were able to combine strong growth in ad inventory supply with strong growth in advertiser demand. On the supply side, we grew the number of people using Facebook on mobile, time spent, and ad load. Our ongoing focus on ad quality and relevance enabled us to deliver a better overall mobile ads experience for our users while increasing the number of ads they see. In Q4, we also benefitted to a lesser extent from increases in ad inventory from Instagram and the Audience Network. On the demand side, we believe our efforts on targeting and measurement solution enabled marketers to achieve better business results at better values. This helped us drive strong growth from a broad array of advertisers including direct response in brand advertisers, large companies and SMBs and both existing and new advertisers. Turning now to the overall price volume metrics, in Q4 the average price per ad increased 21% while total ad impressions increased 29% on a year-over-year basis. It’s worth noting that this was the first quarter since Q3 2013 that total ad impressions increased on a year-over-year basis. This was driven by an increase in mobile ad impressions and was partially offset by a decline in ad impressions that were heard on personal computers, consistent with the ongoing declines in PC usage. The reported increase in price is being driven by the continued mix shift towards mobile which contains higher price newsfeed ads rather than the mix we have on PCs of both newsfeed ads and lower price right-hand column ads. Total payments and other fees revenue was $204 million, down 21% compared to last year. The decline was driven by reduction in payments revenue related to games played on personal computers. Turning now to expenses, Q4 total GAAP expenses were $3.3 billion, up 21%, and non-GAAP expenses were $2.3 billion, up 42%. Our year-over-year GAAP expense growth rate slowed this quarter as we lap the introduction of stock-based compensation charges associated with the WhatsApp transaction. Non-GAAP expenses were driven by increases in head count related costs, cost of revenue and marketing expenses. We ended the year with nearly 12,700 employees, up 38% compared to last year. Our GAAP operating income was approximately $2.6 billion, representing a 44% operating margin. Our non-GAAP operating income was $3.5 billion, representing a 60% operating margin. Our Q4 GAAP and non-GAAP tax rates were 39% and 36% respectively. Our Q4 GAAP net income was approximately $1.6 billion or $0.54 per share, and our non-GAAP net income was $2.3 billion or $0.79 per share. In the full year 2015, capital expenditures were $2.5 billion as we continued to invest in servers, data centers, network infrastructure, and office facilities to support the rapid growth of the business. We ended the year with over $18.4 billion in cash and investments. Turning now to the outlook, first some color on revenue. We expect the factors that drove the strong growth of our advertising business in 2015 will continue into 2016. However, we expect to continue to face foreign exchange headwinds especially early in the year as we will be lapping periods where the dollar was relatively weaker than it is today. More importantly -- sorry, more broadly, the overall macro-environment introduces the level of uncertainty around global growth and exchange rates that could impact our business in 2016. And we do expect to face tougher comparables as the year progresses, given the remarkably strong advertising performance in 2015. Turning now to expense guidance, 2016 will be another significant investment year for Facebook. In 2015, we continued investing heavily in the core. At the same time, we doubled our investment levels in our next generation services which includes WhatsApp, Instagram and Messenger and we tripled our investment levels in our long-term areas of focus which includes our connectivity efforts, Oculus and our AI investments. We will continue investing significantly in all of these areas in 2016. We expect the year-over-year growth rate for full year 2016 total GAAP expenses to be approximately 30% to 40%, and for full year 2016 total non-GAAP expenses to be approximately 45% to 55%. Note these ranges represent total operating expenses -- including cost of revenue. These ranges also include the cost of revenue impact of the expected shipments of Oculus Rift, so we expect that impact to be immaterial to our overall total expenses for the year. We anticipate our 2016 capital expenditures will be in the range of $4 billion to $4.5 billion. We recently announced that we will be -- begin building a new data center in Clonee, Ireland and that project is on top of the new data center being built in Fort Worth Texas. We expect our 2016 stock-based compensation to be in the range of $3.1 billion to $3.3 billion, approximately half of which is related to our prior acquisitions, most notably WhatsApp. We expect 2016 amortization expenses to be approximately $700 million to $800 million. And lastly, we anticipate that our Q1 and full year 2016 GAAP and non-GAAP tax rates to be in the low 30s on a percentage basis, down from our 2015 range. We expect our tax rates will decline further over time and resemble those for our global peers over the next several years. In addition in 2016, we expect for the first time to pay a significant amount of U.S. income tax on a cash basis. To conclude, 2015 was an outstanding year for Facebook. Our performance reflects the strong growth and engagement of our community, the momentum we’re seeing in our ads business, and significant progress we’re making on our mission to connect the world. With that Chris, we would like to open up the call for questions."
},
{
"speaker": "Operator",
"text": "Thank you. And we will now open the line for question-and-answer session. [Operator Instructions] Your first question comes from the line of Douglas Anmuth with JP Morgan. Your line is open."
},
{
"speaker": "Douglas Anmuth",
"text": "Thanks for taking my question. Two things I wanted to ask. First Mark, just on Messenger and WhatsApp, can you just talk more about the takeaway on the Messenger platform now that it’s been open for nearly a year to developers and how that’s informed your view on what you’re going to do with WhatsApp going forward? And then secondly Dave perhaps or Sheryl on the ad load, few years ago you talked about ad load at mid-single-digit levels and then more recently is up significantly since then. Do you still feel like there is still significant room to increase ad load here and how do you think about the theoretical ceiling there? Thanks."
},
{
"speaker": "Dave Wehner",
"text": "I can start with the ad load question, Doug. So, ad load is definitely up significantly from where we were a couple of years ago. And as I mentioned, it’s one of the factors driving an increasing inventory. Really one thing to kind of think about here is that improving the quality and the relevance of the ads has enabled us to show more of them and without harming the experience, and our focus really remains on the experience. So, we’ll continue to monitor engagement and sentiment very carefully. I mentioned that we expect the factors that drove the performance in 2015 to continue to drive the performance in 2016. So, I think that’s the color I can give on ad loads."
},
{
"speaker": "Mark Zuckerberg",
"text": "On Messenger, the platform efforts in 2015 focused on two things. One was expanding the different types of content that people could share in Messenger. And that diversity is going really well. And we see continued increase in video sharing and photos and stickers, and a lot of stuff that you would just call fun but that people really enjoy as different ways to express themselves. But in terms of the business, the more important piece is how people can interact with businesses through Messenger. And we started some early small tests around f8 last year where with some ecommerce services made it so that people who were buying things could follow up with the business and get customer support and buy more things. And we went through this process of integrating that and making sure that it’s integrated with all these system well. And I think everyone is really happy with that so far. So we started off pretty slowly, but that’s going to be some of the basis for how we look to make Messenger a business going forward. And we’re happy with the initial results. There is obviously a lot more there that we need to do and we’ll have more to talk about this year and beyond."
},
{
"speaker": "Operator",
"text": "The next question is from John Blackledge with Cowen & Company. Your line is open."
},
{
"speaker": "John Blackledge",
"text": "So, it was a phenomenal quarter and year for Facebook. And given we’re about a month into 2016, there is a lot of discussion around the global macro headwind. Just wondering how the business is trending thus far in the quarter or maybe by market U.S., Europe Asia-Pacific and Rest of World; and generally, just how Facebook is positioned if the global macro environment softens a bit? Thank you."
},
{
"speaker": "Dave Wehner",
"text": "Yes, John, it’s Dave. Just on that question, we’re not commenting specifically on Q1. We didn’t see anything in Q4 that indicated broad-based macro weakness beyond of course the impact that FX was having, which was pretty significant. I mean we saw the impact in places like Brazil, where you’ve gotten in currency headwind of over 30%. So, you’re certainly seeing that impacted. And obviously those sort of global macroeconomic and currency factors will continue to impact us. We’re obviously benefiting from a strong secular shift to usage of mobile and we feel we’re very well positioned in that. We’re seeing more and more advertisers move to mobile; they realize that it’s no longer question of whether they need to be on mobile, but it’s really how they’re going to be on mobile, and we think we’ve got the best solution for that and we’re investing to make it even better. So, I think from a secular trend point of view, we’re very well-positioned, but obviously we’ll continue to monitor the macro conditions and currency."
},
{
"speaker": "Operator",
"text": "The next question is from Eric Sheridan with UBS. Your line is open."
},
{
"speaker": "Eric Sheridan",
"text": "Thanks for taking the question. Maybe just asking for more color on Instagram, it’s obviously still very early days on Instagram. But what are you seeing in terms of user engagement as you continue to move ad load up on the product? What advertiser adoption of the product is? I know you gave us a little bit of color during the prepared comments. And also pricing on the environment inside the platform, as you continue to rollout deeper with the advertising products? Thank you so much."
},
{
"speaker": "Sheryl Sandberg",
"text": "When we introduce ads into feed and continue to increase the ad load, we monitor really carefully. We’re looking at user engagement on the platform, we also look at the quality of ads. And our basic belief is that if we have high quality ads, those create a good consumer experience and we can look at what consumers are doing, because we can understand how actively engaged they are on the platform. For Instagram, we don’t break out revenue. Instagram, and we’re pleased with the growth on Instagram. And as I mentioned, 98 of our top 100 advertisers in Facebook are now advertising on Instagram. It’s also the case that Facebook had remarkably strong growth as well. So, we’re seeing strong growth across those platforms. I think what’s exciting about those platforms is that they combine the art and the science of both a creative canvas that marketers are excited about and targeting. So to share another example from a holiday, Shutterfly did a Facebook and Instagram, both the brand and direct response holiday campaign on mobile. And what they did was just beautiful pictures but also targeting very specifically to women with specific interest, such as things like weddings and babies, and they saw a 6.4 times return on ad spend. We think that’s what’s possible when you combine the creative canvas we have using the technology and using the platform that we’ve created."
},
{
"speaker": "Operator",
"text": "The next question is from Heather Bellini with Goldman Sachs. Your line is open."
},
{
"speaker": "Heather Bellini",
"text": "I just had two quick questions. One, Sheryl, I just wanted to follow up on what you said about Facebook and Instagram, and the overlap in the advertisers. And I was wondering if you could share with us how you feel those advertisers view it; do they view it as an incremental platform or there has been some question about whether or not some advertisers might take their spending and just move it over to Instagram. I am just wondering if you see incremental spending as a result of opening up both platforms. And then the second question would just be to Mark. Just I was wondering -- I know you mentioned Oculus and the preorders. I was just wondering if you could give us your take on whether or not you’re happy with the initial launch of Oculus preorders. And also we obviously all know the big gaming impact. But I am just wondering from your perspective, as you look out what industries do you think are -- where this could be the most disruptive outside of gaming? Thank you."
},
{
"speaker": "Mark Zuckerberg",
"text": "I will take the Oculus one first. Yes, I am happy. I don’t show much joy, but I am happy. It’s going to be gaming for the beginning. That’s the initial market. There are about -- I think it’s around 250 million people who have Xboxes, Play Station, or Wiis. That’s the initial marketer folks who we think are going to be most interested from the early VR experiences, especially at some of the higher price points. But overall, I mean the reason why we’re interested in this as the social company is that we think that this is going to be a new way that people interact. And if you tried out the Toybox demo with the hands, Oculus Touch, what you see is when you’re in virtual reality with another person and you can interact with the environment and use your hands, you can -- it’s not just about where you are and the fact that you can instantaneously teleport to another place, it’s just you can interact with people in all these different ways that would be very difficult in the rest of the world. So, we’re very excited about that. That’s going to be a big area of investment for us. And it is ultimately I think going to change the way that we communicate and live and work in addition to how we play games. But I think we’re off to a good start."
},
{
"speaker": "Sheryl Sandberg",
"text": "On the Instagram question, certainly in the short-run, some of the spend is incremental and some of it isn’t. Some of our clients approached us where they have a social budget or Facebook budget and some of that moves to Instagram and some people, it’s incremental spend. In the medium to long-run however, we believe that we’re really well-positioned to take share from other platforms out there. We believe both Facebook and Instagram have this combination of an ability to do great creative with the best targeting in a most sophisticated measurement which shows businesses how we help them move products off shelves. And we want and we tell our clients we want to be the best dollar, the best euro, the best pound and the best minute you spend. And we really encourage them to measure their ROI and compare us to other platforms. We think that comparison bodes very well for our growth. We also think that continued consumer shift to mobile devices bodes well for our growth as well. That said, we have to continue to execute. We know this won’t be easy. We have to continue to build the right products. We have to continue to measure all the way through from seeing an ad impression to sell. And so it’s up to us to stay focused in the coming year and years."
},
{
"speaker": "Operator",
"text": "The next question is from Ben Schachter with Macquarie. Your line is open."
},
{
"speaker": "Ben Schachter",
"text": "You’ve had a lot of success with standalone apps, so should we expect to see you launching more such apps and could a standalone video app would be a part of that particularly for people who just want to watch a video? And then secondly on the virtual reality, another question. Can you just discuss the supply constraints in terms of how many units you can ship per month? And should we expect those shipments to accelerate into the holiday? And then also related to that, how are you going to work with retailers to show consumers the power of Oculus in store and in person? Thanks."
},
{
"speaker": "Mark Zuckerberg",
"text": "So, on the apps question, the ones that have done the best are things that augment core Facebook functionality for large subsets of the community. So, for example, we have this Pages Manager App. There are 50 million businesses that have pages on Facebook. And while that is not a huge number compared to the size of the overall community of people, it’s a very large number of people and businesses. And giving a focused experience for the person who wants to run their business through Facebook and be communicating with their customers all day long, that’s just proven to be an incredibly engaging experience that drives content into the system and is good overall. We have introduced a number of things like that for public figures, for groups, messengers, probably been the most successful; it’s something that’s connected to the Facebook experience that now has more than 800 million people using it. So, I do think that there’re additional opportunities for this and we’ll continue looking at them."
},
{
"speaker": "Dave Wehner",
"text": "Ben just following up on VR and supply constraints, so we have two products. You’ve got Gear VR and Samsung is really handling all of that from a hardware perspective, and obviously they’re well prepared on that front. With Rift, it’s really -- it’s early in the evolution of VR; it’s early to be talking about large volumes. So, at this point I don’t think we’re giving a lot of color around supply chain and that sort of thing. It’s not going to be material to our financials this year."
},
{
"speaker": "Operator",
"text": "The next question is from Brian Nowak with Morgan Stanley. Your line is open."
},
{
"speaker": "Brian Nowak",
"text": "I have two, the first one is to go back to some of the core Facebook advertising success. I wonder if you could talk about some of the Facebook video, ad, learning and kind of positive you have encountered and hurdles that you still encounter that could be holding back advertisers from moving further, video budgets out of the platform. And then the second one, we always see this gap between Asia and rest of world monetization versus North America and Europe. I was wondering if you just kind talk through some strategies and qualitative drivers you see over the next couple of years that are going increase the overall Asia and rest of world monetization even further?"
},
{
"speaker": "Sheryl Sandberg",
"text": "I think our approach to increasing monetization around the world is really the same. We need to build really compelling ad products with great formats that let marketers be creative and be convincing. I’ll share an example of something we did for an emerging market. I’ve mentioned briefly in my remarks, Slideshow, the Slideshow product is -- enables a video like experience which phone with lower connection speeds and feature phone by series of photos. So, Coca-Cola used that in Kenya and Nigeria. They took screenshots of a video ad they have produced for other markets, they uploaded them with text; and they reached 2 million people with a 10-point lift in ad awareness. So, the way we need to drive sales around the world is by understanding markets, launching things like click to missed call ads in India and making sure our products work for market but also being able to connect to those advertising metrics and business metrics around the world. Video ads are important on our platform and the most important thing that’s growing well there is consumer engagement with video is growing. We have 500 million people watching video a day. And the fact that so much video is being consumed on our platform gives us room for an ads business to grow because we want the formats to match. Marketers also really love video and it’s a really compelling way to reach people and video is contributing to our growth. It’s important to note that it’s not just large brand advertisers that are doing video but all of our market segments. Direct response, SMBs who have uploaded 1.5 million videos and have both organic and paid in the last month, and developers. The video ad spend is not all incremental of course because every time we put an ad in newsfeed, if it’s a video ad, it’s taking a place of an ad with another format. In terms of learnings, one of the most important learnings we have is that video formats are different on Facebook. There’re certainly people that are watching the whole 30-second video ad with sound, but there are some people that are doing at less, they’re watching shorter formats and they’re watching with sound. And one of the challenges we have in the market is convincing marketers and agencies and people that make the video to expand them with different formats. The good news is that we’re getting great results like the Halo 5 example I shared in my remarks that when people are willing to experiment, this is a pretty unique canvas. You can do short form with sound off, you can be longer firm with sound on and everything in between. And our ability to persuade marketers to experiment is going to be a major driver of how much we can do here."
},
{
"speaker": "Operator",
"text": "The next question is from Justin Post with Bank of America Merrill Lynch. Your line is open."
},
{
"speaker": "Justin Post",
"text": "I’ll ask couple of longer term questions. First, I know a year ago you gave us usage update and time spent, wondering if video or any other products are having a big impact on usage and if you can give us any metrics there. And then maybe one for Sheryl, we have you have at 8% of all media time spent. I’m just wondering if you think Facebook could monetize better than other forms of media based on time spent or maybe a little bit below. And then maybe one for Dave, 60% margins last quarter, obviously very strong. And just wondering what you think about the long-term, any comments on long-term margins?"
},
{
"speaker": "Sheryl Sandberg",
"text": "In terms of monetizing time spent, it’s certainly the case that consumers have shifted to mobile and businesses need to catch up. The exact [ph] percentage we can monetize that we’ll see, but we certainly think that we will continue to benefit from the consumer shift to mobile, because businesses are behind. If you ask even our largest clients, our largest clients, if they drew a pie chart of where their consumer spend their time and money and whether they spend their time, we’re still under-indexed. That said I’ll say it again, we’ve a lot of hard work to do. We really need to prove to clients particularly as they scale and we become a bigger part of their spent that we’re driving results. Other platforms, other forms of advertising like TV and other have very established metrics that people have believed for a very long time. We think our targeting can be better than any other platform. We also believe our ability to measure results can be deeper, but it’s up to us to prove and to prove that client-to-client. It’s also worth noting that we work really well with TV. It’s not always the choice of TV or Facebook, but often we can be a complement. We’ve done a bunch of work with Nielsen to measure what happens when marketers do big TV campaigns and do campaigns that are broadly, broadly targeted on Facebook. And we are able to increase the reach and increase brand favorability. So for the most part when people are doing big campaigns, they’re doing them across multiple platforms and we think that will continue."
},
{
"speaker": "Dave Wehner",
"text": "Justin on time spent, there is no question that video is helping us on time spent and engagement. We’re not -- you won’t have any specific stats other than the hours per day -- or sorry time spent per day that Mark mentioned on video. So no updates on stats there other than that. In terms of our long-term margins, we’re not managing the business to a specific margin target in any year. We still think we’re early in investing in the business. And we’re really investing in new areas today where we see a long-term opportunity for revenue growth. That being said, we do think there is a lot of margin potential in this business, given the focus on advertising, but no target at this point."
},
{
"speaker": "Operator",
"text": "The next question is from Anthony DiClemente with Nomura. Your line is open."
},
{
"speaker": "Anthony DiClemente",
"text": "Thanks for the questions and good afternoon. It’s for Mark or Sheryl, I’m wondering what is your strategy for professional video content going forward. You talked a lot about video with bringing professional media content to Facebook, accelerate video engagement adoption. And then for Dave just kind of back to the quarter, you don’t break out Instagram revenue or financials. But wondering if the acceleration in the quarter, would you say -- was that driven more so by the step up in Instagram given the opening up of the API, the incremental Instagram ad load or was there a commensurate acceleration in the core of Facebook revenue? Thanks."
},
{
"speaker": "Sheryl Sandberg",
"text": "In terms of video content, newsfeed is as interesting as the quality of the content in it. What we’re seeing is that users are generating a lot of really high quality content, often pretty short form that people are really happy to consume. And we believe that trend will continue because we’re at the very beginning with people really understanding the power of the smartphones and lot of people are walking around with particularly in developed market. We are working with publishers to try to make the content experience better inside of newsfeed. The best example of that is probably news with Instant Articles where we figured out that, it was the slowest upload experience you could have in newsfeed to link off to an outside article. So, we worked with publishers to upload more news articles natively to Facebook and we’re seeing great engagement from that. Similarly, we’ve had conversations with makers of Premium Content, I think they’re excited by the work they already do with us to use Facebook to distribute their content and we’re interested and doing more. It’s probably worth noting that much of the engagement and consumption we have is short form, not long form."
},
{
"speaker": "Dave Wehner",
"text": "Yes, Anthony, it’s Dave. Instagram, we’re certainly very pleased with the performance of Instagram and it certainly made a contribution this quarter. But make no mistake, Facebook, core Facebook is really driving the top-line. And we’re very pleased with the strong performance that we had with Facebook itself in the quarter."
},
{
"speaker": "Operator",
"text": "The next question is from Carlos Karjner with Bernstein. Your line is open."
},
{
"speaker": "Carlos Karjner",
"text": "I have two quick questions. I’m interested in the plans to allow users to do other things beyond liking content. I think you call it Reactions; I call it adding more words to the Facebook graph. Can you talk about the rollout of this capability and whether this is something that you only see at Facebook.com or whether it’s going to be widespread across the web and other sites, much like the like button? And secondly, can you talk about thinking of the role of the different Facebook platforms in payments? I think that you will not do, because you don’t have or do not want to acquire [indiscernible] assets and what’s the boundary for what you could do vis-à-vis payments? Thank you."
},
{
"speaker": "Mark Zuckerberg",
"text": "Sure. So Reactions is going to rollout on every platform. We’re testing it in a handful of countries to start just to make sure that we have the UI and interaction simple enough that people could express more of what they wanted without getting in their way, it is adding a little bit of complexity to something that is very simple, say just a one tap like button. But the philosophy behind it is that when you only have a like button, if you share a sad piece of content or something that makes you angry, people may not have the tool to react to it. And therefore over time the community feels less comfortable sharing that kind of content on Facebook. And we want people to be able to share all of the things that are meaningful to them not just the things that are happy and that people are going to like when they see it. And we think that that’s just really important to the mission of the company and we’ll increasing engagement and sharing and openness, and all of the things that we care about. And so far I think there are a few tweaks that we needed to make to reaction since initially testing it. But its’ going well and I think we plan to roll it out every where pretty soon, so that’s the game plan there. On payments, the basic strategy that we have is to make it especially in products like Messenger that where the business interaction maybe a bit more transactional, to take all the friction out of making the transactions that you need. So, we don’t view ourselves as a payments business, that’s not the type of company that we are. We’ll partner with everyone who does payment. We look at the stuff that Apple is doing with Apple Pay for example as a really neat innovation in the space that takes a lot of friction out of transactions as well. And our view is that the less friction, the better the user experience, the more people can easily interact with businesses that they care about. And ultimately for our business that will drive up the amount that businesses are willing to pay to advertise to send people into those interactions because they perform well. So it’s good for everyone but that’s how we think about that."
},
{
"speaker": "Operator",
"text": "The next question is from Michael Nathanson with Moffett Nathanson. Your line is open."
},
{
"speaker": "Michael Nathanson",
"text": "Following on Mark’s answer to the question about payments, I wonder Sheryl if you look at the fourth quarter, as you said as defining moment for marketers and with the friction of transactions again easier. Was there any type of shift in the marketers or verticals that move money to Facebook in the quarter? Do you see more retail let’s say or anything different in terms of the competition of who is buying in fourth quarter?"
},
{
"speaker": "Sheryl Sandberg",
"text": "Fourth quarter is a holiday quarter, so our top verticals were ecommerce, CPG and retail. Our growth is really broad-based, and I think it really shows how important the targeting can be. What we’ve definitely done over the last year and plan to invest even more in over the next year is worked hard on vertical specific targeting. So for example for the telecom industry being able to target existing consumers with new consumers with people who are -- their voice plan or data plan’s about to expire. With the auto industry, really important industry for growth for us, helping them figure out who their current customers are, who their potential customers are and where are the audience segments out there who have similar likes, interests, backgrounds, demographics to their current customers so that they can serve right ad to the right people. The kind of things we’re able to do with targeting and measurement apply across industries and obviously have to be industry and vertical specific and we’re working hard at that."
},
{
"speaker": "Operator",
"text": "The next question is from Mark Mahaney with RBC Capital Markets. Your line is open."
},
{
"speaker": "Mark Mahaney",
"text": "Two questions, Sheryl, could you just talk about political advertising and how you think about the attractiveness of -- and any anecdotes you have on Facebook as a platform for political campaign? And then Mark, the story is in 2012 with beginning of that year you realized just how powerful the movement was towards mobile devices and you turned to your engineers and said we need to generate $1 billion in revenue off of mobile devices. And I wonder if you’ve had that same had conversation with your engineers when you think about these two messaging platforms that you have that got a large number of users and clearly globally we’ve seen this massive shift of the words messaging, the interest is changed now, people have engaged with it. Do you feel like you’ve had or do you need to have that $1 billion conversation with your engineers about those two messaging platforms? Thanks."
},
{
"speaker": "Sheryl Sandberg",
"text": "In terms of the election, it’s important to note that we’re large and diversified, so no one vertical drives our business. Yes, the 2016 election is a big deal in terms of ad spend but so is the World Cup, so Super Bowl every year, so are events like the Olympics. We are excited about the targeting we’re able to offer for our ad platform. We believe we have position that doesn’t exist on any other platforms. So for example, using Facebook and Instagram ads you can target by congressional district, you can target by interest, you can target by demographics or any combination of those. And we’re seeing politicians at all level really take advantage of that targeting. It’s also probably worth saying that we’re pretty excited about what’s happening with the elections organically on Facebook. Facebook is really the new town hall. And connecting the people who are running for office, both at the national and the local level with people directly has been really important. Every member of Congress in the United States is now on Facebook. We’re seeing some of them post every vote and explain why they’re doing votes. We’re seeing a bunch of that candidates for president get on Facebook themselves and interact taking questions from their potential voters directly. And we think that kind of direct engagement where people can hold their elected officials accountable and elected officials can speak directly to constituents is a really important part of our mission and we’re excited about the 2016 election and what’s happening there."
},
{
"speaker": "Mark Zuckerberg",
"text": "Well, I’ll answer the other one. In terms of the story that you said, I think you have it wrong. I don’t know where you got that story from, I’ve never had a conversation with the team where we were behind on mobile and then I said we need to do this to make money. That’s not really how we operate. What happened is we realized that mobile was growing faster than desktop and that people were shifting their usage and that it was the more important thing for people’s consumer experience. And that’s when we made the shift, not in our business first but in how we develop products. And I told all of our product team and when they come in reviews really just coming with mobile. If you come in and you try to show me a desktop product, then I am going to kick you out; you have to come in and show me a mobile product. And that I think was just as a crude leadership tactic, somewhat effective and helping to motivate the organization to shift its energy towards focusing on mobile. But if you remember, we actually went through a pretty tough period because we went through this period where our mobile experience was not as good as we wanted it to be and we had no ads on mobile. And we actually prioritized making the mobile experience good before putting ad there. So there was a long time where people thought that our business might not be as good because we had no ads on mobile, and that was because we always prioritized the experience for people above, even if it’s going to be a painful thing for the company. So that’s how I think about messaging. We know that messaging is going to be increasingly important, that’s why we went out and hired David Marcus who is one of the best product leaders in the field to Messenger and why we bought WhatsApp, which the leading messaging product worldwide. And we have a formula for how we build these businesses. First, you build a great consumer experience that helps people share in a new way that’s really important. Then after that you can start to introduce organic ways that people can interact with businesses, so that in Facebook is pages, the businesses that people want to interact with, the public figures, the politicians, not necessary ads but organic interactions around not necessarily just your friends and families but more public figures and businesses. And then only once you have that ramped up to a good scale, can you really start dialing up advertising having that feel good and be a good part of your experience with good content because all those public figures and businesses are already participating in the platform at scale. So, you could expect to see that playbook in Instagram, we’re pretty far along in terms of having quite a mature pubic content. Ecosystem and ads are ramping well with good high quality ads because a lot of public figures and businesses are already investing in creating that kind of good content that goes in Instagram. And you’re going to see the same playbook in Messenger and WhatsApp. In terms of making it so there are organic businesses and public figures, there is a bit more of that on WhatsApp already in terms of businesses using it and our Messenger, we are catching on Messenger; we’ll do that on both. And once we have those ecosystems built out, we will build businesses around them. And that’s how we think about stuff and we’ll do that in all of our products and the different things that we do going forward."
},
{
"speaker": "Deborah Crawford",
"text": "Operator, it looks like we have time for one last question."
},
{
"speaker": "Operator",
"text": "Certainly, the final question is from Paul Vogel with Barclays. Your line is open."
},
{
"speaker": "Paul Vogel",
"text": "Great, thanks. Just two questions, one on the Facebook Sports Stadium, I’m just wondering how you think about that in terms of how is going to be different from other offerings, what’s the big differentiating factor and how do you get folks to participate in that? And the second, so just on the margin side again. Do your revenue and cost line out geographically, so there is obviously a translation impact to the numbers, but is there any operating mismatch between revenue and cost that would either benefit or margins?"
},
{
"speaker": "Sheryl K. Sandberg",
"text": "On the Sports Stadium, this is an early test, but we’re pretty excited about it. We are the largest community of sports fans in the world; we have 650 million sports fans on our platform. And people are already using Facebook to share during real-time events. It’s an increasingly important use case for us. So this gives people to share, a place to share that one event and participate in it. I think what you will see from us is always a focus on driving users and driving engagement. This is one way to do it. We’ll see how it works; we’re pretty open to experimentation. So, we feel pretty confident that real-time sharing is an increasingly important part of the platform and one we’ll continue to invest in."
},
{
"speaker": "Dave Wehner",
"text": "And Paul, it’s Dave. I think that question is really around sort of FX and how it relates on the revenue side versus the cost side. And on that front, we’re -- substantial majority of our expenses are U.S. dollar base. So certainly we see an impact to margins with FX headwind. So that’s just the reality of having most of our development resources for instance in the U.S. So beyond that, we don’t do geographic cost breakouts and allocations; it’s not how we run the business. But certainly from an FX point of view, FX headwinds have a dampening effect on margins."
},
{
"speaker": "Deborah Crawford",
"text": "Alright. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today’s conference call. Thank you for joining us. You may now disconnect your lines."
}
] | null | null |
META | 3 | 2,015 | 2015-11-04 17:00:00 | Executives: Deborah Crawford - Director-Investor Relations Mark Elliot Zuckerberg - Chairman & Chief Executive Officer Sheryl K. Sandberg - Chief Operating Officer & Director David M. Wehner - Chief Financial Officer
Analysts: Eric J. Sheridan - UBS Securities LLC Heather Anne Bellini - Goldman Sachs & Co. Douglas T. Anmuth - JPMorgan Securities LLC Brian Nowak - Morgan Stanley & Co. LLC Justin Post - Bank of America Merrill Lynch Anthony DiClemente - Nomura Securities International, Inc. John Blackledge - Cowen & Co. LLC Paul Vogel - Barclays Capital, Inc. Rich Greenfield - BTIG LLC Mark A. May - Citigroup Global Markets, Inc. (Broker) Ross Sandler - Deutsche Bank Securities, Inc. Mark S. Mahaney - RBC Capital Markets LLC
Operator: Good afternoon. My name is Chris and I'll be your conference operator today. At this time, I would like to welcome everyone to the Facebook Third Quarter 2015 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin.
Deborah Crawford - Director-Investor Relations: Thank you. Good afternoon and welcome to Facebook's third quarter earnings conference call. Joining me today to talk about our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements and actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our quarterly report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I'd like to turn the call over to Mark.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: Thanks, Deborah, and thanks, everyone, for joining us today. This was another good quarter, and we continue to grow the size and engagement of our community. 1.55 billion people now use Facebook every month and more than 1 billion people use Facebook every day. On mobile, we continue to have a lot of momentum. 1.39 billion people now use Facebook on mobile devices, including more than 1 billion on Android. 50 million people also use Facebook Lite, our app for people on low bandwidth connections and one of our fastest-growing interfaces. This is a great sign for how our mobile strategy continues to make progress across markets, devices and platforms. When it comes to our business, we're also pleased with our results. This quarter, total revenue reached $4.5 billion and advertising revenue grew by 45% from a year ago. We've already accomplished a lot this year, and these results show how we're getting stronger as a community and as a business. But we want to serve the entire global community, not just the people who are on Facebook today. Connecting everyone is one of the fundamental challenges of our time and to achieve this, we need to continue innovating faster and investing for the long-term. That means continuing to invest in our core products and services as well as technologies and strategies that allow us to achieve a truly global reach over time. Let's talk about how we're doing this, and let's start with how we're improving our core products to better serve our existing communities and businesses. This quarter, we introduced some big updates on Facebook to give people more options for expressing themselves. We began rolling out an improved mobile profile design, including the ability to add a profile video instead of just a photo. We also started testing Reactions, a new version of the Like button that provides more ways for expressing love, awe and sympathy. We think this is going to provide a much more engaging experience. Another way we're working to improve people's experiences on Facebook is by helping them to share many different types of content with different groups of people they care about. One example is our progress with Groups on Facebook. More than 925 million people now use Groups each month. In some countries, more than half of the population is participating. From a youth organization in Chicago to aid workers dealing with the refugee crisis in Europe, we've seen many inspiring examples of people using Groups to collaborate. Video is another area where we continue to make progress. On average, there are now more than 8 billion daily video views on Facebook and more than 500 million people who are watching daily. To offer even more engaging video experiences, we've added live video to our Mentions app for public figures, and we now support interactive 360 videos in News Feed. We've also rolled out new video tools for pages and begun testing a dedicated video section on Facebook. Over the next few years, video is going to be some of the most engaging content online, and by continuing to innovate here, we have a chance to build the best place to watch and share videos. When it comes to serving businesses, we continue to create a lot of value. We now have more than 2.5 million active advertisers on Facebook and more than 45 million small and medium-sized businesses actively using Facebook pages. This quarter, we continued to focus on helping marketers achieve results while using our ad product, including video and carousel ads as well as on Instagram, and as usual, Sheryl is going to talk more about this in a moment. Now, let's talk about how we're working to develop our next generation of apps and services. For Instagram, this was a busy quarter. The community celebrated its five-year anniversary and reached a new milestone of 400 million monthly actives. More than 80 million photos are now shared on Instagram every day, and the pace of adoption among public figures, organizations and people around the world continues to grow really well. When President Obama visited Alaska in September, he used Instagram to document his trip, and this is a great example of how Instagram is changing the way that people see the world. With our efforts in messaging, we're also making progress at building WhatsApp and Messenger both into great platforms of global scale. Last quarter, WhatsApp reached 900 million monthly actives and continues to be on a path to reach 1 billion people and beyond. Messenger has over 700 million monthly actives, and we continue to focus on improving the core messaging experience. A good sign of our progress is the more than 9.5 billion photos now sent monthly on Messenger. We're also building many different tools that can offer useful experiences to people beyond just traditional messaging. One example is M, a digital assistant we introduced this quarter that over time will use AI to help people complete tasks. Finally, let's talk about some of our longer-term efforts in innovation to help connect the world. With Internet.org, we have a lot of momentum. We've now rolled out free basic Internet services to people in 29 countries, and overall brought more than 15 million people online. As we rolled out the program, we've made a number of improvements based on feedback from communities and partners, including opening up our platform for free basic services to all developers who want to build. Meanwhile, our work on new technologies to connect people in the most remote regions continues to make progress. This quarter we revealed Aquila, our first aircraft designed to beam internet into communities down from the sky. And we also announced a partnership to bring internet to large parts of sub-Saharan Africa using a satellite, which is launching next year. And with Oculus, we're in a great position to begin delivering a new generation of shared immersive experiences, we plan to ship the Rift headset early next year. And Gear VR, our mobile product with Samsung, is going to have its first consumer release this holiday season retailing for $99. And we also announced new partnerships with Minecraft, Netflix and Twitch and many other content partners. Virtual reality has the potential to be the next computing platform that changes all of our lives. It's important also to recognize that this is going to grow slowly, like computers and mobile phones when they first arrived. So we're committed to Oculus and virtual reality for the long-term. So that's how we've continued to make progress on our strategy this quarter. The results we've achieved show that our investments are creating a lot of value for our community and the world. I just want to thank the entire Facebook community, our employees, our partners and our shareholders for helping us to continue moving forward. We've done a lot, but there's always more to do. And now I'm going to hand it off to Sheryl.
Sheryl K. Sandberg - Chief Operating Officer & Director: Thanks, Mark. And hi, everyone. We had an excellent third quarter. Results were strong across the board. Ad revenue grew 45% year-over-year or 57% on a constant currency basis. Mobile ad revenue was $3.4 billion and grew 73% year-over-year. Mobile now makes up 78% of our total advertising revenue. Our business grew across all regions and marketer segments. Like last quarter, we saw especially strong growth in our North America and Asia-Pacific regions. Overall, we're really pleased with marketer adoption of our ad products around the world. Our results show that we continue to make progress on our three priorities: capitalizing on the shift to mobile, growing the number of marketers using our ad products and making our ads more relevant and effective. First, capitalizing on the shift to mobile. People have already shifted to mobile and this shift is driving engagement on Facebook. The average American adult spends 25% of their media time on mobile, and Facebook and Instagram together continue to account for over one minute in five minutes on mobile in the U.S. Businesses are lagging behind consumers in making this shift to mobile, and we believe we're well positioned to help them catch up. Facebook Pages are already the mobile solution for millions of businesses. Pages now offer better messaging capabilities, call-to-action buttons and news sections that enable businesses to highlight important information. We're also capitalizing on the shift to mobile by expanding ads on Instagram. This quarter on Instagram, we introduced new ad formats and objectives, opened up our API and launched self-serve ad capabilities. Instagram ads are now available in all countries where we offer Facebook ads, and marketers can manage campaigns across both platforms with the same targeting. We're really pleased with the marketer demand for Instagram ads. Our second priority is growing the number of marketers using our ad products. In September at Adweek, we announced that we have over 2.5 million active advertisers on Facebook. With more than 45 million active SMB Pages on Facebook, we think there's a lot of opportunity to turn even more of these businesses into marketers. Marketers come to Facebook and Instagram because we have the best performing mobile ad products, and video is making them even better. Marketers have always loved using video to tell stories. As Mark discussed, video is a natural and growing part of our mobile News Feed experience. Video on Facebook gives marketers not just mass reach, but better cross-device targeting and measurement than we believe is available on any other platform. We're especially pleased with the breadth of marketers using video on Facebook, from brands to direct response to SMBs. Over 1.5 million small businesses posted video, which includes organic video posts and video ads on Facebook in the month of September alone. Video ads complement TV ads. According to a recent study with Nielsen Research, marketers using Facebook ads with TV ads saw higher reach, ad recall, brand linkage and likeability. To share one example, GMC used video and other ads on Facebook to extend the reach of their TV brand campaign highlighting their premium trucks and SUVs. The Facebook campaign drove a 13-point lift in ad recall and a 6-point lift in brand favorability. We recently introduced target rating point, TRP, buying so that marketers can plan, buy and measure video ads on Facebook the same way they do on TV. We're pleased with the feedback we're receiving on this from marketers and agencies. Our third priority is making our ads more relevant and effective. We know relevant ads are more engaging for people and, therefore, drive better results for businesses. Products like carousel ads and dynamic product ads help improve effectiveness for marketers. Carousel ads show multiple images and now videos and drive 30% to 50% lower cost per conversion than single image link ads. Dynamic product ads, which allow marketers to upload their product catalog, are driving ROI comparable to Search. For example, Marriott uses DPA to re-target travelers based on their travel search habits and they are now scaling globally across their portfolio of brands. LatAm e-commerce company, MercadoLibre, uses DPA to re-market over 38 million products in over 13 countries. Both are seeing high ROI and continuing to invest. On the measurement side, Conversion Lift is helping clients see the real business results from their campaigns. Boost Mobile, a Sprint brand, showed ads to people eligible for device upgrades. Using Conversion Lift, they were able to attribute a 4% lift in in-store sales to their Facebook campaign. Finally, we're continuing to invest in ad tech across Atlas, LiveRail and the Audience Network. This quarter, we expanded the ad formats publishers in the Audience Network can add to their mobile apps. On LiveRail, this quarter we began testing age and gender targeting. LiveRail can now deliver over 90% accuracy on age and gender segments across desktop, mobile web and mobile apps versus a non-target rate of only 31% to 55% when not using LiveRail technology. I want to take a moment to thank our clients around the world for their continued partnership and congratulate our global Facebook teams on great execution. Looking forward, we're going to stay focused on our priorities to continue to build a solid foundation for our long-term business. Now here's Dave.
David M. Wehner - Chief Financial Officer: Thanks, Sheryl. And good afternoon, everyone. Echoing Mark and Sheryl's comments, Q3 was another strong quarter for Facebook. We generated $4.5 billion in revenue and over $1.4 billion in free cash flow. Growth and engagement of our community again provided a great platform for our strong financial performance this quarter. In September, we reached a new milestone with over 1 billion people using Facebook on an average day, an increase of 17% compared to last year. This daily number represents 65% of the 1.55 billion people who used Facebook during the month of September. Mobile continued to drive our growth. In September, approximately 1.39 billion people accessed Facebook on mobile devices, up 23% from last year. Additionally, our next generation of services continued to grow, with Instagram, Messenger and WhatsApp now exceeding 400 million, 700 million and 900 million monthly actives respectively. Now turning to the financials. All of our comparisons are on a year-over-year basis unless otherwise noted. Additionally, our non-GAAP measures exclude stock-based compensation and the amortization of intangibles. Total revenue was $4.5 billion, up 41%, or 51% on a constant currency basis. Ad revenue was $4.3 billion, up 45%, or 57% on a constant currency basis. The strengthening of the U.S. dollar continued to have an unfavorable impact on our revenue in Q3. Had foreign exchange rates remained constant with Q3 2014 levels, our total revenue would have been approximately $340 million higher. Regionally, U.S. and Canada and Asia-Pacific were our strongest markets, producing ad revenue growth of 56% and 48% respectively. Europe and Rest of World grew more slowly at 33% and 29% respectively, impacted by our currency exposure in both of those regions. As Sheryl mentioned, mobile continued to drive our revenue growth. Mobile ad revenue was $3.4 billion, up 73% from last year representing 78% of our advertising revenue. Revenue from ads served on personal computers was down approximately 8%. We have been very pleased with the sustained high growth of mobile advertising revenue. There are a number of important factors contributing to that growth both from the supply and demand side. The drivers of year-over-year mobile revenue growth fell into three main categories. First, as Sheryl covered, we have continued to have success driving strong advertiser demand. Second, we've grown both the number of people using Facebook and the time that they spend with us. And third, the growth in advertiser demand and ad quality has enabled us to increase ad load over time. As we have grown mobile advertising, we have remained very pleased with overall engagement levels, user satisfaction with News Feed and the overall quality of the ads themselves. Turning now to our overall price/volume metrics. In Q3, the average price per ad increased 61% while total ad impressions declined 10% on a year-over-year basis. As I've indicated on prior calls, the changes in our reported price-volume metrics have been driven recently by the change in the number of right hand column ads and the shift to mobile. These factors will have a less significant impact on the reported price-volume metrics going forward now that a full year has elapsed since the redesign of right-hand column ads, and now that mobile impressions have grown to become the majority of impressions. In fact, the quarter-over-quarter trends already point to that. In Q3, total ad impression increased 7% sequentially and average price per ad increased 5%. Total payments and other fees revenue was $202 million, down 18% compared to last year. The decline was expected and was driven by a reduction in payments revenue related to games played on personal computers. Turning now to expenses. Our Q3 total GAAP expenses were $3 billion, up 68%, and non-GAAP expenses were $2.1 billion, up 51%. Similar to last quarter, stock-based compensation and amortization expenses related to the WhatsApp acquisition contributed significantly to the year-over-year growth in GAAP expenses. Non-GAAP expenses were driven by increases in head count related costs, cost of revenue and marketing expenses. We ended Q3 with nearly 12,000 employees, up 44% compared to last year. We added over 1,000 employees to Facebook in the quarter and we are pleased with the continued strength in our recruiting efforts. Our Q3 GAAP operating income was approximately $1.5 billion, representing a 32% operating margin. Our non-GAAP operating income was $2.4 billion, representing a 54% margin. Our Q3 GAAP and non-GAAP tax rates were 37% and 32% respectively. Our Q3 GAAP net income was $896 million or $0.31 per share, and our non-GAAP net income was $1.6 billion or $0.57 per share. In Q3, capital expenditures were $780 million as we continued to invest in servers, network infrastructure, and the build-out of data centers and other facilities to support the rapid growth of the business. We generated $1.4 billion of free cash flow and ended the quarter with over $15.8 billion in cash and investments. Turning now to the revenue outlook. We remain focused on growing the number of people who use our services, increasing advertiser demand and improving the quality and relevance of our ads. Across these dimensions, we continue to see healthy growth opportunities ahead for Facebook and Instagram. Given the strengthening of the U.S. dollar over the past year, we will continue to face currency headwinds next quarter, particularly in Europe and Latin America. In addition, we expect our total payments and other fees revenues to decline sequentially from Q3 to Q4, similar to the trend that we have experienced over the last couple quarters. Now, turning to the expense outlook. We expect the year-over-year growth rate for total full year 2015 GAAP expenses to be approximately 55%, and for total full year non-GAAP expenses to be approximately 50%. We anticipate our 2015 capital expenditures will be in the range of $2.5 billion to $2.7 billion. We continue to expect our 2015 stock-based compensation to be in the range of $3 billion to $3.2 billion, approximately half of which is related to our prior acquisitions, most notably WhatsApp. We expect amortization expenses for the full year 2015 to be approximately $700 million to $800 million. And lastly, we anticipate our Q4 and full year 2015 GAAP and non-GAAP tax rates to be several percentage points above the respective Q3 rates. In summary, Q3 was another strong quarter for Facebook. We are pleased with the growth and engagement of our community and the momentum in our business, which together support our ability to continue investing to build our next generation of services and execute on our mission of connecting the world. With that, operator, let's open up the call for questions.
Operator: Thank you. Your first question comes from Eric Sheridan with UBS. Your line is open.
Eric J. Sheridan - UBS Securities LLC: Thanks for taking the questions. Mark, maybe one for you and one for Sheryl. For Mark, on virtual reality and Oculus, how do you see the development of the entertainment and content ecosystem around virtual reality playing out in 2016 and beyond? And what's the role Facebook's going to have to play in maybe seeding some of the content and entertainment side of VR. And then for Sheryl, any color you can give us on Instagram? We've obviously seen a ramp-up now in advertising on the property. How the company's thinking about ad load monetization, some of the opportunities and how those will be balanced against engagement. Thank you.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: I can start off talking about Oculus and virtual reality. So the first thing that I want to stress here is that these kind of new platforms take a long time to develop. So we've said often that we think that virtual reality and augmented reality could be the next big computing platform. But just to put that in perspective and compare it to the development of previous computing platforms like phones and computers, I think the first smartphones came out in 2003, and in the first year, I think BlackBerry and Palm Treo were the initial smartphones that came out. And I think they each sold in the hundreds of thousands of units. So just to kind of give a sense of the timeframe that we're thinking about this and how we expect this to develop, that's how we're thinking about that. In terms of the actual content, first, we think gaming is going to be the most obvious market. There are around, I think, more than 200 million, almost 250 million people who have either an Xbox, a PlayStation or a Wii, and we think that that audience is going to the type of people who are going to be very excited about the type of experiences initially that you can have with virtual reality. And the advantage of that is also that some of those can be single player experiences. They don't require a big network effect or a lot of people having the technology or a large installed base. Once we start getting a bit further along with that, then the next thing that we think is going to be huge is video and immersive experiences, both things that people can create, like the social content that they share on Facebook today, and more professional and premium content both short form and longer form. But we'll start to see some experimentation with that. There already is some very good content. But until there are millions of units out in the market, I don't expect that to be a big industry for folks to be investing a huge amount in 2016. Then when they're starting to get to be more units, just like every other major computing platform before that, what we expect is that a large portion of what people do in it will be communication and social behavior, and that's where Facebook really has the DNA and experience to, I think, build the best experiences. And we're investing in trying to figure out what that's going to look like, and that's ultimately a lot of what we're extremely excited about for a number of years down the road.
Sheryl K. Sandberg - Chief Operating Officer & Director: On Instagram, we think that with Facebook and Instagram, we now have the two most important mobile platforms out there. And what we bring to this is a common ad infrastructure. So Instagram ads, now that we've rolled out as we have this past quarter and gotten to a really good product offering, combined the creative format of Instagram which is very visually compelling and has a lot of engagement from people with the back-end infrastructure and marketer base that Facebook has. So now, we have self-service ads rolled out. We've rolled out in all countries where we offer Facebook ads. We have new ad formats for Instagram. We're able to do more business objectives, all of which can use the same targeting as we have on Facebook and all of which are increasingly tapping into our measurement capabilities. On ad load, we have a lot of experience rolling out ads into feed-based products and we monitor it very carefully and we're going to continue to monitor really carefully. We're also excited about how they work together. Just to share one example, American Express working with Digitas, rolled out carousel ads on Instagram that targeted travel-related interest groups for people who are 18 years and older. They then retargeted those same people on Facebook. And what they created was a really visual journey using the format that is Instagram, the format that is Facebook and combining the two platforms that they're targeting. We think we're at the very beginning of what's possible when we combine these two.
Operator: The next question is from Heather Bellini with Goldman Sachs. Your line is open.
Heather Anne Bellini - Goldman Sachs & Co.: Great. Thank you. I had two quick questions as well. One, Sheryl, just to follow up on what you mentioned about Instagram, obviously, it's a very visual experience. I'm just wondering, when you're talking to advertisers, are they viewing this as a separate channel? So I think there's been some questions as to the incremental nature of Instagram. And it would seem like it could be extremely incremental, given these are the two top platforms in mobile. So I was wondering if you could talk a little bit about what the advertisers say about blending the experiences. And also, a question for Mark. I was just wondering if you could share with us how we might see your content strategy evolve over time and, in particular, just wondering what your view is on longer form content on the video side, sorry. Thank you.
Sheryl K. Sandberg - Chief Operating Officer & Director: Yeah. To the Instagram question, what we see in the short run is that some of the spend on Instagram is incremental to Facebook and some isn't. Some clients are comfortable with Instagram and bringing a new budget to bear. Some clients are shifting some of their Facebook budget. For us in the medium to long run, we believe that we're not competing between Facebook and Instagram. We're competing with other forms of media. And if you want the most eyeballs and we think the highest ROI, over time we think that will benefit Facebook and Instagram. And so, for us, what we really want is people to experiment and learn and get to experience Instagram as they have on Facebook so that we can make the case that we can improve the ROI and then we believe if you look at the consumer metrics of where people were spending their time, we will be able to gain share compared to almost anything else you can buy out there.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: And to your question about long form content, the more natural starting point for us is shorter form content which can either be social content or premium short form content. But some of – the vast majority of the content that's consumed on Facebook just talking about video right now is people browsing through feed. They discover something interesting that they weren't necessarily looking for previously that's very powerful because that's a behavior that there isn't really anywhere else to do at scale on the Internet today in a great way, and then people watch it there or they bookmark it to watch later. But if you're talking about watching inline and feed, that's not the place where you're necessarily going to see a TV show and then watch an hour-long clip right there. So what we're actually seeing is that a lot of the best or at least from my perspective, TV shows that we see folks like Jimmy Fallon breaking up their show into clips that they can now share to be consumed over social media and on the Internet in three-minute to five-minute or seven-minute segments which are more of what people want when browsing through News Feed. So I do think over time we will get to more different types of content and we'll build products that serve that. The current market of trying to help people share and experience all these shorter form clips is massive. We are nowhere near serving that as well as we want to. So I actually think in a lot of ways though the more interesting question is not in the near-term what we're going to do to develop ways to consume long form content, but what traditional media and content producers who have traditionally produced short and long form content are going to do to chunk their stuff up better so that way it can be more easily consumed by this big community online.
Operator: The next question is from Douglas Anmuth with JPMorgan. Your line is open.
Douglas T. Anmuth - JPMorgan Securities LLC: Thank you for taking the question. One for Mark and then one for Dave. Mark, you recently spent time in China and India. And I was hoping to get some of your key takeaways both in terms of Internet.org and then also about Facebook's potential in China. And then secondly, Dave, I was hoping to get some early thoughts on OpEx for 2016, at least perhaps qualitatively, if you could walk us through some of the puts and takes for next year, Oculus in particular. Thanks.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: Sure. I can start off with the India and China question. So they are very different situations. So India is a unique country where there are 1.25 billion people, more than 1 billion of them are not on the Internet. So it is the country in the world that benefits the most from connectivity. And there's a lot of research that we've seen and reports that third parties have put out that show, that when you connect to place like India, it makes a very big difference socially and for the economy there. A lot of us here, everyone we know is on the internet and we think about the internet as entertainment and basic communication but if you don't have access to a good school, then getting basic Internet access could be your best educational information or if you don't have access to a good doctor, then getting access to the Internet could be the only way that you can learn about how to avoid certain diseases or how to raise your kids and help them avoid certain diseases and find jobs and a lot of stuff. So what we find through the research is that for every 10 people who get connected to the Internet, just a little less than or right around one person gets lifted out of poverty and one new job gets created. So we're very focused on this. It's a huge priority for the Indian government and anything that we can do to help there, we think is very good for the world and we're invested in that, and we're happy to support. So in Internet.org in India now, there are already more than 1 million people who now have access to the Internet who didn't otherwise because of our efforts, so we're proud of that but obviously that's still very early on. We're only working with one operator currently in part of the country. So there's a lot of room to expand that and that's just a big opportunity for the Internet overall and for India over the next decade and we hope to play a role in that. On China, that is a more complex situation. Obviously, you can't have a mission of wanting to connect everyone in the world and leave out the biggest country. So over the long-term, that is a situation that we will need to try to figure out a way forward on. For now, the thing that I would leave you with is that people think that Facebook isn't in China at all and that's actually not true. Our consumer service isn't active there, but it actually is already one of the biggest advertising markets that we have. Because there are a lot of really big and important Chinese companies who sell a lot of products to people outside of China, and they use Facebook as one of their primary tools in a lot of cases to spread information about what they're doing and grow their customer base. So we're happy to do whatever we can to help develop the economies in both of those countries and they're both long-term efforts for us.
David M. Wehner - Chief Financial Officer: Doug, on your question on 2016, we're not going to obviously give specific guidance at this time, that'll be coming with our Q4 call. But we're focused on continuing to invest heavily in the business across our near, mid and long-term opportunities and we see a bunch of great opportunities to invest there. So in the near term, we're focused on growing the community and executing on our existing business. In the medium-term, we're focused on those next generation of services, Instagram, Messenger and WhatsApp. And in the long-term, we've got the investments we're making and things like artificial intelligence, VR, and obviously the Internet.org efforts that Mark just spoke about. Specifically with regards to Oculus and how that could impact the plan for next year, we're, as Mark said, very bullish about the long-term opportunity for VR and excited about the launch for the Rift next year. But VR is still very much in the development stage. So it would be early to be talking about large shipment volumes.
Operator: The next question is from Brian Nowak with Morgan Stanley. Your line is open.
Brian Nowak - Morgan Stanley & Co. LLC: Thanks for taking my questions. I have two, one for Mark and one for Sheryl. Mark, can you talk a little about what factors and metrics you consider when you're thinking about a multi-app strategy versus rolling out more products and offerings on Facebook? There's a difference in Facebook Paper, Messenger, the video viewer on the platform. Just be curious how you think about multi-app versus adding more functionality to the mothership. And then for Sheryl, it sounds like there's still a lot of SMBs on the platform that are not yet paying advertisers. Can you talk about some of the biggest hurdles you need to overcome to get more SMBs paying and initiatives you have in place? Thanks.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: Sure. So I can talk to the multi-app question first. So we view the social space as almost this matrix. You can think about it as a two-dimensional grid where one axis is the richness of the content that people want to share, then other axis is the size of the audience, or intimacy of how people want to share. So on the first axis, you get everything ranging from text to links, to photos, to videos, to immersive 360 videos and virtual reality content and this progression. And on the other axis, you get everything ranging from one-to-one messaging to small group communication, to communicating with all your friends at once, to big interest groups, to completely public. And what we believe is that you can intersect at any point on that. And there will be something interesting to build. So a small group product for sharing video, that's going to be a thing. A one-on-one product for sharing text or calling, that's clearly a thing. A public sharing and consumption product for video, that's a thing. And what we've tried to do is basically figure out the areas that we think are open and are not currently served by the set of products that the industry has built and figure out a way to offer those. So one of the big opportunities that I'm really excited about right now is I think that there's a pretty big opening between very private messaging, the one-on-one messaging products like Messenger and WhatsApp, and products like Facebook where you share with all your friends at once or Instagram. And in between there, what we're seeing is this huge growth of private groups, right, and Groups remains one of the I think least talked about products on Facebook. But I just said earlier that we have more than 900 million people are using that every month. It's a huge thing and it's a big area that we can develop going forward. So we experiment with all these things in terms of some of them make sense to naturally have inside the Facebook app because you're using the same set of friends and network and connections. Some of them get clear value by being separate, like Messenger, for example, where we can make sure that everyone has their push notifications turned on, which is extremely important for a messaging app. But overall, there's a lot of stuff in the space. And the amount that people want to share and communicate is boundless and that's I think partially why we're seeing the growth that we are with so many of these products.
Sheryl K. Sandberg - Chief Operating Officer & Director: On SMBs, I think it's one of the most compelling opportunities we have for Facebook and that's because I think we solve a really big problem for SMBs, which is how are they going to reach customers. In the United States, which is usually the most advanced market, 35% of small businesses have no web presence at all. And building a mobile presence is even harder than a web presence because most people don't use the mobile web and mobile apps are expensive to build and hard to get people to use, especially if you're a small business. That's why there are 45 million SMB pages on Facebook. These are people who are using Facebook and this free product to create an online and increasingly a mobile presence. And then our job is to make sure that free product works for them and then over time bring them into our paid products. We have 2.5 million advertisers and over 80% of them started on Pages and then started with simplified ad products. And that's what we've done over time and we'll continue to do that. And what you see is that it's as easy for them to use it as profile and we can give them opportunities to do things they otherwise couldn't do. So to what I said in my transcript before, 1.5 million SMBs posting videos in one month alone. 1.5 million SMBs have not posted or created video on any other platform, but with us it's cheap, it's very easy to use and that gives us a way to continue to work with SMBs and increasingly grow our business with them.
Operator: The next question is from Justin Post with Bank of America Merrill Lynch. Your line is open.
Justin Post - Bank of America Merrill Lynch: First, Mark, could you talk a little bit about how much activity you see around Events on Facebook and maybe your views on whether Facebook could benefit from political activity or advertising? And then, Sheryl, could you talk a little bit about where ad loads are today? Is there still room there? And also just what your feedback you're getting on advertiser ROIs, is there still more room there? Thank you.
David M. Wehner - Chief Financial Officer: Yeah, sure. I'll start with the question on ad load. It's Dave and then Sheryl can follow up on the political question. So, yeah, so, Justin, over time ad load has been one of the factors driving year-over-year growth. It's just worth noting that it is up significantly from where we were two years ago. Looking forward, we continue to feel like there are good opportunities to grow the business. I talked about the three factors that contributed to growth this quarter: ad demand, users and engagement and ad load. And we see all of those continuing to be factors for growth going forward. And then, Sheryl, did you want to take the question on the political?
Sheryl K. Sandberg - Chief Operating Officer & Director: Yeah. And I'll take Events, too. Just as Mark said with Groups, Events are growing quickly on Facebook. We don't break out by product, but we're pleased with the growth. On the elections and political activity and political advertising, we're excited about the elections because we think we give politicians and people a really compelling way to interact. If you wanted to feel like you were interacting with someone running for office before, you had to go to a town hall meeting. And increasingly, that's happening on Facebook. So between January 1 and October 7 of this year, over 68 million people on Facebook in the U.S. made over 1 billion interactions about the campaign alone, and every candidate and every member of Congress is on Facebook now. In terms of the revenue impact, no one vertical drives our business. We have a very large and diversified business. But we think we offer something pretty compelling, which is the reach of Facebook with very unique targeting. So on Facebook, you can target an ad by district, by interest. Ben Carson ran 240 different ads targeted at different audiences, and so we're starting to see candidates use our platform to communicate, to advertise and to share.
Operator: The next question is from Anthony DiClemente with Nomura. Your line is open.
Anthony DiClemente - Nomura Securities International, Inc.: Thank you very much. Mark, on the subject of media content on Facebook, it seems like the big opportunity is for Facebook to be the portal with which to access the short form video content that you mentioned earlier, and maybe the idea is to keep the consumption of that content in line or inside the Facebook wall, the garden. So the follow-up question that I would have is how do you think you could best partner with the media providers and convince them the merits of bringing their valuable, in some cases expensive, content into the Facebook world, particularly at a time in media when they're really trying hard to guard their own existing ecosystems? And then a question for Sheryl. I wonder if you could just touch on the relative growth of branded advertising versus direct response ads. You mentioned total ratings point buying. Can you help us think about the mix of branded versus DR? And for you, do you think that TRP buying and video is going to shift your ad mix more towards branded over time? Thanks.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: I can talk about video and the business model around that. So you're definitely right that there's a certain class of content which is only going to come on to Facebook if there's a good way to compensate the content owners for that. And we've recently rolled out the business model for this, which is for premium content, we'll give a revenue share on a portion of the views to the content owners. And we've got good feedback so far on that. We're working with a small set of partners to start, and we'll roll it out beyond that as that keeps on going. But it's important to keep in mind that there are a few different reasons why people share content on Facebook, and that's just one of the use cases, right? There are a lot of people who are just sharing content socially, right, because they want to get a message out. That may not be business motivated. There are a lot of folks who are business motivated but who primarily post content in order to promote something or gain distribution for something. And that you can gain value without some kind of rev share, and that's why the video ecosystem has grown so quickly even before we rolled out a revenue share. And now the third class of content, which I think is going to be important and increasingly important over time is the one that you basically want to essentially trade the content for money, and that is one where you need the rev share to unlock that. But we're getting good feedback on that upfront. So we're looking forward to seeing how that trends.
Sheryl K. Sandberg - Chief Operating Officer & Director: On our marketer segments, we don't break out by segment, but all of our marketer segments are growing. We're seeing strong growth in brand, and we believe that's because we're delivering on the promise of personalized marketing at scale. So we've worked hard on things that will help brand purchasers feel comfortable on the platform and measure their ROI. So that's where TRP buying comes in, allowing people who usually buy TV ads to plan, buy and measure Facebook ads the same way, enables apples-to-apples comparison that we believe is very strong for our ROI. We've also worked on brand awareness optimization, mobile polling to measure campaign effectiveness, and we're working client by client. Our other segments are growing as well. We're working hard in the direct response area, rolling out things like carousel ads and dynamic product ads. And one thing that's worth understanding is that all of these different marketer segments often work together. So to share one example, IKEA wanted to boost their online sales when their stores were closed. So in Norway, most retailers are closed Saturday to Sunday night. So they invested in carousel ads and only show them when their stores were closed and they turned a $35,000 investment in carousel ads into $2 million in sales which happened precisely when they want it to happen. That's a direct response ad buy because it's very specific carousel ads product but it's also a brand play for them as they strengthen their brand and get people to interact with them as they want them to.
Operator: The next question is from John Blackledge with Cowen & Company. Your line is open.
John Blackledge - Cowen & Co. LLC: Great. Thank you. Two questions. So with the explosive video consumption growth and growth in public content being consumed in the News Feed, could engagement perhaps materially increase from current levels over the next couple years? And then on WhatsApp, as it heads towards 1 billion MAUs, and/or greater, could you give us a sense of how you're thinking about monetization of that platform and perhaps timing of the monetization? Thank you.
David M. Wehner - Chief Financial Officer: On engagement, John, I think we're obviously focused across a number of different dimensions to drive engagement. Videos had a big contribution there. So that's certainly been helpful in terms of making News Feed even more engaging and we'll continue to be focusing on a number of initiatives, public content and just sharing with your friends. So there's lots that we are working on on engagement that continue to drive time spent. On WhatsApp, I don't think there's a particular magical number with 1 billion users. The focus really for our messaging products is to continue to drive user growth and continue to build great products that are fast, useful, engaging and fun. And on that front, they're both doing great. Messenger has over 700 million users and WhatsApp obviously has over 900 million users. So the business side is not the main focus right now, but we believe there are going to be opportunities as we further scale those properties.
Operator: The next question is from Paul Vogel with Barclays. Your line is open.
Paul Vogel - Barclays Capital, Inc.: Great. Thanks. Two questions. One, big picture, Mark, there's a lot of debate around what content is appropriate for Facebook to block and not block. I'm just wondering if you could talk a little bit about how you decide what to censor and not censor in terms of on the content side. And then less big picture, but just in terms of fourth quarter, given it's a big retail quarter, any increased testing around direct retail on the platform? Thanks.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: I can answer the policy question and then I guess Sheryl will take the other one. The guiding principle for us on this is that we want to give the most voice to the most people. And the idea is that there are all these different barriers that any given person has to being able to share and express everything that they want, from technical barriers, it's really hard to communicate with someone if you're not on the internet and they're far away, to product barriers, it's hard to share videos if we don't have a good product for sharing videos, to legal barriers, it's hard to share content that your government says is illegal for you to share. And at the end of the day, there's also policy and you're in a community and we have community standards for how we think people should communicate in order to be safe. Because even if you have all of the internet connectivity and the products and the legal framework that you need, if you don't feel safe saying what you want to express, then you're probably not going to share it. And we see a lot of that online and that's a pretty big issue from everything from bullying to terrorism, there are lots of reasons why people might otherwise have the tools to share what they would want but feel silenced. And that isn't giving the most voice to the most people. So we feel a responsibility to have policies for our community which limit hate speech and limit things which are going to create just an overwhelmingly uncomfortable environment for people that is going to silence other people's speech in order to make sure that over the long-term we are enabling the most people to be able to express as much as possible as they can. And that's the philosophy that we have.
Sheryl K. Sandberg - Chief Operating Officer & Director: On commerce going into the holiday season, commerce is a really important vertical for us and we're working hard to make our ads more effective. So what we're seeing from DPA ads and carousel ads, we're really happy with. We're seeing lower cost per conversion. When people do multiple objectives and video, we're seeing lower cost per click than single image link ads. And importantly, we're also creating better experiences for people because when an ad is more targeted, more relevant, when you see a product you're interested in or a service you're interested in, that's a better experience. So we go into the holidays feeling that we have a really strong product offering, certainly the best product offering we've ever had to connect people to the products they're going to buy this holiday.
Operator: The next question is from Rich Greenfield with BTIG. Your line is open.
Rich Greenfield - BTIG LLC: Hi. Thanks for taking the question. When you look at ad quality, I think when Facebook started, Sheryl, you were really adamant that you were focused on improving the ad quality and really making sure you were serving the highest quality ad to the right person. When you look at Instagram, I felt like you took incredible care to make sure that the advertising, like every ad, was of the highest quality. And as you've opened up the API, there's a tremendous amount of ads, some of them incredibly good quality, but some of them of lesser quality. How do you work to make sure that Instagram maintains what you started it with, which is incredibly beautiful ads that fit the platform and so that you don't get criticized by users for pushing, not so much the amount of ads, but the type of ads?
Sheryl K. Sandberg - Chief Operating Officer & Director: You're right. The quality is really important to us because your experience on Facebook or Instagram is about the quality of what you see, both in terms of the organic posts you see from your friends or public people you're following and the ads as well. And what we do is we monitor it carefully. We ramp slowly, we monitor engagement, sentiment, quality of ads. We get a lot of feedback directly from people who use Facebook. They can X out the ads. If they do, we ask them why they're Xing out the ads and we just continue to monitor the metrics. We're pleased with what's happened with quality on our platform overall. And a lot of the product innovations and investments I've been talking about on this call feed into quality. So the carousel ads, they're not just that they're showing multiple products, it's that they're showing products that are more specifically directed at the person. And so a lot of the underlying things we do to build our ad systems don't just feed into revenue, they feed into quality. And that's important because over the long run our quality today is our revenue tomorrow.
Operator: The next question is from Mark May with Citi. Your line is open.
Mark A. May - Citigroup Global Markets, Inc. (Broker): Thanks. I had two, if I could. We noticed a very impressive acceleration in user MAU growth and focus in the quarter. It seemed like it was pretty much in every region of the world. What, if anything, can you attribute that to? I know that you seem to be running more TV ads, at least where I live. But wonder if anything you could attribute that to. And then secondly, again on video, as more and more people and businesses are uploading video, I assume that there's a lot of good video content on Facebook, but I don't see all of it. Question is really around video discovery. What strategies do you have going forward to improve video discovery from what is today more of a push-based model to something that may be akin to a pull-based model where I can enjoy all the great video content that's on Facebook? Thanks.
David M. Wehner - Chief Financial Officer: Hey, Mark, it's Dave. Just on the user growth point, we're obviously pleased with the growth we're seeing across the globe in terms of DAU growth. The three largest countries were India, the U.S. and Brazil. So we're seeing good diversified growth. I mean, specifically we've made a lot of initiatives to help improve and invest in the Facebook experience in emerging markets and that has helped drive some of the acceleration in growth. And so we've made a number of product and performance investments there with Facebook like being a good example of that. The question then was on video and discovery and...
Mark A. May - Citigroup Global Markets, Inc. (Broker): Yeah.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: And also just on the growth point, I just think the team that's working on that is executing extremely well. I mean, sometimes it's not that you came up with some brilliant strategy, it's just like really good work consistently over a long period of time. So – and then I think they are. On video, yeah, right now the strength in our system is definitely through helping people discover content that they hadn't really asked for through News Feed. And a lot of, I think, what we need to do is give people a way to see all of the videos that page that they like or follow is interested in sharing on Facebook. And there's a pretty clear roadmap of stuff that we're going to do over the next couple of years that I'm quite excited about to add some more dimensions to the video experience on Facebook. But we're just so early in this right now. It's pretty amazing how quickly it's growing but there's a lot more to do.
Operator: The next question is from Ross Sandler with Deutsche Bank. Your line is open.
Ross Sandler - Deutsche Bank Securities, Inc.: Great. I just had one for Sheryl. Sheryl, you mentioned that Marriott and MercadoLibre are both using DPA and seeing comparable ROI to paid search. That's a pretty incredible data point. So I guess the question is, what kind of lift in ROI and overall budget do you see as e-commerce or travel marketers migrate from your first few products, like custom audiences and other to DPA? And are the yields that you're getting from DPA ads higher than other formats like video and app downloads and those types of things? Thank you.
Sheryl K. Sandberg - Chief Operating Officer & Director: Our goal is to give marketers the highest return they can and over time to capture the amount of budget that's equivalent to the percentage of media time we capture and we're not there. Consumers have shifted to mobile and consumers have moved to Facebook and Instagram more quickly than ad budgets. And that's the opportunity we have in front of us. What product you use really depends upon what you're trying to do. If you're trying to tell a brand story, then you want to do a video ad. If you're trying to sell a direct product, then you want to use DPA ads. And all of these products and all of the underlying targeting like custom audiences are designed to help people meet different objectives and we're trying to be really clear on that. If you're trying to move a brand objective, if you want to move favorability or brand sentiment, we can do that and that's often a video ad or one of our branded ads where you optimize for brand awareness. If you're trying to sell a product, you might want to use carousel ads or dynamic product ads. And the targeting that is custom audiences underlies all of our product offerings. So our goal is to have lots of different things we can do for our marketers and measure them really deeply all the way through to business results.
David M. Wehner - Chief Financial Officer: And – sorry, Ross, you just asked about yields. The way the auction system works is going to just be whatever is the ad that is going to necessarily have the best return is going to win in the auction. So it doesn't necessarily mean you're paying a premium for a given product and so if we've got a good DPA ad that might win in the auction for a given user.
Deborah Crawford - Director-Investor Relations: Operator, we have time for one last question.
Operator: Certainly. The final question is from Mark Mahaney with RBC Capital Markets. Your line is open.
Mark S. Mahaney - RBC Capital Markets LLC: Okay. Let me try going back to future use cases and, Mark, I think this was touched on a couple times. But can you talk about whether you're seeing greater attempts to do Search, the Search functionality on the site and how that could change over the next three years to five years, and also comment on news and to the extent to which you're seeing a rising utilization by regular users of Facebook as a way to get news and what you can do to make that even easier for people if that's something a behavior you want to facilitate? Thank you.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: Sure. So on Search, we already have one very big use case which is people basically using our search engine to look out pages and people who are on Facebook and that by itself is already one of the biggest search engines in the world. The next big use case that we've really been working on for a couple of years now and I think is going to – is starting to roll out and is growing quickly is people finding content on Facebook. So that's trending. It's people finding post that their friends or others had posted in News Feed that they saw but then might want to go check out later. And I think this is going to be a very important part of the video experience as well, because one half is pushed, right, going to News Feed and not asking for content but just coming across and discovering it. And then the other half is pull, right, and going to some experience where you're asking for some type of content and getting to a point where we can do that very well is just going to add a whole new dimension to the service. So that's something I remain very excited about. In some ways, it's taken a little bit longer than I'd expected to get to a point where it's growing quickly. The people and page lookup part is doing very well, the post part has taken a bit longer but I'm very excited about that going forward. In terms of news, I mean the biggest issue with news today in Facebook is that it is the slowest part of the experience, right? When you go to load a video and it loads quickly, we made it auto-play to load even quicker. You tap on a photo, you expect it to expand immediately, but you tap on a link, and often it can take 10 seconds to load and if you're on a 2G connection somewhere in the developing world, that could take 30 seconds to load. So the big initiative that we have here which I'm really excited about is Instant Articles and the big thing that that does is just it lets publishers basically put the content on our servers ahead of time and that way when people tap on it, it loads instantaneously. And it can be a much more immersive experience and we've already found from the initial experiments that we've done that the engagement is positive and we're starting to roll that out more broadly. So I think that that's going to be a really big deal for improving the experience of reading news on Facebook and it's something that we've been working on for a while, and I'm very excited about it. So, yeah, I would expect that we will see an expansion of sharing and consumption of all of the different types of things that you asked about: news, video, search and the different experiences there, and these are some of the big areas that we're investing in and they're long-term investments and they're big investments and we're going to keep on pushing on them, but I think that's what we need to do to serve our community well and ultimately connect everyone in the world. So thank you, guys.
Deborah Crawford - Director-Investor Relations: Great. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again.
Operator: Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines. | [
{
"speaker": "Executives",
"text": "Deborah Crawford - Director-Investor Relations Mark Elliot Zuckerberg - Chairman & Chief Executive Officer Sheryl K. Sandberg - Chief Operating Officer & Director David M. Wehner - Chief Financial Officer"
},
{
"speaker": "Analysts",
"text": "Eric J. Sheridan - UBS Securities LLC Heather Anne Bellini - Goldman Sachs & Co. Douglas T. Anmuth - JPMorgan Securities LLC Brian Nowak - Morgan Stanley & Co. LLC Justin Post - Bank of America Merrill Lynch Anthony DiClemente - Nomura Securities International, Inc. John Blackledge - Cowen & Co. LLC Paul Vogel - Barclays Capital, Inc. Rich Greenfield - BTIG LLC Mark A. May - Citigroup Global Markets, Inc. (Broker) Ross Sandler - Deutsche Bank Securities, Inc. Mark S. Mahaney - RBC Capital Markets LLC"
},
{
"speaker": "Operator",
"text": "Good afternoon. My name is Chris and I'll be your conference operator today. At this time, I would like to welcome everyone to the Facebook Third Quarter 2015 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford - Director-Investor Relations",
"text": "Thank you. Good afternoon and welcome to Facebook's third quarter earnings conference call. Joining me today to talk about our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements and actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and in our quarterly report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I'd like to turn the call over to Mark."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "Thanks, Deborah, and thanks, everyone, for joining us today. This was another good quarter, and we continue to grow the size and engagement of our community. 1.55 billion people now use Facebook every month and more than 1 billion people use Facebook every day. On mobile, we continue to have a lot of momentum. 1.39 billion people now use Facebook on mobile devices, including more than 1 billion on Android. 50 million people also use Facebook Lite, our app for people on low bandwidth connections and one of our fastest-growing interfaces. This is a great sign for how our mobile strategy continues to make progress across markets, devices and platforms. When it comes to our business, we're also pleased with our results. This quarter, total revenue reached $4.5 billion and advertising revenue grew by 45% from a year ago. We've already accomplished a lot this year, and these results show how we're getting stronger as a community and as a business. But we want to serve the entire global community, not just the people who are on Facebook today. Connecting everyone is one of the fundamental challenges of our time and to achieve this, we need to continue innovating faster and investing for the long-term. That means continuing to invest in our core products and services as well as technologies and strategies that allow us to achieve a truly global reach over time. Let's talk about how we're doing this, and let's start with how we're improving our core products to better serve our existing communities and businesses. This quarter, we introduced some big updates on Facebook to give people more options for expressing themselves. We began rolling out an improved mobile profile design, including the ability to add a profile video instead of just a photo. We also started testing Reactions, a new version of the Like button that provides more ways for expressing love, awe and sympathy. We think this is going to provide a much more engaging experience. Another way we're working to improve people's experiences on Facebook is by helping them to share many different types of content with different groups of people they care about. One example is our progress with Groups on Facebook. More than 925 million people now use Groups each month. In some countries, more than half of the population is participating. From a youth organization in Chicago to aid workers dealing with the refugee crisis in Europe, we've seen many inspiring examples of people using Groups to collaborate. Video is another area where we continue to make progress. On average, there are now more than 8 billion daily video views on Facebook and more than 500 million people who are watching daily. To offer even more engaging video experiences, we've added live video to our Mentions app for public figures, and we now support interactive 360 videos in News Feed. We've also rolled out new video tools for pages and begun testing a dedicated video section on Facebook. Over the next few years, video is going to be some of the most engaging content online, and by continuing to innovate here, we have a chance to build the best place to watch and share videos. When it comes to serving businesses, we continue to create a lot of value. We now have more than 2.5 million active advertisers on Facebook and more than 45 million small and medium-sized businesses actively using Facebook pages. This quarter, we continued to focus on helping marketers achieve results while using our ad product, including video and carousel ads as well as on Instagram, and as usual, Sheryl is going to talk more about this in a moment. Now, let's talk about how we're working to develop our next generation of apps and services. For Instagram, this was a busy quarter. The community celebrated its five-year anniversary and reached a new milestone of 400 million monthly actives. More than 80 million photos are now shared on Instagram every day, and the pace of adoption among public figures, organizations and people around the world continues to grow really well. When President Obama visited Alaska in September, he used Instagram to document his trip, and this is a great example of how Instagram is changing the way that people see the world. With our efforts in messaging, we're also making progress at building WhatsApp and Messenger both into great platforms of global scale. Last quarter, WhatsApp reached 900 million monthly actives and continues to be on a path to reach 1 billion people and beyond. Messenger has over 700 million monthly actives, and we continue to focus on improving the core messaging experience. A good sign of our progress is the more than 9.5 billion photos now sent monthly on Messenger. We're also building many different tools that can offer useful experiences to people beyond just traditional messaging. One example is M, a digital assistant we introduced this quarter that over time will use AI to help people complete tasks. Finally, let's talk about some of our longer-term efforts in innovation to help connect the world. With Internet.org, we have a lot of momentum. We've now rolled out free basic Internet services to people in 29 countries, and overall brought more than 15 million people online. As we rolled out the program, we've made a number of improvements based on feedback from communities and partners, including opening up our platform for free basic services to all developers who want to build. Meanwhile, our work on new technologies to connect people in the most remote regions continues to make progress. This quarter we revealed Aquila, our first aircraft designed to beam internet into communities down from the sky. And we also announced a partnership to bring internet to large parts of sub-Saharan Africa using a satellite, which is launching next year. And with Oculus, we're in a great position to begin delivering a new generation of shared immersive experiences, we plan to ship the Rift headset early next year. And Gear VR, our mobile product with Samsung, is going to have its first consumer release this holiday season retailing for $99. And we also announced new partnerships with Minecraft, Netflix and Twitch and many other content partners. Virtual reality has the potential to be the next computing platform that changes all of our lives. It's important also to recognize that this is going to grow slowly, like computers and mobile phones when they first arrived. So we're committed to Oculus and virtual reality for the long-term. So that's how we've continued to make progress on our strategy this quarter. The results we've achieved show that our investments are creating a lot of value for our community and the world. I just want to thank the entire Facebook community, our employees, our partners and our shareholders for helping us to continue moving forward. We've done a lot, but there's always more to do. And now I'm going to hand it off to Sheryl."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "Thanks, Mark. And hi, everyone. We had an excellent third quarter. Results were strong across the board. Ad revenue grew 45% year-over-year or 57% on a constant currency basis. Mobile ad revenue was $3.4 billion and grew 73% year-over-year. Mobile now makes up 78% of our total advertising revenue. Our business grew across all regions and marketer segments. Like last quarter, we saw especially strong growth in our North America and Asia-Pacific regions. Overall, we're really pleased with marketer adoption of our ad products around the world. Our results show that we continue to make progress on our three priorities: capitalizing on the shift to mobile, growing the number of marketers using our ad products and making our ads more relevant and effective. First, capitalizing on the shift to mobile. People have already shifted to mobile and this shift is driving engagement on Facebook. The average American adult spends 25% of their media time on mobile, and Facebook and Instagram together continue to account for over one minute in five minutes on mobile in the U.S. Businesses are lagging behind consumers in making this shift to mobile, and we believe we're well positioned to help them catch up. Facebook Pages are already the mobile solution for millions of businesses. Pages now offer better messaging capabilities, call-to-action buttons and news sections that enable businesses to highlight important information. We're also capitalizing on the shift to mobile by expanding ads on Instagram. This quarter on Instagram, we introduced new ad formats and objectives, opened up our API and launched self-serve ad capabilities. Instagram ads are now available in all countries where we offer Facebook ads, and marketers can manage campaigns across both platforms with the same targeting. We're really pleased with the marketer demand for Instagram ads. Our second priority is growing the number of marketers using our ad products. In September at Adweek, we announced that we have over 2.5 million active advertisers on Facebook. With more than 45 million active SMB Pages on Facebook, we think there's a lot of opportunity to turn even more of these businesses into marketers. Marketers come to Facebook and Instagram because we have the best performing mobile ad products, and video is making them even better. Marketers have always loved using video to tell stories. As Mark discussed, video is a natural and growing part of our mobile News Feed experience. Video on Facebook gives marketers not just mass reach, but better cross-device targeting and measurement than we believe is available on any other platform. We're especially pleased with the breadth of marketers using video on Facebook, from brands to direct response to SMBs. Over 1.5 million small businesses posted video, which includes organic video posts and video ads on Facebook in the month of September alone. Video ads complement TV ads. According to a recent study with Nielsen Research, marketers using Facebook ads with TV ads saw higher reach, ad recall, brand linkage and likeability. To share one example, GMC used video and other ads on Facebook to extend the reach of their TV brand campaign highlighting their premium trucks and SUVs. The Facebook campaign drove a 13-point lift in ad recall and a 6-point lift in brand favorability. We recently introduced target rating point, TRP, buying so that marketers can plan, buy and measure video ads on Facebook the same way they do on TV. We're pleased with the feedback we're receiving on this from marketers and agencies. Our third priority is making our ads more relevant and effective. We know relevant ads are more engaging for people and, therefore, drive better results for businesses. Products like carousel ads and dynamic product ads help improve effectiveness for marketers. Carousel ads show multiple images and now videos and drive 30% to 50% lower cost per conversion than single image link ads. Dynamic product ads, which allow marketers to upload their product catalog, are driving ROI comparable to Search. For example, Marriott uses DPA to re-target travelers based on their travel search habits and they are now scaling globally across their portfolio of brands. LatAm e-commerce company, MercadoLibre, uses DPA to re-market over 38 million products in over 13 countries. Both are seeing high ROI and continuing to invest. On the measurement side, Conversion Lift is helping clients see the real business results from their campaigns. Boost Mobile, a Sprint brand, showed ads to people eligible for device upgrades. Using Conversion Lift, they were able to attribute a 4% lift in in-store sales to their Facebook campaign. Finally, we're continuing to invest in ad tech across Atlas, LiveRail and the Audience Network. This quarter, we expanded the ad formats publishers in the Audience Network can add to their mobile apps. On LiveRail, this quarter we began testing age and gender targeting. LiveRail can now deliver over 90% accuracy on age and gender segments across desktop, mobile web and mobile apps versus a non-target rate of only 31% to 55% when not using LiveRail technology. I want to take a moment to thank our clients around the world for their continued partnership and congratulate our global Facebook teams on great execution. Looking forward, we're going to stay focused on our priorities to continue to build a solid foundation for our long-term business. Now here's Dave."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Thanks, Sheryl. And good afternoon, everyone. Echoing Mark and Sheryl's comments, Q3 was another strong quarter for Facebook. We generated $4.5 billion in revenue and over $1.4 billion in free cash flow. Growth and engagement of our community again provided a great platform for our strong financial performance this quarter. In September, we reached a new milestone with over 1 billion people using Facebook on an average day, an increase of 17% compared to last year. This daily number represents 65% of the 1.55 billion people who used Facebook during the month of September. Mobile continued to drive our growth. In September, approximately 1.39 billion people accessed Facebook on mobile devices, up 23% from last year. Additionally, our next generation of services continued to grow, with Instagram, Messenger and WhatsApp now exceeding 400 million, 700 million and 900 million monthly actives respectively. Now turning to the financials. All of our comparisons are on a year-over-year basis unless otherwise noted. Additionally, our non-GAAP measures exclude stock-based compensation and the amortization of intangibles. Total revenue was $4.5 billion, up 41%, or 51% on a constant currency basis. Ad revenue was $4.3 billion, up 45%, or 57% on a constant currency basis. The strengthening of the U.S. dollar continued to have an unfavorable impact on our revenue in Q3. Had foreign exchange rates remained constant with Q3 2014 levels, our total revenue would have been approximately $340 million higher. Regionally, U.S. and Canada and Asia-Pacific were our strongest markets, producing ad revenue growth of 56% and 48% respectively. Europe and Rest of World grew more slowly at 33% and 29% respectively, impacted by our currency exposure in both of those regions. As Sheryl mentioned, mobile continued to drive our revenue growth. Mobile ad revenue was $3.4 billion, up 73% from last year representing 78% of our advertising revenue. Revenue from ads served on personal computers was down approximately 8%. We have been very pleased with the sustained high growth of mobile advertising revenue. There are a number of important factors contributing to that growth both from the supply and demand side. The drivers of year-over-year mobile revenue growth fell into three main categories. First, as Sheryl covered, we have continued to have success driving strong advertiser demand. Second, we've grown both the number of people using Facebook and the time that they spend with us. And third, the growth in advertiser demand and ad quality has enabled us to increase ad load over time. As we have grown mobile advertising, we have remained very pleased with overall engagement levels, user satisfaction with News Feed and the overall quality of the ads themselves. Turning now to our overall price/volume metrics. In Q3, the average price per ad increased 61% while total ad impressions declined 10% on a year-over-year basis. As I've indicated on prior calls, the changes in our reported price-volume metrics have been driven recently by the change in the number of right hand column ads and the shift to mobile. These factors will have a less significant impact on the reported price-volume metrics going forward now that a full year has elapsed since the redesign of right-hand column ads, and now that mobile impressions have grown to become the majority of impressions. In fact, the quarter-over-quarter trends already point to that. In Q3, total ad impression increased 7% sequentially and average price per ad increased 5%. Total payments and other fees revenue was $202 million, down 18% compared to last year. The decline was expected and was driven by a reduction in payments revenue related to games played on personal computers. Turning now to expenses. Our Q3 total GAAP expenses were $3 billion, up 68%, and non-GAAP expenses were $2.1 billion, up 51%. Similar to last quarter, stock-based compensation and amortization expenses related to the WhatsApp acquisition contributed significantly to the year-over-year growth in GAAP expenses. Non-GAAP expenses were driven by increases in head count related costs, cost of revenue and marketing expenses. We ended Q3 with nearly 12,000 employees, up 44% compared to last year. We added over 1,000 employees to Facebook in the quarter and we are pleased with the continued strength in our recruiting efforts. Our Q3 GAAP operating income was approximately $1.5 billion, representing a 32% operating margin. Our non-GAAP operating income was $2.4 billion, representing a 54% margin. Our Q3 GAAP and non-GAAP tax rates were 37% and 32% respectively. Our Q3 GAAP net income was $896 million or $0.31 per share, and our non-GAAP net income was $1.6 billion or $0.57 per share. In Q3, capital expenditures were $780 million as we continued to invest in servers, network infrastructure, and the build-out of data centers and other facilities to support the rapid growth of the business. We generated $1.4 billion of free cash flow and ended the quarter with over $15.8 billion in cash and investments. Turning now to the revenue outlook. We remain focused on growing the number of people who use our services, increasing advertiser demand and improving the quality and relevance of our ads. Across these dimensions, we continue to see healthy growth opportunities ahead for Facebook and Instagram. Given the strengthening of the U.S. dollar over the past year, we will continue to face currency headwinds next quarter, particularly in Europe and Latin America. In addition, we expect our total payments and other fees revenues to decline sequentially from Q3 to Q4, similar to the trend that we have experienced over the last couple quarters. Now, turning to the expense outlook. We expect the year-over-year growth rate for total full year 2015 GAAP expenses to be approximately 55%, and for total full year non-GAAP expenses to be approximately 50%. We anticipate our 2015 capital expenditures will be in the range of $2.5 billion to $2.7 billion. We continue to expect our 2015 stock-based compensation to be in the range of $3 billion to $3.2 billion, approximately half of which is related to our prior acquisitions, most notably WhatsApp. We expect amortization expenses for the full year 2015 to be approximately $700 million to $800 million. And lastly, we anticipate our Q4 and full year 2015 GAAP and non-GAAP tax rates to be several percentage points above the respective Q3 rates. In summary, Q3 was another strong quarter for Facebook. We are pleased with the growth and engagement of our community and the momentum in our business, which together support our ability to continue investing to build our next generation of services and execute on our mission of connecting the world. With that, operator, let's open up the call for questions."
},
{
"speaker": "Operator",
"text": "Thank you. Your first question comes from Eric Sheridan with UBS. Your line is open."
},
{
"speaker": "Eric J. Sheridan - UBS Securities LLC",
"text": "Thanks for taking the questions. Mark, maybe one for you and one for Sheryl. For Mark, on virtual reality and Oculus, how do you see the development of the entertainment and content ecosystem around virtual reality playing out in 2016 and beyond? And what's the role Facebook's going to have to play in maybe seeding some of the content and entertainment side of VR. And then for Sheryl, any color you can give us on Instagram? We've obviously seen a ramp-up now in advertising on the property. How the company's thinking about ad load monetization, some of the opportunities and how those will be balanced against engagement. Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "I can start off talking about Oculus and virtual reality. So the first thing that I want to stress here is that these kind of new platforms take a long time to develop. So we've said often that we think that virtual reality and augmented reality could be the next big computing platform. But just to put that in perspective and compare it to the development of previous computing platforms like phones and computers, I think the first smartphones came out in 2003, and in the first year, I think BlackBerry and Palm Treo were the initial smartphones that came out. And I think they each sold in the hundreds of thousands of units. So just to kind of give a sense of the timeframe that we're thinking about this and how we expect this to develop, that's how we're thinking about that. In terms of the actual content, first, we think gaming is going to be the most obvious market. There are around, I think, more than 200 million, almost 250 million people who have either an Xbox, a PlayStation or a Wii, and we think that that audience is going to the type of people who are going to be very excited about the type of experiences initially that you can have with virtual reality. And the advantage of that is also that some of those can be single player experiences. They don't require a big network effect or a lot of people having the technology or a large installed base. Once we start getting a bit further along with that, then the next thing that we think is going to be huge is video and immersive experiences, both things that people can create, like the social content that they share on Facebook today, and more professional and premium content both short form and longer form. But we'll start to see some experimentation with that. There already is some very good content. But until there are millions of units out in the market, I don't expect that to be a big industry for folks to be investing a huge amount in 2016. Then when they're starting to get to be more units, just like every other major computing platform before that, what we expect is that a large portion of what people do in it will be communication and social behavior, and that's where Facebook really has the DNA and experience to, I think, build the best experiences. And we're investing in trying to figure out what that's going to look like, and that's ultimately a lot of what we're extremely excited about for a number of years down the road."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "On Instagram, we think that with Facebook and Instagram, we now have the two most important mobile platforms out there. And what we bring to this is a common ad infrastructure. So Instagram ads, now that we've rolled out as we have this past quarter and gotten to a really good product offering, combined the creative format of Instagram which is very visually compelling and has a lot of engagement from people with the back-end infrastructure and marketer base that Facebook has. So now, we have self-service ads rolled out. We've rolled out in all countries where we offer Facebook ads. We have new ad formats for Instagram. We're able to do more business objectives, all of which can use the same targeting as we have on Facebook and all of which are increasingly tapping into our measurement capabilities. On ad load, we have a lot of experience rolling out ads into feed-based products and we monitor it very carefully and we're going to continue to monitor really carefully. We're also excited about how they work together. Just to share one example, American Express working with Digitas, rolled out carousel ads on Instagram that targeted travel-related interest groups for people who are 18 years and older. They then retargeted those same people on Facebook. And what they created was a really visual journey using the format that is Instagram, the format that is Facebook and combining the two platforms that they're targeting. We think we're at the very beginning of what's possible when we combine these two."
},
{
"speaker": "Operator",
"text": "The next question is from Heather Bellini with Goldman Sachs. Your line is open."
},
{
"speaker": "Heather Anne Bellini - Goldman Sachs & Co.",
"text": "Great. Thank you. I had two quick questions as well. One, Sheryl, just to follow up on what you mentioned about Instagram, obviously, it's a very visual experience. I'm just wondering, when you're talking to advertisers, are they viewing this as a separate channel? So I think there's been some questions as to the incremental nature of Instagram. And it would seem like it could be extremely incremental, given these are the two top platforms in mobile. So I was wondering if you could talk a little bit about what the advertisers say about blending the experiences. And also, a question for Mark. I was just wondering if you could share with us how we might see your content strategy evolve over time and, in particular, just wondering what your view is on longer form content on the video side, sorry. Thank you."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "Yeah. To the Instagram question, what we see in the short run is that some of the spend on Instagram is incremental to Facebook and some isn't. Some clients are comfortable with Instagram and bringing a new budget to bear. Some clients are shifting some of their Facebook budget. For us in the medium to long run, we believe that we're not competing between Facebook and Instagram. We're competing with other forms of media. And if you want the most eyeballs and we think the highest ROI, over time we think that will benefit Facebook and Instagram. And so, for us, what we really want is people to experiment and learn and get to experience Instagram as they have on Facebook so that we can make the case that we can improve the ROI and then we believe if you look at the consumer metrics of where people were spending their time, we will be able to gain share compared to almost anything else you can buy out there."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "And to your question about long form content, the more natural starting point for us is shorter form content which can either be social content or premium short form content. But some of – the vast majority of the content that's consumed on Facebook just talking about video right now is people browsing through feed. They discover something interesting that they weren't necessarily looking for previously that's very powerful because that's a behavior that there isn't really anywhere else to do at scale on the Internet today in a great way, and then people watch it there or they bookmark it to watch later. But if you're talking about watching inline and feed, that's not the place where you're necessarily going to see a TV show and then watch an hour-long clip right there. So what we're actually seeing is that a lot of the best or at least from my perspective, TV shows that we see folks like Jimmy Fallon breaking up their show into clips that they can now share to be consumed over social media and on the Internet in three-minute to five-minute or seven-minute segments which are more of what people want when browsing through News Feed. So I do think over time we will get to more different types of content and we'll build products that serve that. The current market of trying to help people share and experience all these shorter form clips is massive. We are nowhere near serving that as well as we want to. So I actually think in a lot of ways though the more interesting question is not in the near-term what we're going to do to develop ways to consume long form content, but what traditional media and content producers who have traditionally produced short and long form content are going to do to chunk their stuff up better so that way it can be more easily consumed by this big community online."
},
{
"speaker": "Operator",
"text": "The next question is from Douglas Anmuth with JPMorgan. Your line is open."
},
{
"speaker": "Douglas T. Anmuth - JPMorgan Securities LLC",
"text": "Thank you for taking the question. One for Mark and then one for Dave. Mark, you recently spent time in China and India. And I was hoping to get some of your key takeaways both in terms of Internet.org and then also about Facebook's potential in China. And then secondly, Dave, I was hoping to get some early thoughts on OpEx for 2016, at least perhaps qualitatively, if you could walk us through some of the puts and takes for next year, Oculus in particular. Thanks."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "Sure. I can start off with the India and China question. So they are very different situations. So India is a unique country where there are 1.25 billion people, more than 1 billion of them are not on the Internet. So it is the country in the world that benefits the most from connectivity. And there's a lot of research that we've seen and reports that third parties have put out that show, that when you connect to place like India, it makes a very big difference socially and for the economy there. A lot of us here, everyone we know is on the internet and we think about the internet as entertainment and basic communication but if you don't have access to a good school, then getting basic Internet access could be your best educational information or if you don't have access to a good doctor, then getting access to the Internet could be the only way that you can learn about how to avoid certain diseases or how to raise your kids and help them avoid certain diseases and find jobs and a lot of stuff. So what we find through the research is that for every 10 people who get connected to the Internet, just a little less than or right around one person gets lifted out of poverty and one new job gets created. So we're very focused on this. It's a huge priority for the Indian government and anything that we can do to help there, we think is very good for the world and we're invested in that, and we're happy to support. So in Internet.org in India now, there are already more than 1 million people who now have access to the Internet who didn't otherwise because of our efforts, so we're proud of that but obviously that's still very early on. We're only working with one operator currently in part of the country. So there's a lot of room to expand that and that's just a big opportunity for the Internet overall and for India over the next decade and we hope to play a role in that. On China, that is a more complex situation. Obviously, you can't have a mission of wanting to connect everyone in the world and leave out the biggest country. So over the long-term, that is a situation that we will need to try to figure out a way forward on. For now, the thing that I would leave you with is that people think that Facebook isn't in China at all and that's actually not true. Our consumer service isn't active there, but it actually is already one of the biggest advertising markets that we have. Because there are a lot of really big and important Chinese companies who sell a lot of products to people outside of China, and they use Facebook as one of their primary tools in a lot of cases to spread information about what they're doing and grow their customer base. So we're happy to do whatever we can to help develop the economies in both of those countries and they're both long-term efforts for us."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Doug, on your question on 2016, we're not going to obviously give specific guidance at this time, that'll be coming with our Q4 call. But we're focused on continuing to invest heavily in the business across our near, mid and long-term opportunities and we see a bunch of great opportunities to invest there. So in the near term, we're focused on growing the community and executing on our existing business. In the medium-term, we're focused on those next generation of services, Instagram, Messenger and WhatsApp. And in the long-term, we've got the investments we're making and things like artificial intelligence, VR, and obviously the Internet.org efforts that Mark just spoke about. Specifically with regards to Oculus and how that could impact the plan for next year, we're, as Mark said, very bullish about the long-term opportunity for VR and excited about the launch for the Rift next year. But VR is still very much in the development stage. So it would be early to be talking about large shipment volumes."
},
{
"speaker": "Operator",
"text": "The next question is from Brian Nowak with Morgan Stanley. Your line is open."
},
{
"speaker": "Brian Nowak - Morgan Stanley & Co. LLC",
"text": "Thanks for taking my questions. I have two, one for Mark and one for Sheryl. Mark, can you talk a little about what factors and metrics you consider when you're thinking about a multi-app strategy versus rolling out more products and offerings on Facebook? There's a difference in Facebook Paper, Messenger, the video viewer on the platform. Just be curious how you think about multi-app versus adding more functionality to the mothership. And then for Sheryl, it sounds like there's still a lot of SMBs on the platform that are not yet paying advertisers. Can you talk about some of the biggest hurdles you need to overcome to get more SMBs paying and initiatives you have in place? Thanks."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "Sure. So I can talk to the multi-app question first. So we view the social space as almost this matrix. You can think about it as a two-dimensional grid where one axis is the richness of the content that people want to share, then other axis is the size of the audience, or intimacy of how people want to share. So on the first axis, you get everything ranging from text to links, to photos, to videos, to immersive 360 videos and virtual reality content and this progression. And on the other axis, you get everything ranging from one-to-one messaging to small group communication, to communicating with all your friends at once, to big interest groups, to completely public. And what we believe is that you can intersect at any point on that. And there will be something interesting to build. So a small group product for sharing video, that's going to be a thing. A one-on-one product for sharing text or calling, that's clearly a thing. A public sharing and consumption product for video, that's a thing. And what we've tried to do is basically figure out the areas that we think are open and are not currently served by the set of products that the industry has built and figure out a way to offer those. So one of the big opportunities that I'm really excited about right now is I think that there's a pretty big opening between very private messaging, the one-on-one messaging products like Messenger and WhatsApp, and products like Facebook where you share with all your friends at once or Instagram. And in between there, what we're seeing is this huge growth of private groups, right, and Groups remains one of the I think least talked about products on Facebook. But I just said earlier that we have more than 900 million people are using that every month. It's a huge thing and it's a big area that we can develop going forward. So we experiment with all these things in terms of some of them make sense to naturally have inside the Facebook app because you're using the same set of friends and network and connections. Some of them get clear value by being separate, like Messenger, for example, where we can make sure that everyone has their push notifications turned on, which is extremely important for a messaging app. But overall, there's a lot of stuff in the space. And the amount that people want to share and communicate is boundless and that's I think partially why we're seeing the growth that we are with so many of these products."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "On SMBs, I think it's one of the most compelling opportunities we have for Facebook and that's because I think we solve a really big problem for SMBs, which is how are they going to reach customers. In the United States, which is usually the most advanced market, 35% of small businesses have no web presence at all. And building a mobile presence is even harder than a web presence because most people don't use the mobile web and mobile apps are expensive to build and hard to get people to use, especially if you're a small business. That's why there are 45 million SMB pages on Facebook. These are people who are using Facebook and this free product to create an online and increasingly a mobile presence. And then our job is to make sure that free product works for them and then over time bring them into our paid products. We have 2.5 million advertisers and over 80% of them started on Pages and then started with simplified ad products. And that's what we've done over time and we'll continue to do that. And what you see is that it's as easy for them to use it as profile and we can give them opportunities to do things they otherwise couldn't do. So to what I said in my transcript before, 1.5 million SMBs posting videos in one month alone. 1.5 million SMBs have not posted or created video on any other platform, but with us it's cheap, it's very easy to use and that gives us a way to continue to work with SMBs and increasingly grow our business with them."
},
{
"speaker": "Operator",
"text": "The next question is from Justin Post with Bank of America Merrill Lynch. Your line is open."
},
{
"speaker": "Justin Post - Bank of America Merrill Lynch",
"text": "First, Mark, could you talk a little bit about how much activity you see around Events on Facebook and maybe your views on whether Facebook could benefit from political activity or advertising? And then, Sheryl, could you talk a little bit about where ad loads are today? Is there still room there? And also just what your feedback you're getting on advertiser ROIs, is there still more room there? Thank you."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Yeah, sure. I'll start with the question on ad load. It's Dave and then Sheryl can follow up on the political question. So, yeah, so, Justin, over time ad load has been one of the factors driving year-over-year growth. It's just worth noting that it is up significantly from where we were two years ago. Looking forward, we continue to feel like there are good opportunities to grow the business. I talked about the three factors that contributed to growth this quarter: ad demand, users and engagement and ad load. And we see all of those continuing to be factors for growth going forward. And then, Sheryl, did you want to take the question on the political?"
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "Yeah. And I'll take Events, too. Just as Mark said with Groups, Events are growing quickly on Facebook. We don't break out by product, but we're pleased with the growth. On the elections and political activity and political advertising, we're excited about the elections because we think we give politicians and people a really compelling way to interact. If you wanted to feel like you were interacting with someone running for office before, you had to go to a town hall meeting. And increasingly, that's happening on Facebook. So between January 1 and October 7 of this year, over 68 million people on Facebook in the U.S. made over 1 billion interactions about the campaign alone, and every candidate and every member of Congress is on Facebook now. In terms of the revenue impact, no one vertical drives our business. We have a very large and diversified business. But we think we offer something pretty compelling, which is the reach of Facebook with very unique targeting. So on Facebook, you can target an ad by district, by interest. Ben Carson ran 240 different ads targeted at different audiences, and so we're starting to see candidates use our platform to communicate, to advertise and to share."
},
{
"speaker": "Operator",
"text": "The next question is from Anthony DiClemente with Nomura. Your line is open."
},
{
"speaker": "Anthony DiClemente - Nomura Securities International, Inc.",
"text": "Thank you very much. Mark, on the subject of media content on Facebook, it seems like the big opportunity is for Facebook to be the portal with which to access the short form video content that you mentioned earlier, and maybe the idea is to keep the consumption of that content in line or inside the Facebook wall, the garden. So the follow-up question that I would have is how do you think you could best partner with the media providers and convince them the merits of bringing their valuable, in some cases expensive, content into the Facebook world, particularly at a time in media when they're really trying hard to guard their own existing ecosystems? And then a question for Sheryl. I wonder if you could just touch on the relative growth of branded advertising versus direct response ads. You mentioned total ratings point buying. Can you help us think about the mix of branded versus DR? And for you, do you think that TRP buying and video is going to shift your ad mix more towards branded over time? Thanks."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "I can talk about video and the business model around that. So you're definitely right that there's a certain class of content which is only going to come on to Facebook if there's a good way to compensate the content owners for that. And we've recently rolled out the business model for this, which is for premium content, we'll give a revenue share on a portion of the views to the content owners. And we've got good feedback so far on that. We're working with a small set of partners to start, and we'll roll it out beyond that as that keeps on going. But it's important to keep in mind that there are a few different reasons why people share content on Facebook, and that's just one of the use cases, right? There are a lot of people who are just sharing content socially, right, because they want to get a message out. That may not be business motivated. There are a lot of folks who are business motivated but who primarily post content in order to promote something or gain distribution for something. And that you can gain value without some kind of rev share, and that's why the video ecosystem has grown so quickly even before we rolled out a revenue share. And now the third class of content, which I think is going to be important and increasingly important over time is the one that you basically want to essentially trade the content for money, and that is one where you need the rev share to unlock that. But we're getting good feedback on that upfront. So we're looking forward to seeing how that trends."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "On our marketer segments, we don't break out by segment, but all of our marketer segments are growing. We're seeing strong growth in brand, and we believe that's because we're delivering on the promise of personalized marketing at scale. So we've worked hard on things that will help brand purchasers feel comfortable on the platform and measure their ROI. So that's where TRP buying comes in, allowing people who usually buy TV ads to plan, buy and measure Facebook ads the same way, enables apples-to-apples comparison that we believe is very strong for our ROI. We've also worked on brand awareness optimization, mobile polling to measure campaign effectiveness, and we're working client by client. Our other segments are growing as well. We're working hard in the direct response area, rolling out things like carousel ads and dynamic product ads. And one thing that's worth understanding is that all of these different marketer segments often work together. So to share one example, IKEA wanted to boost their online sales when their stores were closed. So in Norway, most retailers are closed Saturday to Sunday night. So they invested in carousel ads and only show them when their stores were closed and they turned a $35,000 investment in carousel ads into $2 million in sales which happened precisely when they want it to happen. That's a direct response ad buy because it's very specific carousel ads product but it's also a brand play for them as they strengthen their brand and get people to interact with them as they want them to."
},
{
"speaker": "Operator",
"text": "The next question is from John Blackledge with Cowen & Company. Your line is open."
},
{
"speaker": "John Blackledge - Cowen & Co. LLC",
"text": "Great. Thank you. Two questions. So with the explosive video consumption growth and growth in public content being consumed in the News Feed, could engagement perhaps materially increase from current levels over the next couple years? And then on WhatsApp, as it heads towards 1 billion MAUs, and/or greater, could you give us a sense of how you're thinking about monetization of that platform and perhaps timing of the monetization? Thank you."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "On engagement, John, I think we're obviously focused across a number of different dimensions to drive engagement. Videos had a big contribution there. So that's certainly been helpful in terms of making News Feed even more engaging and we'll continue to be focusing on a number of initiatives, public content and just sharing with your friends. So there's lots that we are working on on engagement that continue to drive time spent. On WhatsApp, I don't think there's a particular magical number with 1 billion users. The focus really for our messaging products is to continue to drive user growth and continue to build great products that are fast, useful, engaging and fun. And on that front, they're both doing great. Messenger has over 700 million users and WhatsApp obviously has over 900 million users. So the business side is not the main focus right now, but we believe there are going to be opportunities as we further scale those properties."
},
{
"speaker": "Operator",
"text": "The next question is from Paul Vogel with Barclays. Your line is open."
},
{
"speaker": "Paul Vogel - Barclays Capital, Inc.",
"text": "Great. Thanks. Two questions. One, big picture, Mark, there's a lot of debate around what content is appropriate for Facebook to block and not block. I'm just wondering if you could talk a little bit about how you decide what to censor and not censor in terms of on the content side. And then less big picture, but just in terms of fourth quarter, given it's a big retail quarter, any increased testing around direct retail on the platform? Thanks."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "I can answer the policy question and then I guess Sheryl will take the other one. The guiding principle for us on this is that we want to give the most voice to the most people. And the idea is that there are all these different barriers that any given person has to being able to share and express everything that they want, from technical barriers, it's really hard to communicate with someone if you're not on the internet and they're far away, to product barriers, it's hard to share videos if we don't have a good product for sharing videos, to legal barriers, it's hard to share content that your government says is illegal for you to share. And at the end of the day, there's also policy and you're in a community and we have community standards for how we think people should communicate in order to be safe. Because even if you have all of the internet connectivity and the products and the legal framework that you need, if you don't feel safe saying what you want to express, then you're probably not going to share it. And we see a lot of that online and that's a pretty big issue from everything from bullying to terrorism, there are lots of reasons why people might otherwise have the tools to share what they would want but feel silenced. And that isn't giving the most voice to the most people. So we feel a responsibility to have policies for our community which limit hate speech and limit things which are going to create just an overwhelmingly uncomfortable environment for people that is going to silence other people's speech in order to make sure that over the long-term we are enabling the most people to be able to express as much as possible as they can. And that's the philosophy that we have."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "On commerce going into the holiday season, commerce is a really important vertical for us and we're working hard to make our ads more effective. So what we're seeing from DPA ads and carousel ads, we're really happy with. We're seeing lower cost per conversion. When people do multiple objectives and video, we're seeing lower cost per click than single image link ads. And importantly, we're also creating better experiences for people because when an ad is more targeted, more relevant, when you see a product you're interested in or a service you're interested in, that's a better experience. So we go into the holidays feeling that we have a really strong product offering, certainly the best product offering we've ever had to connect people to the products they're going to buy this holiday."
},
{
"speaker": "Operator",
"text": "The next question is from Rich Greenfield with BTIG. Your line is open."
},
{
"speaker": "Rich Greenfield - BTIG LLC",
"text": "Hi. Thanks for taking the question. When you look at ad quality, I think when Facebook started, Sheryl, you were really adamant that you were focused on improving the ad quality and really making sure you were serving the highest quality ad to the right person. When you look at Instagram, I felt like you took incredible care to make sure that the advertising, like every ad, was of the highest quality. And as you've opened up the API, there's a tremendous amount of ads, some of them incredibly good quality, but some of them of lesser quality. How do you work to make sure that Instagram maintains what you started it with, which is incredibly beautiful ads that fit the platform and so that you don't get criticized by users for pushing, not so much the amount of ads, but the type of ads?"
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "You're right. The quality is really important to us because your experience on Facebook or Instagram is about the quality of what you see, both in terms of the organic posts you see from your friends or public people you're following and the ads as well. And what we do is we monitor it carefully. We ramp slowly, we monitor engagement, sentiment, quality of ads. We get a lot of feedback directly from people who use Facebook. They can X out the ads. If they do, we ask them why they're Xing out the ads and we just continue to monitor the metrics. We're pleased with what's happened with quality on our platform overall. And a lot of the product innovations and investments I've been talking about on this call feed into quality. So the carousel ads, they're not just that they're showing multiple products, it's that they're showing products that are more specifically directed at the person. And so a lot of the underlying things we do to build our ad systems don't just feed into revenue, they feed into quality. And that's important because over the long run our quality today is our revenue tomorrow."
},
{
"speaker": "Operator",
"text": "The next question is from Mark May with Citi. Your line is open."
},
{
"speaker": "Mark A. May - Citigroup Global Markets, Inc. (Broker)",
"text": "Thanks. I had two, if I could. We noticed a very impressive acceleration in user MAU growth and focus in the quarter. It seemed like it was pretty much in every region of the world. What, if anything, can you attribute that to? I know that you seem to be running more TV ads, at least where I live. But wonder if anything you could attribute that to. And then secondly, again on video, as more and more people and businesses are uploading video, I assume that there's a lot of good video content on Facebook, but I don't see all of it. Question is really around video discovery. What strategies do you have going forward to improve video discovery from what is today more of a push-based model to something that may be akin to a pull-based model where I can enjoy all the great video content that's on Facebook? Thanks."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Hey, Mark, it's Dave. Just on the user growth point, we're obviously pleased with the growth we're seeing across the globe in terms of DAU growth. The three largest countries were India, the U.S. and Brazil. So we're seeing good diversified growth. I mean, specifically we've made a lot of initiatives to help improve and invest in the Facebook experience in emerging markets and that has helped drive some of the acceleration in growth. And so we've made a number of product and performance investments there with Facebook like being a good example of that. The question then was on video and discovery and..."
},
{
"speaker": "Mark A. May - Citigroup Global Markets, Inc. (Broker)",
"text": "Yeah."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "And also just on the growth point, I just think the team that's working on that is executing extremely well. I mean, sometimes it's not that you came up with some brilliant strategy, it's just like really good work consistently over a long period of time. So – and then I think they are. On video, yeah, right now the strength in our system is definitely through helping people discover content that they hadn't really asked for through News Feed. And a lot of, I think, what we need to do is give people a way to see all of the videos that page that they like or follow is interested in sharing on Facebook. And there's a pretty clear roadmap of stuff that we're going to do over the next couple of years that I'm quite excited about to add some more dimensions to the video experience on Facebook. But we're just so early in this right now. It's pretty amazing how quickly it's growing but there's a lot more to do."
},
{
"speaker": "Operator",
"text": "The next question is from Ross Sandler with Deutsche Bank. Your line is open."
},
{
"speaker": "Ross Sandler - Deutsche Bank Securities, Inc.",
"text": "Great. I just had one for Sheryl. Sheryl, you mentioned that Marriott and MercadoLibre are both using DPA and seeing comparable ROI to paid search. That's a pretty incredible data point. So I guess the question is, what kind of lift in ROI and overall budget do you see as e-commerce or travel marketers migrate from your first few products, like custom audiences and other to DPA? And are the yields that you're getting from DPA ads higher than other formats like video and app downloads and those types of things? Thank you."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "Our goal is to give marketers the highest return they can and over time to capture the amount of budget that's equivalent to the percentage of media time we capture and we're not there. Consumers have shifted to mobile and consumers have moved to Facebook and Instagram more quickly than ad budgets. And that's the opportunity we have in front of us. What product you use really depends upon what you're trying to do. If you're trying to tell a brand story, then you want to do a video ad. If you're trying to sell a direct product, then you want to use DPA ads. And all of these products and all of the underlying targeting like custom audiences are designed to help people meet different objectives and we're trying to be really clear on that. If you're trying to move a brand objective, if you want to move favorability or brand sentiment, we can do that and that's often a video ad or one of our branded ads where you optimize for brand awareness. If you're trying to sell a product, you might want to use carousel ads or dynamic product ads. And the targeting that is custom audiences underlies all of our product offerings. So our goal is to have lots of different things we can do for our marketers and measure them really deeply all the way through to business results."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "And – sorry, Ross, you just asked about yields. The way the auction system works is going to just be whatever is the ad that is going to necessarily have the best return is going to win in the auction. So it doesn't necessarily mean you're paying a premium for a given product and so if we've got a good DPA ad that might win in the auction for a given user."
},
{
"speaker": "Deborah Crawford - Director-Investor Relations",
"text": "Operator, we have time for one last question."
},
{
"speaker": "Operator",
"text": "Certainly. The final question is from Mark Mahaney with RBC Capital Markets. Your line is open."
},
{
"speaker": "Mark S. Mahaney - RBC Capital Markets LLC",
"text": "Okay. Let me try going back to future use cases and, Mark, I think this was touched on a couple times. But can you talk about whether you're seeing greater attempts to do Search, the Search functionality on the site and how that could change over the next three years to five years, and also comment on news and to the extent to which you're seeing a rising utilization by regular users of Facebook as a way to get news and what you can do to make that even easier for people if that's something a behavior you want to facilitate? Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "Sure. So on Search, we already have one very big use case which is people basically using our search engine to look out pages and people who are on Facebook and that by itself is already one of the biggest search engines in the world. The next big use case that we've really been working on for a couple of years now and I think is going to – is starting to roll out and is growing quickly is people finding content on Facebook. So that's trending. It's people finding post that their friends or others had posted in News Feed that they saw but then might want to go check out later. And I think this is going to be a very important part of the video experience as well, because one half is pushed, right, going to News Feed and not asking for content but just coming across and discovering it. And then the other half is pull, right, and going to some experience where you're asking for some type of content and getting to a point where we can do that very well is just going to add a whole new dimension to the service. So that's something I remain very excited about. In some ways, it's taken a little bit longer than I'd expected to get to a point where it's growing quickly. The people and page lookup part is doing very well, the post part has taken a bit longer but I'm very excited about that going forward. In terms of news, I mean the biggest issue with news today in Facebook is that it is the slowest part of the experience, right? When you go to load a video and it loads quickly, we made it auto-play to load even quicker. You tap on a photo, you expect it to expand immediately, but you tap on a link, and often it can take 10 seconds to load and if you're on a 2G connection somewhere in the developing world, that could take 30 seconds to load. So the big initiative that we have here which I'm really excited about is Instant Articles and the big thing that that does is just it lets publishers basically put the content on our servers ahead of time and that way when people tap on it, it loads instantaneously. And it can be a much more immersive experience and we've already found from the initial experiments that we've done that the engagement is positive and we're starting to roll that out more broadly. So I think that that's going to be a really big deal for improving the experience of reading news on Facebook and it's something that we've been working on for a while, and I'm very excited about it. So, yeah, I would expect that we will see an expansion of sharing and consumption of all of the different types of things that you asked about: news, video, search and the different experiences there, and these are some of the big areas that we're investing in and they're long-term investments and they're big investments and we're going to keep on pushing on them, but I think that's what we need to do to serve our community well and ultimately connect everyone in the world. So thank you, guys."
},
{
"speaker": "Deborah Crawford - Director-Investor Relations",
"text": "Great. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines."
}
] | null | null |
META | 2 | 2,015 | 2015-07-29 17:00:00 | Executives: Deborah Crawford - Director-Investor Relations Mark Elliot Zuckerberg - Chairman & Chief Executive Officer Sheryl K. Sandberg - Chief Operating Officer & Director David M. Wehner - Chief Financial Officer
Analysts: Anthony DiClemente - Nomura Securities International, Inc. Douglas T. Anmuth - JPMorgan Securities LLC Heather A. Bellini - Goldman Sachs & Co. Brian Nowak - Morgan Stanley & Co. LLC John R Blackledge - Cowen & Co. LLC Justin Post - Merrill Lynch, Pierce, Fenner & Smith, Inc. Ross Sandler - Deutsche Bank Securities, Inc. Mark May - Citi Investment Research Ben Schachter - Macquarie Capital (USA), Inc. Mark S. Mahaney - RBC Capital Markets LLC Paul Vogel - Barclays Capital, Inc. Brian W. Wieser - Pivotal Research Group LLC Peter C. Stabler - Wells Fargo Securities LLC Eric J. Sheridan - UBS Securities LLC Brian J. Pitz - Jefferies LLC
Operator: Good afternoon. My name is Chris, and I'll be your conference operator today. At this time, I would like to welcome everyone to the Facebook Second Quarter 2015 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin.
Deborah Crawford - Director-Investor Relations: Thank you. Good afternoon, and welcome to Facebook's Second Quarter Earnings Conference Call. Joining me today to talk about our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements and actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and on our Annual Report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these statements as a result of new information or future events. During this call, we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I'd like to turn the call over to Mark.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: Thanks, Deborah. And thanks, everyone, for joining today. This is a good quarter for us. We've continued to make good progress in the growth of our community with 1.49 billion people now using Facebook each month and more than 1.3 billion people using Facebook on mobile. We've also continued to make gains in engagement. More than 968 million people worldwide now use Facebook daily, and 65% of our monthly actives are daily actives. Several products in the Facebook app are reaching global scale, too, now with more than 450 million people using Events each month and more than 850 million people using Groups. And when it comes to time spent across Facebook, Messenger and Instagram, people are now spending more than 46 minutes per day on average, and that doesn't include WhatsApp. Our business performance has grown with our community. This quarter, our total revenue is more than $4 billion for the first time, and advertising revenue grew by 43% year-over-year. These results reflect the ongoing investments and improvements we've made and the quality, performance and usefulness of our services, and continuing to make progress here remains our biggest priority. Now, with that in mind, I'd like to talk about how we're working on this across our current product, our next generation of apps and our long-term innovation efforts. Over the next few years, our main focus is on helping our existing communities and businesses reach their full potential. An important part of our strategy is continuing to deliver great experiences across all our products. This means improving the speed and reliability of our apps and building new infrastructure to support our global scale, like our new data center in Texas. Over the last six months, we've improved the performance of our core app, reducing crashes on iOS by more than 30% and some Android phones by more than 40%. On Messenger, people can now send messages up to 20% faster, and it's twice as fast when you start the app. These are just a few examples of how our engineering focus is delivering better experiences for everyone in our community. Another part of delivering great experiences is helping people connect to the content they want. This quarter, we've continued to focus on improving people's experience in News Feed by making it easier to find more relevant and engaging content from friends and the entire community. Connecting people with more great video content is an important part. Video continues to be some of the richest and most engaging content for people and publishers, and since the start of the year, pages are also sharing more than 40% more videos. This quarter, we updated our News Feed ranking to help people see more of the videos they care about and also began testing new options for video monetization to help our partners build their businesses. We're excited about the potential for continued work here. The focus we've had on video also supports our efforts to connect more people around important public moments and events. From the 59 million people who generated more than 300 million interactions around the Copa America to the 26 million people who changed their profile photos for Pride or the more than 150 million people who were notified that their friends were safe after the Nepal earthquake. Facebook has clearly become the home for global conversations about things that people care about. And when it comes to serving businesses on our platform, this quarter, we continued to focus on delivering more useful tools and resources to help them achieve their goals. Helping marketers to tell more visually engaging stories through video and carousel ads is an important focus, as well as supporting small businesses. There are now more than 40 million small and medium-size businesses, using pages on Facebook. So we have a big opportunity to create value for communities all over the world, and Sheryl is going to talk more about this in a moment. Next, let's talk about how we're building our next generation of services, which we also expect to be important parts of our business over the next few years. With Instagram, the continued growth in the size and engagement of the community shows how this is becoming one of the best places to get a real-time snapshot of the world. For moments from the U.S. presidential campaign trail to NASA's first photos from Pluto, people are using Instagram in a lot of interesting ways. This quarter, we made some big improvements to the app, including upgrading our search and explore functionality and introducing trending content, which we expect will provide even more engaging experiences. On Messenger, this quarter, we rolled out a number of new features, including mobile video calling, a new way to share locations and the option to sign up for Messenger without using a Facebook account. We also continue to make good progress building out the Messenger platform. We expect these improvements to continue making Messenger a more useful and engaging experience for lots of people. More than 700 million people now use Messenger and we've reached more than $1 billion downloads on Android. These milestones are a good sign that we're on the right path here. With WhatsApp, we're pleased with our continued growth, and the team is continuing to roll out new features to serve the whole community. We've continued to improve the web experience for WhatsApp as well as launching voice calling to more people and on more devices. With Search, we are continuing to build a better experience for our whole community. We recently crossed 1.5 billion searches per day, and we've now indexed more than two trillion posts. This is a huge set of unique experiences and perspectives, and by allowing people to unlock this knowledge, we have a huge opportunity to create value for the world in the coming years. Finally, let's talk about our other efforts that we expect to deliver impact over the longer term. With Internet.org, we have a lot of momentum with our goal of connecting everyone in the world to the Internet. A year ago, we launched the Internet.org app for the first time in Zambia. And since then, we've made free basic Internet services available to more than 1 billion people in 17 countries. Our results show that Internet.org is working. After launching free basic services, mobile operators are seeing people adopt mobile data 50% faster than before. And more than half the new people coming online through Internet.org choose to pay for data and access, more Internet services within their first 30 days. We recently made changes to the Internet.org program for both developers and operators that will give more people access to even more free services. With the Internet.org platform, now it's easy for any developer to create services that integrate with Internet.org. And just this week, we announced a portal for operators that makes it easy for them to quickly launch free basic services in new countries. We're also making progress on our efforts to connect people living in some of the most remote communities on earth. Our Connectivity Lab is working on new technologies for connecting communities, that include drones satellites and laser communication systems, and we'll be sharing more of our progress here very soon. And with Oculus, we've announced that the Rift will ship to consumers in the first quarter of 2016. The team recently introduced details about the full hardware and software experience that people can expect, including our new touch controllers. Oculus is going to be the best VR experience in the world when it launches and I'm really excited for us to begin to delivering on the promise of virtual reality. S that's how we've focused our efforts over the last quarter. We're preparing for the future, but we're also working to deliver better experiences and value to our community today. And as usual, I want to thank our whole community, including our employees, our shareholders and our partners. Thanks to you, our community is getting stronger and stronger every day and we're making progress on our mission to make the world more open and connected. So thank you. And now here's Sheryl.
Sheryl K. Sandberg - Chief Operating Officer & Director: Thanks, Mark. And hi, everyone. We had another strong quarter and a great first half of the year. Ad revenue grew 43% year-over-year, 55% on a constant currency basis. Mobile ad revenue grew 74% year-over-year, making it over three-quarters of total ad revenue. Our growth was broad-based across all marketer segments and industry verticals. Similar to Q1, we're pleased with the adoption of our ad products across all regions and we saw strong revenue growth in North America and Asia-Pacific in particular. We're staying focused on our three main priorities: capitalizing on the shift to mobile, growing the number of Facebook marketers and making our ads more relevant and effective. First, capitalizing on the shift to mobile. People are spending more time on their mobile devices and on Facebook apps. We continue to get more than one out of every five minutes on smartphones in the U.S. and mobile usage is driving our growth globally as well. We believe we have the best performing mobile ad product in the market and video's making it even better. With so many consumer videos being watched on Facebook, video ads are a natural part of the News Feed experience. For marketers, video has always been a compelling format. Now Facebook enables mass reach and cross device targeting and measurement abilities far superior to what other platforms offer. Mobile video was a major theme at the Cannes Lions Festival last month, where some of the biggest winners, like Under Armour's I WILL WHAT I WANT with Droga5, and Procter & Gamble's Like a Girl with Leo Burnett used mobile video on Facebook as part of their campaign. Our second priority is growing the number of marketers using our ad products. In Q2, we announced that 40 million small and medium businesses have active Facebook pages, and this number continues to grow. Earlier this month, I hosted SMB roundtables in Berlin and London. I got to hear firsthand how advertising on Facebook is helping SMBs sell their products, grow their businesses, hire new employees and even expand to other cities and countries. One of the business owners I met was Kelly Wright (11:43), a single mom who started selling dresses from her home. She began by shooting videos of her dresses on her mobile phone and promoting them on Facebook for just a few pounds. Using Facebook as her only marketing channel, Kelly grew her business, Krista Lee Fashion, (11:59) to over £3 million pounds annually and she now has 10 employees. We're increasing our engagement with the global SMB community and have now held more than 80 local Boost Your Business events around the world, meeting thousands of businesses and getting their feedback on how we can make our products work better for them. We're also building out our leadership teams around the world. In recent weeks we've added senior talent to our international teams, including a new head of Latin America and new regional leadership in several countries in EMEA. We also opened an office in Johannesburg, our first in Africa. Our third priority is making our ads more relevant and effective. Better, more engaging and relevant ads are good for people and marketers, and we're working hard to improve them. We continue to innovate at a rapid pace by introducing new ad formats and new tools for marketers. This quarter we expanded carousel ads, which show multiple images in one ad unit. We introduced dynamic product ads, which allow marketers to upload their product catalog and show the right product to the right person at the right time. We also introduced a new ad format called Lead Ads, a simpler way for people to connect with companies they're interested in hearing from. We continue to focus on providing world-class products and tools for direct response advertisers. Booking.com, a Priceline Group company, is using Facebook link ads featuring Book Now button to drive reservations. In Q2, Facebook ads drove a meaningful increase in room reservations for Booking.com, helping them meet their ROI goals for the campaign. They're now expanding their use of Facebook ads across multiple markets. We continue to make progress with ads on Instagram. In Q2, we launched Instagram ads in Brazil, Germany and Japan. We also introduced additional capabilities for marketers, including carousel ads on Instagram, which brands are using in creative ways. For example, to showcase a spring fashion collection, gradually reveal a full panorama or show different views of a location. Over the coming months, Instagram ads will be available to more advertisers with new formats, better targeting and the ability to buy online as well as through third-party planners. As we ramp Instagram ads, we remain focused on quality and relevance to ensure the best experience for people and the highest performance for marketers. And as always, our highest focus is on the consumer experience with Instagram. Measurement is a key priority as we work to expand our share of global marketing budgets. Since we introduced conversion lift, which measures the direct impact that Facebook ads have on sales, we've seen adoption for marketers across verticals. When Acura launched the TLX, the largest launch in their history, they used Facebook video to show the TLX in scenarios that quickly captured people's attention, like imitating a roller coaster. They then used our retargeting technology to show more detailed ads only to the people who watched the videos. Using conversion lift, they proved that Facebook ads directly drove vehicle sales. To help marketers target and measure campaigns both on and off Facebook, we're continuing to build out our ad tech platform with Atlas LiveRail on the Audience Network. Entertainment company Live Nation knew that people browsed for concert tickets on mobile devices, but they were never able to measure whether they converted into sales. Using Atlas, Live Nation was able to link their mobile ads to 66% more ticket purchases for one of their largest artists. This shows the promise of Atlas to measure cross device conversion. We're pleased with the progress we're making on all three of our main priorities and we plan to stay focused. Now here's Dave.
David M. Wehner - Chief Financial Officer: Thanks, Sheryl, and good afternoon, everyone. Q2 was another strong quarter for Facebook. We generated $4 billion in revenue and $1.3 billion in free cash flow. Strong community growth and engagement underpinned our financial performance. In June, approximately 968 million people used Facebook on an average day, an increase of 17% compared to last year. This daily number represents 65% of the 1.49 billion people who used Facebook during the month of June. That MAU number grew by 173 million year-over-year, and by this measure the second quarter was our strongest in terms of community growth since 2013. Mobile remains the key driver of our growth. In June, approximately 1.31 billion people accessed Facebook on mobile devices, up 23% from last year. We also saw strong growth in our next generation of services with Instagram, Messenger and WhatsApp now exceeding 300 million, 700 million and 800 million MAU respectively. Now turning to the financials. All of our comparisons are on a year-over-year basis unless otherwise noted. Additionally, our non-GAAP measures exclude stock-based compensation and the amortization of intangibles. Total revenue was $4 billion, up 39%, or 50% on a constant currency basis. Ad revenue was $3.8 billion, up 43%, or 55% on a constant currency basis. The strengthening of the U.S. dollar has continued to have an unfavorable impact on our revenue. Had foreign exchange rates remained constant with Q2 2014 levels, our total revenue this quarter would have been approximately $330 million higher. Regionally, we saw strong North American ad revenue growth of 55% in the quarter, and APAC growth also remained strong at 48%. Europe and the rest of the world ad revenue grew more slowly at 30% and 22% respectively, as currency had a significant negative impact on each of those regions' year-over-year growth rates. Mobile is the engine of our revenue growth. Mobile ad revenue in Q2 was $2.9 billion, up 74% from last year, and represents 76% of our advertising revenue. Revenue from ads served on personal computers was down approximately 8%. In Q2, the average price per ad increased 220% while total ad impressions declined 55%. Similar to last quarter, these price volume trends were primarily driven by the redesign of our right hand column ads, which rolled out in the third quarter of last year. To a lesser degree, the shift of usage towards mobile, where we don't have right hand column ads, also contributed to the reported price volume trends. Total payments and other fees revenue was $215 million, down 8% compared to last year. The decline was driven by a 19% year-over-year reduction in payments revenue related to games played on personal computers, offset primarily by the addition of other revenue related to acquisitions closed in the second half of 2014. Turning now to expenses. Our Q2 total GAAP expenses were $2.8 billion, up 82%, and non-GAAP expenses were $1.8 billion, up 57%. Similar to last quarter, stock-based compensation and amortization expenses related to the WhatsApp acquisition contributed significantly to the year-over-year growth in GAAP expenses. Non-GAAP expense growth was primarily driven by increases in head count-related costs, cost of revenue and marketing expenses. We ended the quarter with 10,955 employees, up 52% compared to last year. With 873 additional employees, Q2 was one of our strongest quarters in terms of hiring, and the majority of the new employees were added in R&D. Our Q2 GAAP operating income was $1.3 billion, representing a 31% operating margin. Non-GAAP operating income was $2.2 billion, representing a 55% margin. Our Q2 GAAP and non-GAAP tax rates were 44% and 36%, respectively. Q2 GAAP net income was $719 million or $0.25 per share, and non-GAAP net income was $1.4 billion or $0.50 per share. In Q2, capital expenditures were $549 million and we generated $1.3 billion of free cash flow. We ended the quarter with $14.1 billion in cash and investments. Turning now to the outlook. Let's start with revenue. Since the first quarter of 2014, we have seen year-over-year advertising revenue growth rates decline each subsequent quarter. We expect this trend to continue in Q3 and Q4 as we continue to grow off a much larger base and face currency headwinds due to the strong dollar. In addition, we expect our total payments and other fees revenues to decline on a year-over-year basis for the remainder of the year. The decline in the second half of the year should be closer to the 19% year-over-year decline we experienced in the Payments business alone as we will be lapping periods in which we added other fees revenue from acquisitions closed in the second half of 2014. Turning to expense guidance. Based on our second-quarter results, we are narrowing the expense guidance range for 2015. We now expect the year-over-year growth rate for total 2015 GAAP expenses to be between 55% and 60%, narrowed from the prior range of 55% to 65%. And we expect the year-over-year growth rate for total 2015 non-GAAP expenses to be between 50% and 55%, narrowed from the prior range of 50% to 60%. We anticipate our 2015 capital expenditures will be in the neighborhood of $2.5 billion to $3 billion, down slightly from the prior range of $2.7 billion to $3.2 billion. We continue to expect stock-based compensation in 2015 to be in the range of $3 billion to $3.3 billion, approximately half of which is related to our prior acquisitions, most notably WhatsApp. We expect amortization expenses in 2015 to be approximately $700 million to $800 million. And lastly, we anticipate our Q3 and full year 2015 GAAP and non-GAAP tax rates to be consistent with the rates in the second quarter. We had a great first half of the year with solid revenue performance underpinned by healthy community growth across all of our services and regions. We have many exciting opportunities ahead, and we are investing in the talent and resources to capitalize on them as we seek to build long-term shareholder value. With that, operator, let's open up the call for questions.
Operator: Thank you. We will now open the lines for the question-and-answer session. Your first question comes from the line of Anthony DiClemente with Nomura Securities. Your line is open.
Anthony DiClemente - Nomura Securities International, Inc.: Thanks a lot. I have one for Mark and one for Dave. Mark, Facebook has had so much success in terms of the engagement, the growth of the engagement. I'm just wondering if there's a framework that you used to think about how much of that success is due to just the core value proposition of Facebook itself continuing to resonate with people at its most basic level as opposed to the product innovation that you've detailed in your prepared remarks or in your use cases? Which are more of a driver in your mind? And then second one for Dave. CapEx being down as a percentage of revenue in 2Q and you lowered the guidance. It doesn't feel like you guys are in the midst of ramping investment in the infrastructure. I wonder, as you look at the assets, you have so much growth, you have a shift to bandwidth intensive content and applications. Do you feel like you guys have just been more efficient in terms of your CapEx spend, or at some point should we anticipate a reacceleration of CapEx? Thanks.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: I can talk to the first part. So at some level, I do think that the core mission and promise of helping to connect people with their friends and family is very fundamental, right? And everyone has friends and family and wants to stay connected and uses a variety of tools and ways to do that in the world today, which are often very inefficient, and the Internet offers new opportunities to make that a lot better. When you look at the specific products that – and the work that we're doing, there's this process that we've followed that – where basically we'll look at an area of our products that people are using. So for example, going back a few years, News Feed, right, was – it's always been, since we rolled it out, a very central part of the product. But we're looking at the stuff with increasing rigor now where we organized the company into these product groups, and each product group leader will not just look at the product as one thing, but what are the key three or four or five use cases which often can really be their own product lines on their own, and we go through and we build those out to be world-class. And I think a lot of the success that we've seen has been because of some of the work that we've done a few years back at this point in products like News Feed and I mean that team has executed really well. But when I look forward, I'm very excited about doing the same thing for messaging and groups and video. There's many different use cases. You don't want to just look at these as one thing. There are a bunch of different use cases, and we want to be the best at each of them. And if you have good people leading those teams, then I think you can deliver that over time. So I think yes is the answer to your question. The mission is fundamentally deeply important to people, but that has to be coupled with good thorough execution of each of the available opportunities.
David M. Wehner - Chief Financial Officer: Yeah, Anthony. It's Dave. So on CapEx, we are absolutely investing in the infrastructure and 2015 is an investment year, so we are ramping CapEx versus 2014. The guidance is $2.5 billion to $3 billion, and that's up from $1.8 billion last year. We've got a lot of infrastructure investment that we're making across data centers, servers, network. We are clearly investing for the growth of both Facebook at its core and then also the additional services that we're bringing on. So we're proud about the efficiencies that we've had. The infrastructure team has done an outstanding job in driving good efficiencies through things like the Open Compute Project, which allows us to leverage an open-source strategy to lower our costs on server and other expensive hardware. It's been a great strategy for us. But given the growth we have in the business, given the opportunity we have before us, we're very much in investment mode in terms of the infrastructure.
Operator: Your next question is from Douglas Anmuth with JPMorgan. Your line is open.
Douglas T. Anmuth - JPMorgan Securities LLC: Thanks for taking the question. Mark, you talked about Oculus Rift shipping in 1Q 2016. Can you talk more about what you're most excited about in terms of the primary applications when it's into the mainstream? And then, Dave, can you also help us understand the cost structure more here as that product ramps? And then, Sheryl, if you could help us understand how broadly Instagram will open up to advertisers by year end? Thank you.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: I can talk about Oculus. So the reason why Facebook is excited in this space is I can give you two reasons for this. One is there's this continued progression of people getting richer and richer ways to share what's on their minds. So if you go back 10 years, most of how people communicated and shared was text. We are going through a period where now it's mostly visual and photos. We are entering into a period where that's going to increasingly be primarily video, and we're seeing huge growth there. But that's not the end of the line. I mean, there's always a richer way that people want to share and consume thoughts and ideas and I think that immersive 3D content is the obvious next thing after video. So if you look at what the initial use cases are going to be around that, I think it's a lot of the stuff that you hear people talking about. Video I think will be huge. So just taking that to be 3D and immersive. Gaming will be huge. And those are both areas that Facebook has been involved with. Once we start to get more of a critical mass, I think you can start to get social applications, which is what we as a company are more interested in over the long term and think have a huge amount of potential in addition to the video and gaming stuff, which I just think is going to be awesome in the next few years as well.
David M. Wehner - Chief Financial Officer: Hey, Doug. It's Dave. So just on the question of how Oculus would affect the cost structure, it's premature for us to be giving guidance on the cost structure in 2016. But I think one of the things to recognize here is that we're still early with Oculus. We haven't announced any specific plans as it relates to shipment volumes for the consumer for Rift. But we are still early in the development stage, so it'd be early to be talking about large volume shipments. Obviously, we're investing on the research and development side on Oculus in 2015 and that's factored into our expense guidance for this year.
Sheryl K. Sandberg - Chief Operating Officer & Director: On Instagram, we are opening up to more advertisers. I talked about some of our global rollouts in the past quarter. We're also opening up more capabilities, which means more formats, like direct response, more ways to buy, like self-serve. That said, and it's important to understand this, while we think there's a lot of interest and great opportunity, we're going to be really thoughtful and strategic about how we ramp revenue. Instagram remains small relative to Facebook and it's going to really take time to have significant impact on our growth.
Operator: Your next question is from Heather Bellini with Goldman Sachs. Your line is open.
Heather A. Bellini - Goldman Sachs & Co.: Great. Thank you for taking the question. I just wanted to ask a little bit more about as you start to speak with more advertisers on the Instagram opportunity, how are you and they thinking about the differences in how they'll engage with their customers across both platforms? And I guess what I'm getting at is do you see Instagram targeting a different type of advertiser, or do you expect people to leverage both platforms and almost think of them as kind of separate areas to budget for?
Sheryl K. Sandberg - Chief Operating Officer & Director: I think one of the things that's interesting about Instagram is while the ads are really visually appealing and that brings to mind certain verticals like fashion or autos, things where the visual really matters, what we're seeing is that lots of different verticals can use the platform really well. So a recent example, HTC working with their agency Swift did Instagram videos to raise awareness of their mobile device warranty program. So they targeted 18- to 34-year olds, they did five short videos with these funny moments of where you're about to break your phone, and they got a 6 point lift in awareness of what is a warranty program. I think that's not something you would think of typically as Instagram. In terms of Instagram and Facebook, we believe that marketers are looking to connect with people in a really deep way, connect with the right people, and our targeting we think is really strong compared to any other platform, at the right time. And that really means mobile. And we see such engagement on both Facebook and Instagram along with the different targeting and ad formats, we believe we'll be able to have and are already starting to have a relationship with marketers which grow across both platforms. Our focus with our marketing partners is their business results. I talked about in my remarks how we're looking for conversions. We're trying to help them measure. If you do a car ad for us, how many vehicles were driven off the lot? We see what products you use within Facebook or Instagram, or Facebook and Instagram, as less important as the best products for the right marketer at the right time to drive their business results. And we like having more abilities, more products, more apps to work with so that we can drive those business results.
Operator: Your next question is from Brian Nowak with Morgan Stanley. Your line is open.
Brian Nowak - Morgan Stanley & Co. LLC: Thanks for taking my question. There are two. In early June you rolled out some new CPC measurement methods about how the changes in the clicks and the CPCs are measured. Just being curious about kind of early findings you see in ad engagement growth, average price per ad, and then the advertiser feedback or change in budgeting since you've rolled out these CPC measurement changes? And then the second one, the North American advertising results are really strong, I think you had accelerating growth. Sheryl, could you just call out any specific ad products that are driving this faster North American ad growth? Thanks.
Sheryl K. Sandberg - Chief Operating Officer & Director: On the first, we're always trying to improve our ad products so marketers can buy what they want and pay as they want to pay. We recently announced that we're updating the definition of CPC so that includes only websites and apps. But you can also buy on a cost per engagement basis, and that include likes, comments, and shares. It's too early to see any direct impact, but I think it's part of the innovation that you'll see from us as we continue to roll out different ways that marketers can use our tools, different ways they can pay, different results they can target. When you look at our overall growth, our growth is very broad-based. We're broad-based against all of our segments of marketers, so brand and direct response, SMBs and developers. Definitely a part of the story here is video. Our video demand is very deep. People love the format of video. It's long been used to reach people in a compelling way, and we can do targeting in a way that's really unique. So I'll share another example. Wendy's, working with their agency, VML, launched their Jalapeno Fresco Spicy Chicken product and they were trying to reach millennials and spicy food lovers. So working with us, they did five video ads, and on our platform, they could not just do the video format but they could target millennials and people who like spicy food, which is very specific targeting. They got an eight-point lift in ad recall and a four-point lift in purchase intent among their millennial target. And so what that shows is our growth is being driven by the ability of us to do this broad-based consumer media advertising but do it in a more targeted way.
David M. Wehner - Chief Financial Officer: Yeah. And I think, Brian, you were also commenting on North America. Obviously, it's probably, everybody realizes this, but the big disparity between the U.S.-Canada growth rates versus the other regions like Europe and the rest of world are the currency headwinds, which had a very significant impact to the year-over-year advertising growth rates in those regions.
Operator: Your next question is from John Blackledge with Cowen & Company. Your line is open.
John R Blackledge - Cowen & Co. LLC: Oh, great. Thank you. A couple of questions on video. Mark, I think you mentioned potentially some new options for video monetization. Maybe could you discuss some of the new options that we may see implemented? And just more broadly, how does video content evolve on Facebook from kind of what we see today? Thank you.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: Well, I can talk – oh, you want...
David M. Wehner - Chief Financial Officer: You can go first.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: Yeah, I mean, on the options on video monetization, it's going to be, still our focus is going to be on continuing to grow autoplay and continuing to leverage the video unit in News Feed. That's going to be the primary driver of video growth for us. So that's really the main focus. We've got other areas that we're experimenting with like suggested videos, which are going to be very much like those ads in a feed of suggested videos, which are also an opportunity for us. But essentially, the focus is going to be on monetizing through feed ads for video.
David M. Wehner - Chief Financial Officer: I think you got them.
Operator: Your next question is from Justin Post with Merrill Lynch. Your line is open.
Justin Post - Merrill Lynch, Pierce, Fenner & Smith, Inc.: Great. Thank you. I think on the call, you said times spent was 46 minutes per day. Any comparable metric from past quarters? And then how would you, if you can give us that, how would you gauge the overall engagement of Facebook just for the core site? Maybe some help about what you're seeing there and what products are really having an impact. Thank you.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: Well, I think in terms of engagement the product is having, the biggest impact is News Feed continuing to do very well. So News Feed at the core is proving to be just a great experience for users. It's getting better. We continue to invest in that. As people spend more time with News Feed, we get better about understanding what they like and getting the content that they care about in front of them. So we're investing on that front. We're also doing more with public content. That's having an impact. So we're seeing across the board good improvements to News Feed. Video is another big contributor there as well. So, I mean, that's what we're seeing in terms of driving engagement. Engagement across the different regions as we think about it from a DAU-to-MAU perspective was at record levels in the quarter, so we're pleased with that. And we continue to see time spent grow across the platform. So on all those measures, we really like what we're seeing and we like the investments that we're making to make that News Feed experience even better.
Operator: Your next question is from Ross Sandler with Deutsche Bank. Your line is open.
Ross Sandler - Deutsche Bank Securities, Inc.: Great. I just had two questions, one for Mark and then one clarification for Dave. Mark, question on the messaging app. So the (37:37) from the first day keynote at the end of the day, Brian Acton and David Marcus were basically presenting different strategies in terms of their long-term philosophy around monetization of those two platforms. So if you look out three or five years, do you see the opportunity with Messenger and WhatsApp as being similar or can you just talk about the strategy there? And is the engagement for the messaging apps similar, higher, lower than the average for the core Facebook app in terms of daily visits? And then, Dave, you mentioned that you expect ad revenue to decelerate. I'm guessing that's a function of some of the FX headwinds. Can you talk about that on a currency neutral basis relative to the 55% in the second quarter? Thanks.
David M. Wehner - Chief Financial Officer: Sure. I can take the second part first. So in terms of – also you had asked about the growth rate in the back half of the year, so I'd kind of reiterate what I said in my comments. The business continues to perform very well, driven off the strength of our mobile News Feed apps business, and really consistent with the trend we've seen in the last several quarters, we would expect that year-over-year ads growth rate to decline modestly in Q3 and Q4, and it's really because we're delivering growth against a much larger scale News Feed business in the prior-year period and also, of course, headwinds are an impact as well, as you mentioned.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: And I can talk to the messaging strategy question. So the playbook that we're going to run with Messenger and WhatsApp is kind of similar to how we thought about building a business in Facebook and News Feed, where if you go back to 2006 and 2007, there were a lot of people who were kind of encouraging us to just put banner ads and kind of inorganic content into the experience, and what we decided was that over the long term, the ads and monetization would perform better if there was an organic interaction between people using the product and businesses. So instead of focusing on ads first, what we did was we built pages, and we made that free, that way as many businesses as possible could get into the network. And we built insights to make it so that businesses knew how they were driving business when they used pages for free and could post them to News Feed. And then on top of that whole ecosystem, we then had the opportunity to build what has turned into a News Feed business that we're really proud of, right. That we think is driving a lot of value and good content for people who are using the platform and helping a lot of businesses find customers and sell their products and grow overall. Messaging, I think, is going to be pretty similar, right? Where right now some people in WhatsApp use the service in order to message businesses, Messenger is, I think, more people-to-people today. We're working on a lot of different things that make it so that people can get value from interacting with businesses. We launched some of them at F8. We have a number of other things that we're working on across Messenger and WhatsApp. But the long term bet is that by enabling people to have good organic interactions with businesses, that will end up being a massive multiplier on the value of the monetization down the road when we work on that and really focus on that in a bigger way. So we'd ask for some patience on this to do this correctly, and the game plan will be more similar to what we did in Facebook with News Feed.
David M. Wehner - Chief Financial Officer: And, Ross, you also asked about, I think, the impact of Messenger on our user statistics and the daily users. The vast, vast majority, virtually all of Messenger users, are using News Feed as well. So Messenger-only usage is not having a material impact on our overall usage stats.
Operator: Your next question is from Mark May with Citi. Your line is open.
Mark May - Citi Investment Research: Thanks for taking my questions. I had one on search. I think you mentioned 1.5 billion daily searches. Just kind of curious what portion of those are commercial, if you will, not so much lookups for friends and family but more commercial oriented, and kind of can you give us an update of where you are in the process of building out an even more robust search experience on Facebook and across the other family of apps? And then on Instagram, just a question on kind of how we should be thinking about the ramp as well as the long term opportunity. I guess the question would be in your tests, have you noticed any meaningful difference in Instagram users' willingness to see or interact with ads and their News Feed as compared with an average Facebook user, recognizing that probably Instagram's audience is more geared toward some of the developing markets in the U.S. relative to Facebook? Thanks.
David M. Wehner - Chief Financial Officer: Sure. On the search experience, and Mark can add anything if he'd like, but on the search experience from a monetization perspective, the vast majority of the searches are for people or posts, and there can be – there's the potential for there to be commercially relevant content in people's posts, people searches, which is the largest part of searching, is not something that we think is really up the monetizing category. But there's certainly great content that people are finding using post search, but it's really – the focus is really to try and allow people to discover content that's been shared on Facebook that's relevant to them, and that's going to be the focus in the near term. And as people consume more content on Facebook, there's opportunities to show them ads in Feed, so there's an opportunity there, but it's really around engaging with content that you want to find on Facebook.
Sheryl K. Sandberg - Chief Operating Officer & Director: On Instagram, we haven't noticed any difference in willingness to engage with ads between the platforms for Instagram and Facebook, but we've ramped really slowly and we're very, very cautious. And again, we're going to continue to focus on the user experience, focus on the community growth and monetization will follow.
Operator: Your next question is from Ben Schachter with Macquarie. Your line is open.
Ben Schachter - Macquarie Capital (USA), Inc.: Yeah, just a couple of questions. One, given your success with standalone apps, should we expect to see more apps in the future, and could one of those focus specifically on video? And then on Oculus, the monetization for that, should we expect an App Store-like model where you'll be sharing revenue with the content partners? Thanks.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: We work on a lot of different things. I don't think we'd rule out the things that you just mentioned, but we don't have anything specific to talk about today on either of them I think.
David M. Wehner - Chief Financial Officer: Obviously, a big part of our investment strategy is investing in this next generation of apps and the focus there is on growing the communities around Messenger, WhatsApp and, of course, Instagram. That's all going really well and that's a big focus of our investment.
Operator: Your next question is from Mark Mahaney with RBC Capital Markets. Your line is open.
Mark S. Mahaney - RBC Capital Markets LLC: Great. Thanks. Two questions. David, the sales and marketing expenses this quarter were almost flattish sequentially. You don't normally see that in your business. Is there anything, any particular reason behind that why you didn't have that area grow? I assume it will continue to grow going forwards. And then, Mark, you made a comment about. I think you were referring to Instagram becoming one of the best places to get a real-time snapshot of the world. And it kind of reminds me or makes me think about some other leading platforms on the Internet. And I wonder how does that happen with Instagram? Is that something that you're already seeing users use Instagram to make that happen? Or is that something that you have to kind of tweak the user interface and change the product a little bit in order to try to have people think about it that way? How does it become that real-time snapshot of the world? Thanks.
David M. Wehner - Chief Financial Officer: So on the sales and marketing expenses, Mark, I think you're going to see that be lumpy. That's just due to product marketing and that's just not going to necessarily be a steady quarter-to-quarter trend. So you're going to see that be lumpy. But, yes, we are investing more in general in sales and marketing over time, so you'd expect to see that line grow in line with the expense guidance that we're giving. So it's definitely an area that we'll be investing in on an ongoing basis and I wouldn't read too much into the quarterly trend there.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: Yeah, and in terms of Instagram, I just think Kevin and the team are doing amazing work. The clarity of focus and clarity of the vision that Kevin and Mike have has been exceptional. And this is something that they've always focused on. They've cared deeply about it since the first conversations I've had with Kevin. And I think it takes real composure as a leader to scale something to many x where it was just a few years ago and build up the organization and be able to continue pushing the products forward every day to be able to do that. And I think it's rare that you get someone who's as talented as the folks who are leading this. And they're just doing an amazing job.
Operator: Your next question is from Paul Vogel with Barclays. Your line is open.
Paul Vogel - Barclays Capital, Inc.: Great. Thanks. Kind of a similar follow-up question to Mark's. Your DAU to MAU number has been exceptionally strong and moving up. I'm going to guess a lot of that is mobile related. So I guess that would be question number one. Is it a lot mobile? And the second question would be sort of again around this real-time issue. Are you seeing more real-time usage of Facebook and are you developing more products specifically around kind of real-time usage of Facebook as a platform? Thank you.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: I think a lot of it is that we're getting better and better at ranking and showing people the content they want. And part of it is that there's of course a bigger opportunity when people have their phones with them all the time, but I think that there are plenty of other worlds that we could be living in where we wouldn't have necessarily executed on that opportunity. And the execution is hard, right? And just kind of having something that's appealing universally to people wanting to stay connected with their friends, that's an important piece of it. But I mean, the team has just done really good work in terms of ranking the content and making the experience faster and building out better ways to get feedback from our community on what kinds of content they want to see in News Feed and helping people have the tools that they need to share the social content and news and video content that they want so that way it exists in the corpus of content that can be shown. And I just think the team is doing a really good work on all of these, and I'm really proud of them.
David M. Wehner - Chief Financial Officer: And, Paul, there's no doubt that mobile has a beneficial effect on our engagement in the U.S. Two out of three smartphone users check their phone as soon as they wake up in the morning. It's just having that experience readily available in your pocket is tremendous, and we just see that being helpful across the business as it relates to mobile engagement.
Operator: Your next question is from Brian Wieser with Pivotal Research. Your line is open.
Brian W. Wieser - Pivotal Research Group LLC: Thanks for taking the question. You mentioned 40 million small businesses have active Pages. I'm wondering if you could update us on how many individual small businesses, or businesses in total are buying ads right now? And separately, I was curious about your current thoughts on how ad tech businesses will evolve. If you see integrated marketplace evolving, or if you see a discreet demand in supply-side businesses evolving?
Sheryl K. Sandberg - Chief Operating Officer & Director: So on the first, we announced that we have over 2 million advertisers who are buying ads on Facebook. And the process for that is often that small businesses become organic users, so those 40 million small business Pages that are using it once a month and then we're able to move them onto being advertisers. And the best way we've done that is by simplified ad products. 82% of people who start advertising with us start with our really simple ad products. You know, do you want to pay a few dollars or a few pounds or a few euro to sponsor this post is a really easy on-ramp for a small business. In terms of overall ad tech world, I think a lot is happening and there's a lot that's going to evolve in the whole ecosystem. Our focus is on bringing people-based marketing and the effectiveness and relevance of Facebook ads off of Facebook so we can give marketers and publishers the tools to reach people across all of their devices. An importantly for our business, is connect the dots between online marketing and business outcomes. And you heard on this call me give a few examples of where we're already able to connect what happens in terms of ads with real sales of real products. For us, this is an important investment and it's very strategic. We are going to put the time in to make this work rather than look for any short-run specific return.
Operator: Your next question is from Peter Stabler with Wells Fargo Securities. Your line's open.
Peter C. Stabler - Wells Fargo Securities LLC: Good afternoon. Drafting off that. Sheryl, I'm wondering if you could update us on Atlas. We understand Atlas in and of itself is not likely be a major revenue driver, but we do see it as a strategically important piece of your toolset. So wondering if you can comment on agency adoption. Is it going according to plan? Are you happy with it? And then secondly, on SMB, just wondering, the 80 events that you've held around the world. In terms of learning come out of those, you talked a little bit about how folks get introduced as users, and that makes sense. Is the toolset simple enough today for SMB's to grasp? Or are there significant additions that you need to make to the toolset to accelerate the growth of SMB advertisers? Thanks very much.
Sheryl K. Sandberg - Chief Operating Officer & Director: So on the first, Atlas is really important because it's solving a measurement problem which is that the current systems for serving and measuring ads are really flawed. They basically assume that you are one person on one of device, and we know that's not true. They are only about 65% accurate in demographic targeting, they don't work on mobile because they are cookie based, they don't work on multiple devices, they don't go off-line to on-line and they overemphasize the last click and reach. And so our focus with Atlas is helping people really understand the results they get with ads. And you heard my Live Nation example earlier where we are able to connect Facebook ads and our platform directly to ticket sales. We never could have done that without Atlas measurements. In terms of the migration process, this is an enterprise sale. We have to work client by client. Then they have to choose us, then they have to migrate their systems, and so it's going to take time. What really matters is that when we get that migration and we are seeing it, we are able to show them the value because it makes their buying much more effective because they understand real results in a new way. In tune with SMBs I would say two things. I would say that, one, our products aren't simple enough yet, because they can never be simple enough for SMBs, but two, our products are probably the simplest ones out there. And so I think we're leading and I think we have a lot more to do. If we look at even in the United States, which is a very advanced market, I think it's something like 35% of SMBs don't have a web presence of any kind. But a great majority of those do have a Facebook page, and that's because setting up a web presence for an SMB is complicated and expensive. You can't just start a webpage. But it is easier and free to start a Facebook page until you see broad adoption. We also make a lot of things that they couldn't do in other platforms available on us. So over 1 million SMBs have posted a video on Facebook, which is pretty amazing, because I doubt 1 million SMBs have ever run what is a video or TV ad. That's because you can shoot it on your mobile device, you can upload it, you can do that for free or you can pay us for the ad. And so I think our tools are the simplest, but I think we still need to do better because what we hear from SMBs is simple, fast, inexpensive, showing them real return, and we're going to continue to focus on all of those things.
Operator: Your next question is from Eric Sheridan with UBS. Your line is open.
Eric J. Sheridan - UBS Securities LLC: Thanks for taking the questions. I wonder if I could get an update on the e-commerce initiatives including the partnership with Shopify and how we should be thinking longer term about e-commerce becoming a bigger and bigger part of the platform. Sheryl, you called out Priceline.com and the booking relationship during your prepared remarks. Just curious how far that might go longer term. Thanks.
Sheryl K. Sandberg - Chief Operating Officer & Director: So e-commerce is one of our top categories of advertisers, and we are already driving a lot of product sales through Facebook but importantly, our e-commerce initiatives are really about connecting consumers with marketers so that they can buy from companies. They're not buying through us. We are testing a buy button in the new shop section on pages, but again, that buy button is letting people buy directly from their advertisers, not from us. It's pretty early days. We're excited by what we see in the e-commerce vertical and we're going to continue to invest in growing that vertical as part of our ads business.
Deborah Crawford - Director-Investor Relations: Okay. Operator, we have time for one last question.
Operator: Certainly. Your final question is from Brian Pitz with Jefferies. Your line is open.
Brian J. Pitz - Jefferies LLC: Thanks. Questions on audience network. Any updates here including a sense for the level of adoption you're seeing from developers? Also any synergies with the mobile app install product? And finally any comments on ad price comparisons to traditional News Feed ads? Thanks.
Sheryl K. Sandberg - Chief Operating Officer & Director: We're seeing investment, we're investing in the audience network and we think it's important because it takes – it makes the ads more relevant. It's part of our overall ad tech push to bring the effectiveness and relevance of our ads off us. We're growing the number of advertisers and publishers, and we're continuing to see growth and we'll continue to invest. When you think about mobile app install ads, those are an important but relatively small part of our revenue. The important thing to understand here is that they're not only used by developers, they're used by all four marketer segments. So for example, HBO used our video retargeting mobile app install ads on Facebook to drive downloads at HBO now, and Facebook is now the number one channel driving subscribers. And I think when people think about our mobile app install ads they often think this only applies to developers and small companies, and really it's them as well but it's also companies like HBO which are using those ads to drive adoption and downloads.
Deborah Crawford - Director-Investor Relations: Thank you for joining us today. We appreciate your time, and we look forward to speaking with you all again.
Operator: Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines. | [
{
"speaker": "Executives",
"text": "Deborah Crawford - Director-Investor Relations Mark Elliot Zuckerberg - Chairman & Chief Executive Officer Sheryl K. Sandberg - Chief Operating Officer & Director David M. Wehner - Chief Financial Officer"
},
{
"speaker": "Analysts",
"text": "Anthony DiClemente - Nomura Securities International, Inc. Douglas T. Anmuth - JPMorgan Securities LLC Heather A. Bellini - Goldman Sachs & Co. Brian Nowak - Morgan Stanley & Co. LLC John R Blackledge - Cowen & Co. LLC Justin Post - Merrill Lynch, Pierce, Fenner & Smith, Inc. Ross Sandler - Deutsche Bank Securities, Inc. Mark May - Citi Investment Research Ben Schachter - Macquarie Capital (USA), Inc. Mark S. Mahaney - RBC Capital Markets LLC Paul Vogel - Barclays Capital, Inc. Brian W. Wieser - Pivotal Research Group LLC Peter C. Stabler - Wells Fargo Securities LLC Eric J. Sheridan - UBS Securities LLC Brian J. Pitz - Jefferies LLC"
},
{
"speaker": "Operator",
"text": "Good afternoon. My name is Chris, and I'll be your conference operator today. At this time, I would like to welcome everyone to the Facebook Second Quarter 2015 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. This call will be recorded. Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford - Director-Investor Relations",
"text": "Thank you. Good afternoon, and welcome to Facebook's Second Quarter Earnings Conference Call. Joining me today to talk about our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements and actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and on our Annual Report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these statements as a result of new information or future events. During this call, we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I'd like to turn the call over to Mark."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "Thanks, Deborah. And thanks, everyone, for joining today. This is a good quarter for us. We've continued to make good progress in the growth of our community with 1.49 billion people now using Facebook each month and more than 1.3 billion people using Facebook on mobile. We've also continued to make gains in engagement. More than 968 million people worldwide now use Facebook daily, and 65% of our monthly actives are daily actives. Several products in the Facebook app are reaching global scale, too, now with more than 450 million people using Events each month and more than 850 million people using Groups. And when it comes to time spent across Facebook, Messenger and Instagram, people are now spending more than 46 minutes per day on average, and that doesn't include WhatsApp. Our business performance has grown with our community. This quarter, our total revenue is more than $4 billion for the first time, and advertising revenue grew by 43% year-over-year. These results reflect the ongoing investments and improvements we've made and the quality, performance and usefulness of our services, and continuing to make progress here remains our biggest priority. Now, with that in mind, I'd like to talk about how we're working on this across our current product, our next generation of apps and our long-term innovation efforts. Over the next few years, our main focus is on helping our existing communities and businesses reach their full potential. An important part of our strategy is continuing to deliver great experiences across all our products. This means improving the speed and reliability of our apps and building new infrastructure to support our global scale, like our new data center in Texas. Over the last six months, we've improved the performance of our core app, reducing crashes on iOS by more than 30% and some Android phones by more than 40%. On Messenger, people can now send messages up to 20% faster, and it's twice as fast when you start the app. These are just a few examples of how our engineering focus is delivering better experiences for everyone in our community. Another part of delivering great experiences is helping people connect to the content they want. This quarter, we've continued to focus on improving people's experience in News Feed by making it easier to find more relevant and engaging content from friends and the entire community. Connecting people with more great video content is an important part. Video continues to be some of the richest and most engaging content for people and publishers, and since the start of the year, pages are also sharing more than 40% more videos. This quarter, we updated our News Feed ranking to help people see more of the videos they care about and also began testing new options for video monetization to help our partners build their businesses. We're excited about the potential for continued work here. The focus we've had on video also supports our efforts to connect more people around important public moments and events. From the 59 million people who generated more than 300 million interactions around the Copa America to the 26 million people who changed their profile photos for Pride or the more than 150 million people who were notified that their friends were safe after the Nepal earthquake. Facebook has clearly become the home for global conversations about things that people care about. And when it comes to serving businesses on our platform, this quarter, we continued to focus on delivering more useful tools and resources to help them achieve their goals. Helping marketers to tell more visually engaging stories through video and carousel ads is an important focus, as well as supporting small businesses. There are now more than 40 million small and medium-size businesses, using pages on Facebook. So we have a big opportunity to create value for communities all over the world, and Sheryl is going to talk more about this in a moment. Next, let's talk about how we're building our next generation of services, which we also expect to be important parts of our business over the next few years. With Instagram, the continued growth in the size and engagement of the community shows how this is becoming one of the best places to get a real-time snapshot of the world. For moments from the U.S. presidential campaign trail to NASA's first photos from Pluto, people are using Instagram in a lot of interesting ways. This quarter, we made some big improvements to the app, including upgrading our search and explore functionality and introducing trending content, which we expect will provide even more engaging experiences. On Messenger, this quarter, we rolled out a number of new features, including mobile video calling, a new way to share locations and the option to sign up for Messenger without using a Facebook account. We also continue to make good progress building out the Messenger platform. We expect these improvements to continue making Messenger a more useful and engaging experience for lots of people. More than 700 million people now use Messenger and we've reached more than $1 billion downloads on Android. These milestones are a good sign that we're on the right path here. With WhatsApp, we're pleased with our continued growth, and the team is continuing to roll out new features to serve the whole community. We've continued to improve the web experience for WhatsApp as well as launching voice calling to more people and on more devices. With Search, we are continuing to build a better experience for our whole community. We recently crossed 1.5 billion searches per day, and we've now indexed more than two trillion posts. This is a huge set of unique experiences and perspectives, and by allowing people to unlock this knowledge, we have a huge opportunity to create value for the world in the coming years. Finally, let's talk about our other efforts that we expect to deliver impact over the longer term. With Internet.org, we have a lot of momentum with our goal of connecting everyone in the world to the Internet. A year ago, we launched the Internet.org app for the first time in Zambia. And since then, we've made free basic Internet services available to more than 1 billion people in 17 countries. Our results show that Internet.org is working. After launching free basic services, mobile operators are seeing people adopt mobile data 50% faster than before. And more than half the new people coming online through Internet.org choose to pay for data and access, more Internet services within their first 30 days. We recently made changes to the Internet.org program for both developers and operators that will give more people access to even more free services. With the Internet.org platform, now it's easy for any developer to create services that integrate with Internet.org. And just this week, we announced a portal for operators that makes it easy for them to quickly launch free basic services in new countries. We're also making progress on our efforts to connect people living in some of the most remote communities on earth. Our Connectivity Lab is working on new technologies for connecting communities, that include drones satellites and laser communication systems, and we'll be sharing more of our progress here very soon. And with Oculus, we've announced that the Rift will ship to consumers in the first quarter of 2016. The team recently introduced details about the full hardware and software experience that people can expect, including our new touch controllers. Oculus is going to be the best VR experience in the world when it launches and I'm really excited for us to begin to delivering on the promise of virtual reality. S that's how we've focused our efforts over the last quarter. We're preparing for the future, but we're also working to deliver better experiences and value to our community today. And as usual, I want to thank our whole community, including our employees, our shareholders and our partners. Thanks to you, our community is getting stronger and stronger every day and we're making progress on our mission to make the world more open and connected. So thank you. And now here's Sheryl."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "Thanks, Mark. And hi, everyone. We had another strong quarter and a great first half of the year. Ad revenue grew 43% year-over-year, 55% on a constant currency basis. Mobile ad revenue grew 74% year-over-year, making it over three-quarters of total ad revenue. Our growth was broad-based across all marketer segments and industry verticals. Similar to Q1, we're pleased with the adoption of our ad products across all regions and we saw strong revenue growth in North America and Asia-Pacific in particular. We're staying focused on our three main priorities: capitalizing on the shift to mobile, growing the number of Facebook marketers and making our ads more relevant and effective. First, capitalizing on the shift to mobile. People are spending more time on their mobile devices and on Facebook apps. We continue to get more than one out of every five minutes on smartphones in the U.S. and mobile usage is driving our growth globally as well. We believe we have the best performing mobile ad product in the market and video's making it even better. With so many consumer videos being watched on Facebook, video ads are a natural part of the News Feed experience. For marketers, video has always been a compelling format. Now Facebook enables mass reach and cross device targeting and measurement abilities far superior to what other platforms offer. Mobile video was a major theme at the Cannes Lions Festival last month, where some of the biggest winners, like Under Armour's I WILL WHAT I WANT with Droga5, and Procter & Gamble's Like a Girl with Leo Burnett used mobile video on Facebook as part of their campaign. Our second priority is growing the number of marketers using our ad products. In Q2, we announced that 40 million small and medium businesses have active Facebook pages, and this number continues to grow. Earlier this month, I hosted SMB roundtables in Berlin and London. I got to hear firsthand how advertising on Facebook is helping SMBs sell their products, grow their businesses, hire new employees and even expand to other cities and countries. One of the business owners I met was Kelly Wright (11:43), a single mom who started selling dresses from her home. She began by shooting videos of her dresses on her mobile phone and promoting them on Facebook for just a few pounds. Using Facebook as her only marketing channel, Kelly grew her business, Krista Lee Fashion, (11:59) to over £3 million pounds annually and she now has 10 employees. We're increasing our engagement with the global SMB community and have now held more than 80 local Boost Your Business events around the world, meeting thousands of businesses and getting their feedback on how we can make our products work better for them. We're also building out our leadership teams around the world. In recent weeks we've added senior talent to our international teams, including a new head of Latin America and new regional leadership in several countries in EMEA. We also opened an office in Johannesburg, our first in Africa. Our third priority is making our ads more relevant and effective. Better, more engaging and relevant ads are good for people and marketers, and we're working hard to improve them. We continue to innovate at a rapid pace by introducing new ad formats and new tools for marketers. This quarter we expanded carousel ads, which show multiple images in one ad unit. We introduced dynamic product ads, which allow marketers to upload their product catalog and show the right product to the right person at the right time. We also introduced a new ad format called Lead Ads, a simpler way for people to connect with companies they're interested in hearing from. We continue to focus on providing world-class products and tools for direct response advertisers. Booking.com, a Priceline Group company, is using Facebook link ads featuring Book Now button to drive reservations. In Q2, Facebook ads drove a meaningful increase in room reservations for Booking.com, helping them meet their ROI goals for the campaign. They're now expanding their use of Facebook ads across multiple markets. We continue to make progress with ads on Instagram. In Q2, we launched Instagram ads in Brazil, Germany and Japan. We also introduced additional capabilities for marketers, including carousel ads on Instagram, which brands are using in creative ways. For example, to showcase a spring fashion collection, gradually reveal a full panorama or show different views of a location. Over the coming months, Instagram ads will be available to more advertisers with new formats, better targeting and the ability to buy online as well as through third-party planners. As we ramp Instagram ads, we remain focused on quality and relevance to ensure the best experience for people and the highest performance for marketers. And as always, our highest focus is on the consumer experience with Instagram. Measurement is a key priority as we work to expand our share of global marketing budgets. Since we introduced conversion lift, which measures the direct impact that Facebook ads have on sales, we've seen adoption for marketers across verticals. When Acura launched the TLX, the largest launch in their history, they used Facebook video to show the TLX in scenarios that quickly captured people's attention, like imitating a roller coaster. They then used our retargeting technology to show more detailed ads only to the people who watched the videos. Using conversion lift, they proved that Facebook ads directly drove vehicle sales. To help marketers target and measure campaigns both on and off Facebook, we're continuing to build out our ad tech platform with Atlas LiveRail on the Audience Network. Entertainment company Live Nation knew that people browsed for concert tickets on mobile devices, but they were never able to measure whether they converted into sales. Using Atlas, Live Nation was able to link their mobile ads to 66% more ticket purchases for one of their largest artists. This shows the promise of Atlas to measure cross device conversion. We're pleased with the progress we're making on all three of our main priorities and we plan to stay focused. Now here's Dave."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Thanks, Sheryl, and good afternoon, everyone. Q2 was another strong quarter for Facebook. We generated $4 billion in revenue and $1.3 billion in free cash flow. Strong community growth and engagement underpinned our financial performance. In June, approximately 968 million people used Facebook on an average day, an increase of 17% compared to last year. This daily number represents 65% of the 1.49 billion people who used Facebook during the month of June. That MAU number grew by 173 million year-over-year, and by this measure the second quarter was our strongest in terms of community growth since 2013. Mobile remains the key driver of our growth. In June, approximately 1.31 billion people accessed Facebook on mobile devices, up 23% from last year. We also saw strong growth in our next generation of services with Instagram, Messenger and WhatsApp now exceeding 300 million, 700 million and 800 million MAU respectively. Now turning to the financials. All of our comparisons are on a year-over-year basis unless otherwise noted. Additionally, our non-GAAP measures exclude stock-based compensation and the amortization of intangibles. Total revenue was $4 billion, up 39%, or 50% on a constant currency basis. Ad revenue was $3.8 billion, up 43%, or 55% on a constant currency basis. The strengthening of the U.S. dollar has continued to have an unfavorable impact on our revenue. Had foreign exchange rates remained constant with Q2 2014 levels, our total revenue this quarter would have been approximately $330 million higher. Regionally, we saw strong North American ad revenue growth of 55% in the quarter, and APAC growth also remained strong at 48%. Europe and the rest of the world ad revenue grew more slowly at 30% and 22% respectively, as currency had a significant negative impact on each of those regions' year-over-year growth rates. Mobile is the engine of our revenue growth. Mobile ad revenue in Q2 was $2.9 billion, up 74% from last year, and represents 76% of our advertising revenue. Revenue from ads served on personal computers was down approximately 8%. In Q2, the average price per ad increased 220% while total ad impressions declined 55%. Similar to last quarter, these price volume trends were primarily driven by the redesign of our right hand column ads, which rolled out in the third quarter of last year. To a lesser degree, the shift of usage towards mobile, where we don't have right hand column ads, also contributed to the reported price volume trends. Total payments and other fees revenue was $215 million, down 8% compared to last year. The decline was driven by a 19% year-over-year reduction in payments revenue related to games played on personal computers, offset primarily by the addition of other revenue related to acquisitions closed in the second half of 2014. Turning now to expenses. Our Q2 total GAAP expenses were $2.8 billion, up 82%, and non-GAAP expenses were $1.8 billion, up 57%. Similar to last quarter, stock-based compensation and amortization expenses related to the WhatsApp acquisition contributed significantly to the year-over-year growth in GAAP expenses. Non-GAAP expense growth was primarily driven by increases in head count-related costs, cost of revenue and marketing expenses. We ended the quarter with 10,955 employees, up 52% compared to last year. With 873 additional employees, Q2 was one of our strongest quarters in terms of hiring, and the majority of the new employees were added in R&D. Our Q2 GAAP operating income was $1.3 billion, representing a 31% operating margin. Non-GAAP operating income was $2.2 billion, representing a 55% margin. Our Q2 GAAP and non-GAAP tax rates were 44% and 36%, respectively. Q2 GAAP net income was $719 million or $0.25 per share, and non-GAAP net income was $1.4 billion or $0.50 per share. In Q2, capital expenditures were $549 million and we generated $1.3 billion of free cash flow. We ended the quarter with $14.1 billion in cash and investments. Turning now to the outlook. Let's start with revenue. Since the first quarter of 2014, we have seen year-over-year advertising revenue growth rates decline each subsequent quarter. We expect this trend to continue in Q3 and Q4 as we continue to grow off a much larger base and face currency headwinds due to the strong dollar. In addition, we expect our total payments and other fees revenues to decline on a year-over-year basis for the remainder of the year. The decline in the second half of the year should be closer to the 19% year-over-year decline we experienced in the Payments business alone as we will be lapping periods in which we added other fees revenue from acquisitions closed in the second half of 2014. Turning to expense guidance. Based on our second-quarter results, we are narrowing the expense guidance range for 2015. We now expect the year-over-year growth rate for total 2015 GAAP expenses to be between 55% and 60%, narrowed from the prior range of 55% to 65%. And we expect the year-over-year growth rate for total 2015 non-GAAP expenses to be between 50% and 55%, narrowed from the prior range of 50% to 60%. We anticipate our 2015 capital expenditures will be in the neighborhood of $2.5 billion to $3 billion, down slightly from the prior range of $2.7 billion to $3.2 billion. We continue to expect stock-based compensation in 2015 to be in the range of $3 billion to $3.3 billion, approximately half of which is related to our prior acquisitions, most notably WhatsApp. We expect amortization expenses in 2015 to be approximately $700 million to $800 million. And lastly, we anticipate our Q3 and full year 2015 GAAP and non-GAAP tax rates to be consistent with the rates in the second quarter. We had a great first half of the year with solid revenue performance underpinned by healthy community growth across all of our services and regions. We have many exciting opportunities ahead, and we are investing in the talent and resources to capitalize on them as we seek to build long-term shareholder value. With that, operator, let's open up the call for questions."
},
{
"speaker": "Operator",
"text": "Thank you. We will now open the lines for the question-and-answer session. Your first question comes from the line of Anthony DiClemente with Nomura Securities. Your line is open."
},
{
"speaker": "Anthony DiClemente - Nomura Securities International, Inc.",
"text": "Thanks a lot. I have one for Mark and one for Dave. Mark, Facebook has had so much success in terms of the engagement, the growth of the engagement. I'm just wondering if there's a framework that you used to think about how much of that success is due to just the core value proposition of Facebook itself continuing to resonate with people at its most basic level as opposed to the product innovation that you've detailed in your prepared remarks or in your use cases? Which are more of a driver in your mind? And then second one for Dave. CapEx being down as a percentage of revenue in 2Q and you lowered the guidance. It doesn't feel like you guys are in the midst of ramping investment in the infrastructure. I wonder, as you look at the assets, you have so much growth, you have a shift to bandwidth intensive content and applications. Do you feel like you guys have just been more efficient in terms of your CapEx spend, or at some point should we anticipate a reacceleration of CapEx? Thanks."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "I can talk to the first part. So at some level, I do think that the core mission and promise of helping to connect people with their friends and family is very fundamental, right? And everyone has friends and family and wants to stay connected and uses a variety of tools and ways to do that in the world today, which are often very inefficient, and the Internet offers new opportunities to make that a lot better. When you look at the specific products that – and the work that we're doing, there's this process that we've followed that – where basically we'll look at an area of our products that people are using. So for example, going back a few years, News Feed, right, was – it's always been, since we rolled it out, a very central part of the product. But we're looking at the stuff with increasing rigor now where we organized the company into these product groups, and each product group leader will not just look at the product as one thing, but what are the key three or four or five use cases which often can really be their own product lines on their own, and we go through and we build those out to be world-class. And I think a lot of the success that we've seen has been because of some of the work that we've done a few years back at this point in products like News Feed and I mean that team has executed really well. But when I look forward, I'm very excited about doing the same thing for messaging and groups and video. There's many different use cases. You don't want to just look at these as one thing. There are a bunch of different use cases, and we want to be the best at each of them. And if you have good people leading those teams, then I think you can deliver that over time. So I think yes is the answer to your question. The mission is fundamentally deeply important to people, but that has to be coupled with good thorough execution of each of the available opportunities."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Yeah, Anthony. It's Dave. So on CapEx, we are absolutely investing in the infrastructure and 2015 is an investment year, so we are ramping CapEx versus 2014. The guidance is $2.5 billion to $3 billion, and that's up from $1.8 billion last year. We've got a lot of infrastructure investment that we're making across data centers, servers, network. We are clearly investing for the growth of both Facebook at its core and then also the additional services that we're bringing on. So we're proud about the efficiencies that we've had. The infrastructure team has done an outstanding job in driving good efficiencies through things like the Open Compute Project, which allows us to leverage an open-source strategy to lower our costs on server and other expensive hardware. It's been a great strategy for us. But given the growth we have in the business, given the opportunity we have before us, we're very much in investment mode in terms of the infrastructure."
},
{
"speaker": "Operator",
"text": "Your next question is from Douglas Anmuth with JPMorgan. Your line is open."
},
{
"speaker": "Douglas T. Anmuth - JPMorgan Securities LLC",
"text": "Thanks for taking the question. Mark, you talked about Oculus Rift shipping in 1Q 2016. Can you talk more about what you're most excited about in terms of the primary applications when it's into the mainstream? And then, Dave, can you also help us understand the cost structure more here as that product ramps? And then, Sheryl, if you could help us understand how broadly Instagram will open up to advertisers by year end? Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "I can talk about Oculus. So the reason why Facebook is excited in this space is I can give you two reasons for this. One is there's this continued progression of people getting richer and richer ways to share what's on their minds. So if you go back 10 years, most of how people communicated and shared was text. We are going through a period where now it's mostly visual and photos. We are entering into a period where that's going to increasingly be primarily video, and we're seeing huge growth there. But that's not the end of the line. I mean, there's always a richer way that people want to share and consume thoughts and ideas and I think that immersive 3D content is the obvious next thing after video. So if you look at what the initial use cases are going to be around that, I think it's a lot of the stuff that you hear people talking about. Video I think will be huge. So just taking that to be 3D and immersive. Gaming will be huge. And those are both areas that Facebook has been involved with. Once we start to get more of a critical mass, I think you can start to get social applications, which is what we as a company are more interested in over the long term and think have a huge amount of potential in addition to the video and gaming stuff, which I just think is going to be awesome in the next few years as well."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Hey, Doug. It's Dave. So just on the question of how Oculus would affect the cost structure, it's premature for us to be giving guidance on the cost structure in 2016. But I think one of the things to recognize here is that we're still early with Oculus. We haven't announced any specific plans as it relates to shipment volumes for the consumer for Rift. But we are still early in the development stage, so it'd be early to be talking about large volume shipments. Obviously, we're investing on the research and development side on Oculus in 2015 and that's factored into our expense guidance for this year."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "On Instagram, we are opening up to more advertisers. I talked about some of our global rollouts in the past quarter. We're also opening up more capabilities, which means more formats, like direct response, more ways to buy, like self-serve. That said, and it's important to understand this, while we think there's a lot of interest and great opportunity, we're going to be really thoughtful and strategic about how we ramp revenue. Instagram remains small relative to Facebook and it's going to really take time to have significant impact on our growth."
},
{
"speaker": "Operator",
"text": "Your next question is from Heather Bellini with Goldman Sachs. Your line is open."
},
{
"speaker": "Heather A. Bellini - Goldman Sachs & Co.",
"text": "Great. Thank you for taking the question. I just wanted to ask a little bit more about as you start to speak with more advertisers on the Instagram opportunity, how are you and they thinking about the differences in how they'll engage with their customers across both platforms? And I guess what I'm getting at is do you see Instagram targeting a different type of advertiser, or do you expect people to leverage both platforms and almost think of them as kind of separate areas to budget for?"
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "I think one of the things that's interesting about Instagram is while the ads are really visually appealing and that brings to mind certain verticals like fashion or autos, things where the visual really matters, what we're seeing is that lots of different verticals can use the platform really well. So a recent example, HTC working with their agency Swift did Instagram videos to raise awareness of their mobile device warranty program. So they targeted 18- to 34-year olds, they did five short videos with these funny moments of where you're about to break your phone, and they got a 6 point lift in awareness of what is a warranty program. I think that's not something you would think of typically as Instagram. In terms of Instagram and Facebook, we believe that marketers are looking to connect with people in a really deep way, connect with the right people, and our targeting we think is really strong compared to any other platform, at the right time. And that really means mobile. And we see such engagement on both Facebook and Instagram along with the different targeting and ad formats, we believe we'll be able to have and are already starting to have a relationship with marketers which grow across both platforms. Our focus with our marketing partners is their business results. I talked about in my remarks how we're looking for conversions. We're trying to help them measure. If you do a car ad for us, how many vehicles were driven off the lot? We see what products you use within Facebook or Instagram, or Facebook and Instagram, as less important as the best products for the right marketer at the right time to drive their business results. And we like having more abilities, more products, more apps to work with so that we can drive those business results."
},
{
"speaker": "Operator",
"text": "Your next question is from Brian Nowak with Morgan Stanley. Your line is open."
},
{
"speaker": "Brian Nowak - Morgan Stanley & Co. LLC",
"text": "Thanks for taking my question. There are two. In early June you rolled out some new CPC measurement methods about how the changes in the clicks and the CPCs are measured. Just being curious about kind of early findings you see in ad engagement growth, average price per ad, and then the advertiser feedback or change in budgeting since you've rolled out these CPC measurement changes? And then the second one, the North American advertising results are really strong, I think you had accelerating growth. Sheryl, could you just call out any specific ad products that are driving this faster North American ad growth? Thanks."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "On the first, we're always trying to improve our ad products so marketers can buy what they want and pay as they want to pay. We recently announced that we're updating the definition of CPC so that includes only websites and apps. But you can also buy on a cost per engagement basis, and that include likes, comments, and shares. It's too early to see any direct impact, but I think it's part of the innovation that you'll see from us as we continue to roll out different ways that marketers can use our tools, different ways they can pay, different results they can target. When you look at our overall growth, our growth is very broad-based. We're broad-based against all of our segments of marketers, so brand and direct response, SMBs and developers. Definitely a part of the story here is video. Our video demand is very deep. People love the format of video. It's long been used to reach people in a compelling way, and we can do targeting in a way that's really unique. So I'll share another example. Wendy's, working with their agency, VML, launched their Jalapeno Fresco Spicy Chicken product and they were trying to reach millennials and spicy food lovers. So working with us, they did five video ads, and on our platform, they could not just do the video format but they could target millennials and people who like spicy food, which is very specific targeting. They got an eight-point lift in ad recall and a four-point lift in purchase intent among their millennial target. And so what that shows is our growth is being driven by the ability of us to do this broad-based consumer media advertising but do it in a more targeted way."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Yeah. And I think, Brian, you were also commenting on North America. Obviously, it's probably, everybody realizes this, but the big disparity between the U.S.-Canada growth rates versus the other regions like Europe and the rest of world are the currency headwinds, which had a very significant impact to the year-over-year advertising growth rates in those regions."
},
{
"speaker": "Operator",
"text": "Your next question is from John Blackledge with Cowen & Company. Your line is open."
},
{
"speaker": "John R Blackledge - Cowen & Co. LLC",
"text": "Oh, great. Thank you. A couple of questions on video. Mark, I think you mentioned potentially some new options for video monetization. Maybe could you discuss some of the new options that we may see implemented? And just more broadly, how does video content evolve on Facebook from kind of what we see today? Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "Well, I can talk – oh, you want..."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "You can go first."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "Yeah, I mean, on the options on video monetization, it's going to be, still our focus is going to be on continuing to grow autoplay and continuing to leverage the video unit in News Feed. That's going to be the primary driver of video growth for us. So that's really the main focus. We've got other areas that we're experimenting with like suggested videos, which are going to be very much like those ads in a feed of suggested videos, which are also an opportunity for us. But essentially, the focus is going to be on monetizing through feed ads for video."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "I think you got them."
},
{
"speaker": "Operator",
"text": "Your next question is from Justin Post with Merrill Lynch. Your line is open."
},
{
"speaker": "Justin Post - Merrill Lynch, Pierce, Fenner & Smith, Inc.",
"text": "Great. Thank you. I think on the call, you said times spent was 46 minutes per day. Any comparable metric from past quarters? And then how would you, if you can give us that, how would you gauge the overall engagement of Facebook just for the core site? Maybe some help about what you're seeing there and what products are really having an impact. Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "Well, I think in terms of engagement the product is having, the biggest impact is News Feed continuing to do very well. So News Feed at the core is proving to be just a great experience for users. It's getting better. We continue to invest in that. As people spend more time with News Feed, we get better about understanding what they like and getting the content that they care about in front of them. So we're investing on that front. We're also doing more with public content. That's having an impact. So we're seeing across the board good improvements to News Feed. Video is another big contributor there as well. So, I mean, that's what we're seeing in terms of driving engagement. Engagement across the different regions as we think about it from a DAU-to-MAU perspective was at record levels in the quarter, so we're pleased with that. And we continue to see time spent grow across the platform. So on all those measures, we really like what we're seeing and we like the investments that we're making to make that News Feed experience even better."
},
{
"speaker": "Operator",
"text": "Your next question is from Ross Sandler with Deutsche Bank. Your line is open."
},
{
"speaker": "Ross Sandler - Deutsche Bank Securities, Inc.",
"text": "Great. I just had two questions, one for Mark and then one clarification for Dave. Mark, question on the messaging app. So the (37:37) from the first day keynote at the end of the day, Brian Acton and David Marcus were basically presenting different strategies in terms of their long-term philosophy around monetization of those two platforms. So if you look out three or five years, do you see the opportunity with Messenger and WhatsApp as being similar or can you just talk about the strategy there? And is the engagement for the messaging apps similar, higher, lower than the average for the core Facebook app in terms of daily visits? And then, Dave, you mentioned that you expect ad revenue to decelerate. I'm guessing that's a function of some of the FX headwinds. Can you talk about that on a currency neutral basis relative to the 55% in the second quarter? Thanks."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Sure. I can take the second part first. So in terms of – also you had asked about the growth rate in the back half of the year, so I'd kind of reiterate what I said in my comments. The business continues to perform very well, driven off the strength of our mobile News Feed apps business, and really consistent with the trend we've seen in the last several quarters, we would expect that year-over-year ads growth rate to decline modestly in Q3 and Q4, and it's really because we're delivering growth against a much larger scale News Feed business in the prior-year period and also, of course, headwinds are an impact as well, as you mentioned."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "And I can talk to the messaging strategy question. So the playbook that we're going to run with Messenger and WhatsApp is kind of similar to how we thought about building a business in Facebook and News Feed, where if you go back to 2006 and 2007, there were a lot of people who were kind of encouraging us to just put banner ads and kind of inorganic content into the experience, and what we decided was that over the long term, the ads and monetization would perform better if there was an organic interaction between people using the product and businesses. So instead of focusing on ads first, what we did was we built pages, and we made that free, that way as many businesses as possible could get into the network. And we built insights to make it so that businesses knew how they were driving business when they used pages for free and could post them to News Feed. And then on top of that whole ecosystem, we then had the opportunity to build what has turned into a News Feed business that we're really proud of, right. That we think is driving a lot of value and good content for people who are using the platform and helping a lot of businesses find customers and sell their products and grow overall. Messaging, I think, is going to be pretty similar, right? Where right now some people in WhatsApp use the service in order to message businesses, Messenger is, I think, more people-to-people today. We're working on a lot of different things that make it so that people can get value from interacting with businesses. We launched some of them at F8. We have a number of other things that we're working on across Messenger and WhatsApp. But the long term bet is that by enabling people to have good organic interactions with businesses, that will end up being a massive multiplier on the value of the monetization down the road when we work on that and really focus on that in a bigger way. So we'd ask for some patience on this to do this correctly, and the game plan will be more similar to what we did in Facebook with News Feed."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "And, Ross, you also asked about, I think, the impact of Messenger on our user statistics and the daily users. The vast, vast majority, virtually all of Messenger users, are using News Feed as well. So Messenger-only usage is not having a material impact on our overall usage stats."
},
{
"speaker": "Operator",
"text": "Your next question is from Mark May with Citi. Your line is open."
},
{
"speaker": "Mark May - Citi Investment Research",
"text": "Thanks for taking my questions. I had one on search. I think you mentioned 1.5 billion daily searches. Just kind of curious what portion of those are commercial, if you will, not so much lookups for friends and family but more commercial oriented, and kind of can you give us an update of where you are in the process of building out an even more robust search experience on Facebook and across the other family of apps? And then on Instagram, just a question on kind of how we should be thinking about the ramp as well as the long term opportunity. I guess the question would be in your tests, have you noticed any meaningful difference in Instagram users' willingness to see or interact with ads and their News Feed as compared with an average Facebook user, recognizing that probably Instagram's audience is more geared toward some of the developing markets in the U.S. relative to Facebook? Thanks."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Sure. On the search experience, and Mark can add anything if he'd like, but on the search experience from a monetization perspective, the vast majority of the searches are for people or posts, and there can be – there's the potential for there to be commercially relevant content in people's posts, people searches, which is the largest part of searching, is not something that we think is really up the monetizing category. But there's certainly great content that people are finding using post search, but it's really – the focus is really to try and allow people to discover content that's been shared on Facebook that's relevant to them, and that's going to be the focus in the near term. And as people consume more content on Facebook, there's opportunities to show them ads in Feed, so there's an opportunity there, but it's really around engaging with content that you want to find on Facebook."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "On Instagram, we haven't noticed any difference in willingness to engage with ads between the platforms for Instagram and Facebook, but we've ramped really slowly and we're very, very cautious. And again, we're going to continue to focus on the user experience, focus on the community growth and monetization will follow."
},
{
"speaker": "Operator",
"text": "Your next question is from Ben Schachter with Macquarie. Your line is open."
},
{
"speaker": "Ben Schachter - Macquarie Capital (USA), Inc.",
"text": "Yeah, just a couple of questions. One, given your success with standalone apps, should we expect to see more apps in the future, and could one of those focus specifically on video? And then on Oculus, the monetization for that, should we expect an App Store-like model where you'll be sharing revenue with the content partners? Thanks."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "We work on a lot of different things. I don't think we'd rule out the things that you just mentioned, but we don't have anything specific to talk about today on either of them I think."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Obviously, a big part of our investment strategy is investing in this next generation of apps and the focus there is on growing the communities around Messenger, WhatsApp and, of course, Instagram. That's all going really well and that's a big focus of our investment."
},
{
"speaker": "Operator",
"text": "Your next question is from Mark Mahaney with RBC Capital Markets. Your line is open."
},
{
"speaker": "Mark S. Mahaney - RBC Capital Markets LLC",
"text": "Great. Thanks. Two questions. David, the sales and marketing expenses this quarter were almost flattish sequentially. You don't normally see that in your business. Is there anything, any particular reason behind that why you didn't have that area grow? I assume it will continue to grow going forwards. And then, Mark, you made a comment about. I think you were referring to Instagram becoming one of the best places to get a real-time snapshot of the world. And it kind of reminds me or makes me think about some other leading platforms on the Internet. And I wonder how does that happen with Instagram? Is that something that you're already seeing users use Instagram to make that happen? Or is that something that you have to kind of tweak the user interface and change the product a little bit in order to try to have people think about it that way? How does it become that real-time snapshot of the world? Thanks."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "So on the sales and marketing expenses, Mark, I think you're going to see that be lumpy. That's just due to product marketing and that's just not going to necessarily be a steady quarter-to-quarter trend. So you're going to see that be lumpy. But, yes, we are investing more in general in sales and marketing over time, so you'd expect to see that line grow in line with the expense guidance that we're giving. So it's definitely an area that we'll be investing in on an ongoing basis and I wouldn't read too much into the quarterly trend there."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "Yeah, and in terms of Instagram, I just think Kevin and the team are doing amazing work. The clarity of focus and clarity of the vision that Kevin and Mike have has been exceptional. And this is something that they've always focused on. They've cared deeply about it since the first conversations I've had with Kevin. And I think it takes real composure as a leader to scale something to many x where it was just a few years ago and build up the organization and be able to continue pushing the products forward every day to be able to do that. And I think it's rare that you get someone who's as talented as the folks who are leading this. And they're just doing an amazing job."
},
{
"speaker": "Operator",
"text": "Your next question is from Paul Vogel with Barclays. Your line is open."
},
{
"speaker": "Paul Vogel - Barclays Capital, Inc.",
"text": "Great. Thanks. Kind of a similar follow-up question to Mark's. Your DAU to MAU number has been exceptionally strong and moving up. I'm going to guess a lot of that is mobile related. So I guess that would be question number one. Is it a lot mobile? And the second question would be sort of again around this real-time issue. Are you seeing more real-time usage of Facebook and are you developing more products specifically around kind of real-time usage of Facebook as a platform? Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "I think a lot of it is that we're getting better and better at ranking and showing people the content they want. And part of it is that there's of course a bigger opportunity when people have their phones with them all the time, but I think that there are plenty of other worlds that we could be living in where we wouldn't have necessarily executed on that opportunity. And the execution is hard, right? And just kind of having something that's appealing universally to people wanting to stay connected with their friends, that's an important piece of it. But I mean, the team has just done really good work in terms of ranking the content and making the experience faster and building out better ways to get feedback from our community on what kinds of content they want to see in News Feed and helping people have the tools that they need to share the social content and news and video content that they want so that way it exists in the corpus of content that can be shown. And I just think the team is doing a really good work on all of these, and I'm really proud of them."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "And, Paul, there's no doubt that mobile has a beneficial effect on our engagement in the U.S. Two out of three smartphone users check their phone as soon as they wake up in the morning. It's just having that experience readily available in your pocket is tremendous, and we just see that being helpful across the business as it relates to mobile engagement."
},
{
"speaker": "Operator",
"text": "Your next question is from Brian Wieser with Pivotal Research. Your line is open."
},
{
"speaker": "Brian W. Wieser - Pivotal Research Group LLC",
"text": "Thanks for taking the question. You mentioned 40 million small businesses have active Pages. I'm wondering if you could update us on how many individual small businesses, or businesses in total are buying ads right now? And separately, I was curious about your current thoughts on how ad tech businesses will evolve. If you see integrated marketplace evolving, or if you see a discreet demand in supply-side businesses evolving?"
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "So on the first, we announced that we have over 2 million advertisers who are buying ads on Facebook. And the process for that is often that small businesses become organic users, so those 40 million small business Pages that are using it once a month and then we're able to move them onto being advertisers. And the best way we've done that is by simplified ad products. 82% of people who start advertising with us start with our really simple ad products. You know, do you want to pay a few dollars or a few pounds or a few euro to sponsor this post is a really easy on-ramp for a small business. In terms of overall ad tech world, I think a lot is happening and there's a lot that's going to evolve in the whole ecosystem. Our focus is on bringing people-based marketing and the effectiveness and relevance of Facebook ads off of Facebook so we can give marketers and publishers the tools to reach people across all of their devices. An importantly for our business, is connect the dots between online marketing and business outcomes. And you heard on this call me give a few examples of where we're already able to connect what happens in terms of ads with real sales of real products. For us, this is an important investment and it's very strategic. We are going to put the time in to make this work rather than look for any short-run specific return."
},
{
"speaker": "Operator",
"text": "Your next question is from Peter Stabler with Wells Fargo Securities. Your line's open."
},
{
"speaker": "Peter C. Stabler - Wells Fargo Securities LLC",
"text": "Good afternoon. Drafting off that. Sheryl, I'm wondering if you could update us on Atlas. We understand Atlas in and of itself is not likely be a major revenue driver, but we do see it as a strategically important piece of your toolset. So wondering if you can comment on agency adoption. Is it going according to plan? Are you happy with it? And then secondly, on SMB, just wondering, the 80 events that you've held around the world. In terms of learning come out of those, you talked a little bit about how folks get introduced as users, and that makes sense. Is the toolset simple enough today for SMB's to grasp? Or are there significant additions that you need to make to the toolset to accelerate the growth of SMB advertisers? Thanks very much."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "So on the first, Atlas is really important because it's solving a measurement problem which is that the current systems for serving and measuring ads are really flawed. They basically assume that you are one person on one of device, and we know that's not true. They are only about 65% accurate in demographic targeting, they don't work on mobile because they are cookie based, they don't work on multiple devices, they don't go off-line to on-line and they overemphasize the last click and reach. And so our focus with Atlas is helping people really understand the results they get with ads. And you heard my Live Nation example earlier where we are able to connect Facebook ads and our platform directly to ticket sales. We never could have done that without Atlas measurements. In terms of the migration process, this is an enterprise sale. We have to work client by client. Then they have to choose us, then they have to migrate their systems, and so it's going to take time. What really matters is that when we get that migration and we are seeing it, we are able to show them the value because it makes their buying much more effective because they understand real results in a new way. In tune with SMBs I would say two things. I would say that, one, our products aren't simple enough yet, because they can never be simple enough for SMBs, but two, our products are probably the simplest ones out there. And so I think we're leading and I think we have a lot more to do. If we look at even in the United States, which is a very advanced market, I think it's something like 35% of SMBs don't have a web presence of any kind. But a great majority of those do have a Facebook page, and that's because setting up a web presence for an SMB is complicated and expensive. You can't just start a webpage. But it is easier and free to start a Facebook page until you see broad adoption. We also make a lot of things that they couldn't do in other platforms available on us. So over 1 million SMBs have posted a video on Facebook, which is pretty amazing, because I doubt 1 million SMBs have ever run what is a video or TV ad. That's because you can shoot it on your mobile device, you can upload it, you can do that for free or you can pay us for the ad. And so I think our tools are the simplest, but I think we still need to do better because what we hear from SMBs is simple, fast, inexpensive, showing them real return, and we're going to continue to focus on all of those things."
},
{
"speaker": "Operator",
"text": "Your next question is from Eric Sheridan with UBS. Your line is open."
},
{
"speaker": "Eric J. Sheridan - UBS Securities LLC",
"text": "Thanks for taking the questions. I wonder if I could get an update on the e-commerce initiatives including the partnership with Shopify and how we should be thinking longer term about e-commerce becoming a bigger and bigger part of the platform. Sheryl, you called out Priceline.com and the booking relationship during your prepared remarks. Just curious how far that might go longer term. Thanks."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "So e-commerce is one of our top categories of advertisers, and we are already driving a lot of product sales through Facebook but importantly, our e-commerce initiatives are really about connecting consumers with marketers so that they can buy from companies. They're not buying through us. We are testing a buy button in the new shop section on pages, but again, that buy button is letting people buy directly from their advertisers, not from us. It's pretty early days. We're excited by what we see in the e-commerce vertical and we're going to continue to invest in growing that vertical as part of our ads business."
},
{
"speaker": "Deborah Crawford - Director-Investor Relations",
"text": "Okay. Operator, we have time for one last question."
},
{
"speaker": "Operator",
"text": "Certainly. Your final question is from Brian Pitz with Jefferies. Your line is open."
},
{
"speaker": "Brian J. Pitz - Jefferies LLC",
"text": "Thanks. Questions on audience network. Any updates here including a sense for the level of adoption you're seeing from developers? Also any synergies with the mobile app install product? And finally any comments on ad price comparisons to traditional News Feed ads? Thanks."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "We're seeing investment, we're investing in the audience network and we think it's important because it takes – it makes the ads more relevant. It's part of our overall ad tech push to bring the effectiveness and relevance of our ads off us. We're growing the number of advertisers and publishers, and we're continuing to see growth and we'll continue to invest. When you think about mobile app install ads, those are an important but relatively small part of our revenue. The important thing to understand here is that they're not only used by developers, they're used by all four marketer segments. So for example, HBO used our video retargeting mobile app install ads on Facebook to drive downloads at HBO now, and Facebook is now the number one channel driving subscribers. And I think when people think about our mobile app install ads they often think this only applies to developers and small companies, and really it's them as well but it's also companies like HBO which are using those ads to drive adoption and downloads."
},
{
"speaker": "Deborah Crawford - Director-Investor Relations",
"text": "Thank you for joining us today. We appreciate your time, and we look forward to speaking with you all again."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's conference call. Thank you for joining us. You may now disconnect your lines."
}
] | null | null |
META | 1 | 2,015 | 2015-04-22 17:00:00 | Executives: Deborah Crawford - Director-Investor Relations Mark Elliot Zuckerberg - Chairman & Chief Executive Officer Sheryl K. Sandberg - Chief Operating Officer & Director David M. Wehner - Chief Financial Officer
Analysts: Brian Nowak - Morgan Stanley & Co. LLC Douglas T. Anmuth - JPMorgan Securities LLC Heather Anne Bellini - Goldman Sachs & Co. Eric J. Sheridan - UBS Securities LLC Youssef H. Squali - Cantor Fitzgerald Securities Mark S. Mahaney - RBC Capital Markets LLC Paul Vogel - Barclays Capital, Inc. John R Blackledge - Cowen & Co. LLC Justin Post - Bank of America Merrill Lynch Ross Sandler - Deutsche Bank Securities, Inc. Brian J. Pitz - Jefferies LLC Ben Schachter - Macquarie Capital (USA), Inc. Peter C. Stabler - Wells Fargo Securities LLC Mark A. May - Citigroup Global Markets, Inc. (Broker)
Operator: Good afternoon. My name is Chris, and I'll be your conference operator today. At this time, I would like to welcome everyone to the Facebook First Quarter 2015 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operation Instructions] Ms. Deborah Crawford, Facebook's Vice President, Investor Relations, you may begin.
Deborah Crawford - Director-Investor Relations: Thank you. Good afternoon, and welcome to Facebook's first quarter earnings conference Call. Joining me today to talk about our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements and actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and on our Annual Report on Form 10-K filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these statements as a result of new information or future events. During this call, we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I'd like to turn the call over to Mark.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: Thanks, Deborah, and thanks, everyone for joining us today. This was a good quarter and a good start to the year. We continue to grow the size and engagement of our community, now with 1.44 billion people using Facebook each month and 936 million people daily. We continue to see strong growth in daily engagement around the world, including in our most engaged markets. On mobile, nearly 1.25 billion people now use Facebook every month, 240 million than a year ago, and we now see more than 1 billion mobile searches every day. Looking at our business, we continue to achieve impressive growth. Total revenue grew by 42% year-over-year, and advertising revenue grew by 46%. Mobile now accounts for 73% of our ads revenue. These results show that we're making progress in our mission to connect the world and we're executing well against our priorities. But this quarter also shows how Facebook is continuing to make progress for the years ahead. Facebook has evolved from a single blue app on your phone into a family of apps. Now, many of these apps are reaching a global scale. More than 1.4 billion people use the core Facebook service, 800 million also use WhatsApp, 700 million use our Groups product, 600 million use Messenger, and on Instagram, there are more than 300 million active members of the community. We're building this family of apps because we want people to be able to share whatever moments they want with all the different sets of people they care about. Over time, we expect people to share richer content with an increasing frequency so we want to continue developing new and better tools to facilitate this expression. So with that in mind, let's talk about our efforts over the quarter. First, we're working to help people share and connect with all the things they care about today. An important part of our approach is helping our community to connect around important public moments and personalities. Facebook is the largest community of sports fans in the world, with 650 million people connecting to sports pages. For this year's Super Bowl, more than 65 million people generated more than 265 million interactions on Facebook, the highest level of conversation we've seen for a Super Bowl to-date. For the Cricket World Cup, there were more than 700 million interactions by 53 million people, which shows the strength of the global reach of our community. We're also making good progress with video. We're very pleased with our growth here, and this quarter we reached a new milestone of more than 4 billion daily videos views. We also launched an embedded video player that allows people to watch Facebook videos across the web, and more than 80,000 videos have now been embedded on third-party websites. Spherical videos are going to be supported in News Feed later this year, allowing you to change your viewing angle for a more immersive experience. Supporting new types of content like this is an important part of preparing for the future of how people want to share. Now, another part of our strategy is helping people connect with businesses. This quarter, we announced that there are now 2 million advertisers on Facebook. This is an important milestone for our community, and we're encouraged that so many businesses are finding value on Facebook. We continue to focus on innovation in our ads business, and Sheryl is going to talk a bit more about that in a moment. Now, here's how we're working to develop our family of apps so we can give people more options for sharing in different ways. In the future, we expect that people are going to want to share content with their closest friends at an even greater frequency than they do today, so messaging is a big priority for us. Across the Facebook family of apps, our efforts have a lot of momentum. On average, more than 45 billion messages are sent every day. With voice calling, we're also starting to make some good progress. This quarter, we started rolling out Voice over IP calls on WhatsApp to let people call friends for free around the world. And meanwhile, Messenger already accounts for more than 10% of mobile VoIP calls globally. With WhatsApp, we continue to be pleased with our growth and the team remains very focused on building new features to serve their community and expand. For Messenger, this has been a particularly busy quarter. We launched the Messenger Platform, which allows people to use creative new apps to have richer conversations. We also began rolling out payments on Messenger to give people an easy, secure way to send money to their friends. And we announced a new way for people to communicate with businesses using Messenger. We're really excited by the potential to build Messenger into a service that helps people to express themselves in rich new ways and to access useful services. With Instagram, our growth remains impressive, and this quarter, we reached a new milestone of more than 200 million daily actives. Growth in Asia, Europe, and Latin America is particularly strong, with our community growing in some countries by more than 100% year-over-year, including Japan, South Korea, and Indonesia. Combined with an average 21 minutes a day that people spend on Instagram, this is a good sign of this community's continuing and growing strength. Now, let's talk about how we're working with developers. Last month, we held F8, our annual event for the global developer community. Creating the future of sharing isn't something that we can do on our own, but by supporting developers, we can deliver more apps and experiences for our community. At F8, we presented new tools to help developers build, grow, and monetize their apps, including better sharing experiences from apps to Facebook and new analytics to help developers better understand how people are using their services. More than 30 million apps and sites have been built using Facebook developer tools, and last year we drove more than 3.5 billion app installs. We think these improvements are going to create a lot of value for our community. All right. Finally, let's talk about some of our most long-term innovation efforts. Internet.org, our effort to connect everyone in the world to the Internet, continues to gather momentum. We've now made free basic Internet services available to more than 800 million people in nine countries, including just in this quarter, launching in India, Colombia, Ghana, Guatemala, and the Philippines. More than seven million people who weren't connected to the Internet before now use internet.org to get online. And this year, we expect to connect even more people. With our efforts in search, AI and Oculus, we're also continuing to build a new generation of Internet services that are more useful, intuitive, and immersive. And over the coming months, we'll have more to share about these. So that's how we're thinking about innovation and the future of sharing. It's been a busy quarter. In the last few months, I've visited countries in Asia, Europe, and Latin America. In many communities, I've gotten the chance to see how the Internet is changing lives and creating opportunities for people. I've heard from people who can't wait to get access to the same tools that so many of us take for granted. We're making progress on our mission and working to accelerate towards the day when everyone in the world can be connected. Thanks to our entire community and all of our employees, partners, and shareholders for being a part of this journey and for helping to build something great. Now, here's Sheryl.
Sheryl K. Sandberg - Chief Operating Officer & Director: Thanks, Mark, and hi, everyone. Q1 was a strong quarter and a great start to the year. Ad revenue was $3.3 billion, up 46% or 55% on a constant currency basis. Mobile ad revenue grew 82% and is now 73% of total ad revenue. Our performance was strong across all marketer segments and we're pleased with the broad-based growth across our industry verticals. From a regional perspective, we saw strong growth in North America and Asia-Pacific, while Latin America and Europe were affected by foreign exchange headwinds and macroeconomic factors. That said, we're pleased with advertiser adoption of our ad products across all regions. Innovation drives our ads business. It's how we continually improve the quality of our ads, offer new tools to marketers, and build better experiences for the people who use Facebook. We believe that this ability to innovate will continue to drive our business. So today I want to focus on innovation across our three strategic priorities, capitalizing on the shift to mobile, growing the number of marketers using our ad products, and making our ads more relevant. First, capitalizing on the shift to mobile. Mobile continues to be a great opportunity for us. People continue to be highly engaged with our mobile apps. In the United States, for example, Facebook and Instagram get more than one out of every five minutes spent on mobile. As consumers shift to mobile, businesses are following, and we're focusing on helping them take advantage of this opportunity to use mobile to build their businesses. Two new products we introduced this quarter are good examples of this. The Mobile Ads Manager app gives marketers the ability to manage their ad campaigns from their mobile devices. It's early, but we're already seeing more marketers managing their activity on mobile. We also launched a page creation tool for feature phones, which has been a big driver of page adoption in high-growth emerging markets where smartphones are less common. Looking ahead, we believe video will play a significant role in bringing more marketers to mobile. More than 75% of global video views on Facebook occur on mobile, and we believe mobile video will become more important to marketers over time. Lionsgate's Age of Adaline premiere is a great example. To promote the film, Lionsgate targeted young women on Instagram with multiple video ads over the last few weeks. This week, since the film opens on Friday, they are retargeting the audience from the Instagram campaign on Facebook. We expect more marketers to put mobile video at the heart of their campaigns in the future and we're well-positioned to drive this shift. Our second priority is growing the number of marketers using our ad products and we're making great progress. In Q2 of last year, we shared that we reached 30 million active business Pages on Facebook. This number continues to grow as more and more small businesses are using our Free Pages product, and we remain focused on converting these Page owners into advertisers. One way we're doing this is by providing simple, easy to use products. Over 80% of our new advertisers start with entry level tools like a promoted post or a Page like. We are increasingly focused on making sure these tools work well on mobile. We're also educating marketers on how to use Facebook more effectively. We recently launched two online training resources: Blueprint for large clients and agencies, and Learn How videos for small businesses. These efforts are paying off. In Q1, we announced that we now have over 2 million active advertisers. Our third priority is making our ads more relevant. More relevant ads lead to better returns for marketers and better experiences for people. We're pleased with the increased adoption of our targeting tools like Custom Audiences and Conversion Tracking. In Q1, we introduced Dynamic Product Ads, which allow marketers to launch ads for different audiences. We also introduced carousel ads on Facebook and Instagram, which allow marketers to advertise for specific products. Adoption of our targeting tools and these new ad formats help make our ads more relevant. We're also focused on insights and measurement. We want to help marketers accurately measure the performance of their campaigns and then apply that learning to improve their returns. In Q1, we released an ad relevance score, a way for marketers to better understand how people respond to their ads. This helps marketers test different types of creative and optimize performance. We also launched Conversion Lift, a tool that scientifically measures how much additional business was driven from Facebook ads. This is important because it shows that ads on mobile can drive sales in retail stores and via other channels. For example, Cellbes is a women's fashion retailer in Europe. Using Conversion Lift, they proved that ads on Facebook mobile drove sales on desktop and via phone calls to sales reps at their call centers. On the ad tech side, we're pleased with the results we're driving for advertisers and publishers. A good example of this is Cheetah Mobile. Using native ads from the Audience Network in its apps, the company is getting more than two-times the CPMs compared to other ad networks. We continue to invest in our ad tech platform. At our F8 Developer Conference last month, we made new two important LiveRail announcements that will improve the relevance of ads people see across sites, apps, and devices. We extended LiveRail's video ad platform into in-app mobile display, which will give publishers better ways to manage their ad inventory across devices. We also announced that LiveRail will give publishers access to Facebook's anonymized demographic information, enabling us to serve more relevant ads to people. We've had a great start to the year and we're really optimistic about what's to come. Our teams are executing well, staying focused on our big priorities and continuing to innovate. Now, here's Dave.
David M. Wehner - Chief Financial Officer: Thanks, Sheryl, and good afternoon, everyone. Q1 was a strong quarter for Facebook. We generated $3.5 billion in revenue and $1.2 billion in free cash flow and continued making investments to position us for both near-term and long-term growth. We are pleased with the growth and engagement of our community. In March, 936 million people used Facebook on an average day, an increase of 17% compared to last year. This daily number represents 65% of the 1.44 billion people who used Facebook during the month of March. Mobile remains the key driver of our growth. In March, approximately 1.25 billion people accessed Facebook on mobile devices, up 24% from last year. In addition to Facebook, Instagram, Messenger, and WhatsApp continue to grow, exceeding 300 million, 600 million, and 800 million MAU, respectively. Now turning to the financials. All of our comparisons are on a year-over-year basis unless otherwise noted. Additionally, as a reminder, our non-GAAP measures exclude stock-based compensation and the amortization of intangibles. Total revenue was $3.5 billion, up 42% or 49% on a constant currency basis. Ad revenue was $3.3 billion, up 46% or 55% on a constant currency basis. The general strengthening of the U.S. dollar in the past year had an unfavorable impact on our revenue. Had foreign exchange rates remained constant with Q1 2014 levels, our total revenue this quarter would have been approximately $190 million higher. Regionally, we saw strong North American ad revenue growth of 53% in the quarter, second only to APAC, which grew 57%. Europe and the rest of world revenue grew more slowly at 35% and 32%, respectively, with currency impacts leading to a significant reduction in these regions' year-over-year growth rates. Mobile ad revenue in Q1 was $2.4 billion, up from approximately $1.3 billion last year. Revenue from ads served on personal computers was down approximately 4% and we continue to see overall usage on PCs decline. In Q1, the average price per ad increased 285% while total ad impressions declined 62%. Similar to last quarter, these price volume trends were primarily driven by the redesign of our right-hand column ads, which rolled out in the third quarter of last year. To a lesser degree, the shift of usage towards mobile, where we don't have right-hand column ads, also contributed to the reported price volume trends. Total payments and other fees revenue was $226 million, down 5% compared to last year, a trend we expect to continue. The decline was driven by the year-over-year reduction in payments revenue related to games played on personal computers. Turning now to expenses. Our Q1 total GAAP expenses were $2.6 billion, up 83%, and non-GAAP expenses were $1.7 billion, up 57%. Similar to last quarter, stock-based compensation and amortization expenses related to the WhatsApp acquisition contributed significantly to the year-over-year growth in GAAP expenses. Non-GAAP expense growth was primarily driven by increases in head count-related costs, cost of revenue, and marketing expenses. We ended Q1 with 10,082 employees, up 48% compared to last year. We remain very pleased with our ability to attract and retain top-tier talent. Q1 operating income was $933 million, representing a 26% operating margin. Non-GAAP operating income was $1.8 billion, representing a 52% margin. Our Q1 GAAP and non-GAAP tax rates were 45% and 35%, respectively. Q1 GAAP net income was $512 million or $0.18 per share, and non-GAAP net income was $1.2 billion or $0.42 per share. In Q1, capital expenditures were $502 million and we generated $1.2 billion of free cash flow. We ended the quarter with $12.4 billion in cash and investments. Turning now to the outlook. Let's start with revenue. The strengthening of the U.S. dollar in the past year reduced our Q1 total revenue growth rate by 7 percentage points, or approximately $190 million. The dollar strengthened over the course of the quarter and, in the month of March, our year-over-year total revenue growth rate was approximately 10% lower than it would have been in constant currency terms. Based on this, we estimate that foreign exchange headwinds in Q2 will likely be greater than those we experienced in Q1. In addition, we expect our total payments and other fees revenue to decline on a year-over-year basis for the remainder of the year. Turning to expense guidance. We are tightening our expense guidance range modestly based on better visibility into our annual spending. We expect that the year-over-year growth rate for total 2015 GAAP expenses will be in the range of 55% to 65%, as compared to our prior guidance of 55% to 70%. We expect that the year-over-year growth rate for total 2015 non-GAAP expenses will be in the range of 50% to 60% as compared to our prior guidance of 50% to 65%. Our expense outlook reflects the broad range of investments that we're making in both our services and infrastructure as we continue to enhance the core experiences on Facebook and Instagram, grow our messaging products, strengthen our advertising business globally and invest in long-term growth areas like Oculus and internet.org. The remainder of our guidance remains unchanged. We anticipate our 2015 capital expenditures will be in the neighborhood of $2.7 billion to $3.2 billion. We expect stock-based compensation in 2015 to be in the range of $3 billion to $3.3 billion, approximately half of which is related to our prior acquisitions, most notably WhatsApp. We expect amortization expenses in 2015 to be approximately $700 million to $800 million. And lastly, we anticipate our Q2 and full-year 2015 GAAP and non-GAAP tax rates to be consistent with the rates in the first quarter. In summary, Q1 was a great start to the year for Facebook. We're very pleased with the growth of our community, the strength of our business, and the investments we're making to build long-term shareholder value. With that, Chris, let's open up the call for questions.
Operator: Thank you. We'll now open the lines for a question-and-answer session. Your first question comes from the line of Brian Nowak with Morgan Stanley. Your line is open.
Brian Nowak - Morgan Stanley & Co. LLC: Thanks for taking the questions. I have two. The first one, I guess, can you talk a little about early advertiser and publisher feedback from the LiveRail in-app mobile product and what are some areas where you see potential for improvements to drive faster adoption? And then on the OpEx side, I appreciate you're tightening the range. Can you help us at all on expectations for head count growth this year and what are the biggest areas you see investing in incremental employees this year?
Sheryl K. Sandberg - Chief Operating Officer & Director: So, on LiveRail, we're pleased with the performance and the changes we've been able to make. Video is obviously super important so having the ability to do – work on video across the web has been really great. And then at F8 we made two more announcements that I mentioned. What we're hearing from publishers is that this is a good opportunity and they're pleased with the extensions we're making because it can make their ad serving and buying more efficient across the platforms they use. In terms of areas for improvement, I think there's a lot we can do. I think have you to look at our ad tech investments very holistically from Atlas to LiveRail to the Audience Network. These are all different pieces of the ad tech but what they're all working on is taking the relevance and the ability to do people-based marketing and make that available to work on Facebook but also off Facebook. We believe that because we can do marketing to people and then measure results across what people do in privacy-protective ways, we have an ability to improve the relevance of marketing which will make it better for consumers and increase returns for marketers.
David M. Wehner - Chief Financial Officer: And Brian, it's Dave. Just on the OpEx question, I think the key is that we're investing in our near, mid-term, and long-term priorities, so in the near-term we're investing to grow the community, execute on the existing business, both on the product side and then the advertising and sales force side. And in the mid-term, we're building out those next-generation of services to be great businesses that reach their full potential, so that's Instagram, WhatsApp, Messenger. And then in the long-term, we're investing in areas like the next-generation computing platform, internet.org, AI. In general, I would say our head count growth has skewed towards the R&D side because a lot of these initiatives have long-term development needs. So we've been investing there. But we are investing across the board. In terms of a specific head count guidance, I would just stick with our expense guidance. But I'd note that the 48% year-over-year does include some inorganic growth from the pickup of the three larger acquisitions, Oculus, LiveRail, and WhatsApp. We haven't lapped those at this point.
Operator: Your next question is from Douglas Anmuth with JPMorgan. Your line is open.
Douglas T. Anmuth - JPMorgan Securities LLC: Thanks for taking the question. One for Sheryl and one more Mark. Sheryl, I just wanted to ask you to talk a little bit more about big brands, give us a sense for what's working best in terms of products? And then also how penetrated do you think Facebook is now with some of the larger brands? And, Mark, what are the signals that you'll be looking for to tell you when it's the right time to ramp-up the advertising on Instagram more? Thanks.
Sheryl K. Sandberg - Chief Operating Officer & Director: Our growth was really strong across all of our marketer segments, but we had a particularly good quarter in brands, I think driven by two things. The first is that we really have a great platform to do creative storytelling on mobile and I think we have that in a way that no one else does. Our mobile ad product is so integrated into the user experience and provides real creative flexibility that people have a way to reach people on mobile and that's becoming increasingly important in telling the stories that drive their business. The second thing is video. Video is exploding on Facebook, as Mark talked about, and that gives us an opportunity to do a lot of work with marketers on video. This is the first time the technology and media vertical was one of our top four verticals. And that's largely because of the use of mobile. And so that's been really a great story for us. In terms of penetration, we work with almost all the large marketers almost everywhere in the world. But even for the largest, the largest clients we have, we are a very small part of their budget. I don't think we have any large clients, if you look at 25% in the U.S. of consumer media time is on mobile and then 20% of mobile time goes to Facebook and Instagram that would be 5% of U.S. consumer media time. With our largest clients, even our large ones, we're not close to 5% of their spend. And so I think we have a considerable opportunity to grow, and we also expect those underlying numbers time on mobile to continue to grow.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: Yeah. Your second question about Instagram and the ads opportunity there, we think about this the same way that we do ads in Facebook today. The primary goal is to increase the quality. That's our strategy for growing the business. There's more inventory that we can open up on Instagram over time because it's so early, but we're going to do that once we get to formats that are working well for businesses and that we feel really good about in the consumer experience. And this has been a theme for our ad strategy and product development for more than a year now, maybe two years, where folks have consistently asked us what we're going to do to increase the amount of ads that we're showing. And our response has been that we're going to focus on improving the quality and relevance and that's both going to perform better for the people using our services and businesses who are buying ads. And that strategy, I think, is bearing out and we'll continue to apply it to all of the things that we do.
Sheryl K. Sandberg - Chief Operating Officer & Director: One clarification, I think I said tech and media as a vertical, I meant entertainment and media that this is the first quarter that entertainment and media is one of our top verticals.
Operator: Your next question is from Heather Bellini of Goldman Sachs. Your line is open.
Heather Anne Bellini - Goldman Sachs & Co.: Great. Thank you. I just had two quick ones. I was wondering, Mark, I think you mentioned you're seeing 1 billion searches per day on mobile. I was wondering if you could give us an update on your initiatives here. And also when you think about Facebook kind of as a microcosm of different applications, at some point is there a plan that we will be able to search – use the search functionality to go across all the different Facebook apps that we might have installed on our mobile devices?
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: So we're pretty early in this whole thing and there's so much unique content that people share in Facebook that I think that that is the clear, unique opportunity to go for first, right? I mean there's – if you think about the overall web, there's a lot of public content that's out there that any web search engine can go index and provide. But a lot of what we can get at are recommendations on products and travel and restaurants and things that your friends have shared, they haven't shared publicly, and knowing different correlations, or interesting things about what your friends are interested in, and that's the type of stuff, those are questions that we can answer that no one else can answer, and that's probably going to be what we continue to focus on doing first. And I think what you're seeing is that as we enable more use cases and as we just get a lot of the basics right around performance and bringing the mobile features into parity and beyond what we've been able to do on desktop, the volume is growing quickly. I think on a recent earnings call we just announced that we passed 1 billion searches total so now being more than 1 billion on mobile shows some progress that I'm pretty proud of for the search team.
Operator: Your next question is from Eric Sheridan with UBS. Your line is open.
Eric J. Sheridan - UBS Securities LLC: Thanks for taking the questions. Maybe one for Mark and one more Sheryl. Mark, you talked about the family of apps at Facebook. As more and more people are consuming professional content, different verticals like news, sports, and video format on Facebook, how do you think about the use case for the consumption of that content inside the main Facebook app versus maybe an even separate app for more professional content long-term for Facebook? And then for Sheryl, appreciate the color you gave us on the evolution of targeting on Facebook. Wanted to know either qualitatively or quantitatively if you could talk a little bit about the way those ads are performing as you continue to evolve the product set around targeting on Facebook and off, in particular around Dynamic Product Ads and what that might mean for closing the loop longer term. Thanks so much, guys.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: Yeah. So in terms of news and different kinds of content, I know this has traditionally been something that we've delivered a really good experience for in terms of people being able to share the content that they want, being able to get access to the content that they want, different recommendations from friends, and we've a lot more coming there, so I'm excited about that. And we definitely do see in this family of app strategy that there's so many new ways that people want to share content, and so many different types of sets of people that people want to share with, right, ranging from one person at a time and that would be messaging or small group sharing or sharing with interest-based communities or sharing with all your friends at once or sharing with public. There are just a lot of different experience that needs to get built. And a lot of what we're trying to do is enable a number of those things through Facebook, while also building unique world-class services to enable people to share all the things they care about with all the different sets of people that they care about. So we're going to keep on doing more there. But we're happy with where we are now. We have a number of services that are reaching pretty good scale and I think we'll keep on pushing that.
Sheryl K. Sandberg - Chief Operating Officer & Director: To your question on targeting and closing the loop, these are two really important pieces for what we want to do. Our goal when we work with marketers is to drive their business, and that means their products off the shelves, their services into the hands of people, and so in order to do that well, we need to work on targeting and we need to work on measurement. So with targeting, a more relevant ad is just better, it's better experience for consumers because they see something they like in their News Feed and it has a higher return for marketers. And so we're very focused on getting more people to use our targeting tools from Custom Audiences which lets people target ads differently to their current customers or people who they'd like to be their customers to look like audiences which enables us to identify the kind of characteristics of your current customers and then find other people on Facebook who share those characteristics so, again, the ad is well targeted. I think our targeting abilities are really second to none, and I'll share a recent example. XFINITY put out a voice guide for visual disabilities, and they did this, they did this by doing an Oscar commercial with a girl who is blind imagining what Wizard of Oz characters looked like. Now by doing that at the Oscars, that's obviously TV and it's a very broad ad and that's because they were both showing a product but also working on their brand. On Facebook, they took that ad and showed it to movie fans, Wizard of Oz fans and also people connected to accessibility causes. That's actually pretty specific targeting that lets them hit exactly the right audience and amplify what they were doing on TV, and I think that's the kind of thing that only we can do at scale, and it shows how important targeting is. When you think about closing the loop, you then have to add in the measurement piece because if we can connect, people seeing ads on Facebook to what they buy, in stores or in other ways, that's how you close the loop and that's why we put so much investment and hopefully so much innovation behind measurement. So conversion tracking is increasingly used, and we work with our marketers to use it even more, and we're also really excited about conversion list because that's the first product we've had which scientifically measures the additional business you get from Facebook ads. It compares test groups that see ads with control groups that don't. So whatever you're measuring in terms of conversions whether it's sales or website clicks or registrations, we can A, B test and see exactly what the impact Facebook has. I think we're still at the beginning of this. I think there is so much more we can do to make ads more relevant on Facebook and so much more we can do to measure results, and I think our future growth will depend on executing on that very well.
Operator: Your next question is from Youssef Squali with Cantor Fitzgerald. Your line is open.
Youssef H. Squali - Cantor Fitzgerald Securities: Thank you very much. A question for Dave and then maybe one for Mark or Sheryl. FX adjusted ARPU growth this past quarter, it was about 35%, which is by our math about half of what it was last year and within mobile, it was about 45%, that's about a third of what it was last year. Other than tough comps, what else is driving that decline? Is it just Q1 seasonality getting more pronounced? Is there anything else – we would have thought maybe video advertising would have had actually the opposite effect. And then what's your – maybe Mark or Sheryl, what's your experience so far with Voice over IP? What is the strategy, I guess, over time? Is that something that you can start charging for or either through maybe a subscription or is there another way of monetizing it? Thanks, guys.
David M. Wehner - Chief Financial Officer: Youssef, it's Dave. So on the FX adjusted ARPU growth, I would just really point to the overall revenue growth rate, that's what's driving it. So you're coming up against a bigger business last year than we had in the past. So you're seeing declining rate on that basis. So I don't think there's anything specific to ARPU, it's just a reflection of what we're seeing on the revenue front as we scale, and it's sort of as expected there. So we're really pleased with the performance that we're seeing on the revenue front, certainly on the FX adjusted basis. We're seeing strong growth in the face of really a tough currency environment. So we're really pleased with that. We think we've got the best mobile ad product out there in the market and it's just getting better. So we're really pleased with what we're doing on the revenue front.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: Yeah, and in terms of voice calling, no, we're not going to charge for it just like we're not going to charge for messaging. What we're focused on doing is providing more higher quality services for free than what you could otherwise get in paying for them. And one thing that you may not know about voice calling is that by using the Internet for calling rather than the relatively low bit rate voice networks, you can actually get higher quality calls using VoIP. So one of our theories in this is that it's one of the reasons why voice calling has been a little slower to catch on is because you need the large established network of people who you know will have access to be able to receive a voice call before it, before that behavior can really take on in a big global community. But now between Facebook Messenger and WhatsApp, which are two very broad communication networks, we're pretty confident that because of the higher quality of calling that you can get through the services that we're providing that this is going to continue growing very quickly. I mean, a lot of people still – we're just very early in rolling out and promoting it. Even in Facebook Messenger, it's been out for a little while and we're already more than 10% of the global VoIP market. And I think that that's just going to continue growing and I'm really looking forward to getting the first stats on WhatsApp VoIP as well soon.
Operator: Your next question is from Mark Mahaney with RBC Capital Markets. Your line is open.
Mark S. Mahaney - RBC Capital Markets LLC: Thanks. One question for Mark, one for Sheryl. Mark, there's just this explosion in these messaging platforms worldwide you obviously bought into one. The growth has been greater than we would have expected, and perhaps you too. Do you – have you – has your thinking changed on the opportunity or maybe the need but really the opportunity to integrate WhatsApp and Facebook over the next couple of years because of the growth of WhatsApp to-date? And then Sheryl, you mentioned some verticals that are doing well. I was just wondering if I could ask about automotive and insurance, just a couple of verticals that have always been skewed very heavily towards TV advertising and the question is whether they've really skewed up more now on Facebook given the auto play video ad format. Thank you.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: I mean, on the messaging question, yeah, we're pretty happy with how it's all going. I think if we're going to pay $19 billion for a company, we should have pretty high expectations for how it's going to do. So I do feel good about how we're doing, but it needs to do a lot more obviously and we're very excited about the roadmap of things that we have ahead. In terms of integrating them, no, we're not going to do that. One of the things that had been interesting, while we were watching these different services grow, was just how quickly multiple different messaging and communication services were growing at the same time, and it seemed a little bit counter-intuitive at first because it seemed like there should have been more overlap than it actually, now in retrospect looking back, seems like there is. So you can look at countries where both services, WhatsApp and Messenger, are growing very quickly like Brazil, for example. And what you'll see is that basically people use them a little bit differently. I mean, WhatsApp is more of a clear text messaging replacement. Facebook Messenger people use to connect with people that they know on Facebook primarily. And then there are differences in the feature sets where WhatsApp is extremely utilitarian and focused on texting and now voice calling, whereas Messenger is very focused on expression and the whole set of things that fit into the tools around the Messenger platform that we rolled out at F8, communicating with businesses now, richer tools to communicate in different ways. So I think that these are just going to keep on growing is my expectation and hope, and we're excited to kind of pursue both different products to serve the different communities.
Sheryl K. Sandberg - Chief Operating Officer & Director: On the auto and insurance verticals, they're both still small which makes them good opportunities to grow. We're seeing good progress on both of them, and interestingly, insurance companies have been pretty active both on Facebook and Instagram, so we're optimistic about that.
Operator: Your next question is from Paul Vogel with Barclays. Your line is open.
Paul Vogel - Barclays Capital, Inc.: Great. Thanks. Two questions. One for Mark and one for Dave. I guess, Mark, just going back to the video question again real quick. I'm wondering, given all the noise around over-the-top and long form content and given your push in video, I'm just sort of curious as to whether or not you think Facebook can or should be a player in more studio content, professionally-driven content. And then Dave, I guess for you, just in terms of CapEx, you gave guidance for this year, but again, given sort of the ramp-up in video in search, how should we think about CapEx longer term relative to, either in absolute terms, or maybe relative to revenue growth? Thanks.
David M. Wehner - Chief Financial Officer: I can go first. So on the CapEx growth for this year, Paul, yeah, we are ramping CapEx, obviously, to support the initiatives that we have. 2015 is a big investment year for us, both in CapEx and OpEx. It's a little bit early to be talking about how that's going to scale going forward. But, clearly, we've got a lot of areas that we're investing in, including video, including the various other services on top of Facebook. So, we're going to be investing to deliver the best quality services that we can for our users, so we'll continue to invest heavily on the datacenter and infrastructure side going forward. But 2015 is a big investment year for us across the board.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: Yeah, and on video, we're excited about people sharing all different kinds of content on Facebook. Right now, a lot of what people are sharing are their social videos and content. There a lot of public figures who have pages often with millions or tens of millions of followers producing unique and really high-quality content that they're pushing out to all their fans on the network today. So, yeah, we'll continue looking at ways to grow that and it's – the product experience that we have right now is growing quite well so we feel good about it.
Operator: Your next question is from John Blackledge with Cowen & Co. Your line is open.
John R Blackledge - Cowen & Co. LLC: Great. Thanks. Two questions. One more on video. So with the explosive ramp in video views over the last six months, could you discuss the video advertising ramp this year? And then maybe talk about the video versus static ads within the News Feed. And then the other question would be, you reference Facebook hitting 2 million active advertisers in the first quarter, and with over 30 million company pages, how should we think about the advertiser TAM for Facebook next year and over time? Thank you.
Sheryl K. Sandberg - Chief Operating Officer & Director: So, to the first question, video is a big opportunity for us. Mark talked about how we have 4 billion video views on Facebook everyday and we've always believed that the format of our ads should follow the format of what consumers are doing on Facebook. So many years ago when the homepage ticker was in vogue, we never did that. And so the fact that there's so much consumer video, that gives us the opportunity to do more marketing video as well. It's still early days and we're very focused on quality and it's worth noting that not all of the revenue from video is incremental, because the video ads take the place of other ads that we would have served into News Feed. That said, we're really excited about the opportunity I talked about, increasing the entertainment and media vertical and brand marketers, particularly. But I think all marketers have the opportunity to do video, and that's pretty exciting, including SMBs who would never be able to hire a film crew and buy a TV ad. We're seeing those put videos in. Over 1 million SMBs have posted videos and done really small ad buys around them. And that's pretty cool because I don't think there are probably 1 million advertisers who have bought TV ads in that same period of time. When you think about our marketer growth, I think we have an ability to grow both the number of advertisers who use our platform, but also the percentage of their business that we get. So 30 million small business pages continuing to grow. We have an opportunity to turn those businesses into advertisers and marketers, and that's what we've done successfully and we're going to continue to focus on that. And we do that by building very simple ad products. And then when you think about the percentage of spend we have, what I said before on this call, which is we only have a small percentage of even our large customers, that's true of our small customers, too. Now, there are some who spend a large portion of their budget on Facebook, but that's actually very unusual. For most people, even when they start spending with us, we're a small portion of their budget. And when you look at the consumer time we get, we are not getting the equivalent amount of time or resources from our marketers really of any size, and therein lies our opportunity to grow.
Operator: Your next question is from Justin Post with Merrill Lynch. Your line is open.
Justin Post - Bank of America Merrill Lynch: Thank you. Dave, maybe you could help us breakdown the 55% ad revenue growth a little bit. Between usage, kind of are you increasing ad loads at all? Maybe you talk about the formats or is Instagram helping at all, just a little granularity on that or maybe it's just a format shift, but just help us understand what the key drivers are and how much room you still have to go on each of these things. Thank you.
David M. Wehner - Chief Financial Officer: Yeah, Justin. So in terms of the 55% revenue growth, obviously, it's mobile News Feed is what's driving it from a fundamental point of view. In terms of what the opportunity there is to drive it, it's really about increasing the relevance and quality of the ads. That's been a key part of what we've been doing, and that will just continue to be the big driver in the near- and medium-term. And we're doing that on a number of different fronts. Part of it's about finding the right format, so it's getting the video units there for the people for whom video ads are going to make sense. It's getting the dynamic products ads in front of people for people who are going to find those ads interesting and engaging. And it's really just continuing to learn more and more about the people who are using Facebook and what types of ads they interact with and the like. And so that's part of what we're trying to do across the board. And then at the same time, we're bringing more and more advertisers into the system and that's giving us a better selection of the ads that we can serve to the people using Facebook, and that, again, improves the quality and the relevance. So the main thing that we're seeing drive this is just improving the quality and the relevance of the ads experience for the people using Facebook, and I think that's going to continue to be the story. I think the specific ads will be part of how we do that, but it won't be the only way. It will also be the targeting that we have and the targeting capabilities that we're doing with things like Custom Audiences and getting better and better at that. So there's a lot of different fronts that we're working on. It's hard to tease out every individual component of it. But all in all, we're really pleased with the revenue growth that we're seeing. And also, that's coupled with good engagement growth, so we're doing a nice balance of having an experience that's working well for our advertisers but it's also working really well for the people who are using Facebook.
Operator: Your next question is from Ross Sandler with Deutsche Bank. Your line is open.
Ross Sandler - Deutsche Bank Securities, Inc.: Great. Just two quick questions. First, on the News Feed organic reach and then, Mark, one on Apple Watch and wearables. So on the News Feed, you guys recently made tweak to kind of alter the algorithm in favor of friend-oriented content. And then on the other hand, you're also moving towards, like, hosting publisher content from New York Times and BuzzFeed and folks like that. So how are you balancing out organic reach between these algorithm changes and then whether or not professional content is hosted inside of Facebook versus coming from a third-party website? And then the second question is, Mark, how do you view the shift to wearables with smaller screens and shorter interactions? So it looks like you guys have gotten most of the apps on the Apple Watch. Just wondering what you're doing to kind of adapt to these new smaller screens. Thanks.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: Sure. So I can speak to both of those. For the News Feed question, the North Star for us in News Feed is that we want to produce the best experience for everyone who is using the app and loading News Feed to see what is going on in the world around them, right? So when it comes to – there are lots of businesses on Facebook, there are professional content producers, our main interest here is the people in the community who are using News Feed, not those guys, right? So of course we want to build tools to enable them to share their content and all of that, but we're constantly refining the algorithms in order to make it so the experience is the best for you when you open up your phone and look at Facebook and, there are a bunch of things that are going on, we want to make sure that we're getting what you care about the most. And we go to a lot of lengths to make sure that we're getting signals from people in our community to make sure that we're doing this correctly, in addition to the different signals that we would get from seeing people use the products. We also do a lot of qualitative surveys to see what people, what makes – what people write in that they want to see from us, what people tell us is the most important thing that they saw in Facebook today or saw anywhere in the world today and what they would've wanted to have seen on Facebook. And our goal is to just constantly refine this and make it better and we're going to keep on doing that because we think there's a lot of upside and there's a lot more that we can do. Now, at the same time, in order to make this experience good, there also needs to be good content in the system, right, so we need to make sure that people have the tools to able to share the moments that they care about. But if you're a professional publisher, you need to have the ability to share a version of the content that you're producing that you're proud of, that can load quickly, that can be as rich as the tools enable people to see, and we're working on a lot of different tools for that. And you can imagine that as the tools for any of this content get better, people taking photos, newspapers, writing news articles, advertisers, putting out ads for content that they want to sell, the better that content gets, the more people are excited to see it and then that informs the ranking in what the community qualitatively tells us that they want to see from us over time as well. So it's just a constant cycle on that. What was the other question?
David M. Wehner - Chief Financial Officer: The watch.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: Oh, the watch.
Sheryl K. Sandberg - Chief Operating Officer & Director: Wearables.
Mark Elliot Zuckerberg - Chairman & Chief Executive Officer: You know, I haven't actually spent that much time with this so far so, I mean, I mostly just want to congratulate Apple on shipping something that seems like a pretty amazing piece of technology and work, and we're proud to be supporting. And I know that we have a bunch of apps, and it's a space that's going to be really interesting and we're going watch closely and build what our community wants us to.
Operator: Your next question is from Brian Pitz with Jefferies. Your line is open.
Brian J. Pitz - Jefferies LLC: Thank you. Two more quick questions on video. Roughly, what percentage of videos are currently monetized via ads and where do you see it headed over time? And as you look at the early video ads on the platform, how is pricing comparing to other ad formats? Thanks.
David M. Wehner - Chief Financial Officer: I can take this. I mean, in terms of – in terms of what percentage of videos or ads, we're not breaking that out. I think what we said was that we're really pleased with the consumer adoption we're seeing. That's kind of the fundamental table stakes that need to be there and that's the most important thing, and we're really pleased with the 4 billion video views daily that we're getting. We know that marketers love videos so there's a great opportunity here. It's still early. It's worth pointing out that, as Sheryl mentioned, video does displace other ads in News Feed. And let me just kind of speak to how that plays into pricing as well. Video is just a format that's bid into the auction. So video is effectively winning in the auction if it's higher priced. So if somebody's willing to pay more for a video, it's going to get served before another type of format ad. But there's not really a price differential you're paying for a video, it's just what are you willing to pay into the system. So there's not differential pricing by product, it's just what are you willing to bid for the format that you want to show to the people that you want to show it to and that's how the system works.
Operator: Your next question is from Ben Schachter with Macquarie. Your line is open.
Ben Schachter - Macquarie Capital (USA), Inc.: Mark, does the OpEx guide assume an Oculus product for consumers this calendar year? And will the initial products focus on gaming or more on some of the experiences that you showed at F8 around non-gaming like that Saturday Night Live demo? And then separately, beyond searching within Facebook, should we expect to see Facebook leverage its 2 million advertiser relationships against third-party search queries? For example, when a user searches on, say, Yahoo! or maybe some Apple device, Facebook might tap it to advertisers to provide relevant sponsored results. Thanks.
David M. Wehner - Chief Financial Officer: Ben, let me take the OpEx guidance question. So we have not announced any specific plans for shipment volumes in 2015 related to Oculus. I just know that Oculus is very much in the development stage so it's early to be talking about large shipment volumes, and our expense guidance reflects any volumes that we might do in 2015.
Sheryl K. Sandberg - Chief Operating Officer & Director: And no plans to work with our marketers in the way you described.
Operator: Your next question is from Peter Stabler with Wells Fargo Securities. Your line is open.
Peter C. Stabler - Wells Fargo Securities LLC: Good afternoon. Thanks. Dave, I just wanted to return to, I think, Justin's question about the drivers behind ad growth. You mentioned gains made in relevance and quality and format. Wondering if you could provide any quantitative color around ad engagement trends, clicks, shares, likes or anything like that? And then secondly, one quickly for Sheryl. In your SMB discussions, wondering if you're ever asked to help facilitate transactions in that space? Or that's an area of small business that you're interested in? Thank you.
David M. Wehner - Chief Financial Officer: Yeah. So, Peter, just on the – on ads engagement, that's an area that we've obviously been very focused on, and we're really pleased with the results that we're seeing there in terms of driving better engagement per ad, and that's really the focus of a lot of our quality and relevance efforts. How do we find those ads that are going to be more engaging, they're going to get more clicks, that they're going to get more views, that are going to get more installs. We're working on focusing on all of those, on optimizing the relevance of the ads for all of those different potential actions that happen downstream and we're pleased with what we're doing there and the trends that we're seeing there. And, again, that's a big part of what we're trying to do to drive the overall ads growth story, as well as providing a good experience for users with the ads that they're seeing.
Sheryl K. Sandberg - Chief Operating Officer & Director: On SMBs, we have a very small test in the U.S. We started last quarter for buy-on Facebook, and that enables people to buy products from merchants with a buy button on Pages, and it is a product that is used and aimed at SMBs. We're also very focused on helping SMBs have a presence, especially a mobile presence. 35% of SMBs in the United States, which is probably ahead of most other countries, don't have a web presence at all, and an even smaller percentage of SMBs have a mobile web presence or any kind of mobile presence that works. And so Pages are a good and free and easy way to have a mobile presence, and that's something we're very focused on growing.
Deborah Crawford - Director-Investor Relations: Operator, we have time for one last question.
Operator: Certainly. Your final question is from Mark May with Citi. Your line is open.
Mark A. May - Citigroup Global Markets, Inc. (Broker): Thanks a lot. I had two. You've recently announced plans to enable longer form video content, as well as to allow those videos to be syndicated or distributed on third-party publishers. What, if any, initiatives do you have to help with this content, contributors and the publishers to generate revenue from those videos? And then secondly, on public content, what, if anything, are you doing to try to secure more unique public content, content that's potentially unique to Facebook from personalities and other sources? Thanks.
Sheryl K. Sandberg - Chief Operating Officer & Director: On the video question, we're basically focused primarily on video on our own site and service, and video tends to be pretty short form content right now on Facebook because it's playing in News Feed. We do see some pretty cool examples of people using it well. So for example, in the election, you saw Hillary Clinton announce her candidacy very recently, obviously, and that video got 2.7 million views. Ted Cruz and others have done the same and they've gotten large numbers of video views. So we think it's a very attractive platform for people to reach people with video messages.
Deborah Crawford - Director-Investor Relations: Great. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again.
Operator: Ladies and gentlemen, this concludes today's conference call. You may now disconnect. | [
{
"speaker": "Executives",
"text": "Deborah Crawford - Director-Investor Relations Mark Elliot Zuckerberg - Chairman & Chief Executive Officer Sheryl K. Sandberg - Chief Operating Officer & Director David M. Wehner - Chief Financial Officer"
},
{
"speaker": "Analysts",
"text": "Brian Nowak - Morgan Stanley & Co. LLC Douglas T. Anmuth - JPMorgan Securities LLC Heather Anne Bellini - Goldman Sachs & Co. Eric J. Sheridan - UBS Securities LLC Youssef H. Squali - Cantor Fitzgerald Securities Mark S. Mahaney - RBC Capital Markets LLC Paul Vogel - Barclays Capital, Inc. John R Blackledge - Cowen & Co. LLC Justin Post - Bank of America Merrill Lynch Ross Sandler - Deutsche Bank Securities, Inc. Brian J. Pitz - Jefferies LLC Ben Schachter - Macquarie Capital (USA), Inc. Peter C. Stabler - Wells Fargo Securities LLC Mark A. May - Citigroup Global Markets, Inc. (Broker)"
},
{
"speaker": "Operator",
"text": "Good afternoon. My name is Chris, and I'll be your conference operator today. At this time, I would like to welcome everyone to the Facebook First Quarter 2015 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operation Instructions] Ms. Deborah Crawford, Facebook's Vice President, Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford - Director-Investor Relations",
"text": "Thank you. Good afternoon, and welcome to Facebook's first quarter earnings conference Call. Joining me today to talk about our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements and actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release and on our Annual Report on Form 10-K filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these statements as a result of new information or future events. During this call, we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I'd like to turn the call over to Mark."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "Thanks, Deborah, and thanks, everyone for joining us today. This was a good quarter and a good start to the year. We continue to grow the size and engagement of our community, now with 1.44 billion people using Facebook each month and 936 million people daily. We continue to see strong growth in daily engagement around the world, including in our most engaged markets. On mobile, nearly 1.25 billion people now use Facebook every month, 240 million than a year ago, and we now see more than 1 billion mobile searches every day. Looking at our business, we continue to achieve impressive growth. Total revenue grew by 42% year-over-year, and advertising revenue grew by 46%. Mobile now accounts for 73% of our ads revenue. These results show that we're making progress in our mission to connect the world and we're executing well against our priorities. But this quarter also shows how Facebook is continuing to make progress for the years ahead. Facebook has evolved from a single blue app on your phone into a family of apps. Now, many of these apps are reaching a global scale. More than 1.4 billion people use the core Facebook service, 800 million also use WhatsApp, 700 million use our Groups product, 600 million use Messenger, and on Instagram, there are more than 300 million active members of the community. We're building this family of apps because we want people to be able to share whatever moments they want with all the different sets of people they care about. Over time, we expect people to share richer content with an increasing frequency so we want to continue developing new and better tools to facilitate this expression. So with that in mind, let's talk about our efforts over the quarter. First, we're working to help people share and connect with all the things they care about today. An important part of our approach is helping our community to connect around important public moments and personalities. Facebook is the largest community of sports fans in the world, with 650 million people connecting to sports pages. For this year's Super Bowl, more than 65 million people generated more than 265 million interactions on Facebook, the highest level of conversation we've seen for a Super Bowl to-date. For the Cricket World Cup, there were more than 700 million interactions by 53 million people, which shows the strength of the global reach of our community. We're also making good progress with video. We're very pleased with our growth here, and this quarter we reached a new milestone of more than 4 billion daily videos views. We also launched an embedded video player that allows people to watch Facebook videos across the web, and more than 80,000 videos have now been embedded on third-party websites. Spherical videos are going to be supported in News Feed later this year, allowing you to change your viewing angle for a more immersive experience. Supporting new types of content like this is an important part of preparing for the future of how people want to share. Now, another part of our strategy is helping people connect with businesses. This quarter, we announced that there are now 2 million advertisers on Facebook. This is an important milestone for our community, and we're encouraged that so many businesses are finding value on Facebook. We continue to focus on innovation in our ads business, and Sheryl is going to talk a bit more about that in a moment. Now, here's how we're working to develop our family of apps so we can give people more options for sharing in different ways. In the future, we expect that people are going to want to share content with their closest friends at an even greater frequency than they do today, so messaging is a big priority for us. Across the Facebook family of apps, our efforts have a lot of momentum. On average, more than 45 billion messages are sent every day. With voice calling, we're also starting to make some good progress. This quarter, we started rolling out Voice over IP calls on WhatsApp to let people call friends for free around the world. And meanwhile, Messenger already accounts for more than 10% of mobile VoIP calls globally. With WhatsApp, we continue to be pleased with our growth and the team remains very focused on building new features to serve their community and expand. For Messenger, this has been a particularly busy quarter. We launched the Messenger Platform, which allows people to use creative new apps to have richer conversations. We also began rolling out payments on Messenger to give people an easy, secure way to send money to their friends. And we announced a new way for people to communicate with businesses using Messenger. We're really excited by the potential to build Messenger into a service that helps people to express themselves in rich new ways and to access useful services. With Instagram, our growth remains impressive, and this quarter, we reached a new milestone of more than 200 million daily actives. Growth in Asia, Europe, and Latin America is particularly strong, with our community growing in some countries by more than 100% year-over-year, including Japan, South Korea, and Indonesia. Combined with an average 21 minutes a day that people spend on Instagram, this is a good sign of this community's continuing and growing strength. Now, let's talk about how we're working with developers. Last month, we held F8, our annual event for the global developer community. Creating the future of sharing isn't something that we can do on our own, but by supporting developers, we can deliver more apps and experiences for our community. At F8, we presented new tools to help developers build, grow, and monetize their apps, including better sharing experiences from apps to Facebook and new analytics to help developers better understand how people are using their services. More than 30 million apps and sites have been built using Facebook developer tools, and last year we drove more than 3.5 billion app installs. We think these improvements are going to create a lot of value for our community. All right. Finally, let's talk about some of our most long-term innovation efforts. Internet.org, our effort to connect everyone in the world to the Internet, continues to gather momentum. We've now made free basic Internet services available to more than 800 million people in nine countries, including just in this quarter, launching in India, Colombia, Ghana, Guatemala, and the Philippines. More than seven million people who weren't connected to the Internet before now use internet.org to get online. And this year, we expect to connect even more people. With our efforts in search, AI and Oculus, we're also continuing to build a new generation of Internet services that are more useful, intuitive, and immersive. And over the coming months, we'll have more to share about these. So that's how we're thinking about innovation and the future of sharing. It's been a busy quarter. In the last few months, I've visited countries in Asia, Europe, and Latin America. In many communities, I've gotten the chance to see how the Internet is changing lives and creating opportunities for people. I've heard from people who can't wait to get access to the same tools that so many of us take for granted. We're making progress on our mission and working to accelerate towards the day when everyone in the world can be connected. Thanks to our entire community and all of our employees, partners, and shareholders for being a part of this journey and for helping to build something great. Now, here's Sheryl."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "Thanks, Mark, and hi, everyone. Q1 was a strong quarter and a great start to the year. Ad revenue was $3.3 billion, up 46% or 55% on a constant currency basis. Mobile ad revenue grew 82% and is now 73% of total ad revenue. Our performance was strong across all marketer segments and we're pleased with the broad-based growth across our industry verticals. From a regional perspective, we saw strong growth in North America and Asia-Pacific, while Latin America and Europe were affected by foreign exchange headwinds and macroeconomic factors. That said, we're pleased with advertiser adoption of our ad products across all regions. Innovation drives our ads business. It's how we continually improve the quality of our ads, offer new tools to marketers, and build better experiences for the people who use Facebook. We believe that this ability to innovate will continue to drive our business. So today I want to focus on innovation across our three strategic priorities, capitalizing on the shift to mobile, growing the number of marketers using our ad products, and making our ads more relevant. First, capitalizing on the shift to mobile. Mobile continues to be a great opportunity for us. People continue to be highly engaged with our mobile apps. In the United States, for example, Facebook and Instagram get more than one out of every five minutes spent on mobile. As consumers shift to mobile, businesses are following, and we're focusing on helping them take advantage of this opportunity to use mobile to build their businesses. Two new products we introduced this quarter are good examples of this. The Mobile Ads Manager app gives marketers the ability to manage their ad campaigns from their mobile devices. It's early, but we're already seeing more marketers managing their activity on mobile. We also launched a page creation tool for feature phones, which has been a big driver of page adoption in high-growth emerging markets where smartphones are less common. Looking ahead, we believe video will play a significant role in bringing more marketers to mobile. More than 75% of global video views on Facebook occur on mobile, and we believe mobile video will become more important to marketers over time. Lionsgate's Age of Adaline premiere is a great example. To promote the film, Lionsgate targeted young women on Instagram with multiple video ads over the last few weeks. This week, since the film opens on Friday, they are retargeting the audience from the Instagram campaign on Facebook. We expect more marketers to put mobile video at the heart of their campaigns in the future and we're well-positioned to drive this shift. Our second priority is growing the number of marketers using our ad products and we're making great progress. In Q2 of last year, we shared that we reached 30 million active business Pages on Facebook. This number continues to grow as more and more small businesses are using our Free Pages product, and we remain focused on converting these Page owners into advertisers. One way we're doing this is by providing simple, easy to use products. Over 80% of our new advertisers start with entry level tools like a promoted post or a Page like. We are increasingly focused on making sure these tools work well on mobile. We're also educating marketers on how to use Facebook more effectively. We recently launched two online training resources: Blueprint for large clients and agencies, and Learn How videos for small businesses. These efforts are paying off. In Q1, we announced that we now have over 2 million active advertisers. Our third priority is making our ads more relevant. More relevant ads lead to better returns for marketers and better experiences for people. We're pleased with the increased adoption of our targeting tools like Custom Audiences and Conversion Tracking. In Q1, we introduced Dynamic Product Ads, which allow marketers to launch ads for different audiences. We also introduced carousel ads on Facebook and Instagram, which allow marketers to advertise for specific products. Adoption of our targeting tools and these new ad formats help make our ads more relevant. We're also focused on insights and measurement. We want to help marketers accurately measure the performance of their campaigns and then apply that learning to improve their returns. In Q1, we released an ad relevance score, a way for marketers to better understand how people respond to their ads. This helps marketers test different types of creative and optimize performance. We also launched Conversion Lift, a tool that scientifically measures how much additional business was driven from Facebook ads. This is important because it shows that ads on mobile can drive sales in retail stores and via other channels. For example, Cellbes is a women's fashion retailer in Europe. Using Conversion Lift, they proved that ads on Facebook mobile drove sales on desktop and via phone calls to sales reps at their call centers. On the ad tech side, we're pleased with the results we're driving for advertisers and publishers. A good example of this is Cheetah Mobile. Using native ads from the Audience Network in its apps, the company is getting more than two-times the CPMs compared to other ad networks. We continue to invest in our ad tech platform. At our F8 Developer Conference last month, we made new two important LiveRail announcements that will improve the relevance of ads people see across sites, apps, and devices. We extended LiveRail's video ad platform into in-app mobile display, which will give publishers better ways to manage their ad inventory across devices. We also announced that LiveRail will give publishers access to Facebook's anonymized demographic information, enabling us to serve more relevant ads to people. We've had a great start to the year and we're really optimistic about what's to come. Our teams are executing well, staying focused on our big priorities and continuing to innovate. Now, here's Dave."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Thanks, Sheryl, and good afternoon, everyone. Q1 was a strong quarter for Facebook. We generated $3.5 billion in revenue and $1.2 billion in free cash flow and continued making investments to position us for both near-term and long-term growth. We are pleased with the growth and engagement of our community. In March, 936 million people used Facebook on an average day, an increase of 17% compared to last year. This daily number represents 65% of the 1.44 billion people who used Facebook during the month of March. Mobile remains the key driver of our growth. In March, approximately 1.25 billion people accessed Facebook on mobile devices, up 24% from last year. In addition to Facebook, Instagram, Messenger, and WhatsApp continue to grow, exceeding 300 million, 600 million, and 800 million MAU, respectively. Now turning to the financials. All of our comparisons are on a year-over-year basis unless otherwise noted. Additionally, as a reminder, our non-GAAP measures exclude stock-based compensation and the amortization of intangibles. Total revenue was $3.5 billion, up 42% or 49% on a constant currency basis. Ad revenue was $3.3 billion, up 46% or 55% on a constant currency basis. The general strengthening of the U.S. dollar in the past year had an unfavorable impact on our revenue. Had foreign exchange rates remained constant with Q1 2014 levels, our total revenue this quarter would have been approximately $190 million higher. Regionally, we saw strong North American ad revenue growth of 53% in the quarter, second only to APAC, which grew 57%. Europe and the rest of world revenue grew more slowly at 35% and 32%, respectively, with currency impacts leading to a significant reduction in these regions' year-over-year growth rates. Mobile ad revenue in Q1 was $2.4 billion, up from approximately $1.3 billion last year. Revenue from ads served on personal computers was down approximately 4% and we continue to see overall usage on PCs decline. In Q1, the average price per ad increased 285% while total ad impressions declined 62%. Similar to last quarter, these price volume trends were primarily driven by the redesign of our right-hand column ads, which rolled out in the third quarter of last year. To a lesser degree, the shift of usage towards mobile, where we don't have right-hand column ads, also contributed to the reported price volume trends. Total payments and other fees revenue was $226 million, down 5% compared to last year, a trend we expect to continue. The decline was driven by the year-over-year reduction in payments revenue related to games played on personal computers. Turning now to expenses. Our Q1 total GAAP expenses were $2.6 billion, up 83%, and non-GAAP expenses were $1.7 billion, up 57%. Similar to last quarter, stock-based compensation and amortization expenses related to the WhatsApp acquisition contributed significantly to the year-over-year growth in GAAP expenses. Non-GAAP expense growth was primarily driven by increases in head count-related costs, cost of revenue, and marketing expenses. We ended Q1 with 10,082 employees, up 48% compared to last year. We remain very pleased with our ability to attract and retain top-tier talent. Q1 operating income was $933 million, representing a 26% operating margin. Non-GAAP operating income was $1.8 billion, representing a 52% margin. Our Q1 GAAP and non-GAAP tax rates were 45% and 35%, respectively. Q1 GAAP net income was $512 million or $0.18 per share, and non-GAAP net income was $1.2 billion or $0.42 per share. In Q1, capital expenditures were $502 million and we generated $1.2 billion of free cash flow. We ended the quarter with $12.4 billion in cash and investments. Turning now to the outlook. Let's start with revenue. The strengthening of the U.S. dollar in the past year reduced our Q1 total revenue growth rate by 7 percentage points, or approximately $190 million. The dollar strengthened over the course of the quarter and, in the month of March, our year-over-year total revenue growth rate was approximately 10% lower than it would have been in constant currency terms. Based on this, we estimate that foreign exchange headwinds in Q2 will likely be greater than those we experienced in Q1. In addition, we expect our total payments and other fees revenue to decline on a year-over-year basis for the remainder of the year. Turning to expense guidance. We are tightening our expense guidance range modestly based on better visibility into our annual spending. We expect that the year-over-year growth rate for total 2015 GAAP expenses will be in the range of 55% to 65%, as compared to our prior guidance of 55% to 70%. We expect that the year-over-year growth rate for total 2015 non-GAAP expenses will be in the range of 50% to 60% as compared to our prior guidance of 50% to 65%. Our expense outlook reflects the broad range of investments that we're making in both our services and infrastructure as we continue to enhance the core experiences on Facebook and Instagram, grow our messaging products, strengthen our advertising business globally and invest in long-term growth areas like Oculus and internet.org. The remainder of our guidance remains unchanged. We anticipate our 2015 capital expenditures will be in the neighborhood of $2.7 billion to $3.2 billion. We expect stock-based compensation in 2015 to be in the range of $3 billion to $3.3 billion, approximately half of which is related to our prior acquisitions, most notably WhatsApp. We expect amortization expenses in 2015 to be approximately $700 million to $800 million. And lastly, we anticipate our Q2 and full-year 2015 GAAP and non-GAAP tax rates to be consistent with the rates in the first quarter. In summary, Q1 was a great start to the year for Facebook. We're very pleased with the growth of our community, the strength of our business, and the investments we're making to build long-term shareholder value. With that, Chris, let's open up the call for questions."
},
{
"speaker": "Operator",
"text": "Thank you. We'll now open the lines for a question-and-answer session. Your first question comes from the line of Brian Nowak with Morgan Stanley. Your line is open."
},
{
"speaker": "Brian Nowak - Morgan Stanley & Co. LLC",
"text": "Thanks for taking the questions. I have two. The first one, I guess, can you talk a little about early advertiser and publisher feedback from the LiveRail in-app mobile product and what are some areas where you see potential for improvements to drive faster adoption? And then on the OpEx side, I appreciate you're tightening the range. Can you help us at all on expectations for head count growth this year and what are the biggest areas you see investing in incremental employees this year?"
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "So, on LiveRail, we're pleased with the performance and the changes we've been able to make. Video is obviously super important so having the ability to do – work on video across the web has been really great. And then at F8 we made two more announcements that I mentioned. What we're hearing from publishers is that this is a good opportunity and they're pleased with the extensions we're making because it can make their ad serving and buying more efficient across the platforms they use. In terms of areas for improvement, I think there's a lot we can do. I think have you to look at our ad tech investments very holistically from Atlas to LiveRail to the Audience Network. These are all different pieces of the ad tech but what they're all working on is taking the relevance and the ability to do people-based marketing and make that available to work on Facebook but also off Facebook. We believe that because we can do marketing to people and then measure results across what people do in privacy-protective ways, we have an ability to improve the relevance of marketing which will make it better for consumers and increase returns for marketers."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "And Brian, it's Dave. Just on the OpEx question, I think the key is that we're investing in our near, mid-term, and long-term priorities, so in the near-term we're investing to grow the community, execute on the existing business, both on the product side and then the advertising and sales force side. And in the mid-term, we're building out those next-generation of services to be great businesses that reach their full potential, so that's Instagram, WhatsApp, Messenger. And then in the long-term, we're investing in areas like the next-generation computing platform, internet.org, AI. In general, I would say our head count growth has skewed towards the R&D side because a lot of these initiatives have long-term development needs. So we've been investing there. But we are investing across the board. In terms of a specific head count guidance, I would just stick with our expense guidance. But I'd note that the 48% year-over-year does include some inorganic growth from the pickup of the three larger acquisitions, Oculus, LiveRail, and WhatsApp. We haven't lapped those at this point."
},
{
"speaker": "Operator",
"text": "Your next question is from Douglas Anmuth with JPMorgan. Your line is open."
},
{
"speaker": "Douglas T. Anmuth - JPMorgan Securities LLC",
"text": "Thanks for taking the question. One for Sheryl and one more Mark. Sheryl, I just wanted to ask you to talk a little bit more about big brands, give us a sense for what's working best in terms of products? And then also how penetrated do you think Facebook is now with some of the larger brands? And, Mark, what are the signals that you'll be looking for to tell you when it's the right time to ramp-up the advertising on Instagram more? Thanks."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "Our growth was really strong across all of our marketer segments, but we had a particularly good quarter in brands, I think driven by two things. The first is that we really have a great platform to do creative storytelling on mobile and I think we have that in a way that no one else does. Our mobile ad product is so integrated into the user experience and provides real creative flexibility that people have a way to reach people on mobile and that's becoming increasingly important in telling the stories that drive their business. The second thing is video. Video is exploding on Facebook, as Mark talked about, and that gives us an opportunity to do a lot of work with marketers on video. This is the first time the technology and media vertical was one of our top four verticals. And that's largely because of the use of mobile. And so that's been really a great story for us. In terms of penetration, we work with almost all the large marketers almost everywhere in the world. But even for the largest, the largest clients we have, we are a very small part of their budget. I don't think we have any large clients, if you look at 25% in the U.S. of consumer media time is on mobile and then 20% of mobile time goes to Facebook and Instagram that would be 5% of U.S. consumer media time. With our largest clients, even our large ones, we're not close to 5% of their spend. And so I think we have a considerable opportunity to grow, and we also expect those underlying numbers time on mobile to continue to grow."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "Yeah. Your second question about Instagram and the ads opportunity there, we think about this the same way that we do ads in Facebook today. The primary goal is to increase the quality. That's our strategy for growing the business. There's more inventory that we can open up on Instagram over time because it's so early, but we're going to do that once we get to formats that are working well for businesses and that we feel really good about in the consumer experience. And this has been a theme for our ad strategy and product development for more than a year now, maybe two years, where folks have consistently asked us what we're going to do to increase the amount of ads that we're showing. And our response has been that we're going to focus on improving the quality and relevance and that's both going to perform better for the people using our services and businesses who are buying ads. And that strategy, I think, is bearing out and we'll continue to apply it to all of the things that we do."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "One clarification, I think I said tech and media as a vertical, I meant entertainment and media that this is the first quarter that entertainment and media is one of our top verticals."
},
{
"speaker": "Operator",
"text": "Your next question is from Heather Bellini of Goldman Sachs. Your line is open."
},
{
"speaker": "Heather Anne Bellini - Goldman Sachs & Co.",
"text": "Great. Thank you. I just had two quick ones. I was wondering, Mark, I think you mentioned you're seeing 1 billion searches per day on mobile. I was wondering if you could give us an update on your initiatives here. And also when you think about Facebook kind of as a microcosm of different applications, at some point is there a plan that we will be able to search – use the search functionality to go across all the different Facebook apps that we might have installed on our mobile devices?"
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "So we're pretty early in this whole thing and there's so much unique content that people share in Facebook that I think that that is the clear, unique opportunity to go for first, right? I mean there's – if you think about the overall web, there's a lot of public content that's out there that any web search engine can go index and provide. But a lot of what we can get at are recommendations on products and travel and restaurants and things that your friends have shared, they haven't shared publicly, and knowing different correlations, or interesting things about what your friends are interested in, and that's the type of stuff, those are questions that we can answer that no one else can answer, and that's probably going to be what we continue to focus on doing first. And I think what you're seeing is that as we enable more use cases and as we just get a lot of the basics right around performance and bringing the mobile features into parity and beyond what we've been able to do on desktop, the volume is growing quickly. I think on a recent earnings call we just announced that we passed 1 billion searches total so now being more than 1 billion on mobile shows some progress that I'm pretty proud of for the search team."
},
{
"speaker": "Operator",
"text": "Your next question is from Eric Sheridan with UBS. Your line is open."
},
{
"speaker": "Eric J. Sheridan - UBS Securities LLC",
"text": "Thanks for taking the questions. Maybe one for Mark and one more Sheryl. Mark, you talked about the family of apps at Facebook. As more and more people are consuming professional content, different verticals like news, sports, and video format on Facebook, how do you think about the use case for the consumption of that content inside the main Facebook app versus maybe an even separate app for more professional content long-term for Facebook? And then for Sheryl, appreciate the color you gave us on the evolution of targeting on Facebook. Wanted to know either qualitatively or quantitatively if you could talk a little bit about the way those ads are performing as you continue to evolve the product set around targeting on Facebook and off, in particular around Dynamic Product Ads and what that might mean for closing the loop longer term. Thanks so much, guys."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "Yeah. So in terms of news and different kinds of content, I know this has traditionally been something that we've delivered a really good experience for in terms of people being able to share the content that they want, being able to get access to the content that they want, different recommendations from friends, and we've a lot more coming there, so I'm excited about that. And we definitely do see in this family of app strategy that there's so many new ways that people want to share content, and so many different types of sets of people that people want to share with, right, ranging from one person at a time and that would be messaging or small group sharing or sharing with interest-based communities or sharing with all your friends at once or sharing with public. There are just a lot of different experience that needs to get built. And a lot of what we're trying to do is enable a number of those things through Facebook, while also building unique world-class services to enable people to share all the things they care about with all the different sets of people that they care about. So we're going to keep on doing more there. But we're happy with where we are now. We have a number of services that are reaching pretty good scale and I think we'll keep on pushing that."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "To your question on targeting and closing the loop, these are two really important pieces for what we want to do. Our goal when we work with marketers is to drive their business, and that means their products off the shelves, their services into the hands of people, and so in order to do that well, we need to work on targeting and we need to work on measurement. So with targeting, a more relevant ad is just better, it's better experience for consumers because they see something they like in their News Feed and it has a higher return for marketers. And so we're very focused on getting more people to use our targeting tools from Custom Audiences which lets people target ads differently to their current customers or people who they'd like to be their customers to look like audiences which enables us to identify the kind of characteristics of your current customers and then find other people on Facebook who share those characteristics so, again, the ad is well targeted. I think our targeting abilities are really second to none, and I'll share a recent example. XFINITY put out a voice guide for visual disabilities, and they did this, they did this by doing an Oscar commercial with a girl who is blind imagining what Wizard of Oz characters looked like. Now by doing that at the Oscars, that's obviously TV and it's a very broad ad and that's because they were both showing a product but also working on their brand. On Facebook, they took that ad and showed it to movie fans, Wizard of Oz fans and also people connected to accessibility causes. That's actually pretty specific targeting that lets them hit exactly the right audience and amplify what they were doing on TV, and I think that's the kind of thing that only we can do at scale, and it shows how important targeting is. When you think about closing the loop, you then have to add in the measurement piece because if we can connect, people seeing ads on Facebook to what they buy, in stores or in other ways, that's how you close the loop and that's why we put so much investment and hopefully so much innovation behind measurement. So conversion tracking is increasingly used, and we work with our marketers to use it even more, and we're also really excited about conversion list because that's the first product we've had which scientifically measures the additional business you get from Facebook ads. It compares test groups that see ads with control groups that don't. So whatever you're measuring in terms of conversions whether it's sales or website clicks or registrations, we can A, B test and see exactly what the impact Facebook has. I think we're still at the beginning of this. I think there is so much more we can do to make ads more relevant on Facebook and so much more we can do to measure results, and I think our future growth will depend on executing on that very well."
},
{
"speaker": "Operator",
"text": "Your next question is from Youssef Squali with Cantor Fitzgerald. Your line is open."
},
{
"speaker": "Youssef H. Squali - Cantor Fitzgerald Securities",
"text": "Thank you very much. A question for Dave and then maybe one for Mark or Sheryl. FX adjusted ARPU growth this past quarter, it was about 35%, which is by our math about half of what it was last year and within mobile, it was about 45%, that's about a third of what it was last year. Other than tough comps, what else is driving that decline? Is it just Q1 seasonality getting more pronounced? Is there anything else – we would have thought maybe video advertising would have had actually the opposite effect. And then what's your – maybe Mark or Sheryl, what's your experience so far with Voice over IP? What is the strategy, I guess, over time? Is that something that you can start charging for or either through maybe a subscription or is there another way of monetizing it? Thanks, guys."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Youssef, it's Dave. So on the FX adjusted ARPU growth, I would just really point to the overall revenue growth rate, that's what's driving it. So you're coming up against a bigger business last year than we had in the past. So you're seeing declining rate on that basis. So I don't think there's anything specific to ARPU, it's just a reflection of what we're seeing on the revenue front as we scale, and it's sort of as expected there. So we're really pleased with the performance that we're seeing on the revenue front, certainly on the FX adjusted basis. We're seeing strong growth in the face of really a tough currency environment. So we're really pleased with that. We think we've got the best mobile ad product out there in the market and it's just getting better. So we're really pleased with what we're doing on the revenue front."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "Yeah, and in terms of voice calling, no, we're not going to charge for it just like we're not going to charge for messaging. What we're focused on doing is providing more higher quality services for free than what you could otherwise get in paying for them. And one thing that you may not know about voice calling is that by using the Internet for calling rather than the relatively low bit rate voice networks, you can actually get higher quality calls using VoIP. So one of our theories in this is that it's one of the reasons why voice calling has been a little slower to catch on is because you need the large established network of people who you know will have access to be able to receive a voice call before it, before that behavior can really take on in a big global community. But now between Facebook Messenger and WhatsApp, which are two very broad communication networks, we're pretty confident that because of the higher quality of calling that you can get through the services that we're providing that this is going to continue growing very quickly. I mean, a lot of people still – we're just very early in rolling out and promoting it. Even in Facebook Messenger, it's been out for a little while and we're already more than 10% of the global VoIP market. And I think that that's just going to continue growing and I'm really looking forward to getting the first stats on WhatsApp VoIP as well soon."
},
{
"speaker": "Operator",
"text": "Your next question is from Mark Mahaney with RBC Capital Markets. Your line is open."
},
{
"speaker": "Mark S. Mahaney - RBC Capital Markets LLC",
"text": "Thanks. One question for Mark, one for Sheryl. Mark, there's just this explosion in these messaging platforms worldwide you obviously bought into one. The growth has been greater than we would have expected, and perhaps you too. Do you – have you – has your thinking changed on the opportunity or maybe the need but really the opportunity to integrate WhatsApp and Facebook over the next couple of years because of the growth of WhatsApp to-date? And then Sheryl, you mentioned some verticals that are doing well. I was just wondering if I could ask about automotive and insurance, just a couple of verticals that have always been skewed very heavily towards TV advertising and the question is whether they've really skewed up more now on Facebook given the auto play video ad format. Thank you."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "I mean, on the messaging question, yeah, we're pretty happy with how it's all going. I think if we're going to pay $19 billion for a company, we should have pretty high expectations for how it's going to do. So I do feel good about how we're doing, but it needs to do a lot more obviously and we're very excited about the roadmap of things that we have ahead. In terms of integrating them, no, we're not going to do that. One of the things that had been interesting, while we were watching these different services grow, was just how quickly multiple different messaging and communication services were growing at the same time, and it seemed a little bit counter-intuitive at first because it seemed like there should have been more overlap than it actually, now in retrospect looking back, seems like there is. So you can look at countries where both services, WhatsApp and Messenger, are growing very quickly like Brazil, for example. And what you'll see is that basically people use them a little bit differently. I mean, WhatsApp is more of a clear text messaging replacement. Facebook Messenger people use to connect with people that they know on Facebook primarily. And then there are differences in the feature sets where WhatsApp is extremely utilitarian and focused on texting and now voice calling, whereas Messenger is very focused on expression and the whole set of things that fit into the tools around the Messenger platform that we rolled out at F8, communicating with businesses now, richer tools to communicate in different ways. So I think that these are just going to keep on growing is my expectation and hope, and we're excited to kind of pursue both different products to serve the different communities."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "On the auto and insurance verticals, they're both still small which makes them good opportunities to grow. We're seeing good progress on both of them, and interestingly, insurance companies have been pretty active both on Facebook and Instagram, so we're optimistic about that."
},
{
"speaker": "Operator",
"text": "Your next question is from Paul Vogel with Barclays. Your line is open."
},
{
"speaker": "Paul Vogel - Barclays Capital, Inc.",
"text": "Great. Thanks. Two questions. One for Mark and one for Dave. I guess, Mark, just going back to the video question again real quick. I'm wondering, given all the noise around over-the-top and long form content and given your push in video, I'm just sort of curious as to whether or not you think Facebook can or should be a player in more studio content, professionally-driven content. And then Dave, I guess for you, just in terms of CapEx, you gave guidance for this year, but again, given sort of the ramp-up in video in search, how should we think about CapEx longer term relative to, either in absolute terms, or maybe relative to revenue growth? Thanks."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "I can go first. So on the CapEx growth for this year, Paul, yeah, we are ramping CapEx, obviously, to support the initiatives that we have. 2015 is a big investment year for us, both in CapEx and OpEx. It's a little bit early to be talking about how that's going to scale going forward. But, clearly, we've got a lot of areas that we're investing in, including video, including the various other services on top of Facebook. So, we're going to be investing to deliver the best quality services that we can for our users, so we'll continue to invest heavily on the datacenter and infrastructure side going forward. But 2015 is a big investment year for us across the board."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "Yeah, and on video, we're excited about people sharing all different kinds of content on Facebook. Right now, a lot of what people are sharing are their social videos and content. There a lot of public figures who have pages often with millions or tens of millions of followers producing unique and really high-quality content that they're pushing out to all their fans on the network today. So, yeah, we'll continue looking at ways to grow that and it's – the product experience that we have right now is growing quite well so we feel good about it."
},
{
"speaker": "Operator",
"text": "Your next question is from John Blackledge with Cowen & Co. Your line is open."
},
{
"speaker": "John R Blackledge - Cowen & Co. LLC",
"text": "Great. Thanks. Two questions. One more on video. So with the explosive ramp in video views over the last six months, could you discuss the video advertising ramp this year? And then maybe talk about the video versus static ads within the News Feed. And then the other question would be, you reference Facebook hitting 2 million active advertisers in the first quarter, and with over 30 million company pages, how should we think about the advertiser TAM for Facebook next year and over time? Thank you."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "So, to the first question, video is a big opportunity for us. Mark talked about how we have 4 billion video views on Facebook everyday and we've always believed that the format of our ads should follow the format of what consumers are doing on Facebook. So many years ago when the homepage ticker was in vogue, we never did that. And so the fact that there's so much consumer video, that gives us the opportunity to do more marketing video as well. It's still early days and we're very focused on quality and it's worth noting that not all of the revenue from video is incremental, because the video ads take the place of other ads that we would have served into News Feed. That said, we're really excited about the opportunity I talked about, increasing the entertainment and media vertical and brand marketers, particularly. But I think all marketers have the opportunity to do video, and that's pretty exciting, including SMBs who would never be able to hire a film crew and buy a TV ad. We're seeing those put videos in. Over 1 million SMBs have posted videos and done really small ad buys around them. And that's pretty cool because I don't think there are probably 1 million advertisers who have bought TV ads in that same period of time. When you think about our marketer growth, I think we have an ability to grow both the number of advertisers who use our platform, but also the percentage of their business that we get. So 30 million small business pages continuing to grow. We have an opportunity to turn those businesses into advertisers and marketers, and that's what we've done successfully and we're going to continue to focus on that. And we do that by building very simple ad products. And then when you think about the percentage of spend we have, what I said before on this call, which is we only have a small percentage of even our large customers, that's true of our small customers, too. Now, there are some who spend a large portion of their budget on Facebook, but that's actually very unusual. For most people, even when they start spending with us, we're a small portion of their budget. And when you look at the consumer time we get, we are not getting the equivalent amount of time or resources from our marketers really of any size, and therein lies our opportunity to grow."
},
{
"speaker": "Operator",
"text": "Your next question is from Justin Post with Merrill Lynch. Your line is open."
},
{
"speaker": "Justin Post - Bank of America Merrill Lynch",
"text": "Thank you. Dave, maybe you could help us breakdown the 55% ad revenue growth a little bit. Between usage, kind of are you increasing ad loads at all? Maybe you talk about the formats or is Instagram helping at all, just a little granularity on that or maybe it's just a format shift, but just help us understand what the key drivers are and how much room you still have to go on each of these things. Thank you."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Yeah, Justin. So in terms of the 55% revenue growth, obviously, it's mobile News Feed is what's driving it from a fundamental point of view. In terms of what the opportunity there is to drive it, it's really about increasing the relevance and quality of the ads. That's been a key part of what we've been doing, and that will just continue to be the big driver in the near- and medium-term. And we're doing that on a number of different fronts. Part of it's about finding the right format, so it's getting the video units there for the people for whom video ads are going to make sense. It's getting the dynamic products ads in front of people for people who are going to find those ads interesting and engaging. And it's really just continuing to learn more and more about the people who are using Facebook and what types of ads they interact with and the like. And so that's part of what we're trying to do across the board. And then at the same time, we're bringing more and more advertisers into the system and that's giving us a better selection of the ads that we can serve to the people using Facebook, and that, again, improves the quality and the relevance. So the main thing that we're seeing drive this is just improving the quality and the relevance of the ads experience for the people using Facebook, and I think that's going to continue to be the story. I think the specific ads will be part of how we do that, but it won't be the only way. It will also be the targeting that we have and the targeting capabilities that we're doing with things like Custom Audiences and getting better and better at that. So there's a lot of different fronts that we're working on. It's hard to tease out every individual component of it. But all in all, we're really pleased with the revenue growth that we're seeing. And also, that's coupled with good engagement growth, so we're doing a nice balance of having an experience that's working well for our advertisers but it's also working really well for the people who are using Facebook."
},
{
"speaker": "Operator",
"text": "Your next question is from Ross Sandler with Deutsche Bank. Your line is open."
},
{
"speaker": "Ross Sandler - Deutsche Bank Securities, Inc.",
"text": "Great. Just two quick questions. First, on the News Feed organic reach and then, Mark, one on Apple Watch and wearables. So on the News Feed, you guys recently made tweak to kind of alter the algorithm in favor of friend-oriented content. And then on the other hand, you're also moving towards, like, hosting publisher content from New York Times and BuzzFeed and folks like that. So how are you balancing out organic reach between these algorithm changes and then whether or not professional content is hosted inside of Facebook versus coming from a third-party website? And then the second question is, Mark, how do you view the shift to wearables with smaller screens and shorter interactions? So it looks like you guys have gotten most of the apps on the Apple Watch. Just wondering what you're doing to kind of adapt to these new smaller screens. Thanks."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "Sure. So I can speak to both of those. For the News Feed question, the North Star for us in News Feed is that we want to produce the best experience for everyone who is using the app and loading News Feed to see what is going on in the world around them, right? So when it comes to – there are lots of businesses on Facebook, there are professional content producers, our main interest here is the people in the community who are using News Feed, not those guys, right? So of course we want to build tools to enable them to share their content and all of that, but we're constantly refining the algorithms in order to make it so the experience is the best for you when you open up your phone and look at Facebook and, there are a bunch of things that are going on, we want to make sure that we're getting what you care about the most. And we go to a lot of lengths to make sure that we're getting signals from people in our community to make sure that we're doing this correctly, in addition to the different signals that we would get from seeing people use the products. We also do a lot of qualitative surveys to see what people, what makes – what people write in that they want to see from us, what people tell us is the most important thing that they saw in Facebook today or saw anywhere in the world today and what they would've wanted to have seen on Facebook. And our goal is to just constantly refine this and make it better and we're going to keep on doing that because we think there's a lot of upside and there's a lot more that we can do. Now, at the same time, in order to make this experience good, there also needs to be good content in the system, right, so we need to make sure that people have the tools to able to share the moments that they care about. But if you're a professional publisher, you need to have the ability to share a version of the content that you're producing that you're proud of, that can load quickly, that can be as rich as the tools enable people to see, and we're working on a lot of different tools for that. And you can imagine that as the tools for any of this content get better, people taking photos, newspapers, writing news articles, advertisers, putting out ads for content that they want to sell, the better that content gets, the more people are excited to see it and then that informs the ranking in what the community qualitatively tells us that they want to see from us over time as well. So it's just a constant cycle on that. What was the other question?"
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "The watch."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "Oh, the watch."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "Wearables."
},
{
"speaker": "Mark Elliot Zuckerberg - Chairman & Chief Executive Officer",
"text": "You know, I haven't actually spent that much time with this so far so, I mean, I mostly just want to congratulate Apple on shipping something that seems like a pretty amazing piece of technology and work, and we're proud to be supporting. And I know that we have a bunch of apps, and it's a space that's going to be really interesting and we're going watch closely and build what our community wants us to."
},
{
"speaker": "Operator",
"text": "Your next question is from Brian Pitz with Jefferies. Your line is open."
},
{
"speaker": "Brian J. Pitz - Jefferies LLC",
"text": "Thank you. Two more quick questions on video. Roughly, what percentage of videos are currently monetized via ads and where do you see it headed over time? And as you look at the early video ads on the platform, how is pricing comparing to other ad formats? Thanks."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "I can take this. I mean, in terms of – in terms of what percentage of videos or ads, we're not breaking that out. I think what we said was that we're really pleased with the consumer adoption we're seeing. That's kind of the fundamental table stakes that need to be there and that's the most important thing, and we're really pleased with the 4 billion video views daily that we're getting. We know that marketers love videos so there's a great opportunity here. It's still early. It's worth pointing out that, as Sheryl mentioned, video does displace other ads in News Feed. And let me just kind of speak to how that plays into pricing as well. Video is just a format that's bid into the auction. So video is effectively winning in the auction if it's higher priced. So if somebody's willing to pay more for a video, it's going to get served before another type of format ad. But there's not really a price differential you're paying for a video, it's just what are you willing to pay into the system. So there's not differential pricing by product, it's just what are you willing to bid for the format that you want to show to the people that you want to show it to and that's how the system works."
},
{
"speaker": "Operator",
"text": "Your next question is from Ben Schachter with Macquarie. Your line is open."
},
{
"speaker": "Ben Schachter - Macquarie Capital (USA), Inc.",
"text": "Mark, does the OpEx guide assume an Oculus product for consumers this calendar year? And will the initial products focus on gaming or more on some of the experiences that you showed at F8 around non-gaming like that Saturday Night Live demo? And then separately, beyond searching within Facebook, should we expect to see Facebook leverage its 2 million advertiser relationships against third-party search queries? For example, when a user searches on, say, Yahoo! or maybe some Apple device, Facebook might tap it to advertisers to provide relevant sponsored results. Thanks."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Ben, let me take the OpEx guidance question. So we have not announced any specific plans for shipment volumes in 2015 related to Oculus. I just know that Oculus is very much in the development stage so it's early to be talking about large shipment volumes, and our expense guidance reflects any volumes that we might do in 2015."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "And no plans to work with our marketers in the way you described."
},
{
"speaker": "Operator",
"text": "Your next question is from Peter Stabler with Wells Fargo Securities. Your line is open."
},
{
"speaker": "Peter C. Stabler - Wells Fargo Securities LLC",
"text": "Good afternoon. Thanks. Dave, I just wanted to return to, I think, Justin's question about the drivers behind ad growth. You mentioned gains made in relevance and quality and format. Wondering if you could provide any quantitative color around ad engagement trends, clicks, shares, likes or anything like that? And then secondly, one quickly for Sheryl. In your SMB discussions, wondering if you're ever asked to help facilitate transactions in that space? Or that's an area of small business that you're interested in? Thank you."
},
{
"speaker": "David M. Wehner - Chief Financial Officer",
"text": "Yeah. So, Peter, just on the – on ads engagement, that's an area that we've obviously been very focused on, and we're really pleased with the results that we're seeing there in terms of driving better engagement per ad, and that's really the focus of a lot of our quality and relevance efforts. How do we find those ads that are going to be more engaging, they're going to get more clicks, that they're going to get more views, that are going to get more installs. We're working on focusing on all of those, on optimizing the relevance of the ads for all of those different potential actions that happen downstream and we're pleased with what we're doing there and the trends that we're seeing there. And, again, that's a big part of what we're trying to do to drive the overall ads growth story, as well as providing a good experience for users with the ads that they're seeing."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "On SMBs, we have a very small test in the U.S. We started last quarter for buy-on Facebook, and that enables people to buy products from merchants with a buy button on Pages, and it is a product that is used and aimed at SMBs. We're also very focused on helping SMBs have a presence, especially a mobile presence. 35% of SMBs in the United States, which is probably ahead of most other countries, don't have a web presence at all, and an even smaller percentage of SMBs have a mobile web presence or any kind of mobile presence that works. And so Pages are a good and free and easy way to have a mobile presence, and that's something we're very focused on growing."
},
{
"speaker": "Deborah Crawford - Director-Investor Relations",
"text": "Operator, we have time for one last question."
},
{
"speaker": "Operator",
"text": "Certainly. Your final question is from Mark May with Citi. Your line is open."
},
{
"speaker": "Mark A. May - Citigroup Global Markets, Inc. (Broker)",
"text": "Thanks a lot. I had two. You've recently announced plans to enable longer form video content, as well as to allow those videos to be syndicated or distributed on third-party publishers. What, if any, initiatives do you have to help with this content, contributors and the publishers to generate revenue from those videos? And then secondly, on public content, what, if anything, are you doing to try to secure more unique public content, content that's potentially unique to Facebook from personalities and other sources? Thanks."
},
{
"speaker": "Sheryl K. Sandberg - Chief Operating Officer & Director",
"text": "On the video question, we're basically focused primarily on video on our own site and service, and video tends to be pretty short form content right now on Facebook because it's playing in News Feed. We do see some pretty cool examples of people using it well. So for example, in the election, you saw Hillary Clinton announce her candidacy very recently, obviously, and that video got 2.7 million views. Ted Cruz and others have done the same and they've gotten large numbers of video views. So we think it's a very attractive platform for people to reach people with video messages."
},
{
"speaker": "Deborah Crawford - Director-Investor Relations",
"text": "Great. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's conference call. You may now disconnect."
}
] | null | null |
META | 4 | 2,014 | 2015-01-28 17:00:00 | Executives: Deborah Crawford – Vice President-Investor Relations Mark Zuckerberg – Founder, Chairman and Chief Executive Officer Sheryl Sandberg – Chief Operating Officer Dave Wehner – Chief Financial Officer
Analysts: Heather Bellini – Goldman Sachs Eric Sheridan – UBS John Blackledge – Cowen Justin Post – Merrill Lynch Ben Swinburne – Morgan Stanley Brian Wieser – Pivotal Research Peter Stabler – Wells Fargo Anthony DiClemente – Nomura Ross Sandler – Deutsche Bank Colin Sebastian – Robert Baird Carlos Karjner – Bernstein Paul Vogel – Barclays Robert Peck – SunTrust Arvind Bhatia – Sterne Agee Mark Mahaney – RBC Capital Markets
Operator: Good afternoon. My name is Courtney and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook Fourth Quarter and Full Year 2014 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin.
Deborah Crawford: Thank you. Good afternoon and welcome to Facebook’s fourth quarter earnings conference call. Joining me today to talk about our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements, and actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today’s press release and on our Annual Report on Form 10-K and our most recent quarterly report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these statements as a result of new information or future events. During this call, we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today’s earnings press release. The press release and an accompanying investor presentation are available on our Web site at investor.fb.com. And now, I’d like to turn the call over to Mark.
Mark Zuckerberg: Thanks Deborah and thanks everyone for joining today. This has been a good quarter for Facebook and a great end to the year. Our community continued to grow in size and engagement and we’re very pleased with the growth of our business. Overall 2014 was a year of great progress for the Facebook community. 1.39 billion people now use Facebook each month and 890 million people daily, an increase of active and 133 million daily active this year. Time spent per person per day across our services continue to rise growing this quarter by more 10% compared to last year and that doesn’t even include WhatsApp, which joined us late last year. These milestone shows our community continues to get stronger. But it’s not just our community where we’ve made a lot of progress. 2014 was also a year of big investments in our future. This year we made big bets on the next generation of communication and computing platforms by acquiring WhatsApp and Oculus. We focused on serving our community better across all of our products, raising the quality and relevance of content to News Feed, improving our search and video products and improving the performance and efficiency of our mobile apps. We continue to invest in our employees and infrastructure, grown our headcount by 45% this year and opening our newest data center in November in Altoona, Iowa. When you consider the progress of our community and our investments, 2014 was an important year for us and a good sign of how we’re thinking about the future. In the next decade, Facebook is focused on our mission to connect the entire world, welcoming billions of people to our community and connecting many more people to the Internet through Internet.org. To serve the entire world, we need to build products that serve our community and allow people to share different types of content with different audiences. We need to offer new services and infrastructure at greater scale, but we need to create new tools and innovate to solve fundamental challenges in the places we want to connect. Doing this will take a lot of effort over the coming years and Facebook is going to have to evolve. Similar to our transition to mobile over the last couple of years, now we want to really focus on serving everyone in the world. Our mission has always been to make the world more open and connected. This is something we’ve been preparing for over the last decade. Everything we’ve achieved in 2014 and over the last ten years has helped us to build a foundation for future of greater scale. I’m excited for our progress in 2015. Now, with that in mind, I’m going to talk about the things that we expect to execute on over the next three, five and 10 years. Over the next three years, our main focus is to continue to serve and grow our community by delivering better services for people and businesses around the world. One sign of our continued growth and engagement is our progress on visual and public content. More than 2 billion photos are now shared daily across Facebook, Instagram, Messenger and WhatsApp. Video grew significantly this year to an average of more than 3 billion video views per day on Facebook. But we now have more than 2 billion interactions every week on Facebook between public figures and their fans. Instagram is also growing and helping people share and consume the most engaging content in different communities across the world. Instagram reached 300 million monthly actives with more than 70% outside of the U.S. Average time spent using the app continues to be very strong compared to other mobile services. Across Facebook and Instagram, we’ve done a very good job on engagement, especially when it comes to helping people find and consume content they like. In 2015, we’ll continue working on this as well as developing more ways for people to share even more of the moment they care about on Facebook. Five years ago, most of the content shared on Facebook was text and some photos. Today, it’s primarily photos with some text and video. Over the next five years, we want to keep developing new products and features to help people share the way they want. When it comes to serving businesses, we continue to help drive results for businesses of every size around the world. Last week, a Deloitte's report found that in 2014 Facebook created more than $225 billion of global economic impact and $4.5 million new jobs. This is an important reminder of the big opportunity we have to create value for businesses and why we’re committed to serving them well. In 2014, we invested aggressively in improving our ad-tech and measurement tools. We’re going to continue working to provide new capabilities for marketers. Sure, I’ll talk about this more in a moment. Next, let’s talk about our efforts over the next five years to build the next generation of Facebook services. We expect WhatsApp and Messenger to connect hundreds of millions of more people and become indispensable services for the world as well as important contributors to our business. Messenger and WhatsApp recently achieved impressive new milestone. In November, Messenger reached 500 million monthly actives, and at the beginning of January, WhatsApp reached 700 million monthly actives with more than 30 billion messages sent each day. These numbers speaks the quality of both products and the size of the opportunity ahead to help billions of people communicate and collaborate. Search at Facebook is another important effort that we expect to create a lot of value over the next few years. In this quarter, we launched updates to Facebook search to make it easier to find content and posts on mobile and desktop. We’re going to continue listening the feedback from our community and to admit time to build really valuable products here. We’re optimistic about our ability to deliver value that only Facebook is able to provide. Working with developers is the other part of our strategy. In this quarter, we continue to make progress with helping developers build, grow and monetize their apps. In October, we rolled out our audience network around the world. And since then, the number of apps in the network has nearly tripled and impressions served by the network have more than quadrupled. In 2015, we’ll continue to build upon our long-term goal of making Facebook a truly cross platform, platform, to allow those developers to share their work on every major mobile platform and we look forward to sharing more details at our next F8 event in San Francisco this March. Finally, let’s talk about our plans over the next decade to connect everyone to the internet through Internet.org and to develop the next generation of computing platforms with Oculus. Internet.org now has a lot of momentum. We launched three basic internet services in Zambia, Tanzania, Ghana, Kenya, and Columbia. More than a 150 million people living in these countries now have the option to connect to the internet using the Internet.org, but we’ve already connected 6 million of them to the internet, who did not accessed before. We’re very excited by Internet.org’s progress and the level of interest we’re seeing across industries, governments, and our community. 2015 is going to be an important year for our long-term plans and I expected to share more updates about our progress here over the coming months. Oculus continues to make progress towards the future of immersive VR experiences that are part of daily life for millions of people. This month the team done another good showing of ZS and developer’s interest in Oculus platform continues to grow. So that’s my update for this quarter. It’s been a good quarter and a good end and it’s an important year for us. I want to thank you everyone in our Facebook community and our employees, our partners, and stockholders for their support. Thanks to you. Our community is growing stronger everyday and we’re making progress towards making the entire world more open and connected. Thanks and now here is Sheryl.
Sheryl Sandberg: Thanks Mark and hi everyone. Q4 was strong across the board, tapping a great year. This is our first quarter with over $3 billion in ad revenue and over $2 billion in mobile ad revenue. Our Q4 ad revenue grew 53% year-over-year. Our mobile ad revenue was 69% of the total ad revenue and double than the past year. Our growth is strong across all verticals in marketer segments. We also saw healthy growth around the world although growth rates outside the U.S. were effected by exchange rates. Looking back at 2014, our team has made great progress on our three main priorities. Capitalizing on the shift to mobile, growing the number of marketers using our ad products and making our ad more relevant. We believe that the market increasingly understands that we have the leading mobile ad products and are the only platform that delivers people based marketing upscale. A shift to mobile is changing the way people consume video. As Mark said, video grew dramatically on Facebook in 2014, especially around global events like the World Cup and the ALS Ice Bucket Challenge. In just one year, the number of video posts per person on Facebook increased 75% globally and 94% in the U.S. Today, over 50% of people in the U.S. who come to Facebook daily watching at least one video per day and globally over 65% of Facebook video views occur on mobile. Marketers have followed this trend and are using video to help people discover and learn about their brands. In Q4, we expanded autoplay video ads internationally. During the holiday season, we saw many clients telling their stories creatively through video. 2014 was also the year we began scaling Instagram ads. In Q4, we rolled out Instagram ads in Australia and Canada. Marketers are excited to have access to the 300 million people views Instagram and the creativity it inspires. We’re seeing beautiful creative and great results from brand marketers across verticals from insurance and tax to retail and entertainment. For example as one of our first Instagram video advertisers, Banana Republic developed a series of videos to promote its BR clothing lines. The video showed fashion sketches from the new collection and drove a 23 point lift in ad recall. While, it’s still early and we’re being deliberate in our rollout. We believe that Instagram will become core to advertisers and mobile brand building efforts. We also made progress growing a number of marketers using our ad products. Custom audiences, our suite of proprietary targeting product has become an essential tool for segment current and potential customers. Conversion tracking away from marketers to measure the impact of their campaigns online is also seeing wider adoption. We’ve made it easier for businesses of all sizes to plan and manage their ad campaign and for small businesses to use our targeting tools. Travel company, Thomas Cook, recently used Facebook in Belgium to reach a broad audience and used custom audiences to send targeted messages to existing customers based on the places they’d expressed interest in. It reached 30% of the Belgium population in just one day and achieved a 3.85 times of return on investment. Results like these are attracting more marketers of all kinds to our platform. Finally, we made great progress improving ad relevance and measurements. To do this, we made significant investments in both our core measurement and targeting tools as well as ad-tech. Earlier in 2014, we introduced ad buying capabilities based on each and frequency metrics which is similar to how brand marketers by TV ads and therefore enables better cross comparison. We improved our Ads Manager product to give better in place into ad campaign to audience an impact. In the fall, we re-launched Atlas to help marketers reach real people and measure results across multiple devices. Omnicom is our first global client and this month we announced a partnership with Havas to further expand globally. We also invested in Audience Network, which helps marketers to extend their campaign off of Facebook and LiveRail which provides publishers the video tools to monetize their inventory more efficiently. Heading into 2015, we’re excited to build on the progress we’ve made with our core ad products as well as with newer areas like video, Instagram, and ad-tech. It is still early days in all of these efforts. There is a lot of hard work to do and we plan to invest aggressively. Our ultimate goal is to be a critical business partner to our clients, providing people-based marketing of scale to build their brands and move their off shelves. Over the past few weeks, I have had a chance to meet with many of our largest global clients and agency partners and talked about how we can drive real business results for them, making every impression and every dollar they spend improves their bottom line. Our clients are excited by the opportunity to use video Instagram and ads on and off Facebook to reach the right people with the right message. In turn, as their ads become more relevant, we provide a better experience for the people who use Facebook. Humming off our biggest year ever I want to say a special thank you to the Facebook teams around the world, to our global sales engineering, product design and infrastructure teams, your accomplishments over this past year are the reason our business is in such a great place. To our entire company, I feel lucky to work with you as we stay focused on our priorities and work together to help connect the world. And to our clients thank you for your partnership and your trust in us. Heading into 2015, we have big opportunities and a lot of work ahead. Thanks and now here is Dave.
Dave Wehner: Thanks Sheryl and good afternoon everyone. Q4 wrapped up a strong year for Facebook. In 2014, our revenue grew 58% to approximately $12.5 billion and we generated over $3.6 billion in free cash flow. We are very pleased with the continuing growth of our network. In December, the number of people using Facebook on an average day increased by 18%, compared to last year to 890 million. The daily number represents 64% of the 1.39 billion people who used Facebook during the month. Mobile remains the primary driver of our growth. We ended the year with 1.19 billion people using Facebook on mobile in the month. We also continue to see solid growth with Instagram, Messenger and WhatsApp recently crossing 300 million, 500 million and 700 million MAU respectively. Turning now to the financials, all of our comparisons are on a year-over-year basis unless otherwise noted. In addition as a reminder, our non-GAAP measures exclude stock-based compensation and the amortization of intangibles. Total revenue in Q4 was $3.9 billion, up 49% or 53% on a constant currency basis, given how significantly exchange rates have continued to move, we anticipate that this currency headwind will increase in 2015. I will give more color on this later in the call. Ad revenue was $3.6 billion, up 53% or 58% on a constant currency basis. Mobile ad revenue in Q4 doubled to $2.5 billion or 69% of ad revenue compared to approximately $1.2 billion or 53% of ad revenue last year. Desktop ad revenue was up approximately 1% despite the fact that overall desktop usage was down. In Q4, the average price per ad increased 335%; well total ad impressions declined 65%. Similar to last quarter, these price volume trends were primarily driven by the redesign of our right-hand column ads which rolled out in the third quarter. Total payments and other fees revenue was $257 million, up 7%. Note that the growth was driven by revenue from acquisitions made in the past year. On an organic basis, payment revenue from gains, which represents the substantial majority of our payments and other fees revenue declined 10% compared to last year. As previously noted, we expect this trend to continue as desktop usage declines. Turning now to expenses; our Q4 total GAAP expenses were $2.7 billion, up 87%, and non-GAAP expenses were $1.6 billion, up 50%. GAAP expense growth was driven primarily by significant stock-based compensation and amortization expenses related to the WhatsApp acquisition. Non-GAAP expense growth was driven primarily by increases in headcount related costs, cost of revenue and marketing expenses. On a full year basis, our 2014 GAAP expenses were $7.4 billion, up 47%, and our non-GAAP expenses were $5.3 billion, up 34%. We ended the year with roughly 92,000 employees, up 45%. Overall, we remain very pleased with our ability to attract and retain top tier talent. GAAP operating income was $1.1 billion in Q4, representing a 29% operating margin, down from 44% last year; again, primarily due to expenses related to our recent large acquisitions. Non-GAAP operating income was $2.2 billion in Q4, representing a 58% operating margin consistent with the margin last year. Interest and other income and expense was a net expense of $19 million in Q4 versus a net expense of $3 million in Q4 last year. This increase in expense was primarily due to foreign exchange losses resulting from the periodic remeasurement of our foreign currency balances during the period. In Q4, we benefited from the reinstatement of the R&D tax credit. Our GAAP tax rate was 37% and would have been approximately 42% excluding the benefit of the tax credit. Our Q4 non-GAAP tax rate was 31% and would have been approximately 32% excluding this benefit. Q4 net income was $701 million, or $0.25 per share, and non-GAAP net income was $1.5 billion, or $0.54 per share. In 2014, we spent $1.8 billion on CapEx and generated over $3.6 billion of free cash flow. We ended 2014 with $11.2 billion in cash and investments and a net operating loss carry forward of approximately $4.5 billion. Turning now to the outlook, let me start with revenue. We’re still in the early stages of building out many aspects of our ads business and we remain optimistic about our long-term opportunities. Looking at 2015, there are a couple of things I want to note. The first involves how the recent movements in exchange rates might impact our 2015 revenue. Assuming exchange rates were to remain constant at today’s level. We would expect that our total revenue in 2015 would be approximately 5% lower than it would be under 2014 exchange rates. Note this 5% represents the expected reduction in 2015 total revenue, not the reduction in the year-over-year growth rate. And second, we are reporting revenue from Atlas, LiveRail, and the Audience Network on a net, not a gross, basis. So the growth in those products will have less of an impact on our overall reported revenue growth in 2015. Turning now to expenses. We’re tightening our ranges modestly given the better visibility into 2015 spending. We expect that our full year 2015 total GAAP expenses will increase 55% to 70% compared to 2014. We expect that our 2015 total non-GAAP expenses will increase 50% to 65%. A simple way of thinking about our investments is across three categories: people, product, and infrastructure. On the people side, we enter 2015 with 45% more employees than we did a year ago and we will continue to invest in and grow the talent base throughout the year. In terms of product, we are investing to build great experiences for people, marketers and developers, ranging from our existing products and services to newer initiatives such as ad-tech, Internet.org, Oculus, and WhatsApp. We’ll also invest in marketing to support all of these initiatives which, as I noted, was a driver of expense growth in Q4. Turning to infrastructure. We continue to build out our global infrastructure to enable billions of people around the world to connect, message, and share with each other. We will be investing in data centers, our network and servers to grow our existing services and support newer initiatives such as video and our global connectivity efforts through Internet.org. We anticipate our 2015 CapEx will be in the neighborhood of $2.7 billion to $3.2 billion. We expect stock-based compensation for 2015 to be in the range of $3 billion to $3.3 billion approximately half of which is related to our prior acquisitions, most notably WhatsApp. We expect amortization expenses for 2015 to be approximately $700 million to $800 million. And finally, we anticipate our Q1 and full year 2015 GAAP tax rates to be in the mid to high 40s and non-GAAP rates to be in the mid to high 30s. In summary, Q4 caps off a great year for Facebook in which we executed well and also made some very important investments for our future. In 2015, we are focused on continuing to execute on the business and investing in our long-term mission and success. With that Courtney, let’s open up the call for questions.
Operator: We will now open the lines for question-and-answer session. [Operator Instructions] Your first question comes from the line of Heather Bellini with Goldman Sachs. Your line is open.
Heather Bellini: Great, thank you. I just had two quick questions. Sheryl or Mark, I was just wondering, from a brand advertising perspective, is there a way you could share with us how your conversations with these advertisers have been trending over the past 12 months, how they've been evolving, and kind of how they are thinking about the video opportunity? And then, Dave, I just wanted to follow-up on your question about total expense guidance, because in the past you've given a 5-point range, I believe, for total expenses and this year it's 15. Granted, you did tighten it, which we appreciate. And just wondering the parameters around how we think about the low end versus the high end?
Sheryl Sandberg: It’s a great time for the brand question because over the past few weeks I’ve spent a lot of time kicking off 2015 with our largest agency partners and largest clients. And I would say that people remain really excited about Facebook, but people are bigger believers because we’ve had an opportunity to do more measurement over the past year. I think there are few things about the Facebook platform that are really exciting for brand marketers. The first is the creativity and storytelling and certainly as you mentioned video is a big part of that because video is a format that marketers have used for a long time to building those connection to brands. And the second is measurement. And what clients want and what they should want is an ability to look at their ad spend and see how effective it is, not just in the brand less metrics even though those are important but in moving products off shelves. And over the past year and half the investments we’ve made in building out that measurement have paid off. So when I sit down with clients at the beginning of this year compared to last year, we have more actual case studies of marketing we’ve done with them. We’ve been able to ad test, Facebook ads versus no Facebook ads and what the effectiveness is on their sales. And I think across the board, we’re showing very healthy, very competitive ROI. The opportunity and the challenge now is to [indiscernible] even for our largest clients globally, we still represent a really small part of what they do. And so, it’s on us to prove to them that the results we’re showing them in these smaller tests can happen in more bands and more countries with a larger part of their business.
Dave Wehner: Hi, Heather, it’s Dave. So just - yes, just following up on that where we land in the range of guidance on [indiscernible] will depend on a number of different factors. It’s going to depend on how successful we are at hitting our recruiting goals, how much we ramp in areas like marketing and how could we deploy our capital against our CapEx plan and then how we execute against our plan of ramping investments in new areas like Oculus, WhatsApp, Internet.org, et cetera. We feel good about where we are. We’re going into 2015 on a high note. So I feel like we’re making these investments from a position of strength and excited about the opportunities to put more capital to work in 2015.
Operator: Your next question comes from the line of Eric Sheridan with UBS. Your line is open.
Eric Sheridan: Thanks for taking the question. Mark, I wanted to follow-up on your comment around search, its early days, but what the company is seeing in terms of the way people are interacting with the new search functionality inside Facebook broadly? And then maybe tying it back to advertising, what that might mean for closing the loop with some of your small and medium sized business advertisers and maybe even the places initiative long-term? Thanks.
Mark Zuckerberg : Sure. So, our view on this is that there is a lot of unique content that people have shared in Facebook, a lot of personal content, recommendations from friends that you can get that you just wouldn’t be able to get through a traditional web search service or other app. And if we’re on this multiyear voyage to basically index all the content and make it available to people and rank it well. We started off by launching graph search which I think included more than a trillion different connections in the first system. And the second round of the search progress that we just started rolling out at the end of last year was post search, which now has index more than I think a trillion posts, which I mean the sizes of these corpuses are bigger than anything in a traditional web search corpus that you would find. So it’s an interesting and fun challenge to make this work. We’re seeing that that people immediately understand how they can use this and find content that they seen in news feed before or that they’ve posted with just a few keywords. And we’re excited about that, but there is a lot more to do. So that we’re not really thinking about advertising in it yet on the scale that our community operates, a billion searches per day is actually not that big compared to what we think the opportunity here should be. And we’re just continued to keep on working on it because there is just a lot of unique value that people should be able to get their friends on Facebook research.
Operator: Your next question comes from the line of John Blackledge with Cowen. Your line is open.
John Blackledge: Great, thanks. Just wondered if you could provide your view on Facebook as a video platform given that video views per day increased to 3 billion in December from 1 billion in September of 2014 and how we should think about the video content mix over the next couple of years, and just same kind of topic, if you can give a sense of user and advertiser feedback on the autoplay video ads. That would be great? Thank you.
Dave Wehner: I'll talk about the consumer product and then Sheryl can jump in about as. So what we are seeing and I alluded to little bit in my opening remarks is that there has been this evolution of content on Facebook over the last 10 years, towards richer format that convey more of the moment that people care about. So if you go back five years ago, a lot of Facebook was primarily capture it in a little bit of photos and also I think the primary mode that people are using to share is photos and they wouldn't be surprised up in the future that shifted more and more towards videos. So we’re thinking about how to enable consumption first to the content of people who are sharing, and this year an increased focus on new opportunities around production so it is easier for people to capture the moment that are important to them, create higher-quality moments and pictures of content out of those and increase their experiences through that. So there is a lot more to do here and I think the business going to be one of the big trends over the next three to five years, is the growth in video and richer content in our service.
Sheryl Sandberg: From a consumer and marketers feedback on video ads point of view, there is two things really go together. It’s exciting that we’ve gotten to 3 billion video views per day, because that means consumers are using video ads and enjoying them on Facebook and in news feed. The way we think about our ads product is we want them to blend in with the consumer experience. And so the fact that we have this much consumer video on Facebook, means we have an opportunity to grow our ad business and that’s exciting for marketers.
Operator: Your next question comes from the line of Justin Post with Merrill Lynch. Your line is open.
Justin Post: Great, it looks like you did about $9 of revenue in the U.S. per MAU which implies over $30 run rate which is impressive. Sheryl may be the first question to you. How do you grow that from here is it usage, is it more higher ad loads, is it the mix of ads or is it targeting may be some thoughts on how you grow from there. And then Mark, if you look at other your three platforms WhatsApp, Instagram, Messenger and other things. You probably have in mind. Can I monetize anywhere as well as Facebook if you look out your five year plan? Thank you.
Sheryl Sandberg: Yes, thanks for the question. When you think about what’s happening, certainly the growth has been good, but it’s still true that marketing dollars have not followed consumer time and the same percentages. So in the U.S., mobile gets 25% of consumer media time, but only 10% of the ad budgets. And to take one comparable example, that means that for every consumer hours spent on print, marketers spend $1 and they spend $0.07 per hour on mobile, which means that we have an opportunity to grow. One of the most important ways we grow is not just bringing more marketers into Facebook, having them use more of our ad products, but as you mentioned better targeting. A more relevant ad is a better ad experience for consumer - for consumers, but also drives them much higher returns from marketers and since we’re running an action, as our ads get more relevant and we provide higher ROI. We should be able to continue to grow. I think we’ve done a good job over the last year, making our ads more relevant. I think most people on this call would say that you seek more relevant ads than you used to a year ago, but I still think, you know, some of the Facebook ads still have rooms for improvement in terms of relevance. And so, we see a lot of room for improvements there, both in the ROI we deliver and in the experience we can provide to consumers.
Mark Zuckerberg: Yes, so I will add something to that just on the side of how we think about value through Facebook and I will talk about the other apps. In terms of the product developments that we do here, we have four major groups inside of the company. This is kind of how our company is organized. We have one which is focused on growing the community, one which is focused on kind of increasing content consumption and people’s engagement, another which is focused on kind of efficiency and helping people to get the most value out of each moment that they’re spending in Facebook. And then the fourth group is our core business, which is focused on helping people to see the best ads and basically make the most money per moment that people are spending at the lowest cost in most efficiency in terms of serving people. And there is, I think, big upside in each of those four categories. I mean our community is growing. I mentioned in our comments upfront that time spent across our services is growing by - grew by 10% year-over-year per person, which is pretty meaningful. Utility and efficiency are increasing and of course the ad business per person and the efficiency of our services are both increasing as well. So I am pretty excited about that and think we’re organized in a way where we can continue visiting of that. The other opportunities, Instagram, Messenger, and WhatsApp, I am really excited about and I do think that they’re going to reach the level where they contribute to our business in a pretty big way, but it’s really important to get this right and not rushing. And you know what I would say around messaging, as we’re pretty early in that cycle, we are about where Facebook was in around 2006 or 2007 where at that point Facebook was really just a consumer product. There were no businesses in the ecosystem. And a lot of people were telling, okay, don’t put better ads in. And that’s not wrong. I didn’t think that that was going to be the right way to build the products or build the business. So instead what we did was built pages, which was a way for businesses to interact for free in the system and start creating organic interactions between people and business. And so we could figure out what - the people are using Facebook 1 and from businesses within Facebook and we built more tools for pages and businesses to engages. And our recent success with advertising is really just built on some of those organic interactions between people and businesses. And what you see in Messenger and WhatsApp now is we’re still in the early end of that curve where the interaction is still primarily people to people and businesses are starting to figure out in the case of WhatsApp much less than Messenger so far. What the organic interaction is, but we’re going to have to go through a whole cycle of figuring out how that works before it really make sense to start monetizing them in a big way. But yes, I mean, I am a big fundamental believer and that these are going to be very big contributors to our businesses over time, but we just have to do it right.
Operator: Your next question comes from line of Ben Swinburne with Morgan Stanley. Your line is open.
Ben Swinburne: Thank you, two questions. Sheryl, can you talk about where we are in the North American market versus your other regions in terms of sort of advertiser maturation and acceptance of the Facebook platform? The growth rates in North America to be really impressive despite of being your biggest business when you look at the ARPU trends and as compared to the other regions that was tend to be - seem to be moderating a bit. And then I was wondering, Dave, if you could talk about the pricing growth which actually accelerated from Q3 to Q4, can you give us some color there. I know there were changes to LiveRail, but anything else you would add about why there was a huge acceleration in pricing growth? Thanks.
Sheryl Sandberg: North America remains a really important market for us. And as you said, we’ve had growth. We’re very happy with. It’s still true that for any kind, no matter how big they are for us, we represent a really tiny part of their ad spends and we represent an underinvestment in terms of where they can reach their consumers. So we believe by continuing to make these investments, we can really continue to grow. We get 20% of people’s time on mobile phone in the U.S. between Facebook and Instagram. We don’t get close to that in terms of anyone’s marketing spend or the time they may spent. We say to our clients over and over again is that we want to drive their business. And that’s what probably the most important thing we’re doing for these large North American spenders is around the measurement work we’ve done. Two years ago, we were not able to measure all the way through to purchase off the shelves and now we can. Yesterday, we rolled out a product we call lift, which is really the next consideration of our measurement capabilities. That enables larger customers to go and set up ads with control test groups, and so they can AB test. This group of people saw Facebook ad, this group of people didn’t and they can measure all the ways through to conversion of whatever they’re measuring whether it’s an online conversion to a sale. We think the measurement out there online and digitally is not particularly accurate. People don’t have real people based measurement through our investments in Atlas and through our investments in - the core Facebook measuring tools. We think if we can show the ROI marketers are getting and we can increasingly do so, we can continue to penetrate the North American market.
Dave Wehner: Ben, its Dave. So also just building on what Sheryl said worth noting that the drop in the value of international currencies impacted our results outside the U.S. to some of what you’re seeing here is a result of that. It reduced year-over-year revenue growth rate by 7% to 8% in the different international regions. So that’s a big reason why you see the U.S. doing much better as well as the fact that’s just more advanced market in what we’ve done in terms of just building up the advertiser base and getting into option of our best targeting products as Sheryl was talking about. Going to your question on pricing growth, I just reiterate what I said in my comments, it’s largely due to the right hand column redesign and then also the shift to mobile where we don’t show right hand column ads. So that’s really what’s causing the pricing shifts. Then fundamentally, we just continue to get better targeting and that drives better engagement. And as we get better engagement that drives better ROI for our advertisers, which ultimately, I think as Sheryl commented on earlier, gets reflected in better pricing of our ads. And that’s a big opportunity for us and we are seeing that we’re getting better and better of driving engagement from the ad units that we have and getting the right ad in front of the right person. So that’s a big factor as well.
Operator: Your next question comes from the line of Douglas Anmuth with JPMorgan. Your line is open. Douglas Anmuth, your line is now open. Your next question comes from the line of Brian Wieser with Pivotal Research. Your line is open.
Brian Wieser: Hi, thanks for taking the question. First, I was wondering if you could talk about the degree which you think premium video content is - or is not necessary to opt when we capture budgets from advertisers that might otherwise have gone to TV, you have a couple of initiatives around ABC and NFL. So I was curious to get your thoughts on that? And separately, I am not quite sure you’re using Atlas and specially those - or new to Atlas. Do you have a sense that your spending on digital media is changing or if so how - alternately are they just happy with campaign management tools? Thanks very much.
Sheryl Sandberg: So on video ads what really matters is that consumers are using video on Facebook, because that gives us an opportunity, one, to provide a great consumer experience, but two, to have ads in ad-tech consumer experience. If the other consumer video on Facebook, video ads and new feed will be very joined, as a percentages of the video you’re seeing, video ads gets nicely into that experience. I think it matters as much what the video content is and so well we are certainly exploring some premium content as he said, we have an Annabelle Verizon test out there in the public ad. We’re already seeing pretty exclusive growth without that kind of premium content in the system in large numbers and so we’ll continue to figure out. We’re certainly open to increasing video content either way. But we haven’t quite figured out what the mix needs to be and right now the growth is very strong. In terms of Atlas, we just relaunched this fall and we’re just seeing as deals get done in broad adoption. So I think its too soon for us to report that Atlas drives an increase in digital spend or an increase in any particular kind of spend but you should be believe really deeply, which is that Atlas is going to revitalize marketing by making the measurement more accurate. If you look at how digital ads are being measured. They are being measured based on a cookie based world that assumes that people have one device, largely a PC. And that is not real, consumers have phone, they have tablet, they have PC's as well and the ability to understand that one person to serve an ad and measure all the way through correctly. We think it’s going to massively improve the efficiency in the system as we get the battle.
Operator: Your next question comes from the line of Peter Stabler with Wells Fargo. Your line is open.
Peter Stabler: Thanks for taking the question. One for Sheryl. Sheryl, as you push further toward monetizing off platform inventory. I’m wondering if you could speak to state of your relationships with premium publishers. There is a narrative out there, we sometimes encounter that, that publishers are growing a bit concerned about the power you guys wheel, particularly as you push into monetizing off the platform. Thanks very much.
Sheryl Sandberg: Our audience network efforts are still pretty new. We have a goal of serving more relevant ads to people off Facebook which will provide greater reach for Facebook marketers and also a better opportunity to monetize for publishers. We are seeing some nice results as Shazam reported that using audience network increase the revenue from ad networks by 37%. We believe that working with publishers, if we can increase the value of their inventory by providing more relevant and targeted ads. They are going to be really happy with that opportunity and we are in the early stages of finding those partners.
Operator: Your next question comes from the line of Anthony DiClemente with Nomura. Your line is open.
Anthony DiClemente: Thanks a lot. First for either Mark or Sheryl on the subject of public video content and what you guys are doing to increase the amount of a video in the News Feed are there things in terms of actors, celebrities, public figures that you can do to economically incentivize those creators of, let they, the higher-quality user generated content onto the Facebook platform be at a revenue share what have you, were relative to the economic for those types of folks on competing online video platforms. And then just one quick one for Dave, you mentioned - as you mentioned you will be shifting the accounting for Facebook audience network and live rail to be for revenue to be net of pack in 2015 versus growth in 2014. I’m just wondering why [indiscernible] to do that and is there any you can help us with in terms of order of magnitude of that shift. Thanks.
Sheryl Sandberg: So, on premium video content, we haven’t figured out exactly how important this is to the ecosystem or how much we are going to invest or what kind of monetization we are going to offer. Video is a growing quite nicely through the ecosystem right now. we have made a lot of investments in public content working with public figures to use the Facebook platform, we’re by far the largest social platform and increasingly you are seeing public figures, everything from news broadcaster to journalist at a public figures do a lot on Facebook and that’s important to us. Because it provides the kind of sharing people want, people come to Facebook to share with their friends and family but they also come to Facebook to connect with everyone from politicians to journalist to celebrities they want to connect with and get news and we definitely seeing public content grow as a percentage of what people get. We also had some nice wins with the Golden Globe this year other things we are doing to get people doing some partnership we did [indiscernible] with CNBC to show how we can help content creators increased their distribution and reach people directly on Facebook.
Dave Wehner: Yes, Anthony, it’s Dave. So, just to be clear that net revenue recognition for those products that’s how we did it in Q4 as well those are all small today, but there is not a change in accounting in 2015 that’s how we accounted for those products in Q4, as far as the net versus gross we just evaluated all the facts in circumstances and made the judgments that net revenue recognition with the most appropriate treatment here.
Operator: Your next question comes from the line of Ross Sandler with Deutsche Bank. Your line is open.
Ross Sandler: Thanks. Just following upon the video concept how important is it that Facebook post the videos versus I guess sharing clips from third-party players in the feed and what percent of that $3 billion streams daily is Facebook embedded versus from other players and are you able to monetize videos from third party players today there is a way to walk around that in the future. Thanks.
Dave Wehner: This thought that we shared of 3 billion a day is all made on Facebook. So there are probably other shares from other video services as well. But the way that there was looking our services or as if there is links to other sites, and the reason why I think made a video is so valuable for people using our service is that when someone uploads a video to Facebook directly we can optimize how it delivers right. So we can make it autoplay. We can find the right quality and bit rate to send down to the person based on their connection overtime. And optimize all kinds of different things. So what I think people are finding from public figures to everyday videos that people are uploading is that the best experience that you can get is by uploading content native to Facebook, which is, I think the big part of the growth that we seeing there.
Operator: Your next question comes from the line of Colin Sebastian with Robert Baird. Your line is open.
Colin Sebastian: Great, thank you. I wonder if it’s possible to distinguish how much of the growth in advertising revenues can be attributed to changes in organic compressions. And how you balance the desire of business partners to contribute content to feeds versus monetization. Thank you.
Dave Wehner: That’s right. Exactly understand the question. But let me see if I can take a crack at it, Colin. I mean, we are seeing obviously great growth in DAU, which is up 18%. We are seeing growth in times spent across the network up 10% per DAU. So you got those sort of underlying drivers of engagements driving growth. We are also monetizing at higher rates because we are able to get better targeting into the ads and get better conversion for advertisers. So that’s reflected in better pricing. So there is a number of different factors that are coming into play. But clearly driving organic growth in engagement, it’s critical in the business and we are seeing good success there.
Mark Zuckerberg: One thing that I’d just add to emphasize here because its I think there have been a couple of questions so this is the fact our primary strategy for growing the ad business is increasing the quality of the content, not increasing the number of ads to our story that people are seeing on Facebook. So there are impacts like as people consume more content on Facebook, within the ratio of ads that organic content that will showed might be more ads. But overall, our strategy is much less to that increasing the volume of ads and much more about increasing the quality of the content and the quality of the targeting to get the right content to the right people. And this is a pretty controversial strategy internally and we will ensure that is going to work out. But for the last year it’s really fueled our growth in a good way and we feel very confident that this is the right path going forward as well.
Operator: Your next question comes from the line Carlos Karjner with Bernstein. Your line is open.
Carlos Karjner: Hi, I have two quick questions. First when you say that time spent decreased 10% year-on-year it is roughly uniform across your geographic regions. And secondly, Mark I think we have Mark’s in every earnings call you talk to investors for a considerable amount of time about Facebook first to connect the world, and specifically about the Internet.org which suggest you think this is important for the investors. Can you clarify why you think this most of the investors and importantly why you think Facebook can make a significant difference of scale even that you’re unauthorized per user in emerging market is about five bucks to connect and the user who has no device accomplish maybe at least in terms of dollars. Thank you.
Dave Wehner: Well, it matters to the kind of investors that we want to have. Because we’re really mission focused company and we wake up every day and make decision because we want to help connect the world and that’s what we’re doing here. So part of that the subtext of your question is that yes, if we were only focused on making money we might put all of our energy on just increasing ads to people in the U.S. and the other most developed countries. But that’s not the only thing that we care about here. So I do think that over the long-term that focusing on the helping connect everyone will be a good business opportunity for us as well. And we may not be able to tell you exactly how many years that’s going to happen and but I think these countries get more connected the economics growth the ad markets growth and Facebook and the other services in our community or the number one and number two, three, four, five services that people are using then over time we will be compensated for some of the value that we have provided but this is why we are here, we are here because our mission is to connect the world and I just thinks its really important than investors know that.
Mark Zuckerberg: And Carlos on that time spent per DAU that we are just giving the one point, we are not breaking any thing out by region.
Operator: Your next question comes from the line of Paul Vogel with Barclays. Your line is open.
Paul Vogel: Great thank you very much. I am just curious given the impact that currency had on the quarter on growth rates outside the U.S. is there any market should be fall out particularly either better or worst that might be massed by the currency swings number one. And number two I’m just sort of curious if currency does stay where it is, does it all impact sort of your spending plans or how and where and when you’ll invest? Thanks.
Dave Wehner: Hi, Paul, it’s Dave. It - sort of taking your second part first we’re not really making investments decisions on short-term fluctuations in currency. So I would say in general no, it’s not effecting those decisions. There are certainly big macro effects that are going on and part of those are what’s driving a lot of the currency fluctuation as well. So you have regions that are certainly growing more quickly and growing more slowly. So from a macro perspective, the United States is doing better in terms of growth versus Europe versus Latin America. You see those compounded in both currency and sort of macroeconomic conditions in those regions. So I think generally we’ve got more favorable market conditions in which to operate in the U.S. Overall, I would say the business is driven by the fundamentals of us, continuing to execute against our plan. So whether you’re in a market that’s suffering a little bit from a macro economic headwinds, we’re still - we still have the best mobile product in the market, in that market and we’re growing. So, I think at the end of the day, it’s the fundamentals of our business that are going to drive our success and we’re kind of focused on that. The one of these at least give some color around how the currencies might impact the 2015 results.
Operator: Your next question comes from the line of Robert Peck with SunTrust. Your line is open.
Robert Peck: Yes, I have two quick questions. One Mark, you’ve spoken much here today about the e-commerce opportunity in front of Facebook and particularly the buy button. Could you elaborate a little bit on plans around e-commerce than what you see that opportunity? And then Dave, I was wondering for investors, could you maybe go through your view and how you look at capital efficiency and ROI so that whether it would be acquisitions or CapEx or even OpEx. How you look and see you’re getting a good return on that spend. Thanks so much.
Sheryl Sandberg: Q4 is a really important quarter in general, but its particularly important quarter for e-commerce, so it’s a timely question. When you think about buy on Facebook, it’s a [indiscernible] U.S. we started last quarter and enables people to buy on pages. To be clear, you’re not buying from Facebook, you’re buying directly from the merchants and it’s really an SMB product to give them capability they haven’t had. We’ll see what happens in terms of where people convert whether it’s on Facebook, but we think the opportunity to connect consumers with the product that they then purchased is a really big one where we play in that most directly, it’s a time and attention consumers have as well as the information to do very relevant advertising and we’re going to stay focused there.
Robert Peck: Robert, I think the bulk of the investment that we’re doing is really focused on the capital in the OpEx to deliver against the core mission of enabling billions of people to connect and share. So for the most part, we’re looking at what should we need to deploy to deliver against the mission to deliver against our overall financial results. There’re places where we can individually takeout specific projects whether it would be M&A or specific capital investments and then we’ll look at those on an IRR basis for specific projects, but you have to recognize that we’re basically one large business and we’re operating against capital deployment against delivering against the objectives of that business. So that’s the bulk of the spend that we do, but certainly we look at things on an ROI basis on individual project basis as well.
Operator: Your next question comes from the line of Arvind Bhatia with Sterne Agee. Your line is open.
Arvind Bhatia: Thanks for taking the question. Just quickly on WhatsApp, I know this focus will be user growth for a while, but in the future as you do turn on the monetization engine, just curious what are some of the primary ways that you’re assuming growth will come from advertising - or games perhaps and also on WhatsApp user growth would you be able to callout where that’s coming from? Is there any particular areas that are stronger and curious how that’s doing in the U.S.? Thank you.
Dave Wehner: So you’re right that the focus for WhatsApp is on helping to connect a lot more people, all right. So when John and team joined us, one of the first things that we agreed on and why I think it made sense for them to join is that now they can focus for a few years on getting to one billion more than that and continuing to scale beyond that. SMS is an incredibly global and universal product and I think WhatsApp just has a huge opportunity to third billions of people. In terms of what the business looks like, I mean at the end of the day, it’s a distribution business like Facebook and Instagram, how you most effectively convert that into business opportunities for customers whether that’s through payments or ads or other different kinds of structures. We’ll figure that out what the optimal thing will be, but the first order of thing to do is to helps our billions of people here, help to continue to increase engagement, I mean people are spending a lot of time in WhatsApp, sending more than 30 billion messages a day, which is really crazy when you think about the volume there compared to the global SMS volume overall. And I think if we do that there will be a number of opportunities. I mean people ask me this question awhile ago about - when we talked about games on Facebook as well. And I always talked about our canvas business on desktop even though its payment is actually the same thing as our business on mobile around app install and engagement. What developers test for is distribution and whether they’re doing that through payments or ads or whatever it is, it kind of is all the same. The most important thing is to help people connect, help people and businesses connect and create business opportunities and then you get a small amount of the value that you’re creating on top. So that will play out over the next set of years and it’s one of the intellectual challenges that I am really looking forward to tackle.
Sheryl Sandberg: Operator, we have time for one last question.
Operator: Your last question comes from the line of Mark Mahaney with RBC Capital Markets. Your line is open.
Mark Mahaney: Great, thank you. Sheryl, the size of the ad revenue that the Facebook is generating in the growth, there is - these are large budgets that are shifting over to Facebook. Any commentary on where you think those budgets are coming from? What are the sources of funds? And then I know, Dave, the engagement levels seem to be rising, there seem to be a little slip in engagement levels and the DAU over MAU ratio in Asia and rest of the world at least sequentially. Is that just noise or is that a reason to panic? Thanks.
Sheryl Sandberg: I don’t think there is any single source of where the dollars are coming from certainly as consumer time and attention is shifting to mobile, the marketer time and attention. We pay a lot of attention to the marketer segments we work with that we’re seeing strong growth from brand from direct response like e-commerce from SMBs and developers. And we stay pretty focused not really on the source of where the money is coming from, but what are the objective people are spending against on Facebook, so that we can meet all the different objectives. We understand that in order to continue to grow, we want to continue to grow. We’re going to have serve multiple objectives on the Facebook platform and that’s what we’re focused on.
Dave Wehner: Mark, I think the simple story as we’re really pleased with how we’re executing on the engagement front, 64% of people is coming to Facebook monthly coming on an average day as we think a great stat. I think small changes are pretty much noise. I mean we’re really happy with it. We talked about things like the video engagement. Mark shared some stuffs like photo - how much photo sharing is going on across our properties. So overall I think engagement is a great story for us and we’re really happy with it.
Deborah Crawford: Great, thank you everyone for joining us today. We appreciate your time and we look forward to speaking with you again.
Operator: This concludes today’s conference call. You may now disconnect. | [
{
"speaker": "Executives",
"text": "Deborah Crawford – Vice President-Investor Relations Mark Zuckerberg – Founder, Chairman and Chief Executive Officer Sheryl Sandberg – Chief Operating Officer Dave Wehner – Chief Financial Officer"
},
{
"speaker": "Analysts",
"text": "Heather Bellini – Goldman Sachs Eric Sheridan – UBS John Blackledge – Cowen Justin Post – Merrill Lynch Ben Swinburne – Morgan Stanley Brian Wieser – Pivotal Research Peter Stabler – Wells Fargo Anthony DiClemente – Nomura Ross Sandler – Deutsche Bank Colin Sebastian – Robert Baird Carlos Karjner – Bernstein Paul Vogel – Barclays Robert Peck – SunTrust Arvind Bhatia – Sterne Agee Mark Mahaney – RBC Capital Markets"
},
{
"speaker": "Operator",
"text": "Good afternoon. My name is Courtney and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook Fourth Quarter and Full Year 2014 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford",
"text": "Thank you. Good afternoon and welcome to Facebook’s fourth quarter earnings conference call. Joining me today to talk about our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements, and actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today’s press release and on our Annual Report on Form 10-K and our most recent quarterly report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these statements as a result of new information or future events. During this call, we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today’s earnings press release. The press release and an accompanying investor presentation are available on our Web site at investor.fb.com. And now, I’d like to turn the call over to Mark."
},
{
"speaker": "Mark Zuckerberg",
"text": "Thanks Deborah and thanks everyone for joining today. This has been a good quarter for Facebook and a great end to the year. Our community continued to grow in size and engagement and we’re very pleased with the growth of our business. Overall 2014 was a year of great progress for the Facebook community. 1.39 billion people now use Facebook each month and 890 million people daily, an increase of active and 133 million daily active this year. Time spent per person per day across our services continue to rise growing this quarter by more 10% compared to last year and that doesn’t even include WhatsApp, which joined us late last year. These milestone shows our community continues to get stronger. But it’s not just our community where we’ve made a lot of progress. 2014 was also a year of big investments in our future. This year we made big bets on the next generation of communication and computing platforms by acquiring WhatsApp and Oculus. We focused on serving our community better across all of our products, raising the quality and relevance of content to News Feed, improving our search and video products and improving the performance and efficiency of our mobile apps. We continue to invest in our employees and infrastructure, grown our headcount by 45% this year and opening our newest data center in November in Altoona, Iowa. When you consider the progress of our community and our investments, 2014 was an important year for us and a good sign of how we’re thinking about the future. In the next decade, Facebook is focused on our mission to connect the entire world, welcoming billions of people to our community and connecting many more people to the Internet through Internet.org. To serve the entire world, we need to build products that serve our community and allow people to share different types of content with different audiences. We need to offer new services and infrastructure at greater scale, but we need to create new tools and innovate to solve fundamental challenges in the places we want to connect. Doing this will take a lot of effort over the coming years and Facebook is going to have to evolve. Similar to our transition to mobile over the last couple of years, now we want to really focus on serving everyone in the world. Our mission has always been to make the world more open and connected. This is something we’ve been preparing for over the last decade. Everything we’ve achieved in 2014 and over the last ten years has helped us to build a foundation for future of greater scale. I’m excited for our progress in 2015. Now, with that in mind, I’m going to talk about the things that we expect to execute on over the next three, five and 10 years. Over the next three years, our main focus is to continue to serve and grow our community by delivering better services for people and businesses around the world. One sign of our continued growth and engagement is our progress on visual and public content. More than 2 billion photos are now shared daily across Facebook, Instagram, Messenger and WhatsApp. Video grew significantly this year to an average of more than 3 billion video views per day on Facebook. But we now have more than 2 billion interactions every week on Facebook between public figures and their fans. Instagram is also growing and helping people share and consume the most engaging content in different communities across the world. Instagram reached 300 million monthly actives with more than 70% outside of the U.S. Average time spent using the app continues to be very strong compared to other mobile services. Across Facebook and Instagram, we’ve done a very good job on engagement, especially when it comes to helping people find and consume content they like. In 2015, we’ll continue working on this as well as developing more ways for people to share even more of the moment they care about on Facebook. Five years ago, most of the content shared on Facebook was text and some photos. Today, it’s primarily photos with some text and video. Over the next five years, we want to keep developing new products and features to help people share the way they want. When it comes to serving businesses, we continue to help drive results for businesses of every size around the world. Last week, a Deloitte's report found that in 2014 Facebook created more than $225 billion of global economic impact and $4.5 million new jobs. This is an important reminder of the big opportunity we have to create value for businesses and why we’re committed to serving them well. In 2014, we invested aggressively in improving our ad-tech and measurement tools. We’re going to continue working to provide new capabilities for marketers. Sure, I’ll talk about this more in a moment. Next, let’s talk about our efforts over the next five years to build the next generation of Facebook services. We expect WhatsApp and Messenger to connect hundreds of millions of more people and become indispensable services for the world as well as important contributors to our business. Messenger and WhatsApp recently achieved impressive new milestone. In November, Messenger reached 500 million monthly actives, and at the beginning of January, WhatsApp reached 700 million monthly actives with more than 30 billion messages sent each day. These numbers speaks the quality of both products and the size of the opportunity ahead to help billions of people communicate and collaborate. Search at Facebook is another important effort that we expect to create a lot of value over the next few years. In this quarter, we launched updates to Facebook search to make it easier to find content and posts on mobile and desktop. We’re going to continue listening the feedback from our community and to admit time to build really valuable products here. We’re optimistic about our ability to deliver value that only Facebook is able to provide. Working with developers is the other part of our strategy. In this quarter, we continue to make progress with helping developers build, grow and monetize their apps. In October, we rolled out our audience network around the world. And since then, the number of apps in the network has nearly tripled and impressions served by the network have more than quadrupled. In 2015, we’ll continue to build upon our long-term goal of making Facebook a truly cross platform, platform, to allow those developers to share their work on every major mobile platform and we look forward to sharing more details at our next F8 event in San Francisco this March. Finally, let’s talk about our plans over the next decade to connect everyone to the internet through Internet.org and to develop the next generation of computing platforms with Oculus. Internet.org now has a lot of momentum. We launched three basic internet services in Zambia, Tanzania, Ghana, Kenya, and Columbia. More than a 150 million people living in these countries now have the option to connect to the internet using the Internet.org, but we’ve already connected 6 million of them to the internet, who did not accessed before. We’re very excited by Internet.org’s progress and the level of interest we’re seeing across industries, governments, and our community. 2015 is going to be an important year for our long-term plans and I expected to share more updates about our progress here over the coming months. Oculus continues to make progress towards the future of immersive VR experiences that are part of daily life for millions of people. This month the team done another good showing of ZS and developer’s interest in Oculus platform continues to grow. So that’s my update for this quarter. It’s been a good quarter and a good end and it’s an important year for us. I want to thank you everyone in our Facebook community and our employees, our partners, and stockholders for their support. Thanks to you. Our community is growing stronger everyday and we’re making progress towards making the entire world more open and connected. Thanks and now here is Sheryl."
},
{
"speaker": "Sheryl Sandberg",
"text": "Thanks Mark and hi everyone. Q4 was strong across the board, tapping a great year. This is our first quarter with over $3 billion in ad revenue and over $2 billion in mobile ad revenue. Our Q4 ad revenue grew 53% year-over-year. Our mobile ad revenue was 69% of the total ad revenue and double than the past year. Our growth is strong across all verticals in marketer segments. We also saw healthy growth around the world although growth rates outside the U.S. were effected by exchange rates. Looking back at 2014, our team has made great progress on our three main priorities. Capitalizing on the shift to mobile, growing the number of marketers using our ad products and making our ad more relevant. We believe that the market increasingly understands that we have the leading mobile ad products and are the only platform that delivers people based marketing upscale. A shift to mobile is changing the way people consume video. As Mark said, video grew dramatically on Facebook in 2014, especially around global events like the World Cup and the ALS Ice Bucket Challenge. In just one year, the number of video posts per person on Facebook increased 75% globally and 94% in the U.S. Today, over 50% of people in the U.S. who come to Facebook daily watching at least one video per day and globally over 65% of Facebook video views occur on mobile. Marketers have followed this trend and are using video to help people discover and learn about their brands. In Q4, we expanded autoplay video ads internationally. During the holiday season, we saw many clients telling their stories creatively through video. 2014 was also the year we began scaling Instagram ads. In Q4, we rolled out Instagram ads in Australia and Canada. Marketers are excited to have access to the 300 million people views Instagram and the creativity it inspires. We’re seeing beautiful creative and great results from brand marketers across verticals from insurance and tax to retail and entertainment. For example as one of our first Instagram video advertisers, Banana Republic developed a series of videos to promote its BR clothing lines. The video showed fashion sketches from the new collection and drove a 23 point lift in ad recall. While, it’s still early and we’re being deliberate in our rollout. We believe that Instagram will become core to advertisers and mobile brand building efforts. We also made progress growing a number of marketers using our ad products. Custom audiences, our suite of proprietary targeting product has become an essential tool for segment current and potential customers. Conversion tracking away from marketers to measure the impact of their campaigns online is also seeing wider adoption. We’ve made it easier for businesses of all sizes to plan and manage their ad campaign and for small businesses to use our targeting tools. Travel company, Thomas Cook, recently used Facebook in Belgium to reach a broad audience and used custom audiences to send targeted messages to existing customers based on the places they’d expressed interest in. It reached 30% of the Belgium population in just one day and achieved a 3.85 times of return on investment. Results like these are attracting more marketers of all kinds to our platform. Finally, we made great progress improving ad relevance and measurements. To do this, we made significant investments in both our core measurement and targeting tools as well as ad-tech. Earlier in 2014, we introduced ad buying capabilities based on each and frequency metrics which is similar to how brand marketers by TV ads and therefore enables better cross comparison. We improved our Ads Manager product to give better in place into ad campaign to audience an impact. In the fall, we re-launched Atlas to help marketers reach real people and measure results across multiple devices. Omnicom is our first global client and this month we announced a partnership with Havas to further expand globally. We also invested in Audience Network, which helps marketers to extend their campaign off of Facebook and LiveRail which provides publishers the video tools to monetize their inventory more efficiently. Heading into 2015, we’re excited to build on the progress we’ve made with our core ad products as well as with newer areas like video, Instagram, and ad-tech. It is still early days in all of these efforts. There is a lot of hard work to do and we plan to invest aggressively. Our ultimate goal is to be a critical business partner to our clients, providing people-based marketing of scale to build their brands and move their off shelves. Over the past few weeks, I have had a chance to meet with many of our largest global clients and agency partners and talked about how we can drive real business results for them, making every impression and every dollar they spend improves their bottom line. Our clients are excited by the opportunity to use video Instagram and ads on and off Facebook to reach the right people with the right message. In turn, as their ads become more relevant, we provide a better experience for the people who use Facebook. Humming off our biggest year ever I want to say a special thank you to the Facebook teams around the world, to our global sales engineering, product design and infrastructure teams, your accomplishments over this past year are the reason our business is in such a great place. To our entire company, I feel lucky to work with you as we stay focused on our priorities and work together to help connect the world. And to our clients thank you for your partnership and your trust in us. Heading into 2015, we have big opportunities and a lot of work ahead. Thanks and now here is Dave."
},
{
"speaker": "Dave Wehner",
"text": "Thanks Sheryl and good afternoon everyone. Q4 wrapped up a strong year for Facebook. In 2014, our revenue grew 58% to approximately $12.5 billion and we generated over $3.6 billion in free cash flow. We are very pleased with the continuing growth of our network. In December, the number of people using Facebook on an average day increased by 18%, compared to last year to 890 million. The daily number represents 64% of the 1.39 billion people who used Facebook during the month. Mobile remains the primary driver of our growth. We ended the year with 1.19 billion people using Facebook on mobile in the month. We also continue to see solid growth with Instagram, Messenger and WhatsApp recently crossing 300 million, 500 million and 700 million MAU respectively. Turning now to the financials, all of our comparisons are on a year-over-year basis unless otherwise noted. In addition as a reminder, our non-GAAP measures exclude stock-based compensation and the amortization of intangibles. Total revenue in Q4 was $3.9 billion, up 49% or 53% on a constant currency basis, given how significantly exchange rates have continued to move, we anticipate that this currency headwind will increase in 2015. I will give more color on this later in the call. Ad revenue was $3.6 billion, up 53% or 58% on a constant currency basis. Mobile ad revenue in Q4 doubled to $2.5 billion or 69% of ad revenue compared to approximately $1.2 billion or 53% of ad revenue last year. Desktop ad revenue was up approximately 1% despite the fact that overall desktop usage was down. In Q4, the average price per ad increased 335%; well total ad impressions declined 65%. Similar to last quarter, these price volume trends were primarily driven by the redesign of our right-hand column ads which rolled out in the third quarter. Total payments and other fees revenue was $257 million, up 7%. Note that the growth was driven by revenue from acquisitions made in the past year. On an organic basis, payment revenue from gains, which represents the substantial majority of our payments and other fees revenue declined 10% compared to last year. As previously noted, we expect this trend to continue as desktop usage declines. Turning now to expenses; our Q4 total GAAP expenses were $2.7 billion, up 87%, and non-GAAP expenses were $1.6 billion, up 50%. GAAP expense growth was driven primarily by significant stock-based compensation and amortization expenses related to the WhatsApp acquisition. Non-GAAP expense growth was driven primarily by increases in headcount related costs, cost of revenue and marketing expenses. On a full year basis, our 2014 GAAP expenses were $7.4 billion, up 47%, and our non-GAAP expenses were $5.3 billion, up 34%. We ended the year with roughly 92,000 employees, up 45%. Overall, we remain very pleased with our ability to attract and retain top tier talent. GAAP operating income was $1.1 billion in Q4, representing a 29% operating margin, down from 44% last year; again, primarily due to expenses related to our recent large acquisitions. Non-GAAP operating income was $2.2 billion in Q4, representing a 58% operating margin consistent with the margin last year. Interest and other income and expense was a net expense of $19 million in Q4 versus a net expense of $3 million in Q4 last year. This increase in expense was primarily due to foreign exchange losses resulting from the periodic remeasurement of our foreign currency balances during the period. In Q4, we benefited from the reinstatement of the R&D tax credit. Our GAAP tax rate was 37% and would have been approximately 42% excluding the benefit of the tax credit. Our Q4 non-GAAP tax rate was 31% and would have been approximately 32% excluding this benefit. Q4 net income was $701 million, or $0.25 per share, and non-GAAP net income was $1.5 billion, or $0.54 per share. In 2014, we spent $1.8 billion on CapEx and generated over $3.6 billion of free cash flow. We ended 2014 with $11.2 billion in cash and investments and a net operating loss carry forward of approximately $4.5 billion. Turning now to the outlook, let me start with revenue. We’re still in the early stages of building out many aspects of our ads business and we remain optimistic about our long-term opportunities. Looking at 2015, there are a couple of things I want to note. The first involves how the recent movements in exchange rates might impact our 2015 revenue. Assuming exchange rates were to remain constant at today’s level. We would expect that our total revenue in 2015 would be approximately 5% lower than it would be under 2014 exchange rates. Note this 5% represents the expected reduction in 2015 total revenue, not the reduction in the year-over-year growth rate. And second, we are reporting revenue from Atlas, LiveRail, and the Audience Network on a net, not a gross, basis. So the growth in those products will have less of an impact on our overall reported revenue growth in 2015. Turning now to expenses. We’re tightening our ranges modestly given the better visibility into 2015 spending. We expect that our full year 2015 total GAAP expenses will increase 55% to 70% compared to 2014. We expect that our 2015 total non-GAAP expenses will increase 50% to 65%. A simple way of thinking about our investments is across three categories: people, product, and infrastructure. On the people side, we enter 2015 with 45% more employees than we did a year ago and we will continue to invest in and grow the talent base throughout the year. In terms of product, we are investing to build great experiences for people, marketers and developers, ranging from our existing products and services to newer initiatives such as ad-tech, Internet.org, Oculus, and WhatsApp. We’ll also invest in marketing to support all of these initiatives which, as I noted, was a driver of expense growth in Q4. Turning to infrastructure. We continue to build out our global infrastructure to enable billions of people around the world to connect, message, and share with each other. We will be investing in data centers, our network and servers to grow our existing services and support newer initiatives such as video and our global connectivity efforts through Internet.org. We anticipate our 2015 CapEx will be in the neighborhood of $2.7 billion to $3.2 billion. We expect stock-based compensation for 2015 to be in the range of $3 billion to $3.3 billion approximately half of which is related to our prior acquisitions, most notably WhatsApp. We expect amortization expenses for 2015 to be approximately $700 million to $800 million. And finally, we anticipate our Q1 and full year 2015 GAAP tax rates to be in the mid to high 40s and non-GAAP rates to be in the mid to high 30s. In summary, Q4 caps off a great year for Facebook in which we executed well and also made some very important investments for our future. In 2015, we are focused on continuing to execute on the business and investing in our long-term mission and success. With that Courtney, let’s open up the call for questions."
},
{
"speaker": "Operator",
"text": "We will now open the lines for question-and-answer session. [Operator Instructions] Your first question comes from the line of Heather Bellini with Goldman Sachs. Your line is open."
},
{
"speaker": "Heather Bellini",
"text": "Great, thank you. I just had two quick questions. Sheryl or Mark, I was just wondering, from a brand advertising perspective, is there a way you could share with us how your conversations with these advertisers have been trending over the past 12 months, how they've been evolving, and kind of how they are thinking about the video opportunity? And then, Dave, I just wanted to follow-up on your question about total expense guidance, because in the past you've given a 5-point range, I believe, for total expenses and this year it's 15. Granted, you did tighten it, which we appreciate. And just wondering the parameters around how we think about the low end versus the high end?"
},
{
"speaker": "Sheryl Sandberg",
"text": "It’s a great time for the brand question because over the past few weeks I’ve spent a lot of time kicking off 2015 with our largest agency partners and largest clients. And I would say that people remain really excited about Facebook, but people are bigger believers because we’ve had an opportunity to do more measurement over the past year. I think there are few things about the Facebook platform that are really exciting for brand marketers. The first is the creativity and storytelling and certainly as you mentioned video is a big part of that because video is a format that marketers have used for a long time to building those connection to brands. And the second is measurement. And what clients want and what they should want is an ability to look at their ad spend and see how effective it is, not just in the brand less metrics even though those are important but in moving products off shelves. And over the past year and half the investments we’ve made in building out that measurement have paid off. So when I sit down with clients at the beginning of this year compared to last year, we have more actual case studies of marketing we’ve done with them. We’ve been able to ad test, Facebook ads versus no Facebook ads and what the effectiveness is on their sales. And I think across the board, we’re showing very healthy, very competitive ROI. The opportunity and the challenge now is to [indiscernible] even for our largest clients globally, we still represent a really small part of what they do. And so, it’s on us to prove to them that the results we’re showing them in these smaller tests can happen in more bands and more countries with a larger part of their business."
},
{
"speaker": "Dave Wehner",
"text": "Hi, Heather, it’s Dave. So just - yes, just following up on that where we land in the range of guidance on [indiscernible] will depend on a number of different factors. It’s going to depend on how successful we are at hitting our recruiting goals, how much we ramp in areas like marketing and how could we deploy our capital against our CapEx plan and then how we execute against our plan of ramping investments in new areas like Oculus, WhatsApp, Internet.org, et cetera. We feel good about where we are. We’re going into 2015 on a high note. So I feel like we’re making these investments from a position of strength and excited about the opportunities to put more capital to work in 2015."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Eric Sheridan with UBS. Your line is open."
},
{
"speaker": "Eric Sheridan",
"text": "Thanks for taking the question. Mark, I wanted to follow-up on your comment around search, its early days, but what the company is seeing in terms of the way people are interacting with the new search functionality inside Facebook broadly? And then maybe tying it back to advertising, what that might mean for closing the loop with some of your small and medium sized business advertisers and maybe even the places initiative long-term? Thanks."
},
{
"speaker": "Mark Zuckerberg",
"text": "Sure. So, our view on this is that there is a lot of unique content that people have shared in Facebook, a lot of personal content, recommendations from friends that you can get that you just wouldn’t be able to get through a traditional web search service or other app. And if we’re on this multiyear voyage to basically index all the content and make it available to people and rank it well. We started off by launching graph search which I think included more than a trillion different connections in the first system. And the second round of the search progress that we just started rolling out at the end of last year was post search, which now has index more than I think a trillion posts, which I mean the sizes of these corpuses are bigger than anything in a traditional web search corpus that you would find. So it’s an interesting and fun challenge to make this work. We’re seeing that that people immediately understand how they can use this and find content that they seen in news feed before or that they’ve posted with just a few keywords. And we’re excited about that, but there is a lot more to do. So that we’re not really thinking about advertising in it yet on the scale that our community operates, a billion searches per day is actually not that big compared to what we think the opportunity here should be. And we’re just continued to keep on working on it because there is just a lot of unique value that people should be able to get their friends on Facebook research."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of John Blackledge with Cowen. Your line is open."
},
{
"speaker": "John Blackledge",
"text": "Great, thanks. Just wondered if you could provide your view on Facebook as a video platform given that video views per day increased to 3 billion in December from 1 billion in September of 2014 and how we should think about the video content mix over the next couple of years, and just same kind of topic, if you can give a sense of user and advertiser feedback on the autoplay video ads. That would be great? Thank you."
},
{
"speaker": "Dave Wehner",
"text": "I'll talk about the consumer product and then Sheryl can jump in about as. So what we are seeing and I alluded to little bit in my opening remarks is that there has been this evolution of content on Facebook over the last 10 years, towards richer format that convey more of the moment that people care about. So if you go back five years ago, a lot of Facebook was primarily capture it in a little bit of photos and also I think the primary mode that people are using to share is photos and they wouldn't be surprised up in the future that shifted more and more towards videos. So we’re thinking about how to enable consumption first to the content of people who are sharing, and this year an increased focus on new opportunities around production so it is easier for people to capture the moment that are important to them, create higher-quality moments and pictures of content out of those and increase their experiences through that. So there is a lot more to do here and I think the business going to be one of the big trends over the next three to five years, is the growth in video and richer content in our service."
},
{
"speaker": "Sheryl Sandberg",
"text": "From a consumer and marketers feedback on video ads point of view, there is two things really go together. It’s exciting that we’ve gotten to 3 billion video views per day, because that means consumers are using video ads and enjoying them on Facebook and in news feed. The way we think about our ads product is we want them to blend in with the consumer experience. And so the fact that we have this much consumer video on Facebook, means we have an opportunity to grow our ad business and that’s exciting for marketers."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Justin Post with Merrill Lynch. Your line is open."
},
{
"speaker": "Justin Post",
"text": "Great, it looks like you did about $9 of revenue in the U.S. per MAU which implies over $30 run rate which is impressive. Sheryl may be the first question to you. How do you grow that from here is it usage, is it more higher ad loads, is it the mix of ads or is it targeting may be some thoughts on how you grow from there. And then Mark, if you look at other your three platforms WhatsApp, Instagram, Messenger and other things. You probably have in mind. Can I monetize anywhere as well as Facebook if you look out your five year plan? Thank you."
},
{
"speaker": "Sheryl Sandberg",
"text": "Yes, thanks for the question. When you think about what’s happening, certainly the growth has been good, but it’s still true that marketing dollars have not followed consumer time and the same percentages. So in the U.S., mobile gets 25% of consumer media time, but only 10% of the ad budgets. And to take one comparable example, that means that for every consumer hours spent on print, marketers spend $1 and they spend $0.07 per hour on mobile, which means that we have an opportunity to grow. One of the most important ways we grow is not just bringing more marketers into Facebook, having them use more of our ad products, but as you mentioned better targeting. A more relevant ad is a better ad experience for consumer - for consumers, but also drives them much higher returns from marketers and since we’re running an action, as our ads get more relevant and we provide higher ROI. We should be able to continue to grow. I think we’ve done a good job over the last year, making our ads more relevant. I think most people on this call would say that you seek more relevant ads than you used to a year ago, but I still think, you know, some of the Facebook ads still have rooms for improvement in terms of relevance. And so, we see a lot of room for improvements there, both in the ROI we deliver and in the experience we can provide to consumers."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yes, so I will add something to that just on the side of how we think about value through Facebook and I will talk about the other apps. In terms of the product developments that we do here, we have four major groups inside of the company. This is kind of how our company is organized. We have one which is focused on growing the community, one which is focused on kind of increasing content consumption and people’s engagement, another which is focused on kind of efficiency and helping people to get the most value out of each moment that they’re spending in Facebook. And then the fourth group is our core business, which is focused on helping people to see the best ads and basically make the most money per moment that people are spending at the lowest cost in most efficiency in terms of serving people. And there is, I think, big upside in each of those four categories. I mean our community is growing. I mentioned in our comments upfront that time spent across our services is growing by - grew by 10% year-over-year per person, which is pretty meaningful. Utility and efficiency are increasing and of course the ad business per person and the efficiency of our services are both increasing as well. So I am pretty excited about that and think we’re organized in a way where we can continue visiting of that. The other opportunities, Instagram, Messenger, and WhatsApp, I am really excited about and I do think that they’re going to reach the level where they contribute to our business in a pretty big way, but it’s really important to get this right and not rushing. And you know what I would say around messaging, as we’re pretty early in that cycle, we are about where Facebook was in around 2006 or 2007 where at that point Facebook was really just a consumer product. There were no businesses in the ecosystem. And a lot of people were telling, okay, don’t put better ads in. And that’s not wrong. I didn’t think that that was going to be the right way to build the products or build the business. So instead what we did was built pages, which was a way for businesses to interact for free in the system and start creating organic interactions between people and business. And so we could figure out what - the people are using Facebook 1 and from businesses within Facebook and we built more tools for pages and businesses to engages. And our recent success with advertising is really just built on some of those organic interactions between people and businesses. And what you see in Messenger and WhatsApp now is we’re still in the early end of that curve where the interaction is still primarily people to people and businesses are starting to figure out in the case of WhatsApp much less than Messenger so far. What the organic interaction is, but we’re going to have to go through a whole cycle of figuring out how that works before it really make sense to start monetizing them in a big way. But yes, I mean, I am a big fundamental believer and that these are going to be very big contributors to our businesses over time, but we just have to do it right."
},
{
"speaker": "Operator",
"text": "Your next question comes from line of Ben Swinburne with Morgan Stanley. Your line is open."
},
{
"speaker": "Ben Swinburne",
"text": "Thank you, two questions. Sheryl, can you talk about where we are in the North American market versus your other regions in terms of sort of advertiser maturation and acceptance of the Facebook platform? The growth rates in North America to be really impressive despite of being your biggest business when you look at the ARPU trends and as compared to the other regions that was tend to be - seem to be moderating a bit. And then I was wondering, Dave, if you could talk about the pricing growth which actually accelerated from Q3 to Q4, can you give us some color there. I know there were changes to LiveRail, but anything else you would add about why there was a huge acceleration in pricing growth? Thanks."
},
{
"speaker": "Sheryl Sandberg",
"text": "North America remains a really important market for us. And as you said, we’ve had growth. We’re very happy with. It’s still true that for any kind, no matter how big they are for us, we represent a really tiny part of their ad spends and we represent an underinvestment in terms of where they can reach their consumers. So we believe by continuing to make these investments, we can really continue to grow. We get 20% of people’s time on mobile phone in the U.S. between Facebook and Instagram. We don’t get close to that in terms of anyone’s marketing spend or the time they may spent. We say to our clients over and over again is that we want to drive their business. And that’s what probably the most important thing we’re doing for these large North American spenders is around the measurement work we’ve done. Two years ago, we were not able to measure all the way through to purchase off the shelves and now we can. Yesterday, we rolled out a product we call lift, which is really the next consideration of our measurement capabilities. That enables larger customers to go and set up ads with control test groups, and so they can AB test. This group of people saw Facebook ad, this group of people didn’t and they can measure all the ways through to conversion of whatever they’re measuring whether it’s an online conversion to a sale. We think the measurement out there online and digitally is not particularly accurate. People don’t have real people based measurement through our investments in Atlas and through our investments in - the core Facebook measuring tools. We think if we can show the ROI marketers are getting and we can increasingly do so, we can continue to penetrate the North American market."
},
{
"speaker": "Dave Wehner",
"text": "Ben, its Dave. So also just building on what Sheryl said worth noting that the drop in the value of international currencies impacted our results outside the U.S. to some of what you’re seeing here is a result of that. It reduced year-over-year revenue growth rate by 7% to 8% in the different international regions. So that’s a big reason why you see the U.S. doing much better as well as the fact that’s just more advanced market in what we’ve done in terms of just building up the advertiser base and getting into option of our best targeting products as Sheryl was talking about. Going to your question on pricing growth, I just reiterate what I said in my comments, it’s largely due to the right hand column redesign and then also the shift to mobile where we don’t show right hand column ads. So that’s really what’s causing the pricing shifts. Then fundamentally, we just continue to get better targeting and that drives better engagement. And as we get better engagement that drives better ROI for our advertisers, which ultimately, I think as Sheryl commented on earlier, gets reflected in better pricing of our ads. And that’s a big opportunity for us and we are seeing that we’re getting better and better of driving engagement from the ad units that we have and getting the right ad in front of the right person. So that’s a big factor as well."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Douglas Anmuth with JPMorgan. Your line is open. Douglas Anmuth, your line is now open. Your next question comes from the line of Brian Wieser with Pivotal Research. Your line is open."
},
{
"speaker": "Brian Wieser",
"text": "Hi, thanks for taking the question. First, I was wondering if you could talk about the degree which you think premium video content is - or is not necessary to opt when we capture budgets from advertisers that might otherwise have gone to TV, you have a couple of initiatives around ABC and NFL. So I was curious to get your thoughts on that? And separately, I am not quite sure you’re using Atlas and specially those - or new to Atlas. Do you have a sense that your spending on digital media is changing or if so how - alternately are they just happy with campaign management tools? Thanks very much."
},
{
"speaker": "Sheryl Sandberg",
"text": "So on video ads what really matters is that consumers are using video on Facebook, because that gives us an opportunity, one, to provide a great consumer experience, but two, to have ads in ad-tech consumer experience. If the other consumer video on Facebook, video ads and new feed will be very joined, as a percentages of the video you’re seeing, video ads gets nicely into that experience. I think it matters as much what the video content is and so well we are certainly exploring some premium content as he said, we have an Annabelle Verizon test out there in the public ad. We’re already seeing pretty exclusive growth without that kind of premium content in the system in large numbers and so we’ll continue to figure out. We’re certainly open to increasing video content either way. But we haven’t quite figured out what the mix needs to be and right now the growth is very strong. In terms of Atlas, we just relaunched this fall and we’re just seeing as deals get done in broad adoption. So I think its too soon for us to report that Atlas drives an increase in digital spend or an increase in any particular kind of spend but you should be believe really deeply, which is that Atlas is going to revitalize marketing by making the measurement more accurate. If you look at how digital ads are being measured. They are being measured based on a cookie based world that assumes that people have one device, largely a PC. And that is not real, consumers have phone, they have tablet, they have PC's as well and the ability to understand that one person to serve an ad and measure all the way through correctly. We think it’s going to massively improve the efficiency in the system as we get the battle."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Peter Stabler with Wells Fargo. Your line is open."
},
{
"speaker": "Peter Stabler",
"text": "Thanks for taking the question. One for Sheryl. Sheryl, as you push further toward monetizing off platform inventory. I’m wondering if you could speak to state of your relationships with premium publishers. There is a narrative out there, we sometimes encounter that, that publishers are growing a bit concerned about the power you guys wheel, particularly as you push into monetizing off the platform. Thanks very much."
},
{
"speaker": "Sheryl Sandberg",
"text": "Our audience network efforts are still pretty new. We have a goal of serving more relevant ads to people off Facebook which will provide greater reach for Facebook marketers and also a better opportunity to monetize for publishers. We are seeing some nice results as Shazam reported that using audience network increase the revenue from ad networks by 37%. We believe that working with publishers, if we can increase the value of their inventory by providing more relevant and targeted ads. They are going to be really happy with that opportunity and we are in the early stages of finding those partners."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Anthony DiClemente with Nomura. Your line is open."
},
{
"speaker": "Anthony DiClemente",
"text": "Thanks a lot. First for either Mark or Sheryl on the subject of public video content and what you guys are doing to increase the amount of a video in the News Feed are there things in terms of actors, celebrities, public figures that you can do to economically incentivize those creators of, let they, the higher-quality user generated content onto the Facebook platform be at a revenue share what have you, were relative to the economic for those types of folks on competing online video platforms. And then just one quick one for Dave, you mentioned - as you mentioned you will be shifting the accounting for Facebook audience network and live rail to be for revenue to be net of pack in 2015 versus growth in 2014. I’m just wondering why [indiscernible] to do that and is there any you can help us with in terms of order of magnitude of that shift. Thanks."
},
{
"speaker": "Sheryl Sandberg",
"text": "So, on premium video content, we haven’t figured out exactly how important this is to the ecosystem or how much we are going to invest or what kind of monetization we are going to offer. Video is a growing quite nicely through the ecosystem right now. we have made a lot of investments in public content working with public figures to use the Facebook platform, we’re by far the largest social platform and increasingly you are seeing public figures, everything from news broadcaster to journalist at a public figures do a lot on Facebook and that’s important to us. Because it provides the kind of sharing people want, people come to Facebook to share with their friends and family but they also come to Facebook to connect with everyone from politicians to journalist to celebrities they want to connect with and get news and we definitely seeing public content grow as a percentage of what people get. We also had some nice wins with the Golden Globe this year other things we are doing to get people doing some partnership we did [indiscernible] with CNBC to show how we can help content creators increased their distribution and reach people directly on Facebook."
},
{
"speaker": "Dave Wehner",
"text": "Yes, Anthony, it’s Dave. So, just to be clear that net revenue recognition for those products that’s how we did it in Q4 as well those are all small today, but there is not a change in accounting in 2015 that’s how we accounted for those products in Q4, as far as the net versus gross we just evaluated all the facts in circumstances and made the judgments that net revenue recognition with the most appropriate treatment here."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ross Sandler with Deutsche Bank. Your line is open."
},
{
"speaker": "Ross Sandler",
"text": "Thanks. Just following upon the video concept how important is it that Facebook post the videos versus I guess sharing clips from third-party players in the feed and what percent of that $3 billion streams daily is Facebook embedded versus from other players and are you able to monetize videos from third party players today there is a way to walk around that in the future. Thanks."
},
{
"speaker": "Dave Wehner",
"text": "This thought that we shared of 3 billion a day is all made on Facebook. So there are probably other shares from other video services as well. But the way that there was looking our services or as if there is links to other sites, and the reason why I think made a video is so valuable for people using our service is that when someone uploads a video to Facebook directly we can optimize how it delivers right. So we can make it autoplay. We can find the right quality and bit rate to send down to the person based on their connection overtime. And optimize all kinds of different things. So what I think people are finding from public figures to everyday videos that people are uploading is that the best experience that you can get is by uploading content native to Facebook, which is, I think the big part of the growth that we seeing there."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Colin Sebastian with Robert Baird. Your line is open."
},
{
"speaker": "Colin Sebastian",
"text": "Great, thank you. I wonder if it’s possible to distinguish how much of the growth in advertising revenues can be attributed to changes in organic compressions. And how you balance the desire of business partners to contribute content to feeds versus monetization. Thank you."
},
{
"speaker": "Dave Wehner",
"text": "That’s right. Exactly understand the question. But let me see if I can take a crack at it, Colin. I mean, we are seeing obviously great growth in DAU, which is up 18%. We are seeing growth in times spent across the network up 10% per DAU. So you got those sort of underlying drivers of engagements driving growth. We are also monetizing at higher rates because we are able to get better targeting into the ads and get better conversion for advertisers. So that’s reflected in better pricing. So there is a number of different factors that are coming into play. But clearly driving organic growth in engagement, it’s critical in the business and we are seeing good success there."
},
{
"speaker": "Mark Zuckerberg",
"text": "One thing that I’d just add to emphasize here because its I think there have been a couple of questions so this is the fact our primary strategy for growing the ad business is increasing the quality of the content, not increasing the number of ads to our story that people are seeing on Facebook. So there are impacts like as people consume more content on Facebook, within the ratio of ads that organic content that will showed might be more ads. But overall, our strategy is much less to that increasing the volume of ads and much more about increasing the quality of the content and the quality of the targeting to get the right content to the right people. And this is a pretty controversial strategy internally and we will ensure that is going to work out. But for the last year it’s really fueled our growth in a good way and we feel very confident that this is the right path going forward as well."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line Carlos Karjner with Bernstein. Your line is open."
},
{
"speaker": "Carlos Karjner",
"text": "Hi, I have two quick questions. First when you say that time spent decreased 10% year-on-year it is roughly uniform across your geographic regions. And secondly, Mark I think we have Mark’s in every earnings call you talk to investors for a considerable amount of time about Facebook first to connect the world, and specifically about the Internet.org which suggest you think this is important for the investors. Can you clarify why you think this most of the investors and importantly why you think Facebook can make a significant difference of scale even that you’re unauthorized per user in emerging market is about five bucks to connect and the user who has no device accomplish maybe at least in terms of dollars. Thank you."
},
{
"speaker": "Dave Wehner",
"text": "Well, it matters to the kind of investors that we want to have. Because we’re really mission focused company and we wake up every day and make decision because we want to help connect the world and that’s what we’re doing here. So part of that the subtext of your question is that yes, if we were only focused on making money we might put all of our energy on just increasing ads to people in the U.S. and the other most developed countries. But that’s not the only thing that we care about here. So I do think that over the long-term that focusing on the helping connect everyone will be a good business opportunity for us as well. And we may not be able to tell you exactly how many years that’s going to happen and but I think these countries get more connected the economics growth the ad markets growth and Facebook and the other services in our community or the number one and number two, three, four, five services that people are using then over time we will be compensated for some of the value that we have provided but this is why we are here, we are here because our mission is to connect the world and I just thinks its really important than investors know that."
},
{
"speaker": "Mark Zuckerberg",
"text": "And Carlos on that time spent per DAU that we are just giving the one point, we are not breaking any thing out by region."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Paul Vogel with Barclays. Your line is open."
},
{
"speaker": "Paul Vogel",
"text": "Great thank you very much. I am just curious given the impact that currency had on the quarter on growth rates outside the U.S. is there any market should be fall out particularly either better or worst that might be massed by the currency swings number one. And number two I’m just sort of curious if currency does stay where it is, does it all impact sort of your spending plans or how and where and when you’ll invest? Thanks."
},
{
"speaker": "Dave Wehner",
"text": "Hi, Paul, it’s Dave. It - sort of taking your second part first we’re not really making investments decisions on short-term fluctuations in currency. So I would say in general no, it’s not effecting those decisions. There are certainly big macro effects that are going on and part of those are what’s driving a lot of the currency fluctuation as well. So you have regions that are certainly growing more quickly and growing more slowly. So from a macro perspective, the United States is doing better in terms of growth versus Europe versus Latin America. You see those compounded in both currency and sort of macroeconomic conditions in those regions. So I think generally we’ve got more favorable market conditions in which to operate in the U.S. Overall, I would say the business is driven by the fundamentals of us, continuing to execute against our plan. So whether you’re in a market that’s suffering a little bit from a macro economic headwinds, we’re still - we still have the best mobile product in the market, in that market and we’re growing. So, I think at the end of the day, it’s the fundamentals of our business that are going to drive our success and we’re kind of focused on that. The one of these at least give some color around how the currencies might impact the 2015 results."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Robert Peck with SunTrust. Your line is open."
},
{
"speaker": "Robert Peck",
"text": "Yes, I have two quick questions. One Mark, you’ve spoken much here today about the e-commerce opportunity in front of Facebook and particularly the buy button. Could you elaborate a little bit on plans around e-commerce than what you see that opportunity? And then Dave, I was wondering for investors, could you maybe go through your view and how you look at capital efficiency and ROI so that whether it would be acquisitions or CapEx or even OpEx. How you look and see you’re getting a good return on that spend. Thanks so much."
},
{
"speaker": "Sheryl Sandberg",
"text": "Q4 is a really important quarter in general, but its particularly important quarter for e-commerce, so it’s a timely question. When you think about buy on Facebook, it’s a [indiscernible] U.S. we started last quarter and enables people to buy on pages. To be clear, you’re not buying from Facebook, you’re buying directly from the merchants and it’s really an SMB product to give them capability they haven’t had. We’ll see what happens in terms of where people convert whether it’s on Facebook, but we think the opportunity to connect consumers with the product that they then purchased is a really big one where we play in that most directly, it’s a time and attention consumers have as well as the information to do very relevant advertising and we’re going to stay focused there."
},
{
"speaker": "Robert Peck",
"text": "Robert, I think the bulk of the investment that we’re doing is really focused on the capital in the OpEx to deliver against the core mission of enabling billions of people to connect and share. So for the most part, we’re looking at what should we need to deploy to deliver against the mission to deliver against our overall financial results. There’re places where we can individually takeout specific projects whether it would be M&A or specific capital investments and then we’ll look at those on an IRR basis for specific projects, but you have to recognize that we’re basically one large business and we’re operating against capital deployment against delivering against the objectives of that business. So that’s the bulk of the spend that we do, but certainly we look at things on an ROI basis on individual project basis as well."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Arvind Bhatia with Sterne Agee. Your line is open."
},
{
"speaker": "Arvind Bhatia",
"text": "Thanks for taking the question. Just quickly on WhatsApp, I know this focus will be user growth for a while, but in the future as you do turn on the monetization engine, just curious what are some of the primary ways that you’re assuming growth will come from advertising - or games perhaps and also on WhatsApp user growth would you be able to callout where that’s coming from? Is there any particular areas that are stronger and curious how that’s doing in the U.S.? Thank you."
},
{
"speaker": "Dave Wehner",
"text": "So you’re right that the focus for WhatsApp is on helping to connect a lot more people, all right. So when John and team joined us, one of the first things that we agreed on and why I think it made sense for them to join is that now they can focus for a few years on getting to one billion more than that and continuing to scale beyond that. SMS is an incredibly global and universal product and I think WhatsApp just has a huge opportunity to third billions of people. In terms of what the business looks like, I mean at the end of the day, it’s a distribution business like Facebook and Instagram, how you most effectively convert that into business opportunities for customers whether that’s through payments or ads or other different kinds of structures. We’ll figure that out what the optimal thing will be, but the first order of thing to do is to helps our billions of people here, help to continue to increase engagement, I mean people are spending a lot of time in WhatsApp, sending more than 30 billion messages a day, which is really crazy when you think about the volume there compared to the global SMS volume overall. And I think if we do that there will be a number of opportunities. I mean people ask me this question awhile ago about - when we talked about games on Facebook as well. And I always talked about our canvas business on desktop even though its payment is actually the same thing as our business on mobile around app install and engagement. What developers test for is distribution and whether they’re doing that through payments or ads or whatever it is, it kind of is all the same. The most important thing is to help people connect, help people and businesses connect and create business opportunities and then you get a small amount of the value that you’re creating on top. So that will play out over the next set of years and it’s one of the intellectual challenges that I am really looking forward to tackle."
},
{
"speaker": "Sheryl Sandberg",
"text": "Operator, we have time for one last question."
},
{
"speaker": "Operator",
"text": "Your last question comes from the line of Mark Mahaney with RBC Capital Markets. Your line is open."
},
{
"speaker": "Mark Mahaney",
"text": "Great, thank you. Sheryl, the size of the ad revenue that the Facebook is generating in the growth, there is - these are large budgets that are shifting over to Facebook. Any commentary on where you think those budgets are coming from? What are the sources of funds? And then I know, Dave, the engagement levels seem to be rising, there seem to be a little slip in engagement levels and the DAU over MAU ratio in Asia and rest of the world at least sequentially. Is that just noise or is that a reason to panic? Thanks."
},
{
"speaker": "Sheryl Sandberg",
"text": "I don’t think there is any single source of where the dollars are coming from certainly as consumer time and attention is shifting to mobile, the marketer time and attention. We pay a lot of attention to the marketer segments we work with that we’re seeing strong growth from brand from direct response like e-commerce from SMBs and developers. And we stay pretty focused not really on the source of where the money is coming from, but what are the objective people are spending against on Facebook, so that we can meet all the different objectives. We understand that in order to continue to grow, we want to continue to grow. We’re going to have serve multiple objectives on the Facebook platform and that’s what we’re focused on."
},
{
"speaker": "Dave Wehner",
"text": "Mark, I think the simple story as we’re really pleased with how we’re executing on the engagement front, 64% of people is coming to Facebook monthly coming on an average day as we think a great stat. I think small changes are pretty much noise. I mean we’re really happy with it. We talked about things like the video engagement. Mark shared some stuffs like photo - how much photo sharing is going on across our properties. So overall I think engagement is a great story for us and we’re really happy with it."
},
{
"speaker": "Deborah Crawford",
"text": "Great, thank you everyone for joining us today. We appreciate your time and we look forward to speaking with you again."
},
{
"speaker": "Operator",
"text": "This concludes today’s conference call. You may now disconnect."
}
] | null | null |
META | 3 | 2,014 | 2014-10-28 17:00:00 | Executives: Deborah Crawford - VP, IR Mark Zuckerberg - CEO Sheryl Sandberg - COO Dave Wehner - VP, Finance and CFO
Analysts: Douglas Anmuth - JPMorgan Ben Sachachter - Mcquarie Heather Bellini - Goldman Sachs Eric Sheridan - UBS Ross Sandler - Deutsche Bank Mark Mahaney - RBC Capital Markets Paul Vogel - Barclays Mark May - Citi John Blackledge - Cowen & Co. Justin Post - Merrill Lynch Anthony DiClemente - Nomura Securities Stephen Ju - Credit Suisse Youssef Squali - Cantor Scott Devitt - Stifel
Operator: Good afternoon. My name is Jay and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook Third Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions). Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin.
Deborah Crawford: Thank you. Good afternoon and welcome to Facebook’s third quarter earnings conference call. Joining me today to talk about our results are Mark Zuckerberg, CEO, Sheryl Sandberg, COO and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements, and actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today’s press release and on our Quarterly Report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these statements as a result of new information or future events. During this call we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today’s earnings press release. The press release and an accompanying investor presentation are available on our Web site at investor.fb.com. And now, I’d like to turn the call over to Mark.
Mark Zuckerberg: Thanks Deborah, and thanks everyone for joining today. This has been a good quarter for Facebook and we’ve achieved strong results across the board. We've continued to grow our community in both size and engagement with 1.35 billion people now using each month and 64% using Facebook daily. On mobile 1.12 billion people now use Facebook each month and 703 million people each day, nearly 40% growth from this time last year. Looking to our business, we continue to do well. This quarter total revenue reached $3.2 billion and advertising revenue grew 64% year-over-year. Mobile now accounts for 66% of our advertising revenue. These results show that Facebook is getting stronger every day, as a community, a partner for developers and marketers and as a business. One thing that I'm particularly pleased about is that while we’re investing aggressively and making progress towards our big long-term goals, we also continue to execute well against our near-term priorities. On previous calls, you’ve heard me talk about our big company goals of connecting everyone, understanding the world and building the next generation of platforms. These goals are important for us and part of our foundation of our strategy for the next decade, but achieving these will involve many different efforts and steps along the way, some that will be achieved rapidly and others that are going to take longer. So with that in mind, I’d like to run through our progress this quarter on the different efforts that we expect to deliver a lot of impact over the next three, five and 10 years. Let's begin with our three-year goals. Over the next three years, our main goals are around continuing to grow and serve our existing communities and businesses and help them reach their full potential. When you look at the size and engagement of our community, our progress remains very strong. 864 million use Facebook every day and across our core products, we continue to see huge engagement. For example around 700 million people now use Facebook Groups every month. Achieving this scale shows that we're delivering experiences for the way that people want to share and connect. Another example is our progress on public content. Last quarter I talked about how we're working to connect people around important public moments and personalities on Facebook. This quarter we've continued to build on our results and there are now more than 1 billion interactions every week between public figures and their fans on Facebook. The investments we have made in video have also played a big part here. This quarter we announced a new milestone for video on Facebook achieving 1 billion video views, a day of made of videos. During the summers the ice bucket challenge drew more than 10 billion video views by 440 million people which is a good sign of how far our video product has come. Instagram has also made a lot of progress this quarter. In August, the Instagram team launched Hyperlapse, a standalone app for time lapse of videos on iOS. The team has also invested heavily in improving the speed and performance of Instagram on Android. This has helped drive Instagram's strong international growth which in some countries has achieved more than 100% year-over-year growth. Globally, people using Instagram now spend around 21 minutes a day on average using the app. This is a strong figure compared to the industry and a good sign that Instagram's strategy is on the right path. Our other big focus over the next three years is to continue to serving businesses well and creating a lot of value for marketers. As our results show, our approach here is working. To continue delivering value for businesses, we work to improve the quality of ads and news feed by reducing low quality content and improving our targeting to show more timely and relevant content. We’ve also made some big advances in our ad tech, most importantly the launch of our new Atlas platform. Atlas offers marketers a lot of new capabilities to help reach people across devices, platforms and publishers as well as improving measurement in online campaign. We're very excited for the future of Atlas and Cheryl is going to talk more about this in a moment. Next, let's talk about our strategy over the next five years. Over the next five years, our goals are around taking our next generation of services, Instagram, Messenger, WhatsApp and Search and helping them connect billions of people and become important businesses in their own right. One big priority for us here is messaging. And continuing to build and grow Messenger and now WhatsApp as well as great services. This quarter we made an important change to our mobile messaging efforts by transitioning people to Messenger on iOS, Android and Windows Phone. We believe that this change allows us to offer a better and faster messaging experience on mobile, and our data shows that people who use Messenger, usually respond to messages about 20% faster. This month we also completed our acquisition of WhatsApp. I'm excited to be working with this team and John to join our Board. WhatsApp continues to be on a path to connect more than 1 billion people around the world and we're going to be working into accelerate their efforts here. Another key part of our strategy is helping developers to build more great social experiences on our platform. Over the next few years, our goal is to make Facebook a cross-platform platform that allows developers to build, grow and monetize their apps across every major mobile platform. We’ve continued to make good progress here. This quarter, we opened our audience networks to all developers and publishers, allowing over 1.5 million advertisers on Facebook to extend their campaigns across mobile and for developers to begin monetizing their apps. We're also excited by the continued adoption of App Links, our deep-linking technology for mobile apps. App Links is now used by hundreds of apps across iOS, Android and Windows phone and in just the past six months, the developers have created links to more than 3 billion individual destinations in these apps. Now let's talk about how we're approaching our goals over the next 10 years. For the next 10 years our focus is on driving the fundamental changes in the world that we need to achieve our mission, connecting the whole world, understanding a world with big leaps in AIs and developing the next generation of platforms, especially in computing. This is a very big period, a very busy period for our efforts with Internet.org. In July we worked with Airtel to launch the Internet.org app in Zambia. This provides free data access to a set of basic internet services for health, education, employment and communication. The results from this are very encouraging. We've already heard a lot amazing stories about how people are using the internet to add value to their lives. We hope to bring the Internet.org app to many more countries soon. Over the last few months, I've also travelled to several countries and met with policy makers, key distributors and people and communities that are coming online for the first time. Increasingly industry and governments are seeing expanding internet access as one of their core priorities. This is positive development for our work with Internet.org in our long-term goal of connecting everyone in the world. Finally, let's talk for a minute about our progress of Oculus. As I've said before, with Oculus, we're making a long-term bet on the future of computing. Every 10 to 15 years, a new major computing platform arrives and we think that virtual and augmented reality are important parts of this upcoming next platform. This quarter, Oculus continued to make progress towards this vision. In September, the first Oculus developer conference took place, where we announced a new prototype VR headset on the path of a consumer version of the Rift. We continue to see a lot of excitement in the developer community and we've now shipped more than 100,000 of Rift developer kit to over a 130 countries. It's still early for Oculus but we are encouraged to see the variety of apps and games being developed for this platform. Internet.org and Oculus are just two of the huge opportunities ahead. Our efforts here will take longer to achieve their full impact, but we're going to continue preparing for the future by investing aggressively. So that’s how we’re approaching our strategy over the next three, five and 10 years, while focusing on our big goals of connecting everyone, understanding the world and building the next generation of platforms. This has been a quarter with strong results. I want to thank the entire Facebook community, our employees, our partners and our stockholders for their continued support. Because of your contribution, Facebook continues to grow in strength and to create greater value in the world for people, partners and businesses. We have a long journey ahead, we’re on the right path and I'm excited about the progress that we’re making. Thank you and now here’s Sheryl.
Sheryl Sandberg: Thanks Mark and hi everyone. We had another strong quarter and we’re continuing to execute well on our priorities; capitalizing on the shift to mobile; growing the number of Facebook marketers and building products to make our ads more relevant. Our growth this quarter was again very broad-based. We saw strong performance around the world as well as across verticals on our four marketer segments, brands, direct marketers, developers and small and medium businesses. I’d like to briefly highlight some of our progress on the product front and then focus on important new investments we're making in ad-tech. One of our main ad protocols is to make ads more relevant. Just like content and news feed, when ads are more relevant, they provide a better experience for people using Facebook and a better return for marketers. One of the best ways to improve relevance is to help advertisers reach the right audience with their messages. Facebook age and gender targeting is 45% more accurate than the digital industry average. Working with Facebook advertisers can also target based on peoples interests. In addition, we’re continuing to build out custom audiences, which enable marketers to use their own data to segment current and prospective customers. We’re pleased with the response from clients and we’re focused on driving deeper penetration with those existing and new clients. We also offer lookalike audiences, which help marketers find potential new customers who are similar to their current customers. To share one recent example, earlier this year global financial services company MetLife wanted to find new customers for life insurance policies. Working with this agency Markel, they used lookalike audiences to find people more like their existing customers, MetLife ran ads that let people to their get a quote website page. Over the six-month campaign, the leads that came from Facebook resulted in new policies at a 2.4 times higher rate than MetLife’s next best performing channel and at half the cost of display ads. We’re also making steady progress with newer ad initiatives. Throughout this quarter we continue to enable auto play for more video ads. We’re also continuing to roll our ads on Instagram. We think there is good opportunity with both video and Instagram ads but we're going to remain deliberate and slow in our approach to scaling those businesses. We’re also making longer-term investments that we believe will be important for Facebook and the ad industry. In Q3, we re-launched Atlas, closed our acquisition of LiveRail and rolled out our audience network. So I want to spend a few minutes discussing our longer-term ad-tech strategy. We’re investing in ad-tech for a simple reason. Consumers are shifting quickly to mobile and the advertising industry is not keeping up. 2013 was the first year the average American adults spent more time on digital media than watching TV and that gap has continued to grow. Today the average adult in the U.S. spends nearly 25% of their media time on mobile, but advertisers spend only about 11% of their budgets there. One of the main reasons the budgets aren’t moving as quickly as consumers is that advertisers hasn’t yet had an effective way to serve ads and measure their returns on mobile. Current solutions work well for person with one device, especially, a PC and for sales that happen online. But today people often have multiple devices and still make many purchases in physical stores. Nilsson OCR [ph] data shows that the digital industry is less than 60% accurate in demographic targeting of ads, which means that four in 10 people are seeing the wrong ads. Similarly marketers are not confident that they can measure mobile ad performance. Many of the most commonly used measurement systems over emphasize the value of the last click. This does not make sense, given that studies of Facebook campaigns show that over 90% of ad driven in-store sales come from people who saw an ad but didn’t click on it. It's clear that marketers and publishers need better tools for the mobile world. This is an industry problem that we believe we are well placed to solve. Our re-launch of Atlas last month during Adweek was an important early step that builds on the advancements and measurements we have made over the past two years. The new Atlas is an ad serving and measurement platform, we completely rebuilt. By using Facebook data, Atlas can deliver highly relevant ads, regardless of device. Atlas is also able to provide accurate measurement by connecting online marketing to in store sales. Importantly, Atlas does all of this in a privacy protected way. Neither Atlas nor Facebook tells marketers who you are. At Adweek, we had productive conversations about Atlas with many marketers and agencies. We are pleased with their interest. We’re also investing in additional pieces of our ad-tech platform. Our audience network improves the relevance of ads inside mobile apps. LiveRail provides tools for publishers to enable personalized marketing at scale via their apps and websites. We believe LiveRail can build on their success in desktop video with the concrete solution for mobile publishers. I want to emphasize that the investments we’re making in ad-tech are long-term. These are large and strategic investments. The path will take time, but we think that provide a necessary foundation for the advertising industry to make the shift to mobile and for Facebook’s long-term growth. We recognize that by staffing engineers in these strategic ad-tech areas, we forego shorter term product improvement improvements which would generate revenue more quickly. We believe these are the right decisions. As we look toward 2015, we're going to stay focused on the areas I've talked about today; capitalizing on the shift to mobile, growing the number of Facebook marketers and building products that make ads more relevant. Our investments in ad-tech will be an increasingly important part of all of these efforts. Thanks everyone and now here is Dave.
Dave Wehner: Thanks, Sheryl and good afternoon everyone. Q3 was a solid quarter across the board. We had strong revenue growth, generated $766 million in free cash flow and continued to make investments to position us for long-term growth. 864 million people use Facebook on an average day in September, up a 136 million from last year. This represents 64% of the 1.35 billion people that used Facebook during the month of September. Mobile continues to be the core driver of our growth. Over 1.1 billion people used Facebook on mobile during the month of September, up 250 million from last year. In addition, we have hundreds of millions of people on mobile using Instagram, Messenger and WhatsApp. Turning now to the financials. Total revenue in Q3 was $3.2 billion, up 59% compared to last year or 58% on a constant currency basis. Total ad revenue was nearly $3 billion, up 64% compared to last year or 63% on a constant currency basis. Ad revenue growth was strong around the world with each of our four reported geographic regions growing by 50% or more compared to last year. Mobile ad revenue was approximately $1.9 billion or 66% ad revenue, compared to approximately $881 million or 49% of ad revenue last year. Desktop ad revenue was up 11% compared to last year, but was flat sequentially. In Q3, the average price per ad increased 274% compared to last year, while total ad impressions declined 56%. The increase in the average effective price per ad was driven primarily by the redesign of our right hand column ads which resulted in larger, more engaging ads that delivered more value to marketers and thus had higher reflective prices. These right hand column ads were also fewer in number, which drove the decrease of impressions in the quarter. To a lesser degree, the shift of usage to mobile, where we don't have right hand column ads also continued to contribute to the reported price volume trends. The price volume trends were largely consistent across our four geographic regions. Total payments and other fees revenue was $246 million, up 13% versus last year, however payments volume from gains which represents the substantial majority of our payments and other fees revenue declined 2% compared to last year, notably for the first time and we expect this trend to continue as desktop usage continues to decline. Turning now to expenses. Note that beginning in Q3 our definition of non-GAAP also excludes the amortization of intangible assets and historical non-GAAP measures discussed today have been updated accordingly. You can find our GAAP to non-GAAP reconciliations on page 10 of the Q3 press release. Our Q3 total GAAP expenses were $1.8 billion, up 41% from last year and non-GAAP expenses were $1.4 billion, up 39% from last year. Cost of revenue grew 11% on a GAAP basis and 7% on a non-GAAP basis. We incurred expenses in the third quarter of 2013 related to the transition out of certain lease data centers. This mitigated our cost of revenue growth rate in Q3 2014, as it has done in the last two quarters. Operating expenses excluding cost of revenue were up 61% on a GAAP basis and 72% on a non-GAAP basis versus last year, primarily due to an increase in headcount related costs. We ended Q3 with 8,348 employees, up 44% from last year. Of the nearly 1,200 people we added sequentially about a quarter were from acquisition. Organic growth was high as the third quarter is our seasonally strongest new hire start period. Overall we are pleased with our ability to attract and retain talented people who enable us to make strong progress against our mission. Q3 operating income was $1.4 billion, representing a 44% operating margin, up from 37% last year and our non-GAAP operating income was $1.8 billion, representing 57% operating margin, up from 51% last year. Interest and other income and expense was a net expense of $61 million in the quarter, versus a net expense of $10 million last year. This increase in expense was primarily due to foreign exchange losses resulting from the periodic re-measurement of our foreign currency balances and largely resulted from the substantial reduction in the value of the euro relative to the dollar experienced form the beginning to the end of the quarter. Our GAAP and non-GAAP tax rates for the quarter were 40% and 35% respectively. GAAP net income was $806 million or $0.30 per share and our non-GAAP net income was $1.1 billion or $0.43 per share. In Q3, we spent $482 million on CapEx and generated $766 million of free cash flow. We ended Q3 with approximately $14.3 billion in cash and investments. This does not reflect the approximately $4.6 billion cash payment that we made in conjunction with the WhatsApp acquisition, which closed earlier this month. Turning now to outlook. I'd like to start by noting that my forward-looking statements include the impact of both Oculus and WhatsApp. In addition, as part of the WhatsApp deal, we agreed to file a registration statement to register for resale approximately 178 million shares issued to the WhatsApp stockholders. Nearly all of those shares will be fully registered and tradable during open trading windows in Q4 2014 and Q1 2015 under the registration statement we plan to file later this week. In light of our recent acquisitions and our plans to file this registration statement, we are providing some additional guidance this quarter, including a more specific outlook on the current quarter revenue and a preliminary view on 2015 expenses. This is a more detailed outlook than we have historically provided or plan to provide on future earnings calls. Let me start with 2014 expenses, we expect our full year 2014 total GAAP expenses, including cost of revenues, stock compensation and the amortization of intangibles will grow approximately 45% to 50% versus the full year 2013. This increase from our prior range of 30% to 35% is primarily due to the impact of this WhatsApp acquisition on stock-based compensation charges in the fourth quarter. We continue to expect that our full year 2014 total non-GAAP expenses, including cost of revenue but excluding stock compensation and amortization of intangibles will likely grow in the neighborhood of 30% to 35% versus the full year 2013. Turning now to revenue, we expect that total revenue in the fourth quarter will grow in the range of 40% to 47% versus the same quarter of last year. Please keep in mind that Q4 of 2013 was our first holiday season with the rollout of new seed ads at scale, which makes for a difficult comparison. For taxes, we anticipate the GAAP tax rate in the fourth quarter will be approximately 45% to 50%, which is higher than the current rate due to large non-deductible stock-based compensation charges related to the closing of the WhatsApp transaction. Our Q4 non-GAAP tax rate should be similar to our Q3 rate. For share count, we expected our fourth quarter fully diluted share count will be approximately 2.8 billion shares, taking into account the shares that we issued upon the closing of the WhatsApp deal. We expect that our 2014 CapEx will be at the low end of our prior $2 billion to $2.5 billion CapEx guidance. And lastly, while it is relatively early, I wanted to provide some preliminary color on our expense outlook for 2015. As Mark discussed in his remarks, we believe that we have very substantial growth opportunities in front of us and we plan to invest aggressively to capitalize on those opportunities. As such, we plan on 2015 being a significant investment year. Our current expectation is that total cost and expenses on a GAAP basis, inclusive of stock-based compensation charges related to the recent transactions are likely to increase 55% to 75% compared to the full year 2014. On a non-GAAP basis, we expect total cost to increase approximately 50% to 70% compared to 2014. Tax rates for 2015 should be similar to our fourth quarter rates on both a GAAP and non-GAAP basis. In summary, we’re very pleased with the growth of our network, the great momentum we continue to see in our ads business and the significant investments we're making to drive near-term and long-term growth. We have large opportunities ahead of us and we’re focused on capitalizing on those to achieve our mission and track long-term shareholder value. With that operator, let's open up the call for questions.
Operator: We will now open the lines for a question-and-answer session. (Operator Instructions). Your first question comes from the line of Douglas Anmuth with JPMorgan. Your line is open.
Douglas Anmuth - JPMorgan: Dave, just to follow up on the comments that you just made on the outlook or expenses for ’15, can you just help us understand more on the non-GAAP expenses, the 50% to 70% and where we should be thinking about the incremental dollars being spent there primarily? And then secondly, can you just talk Sheryl, perhaps about what you’re seeing in terms of branded advertising, whether you’re seeing more of it in fraction there as more bigger brand CPG companies, auto OEMs are coming onboard and how you're positioned there for the holidays? Thanks.
Dave Wehner:
: From an infrastructure side, we plan to invest to support the growth of the core business. That includes things like video. It also includes things like our global growth efforts with Internet.org. So we’re really kind of investing across the board on that. And I guess in summary, we've got -- the strength of the business today is really putting us in a strong position to invest smartly for the future and we’re doing that.
Sheryl Sandberg:
: With all of this, we know we need to go client by client and we're especially focused on measurement because measurement is so key for this segment. A lot of the products that brand marketers are selling are bought in store and so showing that online and mobile ads lead to in store purchases is a hugely important part of our strategy going forward as I talked about, and video is really exciting as well. When you think about the holiday season, Q4 is a really important time for our client and that makes it a really important time for us. And I think people are increasingly recognizing that mobile is important. 65% of people use their phones while they are out shopping and people are recognizing that opportunity. From an earnings perspective, last Q4 was a great quarter, both because our business was growing but also because that was when we rolled out ads fully into news feeds and so it’s worth keeping that in mind when you think about how you think about our business going forward.
Operator: The next question comes from Ben Sachachter with Mcquarie. Your line is open.
Ben Sachachter - Mcquarie: A few questions. David, there was no mention of a '15 revenue range but I was wondering if you could give us any thoughts on how much margin should compress in '15 versus '14? Then a couple for Mark. Mark, now that you've spent more time with the Oculus team, can you update us on how your plans for Oculus have evolved since you first tried the device on. And then you mentioned it when you talked about your 10 year outlook. Does that mean we shouldn't expect any consumer Oculus product in the next one or two years? And then similarly on Search, you mentioned your five plan. So does that mean we shouldn’t expect anything on Search for the next five years?
Dave Wehner: Hey, Ben, it's Dave. We're not really giving any guidance on 2015 revenue. We gave the growth range that we're expecting on Q4, which was 40% to 47% and that's down from 59% in Q3. But we're not providing any specific guidance on 2015. Revenue sort of outlined the expense growth that we expect because of the substantial investments that we're making, also driven by some of the acquisitions that we've made. So hope that, that is helpful for everybody.
Mark Zuckerberg : Sure. And on your questions around Oculus and Search and some of the other things that we're doing; the strategy for Oculus is to help accelerate their growth. They have two products around Rift on PC and they are supporting Gear VR and the Samsung team and building the mobile version. And I'm really excited about both of them. I don't think that this is going to be -- it needs to rich a very large sale, 50 million to 100 million units before it will really be a very meaningful thing as a computing platform. So I do think it's going to take a bunch of years to get there. Maybe -- I don’t know, it's hard to predict exactly but I don't think it's going to get to 50 million or 100 million units in the next few years. So that will take a few cycles of the device to get there and that's kind of what I'm talking about. And then when you get to that scale, that's when it starts to be interesting as a business in terms of developing out the ecosystem. So when I'm talking about that as a 10 year thing, its building the first set of devices and building the audience and the ecosystem around that until it eventually becomes a business. Some of the things like Search and some of these other products, this may sound a little ridiculous to say, but for us, products don't really get that interesting to turn into businesses until they have about a 1 billion people using them. And so for Facebook, we're there with News Feed and that's why in the near term our priority is really around continuing to grow and serve that community and making sure that the business around News Feed and those mobile ads fully reach their potential. Over a five year time frame, we have a number of services, which we think are well on their way to reaching a 1 billion people. Messenger, WhatsApp, Instagram and Search are a number of them. And once we get to that scale, then we think that they will start to become meaningful businesses in their own right. And I think that the right way to think about that, as I've tried to say repeatedly on these calls is, not that we're going to try to monetize them very aggressively in the next year or two, because I really think for each of those categories, the right strategy is to first focus on connecting 1 billion plus people and reaching the full potential before very aggressively turning them into businesses. But I do think that this is such a big opportunity ahead of us. I can't think of that many other companies or products that have multiple lines of products that are on track to reach and connect 1 billion that have a clear path of how we can turn them into a business. So that will be a very fun and exciting challenge to work on over the next five years.
Operator: Your next question comes from Heather Bellini with Goldman Sachs. Your line is open.
Heather Bellini - Goldman Sachs: I just had two. I guess, one for Sheryl, if you could talk about the comments you made about giving advertisers a better feel for attribution, I was just wondering what percent of attribution do you find today is given to the last click and how overstated do you think that is right now? And then just a follow up question for Dave. Given your total expense range of 50 to 70, wider than what we've seen in the past. I'm just wondering how should we think about the low end versus the high end. Under what scenarios are you thinking about those ranges?
Sheryl Sandberg: Heather to your first question. We think measurement really, really needs to evolve for the world we're in today in many ways. One of those is over emphasizing the last click and the percentages by which that's done really varies but we think substantially across the industry are over emphasized. But there are also other problems. The current measurement systems don't work on mobile, because they are largely cookie based. They are not accurate and we think they are only 59% accurate in even the most basic demographic targeting, they just go offline to online. They really work well for one person with one device, usually a PC, thus making online purchases. The world we live in today, I bet you, everyone on his phone call has multiple devices and people look at ads online and then purchase offline, as well as deserve more relevant ads and better targeting. So, as we re-launch Atlas, as we think about investing in ad-tech, we’re looking to solve all of these problems and we think our re-launch is the first step in doing that.
Dave Wehner: Heather, yes, and on the range of guidance, it is wider, it is obviously an early view into 2015. And so consequently it is a wide range. It's giving you the best view that we have on it at this time and we’ll be updating that in the future in terms of the expense guidance range that we have in the past on an annual basis each quarter. So the big drivers will be things like the pace of hiring, the success we have in building, the great teams that we want to build at Facebook, but we’ll be updating that on an ongoing basis,
Operator: Your next question comes from Eric Sheridan with UBS. Your line is open.
Eric Sheridan - UBS: Mark you made comments about public content and the way that’s evolved on Facebook. I'd love to get deeper thoughts there about the way you think content distributions sort of develops on pace over the longer term? And then one for Sheryl. With the ad-tech acquisitions and moves you’ve made over the last year or to two, wanted to know when you think we should be looking at ad-tech being fully deployed in the marketplace, and what sort of returns that might generate for Facebook? Thanks.
Mark Zuckerberg: Sure, well I can start off by talking about public content. So historically a lot of people use Facebook for sharing moments in their lives with their friends and smaller sets of people, right? So we have Messenger for one-to-one communication, Group that just reached 700 million monthly active this quarter and then News Feed, which is kind of the primary thing that people are using to share with all their friends at once. And one of the big things that we -- looking at the FICO system, thought that there was a big opportunity in was public content, where its content that people are either comfortable sharing with everyone or want to consume that is public and shared with everyone. So we’re looking at a few different areas. Video is a very big priority. News is a very big priority, because a lot of people want to share that on Facebook already. And enabling public figures, whether they are celebrities, they are athletes, they are actors, or politicians or leaders in different kind of communities to get on Facebook and use the platform to distribute the content that they want. So those are the three areas that where -- that you'll probably see us investing the most in over the next year or so. And we’re making a lot of progress and I shared some of the stats before, but we’re very proud of what we’re doing and we’ll have more to report soon.
Sheryl Sandberg: On ad-tech, I think we’re in the middle of what is a very fundamental shift from marketing that is cookie based on a PC, one desktop to people based marketing on multiple devices, to marketing that is primarily for online sales, to marketing that affects those online and offline sales on mobile. So I think we're right now in a pretty big shift and we’re not close to fully deployed there. We have a lot of pieces to do. Our Atlas re-launch is new. We’re first growing our client base and we're pleased with our progress there and we're putting these other pieces in place on audience network and LiveRail. So I think we're pretty far from being fully deployed on even this big shift. But I think in our industry nothing ever fully deployed, that as soon as we catch up here, there is going to be another movement and something else that happens that we have to react to and build the technology for. And so we remain -- we're a long term company run by a founder with a long run vision and we want to keep our eyes ahead on these changes and technology and keep deploying against them.
Operator: Your next question comes from Ross Sandler with Deutsche Bank. Your line is open.
Ross Sandler - Deutsche Bank: I just have two questions, one for Mark and then a quick one for Dave. Mark, I don’t think I heard you mention payments in the three, five, 10 year plan. There has been some speculation of payment offerings within Messenger. Can you give us a sense at a high level of what you've envisioned Facebook potentially doing in the payment space longer-term across merchant payments, consumers' products like savings and lending or peer-to-peer? And then how do you see social interactions tied in with payments evolving? Does messenger make payments better than what’s out there in the market? And then Dave, just a clarification. So the high end of the 4Q revenue guidance assumes a pretty sharp drop-off, even normalizing for some extra currency hit. So are you seeing anything out there that makes you concerned about pacing into the quarter or is it largely business as usual or it's just a tougher law of large numbers type situation?
Mark Zuckerberg: I’ll start on payment. So payments is an important part of the online business ecosystem, but we’ve traditionally thought about this as something that we’re going to partner with other companies on to enable great solutions, rather than trying to compete and do it as a business ourselves. And the reason why we’ve taken this approach is it's very important for all online businesses and our customers and partners that there is a good online payment system. People run ads to get customers and sell products and at the end of that conversion, if there is a good payment system that is smooth, then people will buy more things, which ultimately makes the ads and all of whole online flow more valuable for those partners and therefore more revenue and profit for our business as well. We view the ads part of the business as a more efficient part of the businesses than payments itself. Payments tends to be fixed fee whereas and ad, because of the option model, there is really good price discrimination built in. So a partner or business who is willing to pay us 30% of their revenue can bid that and some of these willing to only pay 5% of the revenue can bid that and the auction model inherently takes care of that. So we think that focusing on the ads part is going end up being the more effective thing for us to do but we realize that it’s important for the ad system over time for and for all of our partners for there to be a payment system, which is why we're excited about partnering with credit card companies and partnering with PayPal and all of the different folks doing online payments to make their solutions as good as possible as well.
Dave Wehner: Hey Ross, it's Dave. Our view now is that Q4 revenue will come in that 40% to 47% year-over-year growth range. As I mentioned, Q4 of '13 was just an absolutely fantastic quarter for us. We had News Feed sort of rolled out at scale. It was our first $1 billion dollar mobile quarter. So we're comping against just really outstanding quarter last year. That's really the largest issue. You asked about currency. We did see the euro drop about 7% in value over the course of Q3 and that really didn't pick up as you saw. It didn't pick up in an impact in Q3 at all because it happened at the end of the quarter. So that will be a headwind that we see and that's factored into the guidance.
Operator: Your next question comes from the Mark Mahaney with RBC Capital Markets. Your line is open.
Mark Mahaney - RBC Capital Markets: Great, Sheryl. You talked about being careful about -- and slow about the rolling of the video ads -- auto play video ads and Instagram monetization. Have you seen any pushback in terms of user experiences to date on videos or on video ads, is that overall caution? Is there anything you've seen in the data that suggests that you want to keep it at a really slow pace? Thank you.
Sheryl Sandberg: We're pleased with the consumer response we've had on both fronts and we remain really optimistic over the long run about Instagram and Video, because there's a lot of interest. I spoke before about creative story telling images. Video can be such a big part of that and it create a really resonant experience for brands and companies. We really believe in going slow, that as we grow products, we pay attention to the consumer experience. We want the consumer experience always to come first. So although we're very optimistic about the opportunity here, we continue to grow slowly and pay lot of attention to the quality of the advertising we see. To share one example, we are seeing people using both Facebook and Instagram and also Video and other ad products in combination. Mercedes Benz launched the GLA, which was their first compact SUV on Facebook and Instagram and they found that by doing Facebook and Instagram together, they got a 54% increase on their website visit. So a lot of our products as you do one, you also do more Facebook ads as well and that's something we're paying a lot of attention to.
Operator: Then next question comes from Paul Vogel with Barclays. Your line is open.
Paul Vogel - Barclays : I was just wondering if you could talk a little bit on the engagement side. Your DAUs to MAUs continue to be very strong. Can you just sort of maybe talk a little about your older cohorts versus your newer cohorts and how they're behaving and then also geographically? And then sort of on top of that, on the frequency side, obviously DAU doesn’t measure how often people come back more than once per day. So is there any update on increasing the frequency of visits? Thanks.
Dave Wehner: I don’t think anything to update on the later front Paul, but the DAU to MAU ratio, which we focus on engagement was strong across all the geographic regions. So North America remains at the high end and we're really pleased with what we're seeing there. Nothing to update on cohorts. Obviously we are really pleased overall, what the mobile impact has on the DAU to MAU ratio and really encouraged what we're seeing across the Board on engagement. So I don’t think anything other than that specifically to call out.
Operator: The next question comes from Mark May with Citi. Your line is open.
Mark May - Citi: Thanks. For the last couple of years, -- back on the OpEx for next year guidance, for the last couple of years you've grown your cash OpEx by around a $1 billion a year with some consistency and I think that seems to be continuing in the second half of the year. But obviously your midpoint guidance -- OpEx guidance for next year represents a very significant - I think it's like 2.5% -- $2.5 billion increase at the midpoint. You obviously plan to change the level of investment in something quite significantly. So I'm just wondering if you could talk a little bit more specifically what are a couple of the projects that are capital intensive projects that you're planning for next year and is it physically possible to accelerate your hiring by that much next year?
Dave Wehner: Yes, thanks Mark. The projects really that Mark and Sheryl both outlined in terms of continuing to invest in the core Facebook experiences, growth engagement and monetization, they are building up the ad-tech side and the investments that we want to make, as well as the recent -- continuing to invest against the recent acquisitions that we made in terms of WhatsApp and Oculus. So it’s really the investments we're making there. We're also going to be supporting global growth with our Internet.org initiative, investing there. So it's a number of the key initiatives that Mark outlined in his comments that we’re investing against and again we’re giving a range on what we think is a reasonable range of guidance on that. You saw headcount. We had a good growth to headcount this quarter and we’re going to be continuing to invest as we think that these will be good investments over the long run in terms of being able to drop our long-term growth.
Operator: The next question comes from John Blackledge with Cowen & Company. Your line is open.
John Blackledge - Cowen & Co.: Just a couple of questions on video. How should we think about Facebook as a video platform and how does the mix of video between user generated versus public content versus professionally produced content evolve over time? And for example, is the upcoming short-film content produced by Lionsgate around the Twilight franchise that will be shown exclusively on Facebook. Would that increasingly be the type of content Facebook users will see in the future? And then if you could just give an update on the Instagram monthly active user comp, that would be great? Thank you.
Mark Zuckerberg: I can speak to the video point. I think it's going to be all of the above in terms of what you said. Most of the content on Facebook is things that people are sharing with their friends and the people around them. So I think we’ll continue to see that in video as well. There's definitely the mis-trend over the last few years where, if you go back five years most of the content was text. Now a lot of it is photos and if you look in the future, as networks get letter and the ability to capture good video and share in a good way improves then -- I think that going forward a lot of the content that people share will be video. It's just a very compelling. There is also a lot of great public content that’s video, especially the shorter form content that they are mentioning I think will fit very well into the feed form factor that people consume on Facebook. So I think we’re going to see a lot of both of these things and it's going to be an evolution over the next few years. But I think you can expect to see a ramp up of all this.
Dave Wehner: And on Instagram, we haven’t updated the number. They continue to grow nicely, but we haven’t announced a new public number on Instagram.
Operator: The next question comes from Justin Post with Merrill Lynch. Your line is open.
Justin Post - Merrill Lynch : Mark it seems like you taking a portfolio approach to apps and you've got a several different experiences for people on mobile devices and other devices. Can you give us your philosophy around that? And as people use things like WhatsApp and Instagram, is it actually, maybe partially hurting Facebook’s reported metrics and how do you think about putting this altogether and helping every app kind of work?
Mark Zuckerberg: Sure. So one of the things that’s happening on mobile is that there's an increased focus for apps to do one thing really well. Like so on desktop a lot of the things that might have fit well into a single Facebook website now are -- in order to best serve people, you need to build multiple standalone different apps. So we’re seeing that with Facebook and Messenger and the work that we did to kind of split out Messenger from the Facebook app to give a dedicated experience or an app that we think is a better experience. And we’re going to do more of that in the future, as well at the Facebook Creative Labs product that we’re releasing. Part of what we’ve seen is that the use cases for products like Instagram and WhatsApp are actually more different and nuanced from then the products that people compare them to, that Facebook had already built. So for example on the WhatsApp and Messenger side, Messenger is primarily used today for people to chat with their Facebook friends, within this context of maybe it's not like a real-time text. Like you would send an SMS on your phone, but it's something that you are sending to one of your Facebook friends and if they happen to be there, then you can text back and forth or maybe they respond later. SMS and WhatsApp are more for kind of real-time activity. People have contacts on WhatsApp who they wouldn’t want to make friends on Facebook. Their graphs are somewhat different. So one of the things that we found interestingly to us as well was that, Messenger and WhatsApp are actually growing quickly in the lot of the same countries. There's countries that they're growing in that are different and there are countries that they are growing in that are the same, which to me suggests that they actually are in more different markets than you probably intuitively would have thought and that was definitely our understanding as we dug more into this. Same with Instagram, and the type of sharing that happens on Instagram versus News Feed. We’ve recently started doing more to help promote and accelerate the growth of Instagram from the Facebook app itself because what we found is that by doing that, we’re net overall increasing the amount of sharing the people can do and connecting what they can do within our whole family of apps. So we're definitely seeing that this is all accretive and positive and we think that in the future there will probably be room for more apps for sharing as well.
Operator: The next question comes from Anthony DiClemente with Nomura Securities. Your line is open.
Anthony DiClemente - Nomura Securities: First for Sheryl, I want to just come back to the theme of media measurement you gave us in good perspective. Can you help me with first party data versus third party data? Can you get where you need to go with brand marketers using your in-house tools like Atlas or do you think you need the validity and integrity of a third party measurement source i.e. Nicholson in order to get there. And then second question for Mark. Mark I was just wondering, where do you see Facebook at this point in terms of its place in the hardware ecosystem? And given so much time is spend in your apps, do you think it’s possible that you could get more aggressive in devices, in hardware in order to achieve some of your longer-term or 10 year goals that you've laid out?
Sheryl Sandberg: To your first question, data is really important for both the measurement and targeting. And when you think about first party and third party data, you have to think about both of those usage. Certainly with measurement, third party verification of that data can be very important. A lot of our largest clients and agencies also build their own data systems, which are a very important part of measuring and kind of certifying everything we do with them. So we're using a combination of first party and third party. I think where this really gets interesting is around relevance. And as I spoke about, that's a major theme for us because we think one of the best things we can do to drive more value for marketers and improve the consumer experience on Facebook is improve relevance, and data is a great way of doing that. So for example with custom audiences, custom audiences is a combination of our clients using the data they have on their client base, combined with the data we have that we can target. Let's say target one ad to existing customers to get them to engage more and buy more; and one add to brand new customers. And you could see how you're different ads for people who have never bought your product and a different ad for people who are currently buying your product would make a lot of sense. And then you look at something like look alike audiences, where we're looking to map customers who share characteristics, age, demos, likes, interests with current customers. And all of this takes a combination of first party and third party data, all of which we do in a very privacy protected way.
Operator: The next question comes from Stephen Ju with Credit Suisse. Your line is open.
Stephen Ju - Credit Suisse: So Sheryl, from a product development perspective, it feels like from the outside looking in that you have accelerated the roll out and delivery of various products. So wondering how you are thinking about how your product delivery cadence will change, especially given the investments you have guided to for 2015. Thanks.
Mark Zuckerberg: Before we go to that, I'll just quickly answer the hardware question that we didn’t get a chance to answer on the last question. We actually probably do more with hardware already than is apparent because we design and work with folks to build up all of our data centers and the servers there. So I do think that if that ever became the right thing for us to focus on from a product perspective, we have some of the skills there already. And when we are thinking about working Oculus, that's actually one of the areas where we think we can help out because we've up a supply chain team and we've been I think pretty effective at delivering what we've needed to run Facebook as this large system of scale. So -- but that said, I think that there is a huge amount of value in delivering these network and software services and that's where you should expect to focus, on the things that we talked about.
Sheryl Sandberg: To the question about the roll out of products. I think the usual way we do things is that we roll out products slowly and then we iterate. So one example is custom audiences. We roll out custom audiences. Then we add on that website custom audiences to target ads to people visiting websites or then mobile app custom audiences, ads to people who have visited mobile apps. And one is building on the next, building on the next. Similarly, this month -- earlier this month we have launched local awareness targeting. It's a new option that allows local businesses to reach nearby customers. And what you saw that -- it wasn't a massive launch. It was a small launch where we enabled this targeting, get people to use it and we'll develop it. Then there are the exceptions such as Atlas. Atlas was one big launch that we're still in the process of doing and that's really because of the product that we've bought and needed to rebuild. But for the most part, our product development tends to be very iterative and that's what you can expect from us going forward.
Operator: The next question comes from Youssef Squali with Cantor. Your line is open.
Youssef Squali - Cantor: First question for Mark. Mark you recently came back from China. How do you think about that opportunity and what gives you the confidence that you can actually be successful where so many have failed. And then the second on Instagram; we've seen some very complementary data that shows that Instagram is actually becoming more popular than ever with some brand marketers. Just wondering what are the best performing ads formats on the platform right now and where is the ad load versus where Facebook is.
Mark Zuckerberg: Sure. So on China, we're already doing more in China on the business side than I think a lot of folks think about. A lot of Chinese businesses use Facebook to grow their export businesses and to help find customers around the rest of the world and grow the Chinese economy there. So that's actually a pretty meaningful thing for us already and we always are looking to find ways to help businesses around the world to grow. And that will be just a long term thing. I mean our approach to China and all these -- and every country is very kind of long term. We're going to be here for decades and we want to create good relationships with these countries and businesses around the world that will help and grow over the long-term. On the Instagram side, I think we're pretty early. There have been a number of good ads, both video and images that I think have been pretty effective, but it's fairly early and in the growth phase at this point, the top priority for Instagram is to grow from 200 to more and eventually connect billion or more people and I think that that's something that should be possible and that’s what I'm really focused on and excited about now, while we also start building out some of the parts of the business as well.
Deborah Crawford: Operator, we have time for one last question.
Operator: Your last question will come from Scott Devitt with Stifel. Your line is open.
Scott Devitt - Stifel: I think this question is for Sheryl. The app download business seems to have grown quickly and become a big contributor of the ad revenue total for Facebook and just wondering how you think about app reengagement relative to app downloads and which of those you think is a larger, long-term opportunity for the Company. Thanks.
Sheryl Sandberg: I'm glad you asked the question because I think there has been some confusion around our mobile apps and our mobile app ads and our mobile app engagement ads. So engagement ads, it's still pretty early and we have rolled those out and rolled those out after mobile app ads. So we definitely seen lots of them. But we do think there is an opportunity. I think the broader point is that our growth in mobile ads is very broad based. It's across all market or segments and it's across all of our different ad formats and we talk about our mobile ad business growing. Mobile app ads are a small part of that, that's growing in line with our total business. The other thing that I think people get a little confused about is who is using mobile app ads. I think commonly when you think about mobile app ads, people often think about developers and developers are moving them and we're pleased we're able to help them grow. But they're also being used by some of the largest branders and marketers in the world. So for example Burger King. Burger King just used our mobile app ads to do app installs for their app. And the app was to find Burger King, look at their menu and nutritional options, use mobile coupons and use virtual gift cards. So that was one use of our mobile app ads, which is not what people typically think of.
Deborah Crawford: Great. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again.
Operator: This concludes today’s conference call. You may now disconnect. | [
{
"speaker": "Executives",
"text": "Deborah Crawford - VP, IR Mark Zuckerberg - CEO Sheryl Sandberg - COO Dave Wehner - VP, Finance and CFO"
},
{
"speaker": "Analysts",
"text": "Douglas Anmuth - JPMorgan Ben Sachachter - Mcquarie Heather Bellini - Goldman Sachs Eric Sheridan - UBS Ross Sandler - Deutsche Bank Mark Mahaney - RBC Capital Markets Paul Vogel - Barclays Mark May - Citi John Blackledge - Cowen & Co. Justin Post - Merrill Lynch Anthony DiClemente - Nomura Securities Stephen Ju - Credit Suisse Youssef Squali - Cantor Scott Devitt - Stifel"
},
{
"speaker": "Operator",
"text": "Good afternoon. My name is Jay and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook Third Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions). Thank you very much. Ms. Deborah Crawford, Facebook's Vice President of Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford",
"text": "Thank you. Good afternoon and welcome to Facebook’s third quarter earnings conference call. Joining me today to talk about our results are Mark Zuckerberg, CEO, Sheryl Sandberg, COO and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements, and actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today’s press release and on our Quarterly Report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these statements as a result of new information or future events. During this call we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today’s earnings press release. The press release and an accompanying investor presentation are available on our Web site at investor.fb.com. And now, I’d like to turn the call over to Mark."
},
{
"speaker": "Mark Zuckerberg",
"text": "Thanks Deborah, and thanks everyone for joining today. This has been a good quarter for Facebook and we’ve achieved strong results across the board. We've continued to grow our community in both size and engagement with 1.35 billion people now using each month and 64% using Facebook daily. On mobile 1.12 billion people now use Facebook each month and 703 million people each day, nearly 40% growth from this time last year. Looking to our business, we continue to do well. This quarter total revenue reached $3.2 billion and advertising revenue grew 64% year-over-year. Mobile now accounts for 66% of our advertising revenue. These results show that Facebook is getting stronger every day, as a community, a partner for developers and marketers and as a business. One thing that I'm particularly pleased about is that while we’re investing aggressively and making progress towards our big long-term goals, we also continue to execute well against our near-term priorities. On previous calls, you’ve heard me talk about our big company goals of connecting everyone, understanding the world and building the next generation of platforms. These goals are important for us and part of our foundation of our strategy for the next decade, but achieving these will involve many different efforts and steps along the way, some that will be achieved rapidly and others that are going to take longer. So with that in mind, I’d like to run through our progress this quarter on the different efforts that we expect to deliver a lot of impact over the next three, five and 10 years. Let's begin with our three-year goals. Over the next three years, our main goals are around continuing to grow and serve our existing communities and businesses and help them reach their full potential. When you look at the size and engagement of our community, our progress remains very strong. 864 million use Facebook every day and across our core products, we continue to see huge engagement. For example around 700 million people now use Facebook Groups every month. Achieving this scale shows that we're delivering experiences for the way that people want to share and connect. Another example is our progress on public content. Last quarter I talked about how we're working to connect people around important public moments and personalities on Facebook. This quarter we've continued to build on our results and there are now more than 1 billion interactions every week between public figures and their fans on Facebook. The investments we have made in video have also played a big part here. This quarter we announced a new milestone for video on Facebook achieving 1 billion video views, a day of made of videos. During the summers the ice bucket challenge drew more than 10 billion video views by 440 million people which is a good sign of how far our video product has come. Instagram has also made a lot of progress this quarter. In August, the Instagram team launched Hyperlapse, a standalone app for time lapse of videos on iOS. The team has also invested heavily in improving the speed and performance of Instagram on Android. This has helped drive Instagram's strong international growth which in some countries has achieved more than 100% year-over-year growth. Globally, people using Instagram now spend around 21 minutes a day on average using the app. This is a strong figure compared to the industry and a good sign that Instagram's strategy is on the right path. Our other big focus over the next three years is to continue to serving businesses well and creating a lot of value for marketers. As our results show, our approach here is working. To continue delivering value for businesses, we work to improve the quality of ads and news feed by reducing low quality content and improving our targeting to show more timely and relevant content. We’ve also made some big advances in our ad tech, most importantly the launch of our new Atlas platform. Atlas offers marketers a lot of new capabilities to help reach people across devices, platforms and publishers as well as improving measurement in online campaign. We're very excited for the future of Atlas and Cheryl is going to talk more about this in a moment. Next, let's talk about our strategy over the next five years. Over the next five years, our goals are around taking our next generation of services, Instagram, Messenger, WhatsApp and Search and helping them connect billions of people and become important businesses in their own right. One big priority for us here is messaging. And continuing to build and grow Messenger and now WhatsApp as well as great services. This quarter we made an important change to our mobile messaging efforts by transitioning people to Messenger on iOS, Android and Windows Phone. We believe that this change allows us to offer a better and faster messaging experience on mobile, and our data shows that people who use Messenger, usually respond to messages about 20% faster. This month we also completed our acquisition of WhatsApp. I'm excited to be working with this team and John to join our Board. WhatsApp continues to be on a path to connect more than 1 billion people around the world and we're going to be working into accelerate their efforts here. Another key part of our strategy is helping developers to build more great social experiences on our platform. Over the next few years, our goal is to make Facebook a cross-platform platform that allows developers to build, grow and monetize their apps across every major mobile platform. We’ve continued to make good progress here. This quarter, we opened our audience networks to all developers and publishers, allowing over 1.5 million advertisers on Facebook to extend their campaigns across mobile and for developers to begin monetizing their apps. We're also excited by the continued adoption of App Links, our deep-linking technology for mobile apps. App Links is now used by hundreds of apps across iOS, Android and Windows phone and in just the past six months, the developers have created links to more than 3 billion individual destinations in these apps. Now let's talk about how we're approaching our goals over the next 10 years. For the next 10 years our focus is on driving the fundamental changes in the world that we need to achieve our mission, connecting the whole world, understanding a world with big leaps in AIs and developing the next generation of platforms, especially in computing. This is a very big period, a very busy period for our efforts with Internet.org. In July we worked with Airtel to launch the Internet.org app in Zambia. This provides free data access to a set of basic internet services for health, education, employment and communication. The results from this are very encouraging. We've already heard a lot amazing stories about how people are using the internet to add value to their lives. We hope to bring the Internet.org app to many more countries soon. Over the last few months, I've also travelled to several countries and met with policy makers, key distributors and people and communities that are coming online for the first time. Increasingly industry and governments are seeing expanding internet access as one of their core priorities. This is positive development for our work with Internet.org in our long-term goal of connecting everyone in the world. Finally, let's talk for a minute about our progress of Oculus. As I've said before, with Oculus, we're making a long-term bet on the future of computing. Every 10 to 15 years, a new major computing platform arrives and we think that virtual and augmented reality are important parts of this upcoming next platform. This quarter, Oculus continued to make progress towards this vision. In September, the first Oculus developer conference took place, where we announced a new prototype VR headset on the path of a consumer version of the Rift. We continue to see a lot of excitement in the developer community and we've now shipped more than 100,000 of Rift developer kit to over a 130 countries. It's still early for Oculus but we are encouraged to see the variety of apps and games being developed for this platform. Internet.org and Oculus are just two of the huge opportunities ahead. Our efforts here will take longer to achieve their full impact, but we're going to continue preparing for the future by investing aggressively. So that’s how we’re approaching our strategy over the next three, five and 10 years, while focusing on our big goals of connecting everyone, understanding the world and building the next generation of platforms. This has been a quarter with strong results. I want to thank the entire Facebook community, our employees, our partners and our stockholders for their continued support. Because of your contribution, Facebook continues to grow in strength and to create greater value in the world for people, partners and businesses. We have a long journey ahead, we’re on the right path and I'm excited about the progress that we’re making. Thank you and now here’s Sheryl."
},
{
"speaker": "Sheryl Sandberg",
"text": "Thanks Mark and hi everyone. We had another strong quarter and we’re continuing to execute well on our priorities; capitalizing on the shift to mobile; growing the number of Facebook marketers and building products to make our ads more relevant. Our growth this quarter was again very broad-based. We saw strong performance around the world as well as across verticals on our four marketer segments, brands, direct marketers, developers and small and medium businesses. I’d like to briefly highlight some of our progress on the product front and then focus on important new investments we're making in ad-tech. One of our main ad protocols is to make ads more relevant. Just like content and news feed, when ads are more relevant, they provide a better experience for people using Facebook and a better return for marketers. One of the best ways to improve relevance is to help advertisers reach the right audience with their messages. Facebook age and gender targeting is 45% more accurate than the digital industry average. Working with Facebook advertisers can also target based on peoples interests. In addition, we’re continuing to build out custom audiences, which enable marketers to use their own data to segment current and prospective customers. We’re pleased with the response from clients and we’re focused on driving deeper penetration with those existing and new clients. We also offer lookalike audiences, which help marketers find potential new customers who are similar to their current customers. To share one recent example, earlier this year global financial services company MetLife wanted to find new customers for life insurance policies. Working with this agency Markel, they used lookalike audiences to find people more like their existing customers, MetLife ran ads that let people to their get a quote website page. Over the six-month campaign, the leads that came from Facebook resulted in new policies at a 2.4 times higher rate than MetLife’s next best performing channel and at half the cost of display ads. We’re also making steady progress with newer ad initiatives. Throughout this quarter we continue to enable auto play for more video ads. We’re also continuing to roll our ads on Instagram. We think there is good opportunity with both video and Instagram ads but we're going to remain deliberate and slow in our approach to scaling those businesses. We’re also making longer-term investments that we believe will be important for Facebook and the ad industry. In Q3, we re-launched Atlas, closed our acquisition of LiveRail and rolled out our audience network. So I want to spend a few minutes discussing our longer-term ad-tech strategy. We’re investing in ad-tech for a simple reason. Consumers are shifting quickly to mobile and the advertising industry is not keeping up. 2013 was the first year the average American adults spent more time on digital media than watching TV and that gap has continued to grow. Today the average adult in the U.S. spends nearly 25% of their media time on mobile, but advertisers spend only about 11% of their budgets there. One of the main reasons the budgets aren’t moving as quickly as consumers is that advertisers hasn’t yet had an effective way to serve ads and measure their returns on mobile. Current solutions work well for person with one device, especially, a PC and for sales that happen online. But today people often have multiple devices and still make many purchases in physical stores. Nilsson OCR [ph] data shows that the digital industry is less than 60% accurate in demographic targeting of ads, which means that four in 10 people are seeing the wrong ads. Similarly marketers are not confident that they can measure mobile ad performance. Many of the most commonly used measurement systems over emphasize the value of the last click. This does not make sense, given that studies of Facebook campaigns show that over 90% of ad driven in-store sales come from people who saw an ad but didn’t click on it. It's clear that marketers and publishers need better tools for the mobile world. This is an industry problem that we believe we are well placed to solve. Our re-launch of Atlas last month during Adweek was an important early step that builds on the advancements and measurements we have made over the past two years. The new Atlas is an ad serving and measurement platform, we completely rebuilt. By using Facebook data, Atlas can deliver highly relevant ads, regardless of device. Atlas is also able to provide accurate measurement by connecting online marketing to in store sales. Importantly, Atlas does all of this in a privacy protected way. Neither Atlas nor Facebook tells marketers who you are. At Adweek, we had productive conversations about Atlas with many marketers and agencies. We are pleased with their interest. We’re also investing in additional pieces of our ad-tech platform. Our audience network improves the relevance of ads inside mobile apps. LiveRail provides tools for publishers to enable personalized marketing at scale via their apps and websites. We believe LiveRail can build on their success in desktop video with the concrete solution for mobile publishers. I want to emphasize that the investments we’re making in ad-tech are long-term. These are large and strategic investments. The path will take time, but we think that provide a necessary foundation for the advertising industry to make the shift to mobile and for Facebook’s long-term growth. We recognize that by staffing engineers in these strategic ad-tech areas, we forego shorter term product improvement improvements which would generate revenue more quickly. We believe these are the right decisions. As we look toward 2015, we're going to stay focused on the areas I've talked about today; capitalizing on the shift to mobile, growing the number of Facebook marketers and building products that make ads more relevant. Our investments in ad-tech will be an increasingly important part of all of these efforts. Thanks everyone and now here is Dave."
},
{
"speaker": "Dave Wehner",
"text": "Thanks, Sheryl and good afternoon everyone. Q3 was a solid quarter across the board. We had strong revenue growth, generated $766 million in free cash flow and continued to make investments to position us for long-term growth. 864 million people use Facebook on an average day in September, up a 136 million from last year. This represents 64% of the 1.35 billion people that used Facebook during the month of September. Mobile continues to be the core driver of our growth. Over 1.1 billion people used Facebook on mobile during the month of September, up 250 million from last year. In addition, we have hundreds of millions of people on mobile using Instagram, Messenger and WhatsApp. Turning now to the financials. Total revenue in Q3 was $3.2 billion, up 59% compared to last year or 58% on a constant currency basis. Total ad revenue was nearly $3 billion, up 64% compared to last year or 63% on a constant currency basis. Ad revenue growth was strong around the world with each of our four reported geographic regions growing by 50% or more compared to last year. Mobile ad revenue was approximately $1.9 billion or 66% ad revenue, compared to approximately $881 million or 49% of ad revenue last year. Desktop ad revenue was up 11% compared to last year, but was flat sequentially. In Q3, the average price per ad increased 274% compared to last year, while total ad impressions declined 56%. The increase in the average effective price per ad was driven primarily by the redesign of our right hand column ads which resulted in larger, more engaging ads that delivered more value to marketers and thus had higher reflective prices. These right hand column ads were also fewer in number, which drove the decrease of impressions in the quarter. To a lesser degree, the shift of usage to mobile, where we don't have right hand column ads also continued to contribute to the reported price volume trends. The price volume trends were largely consistent across our four geographic regions. Total payments and other fees revenue was $246 million, up 13% versus last year, however payments volume from gains which represents the substantial majority of our payments and other fees revenue declined 2% compared to last year, notably for the first time and we expect this trend to continue as desktop usage continues to decline. Turning now to expenses. Note that beginning in Q3 our definition of non-GAAP also excludes the amortization of intangible assets and historical non-GAAP measures discussed today have been updated accordingly. You can find our GAAP to non-GAAP reconciliations on page 10 of the Q3 press release. Our Q3 total GAAP expenses were $1.8 billion, up 41% from last year and non-GAAP expenses were $1.4 billion, up 39% from last year. Cost of revenue grew 11% on a GAAP basis and 7% on a non-GAAP basis. We incurred expenses in the third quarter of 2013 related to the transition out of certain lease data centers. This mitigated our cost of revenue growth rate in Q3 2014, as it has done in the last two quarters. Operating expenses excluding cost of revenue were up 61% on a GAAP basis and 72% on a non-GAAP basis versus last year, primarily due to an increase in headcount related costs. We ended Q3 with 8,348 employees, up 44% from last year. Of the nearly 1,200 people we added sequentially about a quarter were from acquisition. Organic growth was high as the third quarter is our seasonally strongest new hire start period. Overall we are pleased with our ability to attract and retain talented people who enable us to make strong progress against our mission. Q3 operating income was $1.4 billion, representing a 44% operating margin, up from 37% last year and our non-GAAP operating income was $1.8 billion, representing 57% operating margin, up from 51% last year. Interest and other income and expense was a net expense of $61 million in the quarter, versus a net expense of $10 million last year. This increase in expense was primarily due to foreign exchange losses resulting from the periodic re-measurement of our foreign currency balances and largely resulted from the substantial reduction in the value of the euro relative to the dollar experienced form the beginning to the end of the quarter. Our GAAP and non-GAAP tax rates for the quarter were 40% and 35% respectively. GAAP net income was $806 million or $0.30 per share and our non-GAAP net income was $1.1 billion or $0.43 per share. In Q3, we spent $482 million on CapEx and generated $766 million of free cash flow. We ended Q3 with approximately $14.3 billion in cash and investments. This does not reflect the approximately $4.6 billion cash payment that we made in conjunction with the WhatsApp acquisition, which closed earlier this month. Turning now to outlook. I'd like to start by noting that my forward-looking statements include the impact of both Oculus and WhatsApp. In addition, as part of the WhatsApp deal, we agreed to file a registration statement to register for resale approximately 178 million shares issued to the WhatsApp stockholders. Nearly all of those shares will be fully registered and tradable during open trading windows in Q4 2014 and Q1 2015 under the registration statement we plan to file later this week. In light of our recent acquisitions and our plans to file this registration statement, we are providing some additional guidance this quarter, including a more specific outlook on the current quarter revenue and a preliminary view on 2015 expenses. This is a more detailed outlook than we have historically provided or plan to provide on future earnings calls. Let me start with 2014 expenses, we expect our full year 2014 total GAAP expenses, including cost of revenues, stock compensation and the amortization of intangibles will grow approximately 45% to 50% versus the full year 2013. This increase from our prior range of 30% to 35% is primarily due to the impact of this WhatsApp acquisition on stock-based compensation charges in the fourth quarter. We continue to expect that our full year 2014 total non-GAAP expenses, including cost of revenue but excluding stock compensation and amortization of intangibles will likely grow in the neighborhood of 30% to 35% versus the full year 2013. Turning now to revenue, we expect that total revenue in the fourth quarter will grow in the range of 40% to 47% versus the same quarter of last year. Please keep in mind that Q4 of 2013 was our first holiday season with the rollout of new seed ads at scale, which makes for a difficult comparison. For taxes, we anticipate the GAAP tax rate in the fourth quarter will be approximately 45% to 50%, which is higher than the current rate due to large non-deductible stock-based compensation charges related to the closing of the WhatsApp transaction. Our Q4 non-GAAP tax rate should be similar to our Q3 rate. For share count, we expected our fourth quarter fully diluted share count will be approximately 2.8 billion shares, taking into account the shares that we issued upon the closing of the WhatsApp deal. We expect that our 2014 CapEx will be at the low end of our prior $2 billion to $2.5 billion CapEx guidance. And lastly, while it is relatively early, I wanted to provide some preliminary color on our expense outlook for 2015. As Mark discussed in his remarks, we believe that we have very substantial growth opportunities in front of us and we plan to invest aggressively to capitalize on those opportunities. As such, we plan on 2015 being a significant investment year. Our current expectation is that total cost and expenses on a GAAP basis, inclusive of stock-based compensation charges related to the recent transactions are likely to increase 55% to 75% compared to the full year 2014. On a non-GAAP basis, we expect total cost to increase approximately 50% to 70% compared to 2014. Tax rates for 2015 should be similar to our fourth quarter rates on both a GAAP and non-GAAP basis. In summary, we’re very pleased with the growth of our network, the great momentum we continue to see in our ads business and the significant investments we're making to drive near-term and long-term growth. We have large opportunities ahead of us and we’re focused on capitalizing on those to achieve our mission and track long-term shareholder value. With that operator, let's open up the call for questions."
},
{
"speaker": "Operator",
"text": "We will now open the lines for a question-and-answer session. (Operator Instructions). Your first question comes from the line of Douglas Anmuth with JPMorgan. Your line is open."
},
{
"speaker": "Douglas Anmuth - JPMorgan",
"text": "Dave, just to follow up on the comments that you just made on the outlook or expenses for ’15, can you just help us understand more on the non-GAAP expenses, the 50% to 70% and where we should be thinking about the incremental dollars being spent there primarily? And then secondly, can you just talk Sheryl, perhaps about what you’re seeing in terms of branded advertising, whether you’re seeing more of it in fraction there as more bigger brand CPG companies, auto OEMs are coming onboard and how you're positioned there for the holidays? Thanks."
},
{
"speaker": "Dave Wehner",
"text": ""
},
{
"speaker": "",
"text": "From an infrastructure side, we plan to invest to support the growth of the core business. That includes things like video. It also includes things like our global growth efforts with Internet.org. So we’re really kind of investing across the board on that. And I guess in summary, we've got -- the strength of the business today is really putting us in a strong position to invest smartly for the future and we’re doing that."
},
{
"speaker": "Sheryl Sandberg",
"text": ""
},
{
"speaker": "",
"text": "With all of this, we know we need to go client by client and we're especially focused on measurement because measurement is so key for this segment. A lot of the products that brand marketers are selling are bought in store and so showing that online and mobile ads lead to in store purchases is a hugely important part of our strategy going forward as I talked about, and video is really exciting as well. When you think about the holiday season, Q4 is a really important time for our client and that makes it a really important time for us. And I think people are increasingly recognizing that mobile is important. 65% of people use their phones while they are out shopping and people are recognizing that opportunity. From an earnings perspective, last Q4 was a great quarter, both because our business was growing but also because that was when we rolled out ads fully into news feeds and so it’s worth keeping that in mind when you think about how you think about our business going forward."
},
{
"speaker": "Operator",
"text": "The next question comes from Ben Sachachter with Mcquarie. Your line is open."
},
{
"speaker": "Ben Sachachter - Mcquarie",
"text": "A few questions. David, there was no mention of a '15 revenue range but I was wondering if you could give us any thoughts on how much margin should compress in '15 versus '14? Then a couple for Mark. Mark, now that you've spent more time with the Oculus team, can you update us on how your plans for Oculus have evolved since you first tried the device on. And then you mentioned it when you talked about your 10 year outlook. Does that mean we shouldn't expect any consumer Oculus product in the next one or two years? And then similarly on Search, you mentioned your five plan. So does that mean we shouldn’t expect anything on Search for the next five years?"
},
{
"speaker": "Dave Wehner",
"text": "Hey, Ben, it's Dave. We're not really giving any guidance on 2015 revenue. We gave the growth range that we're expecting on Q4, which was 40% to 47% and that's down from 59% in Q3. But we're not providing any specific guidance on 2015. Revenue sort of outlined the expense growth that we expect because of the substantial investments that we're making, also driven by some of the acquisitions that we've made. So hope that, that is helpful for everybody."
},
{
"speaker": "Mark Zuckerberg",
"text": "Sure. And on your questions around Oculus and Search and some of the other things that we're doing; the strategy for Oculus is to help accelerate their growth. They have two products around Rift on PC and they are supporting Gear VR and the Samsung team and building the mobile version. And I'm really excited about both of them. I don't think that this is going to be -- it needs to rich a very large sale, 50 million to 100 million units before it will really be a very meaningful thing as a computing platform. So I do think it's going to take a bunch of years to get there. Maybe -- I don’t know, it's hard to predict exactly but I don't think it's going to get to 50 million or 100 million units in the next few years. So that will take a few cycles of the device to get there and that's kind of what I'm talking about. And then when you get to that scale, that's when it starts to be interesting as a business in terms of developing out the ecosystem. So when I'm talking about that as a 10 year thing, its building the first set of devices and building the audience and the ecosystem around that until it eventually becomes a business. Some of the things like Search and some of these other products, this may sound a little ridiculous to say, but for us, products don't really get that interesting to turn into businesses until they have about a 1 billion people using them. And so for Facebook, we're there with News Feed and that's why in the near term our priority is really around continuing to grow and serve that community and making sure that the business around News Feed and those mobile ads fully reach their potential. Over a five year time frame, we have a number of services, which we think are well on their way to reaching a 1 billion people. Messenger, WhatsApp, Instagram and Search are a number of them. And once we get to that scale, then we think that they will start to become meaningful businesses in their own right. And I think that the right way to think about that, as I've tried to say repeatedly on these calls is, not that we're going to try to monetize them very aggressively in the next year or two, because I really think for each of those categories, the right strategy is to first focus on connecting 1 billion plus people and reaching the full potential before very aggressively turning them into businesses. But I do think that this is such a big opportunity ahead of us. I can't think of that many other companies or products that have multiple lines of products that are on track to reach and connect 1 billion that have a clear path of how we can turn them into a business. So that will be a very fun and exciting challenge to work on over the next five years."
},
{
"speaker": "Operator",
"text": "Your next question comes from Heather Bellini with Goldman Sachs. Your line is open."
},
{
"speaker": "Heather Bellini - Goldman Sachs",
"text": "I just had two. I guess, one for Sheryl, if you could talk about the comments you made about giving advertisers a better feel for attribution, I was just wondering what percent of attribution do you find today is given to the last click and how overstated do you think that is right now? And then just a follow up question for Dave. Given your total expense range of 50 to 70, wider than what we've seen in the past. I'm just wondering how should we think about the low end versus the high end. Under what scenarios are you thinking about those ranges?"
},
{
"speaker": "Sheryl Sandberg",
"text": "Heather to your first question. We think measurement really, really needs to evolve for the world we're in today in many ways. One of those is over emphasizing the last click and the percentages by which that's done really varies but we think substantially across the industry are over emphasized. But there are also other problems. The current measurement systems don't work on mobile, because they are largely cookie based. They are not accurate and we think they are only 59% accurate in even the most basic demographic targeting, they just go offline to online. They really work well for one person with one device, usually a PC, thus making online purchases. The world we live in today, I bet you, everyone on his phone call has multiple devices and people look at ads online and then purchase offline, as well as deserve more relevant ads and better targeting. So, as we re-launch Atlas, as we think about investing in ad-tech, we’re looking to solve all of these problems and we think our re-launch is the first step in doing that."
},
{
"speaker": "Dave Wehner",
"text": "Heather, yes, and on the range of guidance, it is wider, it is obviously an early view into 2015. And so consequently it is a wide range. It's giving you the best view that we have on it at this time and we’ll be updating that in the future in terms of the expense guidance range that we have in the past on an annual basis each quarter. So the big drivers will be things like the pace of hiring, the success we have in building, the great teams that we want to build at Facebook, but we’ll be updating that on an ongoing basis,"
},
{
"speaker": "Operator",
"text": "Your next question comes from Eric Sheridan with UBS. Your line is open."
},
{
"speaker": "Eric Sheridan - UBS",
"text": "Mark you made comments about public content and the way that’s evolved on Facebook. I'd love to get deeper thoughts there about the way you think content distributions sort of develops on pace over the longer term? And then one for Sheryl. With the ad-tech acquisitions and moves you’ve made over the last year or to two, wanted to know when you think we should be looking at ad-tech being fully deployed in the marketplace, and what sort of returns that might generate for Facebook? Thanks."
},
{
"speaker": "Mark Zuckerberg",
"text": "Sure, well I can start off by talking about public content. So historically a lot of people use Facebook for sharing moments in their lives with their friends and smaller sets of people, right? So we have Messenger for one-to-one communication, Group that just reached 700 million monthly active this quarter and then News Feed, which is kind of the primary thing that people are using to share with all their friends at once. And one of the big things that we -- looking at the FICO system, thought that there was a big opportunity in was public content, where its content that people are either comfortable sharing with everyone or want to consume that is public and shared with everyone. So we’re looking at a few different areas. Video is a very big priority. News is a very big priority, because a lot of people want to share that on Facebook already. And enabling public figures, whether they are celebrities, they are athletes, they are actors, or politicians or leaders in different kind of communities to get on Facebook and use the platform to distribute the content that they want. So those are the three areas that where -- that you'll probably see us investing the most in over the next year or so. And we’re making a lot of progress and I shared some of the stats before, but we’re very proud of what we’re doing and we’ll have more to report soon."
},
{
"speaker": "Sheryl Sandberg",
"text": "On ad-tech, I think we’re in the middle of what is a very fundamental shift from marketing that is cookie based on a PC, one desktop to people based marketing on multiple devices, to marketing that is primarily for online sales, to marketing that affects those online and offline sales on mobile. So I think we're right now in a pretty big shift and we’re not close to fully deployed there. We have a lot of pieces to do. Our Atlas re-launch is new. We’re first growing our client base and we're pleased with our progress there and we're putting these other pieces in place on audience network and LiveRail. So I think we're pretty far from being fully deployed on even this big shift. But I think in our industry nothing ever fully deployed, that as soon as we catch up here, there is going to be another movement and something else that happens that we have to react to and build the technology for. And so we remain -- we're a long term company run by a founder with a long run vision and we want to keep our eyes ahead on these changes and technology and keep deploying against them."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ross Sandler with Deutsche Bank. Your line is open."
},
{
"speaker": "Ross Sandler - Deutsche Bank",
"text": "I just have two questions, one for Mark and then a quick one for Dave. Mark, I don’t think I heard you mention payments in the three, five, 10 year plan. There has been some speculation of payment offerings within Messenger. Can you give us a sense at a high level of what you've envisioned Facebook potentially doing in the payment space longer-term across merchant payments, consumers' products like savings and lending or peer-to-peer? And then how do you see social interactions tied in with payments evolving? Does messenger make payments better than what’s out there in the market? And then Dave, just a clarification. So the high end of the 4Q revenue guidance assumes a pretty sharp drop-off, even normalizing for some extra currency hit. So are you seeing anything out there that makes you concerned about pacing into the quarter or is it largely business as usual or it's just a tougher law of large numbers type situation?"
},
{
"speaker": "Mark Zuckerberg",
"text": "I’ll start on payment. So payments is an important part of the online business ecosystem, but we’ve traditionally thought about this as something that we’re going to partner with other companies on to enable great solutions, rather than trying to compete and do it as a business ourselves. And the reason why we’ve taken this approach is it's very important for all online businesses and our customers and partners that there is a good online payment system. People run ads to get customers and sell products and at the end of that conversion, if there is a good payment system that is smooth, then people will buy more things, which ultimately makes the ads and all of whole online flow more valuable for those partners and therefore more revenue and profit for our business as well. We view the ads part of the business as a more efficient part of the businesses than payments itself. Payments tends to be fixed fee whereas and ad, because of the option model, there is really good price discrimination built in. So a partner or business who is willing to pay us 30% of their revenue can bid that and some of these willing to only pay 5% of the revenue can bid that and the auction model inherently takes care of that. So we think that focusing on the ads part is going end up being the more effective thing for us to do but we realize that it’s important for the ad system over time for and for all of our partners for there to be a payment system, which is why we're excited about partnering with credit card companies and partnering with PayPal and all of the different folks doing online payments to make their solutions as good as possible as well."
},
{
"speaker": "Dave Wehner",
"text": "Hey Ross, it's Dave. Our view now is that Q4 revenue will come in that 40% to 47% year-over-year growth range. As I mentioned, Q4 of '13 was just an absolutely fantastic quarter for us. We had News Feed sort of rolled out at scale. It was our first $1 billion dollar mobile quarter. So we're comping against just really outstanding quarter last year. That's really the largest issue. You asked about currency. We did see the euro drop about 7% in value over the course of Q3 and that really didn't pick up as you saw. It didn't pick up in an impact in Q3 at all because it happened at the end of the quarter. So that will be a headwind that we see and that's factored into the guidance."
},
{
"speaker": "Operator",
"text": "Your next question comes from the Mark Mahaney with RBC Capital Markets. Your line is open."
},
{
"speaker": "Mark Mahaney - RBC Capital Markets",
"text": "Great, Sheryl. You talked about being careful about -- and slow about the rolling of the video ads -- auto play video ads and Instagram monetization. Have you seen any pushback in terms of user experiences to date on videos or on video ads, is that overall caution? Is there anything you've seen in the data that suggests that you want to keep it at a really slow pace? Thank you."
},
{
"speaker": "Sheryl Sandberg",
"text": "We're pleased with the consumer response we've had on both fronts and we remain really optimistic over the long run about Instagram and Video, because there's a lot of interest. I spoke before about creative story telling images. Video can be such a big part of that and it create a really resonant experience for brands and companies. We really believe in going slow, that as we grow products, we pay attention to the consumer experience. We want the consumer experience always to come first. So although we're very optimistic about the opportunity here, we continue to grow slowly and pay lot of attention to the quality of the advertising we see. To share one example, we are seeing people using both Facebook and Instagram and also Video and other ad products in combination. Mercedes Benz launched the GLA, which was their first compact SUV on Facebook and Instagram and they found that by doing Facebook and Instagram together, they got a 54% increase on their website visit. So a lot of our products as you do one, you also do more Facebook ads as well and that's something we're paying a lot of attention to."
},
{
"speaker": "Operator",
"text": "Then next question comes from Paul Vogel with Barclays. Your line is open."
},
{
"speaker": "Paul Vogel - Barclays",
"text": "I was just wondering if you could talk a little bit on the engagement side. Your DAUs to MAUs continue to be very strong. Can you just sort of maybe talk a little about your older cohorts versus your newer cohorts and how they're behaving and then also geographically? And then sort of on top of that, on the frequency side, obviously DAU doesn’t measure how often people come back more than once per day. So is there any update on increasing the frequency of visits? Thanks."
},
{
"speaker": "Dave Wehner",
"text": "I don’t think anything to update on the later front Paul, but the DAU to MAU ratio, which we focus on engagement was strong across all the geographic regions. So North America remains at the high end and we're really pleased with what we're seeing there. Nothing to update on cohorts. Obviously we are really pleased overall, what the mobile impact has on the DAU to MAU ratio and really encouraged what we're seeing across the Board on engagement. So I don’t think anything other than that specifically to call out."
},
{
"speaker": "Operator",
"text": "The next question comes from Mark May with Citi. Your line is open."
},
{
"speaker": "Mark May - Citi",
"text": "Thanks. For the last couple of years, -- back on the OpEx for next year guidance, for the last couple of years you've grown your cash OpEx by around a $1 billion a year with some consistency and I think that seems to be continuing in the second half of the year. But obviously your midpoint guidance -- OpEx guidance for next year represents a very significant - I think it's like 2.5% -- $2.5 billion increase at the midpoint. You obviously plan to change the level of investment in something quite significantly. So I'm just wondering if you could talk a little bit more specifically what are a couple of the projects that are capital intensive projects that you're planning for next year and is it physically possible to accelerate your hiring by that much next year?"
},
{
"speaker": "Dave Wehner",
"text": "Yes, thanks Mark. The projects really that Mark and Sheryl both outlined in terms of continuing to invest in the core Facebook experiences, growth engagement and monetization, they are building up the ad-tech side and the investments that we want to make, as well as the recent -- continuing to invest against the recent acquisitions that we made in terms of WhatsApp and Oculus. So it’s really the investments we're making there. We're also going to be supporting global growth with our Internet.org initiative, investing there. So it's a number of the key initiatives that Mark outlined in his comments that we’re investing against and again we’re giving a range on what we think is a reasonable range of guidance on that. You saw headcount. We had a good growth to headcount this quarter and we’re going to be continuing to invest as we think that these will be good investments over the long run in terms of being able to drop our long-term growth."
},
{
"speaker": "Operator",
"text": "The next question comes from John Blackledge with Cowen & Company. Your line is open."
},
{
"speaker": "John Blackledge - Cowen & Co.",
"text": "Just a couple of questions on video. How should we think about Facebook as a video platform and how does the mix of video between user generated versus public content versus professionally produced content evolve over time? And for example, is the upcoming short-film content produced by Lionsgate around the Twilight franchise that will be shown exclusively on Facebook. Would that increasingly be the type of content Facebook users will see in the future? And then if you could just give an update on the Instagram monthly active user comp, that would be great? Thank you."
},
{
"speaker": "Mark Zuckerberg",
"text": "I can speak to the video point. I think it's going to be all of the above in terms of what you said. Most of the content on Facebook is things that people are sharing with their friends and the people around them. So I think we’ll continue to see that in video as well. There's definitely the mis-trend over the last few years where, if you go back five years most of the content was text. Now a lot of it is photos and if you look in the future, as networks get letter and the ability to capture good video and share in a good way improves then -- I think that going forward a lot of the content that people share will be video. It's just a very compelling. There is also a lot of great public content that’s video, especially the shorter form content that they are mentioning I think will fit very well into the feed form factor that people consume on Facebook. So I think we’re going to see a lot of both of these things and it's going to be an evolution over the next few years. But I think you can expect to see a ramp up of all this."
},
{
"speaker": "Dave Wehner",
"text": "And on Instagram, we haven’t updated the number. They continue to grow nicely, but we haven’t announced a new public number on Instagram."
},
{
"speaker": "Operator",
"text": "The next question comes from Justin Post with Merrill Lynch. Your line is open."
},
{
"speaker": "Justin Post - Merrill Lynch",
"text": "Mark it seems like you taking a portfolio approach to apps and you've got a several different experiences for people on mobile devices and other devices. Can you give us your philosophy around that? And as people use things like WhatsApp and Instagram, is it actually, maybe partially hurting Facebook’s reported metrics and how do you think about putting this altogether and helping every app kind of work?"
},
{
"speaker": "Mark Zuckerberg",
"text": "Sure. So one of the things that’s happening on mobile is that there's an increased focus for apps to do one thing really well. Like so on desktop a lot of the things that might have fit well into a single Facebook website now are -- in order to best serve people, you need to build multiple standalone different apps. So we’re seeing that with Facebook and Messenger and the work that we did to kind of split out Messenger from the Facebook app to give a dedicated experience or an app that we think is a better experience. And we’re going to do more of that in the future, as well at the Facebook Creative Labs product that we’re releasing. Part of what we’ve seen is that the use cases for products like Instagram and WhatsApp are actually more different and nuanced from then the products that people compare them to, that Facebook had already built. So for example on the WhatsApp and Messenger side, Messenger is primarily used today for people to chat with their Facebook friends, within this context of maybe it's not like a real-time text. Like you would send an SMS on your phone, but it's something that you are sending to one of your Facebook friends and if they happen to be there, then you can text back and forth or maybe they respond later. SMS and WhatsApp are more for kind of real-time activity. People have contacts on WhatsApp who they wouldn’t want to make friends on Facebook. Their graphs are somewhat different. So one of the things that we found interestingly to us as well was that, Messenger and WhatsApp are actually growing quickly in the lot of the same countries. There's countries that they're growing in that are different and there are countries that they are growing in that are the same, which to me suggests that they actually are in more different markets than you probably intuitively would have thought and that was definitely our understanding as we dug more into this. Same with Instagram, and the type of sharing that happens on Instagram versus News Feed. We’ve recently started doing more to help promote and accelerate the growth of Instagram from the Facebook app itself because what we found is that by doing that, we’re net overall increasing the amount of sharing the people can do and connecting what they can do within our whole family of apps. So we're definitely seeing that this is all accretive and positive and we think that in the future there will probably be room for more apps for sharing as well."
},
{
"speaker": "Operator",
"text": "The next question comes from Anthony DiClemente with Nomura Securities. Your line is open."
},
{
"speaker": "Anthony DiClemente - Nomura Securities",
"text": "First for Sheryl, I want to just come back to the theme of media measurement you gave us in good perspective. Can you help me with first party data versus third party data? Can you get where you need to go with brand marketers using your in-house tools like Atlas or do you think you need the validity and integrity of a third party measurement source i.e. Nicholson in order to get there. And then second question for Mark. Mark I was just wondering, where do you see Facebook at this point in terms of its place in the hardware ecosystem? And given so much time is spend in your apps, do you think it’s possible that you could get more aggressive in devices, in hardware in order to achieve some of your longer-term or 10 year goals that you've laid out?"
},
{
"speaker": "Sheryl Sandberg",
"text": "To your first question, data is really important for both the measurement and targeting. And when you think about first party and third party data, you have to think about both of those usage. Certainly with measurement, third party verification of that data can be very important. A lot of our largest clients and agencies also build their own data systems, which are a very important part of measuring and kind of certifying everything we do with them. So we're using a combination of first party and third party. I think where this really gets interesting is around relevance. And as I spoke about, that's a major theme for us because we think one of the best things we can do to drive more value for marketers and improve the consumer experience on Facebook is improve relevance, and data is a great way of doing that. So for example with custom audiences, custom audiences is a combination of our clients using the data they have on their client base, combined with the data we have that we can target. Let's say target one ad to existing customers to get them to engage more and buy more; and one add to brand new customers. And you could see how you're different ads for people who have never bought your product and a different ad for people who are currently buying your product would make a lot of sense. And then you look at something like look alike audiences, where we're looking to map customers who share characteristics, age, demos, likes, interests with current customers. And all of this takes a combination of first party and third party data, all of which we do in a very privacy protected way."
},
{
"speaker": "Operator",
"text": "The next question comes from Stephen Ju with Credit Suisse. Your line is open."
},
{
"speaker": "Stephen Ju - Credit Suisse",
"text": "So Sheryl, from a product development perspective, it feels like from the outside looking in that you have accelerated the roll out and delivery of various products. So wondering how you are thinking about how your product delivery cadence will change, especially given the investments you have guided to for 2015. Thanks."
},
{
"speaker": "Mark Zuckerberg",
"text": "Before we go to that, I'll just quickly answer the hardware question that we didn’t get a chance to answer on the last question. We actually probably do more with hardware already than is apparent because we design and work with folks to build up all of our data centers and the servers there. So I do think that if that ever became the right thing for us to focus on from a product perspective, we have some of the skills there already. And when we are thinking about working Oculus, that's actually one of the areas where we think we can help out because we've up a supply chain team and we've been I think pretty effective at delivering what we've needed to run Facebook as this large system of scale. So -- but that said, I think that there is a huge amount of value in delivering these network and software services and that's where you should expect to focus, on the things that we talked about."
},
{
"speaker": "Sheryl Sandberg",
"text": "To the question about the roll out of products. I think the usual way we do things is that we roll out products slowly and then we iterate. So one example is custom audiences. We roll out custom audiences. Then we add on that website custom audiences to target ads to people visiting websites or then mobile app custom audiences, ads to people who have visited mobile apps. And one is building on the next, building on the next. Similarly, this month -- earlier this month we have launched local awareness targeting. It's a new option that allows local businesses to reach nearby customers. And what you saw that -- it wasn't a massive launch. It was a small launch where we enabled this targeting, get people to use it and we'll develop it. Then there are the exceptions such as Atlas. Atlas was one big launch that we're still in the process of doing and that's really because of the product that we've bought and needed to rebuild. But for the most part, our product development tends to be very iterative and that's what you can expect from us going forward."
},
{
"speaker": "Operator",
"text": "The next question comes from Youssef Squali with Cantor. Your line is open."
},
{
"speaker": "Youssef Squali - Cantor",
"text": "First question for Mark. Mark you recently came back from China. How do you think about that opportunity and what gives you the confidence that you can actually be successful where so many have failed. And then the second on Instagram; we've seen some very complementary data that shows that Instagram is actually becoming more popular than ever with some brand marketers. Just wondering what are the best performing ads formats on the platform right now and where is the ad load versus where Facebook is."
},
{
"speaker": "Mark Zuckerberg",
"text": "Sure. So on China, we're already doing more in China on the business side than I think a lot of folks think about. A lot of Chinese businesses use Facebook to grow their export businesses and to help find customers around the rest of the world and grow the Chinese economy there. So that's actually a pretty meaningful thing for us already and we always are looking to find ways to help businesses around the world to grow. And that will be just a long term thing. I mean our approach to China and all these -- and every country is very kind of long term. We're going to be here for decades and we want to create good relationships with these countries and businesses around the world that will help and grow over the long-term. On the Instagram side, I think we're pretty early. There have been a number of good ads, both video and images that I think have been pretty effective, but it's fairly early and in the growth phase at this point, the top priority for Instagram is to grow from 200 to more and eventually connect billion or more people and I think that that's something that should be possible and that’s what I'm really focused on and excited about now, while we also start building out some of the parts of the business as well."
},
{
"speaker": "Deborah Crawford",
"text": "Operator, we have time for one last question."
},
{
"speaker": "Operator",
"text": "Your last question will come from Scott Devitt with Stifel. Your line is open."
},
{
"speaker": "Scott Devitt - Stifel",
"text": "I think this question is for Sheryl. The app download business seems to have grown quickly and become a big contributor of the ad revenue total for Facebook and just wondering how you think about app reengagement relative to app downloads and which of those you think is a larger, long-term opportunity for the Company. Thanks."
},
{
"speaker": "Sheryl Sandberg",
"text": "I'm glad you asked the question because I think there has been some confusion around our mobile apps and our mobile app ads and our mobile app engagement ads. So engagement ads, it's still pretty early and we have rolled those out and rolled those out after mobile app ads. So we definitely seen lots of them. But we do think there is an opportunity. I think the broader point is that our growth in mobile ads is very broad based. It's across all market or segments and it's across all of our different ad formats and we talk about our mobile ad business growing. Mobile app ads are a small part of that, that's growing in line with our total business. The other thing that I think people get a little confused about is who is using mobile app ads. I think commonly when you think about mobile app ads, people often think about developers and developers are moving them and we're pleased we're able to help them grow. But they're also being used by some of the largest branders and marketers in the world. So for example Burger King. Burger King just used our mobile app ads to do app installs for their app. And the app was to find Burger King, look at their menu and nutritional options, use mobile coupons and use virtual gift cards. So that was one use of our mobile app ads, which is not what people typically think of."
},
{
"speaker": "Deborah Crawford",
"text": "Great. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again."
},
{
"speaker": "Operator",
"text": "This concludes today’s conference call. You may now disconnect."
}
] | null | null |
META | 2 | 2,014 | 2014-07-23 17:00:00 | Executives: Deborah Crawford - Director, IR Mark Zuckerberg - CEO Sheryl Sandberg - COO Dave Wehner - CFO
Analysts: Eric Sheridan - UBS Heather Bellini - Goldman Sachs Douglas Anmuth - JPMorgan Ross Sandler - Deutsche Bank Justin Post - Merrill Lynch Mark Mahaney - RBC Capital Markets Arvind Bhatia - Sterne Agee Neil Doshi - CRT Capital Ken Sena - Evercore Brian Nowak - SIG Brian Pitz - Jefferies Colin Sebastian - Robert Baird Ben Schachter - Macquarie
Operator: Good afternoon. My name is Jay and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook Second Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions). Thank you very much. Ms. Deborah Crawford, Facebook's Director of Investor Relations, you may begin.
Deborah Crawford: Thank you. Good afternoon and welcome to Facebook’s second quarter earnings conference call. Joining me today to talk about our results are Mark Zuckerberg, CEO, Sheryl Sandberg, COO and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements, and actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today’s press release and our Quarterly Report on Form 10-K filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these statements as a result of new information or future events. During this call we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today’s earnings press release. The press release and an accompanying investor presentation are available on our Web site at investor.fb.com. And now, I’d like to turn the call over to Mark.
Mark Zuckerberg: Thanks Deborah, and thanks everyone for joining today. This was a good quarter for us and a good end to the first half of the year. We’ve continued to grow our community in size and engagement with 1.32 billion people now connecting on Facebook each month, and 63% of them visiting daily. Our momentum remains especially strong on mobile to now 829 million people using Facebook everyday with more than 650 million people using our services on mobile every day. One thing that’s exciting is that there is still so much room to grow. On average, people on the Facebook in the U.S. spend around 40 minutes each day using our service, including about one in five minutes on mobile. This is more than any other app by are, but overall people in the U.S. spend about nine hours per day engaging with digital media on TVs, phones and computers. So there is a big opportunity to improve the way that people connect and share across -- how we all engage with the rest of media as well. Now when it comes to our business, we continue to be pleased with our growth. This quarter, our total revenue grew to over 2.9 billion and advertising revenue grew by 67% from a year ago. Mobile now accounts for 62% of our advertising revenue, which is a good sign of how the growth of our community mobile is also producing better business results for our partners. The results this quarter show our continued focus on improving our core products and business. We’re going to continue investing aggressively in areas that are important for our mission and long term strategy, but we’re also going to stay focused on our core products and business. This is the best way for us to continue creating value for our community. Now let’s talk about how we’re making progress and our three big company goals; connecting everyone; understanding the world; and building the knowledge economy. Our strategy for connecting everyone has two basic approaches. Our first approach is Internet.org; our effort to bring affordable Internet access to every person in the world. Our second approach is by giving everyone more tools for connecting, so they can share all the different kinds of content they want with the right people. Instagram, Messenger and creative laptops are a part of the second approach. So with Internet.org this quarter we’ve continued to deepen our partnerships with global operators and laid a foundation for running tests in more countries. Already, our initial partnerships in the Philippine, Paraguay and Tanzania have helped around 3 million people connect to the Internet who had no access before. We’re really proud of these early results. In June we acquired Pryte, which has a lot of expertise bringing affordable Internet access to communities by partnering with mobile operators, app developers and content providers. Later this year, we expect to launch a broader set of free basic Internet services in a number of other countries as well. In our app efforts, we’re continuing to build momentum with messaging. People now send than 12 billion messages a day on Facebook, and in April we reached 200 million monthly actives on messenger. Last month we announced that David Marcus will be joining us from PayPal to lead our messaging efforts. We expect David to continue growing Messenger, building out new experiences to serve our community and ultimately to build Messenger into an important business. Instagram continues to make great progress in giving people new ways to share their stories through photos and videos. Last month we made one of the biggest updates ever to Instagram by adding new creative tools that allow people to refine exactly how their photos look and feel. This is an important part of building out Instagram’s capability as a platform and serving the creativity of the Instagram community. Next, let’s talk about understanding the world. As of last month, on average, more than 1 billion search queries are made every day on Facebook. This is a great milestone and it shows we're in a unique position to answer a lot of questions for people. But this is just a start. And over the next few years as we make progress on building out search and our broader efforts in artificial intelligence, I expect us to deliver even greater utility for people. Our progress on public content is also very promising. As part of helping people to better understand the world, we want to help you connect around important public moments and personalities. And now nearly 800 million people on Facebook are connected to public figures. These connections are driving conversations at a huge scale. During the World Cup over 350 million people made over 3 billion interactions on Facebook. To enable even more of these conversations, we've improved the ranking of videos and newsfeed and launched new APIs to help TV and media organizations use Facebook content in their productions. Public content will continue to be a growing focus for us over the coming months and we plan to invest in building more great products and partnerships in this area. Now building great social experiences to serve our community isn’t something we do alone. Supporting developers is a key part of our strategy, and in our F8 conference in April we announced new ways to help mobile developers build, grow and monetize their apps. Over 1 billion people use Facebook on their phones every month and more than 80% of the top apps on iOS and Android now use Facebook logins. So we think we’re in a great position to be the cross platform-platform that lets developers build great apps across every platform. So far we’re very encouraged by the reaction from developers. App Links, our new method of deep linking to specific content in any app is now being used by 100s of apps across iOS, Android and Windows phone, with links to more than 1 billion individual destinations in these apps. We also launched our Audience Network, our first big effort to help developers monetize on mobile and we’ve received a lot of interest from developers. We’re rolling out the Audience Network gradually. We’re going to continue to ramp this app over the coming months and are excited by the opportunities ahead. Finally, let’s talk about our efforts to build the knowledge economy. This has been a strong period for us, and we’ve reached some new milestones in the business. Now more than 30 million small businesses use Facebook pages to connect with their customers and more than 1.5 million of them are active marketers on Facebook. To continue delivering the best returns for marketers, we’ve been very focused on improving the quality of the ad experiences for our community. Our goal here is to make ads as interesting and useful as your friend’s content on Facebook. We’re investing heavily in this area. In this quarter we launched a number of efforts to improve the quality and relevance of our ads, including our new ads preferences tool, interest based advertising and improvements to News Feed design to reduce low quality content. In some countries our surveys indicate that our ads are getting close to the quality level of organic content. But in most developed countries we still have lot to do. We expect to continue to focusing on this for a long time. So that’s my update on how we’ve been executing over the last quarter. It’s been a quarter with good performance and continued momentum. So I want to thank everyone who works with Facebook and is part of our community, including our shareholders and partners. Because of your efforts, we’re continuing to make progress towards our mission to help connect the world, and we’re improving 100s of millions of peoples’ lives every day. I am grateful for your support and to have the chance to work with all of you. Thanks and now here's Sheryl.
Sheryl Sandberg: Thanks Mark and hi everyone. As Mark said, we had a strong second quarter. Ad revenue grew 67% year-over-year to more than 2.6 billion. Mobile ad revenue grew 151% year-over-year and that makes up 62% of our ad revenue. We continue to focus on three key areas in investment; capitalizing on the shift to mobile; growing the number of marketers using Facebook; and building our ad products. These investments continue to generate broad based growth. All geographies and all marketer segments performed well this quarter. Our team has a really strong belief in what we’re building; the world’s first ad platform that delivers personalized marketing at scale. While we believe it’s still early days, we’re pleased with the progress we’re making and I want to join Mark in congratulating our global teams on their continued execution. Today I'm going to focus on two of our key marketer segments; small business and brand marketers, as well as cover some of the investments we’re making on the products in ad-tech front. We believe that personalized marketing of scale can drivers else for all types of marketers. Just a few weeks ago, I was in India and I hosted our first India SMB roundtable. One of the entrepreneurs I met, Vivek Prabhakar built his house just a few years ago to raise the money to start his and his wife’s dream business Chumbak, a company that makes India Inspired products. Facebook is Chumbak’s leading marketing channel and is responsible for 35% of online revenue and 38% of their Web site traffic. Their Facebook ads deliver a 5x return on advertising spend and has helped company grow to more than 150 employees in three offices. We have more than 30 million active small business pages, and over 19 million of these are active on mobile. We think we have a big opportunity to help SMBs like Chumbak grow their businesses, and I'm pleased to announce today that we have over 1.5 million active advertisers. We’re also ramping up our engagement with this community. In the U.S., we’re hosting Facebook Fit workshops in cities like New York, Chicago and Miami to help small businesses. And we’re doing this globally, including forming our first European SMB cap. We’re also making great strides in our work with our larger brands to increasingly recognize how our scale, targeting and measurement capabilities can drive great results. For example, P&G and Gillette worked with us and agencies IVS and Mediacom to launch its Vector III razor to men in India. 80% of the 100 million Facebook users in India are on mobile and a majority of these are using feature phones. This was our first feature phone only Facebook campaign. It reached 60% of Gillette's target audience and generated significant lift in both message and ad recall. As we work with brand marketers around the world, we focus on how they can leverage our technology platform to build their brands to create a story telling. We saw many great examples of this, at the recent online festival. We were excited that campaigns that make Facebook a key part of their effort took home prestigious awards. The World Cup also provided a great opportunity for brand building on Facebook. Facebook was an important part of this global event with 350 million people joining a conversation, generating 3 billion interactions. The final was the single most talked about sporting event in Facebook history, generating 280 million interactions from 88 million people. Brands such as Diesel, Nike, Ford and McDonalds capitalize on this global conversation. McDonalds worked with agencies, OMD, Framestore, and ARC sponsorship, as well as Facebook's Creative Shop to produce 30 videos that used french fries as players. FryFutbol recreated the most spectacular World Cup moments and ran them as videos the very next day with the french fries acting as the players. This campaign reached 125 million people in 158 countries. We also remain committed to investing in product development to drive higher returns for all of our marketers. Our custom audience's capabilities, which enable better targeting are been adopted quickly and are now been used by 91 Ad Age 100. Earlier this year, we launched website Custom Audiences, which enabled marketers to target recent visitors to their websites. This is likely targeting but it’s even more effective because it works across both web and mobile. We're pleased with the early reaction from marketers. We also introduced premium autoplay video ads this year. Video on Facebook helps brands extend their TV investments by combining traditional reach focus campaigns with our unparalleled targeting abilities. Today, we run about a dozen campaigns and the early data show promising results. We’ll continue to roll this product out slowly and carefully. Similarly we’re seeing positive early demand for marketers for ads on Instagram and we’re rolling these ads outs carefully as well. In all of this we remained focused on the transition to mobile. Our recently launched audience network lets advertisers use Facebook targeting while extending their campaign beyond Facebook. This can improve the relevance of ad peoples see both on and off Facebook and we’re encouraged by the early response. Finally, earlier this summer we announced the acquisition of LiveRail, a leading online video advertising platform that enables customers like MLB.com and A&E Networks to monetize their video inventory efficiently. We have a lot to do here, but with LiveRail we’re investing in tools that can improve the relevance of video ads across the web. In summary, we’re pleased with our performance and the progress we’re making. We're the first platform that can deliver personalized marketing at scale and marketers are increasingly recognizing to great result so we can drive for them. Staying focused and executing will remain a major thing for us moving forward. Our teams know that our future success depends upon our continued acquisition and our plan is to stay focused. Thanks. And now here is Dave.
Dave Wehner: Thanks, Sheryl. And good afternoon everyone. Q2 was a good quarter for us across our key operating and financial metrics. We generated strong revenue growth in operating margins and delivered $872 million of free cash flow and we continue to make investments to drive our core business, as well as to support our long term strategic priorities. Let’s start with a review of our network. We are executing well on our ongoing mission to connect everyone. 829 million people use Facebook on an average day in June, up 130 million from a year ago. This represents 63% of the 1.32 billion people who used Facebook during June. Mobile continues to be a strong driver of our growth with over 1 billion people using Facebook monthly on mobile. At the same time we’re enabling more ways for people to connect and share beyond the core Facebook app. For instance, both Instagram and Messenger have each passed over 200 million MAU and continue to grow nicely. Turning now to the financials, total revenue in the second quarter was 2.9 billion up 61% or 59% on a constant currency basis. Total ad revenue was $2.7 billion, up 67% or 65% on a constant currency basis. Ad revenue growth was strong around the world with each of our four geographic regions growing by over 60%. Mobile ad revenue was approximately 1.66 billion or 62% of ad revenue, compared to approximately $660 million or 41% of ad revenue last year. Desktop ad revenue was up 8% year-over-year. In Q2, the average affective price per ad increased 123% compared to last year, while total ad impressions declined 25%. The decrease in ad impressions continues to be driven by the shift towards mobile usage where people are shown fewer ads compared to desktop. The increase in the average price per ad was primarily driven by an increase in the percentage of our ads being served in News Feed. The price volume trends were generally consistent across all four reported geographic regions. Total payments and other fees revenue was $234 million up 9% versus last year. As we have noted in the past we believe the more meaningful comparison that better reflects the organic growth rate of the payments business, comes from looking at payments volume from games specifically, which was up 1% in Q2 versus last year. Our current games payment revenue comes entirely from desktop usage and we are seeing declines in the number of people using Facebook on desktop, a trend that will make growing this business challenging going forward. Turning to expenses, our Q2 GAAP expenses were $1.5 billion, up 22%, and our non-GAAP expenses were $1.2 billion, up 18%. Note that cost of revenue grew 2% on a GAAP basis and 1% on a non-GAAP basis, mainly driven by unusually high expenses in 2013 related to the transition out of certain leased data centers. This flatness in cost of revenue was the primary reason overall expenses grew relatively slowly. Operating expenses excluding cost of revenue grew 33% on a GAAP basis and 31% on a non-GAAP basis. We ended Q2 with 7185 employees, up 36% from last year. Our Q2 GAAP operating income was $1.4 billion, representing a 48% operating margin, up from 31% last year and our non-GAAP operating income was $1.7 billion, representing a 59% non-GAAP operating margin, up from 44% last year. Our GAAP and non-GAAP tax rates were 43% and 36%, respectively. GAAP net income was $791 million or $0.30 per share, and non-GAAP net income was $1.1 billion or $0.42 per share. In Q2, we spent $469 million on CapEx and generated $872 million of free cash flow. We ended Q2 with approximately $14 billion in cash and investments. This excludes the impact of the Oculus acquisition which was closed earlier this week and included am approximately $400 million cash payment. Now looking forward, let me start by noting that the forward-looking comments I’ll share today for 2014 include the impact from the recently closed acquisition of Oculus, but exclude except where otherwise noted the impact from WhatsApp which we continue to expect will close later this year. In terms of expenses, we expect that our total 2014 GAAP expenses, including cost of revenue and stock compensation, will likely grow in the neighborhood of 30% to 35%, and that our non-GAAP expenses, including cost of revenue but excluding stock compensation, will grow at a similar rate. These rates are slightly lower than our prior expectations due to the efficiencies in areas like cost of revenue and G&A. However, we believe that we are still in the early days of building out all of the services to maximize Facebook’s impact on the world and we intend to continue to invest aggressively in people, products and infrastructure in the second half of 2014 and beyond. Though it is premature to give a specific outlook for 2015 expenses, I wanted to note that we expect significant stock-based compensation and amortization expenses, as well as substantial incremental operating costs related to the acquisitions of Oculus and WhatsApp. This will add to our overall expenses in 2015 and subsequent periods. These costs will be incremental to core Facebook expenses, which will continue to grow significantly in 2015 as we ramp investments in people, products and infrastructure. For taxes, we expect GAAP and non-GAAP rates for the rest of 2014 to be similar to our Q2 rates, although these could vary widely depending on our international revenue and expense mix, and other factors, most notably the impact from acquisitions, including the expected closing of WhatsApp later this year. We continue to anticipate that 2014 CapEx will be approximately $2 billion to $2.5 billion. We expect shares outstanding to grow from around 2.6 billion at the end of 2013 to approximately 2.9 billion at the end of 2014, again assuming WhatsApp closes by the end of the year. Turning last to revenue. As we saw in Q2, our year-over-year growth rate declined from 72% in Q1 to 61% in Q2 or 59% on a constant currency basis. This is consistent with our comments on the Q1 call when we indicated that over the course of 2014, the year-over-year growth rates in revenue would decline meaningfully as the comps became more difficult. We expect this trend to continue over the course of the second half of the year. While we are excited about the long-term potential of our app initiatives like Instagram, autoplay video, and the Audience Network, we are still in the early days of building these businesses and expect their revenue contribution to remain small in the near term. We remain optimistic as ever about the long-term opportunity to grow revenue by improving the quality and relevance of our ads and increasing the value we bring to marketers through our products, tools and technologies. In summary, we're very pleased with our overall performance in Q2 and in particular the continued growth of our mobile audience, the strength of our ads business and the investments we're making to build long-term shareholder value. With that, Jay, let’s open up the call for questions
Operator: We will now open the line for a question-and-answer session. (Operator Instructions) Your first question comes from the line of Eric Sheridan with UBS. Please go ahead.
Deborah Crawford: Please go to next question.
Operator: Next we have Heather Bellini with Goldman Sachs. Please go ahead. We have our question from Eric Sheridan. Your line is open. Please go ahead.
Eric Sheridan - UBS: Sorry about that. I don’t know if you heard the question. But Sheryl, one on sort of Audience Network and LiveRail. Maybe you can give us a little better sense of the depth of the conversations with advertisers and what that might do to the platform longer term 2014 and beyond in terms of broadening out Facebook’s advertising effort? And second question Dave, on the Oculus and WhatsApp, is there any way to get a sense of employee counts at the companies or the pressure that we might see from OpEx going forward? Thanks.
Sheryl Sandberg: So I’ll start. One of the goals we have, we talk about in all of these calls is to make ads more relevant for people and marketers, and increasingly with the Audience Network we have a goal to do that for publishers as well. Video is really important. It’s one of the fastest growing ad mediums out there in both desktop and mobile. So LiveRail has a leading online video advertising platform and we think we can use it to effectively expand video ads to marketers and to publishers outside of Facebook and offer greater audience reach and ability to [indiscernible] video advertisers. When you look at the Audience Network, we’re still in really early days and we only have some publishers in our network. But we see this as an opportunity to provide greater reach for Facebook marketers and developers. Again, to improve the relevance of the ads people see both on and off Facebook.
Dave Wehner: Thanks Eric. On Oculus and WhatsApp, we’re in -- very much in investment mode on our overall business and we expect to continue to ramp investments in the core business through 2015. And like I said, we’ll be layering on top of that costs related to Oculus and WhatsApp. But we’re not getting into more specifics on the exact headcounts on those. But we believe those are significant opportunities in the long run and so we’re going to be investing aggressively accordingly.
Operator: Your next question comes from Heather Bellini with Goldman Sachs. Your line is open.
Heather Bellini - Goldman Sachs: Two quick questions from me. First would just be, if you could share with us any qualitative commentary about the breadth of mobile ad revenue. There is always a lot of debate back and forth about how big mobile app installs are. And if there is anything you could share with us about the breadth of these -- the breadth of mobile has kind of been changing over the last year or so? And then the follow up question would just be related to; how your conversations with advertisers are changing as people start to think collectively about their TV and video budget together. I'm just wondering if you’re starting to see your conversations with big TV advertisers start to change somewhat over the last six months or so? Thank you.
Sheryl Sandberg: So when you think about our mobile ads, and I'm really glad you asked this question. I do think sometimes people think that mobile app install ads are all of the revenue or a great majority of revenue and they’re not. They’re only part of the mobile ads revenue. Our mobile ads revenue is pretty, it’s broad based. We have large brand advertisers, small SMBs, direct response advertisers as well as developers using our mobile ads. The mobile app install ads, which are run not only by developers but also by large companies that want to get people to install apps are growing. They remain a good part of our mobile ads revenue and we’re excited about the opportunities there. But we see our opportunities in mobile ads as much broader than just installing apps. So the second question, I do think one of the things that’s happened in the last really year, year and a half on Facebook, is people understanding how strong the creative opportunity is. We’ve built out the technology platform and made our product investments and we’re really created particularly with the move to mobile and our ads on News Feed, an opportunity to do great creative story telling. A great recent example is the progressive baby ads if you’ve seen them. They’re really engaging and really fun, but they’re making a really important point, which is people should be buying their own insurance, but the ability for them to do that ad is based on the technology we created and also the great work they’ve done with Arnold Worldwide, their agency on the creative part. And so I think for a long time people have thought TV whisper creative storytelling and online ads work for more targeted text based results. And I think we’re seeing that change, which means that the way people approach TV, they’ll also approach Facebook and are starting to, which makes those budgets work much better together.
Operator: Your next question comes from the line of Douglas Anmuth with JPMorgan. Your line is open.
Douglas Anmuth - JPMorgan: Two things I wanted to ask. First Mark has been talking -- it was on your blog about testing a buy button within the platform. So I was hoping you could talk about how important you think commerce is to Facebook going forward and then perhaps also payments as well. And then secondly Sheryl, you mentioned some of the major brands that advertised during the World Cup. Do you talk about how you get the follow through from those brands, now that that major event has passed and how you keep those ad dollars on Facebook? Thanks.
Sheryl Sandberg: So, on the buy button, we launched a small test in the U.S. only, which enables people to hit a buy button and on pages or in page post ads on Facebook. It streamlines the process of buying from our clients. No one is buying from us. We’re just streamlining the process of buying from our clients. I think commerce is really important and is a growing important part of our business as all marketer segments are growing. But I don’t think people should confuse that with Facebook selling things directly. The more people buy online, the more people buy things they discover through their mobile phones, the more people discover things from a News Feed and go on to purchase, the more important we are in driving e-commerce and I think we are increasingly important. That doesn’t mean we’re going to or have to sell products.
Mark Zuckerberg: Yes, and I'd just add to that because some of the question was about payments that we will clearly do work in payments to accept payments for advertising and on platform and other things that we do. But just because we will do that, it doesn’t -- we still basically view ourselves as a partner to other companies in the payment space rather than trying to compete directly for that. Our main business is advertising and I think we're mostly, to the extent that we do payments, it’s going to be supportive to that. I wanted to make one more point, just related to that because I think some of the questions around payments are connected to what we’re planning on doing in the other apps outside of Facebook. So things like Messenger and WhatsApp over time, when that closes and Instagram, I really do just want to emphasize that there is a lot of work to set up the foundation for having a good business community and ecosystem and in those that we think it’s going to be years of work before those are huge businesses for us. And I'm liking where we are now on something like the Messenger, to where we were on Facebook in like 2006 or 2007, where it was primarily consumer product at that time where you really only communicated with friends. And a bunch of people asked us, and said that we should put ads. But before we did that we wanted to create really good organic consumer experiences for people to interact with different entities. So we created Pages, so people could interact with organic businesses. And then in order to make it so that businesses and public figures and folks would create pages, we offered Insights on different products. And we gave all those things away for free. Pages were free and continue to be free and that’s partially why we have 30 million businesses today, using Pages on the platform, and Insights, we kind of give away for free in order to enable more folks to use Pages. Then only after we had a good kind of organic interaction that people could and would want to interact with these different businesses and entities; that we really layer ads on top of that and start to build the business that we have today. So I just think it is worth emphasizing this because we’ve said in a number of comments that we think that some of these newer initiatives are going to ramp over time. We really do mean that. And we are serious about doing this the right way and building up new ecosystems and I think that’s for some of these apps, we’re just kind of build all the infrastructure that we need to make it be something that's scalable over time, rather than trying to have this be an impact that you will notice in the next, I don’t know, short-term period of time.
Sheryl Sandberg: To the World Cup part of your question; brands certainly use the World Cup and big events like this to launch things as they continue to as ad campaign. They also have other big events that come along as well as their own events around product launches. And so we think, obviously not every day is a World Cup, but there are lots of opportunities throughout the year and through the product cycle to work with brand advertisers in big ways.
Operator: Your next question comes from Ross Sandler with Deutsche Bank. Your line is open.
Ross Sandler - Deutsche Bank: I have one question for Mark on the product side and then one for Dave. Mark, so App Links just launched, if you go out a few years, how much do you think something like deep linking could increase engagement or ad effectiveness for Facebook and for those 1 billion links that you have up and running already, what are you seeing in those early tests? And then Dave, we know you don’t breakout the price versus volume metrics for Mobile, but just directionally could you give us some color on how the ad-impression growth in mobile compares with the 31% BAU growth in mobile.
Mark Zuckerberg: Sure, so I don’t have much color that’s useful to share here on App Links. It's still early. People have marked up a bunch of apps with this metadata, that allows us to search for it, but Search for Facebook is going to be a multiyear voyage and there is just so much content that is unique to the Facebook ecosystem that we can answer questions for you that really no other service can. Just like the other day I was curious about finding out which of one of my friend’s friend, like at a company. And it’s like I don’t know any other service where you can just go do that query but on Facebook you can and the secret to this is going to be basically just over a long period of time indexing all of the different content that's on Facebook in every different way. So we started off with people. There's obviously a need to be able to find people in order to use the product and add friends and just have our core kind of ecosystem work but we're indexing more into connections and now we're getting into more of the content and it's a huge amount of contents. I think there was more than a trillion posts, which some of the search engineers on the team like to remind me is bigger than any web search corpus that’s out there. But that’s just kind of one part of the data, and we’re going to keep on doing more and more. We're going to start of focusing on stuff that’s unique to Facebook, that you couldn’t really answer those questions elsewhere. App Links by definition of being outside of Facebook are not going to be unique to Facebook. So we'll get to that overtime. I think it will be a valuable part of the ecosystem. But honestly we're mostly interested in that to enable value for other developers and pushing distribution to them than we are for our own search. It’s going to enable interesting ways for a developer to be able to make a set of people in their app, can share content on Facebook and then link directly to the right part of the app, and enable some engagement ads. So that way a developer can say a person was using my app and they were going to buy something but they dropped out of the checkout flow. So we’re going to have an ad that helps them link right back to the checkout flow, so that they can complete their conversion. And you want deep linking to be able to enable things like that but it’s going to take a while for it to play out with search.
Dave Wehner: Yes, and Ross on your question on mobile ads. Mobile BAU is ramping nicely, 39% growth and we’re seeing it grow nicely across all of our geographic regions. Of course mobile ads are ramping as well. In terms of pricing we don’t break it out but on the reported pricing trend, as I was, as I think I made clear, the 123% increase in price was driven by a mix shift with a higher percentage of News Feed ads. And new feed ads are really effective for marketers and that includes mobile News Feed ads as well. They deliver a lot of value for marketers. That’s why they’re getting a higher price in the auction, because the price of ads really correlates to the value that they create. And we continue to focus on making those ad units better and better, more relevant and targeted for the people who use Facebook as well as for marketers. And we’re seeing good results. Marketers are getting good ROI and they’re coming back and spending more with us. So we’re pleased about all of that.
Operator: Your next question comes from Justin Post with Merrill Lynch. Your line is open.
Justin Post - Merrill Lynch: I’d like to follow up a little bit on the ad pricing, obviously up 122%. Sheryl maybe you can comment a little bit about the organic growth for like for ads there? And do you see opportunities to continue to see nice pricing growth as you look out the next couple of years? And then as you think about the new ad formats, video and other things, would you think that could continue to drive pricing higher, meaning new ad formats could drive even more value than the existing ads that you have on Facebook? Thank you.
Dave Wehner: Justin, its Dave. Just following up on that, in terms of the pricing as I said, it’s really about the mix shift towards the News Feed ads is what’s driving the overall reported pricing trends but we are focused on making our ads all better and driving better returns for our marketers. And we see that reflected in the price. There's other things, for instance. We’re making our right hand column ads more effective by changing the format of those. Those will be higher value to our marketers because they’ll drive more engagement. And it will -- but there’ll be fewer of them. So that will impact pricing. But everything that we’re doing is about trying to drive more value for our marketers, as well as trying to drive more relevant ad experiences for the people who use Facebook. And if we’re successful in doing that, we’ll drive ROI for the marketers, we’ll drive good experiences and we’ll get good pricing.
Operator: Your next question comes from Mark Mahaney with RBC Capital Markets. Your line is open.
Mark Mahaney - RBC Capital Markets: Thanks. Two questions please. Anything you could share with us with regards to China and efforts to develop more of a presence there? And then maybe a follow up question on David Marcus coming over and somebody with a huge payments background running the Messaging product, it’s kind of like hiring -- signing Messi up to the Miami Heat, like it’s little of an odd transition. Are we looking at it wrong? Is there any particular reason why he wouldn’t be more focused on payments? Thank you.
Sheryl Sandberg: So I’ll talk about China. Our mission is to enable everyone in the world to share and connect. And so, we’ve been studying and learning about China for a number of years and we remain very interested. We are seeing Chinese based companies use Facebook to reach the global audience and we are -- we think we have an important opportunity just with their export market and we’re focused on that for now.
Mark Zuckerberg: Yes, and I mean on messenger and David, I think he is just a real talented product generalist. He's done a number of different things, including in his past he ran and built a messaging company. Most recently clearly he ran a very important company and I think was pretty successful in helping get really good results there. Messenger will have -- over time there will be some overlap between that and payments. But I guess what I'm just trying to say is two things. One is, the payments piece will be a part of what will help drive the overall success and help people share with each other and interact with businesses. But we’re really focused on the interactions overall, rather than the mechanism and David shares that view. And the second thing is just that there's so much ground work that we need to do in order to make it so that people are communicating with businesses and public figures and entities in these other apps that we’re building, which is part of the business ecosystem. And I really can’t underscore that enough that we have a lot of work to do and we could take the cheap and easy approach and just try to put ads in or do payments and make some money in the short term. But we’re not going to do that. So to the extent that any of your models or anything reflects that we might be doing that, I would strongly encourage you hereon to just that, because we’re not going to and we’re going to take time to do this in the way that we think that’s going to be right over multiple years.
Operator: Your next question comes from Arvind Bhatia with Sterne Agee. Your line is open.
Arvind Bhatia - Sterne Agee: Just a quick question on WhatsApp. I realized it hasn’t closed yet. But can you give us any indications to us on kind of the user trends and engagement, et cetera? Sheryl you mentioned India where we see a lot of usage coming out of there for WhatsApp in particular?
Dave Wehner: No, the deal hasn’t closed. We have nothing to say.
Operator: Our next question comes from Neil Doshi with CRT Capital. Your line is open.
Neil Doshi - CRT Capital: Sheryl, I think attribution it could be a very big opportunity, especially for local businesses to help them realize ROIs. People going from online to offline. With 30 million businesses now on Facebook, how are you helping those businesses realize the online to offline conversation to Facebook, to drive more dollars going to local businesses? Thanks.
Sheryl Sandberg: I agree strongly that this is a huge opportunity. Our goal with all of our clients, from the biggest to the smallest is to drive their business results and as usually selling a product, sometimes online but often in stores. We’ve done a lot of work over the last year to measurement. We talk about measurement in all of these calls and that’s because investing measurement and connecting not just some online to online, but online to offline is super important. Because that we can prove those results to our marketers large and small, they'll continue to invest. We think we have a real advantage here, that we have real identity. We have real identity across the desktop and across mobile. And we have found ways, in very privacy protective ways to work with third parties -- third party users of data to connect offline sales to online ads and those investments remain a very big focus for us.
Operator: Your next question comes from Ken Sena with Evercore. Your line is open.
Ken Sena - Evercore: So you mentioned over 1 billion users, 80% of app developers use the Facebook login on iOS and Android. When we think about Facebook as a platform, can you provide any stats on the number of developers who are starting to build their experience on Facebook? And then how do they need to be to see things like app linking, data formats, auto play video or other? Thanks.
Mark Zuckerberg: We’ve shifted to this model on mobile where developers aren’t really building their apps inside Facebook, right. So we’re not an operating system. We had a little bit more of this dynamic with Ken, just on desktop, but now we’ve shifted the strategy to helping developers with three things, build, grow and monetize their apps. And we have a number of services that developers can plug into their apps to help out with all three of those. So for example we have -- and for helping people build their app, we do things like login and we have services like parse that help developers build apps more easily. That stuff is all great for helping folks build social apps in a way that's faster than they could have otherwise. In terms of growth, I think we offer tools like sharing and messaging that people can enable. Our developer can enable their users to be able to organically spread the app. We also have things like app installs and engagement ads that make it so that developers and pay to increase that. And then on the monetize side, we are rolling out the Audience Network and we have -- and then I guess on canvas we have things like payments to help developers monetize and that’s an increasing focus as well and Audience Network is new and it’s getting started. So it’s -- again it’s one of the things that will be pretty slow for a while but we really want do a great. But that’s going to be an important part to this as well. So I think that’s kind of how you want to think about developers. And right now we’re really proud about 80% of the top developers, the value and touching a part of our platform. We obviously want to get the last 20, but we’re excited about that the progress so far.
Sheryl Sandberg: And in terms of those developers using our different ad products, as we say we roll out slowly and slowly. Usually we pick a handful of advertisers to work with us, certainly what we’ve been doing on autoplay video ads. But in time our goal is to make our ad products available to all of our marketer segments and that’s what we'll work on. So over the long run, any developer, any small or large business, whether they're using other parts of our platform or not, would be able to purchase any type of our ads.
Operator: Your next question comes from Brian Nowak with SIG. Your line is open.
Brian Nowak - SIG: I have two. The first one is on the video ads. You mentioned it’s the early days on video advertising and just wondering, if you could talk to some of your early learnings, what you’re pleased with and where you see areas for improvement and which metrics your gauging to determine when to undergo a broader roll out. And then secondly on the -- I think you mentioned the larger higher quality LiveRail desktop ads. There has been some changes in experimentation around that inventory. How does the advertiser receptivity bend to those ad units compared to the old LiveRail and where are those dollars coming from? Is that new dollars to the platform or are they are shifting from old sponsored stories or LiveRail. Thanks.
Mark Zuckerberg: So I’ll talk about video and then Sheryl can answer on the right hand column. The biggest thing that we want to make sure is that quality is really good as we roll this out and that’s going to be the same on all of these different initiatives. And one of the reasons why we’re optimistic about video ad is that -- in autoplay specifically is the format for both organic and paid content is that you’re scrolling through a feed and you -- if the content catches your eye and you like it, then it’s playing and it's loaded and you can just easily continue watching it or otherwise the person has complete control, and if they don’t like it, they can just keep on going through it. So the content has to be really good and we think that that’s going to be a real high quality experience. There are still a number of things that we really want to prove and make sure that we're doing well here. We want to make sure that when people are see an autoplay video, that’s not only paid content. We want a lot of that to be organic content as well. So we're trying to ramp up the amount of public content and content that people share at that same time as we're ramping up on the autoplay video ads. We also want to make sure that this doesn’t consume a lot of people’s data. So we're just being really careful about how we handle that and getting that really right across different markets, that’s going to be a different thing that we want to be really sensitive to. So it really just -- in a word this all comes down to quality and we’re more focused on just making sure that this is the right and best thing over time than something in the near term. And that I think is a theme of a lot of the areas that we’ve talked about, whether it’s new apps that we are building, things like Messenger or Instagram and what we're doing there, working with Audience Network, which we just announced or video ads. There's just a lot of things that we're super excited about and obviously will talk about them publically because we’re working with partners and we’re excited to talk about them here as well because we do really think that these are going to be great things to help build businesses overtime. But we want to make sure that we don’t get ahead of ourselves because these things are early and quality is the most important thing for growing this the right way overtime.
Sheryl Sandburg : On the right hand column redesign; the redesign was driven by making the ads more consistent with News Feed which results in fewer but larger ads. But they just don’t come from any one place and I think when you think about Facebook's growing part in the ad ecosystem, you really have to think about ad dollars shifting online as the majority of the driver of budget shifting and ad dollars coming on to mobile. We are pleased that we see higher engagement rates from the people who were shown in new ads compared to the old, which makes us optimistic that these are more valuable.
Operator: Your next question comes from Brian Pitz with Jefferies. Your line is open.
Brian Pitz - Jefferies: Maybe a question in a different direction regarding privacy and maybe you could just walk us through your current thoughts. The reason I asked is because Facebook recently introduced the anonymous login product at F8 this year and new services like save or hidden from friends unless users specifically opt in, can you just give us a sense, is this kind of a change of a strategic shift in thinking or tone with regards to privacy? Thank you so much.
Mark Zuckerberg: This is - it’s a really important question, I think somebody is misunderstood about Facebook. One of the things that we focused on the most is creating private faces for people to share things and have interactions that they couldn’t have had elsewhere. So if you go back to the very beginning of Facebook, we’re more than 10 years. There were blogs and things where you could be completely public and there were emails right. So you could circulate something completely privately. So there was no space where you could share with just your friends and have that -- it wasn’t a completely private experience, but it's not completely public and that it's 100 or 150 of the people that you care about. And creating that space, which was a space that had the kind of privacy that no one had ever seen before was what enabled and continues to enable the kind of interactions and the content that people feel comfortable sharing in this network that don’t exist in other places in the world. So we're comfortably looking for new opportunities to create new dynamics like that and open up new different private spaces for people where they can then feel comfortable sharing and having the freedom to express something you otherwise wouldn’t be able to. It’s one of the reasons why I'm personally so excited about messaging. Because like right now I think at some level, there are only so many photos that you’re going to want to share with all of your friends. We still think that there's more to do there but it's like the amount of messaging and how quickly we see that growing, it's crazy. Because like there is just a lot more that people want to express and that they need the tools to express with smaller groups of people, not just one person at a time but smaller groups as well. Things like anonymous login totally unlocks different behavior. So how many times would you want to sign in to an app but you don’t necessarily want to share a lot of information with that app but if you can do it anonymously, we think that can unlock of lot of different interactions and experiences that people want to have. So we do our jobs as like very fundamentally providing people with these spaces and tools, which I think is very different from how a lot of people think about what Facebook is but it’s an important thing to think about how we do our product development.
Operator: Your next question comes from Colin Sebastian with Robert Baird. Your line is open.
Colin Sebastian - Robert Baird: I have a couple of questions as well. First on mobile advertising and ad loads, just curious what you are seeing in terms of the ad load thresholds? Is that you are at the point now where the relevancy and quality of ads means that you can take that up perhaps a little bit? And then secondly on Oculus and Virtual Reality applications, how should we think about the pace of development of this technology and the potential integration with Facebook’s applications? Thank you.
Dave Wehner: I can take care of the mobile ad load question. So ad load is really one of dozens of factors that we focus on. Others are of course the quality, the relevance and then the prominence of the ads. And we monitor the sentiment and engagement of people, engaging in News Feed and we’re really pleased with the strength of sentiment and engagement as we’ve ramped up News Feed apps and we feel like we’re in a good position, given where we are with that to continue to grow the advertising business, while driving good user experience. So we’re in a good place on that.
Mark Zuckerberg: I can talk about Oculus. So we’re really excited about this the acquisition just closed earlier this week and we’re really excited to welcome that team. They’re extremely talented and they’ve pulled off something that people have been talking about for a really long time and now it’s possible, given the technology that this team has developed. And this hits on a different part of our strategy, which -- the way that I organize my remarks every quarter are around these 10 year goals and themes that we have for the Company, connecting everyone, understanding the world, helping to build the knowledge economy and these future platforms. So when I'm talking about how I think things like the businesses that we’re talking about are further out than you think, I think that this stuff is actually even further out than that. But there are huge opportunities to build the next generation of computing platform. When mobile was getting defined we were basically just getting founded, in 2004. The first Smartphone came out and 2003. And we have mostly been a company that has played on top of the different mobile foundations that other companies have built. And one of the things that I care really deeply about on some of the tenures arc for the company is having a different relationship to whatever the next set of computing platforms are and investing accordingly now to make sure that when the next set of computing platforms get defined, we can help define what the next generation of computing is going to be. So I think virtual reality, augmented reality, vision, some of the AI work that we’re doing, is all going to play into this in an important way. And I just think while I was emphasizing that we’re early on some of those businesses and we’re not going to rush those. The flip side to the coin is to emphasize that we’re also going to spend a lot and invest very heavily in a bunch of these things to do it right over the long term. And so I think David pointed out that we expect to continue investing heavily and that our costs will increase. And I just want to underscore that as well, because I expect that continue to be true and it’s not that we’re necessarily going to go out and have a lot more new strategic priorities, but we expect to go very deep on the priorities that we have to make sure that we completely nail them all, whether it’s a five year or a 10 year time frame.
Deborah Crawford: Operator, I think we have time for one last question.
Operator: Your last question will come from Ben Schachter with Macquarie. Your line is open.
Ben Schachter - Macquarie: Thanks for taking my question. Mark you talked about the focus on public content. Does that include a focus on exclusive content that we should be expecting to pay for or have revenue share agreements with the content with some key public figures? Separately on Search, I think you still have a quite a large team working on it, including Search, but our greatest point, we haven’t seen many changes since the original played the graph as part of the launch. So when should we expect to see those improvements and how would you rank Search in terms of with your priorities? And then finally just a quick housekeeping question; David, the D&A continues to trend down over the past few quarters. Why is that happening and should we expect that to continue?
Dave Wehner: I can take the D&A question first if you’d like. So ultimately depreciation is going to track more folks closely against the CapEx. So in the first half of the year we’ve been aggressively investing in the things we want to invest and that includes infrastructure. So CapEx is up 40% in the first half of the year. There are some investments that we’re making notably in the Iowa datacenter, also the new headquarters we’re building where those facilities have not gone into service. So they’re not hitting depreciation yet. So, we’re making the big investments in CapEx that will ultimately flow through in Depreciation. So I think in short the answer to your question is we’ll see depreciation come up as those things come online.
Mark Zuckerberg: And I guess I can answer the other. So on public content, we actually do get a lot of exclusive content. We don’t pay for it. But I mean so -- this week for example I think Shakira hit her 100 million fans moment on Facebook. And part of the reason why some of these public figures and political leaders and folks have such big following is because they’re constantly providing insight into their lives and unique types of contents that other folks -- that you can’t get anywhere else. And there is a format that I think make sense for Facebook. It’s not and you’re not going to come to Facebook to watch a movie or watch a whole TV show. That’s really long form stuff. But I mean in the modes that we have today in our service that kind of attraction is the best place for a number of types of content like this that we’re starting to see that we get. So we’re mostly focused on driving success for our partners, where they are news organizations that are publishing content that people share or public figures and individuals who are engaging directly on Facebook. Our view is that the more success in distribution and engagement we can drive for them, the better the content and the quality that they’re going to invest in building for Facebook. And types of search, I think -- I mentioned in my opening remarks that this quarter I think for the first time we are over on average 1 billion searches a day, which is awesome and it's something that we’re really proud of and have worked a lot on, especially given that we generally found that people search a little bit less on average on mobile. So we went through a period where in order to have that increase, we had to like do some really good work and make it a lot faster and improve ranking and do a lot of the basic things that needed to get done. There is just so much more content that needs to get indexed. So if you want to go find that Shakira video that I was just talking about, I don’t know if today the product fully delivers on that but it will soon and in the next six months we’re going to be able to do that and then if we do well and them a year later we’re going to have more content in the system and be able to index that better. So it’s an ongoing thing. There is huge potential. There are a lot of questions that only Facebook can answer, that other services aren’t going to be able to answer for you. We’re really committed to investing in that and building out this unique service over the long-term. And I think at some point there is going to be an inflection where it starts to be useful for a lot of used cases. But that may still be years away. But we’re just committed to doing this investment and making this right.
Deborah Crawford: Great. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again.
Operator: This concludes today’s conference call. You may now disconnect. | [
{
"speaker": "Executives",
"text": "Deborah Crawford - Director, IR Mark Zuckerberg - CEO Sheryl Sandberg - COO Dave Wehner - CFO"
},
{
"speaker": "Analysts",
"text": "Eric Sheridan - UBS Heather Bellini - Goldman Sachs Douglas Anmuth - JPMorgan Ross Sandler - Deutsche Bank Justin Post - Merrill Lynch Mark Mahaney - RBC Capital Markets Arvind Bhatia - Sterne Agee Neil Doshi - CRT Capital Ken Sena - Evercore Brian Nowak - SIG Brian Pitz - Jefferies Colin Sebastian - Robert Baird Ben Schachter - Macquarie"
},
{
"speaker": "Operator",
"text": "Good afternoon. My name is Jay and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook Second Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions). Thank you very much. Ms. Deborah Crawford, Facebook's Director of Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford",
"text": "Thank you. Good afternoon and welcome to Facebook’s second quarter earnings conference call. Joining me today to talk about our results are Mark Zuckerberg, CEO, Sheryl Sandberg, COO and Dave Wehner, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements, and actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today’s press release and our Quarterly Report on Form 10-K filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these statements as a result of new information or future events. During this call we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today’s earnings press release. The press release and an accompanying investor presentation are available on our Web site at investor.fb.com. And now, I’d like to turn the call over to Mark."
},
{
"speaker": "Mark Zuckerberg",
"text": "Thanks Deborah, and thanks everyone for joining today. This was a good quarter for us and a good end to the first half of the year. We’ve continued to grow our community in size and engagement with 1.32 billion people now connecting on Facebook each month, and 63% of them visiting daily. Our momentum remains especially strong on mobile to now 829 million people using Facebook everyday with more than 650 million people using our services on mobile every day. One thing that’s exciting is that there is still so much room to grow. On average, people on the Facebook in the U.S. spend around 40 minutes each day using our service, including about one in five minutes on mobile. This is more than any other app by are, but overall people in the U.S. spend about nine hours per day engaging with digital media on TVs, phones and computers. So there is a big opportunity to improve the way that people connect and share across -- how we all engage with the rest of media as well. Now when it comes to our business, we continue to be pleased with our growth. This quarter, our total revenue grew to over 2.9 billion and advertising revenue grew by 67% from a year ago. Mobile now accounts for 62% of our advertising revenue, which is a good sign of how the growth of our community mobile is also producing better business results for our partners. The results this quarter show our continued focus on improving our core products and business. We’re going to continue investing aggressively in areas that are important for our mission and long term strategy, but we’re also going to stay focused on our core products and business. This is the best way for us to continue creating value for our community. Now let’s talk about how we’re making progress and our three big company goals; connecting everyone; understanding the world; and building the knowledge economy. Our strategy for connecting everyone has two basic approaches. Our first approach is Internet.org; our effort to bring affordable Internet access to every person in the world. Our second approach is by giving everyone more tools for connecting, so they can share all the different kinds of content they want with the right people. Instagram, Messenger and creative laptops are a part of the second approach. So with Internet.org this quarter we’ve continued to deepen our partnerships with global operators and laid a foundation for running tests in more countries. Already, our initial partnerships in the Philippine, Paraguay and Tanzania have helped around 3 million people connect to the Internet who had no access before. We’re really proud of these early results. In June we acquired Pryte, which has a lot of expertise bringing affordable Internet access to communities by partnering with mobile operators, app developers and content providers. Later this year, we expect to launch a broader set of free basic Internet services in a number of other countries as well. In our app efforts, we’re continuing to build momentum with messaging. People now send than 12 billion messages a day on Facebook, and in April we reached 200 million monthly actives on messenger. Last month we announced that David Marcus will be joining us from PayPal to lead our messaging efforts. We expect David to continue growing Messenger, building out new experiences to serve our community and ultimately to build Messenger into an important business. Instagram continues to make great progress in giving people new ways to share their stories through photos and videos. Last month we made one of the biggest updates ever to Instagram by adding new creative tools that allow people to refine exactly how their photos look and feel. This is an important part of building out Instagram’s capability as a platform and serving the creativity of the Instagram community. Next, let’s talk about understanding the world. As of last month, on average, more than 1 billion search queries are made every day on Facebook. This is a great milestone and it shows we're in a unique position to answer a lot of questions for people. But this is just a start. And over the next few years as we make progress on building out search and our broader efforts in artificial intelligence, I expect us to deliver even greater utility for people. Our progress on public content is also very promising. As part of helping people to better understand the world, we want to help you connect around important public moments and personalities. And now nearly 800 million people on Facebook are connected to public figures. These connections are driving conversations at a huge scale. During the World Cup over 350 million people made over 3 billion interactions on Facebook. To enable even more of these conversations, we've improved the ranking of videos and newsfeed and launched new APIs to help TV and media organizations use Facebook content in their productions. Public content will continue to be a growing focus for us over the coming months and we plan to invest in building more great products and partnerships in this area. Now building great social experiences to serve our community isn’t something we do alone. Supporting developers is a key part of our strategy, and in our F8 conference in April we announced new ways to help mobile developers build, grow and monetize their apps. Over 1 billion people use Facebook on their phones every month and more than 80% of the top apps on iOS and Android now use Facebook logins. So we think we’re in a great position to be the cross platform-platform that lets developers build great apps across every platform. So far we’re very encouraged by the reaction from developers. App Links, our new method of deep linking to specific content in any app is now being used by 100s of apps across iOS, Android and Windows phone, with links to more than 1 billion individual destinations in these apps. We also launched our Audience Network, our first big effort to help developers monetize on mobile and we’ve received a lot of interest from developers. We’re rolling out the Audience Network gradually. We’re going to continue to ramp this app over the coming months and are excited by the opportunities ahead. Finally, let’s talk about our efforts to build the knowledge economy. This has been a strong period for us, and we’ve reached some new milestones in the business. Now more than 30 million small businesses use Facebook pages to connect with their customers and more than 1.5 million of them are active marketers on Facebook. To continue delivering the best returns for marketers, we’ve been very focused on improving the quality of the ad experiences for our community. Our goal here is to make ads as interesting and useful as your friend’s content on Facebook. We’re investing heavily in this area. In this quarter we launched a number of efforts to improve the quality and relevance of our ads, including our new ads preferences tool, interest based advertising and improvements to News Feed design to reduce low quality content. In some countries our surveys indicate that our ads are getting close to the quality level of organic content. But in most developed countries we still have lot to do. We expect to continue to focusing on this for a long time. So that’s my update on how we’ve been executing over the last quarter. It’s been a quarter with good performance and continued momentum. So I want to thank everyone who works with Facebook and is part of our community, including our shareholders and partners. Because of your efforts, we’re continuing to make progress towards our mission to help connect the world, and we’re improving 100s of millions of peoples’ lives every day. I am grateful for your support and to have the chance to work with all of you. Thanks and now here's Sheryl."
},
{
"speaker": "Sheryl Sandberg",
"text": "Thanks Mark and hi everyone. As Mark said, we had a strong second quarter. Ad revenue grew 67% year-over-year to more than 2.6 billion. Mobile ad revenue grew 151% year-over-year and that makes up 62% of our ad revenue. We continue to focus on three key areas in investment; capitalizing on the shift to mobile; growing the number of marketers using Facebook; and building our ad products. These investments continue to generate broad based growth. All geographies and all marketer segments performed well this quarter. Our team has a really strong belief in what we’re building; the world’s first ad platform that delivers personalized marketing at scale. While we believe it’s still early days, we’re pleased with the progress we’re making and I want to join Mark in congratulating our global teams on their continued execution. Today I'm going to focus on two of our key marketer segments; small business and brand marketers, as well as cover some of the investments we’re making on the products in ad-tech front. We believe that personalized marketing of scale can drivers else for all types of marketers. Just a few weeks ago, I was in India and I hosted our first India SMB roundtable. One of the entrepreneurs I met, Vivek Prabhakar built his house just a few years ago to raise the money to start his and his wife’s dream business Chumbak, a company that makes India Inspired products. Facebook is Chumbak’s leading marketing channel and is responsible for 35% of online revenue and 38% of their Web site traffic. Their Facebook ads deliver a 5x return on advertising spend and has helped company grow to more than 150 employees in three offices. We have more than 30 million active small business pages, and over 19 million of these are active on mobile. We think we have a big opportunity to help SMBs like Chumbak grow their businesses, and I'm pleased to announce today that we have over 1.5 million active advertisers. We’re also ramping up our engagement with this community. In the U.S., we’re hosting Facebook Fit workshops in cities like New York, Chicago and Miami to help small businesses. And we’re doing this globally, including forming our first European SMB cap. We’re also making great strides in our work with our larger brands to increasingly recognize how our scale, targeting and measurement capabilities can drive great results. For example, P&G and Gillette worked with us and agencies IVS and Mediacom to launch its Vector III razor to men in India. 80% of the 100 million Facebook users in India are on mobile and a majority of these are using feature phones. This was our first feature phone only Facebook campaign. It reached 60% of Gillette's target audience and generated significant lift in both message and ad recall. As we work with brand marketers around the world, we focus on how they can leverage our technology platform to build their brands to create a story telling. We saw many great examples of this, at the recent online festival. We were excited that campaigns that make Facebook a key part of their effort took home prestigious awards. The World Cup also provided a great opportunity for brand building on Facebook. Facebook was an important part of this global event with 350 million people joining a conversation, generating 3 billion interactions. The final was the single most talked about sporting event in Facebook history, generating 280 million interactions from 88 million people. Brands such as Diesel, Nike, Ford and McDonalds capitalize on this global conversation. McDonalds worked with agencies, OMD, Framestore, and ARC sponsorship, as well as Facebook's Creative Shop to produce 30 videos that used french fries as players. FryFutbol recreated the most spectacular World Cup moments and ran them as videos the very next day with the french fries acting as the players. This campaign reached 125 million people in 158 countries. We also remain committed to investing in product development to drive higher returns for all of our marketers. Our custom audience's capabilities, which enable better targeting are been adopted quickly and are now been used by 91 Ad Age 100. Earlier this year, we launched website Custom Audiences, which enabled marketers to target recent visitors to their websites. This is likely targeting but it’s even more effective because it works across both web and mobile. We're pleased with the early reaction from marketers. We also introduced premium autoplay video ads this year. Video on Facebook helps brands extend their TV investments by combining traditional reach focus campaigns with our unparalleled targeting abilities. Today, we run about a dozen campaigns and the early data show promising results. We’ll continue to roll this product out slowly and carefully. Similarly we’re seeing positive early demand for marketers for ads on Instagram and we’re rolling these ads outs carefully as well. In all of this we remained focused on the transition to mobile. Our recently launched audience network lets advertisers use Facebook targeting while extending their campaign beyond Facebook. This can improve the relevance of ad peoples see both on and off Facebook and we’re encouraged by the early response. Finally, earlier this summer we announced the acquisition of LiveRail, a leading online video advertising platform that enables customers like MLB.com and A&E Networks to monetize their video inventory efficiently. We have a lot to do here, but with LiveRail we’re investing in tools that can improve the relevance of video ads across the web. In summary, we’re pleased with our performance and the progress we’re making. We're the first platform that can deliver personalized marketing at scale and marketers are increasingly recognizing to great result so we can drive for them. Staying focused and executing will remain a major thing for us moving forward. Our teams know that our future success depends upon our continued acquisition and our plan is to stay focused. Thanks. And now here is Dave."
},
{
"speaker": "Dave Wehner",
"text": "Thanks, Sheryl. And good afternoon everyone. Q2 was a good quarter for us across our key operating and financial metrics. We generated strong revenue growth in operating margins and delivered $872 million of free cash flow and we continue to make investments to drive our core business, as well as to support our long term strategic priorities. Let’s start with a review of our network. We are executing well on our ongoing mission to connect everyone. 829 million people use Facebook on an average day in June, up 130 million from a year ago. This represents 63% of the 1.32 billion people who used Facebook during June. Mobile continues to be a strong driver of our growth with over 1 billion people using Facebook monthly on mobile. At the same time we’re enabling more ways for people to connect and share beyond the core Facebook app. For instance, both Instagram and Messenger have each passed over 200 million MAU and continue to grow nicely. Turning now to the financials, total revenue in the second quarter was 2.9 billion up 61% or 59% on a constant currency basis. Total ad revenue was $2.7 billion, up 67% or 65% on a constant currency basis. Ad revenue growth was strong around the world with each of our four geographic regions growing by over 60%. Mobile ad revenue was approximately 1.66 billion or 62% of ad revenue, compared to approximately $660 million or 41% of ad revenue last year. Desktop ad revenue was up 8% year-over-year. In Q2, the average affective price per ad increased 123% compared to last year, while total ad impressions declined 25%. The decrease in ad impressions continues to be driven by the shift towards mobile usage where people are shown fewer ads compared to desktop. The increase in the average price per ad was primarily driven by an increase in the percentage of our ads being served in News Feed. The price volume trends were generally consistent across all four reported geographic regions. Total payments and other fees revenue was $234 million up 9% versus last year. As we have noted in the past we believe the more meaningful comparison that better reflects the organic growth rate of the payments business, comes from looking at payments volume from games specifically, which was up 1% in Q2 versus last year. Our current games payment revenue comes entirely from desktop usage and we are seeing declines in the number of people using Facebook on desktop, a trend that will make growing this business challenging going forward. Turning to expenses, our Q2 GAAP expenses were $1.5 billion, up 22%, and our non-GAAP expenses were $1.2 billion, up 18%. Note that cost of revenue grew 2% on a GAAP basis and 1% on a non-GAAP basis, mainly driven by unusually high expenses in 2013 related to the transition out of certain leased data centers. This flatness in cost of revenue was the primary reason overall expenses grew relatively slowly. Operating expenses excluding cost of revenue grew 33% on a GAAP basis and 31% on a non-GAAP basis. We ended Q2 with 7185 employees, up 36% from last year. Our Q2 GAAP operating income was $1.4 billion, representing a 48% operating margin, up from 31% last year and our non-GAAP operating income was $1.7 billion, representing a 59% non-GAAP operating margin, up from 44% last year. Our GAAP and non-GAAP tax rates were 43% and 36%, respectively. GAAP net income was $791 million or $0.30 per share, and non-GAAP net income was $1.1 billion or $0.42 per share. In Q2, we spent $469 million on CapEx and generated $872 million of free cash flow. We ended Q2 with approximately $14 billion in cash and investments. This excludes the impact of the Oculus acquisition which was closed earlier this week and included am approximately $400 million cash payment. Now looking forward, let me start by noting that the forward-looking comments I’ll share today for 2014 include the impact from the recently closed acquisition of Oculus, but exclude except where otherwise noted the impact from WhatsApp which we continue to expect will close later this year. In terms of expenses, we expect that our total 2014 GAAP expenses, including cost of revenue and stock compensation, will likely grow in the neighborhood of 30% to 35%, and that our non-GAAP expenses, including cost of revenue but excluding stock compensation, will grow at a similar rate. These rates are slightly lower than our prior expectations due to the efficiencies in areas like cost of revenue and G&A. However, we believe that we are still in the early days of building out all of the services to maximize Facebook’s impact on the world and we intend to continue to invest aggressively in people, products and infrastructure in the second half of 2014 and beyond. Though it is premature to give a specific outlook for 2015 expenses, I wanted to note that we expect significant stock-based compensation and amortization expenses, as well as substantial incremental operating costs related to the acquisitions of Oculus and WhatsApp. This will add to our overall expenses in 2015 and subsequent periods. These costs will be incremental to core Facebook expenses, which will continue to grow significantly in 2015 as we ramp investments in people, products and infrastructure. For taxes, we expect GAAP and non-GAAP rates for the rest of 2014 to be similar to our Q2 rates, although these could vary widely depending on our international revenue and expense mix, and other factors, most notably the impact from acquisitions, including the expected closing of WhatsApp later this year. We continue to anticipate that 2014 CapEx will be approximately $2 billion to $2.5 billion. We expect shares outstanding to grow from around 2.6 billion at the end of 2013 to approximately 2.9 billion at the end of 2014, again assuming WhatsApp closes by the end of the year. Turning last to revenue. As we saw in Q2, our year-over-year growth rate declined from 72% in Q1 to 61% in Q2 or 59% on a constant currency basis. This is consistent with our comments on the Q1 call when we indicated that over the course of 2014, the year-over-year growth rates in revenue would decline meaningfully as the comps became more difficult. We expect this trend to continue over the course of the second half of the year. While we are excited about the long-term potential of our app initiatives like Instagram, autoplay video, and the Audience Network, we are still in the early days of building these businesses and expect their revenue contribution to remain small in the near term. We remain optimistic as ever about the long-term opportunity to grow revenue by improving the quality and relevance of our ads and increasing the value we bring to marketers through our products, tools and technologies. In summary, we're very pleased with our overall performance in Q2 and in particular the continued growth of our mobile audience, the strength of our ads business and the investments we're making to build long-term shareholder value. With that, Jay, let’s open up the call for questions"
},
{
"speaker": "Operator",
"text": "We will now open the line for a question-and-answer session. (Operator Instructions) Your first question comes from the line of Eric Sheridan with UBS. Please go ahead."
},
{
"speaker": "Deborah Crawford",
"text": "Please go to next question."
},
{
"speaker": "Operator",
"text": "Next we have Heather Bellini with Goldman Sachs. Please go ahead. We have our question from Eric Sheridan. Your line is open. Please go ahead."
},
{
"speaker": "Eric Sheridan - UBS",
"text": "Sorry about that. I don’t know if you heard the question. But Sheryl, one on sort of Audience Network and LiveRail. Maybe you can give us a little better sense of the depth of the conversations with advertisers and what that might do to the platform longer term 2014 and beyond in terms of broadening out Facebook’s advertising effort? And second question Dave, on the Oculus and WhatsApp, is there any way to get a sense of employee counts at the companies or the pressure that we might see from OpEx going forward? Thanks."
},
{
"speaker": "Sheryl Sandberg",
"text": "So I’ll start. One of the goals we have, we talk about in all of these calls is to make ads more relevant for people and marketers, and increasingly with the Audience Network we have a goal to do that for publishers as well. Video is really important. It’s one of the fastest growing ad mediums out there in both desktop and mobile. So LiveRail has a leading online video advertising platform and we think we can use it to effectively expand video ads to marketers and to publishers outside of Facebook and offer greater audience reach and ability to [indiscernible] video advertisers. When you look at the Audience Network, we’re still in really early days and we only have some publishers in our network. But we see this as an opportunity to provide greater reach for Facebook marketers and developers. Again, to improve the relevance of the ads people see both on and off Facebook."
},
{
"speaker": "Dave Wehner",
"text": "Thanks Eric. On Oculus and WhatsApp, we’re in -- very much in investment mode on our overall business and we expect to continue to ramp investments in the core business through 2015. And like I said, we’ll be layering on top of that costs related to Oculus and WhatsApp. But we’re not getting into more specifics on the exact headcounts on those. But we believe those are significant opportunities in the long run and so we’re going to be investing aggressively accordingly."
},
{
"speaker": "Operator",
"text": "Your next question comes from Heather Bellini with Goldman Sachs. Your line is open."
},
{
"speaker": "Heather Bellini - Goldman Sachs",
"text": "Two quick questions from me. First would just be, if you could share with us any qualitative commentary about the breadth of mobile ad revenue. There is always a lot of debate back and forth about how big mobile app installs are. And if there is anything you could share with us about the breadth of these -- the breadth of mobile has kind of been changing over the last year or so? And then the follow up question would just be related to; how your conversations with advertisers are changing as people start to think collectively about their TV and video budget together. I'm just wondering if you’re starting to see your conversations with big TV advertisers start to change somewhat over the last six months or so? Thank you."
},
{
"speaker": "Sheryl Sandberg",
"text": "So when you think about our mobile ads, and I'm really glad you asked this question. I do think sometimes people think that mobile app install ads are all of the revenue or a great majority of revenue and they’re not. They’re only part of the mobile ads revenue. Our mobile ads revenue is pretty, it’s broad based. We have large brand advertisers, small SMBs, direct response advertisers as well as developers using our mobile ads. The mobile app install ads, which are run not only by developers but also by large companies that want to get people to install apps are growing. They remain a good part of our mobile ads revenue and we’re excited about the opportunities there. But we see our opportunities in mobile ads as much broader than just installing apps. So the second question, I do think one of the things that’s happened in the last really year, year and a half on Facebook, is people understanding how strong the creative opportunity is. We’ve built out the technology platform and made our product investments and we’re really created particularly with the move to mobile and our ads on News Feed, an opportunity to do great creative story telling. A great recent example is the progressive baby ads if you’ve seen them. They’re really engaging and really fun, but they’re making a really important point, which is people should be buying their own insurance, but the ability for them to do that ad is based on the technology we created and also the great work they’ve done with Arnold Worldwide, their agency on the creative part. And so I think for a long time people have thought TV whisper creative storytelling and online ads work for more targeted text based results. And I think we’re seeing that change, which means that the way people approach TV, they’ll also approach Facebook and are starting to, which makes those budgets work much better together."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Douglas Anmuth with JPMorgan. Your line is open."
},
{
"speaker": "Douglas Anmuth - JPMorgan",
"text": "Two things I wanted to ask. First Mark has been talking -- it was on your blog about testing a buy button within the platform. So I was hoping you could talk about how important you think commerce is to Facebook going forward and then perhaps also payments as well. And then secondly Sheryl, you mentioned some of the major brands that advertised during the World Cup. Do you talk about how you get the follow through from those brands, now that that major event has passed and how you keep those ad dollars on Facebook? Thanks."
},
{
"speaker": "Sheryl Sandberg",
"text": "So, on the buy button, we launched a small test in the U.S. only, which enables people to hit a buy button and on pages or in page post ads on Facebook. It streamlines the process of buying from our clients. No one is buying from us. We’re just streamlining the process of buying from our clients. I think commerce is really important and is a growing important part of our business as all marketer segments are growing. But I don’t think people should confuse that with Facebook selling things directly. The more people buy online, the more people buy things they discover through their mobile phones, the more people discover things from a News Feed and go on to purchase, the more important we are in driving e-commerce and I think we are increasingly important. That doesn’t mean we’re going to or have to sell products."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yes, and I'd just add to that because some of the question was about payments that we will clearly do work in payments to accept payments for advertising and on platform and other things that we do. But just because we will do that, it doesn’t -- we still basically view ourselves as a partner to other companies in the payment space rather than trying to compete directly for that. Our main business is advertising and I think we're mostly, to the extent that we do payments, it’s going to be supportive to that. I wanted to make one more point, just related to that because I think some of the questions around payments are connected to what we’re planning on doing in the other apps outside of Facebook. So things like Messenger and WhatsApp over time, when that closes and Instagram, I really do just want to emphasize that there is a lot of work to set up the foundation for having a good business community and ecosystem and in those that we think it’s going to be years of work before those are huge businesses for us. And I'm liking where we are now on something like the Messenger, to where we were on Facebook in like 2006 or 2007, where it was primarily consumer product at that time where you really only communicated with friends. And a bunch of people asked us, and said that we should put ads. But before we did that we wanted to create really good organic consumer experiences for people to interact with different entities. So we created Pages, so people could interact with organic businesses. And then in order to make it so that businesses and public figures and folks would create pages, we offered Insights on different products. And we gave all those things away for free. Pages were free and continue to be free and that’s partially why we have 30 million businesses today, using Pages on the platform, and Insights, we kind of give away for free in order to enable more folks to use Pages. Then only after we had a good kind of organic interaction that people could and would want to interact with these different businesses and entities; that we really layer ads on top of that and start to build the business that we have today. So I just think it is worth emphasizing this because we’ve said in a number of comments that we think that some of these newer initiatives are going to ramp over time. We really do mean that. And we are serious about doing this the right way and building up new ecosystems and I think that’s for some of these apps, we’re just kind of build all the infrastructure that we need to make it be something that's scalable over time, rather than trying to have this be an impact that you will notice in the next, I don’t know, short-term period of time."
},
{
"speaker": "Sheryl Sandberg",
"text": "To the World Cup part of your question; brands certainly use the World Cup and big events like this to launch things as they continue to as ad campaign. They also have other big events that come along as well as their own events around product launches. And so we think, obviously not every day is a World Cup, but there are lots of opportunities throughout the year and through the product cycle to work with brand advertisers in big ways."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ross Sandler with Deutsche Bank. Your line is open."
},
{
"speaker": "Ross Sandler - Deutsche Bank",
"text": "I have one question for Mark on the product side and then one for Dave. Mark, so App Links just launched, if you go out a few years, how much do you think something like deep linking could increase engagement or ad effectiveness for Facebook and for those 1 billion links that you have up and running already, what are you seeing in those early tests? And then Dave, we know you don’t breakout the price versus volume metrics for Mobile, but just directionally could you give us some color on how the ad-impression growth in mobile compares with the 31% BAU growth in mobile."
},
{
"speaker": "Mark Zuckerberg",
"text": "Sure, so I don’t have much color that’s useful to share here on App Links. It's still early. People have marked up a bunch of apps with this metadata, that allows us to search for it, but Search for Facebook is going to be a multiyear voyage and there is just so much content that is unique to the Facebook ecosystem that we can answer questions for you that really no other service can. Just like the other day I was curious about finding out which of one of my friend’s friend, like at a company. And it’s like I don’t know any other service where you can just go do that query but on Facebook you can and the secret to this is going to be basically just over a long period of time indexing all of the different content that's on Facebook in every different way. So we started off with people. There's obviously a need to be able to find people in order to use the product and add friends and just have our core kind of ecosystem work but we're indexing more into connections and now we're getting into more of the content and it's a huge amount of contents. I think there was more than a trillion posts, which some of the search engineers on the team like to remind me is bigger than any web search corpus that’s out there. But that’s just kind of one part of the data, and we’re going to keep on doing more and more. We're going to start of focusing on stuff that’s unique to Facebook, that you couldn’t really answer those questions elsewhere. App Links by definition of being outside of Facebook are not going to be unique to Facebook. So we'll get to that overtime. I think it will be a valuable part of the ecosystem. But honestly we're mostly interested in that to enable value for other developers and pushing distribution to them than we are for our own search. It’s going to enable interesting ways for a developer to be able to make a set of people in their app, can share content on Facebook and then link directly to the right part of the app, and enable some engagement ads. So that way a developer can say a person was using my app and they were going to buy something but they dropped out of the checkout flow. So we’re going to have an ad that helps them link right back to the checkout flow, so that they can complete their conversion. And you want deep linking to be able to enable things like that but it’s going to take a while for it to play out with search."
},
{
"speaker": "Dave Wehner",
"text": "Yes, and Ross on your question on mobile ads. Mobile BAU is ramping nicely, 39% growth and we’re seeing it grow nicely across all of our geographic regions. Of course mobile ads are ramping as well. In terms of pricing we don’t break it out but on the reported pricing trend, as I was, as I think I made clear, the 123% increase in price was driven by a mix shift with a higher percentage of News Feed ads. And new feed ads are really effective for marketers and that includes mobile News Feed ads as well. They deliver a lot of value for marketers. That’s why they’re getting a higher price in the auction, because the price of ads really correlates to the value that they create. And we continue to focus on making those ad units better and better, more relevant and targeted for the people who use Facebook as well as for marketers. And we’re seeing good results. Marketers are getting good ROI and they’re coming back and spending more with us. So we’re pleased about all of that."
},
{
"speaker": "Operator",
"text": "Your next question comes from Justin Post with Merrill Lynch. Your line is open."
},
{
"speaker": "Justin Post - Merrill Lynch",
"text": "I’d like to follow up a little bit on the ad pricing, obviously up 122%. Sheryl maybe you can comment a little bit about the organic growth for like for ads there? And do you see opportunities to continue to see nice pricing growth as you look out the next couple of years? And then as you think about the new ad formats, video and other things, would you think that could continue to drive pricing higher, meaning new ad formats could drive even more value than the existing ads that you have on Facebook? Thank you."
},
{
"speaker": "Dave Wehner",
"text": "Justin, its Dave. Just following up on that, in terms of the pricing as I said, it’s really about the mix shift towards the News Feed ads is what’s driving the overall reported pricing trends but we are focused on making our ads all better and driving better returns for our marketers. And we see that reflected in the price. There's other things, for instance. We’re making our right hand column ads more effective by changing the format of those. Those will be higher value to our marketers because they’ll drive more engagement. And it will -- but there’ll be fewer of them. So that will impact pricing. But everything that we’re doing is about trying to drive more value for our marketers, as well as trying to drive more relevant ad experiences for the people who use Facebook. And if we’re successful in doing that, we’ll drive ROI for the marketers, we’ll drive good experiences and we’ll get good pricing."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mark Mahaney with RBC Capital Markets. Your line is open."
},
{
"speaker": "Mark Mahaney - RBC Capital Markets",
"text": "Thanks. Two questions please. Anything you could share with us with regards to China and efforts to develop more of a presence there? And then maybe a follow up question on David Marcus coming over and somebody with a huge payments background running the Messaging product, it’s kind of like hiring -- signing Messi up to the Miami Heat, like it’s little of an odd transition. Are we looking at it wrong? Is there any particular reason why he wouldn’t be more focused on payments? Thank you."
},
{
"speaker": "Sheryl Sandberg",
"text": "So I’ll talk about China. Our mission is to enable everyone in the world to share and connect. And so, we’ve been studying and learning about China for a number of years and we remain very interested. We are seeing Chinese based companies use Facebook to reach the global audience and we are -- we think we have an important opportunity just with their export market and we’re focused on that for now."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yes, and I mean on messenger and David, I think he is just a real talented product generalist. He's done a number of different things, including in his past he ran and built a messaging company. Most recently clearly he ran a very important company and I think was pretty successful in helping get really good results there. Messenger will have -- over time there will be some overlap between that and payments. But I guess what I'm just trying to say is two things. One is, the payments piece will be a part of what will help drive the overall success and help people share with each other and interact with businesses. But we’re really focused on the interactions overall, rather than the mechanism and David shares that view. And the second thing is just that there's so much ground work that we need to do in order to make it so that people are communicating with businesses and public figures and entities in these other apps that we’re building, which is part of the business ecosystem. And I really can’t underscore that enough that we have a lot of work to do and we could take the cheap and easy approach and just try to put ads in or do payments and make some money in the short term. But we’re not going to do that. So to the extent that any of your models or anything reflects that we might be doing that, I would strongly encourage you hereon to just that, because we’re not going to and we’re going to take time to do this in the way that we think that’s going to be right over multiple years."
},
{
"speaker": "Operator",
"text": "Your next question comes from Arvind Bhatia with Sterne Agee. Your line is open."
},
{
"speaker": "Arvind Bhatia - Sterne Agee",
"text": "Just a quick question on WhatsApp. I realized it hasn’t closed yet. But can you give us any indications to us on kind of the user trends and engagement, et cetera? Sheryl you mentioned India where we see a lot of usage coming out of there for WhatsApp in particular?"
},
{
"speaker": "Dave Wehner",
"text": "No, the deal hasn’t closed. We have nothing to say."
},
{
"speaker": "Operator",
"text": "Our next question comes from Neil Doshi with CRT Capital. Your line is open."
},
{
"speaker": "Neil Doshi - CRT Capital",
"text": "Sheryl, I think attribution it could be a very big opportunity, especially for local businesses to help them realize ROIs. People going from online to offline. With 30 million businesses now on Facebook, how are you helping those businesses realize the online to offline conversation to Facebook, to drive more dollars going to local businesses? Thanks."
},
{
"speaker": "Sheryl Sandberg",
"text": "I agree strongly that this is a huge opportunity. Our goal with all of our clients, from the biggest to the smallest is to drive their business results and as usually selling a product, sometimes online but often in stores. We’ve done a lot of work over the last year to measurement. We talk about measurement in all of these calls and that’s because investing measurement and connecting not just some online to online, but online to offline is super important. Because that we can prove those results to our marketers large and small, they'll continue to invest. We think we have a real advantage here, that we have real identity. We have real identity across the desktop and across mobile. And we have found ways, in very privacy protective ways to work with third parties -- third party users of data to connect offline sales to online ads and those investments remain a very big focus for us."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ken Sena with Evercore. Your line is open."
},
{
"speaker": "Ken Sena - Evercore",
"text": "So you mentioned over 1 billion users, 80% of app developers use the Facebook login on iOS and Android. When we think about Facebook as a platform, can you provide any stats on the number of developers who are starting to build their experience on Facebook? And then how do they need to be to see things like app linking, data formats, auto play video or other? Thanks."
},
{
"speaker": "Mark Zuckerberg",
"text": "We’ve shifted to this model on mobile where developers aren’t really building their apps inside Facebook, right. So we’re not an operating system. We had a little bit more of this dynamic with Ken, just on desktop, but now we’ve shifted the strategy to helping developers with three things, build, grow and monetize their apps. And we have a number of services that developers can plug into their apps to help out with all three of those. So for example we have -- and for helping people build their app, we do things like login and we have services like parse that help developers build apps more easily. That stuff is all great for helping folks build social apps in a way that's faster than they could have otherwise. In terms of growth, I think we offer tools like sharing and messaging that people can enable. Our developer can enable their users to be able to organically spread the app. We also have things like app installs and engagement ads that make it so that developers and pay to increase that. And then on the monetize side, we are rolling out the Audience Network and we have -- and then I guess on canvas we have things like payments to help developers monetize and that’s an increasing focus as well and Audience Network is new and it’s getting started. So it’s -- again it’s one of the things that will be pretty slow for a while but we really want do a great. But that’s going to be an important part to this as well. So I think that’s kind of how you want to think about developers. And right now we’re really proud about 80% of the top developers, the value and touching a part of our platform. We obviously want to get the last 20, but we’re excited about that the progress so far."
},
{
"speaker": "Sheryl Sandberg",
"text": "And in terms of those developers using our different ad products, as we say we roll out slowly and slowly. Usually we pick a handful of advertisers to work with us, certainly what we’ve been doing on autoplay video ads. But in time our goal is to make our ad products available to all of our marketer segments and that’s what we'll work on. So over the long run, any developer, any small or large business, whether they're using other parts of our platform or not, would be able to purchase any type of our ads."
},
{
"speaker": "Operator",
"text": "Your next question comes from Brian Nowak with SIG. Your line is open."
},
{
"speaker": "Brian Nowak - SIG",
"text": "I have two. The first one is on the video ads. You mentioned it’s the early days on video advertising and just wondering, if you could talk to some of your early learnings, what you’re pleased with and where you see areas for improvement and which metrics your gauging to determine when to undergo a broader roll out. And then secondly on the -- I think you mentioned the larger higher quality LiveRail desktop ads. There has been some changes in experimentation around that inventory. How does the advertiser receptivity bend to those ad units compared to the old LiveRail and where are those dollars coming from? Is that new dollars to the platform or are they are shifting from old sponsored stories or LiveRail. Thanks."
},
{
"speaker": "Mark Zuckerberg",
"text": "So I’ll talk about video and then Sheryl can answer on the right hand column. The biggest thing that we want to make sure is that quality is really good as we roll this out and that’s going to be the same on all of these different initiatives. And one of the reasons why we’re optimistic about video ad is that -- in autoplay specifically is the format for both organic and paid content is that you’re scrolling through a feed and you -- if the content catches your eye and you like it, then it’s playing and it's loaded and you can just easily continue watching it or otherwise the person has complete control, and if they don’t like it, they can just keep on going through it. So the content has to be really good and we think that that’s going to be a real high quality experience. There are still a number of things that we really want to prove and make sure that we're doing well here. We want to make sure that when people are see an autoplay video, that’s not only paid content. We want a lot of that to be organic content as well. So we're trying to ramp up the amount of public content and content that people share at that same time as we're ramping up on the autoplay video ads. We also want to make sure that this doesn’t consume a lot of people’s data. So we're just being really careful about how we handle that and getting that really right across different markets, that’s going to be a different thing that we want to be really sensitive to. So it really just -- in a word this all comes down to quality and we’re more focused on just making sure that this is the right and best thing over time than something in the near term. And that I think is a theme of a lot of the areas that we’ve talked about, whether it’s new apps that we are building, things like Messenger or Instagram and what we're doing there, working with Audience Network, which we just announced or video ads. There's just a lot of things that we're super excited about and obviously will talk about them publically because we’re working with partners and we’re excited to talk about them here as well because we do really think that these are going to be great things to help build businesses overtime. But we want to make sure that we don’t get ahead of ourselves because these things are early and quality is the most important thing for growing this the right way overtime."
},
{
"speaker": "Sheryl Sandburg",
"text": "On the right hand column redesign; the redesign was driven by making the ads more consistent with News Feed which results in fewer but larger ads. But they just don’t come from any one place and I think when you think about Facebook's growing part in the ad ecosystem, you really have to think about ad dollars shifting online as the majority of the driver of budget shifting and ad dollars coming on to mobile. We are pleased that we see higher engagement rates from the people who were shown in new ads compared to the old, which makes us optimistic that these are more valuable."
},
{
"speaker": "Operator",
"text": "Your next question comes from Brian Pitz with Jefferies. Your line is open."
},
{
"speaker": "Brian Pitz - Jefferies",
"text": "Maybe a question in a different direction regarding privacy and maybe you could just walk us through your current thoughts. The reason I asked is because Facebook recently introduced the anonymous login product at F8 this year and new services like save or hidden from friends unless users specifically opt in, can you just give us a sense, is this kind of a change of a strategic shift in thinking or tone with regards to privacy? Thank you so much."
},
{
"speaker": "Mark Zuckerberg",
"text": "This is - it’s a really important question, I think somebody is misunderstood about Facebook. One of the things that we focused on the most is creating private faces for people to share things and have interactions that they couldn’t have had elsewhere. So if you go back to the very beginning of Facebook, we’re more than 10 years. There were blogs and things where you could be completely public and there were emails right. So you could circulate something completely privately. So there was no space where you could share with just your friends and have that -- it wasn’t a completely private experience, but it's not completely public and that it's 100 or 150 of the people that you care about. And creating that space, which was a space that had the kind of privacy that no one had ever seen before was what enabled and continues to enable the kind of interactions and the content that people feel comfortable sharing in this network that don’t exist in other places in the world. So we're comfortably looking for new opportunities to create new dynamics like that and open up new different private spaces for people where they can then feel comfortable sharing and having the freedom to express something you otherwise wouldn’t be able to. It’s one of the reasons why I'm personally so excited about messaging. Because like right now I think at some level, there are only so many photos that you’re going to want to share with all of your friends. We still think that there's more to do there but it's like the amount of messaging and how quickly we see that growing, it's crazy. Because like there is just a lot more that people want to express and that they need the tools to express with smaller groups of people, not just one person at a time but smaller groups as well. Things like anonymous login totally unlocks different behavior. So how many times would you want to sign in to an app but you don’t necessarily want to share a lot of information with that app but if you can do it anonymously, we think that can unlock of lot of different interactions and experiences that people want to have. So we do our jobs as like very fundamentally providing people with these spaces and tools, which I think is very different from how a lot of people think about what Facebook is but it’s an important thing to think about how we do our product development."
},
{
"speaker": "Operator",
"text": "Your next question comes from Colin Sebastian with Robert Baird. Your line is open."
},
{
"speaker": "Colin Sebastian - Robert Baird",
"text": "I have a couple of questions as well. First on mobile advertising and ad loads, just curious what you are seeing in terms of the ad load thresholds? Is that you are at the point now where the relevancy and quality of ads means that you can take that up perhaps a little bit? And then secondly on Oculus and Virtual Reality applications, how should we think about the pace of development of this technology and the potential integration with Facebook’s applications? Thank you."
},
{
"speaker": "Dave Wehner",
"text": "I can take care of the mobile ad load question. So ad load is really one of dozens of factors that we focus on. Others are of course the quality, the relevance and then the prominence of the ads. And we monitor the sentiment and engagement of people, engaging in News Feed and we’re really pleased with the strength of sentiment and engagement as we’ve ramped up News Feed apps and we feel like we’re in a good position, given where we are with that to continue to grow the advertising business, while driving good user experience. So we’re in a good place on that."
},
{
"speaker": "Mark Zuckerberg",
"text": "I can talk about Oculus. So we’re really excited about this the acquisition just closed earlier this week and we’re really excited to welcome that team. They’re extremely talented and they’ve pulled off something that people have been talking about for a really long time and now it’s possible, given the technology that this team has developed. And this hits on a different part of our strategy, which -- the way that I organize my remarks every quarter are around these 10 year goals and themes that we have for the Company, connecting everyone, understanding the world, helping to build the knowledge economy and these future platforms. So when I'm talking about how I think things like the businesses that we’re talking about are further out than you think, I think that this stuff is actually even further out than that. But there are huge opportunities to build the next generation of computing platform. When mobile was getting defined we were basically just getting founded, in 2004. The first Smartphone came out and 2003. And we have mostly been a company that has played on top of the different mobile foundations that other companies have built. And one of the things that I care really deeply about on some of the tenures arc for the company is having a different relationship to whatever the next set of computing platforms are and investing accordingly now to make sure that when the next set of computing platforms get defined, we can help define what the next generation of computing is going to be. So I think virtual reality, augmented reality, vision, some of the AI work that we’re doing, is all going to play into this in an important way. And I just think while I was emphasizing that we’re early on some of those businesses and we’re not going to rush those. The flip side to the coin is to emphasize that we’re also going to spend a lot and invest very heavily in a bunch of these things to do it right over the long term. And so I think David pointed out that we expect to continue investing heavily and that our costs will increase. And I just want to underscore that as well, because I expect that continue to be true and it’s not that we’re necessarily going to go out and have a lot more new strategic priorities, but we expect to go very deep on the priorities that we have to make sure that we completely nail them all, whether it’s a five year or a 10 year time frame."
},
{
"speaker": "Deborah Crawford",
"text": "Operator, I think we have time for one last question."
},
{
"speaker": "Operator",
"text": "Your last question will come from Ben Schachter with Macquarie. Your line is open."
},
{
"speaker": "Ben Schachter - Macquarie",
"text": "Thanks for taking my question. Mark you talked about the focus on public content. Does that include a focus on exclusive content that we should be expecting to pay for or have revenue share agreements with the content with some key public figures? Separately on Search, I think you still have a quite a large team working on it, including Search, but our greatest point, we haven’t seen many changes since the original played the graph as part of the launch. So when should we expect to see those improvements and how would you rank Search in terms of with your priorities? And then finally just a quick housekeeping question; David, the D&A continues to trend down over the past few quarters. Why is that happening and should we expect that to continue?"
},
{
"speaker": "Dave Wehner",
"text": "I can take the D&A question first if you’d like. So ultimately depreciation is going to track more folks closely against the CapEx. So in the first half of the year we’ve been aggressively investing in the things we want to invest and that includes infrastructure. So CapEx is up 40% in the first half of the year. There are some investments that we’re making notably in the Iowa datacenter, also the new headquarters we’re building where those facilities have not gone into service. So they’re not hitting depreciation yet. So, we’re making the big investments in CapEx that will ultimately flow through in Depreciation. So I think in short the answer to your question is we’ll see depreciation come up as those things come online."
},
{
"speaker": "Mark Zuckerberg",
"text": "And I guess I can answer the other. So on public content, we actually do get a lot of exclusive content. We don’t pay for it. But I mean so -- this week for example I think Shakira hit her 100 million fans moment on Facebook. And part of the reason why some of these public figures and political leaders and folks have such big following is because they’re constantly providing insight into their lives and unique types of contents that other folks -- that you can’t get anywhere else. And there is a format that I think make sense for Facebook. It’s not and you’re not going to come to Facebook to watch a movie or watch a whole TV show. That’s really long form stuff. But I mean in the modes that we have today in our service that kind of attraction is the best place for a number of types of content like this that we’re starting to see that we get. So we’re mostly focused on driving success for our partners, where they are news organizations that are publishing content that people share or public figures and individuals who are engaging directly on Facebook. Our view is that the more success in distribution and engagement we can drive for them, the better the content and the quality that they’re going to invest in building for Facebook. And types of search, I think -- I mentioned in my opening remarks that this quarter I think for the first time we are over on average 1 billion searches a day, which is awesome and it's something that we’re really proud of and have worked a lot on, especially given that we generally found that people search a little bit less on average on mobile. So we went through a period where in order to have that increase, we had to like do some really good work and make it a lot faster and improve ranking and do a lot of the basic things that needed to get done. There is just so much more content that needs to get indexed. So if you want to go find that Shakira video that I was just talking about, I don’t know if today the product fully delivers on that but it will soon and in the next six months we’re going to be able to do that and then if we do well and them a year later we’re going to have more content in the system and be able to index that better. So it’s an ongoing thing. There is huge potential. There are a lot of questions that only Facebook can answer, that other services aren’t going to be able to answer for you. We’re really committed to investing in that and building out this unique service over the long-term. And I think at some point there is going to be an inflection where it starts to be useful for a lot of used cases. But that may still be years away. But we’re just committed to doing this investment and making this right."
},
{
"speaker": "Deborah Crawford",
"text": "Great. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again."
},
{
"speaker": "Operator",
"text": "This concludes today’s conference call. You may now disconnect."
}
] | null | null |
META | 1 | 2,014 | 2014-04-23 17:00:00 | Executives: Deborah Crawford - Director of IR Mark Zuckerberg - Chairman and CEO Sheryl Sandberg - COO David Ebersman - CFO
Analysts: Heather Bellini - Goldman Sachs Douglas Anmuth - JPMorgan Carlos Kirjner - Sanford Bernstein Eric Sheridan - UBS Peter Stabler - Wells Fargo Ben Schachter - Macquarie Evan Wilson - Pacific Crest Anthony DiClemente - Nomura Mark Mahaney - RBC Capital Markets Justin Post - BofA Merrill Lynch Youssef Squali - Cantor Fitzgerald Colin Sebastian - Robert Baird Brian Wieser - Pivotal Research Ross Sandler - Deutsche Bank John Blackledge - Cowen & Company
Operator: Operator: Good afternoon. My name is Jake and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook First Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] Thank you very much. Ms. Deborah Crawford, Facebook's Director of Investor Relations, you may begin.
Deborah Crawford: Thank you. Good afternoon and welcome to Facebook’s first quarter earnings conference call. Joining me today to talk about our results are Mark Zuckerberg, CEO, Sheryl Sandberg, COO and David Ebersman, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements, and actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today’s press release and our annual report on form 10-K filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these statements as a result of new information or future events. During this call we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to Non-GAAP measures is included in today’s earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I’d like to turn the call over to Mark.
Mark Zuckerberg: Thanks Deborah, and thanks everyone for joining today. This was a very busy quarter and a strong start to 2014. We continued to grow our community in size and engagement, with nearly 1.28 billion people now using Facebook each month and almost 63% visiting daily. We also reached new milestones as a mobile company, with more than one billion monthly actives on mobile and almost 55% of our daily actives only connecting on mobile. When you look at our business performance, we’ve also made some good progress. Our total revenue grew 72% year-over-year. Our advertising grew 82%, our strongest annual growth rate in nearly three years. And mobile accounted for 59% of our advertising revenue. These results show Facebook’s business is strong and growing, and we’re in a great position to continue making progress towards our mission. This quarter we made a number of big investments in our future. We reached agreements to acquire WhatsApp and Oculus, and we announced our new Connectivity Lab that’s focused on developing technologies to expand Internet access around the world. These are important efforts that we believe will help us continue making progress towards our mission over the long term. But as this quarter shows, we’re also staying focused on execution, and carefully improving our core products and business. Execution gives us the strength to bet on the future, and our success over the long term depends on us serving our community today and delivering against our current strategy. So, with that in mind, I’d like to run through our progress this quarter towards our three big company goals; connecting everyone, understanding the world and building the knowledge economy. Connecting everyone is about making Internet services available to everyone in the world, and allowing everyone to connect with the people and things that they care about. Our strategy for connecting everyone is based on two approaches. The first is about giving people new apps for sharing different kinds of content with different people. Today our apps are at different stages of maturity. Our core Facebook app has an audience of over one billion people, and has become an essential sharing infrastructure for the world. We’re currently focused on building a great business around this, and our continuing revenue growth on mobile this quarter shows our strong momentum here. For the next set of apps like Messenger, Instagram and hopefully soon WhatsApp, the current priority is growth. Messenger and Instagram both reached 200 million monthly actives this quarter. We believe these apps have a lot of room to grow and will start to be important businesses in the future, but monetization isn’t our near-term priority here. And for the new apps that we’re building as part of our Creative Labs effort, we’re still in the very early stages of development. We’re working hard to develop the technical foundations for these services so that we can rapidly launch new products and then refine them based on the initial feedback from our community. For Creative Labs projects that demonstrate a lot of value, our next priority will be to grow them to reach 100 million people, before we start developing them into significant businesses. Now we’re pleased by the early reaction to Paper, our first app from Creative Labs, and we expect this to be a good test case for our strategy. The longer term part of our strategy for connecting everyone is focused on Internet.org, our effort to make affordable basic Internet services available to the entire world. We recently reached 100 million monthly actives in India, and through Internet.org we’re looking to build on this kind of success. We’ve already started to deliver results. By partnering with mobile operators in the Philippines and Paraguay, we’ve doubled the number of people using mobile data with our partners and brought almost three million more people onto the Internet. Our early tests and research into new technologies such as drones and other infrastructure to connect people are promising. And over the long term we also expect WhatsApp to play an important part in connecting everyone by offering a simple, fast and reliable messaging system that could be as ubiquitous as Facebook one day. We’ll have more to share after the deal closes. Next, let’s talk about understanding the world. Understanding the world is about using Facebook to build up long term knowledge about the world and helping to answer questions for people that no other service can. Next week Facebook holds our fifth f8 conference, the main event for our developer community. We do this because even with all the experiences we’re building, we understand that there will always be more social experiences that we can’t build. So we want to keep serving developers better, and to help them build, grow and monetize their apps. We’ve made good progress here. On mobile, App Installs has been one of our best performing ad products, driving over 350 million installs to date. Over 60% of the top grossing apps on the Apple App Store and Google Play use Mobile App Ads, which is pretty impressive performance for a product that launched in January last year. On desktop, games continue to be popular on our platform and over the last twelve months desktop game developers generated more than $3 billion in payments volume on Facebook. It's worth noting that even though our mobile and desktop products seem completely different, they're both delivering the same value to developers; the ability to reach a large targeted audience. That's what we provide, and regardless of the format we will continue to improve this value. We see a big opportunity to continue improving the relevancy of the ads people see on and off Facebook, to help mobile developers better monetize their apps, and to help provide greater reach for marketers. I look forward to sharing more details next week at f8. Finally, let’s talk about our efforts to build the knowledge economy. Building the knowledge economy is about building out the technology platforms the world needs for the future, so everyone can use information to do their jobs better. Advertising and the ability to reach people more broadly is one of the most important technology platforms for achieving this, and we're investing a lot to serve four major kinds of partners: small businesses, brands, developers and e-commerce partners. After introducing News Feed ads, which increased the supply of ads in our system, our recent efforts have primarily focused on improving the relevance and quality of these ads. To do this, we’ve been working to improve the tools we provide for marketers, so they have access to better targeting capabilities, simpler ad products and more useful measurement tools. Our approach is less about developing new products for marketers and more about improving our existing ones and helping businesses to use them efficiently. Our goal is to make our ads as interesting as organic content on Facebook, so that more people find ads useful and businesses can engage effectively with our community and grow. Our most recent data shows that this approach is working well, and we continue to be really encouraged by the feedback we’re seeing from people about our ads. There is still more work to be done here, but we’ve shown that we can continue to serve our community well while also growing a healthy business. So that’s my update on how we’ve been executing against our strategy over the last quarter. It’s been a busy quarter and a strong one. We’re proud of our progress as a company and everything that we’re accomplishing today. In large part this is due to the incredible quality of our team, and I’m very grateful for the support of everyone here at Facebook, as well as our stockholders and partners, as we continue working to achieve our mission. In addition to thanking our employees, I'd also like to thank one person in particular: David Ebersman, who is stepping down as CFO after almost five years. David has been a great partner in building Facebook. He has set the right tone about operating efficiently. He has set us up to make the long term investments we need. And most importantly, he has built an incredibly strong team, including Dave Wehner, who will be our next CFO. I've learned a lot from David, both personally and professionally, and I'm grateful for everything he has done to help make the world more open and connected. Thanks, and now here’s Sheryl.
Sheryl Sandberg: Thanks Mark and hi everyone. Before I start, I want to join Mark in thanking David for being an extraordinary partner and friend over these past five years. As Mark said, he has contributed so much to our company and I've learned so much, personally, working with him. Great people build great teams and that's what David has done. And so I’m also really excited to continue working with Dave Wehner as he steps into his new role as our CFO. We are off to an outstanding start in 2014. Our total revenues were up 72% year-over-year and our advertising revenue growth accelerated to 82%. That’s our strongest year-over-year advertising growth rate in nearly three years. We’re really pleased with these results and the level of execution in our business. The team is staying focused on each element of our monetization strategy: capitalizing on the shift to mobile, growing the number of marketers who advertise with us, and investing in our ad products. Mobile continues to be a big driver for us – and a big opportunity. Mobile comprised 59% of our ad revenue in the quarter, up six percentage points from Q4. We continue to believe that this is because Facebook has the best mobile ad product in the market. We also continue to grow the number of marketers using Facebook and saw growth from existing advertisers as well. Our growth is very broad-based and coming from all types of marketers, with particular strength from SMB and direct response. We saw strong performance this quarter from verticals such as mobile gaming, e-commerce, and consumer-packaged goods. I am especially pleased with what we are seeing and hearing from clients around the world as they shift budgets to online, to mobile, and to Facebook. One recent powerful example is Sport Chek, Canada’s largest sports retailer. They recently decided to pull their paper circulars, which their company have relied on as its primary ad vehicle for 92 years for two weeks and replace them completely with digital spend, a majority of which was on Facebook. During those two weeks, national in-store sales grew 12% year-over-year and in-store sales of the items they promoted on Facebook grew 23%. As a result, they are going to continue with their tests and their goal is to transition more than 25% of their print spend to digital and Facebook in the next year. And last week I was in Europe meetings with clients, agencies, SMBs and developers and what I heard from them was how FB was becoming increasingly important in driving their businesses. Investing to improve and expand our ad products remains a very important priority for us. Our goal is to continue to develop new ways to help marketers reach their customers. We’ve done this over the last couple of years by enhancing our targeting capabilities, simplifying our ad products, and improving our measurement tools. I’ll touch on each of these three areas. First, targeting. Along with Facebook’s reach and scale, marketers value our proprietary targeting to help them reach the right customers and create more personalized and, therefore, more efficient and effective ad campaigns. Ten times more marketers are now using our Custom Audiences targeting feature compared to last year. To share just one recent example, Ben & Jerry’s wanted to drive more sales from its classic flavors. They used a wide range of our targeting capabilities, including Custom Audiences and Partner Categories, to reach premium ice cream buyers. Their campaign reached 14 million people, roughly 90% on mobile and drove an 8.1% sales lift from those consumers. As more marketers use our targeting tools, our ads become more relevant for our users and drive even better results for marketers. Second, we are simplifying and enhancing our ad tools for the over one million advertisers on Facebook. The tools that were previously available to only the biggest and most sophisticated advertisers like Custom Audiences and Partner Categories are now available in our self-service ad creation process. By making these tools more accessible, we believe we can grow the number of advertisers on our platform and improve their results. Additionally, for direct response marketers, we’ve added more specific calls to action in our ads, including “buy now” or “install now” buttons that greatly improve the efficacy of these ads. Finally, we’re also really pleased with the results we’re seeing from our investments in measurement tools. Our online conversion measurement tools enable our direct response advertisers to measure the impact their Facebook ad campaigns have on online sales. And, we recently launched new offline conversion tools to measure in-store sales, which have yielded positive initial results. Our ongoing focus will continue to be on improving the quality, relevance and performance of our ads and demonstrating value to marketers. We believe we still have a lot of opportunity to generate future returns by continuing to focus in these areas. We also have significant opportunities to develop newer products like premium video, ads on Instagram and our recently launched ad network test. Our initial efforts show a lot of promise and we’ve gotten good feedback from marketers in all of these areas. But, it’s still very early and we don't expect meaningful contributions from these projects this year. To summarize, our ads business is performing very well. I want to take a minute to congratulate and thank our teams all around the world and our ads engineering, product and design teams on the progress we have made. I also want to thank our clients, agencies, PMDs, and other partners, who work with us every day to use our platform to build their relationships with their customers to create personalized marketing at scale. It’s an exciting time for us as more marketers around the world gain conviction in the results they can achieve on Facebook. We have a great opportunity to build the world’s first platform for personalized marketing at scale. It’s early in that journey and we are going to stay focused on making the right investments in our ads business and executing against our plan. Thanks everyone, and now here’s David.
David Ebersman: Thanks Sheryl and good afternoon everyone. Before I dive into the numbers, I wanted to say a few words about my decision to step down as CFO. This was a hard decision for me because of how much I love Facebook and all the people I work with here. In particular, I can’t thank Mark and Sheryl enough for their friendship and support and for letting me be a part of their team. I’m confident that Facebook’s best days lie ahead and I’m excited about the path Mark and Sheryl are leading the company on. My decision’s a personal one based on my desire to get back into health care where I spent my entire career before Facebook. And, after ten years as a CFO, half of them here, I’m ready for a different role and challenge. Right now feels like a good time for this change. The business is doing well, the foundation is solid, and in Dave Wehner we have a terrific successor who’s up to speed and ready to go. I have complete confidence in Dave and the rest of the Finance team. Dave will formally take over me in June and he’ll take my place on the next earnings call, though I plan to stay with the company through September to ensure a smooth transition. I also want to thank our shareholders for your partnership and support. Now to the quarter. Q1 was a strong quarter for us across the business. We increased our revenue growth rate, expanded operating margins, delivered free cash flow of over $900 million, and continued to make investments to position the company for near-term and long-term growth. Let’s start with some people metrics. The number of people using Facebook on an average day in March grew to 802 million, up 137 million from a year ago. As Mark mentioned, this daily number represents almost 63% of the 1.28 billion people who used Facebook during the month. And overall engagement remains strong. Additionally, these stats don’t include Instagram, which now has more than 200 million monthly active users, showing the remarkable progress by the team. Two years ago this month, when the acquisition was announced, Instagram had fewer than 22 million monthly actives. Turning now to the financials. Q1 total revenue was $2.50 billion, up 72% versus Q1 last year, and total ad revenue was $2.27 billion, up 82%. Ad revenue growth was strong around the world, with each of our four geographic regions growing by over 70%. Mobile ad revenue was approximately $1.3 billion, compared to around $377 million in Q1 last year, and notably mobile ad revenue was up 7% sequentially, despite the seasonal benefits in Q4. Desktop ad revenue in Q1 was up 8% compared to Q1 last year. In Q1, the average effective price per ad displayed increased 118% year-over-year while total ad impressions declined 17%. The decrease in ad impressions was due to factors including the continued shift towards mobile use, where people are shown fewer ads compared to desktop. The increase in average price per ad was primarily driven by a mix shift with more ads being shown in News Feed. News Feed ads have significantly higher engagement, click through rates, and price per ad compared to right hand column ads, so a higher proportion of ads appearing in News Feed drives up the overall average price per ad. The price volume trends were pretty consistent across our four geographic regions. Total Payments and Other Fees revenue was $237 million, up 11% versus Q1 last year. However, the more meaningful comparison, that better reflects the organic growth we saw in the Payments business, comes from looking at Payments volume from Games specifically, which was up 1% in Q1 compared to Q1 last year, down from the 8% year-over-year growth rate we saw in Q4. As we’ve discussed before, the shift to mobile is a significant headwind since our Games Payments revenue comes from desktop only, where usage is flat or declining, so growing this business going forward will be challenging. Turning to expenses, our Q1 GAAP expenses were $1.4 billion, up 32%, and our non-GAAP expenses were $1.1 billion, up 26%. Our headcount increased 39% from a year ago. Our Q1 GAAP operating income was $1.1 billion, representing a 43% operating margin, and our non-GAAP operating income was $1.4 billion, representing a 55% margin, up from 39% last year. While the margin improvement was helped by some non-recurring items that drove up costs in Q1 last year, we’re pleased that the increase in margins came mostly from cost of revenue and G&A. As planned, we’ve created efficiencies in infrastructure and administration while continuing to aggressively grow our investment in R&D along with marketing and sales to drive future performance. Our GAAP and non-GAAP tax rates were 40% and 36%, respectively. GAAP net income was $642 million or $0.25 per share, and non-GAAP net income was $885 million or $0.34 per share. In Q1, we spent $363 million on CapEx and generated $922 million in free cash flow. We ended Q1 with $12.6 billion in cash and investments. Now, looking forward. First, I want to note that the forward-looking comments I’ll share today do not reflect any impact from the recently announced acquisitions of WhatsApp and Oculus, neither of which has closed. After the deals close, we’ll update our guidance as appropriate. In terms of expenses, consistent with what we’ve said previously, we’re planning that our total 2014 GAAP expenses, including cost of revenue and stock comp, will likely grow in the neighborhood of 35% to 40%, and that non-GAAP expenses, including cost of revenue but excluding stock comp, will likely grow in the neighborhood of 40% to 45%. For taxes, we expect GAAP and non-GAAP rates for the rest of 2014 to be similar to or a bit higher than our Q1 rates, although this could vary widely depending upon our international revenue and expense mix, and other factors including the impact from acquisitions. We continue to anticipate our 2014 CapEx will be approximately $2 billion to $2.5 billion. We also continue to expect shares outstanding for calculating EPS to grow from around 2.6 billion at year-end 2013 by 2% to 2.5% in 2014 excluding the two large deals we’ve announced. Those deals once closed will add another 207 million shares, as well as additional unvested RSUs that will affect our share count over the subsequent four to five years. Turning last to ad revenue. As you know, our year-over-year comparables will get more challenging going forward from here because of the timing of the ramp up of News Feed ads in 2013. As the comps become more difficult, we continue to expect that over the rest of 2014, our year-over-year ad revenue growth rates will decline from the Q1 rate and be meaningfully lower by the end of the year. That being said, we believe, we are still in the early stages of building our ads business, and we remain as optimistic as ever about the long-term opportunity to grow revenue impressively by improving the quality and relevance of our ads and increasing the value we bring to marketers. In summary, Q1 was a great start to the year. We're very pleased with how well our ads performed. The strong marketer interest in our ads platform particularly on mobile and the investments we're making to build long-term shareholder value. Now let's open for questions.
Operator: We will now open the line for a question-and-answer session. [Operator Instructions] Your first question comes from the line of Heather Bellini with Goldman Sachs. Your line is open.
Heather Bellini - Goldman Sachs: Great. Thank you very much. I was just wondering, Mark or Sheryl, if you can share with us your vision of payments for Facebook, and how the Company might be able to play a role in reducing the friction that exists today when users are trying to engage in mobile e-commerce. And then the follow-up question was just going to be if you could share with us what inning do you think we are in, in terms of improving the relevancy of the ads that you are showing? Thank you.
Sheryl Sandberg: On payments, our payments business has been important in supporting some of the developer activity on Facebook, primarily games. So we continue to be interested in that. I guess really important to know that, our advertising business is very relevant for e-commerce and that doesn't depend on taking payments and it doesn't depend on a payment strategy because we provide a really great opportunity for marketers to find customers who are then going to go ahead and buy their products both online and offline. In terms of relevance, I think we are in really early innings. I think people can see it from their own experience. Those people I talk to and certainly the data we have across the base of people use Facebook suggest that the ads are getting more relevant, but there is a long way to go. Our goal is that every time you open newsfeed, every time you look at Facebook, you see something whether it's from consumers, or whether it's from marketers, that really delights you, that you're genuinely happy to see. I think we hit that more than we used to with our ads, but I think the truth is we still have a long way to go to hit that bar and that's the bar we are striving for.
Operator: Your next question comes from Douglas Anmuth with JPMorgan. Your line is open.
Douglas Anmuth - JPMorgan: Great. Thanks for taking the question. David, just wanted to ask you a little bit more about margins, in particular. If we look at this quarter, it looks like the incremental margins here are 78% or so. So, I was hoping you could drill down a little more just on the drivers within cost of revenues and how you are thinking about the sustainability of that going forward. And is the 40% to 45% growth that you mentioned in non-GAAP OpEx, is that taking into account the acquisitions at all? Just thinking about how you can get to that level of spend given what you are starting the year. Thanks
David Ebersman: Yeah. Thanks for the question Doug. I think Q1 is traditionally a light spending quarter for us because we budget with an annual cycle and often it takes some time to sort of ramp up the new program. So I don't think it's surprising that Q1 year-over-year increase would come in a little lighter than we expect for the full year. Additionally there were some one-time things that benefited the quarter, that kept expenses down particularly in cost of revenue as we continue to exit lease data centers and sort of amend our supply chain. I think that going forward our expectation was and remains the 40% to 45% growth excluding the impact from the acquisitions. So, we will update that guidance once the integration plans are clearer and have a better sense for what those spend patterns will look like. In general in terms of margins, the comments I would make are that, we don’t have a quarter-to-quarter target margin that we're managing closely to. To do so, would require varying our spend patterns as revenue changes up and down over time. And I think that's the wrong way to focus on how you spend your money in the company. Our priority is really to try and make investments that are high quality that drive the creation of value and makes the business better. And since many of those investments take a longer period to mature, we want to be able to think about our spend increases over a longer term horizon. And as you can see looking back at the last couple of years and then our plans for this year, there has been a pretty steady rate at which we've been growing spend particularly in R&D and marketing and sales where we really want to focus on making sure we're growing smartly and thoughtfully at a rate we can manage wisely and doesn't get ahead of our ability to manage it. On cost of revenue and G&A what you can see in the Q1 numbers is the fruits of a lot of labor trying to manage those parts of the business really efficiently and free up resources to invest elsewhere. So, I think we've always believed that Facebook has the opportunity to be a sustainably high margin business and we continue to believe that, noting that there were some individual items that helped us in Q1.
Operator: The next question comes from Carlos Kirjner with Sanford Bernstein. Your line is open.
Carlos Kirjner - Sanford Bernstein: I think for Mark, how do you think about the evolution of browser technology, HTML5, and development tools versus native apps? If you look two to three years out, do you think native apps could finally become less important for many use cases? Or, in other words, maybe you guys were not wrong when you tried HTML5, you were just too early. Thank you.
Mark Zuckerberg: Yeah, well timing matters a lot and so, I do think that there's nothing wrong with the standard of HTML5 technically. I think a lot of what we see is what the main platform providers want to push as the standard for developing on their own platforms. And what we've seen is that both Apple and Google have really favored and made it easier to build high quality experiences in their own proprietary formats rather than the open web format. So, while our bias for a number of reasons would have been to have really pushed on HTML5 and I don't want to sound like we've walked away from this because a large number of people access Facebook from the mobile web and I don't know if we break that out specifically but it's quite a large number of people. So, we're continuing to develop that, but for the foreseeable future, we see the best path to continuing to deliver great experiences by working on the native app experiences that we have now.
Operator: The next question comes from Eric Sheridan with UBS. Your line is open.
Eric Sheridan - UBS: Thanks for taking the questions. Congratulations, David, on your future endeavors, as well. Mark, maybe a quick question for you about the way in which you think Facebook, and the various applications Facebook is developing also, move towards a communication ecosystem longer term. A big picture question on where the various applications go, the ones that are in the process of being acquired and the ones you are developing organically. And then second question, to use the baseball analogy again, as you continue to take ad impressions out of the Facebook platform, wonder if we should think about where you get to longer term on a level of ad impressions that you think are the perfect mix for balancing engagement and monetization, and what inning we are in that process.
Mark Zuckerberg: Sure. I think I can probably take both of those. So in terms of building out a whole communication ecosystem, the way that we think about the new apps and products that we're building is that people want to share all kinds of different content with all kinds of different audiences. Right so, sometimes you want to have one-on-one conversation or text or chat or voice call up to having a small group conversation to communicating, updating all your friends and something at once. And sometimes there is really good public content, whether it’s news or premium video or things like that. At the intersection of each type of content and each audience, we think that there is a really compelling experience to be built. And Facebook historically is focused on friends and public content, now with Messenger and WhatsApp we're taking a couple of different approaches towards more private content as well. You're going to see us do more things in more private content I think, I don’t know that’s an ecosystem that's growing incredibly quickly and also that speaks to why WhatsApp and Messenger are both growing independently quickly is because they actually serve pretty different used cases within private sharing and private content. In terms of our investments, I think you want to look at it, I kind of outline this in my remarks, but I think it's important enough to say again. There are different stages of maturity for the different things that we're doing. So, the Facebook app by itself is the furthest along and more than a billion people use it and it's not only one of the most used apps, but it's the most used app it's also at the core of our business. Then the second set of apps that we have are Messenger, Instagram and soon WhatsApp and you know Messenger and Instagram are each now greater than 200 million active users. I think the WhatsApp folks independently announced, I think it was yesterday that they just passed 500 million active. So these are apps that are now at a pretty big scale and the immediate priority is going to be getting them to a billion people where they're continuing to focus on that before focusing on monetization and the way that we have with the core Facebook app, so that's kind of a second stage. The third set are the new Facebook Creative Labs apps that we're just getting started. The things like Paper and a number of other things that we might announce that at some point. Those are even further along than even Messenger, Instagram and WhatsApp, where it will probably take few years for those to even to get to the stage that Instagram, Messenger and WhatsApp are at, which by themselves are probably a few years away from being important businesses for us. So that's kind of the pipeline of things that we see and there is kind of a full ecosystem of different ways the people want to share with different people. In terms of ads going to your second question, I don't actually think we have a strategy that decrease ad impression. I think what you're seeing and what David mentioned is, we have newsfeed ads, which are higher quality and perform better and then we have this legacy of right hand column ads on desktop, which generally are just showing higher volume and they performed less well per ad unit. So as we shift more towards newsfeed, what you're seeing is the total raw number of impressions as decreasing, but actually the amount of value that we're delivering is increasing. So that might continue to shift as we continue to shift towards mobile, but I think overall what we're trying to do is make it that the individual load on a per person basis is isn’t increasing at a dramatic rate, but instead we're driving most of the wins in user experience, advertiser performance and our own revenue to increasing the quality primarily around newsfeed ads. And we think that there is quite a lot to go there as Sheryl said. We want to get to a state where the ad content is as good as the organic content and we see we're getting pretty close in a few countries but we want to get to that everywhere.
Operator: Your next question comes from Peter Stabler with Wells Fargo. Your line is open.
Peter Stabler - Wells Fargo: Good afternoon. Thanks for taking my question. I wanted to ask a question about engagement. By one measure, DAU over MAU, it's at an all-time high. But no doubt you always have a body of last users. I'm wondering if you could share any color on what types of algorithm or product tweaks that you've made have yielded the most return or the greatest return in terms of re-engaging last users. And then, secondly, just quickly, any color you could provide on your estimate of the overlap of Instagram and Facebook users, perhaps based on the linking of those accounts. Thank you very much.
Mark Zuckerberg: Unfortunately, I don’t think I'm going to have much color on either of those. We are constantly doing things to make it so that people can share the content that they want, that they have the tools, that the new network showing them most relevant content to people. That is always going to be the way that people will use the service not through some kind of trick or something that we're using to reengage people. One stat that I think is pretty interesting is that, you would expect naturally that as our -- the community continues to grow and we're getting into later and later adapters, that the percent of people who are using Facebook or use it every day would decrease. And I have actually predicted for a long time, that eventually that would flatten out and I thought it would decrease but actually it continues to increase much to our surprise and joys. And you know now this quarter I think, we're add almost 63% of people who use Facebook in a month will use it in a given day. And I think another stat, I think is actually quite interesting, is we tracked how many people use Facebook not just every day. So I mean one day out of -- so what percent of our monthly folks use it today. But what percent of people used it six out of seven days of the week. And that number for the first time in the last quarter passed 50%. So I mean that's pretty crazy if you think about is that, you have this really big engaged community and not only are almost 63% of people touching it in a given day and using the service because it's really engaging content, but we've gone to a period where more than 50% of people have used it six out of seven a week, almost every single day of a week. That just speaks to I think - just the underlying kind of fundamental strength in the content and the work that we're doing just surface the best content of best people.
Operator: Your next question comes from Ben Schachter with Macquarie. Your line is open.
Ben Schachter - Macquarie: First, David, let me add my congratulations on your success. And good luck with the future role. Mark, beyond games, do you see other categories of apps that are ramping? And do you need to see that or can games continue to be the primary driver of app install and app engagement ads? And then, separately, on Graph Search, do you see the potential for more partnerships for Graph Search in terms of additional data sets and distributions partners? Or is this more go-it-along? And then, finally, maybe for Sheryl or David, can you just give us a sense on pricing trends on app install ads? Thanks.
Mark Zuckerberg: Yes, I mean on app-installs, I actually think we see more diversity in the customers and developers on mobile now then we saw on desktop with Canvas. So Canvas the business was almost entirely games that is now -- we see that a lot of these games, but a lot of it is other kind of folks because I mean everyone who is building apps on mobile needs installs and we have the number one products out there for delivering that. So, we see that happening and we feel pretty good about that.
Sheryl Sandberg: On pricing, we don't break our pricing by type of ad, but overall in the ecosystem, our prices are up as Mark said, the effective price per ad shown is driven up by more ads and newsfeed, and that's because newsfeed ads have significantly higher engagement and click-through rates.
Operator: The next question comes from Evan Wilson with Pacific Crest. Your line is open.
Evan Wilson - Pacific Crest: Hi, thanks for the question. Just a small item. It looks like the Asia engagement metric, the MAU, was down sequentially, slightly. Was there something there that impacted that in Q1 or was there something competitive there you think might be impacting that part of the business, like the big mobile messaging services? Thanks.
David Ebersman: I don't know that I would read anything into that yet. We haven't identified that as a trend that we're focused on at this point. The number is $2 bucks around a little bit from quarter-to-quarter in various regions.
Operator: The next question comes from Anthony DiClemente with Nomura. Your line is open.
Anthony DiClemente - Nomura: Congratulations, David. And best of luck in your new endeavors, as well. One question for David and one for Sheryl. David, I just wondered if you could talk about your mix of impressions in terms of brand versus direct response. How has that changed this quarter versus prior quarters? And what else can be said about that split? And then, secondly, for Sheryl, just wondered if you could give us a little more of an update on premium video ads. Specifically, I'm curious as to how those are sold. Are they sold on an impression basis or on a performance basis, or some hybrid of the two? And then I know you don't give pricing by property, but is there a way to think about the premium or premium multiple of price that premium video ads would go for as compared to core News Feed ads? Thanks for any color on that.
David Ebersman: Thanks Anthony, I'm happy to take the first part of the question. I think in the first quarter we delivered strong performance across all the advertiser segments that we focus on. And so I think they are all growing nicely. We don't have a perfect measure for what kind of demand is, brand versus DR per say, because someone doesn't have to input that into the system when they come in. We've lots of things we do to try and find surrogates for that and are happy to see using some of that data, we're seeing nice growth across the various segments.
Sheryl Sandberg: On video ads, video represents a really big opportunity, really driven by consumer behavior. Smartphones are going better and faster and more people have phones that can provide a great video experience. So we're seeing consumers do a lot more in video. There's also a lot more video going through newsfeed that consumers are putting in and that creates an opportunity for us, both on the consumer side and the ad side. We have our current product in the market, it's a click to play video ad, it's part of the page post, you can post the video. Those are so both CPM and CPC and those are going really well and I think explains some of the growth we are seeing in our ads business. We also have been in early conversations with some clients about what would be a CPM autoplay video ad and in terms of the expectations for that, we really want to see autoplay video ads be something that's pretty common in the newsfeed experience based on consumer usage before we push very hard in the ads business. So we remain, long term very excited, we do expect that product, demand to premium product but as I said in my remarks, we won't see a material contribution from it this year.
Operator: Your next question comes from Mark Mahaney with RBC. Your line is open
Mark Mahaney - RBC Capital Markets: On those autoplay videos, as an average Facebook user, I've noticed them more and more in my News Feed, and I think they're really neat. I think all my friends love watching videos of my kids play basketball. The question I'd have for you is what have you seen internally in terms of engagement. I assume that since I'm seeing more, other people are too, and that users like having them in. But is there any way you could quantify or maybe talk broadly about the impact that's having on usage? Thank you.
Sheryl Sandberg: Our goal is to make newsfeed as engaging as possible and I think if you look at the engagement we have on mobile, we're getting 20% of mobile time on Facebook in the U.S. and growing globally as well. I think you see with that engagements grade, I'm sure your friends love seeing your kids play basketball. I think they probably like to see more of those. And when and if we deliver a really great ad experience and ads that you love, something you're interested in, I think you're going to like that just as much, we look forward to the growth.
Operator: Your next question comes from Justin Post with Merrill Lynch. Your line is open.
Justin Post - BofA Merrill Lynch: Great. I have a couple questions. On the app installs, can you help us at all understand what -- I know you gave us the number of total apps, but maybe how that revenue as a percentage of total, how important it is to you? And then there's a lot of competitors targeting that market with new products. Maybe you could outline some of Facebook's competitive advantages in that market. And then one for Dave. We will miss you. Maybe you could talk a little bit about maybe some things Facebook could do to offset some of the dilution from the acquisitions, if anything. Thank you.
Sheryl Sandberg: On mobile app ads, we've seen really strong adoption and this is a very nascent but growing market. I think people sometimes think that a lot of our mobile ad revenue is coming from this one type of ad and our mobile ad revenue is very broad based. We know you're seeing in newsfeed and what we see are ads from brand marketer's direct response, SMB's end developers and so we're pretty distributed there and pretty happy about that. I think it's not surprising that other people are entering states, it's obviously growing, it's one that performs well. I think we continue to be excited by the results we're seeing for our marketers and developers. The results we are seeing from consumers and we think the fact that we've already been investing and learning and growing, puts us in a great position to continue to have a very strong product offering even in a more competitive space.
David Ebersman: So, Justin on the -- the acquisition is the most important thing we'll do to truly I would say justify, the delusion will be to make those acquisitions successful and over time ensure that the unique assists that we're buying contribute to Facebook success and to our cash flows over time. This business is obviously in really healthy shape right now in terms of the cash it's generating and we look forward at the moment to really continuing to prioritize where it's appropriate, investing that in the business to drive future growth.
Operator: Your next question comes from Youssef Squali with Cantor Fitzgerald. Your line is open.
Youssef Squali - Cantor Fitzgerald: Thank you very much. So firstly David, can you talk a little bit about the ad load during the quarter? We saw noticeable increases here in the holidays and through Q1 versus that 5% or 6% you mentioned back on the Q3 call. Is the new ad load we are seeing sustainable, do you think, going forward? And, second, maybe Mark or Sheryl, can you just talk a little bit about timing for monetization of Instagram? Are there any thresholds, either in terms of users, user engagement, whatnot, before you can ramp that advertising, or advertise on that platform? I think, David, you were talking earlier about maybe reaching a billion, but I think that was a general comment. Thanks.
David Ebersman: Yeah, thanks Youssef. So as Mark sort of alluded to earlier as it relates to ad load, what we're trying to do is optimize across multiple variables that really produce the best experience for people who use the network and help us to grow the business. And ad load is one of the variables that we look at. And of course we also look at things like the size of the ad, the prominence of the ads and of course the quality of the ads. And what we're trying to do is to continually really tweak all of those variables and then measure what impacts we're having on engagements, on feedback from people, on revenue and trying to optimize using that data and the changes that we've made. And I think the story there is a really good one. Things continue to go very well obviously in terms of revenue what you see, but also in terms of engagement, in terms of feedback we get from people when we survey them. So we think we remain in a really very strong position in that way. Actually we'd not validate the assertion that you gave that the ad load increased dramatically in the timeframe you described since that's not consistent in aggregate with our data. What I can say is that, every person who uses Facebook has their own experience and the experience including the ad experience is personalized based on the other content we have available based on how much they've engaged with ads we've shown in the past etcetera. So, ideally we'd like to personalize not just the organic content that you see, but also your ad experience in a way that's really optimized for you and your interests.
Sheryl Sandberg: On Instagram, Instagram is a great product. I think that's why we see so much engagement from people who are using it and the gross passing 200 million. It's also a great advertising product and there's just tons of demand because you know, the picture themselves are so visually appealing and also there's so much consumer engagement. We're in really early days, we've seen some great results, just to mention one, Levi's is running an ad, which is basically pictures of people wearing denim in really beautiful outdoor spaces. They targeted people 18 to 34 in United States. Reached over seven million people and importantly they drove a 24%-- 24 point left in ad recall which was three times the control group. So, I think that shows that just as people engage with consumer pictures on Instagram, they're going to engaged with the right pictures from marketers. That said, we're very focused on consumer growth and we move slowly and deliberately in monetization. So, we don't see the need or the urge to ramp this as quickly as we possibly could but really want to grow it slowly, grow it deliberately and continue the growth on the consumer side and a great returns for marketers.
Operator: Your next question comes from Colin Sebastian with Robert Baird. Your line is open.
Colin Sebastian - Robert Baird: Thanks, I appreciate the chance to ask two questions. The first one is, I wonder if there's any way we can generalize or correlate around the growth in mobile monetization with the shift to 4G LTE, and whether this could be a driver, as well, of improving monetization internationally, as those higher-speed networks are deployed in new markets. And then, secondly, regarding Nearby Friends, just wondering how you plan to tie that feature and data set into more of a commercialized local offering for businesses, whether that's geo targeting or other related services. Thank you.
Mark Zuckerberg: Well, a lot of what we're trying to do with internet.org is making so that everyone has the cellular networks that they need to be able to get on the Internet and access basic services, which we think are text-based communication services, whether it's things like social networks or messaging or email or search, whether stock prices,-- like basic stuff like that, that people will use on a day-to-day basis, but don't require huge amount of data. We're pretty happy with the early progress that we've made. We have a multi-year initiative to work with operators around the world to roll-out a program where folks can have free basic services. And as I mentioned before, a lot of the initial work is the initial partnerships were in the Philippines and Paraguay. And what we're really pleased with, even just a few months of work, we were able to help almost three million people get access to data for the first time. So, there is no doubt that going from having no access to data to having some access is a huge jump in terms of the activity on the business that we see -- that's available from people. Moving towards things like LTE later on in the funnel, will be helpful as we move towards richer types of contents like higher resolution photos and videos. so that will be important especially as the mix of content that people share moves towards the richer media. But we're really focused on both and we have a huge investment as well and the internet.org starting just making sure that everyone in the world gets connected.
Sheryl Sandberg: And Nearby Friends, it's a great new features, is an optional feature we just rolled out last week, I don't know if, people have had a chance to try it yet. But, rolling out slowly, but it’s a great product experience one we're excited to be able to offer. We use the information like this to enhance all the services we provide, and make things more relevant including relevant ads.
Operator: Your next question comes from Brian Wieser with Pivotal Research. Your line is open.
Brian Wieser - Pivotal Research: Hi. Thanks for taking the questions. First of all, I was wondering, with regard to the WhatsApp acquisition, I was wondering if you could update us on the status, if the current situation with Russia poses any issues given the development team space there. And then, separately, I was wondering if you could talk Nielsen and the use of OCR with respect to advertisers' interest in using OCR tools. Do you find that that's making a difference at the present time in terms of brands spending money with you, in general?
Sheryl Sandberg: On the first, yeah, the development team is located in Mountain View not in Russia. So…
Brian Wieser - Pivotal Research: And they are doing extremely well.
Sheryl Sandberg: Yes, they're doing really well.
Mark Zuckerberg: The deal has been closed. We don't have anything to share. But I just would just point you to a blog post that Jan wrote. I think it was yesterday announcing that they just help to connect 0.5 billion monthly asset. We're growing very quickly. So I think that's up to about 460 million monthly is just a couple of months ago when we announced the deal was done in the first place.
David Ebersman: And I think that Jan specifically called out a few countries including Russia and Brazil and I think India is some of the fastest growing markets for WhatsApp. So I'd just direct you that statement and you should read that for more information on how they're doing and we'll update you more when the deal closes.
Sheryl Sandberg: And Nielsen OCR anything that helps advertisers measure their spend is really important. I've talked on the call a bunch about how measuring online and in-store sales really matters. It also matters to marketers to be able to measure their spend compared to other investments they can make. And what OCR has done, it's given advertisers and marketers comparability between TV and digital and our spend. I think in those comparisons we do very well. And I think that is part of the shift that’s happening and its part of why we see growing interest from clients.
Operator: Your next question comes from Ross Sandler with Deutsche Bank. Your line is open. Ross Sandler, your line is open.
Ross Sandler - Deutsche Bank: Good afternoon. Can you guys hear me now? Okay, Just two quick questions. Facebook's on pace to represent around 20% of global display advertising or non search advertising in 2014. Do you view that as your addressable market? And, if so, what do you see as the potential market share you guys can capture relative to the -- I think, Sheryl, you said it is 23% mobile consumption, ex-China, globally today. And then the second question is, there's been some press recently that Facebook is looking at building peer-to-peer money transfer services. Is that a market that you view as an opportunity? Would that fit into Messenger or potentially a standalone app?
Sheryl Sandberg: We had our payments business for a while and we continue to have one and nothing new to apps there. On the first question, I think our adjustable market is much bigger than digital and you see that in the trends. The big trend that’s happening is the shift from consumer time. So last year was the very first time those lines crossed and consumers spent more time in digital, which is mobile and desktop than they did on TV. That continues to grow, so where we are right now is, the average U.S. consumer as an example spent 4.5 hours per day on TV but five and three quarter on digital and that’s largely been driven by mobile. That means that as consumer time and attention shifts, we think ad budget shift as well particularly if you have good mobile ad products and you can measure results. So we definitely believe there will be and continuous to be a shift happening. I talked about a print shift happening with that example of Sport Chek in Canada. But we see this across the board that marketers are looking for the highest ROI they can find and they should be comparing us and everyone else across and they do that not just across digital but across print, across radio, across TV, across any other vehicle they can. I think our investments and measurement really pay-off here. We say to our clients all around the world, we want to earn your business because we want to be the best dollar and the best minute you send because both their dollars and their time are so valuable. And we want them to compare us to the other investments that could make to see who can drive the most value to the bottom line and that's what we are focused on and that goes way beyond digital.
Deborah Crawford: I think we have time for one last question.
Operator: Your next question comes from John Blackledge with Cowen & Company. Your line is open.
John Blackledge - Cowen & Company: Great. Thanks for the questions. Just wondered if you could discuss how Facebook's potential mobile ad network would provide additional value to advertisers than other existing mobile ad networks. And then just a second question for David. I don't know if you could help quantify what meaningfully lower year-over-year ad revenue growth is, or just give us a sense of how to think about it for modeling purposes. Thank you.
Sheryl Sandberg: On the ad network, we are in very testing for mobile ad network. We do see a big opportunity here. We think because we're people based, we have an opportunity first to provide greater reach for marketers and developers who are working with Facebook across other platforms, but also improve the relevance of the ads people see both on and off Facebook. And I think that has been our core advantage and will continue to be. That said, it's really early days and we're on the early testing phase.
David Ebersman: Yes John, obviously the Q1 ad revenues growth here was 82% which is fantastic and a real tribute to the team and the platform. One of the things that contributed to that growth rate is the ramp up of newsfeed ads that in Q1 of last year was still really early in that part of the journey and so the comparison between the state of newsfeed ads in the Q1 we're reporting now in a year ago is meaningfully different. As you'll remember from last year, newsfeed ad really ramped up in the second quarter and revenue growth ramped up as well. So that’s just going to impact the comparisons in the subsequent quarters of the year. Having said that, there is lots of things that we're focused on, that will continue to drive our ad revenue growth including more users and critically more marketer demand. So bringing more marketers into the system, improving our products and tools to increase their returns and their ability to measure those returns and generally improving the quality and relevance and value of the ad. So those are the things that we'll stay focused on.
Deborah Crawford: Great. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again.
Operator: This concludes today's conference call. You may now disconnect. | [
{
"speaker": "Executives",
"text": "Deborah Crawford - Director of IR Mark Zuckerberg - Chairman and CEO Sheryl Sandberg - COO David Ebersman - CFO"
},
{
"speaker": "Analysts",
"text": "Heather Bellini - Goldman Sachs Douglas Anmuth - JPMorgan Carlos Kirjner - Sanford Bernstein Eric Sheridan - UBS Peter Stabler - Wells Fargo Ben Schachter - Macquarie Evan Wilson - Pacific Crest Anthony DiClemente - Nomura Mark Mahaney - RBC Capital Markets Justin Post - BofA Merrill Lynch Youssef Squali - Cantor Fitzgerald Colin Sebastian - Robert Baird Brian Wieser - Pivotal Research Ross Sandler - Deutsche Bank John Blackledge - Cowen & Company"
},
{
"speaker": "Operator",
"text": "Operator: Good afternoon. My name is Jake and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook First Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] Thank you very much. Ms. Deborah Crawford, Facebook's Director of Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford",
"text": "Thank you. Good afternoon and welcome to Facebook’s first quarter earnings conference call. Joining me today to talk about our results are Mark Zuckerberg, CEO, Sheryl Sandberg, COO and David Ebersman, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements, and actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today’s press release and our annual report on form 10-K filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these statements as a result of new information or future events. During this call we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to Non-GAAP measures is included in today’s earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I’d like to turn the call over to Mark."
},
{
"speaker": "Mark Zuckerberg",
"text": "Thanks Deborah, and thanks everyone for joining today. This was a very busy quarter and a strong start to 2014. We continued to grow our community in size and engagement, with nearly 1.28 billion people now using Facebook each month and almost 63% visiting daily. We also reached new milestones as a mobile company, with more than one billion monthly actives on mobile and almost 55% of our daily actives only connecting on mobile. When you look at our business performance, we’ve also made some good progress. Our total revenue grew 72% year-over-year. Our advertising grew 82%, our strongest annual growth rate in nearly three years. And mobile accounted for 59% of our advertising revenue. These results show Facebook’s business is strong and growing, and we’re in a great position to continue making progress towards our mission. This quarter we made a number of big investments in our future. We reached agreements to acquire WhatsApp and Oculus, and we announced our new Connectivity Lab that’s focused on developing technologies to expand Internet access around the world. These are important efforts that we believe will help us continue making progress towards our mission over the long term. But as this quarter shows, we’re also staying focused on execution, and carefully improving our core products and business. Execution gives us the strength to bet on the future, and our success over the long term depends on us serving our community today and delivering against our current strategy. So, with that in mind, I’d like to run through our progress this quarter towards our three big company goals; connecting everyone, understanding the world and building the knowledge economy. Connecting everyone is about making Internet services available to everyone in the world, and allowing everyone to connect with the people and things that they care about. Our strategy for connecting everyone is based on two approaches. The first is about giving people new apps for sharing different kinds of content with different people. Today our apps are at different stages of maturity. Our core Facebook app has an audience of over one billion people, and has become an essential sharing infrastructure for the world. We’re currently focused on building a great business around this, and our continuing revenue growth on mobile this quarter shows our strong momentum here. For the next set of apps like Messenger, Instagram and hopefully soon WhatsApp, the current priority is growth. Messenger and Instagram both reached 200 million monthly actives this quarter. We believe these apps have a lot of room to grow and will start to be important businesses in the future, but monetization isn’t our near-term priority here. And for the new apps that we’re building as part of our Creative Labs effort, we’re still in the very early stages of development. We’re working hard to develop the technical foundations for these services so that we can rapidly launch new products and then refine them based on the initial feedback from our community. For Creative Labs projects that demonstrate a lot of value, our next priority will be to grow them to reach 100 million people, before we start developing them into significant businesses. Now we’re pleased by the early reaction to Paper, our first app from Creative Labs, and we expect this to be a good test case for our strategy. The longer term part of our strategy for connecting everyone is focused on Internet.org, our effort to make affordable basic Internet services available to the entire world. We recently reached 100 million monthly actives in India, and through Internet.org we’re looking to build on this kind of success. We’ve already started to deliver results. By partnering with mobile operators in the Philippines and Paraguay, we’ve doubled the number of people using mobile data with our partners and brought almost three million more people onto the Internet. Our early tests and research into new technologies such as drones and other infrastructure to connect people are promising. And over the long term we also expect WhatsApp to play an important part in connecting everyone by offering a simple, fast and reliable messaging system that could be as ubiquitous as Facebook one day. We’ll have more to share after the deal closes. Next, let’s talk about understanding the world. Understanding the world is about using Facebook to build up long term knowledge about the world and helping to answer questions for people that no other service can. Next week Facebook holds our fifth f8 conference, the main event for our developer community. We do this because even with all the experiences we’re building, we understand that there will always be more social experiences that we can’t build. So we want to keep serving developers better, and to help them build, grow and monetize their apps. We’ve made good progress here. On mobile, App Installs has been one of our best performing ad products, driving over 350 million installs to date. Over 60% of the top grossing apps on the Apple App Store and Google Play use Mobile App Ads, which is pretty impressive performance for a product that launched in January last year. On desktop, games continue to be popular on our platform and over the last twelve months desktop game developers generated more than $3 billion in payments volume on Facebook. It's worth noting that even though our mobile and desktop products seem completely different, they're both delivering the same value to developers; the ability to reach a large targeted audience. That's what we provide, and regardless of the format we will continue to improve this value. We see a big opportunity to continue improving the relevancy of the ads people see on and off Facebook, to help mobile developers better monetize their apps, and to help provide greater reach for marketers. I look forward to sharing more details next week at f8. Finally, let’s talk about our efforts to build the knowledge economy. Building the knowledge economy is about building out the technology platforms the world needs for the future, so everyone can use information to do their jobs better. Advertising and the ability to reach people more broadly is one of the most important technology platforms for achieving this, and we're investing a lot to serve four major kinds of partners: small businesses, brands, developers and e-commerce partners. After introducing News Feed ads, which increased the supply of ads in our system, our recent efforts have primarily focused on improving the relevance and quality of these ads. To do this, we’ve been working to improve the tools we provide for marketers, so they have access to better targeting capabilities, simpler ad products and more useful measurement tools. Our approach is less about developing new products for marketers and more about improving our existing ones and helping businesses to use them efficiently. Our goal is to make our ads as interesting as organic content on Facebook, so that more people find ads useful and businesses can engage effectively with our community and grow. Our most recent data shows that this approach is working well, and we continue to be really encouraged by the feedback we’re seeing from people about our ads. There is still more work to be done here, but we’ve shown that we can continue to serve our community well while also growing a healthy business. So that’s my update on how we’ve been executing against our strategy over the last quarter. It’s been a busy quarter and a strong one. We’re proud of our progress as a company and everything that we’re accomplishing today. In large part this is due to the incredible quality of our team, and I’m very grateful for the support of everyone here at Facebook, as well as our stockholders and partners, as we continue working to achieve our mission. In addition to thanking our employees, I'd also like to thank one person in particular: David Ebersman, who is stepping down as CFO after almost five years. David has been a great partner in building Facebook. He has set the right tone about operating efficiently. He has set us up to make the long term investments we need. And most importantly, he has built an incredibly strong team, including Dave Wehner, who will be our next CFO. I've learned a lot from David, both personally and professionally, and I'm grateful for everything he has done to help make the world more open and connected. Thanks, and now here’s Sheryl."
},
{
"speaker": "Sheryl Sandberg",
"text": "Thanks Mark and hi everyone. Before I start, I want to join Mark in thanking David for being an extraordinary partner and friend over these past five years. As Mark said, he has contributed so much to our company and I've learned so much, personally, working with him. Great people build great teams and that's what David has done. And so I’m also really excited to continue working with Dave Wehner as he steps into his new role as our CFO. We are off to an outstanding start in 2014. Our total revenues were up 72% year-over-year and our advertising revenue growth accelerated to 82%. That’s our strongest year-over-year advertising growth rate in nearly three years. We’re really pleased with these results and the level of execution in our business. The team is staying focused on each element of our monetization strategy: capitalizing on the shift to mobile, growing the number of marketers who advertise with us, and investing in our ad products. Mobile continues to be a big driver for us – and a big opportunity. Mobile comprised 59% of our ad revenue in the quarter, up six percentage points from Q4. We continue to believe that this is because Facebook has the best mobile ad product in the market. We also continue to grow the number of marketers using Facebook and saw growth from existing advertisers as well. Our growth is very broad-based and coming from all types of marketers, with particular strength from SMB and direct response. We saw strong performance this quarter from verticals such as mobile gaming, e-commerce, and consumer-packaged goods. I am especially pleased with what we are seeing and hearing from clients around the world as they shift budgets to online, to mobile, and to Facebook. One recent powerful example is Sport Chek, Canada’s largest sports retailer. They recently decided to pull their paper circulars, which their company have relied on as its primary ad vehicle for 92 years for two weeks and replace them completely with digital spend, a majority of which was on Facebook. During those two weeks, national in-store sales grew 12% year-over-year and in-store sales of the items they promoted on Facebook grew 23%. As a result, they are going to continue with their tests and their goal is to transition more than 25% of their print spend to digital and Facebook in the next year. And last week I was in Europe meetings with clients, agencies, SMBs and developers and what I heard from them was how FB was becoming increasingly important in driving their businesses. Investing to improve and expand our ad products remains a very important priority for us. Our goal is to continue to develop new ways to help marketers reach their customers. We’ve done this over the last couple of years by enhancing our targeting capabilities, simplifying our ad products, and improving our measurement tools. I’ll touch on each of these three areas. First, targeting. Along with Facebook’s reach and scale, marketers value our proprietary targeting to help them reach the right customers and create more personalized and, therefore, more efficient and effective ad campaigns. Ten times more marketers are now using our Custom Audiences targeting feature compared to last year. To share just one recent example, Ben & Jerry’s wanted to drive more sales from its classic flavors. They used a wide range of our targeting capabilities, including Custom Audiences and Partner Categories, to reach premium ice cream buyers. Their campaign reached 14 million people, roughly 90% on mobile and drove an 8.1% sales lift from those consumers. As more marketers use our targeting tools, our ads become more relevant for our users and drive even better results for marketers. Second, we are simplifying and enhancing our ad tools for the over one million advertisers on Facebook. The tools that were previously available to only the biggest and most sophisticated advertisers like Custom Audiences and Partner Categories are now available in our self-service ad creation process. By making these tools more accessible, we believe we can grow the number of advertisers on our platform and improve their results. Additionally, for direct response marketers, we’ve added more specific calls to action in our ads, including “buy now” or “install now” buttons that greatly improve the efficacy of these ads. Finally, we’re also really pleased with the results we’re seeing from our investments in measurement tools. Our online conversion measurement tools enable our direct response advertisers to measure the impact their Facebook ad campaigns have on online sales. And, we recently launched new offline conversion tools to measure in-store sales, which have yielded positive initial results. Our ongoing focus will continue to be on improving the quality, relevance and performance of our ads and demonstrating value to marketers. We believe we still have a lot of opportunity to generate future returns by continuing to focus in these areas. We also have significant opportunities to develop newer products like premium video, ads on Instagram and our recently launched ad network test. Our initial efforts show a lot of promise and we’ve gotten good feedback from marketers in all of these areas. But, it’s still very early and we don't expect meaningful contributions from these projects this year. To summarize, our ads business is performing very well. I want to take a minute to congratulate and thank our teams all around the world and our ads engineering, product and design teams on the progress we have made. I also want to thank our clients, agencies, PMDs, and other partners, who work with us every day to use our platform to build their relationships with their customers to create personalized marketing at scale. It’s an exciting time for us as more marketers around the world gain conviction in the results they can achieve on Facebook. We have a great opportunity to build the world’s first platform for personalized marketing at scale. It’s early in that journey and we are going to stay focused on making the right investments in our ads business and executing against our plan. Thanks everyone, and now here’s David."
},
{
"speaker": "David Ebersman",
"text": "Thanks Sheryl and good afternoon everyone. Before I dive into the numbers, I wanted to say a few words about my decision to step down as CFO. This was a hard decision for me because of how much I love Facebook and all the people I work with here. In particular, I can’t thank Mark and Sheryl enough for their friendship and support and for letting me be a part of their team. I’m confident that Facebook’s best days lie ahead and I’m excited about the path Mark and Sheryl are leading the company on. My decision’s a personal one based on my desire to get back into health care where I spent my entire career before Facebook. And, after ten years as a CFO, half of them here, I’m ready for a different role and challenge. Right now feels like a good time for this change. The business is doing well, the foundation is solid, and in Dave Wehner we have a terrific successor who’s up to speed and ready to go. I have complete confidence in Dave and the rest of the Finance team. Dave will formally take over me in June and he’ll take my place on the next earnings call, though I plan to stay with the company through September to ensure a smooth transition. I also want to thank our shareholders for your partnership and support. Now to the quarter. Q1 was a strong quarter for us across the business. We increased our revenue growth rate, expanded operating margins, delivered free cash flow of over $900 million, and continued to make investments to position the company for near-term and long-term growth. Let’s start with some people metrics. The number of people using Facebook on an average day in March grew to 802 million, up 137 million from a year ago. As Mark mentioned, this daily number represents almost 63% of the 1.28 billion people who used Facebook during the month. And overall engagement remains strong. Additionally, these stats don’t include Instagram, which now has more than 200 million monthly active users, showing the remarkable progress by the team. Two years ago this month, when the acquisition was announced, Instagram had fewer than 22 million monthly actives. Turning now to the financials. Q1 total revenue was $2.50 billion, up 72% versus Q1 last year, and total ad revenue was $2.27 billion, up 82%. Ad revenue growth was strong around the world, with each of our four geographic regions growing by over 70%. Mobile ad revenue was approximately $1.3 billion, compared to around $377 million in Q1 last year, and notably mobile ad revenue was up 7% sequentially, despite the seasonal benefits in Q4. Desktop ad revenue in Q1 was up 8% compared to Q1 last year. In Q1, the average effective price per ad displayed increased 118% year-over-year while total ad impressions declined 17%. The decrease in ad impressions was due to factors including the continued shift towards mobile use, where people are shown fewer ads compared to desktop. The increase in average price per ad was primarily driven by a mix shift with more ads being shown in News Feed. News Feed ads have significantly higher engagement, click through rates, and price per ad compared to right hand column ads, so a higher proportion of ads appearing in News Feed drives up the overall average price per ad. The price volume trends were pretty consistent across our four geographic regions. Total Payments and Other Fees revenue was $237 million, up 11% versus Q1 last year. However, the more meaningful comparison, that better reflects the organic growth we saw in the Payments business, comes from looking at Payments volume from Games specifically, which was up 1% in Q1 compared to Q1 last year, down from the 8% year-over-year growth rate we saw in Q4. As we’ve discussed before, the shift to mobile is a significant headwind since our Games Payments revenue comes from desktop only, where usage is flat or declining, so growing this business going forward will be challenging. Turning to expenses, our Q1 GAAP expenses were $1.4 billion, up 32%, and our non-GAAP expenses were $1.1 billion, up 26%. Our headcount increased 39% from a year ago. Our Q1 GAAP operating income was $1.1 billion, representing a 43% operating margin, and our non-GAAP operating income was $1.4 billion, representing a 55% margin, up from 39% last year. While the margin improvement was helped by some non-recurring items that drove up costs in Q1 last year, we’re pleased that the increase in margins came mostly from cost of revenue and G&A. As planned, we’ve created efficiencies in infrastructure and administration while continuing to aggressively grow our investment in R&D along with marketing and sales to drive future performance. Our GAAP and non-GAAP tax rates were 40% and 36%, respectively. GAAP net income was $642 million or $0.25 per share, and non-GAAP net income was $885 million or $0.34 per share. In Q1, we spent $363 million on CapEx and generated $922 million in free cash flow. We ended Q1 with $12.6 billion in cash and investments. Now, looking forward. First, I want to note that the forward-looking comments I’ll share today do not reflect any impact from the recently announced acquisitions of WhatsApp and Oculus, neither of which has closed. After the deals close, we’ll update our guidance as appropriate. In terms of expenses, consistent with what we’ve said previously, we’re planning that our total 2014 GAAP expenses, including cost of revenue and stock comp, will likely grow in the neighborhood of 35% to 40%, and that non-GAAP expenses, including cost of revenue but excluding stock comp, will likely grow in the neighborhood of 40% to 45%. For taxes, we expect GAAP and non-GAAP rates for the rest of 2014 to be similar to or a bit higher than our Q1 rates, although this could vary widely depending upon our international revenue and expense mix, and other factors including the impact from acquisitions. We continue to anticipate our 2014 CapEx will be approximately $2 billion to $2.5 billion. We also continue to expect shares outstanding for calculating EPS to grow from around 2.6 billion at year-end 2013 by 2% to 2.5% in 2014 excluding the two large deals we’ve announced. Those deals once closed will add another 207 million shares, as well as additional unvested RSUs that will affect our share count over the subsequent four to five years. Turning last to ad revenue. As you know, our year-over-year comparables will get more challenging going forward from here because of the timing of the ramp up of News Feed ads in 2013. As the comps become more difficult, we continue to expect that over the rest of 2014, our year-over-year ad revenue growth rates will decline from the Q1 rate and be meaningfully lower by the end of the year. That being said, we believe, we are still in the early stages of building our ads business, and we remain as optimistic as ever about the long-term opportunity to grow revenue impressively by improving the quality and relevance of our ads and increasing the value we bring to marketers. In summary, Q1 was a great start to the year. We're very pleased with how well our ads performed. The strong marketer interest in our ads platform particularly on mobile and the investments we're making to build long-term shareholder value. Now let's open for questions."
},
{
"speaker": "Operator",
"text": "We will now open the line for a question-and-answer session. [Operator Instructions] Your first question comes from the line of Heather Bellini with Goldman Sachs. Your line is open."
},
{
"speaker": "Heather Bellini - Goldman Sachs",
"text": "Great. Thank you very much. I was just wondering, Mark or Sheryl, if you can share with us your vision of payments for Facebook, and how the Company might be able to play a role in reducing the friction that exists today when users are trying to engage in mobile e-commerce. And then the follow-up question was just going to be if you could share with us what inning do you think we are in, in terms of improving the relevancy of the ads that you are showing? Thank you."
},
{
"speaker": "Sheryl Sandberg",
"text": "On payments, our payments business has been important in supporting some of the developer activity on Facebook, primarily games. So we continue to be interested in that. I guess really important to know that, our advertising business is very relevant for e-commerce and that doesn't depend on taking payments and it doesn't depend on a payment strategy because we provide a really great opportunity for marketers to find customers who are then going to go ahead and buy their products both online and offline. In terms of relevance, I think we are in really early innings. I think people can see it from their own experience. Those people I talk to and certainly the data we have across the base of people use Facebook suggest that the ads are getting more relevant, but there is a long way to go. Our goal is that every time you open newsfeed, every time you look at Facebook, you see something whether it's from consumers, or whether it's from marketers, that really delights you, that you're genuinely happy to see. I think we hit that more than we used to with our ads, but I think the truth is we still have a long way to go to hit that bar and that's the bar we are striving for."
},
{
"speaker": "Operator",
"text": "Your next question comes from Douglas Anmuth with JPMorgan. Your line is open."
},
{
"speaker": "Douglas Anmuth - JPMorgan",
"text": "Great. Thanks for taking the question. David, just wanted to ask you a little bit more about margins, in particular. If we look at this quarter, it looks like the incremental margins here are 78% or so. So, I was hoping you could drill down a little more just on the drivers within cost of revenues and how you are thinking about the sustainability of that going forward. And is the 40% to 45% growth that you mentioned in non-GAAP OpEx, is that taking into account the acquisitions at all? Just thinking about how you can get to that level of spend given what you are starting the year. Thanks"
},
{
"speaker": "David Ebersman",
"text": "Yeah. Thanks for the question Doug. I think Q1 is traditionally a light spending quarter for us because we budget with an annual cycle and often it takes some time to sort of ramp up the new program. So I don't think it's surprising that Q1 year-over-year increase would come in a little lighter than we expect for the full year. Additionally there were some one-time things that benefited the quarter, that kept expenses down particularly in cost of revenue as we continue to exit lease data centers and sort of amend our supply chain. I think that going forward our expectation was and remains the 40% to 45% growth excluding the impact from the acquisitions. So, we will update that guidance once the integration plans are clearer and have a better sense for what those spend patterns will look like. In general in terms of margins, the comments I would make are that, we don’t have a quarter-to-quarter target margin that we're managing closely to. To do so, would require varying our spend patterns as revenue changes up and down over time. And I think that's the wrong way to focus on how you spend your money in the company. Our priority is really to try and make investments that are high quality that drive the creation of value and makes the business better. And since many of those investments take a longer period to mature, we want to be able to think about our spend increases over a longer term horizon. And as you can see looking back at the last couple of years and then our plans for this year, there has been a pretty steady rate at which we've been growing spend particularly in R&D and marketing and sales where we really want to focus on making sure we're growing smartly and thoughtfully at a rate we can manage wisely and doesn't get ahead of our ability to manage it. On cost of revenue and G&A what you can see in the Q1 numbers is the fruits of a lot of labor trying to manage those parts of the business really efficiently and free up resources to invest elsewhere. So, I think we've always believed that Facebook has the opportunity to be a sustainably high margin business and we continue to believe that, noting that there were some individual items that helped us in Q1."
},
{
"speaker": "Operator",
"text": "The next question comes from Carlos Kirjner with Sanford Bernstein. Your line is open."
},
{
"speaker": "Carlos Kirjner - Sanford Bernstein",
"text": "I think for Mark, how do you think about the evolution of browser technology, HTML5, and development tools versus native apps? If you look two to three years out, do you think native apps could finally become less important for many use cases? Or, in other words, maybe you guys were not wrong when you tried HTML5, you were just too early. Thank you."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yeah, well timing matters a lot and so, I do think that there's nothing wrong with the standard of HTML5 technically. I think a lot of what we see is what the main platform providers want to push as the standard for developing on their own platforms. And what we've seen is that both Apple and Google have really favored and made it easier to build high quality experiences in their own proprietary formats rather than the open web format. So, while our bias for a number of reasons would have been to have really pushed on HTML5 and I don't want to sound like we've walked away from this because a large number of people access Facebook from the mobile web and I don't know if we break that out specifically but it's quite a large number of people. So, we're continuing to develop that, but for the foreseeable future, we see the best path to continuing to deliver great experiences by working on the native app experiences that we have now."
},
{
"speaker": "Operator",
"text": "The next question comes from Eric Sheridan with UBS. Your line is open."
},
{
"speaker": "Eric Sheridan - UBS",
"text": "Thanks for taking the questions. Congratulations, David, on your future endeavors, as well. Mark, maybe a quick question for you about the way in which you think Facebook, and the various applications Facebook is developing also, move towards a communication ecosystem longer term. A big picture question on where the various applications go, the ones that are in the process of being acquired and the ones you are developing organically. And then second question, to use the baseball analogy again, as you continue to take ad impressions out of the Facebook platform, wonder if we should think about where you get to longer term on a level of ad impressions that you think are the perfect mix for balancing engagement and monetization, and what inning we are in that process."
},
{
"speaker": "Mark Zuckerberg",
"text": "Sure. I think I can probably take both of those. So in terms of building out a whole communication ecosystem, the way that we think about the new apps and products that we're building is that people want to share all kinds of different content with all kinds of different audiences. Right so, sometimes you want to have one-on-one conversation or text or chat or voice call up to having a small group conversation to communicating, updating all your friends and something at once. And sometimes there is really good public content, whether it’s news or premium video or things like that. At the intersection of each type of content and each audience, we think that there is a really compelling experience to be built. And Facebook historically is focused on friends and public content, now with Messenger and WhatsApp we're taking a couple of different approaches towards more private content as well. You're going to see us do more things in more private content I think, I don’t know that’s an ecosystem that's growing incredibly quickly and also that speaks to why WhatsApp and Messenger are both growing independently quickly is because they actually serve pretty different used cases within private sharing and private content. In terms of our investments, I think you want to look at it, I kind of outline this in my remarks, but I think it's important enough to say again. There are different stages of maturity for the different things that we're doing. So, the Facebook app by itself is the furthest along and more than a billion people use it and it's not only one of the most used apps, but it's the most used app it's also at the core of our business. Then the second set of apps that we have are Messenger, Instagram and soon WhatsApp and you know Messenger and Instagram are each now greater than 200 million active users. I think the WhatsApp folks independently announced, I think it was yesterday that they just passed 500 million active. So these are apps that are now at a pretty big scale and the immediate priority is going to be getting them to a billion people where they're continuing to focus on that before focusing on monetization and the way that we have with the core Facebook app, so that's kind of a second stage. The third set are the new Facebook Creative Labs apps that we're just getting started. The things like Paper and a number of other things that we might announce that at some point. Those are even further along than even Messenger, Instagram and WhatsApp, where it will probably take few years for those to even to get to the stage that Instagram, Messenger and WhatsApp are at, which by themselves are probably a few years away from being important businesses for us. So that's kind of the pipeline of things that we see and there is kind of a full ecosystem of different ways the people want to share with different people. In terms of ads going to your second question, I don't actually think we have a strategy that decrease ad impression. I think what you're seeing and what David mentioned is, we have newsfeed ads, which are higher quality and perform better and then we have this legacy of right hand column ads on desktop, which generally are just showing higher volume and they performed less well per ad unit. So as we shift more towards newsfeed, what you're seeing is the total raw number of impressions as decreasing, but actually the amount of value that we're delivering is increasing. So that might continue to shift as we continue to shift towards mobile, but I think overall what we're trying to do is make it that the individual load on a per person basis is isn’t increasing at a dramatic rate, but instead we're driving most of the wins in user experience, advertiser performance and our own revenue to increasing the quality primarily around newsfeed ads. And we think that there is quite a lot to go there as Sheryl said. We want to get to a state where the ad content is as good as the organic content and we see we're getting pretty close in a few countries but we want to get to that everywhere."
},
{
"speaker": "Operator",
"text": "Your next question comes from Peter Stabler with Wells Fargo. Your line is open."
},
{
"speaker": "Peter Stabler - Wells Fargo",
"text": "Good afternoon. Thanks for taking my question. I wanted to ask a question about engagement. By one measure, DAU over MAU, it's at an all-time high. But no doubt you always have a body of last users. I'm wondering if you could share any color on what types of algorithm or product tweaks that you've made have yielded the most return or the greatest return in terms of re-engaging last users. And then, secondly, just quickly, any color you could provide on your estimate of the overlap of Instagram and Facebook users, perhaps based on the linking of those accounts. Thank you very much."
},
{
"speaker": "Mark Zuckerberg",
"text": "Unfortunately, I don’t think I'm going to have much color on either of those. We are constantly doing things to make it so that people can share the content that they want, that they have the tools, that the new network showing them most relevant content to people. That is always going to be the way that people will use the service not through some kind of trick or something that we're using to reengage people. One stat that I think is pretty interesting is that, you would expect naturally that as our -- the community continues to grow and we're getting into later and later adapters, that the percent of people who are using Facebook or use it every day would decrease. And I have actually predicted for a long time, that eventually that would flatten out and I thought it would decrease but actually it continues to increase much to our surprise and joys. And you know now this quarter I think, we're add almost 63% of people who use Facebook in a month will use it in a given day. And I think another stat, I think is actually quite interesting, is we tracked how many people use Facebook not just every day. So I mean one day out of -- so what percent of our monthly folks use it today. But what percent of people used it six out of seven days of the week. And that number for the first time in the last quarter passed 50%. So I mean that's pretty crazy if you think about is that, you have this really big engaged community and not only are almost 63% of people touching it in a given day and using the service because it's really engaging content, but we've gone to a period where more than 50% of people have used it six out of seven a week, almost every single day of a week. That just speaks to I think - just the underlying kind of fundamental strength in the content and the work that we're doing just surface the best content of best people."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ben Schachter with Macquarie. Your line is open."
},
{
"speaker": "Ben Schachter - Macquarie",
"text": "First, David, let me add my congratulations on your success. And good luck with the future role. Mark, beyond games, do you see other categories of apps that are ramping? And do you need to see that or can games continue to be the primary driver of app install and app engagement ads? And then, separately, on Graph Search, do you see the potential for more partnerships for Graph Search in terms of additional data sets and distributions partners? Or is this more go-it-along? And then, finally, maybe for Sheryl or David, can you just give us a sense on pricing trends on app install ads? Thanks."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yes, I mean on app-installs, I actually think we see more diversity in the customers and developers on mobile now then we saw on desktop with Canvas. So Canvas the business was almost entirely games that is now -- we see that a lot of these games, but a lot of it is other kind of folks because I mean everyone who is building apps on mobile needs installs and we have the number one products out there for delivering that. So, we see that happening and we feel pretty good about that."
},
{
"speaker": "Sheryl Sandberg",
"text": "On pricing, we don't break our pricing by type of ad, but overall in the ecosystem, our prices are up as Mark said, the effective price per ad shown is driven up by more ads and newsfeed, and that's because newsfeed ads have significantly higher engagement and click-through rates."
},
{
"speaker": "Operator",
"text": "The next question comes from Evan Wilson with Pacific Crest. Your line is open."
},
{
"speaker": "Evan Wilson - Pacific Crest",
"text": "Hi, thanks for the question. Just a small item. It looks like the Asia engagement metric, the MAU, was down sequentially, slightly. Was there something there that impacted that in Q1 or was there something competitive there you think might be impacting that part of the business, like the big mobile messaging services? Thanks."
},
{
"speaker": "David Ebersman",
"text": "I don't know that I would read anything into that yet. We haven't identified that as a trend that we're focused on at this point. The number is $2 bucks around a little bit from quarter-to-quarter in various regions."
},
{
"speaker": "Operator",
"text": "The next question comes from Anthony DiClemente with Nomura. Your line is open."
},
{
"speaker": "Anthony DiClemente - Nomura",
"text": "Congratulations, David. And best of luck in your new endeavors, as well. One question for David and one for Sheryl. David, I just wondered if you could talk about your mix of impressions in terms of brand versus direct response. How has that changed this quarter versus prior quarters? And what else can be said about that split? And then, secondly, for Sheryl, just wondered if you could give us a little more of an update on premium video ads. Specifically, I'm curious as to how those are sold. Are they sold on an impression basis or on a performance basis, or some hybrid of the two? And then I know you don't give pricing by property, but is there a way to think about the premium or premium multiple of price that premium video ads would go for as compared to core News Feed ads? Thanks for any color on that."
},
{
"speaker": "David Ebersman",
"text": "Thanks Anthony, I'm happy to take the first part of the question. I think in the first quarter we delivered strong performance across all the advertiser segments that we focus on. And so I think they are all growing nicely. We don't have a perfect measure for what kind of demand is, brand versus DR per say, because someone doesn't have to input that into the system when they come in. We've lots of things we do to try and find surrogates for that and are happy to see using some of that data, we're seeing nice growth across the various segments."
},
{
"speaker": "Sheryl Sandberg",
"text": "On video ads, video represents a really big opportunity, really driven by consumer behavior. Smartphones are going better and faster and more people have phones that can provide a great video experience. So we're seeing consumers do a lot more in video. There's also a lot more video going through newsfeed that consumers are putting in and that creates an opportunity for us, both on the consumer side and the ad side. We have our current product in the market, it's a click to play video ad, it's part of the page post, you can post the video. Those are so both CPM and CPC and those are going really well and I think explains some of the growth we are seeing in our ads business. We also have been in early conversations with some clients about what would be a CPM autoplay video ad and in terms of the expectations for that, we really want to see autoplay video ads be something that's pretty common in the newsfeed experience based on consumer usage before we push very hard in the ads business. So we remain, long term very excited, we do expect that product, demand to premium product but as I said in my remarks, we won't see a material contribution from it this year."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mark Mahaney with RBC. Your line is open"
},
{
"speaker": "Mark Mahaney - RBC Capital Markets",
"text": "On those autoplay videos, as an average Facebook user, I've noticed them more and more in my News Feed, and I think they're really neat. I think all my friends love watching videos of my kids play basketball. The question I'd have for you is what have you seen internally in terms of engagement. I assume that since I'm seeing more, other people are too, and that users like having them in. But is there any way you could quantify or maybe talk broadly about the impact that's having on usage? Thank you."
},
{
"speaker": "Sheryl Sandberg",
"text": "Our goal is to make newsfeed as engaging as possible and I think if you look at the engagement we have on mobile, we're getting 20% of mobile time on Facebook in the U.S. and growing globally as well. I think you see with that engagements grade, I'm sure your friends love seeing your kids play basketball. I think they probably like to see more of those. And when and if we deliver a really great ad experience and ads that you love, something you're interested in, I think you're going to like that just as much, we look forward to the growth."
},
{
"speaker": "Operator",
"text": "Your next question comes from Justin Post with Merrill Lynch. Your line is open."
},
{
"speaker": "Justin Post - BofA Merrill Lynch",
"text": "Great. I have a couple questions. On the app installs, can you help us at all understand what -- I know you gave us the number of total apps, but maybe how that revenue as a percentage of total, how important it is to you? And then there's a lot of competitors targeting that market with new products. Maybe you could outline some of Facebook's competitive advantages in that market. And then one for Dave. We will miss you. Maybe you could talk a little bit about maybe some things Facebook could do to offset some of the dilution from the acquisitions, if anything. Thank you."
},
{
"speaker": "Sheryl Sandberg",
"text": "On mobile app ads, we've seen really strong adoption and this is a very nascent but growing market. I think people sometimes think that a lot of our mobile ad revenue is coming from this one type of ad and our mobile ad revenue is very broad based. We know you're seeing in newsfeed and what we see are ads from brand marketer's direct response, SMB's end developers and so we're pretty distributed there and pretty happy about that. I think it's not surprising that other people are entering states, it's obviously growing, it's one that performs well. I think we continue to be excited by the results we're seeing for our marketers and developers. The results we are seeing from consumers and we think the fact that we've already been investing and learning and growing, puts us in a great position to continue to have a very strong product offering even in a more competitive space."
},
{
"speaker": "David Ebersman",
"text": "So, Justin on the -- the acquisition is the most important thing we'll do to truly I would say justify, the delusion will be to make those acquisitions successful and over time ensure that the unique assists that we're buying contribute to Facebook success and to our cash flows over time. This business is obviously in really healthy shape right now in terms of the cash it's generating and we look forward at the moment to really continuing to prioritize where it's appropriate, investing that in the business to drive future growth."
},
{
"speaker": "Operator",
"text": "Your next question comes from Youssef Squali with Cantor Fitzgerald. Your line is open."
},
{
"speaker": "Youssef Squali - Cantor Fitzgerald",
"text": "Thank you very much. So firstly David, can you talk a little bit about the ad load during the quarter? We saw noticeable increases here in the holidays and through Q1 versus that 5% or 6% you mentioned back on the Q3 call. Is the new ad load we are seeing sustainable, do you think, going forward? And, second, maybe Mark or Sheryl, can you just talk a little bit about timing for monetization of Instagram? Are there any thresholds, either in terms of users, user engagement, whatnot, before you can ramp that advertising, or advertise on that platform? I think, David, you were talking earlier about maybe reaching a billion, but I think that was a general comment. Thanks."
},
{
"speaker": "David Ebersman",
"text": "Yeah, thanks Youssef. So as Mark sort of alluded to earlier as it relates to ad load, what we're trying to do is optimize across multiple variables that really produce the best experience for people who use the network and help us to grow the business. And ad load is one of the variables that we look at. And of course we also look at things like the size of the ad, the prominence of the ads and of course the quality of the ads. And what we're trying to do is to continually really tweak all of those variables and then measure what impacts we're having on engagements, on feedback from people, on revenue and trying to optimize using that data and the changes that we've made. And I think the story there is a really good one. Things continue to go very well obviously in terms of revenue what you see, but also in terms of engagement, in terms of feedback we get from people when we survey them. So we think we remain in a really very strong position in that way. Actually we'd not validate the assertion that you gave that the ad load increased dramatically in the timeframe you described since that's not consistent in aggregate with our data. What I can say is that, every person who uses Facebook has their own experience and the experience including the ad experience is personalized based on the other content we have available based on how much they've engaged with ads we've shown in the past etcetera. So, ideally we'd like to personalize not just the organic content that you see, but also your ad experience in a way that's really optimized for you and your interests."
},
{
"speaker": "Sheryl Sandberg",
"text": "On Instagram, Instagram is a great product. I think that's why we see so much engagement from people who are using it and the gross passing 200 million. It's also a great advertising product and there's just tons of demand because you know, the picture themselves are so visually appealing and also there's so much consumer engagement. We're in really early days, we've seen some great results, just to mention one, Levi's is running an ad, which is basically pictures of people wearing denim in really beautiful outdoor spaces. They targeted people 18 to 34 in United States. Reached over seven million people and importantly they drove a 24%-- 24 point left in ad recall which was three times the control group. So, I think that shows that just as people engage with consumer pictures on Instagram, they're going to engaged with the right pictures from marketers. That said, we're very focused on consumer growth and we move slowly and deliberately in monetization. So, we don't see the need or the urge to ramp this as quickly as we possibly could but really want to grow it slowly, grow it deliberately and continue the growth on the consumer side and a great returns for marketers."
},
{
"speaker": "Operator",
"text": "Your next question comes from Colin Sebastian with Robert Baird. Your line is open."
},
{
"speaker": "Colin Sebastian - Robert Baird",
"text": "Thanks, I appreciate the chance to ask two questions. The first one is, I wonder if there's any way we can generalize or correlate around the growth in mobile monetization with the shift to 4G LTE, and whether this could be a driver, as well, of improving monetization internationally, as those higher-speed networks are deployed in new markets. And then, secondly, regarding Nearby Friends, just wondering how you plan to tie that feature and data set into more of a commercialized local offering for businesses, whether that's geo targeting or other related services. Thank you."
},
{
"speaker": "Mark Zuckerberg",
"text": "Well, a lot of what we're trying to do with internet.org is making so that everyone has the cellular networks that they need to be able to get on the Internet and access basic services, which we think are text-based communication services, whether it's things like social networks or messaging or email or search, whether stock prices,-- like basic stuff like that, that people will use on a day-to-day basis, but don't require huge amount of data. We're pretty happy with the early progress that we've made. We have a multi-year initiative to work with operators around the world to roll-out a program where folks can have free basic services. And as I mentioned before, a lot of the initial work is the initial partnerships were in the Philippines and Paraguay. And what we're really pleased with, even just a few months of work, we were able to help almost three million people get access to data for the first time. So, there is no doubt that going from having no access to data to having some access is a huge jump in terms of the activity on the business that we see -- that's available from people. Moving towards things like LTE later on in the funnel, will be helpful as we move towards richer types of contents like higher resolution photos and videos. so that will be important especially as the mix of content that people share moves towards the richer media. But we're really focused on both and we have a huge investment as well and the internet.org starting just making sure that everyone in the world gets connected."
},
{
"speaker": "Sheryl Sandberg",
"text": "And Nearby Friends, it's a great new features, is an optional feature we just rolled out last week, I don't know if, people have had a chance to try it yet. But, rolling out slowly, but it’s a great product experience one we're excited to be able to offer. We use the information like this to enhance all the services we provide, and make things more relevant including relevant ads."
},
{
"speaker": "Operator",
"text": "Your next question comes from Brian Wieser with Pivotal Research. Your line is open."
},
{
"speaker": "Brian Wieser - Pivotal Research",
"text": "Hi. Thanks for taking the questions. First of all, I was wondering, with regard to the WhatsApp acquisition, I was wondering if you could update us on the status, if the current situation with Russia poses any issues given the development team space there. And then, separately, I was wondering if you could talk Nielsen and the use of OCR with respect to advertisers' interest in using OCR tools. Do you find that that's making a difference at the present time in terms of brands spending money with you, in general?"
},
{
"speaker": "Sheryl Sandberg",
"text": "On the first, yeah, the development team is located in Mountain View not in Russia. So…"
},
{
"speaker": "Brian Wieser - Pivotal Research",
"text": "And they are doing extremely well."
},
{
"speaker": "Sheryl Sandberg",
"text": "Yes, they're doing really well."
},
{
"speaker": "Mark Zuckerberg",
"text": "The deal has been closed. We don't have anything to share. But I just would just point you to a blog post that Jan wrote. I think it was yesterday announcing that they just help to connect 0.5 billion monthly asset. We're growing very quickly. So I think that's up to about 460 million monthly is just a couple of months ago when we announced the deal was done in the first place."
},
{
"speaker": "David Ebersman",
"text": "And I think that Jan specifically called out a few countries including Russia and Brazil and I think India is some of the fastest growing markets for WhatsApp. So I'd just direct you that statement and you should read that for more information on how they're doing and we'll update you more when the deal closes."
},
{
"speaker": "Sheryl Sandberg",
"text": "And Nielsen OCR anything that helps advertisers measure their spend is really important. I've talked on the call a bunch about how measuring online and in-store sales really matters. It also matters to marketers to be able to measure their spend compared to other investments they can make. And what OCR has done, it's given advertisers and marketers comparability between TV and digital and our spend. I think in those comparisons we do very well. And I think that is part of the shift that’s happening and its part of why we see growing interest from clients."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ross Sandler with Deutsche Bank. Your line is open. Ross Sandler, your line is open."
},
{
"speaker": "Ross Sandler - Deutsche Bank",
"text": "Good afternoon. Can you guys hear me now? Okay, Just two quick questions. Facebook's on pace to represent around 20% of global display advertising or non search advertising in 2014. Do you view that as your addressable market? And, if so, what do you see as the potential market share you guys can capture relative to the -- I think, Sheryl, you said it is 23% mobile consumption, ex-China, globally today. And then the second question is, there's been some press recently that Facebook is looking at building peer-to-peer money transfer services. Is that a market that you view as an opportunity? Would that fit into Messenger or potentially a standalone app?"
},
{
"speaker": "Sheryl Sandberg",
"text": "We had our payments business for a while and we continue to have one and nothing new to apps there. On the first question, I think our adjustable market is much bigger than digital and you see that in the trends. The big trend that’s happening is the shift from consumer time. So last year was the very first time those lines crossed and consumers spent more time in digital, which is mobile and desktop than they did on TV. That continues to grow, so where we are right now is, the average U.S. consumer as an example spent 4.5 hours per day on TV but five and three quarter on digital and that’s largely been driven by mobile. That means that as consumer time and attention shifts, we think ad budget shift as well particularly if you have good mobile ad products and you can measure results. So we definitely believe there will be and continuous to be a shift happening. I talked about a print shift happening with that example of Sport Chek in Canada. But we see this across the board that marketers are looking for the highest ROI they can find and they should be comparing us and everyone else across and they do that not just across digital but across print, across radio, across TV, across any other vehicle they can. I think our investments and measurement really pay-off here. We say to our clients all around the world, we want to earn your business because we want to be the best dollar and the best minute you send because both their dollars and their time are so valuable. And we want them to compare us to the other investments that could make to see who can drive the most value to the bottom line and that's what we are focused on and that goes way beyond digital."
},
{
"speaker": "Deborah Crawford",
"text": "I think we have time for one last question."
},
{
"speaker": "Operator",
"text": "Your next question comes from John Blackledge with Cowen & Company. Your line is open."
},
{
"speaker": "John Blackledge - Cowen & Company",
"text": "Great. Thanks for the questions. Just wondered if you could discuss how Facebook's potential mobile ad network would provide additional value to advertisers than other existing mobile ad networks. And then just a second question for David. I don't know if you could help quantify what meaningfully lower year-over-year ad revenue growth is, or just give us a sense of how to think about it for modeling purposes. Thank you."
},
{
"speaker": "Sheryl Sandberg",
"text": "On the ad network, we are in very testing for mobile ad network. We do see a big opportunity here. We think because we're people based, we have an opportunity first to provide greater reach for marketers and developers who are working with Facebook across other platforms, but also improve the relevance of the ads people see both on and off Facebook. And I think that has been our core advantage and will continue to be. That said, it's really early days and we're on the early testing phase."
},
{
"speaker": "David Ebersman",
"text": "Yes John, obviously the Q1 ad revenues growth here was 82% which is fantastic and a real tribute to the team and the platform. One of the things that contributed to that growth rate is the ramp up of newsfeed ads that in Q1 of last year was still really early in that part of the journey and so the comparison between the state of newsfeed ads in the Q1 we're reporting now in a year ago is meaningfully different. As you'll remember from last year, newsfeed ad really ramped up in the second quarter and revenue growth ramped up as well. So that’s just going to impact the comparisons in the subsequent quarters of the year. Having said that, there is lots of things that we're focused on, that will continue to drive our ad revenue growth including more users and critically more marketer demand. So bringing more marketers into the system, improving our products and tools to increase their returns and their ability to measure those returns and generally improving the quality and relevance and value of the ad. So those are the things that we'll stay focused on."
},
{
"speaker": "Deborah Crawford",
"text": "Great. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again."
},
{
"speaker": "Operator",
"text": "This concludes today's conference call. You may now disconnect."
}
] | null | null |
META | 4 | 2,013 | 2014-01-29 17:00:00 | Executives: Deborah Crawford - Director of Investor Relations Mark Zuckerberg - Chairman of the Board, Chief Executive Officer Sheryl Sandberg - Chief Operating Officer David Ebersman - Chief Financial Officer
Analysts: Ben Schachter - Macquarie Heather Bellini - Goldman Sachs Mark May - Citibank Anthony DiClemente - Nomura Douglas Anmuth - JPMorgan Scott Devitt - Morgan Stanley Eric Sheridan - UBS John Blackledge - Cowen & Company Brian Pitz - Jefferies & Company Ross Sandler - Deutsche Bank Tom Forte - Telsey Advisory Group Jordan Rohan - Stifel Nicolaus Colin Sebastian - Robert Baird Mark Mahaney - RBC Capital Markets
Operator: Good afternoon. [Operator instructions.] Ms. Deborah Crawford, Facebook's director of investor relations, you may begin.
Deborah Crawford: Thank you. Good afternoon, and welcome to Facebook's fourth quarter earnings conference call. Joining me today to talk about our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and David Ebersman, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements, and actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release, our annual report on Form 10-K, and our most recent quarterly report on Form 10-Q, filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I’d like to turn the call over to Mark.
Mark Zuckerberg: Thanks, Deborah, and thanks, everyone, for joining today. This was a great quarter and a great way to end the year. We saw strong growth in engagement around the world, and we’re very pleased with the growth of our ad business, especially on mobile. Overall, 2013 was an important year for us. If 2012 was the year we turned our core product into a mobile product, then 2013 was the year when we turned our business into a mobile business. I expect 2014 will be the year when we begin to deliver new and engaging types of mobile experiences. As of the end of the year, more than 1.23 billion people now use Facebook each month. Last quarter was our first quarter where more than 50% of our ad revenue came from mobile. Looking back at the year, we launched an important products and initiatives: internet.org, graph search, Instagram video, and Messenger 3.0. We also made a lot of improvements to the performance and reliability of all our mobile apps. One important trend from the last year is the continued growth in size and engagement of our community. In 2013, we added 172 million monthly actives and 139 million daily actives. That means that our daily engagement continues to increase. In the latest quarter, more than 60% of our monthly actives visited Facebook daily. Given the size of our community, we’re very excited about this pace of growth. We’re also seeing people engaging more. On the average day in December, we saw more than 6 billion likes. That’s up 59% from 3.8 billion likes a year ago. These trends show that our strategy of improving the quality of our core experiences over the last year has paid off, and we’re now in a good position to focus on our longer term goals of connecting everyone, understanding the world, and building the knowledge economy. Connecting everyone is about bringing the internet to everyone and giving them the tools to stay connected with the people and things that matter to them. Today, more than 750 million people use Facebook every day. While that makes up by far the largest social network in the world, we’re still a small part of the world’s population. Only one-third of the world’s population has access to the internet today, and for even many of those, the return on experience remains pretty weak. Helping more people get connected is important the developing the global knowledge economy. Once people are connected, they can access tools like basic financial services, health information, and education tools to help them take care of their families and join the worldwide economy. That’s why last summer we launched internet.org, a partnership with industry leaders to make affordable internet access available to everyone in the world. In 2014, we’re going to focus on achieving internet.org’s mission by deepening the relationships with mobile operators around the world and working to develop new models for internet access. Our existing partnerships with operators are something we’ve already invested a lot in over the years, and this is an area where we’re really excited to build on going forward. Connecting everyone ultimately means giving people the power to share different kinds of content with different groups of people. This is something we’ve focused on by building separate mobile apps beyond the main Facebook app. Messenger and Instagram are examples of this. We launched a new version of Messenger to make the app even faster for mobile to mobile communications. Messenger was among the topmost downloaded apps on iOS and Android in December, and we’ve seen meaningful growth in engagement since launching. The number of people using Messenger grew more than 70% in the past three months, and we’ve seen a large increase in the number of messages sent. We have a lot more coming to messenger in the first half of this year, and I’m excited to build on these early results. Instagram also had a busy quarter, bringing Instagram to Windows Phone, launching our first ads, and launching Instagram Direct, the new way to send private photo and video messages. We’re pleased with the early reaction to all these products. With ads, the team has taken an especially careful approach, working closely with a small number of brands that are already important members of the Instagram community to create a great early experience. I’m also excited to report that there are now more than 500 million people using Facebook Groups every month. Groups is one of our core products, and it provides a private space for sharing with small groups like your family, close friends, or a sports team, or for larger communities, like schools or even companies. One theme that should be clear from our work on products like Messenger, Groups, and Instagram is that our vision for Facebook is to create a set of products that help you share any kind of content you want within the audience you want. We’re not just focused on improving the experience of sharing with all of your friends at once, although that’s growing quickly too. A lot of the new growth we see is coming from giving people the tools to share with different sized groups of people. Now, moving on to our business, last quarter I talked about our efforts to grow our business through improving the quality of our ads rather than just increasing the quantity. Our goal is to reach a point where the ads are as relevant and timely as the content your friends share with you. To do this, we’ve put a lot of effort into measuring people’s sentiment around our ads and seeing how people engage with them. We do some of the broadest surveys in the world. We survey more than 35,000 people every day to see how we’re doing, and we use the results to drive our product development. Our approach is working. In the second half of 2013, we saw an improvement in sentiment about ads on mobile, even as volume grew during that period. We also saw sentiment on desktop remain stable. Interestingly, even as the volume of newsfeed ads has grown, clickthrough rates have also remained stable. We’re very pleased with these results, and they suggest our strategy of improving quality is working. Our plan is to continue focusing on improving quality, since we think this is the best way for us to improve the experience for people on Facebook, returns for advertisers, and our own revenue, as well as achieving our long term goal of providing ads that are as relevant as organic content. So that’s my update on where we’re focusing our efforts in the context of our longer-term goals. It’s been a strong quarter and a great year for Facebook. Next week, Facebook turns 10 years old. It’s been an amazing journey so far, for me personally and for all of us at the company. But what’s ahead of us is even more exciting. Many of the successes of the past 10 years have simply been steps on the path to achieving our long term vision of connecting everyone and improving the world through sharing. Over the coming months and years, you’ll see us continue focusing on many of the same themes, but now with greater scale, ambition, and resources. Finally, I just want to thank everyone who works at Facebook for a great year in 2013 and over the past 10 years. What we’ve achieved together has been a result of all your hard work, and I’m grateful that so many talented people are a part of our team. Thank you, and now here’s Sheryl.
Sheryl Sandberg: Thanks, Mark, and hi, everyone. I am really excited to report earnings this quarter, and proud of the teams at Facebook who delivered these results. We ended 2013 with a terrific quarter, continuing the strong momentum we saw throughout the year. Our total revenue grew 63% year over year, led by 76% growth in advertising revenue. Approximately 53% of our ad revenue came from mobile. This is not only the first time we crossed the 50% threshold in mobile, but it’s also our first billion dollar mobile quarter. In fact, our Q4 mobile ad revenue of $1.25 billion was nearly as large as our total ad revenue in Q4 of last year. This growth continues to be very broad-based. The combination Mark spoke about of our growth in users and engagement and the effectiveness of our ads in newsfeed work together to provide marketers with a powerful way to reach people. This impact is evident in our results. This quarter, we saw healthy increases in every region around the world and positive momentum in all four marketer segments. There are three key drivers propelling our business. First and foremost is strong mobile engagement. Every day, more people around the world are spending more time on their mobile devices, and marketers are starting to shift their budgets to reach them. This was especially clear during the holiday season, where not surprisingly, Black Friday was our single biggest mobile ad revenue day in the quarter. When people are shopping in stores, they’re on their phones, and when they’re on their phones, they’re on Facebook. A recent study by Millward Brown Digital showed that while shopping in store, people who use Facebook do so at four times the rate of any other app or search. And for those people that use Facebook as a source before shopping, over half stated that it was a very influential source of information for them while they were shopping in the store. The second driver of our ad business is a continued growth in the number of marketers using Facebook. Again, this growth is broad-based and diverse, across marketers, verticals, and geographies. I’ll update you briefly on each of our four marketer segments. Demand from direct response marketers was strong in the Q4 holiday shopping periods, particularly in ecommerce. These marketers focus on short term ROI, so the growth we’re seeing speaks to our ability to efficiently drive sales for them. For example, online retailer NoMoreRack used Facebook to promote its holiday deals. They hit their aggressive ROI targets and they generated $8 million dollars in revenue on Black Friday alone. We’re also making remarkable progress with SMBs, a segment that many in the industry have long considered the Holy Grail of online advertising, and a segment that I’ve been particularly focused on throughout my career. In November, we reported that more than 25 million SMBs maintain an active page on Facebook. We’ve made a big investment in simplifying our ad products over the last year, and that investment is working to convert these SMBs into advertisers. Of the new SMB advertisers we acquired in Q4,72% started with our most simple ad product. For developers, mobile apps are generating very healthy revenue growth. We launched mobile app [install] ads just over a year ago, and mobile app engagement ads last quarter, based on a very simple idea, that we can help people find and use great apps. This is working even better than we hoped. We’re helping developers attract new customers and keep them engaged. We remain excited about the opportunities in this small but quickly growing category. In addition, last week we announced a small test to show Facebook ads in third-party mobile apps. We won’t have meaningful results for a while, but it’s an interesting area for us to explore. And finally, we’re making steady progress with our brand marketers, particularly in verticals like CPG. We’re helping them connect with customers in more dynamic ways, starting a small test of our new video ad product, and measuring our impact on their sales, which is super important to driving their business. The third driver for both the quarter and the full year has been our investment in product development. We’re especially pleased with the improvements we’ve made to our targeting capabilities and measurement tools. Our goal, as Mark said, is to make our ads as useful as possible for consumers and to generate greater returns for marketers, eventually making all of our ads as valuable to users as our organic content. Custom audiences is our most important product in this effort. When we launched it over a year ago, it allowed marketers to reach their current customers on Facebook. Since then, we’ve built more targeting capabilities while maintaining user privacy. These include lookalike targeting that lets marketers reach people who are similar to their best customers and partner categories which use third-party data to improve our targeting. Now marketers can reach exactly the people they’re looking for, such as people who buy fashion apparel or are in the market for a new car. We’ve more than doubled the number of partner categories in the U.S., and now offer more than 1,000. And we believe there’s still significant opportunity ahead, as we continue to improve our targeting capabilities. We’re also making major investments in measurement so that we can measure the impact of our advertising on in-store sales. In December, we launched offline conversion measurement. To date, our results show that the average return on ad spend for newsfeed campaigns is 8x, a result that is really impressive when compared to other returns marketers have available. As Mark noted, this is the beginning of a new year, and our 10th anniversary, so I want to reflect really briefly on where our advertising business and we believe the marketing industry is headed. Before mass media, all business was personal. Sales happened customer by customer at the local store or door to door. The evolution of mass media made it possible to sell at scale, but business was no longer personal. On Facebook, marketers can do both. We’re building the world’s first global platform that lets marketers personalize their messages at unprecedented scale. This is marketing where you are for who you are. This shift to personalization represents the biggest shift in marketing in generations, and it’s one that we are uniquely positioned to lead. Facebook is the only place where 750 million people visit every day, increasingly on mobile, to discover what matters to them. As we continue to leverage our understanding of people to make marketing more personal, and do it at massive scale, we will dramatically improve the quality of ads and drive more personal discovery. Facebook is making business personal again, and like Mark, I want to thank the teams that we get to work with every day at Facebook for doing a great job to make this happen. Now I’d like to turn it over to David.
David Ebersman : Thanks, Sheryl. Overall, 2013 was a great year for Facebook. We performed well against all our key financial priorities, growing revenue to $7.9 billion, delivering operating profit and free cash flow each of over $2.8 billion, and making investments that position the company for continued growth. Today’s results strengthen our conviction that we’re in the early days of capitalizing on a significant opportunity. Let’s start with some user and engagement highlights. During the year, the population of people using Facebook on a daily basis increased by 139 million to 757 million, and the population of people using Facebook each month grew by 172 million to 1.23 billion. In December, 62% of our monthly users used Facebook on an average day. Mobile continues to drive our growth. When we began 2013, we had more daily users on desktop than mobile. By the end of this year, our daily users on mobile outnumbered desktop by around 200 million. We’re also pleased that engagement per user continued to increase in 2013, based on measures such as time spent per user and feedback per user. And none of these stats include Instagram, which doubled its user base over the past year. The network of people who use our products remains the foundation for everything we do, and they’re the most important audience we’re trying to serve and delight every day. Turning now to the financials, in Q4, total revenue was $2.95 billion, up 63%, and ad revenue was $2.34 billion, up 76%, for our highest year over year growth rate since mid-2011. Exchange rates had no meaningful impact. We continue to experience strong revenue growth around the world. Ad revenue in each of our four recorded geographic regions grew by more than 65% in Q4 compared to last year. The key driver of ad revenue growth continued to be the strong performance of newsfeed ads on mobile and desktop, which helped us attract more advertiser demand. Mobile ad revenue increased from approximately $881 million in Q3 to approximately $1.25 billion in Q4, a healthy increase that of course benefited from seasonal effects. In Q4, total ad impressions declined 8%, and the average effective price per ad was up 92% compared to last year. The decline in ad impressions was primarily due to the shift in usage towards mobile devices, where people are shown fewer ads compared to desktop, since there’s no right hand column ads on mobile. The significant increase in average price per ad was driven by the mix shift to more newsfeed ads that have much higher engagement and clickthrough rates, increasing the average effective price per ad impression. The price volume trends were pretty similar across our four geographies. Total payments and other fees revenue in Q4 was $241 million, down 6% versus last year, remembering that in Q4 last year we recognized revenue from four months of payments transactions. On a more apples-to-apples basis, payments revenue from games, which represents the substantial majority of our payments and other fees revenue, grew approximately 8% in Q4 versus last year, despite the fact that our payments revenue from games is limited to our desktop users, a population that’s declining. Turning now to expenses, our Q4 GAAP expenses were $1.45 billion, up 37%, and non-GAAP expenses were $1.13 billion, up 33%. For the full year, our non-GAAP expenses were up 44%, driven largely by growth in infrastructure expense and a 37% increase in headcount over the year. As our revenue has grown, we’ve worked hard to stay disciplined in terms of our expense growth, focusing on investments where we’re most confident of creating value and meaningful ROI. We’re pleased with the returns we achieved from many of our investments that we made in 2013, including those to advance our ad products, improve mobile product quality, increase engagement, and drive efficiency improvements in our infrastructure. Our Q4 GAAP operating income was $1.13 billion, representing a 44% operating margin, and our non-GAAP operating income was $1.46 billion, representing a 56% margin, up from 46% last year. As you know, margins are typically the strongest in the fourth quarter, given the seasonal strength in our advertising business. Our GAAP and non-GAAP tax rates for Q4 were 54% and 46% respectively, and for the full year 2013, our GAAP and non-GAAP tax rates were 46% and 41%. The tax rates in Q4 were higher than the rates for prior quarters of the year, primarily because of intercompany payments that occurred in Q4 related to our international operations. Also, at the end of 2013, we had a tax net operating loss, or NOL, carryforward of almost $8 billion. In Q4, GAAP net income was $523 million, or $0.20 per share, and non-GAAP net income was $780 million, or $0.31 per share, up approximately 80% compared to last year. Capex was $483 million in Q4, and $1.37 billion for the full year. Our efficiency investments, including the Open Compute project on the hardware side and proprietary work on the software side, have enabled us to significantly increase the amount of data and the number of users we can support with each server we buy, and these investments have saved us over $1 billion over the past three years. We wouldn’t be able to deliver the profit and cash flow numbers we’re reporting today without the success of these efficiency investments. Our Q4 free cash flow was $748 million, and our full year free cash flow was $2.8 billion, including the benefit from a $419 million tax refund in Q2. Turning to the balance sheet, we ended the year with $11.4 billion in cash and investments. This number includes $1.5 billion from our secondary offering of 27 million shares in December at the time of our inclusion in the S&P 500 index. Now I want to share a few thoughts on 2014. In terms of expenses, we’re planning that our total 2014 GAAP expenses, including cost of revenue and including stock comp, will likely grow in the neighborhood of 35% to 40%, and non-GAAP expenses, including cost of revenue but excluding stock comp, will likely grow in the neighborhood of 40% to 45%. We plan to invest with a continued emphasis on technical headcount and product development to take advantage of the opportunities we see to create new experiences and more value for our users, marketers, and developers. On taxes, we expect our GAAP and non-GAAP tax rates in 2014 to be roughly similar to our full year tax rates in 2013, although this could vary widely depending upon acquisitions, our international revenue and expense mix, and other factors. Our tax rate in 2014 and over the next several years will continue to reflect the fact that we’re in the early years of investing in our international operations. Longer term, we expect our tax rate to be in line with peer companies who have similar operations and international revenue mixes. We ended 2013 with 2.6 billion diluted shares outstanding, including the December stock offering, and we estimate that our diluted share count will increase roughly 2% to 2.5% by the end of 2014, although this may vary depending upon our stock price and new share issuances, for example to support M&A. We anticipate our 2014 capex will increase to be in the range of $2 billion to $2.5 billion. The significant year over year growth will be driven by an expansion of our Menlo Park headquarters, infrastructure-related expenses such as the buildout of our Iowa data center, and by our investment plans to support initiatives like internet.org that are designed to increase internet penetration in the developing world. We’ll also continue to make strategic investments to improve capital efficiency. Last, in terms of revenue, in 2014 we hope to build on our success from last year. 2013 strong growth in ads revenue was driven by the rapid ramp up of newsfeed ads, growth in users, engagement, and marketers using Facebook, and by the product investments we made that improve the quality relevance, and performance of our ads. As Sheryl described, we believe we’re still early in the evolution of our advertising business and the mobile ad business in general. This makes for a difficult time to forecast near term revenues with any precision, but it also makes for an exciting time, and we’re looking forward to capitalizing on this opportunity. To sum up, Q4 was a strong end to a great year for Facebook. Thanks for joining us on the call today, and now let’s open for questions.
Operator: [Operator instructions.] Your first question comes from the line of Ben Schachter with Macquarie.
Ben Schachter - Macquarie: Sheryl, I was wondering if you could rank order the four groups of marketers and discuss how SMBs play out over time versus the larger enterprise companies. And then Mark, if you could talk more, expand more, on what you mean by standalone mobile apps, and really what your vision is there. And I understand you’re speaking at Mobile World Congress, so any update on what we should expect on that?
Sheryl Sandberg : We don’t break out by segment, but all four segments are growing, and we’re pleased with the growth there. I’m glad you asked about SMBs, because it’s a particular focus for us, and somewhere I’m really proud of our performance. Our teams, led by Dan Levy and others, have just done a great job. There are 25 million SMBs that have pages on Facebook, and that’s a really great first step, because just historically, it’s very hard to get small businesses online. What we’ve done over the last year is we’ve really worked at simplifying our ad product. And that’s working, because the way to convert our SMBs who are using our free product into being advertisers are with these really simple ad products. So rather than going to them and saying, do you want to become an advertiser, you say, do you want to promote a post. And that’s what’s working, and we’re able to convert them to advertising, and then upsell them from there in large numbers. And we’re excited about it.
Mark Zuckerberg : And in terms of the focus on building new and separate experiences, our theory is that there are all these different ways that people want to share and communicate. Almost any kind of content that you can imagine sharing: text, photos, videos, links, locations, events, games, any type of content, with any type of audience. You know, whether it’s privately in a one-on-one situation, or small groups, or with all of your friends, or a larger community, or publicly. There’s an interesting intersection between most of these things, and one of the things that we want to try to do over the next few years is build a handful of great new experiences that are separate from what you think of as Facebook today that are just kind of helping to explore that space and give people new ways to share. I think you can see that that’s something that people want, from some of the mobile apps that exist out there today. You can see it from our own offering, with not just Facebook but also Instagram and messenger already today. And we’re going to keep on working on this over the next few years.
Operator: The next question comes from Heather Bellini with Goldman Sachs.
Heather Bellini - Goldman Sachs : I have two questions. The first one, there’s been a lot of talk about Messenger over the last couple of quarters. I’m just wondering if you could share with us how you see the competitive environment for Facebook in the area of messaging, in particular in regions like Asia. And how do you see Facebook differentiating itself and maybe changing the user behavior from some of the newer companies that have aggregated a large number of users in the space? And then my second question is just for David in regard to seasonality of ad revenue. And obviously it typically declines in Q1. I’m just wondering if we’re at the point now where we should see seasonality of mobile ad revenue in Q1.
Mark Zuckerberg : I can talk to Messenger a bit. If you think about the overall space of sharing and communication, there’s not just one thing that people are doing. People want to have the ability to share any kind of content with any audience. There are going to be a lot of different apps that exist, and Facebook has always had the mission of helping people share any kind of content with any audience, but historically we’ve done that through a single app. And one of the stats that I shared today is that we now have more than half a billion people using Groups every month. And that’s not something that I think a lot of people are paying attention to, because it was sort of seen as a feature of the Facebook app rather than its own product. So what we’re doing with Messenger now, similarly, a lot of people are using Messenger every day, but it’s like a feature of Facebook rather than its own network or standalone thing. And we’re making it more of a standalone app, and we’ve actually, in the latest quarter, we’ve taken it out of the main app, so that way it gets room to breathe and blossom as its own great experience. And we’re going to focus on making that really good and adding a lot of new things. I mean, some of the stats that I shared are incredibly promising. In the last few months, 70% more people are using it, and a lot of message volume growth. So we’re still focused on kind of general growth for Messenger rather than going country-specific at this point in its evolution.
David Ebersman : Thanks for your question on seasonality. Of course seasonality is an important factor in an advertising business, and affects Q4 and makes it a typically strong quarter. At this point, given how new we are with the mobile business, I think it’s really difficult for us to quantify the impact of seasonality. I think it will take some more time before we can understand it better than we do.
Operator: The next question comes from Mark May with Citibank.
Mark May - Citibank: Just would love to get some updates on some of the efforts that you’re making in terms of brand and real time conversation. I think on the user side, would love to get some interest in terms of the usage and engagement with video content early on, and real time conversations, particularly around entertainment related content. And then on the advertiser side, kind of early adoption by brand and TV-like advertisers with some of the brand and video solutions that you have out there. And then for David, given the significant transition that the business continues to go through that is affecting these ad impression and average price metrics, can you give us a sense of the breakdown between the ad impressions between desktop and mobile?
Mark Zuckerberg : I’ll start here on the public content piece, and then I think Sheryl will get into some of the specifics. But I just want to put this in the context of the overall strategy here. We were just talking about some of the standalone experiences and Messenger, and public content is part of this overall spectrum of content that people want to share and consume as well. In some ways, it’s the complete opposite side of the spectrum from one-on-one messaging, but it’s also an area where I think the medium of newsfeed and Facebook works really well. So we’ve been focused on improving the tools for public discussion and folks to be able to share public content, including premium content like videos and making it so that they can autoplay in feed. And this is an area where, just like Messaging and some of the other things we’ve talked about, you should expect us to keep focusing on a lot. It’s part of the overall space of sharing that we think is quite valuable. I think Sheryl is going to get into some of the specifics.
Sheryl Sandberg : Yeah, I can start with video and then go to the overall brand question you started with. We have a current video ads product that works very well. It’s part of what’s driving our growth. We have also recently started testing an autoplay video ad. That’s just a very small test. But overall, we’re seeing what Mark has talked about, which is that marketers and users are using video more, as they have the technology to do so. And we expect that to continue to grow. In our overall brand effort, we’re making really good and steady progress as we are with all of our market segments. All of the Ad Age Global 100 advertised with us over the past year. And the real key there is proving measurement to our clients. Our team, led by Carolyn Everson and her people all around the world, really have to go client by client and show them that we can not just increase people’s happiness or brand affiliation, but ring the cash register at the end of the day. I think this is part of the big story for us in 2013, which is if you look back a year, we didn’t have that ability to look at the [AB] test of who saw our ads, and what the different in sales is. And now we have that. And we still have a lot of hard work to do, client by client, ahead of us, but being able to prove that we have really strong ROI, and I think increasingly efficient ROI, compared to the other marketing opportunities they have, is what is going to move the brand marketers to Facebook and to mobile.
David Ebersman : Your second question about mobile and desktop impressions, as you know, per user or per unit of time on the desktop, we show a higher number of ads, because there’s the right hand column ads in addition to newsfeed. But we’re extremely pleased with how well the newsfeed ads continue to performance, and that’s really what’s driving up the average price per ad, as I described. So these ads perform well for marketers and are still continuing to contribute to the positive user experience that Mark described earlier.
Operator: The next question comes from Anthony DiClemente with Nomura.
Anthony DiClemente - Nomura: First, for David, I wonder if you could comment on the ad load on Facebook. Do you expect that to continue to remain stable, or is there a possibility that the ad load creeps up over time? And on Instagram, I know it’s a new product, and you guys are taking it slowly at first, but I wonder if you could also talk about how long it might take for Instagram to get to a similar ad load to Facebook’s levels. And then one last question for Sheryl, I wonder is there a way, when you compare Facebook to television for brand marketers, to look at the disparity of ROI, or I should say the improved ROI for Facebook, and sort of extrapolate where you think pricing could go. Obviously pricing doubling quite a bit. How much more upside to Facebook newsfeed pricing can we expect to see based on the ROI differential?
Mark Zuckerberg : I just want to start off here, and then David can get into some of the details on the number of ads and all that. But you know, the strategy has been, for the last period, and will continue to be, to primarily focus on increasing the quality of the ads and the experience. And I really think that it’s easy to look at the model and say, okay, if we ran more ads then the business would grow faster in the short term, but investing in quality is really actually the most important thing, because it’s what improves the experience for the people who use the product. It drives greater returns for advertisers, and over time it increases the potential size of our business. And I think you can say that that’s a harder path for us to take, but I actually think that the results over the last couple of quarters have really shown that by focusing on improving quality instead of just increasing quantity, we can actually drive pretty incredible business results. So we think that there’s more to do here, and that’s what we’re going to keep on doing.
David Ebersman : I think I can take most of the rest of this. In terms of ad load, the one piece of context maybe to start with is the variable we’re really focused on optimizing isn’t ad load per se, but it’s the user experience, as you can measure that based on engagement or user feedback, etc. And ad load is one of the variables that impacts that, but there’s other relevant variables as well, such as the positioning of the ads, the size of the ads, and of course critically the quality of the ads. So ad load only gives a part of the picture. And we’re really one or two years into this, and we’re still learning how to provide the best experience. I think one of the most important pieces of positive news from 2013 was as we ramped up newsfeed ads, they performed as well as they did, delivering great value for marketers, having a very minimal effect on the user experience, and enabling Facebook to deliver the kind of results that we reported today. So going forward, we’ll continue to tweak what we do in terms of trying to find the right balance and optimize the performance of the ads for marketers and for users, but generally, as Mark said, the most important place for us to invest is going to be in improving the quality and relevance of the ads. You asked about Instagram and pricing, so let me just cover those quickly. Instagram I would say we’re just really early with Instagram. So it’s too early to talk about where we’re going to be going. We’re still trying to learn what the right way to approach that product is, and we’re going to move slowly, because we think that’s the right thing to do for Instagram In terms of pricing, it was our expectation that if ads in newsfeed worked well, that they would deliver more value for marketers, be more engaging, and that they would contribute to the average price per ad on Facebook going up. And we also believe, looking forward, if we continue to improve the quality and relevance of the ads we show, that that’s a critical way that we can drive pricing up in the future.
Operator: The next question comes from Douglas Anmuth from JPMorgan.
Douglas Anmuth - JPMorgan : Just wanted to ask two things. First, you announced an initiative or perhaps an algorithm tweak, I think, in early December to have more news stories in users’ feeds. And I was just curious what the adoption has been thus far from users there, and what are the implications on usage and engagement, and then also ad load. And then secondly, can you give us an update on teen engagement trends?
Mark Zuckerberg : To start with the public content, the change that we made is basically a lot of what our algorithm looks at is straight engagement. So the amount of content that people click, like, comment, and share in feed. But what we found was that when we asked people qualitatively what they prefer getting, it didn’t often match up, because a lot of things like memes scored very high in terms of getting a lot of people to like them, but weren’t necessarily, when you asked people, what they wanted to see in feed, or what they were happy seeing, didn’t score that way. So we ended up doing an adjustment to the algorithm, which made it so that qualitatively things and especially public content and news that people rated as higher quality qualitatively scored more, and that was basically the adjustment to the algorithm. It had really no impact on ads. It was an organic content adjustment that we made to improve the quality of the experience. So I think David can talk about teens.
David Ebersman : In terms of teens, we don’t have any new data to report today. As you know, we take engagement very seriously, and we’re focused on building great products that all our users, including teens, will find useful and engaging. And that’s the most important thing for us to stay focused on.
Operator: The next question comes from Scott Devitt from Morgan Stanley.
Scott Devitt - Morgan Stanley : I had a couple of product questions for Mark. The first one on Graph Search, just wondering how users are engaging with the product, how it developed, what the product is, in terms of what we can see today relative to what your longer term aspirations are for the product. And then just a follow up on Doug’s question, related to the news flow integration into newsfeed. You know, another feature that’s been added more recently is trending and attaching trending to news articles in newsfeed as well. So if you could talk more broadly about your interest in real time information and news as it relates to public content, that would be helpful.
Mark Zuckerberg : Starting with Graph Search, we’re really early in the game on this, and I think you can see that because we haven’t even really rolled out our mobile version of Graph Search yet, and we’re a mobile company, and we started on desktop. The way that we’re thinking about this, there’s just so much content that people have shared on Facebook that simply building the infrastructure to index all of it and start ranking it is a multiyear effort, which we’re making our way through. So the first release indexed more than a trillion connections between all the people and interests and events and groups and things that everyone was connected to. The second release that we did recently was around all the updates. So there are more than a trillion status updates and unstructured text posts and photos and pieces of content that people have shared over the past 10 years, and indexing that was a really big deal, because as the number of people on the team who have worked on web search engines in the past have told me, a trillion pieces of content is more than the index in any web search engine. So we’re kind of making our way through this. Pretty soon, I think you should expect us to roll out the mobile version of this. I think that’s going to be an important step, because most of the usage in Facebook overall is on mobile, so we expect that that’s where engagement will really start to come from on Graph Search over time. But it’s also only in English so far, and we have to internationalize it. So there’s a long roadmap of things that we need to do that I think is pretty clear, but it’s just going to be incredibly useful when it’s ready. We look at this as an investment over a three to five year period rather than a one to two or shorter period. So that’s how I think about that. The other question was about trending topics, and that really ties into the public content push that we have. And we talked a bit about this before. We’re trying to build great experiences for all types of content that people want to share and consume with all audiences. We think public content is great. Folks who are making news, or premium content on TV, or movies, or celebrities and different types of folks are extremely interesting and produce great content, and we want to be a great place for people to share that content, and for people to be able to learn about it and consume it. So trending topics is one step in what you will see as a pretty long roadmap of things that we’re going to do to make Facebook great for public content.
Operator: The next question comes from Eric Sheridan with UBS.
Eric Sheridan - UBS: First one for Sheryl. I would love to get an update on how the company’s thinking about mobile retargeting ads. You’ve seen a lot of success with retargeting on desktop, but how you can think about the evolution of retargeting in the mobile environment as a future product. And I guess second question for Mark, not a lot of talk on the payments business so far in the call, and just wanting to understand, maybe an update around games or other areas of ecommerce that you think are opportunities for the payments business.
Sheryl Sandberg : On retargeting, retargeting has been proven really valuable across all platforms. We’ve allowed it through [FBX], and increasingly we’re allowing it through our own products as well. As part of our custom audiences suite of offerings, we’re offering website custom audiences and mobile app custom audiences. And these all allow marketers to target ads in privacy safe ways that improve the relevance and improve results. I think when people think about targeting, what they’re really thinking about is relevance, and taking the data and using it in a privacy safe way to increase the relevance of ads to users. And that’s something we’re working on.
Mark Zuckerberg : For payments, we don’t think about our business so much as an advertising or payments business as we’ve built this network and we help businesses reach people with relevant messages. And payments historically has been a great way for game developers, especially on desktop, an efficient way for us to monetize that business, because instead of charging them up front for most of the ads, we can charge them only when their business grows because someone is paying for something. On mobile, I think the natural evolution of this is for that to move toward app install ads, where we’re not running the payment system on mobile. The operating systems are integrated with that. But because a lot of the goods that people are buying in games are no marginal cost, a developer’s economic incentive is to advertise to get more people to come into their flow for as many people as they can get to buy the goods. So even though a game developer might be paying 30% to the operating system maker for payments, we’re finding that people also really want to buy a lot of app install ads, and that’s grown incredibly quickly, and is one of the best parts of the ad work that we did over the last year.
Operator: The next question comes from John Blackledge with Cowen & Company.
John Blackledge - Cowen & Company: Two questions. First, Mark, you referenced 2014 as a year of rolling out new and engaging mobile products. Maybe could you provide some color or highlight the types of products that users can expect, or maybe how you think about improving mobile engagement? And then just on Instagram, can you give us an update on the number of monthly active users ending 2013 and give us a sense of how the data testing is going with advertisers, and when it might be available for all advertisers?
Mark Zuckerberg : Before I get into some of the newer types of things, which we’ve actually touched on most of them already on the call, I also want to take a moment just to emphasize that we’re going to start building new experiences, but they’re going to start small compared to where the core of Facebook is. So most of the results that we’re going to see in terms of the increase in engagement and sharing and our business are going to come from the core Facebook experience, because mathematically, it’s just so much bigger than everything else that is out there that the numbers, you’d have to be multiyear investments to add up to that. I mean, you can look at, for example, comScore puts out these numbers every month or so that reference the amount of time that people spend in different mobile apps. Facebook I think is almost 5-10 times bigger than the next app that is out there. So it’s going to take a while for any of these things to turn into huge things. So some of the things that we’re thinking about are all of the different kinds of ways that people might want to share different kinds of content with different audiences. So I talked about Groups earlier on the call. That’s something that half a billion people are using. It’s currently a feature within the Facebook app. Giving experiences like that room to breathe and really develop to be their own brand, I think, is a huge and valuable thing. It’s not necessarily the next thing that we’re going to go do, but it’s kind of an example of the type of audience and type of content that people might want to share. Examples of things that we have done are Messenger is a really big focus for us, and we’re focusing on that as a standalone experience. Instagram is a different kind of community than Facebook. We just launched Instagram Direct within Instagram, which is one on one or small group photo and video sharing. And you can kind of view that as the kind of experience that we’re going to be rolling out. But there’s a lot of space here, for a lot of different kinds of things, and what I think you should take away from this is that while the core business growth is going to come from the main app that exists, just because the numbers are so much bigger than everything else today, that that’s going to just be where most of the momentum comes from. You should also expect us to start building a few of these other things that we’ll focus on over a long period of time and hopefully build into meaningful things, like Messenger and Instagram are today.
Operator: The next question comes from Brian Pitz with Jefferies.
Brian Pitz - Jefferies & Company : Mark, last week on the Facebook developer’s blog, there was an entry that noted you were testing placement of ads in third party mobile apps. Just wondered if you could provide an update on how these tests may be going. And then separately, it appears that the growth on desktop ads reaccelerated during the quarter. Can you talk a bit about the drivers of that?
Sheryl Sandberg : On the Facebook ads in third-party mobile apps, it’s a small test we just started that aims to show Facebook ads off of Facebook for mobile apps. So we don’t have results yet. We are very excited about the mobile app space in general. If you look at our mobile app installation [adds], we’ve really done a great job working with developers to help users discover and download their apps. And the product we rolled out last quarter, which is the engagement ads, then help developers get people engaged or reengaged in their apps. And so it’s a small, important, and growing space, and we feel really good about the progress we’ve made with those ads on Facebook. When you look at off-Facebook, really early test.
David Ebersman : In terms of desktop, I’d say the two trends that really benefitted desktop in the fourth quarter were similar to what we described earlier. One was just holiday strength that we saw in the business and the second was the strong performance of newsfeed ads, which we show in both mobile and desktop. So that worked well for us in the fourth quarter, just recognizing still that the user numbers on desktop continue to sort of decline modestly overall, and that’s obviously an important headwind for the revenue from that part of the business.
Operator: The next question comes from Ross Sandler with Deutsche Bank.
Ross Sandler - Deutsche Bank : Mark, I had a follow up from one of the previous questions, on closing the loop in mobile. You guys have made a lot of progress improving the total mobile ad experience, yet there’s still a lot of friction in downloading apps and making purchases today. You guys have recently rolled out some new ad formats, and you have some partnerships with the likes of Braintree and Stripe and some of the other payment guys. So what’s your vision for removing some of this friction for marketers, and do you envision a scenario where users can buy physical or digital products within the Facebook mobile apps?
Sheryl Sandberg : I can take this. Obviously, the mobile app world is a new world, and not just the functionality in ads is still developing, but the functionality of what then people can do. You can do a lot more on the desktop in many ways than you can on mobile. I think the best role we play is to help connect consumers with marketers and with companies and services, and I think reducing the friction there is really important. We don’t have any plans to go into the direct ecommerce market, because the advertising products we provide I think are the best thing we can provide to help grow this market.
Operator: The next question comes from Tom Forte with Telsey Advisory Group.
Tom Forte - Telsey Advisory Group: On contextual advertising, this is essentially the Holy Grail for Facebook, and I think you understand this. Can you talk about where we are as far as innings on getting contextual ads? And can you talk about the role that Instagram plays with visually appealing ads and the role that video plays?
Sheryl Sandberg : As I said, and I’ve talked about each quarter, targeting is a huge, huge issue for us, and a huge opportunity and challenge. Our goal is in a privacy safe way to get information we can about what consumers want, and then help connect marketers, so that the ad experience is great for users. We’re serving relevant ads. Whether that information comes from the kind of things people like on Facebook or other websites they visit, or contextual statements they might make in their status updates, our goal is to use that information in a privacy safe way to improve the targeting of the ads on Facebook. To take one example, if you look at what’s happening with our direct response business, which has been a very strong segment for us, if you look at people trying to find consumers, we offer the opportunity to get people before they search. We can judge interest based on other things, other things they’re interested in, and give people the opportunity to find consumers before they search so that they can then move them all the way down the funnel into purchase.
Operator: The next question comes from Jordan Rohan with Stifel.
Jordan Rohan - Stifel Nicolaus : I’m curious if you could help me understand the international market development and modernization for Facebook’s ad platforms. Specifically, can you speak to the buildout of international direct sales force, the channel partners, the number of international markets, in which FBX is operational, and the extent of geographic rollout of the cost per install ad units in the newsfeed? Is that available everywhere? Where are we compared to the U.S.?
Sheryl Sandberg : The buildout globally is going well. We’ve always been pretty conservative. We wait until we have a very strong user base in other countries, and we wait until there’s a developed ad market. But we’re growing. We have a PMD ecosystem, which now covers 45 countries. I was actually in Turkey at the beginning of last week and had a chance to meet with our advertising partners there, and they are increasingly using our platform to reach consumers. We are growing our offices. We’re growing our offices in Asia particularly this year, and we’ve rolled out offices across Europe as well. In terms of rolling out products, we tend to roll out products in our most developed markets first. And as we extend those products, we then extend them to the rest of the world.
Operator: The next question comes from Colin Sebastian with Robert Baird & Company.
Colin Sebastian - Robert Baird : I just have a couple of questions. The first one, I guess, on app install ads, if you could quantify how much those are driving growth in newsfeed advertising. And if not specifically, then maybe on a relative basis, through other mobile ad formats? And then second, Mark, the company has made some interesting hires in the area of machine learning, and I’m curious if you could characterize how important this initiative is to the company, and how you think that AI will help Facebook over time.
Sheryl Sandberg : On the first, we’re excited about our mobile app install ads and our mobile app engagement ads. It’s a small but growing category. We don’t split out by segment. But one thing that’s really important to note is that our mobile ad strength is very broad-based. Our mobile ads are not just bought by people who are looking to drive engagement or usage of mobile apps, but is very broad-based. We’re being used by SMBs, brand advertisers, and direct response advertisers as well.
Mark Zuckerberg : And I can speak to some of the deep learning work. In the last quarter, Yann Lecun, one of the really earliest folks, and one of the founders of deep learning, and a professor at NYU, joined us to lead our AI group. And this is a long term research group that we have. It’s going to fit into our strategy over a longer, maybe five or ten year, period. And their goal is really just to try to understand how everything on Facebook is connected, by understanding what the posts that people write mean, and the content that is in the photos and videos that people are sharing, help people with tasks like if you’re sharing a voice clip in messenger, being able to transcribe that for people, so that they can receive it more easily. So these are some pretty big tasks in AI that are things that we have teams that are working on that will need to be researched over time, and will have obvious implications for the products that we do, but over time the real value will be if we can understand the meaning of all the content that people are sharing, that we can just provide much more relevant experiences for people across everything that we do. Internally, we talk about our strategy, and there’s a three-year strategy, a five-year strategy, and a 10-year strategy. And the three-year plan is really all about building new kinds of experiences for sharing, like so many of the questions on this call have been about. The five-year approach is really mostly about helping people use their network to answer interesting questions or solve problems that they have. And that’s where all the Graph Search work and the open graph work and some of the early parts of the AI work that we’re doing you’re going to start to see over that period of time. And then over a 10-year period, I think you’ll really start to see a lot of the impact of some of the internet.org work that we’re doing, where hopefully we’ll see some impact a lot sooner than that as well. But over a 10-year period, if we can get a lot more of the world on the internet, I think that’s going to really mean a quite different world in terms of what folks in a lot of developing countries have access to in terms of some of the things I said in my opening remarks, around basic financial services, and people can get credit to start businesses, and buy homes, really life-changing stuff, or get access to health information or education materials, which I think are just a really big deal. And over the long term, we’ve always wanted to help out with that, and I think that’s where we’re going to go on that.
Operator: Our last question will come from Mark Mahaney from RBC.
Mark Mahaney - RBC Capital Markets : David, can you just talk about the sustainability of the gross margin that you had in the quarter? It seemed pretty high. And then Mark, hopefully this isn’t redundant. When you think about the potential for ad quality at Facebook over the next three to five years, and you’ve gone through a lot of learnings over the last two years on ad quality, how do you think about what the upside is? I know that’s a broad, general question, but if you think about all the different drivers, have there been certain moments when you’ve seen real gap opportunities? Are there any proxies out there that you see that you say, well, this is where Facebook could be? Any thoughts on how much higher, how much better, over the years, ad quality could be on Facebook?
David Ebersman : I’ll start with the question on gross margins. I think in Q4, as you know, gross margins tend to be seasonally strong, because revenue goes up in the fourth quarter and the costs associated with operating our infrastructure don’t go up accordingly with the seasonal strength in advertising revenue. So directionally, I think it’s important to note we really had a great year in 2013, in terms of the efficiency investments that we made. But going forward, this is a compute heavy service we provide. It requires a lot of data centers and servers and infrastructure. We’re going to continue to invest in those things and we do expect to increase our infrastructure costs over time while trying to do that as efficiently as possible.
Mark Zuckerberg : And in terms of quality, I just think that there’s a lot of room to grow here. I said in my opening remarks that we have this long term goal of making the advertising quality content as good and as relevant and timely as the content that your friends are sharing with you. And at first blush, I think that seems kind of crazy in that your friends’ stuff will obviously always have the advantage of being immediately socially relevant to you. But at the same time, a lot of the folks who are advertising really invest in the quality of the content that they’re producing and putting into their ads, and improving the targeting of their ads to deliver the right messages to the right people. And I don’t think that there’s a single step function that we’re going to see here, although there are things like the video formats that really enable new kinds of rich experiences, that folks who can invest in building those can really benefit from. At the same time, I think a lot of this is going to be incremental. So as we make improvements, more advertisers come into the system, and as more advertisers come into the system, we have more options of relevant content to show to people, and that improves the quality as well. So this is just going to be something that we’re going to focus on for a while, and there’s a long way to go before we get to the quality level that we want. But I think over a multiyear period, we can get there, or at least very close.
Sheryl Sandberg : And that’s a nice way to end the call, because one of the really big opportunities we have is to make these ads [at scale] more personal. So just as we can have social context, obviously, from the user content, we put social context into ads. So we can take these ads that marketers can deliver up scale, improve the targeting, and give them social context, which will help drive the kind of opportunities Mark is talking about to make the ads as relevant as the user content.
Deborah Crawford: Thank you for joining us today. We appreciate your time, and we look forward to speaking to you again next quarter. | [
{
"speaker": "Executives",
"text": "Deborah Crawford - Director of Investor Relations Mark Zuckerberg - Chairman of the Board, Chief Executive Officer Sheryl Sandberg - Chief Operating Officer David Ebersman - Chief Financial Officer"
},
{
"speaker": "Analysts",
"text": "Ben Schachter - Macquarie Heather Bellini - Goldman Sachs Mark May - Citibank Anthony DiClemente - Nomura Douglas Anmuth - JPMorgan Scott Devitt - Morgan Stanley Eric Sheridan - UBS John Blackledge - Cowen & Company Brian Pitz - Jefferies & Company Ross Sandler - Deutsche Bank Tom Forte - Telsey Advisory Group Jordan Rohan - Stifel Nicolaus Colin Sebastian - Robert Baird Mark Mahaney - RBC Capital Markets"
},
{
"speaker": "Operator",
"text": "Good afternoon. [Operator instructions.] Ms. Deborah Crawford, Facebook's director of investor relations, you may begin."
},
{
"speaker": "Deborah Crawford",
"text": "Thank you. Good afternoon, and welcome to Facebook's fourth quarter earnings conference call. Joining me today to talk about our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and David Ebersman, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements, and actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release, our annual report on Form 10-K, and our most recent quarterly report on Form 10-Q, filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I’d like to turn the call over to Mark."
},
{
"speaker": "Mark Zuckerberg",
"text": "Thanks, Deborah, and thanks, everyone, for joining today. This was a great quarter and a great way to end the year. We saw strong growth in engagement around the world, and we’re very pleased with the growth of our ad business, especially on mobile. Overall, 2013 was an important year for us. If 2012 was the year we turned our core product into a mobile product, then 2013 was the year when we turned our business into a mobile business. I expect 2014 will be the year when we begin to deliver new and engaging types of mobile experiences. As of the end of the year, more than 1.23 billion people now use Facebook each month. Last quarter was our first quarter where more than 50% of our ad revenue came from mobile. Looking back at the year, we launched an important products and initiatives: internet.org, graph search, Instagram video, and Messenger 3.0. We also made a lot of improvements to the performance and reliability of all our mobile apps. One important trend from the last year is the continued growth in size and engagement of our community. In 2013, we added 172 million monthly actives and 139 million daily actives. That means that our daily engagement continues to increase. In the latest quarter, more than 60% of our monthly actives visited Facebook daily. Given the size of our community, we’re very excited about this pace of growth. We’re also seeing people engaging more. On the average day in December, we saw more than 6 billion likes. That’s up 59% from 3.8 billion likes a year ago. These trends show that our strategy of improving the quality of our core experiences over the last year has paid off, and we’re now in a good position to focus on our longer term goals of connecting everyone, understanding the world, and building the knowledge economy. Connecting everyone is about bringing the internet to everyone and giving them the tools to stay connected with the people and things that matter to them. Today, more than 750 million people use Facebook every day. While that makes up by far the largest social network in the world, we’re still a small part of the world’s population. Only one-third of the world’s population has access to the internet today, and for even many of those, the return on experience remains pretty weak. Helping more people get connected is important the developing the global knowledge economy. Once people are connected, they can access tools like basic financial services, health information, and education tools to help them take care of their families and join the worldwide economy. That’s why last summer we launched internet.org, a partnership with industry leaders to make affordable internet access available to everyone in the world. In 2014, we’re going to focus on achieving internet.org’s mission by deepening the relationships with mobile operators around the world and working to develop new models for internet access. Our existing partnerships with operators are something we’ve already invested a lot in over the years, and this is an area where we’re really excited to build on going forward. Connecting everyone ultimately means giving people the power to share different kinds of content with different groups of people. This is something we’ve focused on by building separate mobile apps beyond the main Facebook app. Messenger and Instagram are examples of this. We launched a new version of Messenger to make the app even faster for mobile to mobile communications. Messenger was among the topmost downloaded apps on iOS and Android in December, and we’ve seen meaningful growth in engagement since launching. The number of people using Messenger grew more than 70% in the past three months, and we’ve seen a large increase in the number of messages sent. We have a lot more coming to messenger in the first half of this year, and I’m excited to build on these early results. Instagram also had a busy quarter, bringing Instagram to Windows Phone, launching our first ads, and launching Instagram Direct, the new way to send private photo and video messages. We’re pleased with the early reaction to all these products. With ads, the team has taken an especially careful approach, working closely with a small number of brands that are already important members of the Instagram community to create a great early experience. I’m also excited to report that there are now more than 500 million people using Facebook Groups every month. Groups is one of our core products, and it provides a private space for sharing with small groups like your family, close friends, or a sports team, or for larger communities, like schools or even companies. One theme that should be clear from our work on products like Messenger, Groups, and Instagram is that our vision for Facebook is to create a set of products that help you share any kind of content you want within the audience you want. We’re not just focused on improving the experience of sharing with all of your friends at once, although that’s growing quickly too. A lot of the new growth we see is coming from giving people the tools to share with different sized groups of people. Now, moving on to our business, last quarter I talked about our efforts to grow our business through improving the quality of our ads rather than just increasing the quantity. Our goal is to reach a point where the ads are as relevant and timely as the content your friends share with you. To do this, we’ve put a lot of effort into measuring people’s sentiment around our ads and seeing how people engage with them. We do some of the broadest surveys in the world. We survey more than 35,000 people every day to see how we’re doing, and we use the results to drive our product development. Our approach is working. In the second half of 2013, we saw an improvement in sentiment about ads on mobile, even as volume grew during that period. We also saw sentiment on desktop remain stable. Interestingly, even as the volume of newsfeed ads has grown, clickthrough rates have also remained stable. We’re very pleased with these results, and they suggest our strategy of improving quality is working. Our plan is to continue focusing on improving quality, since we think this is the best way for us to improve the experience for people on Facebook, returns for advertisers, and our own revenue, as well as achieving our long term goal of providing ads that are as relevant as organic content. So that’s my update on where we’re focusing our efforts in the context of our longer-term goals. It’s been a strong quarter and a great year for Facebook. Next week, Facebook turns 10 years old. It’s been an amazing journey so far, for me personally and for all of us at the company. But what’s ahead of us is even more exciting. Many of the successes of the past 10 years have simply been steps on the path to achieving our long term vision of connecting everyone and improving the world through sharing. Over the coming months and years, you’ll see us continue focusing on many of the same themes, but now with greater scale, ambition, and resources. Finally, I just want to thank everyone who works at Facebook for a great year in 2013 and over the past 10 years. What we’ve achieved together has been a result of all your hard work, and I’m grateful that so many talented people are a part of our team. Thank you, and now here’s Sheryl."
},
{
"speaker": "Sheryl Sandberg",
"text": "Thanks, Mark, and hi, everyone. I am really excited to report earnings this quarter, and proud of the teams at Facebook who delivered these results. We ended 2013 with a terrific quarter, continuing the strong momentum we saw throughout the year. Our total revenue grew 63% year over year, led by 76% growth in advertising revenue. Approximately 53% of our ad revenue came from mobile. This is not only the first time we crossed the 50% threshold in mobile, but it’s also our first billion dollar mobile quarter. In fact, our Q4 mobile ad revenue of $1.25 billion was nearly as large as our total ad revenue in Q4 of last year. This growth continues to be very broad-based. The combination Mark spoke about of our growth in users and engagement and the effectiveness of our ads in newsfeed work together to provide marketers with a powerful way to reach people. This impact is evident in our results. This quarter, we saw healthy increases in every region around the world and positive momentum in all four marketer segments. There are three key drivers propelling our business. First and foremost is strong mobile engagement. Every day, more people around the world are spending more time on their mobile devices, and marketers are starting to shift their budgets to reach them. This was especially clear during the holiday season, where not surprisingly, Black Friday was our single biggest mobile ad revenue day in the quarter. When people are shopping in stores, they’re on their phones, and when they’re on their phones, they’re on Facebook. A recent study by Millward Brown Digital showed that while shopping in store, people who use Facebook do so at four times the rate of any other app or search. And for those people that use Facebook as a source before shopping, over half stated that it was a very influential source of information for them while they were shopping in the store. The second driver of our ad business is a continued growth in the number of marketers using Facebook. Again, this growth is broad-based and diverse, across marketers, verticals, and geographies. I’ll update you briefly on each of our four marketer segments. Demand from direct response marketers was strong in the Q4 holiday shopping periods, particularly in ecommerce. These marketers focus on short term ROI, so the growth we’re seeing speaks to our ability to efficiently drive sales for them. For example, online retailer NoMoreRack used Facebook to promote its holiday deals. They hit their aggressive ROI targets and they generated $8 million dollars in revenue on Black Friday alone. We’re also making remarkable progress with SMBs, a segment that many in the industry have long considered the Holy Grail of online advertising, and a segment that I’ve been particularly focused on throughout my career. In November, we reported that more than 25 million SMBs maintain an active page on Facebook. We’ve made a big investment in simplifying our ad products over the last year, and that investment is working to convert these SMBs into advertisers. Of the new SMB advertisers we acquired in Q4,72% started with our most simple ad product. For developers, mobile apps are generating very healthy revenue growth. We launched mobile app [install] ads just over a year ago, and mobile app engagement ads last quarter, based on a very simple idea, that we can help people find and use great apps. This is working even better than we hoped. We’re helping developers attract new customers and keep them engaged. We remain excited about the opportunities in this small but quickly growing category. In addition, last week we announced a small test to show Facebook ads in third-party mobile apps. We won’t have meaningful results for a while, but it’s an interesting area for us to explore. And finally, we’re making steady progress with our brand marketers, particularly in verticals like CPG. We’re helping them connect with customers in more dynamic ways, starting a small test of our new video ad product, and measuring our impact on their sales, which is super important to driving their business. The third driver for both the quarter and the full year has been our investment in product development. We’re especially pleased with the improvements we’ve made to our targeting capabilities and measurement tools. Our goal, as Mark said, is to make our ads as useful as possible for consumers and to generate greater returns for marketers, eventually making all of our ads as valuable to users as our organic content. Custom audiences is our most important product in this effort. When we launched it over a year ago, it allowed marketers to reach their current customers on Facebook. Since then, we’ve built more targeting capabilities while maintaining user privacy. These include lookalike targeting that lets marketers reach people who are similar to their best customers and partner categories which use third-party data to improve our targeting. Now marketers can reach exactly the people they’re looking for, such as people who buy fashion apparel or are in the market for a new car. We’ve more than doubled the number of partner categories in the U.S., and now offer more than 1,000. And we believe there’s still significant opportunity ahead, as we continue to improve our targeting capabilities. We’re also making major investments in measurement so that we can measure the impact of our advertising on in-store sales. In December, we launched offline conversion measurement. To date, our results show that the average return on ad spend for newsfeed campaigns is 8x, a result that is really impressive when compared to other returns marketers have available. As Mark noted, this is the beginning of a new year, and our 10th anniversary, so I want to reflect really briefly on where our advertising business and we believe the marketing industry is headed. Before mass media, all business was personal. Sales happened customer by customer at the local store or door to door. The evolution of mass media made it possible to sell at scale, but business was no longer personal. On Facebook, marketers can do both. We’re building the world’s first global platform that lets marketers personalize their messages at unprecedented scale. This is marketing where you are for who you are. This shift to personalization represents the biggest shift in marketing in generations, and it’s one that we are uniquely positioned to lead. Facebook is the only place where 750 million people visit every day, increasingly on mobile, to discover what matters to them. As we continue to leverage our understanding of people to make marketing more personal, and do it at massive scale, we will dramatically improve the quality of ads and drive more personal discovery. Facebook is making business personal again, and like Mark, I want to thank the teams that we get to work with every day at Facebook for doing a great job to make this happen. Now I’d like to turn it over to David."
},
{
"speaker": "David Ebersman",
"text": "Thanks, Sheryl. Overall, 2013 was a great year for Facebook. We performed well against all our key financial priorities, growing revenue to $7.9 billion, delivering operating profit and free cash flow each of over $2.8 billion, and making investments that position the company for continued growth. Today’s results strengthen our conviction that we’re in the early days of capitalizing on a significant opportunity. Let’s start with some user and engagement highlights. During the year, the population of people using Facebook on a daily basis increased by 139 million to 757 million, and the population of people using Facebook each month grew by 172 million to 1.23 billion. In December, 62% of our monthly users used Facebook on an average day. Mobile continues to drive our growth. When we began 2013, we had more daily users on desktop than mobile. By the end of this year, our daily users on mobile outnumbered desktop by around 200 million. We’re also pleased that engagement per user continued to increase in 2013, based on measures such as time spent per user and feedback per user. And none of these stats include Instagram, which doubled its user base over the past year. The network of people who use our products remains the foundation for everything we do, and they’re the most important audience we’re trying to serve and delight every day. Turning now to the financials, in Q4, total revenue was $2.95 billion, up 63%, and ad revenue was $2.34 billion, up 76%, for our highest year over year growth rate since mid-2011. Exchange rates had no meaningful impact. We continue to experience strong revenue growth around the world. Ad revenue in each of our four recorded geographic regions grew by more than 65% in Q4 compared to last year. The key driver of ad revenue growth continued to be the strong performance of newsfeed ads on mobile and desktop, which helped us attract more advertiser demand. Mobile ad revenue increased from approximately $881 million in Q3 to approximately $1.25 billion in Q4, a healthy increase that of course benefited from seasonal effects. In Q4, total ad impressions declined 8%, and the average effective price per ad was up 92% compared to last year. The decline in ad impressions was primarily due to the shift in usage towards mobile devices, where people are shown fewer ads compared to desktop, since there’s no right hand column ads on mobile. The significant increase in average price per ad was driven by the mix shift to more newsfeed ads that have much higher engagement and clickthrough rates, increasing the average effective price per ad impression. The price volume trends were pretty similar across our four geographies. Total payments and other fees revenue in Q4 was $241 million, down 6% versus last year, remembering that in Q4 last year we recognized revenue from four months of payments transactions. On a more apples-to-apples basis, payments revenue from games, which represents the substantial majority of our payments and other fees revenue, grew approximately 8% in Q4 versus last year, despite the fact that our payments revenue from games is limited to our desktop users, a population that’s declining. Turning now to expenses, our Q4 GAAP expenses were $1.45 billion, up 37%, and non-GAAP expenses were $1.13 billion, up 33%. For the full year, our non-GAAP expenses were up 44%, driven largely by growth in infrastructure expense and a 37% increase in headcount over the year. As our revenue has grown, we’ve worked hard to stay disciplined in terms of our expense growth, focusing on investments where we’re most confident of creating value and meaningful ROI. We’re pleased with the returns we achieved from many of our investments that we made in 2013, including those to advance our ad products, improve mobile product quality, increase engagement, and drive efficiency improvements in our infrastructure. Our Q4 GAAP operating income was $1.13 billion, representing a 44% operating margin, and our non-GAAP operating income was $1.46 billion, representing a 56% margin, up from 46% last year. As you know, margins are typically the strongest in the fourth quarter, given the seasonal strength in our advertising business. Our GAAP and non-GAAP tax rates for Q4 were 54% and 46% respectively, and for the full year 2013, our GAAP and non-GAAP tax rates were 46% and 41%. The tax rates in Q4 were higher than the rates for prior quarters of the year, primarily because of intercompany payments that occurred in Q4 related to our international operations. Also, at the end of 2013, we had a tax net operating loss, or NOL, carryforward of almost $8 billion. In Q4, GAAP net income was $523 million, or $0.20 per share, and non-GAAP net income was $780 million, or $0.31 per share, up approximately 80% compared to last year. Capex was $483 million in Q4, and $1.37 billion for the full year. Our efficiency investments, including the Open Compute project on the hardware side and proprietary work on the software side, have enabled us to significantly increase the amount of data and the number of users we can support with each server we buy, and these investments have saved us over $1 billion over the past three years. We wouldn’t be able to deliver the profit and cash flow numbers we’re reporting today without the success of these efficiency investments. Our Q4 free cash flow was $748 million, and our full year free cash flow was $2.8 billion, including the benefit from a $419 million tax refund in Q2. Turning to the balance sheet, we ended the year with $11.4 billion in cash and investments. This number includes $1.5 billion from our secondary offering of 27 million shares in December at the time of our inclusion in the S&P 500 index. Now I want to share a few thoughts on 2014. In terms of expenses, we’re planning that our total 2014 GAAP expenses, including cost of revenue and including stock comp, will likely grow in the neighborhood of 35% to 40%, and non-GAAP expenses, including cost of revenue but excluding stock comp, will likely grow in the neighborhood of 40% to 45%. We plan to invest with a continued emphasis on technical headcount and product development to take advantage of the opportunities we see to create new experiences and more value for our users, marketers, and developers. On taxes, we expect our GAAP and non-GAAP tax rates in 2014 to be roughly similar to our full year tax rates in 2013, although this could vary widely depending upon acquisitions, our international revenue and expense mix, and other factors. Our tax rate in 2014 and over the next several years will continue to reflect the fact that we’re in the early years of investing in our international operations. Longer term, we expect our tax rate to be in line with peer companies who have similar operations and international revenue mixes. We ended 2013 with 2.6 billion diluted shares outstanding, including the December stock offering, and we estimate that our diluted share count will increase roughly 2% to 2.5% by the end of 2014, although this may vary depending upon our stock price and new share issuances, for example to support M&A. We anticipate our 2014 capex will increase to be in the range of $2 billion to $2.5 billion. The significant year over year growth will be driven by an expansion of our Menlo Park headquarters, infrastructure-related expenses such as the buildout of our Iowa data center, and by our investment plans to support initiatives like internet.org that are designed to increase internet penetration in the developing world. We’ll also continue to make strategic investments to improve capital efficiency. Last, in terms of revenue, in 2014 we hope to build on our success from last year. 2013 strong growth in ads revenue was driven by the rapid ramp up of newsfeed ads, growth in users, engagement, and marketers using Facebook, and by the product investments we made that improve the quality relevance, and performance of our ads. As Sheryl described, we believe we’re still early in the evolution of our advertising business and the mobile ad business in general. This makes for a difficult time to forecast near term revenues with any precision, but it also makes for an exciting time, and we’re looking forward to capitalizing on this opportunity. To sum up, Q4 was a strong end to a great year for Facebook. Thanks for joining us on the call today, and now let’s open for questions."
},
{
"speaker": "Operator",
"text": "[Operator instructions.] Your first question comes from the line of Ben Schachter with Macquarie."
},
{
"speaker": "Ben Schachter - Macquarie",
"text": "Sheryl, I was wondering if you could rank order the four groups of marketers and discuss how SMBs play out over time versus the larger enterprise companies. And then Mark, if you could talk more, expand more, on what you mean by standalone mobile apps, and really what your vision is there. And I understand you’re speaking at Mobile World Congress, so any update on what we should expect on that?"
},
{
"speaker": "Sheryl Sandberg",
"text": "We don’t break out by segment, but all four segments are growing, and we’re pleased with the growth there. I’m glad you asked about SMBs, because it’s a particular focus for us, and somewhere I’m really proud of our performance. Our teams, led by Dan Levy and others, have just done a great job. There are 25 million SMBs that have pages on Facebook, and that’s a really great first step, because just historically, it’s very hard to get small businesses online. What we’ve done over the last year is we’ve really worked at simplifying our ad product. And that’s working, because the way to convert our SMBs who are using our free product into being advertisers are with these really simple ad products. So rather than going to them and saying, do you want to become an advertiser, you say, do you want to promote a post. And that’s what’s working, and we’re able to convert them to advertising, and then upsell them from there in large numbers. And we’re excited about it."
},
{
"speaker": "Mark Zuckerberg",
"text": "And in terms of the focus on building new and separate experiences, our theory is that there are all these different ways that people want to share and communicate. Almost any kind of content that you can imagine sharing: text, photos, videos, links, locations, events, games, any type of content, with any type of audience. You know, whether it’s privately in a one-on-one situation, or small groups, or with all of your friends, or a larger community, or publicly. There’s an interesting intersection between most of these things, and one of the things that we want to try to do over the next few years is build a handful of great new experiences that are separate from what you think of as Facebook today that are just kind of helping to explore that space and give people new ways to share. I think you can see that that’s something that people want, from some of the mobile apps that exist out there today. You can see it from our own offering, with not just Facebook but also Instagram and messenger already today. And we’re going to keep on working on this over the next few years."
},
{
"speaker": "Operator",
"text": "The next question comes from Heather Bellini with Goldman Sachs."
},
{
"speaker": "Heather Bellini - Goldman Sachs",
"text": "I have two questions. The first one, there’s been a lot of talk about Messenger over the last couple of quarters. I’m just wondering if you could share with us how you see the competitive environment for Facebook in the area of messaging, in particular in regions like Asia. And how do you see Facebook differentiating itself and maybe changing the user behavior from some of the newer companies that have aggregated a large number of users in the space? And then my second question is just for David in regard to seasonality of ad revenue. And obviously it typically declines in Q1. I’m just wondering if we’re at the point now where we should see seasonality of mobile ad revenue in Q1."
},
{
"speaker": "Mark Zuckerberg",
"text": "I can talk to Messenger a bit. If you think about the overall space of sharing and communication, there’s not just one thing that people are doing. People want to have the ability to share any kind of content with any audience. There are going to be a lot of different apps that exist, and Facebook has always had the mission of helping people share any kind of content with any audience, but historically we’ve done that through a single app. And one of the stats that I shared today is that we now have more than half a billion people using Groups every month. And that’s not something that I think a lot of people are paying attention to, because it was sort of seen as a feature of the Facebook app rather than its own product. So what we’re doing with Messenger now, similarly, a lot of people are using Messenger every day, but it’s like a feature of Facebook rather than its own network or standalone thing. And we’re making it more of a standalone app, and we’ve actually, in the latest quarter, we’ve taken it out of the main app, so that way it gets room to breathe and blossom as its own great experience. And we’re going to focus on making that really good and adding a lot of new things. I mean, some of the stats that I shared are incredibly promising. In the last few months, 70% more people are using it, and a lot of message volume growth. So we’re still focused on kind of general growth for Messenger rather than going country-specific at this point in its evolution."
},
{
"speaker": "David Ebersman",
"text": "Thanks for your question on seasonality. Of course seasonality is an important factor in an advertising business, and affects Q4 and makes it a typically strong quarter. At this point, given how new we are with the mobile business, I think it’s really difficult for us to quantify the impact of seasonality. I think it will take some more time before we can understand it better than we do."
},
{
"speaker": "Operator",
"text": "The next question comes from Mark May with Citibank."
},
{
"speaker": "Mark May - Citibank",
"text": "Just would love to get some updates on some of the efforts that you’re making in terms of brand and real time conversation. I think on the user side, would love to get some interest in terms of the usage and engagement with video content early on, and real time conversations, particularly around entertainment related content. And then on the advertiser side, kind of early adoption by brand and TV-like advertisers with some of the brand and video solutions that you have out there. And then for David, given the significant transition that the business continues to go through that is affecting these ad impression and average price metrics, can you give us a sense of the breakdown between the ad impressions between desktop and mobile?"
},
{
"speaker": "Mark Zuckerberg",
"text": "I’ll start here on the public content piece, and then I think Sheryl will get into some of the specifics. But I just want to put this in the context of the overall strategy here. We were just talking about some of the standalone experiences and Messenger, and public content is part of this overall spectrum of content that people want to share and consume as well. In some ways, it’s the complete opposite side of the spectrum from one-on-one messaging, but it’s also an area where I think the medium of newsfeed and Facebook works really well. So we’ve been focused on improving the tools for public discussion and folks to be able to share public content, including premium content like videos and making it so that they can autoplay in feed. And this is an area where, just like Messaging and some of the other things we’ve talked about, you should expect us to keep focusing on a lot. It’s part of the overall space of sharing that we think is quite valuable. I think Sheryl is going to get into some of the specifics."
},
{
"speaker": "Sheryl Sandberg",
"text": "Yeah, I can start with video and then go to the overall brand question you started with. We have a current video ads product that works very well. It’s part of what’s driving our growth. We have also recently started testing an autoplay video ad. That’s just a very small test. But overall, we’re seeing what Mark has talked about, which is that marketers and users are using video more, as they have the technology to do so. And we expect that to continue to grow. In our overall brand effort, we’re making really good and steady progress as we are with all of our market segments. All of the Ad Age Global 100 advertised with us over the past year. And the real key there is proving measurement to our clients. Our team, led by Carolyn Everson and her people all around the world, really have to go client by client and show them that we can not just increase people’s happiness or brand affiliation, but ring the cash register at the end of the day. I think this is part of the big story for us in 2013, which is if you look back a year, we didn’t have that ability to look at the [AB] test of who saw our ads, and what the different in sales is. And now we have that. And we still have a lot of hard work to do, client by client, ahead of us, but being able to prove that we have really strong ROI, and I think increasingly efficient ROI, compared to the other marketing opportunities they have, is what is going to move the brand marketers to Facebook and to mobile."
},
{
"speaker": "David Ebersman",
"text": "Your second question about mobile and desktop impressions, as you know, per user or per unit of time on the desktop, we show a higher number of ads, because there’s the right hand column ads in addition to newsfeed. But we’re extremely pleased with how well the newsfeed ads continue to performance, and that’s really what’s driving up the average price per ad, as I described. So these ads perform well for marketers and are still continuing to contribute to the positive user experience that Mark described earlier."
},
{
"speaker": "Operator",
"text": "The next question comes from Anthony DiClemente with Nomura."
},
{
"speaker": "Anthony DiClemente - Nomura",
"text": "First, for David, I wonder if you could comment on the ad load on Facebook. Do you expect that to continue to remain stable, or is there a possibility that the ad load creeps up over time? And on Instagram, I know it’s a new product, and you guys are taking it slowly at first, but I wonder if you could also talk about how long it might take for Instagram to get to a similar ad load to Facebook’s levels. And then one last question for Sheryl, I wonder is there a way, when you compare Facebook to television for brand marketers, to look at the disparity of ROI, or I should say the improved ROI for Facebook, and sort of extrapolate where you think pricing could go. Obviously pricing doubling quite a bit. How much more upside to Facebook newsfeed pricing can we expect to see based on the ROI differential?"
},
{
"speaker": "Mark Zuckerberg",
"text": "I just want to start off here, and then David can get into some of the details on the number of ads and all that. But you know, the strategy has been, for the last period, and will continue to be, to primarily focus on increasing the quality of the ads and the experience. And I really think that it’s easy to look at the model and say, okay, if we ran more ads then the business would grow faster in the short term, but investing in quality is really actually the most important thing, because it’s what improves the experience for the people who use the product. It drives greater returns for advertisers, and over time it increases the potential size of our business. And I think you can say that that’s a harder path for us to take, but I actually think that the results over the last couple of quarters have really shown that by focusing on improving quality instead of just increasing quantity, we can actually drive pretty incredible business results. So we think that there’s more to do here, and that’s what we’re going to keep on doing."
},
{
"speaker": "David Ebersman",
"text": "I think I can take most of the rest of this. In terms of ad load, the one piece of context maybe to start with is the variable we’re really focused on optimizing isn’t ad load per se, but it’s the user experience, as you can measure that based on engagement or user feedback, etc. And ad load is one of the variables that impacts that, but there’s other relevant variables as well, such as the positioning of the ads, the size of the ads, and of course critically the quality of the ads. So ad load only gives a part of the picture. And we’re really one or two years into this, and we’re still learning how to provide the best experience. I think one of the most important pieces of positive news from 2013 was as we ramped up newsfeed ads, they performed as well as they did, delivering great value for marketers, having a very minimal effect on the user experience, and enabling Facebook to deliver the kind of results that we reported today. So going forward, we’ll continue to tweak what we do in terms of trying to find the right balance and optimize the performance of the ads for marketers and for users, but generally, as Mark said, the most important place for us to invest is going to be in improving the quality and relevance of the ads. You asked about Instagram and pricing, so let me just cover those quickly. Instagram I would say we’re just really early with Instagram. So it’s too early to talk about where we’re going to be going. We’re still trying to learn what the right way to approach that product is, and we’re going to move slowly, because we think that’s the right thing to do for Instagram In terms of pricing, it was our expectation that if ads in newsfeed worked well, that they would deliver more value for marketers, be more engaging, and that they would contribute to the average price per ad on Facebook going up. And we also believe, looking forward, if we continue to improve the quality and relevance of the ads we show, that that’s a critical way that we can drive pricing up in the future."
},
{
"speaker": "Operator",
"text": "The next question comes from Douglas Anmuth from JPMorgan."
},
{
"speaker": "Douglas Anmuth - JPMorgan",
"text": "Just wanted to ask two things. First, you announced an initiative or perhaps an algorithm tweak, I think, in early December to have more news stories in users’ feeds. And I was just curious what the adoption has been thus far from users there, and what are the implications on usage and engagement, and then also ad load. And then secondly, can you give us an update on teen engagement trends?"
},
{
"speaker": "Mark Zuckerberg",
"text": "To start with the public content, the change that we made is basically a lot of what our algorithm looks at is straight engagement. So the amount of content that people click, like, comment, and share in feed. But what we found was that when we asked people qualitatively what they prefer getting, it didn’t often match up, because a lot of things like memes scored very high in terms of getting a lot of people to like them, but weren’t necessarily, when you asked people, what they wanted to see in feed, or what they were happy seeing, didn’t score that way. So we ended up doing an adjustment to the algorithm, which made it so that qualitatively things and especially public content and news that people rated as higher quality qualitatively scored more, and that was basically the adjustment to the algorithm. It had really no impact on ads. It was an organic content adjustment that we made to improve the quality of the experience. So I think David can talk about teens."
},
{
"speaker": "David Ebersman",
"text": "In terms of teens, we don’t have any new data to report today. As you know, we take engagement very seriously, and we’re focused on building great products that all our users, including teens, will find useful and engaging. And that’s the most important thing for us to stay focused on."
},
{
"speaker": "Operator",
"text": "The next question comes from Scott Devitt from Morgan Stanley."
},
{
"speaker": "Scott Devitt - Morgan Stanley",
"text": "I had a couple of product questions for Mark. The first one on Graph Search, just wondering how users are engaging with the product, how it developed, what the product is, in terms of what we can see today relative to what your longer term aspirations are for the product. And then just a follow up on Doug’s question, related to the news flow integration into newsfeed. You know, another feature that’s been added more recently is trending and attaching trending to news articles in newsfeed as well. So if you could talk more broadly about your interest in real time information and news as it relates to public content, that would be helpful."
},
{
"speaker": "Mark Zuckerberg",
"text": "Starting with Graph Search, we’re really early in the game on this, and I think you can see that because we haven’t even really rolled out our mobile version of Graph Search yet, and we’re a mobile company, and we started on desktop. The way that we’re thinking about this, there’s just so much content that people have shared on Facebook that simply building the infrastructure to index all of it and start ranking it is a multiyear effort, which we’re making our way through. So the first release indexed more than a trillion connections between all the people and interests and events and groups and things that everyone was connected to. The second release that we did recently was around all the updates. So there are more than a trillion status updates and unstructured text posts and photos and pieces of content that people have shared over the past 10 years, and indexing that was a really big deal, because as the number of people on the team who have worked on web search engines in the past have told me, a trillion pieces of content is more than the index in any web search engine. So we’re kind of making our way through this. Pretty soon, I think you should expect us to roll out the mobile version of this. I think that’s going to be an important step, because most of the usage in Facebook overall is on mobile, so we expect that that’s where engagement will really start to come from on Graph Search over time. But it’s also only in English so far, and we have to internationalize it. So there’s a long roadmap of things that we need to do that I think is pretty clear, but it’s just going to be incredibly useful when it’s ready. We look at this as an investment over a three to five year period rather than a one to two or shorter period. So that’s how I think about that. The other question was about trending topics, and that really ties into the public content push that we have. And we talked a bit about this before. We’re trying to build great experiences for all types of content that people want to share and consume with all audiences. We think public content is great. Folks who are making news, or premium content on TV, or movies, or celebrities and different types of folks are extremely interesting and produce great content, and we want to be a great place for people to share that content, and for people to be able to learn about it and consume it. So trending topics is one step in what you will see as a pretty long roadmap of things that we’re going to do to make Facebook great for public content."
},
{
"speaker": "Operator",
"text": "The next question comes from Eric Sheridan with UBS."
},
{
"speaker": "Eric Sheridan - UBS",
"text": "First one for Sheryl. I would love to get an update on how the company’s thinking about mobile retargeting ads. You’ve seen a lot of success with retargeting on desktop, but how you can think about the evolution of retargeting in the mobile environment as a future product. And I guess second question for Mark, not a lot of talk on the payments business so far in the call, and just wanting to understand, maybe an update around games or other areas of ecommerce that you think are opportunities for the payments business."
},
{
"speaker": "Sheryl Sandberg",
"text": "On retargeting, retargeting has been proven really valuable across all platforms. We’ve allowed it through [FBX], and increasingly we’re allowing it through our own products as well. As part of our custom audiences suite of offerings, we’re offering website custom audiences and mobile app custom audiences. And these all allow marketers to target ads in privacy safe ways that improve the relevance and improve results. I think when people think about targeting, what they’re really thinking about is relevance, and taking the data and using it in a privacy safe way to increase the relevance of ads to users. And that’s something we’re working on."
},
{
"speaker": "Mark Zuckerberg",
"text": "For payments, we don’t think about our business so much as an advertising or payments business as we’ve built this network and we help businesses reach people with relevant messages. And payments historically has been a great way for game developers, especially on desktop, an efficient way for us to monetize that business, because instead of charging them up front for most of the ads, we can charge them only when their business grows because someone is paying for something. On mobile, I think the natural evolution of this is for that to move toward app install ads, where we’re not running the payment system on mobile. The operating systems are integrated with that. But because a lot of the goods that people are buying in games are no marginal cost, a developer’s economic incentive is to advertise to get more people to come into their flow for as many people as they can get to buy the goods. So even though a game developer might be paying 30% to the operating system maker for payments, we’re finding that people also really want to buy a lot of app install ads, and that’s grown incredibly quickly, and is one of the best parts of the ad work that we did over the last year."
},
{
"speaker": "Operator",
"text": "The next question comes from John Blackledge with Cowen & Company."
},
{
"speaker": "John Blackledge - Cowen & Company",
"text": "Two questions. First, Mark, you referenced 2014 as a year of rolling out new and engaging mobile products. Maybe could you provide some color or highlight the types of products that users can expect, or maybe how you think about improving mobile engagement? And then just on Instagram, can you give us an update on the number of monthly active users ending 2013 and give us a sense of how the data testing is going with advertisers, and when it might be available for all advertisers?"
},
{
"speaker": "Mark Zuckerberg",
"text": "Before I get into some of the newer types of things, which we’ve actually touched on most of them already on the call, I also want to take a moment just to emphasize that we’re going to start building new experiences, but they’re going to start small compared to where the core of Facebook is. So most of the results that we’re going to see in terms of the increase in engagement and sharing and our business are going to come from the core Facebook experience, because mathematically, it’s just so much bigger than everything else that is out there that the numbers, you’d have to be multiyear investments to add up to that. I mean, you can look at, for example, comScore puts out these numbers every month or so that reference the amount of time that people spend in different mobile apps. Facebook I think is almost 5-10 times bigger than the next app that is out there. So it’s going to take a while for any of these things to turn into huge things. So some of the things that we’re thinking about are all of the different kinds of ways that people might want to share different kinds of content with different audiences. So I talked about Groups earlier on the call. That’s something that half a billion people are using. It’s currently a feature within the Facebook app. Giving experiences like that room to breathe and really develop to be their own brand, I think, is a huge and valuable thing. It’s not necessarily the next thing that we’re going to go do, but it’s kind of an example of the type of audience and type of content that people might want to share. Examples of things that we have done are Messenger is a really big focus for us, and we’re focusing on that as a standalone experience. Instagram is a different kind of community than Facebook. We just launched Instagram Direct within Instagram, which is one on one or small group photo and video sharing. And you can kind of view that as the kind of experience that we’re going to be rolling out. But there’s a lot of space here, for a lot of different kinds of things, and what I think you should take away from this is that while the core business growth is going to come from the main app that exists, just because the numbers are so much bigger than everything else today, that that’s going to just be where most of the momentum comes from. You should also expect us to start building a few of these other things that we’ll focus on over a long period of time and hopefully build into meaningful things, like Messenger and Instagram are today."
},
{
"speaker": "Operator",
"text": "The next question comes from Brian Pitz with Jefferies."
},
{
"speaker": "Brian Pitz - Jefferies & Company",
"text": "Mark, last week on the Facebook developer’s blog, there was an entry that noted you were testing placement of ads in third party mobile apps. Just wondered if you could provide an update on how these tests may be going. And then separately, it appears that the growth on desktop ads reaccelerated during the quarter. Can you talk a bit about the drivers of that?"
},
{
"speaker": "Sheryl Sandberg",
"text": "On the Facebook ads in third-party mobile apps, it’s a small test we just started that aims to show Facebook ads off of Facebook for mobile apps. So we don’t have results yet. We are very excited about the mobile app space in general. If you look at our mobile app installation [adds], we’ve really done a great job working with developers to help users discover and download their apps. And the product we rolled out last quarter, which is the engagement ads, then help developers get people engaged or reengaged in their apps. And so it’s a small, important, and growing space, and we feel really good about the progress we’ve made with those ads on Facebook. When you look at off-Facebook, really early test."
},
{
"speaker": "David Ebersman",
"text": "In terms of desktop, I’d say the two trends that really benefitted desktop in the fourth quarter were similar to what we described earlier. One was just holiday strength that we saw in the business and the second was the strong performance of newsfeed ads, which we show in both mobile and desktop. So that worked well for us in the fourth quarter, just recognizing still that the user numbers on desktop continue to sort of decline modestly overall, and that’s obviously an important headwind for the revenue from that part of the business."
},
{
"speaker": "Operator",
"text": "The next question comes from Ross Sandler with Deutsche Bank."
},
{
"speaker": "Ross Sandler - Deutsche Bank",
"text": "Mark, I had a follow up from one of the previous questions, on closing the loop in mobile. You guys have made a lot of progress improving the total mobile ad experience, yet there’s still a lot of friction in downloading apps and making purchases today. You guys have recently rolled out some new ad formats, and you have some partnerships with the likes of Braintree and Stripe and some of the other payment guys. So what’s your vision for removing some of this friction for marketers, and do you envision a scenario where users can buy physical or digital products within the Facebook mobile apps?"
},
{
"speaker": "Sheryl Sandberg",
"text": "I can take this. Obviously, the mobile app world is a new world, and not just the functionality in ads is still developing, but the functionality of what then people can do. You can do a lot more on the desktop in many ways than you can on mobile. I think the best role we play is to help connect consumers with marketers and with companies and services, and I think reducing the friction there is really important. We don’t have any plans to go into the direct ecommerce market, because the advertising products we provide I think are the best thing we can provide to help grow this market."
},
{
"speaker": "Operator",
"text": "The next question comes from Tom Forte with Telsey Advisory Group."
},
{
"speaker": "Tom Forte - Telsey Advisory Group",
"text": "On contextual advertising, this is essentially the Holy Grail for Facebook, and I think you understand this. Can you talk about where we are as far as innings on getting contextual ads? And can you talk about the role that Instagram plays with visually appealing ads and the role that video plays?"
},
{
"speaker": "Sheryl Sandberg",
"text": "As I said, and I’ve talked about each quarter, targeting is a huge, huge issue for us, and a huge opportunity and challenge. Our goal is in a privacy safe way to get information we can about what consumers want, and then help connect marketers, so that the ad experience is great for users. We’re serving relevant ads. Whether that information comes from the kind of things people like on Facebook or other websites they visit, or contextual statements they might make in their status updates, our goal is to use that information in a privacy safe way to improve the targeting of the ads on Facebook. To take one example, if you look at what’s happening with our direct response business, which has been a very strong segment for us, if you look at people trying to find consumers, we offer the opportunity to get people before they search. We can judge interest based on other things, other things they’re interested in, and give people the opportunity to find consumers before they search so that they can then move them all the way down the funnel into purchase."
},
{
"speaker": "Operator",
"text": "The next question comes from Jordan Rohan with Stifel."
},
{
"speaker": "Jordan Rohan - Stifel Nicolaus",
"text": "I’m curious if you could help me understand the international market development and modernization for Facebook’s ad platforms. Specifically, can you speak to the buildout of international direct sales force, the channel partners, the number of international markets, in which FBX is operational, and the extent of geographic rollout of the cost per install ad units in the newsfeed? Is that available everywhere? Where are we compared to the U.S.?"
},
{
"speaker": "Sheryl Sandberg",
"text": "The buildout globally is going well. We’ve always been pretty conservative. We wait until we have a very strong user base in other countries, and we wait until there’s a developed ad market. But we’re growing. We have a PMD ecosystem, which now covers 45 countries. I was actually in Turkey at the beginning of last week and had a chance to meet with our advertising partners there, and they are increasingly using our platform to reach consumers. We are growing our offices. We’re growing our offices in Asia particularly this year, and we’ve rolled out offices across Europe as well. In terms of rolling out products, we tend to roll out products in our most developed markets first. And as we extend those products, we then extend them to the rest of the world."
},
{
"speaker": "Operator",
"text": "The next question comes from Colin Sebastian with Robert Baird & Company."
},
{
"speaker": "Colin Sebastian - Robert Baird",
"text": "I just have a couple of questions. The first one, I guess, on app install ads, if you could quantify how much those are driving growth in newsfeed advertising. And if not specifically, then maybe on a relative basis, through other mobile ad formats? And then second, Mark, the company has made some interesting hires in the area of machine learning, and I’m curious if you could characterize how important this initiative is to the company, and how you think that AI will help Facebook over time."
},
{
"speaker": "Sheryl Sandberg",
"text": "On the first, we’re excited about our mobile app install ads and our mobile app engagement ads. It’s a small but growing category. We don’t split out by segment. But one thing that’s really important to note is that our mobile ad strength is very broad-based. Our mobile ads are not just bought by people who are looking to drive engagement or usage of mobile apps, but is very broad-based. We’re being used by SMBs, brand advertisers, and direct response advertisers as well."
},
{
"speaker": "Mark Zuckerberg",
"text": "And I can speak to some of the deep learning work. In the last quarter, Yann Lecun, one of the really earliest folks, and one of the founders of deep learning, and a professor at NYU, joined us to lead our AI group. And this is a long term research group that we have. It’s going to fit into our strategy over a longer, maybe five or ten year, period. And their goal is really just to try to understand how everything on Facebook is connected, by understanding what the posts that people write mean, and the content that is in the photos and videos that people are sharing, help people with tasks like if you’re sharing a voice clip in messenger, being able to transcribe that for people, so that they can receive it more easily. So these are some pretty big tasks in AI that are things that we have teams that are working on that will need to be researched over time, and will have obvious implications for the products that we do, but over time the real value will be if we can understand the meaning of all the content that people are sharing, that we can just provide much more relevant experiences for people across everything that we do. Internally, we talk about our strategy, and there’s a three-year strategy, a five-year strategy, and a 10-year strategy. And the three-year plan is really all about building new kinds of experiences for sharing, like so many of the questions on this call have been about. The five-year approach is really mostly about helping people use their network to answer interesting questions or solve problems that they have. And that’s where all the Graph Search work and the open graph work and some of the early parts of the AI work that we’re doing you’re going to start to see over that period of time. And then over a 10-year period, I think you’ll really start to see a lot of the impact of some of the internet.org work that we’re doing, where hopefully we’ll see some impact a lot sooner than that as well. But over a 10-year period, if we can get a lot more of the world on the internet, I think that’s going to really mean a quite different world in terms of what folks in a lot of developing countries have access to in terms of some of the things I said in my opening remarks, around basic financial services, and people can get credit to start businesses, and buy homes, really life-changing stuff, or get access to health information or education materials, which I think are just a really big deal. And over the long term, we’ve always wanted to help out with that, and I think that’s where we’re going to go on that."
},
{
"speaker": "Operator",
"text": "Our last question will come from Mark Mahaney from RBC."
},
{
"speaker": "Mark Mahaney - RBC Capital Markets",
"text": "David, can you just talk about the sustainability of the gross margin that you had in the quarter? It seemed pretty high. And then Mark, hopefully this isn’t redundant. When you think about the potential for ad quality at Facebook over the next three to five years, and you’ve gone through a lot of learnings over the last two years on ad quality, how do you think about what the upside is? I know that’s a broad, general question, but if you think about all the different drivers, have there been certain moments when you’ve seen real gap opportunities? Are there any proxies out there that you see that you say, well, this is where Facebook could be? Any thoughts on how much higher, how much better, over the years, ad quality could be on Facebook?"
},
{
"speaker": "David Ebersman",
"text": "I’ll start with the question on gross margins. I think in Q4, as you know, gross margins tend to be seasonally strong, because revenue goes up in the fourth quarter and the costs associated with operating our infrastructure don’t go up accordingly with the seasonal strength in advertising revenue. So directionally, I think it’s important to note we really had a great year in 2013, in terms of the efficiency investments that we made. But going forward, this is a compute heavy service we provide. It requires a lot of data centers and servers and infrastructure. We’re going to continue to invest in those things and we do expect to increase our infrastructure costs over time while trying to do that as efficiently as possible."
},
{
"speaker": "Mark Zuckerberg",
"text": "And in terms of quality, I just think that there’s a lot of room to grow here. I said in my opening remarks that we have this long term goal of making the advertising quality content as good and as relevant and timely as the content that your friends are sharing with you. And at first blush, I think that seems kind of crazy in that your friends’ stuff will obviously always have the advantage of being immediately socially relevant to you. But at the same time, a lot of the folks who are advertising really invest in the quality of the content that they’re producing and putting into their ads, and improving the targeting of their ads to deliver the right messages to the right people. And I don’t think that there’s a single step function that we’re going to see here, although there are things like the video formats that really enable new kinds of rich experiences, that folks who can invest in building those can really benefit from. At the same time, I think a lot of this is going to be incremental. So as we make improvements, more advertisers come into the system, and as more advertisers come into the system, we have more options of relevant content to show to people, and that improves the quality as well. So this is just going to be something that we’re going to focus on for a while, and there’s a long way to go before we get to the quality level that we want. But I think over a multiyear period, we can get there, or at least very close."
},
{
"speaker": "Sheryl Sandberg",
"text": "And that’s a nice way to end the call, because one of the really big opportunities we have is to make these ads [at scale] more personal. So just as we can have social context, obviously, from the user content, we put social context into ads. So we can take these ads that marketers can deliver up scale, improve the targeting, and give them social context, which will help drive the kind of opportunities Mark is talking about to make the ads as relevant as the user content."
},
{
"speaker": "Deborah Crawford",
"text": "Thank you for joining us today. We appreciate your time, and we look forward to speaking to you again next quarter."
}
] | null | null |
META | 3 | 2,013 | 2013-10-30 17:00:00 | Executives: Deborah Crawford - Director of Investor Relations Mark Zuckerberg - Chairman of the Board, Chief Executive Officer David Ebersman - Chief Financial Officer Sheryl Sandberg - Chief Operating Officer, Director
Analysts: Heather Bellini - Goldman Sachs Scott Devitt - Morgan Stanley Mark May - Citigroup Douglas Anmuth - JPMorgan Mark Mahaney - RBC Capital Markets Justin Post - Merrill Lynch Carlos Karjner - Sanford Bernstein Jason Helfstein - Oppenheimer & Company Ross Sandler - Deutsche Bank Eric Sheridan - UBS Peter Stabler - Wells Fargo Brian Nowak - Susquehanna Richard Greenfield - BTIG Brian Wieser - Pivotal Research
Operator: Good afternoon. My name is Jay, and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook third quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions). Thank you very much. Ms. Deborah Crawford, Facebook's Director of Investor Relations, you may begin.
Deborah Crawford: Thank you. Good afternoon, and welcome to Facebook's third quarter earnings conference call. Joining me today to talk about our results are Mark Zuckerberg, CEO, Sheryl Sandberg, COO and David Ebersman, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. The actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release, our Annual Report on Form 10-K and our most recent quarterly report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these statements as a result of new information or future events. During this call, we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. This press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I would like to turn the call over to Mark.
Mark Zuckerberg: Thanks, Deborah and thanks everyone for joining today. This has been a busy quarter at Facebook where we planted the seeds to achieve our long-term goals with internet.org, our AI group and our efforts to build the knowledge economy. We continue to see strong overall engagement and are making good progress in our strategy, especially in mobile. This contributes to the result we have reported today. Strong revenue growth, strong growth in daily active and good growth in engagement, as our ratio of daily actives to monthly actives continues to grow. We have also reached new milestones as a mobile company. Now 49% of our revenue comes from mobile and 48% of the people use Facebook in any given day are only accessing it from mobile. That's almost half of the people only using Facebook from their phones, and it's a pretty incredible sign of how Facebook is evolved over the last year. On our last earnings call, I talked about our three big goals for the next phase of our company, connecting everyone, understanding the world and helping to build the knowledge economy. Connecting everyone means giving everyone in the world the power to use the internet and stay connected to the peoples and things that matters them. Understanding the world means helping people not just share day-to-day updates, but also building up long-term knowledge about the world and being able to answer questions for you that no other service can. Building the knowledge economy is about helping people create growth in jobs and supporting a larger economic shift in the world based on information and ideas. This framework can tell off things about our progress as a company over the next few years, so it's useful way to look at our progress over this quarter as well. We'll start with connecting the world. This quarter, we took an important step. In August, we launched internet.org, a global effort Samsung, Ericsson, QUALCOMM and other industry leaders to make affordable internet access available to everyone in the world. Today, only about a third of the world's population is online and internet's is growing more slowly than you probably expect less than 9% a year. We want to change that. Our mission has always been to connect the world and to us that means everyone. When the next 5 billion people have a chance to use these basic services and participate in the global economy, that's going to create huge benefits for everyone in the world. By working together on technology and new business models, we think we can help accelerate the process of connecting everyone. We believe we are in a unique place to help encourage broader growth of the Internet, because so much of what people do on the Internet is Facebook. According to comScore, around 20% of the time that people spend in apps in the U.S. alone is in Facebook services when you a lot of people in developing countries what service they care about using most, the answer is often Facebook. We are already trying to make access to Facebook cheaper. All the same tools of innovation that we are developing to do this can be applied to other basic Internet services as well, but messaging, search, whether and Wikipedia to make those services cheaper or free to deliver. We also recently acquired Onavo, business team that builds world-class data compression technology in mobile analytics and they will play an important role in helping us build more efficient technologies and services that use less data. Of course no single company can do this alone and we are working closely with our partners to develop our future plans. It's still very early for internet.org and we will have more to say in the months ahead, but I am very excited about this effort and I am grateful to our partners for being a part of it. Next, let's talk about understanding the world. What I mean by this is that everyday people post billions of pieces of content and connections into the graph. In doing this, they are helping to build the clearest models of everything there is to know in the world. A big part of why this works is that people can share things with any audience they want. They don't have to share publicly with everyone at the time. they can share with just their friends, so this means that the model the world that people are building our systems include things that people only want to share with just a few people. This has the potential to be really powerful, but right now we have to do very little to utilize the knowledge that people have shared to benefit everyone in our community. The service we invest in the most news feeds, which gives you a great sense of what's going on with your community today. The news feed has proved itself incredibly useful for people and the most used app on peoples scoring by far, but this is just the start of what's possible. When we get to the point, where everyone can easily ask any question to Facebook and get it answered by our community. That's going to be very powerful. In the last quarter, there had been several important evolutions in our strategy of understanding the world. The first is around Graph Search. At the beginning of this year, we announced the first beta version of the service on desktop and that indexed more than 1 trillion connections between people in this segment. In the last quarter, we started testing what we call host search allows you to search all the unstructured text and posts that people have ever made on Facebook. About 1.2 trillion more posts. The folks on the team who have worked on web search engines in the past tell me that the Graph Search corpus is bigger than any other web search index out there. It's still early for Graph Search, because it's still in beta, only in English and we haven't launched our mobile version yet, but it's something I am really excited about. Another evolution in our progress to understand the world is around our efforts to building mobile apps. Our goal has always been to help people share anything they want with anyone they want. Historically, we have done this by building a lot of features into the core Facebook app, but we also have a few separate apps that are widely used like Instagram and messenger, our standalone messaging app. These are each large services that help people share in different ways Instagram enables more than 150 monthly actives to share beautiful photos also more publicly than people would want to share on Facebook. Messenger is part of how people spend billions of private one-to-one and group messages every day and with the latest release of the app yesterday, we are continuing to add features and make this a better experience. In the future, we expect to develop more services help people share different content with different groups of people and we will continue to build up messenger as better distinct messaging experience. There is one more evolution in our strategy to understand the world that I want to mention. In September, we formed the Facebook AI Group to do world-class artificial intelligence research using all the knowledge that people have shared on Facebook. The goal here is to use new approaches in AI to help make sense of all the content that people share so we can generate new insights about the world to answer people's questions. We started assembling a team of some of the best people in the field to work on these problems. We also announced the acquisition of Mobile Technologies, a speech recognition and machine translation company that will help expand our work in the field beyond just photo recognition to voice. Over time, I think it is going to be possible to build services that are much more natural to interact with and can help solving many more problems than any existing technologies today. I am excited that we are working on this problem and I am looking forward to doing a lot more here. Finally, let's talk about the progress we have made towards building the knowledge economy. The key to building the knowledge economy is building tools for everyone to use information to do their jobs better. So in addition to connecting everyone and understanding the world, we are also focused on building new services for businesses as a way to accelerate the growth of this new economy. The way businesses will experience this effort is that we will keep building better services for them to reach their customers with higher quality ads, more efficient leads with better targeting, better analytics and using richer formats. The way people will experience this effort is that the ads they see will become more and more relevant to their lives. Last quarter, I started talking about how our approach going forward would be to grow our business through improving the quality of our ads rather than by just increasing the quantity. This quarter we have continue to do this. And the results show our approach is working. We have been able to deliver better content and grow business for our customers and ourselves. We are planning that a lot more people are finding their ads useful and engaging with them and the average daily actives is engaging with more than ad per week. Most people probably wouldn't expect to engage with ads that often, so I think it's a great time that people are finding ads useful and they are adding value to the experience on Facebook. I think there is still a lot of room to improve the quality of our ads and grow our business over time. So this is something that we are going to keep on investing in going forward. So that's my update on how we are thinking about the next big changes we want to make in the world. Connecting everyone, understanding the world and building the knowledge economy. We have made a lot of progress this quarter and I want to take a moment to thank everyone who works with our company and everyone who is a part of our community for all the efforts that make Facebook great. Looking ahead, you can expect us to keep preparing for the future, even as we keep on building momentum today. As I said in our original S-1 filing, we don't build services to make money, we make money to build better services. This approach has served people who use Facebook, marketers and our entire Facebook community well. It's a different way of looking at the world but its how we are going to keep succeeding as a company. Thank you for being with us today and now I am going to hand it over to Sheryl.
Sheryl Sandberg: Thanks, Mark. We continue to see strong growth in our ads business, especially mobile. Q3 total ad revenue grew 66% year-over-year to $1.8 billion and mobile ad revenue grew to 49% of our total ad revenue. This is a remarkable milestone in a short time since we initiated mobile newsfeed ads just last year. Similar to last quarter, our performance is very broad based with strong growth across all geographies and types of marketers. At the same time, our overall user engagement metrics remained strong. We think this validates the careful approach we are taking to the building our ads business. I would like to highlight some of the key drivers of our performance this quarter. These are, to a large degree, the results of investments we have made over the past few years and they will continue to be our priorities going forward. The first driver is the continued growth of mobile engagement around the world. In 2013, for the very first time, people will spend more time with digital media than watching TV. Emarketer estimates more than 5.25 hours a day on digital services including mobile compared with 4.5 hours watching TV in the U.S. Facebook is well-positioned to benefit from this shift. In the United States, Facebook including Instagram, just one in eight minutes people spend on the desktop, but one in five minutes on mobile. According to comScore, Facebook and Instagram have more mobile time spent than many of the next largest services including YouTube, Pandora, Yahoo, Twitter, Pinterest, Tumblr, AOL, Snapchat and LinkedIn combined. Along with this engagement, we believe that we have the best mobile ad product with ads that are integrated unit into newsfeed for people who spend the most of their time on Facebook. As people shift where they spend their time, marketers are starting to follow. Our results today show that we are benefiting from this shift to mobile and we believe this shift will continue and will continue to benefit us. Today, mobile represents 12% of consumer media time, but it's still only 3% of ad budget. The second driver of our performance is an increasing number of marketers spending their ad dollars on Facebook. From brand to direct response, to local businesses to developers, more marketers are advertising on Facebook, because they recognize that our ads work to drive sales. This growth is taking place globally. In the third quarter, the number of Facebook advertisers in EMEA, nearly equaled the number in North America, reflecting global growth in our online advertising. The third driver of our growth is product development. We are working in a number of areas to make the ad people see on Facebook better. More targeted ads are better and we are improving our ad targeting to increase relevance. We are investing in features like custom audience and partner categories to improve targeted. These are great tools that are still in their early days and we will continue to invest. We also want to make it easier for marketers of all sizes to buy ads and measure their impact. In late September, we rolled out ad format changes, make ad a bit more consistent across Facebook and we reduced the number of ad units marketers have to choose from to reduce complexity. Then earlier this month, we rolled out a full redesign of our ad buying tools to simplify the ads creation process. Advertisers now select from one of eight business objectives such as website conversion are [often]. We think these product investments make it easier for marketers to achieve their goals. We are also expanding our products for developers. We already have launched mobile app install ads and these are going very well and we now launched mobile app install ads for engagement. These ads help developers and businesses reach people that have already installed their apps and direct them back to increased engagement. We believe these apps are a nice complement to our install ads and represent a unique opportunity. We also continued to invest in helping brands stay with our campaigns and increase same-store sales. We recently launched Outcome Measurement for the telecommunications industry. An initial test showed that more than 90% of people who made a purchase after viewing a Facebook ad have never clicked on that ad. This shows that impressions matter and focusing only on clicks does not tell the whole story. Similarly, a recent study by (Inaudible), one of our leading preferred market developer partners proves this point. The (Inaudible) study found that marketers who use the multi-touch attributions to measure campaign ROI credited 12% to 13% more value from Facebook than marketers to use off-click attributions, but we still have work to do. Brand marketers aren't moving as quickly as we would like and we believe measurement is key to influencing the app advertisers. Another important trend influencing our growth is our preferred marketing developer of PMD program. Over the past few years, we have invested in building an ecosystem that supports all types of marketers and PMD has helped those marketers advertise effectively with us. Today, this program is a community of hundreds of technology and service companies spread across more than 45 countries. In summary, we think our strong performance this quarter further validates that our ads strategy is working. Marketers are responding favorably as we heard during ad week in New York. Our messages around reach, targeting and measurements are resonating and will continue to reinforce them. Our ads are getting better and we still have a long way to go. Moving forward, our focus remains the same, continuing to capitalize on a shift to mobile, increasing the number of marketers who advertise with us and continuing to invest in our ad products. We believe that we are in the early stages of a major transitioning and advertising and we are uniquely positioned to capitalize on that opportunity. Now, David.
David Ebersman: Thanks, Sheryl, and good afternoon everyone. Q3 was a strong quarter for us in terms of our financial results. Our business grew rapidly around the world and we are pleased with our performance across our key financial metrics highlighted by the fact that Q3 was our first $2 billion quarter in terms of revenue. Let's start with the size and engagement of the Facebook community, which continues to grow. 728 million people used Facebook on an average day in September, up 25% from last year, continues to be driven by mobile. In Q3 for the first time, daily access on web declined year-over-year, albeit very modestly. Daily users represented 61% of the 1.19 billion people who accessed Facebook during the month of September and our overall engagement data remains strong. Also as we announced in September, Instagram now is over 150 million monthly actives. I want to say a few words about used engagement on Facebook. As we have said previously, this is a hard issue for us to measure, because self-reported age data is unreliable for younger users. So we have developed other analytical methods to help us estimate usage by age. Our best synopsis on youth engagement in the U.S. reveals that usage of Facebook among U.S. teens overall was stable from Q2 to Q3. So we did see a decrease in daily users specifically among younger teens. We won't typically call out such granular data, especially when it's of questionable statistical significance given the lack of precision of our age estimates for younger users. But we wanted to share this with you now since we get a lot of questions about teens. We are pleased that we remain close to fully penetrated among teens in the U.S., our monthly user numbers remain steady and overall engagement on Facebook remains strong. We will continue to focus our development efforts to build products that drive engagement for people of all ages. Turning to the financials. Total revenue in Q3 was $2 billion, up 60% and ad revenue was $1.8 billion, up 66%. Exchange rates had no meaningful impact. Revenue growth was strong around the world with each of the four geographic regions we report on growing by more than 50% versus last year. The primary drivers of ad revenue growth were an increase in the number of and the strong performance of newsfeed ads and an increase in the number of marketers using Facebook and increased demand in our system. In Q3, overall ad impressions were up 16% and the average price per ad was up 42% compared to last year. The growth in ad impressions was primarily due to market where using our service combined with the impact of a price floor reduction late in the third quarter last year. The growth in price per ad was primarily due to the increase in news feed ads. In the U.S. and Canada, where last year's price floor change had a smaller impact, ad impressions decreased 8% and average price per ad increased over 60% compared to last year. The decrease in ad impressions despite an increase in the number of users in the U.S. and Canada was due to the continued migration of usage to mobile devices where we show fewer ads per person compared to web. The greater than 60% increase in average price per ad in the U.S. and Canada was primarily due to the increase in the number of news feed ads shown on both mobile and web. Due to their high engagement levels, news feed ads have a significantly higher price per ad than right hand column ads. Therefore the mix shift of our ads towards the higher percentage being in news feed versus right hand column is driving up our average price per ad. Mobile ad revenue in Q3 was approximately 49% of our ad revenue, up from 41% in Q2. The sequential quarterly growth of mobile ad revenue was due to three factors. An increase in the average price per mobile ad, an increase in the number of mobile users and an increase in ads shown per mobile user. Looking now at web. Ad revenue from web usage decreased both sequentially and year-over-year. Web ad revenue includes both news feed ads on web and right hand column ads on web. Revenue from news feed ads on web increased significantly in Q3, sequentially and year-over-year, driven largely by an increase in the number of news feed ads per web user. The increase was not enough to offset the revenue decline from right hand column ads. Total payments and other fees revenue was up 24% year-over-year to $218 million and roughly flat sequentially. Payments revenue from games was up 18% from last year. So we believe 12% represents the best apples-to-apples comparisons adjusting for accounting items such as the change in revenue recognition timing from late last year. Overall ARPU of $1.72 per user was up 33% compared to last year. We saw 43% increase in the U.S. and Canada and greater than 40% gains in each of the other three regions we report on. Turning now to expenses. In Q3, our total GAAP expenses were $1.28 billion. On a non-GAAP basis, excluding stock compensation, total expenses increased 40% to $1.03 billion, driven by higher headcount and infrastructure spend. We ended Q3 with just under 5,800 employees, up 34% from last year and we continue to be pleased with our success in attracting talent. Our Q3 GAAP operating income was $736 million, representing a 37% operating margin up from 30% last year. And on a non-GAAP basis, operating income was $987 million, a 49% margin, up from 42% last year. Our GAAP and non-GAAP tax rates for Q3 were 41% and 36% respectively. GAAP net income was $425 million or $0.17 per share. Non-GAAP net income was $621 million or $0.25 per share, up around 100% from last year. In Q3, we spent $284 million on CapEx and free cash flow was $666 million. Looking at our balance sheet, we ended Q3 with $9.3 billion in cash and investments. During the third quarter, we repaid our $1.5 billion term loan and replaced it with a new $6.5 billion line of credit, which is currently undrawn. We will continue to manage our balance sheet to meet our liquidity needs, protect the business against risk and provide us with flexibility to invest in new opportunities to grow the business. Now let's look forward. We continue to believe that improving the quality and relevance of news feed ads provides us with a big long-term opportunity, however as we think about the future, we do not expect to significantly increase ads as a percentage of news feed stories beyond where we were at the end of Q3. This is important because increasing ads in news feed has been a meaningful driver of our revenue growth in 2013, so this should be factored into your expectations for next year. Turning to payments revenue. Remember that in the fourth quarter of 2012, we recognized revenue from four months of payments transactions, so for that reasons we expect payments revenue will be down this coming Q4 compared to last year. Looking at expenses, we now expect that our 2013 total non-GAAP expenses, including cost of revenue but excluding stock compensation will likely grow around 45%. In terms of our tax rate, we expect that our Q4 and full year non-GAAP tax rates will be a few percentage points higher than our Q3 rates. Finally, we expect our 2013 CapEx to be in the neighborhood of $1.4 billion. This is down from our prior estimate of $1.6 billion due to a combination of efficiency gains and changes in the timing of our planned purchases. To sum up, in Q3 we make great process against our key financial objectives, growing revenue, investing for growth and positioning the company to maximize long-term returns for our shareholders and we remain excited about the opportunities ahead. Now, we are ready to open the call for questions.
Operator: We will now open the line for a question-and-answer session. (Operator Instructions) Your first question comes from the line Heather Bellini with Goldman Sachs. Your line is open.
Heather Bellini - Goldman Sachs: Thank you for taking the question. I just had two one for Mark, and then one for Sheryl or David. Mark, the first one and as Facebook, value proposition is connecting the world, how should we expect Facebook in the future to more specifically leverage [geo] location, data of advertisers, to mobile ads even more useful for your users? Over what timeframe should we expect that to kind of play out in your mind? Then the second question for Sheryl or David would just be, you talked about brand advertisers taking a little bit more time, I think, than you would have liked spent than you might have liked. Just wondering if you could help us there with that higher mix between DR and brand advertisers as kind of played out over the course of the year, if you could just give us some rough ideas. Thank you.
Sheryl Sandberg: The way we think, I'll take this actually. The way we think about using location data is that every time we use data, we use it in accordance with the privacy controls we offer people and we are working hard at making our ads better targeted. Over time, I think you will see the industry continue to evolve to get better at targeting more ads. We certainly see it as a significant upside for us to get better at targeting more ads, not just from geo-location data but from all kinds of different data we get based on what users do with our service. On brand advertisers, we don't breakout the different marketer segments. Our results this quarter are based on growth in all marketer segments, including brand and we continue to make progress. We have every one of the AdAge Global 100 have advertised with us over the past year. My comment was based on the fact that marketing spend is just not keeping pace with the transition to time on line in mobile in that segment of the market. Since that segment of the market is so big, helping that transition happen present significant upside for us. Our focus there is measurement. We have to show brand marketers that our ads drives in-store-sales and we work on that, we work on that client-by-client to share a few examples from this quarter Cadbury in the U.K. works with us to sell their cream egg product kind of find the table for Halloween to talk about candy to 16 to 24 year old. They used Facebook media for user generated post along with TV, they reached 15 million people, 21% of those people they only reached on Facebook not TV and the combined impact of TV and Facebook where sales were up 9%. Another example because it shows how we can move awareness is the Alfa Romeo 4c launched in Portugal, (inaudible) where a person could do a test drive with a Formula One driver and they got the highest buzz they have ever had in Google Trends for a product launch. So as we think it's a big opportunity ahead of us and you have to work on these clients, account-by-account, client-by-client. But we think as the shift to mobile and digital happens, it's a big opportunity and we are focused on helping that shift happen.
Operator: The next question comes from Scott Devitt with Morgan Stanley. Your line is open.
Scott Devitt - Morgan Stanley: Hi, thanks. Sheryl mentioned some of the tools that have been added to make it easier for advertisers to access and use the ad platform. One example was the objective-based ad buying. I was just wondering how much you would attribute reduction in friction, like the examples that were referenced on the call, leading to direct and immediate increases in flow of ad dollars versus being more gradual in nature? Then secondly, for Mark. Mark, the concept of the knowledge economy. I was just wondering, how you envision what the consumer will be doing on the site five years from now? If today is more about and sharing and sharing is more developed than search and production integrations, how do you think about that relationship between those three activities on the site over a five-ish year time horizon? Thanks
Sheryl Sandberg: On the first. Our growth overall is based on the strong performance of news feed ads, an increase in the number of news feed ads per user and also more marketers. The simplification of products has actually been very important in attracting new marketers. If you look at the new advertisers we acquired in Q3, 62% of them started with either promoted posts or promoted page likes which are the most simple of our advertising formats. So we are continuing to rollout very simple ways to become an advertiser is driving our growth and we will continue to. The larger question you asked was based on our focus of business objectives and that's actually really a big deal for us. We are now getting to the point where our ad product supports really helping marketers achieve their core business objectives. So before, people use to buy via the product, what product do you want to buy. And now they are buying from, I would say, identifying, I want to get mobile app installed. I want to get mobile engagement. I want to get website conversions. I think the fact that we are pivoting to focus on those end business results and making everything else including social a part of meeting those business results is a really important part of our strategy. It's driving our growth and I think it's going to continue to.
Operator: The next question comes from Mark May with Citigroup.
Deborah Crawford: Sorry, operator, can we just go back to the second half of that question.
David Ebersman: Yes. I just want to answer the part of question about the product experience over time. I know there are two pieces of this that we are thinking about related to the knowledge economy. The first is just helping our customers use information better to grow their businesses and create jobs. Right. So we are thinking about small businesses and making it so they can have better insights into who their customers are and better ability to reach them. Now developers have been able to use better analytics for being able to find new customers as well. And those are a lot of the inspiration and the strategy behind the ad products that we are delivering. On the side of the product experiences that we are creating for people who use Facebook, right now I do think that the Facebook experience is very push based, in that you go to Facebook and we are suggesting content to you through something like news feed. Overtime, I think, if we do a good job, we should be able to create more value through all of the knowledge that has been shared over time that we are not really surfacing on a day-to-day basis right now in terms of helping people answer a lot of different questions that they have around the world. That's kind of the direction that we are starting to go in with Graph Search and a few other areas as well. But it's pretty early. So I think around a five year time frame like you are saying, hopefully we will make very significant progress towards going in that direction.
Sheryl Sandberg: Great. Next question?
Operator: The next question comes from the line of Mark May with Citigroup. Your line is open.
Mark May - Citigroup: Thanks for taking my questions. Maybe the first one for Sheryl and then David. It seems like a year and half ago around the time of the IPO, the company was very focused on top of the funnel brand related advertising. But over the last year or so, it's been much more around direct response but certainly get the sense that on the top of the funnel brand is starting to move in a more meaningful way. What is the company doing and what are some of the main projects that you are working on that you think will really start to move to dial on the top of the funnel segment of the market. What role does video maybe play into that? Then for David regarding the ad load comment had ad load not increased in North America, give us a sense of what the ad revenue growth would have been if you normalize for that? Thanks.
Sheryl Sandberg: Top of the funnel ads remain really important to us. Again, our growth this quarter was a very broad based, including top of the funnel ads. The reason they are important is that Facebook is such a unique and powerful discovery place. When you are on Facebook, you are open to discover, you are open to getting messages and that's what we are seeing with news feed messages from friends and with us as well. The key for us is measurement, the way we are really going to make progress is better measurement. It's easier to understand and measure a click that goes to return online sales. It's harder to measure how you - household that see ads and don't see ads change their purchase behavior in stores The thing I think we have done a lot over the last year and we are continuing to do that to put those measurements in place, so I talked on in my opening remarks about measurement of telecom. We have also done a ton of work around CPG, so that we can look at households that saw an ad, households that didn't see in an ad and what their difference is. Just to share one more example, (Inaudible) did a promotion with us for the (Inaudible) in the U.S. They were targeting 35 to 43 seen ads in months, because we were able to do this type of measurement that we could have a year ago, we were able to show that they get side extra turn on their ad spend. We measured household spending who saw their ads versus household who didn't saw their ads and there was a 9% difference. They were also able to tell that a lot of those 9% was driven by new buyers of their products, which is what they want, so I do think we have a big opportunity, I do think the brands are going to continue to need to be convinced account-by-account, but this moves products off shelf and that's what we are doing.
David Ebersman: Mark, thanks for your question. This is David. Truly not possible to tease out individual contributions because the way the auction works, everything is dependent, so if we have fewer ads that's going to play out with different pricing and other sorts of things, so I can give you sort of our gut feel for it, but I can't quantify precisely. If you look at overall ad revenue growth for example on that third quarter compared to the second quarter, there is probably three factors that are contributed materially that are important to understand. One is just growth in users. Second is growth in demand, which plays out into pricing. Then the third is an increase in the number of ads that we showed in news feed per users. I would probably order the ad load, probably third of the straight relative to the sequential growth. I think it plays out a little bit differently on mobile versus web. On mobile, we really increased the number of ads as a percentage of the overall mobile experience quite modestly in the third quarter versus the second quarter. On web, the increase in the number of ads or the percentage of ads in the web news feed experience went up more significantly than mobile did in the third quarter versus the second.
Operator: Your next question comes from Douglas Anmuth with JPMorgan. Your line is open.
Douglas Anmuth - JPMorgan: Okay. Thanks for taking the question. Just wanted to ask you about two things. First on video, can you talk about what you have learned from the recent launch of video on Instagram and how that may have shaped your thinking on rolling out video ads on Facebook? Then secondly, just following-up on the ad volume, just to clarify when you are saying the ad volume won't necessarily increase any more beyond where it was at the end of Q3. Is that on average or in the more penetrated markets? Then can you comment relative to the 5% of stories in the news feed that you mentioned last quarter? Thanks.
Mark Zuckerberg: The experience with video on Instagram has been very positive so far, right? I think that we proved that having a quick start auto play can be a good experience inline in the feed and that people really feel they are in and control they are experience. They can just grow if they don't like content. If it's good content then that can be really good, so we are heartened by that. This is that important launch for Facebook overall, because the addition of video content to the stream could be one of the most positive things that we have done in a long time for making it more engaging, but if we do it quarterly then it could also be a negative thing and we are trying to take our time to make sure that we do this in a very positive way and I am pretty confident that we will. But that's why you are seeing us take the process that we have on this.
Sheryl Sandberg: Now I will add on videos ads. We do have a video ad product today, because any one can embed a video in page post. And we are actually seeing very good results, particularly around entertainment and media. This is driving some of our ad spend. And the area remains pretty exciting because this is a very compelling way for marketers to tell their story.
David Ebersman: So I thought you asked what we mean when we say ad volume won't increase. So the first thing I would say is, I would frame that in the context as a percentage of the user experience. Obviously, if we can drive more engagement that provides more opportunity for us to show more ads. In general, I think your question referenced whether this was geographic. The ad load in news feed is reasonably consistent across the world. It's a little bit less in the least developed markets because we have less advertiser there. But it's not different grossly different. So I think that comment holds generally across most of the markets where we make our advertising dollars. In terms of relative to the 5%. So what we said last quarter was that, of the total volume of stories in news feed, about 5% of those were ads. As I said on the last question, the mobile piece of that didn't change very substantially in the third quarter versus the second. The web percentage did go up. So if you mix those two together, the Q3 number would be modestly higher than the 5% number from Q2.
Operator: The next question comes from Justin Post with Merrill Lynch. Your line is open. Justin Post with Merrill Lynch, your line is open. The next question comes from Mark Mahaney with RBC Capital Markets. Your line is open.
Mark Mahaney - RBC Capital Markets: Great, thanks. Two question. First, David, could you just give us some color or why the reduction in the OpEx growth for this year? Were there certain investment projects you decided to cut? And what were those and why? Then secondly. Mark, this kind of five year vision of moving towards, going from push base to pull based, that opens up a lot of opportunities. I mean that's been kind of the sauce maybe behind Google and it's an interesting part of Twitter, et cetera. But could you talk about the challenges in order to get there, and maybe both in terms of user experience the advertiser opportunity, how difficult and substantial the technology challenges are to get there? It's a very different direction and there is lot of opportunity but how do you get from point A to point B? Thanks.
David Ebersman: Hi, Mark. In terms of OpEx growth, so we are continuing to invest aggressively in the business with particular emphasis on technical hiring and building out our infrastructure. At the same time, we are trying to do this in a disciplined fashion making sure that all the investments we make and the dollars we spend are spent wisely in terms of furthering our mission and creating returns for the company. I am really quite pleased with how things are going in that regard in 2013. From an R&D standpoint, we are really on track for anything ahead of what we expected to be in terms of hiring and spend. And that's surely the most important area for us in terms of investing to drive future growth. In other areas of the business, such as cost of revenue, G&A, marketing and sales, I think we are ramping up spend less than we anticipated for a couple of reasons. One is better success than we expected in some of the efficiency projects that are helping to keep the company small, even as revenue ramps up. A second reason is, some slower than expected ramp up in both hiring in new projects. And then the third contributing factor is just we have in the budget some expectations for the unplanned stuff that comes along that can drive spend, like an asset acquisition or something like that and we really haven't spent this much money as we have expected in the unplanned areas.
Mark Zuckerberg: Yes, and to your question about on how do we make the knowledge that's been shared in Facebook more useful. The first thing we needed to do is just index it all and build the infrastructure to start being able to use it in different ways. I mean the first data for Graph Search, we had indexed to more than a trillion connections, friendship connections, group membership, like connections and then for post search, we indexed more than a trillion of the post that people that people have put into the system. The basic insight that we think we are operating on here, is that right now a lot of the behavior and engagement on Facebook is very day-to-day where you are sharing something and Facebook is the best place for you to share photos or events that's going on in your life and if you go to news feed and see what's going on with the people around you. What has happened is that, over the past almost 10 years of this behavior, this amazing base of knowledge has been build up, but there is trillions of pieces of content and information that now we are just trying to find different ways to expose and basically make that more useful to people instead of just the stuff that's been shared in the last day or so. Graph Search is one way that you can see that coming to light in terms of people being able to do directed queries for different types of content. There are other kind of services that we think we can build as well that just a few people more utility from the corpus of knowledge that's been built out and that's going to be a big focus for us over the next few years.
Operator: Your next question comes from Justin Post with Merrill Lynch. Your line is open.
Justin Post - Merrill Lynch: Mark, after a successful revenue year, you kind of start next year with a clean slate and you highlighted some big ambitions in your prepared remarks about access and improving search. Just maybe you remind us how you think about driving profit growth as you look at the company relative to kind of your long-term objectives for the company. Thank you.
Mark Zuckerberg: Well. I mean, we care a lot about that. In terms of the shareholder value that we are generating as well. I think in the recent results and what I said at the end of my remarks there was that, we are going to keep on planting seeds for our future growth while continuing to build momentum now and I know that's a philosophy that we have taken in term of building the company. We generally wanted to be profitable as such, but I don't think we are going to commit or have any specific guidance on this right now.
Operator: The next question comes from Carlos Karjner with Sanford Bernstein. Your line is open.
Carlos Karjner - Sanford Bernstein: Thank you. Mark, can you talk a little bit more about how the knowledge in the Facebook graph compares with the knowledge in the overall web today qualitatively and quantitatively? Is there a plan to connect the worldwide web graph to the Facebook graph when you think the answer that you are going to give people into future? Secondly, the graph regulation in the European Commission in Brazil at least may require internet companies such as Facebook to store all their data locally. What do you think will be the impact on Facebook's CapEx and expenses if these regulations are indeed implemented? Thank you.
Mark Zuckerberg: Yes. Sure. On your question about the graph of Facebook, the graph that people share on Facebook versus the web overall, I think they are pretty different. In terms of quantity, they are getting to a pretty comparable size, so engineers on the graph search teams have told me folks who have worked on other web search engines before tell me that the scale of things like post search are as big or bigger than any web search index that's out there but they are they are just different used cases with different kinds of knowledge and people are going to use them for different things, so our approach with Graph Search is not to build something which is web search. I mean, we think that companies have done that and they are doing a good job at that, but there is different kinds of knowledge. Things that you want more opinion on from people that you trust that I think is kind of a late inside Facebook that we need to do a better job of servicing that, so that's going to be the focus on that. I mean, over time, there are a lot of possibilities for things that we can do and I am not really ready to talk about a lot of them today, but you can kind of look at what we have launched in the couple of the Graph Search launches that we have done so far and we are pretty early in that journey.
David Ebersman: Carlos, the second part of your question about draft legislation or discussion about companies needing to store data locally in various companies, it's an interesting question and definitely something we are tracking, but the answer is really going to depend on the details of what that looks like. It's very hard assess what kind of implication it would have for company like Facebook without understanding what we would need to do, so, we will continue to pay less attention to it, but really hard to give anything in the way of the specific answer at this point.
Operator: Your next question comes from Jason Helfstein with Oppenheimer & Company. Your line is open.
Jason Helfstein - Oppenheimer & Company: Thanks. Can you give us some color on how many advertisers you guys ended the quarter? How that grew? And if there is a way to think about how many advertisers have claimed pages so we can get a sense of how deep the penetration is. Because it looks like you guys are more successful than other companies and growing at a faster rate, particularly on the local penetration side? Thanks.
Sheryl Sandberg: So last quarter we reported that we had a million active advertisers and that number continues to grow and continues to grow healthily. We believe, globally, we have 20 million small businesses, local businesses of some kind who have pages. So obviously just a fraction of those are advertisers. And I think its one of the most exciting opportunities in front of Facebook. It's really hard to get small businesses to use technological products and 20 million small businesses are using us and we haven't gone out and done aggressive sales efforts to make that happen. Going from having a page that you are using for organic distribution to paid distribution, it's something we are very,-very focused on. It's why we rolled out these simple products. And I think our track record at doing that is good and we plan on getting better at it.
Operator: The next question comes from Ross Sandler with Deutsche Bank. Your line is open.
Ross Sandler - Deutsche Bank: David, sorry to beat a dead horse, but back to the ads per user comment. Can you give us some color on, I guess since you guys started the mobile news feed ads a year and change ago, how much CPC and click through rate improvement you have been able to drive? And should we think about it, going forward if mobile users are growing at 18% in the U.K., 20% in the U.S. and I think 60% for ROW, should we think about revenue growth as a slight premium to that but somewhat co-related to that? Thanks.
David Ebersman: Sure, Ross. So I think if you look back over the last year, some of the metrics that I think have been most positive for us have been, as we have ramped from a very low volume, very few ads shown in news feeds to larger numbers, what one could reasonably have expected given the way the auction dynamics work, is that the pricing would really come down as we were delivering more clicks and as we were I think deeper into the pool of the advertising demand. And the way pricing has really held up and click rates have held up and CPCs have held up, as we have progressed through this over the last year, I think has really validated our confidence that news feed ads were going to be really important product that could really drive the performance of the business. So we remain really encouraged and pleased by that. Going forward. Clearly, we will try to continue to grow the user base, as you described, and that's been an important part of our revenue growth since the company started. And the other opportunity is for us is continue to improve the quality, the relevance and the performance of the ads and to drive up pricing by bringing more demand into our system. We are certainly doing a good job of that right now and we have got to continue to execute.
Operator: The next question comes from Eric Sheridan with UBS. Your line is open.
Eric Sheridan - UBS: Sure. Thanks, guys. Two quick questions. One, following up on the last one with respect to ROI around advertising products going forward. I guess, maybe more for Sheryl, but how do you guys think about the dialogue between advertisers and yourself about ROI and how much of that fits with measurement and attribution tools that you guys would need to develop internally versus what they need to think about in terms of the ROI on your properties versus other online and offline properties. And second question on mobile app install ads. Question about the diversification of the advertiser base and how that sort of developed since the product has been launched? Thanks.
Sheryl Sandberg: So the first question, it's really both. In order to measure all the way from seeing a Facebook ad through to a purchase, particularly when that's offline. That takes work and tools on our side including the data systems and it also takes thinking about measurement on their side. The industry overall is moving. We have been really pleased to see more embracing of multi-click over last step attribution. You can see that happening with a number of big players in the industry. The PMDs are really important here. The PMDs are good at helping people and helping marketers measure. But really the developers' measurement system take our measurement, take industry measurements. Particularly for brand advertisers, they also take some rethinking of the ways they have measured ads and ads' performance before and we work very closely with our clients on that. On mobile app install and mobile engagement ads, we are very focused on growing across the board. We want growth in all of our marketer segments and we want to grow that broadly across the world. Developers are really interesting place for us, because we think not only do we have we think the best mobile ad product in general, because people spend a lot of their time in news feed. They spend more time in news feed than they spend on any other part of our service. That gives us an opportunity to sell ads broadly, but it also gives a great opportunity for developers, because the developers want people to do happen on their mobile phones and on their desktop. Mobile app install ads have been very successful for us and they are interesting, because the mobile app install market didn't even exist a few years ago. I think the move to rollout engagement ads further deepens our relationship with developers and shows that we can help different users and then we can get those users to continuously use their products, so we are pretty excited about this part of market, because we think it can grow quickly and we think our ad products and offerings are so unique.
Operator: The next question comes from Peter Stabler with Wells Fargo. Your line is open.
Peter Stabler - Wells Fargo: Good afternoon. Thanks very much for taking the questions. You introduced hashtags in June and I am just wondering if you could comment on usage trends. How strategically important hashtags are to index in the knowledge graph going forward and where their hashtags could become a meaningful part of an ad targeting opportunity in the future if usage catches on in a significant way. Thank you
Mark Zuckerberg: The launch of hashtags was more just following behavior that we see from people, right? All we really did was take hashtag that people are putting into the product and make them linked, so if you could find other posts that have the same tag. The effort that I think you are latching on to is basically we are putting some more effort now into both, public content on Facebook and more private content, right? As there are a bunch of different sets of people that a person will want to share with, one is all of their friends, but a lot of the sharing and the communication done is one-on-one in messaging or with small groups or with the communities. Then there is a large set of content that's public, which is often very high quality content as well and we have efforts in all of those areas to make a set people can share all of those different kinds of contents on Facebook. That's going to be something that we are going to continue to do.
Operator: The next question comes from Brian Novak with Susquehanna. Your line is open.
Brian Nowak - Susquehanna: Thanks. I have two please. You continue rolling out a lot of new products, I was wondering if you could speak to the to the traction and kind of anything user adoption of the early topical and interest trending that you have rolled out. Last quarter you talked about strengthened e-commerce driving some of the advertising which kind of verticals would you speak to this quarter and as we are heading into the holiday season, you still see e-commerce as being a big driver again? Thanks.
Mark Zuckerberg: Yes. You are asking about the effectiveness of some of the public content efforts that we have done. I think it's starting to do very well and we are very pleased with it. Some of the questions that we have gotten has asked if this is an area that we have started focusing on recently, which actually it isn't something we have been working on for a while, but I think the question as a sign that the results are starting to be quite good and folks are starting to note it. The traffic that we are driving and the higher quality content that's public that people came for us on Facebook, so we are going to keep focusing on this. It's not just about public content, it's about giving people the power to share with every different audience that they want, weather it's most private one-on-one communication and tread up to the most public content that you want to get out for everyone in the world to be able to consume, down the road we are going to keep watching all of that.
Sheryl Sandberg: To your second question, direct response including e-commerce continues to perform well. We have high click-through competitive CPC, so we are attractive from marketers. When you think about verticals, I think we have very tremendous opportunity in basically all of them. Things that are performing particularly well right now financial services, media and entertainment, e-commerce, professional services. But if you look to a vertical like auto, that we haven't historically been strong in, I think we are starting to make real inroads, client-by-client, like the Alfa Romeo case study I showed, because we had such a great opportunity to engage the people they want to reach. Our targeting is also getting better. So with custom audiences and partner categories, we are able to identify, here the people you want to show your ads to who, we believe are in the market to buy a car, for example. And so the combination of the measurement work we are doing and the ability to target, I think means we have a strong play in every vertical.
Operator: The next question comes from Richard Greenfield with BTIG. Your line is open.
Richard Greenfield - BTIG: Hi. I really wanted to ask you about the Instagram blog post that you put up the other week, where you stated specifically that, I think the quote from the blog was, you want ads to be creative and engaging, and that seems pretty different than most of the advertising that I have seen on Facebook, whether on mobile or on the desktop. I wanted to ask you how do you think, or is it possible that if this strategy of advertising works well on Instagram, could we actually see a new form of advertising appear on Facebook sometime in 2014 or 2015.
Sheryl Sandberg: So what we announced last week is a small test with 10 advertisers to start showing ad in the Instagram feed. And we are excited about it because there is a lot of interest and a lot of excited brands. When you think about ads being exciting and engaging, I think we think about two things. We think about ads that fit the format of the product that they are part of. So the Instagram ads right now are the pictures and videos which are exactly what people post on Instagram. If you look at the progress we have made with our news feed ads, those ads, those in the size, the shape. You know they got larger when they moved over from the right hand side, right hand column but they are also meant to be as exciting, as engaging as the content. So our goal is, we want our ads to be as good as the user shared content. Some of them are, a lot of them aren't. We have a lot of room to grow in improving that quality. But in terms of the excitement you will see or the interest, that is our goal. And we are just going to match the format of the products we are working with as we rollout ads.
Deborah Crawford: Operator, we have time for one last question.
Operator: The next question comes from Brian Wieser with Pivotal Research. Your line is open.
Brian Wieser - Pivotal Research: Hi. Thanks for taking the question. I have taken notice of the number of businesses advertising. I was wondering if you could just quantify the number of new small businesses perhaps or number of advertisers going beyond that one million in the quarter? The reason I ask is, I am trying to understand to what degree that maybe the shift is spending mix towards smaller business may have contributed to margin expansion. And maybe can talk about the margin profile that different segments of marketers bring to your business?
Sheryl Sandberg: So we don't break out our business by marketer segment and we don't give margins by marketer segment. But to help answer you question, we have seeing strong growth across all of our marketer segment. All of them are growing brands, growing direct response and E-commerce are growing, F&B and local businesses are growing, developers are growing. We definitely think there is a big opportunity for those to grow same-store sales of our large clients, particularly with the shift that's happening from TV to digital and mobile. We think that there is a really exciting opportunity. We also think SMBs are a big opportunity for us and certainly in an advertiser base of over a million advertisers, the great majority of that is obviously the small to medium sized businesses. We worked hard on our sales efforts, so that we have the right sales and support effort to meet our clients. We care about our margins. We certainly have simplified products such as we have rolled out over the last year, make it easier and cheaper for SMBs to use our products. Easier for them and cheaper for us. And we will continue to focus on the automated tools that help. I think the most important thing we have done on this goes back to an earlier question about focusing on marketer objective. Before we were asking marketers to come in and choose what ad products they were buying. With our shift to focusing on marketer objectives, it's easier for everyone from largest to the smallest. You know, a small business owner can come in and say, I want my app install or I want web conversions or I want web clicks and then we are doing the harder work of figuring out what products are there, figuring out which of those ads should have digital content, so that we can meet those objectives I think that move of moving more towards using their language and focusing on their business needs is a simpler product for them. It will help gain us more marketers and it helps us work with them in a more efficient way.
Deborah Crawford: Great. That's it. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again next quarter.
Operator: This concludes today's conference call. You may now disconnect. | [
{
"speaker": "Executives",
"text": "Deborah Crawford - Director of Investor Relations Mark Zuckerberg - Chairman of the Board, Chief Executive Officer David Ebersman - Chief Financial Officer Sheryl Sandberg - Chief Operating Officer, Director"
},
{
"speaker": "Analysts",
"text": "Heather Bellini - Goldman Sachs Scott Devitt - Morgan Stanley Mark May - Citigroup Douglas Anmuth - JPMorgan Mark Mahaney - RBC Capital Markets Justin Post - Merrill Lynch Carlos Karjner - Sanford Bernstein Jason Helfstein - Oppenheimer & Company Ross Sandler - Deutsche Bank Eric Sheridan - UBS Peter Stabler - Wells Fargo Brian Nowak - Susquehanna Richard Greenfield - BTIG Brian Wieser - Pivotal Research"
},
{
"speaker": "Operator",
"text": "Good afternoon. My name is Jay, and I will be your conference operator today. At this time, I would like to welcome everyone to the Facebook third quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions). Thank you very much. Ms. Deborah Crawford, Facebook's Director of Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford",
"text": "Thank you. Good afternoon, and welcome to Facebook's third quarter earnings conference call. Joining me today to talk about our results are Mark Zuckerberg, CEO, Sheryl Sandberg, COO and David Ebersman, CFO. Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements. The actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are set forth in today's press release, our Annual Report on Form 10-K and our most recent quarterly report on Form 10-Q filed with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these statements as a result of new information or future events. During this call, we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. This press release and an accompanying investor presentation are available on our website at investor.fb.com. And now, I would like to turn the call over to Mark."
},
{
"speaker": "Mark Zuckerberg",
"text": "Thanks, Deborah and thanks everyone for joining today. This has been a busy quarter at Facebook where we planted the seeds to achieve our long-term goals with internet.org, our AI group and our efforts to build the knowledge economy. We continue to see strong overall engagement and are making good progress in our strategy, especially in mobile. This contributes to the result we have reported today. Strong revenue growth, strong growth in daily active and good growth in engagement, as our ratio of daily actives to monthly actives continues to grow. We have also reached new milestones as a mobile company. Now 49% of our revenue comes from mobile and 48% of the people use Facebook in any given day are only accessing it from mobile. That's almost half of the people only using Facebook from their phones, and it's a pretty incredible sign of how Facebook is evolved over the last year. On our last earnings call, I talked about our three big goals for the next phase of our company, connecting everyone, understanding the world and helping to build the knowledge economy. Connecting everyone means giving everyone in the world the power to use the internet and stay connected to the peoples and things that matters them. Understanding the world means helping people not just share day-to-day updates, but also building up long-term knowledge about the world and being able to answer questions for you that no other service can. Building the knowledge economy is about helping people create growth in jobs and supporting a larger economic shift in the world based on information and ideas. This framework can tell off things about our progress as a company over the next few years, so it's useful way to look at our progress over this quarter as well. We'll start with connecting the world. This quarter, we took an important step. In August, we launched internet.org, a global effort Samsung, Ericsson, QUALCOMM and other industry leaders to make affordable internet access available to everyone in the world. Today, only about a third of the world's population is online and internet's is growing more slowly than you probably expect less than 9% a year. We want to change that. Our mission has always been to connect the world and to us that means everyone. When the next 5 billion people have a chance to use these basic services and participate in the global economy, that's going to create huge benefits for everyone in the world. By working together on technology and new business models, we think we can help accelerate the process of connecting everyone. We believe we are in a unique place to help encourage broader growth of the Internet, because so much of what people do on the Internet is Facebook. According to comScore, around 20% of the time that people spend in apps in the U.S. alone is in Facebook services when you a lot of people in developing countries what service they care about using most, the answer is often Facebook. We are already trying to make access to Facebook cheaper. All the same tools of innovation that we are developing to do this can be applied to other basic Internet services as well, but messaging, search, whether and Wikipedia to make those services cheaper or free to deliver. We also recently acquired Onavo, business team that builds world-class data compression technology in mobile analytics and they will play an important role in helping us build more efficient technologies and services that use less data. Of course no single company can do this alone and we are working closely with our partners to develop our future plans. It's still very early for internet.org and we will have more to say in the months ahead, but I am very excited about this effort and I am grateful to our partners for being a part of it. Next, let's talk about understanding the world. What I mean by this is that everyday people post billions of pieces of content and connections into the graph. In doing this, they are helping to build the clearest models of everything there is to know in the world. A big part of why this works is that people can share things with any audience they want. They don't have to share publicly with everyone at the time. they can share with just their friends, so this means that the model the world that people are building our systems include things that people only want to share with just a few people. This has the potential to be really powerful, but right now we have to do very little to utilize the knowledge that people have shared to benefit everyone in our community. The service we invest in the most news feeds, which gives you a great sense of what's going on with your community today. The news feed has proved itself incredibly useful for people and the most used app on peoples scoring by far, but this is just the start of what's possible. When we get to the point, where everyone can easily ask any question to Facebook and get it answered by our community. That's going to be very powerful. In the last quarter, there had been several important evolutions in our strategy of understanding the world. The first is around Graph Search. At the beginning of this year, we announced the first beta version of the service on desktop and that indexed more than 1 trillion connections between people in this segment. In the last quarter, we started testing what we call host search allows you to search all the unstructured text and posts that people have ever made on Facebook. About 1.2 trillion more posts. The folks on the team who have worked on web search engines in the past tell me that the Graph Search corpus is bigger than any other web search index out there. It's still early for Graph Search, because it's still in beta, only in English and we haven't launched our mobile version yet, but it's something I am really excited about. Another evolution in our progress to understand the world is around our efforts to building mobile apps. Our goal has always been to help people share anything they want with anyone they want. Historically, we have done this by building a lot of features into the core Facebook app, but we also have a few separate apps that are widely used like Instagram and messenger, our standalone messaging app. These are each large services that help people share in different ways Instagram enables more than 150 monthly actives to share beautiful photos also more publicly than people would want to share on Facebook. Messenger is part of how people spend billions of private one-to-one and group messages every day and with the latest release of the app yesterday, we are continuing to add features and make this a better experience. In the future, we expect to develop more services help people share different content with different groups of people and we will continue to build up messenger as better distinct messaging experience. There is one more evolution in our strategy to understand the world that I want to mention. In September, we formed the Facebook AI Group to do world-class artificial intelligence research using all the knowledge that people have shared on Facebook. The goal here is to use new approaches in AI to help make sense of all the content that people share so we can generate new insights about the world to answer people's questions. We started assembling a team of some of the best people in the field to work on these problems. We also announced the acquisition of Mobile Technologies, a speech recognition and machine translation company that will help expand our work in the field beyond just photo recognition to voice. Over time, I think it is going to be possible to build services that are much more natural to interact with and can help solving many more problems than any existing technologies today. I am excited that we are working on this problem and I am looking forward to doing a lot more here. Finally, let's talk about the progress we have made towards building the knowledge economy. The key to building the knowledge economy is building tools for everyone to use information to do their jobs better. So in addition to connecting everyone and understanding the world, we are also focused on building new services for businesses as a way to accelerate the growth of this new economy. The way businesses will experience this effort is that we will keep building better services for them to reach their customers with higher quality ads, more efficient leads with better targeting, better analytics and using richer formats. The way people will experience this effort is that the ads they see will become more and more relevant to their lives. Last quarter, I started talking about how our approach going forward would be to grow our business through improving the quality of our ads rather than by just increasing the quantity. This quarter we have continue to do this. And the results show our approach is working. We have been able to deliver better content and grow business for our customers and ourselves. We are planning that a lot more people are finding their ads useful and engaging with them and the average daily actives is engaging with more than ad per week. Most people probably wouldn't expect to engage with ads that often, so I think it's a great time that people are finding ads useful and they are adding value to the experience on Facebook. I think there is still a lot of room to improve the quality of our ads and grow our business over time. So this is something that we are going to keep on investing in going forward. So that's my update on how we are thinking about the next big changes we want to make in the world. Connecting everyone, understanding the world and building the knowledge economy. We have made a lot of progress this quarter and I want to take a moment to thank everyone who works with our company and everyone who is a part of our community for all the efforts that make Facebook great. Looking ahead, you can expect us to keep preparing for the future, even as we keep on building momentum today. As I said in our original S-1 filing, we don't build services to make money, we make money to build better services. This approach has served people who use Facebook, marketers and our entire Facebook community well. It's a different way of looking at the world but its how we are going to keep succeeding as a company. Thank you for being with us today and now I am going to hand it over to Sheryl."
},
{
"speaker": "Sheryl Sandberg",
"text": "Thanks, Mark. We continue to see strong growth in our ads business, especially mobile. Q3 total ad revenue grew 66% year-over-year to $1.8 billion and mobile ad revenue grew to 49% of our total ad revenue. This is a remarkable milestone in a short time since we initiated mobile newsfeed ads just last year. Similar to last quarter, our performance is very broad based with strong growth across all geographies and types of marketers. At the same time, our overall user engagement metrics remained strong. We think this validates the careful approach we are taking to the building our ads business. I would like to highlight some of the key drivers of our performance this quarter. These are, to a large degree, the results of investments we have made over the past few years and they will continue to be our priorities going forward. The first driver is the continued growth of mobile engagement around the world. In 2013, for the very first time, people will spend more time with digital media than watching TV. Emarketer estimates more than 5.25 hours a day on digital services including mobile compared with 4.5 hours watching TV in the U.S. Facebook is well-positioned to benefit from this shift. In the United States, Facebook including Instagram, just one in eight minutes people spend on the desktop, but one in five minutes on mobile. According to comScore, Facebook and Instagram have more mobile time spent than many of the next largest services including YouTube, Pandora, Yahoo, Twitter, Pinterest, Tumblr, AOL, Snapchat and LinkedIn combined. Along with this engagement, we believe that we have the best mobile ad product with ads that are integrated unit into newsfeed for people who spend the most of their time on Facebook. As people shift where they spend their time, marketers are starting to follow. Our results today show that we are benefiting from this shift to mobile and we believe this shift will continue and will continue to benefit us. Today, mobile represents 12% of consumer media time, but it's still only 3% of ad budget. The second driver of our performance is an increasing number of marketers spending their ad dollars on Facebook. From brand to direct response, to local businesses to developers, more marketers are advertising on Facebook, because they recognize that our ads work to drive sales. This growth is taking place globally. In the third quarter, the number of Facebook advertisers in EMEA, nearly equaled the number in North America, reflecting global growth in our online advertising. The third driver of our growth is product development. We are working in a number of areas to make the ad people see on Facebook better. More targeted ads are better and we are improving our ad targeting to increase relevance. We are investing in features like custom audience and partner categories to improve targeted. These are great tools that are still in their early days and we will continue to invest. We also want to make it easier for marketers of all sizes to buy ads and measure their impact. In late September, we rolled out ad format changes, make ad a bit more consistent across Facebook and we reduced the number of ad units marketers have to choose from to reduce complexity. Then earlier this month, we rolled out a full redesign of our ad buying tools to simplify the ads creation process. Advertisers now select from one of eight business objectives such as website conversion are [often]. We think these product investments make it easier for marketers to achieve their goals. We are also expanding our products for developers. We already have launched mobile app install ads and these are going very well and we now launched mobile app install ads for engagement. These ads help developers and businesses reach people that have already installed their apps and direct them back to increased engagement. We believe these apps are a nice complement to our install ads and represent a unique opportunity. We also continued to invest in helping brands stay with our campaigns and increase same-store sales. We recently launched Outcome Measurement for the telecommunications industry. An initial test showed that more than 90% of people who made a purchase after viewing a Facebook ad have never clicked on that ad. This shows that impressions matter and focusing only on clicks does not tell the whole story. Similarly, a recent study by (Inaudible), one of our leading preferred market developer partners proves this point. The (Inaudible) study found that marketers who use the multi-touch attributions to measure campaign ROI credited 12% to 13% more value from Facebook than marketers to use off-click attributions, but we still have work to do. Brand marketers aren't moving as quickly as we would like and we believe measurement is key to influencing the app advertisers. Another important trend influencing our growth is our preferred marketing developer of PMD program. Over the past few years, we have invested in building an ecosystem that supports all types of marketers and PMD has helped those marketers advertise effectively with us. Today, this program is a community of hundreds of technology and service companies spread across more than 45 countries. In summary, we think our strong performance this quarter further validates that our ads strategy is working. Marketers are responding favorably as we heard during ad week in New York. Our messages around reach, targeting and measurements are resonating and will continue to reinforce them. Our ads are getting better and we still have a long way to go. Moving forward, our focus remains the same, continuing to capitalize on a shift to mobile, increasing the number of marketers who advertise with us and continuing to invest in our ad products. We believe that we are in the early stages of a major transitioning and advertising and we are uniquely positioned to capitalize on that opportunity. Now, David."
},
{
"speaker": "David Ebersman",
"text": "Thanks, Sheryl, and good afternoon everyone. Q3 was a strong quarter for us in terms of our financial results. Our business grew rapidly around the world and we are pleased with our performance across our key financial metrics highlighted by the fact that Q3 was our first $2 billion quarter in terms of revenue. Let's start with the size and engagement of the Facebook community, which continues to grow. 728 million people used Facebook on an average day in September, up 25% from last year, continues to be driven by mobile. In Q3 for the first time, daily access on web declined year-over-year, albeit very modestly. Daily users represented 61% of the 1.19 billion people who accessed Facebook during the month of September and our overall engagement data remains strong. Also as we announced in September, Instagram now is over 150 million monthly actives. I want to say a few words about used engagement on Facebook. As we have said previously, this is a hard issue for us to measure, because self-reported age data is unreliable for younger users. So we have developed other analytical methods to help us estimate usage by age. Our best synopsis on youth engagement in the U.S. reveals that usage of Facebook among U.S. teens overall was stable from Q2 to Q3. So we did see a decrease in daily users specifically among younger teens. We won't typically call out such granular data, especially when it's of questionable statistical significance given the lack of precision of our age estimates for younger users. But we wanted to share this with you now since we get a lot of questions about teens. We are pleased that we remain close to fully penetrated among teens in the U.S., our monthly user numbers remain steady and overall engagement on Facebook remains strong. We will continue to focus our development efforts to build products that drive engagement for people of all ages. Turning to the financials. Total revenue in Q3 was $2 billion, up 60% and ad revenue was $1.8 billion, up 66%. Exchange rates had no meaningful impact. Revenue growth was strong around the world with each of the four geographic regions we report on growing by more than 50% versus last year. The primary drivers of ad revenue growth were an increase in the number of and the strong performance of newsfeed ads and an increase in the number of marketers using Facebook and increased demand in our system. In Q3, overall ad impressions were up 16% and the average price per ad was up 42% compared to last year. The growth in ad impressions was primarily due to market where using our service combined with the impact of a price floor reduction late in the third quarter last year. The growth in price per ad was primarily due to the increase in news feed ads. In the U.S. and Canada, where last year's price floor change had a smaller impact, ad impressions decreased 8% and average price per ad increased over 60% compared to last year. The decrease in ad impressions despite an increase in the number of users in the U.S. and Canada was due to the continued migration of usage to mobile devices where we show fewer ads per person compared to web. The greater than 60% increase in average price per ad in the U.S. and Canada was primarily due to the increase in the number of news feed ads shown on both mobile and web. Due to their high engagement levels, news feed ads have a significantly higher price per ad than right hand column ads. Therefore the mix shift of our ads towards the higher percentage being in news feed versus right hand column is driving up our average price per ad. Mobile ad revenue in Q3 was approximately 49% of our ad revenue, up from 41% in Q2. The sequential quarterly growth of mobile ad revenue was due to three factors. An increase in the average price per mobile ad, an increase in the number of mobile users and an increase in ads shown per mobile user. Looking now at web. Ad revenue from web usage decreased both sequentially and year-over-year. Web ad revenue includes both news feed ads on web and right hand column ads on web. Revenue from news feed ads on web increased significantly in Q3, sequentially and year-over-year, driven largely by an increase in the number of news feed ads per web user. The increase was not enough to offset the revenue decline from right hand column ads. Total payments and other fees revenue was up 24% year-over-year to $218 million and roughly flat sequentially. Payments revenue from games was up 18% from last year. So we believe 12% represents the best apples-to-apples comparisons adjusting for accounting items such as the change in revenue recognition timing from late last year. Overall ARPU of $1.72 per user was up 33% compared to last year. We saw 43% increase in the U.S. and Canada and greater than 40% gains in each of the other three regions we report on. Turning now to expenses. In Q3, our total GAAP expenses were $1.28 billion. On a non-GAAP basis, excluding stock compensation, total expenses increased 40% to $1.03 billion, driven by higher headcount and infrastructure spend. We ended Q3 with just under 5,800 employees, up 34% from last year and we continue to be pleased with our success in attracting talent. Our Q3 GAAP operating income was $736 million, representing a 37% operating margin up from 30% last year. And on a non-GAAP basis, operating income was $987 million, a 49% margin, up from 42% last year. Our GAAP and non-GAAP tax rates for Q3 were 41% and 36% respectively. GAAP net income was $425 million or $0.17 per share. Non-GAAP net income was $621 million or $0.25 per share, up around 100% from last year. In Q3, we spent $284 million on CapEx and free cash flow was $666 million. Looking at our balance sheet, we ended Q3 with $9.3 billion in cash and investments. During the third quarter, we repaid our $1.5 billion term loan and replaced it with a new $6.5 billion line of credit, which is currently undrawn. We will continue to manage our balance sheet to meet our liquidity needs, protect the business against risk and provide us with flexibility to invest in new opportunities to grow the business. Now let's look forward. We continue to believe that improving the quality and relevance of news feed ads provides us with a big long-term opportunity, however as we think about the future, we do not expect to significantly increase ads as a percentage of news feed stories beyond where we were at the end of Q3. This is important because increasing ads in news feed has been a meaningful driver of our revenue growth in 2013, so this should be factored into your expectations for next year. Turning to payments revenue. Remember that in the fourth quarter of 2012, we recognized revenue from four months of payments transactions, so for that reasons we expect payments revenue will be down this coming Q4 compared to last year. Looking at expenses, we now expect that our 2013 total non-GAAP expenses, including cost of revenue but excluding stock compensation will likely grow around 45%. In terms of our tax rate, we expect that our Q4 and full year non-GAAP tax rates will be a few percentage points higher than our Q3 rates. Finally, we expect our 2013 CapEx to be in the neighborhood of $1.4 billion. This is down from our prior estimate of $1.6 billion due to a combination of efficiency gains and changes in the timing of our planned purchases. To sum up, in Q3 we make great process against our key financial objectives, growing revenue, investing for growth and positioning the company to maximize long-term returns for our shareholders and we remain excited about the opportunities ahead. Now, we are ready to open the call for questions."
},
{
"speaker": "Operator",
"text": "We will now open the line for a question-and-answer session. (Operator Instructions) Your first question comes from the line Heather Bellini with Goldman Sachs. Your line is open."
},
{
"speaker": "Heather Bellini - Goldman Sachs",
"text": "Thank you for taking the question. I just had two one for Mark, and then one for Sheryl or David. Mark, the first one and as Facebook, value proposition is connecting the world, how should we expect Facebook in the future to more specifically leverage [geo] location, data of advertisers, to mobile ads even more useful for your users? Over what timeframe should we expect that to kind of play out in your mind? Then the second question for Sheryl or David would just be, you talked about brand advertisers taking a little bit more time, I think, than you would have liked spent than you might have liked. Just wondering if you could help us there with that higher mix between DR and brand advertisers as kind of played out over the course of the year, if you could just give us some rough ideas. Thank you."
},
{
"speaker": "Sheryl Sandberg",
"text": "The way we think, I'll take this actually. The way we think about using location data is that every time we use data, we use it in accordance with the privacy controls we offer people and we are working hard at making our ads better targeted. Over time, I think you will see the industry continue to evolve to get better at targeting more ads. We certainly see it as a significant upside for us to get better at targeting more ads, not just from geo-location data but from all kinds of different data we get based on what users do with our service. On brand advertisers, we don't breakout the different marketer segments. Our results this quarter are based on growth in all marketer segments, including brand and we continue to make progress. We have every one of the AdAge Global 100 have advertised with us over the past year. My comment was based on the fact that marketing spend is just not keeping pace with the transition to time on line in mobile in that segment of the market. Since that segment of the market is so big, helping that transition happen present significant upside for us. Our focus there is measurement. We have to show brand marketers that our ads drives in-store-sales and we work on that, we work on that client-by-client to share a few examples from this quarter Cadbury in the U.K. works with us to sell their cream egg product kind of find the table for Halloween to talk about candy to 16 to 24 year old. They used Facebook media for user generated post along with TV, they reached 15 million people, 21% of those people they only reached on Facebook not TV and the combined impact of TV and Facebook where sales were up 9%. Another example because it shows how we can move awareness is the Alfa Romeo 4c launched in Portugal, (inaudible) where a person could do a test drive with a Formula One driver and they got the highest buzz they have ever had in Google Trends for a product launch. So as we think it's a big opportunity ahead of us and you have to work on these clients, account-by-account, client-by-client. But we think as the shift to mobile and digital happens, it's a big opportunity and we are focused on helping that shift happen."
},
{
"speaker": "Operator",
"text": "The next question comes from Scott Devitt with Morgan Stanley. Your line is open."
},
{
"speaker": "Scott Devitt - Morgan Stanley",
"text": "Hi, thanks. Sheryl mentioned some of the tools that have been added to make it easier for advertisers to access and use the ad platform. One example was the objective-based ad buying. I was just wondering how much you would attribute reduction in friction, like the examples that were referenced on the call, leading to direct and immediate increases in flow of ad dollars versus being more gradual in nature? Then secondly, for Mark. Mark, the concept of the knowledge economy. I was just wondering, how you envision what the consumer will be doing on the site five years from now? If today is more about and sharing and sharing is more developed than search and production integrations, how do you think about that relationship between those three activities on the site over a five-ish year time horizon? Thanks"
},
{
"speaker": "Sheryl Sandberg",
"text": "On the first. Our growth overall is based on the strong performance of news feed ads, an increase in the number of news feed ads per user and also more marketers. The simplification of products has actually been very important in attracting new marketers. If you look at the new advertisers we acquired in Q3, 62% of them started with either promoted posts or promoted page likes which are the most simple of our advertising formats. So we are continuing to rollout very simple ways to become an advertiser is driving our growth and we will continue to. The larger question you asked was based on our focus of business objectives and that's actually really a big deal for us. We are now getting to the point where our ad product supports really helping marketers achieve their core business objectives. So before, people use to buy via the product, what product do you want to buy. And now they are buying from, I would say, identifying, I want to get mobile app installed. I want to get mobile engagement. I want to get website conversions. I think the fact that we are pivoting to focus on those end business results and making everything else including social a part of meeting those business results is a really important part of our strategy. It's driving our growth and I think it's going to continue to."
},
{
"speaker": "Operator",
"text": "The next question comes from Mark May with Citigroup."
},
{
"speaker": "Deborah Crawford",
"text": "Sorry, operator, can we just go back to the second half of that question."
},
{
"speaker": "David Ebersman",
"text": "Yes. I just want to answer the part of question about the product experience over time. I know there are two pieces of this that we are thinking about related to the knowledge economy. The first is just helping our customers use information better to grow their businesses and create jobs. Right. So we are thinking about small businesses and making it so they can have better insights into who their customers are and better ability to reach them. Now developers have been able to use better analytics for being able to find new customers as well. And those are a lot of the inspiration and the strategy behind the ad products that we are delivering. On the side of the product experiences that we are creating for people who use Facebook, right now I do think that the Facebook experience is very push based, in that you go to Facebook and we are suggesting content to you through something like news feed. Overtime, I think, if we do a good job, we should be able to create more value through all of the knowledge that has been shared over time that we are not really surfacing on a day-to-day basis right now in terms of helping people answer a lot of different questions that they have around the world. That's kind of the direction that we are starting to go in with Graph Search and a few other areas as well. But it's pretty early. So I think around a five year time frame like you are saying, hopefully we will make very significant progress towards going in that direction."
},
{
"speaker": "Sheryl Sandberg",
"text": "Great. Next question?"
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Mark May with Citigroup. Your line is open."
},
{
"speaker": "Mark May - Citigroup",
"text": "Thanks for taking my questions. Maybe the first one for Sheryl and then David. It seems like a year and half ago around the time of the IPO, the company was very focused on top of the funnel brand related advertising. But over the last year or so, it's been much more around direct response but certainly get the sense that on the top of the funnel brand is starting to move in a more meaningful way. What is the company doing and what are some of the main projects that you are working on that you think will really start to move to dial on the top of the funnel segment of the market. What role does video maybe play into that? Then for David regarding the ad load comment had ad load not increased in North America, give us a sense of what the ad revenue growth would have been if you normalize for that? Thanks."
},
{
"speaker": "Sheryl Sandberg",
"text": "Top of the funnel ads remain really important to us. Again, our growth this quarter was a very broad based, including top of the funnel ads. The reason they are important is that Facebook is such a unique and powerful discovery place. When you are on Facebook, you are open to discover, you are open to getting messages and that's what we are seeing with news feed messages from friends and with us as well. The key for us is measurement, the way we are really going to make progress is better measurement. It's easier to understand and measure a click that goes to return online sales. It's harder to measure how you - household that see ads and don't see ads change their purchase behavior in stores The thing I think we have done a lot over the last year and we are continuing to do that to put those measurements in place, so I talked on in my opening remarks about measurement of telecom. We have also done a ton of work around CPG, so that we can look at households that saw an ad, households that didn't see in an ad and what their difference is. Just to share one more example, (Inaudible) did a promotion with us for the (Inaudible) in the U.S. They were targeting 35 to 43 seen ads in months, because we were able to do this type of measurement that we could have a year ago, we were able to show that they get side extra turn on their ad spend. We measured household spending who saw their ads versus household who didn't saw their ads and there was a 9% difference. They were also able to tell that a lot of those 9% was driven by new buyers of their products, which is what they want, so I do think we have a big opportunity, I do think the brands are going to continue to need to be convinced account-by-account, but this moves products off shelf and that's what we are doing."
},
{
"speaker": "David Ebersman",
"text": "Mark, thanks for your question. This is David. Truly not possible to tease out individual contributions because the way the auction works, everything is dependent, so if we have fewer ads that's going to play out with different pricing and other sorts of things, so I can give you sort of our gut feel for it, but I can't quantify precisely. If you look at overall ad revenue growth for example on that third quarter compared to the second quarter, there is probably three factors that are contributed materially that are important to understand. One is just growth in users. Second is growth in demand, which plays out into pricing. Then the third is an increase in the number of ads that we showed in news feed per users. I would probably order the ad load, probably third of the straight relative to the sequential growth. I think it plays out a little bit differently on mobile versus web. On mobile, we really increased the number of ads as a percentage of the overall mobile experience quite modestly in the third quarter versus the second quarter. On web, the increase in the number of ads or the percentage of ads in the web news feed experience went up more significantly than mobile did in the third quarter versus the second."
},
{
"speaker": "Operator",
"text": "Your next question comes from Douglas Anmuth with JPMorgan. Your line is open."
},
{
"speaker": "Douglas Anmuth - JPMorgan",
"text": "Okay. Thanks for taking the question. Just wanted to ask you about two things. First on video, can you talk about what you have learned from the recent launch of video on Instagram and how that may have shaped your thinking on rolling out video ads on Facebook? Then secondly, just following-up on the ad volume, just to clarify when you are saying the ad volume won't necessarily increase any more beyond where it was at the end of Q3. Is that on average or in the more penetrated markets? Then can you comment relative to the 5% of stories in the news feed that you mentioned last quarter? Thanks."
},
{
"speaker": "Mark Zuckerberg",
"text": "The experience with video on Instagram has been very positive so far, right? I think that we proved that having a quick start auto play can be a good experience inline in the feed and that people really feel they are in and control they are experience. They can just grow if they don't like content. If it's good content then that can be really good, so we are heartened by that. This is that important launch for Facebook overall, because the addition of video content to the stream could be one of the most positive things that we have done in a long time for making it more engaging, but if we do it quarterly then it could also be a negative thing and we are trying to take our time to make sure that we do this in a very positive way and I am pretty confident that we will. But that's why you are seeing us take the process that we have on this."
},
{
"speaker": "Sheryl Sandberg",
"text": "Now I will add on videos ads. We do have a video ad product today, because any one can embed a video in page post. And we are actually seeing very good results, particularly around entertainment and media. This is driving some of our ad spend. And the area remains pretty exciting because this is a very compelling way for marketers to tell their story."
},
{
"speaker": "David Ebersman",
"text": "So I thought you asked what we mean when we say ad volume won't increase. So the first thing I would say is, I would frame that in the context as a percentage of the user experience. Obviously, if we can drive more engagement that provides more opportunity for us to show more ads. In general, I think your question referenced whether this was geographic. The ad load in news feed is reasonably consistent across the world. It's a little bit less in the least developed markets because we have less advertiser there. But it's not different grossly different. So I think that comment holds generally across most of the markets where we make our advertising dollars. In terms of relative to the 5%. So what we said last quarter was that, of the total volume of stories in news feed, about 5% of those were ads. As I said on the last question, the mobile piece of that didn't change very substantially in the third quarter versus the second. The web percentage did go up. So if you mix those two together, the Q3 number would be modestly higher than the 5% number from Q2."
},
{
"speaker": "Operator",
"text": "The next question comes from Justin Post with Merrill Lynch. Your line is open. Justin Post with Merrill Lynch, your line is open. The next question comes from Mark Mahaney with RBC Capital Markets. Your line is open."
},
{
"speaker": "Mark Mahaney - RBC Capital Markets",
"text": "Great, thanks. Two question. First, David, could you just give us some color or why the reduction in the OpEx growth for this year? Were there certain investment projects you decided to cut? And what were those and why? Then secondly. Mark, this kind of five year vision of moving towards, going from push base to pull based, that opens up a lot of opportunities. I mean that's been kind of the sauce maybe behind Google and it's an interesting part of Twitter, et cetera. But could you talk about the challenges in order to get there, and maybe both in terms of user experience the advertiser opportunity, how difficult and substantial the technology challenges are to get there? It's a very different direction and there is lot of opportunity but how do you get from point A to point B? Thanks."
},
{
"speaker": "David Ebersman",
"text": "Hi, Mark. In terms of OpEx growth, so we are continuing to invest aggressively in the business with particular emphasis on technical hiring and building out our infrastructure. At the same time, we are trying to do this in a disciplined fashion making sure that all the investments we make and the dollars we spend are spent wisely in terms of furthering our mission and creating returns for the company. I am really quite pleased with how things are going in that regard in 2013. From an R&D standpoint, we are really on track for anything ahead of what we expected to be in terms of hiring and spend. And that's surely the most important area for us in terms of investing to drive future growth. In other areas of the business, such as cost of revenue, G&A, marketing and sales, I think we are ramping up spend less than we anticipated for a couple of reasons. One is better success than we expected in some of the efficiency projects that are helping to keep the company small, even as revenue ramps up. A second reason is, some slower than expected ramp up in both hiring in new projects. And then the third contributing factor is just we have in the budget some expectations for the unplanned stuff that comes along that can drive spend, like an asset acquisition or something like that and we really haven't spent this much money as we have expected in the unplanned areas."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yes, and to your question about on how do we make the knowledge that's been shared in Facebook more useful. The first thing we needed to do is just index it all and build the infrastructure to start being able to use it in different ways. I mean the first data for Graph Search, we had indexed to more than a trillion connections, friendship connections, group membership, like connections and then for post search, we indexed more than a trillion of the post that people that people have put into the system. The basic insight that we think we are operating on here, is that right now a lot of the behavior and engagement on Facebook is very day-to-day where you are sharing something and Facebook is the best place for you to share photos or events that's going on in your life and if you go to news feed and see what's going on with the people around you. What has happened is that, over the past almost 10 years of this behavior, this amazing base of knowledge has been build up, but there is trillions of pieces of content and information that now we are just trying to find different ways to expose and basically make that more useful to people instead of just the stuff that's been shared in the last day or so. Graph Search is one way that you can see that coming to light in terms of people being able to do directed queries for different types of content. There are other kind of services that we think we can build as well that just a few people more utility from the corpus of knowledge that's been built out and that's going to be a big focus for us over the next few years."
},
{
"speaker": "Operator",
"text": "Your next question comes from Justin Post with Merrill Lynch. Your line is open."
},
{
"speaker": "Justin Post - Merrill Lynch",
"text": "Mark, after a successful revenue year, you kind of start next year with a clean slate and you highlighted some big ambitions in your prepared remarks about access and improving search. Just maybe you remind us how you think about driving profit growth as you look at the company relative to kind of your long-term objectives for the company. Thank you."
},
{
"speaker": "Mark Zuckerberg",
"text": "Well. I mean, we care a lot about that. In terms of the shareholder value that we are generating as well. I think in the recent results and what I said at the end of my remarks there was that, we are going to keep on planting seeds for our future growth while continuing to build momentum now and I know that's a philosophy that we have taken in term of building the company. We generally wanted to be profitable as such, but I don't think we are going to commit or have any specific guidance on this right now."
},
{
"speaker": "Operator",
"text": "The next question comes from Carlos Karjner with Sanford Bernstein. Your line is open."
},
{
"speaker": "Carlos Karjner - Sanford Bernstein",
"text": "Thank you. Mark, can you talk a little bit more about how the knowledge in the Facebook graph compares with the knowledge in the overall web today qualitatively and quantitatively? Is there a plan to connect the worldwide web graph to the Facebook graph when you think the answer that you are going to give people into future? Secondly, the graph regulation in the European Commission in Brazil at least may require internet companies such as Facebook to store all their data locally. What do you think will be the impact on Facebook's CapEx and expenses if these regulations are indeed implemented? Thank you."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yes. Sure. On your question about the graph of Facebook, the graph that people share on Facebook versus the web overall, I think they are pretty different. In terms of quantity, they are getting to a pretty comparable size, so engineers on the graph search teams have told me folks who have worked on other web search engines before tell me that the scale of things like post search are as big or bigger than any web search index that's out there but they are they are just different used cases with different kinds of knowledge and people are going to use them for different things, so our approach with Graph Search is not to build something which is web search. I mean, we think that companies have done that and they are doing a good job at that, but there is different kinds of knowledge. Things that you want more opinion on from people that you trust that I think is kind of a late inside Facebook that we need to do a better job of servicing that, so that's going to be the focus on that. I mean, over time, there are a lot of possibilities for things that we can do and I am not really ready to talk about a lot of them today, but you can kind of look at what we have launched in the couple of the Graph Search launches that we have done so far and we are pretty early in that journey."
},
{
"speaker": "David Ebersman",
"text": "Carlos, the second part of your question about draft legislation or discussion about companies needing to store data locally in various companies, it's an interesting question and definitely something we are tracking, but the answer is really going to depend on the details of what that looks like. It's very hard assess what kind of implication it would have for company like Facebook without understanding what we would need to do, so, we will continue to pay less attention to it, but really hard to give anything in the way of the specific answer at this point."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jason Helfstein with Oppenheimer & Company. Your line is open."
},
{
"speaker": "Jason Helfstein - Oppenheimer & Company",
"text": "Thanks. Can you give us some color on how many advertisers you guys ended the quarter? How that grew? And if there is a way to think about how many advertisers have claimed pages so we can get a sense of how deep the penetration is. Because it looks like you guys are more successful than other companies and growing at a faster rate, particularly on the local penetration side? Thanks."
},
{
"speaker": "Sheryl Sandberg",
"text": "So last quarter we reported that we had a million active advertisers and that number continues to grow and continues to grow healthily. We believe, globally, we have 20 million small businesses, local businesses of some kind who have pages. So obviously just a fraction of those are advertisers. And I think its one of the most exciting opportunities in front of Facebook. It's really hard to get small businesses to use technological products and 20 million small businesses are using us and we haven't gone out and done aggressive sales efforts to make that happen. Going from having a page that you are using for organic distribution to paid distribution, it's something we are very,-very focused on. It's why we rolled out these simple products. And I think our track record at doing that is good and we plan on getting better at it."
},
{
"speaker": "Operator",
"text": "The next question comes from Ross Sandler with Deutsche Bank. Your line is open."
},
{
"speaker": "Ross Sandler - Deutsche Bank",
"text": "David, sorry to beat a dead horse, but back to the ads per user comment. Can you give us some color on, I guess since you guys started the mobile news feed ads a year and change ago, how much CPC and click through rate improvement you have been able to drive? And should we think about it, going forward if mobile users are growing at 18% in the U.K., 20% in the U.S. and I think 60% for ROW, should we think about revenue growth as a slight premium to that but somewhat co-related to that? Thanks."
},
{
"speaker": "David Ebersman",
"text": "Sure, Ross. So I think if you look back over the last year, some of the metrics that I think have been most positive for us have been, as we have ramped from a very low volume, very few ads shown in news feeds to larger numbers, what one could reasonably have expected given the way the auction dynamics work, is that the pricing would really come down as we were delivering more clicks and as we were I think deeper into the pool of the advertising demand. And the way pricing has really held up and click rates have held up and CPCs have held up, as we have progressed through this over the last year, I think has really validated our confidence that news feed ads were going to be really important product that could really drive the performance of the business. So we remain really encouraged and pleased by that. Going forward. Clearly, we will try to continue to grow the user base, as you described, and that's been an important part of our revenue growth since the company started. And the other opportunity is for us is continue to improve the quality, the relevance and the performance of the ads and to drive up pricing by bringing more demand into our system. We are certainly doing a good job of that right now and we have got to continue to execute."
},
{
"speaker": "Operator",
"text": "The next question comes from Eric Sheridan with UBS. Your line is open."
},
{
"speaker": "Eric Sheridan - UBS",
"text": "Sure. Thanks, guys. Two quick questions. One, following up on the last one with respect to ROI around advertising products going forward. I guess, maybe more for Sheryl, but how do you guys think about the dialogue between advertisers and yourself about ROI and how much of that fits with measurement and attribution tools that you guys would need to develop internally versus what they need to think about in terms of the ROI on your properties versus other online and offline properties. And second question on mobile app install ads. Question about the diversification of the advertiser base and how that sort of developed since the product has been launched? Thanks."
},
{
"speaker": "Sheryl Sandberg",
"text": "So the first question, it's really both. In order to measure all the way from seeing a Facebook ad through to a purchase, particularly when that's offline. That takes work and tools on our side including the data systems and it also takes thinking about measurement on their side. The industry overall is moving. We have been really pleased to see more embracing of multi-click over last step attribution. You can see that happening with a number of big players in the industry. The PMDs are really important here. The PMDs are good at helping people and helping marketers measure. But really the developers' measurement system take our measurement, take industry measurements. Particularly for brand advertisers, they also take some rethinking of the ways they have measured ads and ads' performance before and we work very closely with our clients on that. On mobile app install and mobile engagement ads, we are very focused on growing across the board. We want growth in all of our marketer segments and we want to grow that broadly across the world. Developers are really interesting place for us, because we think not only do we have we think the best mobile ad product in general, because people spend a lot of their time in news feed. They spend more time in news feed than they spend on any other part of our service. That gives us an opportunity to sell ads broadly, but it also gives a great opportunity for developers, because the developers want people to do happen on their mobile phones and on their desktop. Mobile app install ads have been very successful for us and they are interesting, because the mobile app install market didn't even exist a few years ago. I think the move to rollout engagement ads further deepens our relationship with developers and shows that we can help different users and then we can get those users to continuously use their products, so we are pretty excited about this part of market, because we think it can grow quickly and we think our ad products and offerings are so unique."
},
{
"speaker": "Operator",
"text": "The next question comes from Peter Stabler with Wells Fargo. Your line is open."
},
{
"speaker": "Peter Stabler - Wells Fargo",
"text": "Good afternoon. Thanks very much for taking the questions. You introduced hashtags in June and I am just wondering if you could comment on usage trends. How strategically important hashtags are to index in the knowledge graph going forward and where their hashtags could become a meaningful part of an ad targeting opportunity in the future if usage catches on in a significant way. Thank you"
},
{
"speaker": "Mark Zuckerberg",
"text": "The launch of hashtags was more just following behavior that we see from people, right? All we really did was take hashtag that people are putting into the product and make them linked, so if you could find other posts that have the same tag. The effort that I think you are latching on to is basically we are putting some more effort now into both, public content on Facebook and more private content, right? As there are a bunch of different sets of people that a person will want to share with, one is all of their friends, but a lot of the sharing and the communication done is one-on-one in messaging or with small groups or with the communities. Then there is a large set of content that's public, which is often very high quality content as well and we have efforts in all of those areas to make a set people can share all of those different kinds of contents on Facebook. That's going to be something that we are going to continue to do."
},
{
"speaker": "Operator",
"text": "The next question comes from Brian Novak with Susquehanna. Your line is open."
},
{
"speaker": "Brian Nowak - Susquehanna",
"text": "Thanks. I have two please. You continue rolling out a lot of new products, I was wondering if you could speak to the to the traction and kind of anything user adoption of the early topical and interest trending that you have rolled out. Last quarter you talked about strengthened e-commerce driving some of the advertising which kind of verticals would you speak to this quarter and as we are heading into the holiday season, you still see e-commerce as being a big driver again? Thanks."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yes. You are asking about the effectiveness of some of the public content efforts that we have done. I think it's starting to do very well and we are very pleased with it. Some of the questions that we have gotten has asked if this is an area that we have started focusing on recently, which actually it isn't something we have been working on for a while, but I think the question as a sign that the results are starting to be quite good and folks are starting to note it. The traffic that we are driving and the higher quality content that's public that people came for us on Facebook, so we are going to keep focusing on this. It's not just about public content, it's about giving people the power to share with every different audience that they want, weather it's most private one-on-one communication and tread up to the most public content that you want to get out for everyone in the world to be able to consume, down the road we are going to keep watching all of that."
},
{
"speaker": "Sheryl Sandberg",
"text": "To your second question, direct response including e-commerce continues to perform well. We have high click-through competitive CPC, so we are attractive from marketers. When you think about verticals, I think we have very tremendous opportunity in basically all of them. Things that are performing particularly well right now financial services, media and entertainment, e-commerce, professional services. But if you look to a vertical like auto, that we haven't historically been strong in, I think we are starting to make real inroads, client-by-client, like the Alfa Romeo case study I showed, because we had such a great opportunity to engage the people they want to reach. Our targeting is also getting better. So with custom audiences and partner categories, we are able to identify, here the people you want to show your ads to who, we believe are in the market to buy a car, for example. And so the combination of the measurement work we are doing and the ability to target, I think means we have a strong play in every vertical."
},
{
"speaker": "Operator",
"text": "The next question comes from Richard Greenfield with BTIG. Your line is open."
},
{
"speaker": "Richard Greenfield - BTIG",
"text": "Hi. I really wanted to ask you about the Instagram blog post that you put up the other week, where you stated specifically that, I think the quote from the blog was, you want ads to be creative and engaging, and that seems pretty different than most of the advertising that I have seen on Facebook, whether on mobile or on the desktop. I wanted to ask you how do you think, or is it possible that if this strategy of advertising works well on Instagram, could we actually see a new form of advertising appear on Facebook sometime in 2014 or 2015."
},
{
"speaker": "Sheryl Sandberg",
"text": "So what we announced last week is a small test with 10 advertisers to start showing ad in the Instagram feed. And we are excited about it because there is a lot of interest and a lot of excited brands. When you think about ads being exciting and engaging, I think we think about two things. We think about ads that fit the format of the product that they are part of. So the Instagram ads right now are the pictures and videos which are exactly what people post on Instagram. If you look at the progress we have made with our news feed ads, those ads, those in the size, the shape. You know they got larger when they moved over from the right hand side, right hand column but they are also meant to be as exciting, as engaging as the content. So our goal is, we want our ads to be as good as the user shared content. Some of them are, a lot of them aren't. We have a lot of room to grow in improving that quality. But in terms of the excitement you will see or the interest, that is our goal. And we are just going to match the format of the products we are working with as we rollout ads."
},
{
"speaker": "Deborah Crawford",
"text": "Operator, we have time for one last question."
},
{
"speaker": "Operator",
"text": "The next question comes from Brian Wieser with Pivotal Research. Your line is open."
},
{
"speaker": "Brian Wieser - Pivotal Research",
"text": "Hi. Thanks for taking the question. I have taken notice of the number of businesses advertising. I was wondering if you could just quantify the number of new small businesses perhaps or number of advertisers going beyond that one million in the quarter? The reason I ask is, I am trying to understand to what degree that maybe the shift is spending mix towards smaller business may have contributed to margin expansion. And maybe can talk about the margin profile that different segments of marketers bring to your business?"
},
{
"speaker": "Sheryl Sandberg",
"text": "So we don't break out our business by marketer segment and we don't give margins by marketer segment. But to help answer you question, we have seeing strong growth across all of our marketer segment. All of them are growing brands, growing direct response and E-commerce are growing, F&B and local businesses are growing, developers are growing. We definitely think there is a big opportunity for those to grow same-store sales of our large clients, particularly with the shift that's happening from TV to digital and mobile. We think that there is a really exciting opportunity. We also think SMBs are a big opportunity for us and certainly in an advertiser base of over a million advertisers, the great majority of that is obviously the small to medium sized businesses. We worked hard on our sales efforts, so that we have the right sales and support effort to meet our clients. We care about our margins. We certainly have simplified products such as we have rolled out over the last year, make it easier and cheaper for SMBs to use our products. Easier for them and cheaper for us. And we will continue to focus on the automated tools that help. I think the most important thing we have done on this goes back to an earlier question about focusing on marketer objective. Before we were asking marketers to come in and choose what ad products they were buying. With our shift to focusing on marketer objectives, it's easier for everyone from largest to the smallest. You know, a small business owner can come in and say, I want my app install or I want web conversions or I want web clicks and then we are doing the harder work of figuring out what products are there, figuring out which of those ads should have digital content, so that we can meet those objectives I think that move of moving more towards using their language and focusing on their business needs is a simpler product for them. It will help gain us more marketers and it helps us work with them in a more efficient way."
},
{
"speaker": "Deborah Crawford",
"text": "Great. That's it. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again next quarter."
},
{
"speaker": "Operator",
"text": "This concludes today's conference call. You may now disconnect."
}
] | null | null |
META | 2 | 2,013 | 2013-07-24 05:00:00 | Executives: Mark Zuckerberg - Chairman and CEO Sheryl Sandberg - COO David Ebersman - CFO Deborah Crawford - Director, Investor Relations
Analysts: Douglas Anmuth - JPMorgan Heather Bellini - Goldman Sachs Mark Mahaney - RBC Capital Markets Jordan Rohan - Stifel, Nicolaus & Company Youssef Squali - Cantor Fitzgerald Anthony Diclemente - Barclays Justin Post - Bank of America Merrill Lynch Ross Sandler - Deutsche Bank Securities Inc. Brian Pitz - Jefferies & Company Ben Schachter - Macquarie Research Equities Scott Devitt - Morgan Stanley Mark May - Citi Investment Research Kenneth Sena - Evercore Partners Rory Maher - Hillside Partners Laura Martin - Needham & Company Eric Sheridan - UBS
Operator: Good afternoon. My name is Jay, and I’ll be your conference operator today. At this time, I’d like to welcome everyone to the Facebook Second Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator Instructions) Thank you very much. Ms. Deborah Crawford, Facebook’s Director of Investor Relations, you may begin.
Deborah Crawford: Thank you. Good afternoon and welcome to Facebook’s second quarter earnings conference call. Joining me today to talk about our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and David Ebersman, CFO. Before we get started, I’d like to take this opportunity to remind you that during the course of this call, we’ll make forward-looking statements regarding future events and the future financial performance of the Company. We caution you to consider the important risk factors that could cause actual results to differ materially from those in the forward-looking statements in the press release and this conference call. These risk factors are described in our press release and are more fully detailed under the caption Risk Factors in our quarterly report on Form 10-Q filed with the SEC on May 2, 2013. In addition, please note that the date of this conference call is July 24, 2013 and any forward-looking statements that we make today are based on assumptions as of this day. We undertake no obligation to update these statements as a result of new information or future events. During this call, we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today’s earnings press release. This call is being broadcast on the Internet and is available on the Investor Relations section of the Facebook website at investor.fb.com. A rebroadcast of the call will be available after 6 p.m. Pacific Time today. The earnings press release and an accompanying investor presentation are also available on our website. I’d also like to mention that we recently launched our Facebook IR page at facebook.com/Facebook investor relations. While we don’t currently intend to use the page as an exclusive vehicle for corporate disclosure, the IR page is designed as a curated resource for anyone interested in getting better acquainted with the Company. And now, I’d like to turn the call over to Mark.
Mark Zuckerberg: Thanks, Deborah and thanks everyone for joining us today. We made some really good progress this quarter with the growth of – in the growth and engagement of our community, the release of new products like Instagram video and advertising growth, especially on mobile. When it comes to mobile, I’m very pleased with the results. We now have more daily actives on mobile than on desktop. Nearly half a billion people use Facebook on their phones everyday and soon we’ll have more revenue on mobile than on desktop as well. This progress is the result of investments we started making more than a year-ago and in some cases years ago. I appreciate the patience and trust of our team, our community, and our investors have given us and we’re looking forward to seeing other long-term investments and achieved great results as well. One of the questions I frequently get asked are what are the big changes we want to make in the world over the next 5 or 12 years? Now that we’ve connected a 1 billion people, what is the next big ambition? There are three main goals I would like us to achieve. Connect everyone, understand the world and help build the knowledge economy. Connecting everyone is about growing our community to reach the next 5 billion people. Our mission is to give all people the power to share and make your world more open and connected. And that means everyone. Not just product in developed countries. Most people in the world, they only had the smartphones or data access, but we know that we want to be connected. We are focused on making this possible, while also strengthening engagement within our existing community. Understanding the world is that helping people share not just day-to-day updates like text messages and photos, but also building up long-term knowledge about the world. But what people are interested in, which restaurants are good, which hotels your friend’s have stayed out and so on. We should be able to build intelligent services that help you use your network that could answer lots of questions for you to note if service can. I want to read our community to create a graph of all that understanding to power this intelligence. Building the knowledge economy is about helping people create companies and jobs, using information. The way I see our advertising product, we’re just building a strong monetization engine for our Company. We are creating tools to enable new growth jobs and businesses, [indiscernible] (2 2:24) Platform to support a larger economic shift in the world based on knowledge and information. I’m proud of the work we’re doing here to help developers create apps to help local businesses, find customers, to help great brand tell their stories and this is the core part of our mission. Now let’s talk about the progress we’ve made in each of these areas. Starting with connecting everyone. The Facebook community has grown steadily this quarter, adding 45 million new monthly actives and the number of monthly active is steady or increasing across demographics and countries. One thing that surprised me as we’ve grown is I’ve always expected our ratio of daily actives to monthly actives were decreased as later technology adapters used our service. The opposite is actually been true, but now 61% of monthly actives or daily actives and that ratio has just continued to increase. In our most penetrated markets like the U.S., more than 70% of our monthly actives use our services daily. And now more than 700 million people worldwide use Facebook daily as of today. As more social services get created, one question is how that affects the sharing and time that people spend on Facebook? You can naively assume that more new services means people spend less time on Facebook, but that isn’t happening. In fact, people on average are spending more time on Facebook than ever before. It’s possible that because the market is expanding due to mobile, even as time spent per person increases on Facebook, maybe our market share can decrease. But that doesn’t seem to be happening either. So according to third-party metrics like comScore and Nielsen, Facebook share of time spent in the U.S. is either steady or increasing. Now we believe that’s either steady or increasing everywhere else as well. This makes sense to me because Facebook helps to maintain your real identity in relationship, which are universal need. We believe that if we execute well, we have a good shot at growing the amount of time that people spend using Facebook, while also maintaining or increasing our overall share of time spend. One specific demographic I want to address is U.S. teens. There has been a lot of speculation reporting that fewer teens are using Facebook. But based on our data, that just isn’t true. It’s difficult to measure this perfectly, since some young people lied of their age. But based on the best data we have, we believe that we’re close to fully penetrated in the U.S. teen demographic for a while and the number of teens using Facebook on both a daily and monthly basis has been steady over the past year and half. Teems also remain really highly engaged using Facebook. Now it’s also worth mentioning that these stats are for Facebook only. Instagram is growing quickly as well. If you combine the two services together, we believe our engagement and share of time spend are likely growing quickly throughout the world. Next, let's talk about building more useful services on the path to understanding the world. The newest product I'm most excited about from our last quarter is Instagram video. Adding video fits really naturally with the Instagram mission of capturing and sharing the world's moments. It's off to a great start. People are already uploading hours of video to Instagram every minute. I'm really proud of the team and I think they did a great job with this product. When I first talked to Kevin about this, he had a really smart insight. Instagram has always been about helping people capture moments in a way they're proud of. Filters were necessary for photos because when Instagram started, most phone cameras weren't good enough to take high quality photos. But lack of filters isn't what's holding back videos from being great. It's that they're shaky and feel unprofessional. Kevin realized that if we can deliver a product that helps people produce stable videos that would really change the landscape and I think it already is. Now some products that video fit into the flow of what people are doing and they take off quickly. Others like Graph Search and Home are completely new kinds of products and they're just going to take longer to develop. I've used the right strategy to have a balance of long-term foundational new products in ones that fit in immediate demand. We're committed to building all of these into market-leading products. Finally, let's talk about building the knowledge economy and what that means for our core business. This quarter has been a strong period for us. A lot of new businesses have signed up to advertise with us and we now have more than 1 million active advertisers. Our News Feed Ad products are working well for them. One of the things I watch most closely is the quality of our ads and peoples' sentiment around them. Right now ads on average make up about 5% or 1 in 20 stories in News Feed. We haven't measured a meaningful drop in satisfaction when we ask people about their experience with Facebook. We're comparing that to the result we get when we ask the same question to people using a version of Facebook with no feed ads at all. With that said, in recent studies people have told us that they noticed the ads more, so we're going to invest more in improving the quality. Our top priority is to expand the number of marketers and overall demand in our system rather than just increasing the number of ads that we show. We believe that this will help us improve the quality of the ads that we show by creating a more competitive auction and this will create the best experience for people who use our products, the best returns for more marketers and the best results for us. So that's my update for this quarter. We had a lot of progress in the last three months on growing our community engagement, releasing a successful major product and generating strong financial results. This quarter also marks the end of our first year as a public company and I think we created a good foundation for the future. I want to take a moment to thank everyone who works at Facebook and everyone who's a part of this great community. You are all helping to connect the world and push it forward. I'm grateful to have the chance to work with all of you on this. So thank you and thanks to everyone on this call for joining us today. I look forward to having more to share next quarter. And now, Sheryl.
Sheryl Sandberg: Thank Mark. Our advertising business gained significant momentum this quarter growing 61% year-over-year to 1.6 billion. Our mobile ad revenue grew significantly as well and is now approximately 41% of total ad revenue, up from about 30% in Q1. This growth was robust across all regions and each of our four marketing segments increased spending about this quarter. We believe this is because our ad products are delivering impressive ROI for each of these types of marketers. Direct response marketers, including ecommerce companies, increased their spent significantly. Year-over-year ad revenue from ecommerce companies doubled in the second quarter. Direct response marketers are taking advantage of our high click-through rates and competitive CTCs to grow their businesses. These marketers are typically very measurement focused and they quickly increased their budgets as we deliver compelling ROI. Revenue from mobile app install ads also continues to accelerate. The app market is relatively new but it is already large and growing very rapidly. We believe that Facebook is one of the most effective ways for developers to acquire new customers at competitive rates. We're increasing our share and helping to grow this market. Local businesses also grew spend significantly. We surpassed 1 million active advertisers this quarter, more than double the number we had only a year ago. We believe that this rapid growth is being driven by our unique ability to target ads and the simpler ad products we rolled out in the past year. We're all really excited that we can help local businesses grow around the world. One of my favorite local examples is right in our backyard, Artisan State, a San Francisco business that prints photo books. The owner told us that running News Feed ads gave him so many customers so quickly that they had to pause their campaigns to let their manufacturing catch up. Nearly 18 million local businesses now have Facebook pages, but we are excited to hit 1 million active advertisers, we know that this is just a small fraction of the local businesses on Facebook. So this remains a large growth opportunity for us. And finally, brand marketers also continue to grow spend. We have a massive and engaged audience around the world that brands can use to build awareness and drive scales. Every night 88 million to 100 million people are actively using Facebook during primetime TV hours in United States alone. One recent example is from Reckitt Benckiser, a global CGP company. Their campaign for Lysol targeted moms and drove a two times return on ad spent for their brand. Their campaign for Air Wick was even better driving a 5x return on ad spent. As they have seen these results, they have more than doubled their ad spent with us over the last year. News Feed ads are performing very well. In an analysis by Datalogix of 55 ad campaigns on Facebook over the past six months, marketers saw a median return on ad sales of three times of campaigns that did not include adding new feeds, which is very solid performance. Campaigns that included News Feed ads, the median return on ad sales was nearly double at 5.9x. During the second quarter we increased the number and type of ads in News Feed. At the same time, our click-though rates and cost-per-click metrics for News Feed ads remains strong during the quarter providing a good indicator of healthy and growing advertiser demand and continued user interest in these ads. Custom Audiences is another key product that continues to gain momentum. This product enables our clients to enhance their ad targeting by marrying their data with ours in a privacy protective way. In Q2 the number of marketers using custom audiences more than doubled relative to Q1. We also continue to innovate around our mobile app products. In April we launched ad targeting for future trends. This helps marketers, everyone from multinationals to local businesses, reach people in emerging markets who they could not easily reach before. While these ad markets are not especially large today, they'll become increasingly important in the years to come. In summary, we believe we're making strong progress executing our strategy. As I have mentioned in previous quarters, we are investing in mobile measurements and product innovations. The results we are reporting today demonstrate the early returns on these investments. Looking ahead, we're enthusiastic about the launch and prospects for our business. The time people are spending on mobile devices is increasing dramatically that mobile represents just 2% of ad spent globally and 3% in the U.S. We have a massive and growing mobile user base. We have an impressive share of mobile time spent and we have one if not the most effective mobile app products. Together this positions us well to lead the mobile app market. We believe that over time, marketers will increasingly rely on Facebook not just to reach people wherever they are but to fundamentally transform the way they build their businesses. As Facebook delivers personalized experiences to over 1.1 billion people, we also have a unique opportunity to deliver a more personalized advertising experience. As I meet with marketers all around the world, I find more and more that they are understanding the benefits of this opportunity. As a result, Facebook is placed to play an essential role in the evolution of marketing. We know we still have a lot of hard work to do, but we're excited about this quarter and the opportunity in front of us. Now David.
David Ebersman: Thanks Sheryl and good afternoon, everyone. Today, I'd like to update you on our progress in Q2 against our key financial objectives. Increasing revenue, investing to drive our future growth and positioning the company to maximize long-term returns for our shareholders. It was a great quarter across the board as we continue to benefit from and effectively navigate the transition to mobile. Let's start with our network. Usage and engagement on Facebook remain extremely strong as evidenced by the following. On an average day in June, 699 million people used Facebook, up 27% from last year. This represents 61% of the 1.15 billion people who accessed Facebook at any point during the month of June. Additionally, time spent per person on Facebook continues to increase. An aggregate across everyone in our network, time spent on Facebook exceeded 20 billion minutes each day in June. Separately, Instagram continues to grow rapidly with impressive engagement and we announced last month we had over 130 million actives using the service. Overall we’re really pleased by the unprecedented growth in engagement of our community at this scale. Now let’s turn to the financials. In Q2, total revenue was $1.81 billion up 53% or 54% when adjusted for constant exchange rates. Ad revenue was $1.6 billion up 61% in the quarter or 63% when adjusted for constant exchange rates. This was our strongest quarter in terms of advertising revenue growth since the third quarter of 2011. The performance was strong throughout the world with ad revenue in each of our geographic regions growing by greater than 15%. Growth in advertising revenue was driven by an increase in the number of marketers, overall advertising demand and the strong performance of newsfeed ads. Newsfeed ads were, they have been remarkably effective at delivering high levels of engagement a significant increase in click through rates and overall number of clicks and marketers have increased budgets meaningfully in response. Overall ad impressions were up 43% and the average price per ad was up 13% compared to last year. Ad impressions are up due to more people using our service worldwide combined with the impact of reducing the price floor late in 2012 which resulted in more ads being shown particularly in developing markets. In the U.S. and Canada where the price floor changes had a smaller impact, ad volume increased 6% and average price per ad increased over 40% year-over-year driven by the growth higher performing newsfeed ads. Total payments and other fees revenue was $214 million in Q2, an increase of 11% versus last year. Payments revenue from games specifically was up 7% so we believe 11% represents the best apples-to-apples comparison if we adjust for items such as the change in revenue recognition timing we made late last year. We were pleased to see Kings continued rapid growth on our games platform in Q2. Kings strategy of launching games like Candy Crush Saga on Facebook and subsequently launching on mobile has proved to be an effective approach that enables people to seamlessly play games across desktop and mobile and we expect other game developers to pursue a similar strategy. We believe Facebook continues to offer a compelling platform for developers to build great games and businesses. Overall ARPU increased 25% compared to last year to $1.60 per user for the quarter including a 35% increase in the United States and Canada as well as 30 plus percent gains in all our other regions. Turning now to expenses, in Q2 our GAAP total expenses were $1.25 billion, excluding stock compensation non-GAAP total expenses increased 52% to $1.02 billion primarily driven by headcount and infrastructure. We ended the quarter just shy of 5,300 employees up 33% from last year and we continue to be pleased with our success in attracting talent. Our Q2, GAAP operating income was $562 million representing 31% operating margin. Excluding stock comp our non-GAAP operating income was $794 million up 44% non-GAAP operating margin. Our GAAP tax rate for Q2 was 39% and our non-GAAP tax rate was 37%. GAAP net income was $333 million or $0.13 per share and non-GAAP net income was $488 million or $0.19 per share. We spent $268 million on CapEx in Q2, as we continue to invest in our datacenters and facilities. While the relatively lower spend on CapEx in Q2 is partially the result of timing of purchases. It also reflects the returns from a significant effort by employees throughout the company to make our software and hardware more efficient. CapEx will remain one of our primary areas of spend since we need a powerful infrastructure to provide content rich and personalized information to all the people who use our service around the world. The projects like Open Compute and many others are providing great returns for us and helping ensure we’re able to invest our resources in a disciplined and efficient manner. Of note, free cash flow in Q2 was over $1 billion. This is much higher than we expect in coming quarters as Q2 free cash flow benefited from $419 million tax refund and light quarterly spend on CapEx. But still $1 billion in free cash flow is a nice milestone for us against an important financial metric. In Q2 similar to prior quarters, upon the vesting of employee RSUs, we withheld shares and paid the associated income taxes for our employees, with provides an outcome similar to Facebook having repurchased approximately $153 million worth of shares in the quarter. We ended Q2 with $10.3 billion in cash and investments. Now I want to conclude by sharing some thoughts about the second half of 2013. We expect newsfeed ads to remain the main driver of revenue growth in the second half of the year and we believe we have a great opportunity to continue to drive long-term growth by improving the quality and relevance of these ads. However remember that newsfeed ads really began to contribute to our revenue in the third and fourth quarters last year which will make for more difficult year-over-year comparisons in Q3 and Q4 relative to Q2. Looking at expenses, consistent with what we said previously we plan to invest in our business and continue to expect that our total non-GAAP expenses including cost of revenue but excluding stock comp will likely grow in the neighborhood of 50% for the full-year 2013 compared to 2012. We also continue to expect that this full-year over full-year expense growth rate will be faster than our year-over-year revenue growth rate for the full-year 2013 compared to 2012. In terms of our tax rate, we expect that our Q3 and full-year non-GAAP tax rate with be a few percentage points higher than our Q2 rate and finally we expect 2013 CapEx to be in the neighborhood of $1.6 billion. This is down from our prior estimate of $1.8 billion due to a combination of efficiency gains and changes in timing of purchases while Q2 was a very strong quarter for us. We believe we’re executing well in particular with regard to the mobile transition, the investments we have been making over the past year are paying off, the business is growing rapidly and we’re excited about the opportunities ahead of us. Now let’s open the call for questions.
Operator: (Operator Instructions) The first question comes from the line of Douglas Anmuth with JPMorgan. Your line is open.
Douglas Anmuth - JPMorgan: Great, thanks for taking the question. I just wanted to drill down a little bit more on the ad revenue growth during the quarter, and it was very helpful to get the four segments broken down but, can you just help us understand a little more on the Sheryl you’re cutting on the increased number and then the types of ads in the newsfeed in 2Q and trying to understand if this is more sort of specific product driven or if this is just the combination of all the efforts that have been going into newsfeed ads essentially over the last year? Thanks.
Sheryl Sandberg: So over the past during these calls we’ve been talking about our three priorities in growing our ads business, mobile, measurement and product innovation. I think what you’re seeing here is all three of these are paying off. Obviously the transition to mobile was a really big one. We had almost no mobile ads a year-ago, were up to 41% this quarter. We have done a lot of measurement and product innovation newsfeed ads has been the most important thing we’ve done now, and we’ve done other things as well. In terms of the marketer segments, all four marketer segments are growing and contributing to our growth. So we’re seeing both the increased supply that we talked about with newsfeed ads, but also the increase in demand that all four of these marketer segments represent.
Douglas Anmuth - JPMorgan: And just as a follow-up, can you help us understand how impactful or how big mobile app install ads are within the mix?
Sheryl Sandberg: Yeah, we don’t break out by segment, the four market segments but again all four are growing. Mobile app install ads, we think are -- they’re small but they’re important and they’re growing rapidly. It's basically a totally new market. People who are selling either mobile apps as their revenue or things that are bought through mobile app are looking for a way to find new customers and we represent one of the only ways in a very effective way to do that. So, we’re growing quickly and I think we’re helping to grow this market.
Douglas Anmuth - JPMorgan: Thank you.
Operator: The next question comes from Heather Bellini with Goldman Sachs. Your line is open.
Heather Bellini - Goldman Sachs: Great. Thank you very much and congratulations. I was wondering you talked about before improved targeting and relevance of newsfeed ads that lies ahead. I was just wondering if you could share with us the progress you think you’ve made on this initiative and kind of what is to come?
Sheryl Sandberg: Targeting is really important, because what takes an ad and makes it a good ad is whether it's relevant to you. When I see something on Facebook or anywhere that I’m interested in that’s a great experience. When I see something that I’m not interested in, that’s not -- and so we have done a lot of work around targeting. The most important work we've done over the past year and I think you're seeing its results and it is around Custom Audiences, which enables people to use their data in a privacy protective way with us. It enables them to show different ads to people who are current customers versus new customers who are interested in different things. And I think we're really pleased with the adoption. The number of marketers using Custom Audiences more than doubled in Q2 and we're now up to 50 of the AdAge 100 who have already started using the products. We also think there is room to improve. We can do more and we will continue to do more to improve the targeting, the relevance of our ads.
Operator: The next question comes from Mark Mahaney with RBC Capital Markets. Your line is open.
Mark Mahaney - RBC Capital Markets: Great, thanks. Two questions please. Could you talk about thoughts on monetization of Instagram and maybe just potentially how you think about the ability to monetize that versus your core Facebook asset? And then secondly, Sheryl, could you talk about on the vertical basis where you think the biggest wide space opportunities are for advertising revenue for Facebook and the particular industries that you look at that they are materially underrepresented on Facebook where you could have the greatest growth going forward? Thanks a lot.
Mark Zuckerberg: Sure. I'll answer the Instagram question. Kevin has always been clear that we're building Instagram to be at business and that we expect that over time we're going to generate a lot of profit from it and probably through advertising. Now that all said, right now it's just growing still quickly. I mean the number that we just said was 130 million monthly actives. Video product is growing really quickly. There are so many directions to expand this in that we think that the right focus for now is to continue just focusing on increasing the footprint of Instagram. And when the right time comes then we'll think about doing advertising as well, but I think that's going to be a really big opportunity.
Sheryl Sandberg: In terms of growth opportunities, I think in terms of vertical categories, we have big growth opportunities across the board. There are certainly verticals that were stronger than others which were very strong, for example in CPG. But even though we've grown spend significantly, we're still a tiny portion of the spent that CPG advertises. And even in the verticals where I think we've done very well, starting to penetrate, there's a lot of room for growth. I think as you think about different industries using the power of online marketing, we see different levels of adoption but I'm a believer that over time this is where people are spending their time and any marketer who's trying to reach people is going to spend their resources there as well.
Operator: The next question comes from the line of Jordan Rohan with Stifel, Nicolaus. Your line is open.
Jordan Rohan - Stifel, Nicolaus & Company: Thanks so much. I think it's fairly easy too when talking to advertisers to access that there has been this latent demand for advertising on Facebook. But when you look across the globe, it's a little bit harder to address the advertising community. Can you talk about the growth of the ad sales force and the ad ops and all the people required to really bring that outside of the major U.S. and Western European markets? And specifically is there a chance that you believe that Asia-Pacific and rest of world markets can see a meaningful continued and sustainable shift higher in ARPU than where we are today? Thank you.
Sheryl Sandberg: Yes, I'm a big believer that revenue opportunities exist all over the world and our gross was very strong across regions, including outside of the U.S. for this time. We're up to over 40 offices and we have sales teams on the ground in over 40 offices and we're seeing really good adoption and really good growth across. You mentioned Asia, I was actually in Japan and Korea meeting with advertisers just a few weeks ago and we are seeing companies that really weren't doing much with us a year ago increasingly adopt us as part of a core part of their spend. So I remain very optimistic about our growth across Asia and the rest of the world.
Operator: The next question comes from Youssef Squali with Cantor Fitzgerald. Your line is open.
Youssef Squali - Cantor Fitzgerald: Thank you very much. Two questions please. Can you talk about the mix of growth in direct selling versus programmatic selling for you guys and where do you see that going forward? And in terms of just on the cost side, I guess looking at the investment and by the way David, thanks for the color about operating expenses and guidance for the second half, but as you look at longer term, how far can you see that 50% increase in operating expenses still being sustained as you, I guess just looking at 2014? I know you're not guiding to 2014 right now, but just as we look at the model going forward how far do you think you can sustain growth in operating expenses faster than growth in revenues? Thank you.
David Ebersman: Yeah, thanks for your question. Your first question about direct selling versus programmatic, the mechanism that most people buy from Facebook is through the option that we offer, but that doesn't mean that we're not – we don't have a sales force that's out calling on clients. Sheryl can expand on that if you want.
Sheryl Sandberg: Yeah, we sell both directly to our sales team so it's in-person and online. And what I think you mean by programmatic which is through third party such as DSPs and other – one thing worth noting is that FBX which is part of that programmatic selling is actually a very small part of our business and I think sometimes people don't understand that. So that piece is quite small. We are expanding both our direct selling efforts both to sales teams and online as well as the third parties we work with, and we think having a healthy and growing ecosystem on both sides is really good for the development of our business.
David Ebersman: You asked about investments looking forward to next year, I think philosophically is the easiest way to answer that which is we still think we're early in the journey of building the service that we want Facebook to be and there's lots of work ahead of us to do and lots of things to do. And our plan will continue to be to invest aggressively in the areas that we think are important to improve our strategic positioning and to drive our ability to grow revenues and profits over the long run. We also know that to be the great company that we want to be, we have to be disciplined in everything that we do and focus our spend on the areas that are really most important. So, the challenge for us just by any company is finding that right balance. I really can't comment on 2014 yet honestly just because we haven't – I don't know what 2014 is going to look like. We tend to plan in six-month blocks and I think have our act together pretty well for what we're going to try to do in the second half of this year, but haven't been on the conversation about next year yet.
Operator: The next question comes from the line of Anthony Diclemente with Barclays. Your line is open.
Anthony Diclemente - Barclays: Thanks a lot. I have one for Sheryl and one for David. Sheryl, I'd be interested in hearing a little bit about the relative progress of impression-based selling versus performance-based and you mentioned the ecommerce – the doubling from ecommerce from direct response and I guess I just wanted to know if you've increased the amount of inventory that you're selling on an impression basis versus performance? And then David, I had a follow-up on the CapEx. It just seems like an interesting time for CapEx to be coming in when video usage and video uploads could be growing…
Sheryl Sandberg: We may have lost the question, but I'll take the first half while we wait for the second piece to come back. On the first piece, our system works that you can buy by CPM or CPC and we let advertisers choose. I think both parts of our business are healthy and growing. I think when people talk about impression-based purchasing or buying, what they're really trying to get at is brands. And brand is a very important, one of our four segments and one that's growing. When you think about what brand spenders are doing, they're trying to get discovery. And I think we've made a lot of progress there. We now work with every one of the global AdAge 100 over the past year. Now that said, people are in different parts of that spectrum. We have brand advertisers who are looking for discovery who have advertised with us for a long time, proven the value and are really expanding and these others that are newer, that are experimenting that aren't as convinced yet and it's our job to get there and convince them. I think what people are increasingly seeing is we have a big brand opportunity. We have a massive engaged audience, 88 million to 100 million people in the U.S. during primetime hours who are on Facebook. We offer discovery and we have a unique opportunity to take people all the way through the funnel. In one example, a recent one that I really like is T-Mobile did an ad campaign with us to attract people to sell new phones. They used our offer ads to do it. 9% of the people who claimed the offer converted to T-Mobile within 10 days and they had over 20 times return on their ad spend which is just incredibly strong in the industry and I think that shows the power of what we can do with impressions, taking people all the way through the funnel.
David Ebersman: Anthony, I'll try and answer your question about CapEx as best I could. You got cut off as you probably know, so I only got about – well, I don't know how much of it I got but I got enough to give it a shot. And really the best way I can think to answer it is to describe for you the variables that influence what CapEx requirements are for the company. So clearly the number of users is near the top of the list, and also the time at which the users use the service. So adding users who are off peak -- the Facebook peak provides less of a burden for our infrastructure than people who are using at the same time as our peak hours, because we can leverage what we built to peak. A second thing is definitely the level of engagement with those users and that seem to be where you were going with your question about video. That is and will continue to be, we hope something that drives up requirements for our infrastructure because it means people are really engaging and finding new ways to use the service. What has helped us I think is the two variables that come next. One is just the cost of the equipment itself and the datacenters and over time Moore’s Law and other things and competition in the market have helped us to really be able to bring down the cost for each unit of equipment we use. And then the next variable which I mentioned in my remarks which I think is a really important one is just the efficiency of what we build. So over time I think Facebook has impressively succeeded at making the hardware we use more efficient and the software that we run on it more efficient in terms of how much compute power that is needs. The last variable of course probably the hardest to predict is product development, is just what we build and how that influences what the computer requirements are. So clearly the variable you emphasized which was engaging with higher content things is one of the things that will influence the CapEx over time, but it's a pretty complicated equation, but I think right now we’re managing well. I think we’re pleased with how 2013 is coming together in that regard.
Operator: The next question comes from Justin Post with Merrill Lynch. Your line is open.
Justin Post - Bank of America Merrill Lynch: Thank you. As we look back since mobile ramp back in 3Q last year, it's been pretty lumpy and it bounced around quarter-over-quarter, but it looks like a pretty big inflection this quarter. Can you help us understand why it has been so lumpy, at least we can think about going forward and maybe what caused the inflection this quarter? And then, I really appreciated the Time Spent metric, I think you said 20 billion minutes per day, but can you tell us how that compares to say a quarter ago or a year ago? Thank you.
David Ebersman: So in terms of the progression of mobile, and we’re really pleased overall that on newsfeed ads in general and on mobile in particular are working so well in terms of the performance they’re providing to marketers and how users are engaging with them. For a new product like this, I don’t think we should be that surprised at the sort of quarter-to-quarter progression it's going to be harder to predict than it would be for a more mature product. I think one of the things that happened in the second quarter is that as the investments we’ve made started to really come together. We had a lot more demand in our system that met the quality bar that we set for feed, so we’re able to place that demand intelligently in a manner where it performed well and didn’t have a meaningful impact on the user experience. So I think that more feed eligible demand was a big part of the story. And I think one of the really good pieces of news for us is how well the price held up as we did that, as we increased the number of ads we showed in feed. So for many of our ads as you know marketers are bidding for clicks in an auction and the auction determines the price for supply both demand, the cost per click price. And in the second quarter and this specific, I’m going to give you is relative to the first quarter of this year because it's hard to do a year-over-year for mobile and for newsfeed because it just didn’t really didn’t exit a year-ago. Q2 relative to Q1, the number of clicks in our system went up a lot and we might have assumed that price would decline as click number increased because we’re basically pushing out the supply curve and changing the point where supply would meet demand. And that’s not what happened. Cost per clicks for feed ads increased and really demonstrating to us that demand was growing rapidly as well as we’re increasing the supply of ads we were showing. So it's not a perfect comparison because Q2 is seasonally stronger than Q1, but it's -- I don’t think the seasonality explains the agenda I just provided. And I think that’s a really encouraging metric for us. And your second question was …
Justin Post - Bank of America Merrill Lynch: Time spent.
David Ebersman: Time Spent. We just -- unfortunately we don’t have a lot of longitudinal data for Time Spent. It's not something that we had instrumented well going back more deeply in time because it's hard -- well it's hard on every interface and it's particular hard on mobile. We feel pretty good about where we are now in terms of the quality of the instrumentation. It is up on a per user basis. As you would imagine it's not -- it's gone quarter-over-quarter sequentially on a per user basis, it will be growing slowly. On an aggregate basis of course it's benefited from the fact that we have such a nice and consistent increase in the number of daily users of this service.
Operator: The next question comes from Ross Sandler with Deutsche Bank. Your line is open.
Ross Sandler - Deutsche Bank Securities Inc.: Great, thanks guys. David, just the continuation of what you were just talking about, so on the mobile newsfeed ads is the 5% number -- your 5% of stories being at the right number and is that consistent across geo’s. And then is the growth a function of, you just said price is going up sequentially obviously your mobile DAUs are going up or MAUs are going to up sequentially, then you’re probably also seeing improving click through rates. So, of those three variables, users, click through rate and price, which is driving the sequential increase the most in mobile? Thanks.
David Ebersman: So in terms of the 5% number again, what we know is where we are now, and we’re pleased that things are going as well as they are at the current level. So, the number was zero a year ago, it increased steadily over the past year and the 5% number is a average number globally, it does differ by geography and it also differs by person. It will be higher for people for whom we have a lot of more ads that are targeted towards them and are relevant for them, and what we’re trying to do is find the right balance ideally for each user where we’re balancing their experience with Facebook and the performance of the ads and continually tweaking the product, learning from our experience to try and do that as well as we can. Going forward, I think as we have -- I think I’m consistent in saying the biggest opportunity for us is to improve the quality of the ads so that we can show ads that are engaging in relevant for the users involved. Your question about what drove the increase? I think everything contributed. I think that’s one of the things that’s encouraging about where we're, is we do have more users. We have more demand that enabled us to share more newsfeed ads. We’re really pleased with how click through had held up, and I mentioned what was happening in terms of cost per click increasing sequentially. So it's a nice balance contribution from the variables that determine what our revenue performance is.
Operator: The next question comes from Brian Pitz with Jefferies. Your line is open.
Brian Pitz - Jefferies & Company: Thank you, I wonder if you could give us a sense for what the major hurdles are to overcome before deploying a major video ad product on the core site. As you’re out talking to potential clients, can you help us understand what demand looks like for that product. And then maybe separately just a sense for what you’re seeing in Europe from a macro perspective just given some of the mixed news we heard on the economy over there? Thanks so much.
Sheryl Sandberg: On Video ads, we have a current video ad product, because marketers can embed a video in a page post and we see a lot of marketers using that product and seeing good results as a demand to do more in video on Facebook is there. And we’re exploring how we can expand that, but we don’t have anything new to announce today. In terms of Europe, we heard the same things and obviously on the macro environment, but our growth has been very strong. We had a new Head of our European Operations as well. Nicola Mendelsohn who just started, we’re excited to have her and we’re experiencing a strong growth.
Operator: The next question comes from Ben Schachter with Macquarie. Your line is open.
Ben Schachter - Macquarie Research Equities: Congratulations on a really outstanding quarter. Mark I want to ask about the platform strategy and its broadly, how was the strategic vision to allow third-parties to provide services to the network evolved over the past year, and what needs to happen that more of a contribution from non-advertising based businesses?. And David just quickly from modeling, the mobile ad revenue, can you talk about how that progressed through the quarter, did it exit June much stronger than it was earlier in the quarter? Thanks.
Mark Zuckerberg: Yeah, I mean, I can get the platform question. The strategy for that has – we shifted a bit to focus on building more business tools for developers than a lot of work we’re seeing is folks have shifted towards using products like mobile app installs and originally we were – we had a little bit of skepticism about how happy developers would be with a system where they would pay to get more distribution. But what we’ve actually found is that the NBS is really high for this, because it’s just more stable than anything else that they’ve had. In the past it’s the most stable way that they have to grow their app. So we’re basically focused on doing now is – we think about advertisers in terms of these used cases that folks had on this local businesses. They are great brands. They are developers, who are building app, there is an eCommerce and we’re really focused on building up the platform to be one of those big verticals to be a big part of the business. There is also a games part of the platform, which is kind of the first piece of platform that we launched and that is just continuing to grow at a slower, but steady rate.
David Ebersman: Your second question was about progress through the quarter, nothing notable to report there. It was really a strong quarter from the beginning to the end.
Operator: Next, we have a question from Scott Devitt with Morgan Stanley. Your line is open.
Scott Devitt - Morgan Stanley: Thanks. I had a bigger picture question for Mark. I was hoping you could give sort of a scorecard when you're in relative to your founder letter. I know it's been only 14 months and that's a short period of time, but it will be interesting to hear your views on the company's performance against the longer term aspirations and core values that you've put in the letter? Thanks.
Mark Zuckerberg: Yeah, I think we're early. And one of the interesting things over the past six months or so is reaching 1 billion people was this big rallying cry for the company for a long period of time. And I think as we've passed that, we've seen the ambition that the company has grow. And reaching 1 billion users was a great first thing to focus on because no one had ever built a service that had 1 billion active people who were signed in and had real identity before. But in a way it's actually kind of just an abstract, there's nothing magical about 1 billion. The real goal is to connect everyone in the world and help people map out everything that there is. Well, I think what we're seeing is as some of the products succeed is just the ambition increased to be able to do more of these and taking on more longer term things. At the same time, I think what you have is we weren't happy with the quality of our mobile experiences, rewinding 18 months. So we had just a lot of foundational work to do and I think coming into this year, we kind of could tell internally that we were turning a corner on that. We were in good shape and could start to play a bit more offense. But as I think the numbers from this quarter suggest, I think we're really starting to see the upside of some of the investments that we've been making over the last period.
Operator: The next question comes from Mark May with Citigroup. Your line is open.
Mark May - Citi Investment Research: Thanks for taking my question. I have two. One of the things that stood out in your prepared remarks is I think you mentioned 40% year-on-year increase in average price per ad in North America in Q2. I was hoping you could remind us how that compared to say Q1 and given that I think you contributed that to higher performing ads, if maybe you could call out specifically what one or two either ad units or ad targeting enhancements were the kind of key contributors to that growth? And then secondly, David, I think you called out the more challenging comps as you enter into the second half of the year. Are you suggesting that it's kind of unreasonable for us to look at the sequential growth that you saw in the second half of 2012 and assume that that sort of rate of growth is repeatable this year?
David Ebersman: Okay. In terms of pricing I think – we were pleased with the pricing growth in the first quarter too. The net across the world was a 3% average in the first quarter but that was much higher in the U.S. and Canada, because again for the same reason it wasn't impacted by the price floor change. So it was about 25% in the U.S. and Canada and was even stronger in the second quarter. And similarly in other territories, I think pricing is just going really well and would be stronger than the result show if not for the impact of the price floor. We probably have numbers that are similar to the U.S. and Canada, if not stronger in our other regions as well. In terms of the comps, I don't think there is anything particularly complicated so what I was saying, it's just if you're looking at the percentage growth rates for Q2, you're comparing to a quarter last year that really didn't have much mobile revenue or News Feed revenue in it at all and that really started to ramp up in the third quarter and the fourth quarter. So it's there in one side of the comparison going forward.
Sheryl Sandberg: In terms of where the growth is coming from in terms of ad units, in terms of our market segments direct response marketers are a very big contributor to the growth. That's why I started with them in the remarks and in the Q&A. Ecommerce doubled year-over-year and they're doing that by using a bunch of our different ad products; everything from post to offers to other things, but it's really about looking for those contributions. We've also seen a lot of growth, as I said, in mobile app install ads; small market but growing rapidly and it's a market where we offer a product that there is almost nowhere else to get the kind of returns and opportunity we offer.
David Ebersman: I'm just going to add one more thing just in case I, in anyway, created any confusion and I have no evidence that I did yet. But the price per ad that I was talking about in this question reflects not the same thing as the cost-per-clicks that I answered in a question earlier because price per ad will also incorporate the click-through rate as well as the cost-per-click for click-based ad and also includes ads that are purchased on an impression basis. So most of the pricing metrics we provide are per ad inclusive of click-through rates and impression-based ads. The CPC metric I gave earlier was just, I think, a specific and useful metric in understanding how much strong demand contributed in the second quarter.
Operator: The next question comes from Ken Sena with Evercore Partners. Your line is open.
Kenneth Sena - Evercore Partners: Hi. So just maybe if we could drill into the comment around ecommerce spending doubling and it seems as though FBX and third party effort, its growing fast but its small and the same with the app install effort. But can you talk a little bit about what drove that doubling in Europe year-on-year? Thanks.
Sheryl Sandberg: I think direct response marketers have had more opportunities to use our system, use our product and we've also made a very major investment in helping them measure returns and helping them connect what's happening both online and as well as throughout the system. So direct response marketers tend to be buyers when they have an ROI metric. They're looking for that ROI metric and their budgets are flexible around those ROIs. So as they've invested with us and hit their ROI metrics, their budgets go up and they make those adjustments very quickly. That's why when they start using the products and see the value they create, they are able to grow very quickly even within a quarter or within a week or within a month because they adjusted their budgets.
Operator: Your next question comes from Rory Maher with Hillside Partners. Your line is open.
Rory Maher - Hillside Partners: Thanks. A couple of quick questions. First on hiring, there's been a lot of discussion in the press about tech companies' need for more highly skilled workers and I'm curious if you're feeling pressure to find that kind of highly skilled talent and what areas you find hardest to fill and maybe some successfully that you're finding good engineering talent? And then secondly on the advertiser mix, have you guys discussed your mix of brand advertisers by category like auto, retail, telecom, that kind of category mix? And are there any that have grown particularly well the past year?
Mark Zuckerberg: Yeah, I can take this. Hiring great people especially engineers is one of the biggest challenges that any technology company has. We're doing really well against the hiring goals that we have. But I mean there was a systemic issue where our country doesn't produce the volume of engineers that the companies would want to hire. And I think that that's a lot of what you hear these companies talking about. We're doing really well competitively right now. We have a really strong program on colleges where we can continue to attract a lot of best people who are graduating. We do really well at hiring senior engineers from across the valley as well. But it's just something that we invest a huge amount of time and it's really important.
Sheryl Sandberg: In terms of where we're growing by category; I've mentioned CPG, gaming, retail, these are vertical categories where we're strong. But again we're growing. We're growing; we're watching people really experiment. One of the things that's been really fun to see even though it's not a pay product is GE is Instagram work. GE is doing super interesting photos on Instagram which show us that other industries are also going to adapt to the social environment and to some of the new ways to reach customers globally.
Operator: The next question comes from Laura Martin with Needham & Company. Your line is open.
Laura Martin - Needham & Company: Hi, there. Great numbers, you guys. Congratulations. Two questions. One on, could you guys clarify the custom advertising bucket? I know you said it was up 100% year-over-year or quarter-over-quarter and a lot of the brands are talking about this as a key growth area. So I'm really interested in how big it's starting for you guys? And then my second question is we're also talking to a lot of companies that target your metrics using UTI integrations and would that create an arbitrage I'm wondering if over time you foresee that being a stable ecosystem or are you guys going to try to ease those guys out over time and grab some of that upside that these arbitragers that are using our platform are garnering today? Thanks.
Sheryl Sandberg: On the first, Custom Audiences is small but growing and important. We doubled what I said as we doubled the number of marketers using the product Q2 over Q1, and that also has included getting us to 50 of the AdAge 100. As I've talked about as a large brand advertisers the AdAge from 100 have a long sales cycle and it takes a lot of work that happened to adapt products and so seeing adoption this quickly of something, we think shows how powerful that targeting is. In terms of some of the more programmatic ways people buy, we think it’s really healthy for us to have multiple sales channels. We like having a direct sales channel, which we have in our 40 – over 40 offices. We like having online and robust sales, because that means that even in countries where we’ve done half offices, we have the ability to sell into those markets. We also like having an eager system of what we call PMDs, third-party sellers who can work with our clients to provide some of the kind of features that we don’t have or some of the kind of capability that they may not have in house. And so for us, we’d like to see all of our sales channels continue to grow and thrive.
Deborah Crawford: Operator, I think we’ve time for one last question.
Operator: The next question comes from Eric Sheridan with UBS. Your line is open.
Eric Sheridan - UBS: Thanks, guys. Congratulations on the numbers. Mark, longer term question focused on your initial comments, how have some of the recent products that are consumer facing that you guys have launched like Graph Search and Facebook Home sort of taught you what the consumer acceptance is for certain things, learnings about how the platform can be developed and evolved over time, would love to get your takeaways on that?
Mark Zuckerberg: Yeah. Well, I mean I think that there are bunch of different kinds of products that you can ship. I mean everyday we ship a lot of tweaks to the products, or small changes to existing products. Then there are going be to products like Instagram video, which is really doing well and it fits very naturally into the current flow of how people use Instagram to capture moments that they’re proud of. So that makes sense. I think the team did a really good job there. The thing is like Home and Graph Search are really new used cases. I mean in the case of Home, it’s a new category of product that’s different from anything that exist out there and I think of its more a seed that we’re planting that its going to create completely new pillar of the ecosystem rather than drafting off behavior that people already have in the system today. So, I definitely think that we just have to look at this over the long-term. And it’s very – when we’re building models for the Company and we basically think that it’s going to be something that we will invest in for years. And we expect these to become marketing – market leading products and they’re doing things that no-one else really has, the strategic position or content to be able to build these products. So we’re excited about them. There is going to be longer term back. So I think if you wan to look at the different things that we’re doing in terms of how naturally they fit into the flow of a person’s day to day life today to get a sense of how quickly it’s going to ramp up over time.
Deborah Crawford: Great. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again next quarter.
Operator: This concludes today’s conference call. You may now disconnect. | [
{
"speaker": "Executives",
"text": "Mark Zuckerberg - Chairman and CEO Sheryl Sandberg - COO David Ebersman - CFO Deborah Crawford - Director, Investor Relations"
},
{
"speaker": "Analysts",
"text": "Douglas Anmuth - JPMorgan Heather Bellini - Goldman Sachs Mark Mahaney - RBC Capital Markets Jordan Rohan - Stifel, Nicolaus & Company Youssef Squali - Cantor Fitzgerald Anthony Diclemente - Barclays Justin Post - Bank of America Merrill Lynch Ross Sandler - Deutsche Bank Securities Inc. Brian Pitz - Jefferies & Company Ben Schachter - Macquarie Research Equities Scott Devitt - Morgan Stanley Mark May - Citi Investment Research Kenneth Sena - Evercore Partners Rory Maher - Hillside Partners Laura Martin - Needham & Company Eric Sheridan - UBS"
},
{
"speaker": "Operator",
"text": "Good afternoon. My name is Jay, and I’ll be your conference operator today. At this time, I’d like to welcome everyone to the Facebook Second Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator Instructions) Thank you very much. Ms. Deborah Crawford, Facebook’s Director of Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford",
"text": "Thank you. Good afternoon and welcome to Facebook’s second quarter earnings conference call. Joining me today to talk about our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and David Ebersman, CFO. Before we get started, I’d like to take this opportunity to remind you that during the course of this call, we’ll make forward-looking statements regarding future events and the future financial performance of the Company. We caution you to consider the important risk factors that could cause actual results to differ materially from those in the forward-looking statements in the press release and this conference call. These risk factors are described in our press release and are more fully detailed under the caption Risk Factors in our quarterly report on Form 10-Q filed with the SEC on May 2, 2013. In addition, please note that the date of this conference call is July 24, 2013 and any forward-looking statements that we make today are based on assumptions as of this day. We undertake no obligation to update these statements as a result of new information or future events. During this call, we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today’s earnings press release. This call is being broadcast on the Internet and is available on the Investor Relations section of the Facebook website at investor.fb.com. A rebroadcast of the call will be available after 6 p.m. Pacific Time today. The earnings press release and an accompanying investor presentation are also available on our website. I’d also like to mention that we recently launched our Facebook IR page at facebook.com/Facebook investor relations. While we don’t currently intend to use the page as an exclusive vehicle for corporate disclosure, the IR page is designed as a curated resource for anyone interested in getting better acquainted with the Company. And now, I’d like to turn the call over to Mark."
},
{
"speaker": "Mark Zuckerberg",
"text": "Thanks, Deborah and thanks everyone for joining us today. We made some really good progress this quarter with the growth of – in the growth and engagement of our community, the release of new products like Instagram video and advertising growth, especially on mobile. When it comes to mobile, I’m very pleased with the results. We now have more daily actives on mobile than on desktop. Nearly half a billion people use Facebook on their phones everyday and soon we’ll have more revenue on mobile than on desktop as well. This progress is the result of investments we started making more than a year-ago and in some cases years ago. I appreciate the patience and trust of our team, our community, and our investors have given us and we’re looking forward to seeing other long-term investments and achieved great results as well. One of the questions I frequently get asked are what are the big changes we want to make in the world over the next 5 or 12 years? Now that we’ve connected a 1 billion people, what is the next big ambition? There are three main goals I would like us to achieve. Connect everyone, understand the world and help build the knowledge economy. Connecting everyone is about growing our community to reach the next 5 billion people. Our mission is to give all people the power to share and make your world more open and connected. And that means everyone. Not just product in developed countries. Most people in the world, they only had the smartphones or data access, but we know that we want to be connected. We are focused on making this possible, while also strengthening engagement within our existing community. Understanding the world is that helping people share not just day-to-day updates like text messages and photos, but also building up long-term knowledge about the world. But what people are interested in, which restaurants are good, which hotels your friend’s have stayed out and so on. We should be able to build intelligent services that help you use your network that could answer lots of questions for you to note if service can. I want to read our community to create a graph of all that understanding to power this intelligence. Building the knowledge economy is about helping people create companies and jobs, using information. The way I see our advertising product, we’re just building a strong monetization engine for our Company. We are creating tools to enable new growth jobs and businesses, [indiscernible] (2 2:24) Platform to support a larger economic shift in the world based on knowledge and information. I’m proud of the work we’re doing here to help developers create apps to help local businesses, find customers, to help great brand tell their stories and this is the core part of our mission. Now let’s talk about the progress we’ve made in each of these areas. Starting with connecting everyone. The Facebook community has grown steadily this quarter, adding 45 million new monthly actives and the number of monthly active is steady or increasing across demographics and countries. One thing that surprised me as we’ve grown is I’ve always expected our ratio of daily actives to monthly actives were decreased as later technology adapters used our service. The opposite is actually been true, but now 61% of monthly actives or daily actives and that ratio has just continued to increase. In our most penetrated markets like the U.S., more than 70% of our monthly actives use our services daily. And now more than 700 million people worldwide use Facebook daily as of today. As more social services get created, one question is how that affects the sharing and time that people spend on Facebook? You can naively assume that more new services means people spend less time on Facebook, but that isn’t happening. In fact, people on average are spending more time on Facebook than ever before. It’s possible that because the market is expanding due to mobile, even as time spent per person increases on Facebook, maybe our market share can decrease. But that doesn’t seem to be happening either. So according to third-party metrics like comScore and Nielsen, Facebook share of time spent in the U.S. is either steady or increasing. Now we believe that’s either steady or increasing everywhere else as well. This makes sense to me because Facebook helps to maintain your real identity in relationship, which are universal need. We believe that if we execute well, we have a good shot at growing the amount of time that people spend using Facebook, while also maintaining or increasing our overall share of time spend. One specific demographic I want to address is U.S. teens. There has been a lot of speculation reporting that fewer teens are using Facebook. But based on our data, that just isn’t true. It’s difficult to measure this perfectly, since some young people lied of their age. But based on the best data we have, we believe that we’re close to fully penetrated in the U.S. teen demographic for a while and the number of teens using Facebook on both a daily and monthly basis has been steady over the past year and half. Teems also remain really highly engaged using Facebook. Now it’s also worth mentioning that these stats are for Facebook only. Instagram is growing quickly as well. If you combine the two services together, we believe our engagement and share of time spend are likely growing quickly throughout the world. Next, let's talk about building more useful services on the path to understanding the world. The newest product I'm most excited about from our last quarter is Instagram video. Adding video fits really naturally with the Instagram mission of capturing and sharing the world's moments. It's off to a great start. People are already uploading hours of video to Instagram every minute. I'm really proud of the team and I think they did a great job with this product. When I first talked to Kevin about this, he had a really smart insight. Instagram has always been about helping people capture moments in a way they're proud of. Filters were necessary for photos because when Instagram started, most phone cameras weren't good enough to take high quality photos. But lack of filters isn't what's holding back videos from being great. It's that they're shaky and feel unprofessional. Kevin realized that if we can deliver a product that helps people produce stable videos that would really change the landscape and I think it already is. Now some products that video fit into the flow of what people are doing and they take off quickly. Others like Graph Search and Home are completely new kinds of products and they're just going to take longer to develop. I've used the right strategy to have a balance of long-term foundational new products in ones that fit in immediate demand. We're committed to building all of these into market-leading products. Finally, let's talk about building the knowledge economy and what that means for our core business. This quarter has been a strong period for us. A lot of new businesses have signed up to advertise with us and we now have more than 1 million active advertisers. Our News Feed Ad products are working well for them. One of the things I watch most closely is the quality of our ads and peoples' sentiment around them. Right now ads on average make up about 5% or 1 in 20 stories in News Feed. We haven't measured a meaningful drop in satisfaction when we ask people about their experience with Facebook. We're comparing that to the result we get when we ask the same question to people using a version of Facebook with no feed ads at all. With that said, in recent studies people have told us that they noticed the ads more, so we're going to invest more in improving the quality. Our top priority is to expand the number of marketers and overall demand in our system rather than just increasing the number of ads that we show. We believe that this will help us improve the quality of the ads that we show by creating a more competitive auction and this will create the best experience for people who use our products, the best returns for more marketers and the best results for us. So that's my update for this quarter. We had a lot of progress in the last three months on growing our community engagement, releasing a successful major product and generating strong financial results. This quarter also marks the end of our first year as a public company and I think we created a good foundation for the future. I want to take a moment to thank everyone who works at Facebook and everyone who's a part of this great community. You are all helping to connect the world and push it forward. I'm grateful to have the chance to work with all of you on this. So thank you and thanks to everyone on this call for joining us today. I look forward to having more to share next quarter. And now, Sheryl."
},
{
"speaker": "Sheryl Sandberg",
"text": "Thank Mark. Our advertising business gained significant momentum this quarter growing 61% year-over-year to 1.6 billion. Our mobile ad revenue grew significantly as well and is now approximately 41% of total ad revenue, up from about 30% in Q1. This growth was robust across all regions and each of our four marketing segments increased spending about this quarter. We believe this is because our ad products are delivering impressive ROI for each of these types of marketers. Direct response marketers, including ecommerce companies, increased their spent significantly. Year-over-year ad revenue from ecommerce companies doubled in the second quarter. Direct response marketers are taking advantage of our high click-through rates and competitive CTCs to grow their businesses. These marketers are typically very measurement focused and they quickly increased their budgets as we deliver compelling ROI. Revenue from mobile app install ads also continues to accelerate. The app market is relatively new but it is already large and growing very rapidly. We believe that Facebook is one of the most effective ways for developers to acquire new customers at competitive rates. We're increasing our share and helping to grow this market. Local businesses also grew spend significantly. We surpassed 1 million active advertisers this quarter, more than double the number we had only a year ago. We believe that this rapid growth is being driven by our unique ability to target ads and the simpler ad products we rolled out in the past year. We're all really excited that we can help local businesses grow around the world. One of my favorite local examples is right in our backyard, Artisan State, a San Francisco business that prints photo books. The owner told us that running News Feed ads gave him so many customers so quickly that they had to pause their campaigns to let their manufacturing catch up. Nearly 18 million local businesses now have Facebook pages, but we are excited to hit 1 million active advertisers, we know that this is just a small fraction of the local businesses on Facebook. So this remains a large growth opportunity for us. And finally, brand marketers also continue to grow spend. We have a massive and engaged audience around the world that brands can use to build awareness and drive scales. Every night 88 million to 100 million people are actively using Facebook during primetime TV hours in United States alone. One recent example is from Reckitt Benckiser, a global CGP company. Their campaign for Lysol targeted moms and drove a two times return on ad spent for their brand. Their campaign for Air Wick was even better driving a 5x return on ad spent. As they have seen these results, they have more than doubled their ad spent with us over the last year. News Feed ads are performing very well. In an analysis by Datalogix of 55 ad campaigns on Facebook over the past six months, marketers saw a median return on ad sales of three times of campaigns that did not include adding new feeds, which is very solid performance. Campaigns that included News Feed ads, the median return on ad sales was nearly double at 5.9x. During the second quarter we increased the number and type of ads in News Feed. At the same time, our click-though rates and cost-per-click metrics for News Feed ads remains strong during the quarter providing a good indicator of healthy and growing advertiser demand and continued user interest in these ads. Custom Audiences is another key product that continues to gain momentum. This product enables our clients to enhance their ad targeting by marrying their data with ours in a privacy protective way. In Q2 the number of marketers using custom audiences more than doubled relative to Q1. We also continue to innovate around our mobile app products. In April we launched ad targeting for future trends. This helps marketers, everyone from multinationals to local businesses, reach people in emerging markets who they could not easily reach before. While these ad markets are not especially large today, they'll become increasingly important in the years to come. In summary, we believe we're making strong progress executing our strategy. As I have mentioned in previous quarters, we are investing in mobile measurements and product innovations. The results we are reporting today demonstrate the early returns on these investments. Looking ahead, we're enthusiastic about the launch and prospects for our business. The time people are spending on mobile devices is increasing dramatically that mobile represents just 2% of ad spent globally and 3% in the U.S. We have a massive and growing mobile user base. We have an impressive share of mobile time spent and we have one if not the most effective mobile app products. Together this positions us well to lead the mobile app market. We believe that over time, marketers will increasingly rely on Facebook not just to reach people wherever they are but to fundamentally transform the way they build their businesses. As Facebook delivers personalized experiences to over 1.1 billion people, we also have a unique opportunity to deliver a more personalized advertising experience. As I meet with marketers all around the world, I find more and more that they are understanding the benefits of this opportunity. As a result, Facebook is placed to play an essential role in the evolution of marketing. We know we still have a lot of hard work to do, but we're excited about this quarter and the opportunity in front of us. Now David."
},
{
"speaker": "David Ebersman",
"text": "Thanks Sheryl and good afternoon, everyone. Today, I'd like to update you on our progress in Q2 against our key financial objectives. Increasing revenue, investing to drive our future growth and positioning the company to maximize long-term returns for our shareholders. It was a great quarter across the board as we continue to benefit from and effectively navigate the transition to mobile. Let's start with our network. Usage and engagement on Facebook remain extremely strong as evidenced by the following. On an average day in June, 699 million people used Facebook, up 27% from last year. This represents 61% of the 1.15 billion people who accessed Facebook at any point during the month of June. Additionally, time spent per person on Facebook continues to increase. An aggregate across everyone in our network, time spent on Facebook exceeded 20 billion minutes each day in June. Separately, Instagram continues to grow rapidly with impressive engagement and we announced last month we had over 130 million actives using the service. Overall we’re really pleased by the unprecedented growth in engagement of our community at this scale. Now let’s turn to the financials. In Q2, total revenue was $1.81 billion up 53% or 54% when adjusted for constant exchange rates. Ad revenue was $1.6 billion up 61% in the quarter or 63% when adjusted for constant exchange rates. This was our strongest quarter in terms of advertising revenue growth since the third quarter of 2011. The performance was strong throughout the world with ad revenue in each of our geographic regions growing by greater than 15%. Growth in advertising revenue was driven by an increase in the number of marketers, overall advertising demand and the strong performance of newsfeed ads. Newsfeed ads were, they have been remarkably effective at delivering high levels of engagement a significant increase in click through rates and overall number of clicks and marketers have increased budgets meaningfully in response. Overall ad impressions were up 43% and the average price per ad was up 13% compared to last year. Ad impressions are up due to more people using our service worldwide combined with the impact of reducing the price floor late in 2012 which resulted in more ads being shown particularly in developing markets. In the U.S. and Canada where the price floor changes had a smaller impact, ad volume increased 6% and average price per ad increased over 40% year-over-year driven by the growth higher performing newsfeed ads. Total payments and other fees revenue was $214 million in Q2, an increase of 11% versus last year. Payments revenue from games specifically was up 7% so we believe 11% represents the best apples-to-apples comparison if we adjust for items such as the change in revenue recognition timing we made late last year. We were pleased to see Kings continued rapid growth on our games platform in Q2. Kings strategy of launching games like Candy Crush Saga on Facebook and subsequently launching on mobile has proved to be an effective approach that enables people to seamlessly play games across desktop and mobile and we expect other game developers to pursue a similar strategy. We believe Facebook continues to offer a compelling platform for developers to build great games and businesses. Overall ARPU increased 25% compared to last year to $1.60 per user for the quarter including a 35% increase in the United States and Canada as well as 30 plus percent gains in all our other regions. Turning now to expenses, in Q2 our GAAP total expenses were $1.25 billion, excluding stock compensation non-GAAP total expenses increased 52% to $1.02 billion primarily driven by headcount and infrastructure. We ended the quarter just shy of 5,300 employees up 33% from last year and we continue to be pleased with our success in attracting talent. Our Q2, GAAP operating income was $562 million representing 31% operating margin. Excluding stock comp our non-GAAP operating income was $794 million up 44% non-GAAP operating margin. Our GAAP tax rate for Q2 was 39% and our non-GAAP tax rate was 37%. GAAP net income was $333 million or $0.13 per share and non-GAAP net income was $488 million or $0.19 per share. We spent $268 million on CapEx in Q2, as we continue to invest in our datacenters and facilities. While the relatively lower spend on CapEx in Q2 is partially the result of timing of purchases. It also reflects the returns from a significant effort by employees throughout the company to make our software and hardware more efficient. CapEx will remain one of our primary areas of spend since we need a powerful infrastructure to provide content rich and personalized information to all the people who use our service around the world. The projects like Open Compute and many others are providing great returns for us and helping ensure we’re able to invest our resources in a disciplined and efficient manner. Of note, free cash flow in Q2 was over $1 billion. This is much higher than we expect in coming quarters as Q2 free cash flow benefited from $419 million tax refund and light quarterly spend on CapEx. But still $1 billion in free cash flow is a nice milestone for us against an important financial metric. In Q2 similar to prior quarters, upon the vesting of employee RSUs, we withheld shares and paid the associated income taxes for our employees, with provides an outcome similar to Facebook having repurchased approximately $153 million worth of shares in the quarter. We ended Q2 with $10.3 billion in cash and investments. Now I want to conclude by sharing some thoughts about the second half of 2013. We expect newsfeed ads to remain the main driver of revenue growth in the second half of the year and we believe we have a great opportunity to continue to drive long-term growth by improving the quality and relevance of these ads. However remember that newsfeed ads really began to contribute to our revenue in the third and fourth quarters last year which will make for more difficult year-over-year comparisons in Q3 and Q4 relative to Q2. Looking at expenses, consistent with what we said previously we plan to invest in our business and continue to expect that our total non-GAAP expenses including cost of revenue but excluding stock comp will likely grow in the neighborhood of 50% for the full-year 2013 compared to 2012. We also continue to expect that this full-year over full-year expense growth rate will be faster than our year-over-year revenue growth rate for the full-year 2013 compared to 2012. In terms of our tax rate, we expect that our Q3 and full-year non-GAAP tax rate with be a few percentage points higher than our Q2 rate and finally we expect 2013 CapEx to be in the neighborhood of $1.6 billion. This is down from our prior estimate of $1.8 billion due to a combination of efficiency gains and changes in timing of purchases while Q2 was a very strong quarter for us. We believe we’re executing well in particular with regard to the mobile transition, the investments we have been making over the past year are paying off, the business is growing rapidly and we’re excited about the opportunities ahead of us. Now let’s open the call for questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) The first question comes from the line of Douglas Anmuth with JPMorgan. Your line is open."
},
{
"speaker": "Douglas Anmuth - JPMorgan",
"text": "Great, thanks for taking the question. I just wanted to drill down a little bit more on the ad revenue growth during the quarter, and it was very helpful to get the four segments broken down but, can you just help us understand a little more on the Sheryl you’re cutting on the increased number and then the types of ads in the newsfeed in 2Q and trying to understand if this is more sort of specific product driven or if this is just the combination of all the efforts that have been going into newsfeed ads essentially over the last year? Thanks."
},
{
"speaker": "Sheryl Sandberg",
"text": "So over the past during these calls we’ve been talking about our three priorities in growing our ads business, mobile, measurement and product innovation. I think what you’re seeing here is all three of these are paying off. Obviously the transition to mobile was a really big one. We had almost no mobile ads a year-ago, were up to 41% this quarter. We have done a lot of measurement and product innovation newsfeed ads has been the most important thing we’ve done now, and we’ve done other things as well. In terms of the marketer segments, all four marketer segments are growing and contributing to our growth. So we’re seeing both the increased supply that we talked about with newsfeed ads, but also the increase in demand that all four of these marketer segments represent."
},
{
"speaker": "Douglas Anmuth - JPMorgan",
"text": "And just as a follow-up, can you help us understand how impactful or how big mobile app install ads are within the mix?"
},
{
"speaker": "Sheryl Sandberg",
"text": "Yeah, we don’t break out by segment, the four market segments but again all four are growing. Mobile app install ads, we think are -- they’re small but they’re important and they’re growing rapidly. It's basically a totally new market. People who are selling either mobile apps as their revenue or things that are bought through mobile app are looking for a way to find new customers and we represent one of the only ways in a very effective way to do that. So, we’re growing quickly and I think we’re helping to grow this market."
},
{
"speaker": "Douglas Anmuth - JPMorgan",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Heather Bellini with Goldman Sachs. Your line is open."
},
{
"speaker": "Heather Bellini - Goldman Sachs",
"text": "Great. Thank you very much and congratulations. I was wondering you talked about before improved targeting and relevance of newsfeed ads that lies ahead. I was just wondering if you could share with us the progress you think you’ve made on this initiative and kind of what is to come?"
},
{
"speaker": "Sheryl Sandberg",
"text": "Targeting is really important, because what takes an ad and makes it a good ad is whether it's relevant to you. When I see something on Facebook or anywhere that I’m interested in that’s a great experience. When I see something that I’m not interested in, that’s not -- and so we have done a lot of work around targeting. The most important work we've done over the past year and I think you're seeing its results and it is around Custom Audiences, which enables people to use their data in a privacy protective way with us. It enables them to show different ads to people who are current customers versus new customers who are interested in different things. And I think we're really pleased with the adoption. The number of marketers using Custom Audiences more than doubled in Q2 and we're now up to 50 of the AdAge 100 who have already started using the products. We also think there is room to improve. We can do more and we will continue to do more to improve the targeting, the relevance of our ads."
},
{
"speaker": "Operator",
"text": "The next question comes from Mark Mahaney with RBC Capital Markets. Your line is open."
},
{
"speaker": "Mark Mahaney - RBC Capital Markets",
"text": "Great, thanks. Two questions please. Could you talk about thoughts on monetization of Instagram and maybe just potentially how you think about the ability to monetize that versus your core Facebook asset? And then secondly, Sheryl, could you talk about on the vertical basis where you think the biggest wide space opportunities are for advertising revenue for Facebook and the particular industries that you look at that they are materially underrepresented on Facebook where you could have the greatest growth going forward? Thanks a lot."
},
{
"speaker": "Mark Zuckerberg",
"text": "Sure. I'll answer the Instagram question. Kevin has always been clear that we're building Instagram to be at business and that we expect that over time we're going to generate a lot of profit from it and probably through advertising. Now that all said, right now it's just growing still quickly. I mean the number that we just said was 130 million monthly actives. Video product is growing really quickly. There are so many directions to expand this in that we think that the right focus for now is to continue just focusing on increasing the footprint of Instagram. And when the right time comes then we'll think about doing advertising as well, but I think that's going to be a really big opportunity."
},
{
"speaker": "Sheryl Sandberg",
"text": "In terms of growth opportunities, I think in terms of vertical categories, we have big growth opportunities across the board. There are certainly verticals that were stronger than others which were very strong, for example in CPG. But even though we've grown spend significantly, we're still a tiny portion of the spent that CPG advertises. And even in the verticals where I think we've done very well, starting to penetrate, there's a lot of room for growth. I think as you think about different industries using the power of online marketing, we see different levels of adoption but I'm a believer that over time this is where people are spending their time and any marketer who's trying to reach people is going to spend their resources there as well."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Jordan Rohan with Stifel, Nicolaus. Your line is open."
},
{
"speaker": "Jordan Rohan - Stifel, Nicolaus & Company",
"text": "Thanks so much. I think it's fairly easy too when talking to advertisers to access that there has been this latent demand for advertising on Facebook. But when you look across the globe, it's a little bit harder to address the advertising community. Can you talk about the growth of the ad sales force and the ad ops and all the people required to really bring that outside of the major U.S. and Western European markets? And specifically is there a chance that you believe that Asia-Pacific and rest of world markets can see a meaningful continued and sustainable shift higher in ARPU than where we are today? Thank you."
},
{
"speaker": "Sheryl Sandberg",
"text": "Yes, I'm a big believer that revenue opportunities exist all over the world and our gross was very strong across regions, including outside of the U.S. for this time. We're up to over 40 offices and we have sales teams on the ground in over 40 offices and we're seeing really good adoption and really good growth across. You mentioned Asia, I was actually in Japan and Korea meeting with advertisers just a few weeks ago and we are seeing companies that really weren't doing much with us a year ago increasingly adopt us as part of a core part of their spend. So I remain very optimistic about our growth across Asia and the rest of the world."
},
{
"speaker": "Operator",
"text": "The next question comes from Youssef Squali with Cantor Fitzgerald. Your line is open."
},
{
"speaker": "Youssef Squali - Cantor Fitzgerald",
"text": "Thank you very much. Two questions please. Can you talk about the mix of growth in direct selling versus programmatic selling for you guys and where do you see that going forward? And in terms of just on the cost side, I guess looking at the investment and by the way David, thanks for the color about operating expenses and guidance for the second half, but as you look at longer term, how far can you see that 50% increase in operating expenses still being sustained as you, I guess just looking at 2014? I know you're not guiding to 2014 right now, but just as we look at the model going forward how far do you think you can sustain growth in operating expenses faster than growth in revenues? Thank you."
},
{
"speaker": "David Ebersman",
"text": "Yeah, thanks for your question. Your first question about direct selling versus programmatic, the mechanism that most people buy from Facebook is through the option that we offer, but that doesn't mean that we're not – we don't have a sales force that's out calling on clients. Sheryl can expand on that if you want."
},
{
"speaker": "Sheryl Sandberg",
"text": "Yeah, we sell both directly to our sales team so it's in-person and online. And what I think you mean by programmatic which is through third party such as DSPs and other – one thing worth noting is that FBX which is part of that programmatic selling is actually a very small part of our business and I think sometimes people don't understand that. So that piece is quite small. We are expanding both our direct selling efforts both to sales teams and online as well as the third parties we work with, and we think having a healthy and growing ecosystem on both sides is really good for the development of our business."
},
{
"speaker": "David Ebersman",
"text": "You asked about investments looking forward to next year, I think philosophically is the easiest way to answer that which is we still think we're early in the journey of building the service that we want Facebook to be and there's lots of work ahead of us to do and lots of things to do. And our plan will continue to be to invest aggressively in the areas that we think are important to improve our strategic positioning and to drive our ability to grow revenues and profits over the long run. We also know that to be the great company that we want to be, we have to be disciplined in everything that we do and focus our spend on the areas that are really most important. So, the challenge for us just by any company is finding that right balance. I really can't comment on 2014 yet honestly just because we haven't – I don't know what 2014 is going to look like. We tend to plan in six-month blocks and I think have our act together pretty well for what we're going to try to do in the second half of this year, but haven't been on the conversation about next year yet."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Anthony Diclemente with Barclays. Your line is open."
},
{
"speaker": "Anthony Diclemente - Barclays",
"text": "Thanks a lot. I have one for Sheryl and one for David. Sheryl, I'd be interested in hearing a little bit about the relative progress of impression-based selling versus performance-based and you mentioned the ecommerce – the doubling from ecommerce from direct response and I guess I just wanted to know if you've increased the amount of inventory that you're selling on an impression basis versus performance? And then David, I had a follow-up on the CapEx. It just seems like an interesting time for CapEx to be coming in when video usage and video uploads could be growing…"
},
{
"speaker": "Sheryl Sandberg",
"text": "We may have lost the question, but I'll take the first half while we wait for the second piece to come back. On the first piece, our system works that you can buy by CPM or CPC and we let advertisers choose. I think both parts of our business are healthy and growing. I think when people talk about impression-based purchasing or buying, what they're really trying to get at is brands. And brand is a very important, one of our four segments and one that's growing. When you think about what brand spenders are doing, they're trying to get discovery. And I think we've made a lot of progress there. We now work with every one of the global AdAge 100 over the past year. Now that said, people are in different parts of that spectrum. We have brand advertisers who are looking for discovery who have advertised with us for a long time, proven the value and are really expanding and these others that are newer, that are experimenting that aren't as convinced yet and it's our job to get there and convince them. I think what people are increasingly seeing is we have a big brand opportunity. We have a massive engaged audience, 88 million to 100 million people in the U.S. during primetime hours who are on Facebook. We offer discovery and we have a unique opportunity to take people all the way through the funnel. In one example, a recent one that I really like is T-Mobile did an ad campaign with us to attract people to sell new phones. They used our offer ads to do it. 9% of the people who claimed the offer converted to T-Mobile within 10 days and they had over 20 times return on their ad spend which is just incredibly strong in the industry and I think that shows the power of what we can do with impressions, taking people all the way through the funnel."
},
{
"speaker": "David Ebersman",
"text": "Anthony, I'll try and answer your question about CapEx as best I could. You got cut off as you probably know, so I only got about – well, I don't know how much of it I got but I got enough to give it a shot. And really the best way I can think to answer it is to describe for you the variables that influence what CapEx requirements are for the company. So clearly the number of users is near the top of the list, and also the time at which the users use the service. So adding users who are off peak -- the Facebook peak provides less of a burden for our infrastructure than people who are using at the same time as our peak hours, because we can leverage what we built to peak. A second thing is definitely the level of engagement with those users and that seem to be where you were going with your question about video. That is and will continue to be, we hope something that drives up requirements for our infrastructure because it means people are really engaging and finding new ways to use the service. What has helped us I think is the two variables that come next. One is just the cost of the equipment itself and the datacenters and over time Moore’s Law and other things and competition in the market have helped us to really be able to bring down the cost for each unit of equipment we use. And then the next variable which I mentioned in my remarks which I think is a really important one is just the efficiency of what we build. So over time I think Facebook has impressively succeeded at making the hardware we use more efficient and the software that we run on it more efficient in terms of how much compute power that is needs. The last variable of course probably the hardest to predict is product development, is just what we build and how that influences what the computer requirements are. So clearly the variable you emphasized which was engaging with higher content things is one of the things that will influence the CapEx over time, but it's a pretty complicated equation, but I think right now we’re managing well. I think we’re pleased with how 2013 is coming together in that regard."
},
{
"speaker": "Operator",
"text": "The next question comes from Justin Post with Merrill Lynch. Your line is open."
},
{
"speaker": "Justin Post - Bank of America Merrill Lynch",
"text": "Thank you. As we look back since mobile ramp back in 3Q last year, it's been pretty lumpy and it bounced around quarter-over-quarter, but it looks like a pretty big inflection this quarter. Can you help us understand why it has been so lumpy, at least we can think about going forward and maybe what caused the inflection this quarter? And then, I really appreciated the Time Spent metric, I think you said 20 billion minutes per day, but can you tell us how that compares to say a quarter ago or a year ago? Thank you."
},
{
"speaker": "David Ebersman",
"text": "So in terms of the progression of mobile, and we’re really pleased overall that on newsfeed ads in general and on mobile in particular are working so well in terms of the performance they’re providing to marketers and how users are engaging with them. For a new product like this, I don’t think we should be that surprised at the sort of quarter-to-quarter progression it's going to be harder to predict than it would be for a more mature product. I think one of the things that happened in the second quarter is that as the investments we’ve made started to really come together. We had a lot more demand in our system that met the quality bar that we set for feed, so we’re able to place that demand intelligently in a manner where it performed well and didn’t have a meaningful impact on the user experience. So I think that more feed eligible demand was a big part of the story. And I think one of the really good pieces of news for us is how well the price held up as we did that, as we increased the number of ads we showed in feed. So for many of our ads as you know marketers are bidding for clicks in an auction and the auction determines the price for supply both demand, the cost per click price. And in the second quarter and this specific, I’m going to give you is relative to the first quarter of this year because it's hard to do a year-over-year for mobile and for newsfeed because it just didn’t really didn’t exit a year-ago. Q2 relative to Q1, the number of clicks in our system went up a lot and we might have assumed that price would decline as click number increased because we’re basically pushing out the supply curve and changing the point where supply would meet demand. And that’s not what happened. Cost per clicks for feed ads increased and really demonstrating to us that demand was growing rapidly as well as we’re increasing the supply of ads we were showing. So it's not a perfect comparison because Q2 is seasonally stronger than Q1, but it's -- I don’t think the seasonality explains the agenda I just provided. And I think that’s a really encouraging metric for us. And your second question was …"
},
{
"speaker": "Justin Post - Bank of America Merrill Lynch",
"text": "Time spent."
},
{
"speaker": "David Ebersman",
"text": "Time Spent. We just -- unfortunately we don’t have a lot of longitudinal data for Time Spent. It's not something that we had instrumented well going back more deeply in time because it's hard -- well it's hard on every interface and it's particular hard on mobile. We feel pretty good about where we are now in terms of the quality of the instrumentation. It is up on a per user basis. As you would imagine it's not -- it's gone quarter-over-quarter sequentially on a per user basis, it will be growing slowly. On an aggregate basis of course it's benefited from the fact that we have such a nice and consistent increase in the number of daily users of this service."
},
{
"speaker": "Operator",
"text": "The next question comes from Ross Sandler with Deutsche Bank. Your line is open."
},
{
"speaker": "Ross Sandler - Deutsche Bank Securities Inc.",
"text": "Great, thanks guys. David, just the continuation of what you were just talking about, so on the mobile newsfeed ads is the 5% number -- your 5% of stories being at the right number and is that consistent across geo’s. And then is the growth a function of, you just said price is going up sequentially obviously your mobile DAUs are going up or MAUs are going to up sequentially, then you’re probably also seeing improving click through rates. So, of those three variables, users, click through rate and price, which is driving the sequential increase the most in mobile? Thanks."
},
{
"speaker": "David Ebersman",
"text": "So in terms of the 5% number again, what we know is where we are now, and we’re pleased that things are going as well as they are at the current level. So, the number was zero a year ago, it increased steadily over the past year and the 5% number is a average number globally, it does differ by geography and it also differs by person. It will be higher for people for whom we have a lot of more ads that are targeted towards them and are relevant for them, and what we’re trying to do is find the right balance ideally for each user where we’re balancing their experience with Facebook and the performance of the ads and continually tweaking the product, learning from our experience to try and do that as well as we can. Going forward, I think as we have -- I think I’m consistent in saying the biggest opportunity for us is to improve the quality of the ads so that we can show ads that are engaging in relevant for the users involved. Your question about what drove the increase? I think everything contributed. I think that’s one of the things that’s encouraging about where we're, is we do have more users. We have more demand that enabled us to share more newsfeed ads. We’re really pleased with how click through had held up, and I mentioned what was happening in terms of cost per click increasing sequentially. So it's a nice balance contribution from the variables that determine what our revenue performance is."
},
{
"speaker": "Operator",
"text": "The next question comes from Brian Pitz with Jefferies. Your line is open."
},
{
"speaker": "Brian Pitz - Jefferies & Company",
"text": "Thank you, I wonder if you could give us a sense for what the major hurdles are to overcome before deploying a major video ad product on the core site. As you’re out talking to potential clients, can you help us understand what demand looks like for that product. And then maybe separately just a sense for what you’re seeing in Europe from a macro perspective just given some of the mixed news we heard on the economy over there? Thanks so much."
},
{
"speaker": "Sheryl Sandberg",
"text": "On Video ads, we have a current video ad product, because marketers can embed a video in a page post and we see a lot of marketers using that product and seeing good results as a demand to do more in video on Facebook is there. And we’re exploring how we can expand that, but we don’t have anything new to announce today. In terms of Europe, we heard the same things and obviously on the macro environment, but our growth has been very strong. We had a new Head of our European Operations as well. Nicola Mendelsohn who just started, we’re excited to have her and we’re experiencing a strong growth."
},
{
"speaker": "Operator",
"text": "The next question comes from Ben Schachter with Macquarie. Your line is open."
},
{
"speaker": "Ben Schachter - Macquarie Research Equities",
"text": "Congratulations on a really outstanding quarter. Mark I want to ask about the platform strategy and its broadly, how was the strategic vision to allow third-parties to provide services to the network evolved over the past year, and what needs to happen that more of a contribution from non-advertising based businesses?. And David just quickly from modeling, the mobile ad revenue, can you talk about how that progressed through the quarter, did it exit June much stronger than it was earlier in the quarter? Thanks."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yeah, I mean, I can get the platform question. The strategy for that has – we shifted a bit to focus on building more business tools for developers than a lot of work we’re seeing is folks have shifted towards using products like mobile app installs and originally we were – we had a little bit of skepticism about how happy developers would be with a system where they would pay to get more distribution. But what we’ve actually found is that the NBS is really high for this, because it’s just more stable than anything else that they’ve had. In the past it’s the most stable way that they have to grow their app. So we’re basically focused on doing now is – we think about advertisers in terms of these used cases that folks had on this local businesses. They are great brands. They are developers, who are building app, there is an eCommerce and we’re really focused on building up the platform to be one of those big verticals to be a big part of the business. There is also a games part of the platform, which is kind of the first piece of platform that we launched and that is just continuing to grow at a slower, but steady rate."
},
{
"speaker": "David Ebersman",
"text": "Your second question was about progress through the quarter, nothing notable to report there. It was really a strong quarter from the beginning to the end."
},
{
"speaker": "Operator",
"text": "Next, we have a question from Scott Devitt with Morgan Stanley. Your line is open."
},
{
"speaker": "Scott Devitt - Morgan Stanley",
"text": "Thanks. I had a bigger picture question for Mark. I was hoping you could give sort of a scorecard when you're in relative to your founder letter. I know it's been only 14 months and that's a short period of time, but it will be interesting to hear your views on the company's performance against the longer term aspirations and core values that you've put in the letter? Thanks."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yeah, I think we're early. And one of the interesting things over the past six months or so is reaching 1 billion people was this big rallying cry for the company for a long period of time. And I think as we've passed that, we've seen the ambition that the company has grow. And reaching 1 billion users was a great first thing to focus on because no one had ever built a service that had 1 billion active people who were signed in and had real identity before. But in a way it's actually kind of just an abstract, there's nothing magical about 1 billion. The real goal is to connect everyone in the world and help people map out everything that there is. Well, I think what we're seeing is as some of the products succeed is just the ambition increased to be able to do more of these and taking on more longer term things. At the same time, I think what you have is we weren't happy with the quality of our mobile experiences, rewinding 18 months. So we had just a lot of foundational work to do and I think coming into this year, we kind of could tell internally that we were turning a corner on that. We were in good shape and could start to play a bit more offense. But as I think the numbers from this quarter suggest, I think we're really starting to see the upside of some of the investments that we've been making over the last period."
},
{
"speaker": "Operator",
"text": "The next question comes from Mark May with Citigroup. Your line is open."
},
{
"speaker": "Mark May - Citi Investment Research",
"text": "Thanks for taking my question. I have two. One of the things that stood out in your prepared remarks is I think you mentioned 40% year-on-year increase in average price per ad in North America in Q2. I was hoping you could remind us how that compared to say Q1 and given that I think you contributed that to higher performing ads, if maybe you could call out specifically what one or two either ad units or ad targeting enhancements were the kind of key contributors to that growth? And then secondly, David, I think you called out the more challenging comps as you enter into the second half of the year. Are you suggesting that it's kind of unreasonable for us to look at the sequential growth that you saw in the second half of 2012 and assume that that sort of rate of growth is repeatable this year?"
},
{
"speaker": "David Ebersman",
"text": "Okay. In terms of pricing I think – we were pleased with the pricing growth in the first quarter too. The net across the world was a 3% average in the first quarter but that was much higher in the U.S. and Canada, because again for the same reason it wasn't impacted by the price floor change. So it was about 25% in the U.S. and Canada and was even stronger in the second quarter. And similarly in other territories, I think pricing is just going really well and would be stronger than the result show if not for the impact of the price floor. We probably have numbers that are similar to the U.S. and Canada, if not stronger in our other regions as well. In terms of the comps, I don't think there is anything particularly complicated so what I was saying, it's just if you're looking at the percentage growth rates for Q2, you're comparing to a quarter last year that really didn't have much mobile revenue or News Feed revenue in it at all and that really started to ramp up in the third quarter and the fourth quarter. So it's there in one side of the comparison going forward."
},
{
"speaker": "Sheryl Sandberg",
"text": "In terms of where the growth is coming from in terms of ad units, in terms of our market segments direct response marketers are a very big contributor to the growth. That's why I started with them in the remarks and in the Q&A. Ecommerce doubled year-over-year and they're doing that by using a bunch of our different ad products; everything from post to offers to other things, but it's really about looking for those contributions. We've also seen a lot of growth, as I said, in mobile app install ads; small market but growing rapidly and it's a market where we offer a product that there is almost nowhere else to get the kind of returns and opportunity we offer."
},
{
"speaker": "David Ebersman",
"text": "I'm just going to add one more thing just in case I, in anyway, created any confusion and I have no evidence that I did yet. But the price per ad that I was talking about in this question reflects not the same thing as the cost-per-clicks that I answered in a question earlier because price per ad will also incorporate the click-through rate as well as the cost-per-click for click-based ad and also includes ads that are purchased on an impression basis. So most of the pricing metrics we provide are per ad inclusive of click-through rates and impression-based ads. The CPC metric I gave earlier was just, I think, a specific and useful metric in understanding how much strong demand contributed in the second quarter."
},
{
"speaker": "Operator",
"text": "The next question comes from Ken Sena with Evercore Partners. Your line is open."
},
{
"speaker": "Kenneth Sena - Evercore Partners",
"text": "Hi. So just maybe if we could drill into the comment around ecommerce spending doubling and it seems as though FBX and third party effort, its growing fast but its small and the same with the app install effort. But can you talk a little bit about what drove that doubling in Europe year-on-year? Thanks."
},
{
"speaker": "Sheryl Sandberg",
"text": "I think direct response marketers have had more opportunities to use our system, use our product and we've also made a very major investment in helping them measure returns and helping them connect what's happening both online and as well as throughout the system. So direct response marketers tend to be buyers when they have an ROI metric. They're looking for that ROI metric and their budgets are flexible around those ROIs. So as they've invested with us and hit their ROI metrics, their budgets go up and they make those adjustments very quickly. That's why when they start using the products and see the value they create, they are able to grow very quickly even within a quarter or within a week or within a month because they adjusted their budgets."
},
{
"speaker": "Operator",
"text": "Your next question comes from Rory Maher with Hillside Partners. Your line is open."
},
{
"speaker": "Rory Maher - Hillside Partners",
"text": "Thanks. A couple of quick questions. First on hiring, there's been a lot of discussion in the press about tech companies' need for more highly skilled workers and I'm curious if you're feeling pressure to find that kind of highly skilled talent and what areas you find hardest to fill and maybe some successfully that you're finding good engineering talent? And then secondly on the advertiser mix, have you guys discussed your mix of brand advertisers by category like auto, retail, telecom, that kind of category mix? And are there any that have grown particularly well the past year?"
},
{
"speaker": "Mark Zuckerberg",
"text": "Yeah, I can take this. Hiring great people especially engineers is one of the biggest challenges that any technology company has. We're doing really well against the hiring goals that we have. But I mean there was a systemic issue where our country doesn't produce the volume of engineers that the companies would want to hire. And I think that that's a lot of what you hear these companies talking about. We're doing really well competitively right now. We have a really strong program on colleges where we can continue to attract a lot of best people who are graduating. We do really well at hiring senior engineers from across the valley as well. But it's just something that we invest a huge amount of time and it's really important."
},
{
"speaker": "Sheryl Sandberg",
"text": "In terms of where we're growing by category; I've mentioned CPG, gaming, retail, these are vertical categories where we're strong. But again we're growing. We're growing; we're watching people really experiment. One of the things that's been really fun to see even though it's not a pay product is GE is Instagram work. GE is doing super interesting photos on Instagram which show us that other industries are also going to adapt to the social environment and to some of the new ways to reach customers globally."
},
{
"speaker": "Operator",
"text": "The next question comes from Laura Martin with Needham & Company. Your line is open."
},
{
"speaker": "Laura Martin - Needham & Company",
"text": "Hi, there. Great numbers, you guys. Congratulations. Two questions. One on, could you guys clarify the custom advertising bucket? I know you said it was up 100% year-over-year or quarter-over-quarter and a lot of the brands are talking about this as a key growth area. So I'm really interested in how big it's starting for you guys? And then my second question is we're also talking to a lot of companies that target your metrics using UTI integrations and would that create an arbitrage I'm wondering if over time you foresee that being a stable ecosystem or are you guys going to try to ease those guys out over time and grab some of that upside that these arbitragers that are using our platform are garnering today? Thanks."
},
{
"speaker": "Sheryl Sandberg",
"text": "On the first, Custom Audiences is small but growing and important. We doubled what I said as we doubled the number of marketers using the product Q2 over Q1, and that also has included getting us to 50 of the AdAge 100. As I've talked about as a large brand advertisers the AdAge from 100 have a long sales cycle and it takes a lot of work that happened to adapt products and so seeing adoption this quickly of something, we think shows how powerful that targeting is. In terms of some of the more programmatic ways people buy, we think it’s really healthy for us to have multiple sales channels. We like having a direct sales channel, which we have in our 40 – over 40 offices. We like having online and robust sales, because that means that even in countries where we’ve done half offices, we have the ability to sell into those markets. We also like having an eager system of what we call PMDs, third-party sellers who can work with our clients to provide some of the kind of features that we don’t have or some of the kind of capability that they may not have in house. And so for us, we’d like to see all of our sales channels continue to grow and thrive."
},
{
"speaker": "Deborah Crawford",
"text": "Operator, I think we’ve time for one last question."
},
{
"speaker": "Operator",
"text": "The next question comes from Eric Sheridan with UBS. Your line is open."
},
{
"speaker": "Eric Sheridan - UBS",
"text": "Thanks, guys. Congratulations on the numbers. Mark, longer term question focused on your initial comments, how have some of the recent products that are consumer facing that you guys have launched like Graph Search and Facebook Home sort of taught you what the consumer acceptance is for certain things, learnings about how the platform can be developed and evolved over time, would love to get your takeaways on that?"
},
{
"speaker": "Mark Zuckerberg",
"text": "Yeah. Well, I mean I think that there are bunch of different kinds of products that you can ship. I mean everyday we ship a lot of tweaks to the products, or small changes to existing products. Then there are going be to products like Instagram video, which is really doing well and it fits very naturally into the current flow of how people use Instagram to capture moments that they’re proud of. So that makes sense. I think the team did a really good job there. The thing is like Home and Graph Search are really new used cases. I mean in the case of Home, it’s a new category of product that’s different from anything that exist out there and I think of its more a seed that we’re planting that its going to create completely new pillar of the ecosystem rather than drafting off behavior that people already have in the system today. So, I definitely think that we just have to look at this over the long-term. And it’s very – when we’re building models for the Company and we basically think that it’s going to be something that we will invest in for years. And we expect these to become marketing – market leading products and they’re doing things that no-one else really has, the strategic position or content to be able to build these products. So we’re excited about them. There is going to be longer term back. So I think if you wan to look at the different things that we’re doing in terms of how naturally they fit into the flow of a person’s day to day life today to get a sense of how quickly it’s going to ramp up over time."
},
{
"speaker": "Deborah Crawford",
"text": "Great. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again next quarter."
},
{
"speaker": "Operator",
"text": "This concludes today’s conference call. You may now disconnect."
}
] | null | null |
META | 1 | 2,013 | 2013-05-01 17:00:00 | Executives: Mark Zuckerberg - Chairman of the Board, Chief Executive Officer Sheryl Sandberg - Chief Operating Officer, Director David Ebersman - Chief Financial Officer Deborah Crawford - Director of Investor Relations
Analysts: Heather Bellini - Goldman Sachs Anthony Diclemente - Barclays Jordan Rohan - Stifel, Nicolaus & Company Ben Schachter - Macquarie Mark Mahaney - RBC Capital Markets Brian Wieser - Pivotal Research Aaron Kessler - Raymond James Daniel Ernst - Hudson Square Research Ross Sandler - Deutsche Bank Securities Inc. Jordan Monahan - Morgan Stanley Youssef Squali - Cantor Fitzgerald Justin Post - Bank of America Merrill Lynch Gene Munster - Piper Jaffray Kenneth Sena - Evercore Partners Douglas Anmuth - JPMorgan
Operator: Good afternoon. My name is Jay, and I’ll be your conference operator today. At this time, I’d like to welcome everyone to the Facebook First Quarter 2013 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator Instructions) Thank you very much. Ms. Deborah Crawford, Facebook’s Director of Investor Relations, you may begin.
Deborah Crawford: Thank you. Good afternoon, and welcome to Facebook’s first quarter and earnings conference call. Joining me today to talk about our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and David Ebersman, CFO. Before we get started, I’d like to take this opportunity to remind you that during the course of this call, we’ll make forward-looking statements regarding future events and the future financial performance of the Company. We caution you to consider the important risk factors that could cause actual results to differ materially from those in the forward-looking statements in the press release and this conference call. These risk factors are described in our press release and are more fully detailed under the caption Risk Factors in our annual report on Form 10-K filed with the SEC on February 1, 2013. In addition, please note that the date of this conference call is May 2, 2013 and any forward-looking statements that we make today are based on assumptions as of this day. We undertake no obligation to update these statements as a result of new information or future events. During this call, we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today’s earnings press release. This call is being broadcast on the Internet and is available on the Investor Relations section of the Facebook website at investor.fb.com. A rebroadcast of the call will be available after 6 p.m. Pacific Time today. The earnings press release and an accompanying investor presentation are also available on our website. After management’s remarks, we will host a Q&A session. And now, I’d like to turn the call over to Mark.
Mark Zuckerberg: Thanks Deborah and thanks everyone for joining us today. We got off to a good start this year with strong engagements and growth across the community, several major new product announcements and some good financial results. Sometimes it surprises me that our community can still grow so quickly beyond a billion active members. More than 100 million new monthly active members have joined in the last half of the year, and now there are more than 650 million people who use Facebook every day. It's more than 60% of our community every day. We continue to see high levels of engagement globally across our whole community. We take our stewardship of this very seriously. We want to make sure we give every person in the world the power to share and we are proud of these results. Overall, there are three main parts of our strategy. Build the best mobile product, build a platform with new services that leverage the social graph, and build a strong monetization engine. I am going to use my time here with you today to give my assessment of how I think we are doing in each of these areas. Let's start with mobile. One of the products I am most excited about is Facebook Home. It's a family of apps that you can install in your Android phone to make the whole experience of your phone much more personal and about people and not apps. We know that people spend an average of 20% or more of their time in apps on Facebook. Staying up to date with the people they care about, are doing. We use to open the Facebook app maybe 10 to 15 times per day. But we probably check our phones over a hundred times a day. So with Home, you can see fresh news and content from people and topics you care about every time you turn on your screen. It really brings your phone to life and provides with a completely new experience. This product is still very early and this is just a first release in a long journey. We are planning on iterating quickly and tuning things based on feedback. We haven’t really started encouraging people to install it from within app yet, and it's only available on a few phones. But over the next few months we hope to push this out much more broadly and get this in the hands of a lot more people. We are excited about Home because we think it's a great product. But Home is also an important milestone for our company. This is completely new kind of mobile experience based on people, not apps. And we think this is how phones and computers should work. I am looking forward to sharing more with you on the experiences that are brought on mobile that we are building over the rest of this year. Now beyond Home, I am really proud of how Instagram is doing. Kevin and his team have made amazing progress since last April. When we agreed to acquire them, the Instagram community had 22 million people actively using their service every month. And today over 100 million people are using Instagram each month. The Instagram community is growing even faster than the Facebook community did when it was this size. And the two communities complement each other to create some great experiences where you can capture any moment in your life and easily share across all the communities you care about. Now I would like to talk about platform and building new services using a social graph. A couple of months ago we announced a new, richer and simpler design for our News Feed that’s more visual and engaging for all the content that you might want to (inaudible). From new stories from the New York Times to pins from Pinterest, or activities from a game that you played. This new design opens up a nicer canvas for content for every developer and publisher out there. And we think it's going to create a lot more opportunities for engagement. Early feedback has been positive on the versions we have rolled out on iPhone, iPad and desktop web, and we are looking forward to rolling this out more widely since. For our development platform, we have had a long roadmap to build the tools for iOS and Android to make building social app and advertising with Facebook as easy on mobile as it is on desktop web. We conceded this transition by bringing open bringing Open Graph to mobile this month. And our efforts are paying off with now 81 of the top 100 growth in iOS apps and 70 of the top 100 Android apps integrating with Facebook and continuing to grow. One of the developments that’s been interesting is seeing how big of an opportunity mobile apps can be for Facebook. Because of the rules Apple and Google have in this space with their app stores, it wasn’t this clear earlier on what kind of a role Facebook can play. But I think it's clear now that we can create a lot of value for developers by providing a platform for identity and distribution. We are starting to see real revenue through selling mobile apps themselves. We just announced the acquisition of Parse, a platform of service provider for mobile apps as part of our strategy to provide greater support for developers. Both of these products make it easier for developers to create and grow their apps and this could be the start of something much bigger. Now I want to talk a bit about monetization. I just mentioned mobile apps install ads, which are growing quite well and it becomes one of our most important new ad product. This supports our hypothesis that Facebook should help you discover new apps and content that you may want to use. And even it is not every recommendation we make is one that you take. I think this is still starting to provide some really good content for our community and I guess into the business opportunity here. This type of ads makes sense to me on mobile. On desktop web, most ads encourage you to visit a new website. On mobile, it makes sense that most ads encourage you to visit apps instead. And in order to visit apps you first need to install. So these ads are the obvious first step. On mobile, the set of companies that produce apps is much broader than what you might think of as traditional developer. Every major brand, company or service wants to build apps as a storefront or interface for their customers and each of these companies wants to reach their customers to encourage them to install their apps. This market is already big and I expect it to continue to grow quickly. One more thing that’s important to reinforce here is that we continue to measure people’s satisfaction with all the content they see on Facebook, including ads. We haven’t seen any meaningful impact on the satisfaction and we’re continuing to watch this very closely. This is important to us as stewards of this community. We aspire to have ads -- to show ads that improve the content experience over time. If we continue making progress on this then one day we can get there. So that’s my update on our strategy for this quarter. We’ve already accomplished a lot so far this year. We’ve seen strong growth in engagement across our whole community, several major product announcements and good financial results. We think the products like Home and Graph Search are big opportunities to deliver some unique and important services to the world that we’re positioned to do better than anyone else. But these services are also big, long term investments. So I want to be clear upfront that we’re making these big investments because I think these are important areas for us to focus on. Now finally, I want to take a moment to thank everyone who works at Facebook and everyone who makes this community great. All of you are contributing in building these new experiences and helping more than a billion people stay connected. So thank you all and thanks to everyone on this call for being with us today. I look forward to having more to share and report on next quarter. And now I’d like to turn the call over to Sheryl.
Sheryl Sandberg: Thanks Mark. As Mark said, we had a very solid start to this year and we’re excited about the opportunities ahead of us. Our first quarter total revenue was $1.458 billion and total advertising revenue grew to $1.245 billion. This means that ad revenue was up 43% year over year, faster growth than we’ve had in any quarter in 2012. We believe that this shows that our ad products innovations are helping marketers to reach customers effectively. Our growth is particularly strong from new small and medium sized marketers, direct response marketers and app developers. I will use my time with you today to update you on the progress we’ve made in our three strategic ads priorities, mobile, measurements and product innovation. First mobile. As Mark just said, having billions of people carry social devices in their pockets, checking them multiple times a day, often checking Facebook is a huge opportunity for us. A recent comScore report showed that in the U.S, people spend more time on Facebook than on any other app on their smartphones. The opportunity for us to connect people to each other and to marketers has never been greater. We are uniquely positioned to offer marketers massive reach on a daily basis. In Q1, mobile was approximately 30% of our ad revenue, up from about 23% in Q4. Importantly, we’re seeing strong growth in our mobile ads business all around the world, particularly in Asia. As an example, our mobile app install adds performed very well this quarter. We offer developers unique opportunities to drive downloads of their mobile apps as Mark talked about. During the quarter, 3,800 developers used these ads to drive nearly 25 million downloads. Of the top 100 grossing apps from both iOS and Android in the last week of Q1, about 40% of them used our mobile app install ads. In gaming, travel, e-commerce and financial service industry, the early indicators are that our cost per install are highly competitive. In one example, British Telecom provider O2 used Facebook as its only digital marketing channel to promote its new music app, O2 Tracks. In just three days, they reached 9 million people and got to sixth place in iOS apps in music. Second, I want to discuss our progress in measurements. One of the challenges we face is helping marketers understand the value of our ads. This has been a major focus for us over the past several quarters. We’re partnering closely with our clients to help them understand how their campaigns are performing and this measurement work also helps them gain a better understanding of their customers which then makes their future campaigns even better. In the last nine months, we’ve conducted campaign effectiveness studies on over 100 campaigns across CPG, auto, retail and telco. One of these studies was Bud Light. Bud Light ran Page Post ads to its 5.8 million fans on Facebook and these ads appeared in all of our placements, including mobile newsfeeds. We worked with DataLogix and found that these ads reached 20% of U.S. households and had 3.3% sales lift, yielding a six times return on ad spend. A result, we are very proud of and Bud Light is really excited about. We plan to continue to invest heavily in (inaudible) with our clients throughout the upcoming year. We are also really excited about our acquisition of Atlas, which closed just last week and I was able to welcome the team to Facebook earlier today. Atlas is a really important part of continuing to develop our measurement capabilities. For the past decade, digital marketers have primarily measured success by focusing only on clicks. But this over simplifies how people make purchase decisions, both offline and online because it ignores everything people do and see before they do that last press. Smart marketers are looking for a better way to value all of the impressions that they buy and engage thus leading up to purchase. Multiple industry-wide spendings have validated this multi-click attribution approach. For offline sales, both Nielsen and comScore have repeatedly shown that clicks are not a good predictor of sales lift. For online sales, Aggregate Knowledge found in an analysis of more than 500 online campaigns that when clients moved from allocating their advertising spend using last touch attribution to using multi-touch attribution, they saw a 33% increase in actions, conversions in sales. In a study of campaigns from Q4 2012, they found that when measured holistically, costs per acquisition on Facebook is 68% less than other online channels. The DataLogix study validates this finding as well, demonstrating that on average 99% of people who saw Facebook ads and then bought a product in a store never clicked on an ad at all. We believe the Atlas platform will help us demonstrate even more clearly the connection between ad impressions and purchases. We could help marketers measure the effectiveness of their ad impressions better not just on Facebook, but across the entire internet. This means we can take the advancements we have made in measurements on Facebook, including our integrations with Nielsen and Datalogix, and expand them to a much larger audience and to many more purchases. Third, I would like to highlight product innovation in ads. Over the last year we have invested heavily in product innovation and I am excited about what we have accomplished at a relatively short period of time. As always, our top focus is on the results we generate for the marketers, and we are pleased to see the ROI we can provide as well as providing a good experience for our users. We continue to innovate new targeting capability that make it easier for businesses of all sizes to reach the right people, both on desktop and on mobile. In Q1, we gained traction with our Custom Audiences product. This product allows marketers to reach their target audiences based on their own customer databases or databases maintained by third party. For example, a marketer can target ads to customer who have not returned to their store in the past month but do have made purchases before. This product improves their targeting and generates higher ROI for the marketers and a better ad experience for our users. We are really pleased with the adoption of this product. In Q1, more than twice as many marketers used Custom Audiences than in Q4, including, 23 of the Ad Age 100 top global marketers and many other important clients. Companies from Hotels.com to Intuit, to Virgin America are seeing success with this product. In April, we launched another powerful targeted product, Partner Categories. This enables marketers to use third party data from Acxiom, Epsilon and other data providers to target their ads. For example, we can deliver ads to the 12 million people in the U.S. who are likely to purchase a car in the next six months, or to the 19 million people who are active purchasers of hair care products, households that purchase hair care products at multiples with other households, or to the 23 million people in the U.S. who are heavy soda drinkers, we apologize, Mayor Bloomberg. We have also seen more customers begin to use FBX. And we recently launched FBX in News Feed on desktop. We think this will continue to drive the advertiser's options, given that we generally see higher engagement for ads in News Feed. In the last six months of 2012, as one example, re-targeting platform AdRoll saw a 70% lower cost per click on Facebook and on traditional web targeting. FBX was so successful for them that by the beginning of Q1, AdRoll reallocated 63% of their total impressions to Facebook. Overall, we feel really good about our first quarter results. We've made tremendous strides in mobile. We continue to improve our measurement capabilities, most notably with our acquisition of Atlas and we continue to innovate on our key advertising products and tools. We’re still in the early days of developing our adds business and huge opportunities ahead of us. And we thank all of you for your continued interest in our business. Thank you. Now I’ll turn it over to David.
David Ebersman: Thanks, Sheryl, and good afternoon, everyone. I’d like to share with you the progress we made in Q1 against our key financial objectives to increase revenue, to invest aggressively to drive our future growth and to position the company to maximize long term returns for our investors. In March on average 665 million people access Facebook each day, up 26% from last year and representing 60% of the 1.11 billion people who used Facebook during the month. Consistent with last quarter, mobile continues to drive growth and visitation and engagement. 751 million people accessed Facebook from mobile devices in March, up 54% from last year. These numbers do not include Instagram, which continues to grow rapidly as Mark mentioned. Turning to revenue, in Q1 total revenue was up 38% and ad revenue was up 43% compared to last year, driven by the strong performance of newsfeed ads. Exchange rates had no meaningful impact on our revenue growth rates. Ad impressions were up 39% and average price per ad was up 3% compared to last year. The product changes we made and discussed last quarter, primarily lowering the price floor in our option had a significant impact on the price and volume year over year comparisons. In the United States and Canada, where the price floor changes had a smaller effect, average price per ad increased over 25% relative to Q1 of last year, driven by a higher engagement and performance of News feed ads. Mobile ad revenue came in at approximately 30% of ad revenue this quarter versus zero last year and desktop ad revenue in Q1 was essentially flat with last year. As we’ve discussed in the past, most of our advertising clients do not specify that their Facebook ads be shown on desktop only or on mobile only, or rather they put their ads into our system and allow us to show the ads on whatever device where the ads will perform best. Because of this, the flat desktop revenue does not reflect a particular trend relative to desktop demand so much as it reflects the fact that more of our valuable ad inventory is being shown on mobile because that’s where people are spending increasing amounts of time and because the mobile ads perform well. We believe our aggregate ad revenue number remains the most important reflection of our performance in terms of increasing overall advertising demand. And the most important ways for us to continue to increase ad revenue are to grow users and engagements and to build advertising products and measurement tools that increase demand from advertisers of all types around the world. Total payments and other fees revenues was $213 million in Q1, an increase of 15% versus last year. payments revenues from games was up 12%, though we believe 6% represents the best apples to apples comparison in terms of the increase for payments from games if we adjust for items such as the Q4 change in revenue recognition timing. We’re pleased that Q1 represented our largest three months quarter of games revenue to date despite a 37% drop in year over year payments volume from our largest developers as our other developers increased their payments volumes by almost 60% and we saw a record number of people playing games on Facebook. Games revenue in Q1 benefited from the growth of games launched over the past year and also from our efforts to increase games distribution, usage and payments conversion. We believe Facebook continues to offer a compelling platform for developers to build great games and businesses and we will continue to invest in this area. Overall, ARPU increased 12% to $1.35 for the quarter, including a 21% increase in the United States and Canada and double digit gains in the other major regions as well. Shifting now to expenses, in Q1 our total GAAP expenses were $1.08 billion. Excluding stock compensation, total expenses increased 56% to $895 million, driven primarily by headcount and infrastructure spend to support our growth. We continue to expect that our total non-GAAP expenses, including cost of revenue but excluding stock comp, will likely grow in the neighborhood of 50% in 2013 consistent with what we said last quarter as we continue to invest in products to grow engagements and monetization. Our Q1 GAAP operating income was $373 million, representing a 26% operating margin. Excluding stock comp, our non-GAAP operating income was $563 million, representing a 39% non-GAAP operating margin. Our GAAP tax rate for Q1 was 38% and benefitted significantly from the realization of the onetime $94 million R&D tax credit in the quarter. Our Q1 non-GAAP tax rate was 43% and we expect that our full year non-GAAP tax rate will be similar to Q1. GAAP net income and EPS for the quarter were $219 million or $0.09 per share and non-GAAP net income and EPS were $312 million or $0.12 per share. We spent $327 million on CapEx in Q1 and we continue to expect 2013 CapEx to be in the neighborhood of $1.8 billion as we invest in servers and data centers to rapidly and reliably provide our products to people around the world. In Q1, similar to Q4, upon the vesting of employee RSUs, we withheld shares and paid the associated income taxes for our employees, which resulted in an outcome that’s functionally very similar to Facebook having repurchased approximately $400 million worth of shares in Q1. We ended Q1 with $9.5 billion in cash and investments. Overall, we believe that 2013 is off to a good start. We are pleased with our financial performance as well as our progress and product development. We are continuing to invest aggressively in new products that we think will drive long-term engagement as well as product and tools to grow our revenues and increase returns for the advertisers and developers working with us. And we are excited about the opportunity ahead of us to build out the network of people using Facebook and to bring our unique asset in terms of reach, engagement, and identity to our large and important market opportunities. Now let's open the call for questions.
Operator: (Operator Instructions) Your first question comes from Heather Bellini with Goldman Sachs. Your line is open.
Heather Bellini - Goldman Sachs: Mark, I was wondering, you shared with us the continued success of mobile install ads, I was wondering if you could share with us the other monetization initiative that you have that you are most excited about for 2013. And then my follow up for David would be, if you can share with us qualitatively how CPM trended in the various regions on a year-over-year basis.
Sheryl Sandberg: I will take the first question. In terms of our ads priorities, they are what I mentioned, mobile, measurements and product innovation. We are particularly focused on improving the quality of our ads because we think that is the best way to have a great experience for users on Facebook as well as for marketers. I think if you look at the success of Custom Audiences, Partner Categories, FBX, what you see in that are products all move us towards better targeting, more relevance, better experience for users and for our marketers. And we are going to continue to invest very heavily in making the ad experiences as high return as they can for everyone involved.
Mark Zuckerberg: Yes. I will just emphasize the same point. I mean the things I am most excited about are things that are driving quality. I mean the two big levers for the business are, a, obviously a lot of people spend a lot of time using Facebook to stay connected with all the people around them. And second, that is an opportunity to advertise. But I actually think over the long term, the thing that’s going to drive the business to most is getting the ads to be very high quality. Personalize, good content in there. And a lot of the things that we are doing are aligned with that. So App install, a lot of that stuff is just good content that people are interested and there is no great way to find app stores today to discover a lot of apps on mobile devices. Similarly, I talked about the News Feed redesign that we are rolling out. And the content in there is much more visual. And we have always had the policy that the advertising content will display in exactly the same way that the consumer content display is. And making it so that people can share a much more visual content. Making that naturally advertisements can now have the same kind of compelling creative as well, which I think will increase the quality of that and overtime increase the effectiveness as well.
David Ebersman: So Heather, in terms of your question about CPMs. Ads revenue grew well across all the geographic regions that we report on. I mentioned the U.S. and Canada growth in CPMs. We saw a similar number, a little bit lower but similar in Asia. For Europe and rest of the world the numbers were much lower. A little a bit above zero in the case of Europe, a little bit below in the case of the rest of the world. The interesting question around this is, what those numbers might have looked like if we hadn’t made changes in the option dynamics and, such as the price floor and obviously we can’t answer that question quantitatively because we don’t have the data. But we feel pretty strongly and pretty confident that prices would have increased substantially more in all of the regions if we hadn’t made those changes.
Operator: Your next question comes from Ross Sandler with Deutsche Bank. Your line is open.
Ross Sandler - Deutsche Bank Securities Inc.: Just two questions. Engagement first was up across most of the geographies. We assume that’s primarily driven by mobile, but can you talk about anything else that’s driving up engagement. And then just a follow up on the geographies. So it looked like the U.S. had a normal seasonal downtick sequentially whereas international most of those regions held up sequentially. So can you talk about the difference between sell-through rate in the U.S. in newsfeed versus some of those international markets?
David Ebersman: In terms of growth and engagement geographically, I think you can see from the numbers that growth was strong across all the areas of the world. We continue to add a lot of users in places like India and Brazil. And in engagement trends I think were similarly strong throughout and mobile is clearly a big part of that equation and been very helpful to us in terms of getting more users, more daily users and more engagement from those users. In terms of revenue by geography, I don’t know that there’s a lot to add to what the numbers I’ve already said. Europe looks good in the first quarter after being a little bit softer towards the end of last year and we continue to grow well in Asia and the rest of the world. So I think just pretty consistent performance there.
Operator: The next question comes from Scott Devitt with Morgan Stanley. Your line is open.
Jordan Monahan - Morgan Stanley: It’s Jordan Monahan on for Scott. Just two quick questions. The first is, one of your competitors recently said something to the effect of if you’re building for mobile you’re building for today but not tomorrow, suggesting that tomorrow is a multi-screen world with all sorts of personalized devices. And I’m just curious, what opportunities do you see when you think about tomorrow? Would you agree that screen fragmentation will continue to increase and does moving ads towards newsfeed and away from right hand side help you in that environment? And then the second question is just about engagement. Engagement continue to improve despite more ads which validates your strategy. So every time you launch a new product people get concerned that engagement may actually tick down, but it seems to do the opposite. So are there other ad formats that you’re thinking about that are likely to be complimentary to engagement?
Mark Zuckerberg: All right, I’ll start. I think that the trend of more different form factors I think is somewhat orthogonal from the main trend that we see which is just people sharing more in different ways. And people want to stay connected with their friends and family and all these different folks in their lives and they’re going to use whatever technology they have to enable that, whether that’s desktop computers or laptops or phones or tablets or glasses, like whatever the products are. And I think that there’s going to be good ways for people to be able to consume a social content on all of those. So I think the big question for us is just which platforms do we see growing the quickest? We’re not tooled up as a company right now to make 10 huge investments like that at a time. But we can do a couple. Certainly in tablets are growing very quickly and I think that’s going to be increasingly important. But I think that consuming social content and staying connected with people is such a fundamental human need that that’s going to be important on all of these. And getting ads in newsfeed was a valuable step in making it so that everywhere where someone is consuming content from Facebook, the business model goes along with that naturally. And those were the early challenges that we had with mobile with ad for the first six or seven years of Facebook we’re just this right hand column and nothing trends like in mobile. But it was fairly easy with some amount of work just to make that transition. We’re there now and now I think whatever the form factor is going forward we’ll be able to deliver advertising content in a proportion that we think is good along with consumer content. For the sentiment stuff, I think what we’re seeing is really positive. It’s better than expectations and we assumed that sentiment and satisfaction might drop some amount. We continue to watch this really carefully because there’s no guarantee that it won’t in the future. But right now what we have seen has made us more confident that we can do more with advertising over time and can ramp that up. Our strategy isn’t to have like a ton of different ad units. We really want to make it so that we are delivering these end-to-end solutions for our customers and only have a small number of simple things, make it easier for advertisers to work with us. We want to deliver that and we are kind of underway on this long road map to execute that.
Operator: The next question comes from Anthony Diclemente with Barclays. Your line is open.
Anthony Diclemente - Barclays: I have one for Sheryl and one for David. Sheryl, you talked about Atlas and the measurement capabilities there. And you phrased it in terms of click-based ads and I am wondering is there also an opportunity for Atlas to improve or standardize measurement for impression based ads. And I guess the spirit of the question more generally, can you just talk about or update us on the potential for impression based ads in terms of increasing as a percentage of the mix versus performance based ads on Facebook. And then, David, question would be, a little bit of a decel in the rate of growth of ARPU in the U.S. I am wondering if there are other things you can call out in the first quarter, be it dollars from large events, TV events like the Super Bowl or other things, other than seasonality. Or maybe you can quantify or comment on the seasonality factor in the U.S. and Canada for the 1Q?
Sheryl Sandberg: So on Atlas you are exactly right. Our focus with Atlas is on impression based ads. And the idea is that, you know historically a lot of ads online which were more based on search, the attribution was always that last click. And as people have looked more holistically at all the ad spending they are doing, what they find is that it's not just the last click that matters but it's all the impressions leading up to that click. Importantly, we also drive sales offline. And offline people aren’t clicking through the purchase at all but they are actually walking into a store. So in some sense there is no last click. And so our focus with Atlas is to take that technology and enable us to improve our ability to connect ad impressions to purchase behavior both offline and online, and not just on clicks but across different ad purchases people do. So that’s exactly why we made that purchase.
David Ebersman: In terms of ARPU in the U.S. and Canada was up 21% versus last year, so continuing to make good progress there. I really don’t have anything unique to say about seasonality in 2013. We see it from Q4 to Q1 across the years that we have been in an advertising business. And I am sure there are unique things that impact each year but there is nothing that we are aware of that was particularly important in 2013 in that regard.
Operator: The next question comes from Jordan Rohan with Stifel. Your line is open.
Jordan Rohan - Stifel, Nicolaus & Company: I am curious about how you address markets where it's a little bit harder to sell advertising. Specifically, if I'm calculating correctly, 41% of monthly active users are in the U.S., Canada and Europe, as you defined those geographies in your slides, and that's 74% of the ad revenues. How can the other geographies of the world step up to be an even more meaningful percentage of total revenue? Do you have to add a lot of heads, a lot of sales infrastructure and technology infrastructure that you don't currently have? And from that perspective, did you meet your objectives in terms of hiring and expenses, because I know how hard it is to support a business as global as Facebook. Thank you.
Sheryl Sandberg: So, I'm very encouraged about our opportunity to sell ads all over the world. One thing I've learnt in my time selling ads on the internet, which is going over a decade now, is that markets that you don't expect to have ad markets develop faster than you would think. So if you were to ask me seven years ago what Turkey's ad market would look like, I would not have predicted it as today. So I'm increasingly encouraged by small businesses around the world and large businesses, and their adoption of the technology. I think with small businesses we have an actually really deep competitive advantage, which is that people all around the world use Facebook. So when small businesses who are historically way too busy to spend a lot of time using technologies, start to use the Facebook platform, they are using something they already use as users. So once you have a timeline or a profile, setting up a page is not a very big ask because you understand it and you are doing it anyway. And that's why we think with almost no direct effort we have 16 million small businesses actively using Facebook pages. I think one of the things we have done well over the past number of quarters is build out simplified ad products like Promoted Posts, where it's easy for those people who are using pages and it happens all over the world typically on the advertisers and we are increasingly optimistic that we can do more and more of that.
David Ebersman: In terms of hiring, I think everything has gone quite well and as we have discussed 2013 is the year where we're investing for future growth, and I think in the first quarter both in terms of hiring and building out our infrastructure we are on track with where we want to be,
Operator: Our next question comes from Youssef Squali with Cantor Fitzgerald. Your line is open.
Youssef Squali - Cantor Fitzgerald: Two questions, maybe one for Sheryl and one for Mark. On ad pricing can you maybe just talk about CPMs for ads in the newsfeed versus ads on the right hand rail? Can you give us maybe just an idea so the magnitude of the difference between the two was that a big driver for that 21% increase? Then on video advertising I was just wondering, what’s the strategy to bring video advertising to Facebook and both in newsfeed and to desktop initially and then eventually on mobile assuming that there's enough bandwidth for that? Thanks.
David Ebersman: This is David; I'll take the first one which is about CPM. So the ads that we show in newsfeed are displayed more prominently and they are more in the flow of the user's attention. So as you would imagine, we get more engagement with those ads and they end up commanding a much higher average price per ad as you would expect.
Sheryl Sandberg: I'll take the second part. So video is a really exciting area because we have leveraged our scale and engagement and our ability to provide relevant ads. We have a video product out today. Advertisers can embed a video in their page post, and we're seeing really strong results. I think both because of that and because of marketers' inherent liking video as a format, we continue to explore new things as well, but we don't have anything to announce today.
Operator: Our next question comes from Justin Post with Bank of America Merrill Lynch. Your line is open.
Justin Post - Bank of America Merrill Lynch: I guess two questions, first on ad formats. Sheryl, do you think you've really optimized the ad formats, especially on PC or is there a lot of room you can do to get better performance from that? And then secondly, maybe you could just give us a business update on Instagram, maybe you could compare where they are to where Facebook was when you turned on ads or any thoughts on how you could monetize that platform maybe far down the road?
Sheryl Sandberg: On the first -- I think there's a lot of room to improve our ads. I don't know whether that'll take the format of different formats. I think more of it will be in terms of quality because I think we feel pretty good about our formats. But one of the main pushes we had is to make each ad a better experience for users, content in those ads, which is as good as the content they'll see from a friend or anything else on the site, as well as make those higher return for marketers and those two go hand in hand. I think the place you will see the most from us is more around targeting, around ability to take the formats we have and make the ads better within those formats. That’s certainly our focus now. But as our site evolves and our product evolves, we never rule out changing the format as well.
Mark Zuckerberg: Yes, on Instagram they're really doing well and growing really quickly. and I think that is the right for them and they have this opportunity to capture and basically build off this huge community. And I think that that should be a 100% of the focus right now. I am really optimistic about the business opportunity there too. You already have a lot of brands and folks who advertise with Facebook putting content in Instagram, getting huge engagement rates. So people are coming to us and asking for ways to make that even richer and it's something that we're thinking about. But right now I think that -- I'm just really product of the team and excited about how quickly they're growing. I mentioned this in my comments early on, but they're growing a lot faster now and we’re faster to get to 100 million than Facebook even was.
Operator: Your next question comes from Gene Munster with Piper Jaffray. Your line is open.
Gene Munster - Piper Jaffray: You've seen some acceleration of revenue over the last three quarters and can you just give us some guidelines in terms of should we continue to see that accelerate? And if not, at some point in the back half of this year or early next year based on some of the investments in new products, could we see another inflection point in growth? Thank you.
David Ebersman: I think we're still in the really early days of what we're doing and that's particularly true in mobile. A year ago, we didn't have any mobile ad revenue and now it's 30% of our ad revenue. So this is great. We're really pleased with the progress and we still believe that mobile has the opportunity to be huge for us if we can execute well. We've got a really large mobile user base. They are very engaged and spend a lot of time with us. We have an ad format that works on mobile and we have identity so that we can put the right ads in front of the right people. So, I think the future for us is I think much more interesting than trying to project it from any particular quarter at this point, just because we've got a lot less to do. And, obviously, we will continue to try and develop tools to enable us to monetize our advertising better and potentially in different ways as well. But the big opportunity that's right in front of us is trying to make the mobile advertising products higher quality and more relevant over time.
Operator: Your next question comes from Ben Schachter with Macquarie. Your line is open.
Ben Schachter - Macquarie: A couple of issues for Mark. I was wondering, first, if you could talk about the platform strategy and maybe give some specific examples of third parties that have really been successful. And in general, what are the lessons that you've learned around the platform strategy, how it's evolved? And then secondly, just around the evolution of Graph Search, any lessons from the launch, positive or negative?
Mark Zuckerberg: Sure. I mean one thing that I think has actually gone well with the platform recently is the gaming ecosystem. I mean David was talking about this earlier, but with the exception of our largest partner, Zynga, whose growth hasn't been as awesome as everyone would hope, the rest of the community is actually growing quite well and is quite healthy. So, we're pretty happy with that and it's a pretty diverse group. I mentioned in my comments at the beginning, I mean we have as many as 81 of the top 100 top grossing iOS apps and 70 of the top grossing Android apps that are connected in with Facebook. So we're getting good coverage, right. And that's all has been the vision, it's making it so that any apps and experience that you have can be social. So that's working well. Also we really want to be a source that developers can come to for distribution and make it such that they can come to Facebook and spread their apps. People have always had good tools to do it organically, but recently the App Install ad product has been another tool in developers' arsenal in order to do that and that's showing some real traction. So, I'm pretty excited about that as well. Graph Search was your other question. And the strategy around it and kind of where we are in rolling out is, we developed it over a period of time at the company and we knew that in order to get it to be really good we had to get some real world data. So we rolled it out to just a small percent of people in order to be able to tune the ranking and all that. We're getting into a state where we are really happy with it before we roll it out to everyone. But we're really optimistic that that will happen over the coming months. So, I'm pretty excited about that. The people who use it, we've gotten very positive feedback from it and I think it's going to be a very big opportunity. But the launch wasn't this point where we expected a ton of people to start using it. We've gated who can use it quite aggressively in order to just make sure that we get the data that we need and the real rollout will hopefully start pretty soon.
Operator: The next question comes from Mark Mahaney with RBC. Your line is open.
Mark Mahaney - RBC Capital Markets: I was wondering if you could talk about engagement per cohort. There is an urban myth that those under 25 are disengaging from Facebook. It's hard for us to see that in obviously the day that you report, but you would know that. Is the mobile engagement, is that offsetting that? Could you talk about that engagement amongst younger cohorts? And then secondly, you talked about advertising on mobile devices performing well. Could you actually make the statement as to whether it performs as well as desktop ads do for advertisers on Facebook, similar to, sometimes great or sometimes less? Could you compare those two? Thank you.
David Ebersman: Sure. I guess I'd start by saying we remain really pleased with the high level of engagement on Facebook by people of all ages around the world. You asked about people under 25, we continue to have really high penetration rates among that age group, both in the U.S. and globally. And the younger users remain among the most active and engaged users that we have on Facebook. And then in addition, younger users are extremely active users of Instagram as well. So that's great and makes our position even stronger. I think, from our standpoint, the urban legend you referenced, sort of flows more often than not from surveys people have done of younger users that indicate that they're using other social services. And we take this feedback seriously but our sense is that much of the concern stems from the assumption that this is a zero sum game and that's not how we see it. We think the overall amount of time spent on services that enable you to connect and share is growing and will continue to grow, because these kinds of services are really engaging and good. And it's great for us to be the leader in a market that's expanding rapidly with the foundation we have with both Facebook and Instagram and I guess the challenge for us is to just continue building great products that appeal to users of all ages. Your second question about the engagement levels are the performance of mobile ads, I think it's fair to say that newsfeed ads on both mobile and desktop both perform extremely well and we're pleased with both formats.
Operator: The next question comes from Ken Sena with Evercore Partners. Your line is open.
Kenneth Sena - Evercore Partners: I was just hoping that you could go back to Atlas for a second and maybe give us a sense of maybe the run rate quarter-on-quarter. And is it correct to see Atlas is kind of an avenue into monetizing potential inventory off of Facebook and how do Home and maybe your mobile Open Graph tie into that strategy. Thank you.
Sheryl Sandberg: Our main focus with Atlas is our own measurement, that being able to measure Facebook ads all the way through to purchase and then compare those on an apples to apples play with other ad purchases you make not on Facebook is really important to drive marketer engagement with us and that's our focus. We have no plans for launching that network. We also don’t break out -- we’re not breaking out the revenues from Atlas.
David Ebersman: And it’s small. So Atlas is -- we didn’t buy Atlas for the run rate of its revenues, but because we feel like it’s a tool that can help us to grow our own business.
Operator: The next question comes from Douglas Anmuth with JPMorgan. Your line is open.
Douglas Anmuth - JPMorgan: Sheryl, you talked about having strong traction with SMBs and also in direct response and app developers and then also about Atlas and attribution. But can you help us understand the biggest hurdles that you have right now with big marketers? And then secondly, David, if you could help us understand the percentage of mobile ads revenue that’s coming from mobile app Install ads?
Sheryl Sandberg: There are lots of types of big marketers. There are big marketers out there who are direct marketers. There are also big marketers who are brand marketers. I think the question probably is about the brand so that's how I’ll answer it, even though it’s worth noting that there are big advertisers across the spectrum of different type of ad buys. As I’ve said before, the thing about brand advertisers is that they got very used to TV and they got very used to search and we are a third thing. And we will win that business client by client, CMO by CMO. It’s something I personally spend a lot of time on and I think we have a great team in the field again. With some of the big brand advertisers, we have been working with them for years and years. A lot of the data and measurement you hear us talking about are studies we’ve done with them based on campaigns that we’ve run with. And I think we have a lot of belief at the top and in many of them we are in the process of going through their companies and getting that same commitment to buy. So we’ll have a CMO who has seen the value, we’ve proven the value and really wants the company to come along. And now we are in the process of working brand by brand, region by region to get that same buy-in lower in the organization, which actually takes more time not surprisingly. With other brand marketers, they are just in a testing phase and they really haven't done enough with us so that we can even do the studies to prove the value. And so the good news with us is we're engaged with all 100, Ad Age 100. So everyone is buying with us on an annual basis and we're working client by client to bring them along that spectrum. The good news is I think we're increasingly proving that we can return on ad spend in different parts of the purchase funnel. So to share one recent example, MGM Resorts have used a different suite of Facebook products to address different customers at different parts of the purchase funnel. They used offers to acquire new customers and they saw a three times return on ad spend. Then they used FBX to retarget people who were in their booking process and dropped out and that gave them a 15 times return on ad spend. And then for past guests who had completed a purchase but hadn’t come back, they used custom audiences to target them to return and they got a five times return. And I think it's experiences like that where we show the breadth of what we can do that really move us forward with the brand spenders.
David Ebersman: You asked about mobile app install ads. So we launched that product I think at the beginning of the fourth quarter more broadly. So it's early in its development, but really doing quite well. And we're pleased with both the quality of experiences we're providing and with the revenue growth that we've seen. It really fits in nicely with the idea of putting content into newsfeeds that we think will be of interest to users and provide value for developers. I guess the only other thing I've noticed that it's an incremental audience for us for the most part from an advertising standpoint which is also nice. Some of those developers were advertising with us before a lot of the mobile app Install Ad purchasers or new advertisers to Facebook.
Operator: The next question comes from Brian Wieser with Pivotal Research. Your line is open.
Brian Wieser - Pivotal Research: First of all, I just want to go back into the segments of the advertisers between the brands, developers, small businesses and performance. Is there any way you can characterize what maybe the growth trends have been, even recognizing some of them below the lines or ultimately growth trends between the different ad products. I find it useful to get a sense of where the relative growth is, that will be useful. And then a second question, I just want to get updated thoughts on datacenters and the role of datacenters for Facebook. The degree to which you think that it is strategic in investing and building these out or if it's really just about operational efficiency?
David Ebersman: So in terms of the segments, it's really hard to breakup the revenue because the same advertiser crosses multiple segments with multiple objectives, sometimes with the same ads. So one of the ways we use the segment is to help focus our product development on understanding the different objectives that marketers might have, but then translating that into individual groups of revenue is difficult. So I think that, as Sheryl mentioned, we're particularly pleased with small businesses. That's something that we can measure on Facebook and see the number of advertisers increasing. In terms of datacenters, I think it is both strategic and operational. There's no question that owning our own datacenters removes sort of another party from the mix relative to when we used to lease datacenter space. It also enables us to build the datacenters to look exactly as we want them to look so that the performance is optimized for precisely what Facebook needs to do with the servers that we put in there, and there's definitely some efficiency that comes from that. But I would also say that it is, given what we are trying to do in the world we are trying to reach, I do think it's strategic for Facebook to not be dependent on third parties to provide that critical part of our supply chain.
Operator: The next question comes from Aaron Kessler with Raymond James. Your line is open.
Aaron Kessler - Raymond James: Yes, couple of questions. On the unpublished Page posts, can you give us an update. I think that got released towards the end of the first quarter, maybe what type of traction you're seeing there. And also going back to kind of U.S. versus Europe, can you just maybe detail -- Europe definitely outperformed U.S. on a sequential basis, was that due to some of the later adoption of some of the sponsor stories in the News Feed or is that something else?
Sheryl Sandberg: On Page post, Page post ads first appeared May of last year and then we just put them into News Feed in March of 2013. In terms of unpublished, what that just means is the ability to target Page post only to the right people. So, for example, without posting it to everyone on your page. For example, if you are a retailer and there was a snow storm in one state, you could target snow shovels or other relevant stuff you want to sell for snow storms only to people in that state. So, it's just a really useful way of segmenting your audience, again part of our overall push to relevant targeting and quality. We're really excited about Page post ads. Over 7.5 million posts have been promoted by pages. Over 30% of the people using the product are new advertisers basically. And I think that speaks to one of the earlier questions on small-to-medium business and their adoption. If you say to an SMB, do you want to become an advertiser, that's a heavy lift. If you say to them, you have a page, you've posted something, do you want to pay a few dollars to promote this post to reach more people, that is a much easier on ramp to advertising spend with us and we think it's working really well.
David Ebersman: In terms of U.S. and Europe, I really don't have a lot more to add. The Europe number as I said was strong in Q1. I'm certain it's true that for some of the products that we roll out the U.S. represents the first adapters and then they spread their way to other clients around the world. But I don't have any specific evidence to support that that was key to the trends in Q1.
Deborah Crawford: Operator, I think we have time for one more question.
Operator: The next question comes from Daniel Ernst with Hudson Square Research. Your line is open.
Daniel Ernst - Hudson Square Research: Two questions if I may. If we look at the broad base of all ad impressions across Facebook whether it's desktop or mobile, can you give us a sense of what percentage of those are generated or conditioned by social statistics or socially relevant data that comes out of the Facebook experience versus ads conditioned by external data like from Acxiom or it's from retargeting traffic from other websites. And then second, within the category of apps and others, can you give us a sense of is there any materiality around the other categories that’s not apps payments or what part of that might have been Facebook type services like gifts? Thank you.
David Ebersman: So to your first question on mobile and I think the question was on mobile ad load, is that right?
Daniel Ernst - Hudson Square Research: No. It was whether it's mobile or desktop, what part of the --?
David Ebersman: All right. I got lost in the second question which I should have written down to the first one. So right now you asked about Acxiom and things like that. That’s a very small percentage of the ad impressions we show. So hopefully overtime we can bring tools to bear that can really increase our ability to do more targeting and more effective targeting than we do today. In terms of the second part, I think you're asking about the whole payments and another fees revenue lines. So I said the whole line grew by 15%. Games represented 12% growth. So the increment in between the 12% and the 15% came primarily from user promoted posts, which is a product we launched last year to a lesser degree also from our gifts product.
Sheryl Sandberg: Great. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again next quarter.
Operator: This concludes today's conference call. You may now disconnect. | [
{
"speaker": "Executives",
"text": "Mark Zuckerberg - Chairman of the Board, Chief Executive Officer Sheryl Sandberg - Chief Operating Officer, Director David Ebersman - Chief Financial Officer Deborah Crawford - Director of Investor Relations"
},
{
"speaker": "Analysts",
"text": "Heather Bellini - Goldman Sachs Anthony Diclemente - Barclays Jordan Rohan - Stifel, Nicolaus & Company Ben Schachter - Macquarie Mark Mahaney - RBC Capital Markets Brian Wieser - Pivotal Research Aaron Kessler - Raymond James Daniel Ernst - Hudson Square Research Ross Sandler - Deutsche Bank Securities Inc. Jordan Monahan - Morgan Stanley Youssef Squali - Cantor Fitzgerald Justin Post - Bank of America Merrill Lynch Gene Munster - Piper Jaffray Kenneth Sena - Evercore Partners Douglas Anmuth - JPMorgan"
},
{
"speaker": "Operator",
"text": "Good afternoon. My name is Jay, and I’ll be your conference operator today. At this time, I’d like to welcome everyone to the Facebook First Quarter 2013 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator Instructions) Thank you very much. Ms. Deborah Crawford, Facebook’s Director of Investor Relations, you may begin."
},
{
"speaker": "Deborah Crawford",
"text": "Thank you. Good afternoon, and welcome to Facebook’s first quarter and earnings conference call. Joining me today to talk about our results are Mark Zuckerberg, CEO; Sheryl Sandberg, COO; and David Ebersman, CFO. Before we get started, I’d like to take this opportunity to remind you that during the course of this call, we’ll make forward-looking statements regarding future events and the future financial performance of the Company. We caution you to consider the important risk factors that could cause actual results to differ materially from those in the forward-looking statements in the press release and this conference call. These risk factors are described in our press release and are more fully detailed under the caption Risk Factors in our annual report on Form 10-K filed with the SEC on February 1, 2013. In addition, please note that the date of this conference call is May 2, 2013 and any forward-looking statements that we make today are based on assumptions as of this day. We undertake no obligation to update these statements as a result of new information or future events. During this call, we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today’s earnings press release. This call is being broadcast on the Internet and is available on the Investor Relations section of the Facebook website at investor.fb.com. A rebroadcast of the call will be available after 6 p.m. Pacific Time today. The earnings press release and an accompanying investor presentation are also available on our website. After management’s remarks, we will host a Q&A session. And now, I’d like to turn the call over to Mark."
},
{
"speaker": "Mark Zuckerberg",
"text": "Thanks Deborah and thanks everyone for joining us today. We got off to a good start this year with strong engagements and growth across the community, several major new product announcements and some good financial results. Sometimes it surprises me that our community can still grow so quickly beyond a billion active members. More than 100 million new monthly active members have joined in the last half of the year, and now there are more than 650 million people who use Facebook every day. It's more than 60% of our community every day. We continue to see high levels of engagement globally across our whole community. We take our stewardship of this very seriously. We want to make sure we give every person in the world the power to share and we are proud of these results. Overall, there are three main parts of our strategy. Build the best mobile product, build a platform with new services that leverage the social graph, and build a strong monetization engine. I am going to use my time here with you today to give my assessment of how I think we are doing in each of these areas. Let's start with mobile. One of the products I am most excited about is Facebook Home. It's a family of apps that you can install in your Android phone to make the whole experience of your phone much more personal and about people and not apps. We know that people spend an average of 20% or more of their time in apps on Facebook. Staying up to date with the people they care about, are doing. We use to open the Facebook app maybe 10 to 15 times per day. But we probably check our phones over a hundred times a day. So with Home, you can see fresh news and content from people and topics you care about every time you turn on your screen. It really brings your phone to life and provides with a completely new experience. This product is still very early and this is just a first release in a long journey. We are planning on iterating quickly and tuning things based on feedback. We haven’t really started encouraging people to install it from within app yet, and it's only available on a few phones. But over the next few months we hope to push this out much more broadly and get this in the hands of a lot more people. We are excited about Home because we think it's a great product. But Home is also an important milestone for our company. This is completely new kind of mobile experience based on people, not apps. And we think this is how phones and computers should work. I am looking forward to sharing more with you on the experiences that are brought on mobile that we are building over the rest of this year. Now beyond Home, I am really proud of how Instagram is doing. Kevin and his team have made amazing progress since last April. When we agreed to acquire them, the Instagram community had 22 million people actively using their service every month. And today over 100 million people are using Instagram each month. The Instagram community is growing even faster than the Facebook community did when it was this size. And the two communities complement each other to create some great experiences where you can capture any moment in your life and easily share across all the communities you care about. Now I would like to talk about platform and building new services using a social graph. A couple of months ago we announced a new, richer and simpler design for our News Feed that’s more visual and engaging for all the content that you might want to (inaudible). From new stories from the New York Times to pins from Pinterest, or activities from a game that you played. This new design opens up a nicer canvas for content for every developer and publisher out there. And we think it's going to create a lot more opportunities for engagement. Early feedback has been positive on the versions we have rolled out on iPhone, iPad and desktop web, and we are looking forward to rolling this out more widely since. For our development platform, we have had a long roadmap to build the tools for iOS and Android to make building social app and advertising with Facebook as easy on mobile as it is on desktop web. We conceded this transition by bringing open bringing Open Graph to mobile this month. And our efforts are paying off with now 81 of the top 100 growth in iOS apps and 70 of the top 100 Android apps integrating with Facebook and continuing to grow. One of the developments that’s been interesting is seeing how big of an opportunity mobile apps can be for Facebook. Because of the rules Apple and Google have in this space with their app stores, it wasn’t this clear earlier on what kind of a role Facebook can play. But I think it's clear now that we can create a lot of value for developers by providing a platform for identity and distribution. We are starting to see real revenue through selling mobile apps themselves. We just announced the acquisition of Parse, a platform of service provider for mobile apps as part of our strategy to provide greater support for developers. Both of these products make it easier for developers to create and grow their apps and this could be the start of something much bigger. Now I want to talk a bit about monetization. I just mentioned mobile apps install ads, which are growing quite well and it becomes one of our most important new ad product. This supports our hypothesis that Facebook should help you discover new apps and content that you may want to use. And even it is not every recommendation we make is one that you take. I think this is still starting to provide some really good content for our community and I guess into the business opportunity here. This type of ads makes sense to me on mobile. On desktop web, most ads encourage you to visit a new website. On mobile, it makes sense that most ads encourage you to visit apps instead. And in order to visit apps you first need to install. So these ads are the obvious first step. On mobile, the set of companies that produce apps is much broader than what you might think of as traditional developer. Every major brand, company or service wants to build apps as a storefront or interface for their customers and each of these companies wants to reach their customers to encourage them to install their apps. This market is already big and I expect it to continue to grow quickly. One more thing that’s important to reinforce here is that we continue to measure people’s satisfaction with all the content they see on Facebook, including ads. We haven’t seen any meaningful impact on the satisfaction and we’re continuing to watch this very closely. This is important to us as stewards of this community. We aspire to have ads -- to show ads that improve the content experience over time. If we continue making progress on this then one day we can get there. So that’s my update on our strategy for this quarter. We’ve already accomplished a lot so far this year. We’ve seen strong growth in engagement across our whole community, several major product announcements and good financial results. We think the products like Home and Graph Search are big opportunities to deliver some unique and important services to the world that we’re positioned to do better than anyone else. But these services are also big, long term investments. So I want to be clear upfront that we’re making these big investments because I think these are important areas for us to focus on. Now finally, I want to take a moment to thank everyone who works at Facebook and everyone who makes this community great. All of you are contributing in building these new experiences and helping more than a billion people stay connected. So thank you all and thanks to everyone on this call for being with us today. I look forward to having more to share and report on next quarter. And now I’d like to turn the call over to Sheryl."
},
{
"speaker": "Sheryl Sandberg",
"text": "Thanks Mark. As Mark said, we had a very solid start to this year and we’re excited about the opportunities ahead of us. Our first quarter total revenue was $1.458 billion and total advertising revenue grew to $1.245 billion. This means that ad revenue was up 43% year over year, faster growth than we’ve had in any quarter in 2012. We believe that this shows that our ad products innovations are helping marketers to reach customers effectively. Our growth is particularly strong from new small and medium sized marketers, direct response marketers and app developers. I will use my time with you today to update you on the progress we’ve made in our three strategic ads priorities, mobile, measurements and product innovation. First mobile. As Mark just said, having billions of people carry social devices in their pockets, checking them multiple times a day, often checking Facebook is a huge opportunity for us. A recent comScore report showed that in the U.S, people spend more time on Facebook than on any other app on their smartphones. The opportunity for us to connect people to each other and to marketers has never been greater. We are uniquely positioned to offer marketers massive reach on a daily basis. In Q1, mobile was approximately 30% of our ad revenue, up from about 23% in Q4. Importantly, we’re seeing strong growth in our mobile ads business all around the world, particularly in Asia. As an example, our mobile app install adds performed very well this quarter. We offer developers unique opportunities to drive downloads of their mobile apps as Mark talked about. During the quarter, 3,800 developers used these ads to drive nearly 25 million downloads. Of the top 100 grossing apps from both iOS and Android in the last week of Q1, about 40% of them used our mobile app install ads. In gaming, travel, e-commerce and financial service industry, the early indicators are that our cost per install are highly competitive. In one example, British Telecom provider O2 used Facebook as its only digital marketing channel to promote its new music app, O2 Tracks. In just three days, they reached 9 million people and got to sixth place in iOS apps in music. Second, I want to discuss our progress in measurements. One of the challenges we face is helping marketers understand the value of our ads. This has been a major focus for us over the past several quarters. We’re partnering closely with our clients to help them understand how their campaigns are performing and this measurement work also helps them gain a better understanding of their customers which then makes their future campaigns even better. In the last nine months, we’ve conducted campaign effectiveness studies on over 100 campaigns across CPG, auto, retail and telco. One of these studies was Bud Light. Bud Light ran Page Post ads to its 5.8 million fans on Facebook and these ads appeared in all of our placements, including mobile newsfeeds. We worked with DataLogix and found that these ads reached 20% of U.S. households and had 3.3% sales lift, yielding a six times return on ad spend. A result, we are very proud of and Bud Light is really excited about. We plan to continue to invest heavily in (inaudible) with our clients throughout the upcoming year. We are also really excited about our acquisition of Atlas, which closed just last week and I was able to welcome the team to Facebook earlier today. Atlas is a really important part of continuing to develop our measurement capabilities. For the past decade, digital marketers have primarily measured success by focusing only on clicks. But this over simplifies how people make purchase decisions, both offline and online because it ignores everything people do and see before they do that last press. Smart marketers are looking for a better way to value all of the impressions that they buy and engage thus leading up to purchase. Multiple industry-wide spendings have validated this multi-click attribution approach. For offline sales, both Nielsen and comScore have repeatedly shown that clicks are not a good predictor of sales lift. For online sales, Aggregate Knowledge found in an analysis of more than 500 online campaigns that when clients moved from allocating their advertising spend using last touch attribution to using multi-touch attribution, they saw a 33% increase in actions, conversions in sales. In a study of campaigns from Q4 2012, they found that when measured holistically, costs per acquisition on Facebook is 68% less than other online channels. The DataLogix study validates this finding as well, demonstrating that on average 99% of people who saw Facebook ads and then bought a product in a store never clicked on an ad at all. We believe the Atlas platform will help us demonstrate even more clearly the connection between ad impressions and purchases. We could help marketers measure the effectiveness of their ad impressions better not just on Facebook, but across the entire internet. This means we can take the advancements we have made in measurements on Facebook, including our integrations with Nielsen and Datalogix, and expand them to a much larger audience and to many more purchases. Third, I would like to highlight product innovation in ads. Over the last year we have invested heavily in product innovation and I am excited about what we have accomplished at a relatively short period of time. As always, our top focus is on the results we generate for the marketers, and we are pleased to see the ROI we can provide as well as providing a good experience for our users. We continue to innovate new targeting capability that make it easier for businesses of all sizes to reach the right people, both on desktop and on mobile. In Q1, we gained traction with our Custom Audiences product. This product allows marketers to reach their target audiences based on their own customer databases or databases maintained by third party. For example, a marketer can target ads to customer who have not returned to their store in the past month but do have made purchases before. This product improves their targeting and generates higher ROI for the marketers and a better ad experience for our users. We are really pleased with the adoption of this product. In Q1, more than twice as many marketers used Custom Audiences than in Q4, including, 23 of the Ad Age 100 top global marketers and many other important clients. Companies from Hotels.com to Intuit, to Virgin America are seeing success with this product. In April, we launched another powerful targeted product, Partner Categories. This enables marketers to use third party data from Acxiom, Epsilon and other data providers to target their ads. For example, we can deliver ads to the 12 million people in the U.S. who are likely to purchase a car in the next six months, or to the 19 million people who are active purchasers of hair care products, households that purchase hair care products at multiples with other households, or to the 23 million people in the U.S. who are heavy soda drinkers, we apologize, Mayor Bloomberg. We have also seen more customers begin to use FBX. And we recently launched FBX in News Feed on desktop. We think this will continue to drive the advertiser's options, given that we generally see higher engagement for ads in News Feed. In the last six months of 2012, as one example, re-targeting platform AdRoll saw a 70% lower cost per click on Facebook and on traditional web targeting. FBX was so successful for them that by the beginning of Q1, AdRoll reallocated 63% of their total impressions to Facebook. Overall, we feel really good about our first quarter results. We've made tremendous strides in mobile. We continue to improve our measurement capabilities, most notably with our acquisition of Atlas and we continue to innovate on our key advertising products and tools. We’re still in the early days of developing our adds business and huge opportunities ahead of us. And we thank all of you for your continued interest in our business. Thank you. Now I’ll turn it over to David."
},
{
"speaker": "David Ebersman",
"text": "Thanks, Sheryl, and good afternoon, everyone. I’d like to share with you the progress we made in Q1 against our key financial objectives to increase revenue, to invest aggressively to drive our future growth and to position the company to maximize long term returns for our investors. In March on average 665 million people access Facebook each day, up 26% from last year and representing 60% of the 1.11 billion people who used Facebook during the month. Consistent with last quarter, mobile continues to drive growth and visitation and engagement. 751 million people accessed Facebook from mobile devices in March, up 54% from last year. These numbers do not include Instagram, which continues to grow rapidly as Mark mentioned. Turning to revenue, in Q1 total revenue was up 38% and ad revenue was up 43% compared to last year, driven by the strong performance of newsfeed ads. Exchange rates had no meaningful impact on our revenue growth rates. Ad impressions were up 39% and average price per ad was up 3% compared to last year. The product changes we made and discussed last quarter, primarily lowering the price floor in our option had a significant impact on the price and volume year over year comparisons. In the United States and Canada, where the price floor changes had a smaller effect, average price per ad increased over 25% relative to Q1 of last year, driven by a higher engagement and performance of News feed ads. Mobile ad revenue came in at approximately 30% of ad revenue this quarter versus zero last year and desktop ad revenue in Q1 was essentially flat with last year. As we’ve discussed in the past, most of our advertising clients do not specify that their Facebook ads be shown on desktop only or on mobile only, or rather they put their ads into our system and allow us to show the ads on whatever device where the ads will perform best. Because of this, the flat desktop revenue does not reflect a particular trend relative to desktop demand so much as it reflects the fact that more of our valuable ad inventory is being shown on mobile because that’s where people are spending increasing amounts of time and because the mobile ads perform well. We believe our aggregate ad revenue number remains the most important reflection of our performance in terms of increasing overall advertising demand. And the most important ways for us to continue to increase ad revenue are to grow users and engagements and to build advertising products and measurement tools that increase demand from advertisers of all types around the world. Total payments and other fees revenues was $213 million in Q1, an increase of 15% versus last year. payments revenues from games was up 12%, though we believe 6% represents the best apples to apples comparison in terms of the increase for payments from games if we adjust for items such as the Q4 change in revenue recognition timing. We’re pleased that Q1 represented our largest three months quarter of games revenue to date despite a 37% drop in year over year payments volume from our largest developers as our other developers increased their payments volumes by almost 60% and we saw a record number of people playing games on Facebook. Games revenue in Q1 benefited from the growth of games launched over the past year and also from our efforts to increase games distribution, usage and payments conversion. We believe Facebook continues to offer a compelling platform for developers to build great games and businesses and we will continue to invest in this area. Overall, ARPU increased 12% to $1.35 for the quarter, including a 21% increase in the United States and Canada and double digit gains in the other major regions as well. Shifting now to expenses, in Q1 our total GAAP expenses were $1.08 billion. Excluding stock compensation, total expenses increased 56% to $895 million, driven primarily by headcount and infrastructure spend to support our growth. We continue to expect that our total non-GAAP expenses, including cost of revenue but excluding stock comp, will likely grow in the neighborhood of 50% in 2013 consistent with what we said last quarter as we continue to invest in products to grow engagements and monetization. Our Q1 GAAP operating income was $373 million, representing a 26% operating margin. Excluding stock comp, our non-GAAP operating income was $563 million, representing a 39% non-GAAP operating margin. Our GAAP tax rate for Q1 was 38% and benefitted significantly from the realization of the onetime $94 million R&D tax credit in the quarter. Our Q1 non-GAAP tax rate was 43% and we expect that our full year non-GAAP tax rate will be similar to Q1. GAAP net income and EPS for the quarter were $219 million or $0.09 per share and non-GAAP net income and EPS were $312 million or $0.12 per share. We spent $327 million on CapEx in Q1 and we continue to expect 2013 CapEx to be in the neighborhood of $1.8 billion as we invest in servers and data centers to rapidly and reliably provide our products to people around the world. In Q1, similar to Q4, upon the vesting of employee RSUs, we withheld shares and paid the associated income taxes for our employees, which resulted in an outcome that’s functionally very similar to Facebook having repurchased approximately $400 million worth of shares in Q1. We ended Q1 with $9.5 billion in cash and investments. Overall, we believe that 2013 is off to a good start. We are pleased with our financial performance as well as our progress and product development. We are continuing to invest aggressively in new products that we think will drive long-term engagement as well as product and tools to grow our revenues and increase returns for the advertisers and developers working with us. And we are excited about the opportunity ahead of us to build out the network of people using Facebook and to bring our unique asset in terms of reach, engagement, and identity to our large and important market opportunities. Now let's open the call for questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from Heather Bellini with Goldman Sachs. Your line is open."
},
{
"speaker": "Heather Bellini - Goldman Sachs",
"text": "Mark, I was wondering, you shared with us the continued success of mobile install ads, I was wondering if you could share with us the other monetization initiative that you have that you are most excited about for 2013. And then my follow up for David would be, if you can share with us qualitatively how CPM trended in the various regions on a year-over-year basis."
},
{
"speaker": "Sheryl Sandberg",
"text": "I will take the first question. In terms of our ads priorities, they are what I mentioned, mobile, measurements and product innovation. We are particularly focused on improving the quality of our ads because we think that is the best way to have a great experience for users on Facebook as well as for marketers. I think if you look at the success of Custom Audiences, Partner Categories, FBX, what you see in that are products all move us towards better targeting, more relevance, better experience for users and for our marketers. And we are going to continue to invest very heavily in making the ad experiences as high return as they can for everyone involved."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yes. I will just emphasize the same point. I mean the things I am most excited about are things that are driving quality. I mean the two big levers for the business are, a, obviously a lot of people spend a lot of time using Facebook to stay connected with all the people around them. And second, that is an opportunity to advertise. But I actually think over the long term, the thing that’s going to drive the business to most is getting the ads to be very high quality. Personalize, good content in there. And a lot of the things that we are doing are aligned with that. So App install, a lot of that stuff is just good content that people are interested and there is no great way to find app stores today to discover a lot of apps on mobile devices. Similarly, I talked about the News Feed redesign that we are rolling out. And the content in there is much more visual. And we have always had the policy that the advertising content will display in exactly the same way that the consumer content display is. And making it so that people can share a much more visual content. Making that naturally advertisements can now have the same kind of compelling creative as well, which I think will increase the quality of that and overtime increase the effectiveness as well."
},
{
"speaker": "David Ebersman",
"text": "So Heather, in terms of your question about CPMs. Ads revenue grew well across all the geographic regions that we report on. I mentioned the U.S. and Canada growth in CPMs. We saw a similar number, a little bit lower but similar in Asia. For Europe and rest of the world the numbers were much lower. A little a bit above zero in the case of Europe, a little bit below in the case of the rest of the world. The interesting question around this is, what those numbers might have looked like if we hadn’t made changes in the option dynamics and, such as the price floor and obviously we can’t answer that question quantitatively because we don’t have the data. But we feel pretty strongly and pretty confident that prices would have increased substantially more in all of the regions if we hadn’t made those changes."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ross Sandler with Deutsche Bank. Your line is open."
},
{
"speaker": "Ross Sandler - Deutsche Bank Securities Inc.",
"text": "Just two questions. Engagement first was up across most of the geographies. We assume that’s primarily driven by mobile, but can you talk about anything else that’s driving up engagement. And then just a follow up on the geographies. So it looked like the U.S. had a normal seasonal downtick sequentially whereas international most of those regions held up sequentially. So can you talk about the difference between sell-through rate in the U.S. in newsfeed versus some of those international markets?"
},
{
"speaker": "David Ebersman",
"text": "In terms of growth and engagement geographically, I think you can see from the numbers that growth was strong across all the areas of the world. We continue to add a lot of users in places like India and Brazil. And in engagement trends I think were similarly strong throughout and mobile is clearly a big part of that equation and been very helpful to us in terms of getting more users, more daily users and more engagement from those users. In terms of revenue by geography, I don’t know that there’s a lot to add to what the numbers I’ve already said. Europe looks good in the first quarter after being a little bit softer towards the end of last year and we continue to grow well in Asia and the rest of the world. So I think just pretty consistent performance there."
},
{
"speaker": "Operator",
"text": "The next question comes from Scott Devitt with Morgan Stanley. Your line is open."
},
{
"speaker": "Jordan Monahan - Morgan Stanley",
"text": "It’s Jordan Monahan on for Scott. Just two quick questions. The first is, one of your competitors recently said something to the effect of if you’re building for mobile you’re building for today but not tomorrow, suggesting that tomorrow is a multi-screen world with all sorts of personalized devices. And I’m just curious, what opportunities do you see when you think about tomorrow? Would you agree that screen fragmentation will continue to increase and does moving ads towards newsfeed and away from right hand side help you in that environment? And then the second question is just about engagement. Engagement continue to improve despite more ads which validates your strategy. So every time you launch a new product people get concerned that engagement may actually tick down, but it seems to do the opposite. So are there other ad formats that you’re thinking about that are likely to be complimentary to engagement?"
},
{
"speaker": "Mark Zuckerberg",
"text": "All right, I’ll start. I think that the trend of more different form factors I think is somewhat orthogonal from the main trend that we see which is just people sharing more in different ways. And people want to stay connected with their friends and family and all these different folks in their lives and they’re going to use whatever technology they have to enable that, whether that’s desktop computers or laptops or phones or tablets or glasses, like whatever the products are. And I think that there’s going to be good ways for people to be able to consume a social content on all of those. So I think the big question for us is just which platforms do we see growing the quickest? We’re not tooled up as a company right now to make 10 huge investments like that at a time. But we can do a couple. Certainly in tablets are growing very quickly and I think that’s going to be increasingly important. But I think that consuming social content and staying connected with people is such a fundamental human need that that’s going to be important on all of these. And getting ads in newsfeed was a valuable step in making it so that everywhere where someone is consuming content from Facebook, the business model goes along with that naturally. And those were the early challenges that we had with mobile with ad for the first six or seven years of Facebook we’re just this right hand column and nothing trends like in mobile. But it was fairly easy with some amount of work just to make that transition. We’re there now and now I think whatever the form factor is going forward we’ll be able to deliver advertising content in a proportion that we think is good along with consumer content. For the sentiment stuff, I think what we’re seeing is really positive. It’s better than expectations and we assumed that sentiment and satisfaction might drop some amount. We continue to watch this really carefully because there’s no guarantee that it won’t in the future. But right now what we have seen has made us more confident that we can do more with advertising over time and can ramp that up. Our strategy isn’t to have like a ton of different ad units. We really want to make it so that we are delivering these end-to-end solutions for our customers and only have a small number of simple things, make it easier for advertisers to work with us. We want to deliver that and we are kind of underway on this long road map to execute that."
},
{
"speaker": "Operator",
"text": "The next question comes from Anthony Diclemente with Barclays. Your line is open."
},
{
"speaker": "Anthony Diclemente - Barclays",
"text": "I have one for Sheryl and one for David. Sheryl, you talked about Atlas and the measurement capabilities there. And you phrased it in terms of click-based ads and I am wondering is there also an opportunity for Atlas to improve or standardize measurement for impression based ads. And I guess the spirit of the question more generally, can you just talk about or update us on the potential for impression based ads in terms of increasing as a percentage of the mix versus performance based ads on Facebook. And then, David, question would be, a little bit of a decel in the rate of growth of ARPU in the U.S. I am wondering if there are other things you can call out in the first quarter, be it dollars from large events, TV events like the Super Bowl or other things, other than seasonality. Or maybe you can quantify or comment on the seasonality factor in the U.S. and Canada for the 1Q?"
},
{
"speaker": "Sheryl Sandberg",
"text": "So on Atlas you are exactly right. Our focus with Atlas is on impression based ads. And the idea is that, you know historically a lot of ads online which were more based on search, the attribution was always that last click. And as people have looked more holistically at all the ad spending they are doing, what they find is that it's not just the last click that matters but it's all the impressions leading up to that click. Importantly, we also drive sales offline. And offline people aren’t clicking through the purchase at all but they are actually walking into a store. So in some sense there is no last click. And so our focus with Atlas is to take that technology and enable us to improve our ability to connect ad impressions to purchase behavior both offline and online, and not just on clicks but across different ad purchases people do. So that’s exactly why we made that purchase."
},
{
"speaker": "David Ebersman",
"text": "In terms of ARPU in the U.S. and Canada was up 21% versus last year, so continuing to make good progress there. I really don’t have anything unique to say about seasonality in 2013. We see it from Q4 to Q1 across the years that we have been in an advertising business. And I am sure there are unique things that impact each year but there is nothing that we are aware of that was particularly important in 2013 in that regard."
},
{
"speaker": "Operator",
"text": "The next question comes from Jordan Rohan with Stifel. Your line is open."
},
{
"speaker": "Jordan Rohan - Stifel, Nicolaus & Company",
"text": "I am curious about how you address markets where it's a little bit harder to sell advertising. Specifically, if I'm calculating correctly, 41% of monthly active users are in the U.S., Canada and Europe, as you defined those geographies in your slides, and that's 74% of the ad revenues. How can the other geographies of the world step up to be an even more meaningful percentage of total revenue? Do you have to add a lot of heads, a lot of sales infrastructure and technology infrastructure that you don't currently have? And from that perspective, did you meet your objectives in terms of hiring and expenses, because I know how hard it is to support a business as global as Facebook. Thank you."
},
{
"speaker": "Sheryl Sandberg",
"text": "So, I'm very encouraged about our opportunity to sell ads all over the world. One thing I've learnt in my time selling ads on the internet, which is going over a decade now, is that markets that you don't expect to have ad markets develop faster than you would think. So if you were to ask me seven years ago what Turkey's ad market would look like, I would not have predicted it as today. So I'm increasingly encouraged by small businesses around the world and large businesses, and their adoption of the technology. I think with small businesses we have an actually really deep competitive advantage, which is that people all around the world use Facebook. So when small businesses who are historically way too busy to spend a lot of time using technologies, start to use the Facebook platform, they are using something they already use as users. So once you have a timeline or a profile, setting up a page is not a very big ask because you understand it and you are doing it anyway. And that's why we think with almost no direct effort we have 16 million small businesses actively using Facebook pages. I think one of the things we have done well over the past number of quarters is build out simplified ad products like Promoted Posts, where it's easy for those people who are using pages and it happens all over the world typically on the advertisers and we are increasingly optimistic that we can do more and more of that."
},
{
"speaker": "David Ebersman",
"text": "In terms of hiring, I think everything has gone quite well and as we have discussed 2013 is the year where we're investing for future growth, and I think in the first quarter both in terms of hiring and building out our infrastructure we are on track with where we want to be,"
},
{
"speaker": "Operator",
"text": "Our next question comes from Youssef Squali with Cantor Fitzgerald. Your line is open."
},
{
"speaker": "Youssef Squali - Cantor Fitzgerald",
"text": "Two questions, maybe one for Sheryl and one for Mark. On ad pricing can you maybe just talk about CPMs for ads in the newsfeed versus ads on the right hand rail? Can you give us maybe just an idea so the magnitude of the difference between the two was that a big driver for that 21% increase? Then on video advertising I was just wondering, what’s the strategy to bring video advertising to Facebook and both in newsfeed and to desktop initially and then eventually on mobile assuming that there's enough bandwidth for that? Thanks."
},
{
"speaker": "David Ebersman",
"text": "This is David; I'll take the first one which is about CPM. So the ads that we show in newsfeed are displayed more prominently and they are more in the flow of the user's attention. So as you would imagine, we get more engagement with those ads and they end up commanding a much higher average price per ad as you would expect."
},
{
"speaker": "Sheryl Sandberg",
"text": "I'll take the second part. So video is a really exciting area because we have leveraged our scale and engagement and our ability to provide relevant ads. We have a video product out today. Advertisers can embed a video in their page post, and we're seeing really strong results. I think both because of that and because of marketers' inherent liking video as a format, we continue to explore new things as well, but we don't have anything to announce today."
},
{
"speaker": "Operator",
"text": "Our next question comes from Justin Post with Bank of America Merrill Lynch. Your line is open."
},
{
"speaker": "Justin Post - Bank of America Merrill Lynch",
"text": "I guess two questions, first on ad formats. Sheryl, do you think you've really optimized the ad formats, especially on PC or is there a lot of room you can do to get better performance from that? And then secondly, maybe you could just give us a business update on Instagram, maybe you could compare where they are to where Facebook was when you turned on ads or any thoughts on how you could monetize that platform maybe far down the road?"
},
{
"speaker": "Sheryl Sandberg",
"text": "On the first -- I think there's a lot of room to improve our ads. I don't know whether that'll take the format of different formats. I think more of it will be in terms of quality because I think we feel pretty good about our formats. But one of the main pushes we had is to make each ad a better experience for users, content in those ads, which is as good as the content they'll see from a friend or anything else on the site, as well as make those higher return for marketers and those two go hand in hand. I think the place you will see the most from us is more around targeting, around ability to take the formats we have and make the ads better within those formats. That’s certainly our focus now. But as our site evolves and our product evolves, we never rule out changing the format as well."
},
{
"speaker": "Mark Zuckerberg",
"text": "Yes, on Instagram they're really doing well and growing really quickly. and I think that is the right for them and they have this opportunity to capture and basically build off this huge community. And I think that that should be a 100% of the focus right now. I am really optimistic about the business opportunity there too. You already have a lot of brands and folks who advertise with Facebook putting content in Instagram, getting huge engagement rates. So people are coming to us and asking for ways to make that even richer and it's something that we're thinking about. But right now I think that -- I'm just really product of the team and excited about how quickly they're growing. I mentioned this in my comments early on, but they're growing a lot faster now and we’re faster to get to 100 million than Facebook even was."
},
{
"speaker": "Operator",
"text": "Your next question comes from Gene Munster with Piper Jaffray. Your line is open."
},
{
"speaker": "Gene Munster - Piper Jaffray",
"text": "You've seen some acceleration of revenue over the last three quarters and can you just give us some guidelines in terms of should we continue to see that accelerate? And if not, at some point in the back half of this year or early next year based on some of the investments in new products, could we see another inflection point in growth? Thank you."
},
{
"speaker": "David Ebersman",
"text": "I think we're still in the really early days of what we're doing and that's particularly true in mobile. A year ago, we didn't have any mobile ad revenue and now it's 30% of our ad revenue. So this is great. We're really pleased with the progress and we still believe that mobile has the opportunity to be huge for us if we can execute well. We've got a really large mobile user base. They are very engaged and spend a lot of time with us. We have an ad format that works on mobile and we have identity so that we can put the right ads in front of the right people. So, I think the future for us is I think much more interesting than trying to project it from any particular quarter at this point, just because we've got a lot less to do. And, obviously, we will continue to try and develop tools to enable us to monetize our advertising better and potentially in different ways as well. But the big opportunity that's right in front of us is trying to make the mobile advertising products higher quality and more relevant over time."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ben Schachter with Macquarie. Your line is open."
},
{
"speaker": "Ben Schachter - Macquarie",
"text": "A couple of issues for Mark. I was wondering, first, if you could talk about the platform strategy and maybe give some specific examples of third parties that have really been successful. And in general, what are the lessons that you've learned around the platform strategy, how it's evolved? And then secondly, just around the evolution of Graph Search, any lessons from the launch, positive or negative?"
},
{
"speaker": "Mark Zuckerberg",
"text": "Sure. I mean one thing that I think has actually gone well with the platform recently is the gaming ecosystem. I mean David was talking about this earlier, but with the exception of our largest partner, Zynga, whose growth hasn't been as awesome as everyone would hope, the rest of the community is actually growing quite well and is quite healthy. So, we're pretty happy with that and it's a pretty diverse group. I mentioned in my comments at the beginning, I mean we have as many as 81 of the top 100 top grossing iOS apps and 70 of the top grossing Android apps that are connected in with Facebook. So we're getting good coverage, right. And that's all has been the vision, it's making it so that any apps and experience that you have can be social. So that's working well. Also we really want to be a source that developers can come to for distribution and make it such that they can come to Facebook and spread their apps. People have always had good tools to do it organically, but recently the App Install ad product has been another tool in developers' arsenal in order to do that and that's showing some real traction. So, I'm pretty excited about that as well. Graph Search was your other question. And the strategy around it and kind of where we are in rolling out is, we developed it over a period of time at the company and we knew that in order to get it to be really good we had to get some real world data. So we rolled it out to just a small percent of people in order to be able to tune the ranking and all that. We're getting into a state where we are really happy with it before we roll it out to everyone. But we're really optimistic that that will happen over the coming months. So, I'm pretty excited about that. The people who use it, we've gotten very positive feedback from it and I think it's going to be a very big opportunity. But the launch wasn't this point where we expected a ton of people to start using it. We've gated who can use it quite aggressively in order to just make sure that we get the data that we need and the real rollout will hopefully start pretty soon."
},
{
"speaker": "Operator",
"text": "The next question comes from Mark Mahaney with RBC. Your line is open."
},
{
"speaker": "Mark Mahaney - RBC Capital Markets",
"text": "I was wondering if you could talk about engagement per cohort. There is an urban myth that those under 25 are disengaging from Facebook. It's hard for us to see that in obviously the day that you report, but you would know that. Is the mobile engagement, is that offsetting that? Could you talk about that engagement amongst younger cohorts? And then secondly, you talked about advertising on mobile devices performing well. Could you actually make the statement as to whether it performs as well as desktop ads do for advertisers on Facebook, similar to, sometimes great or sometimes less? Could you compare those two? Thank you."
},
{
"speaker": "David Ebersman",
"text": "Sure. I guess I'd start by saying we remain really pleased with the high level of engagement on Facebook by people of all ages around the world. You asked about people under 25, we continue to have really high penetration rates among that age group, both in the U.S. and globally. And the younger users remain among the most active and engaged users that we have on Facebook. And then in addition, younger users are extremely active users of Instagram as well. So that's great and makes our position even stronger. I think, from our standpoint, the urban legend you referenced, sort of flows more often than not from surveys people have done of younger users that indicate that they're using other social services. And we take this feedback seriously but our sense is that much of the concern stems from the assumption that this is a zero sum game and that's not how we see it. We think the overall amount of time spent on services that enable you to connect and share is growing and will continue to grow, because these kinds of services are really engaging and good. And it's great for us to be the leader in a market that's expanding rapidly with the foundation we have with both Facebook and Instagram and I guess the challenge for us is to just continue building great products that appeal to users of all ages. Your second question about the engagement levels are the performance of mobile ads, I think it's fair to say that newsfeed ads on both mobile and desktop both perform extremely well and we're pleased with both formats."
},
{
"speaker": "Operator",
"text": "The next question comes from Ken Sena with Evercore Partners. Your line is open."
},
{
"speaker": "Kenneth Sena - Evercore Partners",
"text": "I was just hoping that you could go back to Atlas for a second and maybe give us a sense of maybe the run rate quarter-on-quarter. And is it correct to see Atlas is kind of an avenue into monetizing potential inventory off of Facebook and how do Home and maybe your mobile Open Graph tie into that strategy. Thank you."
},
{
"speaker": "Sheryl Sandberg",
"text": "Our main focus with Atlas is our own measurement, that being able to measure Facebook ads all the way through to purchase and then compare those on an apples to apples play with other ad purchases you make not on Facebook is really important to drive marketer engagement with us and that's our focus. We have no plans for launching that network. We also don’t break out -- we’re not breaking out the revenues from Atlas."
},
{
"speaker": "David Ebersman",
"text": "And it’s small. So Atlas is -- we didn’t buy Atlas for the run rate of its revenues, but because we feel like it’s a tool that can help us to grow our own business."
},
{
"speaker": "Operator",
"text": "The next question comes from Douglas Anmuth with JPMorgan. Your line is open."
},
{
"speaker": "Douglas Anmuth - JPMorgan",
"text": "Sheryl, you talked about having strong traction with SMBs and also in direct response and app developers and then also about Atlas and attribution. But can you help us understand the biggest hurdles that you have right now with big marketers? And then secondly, David, if you could help us understand the percentage of mobile ads revenue that’s coming from mobile app Install ads?"
},
{
"speaker": "Sheryl Sandberg",
"text": "There are lots of types of big marketers. There are big marketers out there who are direct marketers. There are also big marketers who are brand marketers. I think the question probably is about the brand so that's how I’ll answer it, even though it’s worth noting that there are big advertisers across the spectrum of different type of ad buys. As I’ve said before, the thing about brand advertisers is that they got very used to TV and they got very used to search and we are a third thing. And we will win that business client by client, CMO by CMO. It’s something I personally spend a lot of time on and I think we have a great team in the field again. With some of the big brand advertisers, we have been working with them for years and years. A lot of the data and measurement you hear us talking about are studies we’ve done with them based on campaigns that we’ve run with. And I think we have a lot of belief at the top and in many of them we are in the process of going through their companies and getting that same commitment to buy. So we’ll have a CMO who has seen the value, we’ve proven the value and really wants the company to come along. And now we are in the process of working brand by brand, region by region to get that same buy-in lower in the organization, which actually takes more time not surprisingly. With other brand marketers, they are just in a testing phase and they really haven't done enough with us so that we can even do the studies to prove the value. And so the good news with us is we're engaged with all 100, Ad Age 100. So everyone is buying with us on an annual basis and we're working client by client to bring them along that spectrum. The good news is I think we're increasingly proving that we can return on ad spend in different parts of the purchase funnel. So to share one recent example, MGM Resorts have used a different suite of Facebook products to address different customers at different parts of the purchase funnel. They used offers to acquire new customers and they saw a three times return on ad spend. Then they used FBX to retarget people who were in their booking process and dropped out and that gave them a 15 times return on ad spend. And then for past guests who had completed a purchase but hadn’t come back, they used custom audiences to target them to return and they got a five times return. And I think it's experiences like that where we show the breadth of what we can do that really move us forward with the brand spenders."
},
{
"speaker": "David Ebersman",
"text": "You asked about mobile app install ads. So we launched that product I think at the beginning of the fourth quarter more broadly. So it's early in its development, but really doing quite well. And we're pleased with both the quality of experiences we're providing and with the revenue growth that we've seen. It really fits in nicely with the idea of putting content into newsfeeds that we think will be of interest to users and provide value for developers. I guess the only other thing I've noticed that it's an incremental audience for us for the most part from an advertising standpoint which is also nice. Some of those developers were advertising with us before a lot of the mobile app Install Ad purchasers or new advertisers to Facebook."
},
{
"speaker": "Operator",
"text": "The next question comes from Brian Wieser with Pivotal Research. Your line is open."
},
{
"speaker": "Brian Wieser - Pivotal Research",
"text": "First of all, I just want to go back into the segments of the advertisers between the brands, developers, small businesses and performance. Is there any way you can characterize what maybe the growth trends have been, even recognizing some of them below the lines or ultimately growth trends between the different ad products. I find it useful to get a sense of where the relative growth is, that will be useful. And then a second question, I just want to get updated thoughts on datacenters and the role of datacenters for Facebook. The degree to which you think that it is strategic in investing and building these out or if it's really just about operational efficiency?"
},
{
"speaker": "David Ebersman",
"text": "So in terms of the segments, it's really hard to breakup the revenue because the same advertiser crosses multiple segments with multiple objectives, sometimes with the same ads. So one of the ways we use the segment is to help focus our product development on understanding the different objectives that marketers might have, but then translating that into individual groups of revenue is difficult. So I think that, as Sheryl mentioned, we're particularly pleased with small businesses. That's something that we can measure on Facebook and see the number of advertisers increasing. In terms of datacenters, I think it is both strategic and operational. There's no question that owning our own datacenters removes sort of another party from the mix relative to when we used to lease datacenter space. It also enables us to build the datacenters to look exactly as we want them to look so that the performance is optimized for precisely what Facebook needs to do with the servers that we put in there, and there's definitely some efficiency that comes from that. But I would also say that it is, given what we are trying to do in the world we are trying to reach, I do think it's strategic for Facebook to not be dependent on third parties to provide that critical part of our supply chain."
},
{
"speaker": "Operator",
"text": "The next question comes from Aaron Kessler with Raymond James. Your line is open."
},
{
"speaker": "Aaron Kessler - Raymond James",
"text": "Yes, couple of questions. On the unpublished Page posts, can you give us an update. I think that got released towards the end of the first quarter, maybe what type of traction you're seeing there. And also going back to kind of U.S. versus Europe, can you just maybe detail -- Europe definitely outperformed U.S. on a sequential basis, was that due to some of the later adoption of some of the sponsor stories in the News Feed or is that something else?"
},
{
"speaker": "Sheryl Sandberg",
"text": "On Page post, Page post ads first appeared May of last year and then we just put them into News Feed in March of 2013. In terms of unpublished, what that just means is the ability to target Page post only to the right people. So, for example, without posting it to everyone on your page. For example, if you are a retailer and there was a snow storm in one state, you could target snow shovels or other relevant stuff you want to sell for snow storms only to people in that state. So, it's just a really useful way of segmenting your audience, again part of our overall push to relevant targeting and quality. We're really excited about Page post ads. Over 7.5 million posts have been promoted by pages. Over 30% of the people using the product are new advertisers basically. And I think that speaks to one of the earlier questions on small-to-medium business and their adoption. If you say to an SMB, do you want to become an advertiser, that's a heavy lift. If you say to them, you have a page, you've posted something, do you want to pay a few dollars to promote this post to reach more people, that is a much easier on ramp to advertising spend with us and we think it's working really well."
},
{
"speaker": "David Ebersman",
"text": "In terms of U.S. and Europe, I really don't have a lot more to add. The Europe number as I said was strong in Q1. I'm certain it's true that for some of the products that we roll out the U.S. represents the first adapters and then they spread their way to other clients around the world. But I don't have any specific evidence to support that that was key to the trends in Q1."
},
{
"speaker": "Deborah Crawford",
"text": "Operator, I think we have time for one more question."
},
{
"speaker": "Operator",
"text": "The next question comes from Daniel Ernst with Hudson Square Research. Your line is open."
},
{
"speaker": "Daniel Ernst - Hudson Square Research",
"text": "Two questions if I may. If we look at the broad base of all ad impressions across Facebook whether it's desktop or mobile, can you give us a sense of what percentage of those are generated or conditioned by social statistics or socially relevant data that comes out of the Facebook experience versus ads conditioned by external data like from Acxiom or it's from retargeting traffic from other websites. And then second, within the category of apps and others, can you give us a sense of is there any materiality around the other categories that’s not apps payments or what part of that might have been Facebook type services like gifts? Thank you."
},
{
"speaker": "David Ebersman",
"text": "So to your first question on mobile and I think the question was on mobile ad load, is that right?"
},
{
"speaker": "Daniel Ernst - Hudson Square Research",
"text": "No. It was whether it's mobile or desktop, what part of the --?"
},
{
"speaker": "David Ebersman",
"text": "All right. I got lost in the second question which I should have written down to the first one. So right now you asked about Acxiom and things like that. That’s a very small percentage of the ad impressions we show. So hopefully overtime we can bring tools to bear that can really increase our ability to do more targeting and more effective targeting than we do today. In terms of the second part, I think you're asking about the whole payments and another fees revenue lines. So I said the whole line grew by 15%. Games represented 12% growth. So the increment in between the 12% and the 15% came primarily from user promoted posts, which is a product we launched last year to a lesser degree also from our gifts product."
},
{
"speaker": "Sheryl Sandberg",
"text": "Great. Thank you for joining us today. We appreciate your time and we look forward to speaking with you again next quarter."
},
{
"speaker": "Operator",
"text": "This concludes today's conference call. You may now disconnect."
}
] | null | null |
GOOGL | 4 | 2,014 | 2015-01-30 16:30:00 | Operator: Good day, everyone and welcome to the Google Inc. Fourth Quarter 2014 Earnings Conference Call. This call is being recorded. At this time I’d like to turn the call over to Ellen West, Vice President, Investor Relations. Please go ahead.
Ellen West: Thanks so much, Jamie. Good afternoon, everyone, and welcome to Google’s fourth quarter 2014 earnings conference call. With us today are Patrick Pichette and Omid Kordestani. As you know, we distribute our earnings release through our Investor Relations website located at investor.google.com. So please refer to our IR website for our earnings releases as well as the supplementary slides that accompany the call. This call is also being webcast from investor.google.com. A replay of the call will be available on our website later today. Now, let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward-looking including statements regarding Google’s future investments, our long-term growth and innovation, the expected performance of our businesses and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on this call, such as operating income and operating margin, are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation and, as applicable, other special items. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will now turn the call over to Patrick.
Patrick Pichette: Thanks, Ellen. And welcome to 2015 everyone. Before we get into the numbers, I am going to give a brief overview of our performance this quarter, as the data is actually quite noisy through the P&L. So to start, let’s say, that we saw continued strength in our core advertising business. This was really driven by a strong holiday and mobile performance from our Sites line. We saw a great momentum in our programmatic business highlighted by our mobile display and our ads platform product. But we also faced a few real challenges as well. On the revenue side, clearly as you heard out the strengthening of the U.S. dollar resulted in a gross negative currency impact of $616 million just into Q4. But thanks to our hedging program the net impact was actually attenuated, with a net revenue impact of $468 million. Also on the Other Revenue line not only did we see that negative currency impact really impact the Play growth, particularly in Japan, but also while the Nexus 7 was very well received as a new phone, we had real issues and unable to secure sufficient inventory to meet the demand that we had forecasted. So for both these factors in fact, we see lower other revenue growth this quarter. On the expense side, we had number of unusual charges to our operating expenses hit this quarter. I’ll provide you more details in a few minutes as we go through the conversation. But together these items added up to slightly over $300 million in expenses to our P&L. Lastly, if you go through the CapEx line, you will note that we’ve made real estate purchases in Q4, which helped us relieve both pressure on our work space for current employees but also to accommodate our future growth. And this also resulted in a large sequential increase in our real estate capital expenditures this quarter. So now that you have the basics, why don’t we dive into the details? Our gross total consolidated revenue grew 15% year-over-year to $18.1 billion, and it was up 10% quarter-over-quarter. Without currency fluctuations our gross consolidated revenue growth would have, in fact, been 18% year-over-year. And despite all the FX pressure our Google Sites revenue was up a healthy 18% year-over-year to $12.4 billion, was up 10% quarter-over-quarter, in part driven by the strength in our mobile search. Network revenue was up 6% year-over-year at $3.7 billion and was up 8% quarter-over-quarter. As a reminder, our network business includes really two types of businesses with different growth profiles, our legacy AdSense business, particularly AdSense for search, where we’ve continued to make policy changes for the benefit of our user experience, but which has negatively impacted the growth in clicks specifically. Our clean-up efforts have resulted in fewer clicks, but also higher CPCs as I’ll discuss in a minute. The other business that in the network line are newer display and programmatic businesses including AdMob, AdExchange, DoubleClick Bid Manager, and these continue to grow at a strong rate. Finally, Google’s other revenue grew 19% year-over-year to $2 billion was up 6% quarter-over-quarter, driven by year-over-year growth in our Play Store, but offset by the FX impact and the challenges in our hardware business I mentioned earlier. Our global aggregate paid clicks were up 14% year-over-year, and up 11% quarter-over-quarter. Aggregate CPCs were down 3% year-over-year and also down 3% quarter-over-quarter. And if we go on our monetization by property, the Google site paid clicks were up 25% year-over-year and up 18% quarter-over-quarter. With Google sites’ CPCs were down 8% year-over-year and down 8% quarter-over-quarter. On the network side, network paid clicks were down 11% year-over-year and down 7% quarter-over-quarter, but our network CPCs were up year-over-year 6% and 10% quarter-over-quarter for the reasons I mentioned. Our monetization metrics continued to be impacted by a number of factors. They include geographic mix, device mix, property mix, FX, as well as ongoing product and policy changes. Turning to geographic performance, if you go to our earning slides, which you’ll find on our Investor Relation website, you’ll see that we’ve broken down our revenues by US, UK and rest of world to show the impact of FX and the benefits of our hedging program. So please refer to those slides for the exact calculations. So despite large currency headwinds we saw solid performance from our core advertising business around the world. The US revenue was up 14% year-over-year to $7.9 billion. The UK was up 10% year-over-year to $1.7 billion. And in fixed FX term it actually grew to 11% year-over-year. Non-US revenue excluding the UK was up 18% year-over-year to $8.6 billion, accounting for 47% of total revenue. And in fixed FX terms in fact the rest of the world grew at healthy 24% year-over-year. So let me turn now to expenses. Traffic acquisition costs were $3.6 billion or 22% of advertising revenue. Our non-GAAP other costs of revenue was $3.1 billion in Q4, which exclude SBC as well. Our non-GAAP operating expenses totaled $5.8 billion, again excluding stock-based compensation. And as a result our non-GAAP operating profit was $5.6 billion and non-GAAP operating margins were 31% in Q4. As I mentioned at the beginning, we had a number of unusual operating expenses that impacted us this quarter. We typically review our estimates accounting policies and balance sheet on an ongoing basis and make adjustments when we think and see it necessary. Normally, I wouldn’t call out these, but because they totaled slightly over $300 million this quarter, I wanted to give you some sense of these adjustments, although I won’t be providing a lot of detailed break-out. So first we took approximately half that amount in compensation charges resulting from a one-time payment and reclassification between SBC and bonus expense. The other half came from a review of our real estate portfolio, where we decide to take write-down on a small number of assets and also one-time payment to buy out a number of leases in a couple of markets where we face acute space pressure. Headcount was up, but just over 2,000 in Q4. In total we ended the quarter with approximately 53,600 full-time employees. You’ll notice also that our effective tax rate was 16%, again another discrepancy for Q4, which was really, primarily impacted by the extension of the R&D tax credits for 2014 with the entire credit being taken in Q4. As well as continued mix shift from earnings between our domestic and international subsidiaries. Let me now turn to cash management. Other income and expenses was $128 million. Interest income and realized gains on investments offset the continued impact of expenses from our FX hedging programs. For more detail on OI&E, please refer to the slides that accompany this call on our IR website. We are pleased with our strong operating cash flow at $6.4 billion. Our CapEx for the quarter was $3.6 billion. And this quarter, most of the CapEx was spent on related to facilities, production equipment, and datacenter construction in that order. So as I mentioned a few minutes ago, we have been opportunistic about acquiring space in real estate where we need to relieve pressure and accommodate for future growth. To that end, our facilities expenditure included just over $900 million of real estate investments during the quarter, of which $585 million was related to the acquisition of our property in Redwood City that we disclosed in our 10-Q for the third quarter. Our free cash flow was $2.8 billion, and I also want to note that we completed in Q4 the sale of Motorola Mobile to Lenovo in October 29. We recognize a gain on disposition of $740 million net of tax, which is included in our net income from discontinued operations. So there you have it, despite a noisy quarter from a P&L perspective. We can say that we had strong results in our core business as evidenced by our 18% fixed FX growth this quarter and are well-positioned for the year ahead in the long-term. As Larry says, although the vast majority of our resources in time continue to be invested in our core products, we also have enthusiasm to invest in new promising ideas like Self-Driving Cars or Loon. We use the same disciplined approach to these new areas that we used for investing in our earlier bets like Android or Chrome or Display. Our projects start with small dedicated teams that are given clear milestones to hit before they can get further investments. And in cases where we achieve success against our milestones, we expand our investments, and you saw this as an example earlier this week with our Fiber teams. We greenlighted 18 cities in four metropolitan areas in the U.S., out of the 34 cities and 9 metros that we had reviewed in 2014, and they’re off to the races. In other cases, when the teams aren’t able to hit hurdles, but we think there are still a lot of promise. We might ask them to take a pause and take the time to reset their strategies, as we recently did in the case of Glass. And in those situations our project don’t have the impact we had hoped for, we do take the tough calls. We make the decision to cancel them and you’ve seen us do this time and time again. So before I turn it over to Omid, I’d like also to note that in many ways 2014 was a year of significant investment growth, both in CapEx and OpEx at Google. From an investment perspective, we’ll continue to seek a healthy balance between growth and discipline and the willingness to throw a little back when we reached the limits of what we believe we can manageably absorb. So with that in mind, I’ll take it over to Omid now to provide more specifics on the successful performance of our core and new businesses. Omid is joining us by phone from another location today. So I hop it over to you, Omid.
Omid Kordestani: Thanks, Patrick. Hi, everyone, happy New Year. And thanks for joining us today. This is Omid. It’s my pleasure to join you from London tonight. I’m glad to be here to reflect on the last quarter and look ahead to 2015. 2014 ended with healthy momentum enabling us to achieve $66 billion in revenue for the year. In Q4, we launched Lollipop, our newest version of Android, refreshed our line of Nexus devices and introduced Inbox by Gmail, a new inbox that enables users to focus on the messages that matter most to them. Meanwhile our sales teams worked diligently with our advertising partners to deliver a strong holiday season. Today, I’ll do a quick walkthrough of the business highlights from Q4. First, I’ll give an overview of the different sectors of our ads business, performance and brand advertising and our advertising platforms. Then I’ll cover progress in our emerging non-ads businesses. Let’s begin with the performance advertising. We continue to evolve the foundation of Google’s advertising business to reflect a multi-screen constantly connected world. Mobile is now a behavior, not a device, and it has a variety of unique characteristics. First, let’s talk about local advertising. On mobile, consumers want to know about the stores and goods near them. We launched some exciting updates last quarter. In October, we announced local availability for product listing ads and local store front, products that give customers real time information about goods that are in stock close to where they are. Major retailers like Macy’s and REI took advantage of these local inventory ads during the holidays. Overall, we saw strong engagement and results from big-box retailers during the holiday season. A second priority has been the creation of new measurement tools. We recently added estimated store visits to our estimated total conversations measurement suite. Now, advertisers can see a reliable estimate of the number of times a search ad click drive the store visit. During the holidays, ULTA Beauty reported that 12% of clicks on search ads led to a store visit with significant gains in ROI from their AdWords search marketing spend. These mobile-specific metrics help advertisers measure the full impact of their mobile marketing. The third area of progress is apps. We have driven hundreds of millions of app downloads on Google Search, AdMob and YouTube. And this business continues to grow at a healthy clip. During the holiday season, Office Depot used Google Search Ads to promote their ElfYourself app that helps shoppers create videos of people re-imagined as dancing elves. By using Google Search Ads they saw a 65% conversion rate. We have recently enabled users to more seamlessly navigate between apps and the web and find what they are looking for in apps more quickly. In organic search 15% of signed-in users’ searches on Android now return deep links to apps. We also offer app deep linking in search ads. Booking.com uses Google Search Ads to drive installs and reengagement via deep linking for their mobile app. Last quarter, we continued to see great traction with our established mobile advertising products as well, particularly Google Shopping. Online growth remains strong with Google Shopping traffic on mobile devices up nearly 100% compared to Q4 2013. For much of the holiday season mobile shopping clicks exceeded those on desktop as users increasingly made purchase decisions on the go. Now, I would like to turn to YouTube, where we continue to deliver great results for brand advertisers. YouTube now has more than 1 billion users. Everyday people watch hundreds of millions of hours of video on YouTube, generating billions of views. Watch time is up 50% year-over-year. We continue to invest in our YouTube Partners and Partner revenue has increased by more than 50% year-over-year. We are seeing great momentum in mobile advertising on YouTube. Mobile revenue on YouTube is up more than 100% year-over-year. TrueView, where advertisers pay only if someone watches their ad also continues to do very well. Walmart U.S.’s holiday performance is one of many success stories. During the week of Black Friday, they used YouTube’s TrueView format to drive a 300% week-over-week increase in views of their channel and more than 28 million views on the week. This was a 600% increase in YouTube channel views over the same week in 2013. And while we are all anticipating a certain football game in Arizona this weekend, the action has already begun for its advertisers on YouTube. Nearly 70 ads or teasers related to the big game have been posted to YouTube this year, up 55% from the same time last year. People have been - people have already watched them more than 44 million times, up 25% from last year and for more than 70 million minutes on YouTube nearly tripled the watch time compared to the same point last year. On average people watch each ad for more than a minute-and-a-half. We continue to develop the tools that make digital work for brand marketers, their agencies and premium publishers. There were two particular areas of focus from Q4 that I would like to highlight, programmatic and measurement. Let’s start with programmatic. Automated ad buying has benefitted performance-driven advertisers for years. We’re now extremely well positioned as brand advertising shifts to programmatic as well. We’re seeing great traction overall from our advertising and agency partners. Today, all the top 10 global agencies use at least one product in our double click suite. Specific products within the double click suite have shown exceptional momentum. DoubleClick Bid Manager, our primary frontend for programmatic buying has doubled in volume over the past year. During the recent us mid-term election, programmatic represented nearly one-third of advertisers’ Google ad budgets. We’re seeing that video, the ultimate brand medium, is starting to move to programmatic as well. After launching in June of 2014, Google Partner Select, our premium programmatic video marketplace now has more than 50 publisher partners including Hearst Television, and Food Network, and includes brands like BMW. Next, we continue to invest in measurement tools that enable advertisers, agencies and publishers to better understand the results of their digital marketing. It starts with addressing the question of viewability. Nothing else matters if a human did not see your ad. This is the top question for the industry and at Google we are doing our part to address it. Since July, we have been rolling out viewability report across our ad platforms, so that brands will know whether their video ads on digital channels were actually seen or not. We recently extended this activity reporting to video ads. Large advertisers are finding technology like this to be very useful. For example, Kellogg’s used DoubleClick Digital Marketing to buy their inventory programmatically and increased their ad viewability by 70%. Once a brand knows that their ads have been viewed they need to determine if the right people saw those ads and if they made an impact. That’s where our tools to measure brand lift come in. We have run more than 6000 brand lift surveys to help determine brand recall and purchase intent. For example, Mondelez wanted to measure the effectiveness of a recent digital campaign for the launch of a gum brand. With brand lift they found a 36% lift in brand awareness versus a control group, and a 97% lift in ad recall versus a control group. Getting these types of feedback in real time is impossible with offline media. This sets digital apart. Let’s move now to our emerging non-ad businesses. Google for Work had a great quarter. We started working with PwC to help them and a company they advise used Google for Work to move their businesses to the cloud. Cloud Platform continues to make good progress. We hosted our second Google Cloud Platform live event in November where we announced several new products such as Google Container Engine. Our digital content businesses are strong. I’m excited about Google Play’s development. Movies are now available in more than the 102 countries, music in 58, and books in 65. It’s growing internationally at unprecedented speed. In December, we partnered with Sony to digitally release the interview. It has been publicly reported that the film generated over $15 million in its first weekend, and that Google Play and YouTube drove the majority of those sales. We launched YouTube music key beta a monthly music subscription service that provides ad free music, background play, and offline viewing. This will also include a subscription to Google Play Music with more than 30 million songs, expert queue rated play lists, and more. Our hardware efforts demonstrate momentum just in time for the holidays we launched the Nexus 6, Nexus 9, and Nexus Player devices. Chromecast continues to be a hit. Just last week, we saw our 1 billionth tap of the cast button. Chromecast usage per device has increased by 60% since launch due to a growing roster of new apps and features. According to NPD Retail Tracking Service, in 2014, Chromecast was the number one selling streaming media device in the U.S. Chromebooks are now available in 33 different markets and enjoying strong success in K-12 education market in the U.S. I continue to be impressed by the work of our marketing teams that they’ve done around the world. The Year in Search has become an instant classic and YouTube Rewind is fast becoming one. From the Android Be Together Not the Same Campaign to Nest’s first TV ads and much more our marketing team contributed to our success in the all-important Q4 to a wide variety of efforts. That’s the wrap for 2014, and we are excited for what lies ahead in 2015. In closing, I want to thank our great partners, customers, and users, without them, we wouldn’t be successful. Thank you all so much. Now, let’s get back to Patrick for Q&A.
Patrick Pichette: Thank you, Omid. Before we turn to Jamie for Q&A, I was highlighted by the team here that, I actually had a slip, I said Nexus 7 instead of Nexus 6. And although the Nexus 7 is still a great device, what I really meant in my comments was to talk about the Nexus 6, which is this amazing device that we have launched with the Lollipop launch. So with that, I’ll turn it to Jamie, and we’ll go to Q&A. Jamie, if you can give the instructions please.
Operator: Thank you. [Operator Instructions] And we’ll take our first question from Stephen Ju with Credit Suisse.
Stephen Ju: Okay, thanks. So Patrick or Omid, I think, it’s been a few years since you talked to the Street about the run rate of your Display business. I wanted to see if you are willing to toss us a nugget here in terms of what your gross billings currently maybe, recognizing that you may be seeing growth in that revenue contribution depending on different products. And also it looks like the UK revenue saw modest bit of acceleration on an FX neutral basis, granted comps were probably modestly easier, but anything you can call out that would help there? Thanks.
Patrick Pichette: Yes, sure. It’s Patrick here. So on both topics, on the UK, we did see a good performance this quarter on UK versus last quarter, and as you said - mentioned, a 11% year-over-year. So the note of the UK is, the core business there is doing well. If you go back to last the deceleration, we have - it’s a big portion, it’s like 10% of our revenue, and we over 10%. The - you will remember that in our mix of products that are in the UK, clearly, our core products are there, but also AFS, like the network business is actually prominent in UK, as well in the U.S. less so in the rest of the world. And so that has an issue on the mix. And then also think of it as a promising item, which is, there is areas of new products, such as Play that are actually stronger international than they would be in the UK or in the U.S. So there lies some of the differences between the growth rates, but in many ways a lot of opportunities there, so that’s what’s going on in the UK, quite pleased with the progress there in Q4. And then on the issue of Display, we haven’t updated the numbers to the Street. And so we have to continue to, kind of, give you the updates that we do, and if we actually have a chance in the future then we’ll let you know when it’s time to do so. So thanks for your questions, Steven. And we’ll go to the next question, please. Jamie?
Operator: And we’ll take our next question from Carlos Kirjner with Bernstein.
Carlos Kirjner: Hi, thank you. Two questions, if I may, Patrick. You hired 2,000 people this quarter versus 1,700 in the same quarter last year, which is a 22% increase. But Google management talks a lot about the opportunity in front of the business. If that’s the case, why aren’t you hiring more people and spending more in R&D. Can you tell us what are the specific constraints that you guys have or imposed on yourselves that prevent you from hiring 3,000 people this quarter instead of 2,000? That’s the first one. The second is the following, a few quarters ago, I seem to recall you saying that, you did not manage the business for margins, but you managed it for profit growth. Yet your operating income is down year-on-year and even if you are, the $200 million is growing very slowly. You could see how investors would look at that and say, well, how do you reconcile these things? How do you think investors should think about this trajectory of operating income growth? Thank you.
Patrick Pichette: Okay. So let’s take them in - each in step. On the issue of hiring, you will notice that relative to last quarter also, which is our third quarter is typically a big quarter, because we get the influx of the hires we do at colleges and otherwise. We actually decelerated from the third quarter as well. What we are managing for is, we just have a very high bar for hiring, if you can pass the bar, then we hire you. We also have capacity constraints on leadership, because there is a natural kind of number that you can kind of absorb within the culture of Google, it’s really important not to lose that culture and to have a velocity, to have traction. So there is no sense bringing 5,000 people that we couldn’t kind of bring into the teams and really make them perform it. So what we manage on the hiring is, we have our plans, and so we have a rate of targets of hires per each of the pals and the areas of the company. And then from there, the next hurdle is really about, can we find these people? And then finally, just making sure that we keep this kind of balance of bringing at a reasonable rate, so that we can actually absorb them in the company without losing the velocity and the culture of the place. So it’s actually a pretty complex puzzle, but we are managing it, it’s never perfect, but we are managing it, to the best we can. So that’s the first question. On the issue of margins, look, we have different, if you think of the businesses in Google, we are looking for growth, we are looking for growth in revenue, we are looking for growth in operating profits absolute dollars, and we are looking for great returns on investment. That’s the puzzle we solve for. So you have an advertising business that may have higher margins, lower capital intensity, than say, another business, which maybe Play, which has much lower margins, great prospect for growth with very large pools of revenue and margins available and we go after them for sure. You have Fiber right, and in the access, which is a completely different kind of capital intensity. But, again, the question is, does it promise, or does it have a case for large dollars operating profit delivery and high revenue and then a decent return on capital, that’s how we manage it. And to kind of say, okay, well, we have what we have today, but if Play could grow at, just to take the case, ten times faster than it is doing right now, right, it would impact margin, because on the weighted average basis, it would drag it down, but we love it. We love to be able to grow Play ten times faster than we are today. So that’s how we think of the puzzle. We manage them each individually for their potential, their returns, we all look for these big margin pools and these big revenue pools, and then we just allocate our capital to make sure that it’s balanced across these initiatives for maximum velocity. That’s the way we think about it, Carlos.
Carlos Kirjner: Thank you.
Patrick Pichette: Thank you very much for your question. Jamie, let’s go to our next question, please.
Operator: And we’ll go next to Anthony DiClemente with Nomura.
Anthony DiClemente: Thanks a lot for the question. I have two. Patrick, given the importance of Google stock price as a motivator for existing employees, for recruitment of new employees. I think, many investors out there wonder if we are getting closer to a point where it might be a wise use of resources to return capital to shareholders. Other large tech companies do it, nearly all the media companies do, at what point would you and at what point would the board of Google consider capital returns? And then second question is, I’m just wondering on the switch of the default browser on Mozilla from Google to Yahoo! in the quarter, and going forward is there any way you can quantify the impact of that? And the investors also wondering, is it possible that could happen for your Safari agreement with Apple? Thanks a lot.
Patrick Pichette: So, why don’t I take the last question first and then the first question. The last question is, you’ve all heard the announcements about Mozilla. And so when we don’t comment on the details of any of our partnerships that we have. Having said that, we continue to do two things that really matter. One is our users continue to actually go in, if they love Google, they will continue to find Google, whichever platform, whichever browser, and that’s really what we’ve focused on doing. And then the second piece is the way to win this in the long-term, right, it’s very simple. You just make wonderful products. And when you make wonderful products that are magical people will find them. And so that’s the strategy that we’re using and we just don’t comment on any of our - we’ve never commented on any of our deals, so we want comment on Mozilla either. And then, for your first question, Anthony, I mean, again I can’t - I just can reiterate the same message that I give on a regular basis, which is share price does matter. It matters to our board. It matters to all of us. We’re all shareholders in the company. And we do review this issue on a regular basis. We review it again responsibly with the Audit Committee, with the board. And I just have nothing to announce today.
Anthony DiClemente: Thank you.
Patrick Pichette: Thank you so much for your question, Jamie. Let’s go to our next question, please.
Operator: And we’ll take our next question from Eric Sheridan with UBS.
Eric Sheridan: Thanks for taking the questions. One on device mix, which, Omid, you called out. Is there any sense you can give us of whether some of the pricing per ad unit is starting to close from the device mix. So even though you’re giving more volumes from mobile whether be smartphone or tablet we’re starting to see any impact of pricing continues to move up versus desktop pricing you’re seeing across your ad portfolio, would love any commentary around that. And then second, Patrick, you called out the FX impact in the Q4, any help you can give us on how we should be thinking about the FX impact going forward on their a gross or a net basis to the business as you see it versus spot today? Thanks.
Patrick Pichette: Sure, I’ll let Omid answer the first question then I’ll jump on the second.
Omid Kordestani: Sure. Thanks, Eric for the question. The way we look at this, as I said, we look at mobile and as a behavior today really as - versus a specific device. And people are using screen interchangeably, simultaneously throughout the day. And we really think about the user and the context rather than a particular form factor or device. And similarly in terms of the pricing model here, what we are focused on really building this ecosystem just the way desktop took a long time to develop and have the right ad formats that really took advantage that the platform had to offer. We’re looking at this the same way. We are developing different kinds of formats, working with marketers on mobile, estimated store visits, app install, app re-engagement ads and cross device conversions. And we really feel good about the traction we’re having and our sales team and advertiser agencies partners are working with us making rapid progress here. So unfortunate, I can disclose any specific breakdowns, but I can just say that we are very focus on all aspects of this just as we evolve to desktop we’re doing the same in this world. On to you, Patrick.
Patrick Pichette: Thank you. On the issue of FX, I think that the most important point to think about in Q4 is - I mean it was material. As I said, it was like on a gross basis over $600 million. You’ve all seen the deterioration of the euro, the GDP, the yen, I mean it’s versus the U.S. dollar. The one thing I would just note from our results in Q4, I mentioned this in the past that, our FX rates are set at Google a month in arrears. So in last week of November we would have set our FX rate for December. So interestingly, the December rates we’ll set January. And you’ve seen already in December a continued kind of nose dive in certain areas, especially the euro, and the yen. So, all I can say is for all the information we have right now is, that’s not going away. And I think that everybody should be kind of considering it. On the flipside of that, I just want to kind of reinforce the fact that our FX hedging program continues to do exactly what it’s supposed to do, which is in a low volatility environment we buy insurance. And in moments where we have such shocks like we’re having right now, we did get a lot of benefit out of this hedging program and just as a remainder we hedge profits, right? We don’t hedge revenue. It just happens that we book the profits to revenue, because of the accounting rules. And so we’ve seen in Q4 approximately $150 million of hedge benefits, which is actually quite a substantial amount on the total $600 million and we’ll continue to have hedge benefits through the course of the year to a certain extent. So I think that from that perspective, right, real hit in December additional, but in a good position from our hedge FX program.
Eric Sheridan: Great. Thank you so much.
Patrick Pichette: Thank you for those questions. Jamie, why don’t we go to our next question, please.
Operator: And we’ll go next to Ross Sandler with Deutsche Bank.
Ross Sandler: Great. I had two questions. Patrick, towards the end of the prepared remarks you said that Google show a balance of growth and discipline, and a willingness to throw a little back. Can you just elaborate on that comment? What do you mean when you say that? Are you referring to the pace of expense growth or throwing something back in terms of capital allocation, just a little clarity on that one? And then, Omid, the question on app indexing, I think you guys said in November that log-in searches have about 15% coverage in terms of app content. Where is that percentage today and when do you guys think it will be closer to 100%? Thanks.
Patrick Pichette: Ross, let me - it’s Patrick, let me jump in on the first question then I’ll let Omid answer the second. On the first one, all I wanted to highlight to our investors, shareholders and community at large is, as I said, 2014 was a year of significant investment growth. I mean, we see real potential in so many areas that are exciting to us and where we see great momentum. That - what I wanted to make sure is that, our investors continue to understand that we will push for growth, but in a disciplined manner. And if things don’t materialize in the way that you don’t hit your hurdles, you don’t hit your timing, right, we are actually disciplined to make sure that we don’t have expenses ahead of the curve and we continue to monitor it quite closely. So in that sense if we see conditions change, it’s really important that you have the confidence that when we manage these investments we do it in the prudent manner, right, optimistic, but there’s always a dose of circumspection to make sure that you get the best bang for your buck in these roll-outs. And that’s what I really want to kind of communicate and signal to the Street, which is, it’s a balance. It’s always about a balance but given our situation, given all of the results that we’ve had, I mean, 18% year-over-year growth, in our sites if you just look at the sites, which is the core of the business growing 18% year-over-year, despite all the FX headwinds, right? It just tells you, look, this is a license to continue to invest smartly in the way we do, but I just want to kind of reaffirm to you that we do it in smart way and a discipline manner. We’re driving forward make sure we don’t waste our shareholders money. So with that, I’ll turn it over to Omid to answer the first question, please.
Omid Kordestani: Yes. Thanks, Ross. So as I said in my opening remarks that 15% of signed-in users’ searches on Android now return deep links to app. The way we are focused on this is that we have opened up app indexing to all Android developers, so their apps can appear in searches, also linking directly to the right content in the apps. And it really becomes the job between the developers trying to understand intent and how obviously our research works and determining the best results to provide, including the deep links. We offer this deep linking and search ads as well. Booking.com use Google Search Ads to drive installs and reengagement via deep linking for their mobile approximately, and we are seeing more and more adoption like this by our advertisers. So, obviously, it’s an area we are going to continue making progress on, we are very pleased to the traction we are having and how mobile monetization is performing. Thank you.
Patrick Pichette: Thanks for your question, Ross. Let’s go to our next question, Jamie, please.
Operator: And we’ll go next to Ben Swinburne with Morgan Stanley.
Benjamin Swinburne: Thank you. Patrick, just going back to return of capital again, there was– there’s some news today that there is a potential bill to allow repatriation of cash back to the U.S. at a 6% tax rate. I’m wondering, would that impact, how you and the board would think about return of capital, or is that sort of a completely relevant separate point? And then second, for me - for either of you, any color you can share with us on your wireless ambitions, I think, both on the MVNO side and 3.5 gigahertz, there has been a lot of discussion in the press about what Google is up to, any update you can give us on that, would be great?
Patrick Pichette: So, on the second question, thank you for your questions, Ben. And on the second question that you’ve asked, right, there is a lot of speculation out there. And if we had to answer off every speculation on Google’s part, what’s going on, I mean, we just would be - my PR team would be really busy. So we just won’t comment on any speculative news. On the first question, on return on capital, absolutely, I mean, we have right now a mix of, kind of, roughly 60-40 between our U.S. 40, international 60 of our cash. We have good use for our cash in both places. But if, in fact, we had a lot more flexibility about repatriating cash, that would make a big difference in the way that we think about it and or, at least, we’d take it in consideration for sure in our dialogue with the board. And so it’s clearly one element, that’s part of the puzzle that we would take in consideration. So if there is anything you can do to get that thing through Congress, Ben, we would really love it and just let us know when that happens.
Benjamin Swinburne: I will call my Congress person. Thank you.
Patrick Pichette: Thank you so much. All right, Jamie, we are going to go to our next question, please.
Operator: And we’ll go next to Douglas Anmuth with JP Morgan.
Douglas Anmuth: Thanks for taking the question. You’ve had greater emphasis on e-commerce over the last few years with Google Shopping and Express. I was hoping you could give us an update on Google Wallet and how strategic that is to your business overall and kind of closing the loop payments in general. And then secondly, can you comment, Patrick, on whether there is just anything in particular in driving the gap that we saw on sites between paid click volume and CPCs beyond some of the normal mix shift issues and FX? Thanks.
Patrick Pichette: So why don’t I take the second question immediately, and then I’ll let, Omid, answer the issue of the commerce. So on the first one, look, it’s - I want to come back on the sites issue, because 25% and then the minus 8% in terms of click growth and CPSs. And I want to start with that, because that’s always the case when people kind of just focus on one, they - we kind of tend to forget the big picture, which is, it’s a mix of these two things that give you this revenue that’s been very strong in sites this quarter, so never look at them in isolation. Having said that, as I said in my prepared remarks, the monetization metrics for sites has all the factors that I kind of usually discuss, which is geographic, device, property, the FX and all the things I talk about. So I think, it would be misguided again this quarter to pin it down to just one trend. I think people have a tendency to say, okay, well, it’s mobile, or it’s FX. And but I would like to point out three things specifically this quarter. As we know as I already mentioned right, FX has been a big impact this quarter. I also noted the strength of mobile performance in our sites earlier. And I remind you that, our sites line also includes YouTube, where we continue to see impressive growth, both in developed countries and emerging markets. So, there is the rest of it, there is all these pieces, but these are some of the pieces that we should take note during this quarter. Does that make sense? I will turn it over to Omid, to answer the first question on what’s going on with Google Shopping et cetera?
Omid Kordestani: Yes, on Shopping and commerce in general, then I’ll talk on payments, really our focus is building products that turn consumers’ shopping intents into actions, quickly, easily and enabling businesses to connect and retain these customers. On payments, the goal is really to remove all the friction that one encounters now in the shopping experience. And what we’re really working on here is, move beyond just tap and pay and have a full functional payment system. Today, users can send to money to friends through Gmail using their wallet app and also just made this functionality available in the UK. Loyalty, gift cards can be stored on the Wallet app to buy with Google button makes it possible for users to purchase with two clicks. So we really are focused on building a rich offering here to make it easier to shop and pay and remove the friction. Thank you, Doug.
Patrick Pichette: Thank you so much for you question, Doug.
Douglas Anmuth: Thank you.
Patrick Pichette: Jamie, let’s go to our next question, please.
Operator: And we’ll go next to Justin Post with Merrill Lynch.
Justin Post: All right. Thank you. I don’t know if you can help us at all, but just kind of overview of core search growth at all, if you can, in some of your mature markets anyway to breakdown that at all? And then as you think about the search improvements you’ve made, just a little high level overview, obviously, big changes with PLAs and enhanced campaigns over the last couple of years, didn’t seem like, there was a lot for this holiday, but maybe outline some of the improvements you’ve made recently? And then any - how is your pipeline looking for this year? Thank you.
Patrick Pichette: Omid, do you want to take that question?
Omid Kordestani: Yes, I’ll start and then we can add more context if you have more color you need, Justin. So in terms of product listing at PLAs, it’s very successful products and we are really pleased with its performance, advertisers are very pleased with it. And we also have local inventory apps that enable merchants to show customers this information in the U.S., UK, France, Germany, Japan, and Australia, and obviously we are going to continue to expand that. As I said in my remarks, we added estimated store visits in December, and it’s been one year since we launched estimated total conversions. And just to give you some anecdotes with customers, PetSmart saw 10% to 18% of clicks on search Ads led to store visits and they’re now investing more in Ads to reach customers across multiple screens, Famous Footwear nationwide chain have 1,100 stores. They found that 15% to 17% of the clicks on Ads resulted in store visits, and they were able to mix up the products that they promote and there is in-store merchandising strategies by region. So it’s - for us it’s early to think about the impact of revenue, but we really expect these suite of products to continue to help the advertisers measure at a full value of their online spending and work with us to enhance those. In terms of specific search numbers, we don’t really break that down, and provide any more data on that. Thank you for your question.
Patrick Pichette: Thank you, Justin. We’ll have - do we have time - couple of more questions, okay. So, Jamie, let’s go to our next question, please.
Operator: And we’ll go next to Mark Mahaney with RBC Capital Markets.
Mark Mahaney: Hey, thanks. I’ll echo Stephen Ju’s comment earlier, I think it would be great if you broke out that nonperformance advertising at some point in the future that data point would be very helpful. The CPC trends on sites that - they kind of inflected back down after showing a positive trend. It’s kind of hard to think that that’s nothing, but FX, I know, you have this mix of other factors, could you just clarify that, or could you quantify what CPC sites, CPSs would have been year-over-year ex-FX? And then finally, Omid, could you just talk broadly about YouTube and you’ve come back you’re more engaged with the company, I think, there is bit of a change in management’s approach, I think, the YouTube and how you want to position it, I know it’s a broad question, but could you just talk about what you want to do differently with YouTube, going forward to the next few years? Thank you.
Patrick Pichette: So on the first question, why don’t I jump in and then I’ll let Omid talk about Q2. Look, as I mentioned just a minute ago, if you look at the sites CPCs, we purposefully actually don’t point to one item, like I think, it would be tempting to just say, okay, so it’s all FX this quarter, because geography has a big impact. As I mentioned right, the different properties on our sites, YouTube has an impact as well in the sense that’s it’s growing and it’s growing in emerging markets, as well as in its core more developed markets. I purposefully made the case that’s important to note that, on the mobile side, I think, we see continued strength in mobile. And so from that perspective, it’s always trying to catch-up to the desktop, which itself as always improving, but we see positive trend there. So it is the mix of all these factors and we don’t give down all of the details on a quarter-by-quarter basis, because they just move all over the place. So that’s the answer for that one, Mark. Sorry, that’s not Mark. And then, I’ll let Omid answer the question on YouTube.
Omid Kordestani: Sure. So first of all, in general, just to give you sense of this, as you said, I’ve come back in, I just spent a lot of time CES, here in Europe spending time with customers as well. And there is just tremendous excitement about YouTube, and over 1 billion people come to the service every month and YouTube mobile revenue is up more than 100% year-to-year. And what we’re really after here is finding the click for brand, GRP brand list, other metrics, and advertisers are already running brand list studies about 6,000 of them have done this with that - already with us. And what’s really unique about this service is the velocity that the creators enjoy to create and deliver content to a worldwide audience, and our investments in the service and the creators just continue to pay back for us. So I know based on my meetings, I spent a lot of time with consumer goods companies at CES with major agencies there. Everybody just wants to do more. There are a lot of success stories the way they engage with us. And for us the challenge frankly is to structure our sales organization, hire the right people to go deeper with these customers with our agencies. And so you’ll just see a lot of success and emphasis from us as we go after the branding dollars.
Mark Mahaney: Thank you, Omid. Thank you.
Patrick Pichette: Thank you so much, Mark. Jamie, we’re going to take one more question, so if you can turn it on, please.
Operator: And we’ll go next to Mark May with Citi.
Patrick Pichette: Mark, are you there?
Operator: And if you check your mute button, sir, we cannot hear you.
Mark May: Hello.
Patrick Pichette: There we are.
Mark May: Right, sorry about that. Two questions please. Could you tell us what your strategy is in the area of digital payments and is there way that you can leverage Android to develop differentiated product in the market. And then, secondly, sorry, if I missed this. But how should we be thinking about the strategic and the financial importance of search partnerships like, for instance, the Safari deal. And if there is anything that we should be reading into the recent changes at Mozilla, and I think before that Spotlight and Siri search as far as either Google strategy and thinking in this area or its competitiveness in these deals? Thanks. Sorry, it’s a lot, but…
Patrick Pichette: That’s okay, Mark. No problem. So I’ll take the second question, and then I’ll flip it over to Omid to answer the Wallet one. So on the issue of partnerships, Google has a lot of partnerships, right, it’s got - it’s an anchor of our strategy, because that actually gives us distribution, distribution is good. And so we also we look for partnerships in many spaces. Partnerships have to be win-wins, and in that sense, right, we’ll always look for those combinations. But also at the end of the day, there’s a second piece of the strategy, which is, as I said earlier, building amazing product, because if you build the amazing products then people want to distribute you product. And so that’s why, we have a meet in the whole search team that actually do this amazing job through the knowledge graph and all of the other elements of search, and no matter what the device, no matter the location, no matter the time of day. If we give you the answer as you’re looking for and 10 clicks less than it was before and then even faster and better all the time, that’s what wins, and that’s the core of what we’re focused on, and then people will find the way to get the Google. So, yes, partnerships matter. But at the core of it, you need partnership, because you have a phenomenal product. And that’s what we’re going to continue to build this amazing company. So I’ll let with that Omid talk about our developments for digital payments.
Omid Kordestani: Hi, Mark, I already addressed this a little earlier, but - so I’ll summarize it again. But we’re really after removing the friction here in all the products to improve commerce and make the experience for our users seamless here. And there’s really two areas we’re focused on; one is really building a full functional payment system that just is beyond tap and pay. So I mentioned that earlier using Gmail and the Wallet App to send money to friends, loyalty and gift cards and buying with Google button with a press of two clicks. So and we just - the NFC devices are available, and we are really getting closer and closer to broader merchandise option. And so you’ll see us emphasizing that through the devices that we are supporting out there, as well as the payment services and commerce services that we provide. So I think, you will see a lot of progress here as we - as I said try to remove the friction here.
Patrick Pichette: Thank you so much for your question, Mark. Omid, I need to thank you. I mean, you’re at the other end of the world and staying late for us, I think, I just can’t thank you enough for all of your support over…
Omid Kordestani: It’s my pleasure. We’re excited about the year ahead and looking forward to future updates with this group of people. Thank you.
Patrick Pichette: For all of you thank you again for your support in 2014. Welcome to 2015, and I couldn’t stop without thanking again all of our partners, our users, and lastly, our employees, all Googlers around the world that make this magic happen every day, couldn’t do it without you, so thank you again. And Jamie, I’ll let you close the call on this.
Operator: Thank you. That does conclude today’s conference. We do appreciate everyone’s participation. Please have a great day. | [
{
"speaker": "Operator",
"text": "Good day, everyone and welcome to the Google Inc. Fourth Quarter 2014 Earnings Conference Call. This call is being recorded. At this time I’d like to turn the call over to Ellen West, Vice President, Investor Relations. Please go ahead."
},
{
"speaker": "Ellen West",
"text": "Thanks so much, Jamie. Good afternoon, everyone, and welcome to Google’s fourth quarter 2014 earnings conference call. With us today are Patrick Pichette and Omid Kordestani. As you know, we distribute our earnings release through our Investor Relations website located at investor.google.com. So please refer to our IR website for our earnings releases as well as the supplementary slides that accompany the call. This call is also being webcast from investor.google.com. A replay of the call will be available on our website later today. Now, let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward-looking including statements regarding Google’s future investments, our long-term growth and innovation, the expected performance of our businesses and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on this call, such as operating income and operating margin, are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation and, as applicable, other special items. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will now turn the call over to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks, Ellen. And welcome to 2015 everyone. Before we get into the numbers, I am going to give a brief overview of our performance this quarter, as the data is actually quite noisy through the P&L. So to start, let’s say, that we saw continued strength in our core advertising business. This was really driven by a strong holiday and mobile performance from our Sites line. We saw a great momentum in our programmatic business highlighted by our mobile display and our ads platform product. But we also faced a few real challenges as well. On the revenue side, clearly as you heard out the strengthening of the U.S. dollar resulted in a gross negative currency impact of $616 million just into Q4. But thanks to our hedging program the net impact was actually attenuated, with a net revenue impact of $468 million. Also on the Other Revenue line not only did we see that negative currency impact really impact the Play growth, particularly in Japan, but also while the Nexus 7 was very well received as a new phone, we had real issues and unable to secure sufficient inventory to meet the demand that we had forecasted. So for both these factors in fact, we see lower other revenue growth this quarter. On the expense side, we had number of unusual charges to our operating expenses hit this quarter. I’ll provide you more details in a few minutes as we go through the conversation. But together these items added up to slightly over $300 million in expenses to our P&L. Lastly, if you go through the CapEx line, you will note that we’ve made real estate purchases in Q4, which helped us relieve both pressure on our work space for current employees but also to accommodate our future growth. And this also resulted in a large sequential increase in our real estate capital expenditures this quarter. So now that you have the basics, why don’t we dive into the details? Our gross total consolidated revenue grew 15% year-over-year to $18.1 billion, and it was up 10% quarter-over-quarter. Without currency fluctuations our gross consolidated revenue growth would have, in fact, been 18% year-over-year. And despite all the FX pressure our Google Sites revenue was up a healthy 18% year-over-year to $12.4 billion, was up 10% quarter-over-quarter, in part driven by the strength in our mobile search. Network revenue was up 6% year-over-year at $3.7 billion and was up 8% quarter-over-quarter. As a reminder, our network business includes really two types of businesses with different growth profiles, our legacy AdSense business, particularly AdSense for search, where we’ve continued to make policy changes for the benefit of our user experience, but which has negatively impacted the growth in clicks specifically. Our clean-up efforts have resulted in fewer clicks, but also higher CPCs as I’ll discuss in a minute. The other business that in the network line are newer display and programmatic businesses including AdMob, AdExchange, DoubleClick Bid Manager, and these continue to grow at a strong rate. Finally, Google’s other revenue grew 19% year-over-year to $2 billion was up 6% quarter-over-quarter, driven by year-over-year growth in our Play Store, but offset by the FX impact and the challenges in our hardware business I mentioned earlier. Our global aggregate paid clicks were up 14% year-over-year, and up 11% quarter-over-quarter. Aggregate CPCs were down 3% year-over-year and also down 3% quarter-over-quarter. And if we go on our monetization by property, the Google site paid clicks were up 25% year-over-year and up 18% quarter-over-quarter. With Google sites’ CPCs were down 8% year-over-year and down 8% quarter-over-quarter. On the network side, network paid clicks were down 11% year-over-year and down 7% quarter-over-quarter, but our network CPCs were up year-over-year 6% and 10% quarter-over-quarter for the reasons I mentioned. Our monetization metrics continued to be impacted by a number of factors. They include geographic mix, device mix, property mix, FX, as well as ongoing product and policy changes. Turning to geographic performance, if you go to our earning slides, which you’ll find on our Investor Relation website, you’ll see that we’ve broken down our revenues by US, UK and rest of world to show the impact of FX and the benefits of our hedging program. So please refer to those slides for the exact calculations. So despite large currency headwinds we saw solid performance from our core advertising business around the world. The US revenue was up 14% year-over-year to $7.9 billion. The UK was up 10% year-over-year to $1.7 billion. And in fixed FX term it actually grew to 11% year-over-year. Non-US revenue excluding the UK was up 18% year-over-year to $8.6 billion, accounting for 47% of total revenue. And in fixed FX terms in fact the rest of the world grew at healthy 24% year-over-year. So let me turn now to expenses. Traffic acquisition costs were $3.6 billion or 22% of advertising revenue. Our non-GAAP other costs of revenue was $3.1 billion in Q4, which exclude SBC as well. Our non-GAAP operating expenses totaled $5.8 billion, again excluding stock-based compensation. And as a result our non-GAAP operating profit was $5.6 billion and non-GAAP operating margins were 31% in Q4. As I mentioned at the beginning, we had a number of unusual operating expenses that impacted us this quarter. We typically review our estimates accounting policies and balance sheet on an ongoing basis and make adjustments when we think and see it necessary. Normally, I wouldn’t call out these, but because they totaled slightly over $300 million this quarter, I wanted to give you some sense of these adjustments, although I won’t be providing a lot of detailed break-out. So first we took approximately half that amount in compensation charges resulting from a one-time payment and reclassification between SBC and bonus expense. The other half came from a review of our real estate portfolio, where we decide to take write-down on a small number of assets and also one-time payment to buy out a number of leases in a couple of markets where we face acute space pressure. Headcount was up, but just over 2,000 in Q4. In total we ended the quarter with approximately 53,600 full-time employees. You’ll notice also that our effective tax rate was 16%, again another discrepancy for Q4, which was really, primarily impacted by the extension of the R&D tax credits for 2014 with the entire credit being taken in Q4. As well as continued mix shift from earnings between our domestic and international subsidiaries. Let me now turn to cash management. Other income and expenses was $128 million. Interest income and realized gains on investments offset the continued impact of expenses from our FX hedging programs. For more detail on OI&E, please refer to the slides that accompany this call on our IR website. We are pleased with our strong operating cash flow at $6.4 billion. Our CapEx for the quarter was $3.6 billion. And this quarter, most of the CapEx was spent on related to facilities, production equipment, and datacenter construction in that order. So as I mentioned a few minutes ago, we have been opportunistic about acquiring space in real estate where we need to relieve pressure and accommodate for future growth. To that end, our facilities expenditure included just over $900 million of real estate investments during the quarter, of which $585 million was related to the acquisition of our property in Redwood City that we disclosed in our 10-Q for the third quarter. Our free cash flow was $2.8 billion, and I also want to note that we completed in Q4 the sale of Motorola Mobile to Lenovo in October 29. We recognize a gain on disposition of $740 million net of tax, which is included in our net income from discontinued operations. So there you have it, despite a noisy quarter from a P&L perspective. We can say that we had strong results in our core business as evidenced by our 18% fixed FX growth this quarter and are well-positioned for the year ahead in the long-term. As Larry says, although the vast majority of our resources in time continue to be invested in our core products, we also have enthusiasm to invest in new promising ideas like Self-Driving Cars or Loon. We use the same disciplined approach to these new areas that we used for investing in our earlier bets like Android or Chrome or Display. Our projects start with small dedicated teams that are given clear milestones to hit before they can get further investments. And in cases where we achieve success against our milestones, we expand our investments, and you saw this as an example earlier this week with our Fiber teams. We greenlighted 18 cities in four metropolitan areas in the U.S., out of the 34 cities and 9 metros that we had reviewed in 2014, and they’re off to the races. In other cases, when the teams aren’t able to hit hurdles, but we think there are still a lot of promise. We might ask them to take a pause and take the time to reset their strategies, as we recently did in the case of Glass. And in those situations our project don’t have the impact we had hoped for, we do take the tough calls. We make the decision to cancel them and you’ve seen us do this time and time again. So before I turn it over to Omid, I’d like also to note that in many ways 2014 was a year of significant investment growth, both in CapEx and OpEx at Google. From an investment perspective, we’ll continue to seek a healthy balance between growth and discipline and the willingness to throw a little back when we reached the limits of what we believe we can manageably absorb. So with that in mind, I’ll take it over to Omid now to provide more specifics on the successful performance of our core and new businesses. Omid is joining us by phone from another location today. So I hop it over to you, Omid."
},
{
"speaker": "Omid Kordestani",
"text": "Thanks, Patrick. Hi, everyone, happy New Year. And thanks for joining us today. This is Omid. It’s my pleasure to join you from London tonight. I’m glad to be here to reflect on the last quarter and look ahead to 2015. 2014 ended with healthy momentum enabling us to achieve $66 billion in revenue for the year. In Q4, we launched Lollipop, our newest version of Android, refreshed our line of Nexus devices and introduced Inbox by Gmail, a new inbox that enables users to focus on the messages that matter most to them. Meanwhile our sales teams worked diligently with our advertising partners to deliver a strong holiday season. Today, I’ll do a quick walkthrough of the business highlights from Q4. First, I’ll give an overview of the different sectors of our ads business, performance and brand advertising and our advertising platforms. Then I’ll cover progress in our emerging non-ads businesses. Let’s begin with the performance advertising. We continue to evolve the foundation of Google’s advertising business to reflect a multi-screen constantly connected world. Mobile is now a behavior, not a device, and it has a variety of unique characteristics. First, let’s talk about local advertising. On mobile, consumers want to know about the stores and goods near them. We launched some exciting updates last quarter. In October, we announced local availability for product listing ads and local store front, products that give customers real time information about goods that are in stock close to where they are. Major retailers like Macy’s and REI took advantage of these local inventory ads during the holidays. Overall, we saw strong engagement and results from big-box retailers during the holiday season. A second priority has been the creation of new measurement tools. We recently added estimated store visits to our estimated total conversations measurement suite. Now, advertisers can see a reliable estimate of the number of times a search ad click drive the store visit. During the holidays, ULTA Beauty reported that 12% of clicks on search ads led to a store visit with significant gains in ROI from their AdWords search marketing spend. These mobile-specific metrics help advertisers measure the full impact of their mobile marketing. The third area of progress is apps. We have driven hundreds of millions of app downloads on Google Search, AdMob and YouTube. And this business continues to grow at a healthy clip. During the holiday season, Office Depot used Google Search Ads to promote their ElfYourself app that helps shoppers create videos of people re-imagined as dancing elves. By using Google Search Ads they saw a 65% conversion rate. We have recently enabled users to more seamlessly navigate between apps and the web and find what they are looking for in apps more quickly. In organic search 15% of signed-in users’ searches on Android now return deep links to apps. We also offer app deep linking in search ads. Booking.com uses Google Search Ads to drive installs and reengagement via deep linking for their mobile app. Last quarter, we continued to see great traction with our established mobile advertising products as well, particularly Google Shopping. Online growth remains strong with Google Shopping traffic on mobile devices up nearly 100% compared to Q4 2013. For much of the holiday season mobile shopping clicks exceeded those on desktop as users increasingly made purchase decisions on the go. Now, I would like to turn to YouTube, where we continue to deliver great results for brand advertisers. YouTube now has more than 1 billion users. Everyday people watch hundreds of millions of hours of video on YouTube, generating billions of views. Watch time is up 50% year-over-year. We continue to invest in our YouTube Partners and Partner revenue has increased by more than 50% year-over-year. We are seeing great momentum in mobile advertising on YouTube. Mobile revenue on YouTube is up more than 100% year-over-year. TrueView, where advertisers pay only if someone watches their ad also continues to do very well. Walmart U.S.’s holiday performance is one of many success stories. During the week of Black Friday, they used YouTube’s TrueView format to drive a 300% week-over-week increase in views of their channel and more than 28 million views on the week. This was a 600% increase in YouTube channel views over the same week in 2013. And while we are all anticipating a certain football game in Arizona this weekend, the action has already begun for its advertisers on YouTube. Nearly 70 ads or teasers related to the big game have been posted to YouTube this year, up 55% from the same time last year. People have been - people have already watched them more than 44 million times, up 25% from last year and for more than 70 million minutes on YouTube nearly tripled the watch time compared to the same point last year. On average people watch each ad for more than a minute-and-a-half. We continue to develop the tools that make digital work for brand marketers, their agencies and premium publishers. There were two particular areas of focus from Q4 that I would like to highlight, programmatic and measurement. Let’s start with programmatic. Automated ad buying has benefitted performance-driven advertisers for years. We’re now extremely well positioned as brand advertising shifts to programmatic as well. We’re seeing great traction overall from our advertising and agency partners. Today, all the top 10 global agencies use at least one product in our double click suite. Specific products within the double click suite have shown exceptional momentum. DoubleClick Bid Manager, our primary frontend for programmatic buying has doubled in volume over the past year. During the recent us mid-term election, programmatic represented nearly one-third of advertisers’ Google ad budgets. We’re seeing that video, the ultimate brand medium, is starting to move to programmatic as well. After launching in June of 2014, Google Partner Select, our premium programmatic video marketplace now has more than 50 publisher partners including Hearst Television, and Food Network, and includes brands like BMW. Next, we continue to invest in measurement tools that enable advertisers, agencies and publishers to better understand the results of their digital marketing. It starts with addressing the question of viewability. Nothing else matters if a human did not see your ad. This is the top question for the industry and at Google we are doing our part to address it. Since July, we have been rolling out viewability report across our ad platforms, so that brands will know whether their video ads on digital channels were actually seen or not. We recently extended this activity reporting to video ads. Large advertisers are finding technology like this to be very useful. For example, Kellogg’s used DoubleClick Digital Marketing to buy their inventory programmatically and increased their ad viewability by 70%. Once a brand knows that their ads have been viewed they need to determine if the right people saw those ads and if they made an impact. That’s where our tools to measure brand lift come in. We have run more than 6000 brand lift surveys to help determine brand recall and purchase intent. For example, Mondelez wanted to measure the effectiveness of a recent digital campaign for the launch of a gum brand. With brand lift they found a 36% lift in brand awareness versus a control group, and a 97% lift in ad recall versus a control group. Getting these types of feedback in real time is impossible with offline media. This sets digital apart. Let’s move now to our emerging non-ad businesses. Google for Work had a great quarter. We started working with PwC to help them and a company they advise used Google for Work to move their businesses to the cloud. Cloud Platform continues to make good progress. We hosted our second Google Cloud Platform live event in November where we announced several new products such as Google Container Engine. Our digital content businesses are strong. I’m excited about Google Play’s development. Movies are now available in more than the 102 countries, music in 58, and books in 65. It’s growing internationally at unprecedented speed. In December, we partnered with Sony to digitally release the interview. It has been publicly reported that the film generated over $15 million in its first weekend, and that Google Play and YouTube drove the majority of those sales. We launched YouTube music key beta a monthly music subscription service that provides ad free music, background play, and offline viewing. This will also include a subscription to Google Play Music with more than 30 million songs, expert queue rated play lists, and more. Our hardware efforts demonstrate momentum just in time for the holidays we launched the Nexus 6, Nexus 9, and Nexus Player devices. Chromecast continues to be a hit. Just last week, we saw our 1 billionth tap of the cast button. Chromecast usage per device has increased by 60% since launch due to a growing roster of new apps and features. According to NPD Retail Tracking Service, in 2014, Chromecast was the number one selling streaming media device in the U.S. Chromebooks are now available in 33 different markets and enjoying strong success in K-12 education market in the U.S. I continue to be impressed by the work of our marketing teams that they’ve done around the world. The Year in Search has become an instant classic and YouTube Rewind is fast becoming one. From the Android Be Together Not the Same Campaign to Nest’s first TV ads and much more our marketing team contributed to our success in the all-important Q4 to a wide variety of efforts. That’s the wrap for 2014, and we are excited for what lies ahead in 2015. In closing, I want to thank our great partners, customers, and users, without them, we wouldn’t be successful. Thank you all so much. Now, let’s get back to Patrick for Q&A."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Omid. Before we turn to Jamie for Q&A, I was highlighted by the team here that, I actually had a slip, I said Nexus 7 instead of Nexus 6. And although the Nexus 7 is still a great device, what I really meant in my comments was to talk about the Nexus 6, which is this amazing device that we have launched with the Lollipop launch. So with that, I’ll turn it to Jamie, and we’ll go to Q&A. Jamie, if you can give the instructions please."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] And we’ll take our first question from Stephen Ju with Credit Suisse."
},
{
"speaker": "Stephen Ju",
"text": "Okay, thanks. So Patrick or Omid, I think, it’s been a few years since you talked to the Street about the run rate of your Display business. I wanted to see if you are willing to toss us a nugget here in terms of what your gross billings currently maybe, recognizing that you may be seeing growth in that revenue contribution depending on different products. And also it looks like the UK revenue saw modest bit of acceleration on an FX neutral basis, granted comps were probably modestly easier, but anything you can call out that would help there? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Yes, sure. It’s Patrick here. So on both topics, on the UK, we did see a good performance this quarter on UK versus last quarter, and as you said - mentioned, a 11% year-over-year. So the note of the UK is, the core business there is doing well. If you go back to last the deceleration, we have - it’s a big portion, it’s like 10% of our revenue, and we over 10%. The - you will remember that in our mix of products that are in the UK, clearly, our core products are there, but also AFS, like the network business is actually prominent in UK, as well in the U.S. less so in the rest of the world. And so that has an issue on the mix. And then also think of it as a promising item, which is, there is areas of new products, such as Play that are actually stronger international than they would be in the UK or in the U.S. So there lies some of the differences between the growth rates, but in many ways a lot of opportunities there, so that’s what’s going on in the UK, quite pleased with the progress there in Q4. And then on the issue of Display, we haven’t updated the numbers to the Street. And so we have to continue to, kind of, give you the updates that we do, and if we actually have a chance in the future then we’ll let you know when it’s time to do so. So thanks for your questions, Steven. And we’ll go to the next question, please. Jamie?"
},
{
"speaker": "Operator",
"text": "And we’ll take our next question from Carlos Kirjner with Bernstein."
},
{
"speaker": "Carlos Kirjner",
"text": "Hi, thank you. Two questions, if I may, Patrick. You hired 2,000 people this quarter versus 1,700 in the same quarter last year, which is a 22% increase. But Google management talks a lot about the opportunity in front of the business. If that’s the case, why aren’t you hiring more people and spending more in R&D. Can you tell us what are the specific constraints that you guys have or imposed on yourselves that prevent you from hiring 3,000 people this quarter instead of 2,000? That’s the first one. The second is the following, a few quarters ago, I seem to recall you saying that, you did not manage the business for margins, but you managed it for profit growth. Yet your operating income is down year-on-year and even if you are, the $200 million is growing very slowly. You could see how investors would look at that and say, well, how do you reconcile these things? How do you think investors should think about this trajectory of operating income growth? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Okay. So let’s take them in - each in step. On the issue of hiring, you will notice that relative to last quarter also, which is our third quarter is typically a big quarter, because we get the influx of the hires we do at colleges and otherwise. We actually decelerated from the third quarter as well. What we are managing for is, we just have a very high bar for hiring, if you can pass the bar, then we hire you. We also have capacity constraints on leadership, because there is a natural kind of number that you can kind of absorb within the culture of Google, it’s really important not to lose that culture and to have a velocity, to have traction. So there is no sense bringing 5,000 people that we couldn’t kind of bring into the teams and really make them perform it. So what we manage on the hiring is, we have our plans, and so we have a rate of targets of hires per each of the pals and the areas of the company. And then from there, the next hurdle is really about, can we find these people? And then finally, just making sure that we keep this kind of balance of bringing at a reasonable rate, so that we can actually absorb them in the company without losing the velocity and the culture of the place. So it’s actually a pretty complex puzzle, but we are managing it, it’s never perfect, but we are managing it, to the best we can. So that’s the first question. On the issue of margins, look, we have different, if you think of the businesses in Google, we are looking for growth, we are looking for growth in revenue, we are looking for growth in operating profits absolute dollars, and we are looking for great returns on investment. That’s the puzzle we solve for. So you have an advertising business that may have higher margins, lower capital intensity, than say, another business, which maybe Play, which has much lower margins, great prospect for growth with very large pools of revenue and margins available and we go after them for sure. You have Fiber right, and in the access, which is a completely different kind of capital intensity. But, again, the question is, does it promise, or does it have a case for large dollars operating profit delivery and high revenue and then a decent return on capital, that’s how we manage it. And to kind of say, okay, well, we have what we have today, but if Play could grow at, just to take the case, ten times faster than it is doing right now, right, it would impact margin, because on the weighted average basis, it would drag it down, but we love it. We love to be able to grow Play ten times faster than we are today. So that’s how we think of the puzzle. We manage them each individually for their potential, their returns, we all look for these big margin pools and these big revenue pools, and then we just allocate our capital to make sure that it’s balanced across these initiatives for maximum velocity. That’s the way we think about it, Carlos."
},
{
"speaker": "Carlos Kirjner",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you very much for your question. Jamie, let’s go to our next question, please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Anthony DiClemente with Nomura."
},
{
"speaker": "Anthony DiClemente",
"text": "Thanks a lot for the question. I have two. Patrick, given the importance of Google stock price as a motivator for existing employees, for recruitment of new employees. I think, many investors out there wonder if we are getting closer to a point where it might be a wise use of resources to return capital to shareholders. Other large tech companies do it, nearly all the media companies do, at what point would you and at what point would the board of Google consider capital returns? And then second question is, I’m just wondering on the switch of the default browser on Mozilla from Google to Yahoo! in the quarter, and going forward is there any way you can quantify the impact of that? And the investors also wondering, is it possible that could happen for your Safari agreement with Apple? Thanks a lot."
},
{
"speaker": "Patrick Pichette",
"text": "So, why don’t I take the last question first and then the first question. The last question is, you’ve all heard the announcements about Mozilla. And so when we don’t comment on the details of any of our partnerships that we have. Having said that, we continue to do two things that really matter. One is our users continue to actually go in, if they love Google, they will continue to find Google, whichever platform, whichever browser, and that’s really what we’ve focused on doing. And then the second piece is the way to win this in the long-term, right, it’s very simple. You just make wonderful products. And when you make wonderful products that are magical people will find them. And so that’s the strategy that we’re using and we just don’t comment on any of our - we’ve never commented on any of our deals, so we want comment on Mozilla either. And then, for your first question, Anthony, I mean, again I can’t - I just can reiterate the same message that I give on a regular basis, which is share price does matter. It matters to our board. It matters to all of us. We’re all shareholders in the company. And we do review this issue on a regular basis. We review it again responsibly with the Audit Committee, with the board. And I just have nothing to announce today."
},
{
"speaker": "Anthony DiClemente",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you so much for your question, Jamie. Let’s go to our next question, please."
},
{
"speaker": "Operator",
"text": "And we’ll take our next question from Eric Sheridan with UBS."
},
{
"speaker": "Eric Sheridan",
"text": "Thanks for taking the questions. One on device mix, which, Omid, you called out. Is there any sense you can give us of whether some of the pricing per ad unit is starting to close from the device mix. So even though you’re giving more volumes from mobile whether be smartphone or tablet we’re starting to see any impact of pricing continues to move up versus desktop pricing you’re seeing across your ad portfolio, would love any commentary around that. And then second, Patrick, you called out the FX impact in the Q4, any help you can give us on how we should be thinking about the FX impact going forward on their a gross or a net basis to the business as you see it versus spot today? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Sure, I’ll let Omid answer the first question then I’ll jump on the second."
},
{
"speaker": "Omid Kordestani",
"text": "Sure. Thanks, Eric for the question. The way we look at this, as I said, we look at mobile and as a behavior today really as - versus a specific device. And people are using screen interchangeably, simultaneously throughout the day. And we really think about the user and the context rather than a particular form factor or device. And similarly in terms of the pricing model here, what we are focused on really building this ecosystem just the way desktop took a long time to develop and have the right ad formats that really took advantage that the platform had to offer. We’re looking at this the same way. We are developing different kinds of formats, working with marketers on mobile, estimated store visits, app install, app re-engagement ads and cross device conversions. And we really feel good about the traction we’re having and our sales team and advertiser agencies partners are working with us making rapid progress here. So unfortunate, I can disclose any specific breakdowns, but I can just say that we are very focus on all aspects of this just as we evolve to desktop we’re doing the same in this world. On to you, Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you. On the issue of FX, I think that the most important point to think about in Q4 is - I mean it was material. As I said, it was like on a gross basis over $600 million. You’ve all seen the deterioration of the euro, the GDP, the yen, I mean it’s versus the U.S. dollar. The one thing I would just note from our results in Q4, I mentioned this in the past that, our FX rates are set at Google a month in arrears. So in last week of November we would have set our FX rate for December. So interestingly, the December rates we’ll set January. And you’ve seen already in December a continued kind of nose dive in certain areas, especially the euro, and the yen. So, all I can say is for all the information we have right now is, that’s not going away. And I think that everybody should be kind of considering it. On the flipside of that, I just want to kind of reinforce the fact that our FX hedging program continues to do exactly what it’s supposed to do, which is in a low volatility environment we buy insurance. And in moments where we have such shocks like we’re having right now, we did get a lot of benefit out of this hedging program and just as a remainder we hedge profits, right? We don’t hedge revenue. It just happens that we book the profits to revenue, because of the accounting rules. And so we’ve seen in Q4 approximately $150 million of hedge benefits, which is actually quite a substantial amount on the total $600 million and we’ll continue to have hedge benefits through the course of the year to a certain extent. So I think that from that perspective, right, real hit in December additional, but in a good position from our hedge FX program."
},
{
"speaker": "Eric Sheridan",
"text": "Great. Thank you so much."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you for those questions. Jamie, why don’t we go to our next question, please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Ross Sandler with Deutsche Bank."
},
{
"speaker": "Ross Sandler",
"text": "Great. I had two questions. Patrick, towards the end of the prepared remarks you said that Google show a balance of growth and discipline, and a willingness to throw a little back. Can you just elaborate on that comment? What do you mean when you say that? Are you referring to the pace of expense growth or throwing something back in terms of capital allocation, just a little clarity on that one? And then, Omid, the question on app indexing, I think you guys said in November that log-in searches have about 15% coverage in terms of app content. Where is that percentage today and when do you guys think it will be closer to 100%? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Ross, let me - it’s Patrick, let me jump in on the first question then I’ll let Omid answer the second. On the first one, all I wanted to highlight to our investors, shareholders and community at large is, as I said, 2014 was a year of significant investment growth. I mean, we see real potential in so many areas that are exciting to us and where we see great momentum. That - what I wanted to make sure is that, our investors continue to understand that we will push for growth, but in a disciplined manner. And if things don’t materialize in the way that you don’t hit your hurdles, you don’t hit your timing, right, we are actually disciplined to make sure that we don’t have expenses ahead of the curve and we continue to monitor it quite closely. So in that sense if we see conditions change, it’s really important that you have the confidence that when we manage these investments we do it in the prudent manner, right, optimistic, but there’s always a dose of circumspection to make sure that you get the best bang for your buck in these roll-outs. And that’s what I really want to kind of communicate and signal to the Street, which is, it’s a balance. It’s always about a balance but given our situation, given all of the results that we’ve had, I mean, 18% year-over-year growth, in our sites if you just look at the sites, which is the core of the business growing 18% year-over-year, despite all the FX headwinds, right? It just tells you, look, this is a license to continue to invest smartly in the way we do, but I just want to kind of reaffirm to you that we do it in smart way and a discipline manner. We’re driving forward make sure we don’t waste our shareholders money. So with that, I’ll turn it over to Omid to answer the first question, please."
},
{
"speaker": "Omid Kordestani",
"text": "Yes. Thanks, Ross. So as I said in my opening remarks that 15% of signed-in users’ searches on Android now return deep links to app. The way we are focused on this is that we have opened up app indexing to all Android developers, so their apps can appear in searches, also linking directly to the right content in the apps. And it really becomes the job between the developers trying to understand intent and how obviously our research works and determining the best results to provide, including the deep links. We offer this deep linking and search ads as well. Booking.com use Google Search Ads to drive installs and reengagement via deep linking for their mobile approximately, and we are seeing more and more adoption like this by our advertisers. So, obviously, it’s an area we are going to continue making progress on, we are very pleased to the traction we are having and how mobile monetization is performing. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks for your question, Ross. Let’s go to our next question, Jamie, please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Ben Swinburne with Morgan Stanley."
},
{
"speaker": "Benjamin Swinburne",
"text": "Thank you. Patrick, just going back to return of capital again, there was– there’s some news today that there is a potential bill to allow repatriation of cash back to the U.S. at a 6% tax rate. I’m wondering, would that impact, how you and the board would think about return of capital, or is that sort of a completely relevant separate point? And then second, for me - for either of you, any color you can share with us on your wireless ambitions, I think, both on the MVNO side and 3.5 gigahertz, there has been a lot of discussion in the press about what Google is up to, any update you can give us on that, would be great?"
},
{
"speaker": "Patrick Pichette",
"text": "So, on the second question, thank you for your questions, Ben. And on the second question that you’ve asked, right, there is a lot of speculation out there. And if we had to answer off every speculation on Google’s part, what’s going on, I mean, we just would be - my PR team would be really busy. So we just won’t comment on any speculative news. On the first question, on return on capital, absolutely, I mean, we have right now a mix of, kind of, roughly 60-40 between our U.S. 40, international 60 of our cash. We have good use for our cash in both places. But if, in fact, we had a lot more flexibility about repatriating cash, that would make a big difference in the way that we think about it and or, at least, we’d take it in consideration for sure in our dialogue with the board. And so it’s clearly one element, that’s part of the puzzle that we would take in consideration. So if there is anything you can do to get that thing through Congress, Ben, we would really love it and just let us know when that happens."
},
{
"speaker": "Benjamin Swinburne",
"text": "I will call my Congress person. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you so much. All right, Jamie, we are going to go to our next question, please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Douglas Anmuth with JP Morgan."
},
{
"speaker": "Douglas Anmuth",
"text": "Thanks for taking the question. You’ve had greater emphasis on e-commerce over the last few years with Google Shopping and Express. I was hoping you could give us an update on Google Wallet and how strategic that is to your business overall and kind of closing the loop payments in general. And then secondly, can you comment, Patrick, on whether there is just anything in particular in driving the gap that we saw on sites between paid click volume and CPCs beyond some of the normal mix shift issues and FX? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "So why don’t I take the second question immediately, and then I’ll let, Omid, answer the issue of the commerce. So on the first one, look, it’s - I want to come back on the sites issue, because 25% and then the minus 8% in terms of click growth and CPSs. And I want to start with that, because that’s always the case when people kind of just focus on one, they - we kind of tend to forget the big picture, which is, it’s a mix of these two things that give you this revenue that’s been very strong in sites this quarter, so never look at them in isolation. Having said that, as I said in my prepared remarks, the monetization metrics for sites has all the factors that I kind of usually discuss, which is geographic, device, property, the FX and all the things I talk about. So I think, it would be misguided again this quarter to pin it down to just one trend. I think people have a tendency to say, okay, well, it’s mobile, or it’s FX. And but I would like to point out three things specifically this quarter. As we know as I already mentioned right, FX has been a big impact this quarter. I also noted the strength of mobile performance in our sites earlier. And I remind you that, our sites line also includes YouTube, where we continue to see impressive growth, both in developed countries and emerging markets. So, there is the rest of it, there is all these pieces, but these are some of the pieces that we should take note during this quarter. Does that make sense? I will turn it over to Omid, to answer the first question on what’s going on with Google Shopping et cetera?"
},
{
"speaker": "Omid Kordestani",
"text": "Yes, on Shopping and commerce in general, then I’ll talk on payments, really our focus is building products that turn consumers’ shopping intents into actions, quickly, easily and enabling businesses to connect and retain these customers. On payments, the goal is really to remove all the friction that one encounters now in the shopping experience. And what we’re really working on here is, move beyond just tap and pay and have a full functional payment system. Today, users can send to money to friends through Gmail using their wallet app and also just made this functionality available in the UK. Loyalty, gift cards can be stored on the Wallet app to buy with Google button makes it possible for users to purchase with two clicks. So we really are focused on building a rich offering here to make it easier to shop and pay and remove the friction. Thank you, Doug."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you so much for you question, Doug."
},
{
"speaker": "Douglas Anmuth",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Jamie, let’s go to our next question, please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Justin Post with Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "All right. Thank you. I don’t know if you can help us at all, but just kind of overview of core search growth at all, if you can, in some of your mature markets anyway to breakdown that at all? And then as you think about the search improvements you’ve made, just a little high level overview, obviously, big changes with PLAs and enhanced campaigns over the last couple of years, didn’t seem like, there was a lot for this holiday, but maybe outline some of the improvements you’ve made recently? And then any - how is your pipeline looking for this year? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Omid, do you want to take that question?"
},
{
"speaker": "Omid Kordestani",
"text": "Yes, I’ll start and then we can add more context if you have more color you need, Justin. So in terms of product listing at PLAs, it’s very successful products and we are really pleased with its performance, advertisers are very pleased with it. And we also have local inventory apps that enable merchants to show customers this information in the U.S., UK, France, Germany, Japan, and Australia, and obviously we are going to continue to expand that. As I said in my remarks, we added estimated store visits in December, and it’s been one year since we launched estimated total conversions. And just to give you some anecdotes with customers, PetSmart saw 10% to 18% of clicks on search Ads led to store visits and they’re now investing more in Ads to reach customers across multiple screens, Famous Footwear nationwide chain have 1,100 stores. They found that 15% to 17% of the clicks on Ads resulted in store visits, and they were able to mix up the products that they promote and there is in-store merchandising strategies by region. So it’s - for us it’s early to think about the impact of revenue, but we really expect these suite of products to continue to help the advertisers measure at a full value of their online spending and work with us to enhance those. In terms of specific search numbers, we don’t really break that down, and provide any more data on that. Thank you for your question."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Justin. We’ll have - do we have time - couple of more questions, okay. So, Jamie, let’s go to our next question, please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Mark Mahaney with RBC Capital Markets."
},
{
"speaker": "Mark Mahaney",
"text": "Hey, thanks. I’ll echo Stephen Ju’s comment earlier, I think it would be great if you broke out that nonperformance advertising at some point in the future that data point would be very helpful. The CPC trends on sites that - they kind of inflected back down after showing a positive trend. It’s kind of hard to think that that’s nothing, but FX, I know, you have this mix of other factors, could you just clarify that, or could you quantify what CPC sites, CPSs would have been year-over-year ex-FX? And then finally, Omid, could you just talk broadly about YouTube and you’ve come back you’re more engaged with the company, I think, there is bit of a change in management’s approach, I think, the YouTube and how you want to position it, I know it’s a broad question, but could you just talk about what you want to do differently with YouTube, going forward to the next few years? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "So on the first question, why don’t I jump in and then I’ll let Omid talk about Q2. Look, as I mentioned just a minute ago, if you look at the sites CPCs, we purposefully actually don’t point to one item, like I think, it would be tempting to just say, okay, so it’s all FX this quarter, because geography has a big impact. As I mentioned right, the different properties on our sites, YouTube has an impact as well in the sense that’s it’s growing and it’s growing in emerging markets, as well as in its core more developed markets. I purposefully made the case that’s important to note that, on the mobile side, I think, we see continued strength in mobile. And so from that perspective, it’s always trying to catch-up to the desktop, which itself as always improving, but we see positive trend there. So it is the mix of all these factors and we don’t give down all of the details on a quarter-by-quarter basis, because they just move all over the place. So that’s the answer for that one, Mark. Sorry, that’s not Mark. And then, I’ll let Omid answer the question on YouTube."
},
{
"speaker": "Omid Kordestani",
"text": "Sure. So first of all, in general, just to give you sense of this, as you said, I’ve come back in, I just spent a lot of time CES, here in Europe spending time with customers as well. And there is just tremendous excitement about YouTube, and over 1 billion people come to the service every month and YouTube mobile revenue is up more than 100% year-to-year. And what we’re really after here is finding the click for brand, GRP brand list, other metrics, and advertisers are already running brand list studies about 6,000 of them have done this with that - already with us. And what’s really unique about this service is the velocity that the creators enjoy to create and deliver content to a worldwide audience, and our investments in the service and the creators just continue to pay back for us. So I know based on my meetings, I spent a lot of time with consumer goods companies at CES with major agencies there. Everybody just wants to do more. There are a lot of success stories the way they engage with us. And for us the challenge frankly is to structure our sales organization, hire the right people to go deeper with these customers with our agencies. And so you’ll just see a lot of success and emphasis from us as we go after the branding dollars."
},
{
"speaker": "Mark Mahaney",
"text": "Thank you, Omid. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you so much, Mark. Jamie, we’re going to take one more question, so if you can turn it on, please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Mark May with Citi."
},
{
"speaker": "Patrick Pichette",
"text": "Mark, are you there?"
},
{
"speaker": "Operator",
"text": "And if you check your mute button, sir, we cannot hear you."
},
{
"speaker": "Mark May",
"text": "Hello."
},
{
"speaker": "Patrick Pichette",
"text": "There we are."
},
{
"speaker": "Mark May",
"text": "Right, sorry about that. Two questions please. Could you tell us what your strategy is in the area of digital payments and is there way that you can leverage Android to develop differentiated product in the market. And then, secondly, sorry, if I missed this. But how should we be thinking about the strategic and the financial importance of search partnerships like, for instance, the Safari deal. And if there is anything that we should be reading into the recent changes at Mozilla, and I think before that Spotlight and Siri search as far as either Google strategy and thinking in this area or its competitiveness in these deals? Thanks. Sorry, it’s a lot, but…"
},
{
"speaker": "Patrick Pichette",
"text": "That’s okay, Mark. No problem. So I’ll take the second question, and then I’ll flip it over to Omid to answer the Wallet one. So on the issue of partnerships, Google has a lot of partnerships, right, it’s got - it’s an anchor of our strategy, because that actually gives us distribution, distribution is good. And so we also we look for partnerships in many spaces. Partnerships have to be win-wins, and in that sense, right, we’ll always look for those combinations. But also at the end of the day, there’s a second piece of the strategy, which is, as I said earlier, building amazing product, because if you build the amazing products then people want to distribute you product. And so that’s why, we have a meet in the whole search team that actually do this amazing job through the knowledge graph and all of the other elements of search, and no matter what the device, no matter the location, no matter the time of day. If we give you the answer as you’re looking for and 10 clicks less than it was before and then even faster and better all the time, that’s what wins, and that’s the core of what we’re focused on, and then people will find the way to get the Google. So, yes, partnerships matter. But at the core of it, you need partnership, because you have a phenomenal product. And that’s what we’re going to continue to build this amazing company. So I’ll let with that Omid talk about our developments for digital payments."
},
{
"speaker": "Omid Kordestani",
"text": "Hi, Mark, I already addressed this a little earlier, but - so I’ll summarize it again. But we’re really after removing the friction here in all the products to improve commerce and make the experience for our users seamless here. And there’s really two areas we’re focused on; one is really building a full functional payment system that just is beyond tap and pay. So I mentioned that earlier using Gmail and the Wallet App to send money to friends, loyalty and gift cards and buying with Google button with a press of two clicks. So and we just - the NFC devices are available, and we are really getting closer and closer to broader merchandise option. And so you’ll see us emphasizing that through the devices that we are supporting out there, as well as the payment services and commerce services that we provide. So I think, you will see a lot of progress here as we - as I said try to remove the friction here."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you so much for your question, Mark. Omid, I need to thank you. I mean, you’re at the other end of the world and staying late for us, I think, I just can’t thank you enough for all of your support over…"
},
{
"speaker": "Omid Kordestani",
"text": "It’s my pleasure. We’re excited about the year ahead and looking forward to future updates with this group of people. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "For all of you thank you again for your support in 2014. Welcome to 2015, and I couldn’t stop without thanking again all of our partners, our users, and lastly, our employees, all Googlers around the world that make this magic happen every day, couldn’t do it without you, so thank you again. And Jamie, I’ll let you close the call on this."
},
{
"speaker": "Operator",
"text": "Thank you. That does conclude today’s conference. We do appreciate everyone’s participation. Please have a great day."
}
] | null | null |
GOOGL | 3 | 2,014 | 2014-10-17 16:30:00 | Operator: Good day and welcome everyone to the Google Inc.'s Third Quarter 2014 Earnings Conference Call. This call is being recorded. At this time, I’d like to turn the call over to Ellen West, Vice President, Investor Relations. Please go ahead.
Ellen West: Thank you, Jamie. Good afternoon, everyone, and welcome to Google's third quarter 2014 earnings conference call. With us today are Patrick Pichette and Omid Kordestani. As you know, we distribute our earnings release through our Investor Relations website located at investor.google.com. So please refer to our IR website for our earnings releases as well as the supplementary slides that accompany the call. You can also visit our Google+ Investor Relations page for the latest Company news and updates. This call is also being webcast from investor.google.com. A replay of the call will be available on our website later today. Now, let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward-looking including statements regarding Google's future investments, our long-term growth and innovation, the expected [Audio Gap] this presentation and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on this call, such as operating income and operating margin, are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation and, as applicable, other special items. We've also adjusted our net cash provided by operating activities to remove capital expenditures which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will now turn the call over to Patrick.
Patrick Pichette: Thanks, Ellen. As some of you may know, we have a new leader in our Investor Relations team at Google. Her name is Ellen West. That’s the great voice you just heard a minute ago, a second ago. Ellen is a long term Googler who joined us in 2007. Although she is here with us today in Mountain View, she is actually based out of New York and that will give us a bit more footprint on the East Coast as well. So, Ellen, welcome to the team. With that, let’s dive into the details of Google’s financial performance for Q3. Our gross total consolidated revenue grew a healthy 20% year-over-year to $16.5 billion and was up 4% quarter-over-quarter. Without currency fluctuations, our gross total consolidated revenue growth would have been 19% year-over-year. Google sites revenue was also up 20% year-over-year to $11.3 billion and was up 3% quarter-over-quarter driven by the strength in our mobile search. Network revenue was up 9% year-over-year at $3.4 billion and was flat quarter-over-quarter driven by improved year-over-year growth in the AdMob and the Ad Exchange businesses. Finally, Google’s other revenue grew a healthy 50% year-over-year to $1.8 billion and was up 15% quarter-over-quarter, this driven by year-over-year growth mainly from the Play Store but also complemented by an increase in licensing revenue. Our global aggregate paid click growth was strong this quarter, up 17% year-over-year and up 2% quarter-over-quarter. Aggregate CPCs were down only 2% year-over-year and flat quarter-over-quarter. And without currency fluctuations, aggregate cost per click would have been down 1%, and in fact, up 1% quarter-over-quarter. As we began to do in our last earnings call, we continue to disclose paid clicks and cost per click changes by property type as well in addition to the aggregate number. So to that end, Google sites paid clicks were up 24% year-over-year and up 4% quarter-over-quarter. Google sites CPC were down 4% year-over-year and down 1% quarter-over-quarter. Our network paid clicks were up 2% year-over-year and down 4% quarter-over-quarter and network CPCs were down 4% year-over-year but up 2% quarter-over-quarter. Our aggregate monetization metrics continue to be impacted by a number of factors including geographic mix, device mix, property mix as well as ongoing products and policy changes. Turning to geographic performance now, we saw solid performance in the U.S. as well as in the rest of the world. In our earnings slides, which you can find on our Investor Relations website, you will see that we've broken down our revenue by U.S., UK and the rest of the world to show the impact of FX and the benefits of our hedging program. So please refer to those slides for the exact calculations. U.S. revenue was up 15% year-on-year to $7 billion. The UK was up 17% year-over-year to 1.6 billion and in fixed FX terms, the UK grew 10% year-over-year. In the UK, growth was impacted by a combination of factors this quarter including platform and property mix as well as tough comps from year-over-year and quarter-over-quarter growth rates for a number of reasons including for example weather. Our non-U.S. revenue excluding the UK was up 26% year-over-year to $7.9 billion. This accounted for 48% of total revenue which includes a 10 million benefit from our hedging program. In fixed FX terms in fact the rest of the world also grew 26% year-over-year, very healthy. Let me turn now to expenses. Traffic acquisition costs were $3.3 billion or 23% of total advertising revenue. Our non-GAAP other cost of revenue was 2.8 billion in Q3 which excludes stock-based compensation and also a non-cash impairment charge of 378 million related to a patent licensing royalty asset acquired as part of our Motorola Mobility purchase. Non-GAAP operating expenses totaled 5 billion, again excluding SBC. And as a result, our non-GAAP operating profit [Audio Gap] and our non-GAAP operating margin were 32% in Q3. Headcount was up roughly 3,000 in Q3. In total, we ended the quarter with approximately 55,000 full time employees. And please note that the headcount does include still approximately 3,500 full time employees from the Motorola business. In the past year, we continued to attract and hire the best talent from the best colleges and universities from all around the world. Continuing our past trend, graduate starts are much more heavily concentrated in Q3, which is part of why you are seeing the significant bump in headcount with the majority being tech hires, I want to kind of emphasize. Our effective tax rate for the quarter was 22% for Q3 and which includes the impact of the impairment charge that I mentioned earlier which is a non-deductible for income tax purposes. Let me turn now to cash management. OI&E or other income and expenses was $133 million. Interest income and realized gains on investments offset the continued impact of expenses from our FX hedging program. And for more details on OI&E, please do refer to the slides that accompany this call on our IR website. We continue to be happy with our strong operating cash flow at $6 billion. CapEx for the quarter was 2.4 billion. In this quarter the majority of the CapEx was related to our data center construction, production equipment and real estate purchases, in that order. It's important to remember that our infrastructure supports all of our products, whether they are core products like or Search or Ads, Maps or YouTube, but in addition to fueling our growth products like Photos and Hangouts, Google For Work and the Cloud platform. If you look at our data center announcements over the last four quarters, you will also see that we've been really busy with both groundbreakings and expansion all around the world including Finland, Taiwan, Singapore, recently announced Netherlands in addition to our ongoing investments in the U.S. In total, our free cash flow was then 3.6 billion. And before I close, I want to give a brief update on Motorola. The team continues to work hard and we look forward to seeing them join the Lenovo team soon. Motorola had a great Q3, with strong user reviews for products like the Moto X, Moto 360 and Moto Hint, clearly demonstrating the impressive momentum of the company. So there you have it. Strong results with continued strong growth in both revenue and profits and an optimism that provides us the confidence to fund strategic growth opportunities including the usual Android, Chromes and YouTube but also Google For Work and Cloud to name a few. Before I hand things over to Omid, I'd like to share with you some great news. I am really thrilled to announce that Omid is now officially Google's Chief Business Officer and this on a permanent basis. All of us at Google couldn't be happier to see Omid at his post running our business organization once again. And with that, I will turn it over to him for more details on our performance in the quarter. And after his remarks as usual, we will have Jamie open up the lines for your questions. Here you go, Omid.
Omid Kordestani: Thank you very much, Patrick. And hello, everyone. I am Omid Kordestani. I am happy to be back at my new old job and thank you for joining us this afternoon. I joined Google back in 1999 to help get our business off the ground and led our business operations until 2009. Since then I have served as an advisor for Larry and outside Google actively helped many entrepreneurs. I am thrilled to be back at Google leading our global business again. We continue to have the same boundless energy and endless curiosity we've always had as a company and we are as focused as ever in our mission of making information useful and accessible to everyone. Case in point, we are really excited about this week's Android Lollipop launch. This is our largest release on Android ever with over 5,000 APIs for developers. It adds new features including better notifications, battery life and security and introduces a refreshed, consistent visual style. And alongside the new devices Nexus 6, Nexus 9 and Nexus Player, consumers in India who bought the recently announced Android One will get the update to the latest software at the same time. Now I’ll do a quick walk through of the business highlights from Q3. As usual, we’ll give an overview of these four areas, performance and brand advertising, our advertising platforms and our emerging non-ads businesses. Let’s start with performance advertising, the core of our business. People want the right information at the right time. They don’t want to have to think about whether it’s on the web or in an app. We’ve learned this first hand as a developer of many services, Maps, YouTube, Gmail that also are some of the world’s most popular mobile apps. With that in mind, we have a simple goal with performance ads: help marketers connect with customers at the right moment to drive measurable results. Our partners have driven hundreds of millions of app downloads with AdMob on our click to download formats. But most mobile apps are downloaded, used once and eventually deleted. So we launched new features to help advertisers re-engage with users post download. For example, advertisers can now deep link from their search ads directly into their mobile apps. To succeed with multi-screen marketing, advertisers also need modern measurement tools so they can understand when their ads drive phone calls from customers resulting conversions on other devices or lead to store visits and purchases. Last October we announced estimated total conversions, our effort to help marketers better measure the value of their multi-screen advertising. We’ve worked to continue developing this product and launched cost device measurement for display ads. Clients have already found that mobile display campaigns drive 15% more conversions than they had previously measured. Let’s shift gears to talk about our shopping efforts. [Audio Gap] with performance ads we are directly connecting people with [Audio Gap] and then enabling them to buy and have them delivered. We keep making improvements to our products to help retailers. Keeping inventory organized and up to date is a constant challenge for retailers. We help them manage this issue by completing the transition of product listing ads to our shopping campaigns platform. And finally, people often want to find stores near them to make a purchase in person. We’ve long had local inventory ads that enabled merchants to show customers this information in the U.S. and we launched these in the UK, France, Germany, Japan and Australia last quarter. In summary, the core of our business, performance advertising, continues to deliver great results. Let’s move on now to our brand business. Our objective is clear here, make digital the best possible canvas for creative and effective brand-building campaigns. First let’s talk about YouTube. Any conversation about great advertising starts with great content. On YouTube, stars produce amazing content that our users love from Bethany Mota to Smosh to Mental Floss. Earlier this year we launched Google Preferred to help connect brands with premium ad inventory on our most popular YouTube channels. Since then we have secured upfront commitments from top media agencies. We’re just getting started with YouTube and its potential. We’ve sold out the majority of our U.S. Google Preferred offering which represents among the top 5% of popular channels inventory on YouTube. And as a result of terrific brand events in Germany, France, UK and Australia, we’re seeing tremendous interest from local agency partners around the world. Last quarter we also saw some great progress in our brand efforts beyond YouTube. We launched new ad formats customized for mobile screens. We also announced an expansion of YouTube’s TrueView ads into AdMob's network of more than 650,000 mobile apps. Everyday our teams work to develop both the products and terrific partner relationships that enable us to tackle any digital marketing challenge across multiple channels together. With encouragement from Google and YouTube, ABC executed a digital first marketing plan for their new fall TV line up. Their effort included custom five second-ads for TrueView and collaborations with homegrown YouTube stars. We’re very excited about the new deal with Mondelez and Starcom MediaVest. This global agreement will focus on video and display and is Mondelez’s largest digital media deal ever. Next let’s take a look at one of the fastest growing parts of digital advertising world, programmatic platforms for agencies and publishers. For many years now our goal has been to provide world class technology for brands, agencies and publishers who power their ads businesses. Today our DoubleClick suite is used by all major agencies and we’re particularly focused on multi-screen and video. DoubleClick Bid Manager is the go-to tool for marketers and agencies to navigate the rapidly growing programmatic advertising space. It’s doubled in size year-over-year by impression volume and we really love the progress we see here. For publishers, we help them make money from their content via our publisher tools from our Ads Exchange to customized private exchanges which complement our core offerings. This quarter we signed new private advertising exchange deals with publishers like Fox TV and Edmunds. This helps publishers generate revenue from premium ad space. We have nearly doubled the number of private [Audio Gap] our system year-over-year. Finally, we’re seeing remarkable momentum in our newer non-ads businesses, whether it’s Play, Hardware or Google For Work, we continue to see strong growth and we’re thrilled to be a platform for our partners' successes as well. Google Play’s growth continues to impress. It’s a linchpin of the amazing Android ecosystem. We brought Play Music to 17 new countries, bringing the total to 45 and our expansion continues. Today, Play Movies is available in 93 countries and Play Books is available in 61 countries. On the hardware front, just yesterday, we unveiled three fantastic new Nexus devices, Nexus 6 phone, Nexus 9 tablet and Nexus [Audio Gap] and Android powered streaming media player. This quarter we worked with HP, Toshiba and Acer to introduce five new Chromebook devices and teamed up with Asus, LG, Motorola, Samsung and Sony to help launch new Android Wear devices. We’re also selling Chromebook in six new countries. They’re now available in 31 countries around the world. And we sold more than 1 million Chromebooks for education this quarter, even more than last quarter. Chromecast celebrated its first birthday this past quarter. It’s been a smashing success. Users have hit the cast button more than 400 million times since it launched to enjoy their favorite sports, music, premium movies and TV shows. In September, we added even more content to Chromecast, including Disney content. And we were so proud to launch Android One, an effort to make high quality low cost smartphones available to as many people as possible. We started in India and we’ll be expanding to other countries, including Indonesia and the Philippines in the coming months. For businesses, what was called Google Enterprise, is now simply Google for Work. This business has great traction. In addition to the tremendous growth in our Apps business, we have more than 1,800 signups for Google Drive for Work every week. Plus there are almost 250 billion active Google Drive users, including consumer, education and business users. We continue to invest in our growing Cloud platform business, helping developers realize the promise of cloud computing by providing affordable on-demand access to world-class technology. We recently announced Google Cloud Platform for Startups and offer up to $100,000 in credits to enable the best and brightest startups to use Google’s Cloud platform. Sony Music recently built an interactive app in less than three weeks using App Engine to engage fans tuning into One Direction Day, an eight-hour YouTube livestream featuring the band, one of the largest ever YouTube music live streams. Lastly, our marketing team had a great quarter as well. Google My Business helped more small businesses get online. And our Art, Copy & Code project showed advertisers the creative potential of digital marketing. And from the annual Google Science Fair to more recent campaigns showcasing amazing content on Play, YouTube stars and the power of the Google App, the magic of Google was on prominent display. All told, it was another terrific quarter at Google, continued momentum in our core business and exciting innovation in new areas. Kudos to the Googlers around the world who made it all happen. I’ll turn it over to Patrick to wrap up and start our Q&A.
Patrick Pichette: Thank you, Omid. So Jamie, if you want to give us the instructions then we’ll get going on the Q&A.
Operator: Thank you (Operator Instructions) And we’ll take our first question from Eric Sheridan with UBS.
Eric Sheridan: Thanks for taking the questions. So, first one, maybe with the announcement that you’re expanding Google Shopping Express into other cities and rebranding it and new retailers are coming on, [Audio Gap] what you saw on those first few cities to think about extending it further into the other cities. And what you might be hearing from feedback from retailers about adopting the platform because a few also dropped off the platform at the same time? Just wanted to get a little bit better color about how that was developing and how you were going to go forward with it. Thanks.
Omid Kordestani: Thank you very much, Eric. So, we're really trying to learn a lot here. Innovation is a messy process and especially with Google Express here. There is a lot of understanding that we need to have on improving efficiency in the logistics process, trying to find price points that shoppers find attractive. And our goal is really to help the over 35 merchant partners succeed and reach their customers. And I'm a user of it and I am really impressed by how much time it saves. I see the cars running around the city around me. And I think our goal is really to take it a step at a time and see the success, understand the logistical operations, how much it costs us to do this and can we deliver this basically in a successful way.
Patrick Pichette: Just Eric, just a couple of kind of additional points; one is, clearly we’ve announced this week three other cities. So if you go back to the fundamental premise of [Audio Gap] which is the first thing was would people show up and want this product. It’s very clear people want this product. The second one was -- and that’s why we’re expanding the product. The second question then is, we've had a lot of questions about monetization, and we've announced this week we're taking real actions on the monetization service, both including commissions on each transaction from merchants, but also service fees that were announced as well. So from that perspective, we kind of think of it as now we're in Phase II of this product where according to our business plan we continue to kind of look for the barriers, the milestones, and then when we hit those milestones, we with enthusiasm keep on going. All this to say, it is nevertheless a scale business, so working on efficiencies, working on all of the issues that are related to logistics continues to be a big focus of ours. And on the partners, I mean we're really thrilled to have the partners we have. You can expect as we kind of grow through this that we have a few coming in, a few coming out, but overall very, very pleased with the trajectory there. And so I think you should see the announcements of this week as this kind of sign of optimism and momentum in it. Thank you so much for your question, Eric.
Eric Sheridan: Great.
Patrick Pichette: Jamie, let's go to our next question.
Operator: And we'll go next to Justin Post with Merrill Lynch.
Justin Post: Thank you. I'm wondering if you can help us at all segregate the search business from other items in Google website and just give us your view on the health of the search business. And then comment a little bit on the paid click deceleration, what's driving that? And do you even see that as an important metric? Thank you.
Patrick Pichette: So I'll take that. The two points is, one, look, we don't give the breakdown of the Google sites, but actually it's pretty healthy on all dimensions. I think that from that perspective, search is going well. And all of the other dimensions of our sites have actually doing pretty well, and that's what you see in our kind of 20% year-over-year just for sites growth. So from that perspective, I think that we're pretty happy on that front. On the CPC issue, it's pretty simple. I mean we really had -- again, you have to think of the CPC and the volume as one basket that actually delivers. So monetization overall is still very strong. We're very happy with the monetization, Jamie. And if we have in one quarter kind of movements between one and the other, that's just basically the continued experimentation and the impact of all the factors that I usually talk about. So from that perspective, there was nothing noteworthy to kind of mention this quarter. We're very happy with the trends in both cases.
Justin Post: Thank you.
Patrick Pichette: Thanks, Jamie. Jamie, we'll go to our next question. Sorry, Justin, I meant. Jamie, we'll go to our next question.
Operator: And we'll go next to [Stephen Zhu] (ph) with Credit Suisse.
Unidentified Analyst: Hey, thanks. So I think in the past you've talked about the opportunity cost of not being there for the user when they're trying to access your products and services as a rationale for making investments. So is there any data you can share on your newest users in the emerging markets who are going straight to mobile? Is it safe to assume that consumption from these new users are running at a pretty similar growth trajectory with what you've seen historically on a desktop and as well as your established markets? Or is their engagement with all of your products more intense? And is there anything you can say in terms of what areas of your business are seeing the more intense level of investments? Is it more your consumer-focused initiatives or more your enterprise-focused cloud initiatives? Thank you.
Patrick Pichette: So a couple points there, and then if Omid has additional comments. One is clearly emerging businesses -- emerging markets are just fundamentally different than the more developed markets, if you think of a country like Indonesia or India where people go straight to mobile. And so in that context, there's clearly a lot of differences between those markets and how they're evolving compared to what would have been 10 years ago the UK or the U.S. So from that perspective, I think that -- and that's why you see us launch things like Android One, right? When you have 1 billion -- just under 2 billion people around the world that have already smartphones, the vast majority of the population looks for things online. So these kind of initiatives that we're launching is the most important piece. From an investment at Google, we're investing -- without giving you all the details, we're clearly investing in our core business. It remains the focus of our activities. But if you look across -- as Omid mentioned, he mentioned the Cloud business, the Google For Work business, all of these other areas, the Play business, the Hardware business, these are all areas where we're investing and we're investing with enthusiasm with each their own specific business case, each of them are actually looking for what is their growth and profitability models and we just monitor them pretty tightly. Okay, so you're welcome. Jamie, let's go to our next question, please.
Operator: And we'll go next to Mark Mahaney with RBC Capital Markets.
Mark Mahaney: Hey, Patrick, in describing the Google search strength, you said you saw particular strength in mobile search. Could you elaborate?
Patrick Pichette: Yeah. I mean, look, it's very clear that mobile is still a big part of our growth. And we're very pleased about it. I mean, it's -- but when we talk about mobile, I think there's a couple things. One is you have to continue to look at both the growth in volume and the growth in pricing. So these are long-term trends that we're seeing. The CPCs and the clicks, they can fluctuate from quarter-to-quarter. It just happens that we've made some changes this quarter that improved the mobile pricing while impacting the lower quality clicks and that's what you see a bit reflected in our numbers. And again, and I wouldn't -- just as an overall statement, remember to everybody that I wouldn't attribute the aggregate CPC movement [Audio Gap] mobile, because there's still a full factor mix that -- as I talked in my remarks about geography and about our product changes. And so all this actually makes a big factor as well. So that's what we've seen in the strength in mobile, but we're still very pleased with the momentum. Thanks, Mark. Jamie, we'll go to our next question, please.
Operator: And we'll go next to Ross Sandler with Deutsche Bank.
Ross Sandler: Thanks, guys. I just had two questions, first on the UK and then second on mobile payments. So the UK growth, looks like it's dropping off pretty hard on an ex-FX basis, either one-year or two-year growth rates. So I think this is an economy that folks generally think is supposed to be holding up pretty well. So can you talk about what you're seeing in the UK? You had mentioned weather and a few other things, but a little bit more color on what's going on with the ad market in the UK. And then mobile payments, that's an area that's getting a lot of attention lately. Can you just give us an update on where the Google Wallet team stands and what kind of traction you're seeing in terms of user adoption and maybe how you plan on addressing merchant payments kind of outside of in-app or things from the app store? Thank you.
Patrick Pichette: So, Ross, why don't I take the first question and then Omid will give you the answer on the second? As we talk about the UK, a couple points are worth note. One is, the UK contributed roughly 10% of our total revenue this quarter, and that's been the same for kind of the past many quarters. And in fact, if you go back years, it will still be in the same range. So there's nothing kind of fundamental that -- it's worth noting that it's still a pretty good market with decent growth. The issue of deceleration this quarter specifically, on platform -- I mean I mentioned a number of elements, right? So platform mix, we do see [Audio Gap] of desktop, tablet searches having a greater impact in UK than anywhere else that we see in our network of countries. On property mix, remember we talked about this also on prior calls. AFS as a business has much bigger part of our both UK and U.S. business, so it will skew to those geographies. And so those are kind of some of the elements. And as I mentioned, year-over-year comps were difficult. And then if you have a great summer in terms of weather or bad summer in weather, it can have some real impact on the growth rates as well. So it's a combination of a number of factors that the UK has driven our performance, but still pretty pleased. But I won't -- that's really what's going on there. In terms of the payments, I'll let Omid give you an update there.
Omid Kordestani: Hi, Ross. I think our goal here is really achieving mass merchant adoption, so the availability of these NFC devices is about that and also making it easier for consumers to replace their wallets with their smartphones hopefully more and more over time. So reducing friction in everyday shopping experiences is how we approach it and the focus on the user and we're really developing a fully functional payment system. So, as you may know, users can send money today to friends through Gmail using the Wallet app. We have loyalty and gift cards that can be stored in the Wallet app. The Buy with Google button makes it possible for users to make purchases very quickly with two clicks. So, again, it's this two-fronted focus on merchant adoption and removing the friction for users. Thank you.
Patrick Pichette: Thanks, Ross. Jamie, let's go to our next question, please.
Operator: And we'll go next to Ben Schachter with Macquarie.
Ben Schachter: Omid, after many years of waiting for television budgets to shift online, it appears to be happening in a more accelerated fashion. So, one, do you agree with that? And two, could you just discuss YouTube's positioning versus competitors and in particular Facebook Video? And then Patrick, a couple of quick ones for you. One, given the evolution of tax laws in Europe, how are you and how should we be thinking about Google's tax rate over the coming years? And then also just any comments on stock comp being particularly high this quarter? Thanks.
Omid Kordestani: Thank you, Ben. This is Omid. So the way we look at it is that users are really accessing Internet on large screens with high broadband speeds, and we're getting great monetization on these screens and advertisers are really paying attention. So we have seen a real shift where marketers and agencies who have historically built their brands on TV are really reorienting this toward investments on digital. And as in regards to YouTube, our focus here is really this focus on investments and more content, more creativity. And I think you also mentioned that you had a Facebook comment. What they are doing I think in video has always helped us with bringing more attention and more innovation to the space, so we welcome that. And the way we're going to approach it is just continue to investing in our platform and on the creators and building better and better monetization solutions. Just again, you may know some of these metrics, but I'll say it again that we have 400 hours of content that are uploaded every minute and partner revenue is up 60% from 2012 to 2013 on YouTube.
Patrick Pichette: Great. Let me jump, Ben, on the -- your two specific questions. [Audio Gap] tax issues, you've heard about the Ireland announcement earlier this week on the double Irish tax structure. I mean, for us, we've always said that it's for politicians to decide what laws they want to put and then for companies just to comply with those laws. And that's what we're basically doing. So we're deeply committed to Ireland. We've worked there for many years. We have a great -- that's our headquarters. We have over 2,500 employees there. And so from that perspective we're committed to the place. And we're going to work with the authorities just to kind of get clarifications over this. But it's really way too early to tell what's going to happen. So we're, just like you, getting the information, the news, and we're going to work with the authorities to understand it better and then comply with the laws. In terms of stock-based compensation, just a few notes on this one for this quarter. We have -- it's the time of year where we do equity refresh. And from a timing perspective last year, we did the equity refresh in Q2 instead of Q3. So there's kind of like a geography of Q2 versus Q3 that kind of hit us in Q3. In addition to this, if you go to our filings, you'll see that our executive compensation -- so think of the top 15 or top 20, I can't remember the exact numbers, but it's stated there – that they do their refreshes every two years and it happens to be this quarter as well. And then finally, I mean, we obviously have more employees. So it's just a compounding set of factors, Ben, that I kind of lumped it all into Q3. So it's no more, no less than that on that -- on that one.
Ben Schachter: Thank you.
Patrick Pichette: Thanks for your question. Jamie, let's go to our next question, please.
Operator: And we'll go next to Anthony DiClemente with Nomura.
Anthony DiClemente: Thanks a lot. Just on core operating expenses, is there anything [Audio Gap] Patrick that you might call out in terms of expense growth in the quarter as you have operating deleverage through the P&L? Just wondering, going forward, if that's likely to continue. And then a question for Omid I suppose on YouTube. You mentioned -- I know that YouTube's investing in its studio as a way to help along new talent, new homegrown talent onto the platform directly. I'm wondering if you can talk about the multichannel networks, how YouTube's relationships with the multichannel networks, the MCNs, are evolving at a high level? How you guys think about that dynamic between the homegrown YouTube talent itself as compared to talent that resides on the MCNs? Thanks.
Patrick Pichette: Okay. Anthony, thank you for your question. Why don't I jump in right now on just expenses for the quarter? I think if I had two comments to make on expenses in the quarter, you may notice that relative to a few models that I saw out there, R&D was higher and other areas are a bit lower. And I just want to highlight that we hire and we focus clearly our hiring in our tech payroll, or think of it as all of our engineering. And that skews to R&D. So as we bring on people and we push forward the growth of our -- we really focus it in the areas that are going to make a fundamental difference to Google, which is engineering, and by doing so, it kind of skews to R&D. So that's why R&D may be a bit higher than expected by some models out there. And so that's one piece. And then the other one is just wanted to reiterate that it's very clearly an extraordinary quarter from a hiring perspective for the comments I've made before. And so we're kind of clearly seeing that. But at the same time I wouldn't say that this is clearly a new run rate for us or anything like that. It just happened that most of these college students end up landing in Q3 and we have the result of a banner year from a hiring perspective all through. It takes a year to hire them all and then they come into this quarter. So that's really kind of the two big elements that have actually flowed, Anthony, through our P&L this quarter. I'll let Omid answer the YouTube question.
Omid Kordestani: Yes. Anthony, so, again, we have a very, very partnership minded organization here and company as a whole. So we view MCNs as -- or organizations that are really going to help develop a great content, support the creators on YouTube. Just like we are doing that with YouTube Studios, I think MCNs can help a lot of these become future stars hopefully and develop more success. So just we view it as another form of partnership that we need to pay attention to and support. So that's how we look at it.
Patrick Pichette: Thank you, Anthony. Jamie, let's go to our next question, please.
Operator: And we'll go next to Carlos Kirjner with Sanford Bernstein.
Carlos Kirjner: Thank you. I have two questions. Patrick, is CapEx still driven by real estate and construction? And if yes, can you explain in a bit more detail what changed about 18 months ago in the way you acquired real estate and build to drive the inflection in capital intensity that we have seen? It looks like you operated for more than 10 years in one way and then there was a shift that has led to this massive inflection. So what happened there? Secondly, do you think that Google login is adopted or inspired to being adopted by a large enough number of important mobile apps for you to be competitive in the long term when it comes to offering mobile [Audio Gap] and can you give us an update on the developer adoption of deep linking? Thank you.
Patrick Pichette: So I can certainly take the first and let Omid answer the second. I've made that comment before in a prior quarter, Carlos. The CapEx intensity and our CapEx program has been built by a combination of, as I mentioned in previous quarter, catching up when we were running too hot in terms of tightening of capacity. And so -- and once I'm very happy that when we really torque our utilization rates, on the other side it creates a lot of operational issues. And that led us to believe that in fact investing ahead of the curve was actually a strategic imperative for us to make sure that if we have the extra capacity, we will grow into it. And I think the difference between -- certainly on the data center side, data center construction and machines, and you'll have noticed that this quarter again, there are priorities. If you look at the nomenclature I gave, construction of data center is the primary. So it is the core infrastructure, it's groundbreaking and it is setting up the core infrastructures. Machine was the second one for this quarter, but you'll notice that it flip flops real estate. In the case of the real estate, we have been investing for our campus and otherwise when we see -- when we hit kind of minimum scale, we need to kind of make investments in real estate. And again with an eye of looking for the long term, rather than just filling at least for the next 12 months or 24 months, because once you kind of -- if you decide you're going to grow in a place, then you need the capacity for multi-years. So all of these factors have actually kind of been the driver for the shift in capital intensity that you've seen over the last 18 months. So that's basically the explanation, Carlos. I'll let Omid kind of jump on the second question about the mobile question.
Omid Kordestani: Sure. Thanks, Carlos. So the AdMob network reaches 900 million unique devices per month and our own apps are hugely popular, Gmail, Maps, Google App and YouTube. And our focus is also -- is helping developers generate app downloads and re-engagement with users who have already downloaded their apps, as I mentioned in my remarks earlier. And we're really helping drive hundreds of millions of app downloads through app promotion products. Again, the goal here is that you just search and not worry about where the answer is either on a webpage or on an app. And we've been in this game for a while. Four years ago, we acquired AdMob and have continued to invest in this space heavily. And this quarter, we launched the next generation of these promotion ads across Google search, Google Display Network, and YouTube. So we're really focused on this area to help the developers and our users.
Patrick Pichette: I think we can clearly say that we're pretty pleased with the developer adoption of this. They see a huge benefit, so they're actually investing in it. Thank you, Carlos.
Carlos Kirjner: Thank you.
Patrick Pichette: Jamie, let's go to our next question, please.
Operator: And we'll go next to Douglas Anmuth with JPMorgan.
Douglas Anmuth: Thanks for taking the question. Just two for Omid. First, you talked about estimated conversions and seeing a 15% increase there. Can you just talk about whether you think that's actually leading to more spend at this point from advertisers? And then, secondly, are you seeing mobile like-for-like pricing improvements at this point? And what gives you the confidence in mobile closing the gap with desktop over time?
Omid Kordestani: Thanks, Douglas. Both are really good questions that are related really. I think the way this is going to play out is that I think advertisers are going to, with these tools, be able to just understand conversions better -- where is it happening? And then the dynamics of how those changes is all the way back to adjusting bids and then paying attention to where the conversions are coming from. So, again, I think just to maybe highlight some examples for you, we have a fashion retailer Express who's an early tester, found that the overall return on their ad spend doubled when offline sales were included in their online advertising results. So we're just continuing to invest here and get this right. It's too early to figure out the impact exactly on revenue, but we expect the estimated total conversions to help the advertisers fully measure this and ultimately adjust their bidding and just get much more sophisticated in these measurements. I hope that answers.
Douglas Anmuth: And mobile on a like-for-like basis?
Omid Kordestani: The way we're focusing this is that users really are using their screens interchangeably simultaneously throughout the day and that we really are not at this point doing this like-by-like comparisons or comment on it because we think it's still early and we're really focused on just again delivering the results. And it took many years, for example, for the desktop ecosystem to develop the right ad formats and really take advantage of the platform. So I think we just need to continue innovating here, experimenting here to get it right.
Douglas Anmuth: Thank you.
Patrick Pichette: Thanks, Douglas. Jamie, let's go to our next question, please.
Operator: And we'll go next to Mark May with Citi.
Mark May: Thanks for taking my question. One on -- there's been quite a bit of attention paid to cloud services space and Google in particular. Wondering if you can comment a little bit around the traction that you're getting with the Compute Engine? And what sort of impact that that's having on revenue or expenses and CapEx for the business? And then secondly, I think earlier you made a comment around some changes you've made in mobile that have impacted some of your network click metrics, so hoping you could elaborate a bit more on that.
Patrick Pichette: Okay. Do you want me to...
Omid Kordestani: Go ahead.
Patrick Pichette: I'll just jump on the cloud and then the last piece and then maybe -- I wasn't sure what the very first part of your question, Mark, was. But clearly, cloud is an area that is kind of booming, right? We know that the long-term trends are very clear for us, which is the vast majority of businesses. Everybody is moving their infrastructures to the cloud. So -- and it is an area where we have fundamentally great assets to contribute to this industry, both in terms of the flexibility, the cost structure, the technology, and that's why we're investing heavily in there. We're seeing great progress from an adoption perspective, signing up new customers. And from a CapEx, obviously you need to kind of -- that's one of them that as I mentioned on the CapEx story with Carlos a few minutes ago, if you do take off and you really get the kind of customer adoption that you expect, if you don't have the capacity in place, it can have a really important kind of differential in your success. So there is one that we're keeping a pretty close eye on from a CapEx perspective in making sure that we have the option value. The third question was mobile that have network clicks. So, yeah, I mean, clicks and CPCs always fluctuate from quarter-to-quarter. It just happens that we've made some -- as I mentioned, made some changes this quarter that improved our mobile pricing while impacting low quality clicks. So sometimes, it goes -- if you think of a long-term trend in the mobile sector piece of our product, sometimes you kind of put a new change in the network and it creates a lot of clicks for it, but then the CPCs are much lower. And then if it doesn't actually create something that's really good for the user, you need to kind of pull back on it, and that's what you've heard, for example, just parallel to the AFS business. So it's kind of constantly fluctuating. What's really important us is really the combined volume and pricing growth. And so for us, it's very clear that we're doing some great work in this area and monetization in aggregate is doing very well. And that's really what we're -- like on a quarter-to-quarter basis, don't panic about little movements here and there. Look at the fundamental trends, and that's where we're very pleased. Now, did you have a first -- was there a first question that I missed, Mark?
Mark May: No. I was hoping on cloud that maybe you could put some numbers behind the level of traction in terms of number of customers impact on expenses, CapEx, the level of investment in the cloud.
Patrick Pichette: I see. Okay. So I've given you what I can give you on that. Again, we're really thrilled by the momentum there and our focus in that area.
Mark May: Thanks.
Patrick Pichette: Thanks, Mark. Jamie, we'll go to our next question, please.
Operator: And we'll go next to Peter Stabler with Wells Fargo Securities.
Peter Stabler: Thanks for taking the question. One for Omid. Going back to estimated total conversions, wondering if we could expect Adometry to be integrated into the DoubleClick platform and how that may or may not work with the estimated total conversions tool? And then, finally, I'm wondering [Audio Gap] on your work around coming up with a solution that reduces the dependence upon cookies and perhaps introduces a cross-platform, a cross-device ID for Google and what impact that could have in the market? Thank you.
Omid Kordestani: Sure. I think -- again, it's early for us to call Adometry. It's a great attribution solution and we've been investing in that tool for a long time now and trying to just get this right by all the innovation that's happening within Google and just really understanding the impact of these usage models and -- between the mobile devices and desktop. And so I think we're going to look at everything that's available out there, both what we're developing and partners out there that we could partner with, and continue to invest here. It's going to take us a while, just like we experienced before with search, to get this right and have a real end-to-end solution for marketers and publishers. And so I think you will see a lot of innovation in this space. What Facebook recently announced is another approach. And we're going to study that and just figure out what is the right set of offerings from us. So I guess, unfortunately, I can't give you a very specific answer here. But I think what you'll see from us is pay a huge amount of attention here, make the measurements and see the impact and then offer a full suite to our customers.
Patrick Pichette: Yeah. So just basically, too early to speculate on these issues, but clearly it's an area of focus at the company. Thank you, Peter. Jamie, our next question, please?
Operator: And we'll go next to Heather Bellini with Goldman Sachs.
Heather Bellini: Great. Thank you. I had two questions. The first was a follow-up on Google Shopping Express. I mean, just wondering, when you think about what Amazon is doing with same-day delivery, they're obviously building these fulfillment centers themselves, which theoretically should give them scale over time. I'm wondering if you could share with us how you see this evolving for Google over time? And then a follow-up question would just be related to your comments about payments. And I'm just wondering, how critical is it for Google itself to [Audio Gap] friction that you're seeing with kind of a ubiquitous digital wallet? Or would you be fine with a third-party doing so for the Android platform?
Patrick Pichette: Thank you, Heather. I'll take the first and then let Omid answer the second. Clearly, Google Shopping Express, there is an issue of scale and it's a combination of an issue of scale, tools and efficiency. I mean, that's how you, if you think over time, can end up with a product that you can deliver within kind of hours at the right value and where you can make money. So it's not only about -- yes, for efficiencies you need centralization. You need a bunch of distribution tools that actually work. We're clearly focused on that as well. I mean it is part of the business case that we're building. But you need more than that. There's a lot of other elements as well. So clearly focused like our competitors would be. And our announcements today, again kind of our -- was it yesterday -- yesterday's announcements on Shopping Express kind of tell you that we are investing both for -- the three new cities kind of give you a hint of, yes, it's about scale. So clearly we're focused on that.
Omid Kordestani: Yeah. And Heather, on the wallet question, I think we're going to continue to be open here. So we are trying to get it right and innovating on multiple fronts, as I mentioned earlier. And if partnering makes sense, we'll take a look at it, as well. So -- and the goal is here really to provide this very seamless experience for the users and then get the merchant adoption and hopefully get this right. I'm certainly delighted every time I use this and it works. And I think if we can all get the ecosystem right and there are multiple players in it and partnerships that are making it happen, we're definitely open to that.
Patrick Pichette: Thank you, Heather. Let's go to our next question.
Operator: And we'll go next to Paul Vogel with Barclays.
Paul Vogel: Yeah. Great. Thank you very much. As Google Play has grown, I'm just wondering if you could talk about the relationships with the carriers and how that's evolving over time.
Patrick Pichette: Yeah, I can answer that. So, essentially, Google Play is doing great and everybody wants to kind of be part of this answer. And so, for our carriers, [Audio Gap] basis. So the real question is, what's the win-win? And so they're all done individually. We have great partnerships with many carriers that actually fuel this, and we're including carrier billing. So all this actually is just a very, very positive ecosystem for us. And so we're totally thrilled to have these partnerships and we expect to continue to do so.
Paul Vogel: Thanks.
Patrick Pichette: Thanks, Paul. Jamie, one more question.
Operator: And we'll take our final question from Brian Pitz with Jefferies.
Brian Pitz: Great. Thanks for the questions. Two for video -- on video for Omid. You mentioned Google Preferred in your comments. Any color on further expanding the upfront process with the ad agencies? Basically, do you anticipate that upwards of 5% to 10% of your top inventory could actually be set aside for preferred longer-term? And then just given the shift of offline TV dollars to online, as you've mentioned, any comments on political specifically or other new categories more aggressively moving on to YouTube? Thanks so much.
Omid Kordestani: Sure. Thank you, Brian. So we secured upfront commitments from five top agencies: IPG, OMD, Digitas, Carat, SMG, and some major brands like General Motors and Coca-Cola and we were actually very, very pleased with how Google Preferred was experienced and adopted. And so I think we're going to definitely continue working on this. And also if you look at our history, we're very used to the selling model that was all about performance. And then as we added properties like YouTube and Brand and Mobile, we're just getting more and more now gaining a better understanding of how to work in this upfront process, for example, to offer the marketers this incredible asset that we have in YouTube and our network. So we're going to just continue getting better at -- on the products side, figure out how to package this inventory better, and then the tools that are needed, and then on the selling side, just get better at also working with the agencies and our advertisers and marketers to get this type of selling right. And on the political vertical, I think clients love to use our products as part of their campaigns for federal, local, state campaigns and it is a really great area for us. We have actually a political sales team that's focused on it. So I think you'll see more of that effort from us.
Brian Pitz: Omid, thanks.
Omid Kordestani: Thank you very much.
Patrick Pichette: Thanks, Brian. Jamie, that's all the time we have. So if you don't mind, I'd just like to close by reiterating what Omid said a bit earlier. This quarter was a great quarter with great momentum again. And I just wanted to thank all the great efforts of our Googlers around the world who make us look good on this call because of their fantastic effort. So with that, Jamie, I'll let you close the call, and have a happy Q4 everyone.
Operator: Thank you again. That does conclude today's conference. We do appreciate everyone's participation. | [
{
"speaker": "Operator",
"text": "Good day and welcome everyone to the Google Inc.'s Third Quarter 2014 Earnings Conference Call. This call is being recorded. At this time, I’d like to turn the call over to Ellen West, Vice President, Investor Relations. Please go ahead."
},
{
"speaker": "Ellen West",
"text": "Thank you, Jamie. Good afternoon, everyone, and welcome to Google's third quarter 2014 earnings conference call. With us today are Patrick Pichette and Omid Kordestani. As you know, we distribute our earnings release through our Investor Relations website located at investor.google.com. So please refer to our IR website for our earnings releases as well as the supplementary slides that accompany the call. You can also visit our Google+ Investor Relations page for the latest Company news and updates. This call is also being webcast from investor.google.com. A replay of the call will be available on our website later today. Now, let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward-looking including statements regarding Google's future investments, our long-term growth and innovation, the expected [Audio Gap] this presentation and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on this call, such as operating income and operating margin, are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation and, as applicable, other special items. We've also adjusted our net cash provided by operating activities to remove capital expenditures which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will now turn the call over to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks, Ellen. As some of you may know, we have a new leader in our Investor Relations team at Google. Her name is Ellen West. That’s the great voice you just heard a minute ago, a second ago. Ellen is a long term Googler who joined us in 2007. Although she is here with us today in Mountain View, she is actually based out of New York and that will give us a bit more footprint on the East Coast as well. So, Ellen, welcome to the team. With that, let’s dive into the details of Google’s financial performance for Q3. Our gross total consolidated revenue grew a healthy 20% year-over-year to $16.5 billion and was up 4% quarter-over-quarter. Without currency fluctuations, our gross total consolidated revenue growth would have been 19% year-over-year. Google sites revenue was also up 20% year-over-year to $11.3 billion and was up 3% quarter-over-quarter driven by the strength in our mobile search. Network revenue was up 9% year-over-year at $3.4 billion and was flat quarter-over-quarter driven by improved year-over-year growth in the AdMob and the Ad Exchange businesses. Finally, Google’s other revenue grew a healthy 50% year-over-year to $1.8 billion and was up 15% quarter-over-quarter, this driven by year-over-year growth mainly from the Play Store but also complemented by an increase in licensing revenue. Our global aggregate paid click growth was strong this quarter, up 17% year-over-year and up 2% quarter-over-quarter. Aggregate CPCs were down only 2% year-over-year and flat quarter-over-quarter. And without currency fluctuations, aggregate cost per click would have been down 1%, and in fact, up 1% quarter-over-quarter. As we began to do in our last earnings call, we continue to disclose paid clicks and cost per click changes by property type as well in addition to the aggregate number. So to that end, Google sites paid clicks were up 24% year-over-year and up 4% quarter-over-quarter. Google sites CPC were down 4% year-over-year and down 1% quarter-over-quarter. Our network paid clicks were up 2% year-over-year and down 4% quarter-over-quarter and network CPCs were down 4% year-over-year but up 2% quarter-over-quarter. Our aggregate monetization metrics continue to be impacted by a number of factors including geographic mix, device mix, property mix as well as ongoing products and policy changes. Turning to geographic performance now, we saw solid performance in the U.S. as well as in the rest of the world. In our earnings slides, which you can find on our Investor Relations website, you will see that we've broken down our revenue by U.S., UK and the rest of the world to show the impact of FX and the benefits of our hedging program. So please refer to those slides for the exact calculations. U.S. revenue was up 15% year-on-year to $7 billion. The UK was up 17% year-over-year to 1.6 billion and in fixed FX terms, the UK grew 10% year-over-year. In the UK, growth was impacted by a combination of factors this quarter including platform and property mix as well as tough comps from year-over-year and quarter-over-quarter growth rates for a number of reasons including for example weather. Our non-U.S. revenue excluding the UK was up 26% year-over-year to $7.9 billion. This accounted for 48% of total revenue which includes a 10 million benefit from our hedging program. In fixed FX terms in fact the rest of the world also grew 26% year-over-year, very healthy. Let me turn now to expenses. Traffic acquisition costs were $3.3 billion or 23% of total advertising revenue. Our non-GAAP other cost of revenue was 2.8 billion in Q3 which excludes stock-based compensation and also a non-cash impairment charge of 378 million related to a patent licensing royalty asset acquired as part of our Motorola Mobility purchase. Non-GAAP operating expenses totaled 5 billion, again excluding SBC. And as a result, our non-GAAP operating profit [Audio Gap] and our non-GAAP operating margin were 32% in Q3. Headcount was up roughly 3,000 in Q3. In total, we ended the quarter with approximately 55,000 full time employees. And please note that the headcount does include still approximately 3,500 full time employees from the Motorola business. In the past year, we continued to attract and hire the best talent from the best colleges and universities from all around the world. Continuing our past trend, graduate starts are much more heavily concentrated in Q3, which is part of why you are seeing the significant bump in headcount with the majority being tech hires, I want to kind of emphasize. Our effective tax rate for the quarter was 22% for Q3 and which includes the impact of the impairment charge that I mentioned earlier which is a non-deductible for income tax purposes. Let me turn now to cash management. OI&E or other income and expenses was $133 million. Interest income and realized gains on investments offset the continued impact of expenses from our FX hedging program. And for more details on OI&E, please do refer to the slides that accompany this call on our IR website. We continue to be happy with our strong operating cash flow at $6 billion. CapEx for the quarter was 2.4 billion. In this quarter the majority of the CapEx was related to our data center construction, production equipment and real estate purchases, in that order. It's important to remember that our infrastructure supports all of our products, whether they are core products like or Search or Ads, Maps or YouTube, but in addition to fueling our growth products like Photos and Hangouts, Google For Work and the Cloud platform. If you look at our data center announcements over the last four quarters, you will also see that we've been really busy with both groundbreakings and expansion all around the world including Finland, Taiwan, Singapore, recently announced Netherlands in addition to our ongoing investments in the U.S. In total, our free cash flow was then 3.6 billion. And before I close, I want to give a brief update on Motorola. The team continues to work hard and we look forward to seeing them join the Lenovo team soon. Motorola had a great Q3, with strong user reviews for products like the Moto X, Moto 360 and Moto Hint, clearly demonstrating the impressive momentum of the company. So there you have it. Strong results with continued strong growth in both revenue and profits and an optimism that provides us the confidence to fund strategic growth opportunities including the usual Android, Chromes and YouTube but also Google For Work and Cloud to name a few. Before I hand things over to Omid, I'd like to share with you some great news. I am really thrilled to announce that Omid is now officially Google's Chief Business Officer and this on a permanent basis. All of us at Google couldn't be happier to see Omid at his post running our business organization once again. And with that, I will turn it over to him for more details on our performance in the quarter. And after his remarks as usual, we will have Jamie open up the lines for your questions. Here you go, Omid."
},
{
"speaker": "Omid Kordestani",
"text": "Thank you very much, Patrick. And hello, everyone. I am Omid Kordestani. I am happy to be back at my new old job and thank you for joining us this afternoon. I joined Google back in 1999 to help get our business off the ground and led our business operations until 2009. Since then I have served as an advisor for Larry and outside Google actively helped many entrepreneurs. I am thrilled to be back at Google leading our global business again. We continue to have the same boundless energy and endless curiosity we've always had as a company and we are as focused as ever in our mission of making information useful and accessible to everyone. Case in point, we are really excited about this week's Android Lollipop launch. This is our largest release on Android ever with over 5,000 APIs for developers. It adds new features including better notifications, battery life and security and introduces a refreshed, consistent visual style. And alongside the new devices Nexus 6, Nexus 9 and Nexus Player, consumers in India who bought the recently announced Android One will get the update to the latest software at the same time. Now I’ll do a quick walk through of the business highlights from Q3. As usual, we’ll give an overview of these four areas, performance and brand advertising, our advertising platforms and our emerging non-ads businesses. Let’s start with performance advertising, the core of our business. People want the right information at the right time. They don’t want to have to think about whether it’s on the web or in an app. We’ve learned this first hand as a developer of many services, Maps, YouTube, Gmail that also are some of the world’s most popular mobile apps. With that in mind, we have a simple goal with performance ads: help marketers connect with customers at the right moment to drive measurable results. Our partners have driven hundreds of millions of app downloads with AdMob on our click to download formats. But most mobile apps are downloaded, used once and eventually deleted. So we launched new features to help advertisers re-engage with users post download. For example, advertisers can now deep link from their search ads directly into their mobile apps. To succeed with multi-screen marketing, advertisers also need modern measurement tools so they can understand when their ads drive phone calls from customers resulting conversions on other devices or lead to store visits and purchases. Last October we announced estimated total conversions, our effort to help marketers better measure the value of their multi-screen advertising. We’ve worked to continue developing this product and launched cost device measurement for display ads. Clients have already found that mobile display campaigns drive 15% more conversions than they had previously measured. Let’s shift gears to talk about our shopping efforts. [Audio Gap] with performance ads we are directly connecting people with [Audio Gap] and then enabling them to buy and have them delivered. We keep making improvements to our products to help retailers. Keeping inventory organized and up to date is a constant challenge for retailers. We help them manage this issue by completing the transition of product listing ads to our shopping campaigns platform. And finally, people often want to find stores near them to make a purchase in person. We’ve long had local inventory ads that enabled merchants to show customers this information in the U.S. and we launched these in the UK, France, Germany, Japan and Australia last quarter. In summary, the core of our business, performance advertising, continues to deliver great results. Let’s move on now to our brand business. Our objective is clear here, make digital the best possible canvas for creative and effective brand-building campaigns. First let’s talk about YouTube. Any conversation about great advertising starts with great content. On YouTube, stars produce amazing content that our users love from Bethany Mota to Smosh to Mental Floss. Earlier this year we launched Google Preferred to help connect brands with premium ad inventory on our most popular YouTube channels. Since then we have secured upfront commitments from top media agencies. We’re just getting started with YouTube and its potential. We’ve sold out the majority of our U.S. Google Preferred offering which represents among the top 5% of popular channels inventory on YouTube. And as a result of terrific brand events in Germany, France, UK and Australia, we’re seeing tremendous interest from local agency partners around the world. Last quarter we also saw some great progress in our brand efforts beyond YouTube. We launched new ad formats customized for mobile screens. We also announced an expansion of YouTube’s TrueView ads into AdMob's network of more than 650,000 mobile apps. Everyday our teams work to develop both the products and terrific partner relationships that enable us to tackle any digital marketing challenge across multiple channels together. With encouragement from Google and YouTube, ABC executed a digital first marketing plan for their new fall TV line up. Their effort included custom five second-ads for TrueView and collaborations with homegrown YouTube stars. We’re very excited about the new deal with Mondelez and Starcom MediaVest. This global agreement will focus on video and display and is Mondelez’s largest digital media deal ever. Next let’s take a look at one of the fastest growing parts of digital advertising world, programmatic platforms for agencies and publishers. For many years now our goal has been to provide world class technology for brands, agencies and publishers who power their ads businesses. Today our DoubleClick suite is used by all major agencies and we’re particularly focused on multi-screen and video. DoubleClick Bid Manager is the go-to tool for marketers and agencies to navigate the rapidly growing programmatic advertising space. It’s doubled in size year-over-year by impression volume and we really love the progress we see here. For publishers, we help them make money from their content via our publisher tools from our Ads Exchange to customized private exchanges which complement our core offerings. This quarter we signed new private advertising exchange deals with publishers like Fox TV and Edmunds. This helps publishers generate revenue from premium ad space. We have nearly doubled the number of private [Audio Gap] our system year-over-year. Finally, we’re seeing remarkable momentum in our newer non-ads businesses, whether it’s Play, Hardware or Google For Work, we continue to see strong growth and we’re thrilled to be a platform for our partners' successes as well. Google Play’s growth continues to impress. It’s a linchpin of the amazing Android ecosystem. We brought Play Music to 17 new countries, bringing the total to 45 and our expansion continues. Today, Play Movies is available in 93 countries and Play Books is available in 61 countries. On the hardware front, just yesterday, we unveiled three fantastic new Nexus devices, Nexus 6 phone, Nexus 9 tablet and Nexus [Audio Gap] and Android powered streaming media player. This quarter we worked with HP, Toshiba and Acer to introduce five new Chromebook devices and teamed up with Asus, LG, Motorola, Samsung and Sony to help launch new Android Wear devices. We’re also selling Chromebook in six new countries. They’re now available in 31 countries around the world. And we sold more than 1 million Chromebooks for education this quarter, even more than last quarter. Chromecast celebrated its first birthday this past quarter. It’s been a smashing success. Users have hit the cast button more than 400 million times since it launched to enjoy their favorite sports, music, premium movies and TV shows. In September, we added even more content to Chromecast, including Disney content. And we were so proud to launch Android One, an effort to make high quality low cost smartphones available to as many people as possible. We started in India and we’ll be expanding to other countries, including Indonesia and the Philippines in the coming months. For businesses, what was called Google Enterprise, is now simply Google for Work. This business has great traction. In addition to the tremendous growth in our Apps business, we have more than 1,800 signups for Google Drive for Work every week. Plus there are almost 250 billion active Google Drive users, including consumer, education and business users. We continue to invest in our growing Cloud platform business, helping developers realize the promise of cloud computing by providing affordable on-demand access to world-class technology. We recently announced Google Cloud Platform for Startups and offer up to $100,000 in credits to enable the best and brightest startups to use Google’s Cloud platform. Sony Music recently built an interactive app in less than three weeks using App Engine to engage fans tuning into One Direction Day, an eight-hour YouTube livestream featuring the band, one of the largest ever YouTube music live streams. Lastly, our marketing team had a great quarter as well. Google My Business helped more small businesses get online. And our Art, Copy & Code project showed advertisers the creative potential of digital marketing. And from the annual Google Science Fair to more recent campaigns showcasing amazing content on Play, YouTube stars and the power of the Google App, the magic of Google was on prominent display. All told, it was another terrific quarter at Google, continued momentum in our core business and exciting innovation in new areas. Kudos to the Googlers around the world who made it all happen. I’ll turn it over to Patrick to wrap up and start our Q&A."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Omid. So Jamie, if you want to give us the instructions then we’ll get going on the Q&A."
},
{
"speaker": "Operator",
"text": "Thank you (Operator Instructions) And we’ll take our first question from Eric Sheridan with UBS."
},
{
"speaker": "Eric Sheridan",
"text": "Thanks for taking the questions. So, first one, maybe with the announcement that you’re expanding Google Shopping Express into other cities and rebranding it and new retailers are coming on, [Audio Gap] what you saw on those first few cities to think about extending it further into the other cities. And what you might be hearing from feedback from retailers about adopting the platform because a few also dropped off the platform at the same time? Just wanted to get a little bit better color about how that was developing and how you were going to go forward with it. Thanks."
},
{
"speaker": "Omid Kordestani",
"text": "Thank you very much, Eric. So, we're really trying to learn a lot here. Innovation is a messy process and especially with Google Express here. There is a lot of understanding that we need to have on improving efficiency in the logistics process, trying to find price points that shoppers find attractive. And our goal is really to help the over 35 merchant partners succeed and reach their customers. And I'm a user of it and I am really impressed by how much time it saves. I see the cars running around the city around me. And I think our goal is really to take it a step at a time and see the success, understand the logistical operations, how much it costs us to do this and can we deliver this basically in a successful way."
},
{
"speaker": "Patrick Pichette",
"text": "Just Eric, just a couple of kind of additional points; one is, clearly we’ve announced this week three other cities. So if you go back to the fundamental premise of [Audio Gap] which is the first thing was would people show up and want this product. It’s very clear people want this product. The second one was -- and that’s why we’re expanding the product. The second question then is, we've had a lot of questions about monetization, and we've announced this week we're taking real actions on the monetization service, both including commissions on each transaction from merchants, but also service fees that were announced as well. So from that perspective, we kind of think of it as now we're in Phase II of this product where according to our business plan we continue to kind of look for the barriers, the milestones, and then when we hit those milestones, we with enthusiasm keep on going. All this to say, it is nevertheless a scale business, so working on efficiencies, working on all of the issues that are related to logistics continues to be a big focus of ours. And on the partners, I mean we're really thrilled to have the partners we have. You can expect as we kind of grow through this that we have a few coming in, a few coming out, but overall very, very pleased with the trajectory there. And so I think you should see the announcements of this week as this kind of sign of optimism and momentum in it. Thank you so much for your question, Eric."
},
{
"speaker": "Eric Sheridan",
"text": "Great."
},
{
"speaker": "Patrick Pichette",
"text": "Jamie, let's go to our next question."
},
{
"speaker": "Operator",
"text": "And we'll go next to Justin Post with Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "Thank you. I'm wondering if you can help us at all segregate the search business from other items in Google website and just give us your view on the health of the search business. And then comment a little bit on the paid click deceleration, what's driving that? And do you even see that as an important metric? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "So I'll take that. The two points is, one, look, we don't give the breakdown of the Google sites, but actually it's pretty healthy on all dimensions. I think that from that perspective, search is going well. And all of the other dimensions of our sites have actually doing pretty well, and that's what you see in our kind of 20% year-over-year just for sites growth. So from that perspective, I think that we're pretty happy on that front. On the CPC issue, it's pretty simple. I mean we really had -- again, you have to think of the CPC and the volume as one basket that actually delivers. So monetization overall is still very strong. We're very happy with the monetization, Jamie. And if we have in one quarter kind of movements between one and the other, that's just basically the continued experimentation and the impact of all the factors that I usually talk about. So from that perspective, there was nothing noteworthy to kind of mention this quarter. We're very happy with the trends in both cases."
},
{
"speaker": "Justin Post",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks, Jamie. Jamie, we'll go to our next question. Sorry, Justin, I meant. Jamie, we'll go to our next question."
},
{
"speaker": "Operator",
"text": "And we'll go next to [Stephen Zhu] (ph) with Credit Suisse."
},
{
"speaker": "Unidentified Analyst",
"text": "Hey, thanks. So I think in the past you've talked about the opportunity cost of not being there for the user when they're trying to access your products and services as a rationale for making investments. So is there any data you can share on your newest users in the emerging markets who are going straight to mobile? Is it safe to assume that consumption from these new users are running at a pretty similar growth trajectory with what you've seen historically on a desktop and as well as your established markets? Or is their engagement with all of your products more intense? And is there anything you can say in terms of what areas of your business are seeing the more intense level of investments? Is it more your consumer-focused initiatives or more your enterprise-focused cloud initiatives? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "So a couple points there, and then if Omid has additional comments. One is clearly emerging businesses -- emerging markets are just fundamentally different than the more developed markets, if you think of a country like Indonesia or India where people go straight to mobile. And so in that context, there's clearly a lot of differences between those markets and how they're evolving compared to what would have been 10 years ago the UK or the U.S. So from that perspective, I think that -- and that's why you see us launch things like Android One, right? When you have 1 billion -- just under 2 billion people around the world that have already smartphones, the vast majority of the population looks for things online. So these kind of initiatives that we're launching is the most important piece. From an investment at Google, we're investing -- without giving you all the details, we're clearly investing in our core business. It remains the focus of our activities. But if you look across -- as Omid mentioned, he mentioned the Cloud business, the Google For Work business, all of these other areas, the Play business, the Hardware business, these are all areas where we're investing and we're investing with enthusiasm with each their own specific business case, each of them are actually looking for what is their growth and profitability models and we just monitor them pretty tightly. Okay, so you're welcome. Jamie, let's go to our next question, please."
},
{
"speaker": "Operator",
"text": "And we'll go next to Mark Mahaney with RBC Capital Markets."
},
{
"speaker": "Mark Mahaney",
"text": "Hey, Patrick, in describing the Google search strength, you said you saw particular strength in mobile search. Could you elaborate?"
},
{
"speaker": "Patrick Pichette",
"text": "Yeah. I mean, look, it's very clear that mobile is still a big part of our growth. And we're very pleased about it. I mean, it's -- but when we talk about mobile, I think there's a couple things. One is you have to continue to look at both the growth in volume and the growth in pricing. So these are long-term trends that we're seeing. The CPCs and the clicks, they can fluctuate from quarter-to-quarter. It just happens that we've made some changes this quarter that improved the mobile pricing while impacting the lower quality clicks and that's what you see a bit reflected in our numbers. And again, and I wouldn't -- just as an overall statement, remember to everybody that I wouldn't attribute the aggregate CPC movement [Audio Gap] mobile, because there's still a full factor mix that -- as I talked in my remarks about geography and about our product changes. And so all this actually makes a big factor as well. So that's what we've seen in the strength in mobile, but we're still very pleased with the momentum. Thanks, Mark. Jamie, we'll go to our next question, please."
},
{
"speaker": "Operator",
"text": "And we'll go next to Ross Sandler with Deutsche Bank."
},
{
"speaker": "Ross Sandler",
"text": "Thanks, guys. I just had two questions, first on the UK and then second on mobile payments. So the UK growth, looks like it's dropping off pretty hard on an ex-FX basis, either one-year or two-year growth rates. So I think this is an economy that folks generally think is supposed to be holding up pretty well. So can you talk about what you're seeing in the UK? You had mentioned weather and a few other things, but a little bit more color on what's going on with the ad market in the UK. And then mobile payments, that's an area that's getting a lot of attention lately. Can you just give us an update on where the Google Wallet team stands and what kind of traction you're seeing in terms of user adoption and maybe how you plan on addressing merchant payments kind of outside of in-app or things from the app store? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "So, Ross, why don't I take the first question and then Omid will give you the answer on the second? As we talk about the UK, a couple points are worth note. One is, the UK contributed roughly 10% of our total revenue this quarter, and that's been the same for kind of the past many quarters. And in fact, if you go back years, it will still be in the same range. So there's nothing kind of fundamental that -- it's worth noting that it's still a pretty good market with decent growth. The issue of deceleration this quarter specifically, on platform -- I mean I mentioned a number of elements, right? So platform mix, we do see [Audio Gap] of desktop, tablet searches having a greater impact in UK than anywhere else that we see in our network of countries. On property mix, remember we talked about this also on prior calls. AFS as a business has much bigger part of our both UK and U.S. business, so it will skew to those geographies. And so those are kind of some of the elements. And as I mentioned, year-over-year comps were difficult. And then if you have a great summer in terms of weather or bad summer in weather, it can have some real impact on the growth rates as well. So it's a combination of a number of factors that the UK has driven our performance, but still pretty pleased. But I won't -- that's really what's going on there. In terms of the payments, I'll let Omid give you an update there."
},
{
"speaker": "Omid Kordestani",
"text": "Hi, Ross. I think our goal here is really achieving mass merchant adoption, so the availability of these NFC devices is about that and also making it easier for consumers to replace their wallets with their smartphones hopefully more and more over time. So reducing friction in everyday shopping experiences is how we approach it and the focus on the user and we're really developing a fully functional payment system. So, as you may know, users can send money today to friends through Gmail using the Wallet app. We have loyalty and gift cards that can be stored in the Wallet app. The Buy with Google button makes it possible for users to make purchases very quickly with two clicks. So, again, it's this two-fronted focus on merchant adoption and removing the friction for users. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks, Ross. Jamie, let's go to our next question, please."
},
{
"speaker": "Operator",
"text": "And we'll go next to Ben Schachter with Macquarie."
},
{
"speaker": "Ben Schachter",
"text": "Omid, after many years of waiting for television budgets to shift online, it appears to be happening in a more accelerated fashion. So, one, do you agree with that? And two, could you just discuss YouTube's positioning versus competitors and in particular Facebook Video? And then Patrick, a couple of quick ones for you. One, given the evolution of tax laws in Europe, how are you and how should we be thinking about Google's tax rate over the coming years? And then also just any comments on stock comp being particularly high this quarter? Thanks."
},
{
"speaker": "Omid Kordestani",
"text": "Thank you, Ben. This is Omid. So the way we look at it is that users are really accessing Internet on large screens with high broadband speeds, and we're getting great monetization on these screens and advertisers are really paying attention. So we have seen a real shift where marketers and agencies who have historically built their brands on TV are really reorienting this toward investments on digital. And as in regards to YouTube, our focus here is really this focus on investments and more content, more creativity. And I think you also mentioned that you had a Facebook comment. What they are doing I think in video has always helped us with bringing more attention and more innovation to the space, so we welcome that. And the way we're going to approach it is just continue to investing in our platform and on the creators and building better and better monetization solutions. Just again, you may know some of these metrics, but I'll say it again that we have 400 hours of content that are uploaded every minute and partner revenue is up 60% from 2012 to 2013 on YouTube."
},
{
"speaker": "Patrick Pichette",
"text": "Great. Let me jump, Ben, on the -- your two specific questions. [Audio Gap] tax issues, you've heard about the Ireland announcement earlier this week on the double Irish tax structure. I mean, for us, we've always said that it's for politicians to decide what laws they want to put and then for companies just to comply with those laws. And that's what we're basically doing. So we're deeply committed to Ireland. We've worked there for many years. We have a great -- that's our headquarters. We have over 2,500 employees there. And so from that perspective we're committed to the place. And we're going to work with the authorities just to kind of get clarifications over this. But it's really way too early to tell what's going to happen. So we're, just like you, getting the information, the news, and we're going to work with the authorities to understand it better and then comply with the laws. In terms of stock-based compensation, just a few notes on this one for this quarter. We have -- it's the time of year where we do equity refresh. And from a timing perspective last year, we did the equity refresh in Q2 instead of Q3. So there's kind of like a geography of Q2 versus Q3 that kind of hit us in Q3. In addition to this, if you go to our filings, you'll see that our executive compensation -- so think of the top 15 or top 20, I can't remember the exact numbers, but it's stated there – that they do their refreshes every two years and it happens to be this quarter as well. And then finally, I mean, we obviously have more employees. So it's just a compounding set of factors, Ben, that I kind of lumped it all into Q3. So it's no more, no less than that on that -- on that one."
},
{
"speaker": "Ben Schachter",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks for your question. Jamie, let's go to our next question, please."
},
{
"speaker": "Operator",
"text": "And we'll go next to Anthony DiClemente with Nomura."
},
{
"speaker": "Anthony DiClemente",
"text": "Thanks a lot. Just on core operating expenses, is there anything [Audio Gap] Patrick that you might call out in terms of expense growth in the quarter as you have operating deleverage through the P&L? Just wondering, going forward, if that's likely to continue. And then a question for Omid I suppose on YouTube. You mentioned -- I know that YouTube's investing in its studio as a way to help along new talent, new homegrown talent onto the platform directly. I'm wondering if you can talk about the multichannel networks, how YouTube's relationships with the multichannel networks, the MCNs, are evolving at a high level? How you guys think about that dynamic between the homegrown YouTube talent itself as compared to talent that resides on the MCNs? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Okay. Anthony, thank you for your question. Why don't I jump in right now on just expenses for the quarter? I think if I had two comments to make on expenses in the quarter, you may notice that relative to a few models that I saw out there, R&D was higher and other areas are a bit lower. And I just want to highlight that we hire and we focus clearly our hiring in our tech payroll, or think of it as all of our engineering. And that skews to R&D. So as we bring on people and we push forward the growth of our -- we really focus it in the areas that are going to make a fundamental difference to Google, which is engineering, and by doing so, it kind of skews to R&D. So that's why R&D may be a bit higher than expected by some models out there. And so that's one piece. And then the other one is just wanted to reiterate that it's very clearly an extraordinary quarter from a hiring perspective for the comments I've made before. And so we're kind of clearly seeing that. But at the same time I wouldn't say that this is clearly a new run rate for us or anything like that. It just happened that most of these college students end up landing in Q3 and we have the result of a banner year from a hiring perspective all through. It takes a year to hire them all and then they come into this quarter. So that's really kind of the two big elements that have actually flowed, Anthony, through our P&L this quarter. I'll let Omid answer the YouTube question."
},
{
"speaker": "Omid Kordestani",
"text": "Yes. Anthony, so, again, we have a very, very partnership minded organization here and company as a whole. So we view MCNs as -- or organizations that are really going to help develop a great content, support the creators on YouTube. Just like we are doing that with YouTube Studios, I think MCNs can help a lot of these become future stars hopefully and develop more success. So just we view it as another form of partnership that we need to pay attention to and support. So that's how we look at it."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Anthony. Jamie, let's go to our next question, please."
},
{
"speaker": "Operator",
"text": "And we'll go next to Carlos Kirjner with Sanford Bernstein."
},
{
"speaker": "Carlos Kirjner",
"text": "Thank you. I have two questions. Patrick, is CapEx still driven by real estate and construction? And if yes, can you explain in a bit more detail what changed about 18 months ago in the way you acquired real estate and build to drive the inflection in capital intensity that we have seen? It looks like you operated for more than 10 years in one way and then there was a shift that has led to this massive inflection. So what happened there? Secondly, do you think that Google login is adopted or inspired to being adopted by a large enough number of important mobile apps for you to be competitive in the long term when it comes to offering mobile [Audio Gap] and can you give us an update on the developer adoption of deep linking? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "So I can certainly take the first and let Omid answer the second. I've made that comment before in a prior quarter, Carlos. The CapEx intensity and our CapEx program has been built by a combination of, as I mentioned in previous quarter, catching up when we were running too hot in terms of tightening of capacity. And so -- and once I'm very happy that when we really torque our utilization rates, on the other side it creates a lot of operational issues. And that led us to believe that in fact investing ahead of the curve was actually a strategic imperative for us to make sure that if we have the extra capacity, we will grow into it. And I think the difference between -- certainly on the data center side, data center construction and machines, and you'll have noticed that this quarter again, there are priorities. If you look at the nomenclature I gave, construction of data center is the primary. So it is the core infrastructure, it's groundbreaking and it is setting up the core infrastructures. Machine was the second one for this quarter, but you'll notice that it flip flops real estate. In the case of the real estate, we have been investing for our campus and otherwise when we see -- when we hit kind of minimum scale, we need to kind of make investments in real estate. And again with an eye of looking for the long term, rather than just filling at least for the next 12 months or 24 months, because once you kind of -- if you decide you're going to grow in a place, then you need the capacity for multi-years. So all of these factors have actually kind of been the driver for the shift in capital intensity that you've seen over the last 18 months. So that's basically the explanation, Carlos. I'll let Omid kind of jump on the second question about the mobile question."
},
{
"speaker": "Omid Kordestani",
"text": "Sure. Thanks, Carlos. So the AdMob network reaches 900 million unique devices per month and our own apps are hugely popular, Gmail, Maps, Google App and YouTube. And our focus is also -- is helping developers generate app downloads and re-engagement with users who have already downloaded their apps, as I mentioned in my remarks earlier. And we're really helping drive hundreds of millions of app downloads through app promotion products. Again, the goal here is that you just search and not worry about where the answer is either on a webpage or on an app. And we've been in this game for a while. Four years ago, we acquired AdMob and have continued to invest in this space heavily. And this quarter, we launched the next generation of these promotion ads across Google search, Google Display Network, and YouTube. So we're really focused on this area to help the developers and our users."
},
{
"speaker": "Patrick Pichette",
"text": "I think we can clearly say that we're pretty pleased with the developer adoption of this. They see a huge benefit, so they're actually investing in it. Thank you, Carlos."
},
{
"speaker": "Carlos Kirjner",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Jamie, let's go to our next question, please."
},
{
"speaker": "Operator",
"text": "And we'll go next to Douglas Anmuth with JPMorgan."
},
{
"speaker": "Douglas Anmuth",
"text": "Thanks for taking the question. Just two for Omid. First, you talked about estimated conversions and seeing a 15% increase there. Can you just talk about whether you think that's actually leading to more spend at this point from advertisers? And then, secondly, are you seeing mobile like-for-like pricing improvements at this point? And what gives you the confidence in mobile closing the gap with desktop over time?"
},
{
"speaker": "Omid Kordestani",
"text": "Thanks, Douglas. Both are really good questions that are related really. I think the way this is going to play out is that I think advertisers are going to, with these tools, be able to just understand conversions better -- where is it happening? And then the dynamics of how those changes is all the way back to adjusting bids and then paying attention to where the conversions are coming from. So, again, I think just to maybe highlight some examples for you, we have a fashion retailer Express who's an early tester, found that the overall return on their ad spend doubled when offline sales were included in their online advertising results. So we're just continuing to invest here and get this right. It's too early to figure out the impact exactly on revenue, but we expect the estimated total conversions to help the advertisers fully measure this and ultimately adjust their bidding and just get much more sophisticated in these measurements. I hope that answers."
},
{
"speaker": "Douglas Anmuth",
"text": "And mobile on a like-for-like basis?"
},
{
"speaker": "Omid Kordestani",
"text": "The way we're focusing this is that users really are using their screens interchangeably simultaneously throughout the day and that we really are not at this point doing this like-by-like comparisons or comment on it because we think it's still early and we're really focused on just again delivering the results. And it took many years, for example, for the desktop ecosystem to develop the right ad formats and really take advantage of the platform. So I think we just need to continue innovating here, experimenting here to get it right."
},
{
"speaker": "Douglas Anmuth",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks, Douglas. Jamie, let's go to our next question, please."
},
{
"speaker": "Operator",
"text": "And we'll go next to Mark May with Citi."
},
{
"speaker": "Mark May",
"text": "Thanks for taking my question. One on -- there's been quite a bit of attention paid to cloud services space and Google in particular. Wondering if you can comment a little bit around the traction that you're getting with the Compute Engine? And what sort of impact that that's having on revenue or expenses and CapEx for the business? And then secondly, I think earlier you made a comment around some changes you've made in mobile that have impacted some of your network click metrics, so hoping you could elaborate a bit more on that."
},
{
"speaker": "Patrick Pichette",
"text": "Okay. Do you want me to..."
},
{
"speaker": "Omid Kordestani",
"text": "Go ahead."
},
{
"speaker": "Patrick Pichette",
"text": "I'll just jump on the cloud and then the last piece and then maybe -- I wasn't sure what the very first part of your question, Mark, was. But clearly, cloud is an area that is kind of booming, right? We know that the long-term trends are very clear for us, which is the vast majority of businesses. Everybody is moving their infrastructures to the cloud. So -- and it is an area where we have fundamentally great assets to contribute to this industry, both in terms of the flexibility, the cost structure, the technology, and that's why we're investing heavily in there. We're seeing great progress from an adoption perspective, signing up new customers. And from a CapEx, obviously you need to kind of -- that's one of them that as I mentioned on the CapEx story with Carlos a few minutes ago, if you do take off and you really get the kind of customer adoption that you expect, if you don't have the capacity in place, it can have a really important kind of differential in your success. So there is one that we're keeping a pretty close eye on from a CapEx perspective in making sure that we have the option value. The third question was mobile that have network clicks. So, yeah, I mean, clicks and CPCs always fluctuate from quarter-to-quarter. It just happens that we've made some -- as I mentioned, made some changes this quarter that improved our mobile pricing while impacting low quality clicks. So sometimes, it goes -- if you think of a long-term trend in the mobile sector piece of our product, sometimes you kind of put a new change in the network and it creates a lot of clicks for it, but then the CPCs are much lower. And then if it doesn't actually create something that's really good for the user, you need to kind of pull back on it, and that's what you've heard, for example, just parallel to the AFS business. So it's kind of constantly fluctuating. What's really important us is really the combined volume and pricing growth. And so for us, it's very clear that we're doing some great work in this area and monetization in aggregate is doing very well. And that's really what we're -- like on a quarter-to-quarter basis, don't panic about little movements here and there. Look at the fundamental trends, and that's where we're very pleased. Now, did you have a first -- was there a first question that I missed, Mark?"
},
{
"speaker": "Mark May",
"text": "No. I was hoping on cloud that maybe you could put some numbers behind the level of traction in terms of number of customers impact on expenses, CapEx, the level of investment in the cloud."
},
{
"speaker": "Patrick Pichette",
"text": "I see. Okay. So I've given you what I can give you on that. Again, we're really thrilled by the momentum there and our focus in that area."
},
{
"speaker": "Mark May",
"text": "Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks, Mark. Jamie, we'll go to our next question, please."
},
{
"speaker": "Operator",
"text": "And we'll go next to Peter Stabler with Wells Fargo Securities."
},
{
"speaker": "Peter Stabler",
"text": "Thanks for taking the question. One for Omid. Going back to estimated total conversions, wondering if we could expect Adometry to be integrated into the DoubleClick platform and how that may or may not work with the estimated total conversions tool? And then, finally, I'm wondering [Audio Gap] on your work around coming up with a solution that reduces the dependence upon cookies and perhaps introduces a cross-platform, a cross-device ID for Google and what impact that could have in the market? Thank you."
},
{
"speaker": "Omid Kordestani",
"text": "Sure. I think -- again, it's early for us to call Adometry. It's a great attribution solution and we've been investing in that tool for a long time now and trying to just get this right by all the innovation that's happening within Google and just really understanding the impact of these usage models and -- between the mobile devices and desktop. And so I think we're going to look at everything that's available out there, both what we're developing and partners out there that we could partner with, and continue to invest here. It's going to take us a while, just like we experienced before with search, to get this right and have a real end-to-end solution for marketers and publishers. And so I think you will see a lot of innovation in this space. What Facebook recently announced is another approach. And we're going to study that and just figure out what is the right set of offerings from us. So I guess, unfortunately, I can't give you a very specific answer here. But I think what you'll see from us is pay a huge amount of attention here, make the measurements and see the impact and then offer a full suite to our customers."
},
{
"speaker": "Patrick Pichette",
"text": "Yeah. So just basically, too early to speculate on these issues, but clearly it's an area of focus at the company. Thank you, Peter. Jamie, our next question, please?"
},
{
"speaker": "Operator",
"text": "And we'll go next to Heather Bellini with Goldman Sachs."
},
{
"speaker": "Heather Bellini",
"text": "Great. Thank you. I had two questions. The first was a follow-up on Google Shopping Express. I mean, just wondering, when you think about what Amazon is doing with same-day delivery, they're obviously building these fulfillment centers themselves, which theoretically should give them scale over time. I'm wondering if you could share with us how you see this evolving for Google over time? And then a follow-up question would just be related to your comments about payments. And I'm just wondering, how critical is it for Google itself to [Audio Gap] friction that you're seeing with kind of a ubiquitous digital wallet? Or would you be fine with a third-party doing so for the Android platform?"
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Heather. I'll take the first and then let Omid answer the second. Clearly, Google Shopping Express, there is an issue of scale and it's a combination of an issue of scale, tools and efficiency. I mean, that's how you, if you think over time, can end up with a product that you can deliver within kind of hours at the right value and where you can make money. So it's not only about -- yes, for efficiencies you need centralization. You need a bunch of distribution tools that actually work. We're clearly focused on that as well. I mean it is part of the business case that we're building. But you need more than that. There's a lot of other elements as well. So clearly focused like our competitors would be. And our announcements today, again kind of our -- was it yesterday -- yesterday's announcements on Shopping Express kind of tell you that we are investing both for -- the three new cities kind of give you a hint of, yes, it's about scale. So clearly we're focused on that."
},
{
"speaker": "Omid Kordestani",
"text": "Yeah. And Heather, on the wallet question, I think we're going to continue to be open here. So we are trying to get it right and innovating on multiple fronts, as I mentioned earlier. And if partnering makes sense, we'll take a look at it, as well. So -- and the goal is here really to provide this very seamless experience for the users and then get the merchant adoption and hopefully get this right. I'm certainly delighted every time I use this and it works. And I think if we can all get the ecosystem right and there are multiple players in it and partnerships that are making it happen, we're definitely open to that."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Heather. Let's go to our next question."
},
{
"speaker": "Operator",
"text": "And we'll go next to Paul Vogel with Barclays."
},
{
"speaker": "Paul Vogel",
"text": "Yeah. Great. Thank you very much. As Google Play has grown, I'm just wondering if you could talk about the relationships with the carriers and how that's evolving over time."
},
{
"speaker": "Patrick Pichette",
"text": "Yeah, I can answer that. So, essentially, Google Play is doing great and everybody wants to kind of be part of this answer. And so, for our carriers, [Audio Gap] basis. So the real question is, what's the win-win? And so they're all done individually. We have great partnerships with many carriers that actually fuel this, and we're including carrier billing. So all this actually is just a very, very positive ecosystem for us. And so we're totally thrilled to have these partnerships and we expect to continue to do so."
},
{
"speaker": "Paul Vogel",
"text": "Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks, Paul. Jamie, one more question."
},
{
"speaker": "Operator",
"text": "And we'll take our final question from Brian Pitz with Jefferies."
},
{
"speaker": "Brian Pitz",
"text": "Great. Thanks for the questions. Two for video -- on video for Omid. You mentioned Google Preferred in your comments. Any color on further expanding the upfront process with the ad agencies? Basically, do you anticipate that upwards of 5% to 10% of your top inventory could actually be set aside for preferred longer-term? And then just given the shift of offline TV dollars to online, as you've mentioned, any comments on political specifically or other new categories more aggressively moving on to YouTube? Thanks so much."
},
{
"speaker": "Omid Kordestani",
"text": "Sure. Thank you, Brian. So we secured upfront commitments from five top agencies: IPG, OMD, Digitas, Carat, SMG, and some major brands like General Motors and Coca-Cola and we were actually very, very pleased with how Google Preferred was experienced and adopted. And so I think we're going to definitely continue working on this. And also if you look at our history, we're very used to the selling model that was all about performance. And then as we added properties like YouTube and Brand and Mobile, we're just getting more and more now gaining a better understanding of how to work in this upfront process, for example, to offer the marketers this incredible asset that we have in YouTube and our network. So we're going to just continue getting better at -- on the products side, figure out how to package this inventory better, and then the tools that are needed, and then on the selling side, just get better at also working with the agencies and our advertisers and marketers to get this type of selling right. And on the political vertical, I think clients love to use our products as part of their campaigns for federal, local, state campaigns and it is a really great area for us. We have actually a political sales team that's focused on it. So I think you'll see more of that effort from us."
},
{
"speaker": "Brian Pitz",
"text": "Omid, thanks."
},
{
"speaker": "Omid Kordestani",
"text": "Thank you very much."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks, Brian. Jamie, that's all the time we have. So if you don't mind, I'd just like to close by reiterating what Omid said a bit earlier. This quarter was a great quarter with great momentum again. And I just wanted to thank all the great efforts of our Googlers around the world who make us look good on this call because of their fantastic effort. So with that, Jamie, I'll let you close the call, and have a happy Q4 everyone."
},
{
"speaker": "Operator",
"text": "Thank you again. That does conclude today's conference. We do appreciate everyone's participation."
}
] | null | null |
GOOGL | 2 | 2,014 | 2014-07-18 18:34:00 | Operator: Good day, everyone, and welcome to the Google Inc. Second Quarter 2014 Earnings Conference Call. This call is being recorded. At this time, I’d like to turn the call over to Jane Penner, Director of IR. Please go ahead ma'am.
Jane Penner: Good afternoon everyone and welcome to Google's second quarter 2014 earnings conference call. With us are Patrick Pichette, Senior Vice President and Chief Financial Officer; and Nikesh Arora, Senior Vice President and Chief Business Officer. Also as you know, we distribute our earnings release through our Investor Relations Web site located at investor.google.com. So, please refer to our IR Web site for our earnings releases as well as the supplementary slides that accompany the call. You can also visit our Google+ Investor Relations' page for latest Company news and updates. Please check it out. This call is also being Webcast from investor.google.com. A replay of the call will be available on our Web site later today. Now, let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward-looking including statements regarding Google's future investments, our long term growth and innovation, the expected performance of our businesses and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revisions to these forward look statements in light of new information or future events. Please refer to our SEC filings for more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on this call such as operating income and operating margin are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation and restructuring. We've also adjusted our net cash provided by operating activities to remove capital expenditures which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will now turn the call over to Patrick.
Patrick Pichette: Thank you, Jane. Good afternoon and thank you for joining us for our second quarter 2014 earnings call. So I will dive right into the numbers. Nikesh is going to give you a business update and then we will open-up for Q&A. So let’s dive into the details of our financial performance for Q2. Our gross total consolidated revenue grew a healthy 22% year-over-year to $16 billion and was up 3% quarter-over-quarter. Without currency fluctuations, our gross total consolidated revenue growth would in fact have been 21% year-over-year, still very healthy. Our Google site revenue was up 23% year-over-year to $10.9 billion and was up 4% quarter-over-quarter driven by strength in our core search advertising business. Our Network revenue was up 7% year-over-year at $3.4 billion and was up 1% quarter-over-quarter driven by year-over-year growth in our AdMob and Ad Exchange businesses. Finally, Google other revenue grew 53% year-over-year to $1.6 billion and was up 3% quarter-over-quarter. Digital sales of apps and content in our Play Store drove the year-over-year growth. Our global aggregate paid click was strong this quarter, up 25% year-over-year and 2% quarter-over-quarter. Aggregate CPC were down 6% year-over-year, but flat quarter-over-quarter. And without currency fluctuation, aggregate cost per click would have been down 7% year-over-year. So currency had a very minimal -- and currency had no impact on quarter-over-quarter CPC growth. As we indicated in our last earnings call, we’re now disclosing paid clicks and cost per click changes by property type in addition to aggregate numbers. So to that end, Google sites paid clicks were up 33% year-over-year and up 6% quarter-over-quarter. Our Google site CPC were down 7% year-over-year and down 2% quarter-over-quarter. On the Network side, network paid clicks were up 9% year-over-year and down 5% quarter-over-quarter. And our network CPCs were down 13% year-over-year and up 3% quarter-over-quarter. Our monetization metrics continue to be impacted by a number of factors at an aggregate level, including geographic mix, device mix, property mix, as well as our ongoing product and policy changes. And since we’re now disclosing additional property metrics related to our monetization, it maybe helpful to remind you all of what we include in each property. So let’s start with sites. Sites monetization metrics includes ads that were served on Google owned and operated properties across different geographies and form factors. So these properties include YouTube search obviously -- YouTube engagement ads like TrueView, and then other owned and operated properties such like Maps or Finance and otherwise. Our Network monetization metrics include ads served on non-Google properties participating in our AdSense for Search, AdSense for Content, and AdMob businesses. We also provide corresponding historical data since Q1 of 2013 for reference, which can be found on -- in our earnings slides. Nikesh and I’ll obviously be happy to respond as usual to your question about our Q2 monetization in the Q&A today. But I’m sure that some of you may have detailed questions about monetization trends from prior quarters. And to help you with that, the IR team will be ready to answer your questions after the call. Turning to geographic performance, we saw solid performance in the U.S. and U.K and continued strong performance in rest of the world. In our earnings slides, which you can find in our Investor Relations' website, you'll see that we've broken down our revenue by U.S., U.K., and rest of world, to show the impact of FX and the benefits of our hedging program. So please do refer to these slides for the exact calculations. The U.S. revenue was up 12% year-over-year to $6.6 billion. The U.K. was up 22% to $1.6 billion and in fixed FX terms, the U.K. grew 15% year-over-year, a clear improvement from last quarter’s performance. As we’ve mentioned in previous quarters, our AdSense for search business skews toward the U.S and the U.K. And our ongoing user focused product and policy changes have continued to have a clear impact on our revenue growth in these two geographies. Our non-U.S. revenue excluding the U.K. was up 31% year-over-year to $7.7 billion, and this accounted for 48% of our total revenue, which includes a $6 million benefit from our hedging program. So in FX term, the rest of the world grew also 31% year-over-year. Let me now turn to expenses. Traffic acquisition costs were $3.3 billion or 23% of total advertising revenue this quarter. Our non-GAAP other cost of revenue was $2.7 billion in Q2. This is excluding stock-based compensation. Our non-GAAP operating expenses totaled $4.8 billion, again excluding SBC and as a result, our non-GAAP operating profit was $5.1 billion and our non-GAAP operating margin stood at 32% in Q2. Headcount was up, roughly 2,200 people in Q2 in the last 90 days. And in total, we ended the quarter with approximately 52,000 full-time employees, but please note that the headcount does include approximately 3,500 full-time employees from the Motorola business. Our effective tax rate was 21% in Q2. Our tax rate this quarter was impacted by the continued mix shift of earnings between our domestic and international subsidiaries. Let me now turn to cash management. Our OI&E, our other income and expense was $145 million for the quarter. Interest income and realized gains on investments offset the continued impact of expenses from our FX hedging program. And for more detail on OI&E, please refer to the slides that accompany this call on our IR Web site. We continue to be happy with our strong operating cash flow at $5.6 billion. And CapEx for the quarter was $2.6 billion. This quarter, the majority of the CapEx spend was related to data center construction, real estate purchases and finally production equipment in that order. Investor should see our investment in CapEx as a positive signal, since it reflects our sustained optimism about Google’s business. As I’ve mentioned before, we will continue to invest for the long-term and our infrastructure and real estate assets remain a key strategic area of investment for us. Our free cash flow for the quarter was $3 billion. And before I close, I want to give a brief update on Motorola. The team continues to be hard at work and we look forward to seeing them join with the Lenovo team soon. Motorola had a great Q2 with the Moto E and Moto G, both showing strong sales momentum especially in emerging markets. So there you have it, strong results and an optimism that provides us the confidence to continue to fund strategic growth opportunities in many areas including our CapEx area that we talked about earlier. And now I'll let Nikesh cover some more details on our business performance in the quarter and after his remarks, I will take it back to open-up the phone lines for questions. Here you go Nikesh.
Nikesh Arora: Thank you, Patrick. You’ve had an amazing last few months at Google and our focus in creating great multi skin experience is paying off. I hope you saw our annual IO Developer Conference a few weeks ago. We were joined by over 6,000 developers in San Francisco along with approximately 1.9 million people globally tuning in online. We unveiled the upcoming Android L release. We also showed how we’re expanding android platform to cars, watches, TVs, as well as making it easy to search Google from anywhere by simply saying okay Google. Making magical products that people love using everyday is what drives our ambition, fuels our business. Last quarter we saw strong growth with $16 billion in gross revenue. We saw particular strength in the travel and retail verticals as well as in several countries like Japan and India. By now you know the four areas driving our business. One, performance or direct response marketing; two helping clients build their brands; third our ad tech platforms for agencies and publishers; and four, our emerging businesses like digital content, enterprise, and hardware. I’ll quickly go through each of them and this quarter I want to highlight the investments we’re making to serve the small businesses. Firstly, in performance advertising, in the long-term we’re battling towards a world where people jump seamlessly across screens of all sizes on all types of surfaces. In today’s world, unlocking the mobile phone opportunity is absolutely key for every marketeer and we’re seeing tremendous amounts of momentum here. We’ve been building popular mobile app formats for years like showcasing a businesses location or click to call, etcetera. The teams are laser focused on making ad campaigns easier across screens and helping businesses measure their effectiveness across devices as well as offline. We already offer great solutions for marketeers wanting to promote app installs, in April at our AdWords performance forum, we supercharged our offerings for app developers across search, display and as well as YouTube. We launched improvements like app deep linking and search to help developers re-engage users, who have already downloaded their app, better targeting options in AdMob to help them recent most likely customers, even a new app install format on YouTube and more powerful measurement tools, so they know exactly how their app is performing at every stage. Mobile hotel booking app Hotel Tonight uses mobile search ads as a the key part of their global marketing efforts because it drives consistently high value users or more likely to purchase quickly in the apps. In fact, international mobile search campaigns drive three times higher conversion rates compared to other direct response channels. We’re also seeing tremendous amounts of momentum in the retailer segments, product listing ads across screen. In fact this past quarter, we sent over three times as much traffic to merchants on smartphones and tablet devices compared to Q2 of last year. Let me go to the second area of brand building. I recently spend some times at Cannes Lions Festival. I know it was working Canne, where Google had a big presence, hosting over 300 meetings with creative agencies and brands. What was actually interesting this year was how much the conversation with brands has changed from years past. Whereas digital used to be just one channel, today’s brand are putting digital at the center of the brand building campaign. We see this from our clients as well and video seems to be the linchpin of the strategy. YouTube continues to be driven by the insanely popular channels from some of our top content creators like breakout hip -- hit Epic Rap Battles of History and new sensation Vice News. We launched our Google Preferred Video offering at BrandCast in April, giving marketeers access to top content at YouTube and we’ve gotten phenomenal amount of support from agencies and brands so far. Digitas was our first agency to sign on and since then Omnicom Media Group has also pledged their support. Brands including General Motors, Coca Cola, and Universal Pictures are also having tremendous amounts of success as Google preferred. Adidas was one of the major brands to leverage our global platform to reach fans during the World Cup. They engaged soccer fans by live streaming events with athletes, promoted them on YouTube through TrueView ads, as well as using beautiful light box ads across our display network. Now a few words about our ad technologies for agencies and publishers. Again, video is at the forefront of our efforts here. Last month we introduced a premium programmatic video marketplace called Google Partner Select to help publishers monetize their video content and to help agencies reach top quality video content across the Web. The feedback that we’ve gotten from agencies and publishers has been great. We continue to see strong growth across premium inventory, particularly with the growth of private exchanges across AdMob and AdSense publishers are increasing their investments in mobile sites and apps and growing their businesses using our platforms. Before I move on to our emerging businesses, I want to talk about an area we continue to invest in, online tools for small businesses. Small businesses are the cornerstone of the world’s economy and a major priority for us at Google. But there is still a huge opportunity as over 50% of SMBs still don’t have a Web site. To help set them up for online success; last month we introduced Google My Business, which helps small businesses manage their online presence across search, maps and Google+. We also have a vibrant ecosystem of partners who have local businesses optimize their AdWords campaigns and we’ve been improving our customer support for small businesses. In fact, over the last few years, we’ve doubled our advertiser customer satisfaction scores which bodes really well. Now, let me talk about emerging new businesses, digital content, enterprise and hardware. Google Play continues to grow at breakneck speed across all types of digital content, helping developers and content partners reach users around the world. For instance, Play Movies is now available in over 90 countries, with its recent additions in Argentina, Poland and the Czech Republic. We also recently signed deals with CBS TV and Viacom to bring their TV content to Google Play. With over a 1 billion active android users to going success of Google Play, means that more developers are building successful global businesses in our platform. As we mentioned at IO, since last June, we paid out more than $5 billion to developers through Play which clearly means it’s a growing business for us as well. Shifting gears to our enterprise business, I can report that over 60% of the Fortune 500 use our paid products. This quarter we added even more like Rockwell Collins. They signed up 20, 00 employees to use Google apps. We also launched Google Drive for work, a premium service of businesses that includes unlimited storage. The reception so far has been great and we even closed our first sale within minutes of the announcement. Our cloud platform business also has momentum with new features announced at IO. On the hardware side, over 1 million Chromebooks were sold into schools. Clearly a record quarter and the popularity of Chromecast continues to grow. Now available in Australia, Korea, Portugal and many more. I got to watch some World Cup games from the ESPN app using my Chromecast. Before I close, I want to mention our marketing team, in addition to a great IO this year, we also launched the Made with Code initiatives with partners like Girl Scouts with the USA and Girls to Code, to inspire the next generation of women coders. We are really excited about the enthusiasm around this initiative and who knows hopefully some of this chorus will join us at Google. With that, I’d like to thank today all the Googlers around the world who helped make this a fantastic quarter. On a personal note, as you might have seen, I’m moving on to a new adventure. I’d like to thank Larry and Sergey and the founders of Google, my colleagues and Larry’s staff as well as everyone at Google for the amazing experiences and the phenomenal 10 years I’ve had. I look forward to working with them in the future and cheering them from the sidelines. I’ll hand back to Patrick.
Patrick Pichette: Thank you, Nikesh. And as you’ve just heard, this will be Nikesh’s last call. So I want to take a minute on behalf of Nikesh, your friends here at Google, your colleagues and also all of Google -- all of our Googlers, to thank you for all of your contributions to Google over like what has been really a decade of work. So thank -- huge thanks. Well many of you on the call may have questions about transition, if you don’t mind, we’d like to the keep the discussion focused on our performance in the last quarter, if you don’t mind. So that’s really where we will focus our questions. And with that, why don’t I turn it over to Jamie who will line us up for our Q&A. Jamie?
Operator: Thank you. (Operator Instructions) We will take our first question from Mark Mahaney with RBC.
Mark Mahaney: Thank you. Two quick questions. The recovery in the growth rate in the U.K., could you provide more color around that or was it just you had hard comps last quarter, but the growth rate really consistent with what you had seen before. And then there was been some recent reporting about YouTube revenues. Could you just clarify even if its just historical data, the size of that asset? And any more color around the growth there, new monetization initiatives etcetera. Thank you.
Patrick Pichette: Yes, so it’s Patrick. And as we -- Mark as we’ve discussed in the last quarter, we had talked about the U.K. having had a tough comp the year before. So you can see basically the recovery of that in the numbers and we’re pretty pleased with the momentum there. In terms of YouTube, I mean we -- I know there has been lot of speculation out there, but in essence, where we’ve is a great opportunities in front of us and we don’t comment on outside estimates. YouTube, you know it serves as a powerful starting point for advertisers, for looking to anchor their brand campaigns online and coupled with the online measurement of the digital audience is being Neilsen, ComScore, everything that we just announced over the last couple quarter, right. Clearly a great runway ahead of it. So that’s basically the story on YouTube.
Mark Mahaney: Thank you, Patrick.
Mark Mahaney: Thanks. Jamie, what’s our next question please?
Operator: We will go next to Eric Sheridan with UBS.
Eric Sheridan: Thanks for taking the question. I guess, on the cash may be you can give update on your e-commerce initiatives. You called out retail as one of the strongest verticals in the quarter. Why didn’t you get a little more detail on what (indiscernible) in San Francisco? Thanks.
Patrick Pichette: Yes, thanks Eric for your question. I think two quick answers that, as we’ve talked in the past PLAs is actually a fundamental sort of existential need of our product. So research business, because as people go to tablets, as people go to mobile devices, they’re looking for more and more precise answers when they search and the ability for them to go directly to the entity they’re searching for is phenomenally powerful when you’re searching lots for these things and Sridhar and his team have done a great job working with every retail out there, try and get as many products listed. And our product listing service, so when you actually search you get a plethora of option in terms of where you can buy the product, what it’s priced at and how many products are available in their category. So it’s actually very, very good evolution from a search perspective, which clearly translates into people clicking on those and thereafter hopefully driving more commerce towards our partners and retail segment. As I said, we drove three times as much traffic this quarter’s and we did same time last year. So its clearly good. In terms of Google shopping express, its start of as an experiment, clearly I use that delighted with the service. I mean, I cant seem to find people who are not happy with Google shopping express. And we’re seeing tremendous results. We’re learning a lot. We are getting a logistics right. We’re getting our processes right and you believe its clearly an opportunity for us and our teams are really, really excited about continuing to invest in that area and you keep experiment with different formats and different solutions to make sure that we can provide the most optimized experience to our users. Yes, just a point of clarification, you talked about an overnight service in San Francisco. In fact, we’ve launched overnight deliver in all of northern California. But that continues to be an amazing demand for the product?
Patrick Pichette: Thanks and good luck going forward Nikesh.
Nikesh Arora: Thanks, Erik.
Patrick Pichette: Thank you very much. Jamie, let’s go to our next question please.
Operator: And we will go next to Ben Schachter with Macquarie.
Ben Schachter: Nikesh, good luck in your new role from me as well. Patrick when you’re budgeting for some of the longer term projects and you’re trying to think about sort of a timeframe to get to profitability. For instance, the team at Google X or Google fiber or something on self driving cars. How do you think about the timeframe for getting to profitability? Is there any general rule on how far away it needs to be? And related to that, in terms of the potential financial contribution within the next say three to five years. What are the new initiatives that you expect to have the most impact? Thanks.
Patrick Pichette: Thanks for your question, Ben. And what you really have is, as I’ve explained many times before, we set up our kind of governance around a bit of like a BC model where we actually have gating and funding. And projects that have -- there are more software based. We will have much shorter life times before we expect a bunch of returns. Projects that are much more kind of fundamental physics R&D, will have much longer life, like kind of timelines for actually funding and expected milestones. But in both cases they’re all set around the boundaries of -- you have a business case, you have a thesis and that thesis is basically tested on a regular basis through the gating of the funding that they get. And in some cases like self driving cars, obviously multiyear and we’ve a couple of other projects and (indiscernible) of that nature were it will take -- we think of kind of half decade, sometimes even a bit longer before we know that -- you can get kind of real momentum on revenue and profitability. Others are much shorter. So that’s how we kind of think about it. What matters most is really that we actually set up that gating and that we have these refinements to the business models and you know Google Shopping Express another great example of that where you just kind of have the gating and then they come back for funding every so many months to kind of look at where its going. So that’s what we have in terms of the next three to five years, I wouldn’t be able to comment on the specifics of anyone of those, but you can basically through the guidance I’ve just given you. You can come through what is really an asset in terms of versus a software kind of intensive kind of play and then it gives you a guidance of how fast and how slow we should expect our returns to be.
Ben Schachter: Great. Thank you.
Patrick Pichette: Thanks, Ben. Great question. Jamie let’s go to our next question please.
Operator: And we will go next to Justin Post with Merrill Lynch.
Justin Post: Okay, thank you. Couple ones. You mentioned on the prepared remarks that the U.S growth has been impacted by some of the network changes. I don’t suppose you could quantify it, but please do if you can. When do you think you kind of work through all those changes and we can start seeing a normalized growth rate or maybe you can answer by how far you’re along that process? And then the second question, pretty excited about Google Play opportunity. Can you just tell us what -- what’s the margin opportunity related to Google Play or the profit opportunity? Thank you.
Patrick Pichette: I will take the first and then I will let Nikesh talk about the second. On the first one, we have -- we’ve talked about this again as you said so rightly Justin, we have talked about a couple of things going on right as early as -- early kind of Q1 of 2013 we announced these DLA policy changes and you all remember that and we also reminded you at the time that by announcing these changes, it will take time to actually flow through to a bunch of partners across 2013. So clearly there is an effect there on a year-over-year basis, as it all -- it didn’t all happen in Q1 of ’13. In addition to that, I mentioned in my prepared remarks that we continue to have ongoing user focused product changes and they continue to impact our AFS business is an example. So AFS, right and then what you end up with is you all remember that AFS or AdWords for search -- essence for search, it really skews to the U.S and the U.K. And because of that, that’s why you see the disproportion into those results. So on the DLA obviously, they will lapse over the course of this year and -- but the additional kind of continued product changes and user focused product changes and policy changes will continue to kind of hammer them to make sure that we get the perfect balance between what is right for the user and what’s right for the advertiser. And so that’s why all in all, I feel pretty confident in what I said, when I said that we’re pretty pleased with our growth rate in the U.S. As for the Play, why don’t I actually let Nikesh give you a bit of comment on that?
Nikesh Arora: I think its important to step back and look at what the Google Play team has achieved. I mean its -- it come from nowhere. It’s a phenomenal platform which provides services, apps, content around the world as we mentioned over 90 countries of Google Play movies. And as Patrick would say, $5 billion developer which is 5,000 million, so lot of money. And its actually really great for innovation. Its phenomenal for the app developer ecosystem and it’s a really good binding glue for the android ecosystem, because people find tremendous (indiscernible) and all the apps and all the services they get at Google Play. For us we’re really, really very excited about the Google Play opportunity. I think in terms of margin, you should be able to look at the market and understand how typically these relationships work and should we know different than what the current market is around the margin opportunity for services in the long-term.
Justin Post: Great. Thank you.
Patrick Pichette: Thank you, Justin. Jamie, let’s go to our next question please.
Operator: We will go next to Ross Sandler with Deutsche Bank.
Ross Sandler: Thanks guys. I have two questions, product related. So at IO you announced some new innovation in search and discovery for apps, including opening up app indexing globally. So what kind of timeline do you think Google is on before we start to see a lot of app content appearing in core search results more regularly and what kind of revenue opportunity do you see around that? And then the second question somewhat related is you also announced a bunch of new screen for android, watches, TVs etcetera. I know its still very early days, but do you envision the long-term business model for these being similar to the existing model with ads in Google Play or do you see potentially feeling close loop transactions as an example? Thanks.
Patrick Pichette: Ross, thank you for your question. Let’s talk about the app indexing first and then about the screen stuff. I mean, if you think about it, Google has been in the business of making sure that we drive traffic on behalf of people and advertise and help people find things. And as you look at mobile phone behavior, people spend a lot of time on apps as well as in the browser searching for things. So I think it’s important for us to make sure that we provide the content that users are looking for. So, you should expect us to most aggressively try and make sure that App Indexing all happens and its available and easily accessible across devices and people are looking for things we’ve provided them the most relevant answer in which in certain cases that happens to be the app. So allowing for people to discover apps as well as creating more engagement for apps that people may not have been engaging with for a while. So, I think clearly an area of focus and clearly you should see -- expect us to see activity in that space. And in terms of revenue its not unlike any revenue we cerate in the search where we help people find things and that allows us to create an advertising opportunity where people are -- we’re able to monetize that on behalf of sort of our properties. In terms of your second question, I think you have to take a longer term point of view towards the screen question. As you can see all the screens are sort of almost designed as island where every screen has its own operating system, has its own ability to work. But we’re noticing more and more people want to switch from screens and retain the service experience. And towards that end, the android team is doing a phenomenal job making sure that we provide that seamlessness across screens and the fungibility of services across those screens. So, I think long-term we have to think about this as a user centric model. We’re helping users take their services fungibily from one screen to the other and making that happen seamlessly. And if that works out I think there is will phenomenal business opportunities for us in the future. But at Google we always worry about the user first and we’ll figure out the monetization when we have a lot of users excited about it.
Patrick Pichette: Thank you.
Patrick Pichette: Jamie, why don’t we go to our next question?
Operator: And we’ll go next to Carlos Kirjner with Bernstein.
Carlos Kirjner: Thank you. Two questions if I may. One on revenue, is there a significant positive net impact of growing penetration in usage of smartphones on search place and revenue? And what happens to search revenue growth if there is no more benefit in developed markets as smartphone penetration approaches a 100%? Second, you added more than 2,400 employees to Google in the quarter versus 1,400 in the second quarter last year; I think that’s the highest quarter of the headcount addition in more than two years. Patrick, it is the new normal in terms of the rate in which you grow headcounts for the core. How do you think about the rate of headcount growth versus gross profit or you don’t think about it at all? Thank you.
Patrick Pichette: Let me tackle that second one and then I’ll let Nikesh, talk about the first one. On the issue of headcount, look we have this amazing opportunity and machine to actually look around the world to look for the best engineers. And we promised ourselves that, given the bar it’s very, very high. When we do find people that fit the culture and that we think will actually do a great contribution and be great Googlers, we actually don’t hesitate and we hire them. Because if we hire them a bit too early or a bit too late it might unbalance, we’re very happy to have them early on. You’re right that, if you look at the last couple of quarters I mean the trend has been pretty kind of solid. And in addition to that you have to look at the impact also of our acquisitions when we make acquisitions that kind of compound’s a bit the numbers. But from that perspective Carlos, we don’t set up a specific target we say we’re going to end up with X amount for this quarter and then that once we hit our quarter we see everybody else next quarter. So from that perspective we’re a bit more organic about it. And we are -- the vast majority of our hiring to kind of give comfort to our investors is, it is really still in the engineering field and the product management field which is really where we want to focus our attention, and we continue to focus there. So, that’s basically the puzzle with which we work. On the question, maybe Nikesh can talk about revenue and smartphone penetration.
Nikesh Arora: Yes, of course (indiscernible) the answer is, yes. As we see more and more users with penetration of smartphones, people spend more time looking for things in their smartphones. And I think there’s a very, very long sort of runway that this opportunity has, because we’re just seeing people getting on to smartphones. Now you’re beginning to see businesses and other websites take mobile very, very seriously. They want to be present on mobile. I think the revenue opportunity is phenomenally high, because right now mobile does not monetize as well as certain other forms. But given the huge influx of queries we’re seeing, we expect as people make it more and more relevant to be able to find information in the long-term, mobile should be monetizing even better than desktops. So, I think as a tremendous runway going forward, I don’t think we have to fear the sort of saturation of smartphone penetration in developed markets for a while.
Patrick Pichette: Thank you, Carlos. We’ll take our next question, Jamie.
Operator: And we’ll go next to Anthony DiClemente with Nomura.
Anthony DiClemente: Thanks very much. Patrick, can you give us an update on your internet access initiatives particularly Google Fiber. Maybe update us on the evolution of the economics of that business and then perhaps even the timing of the Google Fiber rollout for more recently announced cities? And then a separate question on the Google Compute Engine business. How big of a growth driver can GCE be? And what do you guys see as the competitive advantage that Google has and what seems to be an increasingly competitive space in terms of the Cloud? Thanks.
Patrick Pichette: So why don’t I jump on the first one, and Nikesh if you don’t mind talking about GCE afterwards. Look, here’s what's going on with Google Fiber. It’s important to bear in mind the following. First is, the economics of a fiber network today are clearly much cheaper than they were say a decade ago. There have been a lot of improvements in cost reductions and technology components all through the fiber network, but also in the way we build it. The second one is, I just want to remind everyone that, an important part of our strategy is actually to build the demand. So, unlike the typical over builder, actually we have a very different kind of business model and thesis for that. And we do work closely with each city to streamline the process that keeps again the cost of construction way down. So, as an update to you right now, Anthony we have as you know we are working with 34 cities, separate cities with a kind of completed checklist of items to help us prepare for the next kind of wave of our construction project. And we’re going to be basically, they are in the last rows of finishing these checklists and its coming back with us. Over the coming months we’ll actually be going through all of the details with them, whether it would be write away or permitting or otherwise, and that’s what we’re going to use to make decisions as to how broad a program will have. We expect that to kind of give an update between now and the end of the year as the information comes along. So, we’re really thrilled about the opportunity. It continues to be kind of a great piece of focus for us. And just stay tuned for more, the next update on it. As per the GCE, do you want to take it Nikesh or?
Nikesh Arora: Yes. So I think, what's very important on sense, we’ve talked about this in the past, that we believe there is a lot of businesses out there have still to shift to the Cloud. We think in the long-term every business will be most efficient when they shift to the Cloud. So we’re not really concerned about trying to compete with other Cloud providers. What we’re really concerned about is making sure we have an amazing offering for businesses so they find value in working with us and making sure that we can support them in their transition to the Cloud. We think we have a great set of products. Our team is really excited, we’re beginning to ramp up. So, I think there is tremendous opportunity going forward. I think it won’t be time to slice the pie for a long time because a lot of businesses are clambering to move their business to the Cloud, because that’s where the users already are, because we’re used to the Cloud and are personalized and its about time that our businesses that we work in actually got to the bleeding edge of technology as much as the consumer services are.
Anthony DiClemente: Thank you very much.
Patrick Pichette: Thanks, Anthony. Jamie, lets go to our next caller please.
Operator: And we’ll go next to Mark May with Citigroup.
Mark May: Thanks for taking my questions. A follow-up on the network business. I think some of the quality initiatives that you’ve been undergoing and continued too for a while, part of the intended consequence result I would imagine would be to recognize higher overall CPCs or pricing every time, but that doesn’t seem to have been the case so far. So, I wonder if you could shed a whole light as to why we’re not seeing that show up in some of the metrics of kind of what your expectations are going forward, is that in fact one of the intended consequences that we should be expecting going forward? And then secondly, you’ve highlighted not just this quarter, but previously that one of the main headwinds to the company’s overall CPCs has been the mix shift around geography. I wonder if you could shed some light on if you’ve been seeing or making any progress in closing the gap there maybe in markets like APAC and what exactly are you doing to try to improve pricing outside the domestic and more stylish markets?
Patrick Pichette: Yes, so Mark, it’s Patrick. I think that you really pointed a fact that we are spending, there’s so many factor’s. The issue we have with the CPC -- one of the key things about CPC is clearly it gives you a trend, but the trend is really shaped by the combination of CPC and clicks. So, you can’t just look at one in isolation of the other, it’s really that mix of the two. And in the case of network for example, I mean we just discussed at the beginning of the call that, we’ve put a lot of time and a lot of energy in the last 18 months to actually work on quality issues. And that clearly has an impact when you push on quality to -- when you look at the mix to actually drive for the kind of revenues and growth rates that you see in our results on the network. Having said that, it’s also compensated by all of the other positive factors that we see whether it be as you said geography or product mix or otherwise. So, all in all I think that the team is doing a good job, both on network and on sites, and you can see that as well on our detailed information about, of sites where we continue to see the kind of -- or certainly over the last few quarters kind of creeping back up of CPCs which actually continue to push for this quality issue. In terms of geography, I think that yes, geography makes a big difference and that CPCs are much in some cases lower in international markets or emerging market. But the team continues with a number of localization initiatives to, like so we don’t take CPCs as just one general. We will focus on each country, look for initiatives on localizations for each country to get the maximum CPCs on a geographic basis country-by-country basis, and that’s why you’ll see a lot of localization initiatives. They’re just one again, one contributor. And it’s really early days. There’s so much potential in many of these areas and that’s why Sridhar’s team and our Search teams continue to work side-bye-side to continue to push on these areas. So, we see a lot of runway in this one, and geography is just one of these areas. And you mentioned like APAC, but APAC was a combination of more mature markets like Australia and Japan, and then we had the real emerging markets in there as well like Indonesia or India. So, even APAC itself is again localization matters immensely because very different answers for different countries. But all in all a pretty good story, and we’re really proud to continue to focus with this balance between user first and then make sure that we have the right monetization. So, thanks for your question, Mark. Jamie, lets go to our next question please.
Operator: And we’ll go next to Douglas Anmuth with JPMorgan.
Douglas Anmuth: Great. Thanks for taking the question. I just wanted to ask two things. First thing to the added disclosure just on volume and CPCs. If we look at the sites data on pricing, it looks like we’ve seen an inflection here over the last two quarters, and then now more flattish here sequentially in 2Q. Can we interpret from that, that we’ve seen the worst in terms of the negative pricing impact from mobile? And can you give us some color on what you’re seeing in terms of like-for-like mobile pricing as this point? And then secondly just on CapEx, Patrick, can you just help us understand how your philosophy may be has changed around CapEx spending over the last few years and if you’re in this period of building out potentially a lot of excess capacity, is it reasonable to think you’re at some point over the next few quarters we can also see things slow down as the business grows into that spending more? Thanks.
Patrick Pichette: So, Douglas let me start with the last question first and then I’ll jump to the first. On CapEx, listen, if you listen to the script I gave a couple of minutes ago, interestingly this quarter that in priority order was construction of datacenters. Second was actually real-estate which typically would have been historically, you would have heard me talk about kind of equipment, and then equipment was third. So, CapEx continues -- we think continues to be a strategic asset of ours. And you’re correct, and we’ve signaled that, that we’re actually building -- we have a big building program right now because these are long lead time items for our datacenters, and we’ve just talked about a minute ago about GCE and other Cloud services that continue to grow. So, to strategically have the capacity versus not having the capacity is such a strategic asset to us that will continue to look at way. In terms of real-estate we found the same time. We found that we have, when we have opportunities to actually acquire real-estate that it’s a make versus so buy versus lease option. And if you think of our growth and the growth in the strategic areas where we want to be, when we find great opportunities I think that we have a no-regret move in actually taking that action. So, you’re seeing more activities on that front which answers a bit, a lot of questions have been around, is the core business kind of capital intensity growing? Well you can see from these kind of data points that it’s not really that, it’s really a strategic focus that we have right now in making sure that we have the long-term assets necessary to win. So, that’s basically the mindset in which we’re kind of investing in CapEx. In the volume of CPCs, you’re talking about more flattish sequential in Q2, this is for sites I assume. Was that for sites?
Douglas Anmuth: For sites, and the lower or smaller decline over the last two quarters?
Patrick Pichette: Yes, again I would refer you back to the IR team to get a lot of more detailed questions. But I think on a quarterly basis there can be so many fluctuations. I think year-over-year gives you a much more kind of realistic trend about what is fundamentally going on in the business, because one or two changes can really kind of swing, even seasonality can swing quite a bit both in terms of growth rates or CPCs -- clicks and CPCs. So, be aware always of -- and if you can see that in the network numbers, clearly on the quarter-over-quarter as well there is a lot of noise in the data. So you have to be careful in the quarter-over-quarter. But year-over-year actually gives you a pretty good story of the efforts we’re putting into this. That’s how I would do it. Thank you very much for your questions. Jamie, lets go to our next question please.
Operator: And we’ll go next to Peter Stabler with Wells Fargo Securities.
Peter Stabler: Thanks for taking the questions. I just wanted to revisit the topic of small business for a second. Could you help us understand a little bit on some of the qualities of the small business growth profile? Is this about bringing businesses that have no online identity online or is it about taking more mature small businesses and getting a greater share of the spending? Just wondering if you could step back and maybe give yourself a report card on the small business progress you’ve made and where the best opportunities are? Thanks very much.
Nikesh Arora: Thanks Peter for the question. I think again, if you think about the phenomenal scale at which the Google team operates vis-à-vis small businesses it’s staggering. And we have millions of advertisers, millions of publishers we deal with. And we’re trying to make sure that millions of publishers get monetization through advertising at the same time we’re trying to work, make sure that millions of small businesses achieve their goals in trying to drive traffic both online and offline into whatever services they’re offering to their end users. Now, as we’ve gone through this transition to mobile and it’s very important that these small businesses make their transition effectively, because all the user traffic is slowly and steadily shifting towards mobile. And part of our effort is to make sure that we work closely with all of our small business advertisers existing to help them go mobile, at the same time trying to bring on more small businesses both onto the mobile and the desktop platform. So, it’s really a concerted effort to try and support small businesses around the world through very targeted program’s to show them ROI, to show them the value of living online because we believe in the long-term that’s where most businesses are going to get conducted. So, it’s really a long-term strategic effort to bring them all onboard, and I think the teams are doing a phenomenal job executing that ground.
Peter Stabler: Thanks for the color, Nikesh.
Patrick Pichette: Thank you, Peter. Jamie lets go to our next question please.
Operator: And we’ll go next to Heather Bellini with Goldman Sachs.
Heather Bellini: Great. Thank you so much for taking the question. I had two, I guess, given the success of Chromebooks over the past few years, how you think about the direction of Android and Chrome from a development standpoint as you look out, and also when you think about the multi-screen comments that you made before, that the value being able to transfer peoples experiences across screens?
Patrick Pichette: Did you say, you had two questions Heather?
Heather Bellini: Yes, and then I had a second one which just I was going to start with that one since it was long winded. And then the second one was just, Google Shopping Express seems to be a great way to impact the small business environment. I’m just wondering now that we’re seeing that expand into different areas. Is that kind of the, should we start to see an inflection in small business advertising adoption?
Patrick Pichette: Okay, we’ve got the two questions. I think Google Shopping Express is really about local and local is really about both small businesses as well as large businesses. So, it really -- so absolutely small businesses will be as part of the focus area. And we’re engaging with many of them which is actually pretty terrific, but it’s really about local. So it’s not only with the focus of small businesses, and that’s really the focus of Shopping Express. In the case of Chromebook’s and Android, I mean we’ve discussed this many times in the past where basically you have a great convergence because there is humongous strength in both of these platforms, and they’re basically converging in many ways. Today you can get -- for example, on an Android phone right Chrome kind of powers the search and vice versa. So we have a lot of these cross-pollinization between the two teams. They’re under one leadership which is Sundar, and he basically actually makes sure that these two teams continue to work into an integrated fashion. Everybody knows that Chrome has a huge focus on security, and that is in fact a great focus to kind of migrate over into the Android ecosystem to make sure that we have kind of the equivalent of enterprise grade security for all of our users whether they be Chrome or Android. So, I think that, when you think of multi-screen there are both of these OSS are actually very complementary to each other, and that’s why we continue to kind of work in parallel. I think that across these multi-screens you should expect, Android continues to be very much the thing of choice for mass and Chrome continues to be very much the enterprise infrastructure, and you should continue to see kind of that evolve with that collaboration. So that’s how we think about it, Heather. There’s no kind of, its one or the other. I think that they are perfect compliments. So, thank you for your question. Jamie, we’ll go through our next question please.
Operator: And we’ll take our next question from Youssef Squali with Cantor Fitzgerald.
Youssef Squali: Thank you very much. Two quick questions please. Going back to Doug’s question about CapEx; can you -- Patrick, can you give us any example of a non-search initiative where you’ve invested heavily over the last maybe three, four, five years where the ROI today exceeds your threshold, I’m assuming maybe on the display side. And then on the YouTube content strategy, how high in the professionally created content funnel do you want to get over time we’ve seen more and more professionally created content. So, if you can help us with that that will be great. Thank you.
Patrick Pichette: I mean we have a whole host of products where they are, just think of display, think of YouTube, think of maps, think of -- I mean there’s been so many of these products that, Gmail, Chrome, Android I mean all of those, whether they are directly tied to advertising because they are an advertising product or they are a platform that actually gives you distribution that gives you a great infrastructure on which kind of that fuels the searches and the advertising. I think that we have so many areas that we get absolutely terrific return. So, it’s not only about search, it’s really about the entire experience and the delivery around them. Then your second question is, could you just repeat the second question for me please?
Youssef Squali: Sure. Just trying to understand the content strategy within YouTube, so just how high do you want to go up the professionally created content funnel, and how do you plan monetization if it’s all advertising or is there another model?
Nikesh Arora: Thank you, Youssef for the question. I think it’s fair to say that YouTube has all forms of professional content available today. It has all the way from user content to very popular user content with people like Michelle Phan etcetera, and it has a lot of clips from professionally created content from various media partners we talked about CBS and Viacom in the earnings call. So, we have lots and lots of content from different players out there. And our monetization model in YouTube is working. It’s a phenomenal model. It is now the linchpin of each of our brand strategies if our partners and advertisers want to come work with us to create brand campaigns because YouTube allows you to actually target a fragmented set of interest in a most efficient fashion as opposed to try and do burst advertising that you would do in television and broadcast more. So, clearly the monetization model is working. In terms of other models as you’ve seen in the past we have experimented with various models on YouTube and we continue to experiment to see if advertising is the only model or there are ways that we can monetize using subscription of paid for content. I think that we will continue to do and see which ones in those sticks with the users.
Youssef Squali: All right, thanks and all the best Nikesh.
Nikesh Arora: Thank you very much. I appreciate it.
Patrick Pichette: Why don’t we go to our next question please, Jamie?
Operator: And we’ll go next to Richard Kramer with Arete Research.
Richard Kramer: Thanks very much. Nikesh, could you just expand on that last comment, putting together Google Fiber and a year on from YouTube channels. How important is it for Google over time to establish a subscription based type revenue stream especially if content moves to bundles. And for Patrick two things that would help us benchmark Google versus peers. First of all can you talk about the portion of ad growth or even the overall ad sales which are being driven by mobile? And also clearly there’s some questioning of the notion that large amounts of offshore cash can be permanently reinvested. Can you tell us what portion of cash is now offshore and how we should think about international opportunities that might absorb these very large volumes of cash? Thanks.
Patrick Pichette: Richard, thank you very much for the question. I think in terms of your question around Google Fiber, YouTube, content bundling, subscription, revenue streams, I think it’s a very good question and I think it’s an area where there’s a lot of moment across the board where different people are trying different models, where cable is trying to provide content over the top, where YouTube is available on television screens, where people are trying to increase the broadband speeds because everybody gets the sense that we will consume more and more broadband content. I think what's clear to us in this process is that bandwidths will continue to increase. People’s appetite for bandwidths will continue to grow up. It’s clear that people will consume content more and more in a non-linear fashion. And its clear that content will come from different places, not just the traditional mechanisms of cable and television. So, I think that’s pretty clear. It’s also clear that people will monetize content both either in some form of payment or some form of advertising. Beyond that how all of this sort of coagulates and takes form still remains to be seen. I think it’s fair to say, we are experimenting on different ends of the spectrum where we have like YouTube purely advertising based content and monetize today which is over the top which works on broadband. We have Google Fiber, we have channel bundle. So I think we are experimenting, we are playing in every space. And I think eventually the user will decide whatever is most convenient and most able to use, they will decide. But I think it’s fair to say we have a horse in every one of these races.
Patrick Pichette: That’s terrific. Let me jump into the second question. I’m going to once again kind of take a bit of exception through the premise of your argument about well how much is driven by mobile? We really are living in a multi-screen world. You start on mobile, you hop on tablet, you go to your desktop, you kind of come back to your television, you kind of Chromecast back to your TV, that’s the world in which we live. And when people say, how much of your advertising is really driven by one? And we do a lot of research that actually shows that, in fact that’s what we try to show to your advertisers is, how much attribution to kind of show to each of these elements which is in that chain of activities that actually leads to the end which is either a consumption of something or a purchase. So from that perspective that’s why we don’t actually talk about mobile as a percentage of ads. What really matters is that you have the footprint across all of these devices and modes to actually deliver the best answer to our users, and that’s why you heard about IO continuing to kind of expand that landscape. In the case of CapEx in international, like last quarter our offer cash was about kind of 60% and 40% in the U.S. We’ll share those numbers in our 10Q, so stay tuned. But in rough numbers that’s really where we stand today. It may move a percentage, here and there. We do have great opportunities outside the U.S. as well to actually invest our cash whether it be through acquisitions. You’ve seen a number of acquisitions in the last year that were made internationally as well as we’re building datacenters outside of the U.S. where our headquarters in Ireland continues to grow and we’re investing quite a bit of money there as well and to the real-estate. So, when you see our real-estate numbers, they may include over time a number of these projects in Ireland, but also in London and other places where we’re investing. So, we actually have pretty exciting plans for our international portfolio both in APAC and in Europe. And so there’s a real kind of great case to actually continue to keep this amount offshore. It’s not a shortage of opportunities that we have. So it’s just a question of pace and discipline. So, thank you for that.
Richard Kramer: Thank you.
Patrick Pichette: Thank you, Richard. Maybe we have time for one more. We’ll take one more question.
Operator: And we’ll take our final question from Colin Sebastian with Robert W. Baird.
Colin Sebastian: Great. Thanks for taking my questions. First off, Nikesh, congratulations and good luck.
Nikesh Arora: Thank you.
Colin Sebastian: Firstly through Google Play and applications such as Shopping Express, there already is a transactional model in place in terms of purchases and payments. I guess, I wonder if it wouldn’t be natural to assume that some of that transactional functionality could be extended to Google Shopping and PLA more broadly, or is it really about just driving traffic to third party sites for those businesses. And then secondly just a clarification on the cost per click breakout from the report, why aggregated cost per click year-over-year growth is actually better than individually the Google sites and the network sites? Thank you.
Patrick Pichette: I can actually give you the answer to the last one and then you can come back. It’s basically the Simpson's paradox. So, if you go on Wikipedia and you just check the Simpson's paradox you’ll understand that you may have two factors that are actually correlated in the same directions. But when you actually put them together they actually may correlate in an inverse proportion, and that’s where you get into the numbers and that’s why you have this kind of, the discrepancy because we all kind of laughed at this number as well because when we saw it, we said hey, something doesn’t add up and in fact it does add up. So, that’s really the issue there Colin. And unless you already know the Simpson's paradox then don’t go to Wikipedia.
Colin Sebastian: I’ll search Google first.
Patrick Pichette: On the first question …
Nikesh Arora: And on the first -- I’m sorry.
Patrick Pichette: Go ahead, Nikesh.
Nikesh Arora: Okay. On the first question I think that’s a fair observation Colin, and I think if you look at some of the applications that our payments team has developed are on InstaBuy, it’s the ability to do a one click buy where we can partner with merchants and any kinds of transaction providers, where they don’t have to keep entering their data or entering their credit card in different places. So, it gives them the comfort, ease of transaction. So, I think over time its kind of line an open system solution where we have platforms where retailers can work with us and pick and choose what part of our platform they want to leverage and our hope is to create a more and more friction less ability to create transactions which effectively benefits commerce and hopefully creates more revenue opportunities for us.
Colin Sebastian: Great. Thank you.
Patrick Pichette: Thanks, Colin. I usually kind of stop by kind of thanking all the Googlers, but Nikesh.
Nikesh Arora: Yes, Patrick. I just wanted to also take a moment and thank everybody on the call for tolerating and enduring me on this call and supporting me over the last many years. Thank you everyone. I look forward to working with you in the future in a different role.
Patrick Pichette: And with that, we’re going to actually thank all the Googlers for their amazing work over the last 90 days. It’s been a real rollercoaster. It’s continuing with IO and everything else and we look forward to Q3. With that, Jamie -- again Nikesh all the best and Jamie I will let you close the call.
Nikesh Arora: Thank you, Patrick.
Operator: Thank you. Again, that does conclude today's conference. We do appreciate everyone’s participation. Have a great day. | [
{
"speaker": "Operator",
"text": "Good day, everyone, and welcome to the Google Inc. Second Quarter 2014 Earnings Conference Call. This call is being recorded. At this time, I’d like to turn the call over to Jane Penner, Director of IR. Please go ahead ma'am."
},
{
"speaker": "Jane Penner",
"text": "Good afternoon everyone and welcome to Google's second quarter 2014 earnings conference call. With us are Patrick Pichette, Senior Vice President and Chief Financial Officer; and Nikesh Arora, Senior Vice President and Chief Business Officer. Also as you know, we distribute our earnings release through our Investor Relations Web site located at investor.google.com. So, please refer to our IR Web site for our earnings releases as well as the supplementary slides that accompany the call. You can also visit our Google+ Investor Relations' page for latest Company news and updates. Please check it out. This call is also being Webcast from investor.google.com. A replay of the call will be available on our Web site later today. Now, let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward-looking including statements regarding Google's future investments, our long term growth and innovation, the expected performance of our businesses and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revisions to these forward look statements in light of new information or future events. Please refer to our SEC filings for more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on this call such as operating income and operating margin are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation and restructuring. We've also adjusted our net cash provided by operating activities to remove capital expenditures which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will now turn the call over to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Jane. Good afternoon and thank you for joining us for our second quarter 2014 earnings call. So I will dive right into the numbers. Nikesh is going to give you a business update and then we will open-up for Q&A. So let’s dive into the details of our financial performance for Q2. Our gross total consolidated revenue grew a healthy 22% year-over-year to $16 billion and was up 3% quarter-over-quarter. Without currency fluctuations, our gross total consolidated revenue growth would in fact have been 21% year-over-year, still very healthy. Our Google site revenue was up 23% year-over-year to $10.9 billion and was up 4% quarter-over-quarter driven by strength in our core search advertising business. Our Network revenue was up 7% year-over-year at $3.4 billion and was up 1% quarter-over-quarter driven by year-over-year growth in our AdMob and Ad Exchange businesses. Finally, Google other revenue grew 53% year-over-year to $1.6 billion and was up 3% quarter-over-quarter. Digital sales of apps and content in our Play Store drove the year-over-year growth. Our global aggregate paid click was strong this quarter, up 25% year-over-year and 2% quarter-over-quarter. Aggregate CPC were down 6% year-over-year, but flat quarter-over-quarter. And without currency fluctuation, aggregate cost per click would have been down 7% year-over-year. So currency had a very minimal -- and currency had no impact on quarter-over-quarter CPC growth. As we indicated in our last earnings call, we’re now disclosing paid clicks and cost per click changes by property type in addition to aggregate numbers. So to that end, Google sites paid clicks were up 33% year-over-year and up 6% quarter-over-quarter. Our Google site CPC were down 7% year-over-year and down 2% quarter-over-quarter. On the Network side, network paid clicks were up 9% year-over-year and down 5% quarter-over-quarter. And our network CPCs were down 13% year-over-year and up 3% quarter-over-quarter. Our monetization metrics continue to be impacted by a number of factors at an aggregate level, including geographic mix, device mix, property mix, as well as our ongoing product and policy changes. And since we’re now disclosing additional property metrics related to our monetization, it maybe helpful to remind you all of what we include in each property. So let’s start with sites. Sites monetization metrics includes ads that were served on Google owned and operated properties across different geographies and form factors. So these properties include YouTube search obviously -- YouTube engagement ads like TrueView, and then other owned and operated properties such like Maps or Finance and otherwise. Our Network monetization metrics include ads served on non-Google properties participating in our AdSense for Search, AdSense for Content, and AdMob businesses. We also provide corresponding historical data since Q1 of 2013 for reference, which can be found on -- in our earnings slides. Nikesh and I’ll obviously be happy to respond as usual to your question about our Q2 monetization in the Q&A today. But I’m sure that some of you may have detailed questions about monetization trends from prior quarters. And to help you with that, the IR team will be ready to answer your questions after the call. Turning to geographic performance, we saw solid performance in the U.S. and U.K and continued strong performance in rest of the world. In our earnings slides, which you can find in our Investor Relations' website, you'll see that we've broken down our revenue by U.S., U.K., and rest of world, to show the impact of FX and the benefits of our hedging program. So please do refer to these slides for the exact calculations. The U.S. revenue was up 12% year-over-year to $6.6 billion. The U.K. was up 22% to $1.6 billion and in fixed FX terms, the U.K. grew 15% year-over-year, a clear improvement from last quarter’s performance. As we’ve mentioned in previous quarters, our AdSense for search business skews toward the U.S and the U.K. And our ongoing user focused product and policy changes have continued to have a clear impact on our revenue growth in these two geographies. Our non-U.S. revenue excluding the U.K. was up 31% year-over-year to $7.7 billion, and this accounted for 48% of our total revenue, which includes a $6 million benefit from our hedging program. So in FX term, the rest of the world grew also 31% year-over-year. Let me now turn to expenses. Traffic acquisition costs were $3.3 billion or 23% of total advertising revenue this quarter. Our non-GAAP other cost of revenue was $2.7 billion in Q2. This is excluding stock-based compensation. Our non-GAAP operating expenses totaled $4.8 billion, again excluding SBC and as a result, our non-GAAP operating profit was $5.1 billion and our non-GAAP operating margin stood at 32% in Q2. Headcount was up, roughly 2,200 people in Q2 in the last 90 days. And in total, we ended the quarter with approximately 52,000 full-time employees, but please note that the headcount does include approximately 3,500 full-time employees from the Motorola business. Our effective tax rate was 21% in Q2. Our tax rate this quarter was impacted by the continued mix shift of earnings between our domestic and international subsidiaries. Let me now turn to cash management. Our OI&E, our other income and expense was $145 million for the quarter. Interest income and realized gains on investments offset the continued impact of expenses from our FX hedging program. And for more detail on OI&E, please refer to the slides that accompany this call on our IR Web site. We continue to be happy with our strong operating cash flow at $5.6 billion. And CapEx for the quarter was $2.6 billion. This quarter, the majority of the CapEx spend was related to data center construction, real estate purchases and finally production equipment in that order. Investor should see our investment in CapEx as a positive signal, since it reflects our sustained optimism about Google’s business. As I’ve mentioned before, we will continue to invest for the long-term and our infrastructure and real estate assets remain a key strategic area of investment for us. Our free cash flow for the quarter was $3 billion. And before I close, I want to give a brief update on Motorola. The team continues to be hard at work and we look forward to seeing them join with the Lenovo team soon. Motorola had a great Q2 with the Moto E and Moto G, both showing strong sales momentum especially in emerging markets. So there you have it, strong results and an optimism that provides us the confidence to continue to fund strategic growth opportunities in many areas including our CapEx area that we talked about earlier. And now I'll let Nikesh cover some more details on our business performance in the quarter and after his remarks, I will take it back to open-up the phone lines for questions. Here you go Nikesh."
},
{
"speaker": "Nikesh Arora",
"text": "Thank you, Patrick. You’ve had an amazing last few months at Google and our focus in creating great multi skin experience is paying off. I hope you saw our annual IO Developer Conference a few weeks ago. We were joined by over 6,000 developers in San Francisco along with approximately 1.9 million people globally tuning in online. We unveiled the upcoming Android L release. We also showed how we’re expanding android platform to cars, watches, TVs, as well as making it easy to search Google from anywhere by simply saying okay Google. Making magical products that people love using everyday is what drives our ambition, fuels our business. Last quarter we saw strong growth with $16 billion in gross revenue. We saw particular strength in the travel and retail verticals as well as in several countries like Japan and India. By now you know the four areas driving our business. One, performance or direct response marketing; two helping clients build their brands; third our ad tech platforms for agencies and publishers; and four, our emerging businesses like digital content, enterprise, and hardware. I’ll quickly go through each of them and this quarter I want to highlight the investments we’re making to serve the small businesses. Firstly, in performance advertising, in the long-term we’re battling towards a world where people jump seamlessly across screens of all sizes on all types of surfaces. In today’s world, unlocking the mobile phone opportunity is absolutely key for every marketeer and we’re seeing tremendous amounts of momentum here. We’ve been building popular mobile app formats for years like showcasing a businesses location or click to call, etcetera. The teams are laser focused on making ad campaigns easier across screens and helping businesses measure their effectiveness across devices as well as offline. We already offer great solutions for marketeers wanting to promote app installs, in April at our AdWords performance forum, we supercharged our offerings for app developers across search, display and as well as YouTube. We launched improvements like app deep linking and search to help developers re-engage users, who have already downloaded their app, better targeting options in AdMob to help them recent most likely customers, even a new app install format on YouTube and more powerful measurement tools, so they know exactly how their app is performing at every stage. Mobile hotel booking app Hotel Tonight uses mobile search ads as a the key part of their global marketing efforts because it drives consistently high value users or more likely to purchase quickly in the apps. In fact, international mobile search campaigns drive three times higher conversion rates compared to other direct response channels. We’re also seeing tremendous amounts of momentum in the retailer segments, product listing ads across screen. In fact this past quarter, we sent over three times as much traffic to merchants on smartphones and tablet devices compared to Q2 of last year. Let me go to the second area of brand building. I recently spend some times at Cannes Lions Festival. I know it was working Canne, where Google had a big presence, hosting over 300 meetings with creative agencies and brands. What was actually interesting this year was how much the conversation with brands has changed from years past. Whereas digital used to be just one channel, today’s brand are putting digital at the center of the brand building campaign. We see this from our clients as well and video seems to be the linchpin of the strategy. YouTube continues to be driven by the insanely popular channels from some of our top content creators like breakout hip -- hit Epic Rap Battles of History and new sensation Vice News. We launched our Google Preferred Video offering at BrandCast in April, giving marketeers access to top content at YouTube and we’ve gotten phenomenal amount of support from agencies and brands so far. Digitas was our first agency to sign on and since then Omnicom Media Group has also pledged their support. Brands including General Motors, Coca Cola, and Universal Pictures are also having tremendous amounts of success as Google preferred. Adidas was one of the major brands to leverage our global platform to reach fans during the World Cup. They engaged soccer fans by live streaming events with athletes, promoted them on YouTube through TrueView ads, as well as using beautiful light box ads across our display network. Now a few words about our ad technologies for agencies and publishers. Again, video is at the forefront of our efforts here. Last month we introduced a premium programmatic video marketplace called Google Partner Select to help publishers monetize their video content and to help agencies reach top quality video content across the Web. The feedback that we’ve gotten from agencies and publishers has been great. We continue to see strong growth across premium inventory, particularly with the growth of private exchanges across AdMob and AdSense publishers are increasing their investments in mobile sites and apps and growing their businesses using our platforms. Before I move on to our emerging businesses, I want to talk about an area we continue to invest in, online tools for small businesses. Small businesses are the cornerstone of the world’s economy and a major priority for us at Google. But there is still a huge opportunity as over 50% of SMBs still don’t have a Web site. To help set them up for online success; last month we introduced Google My Business, which helps small businesses manage their online presence across search, maps and Google+. We also have a vibrant ecosystem of partners who have local businesses optimize their AdWords campaigns and we’ve been improving our customer support for small businesses. In fact, over the last few years, we’ve doubled our advertiser customer satisfaction scores which bodes really well. Now, let me talk about emerging new businesses, digital content, enterprise and hardware. Google Play continues to grow at breakneck speed across all types of digital content, helping developers and content partners reach users around the world. For instance, Play Movies is now available in over 90 countries, with its recent additions in Argentina, Poland and the Czech Republic. We also recently signed deals with CBS TV and Viacom to bring their TV content to Google Play. With over a 1 billion active android users to going success of Google Play, means that more developers are building successful global businesses in our platform. As we mentioned at IO, since last June, we paid out more than $5 billion to developers through Play which clearly means it’s a growing business for us as well. Shifting gears to our enterprise business, I can report that over 60% of the Fortune 500 use our paid products. This quarter we added even more like Rockwell Collins. They signed up 20, 00 employees to use Google apps. We also launched Google Drive for work, a premium service of businesses that includes unlimited storage. The reception so far has been great and we even closed our first sale within minutes of the announcement. Our cloud platform business also has momentum with new features announced at IO. On the hardware side, over 1 million Chromebooks were sold into schools. Clearly a record quarter and the popularity of Chromecast continues to grow. Now available in Australia, Korea, Portugal and many more. I got to watch some World Cup games from the ESPN app using my Chromecast. Before I close, I want to mention our marketing team, in addition to a great IO this year, we also launched the Made with Code initiatives with partners like Girl Scouts with the USA and Girls to Code, to inspire the next generation of women coders. We are really excited about the enthusiasm around this initiative and who knows hopefully some of this chorus will join us at Google. With that, I’d like to thank today all the Googlers around the world who helped make this a fantastic quarter. On a personal note, as you might have seen, I’m moving on to a new adventure. I’d like to thank Larry and Sergey and the founders of Google, my colleagues and Larry’s staff as well as everyone at Google for the amazing experiences and the phenomenal 10 years I’ve had. I look forward to working with them in the future and cheering them from the sidelines. I’ll hand back to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Nikesh. And as you’ve just heard, this will be Nikesh’s last call. So I want to take a minute on behalf of Nikesh, your friends here at Google, your colleagues and also all of Google -- all of our Googlers, to thank you for all of your contributions to Google over like what has been really a decade of work. So thank -- huge thanks. Well many of you on the call may have questions about transition, if you don’t mind, we’d like to the keep the discussion focused on our performance in the last quarter, if you don’t mind. So that’s really where we will focus our questions. And with that, why don’t I turn it over to Jamie who will line us up for our Q&A. Jamie?"
},
{
"speaker": "Operator",
"text": "Thank you. (Operator Instructions) We will take our first question from Mark Mahaney with RBC."
},
{
"speaker": "Mark Mahaney",
"text": "Thank you. Two quick questions. The recovery in the growth rate in the U.K., could you provide more color around that or was it just you had hard comps last quarter, but the growth rate really consistent with what you had seen before. And then there was been some recent reporting about YouTube revenues. Could you just clarify even if its just historical data, the size of that asset? And any more color around the growth there, new monetization initiatives etcetera. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Yes, so it’s Patrick. And as we -- Mark as we’ve discussed in the last quarter, we had talked about the U.K. having had a tough comp the year before. So you can see basically the recovery of that in the numbers and we’re pretty pleased with the momentum there. In terms of YouTube, I mean we -- I know there has been lot of speculation out there, but in essence, where we’ve is a great opportunities in front of us and we don’t comment on outside estimates. YouTube, you know it serves as a powerful starting point for advertisers, for looking to anchor their brand campaigns online and coupled with the online measurement of the digital audience is being Neilsen, ComScore, everything that we just announced over the last couple quarter, right. Clearly a great runway ahead of it. So that’s basically the story on YouTube."
},
{
"speaker": "Mark Mahaney",
"text": "Thank you, Patrick."
},
{
"speaker": "Mark Mahaney",
"text": "Thanks. Jamie, what’s our next question please?"
},
{
"speaker": "Operator",
"text": "We will go next to Eric Sheridan with UBS."
},
{
"speaker": "Eric Sheridan",
"text": "Thanks for taking the question. I guess, on the cash may be you can give update on your e-commerce initiatives. You called out retail as one of the strongest verticals in the quarter. Why didn’t you get a little more detail on what (indiscernible) in San Francisco? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Yes, thanks Eric for your question. I think two quick answers that, as we’ve talked in the past PLAs is actually a fundamental sort of existential need of our product. So research business, because as people go to tablets, as people go to mobile devices, they’re looking for more and more precise answers when they search and the ability for them to go directly to the entity they’re searching for is phenomenally powerful when you’re searching lots for these things and Sridhar and his team have done a great job working with every retail out there, try and get as many products listed. And our product listing service, so when you actually search you get a plethora of option in terms of where you can buy the product, what it’s priced at and how many products are available in their category. So it’s actually very, very good evolution from a search perspective, which clearly translates into people clicking on those and thereafter hopefully driving more commerce towards our partners and retail segment. As I said, we drove three times as much traffic this quarter’s and we did same time last year. So its clearly good. In terms of Google shopping express, its start of as an experiment, clearly I use that delighted with the service. I mean, I cant seem to find people who are not happy with Google shopping express. And we’re seeing tremendous results. We’re learning a lot. We are getting a logistics right. We’re getting our processes right and you believe its clearly an opportunity for us and our teams are really, really excited about continuing to invest in that area and you keep experiment with different formats and different solutions to make sure that we can provide the most optimized experience to our users. Yes, just a point of clarification, you talked about an overnight service in San Francisco. In fact, we’ve launched overnight deliver in all of northern California. But that continues to be an amazing demand for the product?"
},
{
"speaker": "Patrick Pichette",
"text": "Thanks and good luck going forward Nikesh."
},
{
"speaker": "Nikesh Arora",
"text": "Thanks, Erik."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you very much. Jamie, let’s go to our next question please."
},
{
"speaker": "Operator",
"text": "And we will go next to Ben Schachter with Macquarie."
},
{
"speaker": "Ben Schachter",
"text": "Nikesh, good luck in your new role from me as well. Patrick when you’re budgeting for some of the longer term projects and you’re trying to think about sort of a timeframe to get to profitability. For instance, the team at Google X or Google fiber or something on self driving cars. How do you think about the timeframe for getting to profitability? Is there any general rule on how far away it needs to be? And related to that, in terms of the potential financial contribution within the next say three to five years. What are the new initiatives that you expect to have the most impact? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks for your question, Ben. And what you really have is, as I’ve explained many times before, we set up our kind of governance around a bit of like a BC model where we actually have gating and funding. And projects that have -- there are more software based. We will have much shorter life times before we expect a bunch of returns. Projects that are much more kind of fundamental physics R&D, will have much longer life, like kind of timelines for actually funding and expected milestones. But in both cases they’re all set around the boundaries of -- you have a business case, you have a thesis and that thesis is basically tested on a regular basis through the gating of the funding that they get. And in some cases like self driving cars, obviously multiyear and we’ve a couple of other projects and (indiscernible) of that nature were it will take -- we think of kind of half decade, sometimes even a bit longer before we know that -- you can get kind of real momentum on revenue and profitability. Others are much shorter. So that’s how we kind of think about it. What matters most is really that we actually set up that gating and that we have these refinements to the business models and you know Google Shopping Express another great example of that where you just kind of have the gating and then they come back for funding every so many months to kind of look at where its going. So that’s what we have in terms of the next three to five years, I wouldn’t be able to comment on the specifics of anyone of those, but you can basically through the guidance I’ve just given you. You can come through what is really an asset in terms of versus a software kind of intensive kind of play and then it gives you a guidance of how fast and how slow we should expect our returns to be."
},
{
"speaker": "Ben Schachter",
"text": "Great. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks, Ben. Great question. Jamie let’s go to our next question please."
},
{
"speaker": "Operator",
"text": "And we will go next to Justin Post with Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "Okay, thank you. Couple ones. You mentioned on the prepared remarks that the U.S growth has been impacted by some of the network changes. I don’t suppose you could quantify it, but please do if you can. When do you think you kind of work through all those changes and we can start seeing a normalized growth rate or maybe you can answer by how far you’re along that process? And then the second question, pretty excited about Google Play opportunity. Can you just tell us what -- what’s the margin opportunity related to Google Play or the profit opportunity? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "I will take the first and then I will let Nikesh talk about the second. On the first one, we have -- we’ve talked about this again as you said so rightly Justin, we have talked about a couple of things going on right as early as -- early kind of Q1 of 2013 we announced these DLA policy changes and you all remember that and we also reminded you at the time that by announcing these changes, it will take time to actually flow through to a bunch of partners across 2013. So clearly there is an effect there on a year-over-year basis, as it all -- it didn’t all happen in Q1 of ’13. In addition to that, I mentioned in my prepared remarks that we continue to have ongoing user focused product changes and they continue to impact our AFS business is an example. So AFS, right and then what you end up with is you all remember that AFS or AdWords for search -- essence for search, it really skews to the U.S and the U.K. And because of that, that’s why you see the disproportion into those results. So on the DLA obviously, they will lapse over the course of this year and -- but the additional kind of continued product changes and user focused product changes and policy changes will continue to kind of hammer them to make sure that we get the perfect balance between what is right for the user and what’s right for the advertiser. And so that’s why all in all, I feel pretty confident in what I said, when I said that we’re pretty pleased with our growth rate in the U.S. As for the Play, why don’t I actually let Nikesh give you a bit of comment on that?"
},
{
"speaker": "Nikesh Arora",
"text": "I think its important to step back and look at what the Google Play team has achieved. I mean its -- it come from nowhere. It’s a phenomenal platform which provides services, apps, content around the world as we mentioned over 90 countries of Google Play movies. And as Patrick would say, $5 billion developer which is 5,000 million, so lot of money. And its actually really great for innovation. Its phenomenal for the app developer ecosystem and it’s a really good binding glue for the android ecosystem, because people find tremendous (indiscernible) and all the apps and all the services they get at Google Play. For us we’re really, really very excited about the Google Play opportunity. I think in terms of margin, you should be able to look at the market and understand how typically these relationships work and should we know different than what the current market is around the margin opportunity for services in the long-term."
},
{
"speaker": "Justin Post",
"text": "Great. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Justin. Jamie, let’s go to our next question please."
},
{
"speaker": "Operator",
"text": "We will go next to Ross Sandler with Deutsche Bank."
},
{
"speaker": "Ross Sandler",
"text": "Thanks guys. I have two questions, product related. So at IO you announced some new innovation in search and discovery for apps, including opening up app indexing globally. So what kind of timeline do you think Google is on before we start to see a lot of app content appearing in core search results more regularly and what kind of revenue opportunity do you see around that? And then the second question somewhat related is you also announced a bunch of new screen for android, watches, TVs etcetera. I know its still very early days, but do you envision the long-term business model for these being similar to the existing model with ads in Google Play or do you see potentially feeling close loop transactions as an example? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Ross, thank you for your question. Let’s talk about the app indexing first and then about the screen stuff. I mean, if you think about it, Google has been in the business of making sure that we drive traffic on behalf of people and advertise and help people find things. And as you look at mobile phone behavior, people spend a lot of time on apps as well as in the browser searching for things. So I think it’s important for us to make sure that we provide the content that users are looking for. So, you should expect us to most aggressively try and make sure that App Indexing all happens and its available and easily accessible across devices and people are looking for things we’ve provided them the most relevant answer in which in certain cases that happens to be the app. So allowing for people to discover apps as well as creating more engagement for apps that people may not have been engaging with for a while. So, I think clearly an area of focus and clearly you should see -- expect us to see activity in that space. And in terms of revenue its not unlike any revenue we cerate in the search where we help people find things and that allows us to create an advertising opportunity where people are -- we’re able to monetize that on behalf of sort of our properties. In terms of your second question, I think you have to take a longer term point of view towards the screen question. As you can see all the screens are sort of almost designed as island where every screen has its own operating system, has its own ability to work. But we’re noticing more and more people want to switch from screens and retain the service experience. And towards that end, the android team is doing a phenomenal job making sure that we provide that seamlessness across screens and the fungibility of services across those screens. So, I think long-term we have to think about this as a user centric model. We’re helping users take their services fungibily from one screen to the other and making that happen seamlessly. And if that works out I think there is will phenomenal business opportunities for us in the future. But at Google we always worry about the user first and we’ll figure out the monetization when we have a lot of users excited about it."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Jamie, why don’t we go to our next question?"
},
{
"speaker": "Operator",
"text": "And we’ll go next to Carlos Kirjner with Bernstein."
},
{
"speaker": "Carlos Kirjner",
"text": "Thank you. Two questions if I may. One on revenue, is there a significant positive net impact of growing penetration in usage of smartphones on search place and revenue? And what happens to search revenue growth if there is no more benefit in developed markets as smartphone penetration approaches a 100%? Second, you added more than 2,400 employees to Google in the quarter versus 1,400 in the second quarter last year; I think that’s the highest quarter of the headcount addition in more than two years. Patrick, it is the new normal in terms of the rate in which you grow headcounts for the core. How do you think about the rate of headcount growth versus gross profit or you don’t think about it at all? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Let me tackle that second one and then I’ll let Nikesh, talk about the first one. On the issue of headcount, look we have this amazing opportunity and machine to actually look around the world to look for the best engineers. And we promised ourselves that, given the bar it’s very, very high. When we do find people that fit the culture and that we think will actually do a great contribution and be great Googlers, we actually don’t hesitate and we hire them. Because if we hire them a bit too early or a bit too late it might unbalance, we’re very happy to have them early on. You’re right that, if you look at the last couple of quarters I mean the trend has been pretty kind of solid. And in addition to that you have to look at the impact also of our acquisitions when we make acquisitions that kind of compound’s a bit the numbers. But from that perspective Carlos, we don’t set up a specific target we say we’re going to end up with X amount for this quarter and then that once we hit our quarter we see everybody else next quarter. So from that perspective we’re a bit more organic about it. And we are -- the vast majority of our hiring to kind of give comfort to our investors is, it is really still in the engineering field and the product management field which is really where we want to focus our attention, and we continue to focus there. So, that’s basically the puzzle with which we work. On the question, maybe Nikesh can talk about revenue and smartphone penetration."
},
{
"speaker": "Nikesh Arora",
"text": "Yes, of course (indiscernible) the answer is, yes. As we see more and more users with penetration of smartphones, people spend more time looking for things in their smartphones. And I think there’s a very, very long sort of runway that this opportunity has, because we’re just seeing people getting on to smartphones. Now you’re beginning to see businesses and other websites take mobile very, very seriously. They want to be present on mobile. I think the revenue opportunity is phenomenally high, because right now mobile does not monetize as well as certain other forms. But given the huge influx of queries we’re seeing, we expect as people make it more and more relevant to be able to find information in the long-term, mobile should be monetizing even better than desktops. So, I think as a tremendous runway going forward, I don’t think we have to fear the sort of saturation of smartphone penetration in developed markets for a while."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Carlos. We’ll take our next question, Jamie."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Anthony DiClemente with Nomura."
},
{
"speaker": "Anthony DiClemente",
"text": "Thanks very much. Patrick, can you give us an update on your internet access initiatives particularly Google Fiber. Maybe update us on the evolution of the economics of that business and then perhaps even the timing of the Google Fiber rollout for more recently announced cities? And then a separate question on the Google Compute Engine business. How big of a growth driver can GCE be? And what do you guys see as the competitive advantage that Google has and what seems to be an increasingly competitive space in terms of the Cloud? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "So why don’t I jump on the first one, and Nikesh if you don’t mind talking about GCE afterwards. Look, here’s what's going on with Google Fiber. It’s important to bear in mind the following. First is, the economics of a fiber network today are clearly much cheaper than they were say a decade ago. There have been a lot of improvements in cost reductions and technology components all through the fiber network, but also in the way we build it. The second one is, I just want to remind everyone that, an important part of our strategy is actually to build the demand. So, unlike the typical over builder, actually we have a very different kind of business model and thesis for that. And we do work closely with each city to streamline the process that keeps again the cost of construction way down. So, as an update to you right now, Anthony we have as you know we are working with 34 cities, separate cities with a kind of completed checklist of items to help us prepare for the next kind of wave of our construction project. And we’re going to be basically, they are in the last rows of finishing these checklists and its coming back with us. Over the coming months we’ll actually be going through all of the details with them, whether it would be write away or permitting or otherwise, and that’s what we’re going to use to make decisions as to how broad a program will have. We expect that to kind of give an update between now and the end of the year as the information comes along. So, we’re really thrilled about the opportunity. It continues to be kind of a great piece of focus for us. And just stay tuned for more, the next update on it. As per the GCE, do you want to take it Nikesh or?"
},
{
"speaker": "Nikesh Arora",
"text": "Yes. So I think, what's very important on sense, we’ve talked about this in the past, that we believe there is a lot of businesses out there have still to shift to the Cloud. We think in the long-term every business will be most efficient when they shift to the Cloud. So we’re not really concerned about trying to compete with other Cloud providers. What we’re really concerned about is making sure we have an amazing offering for businesses so they find value in working with us and making sure that we can support them in their transition to the Cloud. We think we have a great set of products. Our team is really excited, we’re beginning to ramp up. So, I think there is tremendous opportunity going forward. I think it won’t be time to slice the pie for a long time because a lot of businesses are clambering to move their business to the Cloud, because that’s where the users already are, because we’re used to the Cloud and are personalized and its about time that our businesses that we work in actually got to the bleeding edge of technology as much as the consumer services are."
},
{
"speaker": "Anthony DiClemente",
"text": "Thank you very much."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks, Anthony. Jamie, lets go to our next caller please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Mark May with Citigroup."
},
{
"speaker": "Mark May",
"text": "Thanks for taking my questions. A follow-up on the network business. I think some of the quality initiatives that you’ve been undergoing and continued too for a while, part of the intended consequence result I would imagine would be to recognize higher overall CPCs or pricing every time, but that doesn’t seem to have been the case so far. So, I wonder if you could shed a whole light as to why we’re not seeing that show up in some of the metrics of kind of what your expectations are going forward, is that in fact one of the intended consequences that we should be expecting going forward? And then secondly, you’ve highlighted not just this quarter, but previously that one of the main headwinds to the company’s overall CPCs has been the mix shift around geography. I wonder if you could shed some light on if you’ve been seeing or making any progress in closing the gap there maybe in markets like APAC and what exactly are you doing to try to improve pricing outside the domestic and more stylish markets?"
},
{
"speaker": "Patrick Pichette",
"text": "Yes, so Mark, it’s Patrick. I think that you really pointed a fact that we are spending, there’s so many factor’s. The issue we have with the CPC -- one of the key things about CPC is clearly it gives you a trend, but the trend is really shaped by the combination of CPC and clicks. So, you can’t just look at one in isolation of the other, it’s really that mix of the two. And in the case of network for example, I mean we just discussed at the beginning of the call that, we’ve put a lot of time and a lot of energy in the last 18 months to actually work on quality issues. And that clearly has an impact when you push on quality to -- when you look at the mix to actually drive for the kind of revenues and growth rates that you see in our results on the network. Having said that, it’s also compensated by all of the other positive factors that we see whether it be as you said geography or product mix or otherwise. So, all in all I think that the team is doing a good job, both on network and on sites, and you can see that as well on our detailed information about, of sites where we continue to see the kind of -- or certainly over the last few quarters kind of creeping back up of CPCs which actually continue to push for this quality issue. In terms of geography, I think that yes, geography makes a big difference and that CPCs are much in some cases lower in international markets or emerging market. But the team continues with a number of localization initiatives to, like so we don’t take CPCs as just one general. We will focus on each country, look for initiatives on localizations for each country to get the maximum CPCs on a geographic basis country-by-country basis, and that’s why you’ll see a lot of localization initiatives. They’re just one again, one contributor. And it’s really early days. There’s so much potential in many of these areas and that’s why Sridhar’s team and our Search teams continue to work side-bye-side to continue to push on these areas. So, we see a lot of runway in this one, and geography is just one of these areas. And you mentioned like APAC, but APAC was a combination of more mature markets like Australia and Japan, and then we had the real emerging markets in there as well like Indonesia or India. So, even APAC itself is again localization matters immensely because very different answers for different countries. But all in all a pretty good story, and we’re really proud to continue to focus with this balance between user first and then make sure that we have the right monetization. So, thanks for your question, Mark. Jamie, lets go to our next question please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Douglas Anmuth with JPMorgan."
},
{
"speaker": "Douglas Anmuth",
"text": "Great. Thanks for taking the question. I just wanted to ask two things. First thing to the added disclosure just on volume and CPCs. If we look at the sites data on pricing, it looks like we’ve seen an inflection here over the last two quarters, and then now more flattish here sequentially in 2Q. Can we interpret from that, that we’ve seen the worst in terms of the negative pricing impact from mobile? And can you give us some color on what you’re seeing in terms of like-for-like mobile pricing as this point? And then secondly just on CapEx, Patrick, can you just help us understand how your philosophy may be has changed around CapEx spending over the last few years and if you’re in this period of building out potentially a lot of excess capacity, is it reasonable to think you’re at some point over the next few quarters we can also see things slow down as the business grows into that spending more? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "So, Douglas let me start with the last question first and then I’ll jump to the first. On CapEx, listen, if you listen to the script I gave a couple of minutes ago, interestingly this quarter that in priority order was construction of datacenters. Second was actually real-estate which typically would have been historically, you would have heard me talk about kind of equipment, and then equipment was third. So, CapEx continues -- we think continues to be a strategic asset of ours. And you’re correct, and we’ve signaled that, that we’re actually building -- we have a big building program right now because these are long lead time items for our datacenters, and we’ve just talked about a minute ago about GCE and other Cloud services that continue to grow. So, to strategically have the capacity versus not having the capacity is such a strategic asset to us that will continue to look at way. In terms of real-estate we found the same time. We found that we have, when we have opportunities to actually acquire real-estate that it’s a make versus so buy versus lease option. And if you think of our growth and the growth in the strategic areas where we want to be, when we find great opportunities I think that we have a no-regret move in actually taking that action. So, you’re seeing more activities on that front which answers a bit, a lot of questions have been around, is the core business kind of capital intensity growing? Well you can see from these kind of data points that it’s not really that, it’s really a strategic focus that we have right now in making sure that we have the long-term assets necessary to win. So, that’s basically the mindset in which we’re kind of investing in CapEx. In the volume of CPCs, you’re talking about more flattish sequential in Q2, this is for sites I assume. Was that for sites?"
},
{
"speaker": "Douglas Anmuth",
"text": "For sites, and the lower or smaller decline over the last two quarters?"
},
{
"speaker": "Patrick Pichette",
"text": "Yes, again I would refer you back to the IR team to get a lot of more detailed questions. But I think on a quarterly basis there can be so many fluctuations. I think year-over-year gives you a much more kind of realistic trend about what is fundamentally going on in the business, because one or two changes can really kind of swing, even seasonality can swing quite a bit both in terms of growth rates or CPCs -- clicks and CPCs. So, be aware always of -- and if you can see that in the network numbers, clearly on the quarter-over-quarter as well there is a lot of noise in the data. So you have to be careful in the quarter-over-quarter. But year-over-year actually gives you a pretty good story of the efforts we’re putting into this. That’s how I would do it. Thank you very much for your questions. Jamie, lets go to our next question please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Peter Stabler with Wells Fargo Securities."
},
{
"speaker": "Peter Stabler",
"text": "Thanks for taking the questions. I just wanted to revisit the topic of small business for a second. Could you help us understand a little bit on some of the qualities of the small business growth profile? Is this about bringing businesses that have no online identity online or is it about taking more mature small businesses and getting a greater share of the spending? Just wondering if you could step back and maybe give yourself a report card on the small business progress you’ve made and where the best opportunities are? Thanks very much."
},
{
"speaker": "Nikesh Arora",
"text": "Thanks Peter for the question. I think again, if you think about the phenomenal scale at which the Google team operates vis-à-vis small businesses it’s staggering. And we have millions of advertisers, millions of publishers we deal with. And we’re trying to make sure that millions of publishers get monetization through advertising at the same time we’re trying to work, make sure that millions of small businesses achieve their goals in trying to drive traffic both online and offline into whatever services they’re offering to their end users. Now, as we’ve gone through this transition to mobile and it’s very important that these small businesses make their transition effectively, because all the user traffic is slowly and steadily shifting towards mobile. And part of our effort is to make sure that we work closely with all of our small business advertisers existing to help them go mobile, at the same time trying to bring on more small businesses both onto the mobile and the desktop platform. So, it’s really a concerted effort to try and support small businesses around the world through very targeted program’s to show them ROI, to show them the value of living online because we believe in the long-term that’s where most businesses are going to get conducted. So, it’s really a long-term strategic effort to bring them all onboard, and I think the teams are doing a phenomenal job executing that ground."
},
{
"speaker": "Peter Stabler",
"text": "Thanks for the color, Nikesh."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Peter. Jamie lets go to our next question please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Heather Bellini with Goldman Sachs."
},
{
"speaker": "Heather Bellini",
"text": "Great. Thank you so much for taking the question. I had two, I guess, given the success of Chromebooks over the past few years, how you think about the direction of Android and Chrome from a development standpoint as you look out, and also when you think about the multi-screen comments that you made before, that the value being able to transfer peoples experiences across screens?"
},
{
"speaker": "Patrick Pichette",
"text": "Did you say, you had two questions Heather?"
},
{
"speaker": "Heather Bellini",
"text": "Yes, and then I had a second one which just I was going to start with that one since it was long winded. And then the second one was just, Google Shopping Express seems to be a great way to impact the small business environment. I’m just wondering now that we’re seeing that expand into different areas. Is that kind of the, should we start to see an inflection in small business advertising adoption?"
},
{
"speaker": "Patrick Pichette",
"text": "Okay, we’ve got the two questions. I think Google Shopping Express is really about local and local is really about both small businesses as well as large businesses. So, it really -- so absolutely small businesses will be as part of the focus area. And we’re engaging with many of them which is actually pretty terrific, but it’s really about local. So it’s not only with the focus of small businesses, and that’s really the focus of Shopping Express. In the case of Chromebook’s and Android, I mean we’ve discussed this many times in the past where basically you have a great convergence because there is humongous strength in both of these platforms, and they’re basically converging in many ways. Today you can get -- for example, on an Android phone right Chrome kind of powers the search and vice versa. So we have a lot of these cross-pollinization between the two teams. They’re under one leadership which is Sundar, and he basically actually makes sure that these two teams continue to work into an integrated fashion. Everybody knows that Chrome has a huge focus on security, and that is in fact a great focus to kind of migrate over into the Android ecosystem to make sure that we have kind of the equivalent of enterprise grade security for all of our users whether they be Chrome or Android. So, I think that, when you think of multi-screen there are both of these OSS are actually very complementary to each other, and that’s why we continue to kind of work in parallel. I think that across these multi-screens you should expect, Android continues to be very much the thing of choice for mass and Chrome continues to be very much the enterprise infrastructure, and you should continue to see kind of that evolve with that collaboration. So that’s how we think about it, Heather. There’s no kind of, its one or the other. I think that they are perfect compliments. So, thank you for your question. Jamie, we’ll go through our next question please."
},
{
"speaker": "Operator",
"text": "And we’ll take our next question from Youssef Squali with Cantor Fitzgerald."
},
{
"speaker": "Youssef Squali",
"text": "Thank you very much. Two quick questions please. Going back to Doug’s question about CapEx; can you -- Patrick, can you give us any example of a non-search initiative where you’ve invested heavily over the last maybe three, four, five years where the ROI today exceeds your threshold, I’m assuming maybe on the display side. And then on the YouTube content strategy, how high in the professionally created content funnel do you want to get over time we’ve seen more and more professionally created content. So, if you can help us with that that will be great. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "I mean we have a whole host of products where they are, just think of display, think of YouTube, think of maps, think of -- I mean there’s been so many of these products that, Gmail, Chrome, Android I mean all of those, whether they are directly tied to advertising because they are an advertising product or they are a platform that actually gives you distribution that gives you a great infrastructure on which kind of that fuels the searches and the advertising. I think that we have so many areas that we get absolutely terrific return. So, it’s not only about search, it’s really about the entire experience and the delivery around them. Then your second question is, could you just repeat the second question for me please?"
},
{
"speaker": "Youssef Squali",
"text": "Sure. Just trying to understand the content strategy within YouTube, so just how high do you want to go up the professionally created content funnel, and how do you plan monetization if it’s all advertising or is there another model?"
},
{
"speaker": "Nikesh Arora",
"text": "Thank you, Youssef for the question. I think it’s fair to say that YouTube has all forms of professional content available today. It has all the way from user content to very popular user content with people like Michelle Phan etcetera, and it has a lot of clips from professionally created content from various media partners we talked about CBS and Viacom in the earnings call. So, we have lots and lots of content from different players out there. And our monetization model in YouTube is working. It’s a phenomenal model. It is now the linchpin of each of our brand strategies if our partners and advertisers want to come work with us to create brand campaigns because YouTube allows you to actually target a fragmented set of interest in a most efficient fashion as opposed to try and do burst advertising that you would do in television and broadcast more. So, clearly the monetization model is working. In terms of other models as you’ve seen in the past we have experimented with various models on YouTube and we continue to experiment to see if advertising is the only model or there are ways that we can monetize using subscription of paid for content. I think that we will continue to do and see which ones in those sticks with the users."
},
{
"speaker": "Youssef Squali",
"text": "All right, thanks and all the best Nikesh."
},
{
"speaker": "Nikesh Arora",
"text": "Thank you very much. I appreciate it."
},
{
"speaker": "Patrick Pichette",
"text": "Why don’t we go to our next question please, Jamie?"
},
{
"speaker": "Operator",
"text": "And we’ll go next to Richard Kramer with Arete Research."
},
{
"speaker": "Richard Kramer",
"text": "Thanks very much. Nikesh, could you just expand on that last comment, putting together Google Fiber and a year on from YouTube channels. How important is it for Google over time to establish a subscription based type revenue stream especially if content moves to bundles. And for Patrick two things that would help us benchmark Google versus peers. First of all can you talk about the portion of ad growth or even the overall ad sales which are being driven by mobile? And also clearly there’s some questioning of the notion that large amounts of offshore cash can be permanently reinvested. Can you tell us what portion of cash is now offshore and how we should think about international opportunities that might absorb these very large volumes of cash? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Richard, thank you very much for the question. I think in terms of your question around Google Fiber, YouTube, content bundling, subscription, revenue streams, I think it’s a very good question and I think it’s an area where there’s a lot of moment across the board where different people are trying different models, where cable is trying to provide content over the top, where YouTube is available on television screens, where people are trying to increase the broadband speeds because everybody gets the sense that we will consume more and more broadband content. I think what's clear to us in this process is that bandwidths will continue to increase. People’s appetite for bandwidths will continue to grow up. It’s clear that people will consume content more and more in a non-linear fashion. And its clear that content will come from different places, not just the traditional mechanisms of cable and television. So, I think that’s pretty clear. It’s also clear that people will monetize content both either in some form of payment or some form of advertising. Beyond that how all of this sort of coagulates and takes form still remains to be seen. I think it’s fair to say, we are experimenting on different ends of the spectrum where we have like YouTube purely advertising based content and monetize today which is over the top which works on broadband. We have Google Fiber, we have channel bundle. So I think we are experimenting, we are playing in every space. And I think eventually the user will decide whatever is most convenient and most able to use, they will decide. But I think it’s fair to say we have a horse in every one of these races."
},
{
"speaker": "Patrick Pichette",
"text": "That’s terrific. Let me jump into the second question. I’m going to once again kind of take a bit of exception through the premise of your argument about well how much is driven by mobile? We really are living in a multi-screen world. You start on mobile, you hop on tablet, you go to your desktop, you kind of come back to your television, you kind of Chromecast back to your TV, that’s the world in which we live. And when people say, how much of your advertising is really driven by one? And we do a lot of research that actually shows that, in fact that’s what we try to show to your advertisers is, how much attribution to kind of show to each of these elements which is in that chain of activities that actually leads to the end which is either a consumption of something or a purchase. So from that perspective that’s why we don’t actually talk about mobile as a percentage of ads. What really matters is that you have the footprint across all of these devices and modes to actually deliver the best answer to our users, and that’s why you heard about IO continuing to kind of expand that landscape. In the case of CapEx in international, like last quarter our offer cash was about kind of 60% and 40% in the U.S. We’ll share those numbers in our 10Q, so stay tuned. But in rough numbers that’s really where we stand today. It may move a percentage, here and there. We do have great opportunities outside the U.S. as well to actually invest our cash whether it be through acquisitions. You’ve seen a number of acquisitions in the last year that were made internationally as well as we’re building datacenters outside of the U.S. where our headquarters in Ireland continues to grow and we’re investing quite a bit of money there as well and to the real-estate. So, when you see our real-estate numbers, they may include over time a number of these projects in Ireland, but also in London and other places where we’re investing. So, we actually have pretty exciting plans for our international portfolio both in APAC and in Europe. And so there’s a real kind of great case to actually continue to keep this amount offshore. It’s not a shortage of opportunities that we have. So it’s just a question of pace and discipline. So, thank you for that."
},
{
"speaker": "Richard Kramer",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Richard. Maybe we have time for one more. We’ll take one more question."
},
{
"speaker": "Operator",
"text": "And we’ll take our final question from Colin Sebastian with Robert W. Baird."
},
{
"speaker": "Colin Sebastian",
"text": "Great. Thanks for taking my questions. First off, Nikesh, congratulations and good luck."
},
{
"speaker": "Nikesh Arora",
"text": "Thank you."
},
{
"speaker": "Colin Sebastian",
"text": "Firstly through Google Play and applications such as Shopping Express, there already is a transactional model in place in terms of purchases and payments. I guess, I wonder if it wouldn’t be natural to assume that some of that transactional functionality could be extended to Google Shopping and PLA more broadly, or is it really about just driving traffic to third party sites for those businesses. And then secondly just a clarification on the cost per click breakout from the report, why aggregated cost per click year-over-year growth is actually better than individually the Google sites and the network sites? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "I can actually give you the answer to the last one and then you can come back. It’s basically the Simpson's paradox. So, if you go on Wikipedia and you just check the Simpson's paradox you’ll understand that you may have two factors that are actually correlated in the same directions. But when you actually put them together they actually may correlate in an inverse proportion, and that’s where you get into the numbers and that’s why you have this kind of, the discrepancy because we all kind of laughed at this number as well because when we saw it, we said hey, something doesn’t add up and in fact it does add up. So, that’s really the issue there Colin. And unless you already know the Simpson's paradox then don’t go to Wikipedia."
},
{
"speaker": "Colin Sebastian",
"text": "I’ll search Google first."
},
{
"speaker": "Patrick Pichette",
"text": "On the first question …"
},
{
"speaker": "Nikesh Arora",
"text": "And on the first -- I’m sorry."
},
{
"speaker": "Patrick Pichette",
"text": "Go ahead, Nikesh."
},
{
"speaker": "Nikesh Arora",
"text": "Okay. On the first question I think that’s a fair observation Colin, and I think if you look at some of the applications that our payments team has developed are on InstaBuy, it’s the ability to do a one click buy where we can partner with merchants and any kinds of transaction providers, where they don’t have to keep entering their data or entering their credit card in different places. So, it gives them the comfort, ease of transaction. So, I think over time its kind of line an open system solution where we have platforms where retailers can work with us and pick and choose what part of our platform they want to leverage and our hope is to create a more and more friction less ability to create transactions which effectively benefits commerce and hopefully creates more revenue opportunities for us."
},
{
"speaker": "Colin Sebastian",
"text": "Great. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks, Colin. I usually kind of stop by kind of thanking all the Googlers, but Nikesh."
},
{
"speaker": "Nikesh Arora",
"text": "Yes, Patrick. I just wanted to also take a moment and thank everybody on the call for tolerating and enduring me on this call and supporting me over the last many years. Thank you everyone. I look forward to working with you in the future in a different role."
},
{
"speaker": "Patrick Pichette",
"text": "And with that, we’re going to actually thank all the Googlers for their amazing work over the last 90 days. It’s been a real rollercoaster. It’s continuing with IO and everything else and we look forward to Q3. With that, Jamie -- again Nikesh all the best and Jamie I will let you close the call."
},
{
"speaker": "Nikesh Arora",
"text": "Thank you, Patrick."
},
{
"speaker": "Operator",
"text": "Thank you. Again, that does conclude today's conference. We do appreciate everyone’s participation. Have a great day."
}
] | null | null |
GOOGL | 1 | 2,014 | 2014-04-17 16:30:00 | Operator: Good day, everyone, and welcome to the Google Inc. Q1 2014 Earnings Call. Today's call is being recorded. At this time, I'd like to turn the conference over to Jane Penner, Director of IR. Please go ahead ma'am.
Jane Penner: Good afternoon everyone and welcome to Google's first quarter 2014 earnings conference call. With us are Patrick Pichette, Senior Vice President and Chief Financial Officer; and Nikesh Arora, Senior Vice President and Chief Business Officer. Also as you know, we distribute our earnings release through our Investor Relations website located at investor.google.com. So, please refer to our IR website for our earnings releases as well as the supplementary slides that accompany the call. You can also visit our Google+ Investor Relations' page for latest company news and updates. Please check it out. This call is being westbound cast from investor.google.com. A replay of the call will be available on our website later today. Now, quickly -- now let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward-looking including statements regarding Google's future investments, our long term growth and innovation, the expected performance of our businesses and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revisions to these forward look statements in light of new information or future events. Please refer to our SEC filings for more detailed descriptions of the risk factors that may affect our results. Please note certain financial measures we use on this call such as operating income and operating margin are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation and restructuring. We've also adjusted our net cash provided by operating activities to remove capital expenditures which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will turn the call over to Patrick.
Patrick Pichette: Good afternoon and thank you for joining us on our first quarter 2014 earnings call. Before we jump into my usual remarks, I'd like to bring two points to everybody's attention. First, a reminder that on April 2nd, we issued our Class C stock dividend with twice as many shares outstanding, our usual per share information will look quite different starting this quarter. Also, second, and also as a reminder, our expected sale of the Motorola business -- mobile business to Lenovo triggered discontinued operations accounting treatment which means Motorola's quarterly results are shown separately from Google net income. You'll see this new presentation in our financials starting this quarter. So with these two caveats noted let's dive into the details of Google's financial performance in Q1. Our gross total consolidated revenue grew a healthy 19% year-over-year to $15.4 billion and it was down 2% quarter-over-quarter. Without currency fluctuations, our gross total consolidated revenue growth would in fact have been 21% year-over-year. Google sites revenue was up 21% year-over-year to $10.5 billion and was down 1% quarter-over-quarter driven by the strength in our core search advertising business. Network revenue was up 4% year-over-year at $3.4 billion and was down 4% quarter-over--quarter driven by improved year-over-year growth from our Ad Exchange and AdMob businesses. Finally, Google's other revenue grew 48% year-over-year to $1.6 billion and was down 6% quarter-over-quarter. Digital sales of apps and content in our Play Store drove year-over-year growth. Chromecast sales were also strong. Our global aggregate paid click growth was strong this quarter again up 26% year-over-year and down just 1% quarter-over-quarter. Our aggregate cost per click was down 9% year-over-year and flat quarter-over-quarter. Currency fluctuations had a minimal impact on Q1 CPC growth. Our monetization metrics continued to be impacted by a number of factors discussed on previous calls, including geographic mix, device mix, property mix as well as products and policy changes. And to help investors better understand the complex dynamics of these monetization metrics, we'll begin disclosing paid clicks and CPC growth by property in Q2. To be clear this means we'll disclose CPC and paid click growth rates for both our sites and network businesses. We will continue to disclose aggregate growth rates for CPC and paid clicks. Turning to the geographic performance, we saw strong performance in the U.S. and rest of world, solid performance in our U.K. In our earnings slides, which you can find in our Investor Relations' website, you'll see that we've broken down our revenue by U.S., U.K., and rest of world, to show the impact of FX and benefits from our hedging program. So, please refer to those slides for the exact calculation. U.S. revenue was up 14% year-over-year to $6.7 billion, the U.K. was up 14% year-over-year to $1.6 billion and in fixed FX terms, it grew 11% year-over-year. Our non-U.S. revenue excluding the U.K. was up 25% year-over-year to $7.2 billion. This accounted for 47% of our total revenue, which includes a $8 million benefit from our hedging program. And in fixed FX terms, the rest of world grew, in fact, 30% year-over-year. Let me now turn to expenses. Traffic acquisition costs were $3.2 billion or 23% of total advertising revenue. Our non-GAAP other cost of revenue was $2.6 billion in Q1, excluding our stock-based compensation. Non-GAAP operating expenses totaled $4.6 billion, again excluding stock-based compensation and as a result, our non-GAAP operating profit was $5 billion and our non-GAAP operating margins were 32% in Q1. Just a quick word on a few items that may have created noise in our operating expenses this quarter. We had some discrete legal expenses that hit our G&A line as well as one-time M&A related costs that increased our operating expenses, particularly in R&D. So, absent these discrete items, our expenses continue to demonstrate the same disciplined agenda we've always had. Headcount was up, roughly 2,100 people in Q1. In total, we ended the quarter with approximately 50,000 full-time employees and please note that the headcount still includes approximately 3,700 full-time employees from the Motorola business as well as the employees from the acquisition completed in this quarter. Our effective tax rate was 18% in Q1 and our tax rate this quarter was impacted obviously by the federal R&D credits, which expired in 2013. Let me now turn to cash management. Other income and expense was $357 million for the quarter and realized gains on investments and interest income, offset the continued impact of expenses from our FX hedging program. For more details on OI&E, please refer to the slides that accompany this call on our IR website. We continue to be happy with our strong operating cash flow at $4.4 billion. CapEx for the quarter was 2.3 billion this quarter; again the majority of CapEx was related to data center construction, production equipment, and real estate purchases. As I mentioned last quarter during my remarks, we continue to invest in the long-term and our infrastructure continues to be a key strategic area of investment for us. Our free cash flow was $2 billion for Q1. And before I close, I want to give a brief update on Motorola. Motorola had a great quarter in Q1 with the Moto G showing strong sales momentum especially in emerging markets. The team continues to be hard at work and we look forward to seeing them join up with Lenovo soon. So, there you have it, strong results and an optimism that provides us the confidence to fund strategic growth opportunities including Android, Chrome, YouTube, enterprise just to name a few. And now I'll cover more details -- I'll let Nikesh, in fact, cover more details of our business performance in the quarter and after his remarks, we'll open up the phone lines for questions. Here you go Nikesh.
Nikesh Arora: Thank you, Patrick. You're welcome to cover more details if you'd like. Our business is growing well, with $15.4 billion in gross revenue; we had a particularly good advertising performance in the United States, highlighted by very strong auto sector showing around the Super Bowl. We had strong Play growth in Asia and we had a few isolated tracks. By now you're aware of the four areas driving our business. The first one direct sponsor, or as I like to call it performance marketing; the second one helping clients build their brands; third our ad tech platform for publishers and agencies; and fourth, our emerging businesses like digital content, enterprise, and hardware. Let me give you an you an update on all of those and talk about industry trends that are driving the investments we're making. On performance advertising, people are now always online and they want seamless, easy experience as they move from screen-to-screen. This constant connectivity is driving our investments here as people use search to navigate their world, Google is well-positioned to help people navigate between web, apps and the places around them. They help the marketers measure the entire customer journey and to drive better monetization. Next week, we'll be welcoming hundreds of advertisers to our adverse performance forum where we'll talk more about our work in this area for marketers. But clients are already benefiting from our recent investments like enhanced campaign and estimated total conversion. For instance, Shutterfly recently began measuring cross device conversion networks to understand sales that start in one device and end on another. As a result, they saw 60% increase in mobile conversions for non-brand terms, leaving them to include 100% of their keywords on mobile devices. We're seeing great momentum in product listing adds as well, with a new shop in campaign system. International retailer Farfetch upgraded shopping campaigns and increased their conversion rate by 13% while reducing cost there per acquisition or CPA by 20%. And Domino's Pizza -- who doesn't like pizza, recently made it easy for customers to pay with Google Wallet, instant buy in their in Android app. Moving on to brand building. For years you've all seen the rise of digital video, over-the-top networks, connected screens, streaming devices and high quality digital programming. Already for example, YouTube reaches more than 1 billion people a month through usually popular channels like fashion guru, Bethany Mota; cooking maven, Rosanna Pansino; and cult hit Nerdist. For marketers this is an irresistible trend, and we're now at a significant industry moment. Marketers and agencies that have historically built their brand on TV are reorienting their creative, planning, and investments with digital at the center. This year nearly all Super Bowl advertisers turned to YouTube to extend the life and reaches of their TV spots and Super Bowl related ads on YouTube have been viewed over 300 million times. That's roughly three times the size of the audience that watch the ads on TV. In Australia, we work with Nissan to create made for YouTube video for the launch of their new Patrol SUV. The campaign which is promoted by TrueView ads and YouTube mass set for over 340% increase of daily visits to their websites, and more than 2% of those were interactive for the campaign booked a test drive. In a few weeks in New York at our annual Brandcast Upfront Event we'll focus on our new Google preferred offering. This features exclusive access to the best, most engaging content on YouTube with guaranteed audiences through third-party measurement providers, Neilson and Counselor. We're really excited about this and we're looking forward to the results of that Upfront Brandcast Event. We're also helping brands through our newest display ad formats. We recently teamed with Tory Burch to bring her New York Fashion Week Show to a global audience across our display network. Then also the first ever live stream of fashion show in an ad using a light box ads, and we're able to share the exclusive event with more than 7 million of their biggest fans. Third, moving to our ad technologies and platforms; our programmatic ad technologies are seeing -- are continue to see great momentum with premium publisher partners like The Local Media Consortium. That's comprised more than 800 daily newspapers and 200 local broadcast stations as well as timing. Both of them signed on with us in February to create private exchanges. This maximizes a value of that ad space for handpicked premium environment. One thing we know is that agencies and publishers want to trust the environment in which they're transacting. Our ad network and exchanges are widely regarded across the industry as having the best quality controls and we continue to invest here. In February we acquired wellium fraud fighter Spider.io and thousands of our clients are already using our MRC-accredited Active View technology to buy high-quality viewable ad impressions. Let me switch over to our emerging new businesses, digital content, hardware and enterprise. Google Play continues to be the thriving hub of our digital content business. This quarter we introduced Google Play movies to 39 new countries, so now people in more than 65 countries can enjoy movies through Play. We also teamed up with Sonos to bring high-fidelity play music into the home and we introduce new development tools for Google Play games including game gifting and iOS multiplayer support. Over 75 million new users joined Google Play games in last six months; all of this is helping turn developers around the world into full-fledged businesses. In fact, we paid out more than four times as much money to developers in 2013 compared to 2012. And following the Open Automotive Alliance that we announced with partners in January designed to bring android as a car, in March we've announced Android Wear, a project that extends android to wearables. We're also already working with several consumer electronics manufacturers, chip makers and fashion brands who can't wait to see what developers come up with for your wrist. We also continue to see strong momentum from our suite of hardware products, our $35 Chromecast is a real hit. Last month we brought Chromecast to 11 more countries. We also recently opened up Chromecast developers, and in just a few weeks, more than 3,000 developers worldwide sign up to bring their apps and websites to the platform. Turning over to enterprise. We continue to see strong product adoption around the globe. We launched Chromebox for meetings, which makes it easy for any company to have high-definition video meetings through the power of Google+ Hangouts and Google apps. We're also investing significantly in the Google cloud platform and I've seen a very positive response to our most recent product announcements. We expect to see continued momentum in this area and we believe we can bring significant value to the many companies that opting public cloud because of our experience in building and operating one of the world's largest cloud computing environments for over a decade. We able to pass on the savings that come from lower digital storage cost to our customers through highly competitive pricing. In addition, every day more businesses, governments and schools start using Google apps to work better together including the state of Sao Paulo who moved to Google apps for more than 4 million students and 300,000 teachers and staff. Before I close, I want to call out our marketing team who continues to highlight the magic of Google to beep around the world, into fourth annual Google Science Fair, the doodle for Google in United States, the hugely popular ad campaigns. They also helped to build great retail experience for Chromecast in over 6,000 stores. I'd like to thank all Googlers around the world who help makes a terrific quarter. I'll now hand over back to Patrick.
Patrick Pichette: Thank you, Nikesh. So we'll work with Jamie to go straight to the Q&A. Jamie?
Operator: Thank you. (Operator Instructions) And we'll take our first question from Ben Schachter with Macquarie.
Ben Schachter: Patrick, I was wondering if you could help us quantify some of the expenses you saw, the one-time nature of G&A and anything else there that was really one-time. Just to help us understand what that run rate would look like if that wasn't in there? And then maybe the cash, if you could talk about the theme of sort of advertising attribution and how that's going to help you potentially bring over more brand dollars, and how do you think about bringing over those television dollars. I mean is that something that's going to come sort of a big rushing in 2014, or it's just going to be a slow evolution over many years. Thanks.
Patrick Pichette: Great. Thanks Ben. When I start, look on the discrete legal expense that impacted, it really impacted our G&A if -- and then the one-time M&A deal cost impacted all of our operating lines, but most prominently our R&D line, which you'll notice will have jumped a bit. The one-time M&A deal costs are largely stemming from the Nest deal, which was a pretty large transaction for us this quarter, but I think that the best way to describe it is that our expenses in Q1, they are completely in line with our objectives if you'd kind of take apart these two items, so that's how I would describe it. Nikesh?
Nikesh Arora: In terms of brand benefit Ben, I think -- thank you Patrick, thank you Ben. The brand question is a very good question. What we've noticed in the past let's just say 1.5 year is that people have slowly started coming to the digital medium to create extensional the existing brand campaigns like I mentioned the Super Bowl ad. People come to YouTube and say I'd like to read certain audiences which are only available on digital medium hence we see those advertising dollars shifting as an enhancing existing television or media campaigns. Now the real fun will began when people start doing campaigns exclusively on digital to go and help them build brands. That requires us to get ahead of the curve and get into the creative process much earlier because usually what we end up doing now is we get up -- we get to the end of the period of process and they just want to extend their brand. So we're working really hard to work with creative ad agencies, the large agency groups as well as our advertisers say how can we get ahead of that creative process, how can we help you conceive of brand campaigns that actually start and end in digital where perhaps you use TV as an extension medium as oppose to the other way around. Now I think this is definitely the Holy Grail. This is going to take us a level of time to get there, but with things like attribution in place with our deals with Nielsen and comScore we're beginning to create the compatibility saying look the same dollar you spend on television equates to so many dollars on digital or vice versa. The fact that we can give them sort of cross media measurement capability, we can give them comfort that their dollars are being well spent, even spent in digital. We will go long way in making sure that we get them to transition from just using traditional media to including digital in their media mix and eventually designing campaigns that start and end up digital.
Patrick Pichette: Thank you, Nikesh. Jamie, let's go to our next question. Thank you, Ben for your question.
Operator: And we'll go next to Douglas Anmuth with JPMorgan.
Douglas Anmuth: Great. Thanks for taking my questions. Just two things I wanted to ask. First, Patrick, just on the U.S. you had commented on the strength here in terms of 14% year-over-year, but it does look like on a sequential basis we saw a little bit more of a DeSale have been in recent 1Qs. Can you just comment if there's any factors there to point out. And then Nikesh, can you just talk about the key drivers of mobile pricing going forward. How you think the gap can close with desktop over the coming quarters and years. Thanks.
Patrick Pichette: All right. Thanks for -- Doug, for your questions. So in the case of the U.S. if you think about it you have the Q4 to Q1 issues that are typical. And then, as we've said before, the network business does skew toward the U.S. on a relative basis, so network clearly grew slower than site. So that's what really what you see is that mix of the two, but in aggregate, right, pretty pleased with the U.S. growth overall. So that was a pretty strong quarter. I'm really happy with it. Well, let Nikesh answer the mobile questions.
Nikesh Arora: Yeah, Doug, I think thank you again for the question. I've had firm belief and I continue to hold on to it that I believe in the medium to long term. Mobile pricing has to be better than desktop pricing. And I think the reason -- the way to think about it is that in mobile you have location and you have context of individuals which you don't have on the desktop. And the more you known about the user and their context, the more effective advertising you can provide to them. The better the conversion is likely to be for a search or any piece of advertising that you do. There's a whole bunch of building blocks that need to come into play for us like you said to get the gap to close. The good news is a lot of people are spending a lot of time on mobile devices. There's a lot of mobile search queries that we get. People are more and more focused about what they look for in mobile devices. They are closer to intent. They are closer to transaction. You see that there's a lot of friction-less ways of paying and converting transactions into commerce which is happening but things like instant buy etcetera. You're also seeing the lot of advertisers seemed through value of making sure that their present and a great experience on the mobile devices. So part of our challenge has been that if you guys just huge massive advertise in the desktop which over the last decade have become better at advertising, Understanding, optimization, understanding conversion, understanding truncation. That journey is just beginning for advertisers in the mobile site. They're just beginning to understand what it takes for the end user to come transact on their website. So like right now we can leave the horse to the water, we can't make it drink. But with all the advertisers coming on-board and working with us, we are actually begging to show them real transactions and asset beings to gain traction. I think we begin to see that gap continue to converge.
Douglas Anmuth: Thanks you.
Patrick Pichette: Thanks Doug for your question. Jamie let's go to the next question.
Operator: I'm going to go to next to Ross Sandler with Deutsche Bank.
Ross Sandler: Great. Thanks guys. I had a question on the Google Play App Store revenues and Nikesh you just mentioned that you guys paid out 300% more revenue to developers in ’13 versus ’12. So, I guess, how much is Play contributing to the overall licensing and other line, and there is clearly some lines or some items in that line that are not growing nearly as fast to get to the current 48% average. So can you talk about maybe what's underperforming in that area? And then last question on this topic is, I think if you go back to the infamous Andy Rubin slides from the Oracle case, the revenue share was around 5% for Google Play App Store revenue share, where is that now and is it changing as the Android ecosystem gets larger?
Patrick Pichette: Thanks. So why don’t I take a shot at this. Ross, the – if you think of our other revenue estimates for this quarter, right – first of all its – we’re really delighted by the Play business. So – and you’ll remember that a year ago we had – I mean, I'm going to bring back everybody to Q1 of 2013. We had a lot of Nexus 4 hardware sales, because we were in stock out in Q4. And that in combination with the accounting change of our Play app content revenue recognition. Again, remember till Q1 of last year both just simply created a bit of tougher year-over-year comp for this quarter, but overall very pleased with all of the kind of big lines of growth in this space. As for the rev share, I mean, obviously, this accounting change kind of goes to this 30% rather than the what you would have seen before which would have the net and – but we don’t divulge with the percentages are, that we keep going forward. So that’s basically where we stand on it and that’s why we are pretty pleased with this line for this quarter.
Nikesh Arora: And if I can add to Patrick, I think, the important part is, it’s taken us a while to get all the capabilities in place around the world in different markets, making sure we have all the content we need, we have all the app providers we need as well as the we have the payment mechanism. So, we really are excited about the Google Play business going forward.
Ross Sandler: Great. Thanks guys.
Patrick Pichette: Thanks. Thanks, Ross. Jamie lets go to our next question.
Operator: And we will go next to Mark May with Citi.
Mark May: Thanks. A question regarding the CPC segmentation for next quarter. Why you may not be in a position to provide these specific data points for Q1. I was hoping that maybe you could give us directionally how CPCs have trended between the owned and network businesses and kind of what are your expectation is going forward? Thanks.
Patrick Pichette: So, Mark, you will get the information in Q2. What we really wanted to do with the recognition as we think about giving more transparency to our shareholders, just looking at having exactly as you just mentioned the split between kind of our core sites and then the network itself. I think it will be useful for everybody and then, obviously, we will have the information going forward. So a lot of insights are going to come out of that and we are very pleased to be able to share with you starting next quarter. We've just made this decision over the last little while and shared it with the Audit Committee, the Board, so just stay tuned for next quarter on it.
Mark May: There are number of dynamics that play into the blended CPC that you've called out before property, policy, geo and device among others. Once you provide this new layer of transparency, does that really capture the major -- is it really the property and maybe to some degree policy differences that are influencing CPCs between owned and network or will geo and devices continue to play a major role in reported CPC, even once you provide this extra segmentation?
Patrick Pichette: Well, they all will and if we do – we may change just the policies that effect network, you will see them much more in transparent way. So in that sense it’s a very positive kind of news. Whether devices kind of have effects on network versus others, you will – it will be much more difficult to see. But, clearly, the impacts that are driven specifically for network or for sites you will be able to see on a quarter-by-quarter basis. So I think that’s good news for our investors. All right. Thank you so much for your question, Mark. Jamie, why don’t we go to our next question, please?
Operator: And we will go next to Mark Mahaney with RBC Capital Markets.
Mark Mahaney: Thanks. Two questions on the U.K. revenue growth at 11% number and on the partner websites at 4%, is there anything you would want to call out that has been unusual drags on those growth rates? I think U.K. is the lowest we've seen and maybe just lot of large numbers and really successful execution of that market. But anything you want to call out for either of those two revenue streams. Thanks.
Patrick Pichette: Well, as I said, well let me start with the U.K. The U.K., look, combination of partner mix this quarter, as well as, again, year-over-year matters a lot and we have happen to have a year ago a real revenue favorable weather. I mean, people kind of tend to forget it, but last year we had a very strong Q1 for the U.K. and the combination of these two things just kind of year-over-year made the comparison a little tighter for this quarter. As it relates to websites – partner websites, I covered that a bit earlier. And we’re – I mean, again, you back to last year where network, if you think about Ad Exchange, that model change in that model continues to be very, very strong. And we will remember again last year that we started the DLA policy change in Q1 or maybe it was in Q4, but the impact of the DLA actually takes time to flow through. We said that would take multi quarters. So, this has not kind of float over completely. So what you have again there is very strong on the quarters where we want sort of the Ad Exchange and AdMob, but on the flipside of that, right, you still have the tails of the DLA change policy that’s for a year ago. But the effects have not fully flowed through, so even in the coming quarters you should see a bit of an effect there, but, overall, pretty pleased with actually these results, Mark.
Mark Mahaney: Thanks Patrick.
Patrick Pichette: Thank you. Jamie, let’s go to our next question, please.
Operator: And we go next to Carlos Kirjner with Bernstein.
Carlos Kirjner: Thank you. I have two questions. First, in the last eight quarters headcount has grown significantly slower than revenue, but this quarter you hired, I think, 2,300 people in the core and headcount grew its revenues. Was this change in hiring rate mostly because of acquisitions and marginally what prevents you from hiring 2,300 people a quarter or even more as the business grows? And secondly, Patrick, in the spirit of giving more transparency to shareholders, can you give us some color on what has driven such a sustained increase in CapEx over the last four quarters? Because, I – I think clearly it’s not just some lumpy behavior. Are you buying data center sites in advance of demand and if this is the case can we infer that CapEx will revert to historical levels. Thank you.
Patrick Pichette: Thank you, Carlos for both of these questions. So, to the headcount question, I think, you've basically nailed it intuitively, which is, the acquisition of Nest – the acquisitions this quarter had a quite a bit of people impact on this number. Or kind of if you think of our organic numbers, have actually not changed in any material way. So it just happened, you know, you buy Nest and it comes with a lot of people. We also had, you remember, the acquisition of DeepMind and few others. So for us we had the double hitter of having the opportunity to continue to attract people on an organic basis to our processes and these few acquisitions kind of moved the needle quite a bit for us this quarter. As it relates to CapEx, listen, you are right that we – and I've mentioned this in the last couple of quarters, where we have – and just a reminder to everybody, if you think of the CapEx categories, right, data centers first, and data construction then production equipment then all other facilities, it’s kind of like the hierarchy of needs. And in the case of data center construction, we have found that the option value of having more capacity on standby and available to us to grow versus not having it is actually a real strategy issue for the company and in that sense if for whatever reason we continue – we had a spike in demand that was really pronounced and sustained for a couple of quarters and we did not have the capacity, it would be a real issue strategically for us, relative to the quite low cost of having the infrastructure in place. So that’s why we’re really pushing ahead of the curve and so it’s with this view of long-term. So from that perspective you are also right that that’s the mindset we are applying and we've always said that CapEx was lumpy, so you have a good manifestation of it right now, right here. So thank you for you those two questions, Carlos.
Carlos Kirjner: Thank you.
Patrick Pichette: Cheers. Jamie, let’s go to our next question, please.
Operator: And we will go next to Stephen Ju with Credit Suisse.
Stephen Ju: Hey, thanks guys. So, Nikesh, so in order to attract greater brand advertising dollars, it seems like safety and context are also important factors, because you are certainly not falling short on reads. So how close do you think you are to either engineering or coming up with some sort of solution to contextualize all the video content on YouTube, so you can guarantee you advertisers brand safety? Thanks
Nikesh Arora: That’s a good question. I think as I alluded to, we are going to do an upfront in a few weeks in New York City called Google Preferred, which is sort of our way of trying to create a premium sort of concentration of content that we can have advertisers advertise against which gives them a higher level of brand safety, a better level of measurement and hopefully plays where they believe that they can actually build the brands and hopefully that will – that will manifest itself in our ability to have a premium compared to what we can attract to the market without providing those kinds of things. So that’s a very good question. I think that’s what we are hoping to achieve and stay tuned for our detailed announcement of Brandcast.
Stephen Ju: Thanks.
Patrick Pichette: Thanks Stephen. Jamie, let’s go to our next question, please.
Operator: And we’ll go next to Justin Post with Merrill Lynch.
Justin Post: Great. I have three quick things. Did Enhanced Campaigns which you rolled out over the summer, impact Q4 and do you see some more benefits coming this year? Second, on PLAs, we think you had very good success in the U.S. in Q4, did that – does that, do you still have some benefits to come from that as you roll that out in Europe. How are you looking at the timing there versus how you rolled that out in the U.S.? And finally in the first quarter, maybe you can call out some specific verticals that might have strong or weak for you. Thank you.
Nikesh Arora: That’s a good question, Justin. Thank you. Not sure I can give you a lot of detail in terms of precise impacts of any individual products that we have. But, Enhanced Campaigns are working. It’s a necessity that we have to do them both for process reasons as well as the reason that consumers are going from screen to screen as well as advertisers need to advertise across multiple screens. So from that perspective Enhanced Campaigns is working, it’s part of life here. We don’t do anything without Enhanced Campaigns across the board. It’s sort of gone from being Enhanced Campaigns to regular campaigns because we don’t have any unenhanced campaigns anymore. In terms of PLAs, it’s something, as I alluded, is actually working. It’s providing a lot of color in the shopping vertical. It’s providing a lot of hold in shopping campaign effort that we have. PLA is working for us and its sort of working from multiple perspectives. It is providing users the detailed information that they need when they are declaring intent and saying and I would like to search for particular product, please don’t send to me to website. So it is working. We are going to roll that out one, separate time around the world. I cannot comment on the timing exactly. But I think both of those things are having a positive impact in our minds to everything we are doing around here.
Patrick Pichette: Just to close on this, just a few verticals here. I mean, again, completely reflecting the economy around us. If you go to – automobile has been quite strong across the world. Travel, actually quite strong in the U.S., so in the U.K. as well as in the rest of the world, a little bit less in the U.S, but just to give you a sense of. And then real estate, clearly, in the U.S. has been a strong vertical as well as in the U.K, so, again, a good reflection of the economy there, Justin. So, Google Trends, I always encourage people to go and checkout Google Trends as well because they continue to give good insights as to what's going on in the economy which would mirror in terms of verticals.
Justin Post: Thanks Patrick. Thanks Nikesh.
Patrick Pichette: Thanks Justin. Jamie, let’s go to your next question, please.
Operator: We’ll go next to Eric Sheridan with UBS.
Eric Sheridan: Thanks for taking the question guys. So two ones. One for Nikesh. Nikesh, I would love to get your view on sort of your view of the travel industry. Sort of how are you approaching that industry as a participant from an economy basis in that industry, both the marketing funnel and potentially the booking funnel? Longer term there’s been a lot sort of written lately about the way in which you guys might approach that industry vertical. And then second, Patrick for you. Maybe taking a stab at the one-time expenses from a different approach, when we look at the model, if you take your comments before about sort of smoothing out the expenses we saw in the back part of the year and even year-over-year, it appears that one-time expenses might have been about 50 basis point to 100 basis point impact on each of those two lines which would have sort of brought the blended number back up to sort of somewhere between 75 basis point to 150 basis points on margins. But just want to take a stab at that from a different direction just to quantify it. Thanks guys.
Nikesh Arora: Thanks Eric. That’s for the question. I was actually talking about pulling up the article which recently -- were Darren Huston talked about the effectiveness of Google Advertising for price line. I think that’s a public endorsement that all our efforts in the last many years in rather travel industry are actually working. They see tremendous value in our ability to help them bring more travelers to their sites and for them to help convert them into a real transaction. So whatever we are doing is working. I think I am expecting – suspecting that the comments we are talking about is our continued efforts in providing more and more detailed information when people do searches. And as we've talked in the past before that people’s information needs are getting more precise and we have to keep evolving the results at Google, whether its knowledge cards or Google Now all the things that we do towards giving them more and more precise answers, in which case sometimes we are required to go work with various industries to get the underlying data to surface it when the users are looking as opposed to send them to other sites where they have to go through that search process again. So I think you can expect us to continue do that. But our intent there is to provide a better answer for the users, whether it’s on their desktop or mobile devices. Accordingly, we also working together with the advertisers to provide them various advertising opportunities which allow them to work effectively with the end-user and provide them the answers that they are looking for or perhaps in this case the ticket or the hotel booking that they are looking for.
Patrick Pichette: Great. And then on my side, Eric, look, as I said in my earlier comment, our Q1 expenses were completely in line with our objectives and there is always seasonality. As you've noticed, from Q4 to Q1 there is always – we spend less on marketing and so that’s true for this year as well. And for the other areas, right, we would have been in line with the objectives we've set for ourselves. So these one-time costs were genuinely and that’s where truly one-time. And – I mean, when you acquire Nest for bit over $3 billion, there is just a lot of stuff that flows through the P&L, lot of accounting, and so that’s really the issue there. So, I would go back to your instinct of at least kind of we should be roughly in line with what our expectations where and they – that’s why the nature of truly extraordinary items. So thanks for that question.
Eric Sheridan: Thank you.
Patrick Pichette: Jamie, let’s go to our next question, please.
Operator: And we will go next to Peter Stabler with Wells Fargo Securities.
Peter Stabler: Good afternoon. Thanks for taking my question. Why don’t you revisit attributions for a moment? Given aspects attribution and I think you guys are doing a great job on the cross screen attribution and taking advantage of your ubiquitous login across different platforms and Enhanced Campaigns. Wanted to get a better understanding of how you’re thinking about online versus offline attribution for those types of marketers, particularly brand advertisers, supermarket advertisers, the 30,000 SKUs and those retail channels that don’t have E-Commerce and really don’t have much of the search opportunity. How are you helping them close the gap between their online activity and offline sales? Thanks very much.
Nikesh Arora: Thanks Peter. Thanks again for the question. I think as you rightfully pointed out the attribution story on the advertising side is kind of becoming clearer as we partner with Nielsen and comScore, and adopted some of the mechanisms that traditional media has used to create the comparability between traditional and internet media. I think you identity a good challenge which is that how do we bridge the gap between online commerce and offline commerce and relate that to advertising opportunity, i.e. when we sell search, we sell traffic to different people, how do we convince them, how do we make them realize that that traffic that they’ve got normally results in online sales, but also results in offline sales at stores and how do we encourage that activity. So over the last many years around the world we have run specific studies, working with various advertisers which are called online to store studies where we actually try and measure what online activity created by them took to control group's results in more foot traffic in their particular stores and certain reasons about. And we've pretty much had very good results across the board. I can't detail specifics right now because they are all specific to individual advertisers who we work with. But we do understand that opportunity and the problem and we work specifically with third-party research teams to work on figuring out how do we keep showing the online to store efficacy. And there are other products as you can see where we start doing conversion, we start looking at things like Google Shopping which also helps us in those areas.
Patrick Pichette: Thanks again, Peter.
Peter Stabler: Thanks for the color.
Patrick Pichette: Jamie, let’s go to our next question, please.
Operator: And we will go next to Heather Bellini with Goldman Sachs.
Heather Bellini: Great. Thank you very much. I just wanted to go back to an earlier question there was – you responded about the building blocks that were needed in order to get mobile pricing, mobile CPCs to convert to desktop. I was just wondering if you could share with us kind of specifically what you think those building blocks are that need to happen over the medium to long-term as you said to see that conversions occur. Thank you.
Nikesh Arora: Of course, thanks Heather for the question. I mean, look, there were some very simple things and there are some complicated things. The simple things are, we will make sure that there is payment enablement for users. So i.e. users have a mechanism that allows them to pay with lowest amount of friction, because honestly you and I don’t want to spend our lives trying to enter payment information on a very small screen where you are trying to conduct the transaction. So that enablement is happening across the industry, across multiple payment platforms. There is also the need that when people search for some things they can get quickly down to the information and they don’t have to browse multiple sites, because people are more keen on declaring intent to mobile devices than going and searching multiple websites and trying to figure out what they are trying to do. And that intent could be in the form of restaurant, could be in the form of a taxi, could be in the form of them looking for individual product. And you are beginning to see apps, you are beginning to see solutions on search that allow you to get to that granularity of information. Of course, there is a big building block which is getting all the people out there which shows the advertisers effectively in this case the merchants who actually have to have experience in the mobile site which are simpler to execute on. So try buying something on many companies’ mobile websites and it's more own risk than their desktop sites because they've been spending a decade trying to optimize the desktop site, but they haven’t spent enough time optimizing mobile experience, in some cases not believing that people want to transact with them in a mobile device and some cases they are just slow and they are just slowly diverting resources from desktop to mobile. So, if you take all those things and take the notion that we need to keep sort of working hard towards getting these building blocks in place, I think there's a finite time where these building blocks will come into plays. And as they keep coming into plays, you will see or as we talked about earlier, perhaps the conversion will happen between pricing in mobile desktop. But there's a whole bunch of other issues, I think but those are the big things that we need to think of right there.
Heather Bellini: Thanks so much.
Patrick Pichette: Thanks for your question Heather. Jamie let's go to our next question please.
Operator: And we'll go next to Colin Sebastian with Robert Baird.
Colin Sebastian: Great thanks. I wanted to ask you a question on the cloud platform. Since this is obviously a huge revenue opportunity for you and first-off if you could put context around the impact of this business on CapEx and OpEx, particularly on the infrastructure of the service part of the business? And then secondly, if you could talk about how you're planning to differentiate the service, is it really about pricing or is it by tying in the software and platform as a service offering, if you could touch on that? Thanks very much.
Patrick Pichette: I can cover the first part and then I'll let Nikesh cover the second. Look we're very comfortable with our cost structure. In light of Google efficiencies, economies of scale, our vertical integration from data center to chip -- to servers, to software. I mean we really have -- we believe we have absolute unique position from a cost structure perspective and therefore, from a margin perspective makes us very, very comfortable. In terms of differentiation, I'll just let Nikesh jump in here.
Nikesh Arora: I think Colin -- thank you again for the question. The important part to at least acknowledge in the space of cloud computing is we think that it's very, very, very early days. I mean if you think about the potential scope and scale of what this opportunity is, that's pretty much every business which is going to be around for the long-term has to operate in the cloud. There's no efficiency compared to the efficiency of the cloud, but in compared to owning your own infrastructure running it by yourself. So, this shift is going to happen. It’s a matter of every company going through that shift one at a time. And if you look at the opportunities out there and the options, there's very few options. So, there's a lot of room for all of us to have a great time for many, many, many years before we start worrying about differentiation and why my sort of thing is better than yours. So, right now, the key is to be able to work with the companies out there, the enterprise customers out there to get them to shift on the legacy systems, get on to the cloud and realize that Google has been working in the cloud for more than a decade, because we have been running one of the largest cloud computing platforms in the world in the public space. And we have all of the expertise and skills that are required to be able to serve these enterprises and get them off their current legacy system onto the cloud. So, our effort is really trying to work with each of these third-party partners, trying to get them off the legacy systems onto our cloud. I don't think the challenge right now is the need to differentiate. I think our biggest differentiator is we have the most experience in the space.
Colin Sebastian: Great. Thank you.
Patrick Pichette: Thanks Colin. Jamie we'll go to our next question please.
Operator: And we'll go next to Jordan Monahan with Morgan Stanley.
Jordan Monahan: Hi, thank you for taking the question. Actually two if I may. A couple of big picture questions, I think for Nikesh. The first is I think there's an ongoing debate about whether mobile web or mobile app is going to win and what the implications are for various businesses, Google included? And I'm just curious to get your view on whether you think one will win over the other and then whether it matters for Google? And then the second is when you look at Google's share of global advertising, you're coming up on about 10% of total, but when you look at your business in the U.K., you're north of 20% of total. So, when you think about your global businesses as economies start to mature, do you think the U.K. is a fair proxy for thinking about your business globally or are there other factors that you think may prevent you from getting to that type of scale globally.
Nikesh Arora: I guess let me answer the second question first Jordan, because I'm standing here Patrick is looking at me asking the same question. I think the way to think about it is that we have 10% by some metric depending on what we believe the total is. As per your metric, we have 10% of the total advertising sort of money. And the U.K. we have 20%. That just tells me there's 90% more opportunity around the world and 80% more opportunity in the U.K. So, we're not going to constrain our thinking in terms of what believe is a stable state. Our aspiration is to be able to serve every advertiser in the long-term and our aspiration is that -- our hope is that every piece of advertising becomes digital advertising. The question is how much of that are we able to provide through our technology platforms, how much are we able to provide through our own sort of properties and how much do we partner with others to provide on their network. So, I guess I'm trying to tell you we don't constrain ourselves and our thinking. I'm not trying to be arrogant, say we want 100%, but we like more than what we have in every market out there. In terms of your question around the mobile web and mobile search, that is a tough question and that is a very involved question and I think the approach -- the best way to think about it is that we're trying to make sure we can make both of them effective for the end-user and make them both work, because we're not about to try and pick winners. Right now, you can see that people spend as much time on mobile devices -- more time mobile devices they are beginning to spend on the desktop and they are spending the time across the mobile web as well as mobile app landscape. We're participating in both those ecosystems, whether it's somewhere placed on the app front, whether it's through our browser-based search properties or through our app-based search properties. So, we're participating across the Board and I think at the end of the day, it's going to boil down to ease-of-use and consumer choice.
Jordan Monahan: Thank you.
Patrick Pichette: Thank you, Jordan. Let's go to our next question please Jamie.
Operator: And we'll go next to Robert Peck with SunTrust.
Robert Peck: Yeah, hi. Thanks for taking my question. Two questions if you don't mind. The first is on the revenue side, can you talk a little bit -- can you maybe give us an update about the breakout of YouTube versus DoubleClick revenues, where are those today and where could they be over time? And then on the cost side, Patrick could you just walk us through just how you think about the ROI on capital? We get a lot of questions from investors asking about spending, could you maybe tell us more about the thought process and how the company looks at the ROIC of capital going forward? Thank you.
Patrick Pichette: Okay, well Robert, let's start with the last one first and then we'll go back to revenue. ROI clearly we have -- we always look at capital intensity. The fact that we're investing quite a bit in CapEx right now is a real tribute to kind of the potential and the optimism we have about our businesses going forward. Most of our core businesses if you think of YouTube or advertising or search are not that capital-intensive relative to other areas that we have such as for example, Google Fiber, if you think of the access portion right which is much more traditional CapEx. For each of these areas, we actually track and make sure that we have good returns and we have a capital efficient. So even though an area that take the advertising business that we run, even though you could argue that it's phenomenally good on return on capital, the questions that we will ask internally is okay so if the utilization rate is X on our machines on this business, right, why can't it be X plus something? So, even though we have already good return on capital in these areas, we continue to always push the envelope to make sure that our capital efficiency continues to be better and better on a year-to-year basis and then across a portfolio, every area has some capital kind of targets to make sure that we're driving for value. Finally, there's a number of areas if you think of take the newer stuff like Loon, for example. In those cases, you test through the hurdles that we kind of we seed capital to the Loon team as they hid their hurdles and they kind of earned their right to the next cost for funding. And in doing so, right, we continue to always have the business case in mind that says here is why this continues to make sense to fund and invest and with an ROIC or value in mind for the long-term, but in the short-term, it's really kind of delivery of milestones on very specific engineers objectives that actually gives them the next round of funding. So, Robert as you can see, given the portfolio of mature stuff we have and growing areas as well as kind of much more R&D and innovation at the early stages, right, we just need to have a basket of tools to actually manage the concept of ROIC or ROI on each of them. And that's what we do. It's not rocket science; it just requires a lot of discipline on our part. On the revenue side, look, we don't break out DoubleClick or YouTube. I can just tell you as I mentioned a bit earlier; we're really pleased with our network revenue in the kind of AdMob, AdExchange. Many of our areas continue to grow very well and we're very, very pleased by these investments and clearly continue to be very pleased with YouTube as mentioned -- Nikesh mentioned a bit earlier.
Robert Peck: Thank you very much.
Patrick Pichette: That's the story there. Thank you. Jamie, we'll take one last question. We're running out of time. So, we'll take one last question if you don't mind.
Operator: And our final question comes from Gene Munster with Piper Jaffrey.
Gene Munster: Hey, good afternoon. Another question regarding trends and mobile CPC. Yesterday you announced an offline conversion tracking plan and program with Datalogic. Is that something potentially the whole online to offline tracking that could have a positive impact on CPCs? And separately any updates on how you think about Fiber longer term? Thanks.
Patrick Pichette: Okay, so why don't I take the last portion and then Nikesh may have views on this data conversion plan. On Fiber look, you've heard our announcement earlier this quarter where we're working with 34 cities and looking for working with these municipalities, they've indicated to us they are really excited about, they kind of self-selected to be really excited about getting Fiber and the next generation of access. So, right now, we're basically working directly with them to look if we have the right conditions to actually go to the next stage which would be the build. So, very excited about it. I think that it's a really good sign of things to come in access in general. I think that everybody now in the industry is talking about the gig. It's becoming the standard and we're absolutely thrilled for all of the users out there that can think in one day they will get a gigabit of symmetrical internet at reasonable price. So, stay tuned on the next part of the chapter, but really excited to work with these communities. And Nikesh maybe you want to talk about--?
Nikesh Arora: Yeah. Thank you, Gene. I mean as I mentioned earlier and the question earlier from -- I think it was Heather that the online to offline conversions are really important opportunity where it's important for offline merchants to be able to understand what results they get from their online activity. And some of the experiments that we talked about required partnerships of third-party data providers to understand how that happens and I think Datalogic is one of those things, which we're looking out to see how we can help quantify the opportunity and quantify the answer for our offline partners. It's just one of those things that we're doing.
Gene Munster: Great. Thank you.
Patrick Pichette: Thank you, Gene. Just in closing before I hand it over to Jamie, just to reiterate the point that Nikesh made a bit earlier to all of our Googlers out there and all of our partners out there, thank you so much for the great work in Q1. What a great start to the year and then we'll see you in Q2. So thanks. Jamie I'll leave it with you to close the call please.
Operator: Thank you. Again, that does conclude today's conference. We do thank everyone for your participation. Please have a great day. | [
{
"speaker": "Operator",
"text": "Good day, everyone, and welcome to the Google Inc. Q1 2014 Earnings Call. Today's call is being recorded. At this time, I'd like to turn the conference over to Jane Penner, Director of IR. Please go ahead ma'am."
},
{
"speaker": "Jane Penner",
"text": "Good afternoon everyone and welcome to Google's first quarter 2014 earnings conference call. With us are Patrick Pichette, Senior Vice President and Chief Financial Officer; and Nikesh Arora, Senior Vice President and Chief Business Officer. Also as you know, we distribute our earnings release through our Investor Relations website located at investor.google.com. So, please refer to our IR website for our earnings releases as well as the supplementary slides that accompany the call. You can also visit our Google+ Investor Relations' page for latest company news and updates. Please check it out. This call is being westbound cast from investor.google.com. A replay of the call will be available on our website later today. Now, quickly -- now let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward-looking including statements regarding Google's future investments, our long term growth and innovation, the expected performance of our businesses and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revisions to these forward look statements in light of new information or future events. Please refer to our SEC filings for more detailed descriptions of the risk factors that may affect our results. Please note certain financial measures we use on this call such as operating income and operating margin are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation and restructuring. We've also adjusted our net cash provided by operating activities to remove capital expenditures which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will turn the call over to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Good afternoon and thank you for joining us on our first quarter 2014 earnings call. Before we jump into my usual remarks, I'd like to bring two points to everybody's attention. First, a reminder that on April 2nd, we issued our Class C stock dividend with twice as many shares outstanding, our usual per share information will look quite different starting this quarter. Also, second, and also as a reminder, our expected sale of the Motorola business -- mobile business to Lenovo triggered discontinued operations accounting treatment which means Motorola's quarterly results are shown separately from Google net income. You'll see this new presentation in our financials starting this quarter. So with these two caveats noted let's dive into the details of Google's financial performance in Q1. Our gross total consolidated revenue grew a healthy 19% year-over-year to $15.4 billion and it was down 2% quarter-over-quarter. Without currency fluctuations, our gross total consolidated revenue growth would in fact have been 21% year-over-year. Google sites revenue was up 21% year-over-year to $10.5 billion and was down 1% quarter-over-quarter driven by the strength in our core search advertising business. Network revenue was up 4% year-over-year at $3.4 billion and was down 4% quarter-over--quarter driven by improved year-over-year growth from our Ad Exchange and AdMob businesses. Finally, Google's other revenue grew 48% year-over-year to $1.6 billion and was down 6% quarter-over-quarter. Digital sales of apps and content in our Play Store drove year-over-year growth. Chromecast sales were also strong. Our global aggregate paid click growth was strong this quarter again up 26% year-over-year and down just 1% quarter-over-quarter. Our aggregate cost per click was down 9% year-over-year and flat quarter-over-quarter. Currency fluctuations had a minimal impact on Q1 CPC growth. Our monetization metrics continued to be impacted by a number of factors discussed on previous calls, including geographic mix, device mix, property mix as well as products and policy changes. And to help investors better understand the complex dynamics of these monetization metrics, we'll begin disclosing paid clicks and CPC growth by property in Q2. To be clear this means we'll disclose CPC and paid click growth rates for both our sites and network businesses. We will continue to disclose aggregate growth rates for CPC and paid clicks. Turning to the geographic performance, we saw strong performance in the U.S. and rest of world, solid performance in our U.K. In our earnings slides, which you can find in our Investor Relations' website, you'll see that we've broken down our revenue by U.S., U.K., and rest of world, to show the impact of FX and benefits from our hedging program. So, please refer to those slides for the exact calculation. U.S. revenue was up 14% year-over-year to $6.7 billion, the U.K. was up 14% year-over-year to $1.6 billion and in fixed FX terms, it grew 11% year-over-year. Our non-U.S. revenue excluding the U.K. was up 25% year-over-year to $7.2 billion. This accounted for 47% of our total revenue, which includes a $8 million benefit from our hedging program. And in fixed FX terms, the rest of world grew, in fact, 30% year-over-year. Let me now turn to expenses. Traffic acquisition costs were $3.2 billion or 23% of total advertising revenue. Our non-GAAP other cost of revenue was $2.6 billion in Q1, excluding our stock-based compensation. Non-GAAP operating expenses totaled $4.6 billion, again excluding stock-based compensation and as a result, our non-GAAP operating profit was $5 billion and our non-GAAP operating margins were 32% in Q1. Just a quick word on a few items that may have created noise in our operating expenses this quarter. We had some discrete legal expenses that hit our G&A line as well as one-time M&A related costs that increased our operating expenses, particularly in R&D. So, absent these discrete items, our expenses continue to demonstrate the same disciplined agenda we've always had. Headcount was up, roughly 2,100 people in Q1. In total, we ended the quarter with approximately 50,000 full-time employees and please note that the headcount still includes approximately 3,700 full-time employees from the Motorola business as well as the employees from the acquisition completed in this quarter. Our effective tax rate was 18% in Q1 and our tax rate this quarter was impacted obviously by the federal R&D credits, which expired in 2013. Let me now turn to cash management. Other income and expense was $357 million for the quarter and realized gains on investments and interest income, offset the continued impact of expenses from our FX hedging program. For more details on OI&E, please refer to the slides that accompany this call on our IR website. We continue to be happy with our strong operating cash flow at $4.4 billion. CapEx for the quarter was 2.3 billion this quarter; again the majority of CapEx was related to data center construction, production equipment, and real estate purchases. As I mentioned last quarter during my remarks, we continue to invest in the long-term and our infrastructure continues to be a key strategic area of investment for us. Our free cash flow was $2 billion for Q1. And before I close, I want to give a brief update on Motorola. Motorola had a great quarter in Q1 with the Moto G showing strong sales momentum especially in emerging markets. The team continues to be hard at work and we look forward to seeing them join up with Lenovo soon. So, there you have it, strong results and an optimism that provides us the confidence to fund strategic growth opportunities including Android, Chrome, YouTube, enterprise just to name a few. And now I'll cover more details -- I'll let Nikesh, in fact, cover more details of our business performance in the quarter and after his remarks, we'll open up the phone lines for questions. Here you go Nikesh."
},
{
"speaker": "Nikesh Arora",
"text": "Thank you, Patrick. You're welcome to cover more details if you'd like. Our business is growing well, with $15.4 billion in gross revenue; we had a particularly good advertising performance in the United States, highlighted by very strong auto sector showing around the Super Bowl. We had strong Play growth in Asia and we had a few isolated tracks. By now you're aware of the four areas driving our business. The first one direct sponsor, or as I like to call it performance marketing; the second one helping clients build their brands; third our ad tech platform for publishers and agencies; and fourth, our emerging businesses like digital content, enterprise, and hardware. Let me give you an you an update on all of those and talk about industry trends that are driving the investments we're making. On performance advertising, people are now always online and they want seamless, easy experience as they move from screen-to-screen. This constant connectivity is driving our investments here as people use search to navigate their world, Google is well-positioned to help people navigate between web, apps and the places around them. They help the marketers measure the entire customer journey and to drive better monetization. Next week, we'll be welcoming hundreds of advertisers to our adverse performance forum where we'll talk more about our work in this area for marketers. But clients are already benefiting from our recent investments like enhanced campaign and estimated total conversion. For instance, Shutterfly recently began measuring cross device conversion networks to understand sales that start in one device and end on another. As a result, they saw 60% increase in mobile conversions for non-brand terms, leaving them to include 100% of their keywords on mobile devices. We're seeing great momentum in product listing adds as well, with a new shop in campaign system. International retailer Farfetch upgraded shopping campaigns and increased their conversion rate by 13% while reducing cost there per acquisition or CPA by 20%. And Domino's Pizza -- who doesn't like pizza, recently made it easy for customers to pay with Google Wallet, instant buy in their in Android app. Moving on to brand building. For years you've all seen the rise of digital video, over-the-top networks, connected screens, streaming devices and high quality digital programming. Already for example, YouTube reaches more than 1 billion people a month through usually popular channels like fashion guru, Bethany Mota; cooking maven, Rosanna Pansino; and cult hit Nerdist. For marketers this is an irresistible trend, and we're now at a significant industry moment. Marketers and agencies that have historically built their brand on TV are reorienting their creative, planning, and investments with digital at the center. This year nearly all Super Bowl advertisers turned to YouTube to extend the life and reaches of their TV spots and Super Bowl related ads on YouTube have been viewed over 300 million times. That's roughly three times the size of the audience that watch the ads on TV. In Australia, we work with Nissan to create made for YouTube video for the launch of their new Patrol SUV. The campaign which is promoted by TrueView ads and YouTube mass set for over 340% increase of daily visits to their websites, and more than 2% of those were interactive for the campaign booked a test drive. In a few weeks in New York at our annual Brandcast Upfront Event we'll focus on our new Google preferred offering. This features exclusive access to the best, most engaging content on YouTube with guaranteed audiences through third-party measurement providers, Neilson and Counselor. We're really excited about this and we're looking forward to the results of that Upfront Brandcast Event. We're also helping brands through our newest display ad formats. We recently teamed with Tory Burch to bring her New York Fashion Week Show to a global audience across our display network. Then also the first ever live stream of fashion show in an ad using a light box ads, and we're able to share the exclusive event with more than 7 million of their biggest fans. Third, moving to our ad technologies and platforms; our programmatic ad technologies are seeing -- are continue to see great momentum with premium publisher partners like The Local Media Consortium. That's comprised more than 800 daily newspapers and 200 local broadcast stations as well as timing. Both of them signed on with us in February to create private exchanges. This maximizes a value of that ad space for handpicked premium environment. One thing we know is that agencies and publishers want to trust the environment in which they're transacting. Our ad network and exchanges are widely regarded across the industry as having the best quality controls and we continue to invest here. In February we acquired wellium fraud fighter Spider.io and thousands of our clients are already using our MRC-accredited Active View technology to buy high-quality viewable ad impressions. Let me switch over to our emerging new businesses, digital content, hardware and enterprise. Google Play continues to be the thriving hub of our digital content business. This quarter we introduced Google Play movies to 39 new countries, so now people in more than 65 countries can enjoy movies through Play. We also teamed up with Sonos to bring high-fidelity play music into the home and we introduce new development tools for Google Play games including game gifting and iOS multiplayer support. Over 75 million new users joined Google Play games in last six months; all of this is helping turn developers around the world into full-fledged businesses. In fact, we paid out more than four times as much money to developers in 2013 compared to 2012. And following the Open Automotive Alliance that we announced with partners in January designed to bring android as a car, in March we've announced Android Wear, a project that extends android to wearables. We're also already working with several consumer electronics manufacturers, chip makers and fashion brands who can't wait to see what developers come up with for your wrist. We also continue to see strong momentum from our suite of hardware products, our $35 Chromecast is a real hit. Last month we brought Chromecast to 11 more countries. We also recently opened up Chromecast developers, and in just a few weeks, more than 3,000 developers worldwide sign up to bring their apps and websites to the platform. Turning over to enterprise. We continue to see strong product adoption around the globe. We launched Chromebox for meetings, which makes it easy for any company to have high-definition video meetings through the power of Google+ Hangouts and Google apps. We're also investing significantly in the Google cloud platform and I've seen a very positive response to our most recent product announcements. We expect to see continued momentum in this area and we believe we can bring significant value to the many companies that opting public cloud because of our experience in building and operating one of the world's largest cloud computing environments for over a decade. We able to pass on the savings that come from lower digital storage cost to our customers through highly competitive pricing. In addition, every day more businesses, governments and schools start using Google apps to work better together including the state of Sao Paulo who moved to Google apps for more than 4 million students and 300,000 teachers and staff. Before I close, I want to call out our marketing team who continues to highlight the magic of Google to beep around the world, into fourth annual Google Science Fair, the doodle for Google in United States, the hugely popular ad campaigns. They also helped to build great retail experience for Chromecast in over 6,000 stores. I'd like to thank all Googlers around the world who help makes a terrific quarter. I'll now hand over back to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Nikesh. So we'll work with Jamie to go straight to the Q&A. Jamie?"
},
{
"speaker": "Operator",
"text": "Thank you. (Operator Instructions) And we'll take our first question from Ben Schachter with Macquarie."
},
{
"speaker": "Ben Schachter",
"text": "Patrick, I was wondering if you could help us quantify some of the expenses you saw, the one-time nature of G&A and anything else there that was really one-time. Just to help us understand what that run rate would look like if that wasn't in there? And then maybe the cash, if you could talk about the theme of sort of advertising attribution and how that's going to help you potentially bring over more brand dollars, and how do you think about bringing over those television dollars. I mean is that something that's going to come sort of a big rushing in 2014, or it's just going to be a slow evolution over many years. Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Great. Thanks Ben. When I start, look on the discrete legal expense that impacted, it really impacted our G&A if -- and then the one-time M&A deal cost impacted all of our operating lines, but most prominently our R&D line, which you'll notice will have jumped a bit. The one-time M&A deal costs are largely stemming from the Nest deal, which was a pretty large transaction for us this quarter, but I think that the best way to describe it is that our expenses in Q1, they are completely in line with our objectives if you'd kind of take apart these two items, so that's how I would describe it. Nikesh?"
},
{
"speaker": "Nikesh Arora",
"text": "In terms of brand benefit Ben, I think -- thank you Patrick, thank you Ben. The brand question is a very good question. What we've noticed in the past let's just say 1.5 year is that people have slowly started coming to the digital medium to create extensional the existing brand campaigns like I mentioned the Super Bowl ad. People come to YouTube and say I'd like to read certain audiences which are only available on digital medium hence we see those advertising dollars shifting as an enhancing existing television or media campaigns. Now the real fun will began when people start doing campaigns exclusively on digital to go and help them build brands. That requires us to get ahead of the curve and get into the creative process much earlier because usually what we end up doing now is we get up -- we get to the end of the period of process and they just want to extend their brand. So we're working really hard to work with creative ad agencies, the large agency groups as well as our advertisers say how can we get ahead of that creative process, how can we help you conceive of brand campaigns that actually start and end in digital where perhaps you use TV as an extension medium as oppose to the other way around. Now I think this is definitely the Holy Grail. This is going to take us a level of time to get there, but with things like attribution in place with our deals with Nielsen and comScore we're beginning to create the compatibility saying look the same dollar you spend on television equates to so many dollars on digital or vice versa. The fact that we can give them sort of cross media measurement capability, we can give them comfort that their dollars are being well spent, even spent in digital. We will go long way in making sure that we get them to transition from just using traditional media to including digital in their media mix and eventually designing campaigns that start and end up digital."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Nikesh. Jamie, let's go to our next question. Thank you, Ben for your question."
},
{
"speaker": "Operator",
"text": "And we'll go next to Douglas Anmuth with JPMorgan."
},
{
"speaker": "Douglas Anmuth",
"text": "Great. Thanks for taking my questions. Just two things I wanted to ask. First, Patrick, just on the U.S. you had commented on the strength here in terms of 14% year-over-year, but it does look like on a sequential basis we saw a little bit more of a DeSale have been in recent 1Qs. Can you just comment if there's any factors there to point out. And then Nikesh, can you just talk about the key drivers of mobile pricing going forward. How you think the gap can close with desktop over the coming quarters and years. Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "All right. Thanks for -- Doug, for your questions. So in the case of the U.S. if you think about it you have the Q4 to Q1 issues that are typical. And then, as we've said before, the network business does skew toward the U.S. on a relative basis, so network clearly grew slower than site. So that's what really what you see is that mix of the two, but in aggregate, right, pretty pleased with the U.S. growth overall. So that was a pretty strong quarter. I'm really happy with it. Well, let Nikesh answer the mobile questions."
},
{
"speaker": "Nikesh Arora",
"text": "Yeah, Doug, I think thank you again for the question. I've had firm belief and I continue to hold on to it that I believe in the medium to long term. Mobile pricing has to be better than desktop pricing. And I think the reason -- the way to think about it is that in mobile you have location and you have context of individuals which you don't have on the desktop. And the more you known about the user and their context, the more effective advertising you can provide to them. The better the conversion is likely to be for a search or any piece of advertising that you do. There's a whole bunch of building blocks that need to come into play for us like you said to get the gap to close. The good news is a lot of people are spending a lot of time on mobile devices. There's a lot of mobile search queries that we get. People are more and more focused about what they look for in mobile devices. They are closer to intent. They are closer to transaction. You see that there's a lot of friction-less ways of paying and converting transactions into commerce which is happening but things like instant buy etcetera. You're also seeing the lot of advertisers seemed through value of making sure that their present and a great experience on the mobile devices. So part of our challenge has been that if you guys just huge massive advertise in the desktop which over the last decade have become better at advertising, Understanding, optimization, understanding conversion, understanding truncation. That journey is just beginning for advertisers in the mobile site. They're just beginning to understand what it takes for the end user to come transact on their website. So like right now we can leave the horse to the water, we can't make it drink. But with all the advertisers coming on-board and working with us, we are actually begging to show them real transactions and asset beings to gain traction. I think we begin to see that gap continue to converge."
},
{
"speaker": "Douglas Anmuth",
"text": "Thanks you."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks Doug for your question. Jamie let's go to the next question."
},
{
"speaker": "Operator",
"text": "I'm going to go to next to Ross Sandler with Deutsche Bank."
},
{
"speaker": "Ross Sandler",
"text": "Great. Thanks guys. I had a question on the Google Play App Store revenues and Nikesh you just mentioned that you guys paid out 300% more revenue to developers in ’13 versus ’12. So, I guess, how much is Play contributing to the overall licensing and other line, and there is clearly some lines or some items in that line that are not growing nearly as fast to get to the current 48% average. So can you talk about maybe what's underperforming in that area? And then last question on this topic is, I think if you go back to the infamous Andy Rubin slides from the Oracle case, the revenue share was around 5% for Google Play App Store revenue share, where is that now and is it changing as the Android ecosystem gets larger?"
},
{
"speaker": "Patrick Pichette",
"text": "Thanks. So why don’t I take a shot at this. Ross, the – if you think of our other revenue estimates for this quarter, right – first of all its – we’re really delighted by the Play business. So – and you’ll remember that a year ago we had – I mean, I'm going to bring back everybody to Q1 of 2013. We had a lot of Nexus 4 hardware sales, because we were in stock out in Q4. And that in combination with the accounting change of our Play app content revenue recognition. Again, remember till Q1 of last year both just simply created a bit of tougher year-over-year comp for this quarter, but overall very pleased with all of the kind of big lines of growth in this space. As for the rev share, I mean, obviously, this accounting change kind of goes to this 30% rather than the what you would have seen before which would have the net and – but we don’t divulge with the percentages are, that we keep going forward. So that’s basically where we stand on it and that’s why we are pretty pleased with this line for this quarter."
},
{
"speaker": "Nikesh Arora",
"text": "And if I can add to Patrick, I think, the important part is, it’s taken us a while to get all the capabilities in place around the world in different markets, making sure we have all the content we need, we have all the app providers we need as well as the we have the payment mechanism. So, we really are excited about the Google Play business going forward."
},
{
"speaker": "Ross Sandler",
"text": "Great. Thanks guys."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks. Thanks, Ross. Jamie lets go to our next question."
},
{
"speaker": "Operator",
"text": "And we will go next to Mark May with Citi."
},
{
"speaker": "Mark May",
"text": "Thanks. A question regarding the CPC segmentation for next quarter. Why you may not be in a position to provide these specific data points for Q1. I was hoping that maybe you could give us directionally how CPCs have trended between the owned and network businesses and kind of what are your expectation is going forward? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "So, Mark, you will get the information in Q2. What we really wanted to do with the recognition as we think about giving more transparency to our shareholders, just looking at having exactly as you just mentioned the split between kind of our core sites and then the network itself. I think it will be useful for everybody and then, obviously, we will have the information going forward. So a lot of insights are going to come out of that and we are very pleased to be able to share with you starting next quarter. We've just made this decision over the last little while and shared it with the Audit Committee, the Board, so just stay tuned for next quarter on it."
},
{
"speaker": "Mark May",
"text": "There are number of dynamics that play into the blended CPC that you've called out before property, policy, geo and device among others. Once you provide this new layer of transparency, does that really capture the major -- is it really the property and maybe to some degree policy differences that are influencing CPCs between owned and network or will geo and devices continue to play a major role in reported CPC, even once you provide this extra segmentation?"
},
{
"speaker": "Patrick Pichette",
"text": "Well, they all will and if we do – we may change just the policies that effect network, you will see them much more in transparent way. So in that sense it’s a very positive kind of news. Whether devices kind of have effects on network versus others, you will – it will be much more difficult to see. But, clearly, the impacts that are driven specifically for network or for sites you will be able to see on a quarter-by-quarter basis. So I think that’s good news for our investors. All right. Thank you so much for your question, Mark. Jamie, why don’t we go to our next question, please?"
},
{
"speaker": "Operator",
"text": "And we will go next to Mark Mahaney with RBC Capital Markets."
},
{
"speaker": "Mark Mahaney",
"text": "Thanks. Two questions on the U.K. revenue growth at 11% number and on the partner websites at 4%, is there anything you would want to call out that has been unusual drags on those growth rates? I think U.K. is the lowest we've seen and maybe just lot of large numbers and really successful execution of that market. But anything you want to call out for either of those two revenue streams. Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Well, as I said, well let me start with the U.K. The U.K., look, combination of partner mix this quarter, as well as, again, year-over-year matters a lot and we have happen to have a year ago a real revenue favorable weather. I mean, people kind of tend to forget it, but last year we had a very strong Q1 for the U.K. and the combination of these two things just kind of year-over-year made the comparison a little tighter for this quarter. As it relates to websites – partner websites, I covered that a bit earlier. And we’re – I mean, again, you back to last year where network, if you think about Ad Exchange, that model change in that model continues to be very, very strong. And we will remember again last year that we started the DLA policy change in Q1 or maybe it was in Q4, but the impact of the DLA actually takes time to flow through. We said that would take multi quarters. So, this has not kind of float over completely. So what you have again there is very strong on the quarters where we want sort of the Ad Exchange and AdMob, but on the flipside of that, right, you still have the tails of the DLA change policy that’s for a year ago. But the effects have not fully flowed through, so even in the coming quarters you should see a bit of an effect there, but, overall, pretty pleased with actually these results, Mark."
},
{
"speaker": "Mark Mahaney",
"text": "Thanks Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you. Jamie, let’s go to our next question, please."
},
{
"speaker": "Operator",
"text": "And we go next to Carlos Kirjner with Bernstein."
},
{
"speaker": "Carlos Kirjner",
"text": "Thank you. I have two questions. First, in the last eight quarters headcount has grown significantly slower than revenue, but this quarter you hired, I think, 2,300 people in the core and headcount grew its revenues. Was this change in hiring rate mostly because of acquisitions and marginally what prevents you from hiring 2,300 people a quarter or even more as the business grows? And secondly, Patrick, in the spirit of giving more transparency to shareholders, can you give us some color on what has driven such a sustained increase in CapEx over the last four quarters? Because, I – I think clearly it’s not just some lumpy behavior. Are you buying data center sites in advance of demand and if this is the case can we infer that CapEx will revert to historical levels. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Carlos for both of these questions. So, to the headcount question, I think, you've basically nailed it intuitively, which is, the acquisition of Nest – the acquisitions this quarter had a quite a bit of people impact on this number. Or kind of if you think of our organic numbers, have actually not changed in any material way. So it just happened, you know, you buy Nest and it comes with a lot of people. We also had, you remember, the acquisition of DeepMind and few others. So for us we had the double hitter of having the opportunity to continue to attract people on an organic basis to our processes and these few acquisitions kind of moved the needle quite a bit for us this quarter. As it relates to CapEx, listen, you are right that we – and I've mentioned this in the last couple of quarters, where we have – and just a reminder to everybody, if you think of the CapEx categories, right, data centers first, and data construction then production equipment then all other facilities, it’s kind of like the hierarchy of needs. And in the case of data center construction, we have found that the option value of having more capacity on standby and available to us to grow versus not having it is actually a real strategy issue for the company and in that sense if for whatever reason we continue – we had a spike in demand that was really pronounced and sustained for a couple of quarters and we did not have the capacity, it would be a real issue strategically for us, relative to the quite low cost of having the infrastructure in place. So that’s why we’re really pushing ahead of the curve and so it’s with this view of long-term. So from that perspective you are also right that that’s the mindset we are applying and we've always said that CapEx was lumpy, so you have a good manifestation of it right now, right here. So thank you for you those two questions, Carlos."
},
{
"speaker": "Carlos Kirjner",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Cheers. Jamie, let’s go to our next question, please."
},
{
"speaker": "Operator",
"text": "And we will go next to Stephen Ju with Credit Suisse."
},
{
"speaker": "Stephen Ju",
"text": "Hey, thanks guys. So, Nikesh, so in order to attract greater brand advertising dollars, it seems like safety and context are also important factors, because you are certainly not falling short on reads. So how close do you think you are to either engineering or coming up with some sort of solution to contextualize all the video content on YouTube, so you can guarantee you advertisers brand safety? Thanks"
},
{
"speaker": "Nikesh Arora",
"text": "That’s a good question. I think as I alluded to, we are going to do an upfront in a few weeks in New York City called Google Preferred, which is sort of our way of trying to create a premium sort of concentration of content that we can have advertisers advertise against which gives them a higher level of brand safety, a better level of measurement and hopefully plays where they believe that they can actually build the brands and hopefully that will – that will manifest itself in our ability to have a premium compared to what we can attract to the market without providing those kinds of things. So that’s a very good question. I think that’s what we are hoping to achieve and stay tuned for our detailed announcement of Brandcast."
},
{
"speaker": "Stephen Ju",
"text": "Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks Stephen. Jamie, let’s go to our next question, please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Justin Post with Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "Great. I have three quick things. Did Enhanced Campaigns which you rolled out over the summer, impact Q4 and do you see some more benefits coming this year? Second, on PLAs, we think you had very good success in the U.S. in Q4, did that – does that, do you still have some benefits to come from that as you roll that out in Europe. How are you looking at the timing there versus how you rolled that out in the U.S.? And finally in the first quarter, maybe you can call out some specific verticals that might have strong or weak for you. Thank you."
},
{
"speaker": "Nikesh Arora",
"text": "That’s a good question, Justin. Thank you. Not sure I can give you a lot of detail in terms of precise impacts of any individual products that we have. But, Enhanced Campaigns are working. It’s a necessity that we have to do them both for process reasons as well as the reason that consumers are going from screen to screen as well as advertisers need to advertise across multiple screens. So from that perspective Enhanced Campaigns is working, it’s part of life here. We don’t do anything without Enhanced Campaigns across the board. It’s sort of gone from being Enhanced Campaigns to regular campaigns because we don’t have any unenhanced campaigns anymore. In terms of PLAs, it’s something, as I alluded, is actually working. It’s providing a lot of color in the shopping vertical. It’s providing a lot of hold in shopping campaign effort that we have. PLA is working for us and its sort of working from multiple perspectives. It is providing users the detailed information that they need when they are declaring intent and saying and I would like to search for particular product, please don’t send to me to website. So it is working. We are going to roll that out one, separate time around the world. I cannot comment on the timing exactly. But I think both of those things are having a positive impact in our minds to everything we are doing around here."
},
{
"speaker": "Patrick Pichette",
"text": "Just to close on this, just a few verticals here. I mean, again, completely reflecting the economy around us. If you go to – automobile has been quite strong across the world. Travel, actually quite strong in the U.S., so in the U.K. as well as in the rest of the world, a little bit less in the U.S, but just to give you a sense of. And then real estate, clearly, in the U.S. has been a strong vertical as well as in the U.K, so, again, a good reflection of the economy there, Justin. So, Google Trends, I always encourage people to go and checkout Google Trends as well because they continue to give good insights as to what's going on in the economy which would mirror in terms of verticals."
},
{
"speaker": "Justin Post",
"text": "Thanks Patrick. Thanks Nikesh."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks Justin. Jamie, let’s go to your next question, please."
},
{
"speaker": "Operator",
"text": "We’ll go next to Eric Sheridan with UBS."
},
{
"speaker": "Eric Sheridan",
"text": "Thanks for taking the question guys. So two ones. One for Nikesh. Nikesh, I would love to get your view on sort of your view of the travel industry. Sort of how are you approaching that industry as a participant from an economy basis in that industry, both the marketing funnel and potentially the booking funnel? Longer term there’s been a lot sort of written lately about the way in which you guys might approach that industry vertical. And then second, Patrick for you. Maybe taking a stab at the one-time expenses from a different approach, when we look at the model, if you take your comments before about sort of smoothing out the expenses we saw in the back part of the year and even year-over-year, it appears that one-time expenses might have been about 50 basis point to 100 basis point impact on each of those two lines which would have sort of brought the blended number back up to sort of somewhere between 75 basis point to 150 basis points on margins. But just want to take a stab at that from a different direction just to quantify it. Thanks guys."
},
{
"speaker": "Nikesh Arora",
"text": "Thanks Eric. That’s for the question. I was actually talking about pulling up the article which recently -- were Darren Huston talked about the effectiveness of Google Advertising for price line. I think that’s a public endorsement that all our efforts in the last many years in rather travel industry are actually working. They see tremendous value in our ability to help them bring more travelers to their sites and for them to help convert them into a real transaction. So whatever we are doing is working. I think I am expecting – suspecting that the comments we are talking about is our continued efforts in providing more and more detailed information when people do searches. And as we've talked in the past before that people’s information needs are getting more precise and we have to keep evolving the results at Google, whether its knowledge cards or Google Now all the things that we do towards giving them more and more precise answers, in which case sometimes we are required to go work with various industries to get the underlying data to surface it when the users are looking as opposed to send them to other sites where they have to go through that search process again. So I think you can expect us to continue do that. But our intent there is to provide a better answer for the users, whether it’s on their desktop or mobile devices. Accordingly, we also working together with the advertisers to provide them various advertising opportunities which allow them to work effectively with the end-user and provide them the answers that they are looking for or perhaps in this case the ticket or the hotel booking that they are looking for."
},
{
"speaker": "Patrick Pichette",
"text": "Great. And then on my side, Eric, look, as I said in my earlier comment, our Q1 expenses were completely in line with our objectives and there is always seasonality. As you've noticed, from Q4 to Q1 there is always – we spend less on marketing and so that’s true for this year as well. And for the other areas, right, we would have been in line with the objectives we've set for ourselves. So these one-time costs were genuinely and that’s where truly one-time. And – I mean, when you acquire Nest for bit over $3 billion, there is just a lot of stuff that flows through the P&L, lot of accounting, and so that’s really the issue there. So, I would go back to your instinct of at least kind of we should be roughly in line with what our expectations where and they – that’s why the nature of truly extraordinary items. So thanks for that question."
},
{
"speaker": "Eric Sheridan",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Jamie, let’s go to our next question, please."
},
{
"speaker": "Operator",
"text": "And we will go next to Peter Stabler with Wells Fargo Securities."
},
{
"speaker": "Peter Stabler",
"text": "Good afternoon. Thanks for taking my question. Why don’t you revisit attributions for a moment? Given aspects attribution and I think you guys are doing a great job on the cross screen attribution and taking advantage of your ubiquitous login across different platforms and Enhanced Campaigns. Wanted to get a better understanding of how you’re thinking about online versus offline attribution for those types of marketers, particularly brand advertisers, supermarket advertisers, the 30,000 SKUs and those retail channels that don’t have E-Commerce and really don’t have much of the search opportunity. How are you helping them close the gap between their online activity and offline sales? Thanks very much."
},
{
"speaker": "Nikesh Arora",
"text": "Thanks Peter. Thanks again for the question. I think as you rightfully pointed out the attribution story on the advertising side is kind of becoming clearer as we partner with Nielsen and comScore, and adopted some of the mechanisms that traditional media has used to create the comparability between traditional and internet media. I think you identity a good challenge which is that how do we bridge the gap between online commerce and offline commerce and relate that to advertising opportunity, i.e. when we sell search, we sell traffic to different people, how do we convince them, how do we make them realize that that traffic that they’ve got normally results in online sales, but also results in offline sales at stores and how do we encourage that activity. So over the last many years around the world we have run specific studies, working with various advertisers which are called online to store studies where we actually try and measure what online activity created by them took to control group's results in more foot traffic in their particular stores and certain reasons about. And we've pretty much had very good results across the board. I can't detail specifics right now because they are all specific to individual advertisers who we work with. But we do understand that opportunity and the problem and we work specifically with third-party research teams to work on figuring out how do we keep showing the online to store efficacy. And there are other products as you can see where we start doing conversion, we start looking at things like Google Shopping which also helps us in those areas."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks again, Peter."
},
{
"speaker": "Peter Stabler",
"text": "Thanks for the color."
},
{
"speaker": "Patrick Pichette",
"text": "Jamie, let’s go to our next question, please."
},
{
"speaker": "Operator",
"text": "And we will go next to Heather Bellini with Goldman Sachs."
},
{
"speaker": "Heather Bellini",
"text": "Great. Thank you very much. I just wanted to go back to an earlier question there was – you responded about the building blocks that were needed in order to get mobile pricing, mobile CPCs to convert to desktop. I was just wondering if you could share with us kind of specifically what you think those building blocks are that need to happen over the medium to long-term as you said to see that conversions occur. Thank you."
},
{
"speaker": "Nikesh Arora",
"text": "Of course, thanks Heather for the question. I mean, look, there were some very simple things and there are some complicated things. The simple things are, we will make sure that there is payment enablement for users. So i.e. users have a mechanism that allows them to pay with lowest amount of friction, because honestly you and I don’t want to spend our lives trying to enter payment information on a very small screen where you are trying to conduct the transaction. So that enablement is happening across the industry, across multiple payment platforms. There is also the need that when people search for some things they can get quickly down to the information and they don’t have to browse multiple sites, because people are more keen on declaring intent to mobile devices than going and searching multiple websites and trying to figure out what they are trying to do. And that intent could be in the form of restaurant, could be in the form of a taxi, could be in the form of them looking for individual product. And you are beginning to see apps, you are beginning to see solutions on search that allow you to get to that granularity of information. Of course, there is a big building block which is getting all the people out there which shows the advertisers effectively in this case the merchants who actually have to have experience in the mobile site which are simpler to execute on. So try buying something on many companies’ mobile websites and it's more own risk than their desktop sites because they've been spending a decade trying to optimize the desktop site, but they haven’t spent enough time optimizing mobile experience, in some cases not believing that people want to transact with them in a mobile device and some cases they are just slow and they are just slowly diverting resources from desktop to mobile. So, if you take all those things and take the notion that we need to keep sort of working hard towards getting these building blocks in place, I think there's a finite time where these building blocks will come into plays. And as they keep coming into plays, you will see or as we talked about earlier, perhaps the conversion will happen between pricing in mobile desktop. But there's a whole bunch of other issues, I think but those are the big things that we need to think of right there."
},
{
"speaker": "Heather Bellini",
"text": "Thanks so much."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks for your question Heather. Jamie let's go to our next question please."
},
{
"speaker": "Operator",
"text": "And we'll go next to Colin Sebastian with Robert Baird."
},
{
"speaker": "Colin Sebastian",
"text": "Great thanks. I wanted to ask you a question on the cloud platform. Since this is obviously a huge revenue opportunity for you and first-off if you could put context around the impact of this business on CapEx and OpEx, particularly on the infrastructure of the service part of the business? And then secondly, if you could talk about how you're planning to differentiate the service, is it really about pricing or is it by tying in the software and platform as a service offering, if you could touch on that? Thanks very much."
},
{
"speaker": "Patrick Pichette",
"text": "I can cover the first part and then I'll let Nikesh cover the second. Look we're very comfortable with our cost structure. In light of Google efficiencies, economies of scale, our vertical integration from data center to chip -- to servers, to software. I mean we really have -- we believe we have absolute unique position from a cost structure perspective and therefore, from a margin perspective makes us very, very comfortable. In terms of differentiation, I'll just let Nikesh jump in here."
},
{
"speaker": "Nikesh Arora",
"text": "I think Colin -- thank you again for the question. The important part to at least acknowledge in the space of cloud computing is we think that it's very, very, very early days. I mean if you think about the potential scope and scale of what this opportunity is, that's pretty much every business which is going to be around for the long-term has to operate in the cloud. There's no efficiency compared to the efficiency of the cloud, but in compared to owning your own infrastructure running it by yourself. So, this shift is going to happen. It’s a matter of every company going through that shift one at a time. And if you look at the opportunities out there and the options, there's very few options. So, there's a lot of room for all of us to have a great time for many, many, many years before we start worrying about differentiation and why my sort of thing is better than yours. So, right now, the key is to be able to work with the companies out there, the enterprise customers out there to get them to shift on the legacy systems, get on to the cloud and realize that Google has been working in the cloud for more than a decade, because we have been running one of the largest cloud computing platforms in the world in the public space. And we have all of the expertise and skills that are required to be able to serve these enterprises and get them off their current legacy system onto the cloud. So, our effort is really trying to work with each of these third-party partners, trying to get them off the legacy systems onto our cloud. I don't think the challenge right now is the need to differentiate. I think our biggest differentiator is we have the most experience in the space."
},
{
"speaker": "Colin Sebastian",
"text": "Great. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks Colin. Jamie we'll go to our next question please."
},
{
"speaker": "Operator",
"text": "And we'll go next to Jordan Monahan with Morgan Stanley."
},
{
"speaker": "Jordan Monahan",
"text": "Hi, thank you for taking the question. Actually two if I may. A couple of big picture questions, I think for Nikesh. The first is I think there's an ongoing debate about whether mobile web or mobile app is going to win and what the implications are for various businesses, Google included? And I'm just curious to get your view on whether you think one will win over the other and then whether it matters for Google? And then the second is when you look at Google's share of global advertising, you're coming up on about 10% of total, but when you look at your business in the U.K., you're north of 20% of total. So, when you think about your global businesses as economies start to mature, do you think the U.K. is a fair proxy for thinking about your business globally or are there other factors that you think may prevent you from getting to that type of scale globally."
},
{
"speaker": "Nikesh Arora",
"text": "I guess let me answer the second question first Jordan, because I'm standing here Patrick is looking at me asking the same question. I think the way to think about it is that we have 10% by some metric depending on what we believe the total is. As per your metric, we have 10% of the total advertising sort of money. And the U.K. we have 20%. That just tells me there's 90% more opportunity around the world and 80% more opportunity in the U.K. So, we're not going to constrain our thinking in terms of what believe is a stable state. Our aspiration is to be able to serve every advertiser in the long-term and our aspiration is that -- our hope is that every piece of advertising becomes digital advertising. The question is how much of that are we able to provide through our technology platforms, how much are we able to provide through our own sort of properties and how much do we partner with others to provide on their network. So, I guess I'm trying to tell you we don't constrain ourselves and our thinking. I'm not trying to be arrogant, say we want 100%, but we like more than what we have in every market out there. In terms of your question around the mobile web and mobile search, that is a tough question and that is a very involved question and I think the approach -- the best way to think about it is that we're trying to make sure we can make both of them effective for the end-user and make them both work, because we're not about to try and pick winners. Right now, you can see that people spend as much time on mobile devices -- more time mobile devices they are beginning to spend on the desktop and they are spending the time across the mobile web as well as mobile app landscape. We're participating in both those ecosystems, whether it's somewhere placed on the app front, whether it's through our browser-based search properties or through our app-based search properties. So, we're participating across the Board and I think at the end of the day, it's going to boil down to ease-of-use and consumer choice."
},
{
"speaker": "Jordan Monahan",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Jordan. Let's go to our next question please Jamie."
},
{
"speaker": "Operator",
"text": "And we'll go next to Robert Peck with SunTrust."
},
{
"speaker": "Robert Peck",
"text": "Yeah, hi. Thanks for taking my question. Two questions if you don't mind. The first is on the revenue side, can you talk a little bit -- can you maybe give us an update about the breakout of YouTube versus DoubleClick revenues, where are those today and where could they be over time? And then on the cost side, Patrick could you just walk us through just how you think about the ROI on capital? We get a lot of questions from investors asking about spending, could you maybe tell us more about the thought process and how the company looks at the ROIC of capital going forward? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Okay, well Robert, let's start with the last one first and then we'll go back to revenue. ROI clearly we have -- we always look at capital intensity. The fact that we're investing quite a bit in CapEx right now is a real tribute to kind of the potential and the optimism we have about our businesses going forward. Most of our core businesses if you think of YouTube or advertising or search are not that capital-intensive relative to other areas that we have such as for example, Google Fiber, if you think of the access portion right which is much more traditional CapEx. For each of these areas, we actually track and make sure that we have good returns and we have a capital efficient. So even though an area that take the advertising business that we run, even though you could argue that it's phenomenally good on return on capital, the questions that we will ask internally is okay so if the utilization rate is X on our machines on this business, right, why can't it be X plus something? So, even though we have already good return on capital in these areas, we continue to always push the envelope to make sure that our capital efficiency continues to be better and better on a year-to-year basis and then across a portfolio, every area has some capital kind of targets to make sure that we're driving for value. Finally, there's a number of areas if you think of take the newer stuff like Loon, for example. In those cases, you test through the hurdles that we kind of we seed capital to the Loon team as they hid their hurdles and they kind of earned their right to the next cost for funding. And in doing so, right, we continue to always have the business case in mind that says here is why this continues to make sense to fund and invest and with an ROIC or value in mind for the long-term, but in the short-term, it's really kind of delivery of milestones on very specific engineers objectives that actually gives them the next round of funding. So, Robert as you can see, given the portfolio of mature stuff we have and growing areas as well as kind of much more R&D and innovation at the early stages, right, we just need to have a basket of tools to actually manage the concept of ROIC or ROI on each of them. And that's what we do. It's not rocket science; it just requires a lot of discipline on our part. On the revenue side, look, we don't break out DoubleClick or YouTube. I can just tell you as I mentioned a bit earlier; we're really pleased with our network revenue in the kind of AdMob, AdExchange. Many of our areas continue to grow very well and we're very, very pleased by these investments and clearly continue to be very pleased with YouTube as mentioned -- Nikesh mentioned a bit earlier."
},
{
"speaker": "Robert Peck",
"text": "Thank you very much."
},
{
"speaker": "Patrick Pichette",
"text": "That's the story there. Thank you. Jamie, we'll take one last question. We're running out of time. So, we'll take one last question if you don't mind."
},
{
"speaker": "Operator",
"text": "And our final question comes from Gene Munster with Piper Jaffrey."
},
{
"speaker": "Gene Munster",
"text": "Hey, good afternoon. Another question regarding trends and mobile CPC. Yesterday you announced an offline conversion tracking plan and program with Datalogic. Is that something potentially the whole online to offline tracking that could have a positive impact on CPCs? And separately any updates on how you think about Fiber longer term? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Okay, so why don't I take the last portion and then Nikesh may have views on this data conversion plan. On Fiber look, you've heard our announcement earlier this quarter where we're working with 34 cities and looking for working with these municipalities, they've indicated to us they are really excited about, they kind of self-selected to be really excited about getting Fiber and the next generation of access. So, right now, we're basically working directly with them to look if we have the right conditions to actually go to the next stage which would be the build. So, very excited about it. I think that it's a really good sign of things to come in access in general. I think that everybody now in the industry is talking about the gig. It's becoming the standard and we're absolutely thrilled for all of the users out there that can think in one day they will get a gigabit of symmetrical internet at reasonable price. So, stay tuned on the next part of the chapter, but really excited to work with these communities. And Nikesh maybe you want to talk about--?"
},
{
"speaker": "Nikesh Arora",
"text": "Yeah. Thank you, Gene. I mean as I mentioned earlier and the question earlier from -- I think it was Heather that the online to offline conversions are really important opportunity where it's important for offline merchants to be able to understand what results they get from their online activity. And some of the experiments that we talked about required partnerships of third-party data providers to understand how that happens and I think Datalogic is one of those things, which we're looking out to see how we can help quantify the opportunity and quantify the answer for our offline partners. It's just one of those things that we're doing."
},
{
"speaker": "Gene Munster",
"text": "Great. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Gene. Just in closing before I hand it over to Jamie, just to reiterate the point that Nikesh made a bit earlier to all of our Googlers out there and all of our partners out there, thank you so much for the great work in Q1. What a great start to the year and then we'll see you in Q2. So thanks. Jamie I'll leave it with you to close the call please."
},
{
"speaker": "Operator",
"text": "Thank you. Again, that does conclude today's conference. We do thank everyone for your participation. Please have a great day."
}
] | null | null |
GOOGL | 4 | 2,013 | 2014-01-31 16:30:00 | Operator: Good day everyone and welcome to the Google Inc. Fourth Quarter 2013 Earnings Call. Today’s call is being recorded. At this time, I’d like to turn the call over to Jane Penner, Director, Investor Relations. Please go ahead.
Jane Penner: Good afternoon, everyone, and welcome to Google’s fourth quarter 2013 earnings conference call. With us now are Patrick Pichette, Senior Vice President and Chief Financial Officer; Nikesh Arora, Senior Vice President and Chief Business Officer. Also, as you know, we distribute our earnings release through our Investor Relations website located at investor.google.com. So please refer to our IR website for our earnings releases, as well as the supplementary slides that accompany the call. You can also visit our Google+ Investor Relations page for the latest Company news and update, please check it out. This call is also being webcast from investor.google.com. A replay of the call will be available on our website later today. Now, let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward-looking, including statements regarding Google's future investments, our long-term growth and innovation, the expected performance of our businesses, and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect the results. Please note that certain financial measures that we use on this call, such as operating income and operating margin are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation and restructuring. We’ve also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I’ll turn the call over to Patrick.
Patrick Pichette: Thank you, Jane. Good afternoon everyone. It’s Patrick and you may remember we mentioned last quarter that Larry will no longer be joining us on a regular basis on this call as he focuses his energy on running the Company. But consistent with our prior calls, Nikesh and I will be here. We will cover the performance as well as answer any questions you have about the business, including significant ad product launches or other developments and in the case that you have a very, very detailed product related question, in some cases we may simply take it off line with you. But with that why don’t we just dive into the details of our financial performance for Q4. Our gross total consolidated revenue for the quarter was $16.9 billion and the overall business was up 17% year-over-year and 13% quarter-over-quarter. Our Google segment, gross revenue grew a healthy 22% year-over-year to $15.7 billion and was up 14% quarter-over-quarter. Without currency fluctuations, the Google segment revenue growth would have been 23% year-over-year and 13% quarter-over-quarter. Our Google sites revenue was up 22% year-over-year to $10.6 billion and was up 12% quarter-over-quarter, driven by the strength of our core search advertising business. Network revenue was up 3% year-over-year at $3.5 billion and was up 12% quarter-over-quarter. This was driven in part by each year year-over-year comparisons as we anniversary some of our ad policy changes implemented at the end of 2012. But we also saw improved year-over-year growth from our ad exchange. Finally, Google’s other revenue grew 99%, almost doubled year-over-year to $1.6 billion and it was up 34% quarter-over-quarter. The digital sales of apps and content in our Play store drove the year-over-year growth in this line as did hardware sales and the Play hardware sales drove most – a big chunk of the quarter-over-quarter growth. Turning to Motorola segment, gross revenue was $1.2 billion. As we announced yesterday Lenovo plans to acquire our Motorola business for approximately $2.9 billion. This is great news for Motorola and the Android ecosystem. And as Larry noted in our press release, Lenovo will have the expertise and the track record to scale Motorola Mobility into a major player within the Android ecosystem. Coming back to our Google segment, our global aggregate paid click growth was strong this quarter, up 31% year-over-year, and up 13% quarter-over-quarter. Our aggregate cost-per-click was down 11% year-over-year and down 2% quarter-over-quarter. And please note that currency fluctuations had a minimal impact on Q4 on the cost-per-click. Our monetization metrics continue to be impacted by a number of factors discussed on previous calls, including FX, geographic mix, platform mix, property mix as well as product and policy changes. Turning to geographic performance of our Google segment, we saw improved performance in the U.S. and the U.K. and strong performance in the rest of the world. In our earnings slides, you can find on our Investor Relations website, you'll see that we've broken down our revenue by U.S., U.K. and rest of the world to show the impact of FX and the benefits of our hedging program. So please refer to those slides for the exact calculations. U.S. revenue was up 16% year-over-year to $6.9 billion. The U.K. was up 15% year-over-year to $1.5 billion, which includes a small $2 million benefit from our hedging program. So currency fluctuation had minimal impact on U.K. revenues in Q4. Our non-U.S. revenue excluding the U.K. was up 30% year-over-year to $7.3 billion. And this accounted for 46% of our total revenue, which included again a very small benefit from our hedging program, in fixed FX terms; the rest of world grew a strong 33% year-over-year. So let’s come back to an aggregate level for the total consolidated business. Our non-GAAP other cost of revenue was $4 billion in Q4 excluding stock-based compensation and Motorola restructuring. Our non-GAAP operating expenses totaled $4.8 billion again excluding SBC and Motorola restructuring. And our non-GAAP operating profit was $4.8 billion in Q4, resulting in a non-GAAP operating margin for the consolidated business of 29%. For our Google segments, specifically our traffic acquisition costs were $3.3 billion or 24% of total advertising revenue. The other cost of revenue was $2.8 billion excluding $127 million of stock-based compensation. And our Google segment operating expenses were $4.3 billion, again excluding SBC of $746 million. Depreciation and amortization expenses on property, plant and equipment for the Google segment was $660 million this quarter. And Google segment profitability was $5.3 billion in Q4, resulting in a Google segment operating margin of 34%. At Motorola, our total segment operating expenses including cost of revenue were $1.6 billion, excluding $29 million of SBC and $15 million of restructuring charges to Motorola. Keep in mind that intangible amortization expenses attributed to Google segment and Motorola segment are included in these segment measures. Of the $279 million in consolidated intangible amortization expense this quarter, $153 million was the result of the acquisition of Motorola of which $116 million was allocated to Google and $37 million was allocated to the Motorola segment. As a result, the operating loss for the Motorola segment was $384 million in Q4 and the operating margin for that segment was negative 31%. Our headcount for the consolidated business was up roughly 1,300 people in Q4. The Google segment added 1,700 people during the quarter and in total the consolidated company ended the quarter with approximately 48,000 full-time employees. Our effective tax rate was 16% in Q4. Tax rate this quarter was impacted by the continuing mix shift of earnings between our domestic and international subsidiaries. Let me now turn to cash management. Our OI&E was 125 million for the quarter. Interest income and realized gains on investments offset the continued impact of our FAS 133 expense from our hedging program. For more detail on OI&E, please refer to the slides that accompany this call on our IR website. We continue to be happy with our strong operating cash flow at $5.2 billion. CapEx for the quarter was 2.3 billion and this quarter the majority of our CapEx spend was related to production equipment, data center construction and real estate purchases. As I mentioned last quarter during my remarks, we continue to invest for the long term and our infrastructure continues to be a key strategic area for us to invest. Our free cash flow, in consequence of all this, was $3 billion. So there you have it, strong results and an optimism that provides us the confidence to fund strategic growth opportunities, including Android, Chrome, YouTube, Enterprise just to name a few. Before I wrap up, I want to cover two quick things. First, I want to remind everybody as I do every time at this time of year that as we start a new year, things such as employer taxes, 401(k) and all these other related accruals tend to be frontloaded in the year. So please consider this as you model your forecast. And second, before I hand it off to Nikesh, I want to give an update on our issuance of Class C shares. Our Board of Directors has formally approved the Class C dividend and has set March 27 as the record date and April 2 of this year as the issuance date. So we expect that Class C shares to begin trading on April 3. We were excited to announce that the Class C shares will actually trade under our original Ticker, that is GOOG, while the Class A shares will trade under a new Ticker GOOGL. We're setting up a link on our Investor Relations site so that it can give you more information on the Class C dividends. With that, I'll let Nikesh cover the details of our business performance in the quarter and after his remarks, we'll open up the phone lines for questions. So, here you go, Nikesh.
Nikesh Arora: Thank you, Patrick. As Patrick mentioned, our business had a strong quarter with $15.7 billion in Google segment gross revenue. Overall performance was strong in retail and automotive and CPG sectors. We had particularly good growth in Asia Pacific including its various emerging countries as well as in Southern Europe. I want to talk about three areas that are fueling growth for Google and our clients. First, our continued efforts to help performance marketers reach customers and drive action across screens. Second, our continued progress in brand advertising. And third, our ad technology platforms used by thousands of agencies and publishers. Then I'll say a few words about new areas like digital content, hardware and enterprise. On performance; performance advertising continues to be a mainstay of our core business. We're seeing good growth. It's driven primarily by increased search activity across all screens. It's driven by new measurement features and more sophisticated marketers are aligning their search and display advertising strategy. Last year we made the move to Enhanced Campaigns in AdWords, 12-months in marketers tell us it helps them get results and reach people across screens in a big way. Our internal slogan for this is 'Advertisers ROIs don't lie.' We also rolled out estimated total conversion. Marketers can now measure results like calls and conversions that take place in different devices. For example, 1-800-Flowers discovered a 7% increase in overall conversions when they figured out that conversions that start on one device then end on the other. This is a great example of our vision as it relates to the seamless multi-screen marketing and something that was impetus for us to launch in ad campaigns. In the holiday season, one thing has become very clear. The Web has truly become the new holiday store window. It's first where people go and it's where everyone gets excited about holiday shopping. In the U.S., Walmart continues to use Google search more and more. They are investing with us more than ever before to drive sales during the holiday season. There's also great momentum in product listing ads and we continue to improve the experience for shoppers and retailers. Last quarter, Google Shopping came to eight more countries. We even helped deliver products to your doorstep in just a few hours. Google Shopping Express, our same day delivery service, has been open to shoppers in the Bay area since last year. I'm very pleased with the feedback we've gotten from our partners and users. Now moving on to brand marketing. Working closer and closer with brand advertisers has been a big priority for us and we're making great strides. Now you might have seen all the teaser ads running on YouTube ahead of the big game Sunday. Given my personal passion for cricket and lack of, pretty much any knowledge of American Football, I decided to turn to Google Trends and see who is leading. I see that Seahawks have more searches than the Bronco, so that's my bet for the Super Bowl. But folks in Denver better get searching if they want the Broncos to win. I don't know what that means for the big game on Sunday, but I do know that we are becoming a central to the biggest brand-building campaigns of the world. There are three big areas of focus that brand and our agency partners really like. First, building our great content on YouTube. YouTube gives brands amazing reach and a passion of unique audience you can't get elsewhere. YouTube has over 1 billion viewers per month and saw a 50% increase in daily watch time last year. Second, the best digital marketing captivates people when it's by the Web, for the Web. It's so much more than simply taking television ads and transplanting them on YouTube. So we're investing in creative ad formats that pivot around user engagement like CUview or engagement ads across the Web. Last year for the first time, three videos by brand marketers were on YouTube's list of top 10 videos for 2013. Third and importantly, better measurement than enables brand and agencies to measure and optimize campaigns based on metrics like reach, recall or awareness. Last quarter we enabled advertisers in our Google Display Network start buying ads based on viewable impressions, a fancy way of saying, ads that people actually saw. In November we began testing Nielsen OCR, measurement on our YouTube and our network. There's a lot more to come here, but it's an important step to helping brands invest online. We think our efforts are really resonating with major clients and agencies from around the world. Our sales team continues to fire on all cylinders. I'm really pleased we hired Kirk Perry as our President of Brand Solutions from Procter & Gamble. His goal is to help the largest brand and agencies in the world embrace digital marketing more and more. He speaks their language, so we hope that he'll be able to convince them that the future for brands is truly digital. We worked with Kraft to build a series of engagement ads, showcasing brand videos, recipes and coupons for its new Fresh Take brand. That campaign was very successful and left an impressive 2.9% engagement rate in that average engagement time of 48 seconds. Moving on to our ad technologies platforms, our DoubleClick buying tools continue to be the choice for agencies around the world, and we're really benefiting from the growth and programmatic spend. One trend we're seeing is the move towards private ad exchanges in which a premium publisher uses our technology to make ad space available to a small number of handpicked, high quality and highly qualified advertisers. This could provide a very safe, real-time environment for both brands and publishers. The volume of compression running through our private exchanges as on average doubled every quarter over the past year. Overall, our monetization solutions like our Ad Exchange, AdSense and AdMob are helping major publishers maximize their revenues from digital advertisers. So that's our core ad business. Let's talk about our trisect of emerging new businesses; Google Play, hardware and enterprise. Google Play continues to win the hearts and minds of people, the latest books, newspapers and magazines, 20 million songs, thousands of movies, textbooks, all access music. You can live your lives on Google Play. People love it so far. This quarter we introduced a Google Play Newsstand that brings together more than 2,000 free and paid news sources including newspapers like the New York Times, Wall Street Journal, Financial Times. We also introduced Google Play for education. It's a design for schools and educator proved ads as well as tools to easily set up a classroom of tablets in minutes. We have a strong holiday season for our growing suite of hardware products. One of the things that has done really well for us is Chromecast. It continues to be a living room favorite remaining a best selling product throughout the entire quarter. We’ve also been adding to the growing list of content available through Chromecast with new supported apps like Hulu plus, HBO Go and Pandora, with more to come. Chromebooks are also seeing great momentum with eight of the top manufactures of computers now making Chromebooks, including new devices from both Dell and Toshiba. One in four devices sold into K-12 education in the U.S. use a Chromebook according to FutureSource. We’ve also been seeing strong momentum in Nexus hardware with great reception for Nexus 5’s. And as cars become more connected we’ve recently themed up with the automotive and technology leaders Audi, GM, Honda, Hyundai and NVIDIA to form the Open Automotive Alliance. Our enterprise business continues to grow steadily as more businesses than ever want their employees to work the way they live. We’re seeing great momentum in the retail space. There is supermarket Waitrose, the clothing retailers Chico’s and the fashion accessory brand Fossil have all gone Google this quarter. On the cloud platform side we announced that Google computer engine is now generally available supporting additional operating systems at new lower prices. But before I close, I also want to give a shout out to our marketing team in particular they had really helped to drive the success of Google Play and the hardware products over the holidays. They have been able to do that through great effective advertising and creating awesome retail environments. And of course, thanks to all the Googlers and our partners for helping us to have a terrific quarter. We are not just embracing the future; we’re helping to shape it. With that, I’ll hand it over to Patrick.
Patrick Pichette: Thank you Nikesh. So, Jamie we’ll look for your instructions to open the lines and get on to the Q&A please.
Operator: (Operator Instructions) And we’ll take our first question from Carlos Kirjner with Bernstein.
Carlos Kirjner: Thank you. Two quick questions, Patrick, if you took your five or six major geographies for search and for each of them you plotted separately the evolution of CPCs for mobile and for PCs and Tablets, and you look at these curves from 5,000 feet, would they be mostly going up, down, flat or all over the place. And secondly, could you let us know if Google Compute Engine and Google App Engine are significant drivers of CapEx, 5% or more of your CapEx? Thank you.
Patrick Pichette: All right, so let me jump by the second one first, Compute Engine - most of our CapEx right now is really driven by data center construction and machines that are actually driving both the core businesses of Google and of course App Engine, but App Engine I wouldn’t describe as any of the core areas where we’re seeing a ton of growth, not that App Engine is not successful; it's just when you compare it to search or other elements that kind of use a lot more capacity. In the case of your first question, it's very clear that we don’t usually breakdown each of these geographies. But the fundamental trends are happening across the web, and in the same way. So all this issue of some markets are growing much faster which is the emerging markets, so you could see that -- you can infer that from our results obviously. Clearly there’s a shift between all those platforms whether it be Mobile, Tablet and Desktop again across the world, so you can infer that as well. Our sites versus network. The U.S. is a strong network area, everybody knows that and so, you can basically kind of from your own inference kind of pick and part these kind of elements, but they together move to actually really make the ecosystem vibrant and growing. And at the end of the day what you have to, just how did you say it? ROI’s don’t lie, Nikesh? So, I mean at the end of the day that’s what you’re pleased about. You’re pleased about great results for our users that get them exactly the right answer they’re looking for and great answers for advertisers. So, that’s how we actually you should think about it, Carlos. Thank you for your question. Let’s go to our next question, Jamie.
Operator: And we’ll take our next question from Mark May with Citi. And Mr. May if you would check your mute button. At this time we cannot hear you.
Patrick Pichette: Why don’t we go to the next question and then Mark can show back up.
Operator: Thank you. We’ll go next to Scott Devitt with Morgan Stanley.
Jordan Monahan: Great, thank you. It's actually Jordan for Scott. I guess two quick questions, the first is you didn’t talk much about Nest and so we were curious whether you were primarily interested in their design team or product or something else. And then on the other revenue line what was the contribution to the other revenue line from Chromebooks or Chrome otherwise in the enterprise?
Patrick Pichette: All right, thank you for your questions, Scott. In the case of Nest, look Nest and Google share a real common vision. Nest, both of us believe that technology should be doing the hard works so that people can get on with their lives and do great things. So our goal is really in the case of Nest is to help them scale. And bringing the resources of Google to increase their investments, reach broader audiences and then scale internationally. So, for us it's a terrific opportunity and then bring people like -- being able to attract people like Tony and Matt to the team is actually wonderful. So, that’s really the context of Nest. Your second question; let me just go back to your second question. The other revenue line. Well actually as I mentioned in my comments, the other revenue it really grew well, like just under a 100% year-over-year. If you look year-over-year the biggest contribution was actually on the Play apps and content. But quarter-over-quarter because of seasonality obviously it’s hardware, but it's both the combination of Nexus 5 which was very strong for us and the Chromecast. You got to remember that most of the Chromebooks are actually sold to other parties. So we’re really a facilitator rather than, and so we don’t book revenue on the Chromebooks. So that’s really the puzzle, Scott. Thank you for your question. Why don’t we go to the next question, please?
Operator: And we’ll take our next question from Douglas Anmuth with JPMorgan.
Douglas Anmuth: Hi, great, thanks for taking the question. Nikesh, I just want to ask you about YouTube in particular. If you could help us understand the growth that you’re seeing in terms of YouTube advertising revenue? And then secondly just on Nielsen OCR tagging, if you could give us some early market or feedback in terms of what you’re seeing there and then a little bit more color on your decision to go with outside measurement rather than how you’ve been doing it internally? Thanks.
Nikesh Arora: Yeah, sure. Look, I think as I mentioned in my prepared remarks, YouTube is one of our core advertising business, so both Search and YouTube are doing well for us around the world. It is part of a broader shift where we’re seeing brand marketers and if you saw us, as I said our strength this quarter was not just from retail or automotive also from CPG. And part of our ability to get CPG customers to come and advertise with us is our ability to convince them that brands can be built on the Internet and YouTube clearly is the key player in our brand story, vis-à-vis advertisers, because they still think visually -- they still video when they think brand advertising not just text ads. So I think YouTube is definitely a key part of our brand story, and it continues to do well. I think our teams around the world have sort of figured out how to pitch YouTube to large customers and customers are paying attention. So I think YouTube continues to do well in addition to our core Search business and people are seeing the value of YouTube vis-à-vis brands. In terms of the OCR tagging and our decision to do it internally versus externally I think look in the long-term what advertisers want is a third party to endorse various media. It's very hard for us to be a media owner to be the person providing measurement against our own media. At the same time we believe there is tremendous amount of development that can be done in the space of measurement where traditional measurement has been both sort of after the fact and also has been on the very limited set of parameters. We believe we as a team can not only increase the parameters that you can measure due to the digital world we also believe that you can look at different metrics simultaneously in the dynamic way and also create new metrics for the future. So our metrics efforts internally have been focused towards creating future metrics as well as more dynamic metrics as opposed to passive or legacy metrics. But that’s work that we continue to do. We continue to work with third party, parties outside including Nielsen and other players of the industry, because we believe that’s where the measurement industry needs to go, and eventually we have to work with them to get them to evolve with us in that direction. In terms of the early feedback on Nielsen OCR tagging, I think it's sort of like, it's table stakes you have to have Nielsen OCR or some metric that is common across various media in the market for you to be, for advertisers to be able to measure your effectiveness or your relevancies vis-à-vis somebody else. And so I think what we’ve done, this is just early table stakes which is sort of a comfort factor for advertisers, when they see that they can look at Nielsen OCR metrics vis-à-vis us and other people and get a sense that they are not spending their money in an unwise fashion, but I think there’s tremendous amounts of evolution and development that’s going to happen in this space.
Douglas Anmuth: Great. Thanks, Nikesh.
Patrick Pichette: Thanks, Nikesh. Jamie, why don’t we go to the next question?
Operator: And we’ll take a question from Mark May with Citi.
Mark May: I apologize about earlier. A question around Google Play; I believe today in just the App business and Mobile App business in general for Google I believe today you don’t do a lot in a way of app marketing, for instance, Map - app install type advertising. First, is that true? If so, is that an opportunity for Google? And then secondly, it seems like that there is a lot of discussion in the market and dollars being put against identity-based ad targeting in addition to or in lieu of cookie-based advertising. What are your thoughts on that? And how is Google, if you think that's a positive trend, how is Google taking advantage of those new forms of ad targeting?
Nikesh Arora: Thanks, Mark. This is Nikesh. In terms of your first question in the area of app install, yes, clearly it has become a larger market recently with this whole mobility factor where everybody is trying to get more and more mobile. We have solutions. We have always had solutions as part of our AdMob product as well as our AdSense products where advertisers can use those forms of advertising towards creating app installs. And we continue to work hard to see where else in our various portfolio of services we can introduce the idea of app install. So you'll hear more from us in that area in the future. But I think you're right. This is an opportunity and we continue to work hard towards making this opportunity real, not just with our existing products but also looking at other ways that we can keep driving this. In terms of your question around cookies and alternatives for cookies, I think it's fair to say that there is a lot of conversation around cookies, there is a lot of stuff going on in terms of how do we continue to evolve this area of technology and make sure that we give the users more control and also make sure that users have security in terms of what data gets transferred for them right and increase the transparency. So, our teams are working on this. There are some early concepts in our teams where they're trying to see how they can – we can evolve this notion in all three parameters that I mentioned. But I think it's too early to talk about what those precise solutions are likely to be.
Mark May: Thanks.
Patrick Pichette: Thanks for your question. Jamie, let's go to the next question please.
Operator: We'll go next to Ben Schachter with Macquarie.
Ben Schachter: Yes, a few question on the Google Wallet initiatives. One, could you just talk about generally what are the problems that that group is trying to solve? Two, can you just tell us a little bit more about the structure of Google Wallet? Who runs the group, who do they report to? And then when you're talking about the number of credit cards that you actually already have in that system, can you give us any – can you help understand the quantity there? Are you measuring in hundreds of millions, tens of millions? And then separately, Nikesh, maybe you could just elaborate a little bit more on initiatives to improve ad attribution and measurement and specifically measuring sort of the online to offline attribution? Thanks.
Nikesh Arora: Thank you very much for those questions. I think – let me start with Google Wallet. I think the best way to think about what Google Wallet is trying to achieve is we're constantly trying to reduce the friction from somebody still doing a search to trying to actually acquire something. But then that is going from online to online, from online to mobile, from mobile to mobile or even online to offline like you referred to in your question at the end. So, the hope of our team is to make sure we reduce the friction and of course create a higher degree of security and comfort vis-à-vis the end user so they get a better experience. Now, Google Wallet is actually a team that is run by our commerce team, which works with Sridhar, who works with Larry. And I think the best way to think about is as people go more and more mobile, we're noticing a lot more people are spending time buying apps and digital content on their mobile devices and they end up signing for Google Wallet as part of their Google Play experience. So, we are seeing lot's more – lots and lots of users use those services. I leave it to you to infer how many Android users there are and how many Google Play users there are and what proportion of them as buying goods and services from us. So that gives you a sense of Google Wallet. It's definitely a number that we are very happy with and it continues to grow.
Patrick Pichette: Thanks for your question, Ben. Ben, this is a complex question. You can always refer back to the IR team for more details on this stuff. Jamie, why don't we go to our next question please?
Operator: We'll go next to Justin Post with Merrill Lynch.
Justin Post: Great. A couple of things. We are seeing rest of world revenues accelerate. Does that have any benefit from product listing ads or some of the mobile changes you made in the platform? And maybe you could talk about how those are going? And then sales and marketing went up quite a bit in Q4. I was just wondering if that was related to Motorola. Thank you.
Patrick Pichette: So why don't I take the second one and then I'll let Nikesh talk about the PLA. Sales and marketing in Q4 was actually just really tied to the holiday season. We had great momentum of the Nexus 5 and the Chromecast. And so at that time of the year we decided when we have such winner products, we would actually support them in addition to a number of other areas where we actually invest. So very, very pleased with the performance of both of those as well as Chromebooks, which have been, if you look in the press, the feedback you get is number one, number two in so many markets. So very, very pleased of actually kind of making that investment in these core products. For the PLA, I'll turn it over to Nikesh.
Nikesh Arora: Hi, Justin. Yes, to break your question down in terms of – there are two or three parts to your question. I think in terms of the growth in the rest of the world, effectively the growth we're seeing in the rest of the world is actually on our core search advertising business and it's across the board. It's across our various products. As I mentioned in my prepared remarks, we've done a lot of work in Enhanced Campaigns and trying to drive solutions from a multi-screen perspective. What we're really seeing is not a particular screen or a particular format, it's actually something which is allowing advertisers to come in and say, hey, I'd like to acquire more customers, I'd like more people on my website, I'd like more people in my store. And effectively them spending money and us helping them optimize across multiple screens how that money should be effectively spent and them measuring the ROIs and saying, this is good, I need to spend more money in this space. So, it's not a particular change in our mobile platform or any other platform, it's actually really our move towards Enhanced Campaigns, which is helping us and the strength in our core business. Vis-à-vis product listing ads, we've talked about this a few quarters ago how we are moving from 10 blue links in certain categories to more entity-level results. And product listing ads is a prime example of how it's happening effectively. We are seeing adoption. As I mentioned, we've added eight more countries this quarter. So, this is part of a continued evolution and it is adding value to both our end users, shoppers as well as store retailers. So it's clearly giving us benefit, our users benefit and obviously more relevant results, allowing merchants to reach specific audiences.
Patrick Pichette: Thanks for your question, Justin. Jamie, we'll go to our next question please.
Operator: Your next question comes from Stephen Ju with Credit Suisse.
Stephen Ju: Hi, guys. So I've always thought of Motorola as an asset for Google to push the agenda for both hardware and software innovation to the OEMs. So, how does the sale to Lenovo affect your ability to do that? Also was your ownership with Motorola ever an impediment to having a closer working relationship with any of the other OEMs before? Thanks.
Patrick Pichette: Well, the short answer is we believe that this is a great transaction where everybody wins. I think that Motorola will find in the mature handset a terrific partner and we'll provide scale and continued really momentum on what is now done very well, which is develop world-class product. In addition to that, Motorola – let's never forget right has really strengthened our Android ecosystem and done a terrific job on that. So I think that both from a perspective of the hardware itself in the handset area as well as for the core Android ecosystem, I think that it's a real win-win for everybody. In addition to that, right, as you know from the Nest acquisition and Glass and Wearables, we continue to innovate and we continue to be committed to the hardware in areas that are kind of enterprising, promising, new frontiers and that's where actually we're focusing on. So I think all in all, quite a great story. Thank you so much, Stephen, for your question. Let's go to our next question, Jamie.
Operator: We'll go next to Eric Sheridan with UBS.
Eric Sheridan: Thanks for taking the question. I guess a broader question, the long term around your e-commerce initiatives, just understanding how you envision continuing to partner more deeply with offline retailers, how PLAs play into that and maybe an update on what you've seen early days from the Google Shopping initiative in San Francisco and now it seems to have expanded into a second market? Thank you.
Nikesh Arora: I think the best way to think about it is that what is happening is over time, people are looking – when they look on the Web, they look for more and more bite-sized [ph] answers and which was the genesis of why we believe that entry level search begins to make more and more sense whether it's in travel, whether it's in hotels, whether it's in product listings, people are looking for more specific answers. And as you get mobile, you want even more bite-sized answers so that people can get the information as quickly as they want. So that sort of is the genesis of product listing ads. If you take that to its logical conclusion, that is people declaring intent that they would like something and that gives you a sense and a signal that, okay, clearly if they're looking for something, they're more than likely wanting to buy it at some point in time. So, we see our role as trying to enable the entire ecosystem across the board of retailers both online and offline to be able to provide those goods and services directly to the end user as quickly as possible with the least amount of friction. And friction comes in their ability to find it. Friction comes in their ability once they've found it to buy it. That's why things like InstaBuy exist in Google Wallet where you can have instant purchasing capability. And then of course there is the notion of gratification or once you've bought it, I want it as quickly as I can get it. So, you can see that our product initiatives are sort of triangulated across all of these things whether it's PLAs in terms of your ability to find it, whether it's payment capabilities to try and close the loop or whether it's delivery, experiments where we see how can we get it to you as soon as possible. So it's more of an open system approach. To be fair where we can help the entire ecosystem and our various partners and you can see that our teams are working really hard towards enabling this vision, but it takes time and great execution.
Eric Sheridan: Great. Thanks, Nikesh.
Patrick Pichette: Thank you, Eric for your question. Jamie, let’s go to our next question please. Operator And we’ll go next to Gene Munster with Piper Jaffray.
Gene Munster: Good afternoon. You’ve talked in the past about enhanced campaigns as being the most significant change to AdWords since its inception and can you give us little bit of context to -- its been rolled out for six months now, is it fully up and running, are advertisers fully embraced or at what period you think that we’re going to kind of hit its stride with enhanced campaigns? Thanks.
Nikesh Arora: Hi, Gene. Yes of course. Actually it’s been an year since we started talking about enhanced campaigns. And we’re very happy with the progress. It’s fully embraced, it’s fully up and running across around the world. Our thousand and thousands of sales people around the world are trained. Our customers and advertising partners have understood that, that’s the way for them to go target audiences and users and really focus in ROI metrics. As we talked about, we will launch the notion of estimated total conversion, so we can look at -- let people think about it during the multi screen way, because more and more we’re seeing that people do not distinguish the activities they conduct in one screen. So earlier we said that people usually search in their desktop and in their mobile devices when they’re mobile, they do different things. But we’re noticing that across any screen you get a sense of pretty much the same activity that happens, which means that advertiser should be somewhat agnostic on where they’re able to reach the user, they should want to reach the user wherever they’re. So our thesis has been proven right. Advertisers are embracing it, users are exhibiting those behavioral patterns, so it’s provided honestly tremendous amounts of efficiency in our ability because we don’t need specialist in various screens, various technologies to kind of work with advertisers. We can have one team work with this product which our product teams have created, which makes it very, very simple and people can look at the ROIs again from spending money with us or individual economy as opposed to having to break it down in silos that doesn’t need to happen. So it’s been very successful. We are happy with it. It’s in its full stride and the effects that you don’t see is the effects we see internally in the amount of efficiency and clarity and our ability to work with advertisers and then being able to measure their ROI effectively.
Gene Munster: Do you think it could have kind of an increasing positive impact going forward or are we kind of seen its full impact in the December quarter?
Nikesh Arora: I think the way to think about it is that if you haven’t done something like this, our lives should have been extremely complex and you might have seen us de-accelerate because we would have get -- gotten sort of tripped up in our own floating. And we wouldn’t want to do that because we’d have to explain why one screen works better than the other screen, how is the ROI from one compared to the other. And you create an artificial differentiation or distinction which doesn’t need to exist because at the end it’ about users, advertisers and publishers.
Gene Munster: Excellent. Thank you.
Patrick Pichette: Thank you so much Gene for your question. Jamie, let’s go to our next question please.
Operator: And we'll go next to Ross Sandler with Deutsche Bank.
Ross Sandler: Thanks, guys. Just a question on, I guess, product or strategy for mobile. You guys are working on assisting users in mobile, not just answering search queries with hyperlinks as you did during the kind of PC browser era. Yet most of the data suggests that mobile users are spending pretty much all their time, summing around in apps all day. So how do you envision Google improving the mobile experience and how do you envision Google potentially controlling a purchase funnel if we stay in apps all day like you controlled it in the PC era? Thanks.
Patrick Pichette: Let me jump in just sort of a very high level and Ross I think that the fundamental tenant is rather than to speak about mobile and only mobile. It’s really living with the user. And once you think through living with the user, supporting our users across all their day, whether it would be on a TV, whether it would be on a mobile phone, whether it would be on the desktop, whether it would be on with Google Glass wearables, that’s really the aim that we’re actually shooting for. And if on -- if it happens that on mobile they spend some of their time on apps, right, that’s just one portion of the puzzle. But when you’re looking for the question, the answer and actually getting you to the real assist across your day, not then just what the devices you’re on, what’s your question or what should we assist you. I think it’s the real question to answer and I think that’s a much broader and a much richer set of the opportunities for us rather than just to be cornered into one. So I kind of defend the premise of your argument, because I think it’s -- I mean our agenda is so much richer and so much more exciting for us, when you think about it in the way we just did it. So that’s the way to think about it. Thanks for your question nonetheless. Let’s go to our next question please, Jamie.
Operator: And we’ll go next to Anthony DiClemente with Nomura.
Anthony DiClemente: Thank you. I have two. First on local advertising, I'm curious about Google Maps, Google Ways. Monetization of local, our geotargeting based products helping local advertisers to drive ROI and what you guys need to do to drive that business in terms of advertising real-time locally? Then the second question, maybe for you, Nikesh, you mentioned the NFL jokingly, I wonder with the growth of YouTube as a platform when you look at the birth and the growth of Chromecast, why is it that you wouldn't find professional content or sports content strategic or useful in terms of driving the next leg or era of growth and monetization for YouTube? Thanks very much.
Nikesh Arora: Let me answer two different parts of it. First is, in terms of your question on local monetization. So, I think we’re clearly experimenting with new ad formats in Google Maps. But I think there is a broader way of thinking about local. It’s not just about app, it’s about location. And as the world begins to interact across multiple screens, you begin to look at location in a whole different way because you’ve a better understanding of where users are and how you can use that as a filter to provide them more precise information and hopefully, much more relevant advertising, which requires both ends of the spectrum. It requires us to understand the users’ location, but also requires the advertisers to make sure they give us the location of where their services are best utilized. So we need location extensions from advertisers, we need locations from users, and we have to be able to marry them across not just Google Maps, but all across pretty much every experience that we’ve, whether it’s search, whether it’s anything, whether it’s YouTube, whatever service that the end-user is using, we’ve to be able to localize it, because location is a great filter and allows us to make things more relevant both from advertising and from an organic perspective. In terms of YouTube, I think we are very happy with the growth that YouTube is having and has had both from a user perspective as well as content provider perspective and as well as from monetization perspective. In terms of content providers, we talk to content providers, large and small across the entire spectrum, because we want you to use the platform where creators of any size can build an audience. They can build an audience of scale; fans can find the content that they want. It’s hard to comment on a particular piece of content because it starts a whole season of conversations. But we’d welcome any content on YouTube as long as people felt that it would add value to the end users and as long as there is a right economic model associated with it.
Anthony DiClemente: Okay, thanks.
Patrick Pichette: Thank you for your question. Great question again. Jamie, let’s go to our next question please.
Operator: And we’ll go next to Mark Mahaney with RBC Capital Markets.
Kevin Potterton: Hi. This is Kevin on for Mark. Just wondering, are you guys seeing Nielsen OCR measurement pushing more brand advertisers towards YouTube?
Nikesh Arora: Thanks, Mark. Sorry, this is Kevin. Sorry. Thanks, Kevin. Kevin, as I mentioned earlier, we had a long spirited answer on measurement. We’re seeing measurement as, table stakes for brand advertisers because they want to understand what is the return of their brand spend. Now it’s easier in performance advertising because you can see the number of clicks you get in your website or you can measure the number of people who walk into your store. On brand it’s a different metrics. We want to actually try and understand how many people were you able to reach of a certain age, certain gender and that’s what Nielsen OCR allows you to do. It allows you to compare it across the various brand media. So its sort of access table stakes and as I said earlier, it is the early set of metrics that are sort of basic entry metrics into this space. But we hope that this market is going to evolve from a measurement perspective over the coming quarters and coming years where we can have more sophisticated metrics and metrics that actually allow you to see the impact of this advertising on your brand.
Patrick Pichette: Thanks. Let’s go to our next question please, Jamie.
Operator: And we’ll go next to Richard Kramer with Arete Research.
Richard Kramer: Thanks very much. Patrick, you’ve talked before about projects like Google Fiber needing to make returns and you see acquisitions like Nest getting replaced by disposals like Motorola. And you’ve now passed the $50 billion mark in terms of net cash. So do you have any plans this year to address this sort of mounting cash pile and as a part of the Google business that that needs to generate returns like the other businesses? And then for Nikesh, you surely seen the various social network and messaging peers absorb some substantial volumes of advertising spend. How does that make you think about the evolution of Google+ and YouTube and some of the other social platforms you have as a complement to the search based business? Thanks.
Patrick Pichette: So, I will jump on the first one. As I’ve reiterated many times before and we were with our Board yesterday at the Audit Committee reviewing this issue, and so it clearly -- the cash position of Google is seen as a strategic asset. It is an important asset to us both in terms of offensive and defensive, given the world in which we live in. And in that context, it's been reviewed regularly and we make sure that actually we get the best return for our investors on that asset as well. So, we have a real strategy for that as well. So, for now we have nothing else to announce on it but just to give comfort to our investors that we do take this issue seriously and it is reviewed on a regular basis by both ourselves, management, but also raised to the Board for the right answer. So, thanks for the question. Thanks for asking. It is always there. I'll turn it over to Nikesh for the second part of the question.
Nikesh Arora: Thanks, Patrick. Thanks, Richard. Let's see – yes, I guess your point, yes, there are other people who are beginning to absorb some amounts of digital ad spend. I think the $15.7 billion for this quarter was a majority of this being advertising, I still think we have a substantial advertising spend coming into us. But again, from a longer term perspective, I think every piece of advertising becomes digital. So, we're still at single – I think at low double digit numbers in terms of how much ad spend is digital versus non-digital. So we need more people in the digital space getting more and more advertising to shift from what we call traditional old media. I think over time television becomes digital, I think every piece of advertising becomes digital because this provides so much efficiency from a measurement perspective and a targeting perspective to take out a lot of waste out of the system. So, with that in mind, I think we're still in the very early days of how much advertising is going to move over to digital media. And I think you're right to identify that, places like Google+, places like YouTube are still very, very sort of in their infancy in the amount of advertising they can support vis-à-vis the amount of usage we're getting. So we continue to work hard. We have to strike the right balance between user services, end user service and the amount of advertising we have presented them, because this continues to be sort of evolving space and what you don't want to do is you don't want to overrun users with tremendous amounts of advertising, because that maybe good in the short term but creates a bad experience with users in the long term. So, you will notice that many of our products still do not have tremendous amounts of advertising because we still believe those products are evolving and the right form of advertising just hasn't been invented for those particular areas. So, we remain hopeful in the long term for finding more and more ways of enabling advertising for users. And for sure, perhaps some of the products may not lend themselves to advertising and users will prefer to pay for an ad-less product as it relates to certain areas like applications or digital content, et cetera. So, those models also exist out there. So I think there is tremendous amounts of scope in the future and I think you have rightly identified some of the areas where we should be concentrating.
Patrick Pichette: Thanks for your question. Let's go to our next question please.
Operator: We'll take our next question from Heather Bellini with Goldman Sachs.
Heather Bellini: Great. Thank you. I was just wondering if you could share with us your strategy to try and reduce fragmentation of Android. And is the sale of Motorola a potential catalyst for this to start to happen? And ultimately, do you think this even matters over the long term? Thank you.
Patrick Pichette: Well, again, Heather, certainly the transaction with Motorola continues to support the ecosystem. So in that sense, right, I think that we have clear objectives of support. We've always had clear objectives to support all of our partners. And after this transaction, it's very clear that we'll continue to be kind of this impartial supporter of the entire ecosystem. As it relates to the detailed fragmentation, we've taken a number of steps. We've talked a lot about this already in the past. There is a number of steps taken to make sure that in fact there isn't fragmentation and I'll just encourage you to kind of circle back to both of what's written as well as circle back to the IR team for more of the details. But we've done a lot of progress already on this over the last kind of 18 months and a lot more to come. So thanks for your question. We have time for one more, so why don't we jump, Jamie, to the last question of the afternoon.
Operator: We'll take our last question from Colin Sebastian with Robert W. Baird.
Colin Sebastian: Great. Thanks. Just a question on enterprise. Obviously, from a SaaS perspective you already have a very good business. But in terms of the infrastructure and platform services, can you talk about how you're approaching the go-to-market? Whether it's based on pricing since there are low margin competitors already in the market or is this more of a broader platform approach to link the services together? Thank you.
Patrick Pichette: Nikesh?
Nikesh Arora: Thank you, Colin, for your question. I'm still trying to parse your question. Look, I think we've done really well from an enterprise perspective. We are steadily growing revenues on our traditional Google apps business. Outside of that on the platform service, the Google Compute Engine, Google App Engine stuff, we continue to make progress. I think we should – we have more room to work harder over there. We understand there are other players out there, but again that is such an early, early stage in that market. We think over the long term, almost every business out there, existing and new, has to be on a cloud platform, has to be on a large scale industrial strength infrastructure platform and there is still few players out there and there's lots and lots of room. So I'm not sure if price is the current factor on which people need to make a decision. People will make a decision based on robustness, based on security, based on availability, based on the breadth of services we can offer in that platform and I just think its early days. So, we should be working on all those things and you should be hearing more from us in the future.
Colin Sebastian: Thank you.
Patrick Pichette: Thanks for that. So, in closing, a couple of points. One is, welcome to 2014 everyone. Having closed down 2013, we're totally excited by this coming year. And just as Nikesh had said at the very beginning, thank you for the people in the financial community for your support as well as to our Googlers, partners, I mean the amazing people that make our job, Nikesh and my job so easy to be on this call because of their superstar performances across all of our products and our markets. So, again, congrats to the Googlers for a great 2013. With that, Jamie, I'll let you close the call.
Operator: Thank you, sir. That does conclude today's conference. We do thank everyone for your participation. Have a great day. | [
{
"speaker": "Operator",
"text": "Good day everyone and welcome to the Google Inc. Fourth Quarter 2013 Earnings Call. Today’s call is being recorded. At this time, I’d like to turn the call over to Jane Penner, Director, Investor Relations. Please go ahead."
},
{
"speaker": "Jane Penner",
"text": "Good afternoon, everyone, and welcome to Google’s fourth quarter 2013 earnings conference call. With us now are Patrick Pichette, Senior Vice President and Chief Financial Officer; Nikesh Arora, Senior Vice President and Chief Business Officer. Also, as you know, we distribute our earnings release through our Investor Relations website located at investor.google.com. So please refer to our IR website for our earnings releases, as well as the supplementary slides that accompany the call. You can also visit our Google+ Investor Relations page for the latest Company news and update, please check it out. This call is also being webcast from investor.google.com. A replay of the call will be available on our website later today. Now, let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward-looking, including statements regarding Google's future investments, our long-term growth and innovation, the expected performance of our businesses, and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect the results. Please note that certain financial measures that we use on this call, such as operating income and operating margin are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation and restructuring. We’ve also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I’ll turn the call over to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Jane. Good afternoon everyone. It’s Patrick and you may remember we mentioned last quarter that Larry will no longer be joining us on a regular basis on this call as he focuses his energy on running the Company. But consistent with our prior calls, Nikesh and I will be here. We will cover the performance as well as answer any questions you have about the business, including significant ad product launches or other developments and in the case that you have a very, very detailed product related question, in some cases we may simply take it off line with you. But with that why don’t we just dive into the details of our financial performance for Q4. Our gross total consolidated revenue for the quarter was $16.9 billion and the overall business was up 17% year-over-year and 13% quarter-over-quarter. Our Google segment, gross revenue grew a healthy 22% year-over-year to $15.7 billion and was up 14% quarter-over-quarter. Without currency fluctuations, the Google segment revenue growth would have been 23% year-over-year and 13% quarter-over-quarter. Our Google sites revenue was up 22% year-over-year to $10.6 billion and was up 12% quarter-over-quarter, driven by the strength of our core search advertising business. Network revenue was up 3% year-over-year at $3.5 billion and was up 12% quarter-over-quarter. This was driven in part by each year year-over-year comparisons as we anniversary some of our ad policy changes implemented at the end of 2012. But we also saw improved year-over-year growth from our ad exchange. Finally, Google’s other revenue grew 99%, almost doubled year-over-year to $1.6 billion and it was up 34% quarter-over-quarter. The digital sales of apps and content in our Play store drove the year-over-year growth in this line as did hardware sales and the Play hardware sales drove most – a big chunk of the quarter-over-quarter growth. Turning to Motorola segment, gross revenue was $1.2 billion. As we announced yesterday Lenovo plans to acquire our Motorola business for approximately $2.9 billion. This is great news for Motorola and the Android ecosystem. And as Larry noted in our press release, Lenovo will have the expertise and the track record to scale Motorola Mobility into a major player within the Android ecosystem. Coming back to our Google segment, our global aggregate paid click growth was strong this quarter, up 31% year-over-year, and up 13% quarter-over-quarter. Our aggregate cost-per-click was down 11% year-over-year and down 2% quarter-over-quarter. And please note that currency fluctuations had a minimal impact on Q4 on the cost-per-click. Our monetization metrics continue to be impacted by a number of factors discussed on previous calls, including FX, geographic mix, platform mix, property mix as well as product and policy changes. Turning to geographic performance of our Google segment, we saw improved performance in the U.S. and the U.K. and strong performance in the rest of the world. In our earnings slides, you can find on our Investor Relations website, you'll see that we've broken down our revenue by U.S., U.K. and rest of the world to show the impact of FX and the benefits of our hedging program. So please refer to those slides for the exact calculations. U.S. revenue was up 16% year-over-year to $6.9 billion. The U.K. was up 15% year-over-year to $1.5 billion, which includes a small $2 million benefit from our hedging program. So currency fluctuation had minimal impact on U.K. revenues in Q4. Our non-U.S. revenue excluding the U.K. was up 30% year-over-year to $7.3 billion. And this accounted for 46% of our total revenue, which included again a very small benefit from our hedging program, in fixed FX terms; the rest of world grew a strong 33% year-over-year. So let’s come back to an aggregate level for the total consolidated business. Our non-GAAP other cost of revenue was $4 billion in Q4 excluding stock-based compensation and Motorola restructuring. Our non-GAAP operating expenses totaled $4.8 billion again excluding SBC and Motorola restructuring. And our non-GAAP operating profit was $4.8 billion in Q4, resulting in a non-GAAP operating margin for the consolidated business of 29%. For our Google segments, specifically our traffic acquisition costs were $3.3 billion or 24% of total advertising revenue. The other cost of revenue was $2.8 billion excluding $127 million of stock-based compensation. And our Google segment operating expenses were $4.3 billion, again excluding SBC of $746 million. Depreciation and amortization expenses on property, plant and equipment for the Google segment was $660 million this quarter. And Google segment profitability was $5.3 billion in Q4, resulting in a Google segment operating margin of 34%. At Motorola, our total segment operating expenses including cost of revenue were $1.6 billion, excluding $29 million of SBC and $15 million of restructuring charges to Motorola. Keep in mind that intangible amortization expenses attributed to Google segment and Motorola segment are included in these segment measures. Of the $279 million in consolidated intangible amortization expense this quarter, $153 million was the result of the acquisition of Motorola of which $116 million was allocated to Google and $37 million was allocated to the Motorola segment. As a result, the operating loss for the Motorola segment was $384 million in Q4 and the operating margin for that segment was negative 31%. Our headcount for the consolidated business was up roughly 1,300 people in Q4. The Google segment added 1,700 people during the quarter and in total the consolidated company ended the quarter with approximately 48,000 full-time employees. Our effective tax rate was 16% in Q4. Tax rate this quarter was impacted by the continuing mix shift of earnings between our domestic and international subsidiaries. Let me now turn to cash management. Our OI&E was 125 million for the quarter. Interest income and realized gains on investments offset the continued impact of our FAS 133 expense from our hedging program. For more detail on OI&E, please refer to the slides that accompany this call on our IR website. We continue to be happy with our strong operating cash flow at $5.2 billion. CapEx for the quarter was 2.3 billion and this quarter the majority of our CapEx spend was related to production equipment, data center construction and real estate purchases. As I mentioned last quarter during my remarks, we continue to invest for the long term and our infrastructure continues to be a key strategic area for us to invest. Our free cash flow, in consequence of all this, was $3 billion. So there you have it, strong results and an optimism that provides us the confidence to fund strategic growth opportunities, including Android, Chrome, YouTube, Enterprise just to name a few. Before I wrap up, I want to cover two quick things. First, I want to remind everybody as I do every time at this time of year that as we start a new year, things such as employer taxes, 401(k) and all these other related accruals tend to be frontloaded in the year. So please consider this as you model your forecast. And second, before I hand it off to Nikesh, I want to give an update on our issuance of Class C shares. Our Board of Directors has formally approved the Class C dividend and has set March 27 as the record date and April 2 of this year as the issuance date. So we expect that Class C shares to begin trading on April 3. We were excited to announce that the Class C shares will actually trade under our original Ticker, that is GOOG, while the Class A shares will trade under a new Ticker GOOGL. We're setting up a link on our Investor Relations site so that it can give you more information on the Class C dividends. With that, I'll let Nikesh cover the details of our business performance in the quarter and after his remarks, we'll open up the phone lines for questions. So, here you go, Nikesh."
},
{
"speaker": "Nikesh Arora",
"text": "Thank you, Patrick. As Patrick mentioned, our business had a strong quarter with $15.7 billion in Google segment gross revenue. Overall performance was strong in retail and automotive and CPG sectors. We had particularly good growth in Asia Pacific including its various emerging countries as well as in Southern Europe. I want to talk about three areas that are fueling growth for Google and our clients. First, our continued efforts to help performance marketers reach customers and drive action across screens. Second, our continued progress in brand advertising. And third, our ad technology platforms used by thousands of agencies and publishers. Then I'll say a few words about new areas like digital content, hardware and enterprise. On performance; performance advertising continues to be a mainstay of our core business. We're seeing good growth. It's driven primarily by increased search activity across all screens. It's driven by new measurement features and more sophisticated marketers are aligning their search and display advertising strategy. Last year we made the move to Enhanced Campaigns in AdWords, 12-months in marketers tell us it helps them get results and reach people across screens in a big way. Our internal slogan for this is 'Advertisers ROIs don't lie.' We also rolled out estimated total conversion. Marketers can now measure results like calls and conversions that take place in different devices. For example, 1-800-Flowers discovered a 7% increase in overall conversions when they figured out that conversions that start on one device then end on the other. This is a great example of our vision as it relates to the seamless multi-screen marketing and something that was impetus for us to launch in ad campaigns. In the holiday season, one thing has become very clear. The Web has truly become the new holiday store window. It's first where people go and it's where everyone gets excited about holiday shopping. In the U.S., Walmart continues to use Google search more and more. They are investing with us more than ever before to drive sales during the holiday season. There's also great momentum in product listing ads and we continue to improve the experience for shoppers and retailers. Last quarter, Google Shopping came to eight more countries. We even helped deliver products to your doorstep in just a few hours. Google Shopping Express, our same day delivery service, has been open to shoppers in the Bay area since last year. I'm very pleased with the feedback we've gotten from our partners and users. Now moving on to brand marketing. Working closer and closer with brand advertisers has been a big priority for us and we're making great strides. Now you might have seen all the teaser ads running on YouTube ahead of the big game Sunday. Given my personal passion for cricket and lack of, pretty much any knowledge of American Football, I decided to turn to Google Trends and see who is leading. I see that Seahawks have more searches than the Bronco, so that's my bet for the Super Bowl. But folks in Denver better get searching if they want the Broncos to win. I don't know what that means for the big game on Sunday, but I do know that we are becoming a central to the biggest brand-building campaigns of the world. There are three big areas of focus that brand and our agency partners really like. First, building our great content on YouTube. YouTube gives brands amazing reach and a passion of unique audience you can't get elsewhere. YouTube has over 1 billion viewers per month and saw a 50% increase in daily watch time last year. Second, the best digital marketing captivates people when it's by the Web, for the Web. It's so much more than simply taking television ads and transplanting them on YouTube. So we're investing in creative ad formats that pivot around user engagement like CUview or engagement ads across the Web. Last year for the first time, three videos by brand marketers were on YouTube's list of top 10 videos for 2013. Third and importantly, better measurement than enables brand and agencies to measure and optimize campaigns based on metrics like reach, recall or awareness. Last quarter we enabled advertisers in our Google Display Network start buying ads based on viewable impressions, a fancy way of saying, ads that people actually saw. In November we began testing Nielsen OCR, measurement on our YouTube and our network. There's a lot more to come here, but it's an important step to helping brands invest online. We think our efforts are really resonating with major clients and agencies from around the world. Our sales team continues to fire on all cylinders. I'm really pleased we hired Kirk Perry as our President of Brand Solutions from Procter & Gamble. His goal is to help the largest brand and agencies in the world embrace digital marketing more and more. He speaks their language, so we hope that he'll be able to convince them that the future for brands is truly digital. We worked with Kraft to build a series of engagement ads, showcasing brand videos, recipes and coupons for its new Fresh Take brand. That campaign was very successful and left an impressive 2.9% engagement rate in that average engagement time of 48 seconds. Moving on to our ad technologies platforms, our DoubleClick buying tools continue to be the choice for agencies around the world, and we're really benefiting from the growth and programmatic spend. One trend we're seeing is the move towards private ad exchanges in which a premium publisher uses our technology to make ad space available to a small number of handpicked, high quality and highly qualified advertisers. This could provide a very safe, real-time environment for both brands and publishers. The volume of compression running through our private exchanges as on average doubled every quarter over the past year. Overall, our monetization solutions like our Ad Exchange, AdSense and AdMob are helping major publishers maximize their revenues from digital advertisers. So that's our core ad business. Let's talk about our trisect of emerging new businesses; Google Play, hardware and enterprise. Google Play continues to win the hearts and minds of people, the latest books, newspapers and magazines, 20 million songs, thousands of movies, textbooks, all access music. You can live your lives on Google Play. People love it so far. This quarter we introduced a Google Play Newsstand that brings together more than 2,000 free and paid news sources including newspapers like the New York Times, Wall Street Journal, Financial Times. We also introduced Google Play for education. It's a design for schools and educator proved ads as well as tools to easily set up a classroom of tablets in minutes. We have a strong holiday season for our growing suite of hardware products. One of the things that has done really well for us is Chromecast. It continues to be a living room favorite remaining a best selling product throughout the entire quarter. We’ve also been adding to the growing list of content available through Chromecast with new supported apps like Hulu plus, HBO Go and Pandora, with more to come. Chromebooks are also seeing great momentum with eight of the top manufactures of computers now making Chromebooks, including new devices from both Dell and Toshiba. One in four devices sold into K-12 education in the U.S. use a Chromebook according to FutureSource. We’ve also been seeing strong momentum in Nexus hardware with great reception for Nexus 5’s. And as cars become more connected we’ve recently themed up with the automotive and technology leaders Audi, GM, Honda, Hyundai and NVIDIA to form the Open Automotive Alliance. Our enterprise business continues to grow steadily as more businesses than ever want their employees to work the way they live. We’re seeing great momentum in the retail space. There is supermarket Waitrose, the clothing retailers Chico’s and the fashion accessory brand Fossil have all gone Google this quarter. On the cloud platform side we announced that Google computer engine is now generally available supporting additional operating systems at new lower prices. But before I close, I also want to give a shout out to our marketing team in particular they had really helped to drive the success of Google Play and the hardware products over the holidays. They have been able to do that through great effective advertising and creating awesome retail environments. And of course, thanks to all the Googlers and our partners for helping us to have a terrific quarter. We are not just embracing the future; we’re helping to shape it. With that, I’ll hand it over to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you Nikesh. So, Jamie we’ll look for your instructions to open the lines and get on to the Q&A please."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) And we’ll take our first question from Carlos Kirjner with Bernstein."
},
{
"speaker": "Carlos Kirjner",
"text": "Thank you. Two quick questions, Patrick, if you took your five or six major geographies for search and for each of them you plotted separately the evolution of CPCs for mobile and for PCs and Tablets, and you look at these curves from 5,000 feet, would they be mostly going up, down, flat or all over the place. And secondly, could you let us know if Google Compute Engine and Google App Engine are significant drivers of CapEx, 5% or more of your CapEx? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "All right, so let me jump by the second one first, Compute Engine - most of our CapEx right now is really driven by data center construction and machines that are actually driving both the core businesses of Google and of course App Engine, but App Engine I wouldn’t describe as any of the core areas where we’re seeing a ton of growth, not that App Engine is not successful; it's just when you compare it to search or other elements that kind of use a lot more capacity. In the case of your first question, it's very clear that we don’t usually breakdown each of these geographies. But the fundamental trends are happening across the web, and in the same way. So all this issue of some markets are growing much faster which is the emerging markets, so you could see that -- you can infer that from our results obviously. Clearly there’s a shift between all those platforms whether it be Mobile, Tablet and Desktop again across the world, so you can infer that as well. Our sites versus network. The U.S. is a strong network area, everybody knows that and so, you can basically kind of from your own inference kind of pick and part these kind of elements, but they together move to actually really make the ecosystem vibrant and growing. And at the end of the day what you have to, just how did you say it? ROI’s don’t lie, Nikesh? So, I mean at the end of the day that’s what you’re pleased about. You’re pleased about great results for our users that get them exactly the right answer they’re looking for and great answers for advertisers. So, that’s how we actually you should think about it, Carlos. Thank you for your question. Let’s go to our next question, Jamie."
},
{
"speaker": "Operator",
"text": "And we’ll take our next question from Mark May with Citi. And Mr. May if you would check your mute button. At this time we cannot hear you."
},
{
"speaker": "Patrick Pichette",
"text": "Why don’t we go to the next question and then Mark can show back up."
},
{
"speaker": "Operator",
"text": "Thank you. We’ll go next to Scott Devitt with Morgan Stanley."
},
{
"speaker": "Jordan Monahan",
"text": "Great, thank you. It's actually Jordan for Scott. I guess two quick questions, the first is you didn’t talk much about Nest and so we were curious whether you were primarily interested in their design team or product or something else. And then on the other revenue line what was the contribution to the other revenue line from Chromebooks or Chrome otherwise in the enterprise?"
},
{
"speaker": "Patrick Pichette",
"text": "All right, thank you for your questions, Scott. In the case of Nest, look Nest and Google share a real common vision. Nest, both of us believe that technology should be doing the hard works so that people can get on with their lives and do great things. So our goal is really in the case of Nest is to help them scale. And bringing the resources of Google to increase their investments, reach broader audiences and then scale internationally. So, for us it's a terrific opportunity and then bring people like -- being able to attract people like Tony and Matt to the team is actually wonderful. So, that’s really the context of Nest. Your second question; let me just go back to your second question. The other revenue line. Well actually as I mentioned in my comments, the other revenue it really grew well, like just under a 100% year-over-year. If you look year-over-year the biggest contribution was actually on the Play apps and content. But quarter-over-quarter because of seasonality obviously it’s hardware, but it's both the combination of Nexus 5 which was very strong for us and the Chromecast. You got to remember that most of the Chromebooks are actually sold to other parties. So we’re really a facilitator rather than, and so we don’t book revenue on the Chromebooks. So that’s really the puzzle, Scott. Thank you for your question. Why don’t we go to the next question, please?"
},
{
"speaker": "Operator",
"text": "And we’ll take our next question from Douglas Anmuth with JPMorgan."
},
{
"speaker": "Douglas Anmuth",
"text": "Hi, great, thanks for taking the question. Nikesh, I just want to ask you about YouTube in particular. If you could help us understand the growth that you’re seeing in terms of YouTube advertising revenue? And then secondly just on Nielsen OCR tagging, if you could give us some early market or feedback in terms of what you’re seeing there and then a little bit more color on your decision to go with outside measurement rather than how you’ve been doing it internally? Thanks."
},
{
"speaker": "Nikesh Arora",
"text": "Yeah, sure. Look, I think as I mentioned in my prepared remarks, YouTube is one of our core advertising business, so both Search and YouTube are doing well for us around the world. It is part of a broader shift where we’re seeing brand marketers and if you saw us, as I said our strength this quarter was not just from retail or automotive also from CPG. And part of our ability to get CPG customers to come and advertise with us is our ability to convince them that brands can be built on the Internet and YouTube clearly is the key player in our brand story, vis-à-vis advertisers, because they still think visually -- they still video when they think brand advertising not just text ads. So I think YouTube is definitely a key part of our brand story, and it continues to do well. I think our teams around the world have sort of figured out how to pitch YouTube to large customers and customers are paying attention. So I think YouTube continues to do well in addition to our core Search business and people are seeing the value of YouTube vis-à-vis brands. In terms of the OCR tagging and our decision to do it internally versus externally I think look in the long-term what advertisers want is a third party to endorse various media. It's very hard for us to be a media owner to be the person providing measurement against our own media. At the same time we believe there is tremendous amount of development that can be done in the space of measurement where traditional measurement has been both sort of after the fact and also has been on the very limited set of parameters. We believe we as a team can not only increase the parameters that you can measure due to the digital world we also believe that you can look at different metrics simultaneously in the dynamic way and also create new metrics for the future. So our metrics efforts internally have been focused towards creating future metrics as well as more dynamic metrics as opposed to passive or legacy metrics. But that’s work that we continue to do. We continue to work with third party, parties outside including Nielsen and other players of the industry, because we believe that’s where the measurement industry needs to go, and eventually we have to work with them to get them to evolve with us in that direction. In terms of the early feedback on Nielsen OCR tagging, I think it's sort of like, it's table stakes you have to have Nielsen OCR or some metric that is common across various media in the market for you to be, for advertisers to be able to measure your effectiveness or your relevancies vis-à-vis somebody else. And so I think what we’ve done, this is just early table stakes which is sort of a comfort factor for advertisers, when they see that they can look at Nielsen OCR metrics vis-à-vis us and other people and get a sense that they are not spending their money in an unwise fashion, but I think there’s tremendous amounts of evolution and development that’s going to happen in this space."
},
{
"speaker": "Douglas Anmuth",
"text": "Great. Thanks, Nikesh."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks, Nikesh. Jamie, why don’t we go to the next question?"
},
{
"speaker": "Operator",
"text": "And we’ll take a question from Mark May with Citi."
},
{
"speaker": "Mark May",
"text": "I apologize about earlier. A question around Google Play; I believe today in just the App business and Mobile App business in general for Google I believe today you don’t do a lot in a way of app marketing, for instance, Map - app install type advertising. First, is that true? If so, is that an opportunity for Google? And then secondly, it seems like that there is a lot of discussion in the market and dollars being put against identity-based ad targeting in addition to or in lieu of cookie-based advertising. What are your thoughts on that? And how is Google, if you think that's a positive trend, how is Google taking advantage of those new forms of ad targeting?"
},
{
"speaker": "Nikesh Arora",
"text": "Thanks, Mark. This is Nikesh. In terms of your first question in the area of app install, yes, clearly it has become a larger market recently with this whole mobility factor where everybody is trying to get more and more mobile. We have solutions. We have always had solutions as part of our AdMob product as well as our AdSense products where advertisers can use those forms of advertising towards creating app installs. And we continue to work hard to see where else in our various portfolio of services we can introduce the idea of app install. So you'll hear more from us in that area in the future. But I think you're right. This is an opportunity and we continue to work hard towards making this opportunity real, not just with our existing products but also looking at other ways that we can keep driving this. In terms of your question around cookies and alternatives for cookies, I think it's fair to say that there is a lot of conversation around cookies, there is a lot of stuff going on in terms of how do we continue to evolve this area of technology and make sure that we give the users more control and also make sure that users have security in terms of what data gets transferred for them right and increase the transparency. So, our teams are working on this. There are some early concepts in our teams where they're trying to see how they can – we can evolve this notion in all three parameters that I mentioned. But I think it's too early to talk about what those precise solutions are likely to be."
},
{
"speaker": "Mark May",
"text": "Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks for your question. Jamie, let's go to the next question please."
},
{
"speaker": "Operator",
"text": "We'll go next to Ben Schachter with Macquarie."
},
{
"speaker": "Ben Schachter",
"text": "Yes, a few question on the Google Wallet initiatives. One, could you just talk about generally what are the problems that that group is trying to solve? Two, can you just tell us a little bit more about the structure of Google Wallet? Who runs the group, who do they report to? And then when you're talking about the number of credit cards that you actually already have in that system, can you give us any – can you help understand the quantity there? Are you measuring in hundreds of millions, tens of millions? And then separately, Nikesh, maybe you could just elaborate a little bit more on initiatives to improve ad attribution and measurement and specifically measuring sort of the online to offline attribution? Thanks."
},
{
"speaker": "Nikesh Arora",
"text": "Thank you very much for those questions. I think – let me start with Google Wallet. I think the best way to think about what Google Wallet is trying to achieve is we're constantly trying to reduce the friction from somebody still doing a search to trying to actually acquire something. But then that is going from online to online, from online to mobile, from mobile to mobile or even online to offline like you referred to in your question at the end. So, the hope of our team is to make sure we reduce the friction and of course create a higher degree of security and comfort vis-à-vis the end user so they get a better experience. Now, Google Wallet is actually a team that is run by our commerce team, which works with Sridhar, who works with Larry. And I think the best way to think about is as people go more and more mobile, we're noticing a lot more people are spending time buying apps and digital content on their mobile devices and they end up signing for Google Wallet as part of their Google Play experience. So, we are seeing lot's more – lots and lots of users use those services. I leave it to you to infer how many Android users there are and how many Google Play users there are and what proportion of them as buying goods and services from us. So that gives you a sense of Google Wallet. It's definitely a number that we are very happy with and it continues to grow."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks for your question, Ben. Ben, this is a complex question. You can always refer back to the IR team for more details on this stuff. Jamie, why don't we go to our next question please?"
},
{
"speaker": "Operator",
"text": "We'll go next to Justin Post with Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "Great. A couple of things. We are seeing rest of world revenues accelerate. Does that have any benefit from product listing ads or some of the mobile changes you made in the platform? And maybe you could talk about how those are going? And then sales and marketing went up quite a bit in Q4. I was just wondering if that was related to Motorola. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "So why don't I take the second one and then I'll let Nikesh talk about the PLA. Sales and marketing in Q4 was actually just really tied to the holiday season. We had great momentum of the Nexus 5 and the Chromecast. And so at that time of the year we decided when we have such winner products, we would actually support them in addition to a number of other areas where we actually invest. So very, very pleased with the performance of both of those as well as Chromebooks, which have been, if you look in the press, the feedback you get is number one, number two in so many markets. So very, very pleased of actually kind of making that investment in these core products. For the PLA, I'll turn it over to Nikesh."
},
{
"speaker": "Nikesh Arora",
"text": "Hi, Justin. Yes, to break your question down in terms of – there are two or three parts to your question. I think in terms of the growth in the rest of the world, effectively the growth we're seeing in the rest of the world is actually on our core search advertising business and it's across the board. It's across our various products. As I mentioned in my prepared remarks, we've done a lot of work in Enhanced Campaigns and trying to drive solutions from a multi-screen perspective. What we're really seeing is not a particular screen or a particular format, it's actually something which is allowing advertisers to come in and say, hey, I'd like to acquire more customers, I'd like more people on my website, I'd like more people in my store. And effectively them spending money and us helping them optimize across multiple screens how that money should be effectively spent and them measuring the ROIs and saying, this is good, I need to spend more money in this space. So, it's not a particular change in our mobile platform or any other platform, it's actually really our move towards Enhanced Campaigns, which is helping us and the strength in our core business. Vis-à-vis product listing ads, we've talked about this a few quarters ago how we are moving from 10 blue links in certain categories to more entity-level results. And product listing ads is a prime example of how it's happening effectively. We are seeing adoption. As I mentioned, we've added eight more countries this quarter. So, this is part of a continued evolution and it is adding value to both our end users, shoppers as well as store retailers. So it's clearly giving us benefit, our users benefit and obviously more relevant results, allowing merchants to reach specific audiences."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks for your question, Justin. Jamie, we'll go to our next question please."
},
{
"speaker": "Operator",
"text": "Your next question comes from Stephen Ju with Credit Suisse."
},
{
"speaker": "Stephen Ju",
"text": "Hi, guys. So I've always thought of Motorola as an asset for Google to push the agenda for both hardware and software innovation to the OEMs. So, how does the sale to Lenovo affect your ability to do that? Also was your ownership with Motorola ever an impediment to having a closer working relationship with any of the other OEMs before? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Well, the short answer is we believe that this is a great transaction where everybody wins. I think that Motorola will find in the mature handset a terrific partner and we'll provide scale and continued really momentum on what is now done very well, which is develop world-class product. In addition to that, Motorola – let's never forget right has really strengthened our Android ecosystem and done a terrific job on that. So I think that both from a perspective of the hardware itself in the handset area as well as for the core Android ecosystem, I think that it's a real win-win for everybody. In addition to that, right, as you know from the Nest acquisition and Glass and Wearables, we continue to innovate and we continue to be committed to the hardware in areas that are kind of enterprising, promising, new frontiers and that's where actually we're focusing on. So I think all in all, quite a great story. Thank you so much, Stephen, for your question. Let's go to our next question, Jamie."
},
{
"speaker": "Operator",
"text": "We'll go next to Eric Sheridan with UBS."
},
{
"speaker": "Eric Sheridan",
"text": "Thanks for taking the question. I guess a broader question, the long term around your e-commerce initiatives, just understanding how you envision continuing to partner more deeply with offline retailers, how PLAs play into that and maybe an update on what you've seen early days from the Google Shopping initiative in San Francisco and now it seems to have expanded into a second market? Thank you."
},
{
"speaker": "Nikesh Arora",
"text": "I think the best way to think about it is that what is happening is over time, people are looking – when they look on the Web, they look for more and more bite-sized [ph] answers and which was the genesis of why we believe that entry level search begins to make more and more sense whether it's in travel, whether it's in hotels, whether it's in product listings, people are looking for more specific answers. And as you get mobile, you want even more bite-sized answers so that people can get the information as quickly as they want. So that sort of is the genesis of product listing ads. If you take that to its logical conclusion, that is people declaring intent that they would like something and that gives you a sense and a signal that, okay, clearly if they're looking for something, they're more than likely wanting to buy it at some point in time. So, we see our role as trying to enable the entire ecosystem across the board of retailers both online and offline to be able to provide those goods and services directly to the end user as quickly as possible with the least amount of friction. And friction comes in their ability to find it. Friction comes in their ability once they've found it to buy it. That's why things like InstaBuy exist in Google Wallet where you can have instant purchasing capability. And then of course there is the notion of gratification or once you've bought it, I want it as quickly as I can get it. So, you can see that our product initiatives are sort of triangulated across all of these things whether it's PLAs in terms of your ability to find it, whether it's payment capabilities to try and close the loop or whether it's delivery, experiments where we see how can we get it to you as soon as possible. So it's more of an open system approach. To be fair where we can help the entire ecosystem and our various partners and you can see that our teams are working really hard towards enabling this vision, but it takes time and great execution."
},
{
"speaker": "Eric Sheridan",
"text": "Great. Thanks, Nikesh."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Eric for your question. Jamie, let’s go to our next question please. Operator And we’ll go next to Gene Munster with Piper Jaffray."
},
{
"speaker": "Gene Munster",
"text": "Good afternoon. You’ve talked in the past about enhanced campaigns as being the most significant change to AdWords since its inception and can you give us little bit of context to -- its been rolled out for six months now, is it fully up and running, are advertisers fully embraced or at what period you think that we’re going to kind of hit its stride with enhanced campaigns? Thanks."
},
{
"speaker": "Nikesh Arora",
"text": "Hi, Gene. Yes of course. Actually it’s been an year since we started talking about enhanced campaigns. And we’re very happy with the progress. It’s fully embraced, it’s fully up and running across around the world. Our thousand and thousands of sales people around the world are trained. Our customers and advertising partners have understood that, that’s the way for them to go target audiences and users and really focus in ROI metrics. As we talked about, we will launch the notion of estimated total conversion, so we can look at -- let people think about it during the multi screen way, because more and more we’re seeing that people do not distinguish the activities they conduct in one screen. So earlier we said that people usually search in their desktop and in their mobile devices when they’re mobile, they do different things. But we’re noticing that across any screen you get a sense of pretty much the same activity that happens, which means that advertiser should be somewhat agnostic on where they’re able to reach the user, they should want to reach the user wherever they’re. So our thesis has been proven right. Advertisers are embracing it, users are exhibiting those behavioral patterns, so it’s provided honestly tremendous amounts of efficiency in our ability because we don’t need specialist in various screens, various technologies to kind of work with advertisers. We can have one team work with this product which our product teams have created, which makes it very, very simple and people can look at the ROIs again from spending money with us or individual economy as opposed to having to break it down in silos that doesn’t need to happen. So it’s been very successful. We are happy with it. It’s in its full stride and the effects that you don’t see is the effects we see internally in the amount of efficiency and clarity and our ability to work with advertisers and then being able to measure their ROI effectively."
},
{
"speaker": "Gene Munster",
"text": "Do you think it could have kind of an increasing positive impact going forward or are we kind of seen its full impact in the December quarter?"
},
{
"speaker": "Nikesh Arora",
"text": "I think the way to think about it is that if you haven’t done something like this, our lives should have been extremely complex and you might have seen us de-accelerate because we would have get -- gotten sort of tripped up in our own floating. And we wouldn’t want to do that because we’d have to explain why one screen works better than the other screen, how is the ROI from one compared to the other. And you create an artificial differentiation or distinction which doesn’t need to exist because at the end it’ about users, advertisers and publishers."
},
{
"speaker": "Gene Munster",
"text": "Excellent. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you so much Gene for your question. Jamie, let’s go to our next question please."
},
{
"speaker": "Operator",
"text": "And we'll go next to Ross Sandler with Deutsche Bank."
},
{
"speaker": "Ross Sandler",
"text": "Thanks, guys. Just a question on, I guess, product or strategy for mobile. You guys are working on assisting users in mobile, not just answering search queries with hyperlinks as you did during the kind of PC browser era. Yet most of the data suggests that mobile users are spending pretty much all their time, summing around in apps all day. So how do you envision Google improving the mobile experience and how do you envision Google potentially controlling a purchase funnel if we stay in apps all day like you controlled it in the PC era? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Let me jump in just sort of a very high level and Ross I think that the fundamental tenant is rather than to speak about mobile and only mobile. It’s really living with the user. And once you think through living with the user, supporting our users across all their day, whether it would be on a TV, whether it would be on a mobile phone, whether it would be on the desktop, whether it would be on with Google Glass wearables, that’s really the aim that we’re actually shooting for. And if on -- if it happens that on mobile they spend some of their time on apps, right, that’s just one portion of the puzzle. But when you’re looking for the question, the answer and actually getting you to the real assist across your day, not then just what the devices you’re on, what’s your question or what should we assist you. I think it’s the real question to answer and I think that’s a much broader and a much richer set of the opportunities for us rather than just to be cornered into one. So I kind of defend the premise of your argument, because I think it’s -- I mean our agenda is so much richer and so much more exciting for us, when you think about it in the way we just did it. So that’s the way to think about it. Thanks for your question nonetheless. Let’s go to our next question please, Jamie."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Anthony DiClemente with Nomura."
},
{
"speaker": "Anthony DiClemente",
"text": "Thank you. I have two. First on local advertising, I'm curious about Google Maps, Google Ways. Monetization of local, our geotargeting based products helping local advertisers to drive ROI and what you guys need to do to drive that business in terms of advertising real-time locally? Then the second question, maybe for you, Nikesh, you mentioned the NFL jokingly, I wonder with the growth of YouTube as a platform when you look at the birth and the growth of Chromecast, why is it that you wouldn't find professional content or sports content strategic or useful in terms of driving the next leg or era of growth and monetization for YouTube? Thanks very much."
},
{
"speaker": "Nikesh Arora",
"text": "Let me answer two different parts of it. First is, in terms of your question on local monetization. So, I think we’re clearly experimenting with new ad formats in Google Maps. But I think there is a broader way of thinking about local. It’s not just about app, it’s about location. And as the world begins to interact across multiple screens, you begin to look at location in a whole different way because you’ve a better understanding of where users are and how you can use that as a filter to provide them more precise information and hopefully, much more relevant advertising, which requires both ends of the spectrum. It requires us to understand the users’ location, but also requires the advertisers to make sure they give us the location of where their services are best utilized. So we need location extensions from advertisers, we need locations from users, and we have to be able to marry them across not just Google Maps, but all across pretty much every experience that we’ve, whether it’s search, whether it’s anything, whether it’s YouTube, whatever service that the end-user is using, we’ve to be able to localize it, because location is a great filter and allows us to make things more relevant both from advertising and from an organic perspective. In terms of YouTube, I think we are very happy with the growth that YouTube is having and has had both from a user perspective as well as content provider perspective and as well as from monetization perspective. In terms of content providers, we talk to content providers, large and small across the entire spectrum, because we want you to use the platform where creators of any size can build an audience. They can build an audience of scale; fans can find the content that they want. It’s hard to comment on a particular piece of content because it starts a whole season of conversations. But we’d welcome any content on YouTube as long as people felt that it would add value to the end users and as long as there is a right economic model associated with it."
},
{
"speaker": "Anthony DiClemente",
"text": "Okay, thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you for your question. Great question again. Jamie, let’s go to our next question please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Mark Mahaney with RBC Capital Markets."
},
{
"speaker": "Kevin Potterton",
"text": "Hi. This is Kevin on for Mark. Just wondering, are you guys seeing Nielsen OCR measurement pushing more brand advertisers towards YouTube?"
},
{
"speaker": "Nikesh Arora",
"text": "Thanks, Mark. Sorry, this is Kevin. Sorry. Thanks, Kevin. Kevin, as I mentioned earlier, we had a long spirited answer on measurement. We’re seeing measurement as, table stakes for brand advertisers because they want to understand what is the return of their brand spend. Now it’s easier in performance advertising because you can see the number of clicks you get in your website or you can measure the number of people who walk into your store. On brand it’s a different metrics. We want to actually try and understand how many people were you able to reach of a certain age, certain gender and that’s what Nielsen OCR allows you to do. It allows you to compare it across the various brand media. So its sort of access table stakes and as I said earlier, it is the early set of metrics that are sort of basic entry metrics into this space. But we hope that this market is going to evolve from a measurement perspective over the coming quarters and coming years where we can have more sophisticated metrics and metrics that actually allow you to see the impact of this advertising on your brand."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks. Let’s go to our next question please, Jamie."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Richard Kramer with Arete Research."
},
{
"speaker": "Richard Kramer",
"text": "Thanks very much. Patrick, you’ve talked before about projects like Google Fiber needing to make returns and you see acquisitions like Nest getting replaced by disposals like Motorola. And you’ve now passed the $50 billion mark in terms of net cash. So do you have any plans this year to address this sort of mounting cash pile and as a part of the Google business that that needs to generate returns like the other businesses? And then for Nikesh, you surely seen the various social network and messaging peers absorb some substantial volumes of advertising spend. How does that make you think about the evolution of Google+ and YouTube and some of the other social platforms you have as a complement to the search based business? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "So, I will jump on the first one. As I’ve reiterated many times before and we were with our Board yesterday at the Audit Committee reviewing this issue, and so it clearly -- the cash position of Google is seen as a strategic asset. It is an important asset to us both in terms of offensive and defensive, given the world in which we live in. And in that context, it's been reviewed regularly and we make sure that actually we get the best return for our investors on that asset as well. So, we have a real strategy for that as well. So, for now we have nothing else to announce on it but just to give comfort to our investors that we do take this issue seriously and it is reviewed on a regular basis by both ourselves, management, but also raised to the Board for the right answer. So, thanks for the question. Thanks for asking. It is always there. I'll turn it over to Nikesh for the second part of the question."
},
{
"speaker": "Nikesh Arora",
"text": "Thanks, Patrick. Thanks, Richard. Let's see – yes, I guess your point, yes, there are other people who are beginning to absorb some amounts of digital ad spend. I think the $15.7 billion for this quarter was a majority of this being advertising, I still think we have a substantial advertising spend coming into us. But again, from a longer term perspective, I think every piece of advertising becomes digital. So, we're still at single – I think at low double digit numbers in terms of how much ad spend is digital versus non-digital. So we need more people in the digital space getting more and more advertising to shift from what we call traditional old media. I think over time television becomes digital, I think every piece of advertising becomes digital because this provides so much efficiency from a measurement perspective and a targeting perspective to take out a lot of waste out of the system. So, with that in mind, I think we're still in the very early days of how much advertising is going to move over to digital media. And I think you're right to identify that, places like Google+, places like YouTube are still very, very sort of in their infancy in the amount of advertising they can support vis-à-vis the amount of usage we're getting. So we continue to work hard. We have to strike the right balance between user services, end user service and the amount of advertising we have presented them, because this continues to be sort of evolving space and what you don't want to do is you don't want to overrun users with tremendous amounts of advertising, because that maybe good in the short term but creates a bad experience with users in the long term. So, you will notice that many of our products still do not have tremendous amounts of advertising because we still believe those products are evolving and the right form of advertising just hasn't been invented for those particular areas. So, we remain hopeful in the long term for finding more and more ways of enabling advertising for users. And for sure, perhaps some of the products may not lend themselves to advertising and users will prefer to pay for an ad-less product as it relates to certain areas like applications or digital content, et cetera. So, those models also exist out there. So I think there is tremendous amounts of scope in the future and I think you have rightly identified some of the areas where we should be concentrating."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks for your question. Let's go to our next question please."
},
{
"speaker": "Operator",
"text": "We'll take our next question from Heather Bellini with Goldman Sachs."
},
{
"speaker": "Heather Bellini",
"text": "Great. Thank you. I was just wondering if you could share with us your strategy to try and reduce fragmentation of Android. And is the sale of Motorola a potential catalyst for this to start to happen? And ultimately, do you think this even matters over the long term? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Well, again, Heather, certainly the transaction with Motorola continues to support the ecosystem. So in that sense, right, I think that we have clear objectives of support. We've always had clear objectives to support all of our partners. And after this transaction, it's very clear that we'll continue to be kind of this impartial supporter of the entire ecosystem. As it relates to the detailed fragmentation, we've taken a number of steps. We've talked a lot about this already in the past. There is a number of steps taken to make sure that in fact there isn't fragmentation and I'll just encourage you to kind of circle back to both of what's written as well as circle back to the IR team for more of the details. But we've done a lot of progress already on this over the last kind of 18 months and a lot more to come. So thanks for your question. We have time for one more, so why don't we jump, Jamie, to the last question of the afternoon."
},
{
"speaker": "Operator",
"text": "We'll take our last question from Colin Sebastian with Robert W. Baird."
},
{
"speaker": "Colin Sebastian",
"text": "Great. Thanks. Just a question on enterprise. Obviously, from a SaaS perspective you already have a very good business. But in terms of the infrastructure and platform services, can you talk about how you're approaching the go-to-market? Whether it's based on pricing since there are low margin competitors already in the market or is this more of a broader platform approach to link the services together? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Nikesh?"
},
{
"speaker": "Nikesh Arora",
"text": "Thank you, Colin, for your question. I'm still trying to parse your question. Look, I think we've done really well from an enterprise perspective. We are steadily growing revenues on our traditional Google apps business. Outside of that on the platform service, the Google Compute Engine, Google App Engine stuff, we continue to make progress. I think we should – we have more room to work harder over there. We understand there are other players out there, but again that is such an early, early stage in that market. We think over the long term, almost every business out there, existing and new, has to be on a cloud platform, has to be on a large scale industrial strength infrastructure platform and there is still few players out there and there's lots and lots of room. So I'm not sure if price is the current factor on which people need to make a decision. People will make a decision based on robustness, based on security, based on availability, based on the breadth of services we can offer in that platform and I just think its early days. So, we should be working on all those things and you should be hearing more from us in the future."
},
{
"speaker": "Colin Sebastian",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks for that. So, in closing, a couple of points. One is, welcome to 2014 everyone. Having closed down 2013, we're totally excited by this coming year. And just as Nikesh had said at the very beginning, thank you for the people in the financial community for your support as well as to our Googlers, partners, I mean the amazing people that make our job, Nikesh and my job so easy to be on this call because of their superstar performances across all of our products and our markets. So, again, congrats to the Googlers for a great 2013. With that, Jamie, I'll let you close the call."
},
{
"speaker": "Operator",
"text": "Thank you, sir. That does conclude today's conference. We do thank everyone for your participation. Have a great day."
}
] | null | null |
GOOGL | 3 | 2,013 | 2013-10-18 16:30:00 | Operator: Good day everyone and welcome to the Google Inc. Third Quarter 2013 Earnings Conference Call. Today’s conference is being recorded. At this time, I’d like to turn the call over to Ms. Jane Penner, Director, Investor Relations. Please go ahead ma'am.
Jane Penner: Good afternoon, everyone, and welcome to today’s third quarter 2013 earnings conference call. With us are Larry Page, Chief Executive Officer; Patrick Pichette, Senior Vice President and Chief Financial Officer; and Nikesh Arora, Senior Vice President and Chief Business Officer. Also, as you know, we distribute our earnings release through our Investor Relations website located at investor.google.com. So please refer to our IR website for our earnings releases, as well as the supplementary slides that accompany the call. You can also visit our Google+ Investor Relations page for the latest Company news and update, please check it out. This call is also being webcast from investor.google.com. A replay of the call will be available on our website later today. Now, let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward-looking, including statements regarding Google's future investments, our long-term growth and innovation, the expected performance of our businesses, and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on the call, such as operating income and operating margin are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation and restructuring. We’ve also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I’ll turn the call over to Larry.
Larry Page: Thank you. Hi, everyone. Thanks for joining us today. Google had another strong quarter with $14.9 billion in revenue and great product progress. We are closing in our goal of a beautiful, simple, and intuitive experience regardless of your device. Research has shown that people tend to overestimate the impact of technology in the short-term, yet underestimate the scale of change longer term. For years everyone talked about the multi screen world. Now it’s arrived, but on a scale few imagined, people increasingly have more than one device and screens are proliferating in the home as well as wearable screens like watches and Google Glass. When android was still a (indiscernible) project I used to feel kind of guilty visiting the team. We are a search company and building a new operating system wasn’t an obvious move to most people. It turns out that was a lot of (indiscernible) over 1 billion android devices have now been activated worldwide and 1.5 million devices are led off everyday. I’m also tremendously excited about Chromebooks, which are growing fast and defining the more general decline in laptops. It’s like the chrome browser; updates are seamless and frequent improving security and usability. It was a great example of technology doing the hard work, so you can get all the stuff that matters. Two weeks ago we launched the new HP Chromebook 11. Its beautifully designed and light weight and just over 2 pounds and at $279, highly affordable. Best of all, it has a high power micro USB charger that can also charge your android phone. Recharging isn’t too much of a sweat and there is tremendous potential to innovate. So it’s great to see progress here. This quarter we also launched the Moto X. The first one that Motorola has developed and produced since Google acquired the company. Super fast and clean and the voice features are great. While it’s still early days, Dennis and the team have already transformed Motorola’s product quality. Now they’re working to build out marketing and distribution. As screens multiply people navigate across them seamlessly becomes more and more important. That’s why I love Chromecast which we launched in July and immediately became a best seller. On your phone, tablet or laptop and start playing some music from Youtube or a show from Google play or Netflix. One click the content is there on the bigger screen in your home, your TV, all for just $35. And unlike some other streaming devices, you can continue to email search and share as the Chromecast handles the hard work without draining your device battery, genuine multi-tasking in a multi screen world. We’ve also making great progress across devices with Youtube. Almost 40% of Youtube’s traffic now comes from mobile, up from 6% two years ago. And in August we updated our Youtube apps for android and iOS. You can now leave a video playing at the bottom of your screen while you explore other content. Our execution in velocity and search from maps is getting better and better and from a very high base. A new map app for iOS and android shipped in July, but is specifically for downloads to make the most of this larger screens. And in September we’ve rebuilt our entire mobile search experience of a simple card interface that is easy to read and have designed, that is optimized for touch. Our momentum on voice search is tremendous. We added four new languages this quarter making available on over 78 languages and accents. We’ve also expanded the quick answers, we can provide just for you. Fast Google for your flight details and up here instantly in your search results, no digging around in your email required. And the search across Google+ photos is extraordinary. Search for sunsets and all the pictures you've ever taken of sunsets to appear instantly. If you haven't tried it, prepare to be amazed. About two years ago, when I became CEO again, my goal was to ensure that Google maintains the passion and soul of a start-up as we grow. It's why I've worked so hard to increase the velocity and execution. So we create great products people love to use and iterate fast to ensure they get better and better. Because great is just never good enough. When you look across the company, it's amazing how well the teams are executing. For example, we rolled out Enhanced Campaigns in AdWords across all devices for all our advertisers in less than a year. Of course none of this would happen without great people and we are so lucky that we have them. I'd like to thank all the Googlers and Motorolans who make everything possible. Keep up that velocity and execution. Before I hand over to Patrick, I want to let you know that going forward, I won't be joining every earnings call. Patrick and Nikesh do a great job covering our business each quarter and they'll continue to do that great work. I know you all would love to have me on, but you are also depending on me to ruthlessly prioritize my time for the benefit of the business. I'm very confident you are in good hands with Patrick and Nikesh. So now, over to Patrick.
Patrick Pichette: Thank you, Larry. Good afternoon, everyone, and thank you for joining us again. Without further ado why don't we just dive into the details of Google's financial performance in Q3? So here we go. Our gross consolidated revenue was just shy of $15 billion at $14.9 billion. The overall business was up 6% quarter-over-quarter and 12% year-over-year. Our Google segment, gross revenue grew a healthy 19% year-over-year to $13.8 billion and was up 5% quarter-over-quarter without currency fluctuations, Google segment revenue would have actually grown 21% year-over-year and the currency impact on sequential growth was actually immaterial in our case this quarter. Google sites revenue was up 22% year-over-year to $9.4 billion and was up 6% quarter-over-quarter, driven by the strength in our core search advertising business. The advertising policy decisions that we implemented earlier this year to ensure good user experience continued to negatively impact Google's network revenue in the short term, and therefore our network revenue was in fact flat year-over-year to $3.1 billion and was down 1% quarter-over-quarter. Despite the short-term pressures we continue to believe that this is clearly the right answer for our users and shareholders in the long term. And finally to finish Google's segment on a positive note, Google's other revenue grew 85% year-over-year to $1.2 billion and was up 18% quarter-over-quarter. Digital sales of apps and content in our Play store drove year-over-year and quarter-over-quarter growth in this line. Turning to Motorola segment, our gross revenue there was $1.2 billion. As Larry mentioned, while it's still the early days, Dennis and the team have already transformed Motorola's product quality and they're working now at building marketing and distribution. By the way, some of you may have noticed that our total consolidated revenue does not exactly equal to some of our segment revenue this quarter. This is driven by new transactions in our Motorola segment resulting in intersegment and certain deferred revenues that are eliminated in our consolidated results. Coming back to our Google segment, our global aggregate paid click growth was strong this quarter, up 26% year-over-year, 8% quarter-over-quarter. Our aggregate cost-per-click was down 8% year-over-year and down 12% quarter-over-quarter. And we should note that the currency fluctuations had a real minimal impact on Q3 cost-per-click. Once again, I wish to remind everyone that our monetization metrics continue to be impacted by a whole set of factors discussed on previous calls. They include geographic mix, channel mix, property mix as well as product and policy changes. Turning to geographic performance of our Google segment, we continue to see steady performance in the U.S. and the U.K. and strong performance in the rest of the world. In our earnings slides, which you can find on our Investor Relations website, you'll see that we've broken down our revenue by U.S., U.K. and rest of world to show the impact of FX and the benefits from our hedging program. So please refer to those slides for the exact calculation. The U.S. revenue was up 13% year-over-year to $6.1 billion and it's worth noting that network revenue that I mentioned a bit earlier which continues to be impacted by ongoing policy decisions skew toward the U.S. The U.K. was up 14% year-over-year to $1.4 billion which includes a small $17 million benefit from our hedging program. In fixed FX the U.K. grew 15% year-over-year. In our non-U.S. revenue excluding the U.K. accounted for 46% of total revenue or $6.3 billion. This was up 28% year-over-year which includes a $5 million benefit from our hedging program and in fixed FX terms, our rest of world actually grew 32% year-over-year. Coming back to an aggregate level for the total consolidated business, our non-GAAP other cost of revenue was $3.3 billion in Q3 excluding SBC and Motorola restructuring. Our non-GAAP operating expenses totaled 4.3 billion again excluding SBC and Motorola restructuring. For a non-GAAP operating profit was $4.3 billion in Q3 resulting in non-GAAP operating margin for the consolidated business of 29%. For Google segment our traffic acquisition costs were $3 billion or 24% of total advertising revenue. Our other cost of revenue was $2.3 billion excluding $133 million of SBC. Google segment operating expenses were $3.9 billion also excluding SBC of $723 million. Depreciation and amortization expense on our property, plant and equipment for the Google segment was $630 million this quarter. And our Google segment operating profit as a result was a strong $4.6 billion in Q3 resulting in Google segment operating margin of 34%. At Motorola our total segment operating expenses including cost of revenue were $1.4 billion. That excludes $30 million of stock-based compensation and $12 million of Motorola restructuring charges. Please keep in mind that intangible amortization expense attributed to the Google segment and Motorola are in fact included in these segment measures. Of the $281 million in consolidated intangible amortization expense in the quarter, $153 million was the result of the acquisition of Motorola of which $116 million was allocated to Google segment and $37 million allocated to the Motorola segment. And as a result, the operating loss at Motorola segment was $248 million in Q3 and operating margins for that segment were negative 21%. Headcount for the consolidated business was roughly 1,500 people, up in Q3. The Google segment added just about 2,000 people during the quarter and in total the consolidated company ended the quarter with approximately 46,000 full-time employees. Our effective tax rate was 15% in Q3. Our tax rate this quarter was impacted by the continued mix shift of earnings between our domestic and international subsidiaries. Let me now turn to cash management. Our other income and expense was 24 million for this quarter. The impact of FAS 133 expense from our hedging program and realized losses mostly offset interest income in this quarter. And as you know we often get questions on quarter-to-quarter volatility of our hedging costs. So to help everyone understand this better, we put together a video tutorial on the topic. You can find the new video on our Investor Relations website. I hope you find it helpful and let us know what you think. For more detail on OI&E, please again refer to the slides that accompany this call on our IR website. We continue to be happy with our strong operating cash flow at $5.1 billion. CapEx for the quarter was $2.3 billion. This quarter the majority of our CapEx was spent on production equipment, data center construction and real estate purchases. As I mentioned last quarter during my remarks, we continue to invest for the long term and our infrastructure continues to be a key strategic area of investment for us. Consequently, our free cash flow was $2.8 billion, very strong again. So there you have it. Strong results and an optimism that provides us the confidence to fund strategic growth fully in the opportunities, areas including Mobile Business, Android, Chrome, YouTube, Enterprise just to name a few. With that I’ll hand it off to Nikesh, who’ll cover more details of our business performance in the quarter and after these remarks we’ll open up the phone lines for questions. Here you go, Nikesh.
Nikesh Arora: Thank you, Patrick. As Patrick mentioned our business had a strong quarter with $13.8 billion in Google segment gross revenue. Overall performance was strong in the retail sector. We had good growth in Japan, South Korea and Australia. There are three key areas I want to talk about today, that are big growth drivers for us and our partners. First; our continued efforts to make advertising seamless, effective and measurable across multiple screens. Second; our progress in bringing bad advertisers online with a special emphasis on our efforts that are on Youtube; and third our early investments in commerce and shopping to help users, retailers and merchants. And last say a few words about newly areas like digital content, hardware and enterprise. On seamless advertising; it's been a few months since our advertisers moved over to enhanced campaigns and AdWords. Clients are telling us they like the new system. Many are still adjusting their campaigns and keywords and developing their multi-screen bidding strategies. For example; we’re seeing advertisers bidding more frequently in mobile keywords because enhanced campaigns makes it so much easier to do so. They’re discovering how they can use the needed capabilities in mobile and their ads, like location Click2Call. Example is discover who has just increased their mobile spend and used it to promote their [it card]. Talking about mobile, we’ve also launched cross device measurement tools and analytics. There are three observations here. First; mobile is driving higher online conversion. American Apparels found that mobile ads were actually driving 16% more conversions than they initially thought and as a result they’re now investing more to drive more sales. Second, mobile drives more phone calls. On average there are more than 40 million calls driven by Google ads every month, this is twice as much as it was a year ago. Third, mobile drives in-store traffic. Moving over to brand in YouTube. You’ve seen that our CPG and entertainment clients have moved online at greater speed with our efforts that are on brand. Spend by our CPG clients on displaying YouTube has grown over 75% over the past two years. For example, the Google YouTube campaign for Dove’s Camera Shy brand in more than 20 countries and delivered over 62 million views for Unilever. We’re also partnering very closely with agencies, we really like integrating our technology, insights and media with their creativity and client relationships. For agencies, marketers and Googlers it's a huge win, win, win. All of the top 10 global agencies now use our DoubleClick products. On the other side YouTube continues to do well. Video ads which include CUview now form a significant part of our YouTube in brand advertising and they’re growing north of 75% year-over-year. We found that YouTube is our brand torch bearer. It offers brands valuable engaged audiences, terrific reach and compelling context. Smart brands are really loving their engagement with YouTube. Moving on to commerce and shopping. As Google search moves to provide people with answers and entities not just links, we’re making good progress helping people take commercial access too like buying products. We’re seeing great traction on product listing ads both in desktop and mobile. As part of this moved to a seamless purchasing experience we’re also helping retailers offer better payment solutions to their customers particularly on mobile where it's traditionally been difficult. Google Wallet InstaBuy helps merchants here up implementing instant buy Google (indiscernible) saw that from May to August users of Google Wallet on their Android app had a purchase conversion rate that was four times higher than other shoppers. Finally I want to talk about an area which we’re being putting more emphasis on which is our investment in emerging non-ads businesses. As we mentioned last quarter, we continue to see acceleration in the new businesses such as hardware, digital content and enterprise. As Larry mentioned Chromecast and Chromebooks are enjoying great success. Chromebooks are now available in over 8000 locations around the world and are being used in more than 20% of school districts in United States. We’re also rolling out unified Google experience in more than 750 Best Buy stores to showcase Chromebooks, Chromecast and the newest Nexus devices under our one Google branded design. On digital apps and content we continue to work hard to roll out Google Play in more markets around the world and add content to it. For instance this quarter to help students go back to school we added a comprehensive catalogue of textbooks to Google Play Books for rental purchase. We brought on content partners like HBO and DC Entertainment. This quarter we brought Play Music to eight more countries and Play Books to 18 new countries. So for example now users in Russia can enjoy music and users in Indonesia can enjoy books. There’s tremendous momentum here and we look forward to making progress in this area. Another strong area of recovering and growing revenue is our enterprise software business, making available the best of Google for work. Some great new clients this quarter include whirlpool which is now using Google Apps to help 30,000 employees collaborate and innovate more quickly. In education, apps for education is being used by 30 million students, faculty and staff worldwide. Beyond apps, Amtrak uses Google Maps to let people see all the trains in the U.S. in real time, and we’re continuing to invest in the Google Cloud Platform which has over 300,000 customers including Sanmina, a Fortune 500 Company using cloud platforms to build internal applications that improve their efficiency across their offices globally. Lastly let me call out the efforts of our marketing team that continues to roll out the Google Welcome Mat to the world. To put on our third annual Google Science Fair honoring 15 global finalists from the ages of 13 to 18 from around the world where we hosted 400 partners and customers who are at our Annual Site Cast Event, more interestingly to introduce the newest version of Android called KitKat, we’ve built a partnership with Nestle to get more than 50 million special Android KitKat chocolate bars on store shelves around the world. And I have to give a shout out to the wonderful ad for our Nexus devices featuring the great sport of cricket that our marketing team is running in Australia, that’s a bit of a personal favorite sport. With that, let me hand it over to Patrick. Thank you again to all the Googlers for all their hard work in getting us here.
Patrick Pichette: So there you have it folks. Why don’t we have Jamie turn on the lines and then we’ll take your questions. So Jamie, over to you.
Operator: Thank you, sir. (Operator Instructions) And we’ll take our first question from Mark Mahaney with RBC Capital Markets.
Mark Mahaney: Great, two questions please. Could you talk about how long you think it will take for advertisers to move over to fully embrace the multi-screen advertising world which enhanced campaign should enable or facilitate. And then secondly the skunk’s works question, voice recognition technology at the Company I think it’s something you’ve been working on for years, I think it's what enables wearable devices in the future. Can you talk about how far along you are in developing a technology to be where you want it to be? Thank you.
Larry Page: Yeah; thanks Mark for the questions. I think the first part of your question I’ll to send Nikesh in a minute and I’ll take the voice recognition question. I think we made tremendous progress on voice recognition. Even in period of months probably the last couple of months or six months the accuracy has gone up quite a bit. If you haven't tried it, I’d really recommend you to try that, it's super fast, on the motor axe, you can say, okay Google now, even if your phone is turned off it will turn on and answer your question. So, I think we’re super excited about that, and I think we made tremendous strives and we’ll continue to improve accuracy in that and to make the products better. But I think they’re already super useful and we have a lot of usage coming from voice. So Nikesh, in the enhanced campaigns.
Nikesh Arora: Hey, Mark as you know on the topic of enhanced campaigns the challenge we had as we moved into a multi-screen world was, everybody was producing solutions where we had to basically run campaigns on different devices in a different way because it's this evolution that happened from desktop to mobile to video ads et cetera. And effectively what our team working with Susan and Sheila’s team have been able to do is to provide one single interface and one single mechanism to be able to manage our campaigns across multiple devices. Now that’s a good thing because it improves process, let’s them see the ROI across various devices with the analytic tools that we’ve come up with. But also there’s a lot of work that needs to happen on the advertisers side because they have to develop beautiful experiences for their customers on mobile devices as well as on their screen. So I think it's a process where we’re all going through this together, advertisers love this new mechanism. They’re adjusting their keywords and they’re bidding models based on all this new effort and we’re seeing great progress in terms people are already advertising those. But not only that, we’re also working with all of our advertisers to make sure they have great experiences on their other screens and other devices so that they can truly leverage this. So, I think this is definitely the sort of the first set of steps we’ve taken to towards future or multi-screen devices and multi-screen advertising but we think this is the way things are going to keep evolving.
Patrick Pichette: Thank you.
Mark Mahaney: Thanks, Larry.
Patrick Pichette: Jamie, why don't we go to our next call?
Operator: We'll take our next question from Ben Schachter with Macquarie.
Ben Schachter: Larry, can you discuss Google's overall ecommerce strategy, how the Knowledge Graph structure data plays into it and generally how Google can improve the users' ecommerce experience? And then Nikesh, you touched briefly on the brand efforts and I was looking at some data recently that shows that over the past 15 years virtually all the games for online advertising has come at the extent of print and radio and none of it has come from television budgets. What specifically is happening now that makes you think it's more likely for the television dollars to finally begin to come online and to Google in particular? And then just a quick housekeeping one for Patrick. Can you just give us a bit more detail on how the accounting works for the intersegment transactions and how it impacts the consolidated model? Thanks.
Larry Page: Like a three-way question [indiscernible]. So I think on the ecommerce side, I think Google's been used for e-commerce for forever and we're really excited about doing a better job of that. I think we want to remove friction when people are buying online or in the real world. We know people often click on an ad in a mobile device and then make their purchase on the laptop or they might in fact buy it in the store and we need to really get the conversion data there to the advertiser. So I think we've done work across all those things, across multi-screens, multi-devices from online to offline. We recently launched cross-device measurement in AdWords and we're also just trying to make it easier for people to buy things in general. It's as simple as that's same day shipping in local inventory and search. Like I said, we're just looking to reduce friction and we're very excited about that.
Nikesh Arora: Yes. Hi, Ben. If you look at the last 15 years of history like you talk about, a lot of the gains of online advertising have actually come at the expense of what we would call performance advertising. Anytime you wanted to interact with users, get people to come into your store, get people to buy your product, get people to click on your website, all those gains have happened in performance which has been great. But what's beginning to happen is as the watch time on various online video sites continues to grow, as more and more online video begins to be available in a nonlinear fashion in television screens or recent as Larry talked about Chromecast, that stuff or a bunch of the gaming devices, a bunch of other TV solutions, they're beginning to see a lot more watch time being expended either on your desktop or on your multi-screen devices or even on your television. As that begins to happen that advertising is more addressable, more directly attributable and provides more measurement and capabilities. So we believe that that's definitely a more superior opportunity for advertisers to be able to attract their brand customers and actually know who's at the other end. So I think that trend is definitely in the right direction and we're getting upward.
Patrick Pichette: So why don't I take the last question which was the housekeeping item. Actually this is pretty straightforward change, Ben. So in Q3 our Motorola and Google segments purchased and sold services to each other and these transactions are reflected in our Google and Motorola segment revenues. The main thing analysts need to realize as they update their model this time is that the total consolidated revenue will no longer necessarily like in the quarters where there is transaction between the two equal the sum of the Google and Motorola segment revenues. So analysts who currently sum up our segment revenues and profits to derive consolidated estimates should need to model in elimination lines for the intersegment revenue and profit in order to get their consolidated estimates. So that's simple as that. Thanks for the questions. So, Jamie, why don't we go – thanks, Ben – to our next caller.
Operator: We'll go next to Carlos Kirjner with Sanford Bernstein.
Carlos Kirjner: Thank you. Larry, I hope that when you come up with voice recognition, it can deal with funny accents. Anyway the perception by people outside the company is that Google spends a material amount in long-term R&D that will not generate revenue in the next two years or so. Larry, can you help us understand how you think about funding this project and how much do they correspond versus your total R&D budget? And secondly, Patrick, you said in the past that CapEx is lumpy and we should expect fluctuations but now we have had three quarters of what looks like high CapEx versus recent past. Have the last few quarters been normal? Thank you.
Larry Page: Yes, thanks, Carlos. I think we definitely are working on accents, so I appreciate that. I think that on the long-term R&D question, I think we don't break all this on detail, but I would say that, my stronghold in general is to get people to spend money on long-term R&D. In most companies I think even companies that have significant R&D budgets, if you look at that maybe 99% of it ends up being really incremental, which is relatively small improvements to kind of your existing businesses, and maybe 1% of that ends up being kind of true long-term things like Android was when it got started. So I think I kind of view my job as the opposite thing is to get people to spend on the long-term R&D. I do think people have a perception that's material. I don't think that – that's not been my experience and so it's very hard to actually spend money on long-term things in any kind of meaningful way. And even the investments we've announced, things like Calico or rather an absolute dollar number's probably significant amounts, they're not significant for Google. And I think you should actually be asking me to make more significant investments. I wish I knew how to do that but I think it's actually very difficult to spend kind of meaningful amounts of money relative to goal scale on things that are speculative.
Patrick Pichette: Thank you, Larry. Carlos, on the issue of CapEx just to reiterate the fact that the majority of the CapEx this quarter was spent on production equipment, so like machines, data center construction looking ahead and building the capacity ahead of our needs to get the flexibility and real estate purchases, so we had a number of kind of really good opportunistic purchases in the portfolio we were targeting and they kind of came online this quarter, so pretty pleased with that. I think that overall investors should see this as a very positive sign and a positive signal. As I mentioned last quarter during my remarks, we continue to invest really for the long term and just a conversation we're having with Larry on the topic of R&D. And our infrastructure continues to be a key strategic area for investment for us. It's really important that when we see signals of or opportunities where we need capacity, the worst thing for us would be to actually not have it in terms of machines and data center capacity. So the strategic value of having it for flexibility for our long-term positions are really important. That's what you see reflected in our investments right now. So thank you for your question, Carlos.
Carlos Kirjner: Thank you.
Patrick Pichette: Jamie, let's go to our next call, please.
Operator: We'll go next to Ross Sandler with Deutsche Bank.
Ross Sandler: Thanks. Larry, just to follow-up on Ben's question earlier, it seems like you guys have all the pieces in place with Android, with Maps, with Google Now, Wallet, credit card information in the Play store to kind of vertically integrate the experience from research search to purchase in the local and transactional areas, kind of the closing of the loop if you will. So can you just elaborate on the overall strategy and how does the recent cross screen conversion estimates enhance play into that? Thanks.
Larry Page: Thanks, Ross. We have all positions available [indiscernible]. I think we certainly agree with that. I think it was a pretty good description of me. We all account many different pieces of your commercial experiences. I think in general I mean now our experience for users is not that seamless and there is lots of different pieces of technology and processes in order to make commerce happen and so on. So I think we have got something we absolutely are looking at improving about closing the loop and so on. I mean I think your question actually is pretty good, so really I don't know that I can add much more.
Patrick Pichette: Thank you for your question. Jamie, let's go to the next caller please.
Operator: We'll go next to Dan Salmon with BMO Capital Markets.
Dan Salmon: Hi. Good afternoon, guys. My question was for Larry. Since you've come back into the CEO's role, one of the things we've noticed with Google is that your own advertising spending has moved up and once upon a time Google was a company that didn't need to advertise and obviously you're in a lot more businesses these days from where you started, but maybe just philosophically how you view that for Google long term as you do launch into more secondary products other than search. And then just one quick follow-up with the Canadian Government announcing this week that they’ll look to pursue unbundling of TV subscriptions; would you ever consider taking Google Fiber to a market outside of the U.S?
Larry Page: Yes, Dan thanks for the questions. And I think we saw a lot of advertising and we do a modest amount of advertising. I think we find that pretty useful and we’ve gone better at doing it, and I think it's good for our business, it's good for us to understand kind of the advertising perspective from a advertisers point of view given that’s some big business for us. I might want Nikesh to elaborate a little bit on that. In Fiber, I think it's really just early days. We’re just getting going on that.
Nikesh Arora: Yeah, to follow-up on the marketing question, I think we still encourage our product teams to go out there and get their products to be used by users, the [merits] of the products, because we believe that’s all the marketing that they can have. But as our products get more and more popular there are many part of the world we want to make sure there’s awareness for those products and people understand what the capabilities and features are. That’s the only time we bring in marketing to kick in. And the other area we do a lot of marketing in is in trying to make sure that our advertisers understand the advertising opportunity so that they can actually can spend money with us; so that’s roughly how we think about marketing. But the primary focus is definitely on making sure we create great products that users use and the products stand and get (indiscernible) their own merits.
Larry Page: All right. That’s very correct. Let’s go to the next question.
Operator: And we’ll go next to Gene Munster with Piper Jaffray.
Gene Munster: Hi, good afternoon. Question for Larry in terms of, you talked about R&D spending and just the amount that you’re going to be gauging at. Can you talk specifically about self driving cars that realizes way down the road, but how real is this as a business and then separately in terms of CPCs how should we see these -- how should we see enhanced campaigns impacting CPCs over the next few quarters? Thanks.
Larry Page: Okay, great questions from Gene; thank you. So I think, I guess on self driving cars specifically I think for any big innovation I think you overestimate short-term and underestimate long-term, that’s probably good summary for self driving cars. I think we made tremendous progress and we’ve driven large amounts of miles, how we change the business from being something that wasn’t going to happen at all to something that now is somewhere inevitable and people’s feelings about it which I think is tremendous progress. That said it’s still pretty early days from the product, I don’t know exactly what I have been saying but its still ways from being a commercial product. Probably overestimate that in the short-term like I said and underestimate that in the long-term. Now for the second part of the question.
Patrick Pichette: Why don’t I jump in for a second, CPCs. Listen we don’t, because you asked the question about, what do we expect quarter over the coming quarters. We don’t really manage the quarterly CPC trends. We actually focus on the user and the advertiser ROI. So in general right we attribute CPC trends to a combination of those five factors I talked about, FX the three mix effects of mobile versus desktop, emerging markets versus developed markets, the channel mix between our sites and our network, then a number of products and policy changes; that’s really the big driver. I think that we’re really pleased as Nikesh mentioned enhanced campaigns is a great platform that enables us for a future and as long as we actually have the format that delivers the great ROI then enhanced campaigns will just accelerate this in the future and that’s what we’re working on. So, it's really the complex puzzle and it's important that not only we think about CPCs in the context of all the factors I talked about. But what's even more important is the dynamic of those CPCs and page clicks together. That’s really the magic that actually talks about our growth.
Larry Page: All right. Our next question please.
Operator: And we’ll go next to Brian Fitzgerald with Jefferies.
Timothy O'Shea: Yeah, hi it's Tim O'Shea for Brian Pitz. I know it's still early, but can you give us a broad sense for how you’re feeling about the holiday shopping season, and do you have any sense of the updated Google shopping or PLA program has made you better positioned to capitalize this holiday. And then just quickly can you give us a sense of what kind of attraction you’re seeing from the recent implementation of localized PLAs during the quarter? Thanks.
Patrick Pichette: Just to say that we clearly do not, as you all know we don’t give any sense of what's going on in the fourth quarter. We actually just are closing our third quarter so we don’t give forward guidance on any of it. I think maybe Nikesh can give a sense of where PLAs are going in general.
Nikesh Arora: Yeah, thanks Patrick. Tim, I think the important part in PLAs since I mentioned in the prepared remarks is that we are transitioning from giving users answers in terms of links to taking them down to entities and PLAs in a product listing ads is definitely a big step in that direction because we believe that’s a great answer for the user and a good user experience of the long-term especially more interesting in mobile devices. So, from a long-term user experience perspective we believe that is the right direction; that is a good user experience to have, not going to particularly comment how that is going to impact, what happens in the next few weeks, for the next few quarters?
Larry Page: All right. Our next question.
Operator: And we’ll go next to Ken Sena with Evercore.
Ken Sena: Hi, thank you. On Google Play it's my understanding that much of the 30% that developers don’t keep actually goes to carriers and OEMs. So I was just wondering if you can update us maybe on those negotiations and kind of when you see Google maybe receiving a greater portion of plays the economics; and then maybe if you could just update us too on your thoughts on travel. Thank you.
Larry Page: Okay, Nikesh will take the play part there.
Nikesh Arora: Yeah, on Google Play as you know that Google Play has been something that our teams have worked really hard on in the last two years to make sure because that sort of fills out the Android ecosystem and as a key part of making the Android experience a great experience by having great content, great apps on the Google Play system. And in terms of economics, the economics like you said rightfully are shared between developers, carriers, OEMs and us and our key with Google Play is to make sure that there is a robust ecosystem. People like Android devices that provides some great functionality and we believe anybody who brings value to that ecosystem should have economics in that ecosystem once a carrier, OEM or a developer or us. We’re not going to specifically talk about who keeps what part of the economics, but just to say that we’re comfortable with the way the economics work out, and the more important part is, it is helping drive the ecosystem in the right direction.
Larry Page: Also Nikesh on travel.
Nikesh Arora: Yeah, on travel we continue to work on travel. As you know we have a great exciting product on flight search and we have our IDA business and we’re happen with the business the way it is. We are working hard on making sure that the entity level concepts that applies to a product it also applies for travel as in terms of flight search.
Ken Sena: All right. Thank you.
Larry Page: All right. The next question.
Operator: And we will go next to Colin Sebastian with Robert Baird & Co.
Colin Sebastian: Great. Thanks very much. First question is, curious how you guys are thinking about the future of cookies in online advertising, obviously a lot of chatter about privacy issues and perhaps Google working on that ideas and alternative. And then secondly haven’t heard a whole lot about Japan, although we’re seeing pretty -- fairly rapid shift to android in that market, I wonder if you can comment on the Google business Japan and the pace of growth there? Thank you.
Larry Page: Okay. So maybe Nikesh can you address the cookie version?
Nikesh Arora: Yes, I mean, from our perspective we believe that technological enhancements can definitely improve user security in order to make sure that the web continues to remain economically viable in that transition. So we’ve a lot of concept to this area, but it’s very early right now to try and actually elaborate them and talk about what’s going to work, what’s not going to work. But as I said the primary motive is to make sure that we can keep enhancing technologically what’s going on, what’s going to make sure that if we don’t bring the system and you make sure that things stay secure and economically viable. In terms of Japan, as I mentioned Japan has been good for us this quarter. And as you rightfully identified that we’re -- we continue to see robust growth in the sort of the multi screen space. In that market, clearly it’s an early adopter market as it relates to mobility and tablets and devices. So you can -- we’re feeling very good about how the consumer behavior there is and how that translates into advertising.
Larry Page: Next question.
Operator: And we will take our next question from Stephen Ju with Credit Suisse.
Stephen Ju: Larry different question on Google Fiber, if I may. It’s now rolled out in a few regions around the country. Can you share with us some of your early learnings in terms of how consumer behavior changed once the connection speed stepped up materially in this new environment? And what kind of new services or products you think Google can rollout or how your existing services can change for the better? Thanks.
Larry Page: Thanks, Stephen. So I think again it’s very early on Google Fiber. It’s announced in several places I think really rolling out in Kansas City. I think one of the things that’s unique about the Google Fiber offering is that your television service is available right through the data connection. So one big change in having a high-speed data connection is actually the entire kind of television experience, cable TV like experience comes straight through your data connection, through your gigabit connection. And people I think have been pretty excited about that experience being a great experience for watching television actually. So our next question.
Operator: We'll go next to John Blackledge with Cowen and Company.
John Blackledge: Great. Thanks for the question. I wondered if you can review the content strategy at YouTube and the willingness to invest in areas like live sports, like the NFL and how the content strategy would play in the evolution of YouTube over time. Thank you.
Larry Page: Thank you, John, for the question. I think I'll also give this one to Nikesh.
Nikesh Arora: Well, again as we've always said that YouTube is an ecosystem which is a combination of great users, great advertisers and great content and we talk to content providers all the time because we understand that users come to YouTube so that they can enjoy both user-generated content, other forms of content both short form and long form. So we're pretty comfortable that we're making great sort of progress. The number of hours that people watch YouTube continues to go up, the amount of videos uploaded to YouTube continues to go up. And as Larry mentioned, we're seeing a lot of YouTube usage coming out of mobiles. So really our content strategy in YouTube is working. We're constantly talking to people about content all the time and so sure, we will talk to anybody who wants to talk about content. But for now we're happy with where we are. In the end our goal is to help make sure that our users have a good experience, that they get to see the right content on there and our advertisers are able to advertise on that platform.
John Blackledge: Thank you.
Larry Page: Our next question.
Operator: We'll go next to Scott Devitt with Morgan Stanley.
Scott Devitt: Hi, thanks. A bigger picture question for Larry and components of the question have been touched on in the call, but there has been a debate for some time about the Internet becoming more vertical and accelerated by the transition to mobile and if that could serve as a headwind for Google's business, yet your core revenue growth has been remarkably stable for several quarters now, above 20%. And Larry you've talked about this broad topic in prior calls, but I was just wondering if you can give an updated view of the landscape as it relates to your efforts to go deeper into the transition funnel to offset verticalization as well as if you could share your perception of Google's competitive position in a multi-device world versus the legacy desktop, laptop world? And then secondly, any timeline or thoughts that you can give on Project Loon in terms of it becoming a commercial offering? Thanks.
Larry Page: All right. Thanks, Scott, for the questions. So I think – so the first topic is pretty complex topic, I think we're very well positioned in mobile. I've said this before where we have the Android. I think we have tremendous services on Android. And we have obviously search and things that work across many different things. I'm tremendously excited about the funding. We have the potential to really improve people's experience as they move more into mobile and spend more time there and to make those experiences much more efficient and pleasurable and beautiful for those users. Often as I do things with third parties and one thing to keep in mind is we've done a lot of effort around the APIs on Android and we're working with top developers in and around Google Play as a marketplace for those developers. Those things are evolving all the time with the help of some users and help of those developers. So we have a lot of ideas there and a lot of work going on. So I'm actually very, very excited about that. I think we're tremendously well positioned to help them [indiscernible] move along and make users' experiences better and to improve our business from the developers' businesses. I think – even I find I'm spending most of my time now on mobile and not so much on the old desktop world, because I guess a lot of people are going to generally do over time. I think on Project Loon, again it's really early for that. So we announced because we had to, because people are seeing them and they're flying around and so on. But it's a small team, it's very exciting. We've been totally amazed by the positive reaction we've gotten across the world and from high speed and telcos and other people wanting to work with us, which is tremendous, we want to work with all of them. I think I found something important in trying to improve rural Internet access, which is something that if you're one of the significant number of people in a rural area or a place that doesn't have great Internet access now, it is something that really matters to your quality of life. So we're excited about that.
Patrick Pichette: We have time probably for two more questions, so why don't we jump in on the last two. Jamie?
Operator: We'll go next to Heather Bellini with Goldman Sachs.
Heather Bellini: Great. Thank you taking the question. Larry, I just was wondering with advertisers having more choice of broad platforms to use for spending their digital ad dollars and in particular on mobile, I'm just wondering do you see a big acceleration in dollars moving from offline to online, do you see that pace accelerating over the next few years? And also how will Google continue to differentiate itself here?
Larry Page: Yes, I guess I'll give that to Nikesh. I'll just say we've always seen a lot of choices in advertising. We've always competed a while in that market and I think people are definitely getting more and more excited about moving dollars online. For us I think the measurability of it, the strength of the tools that are available and technologies to do that we just see as an amazing opportunity and I think people are more and more realizing them. Nikesh?
Nikesh Arora: Yes, to build on what Larry said I think he's right that we are expecting more and more dollars to move towards these platforms for a variety of reasons. One, there are more options for some more players in the market which are – that means they are all working hard towards the same goal of convincing advertisers and this is the place where the users are and this is where advertisers need to be. Also if you think about what's going on, it's as I said earlier in the context of YouTube, we are going to see more and more video coming on to the web and online mechanisms is more targetable and more addressable. In terms of our differentiation, if you look at what we've done over the last many years is we've actually worked in terms of trying to provide a comprehensive solution across all digital capability whether it's on Google, whether it's off Google, whether it's in our network, whether it's with us, whether it's with partners that are on the web, whether it's with mobile devices, whether it's on desktop devices, whether it's from display ads, search ads or video ads, if you look at it what we're trying to do is we're trying to make sure that when an advertiser wants to reach users, we can provide them a comprehensive solution that they can go ahead and advertise. And if you couple that with measurement which is what sort of makes online so much more compelling that if you are going to look at measurement, look at analytics around it, so advertisers get a lot more information. They have lot more options and of course in the end we want to make sure that we focus on very high quality ads. So if you combine all of those things, we think we can continue to be working towards providing them comprehensive solution and we work really hard with all the players in the ecosystem whether it's publishers, agencies or other media property owners, so we feel good about this.
Larry Page: Our next question.
Operator: We'll go next to Justin Post with Merrill Lynch.
Justin Post: Thank you. A couple of things. First, on the rest of world acceleration, could you let us know if there was any platforms like mobile or products like maybe YouTube that really kind of kicked in the quarter that really help drive that, maybe it was Google Play? And then on Motorola it's now getting close to $1 billion run rate on annual losses. Could you remind us of the synergies that you're seeing with that and why you're encouraged by that and maybe when that could start to turn the other way? Thanks.
Patrick Pichette: So clearly on international, not only is our kind of core search business performing very well, but also as you've seen other revenues which includes the Play platform is actually doing pretty well internationally. So those two are the big contributors for that one. As we stand on Motorola, I mean Larry mentioned it very well at the beginning of the call, right? It is still early days for us. I think that we have Dennis and the team have already made a huge transformation at Motorola. We have now great product quality, the Moto X, the first of the products that have come out and it's actually been very well received, a great product. So the team is now really working on building out marketing and distribution which is the kind of phase of it. So that's the mindset that we put in Motorola. This is not a this quarter or next quarter but much more – a more fundamental kind of optimistic and recent view of the company. So that's how we think of these issues. Thanks, Justin.
Larry Page: We may have time for one more question.
Operator: We'll take our final question from Douglas Anmuth with JPMorgan.
Douglas Anmuth: Great. Thanks for taking the question. Just two things I wanted to ask about. First, just on Enhanced Campaigns, can you give us some sense of what it meant for overall spending in the quarter and then also how do you get advertisers to use the location and time of date, modifiers going forward. And then just on the U.S. business there was a [decel] there of about 500 basis points from last quarter? Patrick you mentioned the networks shifts there obviously, but was there anything else going on there?
Patrick Pichette: No, I mean, on your U.S. network it really is as you know there are changes in policies. They basically affect dramatically more our network and because of our network, think of AFS is really very heavy weighted to U.S., that’s really what’s been the main driver for that change. I will let Nikesh take the front end of the question.
Nikesh Arora: Yes, in terms of enhanced campaigns, I’m not quite sure what do you mean by what it meant for overall spending in the quarter.
Unidentified Analyst: Is it positive, I mean, was it incremental to revenue do you think in the quarter?
Nikesh Arora: Yes, we don’t -- do we say it on the enhanced campaign, so we’re not actually trying to quantify the effect, because we believe its part of your overall experience and its step in the right direction in terms of what you want to achieve. In terms of your question as it relates to location and time of day modifiers. I mean these are requests from advertisers, but to give you an example usually when a car rental company advertises when somebody is in airport, they’re likely to get a higher click through rate and higher conversion than if somebody is searching for car rentals when they’re sitting at the desktop. So the location can be used as a great modifier in terms of advertising, in terms of getting better conversion, that’s just one example. We’ve millions of examples like that where you can actually use location very effectively or time of day very effectively, the traditional example of when I’m hungry you show me an ad more likely to click an ad that offers me restaurant choice or food choice than if I’m not hungry and it’s late at night. So there are different modifiers that allow us to pay different advertising. People shop more at lunch time, so there is a whole bunch of stuff that comes in when you start providing location and time of day modifiers. So I think it’s good. Thank you.
Larry Page: I want to thank everyone for spending so much time with us and turn it over to Patrick.
Patrick Pichette: Just before we close the call, I think we’ve great news to announce. I mean all of you that have worked with us, with the investor community group; you know that Willa Chalmers who is part of our IR team has been kind of missing in action for the last few weeks. I’m just incredibly proud to announce that Jacob Allen Chalmers is now in the world and has arrived a couple of days ago, mom is doing incredibly well, so Willa is doing great too. So just to let you know that she has not disappeared, she is doing great, the whole family is. We are all ecstatic about it and it’s another great kind of Googler addition for the family. So that’s why Willa disappeared for a few weeks. With that, I will turn it back to Larry to close the call.
Larry Page: Thank you all.
Patrick Pichette: Cheers. Jimmy off to you. Thank you.
Operator: Thank you. That does conclude today’s conference. We do appreciate your participation and have a great day. | [
{
"speaker": "Operator",
"text": "Good day everyone and welcome to the Google Inc. Third Quarter 2013 Earnings Conference Call. Today’s conference is being recorded. At this time, I’d like to turn the call over to Ms. Jane Penner, Director, Investor Relations. Please go ahead ma'am."
},
{
"speaker": "Jane Penner",
"text": "Good afternoon, everyone, and welcome to today’s third quarter 2013 earnings conference call. With us are Larry Page, Chief Executive Officer; Patrick Pichette, Senior Vice President and Chief Financial Officer; and Nikesh Arora, Senior Vice President and Chief Business Officer. Also, as you know, we distribute our earnings release through our Investor Relations website located at investor.google.com. So please refer to our IR website for our earnings releases, as well as the supplementary slides that accompany the call. You can also visit our Google+ Investor Relations page for the latest Company news and update, please check it out. This call is also being webcast from investor.google.com. A replay of the call will be available on our website later today. Now, let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward-looking, including statements regarding Google's future investments, our long-term growth and innovation, the expected performance of our businesses, and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on the call, such as operating income and operating margin are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation and restructuring. We’ve also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I’ll turn the call over to Larry."
},
{
"speaker": "Larry Page",
"text": "Thank you. Hi, everyone. Thanks for joining us today. Google had another strong quarter with $14.9 billion in revenue and great product progress. We are closing in our goal of a beautiful, simple, and intuitive experience regardless of your device. Research has shown that people tend to overestimate the impact of technology in the short-term, yet underestimate the scale of change longer term. For years everyone talked about the multi screen world. Now it’s arrived, but on a scale few imagined, people increasingly have more than one device and screens are proliferating in the home as well as wearable screens like watches and Google Glass. When android was still a (indiscernible) project I used to feel kind of guilty visiting the team. We are a search company and building a new operating system wasn’t an obvious move to most people. It turns out that was a lot of (indiscernible) over 1 billion android devices have now been activated worldwide and 1.5 million devices are led off everyday. I’m also tremendously excited about Chromebooks, which are growing fast and defining the more general decline in laptops. It’s like the chrome browser; updates are seamless and frequent improving security and usability. It was a great example of technology doing the hard work, so you can get all the stuff that matters. Two weeks ago we launched the new HP Chromebook 11. Its beautifully designed and light weight and just over 2 pounds and at $279, highly affordable. Best of all, it has a high power micro USB charger that can also charge your android phone. Recharging isn’t too much of a sweat and there is tremendous potential to innovate. So it’s great to see progress here. This quarter we also launched the Moto X. The first one that Motorola has developed and produced since Google acquired the company. Super fast and clean and the voice features are great. While it’s still early days, Dennis and the team have already transformed Motorola’s product quality. Now they’re working to build out marketing and distribution. As screens multiply people navigate across them seamlessly becomes more and more important. That’s why I love Chromecast which we launched in July and immediately became a best seller. On your phone, tablet or laptop and start playing some music from Youtube or a show from Google play or Netflix. One click the content is there on the bigger screen in your home, your TV, all for just $35. And unlike some other streaming devices, you can continue to email search and share as the Chromecast handles the hard work without draining your device battery, genuine multi-tasking in a multi screen world. We’ve also making great progress across devices with Youtube. Almost 40% of Youtube’s traffic now comes from mobile, up from 6% two years ago. And in August we updated our Youtube apps for android and iOS. You can now leave a video playing at the bottom of your screen while you explore other content. Our execution in velocity and search from maps is getting better and better and from a very high base. A new map app for iOS and android shipped in July, but is specifically for downloads to make the most of this larger screens. And in September we’ve rebuilt our entire mobile search experience of a simple card interface that is easy to read and have designed, that is optimized for touch. Our momentum on voice search is tremendous. We added four new languages this quarter making available on over 78 languages and accents. We’ve also expanded the quick answers, we can provide just for you. Fast Google for your flight details and up here instantly in your search results, no digging around in your email required. And the search across Google+ photos is extraordinary. Search for sunsets and all the pictures you've ever taken of sunsets to appear instantly. If you haven't tried it, prepare to be amazed. About two years ago, when I became CEO again, my goal was to ensure that Google maintains the passion and soul of a start-up as we grow. It's why I've worked so hard to increase the velocity and execution. So we create great products people love to use and iterate fast to ensure they get better and better. Because great is just never good enough. When you look across the company, it's amazing how well the teams are executing. For example, we rolled out Enhanced Campaigns in AdWords across all devices for all our advertisers in less than a year. Of course none of this would happen without great people and we are so lucky that we have them. I'd like to thank all the Googlers and Motorolans who make everything possible. Keep up that velocity and execution. Before I hand over to Patrick, I want to let you know that going forward, I won't be joining every earnings call. Patrick and Nikesh do a great job covering our business each quarter and they'll continue to do that great work. I know you all would love to have me on, but you are also depending on me to ruthlessly prioritize my time for the benefit of the business. I'm very confident you are in good hands with Patrick and Nikesh. So now, over to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Larry. Good afternoon, everyone, and thank you for joining us again. Without further ado why don't we just dive into the details of Google's financial performance in Q3? So here we go. Our gross consolidated revenue was just shy of $15 billion at $14.9 billion. The overall business was up 6% quarter-over-quarter and 12% year-over-year. Our Google segment, gross revenue grew a healthy 19% year-over-year to $13.8 billion and was up 5% quarter-over-quarter without currency fluctuations, Google segment revenue would have actually grown 21% year-over-year and the currency impact on sequential growth was actually immaterial in our case this quarter. Google sites revenue was up 22% year-over-year to $9.4 billion and was up 6% quarter-over-quarter, driven by the strength in our core search advertising business. The advertising policy decisions that we implemented earlier this year to ensure good user experience continued to negatively impact Google's network revenue in the short term, and therefore our network revenue was in fact flat year-over-year to $3.1 billion and was down 1% quarter-over-quarter. Despite the short-term pressures we continue to believe that this is clearly the right answer for our users and shareholders in the long term. And finally to finish Google's segment on a positive note, Google's other revenue grew 85% year-over-year to $1.2 billion and was up 18% quarter-over-quarter. Digital sales of apps and content in our Play store drove year-over-year and quarter-over-quarter growth in this line. Turning to Motorola segment, our gross revenue there was $1.2 billion. As Larry mentioned, while it's still the early days, Dennis and the team have already transformed Motorola's product quality and they're working now at building marketing and distribution. By the way, some of you may have noticed that our total consolidated revenue does not exactly equal to some of our segment revenue this quarter. This is driven by new transactions in our Motorola segment resulting in intersegment and certain deferred revenues that are eliminated in our consolidated results. Coming back to our Google segment, our global aggregate paid click growth was strong this quarter, up 26% year-over-year, 8% quarter-over-quarter. Our aggregate cost-per-click was down 8% year-over-year and down 12% quarter-over-quarter. And we should note that the currency fluctuations had a real minimal impact on Q3 cost-per-click. Once again, I wish to remind everyone that our monetization metrics continue to be impacted by a whole set of factors discussed on previous calls. They include geographic mix, channel mix, property mix as well as product and policy changes. Turning to geographic performance of our Google segment, we continue to see steady performance in the U.S. and the U.K. and strong performance in the rest of the world. In our earnings slides, which you can find on our Investor Relations website, you'll see that we've broken down our revenue by U.S., U.K. and rest of world to show the impact of FX and the benefits from our hedging program. So please refer to those slides for the exact calculation. The U.S. revenue was up 13% year-over-year to $6.1 billion and it's worth noting that network revenue that I mentioned a bit earlier which continues to be impacted by ongoing policy decisions skew toward the U.S. The U.K. was up 14% year-over-year to $1.4 billion which includes a small $17 million benefit from our hedging program. In fixed FX the U.K. grew 15% year-over-year. In our non-U.S. revenue excluding the U.K. accounted for 46% of total revenue or $6.3 billion. This was up 28% year-over-year which includes a $5 million benefit from our hedging program and in fixed FX terms, our rest of world actually grew 32% year-over-year. Coming back to an aggregate level for the total consolidated business, our non-GAAP other cost of revenue was $3.3 billion in Q3 excluding SBC and Motorola restructuring. Our non-GAAP operating expenses totaled 4.3 billion again excluding SBC and Motorola restructuring. For a non-GAAP operating profit was $4.3 billion in Q3 resulting in non-GAAP operating margin for the consolidated business of 29%. For Google segment our traffic acquisition costs were $3 billion or 24% of total advertising revenue. Our other cost of revenue was $2.3 billion excluding $133 million of SBC. Google segment operating expenses were $3.9 billion also excluding SBC of $723 million. Depreciation and amortization expense on our property, plant and equipment for the Google segment was $630 million this quarter. And our Google segment operating profit as a result was a strong $4.6 billion in Q3 resulting in Google segment operating margin of 34%. At Motorola our total segment operating expenses including cost of revenue were $1.4 billion. That excludes $30 million of stock-based compensation and $12 million of Motorola restructuring charges. Please keep in mind that intangible amortization expense attributed to the Google segment and Motorola are in fact included in these segment measures. Of the $281 million in consolidated intangible amortization expense in the quarter, $153 million was the result of the acquisition of Motorola of which $116 million was allocated to Google segment and $37 million allocated to the Motorola segment. And as a result, the operating loss at Motorola segment was $248 million in Q3 and operating margins for that segment were negative 21%. Headcount for the consolidated business was roughly 1,500 people, up in Q3. The Google segment added just about 2,000 people during the quarter and in total the consolidated company ended the quarter with approximately 46,000 full-time employees. Our effective tax rate was 15% in Q3. Our tax rate this quarter was impacted by the continued mix shift of earnings between our domestic and international subsidiaries. Let me now turn to cash management. Our other income and expense was 24 million for this quarter. The impact of FAS 133 expense from our hedging program and realized losses mostly offset interest income in this quarter. And as you know we often get questions on quarter-to-quarter volatility of our hedging costs. So to help everyone understand this better, we put together a video tutorial on the topic. You can find the new video on our Investor Relations website. I hope you find it helpful and let us know what you think. For more detail on OI&E, please again refer to the slides that accompany this call on our IR website. We continue to be happy with our strong operating cash flow at $5.1 billion. CapEx for the quarter was $2.3 billion. This quarter the majority of our CapEx was spent on production equipment, data center construction and real estate purchases. As I mentioned last quarter during my remarks, we continue to invest for the long term and our infrastructure continues to be a key strategic area of investment for us. Consequently, our free cash flow was $2.8 billion, very strong again. So there you have it. Strong results and an optimism that provides us the confidence to fund strategic growth fully in the opportunities, areas including Mobile Business, Android, Chrome, YouTube, Enterprise just to name a few. With that I’ll hand it off to Nikesh, who’ll cover more details of our business performance in the quarter and after these remarks we’ll open up the phone lines for questions. Here you go, Nikesh."
},
{
"speaker": "Nikesh Arora",
"text": "Thank you, Patrick. As Patrick mentioned our business had a strong quarter with $13.8 billion in Google segment gross revenue. Overall performance was strong in the retail sector. We had good growth in Japan, South Korea and Australia. There are three key areas I want to talk about today, that are big growth drivers for us and our partners. First; our continued efforts to make advertising seamless, effective and measurable across multiple screens. Second; our progress in bringing bad advertisers online with a special emphasis on our efforts that are on Youtube; and third our early investments in commerce and shopping to help users, retailers and merchants. And last say a few words about newly areas like digital content, hardware and enterprise. On seamless advertising; it's been a few months since our advertisers moved over to enhanced campaigns and AdWords. Clients are telling us they like the new system. Many are still adjusting their campaigns and keywords and developing their multi-screen bidding strategies. For example; we’re seeing advertisers bidding more frequently in mobile keywords because enhanced campaigns makes it so much easier to do so. They’re discovering how they can use the needed capabilities in mobile and their ads, like location Click2Call. Example is discover who has just increased their mobile spend and used it to promote their [it card]. Talking about mobile, we’ve also launched cross device measurement tools and analytics. There are three observations here. First; mobile is driving higher online conversion. American Apparels found that mobile ads were actually driving 16% more conversions than they initially thought and as a result they’re now investing more to drive more sales. Second, mobile drives more phone calls. On average there are more than 40 million calls driven by Google ads every month, this is twice as much as it was a year ago. Third, mobile drives in-store traffic. Moving over to brand in YouTube. You’ve seen that our CPG and entertainment clients have moved online at greater speed with our efforts that are on brand. Spend by our CPG clients on displaying YouTube has grown over 75% over the past two years. For example, the Google YouTube campaign for Dove’s Camera Shy brand in more than 20 countries and delivered over 62 million views for Unilever. We’re also partnering very closely with agencies, we really like integrating our technology, insights and media with their creativity and client relationships. For agencies, marketers and Googlers it's a huge win, win, win. All of the top 10 global agencies now use our DoubleClick products. On the other side YouTube continues to do well. Video ads which include CUview now form a significant part of our YouTube in brand advertising and they’re growing north of 75% year-over-year. We found that YouTube is our brand torch bearer. It offers brands valuable engaged audiences, terrific reach and compelling context. Smart brands are really loving their engagement with YouTube. Moving on to commerce and shopping. As Google search moves to provide people with answers and entities not just links, we’re making good progress helping people take commercial access too like buying products. We’re seeing great traction on product listing ads both in desktop and mobile. As part of this moved to a seamless purchasing experience we’re also helping retailers offer better payment solutions to their customers particularly on mobile where it's traditionally been difficult. Google Wallet InstaBuy helps merchants here up implementing instant buy Google (indiscernible) saw that from May to August users of Google Wallet on their Android app had a purchase conversion rate that was four times higher than other shoppers. Finally I want to talk about an area which we’re being putting more emphasis on which is our investment in emerging non-ads businesses. As we mentioned last quarter, we continue to see acceleration in the new businesses such as hardware, digital content and enterprise. As Larry mentioned Chromecast and Chromebooks are enjoying great success. Chromebooks are now available in over 8000 locations around the world and are being used in more than 20% of school districts in United States. We’re also rolling out unified Google experience in more than 750 Best Buy stores to showcase Chromebooks, Chromecast and the newest Nexus devices under our one Google branded design. On digital apps and content we continue to work hard to roll out Google Play in more markets around the world and add content to it. For instance this quarter to help students go back to school we added a comprehensive catalogue of textbooks to Google Play Books for rental purchase. We brought on content partners like HBO and DC Entertainment. This quarter we brought Play Music to eight more countries and Play Books to 18 new countries. So for example now users in Russia can enjoy music and users in Indonesia can enjoy books. There’s tremendous momentum here and we look forward to making progress in this area. Another strong area of recovering and growing revenue is our enterprise software business, making available the best of Google for work. Some great new clients this quarter include whirlpool which is now using Google Apps to help 30,000 employees collaborate and innovate more quickly. In education, apps for education is being used by 30 million students, faculty and staff worldwide. Beyond apps, Amtrak uses Google Maps to let people see all the trains in the U.S. in real time, and we’re continuing to invest in the Google Cloud Platform which has over 300,000 customers including Sanmina, a Fortune 500 Company using cloud platforms to build internal applications that improve their efficiency across their offices globally. Lastly let me call out the efforts of our marketing team that continues to roll out the Google Welcome Mat to the world. To put on our third annual Google Science Fair honoring 15 global finalists from the ages of 13 to 18 from around the world where we hosted 400 partners and customers who are at our Annual Site Cast Event, more interestingly to introduce the newest version of Android called KitKat, we’ve built a partnership with Nestle to get more than 50 million special Android KitKat chocolate bars on store shelves around the world. And I have to give a shout out to the wonderful ad for our Nexus devices featuring the great sport of cricket that our marketing team is running in Australia, that’s a bit of a personal favorite sport. With that, let me hand it over to Patrick. Thank you again to all the Googlers for all their hard work in getting us here."
},
{
"speaker": "Patrick Pichette",
"text": "So there you have it folks. Why don’t we have Jamie turn on the lines and then we’ll take your questions. So Jamie, over to you."
},
{
"speaker": "Operator",
"text": "Thank you, sir. (Operator Instructions) And we’ll take our first question from Mark Mahaney with RBC Capital Markets."
},
{
"speaker": "Mark Mahaney",
"text": "Great, two questions please. Could you talk about how long you think it will take for advertisers to move over to fully embrace the multi-screen advertising world which enhanced campaign should enable or facilitate. And then secondly the skunk’s works question, voice recognition technology at the Company I think it’s something you’ve been working on for years, I think it's what enables wearable devices in the future. Can you talk about how far along you are in developing a technology to be where you want it to be? Thank you."
},
{
"speaker": "Larry Page",
"text": "Yeah; thanks Mark for the questions. I think the first part of your question I’ll to send Nikesh in a minute and I’ll take the voice recognition question. I think we made tremendous progress on voice recognition. Even in period of months probably the last couple of months or six months the accuracy has gone up quite a bit. If you haven't tried it, I’d really recommend you to try that, it's super fast, on the motor axe, you can say, okay Google now, even if your phone is turned off it will turn on and answer your question. So, I think we’re super excited about that, and I think we made tremendous strives and we’ll continue to improve accuracy in that and to make the products better. But I think they’re already super useful and we have a lot of usage coming from voice. So Nikesh, in the enhanced campaigns."
},
{
"speaker": "Nikesh Arora",
"text": "Hey, Mark as you know on the topic of enhanced campaigns the challenge we had as we moved into a multi-screen world was, everybody was producing solutions where we had to basically run campaigns on different devices in a different way because it's this evolution that happened from desktop to mobile to video ads et cetera. And effectively what our team working with Susan and Sheila’s team have been able to do is to provide one single interface and one single mechanism to be able to manage our campaigns across multiple devices. Now that’s a good thing because it improves process, let’s them see the ROI across various devices with the analytic tools that we’ve come up with. But also there’s a lot of work that needs to happen on the advertisers side because they have to develop beautiful experiences for their customers on mobile devices as well as on their screen. So I think it's a process where we’re all going through this together, advertisers love this new mechanism. They’re adjusting their keywords and they’re bidding models based on all this new effort and we’re seeing great progress in terms people are already advertising those. But not only that, we’re also working with all of our advertisers to make sure they have great experiences on their other screens and other devices so that they can truly leverage this. So, I think this is definitely the sort of the first set of steps we’ve taken to towards future or multi-screen devices and multi-screen advertising but we think this is the way things are going to keep evolving."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you."
},
{
"speaker": "Mark Mahaney",
"text": "Thanks, Larry."
},
{
"speaker": "Patrick Pichette",
"text": "Jamie, why don't we go to our next call?"
},
{
"speaker": "Operator",
"text": "We'll take our next question from Ben Schachter with Macquarie."
},
{
"speaker": "Ben Schachter",
"text": "Larry, can you discuss Google's overall ecommerce strategy, how the Knowledge Graph structure data plays into it and generally how Google can improve the users' ecommerce experience? And then Nikesh, you touched briefly on the brand efforts and I was looking at some data recently that shows that over the past 15 years virtually all the games for online advertising has come at the extent of print and radio and none of it has come from television budgets. What specifically is happening now that makes you think it's more likely for the television dollars to finally begin to come online and to Google in particular? And then just a quick housekeeping one for Patrick. Can you just give us a bit more detail on how the accounting works for the intersegment transactions and how it impacts the consolidated model? Thanks."
},
{
"speaker": "Larry Page",
"text": "Like a three-way question [indiscernible]. So I think on the ecommerce side, I think Google's been used for e-commerce for forever and we're really excited about doing a better job of that. I think we want to remove friction when people are buying online or in the real world. We know people often click on an ad in a mobile device and then make their purchase on the laptop or they might in fact buy it in the store and we need to really get the conversion data there to the advertiser. So I think we've done work across all those things, across multi-screens, multi-devices from online to offline. We recently launched cross-device measurement in AdWords and we're also just trying to make it easier for people to buy things in general. It's as simple as that's same day shipping in local inventory and search. Like I said, we're just looking to reduce friction and we're very excited about that."
},
{
"speaker": "Nikesh Arora",
"text": "Yes. Hi, Ben. If you look at the last 15 years of history like you talk about, a lot of the gains of online advertising have actually come at the expense of what we would call performance advertising. Anytime you wanted to interact with users, get people to come into your store, get people to buy your product, get people to click on your website, all those gains have happened in performance which has been great. But what's beginning to happen is as the watch time on various online video sites continues to grow, as more and more online video begins to be available in a nonlinear fashion in television screens or recent as Larry talked about Chromecast, that stuff or a bunch of the gaming devices, a bunch of other TV solutions, they're beginning to see a lot more watch time being expended either on your desktop or on your multi-screen devices or even on your television. As that begins to happen that advertising is more addressable, more directly attributable and provides more measurement and capabilities. So we believe that that's definitely a more superior opportunity for advertisers to be able to attract their brand customers and actually know who's at the other end. So I think that trend is definitely in the right direction and we're getting upward."
},
{
"speaker": "Patrick Pichette",
"text": "So why don't I take the last question which was the housekeeping item. Actually this is pretty straightforward change, Ben. So in Q3 our Motorola and Google segments purchased and sold services to each other and these transactions are reflected in our Google and Motorola segment revenues. The main thing analysts need to realize as they update their model this time is that the total consolidated revenue will no longer necessarily like in the quarters where there is transaction between the two equal the sum of the Google and Motorola segment revenues. So analysts who currently sum up our segment revenues and profits to derive consolidated estimates should need to model in elimination lines for the intersegment revenue and profit in order to get their consolidated estimates. So that's simple as that. Thanks for the questions. So, Jamie, why don't we go – thanks, Ben – to our next caller."
},
{
"speaker": "Operator",
"text": "We'll go next to Carlos Kirjner with Sanford Bernstein."
},
{
"speaker": "Carlos Kirjner",
"text": "Thank you. Larry, I hope that when you come up with voice recognition, it can deal with funny accents. Anyway the perception by people outside the company is that Google spends a material amount in long-term R&D that will not generate revenue in the next two years or so. Larry, can you help us understand how you think about funding this project and how much do they correspond versus your total R&D budget? And secondly, Patrick, you said in the past that CapEx is lumpy and we should expect fluctuations but now we have had three quarters of what looks like high CapEx versus recent past. Have the last few quarters been normal? Thank you."
},
{
"speaker": "Larry Page",
"text": "Yes, thanks, Carlos. I think we definitely are working on accents, so I appreciate that. I think that on the long-term R&D question, I think we don't break all this on detail, but I would say that, my stronghold in general is to get people to spend money on long-term R&D. In most companies I think even companies that have significant R&D budgets, if you look at that maybe 99% of it ends up being really incremental, which is relatively small improvements to kind of your existing businesses, and maybe 1% of that ends up being kind of true long-term things like Android was when it got started. So I think I kind of view my job as the opposite thing is to get people to spend on the long-term R&D. I do think people have a perception that's material. I don't think that – that's not been my experience and so it's very hard to actually spend money on long-term things in any kind of meaningful way. And even the investments we've announced, things like Calico or rather an absolute dollar number's probably significant amounts, they're not significant for Google. And I think you should actually be asking me to make more significant investments. I wish I knew how to do that but I think it's actually very difficult to spend kind of meaningful amounts of money relative to goal scale on things that are speculative."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Larry. Carlos, on the issue of CapEx just to reiterate the fact that the majority of the CapEx this quarter was spent on production equipment, so like machines, data center construction looking ahead and building the capacity ahead of our needs to get the flexibility and real estate purchases, so we had a number of kind of really good opportunistic purchases in the portfolio we were targeting and they kind of came online this quarter, so pretty pleased with that. I think that overall investors should see this as a very positive sign and a positive signal. As I mentioned last quarter during my remarks, we continue to invest really for the long term and just a conversation we're having with Larry on the topic of R&D. And our infrastructure continues to be a key strategic area for investment for us. It's really important that when we see signals of or opportunities where we need capacity, the worst thing for us would be to actually not have it in terms of machines and data center capacity. So the strategic value of having it for flexibility for our long-term positions are really important. That's what you see reflected in our investments right now. So thank you for your question, Carlos."
},
{
"speaker": "Carlos Kirjner",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Jamie, let's go to our next call, please."
},
{
"speaker": "Operator",
"text": "We'll go next to Ross Sandler with Deutsche Bank."
},
{
"speaker": "Ross Sandler",
"text": "Thanks. Larry, just to follow-up on Ben's question earlier, it seems like you guys have all the pieces in place with Android, with Maps, with Google Now, Wallet, credit card information in the Play store to kind of vertically integrate the experience from research search to purchase in the local and transactional areas, kind of the closing of the loop if you will. So can you just elaborate on the overall strategy and how does the recent cross screen conversion estimates enhance play into that? Thanks."
},
{
"speaker": "Larry Page",
"text": "Thanks, Ross. We have all positions available [indiscernible]. I think we certainly agree with that. I think it was a pretty good description of me. We all account many different pieces of your commercial experiences. I think in general I mean now our experience for users is not that seamless and there is lots of different pieces of technology and processes in order to make commerce happen and so on. So I think we have got something we absolutely are looking at improving about closing the loop and so on. I mean I think your question actually is pretty good, so really I don't know that I can add much more."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you for your question. Jamie, let's go to the next caller please."
},
{
"speaker": "Operator",
"text": "We'll go next to Dan Salmon with BMO Capital Markets."
},
{
"speaker": "Dan Salmon",
"text": "Hi. Good afternoon, guys. My question was for Larry. Since you've come back into the CEO's role, one of the things we've noticed with Google is that your own advertising spending has moved up and once upon a time Google was a company that didn't need to advertise and obviously you're in a lot more businesses these days from where you started, but maybe just philosophically how you view that for Google long term as you do launch into more secondary products other than search. And then just one quick follow-up with the Canadian Government announcing this week that they’ll look to pursue unbundling of TV subscriptions; would you ever consider taking Google Fiber to a market outside of the U.S?"
},
{
"speaker": "Larry Page",
"text": "Yes, Dan thanks for the questions. And I think we saw a lot of advertising and we do a modest amount of advertising. I think we find that pretty useful and we’ve gone better at doing it, and I think it's good for our business, it's good for us to understand kind of the advertising perspective from a advertisers point of view given that’s some big business for us. I might want Nikesh to elaborate a little bit on that. In Fiber, I think it's really just early days. We’re just getting going on that."
},
{
"speaker": "Nikesh Arora",
"text": "Yeah, to follow-up on the marketing question, I think we still encourage our product teams to go out there and get their products to be used by users, the [merits] of the products, because we believe that’s all the marketing that they can have. But as our products get more and more popular there are many part of the world we want to make sure there’s awareness for those products and people understand what the capabilities and features are. That’s the only time we bring in marketing to kick in. And the other area we do a lot of marketing in is in trying to make sure that our advertisers understand the advertising opportunity so that they can actually can spend money with us; so that’s roughly how we think about marketing. But the primary focus is definitely on making sure we create great products that users use and the products stand and get (indiscernible) their own merits."
},
{
"speaker": "Larry Page",
"text": "All right. That’s very correct. Let’s go to the next question."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Gene Munster with Piper Jaffray."
},
{
"speaker": "Gene Munster",
"text": "Hi, good afternoon. Question for Larry in terms of, you talked about R&D spending and just the amount that you’re going to be gauging at. Can you talk specifically about self driving cars that realizes way down the road, but how real is this as a business and then separately in terms of CPCs how should we see these -- how should we see enhanced campaigns impacting CPCs over the next few quarters? Thanks."
},
{
"speaker": "Larry Page",
"text": "Okay, great questions from Gene; thank you. So I think, I guess on self driving cars specifically I think for any big innovation I think you overestimate short-term and underestimate long-term, that’s probably good summary for self driving cars. I think we made tremendous progress and we’ve driven large amounts of miles, how we change the business from being something that wasn’t going to happen at all to something that now is somewhere inevitable and people’s feelings about it which I think is tremendous progress. That said it’s still pretty early days from the product, I don’t know exactly what I have been saying but its still ways from being a commercial product. Probably overestimate that in the short-term like I said and underestimate that in the long-term. Now for the second part of the question."
},
{
"speaker": "Patrick Pichette",
"text": "Why don’t I jump in for a second, CPCs. Listen we don’t, because you asked the question about, what do we expect quarter over the coming quarters. We don’t really manage the quarterly CPC trends. We actually focus on the user and the advertiser ROI. So in general right we attribute CPC trends to a combination of those five factors I talked about, FX the three mix effects of mobile versus desktop, emerging markets versus developed markets, the channel mix between our sites and our network, then a number of products and policy changes; that’s really the big driver. I think that we’re really pleased as Nikesh mentioned enhanced campaigns is a great platform that enables us for a future and as long as we actually have the format that delivers the great ROI then enhanced campaigns will just accelerate this in the future and that’s what we’re working on. So, it's really the complex puzzle and it's important that not only we think about CPCs in the context of all the factors I talked about. But what's even more important is the dynamic of those CPCs and page clicks together. That’s really the magic that actually talks about our growth."
},
{
"speaker": "Larry Page",
"text": "All right. Our next question please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Brian Fitzgerald with Jefferies."
},
{
"speaker": "Timothy O'Shea",
"text": "Yeah, hi it's Tim O'Shea for Brian Pitz. I know it's still early, but can you give us a broad sense for how you’re feeling about the holiday shopping season, and do you have any sense of the updated Google shopping or PLA program has made you better positioned to capitalize this holiday. And then just quickly can you give us a sense of what kind of attraction you’re seeing from the recent implementation of localized PLAs during the quarter? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Just to say that we clearly do not, as you all know we don’t give any sense of what's going on in the fourth quarter. We actually just are closing our third quarter so we don’t give forward guidance on any of it. I think maybe Nikesh can give a sense of where PLAs are going in general."
},
{
"speaker": "Nikesh Arora",
"text": "Yeah, thanks Patrick. Tim, I think the important part in PLAs since I mentioned in the prepared remarks is that we are transitioning from giving users answers in terms of links to taking them down to entities and PLAs in a product listing ads is definitely a big step in that direction because we believe that’s a great answer for the user and a good user experience of the long-term especially more interesting in mobile devices. So, from a long-term user experience perspective we believe that is the right direction; that is a good user experience to have, not going to particularly comment how that is going to impact, what happens in the next few weeks, for the next few quarters?"
},
{
"speaker": "Larry Page",
"text": "All right. Our next question."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Ken Sena with Evercore."
},
{
"speaker": "Ken Sena",
"text": "Hi, thank you. On Google Play it's my understanding that much of the 30% that developers don’t keep actually goes to carriers and OEMs. So I was just wondering if you can update us maybe on those negotiations and kind of when you see Google maybe receiving a greater portion of plays the economics; and then maybe if you could just update us too on your thoughts on travel. Thank you."
},
{
"speaker": "Larry Page",
"text": "Okay, Nikesh will take the play part there."
},
{
"speaker": "Nikesh Arora",
"text": "Yeah, on Google Play as you know that Google Play has been something that our teams have worked really hard on in the last two years to make sure because that sort of fills out the Android ecosystem and as a key part of making the Android experience a great experience by having great content, great apps on the Google Play system. And in terms of economics, the economics like you said rightfully are shared between developers, carriers, OEMs and us and our key with Google Play is to make sure that there is a robust ecosystem. People like Android devices that provides some great functionality and we believe anybody who brings value to that ecosystem should have economics in that ecosystem once a carrier, OEM or a developer or us. We’re not going to specifically talk about who keeps what part of the economics, but just to say that we’re comfortable with the way the economics work out, and the more important part is, it is helping drive the ecosystem in the right direction."
},
{
"speaker": "Larry Page",
"text": "Also Nikesh on travel."
},
{
"speaker": "Nikesh Arora",
"text": "Yeah, on travel we continue to work on travel. As you know we have a great exciting product on flight search and we have our IDA business and we’re happen with the business the way it is. We are working hard on making sure that the entity level concepts that applies to a product it also applies for travel as in terms of flight search."
},
{
"speaker": "Ken Sena",
"text": "All right. Thank you."
},
{
"speaker": "Larry Page",
"text": "All right. The next question."
},
{
"speaker": "Operator",
"text": "And we will go next to Colin Sebastian with Robert Baird & Co."
},
{
"speaker": "Colin Sebastian",
"text": "Great. Thanks very much. First question is, curious how you guys are thinking about the future of cookies in online advertising, obviously a lot of chatter about privacy issues and perhaps Google working on that ideas and alternative. And then secondly haven’t heard a whole lot about Japan, although we’re seeing pretty -- fairly rapid shift to android in that market, I wonder if you can comment on the Google business Japan and the pace of growth there? Thank you."
},
{
"speaker": "Larry Page",
"text": "Okay. So maybe Nikesh can you address the cookie version?"
},
{
"speaker": "Nikesh Arora",
"text": "Yes, I mean, from our perspective we believe that technological enhancements can definitely improve user security in order to make sure that the web continues to remain economically viable in that transition. So we’ve a lot of concept to this area, but it’s very early right now to try and actually elaborate them and talk about what’s going to work, what’s not going to work. But as I said the primary motive is to make sure that we can keep enhancing technologically what’s going on, what’s going to make sure that if we don’t bring the system and you make sure that things stay secure and economically viable. In terms of Japan, as I mentioned Japan has been good for us this quarter. And as you rightfully identified that we’re -- we continue to see robust growth in the sort of the multi screen space. In that market, clearly it’s an early adopter market as it relates to mobility and tablets and devices. So you can -- we’re feeling very good about how the consumer behavior there is and how that translates into advertising."
},
{
"speaker": "Larry Page",
"text": "Next question."
},
{
"speaker": "Operator",
"text": "And we will take our next question from Stephen Ju with Credit Suisse."
},
{
"speaker": "Stephen Ju",
"text": "Larry different question on Google Fiber, if I may. It’s now rolled out in a few regions around the country. Can you share with us some of your early learnings in terms of how consumer behavior changed once the connection speed stepped up materially in this new environment? And what kind of new services or products you think Google can rollout or how your existing services can change for the better? Thanks."
},
{
"speaker": "Larry Page",
"text": "Thanks, Stephen. So I think again it’s very early on Google Fiber. It’s announced in several places I think really rolling out in Kansas City. I think one of the things that’s unique about the Google Fiber offering is that your television service is available right through the data connection. So one big change in having a high-speed data connection is actually the entire kind of television experience, cable TV like experience comes straight through your data connection, through your gigabit connection. And people I think have been pretty excited about that experience being a great experience for watching television actually. So our next question."
},
{
"speaker": "Operator",
"text": "We'll go next to John Blackledge with Cowen and Company."
},
{
"speaker": "John Blackledge",
"text": "Great. Thanks for the question. I wondered if you can review the content strategy at YouTube and the willingness to invest in areas like live sports, like the NFL and how the content strategy would play in the evolution of YouTube over time. Thank you."
},
{
"speaker": "Larry Page",
"text": "Thank you, John, for the question. I think I'll also give this one to Nikesh."
},
{
"speaker": "Nikesh Arora",
"text": "Well, again as we've always said that YouTube is an ecosystem which is a combination of great users, great advertisers and great content and we talk to content providers all the time because we understand that users come to YouTube so that they can enjoy both user-generated content, other forms of content both short form and long form. So we're pretty comfortable that we're making great sort of progress. The number of hours that people watch YouTube continues to go up, the amount of videos uploaded to YouTube continues to go up. And as Larry mentioned, we're seeing a lot of YouTube usage coming out of mobiles. So really our content strategy in YouTube is working. We're constantly talking to people about content all the time and so sure, we will talk to anybody who wants to talk about content. But for now we're happy with where we are. In the end our goal is to help make sure that our users have a good experience, that they get to see the right content on there and our advertisers are able to advertise on that platform."
},
{
"speaker": "John Blackledge",
"text": "Thank you."
},
{
"speaker": "Larry Page",
"text": "Our next question."
},
{
"speaker": "Operator",
"text": "We'll go next to Scott Devitt with Morgan Stanley."
},
{
"speaker": "Scott Devitt",
"text": "Hi, thanks. A bigger picture question for Larry and components of the question have been touched on in the call, but there has been a debate for some time about the Internet becoming more vertical and accelerated by the transition to mobile and if that could serve as a headwind for Google's business, yet your core revenue growth has been remarkably stable for several quarters now, above 20%. And Larry you've talked about this broad topic in prior calls, but I was just wondering if you can give an updated view of the landscape as it relates to your efforts to go deeper into the transition funnel to offset verticalization as well as if you could share your perception of Google's competitive position in a multi-device world versus the legacy desktop, laptop world? And then secondly, any timeline or thoughts that you can give on Project Loon in terms of it becoming a commercial offering? Thanks."
},
{
"speaker": "Larry Page",
"text": "All right. Thanks, Scott, for the questions. So I think – so the first topic is pretty complex topic, I think we're very well positioned in mobile. I've said this before where we have the Android. I think we have tremendous services on Android. And we have obviously search and things that work across many different things. I'm tremendously excited about the funding. We have the potential to really improve people's experience as they move more into mobile and spend more time there and to make those experiences much more efficient and pleasurable and beautiful for those users. Often as I do things with third parties and one thing to keep in mind is we've done a lot of effort around the APIs on Android and we're working with top developers in and around Google Play as a marketplace for those developers. Those things are evolving all the time with the help of some users and help of those developers. So we have a lot of ideas there and a lot of work going on. So I'm actually very, very excited about that. I think we're tremendously well positioned to help them [indiscernible] move along and make users' experiences better and to improve our business from the developers' businesses. I think – even I find I'm spending most of my time now on mobile and not so much on the old desktop world, because I guess a lot of people are going to generally do over time. I think on Project Loon, again it's really early for that. So we announced because we had to, because people are seeing them and they're flying around and so on. But it's a small team, it's very exciting. We've been totally amazed by the positive reaction we've gotten across the world and from high speed and telcos and other people wanting to work with us, which is tremendous, we want to work with all of them. I think I found something important in trying to improve rural Internet access, which is something that if you're one of the significant number of people in a rural area or a place that doesn't have great Internet access now, it is something that really matters to your quality of life. So we're excited about that."
},
{
"speaker": "Patrick Pichette",
"text": "We have time probably for two more questions, so why don't we jump in on the last two. Jamie?"
},
{
"speaker": "Operator",
"text": "We'll go next to Heather Bellini with Goldman Sachs."
},
{
"speaker": "Heather Bellini",
"text": "Great. Thank you taking the question. Larry, I just was wondering with advertisers having more choice of broad platforms to use for spending their digital ad dollars and in particular on mobile, I'm just wondering do you see a big acceleration in dollars moving from offline to online, do you see that pace accelerating over the next few years? And also how will Google continue to differentiate itself here?"
},
{
"speaker": "Larry Page",
"text": "Yes, I guess I'll give that to Nikesh. I'll just say we've always seen a lot of choices in advertising. We've always competed a while in that market and I think people are definitely getting more and more excited about moving dollars online. For us I think the measurability of it, the strength of the tools that are available and technologies to do that we just see as an amazing opportunity and I think people are more and more realizing them. Nikesh?"
},
{
"speaker": "Nikesh Arora",
"text": "Yes, to build on what Larry said I think he's right that we are expecting more and more dollars to move towards these platforms for a variety of reasons. One, there are more options for some more players in the market which are – that means they are all working hard towards the same goal of convincing advertisers and this is the place where the users are and this is where advertisers need to be. Also if you think about what's going on, it's as I said earlier in the context of YouTube, we are going to see more and more video coming on to the web and online mechanisms is more targetable and more addressable. In terms of our differentiation, if you look at what we've done over the last many years is we've actually worked in terms of trying to provide a comprehensive solution across all digital capability whether it's on Google, whether it's off Google, whether it's in our network, whether it's with us, whether it's with partners that are on the web, whether it's with mobile devices, whether it's on desktop devices, whether it's from display ads, search ads or video ads, if you look at it what we're trying to do is we're trying to make sure that when an advertiser wants to reach users, we can provide them a comprehensive solution that they can go ahead and advertise. And if you couple that with measurement which is what sort of makes online so much more compelling that if you are going to look at measurement, look at analytics around it, so advertisers get a lot more information. They have lot more options and of course in the end we want to make sure that we focus on very high quality ads. So if you combine all of those things, we think we can continue to be working towards providing them comprehensive solution and we work really hard with all the players in the ecosystem whether it's publishers, agencies or other media property owners, so we feel good about this."
},
{
"speaker": "Larry Page",
"text": "Our next question."
},
{
"speaker": "Operator",
"text": "We'll go next to Justin Post with Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "Thank you. A couple of things. First, on the rest of world acceleration, could you let us know if there was any platforms like mobile or products like maybe YouTube that really kind of kicked in the quarter that really help drive that, maybe it was Google Play? And then on Motorola it's now getting close to $1 billion run rate on annual losses. Could you remind us of the synergies that you're seeing with that and why you're encouraged by that and maybe when that could start to turn the other way? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "So clearly on international, not only is our kind of core search business performing very well, but also as you've seen other revenues which includes the Play platform is actually doing pretty well internationally. So those two are the big contributors for that one. As we stand on Motorola, I mean Larry mentioned it very well at the beginning of the call, right? It is still early days for us. I think that we have Dennis and the team have already made a huge transformation at Motorola. We have now great product quality, the Moto X, the first of the products that have come out and it's actually been very well received, a great product. So the team is now really working on building out marketing and distribution which is the kind of phase of it. So that's the mindset that we put in Motorola. This is not a this quarter or next quarter but much more – a more fundamental kind of optimistic and recent view of the company. So that's how we think of these issues. Thanks, Justin."
},
{
"speaker": "Larry Page",
"text": "We may have time for one more question."
},
{
"speaker": "Operator",
"text": "We'll take our final question from Douglas Anmuth with JPMorgan."
},
{
"speaker": "Douglas Anmuth",
"text": "Great. Thanks for taking the question. Just two things I wanted to ask about. First, just on Enhanced Campaigns, can you give us some sense of what it meant for overall spending in the quarter and then also how do you get advertisers to use the location and time of date, modifiers going forward. And then just on the U.S. business there was a [decel] there of about 500 basis points from last quarter? Patrick you mentioned the networks shifts there obviously, but was there anything else going on there?"
},
{
"speaker": "Patrick Pichette",
"text": "No, I mean, on your U.S. network it really is as you know there are changes in policies. They basically affect dramatically more our network and because of our network, think of AFS is really very heavy weighted to U.S., that’s really what’s been the main driver for that change. I will let Nikesh take the front end of the question."
},
{
"speaker": "Nikesh Arora",
"text": "Yes, in terms of enhanced campaigns, I’m not quite sure what do you mean by what it meant for overall spending in the quarter."
},
{
"speaker": "Unidentified Analyst",
"text": "Is it positive, I mean, was it incremental to revenue do you think in the quarter?"
},
{
"speaker": "Nikesh Arora",
"text": "Yes, we don’t -- do we say it on the enhanced campaign, so we’re not actually trying to quantify the effect, because we believe its part of your overall experience and its step in the right direction in terms of what you want to achieve. In terms of your question as it relates to location and time of day modifiers. I mean these are requests from advertisers, but to give you an example usually when a car rental company advertises when somebody is in airport, they’re likely to get a higher click through rate and higher conversion than if somebody is searching for car rentals when they’re sitting at the desktop. So the location can be used as a great modifier in terms of advertising, in terms of getting better conversion, that’s just one example. We’ve millions of examples like that where you can actually use location very effectively or time of day very effectively, the traditional example of when I’m hungry you show me an ad more likely to click an ad that offers me restaurant choice or food choice than if I’m not hungry and it’s late at night. So there are different modifiers that allow us to pay different advertising. People shop more at lunch time, so there is a whole bunch of stuff that comes in when you start providing location and time of day modifiers. So I think it’s good. Thank you."
},
{
"speaker": "Larry Page",
"text": "I want to thank everyone for spending so much time with us and turn it over to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Just before we close the call, I think we’ve great news to announce. I mean all of you that have worked with us, with the investor community group; you know that Willa Chalmers who is part of our IR team has been kind of missing in action for the last few weeks. I’m just incredibly proud to announce that Jacob Allen Chalmers is now in the world and has arrived a couple of days ago, mom is doing incredibly well, so Willa is doing great too. So just to let you know that she has not disappeared, she is doing great, the whole family is. We are all ecstatic about it and it’s another great kind of Googler addition for the family. So that’s why Willa disappeared for a few weeks. With that, I will turn it back to Larry to close the call."
},
{
"speaker": "Larry Page",
"text": "Thank you all."
},
{
"speaker": "Patrick Pichette",
"text": "Cheers. Jimmy off to you. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. That does conclude today’s conference. We do appreciate your participation and have a great day."
}
] | null | null |
GOOGL | 2 | 2,013 | 2013-07-19 16:30:00 | Operator: Good day everyone and welcome to the Google Inc. Second Quarter 2013 Earnings Conference Call. Today’s call is being recorded. At this time, I’d like to turn the call over to Willa Chalmers, Investor Relations Manager. Please go ahead ma'am.
Willa Chalmers: Thank you, Jamie. Good afternoon, everyone, and welcome to today's second quarter 2013 earnings conference call. With us are Larry Page, Chief Executive Officer; Patrick Pichette, Senior Vice President and Chief Financial Officer; and Nikesh Arora, Senior Vice President and Chief Business Officer. Also, as you know, we distribute our earnings release through our Investor Relations website located at investor.google.com. So please refer to our IR website for our earnings releases, as well as supplementary slides that accompany the6 call. You can also visit our Google+ Investor Relations page for the latest Company news and update, please check it out. This call is also being webcast from investor.google.com. A replay of the call will be available on our website later today. Now, let me quickly go over the Safe Harbor. Some of the statements that we make today may be considered forward-looking, including statements regarding Google's future investments, our long-term growth and innovation, the expected performance of our businesses, and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on this call, such as operating income and operating margin are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I’ll now turn the call over to Larry.
Larry Page: Hello, everyone and thanks for joining our call this afternoon. Google had a great quarter. Over $14 billion of revenue, up 19% year-on-year, amazing performance for a Company that is yet to celebrate its 15th birthday. We live in a world of abundant computing, with multiple operating systems and increasing number of the devices. And it’s a very different environment from when Google started. There was essentially one OS, and one device category, the PC. These kind of changes don’t happen that often. Once a decade, maybe even less are coming. The shift from laptop to mobiles, from on screen to multiple screens, create a tremendous opportunity for Google. With more devices, more information and more activity online than ever, the potential to improve people’s lives is immense. Getting you the right information, just when you need it, creating the tools to make everyone more effective at home and at work, and helping you share and remember the moments that matter in life. That’s why I’m so excited about the velocity and execution of our platforms, apps, and devices. First, platforms. With hindsight, Android and Chrome were no brainers. At the time, they were big bets. The movements across these platforms is tremendous. As you saw in our Annual Average Developer Conference in May, I was astounded, we had over 1 million people tuning in life just to watch our developer keynote. We’ve now activated more than 900 million Android devices worldwide and we’re lining up our over 1.5 million devices every day. That’s pretty amazing as in the first android phone launched less than five years ago and apps usage is increasing fast. Over 50 million apps have been now downloaded from the Google Playstore. In fact, we already paid out more money to Android developers this year than in the whole of 2012. I love the ability to access your stuff on play anywhere. Take our new music subscription service, launched in May, it has a new fun way to discover new music, with all the songs there ready to go. I’ve to think about the delay seriously. Chrome, even though only four year old, has over 750 million users worldwide and growing. The next apps, our goal is to design everything so it’s beautifully simple and hassle free. Users shouldn’t have to need to think about our technology, it should just work. This quarter we completely revamped our maps. The map is a screen, no clutter quarter around the edges, because more information about your surroundings, so it’s easier to explore. And we launched a new improved navigation feature. And not execution about incidents, before you leave and updates to save time if traffic condition change. First of all, this new maps experience is now available on almost all devices, you would be likely to use. The same with Google plus. We’ve done a complete redesign to make using the entire screen and that really looks consistent to whatever the delays or the platform. In addition, the team massively upgraded the photos experience. Making software design for professionals automatically available to everyone for fee. There is no need for wrinkles anymore. Take a look on Plus, many of your photos will now be marked enhanced and improved automatically. Finally we launched a new communication app called Hangouts. You can talk to the people you care about across all the major platforms. Video calls from your phone are very cool, give them a try. And I'm excited about the progress we've continued to make with Search. Our Knowledge Graph is now available in 29 languages and we've expanded the range of information available. For example, we just added nutrition data. Ask Google how many calories there are in a glass of white wine and you'll find out its 123, or an avocado, 235 calories. It's good to have the facts if you want to keep healthy. And we launched Google Now on iOS in April. In the same way, we want to make advertising super simple for customers. Online advertising have developed in very specific ways with separate campaigns for desktop and mobile. This made arduous work for advertisers and agencies and meant mobile opportunities often got missed. It's why we launched Enhanced Campaigns. Advertisers have upgraded 6 million campaigns. That's almost 75% of all their active campaigns. And Nikesh will talk in a little more detail about the positive reaction from clients. This is the biggest ever change to AdWords and the velocity and execution has been great thanks to the hard work of all the teams. Finally, devices; there is so much excitement around new devices today and the potential for innovation is tremendous. You can now buy the HTC One and the Samsung Galaxy S4 Google Play editions and enjoy the best of Google. There's a ton of momentum around Chromebooks, which are growing fast and defying the more general decline in PC sales. Finally, I know you're all eagerly anticipating what Motorola is launching soon. Having been a tester for a while, I'm really excited. We're very optimistic about the opportunities in front of Google today. The potential for technology to make people's lives better is tremendous. But to achieve that potential we need to stay focused. It's why we continue to invest the vast majority of our resources and time in our core products. But my job as CEO is also to think about the future and ensure we continue to bet on new technology that can solve big problems in the world. Project Loon, which we launched in June, is a great example. Bringing affordable, balloon-powered Internet access to remote areas is an idea that Sergey and I had been thinking about for over a decade. It was great to see that project literally get off the ground, and give people a bit more hope for an improving world. None of this would happen without great people and we are so lucky that we have them. I'd like to thank all the Googlers and Motorolans who make everything possible. Keep up that velocity and execution. Now, I'll hand the call over to Patrick.
Patrick Pichette: Thank you, Larry, and good afternoon everyone. Thank you for joining us. So why don't we go dive in by reviewing the details of our overall business financial performance, so here we go. Our gross total consolidated revenue grew 19% year-over-year to $14.1 billion. The overall business was up 1% quarter-over-quarter. Google standalone gross revenue grew 20% year-over-year to 13.1 billion and was up 1% quarter-over-quarter. Our Google website revenues was up 18% year-over-year to 8.9 billion and was in fact up 3% quarter-over-quarter. Our Google network revenue grew 7% year-over-year to 3.2 billion and was down 2% quarter-over-quarter. You'll remember the advertising policy decisions we implemented during Q4 and Q1 to ensure the useful and safe user experience continued to have its negative impact on network revenue. Other revenue grew 138% year-over-year to $1 billion and roughly flat quarter-over-quarter. Play store digital sales of apps and content drove the year-on-year and quarter-over-quarter growth and it's worth noting that in Q1, we included some seasonal hardware sales due to overflow from Q4 which skewed the Q2 comps somewhat. Finally, please note that without currency fluctuations Google standalone revenue growth would in fact have been 22% year-over-year and 3% quarter-over-quarter. Turning to Motorola Mobility, gross revenue there was $998 million, just shy of a $1 billion and it's clear that we've made a lot of progress at Motorola in the past year and that we are especially excited about the future of our upcoming product lineup, so stay tuned. At Google, our global aggregate paid click growth was strong at 22% year-over-year, in fact up 4% quarter-over-quarter. Our aggregate cost-per-paid was down 6% year-over-year and down 2% quarter-over-quarter and currency fluctuations in this case had a minimal effect in Q2 CPC growth, and yet our monetization metrics continued to be impacted by the usual factors that we've discussed many times including geographic mix, channel mix, property mix, our product and policy changes as well as FX. Turning to the geographic performance of Google standalone business, we continued to see a steady performance in the U.S. and rest of world, while the UK was negatively impacted by a warm spring, some FX in their case and a tough year-over-year comp. In our earnings slides which you can find on our Investor Relations website, you'll see that we've broken down our revenue by U.S., UK and rest of world to show the impact of FX and the benefits of our hedging program. So please refer to those slides for the exact calculations. U.S. revenue was up 18% year-over-year to $5.9 billion. The UK was up 12% year-over-year to 1.3 billion which included 24 million of benefits from our hedging program. It is in fact worth noting that in fixed FX terms, the UK grew 15% year-over-year. Non-U.S. revenue, excluding UK, accounted for 45% of the total revenue or 5.9 billion and it was up 23% year-over-year which includes 11 million benefits from our hedging program. In fixed FX terms, rest of world grew a solid 28%. Coming back to an aggregate level for the total consolidated business, our other cost of revenue was 2.9 billion in Q2 excluding stock-based compensation and Motorola restructuring. Our non-GAAP operating expenses totaled 4.2 billion also excluding stock-based compensation and Motorola restructuring and our non-GAAP operating profit was $4 billion in Q2 resulting in a non-GAAP operating margin for the consolidated business of 28%. For standalone Google, our traffic acquisition costs were $3 billion or 25% of total advertising revenue. Other cost of revenue was 2.1 billion, again excluding 110 of stock-based compensation. Non-GAAP operating expenses were 3.8 billion, excluding stock-based compensation of 633 million. And non-GAAP operating profit was $4.2 billion in Q2 resulting in non-GAAP operating margin of 32% for the standalone Google segment. Please note that a reevaluation of our depreciation policy as it relates to our real estate portfolio resulted in an additional 121 million in Google segment depreciation expenses, about half of which were presented a one-time charge for assets that are now fully depreciated. With this change in place, depreciation and amortization expense on property, plant and equipment for standalone Google was 667 million for this quarter. At Motorola Mobility, total non-GAAP operating expenses including cost of revenue were $1.2 billion. Keep in mind intangible amortization expenses attributed to the standalone Google and Motorola Mobility are in fact, included in these non-GAAP measures. Of the 283 million in intangible amortization expense in the quarter, $153 million was the result of the acquisition of Motorola of which 116 million was allocated to Google and 37 million was allocated to Motorola Mobility. And as a result, the non-GAAP operating loss for Motorola Mobility was 218 million in Q2 and an non-GAAP operating margin for that segment of minus 22%. Headcount for the consolidated business was down roughly 9,000 people in Q2. Please keep in mind that consolidated headcount now excludes Motorola Home business. It also reflects the impact of the ongoing mobility restructuring. Standalone Google added about a 1,400 people during the quarter and in total the consolidated Company ended the quarter with around 44,800 full-time employees. While effective tax rate was 24% in Q2, like in Q1 several one-time items as well as the continued shift of earnings between domestic and international subsidiaries impacted our tax rate this quarter and also please remember that in Q1 we also had a significant lower rate in that case due to the 2012 R&D credit which was obviously not applied to our Q2 rate. Let me now turn to cash management. Other income and expense was $247 million for the quarter which reflects realized gains on investments and interest income offset by the continued impact of our FAS 133 expense on our hedging program. For more detail on OI&E again please refer to the slides that accompany this call on our IR website. We continue to be very pleased with our operating cash flow which is strong this quarter at $4.7 billion. CapEx for the quarter was $1.6 billion, and this is versus last quarter at $1.2 billion. I want to remind everybody the majority of our CapEx spend is related to data center construction, facilities related purchases and production equipment. CapEx is just inherently lumpy. And as I mentioned last quarter during my remarks our infrastructure will continue to be a strategic area of investment. It's one of the foundations of our future growth. Our free cash flow again very strong $3.1 billion for the quarter. Larry’s comments make it clearer that there are just enormous growth opportunities ahead of us as a Company. It's in this spirit of optimism that we continue to fully fund strategic growth opportunities with the same confidence and discipline we demonstrated while growing our Mobile Business, Android, YouTube, Chrome, just to name a few. And with this, I’ll hand it off to Nikesh who will cover more details of our business performance in the quarter and after his remarks we’ll open up the lines for questions.
Nikesh Arora: Thank you, Patrick. As Patrick mentioned our businesses had a strong quarter. We had over $13.1 billion in Google standalone gross revenue. Overall the performance was particularly strong in the auto sector in Brazil. And as Patrick mentioned growth in the U.K. was hampered because of a particularly warm spring. Before I talk about trends, we’re seeing in investments we’re making in our business let me call out the effort of our marketing team that continues to create great Google moments. In May, they put on our second annual YouTube brand cast event in New York for 1,800 advertisers. The event was a great way to show YouTube’s unique ability to help marketers connect with highly coveted consumers and ultimately build their brands. At Brandcast, Jeffrey Katzenberg of DreamWorks said YouTube is a whole new entertainment paradigm, and we think he’s right. Also Larry mentioned the team put on another successful Google I/O Development Conference showcasing our incredible momentum across our platforms to over 6000 developers in San Francisco with over a million people tuning in from around the world. We continue to be pleased with how our business is evolving, growing and diversifying. There are three key areas where we continue to make investments. First, our transformation into a marketing platform that works across the connected world Larry described. Second, our systematic move up the marketing funnel helped clients more and more with brand building campaigns. Third, our investments in our non-ads business such as enterprise services, hardware and digital contents for Google Play. First, our message for our constantly connected users. The rapid adoption of new devices means that more people are spending more time online and connected. In fact new devices and new connectivity means we’re moving to a world where people are constantly connected with devices with them all the time. As an example you marketers say for the time spent online our mobile devices by U.S. adults grew 273% from 2009 to 2012. From 2011 to 2012 alone the time spent connected to mobile devices increased by nearly half an hour a day. This means not only a lot of new services and apps available for users and also a huge opportunity exists for businesses looking to reach mobile users at the right time and location. That brings in enhanced campaigns. As Larry talked about this, enhanced campaigns was a big long-term bet that is designed to help advertisers more easily reach customers across devices with the right message, all within one campaign. We already migrated six million of active campaigns to enhanced campaigns over the last many months. Our goal is to migrate all of our advertisers and campaigns by the end of this month. This effort has been executed at breakneck-speed and client reaction has been generally positive. We’re getting back evidence from clients seeing improved performance unit using enhanced campaigns. For example Pizza Hut. Social mobile ROI increased by 20%. They found that mobile click through rate has increased by more than 60% while that cost per order on smartphones is dropped by 17%. We believe enhanced campaigns does set up our clients and our business really well for the long-term and the move towards a constantly connected world goes far beyond just direct response and transaction of marketing. People are spending time watching videos, playing games, consumer news. All this creates great new opportunities from brand marketers to engage users. In fact powered by a TrueView Format, Youtube’s mobile revenue in June of this year was three times what it was at the beginning of the year. And to help advertisers reach viewers across more screens we opened up our TrueView Formats with all of our ad mob network across 1000s of apps. Turning our attention to brand marketers this is a very, very important area for us where we continue to invest broadly. It's important because the largest global marketers from CPG companies to film studios all conduct large major brand advertising campaigns, of course that referenced in the significant budgets that have historically been spent on TV. A good example of this was seen in the Cannes Lions Festival; the Dove real beauty sketches campaign that appeared on YouTube won the Titanium Grand Prix award which is considered the best to the highest honor. We worked with Burberry to launch Burberry Kisses which allows users to send message to loved ones sealed with the digital imprint of their real kiss. This campaign runs on YouTube and our network across desktop, tablets and mobiles. In the last month we began to integrate our recent acquisition Wildfire into the double click platforms so that brands can now manage the broader customer journey across search, display, mobile, social, rich media and video again all within one platform. Finally, I want to talk a little bit about our investment in emerging non-ad businesses. We’ve made a bunch of bets that are now beginning to show profit. We’re seeing acceleration in new business such as hardware, digital content and enterprise. First hardware, we continue to see great momentum across Chromebook’s and mobile devices such as our Nexus program. Around the world Chromebook’s are now in more than 6,600 brick and mortar stores including Walmart and Staples, that’s about a three time increase this quarter. As Larry said, we’ve also added two new devices to the Google Play Store from Samsung and HTC. On the digital ads and content front, through Google Play we continue to see tremendous amount of growth in this area. People from over 190 countries now download apps from Google Play everyday. More than 50 billion apps have been downloaded so far. In the last year Google Play digital content like music and movies has launched in 21 new countries including India, Mexico, Russia, with eight more European countries launching Google Play books this week. Publishers like Penguin, Random House, Time Inc. movie studies like Disney and NBC Universal, and app developers like King and Square Enix are creating terrific experiences for our users. We’ve also collaborated with all the major record labels to launch a new music subscription service that users seem to be enjoying really -- enjoying a lot. Lastly on the enterprise front, that’s another great revenue stream for Google. It comprises productivity apps like Docs and Gmail as well as our Cloud infrastructure. Now more than half of the Fortune 500 companies use the paid enterprise product from Google, and over 5 million businesses use our productivity apps. This means we have close long-term relationships with our enterprise customers. New customers this quarter includes some of our worlds leading businesses, like Federal Express, which has built their store locator in Google Maps, Snapchat which runs an application with Google’s Cloud infrastructure and LinkedIn is using Google Search Appliance. New Google apps customers include Pearson, Keller Williams Realty and the city of Boston. And HP is now Google apps reseller combining Google’s software with HP’s hardware for an initiative to help small businesses called SMB IT in a Box. To conclude, across our entire business we’re investing with enthusiasm and have tremendous opportunities. We strongly believe that we’re making the right moves to our users and clients and we’re extremely optimistic about the future. With that let me hand back to Patrick.
Patrick Pichette: Thank you, Nikesh. So Jamie, if you want to give us the instructions please to get going on the Q&A please. I’d appreciate it.
Operator: Thank you. (Operator Instructions) And we’ll take our first question from Ross Sandler with Deutsche Bank.
Ross Sandler: All right, great. Thanks, guys. Nikesh, I just had one kind of high level question on enhanced campaigns and the transition. So, can you just give us a little bit more color about the ROIs that most of your customers are seeing? You mentioned a few comments but are there going up? And do you see a significant opportunity in providing conversion tracking across different screens? What do you think will happen with search budgets if and when you can solve that problem? Thanks.
Nikesh Arora: Thank you for the question. I think it's fair to say that over the last nine months, we've had to do a super Herculean task to take millions and millions of campaigns, as Larry mentioned, 6 million campaigns that we've had to work with our advertising partners to go ahead and convert them towards enhanced campaigns. And we've had some amazing insights both working with the advertisers and as well as our teams. As many advertisers have discovered that there were not addressing the mobile opportunity appropriately, they discovered new inventory, they discovered better ROI and better conversion. Of course we had disobeyed the conversion analytics who work across every scheme and be able to be made available to all of our advertisers. So, we believe that as we get more and more – as we get better in terms of being able to provide more targeting and more comprehensive ad solutions for mobility and across all screens that the ROI should continue to improve. So, I'm very optimistic in the longer term because we believe mobility provides more context to advertisers in terms of where the users are, where they've been, which will allow for more accurate advertising which is almost like as good as information for them. So if that begins to happen we think the advertising ROI continues to increase and hopefully that means good things for search budgets.
Patrick Pichette: Thank you, Ross, for your question. Jamie, let's go to the next question.
Operator: And we'll go next to Ben Schachter with Macquarie.
Ben Schachter: One question for Larry and one for Patrick. Larry, when you think about hardware, are there other hardware categories beyond just phones and tablets where you believe Google can potentially build meaningful businesses? And then Patrick, in Q1 we didn't really see the usual uptick in expenses that you kind of see annually but then now we do see it in Q2. It sounds like some of that was the accounting issue around depreciation, but can you help us understand what happened there more? Thanks.
Larry Page: Yeah, thanks Ben for the question. I think we've been an early innovator in smartphones and we've been really excited about starting Android when no one really thought it was going to be interesting. And I think it's always a mistake to assume that technology will be static. So I think assuming over the long term, we're going to have new kinds of devices and ways of interacting with computing and the internet. Obviously, we're excited about Google Glass and new ways of interacting with hardware and new types of hardware. With any technological change you probably overestimate the short term and underestimate the long term. So I think we're really excited about making those investments. We're making sure we're positioned to live the future and that's why I won't be using Glass because I feel like every time I'm using Glass, I'm living that future. That's really, really exciting to me.
Patrick Pichette: Why don't I jump on the next question, so on the issue of expenses, look our expenses in Q2 were completely in line with the objectives we set for ourselves. In general, we continue to exercise financial discipline and module our product profitability. But it's on that basis that we recognize the significant opportunities that are ahead of us. And with the view to the long term, we continue to invest significantly and intelligently to fuel these opportunities. The fundamental issue is as I've said a number of times on previous calls if you want to hire X amount of people you have a target for the quarter or for the year. And they come in sometimes a bit over, sometimes a bit under but the real question is, are you still on the right trajectory for the long-term you're shooting for. So that's really the issue between Q1 and Q2.
Nikesh Arora: Ben, thank you for your question. Why don't we go to the next question, Jamie?
Operator: And we'll take our next question from Mark Mahaney with RBC Capital Markets.
Mark Mahaney: Great. Two questions, please. First on CPC, Patrick, you mentioned a couple of factors behind the deflation there. I don't think you ticked off mobile. I don't know if there's any particular reason why you didn't or maybe I missed it. And then in terms of the employee adds, maybe a question for Larry as you think about where you've been able to get employees, the ease or the difficulty with which you've been able to hire the employees that you wanted to hire. Could you comment on how that has changed, if at all, over the last year or two? Thank you.
Patrick Pichette: So why don't I jump in on the first one. Clearly mobile has some effect of it and we've talked about that in the past, so it's just one of the many factors that are at work. I just gave the list and the property mix obviously and the channel mixes includes a bunch of mobile shifts as well and that's part of the equation clearly for sure that drives both sides of the equation. And I just want to remind everybody that it's always kind of dangerous to just look at CPCs by themselves or just look at paid clicks by themselves, but in fact it's a combination of the two that gives you the health of the business and these mixes move all over the place depending on the number of changes going on in any quarter, but overall very pleased with the overall performance. On headcount, I'll lend it to Larry to jump in.
Larry Page: Yeah, Mark, I don't think we've seen any significant change in the short term on hiring. I think we're lucky that we have really great people in the company and more great people want to work with us. We've been able to buy smart companies too where we get great people and I don't see any major changes now that's been changing. I also think retention for the company has been great. People are excited to work here. They're excited to work on important things and make the world better. We're able to hire some of the best people in the world and I think that's been continuing and it's pretty stable.
Nikesh Arora: Thank you for the question, Mark. Jamie, let's go to the next question please.
Operator: And we'll go next to Carlos Kirjner with Sanford Bernstein.
Carlos Kirjner: Thank you. Two questions. Larry, I think sometimes you say the technology has done only 1% of what you can do suggesting that there's a lot of opportunity for Google. If that's the case, why isn't your ROE budget 10%, 20% or materially higher than today or in other words what limit your ability to spend more to capture these opportunities? Secondly, Patrick, can you tell us in general what specific financial operating metrics you use to evaluate the success of Google Fiber as a business? Thank you.
Larry Page: Yeah, that's a really great question, Carlos. I think that's our main job is to figure out how to obviously invest more to achieve greater outcomes for the world for the company and so on, and I think those opportunities are clearly there. You know as we've seen in the past with things like Chrome and Android and I've talked about them a lot. I think that execution and velocity, I talked about a lot too. It's pretty easy to come up with ideas, it's pretty hard to make them real and get them to billions of people. And that for me it's so exciting about being at a company like Google, so we get to do technological innovation at scale and get it out to on the scale of the whole world, to billions of people. But I wish we can just snap our fingers and accomplish that. There's actually lot of hard work and it takes a lot of great people working really hard to make that happen. We're working every day to improve our processes, improve our leadership and improve how we're organized, and to make that all go faster, and that's why I'm come into work excited every day and I think why we're most proud of it. I wish we could snap our fingers and do – just do a tremendous amount more instantly, but throughout its hard work to scale and that's what we do.
Patrick Pichette: Carlos, I'll take the second one related to Google Fiber. Just out of the context for everybody, we have been on the record to say that we're running Google Fiber and excited about it and we'll always have profitability as one of the key criteria for this opportunity. And in terms of kind of metrics, they should be just aligned with any sound business that's in that domain of access which is a combination. At first actually it was interesting because the question was, how successful was going to be the product and then – so meaning how many people would kind of want to take it? And then the second – we've been obviously very pleased by our results in Kansas City and now the announcements of the other two cities we've made since then. And then there's all the regular metrics you can imagine which have to do with cost of infrastructure, cost to serve and then how they grow into a profitability model. So there's no real rocket science in the financials of it. The real kind of magic occurs with the definition of the product, the innovation on the technology that the teams are pushing and what makes Google Fiber 100 times faster than the next best thing. That's really what we're really focused on. So I hope that answers your question. And let's go to the next question, Jamie.
Operator: We'll go next to Doug Anmuth with JPMorgan.
Douglas Anmuth: Great. Thanks for taking the question. I just want to ask about the network sites deceleration that you saw a 12% growth last quarter and 7% growth this quarter. Can you just talk about some of the key drivers there and perhaps how much is self inflicted as you’re sort of cleaning up more of the sites and quality in everything. And then secondly, can you talk about the key drivers that you see in terms of improving conversion rates for mobile ads, I know you mentioned the conversion analytics, but what else do you think gets mobile ad conversion up over the next few years? Thank you.
Patrick Pichette: Yeah, so for the first part, I’ll answer the first part of the question Doug, and then Nikesh will answer the second part. Clearly the network deceleration, I mean that’s why we kind of made the comment last quarter about the DLA and policies and it's clearly having an impact as now we’ve had a number of partners that have through Q1, Q2 have all been notified and have made the changes to their behavior. So these policies are now coming into compliance and as a result of it, right that you see the impact. But we really believe that this is a really good thing for our users. And into the long-term it will really benefit both the users at Google, so that’s the core elements of what's going on there. And then for the second question I’ll let Nikesh jump in.
Nikesh Arora: Yeah, thank you Patrick. I think it's important to understand as I said that improving convergent rates for us requires us to do a lot of things. One is we have to understand the cross device behavior better. We have to understand the cross device convergent being build. People can start to search in one device and conclude it in another device. These opportunities did not exist in the past and would also focus on one screen. In addition to that, as we talk about mobility we start to understand the context of the users a lot better as I said. Where are they? Where have they been? What could their search possibly mean, when they’re searching for, when you’re in a car parking lot you’re searching for other car dealership that gives us a very different signal than if you’re sitting at your desk and searching for a car. So all those attributes, all those factors need to go in into creating better targeting, better advertising for our end users so that, that actually helps to increase our line for advertisers and hopefully ROI for us in the longer term.
Patrick Pichette: Thanks for your question, Doug. Jamie, lets go to our next question please.
Operator: And we’ll go next to Scott Devitt with Morgan Stanley.
Scott Devitt: Hi, I had two questions. First, Larry mentioned some of the new features in the maps update, I think also the Gmail tab update seems like it's been pushed to users now. It’ll be great to know if you could share the timeline just for the full rollout in the U.S. internationally and any implications you foresee that update may have on those that are relying on marketing as a distribution channel. And then secondly, Larry also spoke about balloon deployed internet access. I was wondering if you could talk about another initiative that seems like it has significant opportunity long-term, the automated vehicle opportunity and when you think of that as a commercial opportunity at scale. Thanks.
Larry Page: Yeah, thanks for that question Scott, I think -- I am not sure the detail of the Gmail rollout. I’ve been excited to use it and I think it's a really great experience. I think we’re doing a lot to improve peoples experience on Gmail. I’m not sure we have a huge number of users on Gmail that’s growing quickly and we’re really, really excited about it. And obviously there’s some things around email experience that can be improved and we’re doing a lot to organize commercial offers and things like that, make sure that you’re not getting overwhelmed by spam and so on. And I think those have been great very user positive features enrolling out. I think in terms of automated cars I mean I think again that’s a very early stage thing. I think I’m very excited about it. I think it has potential again to have tremendous impact on people’s lives on our mobility and so on. And I think nothing has changed about that, we’re super excited about it and working hard it's very early stage project obviously. And then there is the last part of your question, I mean I think it's hard to predict exactly when these things will be commercial. My question I always ask is, why aren’t you doing it today? So we try to reduce whatever roadblocks that we can, take anything out as quickly as possible and I think now I think there’s great opportunity there.
Patrick Pichette: Thank you for your question Scott. Jamie, lets go to our next question please.
Operator: And we’ll go next to Anthony DiClemente with Barclays.
Anthony DiClemente: Hi, thanks. I’ve one for Patrick and one for Larry. Patrick, I just wanted to ask about CapEx. I think you mentioned in your comments that data centers and other network infrastructure was lumpy and responsible for the doubling of CapEx. I am just wondering, I am not sure from an accounting perspective what the useful light is on some of those investments and whether or not the amortization of those assets is part of what's causing a little bit of the uplift in operating expenses. So we’ll love to hear a little more about CapEx. And then, Larry as Google continues to invest for future growth, I just wanted to ask, how do you as a leader of the Company ensure that the people at Google and your employees keep the kind of small entrepreneurial culture that Google had and was known for in its earlier days. And thanks a lot for the question.
Patrick Pichette: So let me jump in Anthony on the first part and then I’ll let Larry answer the second. We don’t give the details of the different categories of depreciation by for our assets. But you can imagine that as we build these, the data centers and the computers clearly data centers have a long lifetime because if you think of them as land, electricity, power, building shelves, like cooling towers, all that technology has much longer useful life. And then the computers themselves, the machines, the servers have a much shorter lifetime and we track all those by categories obviously. And clearly there is a relationships between that and our depreciation rates that have been -- between that and that’s been climbing over the last few quarters. But there’s nothing magical about it as well. I mean it's just basically, what you’d expect by category. On the second question, I’ll let Larry answer.
Larry Page: Yeah, it's a great question I think. I think I am very, very exited to see. I mentioned the Project Loon or the automated cars, I think a lot of us are making sure that our employees and Google as a Company has the permission to do important things, and those things always start with a small group of people. They’d start with one or two people and then 10 people and so on, and those people can get a lot of things done. So I think probably I’ll measure out the Company in that way is we’re able to start up new and important things and make traction on them, and that’s the only way we end up with things like Android and Chrome those were once those kind of projects. So, I look at it kind of a portfolio thing. For some number of people that like to work on crazy things that are going to really change the world and want to deal with 10 other trends and work hard on them and kind of make sure we’re creating those opportunities and growing them into things that become Gmail or Android or Chrome, lot of things like that. And so I kind of look at it across the portfolio and I think we’re doing quite well and I’m pretty excited about it.
Patrick Pichette: Thank you for your question Anthony. Jamie, lets go to our next question please.
Operator: And we’ll go next to Mark May with Citigroup.
Mark May: Thanks for taking my questions. The first one, I’m wondering there was an expectation I think starting this quarter that we’d start to see some of the impact of enhanced campaigns and obviously you’re seeing great adoption of that and that adoption and the impact that, that might have on blended prices might offset these mix factors that you referenced. I wonder if you could help walk us through why that wasn’t the case necessarily in this quarter. And then secondly probably for Patrick, I wonder can you help estimate the impact on the network growth in the quarter from the quality improvement initiatives and are these issues that might impact future quarters or was this mainly a first half of this year kind of impact?
Larry Page: Yes, that’s a great question. I will also say maybe one sentence and turn it over to the other guys. I think it's important to keep in mind like enhanced campaigns are the largest change we made in AdWords ever, and it was done pretty quickly, and so I think we’re still very, very early stages with that. We changed tremendous amounts for how our teams operate, how our advertisers operate, how everyone buys those ads, what the users see, and we’ve done it pretty well. It's been pretty smooth which I’m really excited about. But, like I said that’s the early stages of a very, very major change. I think we’re very pleased with how that’s going.
Patrick Pichette: That’s very much so, and so on the second part of your question, Mark I think with the quality -- the forceful quality around our policies, I mean they will take a year to flow through. I mean once you've kind of reset the bar then it actually – by the time people have kind of adhered to these new changes but then you have to actually navigate through the entire year-over-year effects which will probably take a couple more quarters. And that's just a timing issue. Having said that, I just want to remind everybody again that the fundamental issue that we see is its really important for us to actually have a great user experience. And Susan and her team's kind of pounded this by making changes on a constant basis to make sure that at the end of the day there is that [smart bout], the quality of the user experience and the quality of the ads because in the end that's what really drives the benefit in the long term. So, when we have to hit – take some hits in the short term in order to actually get the right answer in the long term for our users and our advertisers, we're always ready to do them and that's a great example of it. So, we're actually not too worried about it. We have so many other areas that we just talked about enhanced campaigns, CLAs and so many other areas that offers us kind of opportunities that we just got to keep this in balance. Thank you for your question, Mark. Jamie, let's go to our next question, please.
Operator: We'll go next to Heather Bellini with Goldman Sachs.
Heather Bellini: Great. Thank you very much for the question. I just wanted to follow-up on enhanced campaigns. One of the questions people are trying to get at is was there any impact from enhanced campaigns on paid clicks and CPCs in the quarter that you can try and help us calibrate? And then I guess the other question would be given obviously it is still new and broad roll out this quarter, how many quarters do you think this needs to be in place for you to have a good sense of the impact that might have on those metrics? And then – sorry, then my last question was anything related to the impact on FX related to CPCs? I didn't think I heard that. Thank you.
Nikesh Arora: Hi, Heather. This is Nikesh. Thank you for your question. I think and let me step back and say first of all it's as Larry mentioned and Patrick mentioned, it is an existential requirement for us to take out advertisers and move them to a campaign strategy which allows us to move them across multiple streams. So this wasn't something that is just a remedy imperative, it's an imperative from a simplicity perspective, from an advertiser return perspective and also from the way our teams operate. So, we have spent the last six months migrating over 6 million campaigns, as I mentioned, and we'll probably be done by the end of this month which is not too far away. As you can imagine that we've been focusing and moving these things across the board, so we're still looking at the full impact since the impact has sort of graduated over the last few months. Now in terms of what the impact of this should be in the longer term, as I mentioned earlier the impact in the longer term should be that we should be able to provide simpler, faster, better ads to our advertisers across multiple streams. In terms of when you should be able to see effects of these things, now obviously there are effects that we see and we monitor and we take a look at, but it's for us to go out and start detailing what the impact these things are. But of course in the long term, it should have a positive impact on conversions and as a result all resulting metrics that affect conversion.
Patrick Pichette: Heather, I'll just jump on your very last question about FX related to CPCs. As I said in my comments, there's actually a marginal effect. I mean FX was not a big factor this quarter. I mean it has been a little bit for the UK as I mentioned but for the rest of the world, it has not been a major impact for the CPC issue. Thank you for your questions, Heather. Jamie, let's go to our next question, please.
Operator: We'll go next to Justin Post with Merrill Lynch.
Justin Post: Great. Thank you. Patrick, the gross profit growth has been trailing revenue growth. I think it was about 14% this quarter for about three quarters especially. Can you talk about what's really kind of drove the step down last year in 3Q? And is there any way to see that gap close and do you use gross profit as a measure or do you look more at revenue growth? Some of the drivers of the difference will be really helpful. Thank you.
Patrick Pichette: Thanks, Justin. Again, a topic that's for financial analysts have been always kind of top of mind. I just want to kind of reiterate kind of some of the basic messages that have not changed and how we think about this. So first of all, we care about revenue growth, we care about profitability, we care about both. And I've said this before, right, we're not in a business to lose money, cross subsidize or any of these things. So regarding margins we really look at every incremental profit dollar that creates shareholder value and really focused on these profit dollars rather than the percentage margins. Many of the new opportunities that we may be exploring whether it be hardware, whether it be Play, whether it be – many of these will have different margins in our core business, but they actually offer great kind of – huge revenue pools, huge margin pools in absolute dollars and then create much shareholder value and in many cases with Larry and the product area leads, great synergistic value between the products to create this great experiences. So, that's basically the mindset that we apply at it and we track them independently and together and make sure that we actually deliver continued revenue growth and profit growth. So that's the mindset which we apply. And don't read in my comment that we're not focused on our core business. It remains our core business. The core is the core is the core, and it continues to give us both revenue and oxygen profits to kind of fuel our growth as well. So that's the balanced answer to your question.
Justin Post: If I could follow-up, is there anything in there that maybe operating right now at negative gross margins that is kind of in-transitory in nature?
Patrick Pichette: I wouldn't comment on a specific product by product, but it's clear that if there are timing issues, if there's a product that actually isn't in investment mode, right, and at the beginning of its investment curves, you know that you're actually investing in it for the timing of future profits. We do that too. I mean you can imagine our very first customer in Kansas City, right. The P&L for that day was negative, but that's not why we did Kansas City, right. We did Kansas City because we know as a city was going to be very profitable, so there is clearly products that have because of the timing investment movements that actually show – will show negative, but not because we want them to be negative just because of where they are during investment phase. So that's how we think about it. Thank you for your question. Jamie, let's go to the next question, please.
Operator: We'll go next to Brian Pitz from Jefferies.
Brian Pitz: Thanks. Nikesh, you briefly mentioned PLAs. We continue to see that format in Search and recently we noticed integrated deals and offers into that format, any additional color on the impact from PLAs in the quarter? And then Larry, regarding product search, I guess more broadly, do you think users will be able to purchase items without ever leaving the Search results page at some point? Thank so much.
Larry Page: Thanks, Brian. I'll take the second question first. I think to the extent and obviously we can streamline the process of doing transactions or fulfilling any task and that's a good thing. I think in the trial we are doing in the Bay Area with [same day] delivery you can buy things very easily and get them delivered in a couple of hours. That was a pretty great experience. So we definitely look at any ways we can find to really improve our user's experience. Nikesh, do you want to take over the PLA part?
Nikesh Arora: As Larry mentioned, we are trying to get the user experience to be better and better. And as we've talked in the past, things are moving from 10 blue links to entity level search where people are searching for specific entities and they expect a response as a specific entity when doing that search. So think about PLA in the broader context, that when people search for something they like to get the answer. And if it's a product they're searching for, of course PLA has satisfied that requirement. So we are signing up tens of thousands of merchants who want to share that data with us, who want to make that data visible as part of Google Search. So we think this is a good thing. Again, as we provide more and more PLA information, obviously it has an impact on peoples clicking on those links. So in the long term that should have a positive impact on fixers on various ad formats, but for now it's too early to talk about the impact of those with the overall numbers that we have.
Nikesh Arora: Thank you for your question, Brian. Jamie, let's go to our next question. We have time for a couple more.
Operator: We'll go next to Gene Munster with Piper Jaffray.
Gene Munster: Good afternoon. A question on Motorola X, I know you haven't said a ton about it but there has been some talk that you're going to be aggressively marketing that. Can you just talk a little bit about this relationship that you have between having the Motorola X phone be enough of a success that you make a statement but not enough of a success that you end up corrupting or impacting your Android partners, so talk about that relationship? Thanks.
Larry Page: Thanks for the question, Gene. I think nothing about what we've said has changed and we operate Motorola independently. As you can see in the level of work that's going on there to operating that business, I think teams are doing a great job as we mentioned. I think they're working hard on making a great product. And I think we're really excited about it. I think they're excited about it and obviously you'll get to try it out pretty soon.
Gene Munster: Do you feel that the – I mean the incremental investment, is it going to be – it's been rumored to be $500 million, is it something in that range?
Larry Page: Are you talking about I guess the people have been speculating about marketing and so on. And I think that obviously we’re going to – we’re operating Motorola independently, running it much the same way we would run any business like that and I think we’re doing things that are normal for that business. I think probably too much has been the made over those things.
Patrick Pichette: Thanks Gene for your question. Okay, we have time for one more question. So Jamie can you give us the last question please?
Operator: Thank you. We will take our final question from Richard Kramer with Arete Research.
Richard Kramer: Thanks. Thanks very much. One for Larry and one for Patrick. For Larry, given the recent launch of YouTube subscriptions and also music services, how widely do you see Google expanding into subscription base businesses in the future and do you see this in three to five years is something that would be a meaningfully sized segment that would drive all network in size for example. And for Patrick, since you had some questions about Motorola being excited about, it is nice. But the business has lost nearly a $1 billion on a GAAP basis in the last three quarters. So, can you give us some sort of time scale for achieving returns here and I know you mentioned, you’re just looking for absolute profit dollars. But what’s the ultimate aim from Motorola in terms of contributing to Google’s profit base or even just to distribute more widely Google services? Thanks.
Larry Page: That’s the question about subscription services. I mean, I think like we said, we’re really excited about the play, music subscription being really well received, I love using it. I think we are always looking for ways to meet our users needs better and obviously subscriptions are one way to do that. So I’m sure over time we will try to meet our users needs better and have our products in that area. I don’t have anything to announce this time there. On the Motorola question, Patrick you want to take down?
Patrick Pichette: Sure. I think the Motorola question has to be put into context of two things. One is while we originally paid for Motorola and all the assets we acquired and the benefits, we got out of that acquisition because there wasn’t only a short-term financial play that was the number of strategic issues. We are very pleased with the divestiture of the home business, which kind of generally quite a bit of cash over the last, in Q2. So, I think that you have to put this conversation in the context of the entire acquisition for which we were really pleased and we also are incredibly proud of what the team has accomplished in the last year. And having now kind of create this great entity under Dennis, who has now kind of lean and mean with 5,000 employees focused on the future and that with the pounding away at next generation of products. So, I will leave it to the coming quarters to kind of really demonstrate the kind of new Motorola that’s showing up and you will see that in the coming weeks actually. Larry, any last comments before we close?
Larry Page: I want to thank everyone for spending so much time with us today. And we will see you on next quarter.
Patrick Pichette: Jamie, I let you close the call. Thank you everybody for your time.
Operator: Thank you, sir. Again, we do thank everyone for their participation. That does conclude today’s conference. Please have a good day. | [
{
"speaker": "Operator",
"text": "Good day everyone and welcome to the Google Inc. Second Quarter 2013 Earnings Conference Call. Today’s call is being recorded. At this time, I’d like to turn the call over to Willa Chalmers, Investor Relations Manager. Please go ahead ma'am."
},
{
"speaker": "Willa Chalmers",
"text": "Thank you, Jamie. Good afternoon, everyone, and welcome to today's second quarter 2013 earnings conference call. With us are Larry Page, Chief Executive Officer; Patrick Pichette, Senior Vice President and Chief Financial Officer; and Nikesh Arora, Senior Vice President and Chief Business Officer. Also, as you know, we distribute our earnings release through our Investor Relations website located at investor.google.com. So please refer to our IR website for our earnings releases, as well as supplementary slides that accompany the6 call. You can also visit our Google+ Investor Relations page for the latest Company news and update, please check it out. This call is also being webcast from investor.google.com. A replay of the call will be available on our website later today. Now, let me quickly go over the Safe Harbor. Some of the statements that we make today may be considered forward-looking, including statements regarding Google's future investments, our long-term growth and innovation, the expected performance of our businesses, and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on this call, such as operating income and operating margin are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I’ll now turn the call over to Larry."
},
{
"speaker": "Larry Page",
"text": "Hello, everyone and thanks for joining our call this afternoon. Google had a great quarter. Over $14 billion of revenue, up 19% year-on-year, amazing performance for a Company that is yet to celebrate its 15th birthday. We live in a world of abundant computing, with multiple operating systems and increasing number of the devices. And it’s a very different environment from when Google started. There was essentially one OS, and one device category, the PC. These kind of changes don’t happen that often. Once a decade, maybe even less are coming. The shift from laptop to mobiles, from on screen to multiple screens, create a tremendous opportunity for Google. With more devices, more information and more activity online than ever, the potential to improve people’s lives is immense. Getting you the right information, just when you need it, creating the tools to make everyone more effective at home and at work, and helping you share and remember the moments that matter in life. That’s why I’m so excited about the velocity and execution of our platforms, apps, and devices. First, platforms. With hindsight, Android and Chrome were no brainers. At the time, they were big bets. The movements across these platforms is tremendous. As you saw in our Annual Average Developer Conference in May, I was astounded, we had over 1 million people tuning in life just to watch our developer keynote. We’ve now activated more than 900 million Android devices worldwide and we’re lining up our over 1.5 million devices every day. That’s pretty amazing as in the first android phone launched less than five years ago and apps usage is increasing fast. Over 50 million apps have been now downloaded from the Google Playstore. In fact, we already paid out more money to Android developers this year than in the whole of 2012. I love the ability to access your stuff on play anywhere. Take our new music subscription service, launched in May, it has a new fun way to discover new music, with all the songs there ready to go. I’ve to think about the delay seriously. Chrome, even though only four year old, has over 750 million users worldwide and growing. The next apps, our goal is to design everything so it’s beautifully simple and hassle free. Users shouldn’t have to need to think about our technology, it should just work. This quarter we completely revamped our maps. The map is a screen, no clutter quarter around the edges, because more information about your surroundings, so it’s easier to explore. And we launched a new improved navigation feature. And not execution about incidents, before you leave and updates to save time if traffic condition change. First of all, this new maps experience is now available on almost all devices, you would be likely to use. The same with Google plus. We’ve done a complete redesign to make using the entire screen and that really looks consistent to whatever the delays or the platform. In addition, the team massively upgraded the photos experience. Making software design for professionals automatically available to everyone for fee. There is no need for wrinkles anymore. Take a look on Plus, many of your photos will now be marked enhanced and improved automatically. Finally we launched a new communication app called Hangouts. You can talk to the people you care about across all the major platforms. Video calls from your phone are very cool, give them a try. And I'm excited about the progress we've continued to make with Search. Our Knowledge Graph is now available in 29 languages and we've expanded the range of information available. For example, we just added nutrition data. Ask Google how many calories there are in a glass of white wine and you'll find out its 123, or an avocado, 235 calories. It's good to have the facts if you want to keep healthy. And we launched Google Now on iOS in April. In the same way, we want to make advertising super simple for customers. Online advertising have developed in very specific ways with separate campaigns for desktop and mobile. This made arduous work for advertisers and agencies and meant mobile opportunities often got missed. It's why we launched Enhanced Campaigns. Advertisers have upgraded 6 million campaigns. That's almost 75% of all their active campaigns. And Nikesh will talk in a little more detail about the positive reaction from clients. This is the biggest ever change to AdWords and the velocity and execution has been great thanks to the hard work of all the teams. Finally, devices; there is so much excitement around new devices today and the potential for innovation is tremendous. You can now buy the HTC One and the Samsung Galaxy S4 Google Play editions and enjoy the best of Google. There's a ton of momentum around Chromebooks, which are growing fast and defying the more general decline in PC sales. Finally, I know you're all eagerly anticipating what Motorola is launching soon. Having been a tester for a while, I'm really excited. We're very optimistic about the opportunities in front of Google today. The potential for technology to make people's lives better is tremendous. But to achieve that potential we need to stay focused. It's why we continue to invest the vast majority of our resources and time in our core products. But my job as CEO is also to think about the future and ensure we continue to bet on new technology that can solve big problems in the world. Project Loon, which we launched in June, is a great example. Bringing affordable, balloon-powered Internet access to remote areas is an idea that Sergey and I had been thinking about for over a decade. It was great to see that project literally get off the ground, and give people a bit more hope for an improving world. None of this would happen without great people and we are so lucky that we have them. I'd like to thank all the Googlers and Motorolans who make everything possible. Keep up that velocity and execution. Now, I'll hand the call over to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Larry, and good afternoon everyone. Thank you for joining us. So why don't we go dive in by reviewing the details of our overall business financial performance, so here we go. Our gross total consolidated revenue grew 19% year-over-year to $14.1 billion. The overall business was up 1% quarter-over-quarter. Google standalone gross revenue grew 20% year-over-year to 13.1 billion and was up 1% quarter-over-quarter. Our Google website revenues was up 18% year-over-year to 8.9 billion and was in fact up 3% quarter-over-quarter. Our Google network revenue grew 7% year-over-year to 3.2 billion and was down 2% quarter-over-quarter. You'll remember the advertising policy decisions we implemented during Q4 and Q1 to ensure the useful and safe user experience continued to have its negative impact on network revenue. Other revenue grew 138% year-over-year to $1 billion and roughly flat quarter-over-quarter. Play store digital sales of apps and content drove the year-on-year and quarter-over-quarter growth and it's worth noting that in Q1, we included some seasonal hardware sales due to overflow from Q4 which skewed the Q2 comps somewhat. Finally, please note that without currency fluctuations Google standalone revenue growth would in fact have been 22% year-over-year and 3% quarter-over-quarter. Turning to Motorola Mobility, gross revenue there was $998 million, just shy of a $1 billion and it's clear that we've made a lot of progress at Motorola in the past year and that we are especially excited about the future of our upcoming product lineup, so stay tuned. At Google, our global aggregate paid click growth was strong at 22% year-over-year, in fact up 4% quarter-over-quarter. Our aggregate cost-per-paid was down 6% year-over-year and down 2% quarter-over-quarter and currency fluctuations in this case had a minimal effect in Q2 CPC growth, and yet our monetization metrics continued to be impacted by the usual factors that we've discussed many times including geographic mix, channel mix, property mix, our product and policy changes as well as FX. Turning to the geographic performance of Google standalone business, we continued to see a steady performance in the U.S. and rest of world, while the UK was negatively impacted by a warm spring, some FX in their case and a tough year-over-year comp. In our earnings slides which you can find on our Investor Relations website, you'll see that we've broken down our revenue by U.S., UK and rest of world to show the impact of FX and the benefits of our hedging program. So please refer to those slides for the exact calculations. U.S. revenue was up 18% year-over-year to $5.9 billion. The UK was up 12% year-over-year to 1.3 billion which included 24 million of benefits from our hedging program. It is in fact worth noting that in fixed FX terms, the UK grew 15% year-over-year. Non-U.S. revenue, excluding UK, accounted for 45% of the total revenue or 5.9 billion and it was up 23% year-over-year which includes 11 million benefits from our hedging program. In fixed FX terms, rest of world grew a solid 28%. Coming back to an aggregate level for the total consolidated business, our other cost of revenue was 2.9 billion in Q2 excluding stock-based compensation and Motorola restructuring. Our non-GAAP operating expenses totaled 4.2 billion also excluding stock-based compensation and Motorola restructuring and our non-GAAP operating profit was $4 billion in Q2 resulting in a non-GAAP operating margin for the consolidated business of 28%. For standalone Google, our traffic acquisition costs were $3 billion or 25% of total advertising revenue. Other cost of revenue was 2.1 billion, again excluding 110 of stock-based compensation. Non-GAAP operating expenses were 3.8 billion, excluding stock-based compensation of 633 million. And non-GAAP operating profit was $4.2 billion in Q2 resulting in non-GAAP operating margin of 32% for the standalone Google segment. Please note that a reevaluation of our depreciation policy as it relates to our real estate portfolio resulted in an additional 121 million in Google segment depreciation expenses, about half of which were presented a one-time charge for assets that are now fully depreciated. With this change in place, depreciation and amortization expense on property, plant and equipment for standalone Google was 667 million for this quarter. At Motorola Mobility, total non-GAAP operating expenses including cost of revenue were $1.2 billion. Keep in mind intangible amortization expenses attributed to the standalone Google and Motorola Mobility are in fact, included in these non-GAAP measures. Of the 283 million in intangible amortization expense in the quarter, $153 million was the result of the acquisition of Motorola of which 116 million was allocated to Google and 37 million was allocated to Motorola Mobility. And as a result, the non-GAAP operating loss for Motorola Mobility was 218 million in Q2 and an non-GAAP operating margin for that segment of minus 22%. Headcount for the consolidated business was down roughly 9,000 people in Q2. Please keep in mind that consolidated headcount now excludes Motorola Home business. It also reflects the impact of the ongoing mobility restructuring. Standalone Google added about a 1,400 people during the quarter and in total the consolidated Company ended the quarter with around 44,800 full-time employees. While effective tax rate was 24% in Q2, like in Q1 several one-time items as well as the continued shift of earnings between domestic and international subsidiaries impacted our tax rate this quarter and also please remember that in Q1 we also had a significant lower rate in that case due to the 2012 R&D credit which was obviously not applied to our Q2 rate. Let me now turn to cash management. Other income and expense was $247 million for the quarter which reflects realized gains on investments and interest income offset by the continued impact of our FAS 133 expense on our hedging program. For more detail on OI&E again please refer to the slides that accompany this call on our IR website. We continue to be very pleased with our operating cash flow which is strong this quarter at $4.7 billion. CapEx for the quarter was $1.6 billion, and this is versus last quarter at $1.2 billion. I want to remind everybody the majority of our CapEx spend is related to data center construction, facilities related purchases and production equipment. CapEx is just inherently lumpy. And as I mentioned last quarter during my remarks our infrastructure will continue to be a strategic area of investment. It's one of the foundations of our future growth. Our free cash flow again very strong $3.1 billion for the quarter. Larry’s comments make it clearer that there are just enormous growth opportunities ahead of us as a Company. It's in this spirit of optimism that we continue to fully fund strategic growth opportunities with the same confidence and discipline we demonstrated while growing our Mobile Business, Android, YouTube, Chrome, just to name a few. And with this, I’ll hand it off to Nikesh who will cover more details of our business performance in the quarter and after his remarks we’ll open up the lines for questions."
},
{
"speaker": "Nikesh Arora",
"text": "Thank you, Patrick. As Patrick mentioned our businesses had a strong quarter. We had over $13.1 billion in Google standalone gross revenue. Overall the performance was particularly strong in the auto sector in Brazil. And as Patrick mentioned growth in the U.K. was hampered because of a particularly warm spring. Before I talk about trends, we’re seeing in investments we’re making in our business let me call out the effort of our marketing team that continues to create great Google moments. In May, they put on our second annual YouTube brand cast event in New York for 1,800 advertisers. The event was a great way to show YouTube’s unique ability to help marketers connect with highly coveted consumers and ultimately build their brands. At Brandcast, Jeffrey Katzenberg of DreamWorks said YouTube is a whole new entertainment paradigm, and we think he’s right. Also Larry mentioned the team put on another successful Google I/O Development Conference showcasing our incredible momentum across our platforms to over 6000 developers in San Francisco with over a million people tuning in from around the world. We continue to be pleased with how our business is evolving, growing and diversifying. There are three key areas where we continue to make investments. First, our transformation into a marketing platform that works across the connected world Larry described. Second, our systematic move up the marketing funnel helped clients more and more with brand building campaigns. Third, our investments in our non-ads business such as enterprise services, hardware and digital contents for Google Play. First, our message for our constantly connected users. The rapid adoption of new devices means that more people are spending more time online and connected. In fact new devices and new connectivity means we’re moving to a world where people are constantly connected with devices with them all the time. As an example you marketers say for the time spent online our mobile devices by U.S. adults grew 273% from 2009 to 2012. From 2011 to 2012 alone the time spent connected to mobile devices increased by nearly half an hour a day. This means not only a lot of new services and apps available for users and also a huge opportunity exists for businesses looking to reach mobile users at the right time and location. That brings in enhanced campaigns. As Larry talked about this, enhanced campaigns was a big long-term bet that is designed to help advertisers more easily reach customers across devices with the right message, all within one campaign. We already migrated six million of active campaigns to enhanced campaigns over the last many months. Our goal is to migrate all of our advertisers and campaigns by the end of this month. This effort has been executed at breakneck-speed and client reaction has been generally positive. We’re getting back evidence from clients seeing improved performance unit using enhanced campaigns. For example Pizza Hut. Social mobile ROI increased by 20%. They found that mobile click through rate has increased by more than 60% while that cost per order on smartphones is dropped by 17%. We believe enhanced campaigns does set up our clients and our business really well for the long-term and the move towards a constantly connected world goes far beyond just direct response and transaction of marketing. People are spending time watching videos, playing games, consumer news. All this creates great new opportunities from brand marketers to engage users. In fact powered by a TrueView Format, Youtube’s mobile revenue in June of this year was three times what it was at the beginning of the year. And to help advertisers reach viewers across more screens we opened up our TrueView Formats with all of our ad mob network across 1000s of apps. Turning our attention to brand marketers this is a very, very important area for us where we continue to invest broadly. It's important because the largest global marketers from CPG companies to film studios all conduct large major brand advertising campaigns, of course that referenced in the significant budgets that have historically been spent on TV. A good example of this was seen in the Cannes Lions Festival; the Dove real beauty sketches campaign that appeared on YouTube won the Titanium Grand Prix award which is considered the best to the highest honor. We worked with Burberry to launch Burberry Kisses which allows users to send message to loved ones sealed with the digital imprint of their real kiss. This campaign runs on YouTube and our network across desktop, tablets and mobiles. In the last month we began to integrate our recent acquisition Wildfire into the double click platforms so that brands can now manage the broader customer journey across search, display, mobile, social, rich media and video again all within one platform. Finally, I want to talk a little bit about our investment in emerging non-ad businesses. We’ve made a bunch of bets that are now beginning to show profit. We’re seeing acceleration in new business such as hardware, digital content and enterprise. First hardware, we continue to see great momentum across Chromebook’s and mobile devices such as our Nexus program. Around the world Chromebook’s are now in more than 6,600 brick and mortar stores including Walmart and Staples, that’s about a three time increase this quarter. As Larry said, we’ve also added two new devices to the Google Play Store from Samsung and HTC. On the digital ads and content front, through Google Play we continue to see tremendous amount of growth in this area. People from over 190 countries now download apps from Google Play everyday. More than 50 billion apps have been downloaded so far. In the last year Google Play digital content like music and movies has launched in 21 new countries including India, Mexico, Russia, with eight more European countries launching Google Play books this week. Publishers like Penguin, Random House, Time Inc. movie studies like Disney and NBC Universal, and app developers like King and Square Enix are creating terrific experiences for our users. We’ve also collaborated with all the major record labels to launch a new music subscription service that users seem to be enjoying really -- enjoying a lot. Lastly on the enterprise front, that’s another great revenue stream for Google. It comprises productivity apps like Docs and Gmail as well as our Cloud infrastructure. Now more than half of the Fortune 500 companies use the paid enterprise product from Google, and over 5 million businesses use our productivity apps. This means we have close long-term relationships with our enterprise customers. New customers this quarter includes some of our worlds leading businesses, like Federal Express, which has built their store locator in Google Maps, Snapchat which runs an application with Google’s Cloud infrastructure and LinkedIn is using Google Search Appliance. New Google apps customers include Pearson, Keller Williams Realty and the city of Boston. And HP is now Google apps reseller combining Google’s software with HP’s hardware for an initiative to help small businesses called SMB IT in a Box. To conclude, across our entire business we’re investing with enthusiasm and have tremendous opportunities. We strongly believe that we’re making the right moves to our users and clients and we’re extremely optimistic about the future. With that let me hand back to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Nikesh. So Jamie, if you want to give us the instructions please to get going on the Q&A please. I’d appreciate it."
},
{
"speaker": "Operator",
"text": "Thank you. (Operator Instructions) And we’ll take our first question from Ross Sandler with Deutsche Bank."
},
{
"speaker": "Ross Sandler",
"text": "All right, great. Thanks, guys. Nikesh, I just had one kind of high level question on enhanced campaigns and the transition. So, can you just give us a little bit more color about the ROIs that most of your customers are seeing? You mentioned a few comments but are there going up? And do you see a significant opportunity in providing conversion tracking across different screens? What do you think will happen with search budgets if and when you can solve that problem? Thanks."
},
{
"speaker": "Nikesh Arora",
"text": "Thank you for the question. I think it's fair to say that over the last nine months, we've had to do a super Herculean task to take millions and millions of campaigns, as Larry mentioned, 6 million campaigns that we've had to work with our advertising partners to go ahead and convert them towards enhanced campaigns. And we've had some amazing insights both working with the advertisers and as well as our teams. As many advertisers have discovered that there were not addressing the mobile opportunity appropriately, they discovered new inventory, they discovered better ROI and better conversion. Of course we had disobeyed the conversion analytics who work across every scheme and be able to be made available to all of our advertisers. So, we believe that as we get more and more – as we get better in terms of being able to provide more targeting and more comprehensive ad solutions for mobility and across all screens that the ROI should continue to improve. So, I'm very optimistic in the longer term because we believe mobility provides more context to advertisers in terms of where the users are, where they've been, which will allow for more accurate advertising which is almost like as good as information for them. So if that begins to happen we think the advertising ROI continues to increase and hopefully that means good things for search budgets."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Ross, for your question. Jamie, let's go to the next question."
},
{
"speaker": "Operator",
"text": "And we'll go next to Ben Schachter with Macquarie."
},
{
"speaker": "Ben Schachter",
"text": "One question for Larry and one for Patrick. Larry, when you think about hardware, are there other hardware categories beyond just phones and tablets where you believe Google can potentially build meaningful businesses? And then Patrick, in Q1 we didn't really see the usual uptick in expenses that you kind of see annually but then now we do see it in Q2. It sounds like some of that was the accounting issue around depreciation, but can you help us understand what happened there more? Thanks."
},
{
"speaker": "Larry Page",
"text": "Yeah, thanks Ben for the question. I think we've been an early innovator in smartphones and we've been really excited about starting Android when no one really thought it was going to be interesting. And I think it's always a mistake to assume that technology will be static. So I think assuming over the long term, we're going to have new kinds of devices and ways of interacting with computing and the internet. Obviously, we're excited about Google Glass and new ways of interacting with hardware and new types of hardware. With any technological change you probably overestimate the short term and underestimate the long term. So I think we're really excited about making those investments. We're making sure we're positioned to live the future and that's why I won't be using Glass because I feel like every time I'm using Glass, I'm living that future. That's really, really exciting to me."
},
{
"speaker": "Patrick Pichette",
"text": "Why don't I jump on the next question, so on the issue of expenses, look our expenses in Q2 were completely in line with the objectives we set for ourselves. In general, we continue to exercise financial discipline and module our product profitability. But it's on that basis that we recognize the significant opportunities that are ahead of us. And with the view to the long term, we continue to invest significantly and intelligently to fuel these opportunities. The fundamental issue is as I've said a number of times on previous calls if you want to hire X amount of people you have a target for the quarter or for the year. And they come in sometimes a bit over, sometimes a bit under but the real question is, are you still on the right trajectory for the long-term you're shooting for. So that's really the issue between Q1 and Q2."
},
{
"speaker": "Nikesh Arora",
"text": "Ben, thank you for your question. Why don't we go to the next question, Jamie?"
},
{
"speaker": "Operator",
"text": "And we'll take our next question from Mark Mahaney with RBC Capital Markets."
},
{
"speaker": "Mark Mahaney",
"text": "Great. Two questions, please. First on CPC, Patrick, you mentioned a couple of factors behind the deflation there. I don't think you ticked off mobile. I don't know if there's any particular reason why you didn't or maybe I missed it. And then in terms of the employee adds, maybe a question for Larry as you think about where you've been able to get employees, the ease or the difficulty with which you've been able to hire the employees that you wanted to hire. Could you comment on how that has changed, if at all, over the last year or two? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "So why don't I jump in on the first one. Clearly mobile has some effect of it and we've talked about that in the past, so it's just one of the many factors that are at work. I just gave the list and the property mix obviously and the channel mixes includes a bunch of mobile shifts as well and that's part of the equation clearly for sure that drives both sides of the equation. And I just want to remind everybody that it's always kind of dangerous to just look at CPCs by themselves or just look at paid clicks by themselves, but in fact it's a combination of the two that gives you the health of the business and these mixes move all over the place depending on the number of changes going on in any quarter, but overall very pleased with the overall performance. On headcount, I'll lend it to Larry to jump in."
},
{
"speaker": "Larry Page",
"text": "Yeah, Mark, I don't think we've seen any significant change in the short term on hiring. I think we're lucky that we have really great people in the company and more great people want to work with us. We've been able to buy smart companies too where we get great people and I don't see any major changes now that's been changing. I also think retention for the company has been great. People are excited to work here. They're excited to work on important things and make the world better. We're able to hire some of the best people in the world and I think that's been continuing and it's pretty stable."
},
{
"speaker": "Nikesh Arora",
"text": "Thank you for the question, Mark. Jamie, let's go to the next question please."
},
{
"speaker": "Operator",
"text": "And we'll go next to Carlos Kirjner with Sanford Bernstein."
},
{
"speaker": "Carlos Kirjner",
"text": "Thank you. Two questions. Larry, I think sometimes you say the technology has done only 1% of what you can do suggesting that there's a lot of opportunity for Google. If that's the case, why isn't your ROE budget 10%, 20% or materially higher than today or in other words what limit your ability to spend more to capture these opportunities? Secondly, Patrick, can you tell us in general what specific financial operating metrics you use to evaluate the success of Google Fiber as a business? Thank you."
},
{
"speaker": "Larry Page",
"text": "Yeah, that's a really great question, Carlos. I think that's our main job is to figure out how to obviously invest more to achieve greater outcomes for the world for the company and so on, and I think those opportunities are clearly there. You know as we've seen in the past with things like Chrome and Android and I've talked about them a lot. I think that execution and velocity, I talked about a lot too. It's pretty easy to come up with ideas, it's pretty hard to make them real and get them to billions of people. And that for me it's so exciting about being at a company like Google, so we get to do technological innovation at scale and get it out to on the scale of the whole world, to billions of people. But I wish we can just snap our fingers and accomplish that. There's actually lot of hard work and it takes a lot of great people working really hard to make that happen. We're working every day to improve our processes, improve our leadership and improve how we're organized, and to make that all go faster, and that's why I'm come into work excited every day and I think why we're most proud of it. I wish we could snap our fingers and do – just do a tremendous amount more instantly, but throughout its hard work to scale and that's what we do."
},
{
"speaker": "Patrick Pichette",
"text": "Carlos, I'll take the second one related to Google Fiber. Just out of the context for everybody, we have been on the record to say that we're running Google Fiber and excited about it and we'll always have profitability as one of the key criteria for this opportunity. And in terms of kind of metrics, they should be just aligned with any sound business that's in that domain of access which is a combination. At first actually it was interesting because the question was, how successful was going to be the product and then – so meaning how many people would kind of want to take it? And then the second – we've been obviously very pleased by our results in Kansas City and now the announcements of the other two cities we've made since then. And then there's all the regular metrics you can imagine which have to do with cost of infrastructure, cost to serve and then how they grow into a profitability model. So there's no real rocket science in the financials of it. The real kind of magic occurs with the definition of the product, the innovation on the technology that the teams are pushing and what makes Google Fiber 100 times faster than the next best thing. That's really what we're really focused on. So I hope that answers your question. And let's go to the next question, Jamie."
},
{
"speaker": "Operator",
"text": "We'll go next to Doug Anmuth with JPMorgan."
},
{
"speaker": "Douglas Anmuth",
"text": "Great. Thanks for taking the question. I just want to ask about the network sites deceleration that you saw a 12% growth last quarter and 7% growth this quarter. Can you just talk about some of the key drivers there and perhaps how much is self inflicted as you’re sort of cleaning up more of the sites and quality in everything. And then secondly, can you talk about the key drivers that you see in terms of improving conversion rates for mobile ads, I know you mentioned the conversion analytics, but what else do you think gets mobile ad conversion up over the next few years? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Yeah, so for the first part, I’ll answer the first part of the question Doug, and then Nikesh will answer the second part. Clearly the network deceleration, I mean that’s why we kind of made the comment last quarter about the DLA and policies and it's clearly having an impact as now we’ve had a number of partners that have through Q1, Q2 have all been notified and have made the changes to their behavior. So these policies are now coming into compliance and as a result of it, right that you see the impact. But we really believe that this is a really good thing for our users. And into the long-term it will really benefit both the users at Google, so that’s the core elements of what's going on there. And then for the second question I’ll let Nikesh jump in."
},
{
"speaker": "Nikesh Arora",
"text": "Yeah, thank you Patrick. I think it's important to understand as I said that improving convergent rates for us requires us to do a lot of things. One is we have to understand the cross device behavior better. We have to understand the cross device convergent being build. People can start to search in one device and conclude it in another device. These opportunities did not exist in the past and would also focus on one screen. In addition to that, as we talk about mobility we start to understand the context of the users a lot better as I said. Where are they? Where have they been? What could their search possibly mean, when they’re searching for, when you’re in a car parking lot you’re searching for other car dealership that gives us a very different signal than if you’re sitting at your desk and searching for a car. So all those attributes, all those factors need to go in into creating better targeting, better advertising for our end users so that, that actually helps to increase our line for advertisers and hopefully ROI for us in the longer term."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks for your question, Doug. Jamie, lets go to our next question please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Scott Devitt with Morgan Stanley."
},
{
"speaker": "Scott Devitt",
"text": "Hi, I had two questions. First, Larry mentioned some of the new features in the maps update, I think also the Gmail tab update seems like it's been pushed to users now. It’ll be great to know if you could share the timeline just for the full rollout in the U.S. internationally and any implications you foresee that update may have on those that are relying on marketing as a distribution channel. And then secondly, Larry also spoke about balloon deployed internet access. I was wondering if you could talk about another initiative that seems like it has significant opportunity long-term, the automated vehicle opportunity and when you think of that as a commercial opportunity at scale. Thanks."
},
{
"speaker": "Larry Page",
"text": "Yeah, thanks for that question Scott, I think -- I am not sure the detail of the Gmail rollout. I’ve been excited to use it and I think it's a really great experience. I think we’re doing a lot to improve peoples experience on Gmail. I’m not sure we have a huge number of users on Gmail that’s growing quickly and we’re really, really excited about it. And obviously there’s some things around email experience that can be improved and we’re doing a lot to organize commercial offers and things like that, make sure that you’re not getting overwhelmed by spam and so on. And I think those have been great very user positive features enrolling out. I think in terms of automated cars I mean I think again that’s a very early stage thing. I think I’m very excited about it. I think it has potential again to have tremendous impact on people’s lives on our mobility and so on. And I think nothing has changed about that, we’re super excited about it and working hard it's very early stage project obviously. And then there is the last part of your question, I mean I think it's hard to predict exactly when these things will be commercial. My question I always ask is, why aren’t you doing it today? So we try to reduce whatever roadblocks that we can, take anything out as quickly as possible and I think now I think there’s great opportunity there."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you for your question Scott. Jamie, lets go to our next question please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Anthony DiClemente with Barclays."
},
{
"speaker": "Anthony DiClemente",
"text": "Hi, thanks. I’ve one for Patrick and one for Larry. Patrick, I just wanted to ask about CapEx. I think you mentioned in your comments that data centers and other network infrastructure was lumpy and responsible for the doubling of CapEx. I am just wondering, I am not sure from an accounting perspective what the useful light is on some of those investments and whether or not the amortization of those assets is part of what's causing a little bit of the uplift in operating expenses. So we’ll love to hear a little more about CapEx. And then, Larry as Google continues to invest for future growth, I just wanted to ask, how do you as a leader of the Company ensure that the people at Google and your employees keep the kind of small entrepreneurial culture that Google had and was known for in its earlier days. And thanks a lot for the question."
},
{
"speaker": "Patrick Pichette",
"text": "So let me jump in Anthony on the first part and then I’ll let Larry answer the second. We don’t give the details of the different categories of depreciation by for our assets. But you can imagine that as we build these, the data centers and the computers clearly data centers have a long lifetime because if you think of them as land, electricity, power, building shelves, like cooling towers, all that technology has much longer useful life. And then the computers themselves, the machines, the servers have a much shorter lifetime and we track all those by categories obviously. And clearly there is a relationships between that and our depreciation rates that have been -- between that and that’s been climbing over the last few quarters. But there’s nothing magical about it as well. I mean it's just basically, what you’d expect by category. On the second question, I’ll let Larry answer."
},
{
"speaker": "Larry Page",
"text": "Yeah, it's a great question I think. I think I am very, very exited to see. I mentioned the Project Loon or the automated cars, I think a lot of us are making sure that our employees and Google as a Company has the permission to do important things, and those things always start with a small group of people. They’d start with one or two people and then 10 people and so on, and those people can get a lot of things done. So I think probably I’ll measure out the Company in that way is we’re able to start up new and important things and make traction on them, and that’s the only way we end up with things like Android and Chrome those were once those kind of projects. So, I look at it kind of a portfolio thing. For some number of people that like to work on crazy things that are going to really change the world and want to deal with 10 other trends and work hard on them and kind of make sure we’re creating those opportunities and growing them into things that become Gmail or Android or Chrome, lot of things like that. And so I kind of look at it across the portfolio and I think we’re doing quite well and I’m pretty excited about it."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you for your question Anthony. Jamie, lets go to our next question please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Mark May with Citigroup."
},
{
"speaker": "Mark May",
"text": "Thanks for taking my questions. The first one, I’m wondering there was an expectation I think starting this quarter that we’d start to see some of the impact of enhanced campaigns and obviously you’re seeing great adoption of that and that adoption and the impact that, that might have on blended prices might offset these mix factors that you referenced. I wonder if you could help walk us through why that wasn’t the case necessarily in this quarter. And then secondly probably for Patrick, I wonder can you help estimate the impact on the network growth in the quarter from the quality improvement initiatives and are these issues that might impact future quarters or was this mainly a first half of this year kind of impact?"
},
{
"speaker": "Larry Page",
"text": "Yes, that’s a great question. I will also say maybe one sentence and turn it over to the other guys. I think it's important to keep in mind like enhanced campaigns are the largest change we made in AdWords ever, and it was done pretty quickly, and so I think we’re still very, very early stages with that. We changed tremendous amounts for how our teams operate, how our advertisers operate, how everyone buys those ads, what the users see, and we’ve done it pretty well. It's been pretty smooth which I’m really excited about. But, like I said that’s the early stages of a very, very major change. I think we’re very pleased with how that’s going."
},
{
"speaker": "Patrick Pichette",
"text": "That’s very much so, and so on the second part of your question, Mark I think with the quality -- the forceful quality around our policies, I mean they will take a year to flow through. I mean once you've kind of reset the bar then it actually – by the time people have kind of adhered to these new changes but then you have to actually navigate through the entire year-over-year effects which will probably take a couple more quarters. And that's just a timing issue. Having said that, I just want to remind everybody again that the fundamental issue that we see is its really important for us to actually have a great user experience. And Susan and her team's kind of pounded this by making changes on a constant basis to make sure that at the end of the day there is that [smart bout], the quality of the user experience and the quality of the ads because in the end that's what really drives the benefit in the long term. So, when we have to hit – take some hits in the short term in order to actually get the right answer in the long term for our users and our advertisers, we're always ready to do them and that's a great example of it. So, we're actually not too worried about it. We have so many other areas that we just talked about enhanced campaigns, CLAs and so many other areas that offers us kind of opportunities that we just got to keep this in balance. Thank you for your question, Mark. Jamie, let's go to our next question, please."
},
{
"speaker": "Operator",
"text": "We'll go next to Heather Bellini with Goldman Sachs."
},
{
"speaker": "Heather Bellini",
"text": "Great. Thank you very much for the question. I just wanted to follow-up on enhanced campaigns. One of the questions people are trying to get at is was there any impact from enhanced campaigns on paid clicks and CPCs in the quarter that you can try and help us calibrate? And then I guess the other question would be given obviously it is still new and broad roll out this quarter, how many quarters do you think this needs to be in place for you to have a good sense of the impact that might have on those metrics? And then – sorry, then my last question was anything related to the impact on FX related to CPCs? I didn't think I heard that. Thank you."
},
{
"speaker": "Nikesh Arora",
"text": "Hi, Heather. This is Nikesh. Thank you for your question. I think and let me step back and say first of all it's as Larry mentioned and Patrick mentioned, it is an existential requirement for us to take out advertisers and move them to a campaign strategy which allows us to move them across multiple streams. So this wasn't something that is just a remedy imperative, it's an imperative from a simplicity perspective, from an advertiser return perspective and also from the way our teams operate. So, we have spent the last six months migrating over 6 million campaigns, as I mentioned, and we'll probably be done by the end of this month which is not too far away. As you can imagine that we've been focusing and moving these things across the board, so we're still looking at the full impact since the impact has sort of graduated over the last few months. Now in terms of what the impact of this should be in the longer term, as I mentioned earlier the impact in the longer term should be that we should be able to provide simpler, faster, better ads to our advertisers across multiple streams. In terms of when you should be able to see effects of these things, now obviously there are effects that we see and we monitor and we take a look at, but it's for us to go out and start detailing what the impact these things are. But of course in the long term, it should have a positive impact on conversions and as a result all resulting metrics that affect conversion."
},
{
"speaker": "Patrick Pichette",
"text": "Heather, I'll just jump on your very last question about FX related to CPCs. As I said in my comments, there's actually a marginal effect. I mean FX was not a big factor this quarter. I mean it has been a little bit for the UK as I mentioned but for the rest of the world, it has not been a major impact for the CPC issue. Thank you for your questions, Heather. Jamie, let's go to our next question, please."
},
{
"speaker": "Operator",
"text": "We'll go next to Justin Post with Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "Great. Thank you. Patrick, the gross profit growth has been trailing revenue growth. I think it was about 14% this quarter for about three quarters especially. Can you talk about what's really kind of drove the step down last year in 3Q? And is there any way to see that gap close and do you use gross profit as a measure or do you look more at revenue growth? Some of the drivers of the difference will be really helpful. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks, Justin. Again, a topic that's for financial analysts have been always kind of top of mind. I just want to kind of reiterate kind of some of the basic messages that have not changed and how we think about this. So first of all, we care about revenue growth, we care about profitability, we care about both. And I've said this before, right, we're not in a business to lose money, cross subsidize or any of these things. So regarding margins we really look at every incremental profit dollar that creates shareholder value and really focused on these profit dollars rather than the percentage margins. Many of the new opportunities that we may be exploring whether it be hardware, whether it be Play, whether it be – many of these will have different margins in our core business, but they actually offer great kind of – huge revenue pools, huge margin pools in absolute dollars and then create much shareholder value and in many cases with Larry and the product area leads, great synergistic value between the products to create this great experiences. So, that's basically the mindset that we apply at it and we track them independently and together and make sure that we actually deliver continued revenue growth and profit growth. So that's the mindset which we apply. And don't read in my comment that we're not focused on our core business. It remains our core business. The core is the core is the core, and it continues to give us both revenue and oxygen profits to kind of fuel our growth as well. So that's the balanced answer to your question."
},
{
"speaker": "Justin Post",
"text": "If I could follow-up, is there anything in there that maybe operating right now at negative gross margins that is kind of in-transitory in nature?"
},
{
"speaker": "Patrick Pichette",
"text": "I wouldn't comment on a specific product by product, but it's clear that if there are timing issues, if there's a product that actually isn't in investment mode, right, and at the beginning of its investment curves, you know that you're actually investing in it for the timing of future profits. We do that too. I mean you can imagine our very first customer in Kansas City, right. The P&L for that day was negative, but that's not why we did Kansas City, right. We did Kansas City because we know as a city was going to be very profitable, so there is clearly products that have because of the timing investment movements that actually show – will show negative, but not because we want them to be negative just because of where they are during investment phase. So that's how we think about it. Thank you for your question. Jamie, let's go to the next question, please."
},
{
"speaker": "Operator",
"text": "We'll go next to Brian Pitz from Jefferies."
},
{
"speaker": "Brian Pitz",
"text": "Thanks. Nikesh, you briefly mentioned PLAs. We continue to see that format in Search and recently we noticed integrated deals and offers into that format, any additional color on the impact from PLAs in the quarter? And then Larry, regarding product search, I guess more broadly, do you think users will be able to purchase items without ever leaving the Search results page at some point? Thank so much."
},
{
"speaker": "Larry Page",
"text": "Thanks, Brian. I'll take the second question first. I think to the extent and obviously we can streamline the process of doing transactions or fulfilling any task and that's a good thing. I think in the trial we are doing in the Bay Area with [same day] delivery you can buy things very easily and get them delivered in a couple of hours. That was a pretty great experience. So we definitely look at any ways we can find to really improve our user's experience. Nikesh, do you want to take over the PLA part?"
},
{
"speaker": "Nikesh Arora",
"text": "As Larry mentioned, we are trying to get the user experience to be better and better. And as we've talked in the past, things are moving from 10 blue links to entity level search where people are searching for specific entities and they expect a response as a specific entity when doing that search. So think about PLA in the broader context, that when people search for something they like to get the answer. And if it's a product they're searching for, of course PLA has satisfied that requirement. So we are signing up tens of thousands of merchants who want to share that data with us, who want to make that data visible as part of Google Search. So we think this is a good thing. Again, as we provide more and more PLA information, obviously it has an impact on peoples clicking on those links. So in the long term that should have a positive impact on fixers on various ad formats, but for now it's too early to talk about the impact of those with the overall numbers that we have."
},
{
"speaker": "Nikesh Arora",
"text": "Thank you for your question, Brian. Jamie, let's go to our next question. We have time for a couple more."
},
{
"speaker": "Operator",
"text": "We'll go next to Gene Munster with Piper Jaffray."
},
{
"speaker": "Gene Munster",
"text": "Good afternoon. A question on Motorola X, I know you haven't said a ton about it but there has been some talk that you're going to be aggressively marketing that. Can you just talk a little bit about this relationship that you have between having the Motorola X phone be enough of a success that you make a statement but not enough of a success that you end up corrupting or impacting your Android partners, so talk about that relationship? Thanks."
},
{
"speaker": "Larry Page",
"text": "Thanks for the question, Gene. I think nothing about what we've said has changed and we operate Motorola independently. As you can see in the level of work that's going on there to operating that business, I think teams are doing a great job as we mentioned. I think they're working hard on making a great product. And I think we're really excited about it. I think they're excited about it and obviously you'll get to try it out pretty soon."
},
{
"speaker": "Gene Munster",
"text": "Do you feel that the – I mean the incremental investment, is it going to be – it's been rumored to be $500 million, is it something in that range?"
},
{
"speaker": "Larry Page",
"text": "Are you talking about I guess the people have been speculating about marketing and so on. And I think that obviously we’re going to – we’re operating Motorola independently, running it much the same way we would run any business like that and I think we’re doing things that are normal for that business. I think probably too much has been the made over those things."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks Gene for your question. Okay, we have time for one more question. So Jamie can you give us the last question please?"
},
{
"speaker": "Operator",
"text": "Thank you. We will take our final question from Richard Kramer with Arete Research."
},
{
"speaker": "Richard Kramer",
"text": "Thanks. Thanks very much. One for Larry and one for Patrick. For Larry, given the recent launch of YouTube subscriptions and also music services, how widely do you see Google expanding into subscription base businesses in the future and do you see this in three to five years is something that would be a meaningfully sized segment that would drive all network in size for example. And for Patrick, since you had some questions about Motorola being excited about, it is nice. But the business has lost nearly a $1 billion on a GAAP basis in the last three quarters. So, can you give us some sort of time scale for achieving returns here and I know you mentioned, you’re just looking for absolute profit dollars. But what’s the ultimate aim from Motorola in terms of contributing to Google’s profit base or even just to distribute more widely Google services? Thanks."
},
{
"speaker": "Larry Page",
"text": "That’s the question about subscription services. I mean, I think like we said, we’re really excited about the play, music subscription being really well received, I love using it. I think we are always looking for ways to meet our users needs better and obviously subscriptions are one way to do that. So I’m sure over time we will try to meet our users needs better and have our products in that area. I don’t have anything to announce this time there. On the Motorola question, Patrick you want to take down?"
},
{
"speaker": "Patrick Pichette",
"text": "Sure. I think the Motorola question has to be put into context of two things. One is while we originally paid for Motorola and all the assets we acquired and the benefits, we got out of that acquisition because there wasn’t only a short-term financial play that was the number of strategic issues. We are very pleased with the divestiture of the home business, which kind of generally quite a bit of cash over the last, in Q2. So, I think that you have to put this conversation in the context of the entire acquisition for which we were really pleased and we also are incredibly proud of what the team has accomplished in the last year. And having now kind of create this great entity under Dennis, who has now kind of lean and mean with 5,000 employees focused on the future and that with the pounding away at next generation of products. So, I will leave it to the coming quarters to kind of really demonstrate the kind of new Motorola that’s showing up and you will see that in the coming weeks actually. Larry, any last comments before we close?"
},
{
"speaker": "Larry Page",
"text": "I want to thank everyone for spending so much time with us today. And we will see you on next quarter."
},
{
"speaker": "Patrick Pichette",
"text": "Jamie, I let you close the call. Thank you everybody for your time."
},
{
"speaker": "Operator",
"text": "Thank you, sir. Again, we do thank everyone for their participation. That does conclude today’s conference. Please have a good day."
}
] | null | null |
GOOGL | 1 | 2,013 | 2013-04-18 16:30:00 | Operator: Good day ladies and gentlemen, and welcome to Google Inc. First Quarter 2013 Earnings Conference. At this time all lines are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. (Operator Instructions) As a reminder, today’s conference is being recorded. I would now like to turn the conference over to your host, Willa Chalmers, Senior Manager, Investor Relations. Please begin.
Willa Chalmers: Thank you, Sean. Good afternoon, everyone, and welcome to today's first quarter 2013 earnings conference call. With us are Larry Page, Chief Executive Officer; Patrick Pichette, Senior Vice President and Chief Financial Officer; and Nikesh Arora, Senior Vice President and Chief Business Officer. Also, as you know, we distribute our earnings release through our Investor Relations website located at investor.google.com. So please refer to our IR website for our earnings releases, as well as supplementary slides that accompany the call. You can also visit our Google+ Investor Relations page for the latest company news and update, please check it out. This call is also being webcast from investor.google.com. A replay of the call will be available on our website later today. Now, let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward-looking, including statements regarding Google's future investments, our long-term growth and innovation, the expected performance of our businesses, and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on this call, such as operating income and operating margin are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will turn the call over to Larry.
Larry Page: Hi, everyone, thank you for joining us. It’s great to be on the call this afternoon. If you’re listening online, I hope you liked our warm-up video. I heard they had a great time making it. Okay, we had a really strong start to 2013, with Q1 revenue up 31% year-on-year to $14 billion. I want to give a big shout-out to the sales teams that made this all possible. We tend to focus on product and engineering, but our business organization is tremendously strong. They are Google’s unsung heroes. Over the last two years, we worked hard to increase our velocity, improve our execution, and focus on the big bets that will make a difference in the world. Take Google now, our goal is to get you the right information at just the right time. Launched nine months ago, Now provides boarding passes, delivery updates, and traffic conditions without you having to ask first. In this quarter, we added movie tickets nicely packaged with directions to the theatre. I am also excited about our Voice Search momentum. Looking for the nearest pharmacy, just ask Google for directions, and we’ll deliver them instantly, no typing needed. And you can now ask conversational questions like do I need a jacket this weekend. Voice commands are going to be increasingly important, it's just much less hassle to talk than type. So in this quarter, we launched Chrome support for Web Speech APIs. Developers can now easily add voice recognition into their web apps. We expect to see a lot of innovation there. The velocity around Google Play is tremendous. It’s a big bet and one that’s fundamental to the success of the Android ecosystem. In our first year, we assigned partnerships with all major movie studios, music labels, and publishers, and our digital content is available in over 20 countries globally, seven of which we launched in Q1, including India and Mexico. And last week, we released a beautiful new UI with better recommendations, bigger images, and a simpler way to buy things. Play is already a great product and we are improving it at a rapid rate. As devices multiply, it’s really important that our products work seamlessly whatever device you are using at the moment. It's why I love Google Play, the ability to buy books, apps, movies or songs and have them instantly available on your Android devices even when you buy it on the web. When you switch devices while reading, your book opens exactly where you left off. In the same way, we need to make advertising across devices really simple for our customers. Online advertising has developed in a very device specific ways with separate campaigns for desktop and mobile. This makes arduous work for advertisers and agencies, and means mobile opportunities often get missed. So in February, we launched Enhanced Campaigns, a significant upgrade to AdWords. Nikesh will talk more about that in a moment. But our goal is simple; to enable advertisers to focus on their audience and their message while we dynamically adapt their campaigns across multiple devices. I've been very pleased with the rate of progress so far. We are smoothly moving a huge advertising system and ecosystem on a dime. In today's multi-screen world, the opportunities are endless. Think about your device. Battery life is a challenge for most people. You shouldn’t need to carry around a charger with you to make it through the day. If your kids spill their drink on their tablet, the screen shouldn't die, and when you drop your phone it shouldn't shatter. There is a real potential to invent new and better experiences, one that are much faster and more intuitive, so having just seen Motorola’s upcoming products myself. I’m really excited about the potential there. In just under a year, they have accomplished a lot and have impressive velocity and execution. I want to finish up by talking a little bit about the future. We invest the vast majority of our resources and time in our core products as well as our big bets like Chrome, YouTube and Android, but as CEO it’s also super important to keep focused on the future. Companies tend to get comfortable doing what they’ve always done with a few minor tweaks. It’s only natural to want to work on other things you know, but incremental improvement is guaranteed to be obsolete over time, especially in technology, where history has shown that there is a lot of revolutionary change. So a big part of my job is to get people focused on things that are not just incremental. Take Gmail, when we released that, we were a search company. It was a leap for us to put out an e-mail product let alone one that gave users 100 times as much storage as anyone else. It was the same with Android, and that’s why we’re investing in what appears to be speculative projects to you today such as self-driving cars. We found that with ambitious goals and a committed team you can make progress pretty quickly. The best people often want to work on the biggest bets and there’s not much competition, because no one else is crazy enough to try. We started Google Fiber because Sergey thought it will be great to show how high speed Internet access can improve people’s lives. Three years later, our first homes are live in Kansas City, and in the last two weeks, we have announced plans to roll out service in Austin and Provo. And just this week, after three years of development, we started handing over Glass devices to developers. I get chills when I use a product that is the future, and that happens when I use Glass. Someday, we will all be amazed [that computing involved] [ph] fishing around in pockets and purses. There are so many opportunities in the world to create technology that makes people’s lives better. We are still only at 1% of what’s possible; we are really just getting started. And that is why I am so excited to be here working hard with Googlers to take our company to the next level. Thank you. And now, I’ll turn the call over to Patrick for some detail.
Patrick Pichette: Thank you, Larry. Good afternoon, everybody, and thank you for joining us. So let me dive in by reviewing the details of our overall business financial performance. So here we go. Our total gross consolidated revenue grew 31% year-over-year to $14 billion in Q1. The overall business was down 3% quarter-over-quarter driven by the softness in Motorola Mobility segment specifically. Were it not for currency fluctuations, our consolidated revenue would have grown 33% year-over-year or an additional $96 million, but the quarter-over-quarter impact was really immaterial. Google standalone gross revenue grew 22% year-over-year to $13 billion and was flat quarter-over-quarter. Google website revenue was up 18% year-over-year to $8.6 billion flat quarter-over-quarter with strength across most major geographies and industries. Google network revenue grew 12% year-over-year to $3.3 billion and down 5% quarter-over-quarter. The quarter-over-quarter impact was largely due to the effect of advertising policy decisions implemented during Q4 and in Q1 as well. Other revenue grew 150% year-year-over to $1 billion and 27% quarter-over-quarter driven by Play store sales, which also includes both hardware and digital commerce sales. It’s worth noting that a significant part of the sequential other revenue growth is due to the implementation of an accounting change in our Play app revenue recognition policy. Currency fluctuations had an immaterial impact of Google standalone revenue both year-year-over and quarter-over-quarter. Turning now to Motorola Mobility, gross revenue was $1 billion. We continue to be very pleased with the velocity of change at Motorola as Larry mentioned. For example, this week we closed our sale of the Home business, as well as the Flextronics outsourcing agreement. We’re seeing a lot of progress across the board in the transformation of the Motorola Mobility. We’re excited about the future, but I wish to remind everyone that results from that segment will continue to be variable. At Google, global aggregate paid click growth was strong, was up 20% year-over-year and, in fact, up 3% quarter-over-quarter. Our aggregate cost-per-click was down 4% year-over-year, as well as down 4% quarter-over-quarter. Currency fluctuations had a minimal impact on Q1 CPC growth. And similar to last quarter, as I mentioned, the advertising policy change affecting network revenue continue to lower the aggregate paid click growth and improve CPC growth on a year-over-year basis. In addition, our monetization metrics continued to be impacted by the usual factors that I’ve covered many times including geomix, channel mix, property mix and product changes. Turning now to geography and our geographic performance of Google standalone business, we continue to see steady performance across the U.S., the U.K. and the rest of the world. In our earnings slides, which you’ll find in our investor relations website, you’ll see that we’ve broken down our revenue by U.S. U.K. and rest of world to show the impact of FX and the benefits of our hedging program. So please refer to those slides for the exact calculations. Revenue was up, from the U.S., was up 20% year-over-year to $5.8 billion. The U.K. was up 21% year-over-year to $1.4 billion, which include $20 million of benefits from our hedging program. And in fixed FX terms, the U.K. actually grew 20%. Non-U.S. revenue excluding U.K. accounted for 44% of our total revenue or $5.7 billion, up 24% year-over-year, which includes a $15 million benefit from our hedging program. And in fixed FX terms, the rest of world in fact grew 27%. So coming back at an aggregate level for total consolidated business, other cost of revenue was $2.9 billion in Q1, excluding stock based compensation and Motorola restructuring. Our non-GAAP operating expenses totaled $3.9 billion, which also exclude our stock based compensation and Motorola restructuring. And our non-GAAP operating profit was $4.2 billion in Q1 resulting in a non-GAAP operating margin of 30%. For standalone Google, traffic acquisition costs were $3 billion or 25% of total advertising revenue. Other cost of revenue was $2.1 billion excluding $99 million of stock-based compensation. The year-year-over increase was primarily driven by equipment cost including costs associated with the hardware sales on Play, carrier OEM revenue share driven by the implementation of our accounting change in our Play app revenue recognition policy that I mentioned a minute ago and content acquisition costs. Non-GAAP operating expenses were $2.5 billion excluding stock-based compensation of $556 million in this case and non-GAAP operating profit was strong at $4.4 billion in Q1 resulting in a non-GAAP operating margin for the Google segment of 34% for standalone. Lastly, depreciation and amortization expense on property, plant and equipment for standalone Google was $520 million for this quarter. At Motorola Mobility, our total non-GAAP operating expenses including cost to revenues were $1.2 billion. And keep in mind that intangible amortization of expenses attributed to the standalone Google and Motorola Mobility are in fact, included in these non-GAAP measures. Of the $315 million in intangible amortization expense in the quarter, $153 million was the result of the acquisition of Motorola of which $116 million was allocated to Google and $37 million was allocated to Motorola Mobility. And as a result, the non-GAAP operating loss for Motorola Mobility was $179 million in Q1 resulting in a non-GAAP operating margin of negative 18% for that segment. Let me turn to head count for the consolidated business. In fact, it was roughly flat for Q1. Keep in mind, the consolidated head count includes the Motorola Home and Home comprise roughly one-third of the total Motorola head count. Standalone Google added about 1,200 people and in total, the consolidated company ended the quarter around 53,900 full-time employees. Many of you may have noticed our effective tax rate that was very low at 8% in Q1. Please note that this quarter, the rate reflects a recognition for the full-year benefit of our 2012 federal R&D tax credit, which Congress extended, but only retroactively in January of this year, so there was a catchup for the full of 2012 in Q1. Additionally, there has been the usual mix shift of earnings between domestic and international subsidiaries that continue to impact our tax rate. Let me now turn to cash management. Other income and expense was $134 million, which reflects interest income and realized gains on investments offset by the continued impact of our FAS 133 expense from our hedging program. For more details on those or any again, please refer to the slides that accompany this call on our IR website. We continue to be happy with our strong operating cash flow at $3.6 billion. CapEx for the quarter was $1.2 billion versus last quarter at $1 billion and the majority of CapEx spend was related to production equipment, data center construction, and facilities related purchases. Our free cash flow was also strong at $2.4 billion and please note that cash flow and CapEx both include the Home business for now. And before I hand it off now to Nikesh, I want to say a few words about investing in our future and preparing for the growth of our businesses. The success of our products and our continued strong performance as portrayed by Larry’s comments, continued support, our optimism, and our confidence to continue to funding the strategic growth areas. These include not only products like Search or YouTube and Android or Chrome, but also our infrastructure as well. With that, I’ll hand it off to Nikesh who will cover in more details, our business performance in the quarter. And after his remarks, we’ll open up the phone for questions. Nikesh, all yours.
Nikesh Arora: Thank you, Patrick. Our business is continuing to perform well. We had over $13 billion in Google standalone gross revenue. Our core business is strong across Search and Display including the continued rise of Mobile. I’m particularly pleased by the positive growth we have continued to achieve in Display. Let’s review a few key highlights for the quarter before we talk in more depth about multi-screens, which Larry alluded to in bad advertising momentum. From a regional perspective, growth was fairly stable across the board this quarter. Asia continues to be our fastest growing region, Southern Europe remains stable despite the continued economic woes in the region. Auto has been a strong sector for us globally and the cold spring in the U.K. has lead to stronger growth in the retail sector there. Our shopping business continues to expand with over 1 billion products listed. This quarter, we rolled out product listing ads in Europe and also brought them to mobile devices. I want to mention our policy efforts that ensure that we're working with only the highest quality partners, which Patrick has already alluded to. We want to make sure we protect users from having bad experiences with websites and online services. So we’ve tightened our policies and enforcement in few areas like downloadable software applications. While these steps may impact network revenue in the short-term, they're essential in the long-term for a better, safer web experience for users and to encourage brands to invest more in online marketing and in our network. We strongly believe what we've done benefits us in the long-term. Shifting gears to our Enterprise business, the Enterprise business continues to experience strong growth, across pretty much all products, regions and industries. While our SMB segment is growing steadily, we're seeing significant increase from large global organizations, in fact 58% of the Fortune 500 are now actively using abate enterprise cloud product from Google. Recent wins include ANA from Japan, the largest airline, Woolworths with over 200,000 users, Australia’s largest retailer, BMW, it will use Google Places and Street View in their ultimate driving machines and the Country of Malaysia, they are adopting Google Apps for 10 million students, teachers and parents. They are going to deploy Chromebooks to primary and secondary schools nationwide. Moving on to our marketing efforts, our marketing team continues to execute flawlessly. They have helped Chromebooks increase their footprint in the U.S. expanding to more than 1,000 Best Buy stores nationwide, which pretty much doubles the previous number of stores we had. The Samsung Chromebook has been the top selling laptop in Amazon since it launched. We have rolled out Nexus 4 in Russia, Indonesia, Brazil, Mexico, and expanded in the U.S. to 3,000 T-Mobile stores. I want to focus the rest of my remarks on two continuing trends that present great opportunities for us. First, the shift to consumers to a multi-screen lifestyle and second, the ongoing movement of brand dollars online. As Larry has said, consumers are accessing content interchangeably on many screens throughout the day. Our clients are hungry to advertise where consumers are. In fact, 95% of our clients have campaigns that run across multiple screens. In February, working with Susan and Sridhar team we rolled out enhanced campaigns to make it easier for clients to manage and measure campaigns that reach people across devices. Market dealers will be able to deliver ads that are more relevant to the users’ context using features like offers and proximity bidding. And they will be able to do a better job of measuring mobile conversions. Enhanced campaigns is an important long-term bet that will help market tiers. You know this is a big change for many of our advertisers and we’ve invested tremendous amounts of time and effort into making the transition as smooth as possible. In the first two month since launch, more than 1.5 million campaigns have already been upgraded to enhanced campaigns. And these clients are beginning to see great results. We expect to migrate all campaigns that we manage by the end of the current quarter. While this is a complicated task, it’s a great example of our focus on flawless execution on behalf of our customers. Now on to brands, we see great remarketing success stories everyday. Nissan, Mexico’s biggest launch of the air, the Pathfinder featured 13 video ads and a new approach to remarketing AdWords of video. Nissan connected their stories of making sure that users who watch their videos were shown a new one each time. Newer brand-friendly formats like our expandable Lifebox ads, our Reserve inventory solution are helping clients create beautiful experience with sight, sound, and motion. Over the past year, the number of advertisers using our Google Display Network Reserve option has increased four-fold. Now, we have two-thirds of the top 100 Ad Age brands using those products. This is really helpful in developing deep partnership with our clients especially in the branding arena. For example, we’re now working directly with Adidas in Germany on the new global branding budget. Brands are also continuing to see the power of YouTube to help them reach consumers across the screens. Today, more than a billion people are finding the channels they love on YouTube every month. Users are now watching over 50 million more hours a day compared to a year ago of 50% increase. We had a record year for our Super Bowl Ad Blitz program views, votes, watch time and advertiser participation were all up from last year. We saw increased engagement across all screens. We had 1.3 million total hours of watch time of commercials on Ad Blitz, that’s equivalent to the length of 325,000 Super Bowls. More brands are also using YouTube as a strategic part of their campaign to reach the younger generation. For example, Chevrolet built awareness of the Chevy Sonic, but made for digital videos supported by YouTube and Google Ads, all contributing to successful launch of this all-new sub-compact car. Our work in brands also helps our publisher partners, our Ad Exchange supports all formats, all screens, and hundreds of publishers and continuing to grow well. We are offering new solutions for publishers like Google Consumer Surveys and Google Play to help them make money from their content. In conclusion, I want to thank all Googlers who helped deliver a great quarter into our business. This industry is moving very fast and the opportunities are numerous. We’re lucky to have such skilled and hardworking employees to help drive Google and our partners in the future. With that, thank you Patrick.
Patrick Pichette: Thank you, Nikesh. Sean, if you don’t mind, we’ll start the Q&A section now. So I’ll ask you to give us the instructions.
Operator: Absolutely, thank you. (Operator Instructions) Our first question comes from Mark Mahaney with RBC. Please go ahead with your question.
Mark Mahaney: Okay, two questions please. First, Patrick, you mentioned this accounting change that I – could you just give us a little bit more detail on what that accounting change was versus Play? And then could you talk about the TAC trends? I know it’s just one part of your business, but you seem to be moving in different directions on your own sites, continuing to rise pretty dramatically, but on your network partner sites, falling off pretty significantly. Can you just help us think about what that should look like going forward for both of those segments? Thanks a lot.
Patrick Pichette: Yeah, thank you for your question, Mark. Let’s take them in row. First on the apps revenue recognition policy, let me explain what happened there, and I’ll use it with an example if you don’t mind. If you – and the way we did it is, we changed the revenue recognition. So if you say, you buy an app for $1 on the PlayStore, $0.70 of that dollar will be paid to the developer and does not impact on P&L, it didn’t before and it still doesn’t today. So that hasn’t changed. In the past though, we would have booked the remaining $0.30 on a net of payments to carriers and OEM and then booked that as gross revenue. Beginning in Q1, however, the entire $0.30 is now booked as gross and the payments for the carriers and the OEMs are now booked on other cost of revenue. So that’s the big change that has happened and basically the reason why we did this is as part, we were looking to the second half of 2012, we were seeing these used to be kind of immaterial numbers for us. And then when we saw through the second half of 2012, we decided to kind of tune our accounting policies and made that change in Q1. So that’s the issue what’s going on the revenue recognition. So you’ll see the impact both on gross and then as I said on other cost of revenue and then you get the net. So on a net basis, it doesn't change. On the TAC issue that you’ve raised, Mark, the answer is pretty simple, right? If TAC is dropped overall, because of the change in our ad policies that we’ve done through Q4 and Q1, so in pushing hard on implementation of our ad policies to the benefit of the user, the impact of that is actually that it lowered our network revenue, but it also lowered our TAC, which is tied to AdSense partners in that role. On Google sites, you have noticed that it continues to grow, and it grows because of mobile growth. So the volume of mobile in our mix is driving TAC to go up. So, overall TAC is down for the quarter as an aggregate basis. The ad policy changes have driven them down and then our mobile for our own sites continue to drive them up. But that’s a good story because it means mobile has really continued to be on fire. So that’s the pieces of the puzzle. Thanks for your questions because it wasn’t that easy to understand at first. But I hope that clarifies the point. Thank you, Mark. Sean, to our next question please?
Operator: Our next question comes from Ben Schachter with Macquarie. Please go ahead with your question.
Ben Schachter: Larry, in your prepared comments, you spent quite a bit of time discussing the non-core future products. I wonder if you could talk about any changes to the amount of resources being invested in Google X and these products? And also, can you tell us how you determine the appropriate size of the investments in these various teams and products? And then just quickly separately, Knowledge Graph, just in general if you can give us an update on the progress and sort of how you measure that progress internally? Thanks.
Larry Page: Yeah, thanks, Ben for the questions. I feel like every time I say anything I get this question. I think honestly my job as CEO is to get people to do those things. If you look at most companies, they will never do anything different and eventually they run into problems for that reason. So I think that’s the common failure mode. I think the reality is it’s pretty hard to invest significant amounts in new things, because it’s actually difficult to get people to do those things. So, we have nothing to say differently about our general philosophy of 80% on our core things. I said that in my remarks basically that we’re still focused on our core products and our big bets. And that’s clearly, the vast majority of our resources, and we’ll add resource to the new things as we’re able to and as they show success. As an investor, I am – I as a big shareholder of Google, I’m certainly not worried about the expense of that because I don’t think like I said it’s not easy to spend that much money on the new things. I’ll be more worried that we don’t do those things fast enough and build on revolutionary change that happens in the technology industries. On the Knowledge Graph, I think there’s been tremendous progress there, we’ve done internationalization. There’s a quality improvement and we’re improving the kind of questions we can answer as I mentioned about weather and other things that happens from improvements to our Knowledge Graph, and I’m very excited about that. And I think we still have big investments there and you still for a long time will continue to see improved products there. So can we have our next question?
Operator: Our next question comes from Anthony DiClemente with Barclays. Please go ahead with your question.
Anthony DiClemente: Thank you very much. First question for, Larry, I’m just wondering if you could give us your thoughts on the impact of Facebook Home for Android just given some have talked about the possible impact on engagement with other Android apps. And then secondly, and I guess this would be for anyone who wants to take it, I think investors are just wondering about Enhanced Campaigns that you talked about launching in February. should we expect any sort of bumpiness or any sort of near-term dislocation from your advertisers who are starting to become accustomed to Enhanced Campaigns, on boarding to that platform with the understanding in the long-term opportunity of course? Thanks.
Larry Page: Thanks, Anthony. I’ll take the first question there; maybe, I’ll give the second one to Nikesh. I think that Google is really focused on building and creating great Android experiences within the strong ecosystem that we have. And it’s really great to see developers really focused on and building for Android. So I’ll give Nikesh the second question about The Enhanced Campaigns. But I’m certainly, as I mentioned, I think it’s gone pretty smoothly. I’m pretty excited about it.
Nikesh Arora: Yeah, thank you, Anthony. As Larry just said that, it was very complicated. We had to train a sales force around the world and to launch simultaneously and work with our product team. But so far, the feedback we’ve gotten from advertisers is, it is positive, because it basically takes away a lot of work from them and we’ve been able to migrate 1.5 million campaigns to enhanced campaigns. we also have some great suggestions from our advertisers about what we should do to make it better and we’re beginning to implement those. So we’re hoping that towards the end of this quarter, we should have migrated all of the campaigns, which are done separately as mobile and separately the desktop as combined and really offer them the benefits of location, context, screens, all with one campaign. So effectively I think in the long-term that should be better ROI.
Anthony DiClemente: Okay, thank you very much.
Nikesh Arora: Sean, why don’t we go to the next question please?
Operator: Absolutely, your next question comes from Justin Post with Merrill Lynch. Please go ahead with your question.
Justin Post: Thank you. My question just is the mobile impact on the business, it looks like your top line revenues have somewhat stabilized. But how is the transition to mobile impacting your kind of high level revenue growth over a period of quarters and also your margins, maybe you could give us a little help on that? And then maybe, Larry, could you address the concern that constantly comes up about people using apps versus a Google Search, obviously, the disclosures you’ve given suggest revenue on mobile is going at or above the industry, but are you seeing any pressure from app usage versus search usage on mobile? Thank you.
Larry Page: Yeah, thank you, Justin. I think, maybe, I’ll take the first one, second one first. You know we always get this question about other apps versus Google Search. I think, I am not super concerned about that issue. I think that people use lots of apps on the web over many strong sites and so on. So we’ve been dealing with that issue for a long time. I think fundamentally search is an amazing thing for publishers and software developers and everybody else and we deliver a lot of traffic and lot of users to things and so, I think in general the information wants to be found and we’re working hard to make sure that the user experience is great and that we are delivering people into the right places. So I think I feel pretty confident on that – in the future that we’ll get through that just fine. So the second half of your question?
Patrick Pichette: The first part of the question was about top line Mobile versus other impacts on the business and margins. Let me just jump in on this one quickly, and it’s really about the new reality where we have all the multi-screens. And I mean, Larry talked about this at length at the last earnings call where the reality now is it’s not about mobile or tablets or desktop, it’s about this unified life that you have where you’re always connected and the question is are you giving the best answer all the time following me throughout my day. And that’s why in fact Enhanced Campaigns is a great signal of that; where you’re saying, hey, let’s find the right ad at the right time and the right answer at the right time for you to during your day. So I think that rather than to ask if you know which small piece part is going to kind of contribute plus or minus, the real question is are we growing the pie of your day with Google and in the long-term are we really kind of contributing to create the best answers both for the advertisers and for users, and that’s really what we’re actually pushing for. So I think that this trend really presents to us enormous opportunities and when people ask about what’s going on with TAC Patrick or what do you think the impact of CPC on a very specific basis, I think that that’s the wrong way to ask the question. The real right way is the excitement we have about kind of helping you throughout your day on all your devices, right and the pie grows for everybody. And that’s the right way to ask the question. So thanks for your question on that, Justin.
Justin Post: Thank you.
Patrick Pichette: Why don’t we go to the next question, Sean?
Operator: Our next question comes from Carlos Kirjner with Sanford Bernstein. Please go ahead with your question.
Carlos Kirjner: Thank you for taking my question. I have two. First on Google Fiber, taking aside the user experience for those who get it. How do you expect Fiber to have major impact given that you take many billions and several years to pass, something like 20 million U.S. homes, and after all of that, time and money, you would be at best and mid-sized provider in a market that accounts for less than half of your current business. Secondly, on the future of Search, Larry you mentioned voice commands in your opening remarks. We already get voice output with Jellybean. Put this together with Google Now and Knowledge Graph and we see our future where you'll get the answer to your question sometimes before you ask it. How do ads come into this view? How do you generate revenues in the world like this where you guys seem to be going to? Thank you.
Patrick Pichette: Why don't I jump on the first question and I'll let Larry answer the second one. Look, on Fiber, I think it's really simple. It's very early days. We're totally excited about delivering a great user experience with faster than Internet speed. And Gigabit as Larry said with Sergey's kind of quest a few years ago, Gigabit speed over hundred times faster than the average American. I mean, that is a great user experience and it's really about pushing for speed and writing the new chapter, the next chapter of the Internet. So for us I think we really are excited about this and that's really where we're focused on. On the second question, I'll let Larry give his comments.
Larry Page: I'm glad you're very ambitious too, because Fiber industry is not big enough for you so I applaud that. I think, we would love to find businesses much bigger than our entire current business to invest in, but I think there's only a very small number of such companies that even exist. So I think, we look at places where we can provide a lot of – on Fiber we look at places where we can provide products that can make really big difference in peoples' lives and we can make a lot of money and resources doing it. And I think it certainly meets that criteria, although as Patrick said, it's very early days. On the voice pass and knowing what people want before they ask for it and how do we make ads on that, how do we make revenue and ads on network. I am not worried about that at all, that’s how we’ve been doing this for a long time and in fact, we really view the reason we’ve been successfully doing advertising is we feel that is another source of information, seeing all the search ads that we show has to be very relevant and make sensitive at that moment. And the more – the better job we can do in providing you information even with [with regard you’re] asking for it, the better we can also provide commercial information to you that people are excited about promoting to. And I think that’s actually huge, huge opportunity for us. We are all about making things more efficient, marketing the right information to the right people at the right time and that’s how we’re going to improve in the kind of world that you are talking about. All right, can we have our next question?
Operator: Our next question comes from Scott Devitt of Morgan Stanley. Please go ahead with your question.
Scott Devitt: Hi, thanks. I had two please; the first one for Nikesh. You recently discussed the opportunity for online advertising to exceed 50% of total advertising in the next five years and you referenced video and Internet connected devices’ as catalyst, it’s a big number. So I was just wondering if you could talk about that in a little more depth and the way Google products actually service catalyst for that change? And then secondly for Larry, could you just discuss the transition in Android management and what exactly Andy Rubin is going to be doing now that he has a new role? Thank you.
Larry Page: Okay, Nikesh, you want to take the first one?
Nikesh Arora: Sure. Scott, thanks for your question. I think what I was referring to was the fact that I believe in the next few years, we will see connected TVs everywhere and we’ll be able to address a TV using IP. When that begins to happen, I think the products we have in place, where we can dynamically serve ads, which are more personalized, which look more like information on display platforms or video platforms is going to be very relevant. So I think over time the television industry shifts to a more addressable, more personalized, more IP addressable type of platform and I think we’re well positioned in that space given our large focus and emphasis on brand, given our huge technology efforts that Susan’s team does in our display and video and really getting our sales force working really well with various brand advertisers around the world. So, we are preparing for that eventuality and we hope it comes sooner than later.
Larry Page: And on the management change question, I think, as we’ve already said, we’ve really exceeded crazy ambitious goals we dreamed of for Android. It’s the most used mobile operating system in the world and a very big thanks to Andy for that. He really decided it was time to hand over the reigns and start a new chapter at Google. And we actually have an outside – we haven’t said what that is and I’m not going to make news today on that. And actually going forward, Sundar is going to lead Android in addition to his existing work on Chrome and apps. He has a great talent for creating products that are really technically excellent yet easy to use and he loves a big bet too. So, we said how that performed I think we had very smooth transition and of course excited about the future.
Nikesh Arora: Sean, let’s go to our next question please?
Operator: Our next question comes from Ross Sandler of Deutsche Bank. Please go ahead with your question.
Ross Sandler: Thank you. Guys, I had a couple of questions about Google Glass. Larry, we had a chance to try out Glass a few weeks ago and we think you guys really nailed it, so congrats to the team. But can you talk about the overall strategy with Glass? How do you plan to build up the ecosystem for the third-party developers? What do you see as the biggest functions that Glass could address for users? And then do you expect the $1,500 price tag to come down to a level that’s more mainstream or is this likely to remain a higher-end luxury device. Thanks?
Larry Page: Yeah. Thanks, Ross. I’m glad you’re excited about Glass. I am too. Now let’s say it is early days on the profit for just, handing over small numbers so far. I think that we’re probably pretty good at third-party ecosystems, our experience on Android and the bunch of other areas. So I’m not too worried about that. There’s been a lot of speculation on that. I would just say it’s early. And I think the price tag was set for developers for an early test. We don’t have any news to announce there, but it was clearly – I’m not sure I’ll call it a luxury price, but certainly a pretty high price. I think that what I’m, like doing with my Glass, I think – what do people do in Glass? I really – I find that photo taking and the video, phone calling, quick messaging, directions, all to be a pretty amazing experience and that’s some of the core functionality we built into the device, we’re excited to really get it out to some developers and have other people create some amazing experiences with it, which we haven’t thought of yet. I guess that it’s still early days. But I think it’s very exciting. Our next question, please.
Operator: Our next question comes from Brian Pitz of Jefferies. Please go ahead with your question.
Brian Pitz: Thanks. You mentioned expansion in the PLA ad format during the call. Would you give us a sense for how maybe CPCs on these PLAs compares to the overall average and what kind of trends you're seeing? And perhaps any comments on the current mix of CPC versus cost per action or convergence and any kind of incremental data on how they perform? Thanks.
Nikesh Arora: Hi, this is Nikesh. So I guess on DLA so far we're very excited, we have a whole billion items in the product listing ads and we just launched it in Europe. It's too early for us to share numbers around that topic, but so far all I would like to say is, it's been neutral. There has been no impact that we’d like to share at the current moment.
Brian Pitz: Okay.
Patrick Pichette: Next question please.
Operator: Our next question comes from Douglas Anmuth with JPMorgan. Please go ahead with your question.
Douglas Anmuth: Okay, thanks for taking the questions. Just want to ask two things. Nikesh, you talked about Southern Europe being stable in terms of macro. Just curious, since over the last three months if you have seen any changes at all in macro across the U.S. or Europe? And then secondly, Patrick, if you could just talk about how you think about the longer-term margins on the Google segment, that would be helpful. Thanks.
Larry Page: I think Nikesh seems to spend a lot of time in Europe due to the nice weather there.
Nikesh Arora: Nice weather just be more recently, Larry, Q1 was pretty dismal, but – from a weather perspective. Douglas, thanks for the question. I think, as I said, Southern Europe has been stable, because there has been concern at the macro level in Southern Europe, but our business has been stable. I think the macro conditions have been going on for a while. As far as the U.S. and Europe, I don't think there was anything out of the ordinary that we saw as it relate to our business results, and our teams continue to execute and we continue to engage with advertisers across the board, large and small, and we haven't seen any shift in those trends.
Larry Page: Let me jump on the second part of the question. Look I – it’s very clear, we care about revenue growth, we care about profitability, and as we’ve said before, right, we’re not in the business of money losing businesses. So regarding margin, for us what really matters is every incremental profit dollar creates shareholder value and we’re focused on growing these profit dollars rather than the specific of the average aggregate margin. So if you have business for us, that can be a $20 billion business that has a much lower margin than ours, but kind of contribute a couple of billion for the bottom line of the company, what’s not to like, right, especially if it’s rather capital light. And these are the areas that we’re, in addition to our core business, right, exploring and by the way, they have a great symbiotic relationship, right. When you have devices that are kind of magical and that kind of feed within our core software businesses, there’s this kind of magical relationship as well that kind of continues to enhance our offering. So the real trick there is to keep focused on dollar margin pools, dollar margin in revenue and then not worry too much about where the aggregate shows up because it’s all good for the shareholders.
Nikesh Arora: We shall say, of course, we always look for businesses that are very high margin and high revenues of course too. We’ll take our next question?
Operator: Our next question comes from Heather Bellini of Goldman Sachs. Please go ahead with your question.
Heather Bellini: Hi, great. I just had a couple of questions. One, I was just wondering if you could talk a little bit about what you guys can do to help prevent Android fragmentation if you could kind of give us your views there. And then on Fiber, I had a follow-up, if maybe you could go beyond the obvious, which is the obvious benefits that people are getting in cities that you’ve rolled out to. If you could maybe help us think about the types of services or offering that you guys see as being possible as this becomes more broadly deployed. And then lastly, especially given your prior comments on capital light, I was just wondering how we should think about your appetite for CapEx for Fiber. Thank you.
Larry Page: Yeah, thanks, Heather. I guess I can talk a little bit about the Android in the area. And I think that I’ve actually had the pleasure recently of using a bunch of different Android phones from different manufacturers. The experiences are a bit different. The return, the menu back button is on different sides or things like that. There’s differences like that, just somewhat fragmented. But beyond that, we had a pretty great overall experience and there’s a lot of innovation and that the platform is moving really quickly and that’s how we designed it. So I think that’s – then the negatives on such fragmentation and the positives on such innovation and flexibility for the different users of the Android ecosystem. So I think actually it’s working pretty well. And we obviously evolve the ecosystem and make sure – making sure that user got a really great experience and making sure, paying attention to the lab and making sure that works well. But I think we’re actually doing a pretty good job. I think on Fiber, you had some questions on Fiber, I think Patrick can address that.
Patrick Pichette: Yeah, I think that the thesis is not only about the future but it’s really a lot about today. Speed matters today, right? When you wait for three seconds to get to a YouTube video today with your current provider, right? That is a terrible answer. And we think that Fiber and the services we offer in Kansas City today actually can go – goes a long way to solving a lot of today’s frustrations independent of tomorrows. In addition to that, our Kansas City offer that we have, right, is already quite differentiated in offering kind of an amazing service, for example, with storage with 2 terabytes of storage available and another in the cloud that really kind of not only is about speed, but it’s about a package that says, you should have abundance. And with abundance, then the third piece which is kind of I think where you were going is the excitement of what the developer community can actually create for a world that is in fact, at blazing speed and with an abundant of storage. So I think it’s already today answering a big need, it’s already today quite differentiated and it is just laying the path for what should be the next change of the Internet. And I think that you see it in Kansas City with so many developers moving to Kansas City to actually kind of create this coming world, just gives you a glimpse of all the opportunities that are out there. And that’s why we are very excited about it. I think it’s a….
Heather Bellini: And that’s great, thank you. And I was just wondering if you could help us think about the appetite for CapEx?
Larry Page: All right. I mean, we’re going to look at these businesses as we look at any business and make appropriate investments. I think that obviously we know what’s going on with our business and excited, it’s early days, we’re excited about it. And we will continue to evolve that. But as I said earlier too, I mean, it’s difficult if you – even if you want to spend a lot of money on these kinds of things I think it is quite difficult to do that. So I think that’s also good to keep in mind, some things have a natural rate of growth, but makes sense we’ve done pretty well with that over time.
Heather Bellini: Great. Thank you.
Nikesh Arora: Let’s go to our next question, Sean, please. We probably have time for one or two.
Operator: Okay. Our next question comes from Stephen Ju with Credit Suisse. Please go ahead with your question.
Stephen Ju: Thanks very much. So Larry, can you give us some sense of how much incremental engagement you think you can see for Google’s products with new form factors like Glass, and I guess, Watch, as we look out over the next three to five years? And how transportable is Android across these form factors and in terms of getting OEMs and other operators beyond just the smartphones and tablets to adopt that. And, Nikesh, thanks for a number of campaigns on the enhanced campaigns platform. Now wondering like what percent of your advertisers do you think have optimized their sites for content delivery across multiple devices? And when do you think we’ll get greater ability for attribution across mobile and desktop? Thank you.
Larry Page: I think, Steve, there is a lot of questions, I think we got (most of them) [ph], let’s see. So incremental engagement from Google’s products from Glass and so on and watches and things, I think that computers are now pretty big part of people’s lives and I think that’s increasing as it gets more and more useful. And so the amount of time, you only have 24 hours in a day, so there is some limit to that. But I think more importantly, the usefulness of your engagement is going to increase. So right now, while you are just kind of using your computer or your phone or your tablet or whatever and you are kind of bored, maybe you will be less bored and more productive or enjoy what you are doing more and seeing more meaningful engagements. And I think that can result in much better business results and happier people and all that. I think obviously Glass runs on Android, so it’s been pretty transportable across devices, and I think that will continue. I think, Nikesh, do you want to address the enhanced campaigns a little bit?
Nikesh Arora: Yeah, so thank you Steven for your question. I think what’s important to note is before we launched our enhanced campaigns journey in February, we have been very actively working for the last year plus on our grow more campaign, which is grow more, because clearly, the first part of anybody leveraging the mobile websites just to have one. So we spent a lot of time working with our advertisers and partners out there both to get them online and also to get them mobile. And I think the enhanced campaigns with them was a logical step beyond that. Once you have mobile capability, once you have mobile sites and desktops, we want to make sure that you can get best ROI across those things. I think we’re still working on this; we’re still down the journey. we have a significant number of our early adopters on to enhanced campaigns and as I said, we intend to get them all migrated in the next few months, another next 10 weeks actually. So should be pretty good. in terms of future, I think we also alluded to the fact that some of the things we’re offering them are things like proximity bidding and offers. so it’s more about first getting them to leverage, their current capabilities, but then also giving more context and more location, which hopefully generates more ROI in the future.
Steve Ju: Thank you.
Nikesh Arora: We have time for one last question. Sean, who’s getting our last question?
Operator: Our final question comes from Neil Doshi with Citigroup. Please go ahead with your question.
Neil Doshi: Great, thanks for squeezing me in. Larry, could you talk a little bit about online/mobile to offline attribution and what Google is doing to help kind of bridge that gap and to help our advertisers realize ROI? And then, Nikesh, can you just give us an update as to how far you are through the apps changes policy with your network partners? Is that pretty much all done now or is there more to go there? Thanks.
Larry Page: Thanks, Neil, for your question. I think maybe Nikesh, who is the expert on both these. I think our business has always been about attributing advertising spending and results accurately. And the whole success of our company is really based on that one thing. So we are paying a lot of attention to those kind of questions. So, Nikesh, take it away.
Nikesh Arora: Yeah, Neil, thanks for the question, and thank you, Larry. I guess, what’s the important part is, we have been working, we have hundreds of studies now working with our advertisers to actually look at both the offline and online impacts? And one of the recent things we did is, online to store as we have helped people understand how their online campaigns are driving more and more people into store, which is most of an online activity. We also look at the entire customer journey. We look at across media effectiveness to show how you can run a campaign in the off-line world, how you can add online to it and what kind of attribution that gets you in all off-line media as well as online media. So we do a bunch of stuff like that. So our research teams are working with external research organizations. So I think we have a reasonably robust practice there working with our advertisers. And in terms of the update, in terms of the ads policy changes, we have implemented all of our ads policies. We obviously have worked with almost all of our network partners. They understand our policies. Many of them have made changes. I think we should be done with most of the transition, but of course, the effect of this policy change will continue to happen throughout the rest of the year.
Larry Page: Okay. Well, thanks.
Patrick Pichette: Yeah. You there?
Larry Page: I'm sorry; I didn’t hear myself, sorry. I was going to ask – thank everyone for spending so much time with us today and we look forward to hearing from you in the next quarter.
Operator: Thank you.
Patrick Pichette: Sean, we'll let you close the call. Thank you everybody for joining us.
Operator: Thank you. Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the conference. You may now disconnect. Good day. | [
{
"speaker": "Operator",
"text": "Good day ladies and gentlemen, and welcome to Google Inc. First Quarter 2013 Earnings Conference. At this time all lines are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. (Operator Instructions) As a reminder, today’s conference is being recorded. I would now like to turn the conference over to your host, Willa Chalmers, Senior Manager, Investor Relations. Please begin."
},
{
"speaker": "Willa Chalmers",
"text": "Thank you, Sean. Good afternoon, everyone, and welcome to today's first quarter 2013 earnings conference call. With us are Larry Page, Chief Executive Officer; Patrick Pichette, Senior Vice President and Chief Financial Officer; and Nikesh Arora, Senior Vice President and Chief Business Officer. Also, as you know, we distribute our earnings release through our Investor Relations website located at investor.google.com. So please refer to our IR website for our earnings releases, as well as supplementary slides that accompany the call. You can also visit our Google+ Investor Relations page for the latest company news and update, please check it out. This call is also being webcast from investor.google.com. A replay of the call will be available on our website later today. Now, let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward-looking, including statements regarding Google's future investments, our long-term growth and innovation, the expected performance of our businesses, and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on this call, such as operating income and operating margin are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will turn the call over to Larry."
},
{
"speaker": "Larry Page",
"text": "Hi, everyone, thank you for joining us. It’s great to be on the call this afternoon. If you’re listening online, I hope you liked our warm-up video. I heard they had a great time making it. Okay, we had a really strong start to 2013, with Q1 revenue up 31% year-on-year to $14 billion. I want to give a big shout-out to the sales teams that made this all possible. We tend to focus on product and engineering, but our business organization is tremendously strong. They are Google’s unsung heroes. Over the last two years, we worked hard to increase our velocity, improve our execution, and focus on the big bets that will make a difference in the world. Take Google now, our goal is to get you the right information at just the right time. Launched nine months ago, Now provides boarding passes, delivery updates, and traffic conditions without you having to ask first. In this quarter, we added movie tickets nicely packaged with directions to the theatre. I am also excited about our Voice Search momentum. Looking for the nearest pharmacy, just ask Google for directions, and we’ll deliver them instantly, no typing needed. And you can now ask conversational questions like do I need a jacket this weekend. Voice commands are going to be increasingly important, it's just much less hassle to talk than type. So in this quarter, we launched Chrome support for Web Speech APIs. Developers can now easily add voice recognition into their web apps. We expect to see a lot of innovation there. The velocity around Google Play is tremendous. It’s a big bet and one that’s fundamental to the success of the Android ecosystem. In our first year, we assigned partnerships with all major movie studios, music labels, and publishers, and our digital content is available in over 20 countries globally, seven of which we launched in Q1, including India and Mexico. And last week, we released a beautiful new UI with better recommendations, bigger images, and a simpler way to buy things. Play is already a great product and we are improving it at a rapid rate. As devices multiply, it’s really important that our products work seamlessly whatever device you are using at the moment. It's why I love Google Play, the ability to buy books, apps, movies or songs and have them instantly available on your Android devices even when you buy it on the web. When you switch devices while reading, your book opens exactly where you left off. In the same way, we need to make advertising across devices really simple for our customers. Online advertising has developed in a very device specific ways with separate campaigns for desktop and mobile. This makes arduous work for advertisers and agencies, and means mobile opportunities often get missed. So in February, we launched Enhanced Campaigns, a significant upgrade to AdWords. Nikesh will talk more about that in a moment. But our goal is simple; to enable advertisers to focus on their audience and their message while we dynamically adapt their campaigns across multiple devices. I've been very pleased with the rate of progress so far. We are smoothly moving a huge advertising system and ecosystem on a dime. In today's multi-screen world, the opportunities are endless. Think about your device. Battery life is a challenge for most people. You shouldn’t need to carry around a charger with you to make it through the day. If your kids spill their drink on their tablet, the screen shouldn't die, and when you drop your phone it shouldn't shatter. There is a real potential to invent new and better experiences, one that are much faster and more intuitive, so having just seen Motorola’s upcoming products myself. I’m really excited about the potential there. In just under a year, they have accomplished a lot and have impressive velocity and execution. I want to finish up by talking a little bit about the future. We invest the vast majority of our resources and time in our core products as well as our big bets like Chrome, YouTube and Android, but as CEO it’s also super important to keep focused on the future. Companies tend to get comfortable doing what they’ve always done with a few minor tweaks. It’s only natural to want to work on other things you know, but incremental improvement is guaranteed to be obsolete over time, especially in technology, where history has shown that there is a lot of revolutionary change. So a big part of my job is to get people focused on things that are not just incremental. Take Gmail, when we released that, we were a search company. It was a leap for us to put out an e-mail product let alone one that gave users 100 times as much storage as anyone else. It was the same with Android, and that’s why we’re investing in what appears to be speculative projects to you today such as self-driving cars. We found that with ambitious goals and a committed team you can make progress pretty quickly. The best people often want to work on the biggest bets and there’s not much competition, because no one else is crazy enough to try. We started Google Fiber because Sergey thought it will be great to show how high speed Internet access can improve people’s lives. Three years later, our first homes are live in Kansas City, and in the last two weeks, we have announced plans to roll out service in Austin and Provo. And just this week, after three years of development, we started handing over Glass devices to developers. I get chills when I use a product that is the future, and that happens when I use Glass. Someday, we will all be amazed [that computing involved] [ph] fishing around in pockets and purses. There are so many opportunities in the world to create technology that makes people’s lives better. We are still only at 1% of what’s possible; we are really just getting started. And that is why I am so excited to be here working hard with Googlers to take our company to the next level. Thank you. And now, I’ll turn the call over to Patrick for some detail."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Larry. Good afternoon, everybody, and thank you for joining us. So let me dive in by reviewing the details of our overall business financial performance. So here we go. Our total gross consolidated revenue grew 31% year-over-year to $14 billion in Q1. The overall business was down 3% quarter-over-quarter driven by the softness in Motorola Mobility segment specifically. Were it not for currency fluctuations, our consolidated revenue would have grown 33% year-over-year or an additional $96 million, but the quarter-over-quarter impact was really immaterial. Google standalone gross revenue grew 22% year-over-year to $13 billion and was flat quarter-over-quarter. Google website revenue was up 18% year-over-year to $8.6 billion flat quarter-over-quarter with strength across most major geographies and industries. Google network revenue grew 12% year-over-year to $3.3 billion and down 5% quarter-over-quarter. The quarter-over-quarter impact was largely due to the effect of advertising policy decisions implemented during Q4 and in Q1 as well. Other revenue grew 150% year-year-over to $1 billion and 27% quarter-over-quarter driven by Play store sales, which also includes both hardware and digital commerce sales. It’s worth noting that a significant part of the sequential other revenue growth is due to the implementation of an accounting change in our Play app revenue recognition policy. Currency fluctuations had an immaterial impact of Google standalone revenue both year-year-over and quarter-over-quarter. Turning now to Motorola Mobility, gross revenue was $1 billion. We continue to be very pleased with the velocity of change at Motorola as Larry mentioned. For example, this week we closed our sale of the Home business, as well as the Flextronics outsourcing agreement. We’re seeing a lot of progress across the board in the transformation of the Motorola Mobility. We’re excited about the future, but I wish to remind everyone that results from that segment will continue to be variable. At Google, global aggregate paid click growth was strong, was up 20% year-over-year and, in fact, up 3% quarter-over-quarter. Our aggregate cost-per-click was down 4% year-over-year, as well as down 4% quarter-over-quarter. Currency fluctuations had a minimal impact on Q1 CPC growth. And similar to last quarter, as I mentioned, the advertising policy change affecting network revenue continue to lower the aggregate paid click growth and improve CPC growth on a year-over-year basis. In addition, our monetization metrics continued to be impacted by the usual factors that I’ve covered many times including geomix, channel mix, property mix and product changes. Turning now to geography and our geographic performance of Google standalone business, we continue to see steady performance across the U.S., the U.K. and the rest of the world. In our earnings slides, which you’ll find in our investor relations website, you’ll see that we’ve broken down our revenue by U.S. U.K. and rest of world to show the impact of FX and the benefits of our hedging program. So please refer to those slides for the exact calculations. Revenue was up, from the U.S., was up 20% year-over-year to $5.8 billion. The U.K. was up 21% year-over-year to $1.4 billion, which include $20 million of benefits from our hedging program. And in fixed FX terms, the U.K. actually grew 20%. Non-U.S. revenue excluding U.K. accounted for 44% of our total revenue or $5.7 billion, up 24% year-over-year, which includes a $15 million benefit from our hedging program. And in fixed FX terms, the rest of world in fact grew 27%. So coming back at an aggregate level for total consolidated business, other cost of revenue was $2.9 billion in Q1, excluding stock based compensation and Motorola restructuring. Our non-GAAP operating expenses totaled $3.9 billion, which also exclude our stock based compensation and Motorola restructuring. And our non-GAAP operating profit was $4.2 billion in Q1 resulting in a non-GAAP operating margin of 30%. For standalone Google, traffic acquisition costs were $3 billion or 25% of total advertising revenue. Other cost of revenue was $2.1 billion excluding $99 million of stock-based compensation. The year-year-over increase was primarily driven by equipment cost including costs associated with the hardware sales on Play, carrier OEM revenue share driven by the implementation of our accounting change in our Play app revenue recognition policy that I mentioned a minute ago and content acquisition costs. Non-GAAP operating expenses were $2.5 billion excluding stock-based compensation of $556 million in this case and non-GAAP operating profit was strong at $4.4 billion in Q1 resulting in a non-GAAP operating margin for the Google segment of 34% for standalone. Lastly, depreciation and amortization expense on property, plant and equipment for standalone Google was $520 million for this quarter. At Motorola Mobility, our total non-GAAP operating expenses including cost to revenues were $1.2 billion. And keep in mind that intangible amortization of expenses attributed to the standalone Google and Motorola Mobility are in fact, included in these non-GAAP measures. Of the $315 million in intangible amortization expense in the quarter, $153 million was the result of the acquisition of Motorola of which $116 million was allocated to Google and $37 million was allocated to Motorola Mobility. And as a result, the non-GAAP operating loss for Motorola Mobility was $179 million in Q1 resulting in a non-GAAP operating margin of negative 18% for that segment. Let me turn to head count for the consolidated business. In fact, it was roughly flat for Q1. Keep in mind, the consolidated head count includes the Motorola Home and Home comprise roughly one-third of the total Motorola head count. Standalone Google added about 1,200 people and in total, the consolidated company ended the quarter around 53,900 full-time employees. Many of you may have noticed our effective tax rate that was very low at 8% in Q1. Please note that this quarter, the rate reflects a recognition for the full-year benefit of our 2012 federal R&D tax credit, which Congress extended, but only retroactively in January of this year, so there was a catchup for the full of 2012 in Q1. Additionally, there has been the usual mix shift of earnings between domestic and international subsidiaries that continue to impact our tax rate. Let me now turn to cash management. Other income and expense was $134 million, which reflects interest income and realized gains on investments offset by the continued impact of our FAS 133 expense from our hedging program. For more details on those or any again, please refer to the slides that accompany this call on our IR website. We continue to be happy with our strong operating cash flow at $3.6 billion. CapEx for the quarter was $1.2 billion versus last quarter at $1 billion and the majority of CapEx spend was related to production equipment, data center construction, and facilities related purchases. Our free cash flow was also strong at $2.4 billion and please note that cash flow and CapEx both include the Home business for now. And before I hand it off now to Nikesh, I want to say a few words about investing in our future and preparing for the growth of our businesses. The success of our products and our continued strong performance as portrayed by Larry’s comments, continued support, our optimism, and our confidence to continue to funding the strategic growth areas. These include not only products like Search or YouTube and Android or Chrome, but also our infrastructure as well. With that, I’ll hand it off to Nikesh who will cover in more details, our business performance in the quarter. And after his remarks, we’ll open up the phone for questions. Nikesh, all yours."
},
{
"speaker": "Nikesh Arora",
"text": "Thank you, Patrick. Our business is continuing to perform well. We had over $13 billion in Google standalone gross revenue. Our core business is strong across Search and Display including the continued rise of Mobile. I’m particularly pleased by the positive growth we have continued to achieve in Display. Let’s review a few key highlights for the quarter before we talk in more depth about multi-screens, which Larry alluded to in bad advertising momentum. From a regional perspective, growth was fairly stable across the board this quarter. Asia continues to be our fastest growing region, Southern Europe remains stable despite the continued economic woes in the region. Auto has been a strong sector for us globally and the cold spring in the U.K. has lead to stronger growth in the retail sector there. Our shopping business continues to expand with over 1 billion products listed. This quarter, we rolled out product listing ads in Europe and also brought them to mobile devices. I want to mention our policy efforts that ensure that we're working with only the highest quality partners, which Patrick has already alluded to. We want to make sure we protect users from having bad experiences with websites and online services. So we’ve tightened our policies and enforcement in few areas like downloadable software applications. While these steps may impact network revenue in the short-term, they're essential in the long-term for a better, safer web experience for users and to encourage brands to invest more in online marketing and in our network. We strongly believe what we've done benefits us in the long-term. Shifting gears to our Enterprise business, the Enterprise business continues to experience strong growth, across pretty much all products, regions and industries. While our SMB segment is growing steadily, we're seeing significant increase from large global organizations, in fact 58% of the Fortune 500 are now actively using abate enterprise cloud product from Google. Recent wins include ANA from Japan, the largest airline, Woolworths with over 200,000 users, Australia’s largest retailer, BMW, it will use Google Places and Street View in their ultimate driving machines and the Country of Malaysia, they are adopting Google Apps for 10 million students, teachers and parents. They are going to deploy Chromebooks to primary and secondary schools nationwide. Moving on to our marketing efforts, our marketing team continues to execute flawlessly. They have helped Chromebooks increase their footprint in the U.S. expanding to more than 1,000 Best Buy stores nationwide, which pretty much doubles the previous number of stores we had. The Samsung Chromebook has been the top selling laptop in Amazon since it launched. We have rolled out Nexus 4 in Russia, Indonesia, Brazil, Mexico, and expanded in the U.S. to 3,000 T-Mobile stores. I want to focus the rest of my remarks on two continuing trends that present great opportunities for us. First, the shift to consumers to a multi-screen lifestyle and second, the ongoing movement of brand dollars online. As Larry has said, consumers are accessing content interchangeably on many screens throughout the day. Our clients are hungry to advertise where consumers are. In fact, 95% of our clients have campaigns that run across multiple screens. In February, working with Susan and Sridhar team we rolled out enhanced campaigns to make it easier for clients to manage and measure campaigns that reach people across devices. Market dealers will be able to deliver ads that are more relevant to the users’ context using features like offers and proximity bidding. And they will be able to do a better job of measuring mobile conversions. Enhanced campaigns is an important long-term bet that will help market tiers. You know this is a big change for many of our advertisers and we’ve invested tremendous amounts of time and effort into making the transition as smooth as possible. In the first two month since launch, more than 1.5 million campaigns have already been upgraded to enhanced campaigns. And these clients are beginning to see great results. We expect to migrate all campaigns that we manage by the end of the current quarter. While this is a complicated task, it’s a great example of our focus on flawless execution on behalf of our customers. Now on to brands, we see great remarketing success stories everyday. Nissan, Mexico’s biggest launch of the air, the Pathfinder featured 13 video ads and a new approach to remarketing AdWords of video. Nissan connected their stories of making sure that users who watch their videos were shown a new one each time. Newer brand-friendly formats like our expandable Lifebox ads, our Reserve inventory solution are helping clients create beautiful experience with sight, sound, and motion. Over the past year, the number of advertisers using our Google Display Network Reserve option has increased four-fold. Now, we have two-thirds of the top 100 Ad Age brands using those products. This is really helpful in developing deep partnership with our clients especially in the branding arena. For example, we’re now working directly with Adidas in Germany on the new global branding budget. Brands are also continuing to see the power of YouTube to help them reach consumers across the screens. Today, more than a billion people are finding the channels they love on YouTube every month. Users are now watching over 50 million more hours a day compared to a year ago of 50% increase. We had a record year for our Super Bowl Ad Blitz program views, votes, watch time and advertiser participation were all up from last year. We saw increased engagement across all screens. We had 1.3 million total hours of watch time of commercials on Ad Blitz, that’s equivalent to the length of 325,000 Super Bowls. More brands are also using YouTube as a strategic part of their campaign to reach the younger generation. For example, Chevrolet built awareness of the Chevy Sonic, but made for digital videos supported by YouTube and Google Ads, all contributing to successful launch of this all-new sub-compact car. Our work in brands also helps our publisher partners, our Ad Exchange supports all formats, all screens, and hundreds of publishers and continuing to grow well. We are offering new solutions for publishers like Google Consumer Surveys and Google Play to help them make money from their content. In conclusion, I want to thank all Googlers who helped deliver a great quarter into our business. This industry is moving very fast and the opportunities are numerous. We’re lucky to have such skilled and hardworking employees to help drive Google and our partners in the future. With that, thank you Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Nikesh. Sean, if you don’t mind, we’ll start the Q&A section now. So I’ll ask you to give us the instructions."
},
{
"speaker": "Operator",
"text": "Absolutely, thank you. (Operator Instructions) Our first question comes from Mark Mahaney with RBC. Please go ahead with your question."
},
{
"speaker": "Mark Mahaney",
"text": "Okay, two questions please. First, Patrick, you mentioned this accounting change that I – could you just give us a little bit more detail on what that accounting change was versus Play? And then could you talk about the TAC trends? I know it’s just one part of your business, but you seem to be moving in different directions on your own sites, continuing to rise pretty dramatically, but on your network partner sites, falling off pretty significantly. Can you just help us think about what that should look like going forward for both of those segments? Thanks a lot."
},
{
"speaker": "Patrick Pichette",
"text": "Yeah, thank you for your question, Mark. Let’s take them in row. First on the apps revenue recognition policy, let me explain what happened there, and I’ll use it with an example if you don’t mind. If you – and the way we did it is, we changed the revenue recognition. So if you say, you buy an app for $1 on the PlayStore, $0.70 of that dollar will be paid to the developer and does not impact on P&L, it didn’t before and it still doesn’t today. So that hasn’t changed. In the past though, we would have booked the remaining $0.30 on a net of payments to carriers and OEM and then booked that as gross revenue. Beginning in Q1, however, the entire $0.30 is now booked as gross and the payments for the carriers and the OEMs are now booked on other cost of revenue. So that’s the big change that has happened and basically the reason why we did this is as part, we were looking to the second half of 2012, we were seeing these used to be kind of immaterial numbers for us. And then when we saw through the second half of 2012, we decided to kind of tune our accounting policies and made that change in Q1. So that’s the issue what’s going on the revenue recognition. So you’ll see the impact both on gross and then as I said on other cost of revenue and then you get the net. So on a net basis, it doesn't change. On the TAC issue that you’ve raised, Mark, the answer is pretty simple, right? If TAC is dropped overall, because of the change in our ad policies that we’ve done through Q4 and Q1, so in pushing hard on implementation of our ad policies to the benefit of the user, the impact of that is actually that it lowered our network revenue, but it also lowered our TAC, which is tied to AdSense partners in that role. On Google sites, you have noticed that it continues to grow, and it grows because of mobile growth. So the volume of mobile in our mix is driving TAC to go up. So, overall TAC is down for the quarter as an aggregate basis. The ad policy changes have driven them down and then our mobile for our own sites continue to drive them up. But that’s a good story because it means mobile has really continued to be on fire. So that’s the pieces of the puzzle. Thanks for your questions because it wasn’t that easy to understand at first. But I hope that clarifies the point. Thank you, Mark. Sean, to our next question please?"
},
{
"speaker": "Operator",
"text": "Our next question comes from Ben Schachter with Macquarie. Please go ahead with your question."
},
{
"speaker": "Ben Schachter",
"text": "Larry, in your prepared comments, you spent quite a bit of time discussing the non-core future products. I wonder if you could talk about any changes to the amount of resources being invested in Google X and these products? And also, can you tell us how you determine the appropriate size of the investments in these various teams and products? And then just quickly separately, Knowledge Graph, just in general if you can give us an update on the progress and sort of how you measure that progress internally? Thanks."
},
{
"speaker": "Larry Page",
"text": "Yeah, thanks, Ben for the questions. I feel like every time I say anything I get this question. I think honestly my job as CEO is to get people to do those things. If you look at most companies, they will never do anything different and eventually they run into problems for that reason. So I think that’s the common failure mode. I think the reality is it’s pretty hard to invest significant amounts in new things, because it’s actually difficult to get people to do those things. So, we have nothing to say differently about our general philosophy of 80% on our core things. I said that in my remarks basically that we’re still focused on our core products and our big bets. And that’s clearly, the vast majority of our resources, and we’ll add resource to the new things as we’re able to and as they show success. As an investor, I am – I as a big shareholder of Google, I’m certainly not worried about the expense of that because I don’t think like I said it’s not easy to spend that much money on the new things. I’ll be more worried that we don’t do those things fast enough and build on revolutionary change that happens in the technology industries. On the Knowledge Graph, I think there’s been tremendous progress there, we’ve done internationalization. There’s a quality improvement and we’re improving the kind of questions we can answer as I mentioned about weather and other things that happens from improvements to our Knowledge Graph, and I’m very excited about that. And I think we still have big investments there and you still for a long time will continue to see improved products there. So can we have our next question?"
},
{
"speaker": "Operator",
"text": "Our next question comes from Anthony DiClemente with Barclays. Please go ahead with your question."
},
{
"speaker": "Anthony DiClemente",
"text": "Thank you very much. First question for, Larry, I’m just wondering if you could give us your thoughts on the impact of Facebook Home for Android just given some have talked about the possible impact on engagement with other Android apps. And then secondly, and I guess this would be for anyone who wants to take it, I think investors are just wondering about Enhanced Campaigns that you talked about launching in February. should we expect any sort of bumpiness or any sort of near-term dislocation from your advertisers who are starting to become accustomed to Enhanced Campaigns, on boarding to that platform with the understanding in the long-term opportunity of course? Thanks."
},
{
"speaker": "Larry Page",
"text": "Thanks, Anthony. I’ll take the first question there; maybe, I’ll give the second one to Nikesh. I think that Google is really focused on building and creating great Android experiences within the strong ecosystem that we have. And it’s really great to see developers really focused on and building for Android. So I’ll give Nikesh the second question about The Enhanced Campaigns. But I’m certainly, as I mentioned, I think it’s gone pretty smoothly. I’m pretty excited about it."
},
{
"speaker": "Nikesh Arora",
"text": "Yeah, thank you, Anthony. As Larry just said that, it was very complicated. We had to train a sales force around the world and to launch simultaneously and work with our product team. But so far, the feedback we’ve gotten from advertisers is, it is positive, because it basically takes away a lot of work from them and we’ve been able to migrate 1.5 million campaigns to enhanced campaigns. we also have some great suggestions from our advertisers about what we should do to make it better and we’re beginning to implement those. So we’re hoping that towards the end of this quarter, we should have migrated all of the campaigns, which are done separately as mobile and separately the desktop as combined and really offer them the benefits of location, context, screens, all with one campaign. So effectively I think in the long-term that should be better ROI."
},
{
"speaker": "Anthony DiClemente",
"text": "Okay, thank you very much."
},
{
"speaker": "Nikesh Arora",
"text": "Sean, why don’t we go to the next question please?"
},
{
"speaker": "Operator",
"text": "Absolutely, your next question comes from Justin Post with Merrill Lynch. Please go ahead with your question."
},
{
"speaker": "Justin Post",
"text": "Thank you. My question just is the mobile impact on the business, it looks like your top line revenues have somewhat stabilized. But how is the transition to mobile impacting your kind of high level revenue growth over a period of quarters and also your margins, maybe you could give us a little help on that? And then maybe, Larry, could you address the concern that constantly comes up about people using apps versus a Google Search, obviously, the disclosures you’ve given suggest revenue on mobile is going at or above the industry, but are you seeing any pressure from app usage versus search usage on mobile? Thank you."
},
{
"speaker": "Larry Page",
"text": "Yeah, thank you, Justin. I think, maybe, I’ll take the first one, second one first. You know we always get this question about other apps versus Google Search. I think, I am not super concerned about that issue. I think that people use lots of apps on the web over many strong sites and so on. So we’ve been dealing with that issue for a long time. I think fundamentally search is an amazing thing for publishers and software developers and everybody else and we deliver a lot of traffic and lot of users to things and so, I think in general the information wants to be found and we’re working hard to make sure that the user experience is great and that we are delivering people into the right places. So I think I feel pretty confident on that – in the future that we’ll get through that just fine. So the second half of your question?"
},
{
"speaker": "Patrick Pichette",
"text": "The first part of the question was about top line Mobile versus other impacts on the business and margins. Let me just jump in on this one quickly, and it’s really about the new reality where we have all the multi-screens. And I mean, Larry talked about this at length at the last earnings call where the reality now is it’s not about mobile or tablets or desktop, it’s about this unified life that you have where you’re always connected and the question is are you giving the best answer all the time following me throughout my day. And that’s why in fact Enhanced Campaigns is a great signal of that; where you’re saying, hey, let’s find the right ad at the right time and the right answer at the right time for you to during your day. So I think that rather than to ask if you know which small piece part is going to kind of contribute plus or minus, the real question is are we growing the pie of your day with Google and in the long-term are we really kind of contributing to create the best answers both for the advertisers and for users, and that’s really what we’re actually pushing for. So I think that this trend really presents to us enormous opportunities and when people ask about what’s going on with TAC Patrick or what do you think the impact of CPC on a very specific basis, I think that that’s the wrong way to ask the question. The real right way is the excitement we have about kind of helping you throughout your day on all your devices, right and the pie grows for everybody. And that’s the right way to ask the question. So thanks for your question on that, Justin."
},
{
"speaker": "Justin Post",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Why don’t we go to the next question, Sean?"
},
{
"speaker": "Operator",
"text": "Our next question comes from Carlos Kirjner with Sanford Bernstein. Please go ahead with your question."
},
{
"speaker": "Carlos Kirjner",
"text": "Thank you for taking my question. I have two. First on Google Fiber, taking aside the user experience for those who get it. How do you expect Fiber to have major impact given that you take many billions and several years to pass, something like 20 million U.S. homes, and after all of that, time and money, you would be at best and mid-sized provider in a market that accounts for less than half of your current business. Secondly, on the future of Search, Larry you mentioned voice commands in your opening remarks. We already get voice output with Jellybean. Put this together with Google Now and Knowledge Graph and we see our future where you'll get the answer to your question sometimes before you ask it. How do ads come into this view? How do you generate revenues in the world like this where you guys seem to be going to? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Why don't I jump on the first question and I'll let Larry answer the second one. Look, on Fiber, I think it's really simple. It's very early days. We're totally excited about delivering a great user experience with faster than Internet speed. And Gigabit as Larry said with Sergey's kind of quest a few years ago, Gigabit speed over hundred times faster than the average American. I mean, that is a great user experience and it's really about pushing for speed and writing the new chapter, the next chapter of the Internet. So for us I think we really are excited about this and that's really where we're focused on. On the second question, I'll let Larry give his comments."
},
{
"speaker": "Larry Page",
"text": "I'm glad you're very ambitious too, because Fiber industry is not big enough for you so I applaud that. I think, we would love to find businesses much bigger than our entire current business to invest in, but I think there's only a very small number of such companies that even exist. So I think, we look at places where we can provide a lot of – on Fiber we look at places where we can provide products that can make really big difference in peoples' lives and we can make a lot of money and resources doing it. And I think it certainly meets that criteria, although as Patrick said, it's very early days. On the voice pass and knowing what people want before they ask for it and how do we make ads on that, how do we make revenue and ads on network. I am not worried about that at all, that’s how we’ve been doing this for a long time and in fact, we really view the reason we’ve been successfully doing advertising is we feel that is another source of information, seeing all the search ads that we show has to be very relevant and make sensitive at that moment. And the more – the better job we can do in providing you information even with [with regard you’re] asking for it, the better we can also provide commercial information to you that people are excited about promoting to. And I think that’s actually huge, huge opportunity for us. We are all about making things more efficient, marketing the right information to the right people at the right time and that’s how we’re going to improve in the kind of world that you are talking about. All right, can we have our next question?"
},
{
"speaker": "Operator",
"text": "Our next question comes from Scott Devitt of Morgan Stanley. Please go ahead with your question."
},
{
"speaker": "Scott Devitt",
"text": "Hi, thanks. I had two please; the first one for Nikesh. You recently discussed the opportunity for online advertising to exceed 50% of total advertising in the next five years and you referenced video and Internet connected devices’ as catalyst, it’s a big number. So I was just wondering if you could talk about that in a little more depth and the way Google products actually service catalyst for that change? And then secondly for Larry, could you just discuss the transition in Android management and what exactly Andy Rubin is going to be doing now that he has a new role? Thank you."
},
{
"speaker": "Larry Page",
"text": "Okay, Nikesh, you want to take the first one?"
},
{
"speaker": "Nikesh Arora",
"text": "Sure. Scott, thanks for your question. I think what I was referring to was the fact that I believe in the next few years, we will see connected TVs everywhere and we’ll be able to address a TV using IP. When that begins to happen, I think the products we have in place, where we can dynamically serve ads, which are more personalized, which look more like information on display platforms or video platforms is going to be very relevant. So I think over time the television industry shifts to a more addressable, more personalized, more IP addressable type of platform and I think we’re well positioned in that space given our large focus and emphasis on brand, given our huge technology efforts that Susan’s team does in our display and video and really getting our sales force working really well with various brand advertisers around the world. So, we are preparing for that eventuality and we hope it comes sooner than later."
},
{
"speaker": "Larry Page",
"text": "And on the management change question, I think, as we’ve already said, we’ve really exceeded crazy ambitious goals we dreamed of for Android. It’s the most used mobile operating system in the world and a very big thanks to Andy for that. He really decided it was time to hand over the reigns and start a new chapter at Google. And we actually have an outside – we haven’t said what that is and I’m not going to make news today on that. And actually going forward, Sundar is going to lead Android in addition to his existing work on Chrome and apps. He has a great talent for creating products that are really technically excellent yet easy to use and he loves a big bet too. So, we said how that performed I think we had very smooth transition and of course excited about the future."
},
{
"speaker": "Nikesh Arora",
"text": "Sean, let’s go to our next question please?"
},
{
"speaker": "Operator",
"text": "Our next question comes from Ross Sandler of Deutsche Bank. Please go ahead with your question."
},
{
"speaker": "Ross Sandler",
"text": "Thank you. Guys, I had a couple of questions about Google Glass. Larry, we had a chance to try out Glass a few weeks ago and we think you guys really nailed it, so congrats to the team. But can you talk about the overall strategy with Glass? How do you plan to build up the ecosystem for the third-party developers? What do you see as the biggest functions that Glass could address for users? And then do you expect the $1,500 price tag to come down to a level that’s more mainstream or is this likely to remain a higher-end luxury device. Thanks?"
},
{
"speaker": "Larry Page",
"text": "Yeah. Thanks, Ross. I’m glad you’re excited about Glass. I am too. Now let’s say it is early days on the profit for just, handing over small numbers so far. I think that we’re probably pretty good at third-party ecosystems, our experience on Android and the bunch of other areas. So I’m not too worried about that. There’s been a lot of speculation on that. I would just say it’s early. And I think the price tag was set for developers for an early test. We don’t have any news to announce there, but it was clearly – I’m not sure I’ll call it a luxury price, but certainly a pretty high price. I think that what I’m, like doing with my Glass, I think – what do people do in Glass? I really – I find that photo taking and the video, phone calling, quick messaging, directions, all to be a pretty amazing experience and that’s some of the core functionality we built into the device, we’re excited to really get it out to some developers and have other people create some amazing experiences with it, which we haven’t thought of yet. I guess that it’s still early days. But I think it’s very exciting. Our next question, please."
},
{
"speaker": "Operator",
"text": "Our next question comes from Brian Pitz of Jefferies. Please go ahead with your question."
},
{
"speaker": "Brian Pitz",
"text": "Thanks. You mentioned expansion in the PLA ad format during the call. Would you give us a sense for how maybe CPCs on these PLAs compares to the overall average and what kind of trends you're seeing? And perhaps any comments on the current mix of CPC versus cost per action or convergence and any kind of incremental data on how they perform? Thanks."
},
{
"speaker": "Nikesh Arora",
"text": "Hi, this is Nikesh. So I guess on DLA so far we're very excited, we have a whole billion items in the product listing ads and we just launched it in Europe. It's too early for us to share numbers around that topic, but so far all I would like to say is, it's been neutral. There has been no impact that we’d like to share at the current moment."
},
{
"speaker": "Brian Pitz",
"text": "Okay."
},
{
"speaker": "Patrick Pichette",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "Our next question comes from Douglas Anmuth with JPMorgan. Please go ahead with your question."
},
{
"speaker": "Douglas Anmuth",
"text": "Okay, thanks for taking the questions. Just want to ask two things. Nikesh, you talked about Southern Europe being stable in terms of macro. Just curious, since over the last three months if you have seen any changes at all in macro across the U.S. or Europe? And then secondly, Patrick, if you could just talk about how you think about the longer-term margins on the Google segment, that would be helpful. Thanks."
},
{
"speaker": "Larry Page",
"text": "I think Nikesh seems to spend a lot of time in Europe due to the nice weather there."
},
{
"speaker": "Nikesh Arora",
"text": "Nice weather just be more recently, Larry, Q1 was pretty dismal, but – from a weather perspective. Douglas, thanks for the question. I think, as I said, Southern Europe has been stable, because there has been concern at the macro level in Southern Europe, but our business has been stable. I think the macro conditions have been going on for a while. As far as the U.S. and Europe, I don't think there was anything out of the ordinary that we saw as it relate to our business results, and our teams continue to execute and we continue to engage with advertisers across the board, large and small, and we haven't seen any shift in those trends."
},
{
"speaker": "Larry Page",
"text": "Let me jump on the second part of the question. Look I – it’s very clear, we care about revenue growth, we care about profitability, and as we’ve said before, right, we’re not in the business of money losing businesses. So regarding margin, for us what really matters is every incremental profit dollar creates shareholder value and we’re focused on growing these profit dollars rather than the specific of the average aggregate margin. So if you have business for us, that can be a $20 billion business that has a much lower margin than ours, but kind of contribute a couple of billion for the bottom line of the company, what’s not to like, right, especially if it’s rather capital light. And these are the areas that we’re, in addition to our core business, right, exploring and by the way, they have a great symbiotic relationship, right. When you have devices that are kind of magical and that kind of feed within our core software businesses, there’s this kind of magical relationship as well that kind of continues to enhance our offering. So the real trick there is to keep focused on dollar margin pools, dollar margin in revenue and then not worry too much about where the aggregate shows up because it’s all good for the shareholders."
},
{
"speaker": "Nikesh Arora",
"text": "We shall say, of course, we always look for businesses that are very high margin and high revenues of course too. We’ll take our next question?"
},
{
"speaker": "Operator",
"text": "Our next question comes from Heather Bellini of Goldman Sachs. Please go ahead with your question."
},
{
"speaker": "Heather Bellini",
"text": "Hi, great. I just had a couple of questions. One, I was just wondering if you could talk a little bit about what you guys can do to help prevent Android fragmentation if you could kind of give us your views there. And then on Fiber, I had a follow-up, if maybe you could go beyond the obvious, which is the obvious benefits that people are getting in cities that you’ve rolled out to. If you could maybe help us think about the types of services or offering that you guys see as being possible as this becomes more broadly deployed. And then lastly, especially given your prior comments on capital light, I was just wondering how we should think about your appetite for CapEx for Fiber. Thank you."
},
{
"speaker": "Larry Page",
"text": "Yeah, thanks, Heather. I guess I can talk a little bit about the Android in the area. And I think that I’ve actually had the pleasure recently of using a bunch of different Android phones from different manufacturers. The experiences are a bit different. The return, the menu back button is on different sides or things like that. There’s differences like that, just somewhat fragmented. But beyond that, we had a pretty great overall experience and there’s a lot of innovation and that the platform is moving really quickly and that’s how we designed it. So I think that’s – then the negatives on such fragmentation and the positives on such innovation and flexibility for the different users of the Android ecosystem. So I think actually it’s working pretty well. And we obviously evolve the ecosystem and make sure – making sure that user got a really great experience and making sure, paying attention to the lab and making sure that works well. But I think we’re actually doing a pretty good job. I think on Fiber, you had some questions on Fiber, I think Patrick can address that."
},
{
"speaker": "Patrick Pichette",
"text": "Yeah, I think that the thesis is not only about the future but it’s really a lot about today. Speed matters today, right? When you wait for three seconds to get to a YouTube video today with your current provider, right? That is a terrible answer. And we think that Fiber and the services we offer in Kansas City today actually can go – goes a long way to solving a lot of today’s frustrations independent of tomorrows. In addition to that, our Kansas City offer that we have, right, is already quite differentiated in offering kind of an amazing service, for example, with storage with 2 terabytes of storage available and another in the cloud that really kind of not only is about speed, but it’s about a package that says, you should have abundance. And with abundance, then the third piece which is kind of I think where you were going is the excitement of what the developer community can actually create for a world that is in fact, at blazing speed and with an abundant of storage. So I think it’s already today answering a big need, it’s already today quite differentiated and it is just laying the path for what should be the next change of the Internet. And I think that you see it in Kansas City with so many developers moving to Kansas City to actually kind of create this coming world, just gives you a glimpse of all the opportunities that are out there. And that’s why we are very excited about it. I think it’s a…."
},
{
"speaker": "Heather Bellini",
"text": "And that’s great, thank you. And I was just wondering if you could help us think about the appetite for CapEx?"
},
{
"speaker": "Larry Page",
"text": "All right. I mean, we’re going to look at these businesses as we look at any business and make appropriate investments. I think that obviously we know what’s going on with our business and excited, it’s early days, we’re excited about it. And we will continue to evolve that. But as I said earlier too, I mean, it’s difficult if you – even if you want to spend a lot of money on these kinds of things I think it is quite difficult to do that. So I think that’s also good to keep in mind, some things have a natural rate of growth, but makes sense we’ve done pretty well with that over time."
},
{
"speaker": "Heather Bellini",
"text": "Great. Thank you."
},
{
"speaker": "Nikesh Arora",
"text": "Let’s go to our next question, Sean, please. We probably have time for one or two."
},
{
"speaker": "Operator",
"text": "Okay. Our next question comes from Stephen Ju with Credit Suisse. Please go ahead with your question."
},
{
"speaker": "Stephen Ju",
"text": "Thanks very much. So Larry, can you give us some sense of how much incremental engagement you think you can see for Google’s products with new form factors like Glass, and I guess, Watch, as we look out over the next three to five years? And how transportable is Android across these form factors and in terms of getting OEMs and other operators beyond just the smartphones and tablets to adopt that. And, Nikesh, thanks for a number of campaigns on the enhanced campaigns platform. Now wondering like what percent of your advertisers do you think have optimized their sites for content delivery across multiple devices? And when do you think we’ll get greater ability for attribution across mobile and desktop? Thank you."
},
{
"speaker": "Larry Page",
"text": "I think, Steve, there is a lot of questions, I think we got (most of them) [ph], let’s see. So incremental engagement from Google’s products from Glass and so on and watches and things, I think that computers are now pretty big part of people’s lives and I think that’s increasing as it gets more and more useful. And so the amount of time, you only have 24 hours in a day, so there is some limit to that. But I think more importantly, the usefulness of your engagement is going to increase. So right now, while you are just kind of using your computer or your phone or your tablet or whatever and you are kind of bored, maybe you will be less bored and more productive or enjoy what you are doing more and seeing more meaningful engagements. And I think that can result in much better business results and happier people and all that. I think obviously Glass runs on Android, so it’s been pretty transportable across devices, and I think that will continue. I think, Nikesh, do you want to address the enhanced campaigns a little bit?"
},
{
"speaker": "Nikesh Arora",
"text": "Yeah, so thank you Steven for your question. I think what’s important to note is before we launched our enhanced campaigns journey in February, we have been very actively working for the last year plus on our grow more campaign, which is grow more, because clearly, the first part of anybody leveraging the mobile websites just to have one. So we spent a lot of time working with our advertisers and partners out there both to get them online and also to get them mobile. And I think the enhanced campaigns with them was a logical step beyond that. Once you have mobile capability, once you have mobile sites and desktops, we want to make sure that you can get best ROI across those things. I think we’re still working on this; we’re still down the journey. we have a significant number of our early adopters on to enhanced campaigns and as I said, we intend to get them all migrated in the next few months, another next 10 weeks actually. So should be pretty good. in terms of future, I think we also alluded to the fact that some of the things we’re offering them are things like proximity bidding and offers. so it’s more about first getting them to leverage, their current capabilities, but then also giving more context and more location, which hopefully generates more ROI in the future."
},
{
"speaker": "Steve Ju",
"text": "Thank you."
},
{
"speaker": "Nikesh Arora",
"text": "We have time for one last question. Sean, who’s getting our last question?"
},
{
"speaker": "Operator",
"text": "Our final question comes from Neil Doshi with Citigroup. Please go ahead with your question."
},
{
"speaker": "Neil Doshi",
"text": "Great, thanks for squeezing me in. Larry, could you talk a little bit about online/mobile to offline attribution and what Google is doing to help kind of bridge that gap and to help our advertisers realize ROI? And then, Nikesh, can you just give us an update as to how far you are through the apps changes policy with your network partners? Is that pretty much all done now or is there more to go there? Thanks."
},
{
"speaker": "Larry Page",
"text": "Thanks, Neil, for your question. I think maybe Nikesh, who is the expert on both these. I think our business has always been about attributing advertising spending and results accurately. And the whole success of our company is really based on that one thing. So we are paying a lot of attention to those kind of questions. So, Nikesh, take it away."
},
{
"speaker": "Nikesh Arora",
"text": "Yeah, Neil, thanks for the question, and thank you, Larry. I guess, what’s the important part is, we have been working, we have hundreds of studies now working with our advertisers to actually look at both the offline and online impacts? And one of the recent things we did is, online to store as we have helped people understand how their online campaigns are driving more and more people into store, which is most of an online activity. We also look at the entire customer journey. We look at across media effectiveness to show how you can run a campaign in the off-line world, how you can add online to it and what kind of attribution that gets you in all off-line media as well as online media. So we do a bunch of stuff like that. So our research teams are working with external research organizations. So I think we have a reasonably robust practice there working with our advertisers. And in terms of the update, in terms of the ads policy changes, we have implemented all of our ads policies. We obviously have worked with almost all of our network partners. They understand our policies. Many of them have made changes. I think we should be done with most of the transition, but of course, the effect of this policy change will continue to happen throughout the rest of the year."
},
{
"speaker": "Larry Page",
"text": "Okay. Well, thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Yeah. You there?"
},
{
"speaker": "Larry Page",
"text": "I'm sorry; I didn’t hear myself, sorry. I was going to ask – thank everyone for spending so much time with us today and we look forward to hearing from you in the next quarter."
},
{
"speaker": "Operator",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Sean, we'll let you close the call. Thank you everybody for joining us."
},
{
"speaker": "Operator",
"text": "Thank you. Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the conference. You may now disconnect. Good day."
}
] | null | null |
GOOGL | 4 | 2,011 | 2012-01-20 16:30:00 | Operator: Good day, everyone, and welcome to the Google Inc. Fourth Quarter 2011 Earnings Conference Call. Today's call is being recorded. At this time, I'd like to turn the call over to Ms. Willa Lo, Investor Relations Manager. Please go ahead, ma'am.
Willa Lo: Good afternoon, everyone, and welcome to today's fourth quarter 2011 earnings conference call. With us are Larry Page, Chief Executive Officer; Patrick Pichette, Senior Vice President and Chief Financial Officer; Susan Wojcicki, Senior Vice President, Advertising; Nikesh Arora, Senior Vice President and Chief Business Officer. Also, as you know, we now distribute our earnings release through our Investor Relations website located at investor.google.com. So please refer to our IR website for our earnings releases, as well as the supplementary slides that accompany this call. This call is also being webcast from investor.google.com. A replay of the call will be available on our website in a few hours. Now let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward-looking, including statements regarding Google's future investments, our long-term growth and innovation, the expected performance of our business and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on this call, such as operating income and operating margin, are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will turn the call over to Larry.
Larry Page: Good afternoon, everyone, and happy new year. Welcome to our first earnings call of 2012. Great to have all of you here. I'm very happy with our results. Google had a very strong quarter with revenues up 25% year-on-year, 9% quarter-on-quarter, and we blew past the $10 billion mark for the first time. Pretty exciting. Looking back on 2011, I am most excited by the fact that we significantly improved our velocity and execution, my priority when I became CEO in April. With Google+, we shipped on average a new feature every day since we launched in June. That's more than 200 updates in total. And those things include a bunch of new Hangout features. In fact, David Beckham just did a great Hangout with his fans here this morning. We launched circles in Gmail and + Pages for businesses and many, many other things. I'm also pleased to announce that there are over 90 million Google+ users, well over double what I announced just a quarter ago on our earnings call. Engagement on + is also growing tremendously. I have some amazing data to share there for the first time. + users are very engaged with our products. Over 60% of them engage daily and over 80% weekly. As I said last quarter, Google+ is much more than the individual features themselves. It's also about building a meaningful relationship with users so that we can dramatically improve the services we offer. Understanding who people are, what they care about and the other people that matter to them is crucial if we are to give users what they need, when they need it. Take last week's Search announcement, which I'm really excited about. We've now included personal results in Search. So you can easily find information like photos and + posts that are super relevant to you, as well as the people you care about or are interested in. You can even restrict all personal results or easily view Google in the world mode just as you would have before. I really like it, and I encourage all of you to try it out, too. Each of improved execution and velocity is focus. There are so many opportunities for Google today. But to make a real impact in the world, we need to make hard choices about where to focus our efforts. Since we last spoke, we've announced that we're closing 12 of our products, including Buzz, Knol and Friend Connect, integrating a whole bunch of others into features of existing products. This means that we can double down on the really big bets we had made like Android, Chrome, Gmail, Display and YouTube. And I'm pleased to say this big bets are really paying off. We're seeing extraordinary velocity, the kind of velocity we only we can dream about. Android is, quite simply, mind-boggling. 700,000 phones are lit up every day. And I'm pleased to announce 250 million Android devices in total, up 50 million since our last announcement just in November. In just 2 days over the holiday weekend, 3.7 million Androids were activated. And today, we're announcing over 11 billion downloads from Android markets. Wow. Ice Cream Sandwich, which is the new Android release in October, is by far our best build yet. And our exciting new phones. I simply love my Galaxy Nexus. Superfast, it's great for photos, has an amazing 720p screen. Chrome is on fire, too. It's a wonderful example of kind of beautifully simple, intuitive experience that really improves users' lives. People thought we were crazy. Who wants another browser? It turns out a lot of people wanted to get to web quickly and securely, and we've got an amazing, fast-growing fan base all around the world. From the start, Gmail had security, accessibility. Get all your emails from anywhere on any device. An insane storage. That made it a winner with consumers, businesses and education. From an internal beta project 8 years ago, I'm proud to tell you today that Google Gmail now has more than 350 million active users, and it's growing rapidly. That [indiscernible] said, our merging high-use project -- products can generate huge new businesses for Google in the long run, just like Search, and we have a ton of experience monetizing those old [ph] products over time. Take Display. We brought the science of search to the art of the Display, creating a business that our latest figures show has now reached an annualized run rate of over $5 billion. I have some exciting new numbers also for the DoubleClick Ad Exchange, spending is up over 130% year-on-year, and the number of buyers and sellers have both more than doubled over the same period. I'm very pleased with the advertising on YouTube. TrueView gives users much more choice over what they watch, and advertisers only pay when someone watches their ad. It's not just in advertising that we're doing well. Enterprise is doing great with over 5,000 new customers signing up every day. In fact, last week, we signed our biggest ever deal, about 110,000 users at BBDA, one of the world's leading banks. All of our experience says that well-run technology businesses with tremendous consumer research, make a lot of money over the long term. Now all of this is made possible by the exceptional people that work here. I've always believed that you attract the best talent by working on things that matter in the world and creating a great workplace environment. People want to feel part of the family even when they're at work. So I'm super pleased that Google topped Fortune 2012's Best Company to Work For list, which was published today. We've taken the #1 spot 3 times now, more than any other company. I want to thank everyone at Google for all their hard work that has made this possible. Let me finish up by saying that 2012 promises to be a fantastic year. We're still at the very, very early stages of what technology can do. By building a meaningful relationship with users, we can start to offer them, just what they need, exactly when they want it. Everyone here at Google is super excited about our work today and what the future holds. It's great to be here. Thank you for taking the time to join us today, and I'll now hand over to Patrick.
Patrick Pichette: Thank you very much, Larry, and good afternoon, everyone, and thank you for joining us again. Like Larry, I'm also very happy with our results. Google had a strong, a really strong quarter, in fact, with revenues up 25% year-over-year, crowning a year of disciplined investment, strong growth and actually great operational and financial performance. Let me go through these financial results, then I'll turn it over to Nikesh and Susan for more commentary on our operating performance. So let's jump right in. Our gross revenue grew 25% year-over-year to $10.6 billion, 9% quarter-over-quarter growth. By the way, it's worth noting that although currency rates had an immaterial impact year-over-year, they, in fact, had a negative impact on revenue quarter-over-quarter. In fact, if we applied last quarter's exchange rates to our Q4 revenue, these would have been roughly $240 million higher. So FX is a key component here. Google website revenue was up, in fact just shy of 30% year-over-year to $7.3 billion and 8% quarter-over-quarter with strength across most major geographies and verticals. Our Google Network revenue was up 15% year-over-year to $2.9 billion and 11% quarter-over-quarter. It's important to note here that the Network revenue was again negatively impacted by the search quality improvements we made early last year, and also that the momentum in our Display business continues, something that Susan will talk about in a few minutes. Our other revenue was up 50% year-over-year to $410 million and 6% quarter-over-quarter. Our global aggregate paid click growth was very strong, up 34% year-over-year and 17% quarter-over-quarter. Our aggregate cost of click growth was down 8% year-over-year and quarter-over-quarter. Remember, too, that this is an aggregate number, which includes both google.com and our AdSense properties. On this, it's important to look at CPCs and clicks together. There are numbers of factors that affect each, again something that Susan will address in the next few minutes. If we turn to our geographic performance, the U.S., U.K. and rest of worlds all were growing at strong pace, reflecting in our result. In our earnings slides, which you can find in our Investor website -- Relations website, you'll see we've broken down our revenue by U.S., U.K. and rest of world to show the impact of FX and the benefits from our hedging programs. So please refer to those slides for the exact calculations. Revenue from the U.S. was up 22% year-over-year to $5 billion. Our non-U.S. revenue accounted for 53% of our total revenue, or $5.6 billion, up 28% year-over-year, which includes a modest $25 million benefit from our hedgings program. The U.K. was up 21% year-over-year to $1.1 billion. Let me now turn to expenses. Traffic acquisition costs were $2.5 billion or 24.1% of total advertising revenue. Other cost of revenue was $1.2 billion, excluding stock-based compensation of $77 million. And finally, operating expenses, which excludes stock-based compensation, totaled $2.9 billion. Our stock-based compensation totaled $459 million, and the increase year-over-year in OpEx was primarily due to payroll, increased advertising and promotional spend and legal and professional services. As a result of all this, our non-GAAP operating profit was $4 billion in Q4, resulting in a non-GAAP operating margin of 38.2%, a strong margin performance that gives us the confidence to continue to fully fund our strategic growth areas in Search, Display, Mobile and apps. If we turn to headcount, it was up approximately 1,100 for the quarter, and we ended the year roughly at 32,500 full-time employees. Our effective tax rate was 22% in Q4, and this reflects the mix of earnings between our domestic and international subsidiaries, but also an impairment charge for Clearwire, which is not [ph] deductible for tax purposes. Let me now turn to cash management. In other income and expenses, our line was minus 18, which is a large negative variance, in fact over $300 million quarter-over-quarter. This reflects a couple of things. First is the impact of our significant FAS 133 expense from hedging program, which accelerated the expense of our portfolio this quarter now that this portfolio is much deeper in the money. In addition, as I mentioned, we took an impairment charge for Clearwire. And so for more details on our OI&E, which changed quite a bit this quarter, again please refer to the slides that accompany this call on our IR website. Our operating cash flow was very strong at $3.9 billion, just shy of $4 billion. Our CapEx for the quarter was $951 million versus last quarter at $680 million, and remember that the majority of our CapEx spend was related to facilities and production equipment. And as a reminder, I wish to continue to make -- we'll continue to make significant CapEx investments, and these have shown to be lumpy from quarter to quarter depending on when we're able to make these investments. In consequence, we're very pleased with our free cash flow, which was $3 billion. So in summary, with such a strong performance, we continue to be optimistic about investing in our growth agenda. Let me now hand it off to Nikesh, who'll cover more of the details of our sales performance for the quarter. Nikesh?
Nikesh Arora: Thank you, Patrick. I will now provide an update on our business activities. We've had an excellent quarter, good growth over the holiday season. Robust [indiscernible] growth on Black Friday and Cyber Monday has led to strong performance across our product portfolio and $10.6 billion in revenue this quarter. Let me talk first about how our sales team have driven the introduction of innovative ad products that delivered impressive results for our advertising customers and outline performance by region. And finally, a few highlights from our marketing and partnerships teams. First in Search. Our core desktop Search maintained robust growth as we continue to help our customers grow their businesses. Beyond our robust core growth supporting online sales, we're increasingly helping our advertisers to use Search for branding, as well as something interesting, which is driving in-store sales for them. For instance, by using the power of data insights, we collaborated Carrefour in France to analyze over 2 years' worth of data demonstrate how 1 euro invested in online ads helps deliver almost EUR 8 of in-store sales. We expect to promote these kinds of programs further in the coming quarters. Additionally, we saw similar success in the study with SFR mobile, France's second largest mobile carrier, where we demonstrated a 20% marketing ROI for off-line sales resulting from online advertising. So our Search business continues to be strong. Let's move on to Display. As Larry mentioned, we're continuing to see great revenue growth. Our investments have really paid off in the last few years. Display has now reached an annualized run rate of over $5 billion as we engage with multiple advertisers and get tremendous support from our agency partners. What is particularly satisfying is how we're able to drive this growth as a consequence as of our continued investment in innovation with products like Ad Exchange and new ad formats like TrueView. I'm sure Susan will talk a lot more about these. All these are resulting in more efficiency and in revenue for both of us and our publisher partners. On the sales side, we have continued to align our teams, now the combined Display and Search sales, to help meet the needs of our advertising partners. We continue to activate the Display ecosystem of agencies, advertisers and other publishers. Advertisers like Ford, GM, Electronic Arts, L'Oreal and their agencies continue to see the efficiency of online branding and move more and more of their marketing spend towards our products, to Google Display Network and YouTube. For example, at L'Oreal, we demonstrated that online advertising is far more efficient than television as our new formats in YouTube, which include TrueView in-stream, in-slate and in-search have provided significant reach for their branding campaigns with millions of impressions, great click-through and efficiency gains. Let's move to Mobile. We had another record quarter for mobile advertising as mobile search continues to surge across all platforms. The number of our clients who are using mobile within their campaigns continues to grow rapidly. For example, Mali [ph] Hotels of Spain with 350 hotels in 35 countries, they use mobile search campaigns to support their mobile e-commerce activities. As a result, Mali [ph] has experienced a 60% increase in visitors for mobile devices, and their mobile-driven bookings have multiplied by 12 in 2011. We also worked hard to develop the Mobile ecosystem. This quarter, we kicked out -- kicked off the go mobile campaign in the city of Mobile, Alabama, where we helped hundreds of customers build their mobile sites for free, starting a program that will inspire, educate and empower businesses to continue to go mobile. Let's move to Enterprise. As Larry mentioned, we are seeing great traction in our Enterprise business, both with large partners, who tend to be early adopters and future looking, and in many small businesses who see Google Apps as a comprehensive and quick solution. We now have more than 5,000 customers signing up to Google Apps every day. As Larry mentioned, BBDA was the first major bank to go Google with Apps. Costco, one of the world's largest retailers, has also gone Google. In addition, in Q4, we signed government deals with the states of Maryland, Utah and 5 top universities, including Berkeley, Harvard and Michigan. Let's move quickly to country performance. From a regional perspective, we continue to see strong performance in the Americas. However, generally, country growth rates are flat or softened slightly partly due to comparisons with a very strong Q4 in 2010. North America saw slight decreases from preceding quarters. Year-to-year growth rates, however, [indiscernible] remained robust boosted by a strong holiday season. In particular, Cyber Monday led the way as the biggest day of the quarter. Western Europe was broadly stable as the U.K., France and Italy held steady, while Spain accelerated slightly for the third quarter in a row. However, revenue growth in Germany slowed this quarter. Our key emerging countries continued to see rapid growth across all of our product areas. Let me switch gears to marketing and partnerships. Our marketing and partnerships programs continue to provide strong foundations for the growth of our business. You may have seen many of our initiatives on Google+ this quarter, in addition to the Hangout with David Beckham Larry mentioned. Our sales teams have helped our customers create over 1 million Google+ pages, as Larry pointed out, including Global brands such as Toyota, Zaphos and The New York Times. Additionally, we continued the momentum of our Get Your Business Online program. In 2011, this program has helped bring hundreds of thousands of businesses online across the world. And we got 100,000 businesses to come online in 20 countries in Q4 alone. Last quarter, we expanded internationally to India, Sweden and Malaysia, as well as domestically to additional states like Michigan and New York. Our partnership team continues to drive great results with our partners. We renewed 35 of our direct search partner deals, and our long-standing Search distributor deal with Mozilla was renewed as well. These and other efforts helped our syndicated Search revenues accelerate in Q4 as we saw the full impact of large deals and fast growth of 3 partners. In closing, Q4 was a great quarter for us, finishing a strong 2011. We're excited to continue serving our customers, partners and users in 2012. And before I hand over to Susan, I want to give a shout-out to our business teams around the world and our partners in product and engineering for these great results. I will now turn over to Susan, who will discuss product performance this quarter. Thank you.
Susan D. Wojcicki: Thanks, Nikesh. Larry mentioned last week's launch of Search, plus Your World. And I'd like to start by talking about that a bit more. Google Search has always been about finding the best results among billions of web pages. And until now, those results have been limited to the public world of the Internet. What we added last week was the ability to search your own world, including Google+ post photos and profiles relevant to you, all from the same search box. Let me give you a few examples of how this transformed my searches. Last week, I searched on CES, the Consumer Electronics Show in Las Vegas, to find out more details about the show. In addition to the public results, my search magically included pictures my friends and colleagues had taken while at the show, as well as products they thought were interesting to share. In addition to seeing all the standard news for CES, I was able to get a much more personalized view of the show. This weekend, I also searched on Yosemite since I was thinking about our summer plans. In my results, I was able to see pictures my friends had taken while in Yosemite and posts about interesting things to do there. There was even an article from my mom that she had shared with my family circle, warning us not to get too close to the waterfalls. Turning now to ads. We continue to improve ads quality, and we launched about 20 improvements this quarter. Patrick mentioned that paid click growth was very strong this quarter and that CPC has declined. It's important to look at clicks and CPC metrics together since more clicks can often lead to decreases in average CPC and vice versa. When we make ads quality or format changes, CPC and paid clicks may be impacted differently. For example, when we introduced sitelinks, we saw an increase in clicks. But the additional clicks were on lower-CPC ads, which reduced the average CPC. Many of the ads quality changes in Q3 increased paid clicks at lower CPCs, and they were revenue positive with good user and good advertiser metrics. These ad quality changes from Q3 had a cumulative effect on Q4 metrics. Another important and key driver of the change in CPC growth was foreign exchange. And lastly, there are mix effects with Mobile and emerging markets. Moving on to new ad formats. These new formats now appear on about 30% of queries that show ads. Product Listing Ads, which include prices and pictures of products, saw a lot of success over the holiday season. Traffic to consumer sites from Product Listing Ads was up over 600% year-on-year. This quarter, we expanded Product Listing Ads so they can show up to 5 products, which was great for holiday shopping. We are also working to make it more efficient for advertisers to use AdWords. Many businesses have a large and dynamic catalog of products, and it can be time consuming for them to select the keywords and the CPCs for each product. So this quarter, we beta-launched Dynamic Search Ads, which generates the ads automatically based on what's on a customer website. This enables businesses to advertise a lot more of their products, and our system can also monitor the advertiser's available inventory and show ads only for what is in stock. For small local businesses, we ramped up AdWords Express. This product lets businesses get up and running with a campaign in just a few minutes. Customer sign-ups have more than tripled in the past 6 months. We now offer AdWords Express in the U.S., U.K., Germany and France, and we are trialing it in several other countries. In Display, which now has reached a $5 billion annualized run rate, as Larry mentioned, we're creating a comprehensive solution to buy and sell display ads across many types of digital media, such as desktop, video and mobile. One key driver of growth has been our success in audience buying. This technology enables marketers to deliver ads to specific audiences across the web, such as in-market hybrid car buyers or adventure travelers. Many audience buyers purchase via the Ad Exchange, which now has customers in 26 countries and is growing very rapidly. We also expanded to video and mobile inventory on the Ad Exchange. And on the Google Display Network, we're also growing audience buying. From Q3 to Q4, the number of active advertisers using interest category marketing increased over 60%. And that was from an already large base. By understanding users' interests, we've been able to serve much more relevant and useful ads to our users. Our success in Display has also been driven by brand advertisers, with video formats being an important factor. Our TrueView in-stream ads give users the option to skip the ads. This means that users who see the ads are more likely to be interested in those products, and advertisers are incented to create compelling ads. View rates range between 15% and 45%, and the people who choose to watch those ads are highly engaged. Over 60% of our in-stream ads are now skippable. It's an increase of over 4x since the beginning of the year. We now serve TrueView video ads across the Google Display Network and on YouTube Mobile. I'd also like to give a quick update on Offers, which has been bringing online users to off-line stores and services. Offers are now live in over 30 cities, and we're starting to feature national offers from partners like REI, JetBlue and Toys "R" Us. We expanded our collection of deals to include offers from partners so that users get a wider variety and partners get access to a broader user base. And lastly, among the many launches that we did in the quarter, I'd like to highlight one project we did called Memories for the Future. This site compares before and after Street View photographs of the areas affected by last year's tsunami in Japan. We drove thousands of miles so that future generations can see what happened. Thanks all for your time. Now back to Patrick.
Patrick Pichette: Thank you, Susan. So what we'll do is we'll turn it over to Jamie to set up the Q&A session.
Operator: [Operator Instructions] And we'll take our first question today from Brian Pitz with UBS.
Brian J. Pitz: Maybe you could just give us a sense for mobile usage. Did you see a major shift in the mobile usage among the consumer during the holiday? And then I've got a quick follow-up.
Larry Page: This is Larry. Let me give that question to Nikesh.
Nikesh Arora: Look, we're seeing mobile usage grow with leap -- by leaps and bounds. It's happening by a proliferation of Android devices around the world. It's happening by a proliferation of tablets around the world. It's happening generally by people getting more and more active on their mobile devices as they discover the utility and the various apps that allow them to be able to go find things, whether they're local searches, they're product searches or they're searches for generic things on Google. So yes, we are seeing tremendous mobile usage, and we saw -- seem to be an uptick during the holiday season where people were looking for products and searching for e-commerce-related activities during the holiday season.
Brian J. Pitz: So just as a follow-up to that, so do you think that the reason for the significant decline in the CPC is -- the down 8%, is a function of the clicks going through mobile more so? Or is it more some of the other factors that you explained to us? Because I'm just trying to get a sense for the down 8% CPC number was, I guess, significantly different than what we were expecting. And I understand the trade-off with the clicks, but is mobile largely responsible for that?
Nikesh Arora: I'm going to pass that question on to my friend Susan here who's going to talk about the CPC.
Susan D. Wojcicki: So there are definitely multiple factors whenever we look at these metrics because these metrics are aggregate. But I would say the 2 biggest factors this quarter were FX as well as the changes that we had made, their ad quality or format changes, which increased the paid clicks and again were revenue positive, advertiser positive, user positive. But those clicks, as I explained, may be lower CPC like in the example that I gave in my script with sitelinks. So those were the 2 factors. But again, it's always important to remember there are many factors that contributed to these aggregate numbers.
Brian J. Pitz: Great. Just a quick housekeeping. Patrick, can you just qualify what's in that $5 billion Display run rate? Is that comparable to the $2.5 billion you provided before?
Patrick Pichette: Yes, it is exactly the same definition. So you take out all the text ads, and then you look at both mobile and desktop. So you go back to the same definition.
Operator: And we'll go next to Spencer Wang with Credit Suisse.
Spencer Wang: Two quick questions. I guess first for Nikesh. It looks like international, excluding the U.K. revenue price load, the most kind of sequentially. I was wondering if the macro economy played at all a role? And if so, any sense of magnitude there? And then secondly, for Susan, with respect to the $5 billion Display run rate number, there's obviously a lot of stuff that goes in there between YouTube and Mobile and the ad network. I was wondering if you could just give us some maybe color of what the blended TAC rate would be for that $5 billion.
Patrick Pichette: So I'll take both questions, if you don't mind. So first, we will not -- we don't provide the TAC rate on the blended. And you're right that, I mean, if you think of the big properties that are in there, right, so you will have the GDN, we'll have YouTube, right, we’ll have all of the additional elements of our Display business, which includes the Teracents and then all of the other optimizers but also the AdMob on mobile. So that's the kind of key elements of it. But we do not -- we don't kind of comment on the details of the blended TAC on them. On the economy, look, we had actually quite a solid Q4 performance, and we're really pleased of our revenue growth. I mean, even despite the FX issues -- so you have to separate the FX issues from the economics fundamentals of our business. And performance in Europe was actually quite healthy despite the environment that we got there. And that's driven by the secular shifts of off-line to online continues, and the secular shifts of more mobile continues. So from that perspective, right, obviously, we don't control the economy, we don't control exchange rates, but we're actually quite pleased with the performance that we've had internationally in addition to the U.K. and the U.S.
Operator: And we'll take our next question from Mark Mahaney with Citi.
Mark S. Mahaney: I just wanted to ask about YouTube. I know that in that Display bucket. Could you quantify it at all? Is the growth you're seeing out of YouTube similar to what you're seeing in the overall Display bucket? And specifically, are you seeing a sign that TV ad budgets specifically are migrating online into assets like YouTube? When you ask advertisers who are spending more money in YouTube, where those dollars are coming from? Where are they coming from?
Patrick Pichette: So let's do a 1-2 punch quickly. YouTube is doing absolutely terrific. And on the advertising side, Nikesh will probably be the better answer to give the details. Or Larry, whichever of the 2.
Larry Page: Yes, I’d say on the advertising side, I think we're tremendously excited about our growth on YouTube. And the amount of success we're having in advertising there is very significant. But it's not significant compared to the overall kind of video advertising space. It's a tiny percentage of that. We have a huge amount to grow. But I don't think the advertisers are thinking about it as being a significant percentage of their other spend on video. So we don't really see that.
Operator: And we'll go next to Ben Schachter with Macquarie.
Benjamin A. Schachter: On Android, the numbers are obviously very, very strong. But can you talk about the monetization potential that’s beyond Search? What has to happen with Android for you to actually make money on this? And how are you going to do it? And then secondly, the revenue growth did decelerate more than I think most people expected. And you had such strong tailwinds with Mobile and Display. Do you think that some of the deceleration came from people going to information directly through apps or going directly through vertical search like going to Amazon directly for commerce or Expedia directly for travel?
Larry Page: Yes, I mean, Ben, maybe I'll take the first on there on Android. I think we are in a very -- as I mentioned in my remarks, we're in the early stages of monetization for a number of our new products, and Android is one of those. I think we do make money from Search on apps. We do make -- we mentioned that we have a very strong advertising business on mobile, which we obviously -- a lot of those people are on Android as well. And I think that you also see we announced 11 billion downloads on Android markets. Obviously, a lot of those are free, but we also are having a lot of people buy stuff there, too. We've seen a lot of potential for us to make money on Android, and I think you'll see us increase that a lot over time. It's hard to give you details about that right now, but I'm very, very optimistic.
Patrick Pichette: On the second part of the question, let me jump in. If you look at our growth -- first of all, you're right that FX played a part. You also have to remember that last year at this time, right, we had such a strong comp. We had such an amazing Q4 of 2010. That the year-over-year comparison in a way represents also this really high kind of level on which to start from. And so from that perspective -- and if you also look at our mix between our own Google websites versus all of our network, I mean, our core properties continue to be actually very strong. So for all these reasons, I wouldn't be worried of the way that you've described it. In fact, we've got -- continue to have very strong growth.
Operator: And we'll go next to Heather Bellini with Goldman Sachs.
Heather Bellini: I just had another follow-up on CPC. And kind of as you look out given -- to the first half of the year, and given the metrics that Susan rank-ordered or impacting them in Q4, how do we think about how those metrics that you rank-ordered might impact them in the first half of the year or just even looking out over the next quarter? What are the things we should be paying attention to?
Patrick Pichette: Yes, I mean, at the highest level and then maybe Susan can jump in if she wants to add additional, if you think of the core elements of it, she mentioned quality. And we -- the -- all of the Panda changes and everything we talked about, right, its full year is going to be represented only by the next spring. And then FX rate, we don't control ourselves. So obviously, it has a significant impact. The rest of it is actually the mix between how the innovation that we drive to our products, which is if you have a great product that drives a ton of clicks and it happens to have lower cost or CPC, then that's still for the benefit of everybody. So then, that's really about our innovation agenda, but we don't give forward guidance on that.
Heather Bellini: Right. But it just looks like those trends that you mentioned that impacted Q4 are in existence as we look out, at least initially, into 2012.
Patrick Pichette: I think you have to make the call on the FX yourself. And then on the...
Heather Bellini: Aside from FX, obviously, right.
Patrick Pichette: Yes, yes and then the quality, I think will going to -- flow through the year, sometime in the spring.
Susan D. Wojcicki: I mean, the one thing I would just add is, the way we think about the business is we're focused on how do we provide better ads for our users and for our advertisers, and we look at all of those metrics combined. And what we saw in Q3 was we made a bunch of changes. They were small. There was no one individually that actually affected things, but it just so happened that the changes we made drew more attention and caused an increase in paid clicks. And so, as I mentioned, there are many factors. But really, what we use as a guiding metric are to understand that something is revenue, advertiser and user positive.
Operator: And we'll go next to Carlos Kirjner with Sanford C. Bernstein.
Carlos Kirjner: Help me reconcile the 15% year-on-year growth in Google partnered revenue with the 130% growth in the DoubleClick Exchange and the $5 billion run rate for Display. I mean, something -- it seems that something must be decreasing. And how do we make these numbers close?
Patrick Pichette: Look, I think that you have to remember -- in the highest level, you have to remember that sites and network lines in our financials are not good proxies for Search and Display revenue, right? I mean, in its most simple term, YouTube, which is Display, right, ends up in our Google sites. And yet, AFS which is Search, is included in the network. So when people actually do the math, right, it's really easy to get confused between these lines. So I would kind of caution you to have one which is growing at 15% obviously being -- jumping to the conclusion that that's Display. That doesn't work.
Carlos Kirjner: So does that mean that a material portion of the $5 billion come from YouTube?
Patrick Pichette: All I'm saying is we don't give the breakdown, but you could -- I just want to make sure that you -- caution you that because of these mix issues, right, it can lead to interpretations that are wrong.
Operator: And we'll go next to Doug Anmuth with JPMorgan.
Douglas Anmuth: I just wanted to go back to the CPCs for a minute. And it sounds like -- and we can obviously take the FX out, but it sounds like you're saying that the improvements in 3Q were perhaps a much bigger factor than the mix shift toward mobile in terms of CPCs. Susan, can you provide any more color there in terms of the improvements that you made which could drive sort of a meaningful shift like that? And then secondly, TAC as a percentage of advertising revenues have been down for many straight quarters now, and here they ticked back up a little bit. Can you clarify that at all, the reason for that?
Patrick Pichette: Yes, on the latter -- let me just jump in on the latter and then I'll let Susan give a bit more color, commentary. But it's just mix issue between partners. So as you have partner mix, it will just affect. But it's not a dramatic number, by the way, right? It's still kind of hovering around 24. So it hasn't plummeted in any way shape or form.
Douglas Anmuth: Is it more partner mix? Or is it possible that it's more mobile mix like desktop to mobile?
Patrick Pichette: Yes is the short answer. But partners mix affects it as well. Like, it's not only mobile, I guess, is my point. I'll let Susan give you more details on the colors of the -- if any, on the changes that we've done that would have impacted the CPC.
Susan D. Wojcicki: So the 2 biggest factors, as I mentioned, were the FX and also the changes that we made to -- in terms of ad quality or format changes that we made. And those were changes that we made in Q3. There was no, I think, one significant one that drove the metrics. Or like this quarter, we made 20 different changes. Last quarter, we made something similar. And it was the combination of those different changes. Now it's important to remember that we rolled those out over the course of Q3. And so that meant that if we rolled one out at the end of Q3, that you wound up seeing that impact in Q4 period. And so there was a cumulative effect. But again, there was not any one big one. It was the sum of a bunch of other changes. And those changes that we wind up making are changes that may make the ads more readable, they may be more visible, they're UI treatments or quality changes. They're a bunch of different things that make it more visible so that users are noticing the ads. And we see those as positive. We measure the metrics, how do our users respond, how do our advertisers respond. And they are revenue positive.
Patrick Pichette: Yes. Another way to think about this is in many quarters, we would have a bunch of them that would actually move down the CPC, a bunch of them that would have moved up in [ph] click. It just happens that in the latter part of this year, they kind of all moved one way, which is not neither good nor bad. It just happens that the quality team and the advertising teams actually have kind of unearthed these type of opportunities. So it's a bit of circumstantial as well.
Operator: And we'll take our next question from Jeetil Patel with Deutsche Bank Securities.
Jeetil J. Patel: Two questions. First of all, I think, Larry, early on you referred -- you talked about shuttering a couple of products and then doubling on key products that are showing some quite bit of success. I guess can you speak to are you still innovating across new products around the consumer? And anything that's not tied to advertising as we look ahead? Second question, can you talk about -- I guess when you look at mobile distribution costs in general, do you envision a scenario where mobile distribution costs stay about where they are today? Or how do you think those kind of play out over time as you think about the development of the mobile market?
Larry Page: Maybe I'll take the first question and Nikesh can take the second part of the question. I think we -- I didn't mean to imply in any way that we're stopping innovating. And I think we will continue to launch new products in new areas and things that aren't necessarily advertising supported, as we have been doing for a while. And I'm very excited about that. But we may not launch 100 such things. We may launch a few of those such things over the next few years. I think we'll try to make sure we're more concentrated in our efforts to make sure we're producing really amazing products for our users and for our customers that are really well thought out and work really well. And so, I mean, we've put a lot of effort into those things. So we're just really just been concentrating our efforts around our innovation and making sure we're doing a really great job on the things that we really care about and that really matter to the world. And so that's very consistent with sort of everything I’ve said. Nikesh?
Nikesh Arora: Yes, I think on mobile distribution, it's pretty similar to what happens on Search today. Many consumers get their mobile applications from Google directly on their devices. Some people get them through our distribution partners, and some people get them through our carriers. And to be honest, the distribution costs really depend on the mix of those devices. And you can see, traditionally the mix is less and less specific to other distribution partners in the middle, and more and more people are organically getting access to device and applications that they choose given the large plethora of opportunities and options that they have.
Operator: And we'll go to Justin Post, Bank of America Merrill Lynch.
Justin Post: A couple of things. Patrick, on the hedging program, you had $134 million loss on the expenses of getting the hedges, but you only made $25 million and it was a pretty volatile quarter. Do you have a lot of backlog saved up for next year in profits? And is this working the way you want? And then maybe for Larry, obviously CPC growth is really accelerating. Can you explain why that's good for Google and why you think you're going in the right direction? The mix seems to be a big controversy, but obviously you're making these changes. Can you really explain the positive benefit to the user experience or to the company?
Patrick Pichette: So on the first question, actually thanks for your question, Justin, because I'm sure a lot of people are thinking about that. Our hedges -- so the cost that we accelerated is actually relative to the entire portfolio of hedges that we have that spans over 18 months forward. So what -- think of it as a complete program that extends 18 months out and -- of which think of it like a bond ladder, right, with a lot in the short term and -- less in the long term. All of those hedges, right, you have to mark to market. And when you have to mark to market, they're so much in the money. Then you have to actually accelerate your expensing of them. So you're absolutely right that today as we stand or as we close our books on the 31st, right, they signaled about the weakness of the euro because the euro had lost quite a bit in the quarter and relative to our portfolio. So we would -- if things stayed exactly the same, right, we wouldn't reap a lot of benefits in the coming quarters and wouldn't have those expenses because we took them all in one shot. So I hope that makes sense. And it's really tied to FASB 133 that doesn't allow you to just do it pretty [ph] early.
Larry Page: I can take, say, a little bit about CPC from my perspective. I think -- and I don't have the detail here, quarter or whatever, but I do think that CPCs -- do vary a fair amount, and we're not surprised by that. There are lots of product changes that we can make that can increase CPCs or decrease CPCs and kind of have a -- or an inverse effect on the number of clicks and sort of not change the actual dollars spent, for example. And that's not that surprising because we can do things that -- in product changes that affect people’s attention to ads that Susan mentioned or that affect the quality of the conversions that advertises receive. They might receive better quality clicks, or they're -- or those -- each CPC that they got that's more likely to convert into what they care about. And so we are constantly optimizing all those things across a number of different product areas and ad placements and everything else. And our advertisers are doing the same, and the algorithms are also doing all that. So I think in any healthy economic -- economy, like we have of advertising, we're going to see variation in the different factors we use to measure it. And I'm not surprised by that.
Justin Post: Are you happy with the results in the quarter? Are they going the direction you expected based on the changes you made?
Larry Page: As I said, I'm very happy with our results overall in the quarter. And I think those are a function of all the metrics that we gave you. So yes, I'm happy with our results.
Susan D. Wojcicki: Yes. I mean, one additional thing I'd like to say about the increase in paid clicks is the increase in paid clicks, in a lot of ways, is a proxy for where the ad is useful. Do the users find interesting enough to click on them? Do we have enough advertisers who served ads? So an increase in paid clicks shows that our advertising system is working, that we have more advertisers, we have more clicks. And as Larry alluded to, there are many, many different variables that go into it, but an increase in paid clicks is something that we see as a sign that our advertising system is in demand and it's healthy.
Operator: And we'll take our next question from Scott Devitt with Morgan Stanley.
Scott W. Devitt: I'll ask about paid clicks and their relationship to CPCs. There's a third-party data that suggest that paid clicks continue to grow faster than free clicks. And so the 34% paid click growth that you reported, it would seem to make that fairly accurate that there's a mix shift that's occurring in favor of paid versus free. And with search quality improvements as the driver of this potentially, it would seem that advertisers would be paying more for better distribution, yet CPC is down. So if you were to look at your business on a same distribution basis normalized for mobile and increased ad coverage and all the other potential drags on CPC, I'm just -- the question is a simple one. If you look at advertisers, are they paying more or less on a unit basis for distribution?
Patrick Pichette: I think that -- let we make 2 statements on this. The first one is that we shy from talking about -- anything about specific which is third-party data, because typically we find there are so much errors and methodology issues with them. I think that we're seeing -- what we have clearly seen this year once again, right, is more holiday shopping happened online this year again, right. Nikesh talked about, right, record Cyber Sundays and Fridays that are black. And, I mean, all of these things have hit record year -- this year again, and we're seeing again a transition of off-line to online. I think that Susan's last point is really the critical point, which is as we're moving and exploring formats that really work well for both the advertiser and the user, you should see a symptom which is more clicking. And that's exactly what we see. And if there's a slight pressure on the CPC as a consequence of it, but overall we get a better result, right, that's actually a pretty healthy environment and an innovative one. And then -- and just again, as we mentioned and as Susan said, it happened that in Q3, we had just a number of them that just went one way. And I wouldn't read any data points in that as saying that that's the future or that it will not revert back to others. It's -- that's just the nature of experimentation in our systems.
Operator: And we'll go next to Jason Maynard with Wells Fargo.
Jason Maynard: I guess I'll spare you on CPC. I have actually a couple of questions for Larry on Google+. Last quarter, I think you referred to it your as social lair. And I guess I almost think of it like Google's -- it's like your social operating system, I guess, to a certain extent. So I'd love to get your vision on how you think G+ can improve engagement across all your properties. And then the second question would be, identities that are on Facebook and Twitter, do you think ultimately those firms will open up the data stream and we could see even richer results with clearly Facebook- and Twitter-like information?
Larry Page: Yes. I think we see -- as I mentioned in my opening remarks that we see really engaging with users on -- really deeply understanding who they are by getting them the right things that make sense for them and so on. It's really, really important. And I think we are at the early stages of that, and Google+ is a big part of that effort. If you look at some of the things we've done, I think that if you look at in Search, you can do a search now and get somebody's name and have that name really appear as a chip in the search. And that means that it's no longer a string that you're searching for, it's actually a real person. That notion of identity is really a deep, deep part of what we're doing. And it's an example of how we can make all of our products better by really understanding people. So we definitely think about that. There's a reason why we called it Google+ in that way. I think -- and so I think you're -- you've got the right idea in general about that. I think that -- I think with other big companies, other big companies that work on social data and so on, I think we've seen very much general tendency to wall that data up and to wall the card in and not make the data available. Where we have publicly been able to access the data -- for example, in Search, we've provided a lot of third-party social data in Search, and we love doing that and we'd love to have more such data. But in general, I would say companies generally have been walling that data up, and we'd love to be able to use more of it.
Jason Maynard: Great. Can I maybe ask a follow-up and get a prediction from you in terms of how many G+ users you expect in a year or so?
Larry Page: Oh my goodness, I won't try to predict that. But we're very excited about the growth we had, and we're certainly seeing tremendous number of people being added every day.
Operator: And we'll go next to Ross Sandler with RBC Capital Markets.
Ross Sandler: Two quick questions, neither on CPC. Susan, on Google Offers, quick question there. Given Google [ph] and LivingSocial’s early success in this space, it seemed like scale is an advantage in the local and national deals area. Is there any reason why Google is only in 30 markets to date? It seemed like you've got all the merchant relationships that you need. So is there something else that's preventing a broader rollout? And then a follow-up for Nikesh on Europe. You mentioned in your prepared remarks that Germany was a little weak in the quarter. Can you give us a little color on which verticals? Was it travel, retail, finance? A little color on the verticals that were weak. Or was it broad-based?
Susan D. Wojcicki: So right now, we have 30 markets to date, and that's just what we have to date. So as there are more markets and as it makes more sense for us over time, then we will roll out more markets. But I do think that there is -- it's very important to understand what's working in a specific market and in a city and perfecting that and really understanding the dynamics that make sense for us for the success of that city. And so as we expand, we'll expand with that knowledge. And we'll expand as we -- as it makes sense for us in terms of the users, the solution and building all of those learnings that we've made in those initial 30 markets.
Patrick Pichette: Nikesh, any comments on your side?
Nikesh Arora: Yes, I guess in terms of verticals, generally auto has been strong around the world. We've seen that. And then in different markets, different verticals have been special in terms of the -- the U.S., we had – education, we had health. So there have been different vertical performances around the world. And Germany has been a market which has been doing really well for us in the last few quarters. So part of it is we're running up against some very, very tough comps versus last year. But it was general sort of weakness across the board. It wasn't specific to any particular vertical that has changed.
Larry Page: I should mention, too, you can actually go to Google Insights for Search, and you can look at our Search free graph over time for any of these verticals yourself. It's some great data.
Operator: And we'll go next to Herman Leung with Susquehanna International Group.
Herman Leung: Just 2 quick questions. First, I remember last year in the fourth quarter there was a pretty big change that you guys made on the quality side, which I think you mentioned a bit on the prepared remarks. Wondering if that -- how much of a headwind that was relative to the fourth quarter of this year. If there's a way you could sort of quantify that. And second question is the hiring rate that you guys have made, 1,100 people, this quarter. Wondering -- that's a bit of a slowdown from the previous quarters in the past. Wondering if there was something there to look into.
Patrick Pichette: So a 1-2 punch on this one, Herman. On the first one, we mentioned it because we thought it was material. It was such a big impact last year. We don't comment on the specifics, but it was sufficiently material that that's -- you're absolutely right that it created a headwind for us this year. No doubt about it. And that's why we mentioned it. On the second question, you'll remember that in Q3, we kind of had a double hitter where Larry had already said that we had reached what was kind of tolerable in terms of the pace of hiring.
Larry Page: The edge of what’s manageable.
Patrick Pichette: The edge of what is manageable. And thank you, Larry, for that clarification. And we also had at the end of Q3 all of the -- we had the summer -- everybody comes -- leaves -- comes from school, comes into Q3. So we had quite a bit of a bump in Q3. We're really pleased by -- and you can see in our results now that actually, it's a good evidence of we're managing -- we have managed down our numbers into Q4, and a good evidence of we are managing it to make it digestible for us.
Operator: And we'll take our final question from Youssef Squali with Jefferies & Company.
Youssef H. Squali: So first, one product we didn't talk much about is Google Wallet. So I was wondering that based -- if based on your early test, is that a product that you're planning on doubling down on? And if so, what is the path to wider adoption? And second, on MMI, I know the deal hasn't obviously closed yet. But just given the size of that transaction, it certainly has the potential to really change Google's growth and margin profile pretty significantly, which is a big concern to many. So at a very high level, Larry, I was wondering if you could maybe just talk about your commitment to be a principal in the handset business. And if so, how does -- how do you avoid channel conflicts with the partners?
Susan D. Wojcicki: Youssef, this is Susan. So I can talk a little bit about Google Wallet. And so as Larry has mentioned a number of times, we want to focus on products that people use every day. So products that are core. And all of us use our wallet every day. And we think that's a big opportunity for us. So we are continuing to invest in our Wallet business. And we see a lot of opportunity. And for example, there might be opportunities in the future in terms of how online and off-line are linked together, and better opportunities with the way different parts of our business wind up working. So we are very excited about Wallet, and we will continue to invest in it.
Larry Page: And I should mention on Motorola obviously we're going to break that out separately, so you’ll be able to track the changes to margins and so on. I think that -- and able to track the business separately. So that should not be an issue. We've been very clear that Motorola's obviously going to remain a licensee of Android, and Android will remain open. And when we announced the deal, we really said our strategy is working with different manufacturers on lead devices is going to continue. And Motorola will bid with -- just like any other OEM for those devices. So that process will be unchanged. And obviously, I think we have done a great job managing our partner ecosystem. That's a difficult thing to do, and I think we do it quite well. And I expect we're going to continue to do that well with Motorola. And obviously, it shows our commitment to Android in making sure that we have the freedom to innovate and as do all of our OEMs.
Patrick Pichette: So even more specifically, we -- you can expect segmented reporting for Motorola. So the Google will continue to be very clear in terms of its performance and transparency to investors. Motorola will also, on its own, be very clear and transparent to investors. And just before we close the call, just a reminder to everybody, as the headcount question that was asked a minute ago reminded me. As we launch into Q1, it's important to remember that there's a lot of expenses. As people kind of think of resetting their models, it's really -- I just want to remind everybody because every year we go through this, that the employer taxes and 401(k)s and all of the things that launch into Q1 typically get reset. And so I just want to give a friendly reminder to all our -- the people that have financial models out there to make sure that -- to take that into consideration because it surprises everybody every year. So rather than get another surprise at the end of Q1, I just thought I'd remind everyone. On that note, I think it's really -- I'd love to, once again on behalf of the 4 of us here, thank profusely our Googlers. I mean, they do an amazing job and, as we said, landing a great quarter, crowning a terrific year and really well set for an absolute exciting year for 2012 and look forward it. So on that, Jamie, I'll let you close the call.
Operator: Thank you, sir. That does conclude today's conference. We appreciate everyone's participation. | [
{
"speaker": "Operator",
"text": "Good day, everyone, and welcome to the Google Inc. Fourth Quarter 2011 Earnings Conference Call. Today's call is being recorded. At this time, I'd like to turn the call over to Ms. Willa Lo, Investor Relations Manager. Please go ahead, ma'am."
},
{
"speaker": "Willa Lo",
"text": "Good afternoon, everyone, and welcome to today's fourth quarter 2011 earnings conference call. With us are Larry Page, Chief Executive Officer; Patrick Pichette, Senior Vice President and Chief Financial Officer; Susan Wojcicki, Senior Vice President, Advertising; Nikesh Arora, Senior Vice President and Chief Business Officer. Also, as you know, we now distribute our earnings release through our Investor Relations website located at investor.google.com. So please refer to our IR website for our earnings releases, as well as the supplementary slides that accompany this call. This call is also being webcast from investor.google.com. A replay of the call will be available on our website in a few hours. Now let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward-looking, including statements regarding Google's future investments, our long-term growth and innovation, the expected performance of our business and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on this call, such as operating income and operating margin, are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will turn the call over to Larry."
},
{
"speaker": "Larry Page",
"text": "Good afternoon, everyone, and happy new year. Welcome to our first earnings call of 2012. Great to have all of you here. I'm very happy with our results. Google had a very strong quarter with revenues up 25% year-on-year, 9% quarter-on-quarter, and we blew past the $10 billion mark for the first time. Pretty exciting. Looking back on 2011, I am most excited by the fact that we significantly improved our velocity and execution, my priority when I became CEO in April. With Google+, we shipped on average a new feature every day since we launched in June. That's more than 200 updates in total. And those things include a bunch of new Hangout features. In fact, David Beckham just did a great Hangout with his fans here this morning. We launched circles in Gmail and + Pages for businesses and many, many other things. I'm also pleased to announce that there are over 90 million Google+ users, well over double what I announced just a quarter ago on our earnings call. Engagement on + is also growing tremendously. I have some amazing data to share there for the first time. + users are very engaged with our products. Over 60% of them engage daily and over 80% weekly. As I said last quarter, Google+ is much more than the individual features themselves. It's also about building a meaningful relationship with users so that we can dramatically improve the services we offer. Understanding who people are, what they care about and the other people that matter to them is crucial if we are to give users what they need, when they need it. Take last week's Search announcement, which I'm really excited about. We've now included personal results in Search. So you can easily find information like photos and + posts that are super relevant to you, as well as the people you care about or are interested in. You can even restrict all personal results or easily view Google in the world mode just as you would have before. I really like it, and I encourage all of you to try it out, too. Each of improved execution and velocity is focus. There are so many opportunities for Google today. But to make a real impact in the world, we need to make hard choices about where to focus our efforts. Since we last spoke, we've announced that we're closing 12 of our products, including Buzz, Knol and Friend Connect, integrating a whole bunch of others into features of existing products. This means that we can double down on the really big bets we had made like Android, Chrome, Gmail, Display and YouTube. And I'm pleased to say this big bets are really paying off. We're seeing extraordinary velocity, the kind of velocity we only we can dream about. Android is, quite simply, mind-boggling. 700,000 phones are lit up every day. And I'm pleased to announce 250 million Android devices in total, up 50 million since our last announcement just in November. In just 2 days over the holiday weekend, 3.7 million Androids were activated. And today, we're announcing over 11 billion downloads from Android markets. Wow. Ice Cream Sandwich, which is the new Android release in October, is by far our best build yet. And our exciting new phones. I simply love my Galaxy Nexus. Superfast, it's great for photos, has an amazing 720p screen. Chrome is on fire, too. It's a wonderful example of kind of beautifully simple, intuitive experience that really improves users' lives. People thought we were crazy. Who wants another browser? It turns out a lot of people wanted to get to web quickly and securely, and we've got an amazing, fast-growing fan base all around the world. From the start, Gmail had security, accessibility. Get all your emails from anywhere on any device. An insane storage. That made it a winner with consumers, businesses and education. From an internal beta project 8 years ago, I'm proud to tell you today that Google Gmail now has more than 350 million active users, and it's growing rapidly. That [indiscernible] said, our merging high-use project -- products can generate huge new businesses for Google in the long run, just like Search, and we have a ton of experience monetizing those old [ph] products over time. Take Display. We brought the science of search to the art of the Display, creating a business that our latest figures show has now reached an annualized run rate of over $5 billion. I have some exciting new numbers also for the DoubleClick Ad Exchange, spending is up over 130% year-on-year, and the number of buyers and sellers have both more than doubled over the same period. I'm very pleased with the advertising on YouTube. TrueView gives users much more choice over what they watch, and advertisers only pay when someone watches their ad. It's not just in advertising that we're doing well. Enterprise is doing great with over 5,000 new customers signing up every day. In fact, last week, we signed our biggest ever deal, about 110,000 users at BBDA, one of the world's leading banks. All of our experience says that well-run technology businesses with tremendous consumer research, make a lot of money over the long term. Now all of this is made possible by the exceptional people that work here. I've always believed that you attract the best talent by working on things that matter in the world and creating a great workplace environment. People want to feel part of the family even when they're at work. So I'm super pleased that Google topped Fortune 2012's Best Company to Work For list, which was published today. We've taken the #1 spot 3 times now, more than any other company. I want to thank everyone at Google for all their hard work that has made this possible. Let me finish up by saying that 2012 promises to be a fantastic year. We're still at the very, very early stages of what technology can do. By building a meaningful relationship with users, we can start to offer them, just what they need, exactly when they want it. Everyone here at Google is super excited about our work today and what the future holds. It's great to be here. Thank you for taking the time to join us today, and I'll now hand over to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you very much, Larry, and good afternoon, everyone, and thank you for joining us again. Like Larry, I'm also very happy with our results. Google had a strong, a really strong quarter, in fact, with revenues up 25% year-over-year, crowning a year of disciplined investment, strong growth and actually great operational and financial performance. Let me go through these financial results, then I'll turn it over to Nikesh and Susan for more commentary on our operating performance. So let's jump right in. Our gross revenue grew 25% year-over-year to $10.6 billion, 9% quarter-over-quarter growth. By the way, it's worth noting that although currency rates had an immaterial impact year-over-year, they, in fact, had a negative impact on revenue quarter-over-quarter. In fact, if we applied last quarter's exchange rates to our Q4 revenue, these would have been roughly $240 million higher. So FX is a key component here. Google website revenue was up, in fact just shy of 30% year-over-year to $7.3 billion and 8% quarter-over-quarter with strength across most major geographies and verticals. Our Google Network revenue was up 15% year-over-year to $2.9 billion and 11% quarter-over-quarter. It's important to note here that the Network revenue was again negatively impacted by the search quality improvements we made early last year, and also that the momentum in our Display business continues, something that Susan will talk about in a few minutes. Our other revenue was up 50% year-over-year to $410 million and 6% quarter-over-quarter. Our global aggregate paid click growth was very strong, up 34% year-over-year and 17% quarter-over-quarter. Our aggregate cost of click growth was down 8% year-over-year and quarter-over-quarter. Remember, too, that this is an aggregate number, which includes both google.com and our AdSense properties. On this, it's important to look at CPCs and clicks together. There are numbers of factors that affect each, again something that Susan will address in the next few minutes. If we turn to our geographic performance, the U.S., U.K. and rest of worlds all were growing at strong pace, reflecting in our result. In our earnings slides, which you can find in our Investor website -- Relations website, you'll see we've broken down our revenue by U.S., U.K. and rest of world to show the impact of FX and the benefits from our hedging programs. So please refer to those slides for the exact calculations. Revenue from the U.S. was up 22% year-over-year to $5 billion. Our non-U.S. revenue accounted for 53% of our total revenue, or $5.6 billion, up 28% year-over-year, which includes a modest $25 million benefit from our hedgings program. The U.K. was up 21% year-over-year to $1.1 billion. Let me now turn to expenses. Traffic acquisition costs were $2.5 billion or 24.1% of total advertising revenue. Other cost of revenue was $1.2 billion, excluding stock-based compensation of $77 million. And finally, operating expenses, which excludes stock-based compensation, totaled $2.9 billion. Our stock-based compensation totaled $459 million, and the increase year-over-year in OpEx was primarily due to payroll, increased advertising and promotional spend and legal and professional services. As a result of all this, our non-GAAP operating profit was $4 billion in Q4, resulting in a non-GAAP operating margin of 38.2%, a strong margin performance that gives us the confidence to continue to fully fund our strategic growth areas in Search, Display, Mobile and apps. If we turn to headcount, it was up approximately 1,100 for the quarter, and we ended the year roughly at 32,500 full-time employees. Our effective tax rate was 22% in Q4, and this reflects the mix of earnings between our domestic and international subsidiaries, but also an impairment charge for Clearwire, which is not [ph] deductible for tax purposes. Let me now turn to cash management. In other income and expenses, our line was minus 18, which is a large negative variance, in fact over $300 million quarter-over-quarter. This reflects a couple of things. First is the impact of our significant FAS 133 expense from hedging program, which accelerated the expense of our portfolio this quarter now that this portfolio is much deeper in the money. In addition, as I mentioned, we took an impairment charge for Clearwire. And so for more details on our OI&E, which changed quite a bit this quarter, again please refer to the slides that accompany this call on our IR website. Our operating cash flow was very strong at $3.9 billion, just shy of $4 billion. Our CapEx for the quarter was $951 million versus last quarter at $680 million, and remember that the majority of our CapEx spend was related to facilities and production equipment. And as a reminder, I wish to continue to make -- we'll continue to make significant CapEx investments, and these have shown to be lumpy from quarter to quarter depending on when we're able to make these investments. In consequence, we're very pleased with our free cash flow, which was $3 billion. So in summary, with such a strong performance, we continue to be optimistic about investing in our growth agenda. Let me now hand it off to Nikesh, who'll cover more of the details of our sales performance for the quarter. Nikesh?"
},
{
"speaker": "Nikesh Arora",
"text": "Thank you, Patrick. I will now provide an update on our business activities. We've had an excellent quarter, good growth over the holiday season. Robust [indiscernible] growth on Black Friday and Cyber Monday has led to strong performance across our product portfolio and $10.6 billion in revenue this quarter. Let me talk first about how our sales team have driven the introduction of innovative ad products that delivered impressive results for our advertising customers and outline performance by region. And finally, a few highlights from our marketing and partnerships teams. First in Search. Our core desktop Search maintained robust growth as we continue to help our customers grow their businesses. Beyond our robust core growth supporting online sales, we're increasingly helping our advertisers to use Search for branding, as well as something interesting, which is driving in-store sales for them. For instance, by using the power of data insights, we collaborated Carrefour in France to analyze over 2 years' worth of data demonstrate how 1 euro invested in online ads helps deliver almost EUR 8 of in-store sales. We expect to promote these kinds of programs further in the coming quarters. Additionally, we saw similar success in the study with SFR mobile, France's second largest mobile carrier, where we demonstrated a 20% marketing ROI for off-line sales resulting from online advertising. So our Search business continues to be strong. Let's move on to Display. As Larry mentioned, we're continuing to see great revenue growth. Our investments have really paid off in the last few years. Display has now reached an annualized run rate of over $5 billion as we engage with multiple advertisers and get tremendous support from our agency partners. What is particularly satisfying is how we're able to drive this growth as a consequence as of our continued investment in innovation with products like Ad Exchange and new ad formats like TrueView. I'm sure Susan will talk a lot more about these. All these are resulting in more efficiency and in revenue for both of us and our publisher partners. On the sales side, we have continued to align our teams, now the combined Display and Search sales, to help meet the needs of our advertising partners. We continue to activate the Display ecosystem of agencies, advertisers and other publishers. Advertisers like Ford, GM, Electronic Arts, L'Oreal and their agencies continue to see the efficiency of online branding and move more and more of their marketing spend towards our products, to Google Display Network and YouTube. For example, at L'Oreal, we demonstrated that online advertising is far more efficient than television as our new formats in YouTube, which include TrueView in-stream, in-slate and in-search have provided significant reach for their branding campaigns with millions of impressions, great click-through and efficiency gains. Let's move to Mobile. We had another record quarter for mobile advertising as mobile search continues to surge across all platforms. The number of our clients who are using mobile within their campaigns continues to grow rapidly. For example, Mali [ph] Hotels of Spain with 350 hotels in 35 countries, they use mobile search campaigns to support their mobile e-commerce activities. As a result, Mali [ph] has experienced a 60% increase in visitors for mobile devices, and their mobile-driven bookings have multiplied by 12 in 2011. We also worked hard to develop the Mobile ecosystem. This quarter, we kicked out -- kicked off the go mobile campaign in the city of Mobile, Alabama, where we helped hundreds of customers build their mobile sites for free, starting a program that will inspire, educate and empower businesses to continue to go mobile. Let's move to Enterprise. As Larry mentioned, we are seeing great traction in our Enterprise business, both with large partners, who tend to be early adopters and future looking, and in many small businesses who see Google Apps as a comprehensive and quick solution. We now have more than 5,000 customers signing up to Google Apps every day. As Larry mentioned, BBDA was the first major bank to go Google with Apps. Costco, one of the world's largest retailers, has also gone Google. In addition, in Q4, we signed government deals with the states of Maryland, Utah and 5 top universities, including Berkeley, Harvard and Michigan. Let's move quickly to country performance. From a regional perspective, we continue to see strong performance in the Americas. However, generally, country growth rates are flat or softened slightly partly due to comparisons with a very strong Q4 in 2010. North America saw slight decreases from preceding quarters. Year-to-year growth rates, however, [indiscernible] remained robust boosted by a strong holiday season. In particular, Cyber Monday led the way as the biggest day of the quarter. Western Europe was broadly stable as the U.K., France and Italy held steady, while Spain accelerated slightly for the third quarter in a row. However, revenue growth in Germany slowed this quarter. Our key emerging countries continued to see rapid growth across all of our product areas. Let me switch gears to marketing and partnerships. Our marketing and partnerships programs continue to provide strong foundations for the growth of our business. You may have seen many of our initiatives on Google+ this quarter, in addition to the Hangout with David Beckham Larry mentioned. Our sales teams have helped our customers create over 1 million Google+ pages, as Larry pointed out, including Global brands such as Toyota, Zaphos and The New York Times. Additionally, we continued the momentum of our Get Your Business Online program. In 2011, this program has helped bring hundreds of thousands of businesses online across the world. And we got 100,000 businesses to come online in 20 countries in Q4 alone. Last quarter, we expanded internationally to India, Sweden and Malaysia, as well as domestically to additional states like Michigan and New York. Our partnership team continues to drive great results with our partners. We renewed 35 of our direct search partner deals, and our long-standing Search distributor deal with Mozilla was renewed as well. These and other efforts helped our syndicated Search revenues accelerate in Q4 as we saw the full impact of large deals and fast growth of 3 partners. In closing, Q4 was a great quarter for us, finishing a strong 2011. We're excited to continue serving our customers, partners and users in 2012. And before I hand over to Susan, I want to give a shout-out to our business teams around the world and our partners in product and engineering for these great results. I will now turn over to Susan, who will discuss product performance this quarter. Thank you."
},
{
"speaker": "Susan D. Wojcicki",
"text": "Thanks, Nikesh. Larry mentioned last week's launch of Search, plus Your World. And I'd like to start by talking about that a bit more. Google Search has always been about finding the best results among billions of web pages. And until now, those results have been limited to the public world of the Internet. What we added last week was the ability to search your own world, including Google+ post photos and profiles relevant to you, all from the same search box. Let me give you a few examples of how this transformed my searches. Last week, I searched on CES, the Consumer Electronics Show in Las Vegas, to find out more details about the show. In addition to the public results, my search magically included pictures my friends and colleagues had taken while at the show, as well as products they thought were interesting to share. In addition to seeing all the standard news for CES, I was able to get a much more personalized view of the show. This weekend, I also searched on Yosemite since I was thinking about our summer plans. In my results, I was able to see pictures my friends had taken while in Yosemite and posts about interesting things to do there. There was even an article from my mom that she had shared with my family circle, warning us not to get too close to the waterfalls. Turning now to ads. We continue to improve ads quality, and we launched about 20 improvements this quarter. Patrick mentioned that paid click growth was very strong this quarter and that CPC has declined. It's important to look at clicks and CPC metrics together since more clicks can often lead to decreases in average CPC and vice versa. When we make ads quality or format changes, CPC and paid clicks may be impacted differently. For example, when we introduced sitelinks, we saw an increase in clicks. But the additional clicks were on lower-CPC ads, which reduced the average CPC. Many of the ads quality changes in Q3 increased paid clicks at lower CPCs, and they were revenue positive with good user and good advertiser metrics. These ad quality changes from Q3 had a cumulative effect on Q4 metrics. Another important and key driver of the change in CPC growth was foreign exchange. And lastly, there are mix effects with Mobile and emerging markets. Moving on to new ad formats. These new formats now appear on about 30% of queries that show ads. Product Listing Ads, which include prices and pictures of products, saw a lot of success over the holiday season. Traffic to consumer sites from Product Listing Ads was up over 600% year-on-year. This quarter, we expanded Product Listing Ads so they can show up to 5 products, which was great for holiday shopping. We are also working to make it more efficient for advertisers to use AdWords. Many businesses have a large and dynamic catalog of products, and it can be time consuming for them to select the keywords and the CPCs for each product. So this quarter, we beta-launched Dynamic Search Ads, which generates the ads automatically based on what's on a customer website. This enables businesses to advertise a lot more of their products, and our system can also monitor the advertiser's available inventory and show ads only for what is in stock. For small local businesses, we ramped up AdWords Express. This product lets businesses get up and running with a campaign in just a few minutes. Customer sign-ups have more than tripled in the past 6 months. We now offer AdWords Express in the U.S., U.K., Germany and France, and we are trialing it in several other countries. In Display, which now has reached a $5 billion annualized run rate, as Larry mentioned, we're creating a comprehensive solution to buy and sell display ads across many types of digital media, such as desktop, video and mobile. One key driver of growth has been our success in audience buying. This technology enables marketers to deliver ads to specific audiences across the web, such as in-market hybrid car buyers or adventure travelers. Many audience buyers purchase via the Ad Exchange, which now has customers in 26 countries and is growing very rapidly. We also expanded to video and mobile inventory on the Ad Exchange. And on the Google Display Network, we're also growing audience buying. From Q3 to Q4, the number of active advertisers using interest category marketing increased over 60%. And that was from an already large base. By understanding users' interests, we've been able to serve much more relevant and useful ads to our users. Our success in Display has also been driven by brand advertisers, with video formats being an important factor. Our TrueView in-stream ads give users the option to skip the ads. This means that users who see the ads are more likely to be interested in those products, and advertisers are incented to create compelling ads. View rates range between 15% and 45%, and the people who choose to watch those ads are highly engaged. Over 60% of our in-stream ads are now skippable. It's an increase of over 4x since the beginning of the year. We now serve TrueView video ads across the Google Display Network and on YouTube Mobile. I'd also like to give a quick update on Offers, which has been bringing online users to off-line stores and services. Offers are now live in over 30 cities, and we're starting to feature national offers from partners like REI, JetBlue and Toys \"R\" Us. We expanded our collection of deals to include offers from partners so that users get a wider variety and partners get access to a broader user base. And lastly, among the many launches that we did in the quarter, I'd like to highlight one project we did called Memories for the Future. This site compares before and after Street View photographs of the areas affected by last year's tsunami in Japan. We drove thousands of miles so that future generations can see what happened. Thanks all for your time. Now back to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Susan. So what we'll do is we'll turn it over to Jamie to set up the Q&A session."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] And we'll take our first question today from Brian Pitz with UBS."
},
{
"speaker": "Brian J. Pitz",
"text": "Maybe you could just give us a sense for mobile usage. Did you see a major shift in the mobile usage among the consumer during the holiday? And then I've got a quick follow-up."
},
{
"speaker": "Larry Page",
"text": "This is Larry. Let me give that question to Nikesh."
},
{
"speaker": "Nikesh Arora",
"text": "Look, we're seeing mobile usage grow with leap -- by leaps and bounds. It's happening by a proliferation of Android devices around the world. It's happening by a proliferation of tablets around the world. It's happening generally by people getting more and more active on their mobile devices as they discover the utility and the various apps that allow them to be able to go find things, whether they're local searches, they're product searches or they're searches for generic things on Google. So yes, we are seeing tremendous mobile usage, and we saw -- seem to be an uptick during the holiday season where people were looking for products and searching for e-commerce-related activities during the holiday season."
},
{
"speaker": "Brian J. Pitz",
"text": "So just as a follow-up to that, so do you think that the reason for the significant decline in the CPC is -- the down 8%, is a function of the clicks going through mobile more so? Or is it more some of the other factors that you explained to us? Because I'm just trying to get a sense for the down 8% CPC number was, I guess, significantly different than what we were expecting. And I understand the trade-off with the clicks, but is mobile largely responsible for that?"
},
{
"speaker": "Nikesh Arora",
"text": "I'm going to pass that question on to my friend Susan here who's going to talk about the CPC."
},
{
"speaker": "Susan D. Wojcicki",
"text": "So there are definitely multiple factors whenever we look at these metrics because these metrics are aggregate. But I would say the 2 biggest factors this quarter were FX as well as the changes that we had made, their ad quality or format changes, which increased the paid clicks and again were revenue positive, advertiser positive, user positive. But those clicks, as I explained, may be lower CPC like in the example that I gave in my script with sitelinks. So those were the 2 factors. But again, it's always important to remember there are many factors that contributed to these aggregate numbers."
},
{
"speaker": "Brian J. Pitz",
"text": "Great. Just a quick housekeeping. Patrick, can you just qualify what's in that $5 billion Display run rate? Is that comparable to the $2.5 billion you provided before?"
},
{
"speaker": "Patrick Pichette",
"text": "Yes, it is exactly the same definition. So you take out all the text ads, and then you look at both mobile and desktop. So you go back to the same definition."
},
{
"speaker": "Operator",
"text": "And we'll go next to Spencer Wang with Credit Suisse."
},
{
"speaker": "Spencer Wang",
"text": "Two quick questions. I guess first for Nikesh. It looks like international, excluding the U.K. revenue price load, the most kind of sequentially. I was wondering if the macro economy played at all a role? And if so, any sense of magnitude there? And then secondly, for Susan, with respect to the $5 billion Display run rate number, there's obviously a lot of stuff that goes in there between YouTube and Mobile and the ad network. I was wondering if you could just give us some maybe color of what the blended TAC rate would be for that $5 billion."
},
{
"speaker": "Patrick Pichette",
"text": "So I'll take both questions, if you don't mind. So first, we will not -- we don't provide the TAC rate on the blended. And you're right that, I mean, if you think of the big properties that are in there, right, so you will have the GDN, we'll have YouTube, right, we’ll have all of the additional elements of our Display business, which includes the Teracents and then all of the other optimizers but also the AdMob on mobile. So that's the kind of key elements of it. But we do not -- we don't kind of comment on the details of the blended TAC on them. On the economy, look, we had actually quite a solid Q4 performance, and we're really pleased of our revenue growth. I mean, even despite the FX issues -- so you have to separate the FX issues from the economics fundamentals of our business. And performance in Europe was actually quite healthy despite the environment that we got there. And that's driven by the secular shifts of off-line to online continues, and the secular shifts of more mobile continues. So from that perspective, right, obviously, we don't control the economy, we don't control exchange rates, but we're actually quite pleased with the performance that we've had internationally in addition to the U.K. and the U.S."
},
{
"speaker": "Operator",
"text": "And we'll take our next question from Mark Mahaney with Citi."
},
{
"speaker": "Mark S. Mahaney",
"text": "I just wanted to ask about YouTube. I know that in that Display bucket. Could you quantify it at all? Is the growth you're seeing out of YouTube similar to what you're seeing in the overall Display bucket? And specifically, are you seeing a sign that TV ad budgets specifically are migrating online into assets like YouTube? When you ask advertisers who are spending more money in YouTube, where those dollars are coming from? Where are they coming from?"
},
{
"speaker": "Patrick Pichette",
"text": "So let's do a 1-2 punch quickly. YouTube is doing absolutely terrific. And on the advertising side, Nikesh will probably be the better answer to give the details. Or Larry, whichever of the 2."
},
{
"speaker": "Larry Page",
"text": "Yes, I’d say on the advertising side, I think we're tremendously excited about our growth on YouTube. And the amount of success we're having in advertising there is very significant. But it's not significant compared to the overall kind of video advertising space. It's a tiny percentage of that. We have a huge amount to grow. But I don't think the advertisers are thinking about it as being a significant percentage of their other spend on video. So we don't really see that."
},
{
"speaker": "Operator",
"text": "And we'll go next to Ben Schachter with Macquarie."
},
{
"speaker": "Benjamin A. Schachter",
"text": "On Android, the numbers are obviously very, very strong. But can you talk about the monetization potential that’s beyond Search? What has to happen with Android for you to actually make money on this? And how are you going to do it? And then secondly, the revenue growth did decelerate more than I think most people expected. And you had such strong tailwinds with Mobile and Display. Do you think that some of the deceleration came from people going to information directly through apps or going directly through vertical search like going to Amazon directly for commerce or Expedia directly for travel?"
},
{
"speaker": "Larry Page",
"text": "Yes, I mean, Ben, maybe I'll take the first on there on Android. I think we are in a very -- as I mentioned in my remarks, we're in the early stages of monetization for a number of our new products, and Android is one of those. I think we do make money from Search on apps. We do make -- we mentioned that we have a very strong advertising business on mobile, which we obviously -- a lot of those people are on Android as well. And I think that you also see we announced 11 billion downloads on Android markets. Obviously, a lot of those are free, but we also are having a lot of people buy stuff there, too. We've seen a lot of potential for us to make money on Android, and I think you'll see us increase that a lot over time. It's hard to give you details about that right now, but I'm very, very optimistic."
},
{
"speaker": "Patrick Pichette",
"text": "On the second part of the question, let me jump in. If you look at our growth -- first of all, you're right that FX played a part. You also have to remember that last year at this time, right, we had such a strong comp. We had such an amazing Q4 of 2010. That the year-over-year comparison in a way represents also this really high kind of level on which to start from. And so from that perspective -- and if you also look at our mix between our own Google websites versus all of our network, I mean, our core properties continue to be actually very strong. So for all these reasons, I wouldn't be worried of the way that you've described it. In fact, we've got -- continue to have very strong growth."
},
{
"speaker": "Operator",
"text": "And we'll go next to Heather Bellini with Goldman Sachs."
},
{
"speaker": "Heather Bellini",
"text": "I just had another follow-up on CPC. And kind of as you look out given -- to the first half of the year, and given the metrics that Susan rank-ordered or impacting them in Q4, how do we think about how those metrics that you rank-ordered might impact them in the first half of the year or just even looking out over the next quarter? What are the things we should be paying attention to?"
},
{
"speaker": "Patrick Pichette",
"text": "Yes, I mean, at the highest level and then maybe Susan can jump in if she wants to add additional, if you think of the core elements of it, she mentioned quality. And we -- the -- all of the Panda changes and everything we talked about, right, its full year is going to be represented only by the next spring. And then FX rate, we don't control ourselves. So obviously, it has a significant impact. The rest of it is actually the mix between how the innovation that we drive to our products, which is if you have a great product that drives a ton of clicks and it happens to have lower cost or CPC, then that's still for the benefit of everybody. So then, that's really about our innovation agenda, but we don't give forward guidance on that."
},
{
"speaker": "Heather Bellini",
"text": "Right. But it just looks like those trends that you mentioned that impacted Q4 are in existence as we look out, at least initially, into 2012."
},
{
"speaker": "Patrick Pichette",
"text": "I think you have to make the call on the FX yourself. And then on the..."
},
{
"speaker": "Heather Bellini",
"text": "Aside from FX, obviously, right."
},
{
"speaker": "Patrick Pichette",
"text": "Yes, yes and then the quality, I think will going to -- flow through the year, sometime in the spring."
},
{
"speaker": "Susan D. Wojcicki",
"text": "I mean, the one thing I would just add is, the way we think about the business is we're focused on how do we provide better ads for our users and for our advertisers, and we look at all of those metrics combined. And what we saw in Q3 was we made a bunch of changes. They were small. There was no one individually that actually affected things, but it just so happened that the changes we made drew more attention and caused an increase in paid clicks. And so, as I mentioned, there are many factors. But really, what we use as a guiding metric are to understand that something is revenue, advertiser and user positive."
},
{
"speaker": "Operator",
"text": "And we'll go next to Carlos Kirjner with Sanford C. Bernstein."
},
{
"speaker": "Carlos Kirjner",
"text": "Help me reconcile the 15% year-on-year growth in Google partnered revenue with the 130% growth in the DoubleClick Exchange and the $5 billion run rate for Display. I mean, something -- it seems that something must be decreasing. And how do we make these numbers close?"
},
{
"speaker": "Patrick Pichette",
"text": "Look, I think that you have to remember -- in the highest level, you have to remember that sites and network lines in our financials are not good proxies for Search and Display revenue, right? I mean, in its most simple term, YouTube, which is Display, right, ends up in our Google sites. And yet, AFS which is Search, is included in the network. So when people actually do the math, right, it's really easy to get confused between these lines. So I would kind of caution you to have one which is growing at 15% obviously being -- jumping to the conclusion that that's Display. That doesn't work."
},
{
"speaker": "Carlos Kirjner",
"text": "So does that mean that a material portion of the $5 billion come from YouTube?"
},
{
"speaker": "Patrick Pichette",
"text": "All I'm saying is we don't give the breakdown, but you could -- I just want to make sure that you -- caution you that because of these mix issues, right, it can lead to interpretations that are wrong."
},
{
"speaker": "Operator",
"text": "And we'll go next to Doug Anmuth with JPMorgan."
},
{
"speaker": "Douglas Anmuth",
"text": "I just wanted to go back to the CPCs for a minute. And it sounds like -- and we can obviously take the FX out, but it sounds like you're saying that the improvements in 3Q were perhaps a much bigger factor than the mix shift toward mobile in terms of CPCs. Susan, can you provide any more color there in terms of the improvements that you made which could drive sort of a meaningful shift like that? And then secondly, TAC as a percentage of advertising revenues have been down for many straight quarters now, and here they ticked back up a little bit. Can you clarify that at all, the reason for that?"
},
{
"speaker": "Patrick Pichette",
"text": "Yes, on the latter -- let me just jump in on the latter and then I'll let Susan give a bit more color, commentary. But it's just mix issue between partners. So as you have partner mix, it will just affect. But it's not a dramatic number, by the way, right? It's still kind of hovering around 24. So it hasn't plummeted in any way shape or form."
},
{
"speaker": "Douglas Anmuth",
"text": "Is it more partner mix? Or is it possible that it's more mobile mix like desktop to mobile?"
},
{
"speaker": "Patrick Pichette",
"text": "Yes is the short answer. But partners mix affects it as well. Like, it's not only mobile, I guess, is my point. I'll let Susan give you more details on the colors of the -- if any, on the changes that we've done that would have impacted the CPC."
},
{
"speaker": "Susan D. Wojcicki",
"text": "So the 2 biggest factors, as I mentioned, were the FX and also the changes that we made to -- in terms of ad quality or format changes that we made. And those were changes that we made in Q3. There was no, I think, one significant one that drove the metrics. Or like this quarter, we made 20 different changes. Last quarter, we made something similar. And it was the combination of those different changes. Now it's important to remember that we rolled those out over the course of Q3. And so that meant that if we rolled one out at the end of Q3, that you wound up seeing that impact in Q4 period. And so there was a cumulative effect. But again, there was not any one big one. It was the sum of a bunch of other changes. And those changes that we wind up making are changes that may make the ads more readable, they may be more visible, they're UI treatments or quality changes. They're a bunch of different things that make it more visible so that users are noticing the ads. And we see those as positive. We measure the metrics, how do our users respond, how do our advertisers respond. And they are revenue positive."
},
{
"speaker": "Patrick Pichette",
"text": "Yes. Another way to think about this is in many quarters, we would have a bunch of them that would actually move down the CPC, a bunch of them that would have moved up in [ph] click. It just happens that in the latter part of this year, they kind of all moved one way, which is not neither good nor bad. It just happens that the quality team and the advertising teams actually have kind of unearthed these type of opportunities. So it's a bit of circumstantial as well."
},
{
"speaker": "Operator",
"text": "And we'll take our next question from Jeetil Patel with Deutsche Bank Securities."
},
{
"speaker": "Jeetil J. Patel",
"text": "Two questions. First of all, I think, Larry, early on you referred -- you talked about shuttering a couple of products and then doubling on key products that are showing some quite bit of success. I guess can you speak to are you still innovating across new products around the consumer? And anything that's not tied to advertising as we look ahead? Second question, can you talk about -- I guess when you look at mobile distribution costs in general, do you envision a scenario where mobile distribution costs stay about where they are today? Or how do you think those kind of play out over time as you think about the development of the mobile market?"
},
{
"speaker": "Larry Page",
"text": "Maybe I'll take the first question and Nikesh can take the second part of the question. I think we -- I didn't mean to imply in any way that we're stopping innovating. And I think we will continue to launch new products in new areas and things that aren't necessarily advertising supported, as we have been doing for a while. And I'm very excited about that. But we may not launch 100 such things. We may launch a few of those such things over the next few years. I think we'll try to make sure we're more concentrated in our efforts to make sure we're producing really amazing products for our users and for our customers that are really well thought out and work really well. And so, I mean, we've put a lot of effort into those things. So we're just really just been concentrating our efforts around our innovation and making sure we're doing a really great job on the things that we really care about and that really matter to the world. And so that's very consistent with sort of everything I’ve said. Nikesh?"
},
{
"speaker": "Nikesh Arora",
"text": "Yes, I think on mobile distribution, it's pretty similar to what happens on Search today. Many consumers get their mobile applications from Google directly on their devices. Some people get them through our distribution partners, and some people get them through our carriers. And to be honest, the distribution costs really depend on the mix of those devices. And you can see, traditionally the mix is less and less specific to other distribution partners in the middle, and more and more people are organically getting access to device and applications that they choose given the large plethora of opportunities and options that they have."
},
{
"speaker": "Operator",
"text": "And we'll go to Justin Post, Bank of America Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "A couple of things. Patrick, on the hedging program, you had $134 million loss on the expenses of getting the hedges, but you only made $25 million and it was a pretty volatile quarter. Do you have a lot of backlog saved up for next year in profits? And is this working the way you want? And then maybe for Larry, obviously CPC growth is really accelerating. Can you explain why that's good for Google and why you think you're going in the right direction? The mix seems to be a big controversy, but obviously you're making these changes. Can you really explain the positive benefit to the user experience or to the company?"
},
{
"speaker": "Patrick Pichette",
"text": "So on the first question, actually thanks for your question, Justin, because I'm sure a lot of people are thinking about that. Our hedges -- so the cost that we accelerated is actually relative to the entire portfolio of hedges that we have that spans over 18 months forward. So what -- think of it as a complete program that extends 18 months out and -- of which think of it like a bond ladder, right, with a lot in the short term and -- less in the long term. All of those hedges, right, you have to mark to market. And when you have to mark to market, they're so much in the money. Then you have to actually accelerate your expensing of them. So you're absolutely right that today as we stand or as we close our books on the 31st, right, they signaled about the weakness of the euro because the euro had lost quite a bit in the quarter and relative to our portfolio. So we would -- if things stayed exactly the same, right, we wouldn't reap a lot of benefits in the coming quarters and wouldn't have those expenses because we took them all in one shot. So I hope that makes sense. And it's really tied to FASB 133 that doesn't allow you to just do it pretty [ph] early."
},
{
"speaker": "Larry Page",
"text": "I can take, say, a little bit about CPC from my perspective. I think -- and I don't have the detail here, quarter or whatever, but I do think that CPCs -- do vary a fair amount, and we're not surprised by that. There are lots of product changes that we can make that can increase CPCs or decrease CPCs and kind of have a -- or an inverse effect on the number of clicks and sort of not change the actual dollars spent, for example. And that's not that surprising because we can do things that -- in product changes that affect people’s attention to ads that Susan mentioned or that affect the quality of the conversions that advertises receive. They might receive better quality clicks, or they're -- or those -- each CPC that they got that's more likely to convert into what they care about. And so we are constantly optimizing all those things across a number of different product areas and ad placements and everything else. And our advertisers are doing the same, and the algorithms are also doing all that. So I think in any healthy economic -- economy, like we have of advertising, we're going to see variation in the different factors we use to measure it. And I'm not surprised by that."
},
{
"speaker": "Justin Post",
"text": "Are you happy with the results in the quarter? Are they going the direction you expected based on the changes you made?"
},
{
"speaker": "Larry Page",
"text": "As I said, I'm very happy with our results overall in the quarter. And I think those are a function of all the metrics that we gave you. So yes, I'm happy with our results."
},
{
"speaker": "Susan D. Wojcicki",
"text": "Yes. I mean, one additional thing I'd like to say about the increase in paid clicks is the increase in paid clicks, in a lot of ways, is a proxy for where the ad is useful. Do the users find interesting enough to click on them? Do we have enough advertisers who served ads? So an increase in paid clicks shows that our advertising system is working, that we have more advertisers, we have more clicks. And as Larry alluded to, there are many, many different variables that go into it, but an increase in paid clicks is something that we see as a sign that our advertising system is in demand and it's healthy."
},
{
"speaker": "Operator",
"text": "And we'll take our next question from Scott Devitt with Morgan Stanley."
},
{
"speaker": "Scott W. Devitt",
"text": "I'll ask about paid clicks and their relationship to CPCs. There's a third-party data that suggest that paid clicks continue to grow faster than free clicks. And so the 34% paid click growth that you reported, it would seem to make that fairly accurate that there's a mix shift that's occurring in favor of paid versus free. And with search quality improvements as the driver of this potentially, it would seem that advertisers would be paying more for better distribution, yet CPC is down. So if you were to look at your business on a same distribution basis normalized for mobile and increased ad coverage and all the other potential drags on CPC, I'm just -- the question is a simple one. If you look at advertisers, are they paying more or less on a unit basis for distribution?"
},
{
"speaker": "Patrick Pichette",
"text": "I think that -- let we make 2 statements on this. The first one is that we shy from talking about -- anything about specific which is third-party data, because typically we find there are so much errors and methodology issues with them. I think that we're seeing -- what we have clearly seen this year once again, right, is more holiday shopping happened online this year again, right. Nikesh talked about, right, record Cyber Sundays and Fridays that are black. And, I mean, all of these things have hit record year -- this year again, and we're seeing again a transition of off-line to online. I think that Susan's last point is really the critical point, which is as we're moving and exploring formats that really work well for both the advertiser and the user, you should see a symptom which is more clicking. And that's exactly what we see. And if there's a slight pressure on the CPC as a consequence of it, but overall we get a better result, right, that's actually a pretty healthy environment and an innovative one. And then -- and just again, as we mentioned and as Susan said, it happened that in Q3, we had just a number of them that just went one way. And I wouldn't read any data points in that as saying that that's the future or that it will not revert back to others. It's -- that's just the nature of experimentation in our systems."
},
{
"speaker": "Operator",
"text": "And we'll go next to Jason Maynard with Wells Fargo."
},
{
"speaker": "Jason Maynard",
"text": "I guess I'll spare you on CPC. I have actually a couple of questions for Larry on Google+. Last quarter, I think you referred to it your as social lair. And I guess I almost think of it like Google's -- it's like your social operating system, I guess, to a certain extent. So I'd love to get your vision on how you think G+ can improve engagement across all your properties. And then the second question would be, identities that are on Facebook and Twitter, do you think ultimately those firms will open up the data stream and we could see even richer results with clearly Facebook- and Twitter-like information?"
},
{
"speaker": "Larry Page",
"text": "Yes. I think we see -- as I mentioned in my opening remarks that we see really engaging with users on -- really deeply understanding who they are by getting them the right things that make sense for them and so on. It's really, really important. And I think we are at the early stages of that, and Google+ is a big part of that effort. If you look at some of the things we've done, I think that if you look at in Search, you can do a search now and get somebody's name and have that name really appear as a chip in the search. And that means that it's no longer a string that you're searching for, it's actually a real person. That notion of identity is really a deep, deep part of what we're doing. And it's an example of how we can make all of our products better by really understanding people. So we definitely think about that. There's a reason why we called it Google+ in that way. I think -- and so I think you're -- you've got the right idea in general about that. I think that -- I think with other big companies, other big companies that work on social data and so on, I think we've seen very much general tendency to wall that data up and to wall the card in and not make the data available. Where we have publicly been able to access the data -- for example, in Search, we've provided a lot of third-party social data in Search, and we love doing that and we'd love to have more such data. But in general, I would say companies generally have been walling that data up, and we'd love to be able to use more of it."
},
{
"speaker": "Jason Maynard",
"text": "Great. Can I maybe ask a follow-up and get a prediction from you in terms of how many G+ users you expect in a year or so?"
},
{
"speaker": "Larry Page",
"text": "Oh my goodness, I won't try to predict that. But we're very excited about the growth we had, and we're certainly seeing tremendous number of people being added every day."
},
{
"speaker": "Operator",
"text": "And we'll go next to Ross Sandler with RBC Capital Markets."
},
{
"speaker": "Ross Sandler",
"text": "Two quick questions, neither on CPC. Susan, on Google Offers, quick question there. Given Google [ph] and LivingSocial’s early success in this space, it seemed like scale is an advantage in the local and national deals area. Is there any reason why Google is only in 30 markets to date? It seemed like you've got all the merchant relationships that you need. So is there something else that's preventing a broader rollout? And then a follow-up for Nikesh on Europe. You mentioned in your prepared remarks that Germany was a little weak in the quarter. Can you give us a little color on which verticals? Was it travel, retail, finance? A little color on the verticals that were weak. Or was it broad-based?"
},
{
"speaker": "Susan D. Wojcicki",
"text": "So right now, we have 30 markets to date, and that's just what we have to date. So as there are more markets and as it makes more sense for us over time, then we will roll out more markets. But I do think that there is -- it's very important to understand what's working in a specific market and in a city and perfecting that and really understanding the dynamics that make sense for us for the success of that city. And so as we expand, we'll expand with that knowledge. And we'll expand as we -- as it makes sense for us in terms of the users, the solution and building all of those learnings that we've made in those initial 30 markets."
},
{
"speaker": "Patrick Pichette",
"text": "Nikesh, any comments on your side?"
},
{
"speaker": "Nikesh Arora",
"text": "Yes, I guess in terms of verticals, generally auto has been strong around the world. We've seen that. And then in different markets, different verticals have been special in terms of the -- the U.S., we had – education, we had health. So there have been different vertical performances around the world. And Germany has been a market which has been doing really well for us in the last few quarters. So part of it is we're running up against some very, very tough comps versus last year. But it was general sort of weakness across the board. It wasn't specific to any particular vertical that has changed."
},
{
"speaker": "Larry Page",
"text": "I should mention, too, you can actually go to Google Insights for Search, and you can look at our Search free graph over time for any of these verticals yourself. It's some great data."
},
{
"speaker": "Operator",
"text": "And we'll go next to Herman Leung with Susquehanna International Group."
},
{
"speaker": "Herman Leung",
"text": "Just 2 quick questions. First, I remember last year in the fourth quarter there was a pretty big change that you guys made on the quality side, which I think you mentioned a bit on the prepared remarks. Wondering if that -- how much of a headwind that was relative to the fourth quarter of this year. If there's a way you could sort of quantify that. And second question is the hiring rate that you guys have made, 1,100 people, this quarter. Wondering -- that's a bit of a slowdown from the previous quarters in the past. Wondering if there was something there to look into."
},
{
"speaker": "Patrick Pichette",
"text": "So a 1-2 punch on this one, Herman. On the first one, we mentioned it because we thought it was material. It was such a big impact last year. We don't comment on the specifics, but it was sufficiently material that that's -- you're absolutely right that it created a headwind for us this year. No doubt about it. And that's why we mentioned it. On the second question, you'll remember that in Q3, we kind of had a double hitter where Larry had already said that we had reached what was kind of tolerable in terms of the pace of hiring."
},
{
"speaker": "Larry Page",
"text": "The edge of what’s manageable."
},
{
"speaker": "Patrick Pichette",
"text": "The edge of what is manageable. And thank you, Larry, for that clarification. And we also had at the end of Q3 all of the -- we had the summer -- everybody comes -- leaves -- comes from school, comes into Q3. So we had quite a bit of a bump in Q3. We're really pleased by -- and you can see in our results now that actually, it's a good evidence of we're managing -- we have managed down our numbers into Q4, and a good evidence of we are managing it to make it digestible for us."
},
{
"speaker": "Operator",
"text": "And we'll take our final question from Youssef Squali with Jefferies & Company."
},
{
"speaker": "Youssef H. Squali",
"text": "So first, one product we didn't talk much about is Google Wallet. So I was wondering that based -- if based on your early test, is that a product that you're planning on doubling down on? And if so, what is the path to wider adoption? And second, on MMI, I know the deal hasn't obviously closed yet. But just given the size of that transaction, it certainly has the potential to really change Google's growth and margin profile pretty significantly, which is a big concern to many. So at a very high level, Larry, I was wondering if you could maybe just talk about your commitment to be a principal in the handset business. And if so, how does -- how do you avoid channel conflicts with the partners?"
},
{
"speaker": "Susan D. Wojcicki",
"text": "Youssef, this is Susan. So I can talk a little bit about Google Wallet. And so as Larry has mentioned a number of times, we want to focus on products that people use every day. So products that are core. And all of us use our wallet every day. And we think that's a big opportunity for us. So we are continuing to invest in our Wallet business. And we see a lot of opportunity. And for example, there might be opportunities in the future in terms of how online and off-line are linked together, and better opportunities with the way different parts of our business wind up working. So we are very excited about Wallet, and we will continue to invest in it."
},
{
"speaker": "Larry Page",
"text": "And I should mention on Motorola obviously we're going to break that out separately, so you’ll be able to track the changes to margins and so on. I think that -- and able to track the business separately. So that should not be an issue. We've been very clear that Motorola's obviously going to remain a licensee of Android, and Android will remain open. And when we announced the deal, we really said our strategy is working with different manufacturers on lead devices is going to continue. And Motorola will bid with -- just like any other OEM for those devices. So that process will be unchanged. And obviously, I think we have done a great job managing our partner ecosystem. That's a difficult thing to do, and I think we do it quite well. And I expect we're going to continue to do that well with Motorola. And obviously, it shows our commitment to Android in making sure that we have the freedom to innovate and as do all of our OEMs."
},
{
"speaker": "Patrick Pichette",
"text": "So even more specifically, we -- you can expect segmented reporting for Motorola. So the Google will continue to be very clear in terms of its performance and transparency to investors. Motorola will also, on its own, be very clear and transparent to investors. And just before we close the call, just a reminder to everybody, as the headcount question that was asked a minute ago reminded me. As we launch into Q1, it's important to remember that there's a lot of expenses. As people kind of think of resetting their models, it's really -- I just want to remind everybody because every year we go through this, that the employer taxes and 401(k)s and all of the things that launch into Q1 typically get reset. And so I just want to give a friendly reminder to all our -- the people that have financial models out there to make sure that -- to take that into consideration because it surprises everybody every year. So rather than get another surprise at the end of Q1, I just thought I'd remind everyone. On that note, I think it's really -- I'd love to, once again on behalf of the 4 of us here, thank profusely our Googlers. I mean, they do an amazing job and, as we said, landing a great quarter, crowning a terrific year and really well set for an absolute exciting year for 2012 and look forward it. So on that, Jamie, I'll let you close the call."
},
{
"speaker": "Operator",
"text": "Thank you, sir. That does conclude today's conference. We appreciate everyone's participation."
}
] | null | null |
GOOGL | 3 | 2,011 | 2011-10-14 16:30:00 | Operator: Good day, everyone, and welcome to the Google Inc. Third Quarter 2011 Earnings Conference Call. This call is being recorded. At this time, I'd like to turn the conference over to Ms. Jane Penner, Head of Investor Relations. Please go ahead, ma'am.
Jane Penner: Good afternoon, everyone, and welcome to today's third quarter 2011 earnings conference call. With us are Larry Page, Chief Executive Officer; Patrick Pichette, Senior Vice President and Chief Financial Officer; Susan Wojcicki, Senior Vice President, Advertising; Nikesh Arora, Senior Vice President and Chief Business Officer. First, Larry, Patrick, Nikesh, and Susan, will provide us with their thoughts on the quarter. Also, as you know, we now distribute our earnings release through our Investor Relations website located at investor.google.com. So please refer to our IR website for our earnings release, as well as supplementary slides that accompany the call. This call is also being webcast from investor.google.com. A replay of the call will be available on our website in a few hours. Now let me quickly cover the safe harbor. Some of the statements that we make today may be considered forward-looking, including statements regarding Google's future investments and our long-term growth and innovation, the expected performance of our business and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on this call, such as operating income and operating margin, are also expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation. We've also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will now turn the call over to Larry.
Larry Page: Well, thank you, and it's great to be here, and thanks for taking the time to be with us today. When I look back over the last quarter, the word that springs to mind is gangbusters. Revenue was up 33% year-on-year, and our quarterly revenue was just short of $10 billion, not bad for a 13-year-old. I'm also incredibly excited about the progress we've made on the product side. Ever since taking over as CEO, I had to focus much of my energy on increasing Google's velocity and execution, and we're beginning to see results. Look at Google+, we had 100 features launched in 90 days, the team is really cranking. We had Hangouts on the phone, Hangouts on air, Will.i.am did a Hangout from his concert in Central Park. You can now share Circles. You can search Google+ and you can play games in Google+. And far and most exciting of all, open sign-ups, Google+ for everyone. Looking at the numbers for Google+, I was taken aback. I now want to announce that we passed the 40 million user mark on Google+. People are flocking into Google+ at an incredible rate and we're just getting started. The engagement we're seeing is phenomenal too. Over 3.4 billion photos have already been uploaded in Google+. But it's still incredibly early days for Google+ because our goal is actually far bigger than the individual feature launches themselves. Our ultimate ambition is to transform the overall Google experience, making it beautifully simple, almost automagical because we understand what you want and can deliver it instantly. This means baking identity and sharing into all of our products so that we build a real relationship with our users. Sharing on the web will be like sharing in real-life across all your stuff. You'll have better, more relevant search results and ads. Think about it this way. Last quarter, we shipped the Plus, and now we're going to ship the Google part. The new visual design, beautiful, consistent UIs for Search, News, Maps, Translate, and lots of other features, is only the beginning of that process. Last quarter, I talked about focus, and we've made great progress here too. To create products that really change people's lives, that they use every day, 2x or 3x a day, is really hard. So we have to make tough decisions about what to focus on or we end up doing things that don't have the impact that we strive for. Since we last spoke, we've begun the process of shutting over 20 different products including Sidewiki, Google Pack, Google Notebook, and Fast Flip, and we'll continue to simplify and streamline our products going forward. This prioritization is crucial if we are to really invest in the extraordinary opportunities in front of Google today. Let me give you a few examples. Chrome, usage is going through the roof. We have now hit over 200 million users and still growing fast. Turns out that people really care about getting to the web quickly and securely and having a whole ecosystem of apps at their fingertips. I'm super pleased with Google Maps, it's a favorite with our users, especially on mobile devices. In August, we launched in 40 new countries, taking our total to 130 countries. The growth of Android is mind-boggling too. Over 190 million devices have now been activated globally. I'm super excited about the soon-to-be released new version of Android called Ice Cream Sandwich, that's right, Ice Cream Sandwich. You won't believe what we managed to get done in this release. We're also seeing a huge positive revenue impact from Mobile, which has grown 2.5x in the last 12 months to a run rate of over $2.5 billion. Generally, I found that high usage products will make a lot of money over time for well-managed technology companies, and that's why it's so important to run these businesses for the long term. That said, we must never lose sight of the fact that today's revenues and growth serve as the engine that funds all of our future innovation. People are a crucial part of Google's long-term success, because great companies are no greater than the efforts and ingenuity of their employees. So our goal is to hire the best people at every level and keep them at Google. Our hiring has to be manageable, if we are to balance our short and long-term needs. You may have noticed quite substantial hiring this quarter, driven in part by a lot of university graduates. Despite the seasonal effect, the total number of people we hired was about the same as last quarter. Our attrition remains low, which is great, though obviously it contributes to our overall current headcount. As I said previously, I continue to believe that our headcount growth is the edge of what's manageable. Let me finish by saying that we are still at the very early stages of what technology can deliver. These tools we use online will look very different in 5 years time. We're building those tools now as Google+, which is why I'm so excited to be here. So thank you. And again, we had a great quarter. And now I'll turn it over to Patrick.
Patrick Pichette: Thank you, Larry. Good afternoon, everyone, and thanks for joining us. Let me first turn to the specifics of our performance in the quarter from a financial perspective. Our gross revenue grew 33% year-over-year to $9.7 billion and 8% quarter-over-quarter. Note that while some currency fluctuation boosted our revenue again this quarter a little bit, even in constant FX terms, our growth rates remain very strong. Our Google website revenue was up 39% year-over-year to $6.7 billion and 8% quarter-over-quarter, which trends across most major geographies and verticals in fact. Our Google Network revenue was up 18% year-over-year to $2.6 billion and 4% quarter-over-quarter. On the one hand, year-over-year network revenue growth slowed slightly due to a few factors, including the Search quality changes that we made earlier this year that we already commented on. On the other hand, the momentum of our Display business, which comprises only part of the network line, continues. And Nikesh will have more to say on this in a few minutes. Our other revenue was up also 52% year-over-year to $385 million, and that was up 24% quarter-over-quarter. Our global aggregate Paid Click growth was very strong, up 28% year-over-year, and up 13% quarter-over-quarter. The corollary, the aggregate cost-per-click growth was up 5% year-over-year and down 5% quarter-over-quarter. Remember too that, that's an aggregate number, which includes both Google.com and our AdSense properties. As usual, there's some variability quarter-over-quarter in these metrics but, overall, we continue to be very pleased with our revenue and the performance of our ad system. Again, Susan will give you a few more comments in a few minutes. So turning to our geographic performance, the U.S. and rest of worlds are growing at a very healthy pace, and our results clearly reflect that. Even the U.K. continues to show some positive momentum. In our earnings slides, which you'll find on our Investor Relations website, you'll see that we've broken down our revenue by U.S., U.K. and rest of world to show the impact of FX and the benefits from our hedging program. So please refer to those slides for the exact calculations. Our revenue from the U.S. was up 26% year-over-year to $4.4 billion. Our non-U.S. revenue accounted for 55% of our total revenue or $5.3 billion, up 41% year-over-year, which includes a modest $1 million of benefits from our hedging program, and this is compared to $89 million benefit in Q3 of last year. The U.K. was up 25% to $1 billion and year-over-year growth and fixed FX still is pretty healthy and would have been 20% -- or is 20%. Let me now turn to expenses. Our traffic acquisition growth and costs were $2.2 billion or 23.7% of total advertising revenue. And our other cost of revenue was $1.1 billion, which exclude stock-based compensation of $72 million. Finally, operating expenses, also excluding SBC, totaled $2.8 billion. And SBC, itself, totaled $499 million in Q3. So our increase year-over-year in SBC is primarily due to the annual equity refresh, which we do at this time of year. And the increase in year-over-year for our OpEx was primarily due, as usual, in payroll, increased professional services and advertising and promotion spend. So as a result of all this, our non-GAAP operating profit was $3.6 billion in Q3, which exclude SBC, and are resulting in non-GAAP operating margin of 37.3%. Headcount was approximately up by 2,585 versus Q2, ending the quarter with 31,353 full-time employees. And as Larry already noted, there are 2 factors at work here. Q3 usually has significant headcount additions and this quarter is no exception due to a bumper crop of university hires. In fact, we had the second-highest number of university hires in Google's history this quarter. Additionally, acquisitions this quarter added a large number of people as well. Our effective tax rate was 19% in Q3, flat with Q2, and the lower tax rate is driven by a mix of earnings between domestic and international subsidiaries. Now let me turn to cash management. Other income and expense was $302 million for Q3. OI&E was driven by a strong portfolio management performance and, additionally, we saw lower-than-expected FX cash flow hedging expenses due to the strengthening of the U.S. dollar in September. For more details on OI&E, again, please refer to the slide that accompanies this call on our IR website. Operating cash flow was very strong at $4 billion. Our CapEx for the quarter, down from last quarter, to $680 million, and the majority of the CapEx once again in Q3 was related to facilities and production equipment. And as a reminder, we continue to make these significant investments in CapEx, and these have shown to be lumpy from quarter-to-quarter depending on where we're able to make these investments. We're very pleased with our free cash flow and consequence of all this, which was $3.3 billion. So before handing it over to Nikesh, I know that many of you have had questions about general economic outlook and have been kind of asking us those questions. Look, what we're seeing is not terribly surprising or different from what you're all seeing, watching on TV, reading in the press. And while, obviously, we don't control the economy or the exchange rates that fluctuate so much, we do very much control our own operating agenda. And that's why we will, as always, stay focused on what we control, our agenda for the long term, with the strategy and investments that are not calibrated for quarter-to-quarter views but really designed to create, as Larry said, fantastic products that transform our users lives and create significant value for our shareholders. With that, let me now hand it off to Nikesh, who will cover more details on our sales performance in this quarter. Nikesh?
Nikesh Arora: Thank you, Patrick. I'll give you an update on our business activities. To reiterate what Patrick said, we saw strong performance across our portfolio, supported by the strength of our products. Our sales, customer support, marketing and partnership activities drove $9.7 billion in revenue this quarter. First, let me talk about the results for our advertising products, then our performance by region, and, finally, some highlights from our amazing marketing team. On Search, our core desktop Search business maintained its momentum. Google.com growth was faster than one year ago. Our syndicated Search revenue also accelerated this quarter with new large global deals contributing to our growth. We're monetizing clicks better by working closely with our clients to grow the value of search advertising. What's interesting is, we're increasingly able to link search marketing efforts to both online and off-line sales with various other media. This quarter, we worked with our clients, such as leading apparel retailer, H&M, to promote sales through classic search campaigns. Additionally, clients like J&J and Sharpie, use search advertising support large online branding campaigns on other media, like YouTube and our Google Display Network. Moving on to Display. Growth this quarter was robust, with products like YouTube and Google Display Network, we're giving advertisers more options to engage with their customers online. What's interesting is, we've seen a marked increase in our average spending from 2009. 2009, our top 20 display deals averaged approximately $2 million each. Now, our top deals are over 7x larger, averaging approximately $15 million each. Some of our biggest display campaigns this quarter came from DreamWorks and Disney. We've launched Space Lab, a partnership between YouTube and Lenovo. It is a video competition for 14- to 18-year-olds, in which winners will have the opportunity to send a science experiment to the International Space Station. So we keep doing interesting things to try and keep driving more usage and more revenues for YouTube and our Google Display Network. We have equally strong traction with our ad agency partners, with whom we're very excited about the partnerships we've developed. Just over the past 6 months, we've signed display deals of agencies which total almost $600 million to help deliver online advertising options to our shared customers, which all form part of our Display initiative. Let's turn to mobile advertising. Larry mentioned $2.5 billion as a run rate. Our revenue growth continues to accelerate even in Mobile, driven primarily by mobile search. This growth, obviously, is driven both by the underlying expansion of Android devices and of tablets, as well as stellar performance of our sales teams who are working closely with our customers to help them craft compelling mobile advertising solutions. Many advertisers have greatly increased the size and frequency of their mobile campaigns. Mobile is becoming a must-have. This includes clients like InterContinental Hotels Group, which spans pretty much across our entire portfolio of properties, including Mobile search, Mobile GDN and AdMob. Moving our sights to Enterprise. We see continued revenue acceleration in our Enterprise business. More companies are fundamentally going Google. Our Apps products continue strong growth with recent app wins, such as people like Goodyear and SOFTBANK of Japan. We're particularly excited, obviously, also, that we just deployed apps to 450,000 teachers in Morocco. Finally, Chromebooks have been available for purchase since mid-June, and we're beginning to see lots of interest and good uptake, both from the businesses and educational institutions. Let's switch gears and look at our country performance. If you look across countries, we continue to see strong business growth despite uncertainty in the global economy. In particular, North America was broadly stable this quarter. U.S. revenues have stayed on their gross trajectory, and Canada has actually accelerated. In much of Western Europe, we have seen some softness in ad sales. However, in markets like Spain, we are seeing that the sales execution efforts are continuing to keep our revenue stable and, in some cases, accelerate the revenue growth. Of course, across Asia and our key emerging markets, we grew much faster. Japan's post-earthquake recovery has continued and it's been driven primarily by large advertisers. We also see revenue growth in Australia, India, Brazil. They all are strong and they're continuing their strong growth trajectory. Finally, let me spend a few minutes on marketing and partnerships. Our marketing and partnership programs continue to help scale and grow usage of our products. Start, we're very proud of our Get Your Business Online program. This is a campaign which, basically, we work with our partners, we help small businesses and bring their companies online. This is great for the business, this is great for the economy, and this is great for future ad spending. So during Q3, we helped 7,000 U.S. businesses get online in places like Texas, Vermont, Kansas and Missouri. We also drove multiple customer launches this year. Our teams have helped expand the footprint for Google Offers, our deals business to about 11 cities in the U.S. after our pilot last quarter in Portland. Additionally, we continue to grow Chrome user base, which I talked about, the penetration continues to grow with our campaign called a Better Web campaign. We've laid the foundation for Chromebooks, which I talked about. If you haven't had a chance, if you fly Virgin America, you might have the opportunity to surf on a Chromebook in-flight. Finally, we've been supporting the growth of Google+, which we're very excited about, building a richer user experience by connecting users to public figures, celebrities, including Will.i.am from right onstage, Britney Spears, Richard Branson, just to name a few. In closing, we had a phenomenal Q3 and we hope to continue the good work for our customers, partners and users in Q4. I will now turn over to my partner and colleague, Susan, who will discuss the product performance of this quarter.
Susan D. Wojcicki: Thanks, Nikesh. Let start by talking about Search. We had another great quarter for Search quality with over 100 launches. We improved our preview feature so that when you hover your mouse over a search result, a large thumbnail of the site appears on the right. We also expanded the site links feature to include more links, with full snippets for each link. A good example of this is when you search on Metropolitan Museum of Art. You can see links to exhibits, the store, and general information. What I love about features like these is they magically make Google easier to use. The same goes for our new speedy Flight Search option. When you enter a query like SFO to JFK, and then click on the Flight link on the left-hand side panel, you can see all the different flight options. You can sort it in a variety of ways, airline, pricing, nonstop, times, and bring up a map that shows the flight route and other potential destination and prices. Flight Search combines IT expertise with Google technology. We are still very early with the product. Think of this first version as the takeoff, not the final destination. Turning to our Ads business. As Patrick mentioned before, our revenue growth was very strong. We are pleased with the Paid Click growth, which increased this quarter while keeping ad quality high. After a number of quarters of strong CPC growth, we continue to see year-on-year CPC growth. As we have said in the past, these average CPC metrics incorporate a number of factors, including mix effects such as Mobile and emerging markets, as well as true changes to keyword prices. It's also important to look at clicks and CPC metrics together, since more clicks can often lead to decreases in average CPC and vice versa. We also made a number of improvements to our core advertising product. Starting with the local and the small business market, we launched AdWords Express in the U.S. and started product trials in the U.K., Germany, and France. There are a lot of businesses who want to advertise online, and they haven't done so because they're too busy running their business. AdWords Express makes it possible for these businesses to start running an ad campaign in just a few minutes. The advertiser gives us some basic information, and we do all the rest. The keywords and the bids are automated. We're excited about this product because we believe it's the first time we successfully simplified all aspects of AdWords, while keeping its effectiveness for local and small businesses. And the results, so far, are quite positive with our advertisers. With regard to the local market, we also expanded Google Offers to 11 cities. The latest launch was in Miami last week. On the other end of the spectrum are large businesses and agencies. We made a number of significant improvements to Google Analytics this quarter, since we know that when site owners have more insight into site traffic and better information about how to optimize their campaigns, they tend to increase their spend. This quarter, we launched multichannel funnels in Google Analytics. This gives marketers aggregate information and insights into the full path to conversion, including clicks from paid and organic searches and display ads, not simply the last click. So advertisers can tell which marketing and ad programs are working. We also added real-time reporting to Google Analytics so that marketers and publishers can see what is happening on their site right now. This is especially useful to measure the immediate impact of social media. So if you put up a new blog post, or you send out a Google+ update, you can instantly see what happens to your site traffic. We also launched a premium version of Analytics with more data, advanced tools, dedicated support, and service level guarantees. Nikesh mentioned how well things are going with display advertising. From a product perspective, we'd like to highlight interest category marketing. We've completed rolling it out to all advertisers at the end of Q2. And since then, thousands of advertisers have signed up and the annual run rate has doubled. With interest categories, we look at the types of pages a user visits, and associates their browser with relevant interest categories, such as ecotourism, mobile phones, or hybrid cars. Then advertisers can show that user relevant ads across all types of sites. Users can opt out at any time, but the results of interest category ads is that they are more useful to users and more effective for advertisers, which, in turn, leads to higher returns for publishers. We are making it a lot easier for advertisers to set up and manage video ad campaigns on YouTube, and the Google Display Network, as well. We began beta testing AdWords for Video, which integrates video buying campaigns directly into the AdWords interface. The momentum around Google+ is starting to apply to our ad products as well. Users can now +1 Display ads on the Google Display Network, and we've had +1 buttons on search ads and results since the end of Q1. Although it's still pretty early, our data shows us that ads and results that are socially annotated are more relevant for users. And finally, we shipped Google Wallet to Sprint Nexus S 4G phones and started working with Visa, American Express, and Discover as partners so their cards could be added to future versions of the apps. This morning, I bought my latte using my phone as a wallet. I'm looking forward to leaving my traditional wallet at home in the future. That's it for now. Thanks, and back to Patrick.
Patrick Pichette: Thank you, Susan. So we'll circle back with Jamie to open up the call and take your questions. Thank you, Susan, Nikesh, and Larry. So everybody, grab their handsets, and we're ready to go. Jamie, we'll look for you for instructions.
Operator: [Operator Instructions] And we'll take our first question from Brian Pitz with UBS.
Brian J. Pitz: I've noted the proliferation of newer, richer ad formats, like product listing ads. Can you help us understand the impact on your financial model? Are they more or less profitable to you? And then secondly, on your comments on Western European ad sales softness, is the softness across all formats or are Mobile and display holding up generally better?
Larry Page: I think I'll ask Nikesh to answer that.
Nikesh Arora: Yes. I think we are constantly improving search as well as improving our ad formats. So if you look at our revenues, we will always be trying to drive new ad formats to our customers because we believe they are better, they provide better information, both to the user as well as they're great for the advertiser. Effectively, I'm not going to comment on the profitability of the ad formats except for the fact that they're great for users and advertisers; and good ads are delivered, and users click on them more, obviously, it will have an impact on the financial end. I'll let you figure that one out. In terms of my comment on Western European ad sales, it was more of a relative comment vis-a-vis prior quarters as opposed to an absolute comment about softness. Generally, we're seeing that the economic impact in some of those markets might flow through to some of these things, but it's just mildly soft. We're generally comfortable. Generally, queries are growing up. People are happier with Mobile, people are happier on Display. We're seeing Search query growth. So it's a bit of a mix across-the-board, but it should not -- it's just slight softness, not weakness.
Operator: And we'll go next to Mark Mahaney with Citi.
Mark S. Mahaney: On that paid click growth, that's a real sharp acceleration but the organic revenue growth didn't sharply accelerate. So could you just provide some color on that? Is that just this market shift towards Mobile searches? What's driving that? And secondly, what's behind that other revenue that really spiked as well?
Larry Page: I'll let Susan take that. Susan?
Susan D. Wojcicki: Yes. So there were certainly a number of factors at play in terms of the CPC and the Paid Click growth. But the most important thing that I want to emphasize is that it's really important to look at these 2 factors together. Since they often move in reverse from one another. The other thing is there certainly was a mix factor where we do see changes in our mix, and that sometimes does have impacts on how our CPCs are -- how the aggregate ones are being affected.
Nikesh Arora: Just on other revenue, let me comment on other revenue. It really is the year-over-year impact of ITA. So, Mark, that's really the key issue there.
Operator: And we'll go next to Spencer Wang with Crédit Suisse.
Spencer Wang: Just 2 quick ones, if I could. First, Larry, on the $2.5 billion Mobile run rate revenue, could you give us a rough sense of how much of that is Mobile search versus Display, perhaps? And then the second question relates to the people strategy. Given, Larry, what you said about being at the edge of what's manageable, should we expect headcount growth to moderate in 4Q and into 2012? And are you contemplating any sort of adjustments to base salaries as you saw earlier this year?
Larry Page: Yes. And I think that we're not going to break out more than we've already given you there. So we thought it was important to show the tremendous success of our business, and so we want to give you a nice milestone for that, but we're not going to break out more data. And also, on headcount, like I said, I think I had already said we're at the edge of what's manageable in terms of our headcount growth and you see our numbers are, as I said, were consistent with last quarter. I think we are always running our business very carefully and prudently, and making sure we're investing in the right places. And we make those kind of decisions every day. And we don't give guidance on what we're going to do in the future.
Operator: And we'll go next to Ben Schachter with Macquarie.
Benjamin A. Schachter: A couple of questions. First, could you discuss the strategy around video content? It seems to me there's sort of UGC premium and then all the stuff in between. Is that how you're thinking about it? And if it is, how are you thinking about emphasizing each area? And then just quickly on emerging markets, you mentioned India and Brazil. Any chance you can quantify some of that, how fast are these markets growing? How big are they overall? Are these top 10 markets, how big are they in the overall scheme of the different countries?
Larry Page: Ben, I think we think about -- certainly, YouTube is just tremendously successful. It's going gangbusters in every way. And we see that site is redefining the way we think about video. And I'd also note that it's very small percentage of people's overall video usage still. So we see opportunities for tremendous growth there. I think the other interesting thing about YouTube is it really blurs the lines between the kinds of content you're talking about. You can move from one type of content to another very easily. And we're finding our users don't really think about it that way. They think about having a great user experience. And we see it as serving our users well, and serving all the content creators well, regardless of their size. And that seems to be working great for us. And for the second part, Nikesh will take that.
Nikesh Arora: Yes. We're not going to break out the numbers for India and Brazil. But what I can give you directionally is both of them are very, very important markets for us. Our products are successful. You see search traffic continuing to rise. YouTube is very popular. Chrome is very popular. So really, we're very happy with the usage of our products, and we believe there's tremendous sort of runway in product usage in those markets because of the changing characteristics of those markets, both from an online penetration perspective and the economic growth perspective of those markets. So with that sort of tailwind behind us, we have great teams on the ground, which are driving businesses to come online. And we're seeing tremendous growth in the ad side, pretty much across-the-board and Display, Search and Mobile. So we're very, very happy with the success of those markets, with the progress of those markets. I'll just give you that as a directional statement.
Operator: And we'll go next to Heather Bellini with Goldman Sachs.
Heather Bellini: But I wanted to ask if you could give us a sense for how much growth in Mobile impacted Paid Click growth this quarter and how sustainable you think that level is? And also, if you could just tell us a little bit on the progress you're seeing in narrowing the gap between CPCs between Mobile and traditional search.
Susan D. Wojcicki: Yes, this is Susan here. So first of all, we don't really break out how Mobile impacted any specific part of Paid growth or CPC. I will say that our ad system is designed to be very flexible. There are always lots of different factors at play that we see changing in terms of users, queries, advertisers, bids. And so, really, we are designing our ad system to be as flexible based on what we're seeing at that specific moment. In terms of narrowing the gap between -- in CPCs of Mobile and traditional search, we see a lot of opportunity for us to continue to grow Mobile. And for example, advertisers having landing pages that are mobile-enabled, we can continue to improve a lot of our algorithms. So we see opportunity for us to continue to improve that over time.
Larry Page: Yes. And I would mention too, Heather, that the mobile phones are just getting amazing. You'll see our work there, and other people's works in coming out, that I think that your experience on phone could actually get to be better than your experience on a computer. I mean, the phone knows where you are, and can help you even when you're mobile and so on. So I definitely -- we definitely see that the experience on mobile improving greatly, especially with Android.
Susan D. Wojcicki: We've introduced a number of formats, just kind of building on Larry's point. So we have advertisers, we can give location. We can actually say, if you search on one specific store, that store is 0.1 miles from where you're located right now, with a map. Or include a phone number, when you click on the phone number, then that's like a CPC. So we're seeing that there are a lot of formats that we can really optimize for mobile, which will make for a great user and advertiser experience.
Operator: And we'll go next to Justin Post with Bank of America Merrill Lynch.
Justin Post: Larry, I know you have to be careful because of litigation, but maybe you could help us understand what steps Google can take to help defend the Android ecosystem on a big picture basis? There's a lot of questions about some licensing threats out there. And then, secondly, maybe this is for Patrick. Can you tell us what verticals performed well in the quarter? I know you've been able to do that in the past. But which verticals really did well in the quarter and maybe others that might have been a little slower?
Larry Page: I think we are very, like I mentioned, we are very excited about Android. And we see our partners and that whole ecosystem continuing to grow hugely. And while there's been lots of people trying to attack that and so on, we see absolutely no signs that, that's effective. And ultimately, we think that other companies' actions there will alienate their customers and their relationships with the other companies. So if anything, we see our strategy is getting stronger there. Obviously, we announced our intention around Motorola, and we're serious about protecting the Android ecosystem, making sure that, that continues to be incredibly successful. But we feel good about our efforts there.
Patrick Pichette: And on my side, Justin, look, we were -- again, quite a reflection of the economy around us. So the U.S., some of the verticals that have been stronger, right, travel, auto, you go to rest of world, interestingly retail, which is not as strong in the U.S. than it would have been in rest of the world because there's more activity in real estate and in retail in rest of world. In the case of the U.K., automobiles have been kind of particularly strong. And so these are the kind of verticals, again, they are a snapshot and reflection of the economy around us. And maybe Nikesh has kind of more color commentary on it.
Nikesh Arora: No. I agree with everything Patrick said. I think the only, sort of nonsecular event that's happening, is that we are continuing to see strength in the CPU verticals. Because we are doing well on Display and CPG have traditionally verticals that advertise more in display. So there was a bit of a opportunity there, whereas search wasn't their prime focus, but those guys are doing really well with the Display offerings we have for them. But I agree with Patrick with everything else.
Operator: And we'll go next to Doug Anmuth with JPMorgan.
Douglas Anmuth: Two things. First, one business you didn't really talk about was Google Offers. I was hoping you could add some more color there in terms of your strategy and what you think you can do differently in this space. And then, secondly, I know this is probably tougher but just related to MMI. We've obviously seen examples in the past around CPTN and Intel and McAfee, around writing in concessions in certain ways. Is that something that Google would potentially be willing to do, in terms of licensing patents, to open source software and then, also, delivering product updates and roadmaps at the same time as for MMI?
Larry Page: I think Nikesh will take the first question there.
Nikesh Arora: I guess it's early days for Google Offers. As I mentioned, we have expanded from one Portland trial to over 11 cities in the U.S. And we are leveraging some of the sales efforts we already have with our Ads business. We are leveraging our relationships with small, medium sized businesses. Google Offers, for us, is just one part of the overall opportunity to work with SMB. So it's early days. We're very happy with the progress we've made so far. You might have seen us launch Google Wallet, which is also a part of an enablement strategy for that. So, so far so good, very pleased with the progress so far.
Larry Page: Yes. As you know, Motorola deal is under review, and I think it would be premature for us to comment about anything we might do with regards to that.
Operator: And our next question comes from Scott Devitt with Morgan Stanley.
Scott W. Devitt: Just had 2 questions. In certain areas like shopping, payments, travel, reviews and mortgages, the company seems to continue to get deeper into the purchase funnel or closer to the actual transaction. And Susan, you noted the ITA example on the call. I was wondering if you could talk a little more broadly about this more vertical approach, the benefits of it, and the categories that you're particularly focused on. And then secondly, noncash stock-based comp, I think was up 31% sequential and 50% year-over-year. Patrick, you noted the annual grant. I was just wondering if this is the new run rate or if there is something one-time or, potentially, there's been a change in the cash versus noncash comp.
Patrick Pichette: Why don't I answer the last question first and then flip it over to Susan. I mean, you're seeing the full year impact of our salary raises last year flowing through in all aspects of our compensation. So when we did the equity refresh this quarter, obviously, it's augmented by the fact that people have 10% more salary and all of the corollary issues around it. So it is a onetime item but you're changing the plateau, if you wish, and then it will flow through into the next year and then it will stabilize itself. That's the best way to think about it. And then on the issue of the verticalization, I'll have Larry take a crack at it, please.
Larry Page: Yes. Thanks, Patrick. I think that we really think about Google as providing the exact right answers when you need them. And those things are not necessarily particular websites or whatever. They're actually -- maybe actually trying to get a very specific piece of information, like you do with an airline ticket, for example, as we were talking about. So I think we see this as a general instance of a problem, of just making search work better across anything you might want to be able to do. And we're pursuing that in a lot of different areas, and have our whole history, basically. So I think you'll see us do a better job of providing a great user experience on more and more specific things over time. And that's what we do, when we make a better search engine.
Operator: And we'll go next to Ross Sandler with RBC Capital Markets.
Ross Sandler: I've got 2 questions. First, a quick follow-up on Android. So we've seen some of the Android partners now agreeing to pay Microsoft licensing fees. So in order to protect the ecosystem, is Google planning on subsidizing a portion of these fees? Or is there -- how does that strategy play out? And then second question on Google Wallet. Is the long-term plan here to partner with other financial transmitters, like PayPal and maybe their credit card networks for some of the heavy lifting in the payment space? Or does Google plan on kind of vertically integrating with the banking system to offer customer service and risk management around transactions for the Google Wallet customers?
Larry Page: I think that maybe I'll answer it in just kind of a general way. Rather than seeing, for example, Microsoft compete in the marketplace with their own smartphones, they've really continued resorting to legal measures to hassle their own customers, right? So it seems kind of odd. And we haven't seen the details of those total agreements, and I suspect that our partners are making good deals for themselves there. And so while there's a lot of press around that, we're really looking forward to our announcements with Samsung next week, which I think will be very exciting. And like I said, we see Android going gangbusters, and we don't see anything that's going to stop that. On your second question about Google Wallet and so on, I think we're very early. We just released a phone with Sprint, the Nexus S with Sprint, that's sold out and has had tremendous demand. And we think that the customers who have gotten that experience are amazingly excited about it. And like Susan mentioned, she can buy her coffee that way. And that's an amazing experience, and we're just at the very early stages of that.
Operator: And we'll go next to Jeetil Patel with DB.
Jeetil J. Patel: A couple of questions. Can you talk about in the Mobile business as a whole, how do you structure some of the revenue sharing agreements that you have on the advertising side relative to in-browser searches? And I guess, who is it, typically, that you're typically paying for that distribution, the wireless carriers, the handset vendors, and how do you see that evolve going forward? And then I have a quick follow-up around kind of vertical integration. You've seen companies launch new devices, hardware-wise, to layer on top of some of the content and applications they sit on. You've obviously looked at Motorola now, and you're stacking from hardware OS into the applications environment. Do you think that, as you look at mobility, the world -- there's a unique opportunity to develop a much richer, deeper relationship? And I guess maybe a little bit more elaboration on the vertical integration there that you're looking at.
Larry Page: Yes, I mean, I think it's an exciting time. There's a lot of innovation going on in different business models and so on. I think we're very excited about our Android ecosystem and the growth of that. And I think we have very, very successful strategy there, as you see from the numbers that we talked about, over 190 million devices, and growing quickly. So I think there's many -- you're asking about different kinds of structures but we're very, very excited about the structure we have now, and about continuing that growth and continuing to evolve that platform ecosystem. And maybe Nikesh can take the second part there.
Nikesh Arora: I think Larry's right. There are many interesting models out there. As you know, Android is an open ecosystem, and our Mobile strategy is a very partner-focused strategy. So in many cases, we work with various partners to deliver the experience to the end user. And there are different partners, there are different value they bring to the equation, whether it's distribution, whether it's making Google Search part of their services, whether it's allowing us to be an ad-serving platform there. So each of the relationships are slightly different, and they have different negotiated deals with them. But generally speaking, I think we believe there's a fair value transfer to whoever in the ecosystem brings value to the table. And we get our fair share for providing services in that ecosystem.
Larry Page: We've been very successful with these models on the web, and we have a lot of experience with it, and I think we're good at doing those kind of deals.
Jeetil J. Patel: It seems like owning content, at least in the Mobile space, seems to be a differentiator. Is that something that you'd possibly look at longer term? Is that owning more the content structure out there?
Larry Page: I think, again, we're not going to comment on what we might or might not do. I think that we've had very, very successful models for a long time without owning content. And I think many of the models of you see don't involve people owning content but actually selling it or distributing in various ways. And I expect that will continue.
Operator: And we'll go next to Jason Maynard with Wells Fargo.
Jason Maynard: One of the threads that drew a lot of these questions in the Mobile market is, how do you increase monetization, and kind of where we're at. And I think one of the things I'd love to get your view on is where we are in the process of bringing together some of the disparate local services? How does Offers intertwine? And when does that sort of take on a little bit more of a unified feel versus sort of a set of one-off products that a user would use?
Larry Page: Jason, I think that's a great question. I think that -- I think first thing to keep in mind is that we're still very early in the Mobile business, and you see it's incredibly exciting business. There's a lot of activity. The user experiences are getting tremendously better, just growing like crazy. And there's a lot of economic activity and so on. So we've done well by having a long-term view about it. And I think that we also sort of want to balance having total integration with really fast iteration and fast progress and experimentation. And I think you definitely, I mentioned our unified look and feel that we've rolled out on Google which I'm very excited about, and we'll continue to do things like that, that really unify experience and make it more intuitive for people. But we're also going to do some experimentation, also, on new things, and then have a little bit less integrated. So it's always a mix of that. I think that offers, specifically, we think about our local business as being how do we help merchants and users, users like yourselves, get really good information and help the merchants get the right users at the right time and for the right amount of money, and so on. And that's a very hard problem across a whole bunch of different areas, basic information about merchants' interaction with between the merchants and the end users. And we have things going on in all of those spaces. And it's going to be a mix of, again, rapid iteration and also the integration of those things into, then, a more cohesive whole. And I'm very excited about that space.
Operator: And we'll take our next question from Anthony DiClemente with Barclays Capital.
Anthony J. DiClemente: I have 2. The first question is for Patrick or Susan. You cite your Mobile business as a run rate, which was very helpful. I was wondering if you could do the same for your Display business, particularly interested in YouTube, and so if you could comment on pricing and volume trends at YouTube in the quarter, at least directionally, that will be helpful. And then I have a follow-up.
Patrick Pichette: So we, as you know, we don't provide any guidance. We had this extraordinary moment this quarter in Mobile where we had a confluence of so many things going on. And that we thought it was on a onetime basis, again, appropriate to kind of provide number of users, the Android ecosystem that's going gangbusters. And therefore, it was, we thought, appropriate to kind of round it up with kind of a snapshot of where we stand. So for that reason, right, and because of the competitive nature of the environment in which we are, we don't divulge typically these numbers, and you shouldn't expect us to actually give you more information in the future on them, whether it be Display, or Mobile, or others. In the case of YouTube, it's the same thing. I mean, as Larry said, we're incredibly pleased about the growth of YouTube, whether it be the number of videos viewed a day, the revenue growth rates, the performance overall of the content, and the ad system within it. So I mean, all I could say is this is a really, really kind of well-growing property for us in which we are really excited.
Anthony J. DiClemente: Okay. And then just for Larry, I'm just wondering if you could comment on your broader media strategy. Unlike traditional cable providers, the Google platform isn't limited by geography. It's not limited by the contiguous networks or territories. So I just wonder -- there's been some conversation in the marketplace about a multichannel video offering in the U.S. to supplement your media product. And so I was just wondering if you could talk a little bit about that, even just philosophically, that would be helpful.
Larry Page: It's hard to talk about what we might do in the future, again. But I think, in general, I just think there's a lot of opportunity in providing better services for end users around media. And you see that, I mean, there's tremendous growth in all these businesses that are doing that. And I think we're, obviously, in a good position to help users find the content and the media and so on that they're looking for. And we're in a great position to also help those companies, and publishers, and authors, and content creators to find the right users, and get paid both through advertising and directly. And so I think that's just a logical place for us to be in, and a logical place where you'll see a lot of activity in general.
Operator: And we'll go next to Jim Friedland with Cowen and Company.
James H. Friedland: Two questions. First, you'd talk about shutting 20 products and you've got some further products in Q1, I believe. Is there any way you can give us sort of a percentage in terms of how much resource that opens up? Is that sort of a 10% increase, or any kind of color you can give us there. And then second, at what level of Google+ users do you need to see a material improvement in ROI and Search, and really move the needle for the business there, just maybe in terms of active users?
Larry Page: Yes, I think those are great questions, Jim. I think that I'm not prepared to give you specific numbers about projects we shut down or whatever, but I will tell you, it's been a pretty significant effort, we've had to really streamline our business and we've made, like I said, tough decisions about where we should be focusing so that we really can generate amazing products and businesses. And those are not easy decisions. So I think there's significant resources involved in the kinds of things we're talking about. And it's also -- it's a fair amount of work, also, for us to just go through those -- that process. But I'm excited about that increased focus for us. I think, as I mentioned on Google+, I think we're seeing tremendous growth, which I'm very excited about. We're still very, very early. It's been out just slightly more than one quarter now, and not even fully open until -- only for a very small part of that. So I think we're very early in that. But on the other hand, I encourage you to all try Google+, and sign up, and flock to it. And you'll find that you will see data on search about what other people are doing. You'll see someone had +1'd something or so on. And I think those things can be very meaningful to you as a user. So I have no doubt that there'll be significant impacts from that.
Operator: That final question will come from Colin Sebastian with RW Baird.
Colin A. Sebastian: Just 2 brief ones. First on Chrome and your efforts there to expand penetration. Can you talk about the specific drivers of growing distribution, adoption, maybe how we might expect this to impact margins over time? And then, secondly, the growth in the Google Site revenues. I wonder if you can add just a little bit of color there on the specific uptick, if that's an acceleration from a Display on YouTube as well as Mobile, or is that core search-related?
Patrick Pichette: I'll take the latter, and then maybe Nikesh will cover the Chrome. On the latter, the answer is yes. Yes, yes, and yes. So yes, YouTube; yes, mobile; yes, format. And I mean, that's why you see such an acceleration of our revenue, and that's why we're so excited about it. And maybe Nikesh, if you have comments on the Chrome and our penetration and how it's working.
Nikesh Arora: I'd love to answer the question like that, like yes, yes, yes. But unfortunately, that's not how the question is phrased. As far as Chrome is concerned, as we have talked about in previous quarters, Chrome is very strategic for us because we believe it is a phenomenal user experience and a user benefit. It just improves the user browsing experience so phenomenally. And we believe that it's important that Chrome be distributed, shared, with almost every user around the world. And a lot of our marketing efforts, and distribution efforts, have been focused around getting Chrome in the hands of our users. We are doing distribution with partners. Our partners encourage people to download Chrome. We are doing distribution where we do direct advertising to consumers to get them to download Chrome with a clear user benefit of better browsing, better video watching, and better security. So we are doing a lot of that. I think, I'm not going to comment on the margin part, but you have to understand, a great consumer experience from Google as part of Chrome makes Google -- makes users use more Google services. So from that perspective, we're very happy with the distribution strategy we have on Chrome. And we don't see any abatement of that strategy.
Larry Page: And I want to thank everyone for all the time that you spent with us. We had a great quarter, very excited about our progress so far. And I also want to thank all of our employees who've worked so hard to make these results that you all see. So thank you, all, very much.
Patrick Pichette: Jamie, we'll let you close the call.
Operator: Thank you, sir. That does conclude today's conference. We appreciate everyone's participation. | [
{
"speaker": "Operator",
"text": "Good day, everyone, and welcome to the Google Inc. Third Quarter 2011 Earnings Conference Call. This call is being recorded. At this time, I'd like to turn the conference over to Ms. Jane Penner, Head of Investor Relations. Please go ahead, ma'am."
},
{
"speaker": "Jane Penner",
"text": "Good afternoon, everyone, and welcome to today's third quarter 2011 earnings conference call. With us are Larry Page, Chief Executive Officer; Patrick Pichette, Senior Vice President and Chief Financial Officer; Susan Wojcicki, Senior Vice President, Advertising; Nikesh Arora, Senior Vice President and Chief Business Officer. First, Larry, Patrick, Nikesh, and Susan, will provide us with their thoughts on the quarter. Also, as you know, we now distribute our earnings release through our Investor Relations website located at investor.google.com. So please refer to our IR website for our earnings release, as well as supplementary slides that accompany the call. This call is also being webcast from investor.google.com. A replay of the call will be available on our website in a few hours. Now let me quickly cover the safe harbor. Some of the statements that we make today may be considered forward-looking, including statements regarding Google's future investments and our long-term growth and innovation, the expected performance of our business and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on this call, such as operating income and operating margin, are also expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation. We've also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will now turn the call over to Larry."
},
{
"speaker": "Larry Page",
"text": "Well, thank you, and it's great to be here, and thanks for taking the time to be with us today. When I look back over the last quarter, the word that springs to mind is gangbusters. Revenue was up 33% year-on-year, and our quarterly revenue was just short of $10 billion, not bad for a 13-year-old. I'm also incredibly excited about the progress we've made on the product side. Ever since taking over as CEO, I had to focus much of my energy on increasing Google's velocity and execution, and we're beginning to see results. Look at Google+, we had 100 features launched in 90 days, the team is really cranking. We had Hangouts on the phone, Hangouts on air, Will.i.am did a Hangout from his concert in Central Park. You can now share Circles. You can search Google+ and you can play games in Google+. And far and most exciting of all, open sign-ups, Google+ for everyone. Looking at the numbers for Google+, I was taken aback. I now want to announce that we passed the 40 million user mark on Google+. People are flocking into Google+ at an incredible rate and we're just getting started. The engagement we're seeing is phenomenal too. Over 3.4 billion photos have already been uploaded in Google+. But it's still incredibly early days for Google+ because our goal is actually far bigger than the individual feature launches themselves. Our ultimate ambition is to transform the overall Google experience, making it beautifully simple, almost automagical because we understand what you want and can deliver it instantly. This means baking identity and sharing into all of our products so that we build a real relationship with our users. Sharing on the web will be like sharing in real-life across all your stuff. You'll have better, more relevant search results and ads. Think about it this way. Last quarter, we shipped the Plus, and now we're going to ship the Google part. The new visual design, beautiful, consistent UIs for Search, News, Maps, Translate, and lots of other features, is only the beginning of that process. Last quarter, I talked about focus, and we've made great progress here too. To create products that really change people's lives, that they use every day, 2x or 3x a day, is really hard. So we have to make tough decisions about what to focus on or we end up doing things that don't have the impact that we strive for. Since we last spoke, we've begun the process of shutting over 20 different products including Sidewiki, Google Pack, Google Notebook, and Fast Flip, and we'll continue to simplify and streamline our products going forward. This prioritization is crucial if we are to really invest in the extraordinary opportunities in front of Google today. Let me give you a few examples. Chrome, usage is going through the roof. We have now hit over 200 million users and still growing fast. Turns out that people really care about getting to the web quickly and securely and having a whole ecosystem of apps at their fingertips. I'm super pleased with Google Maps, it's a favorite with our users, especially on mobile devices. In August, we launched in 40 new countries, taking our total to 130 countries. The growth of Android is mind-boggling too. Over 190 million devices have now been activated globally. I'm super excited about the soon-to-be released new version of Android called Ice Cream Sandwich, that's right, Ice Cream Sandwich. You won't believe what we managed to get done in this release. We're also seeing a huge positive revenue impact from Mobile, which has grown 2.5x in the last 12 months to a run rate of over $2.5 billion. Generally, I found that high usage products will make a lot of money over time for well-managed technology companies, and that's why it's so important to run these businesses for the long term. That said, we must never lose sight of the fact that today's revenues and growth serve as the engine that funds all of our future innovation. People are a crucial part of Google's long-term success, because great companies are no greater than the efforts and ingenuity of their employees. So our goal is to hire the best people at every level and keep them at Google. Our hiring has to be manageable, if we are to balance our short and long-term needs. You may have noticed quite substantial hiring this quarter, driven in part by a lot of university graduates. Despite the seasonal effect, the total number of people we hired was about the same as last quarter. Our attrition remains low, which is great, though obviously it contributes to our overall current headcount. As I said previously, I continue to believe that our headcount growth is the edge of what's manageable. Let me finish by saying that we are still at the very early stages of what technology can deliver. These tools we use online will look very different in 5 years time. We're building those tools now as Google+, which is why I'm so excited to be here. So thank you. And again, we had a great quarter. And now I'll turn it over to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Larry. Good afternoon, everyone, and thanks for joining us. Let me first turn to the specifics of our performance in the quarter from a financial perspective. Our gross revenue grew 33% year-over-year to $9.7 billion and 8% quarter-over-quarter. Note that while some currency fluctuation boosted our revenue again this quarter a little bit, even in constant FX terms, our growth rates remain very strong. Our Google website revenue was up 39% year-over-year to $6.7 billion and 8% quarter-over-quarter, which trends across most major geographies and verticals in fact. Our Google Network revenue was up 18% year-over-year to $2.6 billion and 4% quarter-over-quarter. On the one hand, year-over-year network revenue growth slowed slightly due to a few factors, including the Search quality changes that we made earlier this year that we already commented on. On the other hand, the momentum of our Display business, which comprises only part of the network line, continues. And Nikesh will have more to say on this in a few minutes. Our other revenue was up also 52% year-over-year to $385 million, and that was up 24% quarter-over-quarter. Our global aggregate Paid Click growth was very strong, up 28% year-over-year, and up 13% quarter-over-quarter. The corollary, the aggregate cost-per-click growth was up 5% year-over-year and down 5% quarter-over-quarter. Remember too that, that's an aggregate number, which includes both Google.com and our AdSense properties. As usual, there's some variability quarter-over-quarter in these metrics but, overall, we continue to be very pleased with our revenue and the performance of our ad system. Again, Susan will give you a few more comments in a few minutes. So turning to our geographic performance, the U.S. and rest of worlds are growing at a very healthy pace, and our results clearly reflect that. Even the U.K. continues to show some positive momentum. In our earnings slides, which you'll find on our Investor Relations website, you'll see that we've broken down our revenue by U.S., U.K. and rest of world to show the impact of FX and the benefits from our hedging program. So please refer to those slides for the exact calculations. Our revenue from the U.S. was up 26% year-over-year to $4.4 billion. Our non-U.S. revenue accounted for 55% of our total revenue or $5.3 billion, up 41% year-over-year, which includes a modest $1 million of benefits from our hedging program, and this is compared to $89 million benefit in Q3 of last year. The U.K. was up 25% to $1 billion and year-over-year growth and fixed FX still is pretty healthy and would have been 20% -- or is 20%. Let me now turn to expenses. Our traffic acquisition growth and costs were $2.2 billion or 23.7% of total advertising revenue. And our other cost of revenue was $1.1 billion, which exclude stock-based compensation of $72 million. Finally, operating expenses, also excluding SBC, totaled $2.8 billion. And SBC, itself, totaled $499 million in Q3. So our increase year-over-year in SBC is primarily due to the annual equity refresh, which we do at this time of year. And the increase in year-over-year for our OpEx was primarily due, as usual, in payroll, increased professional services and advertising and promotion spend. So as a result of all this, our non-GAAP operating profit was $3.6 billion in Q3, which exclude SBC, and are resulting in non-GAAP operating margin of 37.3%. Headcount was approximately up by 2,585 versus Q2, ending the quarter with 31,353 full-time employees. And as Larry already noted, there are 2 factors at work here. Q3 usually has significant headcount additions and this quarter is no exception due to a bumper crop of university hires. In fact, we had the second-highest number of university hires in Google's history this quarter. Additionally, acquisitions this quarter added a large number of people as well. Our effective tax rate was 19% in Q3, flat with Q2, and the lower tax rate is driven by a mix of earnings between domestic and international subsidiaries. Now let me turn to cash management. Other income and expense was $302 million for Q3. OI&E was driven by a strong portfolio management performance and, additionally, we saw lower-than-expected FX cash flow hedging expenses due to the strengthening of the U.S. dollar in September. For more details on OI&E, again, please refer to the slide that accompanies this call on our IR website. Operating cash flow was very strong at $4 billion. Our CapEx for the quarter, down from last quarter, to $680 million, and the majority of the CapEx once again in Q3 was related to facilities and production equipment. And as a reminder, we continue to make these significant investments in CapEx, and these have shown to be lumpy from quarter-to-quarter depending on where we're able to make these investments. We're very pleased with our free cash flow and consequence of all this, which was $3.3 billion. So before handing it over to Nikesh, I know that many of you have had questions about general economic outlook and have been kind of asking us those questions. Look, what we're seeing is not terribly surprising or different from what you're all seeing, watching on TV, reading in the press. And while, obviously, we don't control the economy or the exchange rates that fluctuate so much, we do very much control our own operating agenda. And that's why we will, as always, stay focused on what we control, our agenda for the long term, with the strategy and investments that are not calibrated for quarter-to-quarter views but really designed to create, as Larry said, fantastic products that transform our users lives and create significant value for our shareholders. With that, let me now hand it off to Nikesh, who will cover more details on our sales performance in this quarter. Nikesh?"
},
{
"speaker": "Nikesh Arora",
"text": "Thank you, Patrick. I'll give you an update on our business activities. To reiterate what Patrick said, we saw strong performance across our portfolio, supported by the strength of our products. Our sales, customer support, marketing and partnership activities drove $9.7 billion in revenue this quarter. First, let me talk about the results for our advertising products, then our performance by region, and, finally, some highlights from our amazing marketing team. On Search, our core desktop Search business maintained its momentum. Google.com growth was faster than one year ago. Our syndicated Search revenue also accelerated this quarter with new large global deals contributing to our growth. We're monetizing clicks better by working closely with our clients to grow the value of search advertising. What's interesting is, we're increasingly able to link search marketing efforts to both online and off-line sales with various other media. This quarter, we worked with our clients, such as leading apparel retailer, H&M, to promote sales through classic search campaigns. Additionally, clients like J&J and Sharpie, use search advertising support large online branding campaigns on other media, like YouTube and our Google Display Network. Moving on to Display. Growth this quarter was robust, with products like YouTube and Google Display Network, we're giving advertisers more options to engage with their customers online. What's interesting is, we've seen a marked increase in our average spending from 2009. 2009, our top 20 display deals averaged approximately $2 million each. Now, our top deals are over 7x larger, averaging approximately $15 million each. Some of our biggest display campaigns this quarter came from DreamWorks and Disney. We've launched Space Lab, a partnership between YouTube and Lenovo. It is a video competition for 14- to 18-year-olds, in which winners will have the opportunity to send a science experiment to the International Space Station. So we keep doing interesting things to try and keep driving more usage and more revenues for YouTube and our Google Display Network. We have equally strong traction with our ad agency partners, with whom we're very excited about the partnerships we've developed. Just over the past 6 months, we've signed display deals of agencies which total almost $600 million to help deliver online advertising options to our shared customers, which all form part of our Display initiative. Let's turn to mobile advertising. Larry mentioned $2.5 billion as a run rate. Our revenue growth continues to accelerate even in Mobile, driven primarily by mobile search. This growth, obviously, is driven both by the underlying expansion of Android devices and of tablets, as well as stellar performance of our sales teams who are working closely with our customers to help them craft compelling mobile advertising solutions. Many advertisers have greatly increased the size and frequency of their mobile campaigns. Mobile is becoming a must-have. This includes clients like InterContinental Hotels Group, which spans pretty much across our entire portfolio of properties, including Mobile search, Mobile GDN and AdMob. Moving our sights to Enterprise. We see continued revenue acceleration in our Enterprise business. More companies are fundamentally going Google. Our Apps products continue strong growth with recent app wins, such as people like Goodyear and SOFTBANK of Japan. We're particularly excited, obviously, also, that we just deployed apps to 450,000 teachers in Morocco. Finally, Chromebooks have been available for purchase since mid-June, and we're beginning to see lots of interest and good uptake, both from the businesses and educational institutions. Let's switch gears and look at our country performance. If you look across countries, we continue to see strong business growth despite uncertainty in the global economy. In particular, North America was broadly stable this quarter. U.S. revenues have stayed on their gross trajectory, and Canada has actually accelerated. In much of Western Europe, we have seen some softness in ad sales. However, in markets like Spain, we are seeing that the sales execution efforts are continuing to keep our revenue stable and, in some cases, accelerate the revenue growth. Of course, across Asia and our key emerging markets, we grew much faster. Japan's post-earthquake recovery has continued and it's been driven primarily by large advertisers. We also see revenue growth in Australia, India, Brazil. They all are strong and they're continuing their strong growth trajectory. Finally, let me spend a few minutes on marketing and partnerships. Our marketing and partnership programs continue to help scale and grow usage of our products. Start, we're very proud of our Get Your Business Online program. This is a campaign which, basically, we work with our partners, we help small businesses and bring their companies online. This is great for the business, this is great for the economy, and this is great for future ad spending. So during Q3, we helped 7,000 U.S. businesses get online in places like Texas, Vermont, Kansas and Missouri. We also drove multiple customer launches this year. Our teams have helped expand the footprint for Google Offers, our deals business to about 11 cities in the U.S. after our pilot last quarter in Portland. Additionally, we continue to grow Chrome user base, which I talked about, the penetration continues to grow with our campaign called a Better Web campaign. We've laid the foundation for Chromebooks, which I talked about. If you haven't had a chance, if you fly Virgin America, you might have the opportunity to surf on a Chromebook in-flight. Finally, we've been supporting the growth of Google+, which we're very excited about, building a richer user experience by connecting users to public figures, celebrities, including Will.i.am from right onstage, Britney Spears, Richard Branson, just to name a few. In closing, we had a phenomenal Q3 and we hope to continue the good work for our customers, partners and users in Q4. I will now turn over to my partner and colleague, Susan, who will discuss the product performance of this quarter."
},
{
"speaker": "Susan D. Wojcicki",
"text": "Thanks, Nikesh. Let start by talking about Search. We had another great quarter for Search quality with over 100 launches. We improved our preview feature so that when you hover your mouse over a search result, a large thumbnail of the site appears on the right. We also expanded the site links feature to include more links, with full snippets for each link. A good example of this is when you search on Metropolitan Museum of Art. You can see links to exhibits, the store, and general information. What I love about features like these is they magically make Google easier to use. The same goes for our new speedy Flight Search option. When you enter a query like SFO to JFK, and then click on the Flight link on the left-hand side panel, you can see all the different flight options. You can sort it in a variety of ways, airline, pricing, nonstop, times, and bring up a map that shows the flight route and other potential destination and prices. Flight Search combines IT expertise with Google technology. We are still very early with the product. Think of this first version as the takeoff, not the final destination. Turning to our Ads business. As Patrick mentioned before, our revenue growth was very strong. We are pleased with the Paid Click growth, which increased this quarter while keeping ad quality high. After a number of quarters of strong CPC growth, we continue to see year-on-year CPC growth. As we have said in the past, these average CPC metrics incorporate a number of factors, including mix effects such as Mobile and emerging markets, as well as true changes to keyword prices. It's also important to look at clicks and CPC metrics together, since more clicks can often lead to decreases in average CPC and vice versa. We also made a number of improvements to our core advertising product. Starting with the local and the small business market, we launched AdWords Express in the U.S. and started product trials in the U.K., Germany, and France. There are a lot of businesses who want to advertise online, and they haven't done so because they're too busy running their business. AdWords Express makes it possible for these businesses to start running an ad campaign in just a few minutes. The advertiser gives us some basic information, and we do all the rest. The keywords and the bids are automated. We're excited about this product because we believe it's the first time we successfully simplified all aspects of AdWords, while keeping its effectiveness for local and small businesses. And the results, so far, are quite positive with our advertisers. With regard to the local market, we also expanded Google Offers to 11 cities. The latest launch was in Miami last week. On the other end of the spectrum are large businesses and agencies. We made a number of significant improvements to Google Analytics this quarter, since we know that when site owners have more insight into site traffic and better information about how to optimize their campaigns, they tend to increase their spend. This quarter, we launched multichannel funnels in Google Analytics. This gives marketers aggregate information and insights into the full path to conversion, including clicks from paid and organic searches and display ads, not simply the last click. So advertisers can tell which marketing and ad programs are working. We also added real-time reporting to Google Analytics so that marketers and publishers can see what is happening on their site right now. This is especially useful to measure the immediate impact of social media. So if you put up a new blog post, or you send out a Google+ update, you can instantly see what happens to your site traffic. We also launched a premium version of Analytics with more data, advanced tools, dedicated support, and service level guarantees. Nikesh mentioned how well things are going with display advertising. From a product perspective, we'd like to highlight interest category marketing. We've completed rolling it out to all advertisers at the end of Q2. And since then, thousands of advertisers have signed up and the annual run rate has doubled. With interest categories, we look at the types of pages a user visits, and associates their browser with relevant interest categories, such as ecotourism, mobile phones, or hybrid cars. Then advertisers can show that user relevant ads across all types of sites. Users can opt out at any time, but the results of interest category ads is that they are more useful to users and more effective for advertisers, which, in turn, leads to higher returns for publishers. We are making it a lot easier for advertisers to set up and manage video ad campaigns on YouTube, and the Google Display Network, as well. We began beta testing AdWords for Video, which integrates video buying campaigns directly into the AdWords interface. The momentum around Google+ is starting to apply to our ad products as well. Users can now +1 Display ads on the Google Display Network, and we've had +1 buttons on search ads and results since the end of Q1. Although it's still pretty early, our data shows us that ads and results that are socially annotated are more relevant for users. And finally, we shipped Google Wallet to Sprint Nexus S 4G phones and started working with Visa, American Express, and Discover as partners so their cards could be added to future versions of the apps. This morning, I bought my latte using my phone as a wallet. I'm looking forward to leaving my traditional wallet at home in the future. That's it for now. Thanks, and back to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Susan. So we'll circle back with Jamie to open up the call and take your questions. Thank you, Susan, Nikesh, and Larry. So everybody, grab their handsets, and we're ready to go. Jamie, we'll look for you for instructions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] And we'll take our first question from Brian Pitz with UBS."
},
{
"speaker": "Brian J. Pitz",
"text": "I've noted the proliferation of newer, richer ad formats, like product listing ads. Can you help us understand the impact on your financial model? Are they more or less profitable to you? And then secondly, on your comments on Western European ad sales softness, is the softness across all formats or are Mobile and display holding up generally better?"
},
{
"speaker": "Larry Page",
"text": "I think I'll ask Nikesh to answer that."
},
{
"speaker": "Nikesh Arora",
"text": "Yes. I think we are constantly improving search as well as improving our ad formats. So if you look at our revenues, we will always be trying to drive new ad formats to our customers because we believe they are better, they provide better information, both to the user as well as they're great for the advertiser. Effectively, I'm not going to comment on the profitability of the ad formats except for the fact that they're great for users and advertisers; and good ads are delivered, and users click on them more, obviously, it will have an impact on the financial end. I'll let you figure that one out. In terms of my comment on Western European ad sales, it was more of a relative comment vis-a-vis prior quarters as opposed to an absolute comment about softness. Generally, we're seeing that the economic impact in some of those markets might flow through to some of these things, but it's just mildly soft. We're generally comfortable. Generally, queries are growing up. People are happier with Mobile, people are happier on Display. We're seeing Search query growth. So it's a bit of a mix across-the-board, but it should not -- it's just slight softness, not weakness."
},
{
"speaker": "Operator",
"text": "And we'll go next to Mark Mahaney with Citi."
},
{
"speaker": "Mark S. Mahaney",
"text": "On that paid click growth, that's a real sharp acceleration but the organic revenue growth didn't sharply accelerate. So could you just provide some color on that? Is that just this market shift towards Mobile searches? What's driving that? And secondly, what's behind that other revenue that really spiked as well?"
},
{
"speaker": "Larry Page",
"text": "I'll let Susan take that. Susan?"
},
{
"speaker": "Susan D. Wojcicki",
"text": "Yes. So there were certainly a number of factors at play in terms of the CPC and the Paid Click growth. But the most important thing that I want to emphasize is that it's really important to look at these 2 factors together. Since they often move in reverse from one another. The other thing is there certainly was a mix factor where we do see changes in our mix, and that sometimes does have impacts on how our CPCs are -- how the aggregate ones are being affected."
},
{
"speaker": "Nikesh Arora",
"text": "Just on other revenue, let me comment on other revenue. It really is the year-over-year impact of ITA. So, Mark, that's really the key issue there."
},
{
"speaker": "Operator",
"text": "And we'll go next to Spencer Wang with Crédit Suisse."
},
{
"speaker": "Spencer Wang",
"text": "Just 2 quick ones, if I could. First, Larry, on the $2.5 billion Mobile run rate revenue, could you give us a rough sense of how much of that is Mobile search versus Display, perhaps? And then the second question relates to the people strategy. Given, Larry, what you said about being at the edge of what's manageable, should we expect headcount growth to moderate in 4Q and into 2012? And are you contemplating any sort of adjustments to base salaries as you saw earlier this year?"
},
{
"speaker": "Larry Page",
"text": "Yes. And I think that we're not going to break out more than we've already given you there. So we thought it was important to show the tremendous success of our business, and so we want to give you a nice milestone for that, but we're not going to break out more data. And also, on headcount, like I said, I think I had already said we're at the edge of what's manageable in terms of our headcount growth and you see our numbers are, as I said, were consistent with last quarter. I think we are always running our business very carefully and prudently, and making sure we're investing in the right places. And we make those kind of decisions every day. And we don't give guidance on what we're going to do in the future."
},
{
"speaker": "Operator",
"text": "And we'll go next to Ben Schachter with Macquarie."
},
{
"speaker": "Benjamin A. Schachter",
"text": "A couple of questions. First, could you discuss the strategy around video content? It seems to me there's sort of UGC premium and then all the stuff in between. Is that how you're thinking about it? And if it is, how are you thinking about emphasizing each area? And then just quickly on emerging markets, you mentioned India and Brazil. Any chance you can quantify some of that, how fast are these markets growing? How big are they overall? Are these top 10 markets, how big are they in the overall scheme of the different countries?"
},
{
"speaker": "Larry Page",
"text": "Ben, I think we think about -- certainly, YouTube is just tremendously successful. It's going gangbusters in every way. And we see that site is redefining the way we think about video. And I'd also note that it's very small percentage of people's overall video usage still. So we see opportunities for tremendous growth there. I think the other interesting thing about YouTube is it really blurs the lines between the kinds of content you're talking about. You can move from one type of content to another very easily. And we're finding our users don't really think about it that way. They think about having a great user experience. And we see it as serving our users well, and serving all the content creators well, regardless of their size. And that seems to be working great for us. And for the second part, Nikesh will take that."
},
{
"speaker": "Nikesh Arora",
"text": "Yes. We're not going to break out the numbers for India and Brazil. But what I can give you directionally is both of them are very, very important markets for us. Our products are successful. You see search traffic continuing to rise. YouTube is very popular. Chrome is very popular. So really, we're very happy with the usage of our products, and we believe there's tremendous sort of runway in product usage in those markets because of the changing characteristics of those markets, both from an online penetration perspective and the economic growth perspective of those markets. So with that sort of tailwind behind us, we have great teams on the ground, which are driving businesses to come online. And we're seeing tremendous growth in the ad side, pretty much across-the-board and Display, Search and Mobile. So we're very, very happy with the success of those markets, with the progress of those markets. I'll just give you that as a directional statement."
},
{
"speaker": "Operator",
"text": "And we'll go next to Heather Bellini with Goldman Sachs."
},
{
"speaker": "Heather Bellini",
"text": "But I wanted to ask if you could give us a sense for how much growth in Mobile impacted Paid Click growth this quarter and how sustainable you think that level is? And also, if you could just tell us a little bit on the progress you're seeing in narrowing the gap between CPCs between Mobile and traditional search."
},
{
"speaker": "Susan D. Wojcicki",
"text": "Yes, this is Susan here. So first of all, we don't really break out how Mobile impacted any specific part of Paid growth or CPC. I will say that our ad system is designed to be very flexible. There are always lots of different factors at play that we see changing in terms of users, queries, advertisers, bids. And so, really, we are designing our ad system to be as flexible based on what we're seeing at that specific moment. In terms of narrowing the gap between -- in CPCs of Mobile and traditional search, we see a lot of opportunity for us to continue to grow Mobile. And for example, advertisers having landing pages that are mobile-enabled, we can continue to improve a lot of our algorithms. So we see opportunity for us to continue to improve that over time."
},
{
"speaker": "Larry Page",
"text": "Yes. And I would mention too, Heather, that the mobile phones are just getting amazing. You'll see our work there, and other people's works in coming out, that I think that your experience on phone could actually get to be better than your experience on a computer. I mean, the phone knows where you are, and can help you even when you're mobile and so on. So I definitely -- we definitely see that the experience on mobile improving greatly, especially with Android."
},
{
"speaker": "Susan D. Wojcicki",
"text": "We've introduced a number of formats, just kind of building on Larry's point. So we have advertisers, we can give location. We can actually say, if you search on one specific store, that store is 0.1 miles from where you're located right now, with a map. Or include a phone number, when you click on the phone number, then that's like a CPC. So we're seeing that there are a lot of formats that we can really optimize for mobile, which will make for a great user and advertiser experience."
},
{
"speaker": "Operator",
"text": "And we'll go next to Justin Post with Bank of America Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "Larry, I know you have to be careful because of litigation, but maybe you could help us understand what steps Google can take to help defend the Android ecosystem on a big picture basis? There's a lot of questions about some licensing threats out there. And then, secondly, maybe this is for Patrick. Can you tell us what verticals performed well in the quarter? I know you've been able to do that in the past. But which verticals really did well in the quarter and maybe others that might have been a little slower?"
},
{
"speaker": "Larry Page",
"text": "I think we are very, like I mentioned, we are very excited about Android. And we see our partners and that whole ecosystem continuing to grow hugely. And while there's been lots of people trying to attack that and so on, we see absolutely no signs that, that's effective. And ultimately, we think that other companies' actions there will alienate their customers and their relationships with the other companies. So if anything, we see our strategy is getting stronger there. Obviously, we announced our intention around Motorola, and we're serious about protecting the Android ecosystem, making sure that, that continues to be incredibly successful. But we feel good about our efforts there."
},
{
"speaker": "Patrick Pichette",
"text": "And on my side, Justin, look, we were -- again, quite a reflection of the economy around us. So the U.S., some of the verticals that have been stronger, right, travel, auto, you go to rest of world, interestingly retail, which is not as strong in the U.S. than it would have been in rest of the world because there's more activity in real estate and in retail in rest of world. In the case of the U.K., automobiles have been kind of particularly strong. And so these are the kind of verticals, again, they are a snapshot and reflection of the economy around us. And maybe Nikesh has kind of more color commentary on it."
},
{
"speaker": "Nikesh Arora",
"text": "No. I agree with everything Patrick said. I think the only, sort of nonsecular event that's happening, is that we are continuing to see strength in the CPU verticals. Because we are doing well on Display and CPG have traditionally verticals that advertise more in display. So there was a bit of a opportunity there, whereas search wasn't their prime focus, but those guys are doing really well with the Display offerings we have for them. But I agree with Patrick with everything else."
},
{
"speaker": "Operator",
"text": "And we'll go next to Doug Anmuth with JPMorgan."
},
{
"speaker": "Douglas Anmuth",
"text": "Two things. First, one business you didn't really talk about was Google Offers. I was hoping you could add some more color there in terms of your strategy and what you think you can do differently in this space. And then, secondly, I know this is probably tougher but just related to MMI. We've obviously seen examples in the past around CPTN and Intel and McAfee, around writing in concessions in certain ways. Is that something that Google would potentially be willing to do, in terms of licensing patents, to open source software and then, also, delivering product updates and roadmaps at the same time as for MMI?"
},
{
"speaker": "Larry Page",
"text": "I think Nikesh will take the first question there."
},
{
"speaker": "Nikesh Arora",
"text": "I guess it's early days for Google Offers. As I mentioned, we have expanded from one Portland trial to over 11 cities in the U.S. And we are leveraging some of the sales efforts we already have with our Ads business. We are leveraging our relationships with small, medium sized businesses. Google Offers, for us, is just one part of the overall opportunity to work with SMB. So it's early days. We're very happy with the progress we've made so far. You might have seen us launch Google Wallet, which is also a part of an enablement strategy for that. So, so far so good, very pleased with the progress so far."
},
{
"speaker": "Larry Page",
"text": "Yes. As you know, Motorola deal is under review, and I think it would be premature for us to comment about anything we might do with regards to that."
},
{
"speaker": "Operator",
"text": "And our next question comes from Scott Devitt with Morgan Stanley."
},
{
"speaker": "Scott W. Devitt",
"text": "Just had 2 questions. In certain areas like shopping, payments, travel, reviews and mortgages, the company seems to continue to get deeper into the purchase funnel or closer to the actual transaction. And Susan, you noted the ITA example on the call. I was wondering if you could talk a little more broadly about this more vertical approach, the benefits of it, and the categories that you're particularly focused on. And then secondly, noncash stock-based comp, I think was up 31% sequential and 50% year-over-year. Patrick, you noted the annual grant. I was just wondering if this is the new run rate or if there is something one-time or, potentially, there's been a change in the cash versus noncash comp."
},
{
"speaker": "Patrick Pichette",
"text": "Why don't I answer the last question first and then flip it over to Susan. I mean, you're seeing the full year impact of our salary raises last year flowing through in all aspects of our compensation. So when we did the equity refresh this quarter, obviously, it's augmented by the fact that people have 10% more salary and all of the corollary issues around it. So it is a onetime item but you're changing the plateau, if you wish, and then it will flow through into the next year and then it will stabilize itself. That's the best way to think about it. And then on the issue of the verticalization, I'll have Larry take a crack at it, please."
},
{
"speaker": "Larry Page",
"text": "Yes. Thanks, Patrick. I think that we really think about Google as providing the exact right answers when you need them. And those things are not necessarily particular websites or whatever. They're actually -- maybe actually trying to get a very specific piece of information, like you do with an airline ticket, for example, as we were talking about. So I think we see this as a general instance of a problem, of just making search work better across anything you might want to be able to do. And we're pursuing that in a lot of different areas, and have our whole history, basically. So I think you'll see us do a better job of providing a great user experience on more and more specific things over time. And that's what we do, when we make a better search engine."
},
{
"speaker": "Operator",
"text": "And we'll go next to Ross Sandler with RBC Capital Markets."
},
{
"speaker": "Ross Sandler",
"text": "I've got 2 questions. First, a quick follow-up on Android. So we've seen some of the Android partners now agreeing to pay Microsoft licensing fees. So in order to protect the ecosystem, is Google planning on subsidizing a portion of these fees? Or is there -- how does that strategy play out? And then second question on Google Wallet. Is the long-term plan here to partner with other financial transmitters, like PayPal and maybe their credit card networks for some of the heavy lifting in the payment space? Or does Google plan on kind of vertically integrating with the banking system to offer customer service and risk management around transactions for the Google Wallet customers?"
},
{
"speaker": "Larry Page",
"text": "I think that maybe I'll answer it in just kind of a general way. Rather than seeing, for example, Microsoft compete in the marketplace with their own smartphones, they've really continued resorting to legal measures to hassle their own customers, right? So it seems kind of odd. And we haven't seen the details of those total agreements, and I suspect that our partners are making good deals for themselves there. And so while there's a lot of press around that, we're really looking forward to our announcements with Samsung next week, which I think will be very exciting. And like I said, we see Android going gangbusters, and we don't see anything that's going to stop that. On your second question about Google Wallet and so on, I think we're very early. We just released a phone with Sprint, the Nexus S with Sprint, that's sold out and has had tremendous demand. And we think that the customers who have gotten that experience are amazingly excited about it. And like Susan mentioned, she can buy her coffee that way. And that's an amazing experience, and we're just at the very early stages of that."
},
{
"speaker": "Operator",
"text": "And we'll go next to Jeetil Patel with DB."
},
{
"speaker": "Jeetil J. Patel",
"text": "A couple of questions. Can you talk about in the Mobile business as a whole, how do you structure some of the revenue sharing agreements that you have on the advertising side relative to in-browser searches? And I guess, who is it, typically, that you're typically paying for that distribution, the wireless carriers, the handset vendors, and how do you see that evolve going forward? And then I have a quick follow-up around kind of vertical integration. You've seen companies launch new devices, hardware-wise, to layer on top of some of the content and applications they sit on. You've obviously looked at Motorola now, and you're stacking from hardware OS into the applications environment. Do you think that, as you look at mobility, the world -- there's a unique opportunity to develop a much richer, deeper relationship? And I guess maybe a little bit more elaboration on the vertical integration there that you're looking at."
},
{
"speaker": "Larry Page",
"text": "Yes, I mean, I think it's an exciting time. There's a lot of innovation going on in different business models and so on. I think we're very excited about our Android ecosystem and the growth of that. And I think we have very, very successful strategy there, as you see from the numbers that we talked about, over 190 million devices, and growing quickly. So I think there's many -- you're asking about different kinds of structures but we're very, very excited about the structure we have now, and about continuing that growth and continuing to evolve that platform ecosystem. And maybe Nikesh can take the second part there."
},
{
"speaker": "Nikesh Arora",
"text": "I think Larry's right. There are many interesting models out there. As you know, Android is an open ecosystem, and our Mobile strategy is a very partner-focused strategy. So in many cases, we work with various partners to deliver the experience to the end user. And there are different partners, there are different value they bring to the equation, whether it's distribution, whether it's making Google Search part of their services, whether it's allowing us to be an ad-serving platform there. So each of the relationships are slightly different, and they have different negotiated deals with them. But generally speaking, I think we believe there's a fair value transfer to whoever in the ecosystem brings value to the table. And we get our fair share for providing services in that ecosystem."
},
{
"speaker": "Larry Page",
"text": "We've been very successful with these models on the web, and we have a lot of experience with it, and I think we're good at doing those kind of deals."
},
{
"speaker": "Jeetil J. Patel",
"text": "It seems like owning content, at least in the Mobile space, seems to be a differentiator. Is that something that you'd possibly look at longer term? Is that owning more the content structure out there?"
},
{
"speaker": "Larry Page",
"text": "I think, again, we're not going to comment on what we might or might not do. I think that we've had very, very successful models for a long time without owning content. And I think many of the models of you see don't involve people owning content but actually selling it or distributing in various ways. And I expect that will continue."
},
{
"speaker": "Operator",
"text": "And we'll go next to Jason Maynard with Wells Fargo."
},
{
"speaker": "Jason Maynard",
"text": "One of the threads that drew a lot of these questions in the Mobile market is, how do you increase monetization, and kind of where we're at. And I think one of the things I'd love to get your view on is where we are in the process of bringing together some of the disparate local services? How does Offers intertwine? And when does that sort of take on a little bit more of a unified feel versus sort of a set of one-off products that a user would use?"
},
{
"speaker": "Larry Page",
"text": "Jason, I think that's a great question. I think that -- I think first thing to keep in mind is that we're still very early in the Mobile business, and you see it's incredibly exciting business. There's a lot of activity. The user experiences are getting tremendously better, just growing like crazy. And there's a lot of economic activity and so on. So we've done well by having a long-term view about it. And I think that we also sort of want to balance having total integration with really fast iteration and fast progress and experimentation. And I think you definitely, I mentioned our unified look and feel that we've rolled out on Google which I'm very excited about, and we'll continue to do things like that, that really unify experience and make it more intuitive for people. But we're also going to do some experimentation, also, on new things, and then have a little bit less integrated. So it's always a mix of that. I think that offers, specifically, we think about our local business as being how do we help merchants and users, users like yourselves, get really good information and help the merchants get the right users at the right time and for the right amount of money, and so on. And that's a very hard problem across a whole bunch of different areas, basic information about merchants' interaction with between the merchants and the end users. And we have things going on in all of those spaces. And it's going to be a mix of, again, rapid iteration and also the integration of those things into, then, a more cohesive whole. And I'm very excited about that space."
},
{
"speaker": "Operator",
"text": "And we'll take our next question from Anthony DiClemente with Barclays Capital."
},
{
"speaker": "Anthony J. DiClemente",
"text": "I have 2. The first question is for Patrick or Susan. You cite your Mobile business as a run rate, which was very helpful. I was wondering if you could do the same for your Display business, particularly interested in YouTube, and so if you could comment on pricing and volume trends at YouTube in the quarter, at least directionally, that will be helpful. And then I have a follow-up."
},
{
"speaker": "Patrick Pichette",
"text": "So we, as you know, we don't provide any guidance. We had this extraordinary moment this quarter in Mobile where we had a confluence of so many things going on. And that we thought it was on a onetime basis, again, appropriate to kind of provide number of users, the Android ecosystem that's going gangbusters. And therefore, it was, we thought, appropriate to kind of round it up with kind of a snapshot of where we stand. So for that reason, right, and because of the competitive nature of the environment in which we are, we don't divulge typically these numbers, and you shouldn't expect us to actually give you more information in the future on them, whether it be Display, or Mobile, or others. In the case of YouTube, it's the same thing. I mean, as Larry said, we're incredibly pleased about the growth of YouTube, whether it be the number of videos viewed a day, the revenue growth rates, the performance overall of the content, and the ad system within it. So I mean, all I could say is this is a really, really kind of well-growing property for us in which we are really excited."
},
{
"speaker": "Anthony J. DiClemente",
"text": "Okay. And then just for Larry, I'm just wondering if you could comment on your broader media strategy. Unlike traditional cable providers, the Google platform isn't limited by geography. It's not limited by the contiguous networks or territories. So I just wonder -- there's been some conversation in the marketplace about a multichannel video offering in the U.S. to supplement your media product. And so I was just wondering if you could talk a little bit about that, even just philosophically, that would be helpful."
},
{
"speaker": "Larry Page",
"text": "It's hard to talk about what we might do in the future, again. But I think, in general, I just think there's a lot of opportunity in providing better services for end users around media. And you see that, I mean, there's tremendous growth in all these businesses that are doing that. And I think we're, obviously, in a good position to help users find the content and the media and so on that they're looking for. And we're in a great position to also help those companies, and publishers, and authors, and content creators to find the right users, and get paid both through advertising and directly. And so I think that's just a logical place for us to be in, and a logical place where you'll see a lot of activity in general."
},
{
"speaker": "Operator",
"text": "And we'll go next to Jim Friedland with Cowen and Company."
},
{
"speaker": "James H. Friedland",
"text": "Two questions. First, you'd talk about shutting 20 products and you've got some further products in Q1, I believe. Is there any way you can give us sort of a percentage in terms of how much resource that opens up? Is that sort of a 10% increase, or any kind of color you can give us there. And then second, at what level of Google+ users do you need to see a material improvement in ROI and Search, and really move the needle for the business there, just maybe in terms of active users?"
},
{
"speaker": "Larry Page",
"text": "Yes, I think those are great questions, Jim. I think that I'm not prepared to give you specific numbers about projects we shut down or whatever, but I will tell you, it's been a pretty significant effort, we've had to really streamline our business and we've made, like I said, tough decisions about where we should be focusing so that we really can generate amazing products and businesses. And those are not easy decisions. So I think there's significant resources involved in the kinds of things we're talking about. And it's also -- it's a fair amount of work, also, for us to just go through those -- that process. But I'm excited about that increased focus for us. I think, as I mentioned on Google+, I think we're seeing tremendous growth, which I'm very excited about. We're still very, very early. It's been out just slightly more than one quarter now, and not even fully open until -- only for a very small part of that. So I think we're very early in that. But on the other hand, I encourage you to all try Google+, and sign up, and flock to it. And you'll find that you will see data on search about what other people are doing. You'll see someone had +1'd something or so on. And I think those things can be very meaningful to you as a user. So I have no doubt that there'll be significant impacts from that."
},
{
"speaker": "Operator",
"text": "That final question will come from Colin Sebastian with RW Baird."
},
{
"speaker": "Colin A. Sebastian",
"text": "Just 2 brief ones. First on Chrome and your efforts there to expand penetration. Can you talk about the specific drivers of growing distribution, adoption, maybe how we might expect this to impact margins over time? And then, secondly, the growth in the Google Site revenues. I wonder if you can add just a little bit of color there on the specific uptick, if that's an acceleration from a Display on YouTube as well as Mobile, or is that core search-related?"
},
{
"speaker": "Patrick Pichette",
"text": "I'll take the latter, and then maybe Nikesh will cover the Chrome. On the latter, the answer is yes. Yes, yes, and yes. So yes, YouTube; yes, mobile; yes, format. And I mean, that's why you see such an acceleration of our revenue, and that's why we're so excited about it. And maybe Nikesh, if you have comments on the Chrome and our penetration and how it's working."
},
{
"speaker": "Nikesh Arora",
"text": "I'd love to answer the question like that, like yes, yes, yes. But unfortunately, that's not how the question is phrased. As far as Chrome is concerned, as we have talked about in previous quarters, Chrome is very strategic for us because we believe it is a phenomenal user experience and a user benefit. It just improves the user browsing experience so phenomenally. And we believe that it's important that Chrome be distributed, shared, with almost every user around the world. And a lot of our marketing efforts, and distribution efforts, have been focused around getting Chrome in the hands of our users. We are doing distribution with partners. Our partners encourage people to download Chrome. We are doing distribution where we do direct advertising to consumers to get them to download Chrome with a clear user benefit of better browsing, better video watching, and better security. So we are doing a lot of that. I think, I'm not going to comment on the margin part, but you have to understand, a great consumer experience from Google as part of Chrome makes Google -- makes users use more Google services. So from that perspective, we're very happy with the distribution strategy we have on Chrome. And we don't see any abatement of that strategy."
},
{
"speaker": "Larry Page",
"text": "And I want to thank everyone for all the time that you spent with us. We had a great quarter, very excited about our progress so far. And I also want to thank all of our employees who've worked so hard to make these results that you all see. So thank you, all, very much."
},
{
"speaker": "Patrick Pichette",
"text": "Jamie, we'll let you close the call."
},
{
"speaker": "Operator",
"text": "Thank you, sir. That does conclude today's conference. We appreciate everyone's participation."
}
] | null | null |
GOOGL | 2 | 2,011 | 2011-07-15 16:30:00 | Operator: Good day, and welcome, everyone to the Google Inc. Second Quarter 2011 Earnings Conference Call. This call is being recorded. At this time, I'd like to turn the call over to Jane Penner, Senior Manager, Investor Relations. Please go ahead, ma'am.
Jane Penner: Good afternoon, everyone and welcome to today's Second Quarter 2011 Earnings Conference Call. With us are Larry Page, Chief Executive Officer; Patrick Pichette, Senior Vice President and Chief Financial Officer; Susan Wojcicki, Senior Vice President, Advertising; Nikesh Arora, Senior Vice President and Chief Business Officer. First, Larry, Patrick, Nikesh and Susan will provide us with results on the quarter. Also, as you know, we now distribute our earnings release through our Investor Relations website located at investor.google.com. So please refer to our IR website for our earnings releases, as well as supplementary slides that accompany the call. This call is also being webcast from investor.google.com. A replay of the call will be available on our website in a few hours. So let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward-looking, including statements regarding Google's future investments in our long-term growth and innovation, the expected performance of our business and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on this call such as operating income and operating margin, are also expressed on a non-GAAP basis, and have been adjusted to exclude charges related to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will now turn the call over to the Larry.
Larry Page: Well, thank you, and good afternoon, everyone. Thanks for joining us today. It's really exciting to be with you today and share directly with you the progress we have made in my first quarter as CEO. As you will see from our press release, we had a great quarter, with revenue up by 32% year-on-year and a new record for quarterly revenue at over $9 billion. We've substantially increased our velocity and execution this quarter, which is a key goal of mine since taking over as CEO. So I created a new product focus management structure, with clear leaders responsible for each area. The new management team is working together fabulously and has already achieved a lot in just these 3 months. First of all, I want to talk about Google+, which we launched a field trial invitation only. Our goal at Google+ is to make sharing on the web like sharing in real-life, as well as improve the overall Google experience. Circles lets you choose with precision who you're sharing with, not surprisingly this has been very well received, because in real life, we share different things with different people. Hangouts allows for serendipitous interactions. Like in real life, when you run into a few friends, gives you seamless and fun multiuser video, and it's really amazing. Last quarter, we launched the +1 button in search results and ads, enabling users to recommend stuff they like and to have those recommendations show up in the search results of people they know. This quarter, we released the +1 buttons to the entire web and many sites like Huffington Post, The Washington Post, and Best Buy has added +1 buttons. Google+ is still in field trial with limited access as we scale the system. Users have to be invited and sign up with a profile in order to use it. However, the growth on Google+ has been great, and I'm excited to release some new metrics for you today. Over 10 million people have joined Google+. That's a great achievement for the team. There's also a ton of activity, and we are seeing over 1 billion items shared and received in a single day. Our +1 button is already all over the web, and it's being served 2.3 billion times a day. So while we still have a lot of work still to do, we are really excited about our progress with Google+. Google+ is also a great example of another focus of mine, beautiful products that are simple and intuitive to use, and actually was one of the first products to contain our new visual redesign. We also launched that beautiful, consistent and simpler design on our homepage, Gmail and calendar, with many more products soon to come. Reader focus has also been another big feature for me this quarter. More wood behind fewer arrows and last month, we announced that we'll be closing Google Health and Google PowerMeter. We've also done substantial internal work, simplifying and streamlining our product line. While much of that work has not yet become visible externally, I'm very happy with our progress here. Focus and prioritization are crucial given our amazing opportunities. Indeed, I see more opportunities for Google today than ever before, because believe it or not, we are still in the very early stages of what we want to do. Even in Search, which we've been working on for 12 years, there's never been more important changes to make. For example, this quarter, we launched a pilot that shows an author's name and picture in search results, making it easier for users to find things from authors they trust. Of course, when we started doing Search, people thought we were crazy. They said there was no money to be made in search over and above a bit of banner advertising. Most new Internet businesses have had that same criticism. Fast-forward to today, it feels like we're watching the same movie again in slow motion. We have tremendous new businesses being viewed as crazy. Android, I actually have a new metric to report in Android of 550,000 phones activated a day. And that's a huge number, even by Google standards. Chrome is the fastest-growing browser. We have over 160 million users. Now people rightly ask, "How will we monetize these businesses?" Of course, I understand the need to balance the short-term with the longer-term needs because our revenues in growth serve as the engine that funds our innovation. But our emerging high usage products can generate huge new businesses for Google in the long run, just like Search. And we have tons of experience monetizing successful products over time. Well run technology businesses with tremendous consumer usage make a lot of money over the long term. And I think about our products in 3 separate categories. First, there is Search in our Ads products, the core driver of revenue for the company. And Nikesh and Susan are going to talk more about Ads later in the call. Next, we have products that are employing high consumer success: YouTube, Android and Chrome. We are investing in these in order to optimize their long-term success. Then we have our new products, Google+ in commerce and local. We are investing in them to drive innovation and adoption. Overall, we are focused on long-term, absolute profit and growth, as we have always been, and I will continue to have tight financial management we have had in the last two years, even as we were making significant investments in our future. I'd like to finish on our people. Great companies are no greater than the efforts and ingenuity of their people. We're continuing to hire the best. Keeping them happy and well-rewarded is crucial to our future. Many of you will be interested in hiring whether we hired a few hundred more or less than you expected this quarter. But we will optimize headcount for the long-term in the opportunities we see. I'm happy with the investments we've made in people, but we're probably even a little ahead of where we need to be with headcount growth at the edge of what's manageable now. Easy to focus on things we do that are speculative, e.g. driverless cars. But we spend the vast majority of our resources on the core products. We may have a few small speculative projects happening at any given time but we're very careful stewards of shareholder money. We're not betting the farm on this stuff. All of us at Google will want to create services that people in the world use twice a day just like toothbrush. And we strive to make those services beautiful, simple and easy to use. That way we can provide huge benefit to the world. We've made a good start, but we're only at 1% of what's possible. Google is just getting started, and that's why I'm here, working hard to lead the company in the next level. Thank you. And again, we had a great quarter. Now over to Patrick for the financial results.
Patrick Pichette: Thank you, Larry. Thank you, everybody. Thanks for joining us. And Larry is going to stay with us for the Q&A. So I just wanted to make sure that everybody knows he's not going anywhere. Okay, so let's go through the number. We had obviously an excellent quarter with 32% year-over-year revenue growth in Q2, and it clearly demonstrate the continuing power of Google's product innovation, but also the relentless momentum of the digital economy. The strength continues to be driven by our core desktop search ads, but also increasingly, by new emerging areas just like the Mobile, Display, including YouTube and Enterprise that we regularly talk about. So let's turn to the specifics of our performance in the quarter. Growth revenue grew 32% year-over-year and we've reached $9 billion in revenue, 5% quarter-over-quarter growth as well. Note that while currency fluctuation boosted our revenue somewhat, even in constant FX terms, our growth rates remain strong, particularly in what tends to be a seasonally slower quarter. Google website revenue was up 39% year-over-year to $6.2 billion and 6% quarter-over-quarter, with strength across most major geographies and verticals. Google Network revenue was also up 20% year-over-year to $2.5 billion, 2% quarter-over-quarter. Network revenue was again negatively impacted by the Search quality improvements made during the latter part of Q1, as you will remember, and know that Q2 reflects a full quarter of this impact. This impact is to be expected in the short-term, given that it is now different publishers that are receiving traffic and may not have yet optimized their sites for our advertising programs. Other revenue was also up 20% year-over-year, just $310 million and 15% quarter-over-quarter. Our global aggregate paid click growth was strong, up 18% and down 2% quarter-over-quarter. Our UI changes to search ads such as BizURL drove year-over-year click growth in Q2, along with the ongoing and accelerating shift from offline to online. The slight decline quarter-over-quarter is just typically consistent with our summer seasonality. Aggregate cost-per-click growth was also very healthy, up 12% year-over-year and up 6% quarter-over-quarter. Note that FX also had a positive impact on CPC, and remember too that this is an aggregate number that includes both Google.com and our AdSense properties. Turning to our geographic performance, the U.S. and Rest of the World are growing both at very good pace, and our results reflect that. While the U.K. still continues to lag slightly in the global recovery, year-over-year and quarter-over-quarter growth in Q2 continues to show signs of acceleration in the U.K. as well. So revenue from the U.S. was up 26% year-over-year to $4.2 billion, and in our earnings slides, which you can find on our Investor Relations website, you'll see that we've broken down our revenue by U.S., U.K. and Rest of the World to show the impact of FX and the benefits of our hedging programs. So please refer to those slides for the exact calculations. Non-U.S. revenue accounted for 54% of our total revenue or $4.9 billion, up 38% year-over-year, which includes only $4 million of benefits from hedging programs, compared to last year where we had $79 million of benefits for Q2. Year-over-year growth in fixed FX would have been 29% versus the 30% I just mentioned. Japan's future revenue was again negatively impacted by the aftermath of the disaster there, but there again we see signs of faster recovery, faster than expected at first. The U.K. was up 27% year-over-year to $976 million, and year-over-year growth and fixed FX was still a healthy 19% for the U.K. Let me turn to expenses. Traffic Acquisition Costs were $2.1 billion or 24.2% of total advertising revenue. Our other cost of revenue was $1.1 billion dollars, including stock-based compensation of $51 million and finally, our operating expenses, which exclude stock based compensation totaled $2.6 billion. The stock-based compensation totaled $384 million in Q2. The increase in year-over-year in OpEx was primarily due to payroll, increased advertising and promotional spend and also professional services. So as a result, our non-GAAP operating profit was $3.3 billion in Q2 which excludes the stock-based compensation, resulting in a non-GAAP operating margin of 36.7%. Headcount was up approximately 2,450 versus Q1 ending the quarter with 28,768 full-time employees. When we exclude ITA adds of roughly 450, the net headcount growth is roughly similar to Q1. Our effective tax rate was 19% in Q2, and the effective tax rate is down due to the mix of earnings between domestic and international subsidiaries, as well as our hedges. Let me turn now to cash management. In Other Income and Expense, our result was $204 million for Q2, a solid portfolio management performance from our team, which, like every quarter, is offset by the impact of our hedging expenses associated with FAS 133, which in itself was also significantly lower in Q2 gave us these great results. For more detail in OI&E, again, please refer to the slides that accompany this call on our IR website. Operating cash flow, very strong, $3.5 billion for Q2. CapEx for the quarter was $970 million versus last quarter of $890 million. So pretty much in line. The majority of our CapEx spend in Q2 was related to facilities, expenses, and production equipment. And regarding specifically these facility expenses, like last quarter, we just happened to have a great opportunity in Q2 to purchase buildings in Dublin and in Mountain View, and we took opportunity. As a reminder, we'll continue to make significant CapEx investments, and these have shown to be lumpy from quarter to quarter depending on when we're able to actually make these investments. But overall, we can be nothing but pleased with our free cash flow which was $2.6 billion for Q2. As Larry mentioned earlier, we continue to deliver growth with a disciplined agenda. This means investing and making sure that our resources are deployed wisely with focus and a balance between that short and long-term that Larry covered. So with those financial highlights covered, I'm going to turn it over to Nikesh who will actually cover now our sales performance in the quarter. Here you go Nikesh.
Nikesh Arora: Thank you, Patrick. I'm going to give you a quick update on our business activities, which spans sales, partnership marketing, and customer service around the world in support of our product and revenue. Let me start by focusing on the first priority of our sales team, the need to continue to drive revenue growth in core and new businesses. This quarter we continue to drive revenues in our corner areas like Search, as well as new areas like Display, Mobile, and Enterprise. Core Search and Desktop has done very well this quarter, with Google.com accelerating and our large advertisers continuing to spend more as they see more value in Search. We've also have been able to drive tremendous focus on small advertisers around the world, with programs like GXPO, which I will talk about slightly later. Broadly, however, our sales teams are getting better at tailoring Integrated Solutions for clients, using the full area of our advertising products. These solutions create better opportunities to improve our customers marketing ROI. Clients have used Search to focus their targeting capabilities, such us such as audience and topic targeting, to help improve the marketing effectiveness. Some of our most successful Search clients include people like GM and EgyptAir. On the other hand, in addition to our core desktop Search business, we continue to be very excited about our investments in Display and Mobile. Let me first focus on Display. We've seen continued healthy growth in our Display product space across all fronts: Advertiser, publisher and technology solutions. 98 of the top AdAge 100 advertisers have bought Display across YouTube and the Google Display Network this quarter. Customers continue to use our DoubleClick products and we are happy with the increased use for the DoubleClick Ad Exchange and Invite Media for ad buying. With our announcements to acquire Admeld, we hope to deliver even better solutions to our publishers and buyers. Continuing on Display -- on YouTube, where we have over 3 billion daily views, we have had great success bringing popular content to our users, further increasing audience engagement. Take for example, our April broadcast of the Royal Wedding which generated 100 million YouTube views. Our range of platform and content means that advertisers are beginning to use them for superior branding solutions. A great example of our branding products in action was T-Mobile's launch of the Samsung S4G on YouTube. In this campaign T-Mobile took over YouTube running ads in their home page, watch page, Mobile. That particular campaign helped them reach 46 million unique users. Continuing to talk about revenues, our Mobile business continues to be another area of robust growth. The number which Larry just shared of 550,000 Android, that and the success of smartphones in and general Mobile Data devices around the world is acting as an accelerator for our Mobile advertising effort. Let me just take one quick example. One format which was launched by Susan's team called Click-to-Call or Click-to-Share has been particularly successful. Unilever is a great use case of these formats. They integrated our AdMob product into a very large campaign of launching a new product to use the banner to drive traffic to a campaign Mobile site and achieve unprecedented results with almost 700,000 unique visitors accessing their content. Another leg of our revenues is the Enterprise Business. We've seen great results in enterprise as well, in particular apps for business continues to grow as organizations move to the cloud. We've had key wins at Intercontinental Hotels, [indiscernible] State of Wyoming. In addition to that, some small simple changes in our product side have allowed us to tremendously accelerate Google Apps for small businesses. Looking at our revenues from a slightly different perspective, geographies and customer segments, we've seen strong growth in regions and across customers of all sizes. First let's take a look at geographies, we maintained our strength in large, mature countries while we accelerated in emerging ones. Now a large majority of countries which are countries even though some of our facing economic challenges, this secular trend of online advertising and the effectiveness of the teams to continue to drive healthy revenue growth is showing great results. Several countries are worth noting as Patrick mentioned. The U.K. has accelerated this quarter with strong growth by small advertisers. In Japan, we've seen recovery, driven primarily by Display and Mobile spending by large advertisers. Our focused execution in Canada and Spain has led to these markets beginning to show recovery. Finally, we saw tremendous growth in emerging countries especially Brazil and Russia, where our Display products are getting strong adoption from advertisers. Across each country, we focus to improving the product knowledge and selling capability of our sales force, our frontline teams can now sell Search, Display, and Mobile to the needs of our customers, which is a great trend we're seeing of integrated products selling across multiple Mobile ad formats. As a result we're becoming better advisors in the digital space for our large advertisers. For example, Nike, Sony Ericsson, Telefonica, all of them partnered with us to create integrated solutions down there, sponsorship of Copa América. Outside of revenue, one key area of responsibility is marketing. And if we continue to use marketing as a strategic blipper. We use marketing to both drive customer acquisitions as well as usage of our key consumer products. I'm very proud of my team's work on getting business online GXPO as I mentioned in Q2 we successfully launched Brazil, Canada, Australia Thailand. To objective is to try and bring another million small, medium businesses across 20 countries online for the first time. As you know, more advertisers gets more queries, has more adserves against it. There's nothing in a more robust option for us. In addition, also we saw strong results from our own advertising campaigns, including the most recent one around Google Chrome. The web is what you make of it. I'm sure many of you might have seen Justin Bieber and Lady Gaga in these campaigns. These campaigns have shown tremendous effectiveness and have also convince more users to switch to the Chrome browser. Last but not the least, I want to spend a quick minute on talking about something we're more and more passionate about, which is continuing to drive better customer satisfaction on an advertiser front. We continue to improve service and support across all customer segments. We've started providing large sets of advertisers proactive full support and on boarding help, which includes signing up for campaign building, signing up and getting assistance, as well as free full support after they become a customer of ours. As a result of these initiatives and others, spending by our small businesses continue to accelerate. Overall as Patrick and Larry have mentioned, it was a great quarter. I'm very proud of the wok of our teams across the world in various countries. We have done a tremendous amount of effort to serve our customers, partners and users. Now I'm going to turn over to my business partner, Susan, who is going to talk about all the positive impact that our products will have this quarter.
Susan Wojcicki: Thanks, Nikesh. Larry started the call by talking about a few of the quarters product highlights and I'd like to cover some more of them. So let me begin with Search. We're always looking for new ways to help our users find answers to their questions. This quarter, we brought 2 of the most popular mobile search innovations to the desktop, Voice Search and Search by Image. Voice Search traffic for Mobile devices is up 6x in the past year. So we thought this would be a useful feature for our desktop users as well. It's especially useful for searches that you know how to say but don't how to spell like Bolognese sauce or Schenectady, New York, neither of which I could easily spell. With Search by Image you can draw pictures of places, art, or even mischievous creatures like the Loch Ness Monster right into the Google search box and Google can identify and tell you about those pictures. In addition to these changes, we released about 100 other quality improvements to the Search algorithm. More and more people are searching and using apps from Mobile phones, where Android has had terrific momentum. There are now 135 million Android devices that have been activated in total, up from 100 million just 2 months ago. There are also now over 400 different Android devices available globally. Android market is also picking up momentum. It has over 250,000 different apps, and users have downloaded apps over 6 billion times, which is double the downloads from just a few months ago. We're expanding beyond apps too. This week, we started renting movies and selling books on phones from Android market and earlier in Q2, we launched Music Beta, which lets users upload their personal music collections and playlist to the cloud. All this media, movies, music, books and apps, are instantly available on their Android devices, no cable required. Smartphones are also becoming key to the shopping experience. Making shopping mobile and local is a vision behind Google Wallet and Google Offers. We announced the Google Wallet mobile app in May in partnership with Citi, MasterCard, Sprint, and First Data, and we are now testing it in field trials. And as of this week, Google Offers are available in San Francisco, Oakland, New York, and Portland. But now on to Ads, which is the product area that I manage. On the Search Ads side, we had a great quarter for quality with over 50 ads quality improvements and a big upgrade to the ads relevancy system. We launched the latest in a series of small tweaks for a search add format. This format, this quarter, we added the landing URL to the headline so that users know where click will take them. This may seem like a small thing, but we launched several of these small tweaks over the past year and cumulatively, they have had a big impact. There were also a lot of quality improvements across our Display Network. Over 20 launches, making it one of our strongest quarters from a quality perspective. In general, Display advertising is moving to a scientific model based on technologies like real-time bidding. But this technology when you land on a web page, advertisers decide what they want to pay for the ad space, and then auction is held. And the best ad is matched with the publisher's ad space. It's a lot more efficient. It provides better performance for both advertisers and publishers, and more relevant ads for users. Real-time bidding is an important technology shift that we are investing heavily in. Invite Media, which is the buying platform for advertisers and agencies that we bought last year, has doubled its client list in the last year, with over 5x growth outside of the U.S. Mobile Display is starting to take-off too with traffic on the AdMob network up more than 3.5x in the past year. More and more of that traffic is coming from tablets, so we launched a new set of formats designed specifically for tablets. These formats are web-based. They use HTML, and brand advertisers don't need to make different versions of their ads for different models. Nikesh also mentioned our great momentum with YouTube, where we're getting strong performance from the YouTube skippable ads. Because users can choose to skip these in-stream ads, the people who choose to watch them are much more engaged. More and more advertisers are choosing to make their ads skippable and now, over 1/3 of in-stream ads on YouTube are in a skipable format, which is a pretty remarkable stat given that we launched this format in December. Finally, I'd like to update our progress on Chrome. Larry mentioned how we passed 160 million users which is more than double year-on-year. This quarter, our partner Samsung and Acer Search using Phonebooks in 7 countries. Phonebook are designed to be fast, to just work, and to get better over time, thanks to our automatic updates. And they're now available through Amazon and Best Buy. Phonebooks are also available to schools and businesses via subscription model. The subscription includes Phonebooks, of course, administration, warranty, and support, starting at $20 a month. So overall it was a very busy quarter for us. But maybe the coolest thing we did was the Les Paul doodle we ran last month. It was a guitar you could actually play, and users recorded over 40 million songs while it was up. That's about 5 years of music. I'm looking forward to hearing your questions and comments. And for now, back to Patrick.
Patrick Pichette: Thank you, Susan. So Jamie, our operator, is going to help us through this. Jamie, you can just set up the call for Q&A. And as I said, we'll have Susan, Nikesh, Larry, and myself to answer any questions you may have.
Operator: [Operator Instructions] And we'll take our first question from Spencer Wang with Credit Suisse.
Spencer Wang: Two quick questions, if I could. First for Patrick or perhaps Nikesh, International revenue growth as you mentioned was really strong. I was wondering if you could just provide a little bit more color on perhaps that's driving that? If you could give us a sense of how much of that is core Search versus some of the newer initiatives like Mobile, YouTube, and Display. And then the second question is for Larry. I was wondering if you can just talk a little bit, Larry, about the patent strategy. Our understanding is you guys have about 650 patents. So just given the Oracle situation, I was wondering if you could talk about the patent strategy to ensure that you guys can continue to innovate going forward.
Patrick Pichette: I'll let Nikesh answer the first part of the question, and then Larry will talk about the patent issues.
Nikesh Arora: As I mentioned in my prepared remarks, that we've seen tremendous growth across pretty much all product areas. So the growth you're seeing in international is driven by Mobile, by Display, by Search. Clearly international is not one market there are many different countries. So we have seen different effects in different markets. Places like Japan, as I said, have been driven more by Display and Mobile. Various parts of Asia are just getting up the curve for us in Display and are strong contributors in Mobile. Having said that, Russia has been very strong for us. Brazil has been very strong for us. Brazil in the back of Mobile and Display as well, and as well as core Search. So if you think about what we're seeing, we're seeing more and more a pickup of Display and Mobile because we have established sales team are pretty much on almost every major market around the world to help sell Display. And the Mobile tick up based on tick up of smartphones and Android et cetera is helping that trend as well. In addition to that, a lot of effort has gone in to bringing small business online and that increases a number of advertisers in many international markets. As you get more advertisers in international markets. It has a very positive impact on our RPMs in those markets. So we're seeing that effect as well.
Larry Page: To your question on Android and patents and so on. Obviously we have a number of intellectual property patents in progress not just already issued. I must just say, Android's really on a tear. I mentioned there were over 550,000 new Android daily activations previously. And there's over 400 such devices, 39 OEMs, 231 carriers in 123 countries, and over 78 open handset alliance partners. And that velocity is only increasing. And of course despite the efforts of some of our competitors, there hasn't been any slowdown in any of those things. And partners and developers are continuing to expand the Android ecosystem. Of course we're really committed to Android and continued to support that platform and ecosystem, and do it in a cost effective manner.
Operator: And we'll take our next question from Mark Mahaney with Citi.
Mark Mahaney: Two questions Larry. Could you talk about what you have maybe put in to improve the velocity of decision-making? And as you step back and think about the management improvements you could see over the next year or 2, how significant do you think -- how much better -- how much more efficiently do you think Google could be run, than what we've seen maybe over the last 2 or 3 years? And then Susan, real quickly, social search signals, how important do you think they are now? How key are they -- how much of that is Google+'s strategy for trying to make the core search results more relevant?
Larry Page: This is Larry. I'm super excited about the changes we've made and I think as companies scale, we always change how we're running the company over time. So I think we have a much more of a product focused structure now, which I'm very excited about and talked about it. And I think that maintaining and improving our velocity and execution is a really noble goal for us. And it requires always a lot of work in companies. And I think that's super important direction for us, and I'm really excited about it.
Patrick Pichette: Susan, on social?
Susan Wojcicki: Yes, so I think the first thing I would say about social is that we're very early right now. And really our focus with Google+ will be to focus on making sure that we have a wonderful consumer and user experience. From a targeting perspective, there are a number of signals that we use right now. Obviously keyword on Search, contextual, interspaced advertising, demographics, and social signals overtime can be an important part of that. But it would be one of multiple ways that we actually do targeting. When we did rollout Google+, we do have pluses on all the ads this is what we do in search results. So if the user does click on it, and someone on their circle has actually does a query and triggers that, then there will be social annotations, which will be useful information for the user to see that their friend has +1-ed that ad.
Operator: And we'll go next to Ben Schachter with Macquarie.
Benjamin Schachter: Congratulations on the execution and the launch of Google+. Larry, at a high-level what, if any, are some of the key differences on how you think about managing specifically the economic model of the company today versus when Eric was CEO? Specifically any changes to target margins, revenue growth targets, et cetera? And then separately, on Mobile Search specifically, it's clearly been successful in terms of search share. But when we're trying to figure out the overall impact to net revenue in kind of balancing out some of the positives like incremental searches and share gains and higher click-through rates, but also having the headwinds of TAC payments to partners and lower CPCs, how should we think about the overall net impact of Mobile to the business?
Patrick Pichette: Why don't I'd take the second part of that question, and then Larry can talk about the economic model versus in the context of what you said. But for Mobile search, you have to go back and focus on what we focused on. Build businesses that are going to be billion-dollar businesses and that actually contribute significant operating dollar margins. These are businesses that scale to a humongous scale as they grow. So for us, that is the focus that we have. And the second piece in the specifics of Mobile is we really see Mobile a bit like Search was in 2001, 2002, 2003. All these formats are so new that you know that there's so much more room for optimization on top of it. So it is in fact a bit of a mistake to kind of say okay, today whatever we have is a good proxy for what the future will look like. And that's why we're excited about it. And that's why we focus so much on Mobile. For the economic model and how we run the company, maybe Larry, your thoughts on that?
Larry Page: Absolutely, thanks for the question. I think certainly Eric is a great partner and leader for me and for Google for the last 10 years, and continues to play a big part in the company. So I don't think there's, like we said before, there's no major changes in what we're doing. And I'll reiterate maybe a little bit and add a little detail to what I already said. I think about really in our products in 3 separate categories. First, through Search and our Ads business, which is the core driver of revenue for the company. We really invest in that, we work hard on it. Next we have businesses that are enjoying really high consumer success. For example, YouTube, Android, and Chrome. And we invest in those in order top them for long-term success. And we have some new businesses on Google+, Commerce, and Local that we're really excited about and are at pretty early stage and those things we invest in as well. And we don't do things that we don't think will generate really big returns over time. So we're optimizing for our long-term economic success. But we do have these very different buckets of things that we work on.
Operator: And we'll go next to Ross Sandler with RBC.
Ross Sandler: Two questions. First on Google+ and then second on Google Offers. So on plus, we haven't seen real integration. We know it's only a couple of weeks old but with Google's kind of core competencies around search and other things that you've been very successful at in the past. So can you talk about plans on integrating some of Google's core strength into Google+ to further, I guess, differentiate the products from other services that are out there? And then on Google Offers, can you just talk about your overall strategy in terms of rolling out offers? You're in 4 cities today. How fast do you think you're going to accelerate into these newer cities, and is international territories also on the roadmap and the near-term for Offers?
Larry Page: I'll answer the first part, this is Larry. Google+ actually has a lot of interesting product integration. The black Google bar that you see is an entry point and notification point for Plus across basically all of our properties. And we're really excited about that, and think it's a big deal. Suffice to say there are many things that you would do with Plus and with +1 that affect what you would see in search results. Like I mentioned, when you +1 something, your friends will see it in search. So absolutely, and I hope it was clear that was our strategy, but we're very focused on improving all of Google, improving the sharing and identity across all of Google.
Patrick Pichette: Maybe Nikesh can give a comment on the rollout of Google Offers.
Nikesh Arora: Thanks, Patrick. We won't give out details on how we rollout our offer strategy. I think Susan said it very well in our overall strategy, because Offers for us is not just an isolated event. It is a combined, a bit of a commerce offering, which includes their Mobile phone and other things we talked about. We were very happy with the rollout we've had in the one city where we've been for a while, which is Portland, and we just rolled out 2 more cities earlier this week. So from our perspective, you can expect us to roll out other cities, but we're going to be testing and looking at the models see what's working and what's not working because we want to build the next version of how we rollout an Offers product. So stay tuned.
Operator: We'll go next to Brian Pitz with UBS.
Brian Pitz: Two quick questions. As we note the proliferation of the newer, richer ad formats like product image ads that we're seeing more and more of on your site, can you help us better understand the impact on paid click growth specifically? And then separately, can you also give us a little more color on some of the [indiscernible] quality changes you're doing on the network? Any commentary on how much impact to growth of AdSense that had this quarter and how long should we expect to see more than expected impact from continued quality changes?
Patrick Pichette: Why don't I let, actually, Susan tackle those questions? Susan?
Susan Wojcicki: On the richer ad formats, we see a few important opportunities for us, and what we feel about them is it gives us the opportunity to make those ads better for the users. And as we can create better experiences for our users, they're more likely to have the information that a user wants. And so what we'd hope to see is a click-through increase over time. And hopefully, for the advertiser on the back end, a better conversion. So in terms of click growth, and what's actually driving the click growth that we see, it's a matter of factors. One of them is always going to be query growth that we have. Second thing would be on improvements that we have to our back end quality models. So the better the quality model is, the more likely we are to actually match the right advertisement to the right user. And we had a number of good ads, as I mentioned, not just good, we had great ads quality launches this quarter, and a number of ad formats that made the ads more readable. And by making them more readable, the users are more likely to click on them. And that turns into click growth. And then on the last question that you had, which was Panda, Panda was a change made by the search team with the goal of improving overall search experience. There was, as we talked about last time, some negative effects from the AdSense partners. However, Panda does -- or any search quality that we make, does have a change of ranking, which means that there are different sites that wind up getting traffic. And that those sites may adjust their monetization strategy over time. And so it may just take some time for that to actually balance out. And also, in terms of the last question, we don't really comment about future changes that we're going to make, but we're always thinking about the right way to continue to improve the search results for our users.
Patrick Pichette: Panda, once again a great example of putting the user first ends up benefiting everybody in the end, the publishers, the advertisers, and the users.
Operator: And we'll go next to Justin Post with Bank of America Merrill Lynch.
Justin Post: Larry, thanks for joining the call. And while we have you, I'm just going to ask you a question I get all the time. How focused is senior management on the stock either as an employee retention tool or a measure of management's performance over, say a 3 to 5 year period? And then secondly, if I could just ask about the local opportunity, it looks like a lot of launches happening for Google. Do you see it as a different ad market than your current search ad market? And how might your model be different than some of the larger players in that market currently?
Larry Page: We have a lot of stuff to do here at Google, and unfortunately one of the things we don't get to decide is our stock price. So you all are in charge of that. I think we're really focused on our long-term success as a business and the kind of things I mentioned already are absolute, overall profitability over the long-term and our revenue growth. And so, we tend to focus much more on that, with a much more long-term view than we do on our stock price.
Patrick Pichette: Susan, views on the difference and the similarities between the local and our traditional ads market.
Susan Wojcicki: Yes, Local can be thought about 2 different ways. Local can be the large retailers who have many different points of presence. So, for example, Starbucks or Pizza Hut or any retailer which is a large holding company or one large retailer, but then has many different local points of presence and then there's a separate bucket which are the small Joe's coffee shop example. And both of them need different things from a product perspective in order to be able to advertise more broadly. And we are working in both buckets to solve and make them advertisers on AdWords with solutions that will work for them. The large ones need functionality of how do I run a campaign in all of these different locations with different keywords, different pricing. And so we're working to enable location in our AdWords campaigns where you're managing a large account to make that much easier. The Joe's Coffee Shop example, what we're working on is enabling signing up for AdWords to be a much easier experience. So we actually have a product that we released this quarter called Google Boost. And Boost, a product is a 1 page, 5 minute sign-up for advertisers. It's very easy to sign-up. We haven't marketed it a lot right now but we have seen good success with our advertisers. And we're hoping to make that more known to our advertisers.
Patrick Pichette: The last piece in the puzzle is, obviously Susan, Mobile, which is completely integrated from an ads perspective and targeting as well.
Susan Wojcicki: Yes, the other thing too is we would like to make all of our products be accessible from a Mobile perspective. Click-to-Call would be an example. Click-to-Call is really nice so that as someone, for example, is local walking down the street, they can actually call. But it's also really nice from the small retailer perspective, because they can understand that they're getting a call and they're getting a lead, which for them would be much more tangible than actually a click to their page. So we're investing very heavily in that in terms of Click-to-Call technology and the good tracking for the local advertisers.
Operator: And we'll go next to Jeetil Patel with Deutsche Bank Securities.
Jeetil Patel: Two questions. I guess first of all, you've got obviously quite a few products and applications that have had success over the years. Kind of that are out there obviously Search, Gmail, Chrome, Android et cetera. I guess as you think about next generation of consumer relationship and stickiness, how do you think about like integrating a lot of these core assets together in terms of building a consumer relationship, which kind of moves seamlessly from all these different solutions and formats out there, as well as devices? And then second, maybe around Google+, obviously it's only been 2 weeks now. But maybe can you talk about the overall trend in terms of 10 million users? How does that compare against maybe the early days of how Android or Chrome or maybe even search or mail ramped? What kind of trajectory or what kind of trend schedule does it look like right now if you were to pinpoint it against another product in the business?
Larry Page: We are -- on the integration point, we obviously have a lot of different products that do different things for different people. And we know one effort that I mentioned, I've been really excited about, is this visual redesign. And I also mentioned the bar that goes across the black bar that goes across with Google+, that gives you a notification on sharing and so on. We're definitely working hard to integrate our products better to make the user experience simpler, intuitive and beautiful and consistent. And I'm really excited about our progress just in one quarter on that and I think you'll -- we're certainly working hard on that. And we have to continue to over time. On the Plus growth question, we've been very, very excited about the growth we've seen and the engagement we've seen. Over 1 billion items shared and received in a single day. And I think that for us, there's a lot of barriers to use Plus right now. One thing, you have to be invited and so on and it's still in field trial. So I think given all that, were just extremely excited about that. But it's very early days. It's been less than 2 weeks since we released it into field trial.
Operator: And we'll go next to Jason Maynard with Wells Fargo.
Jason Maynard: First on Local. You've got a lot of interesting services and capabilities. But they're still fairly disparate and in some instances there's some overlapping features. I'm just curious, from an end-user perspective, how are you thinking about bringing together your various local commerce products? And then maybe to follow up on the Google+ question, since it is so early, what are your longer-term goals for Plus? I mean measured by their users or number of items shared. How are you thinking about this over say, a 2 year timeframe?
Larry Page: I'll take the second question first, on the Plus, how would we think about success of it. I think we are really, obviously, like I said we want people to make products that everybody uses 2x a day, like their toothbrush. We'd certainly think about plus that way, and also just generally having really great sharing experience and identity experience across Google and all of its products. And so that's kind of how we think about the success there I think it's pretty straightforward. On the first question, integration? Patrick, do you want to take that?
Patrick Pichette: Let me say just that what's been really cool about local for us, in the addition to what Susan has mentioned a few minutes ago is, you have to think of it as we are in fact assembling all the pieces of the puzzle. Local is actually a quite complex experience, but when you have Maps, you have Mobile, you have Wallet, you have all the ads serving, you basically have the pieces of the puzzle to succeed, and it's not as much what was yesterday's tools that we had, and how do we evolve only yesterday's tools, it's about taking those pieces of the puzzle and really creating true innovative services. And that's how we have to think about local. And that's why it's not obvious. But if you look at the arsenal we're building, it's actually quite formidable. So that's why we're excited by that. Thanks Jason for your question.
Operator: And we'll go next to Doug Anmuth with JPMorgan.
Douglas Anmuth: I wanted to ask 2 things. First, Patrick, can you give us some color on the mix as headcount additions? And in particular, if you look at R&D it looks like it was flat sequentially, but yet you added more than 2,000 people during the quarter. So I'm hoping you can provide some color there. And then secondly can you give us some context just in terms of how you think about the Display business and whether you need more O and O inventory.
Patrick Pichette: I'll answer the first one, and then I'll let Susan answer the second. On headcount, again, as we said on the call, roughly, we have IT for 450 so roughly about 2000 for the quarter, and Larry comment on that. And we -- there's still a huge amount of engineers in that. It just happens that R&D is actually in every line item. So you'll find in many other areas of our P&L. And so you should not worry. We have a complete focus to make sure that we actually have a majority of our hiring that is focused on Engineering, which is really the core of the business and then we continue to kind of -- then you have the mix of sales and then just general overhead. It's really engineering and sales that have been the focus in that sequence. For Display, I'll let Susan talk about it.
Larry Page: I'll just add too in the headcount question. None of the focus there has changed substantially from our past.
Susan Wojcicki: On Display, our biggest O and O property is obviously YouTube. And given the numbers that we saw, we've seen tremendous growth there and a huge opportunity to monetize video as more users come online, and more content lines are being uploaded on YouTube. But the strategy, and our Display strategy overall is dependent not just on O and O. It also has many other components. The first of being to be a platform to enable advertisers and publishers to much more easily buy and sell Display advertising. And then second, to enable all of the sites out there, of which there are of course many, many millions, hundreds of millions of them, for them to be able to monetize and sell display advertising and for us to be able to help them as part of that process and via our network, where we have a lot of different targeting techniques to try to serve the right ad to those users. So really our strategy is part O and O with our sites like YouTube, but then also to continue to build a great network and platform products to that advertisers and publishers across the industry can serve Display advertising.
Operator: And we'll go next to the line of Anthony DiClemente from Barclay's Capital.
Anthony DiClemente: I have one for Patrick and one for Larry. Patrick if you just isolate the 6% sequential growth in cost-per-click versus last quarter, wondering if you could help us understand the driver of that acceleration, and moving forward, should we expect that to continue or moderate, given that as Mobile queries start to take up more of the query mix? And then question for Larry, it would appear that in social media that switching costs for users are high perhaps years of photos on a social network platform. And as you look at Google+ and the growth there, what are the most compelling offsets to those switching costs you think or do you perhaps see a future where folks can simultaneously be a part of multiple social networking platforms?
Patrick Pichette: So why don't I let Susan actually give you a bit of color on our CPC and evolution, and then Larry will take on the latter, the social one.
Susan Wojcicki: The drivers of CPC, there are few of them. One of them in this quarter was FX, certainly. But we've been really focused on our ads quality improvements, and how do we continue to obviously make our ads better for our users and for our advertisers. And in doing so, we've actually -- we done a lot of optimization of our ads that appear above the search results like site links, some of the ad changes in the formats that we made this quarter, and a lot of the ads that appear above the top search results tend to be higher CPC because they're the first 3 ads. So as we continue to optimize and really drive a lot of the increased click-through and visibility for the ads that appear above the search results, you will see -- since those tend to be higher CPC because they're at the top of the results, you will see some of that increasing.
Patrick Pichette: Larry on sell-through and switching costs?
Larry Page: I think we've been really excited about Google+ really improving the overall social experience and making it more like how you would share in real-life. And that's really a different product than is out there now. And we're getting just rave reviews for that. People really like being able to share with more discrete groups in an easy way, intuitive way, and there's a lot of magic built into the product that causes that. And as you say, you asked about the photos, we actually have a really great photo experience on the Android. Like if you take a picture on Android and you have Google+ client, which you would have, if you're using it. It uploads your photos automatically, and it's super easy to share them and post-them to your friends, or your family or whatever. It's a really, really great experience. So there is legacy in Google, as a company, believes in users owning their own data and being able to easily move it out of Google. As some of our competitors don't believe in that. We think the users will eventually move to services that are in their best interest and that work really well for them.
Operator: We'll take our final question from Jim Friedland with Cowen and Company.
James Friedland: I wanted to ask a question on -- or follow-up on where you guys said that you're a little ahead of where you expected to be on hiring. Should we think about the hiring and particularly in R&D sort of coming in waves where you hire a bunch of people, get them integrated, it sort of slows down and picks up again? And then the second question and just on the P&L, other cost surviving users of percentage of [indiscernible] TAC seems to be a little high. Is that coming from increased Data Center depreciation or is it may be coming from YouTube and content related costs?
Patrick Pichette: I'll answer the first one, the latter one, and then I'll let Larry talk about hiring in general. The P&L, yes, it is a combination of factors this quarter. So in that cost is also included headcount. And so headcount is actually increased. Power is increased because of seasonality. It's summer now, so our power is a little higher. And we've also had kind of catch up on expenses on some of the equipment. So there's been a bit of a between Q1 and Q2, there's been a bit of a cleanup in some of the areas of equipment that have actually slightly deflated Q1 and inflated Q2 as we finish the clean up, so that was a bit of a catch up there. So I wouldn't read the data point between Q1 and Q2. Don't create a graph with that, with that line. But it's a bit of everything, including a bit of cleanup and some of the equipment accounts. For the issue of hiring, I'll let Larry actually talk about general where we stand right now.
Larry Page: That's a great question. I think just a couple of factors that affected that and I think you know we implemented compensation changes in Q1. We increased our employee compensation. And they've had even more positive effect on hiring and retention than when we expected. It's been a super successful change. And I think in general this has more excited people who want to work at Google and who want to stay working at Google than we expected. And so that's had some impact on those numbers. Of course there's a limit on how many we can -- and how fast we can productively hire, and I said this in my remark, I think kind of my judgments where at the edge of that piece being reasonable. We're just adding a lot of people. And I'd say that we're always looking for good people, and we're always -- the exact rate is going to depend on success and where we really want to invest in the company. We have a really strong management team. I said that's working together fabulously, and we can absorb those hires and put them to use well. But like I said, we're definitely -- we're surprised that the success of our previous changes around compensation as well.
Patrick Pichette: With that, I just want to thank Larry for joining us today, and Nikesh, and Susan for the comments as well as the Q&A. I want to thank, once again as I always do, all the Googlers out there. Our fantastic Googlers that have made this quarter possible. And all of the innovation, especially I think it's worth mentioning, our Google+ team that has done a phenomenal job in this launch. So 2 thumbs up. So on behalf of all of us here, congratulations and many thanks to all of our gang at Google. With that, I'll let you, Jamie, close the call. And thank you, everybody, for participating today.
Operator: Thank you, sir. That does conclude today's conference. We do appreciate everyone's participation. | [
{
"speaker": "Operator",
"text": "Good day, and welcome, everyone to the Google Inc. Second Quarter 2011 Earnings Conference Call. This call is being recorded. At this time, I'd like to turn the call over to Jane Penner, Senior Manager, Investor Relations. Please go ahead, ma'am."
},
{
"speaker": "Jane Penner",
"text": "Good afternoon, everyone and welcome to today's Second Quarter 2011 Earnings Conference Call. With us are Larry Page, Chief Executive Officer; Patrick Pichette, Senior Vice President and Chief Financial Officer; Susan Wojcicki, Senior Vice President, Advertising; Nikesh Arora, Senior Vice President and Chief Business Officer. First, Larry, Patrick, Nikesh and Susan will provide us with results on the quarter. Also, as you know, we now distribute our earnings release through our Investor Relations website located at investor.google.com. So please refer to our IR website for our earnings releases, as well as supplementary slides that accompany the call. This call is also being webcast from investor.google.com. A replay of the call will be available on our website in a few hours. So let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward-looking, including statements regarding Google's future investments in our long-term growth and innovation, the expected performance of our business and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on this call such as operating income and operating margin, are also expressed on a non-GAAP basis, and have been adjusted to exclude charges related to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will now turn the call over to the Larry."
},
{
"speaker": "Larry Page",
"text": "Well, thank you, and good afternoon, everyone. Thanks for joining us today. It's really exciting to be with you today and share directly with you the progress we have made in my first quarter as CEO. As you will see from our press release, we had a great quarter, with revenue up by 32% year-on-year and a new record for quarterly revenue at over $9 billion. We've substantially increased our velocity and execution this quarter, which is a key goal of mine since taking over as CEO. So I created a new product focus management structure, with clear leaders responsible for each area. The new management team is working together fabulously and has already achieved a lot in just these 3 months. First of all, I want to talk about Google+, which we launched a field trial invitation only. Our goal at Google+ is to make sharing on the web like sharing in real-life, as well as improve the overall Google experience. Circles lets you choose with precision who you're sharing with, not surprisingly this has been very well received, because in real life, we share different things with different people. Hangouts allows for serendipitous interactions. Like in real life, when you run into a few friends, gives you seamless and fun multiuser video, and it's really amazing. Last quarter, we launched the +1 button in search results and ads, enabling users to recommend stuff they like and to have those recommendations show up in the search results of people they know. This quarter, we released the +1 buttons to the entire web and many sites like Huffington Post, The Washington Post, and Best Buy has added +1 buttons. Google+ is still in field trial with limited access as we scale the system. Users have to be invited and sign up with a profile in order to use it. However, the growth on Google+ has been great, and I'm excited to release some new metrics for you today. Over 10 million people have joined Google+. That's a great achievement for the team. There's also a ton of activity, and we are seeing over 1 billion items shared and received in a single day. Our +1 button is already all over the web, and it's being served 2.3 billion times a day. So while we still have a lot of work still to do, we are really excited about our progress with Google+. Google+ is also a great example of another focus of mine, beautiful products that are simple and intuitive to use, and actually was one of the first products to contain our new visual redesign. We also launched that beautiful, consistent and simpler design on our homepage, Gmail and calendar, with many more products soon to come. Reader focus has also been another big feature for me this quarter. More wood behind fewer arrows and last month, we announced that we'll be closing Google Health and Google PowerMeter. We've also done substantial internal work, simplifying and streamlining our product line. While much of that work has not yet become visible externally, I'm very happy with our progress here. Focus and prioritization are crucial given our amazing opportunities. Indeed, I see more opportunities for Google today than ever before, because believe it or not, we are still in the very early stages of what we want to do. Even in Search, which we've been working on for 12 years, there's never been more important changes to make. For example, this quarter, we launched a pilot that shows an author's name and picture in search results, making it easier for users to find things from authors they trust. Of course, when we started doing Search, people thought we were crazy. They said there was no money to be made in search over and above a bit of banner advertising. Most new Internet businesses have had that same criticism. Fast-forward to today, it feels like we're watching the same movie again in slow motion. We have tremendous new businesses being viewed as crazy. Android, I actually have a new metric to report in Android of 550,000 phones activated a day. And that's a huge number, even by Google standards. Chrome is the fastest-growing browser. We have over 160 million users. Now people rightly ask, \"How will we monetize these businesses?\" Of course, I understand the need to balance the short-term with the longer-term needs because our revenues in growth serve as the engine that funds our innovation. But our emerging high usage products can generate huge new businesses for Google in the long run, just like Search. And we have tons of experience monetizing successful products over time. Well run technology businesses with tremendous consumer usage make a lot of money over the long term. And I think about our products in 3 separate categories. First, there is Search in our Ads products, the core driver of revenue for the company. And Nikesh and Susan are going to talk more about Ads later in the call. Next, we have products that are employing high consumer success: YouTube, Android and Chrome. We are investing in these in order to optimize their long-term success. Then we have our new products, Google+ in commerce and local. We are investing in them to drive innovation and adoption. Overall, we are focused on long-term, absolute profit and growth, as we have always been, and I will continue to have tight financial management we have had in the last two years, even as we were making significant investments in our future. I'd like to finish on our people. Great companies are no greater than the efforts and ingenuity of their people. We're continuing to hire the best. Keeping them happy and well-rewarded is crucial to our future. Many of you will be interested in hiring whether we hired a few hundred more or less than you expected this quarter. But we will optimize headcount for the long-term in the opportunities we see. I'm happy with the investments we've made in people, but we're probably even a little ahead of where we need to be with headcount growth at the edge of what's manageable now. Easy to focus on things we do that are speculative, e.g. driverless cars. But we spend the vast majority of our resources on the core products. We may have a few small speculative projects happening at any given time but we're very careful stewards of shareholder money. We're not betting the farm on this stuff. All of us at Google will want to create services that people in the world use twice a day just like toothbrush. And we strive to make those services beautiful, simple and easy to use. That way we can provide huge benefit to the world. We've made a good start, but we're only at 1% of what's possible. Google is just getting started, and that's why I'm here, working hard to lead the company in the next level. Thank you. And again, we had a great quarter. Now over to Patrick for the financial results."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Larry. Thank you, everybody. Thanks for joining us. And Larry is going to stay with us for the Q&A. So I just wanted to make sure that everybody knows he's not going anywhere. Okay, so let's go through the number. We had obviously an excellent quarter with 32% year-over-year revenue growth in Q2, and it clearly demonstrate the continuing power of Google's product innovation, but also the relentless momentum of the digital economy. The strength continues to be driven by our core desktop search ads, but also increasingly, by new emerging areas just like the Mobile, Display, including YouTube and Enterprise that we regularly talk about. So let's turn to the specifics of our performance in the quarter. Growth revenue grew 32% year-over-year and we've reached $9 billion in revenue, 5% quarter-over-quarter growth as well. Note that while currency fluctuation boosted our revenue somewhat, even in constant FX terms, our growth rates remain strong, particularly in what tends to be a seasonally slower quarter. Google website revenue was up 39% year-over-year to $6.2 billion and 6% quarter-over-quarter, with strength across most major geographies and verticals. Google Network revenue was also up 20% year-over-year to $2.5 billion, 2% quarter-over-quarter. Network revenue was again negatively impacted by the Search quality improvements made during the latter part of Q1, as you will remember, and know that Q2 reflects a full quarter of this impact. This impact is to be expected in the short-term, given that it is now different publishers that are receiving traffic and may not have yet optimized their sites for our advertising programs. Other revenue was also up 20% year-over-year, just $310 million and 15% quarter-over-quarter. Our global aggregate paid click growth was strong, up 18% and down 2% quarter-over-quarter. Our UI changes to search ads such as BizURL drove year-over-year click growth in Q2, along with the ongoing and accelerating shift from offline to online. The slight decline quarter-over-quarter is just typically consistent with our summer seasonality. Aggregate cost-per-click growth was also very healthy, up 12% year-over-year and up 6% quarter-over-quarter. Note that FX also had a positive impact on CPC, and remember too that this is an aggregate number that includes both Google.com and our AdSense properties. Turning to our geographic performance, the U.S. and Rest of the World are growing both at very good pace, and our results reflect that. While the U.K. still continues to lag slightly in the global recovery, year-over-year and quarter-over-quarter growth in Q2 continues to show signs of acceleration in the U.K. as well. So revenue from the U.S. was up 26% year-over-year to $4.2 billion, and in our earnings slides, which you can find on our Investor Relations website, you'll see that we've broken down our revenue by U.S., U.K. and Rest of the World to show the impact of FX and the benefits of our hedging programs. So please refer to those slides for the exact calculations. Non-U.S. revenue accounted for 54% of our total revenue or $4.9 billion, up 38% year-over-year, which includes only $4 million of benefits from hedging programs, compared to last year where we had $79 million of benefits for Q2. Year-over-year growth in fixed FX would have been 29% versus the 30% I just mentioned. Japan's future revenue was again negatively impacted by the aftermath of the disaster there, but there again we see signs of faster recovery, faster than expected at first. The U.K. was up 27% year-over-year to $976 million, and year-over-year growth and fixed FX was still a healthy 19% for the U.K. Let me turn to expenses. Traffic Acquisition Costs were $2.1 billion or 24.2% of total advertising revenue. Our other cost of revenue was $1.1 billion dollars, including stock-based compensation of $51 million and finally, our operating expenses, which exclude stock based compensation totaled $2.6 billion. The stock-based compensation totaled $384 million in Q2. The increase in year-over-year in OpEx was primarily due to payroll, increased advertising and promotional spend and also professional services. So as a result, our non-GAAP operating profit was $3.3 billion in Q2 which excludes the stock-based compensation, resulting in a non-GAAP operating margin of 36.7%. Headcount was up approximately 2,450 versus Q1 ending the quarter with 28,768 full-time employees. When we exclude ITA adds of roughly 450, the net headcount growth is roughly similar to Q1. Our effective tax rate was 19% in Q2, and the effective tax rate is down due to the mix of earnings between domestic and international subsidiaries, as well as our hedges. Let me turn now to cash management. In Other Income and Expense, our result was $204 million for Q2, a solid portfolio management performance from our team, which, like every quarter, is offset by the impact of our hedging expenses associated with FAS 133, which in itself was also significantly lower in Q2 gave us these great results. For more detail in OI&E, again, please refer to the slides that accompany this call on our IR website. Operating cash flow, very strong, $3.5 billion for Q2. CapEx for the quarter was $970 million versus last quarter of $890 million. So pretty much in line. The majority of our CapEx spend in Q2 was related to facilities, expenses, and production equipment. And regarding specifically these facility expenses, like last quarter, we just happened to have a great opportunity in Q2 to purchase buildings in Dublin and in Mountain View, and we took opportunity. As a reminder, we'll continue to make significant CapEx investments, and these have shown to be lumpy from quarter to quarter depending on when we're able to actually make these investments. But overall, we can be nothing but pleased with our free cash flow which was $2.6 billion for Q2. As Larry mentioned earlier, we continue to deliver growth with a disciplined agenda. This means investing and making sure that our resources are deployed wisely with focus and a balance between that short and long-term that Larry covered. So with those financial highlights covered, I'm going to turn it over to Nikesh who will actually cover now our sales performance in the quarter. Here you go Nikesh."
},
{
"speaker": "Nikesh Arora",
"text": "Thank you, Patrick. I'm going to give you a quick update on our business activities, which spans sales, partnership marketing, and customer service around the world in support of our product and revenue. Let me start by focusing on the first priority of our sales team, the need to continue to drive revenue growth in core and new businesses. This quarter we continue to drive revenues in our corner areas like Search, as well as new areas like Display, Mobile, and Enterprise. Core Search and Desktop has done very well this quarter, with Google.com accelerating and our large advertisers continuing to spend more as they see more value in Search. We've also have been able to drive tremendous focus on small advertisers around the world, with programs like GXPO, which I will talk about slightly later. Broadly, however, our sales teams are getting better at tailoring Integrated Solutions for clients, using the full area of our advertising products. These solutions create better opportunities to improve our customers marketing ROI. Clients have used Search to focus their targeting capabilities, such us such as audience and topic targeting, to help improve the marketing effectiveness. Some of our most successful Search clients include people like GM and EgyptAir. On the other hand, in addition to our core desktop Search business, we continue to be very excited about our investments in Display and Mobile. Let me first focus on Display. We've seen continued healthy growth in our Display product space across all fronts: Advertiser, publisher and technology solutions. 98 of the top AdAge 100 advertisers have bought Display across YouTube and the Google Display Network this quarter. Customers continue to use our DoubleClick products and we are happy with the increased use for the DoubleClick Ad Exchange and Invite Media for ad buying. With our announcements to acquire Admeld, we hope to deliver even better solutions to our publishers and buyers. Continuing on Display -- on YouTube, where we have over 3 billion daily views, we have had great success bringing popular content to our users, further increasing audience engagement. Take for example, our April broadcast of the Royal Wedding which generated 100 million YouTube views. Our range of platform and content means that advertisers are beginning to use them for superior branding solutions. A great example of our branding products in action was T-Mobile's launch of the Samsung S4G on YouTube. In this campaign T-Mobile took over YouTube running ads in their home page, watch page, Mobile. That particular campaign helped them reach 46 million unique users. Continuing to talk about revenues, our Mobile business continues to be another area of robust growth. The number which Larry just shared of 550,000 Android, that and the success of smartphones in and general Mobile Data devices around the world is acting as an accelerator for our Mobile advertising effort. Let me just take one quick example. One format which was launched by Susan's team called Click-to-Call or Click-to-Share has been particularly successful. Unilever is a great use case of these formats. They integrated our AdMob product into a very large campaign of launching a new product to use the banner to drive traffic to a campaign Mobile site and achieve unprecedented results with almost 700,000 unique visitors accessing their content. Another leg of our revenues is the Enterprise Business. We've seen great results in enterprise as well, in particular apps for business continues to grow as organizations move to the cloud. We've had key wins at Intercontinental Hotels, [indiscernible] State of Wyoming. In addition to that, some small simple changes in our product side have allowed us to tremendously accelerate Google Apps for small businesses. Looking at our revenues from a slightly different perspective, geographies and customer segments, we've seen strong growth in regions and across customers of all sizes. First let's take a look at geographies, we maintained our strength in large, mature countries while we accelerated in emerging ones. Now a large majority of countries which are countries even though some of our facing economic challenges, this secular trend of online advertising and the effectiveness of the teams to continue to drive healthy revenue growth is showing great results. Several countries are worth noting as Patrick mentioned. The U.K. has accelerated this quarter with strong growth by small advertisers. In Japan, we've seen recovery, driven primarily by Display and Mobile spending by large advertisers. Our focused execution in Canada and Spain has led to these markets beginning to show recovery. Finally, we saw tremendous growth in emerging countries especially Brazil and Russia, where our Display products are getting strong adoption from advertisers. Across each country, we focus to improving the product knowledge and selling capability of our sales force, our frontline teams can now sell Search, Display, and Mobile to the needs of our customers, which is a great trend we're seeing of integrated products selling across multiple Mobile ad formats. As a result we're becoming better advisors in the digital space for our large advertisers. For example, Nike, Sony Ericsson, Telefonica, all of them partnered with us to create integrated solutions down there, sponsorship of Copa América. Outside of revenue, one key area of responsibility is marketing. And if we continue to use marketing as a strategic blipper. We use marketing to both drive customer acquisitions as well as usage of our key consumer products. I'm very proud of my team's work on getting business online GXPO as I mentioned in Q2 we successfully launched Brazil, Canada, Australia Thailand. To objective is to try and bring another million small, medium businesses across 20 countries online for the first time. As you know, more advertisers gets more queries, has more adserves against it. There's nothing in a more robust option for us. In addition, also we saw strong results from our own advertising campaigns, including the most recent one around Google Chrome. The web is what you make of it. I'm sure many of you might have seen Justin Bieber and Lady Gaga in these campaigns. These campaigns have shown tremendous effectiveness and have also convince more users to switch to the Chrome browser. Last but not the least, I want to spend a quick minute on talking about something we're more and more passionate about, which is continuing to drive better customer satisfaction on an advertiser front. We continue to improve service and support across all customer segments. We've started providing large sets of advertisers proactive full support and on boarding help, which includes signing up for campaign building, signing up and getting assistance, as well as free full support after they become a customer of ours. As a result of these initiatives and others, spending by our small businesses continue to accelerate. Overall as Patrick and Larry have mentioned, it was a great quarter. I'm very proud of the wok of our teams across the world in various countries. We have done a tremendous amount of effort to serve our customers, partners and users. Now I'm going to turn over to my business partner, Susan, who is going to talk about all the positive impact that our products will have this quarter."
},
{
"speaker": "Susan Wojcicki",
"text": "Thanks, Nikesh. Larry started the call by talking about a few of the quarters product highlights and I'd like to cover some more of them. So let me begin with Search. We're always looking for new ways to help our users find answers to their questions. This quarter, we brought 2 of the most popular mobile search innovations to the desktop, Voice Search and Search by Image. Voice Search traffic for Mobile devices is up 6x in the past year. So we thought this would be a useful feature for our desktop users as well. It's especially useful for searches that you know how to say but don't how to spell like Bolognese sauce or Schenectady, New York, neither of which I could easily spell. With Search by Image you can draw pictures of places, art, or even mischievous creatures like the Loch Ness Monster right into the Google search box and Google can identify and tell you about those pictures. In addition to these changes, we released about 100 other quality improvements to the Search algorithm. More and more people are searching and using apps from Mobile phones, where Android has had terrific momentum. There are now 135 million Android devices that have been activated in total, up from 100 million just 2 months ago. There are also now over 400 different Android devices available globally. Android market is also picking up momentum. It has over 250,000 different apps, and users have downloaded apps over 6 billion times, which is double the downloads from just a few months ago. We're expanding beyond apps too. This week, we started renting movies and selling books on phones from Android market and earlier in Q2, we launched Music Beta, which lets users upload their personal music collections and playlist to the cloud. All this media, movies, music, books and apps, are instantly available on their Android devices, no cable required. Smartphones are also becoming key to the shopping experience. Making shopping mobile and local is a vision behind Google Wallet and Google Offers. We announced the Google Wallet mobile app in May in partnership with Citi, MasterCard, Sprint, and First Data, and we are now testing it in field trials. And as of this week, Google Offers are available in San Francisco, Oakland, New York, and Portland. But now on to Ads, which is the product area that I manage. On the Search Ads side, we had a great quarter for quality with over 50 ads quality improvements and a big upgrade to the ads relevancy system. We launched the latest in a series of small tweaks for a search add format. This format, this quarter, we added the landing URL to the headline so that users know where click will take them. This may seem like a small thing, but we launched several of these small tweaks over the past year and cumulatively, they have had a big impact. There were also a lot of quality improvements across our Display Network. Over 20 launches, making it one of our strongest quarters from a quality perspective. In general, Display advertising is moving to a scientific model based on technologies like real-time bidding. But this technology when you land on a web page, advertisers decide what they want to pay for the ad space, and then auction is held. And the best ad is matched with the publisher's ad space. It's a lot more efficient. It provides better performance for both advertisers and publishers, and more relevant ads for users. Real-time bidding is an important technology shift that we are investing heavily in. Invite Media, which is the buying platform for advertisers and agencies that we bought last year, has doubled its client list in the last year, with over 5x growth outside of the U.S. Mobile Display is starting to take-off too with traffic on the AdMob network up more than 3.5x in the past year. More and more of that traffic is coming from tablets, so we launched a new set of formats designed specifically for tablets. These formats are web-based. They use HTML, and brand advertisers don't need to make different versions of their ads for different models. Nikesh also mentioned our great momentum with YouTube, where we're getting strong performance from the YouTube skippable ads. Because users can choose to skip these in-stream ads, the people who choose to watch them are much more engaged. More and more advertisers are choosing to make their ads skippable and now, over 1/3 of in-stream ads on YouTube are in a skipable format, which is a pretty remarkable stat given that we launched this format in December. Finally, I'd like to update our progress on Chrome. Larry mentioned how we passed 160 million users which is more than double year-on-year. This quarter, our partner Samsung and Acer Search using Phonebooks in 7 countries. Phonebook are designed to be fast, to just work, and to get better over time, thanks to our automatic updates. And they're now available through Amazon and Best Buy. Phonebooks are also available to schools and businesses via subscription model. The subscription includes Phonebooks, of course, administration, warranty, and support, starting at $20 a month. So overall it was a very busy quarter for us. But maybe the coolest thing we did was the Les Paul doodle we ran last month. It was a guitar you could actually play, and users recorded over 40 million songs while it was up. That's about 5 years of music. I'm looking forward to hearing your questions and comments. And for now, back to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Susan. So Jamie, our operator, is going to help us through this. Jamie, you can just set up the call for Q&A. And as I said, we'll have Susan, Nikesh, Larry, and myself to answer any questions you may have."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] And we'll take our first question from Spencer Wang with Credit Suisse."
},
{
"speaker": "Spencer Wang",
"text": "Two quick questions, if I could. First for Patrick or perhaps Nikesh, International revenue growth as you mentioned was really strong. I was wondering if you could just provide a little bit more color on perhaps that's driving that? If you could give us a sense of how much of that is core Search versus some of the newer initiatives like Mobile, YouTube, and Display. And then the second question is for Larry. I was wondering if you can just talk a little bit, Larry, about the patent strategy. Our understanding is you guys have about 650 patents. So just given the Oracle situation, I was wondering if you could talk about the patent strategy to ensure that you guys can continue to innovate going forward."
},
{
"speaker": "Patrick Pichette",
"text": "I'll let Nikesh answer the first part of the question, and then Larry will talk about the patent issues."
},
{
"speaker": "Nikesh Arora",
"text": "As I mentioned in my prepared remarks, that we've seen tremendous growth across pretty much all product areas. So the growth you're seeing in international is driven by Mobile, by Display, by Search. Clearly international is not one market there are many different countries. So we have seen different effects in different markets. Places like Japan, as I said, have been driven more by Display and Mobile. Various parts of Asia are just getting up the curve for us in Display and are strong contributors in Mobile. Having said that, Russia has been very strong for us. Brazil has been very strong for us. Brazil in the back of Mobile and Display as well, and as well as core Search. So if you think about what we're seeing, we're seeing more and more a pickup of Display and Mobile because we have established sales team are pretty much on almost every major market around the world to help sell Display. And the Mobile tick up based on tick up of smartphones and Android et cetera is helping that trend as well. In addition to that, a lot of effort has gone in to bringing small business online and that increases a number of advertisers in many international markets. As you get more advertisers in international markets. It has a very positive impact on our RPMs in those markets. So we're seeing that effect as well."
},
{
"speaker": "Larry Page",
"text": "To your question on Android and patents and so on. Obviously we have a number of intellectual property patents in progress not just already issued. I must just say, Android's really on a tear. I mentioned there were over 550,000 new Android daily activations previously. And there's over 400 such devices, 39 OEMs, 231 carriers in 123 countries, and over 78 open handset alliance partners. And that velocity is only increasing. And of course despite the efforts of some of our competitors, there hasn't been any slowdown in any of those things. And partners and developers are continuing to expand the Android ecosystem. Of course we're really committed to Android and continued to support that platform and ecosystem, and do it in a cost effective manner."
},
{
"speaker": "Operator",
"text": "And we'll take our next question from Mark Mahaney with Citi."
},
{
"speaker": "Mark Mahaney",
"text": "Two questions Larry. Could you talk about what you have maybe put in to improve the velocity of decision-making? And as you step back and think about the management improvements you could see over the next year or 2, how significant do you think -- how much better -- how much more efficiently do you think Google could be run, than what we've seen maybe over the last 2 or 3 years? And then Susan, real quickly, social search signals, how important do you think they are now? How key are they -- how much of that is Google+'s strategy for trying to make the core search results more relevant?"
},
{
"speaker": "Larry Page",
"text": "This is Larry. I'm super excited about the changes we've made and I think as companies scale, we always change how we're running the company over time. So I think we have a much more of a product focused structure now, which I'm very excited about and talked about it. And I think that maintaining and improving our velocity and execution is a really noble goal for us. And it requires always a lot of work in companies. And I think that's super important direction for us, and I'm really excited about it."
},
{
"speaker": "Patrick Pichette",
"text": "Susan, on social?"
},
{
"speaker": "Susan Wojcicki",
"text": "Yes, so I think the first thing I would say about social is that we're very early right now. And really our focus with Google+ will be to focus on making sure that we have a wonderful consumer and user experience. From a targeting perspective, there are a number of signals that we use right now. Obviously keyword on Search, contextual, interspaced advertising, demographics, and social signals overtime can be an important part of that. But it would be one of multiple ways that we actually do targeting. When we did rollout Google+, we do have pluses on all the ads this is what we do in search results. So if the user does click on it, and someone on their circle has actually does a query and triggers that, then there will be social annotations, which will be useful information for the user to see that their friend has +1-ed that ad."
},
{
"speaker": "Operator",
"text": "And we'll go next to Ben Schachter with Macquarie."
},
{
"speaker": "Benjamin Schachter",
"text": "Congratulations on the execution and the launch of Google+. Larry, at a high-level what, if any, are some of the key differences on how you think about managing specifically the economic model of the company today versus when Eric was CEO? Specifically any changes to target margins, revenue growth targets, et cetera? And then separately, on Mobile Search specifically, it's clearly been successful in terms of search share. But when we're trying to figure out the overall impact to net revenue in kind of balancing out some of the positives like incremental searches and share gains and higher click-through rates, but also having the headwinds of TAC payments to partners and lower CPCs, how should we think about the overall net impact of Mobile to the business?"
},
{
"speaker": "Patrick Pichette",
"text": "Why don't I'd take the second part of that question, and then Larry can talk about the economic model versus in the context of what you said. But for Mobile search, you have to go back and focus on what we focused on. Build businesses that are going to be billion-dollar businesses and that actually contribute significant operating dollar margins. These are businesses that scale to a humongous scale as they grow. So for us, that is the focus that we have. And the second piece in the specifics of Mobile is we really see Mobile a bit like Search was in 2001, 2002, 2003. All these formats are so new that you know that there's so much more room for optimization on top of it. So it is in fact a bit of a mistake to kind of say okay, today whatever we have is a good proxy for what the future will look like. And that's why we're excited about it. And that's why we focus so much on Mobile. For the economic model and how we run the company, maybe Larry, your thoughts on that?"
},
{
"speaker": "Larry Page",
"text": "Absolutely, thanks for the question. I think certainly Eric is a great partner and leader for me and for Google for the last 10 years, and continues to play a big part in the company. So I don't think there's, like we said before, there's no major changes in what we're doing. And I'll reiterate maybe a little bit and add a little detail to what I already said. I think about really in our products in 3 separate categories. First, through Search and our Ads business, which is the core driver of revenue for the company. We really invest in that, we work hard on it. Next we have businesses that are enjoying really high consumer success. For example, YouTube, Android, and Chrome. And we invest in those in order top them for long-term success. And we have some new businesses on Google+, Commerce, and Local that we're really excited about and are at pretty early stage and those things we invest in as well. And we don't do things that we don't think will generate really big returns over time. So we're optimizing for our long-term economic success. But we do have these very different buckets of things that we work on."
},
{
"speaker": "Operator",
"text": "And we'll go next to Ross Sandler with RBC."
},
{
"speaker": "Ross Sandler",
"text": "Two questions. First on Google+ and then second on Google Offers. So on plus, we haven't seen real integration. We know it's only a couple of weeks old but with Google's kind of core competencies around search and other things that you've been very successful at in the past. So can you talk about plans on integrating some of Google's core strength into Google+ to further, I guess, differentiate the products from other services that are out there? And then on Google Offers, can you just talk about your overall strategy in terms of rolling out offers? You're in 4 cities today. How fast do you think you're going to accelerate into these newer cities, and is international territories also on the roadmap and the near-term for Offers?"
},
{
"speaker": "Larry Page",
"text": "I'll answer the first part, this is Larry. Google+ actually has a lot of interesting product integration. The black Google bar that you see is an entry point and notification point for Plus across basically all of our properties. And we're really excited about that, and think it's a big deal. Suffice to say there are many things that you would do with Plus and with +1 that affect what you would see in search results. Like I mentioned, when you +1 something, your friends will see it in search. So absolutely, and I hope it was clear that was our strategy, but we're very focused on improving all of Google, improving the sharing and identity across all of Google."
},
{
"speaker": "Patrick Pichette",
"text": "Maybe Nikesh can give a comment on the rollout of Google Offers."
},
{
"speaker": "Nikesh Arora",
"text": "Thanks, Patrick. We won't give out details on how we rollout our offer strategy. I think Susan said it very well in our overall strategy, because Offers for us is not just an isolated event. It is a combined, a bit of a commerce offering, which includes their Mobile phone and other things we talked about. We were very happy with the rollout we've had in the one city where we've been for a while, which is Portland, and we just rolled out 2 more cities earlier this week. So from our perspective, you can expect us to roll out other cities, but we're going to be testing and looking at the models see what's working and what's not working because we want to build the next version of how we rollout an Offers product. So stay tuned."
},
{
"speaker": "Operator",
"text": "We'll go next to Brian Pitz with UBS."
},
{
"speaker": "Brian Pitz",
"text": "Two quick questions. As we note the proliferation of the newer, richer ad formats like product image ads that we're seeing more and more of on your site, can you help us better understand the impact on paid click growth specifically? And then separately, can you also give us a little more color on some of the [indiscernible] quality changes you're doing on the network? Any commentary on how much impact to growth of AdSense that had this quarter and how long should we expect to see more than expected impact from continued quality changes?"
},
{
"speaker": "Patrick Pichette",
"text": "Why don't I let, actually, Susan tackle those questions? Susan?"
},
{
"speaker": "Susan Wojcicki",
"text": "On the richer ad formats, we see a few important opportunities for us, and what we feel about them is it gives us the opportunity to make those ads better for the users. And as we can create better experiences for our users, they're more likely to have the information that a user wants. And so what we'd hope to see is a click-through increase over time. And hopefully, for the advertiser on the back end, a better conversion. So in terms of click growth, and what's actually driving the click growth that we see, it's a matter of factors. One of them is always going to be query growth that we have. Second thing would be on improvements that we have to our back end quality models. So the better the quality model is, the more likely we are to actually match the right advertisement to the right user. And we had a number of good ads, as I mentioned, not just good, we had great ads quality launches this quarter, and a number of ad formats that made the ads more readable. And by making them more readable, the users are more likely to click on them. And that turns into click growth. And then on the last question that you had, which was Panda, Panda was a change made by the search team with the goal of improving overall search experience. There was, as we talked about last time, some negative effects from the AdSense partners. However, Panda does -- or any search quality that we make, does have a change of ranking, which means that there are different sites that wind up getting traffic. And that those sites may adjust their monetization strategy over time. And so it may just take some time for that to actually balance out. And also, in terms of the last question, we don't really comment about future changes that we're going to make, but we're always thinking about the right way to continue to improve the search results for our users."
},
{
"speaker": "Patrick Pichette",
"text": "Panda, once again a great example of putting the user first ends up benefiting everybody in the end, the publishers, the advertisers, and the users."
},
{
"speaker": "Operator",
"text": "And we'll go next to Justin Post with Bank of America Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "Larry, thanks for joining the call. And while we have you, I'm just going to ask you a question I get all the time. How focused is senior management on the stock either as an employee retention tool or a measure of management's performance over, say a 3 to 5 year period? And then secondly, if I could just ask about the local opportunity, it looks like a lot of launches happening for Google. Do you see it as a different ad market than your current search ad market? And how might your model be different than some of the larger players in that market currently?"
},
{
"speaker": "Larry Page",
"text": "We have a lot of stuff to do here at Google, and unfortunately one of the things we don't get to decide is our stock price. So you all are in charge of that. I think we're really focused on our long-term success as a business and the kind of things I mentioned already are absolute, overall profitability over the long-term and our revenue growth. And so, we tend to focus much more on that, with a much more long-term view than we do on our stock price."
},
{
"speaker": "Patrick Pichette",
"text": "Susan, views on the difference and the similarities between the local and our traditional ads market."
},
{
"speaker": "Susan Wojcicki",
"text": "Yes, Local can be thought about 2 different ways. Local can be the large retailers who have many different points of presence. So, for example, Starbucks or Pizza Hut or any retailer which is a large holding company or one large retailer, but then has many different local points of presence and then there's a separate bucket which are the small Joe's coffee shop example. And both of them need different things from a product perspective in order to be able to advertise more broadly. And we are working in both buckets to solve and make them advertisers on AdWords with solutions that will work for them. The large ones need functionality of how do I run a campaign in all of these different locations with different keywords, different pricing. And so we're working to enable location in our AdWords campaigns where you're managing a large account to make that much easier. The Joe's Coffee Shop example, what we're working on is enabling signing up for AdWords to be a much easier experience. So we actually have a product that we released this quarter called Google Boost. And Boost, a product is a 1 page, 5 minute sign-up for advertisers. It's very easy to sign-up. We haven't marketed it a lot right now but we have seen good success with our advertisers. And we're hoping to make that more known to our advertisers."
},
{
"speaker": "Patrick Pichette",
"text": "The last piece in the puzzle is, obviously Susan, Mobile, which is completely integrated from an ads perspective and targeting as well."
},
{
"speaker": "Susan Wojcicki",
"text": "Yes, the other thing too is we would like to make all of our products be accessible from a Mobile perspective. Click-to-Call would be an example. Click-to-Call is really nice so that as someone, for example, is local walking down the street, they can actually call. But it's also really nice from the small retailer perspective, because they can understand that they're getting a call and they're getting a lead, which for them would be much more tangible than actually a click to their page. So we're investing very heavily in that in terms of Click-to-Call technology and the good tracking for the local advertisers."
},
{
"speaker": "Operator",
"text": "And we'll go next to Jeetil Patel with Deutsche Bank Securities."
},
{
"speaker": "Jeetil Patel",
"text": "Two questions. I guess first of all, you've got obviously quite a few products and applications that have had success over the years. Kind of that are out there obviously Search, Gmail, Chrome, Android et cetera. I guess as you think about next generation of consumer relationship and stickiness, how do you think about like integrating a lot of these core assets together in terms of building a consumer relationship, which kind of moves seamlessly from all these different solutions and formats out there, as well as devices? And then second, maybe around Google+, obviously it's only been 2 weeks now. But maybe can you talk about the overall trend in terms of 10 million users? How does that compare against maybe the early days of how Android or Chrome or maybe even search or mail ramped? What kind of trajectory or what kind of trend schedule does it look like right now if you were to pinpoint it against another product in the business?"
},
{
"speaker": "Larry Page",
"text": "We are -- on the integration point, we obviously have a lot of different products that do different things for different people. And we know one effort that I mentioned, I've been really excited about, is this visual redesign. And I also mentioned the bar that goes across the black bar that goes across with Google+, that gives you a notification on sharing and so on. We're definitely working hard to integrate our products better to make the user experience simpler, intuitive and beautiful and consistent. And I'm really excited about our progress just in one quarter on that and I think you'll -- we're certainly working hard on that. And we have to continue to over time. On the Plus growth question, we've been very, very excited about the growth we've seen and the engagement we've seen. Over 1 billion items shared and received in a single day. And I think that for us, there's a lot of barriers to use Plus right now. One thing, you have to be invited and so on and it's still in field trial. So I think given all that, were just extremely excited about that. But it's very early days. It's been less than 2 weeks since we released it into field trial."
},
{
"speaker": "Operator",
"text": "And we'll go next to Jason Maynard with Wells Fargo."
},
{
"speaker": "Jason Maynard",
"text": "First on Local. You've got a lot of interesting services and capabilities. But they're still fairly disparate and in some instances there's some overlapping features. I'm just curious, from an end-user perspective, how are you thinking about bringing together your various local commerce products? And then maybe to follow up on the Google+ question, since it is so early, what are your longer-term goals for Plus? I mean measured by their users or number of items shared. How are you thinking about this over say, a 2 year timeframe?"
},
{
"speaker": "Larry Page",
"text": "I'll take the second question first, on the Plus, how would we think about success of it. I think we are really, obviously, like I said we want people to make products that everybody uses 2x a day, like their toothbrush. We'd certainly think about plus that way, and also just generally having really great sharing experience and identity experience across Google and all of its products. And so that's kind of how we think about the success there I think it's pretty straightforward. On the first question, integration? Patrick, do you want to take that?"
},
{
"speaker": "Patrick Pichette",
"text": "Let me say just that what's been really cool about local for us, in the addition to what Susan has mentioned a few minutes ago is, you have to think of it as we are in fact assembling all the pieces of the puzzle. Local is actually a quite complex experience, but when you have Maps, you have Mobile, you have Wallet, you have all the ads serving, you basically have the pieces of the puzzle to succeed, and it's not as much what was yesterday's tools that we had, and how do we evolve only yesterday's tools, it's about taking those pieces of the puzzle and really creating true innovative services. And that's how we have to think about local. And that's why it's not obvious. But if you look at the arsenal we're building, it's actually quite formidable. So that's why we're excited by that. Thanks Jason for your question."
},
{
"speaker": "Operator",
"text": "And we'll go next to Doug Anmuth with JPMorgan."
},
{
"speaker": "Douglas Anmuth",
"text": "I wanted to ask 2 things. First, Patrick, can you give us some color on the mix as headcount additions? And in particular, if you look at R&D it looks like it was flat sequentially, but yet you added more than 2,000 people during the quarter. So I'm hoping you can provide some color there. And then secondly can you give us some context just in terms of how you think about the Display business and whether you need more O and O inventory."
},
{
"speaker": "Patrick Pichette",
"text": "I'll answer the first one, and then I'll let Susan answer the second. On headcount, again, as we said on the call, roughly, we have IT for 450 so roughly about 2000 for the quarter, and Larry comment on that. And we -- there's still a huge amount of engineers in that. It just happens that R&D is actually in every line item. So you'll find in many other areas of our P&L. And so you should not worry. We have a complete focus to make sure that we actually have a majority of our hiring that is focused on Engineering, which is really the core of the business and then we continue to kind of -- then you have the mix of sales and then just general overhead. It's really engineering and sales that have been the focus in that sequence. For Display, I'll let Susan talk about it."
},
{
"speaker": "Larry Page",
"text": "I'll just add too in the headcount question. None of the focus there has changed substantially from our past."
},
{
"speaker": "Susan Wojcicki",
"text": "On Display, our biggest O and O property is obviously YouTube. And given the numbers that we saw, we've seen tremendous growth there and a huge opportunity to monetize video as more users come online, and more content lines are being uploaded on YouTube. But the strategy, and our Display strategy overall is dependent not just on O and O. It also has many other components. The first of being to be a platform to enable advertisers and publishers to much more easily buy and sell Display advertising. And then second, to enable all of the sites out there, of which there are of course many, many millions, hundreds of millions of them, for them to be able to monetize and sell display advertising and for us to be able to help them as part of that process and via our network, where we have a lot of different targeting techniques to try to serve the right ad to those users. So really our strategy is part O and O with our sites like YouTube, but then also to continue to build a great network and platform products to that advertisers and publishers across the industry can serve Display advertising."
},
{
"speaker": "Operator",
"text": "And we'll go next to the line of Anthony DiClemente from Barclay's Capital."
},
{
"speaker": "Anthony DiClemente",
"text": "I have one for Patrick and one for Larry. Patrick if you just isolate the 6% sequential growth in cost-per-click versus last quarter, wondering if you could help us understand the driver of that acceleration, and moving forward, should we expect that to continue or moderate, given that as Mobile queries start to take up more of the query mix? And then question for Larry, it would appear that in social media that switching costs for users are high perhaps years of photos on a social network platform. And as you look at Google+ and the growth there, what are the most compelling offsets to those switching costs you think or do you perhaps see a future where folks can simultaneously be a part of multiple social networking platforms?"
},
{
"speaker": "Patrick Pichette",
"text": "So why don't I let Susan actually give you a bit of color on our CPC and evolution, and then Larry will take on the latter, the social one."
},
{
"speaker": "Susan Wojcicki",
"text": "The drivers of CPC, there are few of them. One of them in this quarter was FX, certainly. But we've been really focused on our ads quality improvements, and how do we continue to obviously make our ads better for our users and for our advertisers. And in doing so, we've actually -- we done a lot of optimization of our ads that appear above the search results like site links, some of the ad changes in the formats that we made this quarter, and a lot of the ads that appear above the top search results tend to be higher CPC because they're the first 3 ads. So as we continue to optimize and really drive a lot of the increased click-through and visibility for the ads that appear above the search results, you will see -- since those tend to be higher CPC because they're at the top of the results, you will see some of that increasing."
},
{
"speaker": "Patrick Pichette",
"text": "Larry on sell-through and switching costs?"
},
{
"speaker": "Larry Page",
"text": "I think we've been really excited about Google+ really improving the overall social experience and making it more like how you would share in real-life. And that's really a different product than is out there now. And we're getting just rave reviews for that. People really like being able to share with more discrete groups in an easy way, intuitive way, and there's a lot of magic built into the product that causes that. And as you say, you asked about the photos, we actually have a really great photo experience on the Android. Like if you take a picture on Android and you have Google+ client, which you would have, if you're using it. It uploads your photos automatically, and it's super easy to share them and post-them to your friends, or your family or whatever. It's a really, really great experience. So there is legacy in Google, as a company, believes in users owning their own data and being able to easily move it out of Google. As some of our competitors don't believe in that. We think the users will eventually move to services that are in their best interest and that work really well for them."
},
{
"speaker": "Operator",
"text": "We'll take our final question from Jim Friedland with Cowen and Company."
},
{
"speaker": "James Friedland",
"text": "I wanted to ask a question on -- or follow-up on where you guys said that you're a little ahead of where you expected to be on hiring. Should we think about the hiring and particularly in R&D sort of coming in waves where you hire a bunch of people, get them integrated, it sort of slows down and picks up again? And then the second question and just on the P&L, other cost surviving users of percentage of [indiscernible] TAC seems to be a little high. Is that coming from increased Data Center depreciation or is it may be coming from YouTube and content related costs?"
},
{
"speaker": "Patrick Pichette",
"text": "I'll answer the first one, the latter one, and then I'll let Larry talk about hiring in general. The P&L, yes, it is a combination of factors this quarter. So in that cost is also included headcount. And so headcount is actually increased. Power is increased because of seasonality. It's summer now, so our power is a little higher. And we've also had kind of catch up on expenses on some of the equipment. So there's been a bit of a between Q1 and Q2, there's been a bit of a cleanup in some of the areas of equipment that have actually slightly deflated Q1 and inflated Q2 as we finish the clean up, so that was a bit of a catch up there. So I wouldn't read the data point between Q1 and Q2. Don't create a graph with that, with that line. But it's a bit of everything, including a bit of cleanup and some of the equipment accounts. For the issue of hiring, I'll let Larry actually talk about general where we stand right now."
},
{
"speaker": "Larry Page",
"text": "That's a great question. I think just a couple of factors that affected that and I think you know we implemented compensation changes in Q1. We increased our employee compensation. And they've had even more positive effect on hiring and retention than when we expected. It's been a super successful change. And I think in general this has more excited people who want to work at Google and who want to stay working at Google than we expected. And so that's had some impact on those numbers. Of course there's a limit on how many we can -- and how fast we can productively hire, and I said this in my remark, I think kind of my judgments where at the edge of that piece being reasonable. We're just adding a lot of people. And I'd say that we're always looking for good people, and we're always -- the exact rate is going to depend on success and where we really want to invest in the company. We have a really strong management team. I said that's working together fabulously, and we can absorb those hires and put them to use well. But like I said, we're definitely -- we're surprised that the success of our previous changes around compensation as well."
},
{
"speaker": "Patrick Pichette",
"text": "With that, I just want to thank Larry for joining us today, and Nikesh, and Susan for the comments as well as the Q&A. I want to thank, once again as I always do, all the Googlers out there. Our fantastic Googlers that have made this quarter possible. And all of the innovation, especially I think it's worth mentioning, our Google+ team that has done a phenomenal job in this launch. So 2 thumbs up. So on behalf of all of us here, congratulations and many thanks to all of our gang at Google. With that, I'll let you, Jamie, close the call. And thank you, everybody, for participating today."
},
{
"speaker": "Operator",
"text": "Thank you, sir. That does conclude today's conference. We do appreciate everyone's participation."
}
] | null | null |
GOOGL | 1 | 2,011 | 2011-04-15 16:30:00 | Operator: Good day, and welcome, everyone, to the Google Inc. First Quarter 2011 Earnings Conference Call. [Operator Instructions] At this time, I would like to turn the call over to Jane Penner, Head of Investor Relations. Please go ahead, ma'am.
Jane Penner: Good afternoon, everyone, and welcome to today's First Quarter 2011 Earnings Conference Call. With us are Patrick Pichette, Senior Vice President and Chief Financial Officer; Susan Wojcicki, Senior Vice President, Advertising; Jeff Huber, Senior Vice President, Commerce and Local; Nikesh Arora, Senior Vice President and Chief Business Officer. First, Patrick, Susan and Jeff will provide us with their thoughts on the quarter, after which Nikesh will join the group to answer your questions. Also, as you know, we now distribute our earnings release through our Investor Relations website located at investor.google.com. So please refer to our IR website for our earnings release, as well as supplementary slides that accompany the call. This call is also being webcast from investor.google.com. A replay of the call will be available on our website in a few hours. Now let me quickly cover the Safe Harbor. Some of the statements we make today may be considered forward looking, including statements regarding Google's future and investments in our long-term growth and innovation, the expected performance of our business and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation to revise or publicly release results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures which we use on this call, such as operating income and operating margin, are all also expressed on a non-GAAP basis and have been adjusted to exclude charges relating to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will now turn the call over to Patrick.
Patrick Pichette: Thank you, Jane. Good afternoon, everybody. We just happen to have a surprise visit. Larry is joining us for a few minutes at the beginning of the call and wanted to make a few comments. So before we start officially our call, I just want to welcome Larry. Welcome, Larry.
Larry Page: Thank you, Patrick. It's great to take just a few minutes with all of you. We've had a tremendous quarter, 27% year-over-year revenue growth in Q1. And we're really excited about that, and I think it shows the strength of our business and our continuing -- and the continuing growth really in the tech industry. And it's really still at the beginning from a user perspective. There's tremendous improvements to be had in our core products and our core business, and we're really excited about that. I also wanted to mention a little bit about the management changes. Everything we told you last quarter has happened as we expected. It's all working very well, exactly as we planned. I'll just reiterate that quickly. I'm managing the day-to-day operations of Google as the CEO, working very closely with my team, and I'm really excited about the progress we've had there. I think we really hit the ground running. And Eric, of course, is focused externally, on the government partnerships, government relations and partnership outreaches. And last quarter alone, he was in Germany and Brazil, Argentina and Spain and has been just doing tremendous things for the company. Sergey, as we mentioned, is working very intensively on a few emerging projects for us. As I said, this was all exactly as we planned, and I'm very, very excited about those changes. I'd also mention we've made a number of changes to just simplify our organ, improve our velocity and execution and basically, simplify our reporting structures and such. Now I'm very excited about Google and our momentum and very, very optimistic about our future. I also just wanted to mention we have Jonathan Rosenberg, who's usually done this call, is transitioning out of the company as was announced a while ago. And I really wanted to thank him for all of his insights and hard work and fine communication with all of you. And so we'll clearly miss him, and we really wanted to thank him from the bottom of our hearts. So those are the main things I wanted to say. I'm tremendously excited about all of the things that lay before us as a company. And I also want to say you're in very good hands with the team here, and Patrick who now should take the call away.
Patrick Pichette: Great. Thank you, Larry. Thank you for taking a few minutes in the schedule to just drop in. So what we'll do now is we are back. So we found a phone for the last 30 seconds, and we're going to be back now with the rest of the team to go back to our regular call. So as an overview, I'll be giving you the regular speech. Susan and Jeff will give you color comments as well in the product area, as well as the monetization side. And Nikesh is with us so that when we go through Q&A, he'll be answer to give you a lot more color commentary in some areas. Look, we're nothing but very, very excited about our reporting 27% year-over-year revenue growth in Q1. This 27% proves really the logic behind our strategy, not only to invest heavily in our core Search business and Ads but also in our new emerging businesses like Display, like Mobile, like Enterprise. From an investment perspective, our Q1 results don't only show our continued commitment to invest in hiring, in marketing and in the other areas, but they also -- as you can see through our expenses, they reflect, for the first time, the full impact of the compensation changes we announced in Q4, the 10% salary increase. Google is clearly benefiting from and is also fueling the unrelenting pace of the digital economy that's around us. And it's growth that we believe will benefit both Google but in fact, the entire ecosystem for a long time to come. So let's turn to the specifics of our performance for the quarter. Gross revenue, as we mentioned already, 27% to $8.6 billion and interestingly, 2% quarter-over-quarter. To put this in context, this is quite remarkable if you think that Q4 was an amazingly strong quarter. And in fact, it adds also the impact of the Nexus One from Q1 of last year and to a lesser extent, the events that have occurred in Japan. So Google website's revenue was up 32% year-over-year, $5.9 billion, with strength across all major geographies and verticals. The Google Network revenue was up 19% year-over-year to $2.4 billion. That Network revenue was negatively impacted by two things, the loss of a Search distribution partnership deal and also, what has been broadly communicated, by Search quality improvement made during the quarter. Regarding the Search quality improvement, remember that we regularly make such trade-offs. We really believe that the quality improvements that benefit the user always serves us well both in the short term and in the mid term in terms of revenue. So Jeff will cover that in more detail in the coming minutes. Other revenue was down 10% year-over-year to $269 million. And note that in Q1 of 2010 was the first quarter that we'd booked Nexus One revenues, and this is what drives the year-over-year decline. Global aggregate paid click gross -- that's my tongue twister for every quarter. It was very strong again, up 18% year-over-year, interestingly, 4% up also quarter-over-quarter and again, reflecting the accelerated shift of off-line to online. Aggregate cost-per-click growth was also quite healthy, up 8% and only 1% down quarter-over-quarter. And you should all know that the FX had a pretty neutral effect on CPC growth year-over-year and quarter-over-quarter. Remember too that that's an aggregate number and includes both google.com and our AdSense properties. So now turning to our geographic performance, the U.S. and the rest of world are both growing at a very healthy pace, and our results reflect that. The U.K. continues to lag a bit because of its global economic recovery, the pace of its -- the recovery. Revenue from the U.S. was up 25% year-over-year to $4 billion. In our earnings slides you can find on our Investor Relations website, you will see that we have broken down our revenue by U.S., U.K. and rest of world to show the impact of FX and the benefit of our hedging program. So please refer to those slides for the exact calculations. International revenue accounted for 53% of our total revenue or $4.6 billion, and it was up 28% year-over-year. It includes a $14 million benefit from our hedging program, and that compares to a $10 million benefit of Q1 of last year. If we use a fixed exchange rate, our international revenue would have been roughly $23 million lower year-over-year. Also, it's worth noting that the tragedy in Japan somewhat negatively impacted our international revenue in Q1. And as I mentioned earlier, the U.K. was up 15% year-over-year to $969 million as the country continues to experience struggling economy. But even that 15% is really 17% in FX adjusted basis. Let me turn to expenses. Traffic acquisition costs were $2.0 billion or 25% of total advertising revenue. Our other cost of revenue, $897 million, including stock-based compensation of $49 million. And finally, all operating expenses totaled $2.8 billion, including approximately $383 million in stock-based compensation. The increase year-over-year in OpEx, primarily due to payroll, increased advertising and promotional spend and some other professional services. So a result of all these expenses, our non-GAAP operating profit, which excludes the stock-based compensation, was $3.2 billion in Q1 of this year, resulting in a non-GAAP operating margin of 37.6%. Headcount was up approximately 1,900 people from Q4, ending the quarter with 26,316 full-time employees. Our effective tax rate was 21% roughly. The exact number is 20.5%. Let we now turn to cash management. Our other income and expenses was $96 million for Q1, in fact, a very solid performance from our portfolio management. And unfortunately, just masked by the impact of our higher hedging expenses associated with our SFAS 133, the accounting of which we know is quite volatile from quarter to quarter. So for more details on OI&E, please again refer to the slides that accompany our call on our IR site. Operating cash flow, very strong, $3.2 billion. CapEx for the quarter, $890 million, significantly below last quarter of $2.5 billion. And remember that last quarter, that increase was largely due to our purchase of the New York City office. Majority of CapEx spend in Q1 was related to facilities, expenses and data center operations. In the facility space, we spent -- was really driven by the purchase of two buildings, one in Dublin and one in Paris. Just as a reminder, we continue to make significant CapEx investments, and we've shown those to be lumpy from quarter to quarter depending on when we're able to make such investments. Obviously, we're pleased with our free cash flow, which was $2.3 billion for the quarter. As I said earlier, our accelerating growth trajectory, it really shows our confidence to expand across products and geographies. Roughly 18 months ago, we began communicating how we were really optimistic about our opportunities, and we had the business confidence to invest heavily in the next phase of innovation and revenue generation. Well, our product innovation over the last 18 months has been nothing short but extraordinary. Let's take a look at this. We have built from scratch the world's most popular smartphone operating system. We've built also from scratch the world's fastest growing browser. And in some countries like India, one in four people are now accessing the web via Chrome. We've reinvented display advertising, creating not only a business but an entire ecosystem with a $2.5 billion annual run rate as of Q3 of last year. We've pushed the frontier of mobile search, creating a whole new search segment that is adding to our overall search volume and brand new monetization opportunities. We've seen YouTube develop into a platform, a win-win platform in fact, where partners can generate significant revenue from their content and users watch 2 billion views a day. And our revenue growth clearly shows the wisdom of those decisions to fuel our growth ahead of the curve. So the facts speak [ph] from the sales really. The second half of 2010, we grew roughly 25% year-over-year. But even more telling, this quarter, growth rate of 27% compared to a comp of 23% just a year ago. We are building multibillion dollar businesses, and we're confident that now is the time to invest. It's with this optimism that we'll continue to do so aggressively but with discipline, with strong focus on fueling the winning products. From an expense point of view, we're taking some bold steps but always with good strategic rationale in mind and discipline in mind. So as our Q1 results continue to reflect some marketing -- you've heard of our marketing going up. It's a very deliberate choice as an example. We have laid, made very specific focus on Chrome, customer and advertiser acquisition in the U.S. and international markets. And in both cases, we're seeing the fruits of these investments. The same is true for our labor strategy. And finally, we continue to invest in our long-term infrastructure. So now let me turn it over to Jeff and Susan to provide you more details on the products that are the engine of both our growth and our optimism. They'll also provide you more details on where we're deploying some of these additional resources as they're coming on board. So with that, I'll turn it over to Jeff.
Jeffrey Huber: Thanks, Patrick, and hi, everyone. In his comments, Patrick mentioned our ambitious hiring this quarter, which was by design. We announced in January, with a blog post to help energize recruiting, that 2011 will be the biggest hiring year in our history, topping the 6,000 people we hired in 2007. And we ended up hiring 1,900 people this quarter. We're very happy about this, because we feel this is a very good time to invest. We look at the factors like our revenue growth and how well our core and growing businesses are doing and say to ourselves, "Who wouldn't want to invest in this business?" So that's what we're doing, hiring great people to invest in the future. In fact, over half the Newglers who joined this quarter are going to be working in high potential and revenue growth areas like YouTube, Mobile, Chrome, commerce and local and Enterprise. So that's what Susan and I are going to talk about today. We'll give you an update on our core business of Search and Ads, as well as these businesses where we're investing. Susan will cover our Ads products, Search Ads, Mobile Ads, local Ads, Display Ads and YouTube, and I'll talk about Search, Android, Chrome and Enterprise. So let's jump in with Search. Search is the most important thing people do online, and there's loads of opportunities to make Search more intelligent and more personal. Intelligent, as in better quality. Our primary focus is to always create the best user experience. So this quarter, we launched over 90 different quality improvements. Most notably, we made an important change to our ranking algorithms to promote higher-quality sites. This noticeably impacted about 12% of our -- of all queries, and it's done a good job. We found it addressed over 80% of the sites that users reported as a poor experience via a Chrome feature we introduced a while ago. This change did have an adverse impact on revenues for some sites in our Display Network, but we've continually found improving Search results and our users' experience is always the best thing to do in the long run and for long-term value. Personal, as in building around people. We improved social search this quarter, making it easier to find information and recommendations from the people that matter to you, whether they're publishing on YouTube or Flickr or their own blog or website. We also launched the +1 button, which makes it easy to share recommendations with the world via Google Search results. And this is just the beginning. We've got lots more useful and relevant social search features coming soon. A lot more of our searches are coming from mobile devices. This traffic has gone up more than 500% in the last two years. Android is obviously a big driver of this. We're activating over 350,000 Android devices every day. Android market is taking off too, over 3 billion apps have been installed, up 50% in just the last quarter. You can now access the market online. Try it at market.android.com so you can shop and browse for apps from your computer, click the purchase, and they just magically show up in your device. We also recently launched In-app Billing, which has been very enthusiastically received and which gives developers more ways to make money from their hard work. Another product and it's doing very well is Chrome. Chrome users are very valuable to Google. And as we've said in past quarters, we're investing in Chrome marketing. The payoff is worth it. We have over 120 million daily users, over 40% of whom we added in the past year as a result of our marketing efforts. The Chrome OS program is also going well, and we look forward to launching devices with our partners later this year. Our Enterprise business is growing across both businesses and schools. As example, this quarter, we deployed Google Apps at InterContinental Hotel Groups and RR Donnelley; signed a reseller agreement with Optus, which is the largest -- second largest telco in Australia; and signed up the University of Texas and Boston University. We were pleased that our deal with ITA Software was approved by the DOJ last week and closed this week. Travel searches in the area with lots of potential for innovation, both for end users and as a platform for the industry. We're looking forward to bringing the ITA team on board and doing great things together. That wraps up my remarks. But before I turn it over to Susan, I just want to take a moment to thank Jonathan Rosenberg, who has been a regular on these calls, for all he's done for Google. Jonathan and I have been friends and colleagues for over 15 years. And on behalf of myself and Susan, who also worked closely with Jonathan for the last nine years, I can assure all of you that he will be missed. Over to you, Susan.
Susan Wojcicki: Thank you, Jeff. Hi, everyone. So there are a lot of things to be excited about in our Ads business, and I'd like to share a few updates from the quarter in Search, Display and Mobile Ads. Search is still our core business. And even though it's a really large business, we see a significant opportunity for growth, as Larry mentioned. One of the things that we've been focusing on is thinking about how we can serve the most perfect ad for every query. A query for a product will require a very different kind of ad than a query about a movie. And in order to do this, we are enabling new creative types and new ways for advertisers to set up their campaigns. One example of this is Product Listing Ads, which we released to U.S. advertisers in Q4. If you're a retailer and have hundreds of thousands of SKUs, it's hard to set up the separate creative for each one of those. So product listing ads automatically creates ads from product feeds rather than from keywords. Then a retailer can run a unique ad for every product without doing any extra work. We're seeing great advertiser adoption, and about half of the largest retailers in the U.S. are now running these ads. If you do a search for soccer cleats, something I'm thinking about buying for my daughter, you can see some of these on the right-hand side. The ads include pictures and prices. That's something you'd want to see if you're going to buy something. The ads are really effective too. They're about twice the click-through of standard text ads in the same location. This quarter, we also launched a much richer ad format for more brand-focused advertisers, and we're calling this format Media Ads, because we're starting with the movie and entertainment advertisers, but we think this format will work for all types of brand advertisers on Search as well. These creatives can include images or videos, and in the case of the movie studios, it will include a movie trailer. Again, there are no keywords, and Google figures out the right queries to serve the ad. To see one of these ads, try searching for the movie Water for Elephants. If you are searching for a movie and the movie -- and you wind up seeing the movie trailer in the ad, we're getting you a lot closer to seeing the perfect ad. So as you can see, there's a lot of opportunity for more innovation within Search Ads. I'd like to move on to Display right now. I'm very proud of how well our Display business has been growing. We bought DoubleClick three years ago. We've done a lot of integration together. And as a result, we've seen a lot of progress. Our Google Display Network is up 5x since acquisition, and we've been doubling annually in several of our key markets, like the U.K., Brazil and Japan. Now most Display advertisers can be bucketed in one of two categories. They can think about themselves as being performance oriented, where they value conversions and clicks or more brand oriented, where they're focused on raising awareness. Last quarter, we started to develop some features for brand advertisers. We had launched Google Display Network reserve, which gives advertisers ability to buy premium inventory on a guaranteed basis, which is how brand advertisers are telling us they want to buy the inventory. We are also giving advertisers tools that help them measure the impact of their campaigns on things like brand lift rather than just clicks and conversions. Our Ad Exchange, which we've been focused on building a unified buying platform so that advertisers and agencies can buy the exact audiences they want across the Internet. The transaction volume on the Ad Exchange has tripled in the past year, and 2/3 of that inventory is being bought via real-time bidding, which is a new technology to enable much more programmatic and scientific ad buying. It also results in better ads for users and gets us closer again to serving the more perfect ad. YouTube is another part of our Display strategy. Revenue is doubling year-over-year, and we share that revenue with over 20,000 content partners. We're starting to see a virtuous cycle. The more money we make for our content partners, the more engaging content they upload. So as you can see, there's been a lot of nice progress in Display due to the results of a lot of people at Google. Moving on to Mobile, we're seeing growth this year really taking off. AdMob, the display network that we acquired last year, has over 150 million iOS and Android devices making requests per month. That's up 50% in the past four months, which gives you an idea of how fast Mobile Display advertising is growing. Many of our advertisers are starting to run mobile-only campaigns as opposed to bundling it with their desktop campaigns. It enables advertisers to move to much more customized mobile experiences. They'll have mobile landing pages and campaigns that can incorporate location. For example, how far away is the advertiser from where you are standing right now? These custom-made stations, again, get us to the perfect ad on Mobile, since users also want to have location, or they want to have phone number. We're also seeing Click-to-Call taking off with more than half a million advertisers using these features. As a result, the mobile-only campaigns are seeing an increase of 11.5% when they run a mobile-only campaign as opposed to a bundled mobile-desktop. So these are just a few of the examples and the opportunity that we see in Mobile. And this overview is just a few and a small set of the many, many projects that we are investing in across that. Now back to Patrick.
Patrick Pichette: Thank you, Susan. Thank you, Susan and Jeff for this comprehensive look at what's going on our core -- across our core products. What I suggest we do now is we turn it back to Jay to give us the instructions on how to get to the Q&A and just jump in right into the Q&A, if you don't mind.
Operator: [Operator Instructions] We'll go first to Spencer Wang with Crédit Suisse.
Spencer Wang: So question on spending for Patrick. I think OpEx, excluding tax, was up something like 45% year-over-year. So is this the type of spending that you think will be required to sustain a high-20% revenue growth going forward? Or is this more reflective of near-term investment to support some of the growth initiative you've talked about and spending tapers off at some point in the future?
Patrick Pichette: But there is clearly the effect of the one-time salary change for this quarter that is flowing through. And in fact, in the increase in salaries, what you have is a triple effect this quarter specifically, right? Everybody at Google got a 10% salary increase. In addition to that, because it's the beginning of the year, the salary increases flow through to many of the benefits, like the 401(k)s and the vacation accruals. So many of the resets that are done in the first quarter are disproportionate in additional kind of flow-through costs. And then finally, we have new Googlers. And the Newglers, I think Jeff made a really good compelling case to explain why we're hiring them and then how we distribute them. So on the labor side, you clearly have a one-time step change, but after that, we're going to continue to be in our regular momentum. In other areas, if I take marketing, for example, marketing has increased through last year, because we see the great returns. And so for marketing, specifically, we continue to -- we don't expect to slow down our marketing, because it is proving such a kind of attractive set of returns both for customer acquisition and for key, key products, like Chrome. So for those, we're actually going to continue our momentum on them. In many areas of the company, we continue to be -- in like most areas, continue to be incredibly disciplined. People have to show up every 90 days to complete a OCQ process, where we do quarterly reviews to get your next chance [ph] for funding. I mean, the discipline of the company has not changed. We're just really bullish on our prospects.
Operator: We'll go next to James Mitchell with Goldman Sachs.
James Mitchell: If I could follow-up with a couple of questions around expenses. And I'll say, we're having some issues downloading the presentation slides, so it'd be great if you could repost them at some point. But first of all, Patrick, you mentioned in your discussion of OpEx there were some other professional expenses in the first quarter. Was that a reference to legal costs or other things? And then secondly, when we look at the substantial marketing spending around Chrome, is that like a short-term campaign or more of a forever wall? And could you talk about what are the strategic benefits to Google of consumers adopting the Chrome browser?
Patrick Pichette: Okay. So let me start with just the professional services and then I'll let Nikesh give you a context of Chrome as well. So for OpEx, it's a number of areas. We're pushing -- right now, we're pushing hard on a few areas including the GEO product, where we're doing a lot of the mapping worldwide. So at the beginning of the year, we just kind of ramped up a number in there. We also have a couple of other areas. We do have slightly more legal expense as well. But also, real estate is the third component, where because of the Googlers coming on board, we just need more services to support those Googlers. So that's the highest level answer for professional services. And for Chrome, if -- let me give you just a 10-second umbrella and then I'll let Nikesh give you more color commentary. There's really a two story on Chrome. And there's a tactical question, and there's a strategic question. Chrome is really pushing the web, and it has a fantastic opportunity that when people have adopted Chrome, right, they basically -- instead of looking for Google and looking for Search, the Omnibox gives them immediate access to Google Searches. So from a strategic perspective, it has that in Chrome OS. And a tactical basis, right, everybody that uses Chrome, right, is a guaranteed locked in user for us in terms of having access to Google. So maybe, Nikesh, if you have more additional comments on the performance of the marketing.
Nikesh Arora: Thanks, Patrick. Just to add to that, I think as Jeff mentioned we have over 120 million daily users, and 40% of them were added in the past year as a result of our marketing efforts. So we've seen the 30% growth quarter-over-quarter in our Chrome usage. So I think from all perspectives, the Chrome strategy is working. And the way we distribute Chrome is people get it organically. Or they get it based on our marketing efforts. Or they see our marketing, and they choose to download it. Or we work with partners who help us promote Chrome to our users and to other users. So in that context, we found that marketing very often ends up with an equivalent or better ROI than us having to go do partnership deals. Sometimes you'll see that our tax and our marketing around Chrome is fungible, where we spend money in marketing we take away from tax as it relates to Chrome. So you can expect us to continue to drive Chrome strategically, because it has not just a Chrome-specific benefit for us, but it also impacts many of our other products that work as part of Chrome. So the lifetime value of a Chrome user is phenomenal.
Operator: We'll go next to Ben Schachter with Macquarie.
Benjamin Schachter: I was wondering if you could give us, from a high level, the view of how Larry views this company differently today, or how we should view it differently given Larry's position. Is it going to change in any meaningful way?
Patrick Pichette: In short, look, I think that the company's position has not changed. Google is a technology company focused on users and looking for products that can affect billions of people. So the very first lens that you have to think through when you think of Google is are we developing computer science helping finding answers to problems where billions of people can be served. If you think that way, right, Chrome makes sense. Android makes sense. Search makes sense. All these things are the fundamentals of the company. From there, there's very clear that -- again, to paraphrase an old saying of ours, right, the 70/20/10 is very much alive and well. Search is the next billion-dollar business. Never forget it. Every quarter you've heard this time, right? 90% kind of improvement on one side 40% on the other. And like, that's one a day, right? That's a lot of engineering work to keep ahead of the -- but these are the next billion-dollar businesses. It's in its infancy and so are two or three other of our key products, which include Mobile, Display, Enterprise. So -- and then the 10%, well, it's commerce, right? It's local that we all know is nascent. It's social that we know also is nascent. And so the strategy the company is continuing to be in the same core lenses, building same products that serve billions of people and to make multibillion-dollar businesses in the waist up.
Benjamin Schachter: Sure. If I could just follow-up briefly. I was really trying to get more at the financial model of the company, if there's any meaningful difference now that Larry is in this different position. Do you and does he think about the financial model in a different way than we had previously?
Patrick Pichette: No. Build great products and then same financial discipline.
Operator: We'll go next to Ross Sandler with RBC Capital Markets.
Ross Sandler: Yes. I hate to beat the dead horse on the operating expense, but just one more follow-up question on that. You guys have stated that a lot of the operating expense uptick has been related to customer acquisition in Chrome, and I know there's some salespeople that have been added to the platform. But if you were making these investments, do you feel that your high-20% year-on-year growth rate would be achievable? Or do you think these OpEx additions are going to be additive in future periods kind of four, six, eight quarters down the road?
Patrick Pichette: I think that you have to look at the strategy. You have to take a look at the strategy in the context of the last four or five quarters, right? Have increased in OpEx, but when you look at our trajectory of revenue growth, right, going from 23% to 24% to 25% to 27% this quarter, we are really funding and accelerating with discipline our revenue growth. That is the fundamental. If we don't see a great ROI, you won't see us spending the money. We just happen to have great opportunities to fuel. Why not carpe diem now? It's there to take. That's really the mindset we put at it.
Ross Sandler: And just one other follow-up on that. So the IV came out and said that the display marketplace in the U.S. is around $10 billion. So if we double that and say global display is $20 billion, you guys would be a little bit north of 10% on a run rate basis of the global display. How big can that business be? And can you talk about as Display becomes a bigger percentage of total revenue, what that has -- what impact that has on your overall operating margin just from that mix shift basis?
Patrick Pichette: Okay, so let me start with the latter and then I'll let Nikesh talk about the former. Clearly, Search is a unique product that has very, very high margin, right? Because Display is more complex -- there's more paperwork involved even today with Display. It's a somewhat lower margin. It's still a great margin product, and it's a product that because of the -- it's still a very good margin product. And so all those dollars I want from an operating margin point of view. So there is no way we would let that -- and there's a great symbiotic relationship between Display. As take Susan's example, right? What was a pure Display Ad before is now embedded in Search. So the symbiotic relationship is very important as well. As to the total size of the market, I'll let Nikesh give you some color commentary.
Nikesh Arora: Thanks, Patrick. I think it's important to look at the advertising market for Display in the context of the overall advertising market, which is a $600 billion to $700 billion market globally. And you can go back and say five years ago that Display was sort of stalled around $15 billion to $16 billion as the market, because we didn't have video in the mix. Now with video, everything changes. We have been recently doing some campaign in the U.K., where we tried to do some efficiency, YouTube versus television. And we found YouTube helps people reach 20% to 24% more consumers in a target segment. And you can do that in a dispersed manner. You don't have to buy one ad, which 20 million people look at. You can do that on a literally user by user basis. So you are seeing the efficiency of the web applied to video, which is going to change the way the entire display market functions. And all of our efforts in the last two or three years have been towards targeting that market, whether it's all our acquisition in the technology side, whether it's all of our efforts in trying to create a multiproduct sales force across 50 different countries around the world. We are getting ourselves to be able to sell Display with special emphasis on rich media and video, which is going to help us sort of make that a relevant space in Google. As far as -- Patrick answered the margin question. But from my perspective, I'm told that every profitable dollar or revenue is good.
Operator: We'll go next to Justin Post with Bank of America Merrill Lynch.
Justin Post: Could we talk about Google's access to social data? Obviously, you're not running a major social network in some geographies. What's your experience there? And do you think having access to social data is going to be important for having the best query results on the web when you look out three to five years?
Jeffrey Huber: This is Jeff. We do see social as very important. Google uses well over 200 signals in terms of how we think about ranking today. And when we think about identity and relationships, those are our key signals that can and should be integrated in the experience. So it is important, but it's one of the many that we use. In terms of assets that apply to that, we do have a very, very large number of users coming to our door every day. A considerable percentage of them are logged-in users that are using multiple of our products. So there is a large variety of signals that we'll be able to use with user support and users seeing value from it to make the overall experience better.
Patrick Pichette: I think it's worth -- just in closing, you've all heard of the launch of +1 a couple of days ago or a couple of weeks ago. And it's, again, a commitment from us to get every signal we can to give the best answer for the users. So you should expect continued focus on social as one of the 200 signals and just get this rich as possible of an answer across the board.
Justin Post: Patrick, if I could do a follow-up. Does Chrome give you any signals that you can use and integrate into your Search results?
Patrick Pichette: Maybe Jeff would know the better answer of that, if Chrome gives us additional signals on social or other types of signals.
Jeffrey Huber: So Chrome we think will be part of the story over time. Chrome does have features where it is personalized today. And for example, the Chrome experience, you can essentially sign into Chrome, and it will synchronize all of your information across different instances across different computers. So that is information that, again, with user engagement and users seeing value from it, that could be useful.
Operator: We'll go next to Mark Mahaney with Citi.
Mark Mahaney: Two questions. First, Patrick, you talked about taking bold steps to address expenses. It's just not obvious in the P&L results. So can you give us any examples of what those bold steps are? And then secondly, I know you're talking about social being one of several hundred signals, but is there any way to indicate that -- evidence you've seen so far that indicates that it's materially greater than those other variables or just as important but no more important than the other variables?
Patrick Pichette: Okay. So one -- on the issue of expenses, what you see is the ramp-up on one side, but I can guarantee you, because we have gone through the planning process for this year, that everybody that has a cost center has to demonstrate productivity. So in the case of data centers, there's productivity requirements that are actually incredibly steep. In the case of the sales force, Nikesh could give you kind of a great set of examples that his productivity, right? Is kind of -- think of it as, in his case, cost per revenue dollar. In the case of [indiscernible] (43:00), it's cost per bps and cost of storage. In the case of all staff functions, whether it be in legal, whether it be in real estate, whether it be in cost of food, whether it be cost of transportation, every one of them are expected to have a productivity curve. So in this fast-growing business -- like Google is growing, like, from a base of revenue of roughly $8 billion, 25% year-over-year. That's $2 billion of revenue. And so from that perspective, you have a tide coming with it. But under that tide, I can tell you every element of the company is scrubbed and scrutinized. So I would -- I just want to give comfort to our shareholders that there is these quarterly review processes. And these annual unit cost continue to kind of haunt many of my managers that when they come to my office. On the signaling portion of it, Jeff probably can give more color commentary about social versus others.
Jeffrey Huber: So as mentioned, it is one of the signals among many that we have. We are very optimistic that we'll be able to do great things with better social signals over time. At this point, it's a little early to tell, but we regularly measure and tune. So we'll be looking forward to that as the experiments continue.
Patrick Pichette: I know that for our shareholders and many analysts on the call, it is top of mind for people, when we grow our expenses in the way we have, to ask that question. So Mark, I just want to thank you, because it lays -- it gave me the opportunity to lay the ground clear on these issues.
Operator: Our next question comes from Brian Pitz with UBS.
Brian Pitz: Could you provide any color on the impacts to the user experience from the recent Panda changes? Has it impacted click-throughs or CPCs on the paid ad side? And then in terms of the overall online display industry, would you differentiate between drivers? Do you think more impactful ad units are driving growth? Or is it more complex data and algorithms and more granular targeting?
Jeffrey Huber: I'll start with the experience of the changes that we've made to improve overall quality and promote high-quality sites. I had mentioned in my comments that on the order of 12% of queries, we're positively affected in our view. And that's in terms of our changes that is a pretty significant change that has that scope. And we felt very good or confident in it, because we were able to measure against the feedback loop that we had of user-reported sites that they found that weren't as great of an experience. Just to confirm, it was web search only, not ads. It didn't have any material measurable impact in search ads in either CPC or CTR. We did mention that there was some effect on the display network of sites that were essentially the receivers of some of those clicks previously, but our focus is, again, overall on the user experience, the best possible user experience and long-term value. I'll turn it over to Susan on the balance of the questions around the Display Network.
Patrick Pichette: Can you, Brian, give us -- repeat the question for the second piece?
Brian Pitz: Yes. The second piece was in terms of overall online display industry, would you guys differentiate between -- do you think more impactful ad units will be driving growth? Or is it more complex data, more complex algorithms and more granular targeting?
Susan Wojcicki: Sure. So this is Susan. I'm happy to answer that one. I think in Display -- I mean, what I see happening right now with Display is that we're really at a point where there's ability to buy audiences and to do much more specific targeting than there ever was in the past. We also have much better tools in order to do that and better formats. So I think the combination of all of these things over time will enable us to have better ads and have them much more targeted at the right users. So that's really a combination across all of them. It is important to note that really -- like one thing that distinguishes our Display strategy is that we are focused on building an end-to-end platform to enable buying across the Internet for all advertisers and for all publishers. And we believe that if we do that and if we do that efficiently, that there will be a lot more dollars that will move over, as Nikesh mentioned, from off-line to online, which is where the users are moving. And so we just need to make sure that the systems and the technology can support that.
Patrick Pichette: Just to reemphasize, just that last point from Susan, there are properties that are going to be kind of tuned to Display, right? It's true for YouTube. It's true -- but the ecosystem itself of the entire web is so much more powerful, and that's why we have the strategy we have.
Operator: We'll go next to Scott Devitt with Morgan Stanley.
Scott Devitt: Two questions, please. The first one, was just wondering if tablet operating share is important to Google as smartphone share. And given Apple's different lower margin pricing strategy on tablets, how Google plans to influence market share in that category. And then just one follow up.
Patrick Pichette: Sure. Jeff, comments on tablet versus smartphones versus PCs.
Jeffrey Huber: Yes. This is Jeff. Tablets are doing very well. There's certainly been a lot of growth in that segment. And in terms of its dynamics, there are some interesting properties where it's really a hybrid between a mobile device and a desktop when you look at user behavior and the kind of things that they're doing with it. So it sort of falls between the two of those. We are very optimistic. Android has some great products coming along. We have the Honeycomb operating system that is developed specifically for tablet application. The Motorola XOOM is the first device that's come along, runs on Motorola now. It was the product of the show at the Consumer Electronics Show in January. I think you'll see a lot of other products coming along and a lot of innovation in the market around tablets and that format. We have also introduced, just jumping into Ads for a little bit, recently, a feature where we can enable advertisers to specifically target tablet devices, which we think will also help that segment.
Scott Devitt: And then secondly, just to the extent that employee bonuses may be partially tied to your social efforts, just wondering if you could define success in that area.
Patrick Pichette: I think what we're going to do is because this is an internal matter -- I mean, the key message that I'd like to leave with everybody is, right, we focus, as we said, across the strategy and across many platforms. We wanted to signal to the employees that social is clearly a signal that is worth investing in, and that's why we've made the decision. But we wouldn't comment further on that.
Operator: Our next question comes from Jeetil Patel with Deutsche Bank Securities.
Jeetil Patel: Two questions. When we talk to a lot of your shareholders, I think the general view is that Search is such a great business and a phenomenal asset. However, it seems like at the same time, there seems to be kind of a growing concern that engagement seems to be a bigger theme that seems to be winning out of this industry, whether it be from smaller companies that have unique products or just different approaches in the marketplace. I'm curious, have you guys looked at the 70/20/10 approach to the business and rethought maybe the allocation should be shifted a bit towards building greater engagement in the business, try to maybe kind of look at how other products and services can be integrated in? I guess, that's question number one. I have a quick follow up.
Patrick Pichette: Let me give you a mega answer related to that, which is if you think of the web in general and how the platforms are growing, right, we would argue that where we're focusing our investment is in areas where -- yes, engagement matters. But if you think of where we're putting emphasis in local, for example or in Mobile, for example or for YouTube, for example, right, all of these areas are all about engagement and their engagement between advertisers and small, medium businesses and their customers that are walking down the street and then adding more signals to the quality of their restaurant experience they had or otherwise. It's true for YouTube, with so much more different kind of either lean back, with kind of chatting and giving kind of ratings. And every one of our products has just naturally evolved. And then with -- again, with Mobile and same thing with Chrome, we see many of these areas. Engagement is another element of the strategy that's kind of pervasive across, but the technology themselves also fuel that. So it's kind of a symbiotic relationship between the two. So at the highest level, Search itself is so much more engaged today than it was three years ago and will be even more engaged in the coming three years. So it's absolutely part of the fabric of the strategy we have.
Jeetil Patel: It sounds like we may be missing it in that it's engagement through frequency of services utilized through everyday life as a consumer as of the, say, engagement through just a share of time over one continuous spectrum.
Patrick Pichette: Well, you have it across -- like, when you're in YouTube, right, the question is are you spending more minutes of your day actually on YouTube, and that's opportunities for engagement. When you're with your Android phone and you're actually living down the street, and you're now in town, your engagement opportunities, both in terms of the product that you use and the engagement of the additional signals that you get with sharing with your friends or otherwise, right, continue to fuel it. But absolutely, the core platforms that we have in place will have that as a core element.
Jeetil Patel: So this Chrome -- just a quick question on Chrome. But do you -- does that give you the potential to create unique products inside of Chrome, such as obviously, folding in apps from Google, as well as creating digital content services within the Chrome environment?
Jeffrey Huber: Yes. This is Jeff. There is great opportunity in Chrome. You start to see the beginnings of that, in that we launched a capability a while ago called the Chrome Web Store, which is bringing the same kind of model that we have with Android Market to that platform. And there's a tremendous amount of innovation that is happening on the web as a platform that we think Chrome will be able to take advantage of and be the best on ramp for.
Operator: Our next question comes from Jason Maynard with Wells Fargo.
Jason Maynard: I have two questions. First, on the Mobile opportunity. What do you think a Mobile user is approximately worth today on an annual basis? And where do you think that can trend as you bring in more local and commerce capabilities? And then real quick, second for Patrick, how should investors think about the financial parameters around potentially larger acquisitions? I'm not talking about the little tech-in type of deals, but if you -- as Google maybe contemplates some bigger type of company purchases, if you will.
Patrick Pichette: Great. Who wants to tackle Mobile? Jeff?
Jeffrey Huber: Yes. So in terms of the specifically quantifying the value of a Mobile user today, that's not something that I can comment on specifically as of how we're valuing them. That said, if you look at the kind of investment which we're making, if you look at the focus of the organization, it is something that we're very, very excited about. And I think that there is great potential there. And if you look at some of just the monetization side of it, there's things that we've done around Click-to-Call ads, if you think about very locally targeted ads that is a capability of our platform. The ability to engage users where they're at with commercial opportunities, it's tremendous overall. So we think that's great. In terms of where it trends over time, increasingly the smartphone is becoming an extension of the person. It becomes how they do everything, how they communicate, how they're entertained, how they're informed. So we think that there will be convergence over time between the phone or mobile device and other behavior that people are historically familiar with.
Jason Maynard: Is there an order of -- if I can maybe follow up on that. Is there an order of magnitude that you think can take place from today versus, say, three years from now without maybe giving specific numbers?
Susan Wojcicki: Hi, this is Susan. I'm going to answer that one. I mean, I -- one way I would think about that, if I think we're still very, very early on in what Mobile can do. But I do think that Mobile will bring completely new ways that we will be interacting with merchants, with advertisers, with our friends over time, and the value of those transactions can be very valuable. But I think what it will actually do is it will grow the overall opportunity, the overall pie and enables us to interact in new ways. So it's hard at this point to really estimate how that will change over time other than we think it's going to grow a lot and that there will be new models that we don't have today.
Patrick Pichette: Yes. So you -- to summarize these two thoughts together, without like really any radical effort -- let me take the case for Android. That is the platform that enabled so much of it. We already announced at the end of Q3 that this was $1 billion run rate business, and we tripped into it with people kind of adapting what was desktop onto Mobile that was clunky. And it's growing at an amazing, blazingly pace in terms of usage. So what you do know is the combination of -- if you think of the areas of Search, of local, of commerce, of entertainment and just on Mobile, just -- we tripped into $1 billion. It just gives you the sense of momentum for the opportunities ahead of us, and that's why we have the focus areas that we have. So that's why we're so optimistic about Mobile. Now Jason, if I circle back to your financial parameters for larger acquisitions, we're quite disciplined, and we've made that comment many times about acquisitions in general at Google. And we have a quadrant in which we operate, where you're looking for the perfect mix between intellectual properties of great code, a great team and great products at a price that we can afford that we think makes strategic sense. So many of -- like, you hear of all the stories of the acquisitions we make. What you don't hear is all the acquisitions that we actually refuse, because they just don't pass our bar. In the case of large transformative ones, we look at them all the time, right? If we had one that actually made sense to finally accelerate a big piece of our agenda, we would do it. We just have not found one yet. And so we'll continue to look at it. We have the position to be able to jump and make big acquisitions. We just want to make sure that we don't have distractions. We have a very focused agenda, and you have to have a really good fit, because big acquisitions can be a massive distraction for Google. Google has a specific culture. It's quite a unique culture. And in that context, we want to make sure that if we were ever to make a large acquisition, it would have to pass a double bar of not only strategic, financial sense, but in addition to that, that it wouldn't become a distraction to the company but in fact, accelerate it. That's a pretty high bar to pass.
Operator: Our next question comes from Jason Helfstein from Oppenheimer.
Jason Helfstein: Two questions. One for Susan and then kind of a bigger picture question. So when we think about the company's ability to grow into local, how important is a local sales force? And are we starting to see the impact of adding local sales people on the expenses? And then secondly, the reorganization, as far as under Larry, based on kind of product would make sense, particularly where we all believe the Internet's going, when we think about, however, like if I look on your Google products page, right? There are just still an enormous amount of products the company offers, albeit revenue is generally concentrated in a few of those products, do you think we'll see a streamlining of products available under the new kind of reorganization?
Patrick Pichette: So I'll let Nikesh talk about the local area, where on the sales side, he's been kind of spearheading activities. And then I'll give you a conversation about the org issues.
Nikesh Arora: Hi. I guess it's important to understand that with millions of advertisers who we service through our various advertising products, we are constantly in touch with small, medium, large business across the board. And most recently we've turned on phone support and on-boarding and soft landing for all of our small advertisers. We do interact with small business. As we have products that work more and more with local advertisers, we anticipate having a team that works with those advertisers. Now how we do it is still something we are constantly debating. In some cases, it works really well with our existing call centers or our existing teams, which work from around the world. It sometimes requires people on feet on the street, which we also have in over 40 countries around the world. So we are going to use a sort of combination of existing sales teams and sales methods and other sales teams and sales methods that might be required to drive some of our products whether they're in the commerce area, the local area or in the area of providing offers to our customers. But more on that as we continue to drive those products to our sales.
Patrick Pichette: For the issue of broad organization, let me make two comments. The first one is we are -- the realignment that Larry talked about earlier on this call has been really about an organization model that we had, where there was a end person and a product person for every core of our product and then often also a salesperson. And so if you think of having to have two or three products to work together, how you end up with sometimes six or nine decision makers having to align themselves. Larry made a very specific call to say for every one of those core product areas -- and we have one here in the room, in fact two, in the room which is Jeff for Commerce and Local. Jeff is now the final arbiter and decision maker -- and that's to drive velocity. And by the way, take comfort also that these are -- the reorg has been on all of the core pillars of the company. So the real core issue that we wanted to make sure, that Larry wanted to have in place when he kind of launched into as CEO is clear decision makers for velocity, and everybody takes comfort about that. And for the rest of the smaller ones, right, too early to tell. We're just not there yet. We're really focused on the big areas for now and then when the time comes, we'll cover the smaller areas. That's the way we approached it, and we're really thrilled to see the momentum already.
Operator: Our next question comes from Youssef Squali with Jefferies & Company.
Youssef Squali: Two quick questions, please. First, starting with Susan. I know you guys won't break out absolute dollar numbers, but if we just look at the non-search, non-CPC business, I mean with CPM and CPA, can you just help us understand or kind of quantify what kind of revenue growth did you see either on a year-on-year basis or on a sequential basis, just to kind of see the magnitude of your success there? And then I guess maybe for Jeff, Google has been pretty quiet about its video strategy out of YouTube's -- outside of YouTube's user-generated content. Does Google have a video strategy for non-UGC that you can speak to us about?
Patrick Pichette: On the first -- let me talk about the latter one first and then let Susan talk about the first one. On the non-UGC content, we have made a number of addition to the YouTube team that have very specific expertise in that area. So you should kind of consider that we have a focus on it, but we have nothing specific to announce. Jeff may have additional comments on that.
Jeffrey Huber: Yes, the -- with YouTube, YouTube's roots obviously start with user-generated content. There's a tremendous both size and activity in the user base there. So there's a great asset that we begin with. We are interested in long-form premium content in the longer-term role of YouTube. Another area that we're very excited about and we announced an acquisition this quarter, a company called Next New Networks, which is signaling intent for developing content that is kind of up volume for this new medium that's being created. So I think you'll see a lot more of that as well.
Patrick Pichette: Susan, on the first question of non-CPC revenues and models?
Susan Wojcicki: Sure. Actually, one thing I do want to kind of step back for is that we are thinking about the best way for our advertisers to be bidding and to be paying for ads across Search and Display. And so we -- with Search, for example, we are enabling our advertisers to bid, for example, with a CPA target. Then Google will figure out the CPCs and the backgrounds. So that's one way that was found, for example, has really grown advertisers' spend on Search. The Product Listing Ads that I talked about in the script actually works with the CPA model. So in Display, we have advertisers who bid on a CPC basis, and when they bought they also bid on a CPM basis. Right now -- and we see advertisers participating in both. A lot of times it has to do with the objective of the advertiser in terms of whether they're more performance driven or more brand driven. As we release more brand features, like I mentioned, like the reserve, that will be a CPM feature. And so really, what we see is that the bidding is very important, that we want to give advertisers a lot of flexibility and how they actually buy it and how they're able to optimize depending upon their objective. And there's no one right way. There's just -- there's a series of things that we will offer to make sure that we have the right product for the advertiser.
Operator: Our next question comes from Jordan Rohan with Stifel, Nicolaus.
Jordan Rohan: Sure. A couple of smaller questions. Can you be a bit more specific about the magnitude of the disruption in the Japanese search market that you saw in the quarter? And second, Android, you mentioned 350,000 devices activated per day. Can you give us some understanding of how that breaks down by smartphone versus tablet and U.S. versus international?
Patrick Pichette: So on Japan, let me make two comments. One is the events really shocked us as well at Google. And I just want to kind of let the investors know that our first and first response to all the events were really to actually help the Japanese community. So it was about people finding people and all the tools that we have for disaster recovery. We spent a lot of time at Google to actually focus on the community rather than trying to optimize anything that had to do with revenue. Clearly, the month of March has seen some impact from revenue, because all of the community in Japan was focused on the events themselves. Tons of searches, by the way, but not monetizable sort of searches. Japan is a great market for us, and it was and continues to be a very good performing market. So from that perspective when we look ahead into Q2 and Q3, the one thing we do know is we've actually asked -- we made a quick search. We asked Hal Varian, our Chief Economist, to look at other events that would have occurred in Japan of say kind of that type of magnitude to see the resiliency of Japan. And he looked, for example, at the economic recovery after the Kobe disaster of '95. And Japan is actually a first-world country with a very good infrastructure. So they bounce back fast. So although we don't -- we can't predict how the Japanese economy is going to rebound on advertising and -- what is very clear is they are a first-world economy that will recover. So from right now, all we can do is say it's already a strong economy for us and a strong market, right? It has had an impact in Q1. We expect some impact in Q2 as they try to recover, but it will continue to be a strong market for us. So that's on the first -- on the second question. On the first question, why don't I turn it over to Jeff?
Jeffrey Huber: Yes. So on Android, as mentioned, over 350,000 devices a day are being activated, which is just tremendous growth. In terms of breaking out share by device or by market, we don't break out share by device. If you just look though at where the distribution relationships and partnerships are, obviously, we've got a great presence in the U.S., strong partners in Europe, Japan, Korea. So international is really growing as a component of the overall pie. In terms of phones versus tablets, Android is relatively early on with tablets. So we have the Honeycomb operating system now, which is developed specifically for the devices. We've got some great initial devices like the Motorola XOOM. But as I mentioned earlier in one of the questions, we're seeing just a tremendous amount of innovation in the markets, but I think you're going to see a lot more great Android tablet devices soon.
Patrick Pichette: Okay, we have time -- we're over time already, so we'll take one last question. I just -- before we take the last question, can I just say that for those on the call that may be having trouble accessing our financial slides, we're working on this issue right now. And it should have been fixed for most of the users and will be done very, very shortly. So just to let you know. So Jay, let's take our last question, please.
Operator: Our final question comes from Heath Terry with Canaccord.
Heath Terry: Nikesh, you mentioned that video is changing everything in Display. Much of the video inventory at YouTube is still going unmonetized. What's limiting that, since clearly, the demand from advertisers is there? And is there a roadmap you can talk about or a level that you're thinking of in terms of getting YouTube to what you would consider full monetization?
Nikesh Arora: I think it's important to understand we monetize video not just on YouTube but also rich media across the Google Display Network. So our intent and our hope is to try and monetize video as a format across the various publisher partners that we have. So that's our point number one. In terms of being able to monetize and continue to grow that, you have to understand there is a value chain that goes through this. We have to make sure that we have the right advertisers, who are excited about this as a medium. I have to make sure that the creative agencies adapt their creatives to work with sort of multiple users. They don't -- you can't just create one ad, which is going to be used on YouTube with 10 million views. You actually have the ability to personalize and target them a bit more. So the creative industry needs to get involved a little bit more in trying to find creative ways, no pun intended, to be able to target all the users that the advertisers would like to target. But having said that, it is a process of selling. We have the sales teams in force. We have the technology in place. We have it integrated across the technology chain in terms of through our exchanges, through our ad serving platforms, et cetera. So we are going down the path [ph] now. We're working with the creative agencies and the most important, the analysis agencies, who actually can prove that there is value in shifting some of the dollars in television towards mediums like YouTube and other video sites around the world. So we're very happy with the progress we're making. We think also that the ducks are in a row. And we hope as we continue to see this trend, this trend is going to shift lots and lots more dollars away from what is now traditionally television towards what I call IP-based video delivery.
Patrick Pichette: Thank you, Nikesh. So with that, let me just take two last comments. The first one is, as usual, thank our Googlers. I mean, Jeff and Susan and Nikesh and I kind of look good here giving you these great results with 27% year-over-year growth and so many innovations in so many areas of the company. It is really the result of our fantastic Googlers working all the time on all of these areas. So I would just want to thank them. And also, my last closing notes on Jonathan. Everybody commented on Jonathan. He couldn't be here today, because it was already planned that he had a vacation with his family. So we're glad to have Susan and Jeff with us. Clearly, Jonathan's passion for our product is legendary at Google. I don't think that the word is too strongly stated. He loved the tension between the combination of Search and Search monetization. And just to quote him, from one of his last times, he said as Search gets better, it actually creates another huge challenge for us, which is the ads need to keep pace to get better too. Otherwise, what would happen is people will click on fewer ads and well that -- to quote him, well, that would be bad. So as a Jonathan-ism to close the call, it's very obvious that we keep -- we just are immensely thankful for Jonathan's contribution and leadership, and we'll keep focused. I know that he's going to be overlooking on us to make sure that we keep that balance between Search and Ads and all the other innovations. With that, Jay, I will let you close the call. And thank you, everybody, for taking the time this afternoon to listen to the story of Q1. We'll talk to you in Q2.
Operator: That does conclude today's conference. We thank you for your participation. | [
{
"speaker": "Operator",
"text": "Good day, and welcome, everyone, to the Google Inc. First Quarter 2011 Earnings Conference Call. [Operator Instructions] At this time, I would like to turn the call over to Jane Penner, Head of Investor Relations. Please go ahead, ma'am."
},
{
"speaker": "Jane Penner",
"text": "Good afternoon, everyone, and welcome to today's First Quarter 2011 Earnings Conference Call. With us are Patrick Pichette, Senior Vice President and Chief Financial Officer; Susan Wojcicki, Senior Vice President, Advertising; Jeff Huber, Senior Vice President, Commerce and Local; Nikesh Arora, Senior Vice President and Chief Business Officer. First, Patrick, Susan and Jeff will provide us with their thoughts on the quarter, after which Nikesh will join the group to answer your questions. Also, as you know, we now distribute our earnings release through our Investor Relations website located at investor.google.com. So please refer to our IR website for our earnings release, as well as supplementary slides that accompany the call. This call is also being webcast from investor.google.com. A replay of the call will be available on our website in a few hours. Now let me quickly cover the Safe Harbor. Some of the statements we make today may be considered forward looking, including statements regarding Google's future and investments in our long-term growth and innovation, the expected performance of our business and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation to revise or publicly release results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures which we use on this call, such as operating income and operating margin, are all also expressed on a non-GAAP basis and have been adjusted to exclude charges relating to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will now turn the call over to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Jane. Good afternoon, everybody. We just happen to have a surprise visit. Larry is joining us for a few minutes at the beginning of the call and wanted to make a few comments. So before we start officially our call, I just want to welcome Larry. Welcome, Larry."
},
{
"speaker": "Larry Page",
"text": "Thank you, Patrick. It's great to take just a few minutes with all of you. We've had a tremendous quarter, 27% year-over-year revenue growth in Q1. And we're really excited about that, and I think it shows the strength of our business and our continuing -- and the continuing growth really in the tech industry. And it's really still at the beginning from a user perspective. There's tremendous improvements to be had in our core products and our core business, and we're really excited about that. I also wanted to mention a little bit about the management changes. Everything we told you last quarter has happened as we expected. It's all working very well, exactly as we planned. I'll just reiterate that quickly. I'm managing the day-to-day operations of Google as the CEO, working very closely with my team, and I'm really excited about the progress we've had there. I think we really hit the ground running. And Eric, of course, is focused externally, on the government partnerships, government relations and partnership outreaches. And last quarter alone, he was in Germany and Brazil, Argentina and Spain and has been just doing tremendous things for the company. Sergey, as we mentioned, is working very intensively on a few emerging projects for us. As I said, this was all exactly as we planned, and I'm very, very excited about those changes. I'd also mention we've made a number of changes to just simplify our organ, improve our velocity and execution and basically, simplify our reporting structures and such. Now I'm very excited about Google and our momentum and very, very optimistic about our future. I also just wanted to mention we have Jonathan Rosenberg, who's usually done this call, is transitioning out of the company as was announced a while ago. And I really wanted to thank him for all of his insights and hard work and fine communication with all of you. And so we'll clearly miss him, and we really wanted to thank him from the bottom of our hearts. So those are the main things I wanted to say. I'm tremendously excited about all of the things that lay before us as a company. And I also want to say you're in very good hands with the team here, and Patrick who now should take the call away."
},
{
"speaker": "Patrick Pichette",
"text": "Great. Thank you, Larry. Thank you for taking a few minutes in the schedule to just drop in. So what we'll do now is we are back. So we found a phone for the last 30 seconds, and we're going to be back now with the rest of the team to go back to our regular call. So as an overview, I'll be giving you the regular speech. Susan and Jeff will give you color comments as well in the product area, as well as the monetization side. And Nikesh is with us so that when we go through Q&A, he'll be answer to give you a lot more color commentary in some areas. Look, we're nothing but very, very excited about our reporting 27% year-over-year revenue growth in Q1. This 27% proves really the logic behind our strategy, not only to invest heavily in our core Search business and Ads but also in our new emerging businesses like Display, like Mobile, like Enterprise. From an investment perspective, our Q1 results don't only show our continued commitment to invest in hiring, in marketing and in the other areas, but they also -- as you can see through our expenses, they reflect, for the first time, the full impact of the compensation changes we announced in Q4, the 10% salary increase. Google is clearly benefiting from and is also fueling the unrelenting pace of the digital economy that's around us. And it's growth that we believe will benefit both Google but in fact, the entire ecosystem for a long time to come. So let's turn to the specifics of our performance for the quarter. Gross revenue, as we mentioned already, 27% to $8.6 billion and interestingly, 2% quarter-over-quarter. To put this in context, this is quite remarkable if you think that Q4 was an amazingly strong quarter. And in fact, it adds also the impact of the Nexus One from Q1 of last year and to a lesser extent, the events that have occurred in Japan. So Google website's revenue was up 32% year-over-year, $5.9 billion, with strength across all major geographies and verticals. The Google Network revenue was up 19% year-over-year to $2.4 billion. That Network revenue was negatively impacted by two things, the loss of a Search distribution partnership deal and also, what has been broadly communicated, by Search quality improvement made during the quarter. Regarding the Search quality improvement, remember that we regularly make such trade-offs. We really believe that the quality improvements that benefit the user always serves us well both in the short term and in the mid term in terms of revenue. So Jeff will cover that in more detail in the coming minutes. Other revenue was down 10% year-over-year to $269 million. And note that in Q1 of 2010 was the first quarter that we'd booked Nexus One revenues, and this is what drives the year-over-year decline. Global aggregate paid click gross -- that's my tongue twister for every quarter. It was very strong again, up 18% year-over-year, interestingly, 4% up also quarter-over-quarter and again, reflecting the accelerated shift of off-line to online. Aggregate cost-per-click growth was also quite healthy, up 8% and only 1% down quarter-over-quarter. And you should all know that the FX had a pretty neutral effect on CPC growth year-over-year and quarter-over-quarter. Remember too that that's an aggregate number and includes both google.com and our AdSense properties. So now turning to our geographic performance, the U.S. and the rest of world are both growing at a very healthy pace, and our results reflect that. The U.K. continues to lag a bit because of its global economic recovery, the pace of its -- the recovery. Revenue from the U.S. was up 25% year-over-year to $4 billion. In our earnings slides you can find on our Investor Relations website, you will see that we have broken down our revenue by U.S., U.K. and rest of world to show the impact of FX and the benefit of our hedging program. So please refer to those slides for the exact calculations. International revenue accounted for 53% of our total revenue or $4.6 billion, and it was up 28% year-over-year. It includes a $14 million benefit from our hedging program, and that compares to a $10 million benefit of Q1 of last year. If we use a fixed exchange rate, our international revenue would have been roughly $23 million lower year-over-year. Also, it's worth noting that the tragedy in Japan somewhat negatively impacted our international revenue in Q1. And as I mentioned earlier, the U.K. was up 15% year-over-year to $969 million as the country continues to experience struggling economy. But even that 15% is really 17% in FX adjusted basis. Let me turn to expenses. Traffic acquisition costs were $2.0 billion or 25% of total advertising revenue. Our other cost of revenue, $897 million, including stock-based compensation of $49 million. And finally, all operating expenses totaled $2.8 billion, including approximately $383 million in stock-based compensation. The increase year-over-year in OpEx, primarily due to payroll, increased advertising and promotional spend and some other professional services. So a result of all these expenses, our non-GAAP operating profit, which excludes the stock-based compensation, was $3.2 billion in Q1 of this year, resulting in a non-GAAP operating margin of 37.6%. Headcount was up approximately 1,900 people from Q4, ending the quarter with 26,316 full-time employees. Our effective tax rate was 21% roughly. The exact number is 20.5%. Let we now turn to cash management. Our other income and expenses was $96 million for Q1, in fact, a very solid performance from our portfolio management. And unfortunately, just masked by the impact of our higher hedging expenses associated with our SFAS 133, the accounting of which we know is quite volatile from quarter to quarter. So for more details on OI&E, please again refer to the slides that accompany our call on our IR site. Operating cash flow, very strong, $3.2 billion. CapEx for the quarter, $890 million, significantly below last quarter of $2.5 billion. And remember that last quarter, that increase was largely due to our purchase of the New York City office. Majority of CapEx spend in Q1 was related to facilities, expenses and data center operations. In the facility space, we spent -- was really driven by the purchase of two buildings, one in Dublin and one in Paris. Just as a reminder, we continue to make significant CapEx investments, and we've shown those to be lumpy from quarter to quarter depending on when we're able to make such investments. Obviously, we're pleased with our free cash flow, which was $2.3 billion for the quarter. As I said earlier, our accelerating growth trajectory, it really shows our confidence to expand across products and geographies. Roughly 18 months ago, we began communicating how we were really optimistic about our opportunities, and we had the business confidence to invest heavily in the next phase of innovation and revenue generation. Well, our product innovation over the last 18 months has been nothing short but extraordinary. Let's take a look at this. We have built from scratch the world's most popular smartphone operating system. We've built also from scratch the world's fastest growing browser. And in some countries like India, one in four people are now accessing the web via Chrome. We've reinvented display advertising, creating not only a business but an entire ecosystem with a $2.5 billion annual run rate as of Q3 of last year. We've pushed the frontier of mobile search, creating a whole new search segment that is adding to our overall search volume and brand new monetization opportunities. We've seen YouTube develop into a platform, a win-win platform in fact, where partners can generate significant revenue from their content and users watch 2 billion views a day. And our revenue growth clearly shows the wisdom of those decisions to fuel our growth ahead of the curve. So the facts speak [ph] from the sales really. The second half of 2010, we grew roughly 25% year-over-year. But even more telling, this quarter, growth rate of 27% compared to a comp of 23% just a year ago. We are building multibillion dollar businesses, and we're confident that now is the time to invest. It's with this optimism that we'll continue to do so aggressively but with discipline, with strong focus on fueling the winning products. From an expense point of view, we're taking some bold steps but always with good strategic rationale in mind and discipline in mind. So as our Q1 results continue to reflect some marketing -- you've heard of our marketing going up. It's a very deliberate choice as an example. We have laid, made very specific focus on Chrome, customer and advertiser acquisition in the U.S. and international markets. And in both cases, we're seeing the fruits of these investments. The same is true for our labor strategy. And finally, we continue to invest in our long-term infrastructure. So now let me turn it over to Jeff and Susan to provide you more details on the products that are the engine of both our growth and our optimism. They'll also provide you more details on where we're deploying some of these additional resources as they're coming on board. So with that, I'll turn it over to Jeff."
},
{
"speaker": "Jeffrey Huber",
"text": "Thanks, Patrick, and hi, everyone. In his comments, Patrick mentioned our ambitious hiring this quarter, which was by design. We announced in January, with a blog post to help energize recruiting, that 2011 will be the biggest hiring year in our history, topping the 6,000 people we hired in 2007. And we ended up hiring 1,900 people this quarter. We're very happy about this, because we feel this is a very good time to invest. We look at the factors like our revenue growth and how well our core and growing businesses are doing and say to ourselves, \"Who wouldn't want to invest in this business?\" So that's what we're doing, hiring great people to invest in the future. In fact, over half the Newglers who joined this quarter are going to be working in high potential and revenue growth areas like YouTube, Mobile, Chrome, commerce and local and Enterprise. So that's what Susan and I are going to talk about today. We'll give you an update on our core business of Search and Ads, as well as these businesses where we're investing. Susan will cover our Ads products, Search Ads, Mobile Ads, local Ads, Display Ads and YouTube, and I'll talk about Search, Android, Chrome and Enterprise. So let's jump in with Search. Search is the most important thing people do online, and there's loads of opportunities to make Search more intelligent and more personal. Intelligent, as in better quality. Our primary focus is to always create the best user experience. So this quarter, we launched over 90 different quality improvements. Most notably, we made an important change to our ranking algorithms to promote higher-quality sites. This noticeably impacted about 12% of our -- of all queries, and it's done a good job. We found it addressed over 80% of the sites that users reported as a poor experience via a Chrome feature we introduced a while ago. This change did have an adverse impact on revenues for some sites in our Display Network, but we've continually found improving Search results and our users' experience is always the best thing to do in the long run and for long-term value. Personal, as in building around people. We improved social search this quarter, making it easier to find information and recommendations from the people that matter to you, whether they're publishing on YouTube or Flickr or their own blog or website. We also launched the +1 button, which makes it easy to share recommendations with the world via Google Search results. And this is just the beginning. We've got lots more useful and relevant social search features coming soon. A lot more of our searches are coming from mobile devices. This traffic has gone up more than 500% in the last two years. Android is obviously a big driver of this. We're activating over 350,000 Android devices every day. Android market is taking off too, over 3 billion apps have been installed, up 50% in just the last quarter. You can now access the market online. Try it at market.android.com so you can shop and browse for apps from your computer, click the purchase, and they just magically show up in your device. We also recently launched In-app Billing, which has been very enthusiastically received and which gives developers more ways to make money from their hard work. Another product and it's doing very well is Chrome. Chrome users are very valuable to Google. And as we've said in past quarters, we're investing in Chrome marketing. The payoff is worth it. We have over 120 million daily users, over 40% of whom we added in the past year as a result of our marketing efforts. The Chrome OS program is also going well, and we look forward to launching devices with our partners later this year. Our Enterprise business is growing across both businesses and schools. As example, this quarter, we deployed Google Apps at InterContinental Hotel Groups and RR Donnelley; signed a reseller agreement with Optus, which is the largest -- second largest telco in Australia; and signed up the University of Texas and Boston University. We were pleased that our deal with ITA Software was approved by the DOJ last week and closed this week. Travel searches in the area with lots of potential for innovation, both for end users and as a platform for the industry. We're looking forward to bringing the ITA team on board and doing great things together. That wraps up my remarks. But before I turn it over to Susan, I just want to take a moment to thank Jonathan Rosenberg, who has been a regular on these calls, for all he's done for Google. Jonathan and I have been friends and colleagues for over 15 years. And on behalf of myself and Susan, who also worked closely with Jonathan for the last nine years, I can assure all of you that he will be missed. Over to you, Susan."
},
{
"speaker": "Susan Wojcicki",
"text": "Thank you, Jeff. Hi, everyone. So there are a lot of things to be excited about in our Ads business, and I'd like to share a few updates from the quarter in Search, Display and Mobile Ads. Search is still our core business. And even though it's a really large business, we see a significant opportunity for growth, as Larry mentioned. One of the things that we've been focusing on is thinking about how we can serve the most perfect ad for every query. A query for a product will require a very different kind of ad than a query about a movie. And in order to do this, we are enabling new creative types and new ways for advertisers to set up their campaigns. One example of this is Product Listing Ads, which we released to U.S. advertisers in Q4. If you're a retailer and have hundreds of thousands of SKUs, it's hard to set up the separate creative for each one of those. So product listing ads automatically creates ads from product feeds rather than from keywords. Then a retailer can run a unique ad for every product without doing any extra work. We're seeing great advertiser adoption, and about half of the largest retailers in the U.S. are now running these ads. If you do a search for soccer cleats, something I'm thinking about buying for my daughter, you can see some of these on the right-hand side. The ads include pictures and prices. That's something you'd want to see if you're going to buy something. The ads are really effective too. They're about twice the click-through of standard text ads in the same location. This quarter, we also launched a much richer ad format for more brand-focused advertisers, and we're calling this format Media Ads, because we're starting with the movie and entertainment advertisers, but we think this format will work for all types of brand advertisers on Search as well. These creatives can include images or videos, and in the case of the movie studios, it will include a movie trailer. Again, there are no keywords, and Google figures out the right queries to serve the ad. To see one of these ads, try searching for the movie Water for Elephants. If you are searching for a movie and the movie -- and you wind up seeing the movie trailer in the ad, we're getting you a lot closer to seeing the perfect ad. So as you can see, there's a lot of opportunity for more innovation within Search Ads. I'd like to move on to Display right now. I'm very proud of how well our Display business has been growing. We bought DoubleClick three years ago. We've done a lot of integration together. And as a result, we've seen a lot of progress. Our Google Display Network is up 5x since acquisition, and we've been doubling annually in several of our key markets, like the U.K., Brazil and Japan. Now most Display advertisers can be bucketed in one of two categories. They can think about themselves as being performance oriented, where they value conversions and clicks or more brand oriented, where they're focused on raising awareness. Last quarter, we started to develop some features for brand advertisers. We had launched Google Display Network reserve, which gives advertisers ability to buy premium inventory on a guaranteed basis, which is how brand advertisers are telling us they want to buy the inventory. We are also giving advertisers tools that help them measure the impact of their campaigns on things like brand lift rather than just clicks and conversions. Our Ad Exchange, which we've been focused on building a unified buying platform so that advertisers and agencies can buy the exact audiences they want across the Internet. The transaction volume on the Ad Exchange has tripled in the past year, and 2/3 of that inventory is being bought via real-time bidding, which is a new technology to enable much more programmatic and scientific ad buying. It also results in better ads for users and gets us closer again to serving the more perfect ad. YouTube is another part of our Display strategy. Revenue is doubling year-over-year, and we share that revenue with over 20,000 content partners. We're starting to see a virtuous cycle. The more money we make for our content partners, the more engaging content they upload. So as you can see, there's been a lot of nice progress in Display due to the results of a lot of people at Google. Moving on to Mobile, we're seeing growth this year really taking off. AdMob, the display network that we acquired last year, has over 150 million iOS and Android devices making requests per month. That's up 50% in the past four months, which gives you an idea of how fast Mobile Display advertising is growing. Many of our advertisers are starting to run mobile-only campaigns as opposed to bundling it with their desktop campaigns. It enables advertisers to move to much more customized mobile experiences. They'll have mobile landing pages and campaigns that can incorporate location. For example, how far away is the advertiser from where you are standing right now? These custom-made stations, again, get us to the perfect ad on Mobile, since users also want to have location, or they want to have phone number. We're also seeing Click-to-Call taking off with more than half a million advertisers using these features. As a result, the mobile-only campaigns are seeing an increase of 11.5% when they run a mobile-only campaign as opposed to a bundled mobile-desktop. So these are just a few of the examples and the opportunity that we see in Mobile. And this overview is just a few and a small set of the many, many projects that we are investing in across that. Now back to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Susan. Thank you, Susan and Jeff for this comprehensive look at what's going on our core -- across our core products. What I suggest we do now is we turn it back to Jay to give us the instructions on how to get to the Q&A and just jump in right into the Q&A, if you don't mind."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] We'll go first to Spencer Wang with Crédit Suisse."
},
{
"speaker": "Spencer Wang",
"text": "So question on spending for Patrick. I think OpEx, excluding tax, was up something like 45% year-over-year. So is this the type of spending that you think will be required to sustain a high-20% revenue growth going forward? Or is this more reflective of near-term investment to support some of the growth initiative you've talked about and spending tapers off at some point in the future?"
},
{
"speaker": "Patrick Pichette",
"text": "But there is clearly the effect of the one-time salary change for this quarter that is flowing through. And in fact, in the increase in salaries, what you have is a triple effect this quarter specifically, right? Everybody at Google got a 10% salary increase. In addition to that, because it's the beginning of the year, the salary increases flow through to many of the benefits, like the 401(k)s and the vacation accruals. So many of the resets that are done in the first quarter are disproportionate in additional kind of flow-through costs. And then finally, we have new Googlers. And the Newglers, I think Jeff made a really good compelling case to explain why we're hiring them and then how we distribute them. So on the labor side, you clearly have a one-time step change, but after that, we're going to continue to be in our regular momentum. In other areas, if I take marketing, for example, marketing has increased through last year, because we see the great returns. And so for marketing, specifically, we continue to -- we don't expect to slow down our marketing, because it is proving such a kind of attractive set of returns both for customer acquisition and for key, key products, like Chrome. So for those, we're actually going to continue our momentum on them. In many areas of the company, we continue to be -- in like most areas, continue to be incredibly disciplined. People have to show up every 90 days to complete a OCQ process, where we do quarterly reviews to get your next chance [ph] for funding. I mean, the discipline of the company has not changed. We're just really bullish on our prospects."
},
{
"speaker": "Operator",
"text": "We'll go next to James Mitchell with Goldman Sachs."
},
{
"speaker": "James Mitchell",
"text": "If I could follow-up with a couple of questions around expenses. And I'll say, we're having some issues downloading the presentation slides, so it'd be great if you could repost them at some point. But first of all, Patrick, you mentioned in your discussion of OpEx there were some other professional expenses in the first quarter. Was that a reference to legal costs or other things? And then secondly, when we look at the substantial marketing spending around Chrome, is that like a short-term campaign or more of a forever wall? And could you talk about what are the strategic benefits to Google of consumers adopting the Chrome browser?"
},
{
"speaker": "Patrick Pichette",
"text": "Okay. So let me start with just the professional services and then I'll let Nikesh give you a context of Chrome as well. So for OpEx, it's a number of areas. We're pushing -- right now, we're pushing hard on a few areas including the GEO product, where we're doing a lot of the mapping worldwide. So at the beginning of the year, we just kind of ramped up a number in there. We also have a couple of other areas. We do have slightly more legal expense as well. But also, real estate is the third component, where because of the Googlers coming on board, we just need more services to support those Googlers. So that's the highest level answer for professional services. And for Chrome, if -- let me give you just a 10-second umbrella and then I'll let Nikesh give you more color commentary. There's really a two story on Chrome. And there's a tactical question, and there's a strategic question. Chrome is really pushing the web, and it has a fantastic opportunity that when people have adopted Chrome, right, they basically -- instead of looking for Google and looking for Search, the Omnibox gives them immediate access to Google Searches. So from a strategic perspective, it has that in Chrome OS. And a tactical basis, right, everybody that uses Chrome, right, is a guaranteed locked in user for us in terms of having access to Google. So maybe, Nikesh, if you have more additional comments on the performance of the marketing."
},
{
"speaker": "Nikesh Arora",
"text": "Thanks, Patrick. Just to add to that, I think as Jeff mentioned we have over 120 million daily users, and 40% of them were added in the past year as a result of our marketing efforts. So we've seen the 30% growth quarter-over-quarter in our Chrome usage. So I think from all perspectives, the Chrome strategy is working. And the way we distribute Chrome is people get it organically. Or they get it based on our marketing efforts. Or they see our marketing, and they choose to download it. Or we work with partners who help us promote Chrome to our users and to other users. So in that context, we found that marketing very often ends up with an equivalent or better ROI than us having to go do partnership deals. Sometimes you'll see that our tax and our marketing around Chrome is fungible, where we spend money in marketing we take away from tax as it relates to Chrome. So you can expect us to continue to drive Chrome strategically, because it has not just a Chrome-specific benefit for us, but it also impacts many of our other products that work as part of Chrome. So the lifetime value of a Chrome user is phenomenal."
},
{
"speaker": "Operator",
"text": "We'll go next to Ben Schachter with Macquarie."
},
{
"speaker": "Benjamin Schachter",
"text": "I was wondering if you could give us, from a high level, the view of how Larry views this company differently today, or how we should view it differently given Larry's position. Is it going to change in any meaningful way?"
},
{
"speaker": "Patrick Pichette",
"text": "In short, look, I think that the company's position has not changed. Google is a technology company focused on users and looking for products that can affect billions of people. So the very first lens that you have to think through when you think of Google is are we developing computer science helping finding answers to problems where billions of people can be served. If you think that way, right, Chrome makes sense. Android makes sense. Search makes sense. All these things are the fundamentals of the company. From there, there's very clear that -- again, to paraphrase an old saying of ours, right, the 70/20/10 is very much alive and well. Search is the next billion-dollar business. Never forget it. Every quarter you've heard this time, right? 90% kind of improvement on one side 40% on the other. And like, that's one a day, right? That's a lot of engineering work to keep ahead of the -- but these are the next billion-dollar businesses. It's in its infancy and so are two or three other of our key products, which include Mobile, Display, Enterprise. So -- and then the 10%, well, it's commerce, right? It's local that we all know is nascent. It's social that we know also is nascent. And so the strategy the company is continuing to be in the same core lenses, building same products that serve billions of people and to make multibillion-dollar businesses in the waist up."
},
{
"speaker": "Benjamin Schachter",
"text": "Sure. If I could just follow-up briefly. I was really trying to get more at the financial model of the company, if there's any meaningful difference now that Larry is in this different position. Do you and does he think about the financial model in a different way than we had previously?"
},
{
"speaker": "Patrick Pichette",
"text": "No. Build great products and then same financial discipline."
},
{
"speaker": "Operator",
"text": "We'll go next to Ross Sandler with RBC Capital Markets."
},
{
"speaker": "Ross Sandler",
"text": "Yes. I hate to beat the dead horse on the operating expense, but just one more follow-up question on that. You guys have stated that a lot of the operating expense uptick has been related to customer acquisition in Chrome, and I know there's some salespeople that have been added to the platform. But if you were making these investments, do you feel that your high-20% year-on-year growth rate would be achievable? Or do you think these OpEx additions are going to be additive in future periods kind of four, six, eight quarters down the road?"
},
{
"speaker": "Patrick Pichette",
"text": "I think that you have to look at the strategy. You have to take a look at the strategy in the context of the last four or five quarters, right? Have increased in OpEx, but when you look at our trajectory of revenue growth, right, going from 23% to 24% to 25% to 27% this quarter, we are really funding and accelerating with discipline our revenue growth. That is the fundamental. If we don't see a great ROI, you won't see us spending the money. We just happen to have great opportunities to fuel. Why not carpe diem now? It's there to take. That's really the mindset we put at it."
},
{
"speaker": "Ross Sandler",
"text": "And just one other follow-up on that. So the IV came out and said that the display marketplace in the U.S. is around $10 billion. So if we double that and say global display is $20 billion, you guys would be a little bit north of 10% on a run rate basis of the global display. How big can that business be? And can you talk about as Display becomes a bigger percentage of total revenue, what that has -- what impact that has on your overall operating margin just from that mix shift basis?"
},
{
"speaker": "Patrick Pichette",
"text": "Okay, so let me start with the latter and then I'll let Nikesh talk about the former. Clearly, Search is a unique product that has very, very high margin, right? Because Display is more complex -- there's more paperwork involved even today with Display. It's a somewhat lower margin. It's still a great margin product, and it's a product that because of the -- it's still a very good margin product. And so all those dollars I want from an operating margin point of view. So there is no way we would let that -- and there's a great symbiotic relationship between Display. As take Susan's example, right? What was a pure Display Ad before is now embedded in Search. So the symbiotic relationship is very important as well. As to the total size of the market, I'll let Nikesh give you some color commentary."
},
{
"speaker": "Nikesh Arora",
"text": "Thanks, Patrick. I think it's important to look at the advertising market for Display in the context of the overall advertising market, which is a $600 billion to $700 billion market globally. And you can go back and say five years ago that Display was sort of stalled around $15 billion to $16 billion as the market, because we didn't have video in the mix. Now with video, everything changes. We have been recently doing some campaign in the U.K., where we tried to do some efficiency, YouTube versus television. And we found YouTube helps people reach 20% to 24% more consumers in a target segment. And you can do that in a dispersed manner. You don't have to buy one ad, which 20 million people look at. You can do that on a literally user by user basis. So you are seeing the efficiency of the web applied to video, which is going to change the way the entire display market functions. And all of our efforts in the last two or three years have been towards targeting that market, whether it's all our acquisition in the technology side, whether it's all of our efforts in trying to create a multiproduct sales force across 50 different countries around the world. We are getting ourselves to be able to sell Display with special emphasis on rich media and video, which is going to help us sort of make that a relevant space in Google. As far as -- Patrick answered the margin question. But from my perspective, I'm told that every profitable dollar or revenue is good."
},
{
"speaker": "Operator",
"text": "We'll go next to Justin Post with Bank of America Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "Could we talk about Google's access to social data? Obviously, you're not running a major social network in some geographies. What's your experience there? And do you think having access to social data is going to be important for having the best query results on the web when you look out three to five years?"
},
{
"speaker": "Jeffrey Huber",
"text": "This is Jeff. We do see social as very important. Google uses well over 200 signals in terms of how we think about ranking today. And when we think about identity and relationships, those are our key signals that can and should be integrated in the experience. So it is important, but it's one of the many that we use. In terms of assets that apply to that, we do have a very, very large number of users coming to our door every day. A considerable percentage of them are logged-in users that are using multiple of our products. So there is a large variety of signals that we'll be able to use with user support and users seeing value from it to make the overall experience better."
},
{
"speaker": "Patrick Pichette",
"text": "I think it's worth -- just in closing, you've all heard of the launch of +1 a couple of days ago or a couple of weeks ago. And it's, again, a commitment from us to get every signal we can to give the best answer for the users. So you should expect continued focus on social as one of the 200 signals and just get this rich as possible of an answer across the board."
},
{
"speaker": "Justin Post",
"text": "Patrick, if I could do a follow-up. Does Chrome give you any signals that you can use and integrate into your Search results?"
},
{
"speaker": "Patrick Pichette",
"text": "Maybe Jeff would know the better answer of that, if Chrome gives us additional signals on social or other types of signals."
},
{
"speaker": "Jeffrey Huber",
"text": "So Chrome we think will be part of the story over time. Chrome does have features where it is personalized today. And for example, the Chrome experience, you can essentially sign into Chrome, and it will synchronize all of your information across different instances across different computers. So that is information that, again, with user engagement and users seeing value from it, that could be useful."
},
{
"speaker": "Operator",
"text": "We'll go next to Mark Mahaney with Citi."
},
{
"speaker": "Mark Mahaney",
"text": "Two questions. First, Patrick, you talked about taking bold steps to address expenses. It's just not obvious in the P&L results. So can you give us any examples of what those bold steps are? And then secondly, I know you're talking about social being one of several hundred signals, but is there any way to indicate that -- evidence you've seen so far that indicates that it's materially greater than those other variables or just as important but no more important than the other variables?"
},
{
"speaker": "Patrick Pichette",
"text": "Okay. So one -- on the issue of expenses, what you see is the ramp-up on one side, but I can guarantee you, because we have gone through the planning process for this year, that everybody that has a cost center has to demonstrate productivity. So in the case of data centers, there's productivity requirements that are actually incredibly steep. In the case of the sales force, Nikesh could give you kind of a great set of examples that his productivity, right? Is kind of -- think of it as, in his case, cost per revenue dollar. In the case of [indiscernible] (43:00), it's cost per bps and cost of storage. In the case of all staff functions, whether it be in legal, whether it be in real estate, whether it be in cost of food, whether it be cost of transportation, every one of them are expected to have a productivity curve. So in this fast-growing business -- like Google is growing, like, from a base of revenue of roughly $8 billion, 25% year-over-year. That's $2 billion of revenue. And so from that perspective, you have a tide coming with it. But under that tide, I can tell you every element of the company is scrubbed and scrutinized. So I would -- I just want to give comfort to our shareholders that there is these quarterly review processes. And these annual unit cost continue to kind of haunt many of my managers that when they come to my office. On the signaling portion of it, Jeff probably can give more color commentary about social versus others."
},
{
"speaker": "Jeffrey Huber",
"text": "So as mentioned, it is one of the signals among many that we have. We are very optimistic that we'll be able to do great things with better social signals over time. At this point, it's a little early to tell, but we regularly measure and tune. So we'll be looking forward to that as the experiments continue."
},
{
"speaker": "Patrick Pichette",
"text": "I know that for our shareholders and many analysts on the call, it is top of mind for people, when we grow our expenses in the way we have, to ask that question. So Mark, I just want to thank you, because it lays -- it gave me the opportunity to lay the ground clear on these issues."
},
{
"speaker": "Operator",
"text": "Our next question comes from Brian Pitz with UBS."
},
{
"speaker": "Brian Pitz",
"text": "Could you provide any color on the impacts to the user experience from the recent Panda changes? Has it impacted click-throughs or CPCs on the paid ad side? And then in terms of the overall online display industry, would you differentiate between drivers? Do you think more impactful ad units are driving growth? Or is it more complex data and algorithms and more granular targeting?"
},
{
"speaker": "Jeffrey Huber",
"text": "I'll start with the experience of the changes that we've made to improve overall quality and promote high-quality sites. I had mentioned in my comments that on the order of 12% of queries, we're positively affected in our view. And that's in terms of our changes that is a pretty significant change that has that scope. And we felt very good or confident in it, because we were able to measure against the feedback loop that we had of user-reported sites that they found that weren't as great of an experience. Just to confirm, it was web search only, not ads. It didn't have any material measurable impact in search ads in either CPC or CTR. We did mention that there was some effect on the display network of sites that were essentially the receivers of some of those clicks previously, but our focus is, again, overall on the user experience, the best possible user experience and long-term value. I'll turn it over to Susan on the balance of the questions around the Display Network."
},
{
"speaker": "Patrick Pichette",
"text": "Can you, Brian, give us -- repeat the question for the second piece?"
},
{
"speaker": "Brian Pitz",
"text": "Yes. The second piece was in terms of overall online display industry, would you guys differentiate between -- do you think more impactful ad units will be driving growth? Or is it more complex data, more complex algorithms and more granular targeting?"
},
{
"speaker": "Susan Wojcicki",
"text": "Sure. So this is Susan. I'm happy to answer that one. I think in Display -- I mean, what I see happening right now with Display is that we're really at a point where there's ability to buy audiences and to do much more specific targeting than there ever was in the past. We also have much better tools in order to do that and better formats. So I think the combination of all of these things over time will enable us to have better ads and have them much more targeted at the right users. So that's really a combination across all of them. It is important to note that really -- like one thing that distinguishes our Display strategy is that we are focused on building an end-to-end platform to enable buying across the Internet for all advertisers and for all publishers. And we believe that if we do that and if we do that efficiently, that there will be a lot more dollars that will move over, as Nikesh mentioned, from off-line to online, which is where the users are moving. And so we just need to make sure that the systems and the technology can support that."
},
{
"speaker": "Patrick Pichette",
"text": "Just to reemphasize, just that last point from Susan, there are properties that are going to be kind of tuned to Display, right? It's true for YouTube. It's true -- but the ecosystem itself of the entire web is so much more powerful, and that's why we have the strategy we have."
},
{
"speaker": "Operator",
"text": "We'll go next to Scott Devitt with Morgan Stanley."
},
{
"speaker": "Scott Devitt",
"text": "Two questions, please. The first one, was just wondering if tablet operating share is important to Google as smartphone share. And given Apple's different lower margin pricing strategy on tablets, how Google plans to influence market share in that category. And then just one follow up."
},
{
"speaker": "Patrick Pichette",
"text": "Sure. Jeff, comments on tablet versus smartphones versus PCs."
},
{
"speaker": "Jeffrey Huber",
"text": "Yes. This is Jeff. Tablets are doing very well. There's certainly been a lot of growth in that segment. And in terms of its dynamics, there are some interesting properties where it's really a hybrid between a mobile device and a desktop when you look at user behavior and the kind of things that they're doing with it. So it sort of falls between the two of those. We are very optimistic. Android has some great products coming along. We have the Honeycomb operating system that is developed specifically for tablet application. The Motorola XOOM is the first device that's come along, runs on Motorola now. It was the product of the show at the Consumer Electronics Show in January. I think you'll see a lot of other products coming along and a lot of innovation in the market around tablets and that format. We have also introduced, just jumping into Ads for a little bit, recently, a feature where we can enable advertisers to specifically target tablet devices, which we think will also help that segment."
},
{
"speaker": "Scott Devitt",
"text": "And then secondly, just to the extent that employee bonuses may be partially tied to your social efforts, just wondering if you could define success in that area."
},
{
"speaker": "Patrick Pichette",
"text": "I think what we're going to do is because this is an internal matter -- I mean, the key message that I'd like to leave with everybody is, right, we focus, as we said, across the strategy and across many platforms. We wanted to signal to the employees that social is clearly a signal that is worth investing in, and that's why we've made the decision. But we wouldn't comment further on that."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jeetil Patel with Deutsche Bank Securities."
},
{
"speaker": "Jeetil Patel",
"text": "Two questions. When we talk to a lot of your shareholders, I think the general view is that Search is such a great business and a phenomenal asset. However, it seems like at the same time, there seems to be kind of a growing concern that engagement seems to be a bigger theme that seems to be winning out of this industry, whether it be from smaller companies that have unique products or just different approaches in the marketplace. I'm curious, have you guys looked at the 70/20/10 approach to the business and rethought maybe the allocation should be shifted a bit towards building greater engagement in the business, try to maybe kind of look at how other products and services can be integrated in? I guess, that's question number one. I have a quick follow up."
},
{
"speaker": "Patrick Pichette",
"text": "Let me give you a mega answer related to that, which is if you think of the web in general and how the platforms are growing, right, we would argue that where we're focusing our investment is in areas where -- yes, engagement matters. But if you think of where we're putting emphasis in local, for example or in Mobile, for example or for YouTube, for example, right, all of these areas are all about engagement and their engagement between advertisers and small, medium businesses and their customers that are walking down the street and then adding more signals to the quality of their restaurant experience they had or otherwise. It's true for YouTube, with so much more different kind of either lean back, with kind of chatting and giving kind of ratings. And every one of our products has just naturally evolved. And then with -- again, with Mobile and same thing with Chrome, we see many of these areas. Engagement is another element of the strategy that's kind of pervasive across, but the technology themselves also fuel that. So it's kind of a symbiotic relationship between the two. So at the highest level, Search itself is so much more engaged today than it was three years ago and will be even more engaged in the coming three years. So it's absolutely part of the fabric of the strategy we have."
},
{
"speaker": "Jeetil Patel",
"text": "It sounds like we may be missing it in that it's engagement through frequency of services utilized through everyday life as a consumer as of the, say, engagement through just a share of time over one continuous spectrum."
},
{
"speaker": "Patrick Pichette",
"text": "Well, you have it across -- like, when you're in YouTube, right, the question is are you spending more minutes of your day actually on YouTube, and that's opportunities for engagement. When you're with your Android phone and you're actually living down the street, and you're now in town, your engagement opportunities, both in terms of the product that you use and the engagement of the additional signals that you get with sharing with your friends or otherwise, right, continue to fuel it. But absolutely, the core platforms that we have in place will have that as a core element."
},
{
"speaker": "Jeetil Patel",
"text": "So this Chrome -- just a quick question on Chrome. But do you -- does that give you the potential to create unique products inside of Chrome, such as obviously, folding in apps from Google, as well as creating digital content services within the Chrome environment?"
},
{
"speaker": "Jeffrey Huber",
"text": "Yes. This is Jeff. There is great opportunity in Chrome. You start to see the beginnings of that, in that we launched a capability a while ago called the Chrome Web Store, which is bringing the same kind of model that we have with Android Market to that platform. And there's a tremendous amount of innovation that is happening on the web as a platform that we think Chrome will be able to take advantage of and be the best on ramp for."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jason Maynard with Wells Fargo."
},
{
"speaker": "Jason Maynard",
"text": "I have two questions. First, on the Mobile opportunity. What do you think a Mobile user is approximately worth today on an annual basis? And where do you think that can trend as you bring in more local and commerce capabilities? And then real quick, second for Patrick, how should investors think about the financial parameters around potentially larger acquisitions? I'm not talking about the little tech-in type of deals, but if you -- as Google maybe contemplates some bigger type of company purchases, if you will."
},
{
"speaker": "Patrick Pichette",
"text": "Great. Who wants to tackle Mobile? Jeff?"
},
{
"speaker": "Jeffrey Huber",
"text": "Yes. So in terms of the specifically quantifying the value of a Mobile user today, that's not something that I can comment on specifically as of how we're valuing them. That said, if you look at the kind of investment which we're making, if you look at the focus of the organization, it is something that we're very, very excited about. And I think that there is great potential there. And if you look at some of just the monetization side of it, there's things that we've done around Click-to-Call ads, if you think about very locally targeted ads that is a capability of our platform. The ability to engage users where they're at with commercial opportunities, it's tremendous overall. So we think that's great. In terms of where it trends over time, increasingly the smartphone is becoming an extension of the person. It becomes how they do everything, how they communicate, how they're entertained, how they're informed. So we think that there will be convergence over time between the phone or mobile device and other behavior that people are historically familiar with."
},
{
"speaker": "Jason Maynard",
"text": "Is there an order of -- if I can maybe follow up on that. Is there an order of magnitude that you think can take place from today versus, say, three years from now without maybe giving specific numbers?"
},
{
"speaker": "Susan Wojcicki",
"text": "Hi, this is Susan. I'm going to answer that one. I mean, I -- one way I would think about that, if I think we're still very, very early on in what Mobile can do. But I do think that Mobile will bring completely new ways that we will be interacting with merchants, with advertisers, with our friends over time, and the value of those transactions can be very valuable. But I think what it will actually do is it will grow the overall opportunity, the overall pie and enables us to interact in new ways. So it's hard at this point to really estimate how that will change over time other than we think it's going to grow a lot and that there will be new models that we don't have today."
},
{
"speaker": "Patrick Pichette",
"text": "Yes. So you -- to summarize these two thoughts together, without like really any radical effort -- let me take the case for Android. That is the platform that enabled so much of it. We already announced at the end of Q3 that this was $1 billion run rate business, and we tripped into it with people kind of adapting what was desktop onto Mobile that was clunky. And it's growing at an amazing, blazingly pace in terms of usage. So what you do know is the combination of -- if you think of the areas of Search, of local, of commerce, of entertainment and just on Mobile, just -- we tripped into $1 billion. It just gives you the sense of momentum for the opportunities ahead of us, and that's why we have the focus areas that we have. So that's why we're so optimistic about Mobile. Now Jason, if I circle back to your financial parameters for larger acquisitions, we're quite disciplined, and we've made that comment many times about acquisitions in general at Google. And we have a quadrant in which we operate, where you're looking for the perfect mix between intellectual properties of great code, a great team and great products at a price that we can afford that we think makes strategic sense. So many of -- like, you hear of all the stories of the acquisitions we make. What you don't hear is all the acquisitions that we actually refuse, because they just don't pass our bar. In the case of large transformative ones, we look at them all the time, right? If we had one that actually made sense to finally accelerate a big piece of our agenda, we would do it. We just have not found one yet. And so we'll continue to look at it. We have the position to be able to jump and make big acquisitions. We just want to make sure that we don't have distractions. We have a very focused agenda, and you have to have a really good fit, because big acquisitions can be a massive distraction for Google. Google has a specific culture. It's quite a unique culture. And in that context, we want to make sure that if we were ever to make a large acquisition, it would have to pass a double bar of not only strategic, financial sense, but in addition to that, that it wouldn't become a distraction to the company but in fact, accelerate it. That's a pretty high bar to pass."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jason Helfstein from Oppenheimer."
},
{
"speaker": "Jason Helfstein",
"text": "Two questions. One for Susan and then kind of a bigger picture question. So when we think about the company's ability to grow into local, how important is a local sales force? And are we starting to see the impact of adding local sales people on the expenses? And then secondly, the reorganization, as far as under Larry, based on kind of product would make sense, particularly where we all believe the Internet's going, when we think about, however, like if I look on your Google products page, right? There are just still an enormous amount of products the company offers, albeit revenue is generally concentrated in a few of those products, do you think we'll see a streamlining of products available under the new kind of reorganization?"
},
{
"speaker": "Patrick Pichette",
"text": "So I'll let Nikesh talk about the local area, where on the sales side, he's been kind of spearheading activities. And then I'll give you a conversation about the org issues."
},
{
"speaker": "Nikesh Arora",
"text": "Hi. I guess it's important to understand that with millions of advertisers who we service through our various advertising products, we are constantly in touch with small, medium, large business across the board. And most recently we've turned on phone support and on-boarding and soft landing for all of our small advertisers. We do interact with small business. As we have products that work more and more with local advertisers, we anticipate having a team that works with those advertisers. Now how we do it is still something we are constantly debating. In some cases, it works really well with our existing call centers or our existing teams, which work from around the world. It sometimes requires people on feet on the street, which we also have in over 40 countries around the world. So we are going to use a sort of combination of existing sales teams and sales methods and other sales teams and sales methods that might be required to drive some of our products whether they're in the commerce area, the local area or in the area of providing offers to our customers. But more on that as we continue to drive those products to our sales."
},
{
"speaker": "Patrick Pichette",
"text": "For the issue of broad organization, let me make two comments. The first one is we are -- the realignment that Larry talked about earlier on this call has been really about an organization model that we had, where there was a end person and a product person for every core of our product and then often also a salesperson. And so if you think of having to have two or three products to work together, how you end up with sometimes six or nine decision makers having to align themselves. Larry made a very specific call to say for every one of those core product areas -- and we have one here in the room, in fact two, in the room which is Jeff for Commerce and Local. Jeff is now the final arbiter and decision maker -- and that's to drive velocity. And by the way, take comfort also that these are -- the reorg has been on all of the core pillars of the company. So the real core issue that we wanted to make sure, that Larry wanted to have in place when he kind of launched into as CEO is clear decision makers for velocity, and everybody takes comfort about that. And for the rest of the smaller ones, right, too early to tell. We're just not there yet. We're really focused on the big areas for now and then when the time comes, we'll cover the smaller areas. That's the way we approached it, and we're really thrilled to see the momentum already."
},
{
"speaker": "Operator",
"text": "Our next question comes from Youssef Squali with Jefferies & Company."
},
{
"speaker": "Youssef Squali",
"text": "Two quick questions, please. First, starting with Susan. I know you guys won't break out absolute dollar numbers, but if we just look at the non-search, non-CPC business, I mean with CPM and CPA, can you just help us understand or kind of quantify what kind of revenue growth did you see either on a year-on-year basis or on a sequential basis, just to kind of see the magnitude of your success there? And then I guess maybe for Jeff, Google has been pretty quiet about its video strategy out of YouTube's -- outside of YouTube's user-generated content. Does Google have a video strategy for non-UGC that you can speak to us about?"
},
{
"speaker": "Patrick Pichette",
"text": "On the first -- let me talk about the latter one first and then let Susan talk about the first one. On the non-UGC content, we have made a number of addition to the YouTube team that have very specific expertise in that area. So you should kind of consider that we have a focus on it, but we have nothing specific to announce. Jeff may have additional comments on that."
},
{
"speaker": "Jeffrey Huber",
"text": "Yes, the -- with YouTube, YouTube's roots obviously start with user-generated content. There's a tremendous both size and activity in the user base there. So there's a great asset that we begin with. We are interested in long-form premium content in the longer-term role of YouTube. Another area that we're very excited about and we announced an acquisition this quarter, a company called Next New Networks, which is signaling intent for developing content that is kind of up volume for this new medium that's being created. So I think you'll see a lot more of that as well."
},
{
"speaker": "Patrick Pichette",
"text": "Susan, on the first question of non-CPC revenues and models?"
},
{
"speaker": "Susan Wojcicki",
"text": "Sure. Actually, one thing I do want to kind of step back for is that we are thinking about the best way for our advertisers to be bidding and to be paying for ads across Search and Display. And so we -- with Search, for example, we are enabling our advertisers to bid, for example, with a CPA target. Then Google will figure out the CPCs and the backgrounds. So that's one way that was found, for example, has really grown advertisers' spend on Search. The Product Listing Ads that I talked about in the script actually works with the CPA model. So in Display, we have advertisers who bid on a CPC basis, and when they bought they also bid on a CPM basis. Right now -- and we see advertisers participating in both. A lot of times it has to do with the objective of the advertiser in terms of whether they're more performance driven or more brand driven. As we release more brand features, like I mentioned, like the reserve, that will be a CPM feature. And so really, what we see is that the bidding is very important, that we want to give advertisers a lot of flexibility and how they actually buy it and how they're able to optimize depending upon their objective. And there's no one right way. There's just -- there's a series of things that we will offer to make sure that we have the right product for the advertiser."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jordan Rohan with Stifel, Nicolaus."
},
{
"speaker": "Jordan Rohan",
"text": "Sure. A couple of smaller questions. Can you be a bit more specific about the magnitude of the disruption in the Japanese search market that you saw in the quarter? And second, Android, you mentioned 350,000 devices activated per day. Can you give us some understanding of how that breaks down by smartphone versus tablet and U.S. versus international?"
},
{
"speaker": "Patrick Pichette",
"text": "So on Japan, let me make two comments. One is the events really shocked us as well at Google. And I just want to kind of let the investors know that our first and first response to all the events were really to actually help the Japanese community. So it was about people finding people and all the tools that we have for disaster recovery. We spent a lot of time at Google to actually focus on the community rather than trying to optimize anything that had to do with revenue. Clearly, the month of March has seen some impact from revenue, because all of the community in Japan was focused on the events themselves. Tons of searches, by the way, but not monetizable sort of searches. Japan is a great market for us, and it was and continues to be a very good performing market. So from that perspective when we look ahead into Q2 and Q3, the one thing we do know is we've actually asked -- we made a quick search. We asked Hal Varian, our Chief Economist, to look at other events that would have occurred in Japan of say kind of that type of magnitude to see the resiliency of Japan. And he looked, for example, at the economic recovery after the Kobe disaster of '95. And Japan is actually a first-world country with a very good infrastructure. So they bounce back fast. So although we don't -- we can't predict how the Japanese economy is going to rebound on advertising and -- what is very clear is they are a first-world economy that will recover. So from right now, all we can do is say it's already a strong economy for us and a strong market, right? It has had an impact in Q1. We expect some impact in Q2 as they try to recover, but it will continue to be a strong market for us. So that's on the first -- on the second question. On the first question, why don't I turn it over to Jeff?"
},
{
"speaker": "Jeffrey Huber",
"text": "Yes. So on Android, as mentioned, over 350,000 devices a day are being activated, which is just tremendous growth. In terms of breaking out share by device or by market, we don't break out share by device. If you just look though at where the distribution relationships and partnerships are, obviously, we've got a great presence in the U.S., strong partners in Europe, Japan, Korea. So international is really growing as a component of the overall pie. In terms of phones versus tablets, Android is relatively early on with tablets. So we have the Honeycomb operating system now, which is developed specifically for the devices. We've got some great initial devices like the Motorola XOOM. But as I mentioned earlier in one of the questions, we're seeing just a tremendous amount of innovation in the markets, but I think you're going to see a lot more great Android tablet devices soon."
},
{
"speaker": "Patrick Pichette",
"text": "Okay, we have time -- we're over time already, so we'll take one last question. I just -- before we take the last question, can I just say that for those on the call that may be having trouble accessing our financial slides, we're working on this issue right now. And it should have been fixed for most of the users and will be done very, very shortly. So just to let you know. So Jay, let's take our last question, please."
},
{
"speaker": "Operator",
"text": "Our final question comes from Heath Terry with Canaccord."
},
{
"speaker": "Heath Terry",
"text": "Nikesh, you mentioned that video is changing everything in Display. Much of the video inventory at YouTube is still going unmonetized. What's limiting that, since clearly, the demand from advertisers is there? And is there a roadmap you can talk about or a level that you're thinking of in terms of getting YouTube to what you would consider full monetization?"
},
{
"speaker": "Nikesh Arora",
"text": "I think it's important to understand we monetize video not just on YouTube but also rich media across the Google Display Network. So our intent and our hope is to try and monetize video as a format across the various publisher partners that we have. So that's our point number one. In terms of being able to monetize and continue to grow that, you have to understand there is a value chain that goes through this. We have to make sure that we have the right advertisers, who are excited about this as a medium. I have to make sure that the creative agencies adapt their creatives to work with sort of multiple users. They don't -- you can't just create one ad, which is going to be used on YouTube with 10 million views. You actually have the ability to personalize and target them a bit more. So the creative industry needs to get involved a little bit more in trying to find creative ways, no pun intended, to be able to target all the users that the advertisers would like to target. But having said that, it is a process of selling. We have the sales teams in force. We have the technology in place. We have it integrated across the technology chain in terms of through our exchanges, through our ad serving platforms, et cetera. So we are going down the path [ph] now. We're working with the creative agencies and the most important, the analysis agencies, who actually can prove that there is value in shifting some of the dollars in television towards mediums like YouTube and other video sites around the world. So we're very happy with the progress we're making. We think also that the ducks are in a row. And we hope as we continue to see this trend, this trend is going to shift lots and lots more dollars away from what is now traditionally television towards what I call IP-based video delivery."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Nikesh. So with that, let me just take two last comments. The first one is, as usual, thank our Googlers. I mean, Jeff and Susan and Nikesh and I kind of look good here giving you these great results with 27% year-over-year growth and so many innovations in so many areas of the company. It is really the result of our fantastic Googlers working all the time on all of these areas. So I would just want to thank them. And also, my last closing notes on Jonathan. Everybody commented on Jonathan. He couldn't be here today, because it was already planned that he had a vacation with his family. So we're glad to have Susan and Jeff with us. Clearly, Jonathan's passion for our product is legendary at Google. I don't think that the word is too strongly stated. He loved the tension between the combination of Search and Search monetization. And just to quote him, from one of his last times, he said as Search gets better, it actually creates another huge challenge for us, which is the ads need to keep pace to get better too. Otherwise, what would happen is people will click on fewer ads and well that -- to quote him, well, that would be bad. So as a Jonathan-ism to close the call, it's very obvious that we keep -- we just are immensely thankful for Jonathan's contribution and leadership, and we'll keep focused. I know that he's going to be overlooking on us to make sure that we keep that balance between Search and Ads and all the other innovations. With that, Jay, I will let you close the call. And thank you, everybody, for taking the time this afternoon to listen to the story of Q1. We'll talk to you in Q2."
},
{
"speaker": "Operator",
"text": "That does conclude today's conference. We thank you for your participation."
}
] | null | null |
GOOGL | 4 | 2,010 | 2011-01-21 16:30:00 | Operator: Good day and welcome, everyone, to the Google Inc. Fourth Quarter 2010 Earnings Conference Call. [Operator Instructions] At this time, I would like to turn the conference over to Jane Penner, Senior IR Manager. Please go ahead.
Jane Penner: Good afternoon, everyone, and welcome to today's Fourth Quarter and Fiscal Year 2010 Earnings Conference Call. With us are Eric Schmidt, Chief Executive Officer and Chairman of the Board; Larry Page, Co-Founder and President, Products; Sergey Brin, Co-Founder and President, Technology; Patrick Pichette, Chief Financial Officer; Jonathan Rosenberg, Senior Vice President, Product Management; and Nikesh Arora, Senior Vice President and Chief Business Officer. This call is also being webcast from investor.google.com. A replay of the call will be available on our website in a few hours. Now let me quickly cover the Safe Harbor. Some of the statements we make today may be considered forward-looking including statements regarding our expected level of capital expenditures, Google's future and investments in our long-term growth and innovation and the expected performance of our business. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures we use on this call, such as operating income and operating margin, are also expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will now turn the call over to Eric.
Eric Schmidt: Thank you very much, Jane, and thanks, everybody, for getting on our call. Your time's very valuable. I'm really glad that you all could join us for our quarterly call as reasonably scheduled. We've jumped on the call to talk about the other announcement of this afternoon, which I think everybody is getting a chance to read. We've had a very strong quarter and a very strong year. And I think as our resultS show today, our outlook is very, very bright. Larry and Sergey and I spent the lot of time talking about how to run everything. The last decade, of course, had been fantastic and we anticipate this will continue. How can we run the company even better? And just after a long series of conversations, we decided to make some changes in the way we are structuring, the way we actually operate things. Historically, we've always been running the decisions together. And ultimately, it adds delay and so forth in the way we make decisions. It's actually better to clarify it. So the proposal, which would ultimately now the board has completely approved, is by elevating me and by having Larry running things day-to-day, Sergey focusing on the areas he's going to talk about. We think that this will produce even better success for the corporation. And of course, we're going to do all this by April. So, Larry, do you want to introduce a little bit about your thoughts?
Larry Page: Well, first, I want to really congratulate Eric. He's done an outstanding job leading Google for the last decade. I don't think when Sergey and I started the company, we would have imagined, we could have possibly have imagined we would have a better leader for the company. And we all are in great debt to Eric. And I think the results really speak for themselves. There is no debate about that at all. And there's really know one else in the universe that could have accomplished what Eric has done. And Eric is really a tremendous leader, and I've learned a ton from him over the years. And I think his advice and efforts going forward as Executive Chairman would be invaluable to me and to the company as I start this new role. Google and I want to say is just incredible opportunity. And when we started Google, people actually thought we were coming in too late, that there were already a lot of other search engines. And the Internet and really people's computing life is really still at the very early stages. And I could not be more excited about moving us forward, and we're really only at the beginning. I just can't wait to get it started
Eric Schmidt: Thank you, Larry. Sergey, do you want to talk a little bit about what you would like to get done in this new structure?
Sergey Brin: I'd like to, first at the outset, mention that I had a great time working together with Larry now for about 15 years and with Eric for about a decade. And both of them have really inspired me and moved me, and I'm looking forward to many more decades of work together. Now as we have tried to make, to clarify our respective roles now, I would like to work more on my personal passions, which corresponds of several significant new products that I hope to tell you about in the future. I'm not going to, I know it's been accused of vaporware just recently in the press and what not, so I don't want to repeat that error. And I hope to tell you about them in the future when I'm ready to show you something. But nonetheless, it's really a privilege to work with these two gentlemen, to continue to work with them, and at this company that I've been really proud to be part of all this time.
Eric Schmidt: Thank you very much. And as for myself, I want to get a chance to work on the things that I'm most interested in, taking a more strategic view of things. And I'm going to focus on customers, partners, various government communications, external issues more than the internal issues that I've historically been focusing on. So that's a significant, I think, improvement in the kind of things that I could do with my time. And I want to say very clearly that I believe Larry is ready. He's been working on this area for a long time. His ideas are very interesting and clever, and it's time for him to have a shot at running this and doing it. And I'm sure he'll do a fantastic job. It's interesting that a decade goes by very fast when you work in a partnership as wonderful as this has been, and I'm quite sure that this partnership will continue. We're friends, we're co-workers, we're computer scientists, we have a common vision. I don't anticipate any material change in any of our strategies or anything. We tend to agree on pretty much everything. But I do believe that as a result of this, we'll operate and execute the business even better. So with that, I thought maybe what we should do is have a few questions before we rush off. And then, Patrick, thank you so much for accommodating us on to your call.
Patrick Pichette: It's our pleasure. Jay, if you don't mind, what we'll do is we'll have two sets of questions for this afternoon. We'll just take a few questions now because we have Larry, Sergey and Eric. And so we'll take a few questions. And then after that, we'll close that section of the call, let them run back, go back to work, guys. And then we'll take the regular call as we usually proceed. So, Jay, if I can ask you to give us the instructions to take a couple of questions for Eric, Larry and Sergey?
Operator: [Operator Instructions] We'll go first to James Mitchell of Goldman Sachs.
James Mitchell: I guess one question I have just stemming from the results from the movements perhaps, when I look at the investments in 1118 Avenue in New York City, do you feel that Google is now at a point where in order to continue facilitating the growth of the Internet, that there will be a land grab for desirable physical locations?
Larry Page: I think our primary reason for purchasing the building there was not the Internet infrastructure there but rather the office space that we really enjoy using. The Internet tenants are great, well-paying tenants. We appreciate having them there, but that's not the primary reason why we purchased the building.
Operator: Our next question comes from Spencer Wang with Credit Suisse.
Spencer Wang: Just a big picture question for Eric. You mentioned that one of your areas of focus will be on government outreach, and it seems like Google's maybe come under a little more regulatory scrutiny over the past several years. So I was wondering if you can just talk a little bit about your strategy with regulators to just ensure that Google can continue to expand as necessary?
Eric Schmidt: The simple answer is that we're talking to them. An awful lot of the problems that we've been having are people don't actually understand what we really do and what we don't do, and some of our competitors are assisting in that misinformation. And so part of our core strategy is literally to communicate. This is what we're doing. We're trying to be as transparent and collaborative as possible. I will tell you very clearly that the regulators have a proper job to do. They're there for a reason and we respect that. And so far, we've been quite successful by just taking the time to get people to understand. And we're sensitive to the close lines. This is where we get too close to something and we try to stay away from that. We try to stay well within the safety zone of the way we're operating, with respect to the legal issues and the competitive issues. We also argue very strongly that the things that we're doing are very pro-competitive. And I genuinely believe that, and I'll be telling people a lot of that for a long time as expected.
Operator: Our next question will come from Imran Khan with JPMorgan.
Imran Khan: Larry, as you become the CEO, I think it was just very interesting juncture of Google's life cycle. And I think there's a lot of questions that we get from investors that the proliferation of social networking and how the traffic, more and more traffic source to the social networking platforms are becoming. So as Google get to the next level, how do you think about the realtime search in the social networking platforms that are becoming a better brand and the Web applications and the Mobile apps? How do you think Google will become the point of play and you can send traffic to other places?
Eric Schmidt: Sergey, you've been driving most of this, and maybe, Larry, you could comment as well.
Sergey Brin: Yes. I think that you point out two important trends, I think. One is the notion of realtime. And the other, the broad notion of social in terms of identity, relationships and so forth. And I think both of those are very important to search. In fact, you've seen over the past year or so us roll out functionality along those lines. First of all, of course, we have the realtime updates now built into our Search, which includes Twitter and other sources. You've also seen us to deploy social search, which allows you to find search results that are related to people who you know and friends of their friends and so forth. And you see those right in the main Search Results of the Web. But I think that this is really just the tip of the iceberg. And I think there is far more opportunity. We've touched just 1% of the capabilities that could be deployed in that realm. And I think you should expect us to continue to develop those kinds of capabilities.
Eric Schmidt: Larry, did you want to add anything to that?
Larry Page: I mean I have the last part of what Sergey said really resonates with me. I think that there's -- if you think about the next five years of what your life will be like, online and socially, and what kind of things the tools would be able to do, we're only at the very, very early stages of that. And I'm incredibly excited about the possibilities to come.
Operator: Our next question comes from Justin Post of Bank of America.
Justin Post: We've noticed a lot of changes on the site, moving you farther down the purchasing funnel. And we've heard some regulatory pushbacks, so maybe this is a question for you, Eric, but also potential some advertiser complaints. So I'm just wondering how the changes in your Search Ad results, are they really driving your revenues and helping drive the strong growth? And how are you dealing with the advertisers and the regulatory environment on some of those changes that might be replacing some of the functionality of other websites?
Eric Schmidt: There's no question that our extraordinary results are partly coming from algorithmic improvements that we do all the time. Our basic strategy, of course, is to have the right ad and the right spot done exactly right every time. And we do, literally, billions of these every day. And so that's sort of the great magic of Google, if you will. We've looked very, very carefully at how we make the decisions as to which ads go where, and so forth. And we're pretty happy with the choice that we make in terms of ranking ads, and so forth. There have been some competitor complaints and so forth of that, and we're doing a pretty thorough review. But so far, we're pretty happy with them, we think it will pass the necessary complaints and so forth that people are hearing. So I think with that, I think we sort of run -- Patrick is saying we really run over our time. I really appreciate everybody sort of letting us come in and do this. I wanted to say to you that it's been a great privilege to be the CEO for 10 years, literally, a decade. And a decade is a long time to be a CEO. So I'm very much looking forward to this new role, a more strategic role in something where I can work on some new things, which I'm excited about. And I'm even more looking forward to working with my, literally, best friends and partners, Larry and Sergey. And I hope you all understand how powerful this triumvirate has been and how for us personally, and how much it means to us as individuals. So thank you all and, Patrick, do you want to sort of take over?
Patrick Pichette: Absolutely. Thank you so much, Larry, Sergey, Eric, to take the time to join us this afternoon. So with that, what we'll do is, if you don't mind muting your buttons, we're going to jump right into it. And we'll go to our more regular conversations. So I will start with my opening remarks and the financials, Jonathan is going to give us his read of the year, and then we'll be joined by Nikesh for our Q&A section. So how else to talk about 2010 in Q4 as a phenomenal ending to the very good year at Google? I mean, our incredibly strong performance in Q4 and 2010 overall, is really a testimonial to the fundamental trends in a digital economy. Those trends, they're fueling huge opportunities for innovation, for growth, both at Google, but also in the entire ecosystem. One of these profound trends is the shift from advertising offline to online, and it continues at a quite rapid clip. And you've seen it fueling growth both in our core Search business but across the board as well. A case in point is revenue growth has in our core accelerated strongly in the second half of 2010, which is really particularly impressive, if you think about it, given that in Q4 2009 was itself a very strong quarter. So in addition, investments in our newer businesses, the usual suspects of Display, Mobile, Enterprise, they are also in parallel, creating a second powerful growth engine for Google. Jonathan will give you more details on that in a minute. But at a high level, I just want to make it clear that how can we not be happy with the overall performance and trajectories of 2010 and on that basis, be excited about our prospects for 2011 and beyond. So let me turn for the specifics of the performance of the quarter now. Let's go through the results. Gross revenue, we grew 26% year-over-year to $8.4 billion. Our Google website revenue was up 28% year-over-year to $5.7 billion, and we saw strengths across most major geographies and verticals. Our AdSense revenue was up 22% year-over-year to $2.5 billion, again, with continuous strength in our Google Display Network. Our other revenue was up 31% to $273 million. Our global aggregate paid clicks growth was very strong, up 18% year-over-year, and up 11% quarter-over-quarter. This is really reflecting, as I mentioned, the acceleration shift of offline to online, without a doubt, as each year shows there is more and more holiday shopping happening online. Our aggregate cost-per-click growth also was pretty healthy, up 5% year-over-year, and 4% quarter-over-quarter. And note that FX had a negative impact on CPC growth year-over-year, although a positive impact quarter-over-quarter. Remember, too, that this is an aggregate number and that includes the dot-com and AdSense properties. If I turn to our geographic performance, the U.S. and the rest of the world are both growing at a very healthy pace, and our results clearly show that, while the U.K. continue to lag a little bit in the global economic recovery. Revenue from the U.S. was up just shy of 30% at 29% to $4.1 billion. And in our earnings slides, that you can find at our investor website, you'll see that we've broken down our revenue by U.S., U.K. and rest of world to show the impact of FX and the benefits from our hedging programs. So I encourage you to go to these slides for the exact calculations. The international revenue accounted for 52% of our revenue, $4.4 billion, and up 25% year-over-year. And it includes $25 million of benefits from our hedging programs so a relatively small number. Using fixed exchange rates though, our international revenue would have been roughly $132 million higher year-over-year. As I said, the U.K. was a little slower, and it was up 14% year-over-year to $878 million. If I turn to expenses, traffic acquisition costs at $2.1 billion, or 25% of advertising revenue. Other cost of revenue was $877 million, including stock-based compensation of $45 million. And finally, all operating expenses totaled $2.5 billion, including approximately $351 million in stock-based compensation, SPC. The increase year-over-year in OpEx was primarily due to our increases in payroll, advertising and promotion spend and professional services. As a result of all this, our non-GAAP operating profit, which excludes our stock-based compensation, increased at $3.4 billion in Q4, resulting in non-GAAP operating margin of 40%. Our headcount was up approximately 1,000 for the quarter. And we ended the year roughly at 24,400 full-time employees. Our effective tax rate, you should note, was 19% in Q4, and this reflects the R&D tax credit legislation that passed in December in the U.S. and for which we recognized the full benefit in Q4. Now let me turn to cash management. OI&E was $160 million for Q4, which reflects the continued good portfolio management performance, and it was offset a little bit by our FAS 133 expenses. For more detail again on OI&E, I just encourage you to refer to the slides that accompany this call on our IR site. Our operating cash flow was very strong at $3.5 billion for the quarter. CapEx for the fourth quarter was $2.5 billion, I mean, obviously significantly above the last quarter, but remember that the majority of this increase was from the purchase of the New York building. The remaining balances was, as usual, primarily related to our data center and operations. As a reminder, we'll continue to make significant CapEx investments and yet, you have another data point to show that they do tend to be lumpy from quarter-to-quarter depending on when we are able to make these investments. We're very pleased with our free cash flow. Despite having purchased the office building in New York, right just shy of $1 billion, and the office building is obviously a one-time event. So with all this being said, Google is in an excellent financial performance for 2010, incremental revenue for the year of $5.7 billion and operating cash flow, around $11 billion. That is a phenomenal performance, plus, a digital economy that's clearly on high gear. So why -- in that context, you can understand why we're so optimistic. And it's with confidence that we're pursuing an aggressive growth agenda. We talk about growth agenda means investing. And so here's a couple of places where we have decided to invest in and will continue to invest. First, we talked about the intense competition, if you remember on our last call, in for labor. So as part of this strategy to answer this challenge, we have announced a compensation change in Q4, which will affect all of our employees. We've made two changes to attract and retain the best talent. First, we raised all base salaries by 10% across-the-board. In addition to that, we shifted some compensation from bonus into base salary for non-execs, and I repeat or non-execs, which will result for them in more stable income for our employees. And please note that all those changes are really becoming effective on January 1 of this year, so they're not included into our Q4 results. Remember also that with salary increases come ripple effects, such as 401(k)s or employee taxes or other that will actually flow through as well. So if that's for compensation, we've also made and continue to make strategic investments in sales and marketing for both new products but also advertiser acquisition. Product areas like Chrome and Chrome OS, which are such part of our future, follow our core philosophy of building these open platforms with big optionality and creating infrastructure where everybody on the Web can succeed. We'll continue to push on those but also, acquiring advertisers will and continues to remain a top priority. We're also investing in our long-term infrastructure, including both facilities and our core computing network. As you've seen in Q4, the purchase of New York City office was not only a wise investment but a clear commitment to our New York City site and frankly, a reflection of our optimism about our growth prospects. Investing in innovation is also about making tough choices. And we've made them throughout 2010 as well by choosing to close products or initiatives that weren't working as well as we would have liked or just had run their courses. So for examples, we did shut down the Wave product, and we've also shut down our consumer channel for Nexus in 2010. And also, many other smaller projects that we wouldn't talk usually on the call but things like GOOG-411. And yes, we're investing aggressively but with discipline. Really, as we mentioned in the last call, pouring a lot of resources on what we call our hockey sticks, with a clear focus on long-term ROI. And yes, we'll continue to invest heavily but with the same proven discipline and results that you've witnessed from us over the last few years. So in summary, we are incredibly pleased of our performance of 2010, optimistic of our trajectory for '11 and beyond. Accordingly, we continue to invest aggressively in a bold, innovation agenda. So with that, I'll turn it over to Jonathan to speak about the product muscles in Q4 in 2010. And then we'll take it over to Q&A. Jonathan, all yours?
Jonathan Rosenberg: Well, thanks, Patrick. So we certainly did have a great year at Google. And I really like to think some of it stems from the unique way that we manage our product and engineering machine. When we hire product managers, they often come in and they ask me, they say, "So how do we measure success at Google?" And I always told them it's simple. At the end of the year, we make a list of all of your successes and your failures. You're then measured on the sum of your successes and by how much you learn from your failures. So at the beginning of 2010, one of our concerns was that as we scaled, this approach might lead to our being spread too thin. Instead, we thought, maybe we needed to put more wood behind fewer arrows. So we made some changes. And I think they addressed this concern without actually affecting the basic philosophy of how we've always run product and engineering at Google. So let's talk about what we changed. At the beginning of the year, we decided to double down on the core, so that's Search and Search Ads, And I think the financial numbers that you guys are seeing today reflect the fact that, that was a successful bet. But behind those numbers is a really relentless stream of new features and product innovations. For example, we made a big effort this year to make Search more interactive, and you can see that with Google Instant. And then more recently, we made previews instant as well. And earlier in the year, we launched new user interfaces for both Web Search and Image Search to make it easier and to make it more intuitive to work with the results after you run a search. And we're also making Search more intelligent. We made several changes to results. So you now you can see things like a concert schedule, or the answers to the questions highlighted right in the snippet. And we're also now starting to roll out Place Search. So when we know that you're looking for something that's in the neighborhood like an ice cream shop or something, we'll pull reviews, webpages, the address and the photo, altogether for you. We also doubled down on the Ad side of the house. In the past year, we've launched several new ad formats, which we've told you about, Sitelinks, seller rating ads. Recently, we just added this product listing ads with photos and prices. It makes sense that if I'm shopping for something like a coffee maker, it's helpful to see more information in the ad. But the biggest boost of all came from good old-fashioned ads quality improvements. Q4 was our best quarter in years from a quality standpoint. We launched over 20 updates, which led to gains that were nearly double those that we would normally see in a strong quarter. So although we've been at this for years, we're still finding lots and lots of ways to make ads better. The other change in 2010 was that several of our new businesses started to achieve escape velocity. And our philosophy is to encourage lots of innovation, and then we see feed the winners and starve the losers. And this creates kind of a Darwinian, but sort of Google-y, environment in which new businesses emerge and grow. And in 2010, it's really clear that some new winners started to emerge, like Display. We now have over 2 million publisher partners. The number of transactions on the DoubleClick Ad Exchange tripled, and publishers who sell their ad space via the Exchange are nearly tripling their revenue when the Exchange wins the auction. YouTube revenue more than doubled. We began adding features like live streaming to help partners deliver and ultimately, of course, to monetize content in new ways. Enterprise added impressive customers like the U.S. government's General Services Administration. And we expanded distribution with partnerships like the deal with Softbank in Japan. Android, now activating over 300,000 phones per day. This helped drive a 10x year-over-year increase in the volume of searches from Android devices. Then finally, in 2010, I think we we're more structured in our approach to our business. The product and sales teams are working together more closely than ever, thanks in large part to my buddy here, Nikesh. Patrick's rigor helped us dynamically reallocate resources and as he mentioned, cancel a few projects like Wave and Nexus One direct to consumer that weren't achieving their goals. So what does all these mean for 2011. I think you can expect more of the same. We're going to double down again on the core of Search and Search Ads. We're going to feed the 2010 winners, Display, YouTube, Enterprise and Android, and we're going to do it all with even greater financial rigor and cross-functional coordination all over the world. But I'm also excited about the prospect for a couple of our newest businesses, Local and Commerce. In Local, over 5 million businesses have claimed their Google place pages. And we recently started testing a new ad product, which we called Boost, and that gives businesses a really easy and fast way to promote themselves online and to connect with the people who are searching for them. In Commerce, we're investing a lot to close the loop from online to offline shopping. I think I've mentioned on four different earnings calls in the past couple of years, the key to unlocking mobile commerce was to make it easier for people to both search and then to consummate their transaction from their mobile device. Someone in my team actually counted back on the calls and it was four times. I think as smartphones become ubiquitous and local businesses put their inventory online, I think this is the year where phones will play the big role in commerce that I've long predicted. There will be some important differences in 2011. We will invest in hiring even more product managers and engineers. We're going to give them greater autonomy, and we're going to push them to work faster. In fact, we're asking everyone here to do more and to do it faster. Through the year, we'll tally our successes. I'm sure you all will probably remind us of any failures, so we can keep learning from them. I hope you all now better understand our sense of optimism from a product perspective for 2011. I'm confident you guys will help us keep track of how this year's product efforts play out on the important score card of financial progress. Thanks a lot and back to Patrick
Patrick Pichette: Thank you, Jonathan. Now Jonathan and I have made a noble attempt on the back of the big announcement of today to keep your attention over the last 10 minutes. So I hope that you'll have taken all the notes that you had to. And now what we'll do is we'll turn it to Jay. Nikesh is joining us, so he is getting set up in his chair with his phone. And we'll turn it over to Jay, and we'll go to the Q&A section of this call. Jay, give us the instructions please?
Operator: [Operator Instructions] And we'll go to Ben Schachter with Macquarie.
Benjamin Schachter: Jonathan, I wanted to ask you question about Mobile, and specifically how Google thinks about the differences between tablet users and smartphone users, and how those differences are really influencing the high-level view of how you're viewing the overall evolving mobile market. And then Patrick, if you could address the sales and marketing line, which I think was somewhat unexpectedly high.
Jonathan Rosenberg: Sure, Ben, we can take that in order. I'll go with the first question. I think it's probably easier to talk about initially how tablets and smartphones are similar, right? Both of them are growing at a terrific pace. As is the case of Mobile, what we see on these devices is that search usage on the tablets tends to peak on the weekend and it dips on the weekdays, so it's generally complementary to desktop, which we've talked about before. What does that suggest? Maybe, the people are using them more for personal usage as opposed to business. We do see on tablets the weekend peak is a little bit more pronounced than it is on phones. I think that's probably the case because people pretty much always carry their smartphone during the week. Some of the bigger differences, the tablet users tend to search more for things like news and they tend to do more shopping-related topics when you compare them to smartphone users. I think there's some anecdotal data that they may convert better, but I haven't actually been through all of that in detail. I tend to think that the tablets behave a little bit more like desktop devices than do smartphones because it's a little easier to input information into them like a credit card. I think the other major difference is the UI approaches are different, right? Apps, like the Gmail App for the tablet, is more designed for the big screen. So I think they're both taking off, and the revenue from tablets as well as smartphones reflects that. Patrick?
Patrick Pichette: All right, I'll take the second question. If there is a good proof that we just don't kind of like streamline our lines in terms of expenses, but we go opportunistically and in a smart move, I think sales and marketing is a great example of that. And if you think of the last 12 months, what we've clearly shown is how much in high gear is the digital economy. And when that opportunity shows up, right, we just needed to jump on it and decide to fuel it. And on the marketing side, and even on sales, I mean Nikesh -- I'll actually ask Nikesh to give you a bit of color on the sales side. But on the marketing side, when you have big platforms like Chrome and Chrome OS, that can and will be incredibly successful if promoted. Why wouldn't you do it now? I hear from the financial community, the other side, which is what are you doing with your money? Well, we have great opportunities, why wouldn't we jump on it with this kind of market? And on the sales side, Nikesh, you could probably give a color commentary as well.
Nikesh Arora: Thank you, Patrick. I think what is important for you to understand, we decided to put our sort of foot to the pedal later in this year. And there was an area of our customer that advertises we decided to continue to put more focus on which is the small to medium-sized advertisers because where that's where a lot of our growth engine is going to come form in the future. And effectively, a lot of the sales costs there are advertiser acquisition's costs because once you bring them into our system, they stay there for a while. And they continue to work and continue to generate more revenues. And some of the revenue performance you're seeing has been across the small channels or the mid-tier channels, and that investment is sort of already beginning to bear fruit.
Operator: Our next question comes from Mark Mahaney with Citi.
Mark Mahaney: If I can ask a question on the local advertising play and it's sounds like you've got a couple of products you've been working on, rolling out for a while, and I think you also may have attempted an acquisition inter-quarter. Can you maybe quantify the opportunity for us, is this something that has always been part of the build up plan? Is there something you saw in the last 12 months that really indicated that this was the time to accelerate the efforts against local advertising? And then, do you already feel like you got all the assets now in place, or are you still going to look for more assets in order to have that play viable?
Patrick Pichette: Let me just -- as a preamble, all right, we do not talk about M&A. Local has always been part of our strategy. And Nikesh can talk about the initiatives, or just about the initiatives we're doing there in terms of the boost in the products that we have, or maybe Jonathan, the boost product. And just it's one more of the initiatives we have in local. But local is, just to kind of give you a sense of framework, right? It's one out of every five searches have some form of local kind of tendency or factor. So it's not kind of side event for us. Jonathan?
Jonathan Rosenberg: Sure, Mark. I mean, I think we've been very focused on Local since, wow, going all the way back to maybe my second year when we acquired Keyhole here with the Google, which was basically the original company that built Google Earth. And really, the idea was that ultimately the Web should be this virtual mirror of the world at all times. And that mirror of the world becomes much more useful. And when it's more relevant -- and it's more relevant to the users when you get everything organized around places in the physical world. And I think the other thing which has come into play more recently is that technology has made it possible through the use of GPS and smartphones for us to understand where you are. And so I think what we've recognized more recently is that because smartphones have become deployed more aggressively, that we can supply you with relevant information about the places that you're near with the appropriate contextual-oriented search. So if you're at a restaurant, you want to pull up a menu, you don't want just the menu that the waiter handed you, you want the one in there that has the reviews and the picks from your friends. So I think what's basically changed over the course of the last year is it's become easier for local businesses to identify themselves in context on Google, and it's become easier for us to find out where you are. And then, of course, we've mapped that with Nikesh's team, which is working on selling Boost and Tags and some of the other ad formats that we've developed specifically for Local.
Operator: Our next question comes from Doug Anmuth with Barclays Capital.
Douglas Anmuth: Patrick, can you talk a little bit more about your philosophy just around the New York headquarters? I think this is the first time where you've actually really come out and confirmed the purchase. And why do you need to own the New York headquarters rather than sort of getting access to it in some other way, and why is this a good use of capital? And then secondly, can you just talk, just following up on Local, discuss whether you really are building out more of a local salesforce in addition to obviously, the local products themselves?
Patrick Pichette: I'll take the first, and then I'll let Nikesh about the initiatives we're doing on the Local side. Look, we have 2,000 employees on site today in New York. And our business and our engineering center, it's a big engineering center, by the way, it's not only a big kind of sales center but it's a big engineering center. So if you think of the eastern hub being in that place, with 2,000 and growing at the pace at which we're growing, it's actually very difficult to find in New York, a place that would accommodate that number of employees in an environment that fits Google's standards and Google's needs. We do not -- I mean, we actually believe that living in a tower where there's a very small footprint on the floor to floor is terrible for the Google culture. So there's very few buildings in New York that actually can accommodate our needs, right? Replacing that building for us or moving out of there would actually be probably very difficult to find another place and then be prohibitively expensive. And then finally, it gives us a lot of control over growing into that space. So all this to say on top of what we believe will be is a very good investment. So for all these reasons, coming back to the previous, it's not about carrier hotel owning. Everything is about the Google-iness. So for all of these reasons, I think it did make sense. And we called it a one-time item because it just fitted so well our strategy. For the Local salesforce, I'll turn it to Nikesh to give you a bit more details on our strategy there.
Nikesh Arora: I think there's more to understand that Local, the way you define that actually ends up in three different interpretations. One is we've always had local features to our adverse products. You can always localized to your advertising towards users who are in a certain area, certain territory. So you always have the ability to localize. The other thing we've done in Local is the way I think local is sometimes synonymous with smaller advertisers and smaller territories. And towards that end, we have created the most simplistic set of products around Tags and Boost, which is more amenable to the advertisers. They don't have to do a lot of work. Sometimes they don't even have their own websites. And that allows them to still participate in the online economy. And third, we, for the longest of times, had partnerships with other companies who've been selling advertising on our behalf to smaller advertisers, be it in small local areas, or we've been using other partners who will use their salesforce to call on smaller advertisers for us. So we are going to use a combination of all of these three efforts to continue to pursue our Local strategy going forward.
Operator: Our next question comes from Brian Pitz with UBS.
Brian Pitz: Patrick, would you give us a rough organic revenue growth rate, excluding acquisitions? And then secondly, a question on Ads, are you guys seeing any competitive share shifts in dollars from Search or Display towards other social platforms or applications?
Patrick Pichette: So on the second one, I'll let Nikesh give you a sense. On first one, I don't have the breakdown and we don't provide the breakdown. But I can tell you that all of our core properties are growing very well, and not only our core properties but also our new growth businesses as well. When you look at the numbers for just the google.com growing year-over-year, 28%, right? How can you not be happy with that kind of performance? And so overall, we're very pleased with our growth rate of revenue. I'll let Nikesh talk about the second piece.
Nikesh Arora: I think it's important to understand that Search for the longest of times had been performance advertising. And so has the large chunk of Display, it's been performance advertising. Some of the newer players you're talking about are sort of playing the brand display space. So overall if you look at it, the stronger trend is shift of brand dollars from the offline world into the online world and continue of shift to some of those dollars, of sales and marketing dollars, into performance-based advertising. So we're seeing that shift both on our Search side. We're seeing that shift both on our Display side and also, seeing some brand dollars in the Search side and some brand dollars in Display side. So I think it's more than fair to say that right now, the bigger trend is the shift from offline to online. And there has been less of an allocation shift within the online world because all these measures, all these means are measurable, and you're seeing better ROI for these measurable events in both in the performance Display, performance Search. So that's where the trend is.
Operator: Our next question comes from Ross Sandler with RBC Capital Markets.
Ross Sandler: Patrick, a question on the Display business. If you look out and analyze the financial statements for just about any publicly traded ad network out there, these businesses seem to peak out, and the operating margin seem to peak out in the 20% to 25% range, do you think there's anything structurally different about Google's approach in the Display business that could allow Google to achieve higher operating margins? Or is it that just the peak for that kind of business model? And then, Nikesh, just the quick question on the ROW acceleration. So 31% year-over-year, can you talk a little bit about which regions that's coming from, or is it across the board? And is there any acceleration from new revenue areas like Display or is it just the core Search business?
Patrick Pichette: The fundamental -- on the first one, let me answer the Display and then I'll let Nikesh talk about the performance worldwide. I think in Display, the most fundamental issue is if you're on your own network or if you're optimizing for other's network and participating in other's network. So if you think of YouTube, it's our own property. And therefore, you have a completely different set of economics. And so you just got to make sure you don't compare apples and oranges. So one, obviously, has a much higher margin than the other, and the question then is the mix. So if you think of us in Display where we have the whole suite of services from what used to be Teracent and all the other pieces, then you have the mix of properties. And that's how you have to think about it. In terms of geographic split and performance, it's a fantastic story, so why not let Nikesh give you the color commentary on it.
Nikesh Arora: Just before this, adding to what Patrick said on the Display side, I think it's also important to understand the contribution of the Ad Exchange, which basically allows you to bring buyers and sellers together. And we are seeing a serious uplift for people who are participating on the Ad Exchange in terms of revenue. So whilst your traditional Display business, you might be seeing margins profiles are different and I can't predict the future margin profiles but clearly, there's an uplift and a benefit to advertisers who participate in the Exchange or publishers who participate in the Exchange. So that's also beneficial...
Patrick Pichette: To tell it differently, we have three resources in that because you have the Ad Exchange on top of that.
Nikesh Arora: So in terms of the sort of rest of the world performance, I think there are some things which are notable this quarter in addition to our usual stalwarts where the U.S. continues to be strong and the rest of the world is strong. Germany has maintained its strength because of its economic development, which has been different from the rest of Europe, so that has showed up in our results as well. I am very particularly excited about some of the turnaround we've achieved in Japan because we've been putting in a considerate effort over the last many months to try and put an aggressive foot out in the marketplace in terms of bringing in more partners, more advertisers and generally, upgrading the entire effort in Japan from our side, so we are seeing the results of that. In addition to that, some of the commodity markets, markets where the commodities are strong, are Brazil, Australia. So those have been strong in general. The U.K. continues to be weak, as you notice, but it is very strong market for us, it's a big market for us as well.
Patrick Pichette: In closing on that topic, I think it's worth noting if you do your financial math and you move rest of world into constant FX, so if you take out the fact that we had crosswinds over year-over-year, in fact, our growth rate for rest of world is over 30%, it's C:\Transcripts\Calls\118059477\VoiceWriter31%. So again, very good momentum there.
Operator: Our next question comes from Scott Devitt with Morgan Stanley.
Scott Devitt: Paid click growth on a percentage basis was the highest rate in two years, and you mentioned a few things on the call, better ads, better targeting, even local monetization. And I was just wondering to what extent some other factors came into play as well, particularly Google Instant and the rollout of that product, as well as the incremental nature of smartphone and tablet queries.
Patrick Pichette: So I think that for paid click growth, that you really have to look at a couple of factors. And I just want to start by kind of debunking a myth on Google Instant, right? Everybody seems to have -- there's kind of a buzz out there that Google Instant is the driver for a lot of the revenue growth. And in fact, Google Instant is neutral. It is not making any significant contribution to our revenue growth. What's really making the contribution is that there's really -- our growth is driven by three interdependent drivers that are all acting and tooling together. One is, clearly, the strength of the economic recovery and the consumer shift online. And you can look -- ever since Thanksgiving, and you've seen it from external sources as well, people have moved online. They're spending a lot of time shopping online, looking for coupons. So the behavior is strong economic recovery, which brings a lot more auction into these -- a lot more participants into the auctions because they want to be where the users are. In addition to that, right you have a second compounding factor pounding on it which is platforms are changing, right? The use of mobile phones, iPads, Instant Search tool, but also GEO, the fact that you get instant location, you can get coupons, all these things, right, just from a platform perspective are driving it on top of it. And then finally, right, it is true that Jonathan's teams fantastic job at making great ads tuning and monetization like the VizURL, and Jonathan you may want to take a second to talk about VizURL. It's those factors that are really driving the CPC growth and the click through rate growth rather than instant search. So I just want to be clear because I know there's a rumor on the street running that it's all about Instant search. And Instant search is about the user. It's people spending 10% faster, that is a huge number, 10%. And that's why we did Instant search. So maybe VizURL is a good example that you want to talk about, Jonathan?
Jonathan Rosenberg: Sure. I guess other than the ads quality improvements, which I can cover in a second, I think the only other area that Patrick didn't cover would basically just be the new ad formats, all of which are boosting click through rates. And I mentioned those in my prepared remarks, the product listing ads, more recently, offer ads, coupon-based ads. The seller ratings, which we've also launched, have significant impact in click through rates as well as the Sitelinks. But I think that probably the most significant thing in terms of what impacted the whole ads area this quarter was this concept that we call Visible URL. And basically, what we did was on the top ads, we moved the advertiser's URL down to its own separate line below the creative rather than having it be part of the creative. And that obviously makes it easier for people to see where they will go as they click. It's actually a little bit of an interesting story. I'll give you some of the background because this is by far the most significant change that we had from ads quality perspective in a very long time. It turned out early in the quarter, some of the engineers in Japan noticed that it was really hard to read the creative because we actually had the ads URL, which was in Latin characters, mixed in with the ad creative which was in Kanji. And it didn't really take brilliant research to figure out that human perception gets really confused when characters switch like that in the middle of a sentence. People just sort of skip the whole sentence. And if they skip something, that's sort of really bad when that sentence is a text ad. So we ran this experiment in Japan and we moved the URL down to its own line, and click through rates went up dramatically. So we launched that feature pretty expeditiously in, I think, Japan, China, Korea and Russia. And then what happened is the engineers kind of said "Well, hey, just for fun, let's try that in the rest of the world. " And we actually didn't expect so much because we didn't have the same dynamic of Latin characters versus Kanji, but it turned out that people skip sentences with long, unusual words in it. So people were tuning out that line. And we quickly launched this feature globally. It was one of the fastest things that we ever launched after the ads testing. I believe we launched it right around Thanksgiving. And that had a very significant change in the clicks that we saw in the course of the quarter.
Patrick Pichette: So just to close on that, just to kind of say, it is, and I know that Jonathan has used that trumpet a number of times in the past, but just continues to illustrate how much more innovation there is left in both formats and in just all the things that we do in terms of innovation in the ad space.
Operator: Our next question comes from Jeetil Patel with Deutsche Bank.
Jeetil Patel: If we look at your kind of a revenue line from a kind of customer base standpoint, whether it's Fortune 500 or Ad Age 100 versus Internet pureplay indemics, and then the small to medium-size business category, I guess the SMB category was weaker during the credit crisis and you had a hard time coming back, I'm curious as to your thoughts as to how it's coming back today. And do you think there is a different way of approaching that SMB market as you look ahead into this year and going forward in terms of products or maybe ways to help drive leads or sales in that segment of the market?
Patrick Pichette: I'll let Nikesh answer the question. Just one point of clarification on your statement though and during the recession a couple of years ago, I think you mentioned that we thought that SMBs were kind of going down. And in fact, Nikesh will clarify, they were going the other way. So Nikesh, I'll leave it to you to answer the question.
Nikesh Arora: I think the important thing to understand is we're seeing such a disproportionate amount of strengths from the very large advertisers across the board because effectively what's happened over the years is that they've gone out and really strength their e-commerce offerings, they've gotten their act together, they've got all the logistics in place. And given that this was the quarter of Christmas and Thanksgiving, you saw a tremendous amount of strengths from large advertisers wanting to play against the pureplay Internet players. Now in addition to that, what has also happened is we've put an effort over the last six months on the SMB and mid-market side. In the mid-market side, we've basically gone ahead and adopted a higher touch strategy. I even spend more time on the phone with our customers. We even go and visit some of our mid-tier customers because to be fair over the years, they have grown to be larger mid-tier customers than they used to be in the past. So we have put in sort of a conscious higher touch strategy. And last but not the least, for the smaller advertisers, we are working very closely with our product team and Jonathan and his team to try and look at various systemic and algorithmic improvements we can make, working with them in large direct marketing campaigns and where we can continue to sort of reduce churn to that the area and continue to acquire more, which is related to the other comment on slightly higher sales spending on trying to acquire smaller advertisers. So we have efforts across the board, across all three categories. We don't think that effort is done and fully over with.
Jeetil Patel: Do you think the business model or pricing model has to be different there, whether it's percentage of sale or some other kind of approach to going after the spend in that segment?
Nikesh Arora: No, I think to be fair, if you look at the simplifications we have done on the ad work side and local products, which is another way of thinking about smaller advertisers, that is a way to create a simpler product for them where they don't have to put in a lot more effort or we have things like keyword-less ads where they don't have to go ahead and sort of work towards creating keywords or will work. On the Display side, we've got contextual targeting where you can create ad groups very, very quickly. So we may continue to make product improvements which allow things to become more and more simple so advertisers can sort of go and do their daily business as opposed to spend time understanding more complicated stuff on our side. So yes, you're right, they are different, simpler products we create for them, which have slightly different pricing, so that they can continue to participate in the online economy.
Operator: Our next question comes from Jason Maynard with Wells Fargo Securities.
Jason Maynard: I had a question just on the Mobile business. Last quarter, obviously, you saw some increased momentum. I'm curious just from a pricing perspective, what you're starting to see from the advertisers? And what kind of progress did you see over the last 90 days? And maybe more importantly, as NFC starts to become more prevalent in smartphones, I mean how do you think that changes the dynamic in terms of what type of effective monetization you're going to see from the Local Commerce side?
Patrick Pichette: So let me give you just a few starts to kind of continue to keep the contacts, right? Mobile search grew 4x on Mobile devices for web browsers in the last year. So there is no doubt that this market is just absolutely cranking. And there's a lot of work, and I'll let Jonathan talk about it, about ad formats are still kind of nascent and building, both on the Display side and on the regular side, and we see a lot of upside. Jonathan, you probably want to kind of cover those.
Jonathan Rosenberg: Yes. We don't really actually break out the details in terms of the exact difference. It's certainly the Click-to-Call ads are generating millions of calls every month. A lot of advertisers are running these campaigns. I think one you can see if you tried is DirectTV. We did launch a call-only option where the only clickable link in the ad is actually a phone number, which not surprisingly substantially increases the click through rates on mobile devices. And we've extended some of the desktop formats pretty successfully to Mobile. Sitelinks is one. If you try a query on Oakley, you'll see one, if you seller ratings on something like running shoes. So I think there's a lot more to learn there, but the advertisers are very excited and engaged. At the moment, I don't have any specific comments on NFC other than to go back to the statements that I've made in previous calls, which is when people are completing transactions with these devices, it becomes much more tractable and obviously significantly more valuable.
Operator: Our last question comes from Steve Weinstein with Pacific Crest.
Steve Weinstein: First, you commented that you're going to be shifting more compensation to base pay from bonus. I was wondering if you could let us know what the ratio had been historically as far as those two components of comp? And finally, obviously, the acceleration of all the metrics is pretty exciting, pretty positive for the outlook. I was wondering if you could help us understand though how much acceleration is happening within the core business? And how much of the acceleration is maybe some of the newer businesses really starting to get some scale, and maybe tipping the overall momentum in the business?
Patrick Pichette: On compensation first, as I said, we raised all salaries. So if you think of kind of financial modeling for a second, all salaries had been raised 10% across-the-board, January 1. And that has a ripple effect on -- the kind of ripple effect of the employee taxes, 401(k)s and all the rest of the benefits. It will also impact, obviously, everybody that we bring on this year as well. So as we bring in new people, they are costing us now slightly more. In addition to that, what we've done is part of the bonus is kind of calculated without giving you the exact number. We had two components to our annual bonus. One, which is a company multiplier, and one which is an individual multiplier. And what we've done for the non-execs, because we want execs to actually continue to be treated differently, the non-execs are treated in that what used to be a company multiplier, which didn't really have a lot of influence on, we shifted over to base pay. And their individual multiplier component of the bonus continues to be a very kind of directly involved into their calculation of their personal bonus. So by shifting that company multiplier we didn't have a lot of influence on, right, it just moves into more predictable cash flows for them all through the year rather than waiting for the end of the year, and that was the rationale for doing it. In terms of revenue growth, I mean, last quarter, we gave kind of two syndication points on Display, on Mobile, right? We've talked about the fact that our core -- if you look at our Enterprise Business, 30 million users, 3 million businesses on apps, the kind of magnitude of numbers we're talking about in each of our growth areas, whether it be Mobile, whether it be Android, whether it be YouTube, where we continue to have YouTube, right. I mean to give you a snippet, YouTube's revenue more than doubled in 2010, right? So that's why we're optimistic across-the-board, and that's why we're very kind of open about the fact that when you have such a digital economy running in high gear, why don't you take the opportunity to invest at the time where it is actually transforming itself. And that's what we're doing, and we're delighted in fact to continue to push hard on that. And that's what you see also in sales and marketing. With that -- let me reiterate, so I probably hope I got your attention back because the front end of this conversation got totally sideswiped by the big three, you guys showing up and taking over our seats and phones, but phenomenal year end to what has been a terrific year. I have to thank all of our Googlers. They do an amazing job every day. It looks easy when I show up with Jonathan and Nikesh and talking about these fantastic results, but our Googlers do an amazing job all around the world, and so does our partners. And so to them, thank you so much for your fantastic efforts in 2010, and we'll just set up for a fantastic 2011 again. With that, I'll let Jay close the call.
Jonathan Rosenberg: That does conclude today's conference. We thank you for your participation. | [
{
"speaker": "Operator",
"text": "Good day and welcome, everyone, to the Google Inc. Fourth Quarter 2010 Earnings Conference Call. [Operator Instructions] At this time, I would like to turn the conference over to Jane Penner, Senior IR Manager. Please go ahead."
},
{
"speaker": "Jane Penner",
"text": "Good afternoon, everyone, and welcome to today's Fourth Quarter and Fiscal Year 2010 Earnings Conference Call. With us are Eric Schmidt, Chief Executive Officer and Chairman of the Board; Larry Page, Co-Founder and President, Products; Sergey Brin, Co-Founder and President, Technology; Patrick Pichette, Chief Financial Officer; Jonathan Rosenberg, Senior Vice President, Product Management; and Nikesh Arora, Senior Vice President and Chief Business Officer. This call is also being webcast from investor.google.com. A replay of the call will be available on our website in a few hours. Now let me quickly cover the Safe Harbor. Some of the statements we make today may be considered forward-looking including statements regarding our expected level of capital expenditures, Google's future and investments in our long-term growth and innovation and the expected performance of our business. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures we use on this call, such as operating income and operating margin, are also expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will now turn the call over to Eric."
},
{
"speaker": "Eric Schmidt",
"text": "Thank you very much, Jane, and thanks, everybody, for getting on our call. Your time's very valuable. I'm really glad that you all could join us for our quarterly call as reasonably scheduled. We've jumped on the call to talk about the other announcement of this afternoon, which I think everybody is getting a chance to read. We've had a very strong quarter and a very strong year. And I think as our resultS show today, our outlook is very, very bright. Larry and Sergey and I spent the lot of time talking about how to run everything. The last decade, of course, had been fantastic and we anticipate this will continue. How can we run the company even better? And just after a long series of conversations, we decided to make some changes in the way we are structuring, the way we actually operate things. Historically, we've always been running the decisions together. And ultimately, it adds delay and so forth in the way we make decisions. It's actually better to clarify it. So the proposal, which would ultimately now the board has completely approved, is by elevating me and by having Larry running things day-to-day, Sergey focusing on the areas he's going to talk about. We think that this will produce even better success for the corporation. And of course, we're going to do all this by April. So, Larry, do you want to introduce a little bit about your thoughts?"
},
{
"speaker": "Larry Page",
"text": "Well, first, I want to really congratulate Eric. He's done an outstanding job leading Google for the last decade. I don't think when Sergey and I started the company, we would have imagined, we could have possibly have imagined we would have a better leader for the company. And we all are in great debt to Eric. And I think the results really speak for themselves. There is no debate about that at all. And there's really know one else in the universe that could have accomplished what Eric has done. And Eric is really a tremendous leader, and I've learned a ton from him over the years. And I think his advice and efforts going forward as Executive Chairman would be invaluable to me and to the company as I start this new role. Google and I want to say is just incredible opportunity. And when we started Google, people actually thought we were coming in too late, that there were already a lot of other search engines. And the Internet and really people's computing life is really still at the very early stages. And I could not be more excited about moving us forward, and we're really only at the beginning. I just can't wait to get it started"
},
{
"speaker": "Eric Schmidt",
"text": "Thank you, Larry. Sergey, do you want to talk a little bit about what you would like to get done in this new structure?"
},
{
"speaker": "Sergey Brin",
"text": "I'd like to, first at the outset, mention that I had a great time working together with Larry now for about 15 years and with Eric for about a decade. And both of them have really inspired me and moved me, and I'm looking forward to many more decades of work together. Now as we have tried to make, to clarify our respective roles now, I would like to work more on my personal passions, which corresponds of several significant new products that I hope to tell you about in the future. I'm not going to, I know it's been accused of vaporware just recently in the press and what not, so I don't want to repeat that error. And I hope to tell you about them in the future when I'm ready to show you something. But nonetheless, it's really a privilege to work with these two gentlemen, to continue to work with them, and at this company that I've been really proud to be part of all this time."
},
{
"speaker": "Eric Schmidt",
"text": "Thank you very much. And as for myself, I want to get a chance to work on the things that I'm most interested in, taking a more strategic view of things. And I'm going to focus on customers, partners, various government communications, external issues more than the internal issues that I've historically been focusing on. So that's a significant, I think, improvement in the kind of things that I could do with my time. And I want to say very clearly that I believe Larry is ready. He's been working on this area for a long time. His ideas are very interesting and clever, and it's time for him to have a shot at running this and doing it. And I'm sure he'll do a fantastic job. It's interesting that a decade goes by very fast when you work in a partnership as wonderful as this has been, and I'm quite sure that this partnership will continue. We're friends, we're co-workers, we're computer scientists, we have a common vision. I don't anticipate any material change in any of our strategies or anything. We tend to agree on pretty much everything. But I do believe that as a result of this, we'll operate and execute the business even better. So with that, I thought maybe what we should do is have a few questions before we rush off. And then, Patrick, thank you so much for accommodating us on to your call."
},
{
"speaker": "Patrick Pichette",
"text": "It's our pleasure. Jay, if you don't mind, what we'll do is we'll have two sets of questions for this afternoon. We'll just take a few questions now because we have Larry, Sergey and Eric. And so we'll take a few questions. And then after that, we'll close that section of the call, let them run back, go back to work, guys. And then we'll take the regular call as we usually proceed. So, Jay, if I can ask you to give us the instructions to take a couple of questions for Eric, Larry and Sergey?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] We'll go first to James Mitchell of Goldman Sachs."
},
{
"speaker": "James Mitchell",
"text": "I guess one question I have just stemming from the results from the movements perhaps, when I look at the investments in 1118 Avenue in New York City, do you feel that Google is now at a point where in order to continue facilitating the growth of the Internet, that there will be a land grab for desirable physical locations?"
},
{
"speaker": "Larry Page",
"text": "I think our primary reason for purchasing the building there was not the Internet infrastructure there but rather the office space that we really enjoy using. The Internet tenants are great, well-paying tenants. We appreciate having them there, but that's not the primary reason why we purchased the building."
},
{
"speaker": "Operator",
"text": "Our next question comes from Spencer Wang with Credit Suisse."
},
{
"speaker": "Spencer Wang",
"text": "Just a big picture question for Eric. You mentioned that one of your areas of focus will be on government outreach, and it seems like Google's maybe come under a little more regulatory scrutiny over the past several years. So I was wondering if you can just talk a little bit about your strategy with regulators to just ensure that Google can continue to expand as necessary?"
},
{
"speaker": "Eric Schmidt",
"text": "The simple answer is that we're talking to them. An awful lot of the problems that we've been having are people don't actually understand what we really do and what we don't do, and some of our competitors are assisting in that misinformation. And so part of our core strategy is literally to communicate. This is what we're doing. We're trying to be as transparent and collaborative as possible. I will tell you very clearly that the regulators have a proper job to do. They're there for a reason and we respect that. And so far, we've been quite successful by just taking the time to get people to understand. And we're sensitive to the close lines. This is where we get too close to something and we try to stay away from that. We try to stay well within the safety zone of the way we're operating, with respect to the legal issues and the competitive issues. We also argue very strongly that the things that we're doing are very pro-competitive. And I genuinely believe that, and I'll be telling people a lot of that for a long time as expected."
},
{
"speaker": "Operator",
"text": "Our next question will come from Imran Khan with JPMorgan."
},
{
"speaker": "Imran Khan",
"text": "Larry, as you become the CEO, I think it was just very interesting juncture of Google's life cycle. And I think there's a lot of questions that we get from investors that the proliferation of social networking and how the traffic, more and more traffic source to the social networking platforms are becoming. So as Google get to the next level, how do you think about the realtime search in the social networking platforms that are becoming a better brand and the Web applications and the Mobile apps? How do you think Google will become the point of play and you can send traffic to other places?"
},
{
"speaker": "Eric Schmidt",
"text": "Sergey, you've been driving most of this, and maybe, Larry, you could comment as well."
},
{
"speaker": "Sergey Brin",
"text": "Yes. I think that you point out two important trends, I think. One is the notion of realtime. And the other, the broad notion of social in terms of identity, relationships and so forth. And I think both of those are very important to search. In fact, you've seen over the past year or so us roll out functionality along those lines. First of all, of course, we have the realtime updates now built into our Search, which includes Twitter and other sources. You've also seen us to deploy social search, which allows you to find search results that are related to people who you know and friends of their friends and so forth. And you see those right in the main Search Results of the Web. But I think that this is really just the tip of the iceberg. And I think there is far more opportunity. We've touched just 1% of the capabilities that could be deployed in that realm. And I think you should expect us to continue to develop those kinds of capabilities."
},
{
"speaker": "Eric Schmidt",
"text": "Larry, did you want to add anything to that?"
},
{
"speaker": "Larry Page",
"text": "I mean I have the last part of what Sergey said really resonates with me. I think that there's -- if you think about the next five years of what your life will be like, online and socially, and what kind of things the tools would be able to do, we're only at the very, very early stages of that. And I'm incredibly excited about the possibilities to come."
},
{
"speaker": "Operator",
"text": "Our next question comes from Justin Post of Bank of America."
},
{
"speaker": "Justin Post",
"text": "We've noticed a lot of changes on the site, moving you farther down the purchasing funnel. And we've heard some regulatory pushbacks, so maybe this is a question for you, Eric, but also potential some advertiser complaints. So I'm just wondering how the changes in your Search Ad results, are they really driving your revenues and helping drive the strong growth? And how are you dealing with the advertisers and the regulatory environment on some of those changes that might be replacing some of the functionality of other websites?"
},
{
"speaker": "Eric Schmidt",
"text": "There's no question that our extraordinary results are partly coming from algorithmic improvements that we do all the time. Our basic strategy, of course, is to have the right ad and the right spot done exactly right every time. And we do, literally, billions of these every day. And so that's sort of the great magic of Google, if you will. We've looked very, very carefully at how we make the decisions as to which ads go where, and so forth. And we're pretty happy with the choice that we make in terms of ranking ads, and so forth. There have been some competitor complaints and so forth of that, and we're doing a pretty thorough review. But so far, we're pretty happy with them, we think it will pass the necessary complaints and so forth that people are hearing. So I think with that, I think we sort of run -- Patrick is saying we really run over our time. I really appreciate everybody sort of letting us come in and do this. I wanted to say to you that it's been a great privilege to be the CEO for 10 years, literally, a decade. And a decade is a long time to be a CEO. So I'm very much looking forward to this new role, a more strategic role in something where I can work on some new things, which I'm excited about. And I'm even more looking forward to working with my, literally, best friends and partners, Larry and Sergey. And I hope you all understand how powerful this triumvirate has been and how for us personally, and how much it means to us as individuals. So thank you all and, Patrick, do you want to sort of take over?"
},
{
"speaker": "Patrick Pichette",
"text": "Absolutely. Thank you so much, Larry, Sergey, Eric, to take the time to join us this afternoon. So with that, what we'll do is, if you don't mind muting your buttons, we're going to jump right into it. And we'll go to our more regular conversations. So I will start with my opening remarks and the financials, Jonathan is going to give us his read of the year, and then we'll be joined by Nikesh for our Q&A section. So how else to talk about 2010 in Q4 as a phenomenal ending to the very good year at Google? I mean, our incredibly strong performance in Q4 and 2010 overall, is really a testimonial to the fundamental trends in a digital economy. Those trends, they're fueling huge opportunities for innovation, for growth, both at Google, but also in the entire ecosystem. One of these profound trends is the shift from advertising offline to online, and it continues at a quite rapid clip. And you've seen it fueling growth both in our core Search business but across the board as well. A case in point is revenue growth has in our core accelerated strongly in the second half of 2010, which is really particularly impressive, if you think about it, given that in Q4 2009 was itself a very strong quarter. So in addition, investments in our newer businesses, the usual suspects of Display, Mobile, Enterprise, they are also in parallel, creating a second powerful growth engine for Google. Jonathan will give you more details on that in a minute. But at a high level, I just want to make it clear that how can we not be happy with the overall performance and trajectories of 2010 and on that basis, be excited about our prospects for 2011 and beyond. So let me turn for the specifics of the performance of the quarter now. Let's go through the results. Gross revenue, we grew 26% year-over-year to $8.4 billion. Our Google website revenue was up 28% year-over-year to $5.7 billion, and we saw strengths across most major geographies and verticals. Our AdSense revenue was up 22% year-over-year to $2.5 billion, again, with continuous strength in our Google Display Network. Our other revenue was up 31% to $273 million. Our global aggregate paid clicks growth was very strong, up 18% year-over-year, and up 11% quarter-over-quarter. This is really reflecting, as I mentioned, the acceleration shift of offline to online, without a doubt, as each year shows there is more and more holiday shopping happening online. Our aggregate cost-per-click growth also was pretty healthy, up 5% year-over-year, and 4% quarter-over-quarter. And note that FX had a negative impact on CPC growth year-over-year, although a positive impact quarter-over-quarter. Remember, too, that this is an aggregate number and that includes the dot-com and AdSense properties. If I turn to our geographic performance, the U.S. and the rest of the world are both growing at a very healthy pace, and our results clearly show that, while the U.K. continue to lag a little bit in the global economic recovery. Revenue from the U.S. was up just shy of 30% at 29% to $4.1 billion. And in our earnings slides, that you can find at our investor website, you'll see that we've broken down our revenue by U.S., U.K. and rest of world to show the impact of FX and the benefits from our hedging programs. So I encourage you to go to these slides for the exact calculations. The international revenue accounted for 52% of our revenue, $4.4 billion, and up 25% year-over-year. And it includes $25 million of benefits from our hedging programs so a relatively small number. Using fixed exchange rates though, our international revenue would have been roughly $132 million higher year-over-year. As I said, the U.K. was a little slower, and it was up 14% year-over-year to $878 million. If I turn to expenses, traffic acquisition costs at $2.1 billion, or 25% of advertising revenue. Other cost of revenue was $877 million, including stock-based compensation of $45 million. And finally, all operating expenses totaled $2.5 billion, including approximately $351 million in stock-based compensation, SPC. The increase year-over-year in OpEx was primarily due to our increases in payroll, advertising and promotion spend and professional services. As a result of all this, our non-GAAP operating profit, which excludes our stock-based compensation, increased at $3.4 billion in Q4, resulting in non-GAAP operating margin of 40%. Our headcount was up approximately 1,000 for the quarter. And we ended the year roughly at 24,400 full-time employees. Our effective tax rate, you should note, was 19% in Q4, and this reflects the R&D tax credit legislation that passed in December in the U.S. and for which we recognized the full benefit in Q4. Now let me turn to cash management. OI&E was $160 million for Q4, which reflects the continued good portfolio management performance, and it was offset a little bit by our FAS 133 expenses. For more detail again on OI&E, I just encourage you to refer to the slides that accompany this call on our IR site. Our operating cash flow was very strong at $3.5 billion for the quarter. CapEx for the fourth quarter was $2.5 billion, I mean, obviously significantly above the last quarter, but remember that the majority of this increase was from the purchase of the New York building. The remaining balances was, as usual, primarily related to our data center and operations. As a reminder, we'll continue to make significant CapEx investments and yet, you have another data point to show that they do tend to be lumpy from quarter-to-quarter depending on when we are able to make these investments. We're very pleased with our free cash flow. Despite having purchased the office building in New York, right just shy of $1 billion, and the office building is obviously a one-time event. So with all this being said, Google is in an excellent financial performance for 2010, incremental revenue for the year of $5.7 billion and operating cash flow, around $11 billion. That is a phenomenal performance, plus, a digital economy that's clearly on high gear. So why -- in that context, you can understand why we're so optimistic. And it's with confidence that we're pursuing an aggressive growth agenda. We talk about growth agenda means investing. And so here's a couple of places where we have decided to invest in and will continue to invest. First, we talked about the intense competition, if you remember on our last call, in for labor. So as part of this strategy to answer this challenge, we have announced a compensation change in Q4, which will affect all of our employees. We've made two changes to attract and retain the best talent. First, we raised all base salaries by 10% across-the-board. In addition to that, we shifted some compensation from bonus into base salary for non-execs, and I repeat or non-execs, which will result for them in more stable income for our employees. And please note that all those changes are really becoming effective on January 1 of this year, so they're not included into our Q4 results. Remember also that with salary increases come ripple effects, such as 401(k)s or employee taxes or other that will actually flow through as well. So if that's for compensation, we've also made and continue to make strategic investments in sales and marketing for both new products but also advertiser acquisition. Product areas like Chrome and Chrome OS, which are such part of our future, follow our core philosophy of building these open platforms with big optionality and creating infrastructure where everybody on the Web can succeed. We'll continue to push on those but also, acquiring advertisers will and continues to remain a top priority. We're also investing in our long-term infrastructure, including both facilities and our core computing network. As you've seen in Q4, the purchase of New York City office was not only a wise investment but a clear commitment to our New York City site and frankly, a reflection of our optimism about our growth prospects. Investing in innovation is also about making tough choices. And we've made them throughout 2010 as well by choosing to close products or initiatives that weren't working as well as we would have liked or just had run their courses. So for examples, we did shut down the Wave product, and we've also shut down our consumer channel for Nexus in 2010. And also, many other smaller projects that we wouldn't talk usually on the call but things like GOOG-411. And yes, we're investing aggressively but with discipline. Really, as we mentioned in the last call, pouring a lot of resources on what we call our hockey sticks, with a clear focus on long-term ROI. And yes, we'll continue to invest heavily but with the same proven discipline and results that you've witnessed from us over the last few years. So in summary, we are incredibly pleased of our performance of 2010, optimistic of our trajectory for '11 and beyond. Accordingly, we continue to invest aggressively in a bold, innovation agenda. So with that, I'll turn it over to Jonathan to speak about the product muscles in Q4 in 2010. And then we'll take it over to Q&A. Jonathan, all yours?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Well, thanks, Patrick. So we certainly did have a great year at Google. And I really like to think some of it stems from the unique way that we manage our product and engineering machine. When we hire product managers, they often come in and they ask me, they say, \"So how do we measure success at Google?\" And I always told them it's simple. At the end of the year, we make a list of all of your successes and your failures. You're then measured on the sum of your successes and by how much you learn from your failures. So at the beginning of 2010, one of our concerns was that as we scaled, this approach might lead to our being spread too thin. Instead, we thought, maybe we needed to put more wood behind fewer arrows. So we made some changes. And I think they addressed this concern without actually affecting the basic philosophy of how we've always run product and engineering at Google. So let's talk about what we changed. At the beginning of the year, we decided to double down on the core, so that's Search and Search Ads, And I think the financial numbers that you guys are seeing today reflect the fact that, that was a successful bet. But behind those numbers is a really relentless stream of new features and product innovations. For example, we made a big effort this year to make Search more interactive, and you can see that with Google Instant. And then more recently, we made previews instant as well. And earlier in the year, we launched new user interfaces for both Web Search and Image Search to make it easier and to make it more intuitive to work with the results after you run a search. And we're also making Search more intelligent. We made several changes to results. So you now you can see things like a concert schedule, or the answers to the questions highlighted right in the snippet. And we're also now starting to roll out Place Search. So when we know that you're looking for something that's in the neighborhood like an ice cream shop or something, we'll pull reviews, webpages, the address and the photo, altogether for you. We also doubled down on the Ad side of the house. In the past year, we've launched several new ad formats, which we've told you about, Sitelinks, seller rating ads. Recently, we just added this product listing ads with photos and prices. It makes sense that if I'm shopping for something like a coffee maker, it's helpful to see more information in the ad. But the biggest boost of all came from good old-fashioned ads quality improvements. Q4 was our best quarter in years from a quality standpoint. We launched over 20 updates, which led to gains that were nearly double those that we would normally see in a strong quarter. So although we've been at this for years, we're still finding lots and lots of ways to make ads better. The other change in 2010 was that several of our new businesses started to achieve escape velocity. And our philosophy is to encourage lots of innovation, and then we see feed the winners and starve the losers. And this creates kind of a Darwinian, but sort of Google-y, environment in which new businesses emerge and grow. And in 2010, it's really clear that some new winners started to emerge, like Display. We now have over 2 million publisher partners. The number of transactions on the DoubleClick Ad Exchange tripled, and publishers who sell their ad space via the Exchange are nearly tripling their revenue when the Exchange wins the auction. YouTube revenue more than doubled. We began adding features like live streaming to help partners deliver and ultimately, of course, to monetize content in new ways. Enterprise added impressive customers like the U.S. government's General Services Administration. And we expanded distribution with partnerships like the deal with Softbank in Japan. Android, now activating over 300,000 phones per day. This helped drive a 10x year-over-year increase in the volume of searches from Android devices. Then finally, in 2010, I think we we're more structured in our approach to our business. The product and sales teams are working together more closely than ever, thanks in large part to my buddy here, Nikesh. Patrick's rigor helped us dynamically reallocate resources and as he mentioned, cancel a few projects like Wave and Nexus One direct to consumer that weren't achieving their goals. So what does all these mean for 2011. I think you can expect more of the same. We're going to double down again on the core of Search and Search Ads. We're going to feed the 2010 winners, Display, YouTube, Enterprise and Android, and we're going to do it all with even greater financial rigor and cross-functional coordination all over the world. But I'm also excited about the prospect for a couple of our newest businesses, Local and Commerce. In Local, over 5 million businesses have claimed their Google place pages. And we recently started testing a new ad product, which we called Boost, and that gives businesses a really easy and fast way to promote themselves online and to connect with the people who are searching for them. In Commerce, we're investing a lot to close the loop from online to offline shopping. I think I've mentioned on four different earnings calls in the past couple of years, the key to unlocking mobile commerce was to make it easier for people to both search and then to consummate their transaction from their mobile device. Someone in my team actually counted back on the calls and it was four times. I think as smartphones become ubiquitous and local businesses put their inventory online, I think this is the year where phones will play the big role in commerce that I've long predicted. There will be some important differences in 2011. We will invest in hiring even more product managers and engineers. We're going to give them greater autonomy, and we're going to push them to work faster. In fact, we're asking everyone here to do more and to do it faster. Through the year, we'll tally our successes. I'm sure you all will probably remind us of any failures, so we can keep learning from them. I hope you all now better understand our sense of optimism from a product perspective for 2011. I'm confident you guys will help us keep track of how this year's product efforts play out on the important score card of financial progress. Thanks a lot and back to Patrick"
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Jonathan. Now Jonathan and I have made a noble attempt on the back of the big announcement of today to keep your attention over the last 10 minutes. So I hope that you'll have taken all the notes that you had to. And now what we'll do is we'll turn it to Jay. Nikesh is joining us, so he is getting set up in his chair with his phone. And we'll turn it over to Jay, and we'll go to the Q&A section of this call. Jay, give us the instructions please?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] And we'll go to Ben Schachter with Macquarie."
},
{
"speaker": "Benjamin Schachter",
"text": "Jonathan, I wanted to ask you question about Mobile, and specifically how Google thinks about the differences between tablet users and smartphone users, and how those differences are really influencing the high-level view of how you're viewing the overall evolving mobile market. And then Patrick, if you could address the sales and marketing line, which I think was somewhat unexpectedly high."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Sure, Ben, we can take that in order. I'll go with the first question. I think it's probably easier to talk about initially how tablets and smartphones are similar, right? Both of them are growing at a terrific pace. As is the case of Mobile, what we see on these devices is that search usage on the tablets tends to peak on the weekend and it dips on the weekdays, so it's generally complementary to desktop, which we've talked about before. What does that suggest? Maybe, the people are using them more for personal usage as opposed to business. We do see on tablets the weekend peak is a little bit more pronounced than it is on phones. I think that's probably the case because people pretty much always carry their smartphone during the week. Some of the bigger differences, the tablet users tend to search more for things like news and they tend to do more shopping-related topics when you compare them to smartphone users. I think there's some anecdotal data that they may convert better, but I haven't actually been through all of that in detail. I tend to think that the tablets behave a little bit more like desktop devices than do smartphones because it's a little easier to input information into them like a credit card. I think the other major difference is the UI approaches are different, right? Apps, like the Gmail App for the tablet, is more designed for the big screen. So I think they're both taking off, and the revenue from tablets as well as smartphones reflects that. Patrick?"
},
{
"speaker": "Patrick Pichette",
"text": "All right, I'll take the second question. If there is a good proof that we just don't kind of like streamline our lines in terms of expenses, but we go opportunistically and in a smart move, I think sales and marketing is a great example of that. And if you think of the last 12 months, what we've clearly shown is how much in high gear is the digital economy. And when that opportunity shows up, right, we just needed to jump on it and decide to fuel it. And on the marketing side, and even on sales, I mean Nikesh -- I'll actually ask Nikesh to give you a bit of color on the sales side. But on the marketing side, when you have big platforms like Chrome and Chrome OS, that can and will be incredibly successful if promoted. Why wouldn't you do it now? I hear from the financial community, the other side, which is what are you doing with your money? Well, we have great opportunities, why wouldn't we jump on it with this kind of market? And on the sales side, Nikesh, you could probably give a color commentary as well."
},
{
"speaker": "Nikesh Arora",
"text": "Thank you, Patrick. I think what is important for you to understand, we decided to put our sort of foot to the pedal later in this year. And there was an area of our customer that advertises we decided to continue to put more focus on which is the small to medium-sized advertisers because where that's where a lot of our growth engine is going to come form in the future. And effectively, a lot of the sales costs there are advertiser acquisition's costs because once you bring them into our system, they stay there for a while. And they continue to work and continue to generate more revenues. And some of the revenue performance you're seeing has been across the small channels or the mid-tier channels, and that investment is sort of already beginning to bear fruit."
},
{
"speaker": "Operator",
"text": "Our next question comes from Mark Mahaney with Citi."
},
{
"speaker": "Mark Mahaney",
"text": "If I can ask a question on the local advertising play and it's sounds like you've got a couple of products you've been working on, rolling out for a while, and I think you also may have attempted an acquisition inter-quarter. Can you maybe quantify the opportunity for us, is this something that has always been part of the build up plan? Is there something you saw in the last 12 months that really indicated that this was the time to accelerate the efforts against local advertising? And then, do you already feel like you got all the assets now in place, or are you still going to look for more assets in order to have that play viable?"
},
{
"speaker": "Patrick Pichette",
"text": "Let me just -- as a preamble, all right, we do not talk about M&A. Local has always been part of our strategy. And Nikesh can talk about the initiatives, or just about the initiatives we're doing there in terms of the boost in the products that we have, or maybe Jonathan, the boost product. And just it's one more of the initiatives we have in local. But local is, just to kind of give you a sense of framework, right? It's one out of every five searches have some form of local kind of tendency or factor. So it's not kind of side event for us. Jonathan?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Sure, Mark. I mean, I think we've been very focused on Local since, wow, going all the way back to maybe my second year when we acquired Keyhole here with the Google, which was basically the original company that built Google Earth. And really, the idea was that ultimately the Web should be this virtual mirror of the world at all times. And that mirror of the world becomes much more useful. And when it's more relevant -- and it's more relevant to the users when you get everything organized around places in the physical world. And I think the other thing which has come into play more recently is that technology has made it possible through the use of GPS and smartphones for us to understand where you are. And so I think what we've recognized more recently is that because smartphones have become deployed more aggressively, that we can supply you with relevant information about the places that you're near with the appropriate contextual-oriented search. So if you're at a restaurant, you want to pull up a menu, you don't want just the menu that the waiter handed you, you want the one in there that has the reviews and the picks from your friends. So I think what's basically changed over the course of the last year is it's become easier for local businesses to identify themselves in context on Google, and it's become easier for us to find out where you are. And then, of course, we've mapped that with Nikesh's team, which is working on selling Boost and Tags and some of the other ad formats that we've developed specifically for Local."
},
{
"speaker": "Operator",
"text": "Our next question comes from Doug Anmuth with Barclays Capital."
},
{
"speaker": "Douglas Anmuth",
"text": "Patrick, can you talk a little bit more about your philosophy just around the New York headquarters? I think this is the first time where you've actually really come out and confirmed the purchase. And why do you need to own the New York headquarters rather than sort of getting access to it in some other way, and why is this a good use of capital? And then secondly, can you just talk, just following up on Local, discuss whether you really are building out more of a local salesforce in addition to obviously, the local products themselves?"
},
{
"speaker": "Patrick Pichette",
"text": "I'll take the first, and then I'll let Nikesh about the initiatives we're doing on the Local side. Look, we have 2,000 employees on site today in New York. And our business and our engineering center, it's a big engineering center, by the way, it's not only a big kind of sales center but it's a big engineering center. So if you think of the eastern hub being in that place, with 2,000 and growing at the pace at which we're growing, it's actually very difficult to find in New York, a place that would accommodate that number of employees in an environment that fits Google's standards and Google's needs. We do not -- I mean, we actually believe that living in a tower where there's a very small footprint on the floor to floor is terrible for the Google culture. So there's very few buildings in New York that actually can accommodate our needs, right? Replacing that building for us or moving out of there would actually be probably very difficult to find another place and then be prohibitively expensive. And then finally, it gives us a lot of control over growing into that space. So all this to say on top of what we believe will be is a very good investment. So for all these reasons, coming back to the previous, it's not about carrier hotel owning. Everything is about the Google-iness. So for all of these reasons, I think it did make sense. And we called it a one-time item because it just fitted so well our strategy. For the Local salesforce, I'll turn it to Nikesh to give you a bit more details on our strategy there."
},
{
"speaker": "Nikesh Arora",
"text": "I think there's more to understand that Local, the way you define that actually ends up in three different interpretations. One is we've always had local features to our adverse products. You can always localized to your advertising towards users who are in a certain area, certain territory. So you always have the ability to localize. The other thing we've done in Local is the way I think local is sometimes synonymous with smaller advertisers and smaller territories. And towards that end, we have created the most simplistic set of products around Tags and Boost, which is more amenable to the advertisers. They don't have to do a lot of work. Sometimes they don't even have their own websites. And that allows them to still participate in the online economy. And third, we, for the longest of times, had partnerships with other companies who've been selling advertising on our behalf to smaller advertisers, be it in small local areas, or we've been using other partners who will use their salesforce to call on smaller advertisers for us. So we are going to use a combination of all of these three efforts to continue to pursue our Local strategy going forward."
},
{
"speaker": "Operator",
"text": "Our next question comes from Brian Pitz with UBS."
},
{
"speaker": "Brian Pitz",
"text": "Patrick, would you give us a rough organic revenue growth rate, excluding acquisitions? And then secondly, a question on Ads, are you guys seeing any competitive share shifts in dollars from Search or Display towards other social platforms or applications?"
},
{
"speaker": "Patrick Pichette",
"text": "So on the second one, I'll let Nikesh give you a sense. On first one, I don't have the breakdown and we don't provide the breakdown. But I can tell you that all of our core properties are growing very well, and not only our core properties but also our new growth businesses as well. When you look at the numbers for just the google.com growing year-over-year, 28%, right? How can you not be happy with that kind of performance? And so overall, we're very pleased with our growth rate of revenue. I'll let Nikesh talk about the second piece."
},
{
"speaker": "Nikesh Arora",
"text": "I think it's important to understand that Search for the longest of times had been performance advertising. And so has the large chunk of Display, it's been performance advertising. Some of the newer players you're talking about are sort of playing the brand display space. So overall if you look at it, the stronger trend is shift of brand dollars from the offline world into the online world and continue of shift to some of those dollars, of sales and marketing dollars, into performance-based advertising. So we're seeing that shift both on our Search side. We're seeing that shift both on our Display side and also, seeing some brand dollars in the Search side and some brand dollars in Display side. So I think it's more than fair to say that right now, the bigger trend is the shift from offline to online. And there has been less of an allocation shift within the online world because all these measures, all these means are measurable, and you're seeing better ROI for these measurable events in both in the performance Display, performance Search. So that's where the trend is."
},
{
"speaker": "Operator",
"text": "Our next question comes from Ross Sandler with RBC Capital Markets."
},
{
"speaker": "Ross Sandler",
"text": "Patrick, a question on the Display business. If you look out and analyze the financial statements for just about any publicly traded ad network out there, these businesses seem to peak out, and the operating margin seem to peak out in the 20% to 25% range, do you think there's anything structurally different about Google's approach in the Display business that could allow Google to achieve higher operating margins? Or is it that just the peak for that kind of business model? And then, Nikesh, just the quick question on the ROW acceleration. So 31% year-over-year, can you talk a little bit about which regions that's coming from, or is it across the board? And is there any acceleration from new revenue areas like Display or is it just the core Search business?"
},
{
"speaker": "Patrick Pichette",
"text": "The fundamental -- on the first one, let me answer the Display and then I'll let Nikesh talk about the performance worldwide. I think in Display, the most fundamental issue is if you're on your own network or if you're optimizing for other's network and participating in other's network. So if you think of YouTube, it's our own property. And therefore, you have a completely different set of economics. And so you just got to make sure you don't compare apples and oranges. So one, obviously, has a much higher margin than the other, and the question then is the mix. So if you think of us in Display where we have the whole suite of services from what used to be Teracent and all the other pieces, then you have the mix of properties. And that's how you have to think about it. In terms of geographic split and performance, it's a fantastic story, so why not let Nikesh give you the color commentary on it."
},
{
"speaker": "Nikesh Arora",
"text": "Just before this, adding to what Patrick said on the Display side, I think it's also important to understand the contribution of the Ad Exchange, which basically allows you to bring buyers and sellers together. And we are seeing a serious uplift for people who are participating on the Ad Exchange in terms of revenue. So whilst your traditional Display business, you might be seeing margins profiles are different and I can't predict the future margin profiles but clearly, there's an uplift and a benefit to advertisers who participate in the Exchange or publishers who participate in the Exchange. So that's also beneficial..."
},
{
"speaker": "Patrick Pichette",
"text": "To tell it differently, we have three resources in that because you have the Ad Exchange on top of that."
},
{
"speaker": "Nikesh Arora",
"text": "So in terms of the sort of rest of the world performance, I think there are some things which are notable this quarter in addition to our usual stalwarts where the U.S. continues to be strong and the rest of the world is strong. Germany has maintained its strength because of its economic development, which has been different from the rest of Europe, so that has showed up in our results as well. I am very particularly excited about some of the turnaround we've achieved in Japan because we've been putting in a considerate effort over the last many months to try and put an aggressive foot out in the marketplace in terms of bringing in more partners, more advertisers and generally, upgrading the entire effort in Japan from our side, so we are seeing the results of that. In addition to that, some of the commodity markets, markets where the commodities are strong, are Brazil, Australia. So those have been strong in general. The U.K. continues to be weak, as you notice, but it is very strong market for us, it's a big market for us as well."
},
{
"speaker": "Patrick Pichette",
"text": "In closing on that topic, I think it's worth noting if you do your financial math and you move rest of world into constant FX, so if you take out the fact that we had crosswinds over year-over-year, in fact, our growth rate for rest of world is over 30%, it's C:\\Transcripts\\Calls\\118059477\\VoiceWriter31%. So again, very good momentum there."
},
{
"speaker": "Operator",
"text": "Our next question comes from Scott Devitt with Morgan Stanley."
},
{
"speaker": "Scott Devitt",
"text": "Paid click growth on a percentage basis was the highest rate in two years, and you mentioned a few things on the call, better ads, better targeting, even local monetization. And I was just wondering to what extent some other factors came into play as well, particularly Google Instant and the rollout of that product, as well as the incremental nature of smartphone and tablet queries."
},
{
"speaker": "Patrick Pichette",
"text": "So I think that for paid click growth, that you really have to look at a couple of factors. And I just want to start by kind of debunking a myth on Google Instant, right? Everybody seems to have -- there's kind of a buzz out there that Google Instant is the driver for a lot of the revenue growth. And in fact, Google Instant is neutral. It is not making any significant contribution to our revenue growth. What's really making the contribution is that there's really -- our growth is driven by three interdependent drivers that are all acting and tooling together. One is, clearly, the strength of the economic recovery and the consumer shift online. And you can look -- ever since Thanksgiving, and you've seen it from external sources as well, people have moved online. They're spending a lot of time shopping online, looking for coupons. So the behavior is strong economic recovery, which brings a lot more auction into these -- a lot more participants into the auctions because they want to be where the users are. In addition to that, right you have a second compounding factor pounding on it which is platforms are changing, right? The use of mobile phones, iPads, Instant Search tool, but also GEO, the fact that you get instant location, you can get coupons, all these things, right, just from a platform perspective are driving it on top of it. And then finally, right, it is true that Jonathan's teams fantastic job at making great ads tuning and monetization like the VizURL, and Jonathan you may want to take a second to talk about VizURL. It's those factors that are really driving the CPC growth and the click through rate growth rather than instant search. So I just want to be clear because I know there's a rumor on the street running that it's all about Instant search. And Instant search is about the user. It's people spending 10% faster, that is a huge number, 10%. And that's why we did Instant search. So maybe VizURL is a good example that you want to talk about, Jonathan?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Sure. I guess other than the ads quality improvements, which I can cover in a second, I think the only other area that Patrick didn't cover would basically just be the new ad formats, all of which are boosting click through rates. And I mentioned those in my prepared remarks, the product listing ads, more recently, offer ads, coupon-based ads. The seller ratings, which we've also launched, have significant impact in click through rates as well as the Sitelinks. But I think that probably the most significant thing in terms of what impacted the whole ads area this quarter was this concept that we call Visible URL. And basically, what we did was on the top ads, we moved the advertiser's URL down to its own separate line below the creative rather than having it be part of the creative. And that obviously makes it easier for people to see where they will go as they click. It's actually a little bit of an interesting story. I'll give you some of the background because this is by far the most significant change that we had from ads quality perspective in a very long time. It turned out early in the quarter, some of the engineers in Japan noticed that it was really hard to read the creative because we actually had the ads URL, which was in Latin characters, mixed in with the ad creative which was in Kanji. And it didn't really take brilliant research to figure out that human perception gets really confused when characters switch like that in the middle of a sentence. People just sort of skip the whole sentence. And if they skip something, that's sort of really bad when that sentence is a text ad. So we ran this experiment in Japan and we moved the URL down to its own line, and click through rates went up dramatically. So we launched that feature pretty expeditiously in, I think, Japan, China, Korea and Russia. And then what happened is the engineers kind of said \"Well, hey, just for fun, let's try that in the rest of the world. \" And we actually didn't expect so much because we didn't have the same dynamic of Latin characters versus Kanji, but it turned out that people skip sentences with long, unusual words in it. So people were tuning out that line. And we quickly launched this feature globally. It was one of the fastest things that we ever launched after the ads testing. I believe we launched it right around Thanksgiving. And that had a very significant change in the clicks that we saw in the course of the quarter."
},
{
"speaker": "Patrick Pichette",
"text": "So just to close on that, just to kind of say, it is, and I know that Jonathan has used that trumpet a number of times in the past, but just continues to illustrate how much more innovation there is left in both formats and in just all the things that we do in terms of innovation in the ad space."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jeetil Patel with Deutsche Bank."
},
{
"speaker": "Jeetil Patel",
"text": "If we look at your kind of a revenue line from a kind of customer base standpoint, whether it's Fortune 500 or Ad Age 100 versus Internet pureplay indemics, and then the small to medium-size business category, I guess the SMB category was weaker during the credit crisis and you had a hard time coming back, I'm curious as to your thoughts as to how it's coming back today. And do you think there is a different way of approaching that SMB market as you look ahead into this year and going forward in terms of products or maybe ways to help drive leads or sales in that segment of the market?"
},
{
"speaker": "Patrick Pichette",
"text": "I'll let Nikesh answer the question. Just one point of clarification on your statement though and during the recession a couple of years ago, I think you mentioned that we thought that SMBs were kind of going down. And in fact, Nikesh will clarify, they were going the other way. So Nikesh, I'll leave it to you to answer the question."
},
{
"speaker": "Nikesh Arora",
"text": "I think the important thing to understand is we're seeing such a disproportionate amount of strengths from the very large advertisers across the board because effectively what's happened over the years is that they've gone out and really strength their e-commerce offerings, they've gotten their act together, they've got all the logistics in place. And given that this was the quarter of Christmas and Thanksgiving, you saw a tremendous amount of strengths from large advertisers wanting to play against the pureplay Internet players. Now in addition to that, what has also happened is we've put an effort over the last six months on the SMB and mid-market side. In the mid-market side, we've basically gone ahead and adopted a higher touch strategy. I even spend more time on the phone with our customers. We even go and visit some of our mid-tier customers because to be fair over the years, they have grown to be larger mid-tier customers than they used to be in the past. So we have put in sort of a conscious higher touch strategy. And last but not the least, for the smaller advertisers, we are working very closely with our product team and Jonathan and his team to try and look at various systemic and algorithmic improvements we can make, working with them in large direct marketing campaigns and where we can continue to sort of reduce churn to that the area and continue to acquire more, which is related to the other comment on slightly higher sales spending on trying to acquire smaller advertisers. So we have efforts across the board, across all three categories. We don't think that effort is done and fully over with."
},
{
"speaker": "Jeetil Patel",
"text": "Do you think the business model or pricing model has to be different there, whether it's percentage of sale or some other kind of approach to going after the spend in that segment?"
},
{
"speaker": "Nikesh Arora",
"text": "No, I think to be fair, if you look at the simplifications we have done on the ad work side and local products, which is another way of thinking about smaller advertisers, that is a way to create a simpler product for them where they don't have to put in a lot more effort or we have things like keyword-less ads where they don't have to go ahead and sort of work towards creating keywords or will work. On the Display side, we've got contextual targeting where you can create ad groups very, very quickly. So we may continue to make product improvements which allow things to become more and more simple so advertisers can sort of go and do their daily business as opposed to spend time understanding more complicated stuff on our side. So yes, you're right, they are different, simpler products we create for them, which have slightly different pricing, so that they can continue to participate in the online economy."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jason Maynard with Wells Fargo Securities."
},
{
"speaker": "Jason Maynard",
"text": "I had a question just on the Mobile business. Last quarter, obviously, you saw some increased momentum. I'm curious just from a pricing perspective, what you're starting to see from the advertisers? And what kind of progress did you see over the last 90 days? And maybe more importantly, as NFC starts to become more prevalent in smartphones, I mean how do you think that changes the dynamic in terms of what type of effective monetization you're going to see from the Local Commerce side?"
},
{
"speaker": "Patrick Pichette",
"text": "So let me give you just a few starts to kind of continue to keep the contacts, right? Mobile search grew 4x on Mobile devices for web browsers in the last year. So there is no doubt that this market is just absolutely cranking. And there's a lot of work, and I'll let Jonathan talk about it, about ad formats are still kind of nascent and building, both on the Display side and on the regular side, and we see a lot of upside. Jonathan, you probably want to kind of cover those."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yes. We don't really actually break out the details in terms of the exact difference. It's certainly the Click-to-Call ads are generating millions of calls every month. A lot of advertisers are running these campaigns. I think one you can see if you tried is DirectTV. We did launch a call-only option where the only clickable link in the ad is actually a phone number, which not surprisingly substantially increases the click through rates on mobile devices. And we've extended some of the desktop formats pretty successfully to Mobile. Sitelinks is one. If you try a query on Oakley, you'll see one, if you seller ratings on something like running shoes. So I think there's a lot more to learn there, but the advertisers are very excited and engaged. At the moment, I don't have any specific comments on NFC other than to go back to the statements that I've made in previous calls, which is when people are completing transactions with these devices, it becomes much more tractable and obviously significantly more valuable."
},
{
"speaker": "Operator",
"text": "Our last question comes from Steve Weinstein with Pacific Crest."
},
{
"speaker": "Steve Weinstein",
"text": "First, you commented that you're going to be shifting more compensation to base pay from bonus. I was wondering if you could let us know what the ratio had been historically as far as those two components of comp? And finally, obviously, the acceleration of all the metrics is pretty exciting, pretty positive for the outlook. I was wondering if you could help us understand though how much acceleration is happening within the core business? And how much of the acceleration is maybe some of the newer businesses really starting to get some scale, and maybe tipping the overall momentum in the business?"
},
{
"speaker": "Patrick Pichette",
"text": "On compensation first, as I said, we raised all salaries. So if you think of kind of financial modeling for a second, all salaries had been raised 10% across-the-board, January 1. And that has a ripple effect on -- the kind of ripple effect of the employee taxes, 401(k)s and all the rest of the benefits. It will also impact, obviously, everybody that we bring on this year as well. So as we bring in new people, they are costing us now slightly more. In addition to that, what we've done is part of the bonus is kind of calculated without giving you the exact number. We had two components to our annual bonus. One, which is a company multiplier, and one which is an individual multiplier. And what we've done for the non-execs, because we want execs to actually continue to be treated differently, the non-execs are treated in that what used to be a company multiplier, which didn't really have a lot of influence on, we shifted over to base pay. And their individual multiplier component of the bonus continues to be a very kind of directly involved into their calculation of their personal bonus. So by shifting that company multiplier we didn't have a lot of influence on, right, it just moves into more predictable cash flows for them all through the year rather than waiting for the end of the year, and that was the rationale for doing it. In terms of revenue growth, I mean, last quarter, we gave kind of two syndication points on Display, on Mobile, right? We've talked about the fact that our core -- if you look at our Enterprise Business, 30 million users, 3 million businesses on apps, the kind of magnitude of numbers we're talking about in each of our growth areas, whether it be Mobile, whether it be Android, whether it be YouTube, where we continue to have YouTube, right. I mean to give you a snippet, YouTube's revenue more than doubled in 2010, right? So that's why we're optimistic across-the-board, and that's why we're very kind of open about the fact that when you have such a digital economy running in high gear, why don't you take the opportunity to invest at the time where it is actually transforming itself. And that's what we're doing, and we're delighted in fact to continue to push hard on that. And that's what you see also in sales and marketing. With that -- let me reiterate, so I probably hope I got your attention back because the front end of this conversation got totally sideswiped by the big three, you guys showing up and taking over our seats and phones, but phenomenal year end to what has been a terrific year. I have to thank all of our Googlers. They do an amazing job every day. It looks easy when I show up with Jonathan and Nikesh and talking about these fantastic results, but our Googlers do an amazing job all around the world, and so does our partners. And so to them, thank you so much for your fantastic efforts in 2010, and we'll just set up for a fantastic 2011 again. With that, I'll let Jay close the call."
},
{
"speaker": "Jonathan Rosenberg",
"text": "That does conclude today's conference. We thank you for your participation."
}
] | null | null |
GOOGL | 3 | 2,010 | 2010-10-15 16:30:00 | Operator: Good day and welcome everyone to the Google Inc. third quarter 2010 earnings conference call. Today’s call is being recorded. At this time, I would like to turn the call over to Ms. Jane Penner, Senior Manager, Investor Relations. Please go ahead, ma’am.
Jane Penner: Good afternoon everyone, and welcome to today’s third quarter 2010 earnings conference call. With us are Patrick Pichette, Chief Financial Officer; Jonathan Rosenberg, Senior Vice President, Product Management; and Nikesh Arora, President, Global Sales Operations and Business Development. First, Jonathan and Patrick will provide us with their thoughts on the quarter, then Nikesh will join Patrick and Jonathan to answer your questions. Also, as you know, we recently began distributing our earnings release exclusively through our Investor Relations Website located at investor.google.com. So, please refer to our IR Website for our earnings releases as well as supplementary slides that accompany the call. This call is also being webcast from investor.google.com. A replay of the call will be available on our Website in a few hours. Now let me quickly cover the Safe Harbor. Some of the statements we make today may be considered forward-looking, including statements regarding Google’s future and investments in our long-term growth and innovation, the expected performance of our business and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures we use on this call such as operating income and operating margin are also expressed on a non-GAAP basis and have been adjusted to exclude charges relating to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will now turn the call over to Patrick.
Patrick Pichette: Thank you, Jane. Good afternoon everyone and thank you for joining us. As Jane mentioned, Jonathan and I will begin with our prepared remarks, and then Nikesh will join us for Q&A. In addition and as a bit of a surprise, we may actually have Eric join us for the first 30 minutes of Q&A before he has to run to a plane. So, let me start by giving you some general thoughts before I get into the details of our financial performance for Q3. At the highest level, we are very pleased with our Q3 results and it’s clear that the digital economy continues to grow rapidly, a relentless trend that continues to drive continued growth in both our core business, core search and creating market and also for fuelling momentum in our newer businesses. Our Q3 results clearly reflect this phenomenon that is our continued strong growth in our core business and continued very strong growth in our emerging businesses year-over-year, and indeed we saw strength in every major product area in Q3, that is search, display, mobile as well as apps enterprise. And when I say our newer businesses are seeing great momentum, I really mean it, and in that, Jonathan will back that statement up with some hard facts in a few minutes. So, stay tuned for the details. Now, let’s turn to specifics of our performance in the quarter from a financial perspective. Let’s move quickly to the results. Gross revenue grew 23% year-over-year to $7.3 billion. Our Google Website revenue was up 22% year-over-year to $4.8 billion, which strength as I mentioned across most major geographies and verticals. Our AdSense revenue was up 22% year-over-year to $2.2 billion, again reflecting continued strength in our Google display network. Our other revenue was up 35% year-over-year to $254 million, down sequentially reflecting the end of our direct-to-consumer sale of the Nexus One. Our global aggregate paid click growth remained healthy up 16% year-over-year and also up 4% quarter-over-quarter. Aggregate cost per click growth was up 3% year-over-year and 2% quarter-over-quarter. You should note that the FX had a negative impact on CPC growth year-over-year, but the impact for quarter-over-quarter was quite neutral. Remember too that this is an aggregate number which includes both Google.com and our AdSense properties. So, now turning to our geographic performance, the U.S. and rest of world are growing at a healthy pace as our results reflect, but also, while the U.K. continues to lag a little bit in the economic recovery again seen in our results. Revenue from the U.S. was up 26% year-over-year to $3.5 billion and in our earnings slides, which you can find in our Investor Relations Website, you will see that we have broken down our revenue by U.S., U.K., and rest of world to show you the impact of FX and the benefits from our hedging programs. So, please refer to those slides for the exact calculations. International revenues accounted for 52% of our total revenue or $2.8 billion, up 20% year-over-year which includes a $89 million benefit from our hedging programs, and that compares to a $39 million benefit for Q3 of last year. If we used fixed exchange rates, our international revenues would have been roughly $169 million higher year-over-year. U.K. was up 10% year-over-year to $840 million, but actually if using a fixed exchange rate, that number would have been just shy of 20%. So now, let me turn to expenses. Our traffic acquisition costs were $1.8 billion or 26% of total advertising revenue for this quarter. Other cost of revenue was $747 million including stock-based compensation of $8 million and finally all other operating expenses totaled $2.2 billion, including approximately $372 million of stock-based compensation. The increase year-over-year in OpEx was primarily due to increase in payroll, professional services, and advertising and promotional spend. So, as a result of all this, our non-GAAP operating profit which excludes the stock-based compensation increased to $2.9 billion in Q3, resulting in our non-GAAP operating margin of 40.2%, essentially the same as last year. Headcount was up approximately 1,500 versus Q2, and we ended the quarter with approximately 23,300 full-time employees, of which about 300 came from acquisitions. Our effective tax rate for the quarter was 20%, down from 24% in Q2 and this is mostly because we released certain tax reserves as a result of the settlement of our 2005-2006 tax audits which are now completed. Let me now turn to cash management. In the line other income and expenses, it was $167 million for Q3, which includes good progress on our portfolio management performance, although that was slightly offset somewhat by the impact of our hedging expenses associated with FASB 133. For more details on OI&E, again, please refer to the slides that accompany this call on our investor Website. Operating cash flow, very strong for the quarter at $2.9 billion. CapEx for the quarter was $757 million, again mostly primarily related to our data center operations, and as a reminder, we continue to make significant investment in CapEx and these have shown to be quite lumpy from quarter-to-quarter depending on when we are able to make these investments. So, in the end, free cash flow was also very good at $2.1 billion. Before I close, I want to say a few words about how we are continuing to grow the business for the long term, and when I say the long term, we really mean not the next quarter or the following quarter, but we are just thinking about the next five to 10 years. Looking ahead, we continue to see tremendous opportunity in our agenda in both our core and in our emerging businesses. So simply put, we are on disclosed agenda at full throttle. We are doing it largely in two ways to think about it, continue to invest heavily in people and also in products. In people, it’s a pretty simple story, the explosive growth in the digital economy that we are experiencing, it’s really created a war for talent in our industry to digital economy, and one that is quite out of sync with what’s happening in the rest of the economy. So, we believe this trend is only accelerated in the next 18 months and will continue to accelerate. So, in context of that, we stepped up our hiring machine, and we are currently exploring how we can continue to attract and retain the very best people in this exceptionally competitive environment. So, we strongly believe that the difference between the winners and the losers in our industry, although be to a large extent determined by who we can attract and who we can retain the best talent. So to that end, we are incredibly proud to have attracted approximately 1,500 people to join Google in Q3, the majority in engineering and sales once again. On the products side, our goal continues to be to develop truly innovative products that leverage computer science to solve these incredible problems that we tackle and offer obviously significant ROI across a number of very large growth opportunities. As I mentioned, Jonathan in a few minutes will be speaking of this great momentum our products are experiencing, and as always we are investing with discipline following the Google tradition of being generous but frugal. So in summary, very pleased with our performance of Q3 across revenue, margins, cash flow, and we plan to continue to attract higher, retain the very best talent in the world wherever they are to fuel our innovation agenda. Now is the moment for me to turn the call over to Jonathan, which I usually mean that my number parts is over, but today, I have actually asked Jonathan to share with you and let me emphasize on a one-time basis a few products, specific metrics that I think everybody will be very interested to hear. And as the CFO, I am usually the official buzz killer, so I need to make it very clear that we will not be updating these numbers going forward. We are merely sharing them with you as a proof point of the great momentum we are experiencing in our emerging businesses. And with that, let me turn it to Jonathan.
Jonathan Rosenberg: Okay. Well, thanks, Patrick. So, I think you guys can see from the financial numbers, we've got tremendous momentum in the core business. But in these emerging businesses, you guys basically have to invoke your Jedi guesstimation skills to try to figure out what's going on. So today, with Patrick's permission, I hope to shed a bit more light on these businesses with some numbers that we've not shared before. But let me start with the core. Search is more important than ever. The Internet, as you guys know, continues to explode. There is lots more websites, there is more videos, there is more images, there is more books and news, all of this stuff is coming online. And at the same time, more people are coming online too. And what do these people do when they get online? The first thing they usually do is search. So search is still at the heart of the web and with all of this new content coming online, doing search well is even harder than ever. I actually believe search remains one of the most challenging computer science problems of our generation and probably the next one as well. This is why we are so incredibly proud of Google Instant. Many of you guys speculated that we launched Instant to make more money. Well, let me tell you that's simply not the case. We launched Instant because it's so much better for the user. In fact, from a revenue standpoint, its impact has been very minimal; and from a resource standpoint, it's actually pretty expensive. So why did we do it? Well, we believe from a user standpoint, Instant is outstanding and the data that we are seeing actually bears this out. We took something that no one thought was a problem and we created something that once you use it, you can't recall how you lived without it before. It saves about two to five seconds per search and users absolutely love it. The percentage of people who select Instant results before they finish their query is steadily rising. So in other words, that means the more they use it, the more they like it. So let me be clear that Instant wasn't based on a narrow financial calculation. We launched it because we could and because it's great for our users, as we have always said. Of course, I know it's an earnings call, so let me be clear on another point. We do in fact care about money. And search is still the most monetizable moment on the web and as search gets better, our ads have to keep pace. The good news is they are. Turns out we also have a lot of great momentum with AdWords and this is particularly true with the new ad formats. On past calls, I've talked about making ads more useful with the new formats like site links and ads with seller ratings and product listing ads, which we think – which we can see now are starting to have a real impact. These ads appear on more than 10% of the queries where we show ads and people like them. We see this because click-through rates are up for some formats as much as 10% and up more than 30% on some others. We are also seeing great momentum in our newer businesses, and this is where Patrick is letting me give you some big numbers. So, I hope you find them useful. The numbers all begin with the letter B. And remember, as I often remind my team at Google, a billion is a thousand million. So first big number, $2.5 billion; as in display is on an annualized run rate of over $2.5 billion. So that's non-text display, meaning it doesn't count text ads running on our network. What it does count is YouTube ads, non-text ads on the Google Display Network, and of course on the DoubleClick platform. So you guys often ask me, "Jonathan, you know, where is the next multibillion dollar business after search"? There is your answer. It's display and it's already here clocking in at over a $2.5 billion run rate. So clearly, we are firing on all cylinders in display, the advertisers are running great branding campaigns, the Ad Exchange is taking off, we are partnering very well with agencies, and of course more publishers are making more money. And if you want to know more on the display front, Nikesh who is here is passionate about this business. He's made enormous strides with the sales force and clients, which I'm sure he will be happy to talk to you guys about in the Q&A. So second big number, 2 billion; as in YouTube is monetizing over 2 billion views per week. That's up over 50% year-over-year. And when you think about that growth, it's important because the RPMs are really strong on YouTube. We have just launched some new ad formats called TrueView where the viewers get to choose which commercials to watch or they can even skip watching the ad altogether. Turns out when advertisers only pay for the commercials people watch, we discover the ads are a lot more valuable to advertisers when they are only paying for viewers who have actually chosen to watch them. Finally, third big number, $1 billion. Mobile is on an annualized run rate of over $1 billion. This means the people who are accessing our products and services through their mobile phones are adding a $1 billion annually to our existing revenue streams. Clearly, this is the future of search in the Internet, more people in more countries coming online from these smartphones. Our mobile search queries have grown five times over the past couple of years. And of course, a lot more of those queries are now coming from Android phones. So, here are the facts that Patrick has let me say just this once. Non-text display, $2.5 billion run rate; YouTube, 2 billion monetized views per week; and mobile, over a $1 billion added to our business. And Patrick, maybe I'll add one more fact here without asking you. You should know, all these businesses are growing. So, I hope this gives all of you a sense of why we are so excited about the incredible emerging businesses at Google. And with that, I'll take it back to Patrick.
Patrick Pichette: Thank you, Jonathan. Before we take your questions, I just want to add one fact regarding the new disclosures that Jonathan just gave you. Obviously, this information reflects our revenues from two different angles of our business. And with it, we've recognized in some cases some small overlaps. So for example, the AdMob revenues are obviously included both in the mobile number because it's a mobile product and in display because it's also a display product. So these are very small, but I wish to just clarify it out for everybody. So with that in mind, what I would like to do is turn it over to Connie to open – and we have Eric with us. So, the "may" is now in "actual," Eric is with us, he has got 20 to 30 minutes, then he is running for a plane. So delighted to have you with us, Eric. And what I'll do is I'll turn it to Connie for the Q&A, questions period. Thank you.
Operator: Thank you. (Operator Instructions). And we will pause for just a moment to assemble the queue. And we will take our first question from James Mitchell from Goldman Sachs.
James Mitchell: Great, thank you. I'll ask two separate questions, if I may. The first one, if I look at your paid lead growth, it's been remarkably consistent and not decelerating. I think it was 4% sequentially in the third quarter of 2008, 4% sequentially in the third quarter of 2009, and then 4% sequentially in the third quarter of 2010. Is that because your query growth is also fairly consistent or are you supplementing query growth with monetization initiatives that increase paid lead takeoff? And then secondly and separately, thank you extremely much for disclosing the billions in terms of mobile and display advertising. But within the $2.5 billion plus of display advertising, how do you account for advertisers spending through the DoubleClick Ad Exchange? Is that on a gross or net basis? Thank you.
Jonathan Rosenberg: I'll try to – I mean, I'll try to take the first question. Certainly the highest correlation between ad clicks and anything else is query growth. So that's going to certainly by far dwarf any other factor. I think the other factors that we are seeing is that the new formats that we have which I had mentioned certainly drive click growth as well. And I mentioned that those formats appear on 10% of the queries. If you try some of those like, Halloween costumes, you will see that they make the ads much more compelling, as do things like merchant ratings if you type in laser printers. So by improving the ad formats, we are increasing the relative number of clicks because the click-through rates grow up.
Patrick Pichette: Great. On the other one the Ad Exchange is included in – so if you think of the elements, the Ad Exchange, DoubleClick platforms, all these are included in display and it's done on a gross basis.
James Mitchell: Thank you.
Patrick Pichette: Thank you for your question. Let's go to the next question, Connie.
Operator: And we will take our next question from Spencer Wang from Credit Suisse.
Spencer Wang: Thanks, and good afternoon. I guess since you guys are sharing some numbers this time, I was just wondering if we can just delve into the YouTube numbers a little bit. Of the 2 billion views, Jonathan, I was wondering what – roughly what percentage of total views is that currently? And then, you guys have talked in the past about getting closer and closer to profitability. I was wondering if you could just give us a sense of where you are with respect to profitability as well. Thank you.
Patrick Pichette: So on profitability, let me jump on that one first which is, we have not made any comments on it. You will remember, we talked about it a long time about ago. Because there was so much distortion in the market, we just thought it was okay to kind of set the clocks properly. But since then, we have not and will not comment on it. On the billions of –
Jonathan Rosenberg: This is Jonathan. So there is basically two points that we've given that you can use to connect those dots. We said that traffic over – that we have over 24 hours of video uploaded every minute and over 2 billion views per day. When you couple that with the 2 million monetized views per week, I think you can get to the answer that you are looking for.
Spencer Wang: Great. Thank you very much.
Patrick Pichette: Thank you. Let's go to the next question, Connie.
Operator: And we will take our next question from Imran Khan from J.P. Morgan.
Imran Khan: Yes, hi. Thank you very much for taking my question. So I have a question for Eric as he is on the call, and then a follow-up housekeeping question. So Eric, I think the two big trends on the Internet, obviously the web is becoming more social and realtime. So, as the web becomes more social and real time, how does Google compete in that world in terms of realtime search market and how does that impact your business? And secondly, on the mobile trend, obviously you have this Apple Ecosystem with i – Apple i-applications and people are going directly to applications and how does that impact Google's business model over the long term? And the housekeeping question, near-term question is the tax rate was 20% on the quarter. Is there anything specific in one – this quarter? How should we think about the tax rate? Thank you.
Eric Schmidt: Imran, let me deal your questions as two separate questions for me. With respect to social and realtime, we use complex signals to do ranking. And overtime, we will add additional social, if you will, ranking clues. Fundamentally, we make search more personal and as we get more information the friends are, we can make the search that much better. We are quite convinced that, that produces a better search results for people who choose to give us that information. People who want to continue to do what is there on an anonymous search, that’s also possible. So, one of the ways to think about that is that we want users to be more logged into Google, more logged in they are, more likely we can buy them not only the social information but the other information. We also estimate real time we already have significant feeds from real-time information providers, we have real-time index which of course is very, very successful for us and you can see that whenever anything interesting happens, it’s already right there in Google. For example, we use Twitter as a real-time source of information. So, if you search for almost anything, you will see the Twitter feed is now part of universal search. Could you repeat the second part of your question for me?
Imran Khan: Second one was, Eric, on the mobile front right, we are seeing explosion on application on mobile platform. So, does that impact your search volume and as people go directly to the vendors to the app, it seems like, you know, Amazon talked about $1 billion sales through coming from mobile devices, so how does that impact Google’s business long-term?
Eric Schmidt: It doesn’t seem to. This is one of those sort of worry work questions that we get all the time, that the success of one thing, could that impinge on something else. And in fact, the rise and tide of all those, and I would say that again, what I hear is the sort of presumption that it’s a zero-sum game and that one wins and another one loses. What’s really happening is that all of the companies that are driving the web and web applications are all doing really well. People are moving from offline to online and in the course of doing that, they are using these systems more, they are searching more, using apps more etcetera. Now, from our perspective, you have this phenomenal success of Android, which is well past anything that I had ever hoped for and looks like it’s on its way to be a huge, huge success within our devices, devices, open model for access, lots and lots of innovation, more dynamic, more competition than any other part of the platform. There are up to 90,000 applications on Android and have grown very, very fast, and those applications of course have sort of drive to them. So, we don’t see them as a negative, we see both as very strong positive.
Patrick Pichette: Thanks, Eric. Let me go back then to, coming on to the tax question. We did get a one-time benefit this quarter on the tax side and it is related, as the statutes expired for 2005 and 2006, all of our taxes are now closed and in doing so, then we had an opportunity to reverse a set of provisions we had taken that we ultimately didn’t have to take so. You can see the tax rate this quarter is a bit of an anomaly again.
Imran Khan: Thank you, Patrick.
Patrick Pichette: Thank you for your questions. Connie, let’s go for the next question please.
Operator: And we will take our next question from Justin Post from Merrill Lynch.
Justin Post: Great. Eric, well, we have you, when I get back into mobile, just when you think about Android as an operating system, how does that proprietary to Google when you think about your search services? Does that give you an advantage over other phones for some of your services and does the phone operate better when you are using Google services? And then second, I think you were quoted in an article saying, maybe someday Google can make $10 per phone. Would you see that as mostly advertising and is that number right something you did say? Thank you.
Eric Schmidt: Yes, the latter one I made out of the mirror. So, we don’t really have a notion of exactly what it is, but it’s probably pretty big. So, one way to think about Android is it’s probably the largest single platform play available in the market today. It’s a platform for computation, for location, for everything you could do with the new and most popular set of computing devices that are emerging. That market is larger than the PC market, the tablet market is a small component of it, it’s an important part of it. So, if you think of mobile as platform, as phone plus tablet, plus all of the other things, we hope to become the leading platform in that space and we are doing it with open source approach. So, in the open source approach, that means we give the software away, which is always paradoxical. People say, well how do you make money from that? Well, let’s start with the fact that the evidence we have is that people who use Android search twice as much as everything else. So, clearly, there is more revenue associated with those searches. And another thing of course is if they are using Android systems, revenue that we share in the search as we shared with operator but not with anybody else. So, again it’s more lucrative. So, not only there are more searches and there is more apps, but it’s also more lucrative. So, on that basis alone, Android is hugely profitable and we maintain the anti-segmentation and other things by a series of contracts around the store and so forth and so on. So, Android is likely to be financially successful to Google without even any of the applications that are possible. So, Patrick calls up and says, okay, what else can you do for us, and the answer of course is, we can layer on value-added services versus how do you get to the $10. And the value-added services, do you have any time. Our primary purpose right now is building this open platform. Google had chose and they did on open systems and open platform on the open web. That service is well so far and it looks like it’s worked really well.
Justin Post: Thank you.
Patrick Pichette: Thank you, Justin. Connie, let’s go to our next question please.
Operator: And we will take our next question from Mark Mahaney from Citi.
Mark Mahaney: Great, thanks. Two questions on the cost side. It looks like this is the first quarter in about a year-and-a-half, which cost per employee on an annualized basis had declined sequentially. Is there something that you have been able to put in place that gives you confidence that, that will continue going forward? And just on the mobile revenue opportunity, are the results strong enough from your perspective in terms of dollars and growth such that you will stay with an indirect monetization approach towards Android, or you are going to keep the door open and potentially charge per operating system as a share of applications in the future? Thank you.
Patrick Pichette: On cost per employee, look, it’s just another reflection of when read anything kind of forward-looking into our results except that it’s just another good example of how we are – I talked earlier about generous but frugal. We are investing, but people should not confuse the fact that we are investing and we are investing aggressively where we really see fantastic opportunities from being wasteful. We are just not a wasteful company. And so in that sense, that’s a good signal and we will continue to do so. On the mobile, maybe Jonathan or Nikesh can give us an indication.
Nikesh Arora: I think just following up on what Eric said earlier, we are very, very keen to build this ecosystem, and I think Jonathan’s disclosure on the fact that we are on a $1 billion run rate mobile is a testament to the fact that we have a revenue model which we are very excited about, and that revenue model sort of proves to that, roughly the revenues are split between our storage efforts, our display efforts, application efforts, and we are able to play across all those three spaces in our mobile monetization efforts. And the more people who use commercials, more people who are able to access the web devices, the more we see the trend that people that are searching them, they are going to give us opportunities to put display advertising. So, we see no reason to change our monetization model. We think the current approach to Android drives more users and more usage and drives these.
Eric Schmidt: And Nikesh, I think you have already viewed that despite a (inaudible) revenue, because of the success that we are seeing (inaudible).
Patrick Pichette: Exactly. Thank you very much Mark for your questions. Let’s go, Connie, for the next question please.
Operator: And we will take our next question from Douglas Anmuth from Barclays Capital.
Douglas Anmuth: Great, thanks for taking the question. First on display, can you give us some context in terms of breaking out (inaudible) and secondly what’s your view on other potentially competitive Android app stores that are out there? Thank you.
Patrick Pichette: So, I will answer the first, and then I will give Jonathan to talk about the Android marketplaces. So, on display, we just don’t break it down. So, we will not – the details where we wanted to give today with the numbers we are sharing is a sense of scale and trajectory. And that’s really what we wanted to share. So, of course, we won’t give any more details on that. On the Android competitive, of course, Eric, maybe you can give us more perspective on it?
Eric Schmidt: Yes, the goal of the store is to – people who are writing the software and applications, and it’s not a revenue goal for Google. So, there certainly will be multiple stores, there will certainly be the key one from us, taken the net of – and that win for everybody. So, but it’s not a primary focus on Google from a revenue perspective, it’s really for the developers.
Patrick Pichette: Thanks, Eric. Connie, our next question please.
Operator: And we will go next to Brian Pitz from UBS.
Brian Pitz: Great, thanks. Would you provide us with a relative idea of how the difference between average CPCs and clicker rates are based on the mobile versus the PC, now that you have a large enough number of devices in the market? And secondly, if there is a gap which I imagine there is, can you close that gap longer term between the two? Thanks.
Jonathan Rosenberg: This is Jonathan, Nikesh can maybe give you more of a customer base perspective. I think that some of you know we recently started smart pricing on the mobile devices, and it is the case that the CPCs on the mobile device are a bit lower. It’s primarily because there is the measurement that there isn’t as much of a consummation of a transaction on the mobile devices. People don’t have their credit cards, and it’s harder to type into them. So, the mobile rates remain relatively lower. As payment platforms get built into the mobile devices and as people are more likely to actually complete the transaction, I think you will see those things go up substantially. I think it's also the case that on devices like the iPad, the kind of activity looks a little bit more like it does on a PC, primarily because people have a larger window, a bigger browser, and they are also more able to input information. Nikesh?
Nikesh Arora: I think the only thing I have to add to that is there are some formats which we started to introduce, which are driving a better monetization on the mobile sites, formats like click-to-call and hyper-local, because people are searching in their mobile devices where they want to then make a phone call or they are searching on their devices and they are looking for something in a very local context and there, we are beginning to see sort of better CPMs and better monetization. Generally, we think that's where the trend is, that's where we are going to see more and more monetization. And clearly, we are seeing monetization in the application side of the mobile, because with the AdMob sort of team that we have and all the advertisers who want to be part of the application, the applications are becoming a big share of people's mobile usage.
Brian Pitz: Great. Thanks.
Patrick Pichette: Thanks, Brian. Connie, our next question, please?
Operator: And we will take our next question from Ross Sandler from RBC Capital.
Ross Sandler: Thanks, guys. Two quick questions. First is, you guys have discussed the cannibalization topic before between smartphone and PC, but have you – when you look at the search data, can you see whether tablet searches or iPad searches are incremental or are there any cannibalization towards PC and is the tablet option within AdWords going to be similar to the desktop/laptop option or is it going to be kind of a separate category? And then the cash, can you just give us a little bit more color on the rest of world growth, just in terms of regions that we are driving that 26%. Was it broad-based or was there anything that stood out? Thank you.
Patrick Pichette: So, we'll let Jonathan answer the first part.
Jonathan Rosenberg: Yes. We – so we don't see cannibalization. We tend to see mobile is very complementary to the desktop. I think you do see some differences in the search patterns. People use mobile at lunch, they use it on – in the evening, they use it on weekends, they use it more on holidays, but we see more mobile and web search traffic growing and they appear to us to be complementary and not cannibalizing each other.
Patrick Pichette: Nikesh, you want to cover the international growth?
Nikesh Arora: Yes. The U.S. growth was very good for us. I'm very pleased with the way our U.S. team has driven the revenues sort of across the board, across our revenue categories. On the international side, I'd say generally, the trend has been positive across the board. I know the U.K. has been a bit weaker, but there is a bit of currency in there as well. But France, Germany, those markets have actually been very, very robust. I'd say Southern Europe has done way better than some of the Northern European countries, but that's expected because they are enjoying sort of bit of a growth curve. And clearly, some of the Asian markets are growing robustly for us. So, good growth across the board.
Patrick Pichette: Thank you, Ross, for your question. Connie, let's go to our next question, please.
Operator: And we will take our next question from Jeetil Patel from Deutsche Bank Securities.
Jeetil Patel: Great, thanks. A couple of questions. I guess you are on a pace of doing about $30 billion on gross revenue run rate. I guess maybe a different way to look at your business. But what – since it's an ROI-driven model, I guess can you quantify or give us a sense of what kind of gross dollar value of transactions that entails for all the merchants and customers that are participating in the system? And second, I guess if you look at your competition in mobile or in other company in this space in mobile, they make about $300 in operating profit per handset sold. I guess, do you think this is more the upper bound as it relates to lifetime profit per handset? Do you think it can be higher? I know obviously you are going after a different strategy, but where do you think is the upper bound in terms of the profit potential on a – let's say, to your handset in terms of monetization?
Patrick Pichette: Let me – on the gross value, what – rather than to try to give you more details on this call, Google has actually published some economic data about the amount of value that is actually transacted across the system. And so, I may just refer you back to the IR team that can actually dig that out, because we actually shared that with the public over the last kind of eight months or six months, and it's actually very detailed into how much economic is actually flowing to our systems.
Eric Schmidt: On the handset question – this is Eric – which you asked, I understand the question that you are asking. Our model, remember, is that the handset manufacturers and the operators are going to make a lot of that money. And our model is that, our operating system is free and that we are going to make money from advertising and value-added services on top of the Android platform. So, it's clearly different model. And so it's not very difficult to compare the two, they are really apples and oranges. It would be I think premature to – for us to estimate what that would be, but if you assume that search monetization on handsets will become equivalent to PCs and then eventually exceed it, which is my personal view, then it should be highly lucrative, because those – the customers that are using Google services, they are going use it more because they are more personal and more targeted. And so ultimately, it should be a very, very strong revenue stream compared to a PC.
Patrick Pichette: Thank you, Eric. And thank you for your question. Connie, let's go to our next question, please.
Operator: And we will take our next question from Jason Maynard from Wells Fargo.
Jason Maynard: Hi guys, good afternoon. Actually I have a question about social search. I am just curious about how do you capture the signal from social networks without a relationship like you have with Twitter, where you can actually get fairly easy access to the data feeds?
Eric Schmidt: One of things we are careful about is not to describe how our signals are actually assembled. But the answer is that there are some ways in which we can do that. And we also have in development other ways in which people can give us that sort of information that can make it even more personal.
Jason Maynard: Okay. And then just maybe a follow-up for Nikesh. When you think about mobile advertising, maybe just sort of help me frame, where do you think advertisers are at in their lifecycle of actually committing dollars to spend in this medium and form factor?
Nikesh Arora: I think the important part to understand on the mobile space is that the reason the billion dollar number is an interesting number is that just means that now the larger advertisers can get more interested, because we can help them spend reasonable amounts of money. It's very hard to go and make a pitch to a large advertiser when the maximum inventory that you can offer them is in the five to 10 or $50,000 range, especially with advertisers who got $100 million or $200 million advertising budgets. So, to get them interested – if they get interested, they would like to be able to deploy reasonable amounts of money against this market. So, the part I am excited about is that the inventory continues to grow. There is diversity in formats. People are interested in search-based advertising. People are interested in display-based advertising. They want to be in the middle of applications and get customer engagement. So we are seeing sort of reasonable broad-based interest. Clearly, the early adopters are people who can actually consummate a transaction. So, insurance services want a click-to-call, they want to be able to pitch, they want the customer to be able to pick up the phone and call them. There are now people who are in the local space, who want the customer to come to their restaurant. They want the customer to come show up, where they are offering a local service. So, that interest is going up. Now the retailers who actually are interested when you are looking for a local J. C. Penney or RadioShack that, if we can tell you where it is and they can actually click and find out where it is. So, the interest continues to grow as you look at the local categories, as you look at the click-to-call categories. And as Jonathan said, as payment capabilities start getting bills into the phone, you will start seeing even more of an interest from the e-commerce players.
Jonathan Rosenberg: Yes. By the way – this is Jonathan. Try typing in some things that will generate the hyper-local feature that we have on mobile search ads. If you try, for example, typing in car rental, there is a very good chance you will see an enterprise rent-a-car ad that tells you how far away it is to your nearest location, half a mile along with the phone number and a link to a map, and I think that will give you a sense of how powerful it is.
Jason Maynard: Okay, thank you.
Patrick Pichette: Thank you, Jason. Connie, let's go to our next question.
Operator: And we will take our next question from Jason Helfstein from Oppenheimer.
Jason Helfstein: Thank you. One of the questions that investors continue to have is ultimately what's the right long-term growth rate to think about for international. Prior to the recession, the company was obviously putting up a very large international growth rate, and we've seen a slowdown and now a rebound. Is there additional color you can give us as far as you think about the long-term opportunities, what they are in the more developing countries and how that's impacting your results internationally? Thanks.
Patrick Pichette: Because it's guidance – forward-looking guidance, I – we just can't comment. I think that you have to take it from the current performance that you see over the last couple of quarters that there is clearly a separation in the world of economic growth in general and the digital economy growth. And from that I mean, you have to infer that – that's why we are so optimistic about the future of international and we are investing so much in it. Let's go to the next question, Connie, please.
Operator: And we will take our next question from Youssef Squali from Jefferies.
Youssef Squali: Thank you very much. Two quick questions. First, Patrick, your traffic acquisition cost rate seems to be the lowest you had I think since IPO. What accounted for that and is that sustainable going forward? And two, growth in the last few quarters was driven largely by volume not price, so to what extent is that driven by more SCO, less SCN, maybe a mix of domestic versus international, and how realistic is it for us to kind of expect, kind of hockey stick or maybe not hockey stick but reacceleration in pricing trends? Thanks.
Patrick Pichette: So, I will take the first question, and then on pricing, Jonathan can probably give you some perspective. On the TAC, it’s very simple. I mean, this quarter, we have had two really factors. One is our MySpace deal is now over, and with it, there was a contract with minimum guarantee and now it has expired. So, that’s one, and then the second one is since the mix of our partners within the network actually will affect our TAC, and that’s really the effect that you see for this quarter. There’s nothing more of us. In terms of forward-looking for volume versus price, Jonathan, any insights or –?
Jonathan Rosenberg: I am not really sure how to answer the question without saying anything forward-looking, is there anything specific use of in terms of trends that you have seen that you are asking for clarification on?
Youssef Squali: Yes, I mean we have been hearing from agencies and advertisers there. They are spending more on SCO, they are getting smarter they have to spend their ad dollars. And so, to the extent that, that continues then that really is putting a dampening effect on CPC growth going forward, the mix between domestic and international should shift to more international and that overtime we should see higher CPCs. I am just trying to kind of see as we look at the business over the next several years, how realistic is to assume that, one i.e., that increased international CPCs will offset the SCO trend?
Jonathan Rosenberg: I guess I don’t actually agree that I have necessarily seen such a trend in terms of more SCO versus SCN. As far as I can tell, SCO has always been pretty big. Pricing has been pretty healthy from my perspective coming out of a recession, bids are healthy. We have got very strong conversion rates, and presumably that’s because the advertisers are seeing buyers again, and the advertisers look at the total value they get from Google, and they are optimizing across everything under purview. So, I am not necessarily sure I agree with the trends the way you have stated them.
Eric Schmidt: It’s interesting that’s going on is that we are continuing to make algorithmic improvements to our app targeting, which flow through the system sort of as the inventions are brought out, we brought out hundreds of them in the quarter, the small ones, but some of them is actually helping drive basically the revenue performance on a per query basis.
Youssef Squali: Okay. Thanks.
Patrick Pichette: Thanks. Let’s go for the next question.
Operator: And we will take our next question from Ben Schachter from Macquarie.
Ben Schachter: Hi guys. A few years ago, there was a lot of discussion around callable exclusive data databases, and while yesterday’s deal with Microsoft and Facebook was not exclusive, I wonder if you think that’s going to be a topic that may become more of an issue going forward particularly with Microsoft? And then also just quickly a lot of discussion lately around daily deals and private sales and those kind of things, can Google participate in that in any way? Thanks.
Eric Schmidt: In general, the web continues to grow at such a blazing pace that if you think of all the signals available, I mean, anyone that will be private is completely swamped in the sea of the Internet, and in that sense, it’s not really a relevant question if you think of, what Jonathan would call it petabyte or terabyte or zettabyte. So, from that perspective, I think that we continue to organize the vastness of this and that’s where most of the value construct. So, I think that we are not concerned on that sense.
Patrick Pichette: There’s always a concern that large, private collections of data are not accessible to web search engines. We have teams that have spent an awful lot of time trying to make sure people know that if they optimize, easily crawl their site maps and other services which are standardized among the web search industry. So, it’s obviously up to the content owner to decide how much of that information to expose. We have taken the position to sort of both in a religious and a business perspective that they will do better off if you take information and making it searchable. It provides a lot of audience, it drives more traffic to your site, etcetera, etcetera, and we fundamentally believe that. Jonathan, do you want to take the second?
Jonathan Rosenberg: All right, sure. There is no question, Ben, there is a very exciting space related to daily deals, which we are seeing, and there is obviously a lot of small companies that are doing a fabulous job there. We do participate to some degree, there are some companies that use site links for hot deals. So, there is a mechanism that we already have where advertisers are actually putting in case deals and highlighting them, but there’s no question. That’s a very exciting and hot space, and there are a lot of innovative players building some pretty effective business models there right now.
Patrick Pichette: Thank you. Connie, why don’t we go to the next question?
Operator: And we will take our next question from Jordan Rohan from Stifel Nicolaus.
Jordan Rohan: Couple of follow-up questions on mobile while we are on the subject. I am a big fan of Google Instant, I am wondering when it will be fully rolled out on BlackBerry, iPhone and other devices there? Also curious, if you happen to disclose the number of Android devices activated in the quarter. I think last quarter, it was around 200,000 a day. And finally, instead of smart pricing, and sort of fearing the discount placed on mobile search clicks or calls, why not let advertising just bid directly on the mobile search inventory, you might be surprised about the yield.
Patrick Pichette: On Instant, Jonathan, when is Instant available for all of these mobile devices?
Jonathan Rosenberg: It’s relatively soon, sometime this fall. Fall last a little bit longer in California though.
Patrick Pichette: Okay. Last public number is 200,000 handsets activated a day, and that’s the last number that we have been using. So, we stick to that one for now. And can you just repeat, Jordan, your last question for me?
Jordan Rohan: Yes, smart pricing is, as I understand, and maybe I am getting it wrong, but Google has an algorithm which discounts value assigned to advertisers that which advertisers have to pay for certain clicks, if it’s believed that those clicks perhaps are less frequently tied to conversion?
Jonathan Rosenberg: Yes, they can set up a separate campaign now, so the smart pricing is a convenient mechanism for them. If they want to leverage the existing campaign across mobile, but many advertisers have increasingly set up separate campaigns for mobile.
Jordan Rohan: They can right now full visibility there, so that’s how you at some level inform your decisions about smart pricing for the rest of the universe, that access –?
Jonathan Rosenberg: I am not sure, no. The smart pricing is done algorithmically on the basis of what we see. We are not doing it. We don’t necessarily look at differentiation between specific bids across different campaigns.
Jordan Rohan: Got it, thank you very much.
Patrick Pichette: Thank you, Jordan. Connie, let’s go to our next question please.
Operator: And we will take our next question from Sandeep Aggarwal from Caris & Company.
Sandeep Aggarwal: Thanks for taking my questions. Actually, I have two questions. One is, Eric, given that non-core search business is becoming more material part of your business, in the past, you allocated resources, that’s (inaudible) there are shifts in terms of how you are allocating resources now? And secondly, this may imply more of asking a guidance, but I guess my question is, by when do you envision mobile advertising overtaking display advertising?
Eric Schmidt: The latter is a very speculative question and not something that – one, we don't know and two, if we – even if we knew, we probably wouldn't talk about it. On the question of allocation of resources, I think at the end of the day and Larry and Sergey and I have talked about sort of our job to use our best judgment based on the sum of technological opportunity, business opportunity and so forth to divide, if you will, between classic core businesses, you are really asking in some of these emerging ones. So we are informed by the hockey stick nature of these things. So there is a couple of ones to give you an example of Android, which is small in resources and growing very quickly. So they pretty much have been able to get whatever resources they need and they are going up against very large giants with the factor of 10 more resources, and so we sort of measured it that way. When we then go back and saw for 70-20-10, it turns out that we are roughly consistent with 70-20-10. It's not really as much of a formula, as is much looking at where the real excitement is. The other thing that we are doing is we are organizing ourselves and Nikesh is actually leading this effort into more of an internal business unit structure, because frankly, it's just become so large and so complicated that it's been difficult for us to keep track of all the details. And so that will give us a better tie-in between where the current and future revenue is and where the resources are going. And I think Nikesh is on the order of 10-15 kind of structure by the time we are done, with the obvious big ones being search and ads and display and enterprise and that kind of stuff, YouTube.
Patrick Pichette: Yes. So and just in closing on that, what really matters the most to us as we actually do the resource allocation is, as Eric said, when you see a hockey stick, pour on gas on that fire and when we do actually and we keep the flexibility to make sure that we really feed the winner so that they keep the momentum as you've seen, for example in Android in the last 24 months, which has been tremendous. All right. Thank you for your question. Connie, we probably have time for two or three more – two more questions. So let's go for the second last.
Operator: Thank you. And we will go next to Mark May from Needham & Company.
Mark May: Thanks. A big picture question about data, because that seems to be an increasing factor of differentiation in growth for online ad companies. How does Google think generally about leveraging user data, both to better target ads and how to stay competitive with those like Facebook and Microsoft and Yahoo! that are leveraging data possibly more so than like Google is today? And I think this is particularly relevant for using search data for your display business, but we would love to get your thoughts on that.
Eric Schmidt: We have a pretty strong opinion that we are not going to do very much of it. The reason is that we take our end user data privacy incredibly seriously, and the trust that people have with respect to giving us that information, both their search histories as well as other piece of information, they get very upset very, very quickly if we, in their view, misuse it. So what we typically tell people is we are not going to do the kind of things that you could do with this, like in particular, use it to generate sort of strange apps against your history and things like that without your explicit permission, and we probably in many cases won't do it forever.
Patrick Pichette: Thank you, Mark. Let's go to our last question, Connie.
Operator: And we will take our final question from Marianne Wolk from Susquehanna.
Marianne Wolk: Thanks very much. It looks like you did a great job converting a lot of the advertising on the content network over to display. Can you talk about to what extent that's now video-based and is that helping monetization rate significantly? And do you expect that to be sort of a 100% display shortly? Thank you.
Patrick Pichette: Nikesh, maybe you want to talk about the display and how it's evolving?
Nikesh Arora: I have been waiting for the entire earnings call, Patrick, to talk about display. I am glad that Patrick and Jonathan have allowed us to disclose the run rate of $2.5 billion. I think this puts us in one of the top three display networks in the world. And I also believe that the technology suite we offer is second to none. So in terms of the video versus the other display formats, it is – primarily a lot of this is still display in terms of banner ads and other formats, and video is beginning to come into it. But we believe in the future there is going to be a lot more rich media involved into display network, because as we go forward you are going to see more and more monetization of video, whether it's on YouTube or other partner sites that's going to happen. So we believe the display network we offer has maximum frequency and maximum reach. We can reach people more times a day than anyone else. So, really excited about display. So, I was not sure what you meant by what becomes 100% of display?
Marianne Wolk: I'm sorry, but of the sort of roughly 1 million partners that are part of the partner network, to what extent is that now converted to display and could that ultimately be entirely part – entirely display network? And then also, just since I've got you, can you clarify the run rate information you gave? Is that a trailing 12-month figure or are you annualizing the current quarter? Thank you.
Nikesh Arora: Yes. So, I'll let Patrick answer the – (inaudible) on $2.5 billion dollars. But in terms of the million partners we have, the entire partner network is part of our display network that we offer and we actually have the ability to offer them display advertising or text-based advertising, and basically it's based on ROI and CPMs that we make that determination or the publisher makes the determination or the advertisers make the determination. So an entire network that we have is open for display advertising already.
Patrick Pichette: And on the previous question – on the follow-up question, it was about – it's just the trailing quarter. So with that, thank you for your question, Marianne. Let me give you a couple of thoughts. One is, just want to reiterate that what we did today was give you a few indications of why we believe we are successful in these emerging businesses. These data points are not about giving you more information on the coming quarters, but more to give you the confidence about where we are investing and it's really fueling great growth rates and building meaningful businesses. I want to thank you Eric for taking the time. I know he is running for the plane, but it's terrific to have you on the call and take a few minutes with our analysts and shareholders. And then I also want to take a moment to thank all the Googlers for their hard work. I mean, all this strong performance is really on the back of fantastic work from our team worldwide, our great engineers, our great sales force, and our great support staff everywhere. So I just wanted to take from the OC, 40 just the time to thank them again on – in the public domain, because they do such a terrific job. With that, Connie, I'll let you close the call.
Operator: Thank you. And this concludes today's conference. We thank you for your participation. | [
{
"speaker": "Operator",
"text": "Good day and welcome everyone to the Google Inc. third quarter 2010 earnings conference call. Today’s call is being recorded. At this time, I would like to turn the call over to Ms. Jane Penner, Senior Manager, Investor Relations. Please go ahead, ma’am."
},
{
"speaker": "Jane Penner",
"text": "Good afternoon everyone, and welcome to today’s third quarter 2010 earnings conference call. With us are Patrick Pichette, Chief Financial Officer; Jonathan Rosenberg, Senior Vice President, Product Management; and Nikesh Arora, President, Global Sales Operations and Business Development. First, Jonathan and Patrick will provide us with their thoughts on the quarter, then Nikesh will join Patrick and Jonathan to answer your questions. Also, as you know, we recently began distributing our earnings release exclusively through our Investor Relations Website located at investor.google.com. So, please refer to our IR Website for our earnings releases as well as supplementary slides that accompany the call. This call is also being webcast from investor.google.com. A replay of the call will be available on our Website in a few hours. Now let me quickly cover the Safe Harbor. Some of the statements we make today may be considered forward-looking, including statements regarding Google’s future and investments in our long-term growth and innovation, the expected performance of our business and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures we use on this call such as operating income and operating margin are also expressed on a non-GAAP basis and have been adjusted to exclude charges relating to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will now turn the call over to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Jane. Good afternoon everyone and thank you for joining us. As Jane mentioned, Jonathan and I will begin with our prepared remarks, and then Nikesh will join us for Q&A. In addition and as a bit of a surprise, we may actually have Eric join us for the first 30 minutes of Q&A before he has to run to a plane. So, let me start by giving you some general thoughts before I get into the details of our financial performance for Q3. At the highest level, we are very pleased with our Q3 results and it’s clear that the digital economy continues to grow rapidly, a relentless trend that continues to drive continued growth in both our core business, core search and creating market and also for fuelling momentum in our newer businesses. Our Q3 results clearly reflect this phenomenon that is our continued strong growth in our core business and continued very strong growth in our emerging businesses year-over-year, and indeed we saw strength in every major product area in Q3, that is search, display, mobile as well as apps enterprise. And when I say our newer businesses are seeing great momentum, I really mean it, and in that, Jonathan will back that statement up with some hard facts in a few minutes. So, stay tuned for the details. Now, let’s turn to specifics of our performance in the quarter from a financial perspective. Let’s move quickly to the results. Gross revenue grew 23% year-over-year to $7.3 billion. Our Google Website revenue was up 22% year-over-year to $4.8 billion, which strength as I mentioned across most major geographies and verticals. Our AdSense revenue was up 22% year-over-year to $2.2 billion, again reflecting continued strength in our Google display network. Our other revenue was up 35% year-over-year to $254 million, down sequentially reflecting the end of our direct-to-consumer sale of the Nexus One. Our global aggregate paid click growth remained healthy up 16% year-over-year and also up 4% quarter-over-quarter. Aggregate cost per click growth was up 3% year-over-year and 2% quarter-over-quarter. You should note that the FX had a negative impact on CPC growth year-over-year, but the impact for quarter-over-quarter was quite neutral. Remember too that this is an aggregate number which includes both Google.com and our AdSense properties. So, now turning to our geographic performance, the U.S. and rest of world are growing at a healthy pace as our results reflect, but also, while the U.K. continues to lag a little bit in the economic recovery again seen in our results. Revenue from the U.S. was up 26% year-over-year to $3.5 billion and in our earnings slides, which you can find in our Investor Relations Website, you will see that we have broken down our revenue by U.S., U.K., and rest of world to show you the impact of FX and the benefits from our hedging programs. So, please refer to those slides for the exact calculations. International revenues accounted for 52% of our total revenue or $2.8 billion, up 20% year-over-year which includes a $89 million benefit from our hedging programs, and that compares to a $39 million benefit for Q3 of last year. If we used fixed exchange rates, our international revenues would have been roughly $169 million higher year-over-year. U.K. was up 10% year-over-year to $840 million, but actually if using a fixed exchange rate, that number would have been just shy of 20%. So now, let me turn to expenses. Our traffic acquisition costs were $1.8 billion or 26% of total advertising revenue for this quarter. Other cost of revenue was $747 million including stock-based compensation of $8 million and finally all other operating expenses totaled $2.2 billion, including approximately $372 million of stock-based compensation. The increase year-over-year in OpEx was primarily due to increase in payroll, professional services, and advertising and promotional spend. So, as a result of all this, our non-GAAP operating profit which excludes the stock-based compensation increased to $2.9 billion in Q3, resulting in our non-GAAP operating margin of 40.2%, essentially the same as last year. Headcount was up approximately 1,500 versus Q2, and we ended the quarter with approximately 23,300 full-time employees, of which about 300 came from acquisitions. Our effective tax rate for the quarter was 20%, down from 24% in Q2 and this is mostly because we released certain tax reserves as a result of the settlement of our 2005-2006 tax audits which are now completed. Let me now turn to cash management. In the line other income and expenses, it was $167 million for Q3, which includes good progress on our portfolio management performance, although that was slightly offset somewhat by the impact of our hedging expenses associated with FASB 133. For more details on OI&E, again, please refer to the slides that accompany this call on our investor Website. Operating cash flow, very strong for the quarter at $2.9 billion. CapEx for the quarter was $757 million, again mostly primarily related to our data center operations, and as a reminder, we continue to make significant investment in CapEx and these have shown to be quite lumpy from quarter-to-quarter depending on when we are able to make these investments. So, in the end, free cash flow was also very good at $2.1 billion. Before I close, I want to say a few words about how we are continuing to grow the business for the long term, and when I say the long term, we really mean not the next quarter or the following quarter, but we are just thinking about the next five to 10 years. Looking ahead, we continue to see tremendous opportunity in our agenda in both our core and in our emerging businesses. So simply put, we are on disclosed agenda at full throttle. We are doing it largely in two ways to think about it, continue to invest heavily in people and also in products. In people, it’s a pretty simple story, the explosive growth in the digital economy that we are experiencing, it’s really created a war for talent in our industry to digital economy, and one that is quite out of sync with what’s happening in the rest of the economy. So, we believe this trend is only accelerated in the next 18 months and will continue to accelerate. So, in context of that, we stepped up our hiring machine, and we are currently exploring how we can continue to attract and retain the very best people in this exceptionally competitive environment. So, we strongly believe that the difference between the winners and the losers in our industry, although be to a large extent determined by who we can attract and who we can retain the best talent. So to that end, we are incredibly proud to have attracted approximately 1,500 people to join Google in Q3, the majority in engineering and sales once again. On the products side, our goal continues to be to develop truly innovative products that leverage computer science to solve these incredible problems that we tackle and offer obviously significant ROI across a number of very large growth opportunities. As I mentioned, Jonathan in a few minutes will be speaking of this great momentum our products are experiencing, and as always we are investing with discipline following the Google tradition of being generous but frugal. So in summary, very pleased with our performance of Q3 across revenue, margins, cash flow, and we plan to continue to attract higher, retain the very best talent in the world wherever they are to fuel our innovation agenda. Now is the moment for me to turn the call over to Jonathan, which I usually mean that my number parts is over, but today, I have actually asked Jonathan to share with you and let me emphasize on a one-time basis a few products, specific metrics that I think everybody will be very interested to hear. And as the CFO, I am usually the official buzz killer, so I need to make it very clear that we will not be updating these numbers going forward. We are merely sharing them with you as a proof point of the great momentum we are experiencing in our emerging businesses. And with that, let me turn it to Jonathan."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Okay. Well, thanks, Patrick. So, I think you guys can see from the financial numbers, we've got tremendous momentum in the core business. But in these emerging businesses, you guys basically have to invoke your Jedi guesstimation skills to try to figure out what's going on. So today, with Patrick's permission, I hope to shed a bit more light on these businesses with some numbers that we've not shared before. But let me start with the core. Search is more important than ever. The Internet, as you guys know, continues to explode. There is lots more websites, there is more videos, there is more images, there is more books and news, all of this stuff is coming online. And at the same time, more people are coming online too. And what do these people do when they get online? The first thing they usually do is search. So search is still at the heart of the web and with all of this new content coming online, doing search well is even harder than ever. I actually believe search remains one of the most challenging computer science problems of our generation and probably the next one as well. This is why we are so incredibly proud of Google Instant. Many of you guys speculated that we launched Instant to make more money. Well, let me tell you that's simply not the case. We launched Instant because it's so much better for the user. In fact, from a revenue standpoint, its impact has been very minimal; and from a resource standpoint, it's actually pretty expensive. So why did we do it? Well, we believe from a user standpoint, Instant is outstanding and the data that we are seeing actually bears this out. We took something that no one thought was a problem and we created something that once you use it, you can't recall how you lived without it before. It saves about two to five seconds per search and users absolutely love it. The percentage of people who select Instant results before they finish their query is steadily rising. So in other words, that means the more they use it, the more they like it. So let me be clear that Instant wasn't based on a narrow financial calculation. We launched it because we could and because it's great for our users, as we have always said. Of course, I know it's an earnings call, so let me be clear on another point. We do in fact care about money. And search is still the most monetizable moment on the web and as search gets better, our ads have to keep pace. The good news is they are. Turns out we also have a lot of great momentum with AdWords and this is particularly true with the new ad formats. On past calls, I've talked about making ads more useful with the new formats like site links and ads with seller ratings and product listing ads, which we think – which we can see now are starting to have a real impact. These ads appear on more than 10% of the queries where we show ads and people like them. We see this because click-through rates are up for some formats as much as 10% and up more than 30% on some others. We are also seeing great momentum in our newer businesses, and this is where Patrick is letting me give you some big numbers. So, I hope you find them useful. The numbers all begin with the letter B. And remember, as I often remind my team at Google, a billion is a thousand million. So first big number, $2.5 billion; as in display is on an annualized run rate of over $2.5 billion. So that's non-text display, meaning it doesn't count text ads running on our network. What it does count is YouTube ads, non-text ads on the Google Display Network, and of course on the DoubleClick platform. So you guys often ask me, \"Jonathan, you know, where is the next multibillion dollar business after search\"? There is your answer. It's display and it's already here clocking in at over a $2.5 billion run rate. So clearly, we are firing on all cylinders in display, the advertisers are running great branding campaigns, the Ad Exchange is taking off, we are partnering very well with agencies, and of course more publishers are making more money. And if you want to know more on the display front, Nikesh who is here is passionate about this business. He's made enormous strides with the sales force and clients, which I'm sure he will be happy to talk to you guys about in the Q&A. So second big number, 2 billion; as in YouTube is monetizing over 2 billion views per week. That's up over 50% year-over-year. And when you think about that growth, it's important because the RPMs are really strong on YouTube. We have just launched some new ad formats called TrueView where the viewers get to choose which commercials to watch or they can even skip watching the ad altogether. Turns out when advertisers only pay for the commercials people watch, we discover the ads are a lot more valuable to advertisers when they are only paying for viewers who have actually chosen to watch them. Finally, third big number, $1 billion. Mobile is on an annualized run rate of over $1 billion. This means the people who are accessing our products and services through their mobile phones are adding a $1 billion annually to our existing revenue streams. Clearly, this is the future of search in the Internet, more people in more countries coming online from these smartphones. Our mobile search queries have grown five times over the past couple of years. And of course, a lot more of those queries are now coming from Android phones. So, here are the facts that Patrick has let me say just this once. Non-text display, $2.5 billion run rate; YouTube, 2 billion monetized views per week; and mobile, over a $1 billion added to our business. And Patrick, maybe I'll add one more fact here without asking you. You should know, all these businesses are growing. So, I hope this gives all of you a sense of why we are so excited about the incredible emerging businesses at Google. And with that, I'll take it back to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Jonathan. Before we take your questions, I just want to add one fact regarding the new disclosures that Jonathan just gave you. Obviously, this information reflects our revenues from two different angles of our business. And with it, we've recognized in some cases some small overlaps. So for example, the AdMob revenues are obviously included both in the mobile number because it's a mobile product and in display because it's also a display product. So these are very small, but I wish to just clarify it out for everybody. So with that in mind, what I would like to do is turn it over to Connie to open – and we have Eric with us. So, the \"may\" is now in \"actual,\" Eric is with us, he has got 20 to 30 minutes, then he is running for a plane. So delighted to have you with us, Eric. And what I'll do is I'll turn it to Connie for the Q&A, questions period. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. (Operator Instructions). And we will pause for just a moment to assemble the queue. And we will take our first question from James Mitchell from Goldman Sachs."
},
{
"speaker": "James Mitchell",
"text": "Great, thank you. I'll ask two separate questions, if I may. The first one, if I look at your paid lead growth, it's been remarkably consistent and not decelerating. I think it was 4% sequentially in the third quarter of 2008, 4% sequentially in the third quarter of 2009, and then 4% sequentially in the third quarter of 2010. Is that because your query growth is also fairly consistent or are you supplementing query growth with monetization initiatives that increase paid lead takeoff? And then secondly and separately, thank you extremely much for disclosing the billions in terms of mobile and display advertising. But within the $2.5 billion plus of display advertising, how do you account for advertisers spending through the DoubleClick Ad Exchange? Is that on a gross or net basis? Thank you."
},
{
"speaker": "Jonathan Rosenberg",
"text": "I'll try to – I mean, I'll try to take the first question. Certainly the highest correlation between ad clicks and anything else is query growth. So that's going to certainly by far dwarf any other factor. I think the other factors that we are seeing is that the new formats that we have which I had mentioned certainly drive click growth as well. And I mentioned that those formats appear on 10% of the queries. If you try some of those like, Halloween costumes, you will see that they make the ads much more compelling, as do things like merchant ratings if you type in laser printers. So by improving the ad formats, we are increasing the relative number of clicks because the click-through rates grow up."
},
{
"speaker": "Patrick Pichette",
"text": "Great. On the other one the Ad Exchange is included in – so if you think of the elements, the Ad Exchange, DoubleClick platforms, all these are included in display and it's done on a gross basis."
},
{
"speaker": "James Mitchell",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you for your question. Let's go to the next question, Connie."
},
{
"speaker": "Operator",
"text": "And we will take our next question from Spencer Wang from Credit Suisse."
},
{
"speaker": "Spencer Wang",
"text": "Thanks, and good afternoon. I guess since you guys are sharing some numbers this time, I was just wondering if we can just delve into the YouTube numbers a little bit. Of the 2 billion views, Jonathan, I was wondering what – roughly what percentage of total views is that currently? And then, you guys have talked in the past about getting closer and closer to profitability. I was wondering if you could just give us a sense of where you are with respect to profitability as well. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "So on profitability, let me jump on that one first which is, we have not made any comments on it. You will remember, we talked about it a long time about ago. Because there was so much distortion in the market, we just thought it was okay to kind of set the clocks properly. But since then, we have not and will not comment on it. On the billions of –"
},
{
"speaker": "Jonathan Rosenberg",
"text": "This is Jonathan. So there is basically two points that we've given that you can use to connect those dots. We said that traffic over – that we have over 24 hours of video uploaded every minute and over 2 billion views per day. When you couple that with the 2 million monetized views per week, I think you can get to the answer that you are looking for."
},
{
"speaker": "Spencer Wang",
"text": "Great. Thank you very much."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you. Let's go to the next question, Connie."
},
{
"speaker": "Operator",
"text": "And we will take our next question from Imran Khan from J.P. Morgan."
},
{
"speaker": "Imran Khan",
"text": "Yes, hi. Thank you very much for taking my question. So I have a question for Eric as he is on the call, and then a follow-up housekeeping question. So Eric, I think the two big trends on the Internet, obviously the web is becoming more social and realtime. So, as the web becomes more social and real time, how does Google compete in that world in terms of realtime search market and how does that impact your business? And secondly, on the mobile trend, obviously you have this Apple Ecosystem with i – Apple i-applications and people are going directly to applications and how does that impact Google's business model over the long term? And the housekeeping question, near-term question is the tax rate was 20% on the quarter. Is there anything specific in one – this quarter? How should we think about the tax rate? Thank you."
},
{
"speaker": "Eric Schmidt",
"text": "Imran, let me deal your questions as two separate questions for me. With respect to social and realtime, we use complex signals to do ranking. And overtime, we will add additional social, if you will, ranking clues. Fundamentally, we make search more personal and as we get more information the friends are, we can make the search that much better. We are quite convinced that, that produces a better search results for people who choose to give us that information. People who want to continue to do what is there on an anonymous search, that’s also possible. So, one of the ways to think about that is that we want users to be more logged into Google, more logged in they are, more likely we can buy them not only the social information but the other information. We also estimate real time we already have significant feeds from real-time information providers, we have real-time index which of course is very, very successful for us and you can see that whenever anything interesting happens, it’s already right there in Google. For example, we use Twitter as a real-time source of information. So, if you search for almost anything, you will see the Twitter feed is now part of universal search. Could you repeat the second part of your question for me?"
},
{
"speaker": "Imran Khan",
"text": "Second one was, Eric, on the mobile front right, we are seeing explosion on application on mobile platform. So, does that impact your search volume and as people go directly to the vendors to the app, it seems like, you know, Amazon talked about $1 billion sales through coming from mobile devices, so how does that impact Google’s business long-term?"
},
{
"speaker": "Eric Schmidt",
"text": "It doesn’t seem to. This is one of those sort of worry work questions that we get all the time, that the success of one thing, could that impinge on something else. And in fact, the rise and tide of all those, and I would say that again, what I hear is the sort of presumption that it’s a zero-sum game and that one wins and another one loses. What’s really happening is that all of the companies that are driving the web and web applications are all doing really well. People are moving from offline to online and in the course of doing that, they are using these systems more, they are searching more, using apps more etcetera. Now, from our perspective, you have this phenomenal success of Android, which is well past anything that I had ever hoped for and looks like it’s on its way to be a huge, huge success within our devices, devices, open model for access, lots and lots of innovation, more dynamic, more competition than any other part of the platform. There are up to 90,000 applications on Android and have grown very, very fast, and those applications of course have sort of drive to them. So, we don’t see them as a negative, we see both as very strong positive."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks, Eric. Let me go back then to, coming on to the tax question. We did get a one-time benefit this quarter on the tax side and it is related, as the statutes expired for 2005 and 2006, all of our taxes are now closed and in doing so, then we had an opportunity to reverse a set of provisions we had taken that we ultimately didn’t have to take so. You can see the tax rate this quarter is a bit of an anomaly again."
},
{
"speaker": "Imran Khan",
"text": "Thank you, Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you for your questions. Connie, let’s go for the next question please."
},
{
"speaker": "Operator",
"text": "And we will take our next question from Justin Post from Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "Great. Eric, well, we have you, when I get back into mobile, just when you think about Android as an operating system, how does that proprietary to Google when you think about your search services? Does that give you an advantage over other phones for some of your services and does the phone operate better when you are using Google services? And then second, I think you were quoted in an article saying, maybe someday Google can make $10 per phone. Would you see that as mostly advertising and is that number right something you did say? Thank you."
},
{
"speaker": "Eric Schmidt",
"text": "Yes, the latter one I made out of the mirror. So, we don’t really have a notion of exactly what it is, but it’s probably pretty big. So, one way to think about Android is it’s probably the largest single platform play available in the market today. It’s a platform for computation, for location, for everything you could do with the new and most popular set of computing devices that are emerging. That market is larger than the PC market, the tablet market is a small component of it, it’s an important part of it. So, if you think of mobile as platform, as phone plus tablet, plus all of the other things, we hope to become the leading platform in that space and we are doing it with open source approach. So, in the open source approach, that means we give the software away, which is always paradoxical. People say, well how do you make money from that? Well, let’s start with the fact that the evidence we have is that people who use Android search twice as much as everything else. So, clearly, there is more revenue associated with those searches. And another thing of course is if they are using Android systems, revenue that we share in the search as we shared with operator but not with anybody else. So, again it’s more lucrative. So, not only there are more searches and there is more apps, but it’s also more lucrative. So, on that basis alone, Android is hugely profitable and we maintain the anti-segmentation and other things by a series of contracts around the store and so forth and so on. So, Android is likely to be financially successful to Google without even any of the applications that are possible. So, Patrick calls up and says, okay, what else can you do for us, and the answer of course is, we can layer on value-added services versus how do you get to the $10. And the value-added services, do you have any time. Our primary purpose right now is building this open platform. Google had chose and they did on open systems and open platform on the open web. That service is well so far and it looks like it’s worked really well."
},
{
"speaker": "Justin Post",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Justin. Connie, let’s go to our next question please."
},
{
"speaker": "Operator",
"text": "And we will take our next question from Mark Mahaney from Citi."
},
{
"speaker": "Mark Mahaney",
"text": "Great, thanks. Two questions on the cost side. It looks like this is the first quarter in about a year-and-a-half, which cost per employee on an annualized basis had declined sequentially. Is there something that you have been able to put in place that gives you confidence that, that will continue going forward? And just on the mobile revenue opportunity, are the results strong enough from your perspective in terms of dollars and growth such that you will stay with an indirect monetization approach towards Android, or you are going to keep the door open and potentially charge per operating system as a share of applications in the future? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "On cost per employee, look, it’s just another reflection of when read anything kind of forward-looking into our results except that it’s just another good example of how we are – I talked earlier about generous but frugal. We are investing, but people should not confuse the fact that we are investing and we are investing aggressively where we really see fantastic opportunities from being wasteful. We are just not a wasteful company. And so in that sense, that’s a good signal and we will continue to do so. On the mobile, maybe Jonathan or Nikesh can give us an indication."
},
{
"speaker": "Nikesh Arora",
"text": "I think just following up on what Eric said earlier, we are very, very keen to build this ecosystem, and I think Jonathan’s disclosure on the fact that we are on a $1 billion run rate mobile is a testament to the fact that we have a revenue model which we are very excited about, and that revenue model sort of proves to that, roughly the revenues are split between our storage efforts, our display efforts, application efforts, and we are able to play across all those three spaces in our mobile monetization efforts. And the more people who use commercials, more people who are able to access the web devices, the more we see the trend that people that are searching them, they are going to give us opportunities to put display advertising. So, we see no reason to change our monetization model. We think the current approach to Android drives more users and more usage and drives these."
},
{
"speaker": "Eric Schmidt",
"text": "And Nikesh, I think you have already viewed that despite a (inaudible) revenue, because of the success that we are seeing (inaudible)."
},
{
"speaker": "Patrick Pichette",
"text": "Exactly. Thank you very much Mark for your questions. Let’s go, Connie, for the next question please."
},
{
"speaker": "Operator",
"text": "And we will take our next question from Douglas Anmuth from Barclays Capital."
},
{
"speaker": "Douglas Anmuth",
"text": "Great, thanks for taking the question. First on display, can you give us some context in terms of breaking out (inaudible) and secondly what’s your view on other potentially competitive Android app stores that are out there? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "So, I will answer the first, and then I will give Jonathan to talk about the Android marketplaces. So, on display, we just don’t break it down. So, we will not – the details where we wanted to give today with the numbers we are sharing is a sense of scale and trajectory. And that’s really what we wanted to share. So, of course, we won’t give any more details on that. On the Android competitive, of course, Eric, maybe you can give us more perspective on it?"
},
{
"speaker": "Eric Schmidt",
"text": "Yes, the goal of the store is to – people who are writing the software and applications, and it’s not a revenue goal for Google. So, there certainly will be multiple stores, there will certainly be the key one from us, taken the net of – and that win for everybody. So, but it’s not a primary focus on Google from a revenue perspective, it’s really for the developers."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks, Eric. Connie, our next question please."
},
{
"speaker": "Operator",
"text": "And we will go next to Brian Pitz from UBS."
},
{
"speaker": "Brian Pitz",
"text": "Great, thanks. Would you provide us with a relative idea of how the difference between average CPCs and clicker rates are based on the mobile versus the PC, now that you have a large enough number of devices in the market? And secondly, if there is a gap which I imagine there is, can you close that gap longer term between the two? Thanks."
},
{
"speaker": "Jonathan Rosenberg",
"text": "This is Jonathan, Nikesh can maybe give you more of a customer base perspective. I think that some of you know we recently started smart pricing on the mobile devices, and it is the case that the CPCs on the mobile device are a bit lower. It’s primarily because there is the measurement that there isn’t as much of a consummation of a transaction on the mobile devices. People don’t have their credit cards, and it’s harder to type into them. So, the mobile rates remain relatively lower. As payment platforms get built into the mobile devices and as people are more likely to actually complete the transaction, I think you will see those things go up substantially. I think it's also the case that on devices like the iPad, the kind of activity looks a little bit more like it does on a PC, primarily because people have a larger window, a bigger browser, and they are also more able to input information. Nikesh?"
},
{
"speaker": "Nikesh Arora",
"text": "I think the only thing I have to add to that is there are some formats which we started to introduce, which are driving a better monetization on the mobile sites, formats like click-to-call and hyper-local, because people are searching in their mobile devices where they want to then make a phone call or they are searching on their devices and they are looking for something in a very local context and there, we are beginning to see sort of better CPMs and better monetization. Generally, we think that's where the trend is, that's where we are going to see more and more monetization. And clearly, we are seeing monetization in the application side of the mobile, because with the AdMob sort of team that we have and all the advertisers who want to be part of the application, the applications are becoming a big share of people's mobile usage."
},
{
"speaker": "Brian Pitz",
"text": "Great. Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks, Brian. Connie, our next question, please?"
},
{
"speaker": "Operator",
"text": "And we will take our next question from Ross Sandler from RBC Capital."
},
{
"speaker": "Ross Sandler",
"text": "Thanks, guys. Two quick questions. First is, you guys have discussed the cannibalization topic before between smartphone and PC, but have you – when you look at the search data, can you see whether tablet searches or iPad searches are incremental or are there any cannibalization towards PC and is the tablet option within AdWords going to be similar to the desktop/laptop option or is it going to be kind of a separate category? And then the cash, can you just give us a little bit more color on the rest of world growth, just in terms of regions that we are driving that 26%. Was it broad-based or was there anything that stood out? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "So, we'll let Jonathan answer the first part."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yes. We – so we don't see cannibalization. We tend to see mobile is very complementary to the desktop. I think you do see some differences in the search patterns. People use mobile at lunch, they use it on – in the evening, they use it on weekends, they use it more on holidays, but we see more mobile and web search traffic growing and they appear to us to be complementary and not cannibalizing each other."
},
{
"speaker": "Patrick Pichette",
"text": "Nikesh, you want to cover the international growth?"
},
{
"speaker": "Nikesh Arora",
"text": "Yes. The U.S. growth was very good for us. I'm very pleased with the way our U.S. team has driven the revenues sort of across the board, across our revenue categories. On the international side, I'd say generally, the trend has been positive across the board. I know the U.K. has been a bit weaker, but there is a bit of currency in there as well. But France, Germany, those markets have actually been very, very robust. I'd say Southern Europe has done way better than some of the Northern European countries, but that's expected because they are enjoying sort of bit of a growth curve. And clearly, some of the Asian markets are growing robustly for us. So, good growth across the board."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Ross, for your question. Connie, let's go to our next question, please."
},
{
"speaker": "Operator",
"text": "And we will take our next question from Jeetil Patel from Deutsche Bank Securities."
},
{
"speaker": "Jeetil Patel",
"text": "Great, thanks. A couple of questions. I guess you are on a pace of doing about $30 billion on gross revenue run rate. I guess maybe a different way to look at your business. But what – since it's an ROI-driven model, I guess can you quantify or give us a sense of what kind of gross dollar value of transactions that entails for all the merchants and customers that are participating in the system? And second, I guess if you look at your competition in mobile or in other company in this space in mobile, they make about $300 in operating profit per handset sold. I guess, do you think this is more the upper bound as it relates to lifetime profit per handset? Do you think it can be higher? I know obviously you are going after a different strategy, but where do you think is the upper bound in terms of the profit potential on a – let's say, to your handset in terms of monetization?"
},
{
"speaker": "Patrick Pichette",
"text": "Let me – on the gross value, what – rather than to try to give you more details on this call, Google has actually published some economic data about the amount of value that is actually transacted across the system. And so, I may just refer you back to the IR team that can actually dig that out, because we actually shared that with the public over the last kind of eight months or six months, and it's actually very detailed into how much economic is actually flowing to our systems."
},
{
"speaker": "Eric Schmidt",
"text": "On the handset question – this is Eric – which you asked, I understand the question that you are asking. Our model, remember, is that the handset manufacturers and the operators are going to make a lot of that money. And our model is that, our operating system is free and that we are going to make money from advertising and value-added services on top of the Android platform. So, it's clearly different model. And so it's not very difficult to compare the two, they are really apples and oranges. It would be I think premature to – for us to estimate what that would be, but if you assume that search monetization on handsets will become equivalent to PCs and then eventually exceed it, which is my personal view, then it should be highly lucrative, because those – the customers that are using Google services, they are going use it more because they are more personal and more targeted. And so ultimately, it should be a very, very strong revenue stream compared to a PC."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Eric. And thank you for your question. Connie, let's go to our next question, please."
},
{
"speaker": "Operator",
"text": "And we will take our next question from Jason Maynard from Wells Fargo."
},
{
"speaker": "Jason Maynard",
"text": "Hi guys, good afternoon. Actually I have a question about social search. I am just curious about how do you capture the signal from social networks without a relationship like you have with Twitter, where you can actually get fairly easy access to the data feeds?"
},
{
"speaker": "Eric Schmidt",
"text": "One of things we are careful about is not to describe how our signals are actually assembled. But the answer is that there are some ways in which we can do that. And we also have in development other ways in which people can give us that sort of information that can make it even more personal."
},
{
"speaker": "Jason Maynard",
"text": "Okay. And then just maybe a follow-up for Nikesh. When you think about mobile advertising, maybe just sort of help me frame, where do you think advertisers are at in their lifecycle of actually committing dollars to spend in this medium and form factor?"
},
{
"speaker": "Nikesh Arora",
"text": "I think the important part to understand on the mobile space is that the reason the billion dollar number is an interesting number is that just means that now the larger advertisers can get more interested, because we can help them spend reasonable amounts of money. It's very hard to go and make a pitch to a large advertiser when the maximum inventory that you can offer them is in the five to 10 or $50,000 range, especially with advertisers who got $100 million or $200 million advertising budgets. So, to get them interested – if they get interested, they would like to be able to deploy reasonable amounts of money against this market. So, the part I am excited about is that the inventory continues to grow. There is diversity in formats. People are interested in search-based advertising. People are interested in display-based advertising. They want to be in the middle of applications and get customer engagement. So we are seeing sort of reasonable broad-based interest. Clearly, the early adopters are people who can actually consummate a transaction. So, insurance services want a click-to-call, they want to be able to pitch, they want the customer to be able to pick up the phone and call them. There are now people who are in the local space, who want the customer to come to their restaurant. They want the customer to come show up, where they are offering a local service. So, that interest is going up. Now the retailers who actually are interested when you are looking for a local J. C. Penney or RadioShack that, if we can tell you where it is and they can actually click and find out where it is. So, the interest continues to grow as you look at the local categories, as you look at the click-to-call categories. And as Jonathan said, as payment capabilities start getting bills into the phone, you will start seeing even more of an interest from the e-commerce players."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yes. By the way – this is Jonathan. Try typing in some things that will generate the hyper-local feature that we have on mobile search ads. If you try, for example, typing in car rental, there is a very good chance you will see an enterprise rent-a-car ad that tells you how far away it is to your nearest location, half a mile along with the phone number and a link to a map, and I think that will give you a sense of how powerful it is."
},
{
"speaker": "Jason Maynard",
"text": "Okay, thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Jason. Connie, let's go to our next question."
},
{
"speaker": "Operator",
"text": "And we will take our next question from Jason Helfstein from Oppenheimer."
},
{
"speaker": "Jason Helfstein",
"text": "Thank you. One of the questions that investors continue to have is ultimately what's the right long-term growth rate to think about for international. Prior to the recession, the company was obviously putting up a very large international growth rate, and we've seen a slowdown and now a rebound. Is there additional color you can give us as far as you think about the long-term opportunities, what they are in the more developing countries and how that's impacting your results internationally? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Because it's guidance – forward-looking guidance, I – we just can't comment. I think that you have to take it from the current performance that you see over the last couple of quarters that there is clearly a separation in the world of economic growth in general and the digital economy growth. And from that I mean, you have to infer that – that's why we are so optimistic about the future of international and we are investing so much in it. Let's go to the next question, Connie, please."
},
{
"speaker": "Operator",
"text": "And we will take our next question from Youssef Squali from Jefferies."
},
{
"speaker": "Youssef Squali",
"text": "Thank you very much. Two quick questions. First, Patrick, your traffic acquisition cost rate seems to be the lowest you had I think since IPO. What accounted for that and is that sustainable going forward? And two, growth in the last few quarters was driven largely by volume not price, so to what extent is that driven by more SCO, less SCN, maybe a mix of domestic versus international, and how realistic is it for us to kind of expect, kind of hockey stick or maybe not hockey stick but reacceleration in pricing trends? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "So, I will take the first question, and then on pricing, Jonathan can probably give you some perspective. On the TAC, it’s very simple. I mean, this quarter, we have had two really factors. One is our MySpace deal is now over, and with it, there was a contract with minimum guarantee and now it has expired. So, that’s one, and then the second one is since the mix of our partners within the network actually will affect our TAC, and that’s really the effect that you see for this quarter. There’s nothing more of us. In terms of forward-looking for volume versus price, Jonathan, any insights or –?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I am not really sure how to answer the question without saying anything forward-looking, is there anything specific use of in terms of trends that you have seen that you are asking for clarification on?"
},
{
"speaker": "Youssef Squali",
"text": "Yes, I mean we have been hearing from agencies and advertisers there. They are spending more on SCO, they are getting smarter they have to spend their ad dollars. And so, to the extent that, that continues then that really is putting a dampening effect on CPC growth going forward, the mix between domestic and international should shift to more international and that overtime we should see higher CPCs. I am just trying to kind of see as we look at the business over the next several years, how realistic is to assume that, one i.e., that increased international CPCs will offset the SCO trend?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I guess I don’t actually agree that I have necessarily seen such a trend in terms of more SCO versus SCN. As far as I can tell, SCO has always been pretty big. Pricing has been pretty healthy from my perspective coming out of a recession, bids are healthy. We have got very strong conversion rates, and presumably that’s because the advertisers are seeing buyers again, and the advertisers look at the total value they get from Google, and they are optimizing across everything under purview. So, I am not necessarily sure I agree with the trends the way you have stated them."
},
{
"speaker": "Eric Schmidt",
"text": "It’s interesting that’s going on is that we are continuing to make algorithmic improvements to our app targeting, which flow through the system sort of as the inventions are brought out, we brought out hundreds of them in the quarter, the small ones, but some of them is actually helping drive basically the revenue performance on a per query basis."
},
{
"speaker": "Youssef Squali",
"text": "Okay. Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks. Let’s go for the next question."
},
{
"speaker": "Operator",
"text": "And we will take our next question from Ben Schachter from Macquarie."
},
{
"speaker": "Ben Schachter",
"text": "Hi guys. A few years ago, there was a lot of discussion around callable exclusive data databases, and while yesterday’s deal with Microsoft and Facebook was not exclusive, I wonder if you think that’s going to be a topic that may become more of an issue going forward particularly with Microsoft? And then also just quickly a lot of discussion lately around daily deals and private sales and those kind of things, can Google participate in that in any way? Thanks."
},
{
"speaker": "Eric Schmidt",
"text": "In general, the web continues to grow at such a blazing pace that if you think of all the signals available, I mean, anyone that will be private is completely swamped in the sea of the Internet, and in that sense, it’s not really a relevant question if you think of, what Jonathan would call it petabyte or terabyte or zettabyte. So, from that perspective, I think that we continue to organize the vastness of this and that’s where most of the value construct. So, I think that we are not concerned on that sense."
},
{
"speaker": "Patrick Pichette",
"text": "There’s always a concern that large, private collections of data are not accessible to web search engines. We have teams that have spent an awful lot of time trying to make sure people know that if they optimize, easily crawl their site maps and other services which are standardized among the web search industry. So, it’s obviously up to the content owner to decide how much of that information to expose. We have taken the position to sort of both in a religious and a business perspective that they will do better off if you take information and making it searchable. It provides a lot of audience, it drives more traffic to your site, etcetera, etcetera, and we fundamentally believe that. Jonathan, do you want to take the second?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "All right, sure. There is no question, Ben, there is a very exciting space related to daily deals, which we are seeing, and there is obviously a lot of small companies that are doing a fabulous job there. We do participate to some degree, there are some companies that use site links for hot deals. So, there is a mechanism that we already have where advertisers are actually putting in case deals and highlighting them, but there’s no question. That’s a very exciting and hot space, and there are a lot of innovative players building some pretty effective business models there right now."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you. Connie, why don’t we go to the next question?"
},
{
"speaker": "Operator",
"text": "And we will take our next question from Jordan Rohan from Stifel Nicolaus."
},
{
"speaker": "Jordan Rohan",
"text": "Couple of follow-up questions on mobile while we are on the subject. I am a big fan of Google Instant, I am wondering when it will be fully rolled out on BlackBerry, iPhone and other devices there? Also curious, if you happen to disclose the number of Android devices activated in the quarter. I think last quarter, it was around 200,000 a day. And finally, instead of smart pricing, and sort of fearing the discount placed on mobile search clicks or calls, why not let advertising just bid directly on the mobile search inventory, you might be surprised about the yield."
},
{
"speaker": "Patrick Pichette",
"text": "On Instant, Jonathan, when is Instant available for all of these mobile devices?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "It’s relatively soon, sometime this fall. Fall last a little bit longer in California though."
},
{
"speaker": "Patrick Pichette",
"text": "Okay. Last public number is 200,000 handsets activated a day, and that’s the last number that we have been using. So, we stick to that one for now. And can you just repeat, Jordan, your last question for me?"
},
{
"speaker": "Jordan Rohan",
"text": "Yes, smart pricing is, as I understand, and maybe I am getting it wrong, but Google has an algorithm which discounts value assigned to advertisers that which advertisers have to pay for certain clicks, if it’s believed that those clicks perhaps are less frequently tied to conversion?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yes, they can set up a separate campaign now, so the smart pricing is a convenient mechanism for them. If they want to leverage the existing campaign across mobile, but many advertisers have increasingly set up separate campaigns for mobile."
},
{
"speaker": "Jordan Rohan",
"text": "They can right now full visibility there, so that’s how you at some level inform your decisions about smart pricing for the rest of the universe, that access –?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I am not sure, no. The smart pricing is done algorithmically on the basis of what we see. We are not doing it. We don’t necessarily look at differentiation between specific bids across different campaigns."
},
{
"speaker": "Jordan Rohan",
"text": "Got it, thank you very much."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Jordan. Connie, let’s go to our next question please."
},
{
"speaker": "Operator",
"text": "And we will take our next question from Sandeep Aggarwal from Caris & Company."
},
{
"speaker": "Sandeep Aggarwal",
"text": "Thanks for taking my questions. Actually, I have two questions. One is, Eric, given that non-core search business is becoming more material part of your business, in the past, you allocated resources, that’s (inaudible) there are shifts in terms of how you are allocating resources now? And secondly, this may imply more of asking a guidance, but I guess my question is, by when do you envision mobile advertising overtaking display advertising?"
},
{
"speaker": "Eric Schmidt",
"text": "The latter is a very speculative question and not something that – one, we don't know and two, if we – even if we knew, we probably wouldn't talk about it. On the question of allocation of resources, I think at the end of the day and Larry and Sergey and I have talked about sort of our job to use our best judgment based on the sum of technological opportunity, business opportunity and so forth to divide, if you will, between classic core businesses, you are really asking in some of these emerging ones. So we are informed by the hockey stick nature of these things. So there is a couple of ones to give you an example of Android, which is small in resources and growing very quickly. So they pretty much have been able to get whatever resources they need and they are going up against very large giants with the factor of 10 more resources, and so we sort of measured it that way. When we then go back and saw for 70-20-10, it turns out that we are roughly consistent with 70-20-10. It's not really as much of a formula, as is much looking at where the real excitement is. The other thing that we are doing is we are organizing ourselves and Nikesh is actually leading this effort into more of an internal business unit structure, because frankly, it's just become so large and so complicated that it's been difficult for us to keep track of all the details. And so that will give us a better tie-in between where the current and future revenue is and where the resources are going. And I think Nikesh is on the order of 10-15 kind of structure by the time we are done, with the obvious big ones being search and ads and display and enterprise and that kind of stuff, YouTube."
},
{
"speaker": "Patrick Pichette",
"text": "Yes. So and just in closing on that, what really matters the most to us as we actually do the resource allocation is, as Eric said, when you see a hockey stick, pour on gas on that fire and when we do actually and we keep the flexibility to make sure that we really feed the winner so that they keep the momentum as you've seen, for example in Android in the last 24 months, which has been tremendous. All right. Thank you for your question. Connie, we probably have time for two or three more – two more questions. So let's go for the second last."
},
{
"speaker": "Operator",
"text": "Thank you. And we will go next to Mark May from Needham & Company."
},
{
"speaker": "Mark May",
"text": "Thanks. A big picture question about data, because that seems to be an increasing factor of differentiation in growth for online ad companies. How does Google think generally about leveraging user data, both to better target ads and how to stay competitive with those like Facebook and Microsoft and Yahoo! that are leveraging data possibly more so than like Google is today? And I think this is particularly relevant for using search data for your display business, but we would love to get your thoughts on that."
},
{
"speaker": "Eric Schmidt",
"text": "We have a pretty strong opinion that we are not going to do very much of it. The reason is that we take our end user data privacy incredibly seriously, and the trust that people have with respect to giving us that information, both their search histories as well as other piece of information, they get very upset very, very quickly if we, in their view, misuse it. So what we typically tell people is we are not going to do the kind of things that you could do with this, like in particular, use it to generate sort of strange apps against your history and things like that without your explicit permission, and we probably in many cases won't do it forever."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Mark. Let's go to our last question, Connie."
},
{
"speaker": "Operator",
"text": "And we will take our final question from Marianne Wolk from Susquehanna."
},
{
"speaker": "Marianne Wolk",
"text": "Thanks very much. It looks like you did a great job converting a lot of the advertising on the content network over to display. Can you talk about to what extent that's now video-based and is that helping monetization rate significantly? And do you expect that to be sort of a 100% display shortly? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Nikesh, maybe you want to talk about the display and how it's evolving?"
},
{
"speaker": "Nikesh Arora",
"text": "I have been waiting for the entire earnings call, Patrick, to talk about display. I am glad that Patrick and Jonathan have allowed us to disclose the run rate of $2.5 billion. I think this puts us in one of the top three display networks in the world. And I also believe that the technology suite we offer is second to none. So in terms of the video versus the other display formats, it is – primarily a lot of this is still display in terms of banner ads and other formats, and video is beginning to come into it. But we believe in the future there is going to be a lot more rich media involved into display network, because as we go forward you are going to see more and more monetization of video, whether it's on YouTube or other partner sites that's going to happen. So we believe the display network we offer has maximum frequency and maximum reach. We can reach people more times a day than anyone else. So, really excited about display. So, I was not sure what you meant by what becomes 100% of display?"
},
{
"speaker": "Marianne Wolk",
"text": "I'm sorry, but of the sort of roughly 1 million partners that are part of the partner network, to what extent is that now converted to display and could that ultimately be entirely part – entirely display network? And then also, just since I've got you, can you clarify the run rate information you gave? Is that a trailing 12-month figure or are you annualizing the current quarter? Thank you."
},
{
"speaker": "Nikesh Arora",
"text": "Yes. So, I'll let Patrick answer the – (inaudible) on $2.5 billion dollars. But in terms of the million partners we have, the entire partner network is part of our display network that we offer and we actually have the ability to offer them display advertising or text-based advertising, and basically it's based on ROI and CPMs that we make that determination or the publisher makes the determination or the advertisers make the determination. So an entire network that we have is open for display advertising already."
},
{
"speaker": "Patrick Pichette",
"text": "And on the previous question – on the follow-up question, it was about – it's just the trailing quarter. So with that, thank you for your question, Marianne. Let me give you a couple of thoughts. One is, just want to reiterate that what we did today was give you a few indications of why we believe we are successful in these emerging businesses. These data points are not about giving you more information on the coming quarters, but more to give you the confidence about where we are investing and it's really fueling great growth rates and building meaningful businesses. I want to thank you Eric for taking the time. I know he is running for the plane, but it's terrific to have you on the call and take a few minutes with our analysts and shareholders. And then I also want to take a moment to thank all the Googlers for their hard work. I mean, all this strong performance is really on the back of fantastic work from our team worldwide, our great engineers, our great sales force, and our great support staff everywhere. So I just wanted to take from the OC, 40 just the time to thank them again on – in the public domain, because they do such a terrific job. With that, Connie, I'll let you close the call."
},
{
"speaker": "Operator",
"text": "Thank you. And this concludes today's conference. We thank you for your participation."
}
] | null | null |
GOOGL | 2 | 2,010 | 2010-07-16 16:30:00 | Operator: Good day and welcome, everyone, to the Google Inc. conference call. This call is being recorded. At this time, I would like to turn the conference over to Ms. Jane Penner, Senior Manager, Investor Relations. Please go ahead, Ma’am.
Jane Penner: Thank you, Connie. Good afternoon, everyone, and welcome to today’s second quarter 2010 earnings conference call. With us are Patrick Pichette, Chief Financial Officer; Jonathan Rosenberg, Senior Vice President, Product Management; and Nikesh Arora, President, Global Sales Operations and Business Development. First, Jonathan and Patrick will provide us with their thoughts on the quarter and then Nikesh will join us to answer your question. Also, as you know last quarter we began distributing our earnings release exclusively through our Investor Relations website located at investor.google.com. So, going forward, please refer to our IR website for our earnings releases as well as supplementary slides that accompany the calls. This call is also being webcast from investor.google.com. A replay of the call will be available on our website in a few hours. Now let me now quickly cover the Safe Harbor. Some of the statements we make today may be considered forward-looking, including statements regarding Google’s future and investments in our long term growth and innovation, the expected performance of our business and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please not that these forward-looking statement reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Also, please note that certain financial measures we use on this call such as operating profit and operating margin are expressed on a non-GAAP basis and have been adjusted to exclude charges relating to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and GAAP to non-GAAP reconciliation can be found in our earnings press release. With that, I will now turn the call over to Patrick.
Patrick Pichette: Thank you, Jane. Good afternoon, everyone, and thank you for joining us. As Jane mentioned, Jonathan and I will begin with the prepared remarks, but we also have Nikesh with us for the Q&A. So, let me start you by giving some high-level thoughts about the quarter and then we will get into our detailed financial performance. So, overall we are very pleased with our Q2 results. We experienced continued solid growth in our core, but also very strong growth in our emerging businesses year-over-year. Taking a step back actually, these results reflect a few really important trends in the digital advertising. First, we are really taking notice that more and more traditional brand advertisers are embracing search and search advertising is a way to build their brands online. A case in point P&G, it’s one of the largest brand advertisers in the world. And it’s now one of our top advertisers in the U.S. Second, we see also a real trend in large advertising, focusing on highly measurable but also integrated campaigns across display, mobile and search. So, as a result, we saw strength in every major product in Q3. Google.com was strong with strong performance across major geographies and most major verticals, including CPG, retail, travel, et cetera. Our growth in display was also very strong. Our continued focus in this product area is clearly generating results. Our display network, which includes YouTube, is growing very rapidly. The scale and quality of our network continues to increase and we see increased demand from traditional brand advertisers in that space as well. In addition, we made yet another significant stride in display this week, when we entered into a strategic agreement with Omnicom Media Group. We will be working together with Omnicom to co-develop their exchange trading desk for the double click ad exchange in the coming years. YouTube specifically we continue to see very impressive growth as brand advertisers also consider it a must-buy. For example, and as I mentioned a moment ago, in Q2 we ran World Cup advertising campaigns for major advertisers of the likes of Coke, Visa, Nike, Sony, et cetera. Finally, on YouTube, I think it’s really worth noting that we are very pleased of course with the court’s decision to rule in our favor in the Viacom case. But more important in this victory, it’s not for us, but for the users and just the Web in general. Specifically for all the blogs and the community forms across the Web that do rely on this user-generated content for sharing information and also for free expression. Look, we were very passionate about this issue at Google and so much so that we have made significant investment of approximately $100 million to win this case. And once again, it just was the right thing to do and we did it. In mobile, our revenue continues to grow as advertiser increasingly opt into their mobile-specific campaigns, and with the successful completion of the AdMob transaction in Q2, our business is gaining momentum. And so we have a very competitive mobile advertising platform now. And of course, underpinning our growth is the success of the Android platform itself with over, as we announced a couple of weeks ago, 160,000 devices activated daily. That’s two every second. And it creates an even larger base of data-centric smart phone users. Finally, enterprise had another good quarter with several high-profile deals, including, for example, Virgin America. The world is simply moving into the cloud. And successful products do require investment. And that’s why we are focusing our resources on products that, as you all know, leverage computer science to solve our big problems, offer great ROIs, and very large growth opportunities. For example, in Q2 we’ve added approximately 1200 employees. That’s obviously counting the acquisitions of AdMobs and the others. But the majority is done in engineering and sales and in the following product areas: search monetization, display, mobile, apps, all the next billion dollar businesses that are growing incredibly rapidly. And that’s why we are investing in them. Jonathan will give you more details about that in a moment. So, now let me turn to our financial results. Gross revenue. Gross revenue grew 24% year-over-year to $6.8 billion. Our Google website’s revenue was also up 23% year-over-year to $4.5 billion, with strength, as I mentioned, across most geographies and verticals. Our AdSense revenue was up 23% as well to $2.1 billion, reflecting our continued strength specifically in the Google display network. Other revenue was up also 39% year-over-year to $258 million. And it includes the last quarter of revenue from the sale of Nexus One. As announced, we are discontinuing the direct-to-consumer channel in Q3, and as a result beyond Q3 we won't recognize any revenue or cost associated with the sale of Nexus Ones. They are still being sold through various carrier partners, both in the U.S. and Europe, however. Our global aggregate paid click growth remain quite healthy, up 15% year-over-year and down 3% quarter-over-quarter due to the typical summer seasonality. Aggregate cost per click growth was up 4% year-over-year and 2% quarter-over-quarter. Note that the FX had a positive effect on our CPC growth year-over-year and a negative one quarter-over-quarter. Remember too that this is an aggregate number and it includes both Google.com and our AdSense properties. Turning now to our geographic performance, on a relative basis the U.K. lagged a bit the global economic recovery, certainly relative to the U.S. and rest of the world, which were strong. Revenue from the U.S. was up 26% year-over-year to $3.3 billion and in our earnings slide you will find on our investor website you will see that we have broken down our revenue by U.S., U.K., and Rest of the World to show you the impact of the FX and benefits from our hedging programs. So, please refer to these slides for these calculations. International revenue accounted for 52% of our total revenue or $3.58 billion, up 21% year-over-year, which includes $79 million benefits from our hedging programs. This is compared to $124 million of benefits in Q2 of last year. If we used fixed exchange rates, our international revenue would have been roughly $24 million lower year-over-year. The U.K. was up 8% year-over-year to $770 million. Let me now turn to expenses. Traffic acquisition cost were $1.7 billion or 26% of our total advertising revenue. Our cost of revenue was $735 million, including stock-based compensation of $8 million and also expenses related to the sale of the Nexus One. And finally, all operating expenses totaled $2 billion. This is also including $301 million of stock-based compensation. The increase in year-over-year OpEx is really primarily due to increases in payroll, professional services and advertising and promotional spend. So, the result of all this, our non-GAAP operating profit, which excludes stock-based compensation increased to $2.7 billion in Q2 resulting in a non-GAAP operating margin of 39%, essentially the same as last year. As I mentioned already, our headcount was up approximately 1200 heads versus Q1 and in the quarter were 21,805 full-time employees and again that reflects the acquisitions as well. Our effective tax rate was up to 24% in Q2 versus 22% in Q1 essentially due to the mix of earnings between domestic and international subsidiary and the impact of our hedging program. Let me quickly turn to cash management. Other income and expense was 69% for Q2 – $69 million, sorry, for Q2, which includes good progress in our portfolio management performance, although it was somewhat offset by the impact of our hedging expenses with FASB 133. For more detail on the OI&E, again, please refer to the slides that accompany this call in our IR website. In addition, we’ve announced today a $3 billion commercial paper program and a related credit facility. This to us is an important step in establishing a more capital-efficient structure that will provide us with low-cost working capital availability and flexibility and it’s also an excellent time to do it given the historical low interest rates. Operating cash flow was very strong at $2.1 billion. CapEx for the quarter was $476 million. Again, primarily related to our data center operations, and as a reminder, we continue to make significant CapEx investments and it just turn out to be lumpy from quarter to quarter. Our free cash flow, therefore, stands at $1.6 billion in a very good position. So, if you take a step back from all these numbers, here is where we stand. We are very pleased with our Q2 performance seeing growth across revenue, margin, and cash flow. And it really paints a picture where we are very confident of our future. And that’s why we continue to attract and hire among the best talent in the world to further invest in our growth agenda. So, with that, and before we open up for questions, let me turn over to Jonathan for his comments. Jonathan?
Jonathan Rosenberg: Okay, well, thanks, Patrick. So, let me start with search. Search used to be pretty simple. You would enter a query and we would return a bunch of links to websites. But now, the Web is much, much more complicated. There is videos, there is books, there is music, there is news, just about any type of media you can name is online. So the scale of the Web now is grand and it isn’t slowing down. To keep pace, we migrated a whole lot of our index to a new infrastructure, which we call Caffeine. And Caffeine is basically a new way of updating our index. So now when we find a new web page or new information like a video or an image, we add them straight to the index without a new delay. This means that the results that you get are a lot fresher and in fact they are about 50% fresher than before. But then, once you get your results, you need tools to work with them to get to the right answer. And we’ve launched a new UI that has a bunch of options on the left hand side to help you filter those results. I especially like the timeline feature, which I think is great when you are doing research and you want to see results from a particular time. So, you can enter, say, oil spill, and click on timeline and 1969 and you can read all about the big Santa Barbara spill that led to the ban on offshore drilling in California. On the other hand, sometimes, you just want an answer. The query is effectively the result and we are getting much better at knowing when that’s the case and giving you what you need. So, enter, for example, Barack Obama birthday and you will see what I mean. You will see his birthday listed, August 4th, 1961, and citations for the different sources where we got that information. All of this works in suggest too. Try typing capital South Africa. By the time you get to the first ‘a’ in Africa, we tell you it’s Pretoria. I point out these things out because the great things about features like these is most people I think don’t even notice the changes. They just notice that they get their answers fast. I think I mentioned on the earnings call back in January that we a working on putting more wood behind fewer arrows. And Search innovation is definitely one of those arrows. Our case here is actually accelerating. Voice search added six languages. We launches spelling full page replacement, suggest with spell correction, and over 100 quality enhancements. So there is lots of stuff going on. In fact there is so much that we are putting out a weekly blog post to document all the search improvements. But, interestingly, as search gets better, it actually creates another huge challenge for us. The ads need to keep pace and get better too. Otherwise what would happen is people will click on relatively fewer ads and that will be bad. So, this dynamic were consumers are in control holds for all types of media and not just search. It used to be consumers had to watch, see, or listen to whatever the advertiser wanted to show, but now they don’t. I think this is a fundamental shift for the advertising industry. When people don’t have to watch your ads, what do you do? Well, you have to make ads people actually want to watch. I was in Piazza San Marco in Venice a couple of weeks ago and there was this huge billboard advertising a ski jacket. It was like 90 degrees and we were sweating in shorts and tee shirts. And I looked and I thought, “What a waste of money.” So I took a photo of the ad with my smartphone and I sent it to my team as proof there is lots of upside in improving ads. And this quarter, we made progress on that upside. We added new ad formats, and we focused even more on quality. The new formats lead advertisers put more useful information into their ads such as pictures of a product or a local address or a phone number. It turns out that when you are searching for something from your phone, you are much more likely to click on the ad which has a phone address in it. This seems obvious, but now we actually know from the data that it’s true. One of our customers, Carnival Cruises increased bookings from mobile phones by 175% when they included click to call ads. Lastly on ads, I know you often ask about quality. And I am proud to say we had one of our most productive quarters there in the last couple of years. Over a dozen launches on search with a strong impact on revenue. We did things like put better ads on the second page of results where we realized that the ads weren’t as good. And we also had over 20 quality improvements on the Google display network. Display, by the way, is going very well. One recent development is that we are working closely with our agency partners to help them move to what they call an audience buying model. And I think this is another fundamental shift in advertising where the ultimate goal is to designate a particular audience on our network like say women between 18 and 35 who like basketball. And we automatically target that audience for you. We are also making progress with features like remarketing, which we launched last quarter. Advertisers can reach people who have already visited their sites. Interest based advertising, which we launched last year is also working very well. And so is the double click ad exchange, which we launched in Q3. We’ve got several of the top ad networks on it and we are tracking some big buyers like agency holding companies. Advertisers really like the technology, which is real-time bidding and publishers like that it’s open to all advertisers and ad networks who they want to work with. We want to be open in everything we do. We believe open systems are better for the Web, they are better for competition. They are better for the user. This is not philanthropy. When the Web is better, more people use it more often. And that means they search more often. Android is a leading example of this. As Patrick mentioned, we are now activating over 160,000 Android devices every day. This is up from 65,000 last quarter. What’s even more interesting there is that most of these devices are developed completely independently off Google. One of those is the Spring EVO, which is actually my favorite phone right now. Has a big screen, it’s got great video. It acts as a WiFi hotspot for me. It has 4G bandwidth at least when you are around Mountain View. The Android market is also open of course, and now has over 70,000 apps. That was around 30,000 in April. As you look at all these new apps being created you also realize that your mobile phone is no loner [ph] anymore. It’s actually connected to several million computers 24/7. This is leading us do things that we used to think were impossible. We just released the new version of Goggles, that lets you take a picture of something in another language with your phone and it translates it for you. I actually use this a lot to read menus on my vacation in Italy. You literally don’t have to guess what you are going to eat any more. Or say you want to know [ph] about how the locals are celebrating their World Cup victory – congratulations to Spain, by the way. Anyway, you just go to elpais.com and Chrome toolbar automatically translates it for you in a second. So, cloud computing also means that enterprises can take advantage of these innovations. We just launched this feature where if you have say a PDF or the image of a scanned document, you can upload it to Docs and we’ll convert it to text, so you can edit it. You don’t have to install any special software or anything. If you are a Google apps customer, it’s just there and it works. Of course, the cloud is pretty good for wasting time too. I hope you played with our special Pac-Man doodle. We put it on May 22nd to celebrate Pac-Man’s 30th birthday and we estimate people spent 4.8 million hours playing it. If you missed it, go to google.com/pacman. Gloop, gloop, gloop. Thank you for your time. Back to Patrick.
Patrick Pichette: Thank you, Jonathan. And, yes, there were these great reports of billions of billions of kind of productivity lost over that little Pac-Man, so obviously we did something right somewhere. Connie, can you actually turn on the Q&A process and I am going to invite the guests also join us at this time.
Operator: Thank you. (Operator instructions) And we’ll take our first question from James Mitchell from Goldman Sachs.
James Mitchell: Thank you very much and thank you for the Pac-Man distraction a few weeks here. My question was about the sequential increase in operating expenses. I was wondering if there was any adjustments (inaudible) rules that went into that sequential increase or was it entirely due to headcount additions and acquisitions and marketing.
Patrick Pichette: It – the bonus accrual would have a small impact on it, so it is really about headcount, about TVCs, about marketing.
James Mitchell: Great. Thank you.
Patrick Pichette: You’re welcome.
Jane Penner: We are ready for the next question.
Operator: And we’ll take our next question from Spencer Wang from Credit Suisse.
Spencer Wang: Thanks. Good afternoon. Two quick questions. First, in terms of the paid click growth of 15%, I was wondering if you could just give us a sense of how much of that is coming from mobile today currently versus say last quarter? And then the second question maybe Patrick, just on TAC, it was down a little bit year-over-year and [ph] sequentially. Can you just give us a sense of where you think on a percentage basis that’s trending especially with the MySpace deal coming up shortly? Thank you.
Jonathan Rosenberg: Yes, this is Jonathan on the mobile question. Mobile is certainly growing faster than other clicks, so everything else being constant, there is a disproportionately larger group of mobile clicks this quarter than in quarters in the past, but we don’t really have any more detail on that.
Patrick Pichette: In the case of TAC, it’s been – I mean most of the TAC that we have today because as you said so rightly that MySpace deal in pending now. I mean we shouldn’t see any – there is no big jump anywhere in the TAC going forward. And it’s been pretty stable actually around – I think you said 27% or – ? And so there is very little variability in it.
Spencer Wang: Great. Thank you.
Patrick Pichette: Thank you, Spencer.
Jane Penner: I think we are ready for the next question.
Operator: And we’ll go next to Imran Khan from JPMorgan.
Imran Khan: Yes, hi, thank you so much for taking the questions. Two quick questions. One, the 1200 or so headcount increase. Could you give us some sense like where are you allocating those headcount either in search or in the new – most of the headcounts are going to new initiatives? And also secondly, in terms of the cost per click, can you give us some sense the differences of cost per click, mobile versus desktop and how quickly you think it can narrow? Thank you.
Patrick Pichette: Great. So, why don’t I start with the 1200? So, remember 1200 just a bit of a clarification, there is probably around 300 of those 1200 that in estimates that come from M&A. So, really kind of organically if you think about it, more like 900, which was not unlike last quarter. The – as I mentioned in my core notes, Imran, the – most of the headcount is in engineering and sales. And most of the headcount like the vast majority is going to the four core areas of focus of the company. So they are about search and search monetization. They are going to mobile and Android. They are going to apps. And they are going to display. We see so much momentum in each of these right now, but that’s where the bulk of the resources are going because that’s where the focus of the company is. On the CPC, Nikesh?
Nikesh Arora: On the CPC – hi, this is Nikesh – on the CPC, I don’t think there is enough data for us to actually look at a trend in terms of where it’s closing or not, but you have to understand the mobile advertiser sees mobile as a very different platform vis-à-vis the desktop advertiser. And you see high CPCs where there are transactions that can be consummated in the mobile, i.e., in digital entertainment. You don’t see as high CPCs as when you are trying to give directions to a certain restaurant or a place where they might (inaudible). So, there is still some disparity between the CPCs in the desktop and mobile. And within mobile, depending on the verticals, there is disparity depending on the type of advertiser.
Jane Penner: I think we are ready for the next question.
Imran Khan: Can I sneak in one – ?
Operator: And we’ll take our next question from Justin Post from Bank of America.
Justin Post: Great. My questions are about Android. Can you talk about how much investment is going into that platform? And then how do you think about it? Is this an investment that just needs to keep going, just you compete in the mobile market or – you know you are not charging for it, is this a real installed base revenue opportunity and we are going to start hearing more communication about how you are going to monetize it down the road? Thank you.
Patrick Pichette: Okay, so let me give you a high-level answer to kind of give everybody comfort, right. Android is not, in terms of cost, it’s not material to the company, and not only that, but let me give you a further kind of proof point of the value of Android is. Some of the key products that have been launched over the last few weeks and few months have not been developed by Google at all. I think that the last Android X or the Motorola, what is it Droid X has been developed by the – by Motorola directly with Verizon and not involving any of the Google resource. So, it’s not a huge resource investment. It’s a formidable return in that what you have is the entire ecosystem exploding. And (inaudible) and give you really the sense of that one. So from the cost side it’s not material. Jonathan.
Jonathan Rosenberg: Yes, and we gave some data just on the scope of the numbers, the 160,000 Android devices as well as the growth in apps from 30,000 to 70,000, but I think the most important most obvious thing to think about from our perspective is what’s the most popular app on these devices. The most popular app is a browser. And what do people do with the browser on these devices? They search an order of magnitude more than they have on any previous type of smartphones, which they had in years past. So, the combination of people browsing on these smartphones connected on very, very fast networks, and searching on them is basically the formula around how Google makes, how Google succeeds.
Justin Post: I don’t know if you are taking a follow-up, but I mean are you seeing search activity really strong on mobile devices with Android and do you think you are losing any ground relative to search activity within applications? Thank you.
Jonathan Rosenberg: Android search grew 300% in the first half of 2010. So, yes, search on Android devices is exploding.
Patrick Pichette: I think that – another way to kind of frame it in numerical numbers I mean the mobile has grown 500% in the last two years in terms of the traffic, so think of that and then think of Android being an accelerator of that because every time you bring the NPV of all these platforms coming forward, you get a lot more. So, that’s how to think about the problem and the solution that we bring.
Jane Penner: Next question please.
Operator: And we’ll take our next question from Doug Anmuth from Barclays Capital.
Doug Anmuth: Great. Thanks for taking the question. Two things I wanted to ask, first, just on the macro environment, can you comment on what you saw at all during 2Q in terms of whether the environment seem to change at all either in the U.S. or Europe and then secondly, just given the $3 billion commercial paper program and can you update your current thoughts on returning cash potentially to shareholders? Thank you.
Patrick Pichette: Okay. Let me start with the last one first. I mean really the commercial paper is a fantastic opportunity for us given the portfolio that we’ve put in place for our cash to actually have the working capital flexibility around it. So, now if I need in fact working capital for my day to day operations, I have that flexibility through commercial paper and that’s really the essence of what we are doing. We have made no decisions at all on share buybacks or as I said to everyone, we – it’s a topic that is regularly debated, brought to the Board for debate and we have nothing to announce on that one. On the macro side, I would say, look there is kind of two things, right. Everybody reads the press; everybody has been seeing all everything that happened in Q2, the Europe, the that, this or that. I mean for us at Google, it’s been a great quarter. We’ve had – our business has been a great quarter and we’ve seen no impact of what’s going on in the macro world to us. And that’s why we said for the last three, four quarters we’ve said we are really kind of performing in this kind of economy and that’s why we feel confident about the future and feel confident about investing now. And that’s why we are doing it.
Doug Anmuth: If I can just follow-up quickly on the first one on cash, can you comment on how much of your cash is international versus in the U.S.?
Patrick Pichette: It’s about 50:50.
Doug Anmuth: Thank you.
Patrick Pichette: Thank you.
Jane Penner: Next question.
Operator: And we’ll go next to Brian Pitz from UBS.
Brian Pitz: Great. Thanks. Would you talk about your advertise and user adoption of some of the new product ad formats that we are actually seeing on your site? Are these ads having material impact on CPC because we understand they are (inaudible) basis? Thanks
Jonathan Rosenberg: This is Jonathan, I can give you a quick review of the top format and then maybe Nikesh can chime in and give you a sense of some of the specific customer experiences that he has had. The click to call ads on the high end mobile phones are doing very well. The click through rates go up 6% when you put ads with a phone number, 8% when you put a local address. So, click to call is doing very well. It’s easy to see some of those. If you want, just take a look for yourself if you tried travel agency from a smartphone, you will see under thousands of active campaigns on click to call, so you can take a look at that. Site links is also making pretty good progress. We’ve given you examples on past calls where you type a big brand like Sears and then you see the more useful links that you can get through and the click through rates on those can go up as much as 30% over the ads without the site links. But we changed the way we do site links and we’ve added a new one line format. And that also allow site links to show up in more places. You can try flowers if you want to see that. Then the other format that’s getting some adoption is the – we are adding the seller ratings, which shows merchants ratings out of six stars aggregated from reviews on the Web. You see that if you look for things like digital cameras. And that’s doing pretty well as well.
Patrick Pichette: Nikesh, any further thought?
Nikesh Arora: No, I guess from an advertise perspective they have always had a sense that over the last few years we’ve actually had some disparity in the quality of our natural search and quality of our ads, things like site links create tremendous parity between what people get in natural search and what they get in from an ad format. So, there is tremendous appetite on our large advertisers to be able to send their consumers or users to a deeper part of the website with site links and all. So, the adoption of site links, the adoption of click to call as Jonathan is extremely sort of more lucrative for them because they can actually track it and they can actually track the transaction that it creates. So, these – the ad formats are definitely helping and are getting out there. One thing what Jonathan did not touch upon is the ad innovation on the display side as well. Now, we’ve had tremendous new formats we’ve launched in the whole YouTube front where we’ve actually increased the inventory because we get more and more content where we can show ads on. In addition to that we also have new ad formats which effectively – I mean imagine a basic add and now getting it to be an auto expandable (inaudible) which shows up on YouTube, which allows us to impact the pricing of the ad format. So the more richer the ad, the more an advertiser is willing to contribute because it creates a more engaging experience and therefore a higher opportunity. So, I think across the board the new ad formats are both – we are seeing more appetite for them and at the same time they are allowing us to create more return for the advertiser, allowing us to price them better.
Jane Penner: Next question please.
Operator: And we’ll take our next question from Ross Sandler from RBC Capital Markets.
Ross Sandler: Hi, just two quick questions. Patrick, you said that cost for Android are fairly immaterial, so can you talk about the operating margin in the display business on a revenue ex-PAC basis? How much was the margin that you are seeing right now coming from display growing faster than search. And then second question is it looks like the ROW region accelerated a bit in the second quarter if you strip out the hedging and currency impact. Can you talk about, Nikesh, which regions are driving that and can you – talk about the environment in Europe given the macro – I know you talked about it for a second earlier, but just any further color about continental Europe? Thanks
Nikesh Arora: I mean it’s – the display business has you know to a certain extent if you take it as a blended slightly lower margins if you take the double click platform, for example, which is more transactional. But overall I think that they still are quite healthy and they don’t – if you think of CPCs the way I think about them is you have really kind of two big components at work. The innovations that Jonathan talked about that actually drive CPC up and then because those products perform better, they add pressure to the auction, and therefore drive CPC up. And then the two or three components that actually drive them down in the short term, it’s not as much display as the places like Brazil and India that are growing very well so internationally. And because they don’t have a strong an auction right now, right, the CPCs are slightly lower, but they are growing so that’s positive and then we already talked about mobile themselves as being lower CPCs. These are the two that actually are growing incredibly rapidly in that, on the mix in the short-term, they kind of put a bit of a downward spin on the CPC formula. But both of them as we know, they are growing one rapidly, so it’s real dollar net in and then on top of that we know there is going to be future pressure on them. So I am pretty pleased about the performance of those. On the issue of Europe and FX and it’s really to – everybody has got a model out there, right. We’ve lived an incredible roller coaster of FX over the last year so if you look at currencies like the euro and the pound, right, they were kind of quite similar on par versus year-over-year but the last quarter versus this quarter a huge change. And then in addition to that, if you look at places like the real in Brazil, the Canadian dollar, the yen, I mean those have quite increased year-over-year. So, when you do your models relative to FX OI&E just take into consideration the fact that year-over-year the net-net position is it’s been strengthening all-in. Quarter over quarter it’s been going down all-in and then on top of that our FX kind of our hedging program is really a long term hedging program. So this quarter we’ve reaped 78 million, 79 million of benefits net. So it’s a tough puzzle to solve. But just please take the time to look at year-over-year and quarter-over-quarter because it’s a puzzle to build. I hope that answers your question.
Jane Penner: We’ll take the next question please.
Operator: And we’ll take our next question from Jeetil Patel from Deutsche Bank.
Jeetil Patel: Great. Two questions. I guess do you think that Android and mobile represents a bit of a defensive strategy since you kind of pride yourself on the lack of cost in that business as a whole and the same time you are adding headcount as a whole in the company? And then second, I guess just curious, yes, the feedback we keep getting in the industry is that the Android kind of infrastructure and support seems to be lower than what at least your ecosystem would like. I guess do you – what is the appetite to create other revenue streams outside of advertising inside let’s say mobile in the form of let’s say an app marketplace that is pretty vibrant? Thanks.
Patrick Pichette: So, let me just give kind of the highest level answer is it’s – the answer is yes. I mean obviously having – we did for offensive reasons, not defensive reasons, right. We believe that actually open platform that create the ecosystem where developers can actually create a whole set of new generations of apps is incredibly important and in addition to that right we do know that these new formats like the smart phones create an entire new set of activities in which you live and you will search and you will transact. So from that perspective, I think that it’s obviously both. I think that – I take your comment that if the market in general is saying do you want more support from us in that space, right, we are investing heavily because we believe, one, that search advertising or acquisition of AdMob by the investments we are making is because for us advertising is completely nascent in this space relative to kind of text search an then second is we ourselves are doing a lot of innovation through cloud computing and others to actually create a whole new generation of apps ourselves. So I think that, yes, defensive, yes, offensive, but in the end benefiting everybody and I am glad to hear that you say you want us to invest more in it.
Jeetil Patel: Why it seems like your handset vendors are aggressively investing and we haven’t seen it from your side at least as we talked to some of your partners out there and I guess it seems like do you think that other models outside of advertising need to be explored at this point? Thanks.
Patrick Pichette: I am not sure I understand you question. Other models such as what?
Jeetil Patel: Oh, let’s say consumer applications, so there are other companies that have created business models around obviously game downloads app, other app downloads that are charged. Obviously you have as well, but it seems like you are—you seem to be maybe it’s early days, but still early in that development.
Patrick Pichette: I think you are absolutely right that it is early days and I think that the 70,000 apps that we have is actually a demonstration of the effervescence of that ecosystem that’s actually just building now.
Jonathan Rosenberg: Yes, I think one – this is Jonathan. I mean it is at a very nascent stage. I think we also – there is a lot more infrastructure that needs to be built to support a lot of the commerce. You know we substantially need to improve the billing capabilities in the market and that’s obviously one of the things that we are investing in pretty aggressively, but I don’t think of this as defensive at all. I mean there is a huge opportunity for incremental usage of search as I talked about earlier and when we see an opportunity for people searching more, that’s obviously something that we want to participate in. So we see this platform is winning. We think that gives us an opportunity to build the mobile Internet and we think that in the long run that’s going to be good for Google, it’s going to be good for the applications developers and it’s going to be good for consumers, so we are investing in building that wining platform.
Jane Penner: I think we are ready for our next question.
Operator: And we’ll take our next question from Steve Weinstein from Pacific Crest.
Steve Weinstein: Great. Thank you. I was hoping you can help explain some of the movement in the P&L expense. You mentioned that most of the hiring is going into engineering and marketing. When I look at the sequential increase in – by dollars kind of expensive – you just had a large increase in G&A about 48 million sequentially and that’s compared to one like $20 million in sales and marketing. So, can you explain a little bit more? Was there anything in the G&A line that is one-time or not repeatable, why are they moving like that?
Patrick Pichette: Yes, you have to look at – there is a couple of things. One is our recruiting – as you go year-over-year and quarter-over-quarter, we had kind of three big elements, one is we had our recruiting machine that started to build last year was not built in Q2 of last year, so – if you think of the hiring infrastructure and the people infrastructure has actually been kind of – been building and now you see the full flow through. We also have had in G&A in general another area. If you think of everything else that’s kind of people, we’ve talked about legal. We’ve had a number of legal costs to this quarter that have also flowed through just because of a number of legal activities that we’ve taken. So, these are the two biggest components that actually would explain the big variances.
Jane Penner: We are ready for the next question.
Operator: And we’ll go next to Mark Mahaney from Citigroup.
Mark Mahaney: Thank you. Two questions please. A year ago, you talked about being close to profitability on YouTube given all the momentum that you’ve seen over the last year. Do you feel like you are a lot closer, are you profitable with the YouTube asset? And the secondly, when you sell display ads, do you feel like you are selling them to existing search customers? Do you think – or do you think that it’s opened up a significantly larger customer pool or a mix of those two? Thank you.
Patrick Pichette: So, let me talk about profitability, but Nikesh will have the answer to your second on display. Look, we don’t comment on YouTube. What I can tell you is we are incredibly pleased by its trajectory. I mean YouTube is – you take a step back, it’s two billion views per day in its fifth year of existence. It’s won over a billion monetization videos per week. It’s a huge kind of a first page and it’s aggregating audiences and you see it today to the top brand advertiser is showing up for it, right. So on the World Cup you saw the Sonys and the Cokes and the – I mean this is the power of YouTube today. It’s like a worldwide audience. So, in that sense I would argue just read in the TVs [ph], it’s a great business for us. On the display side, Nikesh?
Nikesh Arora: Yes, just to add to what Patrick said, to be fair, what display and YouTube has given us it’s allowed us in the case of large search customers to complement the portfolio in terms of being able to offer integrated campaigns, which go all the way from branded sites like YouTube to networks like the Google Display Network and to be able to sort of co-mingle lab research. Not only that many advertisers now actually co-mingle that with television ads as well as their print programs. So you see a much more integrated campaign capability that begins to happen. Here we got examples recently like Patrick mentioned in the Sony folks organ [ph] at the World Cup. What’s interesting is Procter and Gamble has become one of our larger advertisers this quarter. That’s primarily driven by the ability of CBG companies to both see the value of search in their ability to build a brand where they figured out that people research online and – sorry, research – yes, research online and purchase offline; we just call it the ROPO effect. People like P&G are beginning to see that impact. Other consumer companies are beginning to see that impact. In addition to that we are seeing like Patrick mentioned the Omnicom deal, which we just announced, agencies are beginning to realize that this is an integrated buy. This is a buy you need to do across multiple properties not just YouTube, the Google Display Network and the search network hence the notion of trying to create a trading desk not just with people like Omnicom, but we have deals in places, Publicis and Roopan [ph] et cetera as well.
Jane Penner: We are ready for the next question please.
Operator: And we’ll go next to Jason Helfstein from Oppenheimer and Company.
Jason Helfstein: Yes, hi, thanks. Can you comment on Android/Chrome as an operating system? So when we think about Android in and of itself on a mobile device or on a particularly on like a cell phone, we can see kind of the revenue opportunity over time with ads and – basically on apps. When you think about Android or Chrome as perhaps an operating system for tablets or for computers, is there ever a revenue opportunity in the software of shall we think of it the same way as we think about Android today? Thanks.
Jonathan Rosenberg: I think – this is Jonathan – I think it’s probably too early to answer that question. You know I think we are mostly focused with Android on building out the platform on getting more smart phones out. And on the Chrome side, we are – it’s still too early to say.
Jason Helfstein: Thank you.
Jane Penner: Next question please.
Operator: And we’ll take our next question from Scott Devitt from Morgan Stanley.
Scott Devitt: Hi, thanks for taking the question. Regarding paid clicks up 15% year-over-year, it’s been pretty consistently in the teens for almost two years now. I was wondering if you can just talk about may be the top three or four drivers that’s keeping that rate at such robust levels for such an extended period of time? Thank you.
Jonathan Rosenberg: This is Jonathan. I think the biggest thing is just the continued secular shift in advertising from things offline that are not measurable to the ROI-based model of search advertising where the advertisers can actually see the benefits and the ROI that they are receiving on the money that they are spending. We did see a good bit of that during the recession. I think there was a disproportionate fraction of budgets that were spent on things were the ROI can be tracked. I think on our side we are doing a lot in terms of ads quality, as I mentioned, in my scripted remarks. And I think the ad format efforts that both Nikesh and I talked about also serve to increasingly drive clicks.
Nikesh Arora: You know, I – just to complement this, I think that we have seen in fact I would argue the paid clicks move quite a bit over the last couple of years in response to the recession. We have seen that and we’ve seen a great recovery in Q1 and Q2 and on a year-over-year basis. I think that for us what’s really interesting is people are searching, people are – secular trends as Jonathan said are happening and because people are searching, people are clicking and the quality of the ad network and the products themselves continue to improve. I mean we just see the symbiotic relationship happening.
Jane Penner: Next question please.
Operator: And we’ll go next to Youssef Squali from Jefferies.
Youssef Squali: Thank you very much. Two quick questions I guess this is for Patrick. Patrick, as you look at your business needs for the next couple of quarters, do you think that your level of hiring and your level of CapEx which this quarter has doubled from the prior quarter is sustainable, is it at the level you need to get to where you want to get to? And second what are your views on contextual searches that have been implemented by the other search competitors and which at least on the surface seems to have you guys losing some market share? Thanks.
Patrick Pichette: So, let me – I will let Jonathan talk about contextual search in detail. On the issue of market share, just the kind of give the highest level answer, I mean there has been a lot of debate about people’s methodologies from external sources on market share and so I would just – even the press itself kind of cautioned all these numbers off late, so I would just kind of put the flag out again to say just be cautious. I mean we are very pleased with our results right now in terms of market share. And –
Youssef Squali: Do you feel you are losing market share?
Patrick Pichette: And – no. And the issues that we have is if you think of – now I just want to go back to – because there has been so much noise in this data, I think it’s important just to mention it. The – if you go back to the fundamentals of hiring and CapEx, CapEx right is lumpy. And here is a perfect example of lumpiness, right, to be able to work in Scandinavia in the winter is difficult as we said we are building a data center there. Now, it’s spring and we are working there. So, we are also adding machines and it just happens that when you get the generations of chips available and everything is available then you start rolling out. We had a bit of kind of – so the lumpiness shouldn’t surprise anybody. And I think that everybody that I had discussions with when we were at kind of like 189 million or it’s clearly on – also unsustainable at low level. So we are kind of running our plans accordingly. So just stay tuned for CapEx, but is just happened to be lumpy. In terms of hiring I think that it really is the case that we – I am going to take a step back to three quarters ago when we said look for us the recession is over. For us we see great products and we have a mindset of the next half decade and the big platforms we are building that are creating these huge ecosystems, and for us search is one and then mobile and Android as we just talked is one. And then display is amazing, right. It’s really growing. And to not put resources to actually fuel this ecosystem, which is the next decade, it’s just such an opportunity. So that’s why we are investing aggressively. We think it’s the right thing to do at the moment in the company. So – and that’s the balance we are striving. Even in Q3, right, if you think of headcount, we have a lot of people – I should call them – the people that we just graduate form university that are going to joining us, right. So there may be even be you can think of the bump of the accepted but not started because they are going to go backpacking for the summer before they come and join us. But I mean ultimately, right, we are looking at a trend of continuing to invest. And it’s the right thing at this time in the history of the company. So that’s on CapEx and on hiring. And then on contextual search, if there is something that you want to – you need a more refinancer for Jonathan – I am not sure I understand—
Jonathan Rosenberg: I guess I am not sure what data you are looking at or what examples you are referring to.
Youssef Squali: Well just I mean there – the two main competitors have adopted some processes that in a way inflates their – the number of searches that are run on their databases and you guys don’t do it. Wanted to just know if this is something that you guys may pursue as well or –
Jonathan Rosenberg: Sure. I understand. Right, so I mean in general we don’t comment on the third-party data but what you are alluding to are basically the methodological problems that have been publicizes with respect to autoroll slide shows that generate. Basically if you think about it from a search perspective, it’s a spurious request because it’s not merely an incremental search.
Youssef Squali: All right.
Jonathan Rosenberg: So the thing that matters to us is ultimately consummating transactions via conversions that we are sending to advertisers. So what we care about is the number of genuine searches that users are running where they want to get directly to an answer or a website or where they are interested in actually clicking on an advertiser’s ad. It wouldn’t help us in any respect other than in generating counts in share data to cause our search – to cause the total number of searches to artificially go up if there wasn’t user intent behind them that was a value to our advertisers. So, the basic answer to your question is no.
Youssef Squali: Okay. Thanks so much, thanks.
Patrick Pichette: Thank you, sir.
Jane Penner: Next question please.
Operator: And we’ll go next to Jordan Rohan from Stifel Nicolaus.
Jordan Rohan: I would like to delve a little further into some of the growth that you are seeing in the rest of the world territories. Can you talk about how much directionally growth you are seeing out of Asia versus Europe, if that’s a breakdown that you are willing to give? And if not can you talk about which countries really stand out from a growth perspective on the positive side? Thank you.
Patrick Pichette: I will let Nikesh answer that.
Nikesh Arora: I prefer not to talk about regions because in every region there are countries which do fantastically, there are countries which are challenged. If you are asking about Greece, I wouldn’t have to answer the question. So similarly, there are countries like Russia, like Brazil, like India, which are growing fantastically for us and continue to show good growth. It’s a combination of more advertisers; it’s a combination of Internet penetration getting higher. It’s combination of people getting savvier, advertisers getting more and more ready for the (inaudible). So we are seeing good growth this quarter. We saw good growth in Brazil, India, Russia, and we saw great growth. And then we saw good growth from many other parts of the world. So, even places like France performed for us wonderfully this quarter. So, even these are larger markets places like Australia and New Zealand performed well for us. So I am reluctant [ph] to give an answer on a specific territory, I prefer talking about countries because I don’t know how to go visit Asia.
Jordan Rohan: Fair enough. Countries are even more helpful. Thank you.
Jane Penner: Next question please.
Operator: And we’ll go next to Sandeep Aggarwal from Caris and Company.
Sandeep Aggarwal: Thanks for taking my questions. Actually I have two questions, one is if you look at the sponsored clicks versus CPC last quarter, paid clicks were up 15%, CPC was up 7%. Sponsored – paid clicks remained at the same level, but CPC have come down quite a bit. I know some of this is mix shift. May be some of this is OpEx. But I guess my question is, is there any competitive dynamics or may be increasing focus towards organic search or changing user behavior (inaudible) in terms of some weakness in CPC? And then I have a follow-up.
Jonathan Rosenberg: This is Jonathan. I think probably the easier way to answer the question is to just give you my quick observations on the things which are clearly driving – contributing to driving CPCs on average up versus those that are impacting them in the other direction. I don’t see anything from a user perspective or a share perspective that is obvious that’s impacting the overall equation. I think we are seeing on the positive side conversion rates improving, which is driving CPCs up. I think you r comment about the relative shift in mix to google.com from AFC does contribute positively to CPC. Google.com is obviously higher. So any mix shift there, everything else being constant, increases CPC. The obvious things that we’ve talked about in the past that push it in the other direction or emerging markets, Brazil, India and Nikesh talked about some of those examples earlier. Mobile growing in the mix and people increasingly looking for longer tail queries that monetize lower to add into their campaigns. But those are the overall factors.
Sandeep Aggarwal: And—
Patrick Pichette: Sorry, Sandy, go along with your follow-up.
Sandeep Aggarwal: Yes, so, Patrick, actually the other revenue actually on a year-over-year basis is showing visible slowdown versus last quarter. And you specifically made comments that DoubleClick was very strong and then based – also you have your Nexus one which is contributing second quarter in terms the – kind of incremental revenue source. In spite of these things, other revenue was noticeably slowed. So, is there [ph] some kind of slowdown in the Google enterprise business or what else is going on there?
Patrick Pichette: No, I mean in essence, it’s one word; it’s Nexus One. So, that the quarter-over-quarter of Nexus One is driving the substantially that change.
Jane Penner: Next question please.
Operator: And we’ll go next to Aaron Kessler from ThinkEquity.
Aaron Kessler: Yes, hi, a couple of question, first on China, is that China clarified that your understanding that the government is okay with renewed solutions in terms of your search link on this dot "cn" site. And if there is any updates on trends and traffic you can give us that you are seeing in China. Also, just in terms of click through rates for mobile on sponsored ads, any comparison you can give us there versus how you see click the rates on PC? Thank you.
Patrick Pichette: Okay, so I will answer the China and then I will let Jonathan talk about the click to rate mobile versus PC. On China, look, we are basically at the same place when we last discussed or last time we talked about it, which is we have – the good news is we have our license renewal but – and apart from that from a – certainly from a financial perspective I just want to reiterate to everybody, right, revenue from China is not material to our revenue. And having said that, we had decent revenues for Q2. And so given the sensitivities of everything that’s gone on with China, I hope you will understand why. I don’t want to talk more about it. We are working very closely to kind of continue to work through this situation.
Aaron Kessler: Oh, good, thank you. On the click through rate mobile versus PC, Jonathan, insights?
Jonathan Rosenberg: We don’t actually break out the relative click through rates on mobile versus the PC. I mentioned there are new formats and efforts that we’ve offered, that are starting to increase them like the click to call offering. I think the main thing that’s really going to fundamentally have to change there which is the big difference between mobile an d desktop is that today the – on a mobile phone people are actually less likely to consummate a transaction because of the logistics of entering the credit card or being signed in on a browser is somewhat more time-consuming and onerous. So I think that – for the mobile system, to move very aggressively is going to require more of those commercial transactions actually being taken and placed on the mobile devices. The display side, the AdSense for mobile is actually doing very, very well. And one of the reasons that’s doing well is sort of the opposite of what I just stated in terms of effect. On a mobile device the display ad is something that really kind of gets in your face. The screen is relatively small so you see it. It’s unlike a desktop in that you are not typically doing multiple things at once. So display I think is relatively closer to the desktop than is search based ads.
Aaron Kessler: Great. Thank you.
Jane Penner: Next question please.
Operator: And we’ll go next to Sameet Sinha from JMP Securities.
Sameet Sinha: Yes, thank you very much. I just wanted to – if you could comment on this Omnicom deal that you had signed? Can you talk about what the ramifications are, what sort of advertisers do you expect will participate, and any other details would be appreciated?
Patrick Pichette: Yes, sure. You have to understand, as we look at display, there are two significant changes that are happening right. One is display buying which traditionally has been advertising – advertisers buying sites is slowly and surely shifting to audience buying. So, I as an advertiser no longer want to buy Tiffany.com or newyorktimes.com. I want to be able to say I would like 18 to 35 year olds who are savvy, who understand technology and who will be interested in my product. Now as you go towards that audience buying notion, what advertisers are looking for is they’re looking for specific inventory on specific audiences whichever site they might be on. So it becomes even more important for some sort of trading desk type phenomena to exist where an advertiser can buy across any publisher they’d like to buy. Now that makes it even more important that you can find some trading desk or trading exchange where you can have every publisher represented. Because if you have seven different networks, it’s suboptimal as an industry to have an advertiser have to go to seven different networks to be able accumulate what he insists, the different standards, the different way to seven different networks to look like. So if that can leave the ad agencies which are buying advertising – the advertisers would like to have a common platform which allows them to buy across these entire networks. And that’s what we’re working Omnicom with where they believe that if they have the right trading environment setup for their advertisers, it’s going to be tremendous value for the advertisers because advertisers come to a one-stop shop and buy across networks and also allows a tremendous efficiency because the best seller of advertiser may not be the best acquirer or a publisher. So therefore, you can separate that in some sort of an ad exchange context, which is what Omnicom is working with us on. And if you get it right, there is hundreds of millions of dollars that’s taking this kind of a deal because that allows very effective buying across-the-board on a network and every player in that ecosystem can get their fair share of the profit.
Sameet Sinha: Okay. Thank you.
Jane Penner: Okay. Next question please.
Operator: And we’ll go next to Mayuresh Masurekar from Kaufman Brothers.
Mayuresh Masurekar: Hi. Could you talk a little bit about search remarketing? It seems that you are by far the leader in search, so a lot of the spare advertisers would need Google for doing this well. So what kind of growth or traction have you seen for search remarketing? And what’s the pricing for this product compared to other display alternatives? Thank you.
Patrick Pichette: We don’t do search remarketing. We do remarketing in the display side. We basically are able to go, look at what we call interest-based advertising. If you understand the certain uses or interested in certain things, we have based on their – they’re having children to allow us to use that information. We have the ability then market to them and show them ads. And that is way more effective and blindly trying to show advertising to users of clearly we’re seeing tremendous success and adhere but that’s all we do in terms of remarketing.
Mayuresh Masurekar: And what’s the pricing for this compared to other alternatives?
Patrick Pichette: The pricing – look it’s very simple. The more effective the advertising is, the more likely the advertisers are willing to bid more money for it. So you should expect the more efficient we make advertising, the more relevant it become, the more ROI it generates to the advertiser. They will need to compete more aggressively with other advertisers with the same piece of real estate. So we see that. We see the effectiveness of that reflected in higher CTC for that particular product.
Mayuresh Masurekar: Thank you.
Jane Penner: Next question please.
Operator: And we’ll go next to Colin Gillis from BGC Financial.
Colin Gillis: Hey Patrick, how many acquisitions this year? What is the philosophy on the financial discipline used to determine the purchase price, and then separately, with ITA competitiveness?
Patrick Pichette: I’m not going to comment on the last piece. What I’m going to say is, that we have – there’s a real kind of triangulation between two factors in our strategy for acquisitions. So think of it as talent, intellectual property and then price. And so but what we’re looking for is a sweet spot where when we find teams of people that are have clear leadership that if you think about it, the venture capital world is actually kind of voted by them surviving as long as they have and they have as a team great talent – engineering talent specifically. Then on top of that, put the second piece of it which is, they have proven that they actually have good intellectual property whether it be – whatever be up there, they’re working on or whatever in the case is you just mentioned of ITA right, a lot of interesting kind of structural data. So the third piece is obviously price. There is a price after which, is a price – there is a trade-off of on price and what we do is, we do every one of them. We ask ourselves the question, we look at the intellectual – and then you put the overarching last fit which is how does that fit within those four areas that I’ve talked earlier of which is what we’re trying to accelerate our development. So, AdMob is a perfect example of that where great technology, fantastic team at the right price and basically take a huge junk of what was our engineering roadmap and bring it today, integrate it into the team and then we have much smaller team some times of 12 to 15 individual great piece that actually on to and there is another one like that, right, when you think about the video Kotak. So it’s always the – and there are many cases where we look at them and we don’t buy them because we can find us at somewhere in those three. So I mean that’s how we think about it and it is disciplined. And we have the base about them and sometimes we kind of – we often say no. That’s how we think about it. So there are efforts (inaudible) you walk away from just because of the purchase price at the end of the day. Oh, yes we do.
Colin Gillis: I think sort of (inaudible). You just talk a little bit about or help this frame how additive are mobile search is? Is there a rate of search growth you could share for users across all devices may be tied to the same login?
Jonathan Rosenberg: I don’t actually have any data but intuitively, I think that they are additive because – I mean, think about it this way, when you’re at your desktop, if you have your PC at your desktop and you mobile phone, you’re not going to do the search on your mobile phone, so almost all searches that you were otherwise doing on your desktop, I think you’re still going to do on your desktop. On the other hand, there are times when you are out with your mobile phone, and you didn’t have your desktop device, and obviously those are, by definition incremental unless of course in theory you’d remember to go back and do that search when you came back to your desktop. But I don’t think that there is much evidence that that’s the case. I think the vast majority of them are incremental. I think they’re also slightly different usage patterns across desktop and mobile. You tend to see more use of the mobile devices on weekends, which is not surprising but they don’t actually have any more specific data that proves those observations or that hypothesis.
Patrick Pichette: You might imagine those curves, including the transaction curves, ultimately bend towards each other over time.
Colin Gillis: I guess I don’t understand exactly what you’re saying.
Patrick Pichette: Our usage – our mobile usage in the way we use our mobile efficient as we get more broader band. You’ve talked about your 4G connections.
Colin Gillis: Sure.
Patrick Pichette: And our desktop usage, I mean ultimately, there should be much difference between the two of them over time.
Jonathan Rosenberg: Well I think the mobile usage is, the mobile usage will grow and in many ways will be incremented because you’ll be able to do a lot more when you’re out in the field and for example being able to – in within a store, scan a barcode with your smartphone, look at the price on the shelf and determine whether or not you actually would prefer to consummate the transaction through a web-based alternative and then automatically complete the transaction. It’s a kind of thing that’s all going to be incremental and I think as these devices are able to do more of that, the people are going to do it.
Colin Gillis: Yes. Right it makes sense. Thank you.
Jane Penner: Next question please.
Operator: And we’ll go next to Heath Terry from FBR Capital Markets.
Heath Terry: Great thanks. And Patrick, in looking at YouTube beyond views, it’s obvious that the majority of those views still aren’t being monetized and in a way. So what’s standing on the way of more monetization of this inventory, which, for the most part, still seems to be the user-generated content side of thing? How significant as it and does the Viacom ruling, it change your ability to monetize that inventory?
Patrick Pichette: I’m going to let Nikesh to give you the kind of high level answer and then I’ll circle back on the Viacom specific.
Nikesh Arora: Okay. I don’t know, let Patrick about the Viacom but you have to understand first of all, YouTube is five years old, right. So this is a phenomenon that has been created over the last five years. We look at YouTube and we monetize it many different ways. We monetize the homepage of YouTube. We monetize more watch pages on the YouTube. We do promote your videos and looking at best new ways and looking at how we can put ads into content. Now part of the process that has been going on, is we have to continue to free up more and more inventory for it to be available for us to advertise on. So we’ve done a lot of deals recently where whether with music society around the world on the various countries around the world, but we are getting permissions to be able to show advertising in those places, which allow us to create more inventories. That’s so – that’s the inventory side of things. And we believe we’re in a good path to continue to create more and more available inventory. In addition to the inventory side, we have to now keep getting advertisers to start getting giving us quality video advertising, which can be put into YouTube. And my view on this is that, we’re in the very, very early stages of video advertising because what advertisers do, they will splice the video ad that they’ve created for television and they’ll also take it on YouTube. Now if you understand, YouTube allows you two more things which the television does not. It allows you to interact with the ad, which TV does not and most of the ads on – video ads so far are not interactive. So we expect as that begins to happen, people will start creating more and more interactive. Secondly it allows you to – it allows you to create some degree of personalization. The ad your grandmother sees and I see and my daughter see did not necessarily be the same ad for anything. So both those features we think will come into play in more and more in the advertising side. So as you get more personalization, more interactivity, as we get more inventory clarified for YouTube, we think that it’s going to create more and more decisional opportunities and you couple that with the previous conversation on display and the ability by audiences that would just provide sort of the (inaudible) indicate, as this thing goes forward.
Patrick Pichette: Terry, on my side, look on – on the issue of our icon right. We’re still in the PL side. I don’t want to comment on the specifics. What I can say is two things, right. Obviously, with more clarity from this judgment, it gives us more room for experimentation that we didn’t have before because until these rules are clear, you don’t know exactly where the bar is. And with that clear bar, we now have much more room for experimentation. And then on just to comment on, if there was ever a great illustration of Nikesh’s point a minute ago. I mean, just looking the last few weeks about the Old Spice experiment on YouTube and if you have not tried that, just go on YouTube and check Old Spice about the interactivity of Twitter, Facebook, YouTube and advertise it’s just absolutely phenomenal. So it just gives you a glimpse of where the world is going and it tells you again about we’re just scratching the surface.
Heath Terry: Great. Thank you.
Patrick Pichette: Thank you. We’ll go to the next question.
Jane Penner: Yes, operator, we have time for one more question.
Operator: And we’ll take our final question from Richard Fetyko from Merriman & Company.
Richard Fetyko: Now thanks guys. If you breakdown the components of your display strategy in revenue streams, how would you rank the revenue opportunity of each between YouTube, AdSense, Display Network and the Ad Exchange in the long-term?
Patrick Pichette: I’ll let Nikesh to answer it.
Nikesh Arora: I think it’s very important to understand that all these things were to complement each other. The Ad Exchange allows a buyer to buy across multiple networks. So without an Ad Exchange, it makes a very inefficient for advertising we’ve bought and therefore the buyer is not going to go as fast enough. So you want to make sure you can create some consistency in standardization in the way display advertising has been bought. If you want to take the big TV dollars to start coming into display as they had in the early years. I think with Google Display Network it’s our ability to prove that we can create a network of our own of multiple publishers and create premium capability for our advertisers to be able to target those publishers. And last but not the least YouTube becomes our owned and operated property, something like us operating google.com and our Google network. So clearly the margins on our owned and operated properties are higher and that allows us to have a premium property in this space and also allows us to accumulate tremendous amounts of content which we can then that I’ll just advertising and so at present all these three are very relevant to the overall strategy, I’m not trying to prioritize anyone over the other, particularly YouTube being able to monetize bringing more TV dollars into YouTube is fantastic. Google Display Network being able to monetize at opportunity across multiple publishers is great and without Ad Exchange which if we do that’ll bind all these networks together, it is hard to see that industry growing as fast as we’d like to see it grow.
Patrick Pichette: Let me give – if you allow, I mean the CFO answer. These are each and every one of them billions of dollars of revenue opportunities. They’re not hundreds of millions, they’re – the way we think about it in terms of addressable market, this is already a $20 billion industry that is growing really fast and so for us every one of them we talk. And that’s why again, we continue to invest in the total echo system. Listen we’ve had – so thank you very much for all of your questions. I want to thank Nikesh and Jonathan again for joining me. I wish to thank every Googler that’s on the call listening to us, I mean, our engineers, our sales force, our support staff, all these people, I mean every 90 days we look at our results and we continue to be so pleased. But it is really the great part of work all are Googlers. And so for that perspective, I’d just want to give two thumbs up again to the Googlers for a fantastic job over Q2 and with that in mind, I’ll turn it back over to Connie and I wish you a great summer everyone and we’ll talk to you in Q3. Connie, you can close the call please?
Operator: Thank you. And that concludes today’s conference. We thank you for your participation. | [
{
"speaker": "Operator",
"text": "Good day and welcome, everyone, to the Google Inc. conference call. This call is being recorded. At this time, I would like to turn the conference over to Ms. Jane Penner, Senior Manager, Investor Relations. Please go ahead, Ma’am."
},
{
"speaker": "Jane Penner",
"text": "Thank you, Connie. Good afternoon, everyone, and welcome to today’s second quarter 2010 earnings conference call. With us are Patrick Pichette, Chief Financial Officer; Jonathan Rosenberg, Senior Vice President, Product Management; and Nikesh Arora, President, Global Sales Operations and Business Development. First, Jonathan and Patrick will provide us with their thoughts on the quarter and then Nikesh will join us to answer your question. Also, as you know last quarter we began distributing our earnings release exclusively through our Investor Relations website located at investor.google.com. So, going forward, please refer to our IR website for our earnings releases as well as supplementary slides that accompany the calls. This call is also being webcast from investor.google.com. A replay of the call will be available on our website in a few hours. Now let me now quickly cover the Safe Harbor. Some of the statements we make today may be considered forward-looking, including statements regarding Google’s future and investments in our long term growth and innovation, the expected performance of our business and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please not that these forward-looking statement reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Also, please note that certain financial measures we use on this call such as operating profit and operating margin are expressed on a non-GAAP basis and have been adjusted to exclude charges relating to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and GAAP to non-GAAP reconciliation can be found in our earnings press release. With that, I will now turn the call over to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Jane. Good afternoon, everyone, and thank you for joining us. As Jane mentioned, Jonathan and I will begin with the prepared remarks, but we also have Nikesh with us for the Q&A. So, let me start you by giving some high-level thoughts about the quarter and then we will get into our detailed financial performance. So, overall we are very pleased with our Q2 results. We experienced continued solid growth in our core, but also very strong growth in our emerging businesses year-over-year. Taking a step back actually, these results reflect a few really important trends in the digital advertising. First, we are really taking notice that more and more traditional brand advertisers are embracing search and search advertising is a way to build their brands online. A case in point P&G, it’s one of the largest brand advertisers in the world. And it’s now one of our top advertisers in the U.S. Second, we see also a real trend in large advertising, focusing on highly measurable but also integrated campaigns across display, mobile and search. So, as a result, we saw strength in every major product in Q3. Google.com was strong with strong performance across major geographies and most major verticals, including CPG, retail, travel, et cetera. Our growth in display was also very strong. Our continued focus in this product area is clearly generating results. Our display network, which includes YouTube, is growing very rapidly. The scale and quality of our network continues to increase and we see increased demand from traditional brand advertisers in that space as well. In addition, we made yet another significant stride in display this week, when we entered into a strategic agreement with Omnicom Media Group. We will be working together with Omnicom to co-develop their exchange trading desk for the double click ad exchange in the coming years. YouTube specifically we continue to see very impressive growth as brand advertisers also consider it a must-buy. For example, and as I mentioned a moment ago, in Q2 we ran World Cup advertising campaigns for major advertisers of the likes of Coke, Visa, Nike, Sony, et cetera. Finally, on YouTube, I think it’s really worth noting that we are very pleased of course with the court’s decision to rule in our favor in the Viacom case. But more important in this victory, it’s not for us, but for the users and just the Web in general. Specifically for all the blogs and the community forms across the Web that do rely on this user-generated content for sharing information and also for free expression. Look, we were very passionate about this issue at Google and so much so that we have made significant investment of approximately $100 million to win this case. And once again, it just was the right thing to do and we did it. In mobile, our revenue continues to grow as advertiser increasingly opt into their mobile-specific campaigns, and with the successful completion of the AdMob transaction in Q2, our business is gaining momentum. And so we have a very competitive mobile advertising platform now. And of course, underpinning our growth is the success of the Android platform itself with over, as we announced a couple of weeks ago, 160,000 devices activated daily. That’s two every second. And it creates an even larger base of data-centric smart phone users. Finally, enterprise had another good quarter with several high-profile deals, including, for example, Virgin America. The world is simply moving into the cloud. And successful products do require investment. And that’s why we are focusing our resources on products that, as you all know, leverage computer science to solve our big problems, offer great ROIs, and very large growth opportunities. For example, in Q2 we’ve added approximately 1200 employees. That’s obviously counting the acquisitions of AdMobs and the others. But the majority is done in engineering and sales and in the following product areas: search monetization, display, mobile, apps, all the next billion dollar businesses that are growing incredibly rapidly. And that’s why we are investing in them. Jonathan will give you more details about that in a moment. So, now let me turn to our financial results. Gross revenue. Gross revenue grew 24% year-over-year to $6.8 billion. Our Google website’s revenue was also up 23% year-over-year to $4.5 billion, with strength, as I mentioned, across most geographies and verticals. Our AdSense revenue was up 23% as well to $2.1 billion, reflecting our continued strength specifically in the Google display network. Other revenue was up also 39% year-over-year to $258 million. And it includes the last quarter of revenue from the sale of Nexus One. As announced, we are discontinuing the direct-to-consumer channel in Q3, and as a result beyond Q3 we won't recognize any revenue or cost associated with the sale of Nexus Ones. They are still being sold through various carrier partners, both in the U.S. and Europe, however. Our global aggregate paid click growth remain quite healthy, up 15% year-over-year and down 3% quarter-over-quarter due to the typical summer seasonality. Aggregate cost per click growth was up 4% year-over-year and 2% quarter-over-quarter. Note that the FX had a positive effect on our CPC growth year-over-year and a negative one quarter-over-quarter. Remember too that this is an aggregate number and it includes both Google.com and our AdSense properties. Turning now to our geographic performance, on a relative basis the U.K. lagged a bit the global economic recovery, certainly relative to the U.S. and rest of the world, which were strong. Revenue from the U.S. was up 26% year-over-year to $3.3 billion and in our earnings slide you will find on our investor website you will see that we have broken down our revenue by U.S., U.K., and Rest of the World to show you the impact of the FX and benefits from our hedging programs. So, please refer to these slides for these calculations. International revenue accounted for 52% of our total revenue or $3.58 billion, up 21% year-over-year, which includes $79 million benefits from our hedging programs. This is compared to $124 million of benefits in Q2 of last year. If we used fixed exchange rates, our international revenue would have been roughly $24 million lower year-over-year. The U.K. was up 8% year-over-year to $770 million. Let me now turn to expenses. Traffic acquisition cost were $1.7 billion or 26% of our total advertising revenue. Our cost of revenue was $735 million, including stock-based compensation of $8 million and also expenses related to the sale of the Nexus One. And finally, all operating expenses totaled $2 billion. This is also including $301 million of stock-based compensation. The increase in year-over-year OpEx is really primarily due to increases in payroll, professional services and advertising and promotional spend. So, the result of all this, our non-GAAP operating profit, which excludes stock-based compensation increased to $2.7 billion in Q2 resulting in a non-GAAP operating margin of 39%, essentially the same as last year. As I mentioned already, our headcount was up approximately 1200 heads versus Q1 and in the quarter were 21,805 full-time employees and again that reflects the acquisitions as well. Our effective tax rate was up to 24% in Q2 versus 22% in Q1 essentially due to the mix of earnings between domestic and international subsidiary and the impact of our hedging program. Let me quickly turn to cash management. Other income and expense was 69% for Q2 – $69 million, sorry, for Q2, which includes good progress in our portfolio management performance, although it was somewhat offset by the impact of our hedging expenses with FASB 133. For more detail on the OI&E, again, please refer to the slides that accompany this call in our IR website. In addition, we’ve announced today a $3 billion commercial paper program and a related credit facility. This to us is an important step in establishing a more capital-efficient structure that will provide us with low-cost working capital availability and flexibility and it’s also an excellent time to do it given the historical low interest rates. Operating cash flow was very strong at $2.1 billion. CapEx for the quarter was $476 million. Again, primarily related to our data center operations, and as a reminder, we continue to make significant CapEx investments and it just turn out to be lumpy from quarter to quarter. Our free cash flow, therefore, stands at $1.6 billion in a very good position. So, if you take a step back from all these numbers, here is where we stand. We are very pleased with our Q2 performance seeing growth across revenue, margin, and cash flow. And it really paints a picture where we are very confident of our future. And that’s why we continue to attract and hire among the best talent in the world to further invest in our growth agenda. So, with that, and before we open up for questions, let me turn over to Jonathan for his comments. Jonathan?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Okay, well, thanks, Patrick. So, let me start with search. Search used to be pretty simple. You would enter a query and we would return a bunch of links to websites. But now, the Web is much, much more complicated. There is videos, there is books, there is music, there is news, just about any type of media you can name is online. So the scale of the Web now is grand and it isn’t slowing down. To keep pace, we migrated a whole lot of our index to a new infrastructure, which we call Caffeine. And Caffeine is basically a new way of updating our index. So now when we find a new web page or new information like a video or an image, we add them straight to the index without a new delay. This means that the results that you get are a lot fresher and in fact they are about 50% fresher than before. But then, once you get your results, you need tools to work with them to get to the right answer. And we’ve launched a new UI that has a bunch of options on the left hand side to help you filter those results. I especially like the timeline feature, which I think is great when you are doing research and you want to see results from a particular time. So, you can enter, say, oil spill, and click on timeline and 1969 and you can read all about the big Santa Barbara spill that led to the ban on offshore drilling in California. On the other hand, sometimes, you just want an answer. The query is effectively the result and we are getting much better at knowing when that’s the case and giving you what you need. So, enter, for example, Barack Obama birthday and you will see what I mean. You will see his birthday listed, August 4th, 1961, and citations for the different sources where we got that information. All of this works in suggest too. Try typing capital South Africa. By the time you get to the first ‘a’ in Africa, we tell you it’s Pretoria. I point out these things out because the great things about features like these is most people I think don’t even notice the changes. They just notice that they get their answers fast. I think I mentioned on the earnings call back in January that we a working on putting more wood behind fewer arrows. And Search innovation is definitely one of those arrows. Our case here is actually accelerating. Voice search added six languages. We launches spelling full page replacement, suggest with spell correction, and over 100 quality enhancements. So there is lots of stuff going on. In fact there is so much that we are putting out a weekly blog post to document all the search improvements. But, interestingly, as search gets better, it actually creates another huge challenge for us. The ads need to keep pace and get better too. Otherwise what would happen is people will click on relatively fewer ads and that will be bad. So, this dynamic were consumers are in control holds for all types of media and not just search. It used to be consumers had to watch, see, or listen to whatever the advertiser wanted to show, but now they don’t. I think this is a fundamental shift for the advertising industry. When people don’t have to watch your ads, what do you do? Well, you have to make ads people actually want to watch. I was in Piazza San Marco in Venice a couple of weeks ago and there was this huge billboard advertising a ski jacket. It was like 90 degrees and we were sweating in shorts and tee shirts. And I looked and I thought, “What a waste of money.” So I took a photo of the ad with my smartphone and I sent it to my team as proof there is lots of upside in improving ads. And this quarter, we made progress on that upside. We added new ad formats, and we focused even more on quality. The new formats lead advertisers put more useful information into their ads such as pictures of a product or a local address or a phone number. It turns out that when you are searching for something from your phone, you are much more likely to click on the ad which has a phone address in it. This seems obvious, but now we actually know from the data that it’s true. One of our customers, Carnival Cruises increased bookings from mobile phones by 175% when they included click to call ads. Lastly on ads, I know you often ask about quality. And I am proud to say we had one of our most productive quarters there in the last couple of years. Over a dozen launches on search with a strong impact on revenue. We did things like put better ads on the second page of results where we realized that the ads weren’t as good. And we also had over 20 quality improvements on the Google display network. Display, by the way, is going very well. One recent development is that we are working closely with our agency partners to help them move to what they call an audience buying model. And I think this is another fundamental shift in advertising where the ultimate goal is to designate a particular audience on our network like say women between 18 and 35 who like basketball. And we automatically target that audience for you. We are also making progress with features like remarketing, which we launched last quarter. Advertisers can reach people who have already visited their sites. Interest based advertising, which we launched last year is also working very well. And so is the double click ad exchange, which we launched in Q3. We’ve got several of the top ad networks on it and we are tracking some big buyers like agency holding companies. Advertisers really like the technology, which is real-time bidding and publishers like that it’s open to all advertisers and ad networks who they want to work with. We want to be open in everything we do. We believe open systems are better for the Web, they are better for competition. They are better for the user. This is not philanthropy. When the Web is better, more people use it more often. And that means they search more often. Android is a leading example of this. As Patrick mentioned, we are now activating over 160,000 Android devices every day. This is up from 65,000 last quarter. What’s even more interesting there is that most of these devices are developed completely independently off Google. One of those is the Spring EVO, which is actually my favorite phone right now. Has a big screen, it’s got great video. It acts as a WiFi hotspot for me. It has 4G bandwidth at least when you are around Mountain View. The Android market is also open of course, and now has over 70,000 apps. That was around 30,000 in April. As you look at all these new apps being created you also realize that your mobile phone is no loner [ph] anymore. It’s actually connected to several million computers 24/7. This is leading us do things that we used to think were impossible. We just released the new version of Goggles, that lets you take a picture of something in another language with your phone and it translates it for you. I actually use this a lot to read menus on my vacation in Italy. You literally don’t have to guess what you are going to eat any more. Or say you want to know [ph] about how the locals are celebrating their World Cup victory – congratulations to Spain, by the way. Anyway, you just go to elpais.com and Chrome toolbar automatically translates it for you in a second. So, cloud computing also means that enterprises can take advantage of these innovations. We just launched this feature where if you have say a PDF or the image of a scanned document, you can upload it to Docs and we’ll convert it to text, so you can edit it. You don’t have to install any special software or anything. If you are a Google apps customer, it’s just there and it works. Of course, the cloud is pretty good for wasting time too. I hope you played with our special Pac-Man doodle. We put it on May 22nd to celebrate Pac-Man’s 30th birthday and we estimate people spent 4.8 million hours playing it. If you missed it, go to google.com/pacman. Gloop, gloop, gloop. Thank you for your time. Back to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Jonathan. And, yes, there were these great reports of billions of billions of kind of productivity lost over that little Pac-Man, so obviously we did something right somewhere. Connie, can you actually turn on the Q&A process and I am going to invite the guests also join us at this time."
},
{
"speaker": "Operator",
"text": "Thank you. (Operator instructions) And we’ll take our first question from James Mitchell from Goldman Sachs."
},
{
"speaker": "James Mitchell",
"text": "Thank you very much and thank you for the Pac-Man distraction a few weeks here. My question was about the sequential increase in operating expenses. I was wondering if there was any adjustments (inaudible) rules that went into that sequential increase or was it entirely due to headcount additions and acquisitions and marketing."
},
{
"speaker": "Patrick Pichette",
"text": "It – the bonus accrual would have a small impact on it, so it is really about headcount, about TVCs, about marketing."
},
{
"speaker": "James Mitchell",
"text": "Great. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "You’re welcome."
},
{
"speaker": "Jane Penner",
"text": "We are ready for the next question."
},
{
"speaker": "Operator",
"text": "And we’ll take our next question from Spencer Wang from Credit Suisse."
},
{
"speaker": "Spencer Wang",
"text": "Thanks. Good afternoon. Two quick questions. First, in terms of the paid click growth of 15%, I was wondering if you could just give us a sense of how much of that is coming from mobile today currently versus say last quarter? And then the second question maybe Patrick, just on TAC, it was down a little bit year-over-year and [ph] sequentially. Can you just give us a sense of where you think on a percentage basis that’s trending especially with the MySpace deal coming up shortly? Thank you."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yes, this is Jonathan on the mobile question. Mobile is certainly growing faster than other clicks, so everything else being constant, there is a disproportionately larger group of mobile clicks this quarter than in quarters in the past, but we don’t really have any more detail on that."
},
{
"speaker": "Patrick Pichette",
"text": "In the case of TAC, it’s been – I mean most of the TAC that we have today because as you said so rightly that MySpace deal in pending now. I mean we shouldn’t see any – there is no big jump anywhere in the TAC going forward. And it’s been pretty stable actually around – I think you said 27% or – ? And so there is very little variability in it."
},
{
"speaker": "Spencer Wang",
"text": "Great. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Spencer."
},
{
"speaker": "Jane Penner",
"text": "I think we are ready for the next question."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Imran Khan from JPMorgan."
},
{
"speaker": "Imran Khan",
"text": "Yes, hi, thank you so much for taking the questions. Two quick questions. One, the 1200 or so headcount increase. Could you give us some sense like where are you allocating those headcount either in search or in the new – most of the headcounts are going to new initiatives? And also secondly, in terms of the cost per click, can you give us some sense the differences of cost per click, mobile versus desktop and how quickly you think it can narrow? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Great. So, why don’t I start with the 1200? So, remember 1200 just a bit of a clarification, there is probably around 300 of those 1200 that in estimates that come from M&A. So, really kind of organically if you think about it, more like 900, which was not unlike last quarter. The – as I mentioned in my core notes, Imran, the – most of the headcount is in engineering and sales. And most of the headcount like the vast majority is going to the four core areas of focus of the company. So they are about search and search monetization. They are going to mobile and Android. They are going to apps. And they are going to display. We see so much momentum in each of these right now, but that’s where the bulk of the resources are going because that’s where the focus of the company is. On the CPC, Nikesh?"
},
{
"speaker": "Nikesh Arora",
"text": "On the CPC – hi, this is Nikesh – on the CPC, I don’t think there is enough data for us to actually look at a trend in terms of where it’s closing or not, but you have to understand the mobile advertiser sees mobile as a very different platform vis-à-vis the desktop advertiser. And you see high CPCs where there are transactions that can be consummated in the mobile, i.e., in digital entertainment. You don’t see as high CPCs as when you are trying to give directions to a certain restaurant or a place where they might (inaudible). So, there is still some disparity between the CPCs in the desktop and mobile. And within mobile, depending on the verticals, there is disparity depending on the type of advertiser."
},
{
"speaker": "Jane Penner",
"text": "I think we are ready for the next question."
},
{
"speaker": "Imran Khan",
"text": "Can I sneak in one – ?"
},
{
"speaker": "Operator",
"text": "And we’ll take our next question from Justin Post from Bank of America."
},
{
"speaker": "Justin Post",
"text": "Great. My questions are about Android. Can you talk about how much investment is going into that platform? And then how do you think about it? Is this an investment that just needs to keep going, just you compete in the mobile market or – you know you are not charging for it, is this a real installed base revenue opportunity and we are going to start hearing more communication about how you are going to monetize it down the road? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Okay, so let me give you a high-level answer to kind of give everybody comfort, right. Android is not, in terms of cost, it’s not material to the company, and not only that, but let me give you a further kind of proof point of the value of Android is. Some of the key products that have been launched over the last few weeks and few months have not been developed by Google at all. I think that the last Android X or the Motorola, what is it Droid X has been developed by the – by Motorola directly with Verizon and not involving any of the Google resource. So, it’s not a huge resource investment. It’s a formidable return in that what you have is the entire ecosystem exploding. And (inaudible) and give you really the sense of that one. So from the cost side it’s not material. Jonathan."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yes, and we gave some data just on the scope of the numbers, the 160,000 Android devices as well as the growth in apps from 30,000 to 70,000, but I think the most important most obvious thing to think about from our perspective is what’s the most popular app on these devices. The most popular app is a browser. And what do people do with the browser on these devices? They search an order of magnitude more than they have on any previous type of smartphones, which they had in years past. So, the combination of people browsing on these smartphones connected on very, very fast networks, and searching on them is basically the formula around how Google makes, how Google succeeds."
},
{
"speaker": "Justin Post",
"text": "I don’t know if you are taking a follow-up, but I mean are you seeing search activity really strong on mobile devices with Android and do you think you are losing any ground relative to search activity within applications? Thank you."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Android search grew 300% in the first half of 2010. So, yes, search on Android devices is exploding."
},
{
"speaker": "Patrick Pichette",
"text": "I think that – another way to kind of frame it in numerical numbers I mean the mobile has grown 500% in the last two years in terms of the traffic, so think of that and then think of Android being an accelerator of that because every time you bring the NPV of all these platforms coming forward, you get a lot more. So, that’s how to think about the problem and the solution that we bring."
},
{
"speaker": "Jane Penner",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "And we’ll take our next question from Doug Anmuth from Barclays Capital."
},
{
"speaker": "Doug Anmuth",
"text": "Great. Thanks for taking the question. Two things I wanted to ask, first, just on the macro environment, can you comment on what you saw at all during 2Q in terms of whether the environment seem to change at all either in the U.S. or Europe and then secondly, just given the $3 billion commercial paper program and can you update your current thoughts on returning cash potentially to shareholders? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Okay. Let me start with the last one first. I mean really the commercial paper is a fantastic opportunity for us given the portfolio that we’ve put in place for our cash to actually have the working capital flexibility around it. So, now if I need in fact working capital for my day to day operations, I have that flexibility through commercial paper and that’s really the essence of what we are doing. We have made no decisions at all on share buybacks or as I said to everyone, we – it’s a topic that is regularly debated, brought to the Board for debate and we have nothing to announce on that one. On the macro side, I would say, look there is kind of two things, right. Everybody reads the press; everybody has been seeing all everything that happened in Q2, the Europe, the that, this or that. I mean for us at Google, it’s been a great quarter. We’ve had – our business has been a great quarter and we’ve seen no impact of what’s going on in the macro world to us. And that’s why we said for the last three, four quarters we’ve said we are really kind of performing in this kind of economy and that’s why we feel confident about the future and feel confident about investing now. And that’s why we are doing it."
},
{
"speaker": "Doug Anmuth",
"text": "If I can just follow-up quickly on the first one on cash, can you comment on how much of your cash is international versus in the U.S.?"
},
{
"speaker": "Patrick Pichette",
"text": "It’s about 50:50."
},
{
"speaker": "Doug Anmuth",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you."
},
{
"speaker": "Jane Penner",
"text": "Next question."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Brian Pitz from UBS."
},
{
"speaker": "Brian Pitz",
"text": "Great. Thanks. Would you talk about your advertise and user adoption of some of the new product ad formats that we are actually seeing on your site? Are these ads having material impact on CPC because we understand they are (inaudible) basis? Thanks"
},
{
"speaker": "Jonathan Rosenberg",
"text": "This is Jonathan, I can give you a quick review of the top format and then maybe Nikesh can chime in and give you a sense of some of the specific customer experiences that he has had. The click to call ads on the high end mobile phones are doing very well. The click through rates go up 6% when you put ads with a phone number, 8% when you put a local address. So, click to call is doing very well. It’s easy to see some of those. If you want, just take a look for yourself if you tried travel agency from a smartphone, you will see under thousands of active campaigns on click to call, so you can take a look at that. Site links is also making pretty good progress. We’ve given you examples on past calls where you type a big brand like Sears and then you see the more useful links that you can get through and the click through rates on those can go up as much as 30% over the ads without the site links. But we changed the way we do site links and we’ve added a new one line format. And that also allow site links to show up in more places. You can try flowers if you want to see that. Then the other format that’s getting some adoption is the – we are adding the seller ratings, which shows merchants ratings out of six stars aggregated from reviews on the Web. You see that if you look for things like digital cameras. And that’s doing pretty well as well."
},
{
"speaker": "Patrick Pichette",
"text": "Nikesh, any further thought?"
},
{
"speaker": "Nikesh Arora",
"text": "No, I guess from an advertise perspective they have always had a sense that over the last few years we’ve actually had some disparity in the quality of our natural search and quality of our ads, things like site links create tremendous parity between what people get in natural search and what they get in from an ad format. So, there is tremendous appetite on our large advertisers to be able to send their consumers or users to a deeper part of the website with site links and all. So, the adoption of site links, the adoption of click to call as Jonathan is extremely sort of more lucrative for them because they can actually track it and they can actually track the transaction that it creates. So, these – the ad formats are definitely helping and are getting out there. One thing what Jonathan did not touch upon is the ad innovation on the display side as well. Now, we’ve had tremendous new formats we’ve launched in the whole YouTube front where we’ve actually increased the inventory because we get more and more content where we can show ads on. In addition to that we also have new ad formats which effectively – I mean imagine a basic add and now getting it to be an auto expandable (inaudible) which shows up on YouTube, which allows us to impact the pricing of the ad format. So the more richer the ad, the more an advertiser is willing to contribute because it creates a more engaging experience and therefore a higher opportunity. So, I think across the board the new ad formats are both – we are seeing more appetite for them and at the same time they are allowing us to create more return for the advertiser, allowing us to price them better."
},
{
"speaker": "Jane Penner",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "And we’ll take our next question from Ross Sandler from RBC Capital Markets."
},
{
"speaker": "Ross Sandler",
"text": "Hi, just two quick questions. Patrick, you said that cost for Android are fairly immaterial, so can you talk about the operating margin in the display business on a revenue ex-PAC basis? How much was the margin that you are seeing right now coming from display growing faster than search. And then second question is it looks like the ROW region accelerated a bit in the second quarter if you strip out the hedging and currency impact. Can you talk about, Nikesh, which regions are driving that and can you – talk about the environment in Europe given the macro – I know you talked about it for a second earlier, but just any further color about continental Europe? Thanks"
},
{
"speaker": "Nikesh Arora",
"text": "I mean it’s – the display business has you know to a certain extent if you take it as a blended slightly lower margins if you take the double click platform, for example, which is more transactional. But overall I think that they still are quite healthy and they don’t – if you think of CPCs the way I think about them is you have really kind of two big components at work. The innovations that Jonathan talked about that actually drive CPC up and then because those products perform better, they add pressure to the auction, and therefore drive CPC up. And then the two or three components that actually drive them down in the short term, it’s not as much display as the places like Brazil and India that are growing very well so internationally. And because they don’t have a strong an auction right now, right, the CPCs are slightly lower, but they are growing so that’s positive and then we already talked about mobile themselves as being lower CPCs. These are the two that actually are growing incredibly rapidly in that, on the mix in the short-term, they kind of put a bit of a downward spin on the CPC formula. But both of them as we know, they are growing one rapidly, so it’s real dollar net in and then on top of that we know there is going to be future pressure on them. So I am pretty pleased about the performance of those. On the issue of Europe and FX and it’s really to – everybody has got a model out there, right. We’ve lived an incredible roller coaster of FX over the last year so if you look at currencies like the euro and the pound, right, they were kind of quite similar on par versus year-over-year but the last quarter versus this quarter a huge change. And then in addition to that, if you look at places like the real in Brazil, the Canadian dollar, the yen, I mean those have quite increased year-over-year. So, when you do your models relative to FX OI&E just take into consideration the fact that year-over-year the net-net position is it’s been strengthening all-in. Quarter over quarter it’s been going down all-in and then on top of that our FX kind of our hedging program is really a long term hedging program. So this quarter we’ve reaped 78 million, 79 million of benefits net. So it’s a tough puzzle to solve. But just please take the time to look at year-over-year and quarter-over-quarter because it’s a puzzle to build. I hope that answers your question."
},
{
"speaker": "Jane Penner",
"text": "We’ll take the next question please."
},
{
"speaker": "Operator",
"text": "And we’ll take our next question from Jeetil Patel from Deutsche Bank."
},
{
"speaker": "Jeetil Patel",
"text": "Great. Two questions. I guess do you think that Android and mobile represents a bit of a defensive strategy since you kind of pride yourself on the lack of cost in that business as a whole and the same time you are adding headcount as a whole in the company? And then second, I guess just curious, yes, the feedback we keep getting in the industry is that the Android kind of infrastructure and support seems to be lower than what at least your ecosystem would like. I guess do you – what is the appetite to create other revenue streams outside of advertising inside let’s say mobile in the form of let’s say an app marketplace that is pretty vibrant? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "So, let me just give kind of the highest level answer is it’s – the answer is yes. I mean obviously having – we did for offensive reasons, not defensive reasons, right. We believe that actually open platform that create the ecosystem where developers can actually create a whole set of new generations of apps is incredibly important and in addition to that right we do know that these new formats like the smart phones create an entire new set of activities in which you live and you will search and you will transact. So from that perspective, I think that it’s obviously both. I think that – I take your comment that if the market in general is saying do you want more support from us in that space, right, we are investing heavily because we believe, one, that search advertising or acquisition of AdMob by the investments we are making is because for us advertising is completely nascent in this space relative to kind of text search an then second is we ourselves are doing a lot of innovation through cloud computing and others to actually create a whole new generation of apps ourselves. So I think that, yes, defensive, yes, offensive, but in the end benefiting everybody and I am glad to hear that you say you want us to invest more in it."
},
{
"speaker": "Jeetil Patel",
"text": "Why it seems like your handset vendors are aggressively investing and we haven’t seen it from your side at least as we talked to some of your partners out there and I guess it seems like do you think that other models outside of advertising need to be explored at this point? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "I am not sure I understand you question. Other models such as what?"
},
{
"speaker": "Jeetil Patel",
"text": "Oh, let’s say consumer applications, so there are other companies that have created business models around obviously game downloads app, other app downloads that are charged. Obviously you have as well, but it seems like you are—you seem to be maybe it’s early days, but still early in that development."
},
{
"speaker": "Patrick Pichette",
"text": "I think you are absolutely right that it is early days and I think that the 70,000 apps that we have is actually a demonstration of the effervescence of that ecosystem that’s actually just building now."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yes, I think one – this is Jonathan. I mean it is at a very nascent stage. I think we also – there is a lot more infrastructure that needs to be built to support a lot of the commerce. You know we substantially need to improve the billing capabilities in the market and that’s obviously one of the things that we are investing in pretty aggressively, but I don’t think of this as defensive at all. I mean there is a huge opportunity for incremental usage of search as I talked about earlier and when we see an opportunity for people searching more, that’s obviously something that we want to participate in. So we see this platform is winning. We think that gives us an opportunity to build the mobile Internet and we think that in the long run that’s going to be good for Google, it’s going to be good for the applications developers and it’s going to be good for consumers, so we are investing in building that wining platform."
},
{
"speaker": "Jane Penner",
"text": "I think we are ready for our next question."
},
{
"speaker": "Operator",
"text": "And we’ll take our next question from Steve Weinstein from Pacific Crest."
},
{
"speaker": "Steve Weinstein",
"text": "Great. Thank you. I was hoping you can help explain some of the movement in the P&L expense. You mentioned that most of the hiring is going into engineering and marketing. When I look at the sequential increase in – by dollars kind of expensive – you just had a large increase in G&A about 48 million sequentially and that’s compared to one like $20 million in sales and marketing. So, can you explain a little bit more? Was there anything in the G&A line that is one-time or not repeatable, why are they moving like that?"
},
{
"speaker": "Patrick Pichette",
"text": "Yes, you have to look at – there is a couple of things. One is our recruiting – as you go year-over-year and quarter-over-quarter, we had kind of three big elements, one is we had our recruiting machine that started to build last year was not built in Q2 of last year, so – if you think of the hiring infrastructure and the people infrastructure has actually been kind of – been building and now you see the full flow through. We also have had in G&A in general another area. If you think of everything else that’s kind of people, we’ve talked about legal. We’ve had a number of legal costs to this quarter that have also flowed through just because of a number of legal activities that we’ve taken. So, these are the two biggest components that actually would explain the big variances."
},
{
"speaker": "Jane Penner",
"text": "We are ready for the next question."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Mark Mahaney from Citigroup."
},
{
"speaker": "Mark Mahaney",
"text": "Thank you. Two questions please. A year ago, you talked about being close to profitability on YouTube given all the momentum that you’ve seen over the last year. Do you feel like you are a lot closer, are you profitable with the YouTube asset? And the secondly, when you sell display ads, do you feel like you are selling them to existing search customers? Do you think – or do you think that it’s opened up a significantly larger customer pool or a mix of those two? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "So, let me talk about profitability, but Nikesh will have the answer to your second on display. Look, we don’t comment on YouTube. What I can tell you is we are incredibly pleased by its trajectory. I mean YouTube is – you take a step back, it’s two billion views per day in its fifth year of existence. It’s won over a billion monetization videos per week. It’s a huge kind of a first page and it’s aggregating audiences and you see it today to the top brand advertiser is showing up for it, right. So on the World Cup you saw the Sonys and the Cokes and the – I mean this is the power of YouTube today. It’s like a worldwide audience. So, in that sense I would argue just read in the TVs [ph], it’s a great business for us. On the display side, Nikesh?"
},
{
"speaker": "Nikesh Arora",
"text": "Yes, just to add to what Patrick said, to be fair, what display and YouTube has given us it’s allowed us in the case of large search customers to complement the portfolio in terms of being able to offer integrated campaigns, which go all the way from branded sites like YouTube to networks like the Google Display Network and to be able to sort of co-mingle lab research. Not only that many advertisers now actually co-mingle that with television ads as well as their print programs. So you see a much more integrated campaign capability that begins to happen. Here we got examples recently like Patrick mentioned in the Sony folks organ [ph] at the World Cup. What’s interesting is Procter and Gamble has become one of our larger advertisers this quarter. That’s primarily driven by the ability of CBG companies to both see the value of search in their ability to build a brand where they figured out that people research online and – sorry, research – yes, research online and purchase offline; we just call it the ROPO effect. People like P&G are beginning to see that impact. Other consumer companies are beginning to see that impact. In addition to that we are seeing like Patrick mentioned the Omnicom deal, which we just announced, agencies are beginning to realize that this is an integrated buy. This is a buy you need to do across multiple properties not just YouTube, the Google Display Network and the search network hence the notion of trying to create a trading desk not just with people like Omnicom, but we have deals in places, Publicis and Roopan [ph] et cetera as well."
},
{
"speaker": "Jane Penner",
"text": "We are ready for the next question please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Jason Helfstein from Oppenheimer and Company."
},
{
"speaker": "Jason Helfstein",
"text": "Yes, hi, thanks. Can you comment on Android/Chrome as an operating system? So when we think about Android in and of itself on a mobile device or on a particularly on like a cell phone, we can see kind of the revenue opportunity over time with ads and – basically on apps. When you think about Android or Chrome as perhaps an operating system for tablets or for computers, is there ever a revenue opportunity in the software of shall we think of it the same way as we think about Android today? Thanks."
},
{
"speaker": "Jonathan Rosenberg",
"text": "I think – this is Jonathan – I think it’s probably too early to answer that question. You know I think we are mostly focused with Android on building out the platform on getting more smart phones out. And on the Chrome side, we are – it’s still too early to say."
},
{
"speaker": "Jason Helfstein",
"text": "Thank you."
},
{
"speaker": "Jane Penner",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "And we’ll take our next question from Scott Devitt from Morgan Stanley."
},
{
"speaker": "Scott Devitt",
"text": "Hi, thanks for taking the question. Regarding paid clicks up 15% year-over-year, it’s been pretty consistently in the teens for almost two years now. I was wondering if you can just talk about may be the top three or four drivers that’s keeping that rate at such robust levels for such an extended period of time? Thank you."
},
{
"speaker": "Jonathan Rosenberg",
"text": "This is Jonathan. I think the biggest thing is just the continued secular shift in advertising from things offline that are not measurable to the ROI-based model of search advertising where the advertisers can actually see the benefits and the ROI that they are receiving on the money that they are spending. We did see a good bit of that during the recession. I think there was a disproportionate fraction of budgets that were spent on things were the ROI can be tracked. I think on our side we are doing a lot in terms of ads quality, as I mentioned, in my scripted remarks. And I think the ad format efforts that both Nikesh and I talked about also serve to increasingly drive clicks."
},
{
"speaker": "Nikesh Arora",
"text": "You know, I – just to complement this, I think that we have seen in fact I would argue the paid clicks move quite a bit over the last couple of years in response to the recession. We have seen that and we’ve seen a great recovery in Q1 and Q2 and on a year-over-year basis. I think that for us what’s really interesting is people are searching, people are – secular trends as Jonathan said are happening and because people are searching, people are clicking and the quality of the ad network and the products themselves continue to improve. I mean we just see the symbiotic relationship happening."
},
{
"speaker": "Jane Penner",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Youssef Squali from Jefferies."
},
{
"speaker": "Youssef Squali",
"text": "Thank you very much. Two quick questions I guess this is for Patrick. Patrick, as you look at your business needs for the next couple of quarters, do you think that your level of hiring and your level of CapEx which this quarter has doubled from the prior quarter is sustainable, is it at the level you need to get to where you want to get to? And second what are your views on contextual searches that have been implemented by the other search competitors and which at least on the surface seems to have you guys losing some market share? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "So, let me – I will let Jonathan talk about contextual search in detail. On the issue of market share, just the kind of give the highest level answer, I mean there has been a lot of debate about people’s methodologies from external sources on market share and so I would just – even the press itself kind of cautioned all these numbers off late, so I would just kind of put the flag out again to say just be cautious. I mean we are very pleased with our results right now in terms of market share. And –"
},
{
"speaker": "Youssef Squali",
"text": "Do you feel you are losing market share?"
},
{
"speaker": "Patrick Pichette",
"text": "And – no. And the issues that we have is if you think of – now I just want to go back to – because there has been so much noise in this data, I think it’s important just to mention it. The – if you go back to the fundamentals of hiring and CapEx, CapEx right is lumpy. And here is a perfect example of lumpiness, right, to be able to work in Scandinavia in the winter is difficult as we said we are building a data center there. Now, it’s spring and we are working there. So, we are also adding machines and it just happens that when you get the generations of chips available and everything is available then you start rolling out. We had a bit of kind of – so the lumpiness shouldn’t surprise anybody. And I think that everybody that I had discussions with when we were at kind of like 189 million or it’s clearly on – also unsustainable at low level. So we are kind of running our plans accordingly. So just stay tuned for CapEx, but is just happened to be lumpy. In terms of hiring I think that it really is the case that we – I am going to take a step back to three quarters ago when we said look for us the recession is over. For us we see great products and we have a mindset of the next half decade and the big platforms we are building that are creating these huge ecosystems, and for us search is one and then mobile and Android as we just talked is one. And then display is amazing, right. It’s really growing. And to not put resources to actually fuel this ecosystem, which is the next decade, it’s just such an opportunity. So that’s why we are investing aggressively. We think it’s the right thing to do at the moment in the company. So – and that’s the balance we are striving. Even in Q3, right, if you think of headcount, we have a lot of people – I should call them – the people that we just graduate form university that are going to joining us, right. So there may be even be you can think of the bump of the accepted but not started because they are going to go backpacking for the summer before they come and join us. But I mean ultimately, right, we are looking at a trend of continuing to invest. And it’s the right thing at this time in the history of the company. So that’s on CapEx and on hiring. And then on contextual search, if there is something that you want to – you need a more refinancer for Jonathan – I am not sure I understand—"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I guess I am not sure what data you are looking at or what examples you are referring to."
},
{
"speaker": "Youssef Squali",
"text": "Well just I mean there – the two main competitors have adopted some processes that in a way inflates their – the number of searches that are run on their databases and you guys don’t do it. Wanted to just know if this is something that you guys may pursue as well or –"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Sure. I understand. Right, so I mean in general we don’t comment on the third-party data but what you are alluding to are basically the methodological problems that have been publicizes with respect to autoroll slide shows that generate. Basically if you think about it from a search perspective, it’s a spurious request because it’s not merely an incremental search."
},
{
"speaker": "Youssef Squali",
"text": "All right."
},
{
"speaker": "Jonathan Rosenberg",
"text": "So the thing that matters to us is ultimately consummating transactions via conversions that we are sending to advertisers. So what we care about is the number of genuine searches that users are running where they want to get directly to an answer or a website or where they are interested in actually clicking on an advertiser’s ad. It wouldn’t help us in any respect other than in generating counts in share data to cause our search – to cause the total number of searches to artificially go up if there wasn’t user intent behind them that was a value to our advertisers. So, the basic answer to your question is no."
},
{
"speaker": "Youssef Squali",
"text": "Okay. Thanks so much, thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, sir."
},
{
"speaker": "Jane Penner",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Jordan Rohan from Stifel Nicolaus."
},
{
"speaker": "Jordan Rohan",
"text": "I would like to delve a little further into some of the growth that you are seeing in the rest of the world territories. Can you talk about how much directionally growth you are seeing out of Asia versus Europe, if that’s a breakdown that you are willing to give? And if not can you talk about which countries really stand out from a growth perspective on the positive side? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "I will let Nikesh answer that."
},
{
"speaker": "Nikesh Arora",
"text": "I prefer not to talk about regions because in every region there are countries which do fantastically, there are countries which are challenged. If you are asking about Greece, I wouldn’t have to answer the question. So similarly, there are countries like Russia, like Brazil, like India, which are growing fantastically for us and continue to show good growth. It’s a combination of more advertisers; it’s a combination of Internet penetration getting higher. It’s combination of people getting savvier, advertisers getting more and more ready for the (inaudible). So we are seeing good growth this quarter. We saw good growth in Brazil, India, Russia, and we saw great growth. And then we saw good growth from many other parts of the world. So, even places like France performed for us wonderfully this quarter. So, even these are larger markets places like Australia and New Zealand performed well for us. So I am reluctant [ph] to give an answer on a specific territory, I prefer talking about countries because I don’t know how to go visit Asia."
},
{
"speaker": "Jordan Rohan",
"text": "Fair enough. Countries are even more helpful. Thank you."
},
{
"speaker": "Jane Penner",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Sandeep Aggarwal from Caris and Company."
},
{
"speaker": "Sandeep Aggarwal",
"text": "Thanks for taking my questions. Actually I have two questions, one is if you look at the sponsored clicks versus CPC last quarter, paid clicks were up 15%, CPC was up 7%. Sponsored – paid clicks remained at the same level, but CPC have come down quite a bit. I know some of this is mix shift. May be some of this is OpEx. But I guess my question is, is there any competitive dynamics or may be increasing focus towards organic search or changing user behavior (inaudible) in terms of some weakness in CPC? And then I have a follow-up."
},
{
"speaker": "Jonathan Rosenberg",
"text": "This is Jonathan. I think probably the easier way to answer the question is to just give you my quick observations on the things which are clearly driving – contributing to driving CPCs on average up versus those that are impacting them in the other direction. I don’t see anything from a user perspective or a share perspective that is obvious that’s impacting the overall equation. I think we are seeing on the positive side conversion rates improving, which is driving CPCs up. I think you r comment about the relative shift in mix to google.com from AFC does contribute positively to CPC. Google.com is obviously higher. So any mix shift there, everything else being constant, increases CPC. The obvious things that we’ve talked about in the past that push it in the other direction or emerging markets, Brazil, India and Nikesh talked about some of those examples earlier. Mobile growing in the mix and people increasingly looking for longer tail queries that monetize lower to add into their campaigns. But those are the overall factors."
},
{
"speaker": "Sandeep Aggarwal",
"text": "And—"
},
{
"speaker": "Patrick Pichette",
"text": "Sorry, Sandy, go along with your follow-up."
},
{
"speaker": "Sandeep Aggarwal",
"text": "Yes, so, Patrick, actually the other revenue actually on a year-over-year basis is showing visible slowdown versus last quarter. And you specifically made comments that DoubleClick was very strong and then based – also you have your Nexus one which is contributing second quarter in terms the – kind of incremental revenue source. In spite of these things, other revenue was noticeably slowed. So, is there [ph] some kind of slowdown in the Google enterprise business or what else is going on there?"
},
{
"speaker": "Patrick Pichette",
"text": "No, I mean in essence, it’s one word; it’s Nexus One. So, that the quarter-over-quarter of Nexus One is driving the substantially that change."
},
{
"speaker": "Jane Penner",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Aaron Kessler from ThinkEquity."
},
{
"speaker": "Aaron Kessler",
"text": "Yes, hi, a couple of question, first on China, is that China clarified that your understanding that the government is okay with renewed solutions in terms of your search link on this dot \"cn\" site. And if there is any updates on trends and traffic you can give us that you are seeing in China. Also, just in terms of click through rates for mobile on sponsored ads, any comparison you can give us there versus how you see click the rates on PC? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Okay, so I will answer the China and then I will let Jonathan talk about the click to rate mobile versus PC. On China, look, we are basically at the same place when we last discussed or last time we talked about it, which is we have – the good news is we have our license renewal but – and apart from that from a – certainly from a financial perspective I just want to reiterate to everybody, right, revenue from China is not material to our revenue. And having said that, we had decent revenues for Q2. And so given the sensitivities of everything that’s gone on with China, I hope you will understand why. I don’t want to talk more about it. We are working very closely to kind of continue to work through this situation."
},
{
"speaker": "Aaron Kessler",
"text": "Oh, good, thank you. On the click through rate mobile versus PC, Jonathan, insights?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "We don’t actually break out the relative click through rates on mobile versus the PC. I mentioned there are new formats and efforts that we’ve offered, that are starting to increase them like the click to call offering. I think the main thing that’s really going to fundamentally have to change there which is the big difference between mobile an d desktop is that today the – on a mobile phone people are actually less likely to consummate a transaction because of the logistics of entering the credit card or being signed in on a browser is somewhat more time-consuming and onerous. So I think that – for the mobile system, to move very aggressively is going to require more of those commercial transactions actually being taken and placed on the mobile devices. The display side, the AdSense for mobile is actually doing very, very well. And one of the reasons that’s doing well is sort of the opposite of what I just stated in terms of effect. On a mobile device the display ad is something that really kind of gets in your face. The screen is relatively small so you see it. It’s unlike a desktop in that you are not typically doing multiple things at once. So display I think is relatively closer to the desktop than is search based ads."
},
{
"speaker": "Aaron Kessler",
"text": "Great. Thank you."
},
{
"speaker": "Jane Penner",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Sameet Sinha from JMP Securities."
},
{
"speaker": "Sameet Sinha",
"text": "Yes, thank you very much. I just wanted to – if you could comment on this Omnicom deal that you had signed? Can you talk about what the ramifications are, what sort of advertisers do you expect will participate, and any other details would be appreciated?"
},
{
"speaker": "Patrick Pichette",
"text": "Yes, sure. You have to understand, as we look at display, there are two significant changes that are happening right. One is display buying which traditionally has been advertising – advertisers buying sites is slowly and surely shifting to audience buying. So, I as an advertiser no longer want to buy Tiffany.com or newyorktimes.com. I want to be able to say I would like 18 to 35 year olds who are savvy, who understand technology and who will be interested in my product. Now as you go towards that audience buying notion, what advertisers are looking for is they’re looking for specific inventory on specific audiences whichever site they might be on. So it becomes even more important for some sort of trading desk type phenomena to exist where an advertiser can buy across any publisher they’d like to buy. Now that makes it even more important that you can find some trading desk or trading exchange where you can have every publisher represented. Because if you have seven different networks, it’s suboptimal as an industry to have an advertiser have to go to seven different networks to be able accumulate what he insists, the different standards, the different way to seven different networks to look like. So if that can leave the ad agencies which are buying advertising – the advertisers would like to have a common platform which allows them to buy across these entire networks. And that’s what we’re working Omnicom with where they believe that if they have the right trading environment setup for their advertisers, it’s going to be tremendous value for the advertisers because advertisers come to a one-stop shop and buy across networks and also allows a tremendous efficiency because the best seller of advertiser may not be the best acquirer or a publisher. So therefore, you can separate that in some sort of an ad exchange context, which is what Omnicom is working with us on. And if you get it right, there is hundreds of millions of dollars that’s taking this kind of a deal because that allows very effective buying across-the-board on a network and every player in that ecosystem can get their fair share of the profit."
},
{
"speaker": "Sameet Sinha",
"text": "Okay. Thank you."
},
{
"speaker": "Jane Penner",
"text": "Okay. Next question please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Mayuresh Masurekar from Kaufman Brothers."
},
{
"speaker": "Mayuresh Masurekar",
"text": "Hi. Could you talk a little bit about search remarketing? It seems that you are by far the leader in search, so a lot of the spare advertisers would need Google for doing this well. So what kind of growth or traction have you seen for search remarketing? And what’s the pricing for this product compared to other display alternatives? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "We don’t do search remarketing. We do remarketing in the display side. We basically are able to go, look at what we call interest-based advertising. If you understand the certain uses or interested in certain things, we have based on their – they’re having children to allow us to use that information. We have the ability then market to them and show them ads. And that is way more effective and blindly trying to show advertising to users of clearly we’re seeing tremendous success and adhere but that’s all we do in terms of remarketing."
},
{
"speaker": "Mayuresh Masurekar",
"text": "And what’s the pricing for this compared to other alternatives?"
},
{
"speaker": "Patrick Pichette",
"text": "The pricing – look it’s very simple. The more effective the advertising is, the more likely the advertisers are willing to bid more money for it. So you should expect the more efficient we make advertising, the more relevant it become, the more ROI it generates to the advertiser. They will need to compete more aggressively with other advertisers with the same piece of real estate. So we see that. We see the effectiveness of that reflected in higher CTC for that particular product."
},
{
"speaker": "Mayuresh Masurekar",
"text": "Thank you."
},
{
"speaker": "Jane Penner",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Colin Gillis from BGC Financial."
},
{
"speaker": "Colin Gillis",
"text": "Hey Patrick, how many acquisitions this year? What is the philosophy on the financial discipline used to determine the purchase price, and then separately, with ITA competitiveness?"
},
{
"speaker": "Patrick Pichette",
"text": "I’m not going to comment on the last piece. What I’m going to say is, that we have – there’s a real kind of triangulation between two factors in our strategy for acquisitions. So think of it as talent, intellectual property and then price. And so but what we’re looking for is a sweet spot where when we find teams of people that are have clear leadership that if you think about it, the venture capital world is actually kind of voted by them surviving as long as they have and they have as a team great talent – engineering talent specifically. Then on top of that, put the second piece of it which is, they have proven that they actually have good intellectual property whether it be – whatever be up there, they’re working on or whatever in the case is you just mentioned of ITA right, a lot of interesting kind of structural data. So the third piece is obviously price. There is a price after which, is a price – there is a trade-off of on price and what we do is, we do every one of them. We ask ourselves the question, we look at the intellectual – and then you put the overarching last fit which is how does that fit within those four areas that I’ve talked earlier of which is what we’re trying to accelerate our development. So, AdMob is a perfect example of that where great technology, fantastic team at the right price and basically take a huge junk of what was our engineering roadmap and bring it today, integrate it into the team and then we have much smaller team some times of 12 to 15 individual great piece that actually on to and there is another one like that, right, when you think about the video Kotak. So it’s always the – and there are many cases where we look at them and we don’t buy them because we can find us at somewhere in those three. So I mean that’s how we think about it and it is disciplined. And we have the base about them and sometimes we kind of – we often say no. That’s how we think about it. So there are efforts (inaudible) you walk away from just because of the purchase price at the end of the day. Oh, yes we do."
},
{
"speaker": "Colin Gillis",
"text": "I think sort of (inaudible). You just talk a little bit about or help this frame how additive are mobile search is? Is there a rate of search growth you could share for users across all devices may be tied to the same login?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I don’t actually have any data but intuitively, I think that they are additive because – I mean, think about it this way, when you’re at your desktop, if you have your PC at your desktop and you mobile phone, you’re not going to do the search on your mobile phone, so almost all searches that you were otherwise doing on your desktop, I think you’re still going to do on your desktop. On the other hand, there are times when you are out with your mobile phone, and you didn’t have your desktop device, and obviously those are, by definition incremental unless of course in theory you’d remember to go back and do that search when you came back to your desktop. But I don’t think that there is much evidence that that’s the case. I think the vast majority of them are incremental. I think they’re also slightly different usage patterns across desktop and mobile. You tend to see more use of the mobile devices on weekends, which is not surprising but they don’t actually have any more specific data that proves those observations or that hypothesis."
},
{
"speaker": "Patrick Pichette",
"text": "You might imagine those curves, including the transaction curves, ultimately bend towards each other over time."
},
{
"speaker": "Colin Gillis",
"text": "I guess I don’t understand exactly what you’re saying."
},
{
"speaker": "Patrick Pichette",
"text": "Our usage – our mobile usage in the way we use our mobile efficient as we get more broader band. You’ve talked about your 4G connections."
},
{
"speaker": "Colin Gillis",
"text": "Sure."
},
{
"speaker": "Patrick Pichette",
"text": "And our desktop usage, I mean ultimately, there should be much difference between the two of them over time."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Well I think the mobile usage is, the mobile usage will grow and in many ways will be incremented because you’ll be able to do a lot more when you’re out in the field and for example being able to – in within a store, scan a barcode with your smartphone, look at the price on the shelf and determine whether or not you actually would prefer to consummate the transaction through a web-based alternative and then automatically complete the transaction. It’s a kind of thing that’s all going to be incremental and I think as these devices are able to do more of that, the people are going to do it."
},
{
"speaker": "Colin Gillis",
"text": "Yes. Right it makes sense. Thank you."
},
{
"speaker": "Jane Penner",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Heath Terry from FBR Capital Markets."
},
{
"speaker": "Heath Terry",
"text": "Great thanks. And Patrick, in looking at YouTube beyond views, it’s obvious that the majority of those views still aren’t being monetized and in a way. So what’s standing on the way of more monetization of this inventory, which, for the most part, still seems to be the user-generated content side of thing? How significant as it and does the Viacom ruling, it change your ability to monetize that inventory?"
},
{
"speaker": "Patrick Pichette",
"text": "I’m going to let Nikesh to give you the kind of high level answer and then I’ll circle back on the Viacom specific."
},
{
"speaker": "Nikesh Arora",
"text": "Okay. I don’t know, let Patrick about the Viacom but you have to understand first of all, YouTube is five years old, right. So this is a phenomenon that has been created over the last five years. We look at YouTube and we monetize it many different ways. We monetize the homepage of YouTube. We monetize more watch pages on the YouTube. We do promote your videos and looking at best new ways and looking at how we can put ads into content. Now part of the process that has been going on, is we have to continue to free up more and more inventory for it to be available for us to advertise on. So we’ve done a lot of deals recently where whether with music society around the world on the various countries around the world, but we are getting permissions to be able to show advertising in those places, which allow us to create more inventories. That’s so – that’s the inventory side of things. And we believe we’re in a good path to continue to create more and more available inventory. In addition to the inventory side, we have to now keep getting advertisers to start getting giving us quality video advertising, which can be put into YouTube. And my view on this is that, we’re in the very, very early stages of video advertising because what advertisers do, they will splice the video ad that they’ve created for television and they’ll also take it on YouTube. Now if you understand, YouTube allows you two more things which the television does not. It allows you to interact with the ad, which TV does not and most of the ads on – video ads so far are not interactive. So we expect as that begins to happen, people will start creating more and more interactive. Secondly it allows you to – it allows you to create some degree of personalization. The ad your grandmother sees and I see and my daughter see did not necessarily be the same ad for anything. So both those features we think will come into play in more and more in the advertising side. So as you get more personalization, more interactivity, as we get more inventory clarified for YouTube, we think that it’s going to create more and more decisional opportunities and you couple that with the previous conversation on display and the ability by audiences that would just provide sort of the (inaudible) indicate, as this thing goes forward."
},
{
"speaker": "Patrick Pichette",
"text": "Terry, on my side, look on – on the issue of our icon right. We’re still in the PL side. I don’t want to comment on the specifics. What I can say is two things, right. Obviously, with more clarity from this judgment, it gives us more room for experimentation that we didn’t have before because until these rules are clear, you don’t know exactly where the bar is. And with that clear bar, we now have much more room for experimentation. And then on just to comment on, if there was ever a great illustration of Nikesh’s point a minute ago. I mean, just looking the last few weeks about the Old Spice experiment on YouTube and if you have not tried that, just go on YouTube and check Old Spice about the interactivity of Twitter, Facebook, YouTube and advertise it’s just absolutely phenomenal. So it just gives you a glimpse of where the world is going and it tells you again about we’re just scratching the surface."
},
{
"speaker": "Heath Terry",
"text": "Great. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you. We’ll go to the next question."
},
{
"speaker": "Jane Penner",
"text": "Yes, operator, we have time for one more question."
},
{
"speaker": "Operator",
"text": "And we’ll take our final question from Richard Fetyko from Merriman & Company."
},
{
"speaker": "Richard Fetyko",
"text": "Now thanks guys. If you breakdown the components of your display strategy in revenue streams, how would you rank the revenue opportunity of each between YouTube, AdSense, Display Network and the Ad Exchange in the long-term?"
},
{
"speaker": "Patrick Pichette",
"text": "I’ll let Nikesh to answer it."
},
{
"speaker": "Nikesh Arora",
"text": "I think it’s very important to understand that all these things were to complement each other. The Ad Exchange allows a buyer to buy across multiple networks. So without an Ad Exchange, it makes a very inefficient for advertising we’ve bought and therefore the buyer is not going to go as fast enough. So you want to make sure you can create some consistency in standardization in the way display advertising has been bought. If you want to take the big TV dollars to start coming into display as they had in the early years. I think with Google Display Network it’s our ability to prove that we can create a network of our own of multiple publishers and create premium capability for our advertisers to be able to target those publishers. And last but not the least YouTube becomes our owned and operated property, something like us operating google.com and our Google network. So clearly the margins on our owned and operated properties are higher and that allows us to have a premium property in this space and also allows us to accumulate tremendous amounts of content which we can then that I’ll just advertising and so at present all these three are very relevant to the overall strategy, I’m not trying to prioritize anyone over the other, particularly YouTube being able to monetize bringing more TV dollars into YouTube is fantastic. Google Display Network being able to monetize at opportunity across multiple publishers is great and without Ad Exchange which if we do that’ll bind all these networks together, it is hard to see that industry growing as fast as we’d like to see it grow."
},
{
"speaker": "Patrick Pichette",
"text": "Let me give – if you allow, I mean the CFO answer. These are each and every one of them billions of dollars of revenue opportunities. They’re not hundreds of millions, they’re – the way we think about it in terms of addressable market, this is already a $20 billion industry that is growing really fast and so for us every one of them we talk. And that’s why again, we continue to invest in the total echo system. Listen we’ve had – so thank you very much for all of your questions. I want to thank Nikesh and Jonathan again for joining me. I wish to thank every Googler that’s on the call listening to us, I mean, our engineers, our sales force, our support staff, all these people, I mean every 90 days we look at our results and we continue to be so pleased. But it is really the great part of work all are Googlers. And so for that perspective, I’d just want to give two thumbs up again to the Googlers for a fantastic job over Q2 and with that in mind, I’ll turn it back over to Connie and I wish you a great summer everyone and we’ll talk to you in Q3. Connie, you can close the call please?"
},
{
"speaker": "Operator",
"text": "Thank you. And that concludes today’s conference. We thank you for your participation."
}
] | null | null |
GOOGL | 1 | 2,010 | 2010-04-16 16:30:00 | Operator: Welcome to the Google Inc. conference call. Today’s call is being recorded. At this time, I would like to turn the call over to Maria Shim, Investor Relations. Please go ahead, Ma’am.
Maria Shim: Good afternoon everyone and welcome to today’s first quarter 2010 earnings conference call. With us are Patrick Pichette, Chief Financial Officer; Jeff Huber, Senior Vice President of Engineering; Susan Wojcicki, Vice President of Jonathan Rosenberg, Senior Vice President of Product Management; and Nikesh Arora, President Global Sales Operations and Business Development. Also, as you know we are now distributing our earnings release exclusively through our newly revamped Investor Relations website located at investor.google.com. So going forward please refer to our IR website for our earnings releases as well as supplementary slide decks that accompany the calls. This call today is also being webcast from investor.google.com. A replay of this call will also be available on our website in a few hours. Now let me now quickly cover the safe harbor. Some of the statements we make today may be considered forward-looking including statements regarding investments in our innovation agenda, expected performance of our business and our expected level of capital expenditures. These statements involve risks and uncertainties that could cause actual results to differ materially and reflect our opinions only as of the date of this presentation. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings, including our annual report on Form 10-K for the year ended December 31, 2009, as well as our earnings press release for a more detailed description of the risk factors that may affect our results. Copies can be obtained from the SEC or by visiting investor.google.com. In addition, certain financial measures we use on this call, such as operating profit and operating margin, are expressed on a non-GAAP basis and have been adjusted to exclude charges relating to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and GAAP to non-GAAP reconciliation can be found in our earnings press release. With that I will now turn the call over to Patrick.
Patrick Pichette: Thank you Maria. Good afternoon. This is Patrick Pichette speaking. Thank you for joining us. Starting the New Year provides us with a great opportunity to tune and streamline our quarterly earnings communications. As a result, we have today for you a new format for the call. First, the two calls we had last year will be merged into a single call going forward and slightly longer for the Q&A. Second, Eric will not be joining us going forward so I will be leading the call. In the new format Jonathan Rosenberg and I will review the quarter with prepared remarks and then Nikesh Arora, our head of Global Sales and Operations will be joining us for Q&A. Unfortunately today Jonathan couldn’t be with us. However, we have with us Jeff Huber, our Senior Vice President of Engineering for Ads and Susan Wojcicki, our Vice President for Advertising Products sitting in for Jonathan. So here we go. Let me start by giving you some high level thoughts about our situation in Google before I go into the details of our Q1 performance. As we enter 2010 it is really clear the digital economy continues to grow rapidly and at Google our users and advertisers all continue to benefit from this profound and positive trend. Our Q1 results are simply a reflection of these trends and this really fuels our optimism as we continue to invest in innovation for the long run. Consequently, we are continuing to invest heavily in people, products and acquisitions. So you see this already in our results for Q1. On people we have already stepped up hiring which is evident obviously with the numbers presented and we expect to continue hiring aggressively through the year. We have a strong pipeline of candidates primarily focused on engineering and ad sales and we are on-boarding them to fuel our growth agenda as fast as possible. On product we continue really to push the envelope on two fronts. First, we are intensely focused on user experience. Our continued success really depends on delighting users with differentiated products that really inspire. Think of Google Goggles for example. Second, we are continuing to improve our ad business to show the right ad in the right format to the right person at the right time, all of this regardless of device. Susan and Jeff will really cover in the coming minutes both of these sections. Finally, acquisitions. We have been very active so far this year and we have a strong M&A pipeline in place. It is really designed to build on our existing focus areas and to bring new talent and new technology to Google, feeding our entrepreneurial spirit. It really matters to us. So in sum, we continue to be incredibly excited by the opportunities in front of us and in consequence we should expect to see continued investment in each of these areas. On the business front, Q1 was really a strong quarter. The healthy momentum from Q4 and the general economic recovery has simply continued, resulting in a very positive start to the New Year for us. Large advertisers have come back in force versus last year, reflecting really an improved economy and a few really key important trends. For example, it is clear now our offerings are much broader in scope. By this I mean they offer highly measurable but also integrated campaigns across search, display and mobile. As a result, our conversations with advertisers are becoming more and more strategic because of this integration. You can see this in our results and our performance. By this I mean we perform well across every major product area including search, display, mobile and enterprise in Q1, running on all cylinders. Search. Google.com was very strong. Great performance across all geographies and all major verticals including retail, travel, local, technology and finance. Growth in display was also really strong. Q4 momentum continued across all regions, products and channels. The Google Content Network was strong driven by increased demand in consumer packaged goods and entertainment. The Ad Exchange is also gaining great traction as we move all buyers and sellers into the latest version of the platform. Finally, we saw very impressive growth on You Tube with several exciting new content deals signed. Mobile. Third axis. Another great, very important area for Google is also growing very nicely benefiting from both continued growth in Smart Phone volumes and internet usage on the i-hand mobile devices. Finally, enterprise recently launched a host of successful integrations including a large deployment at, for example, KLM, just one example among many. All this great performance is reflected in our financial results and our trajectory. So I will now, if you will let me, go through our results quickly. Financially, gross revenue grew 23% year-over-year to $6.8 billion. Google Websites revenue grew up 20% year-over-year to $4.4 billion with strength, as I mentioned, across all major geographies and verticals. Our AdSense revenue was up 24% year-over-year to $2 billion reflecting again the continued strength in the Google Content Network, an important part of our display business. Other revenue was also up 68% year-over-year to $300 million and that includes the revenue from the sales of our Nexus One product. Global aggregate paid click growth remained healthy up 15% year-over-year and up 5% quarter-over-quarter. Aggregate cost per click growth was up 7% year-over-year but down 4% quarter-over-quarter. You should note that FX had a positive impact on the year-over-year on CPC growth and also a negative impact quarter-over-quarter. A lot of movement in FX year-over-year and quarter-over-quarter. Remember too this is an aggregate number which includes both Google.com and also the AdSense properties. Turning to our geographic performance revenue from the U.S. was up 22% year-over-year to $3.2 billion. In our earnings slides, which you will find on our investor relations website, you will see we have broken down our revenue by U.S., U.K. and rest of world to show the impact of FX and the benefits from our hedging programs so please refer to those slides for the exact calculations. International revenue accounted for 53% of our total revenue or $3.6 billion, up 24% year-over-year which includes $10 million of benefits from our hedging programs. This is a big difference compared to $154 million of benefits in Q1 of last year. Using fixed exchange rates our international revenue would have been roughly $242 million lower year-over-year. Finally, the U.K. was up 15% year-over-year to $842 million. So very strong performance right across the board on the revenue. Let me turn to expenses for a moment. Traffic acquisition costs were $1.7 billion or 26% of total advertising revenue. The other cost of revenue was $741 million including stock based compensation of $6 million which also expenses related to the sale of Nexus One. Finally, all operating expenses totaled $1.8 billion including approximately $285 million of stock based compensation. The increase year-over-year in OpEx was primarily due to increases in payroll and advertising and promotion expense. The results of all this, our non-GAAP operating profit which does exclude stock based compensation increased to $2.8 billion in Q1 resulting in non-GAAP operating margin of 41%, up approximately 180 basis points year-over-year. Headcount was up 800 approximately versus Q4 of last year, ending the quarter with approximately 20,600 full-time employees. Finally, our effective tax rate was 22% for Q1. For a minute let me turn to cash management. Other income and expenses was $18 million for Q1 which includes great progress in our portfolio management performance but also largely offset by the timing and accounting impact of hedging expenses associated with the FASB 133. For more detail on OI&E again please refer to the slides that accompany this call on our IR website. All of this turns out to operating cash flow which was very strong at $2.6 billion. CapEx for the quarter was $239 million again primarily related to our data center operations. As a reminder, CapEx is lumpy from quarter-to-quarter depending on when we are able to make these investments. Free cash flow finished the quarter with a strong $2.3 billion. In summary we are very pleased with the performance in Q1 across revenue, margins and cash flow. As a result we are very optimistic and therefore are pushing ahead with significant investments as I outlined to you a few moments ago. Finally, let me remind you as I do every year at this time that our revenue typically exhibits some seasonality between Q1, Q2 and Q3 because of the coming summer months. With that and before we open it up to questions we will have Susan and Jeff cover their comments and then we will come back to Q&A. Thank you. I will turn it to Susan.
Susan Wojcicki: Thanks Patrick. I would like to take this opportunity today to talk about some of the big areas of investment in our advertising business; search, display and mobile and how they are going so far. We see a lot of opportunity to innovate in these categories and to make the ads better and more useful. As we expand into new kinds of inventory beyond search our goal is to enable high performance, cross-media campaigns from within AdWords. Let me start with search. Starting about a year ago we asked ourselves why do search ads just have to be text links. In organic search the right result might be a video, a book or an update from a social network. We call this universal search. But ads are also information. They are commercial information and in many cases it may be more useful to the users and the advertiser if we show a video or picture or product in the ad. For example, if you search on the query “HP All in One Printer” some of the ads now include pictures of HP printers, prices and where you can buy them. Or if you are looking for a movie and you search “The Losers” the ad may give you the option to watch the movie trailer right within the ads. Other ads which we call site links enable advertisers to drive traffic to specific parts of their site. The query “Toys R Us” is a good example of this with links to products the retailer is promoting such as Nerf toy specials or pre-ordering Barbie. The idea is to make the ads more useful and therefore higher performing. So far they are doing very well. Click through rates on site links, for example, are up as much as 30-40%. We also want to give advertisers more data and insight into their campaigns and customers. Users usually go through a progression of searches and can interact with a number of ads before actually buying the product. For example, a user may search and click on ads for a digital camera and then on Canon before actually clicking on an ad for the Powershot S90 and buying the camera. To help use advertisers optimize for this behavior we launched a new reporting feature this quarter called the search funnel which tells advertisers about those earlier searches and the ads the users interacted with earlier in the buying process. By thinking about the right portfolio of key words, advertisers can maximize their conversions. Moving onto our display business we have seen very strong momentum. We are investing heavily in three different areas. Our platform which includes the DoubleClick suite of products, our AdExchange and our Content Network and You Tube. We are bringing the performance, efficiency and measurability to the display world like we did with search which we believe can overall grow the display market and benefit everyone. On the platform side this quarter launched the largest Google and DoubleClick integration to date, a new version of DoubleClick for publishers which has been re-written on Google technologies. The new version gives publishers more data and better tools to manage and maximize their return directly and indirectly sold ad space. We are also doubling down on our new AdExchange, the second pillar in our display strategy. It is ramping nicely and publishers and advertisers are getting great results. Some publishers are increasing their yield by as much as 130% when compared to ads sold directly to ad networks. One of the key features we are very excited about on the new exchange is real-time bidding which enables advertisers to bid on an impression by impression basis using their own data. By bringing this level of efficiency to display advertising buying everyone wins. Third, on the Content Network we have introduced a number of new features in the past year. It is a long list. Interest based advertising, frequency capping, above the fold targeting, new measurement tools and many new formats among other features. Combined they create a compelling platform for display advertisers to reach users globally. This quarter we added a new feature I would like to talk about called remarketing. Remarketing enables advertisers to show ads to users who have visited the website or the You Tube channel. So if you are shopping around for a vacation destination or go to one resort site and then leave when you visit another site in our network that resort could show you an ad with a discount coupon. As a user this means I can get a much more compelling ad. As an advertiser it is an opportunity to connect with interested users. Mobile is also doing very well. This will be an increasingly important form of advertising as user’s transition to Smart Phones with full browsers. We want to make it easy for advertisers to extend their existing campaigns to mobile rather than having to start from scratch. When advertisers run on desktop and mobile we enable them to separate their campaign staff by desktop or mobile to understand their mobile performance. Many of them are surprised by how much mobile activity they have received. Based on this information they can decide how to customize their mobile campaigns going forward. We also rolled out new formats and targeting options specific for mobile. This quarter we launched a Click to Call feature that automatically puts the phone number in the ad that is running on a Smart Phone. So if you are looking for auto insurance and do that query from your Android or iPhone the ads will include a number to call. Not surprisingly this has increased click through, or should I say call through. I am just scratching the surface of all of the innovations our ad team is working on but I have to hand it over to Jeff now. Thank you.
Jeff Huber: Thanks Susan. Across all of our products we push to push ourselves to continually innovate. We believe in open platforms that encourage everyone else to push innovation too. Our efforts in mobile are a great example of this at work. Eric Schmidt mentioned at a speech at the Mobile World Conference in Barcelona in February that we are taking a mobile first approach to most everything we do. That means doing things that take advantage of the unique characteristics of mobile Smart Phones. One of those is your Smart Phone knows where you are; your location. So this quarter we launched a feature called Near Me Now that essentially turns your location into the search query. If you go to Google.com from a Smart Phone you will see the “near me now” link right under the search box. Click on it and you will see restaurants, cafés, shops, gas stations, ATMs and other things of interest that are closest to you. Another common use case is when you are searching for something at home and then want to find it again when you are out and about. Our new Stars and Search feature helps out there. You do a search say for a chili recipe and when you click on a great result you click on the star next to it. Later when you are at the grocery store to pick up the ingredients you just repeat the search with your Smart Phone which is easy to do with the “suggest” feature. Just type the first character or two, the query will pop up or with voice search which is increasingly ubiquitous across the platforms and that star result shows right up at the top. The same starred results now work on maps too. Do a search at home or work for an address or a restaurant, click a star next to the right result and that star shows up in your map on the Smart Phone making it easy to get directions or get more information about it. These are small features in some ways but a big innovation in how Smart Phones can integrate into your everyday life. Our open platforms, Android and Chrome, are gaining a lot of momentum. Android is now powering 34 devices which is up 70% quarter-over-quarter from 12 different OEMs and over 60,000 Android devices are sold and activated every day. Our whole mantra with Android is “open.” First the Android OS itself is open for partners to modify and extend on their own. Then the Android market for apps is open for apps is open for all developers which is driving a lot of growth and great apps. We are now at over 38,000 apps, up 70% quarter-over-quarter. The net effect is to make web-ready Smart Phones more widely available. It is helping drive a lot of mobile search and apps usage. Chrome is also growing really well, mostly driven by its technical innovations and performance and its security relative to other browsers. The new Chrome feature we launched just a few weeks ago helps address language as barrier to web use around the world. Chrome can now automatically translate any page you are viewing into any one of 52 different languages. If you are an English speaker and want to read the local news in Paris you can go to Lemonde.fr and Chrome will offer to translate the page for you. Uptake has been great. We are already translating over 60 million pages per day. If we can help knock down the language barrier through innovative features like this the web becomes a lot more accessible and useful for everyone around the world. Our latest open ecosystem effort is the apps marketplace for Google Apps. Many of our enterprise customers want to move more of their operations to the cloud including applications that Google doesn’t offer like CRM, accounting, project management, workflow automation, HR, the list goes on. The apps marketplace has had thousands of enterprise apps purchased and installed already all integrated with the Google Apps experience. Finally, we are looking forward to our Google IO developer conference coming up in May. IO sold out in just a few days as developers know that in the event’s short history we have used it to announce some pretty amazing things in addition to covering the huge amount of content on how they can innovate with and leverage Google’s open platforms. When you open up the web and unleash the passion and innovation of thousands and thousands of developers great things happen. Thanks for your time. Back to Patrick.
Patrick Pichette: Thank you Jeff. Thank you Susan. What we will do now is I will invite Nikesh also to join us and ask Maria to open up the call for questions and then Maria will direct the questions for us. Maria?
Maria Shim: Operator, can we start taking questions please?
Operator: (Operator Instructions) The first question comes from the line of James Mitchell - Goldman Sachs.
James Mitchell: In your cash flow statement you have a repurchase of stock minus $97 million and I thought Google wouldn’t buy back stock until the [Ad More] acquisition was complete. Second question, with regard to domestic and international revenue it is great that your domestic revenue is growing almost as fast now as your international revenue but it is also a little bit surprising to me. Is that primarily because you have more new activity like Nexus One contributing domestically than internationally or does that reflect a more V-shaped recovery than internationally?
Patrick Pichette: I will take the first question and then I will let Nikesh answer the second one. On the first one, it is because when we bought On Tube what we wanted to do was it was a share transaction, you will remember, and because it was a share transaction we decided to actually re-buyback the shares thereafter to make it a cash transaction. It is that simple for that transaction. For the international, Nikesh?
Nikesh Arora: I think it is a combination of the things you suggest and a bit more. We are seeing a better recovery in the domestic market, definitely if you look at the comps from last year the numbers look much better. We are seeing tremendous activity from our large advert5risers who are coming back in droves and are actually reconfirming their faith in search advertising. So that is all working. Plus many of our product innovations start in the U.S. which allows us to drive those revenues faster in the U.S. Having said that, internationally our revenues did not take as material a dip as relative to the U.S. so clearly the comps are much stronger on the international side. It is a basked of many, many, many countries so we are seeing recovery in some of the major markets. Other markets are still not on that curve of recovery as we are seeing in some of the more mature, larger markets in Europe.
Operator: The next question comes from the line of Mark Mahaney – Citigroup.
Mark Mahaney: What percentage of your revenue now would come from mobile display and enterprise on a gross basis? Secondly, is Nexus One as a group profitable? Third, could you give us a little color on the CPC rate? Due to the dramatic fall off in conversion rates due to the economy in the fourth quarter of 2008 and first quarter of 2009 it is reasonable to expect perhaps CPCs would have risen more. Is there something else we should think about as kind of tempering the growth in CPCs now?
Patrick Pichette: Remind me of your first question.
Mark Mahaney: What percentage of your revenue comes from mobile display and enterprise combined?
Patrick Pichette: Unfortunately we can’t give you that. We don’t divulge that kind of information. On the Nexus One it is a profitable business for us. We don’t give more detail on the economics but we are driving the business to be a profitable business from the get go. On CPC maybe Susan can give us more comments as to what is going on there.
Susan Wojcicki: I will give a couple of comments about the CPCs. I think there are a number of trends that we see. I think it is important to remember first of all that the CPC and the numbers we release are an aggregate number and so there are a couple of things happening. One of them has to do with the growth rates of the different regions and CPCs being different in the different regions. The second thing which I believe is a long-term positive for Google but may be reflected in the CPC numbers here is we are releasing a lot of tools to enable advertisers to try to find more what I will call long-tail key words. So key words that they might not have been bidding on before hand and they might not be the competitive ones so as a result the CPCs may vary. We believe long-term that is good because we are actually selling more key words and the auctions are becoming more competitive but it may change the mix.
Operator: The next question comes from the line of Benjamin Schachter - Broadpoint Am Tech.
Benjamin Schachter: Did you expect to continue to be the default search provider on Apple products going forward? Then if I look at the quarter correctly it looks like you hired about 800 people. Is there anything unique about that number? Is that roughly the rate you think you will be hiring on a go-forward basis? Finally, if there are any other particular comments you can make around Eric not being on the call? Anything else we could read into that?
Patrick Pichette: Why don’t we take them in reverse order. Eric is everywhere. Eric is in every public…I have seen him in Abu Dhabi and then fly across to D.C. the next day. He is everywhere. The fact we have decided to streamline our process just for earnings doesn’t mean Eric is not available and he is clearly leading as spokesperson of the company. So very transparent and everywhere. On that point it was just simply an issue of streamlining and making more focus on the financial results for this call. You shouldn’t read any more or less into that decision. On the 800 people we have talked about ever since last summer that we are trying to ramp up our machine to hire back specifically in engineering, specifically in the support of sales where we see great opportunities and it takes a couple of quarters to ramp up the machine so we get the levels we want. We are very pleased with the hiring we have done. The bar at Google, let me reemphasize that, has not changed. It is incredibly high. We are very pleased with the on-boarding we have seen this quarter and now that this infrastructure is in place you can expect us to continue to invest heavily in this form. We have so many projects we would love to have more engineers right now that we would like to fuel our growth but it is really paramount for us to continue to focus on it. On the Apple, maybe Jeff can comment.
Jeff Huber: We can’t speculate on the specific relationship around search. We have historically had a strong relationship with Apple across a number of different areas and we hope to and look forward to continuing that in the future.
Operator: The next question comes from the line of Imran Khan – JP Morgan.
Imran Khan: Question about paid clicks growth rate. Considering mobile is growing significantly faster and some of the international countries growing significant faster, paid click growth rate 15% is it fair to assume the domestic paid click growth rate has [decelerated] significantly? Can you give us some color on how should we think about the domestic paid click growth rate? The second question is more of a long-term threat to Google. If you look at third party data it seems like Facebook and other social networking sites while still very low are becoming a bigger part. They are growing significantly faster as a [profit] source to a lot of your big customers like Ebay. How do you think Facebook and other social networking sites are a big long-term threat to Google’s business model?
Patrick Pichette: Why don’t I let Jeff talk about the issue of Facebook and then Susan can cover the CPC growth rate. Susan do you want to start or Jeff?
Jeff Huber: With regard to other folks out there I guess our net view is we don’t see things as a zero sum game whatsoever. Looking at the internet and vibrancy and rate of growth across the internet, other people are growing and we are very happy with our growth. We don’t see that as a significant issue.
Susan Wojcicki: I will comment on the paid click growth. Overall I think we have been very happy with the number and growth we have seen. It is a result of a number of things, certainly the advertisers coming back, some of the largest advertisers spending more money on Google as well as the growth across the board in all regions but was also some of the new ad formats that I spoke about have brought more clicks as to advertisers because they are coming up with formats that are more compelling for users and offering information that is very useful for the users on board and that is causing a lot of growth in paid clicks.
Patrick Pichette: In closing on that one, the bottom line is we see it everywhere. It is not one versus another. That is true for both of the questions you asked.
Operator: The next question comes from the line of Justin Post – BAS-ML.
Justin Post: Last year you were able to give us some intra quarter guidance about how the quarter started and ended. Do you feel better about a trajectory of year-over-year growth exiting the quarter than you did entering the quarter? Secondly on marketing spend I think it is up 48% year-over-year excluding stock based comp. I always thought about you as more of a technology driven company. Why so much marketing spend? Can you talk about your ROI thinking about it or what is it really going to get for Google?
Patrick Pichette: On the latter one, the marketing spend, it is clear that we have opportunities and I will give you a couple of examples. One is there is a ballot in Europe right now for Chrome or there are markets in which there is a lot of appetite for on-boarding customers and so we get great ROIs. Nikesh maybe you have additional comments?
Nikesh Arora: I think it is important to understand our marketing spend for the most part is ROI based. We spend marketing dollars to go and acquire advertisers on our B2B side. We spend marketing dollars to promote various products. It is very clear for us to understand for each dollar we spend what return we get in terms of long-term value to reach a customer that [inaudible] which creates additional monetization across our properties. You can expect us to spend marketing dollars as and when we see relevant for our long-term strategy and have lots more users for our products.
Patrick Pichette: In closing on that one if you think of G&A in general at Google you will find that our G&A is actually like 20-some% as a percentage of revenue. It is not moving that much. What you see is a shift between regular G&A is actually going down which is good news. And you are seeing if we have an incremental dollar and a good ROI base we should take the opportunity on that. As it relates to your first question, we don’t give comments. We had such a crisis in the last 18 months that back then it may have made sense to give some color around quarters but clearly Q4 to Q1 we just look at the level of economic activity and it has continued to pick up which is a great benefit to Google.
Operator: The next question comes from the line of Doug Anmuth – Barclays Capital.
Doug Anmuth: On the Nexus One and in particular can you comment on how many phones you sold during the quarter and if possible you could change the distribution plan going forward so they actually are in stores rather than just online? Secondly, can you comment on China as well and perhaps give us an update there on what you are seeing and any thoughts you might have on what percent of the revenue you might be able to hold onto in that market going forward?
Patrick Pichette: I will let Jeff answer the Nexus and then I will cover China.
Jeff Huber: We are not disclosing the specific number of Nexus One devices sold. We are very happy with the device uptake and the kind of impact that has had across the industry of raising the bar and people’s expectations of what a great Smart Phone can do. I did earlier mention that across the Android landscape we are seeing more than 60,000 devices sold and activations daily. On stores, sorry we can’t comment anything about that right now.
Patrick Pichette: Let me comment on China. We have explained to people that the revenue numbers for China were kind of immaterial to the financial performance of the company in the previous blogs and communications. The bottom line though on China is this was a tough situation where we really believe we have made the right decision. Google stands for really important values like openness, user choice, protection of privacy and in a company that remains true to its values that is what you do. You make a decision that is driven by those values. Having said that, what we announced a few weeks ago or a few days ago clearly has us staying in China. We have just changed our strategy and adapted our strategy but our engineering force remains in China and will continue to develop great products. We continue to keep our sales force in place because there is still an export market and a lot of opportunity in China for sales. What we have done is moved back to Hong Kong for Search where we can offer uncensored. From that perspective, right, you should see a lot of positive moves on Google but we made the right call.
Operator: The next question comes from the line of Brian Pitz – UBS.
Brian Pitz: Can you give us an update on where you are in terms of renewing your distribution deal with News Corp? A quick question on mobile. Is there a plan B if AdMob doesn’t go through? Can you comment on whether you see mobile services eventually being delivered as such through the browser much like the PC rather than individual application downloads?
Patrick Pichette: Let me comment on AdMob and then Susan will probably get more commentary on the monetization. The case for AdMob is there is overwhelming evidence the mobile advertising industry both in terms of platforms and providers is nascent. It is incredibly competitive. It didn’t exist 24 months ago. There are dozens of ad networks out there. Even last week you may have heard there was an announcement from Apple that they were starting their own. It is incredibly competitive and that is why we believe we are very positive about making this transaction happen. The case is on our side. On the specifics of monetization maybe Susan can give you a bit more color and commentary.
Susan Wojcicki: Since you asked about Plan B, I will say Google does have a monetization product for monetizing Google applications AdSense for mobile applications and that is a product we are investing in and we have seen good growth with that one. I just want to reiterate the point Patrick said which is we see this as a very new and nascent market. It is less than 2 years old and there is a lot of competition in this market. We are continuing to work with the FTC on AdMob. Your other comment was about applications versus web. Google is investing and believes that HTML 5 has the opportunity to enable a lot richer applications on the web. That is something we are investing in and we will see over time how applications and HTML 5 both develop.
Patrick Pichette: Let me go back to the very first question you asked which I think the News Corp question was around the MySpace deal. We are working…Google wants every partner in the sense that it is good for the ecosystem it is good for the partners. It gives them opportunities for monetization. We are in negotiations right now of a deal that is to be renewed. These deals like in the case of that specific one, a number of years ago with completely different industry dynamics. We are working with them to find a real win/win and stay tuned for when we have an announcement.
Operator: The next question comes from the line of Spencer Wang - Credit Suisse.
Spencer Wang: On the paid click growth which was up 15% year-over-year that actually reaccelerated for the first time in a couple of years. So I was wondering if you could just give us a sense of what is driving that? Is it a combination of Site links, how much of it is mobile, etc.? Secondly, G&A looks like X stock comp it was actually down year-over-year. Is that kind of the rough right absolute level we should be thinking about for the rest of the year?
Susan Wojcicki: On paid click I think it is a combination of a lot of different factors and it is really important to remember this is also an aggregate number across all of our businesses. So as we saw advertisers come back and start spending again driven by a lot of our largest advertisers really increasing their spend as well as Google and the ad team bringing a lot of new types of products to market in terms of the Site Link product which has not just one place to click but multiple places to click, we started seeing advertisers have higher click through and so all of those higher click throughs that I talked about do manifest themselves in terms of the aggregate paid click number. Mobile is a component of many different types of inventory that Google is expanding to, to increase the overall paid click number.
Patrick Pichette: On the G&A, the short answer is we are going to continue to be disciplined just like you see in the run rate and ramp up you see. We are very disciplined. This place continues to be frugal in many ways. On the other side we are hiring. We are hiring and it is obviously lumpy. So the point is, every time I can find another great engineer to add to the Chrome OS platform I am going to hire them. We are going to hire them. Google needs them. On the flip side there is a lot of discipline around. It is not like you do whatever you want around here. There is discipline.
Operator: The next question comes from the line of Ross Sandler – RBC Capital Markets.
Ross Sandler: If you look at year-over-year growth in the U.K. versus ROW on an organic basis they were about the same. Can you talk about what areas in ROW are outperforming and which ones are underperforming? You had mentioned a month or two ago there was some paid click clean up in the fourth quarter. Was there any of that in 1Q and can you talk about the growth rate of O&O clicks versus Google website clicks versus partner site clicks?
Nikesh Arora: In terms of U.K. versus rest of the world I think rest of the world for us performed even better than the U.K. did in the last quarter. Having said that as I mentioned there are parts of the rest of the world which are continuing to perform really well for us. Places like Brazil, which we talked about last quarter, places like Russia, etc. continue to perform well. Some parts of the European economy as you are aware which are still undergoing some correction like Greece where you clearly can’t expect us to be performing too well. There are pockets of strong performance in rest of the world. They are pretty much in line with our expectations in terms of trends we are seeing which are dependent on broadband penetration and dependent on the e-commerce activity and depending on the small businesses adoption of the internet. As those curves continue to go up we continue to see correspondingly good performance in those markets. We are planning our growth strategies in the markets along those lines.
Patrick Pichette: The key word for refinancing for Greece should be pretty [popular].
Nikesh Arora: Unfortunately I don’t think there are 30 billion Euros on the internet for them to get. We would love some advertising business. Now you made me forget your other question. We did do slightly outside of normal cleanup in the last quarter. We are constantly making sure we are taking care of spam and we are taking care of advertising situations where we don’t believe that is appropriate business. We do that on a regular basis. We have done nothing extraordinary this quarter. Last quarter we did look at our policies in certain areas and cleaned it up which is why we mentioned it.
Operator: The next question comes from the line of Mary Meeker – Morgan Stanley.
Mary Meeker: On the cost per click decline of 4% sequentially by our math if you exclude FOREX the decline was probably closer to 2.5%. I want to rank order the drivers of our sequential decline. Our thinking is that FOREX was the number one driver of the decline. The second was the geographic mix which is an ongoing issue. Third was the tools Susan spoke about to find more long-tail keywords which over time should drive CPC higher or certainly assist CPC. The fourth was the slower economic recovery in Europe versus the U.S. and your comment about Greece related to that. Fifth was another Susan comment, the product innovations roll out in the U.S. first which over time as they roll out in the non-U.S. markets should help CPCs outside of the U.S. One you really didn’t mention was mobile which is probably a factor as well. Is that the right laundry list of drivers of the sequential CPC decline and the right list and the right order in your view?
Patrick Pichette: I think that you have in essence the right laundry list. I can tell you the FX, anybody that looks at public information on FX, it is a big contributor to that 4%. For the other last element of the equation is always the mix between Google properties versus the partner properties which also has and especially in the case of international the U.K. So you have all of the elements you talked about plus you have to look at the mix between the [inaudible] properties versus the partner properties. We don’t give you the breakdown of all of the elements as you know but you have the right basket if you include the last one I just gave you.
Mary Meeker: A question and I am going to give you a fun name, you have been telling us about lumpiness in CapEx for a really long time. CapEx has been actually very constrained. The phrase is going to be lumpy but disciplined. You have been talking about investments in people for the last couple of quarters. You have increased your headcount about 4% sequentially but your operating spending per employee was flat sequentially. The question we have is as you grow as you should do you think you can continue to keep OpEx per employee flat sequentially? So we will call it lumpy but disciplined?
Patrick Pichette: That is the intent. The intent is you onboard Googlers. You take real estate, you take computers, you take computing power but for the model we have right now in the spaces we are it is really about software development and sales. That is the intent. On the CapEx side I could argue it could grow 8% quarter-over-quarter but you are absolutely right we are very disciplined about it and we are very proud of in fact getting so much yield out of our infrastructure. Remember, I tell this because it will happen just like we talked about a few quarters ago we were ramping up on hiring, in the same way when there is a great opportunistic purchase on assets we will be there.
Operator: The next question comes from the line of Jeetil Patel – Deutsche Bank.
Jeetil Patel: Coming off the bottom obviously from an ad market standpoint can you talk about are you seeing from your marketers at least in the U.S. and customers a different allocation of ad dollars between search and display ads and other initiatives as the product listings and the like as you come up from Q4 to Q1 and beyond? Second question, I guess we continue to believe in your investing in the business. I am curious with the incremental 800 ads is there one or two sets of projects you are allocating incremental investment against whether it be mobile or You Tube or what have you? Just give us a flavor of where you are headed from a product innovation and a traffic growth standpoint.
Patrick Pichette: Jeff can talk about all of the areas where we are deploying the engineering. Obviously Nikesh will answer the first quarter. Jeff do you want to give us a sense of where we are plowing resources?
Jeff Huber: It is a combination of the core businesses that is strong and growing. We are continuing to invest in that. Susan mentioned in her section a lot of the innovations and new products we have introduced in the core search and display ad business. Some of the other major areas of engineering investment are some of the things I cited; the open platforms Android and Chrome are growing very quickly and having a big impact. We are also investing incrementally in apps in the enterprise business where we are seeing very strong growth and a lot of customer uptake there.
Nikesh Arora: Let me answer the headcount question first and then I can go back and talk about the marketers and advertising. As Jeff mentioned on the business side we are continuing to add resources selectively in search as we see the market continuing to grow as well as deploying it in markets where we see higher growth as I mentioned earlier. In addition to that we are putting significant amount of resources in our display space as [inaudible] continues to enhance our display offering and give us more features. That will continue to be a focus for us throughout the year going forward. In terms of what we are seeing from [marketers] I think the pull back we have seen about 6-9 months ago is gone. What has also happened in parallel is I continue to see tremendous amounts of capability building the advertiser side. One of the challenges we always have you can go to an advertiser, pitch them with a tremendous search campaign. However, they feel like we lead the horse to water but they still have trouble taking a drink because their websites aren’t fully capable of conducting the e-commerce transactions to the level they would like. Having said I have seen tremendous amounts of capability improvement in the last 6-9 months across a majority of our mature markets, the U.S., U.K., Germany, France, etc. which allows us to go in with this bigger, larger campaigns for these guys and they are beginning to understand that search is diminishing inventory because if they don’t buy it today it is not going to be there tomorrow. So they have to be more willing to be flexible with their budgets and be open depending on what is going on. They are getting more and more averse to waive the search. Clearly we are seeing them get more flexible with their dollars in the search side. They are beginning to understand the value of the products like Susan mentioned like remarketing and how to use the display networks effectively and the CPC model and a CPM model depending on which one they choose. So clearly the more mature markets we are seeing awareness of the digital marketplace. We are seeing them keep the search [while it’s open] and we are seeing tremendous amounts of engagement on the search side.
Patrick Pichette: In closing on that point I think the display market is seeing such an evolution because of the simplicity of the tools that did not exist a year ago are now here and people now have the choice of participating and participating actively. In these campaigns now we would love to have the flexibility from one to another to find the right audience. A tremendous progress we have seen in display and we are very encouraged by what we see.
Jeetil Patel: A question to Nikesh’s commentary if companies are having a hard time getting the transaction in the door once they get the traffic and small business has that same issue, I guess would you ever look at a model such as a percentage of sales model to eliminate that issue and have the transaction occur onsite?
Nikesh Arora: I want to make sure you interpret what I said carefully. I think we said most of the small businesses are very, very good with their allocation. As we have seen from a few quarters ago we have seen a dip in large advertisement and more small advertising because it is always ROI driven and they generally understand how to bring in a search lead and how to convert that search lead into dollars. I think the challenge with the large advertiser has been that a proportional total ad spend to revenue and not being able to allocate a lot of dollars to their search. Now as they build up their capability they are able to do that more effectively.
Susan Wojcicki: One additional thing I would like to add is we definitely see an opportunity to move to taking a percentage of the conversions. In fact we call this CPA, cost per acquisition. One of the products that was developed in this area that we are optimistic about is the product ad product. The way that works is the way the retailer just gives us all of the information about their product; price, listing, description, etc. and then Google actually does the targeting to decide where to show those ads. Then we take a percentage when the product is actually purchased when the user actually converts. We do see that as an opportunity to really simplify the process for advertisers over time and it is something we are investing in.
Operator: The next question comes from the line of Jason Helfstein – Oppenheimer.
Jason Helfstein: Let me ask just a bit about expenses. Did Nexus One have a material impact on sales and marketing expense in the quarter? Two, when we look at seasonal patterns of expenses last year they increased as a percent of revenue in the second quarter. Should we expect a similar pattern this year or is each year different based on your initiatives?
Patrick Pichette: To make it simple, on the Nexus One we did not have a material advertising for it. On the second one I wouldn’t provide any guidance for the coming quarters. I would leave it at that.
Operator: The next question comes from the line of Youseff Squali – Jefferies & Co.
Youseff Squali: I want to go back to the China issue and understand a little bit better what you said. Hong Kong a sustainable strategy for you? Doesn’t that put you at a strong disadvantage versus a native player over time? Susan, among the many products you cited; product search, site links, image ads, etc. help us understand which one or one or two are having the most impact on conversion rates and CPCs.
Patrick Pichette: On the case of China obviously we still have sales in China and the fact that we serve them in Hong Kong and from Hong Kong doesn’t stop us from having all of the opportunities we want from the Chinese market. Remember that there is a huge industrial infrastructure all around Hong Kong and South China. It is really addressing the market from a different perspective and our sales force is ready to serve them from there.
Youseff Squali: Mostly for exporters?
Patrick Pichette: Both actually. Because we really have both opportunities. What we really have done if you think about it is we have stopped censoring but the access to Google is still available for all Chinese people through .hk.
Susan Wojcicki: So from an impact standpoint some of the biggest changes that we make that impact the product and all of the metrics, not just CPC and percentage of click growth, etc. a lot of them have to do with changes in ad quality that we make in the quarter. The reason is because if we can make a percentage increase off of that very large business that can have a significant impact. We had a modest quarter in ad quality. We had more than a dozen different launches that were significant across the board and they certainly over time do play an important role in how they affect the metrics. The other thing I would like to point out that I think also is really an important thing to look at with our overall business is something we have introduced in AdWords called Opportunity Center. Opportunity Center is a way for advertisers to know this is how many more clicks I should be getting or could be getting. What we want to do is we want to give a lot more guidance to advertisers in terms of here are more key words. They are very easy to add to your key word list. We just launched this quarter Bid Suggestions to give them an understanding of what are the tradeoffs between volume and CPCs and where is the optimal place they should be bidding as well as budget suggestions. Because Opportunity Center is applied to the core business and to all of our advertisers it can move the metrics over time in terms of getting more advertisers to buy key words or increase their budgets or change their bids.
Operator: The next question comes from the line of Mark May – Needham & Co.
Mark May: I wonder if you could give some color around the paid click and cost per click growth as it relates to O&O and the network? Did paid clicks grow faster on the O&O network or on the AdSense network? Same for CPCs. The second question is there are a lot of innovative companies in the display space. Earlier you mentioned remarketing but generally speaking there are others out there doing remarketing. So my question is what are the top couple of things that Google is doing that is different in the area of display particularly from a targeting standpoint that is meaningfully differentiated?
Patrick Pichette: On the first one I will punt because we don’t divulge the spread between O&O and other properties. I am sure Susan will talk about the display innovations.
Susan Wojcicki: So you brought up some questions about remarketing and what we are doing there that is unique. I would definitely agree with you that display is a very vibrant space and there is a lot of innovation that is happening right now in the display market and I think ultimately that innovation will enable the market as a whole to grow. But one of the things that we have that is very unique from a remarketing perspective is users or advertisers can refine users across the content network. The content network because we have so many publishers on our site and because we are a global network as well it gives advertisers the opportunity to expand and find a lot more of those users across the network than they probably can with a lot of other options. The other thing we are doing from a targeting perspective is we are trying to make it really easy for advertisers to work with existing interfaces. Right now you can do remarketing within AdWords. So if you are an AdWords advertiser, you can do the remarketing there. If you are a DSA advertiser then you can also from that perspective as well. The other thing that is important because you also asked about different types of targeting, we offer a number of different targeting we think are unique. The one we are best known for is the contextual targeting. So the ability to actually figure out on a page what this page is about dynamically and then serve an ad that is matched to that one specifically. Then we also have placement targeting where we give advertisers the ability to choose where they want their ads to appear by actually selecting these are the sites and this is where I want them to appear. The combination of all of these things together give advertisers a large number of options and we are thinking about how do all of these different targeting mechanisms, how do you combine them in a way to provide the best options for the advertisers and users.
Mark May: When you say content network you do include You Tube in that?
Susan Wojcicki: Yes we do include it within there.
Operator: The next question comes from the line of Jordan Rohan – Thomas Weisel Partners.
Jordan Rohan: I have a drill down question on site links and image ads. The question I have is really how do I think about the core basicness of these new ad formats? Over what percentage of queries or what percentage of advertisers do you think it is relevant? It seems like it would be a relatively narrow set of very commercial queries for very response-driven advertisers. How far penetrated are we? How new is this?
Susan Wojcicki: You are right that site links is new and we are really just beginning to penetrate all of the advertisers that I think would benefit from the site links feature. We do see Site Links appearing mostly on navigational queries where the users is looking for the brand name or the product category but it is a very powerful tool and we believe there are still a lot of advertisers that are not using it today that would benefit from it. The other thing I would say about Site Links is it is rolled out globally and so when you look at the combination of all of the different companies and advertisers globally that could benefit from this we are just getting started because we have just started rolling this out in Q4.
Operator: The next question comes from the line of Marianne Wolk – Susquehanna Financial Group.
Marianne Wolk: With regard to your mobile advertising it sounds like it is an opt-out program now for most AdWords users. If that is true would you also include in-app ads as an opt-out mobile choice as well? Also, is it fair to say based on the comments you made about the content network the mix shifted to the content partners from the search partners by several points this quarter? Did the content network also grow much faster in the U.K. this period than in the U.S.? I know you rolled out the video and display ads on the content network. Can you talk about the uptake there and any positive impact that has had on pricing?
Patrick Pichette: Could you repeat your questions so we will all just write them down?
Marianne Wolk: On the mobile advertising side. It sounds like what you are saying is an opt-out…
Patrick Pichette: The opt-out issue. The second one was about the U.K. versus other geographies for take up rates for different formats?
Marianne Wolk: No for the content network and whether you are getting any pricing benefit there from the introduction of display and video ads recently?
Susan Wojcicki: On the mobile component I will say we do give advertisers the option. The default is for advertisers to be on search, content and mobile and the reason we do that is because we want to make it as easy as possible for advertisers to get as much reach and reach as many potential users as possible and we try to do the right thing for those advertisers. So the default is for them to be opted into both. However, we do offer the ability for advertisers to run a mobile only campaign and under that mobile only campaign we give them the option to target, for example, a specific mobile OS. We give a lot of options within the mobile category. But I really think about that more for advertisers who have the capabilities and are advanced enough to know these are the capabilities they want to do and customize their campaign in order to make it worthwhile for them. On the format question I will also say we definitely have been introducing new formats into the display network and we have been really excited about that. In fact we have a product called Display Ad Builder and Display Ad Builder is a template system that enables us to have lots of different ad formats and to add them very, very easily to our network. From an advertiser standpoint they are very, very easy too to actually start and get running is really the click, click, click and your display ad can be running. Because the content network and the way we choose which ad is actually run is an auction. If display is winning it is winning because it is actually a higher CPM ad. So by bringing display ad to the mix with text there is more competition and more variety and so when it makes sense for a display ad to run then it wins the auction and because it won the auction it is bidding more than the existing text ad. Over time that can bring positive competition to the auction.
Operator: The next question comes from the line of Aaron Kessler – Kaufman Bros.
Aaron Kessler: Can you give us a little more detail on the travel and retail verticals? I know you said all of the verticals are strong. Any more color there? And any updates on your hedging program would be helpful and your thoughts going forward with the hedging.
Patrick Pichette: Maybe I can start with the hedges and then turn it to Nikesh. Our hedging program is really effective. I want to remind everybody for us it is an insurance policy. It is an insurance policy for high volatility and specifically if the U.S. dollar strengthens dramatically. If you look at where the Euro was a year ago versus where it was 90 days ago versus where it is now, and then you go back to last year as we discussed we had booked at this time last year big hedging revenues mostly because we had such a massive appreciation of the U.S. dollar so for us very effective in finding the right sweet spot to make sure we have the right coverage. What we are caught with is the accounting rules which some quarters like last quarter had very little FAS 133 ruling through the P&L and this quarter has a disproportionate amount. They don’t represent our regular cost of hedging so it creates a bit of fluctuation for you to model but in the end we are very happy with what we are getting out of it. In terms of the verticals I will turn it to Nikesh.
Nikesh Arora: As you mentioned travel and retail have been strong. I also alluded to the capability building of e-commerce. Primarily I was talking about the retail verticals where we are seeing good strength. Travel is going strong and is steady. Retail and travel end up being one of our larger verticals in the entire landscape. Having said that, I am seeing good strength as well from CPC and entertainment because that is where a lot of the display advertisers like [focus] because those verticals even though they are smaller numbers those verticals aren’t traditionally strong search verticals but they definitely play into the display space and a lot of the display effort has been targeted at those verticals.
Operator: The next question comes from the line of Collin Gillis – BGC Partners.
Collin Gillis: Was there any tension between Sergei and Eric over China and could that be tied at all to why Eric is not on the call today?
Patrick Pichette: No. I am sorry. Thank you for the question. I have a feeling that I have heard every rumor. Thank you for asking the question so candidly. The answer is no. There is nothing going on at all. As we were doing the planning at the end of last year to all the questions, if you doubt that we actually scrub every department at Google I would scrub too and the question was asked is what can you do differently to be better next year? List we brought up in finance was maybe we should look at the quarterly calls and the whole process and the webcasts and one of them was hey we thought this is an innovation. It has nothing to do with that.
Collin Gillis: The newer ad format, does that provide any lift at all to the CPC? Click to play video, along those lines?
Patrick Pichette: I think it is one to understand. Some of the newer ad formats [audio fades] CPC based where newer ad formats are sold like traditionally in the display space we sell them as launch pages or home pages. So they are not paid click by click.
Operator: The next question comes from the line of Scott Devitt – Morgan Stanley.
Scott Devitt: Just to follow-up on Marianne’s laundry list question, the comment about site revenue and network revenue mix, the site revenue and network revenue were both flat sequentially. I was wondering if you are suggesting that CPCs in the network are actually declining and that was a contributor to the sequential decline in CPC? Secondly, you recently indicated 50 million Chrome users and I think the Smart Phone shipments have been roughly 6 million per quarter run rate. Your thoughts on shipping a tablet to take advantage of this momentum?
Patrick Pichette: Let me answer in two ways. We are really delighted by the Chrome take up rate. It is a fast browser. It is a secure browser. It has all the elements that we have told about it. So this is a terrific opportunity. In terms of tablets, the one announcement we made last year that you will remember with the launch of Chrome OS is we are working with manufacturers to have a netbook out sometime in the fall. We are continuing to work diligently on this. We are very excited about it. We think there is going to be a ton of innovation coming out of that. So there is no doubt that we are pushing for it for all of the reasons you were mentioning. Can you remind me of your first question?
Scott Devitt: The addition to the list earlier in terms of drivers of changes in CPC with the mix shift between site and network. As we go back and look at the sequential growth rate of Google Site revenue and Google Network revenue they were both basically flat. I was wondering if there was any implication from that CPC and one of those two actually changed more than the other?
Patrick Pichette: I don’t have the answer to that. What we will do is we will follow-up with you.
Maria Shim: I think we are done with questions so I am going to turn it over to Patrick for some closing thoughts.
Patrick Pichette: I just want to thank everybody for joining us today. I want to thank every Googler as well who listens to the call. We have Googlers all over the world working so diligently and creating these incredible products and all the options we have. Thanks for your time. We look forward to talking to you at the end of Q2. I will let the operator close the call.
Operator: This concludes today’s conference. We thank you for your participation. | [
{
"speaker": "Operator",
"text": "Welcome to the Google Inc. conference call. Today’s call is being recorded. At this time, I would like to turn the call over to Maria Shim, Investor Relations. Please go ahead, Ma’am."
},
{
"speaker": "Maria Shim",
"text": "Good afternoon everyone and welcome to today’s first quarter 2010 earnings conference call. With us are Patrick Pichette, Chief Financial Officer; Jeff Huber, Senior Vice President of Engineering; Susan Wojcicki, Vice President of Jonathan Rosenberg, Senior Vice President of Product Management; and Nikesh Arora, President Global Sales Operations and Business Development. Also, as you know we are now distributing our earnings release exclusively through our newly revamped Investor Relations website located at investor.google.com. So going forward please refer to our IR website for our earnings releases as well as supplementary slide decks that accompany the calls. This call today is also being webcast from investor.google.com. A replay of this call will also be available on our website in a few hours. Now let me now quickly cover the safe harbor. Some of the statements we make today may be considered forward-looking including statements regarding investments in our innovation agenda, expected performance of our business and our expected level of capital expenditures. These statements involve risks and uncertainties that could cause actual results to differ materially and reflect our opinions only as of the date of this presentation. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings, including our annual report on Form 10-K for the year ended December 31, 2009, as well as our earnings press release for a more detailed description of the risk factors that may affect our results. Copies can be obtained from the SEC or by visiting investor.google.com. In addition, certain financial measures we use on this call, such as operating profit and operating margin, are expressed on a non-GAAP basis and have been adjusted to exclude charges relating to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and GAAP to non-GAAP reconciliation can be found in our earnings press release. With that I will now turn the call over to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you Maria. Good afternoon. This is Patrick Pichette speaking. Thank you for joining us. Starting the New Year provides us with a great opportunity to tune and streamline our quarterly earnings communications. As a result, we have today for you a new format for the call. First, the two calls we had last year will be merged into a single call going forward and slightly longer for the Q&A. Second, Eric will not be joining us going forward so I will be leading the call. In the new format Jonathan Rosenberg and I will review the quarter with prepared remarks and then Nikesh Arora, our head of Global Sales and Operations will be joining us for Q&A. Unfortunately today Jonathan couldn’t be with us. However, we have with us Jeff Huber, our Senior Vice President of Engineering for Ads and Susan Wojcicki, our Vice President for Advertising Products sitting in for Jonathan. So here we go. Let me start by giving you some high level thoughts about our situation in Google before I go into the details of our Q1 performance. As we enter 2010 it is really clear the digital economy continues to grow rapidly and at Google our users and advertisers all continue to benefit from this profound and positive trend. Our Q1 results are simply a reflection of these trends and this really fuels our optimism as we continue to invest in innovation for the long run. Consequently, we are continuing to invest heavily in people, products and acquisitions. So you see this already in our results for Q1. On people we have already stepped up hiring which is evident obviously with the numbers presented and we expect to continue hiring aggressively through the year. We have a strong pipeline of candidates primarily focused on engineering and ad sales and we are on-boarding them to fuel our growth agenda as fast as possible. On product we continue really to push the envelope on two fronts. First, we are intensely focused on user experience. Our continued success really depends on delighting users with differentiated products that really inspire. Think of Google Goggles for example. Second, we are continuing to improve our ad business to show the right ad in the right format to the right person at the right time, all of this regardless of device. Susan and Jeff will really cover in the coming minutes both of these sections. Finally, acquisitions. We have been very active so far this year and we have a strong M&A pipeline in place. It is really designed to build on our existing focus areas and to bring new talent and new technology to Google, feeding our entrepreneurial spirit. It really matters to us. So in sum, we continue to be incredibly excited by the opportunities in front of us and in consequence we should expect to see continued investment in each of these areas. On the business front, Q1 was really a strong quarter. The healthy momentum from Q4 and the general economic recovery has simply continued, resulting in a very positive start to the New Year for us. Large advertisers have come back in force versus last year, reflecting really an improved economy and a few really key important trends. For example, it is clear now our offerings are much broader in scope. By this I mean they offer highly measurable but also integrated campaigns across search, display and mobile. As a result, our conversations with advertisers are becoming more and more strategic because of this integration. You can see this in our results and our performance. By this I mean we perform well across every major product area including search, display, mobile and enterprise in Q1, running on all cylinders. Search. Google.com was very strong. Great performance across all geographies and all major verticals including retail, travel, local, technology and finance. Growth in display was also really strong. Q4 momentum continued across all regions, products and channels. The Google Content Network was strong driven by increased demand in consumer packaged goods and entertainment. The Ad Exchange is also gaining great traction as we move all buyers and sellers into the latest version of the platform. Finally, we saw very impressive growth on You Tube with several exciting new content deals signed. Mobile. Third axis. Another great, very important area for Google is also growing very nicely benefiting from both continued growth in Smart Phone volumes and internet usage on the i-hand mobile devices. Finally, enterprise recently launched a host of successful integrations including a large deployment at, for example, KLM, just one example among many. All this great performance is reflected in our financial results and our trajectory. So I will now, if you will let me, go through our results quickly. Financially, gross revenue grew 23% year-over-year to $6.8 billion. Google Websites revenue grew up 20% year-over-year to $4.4 billion with strength, as I mentioned, across all major geographies and verticals. Our AdSense revenue was up 24% year-over-year to $2 billion reflecting again the continued strength in the Google Content Network, an important part of our display business. Other revenue was also up 68% year-over-year to $300 million and that includes the revenue from the sales of our Nexus One product. Global aggregate paid click growth remained healthy up 15% year-over-year and up 5% quarter-over-quarter. Aggregate cost per click growth was up 7% year-over-year but down 4% quarter-over-quarter. You should note that FX had a positive impact on the year-over-year on CPC growth and also a negative impact quarter-over-quarter. A lot of movement in FX year-over-year and quarter-over-quarter. Remember too this is an aggregate number which includes both Google.com and also the AdSense properties. Turning to our geographic performance revenue from the U.S. was up 22% year-over-year to $3.2 billion. In our earnings slides, which you will find on our investor relations website, you will see we have broken down our revenue by U.S., U.K. and rest of world to show the impact of FX and the benefits from our hedging programs so please refer to those slides for the exact calculations. International revenue accounted for 53% of our total revenue or $3.6 billion, up 24% year-over-year which includes $10 million of benefits from our hedging programs. This is a big difference compared to $154 million of benefits in Q1 of last year. Using fixed exchange rates our international revenue would have been roughly $242 million lower year-over-year. Finally, the U.K. was up 15% year-over-year to $842 million. So very strong performance right across the board on the revenue. Let me turn to expenses for a moment. Traffic acquisition costs were $1.7 billion or 26% of total advertising revenue. The other cost of revenue was $741 million including stock based compensation of $6 million which also expenses related to the sale of Nexus One. Finally, all operating expenses totaled $1.8 billion including approximately $285 million of stock based compensation. The increase year-over-year in OpEx was primarily due to increases in payroll and advertising and promotion expense. The results of all this, our non-GAAP operating profit which does exclude stock based compensation increased to $2.8 billion in Q1 resulting in non-GAAP operating margin of 41%, up approximately 180 basis points year-over-year. Headcount was up 800 approximately versus Q4 of last year, ending the quarter with approximately 20,600 full-time employees. Finally, our effective tax rate was 22% for Q1. For a minute let me turn to cash management. Other income and expenses was $18 million for Q1 which includes great progress in our portfolio management performance but also largely offset by the timing and accounting impact of hedging expenses associated with the FASB 133. For more detail on OI&E again please refer to the slides that accompany this call on our IR website. All of this turns out to operating cash flow which was very strong at $2.6 billion. CapEx for the quarter was $239 million again primarily related to our data center operations. As a reminder, CapEx is lumpy from quarter-to-quarter depending on when we are able to make these investments. Free cash flow finished the quarter with a strong $2.3 billion. In summary we are very pleased with the performance in Q1 across revenue, margins and cash flow. As a result we are very optimistic and therefore are pushing ahead with significant investments as I outlined to you a few moments ago. Finally, let me remind you as I do every year at this time that our revenue typically exhibits some seasonality between Q1, Q2 and Q3 because of the coming summer months. With that and before we open it up to questions we will have Susan and Jeff cover their comments and then we will come back to Q&A. Thank you. I will turn it to Susan."
},
{
"speaker": "Susan Wojcicki",
"text": "Thanks Patrick. I would like to take this opportunity today to talk about some of the big areas of investment in our advertising business; search, display and mobile and how they are going so far. We see a lot of opportunity to innovate in these categories and to make the ads better and more useful. As we expand into new kinds of inventory beyond search our goal is to enable high performance, cross-media campaigns from within AdWords. Let me start with search. Starting about a year ago we asked ourselves why do search ads just have to be text links. In organic search the right result might be a video, a book or an update from a social network. We call this universal search. But ads are also information. They are commercial information and in many cases it may be more useful to the users and the advertiser if we show a video or picture or product in the ad. For example, if you search on the query “HP All in One Printer” some of the ads now include pictures of HP printers, prices and where you can buy them. Or if you are looking for a movie and you search “The Losers” the ad may give you the option to watch the movie trailer right within the ads. Other ads which we call site links enable advertisers to drive traffic to specific parts of their site. The query “Toys R Us” is a good example of this with links to products the retailer is promoting such as Nerf toy specials or pre-ordering Barbie. The idea is to make the ads more useful and therefore higher performing. So far they are doing very well. Click through rates on site links, for example, are up as much as 30-40%. We also want to give advertisers more data and insight into their campaigns and customers. Users usually go through a progression of searches and can interact with a number of ads before actually buying the product. For example, a user may search and click on ads for a digital camera and then on Canon before actually clicking on an ad for the Powershot S90 and buying the camera. To help use advertisers optimize for this behavior we launched a new reporting feature this quarter called the search funnel which tells advertisers about those earlier searches and the ads the users interacted with earlier in the buying process. By thinking about the right portfolio of key words, advertisers can maximize their conversions. Moving onto our display business we have seen very strong momentum. We are investing heavily in three different areas. Our platform which includes the DoubleClick suite of products, our AdExchange and our Content Network and You Tube. We are bringing the performance, efficiency and measurability to the display world like we did with search which we believe can overall grow the display market and benefit everyone. On the platform side this quarter launched the largest Google and DoubleClick integration to date, a new version of DoubleClick for publishers which has been re-written on Google technologies. The new version gives publishers more data and better tools to manage and maximize their return directly and indirectly sold ad space. We are also doubling down on our new AdExchange, the second pillar in our display strategy. It is ramping nicely and publishers and advertisers are getting great results. Some publishers are increasing their yield by as much as 130% when compared to ads sold directly to ad networks. One of the key features we are very excited about on the new exchange is real-time bidding which enables advertisers to bid on an impression by impression basis using their own data. By bringing this level of efficiency to display advertising buying everyone wins. Third, on the Content Network we have introduced a number of new features in the past year. It is a long list. Interest based advertising, frequency capping, above the fold targeting, new measurement tools and many new formats among other features. Combined they create a compelling platform for display advertisers to reach users globally. This quarter we added a new feature I would like to talk about called remarketing. Remarketing enables advertisers to show ads to users who have visited the website or the You Tube channel. So if you are shopping around for a vacation destination or go to one resort site and then leave when you visit another site in our network that resort could show you an ad with a discount coupon. As a user this means I can get a much more compelling ad. As an advertiser it is an opportunity to connect with interested users. Mobile is also doing very well. This will be an increasingly important form of advertising as user’s transition to Smart Phones with full browsers. We want to make it easy for advertisers to extend their existing campaigns to mobile rather than having to start from scratch. When advertisers run on desktop and mobile we enable them to separate their campaign staff by desktop or mobile to understand their mobile performance. Many of them are surprised by how much mobile activity they have received. Based on this information they can decide how to customize their mobile campaigns going forward. We also rolled out new formats and targeting options specific for mobile. This quarter we launched a Click to Call feature that automatically puts the phone number in the ad that is running on a Smart Phone. So if you are looking for auto insurance and do that query from your Android or iPhone the ads will include a number to call. Not surprisingly this has increased click through, or should I say call through. I am just scratching the surface of all of the innovations our ad team is working on but I have to hand it over to Jeff now. Thank you."
},
{
"speaker": "Jeff Huber",
"text": "Thanks Susan. Across all of our products we push to push ourselves to continually innovate. We believe in open platforms that encourage everyone else to push innovation too. Our efforts in mobile are a great example of this at work. Eric Schmidt mentioned at a speech at the Mobile World Conference in Barcelona in February that we are taking a mobile first approach to most everything we do. That means doing things that take advantage of the unique characteristics of mobile Smart Phones. One of those is your Smart Phone knows where you are; your location. So this quarter we launched a feature called Near Me Now that essentially turns your location into the search query. If you go to Google.com from a Smart Phone you will see the “near me now” link right under the search box. Click on it and you will see restaurants, cafés, shops, gas stations, ATMs and other things of interest that are closest to you. Another common use case is when you are searching for something at home and then want to find it again when you are out and about. Our new Stars and Search feature helps out there. You do a search say for a chili recipe and when you click on a great result you click on the star next to it. Later when you are at the grocery store to pick up the ingredients you just repeat the search with your Smart Phone which is easy to do with the “suggest” feature. Just type the first character or two, the query will pop up or with voice search which is increasingly ubiquitous across the platforms and that star result shows right up at the top. The same starred results now work on maps too. Do a search at home or work for an address or a restaurant, click a star next to the right result and that star shows up in your map on the Smart Phone making it easy to get directions or get more information about it. These are small features in some ways but a big innovation in how Smart Phones can integrate into your everyday life. Our open platforms, Android and Chrome, are gaining a lot of momentum. Android is now powering 34 devices which is up 70% quarter-over-quarter from 12 different OEMs and over 60,000 Android devices are sold and activated every day. Our whole mantra with Android is “open.” First the Android OS itself is open for partners to modify and extend on their own. Then the Android market for apps is open for apps is open for all developers which is driving a lot of growth and great apps. We are now at over 38,000 apps, up 70% quarter-over-quarter. The net effect is to make web-ready Smart Phones more widely available. It is helping drive a lot of mobile search and apps usage. Chrome is also growing really well, mostly driven by its technical innovations and performance and its security relative to other browsers. The new Chrome feature we launched just a few weeks ago helps address language as barrier to web use around the world. Chrome can now automatically translate any page you are viewing into any one of 52 different languages. If you are an English speaker and want to read the local news in Paris you can go to Lemonde.fr and Chrome will offer to translate the page for you. Uptake has been great. We are already translating over 60 million pages per day. If we can help knock down the language barrier through innovative features like this the web becomes a lot more accessible and useful for everyone around the world. Our latest open ecosystem effort is the apps marketplace for Google Apps. Many of our enterprise customers want to move more of their operations to the cloud including applications that Google doesn’t offer like CRM, accounting, project management, workflow automation, HR, the list goes on. The apps marketplace has had thousands of enterprise apps purchased and installed already all integrated with the Google Apps experience. Finally, we are looking forward to our Google IO developer conference coming up in May. IO sold out in just a few days as developers know that in the event’s short history we have used it to announce some pretty amazing things in addition to covering the huge amount of content on how they can innovate with and leverage Google’s open platforms. When you open up the web and unleash the passion and innovation of thousands and thousands of developers great things happen. Thanks for your time. Back to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you Jeff. Thank you Susan. What we will do now is I will invite Nikesh also to join us and ask Maria to open up the call for questions and then Maria will direct the questions for us. Maria?"
},
{
"speaker": "Maria Shim",
"text": "Operator, can we start taking questions please?"
},
{
"speaker": "Operator",
"text": "(Operator Instructions) The first question comes from the line of James Mitchell - Goldman Sachs."
},
{
"speaker": "James Mitchell",
"text": "In your cash flow statement you have a repurchase of stock minus $97 million and I thought Google wouldn’t buy back stock until the [Ad More] acquisition was complete. Second question, with regard to domestic and international revenue it is great that your domestic revenue is growing almost as fast now as your international revenue but it is also a little bit surprising to me. Is that primarily because you have more new activity like Nexus One contributing domestically than internationally or does that reflect a more V-shaped recovery than internationally?"
},
{
"speaker": "Patrick Pichette",
"text": "I will take the first question and then I will let Nikesh answer the second one. On the first one, it is because when we bought On Tube what we wanted to do was it was a share transaction, you will remember, and because it was a share transaction we decided to actually re-buyback the shares thereafter to make it a cash transaction. It is that simple for that transaction. For the international, Nikesh?"
},
{
"speaker": "Nikesh Arora",
"text": "I think it is a combination of the things you suggest and a bit more. We are seeing a better recovery in the domestic market, definitely if you look at the comps from last year the numbers look much better. We are seeing tremendous activity from our large advert5risers who are coming back in droves and are actually reconfirming their faith in search advertising. So that is all working. Plus many of our product innovations start in the U.S. which allows us to drive those revenues faster in the U.S. Having said that, internationally our revenues did not take as material a dip as relative to the U.S. so clearly the comps are much stronger on the international side. It is a basked of many, many, many countries so we are seeing recovery in some of the major markets. Other markets are still not on that curve of recovery as we are seeing in some of the more mature, larger markets in Europe."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Mark Mahaney – Citigroup."
},
{
"speaker": "Mark Mahaney",
"text": "What percentage of your revenue now would come from mobile display and enterprise on a gross basis? Secondly, is Nexus One as a group profitable? Third, could you give us a little color on the CPC rate? Due to the dramatic fall off in conversion rates due to the economy in the fourth quarter of 2008 and first quarter of 2009 it is reasonable to expect perhaps CPCs would have risen more. Is there something else we should think about as kind of tempering the growth in CPCs now?"
},
{
"speaker": "Patrick Pichette",
"text": "Remind me of your first question."
},
{
"speaker": "Mark Mahaney",
"text": "What percentage of your revenue comes from mobile display and enterprise combined?"
},
{
"speaker": "Patrick Pichette",
"text": "Unfortunately we can’t give you that. We don’t divulge that kind of information. On the Nexus One it is a profitable business for us. We don’t give more detail on the economics but we are driving the business to be a profitable business from the get go. On CPC maybe Susan can give us more comments as to what is going on there."
},
{
"speaker": "Susan Wojcicki",
"text": "I will give a couple of comments about the CPCs. I think there are a number of trends that we see. I think it is important to remember first of all that the CPC and the numbers we release are an aggregate number and so there are a couple of things happening. One of them has to do with the growth rates of the different regions and CPCs being different in the different regions. The second thing which I believe is a long-term positive for Google but may be reflected in the CPC numbers here is we are releasing a lot of tools to enable advertisers to try to find more what I will call long-tail key words. So key words that they might not have been bidding on before hand and they might not be the competitive ones so as a result the CPCs may vary. We believe long-term that is good because we are actually selling more key words and the auctions are becoming more competitive but it may change the mix."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Benjamin Schachter - Broadpoint Am Tech."
},
{
"speaker": "Benjamin Schachter",
"text": "Did you expect to continue to be the default search provider on Apple products going forward? Then if I look at the quarter correctly it looks like you hired about 800 people. Is there anything unique about that number? Is that roughly the rate you think you will be hiring on a go-forward basis? Finally, if there are any other particular comments you can make around Eric not being on the call? Anything else we could read into that?"
},
{
"speaker": "Patrick Pichette",
"text": "Why don’t we take them in reverse order. Eric is everywhere. Eric is in every public…I have seen him in Abu Dhabi and then fly across to D.C. the next day. He is everywhere. The fact we have decided to streamline our process just for earnings doesn’t mean Eric is not available and he is clearly leading as spokesperson of the company. So very transparent and everywhere. On that point it was just simply an issue of streamlining and making more focus on the financial results for this call. You shouldn’t read any more or less into that decision. On the 800 people we have talked about ever since last summer that we are trying to ramp up our machine to hire back specifically in engineering, specifically in the support of sales where we see great opportunities and it takes a couple of quarters to ramp up the machine so we get the levels we want. We are very pleased with the hiring we have done. The bar at Google, let me reemphasize that, has not changed. It is incredibly high. We are very pleased with the on-boarding we have seen this quarter and now that this infrastructure is in place you can expect us to continue to invest heavily in this form. We have so many projects we would love to have more engineers right now that we would like to fuel our growth but it is really paramount for us to continue to focus on it. On the Apple, maybe Jeff can comment."
},
{
"speaker": "Jeff Huber",
"text": "We can’t speculate on the specific relationship around search. We have historically had a strong relationship with Apple across a number of different areas and we hope to and look forward to continuing that in the future."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Imran Khan – JP Morgan."
},
{
"speaker": "Imran Khan",
"text": "Question about paid clicks growth rate. Considering mobile is growing significantly faster and some of the international countries growing significant faster, paid click growth rate 15% is it fair to assume the domestic paid click growth rate has [decelerated] significantly? Can you give us some color on how should we think about the domestic paid click growth rate? The second question is more of a long-term threat to Google. If you look at third party data it seems like Facebook and other social networking sites while still very low are becoming a bigger part. They are growing significantly faster as a [profit] source to a lot of your big customers like Ebay. How do you think Facebook and other social networking sites are a big long-term threat to Google’s business model?"
},
{
"speaker": "Patrick Pichette",
"text": "Why don’t I let Jeff talk about the issue of Facebook and then Susan can cover the CPC growth rate. Susan do you want to start or Jeff?"
},
{
"speaker": "Jeff Huber",
"text": "With regard to other folks out there I guess our net view is we don’t see things as a zero sum game whatsoever. Looking at the internet and vibrancy and rate of growth across the internet, other people are growing and we are very happy with our growth. We don’t see that as a significant issue."
},
{
"speaker": "Susan Wojcicki",
"text": "I will comment on the paid click growth. Overall I think we have been very happy with the number and growth we have seen. It is a result of a number of things, certainly the advertisers coming back, some of the largest advertisers spending more money on Google as well as the growth across the board in all regions but was also some of the new ad formats that I spoke about have brought more clicks as to advertisers because they are coming up with formats that are more compelling for users and offering information that is very useful for the users on board and that is causing a lot of growth in paid clicks."
},
{
"speaker": "Patrick Pichette",
"text": "In closing on that one, the bottom line is we see it everywhere. It is not one versus another. That is true for both of the questions you asked."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Justin Post – BAS-ML."
},
{
"speaker": "Justin Post",
"text": "Last year you were able to give us some intra quarter guidance about how the quarter started and ended. Do you feel better about a trajectory of year-over-year growth exiting the quarter than you did entering the quarter? Secondly on marketing spend I think it is up 48% year-over-year excluding stock based comp. I always thought about you as more of a technology driven company. Why so much marketing spend? Can you talk about your ROI thinking about it or what is it really going to get for Google?"
},
{
"speaker": "Patrick Pichette",
"text": "On the latter one, the marketing spend, it is clear that we have opportunities and I will give you a couple of examples. One is there is a ballot in Europe right now for Chrome or there are markets in which there is a lot of appetite for on-boarding customers and so we get great ROIs. Nikesh maybe you have additional comments?"
},
{
"speaker": "Nikesh Arora",
"text": "I think it is important to understand our marketing spend for the most part is ROI based. We spend marketing dollars to go and acquire advertisers on our B2B side. We spend marketing dollars to promote various products. It is very clear for us to understand for each dollar we spend what return we get in terms of long-term value to reach a customer that [inaudible] which creates additional monetization across our properties. You can expect us to spend marketing dollars as and when we see relevant for our long-term strategy and have lots more users for our products."
},
{
"speaker": "Patrick Pichette",
"text": "In closing on that one if you think of G&A in general at Google you will find that our G&A is actually like 20-some% as a percentage of revenue. It is not moving that much. What you see is a shift between regular G&A is actually going down which is good news. And you are seeing if we have an incremental dollar and a good ROI base we should take the opportunity on that. As it relates to your first question, we don’t give comments. We had such a crisis in the last 18 months that back then it may have made sense to give some color around quarters but clearly Q4 to Q1 we just look at the level of economic activity and it has continued to pick up which is a great benefit to Google."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Doug Anmuth – Barclays Capital."
},
{
"speaker": "Doug Anmuth",
"text": "On the Nexus One and in particular can you comment on how many phones you sold during the quarter and if possible you could change the distribution plan going forward so they actually are in stores rather than just online? Secondly, can you comment on China as well and perhaps give us an update there on what you are seeing and any thoughts you might have on what percent of the revenue you might be able to hold onto in that market going forward?"
},
{
"speaker": "Patrick Pichette",
"text": "I will let Jeff answer the Nexus and then I will cover China."
},
{
"speaker": "Jeff Huber",
"text": "We are not disclosing the specific number of Nexus One devices sold. We are very happy with the device uptake and the kind of impact that has had across the industry of raising the bar and people’s expectations of what a great Smart Phone can do. I did earlier mention that across the Android landscape we are seeing more than 60,000 devices sold and activations daily. On stores, sorry we can’t comment anything about that right now."
},
{
"speaker": "Patrick Pichette",
"text": "Let me comment on China. We have explained to people that the revenue numbers for China were kind of immaterial to the financial performance of the company in the previous blogs and communications. The bottom line though on China is this was a tough situation where we really believe we have made the right decision. Google stands for really important values like openness, user choice, protection of privacy and in a company that remains true to its values that is what you do. You make a decision that is driven by those values. Having said that, what we announced a few weeks ago or a few days ago clearly has us staying in China. We have just changed our strategy and adapted our strategy but our engineering force remains in China and will continue to develop great products. We continue to keep our sales force in place because there is still an export market and a lot of opportunity in China for sales. What we have done is moved back to Hong Kong for Search where we can offer uncensored. From that perspective, right, you should see a lot of positive moves on Google but we made the right call."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Brian Pitz – UBS."
},
{
"speaker": "Brian Pitz",
"text": "Can you give us an update on where you are in terms of renewing your distribution deal with News Corp? A quick question on mobile. Is there a plan B if AdMob doesn’t go through? Can you comment on whether you see mobile services eventually being delivered as such through the browser much like the PC rather than individual application downloads?"
},
{
"speaker": "Patrick Pichette",
"text": "Let me comment on AdMob and then Susan will probably get more commentary on the monetization. The case for AdMob is there is overwhelming evidence the mobile advertising industry both in terms of platforms and providers is nascent. It is incredibly competitive. It didn’t exist 24 months ago. There are dozens of ad networks out there. Even last week you may have heard there was an announcement from Apple that they were starting their own. It is incredibly competitive and that is why we believe we are very positive about making this transaction happen. The case is on our side. On the specifics of monetization maybe Susan can give you a bit more color and commentary."
},
{
"speaker": "Susan Wojcicki",
"text": "Since you asked about Plan B, I will say Google does have a monetization product for monetizing Google applications AdSense for mobile applications and that is a product we are investing in and we have seen good growth with that one. I just want to reiterate the point Patrick said which is we see this as a very new and nascent market. It is less than 2 years old and there is a lot of competition in this market. We are continuing to work with the FTC on AdMob. Your other comment was about applications versus web. Google is investing and believes that HTML 5 has the opportunity to enable a lot richer applications on the web. That is something we are investing in and we will see over time how applications and HTML 5 both develop."
},
{
"speaker": "Patrick Pichette",
"text": "Let me go back to the very first question you asked which I think the News Corp question was around the MySpace deal. We are working…Google wants every partner in the sense that it is good for the ecosystem it is good for the partners. It gives them opportunities for monetization. We are in negotiations right now of a deal that is to be renewed. These deals like in the case of that specific one, a number of years ago with completely different industry dynamics. We are working with them to find a real win/win and stay tuned for when we have an announcement."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Spencer Wang - Credit Suisse."
},
{
"speaker": "Spencer Wang",
"text": "On the paid click growth which was up 15% year-over-year that actually reaccelerated for the first time in a couple of years. So I was wondering if you could just give us a sense of what is driving that? Is it a combination of Site links, how much of it is mobile, etc.? Secondly, G&A looks like X stock comp it was actually down year-over-year. Is that kind of the rough right absolute level we should be thinking about for the rest of the year?"
},
{
"speaker": "Susan Wojcicki",
"text": "On paid click I think it is a combination of a lot of different factors and it is really important to remember this is also an aggregate number across all of our businesses. So as we saw advertisers come back and start spending again driven by a lot of our largest advertisers really increasing their spend as well as Google and the ad team bringing a lot of new types of products to market in terms of the Site Link product which has not just one place to click but multiple places to click, we started seeing advertisers have higher click through and so all of those higher click throughs that I talked about do manifest themselves in terms of the aggregate paid click number. Mobile is a component of many different types of inventory that Google is expanding to, to increase the overall paid click number."
},
{
"speaker": "Patrick Pichette",
"text": "On the G&A, the short answer is we are going to continue to be disciplined just like you see in the run rate and ramp up you see. We are very disciplined. This place continues to be frugal in many ways. On the other side we are hiring. We are hiring and it is obviously lumpy. So the point is, every time I can find another great engineer to add to the Chrome OS platform I am going to hire them. We are going to hire them. Google needs them. On the flip side there is a lot of discipline around. It is not like you do whatever you want around here. There is discipline."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Ross Sandler – RBC Capital Markets."
},
{
"speaker": "Ross Sandler",
"text": "If you look at year-over-year growth in the U.K. versus ROW on an organic basis they were about the same. Can you talk about what areas in ROW are outperforming and which ones are underperforming? You had mentioned a month or two ago there was some paid click clean up in the fourth quarter. Was there any of that in 1Q and can you talk about the growth rate of O&O clicks versus Google website clicks versus partner site clicks?"
},
{
"speaker": "Nikesh Arora",
"text": "In terms of U.K. versus rest of the world I think rest of the world for us performed even better than the U.K. did in the last quarter. Having said that as I mentioned there are parts of the rest of the world which are continuing to perform really well for us. Places like Brazil, which we talked about last quarter, places like Russia, etc. continue to perform well. Some parts of the European economy as you are aware which are still undergoing some correction like Greece where you clearly can’t expect us to be performing too well. There are pockets of strong performance in rest of the world. They are pretty much in line with our expectations in terms of trends we are seeing which are dependent on broadband penetration and dependent on the e-commerce activity and depending on the small businesses adoption of the internet. As those curves continue to go up we continue to see correspondingly good performance in those markets. We are planning our growth strategies in the markets along those lines."
},
{
"speaker": "Patrick Pichette",
"text": "The key word for refinancing for Greece should be pretty [popular]."
},
{
"speaker": "Nikesh Arora",
"text": "Unfortunately I don’t think there are 30 billion Euros on the internet for them to get. We would love some advertising business. Now you made me forget your other question. We did do slightly outside of normal cleanup in the last quarter. We are constantly making sure we are taking care of spam and we are taking care of advertising situations where we don’t believe that is appropriate business. We do that on a regular basis. We have done nothing extraordinary this quarter. Last quarter we did look at our policies in certain areas and cleaned it up which is why we mentioned it."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Mary Meeker – Morgan Stanley."
},
{
"speaker": "Mary Meeker",
"text": "On the cost per click decline of 4% sequentially by our math if you exclude FOREX the decline was probably closer to 2.5%. I want to rank order the drivers of our sequential decline. Our thinking is that FOREX was the number one driver of the decline. The second was the geographic mix which is an ongoing issue. Third was the tools Susan spoke about to find more long-tail keywords which over time should drive CPC higher or certainly assist CPC. The fourth was the slower economic recovery in Europe versus the U.S. and your comment about Greece related to that. Fifth was another Susan comment, the product innovations roll out in the U.S. first which over time as they roll out in the non-U.S. markets should help CPCs outside of the U.S. One you really didn’t mention was mobile which is probably a factor as well. Is that the right laundry list of drivers of the sequential CPC decline and the right list and the right order in your view?"
},
{
"speaker": "Patrick Pichette",
"text": "I think that you have in essence the right laundry list. I can tell you the FX, anybody that looks at public information on FX, it is a big contributor to that 4%. For the other last element of the equation is always the mix between Google properties versus the partner properties which also has and especially in the case of international the U.K. So you have all of the elements you talked about plus you have to look at the mix between the [inaudible] properties versus the partner properties. We don’t give you the breakdown of all of the elements as you know but you have the right basket if you include the last one I just gave you."
},
{
"speaker": "Mary Meeker",
"text": "A question and I am going to give you a fun name, you have been telling us about lumpiness in CapEx for a really long time. CapEx has been actually very constrained. The phrase is going to be lumpy but disciplined. You have been talking about investments in people for the last couple of quarters. You have increased your headcount about 4% sequentially but your operating spending per employee was flat sequentially. The question we have is as you grow as you should do you think you can continue to keep OpEx per employee flat sequentially? So we will call it lumpy but disciplined?"
},
{
"speaker": "Patrick Pichette",
"text": "That is the intent. The intent is you onboard Googlers. You take real estate, you take computers, you take computing power but for the model we have right now in the spaces we are it is really about software development and sales. That is the intent. On the CapEx side I could argue it could grow 8% quarter-over-quarter but you are absolutely right we are very disciplined about it and we are very proud of in fact getting so much yield out of our infrastructure. Remember, I tell this because it will happen just like we talked about a few quarters ago we were ramping up on hiring, in the same way when there is a great opportunistic purchase on assets we will be there."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Jeetil Patel – Deutsche Bank."
},
{
"speaker": "Jeetil Patel",
"text": "Coming off the bottom obviously from an ad market standpoint can you talk about are you seeing from your marketers at least in the U.S. and customers a different allocation of ad dollars between search and display ads and other initiatives as the product listings and the like as you come up from Q4 to Q1 and beyond? Second question, I guess we continue to believe in your investing in the business. I am curious with the incremental 800 ads is there one or two sets of projects you are allocating incremental investment against whether it be mobile or You Tube or what have you? Just give us a flavor of where you are headed from a product innovation and a traffic growth standpoint."
},
{
"speaker": "Patrick Pichette",
"text": "Jeff can talk about all of the areas where we are deploying the engineering. Obviously Nikesh will answer the first quarter. Jeff do you want to give us a sense of where we are plowing resources?"
},
{
"speaker": "Jeff Huber",
"text": "It is a combination of the core businesses that is strong and growing. We are continuing to invest in that. Susan mentioned in her section a lot of the innovations and new products we have introduced in the core search and display ad business. Some of the other major areas of engineering investment are some of the things I cited; the open platforms Android and Chrome are growing very quickly and having a big impact. We are also investing incrementally in apps in the enterprise business where we are seeing very strong growth and a lot of customer uptake there."
},
{
"speaker": "Nikesh Arora",
"text": "Let me answer the headcount question first and then I can go back and talk about the marketers and advertising. As Jeff mentioned on the business side we are continuing to add resources selectively in search as we see the market continuing to grow as well as deploying it in markets where we see higher growth as I mentioned earlier. In addition to that we are putting significant amount of resources in our display space as [inaudible] continues to enhance our display offering and give us more features. That will continue to be a focus for us throughout the year going forward. In terms of what we are seeing from [marketers] I think the pull back we have seen about 6-9 months ago is gone. What has also happened in parallel is I continue to see tremendous amounts of capability building the advertiser side. One of the challenges we always have you can go to an advertiser, pitch them with a tremendous search campaign. However, they feel like we lead the horse to water but they still have trouble taking a drink because their websites aren’t fully capable of conducting the e-commerce transactions to the level they would like. Having said I have seen tremendous amounts of capability improvement in the last 6-9 months across a majority of our mature markets, the U.S., U.K., Germany, France, etc. which allows us to go in with this bigger, larger campaigns for these guys and they are beginning to understand that search is diminishing inventory because if they don’t buy it today it is not going to be there tomorrow. So they have to be more willing to be flexible with their budgets and be open depending on what is going on. They are getting more and more averse to waive the search. Clearly we are seeing them get more flexible with their dollars in the search side. They are beginning to understand the value of the products like Susan mentioned like remarketing and how to use the display networks effectively and the CPC model and a CPM model depending on which one they choose. So clearly the more mature markets we are seeing awareness of the digital marketplace. We are seeing them keep the search [while it’s open] and we are seeing tremendous amounts of engagement on the search side."
},
{
"speaker": "Patrick Pichette",
"text": "In closing on that point I think the display market is seeing such an evolution because of the simplicity of the tools that did not exist a year ago are now here and people now have the choice of participating and participating actively. In these campaigns now we would love to have the flexibility from one to another to find the right audience. A tremendous progress we have seen in display and we are very encouraged by what we see."
},
{
"speaker": "Jeetil Patel",
"text": "A question to Nikesh’s commentary if companies are having a hard time getting the transaction in the door once they get the traffic and small business has that same issue, I guess would you ever look at a model such as a percentage of sales model to eliminate that issue and have the transaction occur onsite?"
},
{
"speaker": "Nikesh Arora",
"text": "I want to make sure you interpret what I said carefully. I think we said most of the small businesses are very, very good with their allocation. As we have seen from a few quarters ago we have seen a dip in large advertisement and more small advertising because it is always ROI driven and they generally understand how to bring in a search lead and how to convert that search lead into dollars. I think the challenge with the large advertiser has been that a proportional total ad spend to revenue and not being able to allocate a lot of dollars to their search. Now as they build up their capability they are able to do that more effectively."
},
{
"speaker": "Susan Wojcicki",
"text": "One additional thing I would like to add is we definitely see an opportunity to move to taking a percentage of the conversions. In fact we call this CPA, cost per acquisition. One of the products that was developed in this area that we are optimistic about is the product ad product. The way that works is the way the retailer just gives us all of the information about their product; price, listing, description, etc. and then Google actually does the targeting to decide where to show those ads. Then we take a percentage when the product is actually purchased when the user actually converts. We do see that as an opportunity to really simplify the process for advertisers over time and it is something we are investing in."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Jason Helfstein – Oppenheimer."
},
{
"speaker": "Jason Helfstein",
"text": "Let me ask just a bit about expenses. Did Nexus One have a material impact on sales and marketing expense in the quarter? Two, when we look at seasonal patterns of expenses last year they increased as a percent of revenue in the second quarter. Should we expect a similar pattern this year or is each year different based on your initiatives?"
},
{
"speaker": "Patrick Pichette",
"text": "To make it simple, on the Nexus One we did not have a material advertising for it. On the second one I wouldn’t provide any guidance for the coming quarters. I would leave it at that."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Youseff Squali – Jefferies & Co."
},
{
"speaker": "Youseff Squali",
"text": "I want to go back to the China issue and understand a little bit better what you said. Hong Kong a sustainable strategy for you? Doesn’t that put you at a strong disadvantage versus a native player over time? Susan, among the many products you cited; product search, site links, image ads, etc. help us understand which one or one or two are having the most impact on conversion rates and CPCs."
},
{
"speaker": "Patrick Pichette",
"text": "On the case of China obviously we still have sales in China and the fact that we serve them in Hong Kong and from Hong Kong doesn’t stop us from having all of the opportunities we want from the Chinese market. Remember that there is a huge industrial infrastructure all around Hong Kong and South China. It is really addressing the market from a different perspective and our sales force is ready to serve them from there."
},
{
"speaker": "Youseff Squali",
"text": "Mostly for exporters?"
},
{
"speaker": "Patrick Pichette",
"text": "Both actually. Because we really have both opportunities. What we really have done if you think about it is we have stopped censoring but the access to Google is still available for all Chinese people through .hk."
},
{
"speaker": "Susan Wojcicki",
"text": "So from an impact standpoint some of the biggest changes that we make that impact the product and all of the metrics, not just CPC and percentage of click growth, etc. a lot of them have to do with changes in ad quality that we make in the quarter. The reason is because if we can make a percentage increase off of that very large business that can have a significant impact. We had a modest quarter in ad quality. We had more than a dozen different launches that were significant across the board and they certainly over time do play an important role in how they affect the metrics. The other thing I would like to point out that I think also is really an important thing to look at with our overall business is something we have introduced in AdWords called Opportunity Center. Opportunity Center is a way for advertisers to know this is how many more clicks I should be getting or could be getting. What we want to do is we want to give a lot more guidance to advertisers in terms of here are more key words. They are very easy to add to your key word list. We just launched this quarter Bid Suggestions to give them an understanding of what are the tradeoffs between volume and CPCs and where is the optimal place they should be bidding as well as budget suggestions. Because Opportunity Center is applied to the core business and to all of our advertisers it can move the metrics over time in terms of getting more advertisers to buy key words or increase their budgets or change their bids."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Mark May – Needham & Co."
},
{
"speaker": "Mark May",
"text": "I wonder if you could give some color around the paid click and cost per click growth as it relates to O&O and the network? Did paid clicks grow faster on the O&O network or on the AdSense network? Same for CPCs. The second question is there are a lot of innovative companies in the display space. Earlier you mentioned remarketing but generally speaking there are others out there doing remarketing. So my question is what are the top couple of things that Google is doing that is different in the area of display particularly from a targeting standpoint that is meaningfully differentiated?"
},
{
"speaker": "Patrick Pichette",
"text": "On the first one I will punt because we don’t divulge the spread between O&O and other properties. I am sure Susan will talk about the display innovations."
},
{
"speaker": "Susan Wojcicki",
"text": "So you brought up some questions about remarketing and what we are doing there that is unique. I would definitely agree with you that display is a very vibrant space and there is a lot of innovation that is happening right now in the display market and I think ultimately that innovation will enable the market as a whole to grow. But one of the things that we have that is very unique from a remarketing perspective is users or advertisers can refine users across the content network. The content network because we have so many publishers on our site and because we are a global network as well it gives advertisers the opportunity to expand and find a lot more of those users across the network than they probably can with a lot of other options. The other thing we are doing from a targeting perspective is we are trying to make it really easy for advertisers to work with existing interfaces. Right now you can do remarketing within AdWords. So if you are an AdWords advertiser, you can do the remarketing there. If you are a DSA advertiser then you can also from that perspective as well. The other thing that is important because you also asked about different types of targeting, we offer a number of different targeting we think are unique. The one we are best known for is the contextual targeting. So the ability to actually figure out on a page what this page is about dynamically and then serve an ad that is matched to that one specifically. Then we also have placement targeting where we give advertisers the ability to choose where they want their ads to appear by actually selecting these are the sites and this is where I want them to appear. The combination of all of these things together give advertisers a large number of options and we are thinking about how do all of these different targeting mechanisms, how do you combine them in a way to provide the best options for the advertisers and users."
},
{
"speaker": "Mark May",
"text": "When you say content network you do include You Tube in that?"
},
{
"speaker": "Susan Wojcicki",
"text": "Yes we do include it within there."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Jordan Rohan – Thomas Weisel Partners."
},
{
"speaker": "Jordan Rohan",
"text": "I have a drill down question on site links and image ads. The question I have is really how do I think about the core basicness of these new ad formats? Over what percentage of queries or what percentage of advertisers do you think it is relevant? It seems like it would be a relatively narrow set of very commercial queries for very response-driven advertisers. How far penetrated are we? How new is this?"
},
{
"speaker": "Susan Wojcicki",
"text": "You are right that site links is new and we are really just beginning to penetrate all of the advertisers that I think would benefit from the site links feature. We do see Site Links appearing mostly on navigational queries where the users is looking for the brand name or the product category but it is a very powerful tool and we believe there are still a lot of advertisers that are not using it today that would benefit from it. The other thing I would say about Site Links is it is rolled out globally and so when you look at the combination of all of the different companies and advertisers globally that could benefit from this we are just getting started because we have just started rolling this out in Q4."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Marianne Wolk – Susquehanna Financial Group."
},
{
"speaker": "Marianne Wolk",
"text": "With regard to your mobile advertising it sounds like it is an opt-out program now for most AdWords users. If that is true would you also include in-app ads as an opt-out mobile choice as well? Also, is it fair to say based on the comments you made about the content network the mix shifted to the content partners from the search partners by several points this quarter? Did the content network also grow much faster in the U.K. this period than in the U.S.? I know you rolled out the video and display ads on the content network. Can you talk about the uptake there and any positive impact that has had on pricing?"
},
{
"speaker": "Patrick Pichette",
"text": "Could you repeat your questions so we will all just write them down?"
},
{
"speaker": "Marianne Wolk",
"text": "On the mobile advertising side. It sounds like what you are saying is an opt-out…"
},
{
"speaker": "Patrick Pichette",
"text": "The opt-out issue. The second one was about the U.K. versus other geographies for take up rates for different formats?"
},
{
"speaker": "Marianne Wolk",
"text": "No for the content network and whether you are getting any pricing benefit there from the introduction of display and video ads recently?"
},
{
"speaker": "Susan Wojcicki",
"text": "On the mobile component I will say we do give advertisers the option. The default is for advertisers to be on search, content and mobile and the reason we do that is because we want to make it as easy as possible for advertisers to get as much reach and reach as many potential users as possible and we try to do the right thing for those advertisers. So the default is for them to be opted into both. However, we do offer the ability for advertisers to run a mobile only campaign and under that mobile only campaign we give them the option to target, for example, a specific mobile OS. We give a lot of options within the mobile category. But I really think about that more for advertisers who have the capabilities and are advanced enough to know these are the capabilities they want to do and customize their campaign in order to make it worthwhile for them. On the format question I will also say we definitely have been introducing new formats into the display network and we have been really excited about that. In fact we have a product called Display Ad Builder and Display Ad Builder is a template system that enables us to have lots of different ad formats and to add them very, very easily to our network. From an advertiser standpoint they are very, very easy too to actually start and get running is really the click, click, click and your display ad can be running. Because the content network and the way we choose which ad is actually run is an auction. If display is winning it is winning because it is actually a higher CPM ad. So by bringing display ad to the mix with text there is more competition and more variety and so when it makes sense for a display ad to run then it wins the auction and because it won the auction it is bidding more than the existing text ad. Over time that can bring positive competition to the auction."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Aaron Kessler – Kaufman Bros."
},
{
"speaker": "Aaron Kessler",
"text": "Can you give us a little more detail on the travel and retail verticals? I know you said all of the verticals are strong. Any more color there? And any updates on your hedging program would be helpful and your thoughts going forward with the hedging."
},
{
"speaker": "Patrick Pichette",
"text": "Maybe I can start with the hedges and then turn it to Nikesh. Our hedging program is really effective. I want to remind everybody for us it is an insurance policy. It is an insurance policy for high volatility and specifically if the U.S. dollar strengthens dramatically. If you look at where the Euro was a year ago versus where it was 90 days ago versus where it is now, and then you go back to last year as we discussed we had booked at this time last year big hedging revenues mostly because we had such a massive appreciation of the U.S. dollar so for us very effective in finding the right sweet spot to make sure we have the right coverage. What we are caught with is the accounting rules which some quarters like last quarter had very little FAS 133 ruling through the P&L and this quarter has a disproportionate amount. They don’t represent our regular cost of hedging so it creates a bit of fluctuation for you to model but in the end we are very happy with what we are getting out of it. In terms of the verticals I will turn it to Nikesh."
},
{
"speaker": "Nikesh Arora",
"text": "As you mentioned travel and retail have been strong. I also alluded to the capability building of e-commerce. Primarily I was talking about the retail verticals where we are seeing good strength. Travel is going strong and is steady. Retail and travel end up being one of our larger verticals in the entire landscape. Having said that, I am seeing good strength as well from CPC and entertainment because that is where a lot of the display advertisers like [focus] because those verticals even though they are smaller numbers those verticals aren’t traditionally strong search verticals but they definitely play into the display space and a lot of the display effort has been targeted at those verticals."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Collin Gillis – BGC Partners."
},
{
"speaker": "Collin Gillis",
"text": "Was there any tension between Sergei and Eric over China and could that be tied at all to why Eric is not on the call today?"
},
{
"speaker": "Patrick Pichette",
"text": "No. I am sorry. Thank you for the question. I have a feeling that I have heard every rumor. Thank you for asking the question so candidly. The answer is no. There is nothing going on at all. As we were doing the planning at the end of last year to all the questions, if you doubt that we actually scrub every department at Google I would scrub too and the question was asked is what can you do differently to be better next year? List we brought up in finance was maybe we should look at the quarterly calls and the whole process and the webcasts and one of them was hey we thought this is an innovation. It has nothing to do with that."
},
{
"speaker": "Collin Gillis",
"text": "The newer ad format, does that provide any lift at all to the CPC? Click to play video, along those lines?"
},
{
"speaker": "Patrick Pichette",
"text": "I think it is one to understand. Some of the newer ad formats [audio fades] CPC based where newer ad formats are sold like traditionally in the display space we sell them as launch pages or home pages. So they are not paid click by click."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Scott Devitt – Morgan Stanley."
},
{
"speaker": "Scott Devitt",
"text": "Just to follow-up on Marianne’s laundry list question, the comment about site revenue and network revenue mix, the site revenue and network revenue were both flat sequentially. I was wondering if you are suggesting that CPCs in the network are actually declining and that was a contributor to the sequential decline in CPC? Secondly, you recently indicated 50 million Chrome users and I think the Smart Phone shipments have been roughly 6 million per quarter run rate. Your thoughts on shipping a tablet to take advantage of this momentum?"
},
{
"speaker": "Patrick Pichette",
"text": "Let me answer in two ways. We are really delighted by the Chrome take up rate. It is a fast browser. It is a secure browser. It has all the elements that we have told about it. So this is a terrific opportunity. In terms of tablets, the one announcement we made last year that you will remember with the launch of Chrome OS is we are working with manufacturers to have a netbook out sometime in the fall. We are continuing to work diligently on this. We are very excited about it. We think there is going to be a ton of innovation coming out of that. So there is no doubt that we are pushing for it for all of the reasons you were mentioning. Can you remind me of your first question?"
},
{
"speaker": "Scott Devitt",
"text": "The addition to the list earlier in terms of drivers of changes in CPC with the mix shift between site and network. As we go back and look at the sequential growth rate of Google Site revenue and Google Network revenue they were both basically flat. I was wondering if there was any implication from that CPC and one of those two actually changed more than the other?"
},
{
"speaker": "Patrick Pichette",
"text": "I don’t have the answer to that. What we will do is we will follow-up with you."
},
{
"speaker": "Maria Shim",
"text": "I think we are done with questions so I am going to turn it over to Patrick for some closing thoughts."
},
{
"speaker": "Patrick Pichette",
"text": "I just want to thank everybody for joining us today. I want to thank every Googler as well who listens to the call. We have Googlers all over the world working so diligently and creating these incredible products and all the options we have. Thanks for your time. We look forward to talking to you at the end of Q2. I will let the operator close the call."
},
{
"speaker": "Operator",
"text": "This concludes today’s conference. We thank you for your participation."
}
] | null | null |
GOOGL | 4 | 2,008 | 2009-01-23 16:30:00 | Operator: Good day, everyone, and welcome to the Google, Inc. Conference Call. This call is being recorded. At this time, I would like to turn the conference over to Ms. Krista Bessinger, Director of Investor Relations. Please go ahead Ma'am.
Krista Bessinger: Thank you, Operator. Good afternoon, everyone and welcome to today's fourth quarter 2008 earnings follow-up conference call. With us are Patrick Pichette, Chief Financial Officer; and Jonathan Rosenberg, Senior Vice President of Product Management. After we cover some housekeeping items, we'll open the call immediately to your questions. Please limit yourself to one question and one follow-up. Also, please note that this call is being webcast from our investor relations website located at investorgoogle.com. Please refer to our website for important information including our earnings press release and the latest slide deck. A replay of this call will also be available on our website in a few hours. Please note that we routinely post important information on our investor relations website located at investor google.com and we encourage you to make use of that resource. As a reminder, the purpose of this follow-up call is to give participants the opportunity to ask more detailed financial and product questions in an efficient and Reg FD compliant manner. Let me now quickly cover the Safe Harbor. Some of the statements we make today may be considered forward-looking and these statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to provide or publicly release the results of any revision to the forward-looking statements in light of new information or future events. Please refer to our SEC filings including our quarterly report on Form 10-Q for the quarter ended September 30th, 2008, as well as our earnings press release for a more detailed description of the risk factors that may affect our result. Copies can be obtained from the SEC or by visiting the Investor Relations section of our website. Also, please note that certain financial measures we use on this call, such as: EPS, net income, operating margin, operating income, and our effective tax rates are expressed on a non-GAAP basis, have been adjusted to exclude charges related to stock-based compensation. We also have adjusted our net cash provided by operating activity to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and GAAP to non-GAAP reconciliations can be found in our earnings press release. With that, we're ready to take your questions. Operator?
Operator: Thank you. The question-and-answer session will be conducted electronically today. (Operator Instructions). And we'll take our first question from Jeetil Patel from Deutsche Bank.
Jeetil Patel: Hey, guys. A couple of questions. I know you talked on the main call about advertisers having excess budgets to work with. Can you quantify what you have been hearing anecdotally? And, what kind of budgets are available that still haven't been spent? Is there any difference between US and maybe Europe and UK in terms of budget availability out there among some of the marketers and customers you deal with? Secondly, can you talk about depth in the fourth quarter? What have you done as it relates to depth of AdWords as it relates to Q4 relative to let's say Q3 or as a good proxy? Thanks.
Patrick Pichette: I'm not sure I fully understand the second part of the question on depth of AdWords. We can maybe consider how to ask that one a little better. I'll try to address the first part. I think we mentioned on the call that most of the advertisers are not budget constrained, and the way I think one of the folks internally talked about is almost like a broken slot machine. If you're a reasonably intelligent ROI guided marketer, you are not going to tap your spending. It's basically like finding a broken slot machine that you are not going to get up from. And it's broken in the sense that every time you put a dollar in, N dollars come out where N is bigger than the amount that you paying. If that is the case you're going to want to do it 24 hours a day, seven days a week. The traditional markets you would set are quarterly daily budgets along with ROI goals. In our world, in many ways, they've sort of decided to walk away from the machine and let someone else sit down in the seat. We're not really sure why some of them choose to do that. So, fortunately, it is a minority that our budget is constrained. I'm not sure I have much color on how that differs geographically. Patrick might. On depth, I'm not exactly sure what you are asking. We talked about coverage on the call. Are you talking about ads per query? What exactly are the ads?
Jeetil Patel: Yeah. Just the number of ads just serving for a search result out there. I mean, obviously, that may differ in terms of two ads versus three versus four. I guess what have you been doing in the fourth quarter as it relates to the number of results you are putting out top fold relative to quarters past?
Jonathan Rosenberg: I really don't think we go into any detail on the sort of intra ad serving dynamics with respect to the queries.
Jeetil Patel: Is that one way to generate more inventory? Obviously, you've got kind of the broken slot machine concept where the ROI is still positive and working. Why wouldn't you actually open up more inventory obviously being selective and careful about it? Is that something you are constantly refining? Let's say, every month or every couple months around just yield?
Jonathan Rosenberg: We're constantly sticking with the original vision that we have for ads, which is basically trying to improve the quality and show the best ads that we possibly can. We want to really avoid showing poor ads. So we're not really thinking of it from the standpoint of, gee, we could increase yield by adding a few more ads. We're continuing to try to shelve that down.
Patrick Pichette: Let me give an example on this. As we tune for quality relevance and all of the fund review that the engineer work for, you've heard that, in fact, the early 2008 level, you can imagine in a quarter where the exchange rate [changes] really rapidly in a certain geography. People will pay less for this ad and we'll need to pay less for this ad because if it's converted to US dollar it's a lot less. And all of a sudden that would have been totally fine because the change in currency may not be fine any more even though intrinsically it's totally fine in the algorithm. So, engineers spend a lot of time when they look at these wild fluctuations that we have. As an example, we make sure that all the relevant ads should be constant and the relevance they have the right cost, and then when its adjustments is [incidental], but more importantly what people want to see.
Krista Bessinger: So I think we' going to move on now to next question. Thanks.
Operator: And we'll take our next question from Mark May from Needham & Company.
Mark May: Thank you. I guess this is an expense question for Patrick, pretty broad. But how confident are you that even in your worst case revenue forecast for this year that you can maintain the EBITDA margin roughly where you ended the year?
Patrick Pichette: First of all, we don't give guidance. We don't give guidance on margin. The one thing that I would say, as Eric mentioned, I think the management team is really working with two agendas always. One is, manage our resources prudently. I think Eric was right in saying in some ways the easy part was done in Q4. In that sense, this is a worldwide recession with a lot of visibility about what's going to happen. We just have to be prudent, and therefore, we're focused.
Jonathan Rosenberg: One of the things, that's sort of a subtle point that I'm not sure came across in Eric's remarks about Q4, one of the things that I think we did see and benefit from is that there was a lot of inventory on the part of a lot of retailers who had anticipated a better Christmas. Once it became clear that sales were really required and two-for-one deals were required, a whole different dynamic needed to occur to flush that inventory through. Interestingly, what we saw in November and December was consumers searching much more disproportionately for two-for-one, for sales, for coupons, and advertisers really trying to make sure that they were able to sell the inventory which they purchased when they were anticipating a better economic situation. So, one of the things we have to ask ourselves now is how much of that inventory has actually flowed through the system, which gets back to my answers from a revenue standpoint on commerce. Obviously, we would be adversely impacted if there were less total commerce moving forward. So that's really the wildcard from a user standpoint that we need to watch.
Mark May: I guess as a follow-up and another way of asking it is to what extent, Patrick and team, have you identified sufficient enough amount of expenses that you could cut in your worst case revenue forecast and the nature of the expenses, how quickly could you act on those?
Patrick Pichette: Again, I'll only talk about what we've done in Q4 and I'll let the facts speak for themselves. I think this management team, the company, and it's not just me, we're a management team focused on making sure that we deliver the results that we set for ourselves. Sorry, I can't give it otherwise I'd fall into guidance which I don’t want to. We're very prudent in our management for sure. We’ll move to the next question, please.
Operator: And we'll take our next question from Jeffrey Lindsay from Sanford Bernstein.
Jeffrey Lindsay: Hi, thanks for taking my question. Can I ask, will the company be changing its wireless search strategy now that Verizon has decided to move its business to Microsoft, and so can you do about this? Is it a priority for you to actually address that issue? And then second, could you just give us some sort of sense of what you are doing to improve the product development process? Thank you.
Jonathan Rosenberg: Sure this is Jonathan. I don't think that our wireless or mobile strategy really is going to change. I think we have a pretty good balance of both searches that come by the partner channel, as well as searches that come directly. So I'm certainly pretty confident that we've got lots and lots of organic search opportunities that will allow us to continue to move forward aggressively. In terms of fundamentally changing the product and development cycle, yeah, I don't think it's changing that much. I think we're just getting better at measuring it, and I think we're getting better at figuring out how to more expeditiously allocate talent to the depths of things that are most important, and that's really what the whole resource allocation exercise that we did in the fall looked at. We went through every product and we looked at the big drivers of cost, be they bandwidth or CPU, or storage intensive products, and along with the revenue opportunities and really tried to quantify both short run and long run what our expectations were, so that we could do a better job of allocating resources. I don't think we're changing any of the core notions that we probably set forth in the Founder’s Letter when we got started. People are still working on 20% time. We're still putting a big premium on innovation. We're still putting a big premium on focusing on the long term. I think we're increasingly putting a premium on internationalization.
Patrick Pichette: Just one last point I would make on the mobile strategy. I think that as Eric mentioned earlier, in the previous call, it is front and center in the strategy of the company, and Android and mobile continues to be a huge part, so the fact that one deal versus another deal I don't think is central to the strategy.
Jonathan Rosenberg: And Jeffrey, just going back to the question you originally asked on Verizon, one of the things we didn't really get a chance to talk about on the previous call is that we're really seeing significant increases in the sales of the smarter phones, both the iPhone, which we mentioned, but also Android. With those kind of phones, it's going to significantly grow the pie for mobile searches, and these smart phones have full browsers. When you have a full browser, then you are typically not as dependent on a deal that locks somebody into a particular direction from a search perspective. So, the better browsers get, the better phones get, and the better ecosystem that evolves there, the better from our perspective.
Jeffrey Lindsay: Yeah, but you're not on either of the major platforms. So, you're not really on AT&T and you're not on Verizon, Verizon's the largest carrier. That means your partners are really T-Mobile and Sprint. Is that not enough to really to make Android viable?
Jonathan Rosenberg: Well, we think the Android numbers will start to speak for themselves, particular this year, now that we've got some additional partners signed up to get to the next generation from a hardware perspective on the platform. So we are very optimistic about Android.
Patrick Pichette: We will move to the next question, please.
Operator: And, we'll take our next question from Jim Friedland from Cowen & Company.
Jim Friedland: Thanks. Two questions relating both to tech. First, on site tech. It reached 5% of GAAP site revenues up 50 basis points sequentially and scoring a lot faster than the sites GAAP revenue. What's driving that? New deals, changes in deals…? Then on network tech that was down on an absolute basis, quarter-over-quarter, as well as percentage basis, and what's driving that? You mentioned cleaning up AdSense for search on the previous call. If you could add a little bit more color there? Thanks.
Jonathan Rosenberg: Just a couple points on that. One, on our own, Google property's tech have driven a lot by the deals that we have on toolbars and all the others that we have, and honestly, these deals are multiyear, and so as they come through, they will increase in short-term, but we see tremendous value under these, and therefore they are good economics for us. On the partner's tech, obviously mixed overall tech obviously, mix is a big element of it. And so, because of our mix during the quarter, that has big influence on it for sure. And, then the second issue is [AdSense] being weaker, obviously influenced it as well. And, then finally, on a lower marginal basis, but nevertheless, revenue from our hedging activity was also recognized between our properties and then our partner properties as well. Well the combination of all of that makes it that our partner companies has lower that versus (inaudible). I hope that answers the question.
Krista Bessinger: Next question, please. Operator: And we'll take our next question from Youssef Squali from Jefferies & Company.
Youssef Squali: Thank you very much. Patrick, the UK was down 1% year-over-year and 12% sequentially. When you FX that, neutral that - do you have those numbers? And then as a part of that, how much of that is really FX versus maybe the UK market starting to mature a bit? From a monetization perspective, it was already over monetized or relatively more monetized than the rest of your territories. And lastly, on the stock option exchange, why did you guys decide to give employees options or repriced options when you could have maybe opted for restricted stock? Wouldn't have that been less dilutive?
Patrick Pichette: Okay, so is that the question. Let me start first by the UK. We don't do the math for everybody, if you do the analysis and reverse engineer where the FX has gone over the last quarter, you will find that the FX has been a significant factor for the numbers that we reported. And you can't discount (inaudible) the biggest issue for me is the issue of FX for me (having) results, but you can't discount the fact that the macro economic environment and the pressure that they have in the UK, the UK is in a deep recession. So the market also get influenced by this and the dynamics of advertising and spending for products? I'm sure it is. It would be wrong to say that it's not. The UK is really being impacted by a deep recession. So it's a combination of those two rather than the maturity of the market that I think really impacted, with the first being the most significant factor. In the case of the stock option versus the DSU or GSU or restricted stock, I think that there is a philosophy issue that Google has. It wants to continue to make sure that people think of the company and manage the company as it grows. And because of that, the mind-set of the stock options is, in fact, the preferred way in terms of compensation versus GSUs and the balance of things. That’s why we kept on with stock option (Inaudible). We'll go to the next question. Thank you for your question.
Operator: And we will take our next question from Marianne Wolk from Susquehanna.
Marianne Wolk: Sure, the first was regarding AdSense per content, which you implied or it sounded like you are implying, grew faster than even Google.com this quarter. Is that because you are adding partners with DoubleClick ad exchange or is that because pricing is improving? Can you help us try to understand what kind of legs are there? And then the second question I had, if you will, you talk a little bit about the competition if there is any from Microsoft cash-back program? Thanks very much.
Jonathan Rosenberg: This is Jonathan. I'm not sure that we said that AdSense per content was growing relative to Google.com. I think we were talking about cash and I think it would have grown relatively faster compared to AdSense, where we did some of the arbitrage clean up. So, I'm not sure that was what we said, but it is the case that AdSense per content has been growing. I think that one of the interesting dynamics that we're seeing there, because we're monetizing better, and yes, I think a lot of is it product efforts that we're doing along with DoubleClick. We're getting more and increasingly it appears that we are getting better inventory, and it's particularly more recently with the - as the economy has slowed, it appears that some folks are giving us more of their inventory than they had in the past and particularly some of the better inventory. So I think we see, if another network can't sell, the inventory comes to us, we'll monetize it better, so I think that's basically the story. The cash-back efforts that Microsoft is doing, we're watching that as carefully as we can, we don't really see much, and we don't see anything that is particularly sustained. We're continuing to see Google Product Search, do very well from a traffic perspective in the last month, both domestically and internationally, so I don't think we're seeing anything differently.
Patrick Pichette: Thank you. Next question please.
Operator: And we'll take our next question from Sandeep Aggarwal from Collins Stewart.
Sandeep Aggarwal: Thank you. Jonathan, I know you have answered multiple questions on coverage, but I have one question on coverage, and then one or two product related questions. When you were decreasing your coverage ratio in '07 and maybe in '08, you theoretically sacrificed some of the searches for clicks, which could have generated some revenue, and as you expand your coverage again is it fair to assume that you may not regain all those searches, which you probably lost when you were decreasing the coverage ratio?
Jonathan Rosenberg: Well, sure, yes. I'm not going to gain on search that I lost last year.
Sandeep Aggarwal: No, let me clarify. In the sense, because you were decreasing your coverage ratio because you were improving the quality score, so as you expand your coverage, will you be able to capture the nature of those queries which were let go last time?
Jonathan Rosenberg: I don't think it's really symmetrical. I'm not really sure that increasing coverage is directly the opposite of decreasing coverage. So I don't know. I think we'll be showing ads on a better set of queries and continue to get benefits of that ad.
Sandeep Aggarwal: Okay. Let me move to actually two product-related questions. One is how similar or different is a mobile Internet-generated search query versus a PC-generated search query in terms of a CPC, as well as a mix of commercial versus research-related searches?
Jonathan Rosenberg: Yeah. That's interesting. I'm not sure we know the answer with respect to CPCs because I don't think that market has matured as well as it needs to from an option dynamic standpoint. One of the things that we just started doing is making it much easier to run your PC-based queries on the mobile devices and customize the ads, so that they look better and work better on the mobile devices. The only data point that we've seen so far is that click through rates seem similar to that of desktop computers, but I don't think we have a good sense yet for what CPCs will look like in a more mature market. I personally think that they could be much higher, because I think when people are going to the trouble of running a search on a small, portable device, particularly a location aware small portable device they're much closer to consummating a transaction. And so, you can imagine that that search is more valuable, particularly to an advertiser in close proximity to where the search is run. Mobile is bigger on the weekend, which is another trend that we've seen. I think that's probably bigger during the week. But those are really the only other clear trends that we've observed.
Patrick Pichette: Thank you. We'll go to the next question please.
Operator: And we'll go next to Gene Munster from Piper Jaffray.
Gene Munster: Hi. Good evening. If you could talk a little bit about just from a very high level from at the economic environment, I know you're not economists, but is it reasonable to expect some form of seasonality emerging in the business in 2009?
Patrick Pichette: There's obviously seasonality within the business. If you look back to the last few years, Q4 is a very strong quarter. Q1 is also a stronger quarter relative to Q2, Q3 when people are on vacation. Seasonality is part of the business, always has been and continues to be.
Gene Munster: Okay, great. And then second is that you mentioned on the previous call that some of the behaviors around the holiday quarter in comparison to shopping and so forth, more people doing searches, but do you have any expectations about some of that search behavior in 2009 that same kind of Wal-Mart effect continuing or just any general thoughts on search behavior in 2009?
Patrick Pichette: No. I guess the only comment that I can have there is the comments that we made about consumers shopping for deals everyday. We certainly measured some of those things and I think we've shared some of the data points that we had. It is a lot true that on days like Cyber Monday, whichever (inaudible) after Thanksgiving, you see people looking more on coupons and behave in price comparison. But I don't think that behavior was limited to key shopping days. The increase of deal seeking queries then was a minor compared to the surrounding weeks, and I think you are going to see that people are going to continue to shop for deals. It is just clear that their deals are out there.
Krista Bessinger: The next question, please.
Operator: And we'll take our next question from Ross Sandler from RBC Capital Markets.
Ross Sandler: Thanks for taking the question. First, on international and then the second question on display. So, on the international side, if my math is correct, international revenue ex-FX was up 35% year-over-year in the fourth quarter. That was an acceleration from 32% last quarter in 3Q 2008 on an FX neutral basis. So, if the comments around UK showing some macro sluggishness, where was the accelerated growth coming from? Was it particular to a geographic region or was it more a factor of company induced growth initiatives like improving coverage? And then, a follow-up on display. Google's approach has been to kind of position the company for the days when purchasing display ads is an automated format similar to how search is bought today. Do you think there's a need for a strategy in the interim to give large display advertisers and agencies a little bit more hand holding to get things going in display before the buying process is fully automated, which could take a few years? Thanks.
Patrick Pichette: Okay. I'll answer the first and I'll let Jonathan answer the second. We're not going to comment specifically on the numbers you provided, but it is true that in the grand scheme of things, international continues to perform well where Continental Europe certainly is much less mature than the US and the UK. And as discussed in the previous call, some countries like Germany and a few others who are better than the others have done fairly well even in this economic environment. It's also true that we have a number of environments where we are growing rapidly in our [break] countries. We talked about China, we talked about Brazil. We have a lot of optimism for these countries because they are much less mature. So there's a lot of runway in them; different economics, but a lot of runway. That covers the international. Okay. I'll let Jonathan cover the other question.
Jonathan Rosenberg: Yeah. I think your observation is well taken. I think Eric said we want to make display advertising easy and we want to make it acceptable for all advertisers and publishers. The challenge is that today is extremely inefficient, so that does make for a very big challenge. Lots and lots of activity in the display world happen even by faxes, never mind phone call. The logistics involve people doing things like literally cutting and pasting HTML code to get ads up and running on a site. So, I think we absolutely recognize that between now and when we can achieve the kind of science that we'd like, we've got to do a lot to continue to help advertisers get these ads going. One of the things, we've launched a display ad filter which does make it much easier for the small advertisers, particularly AdWords customers to use display and get reasonably creative professional looking display ads with the AdWords interface. I think getting to the long run goal of making this more like Google AdWords is going to take time, and I think we need agencies to help with it, and there are some great agencies and (inaudible) who are helping carry this forward, and we'll keep doing whatever we can incrementally to make it easy for advertisers as well.
Krista Bessinger: Next question, please.
Operator: We'll take our next question from Steve Weinstein from Pacific Crest.
Steve Weinstein: Thank you. I'm curious. In your toolbar or other distribution deals, in those relationships and whether contract ends or you go with another partner, does your revenue commitment to that partner continue as long as someone continues to use that toolbar? Or, is there a finite date where we could stop modeling that as an expense of the business? And then second, you've talked a lot about the display business, and you're obviously very optimistic about it. Can you help us get a sense of scale or size for that business today at Google, and where it might become a meaningful piece of the business?
Jonathan Rosenberg: So, we not going to give you detailed answers to (inaudible) these questions, unfortunately, but typically, in most of the deal type efforts that we're engaged, we're paying for what we're directly receiving. So I'm not going to go beyond that. And we don't comment on sort of the relative size of different businesses. But obviously display is getting to be quite significant and we alluded to the degree to which the DoubleClick integration has made significant progress and YouTube is really using DoubleClick as a platform for the business that they're building. So it's already a meaningful and growing part of the business, but I think that's all we'll say.
Patrick Pichette: Thank you. Next question, please.
Operator: And we'll take our next question from Mark Mahaney from Citigroup.
Mark Mahaney: Thanks, two quick questions. Patrick, back on the cost side. I know you’re not talking about cost going forwards, but what would you point to us as the best examples of cost constraints in just the fourth quarter? The setup for the question is, if we remove the revenue contribution, which must have been all margin from the hedging program, non-GAAP operating margins, actually declined sequentially. So what do you think is the best evidence of the new cost controls that are at the company?
Patrick Pichette: So let me give you, I'm just looking for my list here. We have done in Q4, and I can share that with you, a couple of areas where pretty if you do understand how do you contain cost growth. So obviously, hiring pace is the clear one, right. I think last quarter we had, what, 400 people, now they are now 500 somewhere around there. We have 100 for this quarter. In the previous quarter as well we did talk about managing our contractors and our temps in a better fashion, so there will be opportunities there. We have a lot of office space. Google has, right, because we're everywhere, and we've been publishing from this office building and we don’t need in the short term, we have some options there. Improving machine utilization, I talked about it on the call a bit earlier. Using better machines gave us a lot of CapEx and OpEx. Same thing for better utilization of bandwidth. So, we have, in general, a number of other elements, if you think about professional services, including self-service as well within the Google, so just to give you a sense of the broadness, the comprehensiveness, and it's one where we are just being responsible at managing our resources. So this gives you a sense of the excluding management that we are working with.
Mark Mahaney: Thanks and a quick follow-up just on the AdSense for search. I think the comment was made during the call about cleaning up AdSense for search network. Can you give us any sense of how far along the process you are in doing that?
Patrick Pichette: I'll let Jonathan talk about it. It's more a (inaudible).
Jonathan Rosenberg: Not sure I can give you a sense in terms of proportionally how much of the way we're there. Certainly, I think there's a disproportionate number, I think there were a good number of shopping oriented sites that we are working in a manner that wasn't consistent with our terms, but I don't think I can give you a sense of to what degree we have gotten rid of all of it. Part of it's like dealing with email scams. You get rid of it, and then it comes back. So, I think it's kind of going to be an ongoing battle. I'm not sure I can predict how that's going to play out.
Patrick Pichette: Great. Thanks. We will move to the next question, please.
Operator: And, we'll take our next question from Jason Helfstein from Oppenheimer.
Jason Helfstein: Thanks. I'm going to try to get three quick ones in. So one, there was no mention of apps in the release, and I'm wondering if we should read into that. My second question, without giving specific numbers, can you comment on paid click trends by geography, so perhaps like better or worse than the 18% you reported? And lastly on cash. How much cash resides outside the US? And connected to that, would you consider buying back stock to offset option dilution? Thanks.
Patrick Pichette: On the thing clicks by geo, I just wanted to say, we don't comment on the details. All I can say is, as we've said in the previous calls, we have healthy growth across all major geographies. So, I'll cover that one. I'll let Jonathan talk about the apps and I'll get back to you on the cash issue.
Jonathan Rosenberg: Yes. Apps are certainly one of the top things that I mentioned. I think I talked that we are getting about the fact that we've released over a 100 enhancements to the whole application suite in 2008. I think I said, momentum is particularly strong, both Eric and I (inaudible) the million business on apps number, as well as the 10 million users and three million active users from school. So, we continue to be innovating aggressively on apps. If I think about this last year, there was Google site, Google video. I know we had same tools for Outlook and Blackberry, numbers of large enterprise deployment. Eric has mentioned the general continued demand for (cloud) driven efforts. And I also think that the opportunity here in 2009 as enterprises are struggling to deal with increasing IT cost, in a recession that should be a good opportunity for us. It's relatively low-cost platform that's easily updated and delivers a lot of the functionality that they need.
Patrick Pichette: Let me come back on the cash issue. I just wanted to check out before, we don't disclose that, so that's why (inaudible), I would have given you the latest update, but we do not disclose on that, so sorry for that. Is there a question on (inaudible)?
Jason Helfstein: (I don't know about that).
Patrick Pichette: We look at it all the time, companies do all the time, and there's no one else to make them best. Next question, please.
Operator: And we'll take our next question from Rob Sanderson from Broadpoint AmTech.
Rob Sanderson: Two questions: one on the macro, and one on the currency hedging program. Just want to revisit some of the things said here on the macro environment and the impact we might have on seasonality. I think Jonathan was discussing two-for-ones and discounts. I think that also led to some more aggressive keyword bidding, but don't these dynamics set up a much more seasonal Q1 than we've seen in previous years?
Jonathan Rosenberg: Well again, so we don't give forward guidance, but it goes back to the same thing I said before. It depends on the total amount of commerce and services that are occurring in the economy at large, so I wouldn't read much more into it. Other than that your ability to predict what's going to happen from a macro economic perspective in Q1 there is probably similar to ours. If there's less commerce, overall, then that's going to adversely impact Google. If there's not, and there isn't consumer driven reductions in commerce and spend, then we should be fine.
Rob Sanderson: Okay, thanks. And then on the currency hedging program, Patrick, you mentioned you're not fully implemented in the UK. Is there any way you could give us a sense of what it may look like in Q4, had you been? And just on the basic mechanics of the program, it's forward cash flow you're attempting to hedge out here. Does this mean as the dollar strengthens you see an unrealized gain that then flows back to the income statement over future period that you hedged against? So first, is that the right general mechanics, and then if that's the case, then currency is ready to remain constant from here. Should we expect a similar gain in the future periods as we saw in Q4?
Patrick Pichette: The mechanics is right. I'm not going to pronounce myself about the future, because in the last six months I've been living through this roller coaster, so who knows. And on the first part of your question, all I can say is, we implemented our (click return) hedges in Q3. It's a partial effect, (Inaudible) affecting Q1. I mean, that's all we knew, we can give you. We'll take the next question, please.
Operator: And we'll go next to Imran Khan from JPMorgan.
Imran Khan: Yes, Hi. Thank you again for taking my questions. Two questions, and then I have a clarification, just because I think there was some confusion about that. So the first two questions are, if you look at the seasonality in the fourth quarter business, was there anything abnormal? Have you seen the growth rate, if I look at the year-over-year growth rate, October and November versus December? Any color on that will be very helpful. And secondly, question probably for Jonathan. It’s being reported that the relationship with Warner Music that they are pulling out their content from YouTube. If you can give any color on that in terms of monetizing this music content, that would be very helpful. And in terms of the clarification, the $129 million FX hedging, that flows through your US revenue line or international revenue line? And Google.com versus AdSense. Thank you.
Jonathan Rosenberg: Okay, on the seasonality issue we're not going to give you, we just don’t divulge October, November, December. We just don't go there. Could you just repeat your hedging question?
Imran Khan: Yes. So the $129 million, the benefit that you had, do you recognize the revenue on your US revenue line or does it help the international revenue line?
Jonathan Rosenberg: I understand now. Sorry. We recognized, of the 100% of the 129 we roughly, you can think of it as 70% for Google properties and 30% for the network properties and so therefore you have to have a sense of what’s US versus international. We do it actually not as much. It's 100% obviously international, because we're hedging. We don't need to hedge US, right?
Imran Khan: Right.
Jonathan Rosenberg: So it’s international, but the real question is Google or network.
Imran Khan: Got it. About YouTube and about Warner Music. It's being reported that Warner Music pulled out their content out of YouTube. Any update on that? And it seems like it's also being reported about, I may rephrase the question this way. How can we better monetize music content that you have licensed through the music industry?
Jonathan Rosenberg: Well, we certainly still got great relationships with thousands of partners including many in the music industry, so we'd love to work with Warner. But I think we're going to continue to do what we've been doing; try to continue to make mutually beneficial deals and then try to do some of the things like we talked about on the earlier call with respect to better monetizing YouTube, which we went through and which is on the call that we're currently working on. So I don't think I have more of an answer than that. On Q4, I think we have actually written in the past a little bit about exactly how Q4 differs from other quarters, particularly the blogs that Hal Varian posted, which I think is new clicks, conversion and Christmas 2008, you'll see it. That basically talked about how CPCs tend to go up at the end of the quarter and conversion rates go up even more so that you have better advertiser ROI in December. I think we did still see that this quarter. I think it's a little bit more muted than in previous Q4.
Patrick Pichette: We'll go to the next question, please.
Operator: We'll take our next question from George Askew from Stifel Nicolaus.
George Askew: Yes. Thank you very much. Two quick questions: Does the employee stock option exchange program require a shareholder vote or any other approvals beyond the Board actions already taken?
Patrick Pichette: The answer is no.
George Askew: No. Okay, fair enough. And then, secondly, I believe in the past, you may have tested display ads on Google search result pages. What is the current thinking about that possibility as a new rollout, new opportunity?
Jonathan Rosenberg: This is Jonathan. I am not sure what tests you're referring to with respect to display ads on search. In fact, I can't remember ever having done. I can get somebody to verify that for you. We have done a number of tests on AdSense for content, and obviously we're presently running display there. But I'm not sure what you're referring to with respect to search. The only thing I can think of is we did some very limited test on image search and we're now beginning to experiment with that. But other than that, I don't know of any tests.
George Askew: Okay. What is the appetite for possibly pursuing that on Google search result pages?
Jonathan Rosenberg: We have to figure out the ad format. We have to figure out where it makes sense. I think as a general rule, there are not that many scenarios in which we have a big appetite on search. You run a search for a movie. It'd be nice to show you a movie trailer. So I think there are some limited number of scenarios where that might make sense. But beyond that, I can't really say. I certainly wouldn't say we'd never do something, but we've got to figure out an elegant way to do it in the right way for the user.
Patrick Pichette: Thank you. We'll go to the next question, please.
Operator: We'll go next to William Morrison from ThinkEquity.
William Morrison: Hi. Thanks for taking my question. Couple of questions on the use of data. I'm curious if I should say my understanding is that you do not use data you collect from Google search to improve monetization or the ads on AdSense for content. I just want to confirm if that's true. And if it is, I'm curious if that's something you would never do or it's something you would consider in the future. And then the second question is on Social Media. I think the last quarter or the quarter before you mentioned that monetizing Social Media was a little bit more difficult than you thought. I'm curious if you could give us an update on where you're at and if you're making any progress there. Thanks.
Jonathan Rosenberg: Yeah, I think we can get pretty quick short answers on these. The answer to your first question is, no, we don't do that. The answer to the second half of the first question is that I generally don't want to say what we would or wouldn't ever do in the future. So I'm not going to comment there. The third question, I guess, on Social Media, I think that it continues to be very, very challenging. I don't think we have any [big rates] to report in Q4 with respect to how we're monetizing social media.
Patrick Pichette: Move to the next question, please.
Operator: And we'll go next to Sameet Sinha from JMP Securities.
Sameet Sinha: Yes, thank you. Couple of questions try to squeeze in here. When we spoke about advertisers bringing down CPCs just to make sure that their campaigns are running successfully with the right ROI, can you talk about what was the extent and which verticals did you see that in? Second question is, with you allowing alcohol ads in the US, gambling in the UK, do you see any benefits from that, any initial reaction? And then the third question, Patrick, looking at your cash balance quarter-over-quarter, your interest income increased about $50 million, if I do the math, it seems like you have an interest rate of 3.5%. I was wondering if those numbers look right?
Patrick Pichette: So let me cover the second point first, which is the issue of alcohol and otherwise. Well, we had found it simply that we had inconsistencies in number of places all these things were legal and fun and in some cases we did offer it, and in some cases it was totally legal also in another country but we didn't. So what we did this call is basically a cleanup to be consistent in our rules, wherever they apply.
Jonathan Rosenberg: And it is generating revenue.
Patrick Pichette: It is generating revenue. On the issue of what we've earned it's really in the range of 1.5% to 2% annually on our cash balance, and that's driven by the conservative stance we've taken in our portfolio right now, given with all the uncertainty in the environment, we took the position to be very conservative in the management of our cash balances, and that's why we have a lower yielding portfolio than otherwise contemplated.
Jonathan Rosenberg: Okay, I'm not sure that I can comment specifically to the observation, that (inaudible) in advertiser behavior, and changes in this by vertical. I did mention on the call, as I think he did, that by size of advertisers, we're seeing strength in the small and medium advertisers relative to the large ones. Some of the surprises I think that we saw with the verticals that are interesting are that autos really did much better than I would have expected, given the fact that the auto industry is doing fairly poorly. It appears that the subset of people buying cars are still of enormous value to the folks in the auto industry. I think real estate still remains the hardest hit vertical, although the mix is changing. You see things like suddenly there are more searches on property management. Maybe people are buying houses at cheap prices, and then have to figure out how to use them as rentals. Foreclosure is bigger relative to mortgages than it was a year ago. Then I think maybe the one other area that surprised me, was you typically think that entertainment is a little more recession-resistant as a category, that category I think didn't do as well as, as I would thought, so I assume that that has to do with those some of the day dynamics.
Sameet Sinha: Okay. Just to follow-up on the cash question. Interest income increased by $50 million sequentially, your cash balance increased by $1.4 billion. Was that increase in interest income just due to the higher cash balance, or was it something else in it?
Patrick Pichette: No, we also had a realized gain on investment of $29 million from Q4.
Sameet Sinha: Okay. Thank you.
Patrick Pichette: And you'll find that in the numbers at some point. Great, we have time for one more question. So we'll take the last question, please.
Operator: We'll take our last question from Ben Schachter from UBS.
Ben Schachter: Just a housekeeping on that last point. Was there bad debt? Can you just give any thoughts on the bad debt? And then Patrick, you've only been there about five months and clearly a big part of your focus is on the cost containment initiatives. Can you talk about sort where you are in terms of how you’ve actually influenced the numbers for this quarter or should we expect more of your sort of focus going forward? I mean, Jonathan, I’m broadly speaking, I was wondering if you could talk about any products that are not performing particularly well that you are rethinking and related to that any specific comments about how Checkout performed in the quarter and the future of that business?
Patrick Pichette: Ben, on bad debt. We're very comfortable with our bad debt, where it stands right now, and you will see that in all of the filings. So I'm totally comfortable on it. We're managing it very closely, as you will see and so that is an area of real focus, but not an area of concern for us. We'll continue to manage it tightly. On the issue of cost containment, yes, it's true I've been here five or six months. I think my observations are as follows. And that's why in the script I gave a few minutes ago on the previous call, I believe that and I meant it, (inaudible). It was not an issue of one individual. It's an issue of leadership obviously at the operating committee. When in these times where you have no visibility, it's going to come ahead of you. In every week you get another surprise in the economy and in the market and in the banking system. We just seem to be good as an operating committee and we are so close to reform and these (inaudible) and correct me, if you go to the extreme of that, right, there's no sense throwing a big party while everybody else in the economy around here is losing their job. It's not the responsible thing. And so, I think Google has really responded well for this call. Let's be prudent, let's be responsible. Of course, like every business, right, we have a lot of levers we can use to manage the business responsibly, but let me tell you the most important one which is we are really focused on growing this business for the long-term. We are, in fact, managing the short-term because of all the hiccups going on around us, and Google is not immune to the economics in which we live around us. But I can tell that you 90% of my agenda is really focused on building on the big opportunities that Google has and it's my agenda as well. That's how I will comment online. You had a question for Jonathan as well?
Jonathan Rosenberg: Well, you can focus on the big opportunity; giving me my [bottled water back].
Patrick Pichette: No bottled water, it's not good for the environment.
Jonathan Rosenberg: What you really saw after the reviews that I talked about in some of my remarks at the beginning was that we became a lot more careful about how we were allocating resources as a result. I think there were some areas that were concerning some of which you probably read about, the resources in Google Video and in Notebook and Dodgeball and others did seem disproportionate relative to what we were getting. So I think you've seen already most of the ramifications of reviews that we did. Checkout actually had pretty solid performance. We've got millions of buyers. We have added 0.5 million sellers. There's billions of dollars in transactions. It's only been in the market for two years. Holiday performance was good, particularly if you look at the state in the macro environment. We still see advertisers reporting much better click through rates on the dash ads and higher conversion rate. So I think that there are advertisers who are having good success with Checkout.
Patrick Pichette: Good. So on that note, we're going to end the call. I'll turn it back to Krista for whatever is proper and thank everybody for having participated with your questions. We really look forward to follow us with Krista and Maria.
Krista Bessinger: We just wanted to thank you all for your participation and we look forward to speaking with you again. Thank you.
Operator: This concludes today's conference. We thank you for your participation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day, everyone, and welcome to the Google, Inc. Conference Call. This call is being recorded. At this time, I would like to turn the conference over to Ms. Krista Bessinger, Director of Investor Relations. Please go ahead Ma'am."
},
{
"speaker": "Krista Bessinger",
"text": "Thank you, Operator. Good afternoon, everyone and welcome to today's fourth quarter 2008 earnings follow-up conference call. With us are Patrick Pichette, Chief Financial Officer; and Jonathan Rosenberg, Senior Vice President of Product Management. After we cover some housekeeping items, we'll open the call immediately to your questions. Please limit yourself to one question and one follow-up. Also, please note that this call is being webcast from our investor relations website located at investorgoogle.com. Please refer to our website for important information including our earnings press release and the latest slide deck. A replay of this call will also be available on our website in a few hours. Please note that we routinely post important information on our investor relations website located at investor google.com and we encourage you to make use of that resource. As a reminder, the purpose of this follow-up call is to give participants the opportunity to ask more detailed financial and product questions in an efficient and Reg FD compliant manner. Let me now quickly cover the Safe Harbor. Some of the statements we make today may be considered forward-looking and these statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to provide or publicly release the results of any revision to the forward-looking statements in light of new information or future events. Please refer to our SEC filings including our quarterly report on Form 10-Q for the quarter ended September 30th, 2008, as well as our earnings press release for a more detailed description of the risk factors that may affect our result. Copies can be obtained from the SEC or by visiting the Investor Relations section of our website. Also, please note that certain financial measures we use on this call, such as: EPS, net income, operating margin, operating income, and our effective tax rates are expressed on a non-GAAP basis, have been adjusted to exclude charges related to stock-based compensation. We also have adjusted our net cash provided by operating activity to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and GAAP to non-GAAP reconciliations can be found in our earnings press release. With that, we're ready to take your questions. Operator?"
},
{
"speaker": "Operator",
"text": "Thank you. The question-and-answer session will be conducted electronically today. (Operator Instructions). And we'll take our first question from Jeetil Patel from Deutsche Bank."
},
{
"speaker": "Jeetil Patel",
"text": "Hey, guys. A couple of questions. I know you talked on the main call about advertisers having excess budgets to work with. Can you quantify what you have been hearing anecdotally? And, what kind of budgets are available that still haven't been spent? Is there any difference between US and maybe Europe and UK in terms of budget availability out there among some of the marketers and customers you deal with? Secondly, can you talk about depth in the fourth quarter? What have you done as it relates to depth of AdWords as it relates to Q4 relative to let's say Q3 or as a good proxy? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "I'm not sure I fully understand the second part of the question on depth of AdWords. We can maybe consider how to ask that one a little better. I'll try to address the first part. I think we mentioned on the call that most of the advertisers are not budget constrained, and the way I think one of the folks internally talked about is almost like a broken slot machine. If you're a reasonably intelligent ROI guided marketer, you are not going to tap your spending. It's basically like finding a broken slot machine that you are not going to get up from. And it's broken in the sense that every time you put a dollar in, N dollars come out where N is bigger than the amount that you paying. If that is the case you're going to want to do it 24 hours a day, seven days a week. The traditional markets you would set are quarterly daily budgets along with ROI goals. In our world, in many ways, they've sort of decided to walk away from the machine and let someone else sit down in the seat. We're not really sure why some of them choose to do that. So, fortunately, it is a minority that our budget is constrained. I'm not sure I have much color on how that differs geographically. Patrick might. On depth, I'm not exactly sure what you are asking. We talked about coverage on the call. Are you talking about ads per query? What exactly are the ads?"
},
{
"speaker": "Jeetil Patel",
"text": "Yeah. Just the number of ads just serving for a search result out there. I mean, obviously, that may differ in terms of two ads versus three versus four. I guess what have you been doing in the fourth quarter as it relates to the number of results you are putting out top fold relative to quarters past?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I really don't think we go into any detail on the sort of intra ad serving dynamics with respect to the queries."
},
{
"speaker": "Jeetil Patel",
"text": "Is that one way to generate more inventory? Obviously, you've got kind of the broken slot machine concept where the ROI is still positive and working. Why wouldn't you actually open up more inventory obviously being selective and careful about it? Is that something you are constantly refining? Let's say, every month or every couple months around just yield?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "We're constantly sticking with the original vision that we have for ads, which is basically trying to improve the quality and show the best ads that we possibly can. We want to really avoid showing poor ads. So we're not really thinking of it from the standpoint of, gee, we could increase yield by adding a few more ads. We're continuing to try to shelve that down."
},
{
"speaker": "Patrick Pichette",
"text": "Let me give an example on this. As we tune for quality relevance and all of the fund review that the engineer work for, you've heard that, in fact, the early 2008 level, you can imagine in a quarter where the exchange rate [changes] really rapidly in a certain geography. People will pay less for this ad and we'll need to pay less for this ad because if it's converted to US dollar it's a lot less. And all of a sudden that would have been totally fine because the change in currency may not be fine any more even though intrinsically it's totally fine in the algorithm. So, engineers spend a lot of time when they look at these wild fluctuations that we have. As an example, we make sure that all the relevant ads should be constant and the relevance they have the right cost, and then when its adjustments is [incidental], but more importantly what people want to see."
},
{
"speaker": "Krista Bessinger",
"text": "So I think we' going to move on now to next question. Thanks."
},
{
"speaker": "Operator",
"text": "And we'll take our next question from Mark May from Needham & Company."
},
{
"speaker": "Mark May",
"text": "Thank you. I guess this is an expense question for Patrick, pretty broad. But how confident are you that even in your worst case revenue forecast for this year that you can maintain the EBITDA margin roughly where you ended the year?"
},
{
"speaker": "Patrick Pichette",
"text": "First of all, we don't give guidance. We don't give guidance on margin. The one thing that I would say, as Eric mentioned, I think the management team is really working with two agendas always. One is, manage our resources prudently. I think Eric was right in saying in some ways the easy part was done in Q4. In that sense, this is a worldwide recession with a lot of visibility about what's going to happen. We just have to be prudent, and therefore, we're focused."
},
{
"speaker": "Jonathan Rosenberg",
"text": "One of the things, that's sort of a subtle point that I'm not sure came across in Eric's remarks about Q4, one of the things that I think we did see and benefit from is that there was a lot of inventory on the part of a lot of retailers who had anticipated a better Christmas. Once it became clear that sales were really required and two-for-one deals were required, a whole different dynamic needed to occur to flush that inventory through. Interestingly, what we saw in November and December was consumers searching much more disproportionately for two-for-one, for sales, for coupons, and advertisers really trying to make sure that they were able to sell the inventory which they purchased when they were anticipating a better economic situation. So, one of the things we have to ask ourselves now is how much of that inventory has actually flowed through the system, which gets back to my answers from a revenue standpoint on commerce. Obviously, we would be adversely impacted if there were less total commerce moving forward. So that's really the wildcard from a user standpoint that we need to watch."
},
{
"speaker": "Mark May",
"text": "I guess as a follow-up and another way of asking it is to what extent, Patrick and team, have you identified sufficient enough amount of expenses that you could cut in your worst case revenue forecast and the nature of the expenses, how quickly could you act on those?"
},
{
"speaker": "Patrick Pichette",
"text": "Again, I'll only talk about what we've done in Q4 and I'll let the facts speak for themselves. I think this management team, the company, and it's not just me, we're a management team focused on making sure that we deliver the results that we set for ourselves. Sorry, I can't give it otherwise I'd fall into guidance which I don’t want to. We're very prudent in our management for sure. We’ll move to the next question, please."
},
{
"speaker": "Operator",
"text": "And we'll take our next question from Jeffrey Lindsay from Sanford Bernstein."
},
{
"speaker": "Jeffrey Lindsay",
"text": "Hi, thanks for taking my question. Can I ask, will the company be changing its wireless search strategy now that Verizon has decided to move its business to Microsoft, and so can you do about this? Is it a priority for you to actually address that issue? And then second, could you just give us some sort of sense of what you are doing to improve the product development process? Thank you."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Sure this is Jonathan. I don't think that our wireless or mobile strategy really is going to change. I think we have a pretty good balance of both searches that come by the partner channel, as well as searches that come directly. So I'm certainly pretty confident that we've got lots and lots of organic search opportunities that will allow us to continue to move forward aggressively. In terms of fundamentally changing the product and development cycle, yeah, I don't think it's changing that much. I think we're just getting better at measuring it, and I think we're getting better at figuring out how to more expeditiously allocate talent to the depths of things that are most important, and that's really what the whole resource allocation exercise that we did in the fall looked at. We went through every product and we looked at the big drivers of cost, be they bandwidth or CPU, or storage intensive products, and along with the revenue opportunities and really tried to quantify both short run and long run what our expectations were, so that we could do a better job of allocating resources. I don't think we're changing any of the core notions that we probably set forth in the Founder’s Letter when we got started. People are still working on 20% time. We're still putting a big premium on innovation. We're still putting a big premium on focusing on the long term. I think we're increasingly putting a premium on internationalization."
},
{
"speaker": "Patrick Pichette",
"text": "Just one last point I would make on the mobile strategy. I think that as Eric mentioned earlier, in the previous call, it is front and center in the strategy of the company, and Android and mobile continues to be a huge part, so the fact that one deal versus another deal I don't think is central to the strategy."
},
{
"speaker": "Jonathan Rosenberg",
"text": "And Jeffrey, just going back to the question you originally asked on Verizon, one of the things we didn't really get a chance to talk about on the previous call is that we're really seeing significant increases in the sales of the smarter phones, both the iPhone, which we mentioned, but also Android. With those kind of phones, it's going to significantly grow the pie for mobile searches, and these smart phones have full browsers. When you have a full browser, then you are typically not as dependent on a deal that locks somebody into a particular direction from a search perspective. So, the better browsers get, the better phones get, and the better ecosystem that evolves there, the better from our perspective."
},
{
"speaker": "Jeffrey Lindsay",
"text": "Yeah, but you're not on either of the major platforms. So, you're not really on AT&T and you're not on Verizon, Verizon's the largest carrier. That means your partners are really T-Mobile and Sprint. Is that not enough to really to make Android viable?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Well, we think the Android numbers will start to speak for themselves, particular this year, now that we've got some additional partners signed up to get to the next generation from a hardware perspective on the platform. So we are very optimistic about Android."
},
{
"speaker": "Patrick Pichette",
"text": "We will move to the next question, please."
},
{
"speaker": "Operator",
"text": "And, we'll take our next question from Jim Friedland from Cowen & Company."
},
{
"speaker": "Jim Friedland",
"text": "Thanks. Two questions relating both to tech. First, on site tech. It reached 5% of GAAP site revenues up 50 basis points sequentially and scoring a lot faster than the sites GAAP revenue. What's driving that? New deals, changes in deals…? Then on network tech that was down on an absolute basis, quarter-over-quarter, as well as percentage basis, and what's driving that? You mentioned cleaning up AdSense for search on the previous call. If you could add a little bit more color there? Thanks."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Just a couple points on that. One, on our own, Google property's tech have driven a lot by the deals that we have on toolbars and all the others that we have, and honestly, these deals are multiyear, and so as they come through, they will increase in short-term, but we see tremendous value under these, and therefore they are good economics for us. On the partner's tech, obviously mixed overall tech obviously, mix is a big element of it. And so, because of our mix during the quarter, that has big influence on it for sure. And, then the second issue is [AdSense] being weaker, obviously influenced it as well. And, then finally, on a lower marginal basis, but nevertheless, revenue from our hedging activity was also recognized between our properties and then our partner properties as well. Well the combination of all of that makes it that our partner companies has lower that versus (inaudible). I hope that answers the question."
},
{
"speaker": "Krista Bessinger",
"text": "Next question, please. Operator: And we'll take our next question from Youssef Squali from Jefferies & Company."
},
{
"speaker": "Youssef Squali",
"text": "Thank you very much. Patrick, the UK was down 1% year-over-year and 12% sequentially. When you FX that, neutral that - do you have those numbers? And then as a part of that, how much of that is really FX versus maybe the UK market starting to mature a bit? From a monetization perspective, it was already over monetized or relatively more monetized than the rest of your territories. And lastly, on the stock option exchange, why did you guys decide to give employees options or repriced options when you could have maybe opted for restricted stock? Wouldn't have that been less dilutive?"
},
{
"speaker": "Patrick Pichette",
"text": "Okay, so is that the question. Let me start first by the UK. We don't do the math for everybody, if you do the analysis and reverse engineer where the FX has gone over the last quarter, you will find that the FX has been a significant factor for the numbers that we reported. And you can't discount (inaudible) the biggest issue for me is the issue of FX for me (having) results, but you can't discount the fact that the macro economic environment and the pressure that they have in the UK, the UK is in a deep recession. So the market also get influenced by this and the dynamics of advertising and spending for products? I'm sure it is. It would be wrong to say that it's not. The UK is really being impacted by a deep recession. So it's a combination of those two rather than the maturity of the market that I think really impacted, with the first being the most significant factor. In the case of the stock option versus the DSU or GSU or restricted stock, I think that there is a philosophy issue that Google has. It wants to continue to make sure that people think of the company and manage the company as it grows. And because of that, the mind-set of the stock options is, in fact, the preferred way in terms of compensation versus GSUs and the balance of things. That’s why we kept on with stock option (Inaudible). We'll go to the next question. Thank you for your question."
},
{
"speaker": "Operator",
"text": "And we will take our next question from Marianne Wolk from Susquehanna."
},
{
"speaker": "Marianne Wolk",
"text": "Sure, the first was regarding AdSense per content, which you implied or it sounded like you are implying, grew faster than even Google.com this quarter. Is that because you are adding partners with DoubleClick ad exchange or is that because pricing is improving? Can you help us try to understand what kind of legs are there? And then the second question I had, if you will, you talk a little bit about the competition if there is any from Microsoft cash-back program? Thanks very much."
},
{
"speaker": "Jonathan Rosenberg",
"text": "This is Jonathan. I'm not sure that we said that AdSense per content was growing relative to Google.com. I think we were talking about cash and I think it would have grown relatively faster compared to AdSense, where we did some of the arbitrage clean up. So, I'm not sure that was what we said, but it is the case that AdSense per content has been growing. I think that one of the interesting dynamics that we're seeing there, because we're monetizing better, and yes, I think a lot of is it product efforts that we're doing along with DoubleClick. We're getting more and increasingly it appears that we are getting better inventory, and it's particularly more recently with the - as the economy has slowed, it appears that some folks are giving us more of their inventory than they had in the past and particularly some of the better inventory. So I think we see, if another network can't sell, the inventory comes to us, we'll monetize it better, so I think that's basically the story. The cash-back efforts that Microsoft is doing, we're watching that as carefully as we can, we don't really see much, and we don't see anything that is particularly sustained. We're continuing to see Google Product Search, do very well from a traffic perspective in the last month, both domestically and internationally, so I don't think we're seeing anything differently."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you. Next question please."
},
{
"speaker": "Operator",
"text": "And we'll take our next question from Sandeep Aggarwal from Collins Stewart."
},
{
"speaker": "Sandeep Aggarwal",
"text": "Thank you. Jonathan, I know you have answered multiple questions on coverage, but I have one question on coverage, and then one or two product related questions. When you were decreasing your coverage ratio in '07 and maybe in '08, you theoretically sacrificed some of the searches for clicks, which could have generated some revenue, and as you expand your coverage again is it fair to assume that you may not regain all those searches, which you probably lost when you were decreasing the coverage ratio?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Well, sure, yes. I'm not going to gain on search that I lost last year."
},
{
"speaker": "Sandeep Aggarwal",
"text": "No, let me clarify. In the sense, because you were decreasing your coverage ratio because you were improving the quality score, so as you expand your coverage, will you be able to capture the nature of those queries which were let go last time?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I don't think it's really symmetrical. I'm not really sure that increasing coverage is directly the opposite of decreasing coverage. So I don't know. I think we'll be showing ads on a better set of queries and continue to get benefits of that ad."
},
{
"speaker": "Sandeep Aggarwal",
"text": "Okay. Let me move to actually two product-related questions. One is how similar or different is a mobile Internet-generated search query versus a PC-generated search query in terms of a CPC, as well as a mix of commercial versus research-related searches?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yeah. That's interesting. I'm not sure we know the answer with respect to CPCs because I don't think that market has matured as well as it needs to from an option dynamic standpoint. One of the things that we just started doing is making it much easier to run your PC-based queries on the mobile devices and customize the ads, so that they look better and work better on the mobile devices. The only data point that we've seen so far is that click through rates seem similar to that of desktop computers, but I don't think we have a good sense yet for what CPCs will look like in a more mature market. I personally think that they could be much higher, because I think when people are going to the trouble of running a search on a small, portable device, particularly a location aware small portable device they're much closer to consummating a transaction. And so, you can imagine that that search is more valuable, particularly to an advertiser in close proximity to where the search is run. Mobile is bigger on the weekend, which is another trend that we've seen. I think that's probably bigger during the week. But those are really the only other clear trends that we've observed."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you. We'll go to the next question please."
},
{
"speaker": "Operator",
"text": "And we'll go next to Gene Munster from Piper Jaffray."
},
{
"speaker": "Gene Munster",
"text": "Hi. Good evening. If you could talk a little bit about just from a very high level from at the economic environment, I know you're not economists, but is it reasonable to expect some form of seasonality emerging in the business in 2009?"
},
{
"speaker": "Patrick Pichette",
"text": "There's obviously seasonality within the business. If you look back to the last few years, Q4 is a very strong quarter. Q1 is also a stronger quarter relative to Q2, Q3 when people are on vacation. Seasonality is part of the business, always has been and continues to be."
},
{
"speaker": "Gene Munster",
"text": "Okay, great. And then second is that you mentioned on the previous call that some of the behaviors around the holiday quarter in comparison to shopping and so forth, more people doing searches, but do you have any expectations about some of that search behavior in 2009 that same kind of Wal-Mart effect continuing or just any general thoughts on search behavior in 2009?"
},
{
"speaker": "Patrick Pichette",
"text": "No. I guess the only comment that I can have there is the comments that we made about consumers shopping for deals everyday. We certainly measured some of those things and I think we've shared some of the data points that we had. It is a lot true that on days like Cyber Monday, whichever (inaudible) after Thanksgiving, you see people looking more on coupons and behave in price comparison. But I don't think that behavior was limited to key shopping days. The increase of deal seeking queries then was a minor compared to the surrounding weeks, and I think you are going to see that people are going to continue to shop for deals. It is just clear that their deals are out there."
},
{
"speaker": "Krista Bessinger",
"text": "The next question, please."
},
{
"speaker": "Operator",
"text": "And we'll take our next question from Ross Sandler from RBC Capital Markets."
},
{
"speaker": "Ross Sandler",
"text": "Thanks for taking the question. First, on international and then the second question on display. So, on the international side, if my math is correct, international revenue ex-FX was up 35% year-over-year in the fourth quarter. That was an acceleration from 32% last quarter in 3Q 2008 on an FX neutral basis. So, if the comments around UK showing some macro sluggishness, where was the accelerated growth coming from? Was it particular to a geographic region or was it more a factor of company induced growth initiatives like improving coverage? And then, a follow-up on display. Google's approach has been to kind of position the company for the days when purchasing display ads is an automated format similar to how search is bought today. Do you think there's a need for a strategy in the interim to give large display advertisers and agencies a little bit more hand holding to get things going in display before the buying process is fully automated, which could take a few years? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Okay. I'll answer the first and I'll let Jonathan answer the second. We're not going to comment specifically on the numbers you provided, but it is true that in the grand scheme of things, international continues to perform well where Continental Europe certainly is much less mature than the US and the UK. And as discussed in the previous call, some countries like Germany and a few others who are better than the others have done fairly well even in this economic environment. It's also true that we have a number of environments where we are growing rapidly in our [break] countries. We talked about China, we talked about Brazil. We have a lot of optimism for these countries because they are much less mature. So there's a lot of runway in them; different economics, but a lot of runway. That covers the international. Okay. I'll let Jonathan cover the other question."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yeah. I think your observation is well taken. I think Eric said we want to make display advertising easy and we want to make it acceptable for all advertisers and publishers. The challenge is that today is extremely inefficient, so that does make for a very big challenge. Lots and lots of activity in the display world happen even by faxes, never mind phone call. The logistics involve people doing things like literally cutting and pasting HTML code to get ads up and running on a site. So, I think we absolutely recognize that between now and when we can achieve the kind of science that we'd like, we've got to do a lot to continue to help advertisers get these ads going. One of the things, we've launched a display ad filter which does make it much easier for the small advertisers, particularly AdWords customers to use display and get reasonably creative professional looking display ads with the AdWords interface. I think getting to the long run goal of making this more like Google AdWords is going to take time, and I think we need agencies to help with it, and there are some great agencies and (inaudible) who are helping carry this forward, and we'll keep doing whatever we can incrementally to make it easy for advertisers as well."
},
{
"speaker": "Krista Bessinger",
"text": "Next question, please."
},
{
"speaker": "Operator",
"text": "We'll take our next question from Steve Weinstein from Pacific Crest."
},
{
"speaker": "Steve Weinstein",
"text": "Thank you. I'm curious. In your toolbar or other distribution deals, in those relationships and whether contract ends or you go with another partner, does your revenue commitment to that partner continue as long as someone continues to use that toolbar? Or, is there a finite date where we could stop modeling that as an expense of the business? And then second, you've talked a lot about the display business, and you're obviously very optimistic about it. Can you help us get a sense of scale or size for that business today at Google, and where it might become a meaningful piece of the business?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "So, we not going to give you detailed answers to (inaudible) these questions, unfortunately, but typically, in most of the deal type efforts that we're engaged, we're paying for what we're directly receiving. So I'm not going to go beyond that. And we don't comment on sort of the relative size of different businesses. But obviously display is getting to be quite significant and we alluded to the degree to which the DoubleClick integration has made significant progress and YouTube is really using DoubleClick as a platform for the business that they're building. So it's already a meaningful and growing part of the business, but I think that's all we'll say."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you. Next question, please."
},
{
"speaker": "Operator",
"text": "And we'll take our next question from Mark Mahaney from Citigroup."
},
{
"speaker": "Mark Mahaney",
"text": "Thanks, two quick questions. Patrick, back on the cost side. I know you’re not talking about cost going forwards, but what would you point to us as the best examples of cost constraints in just the fourth quarter? The setup for the question is, if we remove the revenue contribution, which must have been all margin from the hedging program, non-GAAP operating margins, actually declined sequentially. So what do you think is the best evidence of the new cost controls that are at the company?"
},
{
"speaker": "Patrick Pichette",
"text": "So let me give you, I'm just looking for my list here. We have done in Q4, and I can share that with you, a couple of areas where pretty if you do understand how do you contain cost growth. So obviously, hiring pace is the clear one, right. I think last quarter we had, what, 400 people, now they are now 500 somewhere around there. We have 100 for this quarter. In the previous quarter as well we did talk about managing our contractors and our temps in a better fashion, so there will be opportunities there. We have a lot of office space. Google has, right, because we're everywhere, and we've been publishing from this office building and we don’t need in the short term, we have some options there. Improving machine utilization, I talked about it on the call a bit earlier. Using better machines gave us a lot of CapEx and OpEx. Same thing for better utilization of bandwidth. So, we have, in general, a number of other elements, if you think about professional services, including self-service as well within the Google, so just to give you a sense of the broadness, the comprehensiveness, and it's one where we are just being responsible at managing our resources. So this gives you a sense of the excluding management that we are working with."
},
{
"speaker": "Mark Mahaney",
"text": "Thanks and a quick follow-up just on the AdSense for search. I think the comment was made during the call about cleaning up AdSense for search network. Can you give us any sense of how far along the process you are in doing that?"
},
{
"speaker": "Patrick Pichette",
"text": "I'll let Jonathan talk about it. It's more a (inaudible)."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Not sure I can give you a sense in terms of proportionally how much of the way we're there. Certainly, I think there's a disproportionate number, I think there were a good number of shopping oriented sites that we are working in a manner that wasn't consistent with our terms, but I don't think I can give you a sense of to what degree we have gotten rid of all of it. Part of it's like dealing with email scams. You get rid of it, and then it comes back. So, I think it's kind of going to be an ongoing battle. I'm not sure I can predict how that's going to play out."
},
{
"speaker": "Patrick Pichette",
"text": "Great. Thanks. We will move to the next question, please."
},
{
"speaker": "Operator",
"text": "And, we'll take our next question from Jason Helfstein from Oppenheimer."
},
{
"speaker": "Jason Helfstein",
"text": "Thanks. I'm going to try to get three quick ones in. So one, there was no mention of apps in the release, and I'm wondering if we should read into that. My second question, without giving specific numbers, can you comment on paid click trends by geography, so perhaps like better or worse than the 18% you reported? And lastly on cash. How much cash resides outside the US? And connected to that, would you consider buying back stock to offset option dilution? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "On the thing clicks by geo, I just wanted to say, we don't comment on the details. All I can say is, as we've said in the previous calls, we have healthy growth across all major geographies. So, I'll cover that one. I'll let Jonathan talk about the apps and I'll get back to you on the cash issue."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yes. Apps are certainly one of the top things that I mentioned. I think I talked that we are getting about the fact that we've released over a 100 enhancements to the whole application suite in 2008. I think I said, momentum is particularly strong, both Eric and I (inaudible) the million business on apps number, as well as the 10 million users and three million active users from school. So, we continue to be innovating aggressively on apps. If I think about this last year, there was Google site, Google video. I know we had same tools for Outlook and Blackberry, numbers of large enterprise deployment. Eric has mentioned the general continued demand for (cloud) driven efforts. And I also think that the opportunity here in 2009 as enterprises are struggling to deal with increasing IT cost, in a recession that should be a good opportunity for us. It's relatively low-cost platform that's easily updated and delivers a lot of the functionality that they need."
},
{
"speaker": "Patrick Pichette",
"text": "Let me come back on the cash issue. I just wanted to check out before, we don't disclose that, so that's why (inaudible), I would have given you the latest update, but we do not disclose on that, so sorry for that. Is there a question on (inaudible)?"
},
{
"speaker": "Jason Helfstein",
"text": "(I don't know about that)."
},
{
"speaker": "Patrick Pichette",
"text": "We look at it all the time, companies do all the time, and there's no one else to make them best. Next question, please."
},
{
"speaker": "Operator",
"text": "And we'll take our next question from Rob Sanderson from Broadpoint AmTech."
},
{
"speaker": "Rob Sanderson",
"text": "Two questions: one on the macro, and one on the currency hedging program. Just want to revisit some of the things said here on the macro environment and the impact we might have on seasonality. I think Jonathan was discussing two-for-ones and discounts. I think that also led to some more aggressive keyword bidding, but don't these dynamics set up a much more seasonal Q1 than we've seen in previous years?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Well again, so we don't give forward guidance, but it goes back to the same thing I said before. It depends on the total amount of commerce and services that are occurring in the economy at large, so I wouldn't read much more into it. Other than that your ability to predict what's going to happen from a macro economic perspective in Q1 there is probably similar to ours. If there's less commerce, overall, then that's going to adversely impact Google. If there's not, and there isn't consumer driven reductions in commerce and spend, then we should be fine."
},
{
"speaker": "Rob Sanderson",
"text": "Okay, thanks. And then on the currency hedging program, Patrick, you mentioned you're not fully implemented in the UK. Is there any way you could give us a sense of what it may look like in Q4, had you been? And just on the basic mechanics of the program, it's forward cash flow you're attempting to hedge out here. Does this mean as the dollar strengthens you see an unrealized gain that then flows back to the income statement over future period that you hedged against? So first, is that the right general mechanics, and then if that's the case, then currency is ready to remain constant from here. Should we expect a similar gain in the future periods as we saw in Q4?"
},
{
"speaker": "Patrick Pichette",
"text": "The mechanics is right. I'm not going to pronounce myself about the future, because in the last six months I've been living through this roller coaster, so who knows. And on the first part of your question, all I can say is, we implemented our (click return) hedges in Q3. It's a partial effect, (Inaudible) affecting Q1. I mean, that's all we knew, we can give you. We'll take the next question, please."
},
{
"speaker": "Operator",
"text": "And we'll go next to Imran Khan from JPMorgan."
},
{
"speaker": "Imran Khan",
"text": "Yes, Hi. Thank you again for taking my questions. Two questions, and then I have a clarification, just because I think there was some confusion about that. So the first two questions are, if you look at the seasonality in the fourth quarter business, was there anything abnormal? Have you seen the growth rate, if I look at the year-over-year growth rate, October and November versus December? Any color on that will be very helpful. And secondly, question probably for Jonathan. It’s being reported that the relationship with Warner Music that they are pulling out their content from YouTube. If you can give any color on that in terms of monetizing this music content, that would be very helpful. And in terms of the clarification, the $129 million FX hedging, that flows through your US revenue line or international revenue line? And Google.com versus AdSense. Thank you."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Okay, on the seasonality issue we're not going to give you, we just don’t divulge October, November, December. We just don't go there. Could you just repeat your hedging question?"
},
{
"speaker": "Imran Khan",
"text": "Yes. So the $129 million, the benefit that you had, do you recognize the revenue on your US revenue line or does it help the international revenue line?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I understand now. Sorry. We recognized, of the 100% of the 129 we roughly, you can think of it as 70% for Google properties and 30% for the network properties and so therefore you have to have a sense of what’s US versus international. We do it actually not as much. It's 100% obviously international, because we're hedging. We don't need to hedge US, right?"
},
{
"speaker": "Imran Khan",
"text": "Right."
},
{
"speaker": "Jonathan Rosenberg",
"text": "So it’s international, but the real question is Google or network."
},
{
"speaker": "Imran Khan",
"text": "Got it. About YouTube and about Warner Music. It's being reported that Warner Music pulled out their content out of YouTube. Any update on that? And it seems like it's also being reported about, I may rephrase the question this way. How can we better monetize music content that you have licensed through the music industry?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Well, we certainly still got great relationships with thousands of partners including many in the music industry, so we'd love to work with Warner. But I think we're going to continue to do what we've been doing; try to continue to make mutually beneficial deals and then try to do some of the things like we talked about on the earlier call with respect to better monetizing YouTube, which we went through and which is on the call that we're currently working on. So I don't think I have more of an answer than that. On Q4, I think we have actually written in the past a little bit about exactly how Q4 differs from other quarters, particularly the blogs that Hal Varian posted, which I think is new clicks, conversion and Christmas 2008, you'll see it. That basically talked about how CPCs tend to go up at the end of the quarter and conversion rates go up even more so that you have better advertiser ROI in December. I think we did still see that this quarter. I think it's a little bit more muted than in previous Q4."
},
{
"speaker": "Patrick Pichette",
"text": "We'll go to the next question, please."
},
{
"speaker": "Operator",
"text": "We'll take our next question from George Askew from Stifel Nicolaus."
},
{
"speaker": "George Askew",
"text": "Yes. Thank you very much. Two quick questions: Does the employee stock option exchange program require a shareholder vote or any other approvals beyond the Board actions already taken?"
},
{
"speaker": "Patrick Pichette",
"text": "The answer is no."
},
{
"speaker": "George Askew",
"text": "No. Okay, fair enough. And then, secondly, I believe in the past, you may have tested display ads on Google search result pages. What is the current thinking about that possibility as a new rollout, new opportunity?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "This is Jonathan. I am not sure what tests you're referring to with respect to display ads on search. In fact, I can't remember ever having done. I can get somebody to verify that for you. We have done a number of tests on AdSense for content, and obviously we're presently running display there. But I'm not sure what you're referring to with respect to search. The only thing I can think of is we did some very limited test on image search and we're now beginning to experiment with that. But other than that, I don't know of any tests."
},
{
"speaker": "George Askew",
"text": "Okay. What is the appetite for possibly pursuing that on Google search result pages?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "We have to figure out the ad format. We have to figure out where it makes sense. I think as a general rule, there are not that many scenarios in which we have a big appetite on search. You run a search for a movie. It'd be nice to show you a movie trailer. So I think there are some limited number of scenarios where that might make sense. But beyond that, I can't really say. I certainly wouldn't say we'd never do something, but we've got to figure out an elegant way to do it in the right way for the user."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you. We'll go to the next question, please."
},
{
"speaker": "Operator",
"text": "We'll go next to William Morrison from ThinkEquity."
},
{
"speaker": "William Morrison",
"text": "Hi. Thanks for taking my question. Couple of questions on the use of data. I'm curious if I should say my understanding is that you do not use data you collect from Google search to improve monetization or the ads on AdSense for content. I just want to confirm if that's true. And if it is, I'm curious if that's something you would never do or it's something you would consider in the future. And then the second question is on Social Media. I think the last quarter or the quarter before you mentioned that monetizing Social Media was a little bit more difficult than you thought. I'm curious if you could give us an update on where you're at and if you're making any progress there. Thanks."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yeah, I think we can get pretty quick short answers on these. The answer to your first question is, no, we don't do that. The answer to the second half of the first question is that I generally don't want to say what we would or wouldn't ever do in the future. So I'm not going to comment there. The third question, I guess, on Social Media, I think that it continues to be very, very challenging. I don't think we have any [big rates] to report in Q4 with respect to how we're monetizing social media."
},
{
"speaker": "Patrick Pichette",
"text": "Move to the next question, please."
},
{
"speaker": "Operator",
"text": "And we'll go next to Sameet Sinha from JMP Securities."
},
{
"speaker": "Sameet Sinha",
"text": "Yes, thank you. Couple of questions try to squeeze in here. When we spoke about advertisers bringing down CPCs just to make sure that their campaigns are running successfully with the right ROI, can you talk about what was the extent and which verticals did you see that in? Second question is, with you allowing alcohol ads in the US, gambling in the UK, do you see any benefits from that, any initial reaction? And then the third question, Patrick, looking at your cash balance quarter-over-quarter, your interest income increased about $50 million, if I do the math, it seems like you have an interest rate of 3.5%. I was wondering if those numbers look right?"
},
{
"speaker": "Patrick Pichette",
"text": "So let me cover the second point first, which is the issue of alcohol and otherwise. Well, we had found it simply that we had inconsistencies in number of places all these things were legal and fun and in some cases we did offer it, and in some cases it was totally legal also in another country but we didn't. So what we did this call is basically a cleanup to be consistent in our rules, wherever they apply."
},
{
"speaker": "Jonathan Rosenberg",
"text": "And it is generating revenue."
},
{
"speaker": "Patrick Pichette",
"text": "It is generating revenue. On the issue of what we've earned it's really in the range of 1.5% to 2% annually on our cash balance, and that's driven by the conservative stance we've taken in our portfolio right now, given with all the uncertainty in the environment, we took the position to be very conservative in the management of our cash balances, and that's why we have a lower yielding portfolio than otherwise contemplated."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Okay, I'm not sure that I can comment specifically to the observation, that (inaudible) in advertiser behavior, and changes in this by vertical. I did mention on the call, as I think he did, that by size of advertisers, we're seeing strength in the small and medium advertisers relative to the large ones. Some of the surprises I think that we saw with the verticals that are interesting are that autos really did much better than I would have expected, given the fact that the auto industry is doing fairly poorly. It appears that the subset of people buying cars are still of enormous value to the folks in the auto industry. I think real estate still remains the hardest hit vertical, although the mix is changing. You see things like suddenly there are more searches on property management. Maybe people are buying houses at cheap prices, and then have to figure out how to use them as rentals. Foreclosure is bigger relative to mortgages than it was a year ago. Then I think maybe the one other area that surprised me, was you typically think that entertainment is a little more recession-resistant as a category, that category I think didn't do as well as, as I would thought, so I assume that that has to do with those some of the day dynamics."
},
{
"speaker": "Sameet Sinha",
"text": "Okay. Just to follow-up on the cash question. Interest income increased by $50 million sequentially, your cash balance increased by $1.4 billion. Was that increase in interest income just due to the higher cash balance, or was it something else in it?"
},
{
"speaker": "Patrick Pichette",
"text": "No, we also had a realized gain on investment of $29 million from Q4."
},
{
"speaker": "Sameet Sinha",
"text": "Okay. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "And you'll find that in the numbers at some point. Great, we have time for one more question. So we'll take the last question, please."
},
{
"speaker": "Operator",
"text": "We'll take our last question from Ben Schachter from UBS."
},
{
"speaker": "Ben Schachter",
"text": "Just a housekeeping on that last point. Was there bad debt? Can you just give any thoughts on the bad debt? And then Patrick, you've only been there about five months and clearly a big part of your focus is on the cost containment initiatives. Can you talk about sort where you are in terms of how you’ve actually influenced the numbers for this quarter or should we expect more of your sort of focus going forward? I mean, Jonathan, I’m broadly speaking, I was wondering if you could talk about any products that are not performing particularly well that you are rethinking and related to that any specific comments about how Checkout performed in the quarter and the future of that business?"
},
{
"speaker": "Patrick Pichette",
"text": "Ben, on bad debt. We're very comfortable with our bad debt, where it stands right now, and you will see that in all of the filings. So I'm totally comfortable on it. We're managing it very closely, as you will see and so that is an area of real focus, but not an area of concern for us. We'll continue to manage it tightly. On the issue of cost containment, yes, it's true I've been here five or six months. I think my observations are as follows. And that's why in the script I gave a few minutes ago on the previous call, I believe that and I meant it, (inaudible). It was not an issue of one individual. It's an issue of leadership obviously at the operating committee. When in these times where you have no visibility, it's going to come ahead of you. In every week you get another surprise in the economy and in the market and in the banking system. We just seem to be good as an operating committee and we are so close to reform and these (inaudible) and correct me, if you go to the extreme of that, right, there's no sense throwing a big party while everybody else in the economy around here is losing their job. It's not the responsible thing. And so, I think Google has really responded well for this call. Let's be prudent, let's be responsible. Of course, like every business, right, we have a lot of levers we can use to manage the business responsibly, but let me tell you the most important one which is we are really focused on growing this business for the long-term. We are, in fact, managing the short-term because of all the hiccups going on around us, and Google is not immune to the economics in which we live around us. But I can tell that you 90% of my agenda is really focused on building on the big opportunities that Google has and it's my agenda as well. That's how I will comment online. You had a question for Jonathan as well?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Well, you can focus on the big opportunity; giving me my [bottled water back]."
},
{
"speaker": "Patrick Pichette",
"text": "No bottled water, it's not good for the environment."
},
{
"speaker": "Jonathan Rosenberg",
"text": "What you really saw after the reviews that I talked about in some of my remarks at the beginning was that we became a lot more careful about how we were allocating resources as a result. I think there were some areas that were concerning some of which you probably read about, the resources in Google Video and in Notebook and Dodgeball and others did seem disproportionate relative to what we were getting. So I think you've seen already most of the ramifications of reviews that we did. Checkout actually had pretty solid performance. We've got millions of buyers. We have added 0.5 million sellers. There's billions of dollars in transactions. It's only been in the market for two years. Holiday performance was good, particularly if you look at the state in the macro environment. We still see advertisers reporting much better click through rates on the dash ads and higher conversion rate. So I think that there are advertisers who are having good success with Checkout."
},
{
"speaker": "Patrick Pichette",
"text": "Good. So on that note, we're going to end the call. I'll turn it back to Krista for whatever is proper and thank everybody for having participated with your questions. We really look forward to follow us with Krista and Maria."
},
{
"speaker": "Krista Bessinger",
"text": "We just wanted to thank you all for your participation and we look forward to speaking with you again. Thank you."
},
{
"speaker": "Operator",
"text": "This concludes today's conference. We thank you for your participation. You may now disconnect."
}
] | null | null |
GOOGL | 3 | 2,008 | 2008-10-17 16:30:00 | Operator: Good day and welcome everyone to the Google Inc. Conference Call. This call is being recorded. At this time I would like to turn the call over to Ms. Krista Bessinger. Please go ahead, ma'am.
Krista Bessinger: Good afternoon everyone and welcome to today's third quarter 2008 Earnings Call. With us are Eric Schmidt, Chief Executive Officer, Patrick Pichette, Chief Financial Officer, Sergey Brin, Founder and President of Technology, Jonathan Rosenberg, Senior Vice President of Product Management, Omid Kordestani, Senior Vice President of Global Sales and Operations is joining us from London today, and Hal Varian our Chief Economist. Eric, Patrick and Sergey will provide us with their thoughts on the quarter and then Jonathan, Omid and Hal will join us for Q&A. Please note that this call is being webcast from Investor Relations website. Please also refer to our Investor Relations website for important earnings related documents including our press release issued a few minutes ago along with slides that accompany today's prepared remarks. A replay of this call will also be available on our Investor Relations website in a few hours. Now let me quickly cover the Safe Harbor. Some of the statements we make today maybe considered forward-looking including statements regarding investments in our core business, traffic acquisition cost, operational efficiency and cost and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings including our quarterly report on form 10-Q for the quarter ended June 30, 2008, as well as our earnings press release for a more detailed description of the risk factors that may affect our results. Copies can be obtained from the SEC, or by visiting the Investor Relations section of our website. Also please note that certain financial measures we use on this call such as EPS, net income, operating margin and operating income are expressed on a non-GAAP basis and have been adjusted to exclude charges relating to stock-based compensation. We have also adjusted our net cash provided by operating activities, to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and GAAP to non-GAAP reconciliation can be found in our earnings press release. With that it is my pleasure to turn the call over to Eric.
Eric Schmidt: Well. Thank you, very much, Krista, and good afternoon everybody. First, let me welcome Patrick, Patrick Pichette, who is of course our CFO, who is off and hit the ground running. He certainly joined us at an interesting time. Before he goes into the detail, which of course everyone is quite interested in. Let me just talk about some of the highlights. Thanks to everybody's hard work. Google had a good quarter. Traffic and revenue were both solid and we kept tight control on costs. Year-on-year, for example, search query traffic is growing in almost every vertical. We believe that these results reflect the fact that as marketing budgets are squeezed, targeted, measurable ads are becoming more valuable to advertisers. As consumer budgets are squeezed, people use the web for comparison shopping to hunt for bargains online and in stores. Regarding the economic situation, I think everybody on the call and listening understands that it is pretty clear the economic situation today globally is worse than people were predicting just a month ago. So, look at the difference in the papers. What started off as a financial crisis appears at least according to the consensus around the world, to be affecting the wider economy. When I talk to other CEOs in Europe and in America, it is clear that the economic situation is so fluid, that we are all in uncharted territory. The question is how should Google respond? Our answer, as always, is looking at the long-term, and we believe that even more today -- more important today than ever. Search, which of course is Google's core, is where we are putting a lot of our investment -- better search, better ads, [proof latency]. Our user experience is getting much better. Index size is getting much larger, greater personalization for better results globally for every user, lots and lots of language support, more highly relevant ads against as many queries as possible and using more sophisticated tools for advanced bidding and measurement and optimization. So that advertisers, who understand that advertising is directly correlated with revenue, can use those tools to maximize revenue based on the terms that they set and based on the budgets, which is what they care about. So the opportunities are more than just the search and ads. In Apps, for example, the company is going to cut IT costs and increase productivity with greater collaboration well. We are there for them. Our enterprise applications really add value there. In display by improving targeting, we deliver better and more relevant ads for users and for advertisers, agencies and publishers. The DoubleClick integration now going very well. David Rosenblatt from DoubleClick is now President of our display businesses, says it is going great. YouTube is now running 90% – ads against 90% of all the content claimed by partners using our content ID tool. We are experimenting with different advertising formats now well announced in video ads, click-to-buy and pre-roll. Geo-Mobile another core component and new opportunity for us geographically relevant in location based advertising is valuable to users in our view, who are working, developing advertising products that match ads to geographic data. We think that is a big opportunity for us. So along the way, we are going to stay very close, keep a very close eye on costs. It makes sense given everything we read in the papers and we have done that effectively in this quarter. It is the right thing to do and what I like about it. Sergey can talk about this a little bit if he likes. Sergey likes to say scarcity builds clarity. I think it is a great focusing opportunity for Google as well. To a very realistic about the macro economic climate, but we are optimistic about Google's future because we are confident about the enduring value and power of the web. Sergey will talk about this in more, but fundamentally people are moving to the internet, they are moving to more targeted advertising, are using information in a smarter way and Google is one of the significant beneficiaries of that. We fundamentally believe that users will always want information and need to communicate and advertisers will always value relevant and very measurable advertising, which of course these are Google's core strengths. So, with that Sergey maybe you would like to – sorry Patrick maybe you talk about our financials first and then we will go over to Sergey.
Patrick Pichette: Thank you, Eric and good afternoon everyone. So, as Eric said a few minutes ago, we had another solid quarter despite a challenging economic environment. A few numbers: gross revenue was up 31% year-over-year to $5.5 billion reflecting healthy growth across the Google - both Google.com and our network. Google.com was up 34% year-over-year to $3.7 billion driven by steady traffic growth and AdSense was up 15% year-over-year to $1.7 billion, also reflecting solid growth across both content and search. Global aggregate paid click growth was also reasonably good goes up 18% year-over-year and 4% quarter-over-quarter, reflecting healthy growth across all major properties. We saw also steady growth in the US with revenues up 22% year-over-year, to $2.7 billion and up 5% quarter-over-quarter. International revenue also held up reasonably well, accounting for 51% of our total revenue or $2.8 billion. The UK showed some softness, but up 17% year-over-year to $776 million, but essentially flat quarter-over-quarter including the impact of the currency. The rest of EMEA performed better driven by relatively good performance in the Netherlands and Germany. Asia and Latin America were solid as well, mostly driven by relatively good performance in Brazil and China. From an advertisers’ spend perspective, we saw a combination of strong relative performance in many verticals including home appliances, apparels, jobs, but also and not surprisingly some tougher performances in others such as home financing, auto financing, and real estate as everybody can imagine. Let me turn to expenses now to traffic acquisition costs were $1.5 billion in Q3 or 27.9% of total advertising revenue. This is down from $28.4 million in Q2. AdSense TAC was $1.3 billion and Google TAC was $167 million. As we embark on new initiatives, we may see additional pressures on TAC rates going forward. Other costs of revenue they have increased $4 million over Q2 to $678 million and the largest driver of the increase was data center related costs and those include depreciation, equipment and operations. All other operating expenses totaled $1.63 billion, including approximately $269 million in stocks-based compensation and expenses related to payroll and facilities increased $49 million over Q2 to $859 million. On the headcount front, we finished a quarter with approximately 20,000 full-time employees. That is approximately 500 net new employees added in the quarter and over half of these new net hires are in engineering, and then followed by sales and marketing. We have implemented and continue to follow a disciplined hiring process in all areas of the organization, but as we have indicated in the past, we continue to invest in our core business, both in the US and internationally. In consequence of all this management expense the non-GAAP operating profit, which excludes stock-based compensation, crossed the $2 billion threshold for the first time in Q3, driving non-GAAP operating profit margins to 36.5%. As Eric mentioned a little earlier in his comments, it makes sense on the current economic environment to maintain a clear focus on operational efficiency, and cost containment and we have done so, and we will continue to do so, better positioning Google for healthy long-term growth. Let me move on to interest income and other, which was $21 million for the quarter. The primary driver for interest income, and other, are on the positive side, a very strong cash balance, $14.4 billion. The annual interest we earn on that cash is currently in the 2% to 3% range, and we also had a small realized gain on investment of $11 million in Q3. These benefits are to large extent offset by the impact of our, the rollout of our hedging program in Q3. So, in Q3, our hedging expense and related impacts totaled approximately $80 million. Please note that we amortize the cost for the time value of our cash-flow hedging programs in other income and expense on a monthly mark-to-market basis, not a straight line basis. As a result, the amount of amortized expense were recognized in any particular quarter is impacted by how much the option moves in or out of the money, as well as the underlying currency volatility. So, in particularly volatile periods, like the ones we are experiencing now, this can result in a front-end loading of expenses associated with the outstanding hedges, as was in fact the case in Q3. So clearly, currency was working against us in this quarter, but on the good news, our hedging programs are in fact working well. So, a bit more on the hedging program, our FX program should be viewed essentially as an insurance policy. Our programs are designated to protect us against future downside risk to revenue and earnings, reported in US dollars. Our largest currency exposures are the euro, the Canadian dollar and the British pound, and are now hedged and over the coming year. We will rollout incremental hedges to cover much of the remaining exposure. So, how does the accounting for all these hedging works? It is FAS 133, which is the standard in US accounting and we use FAS 133 to account for our cash flow hedging programs. FAS 133 is not a simple standard this by any means. So, it is well worth a time, to take the time to understand the basics and I encourage you to do so. We walk through some of those basics of FAS 133 in our earnings slides deck, which I encourage you to reference. It is posted as Krista mentioned on our Investors Relations site. For the impact on Q3 before hedging, the recent strength of the US dollar relative to other currencies had a negative impact of $59 million on revenues in Q3. We were able to recognize as a benefit of approximately $34 million to revenues through the cash flow hedging this quarter. So, to understand why our hedging does not offset a 100% of the negative impact of currency on revenue, it is important to remember three key factors. First, our cash flow hedges are designed to protect against a downside risk to earnings not revenue. Secondly, our Q3 hedges were made against three major currencies, the Euro, the British pound and the Canadian dollar, but not all currencies. Finally, our pound hedges were put late in the quarter. So, with that let me return to our financial results. I am pleased to report that operating cash flow remain strong at $2.18 billion for the quarter, CapEx for the quarter was $452 million. We have invested very heavily in our data centers and are continuing to do so. As in previous quarters, the majority of our CapEx was related to IT infrastructure including data center construction, production of servers and networking equipment. Because of economies of scale, however, as well as greater efficiencies in our system infrastructure and in some ways Moore's Law, we can actually do a lot more today with less, which is a positive trend for us. That said, we will certainly continue to make significant investments in CapEx in future periods. Finally, free cash flow. A non-GAAP measure, we define the free cash flow from operation less CapEx. It remains strong at $1.73 billion, up 61% year-over-year. So, in summary, our core business continues to demonstrate strength, despite a challenging economic environment, while we are focused on operational efficiency, we have and will continue to make crucial investments that are needed to drive value for our users, our advertisers and our partners. Before I hand it off to Sergey, I would like to take a moment to share with you some of my early thoughts on joining Google. So, I thank Eric for the kind words at the front end of the conversation. First, let me say that I am delighted to be here and to join this company. This is obviously a great team I am joining, and everything you hear is true. These are super smart people, tremendous integrity, positively ambitious for the company and without a doubt our great winning combination. It is a great time to join Google and it is a real pleasure for me. Yes, the financial and economic environment is going through a lot of uncertainty, but with great uncertainty also comes tremendous opportunity. I look forward for leveraging my financial and operational background to take advantage of the tremendous opportunity in front of us and lead with the team the company into the next phase of growth. With that, I would like to thank you for the time and I will turn it over to Sergey for his thoughts on the quarter. Thank you.
Sergey Brin: Thanks, Patrick. I would like to update you this quarter on many different improvements, we made across the board. Let me start with our infrastructure and I am talking about both the hardware and software infrastructure, the powers all of our services. First of all, this quarter we significantly increased the size of our index. To put this in perspective now, every four hours we index the same amount of information that is equivalent to the entire US Library of Congress. I would encourage you, by the way, how can you see this? I encourage you to search for information that might not have that many references about on the web, whether it is a neighbor or local place, something like that, and just to see how much more information we have been able to put on the index. We have also worked a lot on our performance. Particularly, we had a lot of improvements in search, especially if you use the Google toolbar, which I encourage you to do. In YouTube and also many of our Apps, especially Calendar. Hopefully you will see the improvements as snappier performance, when you come back and use these services now. We have also been working on our overall efficiency from an energy point of view and I should report that our data centers now use several times less energy than typical facilities that would house and cool the same number of computers that we would have. Next moving on, Search of course remains core to our business, and now for the second quarter in a row we have launched over 100 search improvements during the quarter, so more than one per day. This is obviously improved things for our users all around the world. Very important feature, Google suggests that we have had available in a variety of different interfaces and now is on Google.com is running in ten countries. This actually really helps users and speeds them up much more than you might expect. As you are typing a query, we will fill out what is likely the query that you might want, spelled correctly and it really significantly speeds the overall search process. We also have continue to take our other corpuses that are not just web pages, things such as books and videos, and we continue to blend more and more of those into the first page of results, across all of our domains. The numbers of these blended results has increased significantly over the past quarter. I would encourage you to try searching, for example, for Michael Phelps. You will see video of swimming and whatnot. This also is very powerful, especially when you look at video, because people think of video as entertainment, but in fact video is a very compelling reference material. It is a really good way to learn something, to really understand it. Oftentimes you will not actually think to search for video. So, for us to present it in the first page of results means people are going to get much higher quality information about what they are looking for than they otherwise would have. On the business front of course, advertising remains the vast majority of our revenue. We continued to improve our ad systems. We have updated our quality based bidding system, which helps weed out underperforming ads and gives us the opportunity to run better ads, and generate a better return on investment for advertisers. We have also made some changes to how we rate landing pages in terms of quality and we really want to make sure that when our users click on ads, they are taken to useful sites. That way, people are encouraged to click on ads in the future. In fact, on the whole, I should mention that our ads add a significant amount of high quality material to our search and we believe it they overall increase our overall search quality experience. We have also been working hard of course, on display ads as Eric mentioned with David Rosenblatt now heading that entire operation, now with DoubleClick integrated, and the various properties that we have with potential display inventory. We are really moving along and we have made about two dozen improvements to our content network over this past quarter. Just last week, we launched a new category, AdSense for games. Over 200 million people play web-based games every week. Our network already reaches almost 10% of them, just at launch. So, we are very excited about that. Speaking of display inventory, I just want to talk a little bit about YouTube. They have been experimenting with a number of monetization methods. We have now, the click-to-buy feature that you might have seen, where now if you watch a YouTube video that is either could be a user uploaded video or uploaded by, for example, a studio and now people can just click-to-buy either CD or a video or other content that is similar to that video and this is obviously a benefit to both end users as well as the publishers and presents a great monetization opportunity. I should also mention that we have launched full length videos from CBS within stream ads and that means they can be pre-roll, mid-roll and post-roll. These full length videos really take you to another level of offering completely different kind of video than one would typically expect on that site. We have also been investing a lot in geographic and local information and I am sure many or all of you have used Google Maps and Google Earth. They are really big monetization opportunity because they are such a local searches and there are many local businesses. Now we have been able to expand just a data available there, so we can provide a better end user experience by launching Map Maker to over 100 additional countries. This is our product of lets end users create and edit the maps for their own countries and regions and by doing so the users have already added over 50,000 kilometers of roads and 75,000 business listings. I should mention that an increasing percentage of our local search queries now deliver user generated maps content. We have launched Street View in Japan and Australia, and we saw significant increases in usage there. Of course free tune as now available on BlackBerries, and many Java enabled phones in addition to the other phones that already had it. It can be pretty handy, you know, when you do a search for now business or store, restaurants something like that, you can just click on the Street View and see what it actually looks like and make sure that is the place you want to go. As I mentioned before, now with the ability to do that on phones, it is very handy. Now speaking of phones, we of course had a very important announcement this past quarter, which is our new Android operating system and which is launching first on the T-Mobile G1. You can get these phones starting next week and at your T-Mobile store. I have been using mine for a few months now as my primary phone and it is been very helpful. It really integrates the Google services very nicely on the phone, it has really great web browser. You know, I am able to search and brows through my Gmail just as if I was at my desk top. The G1 is just the first of a number of phones that will hopefully be running Android. You should take note of all of the partners we have built in the open handset alliance. I would encourage you all to try it out and if it suits your need then please, by all means, get an Android phone. Moving on, we have been busy at work as Eric mentioned on Enterprise. Now we have over 1 million businesses using Google Apps. In fact, we have launched Google Video for your business as part of our Apps premiere edition. Now you may think of video like YouTube this basically for your business a last thing that might be needed in a business. In fact we have had great demand for it. Internally we use video quite a bit. We have so many internal talks that we are able to record and then the people, who miss it, can just watch it online. We have had just a great amount of demand by businesses for this. I think this will be a very compelling feature to our Google Apps product. In addition to businesses, Google Apps are increasingly being adopted by universities. Now over a million students use Google Apps just a couple of years after the launch, and we have had dozens of universities and colleges deploy Apps since the New Year just started including Indiana University, University of Virginia, George Washington, and many others. Now lastly, I wanted to tell you something I am really excited about. I am sure many of you saw, it is a launch of Google Chrome, which is our new web browser. As you know, we created a lot of web services, and an increasing challenge to us is to have a robust enough platform to be able to run those web services quickly, and reliably. Chrome does both of those things. It has incredibly fast JavaScript engine, which we are really excited about called V8. In addition, it has a process model that is much more robust. Now, if you have a problem with one tab in your browser, you can just kill that tab and your browser just keeps running just fine, whereas in the past, number of browsers if you had one tab hang you could hang the entire browser. We are continuing to improve it and we have opened sourced it entirely. So, not just Google, but the whole community is improving Chrome. We hope that it obviously continues to improve Chrome, but also it raises the bar for all browsers because we want all the web platforms out there more capable so we can more easily deploy our services. All in all, it is been a very busy quarter at Google. We have had so many announcements, launches, so many improvements; it is really hard to keep track. I appreciate all of you following it. Thank you and talk to you next quarter.
Eric Schmidt: Well, thank you very much, Sergey. You are going to stay for the Q&A for a few minutes, too.
Sergey Brin: No problem.
Eric Schmidt: Thank you Patrick as well. We will have Hal, Jonathan, and Omid join us and maybe we would move to questions Krista.
Krista Bessinger: Yes, we are ready do queue up for questions, operator.
Operator: Thank you. (Operator Instructions). We will take our first question from Imran Khan from JPMorgan.
Imran Khan: Hi, thank you very much for taking my question. Question about the economy and what the trend you are seeing. I think Eric, you talked about that the economy seems like weakening over the last four weeks or, so that I have been hearing the same thing. Can you give us some color like how is your business trend, July, August, versus September? Did you see the business weakening significantly in the month of September or if you can give us some color regarding what trends you are seeing in October? The second question is regarding the network revenue. Excluding TAC, it seems like network revenue growth rate decelerated quite a bit. I just try to understand that better, thank you.
Eric Schmidt: Thanks, Imran. I am going ask Hal to help me here. We see fluctuations and they are more complex than they may appear; some things go up, some things go down. Obviously, it is going to change as the global financial crisis moves through. It also varies by country and by region. Hal?
Hal Varian: Yes, I think I can give you a little color on some of the things that are being going on. As you know we do not give guidance with respect to our internal numbers, but we have a nice tool out there called Search Insights; we can take the pulse of the consumer. If you look in the last several weeks, there has been this almost obsession with financial markets. Huge increases in inquiries on money market, mutual funds, buy gold, 401(k)s, banking crisis, LIBOR, home safes. So right now, I think it is very difficult to really extrapolate from the current period where you have got this major event going on, really a once in a lifetime event. Let's all hope it it is once in a lifetime. So, it is very hard to tell what things are going to look like going forward basis.
Eric Schmidt: Jonathan, do you have a view on this?
Jonathan Rosenberg: Just very quickly on the second question which I did not think Hal got to the network deceleration. , Imran, there are really two things that you want to look at. Some of it is a function of quality efforts, and the other is basically a function of deal flow in the large partners that we have that are participating. So, those are the two things that you need to look at. Our landing page quality which Sergey mentioned in his introductory remarks relates to the quality issues.
Imran Khan: Got it. Thank you. Hal, I agree with that and hope it is a one-time event of our lifetime.
Eric Schmidt: Our next question?
Operator: We will go next to Mark Mahaney from Citi.
Mark Mahaney: Thanks. I wanted to ask two questions please. First has to do with the thoughts on cost, Eric. You talked about being needing to be more cognizant of cost structure in a deteriorating economic environment, and what is going to be a severe recession. Does that mean you cut back on just on operating costs, or would there be a point where you would actually delay materially major investment priorities like mobile? Then a quick question to Sergey. Could you just talk broadly about what in display advertising you think can be fixed, or what are the major innovations that could be brought to display advertising that we have not seen before? When you look at that, what do you see that Google could bring to that market? Thank you.
Eric Schmidt: Mark, on the question of investments, Google has shown courage, when we need to. We also intend during this period to show very responsible management of our expenses. Patrick, do you want to talk a little bit about how you are structuring this?
Patrick Pichette: Sorry, I got off mute. Yes, absolutely. I mean in these uncertain economic environments, and I think that we have seen it through to Q3 results. I think that the company is very responsible in managing its cost base to make sure that we are adapting to the environment in which we are operating. So, operational efficiencies and cost containment have been in place for couple of quarters already and they continue to do so. So, we are adapting. We are very nimble and very agile in this and we will continue to be. Regarding the second question that you have asked. Strategic investments are strategic investments and those you separate them from day-to-day operations, and every time we have a great opportunity, we are going to jump on it and as I said in my comments, the basics of CapEx infrastructures and the fundamental infrastructure for the company we are not going to stop. So, that is the balance we are striving.
Eric Schmidt: Sergey, the second part of the question.
Sergey Brin: Yes, on display; I think there are certainly a lot of opportunities in display, and let's just not forget when we first got started with AdWords or the predecessors to AdWords, it took us a number of years for those things to even catch up to what then was the big dollar numbers of the display advertising and finally to show the incredible power for both advertisers and end users of search-based advertising. So I think we could see the same thing with display where it actually takes actually while to mature with the new model. One of the things what I think is very valuable for display, even though it might be more brand focused, you still really care about targeting and showing the right ads to the right end users at the right times and try to show them things they might be interested in. You might want to have a return, not be a click necessarily but just be the branding and having generating awareness. Nonetheless, you really want to reach the right people. Now another part of that is we have great measurement tools. You know what happens after people might see an ad and how might they act differently. We also have access now to a vast variety of inventory ranging from our AdSense network to a variety of our DoubleClick technologies. This can give you access to more inventory and finally, our properties such as YouTube and Orkut. So we still see this as an area that is ripe for development and innovation and we think that we can continue to create great tools for display. This includes, by the way, things like not just – we are not just talking about banner ads on web pages, includes AdSense for games as I mentioned earlier, it includes feeds, it includes video like YouTube and other sites. So, it is a big opportunity.
Eric Schmidt: Let's go to our next question.
Operator: We will take our next question from Brian Pitz from Banc of America Securities.
Brian Pitz: Thank you. You announced three changes relatively recently in particular replacing minimum with first page bids I think late in Q3. Would you talk about the early impact these changes are having on the auction process? Thanks.
Jonathan Rosenberg: Yes, sure. This is Jonathan. That particular quality-based bidding effort I think was launched around the first week of September. Basically, the impact that that has is the quality score is calculated real-time on each query. So, what was happening previously was that keywords were inactive and not available based on the quality dynamic. What is happening now is there are keywords that are able to participate in every auction because we are calculating it real-time. So, it is basically allowing us to get what were previously in active keywords to compete in the auction more successfully based on the real-time calculation. That is pretty much it.
Brian Pitz: Any major impact so far that you are seeing as a – how long will it take to really work its way through?
Jonathan Rosenberg: As far as the quality announcements that we typically talk about, it is certainly one of the bigger things we did in the quarter and typically these things tend to manifest themselves in terms of their impact reasonably, expeditiously after the launch. So, I think that most of the benefit of the typical quality enhancements is real very quickly.
Eric Schmidt: If you want to remind everybody that we make very – we commonly make 10, 20, 30, 40, 50 quality improvements in a quarter, these are just some of the better known ones. We are constantly tuning based on our quality testing and again globally as well.
Brian Pitz: Great, thanks.
Eric Schmidt: Our next question?
Operator: We will go next to Christa Quarles from Thomas Weisel Partners.
Christa Quarles: Hi. My question is really related to the Yahoo! deal. Eric, were you surprised by the vitriol in the response from the advertisers out there? Clearly there is reality in how this thing functions versus perception. I would be curious how are you approaching the government meddling in your ability to function and operate and how are you responding as it relates to the Yahoo - Google arrangement?
Eric Schmidt: Well, Christa, thank you. I will let you used the phrase meddling and I am not going to be using that phrase. When we did the deal, we understood that the deal would be both controversial that our competitors would oppose it, and they would oppose it using every tactic that they could and also that there was a proper role for the legal review process. So, we anticipated were turned out to be roughly four-month delay. Literally to give everybody time to talk about it. We are hopefully during the end of that period and we are obviously in communications with the Justice Department and the other groups that are doing it. With respect to the advertiser reaction, we have seen a balance of reactions. We have seen some large advertisers, complain. We have seen other large advertisers say that this is ultimately good for our businesses. I obviously have a bias on this question and in my view many of the complaints are based on the fact that people do not understand how the auctions really work and the benefits that auctions provide. Auctions provide really a clearing price for accurate value and because the prices in our auction are largely set by people, who can back-solve to the cost per acquisition. The cost-per-click and the revenue that we get is largely tied all together. Hal in fact wrote a blog post yesterday precisely on this issue because there has been so much confusion about it. Hal, do you want to comment on that?
Hal Varian: Sure. We have been making a concerted effort to try to educate people more about how our model works. One thing we were bit surprised in is even people, who had been using AdWords did not necessarily understand how and why functions the way it does, so we are really trying across the Board to communicate better with all the sectors that we serve.
Eric Schmidt: So, next question.
Operator: We will go next to Ben Schachter from UBS. Ben Schachter - UBS Congratulations on a nice quarter.
Eric Schmidt: Yes. Thanks Ben.
Ben Schachter: In order for the display strategy to work, do you think you need to offer more inventory on your own sites or can it become meaningful just through better penetration of the AdSense network. Also on Google Checkout in the past there have been a lot of discussion around the badges and how they have increased click through rates and conversions. Seems there is less of an emphasis on that product. Does it make sense to potentially work with PayPal on moving forward. Then one last house keeping one. If you look at depreciation and cost of goods less TAC they seem to be flat quarter-over-quarter, which is never happened before. Any comments on that? Thanks.
Eric Schmidt: So, you asked three questions and so Patrick you will do the third one. Omid can you and thanks Ben for that. Can you talk a little bit about display and Checkout?
Omid Kordestani: Sure. Ben I am calling from London so please let me know if the voice is not getting through correctly. As far as we mentioned earlier we put a concerted effort across all the regions in our product teams and brought Dave Rosenblatt into the position with his vast experience from DoubleClick to help us really pieces all together, and bring a great focus in our execution. Simply, our objective here is that we want to marry the art of display, which is the engagement it offers with the science of search advertising relevancy and measurability. We have a lot of inventory, great inventory both across our Content Network already and across YouTube and that our goal really is to focus both on the advertisers and publishers here for advertisers, really scaling the advertising process for media planning, buying, selling, all the way to optimization and for publishers helping with increasing the yield, and that they are experiencing. We have great, great headways already in Q3. We had NBCOlympics.com using DoubleClick serving ads over 30 million unique users. In Europe, they use the platform very effectively to increase the number of transactions and reduce the cost per transaction by 33%. So, this measurability and reach is already very effective across our network and our existing properties. As Sergey mentioned a long-term focus for us to get all the pieces together and execute and grow the business. As far as Checkout goes, I think again, we continue to evaluate what is the best ways to focus and utilize the existing headway we have made. There is really nothing, really new to announce here other than we are considering how best to apply the service, going forward. We are open to all kinds of options and we will evaluate it as and we see the results.
Eric Schmidt: Patrick, do you want to handle the last question?
Patrick Pichette: Yes, I would just like a clarification. You said about D&A specifically or is it OpEx excluding D&A and TAC that was a question?
Ben Schachter: No, I was really looking at the depreciation and looking at the cost of goods less the TAC. If you look at those excluding stock and they are both flat quarter-over-quarter and that has never happened.
Patrick Pichette: Yes, what we have done is in the first part of the year, we had been accelerated some depreciation amortization in the bunch of equipment now is flow through. That is really the core driver of that.
Ben Schachter: Thanks.
Eric Schmidt: Okay, thanks. Next question?
Operator: We will go next to Doug Anmuth from Barclays Capital.
Doug Anmuth: Thanks for taking my question. First one for Sergey, you made some comments last quarter indicating the coverage may have dipped too low. Can you talk about what you did with coverage during 3Q and a little bit on your updated view on that? A second one for Hal, can you just talk about how advertisers are changing their behavior and strategy in terms of keyword bidding in this environment, and what is happening with average cost-per-click and what is happening with ROIs as well. Thank you.
Hal Varian: Sure. Hi, Doug, I can start briefly on coverage and maybe Sergey can follow-up. I think one of the things that we have probably done a better job in the last year or so, is we have done a much better job of eliminating the bad ads than we have introducing functionality that makes it particularly easy to enable, good ads. This is not really a dial that we just want to turn. We have a very clear goal, which is to show as many high relevant ads against queries as possible and there are lots and lots of queries still out there that we can do better on. We have a good list of those, particularly complicated long queries, or queries that have very diverse meaning. Queries with modifiers, for example if you look on 'Wee Games', we have ads. However, if you type in 'best Wee Games', we do not. Your plumber is not on AdWords. So, the goal is not really too explicitly we try to figure out how we get coverage up. The goal is to figure out how we add the bidding functionality, so that advertisers can serve better ads. If you are actually looking at your components of the RPM equation, which we do not really break out much. Generally you are seeing what we have said in the past, which is the coverage is in the ballpark of the historic lows.
Jonathan Rosenberg: With respect to the advertiser behavioral side, people focus on this aggregate cost-per-click measure. As we have said before, it is misleading, because it is aggregating across the entire world, and it is aggregating across AdWords and AdSense So relatively small changes in the mix can show up in that number. We do not really think it reflects the actual advertiser behavior, in a very clear way. Our experience is advertisers are willing to take all the clicks we can give them at the current CPC, and even in tough times. We think that will continue to be true because nobody wants to turn away a customer. So, we think that is actually a pretty solid number and will continue to be so and thank you.
Sergey Brin: Yes. This is Sergey. You are exactly right, that is what I know in the last quarter. I should mention that we have made progress. For example the quality-based bidding launch that we talked about earlier increased our coverage significantly and fundamentally as Jonathan says look at page of our web search results. I think we are far from the ideal set of advertisements and there are many advertisers that I think ought to be showing up certain situations that that are not for variety of reasons. So, I think there is certainly opportunity to give end users better higher quality, advertisers they are going to add their overall search quality experience.
Eric Schmidt: Okay. Thank you. Thanks Sergey. Next question?
Operator: We will go next to Justin Post from Merrill Lynch.
Justin Post: Thanks. Now you have had a bunch of mobile phone launches. I am wondering if you can give us an update on what you are seeing on the query volumes and maybe an estimate on when that could be maybe 5% of your total volumes and then on the currency I think you said it cost you $80 million in the quarter. Is that one time as you established the hedges or this is ongoing thing that could last a few more quarters?
Eric Schmidt: This is Eric. We said publicly for the last few months that we are seeing an explosion in mobile search volume. It is a lot of it has been enabled by the fact that these new sets of devices have much more powerful browsers. So, they are on 3G or E-Video networks and they have more powerful browsers and people are busy browsing. You know just an amazing amount of time. We do not show the exact numbers, but I can tell you that the compound growth rate is one of the fastest growing things in the company. Patrick, you want to answer the second part?
Patrick Pichette: Yes, the $80 million was – in both Q2 and Q3 because we have launched these programs and put them in place, they are much higher than what you can expect in the future. In fact, we have got the 18-month programs mostly in place for the three big currencies I talked about and now we are going to be in maintenance mode. So, from that perspective it will be less.
Justin Post: If the US dollar keeps appreciating will you continue to see a revenue benefit.
Patrick Pichette: As you put hedges over the long-term, yes, the answer is yes.
Justin Post: Thank you.
Eric Schmidt: You are assuming it will or will not. So, we never know. I will say, yes, we never know, whether currency is going to go up or down. Let's move to our next question.
Operator: We will go next to Ross Sandler from RBC Capital Markets.
Ross Sandler: Thanks for taking my question, just two quick questions. First on the retail category, so eBay painted a pretty disastrous picture for ecommerce and the consumer in general last night, stating that there was a meaningful slowdown in activity beginning in August and deteriorating in the mid-October. Clearly that company is having some specific issues, but you did not mention retail as a category of weakness in your prepared remarks and judging by your numbers, especially in the US that would suggest that you are pretty well diversified. So, can you comment on the current trends in the retail category and then second on the UK?, Google changed its policy on bidding on gambling keywords this morning and it appears that those ads go live tomorrow. So, unlike prior policy changes this one was delivered with a little advanced notice, agencies got the criteria this morning, and campaigns go live right away. So, any reason for the quick rollout there? Thanks very much.
Eric Schmidt: Thank you. We will have Omid, since he is in London, he will answer the second question. The first question, we have looked at what we think will happen in the next few quarters. The problem is, there is so much uncertainty now in the financial markets, in the press, and in potential government action, and so forth. It is very hard for us to give you a sense of what is going to happen in retail or any category between now and the Christmas season or over the next 12 months or so forth. Hal, you have looked at the various categories, if you want to can you give some macro comments about categories for us?
Hal Varian: Well, when you look at the US aggregate statistics, we definitely saw weakness in US offline retail the numbers that are reported by the government. One thing that we think at Google is that when there is a recessionary environment, people are counting their pennies, they are going to be researching their purchases, looking for bargains, and this potentially has something of an upside for Google. We referred to this last time I called it the Wal-Mart effect that as people shop more carefully they are going to be researching the things they buy. So as Eric said, we do not really know what is going to happen. This is a speculative statement but we think that this effect could actually work to Google's benefit potentially.
Eric Schmidt: Omid, do you want to comment on the UK.
Omid Kordestani: Sure. I think to be honest with you, this is one of the benefits we have now of much tighter attention to every aspect of our international operations. We now have both Nikesh, our Head of EMEA and Tim Armstrong, Head of Americas attending our executives meetings, and they are frankly upset of policies and questions that the market had put on us, and we really are being much more responsive to these things to our sales organization and change these policies, very quickly to address to the market demands. So, I think you – we will definitely work with our agency partners and customers to make the transition as smooth as possible.
Eric Schmidt: Thanks. So our next question?
Operator: We will go next to Jeffrey Lindsay from Sanford Bernstein.
Jeffrey Lindsay: Hello and thanks for taking my question. We just wanted to talk a little bit clarification on the improvement in margins. Was this due in any way to improved terms on the AdSense deals or was it primarily expense control? If it was expense control was that really through avoided hiring or was there actually any staff reduction? Thank you.
Patrick Pichette: I can answer on the expense side. Across all categories of expenses, people have been very diligent over the last 90 days and I can – and on the specifics of hiring, I mean, we have continued to hire. We just hire in many areas. We are continuing to hire because we have a lot of needs and then what we are doing is just doing responsibly. So there – we will continue to hire, that is why you see the net improvement in headcount but it is truly broadly across all categories of expenses that we are focusing let it be AdSense, it covers it.
Eric Schmidt: I am not aware of changes that would – on the ad or ad partnership side that would result in margin change. Omid?
Omid Kordestani: No.
Eric Schmidt: Okay. The next question?
Operator: We will take our next question from Youssef Squali from Jefferies.
Youssef Squali: Hi, thank you very much. Two quick ones; first on CapEx, if I look at CapEx this quarter, so $450 million was the lowest we have seen since Q1 of 2006. Are we at a point, well, basically the bulk of the infrastructure is already built and now any incremental is all that much smaller. Is CapEx starting to normalize? Second, a question for Sergey. You talked earlier about GeoLocal with product like Maps and Earth is big monetization opportunity, so we have talked about them for a long time and they remain opportunities. One of the issues there has been this direct access to the advertisers to the local merchant. Have you – are we any – are we closer to cracking the code on that?
Eric Schmidt: Patrick, do you want to give a sense of CapEx?
Patrick Pichette: Yes, with pleasure. I mean essentially, CapEx is a lumpy business in many instances. So think of data centers going up and down I mean one quarter you have it, one quarter you do not, so we are going to continue to invest in CapEx, we are going to continue to invest heavily in CapEx, so we have no plans of slowing down. What you see here is just a nature of that lumpiness. We are obviously getting better at it, so with efficiencies every extra unit of capacity is cheaper for us, so we are going to benefit back.
Youssef Squali: Were there any costs pushed out into CapEx into Q4?
Patrick Pichette: No, none.
Youssef Squali: Okay.
Eric Schmidt: Sergey and maybe Jonathan you want to have a look about the GeoLocal ad opportunities?
Sergey Brin: Yes, let me talk about it. Certainly GeoLocal has been a substantial source of investments on the part of our company and you are absolutely right. I think it is a really big monetization opportunity but it is going to have a pretty long bootstrap time because there are so many small businesses and you have to get them all in the loop. Technology is evolving quickly with respect to things shifting to mobile phones and some of them will have GPS now, some of them do not, some have cell ID different device and things. I do think that this is an investment that we are going to have to keep investing in for some time till we get really big payoff. I should mention we already have fairly substantial revenues from geo local, so it is not the case but somehow this is I mean this is a good chunk of our business and I expect that when we do finally bootstrap lots and lots of local advertisers. When there is some settling of the best user experiences for doing this both on mobile devices as well as on the desktops, I think you will see a substantial ramp there.
Jonathan Rosenberg: Eric, do you want me to add anything. Yes? This is Jonathan. The biggest thing I would reinforce from Sergey's comments is, this is an area where we are winning. Maps is the most popular mapping site in the world. We have got all sorts of data now for over 160 countries. We are also doing some very exciting things in terms of ramping our ability to get data for areas where there are not very good maps, where we are harnessing the power of users to enter information in. On the local side, what we are doing really goes beyond the traditional Yellow Page types of activities and I mean we are taking all the information that a business would want or a user to see; reviews, hours of operations, photos, web results, and we are embedding all of those on to these maps which have a great deal of traffic. So, if you just run a query, steakhouse in Chicago or something like that and when you click on the map and select a particular listing, you can now do things like click on Street View and actually see the restaurant. So we are very pleased with the traffic that is being driven. One other thing I would actually suggest you try one of the coolest maps applications I saw. Go to swisstrains.ch to see the precision of Swiss trains in real-time and you will actually get a visceral sense of what it is going to be like for people when all of this stuff works on their browsers and works in mobile devices.
Eric Schmidt: Let’s go ahead and Krista I think we – this is – we are sure of running out of time, maybe this should be our last question. Krista Bessinger Yes, this is our last question. Please.
Operator: Our last question comes from Jeetil Patel from Deutsche Bank.
Jeetil Patel: Great, thank you. Just one last question; on your AdSense syndication network, can you talk about the rollout of the quality score initiative? Is it still at first half '09 rollout or perhaps a little longer and have you learned anything around the testing that you are doing there or still tweaking that? Thanks.
Eric Schmidt: So, again, you are using the word quality score. Could you just be precisely define what you mean?
Jeetil Patel: The scoring index you are looking at for your syndication network, so rating each partner out there; just curious how that –how that initiative or program that you are looking at launching is progressing?
Eric Schmidt: It is actually in the process of being launched. A number of partners already working with it and the plan is to get it done in early next year. Yes, so and obviously we spent a lot of time with them to make sure that their sites are done properly, our system responds properly to their query traffic and so forth.
Jeetil Patel: Got it. How often will the scoring system change? Will it be real-time or will it take a month at a time or quarter at a time?
Eric Schmidt: We tend to be very dynamic because these systems have feedback in them. So, as they learn, they get better at judging, what is a higher quality click and as they learn they get better and better and that is why such a nice model.
Sergey Brin: This is Sergey. Probably I think we have had this system in place for AdSense for Content for a long, long time. Now it is the extension of that into AdSense for search. These are obviously some of our larger customers that have significant implementations and we are taking our time to roll it out in a way that is have sensible for both us and them. This is something that we have been doing for a long time within AdSense for Content, now that will be applied more broadly.
Eric Schmidt: So, why don't we go ahead and just finish up? I want to thank everybody for spending time. Everybody is very busy with all the things going on around the world. Thank you for our panelists and our call in today. From my perspective, there is an awful lot of stuff going on in the world, there is an awful lot of actions that we hope will be taken correctly by governments around the world, by the bankers and by the institutions that are there to make sure our systems run well. We have a duty and responsibility to run Google well. We take a long term view. We have the opportunity before us and we have the time and the patience to build a great future which is what we hope will happen for everybody. So thank you very much.
Operator: This concludes today's conference. We thank you for your participation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day and welcome everyone to the Google Inc. Conference Call. This call is being recorded. At this time I would like to turn the call over to Ms. Krista Bessinger. Please go ahead, ma'am."
},
{
"speaker": "Krista Bessinger",
"text": "Good afternoon everyone and welcome to today's third quarter 2008 Earnings Call. With us are Eric Schmidt, Chief Executive Officer, Patrick Pichette, Chief Financial Officer, Sergey Brin, Founder and President of Technology, Jonathan Rosenberg, Senior Vice President of Product Management, Omid Kordestani, Senior Vice President of Global Sales and Operations is joining us from London today, and Hal Varian our Chief Economist. Eric, Patrick and Sergey will provide us with their thoughts on the quarter and then Jonathan, Omid and Hal will join us for Q&A. Please note that this call is being webcast from Investor Relations website. Please also refer to our Investor Relations website for important earnings related documents including our press release issued a few minutes ago along with slides that accompany today's prepared remarks. A replay of this call will also be available on our Investor Relations website in a few hours. Now let me quickly cover the Safe Harbor. Some of the statements we make today maybe considered forward-looking including statements regarding investments in our core business, traffic acquisition cost, operational efficiency and cost and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings including our quarterly report on form 10-Q for the quarter ended June 30, 2008, as well as our earnings press release for a more detailed description of the risk factors that may affect our results. Copies can be obtained from the SEC, or by visiting the Investor Relations section of our website. Also please note that certain financial measures we use on this call such as EPS, net income, operating margin and operating income are expressed on a non-GAAP basis and have been adjusted to exclude charges relating to stock-based compensation. We have also adjusted our net cash provided by operating activities, to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and GAAP to non-GAAP reconciliation can be found in our earnings press release. With that it is my pleasure to turn the call over to Eric."
},
{
"speaker": "Eric Schmidt",
"text": "Well. Thank you, very much, Krista, and good afternoon everybody. First, let me welcome Patrick, Patrick Pichette, who is of course our CFO, who is off and hit the ground running. He certainly joined us at an interesting time. Before he goes into the detail, which of course everyone is quite interested in. Let me just talk about some of the highlights. Thanks to everybody's hard work. Google had a good quarter. Traffic and revenue were both solid and we kept tight control on costs. Year-on-year, for example, search query traffic is growing in almost every vertical. We believe that these results reflect the fact that as marketing budgets are squeezed, targeted, measurable ads are becoming more valuable to advertisers. As consumer budgets are squeezed, people use the web for comparison shopping to hunt for bargains online and in stores. Regarding the economic situation, I think everybody on the call and listening understands that it is pretty clear the economic situation today globally is worse than people were predicting just a month ago. So, look at the difference in the papers. What started off as a financial crisis appears at least according to the consensus around the world, to be affecting the wider economy. When I talk to other CEOs in Europe and in America, it is clear that the economic situation is so fluid, that we are all in uncharted territory. The question is how should Google respond? Our answer, as always, is looking at the long-term, and we believe that even more today -- more important today than ever. Search, which of course is Google's core, is where we are putting a lot of our investment -- better search, better ads, [proof latency]. Our user experience is getting much better. Index size is getting much larger, greater personalization for better results globally for every user, lots and lots of language support, more highly relevant ads against as many queries as possible and using more sophisticated tools for advanced bidding and measurement and optimization. So that advertisers, who understand that advertising is directly correlated with revenue, can use those tools to maximize revenue based on the terms that they set and based on the budgets, which is what they care about. So the opportunities are more than just the search and ads. In Apps, for example, the company is going to cut IT costs and increase productivity with greater collaboration well. We are there for them. Our enterprise applications really add value there. In display by improving targeting, we deliver better and more relevant ads for users and for advertisers, agencies and publishers. The DoubleClick integration now going very well. David Rosenblatt from DoubleClick is now President of our display businesses, says it is going great. YouTube is now running 90% – ads against 90% of all the content claimed by partners using our content ID tool. We are experimenting with different advertising formats now well announced in video ads, click-to-buy and pre-roll. Geo-Mobile another core component and new opportunity for us geographically relevant in location based advertising is valuable to users in our view, who are working, developing advertising products that match ads to geographic data. We think that is a big opportunity for us. So along the way, we are going to stay very close, keep a very close eye on costs. It makes sense given everything we read in the papers and we have done that effectively in this quarter. It is the right thing to do and what I like about it. Sergey can talk about this a little bit if he likes. Sergey likes to say scarcity builds clarity. I think it is a great focusing opportunity for Google as well. To a very realistic about the macro economic climate, but we are optimistic about Google's future because we are confident about the enduring value and power of the web. Sergey will talk about this in more, but fundamentally people are moving to the internet, they are moving to more targeted advertising, are using information in a smarter way and Google is one of the significant beneficiaries of that. We fundamentally believe that users will always want information and need to communicate and advertisers will always value relevant and very measurable advertising, which of course these are Google's core strengths. So, with that Sergey maybe you would like to – sorry Patrick maybe you talk about our financials first and then we will go over to Sergey."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Eric and good afternoon everyone. So, as Eric said a few minutes ago, we had another solid quarter despite a challenging economic environment. A few numbers: gross revenue was up 31% year-over-year to $5.5 billion reflecting healthy growth across the Google - both Google.com and our network. Google.com was up 34% year-over-year to $3.7 billion driven by steady traffic growth and AdSense was up 15% year-over-year to $1.7 billion, also reflecting solid growth across both content and search. Global aggregate paid click growth was also reasonably good goes up 18% year-over-year and 4% quarter-over-quarter, reflecting healthy growth across all major properties. We saw also steady growth in the US with revenues up 22% year-over-year, to $2.7 billion and up 5% quarter-over-quarter. International revenue also held up reasonably well, accounting for 51% of our total revenue or $2.8 billion. The UK showed some softness, but up 17% year-over-year to $776 million, but essentially flat quarter-over-quarter including the impact of the currency. The rest of EMEA performed better driven by relatively good performance in the Netherlands and Germany. Asia and Latin America were solid as well, mostly driven by relatively good performance in Brazil and China. From an advertisers’ spend perspective, we saw a combination of strong relative performance in many verticals including home appliances, apparels, jobs, but also and not surprisingly some tougher performances in others such as home financing, auto financing, and real estate as everybody can imagine. Let me turn to expenses now to traffic acquisition costs were $1.5 billion in Q3 or 27.9% of total advertising revenue. This is down from $28.4 million in Q2. AdSense TAC was $1.3 billion and Google TAC was $167 million. As we embark on new initiatives, we may see additional pressures on TAC rates going forward. Other costs of revenue they have increased $4 million over Q2 to $678 million and the largest driver of the increase was data center related costs and those include depreciation, equipment and operations. All other operating expenses totaled $1.63 billion, including approximately $269 million in stocks-based compensation and expenses related to payroll and facilities increased $49 million over Q2 to $859 million. On the headcount front, we finished a quarter with approximately 20,000 full-time employees. That is approximately 500 net new employees added in the quarter and over half of these new net hires are in engineering, and then followed by sales and marketing. We have implemented and continue to follow a disciplined hiring process in all areas of the organization, but as we have indicated in the past, we continue to invest in our core business, both in the US and internationally. In consequence of all this management expense the non-GAAP operating profit, which excludes stock-based compensation, crossed the $2 billion threshold for the first time in Q3, driving non-GAAP operating profit margins to 36.5%. As Eric mentioned a little earlier in his comments, it makes sense on the current economic environment to maintain a clear focus on operational efficiency, and cost containment and we have done so, and we will continue to do so, better positioning Google for healthy long-term growth. Let me move on to interest income and other, which was $21 million for the quarter. The primary driver for interest income, and other, are on the positive side, a very strong cash balance, $14.4 billion. The annual interest we earn on that cash is currently in the 2% to 3% range, and we also had a small realized gain on investment of $11 million in Q3. These benefits are to large extent offset by the impact of our, the rollout of our hedging program in Q3. So, in Q3, our hedging expense and related impacts totaled approximately $80 million. Please note that we amortize the cost for the time value of our cash-flow hedging programs in other income and expense on a monthly mark-to-market basis, not a straight line basis. As a result, the amount of amortized expense were recognized in any particular quarter is impacted by how much the option moves in or out of the money, as well as the underlying currency volatility. So, in particularly volatile periods, like the ones we are experiencing now, this can result in a front-end loading of expenses associated with the outstanding hedges, as was in fact the case in Q3. So clearly, currency was working against us in this quarter, but on the good news, our hedging programs are in fact working well. So, a bit more on the hedging program, our FX program should be viewed essentially as an insurance policy. Our programs are designated to protect us against future downside risk to revenue and earnings, reported in US dollars. Our largest currency exposures are the euro, the Canadian dollar and the British pound, and are now hedged and over the coming year. We will rollout incremental hedges to cover much of the remaining exposure. So, how does the accounting for all these hedging works? It is FAS 133, which is the standard in US accounting and we use FAS 133 to account for our cash flow hedging programs. FAS 133 is not a simple standard this by any means. So, it is well worth a time, to take the time to understand the basics and I encourage you to do so. We walk through some of those basics of FAS 133 in our earnings slides deck, which I encourage you to reference. It is posted as Krista mentioned on our Investors Relations site. For the impact on Q3 before hedging, the recent strength of the US dollar relative to other currencies had a negative impact of $59 million on revenues in Q3. We were able to recognize as a benefit of approximately $34 million to revenues through the cash flow hedging this quarter. So, to understand why our hedging does not offset a 100% of the negative impact of currency on revenue, it is important to remember three key factors. First, our cash flow hedges are designed to protect against a downside risk to earnings not revenue. Secondly, our Q3 hedges were made against three major currencies, the Euro, the British pound and the Canadian dollar, but not all currencies. Finally, our pound hedges were put late in the quarter. So, with that let me return to our financial results. I am pleased to report that operating cash flow remain strong at $2.18 billion for the quarter, CapEx for the quarter was $452 million. We have invested very heavily in our data centers and are continuing to do so. As in previous quarters, the majority of our CapEx was related to IT infrastructure including data center construction, production of servers and networking equipment. Because of economies of scale, however, as well as greater efficiencies in our system infrastructure and in some ways Moore's Law, we can actually do a lot more today with less, which is a positive trend for us. That said, we will certainly continue to make significant investments in CapEx in future periods. Finally, free cash flow. A non-GAAP measure, we define the free cash flow from operation less CapEx. It remains strong at $1.73 billion, up 61% year-over-year. So, in summary, our core business continues to demonstrate strength, despite a challenging economic environment, while we are focused on operational efficiency, we have and will continue to make crucial investments that are needed to drive value for our users, our advertisers and our partners. Before I hand it off to Sergey, I would like to take a moment to share with you some of my early thoughts on joining Google. So, I thank Eric for the kind words at the front end of the conversation. First, let me say that I am delighted to be here and to join this company. This is obviously a great team I am joining, and everything you hear is true. These are super smart people, tremendous integrity, positively ambitious for the company and without a doubt our great winning combination. It is a great time to join Google and it is a real pleasure for me. Yes, the financial and economic environment is going through a lot of uncertainty, but with great uncertainty also comes tremendous opportunity. I look forward for leveraging my financial and operational background to take advantage of the tremendous opportunity in front of us and lead with the team the company into the next phase of growth. With that, I would like to thank you for the time and I will turn it over to Sergey for his thoughts on the quarter. Thank you."
},
{
"speaker": "Sergey Brin",
"text": "Thanks, Patrick. I would like to update you this quarter on many different improvements, we made across the board. Let me start with our infrastructure and I am talking about both the hardware and software infrastructure, the powers all of our services. First of all, this quarter we significantly increased the size of our index. To put this in perspective now, every four hours we index the same amount of information that is equivalent to the entire US Library of Congress. I would encourage you, by the way, how can you see this? I encourage you to search for information that might not have that many references about on the web, whether it is a neighbor or local place, something like that, and just to see how much more information we have been able to put on the index. We have also worked a lot on our performance. Particularly, we had a lot of improvements in search, especially if you use the Google toolbar, which I encourage you to do. In YouTube and also many of our Apps, especially Calendar. Hopefully you will see the improvements as snappier performance, when you come back and use these services now. We have also been working on our overall efficiency from an energy point of view and I should report that our data centers now use several times less energy than typical facilities that would house and cool the same number of computers that we would have. Next moving on, Search of course remains core to our business, and now for the second quarter in a row we have launched over 100 search improvements during the quarter, so more than one per day. This is obviously improved things for our users all around the world. Very important feature, Google suggests that we have had available in a variety of different interfaces and now is on Google.com is running in ten countries. This actually really helps users and speeds them up much more than you might expect. As you are typing a query, we will fill out what is likely the query that you might want, spelled correctly and it really significantly speeds the overall search process. We also have continue to take our other corpuses that are not just web pages, things such as books and videos, and we continue to blend more and more of those into the first page of results, across all of our domains. The numbers of these blended results has increased significantly over the past quarter. I would encourage you to try searching, for example, for Michael Phelps. You will see video of swimming and whatnot. This also is very powerful, especially when you look at video, because people think of video as entertainment, but in fact video is a very compelling reference material. It is a really good way to learn something, to really understand it. Oftentimes you will not actually think to search for video. So, for us to present it in the first page of results means people are going to get much higher quality information about what they are looking for than they otherwise would have. On the business front of course, advertising remains the vast majority of our revenue. We continued to improve our ad systems. We have updated our quality based bidding system, which helps weed out underperforming ads and gives us the opportunity to run better ads, and generate a better return on investment for advertisers. We have also made some changes to how we rate landing pages in terms of quality and we really want to make sure that when our users click on ads, they are taken to useful sites. That way, people are encouraged to click on ads in the future. In fact, on the whole, I should mention that our ads add a significant amount of high quality material to our search and we believe it they overall increase our overall search quality experience. We have also been working hard of course, on display ads as Eric mentioned with David Rosenblatt now heading that entire operation, now with DoubleClick integrated, and the various properties that we have with potential display inventory. We are really moving along and we have made about two dozen improvements to our content network over this past quarter. Just last week, we launched a new category, AdSense for games. Over 200 million people play web-based games every week. Our network already reaches almost 10% of them, just at launch. So, we are very excited about that. Speaking of display inventory, I just want to talk a little bit about YouTube. They have been experimenting with a number of monetization methods. We have now, the click-to-buy feature that you might have seen, where now if you watch a YouTube video that is either could be a user uploaded video or uploaded by, for example, a studio and now people can just click-to-buy either CD or a video or other content that is similar to that video and this is obviously a benefit to both end users as well as the publishers and presents a great monetization opportunity. I should also mention that we have launched full length videos from CBS within stream ads and that means they can be pre-roll, mid-roll and post-roll. These full length videos really take you to another level of offering completely different kind of video than one would typically expect on that site. We have also been investing a lot in geographic and local information and I am sure many or all of you have used Google Maps and Google Earth. They are really big monetization opportunity because they are such a local searches and there are many local businesses. Now we have been able to expand just a data available there, so we can provide a better end user experience by launching Map Maker to over 100 additional countries. This is our product of lets end users create and edit the maps for their own countries and regions and by doing so the users have already added over 50,000 kilometers of roads and 75,000 business listings. I should mention that an increasing percentage of our local search queries now deliver user generated maps content. We have launched Street View in Japan and Australia, and we saw significant increases in usage there. Of course free tune as now available on BlackBerries, and many Java enabled phones in addition to the other phones that already had it. It can be pretty handy, you know, when you do a search for now business or store, restaurants something like that, you can just click on the Street View and see what it actually looks like and make sure that is the place you want to go. As I mentioned before, now with the ability to do that on phones, it is very handy. Now speaking of phones, we of course had a very important announcement this past quarter, which is our new Android operating system and which is launching first on the T-Mobile G1. You can get these phones starting next week and at your T-Mobile store. I have been using mine for a few months now as my primary phone and it is been very helpful. It really integrates the Google services very nicely on the phone, it has really great web browser. You know, I am able to search and brows through my Gmail just as if I was at my desk top. The G1 is just the first of a number of phones that will hopefully be running Android. You should take note of all of the partners we have built in the open handset alliance. I would encourage you all to try it out and if it suits your need then please, by all means, get an Android phone. Moving on, we have been busy at work as Eric mentioned on Enterprise. Now we have over 1 million businesses using Google Apps. In fact, we have launched Google Video for your business as part of our Apps premiere edition. Now you may think of video like YouTube this basically for your business a last thing that might be needed in a business. In fact we have had great demand for it. Internally we use video quite a bit. We have so many internal talks that we are able to record and then the people, who miss it, can just watch it online. We have had just a great amount of demand by businesses for this. I think this will be a very compelling feature to our Google Apps product. In addition to businesses, Google Apps are increasingly being adopted by universities. Now over a million students use Google Apps just a couple of years after the launch, and we have had dozens of universities and colleges deploy Apps since the New Year just started including Indiana University, University of Virginia, George Washington, and many others. Now lastly, I wanted to tell you something I am really excited about. I am sure many of you saw, it is a launch of Google Chrome, which is our new web browser. As you know, we created a lot of web services, and an increasing challenge to us is to have a robust enough platform to be able to run those web services quickly, and reliably. Chrome does both of those things. It has incredibly fast JavaScript engine, which we are really excited about called V8. In addition, it has a process model that is much more robust. Now, if you have a problem with one tab in your browser, you can just kill that tab and your browser just keeps running just fine, whereas in the past, number of browsers if you had one tab hang you could hang the entire browser. We are continuing to improve it and we have opened sourced it entirely. So, not just Google, but the whole community is improving Chrome. We hope that it obviously continues to improve Chrome, but also it raises the bar for all browsers because we want all the web platforms out there more capable so we can more easily deploy our services. All in all, it is been a very busy quarter at Google. We have had so many announcements, launches, so many improvements; it is really hard to keep track. I appreciate all of you following it. Thank you and talk to you next quarter."
},
{
"speaker": "Eric Schmidt",
"text": "Well, thank you very much, Sergey. You are going to stay for the Q&A for a few minutes, too."
},
{
"speaker": "Sergey Brin",
"text": "No problem."
},
{
"speaker": "Eric Schmidt",
"text": "Thank you Patrick as well. We will have Hal, Jonathan, and Omid join us and maybe we would move to questions Krista."
},
{
"speaker": "Krista Bessinger",
"text": "Yes, we are ready do queue up for questions, operator."
},
{
"speaker": "Operator",
"text": "Thank you. (Operator Instructions). We will take our first question from Imran Khan from JPMorgan."
},
{
"speaker": "Imran Khan",
"text": "Hi, thank you very much for taking my question. Question about the economy and what the trend you are seeing. I think Eric, you talked about that the economy seems like weakening over the last four weeks or, so that I have been hearing the same thing. Can you give us some color like how is your business trend, July, August, versus September? Did you see the business weakening significantly in the month of September or if you can give us some color regarding what trends you are seeing in October? The second question is regarding the network revenue. Excluding TAC, it seems like network revenue growth rate decelerated quite a bit. I just try to understand that better, thank you."
},
{
"speaker": "Eric Schmidt",
"text": "Thanks, Imran. I am going ask Hal to help me here. We see fluctuations and they are more complex than they may appear; some things go up, some things go down. Obviously, it is going to change as the global financial crisis moves through. It also varies by country and by region. Hal?"
},
{
"speaker": "Hal Varian",
"text": "Yes, I think I can give you a little color on some of the things that are being going on. As you know we do not give guidance with respect to our internal numbers, but we have a nice tool out there called Search Insights; we can take the pulse of the consumer. If you look in the last several weeks, there has been this almost obsession with financial markets. Huge increases in inquiries on money market, mutual funds, buy gold, 401(k)s, banking crisis, LIBOR, home safes. So right now, I think it is very difficult to really extrapolate from the current period where you have got this major event going on, really a once in a lifetime event. Let's all hope it it is once in a lifetime. So, it is very hard to tell what things are going to look like going forward basis."
},
{
"speaker": "Eric Schmidt",
"text": "Jonathan, do you have a view on this?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Just very quickly on the second question which I did not think Hal got to the network deceleration. , Imran, there are really two things that you want to look at. Some of it is a function of quality efforts, and the other is basically a function of deal flow in the large partners that we have that are participating. So, those are the two things that you need to look at. Our landing page quality which Sergey mentioned in his introductory remarks relates to the quality issues."
},
{
"speaker": "Imran Khan",
"text": "Got it. Thank you. Hal, I agree with that and hope it is a one-time event of our lifetime."
},
{
"speaker": "Eric Schmidt",
"text": "Our next question?"
},
{
"speaker": "Operator",
"text": "We will go next to Mark Mahaney from Citi."
},
{
"speaker": "Mark Mahaney",
"text": "Thanks. I wanted to ask two questions please. First has to do with the thoughts on cost, Eric. You talked about being needing to be more cognizant of cost structure in a deteriorating economic environment, and what is going to be a severe recession. Does that mean you cut back on just on operating costs, or would there be a point where you would actually delay materially major investment priorities like mobile? Then a quick question to Sergey. Could you just talk broadly about what in display advertising you think can be fixed, or what are the major innovations that could be brought to display advertising that we have not seen before? When you look at that, what do you see that Google could bring to that market? Thank you."
},
{
"speaker": "Eric Schmidt",
"text": "Mark, on the question of investments, Google has shown courage, when we need to. We also intend during this period to show very responsible management of our expenses. Patrick, do you want to talk a little bit about how you are structuring this?"
},
{
"speaker": "Patrick Pichette",
"text": "Sorry, I got off mute. Yes, absolutely. I mean in these uncertain economic environments, and I think that we have seen it through to Q3 results. I think that the company is very responsible in managing its cost base to make sure that we are adapting to the environment in which we are operating. So, operational efficiencies and cost containment have been in place for couple of quarters already and they continue to do so. So, we are adapting. We are very nimble and very agile in this and we will continue to be. Regarding the second question that you have asked. Strategic investments are strategic investments and those you separate them from day-to-day operations, and every time we have a great opportunity, we are going to jump on it and as I said in my comments, the basics of CapEx infrastructures and the fundamental infrastructure for the company we are not going to stop. So, that is the balance we are striving."
},
{
"speaker": "Eric Schmidt",
"text": "Sergey, the second part of the question."
},
{
"speaker": "Sergey Brin",
"text": "Yes, on display; I think there are certainly a lot of opportunities in display, and let's just not forget when we first got started with AdWords or the predecessors to AdWords, it took us a number of years for those things to even catch up to what then was the big dollar numbers of the display advertising and finally to show the incredible power for both advertisers and end users of search-based advertising. So I think we could see the same thing with display where it actually takes actually while to mature with the new model. One of the things what I think is very valuable for display, even though it might be more brand focused, you still really care about targeting and showing the right ads to the right end users at the right times and try to show them things they might be interested in. You might want to have a return, not be a click necessarily but just be the branding and having generating awareness. Nonetheless, you really want to reach the right people. Now another part of that is we have great measurement tools. You know what happens after people might see an ad and how might they act differently. We also have access now to a vast variety of inventory ranging from our AdSense network to a variety of our DoubleClick technologies. This can give you access to more inventory and finally, our properties such as YouTube and Orkut. So we still see this as an area that is ripe for development and innovation and we think that we can continue to create great tools for display. This includes, by the way, things like not just – we are not just talking about banner ads on web pages, includes AdSense for games as I mentioned earlier, it includes feeds, it includes video like YouTube and other sites. So, it is a big opportunity."
},
{
"speaker": "Eric Schmidt",
"text": "Let's go to our next question."
},
{
"speaker": "Operator",
"text": "We will take our next question from Brian Pitz from Banc of America Securities."
},
{
"speaker": "Brian Pitz",
"text": "Thank you. You announced three changes relatively recently in particular replacing minimum with first page bids I think late in Q3. Would you talk about the early impact these changes are having on the auction process? Thanks."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yes, sure. This is Jonathan. That particular quality-based bidding effort I think was launched around the first week of September. Basically, the impact that that has is the quality score is calculated real-time on each query. So, what was happening previously was that keywords were inactive and not available based on the quality dynamic. What is happening now is there are keywords that are able to participate in every auction because we are calculating it real-time. So, it is basically allowing us to get what were previously in active keywords to compete in the auction more successfully based on the real-time calculation. That is pretty much it."
},
{
"speaker": "Brian Pitz",
"text": "Any major impact so far that you are seeing as a – how long will it take to really work its way through?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "As far as the quality announcements that we typically talk about, it is certainly one of the bigger things we did in the quarter and typically these things tend to manifest themselves in terms of their impact reasonably, expeditiously after the launch. So, I think that most of the benefit of the typical quality enhancements is real very quickly."
},
{
"speaker": "Eric Schmidt",
"text": "If you want to remind everybody that we make very – we commonly make 10, 20, 30, 40, 50 quality improvements in a quarter, these are just some of the better known ones. We are constantly tuning based on our quality testing and again globally as well."
},
{
"speaker": "Brian Pitz",
"text": "Great, thanks."
},
{
"speaker": "Eric Schmidt",
"text": "Our next question?"
},
{
"speaker": "Operator",
"text": "We will go next to Christa Quarles from Thomas Weisel Partners."
},
{
"speaker": "Christa Quarles",
"text": "Hi. My question is really related to the Yahoo! deal. Eric, were you surprised by the vitriol in the response from the advertisers out there? Clearly there is reality in how this thing functions versus perception. I would be curious how are you approaching the government meddling in your ability to function and operate and how are you responding as it relates to the Yahoo - Google arrangement?"
},
{
"speaker": "Eric Schmidt",
"text": "Well, Christa, thank you. I will let you used the phrase meddling and I am not going to be using that phrase. When we did the deal, we understood that the deal would be both controversial that our competitors would oppose it, and they would oppose it using every tactic that they could and also that there was a proper role for the legal review process. So, we anticipated were turned out to be roughly four-month delay. Literally to give everybody time to talk about it. We are hopefully during the end of that period and we are obviously in communications with the Justice Department and the other groups that are doing it. With respect to the advertiser reaction, we have seen a balance of reactions. We have seen some large advertisers, complain. We have seen other large advertisers say that this is ultimately good for our businesses. I obviously have a bias on this question and in my view many of the complaints are based on the fact that people do not understand how the auctions really work and the benefits that auctions provide. Auctions provide really a clearing price for accurate value and because the prices in our auction are largely set by people, who can back-solve to the cost per acquisition. The cost-per-click and the revenue that we get is largely tied all together. Hal in fact wrote a blog post yesterday precisely on this issue because there has been so much confusion about it. Hal, do you want to comment on that?"
},
{
"speaker": "Hal Varian",
"text": "Sure. We have been making a concerted effort to try to educate people more about how our model works. One thing we were bit surprised in is even people, who had been using AdWords did not necessarily understand how and why functions the way it does, so we are really trying across the Board to communicate better with all the sectors that we serve."
},
{
"speaker": "Eric Schmidt",
"text": "So, next question."
},
{
"speaker": "Operator",
"text": "We will go next to Ben Schachter from UBS. Ben Schachter - UBS Congratulations on a nice quarter."
},
{
"speaker": "Eric Schmidt",
"text": "Yes. Thanks Ben."
},
{
"speaker": "Ben Schachter",
"text": "In order for the display strategy to work, do you think you need to offer more inventory on your own sites or can it become meaningful just through better penetration of the AdSense network. Also on Google Checkout in the past there have been a lot of discussion around the badges and how they have increased click through rates and conversions. Seems there is less of an emphasis on that product. Does it make sense to potentially work with PayPal on moving forward. Then one last house keeping one. If you look at depreciation and cost of goods less TAC they seem to be flat quarter-over-quarter, which is never happened before. Any comments on that? Thanks."
},
{
"speaker": "Eric Schmidt",
"text": "So, you asked three questions and so Patrick you will do the third one. Omid can you and thanks Ben for that. Can you talk a little bit about display and Checkout?"
},
{
"speaker": "Omid Kordestani",
"text": "Sure. Ben I am calling from London so please let me know if the voice is not getting through correctly. As far as we mentioned earlier we put a concerted effort across all the regions in our product teams and brought Dave Rosenblatt into the position with his vast experience from DoubleClick to help us really pieces all together, and bring a great focus in our execution. Simply, our objective here is that we want to marry the art of display, which is the engagement it offers with the science of search advertising relevancy and measurability. We have a lot of inventory, great inventory both across our Content Network already and across YouTube and that our goal really is to focus both on the advertisers and publishers here for advertisers, really scaling the advertising process for media planning, buying, selling, all the way to optimization and for publishers helping with increasing the yield, and that they are experiencing. We have great, great headways already in Q3. We had NBCOlympics.com using DoubleClick serving ads over 30 million unique users. In Europe, they use the platform very effectively to increase the number of transactions and reduce the cost per transaction by 33%. So, this measurability and reach is already very effective across our network and our existing properties. As Sergey mentioned a long-term focus for us to get all the pieces together and execute and grow the business. As far as Checkout goes, I think again, we continue to evaluate what is the best ways to focus and utilize the existing headway we have made. There is really nothing, really new to announce here other than we are considering how best to apply the service, going forward. We are open to all kinds of options and we will evaluate it as and we see the results."
},
{
"speaker": "Eric Schmidt",
"text": "Patrick, do you want to handle the last question?"
},
{
"speaker": "Patrick Pichette",
"text": "Yes, I would just like a clarification. You said about D&A specifically or is it OpEx excluding D&A and TAC that was a question?"
},
{
"speaker": "Ben Schachter",
"text": "No, I was really looking at the depreciation and looking at the cost of goods less the TAC. If you look at those excluding stock and they are both flat quarter-over-quarter and that has never happened."
},
{
"speaker": "Patrick Pichette",
"text": "Yes, what we have done is in the first part of the year, we had been accelerated some depreciation amortization in the bunch of equipment now is flow through. That is really the core driver of that."
},
{
"speaker": "Ben Schachter",
"text": "Thanks."
},
{
"speaker": "Eric Schmidt",
"text": "Okay, thanks. Next question?"
},
{
"speaker": "Operator",
"text": "We will go next to Doug Anmuth from Barclays Capital."
},
{
"speaker": "Doug Anmuth",
"text": "Thanks for taking my question. First one for Sergey, you made some comments last quarter indicating the coverage may have dipped too low. Can you talk about what you did with coverage during 3Q and a little bit on your updated view on that? A second one for Hal, can you just talk about how advertisers are changing their behavior and strategy in terms of keyword bidding in this environment, and what is happening with average cost-per-click and what is happening with ROIs as well. Thank you."
},
{
"speaker": "Hal Varian",
"text": "Sure. Hi, Doug, I can start briefly on coverage and maybe Sergey can follow-up. I think one of the things that we have probably done a better job in the last year or so, is we have done a much better job of eliminating the bad ads than we have introducing functionality that makes it particularly easy to enable, good ads. This is not really a dial that we just want to turn. We have a very clear goal, which is to show as many high relevant ads against queries as possible and there are lots and lots of queries still out there that we can do better on. We have a good list of those, particularly complicated long queries, or queries that have very diverse meaning. Queries with modifiers, for example if you look on 'Wee Games', we have ads. However, if you type in 'best Wee Games', we do not. Your plumber is not on AdWords. So, the goal is not really too explicitly we try to figure out how we get coverage up. The goal is to figure out how we add the bidding functionality, so that advertisers can serve better ads. If you are actually looking at your components of the RPM equation, which we do not really break out much. Generally you are seeing what we have said in the past, which is the coverage is in the ballpark of the historic lows."
},
{
"speaker": "Jonathan Rosenberg",
"text": "With respect to the advertiser behavioral side, people focus on this aggregate cost-per-click measure. As we have said before, it is misleading, because it is aggregating across the entire world, and it is aggregating across AdWords and AdSense So relatively small changes in the mix can show up in that number. We do not really think it reflects the actual advertiser behavior, in a very clear way. Our experience is advertisers are willing to take all the clicks we can give them at the current CPC, and even in tough times. We think that will continue to be true because nobody wants to turn away a customer. So, we think that is actually a pretty solid number and will continue to be so and thank you."
},
{
"speaker": "Sergey Brin",
"text": "Yes. This is Sergey. You are exactly right, that is what I know in the last quarter. I should mention that we have made progress. For example the quality-based bidding launch that we talked about earlier increased our coverage significantly and fundamentally as Jonathan says look at page of our web search results. I think we are far from the ideal set of advertisements and there are many advertisers that I think ought to be showing up certain situations that that are not for variety of reasons. So, I think there is certainly opportunity to give end users better higher quality, advertisers they are going to add their overall search quality experience."
},
{
"speaker": "Eric Schmidt",
"text": "Okay. Thank you. Thanks Sergey. Next question?"
},
{
"speaker": "Operator",
"text": "We will go next to Justin Post from Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "Thanks. Now you have had a bunch of mobile phone launches. I am wondering if you can give us an update on what you are seeing on the query volumes and maybe an estimate on when that could be maybe 5% of your total volumes and then on the currency I think you said it cost you $80 million in the quarter. Is that one time as you established the hedges or this is ongoing thing that could last a few more quarters?"
},
{
"speaker": "Eric Schmidt",
"text": "This is Eric. We said publicly for the last few months that we are seeing an explosion in mobile search volume. It is a lot of it has been enabled by the fact that these new sets of devices have much more powerful browsers. So, they are on 3G or E-Video networks and they have more powerful browsers and people are busy browsing. You know just an amazing amount of time. We do not show the exact numbers, but I can tell you that the compound growth rate is one of the fastest growing things in the company. Patrick, you want to answer the second part?"
},
{
"speaker": "Patrick Pichette",
"text": "Yes, the $80 million was – in both Q2 and Q3 because we have launched these programs and put them in place, they are much higher than what you can expect in the future. In fact, we have got the 18-month programs mostly in place for the three big currencies I talked about and now we are going to be in maintenance mode. So, from that perspective it will be less."
},
{
"speaker": "Justin Post",
"text": "If the US dollar keeps appreciating will you continue to see a revenue benefit."
},
{
"speaker": "Patrick Pichette",
"text": "As you put hedges over the long-term, yes, the answer is yes."
},
{
"speaker": "Justin Post",
"text": "Thank you."
},
{
"speaker": "Eric Schmidt",
"text": "You are assuming it will or will not. So, we never know. I will say, yes, we never know, whether currency is going to go up or down. Let's move to our next question."
},
{
"speaker": "Operator",
"text": "We will go next to Ross Sandler from RBC Capital Markets."
},
{
"speaker": "Ross Sandler",
"text": "Thanks for taking my question, just two quick questions. First on the retail category, so eBay painted a pretty disastrous picture for ecommerce and the consumer in general last night, stating that there was a meaningful slowdown in activity beginning in August and deteriorating in the mid-October. Clearly that company is having some specific issues, but you did not mention retail as a category of weakness in your prepared remarks and judging by your numbers, especially in the US that would suggest that you are pretty well diversified. So, can you comment on the current trends in the retail category and then second on the UK?, Google changed its policy on bidding on gambling keywords this morning and it appears that those ads go live tomorrow. So, unlike prior policy changes this one was delivered with a little advanced notice, agencies got the criteria this morning, and campaigns go live right away. So, any reason for the quick rollout there? Thanks very much."
},
{
"speaker": "Eric Schmidt",
"text": "Thank you. We will have Omid, since he is in London, he will answer the second question. The first question, we have looked at what we think will happen in the next few quarters. The problem is, there is so much uncertainty now in the financial markets, in the press, and in potential government action, and so forth. It is very hard for us to give you a sense of what is going to happen in retail or any category between now and the Christmas season or over the next 12 months or so forth. Hal, you have looked at the various categories, if you want to can you give some macro comments about categories for us?"
},
{
"speaker": "Hal Varian",
"text": "Well, when you look at the US aggregate statistics, we definitely saw weakness in US offline retail the numbers that are reported by the government. One thing that we think at Google is that when there is a recessionary environment, people are counting their pennies, they are going to be researching their purchases, looking for bargains, and this potentially has something of an upside for Google. We referred to this last time I called it the Wal-Mart effect that as people shop more carefully they are going to be researching the things they buy. So as Eric said, we do not really know what is going to happen. This is a speculative statement but we think that this effect could actually work to Google's benefit potentially."
},
{
"speaker": "Eric Schmidt",
"text": "Omid, do you want to comment on the UK."
},
{
"speaker": "Omid Kordestani",
"text": "Sure. I think to be honest with you, this is one of the benefits we have now of much tighter attention to every aspect of our international operations. We now have both Nikesh, our Head of EMEA and Tim Armstrong, Head of Americas attending our executives meetings, and they are frankly upset of policies and questions that the market had put on us, and we really are being much more responsive to these things to our sales organization and change these policies, very quickly to address to the market demands. So, I think you – we will definitely work with our agency partners and customers to make the transition as smooth as possible."
},
{
"speaker": "Eric Schmidt",
"text": "Thanks. So our next question?"
},
{
"speaker": "Operator",
"text": "We will go next to Jeffrey Lindsay from Sanford Bernstein."
},
{
"speaker": "Jeffrey Lindsay",
"text": "Hello and thanks for taking my question. We just wanted to talk a little bit clarification on the improvement in margins. Was this due in any way to improved terms on the AdSense deals or was it primarily expense control? If it was expense control was that really through avoided hiring or was there actually any staff reduction? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "I can answer on the expense side. Across all categories of expenses, people have been very diligent over the last 90 days and I can – and on the specifics of hiring, I mean, we have continued to hire. We just hire in many areas. We are continuing to hire because we have a lot of needs and then what we are doing is just doing responsibly. So there – we will continue to hire, that is why you see the net improvement in headcount but it is truly broadly across all categories of expenses that we are focusing let it be AdSense, it covers it."
},
{
"speaker": "Eric Schmidt",
"text": "I am not aware of changes that would – on the ad or ad partnership side that would result in margin change. Omid?"
},
{
"speaker": "Omid Kordestani",
"text": "No."
},
{
"speaker": "Eric Schmidt",
"text": "Okay. The next question?"
},
{
"speaker": "Operator",
"text": "We will take our next question from Youssef Squali from Jefferies."
},
{
"speaker": "Youssef Squali",
"text": "Hi, thank you very much. Two quick ones; first on CapEx, if I look at CapEx this quarter, so $450 million was the lowest we have seen since Q1 of 2006. Are we at a point, well, basically the bulk of the infrastructure is already built and now any incremental is all that much smaller. Is CapEx starting to normalize? Second, a question for Sergey. You talked earlier about GeoLocal with product like Maps and Earth is big monetization opportunity, so we have talked about them for a long time and they remain opportunities. One of the issues there has been this direct access to the advertisers to the local merchant. Have you – are we any – are we closer to cracking the code on that?"
},
{
"speaker": "Eric Schmidt",
"text": "Patrick, do you want to give a sense of CapEx?"
},
{
"speaker": "Patrick Pichette",
"text": "Yes, with pleasure. I mean essentially, CapEx is a lumpy business in many instances. So think of data centers going up and down I mean one quarter you have it, one quarter you do not, so we are going to continue to invest in CapEx, we are going to continue to invest heavily in CapEx, so we have no plans of slowing down. What you see here is just a nature of that lumpiness. We are obviously getting better at it, so with efficiencies every extra unit of capacity is cheaper for us, so we are going to benefit back."
},
{
"speaker": "Youssef Squali",
"text": "Were there any costs pushed out into CapEx into Q4?"
},
{
"speaker": "Patrick Pichette",
"text": "No, none."
},
{
"speaker": "Youssef Squali",
"text": "Okay."
},
{
"speaker": "Eric Schmidt",
"text": "Sergey and maybe Jonathan you want to have a look about the GeoLocal ad opportunities?"
},
{
"speaker": "Sergey Brin",
"text": "Yes, let me talk about it. Certainly GeoLocal has been a substantial source of investments on the part of our company and you are absolutely right. I think it is a really big monetization opportunity but it is going to have a pretty long bootstrap time because there are so many small businesses and you have to get them all in the loop. Technology is evolving quickly with respect to things shifting to mobile phones and some of them will have GPS now, some of them do not, some have cell ID different device and things. I do think that this is an investment that we are going to have to keep investing in for some time till we get really big payoff. I should mention we already have fairly substantial revenues from geo local, so it is not the case but somehow this is I mean this is a good chunk of our business and I expect that when we do finally bootstrap lots and lots of local advertisers. When there is some settling of the best user experiences for doing this both on mobile devices as well as on the desktops, I think you will see a substantial ramp there."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Eric, do you want me to add anything. Yes? This is Jonathan. The biggest thing I would reinforce from Sergey's comments is, this is an area where we are winning. Maps is the most popular mapping site in the world. We have got all sorts of data now for over 160 countries. We are also doing some very exciting things in terms of ramping our ability to get data for areas where there are not very good maps, where we are harnessing the power of users to enter information in. On the local side, what we are doing really goes beyond the traditional Yellow Page types of activities and I mean we are taking all the information that a business would want or a user to see; reviews, hours of operations, photos, web results, and we are embedding all of those on to these maps which have a great deal of traffic. So, if you just run a query, steakhouse in Chicago or something like that and when you click on the map and select a particular listing, you can now do things like click on Street View and actually see the restaurant. So we are very pleased with the traffic that is being driven. One other thing I would actually suggest you try one of the coolest maps applications I saw. Go to swisstrains.ch to see the precision of Swiss trains in real-time and you will actually get a visceral sense of what it is going to be like for people when all of this stuff works on their browsers and works in mobile devices."
},
{
"speaker": "Eric Schmidt",
"text": "Let’s go ahead and Krista I think we – this is – we are sure of running out of time, maybe this should be our last question. Krista Bessinger Yes, this is our last question. Please."
},
{
"speaker": "Operator",
"text": "Our last question comes from Jeetil Patel from Deutsche Bank."
},
{
"speaker": "Jeetil Patel",
"text": "Great, thank you. Just one last question; on your AdSense syndication network, can you talk about the rollout of the quality score initiative? Is it still at first half '09 rollout or perhaps a little longer and have you learned anything around the testing that you are doing there or still tweaking that? Thanks."
},
{
"speaker": "Eric Schmidt",
"text": "So, again, you are using the word quality score. Could you just be precisely define what you mean?"
},
{
"speaker": "Jeetil Patel",
"text": "The scoring index you are looking at for your syndication network, so rating each partner out there; just curious how that –how that initiative or program that you are looking at launching is progressing?"
},
{
"speaker": "Eric Schmidt",
"text": "It is actually in the process of being launched. A number of partners already working with it and the plan is to get it done in early next year. Yes, so and obviously we spent a lot of time with them to make sure that their sites are done properly, our system responds properly to their query traffic and so forth."
},
{
"speaker": "Jeetil Patel",
"text": "Got it. How often will the scoring system change? Will it be real-time or will it take a month at a time or quarter at a time?"
},
{
"speaker": "Eric Schmidt",
"text": "We tend to be very dynamic because these systems have feedback in them. So, as they learn, they get better at judging, what is a higher quality click and as they learn they get better and better and that is why such a nice model."
},
{
"speaker": "Sergey Brin",
"text": "This is Sergey. Probably I think we have had this system in place for AdSense for Content for a long, long time. Now it is the extension of that into AdSense for search. These are obviously some of our larger customers that have significant implementations and we are taking our time to roll it out in a way that is have sensible for both us and them. This is something that we have been doing for a long time within AdSense for Content, now that will be applied more broadly."
},
{
"speaker": "Eric Schmidt",
"text": "So, why don't we go ahead and just finish up? I want to thank everybody for spending time. Everybody is very busy with all the things going on around the world. Thank you for our panelists and our call in today. From my perspective, there is an awful lot of stuff going on in the world, there is an awful lot of actions that we hope will be taken correctly by governments around the world, by the bankers and by the institutions that are there to make sure our systems run well. We have a duty and responsibility to run Google well. We take a long term view. We have the opportunity before us and we have the time and the patience to build a great future which is what we hope will happen for everybody. So thank you very much."
},
{
"speaker": "Operator",
"text": "This concludes today's conference. We thank you for your participation. You may now disconnect."
}
] | null | null |
GOOGL | 2 | 2,008 | 2008-07-18 16:30:00 | Operator: Welcome, everyone to the Google Inc. conference call. This call is being recorded. At this time, I would like to turn the call over to Ms. Krista Bessinger, Director of Investor Relations. Please go ahead, ma’am.
Krista Bessinger: Good afternoon, everyone and welcome to today’s Q2 2008 earnings conference call. We have a slightly different line-up today. With us are Eric Schmidt, Chief Executive Officer; George Reyes, Chief Financial Officer; Sergey Brin, Founder and President of Technology; Jonathan Rosenberg, SVP of Product Management; Omid Kordestani, SVP of Global Sales and Operations; and Hal Varian, Chief Economist. Eric, George, Hal and Sergey will provide us with their thoughts on the quarter and then Jonathan and Omid will join us for Q&A. Please note that this call is being webcast from our investor relations website and our press release, issued a few minutes ago, is also posted on the website along with slides that accompany today’s prepared remarks. A replay of this call will also be available on our investor relations website in a few hours. Now let me quickly cover the Safe Harbor. Some of the statements we make today may be considered forward-looking, including statements regarding investments in our core business; seasonality; traffic acquisition costs; increases in the cost of sales; international growth; statements regarding the benefits of our acquisition of DoubleClick; and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings including our quarterly report on Form 10-Q for the quarter ended March 31, 2008 as well as our earnings press release for a more detailed description of the risk factors that may affect our results. Copies can be obtained from the SEC or by visiting the investor relations section of our website. Also, please note that certain financial measures that we use on this call such as EPS, net income, operating margin and operating income are expressed on a non-GAAP basis and have been adjusted to exclude charges relating to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and GAAP to non-GAAP reconciliation can be found in our earnings press release. With that, it is my pleasure to turn the call over to Eric.
Eric Schmidt: Thank you very much, Krista. We’re obviously very pleased with what we believe are good results in one of the weaker quarters in our normal yearly cycle. The traffic and revenue growth was strong across all regions and verticals. Traffic and revenue have held up well despite uncertain economic conditions, as everybody knows. International, of course, a big emphasis where Google is once again contributing more than 50% of our revenue; good growth in rapidly growing markets such as Brazil and China. We continue, of course, to make critical and fundamental investments in the infrastructure of the things that are most important, and in particular, search. We continue to scale our index; we continue to make sure that our information is the freshest possible and we are reducing latency or delays that people experience. So as a result, we are continuing to deliver on our fundamental mission of the most relevant and fastest results of web and other kind of information. In ads, in addition to all of the normal ad improvements that we see, the partnership with Yahoo! was obviously the signature event. David Drummond testified two days ago, both for the House and Senate. I liked it so much I wanted to read it. The internet is a dynamic and competitive environment and that is due to the openness that has been a hallmark since its inception. Our non-exclusive commercial agreement – that is very important, by the way, non-exclusive -- with Yahoo! will maintain and expand that competition. It creates new efficiencies that will benefit consumers, advertisers and publishers as well as protecting privacy and spurring innovation. Google and Yahoo! will remain fierce competitors. This continuing competition will help fuel innovation that is good for the internet, users; good for the internet, good for the economy. Openness, interoperability and competition are central to our culture at Google, central to the vibrancy of the internet and central to the growth of a free market. We believe that the non-exclusive ad deal – remember it is not a search deal -- that was done with Yahoo! is a win for the industry primarily because it allows Yahoo! to remain independent, which we believe is very pro-competitive. DoubleClick of course, is the other big piece of news. Integration is now underway and going very smoothly, with display as a big opportunity. And big opportunity, by the way, because the strategy of offering value to advertisers and publishers is one that we can offer very much worldwide. Putting our team together, of course, we've really now delivered on this global organization that everybody here knows about, and it is beginning to bear fruit. [Angalore] for example, developed some great new ad tools that were delivered last quarter; [Zurich] created our new Insight feature on YouTube which lets anyone who uploads videos see traffic information. [Hifa] developed another great new YouTube feature called Imitations. My point here is not to highlight the hundreds and hundreds of ones that happen all the time, every quarter, but to say it really is a global company. So we now have more than 30 products that support more than 30 languages, up from five products and 30 languages just a year ago. So people want to use Google in their own language and we are delivering on that. Just to finish up my hopefully short comments, we are very, very happy to have Patrick Pichette on board as our new CFO with 20 years experience in financial operations and management in the telco industry. I've talked to him; he is coming up to speed. He is going to be a tremendous contributor at Google for many years to come. I am very, very excited about that. I want to make sure that we thank once again George Reyes, my friend and colleague for more than 20 years. George stayed on board even more than a year after he announced his intent to retire. This shows you the kind of person that he is, to try to help Google and to help all of us meet our objectives. He has made a tremendous contribution to Google, which we have highlighted before. We are going to miss him, and we are very much looking forward to working with Patrick. In our order today we are going to have George, who I have just highlighted, if I can boast about him some more without making him too embarrassed; and then we will have him followed by Hal Varian. Larry is out this week. Hal is our Chief Economist and there have been so many questions about Yahoo!/Google economics and so forth. Hal is the perfect person to talk about how does the auction really work and what does the global environment mean for Google? George, do you want to take it away?
George Reyes: We had another strong quarter, with gross revenue increasing 39% over Q2 of 2007 to $5.4 billion. Google.com performed well, up 42% year over year to $3.5 billion, driven by strong traffic growth and to a lesser extent, monetization. AdSense revenue grew 22% over Q2 of 2007 but was down slightly on a sequential basis, reflecting a continued focus on delivering high quality traffic to our advertisers and typical Q2 seasonality. Now let’s take a look at aggregate paid clicks. Aggregate paid clicks include clicks related to ads served on Google properties, as well as ads served on our partner sites. Aggregate paid clicks grew approximately 19% over Q2 of 2007 and were down slightly on a sequential basis, again reflecting a continued focus on delivering high quality traffic to our advertisers and typical Q2 seasonality. Now I’ll discuss our international performance. International revenue accounted for 52% of revenue, or $2.8 billion. The UK was solid with revenues of $774 million, up 29% year over year but down 4% sequentially, reflecting typical Q2 seasonality and negligible FX impact. Revenue growth in EMEA was strong, primarily driven by strong performance in Benelux, Ireland and parts of Western Continental Europe including Germany, France, Spain and Italy, fueled by relatively strong performance in automotive and consumer packaged goods. Asia and Latin America continue to show impressive growth as well with Japan, Argentina, Australia, Brazil and China being notably strong in Q2. Now turning to expenses, traffic acquisition costs were $1.5 billion, or 28.4% of total advertising revenue, down from 29.2% in Q1. AdSense TAC was $1.3 billion, while TAC related to distribution partners and others who direct traffic to our websites totaled $154 million in the quarter. As we grow our AdSense Partner Network and embark on new initiatives, we may see additional pressure on TAC rates going forward. Other cost of revenue, which includes $9 million in stock-based compensation, increased $49 million over Q1 to $674 million. The largest driver of the increase was the increase in costs related to our data centers, including depreciation, equipment and operations. We continue to anticipate that other cost of sales could increase going forward. Other than cost of revenue, operating expenses totaled $1.64 billion, including approximately $264 million in stock-based compensation. Expenses related to payroll and facilities increased $1 million over Q1 to $810 million. At the end of the quarter, we had a full-time employee base of 19,604. We added 448 net new employees in Q2 with roughly half the new non-DoubleClick hires coming on board in engineering, followed by sales and marketing. We have implemented and continue to follow a discipline hiring process in all areas of our organization. But as we have indicated in the past, we will continue to invest in our core business both in the U.S. and internationally. Remember also that we usually see an uptick in starts over the summer, coinciding with the end of the academic year. Turning to non-GAAP operating profit which excludes stock-based compensation, it increased to $1.9 billion in Q2, with non-GAAP operating margins of 34.5%. Note that interest income and other in Q2 was $58 million, down $109 million from Q1. To be clear, this was not a writedown nor was this due to any losses. Instead it was primarily due to lower yields on our cash balance; lower average cash balances as a result of cash used in the first quarter to acquired DoubleClick; lower net realized gains on the sale of our marketable securities; and an increase in expenses as a result of more activity under our foreign exchange hedging programs. Finally, turning to cash, operating cash flow remained strong at $1.77 billion, with CapEx for the quarter of $698 million. As in previous quarters, the majority of our CapEx was related to IT infrastructure investments, including data center construction, production of servers and networking equipment. We expect to continue to make significant investments in CapEx in future quarters. Free cash flow, a non-GAAP measure which we define as cash flow from operations less CapEx, remained strong at $1.7 billion, up 63% year over year. In summary, we believe our core business continues to demonstrate strength while we make key investments to pursue long-term growth opportunities. At this point I want to take a moment to thank Eric, Larry, Sergey and the rest of the management team for having had the privilege of working with all of them. This is an opportunity that I will never forget. Let me turn it over to Hal.
Hal Varian: Thanks, George. Eric asked me to comment on the state of the economic environment and how that’s impacting Google. When we look across sectors of the United States we see that on a year-on-year basis, the query growth has been positive in every sector we track, even including those sectors that are generally economically sensitive such as automotive, real estate and travel. We also see that year-on-year revenue growth is positive in every major sector expect for real estate, and even that one is only down by a small amount. When we look at the sub-sectors, we see some interesting patterns. The weaker components are just the ones you would expect to see based on the macroeconomic climate: auto financing, home financing and real estate agencies. These are the sorts of queries you would expect to see when auto or real estate transactions have already taken place, and we see, as we all know, fewer transactions are taking place in those sectors. It is interesting to note that year-over-year automotive ad spend is up, even though the growth in auto financing is down. I interpret this as saying that auto advertisers are willing to spend on clicks, but the weakness is on the consumer side. However, I should emphasis this behavior is not universal. Spending seems to be holding up pretty well in other consumer durable categories such as home appliances and home furnishings. When we turn to Europe, we see a similar pattern. In the UK we had across-the-board year-to-year growth in both revenue and queries, with the sole expectation being real estate. Continental Europe grew in both queries and revenue in every major vertical. So to summarize, when we look across verticals we see that consumers are being cautious in their online spending patterns just as they are in their offline spending. Despite the weakness in the economy, advertising revenue seems to be holding up remarkably well in most sectors. I think this illustrates the point that we have made several times. During periods of slow economic growth, the last thing an advertiser wants to cut is its spending on search-based advertising. So with that, let me pass the mic to Sergey, who is going to talk about what he will be doing in products.
Sergey Brin: Hello, everyone. It is really exciting for me to update you over the past quarter. We have had a lot of substantial improvements, new launches. Let me just start with search. We have substantially increased the size of our index, and in particular, actually the index of documents that we refresh every few minutes has also grown tremendously. So now, our users get much fresher and faster results, across a greater range of sources. We have -- just all told, to give you a sense for this -- launched over 100 search quality improvements this quarter, so roughly one a day. Some of the highlights: Again, we have increased coverage in universal search, which means you get your web pages mixed in with video and images, news, books, all of those things we are able to show more and more. That improves our search results and it pays us a double dividend for all of the work we have been doing on corpuses such as book search. We also just added blog results at the bottom of the page in the past quarter, and our blending of Maps results we have put into 130 more countries than we had in the past. We have also been running more one box; for example those of you in Europe might have enjoyed our Euro 2008 one box in June during the soccer tournament. Let me just take a step away from just the basic search. Many of you, I know, use iGoogle and in fact we know that because we have had such tremendous growth, especially internationally. More than 60% of iGoogle users are now outside of the U.S. We had some very important developments, in particular with themes this quarter. You might have seen our iGoogle artist campaign where 68 artists across 22 countries created new themes for the product. This encouraged hundreds of thousands of people to sign up for iGoogle, and of course the good thing is so many of them changed their themes to these artist themes. I have personally set my iGoogle page now to go do a rotation across the top themes, and that is really fun. Everyday I get a new feel and they are aesthetically pretty exciting and varied. If you are listening to me right now you probably speak English pretty well, though of course if you are reading a transcript that has been translated using Google Translate then you might not. It is very important to be able to have access to information in languages that you don’t speak, especially if you are a non-English speaker. I mean, the amount of information that’s out there that can be useful to you that’s not necessarily in your native language is huge. To this end, we have been of course working on Google Translate. It now covers over 20 languages. We’ve added 10 just in this past quarter alone and now we let you translate from any one of those languages to any other of those languages. We’ve been able to improve the performance and have tremendous growth in usage as well. We’ve also been working on our cross language search so we don’t necessarily just search literally in the language that you search; we are able to produce translated results in other languages now, more automatically. You can expect us to continue to expand that work. In ads I should highlight a notable development. Our AdSense Network now allows third parties to host and serve ads, and this has been important to many advertisers. Just as one example, Lenovo is now advertising with us because we can support this kind of third-party ad serving. Now advertisers find out more about where they should be advertising because we’ve launch the Google Ad Planner. That lets you see what kind of sites a particular audience that is interested in whatever the advertisers’ are advertising, which sites do they visit? What are the breakdowns of demographics? It lets you do very complicated statistical analysis and I encourage you all to try it out, even if you are not an advertiser, it is pretty fun to be able to play with that data. Let me just jump a little bit onto YouTube. Probably most of you have had a chance to try to watch some YouTube videos, and in fact, our data suggest that more and more of you are. We now have 13 hours of video uploaded every single minute, so as you can imagine, it would take quite a many lifetimes to watch all the YouTube videos. It also gives you the opportunity, of course, to watch video on very specific topics that may be of interest to you. We've also been experimenting on YouTube with a variety of advertising formats and we have had some great successes. Lionsgate marked the opening of the film “The Forbidden Kingdom”, for example, and it had over 4 million video views on YouTube just from that promotion. So that was very exciting for us and for Lionsgate. I should mention that mobile search has been growing quite a bit, and of course you may have heard about our partnership that we've launched in this past quarter with NTT DoCoMo in Japan. Japan is a very strong market for mobile search because of the devices, because of the culture it is just a really tremendous environment. People do many, many mobile searches. We have a robust advertising market there for mobile search. We are certainly optimistic that many of these advances which may initiate in Japan will carry over to the rest of the world as the devices and culture catch up. I want to also mention that our mobile search experience, which we have now rolled out to more countries and we have made substantially faster, is also causing a lot of growth in that segment for us. One of things that I am most excited to tell you about today is our progress with Apps. I should mention first of all that our enterprise business with respect to Apps has been growing very rapidly. There are now more than half a million businesses that are using Google Apps for their day-to-day productivity, and that is just a tremendous number. Just to give you color on what some of these businesses include, in this past quarter Valeo, one of the world’s leading automotive suppliers now has 32,000 users using Google Apps, including of course Gmail, Calendar, Docs and so forth. The Government of Washington D.C. has 38,000 users on Google Apps. General Electric has adopted the security side of the Apps products which was formerly Postini, and that’s running on over 300,000 users. Just to call out a few other highlights, the Telegraph Media Group and Sanmina both also adopted Google Apps. So, it’s been a very exciting quarter for that. Starting from these half a million businesses, including some of these incredibly successful businesses, we really expect this to be an important area for growth and development. I just want to tell you, we don’t view Google Apps and what not as we don’t want to create a closed environment or a walled garden. We really want to encourage more and more cloud computing and we want to see more and more companies out there successful in deploying cloud solutions. One of the things we launched in this past quarter is the Google Apps Engine which basically means that developers can easily write an application and deploy it on our scaled infrastructure rather than having to try to put together all of their own computers, data centers, networking, all of that stuff. We handled all of that for the developers. We have a rapidly growing base. Just a few fun examples: we had a nine-year-old boy who contacted us with a bunch of questions, and then he has been able to develop his app on the Google Apps Engine. He said that he has been able to do it now because previously he was spending all of his allowance on hosting, and he could no longer afford that. Other, more commercial ventures include PixVerse, a chat application that switched to Google Apps Engine after we launched it, and it was subsequently purchased by the social network Hi5. As well as for those of you who are into poking, BuddyPoke, a very popular open social app which is running on Orkut and MySpace has also been developed on the Google Apps Engine. We expect that we're going to have a lot of uptake of our various developer products and APIs, including the Google Apps Engine, and ultimately we think that the cloud is just a really great place to deploy Apps because of the simplicity for end users to access them, the ease of updating and maintaining them; it is really a great environment. We obviously live it everyday and we believe it really helps people be more effective and productive with their day-to-day lives. Anyway, all told, a great quarter, lots and lots of progress and it has been a pleasure to talk to you about it.
Eric Schmidt: Thank you very much, Sergey. Why don’t we go straight to everybody’s questions? So are we ready? Let’s hear the first question.
Operator: (Operator Instructions) We’ll take our first question from Imran Khan - JP Morgan.
Imran Khan: First, if I look at that UK growth rate, it seems like on a year-over-year basis the growth rate decelerated 10 points. I was trying to better understand, is it because of the law of large numbers, or are you seeing any specific weakness that’s dragging the growth down there? My second question is related to the mobile search. Sergey, you talked about the mobile search opportunity. Do you think that the mobile search will expand the search volume? What kind of impact do you expect on your revenue per queries with that? Also, have you have seen any impact from Apple iPhone yet? Thank you.
Eric Schmidt: Jonathan, do you want to go ahead and answer the UK question?
Jonathan Rosenberg: Sure. Thanks, Imran. I think basically we are just seeing the typical Q2 seasonality. If you look back at Q1, that of course was very big. I think we talked in the Q1 call about some of the verticals like travel. The other point would be that we have very, very high market share in the UK. As our market share grows, I think in past quarters when you looked at seasonality, the gains in market share may have been masking some of the seasonality. Now what we’re seeing is just the typical, appropriate Q2 seasonality. [Inaudible] the impact was negligible.
Eric Schmidt: Sergey?
Sergey Brin: On mobile I certainly expect to see an uptick in search volume due to mobile because you are obviously not always at your desktop, but you pretty much always want to know something. With respect to the revenues per query I think that will vary from market to market and I think it will also vary as we develop more specialized monetization programs for mobile phones. You know, in some respects you can’t fit as much advertising, obviously, on a really small screen. On the other hand, the queries are very localized. I mean, you might be standing right next to that pizza place that wants to entice you to become a customer, or something like that. So I think there’s an opportunity for much more fine-tuned targeting. Both of those things are going to balance out. With respect to the iPhone, I don’t have data off the top of my head with respect to the latest iPhone 3G launch but certainly the iPhone, much as I mentioned also the maturity of the Japan market, these better devices -- devices with great browsers like the iPhone that make it easy for people to search and then view the results -- they definitely have much higher usage per device than other kinds of devices. On a rough order of magnitude, imagine that by 30 times as many searches per user might be done by an iPhone user as compared to a conventional cell phone. So I think as you see more iPhones out there, as you see more other phones that also start to have capable browsers and input methods, I think you’re going to see tremendous growth there.
Operator: Your next question comes from Brian Pitz - Banc of America Securities.
Brian Pitz: We have a couple of questions around ad coverage. Clearly you’ve intentionally reduced coverage on Google.com over the last number of quarters to improve ad quality. Would you give us a sense for how far you are in this process? On a related note, you extended Auto Match to more advertisers this quarter. Do you see this as a significant driver of coverage going forward? Any other comments on coverage would be great. Thanks.
Eric Schmidt: Jonathan?
Jonathan Rosenberg: Sure. So basically coverage, you know, coverage I think from a quarter-to-quarter basis has been going down. It’s pretty much at an all-time low relative to the last few quarters. That’s basically our continued focus on quality. I don’t really see that changing significantly. Larry often says that we’d be best off if we just showed one ad, the perfect ad. So I really don’t think that coverage is going to change much.
Eric Schmidt: The second question was?
Brian Pitz: Pertaining to Auto Match, traction there. Do you see this potentially as a driver of coverage?
Jonathan Rosenberg: Yes, sure. We only just started expanding Auto Match. It was in beta so we only expanded it, I think, to a slightly bigger group of advertisers this quarter. Certainly Auto Match can help increase coverage because it helps find more keywords that a query will trigger on, but we’re going to apply the same quality efforts to the output of Auto Match. Overall I think that the net result in terms of total coverage would not be significantly greater. I do think the impact on revenue would be positive.
Brian Pitz: Any sense on what percentage of advertisers aren’t really optimizing their budgets that Auto Match could help with?
Jonathan Rosenberg: Wow. A large number.
Eric Schmidt: I think it’s really too early to give you. The answer is it should apply to everybody. Sergey, do you want to add a little bit about coverage?
Sergey Brin: I just want to talk a little bit about that. There is some evidence that I think we’ve been probably a little bit more aggressive in decreasing coverage than we ought to have been. Historically we’ve had this 50/50 rough notion that when we have an improvement in advertising targeting we try to split the benefit, if you will. We try to reduce our coverage at the same time as improving the monetization. But clearly that’s not the ideal strategy indefinitely, because we don’t want to end up with no ads. And in fact from a quality point of view, we now find our ads are a significant addition quality-wise to our page. They are just a very important source of information. We’ve been actually re-examining some of that. There was some evidence internally that perhaps we were a little overly aggressive in decreasing coverage in this past quarter.
Operator: Your next question comes from James Mitchell - Goldman Sachs.
James Mitchell: Hal, I think you mentioned that queries were up year on year in every major sector, but erratic within subsectors; for example, in auto finance as opposed to autos. If queries are down in a particular subsector, do advertisers generally respond by bidding up the keywords that are available so they can fully spend their budgets? Or is that not the case and budgets go unspent?
Hal Varian: Sometimes we see that happening where advertisers are competing more and more aggressively for a smaller set of consumers. So we typically do see a price response to this slackening in the sector. We’ve seen that even in automotive, for example, in the Spring when there were a lot of deals offered to get cars off the lot and the automakers were advertising quite aggressively in all media to try to convince consumers to buy. So this is an effect that we sometimes encounter.
Operator: Your next question comes from Justin Post - Merrill Lynch.
Justin Post: Eric, on the press release you chose to highlight that you are seeing some economic weakness and I don’t think the company was talking much about that last quarter. Are you seeing things kind of deteriorate a little bit further than where we were a quarter ago? Can you give some color on that? On the YouTube acquisition, I am just wondering where you are at with some press comments out recently. Where you are at on that versus your deal model at this point?
Eric Schmidt: I’m going to have Hal actually talk a little bit about the nature of the environment, because I think all of us have anecdotal evidence but in fact Google has continued to do well. There is obviously evidence of a slowdown in the U.S. and Europe; you read it in the paper every day. We continue to believe that we are very, very well-positioned in such a slowdown and especially if it gets worse. The reason is there’s a flight to quality and in particular a flight to measurability. So our economics are more driven by, for example, if people stop searching for something we might not be able to do ads against it. Maybe Hal can articulate that a little bit better than I can. On the YouTube side, we are enormously happy with YouTube. YouTube is a cultural and end user success that is far, far greater than we ever expected. On the revenue side, we are working on revenue scenarios and new revenue products. I personally do not believe that the perfect ad product for YouTube has been invented yet. We’ve just brought out some little in-video ads which look very good. Hal, maybe you want to talk about the economics and maybe Omid, you can talk a little bit about YouTube sales?
Hal Varian: Sure. On the consumer side I already mentioned that some durables like consumer appliances and furnishings were holding up pretty well. In fact, if you look at apparel and shopping people are still spending money online in a pretty strong way. I think part of what is happening is that as times get a little uncertain price-sensitive consumers are going to shop more carefully to try to make every dollar count. That means they are going to be doing research online and they are going to be doing shopping online. So I think we have a little bit of the Wal-Mart Effect going on that as times get tough, people are going to watch their dollars. In many cases that means doing more shopping online.
Omid Kordestani: I wanted to add to Eric’s comments about YouTube. I think we are spending a lot of time internally on understanding how to streamline and integrate DoubleClick, improve the sales process as well as just pure customer activity. We are having great success. Again, as usual, I’d like to highlight some of our advertising names from Lenovo, Foot Locker, Lionsgate, Oreo, Kraft Foods, Ikea, and Lipton Tea. I mean these are the kinds of advertisers that we really did not have access or the proper types of advertising opportunities for before, as much as we do now. The Foot Locker example is a particularly good one as the media they use on Google was extremely broad from YouTube search, the content network, within the content network, also access to MySpace, Gadget ads, print ads and audio ads. So you can just see the way that our salesforce and our product teams are working with a broader set of advertisers, a broader set of offerings and a very much integrated platform approach. Search has taken a long time for us to develop and it still takes a lot of time for us and a lot of hard work. We’re putting a lot of energy on getting the right approach on YouTube and display advertising.
Operator: Your next question comes from Christa Quarles - Thomas Weisel Partners.
Christa Quarles: A couple of questions on DoubleClick. First I was wondering if you could outline how much it contributed in the quarter? Second, if you could indicate if you’re seeing any macroeconomic impact there. Obviously you made some comments about search specifically, but I was wondering if you could highlight it for DoubleClick? Third, some comments about how you are changing the buying process around display and where you see the innovations coming in display over the next year or two?
Eric Schmidt: We are not going to break out DoubleClick. Basically it’s early and so far we’re very pleased with it. It looks like it was a very, very sharp decision on our part to go ahead and get the integration, the team looks very strong. The strategy, once the acquisition was approved and so forth and so on, was to develop a broad product line that went from the large customer, large advertiser which was the traditional DoubleClick customer all the way down to the very small advertiser through Ad Words and essentially integrate all of that offering. This is public information; we’ve said this for the previous year during the regulatory strategy. Indeed, that’s happening now. So the theory here is that an advertiser will be able to advertise across all of the different sized publishers with one mechanism; that’s the goal. We think we can achieve that, and it will be fairly soon. Some number of months, not years.
Christa Quarles: The macro?
Eric Schmidt: No particular change in the macro environment. DoubleClick is doing well. Omid, do you want to emphasize any of this?
Omid Kordestani: I agree with Eric. I think we have anecdotal experiences. Some customers that act erratically I think are really affected maybe by the macro environments and stop the spending but then we see that pick up again the following month. So it’s very hard to judge this. I don’t think we have any trends that we can comment on.
Jonathan Rosenberg: Some of the innovation has already started. We have an internal roadmap in terms of the innovations for the next couple of years which I obviously can’t go through here. But just this quarter we launched the Ad Planner which basically lets advertisers designate target audiences and see exactly which sites they want to attract for an audience. We’ve got the Google Ad Manager in test which is basically a free tool that helps publishers sell, schedule, deliver and measure their inventory. Sergey I think mentioned in his script the third-party serving and we’ve also got some new features to let advertisers select target sites and keywords. So all of that, I think, is really addressing the big problem in display which is the highly fragmented market. That’s the focus of most of the innovations that you’ll see coming out in the next year or so.
Operator: Your next question comes from Doug Anmuth - Lehman Brothers.
Douglas Anmuth: A question for George, we’re not letting you off the hook quite yet. On the interest income, you detailed four pieces actually that contributed to the decrease in the interest income quarter to quarter. Could you provide a little bit more color there? In particular, how should we think about that going forward? Is this a one quarter effect, or is it something that we’re likely to see continue over the next couple of quarters? Thank you.
George Reyes: I think what we’re trying to portray here is that in fact we have a very healthy business and we have been investing in the business. The lower yield on our cash balances is what has really brought down what you’ve seen thus far, all the way through the average cash balances. As a result, that cash is used first. DoubleClick is also a consumer of that as well.
Douglas Anmuth: In terms of the marketable securities and the FX hedging, are you implying that those two are less significant factors to the impact this quarter?
George Reyes: No, we’re actually in the process of building our internal portfolio here so it’s hard for me to say more than that.
Operator: Your next question comes from Ben Schachter - UBS.
Ben Schachter: The headcount growth was really among its lowest levels in a long time. Is that 500 new net employees a number you are comfortable with on a quarterly basis? Where are you still looking to add and what areas are you comfortable with headcount?
Eric Schmidt: In the first place, we won’t suggest a number going forward. The company is now a reasonably large company by comparison to its peers and we don’t need massive new people in large communities that were not there before. We’ve largely built out a good management structure globally so it’s really dependent upon the kind of quality of people we can hire. You’ll remember a few quarters ago we actually allowed the hiring engine to get ahead of things and we said that we would focus on that a little bit more carefully and we have indeed done so. So I think what you’ll see going forward is prudent management of headcount growth. The company is going to continue to grow. This number may or may not be a specific number going forward but the important point is we are paying a lot of attention to headcount. We want to make sure that we maintain the quality and of course also as a larger company we need to make sure that we can use the resource effectively. We never want to misuse somebody’s talents as an employee.
Ben Schachter: If I could just follow up on a question on mobile, Sergey, you had discussed the evolution of the marketplace. At some point, can we expect to see a completely separate marketplace for mobile ads that comes with its own auction? Or will it continue to be an extension of the current model?
Sergey Brin: Currently we do allow advertisers to place separate ads for mobile. In fact, I see them converging more in the future because once you start to get these phones that have fully capable browsers and things like that, then there’s not that much reason for disparity. Now, at the same time as I mentioned, phones in some sense will have new capabilities that the desktop doesn’t such as location, things like that. We may add some capability beyond the basic desktop advertising capability that we have. I think it will be a more fluid experience for advertisers in terms of you can select “please run on mobile too”, or “don’t”, rather than trying to have completely separate worlds.
Jonathan Rosenberg: Just adding to Sergey’s comments, I agree with him. I’d just like to give you an example of one of the dynamics that will be different on the mobile phones. We’ve been talking for awhile about the fact that when you are on a mobile phone, you are much more likely to be interested in consummating a transaction if you run a search. One of the winners of the 1,700 applications submitted for the Android Developer Challenge was a product that was developed called Android Scan. Basically what it allows a user to do is take a picture of a product with a barcode and then they can research the product on their mobile browser. They can do price comparisons, they can figure out how far a store that can actually sell that product might be, or they could actually figure out who to buy it from online. Imagine the value of an ad in that kind of a scenario. So the bidding mechanisms for some of the local ads will differ in terms of the efforts that we have to scale to get them onto mobile but in many ways, they could be much, much more valuable.
Operator: Your next question comes from Mark Mahaney - Citi.
Mark Mahaney: On the G&A line it seemed a little bit ahead of expectations. Were there any one-time integration-related costs in that G&A line? Back to YouTube, Eric you made a comment about not having yet found maybe the ideal ad solution. Could you just talk about what the technical challenge is there? Or is it finding the right format or figuring out a way to best target ads against, or trying to figure out what the real content of a video is? Thank you very much.
Eric Schmidt: On the YouTube side, we basically are innovators in advertising and we’ve tried post-roll, pre-roll, in the roll kind of ads. We’re having a great deal of success now with these in-view ads where the ads are essentially in the bottom and embedded inside of the video. That looks like a pretty good winner right there. We’ve also had some significant success with gadget ads and gadget video ads are likely to be particularly effective because they allow you to tell a story. If you look, the advertisers that we are working with and the content that we are working with are also using the format differently. As a typical example, the Lionsgate deal which was announced yesterday, Lionsgate works with people who upload segments of the Lionsgate movies that they like and they capture them using our ClaimWare content product, and then they can run ads against them. So again, here’s a community that’s busy making copies that are not authorized of content, and Lionsgate has the good judgment to say rather than go and sue those customers, instead let’s go capture that, show an ad against them and get them even more excited about our content, our other content. So we think those kinds of models are sustainable and scalable on the Internet and are likely to be very, very significant sources of revenue. I think it’s axiomatic that a new form -- and I view YouTube as a new form of video entertainment -- will not ultimately use the old forms to monetize. There will be new monetization forms that will go for the new entertainment form, and that’s what we’re seeking. That is the Holy Grail. When we find it or the combination of it, it’s likely to be very, very large because of the scale and scope of YouTube. On the G&A line, I want to make sure we answer that question.
George Reyes: Mark, this is George Reyes. The main increase was due to legal and professional and outsourcing services, as well as fees. That’s your answer. As you know, we also don’t give guidance.
Mark Mahaney: One-time or generally sustainable?
George Reyes: Generally sustainable? No.
Eric Schmidt: Unfortunately, the legal stuff is bursty because we have suits. It’s “welcome to the information economy.” Next question?
Operator: Your next question comes from Jeetil Patel - Deutsche Bank.
Jeetil Patel: First of all, you talked earlier about basically your ad coverage may have come down a little too much, and Larry’s idea is to be a little bit more targeting oriented, serving the right ad. Can you talk about in terms of that evolution or phase of the business, how far along are you in trying to better optimize the ads against the intent of the consumer across the entire network and platform today? Second, on the AdSense for content side of the business, how difficult or easy would it be to convert it into a display ad network? Is this something that you would look to do? How does display ads around AdSense for content, do those two things marry up nicely or not?
Sergey Brin: Great questions. Let me take them in the reverse order. With respect to display in AdSense for content, we actually allow for display in AdSense for content today. That’s a publisher setting that publishers need to choose. In those cases where they are chosen then we will run display ads to the extent that their yield is higher than the text ads that we can run in that space. So that’s something that we are doing today and we are looking to grow and we are certainly excited about. In general, let me just take a step back. Looking at the evolution of our overall search, text ad system from its initial start when we could barely feed the ad team pizza with the money that we were able to generate off the first iteration of our ads to several iterations down the road, over a number of years, and through the maturation and the attraction of the advertiser base and them being able to set up really good campaigns for them. I mean, that’s a multi-year process to get to where we are now and we obviously are continuing to improve, to attract new advertisers, to improve the targeting and so forth. Now that we have the advertiser base, we don’t necessarily need to wait quite as long to attract the advertiser base to begin with. But for advertisers to create new types of ads for new mediums and what not, these things do take time for us to go through all the experimentation of what formats and systems might work best, that also takes time. Just me looking back going from ‘98, ‘99, 2000 where we were then with search ads, I feel some of these areas -- YouTube ads, content ads, display and what not -- are actually progressing at a faster pace.
Jeetil Patel: You made a point earlier that you may have gone too far on the ad coverage side and the ad relevance. Are you seeing, basically, that it’s affecting the frequency of usage or search frequency because you may have dialed down the ad coverage a little too much? Is that where the impact you are seeing? And if you dial it back up a bit you may see greater usage from a consumer standpoint in terms of frequency of searching across the entire network?
Sergey Brin: First of all, we certainly run plenty of experiments. We’re all the time running experiments. We run some people without any ads at all, and we know that our ads add value so we know that we’re happy about having them. Now, I don’t know it’s the case that we necessarily decreased them past, below the optimal point, but I know that we will do that in the near future if we continue with the system that we had in place. That’s what we’ve really had to have second thoughts about. What makes more sense to me is to go for the optimal coverage, if you will. That’s what we’re trying to figure out exactly how to do now.
Operator: Your next question comes from David Joseph - Morgan Stanley.
David Joseph: Universal search, it seems like you have been ramping it up or you ramped it up more during the quarter. I’m just wondering what percentage of total search results universal search is today? Also, what different user behavior is seen with universal search versus traditional text search? George, it looks like the incremental margin for Google improved pretty nicely sequentially and year over year. We do know that you had an easier comparison with the year-ago period, but I’m wondering if you also have been implementing or if some of the programs that you have been implementing for increased financial discipline are actually starting to work now? Thank you.
George Reyes: Yes, we have actually made a very concerted effort to drive more accountability into the business. That’s a theme that will carry forward.
Eric Schmidt: Sergey, do you want to answer the universal question?
Sergey Brin: Yes, universal search. So we’ve got a bit under one-third of all queries now have some kind of universal search component in them. By comparison, in the first quarter it was more like one-tenth; so it’s a big, big improvement. Our feeling is definitely that this, and experiments by the way, also justify this, but this is significantly improved information for our end users. It’s amazing to me just if I look at the video, for example, video universal which alone is at about 10% now of queries, I mean people have videos for things that you wouldn’t expect. I mentioned before, I was looking to buy a RAID, like an array of disks to store stuff on. It’s not the kind of query you would expect might have good videos about it. But in fact, the particular RAID I was interested in, somebody had put together a video. This is how you take it out of the box; this is how you swap a drive on it; all those things. And in fact, that compelled me to buy that particular RAID. I think that you’ll find increasing universal coverage in purposes that you wouldn’t expect, and that source particularly would be valuable because the user would not have thought to click on the separate video tab in that query. We have to bring that information to the user; that’s what we’re doing.
David Joseph: So are you seeing click-through rates a little bit less on universal search? Does this actually present a little bit of a different model for search, where you’re going to be able to monetize video a little bit differently? Or images, for that matter?
Sergey Brin: Less than universal search?
Eric Schmidt: No, again, the system in aggregate is actually where you are seeing --
Sergey Brin: I see. You are saying “how would it affect”. We monitor these things pretty closely when we launch them and it’s not that we are unwilling to launch things that might adversely affect the ad click-through rates or what not, but in sum total the launches that we’ve done I don’t think are negative. I think it’s positive.
Operator: Your final question comes from Jeffrey Lindsay - Sanford Bernstein.
Jeffrey Lindsay: Could you give us more detail about your wireless strategy and indicate just how you intend to participate in wireless in the U.S. over the next four to five years? Could you give us any updates on the Android alliance? When are Android devices expected? Could you give us an indication of, do you have to share revenues with Apple and/or AT&T to get Google onto the iPhone? Thank you.
Eric Schmidt: Sergey, do you want to start on wireless, overall wireless strategy?
Sergey Brin: Overall wireless is very simple. We want our products and the internet and the web as a whole available on as many devices in as many different markets as possible, so it’s very easy. We have a two-fold approach for that. First, we write our Apps and try to make them available on many different platforms like the iPhone that you mentioned, or we put them on Symbian devices, on BlackBerries, on Windows Mobile devices, all those we have Google Apps for. We’ve also, because we’ve had some challenge sometimes getting things out like necessarily easily being able to get access to location data to make maps work really well or things like that, we’ve developed this Android platform. We’ve had the same calling from carriers, from handset makers and other application makers that they just want to be able to get these things out more easily. So we are very excited about Android. We are still expecting phones before the end of the year to ship with Android.
Eric Schmidt: Jonathan, do you want to talk a little bit about some of the partner stuff?
Jonathan Rosenberg: The main data point in terms of Android, there are 34 companies in the Open Handset Alliance so we are doing pretty well there and I already alluded to the contest that we ran and the results there with that example of the Android Scan barcode. There are others that we are very excited about. I think there’s a Weather Channel application that will alert people and wake them up when there’s a severe weather alert that they need to be aware of. There are some fantastic ones, one called GWalk that helps people take city tours dynamically, and it adjusts to your location and shows points of interest. So there are already very, very significant efforts going on in the developer community in anticipation of the launches later this year.
Eric Schmidt: Let’s finish up. Thank you very much, Jonathan and everybody else. I want to thank everybody for spending so much time with us. We look forward to talking to you next quarter and please have a good summer. Thank you very much. | [
{
"speaker": "Operator",
"text": "Welcome, everyone to the Google Inc. conference call. This call is being recorded. At this time, I would like to turn the call over to Ms. Krista Bessinger, Director of Investor Relations. Please go ahead, ma’am."
},
{
"speaker": "Krista Bessinger",
"text": "Good afternoon, everyone and welcome to today’s Q2 2008 earnings conference call. We have a slightly different line-up today. With us are Eric Schmidt, Chief Executive Officer; George Reyes, Chief Financial Officer; Sergey Brin, Founder and President of Technology; Jonathan Rosenberg, SVP of Product Management; Omid Kordestani, SVP of Global Sales and Operations; and Hal Varian, Chief Economist. Eric, George, Hal and Sergey will provide us with their thoughts on the quarter and then Jonathan and Omid will join us for Q&A. Please note that this call is being webcast from our investor relations website and our press release, issued a few minutes ago, is also posted on the website along with slides that accompany today’s prepared remarks. A replay of this call will also be available on our investor relations website in a few hours. Now let me quickly cover the Safe Harbor. Some of the statements we make today may be considered forward-looking, including statements regarding investments in our core business; seasonality; traffic acquisition costs; increases in the cost of sales; international growth; statements regarding the benefits of our acquisition of DoubleClick; and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings including our quarterly report on Form 10-Q for the quarter ended March 31, 2008 as well as our earnings press release for a more detailed description of the risk factors that may affect our results. Copies can be obtained from the SEC or by visiting the investor relations section of our website. Also, please note that certain financial measures that we use on this call such as EPS, net income, operating margin and operating income are expressed on a non-GAAP basis and have been adjusted to exclude charges relating to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and GAAP to non-GAAP reconciliation can be found in our earnings press release. With that, it is my pleasure to turn the call over to Eric."
},
{
"speaker": "Eric Schmidt",
"text": "Thank you very much, Krista. We’re obviously very pleased with what we believe are good results in one of the weaker quarters in our normal yearly cycle. The traffic and revenue growth was strong across all regions and verticals. Traffic and revenue have held up well despite uncertain economic conditions, as everybody knows. International, of course, a big emphasis where Google is once again contributing more than 50% of our revenue; good growth in rapidly growing markets such as Brazil and China. We continue, of course, to make critical and fundamental investments in the infrastructure of the things that are most important, and in particular, search. We continue to scale our index; we continue to make sure that our information is the freshest possible and we are reducing latency or delays that people experience. So as a result, we are continuing to deliver on our fundamental mission of the most relevant and fastest results of web and other kind of information. In ads, in addition to all of the normal ad improvements that we see, the partnership with Yahoo! was obviously the signature event. David Drummond testified two days ago, both for the House and Senate. I liked it so much I wanted to read it. The internet is a dynamic and competitive environment and that is due to the openness that has been a hallmark since its inception. Our non-exclusive commercial agreement – that is very important, by the way, non-exclusive -- with Yahoo! will maintain and expand that competition. It creates new efficiencies that will benefit consumers, advertisers and publishers as well as protecting privacy and spurring innovation. Google and Yahoo! will remain fierce competitors. This continuing competition will help fuel innovation that is good for the internet, users; good for the internet, good for the economy. Openness, interoperability and competition are central to our culture at Google, central to the vibrancy of the internet and central to the growth of a free market. We believe that the non-exclusive ad deal – remember it is not a search deal -- that was done with Yahoo! is a win for the industry primarily because it allows Yahoo! to remain independent, which we believe is very pro-competitive. DoubleClick of course, is the other big piece of news. Integration is now underway and going very smoothly, with display as a big opportunity. And big opportunity, by the way, because the strategy of offering value to advertisers and publishers is one that we can offer very much worldwide. Putting our team together, of course, we've really now delivered on this global organization that everybody here knows about, and it is beginning to bear fruit. [Angalore] for example, developed some great new ad tools that were delivered last quarter; [Zurich] created our new Insight feature on YouTube which lets anyone who uploads videos see traffic information. [Hifa] developed another great new YouTube feature called Imitations. My point here is not to highlight the hundreds and hundreds of ones that happen all the time, every quarter, but to say it really is a global company. So we now have more than 30 products that support more than 30 languages, up from five products and 30 languages just a year ago. So people want to use Google in their own language and we are delivering on that. Just to finish up my hopefully short comments, we are very, very happy to have Patrick Pichette on board as our new CFO with 20 years experience in financial operations and management in the telco industry. I've talked to him; he is coming up to speed. He is going to be a tremendous contributor at Google for many years to come. I am very, very excited about that. I want to make sure that we thank once again George Reyes, my friend and colleague for more than 20 years. George stayed on board even more than a year after he announced his intent to retire. This shows you the kind of person that he is, to try to help Google and to help all of us meet our objectives. He has made a tremendous contribution to Google, which we have highlighted before. We are going to miss him, and we are very much looking forward to working with Patrick. In our order today we are going to have George, who I have just highlighted, if I can boast about him some more without making him too embarrassed; and then we will have him followed by Hal Varian. Larry is out this week. Hal is our Chief Economist and there have been so many questions about Yahoo!/Google economics and so forth. Hal is the perfect person to talk about how does the auction really work and what does the global environment mean for Google? George, do you want to take it away?"
},
{
"speaker": "George Reyes",
"text": "We had another strong quarter, with gross revenue increasing 39% over Q2 of 2007 to $5.4 billion. Google.com performed well, up 42% year over year to $3.5 billion, driven by strong traffic growth and to a lesser extent, monetization. AdSense revenue grew 22% over Q2 of 2007 but was down slightly on a sequential basis, reflecting a continued focus on delivering high quality traffic to our advertisers and typical Q2 seasonality. Now let’s take a look at aggregate paid clicks. Aggregate paid clicks include clicks related to ads served on Google properties, as well as ads served on our partner sites. Aggregate paid clicks grew approximately 19% over Q2 of 2007 and were down slightly on a sequential basis, again reflecting a continued focus on delivering high quality traffic to our advertisers and typical Q2 seasonality. Now I’ll discuss our international performance. International revenue accounted for 52% of revenue, or $2.8 billion. The UK was solid with revenues of $774 million, up 29% year over year but down 4% sequentially, reflecting typical Q2 seasonality and negligible FX impact. Revenue growth in EMEA was strong, primarily driven by strong performance in Benelux, Ireland and parts of Western Continental Europe including Germany, France, Spain and Italy, fueled by relatively strong performance in automotive and consumer packaged goods. Asia and Latin America continue to show impressive growth as well with Japan, Argentina, Australia, Brazil and China being notably strong in Q2. Now turning to expenses, traffic acquisition costs were $1.5 billion, or 28.4% of total advertising revenue, down from 29.2% in Q1. AdSense TAC was $1.3 billion, while TAC related to distribution partners and others who direct traffic to our websites totaled $154 million in the quarter. As we grow our AdSense Partner Network and embark on new initiatives, we may see additional pressure on TAC rates going forward. Other cost of revenue, which includes $9 million in stock-based compensation, increased $49 million over Q1 to $674 million. The largest driver of the increase was the increase in costs related to our data centers, including depreciation, equipment and operations. We continue to anticipate that other cost of sales could increase going forward. Other than cost of revenue, operating expenses totaled $1.64 billion, including approximately $264 million in stock-based compensation. Expenses related to payroll and facilities increased $1 million over Q1 to $810 million. At the end of the quarter, we had a full-time employee base of 19,604. We added 448 net new employees in Q2 with roughly half the new non-DoubleClick hires coming on board in engineering, followed by sales and marketing. We have implemented and continue to follow a discipline hiring process in all areas of our organization. But as we have indicated in the past, we will continue to invest in our core business both in the U.S. and internationally. Remember also that we usually see an uptick in starts over the summer, coinciding with the end of the academic year. Turning to non-GAAP operating profit which excludes stock-based compensation, it increased to $1.9 billion in Q2, with non-GAAP operating margins of 34.5%. Note that interest income and other in Q2 was $58 million, down $109 million from Q1. To be clear, this was not a writedown nor was this due to any losses. Instead it was primarily due to lower yields on our cash balance; lower average cash balances as a result of cash used in the first quarter to acquired DoubleClick; lower net realized gains on the sale of our marketable securities; and an increase in expenses as a result of more activity under our foreign exchange hedging programs. Finally, turning to cash, operating cash flow remained strong at $1.77 billion, with CapEx for the quarter of $698 million. As in previous quarters, the majority of our CapEx was related to IT infrastructure investments, including data center construction, production of servers and networking equipment. We expect to continue to make significant investments in CapEx in future quarters. Free cash flow, a non-GAAP measure which we define as cash flow from operations less CapEx, remained strong at $1.7 billion, up 63% year over year. In summary, we believe our core business continues to demonstrate strength while we make key investments to pursue long-term growth opportunities. At this point I want to take a moment to thank Eric, Larry, Sergey and the rest of the management team for having had the privilege of working with all of them. This is an opportunity that I will never forget. Let me turn it over to Hal."
},
{
"speaker": "Hal Varian",
"text": "Thanks, George. Eric asked me to comment on the state of the economic environment and how that’s impacting Google. When we look across sectors of the United States we see that on a year-on-year basis, the query growth has been positive in every sector we track, even including those sectors that are generally economically sensitive such as automotive, real estate and travel. We also see that year-on-year revenue growth is positive in every major sector expect for real estate, and even that one is only down by a small amount. When we look at the sub-sectors, we see some interesting patterns. The weaker components are just the ones you would expect to see based on the macroeconomic climate: auto financing, home financing and real estate agencies. These are the sorts of queries you would expect to see when auto or real estate transactions have already taken place, and we see, as we all know, fewer transactions are taking place in those sectors. It is interesting to note that year-over-year automotive ad spend is up, even though the growth in auto financing is down. I interpret this as saying that auto advertisers are willing to spend on clicks, but the weakness is on the consumer side. However, I should emphasis this behavior is not universal. Spending seems to be holding up pretty well in other consumer durable categories such as home appliances and home furnishings. When we turn to Europe, we see a similar pattern. In the UK we had across-the-board year-to-year growth in both revenue and queries, with the sole expectation being real estate. Continental Europe grew in both queries and revenue in every major vertical. So to summarize, when we look across verticals we see that consumers are being cautious in their online spending patterns just as they are in their offline spending. Despite the weakness in the economy, advertising revenue seems to be holding up remarkably well in most sectors. I think this illustrates the point that we have made several times. During periods of slow economic growth, the last thing an advertiser wants to cut is its spending on search-based advertising. So with that, let me pass the mic to Sergey, who is going to talk about what he will be doing in products."
},
{
"speaker": "Sergey Brin",
"text": "Hello, everyone. It is really exciting for me to update you over the past quarter. We have had a lot of substantial improvements, new launches. Let me just start with search. We have substantially increased the size of our index, and in particular, actually the index of documents that we refresh every few minutes has also grown tremendously. So now, our users get much fresher and faster results, across a greater range of sources. We have -- just all told, to give you a sense for this -- launched over 100 search quality improvements this quarter, so roughly one a day. Some of the highlights: Again, we have increased coverage in universal search, which means you get your web pages mixed in with video and images, news, books, all of those things we are able to show more and more. That improves our search results and it pays us a double dividend for all of the work we have been doing on corpuses such as book search. We also just added blog results at the bottom of the page in the past quarter, and our blending of Maps results we have put into 130 more countries than we had in the past. We have also been running more one box; for example those of you in Europe might have enjoyed our Euro 2008 one box in June during the soccer tournament. Let me just take a step away from just the basic search. Many of you, I know, use iGoogle and in fact we know that because we have had such tremendous growth, especially internationally. More than 60% of iGoogle users are now outside of the U.S. We had some very important developments, in particular with themes this quarter. You might have seen our iGoogle artist campaign where 68 artists across 22 countries created new themes for the product. This encouraged hundreds of thousands of people to sign up for iGoogle, and of course the good thing is so many of them changed their themes to these artist themes. I have personally set my iGoogle page now to go do a rotation across the top themes, and that is really fun. Everyday I get a new feel and they are aesthetically pretty exciting and varied. If you are listening to me right now you probably speak English pretty well, though of course if you are reading a transcript that has been translated using Google Translate then you might not. It is very important to be able to have access to information in languages that you don’t speak, especially if you are a non-English speaker. I mean, the amount of information that’s out there that can be useful to you that’s not necessarily in your native language is huge. To this end, we have been of course working on Google Translate. It now covers over 20 languages. We’ve added 10 just in this past quarter alone and now we let you translate from any one of those languages to any other of those languages. We’ve been able to improve the performance and have tremendous growth in usage as well. We’ve also been working on our cross language search so we don’t necessarily just search literally in the language that you search; we are able to produce translated results in other languages now, more automatically. You can expect us to continue to expand that work. In ads I should highlight a notable development. Our AdSense Network now allows third parties to host and serve ads, and this has been important to many advertisers. Just as one example, Lenovo is now advertising with us because we can support this kind of third-party ad serving. Now advertisers find out more about where they should be advertising because we’ve launch the Google Ad Planner. That lets you see what kind of sites a particular audience that is interested in whatever the advertisers’ are advertising, which sites do they visit? What are the breakdowns of demographics? It lets you do very complicated statistical analysis and I encourage you all to try it out, even if you are not an advertiser, it is pretty fun to be able to play with that data. Let me just jump a little bit onto YouTube. Probably most of you have had a chance to try to watch some YouTube videos, and in fact, our data suggest that more and more of you are. We now have 13 hours of video uploaded every single minute, so as you can imagine, it would take quite a many lifetimes to watch all the YouTube videos. It also gives you the opportunity, of course, to watch video on very specific topics that may be of interest to you. We've also been experimenting on YouTube with a variety of advertising formats and we have had some great successes. Lionsgate marked the opening of the film “The Forbidden Kingdom”, for example, and it had over 4 million video views on YouTube just from that promotion. So that was very exciting for us and for Lionsgate. I should mention that mobile search has been growing quite a bit, and of course you may have heard about our partnership that we've launched in this past quarter with NTT DoCoMo in Japan. Japan is a very strong market for mobile search because of the devices, because of the culture it is just a really tremendous environment. People do many, many mobile searches. We have a robust advertising market there for mobile search. We are certainly optimistic that many of these advances which may initiate in Japan will carry over to the rest of the world as the devices and culture catch up. I want to also mention that our mobile search experience, which we have now rolled out to more countries and we have made substantially faster, is also causing a lot of growth in that segment for us. One of things that I am most excited to tell you about today is our progress with Apps. I should mention first of all that our enterprise business with respect to Apps has been growing very rapidly. There are now more than half a million businesses that are using Google Apps for their day-to-day productivity, and that is just a tremendous number. Just to give you color on what some of these businesses include, in this past quarter Valeo, one of the world’s leading automotive suppliers now has 32,000 users using Google Apps, including of course Gmail, Calendar, Docs and so forth. The Government of Washington D.C. has 38,000 users on Google Apps. General Electric has adopted the security side of the Apps products which was formerly Postini, and that’s running on over 300,000 users. Just to call out a few other highlights, the Telegraph Media Group and Sanmina both also adopted Google Apps. So, it’s been a very exciting quarter for that. Starting from these half a million businesses, including some of these incredibly successful businesses, we really expect this to be an important area for growth and development. I just want to tell you, we don’t view Google Apps and what not as we don’t want to create a closed environment or a walled garden. We really want to encourage more and more cloud computing and we want to see more and more companies out there successful in deploying cloud solutions. One of the things we launched in this past quarter is the Google Apps Engine which basically means that developers can easily write an application and deploy it on our scaled infrastructure rather than having to try to put together all of their own computers, data centers, networking, all of that stuff. We handled all of that for the developers. We have a rapidly growing base. Just a few fun examples: we had a nine-year-old boy who contacted us with a bunch of questions, and then he has been able to develop his app on the Google Apps Engine. He said that he has been able to do it now because previously he was spending all of his allowance on hosting, and he could no longer afford that. Other, more commercial ventures include PixVerse, a chat application that switched to Google Apps Engine after we launched it, and it was subsequently purchased by the social network Hi5. As well as for those of you who are into poking, BuddyPoke, a very popular open social app which is running on Orkut and MySpace has also been developed on the Google Apps Engine. We expect that we're going to have a lot of uptake of our various developer products and APIs, including the Google Apps Engine, and ultimately we think that the cloud is just a really great place to deploy Apps because of the simplicity for end users to access them, the ease of updating and maintaining them; it is really a great environment. We obviously live it everyday and we believe it really helps people be more effective and productive with their day-to-day lives. Anyway, all told, a great quarter, lots and lots of progress and it has been a pleasure to talk to you about it."
},
{
"speaker": "Eric Schmidt",
"text": "Thank you very much, Sergey. Why don’t we go straight to everybody’s questions? So are we ready? Let’s hear the first question."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) We’ll take our first question from Imran Khan - JP Morgan."
},
{
"speaker": "Imran Khan",
"text": "First, if I look at that UK growth rate, it seems like on a year-over-year basis the growth rate decelerated 10 points. I was trying to better understand, is it because of the law of large numbers, or are you seeing any specific weakness that’s dragging the growth down there? My second question is related to the mobile search. Sergey, you talked about the mobile search opportunity. Do you think that the mobile search will expand the search volume? What kind of impact do you expect on your revenue per queries with that? Also, have you have seen any impact from Apple iPhone yet? Thank you."
},
{
"speaker": "Eric Schmidt",
"text": "Jonathan, do you want to go ahead and answer the UK question?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Sure. Thanks, Imran. I think basically we are just seeing the typical Q2 seasonality. If you look back at Q1, that of course was very big. I think we talked in the Q1 call about some of the verticals like travel. The other point would be that we have very, very high market share in the UK. As our market share grows, I think in past quarters when you looked at seasonality, the gains in market share may have been masking some of the seasonality. Now what we’re seeing is just the typical, appropriate Q2 seasonality. [Inaudible] the impact was negligible."
},
{
"speaker": "Eric Schmidt",
"text": "Sergey?"
},
{
"speaker": "Sergey Brin",
"text": "On mobile I certainly expect to see an uptick in search volume due to mobile because you are obviously not always at your desktop, but you pretty much always want to know something. With respect to the revenues per query I think that will vary from market to market and I think it will also vary as we develop more specialized monetization programs for mobile phones. You know, in some respects you can’t fit as much advertising, obviously, on a really small screen. On the other hand, the queries are very localized. I mean, you might be standing right next to that pizza place that wants to entice you to become a customer, or something like that. So I think there’s an opportunity for much more fine-tuned targeting. Both of those things are going to balance out. With respect to the iPhone, I don’t have data off the top of my head with respect to the latest iPhone 3G launch but certainly the iPhone, much as I mentioned also the maturity of the Japan market, these better devices -- devices with great browsers like the iPhone that make it easy for people to search and then view the results -- they definitely have much higher usage per device than other kinds of devices. On a rough order of magnitude, imagine that by 30 times as many searches per user might be done by an iPhone user as compared to a conventional cell phone. So I think as you see more iPhones out there, as you see more other phones that also start to have capable browsers and input methods, I think you’re going to see tremendous growth there."
},
{
"speaker": "Operator",
"text": "Your next question comes from Brian Pitz - Banc of America Securities."
},
{
"speaker": "Brian Pitz",
"text": "We have a couple of questions around ad coverage. Clearly you’ve intentionally reduced coverage on Google.com over the last number of quarters to improve ad quality. Would you give us a sense for how far you are in this process? On a related note, you extended Auto Match to more advertisers this quarter. Do you see this as a significant driver of coverage going forward? Any other comments on coverage would be great. Thanks."
},
{
"speaker": "Eric Schmidt",
"text": "Jonathan?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Sure. So basically coverage, you know, coverage I think from a quarter-to-quarter basis has been going down. It’s pretty much at an all-time low relative to the last few quarters. That’s basically our continued focus on quality. I don’t really see that changing significantly. Larry often says that we’d be best off if we just showed one ad, the perfect ad. So I really don’t think that coverage is going to change much."
},
{
"speaker": "Eric Schmidt",
"text": "The second question was?"
},
{
"speaker": "Brian Pitz",
"text": "Pertaining to Auto Match, traction there. Do you see this potentially as a driver of coverage?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yes, sure. We only just started expanding Auto Match. It was in beta so we only expanded it, I think, to a slightly bigger group of advertisers this quarter. Certainly Auto Match can help increase coverage because it helps find more keywords that a query will trigger on, but we’re going to apply the same quality efforts to the output of Auto Match. Overall I think that the net result in terms of total coverage would not be significantly greater. I do think the impact on revenue would be positive."
},
{
"speaker": "Brian Pitz",
"text": "Any sense on what percentage of advertisers aren’t really optimizing their budgets that Auto Match could help with?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Wow. A large number."
},
{
"speaker": "Eric Schmidt",
"text": "I think it’s really too early to give you. The answer is it should apply to everybody. Sergey, do you want to add a little bit about coverage?"
},
{
"speaker": "Sergey Brin",
"text": "I just want to talk a little bit about that. There is some evidence that I think we’ve been probably a little bit more aggressive in decreasing coverage than we ought to have been. Historically we’ve had this 50/50 rough notion that when we have an improvement in advertising targeting we try to split the benefit, if you will. We try to reduce our coverage at the same time as improving the monetization. But clearly that’s not the ideal strategy indefinitely, because we don’t want to end up with no ads. And in fact from a quality point of view, we now find our ads are a significant addition quality-wise to our page. They are just a very important source of information. We’ve been actually re-examining some of that. There was some evidence internally that perhaps we were a little overly aggressive in decreasing coverage in this past quarter."
},
{
"speaker": "Operator",
"text": "Your next question comes from James Mitchell - Goldman Sachs."
},
{
"speaker": "James Mitchell",
"text": "Hal, I think you mentioned that queries were up year on year in every major sector, but erratic within subsectors; for example, in auto finance as opposed to autos. If queries are down in a particular subsector, do advertisers generally respond by bidding up the keywords that are available so they can fully spend their budgets? Or is that not the case and budgets go unspent?"
},
{
"speaker": "Hal Varian",
"text": "Sometimes we see that happening where advertisers are competing more and more aggressively for a smaller set of consumers. So we typically do see a price response to this slackening in the sector. We’ve seen that even in automotive, for example, in the Spring when there were a lot of deals offered to get cars off the lot and the automakers were advertising quite aggressively in all media to try to convince consumers to buy. So this is an effect that we sometimes encounter."
},
{
"speaker": "Operator",
"text": "Your next question comes from Justin Post - Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "Eric, on the press release you chose to highlight that you are seeing some economic weakness and I don’t think the company was talking much about that last quarter. Are you seeing things kind of deteriorate a little bit further than where we were a quarter ago? Can you give some color on that? On the YouTube acquisition, I am just wondering where you are at with some press comments out recently. Where you are at on that versus your deal model at this point?"
},
{
"speaker": "Eric Schmidt",
"text": "I’m going to have Hal actually talk a little bit about the nature of the environment, because I think all of us have anecdotal evidence but in fact Google has continued to do well. There is obviously evidence of a slowdown in the U.S. and Europe; you read it in the paper every day. We continue to believe that we are very, very well-positioned in such a slowdown and especially if it gets worse. The reason is there’s a flight to quality and in particular a flight to measurability. So our economics are more driven by, for example, if people stop searching for something we might not be able to do ads against it. Maybe Hal can articulate that a little bit better than I can. On the YouTube side, we are enormously happy with YouTube. YouTube is a cultural and end user success that is far, far greater than we ever expected. On the revenue side, we are working on revenue scenarios and new revenue products. I personally do not believe that the perfect ad product for YouTube has been invented yet. We’ve just brought out some little in-video ads which look very good. Hal, maybe you want to talk about the economics and maybe Omid, you can talk a little bit about YouTube sales?"
},
{
"speaker": "Hal Varian",
"text": "Sure. On the consumer side I already mentioned that some durables like consumer appliances and furnishings were holding up pretty well. In fact, if you look at apparel and shopping people are still spending money online in a pretty strong way. I think part of what is happening is that as times get a little uncertain price-sensitive consumers are going to shop more carefully to try to make every dollar count. That means they are going to be doing research online and they are going to be doing shopping online. So I think we have a little bit of the Wal-Mart Effect going on that as times get tough, people are going to watch their dollars. In many cases that means doing more shopping online."
},
{
"speaker": "Omid Kordestani",
"text": "I wanted to add to Eric’s comments about YouTube. I think we are spending a lot of time internally on understanding how to streamline and integrate DoubleClick, improve the sales process as well as just pure customer activity. We are having great success. Again, as usual, I’d like to highlight some of our advertising names from Lenovo, Foot Locker, Lionsgate, Oreo, Kraft Foods, Ikea, and Lipton Tea. I mean these are the kinds of advertisers that we really did not have access or the proper types of advertising opportunities for before, as much as we do now. The Foot Locker example is a particularly good one as the media they use on Google was extremely broad from YouTube search, the content network, within the content network, also access to MySpace, Gadget ads, print ads and audio ads. So you can just see the way that our salesforce and our product teams are working with a broader set of advertisers, a broader set of offerings and a very much integrated platform approach. Search has taken a long time for us to develop and it still takes a lot of time for us and a lot of hard work. We’re putting a lot of energy on getting the right approach on YouTube and display advertising."
},
{
"speaker": "Operator",
"text": "Your next question comes from Christa Quarles - Thomas Weisel Partners."
},
{
"speaker": "Christa Quarles",
"text": "A couple of questions on DoubleClick. First I was wondering if you could outline how much it contributed in the quarter? Second, if you could indicate if you’re seeing any macroeconomic impact there. Obviously you made some comments about search specifically, but I was wondering if you could highlight it for DoubleClick? Third, some comments about how you are changing the buying process around display and where you see the innovations coming in display over the next year or two?"
},
{
"speaker": "Eric Schmidt",
"text": "We are not going to break out DoubleClick. Basically it’s early and so far we’re very pleased with it. It looks like it was a very, very sharp decision on our part to go ahead and get the integration, the team looks very strong. The strategy, once the acquisition was approved and so forth and so on, was to develop a broad product line that went from the large customer, large advertiser which was the traditional DoubleClick customer all the way down to the very small advertiser through Ad Words and essentially integrate all of that offering. This is public information; we’ve said this for the previous year during the regulatory strategy. Indeed, that’s happening now. So the theory here is that an advertiser will be able to advertise across all of the different sized publishers with one mechanism; that’s the goal. We think we can achieve that, and it will be fairly soon. Some number of months, not years."
},
{
"speaker": "Christa Quarles",
"text": "The macro?"
},
{
"speaker": "Eric Schmidt",
"text": "No particular change in the macro environment. DoubleClick is doing well. Omid, do you want to emphasize any of this?"
},
{
"speaker": "Omid Kordestani",
"text": "I agree with Eric. I think we have anecdotal experiences. Some customers that act erratically I think are really affected maybe by the macro environments and stop the spending but then we see that pick up again the following month. So it’s very hard to judge this. I don’t think we have any trends that we can comment on."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Some of the innovation has already started. We have an internal roadmap in terms of the innovations for the next couple of years which I obviously can’t go through here. But just this quarter we launched the Ad Planner which basically lets advertisers designate target audiences and see exactly which sites they want to attract for an audience. We’ve got the Google Ad Manager in test which is basically a free tool that helps publishers sell, schedule, deliver and measure their inventory. Sergey I think mentioned in his script the third-party serving and we’ve also got some new features to let advertisers select target sites and keywords. So all of that, I think, is really addressing the big problem in display which is the highly fragmented market. That’s the focus of most of the innovations that you’ll see coming out in the next year or so."
},
{
"speaker": "Operator",
"text": "Your next question comes from Doug Anmuth - Lehman Brothers."
},
{
"speaker": "Douglas Anmuth",
"text": "A question for George, we’re not letting you off the hook quite yet. On the interest income, you detailed four pieces actually that contributed to the decrease in the interest income quarter to quarter. Could you provide a little bit more color there? In particular, how should we think about that going forward? Is this a one quarter effect, or is it something that we’re likely to see continue over the next couple of quarters? Thank you."
},
{
"speaker": "George Reyes",
"text": "I think what we’re trying to portray here is that in fact we have a very healthy business and we have been investing in the business. The lower yield on our cash balances is what has really brought down what you’ve seen thus far, all the way through the average cash balances. As a result, that cash is used first. DoubleClick is also a consumer of that as well."
},
{
"speaker": "Douglas Anmuth",
"text": "In terms of the marketable securities and the FX hedging, are you implying that those two are less significant factors to the impact this quarter?"
},
{
"speaker": "George Reyes",
"text": "No, we’re actually in the process of building our internal portfolio here so it’s hard for me to say more than that."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ben Schachter - UBS."
},
{
"speaker": "Ben Schachter",
"text": "The headcount growth was really among its lowest levels in a long time. Is that 500 new net employees a number you are comfortable with on a quarterly basis? Where are you still looking to add and what areas are you comfortable with headcount?"
},
{
"speaker": "Eric Schmidt",
"text": "In the first place, we won’t suggest a number going forward. The company is now a reasonably large company by comparison to its peers and we don’t need massive new people in large communities that were not there before. We’ve largely built out a good management structure globally so it’s really dependent upon the kind of quality of people we can hire. You’ll remember a few quarters ago we actually allowed the hiring engine to get ahead of things and we said that we would focus on that a little bit more carefully and we have indeed done so. So I think what you’ll see going forward is prudent management of headcount growth. The company is going to continue to grow. This number may or may not be a specific number going forward but the important point is we are paying a lot of attention to headcount. We want to make sure that we maintain the quality and of course also as a larger company we need to make sure that we can use the resource effectively. We never want to misuse somebody’s talents as an employee."
},
{
"speaker": "Ben Schachter",
"text": "If I could just follow up on a question on mobile, Sergey, you had discussed the evolution of the marketplace. At some point, can we expect to see a completely separate marketplace for mobile ads that comes with its own auction? Or will it continue to be an extension of the current model?"
},
{
"speaker": "Sergey Brin",
"text": "Currently we do allow advertisers to place separate ads for mobile. In fact, I see them converging more in the future because once you start to get these phones that have fully capable browsers and things like that, then there’s not that much reason for disparity. Now, at the same time as I mentioned, phones in some sense will have new capabilities that the desktop doesn’t such as location, things like that. We may add some capability beyond the basic desktop advertising capability that we have. I think it will be a more fluid experience for advertisers in terms of you can select “please run on mobile too”, or “don’t”, rather than trying to have completely separate worlds."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Just adding to Sergey’s comments, I agree with him. I’d just like to give you an example of one of the dynamics that will be different on the mobile phones. We’ve been talking for awhile about the fact that when you are on a mobile phone, you are much more likely to be interested in consummating a transaction if you run a search. One of the winners of the 1,700 applications submitted for the Android Developer Challenge was a product that was developed called Android Scan. Basically what it allows a user to do is take a picture of a product with a barcode and then they can research the product on their mobile browser. They can do price comparisons, they can figure out how far a store that can actually sell that product might be, or they could actually figure out who to buy it from online. Imagine the value of an ad in that kind of a scenario. So the bidding mechanisms for some of the local ads will differ in terms of the efforts that we have to scale to get them onto mobile but in many ways, they could be much, much more valuable."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mark Mahaney - Citi."
},
{
"speaker": "Mark Mahaney",
"text": "On the G&A line it seemed a little bit ahead of expectations. Were there any one-time integration-related costs in that G&A line? Back to YouTube, Eric you made a comment about not having yet found maybe the ideal ad solution. Could you just talk about what the technical challenge is there? Or is it finding the right format or figuring out a way to best target ads against, or trying to figure out what the real content of a video is? Thank you very much."
},
{
"speaker": "Eric Schmidt",
"text": "On the YouTube side, we basically are innovators in advertising and we’ve tried post-roll, pre-roll, in the roll kind of ads. We’re having a great deal of success now with these in-view ads where the ads are essentially in the bottom and embedded inside of the video. That looks like a pretty good winner right there. We’ve also had some significant success with gadget ads and gadget video ads are likely to be particularly effective because they allow you to tell a story. If you look, the advertisers that we are working with and the content that we are working with are also using the format differently. As a typical example, the Lionsgate deal which was announced yesterday, Lionsgate works with people who upload segments of the Lionsgate movies that they like and they capture them using our ClaimWare content product, and then they can run ads against them. So again, here’s a community that’s busy making copies that are not authorized of content, and Lionsgate has the good judgment to say rather than go and sue those customers, instead let’s go capture that, show an ad against them and get them even more excited about our content, our other content. So we think those kinds of models are sustainable and scalable on the Internet and are likely to be very, very significant sources of revenue. I think it’s axiomatic that a new form -- and I view YouTube as a new form of video entertainment -- will not ultimately use the old forms to monetize. There will be new monetization forms that will go for the new entertainment form, and that’s what we’re seeking. That is the Holy Grail. When we find it or the combination of it, it’s likely to be very, very large because of the scale and scope of YouTube. On the G&A line, I want to make sure we answer that question."
},
{
"speaker": "George Reyes",
"text": "Mark, this is George Reyes. The main increase was due to legal and professional and outsourcing services, as well as fees. That’s your answer. As you know, we also don’t give guidance."
},
{
"speaker": "Mark Mahaney",
"text": "One-time or generally sustainable?"
},
{
"speaker": "George Reyes",
"text": "Generally sustainable? No."
},
{
"speaker": "Eric Schmidt",
"text": "Unfortunately, the legal stuff is bursty because we have suits. It’s “welcome to the information economy.” Next question?"
},
{
"speaker": "Operator",
"text": "Your next question comes from Jeetil Patel - Deutsche Bank."
},
{
"speaker": "Jeetil Patel",
"text": "First of all, you talked earlier about basically your ad coverage may have come down a little too much, and Larry’s idea is to be a little bit more targeting oriented, serving the right ad. Can you talk about in terms of that evolution or phase of the business, how far along are you in trying to better optimize the ads against the intent of the consumer across the entire network and platform today? Second, on the AdSense for content side of the business, how difficult or easy would it be to convert it into a display ad network? Is this something that you would look to do? How does display ads around AdSense for content, do those two things marry up nicely or not?"
},
{
"speaker": "Sergey Brin",
"text": "Great questions. Let me take them in the reverse order. With respect to display in AdSense for content, we actually allow for display in AdSense for content today. That’s a publisher setting that publishers need to choose. In those cases where they are chosen then we will run display ads to the extent that their yield is higher than the text ads that we can run in that space. So that’s something that we are doing today and we are looking to grow and we are certainly excited about. In general, let me just take a step back. Looking at the evolution of our overall search, text ad system from its initial start when we could barely feed the ad team pizza with the money that we were able to generate off the first iteration of our ads to several iterations down the road, over a number of years, and through the maturation and the attraction of the advertiser base and them being able to set up really good campaigns for them. I mean, that’s a multi-year process to get to where we are now and we obviously are continuing to improve, to attract new advertisers, to improve the targeting and so forth. Now that we have the advertiser base, we don’t necessarily need to wait quite as long to attract the advertiser base to begin with. But for advertisers to create new types of ads for new mediums and what not, these things do take time for us to go through all the experimentation of what formats and systems might work best, that also takes time. Just me looking back going from ‘98, ‘99, 2000 where we were then with search ads, I feel some of these areas -- YouTube ads, content ads, display and what not -- are actually progressing at a faster pace."
},
{
"speaker": "Jeetil Patel",
"text": "You made a point earlier that you may have gone too far on the ad coverage side and the ad relevance. Are you seeing, basically, that it’s affecting the frequency of usage or search frequency because you may have dialed down the ad coverage a little too much? Is that where the impact you are seeing? And if you dial it back up a bit you may see greater usage from a consumer standpoint in terms of frequency of searching across the entire network?"
},
{
"speaker": "Sergey Brin",
"text": "First of all, we certainly run plenty of experiments. We’re all the time running experiments. We run some people without any ads at all, and we know that our ads add value so we know that we’re happy about having them. Now, I don’t know it’s the case that we necessarily decreased them past, below the optimal point, but I know that we will do that in the near future if we continue with the system that we had in place. That’s what we’ve really had to have second thoughts about. What makes more sense to me is to go for the optimal coverage, if you will. That’s what we’re trying to figure out exactly how to do now."
},
{
"speaker": "Operator",
"text": "Your next question comes from David Joseph - Morgan Stanley."
},
{
"speaker": "David Joseph",
"text": "Universal search, it seems like you have been ramping it up or you ramped it up more during the quarter. I’m just wondering what percentage of total search results universal search is today? Also, what different user behavior is seen with universal search versus traditional text search? George, it looks like the incremental margin for Google improved pretty nicely sequentially and year over year. We do know that you had an easier comparison with the year-ago period, but I’m wondering if you also have been implementing or if some of the programs that you have been implementing for increased financial discipline are actually starting to work now? Thank you."
},
{
"speaker": "George Reyes",
"text": "Yes, we have actually made a very concerted effort to drive more accountability into the business. That’s a theme that will carry forward."
},
{
"speaker": "Eric Schmidt",
"text": "Sergey, do you want to answer the universal question?"
},
{
"speaker": "Sergey Brin",
"text": "Yes, universal search. So we’ve got a bit under one-third of all queries now have some kind of universal search component in them. By comparison, in the first quarter it was more like one-tenth; so it’s a big, big improvement. Our feeling is definitely that this, and experiments by the way, also justify this, but this is significantly improved information for our end users. It’s amazing to me just if I look at the video, for example, video universal which alone is at about 10% now of queries, I mean people have videos for things that you wouldn’t expect. I mentioned before, I was looking to buy a RAID, like an array of disks to store stuff on. It’s not the kind of query you would expect might have good videos about it. But in fact, the particular RAID I was interested in, somebody had put together a video. This is how you take it out of the box; this is how you swap a drive on it; all those things. And in fact, that compelled me to buy that particular RAID. I think that you’ll find increasing universal coverage in purposes that you wouldn’t expect, and that source particularly would be valuable because the user would not have thought to click on the separate video tab in that query. We have to bring that information to the user; that’s what we’re doing."
},
{
"speaker": "David Joseph",
"text": "So are you seeing click-through rates a little bit less on universal search? Does this actually present a little bit of a different model for search, where you’re going to be able to monetize video a little bit differently? Or images, for that matter?"
},
{
"speaker": "Sergey Brin",
"text": "Less than universal search?"
},
{
"speaker": "Eric Schmidt",
"text": "No, again, the system in aggregate is actually where you are seeing --"
},
{
"speaker": "Sergey Brin",
"text": "I see. You are saying “how would it affect”. We monitor these things pretty closely when we launch them and it’s not that we are unwilling to launch things that might adversely affect the ad click-through rates or what not, but in sum total the launches that we’ve done I don’t think are negative. I think it’s positive."
},
{
"speaker": "Operator",
"text": "Your final question comes from Jeffrey Lindsay - Sanford Bernstein."
},
{
"speaker": "Jeffrey Lindsay",
"text": "Could you give us more detail about your wireless strategy and indicate just how you intend to participate in wireless in the U.S. over the next four to five years? Could you give us any updates on the Android alliance? When are Android devices expected? Could you give us an indication of, do you have to share revenues with Apple and/or AT&T to get Google onto the iPhone? Thank you."
},
{
"speaker": "Eric Schmidt",
"text": "Sergey, do you want to start on wireless, overall wireless strategy?"
},
{
"speaker": "Sergey Brin",
"text": "Overall wireless is very simple. We want our products and the internet and the web as a whole available on as many devices in as many different markets as possible, so it’s very easy. We have a two-fold approach for that. First, we write our Apps and try to make them available on many different platforms like the iPhone that you mentioned, or we put them on Symbian devices, on BlackBerries, on Windows Mobile devices, all those we have Google Apps for. We’ve also, because we’ve had some challenge sometimes getting things out like necessarily easily being able to get access to location data to make maps work really well or things like that, we’ve developed this Android platform. We’ve had the same calling from carriers, from handset makers and other application makers that they just want to be able to get these things out more easily. So we are very excited about Android. We are still expecting phones before the end of the year to ship with Android."
},
{
"speaker": "Eric Schmidt",
"text": "Jonathan, do you want to talk a little bit about some of the partner stuff?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "The main data point in terms of Android, there are 34 companies in the Open Handset Alliance so we are doing pretty well there and I already alluded to the contest that we ran and the results there with that example of the Android Scan barcode. There are others that we are very excited about. I think there’s a Weather Channel application that will alert people and wake them up when there’s a severe weather alert that they need to be aware of. There are some fantastic ones, one called GWalk that helps people take city tours dynamically, and it adjusts to your location and shows points of interest. So there are already very, very significant efforts going on in the developer community in anticipation of the launches later this year."
},
{
"speaker": "Eric Schmidt",
"text": "Let’s finish up. Thank you very much, Jonathan and everybody else. I want to thank everybody for spending so much time with us. We look forward to talking to you next quarter and please have a good summer. Thank you very much."
}
] | null | null |
GOOGL | 1 | 2,008 | 2008-04-18 16:30:00 | Operator: Good day and welcome everyone to the Google, Inc conference call. Today’s call is being recorded. At this time, I would like to turn the call over to Ms. Krista Bessinger, Director of Investor Relations. Please go ahead, ma’am.
Krista Bessinger: Good afternoon, everyone and welcome to today’s first quarter 2008 earnings conference call. With us are Eric Schmidt, Chief Executive Officer; George Reyes, Chief Financial Officer; Larry Page, Founder and President of Products; Sergey Brin, Founder and President of Technology; Jonathan Rosenberg, Senior Vice President of Product Management; and Omid Kordestani, Senior Vice President of Global Sales and Operations. Eric, George, Larry, and Sergey will provide their thoughts on the quarter and then Jonathan and Omid will join us for Q&A. Please note that this call is being webcast from our investor relations website. Our press release issued a few minutes ago is also posted on the website, along with the slides that accompany today’s prepared remarks. A replay of this call will also be available on our investor relations website in a few hours. Now let me quickly cover the Safe Harbor. Some of the statements we make today may be considered forward looking, including statements regarding our investments, seasonality, traffic acquisition costs, increase in the cost of sales, international growth, operating margins, growth in headcount and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings, including our annual report on Form 10-K for the year ended December 31, 2007 as well as our earnings press release for a more detailed description of the risk factors that may affect our results. Copies can be obtained from the SEC or by visiting the investor relations section of our website. Also please note that certain financial measures we use on this call such as EPS, net income, operating margin and operating income are expressed on a non-GAAP basis and have been adjusted to exclude charges relating to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures which we refer to as free cash flow. Our GAAP results and GAAP to non-GAAP reconciliation can be found in our earnings press release. With that, it’s my pleasure to turn the call over to Eric.
Eric Schmidt: Well thank you very much, Krista, and we’re obviously very pleased with another strong quarter for Google. It’s clear to us that we’re well-positioned for 2008 and beyond, regardless of the business environment that we find ourselves surrounded by. The Search, Ads and Apps strategy that we articulated last year is beginning to show transformative effects; literally things that people could not do before the products and services that we’ve offered in each of the categories. The business model continues to work very well and we’ve had good, disciplined management of our operating expenses, so thank you very much for the management team. It’s also interesting to note that paid clicks growth is much higher than has been speculated by third parties. In Search, we continue to invest in quality, particularly internationally. Quality improvements lead to increased traffic and share. Quality here means better algorithms, more content – deeper, if you will -- into the web; a larger index, faster response, all that surfing. But it also implies things like Maps and Earth and geospatial information, it’s all integrated in a way that people can find things and see things that they could never do before. In Ads, we continue to increase value for advertisers and publishers; again, broader and deeper solutions. Better tools for advertisers, many, many quality improvements in advertising which has the interesting effect, which means that we’re showing fewer but much better ads in each cycle. That’s a key part of the Google success story. We’re putting more and more flexibility and control in the hands of advertisers so they can decide exactly where their ad should go and measure it in the way using Analytics that they could not do before. It’s also important to note that DoubleClick has been added now to the portfolio and DoubleClick is hugely strategic for us. It allows us to offer a much more comprehensive solution for advertisers and publishers. This has been asked for long time and now we are able to do it. In the Apps case, we are working to build out a whole new online web experience and we’re beginning to have all of the pieces now in place. For example, the recently announced Salesforce.com partnership allows us to integrate for an enterprise customer with the Salesforce.com products as well as all of the Google application services and sold through their direct sales operation. By doing these partnerships and by investing heavily in new applications models we think people will spend more and more time online and they will able to do things like sharing documents, sharing calendars, dealing with photos and all those kinds of things in a way that had not been possible before. This has all been possible because of the many, many talented Googlers and the executive leadership that we’ve seen in the last quarter and I want to thank everybody for that. The Google model really does rely on technology and innovation. The repeatable and scalable business that we have built is really poised for global growth. So with that, George, do you want to take us through the numbers?
George Reyes: Thanks, Eric and good afternoon, everyone. Before we begin, please note that our consolidated results as reported today include the results of DoubleClick from March 11, the date of the acquisition, through the end of the quarter. The overall effect was immaterial to revenue and only slightly dilutive to operating income, net income and earnings per share. Turning to our results, we had another strong quarter with gross revenue increasing 42% over Q1 2007 to $5.2 billion. Goggle.com performed very well, up 49% year over year to $3.4 billion, driven by strong traffic growth and to a lesser extent, monetization growth. AdSense revenue grew 25% over Q1 2007, reflecting solid performance across both the Content and Search networks. Now let’s look at aggregate paid clicks growth. Aggregate paid clicks include clicks related to ads served on Google properties, as well as ads served on our partner sites. Aggregate paid clicks grew approximately 20% over Q1 2007 and approximately 4% over Q4. Paid click growth on Google.com in the U.S. remains healthy and other markets are showing strong growth as well. Now I’ll discuss our international performance. International revenue increased to $2.65 billion, now accounting for 51% of total revenue. International markets have tremendous potential for growth. As is typical in the first quarter, the UK was strong with revenues of $803 million and 16% sequential growth as the travel and finance verticals rebounded as expected from Q4. Revenue growth in EMEA was primarily driven by strong performance in the UK, Benelux and the Nordic countries fueled by strong pan-European performance in travel. We also saw solid gains in relatively smaller markets such Ireland, Spain and Italy. Asia and Latin America continue to show impressive growth as well with India, Argentina Australia and Japan being notable performers in the quarter. Now turning to expenses, traffic acquisition costs were $1.5 billion or 29% of total advertising revenue, down from 30% in Q4. AdSense TAC was $1.3 billion, while TAC related to distribution partners and others who direct traffic to our websites totaled $143 million in the quarter. Other cost of revenue, which included $9 million in stock-based compensation increased $108 million over Q4 to $624 million. The largest driver of the increase was the increase in costs related to our data centers including depreciation, equipment and operations. We continue to anticipate that other cost of sales could increase going forward. Other than cost of revenue, operating expenses in Q1 totaled $1.5 billion, including approximately $272 million in stock-based compensation. Expenses related to payroll and facilities increased $53 million over Q4 to $809 million. At the end of the quarter we had a full-time employee base of 19,156 including more than 1,500 heads from DoubleClick. Since the close of the acquisition we’ve conducted a review of our ongoing headcount requirements and approximately 10% of the US DoubleClick workforce was laid off in early April. An additional 15%, approximately, are expected to leave the company in the U.S. in the near to intermediate term, because they are in a transitional role as they move through the system. These headcount reductions apply only to the U.S. and do not include employees associated with the future planned divestitures of the Performics SEM business. To-date there have been no headcount reductions outside the U.S. On an organic basis, excluding DoubleClick, we added approximately 800 employees in Q1 with the majority of new hires in engineering, followed by sales and marketing. We have implemented and continue to follow a disciplined hiring process in all areas of the organization, but as we’ve indicated in the past, we will continue to invest in our core business both in the US and internationally. Non-GAAP operating profit, which excludes stock-based compensation, increased to $1.8 billion in Q1, with non-GAAP operating margins of 35.2%, approximately 30 basis points above Q4. Turning to tax, our effective tax rate for Q1 was 24%, down from 25% in Q4 of ‘07, reflecting the mix of foreign versus domestic earnings. Finally turning to cash, operating cash flow remained strong at $1.78 billion with CapEx for the quarter at $842 million. As in previous quarters, the majority of our CapEx was related to IT infrastructure investments including data center construction, production of servers and networking equipment. We expect to continue to make significant investments in CapEx in future quarters. Free cash flow, a non-GAAP measure which we define as cash flow from operations less CapEx, remained strong at $938 million, up 50% year over year. So in summary, we believe our results reflect the strength of our core business across our three primary initiatives -- Search, Ads, and Apps -- with disciplined investments that position us very well to capitalize on the long-term opportunities we see for Google. Now I’ll turn it over to Sergey.
Sergey Brin: Thanks, George. We are obviously very excited about this past quarter and in listening to the results you’ve heard so far, let me highlight some of the incredible Search improvements we’ve made in the past 90 days. We have launched almost 100 Search quality improvements just in this quarter, so we’re talking about over more than one per day, including weekends. A lot of these have been international Search quality improvements. You will note just on the more visible things, our new tailored homepages in Asian markets. Japan now has a completely new homepage that is tailored to Japan and our Korean Search now has the universal search results that you’ve seen in some other countries. Now we’ve also done a much better job selecting local country results and demoting foreign results in those countries. As a result, we’ve actually seen our Search quality measures uptick significantly in several countries. Also, I just wanted to highlight some of the user interface improvements we’ve been doing. You’ll notice that you can now search within a site directly from the Google Search results. So, you’ll get a top level site in your search results, but if you want to further search within that site there is a box right on the search results page and you can quickly do a query. If you search for something like NASA or a IMDb you’ll see examples of this. Now I’ve told you in the past year how we have deployed Universal Search and I mentioned a number of times but the work wasn’t done with the initial launch. In fact, over the past year since we launched it we’ve been able to double the number of queries where we show these blended results especially in images, video and books. I’m sure many of you are seeing these all the time. This has really improved our ability to answer questions. We’ve also deployed Universal Search in a number a of countries; we just added 17 countries that support the Maps Universal Search feature. I wanted to also just highlight to you on the subject of Maps how we’ve been developing there. We’ve deployed Street View in 30 cities now, up 12 from the past quarter. Our new Street View API has got other sites integrating Street View with them. We are also at the same as we are spending a lot of effort collecting this data ourselves from Apps, we’re including user contributed data. In fact, we now allow users to correct information about local entities and locations on their maps. In fact you can see recent changes as they happen right now if you go to maps.google.com/recentedits. I also want to quickly highlight that we have been working on difficult queries, the challenging ones and we had a substantial initiative over this past quarter where we were able to make a very large improvement in what we consider the hardest 20% of our queries. That was a big achievement and it really stands out in my mind. Finally, let me just tell you a little bit of our progress on Mobile, because more and more people are accessing our Search and other services through mobile devices. We’ve now launched a much faster Search experience and it’s now available in Mobile in 40 languages. Our Mobile Search traffic, as a result, and just due to market growth, is growing very rapidly. That’s for Search, but actually across other properties also, we’ve now launched a new version of our YouTube mobile site and mobile users now can access the entire library of videos. If you remember in the past it was a subset because there was little bit of delay in transcoding, but now all the videos are available. We’ve had mobile playbacks increase tremendously. We also just wanted to highlight that we’re pleased with our participation in the recent 700 megahertz spectrum auction; I know we did not come back within any spectrum wins in that but I feel this has been an important experience for us and we are also very pleased with the results that winners will be adopting these great open access concepts that I think will benefit consumers and developers alike. Anyhow, those are the highlights in Search and Apps and mobile. Now Larry, over to you
Larry Page: Thank you, Sergey. I’m very excited about the quarter as well and I’m going to talk to you a little bit about ads and applications. So, in ads we did a bunch of things in the last quarter. One of the main areas was AdSense where we made improvements for both publishers and advertisers. We launched Google Ad Manager for Publishers, which helps publishers make their entire inventory available on the AdSense network. In testing, publishers greatly increased their revenue with this, so we are really excited about it. We also launched demographic targeting on social networks which uses gender and age information from over 30 social networks to help advertisers place ads. Now switching gears to AdWords, one of the things we launched was a tool that gives customer’s better control and more data and those things are the Conversion Optimizer which we first launched in 3Q07. We are now seeing really rapid adoption across our advertiser base. What that Conversion Optimizer does is let the customers bid per customer conversion rather than per click. You can pay basically when someone buys something rather than when someone clicks something. As you can imagine, that really lets people optimize a lot better and we’re really excited about getting wider and wider adoption of that and it has really been taking off like we had hoped. In Analytics we’ve added industry benchmarking. Google Analytics, if you don’t know what it is, lets you track visitors to your website and your overall traffic and how you are doing, and so on. Industry benchmarking is a new feature we launched so you can tell how you’re doing against others in your same industry, and that’s been a very popular feature. We find that Analytics’ customers, people who adopt Google Analytics, really just end up increasing their advertising spend with us as they better understand their metrics. Now let me switch gears and talk about YouTube. YouTube obviously we are very excited about, it keeps growing extremely fast. We are up to about ten hours of video uploaded every minute on YouTube. So you can imagine just the rate of that is incredible. We have in-video ads, which have great adoption on YouTube and customers are increasing the size of their campaigns. We’ve now launched AdSense for videos, so now these in-video ads can run on sites besides YouTube and they may perform very well; we are seeing much better click-through ads than banner ads and that’s a really big deal and we’re really excited about that. Now we completed our acquisition of DoubleClick and we’re very, very excited about that. They are a technology and networking partner, a tremendous asset and we’re very excited about what we can do together. We’re working on combining our ad network with DoubleClick display ad management products. Together that really helps publishers and advertisers generate more revenue, and we can put much more richer and diverse content on the Internet. So, I think there are huge opportunities there and we’re very excited about how thing are going so far. Now in Apps, I will switch gears to Apps, we launched Google sites which is based on the JobSpot Technology we acquired and makes it easy for anyone to create and manage a website. It makes it easy to add an entry as Wiki. We use it for teams, projects, companies, schools and we’re already seeing a lot of interest in that. We also rolled out Offline Docs using a new browser technology Google Gears where you get offline access to your Google Docs. I think people assume with this cloud applications they’re really great, they are easy to run with, no installation of software they but you wouldn’t be able to run them offline. We have a great new technology Google Gears as I mentioned that lets you run these new web applications even when you are not connected to the Internet. I think that’s a very big deal. We’re also very excited about our Salesforce.com partnership. Salesforce has integrated our Google Apps products into Salesforce. Now their users have a very seamless, nice access to Google Apps within their Salesforce.com experience. We are very, very excited about that, as they are, as well. Finally I just want to mention a quick note on our culture. We were really proud to win Fortune’s Best Place to Work Award for two years in a row. This is an amazing honor to have, I don’t think we expected it, but it is a really great thing. We’re also tops on Fast Company’s Most Innovative Companies List. So we work very hard to maintain the best possible environment for our employees and I think that’s part of why you see the results that you do out of Google. Now I will go to Eric.
Eric Schmidt: Thank you very much, Larry. Why don’t we go ahead and go to your questions and comments. We are very interested in your thoughts on the quarter and any other insights you all might have. Krista, shall we get started?
Krista Bessinger: Yes, operator, we are ready to go ahead and queue-up for questions.
Operator: (Operator Instructions) We’ll take our first question from Ben Schachter - UBS Securities.
Ben Schachter: Guys, congratulations on a nice quarter. I was wondering if you could talk about some of the key initiatives at DoubleClick? What are the areas of integration that you think will be most difficult? Related to that, if you could just give us an update on display and video ads and what types of ads you think are performing better and worse than expected? Finally, any update on the CFO search? Thanks.
Eric Schmidt: Ben, on the CFO search we are very pleased that George has remained and is doing a great job, of course. We have a whole bunch of interesting candidates that we are reasonably close to. We have not made any offers yet and again, it’s an important position for us to fill but we’re very hopeful in the short term. We also have the benefit of having Omid and Jonathan joining us as usual. Omid, do you want to answer the DoubleClick questions to get started, and Jonathan maybe he can help you?
Omid Kordestani: Sure. We are just going through a very complete analysis of all the products and salesforce and service activities. Fundamentally we are looking at maintaining the customer momentum that DoubleClick has had and benefited from. Looking at, in a simple way, how do we get more of the advertising into their network and more of their publishers benefiting from the advertising systems and infrastructure that we are assembling together now. The overall goal here is basically bringing more effectiveness, more accountability more measurements that we’ve been asked for to deliver on. This process in fact was exhaustively reviewed yesterday and there is a strategy in place and you’ll hear of their product announcements in the coming months. From a customer relationship standpoint, on the display side we are very, very active in taking advantage of our properties, especially YouTube and the content network to increase the customer engagements. Just this past quarter, I can just name a few of these names which I think will indicate to you perhaps the nature of how we’re utilizing the salesforce to reach significant types of customers that we haven’t had as advertisers before: Nature Valley, an incredible campaign through YouTube, utilizing everything from the contest platform, brand channel, Contest Gadgets, the content network, FeedBurner so the complete host of our products. Other names like Forex which used CPC placement targeting; Toyota, we actually even had the World Economic Forum at Davos using the YouTube platform; Dunkin’ Donuts, VeriSign. So quite a diversity of advertisers now that we are working with through this integrated relationship across all the properties.
Jonathan Rosenberg: Thanks Omid. Hi Ben, it’s Jonathan. In terms of display and the type of ads that are doing well, if you think about it from a big picture perspective, we really feel we’re in a position to become the world’s largest display ads provider. Over 90% of the daily impressions that we have are eligible for display ads and pretty much all of the publishers accept our new format. The gadget and the rich media creative which are served by third parties are pretty much all being adopted by folks. I think that the biggest thing that we are seeing that Omid alluded to in terms of the examples is the concept of an advertiser owning a concept across the entire web and finding their whole audience. Another example is Activision. I think they use seven Google products to support the launch of the Tony Hawks Proving Ground Game and Search, AFC, the YouTube homepage and I think the in-video format is working particularly well. The one thing I would also add there is they are creating traction on mobile ads.
Operator: Your next question comes from Justin Post - Merrill Lynch.
Justin Post: Thanks, two quick questions. First could you talk about your display model? Do you really see yourself being able to make really interesting profitability on network sites or do you plan to maybe put some display advertising on your own websites, which appear to be growing quite rapidly? The second question may be for George, just the other cost of revenue growth is really about 80% if I back out some of the stock-based comp. I am just wondering what’s driving that, and is that YouTube related at all?
Eric Schmidt: Jonathan and Sergey, maybe you want to talk a little bit about display and how we are going to use it in our network in our own sites?
Sergey Brin: This is Sergey. Just real quickly, I mean there are certainly already sites that are Google-owned sites that run display such as YouTube, for example, is a very obviously prominent one. It has a lot of inventory and obviously that’s going beyond traditional display with the in-video kinds of ads that Jonathan mentioned. I think there are some other Google properties that might be good fits though we haven’t made clear decisions; I mean obviously more visual sites like Orkut there is some potential in Google Images but we don’t have any specific plans to announce today in that respect. I also think that we are certainly making progress on display in our network also and so I’m pretty optimistic on both fronts.
Jonathan Rosenberg: The only thing I would add to that is now that we have got the DoubleClick acquisition behind us, we will also offer the AdSense sites a media planning tool integrated with Dart for Advertisers by DoubleClick. I think you’ll see that will substantially increase the lift that we are getting there.
Eric Schmidt: George did you want to answer the second question?
George Reyes: The driver that you are alluding to is basically driven by data center related expenses, the associated depreciation that comes with that and bandwidth costs as well as some DoubleClick amortization.
Operator: Your next question comes from Doug Anmuth - Lehman Brothers.
Doug Anmuth: Thank you very much for taking my question. You mentioned 100 quality improvements were implemented during the quarter. Can you talk about the degree to which you’re already getting the price per click benefit and whether that’s up to your expectations thus far? Also, do you still stand by your previous view that Google really isn’t seeing any impact from the macro situation? Thank you.
Eric Schmidt: On the macro side, we look at this really carefully and we do not see an impact as of this time. We’ve also had the internal conversation of, what would happen if it were to occur? Our conclusion is that we’re well positioned should economics change to continue to do well because our model is so targeted. Targeted advertising does well in pretty much most scenarios, we think. Sergey or Jonathan, do you want to talk a little bit about the other?
Sergey Brin: Let me just mention, the 100 search quality improvements I mentioned were to the search quality. I wasn’t referring to the advertising quality experience. But we’ve also made improvements there, of course. If you recall the clickable backgrounds that we eliminated recently which while they reduced clicks a little bit increased the quality of clicks, and I think our advertisers certainly appreciate that. But there are likewise -- I don’t know the exact number -- but there are certainly dozens, if not 100 improvements in advertising quality that we also launched over this quarter. That’s going to benefit advertisers and it’s going to benefit end users who are going to see more relevant, interesting advertising and obviously because those connections can be more fruitful, ultimately that benefits publishers as well.
Jonathan Rosenberg: Are you asking about what the specific ads quality improvements were or are you asking whether or not the scope, the degree to which the scope impacted pricing and RPM, what specifically are you asking about the quality?
Doug Anmuth: Well, obviously, as much as you are willing to share Jon. Honestly I am asking which quality improvements on the advertising side would you say have had the biggest benefits thus far?
Jonathan Rosenberg: Sure.
Doug Anmuth: Are they driving price per click, to the degree to which you expected them too?
Jonathan Rosenberg: Sure, quality improvements intra quarter, so Sergey mentioned there were quite a few. I think they were relatively fewer in terms of impact in the quarter than we typically have. I think that was primarily not due to the number but it was due to the fact that more of them came relatively late in the quarter compared to previous quarters. I think the biggest ones that we alluded to publicly that Sergey did mention are the landing page quality improvements; we’ve removed a lot of the need for ad pages so there has been substantial improvements there. There also have been some policy changes, the visible and final URL policy matching so that users always know where they end up when they’re clicking on an ad which we think in the long run is very positive. I think we also announced the change in the UK trademarks policy so that we now removed the restrictions on ads on trademark keywords in the UK, which is the way that we had it to-date. These are all things that are great for users. I think that UK piece isn’t going to go live until Q2 so I am not sure it had much impact in the quarter. But the one other thing that I saw, some folks have noticed was just a very modest test which was our automatic matching beta test and that’s basically trying to extend an advertiser campaign’s reach by finding ads on relevant searches that aren’t triggered by the advertiser’s keyword. But that’s really relatively modest because that’s just an initial test that we just started.
Eric Schmidt: Just to add one more clarification. We often don’t know the exact improvement that we are going to see in the very short term so at least from my perspective, I’m more concerned that the improvements be put in place and that they work well and then of course we’ll get the benefit as the advertiser see those and as the network takes advantage of it. We can take the long view of that.
Operator: Your next question comes from Mark Mahaney - Citi.
Mark Mahaney: I wanted to ask Sergey about some of the mobile data points. Are there enough data points, do you have enough experience particularly in the international markets now to know what the economics of mobile search could like relative to the PC search? Are the leads being generated off of mobile devices as qualified -- more so or less so? Are advertisers willing to pay more or less for that? I wanted to ask another question on the paid clicks. 20% year-over-year growth is obviously much better than was feared. There still is a pretty clear level of deceleration in the paid click growth on a year-over-year basis even if you trend line it going back a year-and-a-half. Part of that must be due to your quality initiatives. Do you think about it terms of trying to get to a paid click growth at a certain anniversarying of these paid click quality improvements whereby that growth will remain in the 20% or low double-digit rate at a more sustainable basis because of these quality improvements? Thank you.
Eric Schmidt: Sergey do you want to talk about mobile?
Sergey Brin: On mobile, I don’t how the hard stats in front of me right this very second. I can tell you kind of anecdotally what I’ve seen in the countries and markets where mobile has developed in the sense that devices have high resolution, networks have low latency, the experience works which basically like Japan and a few others that are up and coming, the mobile search and ads work very well. I don’t have the exact data in front of me right now, as I said, but there is certainly nothing to dissuade me that it would be substantially worse than traditional desktop search. I think that if you look in the US and Europe which are a little bit behind those but I think are progressing, I think you’ll increasingly a greater volume and a greater quality of mobile usage and consequently advertising conversion ultimately. Now, you have a significant challenge in mobile in that the screens are much smaller so you just can’t go displaying nearly as much advertising or take as much space. On the other hand, you have much more relevant and timely information like what location the person might be in and so that on balance leaves me quite optimistic.
Eric Schmidt: The short answer to your deceleration question is the answer is no. We look at the problem of paid clicks as one of the components of an overall quality improvement. We know that if we can improve aggregate quality we know that the value of a click, number of clicks and so forth will grow, and will grow at whatever the technology will allow. So if you look, our absolute growth rate has been very, very significant and we’re very, very optimistic that this model of staying focused on quality will give us not only the strongest ad network but a much broader set of solutions for advertisers and it works well.
Operator: Your next question comes from James Mitchell - Goldman Sachs.
James Mitchell: Great, thank you very much for taking the question. One question was with regard to the user response to Universal Search in non-US territories, have you rolled it out? In particular, why do you think Universal Search can help you gain share in those countries where you are not the market leader and where the incumbent lacks comparable functionality? The other question, I was just looking back over the past few quarters, I believe you stated your business was less seasonally affected in the summer months in 2007 than in prior years. Do you think that something is structurally changing your business to reduce seasonality or do you think that 2007 was erratic in someway?
Eric Schmidt: On the seasonality I’m not sure I agree with that characterization. There are so many variables that have to do with product improvements, product launches, customer deals, renewing and change in TAC rates, all of those kinds of things, it’s very difficult to say that looking at an aggregate number, in particular a change in seasonal growth rate, was a very big deal. We know there is a seasonality in the business; it’s very difficult for us to know exactly where it is. As you correctly pointed out, Q2 and Q3 are traditionally weaker quarters and my guess is that that will be simply true because the majority of Internet users are still in the Northern Hemisphere which is where people tend to take summer vacations. Sergey, do you want to talk about Universal Search?
Sergey Brin: On the Universal Search I think Universal Search is a very big win from the point of view of the Search experience. Now in some of these international markets like if you look at Korea in fact the local competitors there do have something that’s very much akin to Universal Search. So in fact I think the people’s expectations there are already to have Universal Search results and so its not necessarily something new we are introducing to them there. I think our ability to rank and bring in these diverse corpuses that we have will surprise people and they will be impressed by how good it is. In other markets you are right, I think that these additional corpuses and our ability to blend is a substantial distinction and I think we are going to benefit from that in fact and obviously we have lots of international or foreign language videos and images and so forth and we have a certain number of books as well in there. I think we are going to benefit from all that hard work that we’ve put in those corpuses.
Jonathan Rosenberg: This is Jonathan adding one narrow point and one broad point on your question about seasonality. Narrowly within each quarter, there are things that make one year significantly different from another; this year you had Easter falling actual in Q1 whereas in previous years it has fallen in Q2. On the other hand offsetting that this year you had a leap year which in this year was actually on a Friday although since it added one more day in the quarter, the net results of leap year was giving us one more Monday in the quarter. When you think about that, that actually equates to something in the ballpark of about 1%. The broader question in terms of the business moving forward with respect to seasonality is highly dependent on market share. In many markets if you look historically we were gaining share and in some cases in previous years that’s significantly masked seasonality. In markets where we have very, very high share then the business starts become, it starts to look more seasonal in nature than it has in the past.
Operator: Your next question comes from Imran Khan - JP Morgan.
Imran Khan: Larry, you talked about a monetization improvement for social networking, how you are doing more demographic targeting. Could you please give us some color like what kind of progress you made monetizing social networking compared to Q4? The second question is regarding how you’re improving the search quality in the international market. Can you give us some sense in terms of the frequency of search in your lesser developed countries like Continental Europe compared to more developed like US and UK, the frequency of search volume per person? Thank you.
Larry Page: On social networking monetization, I think its been an area where we have really applied a lot of new technologies and then some of the demographic targeting and so on, which has been very successful. I think the challenge and the opportunity there is there is a huge amount of inventory. We have obviously MySpace, Orkut, Inner Network and a number of other social networks. There is a lot of usage of those. So there is a tremendous amount of inventory and so part of it is just getting that advertiser ecosystem built up and people targeting that inventory and doing it in a way that makes sense for those advertisers. So I think we’ve made a lot of improvements and I’m optimistic that there are improvements to be made. That’s balanced against tremendous inventory levels in those areas which it takes some time for advertisers to really realize they are there and start targeting effectively.
Sergey Brin: This is Sergey. I don’t think we consider Continental Europe less developed. I do think that in the advertising space, we have seen that they are sort of coming up on the ramps that the US and UK might have been a year or two ago. So that obviously gives us great opportunity for growth advertising-wise. But in terms of basic Internet usage and searches per user, while once again I don’t have the data in front of me, what we’ve seen is it typically just depends on broadband penetration and quality of broadband and the more people have access to great networks and computers to use them the more searches and overall internet usage they will do. That’s why you see this skew during the week, that Monday to Friday we do tend to get a lot more usage than on weekends. Obviously part of that’s because people are relaxing off the Internet on weekends, but part of it also is that typically often people at home don’t have as good connectivity and Internet access as they do at the office.
Operator: Your next question comes from Christa Quarles - Thomas Weisel Partners.
Christa Quarles: You mentioned in the UK that travel and finance has rebounded, I was just wondering if you could discuss travel, finance and hopefully retail more broadly across the US and some of your other geographies in terms of strength or any relative weakness? The second question is should Yahoo! choose to outsource part of Search to you, I was wondering if you can discuss philosophically what the benefit would be to Google’s own property in the sense that you have a broader, deeper ad network, broader advertising if you will, coming to the site?
Eric Schmidt: On the Yahoo! question we are very excited to be participating in this test, at the beginning of the second week on the test. I don’t think it’s really appropriate to speculate beyond that but its nice to be working with Yahoo! and we like them very much. Omid, do you want to answer the UK question, or Jonathan?
Omid Kordestani: We will both probably take this on. I mean in general what we are seeing is that these verticals really behave by region as you are indicating, and they are the factors that determine for example in each geography we have talked about this in the past, renewal rates for finance or travel reservations that get done in UK drive those verticals. I think, in general we saw in Q1 a bit of a slowdown in retail, some postponement of budgets but we haven’t seen anything that kind of significantly indicates to us that one vertical or another is at risk here. We are just going deeper into these accounts, and in some cases when the budgets are delayed its made up by other online categories.
Jonathan Rosenberg: I think if you think about what economists would typically theorize in a macroeconomic climate that was slowing they look at sectors like some of the ones you’ve mentioned – automotive, luxury goods, we also track travel and finance -- and you look for the ones that are more sensitive to macro-economic conditions, and look to see what’s going on with them. What we tend to see is that clicks in some of those sensitive areas do grow a little less rapidly than our overall growth so the share of their total queries is actually down but on an absolute basis, they are all showing healthy growth in ad revenue. In the UK, for example, people are clicking on travel and local ads at a higher rate than they do in the US. In finance, although certain components of finance are down, foreclosures are up and even more mortgages do pretty well, if you think about foreclosures, every foreclosure at some point becomes a home sale and a mortgage to somebody. So generally what we are seeing is absolute growth even in those areas that are otherwise adversely impacted by macroeconomic conditions.
Christa Quarles: You’re basically indicating that you tend to see price improvements in these areas as the conversions continue?
Jonathan Rosenberg: It varies.
Eric Schmidt: I think the best way to say it is that it’s possible that prices grow up in that situation simply because of the great value of targeted advertising.
Operator: Your next question comes from Brian Pitz - BoA Securities.
Brian Pitz: Can you talk about how much of your international growth is really due to the sunsetting of European best practice funding? Separately, would you provide any updates on China and perhaps discuss any new initiatives that Kai-Fu Lee and team may be working on over there? Thanks.
Eric Schmidt: Sorry, could you repeat the second question?
Brian Pitz: Sure, just updates on China and the team Kai-Fu Lee, things that they’re working on over there, some new initiatives we may not have heard about?
Eric Schmidt: On the China side, things are going well. Why don’t we move to our next question?
Operator: Your next question comes from Ross Sandler - RBC Capital Markets.
Ross Sandler: Great, thanks for taking my question guys. Looking at the US growth rate of 30% approximately in the first quarter, if you had to characterize your small, medium-sized self sign-up advertisers versus your large agency or direct enterprise-sized advertisers, which segment was growing faster in the quarter relative to that 30%? Thanks.
Eric Schmidt: Again, I’m sorry we had a phone problem here. Could you just repeat the substance of the question again?
Ross Sandler: Sure. The growth rate in the U.S. is 30 % year over year. If you had to characterize which area was growing faster between the small to medium-sized self-signup advertisers on your platform versus the larger agency or direct enterprise type clients, which was the faster growing segment in the quarter?
Omid Kordestani: I don’t have the actual breakdown in front of me right now. What I will say is we are doing very interesting collaboration between both of our channels; in fact, in some regions we have three with some resellers involved. One of the things we tend to do is just try to put our relationships with the customers into the right channels. So in many cases where we find that we can in a very effective way service our clients through our online organization we do that and that organization in fact has top-tier clients now that are even some brand names that are well-served by our organization. What we’re trying to do with the direct sales organization is really focus on those higher-end calls into the C-level if you will, to the CMO level where also we are presenting the full suite of products and integrated campaigns between YouTube. In the US obviously we’re also experimenting with a lot of the new initiatives from TV, radio, advertising, and so perhaps on a follow-up call we can get you more specific stats on the different geographies and the ratios between those two channels. But, there is a lot of movement of customers that we do again to optimize the relationship with the customers.
Jonathan Rosenberg: Just trying to add little more to color to Omid. We definitely tend to see that it is the larger customers that are the bigger drivers of growth, whether or not on a relative basis in the previous year they were bigger drivers I think is unclear. But we have released a lot of tools like Analytics and the Conversion Optimizer and those are the type of things that tend to get adopted disproportionately by the larger, more sophisticated advertisers and we do see that as advertisers adopt those tools it substantially fuels growth. So there certainly is significant growth with the larger advertisers.
Operator: Your next question comes from Heath Terry - Credit Suisse.
Heath Terry: You mentioned that you are seeing much better click-throughs on the overlay ads versus your normal banner ad. By our measure, we’re only seeing running overlay ads running on content where you have clear relationships like the NBA and Universal Music. What are the barriers to running ads on a broader spectrum of YouTube’s inventory, particularly the user generated content that you’ve got?
Omid Kordestani: What we’re really focused on right now is working with YouTube management channel team to really actually go from the, if you will the plumbing, and work all the way up with the customer’s advertiser fee; there is a lot of integration work going on. YouTube was already a large DoubleClick customer and we are trying to basically streamline how the integration of DoubleClick and YouTube can be improved and how we can take advantage of our ad networks so that more of these advertisers could be represented. How do we work with the owners of content, user-generated or otherwise, to actually find the right match-up with the right advertiser so if we basically have a much better targeting of ads and also promotion of the right types of content. So it’s a very comprehensive plan that we have put in place. We have a 2008 plan that has a very specific milestones again all the way from the systems and infrastructure that we need to provide that integration all the way to the different types of ads. I think it’s very early to make any kind of a judgment about which ads are working well and which ones are that we’re really trying to have these integrated campaigns, try it out with the salesforce and our customers and do a lot of learning and settle in to a product roadmap.
Eric Schmidt: Thank you. Let’s have a couple more questions. It looks like we missed a question so maybe we could get that caller to call back in as well. Operator, let’s go ahead, next question.
Operator: Your next question comes from David Joseph - Morgan Stanley.
David Joseph: As you integrate DoubleClick into AdSense should we expect that to be a growth driver in addition to contextual ads or is it possible that it actually starts to cannibalize contextual advertising? Also, how is Google Ad Manager going to coexist with the DoubleClick Technology or ad serving technology? Also, should we assume that obviously DoubleClick is running AdSense revenue from here on out? Thank you.
Omid Kordestani: In terms of the DoubleClick products, we really are optimistic that where we are headed to is where our Head of Sales in the US, Tim Armstrong, calls the CMO dashboard. What our hope is that by basically providing the integration across the board here we end up having in a simple way again a lot of DoubleClick access more towards advertisers and having the DoubleClick advertisers have access to the AdSense network. That’s our goal and so we’re really hoping that all of this will be incremental and that ultimately we get to a point where the CMOs can have a very effective way to measure the effectiveness of the advertisers and do the right allocation of their ad budgets across the board here.
Eric Schmidt: Jon, did you want to add anything to that?
Jonathan Rosenberg: I think the only obvious thing to add is that adding more display creates more competition among advertisers; we’ll have more premium inventory from publishers and those things will certainly be added to fuel each other. We certainly don’t think [inaudible] ads are going to result in any kind of cannibalization. There is plenty of reasons to believe that they are positive dynamics and its unclear that there are any negative ones.
Operator: Your next question comes from Brian Pitz - BOA Securities.
Eric Schmidt: Thanks, Brian. It appears as though we didn’t hear your question because there was a phone problem so I apologize. Maybe you could ask your question again, and we will restart up.
Brian Pitz: Sure, no problem. I’m just wondering how much of your international growth was due to the sunsetting of the European best practices funding that you guys had talked about before. Separately, you mentioned 90% of impressions are eligible for display. Can you talk about the effective CPM difference between display and formats versus text links on your network? Thanks.
Eric Schmidt: On the first question, Omid, do you want to talk about -- could you repeat your China question for me?
Brian Pitz: Just an update on China. We just wanted to get a sense for any new initiatives the company was working on over in China, there have been some articles out.
Eric Schmidt: Let me give you a sense on the China situation. We are seeing market share growth and good revenue growth as we have learned to operate in that environment. Although the advertising business is nascent in China, the fact of the matter is that the Chinese Internet is so large that even on a small basis the numbers add up to quite significant with good growth rate. We believe that China will continue to be a good market for us. As we hopefully gain share we have significant new products for the Chinese, Knowledge Chinese, Users Chinese Language, Chinese Search and that’s our core growth, so the message there is good. Omid, do you want to talk about the international?
Omid Kordestani: Yeah on the ETS really it was something we announced a while back and our goal really is to have a very successful relationship with agencies across the world. We just felt that the previous program and actually the goal of the program is really to reward the way we engage properly together in servicing advertisers and also going after these new initiatives. The real performance in Europe comes from the great work that the European team is doing and really understanding the dynamics of the business, putting the right customers in the right channels in each region really understanding the dynamics of each industry vertical that we are selling into and paying attention to the seasonality effects and where to put the resources and servicing and selling clients. On the CPM and CPC question really our goal there is simply to allow again the advertisers to pay the way they wish between the display products and the text products. Ultimately the goal here is to focus on conversions for them so how they can best measure and achieve their campaign objectives.
Eric Schmidt: Jonathan do you want to talk about display?
Jonathan Rosenberg: The question specifically related to content and display and the dynamics in terms of how they interact and how that works and how that’s going?
Brian Pitz: It was more along the lines of just the effect of CPM difference between display formats and text links on the network.
Jonathan Rosenberg: I mean basically what we are doing is we are trying to come up with a way to manage the auction so that you can have the display ads competing with the text ads and multiple text ads basically in the auction have to compete in such a manner that they trump the value of the display ads. So typically three text ads versus one display ad unit. We’re still basically working through that. So that’s basically how it works, I am not quite sure what else you were asking.
Eric Schmidt: Why don’t we go ahead and get our last question. Thank you very much, Brian.
Brian Pitz: Thank you.
Operator: Your next question comes from Mark May - Needham & Company.
Mark May: My question is focused on the US revenues which grew $29 million sequentially. If one could make an estimate of DoubleClick’s contribution, one might conclude that the US revenues were flat to maybe up, marginally, sequentially. Eric I think earlier you said you’re not really seeing a meaningful impact on the business from the macroeconomic environment. I think it was also mentioned that the majority of these search quality improvements occurred outside the US. So the question is, is the sequential growth that you put up this quarter which is far lower than what it has been in the past, is that more a reflection of where we are in the search cycle, search out cycle in the US or given that it’s not really macroeconomic… that would be great.
Eric Schmidt: Well we know what it’s not. We know that it is not macroeconomic. It can have as much to do with the timing of deals, partner activity, the timing of product rollouts and the maturity as you pointed out of the US market; also the rate at which both search quality improvements play out within the quarter as well as advertising quality, because again they don’t necessarily implement exactly linearly in the quarter across every geography. Jonathan, do you want to add any perspective to that?
Jonathan Rosenberg: I think the only obvious thing to look at is you have to be very careful when you look at the annualized year-over-year comparisons to try to isolate the impact in a quarter. The biggest thing that you would separate out there from the US relative to international, is that in the base quarter that you are comparing to which would be this quarter of last year we added a lot of really big partners in Q1 of last year to AdSense and so relative to that year this year we didn’t have that many incremental partners to add so I think that’s everything else being constant otherwise leading you to see what appears to be a relative reduction in the US. But it’s primarily a factor of that. There is also the AdSense for domains cleanup, which we talked about earlier.
Eric Schmidt: And my guess is that the two that Jonathan described are the primary cause and we have to go back and really match it all to be sure. Let’s finish up by saying first thank you very much for everybody spending -- your time is valuable, spending more than an hour listening to us and talking about Google. I also wanted to take a minute to thank Omid for something, I don’t Omid if you remember but right after I started here I told you to go get on an airplane and go build some international operations. You flew to London and the rest is history. This is the quarter where we are now 51% international revenue. I don’t think that percentage is going to go down; the world is a very big place. Congratulations to our international sales teams, the international leadership for making Google a truly global company. Thank you all. | [
{
"speaker": "Operator",
"text": "Good day and welcome everyone to the Google, Inc conference call. Today’s call is being recorded. At this time, I would like to turn the call over to Ms. Krista Bessinger, Director of Investor Relations. Please go ahead, ma’am."
},
{
"speaker": "Krista Bessinger",
"text": "Good afternoon, everyone and welcome to today’s first quarter 2008 earnings conference call. With us are Eric Schmidt, Chief Executive Officer; George Reyes, Chief Financial Officer; Larry Page, Founder and President of Products; Sergey Brin, Founder and President of Technology; Jonathan Rosenberg, Senior Vice President of Product Management; and Omid Kordestani, Senior Vice President of Global Sales and Operations. Eric, George, Larry, and Sergey will provide their thoughts on the quarter and then Jonathan and Omid will join us for Q&A. Please note that this call is being webcast from our investor relations website. Our press release issued a few minutes ago is also posted on the website, along with the slides that accompany today’s prepared remarks. A replay of this call will also be available on our investor relations website in a few hours. Now let me quickly cover the Safe Harbor. Some of the statements we make today may be considered forward looking, including statements regarding our investments, seasonality, traffic acquisition costs, increase in the cost of sales, international growth, operating margins, growth in headcount and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings, including our annual report on Form 10-K for the year ended December 31, 2007 as well as our earnings press release for a more detailed description of the risk factors that may affect our results. Copies can be obtained from the SEC or by visiting the investor relations section of our website. Also please note that certain financial measures we use on this call such as EPS, net income, operating margin and operating income are expressed on a non-GAAP basis and have been adjusted to exclude charges relating to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures which we refer to as free cash flow. Our GAAP results and GAAP to non-GAAP reconciliation can be found in our earnings press release. With that, it’s my pleasure to turn the call over to Eric."
},
{
"speaker": "Eric Schmidt",
"text": "Well thank you very much, Krista, and we’re obviously very pleased with another strong quarter for Google. It’s clear to us that we’re well-positioned for 2008 and beyond, regardless of the business environment that we find ourselves surrounded by. The Search, Ads and Apps strategy that we articulated last year is beginning to show transformative effects; literally things that people could not do before the products and services that we’ve offered in each of the categories. The business model continues to work very well and we’ve had good, disciplined management of our operating expenses, so thank you very much for the management team. It’s also interesting to note that paid clicks growth is much higher than has been speculated by third parties. In Search, we continue to invest in quality, particularly internationally. Quality improvements lead to increased traffic and share. Quality here means better algorithms, more content – deeper, if you will -- into the web; a larger index, faster response, all that surfing. But it also implies things like Maps and Earth and geospatial information, it’s all integrated in a way that people can find things and see things that they could never do before. In Ads, we continue to increase value for advertisers and publishers; again, broader and deeper solutions. Better tools for advertisers, many, many quality improvements in advertising which has the interesting effect, which means that we’re showing fewer but much better ads in each cycle. That’s a key part of the Google success story. We’re putting more and more flexibility and control in the hands of advertisers so they can decide exactly where their ad should go and measure it in the way using Analytics that they could not do before. It’s also important to note that DoubleClick has been added now to the portfolio and DoubleClick is hugely strategic for us. It allows us to offer a much more comprehensive solution for advertisers and publishers. This has been asked for long time and now we are able to do it. In the Apps case, we are working to build out a whole new online web experience and we’re beginning to have all of the pieces now in place. For example, the recently announced Salesforce.com partnership allows us to integrate for an enterprise customer with the Salesforce.com products as well as all of the Google application services and sold through their direct sales operation. By doing these partnerships and by investing heavily in new applications models we think people will spend more and more time online and they will able to do things like sharing documents, sharing calendars, dealing with photos and all those kinds of things in a way that had not been possible before. This has all been possible because of the many, many talented Googlers and the executive leadership that we’ve seen in the last quarter and I want to thank everybody for that. The Google model really does rely on technology and innovation. The repeatable and scalable business that we have built is really poised for global growth. So with that, George, do you want to take us through the numbers?"
},
{
"speaker": "George Reyes",
"text": "Thanks, Eric and good afternoon, everyone. Before we begin, please note that our consolidated results as reported today include the results of DoubleClick from March 11, the date of the acquisition, through the end of the quarter. The overall effect was immaterial to revenue and only slightly dilutive to operating income, net income and earnings per share. Turning to our results, we had another strong quarter with gross revenue increasing 42% over Q1 2007 to $5.2 billion. Goggle.com performed very well, up 49% year over year to $3.4 billion, driven by strong traffic growth and to a lesser extent, monetization growth. AdSense revenue grew 25% over Q1 2007, reflecting solid performance across both the Content and Search networks. Now let’s look at aggregate paid clicks growth. Aggregate paid clicks include clicks related to ads served on Google properties, as well as ads served on our partner sites. Aggregate paid clicks grew approximately 20% over Q1 2007 and approximately 4% over Q4. Paid click growth on Google.com in the U.S. remains healthy and other markets are showing strong growth as well. Now I’ll discuss our international performance. International revenue increased to $2.65 billion, now accounting for 51% of total revenue. International markets have tremendous potential for growth. As is typical in the first quarter, the UK was strong with revenues of $803 million and 16% sequential growth as the travel and finance verticals rebounded as expected from Q4. Revenue growth in EMEA was primarily driven by strong performance in the UK, Benelux and the Nordic countries fueled by strong pan-European performance in travel. We also saw solid gains in relatively smaller markets such Ireland, Spain and Italy. Asia and Latin America continue to show impressive growth as well with India, Argentina Australia and Japan being notable performers in the quarter. Now turning to expenses, traffic acquisition costs were $1.5 billion or 29% of total advertising revenue, down from 30% in Q4. AdSense TAC was $1.3 billion, while TAC related to distribution partners and others who direct traffic to our websites totaled $143 million in the quarter. Other cost of revenue, which included $9 million in stock-based compensation increased $108 million over Q4 to $624 million. The largest driver of the increase was the increase in costs related to our data centers including depreciation, equipment and operations. We continue to anticipate that other cost of sales could increase going forward. Other than cost of revenue, operating expenses in Q1 totaled $1.5 billion, including approximately $272 million in stock-based compensation. Expenses related to payroll and facilities increased $53 million over Q4 to $809 million. At the end of the quarter we had a full-time employee base of 19,156 including more than 1,500 heads from DoubleClick. Since the close of the acquisition we’ve conducted a review of our ongoing headcount requirements and approximately 10% of the US DoubleClick workforce was laid off in early April. An additional 15%, approximately, are expected to leave the company in the U.S. in the near to intermediate term, because they are in a transitional role as they move through the system. These headcount reductions apply only to the U.S. and do not include employees associated with the future planned divestitures of the Performics SEM business. To-date there have been no headcount reductions outside the U.S. On an organic basis, excluding DoubleClick, we added approximately 800 employees in Q1 with the majority of new hires in engineering, followed by sales and marketing. We have implemented and continue to follow a disciplined hiring process in all areas of the organization, but as we’ve indicated in the past, we will continue to invest in our core business both in the US and internationally. Non-GAAP operating profit, which excludes stock-based compensation, increased to $1.8 billion in Q1, with non-GAAP operating margins of 35.2%, approximately 30 basis points above Q4. Turning to tax, our effective tax rate for Q1 was 24%, down from 25% in Q4 of ‘07, reflecting the mix of foreign versus domestic earnings. Finally turning to cash, operating cash flow remained strong at $1.78 billion with CapEx for the quarter at $842 million. As in previous quarters, the majority of our CapEx was related to IT infrastructure investments including data center construction, production of servers and networking equipment. We expect to continue to make significant investments in CapEx in future quarters. Free cash flow, a non-GAAP measure which we define as cash flow from operations less CapEx, remained strong at $938 million, up 50% year over year. So in summary, we believe our results reflect the strength of our core business across our three primary initiatives -- Search, Ads, and Apps -- with disciplined investments that position us very well to capitalize on the long-term opportunities we see for Google. Now I’ll turn it over to Sergey."
},
{
"speaker": "Sergey Brin",
"text": "Thanks, George. We are obviously very excited about this past quarter and in listening to the results you’ve heard so far, let me highlight some of the incredible Search improvements we’ve made in the past 90 days. We have launched almost 100 Search quality improvements just in this quarter, so we’re talking about over more than one per day, including weekends. A lot of these have been international Search quality improvements. You will note just on the more visible things, our new tailored homepages in Asian markets. Japan now has a completely new homepage that is tailored to Japan and our Korean Search now has the universal search results that you’ve seen in some other countries. Now we’ve also done a much better job selecting local country results and demoting foreign results in those countries. As a result, we’ve actually seen our Search quality measures uptick significantly in several countries. Also, I just wanted to highlight some of the user interface improvements we’ve been doing. You’ll notice that you can now search within a site directly from the Google Search results. So, you’ll get a top level site in your search results, but if you want to further search within that site there is a box right on the search results page and you can quickly do a query. If you search for something like NASA or a IMDb you’ll see examples of this. Now I’ve told you in the past year how we have deployed Universal Search and I mentioned a number of times but the work wasn’t done with the initial launch. In fact, over the past year since we launched it we’ve been able to double the number of queries where we show these blended results especially in images, video and books. I’m sure many of you are seeing these all the time. This has really improved our ability to answer questions. We’ve also deployed Universal Search in a number a of countries; we just added 17 countries that support the Maps Universal Search feature. I wanted to also just highlight to you on the subject of Maps how we’ve been developing there. We’ve deployed Street View in 30 cities now, up 12 from the past quarter. Our new Street View API has got other sites integrating Street View with them. We are also at the same as we are spending a lot of effort collecting this data ourselves from Apps, we’re including user contributed data. In fact, we now allow users to correct information about local entities and locations on their maps. In fact you can see recent changes as they happen right now if you go to maps.google.com/recentedits. I also want to quickly highlight that we have been working on difficult queries, the challenging ones and we had a substantial initiative over this past quarter where we were able to make a very large improvement in what we consider the hardest 20% of our queries. That was a big achievement and it really stands out in my mind. Finally, let me just tell you a little bit of our progress on Mobile, because more and more people are accessing our Search and other services through mobile devices. We’ve now launched a much faster Search experience and it’s now available in Mobile in 40 languages. Our Mobile Search traffic, as a result, and just due to market growth, is growing very rapidly. That’s for Search, but actually across other properties also, we’ve now launched a new version of our YouTube mobile site and mobile users now can access the entire library of videos. If you remember in the past it was a subset because there was little bit of delay in transcoding, but now all the videos are available. We’ve had mobile playbacks increase tremendously. We also just wanted to highlight that we’re pleased with our participation in the recent 700 megahertz spectrum auction; I know we did not come back within any spectrum wins in that but I feel this has been an important experience for us and we are also very pleased with the results that winners will be adopting these great open access concepts that I think will benefit consumers and developers alike. Anyhow, those are the highlights in Search and Apps and mobile. Now Larry, over to you"
},
{
"speaker": "Larry Page",
"text": "Thank you, Sergey. I’m very excited about the quarter as well and I’m going to talk to you a little bit about ads and applications. So, in ads we did a bunch of things in the last quarter. One of the main areas was AdSense where we made improvements for both publishers and advertisers. We launched Google Ad Manager for Publishers, which helps publishers make their entire inventory available on the AdSense network. In testing, publishers greatly increased their revenue with this, so we are really excited about it. We also launched demographic targeting on social networks which uses gender and age information from over 30 social networks to help advertisers place ads. Now switching gears to AdWords, one of the things we launched was a tool that gives customer’s better control and more data and those things are the Conversion Optimizer which we first launched in 3Q07. We are now seeing really rapid adoption across our advertiser base. What that Conversion Optimizer does is let the customers bid per customer conversion rather than per click. You can pay basically when someone buys something rather than when someone clicks something. As you can imagine, that really lets people optimize a lot better and we’re really excited about getting wider and wider adoption of that and it has really been taking off like we had hoped. In Analytics we’ve added industry benchmarking. Google Analytics, if you don’t know what it is, lets you track visitors to your website and your overall traffic and how you are doing, and so on. Industry benchmarking is a new feature we launched so you can tell how you’re doing against others in your same industry, and that’s been a very popular feature. We find that Analytics’ customers, people who adopt Google Analytics, really just end up increasing their advertising spend with us as they better understand their metrics. Now let me switch gears and talk about YouTube. YouTube obviously we are very excited about, it keeps growing extremely fast. We are up to about ten hours of video uploaded every minute on YouTube. So you can imagine just the rate of that is incredible. We have in-video ads, which have great adoption on YouTube and customers are increasing the size of their campaigns. We’ve now launched AdSense for videos, so now these in-video ads can run on sites besides YouTube and they may perform very well; we are seeing much better click-through ads than banner ads and that’s a really big deal and we’re really excited about that. Now we completed our acquisition of DoubleClick and we’re very, very excited about that. They are a technology and networking partner, a tremendous asset and we’re very excited about what we can do together. We’re working on combining our ad network with DoubleClick display ad management products. Together that really helps publishers and advertisers generate more revenue, and we can put much more richer and diverse content on the Internet. So, I think there are huge opportunities there and we’re very excited about how thing are going so far. Now in Apps, I will switch gears to Apps, we launched Google sites which is based on the JobSpot Technology we acquired and makes it easy for anyone to create and manage a website. It makes it easy to add an entry as Wiki. We use it for teams, projects, companies, schools and we’re already seeing a lot of interest in that. We also rolled out Offline Docs using a new browser technology Google Gears where you get offline access to your Google Docs. I think people assume with this cloud applications they’re really great, they are easy to run with, no installation of software they but you wouldn’t be able to run them offline. We have a great new technology Google Gears as I mentioned that lets you run these new web applications even when you are not connected to the Internet. I think that’s a very big deal. We’re also very excited about our Salesforce.com partnership. Salesforce has integrated our Google Apps products into Salesforce. Now their users have a very seamless, nice access to Google Apps within their Salesforce.com experience. We are very, very excited about that, as they are, as well. Finally I just want to mention a quick note on our culture. We were really proud to win Fortune’s Best Place to Work Award for two years in a row. This is an amazing honor to have, I don’t think we expected it, but it is a really great thing. We’re also tops on Fast Company’s Most Innovative Companies List. So we work very hard to maintain the best possible environment for our employees and I think that’s part of why you see the results that you do out of Google. Now I will go to Eric."
},
{
"speaker": "Eric Schmidt",
"text": "Thank you very much, Larry. Why don’t we go ahead and go to your questions and comments. We are very interested in your thoughts on the quarter and any other insights you all might have. Krista, shall we get started?"
},
{
"speaker": "Krista Bessinger",
"text": "Yes, operator, we are ready to go ahead and queue-up for questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) We’ll take our first question from Ben Schachter - UBS Securities."
},
{
"speaker": "Ben Schachter",
"text": "Guys, congratulations on a nice quarter. I was wondering if you could talk about some of the key initiatives at DoubleClick? What are the areas of integration that you think will be most difficult? Related to that, if you could just give us an update on display and video ads and what types of ads you think are performing better and worse than expected? Finally, any update on the CFO search? Thanks."
},
{
"speaker": "Eric Schmidt",
"text": "Ben, on the CFO search we are very pleased that George has remained and is doing a great job, of course. We have a whole bunch of interesting candidates that we are reasonably close to. We have not made any offers yet and again, it’s an important position for us to fill but we’re very hopeful in the short term. We also have the benefit of having Omid and Jonathan joining us as usual. Omid, do you want to answer the DoubleClick questions to get started, and Jonathan maybe he can help you?"
},
{
"speaker": "Omid Kordestani",
"text": "Sure. We are just going through a very complete analysis of all the products and salesforce and service activities. Fundamentally we are looking at maintaining the customer momentum that DoubleClick has had and benefited from. Looking at, in a simple way, how do we get more of the advertising into their network and more of their publishers benefiting from the advertising systems and infrastructure that we are assembling together now. The overall goal here is basically bringing more effectiveness, more accountability more measurements that we’ve been asked for to deliver on. This process in fact was exhaustively reviewed yesterday and there is a strategy in place and you’ll hear of their product announcements in the coming months. From a customer relationship standpoint, on the display side we are very, very active in taking advantage of our properties, especially YouTube and the content network to increase the customer engagements. Just this past quarter, I can just name a few of these names which I think will indicate to you perhaps the nature of how we’re utilizing the salesforce to reach significant types of customers that we haven’t had as advertisers before: Nature Valley, an incredible campaign through YouTube, utilizing everything from the contest platform, brand channel, Contest Gadgets, the content network, FeedBurner so the complete host of our products. Other names like Forex which used CPC placement targeting; Toyota, we actually even had the World Economic Forum at Davos using the YouTube platform; Dunkin’ Donuts, VeriSign. So quite a diversity of advertisers now that we are working with through this integrated relationship across all the properties."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Thanks Omid. Hi Ben, it’s Jonathan. In terms of display and the type of ads that are doing well, if you think about it from a big picture perspective, we really feel we’re in a position to become the world’s largest display ads provider. Over 90% of the daily impressions that we have are eligible for display ads and pretty much all of the publishers accept our new format. The gadget and the rich media creative which are served by third parties are pretty much all being adopted by folks. I think that the biggest thing that we are seeing that Omid alluded to in terms of the examples is the concept of an advertiser owning a concept across the entire web and finding their whole audience. Another example is Activision. I think they use seven Google products to support the launch of the Tony Hawks Proving Ground Game and Search, AFC, the YouTube homepage and I think the in-video format is working particularly well. The one thing I would also add there is they are creating traction on mobile ads."
},
{
"speaker": "Operator",
"text": "Your next question comes from Justin Post - Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "Thanks, two quick questions. First could you talk about your display model? Do you really see yourself being able to make really interesting profitability on network sites or do you plan to maybe put some display advertising on your own websites, which appear to be growing quite rapidly? The second question may be for George, just the other cost of revenue growth is really about 80% if I back out some of the stock-based comp. I am just wondering what’s driving that, and is that YouTube related at all?"
},
{
"speaker": "Eric Schmidt",
"text": "Jonathan and Sergey, maybe you want to talk a little bit about display and how we are going to use it in our network in our own sites?"
},
{
"speaker": "Sergey Brin",
"text": "This is Sergey. Just real quickly, I mean there are certainly already sites that are Google-owned sites that run display such as YouTube, for example, is a very obviously prominent one. It has a lot of inventory and obviously that’s going beyond traditional display with the in-video kinds of ads that Jonathan mentioned. I think there are some other Google properties that might be good fits though we haven’t made clear decisions; I mean obviously more visual sites like Orkut there is some potential in Google Images but we don’t have any specific plans to announce today in that respect. I also think that we are certainly making progress on display in our network also and so I’m pretty optimistic on both fronts."
},
{
"speaker": "Jonathan Rosenberg",
"text": "The only thing I would add to that is now that we have got the DoubleClick acquisition behind us, we will also offer the AdSense sites a media planning tool integrated with Dart for Advertisers by DoubleClick. I think you’ll see that will substantially increase the lift that we are getting there."
},
{
"speaker": "Eric Schmidt",
"text": "George did you want to answer the second question?"
},
{
"speaker": "George Reyes",
"text": "The driver that you are alluding to is basically driven by data center related expenses, the associated depreciation that comes with that and bandwidth costs as well as some DoubleClick amortization."
},
{
"speaker": "Operator",
"text": "Your next question comes from Doug Anmuth - Lehman Brothers."
},
{
"speaker": "Doug Anmuth",
"text": "Thank you very much for taking my question. You mentioned 100 quality improvements were implemented during the quarter. Can you talk about the degree to which you’re already getting the price per click benefit and whether that’s up to your expectations thus far? Also, do you still stand by your previous view that Google really isn’t seeing any impact from the macro situation? Thank you."
},
{
"speaker": "Eric Schmidt",
"text": "On the macro side, we look at this really carefully and we do not see an impact as of this time. We’ve also had the internal conversation of, what would happen if it were to occur? Our conclusion is that we’re well positioned should economics change to continue to do well because our model is so targeted. Targeted advertising does well in pretty much most scenarios, we think. Sergey or Jonathan, do you want to talk a little bit about the other?"
},
{
"speaker": "Sergey Brin",
"text": "Let me just mention, the 100 search quality improvements I mentioned were to the search quality. I wasn’t referring to the advertising quality experience. But we’ve also made improvements there, of course. If you recall the clickable backgrounds that we eliminated recently which while they reduced clicks a little bit increased the quality of clicks, and I think our advertisers certainly appreciate that. But there are likewise -- I don’t know the exact number -- but there are certainly dozens, if not 100 improvements in advertising quality that we also launched over this quarter. That’s going to benefit advertisers and it’s going to benefit end users who are going to see more relevant, interesting advertising and obviously because those connections can be more fruitful, ultimately that benefits publishers as well."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Are you asking about what the specific ads quality improvements were or are you asking whether or not the scope, the degree to which the scope impacted pricing and RPM, what specifically are you asking about the quality?"
},
{
"speaker": "Doug Anmuth",
"text": "Well, obviously, as much as you are willing to share Jon. Honestly I am asking which quality improvements on the advertising side would you say have had the biggest benefits thus far?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Sure."
},
{
"speaker": "Doug Anmuth",
"text": "Are they driving price per click, to the degree to which you expected them too?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Sure, quality improvements intra quarter, so Sergey mentioned there were quite a few. I think they were relatively fewer in terms of impact in the quarter than we typically have. I think that was primarily not due to the number but it was due to the fact that more of them came relatively late in the quarter compared to previous quarters. I think the biggest ones that we alluded to publicly that Sergey did mention are the landing page quality improvements; we’ve removed a lot of the need for ad pages so there has been substantial improvements there. There also have been some policy changes, the visible and final URL policy matching so that users always know where they end up when they’re clicking on an ad which we think in the long run is very positive. I think we also announced the change in the UK trademarks policy so that we now removed the restrictions on ads on trademark keywords in the UK, which is the way that we had it to-date. These are all things that are great for users. I think that UK piece isn’t going to go live until Q2 so I am not sure it had much impact in the quarter. But the one other thing that I saw, some folks have noticed was just a very modest test which was our automatic matching beta test and that’s basically trying to extend an advertiser campaign’s reach by finding ads on relevant searches that aren’t triggered by the advertiser’s keyword. But that’s really relatively modest because that’s just an initial test that we just started."
},
{
"speaker": "Eric Schmidt",
"text": "Just to add one more clarification. We often don’t know the exact improvement that we are going to see in the very short term so at least from my perspective, I’m more concerned that the improvements be put in place and that they work well and then of course we’ll get the benefit as the advertiser see those and as the network takes advantage of it. We can take the long view of that."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mark Mahaney - Citi."
},
{
"speaker": "Mark Mahaney",
"text": "I wanted to ask Sergey about some of the mobile data points. Are there enough data points, do you have enough experience particularly in the international markets now to know what the economics of mobile search could like relative to the PC search? Are the leads being generated off of mobile devices as qualified -- more so or less so? Are advertisers willing to pay more or less for that? I wanted to ask another question on the paid clicks. 20% year-over-year growth is obviously much better than was feared. There still is a pretty clear level of deceleration in the paid click growth on a year-over-year basis even if you trend line it going back a year-and-a-half. Part of that must be due to your quality initiatives. Do you think about it terms of trying to get to a paid click growth at a certain anniversarying of these paid click quality improvements whereby that growth will remain in the 20% or low double-digit rate at a more sustainable basis because of these quality improvements? Thank you."
},
{
"speaker": "Eric Schmidt",
"text": "Sergey do you want to talk about mobile?"
},
{
"speaker": "Sergey Brin",
"text": "On mobile, I don’t how the hard stats in front of me right this very second. I can tell you kind of anecdotally what I’ve seen in the countries and markets where mobile has developed in the sense that devices have high resolution, networks have low latency, the experience works which basically like Japan and a few others that are up and coming, the mobile search and ads work very well. I don’t have the exact data in front of me right now, as I said, but there is certainly nothing to dissuade me that it would be substantially worse than traditional desktop search. I think that if you look in the US and Europe which are a little bit behind those but I think are progressing, I think you’ll increasingly a greater volume and a greater quality of mobile usage and consequently advertising conversion ultimately. Now, you have a significant challenge in mobile in that the screens are much smaller so you just can’t go displaying nearly as much advertising or take as much space. On the other hand, you have much more relevant and timely information like what location the person might be in and so that on balance leaves me quite optimistic."
},
{
"speaker": "Eric Schmidt",
"text": "The short answer to your deceleration question is the answer is no. We look at the problem of paid clicks as one of the components of an overall quality improvement. We know that if we can improve aggregate quality we know that the value of a click, number of clicks and so forth will grow, and will grow at whatever the technology will allow. So if you look, our absolute growth rate has been very, very significant and we’re very, very optimistic that this model of staying focused on quality will give us not only the strongest ad network but a much broader set of solutions for advertisers and it works well."
},
{
"speaker": "Operator",
"text": "Your next question comes from James Mitchell - Goldman Sachs."
},
{
"speaker": "James Mitchell",
"text": "Great, thank you very much for taking the question. One question was with regard to the user response to Universal Search in non-US territories, have you rolled it out? In particular, why do you think Universal Search can help you gain share in those countries where you are not the market leader and where the incumbent lacks comparable functionality? The other question, I was just looking back over the past few quarters, I believe you stated your business was less seasonally affected in the summer months in 2007 than in prior years. Do you think that something is structurally changing your business to reduce seasonality or do you think that 2007 was erratic in someway?"
},
{
"speaker": "Eric Schmidt",
"text": "On the seasonality I’m not sure I agree with that characterization. There are so many variables that have to do with product improvements, product launches, customer deals, renewing and change in TAC rates, all of those kinds of things, it’s very difficult to say that looking at an aggregate number, in particular a change in seasonal growth rate, was a very big deal. We know there is a seasonality in the business; it’s very difficult for us to know exactly where it is. As you correctly pointed out, Q2 and Q3 are traditionally weaker quarters and my guess is that that will be simply true because the majority of Internet users are still in the Northern Hemisphere which is where people tend to take summer vacations. Sergey, do you want to talk about Universal Search?"
},
{
"speaker": "Sergey Brin",
"text": "On the Universal Search I think Universal Search is a very big win from the point of view of the Search experience. Now in some of these international markets like if you look at Korea in fact the local competitors there do have something that’s very much akin to Universal Search. So in fact I think the people’s expectations there are already to have Universal Search results and so its not necessarily something new we are introducing to them there. I think our ability to rank and bring in these diverse corpuses that we have will surprise people and they will be impressed by how good it is. In other markets you are right, I think that these additional corpuses and our ability to blend is a substantial distinction and I think we are going to benefit from that in fact and obviously we have lots of international or foreign language videos and images and so forth and we have a certain number of books as well in there. I think we are going to benefit from all that hard work that we’ve put in those corpuses."
},
{
"speaker": "Jonathan Rosenberg",
"text": "This is Jonathan adding one narrow point and one broad point on your question about seasonality. Narrowly within each quarter, there are things that make one year significantly different from another; this year you had Easter falling actual in Q1 whereas in previous years it has fallen in Q2. On the other hand offsetting that this year you had a leap year which in this year was actually on a Friday although since it added one more day in the quarter, the net results of leap year was giving us one more Monday in the quarter. When you think about that, that actually equates to something in the ballpark of about 1%. The broader question in terms of the business moving forward with respect to seasonality is highly dependent on market share. In many markets if you look historically we were gaining share and in some cases in previous years that’s significantly masked seasonality. In markets where we have very, very high share then the business starts become, it starts to look more seasonal in nature than it has in the past."
},
{
"speaker": "Operator",
"text": "Your next question comes from Imran Khan - JP Morgan."
},
{
"speaker": "Imran Khan",
"text": "Larry, you talked about a monetization improvement for social networking, how you are doing more demographic targeting. Could you please give us some color like what kind of progress you made monetizing social networking compared to Q4? The second question is regarding how you’re improving the search quality in the international market. Can you give us some sense in terms of the frequency of search in your lesser developed countries like Continental Europe compared to more developed like US and UK, the frequency of search volume per person? Thank you."
},
{
"speaker": "Larry Page",
"text": "On social networking monetization, I think its been an area where we have really applied a lot of new technologies and then some of the demographic targeting and so on, which has been very successful. I think the challenge and the opportunity there is there is a huge amount of inventory. We have obviously MySpace, Orkut, Inner Network and a number of other social networks. There is a lot of usage of those. So there is a tremendous amount of inventory and so part of it is just getting that advertiser ecosystem built up and people targeting that inventory and doing it in a way that makes sense for those advertisers. So I think we’ve made a lot of improvements and I’m optimistic that there are improvements to be made. That’s balanced against tremendous inventory levels in those areas which it takes some time for advertisers to really realize they are there and start targeting effectively."
},
{
"speaker": "Sergey Brin",
"text": "This is Sergey. I don’t think we consider Continental Europe less developed. I do think that in the advertising space, we have seen that they are sort of coming up on the ramps that the US and UK might have been a year or two ago. So that obviously gives us great opportunity for growth advertising-wise. But in terms of basic Internet usage and searches per user, while once again I don’t have the data in front of me, what we’ve seen is it typically just depends on broadband penetration and quality of broadband and the more people have access to great networks and computers to use them the more searches and overall internet usage they will do. That’s why you see this skew during the week, that Monday to Friday we do tend to get a lot more usage than on weekends. Obviously part of that’s because people are relaxing off the Internet on weekends, but part of it also is that typically often people at home don’t have as good connectivity and Internet access as they do at the office."
},
{
"speaker": "Operator",
"text": "Your next question comes from Christa Quarles - Thomas Weisel Partners."
},
{
"speaker": "Christa Quarles",
"text": "You mentioned in the UK that travel and finance has rebounded, I was just wondering if you could discuss travel, finance and hopefully retail more broadly across the US and some of your other geographies in terms of strength or any relative weakness? The second question is should Yahoo! choose to outsource part of Search to you, I was wondering if you can discuss philosophically what the benefit would be to Google’s own property in the sense that you have a broader, deeper ad network, broader advertising if you will, coming to the site?"
},
{
"speaker": "Eric Schmidt",
"text": "On the Yahoo! question we are very excited to be participating in this test, at the beginning of the second week on the test. I don’t think it’s really appropriate to speculate beyond that but its nice to be working with Yahoo! and we like them very much. Omid, do you want to answer the UK question, or Jonathan?"
},
{
"speaker": "Omid Kordestani",
"text": "We will both probably take this on. I mean in general what we are seeing is that these verticals really behave by region as you are indicating, and they are the factors that determine for example in each geography we have talked about this in the past, renewal rates for finance or travel reservations that get done in UK drive those verticals. I think, in general we saw in Q1 a bit of a slowdown in retail, some postponement of budgets but we haven’t seen anything that kind of significantly indicates to us that one vertical or another is at risk here. We are just going deeper into these accounts, and in some cases when the budgets are delayed its made up by other online categories."
},
{
"speaker": "Jonathan Rosenberg",
"text": "I think if you think about what economists would typically theorize in a macroeconomic climate that was slowing they look at sectors like some of the ones you’ve mentioned – automotive, luxury goods, we also track travel and finance -- and you look for the ones that are more sensitive to macro-economic conditions, and look to see what’s going on with them. What we tend to see is that clicks in some of those sensitive areas do grow a little less rapidly than our overall growth so the share of their total queries is actually down but on an absolute basis, they are all showing healthy growth in ad revenue. In the UK, for example, people are clicking on travel and local ads at a higher rate than they do in the US. In finance, although certain components of finance are down, foreclosures are up and even more mortgages do pretty well, if you think about foreclosures, every foreclosure at some point becomes a home sale and a mortgage to somebody. So generally what we are seeing is absolute growth even in those areas that are otherwise adversely impacted by macroeconomic conditions."
},
{
"speaker": "Christa Quarles",
"text": "You’re basically indicating that you tend to see price improvements in these areas as the conversions continue?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "It varies."
},
{
"speaker": "Eric Schmidt",
"text": "I think the best way to say it is that it’s possible that prices grow up in that situation simply because of the great value of targeted advertising."
},
{
"speaker": "Operator",
"text": "Your next question comes from Brian Pitz - BoA Securities."
},
{
"speaker": "Brian Pitz",
"text": "Can you talk about how much of your international growth is really due to the sunsetting of European best practice funding? Separately, would you provide any updates on China and perhaps discuss any new initiatives that Kai-Fu Lee and team may be working on over there? Thanks."
},
{
"speaker": "Eric Schmidt",
"text": "Sorry, could you repeat the second question?"
},
{
"speaker": "Brian Pitz",
"text": "Sure, just updates on China and the team Kai-Fu Lee, things that they’re working on over there, some new initiatives we may not have heard about?"
},
{
"speaker": "Eric Schmidt",
"text": "On the China side, things are going well. Why don’t we move to our next question?"
},
{
"speaker": "Operator",
"text": "Your next question comes from Ross Sandler - RBC Capital Markets."
},
{
"speaker": "Ross Sandler",
"text": "Great, thanks for taking my question guys. Looking at the US growth rate of 30% approximately in the first quarter, if you had to characterize your small, medium-sized self sign-up advertisers versus your large agency or direct enterprise-sized advertisers, which segment was growing faster in the quarter relative to that 30%? Thanks."
},
{
"speaker": "Eric Schmidt",
"text": "Again, I’m sorry we had a phone problem here. Could you just repeat the substance of the question again?"
},
{
"speaker": "Ross Sandler",
"text": "Sure. The growth rate in the U.S. is 30 % year over year. If you had to characterize which area was growing faster between the small to medium-sized self-signup advertisers on your platform versus the larger agency or direct enterprise type clients, which was the faster growing segment in the quarter?"
},
{
"speaker": "Omid Kordestani",
"text": "I don’t have the actual breakdown in front of me right now. What I will say is we are doing very interesting collaboration between both of our channels; in fact, in some regions we have three with some resellers involved. One of the things we tend to do is just try to put our relationships with the customers into the right channels. So in many cases where we find that we can in a very effective way service our clients through our online organization we do that and that organization in fact has top-tier clients now that are even some brand names that are well-served by our organization. What we’re trying to do with the direct sales organization is really focus on those higher-end calls into the C-level if you will, to the CMO level where also we are presenting the full suite of products and integrated campaigns between YouTube. In the US obviously we’re also experimenting with a lot of the new initiatives from TV, radio, advertising, and so perhaps on a follow-up call we can get you more specific stats on the different geographies and the ratios between those two channels. But, there is a lot of movement of customers that we do again to optimize the relationship with the customers."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Just trying to add little more to color to Omid. We definitely tend to see that it is the larger customers that are the bigger drivers of growth, whether or not on a relative basis in the previous year they were bigger drivers I think is unclear. But we have released a lot of tools like Analytics and the Conversion Optimizer and those are the type of things that tend to get adopted disproportionately by the larger, more sophisticated advertisers and we do see that as advertisers adopt those tools it substantially fuels growth. So there certainly is significant growth with the larger advertisers."
},
{
"speaker": "Operator",
"text": "Your next question comes from Heath Terry - Credit Suisse."
},
{
"speaker": "Heath Terry",
"text": "You mentioned that you are seeing much better click-throughs on the overlay ads versus your normal banner ad. By our measure, we’re only seeing running overlay ads running on content where you have clear relationships like the NBA and Universal Music. What are the barriers to running ads on a broader spectrum of YouTube’s inventory, particularly the user generated content that you’ve got?"
},
{
"speaker": "Omid Kordestani",
"text": "What we’re really focused on right now is working with YouTube management channel team to really actually go from the, if you will the plumbing, and work all the way up with the customer’s advertiser fee; there is a lot of integration work going on. YouTube was already a large DoubleClick customer and we are trying to basically streamline how the integration of DoubleClick and YouTube can be improved and how we can take advantage of our ad networks so that more of these advertisers could be represented. How do we work with the owners of content, user-generated or otherwise, to actually find the right match-up with the right advertiser so if we basically have a much better targeting of ads and also promotion of the right types of content. So it’s a very comprehensive plan that we have put in place. We have a 2008 plan that has a very specific milestones again all the way from the systems and infrastructure that we need to provide that integration all the way to the different types of ads. I think it’s very early to make any kind of a judgment about which ads are working well and which ones are that we’re really trying to have these integrated campaigns, try it out with the salesforce and our customers and do a lot of learning and settle in to a product roadmap."
},
{
"speaker": "Eric Schmidt",
"text": "Thank you. Let’s have a couple more questions. It looks like we missed a question so maybe we could get that caller to call back in as well. Operator, let’s go ahead, next question."
},
{
"speaker": "Operator",
"text": "Your next question comes from David Joseph - Morgan Stanley."
},
{
"speaker": "David Joseph",
"text": "As you integrate DoubleClick into AdSense should we expect that to be a growth driver in addition to contextual ads or is it possible that it actually starts to cannibalize contextual advertising? Also, how is Google Ad Manager going to coexist with the DoubleClick Technology or ad serving technology? Also, should we assume that obviously DoubleClick is running AdSense revenue from here on out? Thank you."
},
{
"speaker": "Omid Kordestani",
"text": "In terms of the DoubleClick products, we really are optimistic that where we are headed to is where our Head of Sales in the US, Tim Armstrong, calls the CMO dashboard. What our hope is that by basically providing the integration across the board here we end up having in a simple way again a lot of DoubleClick access more towards advertisers and having the DoubleClick advertisers have access to the AdSense network. That’s our goal and so we’re really hoping that all of this will be incremental and that ultimately we get to a point where the CMOs can have a very effective way to measure the effectiveness of the advertisers and do the right allocation of their ad budgets across the board here."
},
{
"speaker": "Eric Schmidt",
"text": "Jon, did you want to add anything to that?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I think the only obvious thing to add is that adding more display creates more competition among advertisers; we’ll have more premium inventory from publishers and those things will certainly be added to fuel each other. We certainly don’t think [inaudible] ads are going to result in any kind of cannibalization. There is plenty of reasons to believe that they are positive dynamics and its unclear that there are any negative ones."
},
{
"speaker": "Operator",
"text": "Your next question comes from Brian Pitz - BOA Securities."
},
{
"speaker": "Eric Schmidt",
"text": "Thanks, Brian. It appears as though we didn’t hear your question because there was a phone problem so I apologize. Maybe you could ask your question again, and we will restart up."
},
{
"speaker": "Brian Pitz",
"text": "Sure, no problem. I’m just wondering how much of your international growth was due to the sunsetting of the European best practices funding that you guys had talked about before. Separately, you mentioned 90% of impressions are eligible for display. Can you talk about the effective CPM difference between display and formats versus text links on your network? Thanks."
},
{
"speaker": "Eric Schmidt",
"text": "On the first question, Omid, do you want to talk about -- could you repeat your China question for me?"
},
{
"speaker": "Brian Pitz",
"text": "Just an update on China. We just wanted to get a sense for any new initiatives the company was working on over in China, there have been some articles out."
},
{
"speaker": "Eric Schmidt",
"text": "Let me give you a sense on the China situation. We are seeing market share growth and good revenue growth as we have learned to operate in that environment. Although the advertising business is nascent in China, the fact of the matter is that the Chinese Internet is so large that even on a small basis the numbers add up to quite significant with good growth rate. We believe that China will continue to be a good market for us. As we hopefully gain share we have significant new products for the Chinese, Knowledge Chinese, Users Chinese Language, Chinese Search and that’s our core growth, so the message there is good. Omid, do you want to talk about the international?"
},
{
"speaker": "Omid Kordestani",
"text": "Yeah on the ETS really it was something we announced a while back and our goal really is to have a very successful relationship with agencies across the world. We just felt that the previous program and actually the goal of the program is really to reward the way we engage properly together in servicing advertisers and also going after these new initiatives. The real performance in Europe comes from the great work that the European team is doing and really understanding the dynamics of the business, putting the right customers in the right channels in each region really understanding the dynamics of each industry vertical that we are selling into and paying attention to the seasonality effects and where to put the resources and servicing and selling clients. On the CPM and CPC question really our goal there is simply to allow again the advertisers to pay the way they wish between the display products and the text products. Ultimately the goal here is to focus on conversions for them so how they can best measure and achieve their campaign objectives."
},
{
"speaker": "Eric Schmidt",
"text": "Jonathan do you want to talk about display?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "The question specifically related to content and display and the dynamics in terms of how they interact and how that works and how that’s going?"
},
{
"speaker": "Brian Pitz",
"text": "It was more along the lines of just the effect of CPM difference between display formats and text links on the network."
},
{
"speaker": "Jonathan Rosenberg",
"text": "I mean basically what we are doing is we are trying to come up with a way to manage the auction so that you can have the display ads competing with the text ads and multiple text ads basically in the auction have to compete in such a manner that they trump the value of the display ads. So typically three text ads versus one display ad unit. We’re still basically working through that. So that’s basically how it works, I am not quite sure what else you were asking."
},
{
"speaker": "Eric Schmidt",
"text": "Why don’t we go ahead and get our last question. Thank you very much, Brian."
},
{
"speaker": "Brian Pitz",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mark May - Needham & Company."
},
{
"speaker": "Mark May",
"text": "My question is focused on the US revenues which grew $29 million sequentially. If one could make an estimate of DoubleClick’s contribution, one might conclude that the US revenues were flat to maybe up, marginally, sequentially. Eric I think earlier you said you’re not really seeing a meaningful impact on the business from the macroeconomic environment. I think it was also mentioned that the majority of these search quality improvements occurred outside the US. So the question is, is the sequential growth that you put up this quarter which is far lower than what it has been in the past, is that more a reflection of where we are in the search cycle, search out cycle in the US or given that it’s not really macroeconomic… that would be great."
},
{
"speaker": "Eric Schmidt",
"text": "Well we know what it’s not. We know that it is not macroeconomic. It can have as much to do with the timing of deals, partner activity, the timing of product rollouts and the maturity as you pointed out of the US market; also the rate at which both search quality improvements play out within the quarter as well as advertising quality, because again they don’t necessarily implement exactly linearly in the quarter across every geography. Jonathan, do you want to add any perspective to that?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I think the only obvious thing to look at is you have to be very careful when you look at the annualized year-over-year comparisons to try to isolate the impact in a quarter. The biggest thing that you would separate out there from the US relative to international, is that in the base quarter that you are comparing to which would be this quarter of last year we added a lot of really big partners in Q1 of last year to AdSense and so relative to that year this year we didn’t have that many incremental partners to add so I think that’s everything else being constant otherwise leading you to see what appears to be a relative reduction in the US. But it’s primarily a factor of that. There is also the AdSense for domains cleanup, which we talked about earlier."
},
{
"speaker": "Eric Schmidt",
"text": "And my guess is that the two that Jonathan described are the primary cause and we have to go back and really match it all to be sure. Let’s finish up by saying first thank you very much for everybody spending -- your time is valuable, spending more than an hour listening to us and talking about Google. I also wanted to take a minute to thank Omid for something, I don’t Omid if you remember but right after I started here I told you to go get on an airplane and go build some international operations. You flew to London and the rest is history. This is the quarter where we are now 51% international revenue. I don’t think that percentage is going to go down; the world is a very big place. Congratulations to our international sales teams, the international leadership for making Google a truly global company. Thank you all."
}
] | null | null |
GOOGL | 4 | 2,009 | 2010-01-22 16:30:00 | Operator: Good day and welcome everyone to the Google Inc. conference call. This call is being recorded. At this time, I would like to turn the call over to Maria Shim, Senior Manager of Investor Relations. Please go ahead, Ma’am.
Maria Shim: Good afternoon everyone and welcome to Google's fourth quarter and fiscal year 2009 earnings follow up conference call. With us are Patrick Pichette, Chief Financial Officer, and Jonathan Rosenberg, Senior Vice President of Product Management and Nikesh Arora is also going to be joining us for the first half hour so if you have specific sales, geographic vertical questions for him please direct them to him in the first half hour of the call. After we cover a few housekeeping items we will begin taking questions. This call is being Web cast from our Investor Relations Web site located at investor.google.com. Please refer to our Web site for important information, including our earnings press release and related slide deck. A replay of this call will also be available on our Web site in a few hours. Please note that we routinely post important information on our Investor Relations Web site located at investor.google.com and we encourage you to make use of that resource. As a reminder, the purpose of this follow-up call is to give participants the opportunity to ask more detailed financial and product questions in an efficient and Reg FD-compliant manner. Let me now quickly cover the safe harbor. Some of the statements we make today may be considered forward-looking and these statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings, including our annual report on Form 10-K for the year ended December 31, 2008, as well as our earnings press release for a more detailed description of the risk factors that may affect our results. Copies can be obtained from the SEC or by visiting the Investor Relations section of our Web site. Also, please note that certain financial measures we use on this call, such as operating profit and operating margin, are expressed on a non-GAAP basis and have been adjusted to exclude charges relating to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and GAAP to non-GAAP reconciliation can be found in our earnings press release. With that, we are ready to take your questions. Operator?
Operator: (Operator Instructions) The first question comes from the line of Samit Sinha – JMP Securities.
Samit Sinha: I just wanted to get some more details about CPC growth sequentially. Are there any specific circumstances in the past quarter about how emerging markets where query growth has been strong but CPCs have been lower. Can you just quantify that impact? Secondly, on the CPC question itself anything specifically in Europe regarding to where trademark bidding has slowed down or the efficacy of that has slowed down and maybe pulled down CPC with it?
Jonathan Rosenberg: I will let Nikesh comment on any specific issues related to Europe or any dynamics he is seeing there on the trademark issues. The specific issues which we have traditionally talked about a lot, you are looking at average CPC which obviously is a blended number and it is impacted by some of the things you suggested such as the relative growth in maturing markets versus established markets had some anomalous dynamics when you look at this quarter which I would highlight. First and foremost the FX movement. The dollar was weaker in Q4 2009 when you compare to Q4 2008 so that causes the non-US clicks to have higher CPCs when reported in dollar terms. I think the other thing you may not see is there is an important mix effect going on. We made some quality improvements on the AFC network and basically that had the effect of reducing the total clicks in the AFC network relative to what it would have otherwise been. So we had a higher proportion of clicks coming therefore coming from Google.com and from AFS and that is a mix shift that caused the blended average of CPC the way you are seeing it to otherwise rise. So those are the two things I think are more different in this quarter than in the past. Otherwise I don’t have any more insight.
Operator: The next question comes from the line of Aaron Kessler – Kaufman Bros.
Aaron Kessler: A question on the local side on mobile and how that ties in. There is a lot of assumption on the mobile side that is really going to head out to local group longer term. Just your view on that and how you are seeing the growth on the local side develop to drive mobile longer-term here?
Patrick Pichette: I think that one element of mobile is local but I would far and away not only pin it to local. There is no doubt we are having some great experiments on local but on mobile what you have is a whole set of searches and a whole set of activities that actually just transcends clearly just a local business. Those searches obviously are going to also fuel it. It is a mosaic of opportunities but local is just one of them. Jonathan maybe you have additional comments?
Jonathan Rosenberg: I think local is hugely important. It is going to be much more important in the not too distant future because as we are seeing more integration and as I mentioned in some of my other remarks people who are shopping offline start online and today people still don’t have access to the inventory information of the local stores. I mentioned that in mobile we are seeing that when phone numbers and coupons are offered people are much more likely to click on the mobile ad. Well imagine if the inventory information is there so they can actually consummate a transaction locally. As that information becomes available local is going to be much, much more powerful. We already have some examples where advertisers like AT&T are using some of our local products to help people find local stores. I think we are just starting to get there in terms of capabilities that are going to be necessary for local to take off. But I think local is going to matter much more on these devices because obviously they know where they are with GPS.
Aaron Kessler: I think you filtered out some of your advertisers this quarter. Maybe it was just in essence for content. Maybe you could provide some more details around that?
Patrick Pichette: Sorry could you restate the question?
Aaron Kessler: I think there were some reports that you may have filtered out some of your advertisers this quarter on the ad sense side. Can you provide any more details about that?
Nikesh Arora: Obviously we are constantly looking at our advertisers to see whether there is an extraordinary [expand] that is happening. We have thrown in those advertisers who repeatedly attempt to scam users. So we went through one of our regular processes of looking at advertisers and seeing which ones of those we though weren’t adding quality or adding sort of value to our users. In those cases we chose to suspend them permanently.
Jonathan Rosenberg: This was happening this quarter with the approach we took to suspend the repeated scam users as opposed to before where all we were doing was disabling certain bad ads.
Aaron Kessler: Does this have any material impact on the quarter numbers? It sounds like it could have had a slight impact from what I was reading.
Jonathan Rosenberg: No the impact is slight. It is a relatively small number.
Operator: The next question comes from the line of Ross Sandler – RBC Capital Markets.
Ross Sandler: First on the cyclical nature of paid click growth and then a follow-up from James’ question earlier. So on paid click the growth rate has been decelerating pretty steadily for the last couple of quarters based on some of the mix and some of the natural deceleration you talk about. Do you see any evidence in your data that as the economy recovers in 2010 that paid click could actually reaccelerate? For instance in the fourth quarter you had a reacceleration in the domestic market. Did paid clicks reaccelerate there? What are your thoughts on that? A follow-up from James’ question on the international stuff if we do the math correctly, international growth X currency and X hedging decelerated to around 16% from 19% last quarter. Can you talk about what is driving that deceleration because I think it had accelerated in 3Q.
Patrick Pichette: On the paid clicks the only thing we could tell you because we can’t give you any perspective is obviously as every place there is a recovery and there is robust auctions. There is also seasonality within those auctions. You can have increased CPCs. So that is really the fundamental driver of the CPC growth.
Ross Sandler: You don’t see consumers clicking on ads, not the CPC but actually the volume of page clicks, you don’t see that incidence increasing when the economy is better?
Patrick Pichette: Yes absolutely. People search more and as they search more not only do they search more but they click more. No doubt about it. If you remember if you go back to a couple of quarters ago we had this conversation where we said because people were more shy of shopping they clicked less. So it was a consumer driven phenomenon that drove our CPC at the time. It was simply that no matter how the auction operated the fact that people clicked less. As the economy recovers and people click more obviously it will have an effect on CPC. As for the international, Nikesh do you want to cover the international portion?
Nikesh Arora: I think the important thing to note is if you compare and look at last year’s Q4 we had a decline in the US much more sharper than what we saw in the international markets so the comps in the US look much better than they look for international regions. In addition to that many of our new product areas which we staged globally start in the US and make their way across the globe we have had more of them do well in the US than they have done internationally. So purely from that perspective the US is going to look slightly stronger from the rest of our international markets.
Operator: The next question comes from the line of George Askew – Stifel Nicolaus.
George Askew: First, has Google since the first of the year finished implementing the caffeine search architecture across all your data centers?
Nikesh Arora: I don’t know that we are finished implementing it. I know…
Jonathan Rosenberg: I believe the answer to that is no. The answer to your question is not yet.
George Askew: Obviously display advertising is a huge push for the company. Can you help us please understand how much of your display advertising revenue is from owned and operated properties such as YouTube and how much is powered by tools of Google but does not appear on your websites like Double Click?
Patrick Pichette: We don’t give the mix but clearly it is all of the elements at work.
Nikesh Arora: The best way to think about our business on the display side is we have our business on the display side which corresponds to [inaudible] which is where brand marketers looking for premium advertising slots look to YouTube as a property they want to advertise in competition with other premium inventory that is out there. If you go to the next level the best way to think about them are network which is our collection of publishers which are all the way from small publishers to certain large publishers who give us access to inventory which we are then able to selectively sell at the network both using conceptual advertising as well as using intraspace advertising and that is of course is a different profile as it relates to the margin and revenues as compared to YouTube. The third part is where we use both our tools as well as our exchange properties like Ad Exchange and Double Click platforms which is where you can have different buyers and sellers and different people who put inventory and people who have inventory and that is beginning to gain traction now and most of our top ad networks are in that space. Clearly again that is a very different pricing profile and margin profile in the market. So that is the way to think about our three different businesses from a structural perspective. Clearly from an advertising perspective when we make that pitch we offer the entire gamut of services depending on what campaign objectives they have and what they are trying to achieve.
George Askew: Would Google have another owned and operated display ad site?
Nikesh Arora: We are currently experimenting with various properties we have to see what is the best mechanism and the best format of advertising to use.
Operator: The next question comes from the line of Scott Davis – JP Morgan.
Scott Davis: I think I have a follow-up to Ross’ and James’ question about the rest of the world growth. Given that it decelerated and I understand the products in the US haven’t rolled out there, that would explain why it wouldn’t reaccelerate but it doesn’t explain the deceleration so it sounds like you are saying the primary answer is just the comps which did in fact get a lot more difficult versus the fourth quarter of last year. I was wondering though if there is a third element which has been a number of times on the call it was mentioned large advertisers have come back first. I guess I was wondering if you could give some color on whether the rest of the world make up of advertisers is more small advertisers as compared to large and therefore that lagged a little bit for that reason as well or was it just purely the comps for the first reason that I said?
Nikesh Arora: Thank you for the excellent question. I think there are three elements to what you asked. One clearly is the comp element because as Patrick would say we have had a v-shaped recovery in certain markets we have had sort of a slightly elongated return of markets and some of the markets have been bobbing around. So clearly in the US we have seen a sharper rebound than we have seen elsewhere where they had not as sharp of a decline. So clearly one is a comp issue. The second issue has also to do with the advertiser mix. Actually the large advertiser phenomenon is over weighted to the US than it is towards the emerging parts of the world so in various emerging parts of Southern Europe or in various parts of Asia, Latin America, the Middle East and the other parts of Europe we are clearly not seeing as much divergence between the large advertisers and small advertisers in those markets. The large advertisers haven’t been as aggressively back as they haven’t as aggressively left in the first place. The third case is clearly in some of those markets which are nascent what happened is as the economy took a hit or a stuttered earlier they actually reprioritized their spending and some of them may have pulled back from search and it just takes a little bit longer to get them back onto online advertising because in those markets they are not as reliant or as convinced of online advertising but clearly as I said in places like Brazil we will be making huge efforts to get the education up on advertising and we do that around the globe.
Scott Davis: Do you have an expectation, just to follow-up you are clearly pleased with sales and it is easier for the street including myself to get ahead of ourselves because we can do channel checks and hear about the US and hear about the U.K. and those things accelerated nicely. So it feels like the only thing the bowl is missing is just some condition on when you will see a reacceleration in the rest of the world. Part of it will come just because the comps are getting a lot easier. Do you have a suggestion for what kind of lag you think is involved for those?
Nikesh Arora: Clearly I am not going to try and speculate numbers and try and figure out when these things are going to happen. From a long-term perspective when you think about the US versus these markets clearly some of these markets are further behind in terms of the development where the US is and where certain parts of Europe is. For example, the U.K. is very advanced in the online market. Even if we look at the evolution of some of these markets over the last 3-4 years we have seen a trend. The trend suggests that over time people will start getting more convinced about online advertising as more and more consumers in those markets get online as more and more broadband penetrates those markets. Both dynamics are clearly easy for the street to understand and try and project. Based on that my long-term conviction is that we are going to see the continued shift towards online advertising both on the search side as well as on the display side as Patrick alluded to in the earlier call where the television market is another huge market where the eyeballs are beginning to shift and advertisers will want to target those audiences and we feel confident the tools we are developing based on our experience in the US markets can be deployed around the world. In the long-term I believe there is clearly growth into those markets. I can’t project which we are going to show it in.
Patrick Pichette: I think just as a general comment on the overall total revenue and then the difference between all these markets and geographies, as we said on the previous call we are really pleased with the trajectory of the company and the reason for it is you can see how a quick rebound in the economy in the US, not a strong rebound but a quick rebound actually you can see the leverage model of the Google model so in that sense I think we take a lot of comfort for the long-term.
Operator: The next question comes from the line of Jim Friedland – Cowen & Company.
Jim Friedland: On G&A if I look at Q4 versus Q3 it actually moved up decently. Last year it was flattish but then you were really working on the costs. Was there anything one-time in nature or unique about that increase or was it seasonal or is this just getting back to sort of a more traditional pattern?
Patrick Pichette: I think on G&A the two big areas we talked about one of them was actually ramping up our marketing as we discussed on the previous call. We also had a few expenses more than would be ordinary on the legal side and so those would be the kind of two big bumps in the quarter. Nevertheless, very much under our control. If you think about it if there is one thing we have proven this year at Google is our ability to actually really control our expenses and dial where we think we are going to get a great payback and a great return. That is exactly what you have seen in Q4 where when Eric talked about let’s push back the investments let’s go back into making sure we run the business the way we want to run it. Obviously when you have areas like marketing broadly defined that is the first place you can actually turn on the dial to get a real impact back. That is why we moved that way.
Jim Friedland: On marketing, with the Nexus One we have seen some ads around the Google network but we haven’t seen any more traditional advertising given that it is sort of a meaningful product launch and you are trying to change an industry. Why haven’t we seen a push in that area or are you just telling us that you are going to use sort of the traditional way that Google has gotten out there?
Patrick Pichette: Nikesh will probably have more details on this. Because we launched the product and it is really a new model we are trying to launch with the online store, all we wanted to do and we had so much advertising anyway and marketing around the product itself. We didn’t deem it necessary to actually push it in the same way that other, more traditional channels would have done.
Nikesh Arora: I think Patrick said it and I think we alluded to this in the earlier call that as Eric said this is a new way for selling mobile phones. Clearly the first target group we can go after are the people that like Google, who are the Google aficionados, people who are online, and since we are trying to come up with a model for selling something online it is perfectly logical for us to do online marketing for that and as this evolves and as we test it we can explore other ways going forward.
Operator: The next question comes from the line of Heath Terry – FBR.
Heath Terry: Eric touched on this a little bit on the call but can you give us an idea on where you are seeing the most traction in your display efforts? As you look at the Double Click ad network what are its competitive advantages and what does the development path look like there?
Patrick Pichette: In terms of display I think that Nikesh in the way that he portrayed it a few minutes ago there is really…Let me just give the high level answer and then Nikesh can add color commentary. There is a simplification of the process with Double Click and the Double Click platforms for both the publisher and the advertisers, the simplification of all that has made a huge difference and we can see it in the numbers of people signing up for it. Obviously on the performance and the markets two other big thrusts that actually are good trajectories. Maybe Nikesh you would want to give a bit more in the display itself?
Nikesh Arora: I think that it is very important to think about the evolution of the display market. In the early days of display we have been selling sites and as we look at it there has been a huge explosion of the sites. There are millions and millions of websites that you can actually decide to target ads and target display ads. Now the challenge that it creates is on two ends. One is it creates a challenge in consistency which is where products like Double Click which creates some degree of consistency are served and how they are put across the board and products like Ad Exchange begin to help. Because effectively you are trying to create a consistent way of serving ads in the market. The second part also is sort of the inefficiency of the selling side. It is very hard for an advertiser to go to aggregate multiple sites and try to buy them individually. So it really helps to have an exchange. They can aggregate tremendous amounts of inventory. If you do both of those things then we can layer on top of that both contextual and intraspace advertising. So that is the way to think about it. We are slowing shifting the display behavior to look and mimic what advertisers are currently used to buying. They have been used to buying audiences on an aggregated, large scale. The way we are able to put together the Google Content Network, the Ad Exchange and the Double Click platforms we are trying to replicate the ability to buy large audiences. As that begins to happen and as they are [rebuilding target] more and more you clearly expect it becomes more relevant or them and therefore the prices will react accordingly to the that [inaudible] of the advertisers.
Jonathan Rosenberg: I would summarize the competitive advantage as we are making it easy to buy, sell and serve display ads. One of the things I think is particularly exciting which Eric was asked about on the call earlier was this shifting budget dynamic. One of the dynamics that has been very positive that we have seen is that with products like display ad builder we are actually bringing a lot of new advertisers to display. They can much more easily create display ads now. They can do it directly from the ad works interface. It turns out they are new advertisers to display and they are not fundamentally decreasing their budgets in search so we are winning on both sides.
Operator: The next question comes from the line of Richard Fetyko – Merriman Curhan Ford.
Richard Fetyko: In the past you have talked about changes in ad coverage or density of coverage. I was wondering if you can characterize the changes in the last few quarters if there has been any. Secondly on the mobile strategy I am just wondering if the success you had with the adoption of the Android operating system for the mobile devices what role do you see that playing in your mobile strategy? Does that lead to a certain level of certain opportunity for monetization over time?
Patrick Pichette: Let me answer the mobile first and then I will let Jonathan answer the first question on coverage. The whole mobile strategy is built on building and accelerating an ecosystem. Obviously we have our own mobile teams that have developed these cool aspects. People who know Vic and all of the really cool applications that he conceives with navigations and all the rest, but it is above the ecosystem that there are three things; It really promotes innovation. It has a lower cost of innovation because by being open source you enable everybody to jump in and do it and then as a consequence you keep it open source. The benefit to us really is twofold. The benefit is users get better applications faster at market spreads faster everywhere. So think of the spread of high end devices faster and at a lower cost sooner which drives all these applications and so users get a benefit. Then as a consequence of that as we have talked before consumers that have Android devices we know from our own research they use it 30 times more than what a typical handset would be. In consequence they do a lot more searching and there is a lot more advertising opportunities. So pushing that ecosystem is so critical because that is where the world is going. If you think in terms of NPV as the image I always use, what is the value of accelerating that? It is huge for the users but it is also huge for us. That is why we are pushing it with the three dimensions of mobile, Android and now with the Nexus handsets to kind of set the standards at a higher level. So that is the mindset in which we operate. We benefit nicely from it and so does the user. Now for the ad coverage, Jonathan?
Jonathan Rosenberg: As you know we really don’t break down the components of the RPM equation specifically to cover CPC or click through rates. We have told you in the past on a couple of occasions where there has been a situation where we noticed a dynamic that caused us to make a change which we mentioned a few quarters ago in the past. Right now I think we are pretty happy with where coverage is. We have mostly been focused on improving the quality of the ads themselves and we have talked to you a bit in the past about the tradeoffs we make there in terms of how we decide to take improvements with respect to quality and coverage. I think the main change you can probably see is the new formats we have been launching which we talked about which basically offer a better experience within our ads rather than new ads that were not otherwise showing today. There is not a lot to say in terms of fundamental changes in coverage.
Operator: The next question comes from the line of Mary Meeker – Morgan Stanley.
Mary Meeker: You on the call were obviously very enthusiastic about the growth and monetization opportunities in YouTube, Mobile, Double Click and enterprise. That said desktop is still the vast majority of you revenue. You are the ones that are getting the inbound phone calls about people getting more interested in these categories and to Scott Davis’ question the stock market is not responding that well to your earnings announcement but at the same time you were really enthusiastic about 2010 per your tone and your commentary. Could you give us a sense of when these new initiatives start to add 100 basis points here and there or a couple hundred million of incremental revenue to the business? If not quantitatively just philosophically about when they start to move the needle because that would drive an acceleration in revenue for the company.
Patrick Pichette: Let me start by saying the following; One, display as Eric said is already a pretty significant business for us. In the sense when he talked about it is the next billion dollar business and when you take all of the elements that Nikesh has talked about if you think about YouTube and you think of all of the elements that are within it at some point in the future this will add up to something that we are excited about and two, that moves the needle. You could argue in many areas within this we have already started moving the needle. Then on the other ones, as you said they are nowhere near where the core business is but the trajectory and growth rates we see in the adoption rates and the adoption rate on users gives us…that is why we feel so comfortable when we talk about 2010 and beyond and building this business for the long-term. We see a lot of positive trajectories and we have to celebrate that because two years ago we couldn’t have said that maybe about mobile and we couldn’t have said that about enterprise but two years later when we stand at the end of 2009 we look at the great programs from Jonathan’s comment of putting a few arrows in the right places and then just putting more wood around them, we are very pleased about the trajectories that these have.
Mary Meeker: Is there any stuff around it you can provide us?
Nikesh Arora: If you just think about our business in the various ways we just talked about and I want to sort of underline that search is not by any means exhausted the scenario where we continue to make progress and we continue to see interest. I would say we are seeing more and more large advertisers coming in and that is not just a function of the economy. It is also a function of them having developed their e-commerce capabilities and worked really hard on having online strategies. So as they come forth and build their online strategies across multiple verticals we are beginning to see a resurgence and return of those guys into the online space. Having said that, in addition to from a direct marketing and direct response perspective the next leg which we are beginning to see a surge is that people are beginning to see the offline impact of people searching online. So even if you have a business where you are not selling something on the web it is very clear to most businesses whether they are in pharmaceuticals, consumer goods, autos that most people or 78% of the people will research something online which is a significant value to them or a significant importance whether it is a drug or a car, before they will go make that purchase or before they will make [inaudible]. Clearly that sort of research is being funded by us and various agencies out there and that is continuing to drive that cycle and whilst it is driving that in some of the more mature markets clearly those effects are still making their way into the emerging markets and maturing markets in Europe. So I just want to underline there is tremendous runway and surge still from where we stand. As Patrick said about display, again you have seen the shift from people buying sites to where people are buying audiences and people are getting more and more intraspace which that is how traditional advertisers are used to buying. They are buying frequency, they are buying advertisers, they are often not buying sites because sites over emphasize brand association as opposed to interest targeting. I think that trend is going to continue. If you think about the YouTube space and the online video space I think we have seen that sort of becoming a relevant part of the media mix as far as online advertising is concerned but if you just take structurally in the industry we are beginning to see the emergence of professional content on the web slowly both from broadcasters or from creators as well as people who provide online video. As that trend continues as that puts more and more inventory in the online web we are going to see more and more people get excited about advertising video to the audiences which I think is going to be another big leg for the whole industry not just for us. And if you continue that story Jonathan talked about with mobile, again as we see the emergence of smart phones and devices such as the Nexus One continue successes of various devices from various manufacturers around the world we are again going to see the search traffic begin to move in that direction. So clearly all those things are in the right direction. Of course as Eric alluded to earlier on the enterprise side, we are seeing this big shift to cloud computing. We are beginning to see large customers and even parts of the government, the City of L.A., start to make inroads into those customer segments and clearly other people will watch those customers and gain strength from those that start to convert. Across the board I am very positive about the potential prospects of each of those business lines. Again, as Patrick and Jonathan said we can’t actually comment on when these things will materialize in the quarter but again we remain convinced this is a good market. Does that give you some flavor?
Operator: The next question comes from the line of William Morrison – Think Equity.
William Morrison: A couple of quick modeling questions, how should we be thinking about tax rate in 2010 and then on CapEx before the recession you were kind of consistently spending somewhere in the low teens as a percent of revenue CapEx and that came way down last year. I am curious if we should be expecting CapEx to ramp back up to 10+ percent of revenue or any commentary around CapEx?
Patrick Pichette: The usual suspects continue to be OI&E, CapEx and tax rate. This quarter is no different than the prior quarter. So just to give a bit of color quickly on each, the tax rate has been quite stable through the year and so the big issue we focus on the tax rate because it gets affected by mix and a few other things. The real fundamental issue is legislation for us in this quarter or next quarter so I think that there is nothing in our tax rate that is affecting it more in the long-term than any of these big legislations. That is why we are focused on them. I think it is really important for the US economy and for US companies that are participating internationally to get this right because there are so many jobs in the US associated with it. That is on the tax side. On CapEx sometimes people say too often but it is true. I am really pleased with our CapEx numbers. I think that we are ramping back up. We are ramping back up at a much lower level than what it has been historically but we are ramping back up and every opportunity we have to make sure we meet capacity or we meet CapEx, we will fund everything fully. We have been really fortunate in 2009 that we have had a couple of good breaks in terms of capacity utilization, a bunch of chip sets that worked in our favor in terms of performance as we discussed before and all this. We just dropped right to the bottom line. That is fantastic to us and to our shareholders and we will continue to monitor that very closely. What you should take away is we are going to continue that level of discipline. If you allow me to close on OI&E again big variability quarter-over-quarter so everybody who has their crystal ball on both the variability of FX as well as just variability in general between FX and it drove so much of our FAS 133 that you see the big swing this quarter hit once again but in the other direction. It was also, you will remember I said in the previous call we had taken so much accelerated write offs on our previous hedges portfolio that we had so much of it written off that at some point you get some benefit in the short-term. So that is what has happened. Then also people should know we have started moving off as we discussed in previous quarters we have been so focused during the crisis of late 2008 and early 2009 of cash preservation to make sure we do not put at risk the cash we had accumulated. Over the last couple of quarters we have begun to transition to a more balanced portfolio so you also see the kind of proper ramp up in yields there as well. These are the big ticket items that usually fluctuate or you have questions on the P&L. So I am glad you asked the question.
Operator: The next question comes from the line of James Mitchell - Goldman Sachs.
James Mitchell: I believe you mentioned on the fourth quarter 2008 results call that the quarter was “one of our strongest quality improvement” whereas on the call just now you mentioned that the quality launches are more modest in terms of impact on monetization. Is it fair to infer that fourth quarter 2008 revenue benefited more from quality initiatives versus fourth quarter 2009 revenue?
Patrick Pichette: That is a pretty hard question to fully parse without my actually going back and digging into the data. It is consistently the case that we freeze quality improvements after Thanksgiving so I would have to actually look at what the exact improvements were and when they occurred intra-quarter comparing Q4 this quarter and Q4 last quarter and without actually having that in front of me it is pretty hard to say.
Operator: The next question comes from the line of Mark Mahaney – Citigroup.
Mark Mahaney: There was a recent deal with Twitter in terms of live feed. Jonathan you mentioned your own anecdotal uses of it. Can you make any broad comments about what kind of impact you think that has had on overall usage? Have you found any levels of greater engagement because of the inclusion of real time Twitter results in your overall search results? Anything in terms of click through rates, length of time or number of searches or anything like that?
Jonathan Rosenberg: I am not sure I have any great data to offer you there. The sets of things that we are now incorporating into the real-time search are Tweets, blogs, news, we certainly see those dynamics when you have something that is very interesting like an earthquake. So the feature we think is certainly performing well and it is giving people better quality results much more expeditiously than they previously had but what the overall impact is across search and each of the other metrics I think it is still too early to say.
Patrick Pichette: It is worth saying again if you go back in the last 6-9 months the thing that continues to amaze me on the search side is how people almost take it for granted that search works. When you look at the last 6-9 months real time search introduction which was really done in the second half of this year the complete overhaul of the caffeine so from a speed perspective and tying it all back again to the mobile it is amazing the kind of searches you can do right now, just typing a few words that even six months ago you wouldn’t have dreamed of doing. So from that perspective I think it was really important to us to get real time search up and running because there are a lot of types of information that people want on an actual basis because it just happened and having these feeds provides so much value. I think that there is no doubt they are having an impact. The issue is we haven’t asked the economics team that actually can run these models to give me a sample and then run the experiment and so it is a good question to ask but there is no doubt that it has clearly improved the experience.
Mark Mahaney: On China is there a solution here whereby you can stay committed to China in the future and not censor search results? Is there some sort of work around on that?
Patrick Pichette: The team is working on this. I think it is really important that we stick to Eric’s comments earlier this afternoon. I just refer you back to his comments.
Operator: The next question comes from the line of Benjamin Schachter - Broadpoint Am Tech.
Benjamin Schachter: A couple of housekeeping modeling questions and then Jonathan one for you. On the housekeeping front can you give us specifics on how you are accounting for Nexus One products being sold? Are you taking inventory, how do they go through the P&L and then also on gross margin it is obviously trending up significantly from lower CapEx is there anything that is going to offset that any time soon? Jonathan if you could, CPA product ads, I know it is still the early stages here but how widespread are they? Where are we in the rollout of that product and your general thoughts on the product?
Patrick Pichette: Let me start with the specific Nexus One. On Nexus One we have partnerships as you know with TMobile with that specific handset right now. Actually we book them to other revenue so the revenue comes as other revenue and we recognize the full $529 per device up front. And that is tied into the licensing in other revenue. That is regardless if it is an unlocked phone or a TMobile phone. In terms of the gross margin the cost obviously goes through other costs. On the gross margin I think the thing that you have noticed properly over the last few quarters not only did CapEx run well but because CapEx ran well also our data center expenses as we continue to push for efficiencies we got some benefit out of that as well. Again, can’t push forward to give you any details on the future but you should take comfort that we are actually really managing these efficiencies quite well right now. One last point that you talked about on the Nexus on the inventory side it is really immaterial to us. I mean it is inconsequential. We don’t have a big exposure either on either inventory and clearly not on margin. I will turn it over to Jonathan.
Jonathan Rosenberg: The product ads I think are still occurring on a relatively small portion of the queries. I was trying to come up with an example here and it took me a couple of tries. Jogging strollers if you type into Google will show you one. I think it is a small portion of the queries. There is certainly a lot of interest from the advertisers. We started by focusing on the larger retailers and it was just a relatively small number of them. But it is a great ad experience for users because you see the pictures. You see the prices. It gives you a lot more information to help them decide which product to buy. I am very excited about the form but I think right now it is still in pretty nascent stages in terms of the number of participants and the degree to which it shows itself in the results.
Operator: The next question comes from the line of Justin Post – BAS-ML.
Justin Post: I just wanted to talk about the CapEx efficiencies. You have really been able to pull back your CapEx budget and just going forward do you think you can still see a lot of efficiencies or do you think you just need a ramp up as you see growth reaccelerating? What is your view on that?
Patrick Pichette: It is a tough answer to give for the following reasons and I don’t want to be evasive here but here the real issue is because Google as you know does its own data centers and most of its equipment is built and designed by ourselves, all you need by pushing hard on the limits of this equipment and working really hard to make sure we get good performance. You get a couple of good breaks and as you see in the last 12 months we got a really nice break from a CapEx perspective. In the future we are obviously pushing the team for utilization and design to make sure we get as many of those as possible. What is the beta on that? It is pretty high but every time you get one you get a lot of value and you have at least some evidence we are pretty good at it. So there lay the tension because I am not just assembling stuff that is off the shelf from regular products and I can give you the exact forecast and life goes on, it is much more difficult to actually answer your question. Having said that there is no doubt as you can see in the last 12 months the level of commitment that we have in making sure we are going to be capital efficient and on the flip side of that if we ever needed to actually ramp up our CapEx for any reason we are ready to pounce as well. So that is the balance we are trying to strike.
Operator: The next question comes from the line of Brian Pitz – UBS.
Brian Pitz: Quickly regarding China, I know what you have said so far, but help us think about for a second if you in fact made the decision to leave this market do you think you would still operate your ad sense and/or apps businesses which are pretty much unrelated to censorship in the region?
Patrick Pichette: Again, I am going to ask everybody to be patient over the coming weeks as we are working through the resolution of this issue. I think Eric was quite eloquent in what he tried to communicate. The blog post was very clear as to the objectives we have and Eric was quite eloquent in trying to, so I would circle back to his answers. In a way, work with us as we have over the coming weeks and as you can imagine we are working really hard at this and as soon as we have more information we will let you know.
Operator: The next question comes from the line of Spencer Wang - Credit Suisse.
Spencer Wang: If we look at the international markets I was wondering as you wrap up 2009 and 2010 which geographies do you think you have the most opportunity to gain incremental share in search?
Patrick Pichette: In search the answer is yes. You would expect to have in every area with the kind of product rollout we have and focus we have I wouldn’t say we are favoring one market versus another to actually push. There are just clearly the world is really divided into three separate markets as Nikesh always pointed out right. The very mature markets are the US and the U.K. Then you have the next tier of kind of somewhat mature markets but a lot of headroom is the big European countries, Japan and all of the kind of industrialized nations of that nature. Then you have all of these other emerging economies which are on a very difference CPC but very promising. We have a balanced set of approaches for each of them because they are just so different in terms of where they are and that is why even the marketing is different for each of them because of the different circumstances. Our objective is to continue to actually increase our share of search by having the right total global products but also pushing localization with languages and everything you hear from us. Mary or someone else talked about how we feel optimistic about 2010. I think that we have had, we are very optimistic for the reason we see great trajectories from our 2009. I think Eric said it very well. 2009 was a real year of testing. We tend to forget how fast 12 months has passed. The roller coaster we went through over Q1, Q2, Q3 and Q4 of this year we are delighted to see the recovery in terms of our growth rate, performance of the business and the innovation we drove through 2009. From that perspective that is why the company feels confident about not only 2010 but its long-term prospects in all these areas. With that I would like to thank everybody for your great questions and I look forward to seeing you at the end of Q1. Have a happy New Year.
Operator: This concludes today’s conference. We thank you for your participation. | [
{
"speaker": "Operator",
"text": "Good day and welcome everyone to the Google Inc. conference call. This call is being recorded. At this time, I would like to turn the call over to Maria Shim, Senior Manager of Investor Relations. Please go ahead, Ma’am."
},
{
"speaker": "Maria Shim",
"text": "Good afternoon everyone and welcome to Google's fourth quarter and fiscal year 2009 earnings follow up conference call. With us are Patrick Pichette, Chief Financial Officer, and Jonathan Rosenberg, Senior Vice President of Product Management and Nikesh Arora is also going to be joining us for the first half hour so if you have specific sales, geographic vertical questions for him please direct them to him in the first half hour of the call. After we cover a few housekeeping items we will begin taking questions. This call is being Web cast from our Investor Relations Web site located at investor.google.com. Please refer to our Web site for important information, including our earnings press release and related slide deck. A replay of this call will also be available on our Web site in a few hours. Please note that we routinely post important information on our Investor Relations Web site located at investor.google.com and we encourage you to make use of that resource. As a reminder, the purpose of this follow-up call is to give participants the opportunity to ask more detailed financial and product questions in an efficient and Reg FD-compliant manner. Let me now quickly cover the safe harbor. Some of the statements we make today may be considered forward-looking and these statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings, including our annual report on Form 10-K for the year ended December 31, 2008, as well as our earnings press release for a more detailed description of the risk factors that may affect our results. Copies can be obtained from the SEC or by visiting the Investor Relations section of our Web site. Also, please note that certain financial measures we use on this call, such as operating profit and operating margin, are expressed on a non-GAAP basis and have been adjusted to exclude charges relating to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and GAAP to non-GAAP reconciliation can be found in our earnings press release. With that, we are ready to take your questions. Operator?"
},
{
"speaker": "Operator",
"text": "(Operator Instructions) The first question comes from the line of Samit Sinha – JMP Securities."
},
{
"speaker": "Samit Sinha",
"text": "I just wanted to get some more details about CPC growth sequentially. Are there any specific circumstances in the past quarter about how emerging markets where query growth has been strong but CPCs have been lower. Can you just quantify that impact? Secondly, on the CPC question itself anything specifically in Europe regarding to where trademark bidding has slowed down or the efficacy of that has slowed down and maybe pulled down CPC with it?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I will let Nikesh comment on any specific issues related to Europe or any dynamics he is seeing there on the trademark issues. The specific issues which we have traditionally talked about a lot, you are looking at average CPC which obviously is a blended number and it is impacted by some of the things you suggested such as the relative growth in maturing markets versus established markets had some anomalous dynamics when you look at this quarter which I would highlight. First and foremost the FX movement. The dollar was weaker in Q4 2009 when you compare to Q4 2008 so that causes the non-US clicks to have higher CPCs when reported in dollar terms. I think the other thing you may not see is there is an important mix effect going on. We made some quality improvements on the AFC network and basically that had the effect of reducing the total clicks in the AFC network relative to what it would have otherwise been. So we had a higher proportion of clicks coming therefore coming from Google.com and from AFS and that is a mix shift that caused the blended average of CPC the way you are seeing it to otherwise rise. So those are the two things I think are more different in this quarter than in the past. Otherwise I don’t have any more insight."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Aaron Kessler – Kaufman Bros."
},
{
"speaker": "Aaron Kessler",
"text": "A question on the local side on mobile and how that ties in. There is a lot of assumption on the mobile side that is really going to head out to local group longer term. Just your view on that and how you are seeing the growth on the local side develop to drive mobile longer-term here?"
},
{
"speaker": "Patrick Pichette",
"text": "I think that one element of mobile is local but I would far and away not only pin it to local. There is no doubt we are having some great experiments on local but on mobile what you have is a whole set of searches and a whole set of activities that actually just transcends clearly just a local business. Those searches obviously are going to also fuel it. It is a mosaic of opportunities but local is just one of them. Jonathan maybe you have additional comments?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I think local is hugely important. It is going to be much more important in the not too distant future because as we are seeing more integration and as I mentioned in some of my other remarks people who are shopping offline start online and today people still don’t have access to the inventory information of the local stores. I mentioned that in mobile we are seeing that when phone numbers and coupons are offered people are much more likely to click on the mobile ad. Well imagine if the inventory information is there so they can actually consummate a transaction locally. As that information becomes available local is going to be much, much more powerful. We already have some examples where advertisers like AT&T are using some of our local products to help people find local stores. I think we are just starting to get there in terms of capabilities that are going to be necessary for local to take off. But I think local is going to matter much more on these devices because obviously they know where they are with GPS."
},
{
"speaker": "Aaron Kessler",
"text": "I think you filtered out some of your advertisers this quarter. Maybe it was just in essence for content. Maybe you could provide some more details around that?"
},
{
"speaker": "Patrick Pichette",
"text": "Sorry could you restate the question?"
},
{
"speaker": "Aaron Kessler",
"text": "I think there were some reports that you may have filtered out some of your advertisers this quarter on the ad sense side. Can you provide any more details about that?"
},
{
"speaker": "Nikesh Arora",
"text": "Obviously we are constantly looking at our advertisers to see whether there is an extraordinary [expand] that is happening. We have thrown in those advertisers who repeatedly attempt to scam users. So we went through one of our regular processes of looking at advertisers and seeing which ones of those we though weren’t adding quality or adding sort of value to our users. In those cases we chose to suspend them permanently."
},
{
"speaker": "Jonathan Rosenberg",
"text": "This was happening this quarter with the approach we took to suspend the repeated scam users as opposed to before where all we were doing was disabling certain bad ads."
},
{
"speaker": "Aaron Kessler",
"text": "Does this have any material impact on the quarter numbers? It sounds like it could have had a slight impact from what I was reading."
},
{
"speaker": "Jonathan Rosenberg",
"text": "No the impact is slight. It is a relatively small number."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Ross Sandler – RBC Capital Markets."
},
{
"speaker": "Ross Sandler",
"text": "First on the cyclical nature of paid click growth and then a follow-up from James’ question earlier. So on paid click the growth rate has been decelerating pretty steadily for the last couple of quarters based on some of the mix and some of the natural deceleration you talk about. Do you see any evidence in your data that as the economy recovers in 2010 that paid click could actually reaccelerate? For instance in the fourth quarter you had a reacceleration in the domestic market. Did paid clicks reaccelerate there? What are your thoughts on that? A follow-up from James’ question on the international stuff if we do the math correctly, international growth X currency and X hedging decelerated to around 16% from 19% last quarter. Can you talk about what is driving that deceleration because I think it had accelerated in 3Q."
},
{
"speaker": "Patrick Pichette",
"text": "On the paid clicks the only thing we could tell you because we can’t give you any perspective is obviously as every place there is a recovery and there is robust auctions. There is also seasonality within those auctions. You can have increased CPCs. So that is really the fundamental driver of the CPC growth."
},
{
"speaker": "Ross Sandler",
"text": "You don’t see consumers clicking on ads, not the CPC but actually the volume of page clicks, you don’t see that incidence increasing when the economy is better?"
},
{
"speaker": "Patrick Pichette",
"text": "Yes absolutely. People search more and as they search more not only do they search more but they click more. No doubt about it. If you remember if you go back to a couple of quarters ago we had this conversation where we said because people were more shy of shopping they clicked less. So it was a consumer driven phenomenon that drove our CPC at the time. It was simply that no matter how the auction operated the fact that people clicked less. As the economy recovers and people click more obviously it will have an effect on CPC. As for the international, Nikesh do you want to cover the international portion?"
},
{
"speaker": "Nikesh Arora",
"text": "I think the important thing to note is if you compare and look at last year’s Q4 we had a decline in the US much more sharper than what we saw in the international markets so the comps in the US look much better than they look for international regions. In addition to that many of our new product areas which we staged globally start in the US and make their way across the globe we have had more of them do well in the US than they have done internationally. So purely from that perspective the US is going to look slightly stronger from the rest of our international markets."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of George Askew – Stifel Nicolaus."
},
{
"speaker": "George Askew",
"text": "First, has Google since the first of the year finished implementing the caffeine search architecture across all your data centers?"
},
{
"speaker": "Nikesh Arora",
"text": "I don’t know that we are finished implementing it. I know…"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I believe the answer to that is no. The answer to your question is not yet."
},
{
"speaker": "George Askew",
"text": "Obviously display advertising is a huge push for the company. Can you help us please understand how much of your display advertising revenue is from owned and operated properties such as YouTube and how much is powered by tools of Google but does not appear on your websites like Double Click?"
},
{
"speaker": "Patrick Pichette",
"text": "We don’t give the mix but clearly it is all of the elements at work."
},
{
"speaker": "Nikesh Arora",
"text": "The best way to think about our business on the display side is we have our business on the display side which corresponds to [inaudible] which is where brand marketers looking for premium advertising slots look to YouTube as a property they want to advertise in competition with other premium inventory that is out there. If you go to the next level the best way to think about them are network which is our collection of publishers which are all the way from small publishers to certain large publishers who give us access to inventory which we are then able to selectively sell at the network both using conceptual advertising as well as using intraspace advertising and that is of course is a different profile as it relates to the margin and revenues as compared to YouTube. The third part is where we use both our tools as well as our exchange properties like Ad Exchange and Double Click platforms which is where you can have different buyers and sellers and different people who put inventory and people who have inventory and that is beginning to gain traction now and most of our top ad networks are in that space. Clearly again that is a very different pricing profile and margin profile in the market. So that is the way to think about our three different businesses from a structural perspective. Clearly from an advertising perspective when we make that pitch we offer the entire gamut of services depending on what campaign objectives they have and what they are trying to achieve."
},
{
"speaker": "George Askew",
"text": "Would Google have another owned and operated display ad site?"
},
{
"speaker": "Nikesh Arora",
"text": "We are currently experimenting with various properties we have to see what is the best mechanism and the best format of advertising to use."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Scott Davis – JP Morgan."
},
{
"speaker": "Scott Davis",
"text": "I think I have a follow-up to Ross’ and James’ question about the rest of the world growth. Given that it decelerated and I understand the products in the US haven’t rolled out there, that would explain why it wouldn’t reaccelerate but it doesn’t explain the deceleration so it sounds like you are saying the primary answer is just the comps which did in fact get a lot more difficult versus the fourth quarter of last year. I was wondering though if there is a third element which has been a number of times on the call it was mentioned large advertisers have come back first. I guess I was wondering if you could give some color on whether the rest of the world make up of advertisers is more small advertisers as compared to large and therefore that lagged a little bit for that reason as well or was it just purely the comps for the first reason that I said?"
},
{
"speaker": "Nikesh Arora",
"text": "Thank you for the excellent question. I think there are three elements to what you asked. One clearly is the comp element because as Patrick would say we have had a v-shaped recovery in certain markets we have had sort of a slightly elongated return of markets and some of the markets have been bobbing around. So clearly in the US we have seen a sharper rebound than we have seen elsewhere where they had not as sharp of a decline. So clearly one is a comp issue. The second issue has also to do with the advertiser mix. Actually the large advertiser phenomenon is over weighted to the US than it is towards the emerging parts of the world so in various emerging parts of Southern Europe or in various parts of Asia, Latin America, the Middle East and the other parts of Europe we are clearly not seeing as much divergence between the large advertisers and small advertisers in those markets. The large advertisers haven’t been as aggressively back as they haven’t as aggressively left in the first place. The third case is clearly in some of those markets which are nascent what happened is as the economy took a hit or a stuttered earlier they actually reprioritized their spending and some of them may have pulled back from search and it just takes a little bit longer to get them back onto online advertising because in those markets they are not as reliant or as convinced of online advertising but clearly as I said in places like Brazil we will be making huge efforts to get the education up on advertising and we do that around the globe."
},
{
"speaker": "Scott Davis",
"text": "Do you have an expectation, just to follow-up you are clearly pleased with sales and it is easier for the street including myself to get ahead of ourselves because we can do channel checks and hear about the US and hear about the U.K. and those things accelerated nicely. So it feels like the only thing the bowl is missing is just some condition on when you will see a reacceleration in the rest of the world. Part of it will come just because the comps are getting a lot easier. Do you have a suggestion for what kind of lag you think is involved for those?"
},
{
"speaker": "Nikesh Arora",
"text": "Clearly I am not going to try and speculate numbers and try and figure out when these things are going to happen. From a long-term perspective when you think about the US versus these markets clearly some of these markets are further behind in terms of the development where the US is and where certain parts of Europe is. For example, the U.K. is very advanced in the online market. Even if we look at the evolution of some of these markets over the last 3-4 years we have seen a trend. The trend suggests that over time people will start getting more convinced about online advertising as more and more consumers in those markets get online as more and more broadband penetrates those markets. Both dynamics are clearly easy for the street to understand and try and project. Based on that my long-term conviction is that we are going to see the continued shift towards online advertising both on the search side as well as on the display side as Patrick alluded to in the earlier call where the television market is another huge market where the eyeballs are beginning to shift and advertisers will want to target those audiences and we feel confident the tools we are developing based on our experience in the US markets can be deployed around the world. In the long-term I believe there is clearly growth into those markets. I can’t project which we are going to show it in."
},
{
"speaker": "Patrick Pichette",
"text": "I think just as a general comment on the overall total revenue and then the difference between all these markets and geographies, as we said on the previous call we are really pleased with the trajectory of the company and the reason for it is you can see how a quick rebound in the economy in the US, not a strong rebound but a quick rebound actually you can see the leverage model of the Google model so in that sense I think we take a lot of comfort for the long-term."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Jim Friedland – Cowen & Company."
},
{
"speaker": "Jim Friedland",
"text": "On G&A if I look at Q4 versus Q3 it actually moved up decently. Last year it was flattish but then you were really working on the costs. Was there anything one-time in nature or unique about that increase or was it seasonal or is this just getting back to sort of a more traditional pattern?"
},
{
"speaker": "Patrick Pichette",
"text": "I think on G&A the two big areas we talked about one of them was actually ramping up our marketing as we discussed on the previous call. We also had a few expenses more than would be ordinary on the legal side and so those would be the kind of two big bumps in the quarter. Nevertheless, very much under our control. If you think about it if there is one thing we have proven this year at Google is our ability to actually really control our expenses and dial where we think we are going to get a great payback and a great return. That is exactly what you have seen in Q4 where when Eric talked about let’s push back the investments let’s go back into making sure we run the business the way we want to run it. Obviously when you have areas like marketing broadly defined that is the first place you can actually turn on the dial to get a real impact back. That is why we moved that way."
},
{
"speaker": "Jim Friedland",
"text": "On marketing, with the Nexus One we have seen some ads around the Google network but we haven’t seen any more traditional advertising given that it is sort of a meaningful product launch and you are trying to change an industry. Why haven’t we seen a push in that area or are you just telling us that you are going to use sort of the traditional way that Google has gotten out there?"
},
{
"speaker": "Patrick Pichette",
"text": "Nikesh will probably have more details on this. Because we launched the product and it is really a new model we are trying to launch with the online store, all we wanted to do and we had so much advertising anyway and marketing around the product itself. We didn’t deem it necessary to actually push it in the same way that other, more traditional channels would have done."
},
{
"speaker": "Nikesh Arora",
"text": "I think Patrick said it and I think we alluded to this in the earlier call that as Eric said this is a new way for selling mobile phones. Clearly the first target group we can go after are the people that like Google, who are the Google aficionados, people who are online, and since we are trying to come up with a model for selling something online it is perfectly logical for us to do online marketing for that and as this evolves and as we test it we can explore other ways going forward."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Heath Terry – FBR."
},
{
"speaker": "Heath Terry",
"text": "Eric touched on this a little bit on the call but can you give us an idea on where you are seeing the most traction in your display efforts? As you look at the Double Click ad network what are its competitive advantages and what does the development path look like there?"
},
{
"speaker": "Patrick Pichette",
"text": "In terms of display I think that Nikesh in the way that he portrayed it a few minutes ago there is really…Let me just give the high level answer and then Nikesh can add color commentary. There is a simplification of the process with Double Click and the Double Click platforms for both the publisher and the advertisers, the simplification of all that has made a huge difference and we can see it in the numbers of people signing up for it. Obviously on the performance and the markets two other big thrusts that actually are good trajectories. Maybe Nikesh you would want to give a bit more in the display itself?"
},
{
"speaker": "Nikesh Arora",
"text": "I think that it is very important to think about the evolution of the display market. In the early days of display we have been selling sites and as we look at it there has been a huge explosion of the sites. There are millions and millions of websites that you can actually decide to target ads and target display ads. Now the challenge that it creates is on two ends. One is it creates a challenge in consistency which is where products like Double Click which creates some degree of consistency are served and how they are put across the board and products like Ad Exchange begin to help. Because effectively you are trying to create a consistent way of serving ads in the market. The second part also is sort of the inefficiency of the selling side. It is very hard for an advertiser to go to aggregate multiple sites and try to buy them individually. So it really helps to have an exchange. They can aggregate tremendous amounts of inventory. If you do both of those things then we can layer on top of that both contextual and intraspace advertising. So that is the way to think about it. We are slowing shifting the display behavior to look and mimic what advertisers are currently used to buying. They have been used to buying audiences on an aggregated, large scale. The way we are able to put together the Google Content Network, the Ad Exchange and the Double Click platforms we are trying to replicate the ability to buy large audiences. As that begins to happen and as they are [rebuilding target] more and more you clearly expect it becomes more relevant or them and therefore the prices will react accordingly to the that [inaudible] of the advertisers."
},
{
"speaker": "Jonathan Rosenberg",
"text": "I would summarize the competitive advantage as we are making it easy to buy, sell and serve display ads. One of the things I think is particularly exciting which Eric was asked about on the call earlier was this shifting budget dynamic. One of the dynamics that has been very positive that we have seen is that with products like display ad builder we are actually bringing a lot of new advertisers to display. They can much more easily create display ads now. They can do it directly from the ad works interface. It turns out they are new advertisers to display and they are not fundamentally decreasing their budgets in search so we are winning on both sides."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Richard Fetyko – Merriman Curhan Ford."
},
{
"speaker": "Richard Fetyko",
"text": "In the past you have talked about changes in ad coverage or density of coverage. I was wondering if you can characterize the changes in the last few quarters if there has been any. Secondly on the mobile strategy I am just wondering if the success you had with the adoption of the Android operating system for the mobile devices what role do you see that playing in your mobile strategy? Does that lead to a certain level of certain opportunity for monetization over time?"
},
{
"speaker": "Patrick Pichette",
"text": "Let me answer the mobile first and then I will let Jonathan answer the first question on coverage. The whole mobile strategy is built on building and accelerating an ecosystem. Obviously we have our own mobile teams that have developed these cool aspects. People who know Vic and all of the really cool applications that he conceives with navigations and all the rest, but it is above the ecosystem that there are three things; It really promotes innovation. It has a lower cost of innovation because by being open source you enable everybody to jump in and do it and then as a consequence you keep it open source. The benefit to us really is twofold. The benefit is users get better applications faster at market spreads faster everywhere. So think of the spread of high end devices faster and at a lower cost sooner which drives all these applications and so users get a benefit. Then as a consequence of that as we have talked before consumers that have Android devices we know from our own research they use it 30 times more than what a typical handset would be. In consequence they do a lot more searching and there is a lot more advertising opportunities. So pushing that ecosystem is so critical because that is where the world is going. If you think in terms of NPV as the image I always use, what is the value of accelerating that? It is huge for the users but it is also huge for us. That is why we are pushing it with the three dimensions of mobile, Android and now with the Nexus handsets to kind of set the standards at a higher level. So that is the mindset in which we operate. We benefit nicely from it and so does the user. Now for the ad coverage, Jonathan?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "As you know we really don’t break down the components of the RPM equation specifically to cover CPC or click through rates. We have told you in the past on a couple of occasions where there has been a situation where we noticed a dynamic that caused us to make a change which we mentioned a few quarters ago in the past. Right now I think we are pretty happy with where coverage is. We have mostly been focused on improving the quality of the ads themselves and we have talked to you a bit in the past about the tradeoffs we make there in terms of how we decide to take improvements with respect to quality and coverage. I think the main change you can probably see is the new formats we have been launching which we talked about which basically offer a better experience within our ads rather than new ads that were not otherwise showing today. There is not a lot to say in terms of fundamental changes in coverage."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Mary Meeker – Morgan Stanley."
},
{
"speaker": "Mary Meeker",
"text": "You on the call were obviously very enthusiastic about the growth and monetization opportunities in YouTube, Mobile, Double Click and enterprise. That said desktop is still the vast majority of you revenue. You are the ones that are getting the inbound phone calls about people getting more interested in these categories and to Scott Davis’ question the stock market is not responding that well to your earnings announcement but at the same time you were really enthusiastic about 2010 per your tone and your commentary. Could you give us a sense of when these new initiatives start to add 100 basis points here and there or a couple hundred million of incremental revenue to the business? If not quantitatively just philosophically about when they start to move the needle because that would drive an acceleration in revenue for the company."
},
{
"speaker": "Patrick Pichette",
"text": "Let me start by saying the following; One, display as Eric said is already a pretty significant business for us. In the sense when he talked about it is the next billion dollar business and when you take all of the elements that Nikesh has talked about if you think about YouTube and you think of all of the elements that are within it at some point in the future this will add up to something that we are excited about and two, that moves the needle. You could argue in many areas within this we have already started moving the needle. Then on the other ones, as you said they are nowhere near where the core business is but the trajectory and growth rates we see in the adoption rates and the adoption rate on users gives us…that is why we feel so comfortable when we talk about 2010 and beyond and building this business for the long-term. We see a lot of positive trajectories and we have to celebrate that because two years ago we couldn’t have said that maybe about mobile and we couldn’t have said that about enterprise but two years later when we stand at the end of 2009 we look at the great programs from Jonathan’s comment of putting a few arrows in the right places and then just putting more wood around them, we are very pleased about the trajectories that these have."
},
{
"speaker": "Mary Meeker",
"text": "Is there any stuff around it you can provide us?"
},
{
"speaker": "Nikesh Arora",
"text": "If you just think about our business in the various ways we just talked about and I want to sort of underline that search is not by any means exhausted the scenario where we continue to make progress and we continue to see interest. I would say we are seeing more and more large advertisers coming in and that is not just a function of the economy. It is also a function of them having developed their e-commerce capabilities and worked really hard on having online strategies. So as they come forth and build their online strategies across multiple verticals we are beginning to see a resurgence and return of those guys into the online space. Having said that, in addition to from a direct marketing and direct response perspective the next leg which we are beginning to see a surge is that people are beginning to see the offline impact of people searching online. So even if you have a business where you are not selling something on the web it is very clear to most businesses whether they are in pharmaceuticals, consumer goods, autos that most people or 78% of the people will research something online which is a significant value to them or a significant importance whether it is a drug or a car, before they will go make that purchase or before they will make [inaudible]. Clearly that sort of research is being funded by us and various agencies out there and that is continuing to drive that cycle and whilst it is driving that in some of the more mature markets clearly those effects are still making their way into the emerging markets and maturing markets in Europe. So I just want to underline there is tremendous runway and surge still from where we stand. As Patrick said about display, again you have seen the shift from people buying sites to where people are buying audiences and people are getting more and more intraspace which that is how traditional advertisers are used to buying. They are buying frequency, they are buying advertisers, they are often not buying sites because sites over emphasize brand association as opposed to interest targeting. I think that trend is going to continue. If you think about the YouTube space and the online video space I think we have seen that sort of becoming a relevant part of the media mix as far as online advertising is concerned but if you just take structurally in the industry we are beginning to see the emergence of professional content on the web slowly both from broadcasters or from creators as well as people who provide online video. As that trend continues as that puts more and more inventory in the online web we are going to see more and more people get excited about advertising video to the audiences which I think is going to be another big leg for the whole industry not just for us. And if you continue that story Jonathan talked about with mobile, again as we see the emergence of smart phones and devices such as the Nexus One continue successes of various devices from various manufacturers around the world we are again going to see the search traffic begin to move in that direction. So clearly all those things are in the right direction. Of course as Eric alluded to earlier on the enterprise side, we are seeing this big shift to cloud computing. We are beginning to see large customers and even parts of the government, the City of L.A., start to make inroads into those customer segments and clearly other people will watch those customers and gain strength from those that start to convert. Across the board I am very positive about the potential prospects of each of those business lines. Again, as Patrick and Jonathan said we can’t actually comment on when these things will materialize in the quarter but again we remain convinced this is a good market. Does that give you some flavor?"
},
{
"speaker": "Operator",
"text": "The next question comes from the line of William Morrison – Think Equity."
},
{
"speaker": "William Morrison",
"text": "A couple of quick modeling questions, how should we be thinking about tax rate in 2010 and then on CapEx before the recession you were kind of consistently spending somewhere in the low teens as a percent of revenue CapEx and that came way down last year. I am curious if we should be expecting CapEx to ramp back up to 10+ percent of revenue or any commentary around CapEx?"
},
{
"speaker": "Patrick Pichette",
"text": "The usual suspects continue to be OI&E, CapEx and tax rate. This quarter is no different than the prior quarter. So just to give a bit of color quickly on each, the tax rate has been quite stable through the year and so the big issue we focus on the tax rate because it gets affected by mix and a few other things. The real fundamental issue is legislation for us in this quarter or next quarter so I think that there is nothing in our tax rate that is affecting it more in the long-term than any of these big legislations. That is why we are focused on them. I think it is really important for the US economy and for US companies that are participating internationally to get this right because there are so many jobs in the US associated with it. That is on the tax side. On CapEx sometimes people say too often but it is true. I am really pleased with our CapEx numbers. I think that we are ramping back up. We are ramping back up at a much lower level than what it has been historically but we are ramping back up and every opportunity we have to make sure we meet capacity or we meet CapEx, we will fund everything fully. We have been really fortunate in 2009 that we have had a couple of good breaks in terms of capacity utilization, a bunch of chip sets that worked in our favor in terms of performance as we discussed before and all this. We just dropped right to the bottom line. That is fantastic to us and to our shareholders and we will continue to monitor that very closely. What you should take away is we are going to continue that level of discipline. If you allow me to close on OI&E again big variability quarter-over-quarter so everybody who has their crystal ball on both the variability of FX as well as just variability in general between FX and it drove so much of our FAS 133 that you see the big swing this quarter hit once again but in the other direction. It was also, you will remember I said in the previous call we had taken so much accelerated write offs on our previous hedges portfolio that we had so much of it written off that at some point you get some benefit in the short-term. So that is what has happened. Then also people should know we have started moving off as we discussed in previous quarters we have been so focused during the crisis of late 2008 and early 2009 of cash preservation to make sure we do not put at risk the cash we had accumulated. Over the last couple of quarters we have begun to transition to a more balanced portfolio so you also see the kind of proper ramp up in yields there as well. These are the big ticket items that usually fluctuate or you have questions on the P&L. So I am glad you asked the question."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of James Mitchell - Goldman Sachs."
},
{
"speaker": "James Mitchell",
"text": "I believe you mentioned on the fourth quarter 2008 results call that the quarter was “one of our strongest quality improvement” whereas on the call just now you mentioned that the quality launches are more modest in terms of impact on monetization. Is it fair to infer that fourth quarter 2008 revenue benefited more from quality initiatives versus fourth quarter 2009 revenue?"
},
{
"speaker": "Patrick Pichette",
"text": "That is a pretty hard question to fully parse without my actually going back and digging into the data. It is consistently the case that we freeze quality improvements after Thanksgiving so I would have to actually look at what the exact improvements were and when they occurred intra-quarter comparing Q4 this quarter and Q4 last quarter and without actually having that in front of me it is pretty hard to say."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Mark Mahaney – Citigroup."
},
{
"speaker": "Mark Mahaney",
"text": "There was a recent deal with Twitter in terms of live feed. Jonathan you mentioned your own anecdotal uses of it. Can you make any broad comments about what kind of impact you think that has had on overall usage? Have you found any levels of greater engagement because of the inclusion of real time Twitter results in your overall search results? Anything in terms of click through rates, length of time or number of searches or anything like that?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I am not sure I have any great data to offer you there. The sets of things that we are now incorporating into the real-time search are Tweets, blogs, news, we certainly see those dynamics when you have something that is very interesting like an earthquake. So the feature we think is certainly performing well and it is giving people better quality results much more expeditiously than they previously had but what the overall impact is across search and each of the other metrics I think it is still too early to say."
},
{
"speaker": "Patrick Pichette",
"text": "It is worth saying again if you go back in the last 6-9 months the thing that continues to amaze me on the search side is how people almost take it for granted that search works. When you look at the last 6-9 months real time search introduction which was really done in the second half of this year the complete overhaul of the caffeine so from a speed perspective and tying it all back again to the mobile it is amazing the kind of searches you can do right now, just typing a few words that even six months ago you wouldn’t have dreamed of doing. So from that perspective I think it was really important to us to get real time search up and running because there are a lot of types of information that people want on an actual basis because it just happened and having these feeds provides so much value. I think that there is no doubt they are having an impact. The issue is we haven’t asked the economics team that actually can run these models to give me a sample and then run the experiment and so it is a good question to ask but there is no doubt that it has clearly improved the experience."
},
{
"speaker": "Mark Mahaney",
"text": "On China is there a solution here whereby you can stay committed to China in the future and not censor search results? Is there some sort of work around on that?"
},
{
"speaker": "Patrick Pichette",
"text": "The team is working on this. I think it is really important that we stick to Eric’s comments earlier this afternoon. I just refer you back to his comments."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Benjamin Schachter - Broadpoint Am Tech."
},
{
"speaker": "Benjamin Schachter",
"text": "A couple of housekeeping modeling questions and then Jonathan one for you. On the housekeeping front can you give us specifics on how you are accounting for Nexus One products being sold? Are you taking inventory, how do they go through the P&L and then also on gross margin it is obviously trending up significantly from lower CapEx is there anything that is going to offset that any time soon? Jonathan if you could, CPA product ads, I know it is still the early stages here but how widespread are they? Where are we in the rollout of that product and your general thoughts on the product?"
},
{
"speaker": "Patrick Pichette",
"text": "Let me start with the specific Nexus One. On Nexus One we have partnerships as you know with TMobile with that specific handset right now. Actually we book them to other revenue so the revenue comes as other revenue and we recognize the full $529 per device up front. And that is tied into the licensing in other revenue. That is regardless if it is an unlocked phone or a TMobile phone. In terms of the gross margin the cost obviously goes through other costs. On the gross margin I think the thing that you have noticed properly over the last few quarters not only did CapEx run well but because CapEx ran well also our data center expenses as we continue to push for efficiencies we got some benefit out of that as well. Again, can’t push forward to give you any details on the future but you should take comfort that we are actually really managing these efficiencies quite well right now. One last point that you talked about on the Nexus on the inventory side it is really immaterial to us. I mean it is inconsequential. We don’t have a big exposure either on either inventory and clearly not on margin. I will turn it over to Jonathan."
},
{
"speaker": "Jonathan Rosenberg",
"text": "The product ads I think are still occurring on a relatively small portion of the queries. I was trying to come up with an example here and it took me a couple of tries. Jogging strollers if you type into Google will show you one. I think it is a small portion of the queries. There is certainly a lot of interest from the advertisers. We started by focusing on the larger retailers and it was just a relatively small number of them. But it is a great ad experience for users because you see the pictures. You see the prices. It gives you a lot more information to help them decide which product to buy. I am very excited about the form but I think right now it is still in pretty nascent stages in terms of the number of participants and the degree to which it shows itself in the results."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Justin Post – BAS-ML."
},
{
"speaker": "Justin Post",
"text": "I just wanted to talk about the CapEx efficiencies. You have really been able to pull back your CapEx budget and just going forward do you think you can still see a lot of efficiencies or do you think you just need a ramp up as you see growth reaccelerating? What is your view on that?"
},
{
"speaker": "Patrick Pichette",
"text": "It is a tough answer to give for the following reasons and I don’t want to be evasive here but here the real issue is because Google as you know does its own data centers and most of its equipment is built and designed by ourselves, all you need by pushing hard on the limits of this equipment and working really hard to make sure we get good performance. You get a couple of good breaks and as you see in the last 12 months we got a really nice break from a CapEx perspective. In the future we are obviously pushing the team for utilization and design to make sure we get as many of those as possible. What is the beta on that? It is pretty high but every time you get one you get a lot of value and you have at least some evidence we are pretty good at it. So there lay the tension because I am not just assembling stuff that is off the shelf from regular products and I can give you the exact forecast and life goes on, it is much more difficult to actually answer your question. Having said that there is no doubt as you can see in the last 12 months the level of commitment that we have in making sure we are going to be capital efficient and on the flip side of that if we ever needed to actually ramp up our CapEx for any reason we are ready to pounce as well. So that is the balance we are trying to strike."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Brian Pitz – UBS."
},
{
"speaker": "Brian Pitz",
"text": "Quickly regarding China, I know what you have said so far, but help us think about for a second if you in fact made the decision to leave this market do you think you would still operate your ad sense and/or apps businesses which are pretty much unrelated to censorship in the region?"
},
{
"speaker": "Patrick Pichette",
"text": "Again, I am going to ask everybody to be patient over the coming weeks as we are working through the resolution of this issue. I think Eric was quite eloquent in what he tried to communicate. The blog post was very clear as to the objectives we have and Eric was quite eloquent in trying to, so I would circle back to his answers. In a way, work with us as we have over the coming weeks and as you can imagine we are working really hard at this and as soon as we have more information we will let you know."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Spencer Wang - Credit Suisse."
},
{
"speaker": "Spencer Wang",
"text": "If we look at the international markets I was wondering as you wrap up 2009 and 2010 which geographies do you think you have the most opportunity to gain incremental share in search?"
},
{
"speaker": "Patrick Pichette",
"text": "In search the answer is yes. You would expect to have in every area with the kind of product rollout we have and focus we have I wouldn’t say we are favoring one market versus another to actually push. There are just clearly the world is really divided into three separate markets as Nikesh always pointed out right. The very mature markets are the US and the U.K. Then you have the next tier of kind of somewhat mature markets but a lot of headroom is the big European countries, Japan and all of the kind of industrialized nations of that nature. Then you have all of these other emerging economies which are on a very difference CPC but very promising. We have a balanced set of approaches for each of them because they are just so different in terms of where they are and that is why even the marketing is different for each of them because of the different circumstances. Our objective is to continue to actually increase our share of search by having the right total global products but also pushing localization with languages and everything you hear from us. Mary or someone else talked about how we feel optimistic about 2010. I think that we have had, we are very optimistic for the reason we see great trajectories from our 2009. I think Eric said it very well. 2009 was a real year of testing. We tend to forget how fast 12 months has passed. The roller coaster we went through over Q1, Q2, Q3 and Q4 of this year we are delighted to see the recovery in terms of our growth rate, performance of the business and the innovation we drove through 2009. From that perspective that is why the company feels confident about not only 2010 but its long-term prospects in all these areas. With that I would like to thank everybody for your great questions and I look forward to seeing you at the end of Q1. Have a happy New Year."
},
{
"speaker": "Operator",
"text": "This concludes today’s conference. We thank you for your participation."
}
] | null | null |
GOOGL | 3 | 2,009 | 2009-10-16 16:30:00 | Operator: Good day and welcome, everyone, to the Google Inc. conference call. Today's conference is being recorded. At this time, I would like to turn the call over to Maria Shim.
Maria Shim: Good afternoon, everyone, and welcome Google's third quarter 2009 earnings follow up conference call. With us are Patrick Pichette, Chief Financial Officer, and Jonathan Rosenberg, Senior Vice President of Product Management. After we cover a few housekeeping items we will start taking questions from the moderator page, as we did on the last call. Also, this call is being Web cast from our Investor Relations Web site located at investor.google.com. Please refer to our Web site for important information, including our earnings press release and related slide deck. A replay of this call will also be available on our Web site in a few hours. Please note that we routinely post important information on our Investor Relations Web site located at investor.google.com and we encourage you to make use of that resource. As a reminder, the purpose of this follow-up call is to give participants the opportunity to ask more detailed financial and product questions in an efficient and Reg FD-compliant manner. Let me now quickly cover the safe harbor. Some of the statements we make today may be considered forward-looking and these statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings, including our annual report on Form 10-K for the year ended December 31, 2008, as well as our earnings press release for a more detailed description of the risk factors that may affect our results. Copies can be obtained from the SEC or by visiting the Investor Relations section of our Web site. Also, please note that certain financial measures we use on this call, such as operating profit and operating margin, are expressed on a non-GAAP basis and have been adjusted to exclude charges relating to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and GAAP to non-GAAP reconciliation can be found in our earnings press release. With that, we are going to take as many questions as we can accommodate.
Maria Shim: We will start with a question from Mark Mahaney – Citigroup.
Mark Mahaney: How can a company with $22.0 billion on the balance sheet in cash generate negative net interest income? How about cutting out the hedging program and buying back stock? That's a huge drag on your ROI.
Patrick Pichette: It's obvious that the consequence of the last year is pulling through on OI&E. So just to give you how we're managing it is as soon as a couple of quarters ago, we were all in kind of very conservative portfolio in order to take the cash, given the economic situation. Since then, we have actually revised our investment strategy and have agreed to an investment portfolio for the long term. And we are in the process of actually moving out of that very conservative position we were, but there is an impact, obviously, because we're doing this on a gradual roll-out basis. We are not a money manager in the sense of moving money in and out of billions of dollars on a daily basis. That's not the business of Google, so our business is going to be to build a really good portfolio that ties back to the interests that our community and the board set, which is clearly much better than just staying on day-to-day sovereign-backed securities. So that is going to take a couple of quarters to roll out. In the meantime, we are on the operating income side, you are paying the price for it while we are migrating. We recognize that. But I would separate that. We will fix that, it's just going to take a couple of quarters and it's going to be fixed and then we will not be in the position we're in today. I think that overall I'm really pleased with the fact that we have protected our assets so well over the last year. On the flip side, on the hedging side, I think that our hedging is an insurance policy and if you look at, again, the last 12 months, it served us so incredibly well that there is a really good case to continue to invest the dollars we put there. And as volatility comes does, the costs are also going to come down. So hopefully that will also benefit us. So the net of these two things, I think that we have a very balanced strategy. I would love to be exactly where our target portfolio should be, but we have to do this in a disciplined manner so it's going to happen over a couple of quarters. And then from there we will be in a much more regular state. So from that perspective I think you are right, that the third quarter kind of illustrates a transition period. In terms of the last point of your question, I think Eric mentioned it very clearly on the call. So that's how we think of OI&E. And it's bound to change over the coming quarters.
Maria Shim: The next question comes from Brian Pitz – UBS.
Brian Pitz: Could you broadly discuss Google's strategy regarding search distribution deals? Do you think you have reached a scale in terms of distribution to not overpay for these deals?
Patrick Pichette: Let me talk about the first part because I think the first part of the question is the heart of the matter, which is we look at every distribution deal we can because it's good for the ecosystem. It's good for everybody; everybody makes money when you have a good distribution deal and in that context all we want to make sure is we have also discipline at making sure that when there is a deal it's a win-win. And I wouldn't comment that in the past anybody overpaid for anything. There may be deals that in hindsight didn't make sense and needed restructuring, but that doesn't mean that somebody overpaid. So in my mind right now we have a really good strategy of making sure that every partner we can bring onboard is a good partner and we have just got to make sure that everybody wins at it. So I'm actually quite pleased at the way that this is going and we hope to have even more partners in the future.
Maria Shim: The next question is from Imran Khan - JP Morgan.
Imran Khan: The tax rate was 21%. How should we think about the tax rate going forward?
Patrick Pichette: Tax continues to be quite elusive for many of the analysts that have models because of all of the factors that are at play in taxes. So FX is a big issue for our taxes and also the hedging program and how it flows through the tax effect. So we are pleased to have 21% but we really can't comment about the future because it's so dependent on these big variables and will affect us.
Maria Shim: The next question comes from Heath Terry – FBR.
Heath Terry: You mentioned that mobile search volumes grew 30% quarter-over-quarter. Can you give us a sense of monetization levels of mobile search queries versus a traditional search query and what kind of trends you're seeing in mobile search monetization?
Jonathan Rosenberg: We don't really comment specifically on the monetization statistics of mobile versus desk top. I can certainly say that from a search traffic perspective, search traffic volume is being very nicely driven on mobile by smart phone adoption. In some markets, like in Japan, mobile searches are growing twice as fast as desk top searches over the last year or so. Eric mentioned that advertisers are seeing value and taking advantage of new Google ads products and I think in the long run mobile is really going to emerge as one of those. I think right now what we see is that advertisers are typically just extending their campaigns into mobile and they're not doing as much customization with the campaigns on the mobile side because there's not as much volume there, but as they start seeing more volume they'll customize the campaigns better, which will make the whole ad network work better. I think the other thing we're seeing is that display seems to work very well on some of these devices and I think that's because of the level of engagement that a user has when they're staring at a cell phone and actually seeing a display ad. They tend to notice it more, and unlike when they're on a desk top machine, they're less like to click away from it. So there's much more of a dynamic of forced engagement with display. So I think we're quite optimistic there about AdSense on the high-end mobile devices.
Maria Shim: The next question comes from Scott Devitt – Morgan Stanley.
Scott Devitt: How is Google managing to growth a vertical search platform, particularly in the retail category and should we expect more direct investment in vertical areas such as base product cards check out or a more horizontal approach?
Jonathan Rosenberg: The strategy certainly depends a lot on verticals, so product search and shopping is certainly one where we are particularly focused at the moment. We are continuing to improve the shopping vertical. We launched the find-nearby store, which is the first local shopping feature recently. We are also trying to have a much more visual shopping-one-box. If you type in "chrome toaster" you will see the shopping-one-box and how that works. We are doing well with checkout, there's a payment platform there and I think we're starting to get more focused on some of the other verticals. We have always done well in images. You're certainly aware of the works that we're doing in books. We have made more progress with help. We just launched the poison-control-one-box. Real estate, finance, and travel are also other areas that we're going to get quite focused on and obviously we will also continue to improve Google horizontally.
Maria Shim: The next question comes from Colin Gillis – Brigantine.
Colin Gillis: Can you talk to the value of mobile clicks compared to desk top clicks and specific verticals where the value is much higher.
Jonathan Rosenberg: I think that the dynamics are very different, if you think about it, and it all relates to the probability that the user is actually going to consummate a transaction. So if you're searching locally for a restaurant or a coffee shop, then the value of a click is different from a desk top and in some cases you don't get credit for the click because the user just walks in the store. And so I think we're still sorting some of that out.
Maria Shim: The next question comes from Jeetil Patel - Deutsche Bank Securities.
Jeetil Patel: It is quite commendable that Google is not micro managing its business based on margin percentages. That said, should we think about the business from the standpoint of a cash flow dollar target three, five, seven years out, or a sustainable cash flow growth rate?
Patrick Pichette: Let me just give a bit more comment to what I said on the previous call, which is obviously the focus of the company is on innovation, innovating products that actually serve users and benefit also our advertisers. And so from that perspective the only point we wanted to make on the previous call that is worth restating is that if there were an area where we needed to invest heavily in the short term in order to really fuel growth in a specific area we have the means to do it. And Google wouldn't kind of worry for a quarter, a couple of quarters, if it really was the right strategic decision, to kind of say what's going to be our percentage margin impact. We're here to build businesses and in that sense you have a positive mindset of instead of being stuck in margin land, which most companies live in, we can actually be in the land of capturing opportunities. And for us, that's so much more powerful. So just for an illustration, rather than to make the case for one, if Android continues to have all the runway that it's having right now, you know you go from one handset with one provider in one country to the stats that we shared with you a bit earlier, with like 25 countries and 30 handsets or whichever it was. Maybe the reversal. But it's so much more, if we had that kind of invest in those areas and the question became what's going to the percentage margin, we would never ask that question. And that's why I think we answer that question the way we do, I think that clearly Google is generating a healthy amount of cash and we are really pleased by that and that gives us the strategic to have the freedom to actually do the kinds of things that Eric talked about a bit earlier. So that's really how we think about the business. It's about growth, it's about users, and it's about partners or advertisers. And that's how we think about the business.
Maria Shim: The next question comes from James Mitchell - Goldman Sachs.
James Mitchell: Given the sharp sequential improvement in revenue, did Google also sharply increase bonus accruals?
Patrick Pichette: We had to do some additional accruals—James, I think that's a good catch. Many of you always ask us about these kind of bonus accruals. In Q3 the performance was such that we had to do a bit of catch-up on accruals and that's what we meant when we talked in our comments that part of the quarter-over-quarter increase in expenses went to that as well. But it also went to a couple of other items that I mentioned, like real estate and equipment. So, yes, absolutely we had to have some accrual impact.
Maria Shim: The next question comes from Benjamin Schachter - Broadpoint Am Tech.
Benjamin Schachter: When can we expect to see the CPA model more broadly deployed on Google.com?
Jonathan Rosenberg: The conversion optimizer product is actually a CPA pricing model and we're using it pretty broadly. I think we announced this quarter that it's managing over a billion in annual spend and it's driving pretty good results for the advertisers. They use it to get more conversions and manage it to a lower CPA. We are running some experiments but I think some blogs may have picked up on CPA-based pricing models for some product-focused advertisement and these are generally running on the Google affiliate network on Google.com. I can't comment too much on how that's going until it launches a little bit more broadly.
Maria Shim: The next question comes from Wayne Chang - Canaccord Adams.
Wayne Chang: For the greater willingness to add more heads to staff and invest in the company, could you comment on how aggressive that ramp may look like in 2010 and are there distinct areas you are looking to pull talent?
Patrick Pichette: The bottleneck becomes finding great talent that fits with the culture. And so we have ramped up our hiring practices and our pipelines we hope, so we won't give you specific numbers. But what I can tell you is we are ramping up our pipelines to make sure that we have access. And we also think that in this kind of economic environment there is a great opportunity to actually get great talent as well, so we should capitalize on that as much as possible. Where we're going to invest them, I think Eric made the point that he hopes to have a 50% engineering and then 50% everything else. So it's just a rule of thumb that we use that because this is an engineering-driven company with innovation at its core, it's really important that the bulk of the hiring that we're looking for is in the engineering talent and they will be applied to all of our priority areas and they, yes, include mobile, video, but also search because search continues to be the next billion dollar business as well. And we have a such a healthy agenda on that one as well. So that's how to think about it.
Maria Shim: Your next question comes from Heath Terry – FBR.
Heath Terry: What kind of advantages does the Double Click ad exchange offer over other ad exchanges? How does it stand from a standpoint of advertisers and publishers?
Jonathan Rosenberg: We are really focused more on our customer needs I think than a specific competitive set per se. We think there is a huge opportunity, as I think we have told you about, to create this open ecosystem where buyers and sellers can meet and transact. One of the exciting features is that we're actually able to do this and seamlessly integrate AdWords, advertisers, and AdSense publishers and all of the Double Click advertisers and publishers, which has been part of the vision from the acquisition at the beginning. We are also trying to get very, very fast in real time so you actually have real time bidding for buyers, real time yield management across all of the publisher channels and helping things clear properly, so we are very optimistic about how things are going there.
Maria Shim: The next question comes from Sandeep Aggarwal - Collins Stewart.
Sandeep Aggarwal: What were the trends for search spend by small- and medium-sized advertisers during the quarter?
Jonathan Rosenberg: I think in general we saw fewer macroeconomic effects with the small- and medium-sized advertisers, from the beginning of the recession than we saw with large advertisers. Larger advertisers, I think, were faster to cut as the recession began and they were stronger and faster to rebound as things came back. So the main trend that I think we saw that characterized the last quarter was the larger advertisers coming back. Patrick is that correct?
Patrick Pichette: That is correct. That's why we emphasized it because you will remember we discussed in Q1 and Q2 how the big advertiser had pulled back out and the small-medium businesses were kind of holding their own. And what really we saw in Q3 was the big advertisers depending on the verticals again and depending on the geographies. So not everything is the same everywhere, but these are the ones that made quite a significant difference in the quarter.
Maria Shim: The next question comes from Richard Fetyko of Merriman Curhan Ford.
Richard Fetyko of Merriman Curhan Ford: What are your intentions with the acquisition of [Antou]?
Jonathan Rosenberg: [Antou] is a publicly traded company and the deal hasn't closed. So I don't think we can answer that.
Patrick Pichette: That's right. So in Q4. Wait for the after the closing and ask us the question again.
Jonathan Rosenberg: Yes, we'll keep improving video quality and delivery.
Maria Shim: The next question comes from Mark May - Needham & Company.
Mark May: Please provide more color on your hiring plans. What functional areas of geographies will be most impacted?
Patrick Pichette: Again, rather than to give you a specific answer, I think that if I were an analyst kind of thinking through our own models, the next billion dollars of revenue doesn't require linear hiring in finance. So it really is about innovation. So I think that you can think through our organization and think through, if we really want to focus in the areas of engineering and the areas of sales and support, then it tells you really where we're going to focus our hiring. And then obviously there are a number of other areas that we will continue to grow just because with more businesses you have the complexity of more businesses, so you do need the more lawyers, you need the more of this and the more of that, but the real bulk of it is really in the engineering community and in the sales and support community that really drive these ecosystems. That's how we're thinking about it.
Maria Shim: The next question comes from Jeffrey Lindsay - Sanford C. Bernstein.
Jeffrey Lindsay: Did you enter into a financial agreement with Verizon such as a rough sharing order to persuade to accept Android phones or did they elect to select Android without a financial incentive?
Jonathan Rosenberg: What we announced was a strategic agreement to deliver mobile devices to consumers based on the wonderful open-source Android operating system we have which is going to be serviced and towered by Verizon's great nationwide network. We don't comment on specifics of the deal. But I think we certainly collect that we have the same goals of getting some of these great peer net connected smart phones into the hands of consumers.
Maria Shim: Your next question comes from Jim Friedland – Cowen & Company.
Jim Friedland: How will you be accounting for advertising revenues on the ad exchange?
Patrick Pichette: Why don't we get back to you? I'm pretty sure we're doing it on a gross basis, but why don't we get back to you.
Maria Shim: The next question comes from Imran Khan - JP Morgan.
Imran Khan: How much of your sequential growth was driven by Ad Auality improvement?
Jonathan Rosenberg: Again, we don't tend to break that out. We had a very good quarter from Ad Quality's perspective. I can tell you the significant things that we did. The biggest things, probably in order, or close to order, were the UI tweaks that we did for results pages. We changed the maximum width, decreasing the spacing between the search results and the right hand side ads on wide screen. With that it increased the click-through rate on the right hand side ads and I think we did that some time around the second week in August. We also had some significant ad improvements like site links that basically allow additional links to categorize and deeper advertisers of a site, which you can see if you run a query on something like Chevy, you'll see the Silverado, the Malibu, you will see more information there, which increased click-through rates. We also did some more work on showing more goods at good ads and expanded match. But we don't give a specific sense of exactly the percentage that that resulted in. The more significant of the changes occurred in mid-August.
Maria Shim: The next question comes from Doug Anmuth - Barclays Capital.
Doug Anmuth: As the dollar has weakened, how are you thinking about your hedging program? Will you scale it down going forward? Was the declining quarter cost of hedging in Q3 due to less volatility or less exposure?
Patrick Pichette: Let me answer your question in kind of two or three different ways. First is clearly there was less volatility in Q3 and we had taken, you'll remember in Q2 because there was so much more volatility in Q1 and Q2, we had taken a lot more because of FAS 133. Of these hedging costs through the P&L at that time, and therefore less volatility in Q3. With the combination of less volatility and already taken big write-downs, created less expenses for the quarter itself. That's on piece. Going forward, if international revenue continues to grow, it will create more exposure for us and in that sense we will require more attention on the hedging side. That's how to think about the second part of your question. And the question of are we scaling it back, will be scale it back, clearly not in the sense that when you look at all the benefits we gained last year from this program, it is seen as insurance. It's matters as insurance and therefore there is no plan on scaling it. Having said that, there is a plan for review of it on a constant basis and formally, annually, as we build our plan forward and we go back, if there are areas where we can actually be smarter in terms of more deductibles, if you have less volatility, like there's a science to this, it's not a blind exercise, and we are running an optimum curve where there's actually a specific point where we're trying to manage to. And you try to minimize the cost, obviously, for the maximum benefits. And that's how we're thinking about it and that's how we'll manage going forward. And then in general, about the dollar weakening, I think there may be, for anybody who has a perception that the dollar is going to continue to weaken over the coming two or three or four years, if you made that case, then you would say you don't need your hedging program. And that's the danger that every hedging program falls into, which is people will say why are you investing this much this quarter into a hedging program that has no benefit because I know the dollar is only going to weaken, and then the next thing you know you have a crisis like we had last year and then they say where's your hedging program. So it is insurance, it's part of doing business and in a business like ours, and I will refer you back to the very first two points I've made, which is it's about finding that optimal point, making sure that we're finding the best economic value for these hedging programs, and then it will be driven a lot by the market itself and the exposures we have. But we're putting a lot of science into this.
Maria Shim: The next question comes from Wayne Chang - Canaccord Adams.
Wayne Chang: Could you comment on the level of monetization changes to YouTube and future thoughts on aligning the strategicals for video to over the top distribution.
Jonathan Rosenberg: I guess I don't know exactly what over the top distribution means but I certainly know a lot about what's going on from a monetization perspective on YouTube. So let me try to focus on that. I think we've said before we're monetizing more than a billion views every week and these monetizable views have increased more than three times in the last year. So the model there is making partners money and the success of content to idea over the course of the last several months has been a big part of that. Usage and traffic continues to be very, very strong and we are now doing a good job of monetizing across the four activities that Chad tends to refer to on the site. The home page ads are going great. We have sold out the U.S. YouTube home page over significant periods of time. We are making great progress on the search videos. If you look at the promoted videos on the right hand side, if you put in a query for something like soccer, the watch videos with the in-stream ads are going well, and we're getting some interesting videos uploaded and better engagement with the user community. If you take a look at the Quaker Oats contest that's running now on awakening your senses challenges, we're seeing a lot of interest there. So I think across the board things are going very well from a monetization perspective with YouTube.
Maria Shim: Your next question comes from Jeetil Patel - Deutsche Bank Securities.
Jeetil Patel: With the strong gains you are seeing in the display ad business, can you discuss whether these gains are a function of share gains and online display ads or do these dollars represent new dollars being allocated to the Internet from offline.
Jonathan Rosenberg: We certainly talked about how happy we are with the growth of the display business. We don't typically comment on our market share. I do think display has a huge potential. I think our goal is to obviously help the overall pie grow and I think we have succeeded because we're offering great performance to advertisers and we are going to continue to grow revenue for our publishers. I think significant portions of dollars are coming offline to online.
Maria Shim: Your next question comes from Jeffrey Lindsay - Sanford C. Bernstein.
Jeffrey Lindsay: Is search on mobile devices cannibalistic to PC search or is it additive?
Patrick Pichette: I think that the most exciting thing about mobile is that even though there may be on the margin some stuff that is kind of overlap, it's essentially a new space. And because it's a new space and there has been a lot of research done on this, and there was one, for example, there was one research that I read not long ago where by the end of 2011 or the end of 2012 that the research talks about smart phones surpassing the global PC in sales. So you end up in a world where like it's an "and" world rather than an "or" world where you live very differently with your mobile device than the PC.
Jonathan Rosenberg: I think that the intuitive way to think about it is really that it's largely non-cannibalistic because think about it, having search with you at all times basically opens up new opportunities no matter where you are at the time of day. So certainly a search that somebody was able to do because they had their mobile phone with them when they were away from their desktop is unlikely to be cannibalistic. The other thing that we can actually see in the data is the complimentary aspect of the usage patterns across time of day and day of week. You see mobile usage increase in the middle of the day at lunch, you see it increase after work, you see it increase over the weekend. So I think some of those dynamics suggest that it's largely not cannibalistic but we need to continue to gather data there to better understand it.
Maria Shim: Your next question comes from Benjamin Schachter - Broadpoint Am Tech.
Benjamin Schachter: Will we see more video ads within the Google search pages and how will the YouTube sales force work with the existing bidding system for Google.com?
Jonathan Rosenberg: We are definitely show more videos on Google.com. Like we have that plus box now and you can see it on some queries. Typically the queries that you see it on today are limited to entertainment and movies. I think there are some good product demonstrations. Type in "astro boy." I think that's an example that will generate one of the plus boxes. So I think we're pretty encourage by the user and the advertiser responses there and we're going to keep investing in expanding that some more. I think that we want those formats ultimately to merge with the YouTube efforts from a sales and product perspective, which we're working to do.
Maria Shim: Your next question comes from Sandeep Aggarwal - Collins Stewart.
Sandeep Aggarwal: What are the top three hurdles Google needs to cross to be a significant player in display advertising?
Jonathan Rosenberg: I think we covered some of those already. I think that we talked on the first call, you've got to make it easier for the advertisers to run their campaign. We've got to get the demand for the publisher ad inventory. I think publishers are mostly interested in forecasting, they want to extract the maximum value from the inventory that they have, they want to be able to use products like Network Builder much more easily to manage their inventory across all of their sites. On the other side, the advertisers basically want to use products like the ad planner product so they can get much better at targeting relative to specific audiences. We launched demographic data in Ad Planner for nine or ten markets this last quarter, adding the U.K., France, Japan, Brazil, Australia and others. So I think it's just basically an effort around fixing what historically has been a very fractured and complex ad ecosystem and making it easier for the advertisers and the publishers to engage and thereby grow the pie for everyone.
Patrick Pichette: The way the question is written, I think that it is important to understand that in many ways Google is a very significant player in this play today. The question is, it is a model that is very fragmented. It's a model that really has a ton of inefficiencies and many people would like to participate in the model, if there were an exchange, if there were a place where a publisher could actually interact on an efficient basis. From that perspective. I think it really is a story about fixing an industry that is really cumbersome in a lot of upside rather than a story of are we catching up in some way, shape or form.
Maria Shim: Your next question comes from Christa Quarles - Thomas Weisel Partners.
Christa Quarles: On the display side we hear from marketers and agencies that they are interested in products that are not IAB standard, i.e. screen takeovers. How important is this business for you and how does it compliment what you're doing on the exchange?
Jonathan Rosenberg: Well, we're trying to build display products for all advertisers out there, both on the branded side and on the performance display side, so obviously we want to support creativity as part of our strategy in everything that we do. We have been working on a bunch of tools focused on this, within Double Click as well as within AdWords. The Double Click rich media studio basically being the main focus. So we are going to keep building and differentiating the products and trying to find ways to bring more accountability, showcase the ROI, and let the advertisers and publishers benefit from our innovations there. Exactly how that will manifest itself in terms of what may today may be non-IAB standard formats, I can't say.
Maria Shim: Your next question comes from Youssef Squali - Jefferies & Co.
Youssef Squali: How does the Google exchange differ from others like Right Media, and how does Google overcome the lack of Tier 1 inventory?
Jonathan Rosenberg: I believe that the exchange will have all types of inventory including Tier 1 inventory. It's plain and simple.
Maria Shim: Your next question comes from Jim Friedland – Cowen & Company.
Jim Friedland: Again, a follow-up to Jonathan's comment that display is compelling in the mobile environment. If mobile display is a material opportunity would the company consider monetizing Google products such as Gmail on mobile via display ads.
Jonathan Rosenberg: Would we consider something? Sure, we would consider something. I think that mail on mobile may be a little bit more difficult to aggressively monetize, again, because you're dealing with the small screen size there and it's a little bit more difficult to find adjacent room that doesn't get in the way of a mail message. Certainly we're open to better ways of doing display on the mobile devices. It's not immediately obvious to me, intuitively, that Gmail would me a more monetizable opportunity on mobile devices than it is on desktop devices. But we're certainly going to watch and see how mobile plays out. There are some good examples there with popular apps, Urban Spoon, Shazam, and other, where I think we can get a sense of how some ad formats work and see whether or not there are opportunities there. I would be hesitant to really launch functionality that significantly adverses people's ability to read their mail.
Maria Shim: Your next question comes from Christa Quarles - Thomas Weisel Partners.
Christa Quarles: Other cost of revenue, excluding depreciation, which was 5.7% of gross revenues which is quite a bit lower from a year ago. Can you provide an explanation? Is YouTube more efficient or are you reserving costs lower?
Patrick Pichette: The answer is yes. So, we are more efficient, and even depreciation, if you look at depreciation quarter-over-quarter and year-over-year, essentially when Eric talked a bit earlier about the fact that we really, over the last year from an architectural point of view, did a number of changes to be much more efficient, we got the benefits of that. And we get the benefits on the machine utilization but we also get it on the network side. So overall, you see it both in the opex side as well as the depreciation side. So it is part of the puzzle for that category, so I'm really happy that we're continuing to push hard in that area.
Maria Shim: Your next question comes from Mark Mahaney – Citigroup.
Mark Mahaney: Have Sergey and Larry's roles within the company changed materially over the past two years? Are they still as actively involved as in the past?
Jonathan Rosenberg: They're still my boss. I guess really the most significant change, probably for you all, is that they're not on the earnings call, which they were in the past. But generally I think they're just as engaged and involved in the state of the business as they always have been. I think as a management team we're trying to do a better job of dividing and conquering across different products and different applications so I think many of the folks on Eric's management team are more specifically focused on particular areas. Sergey, for example, is diving deep on the social side. Larry is very involved in Chrome OS and Android. So I think they continue to be very, very much engaged. I think that all of us on the management team are trying to get focused on specific efforts within the business because the businesses now are so large that we can't all focus on everything.
Patrick Pichette: But I think it's fair to say that they are incredibly involved. I mean, in my mind, these two founders, we see them daily, we see them through the week. On the areas where they are focused, they are incredibly focused. They are very present. I get—Larry to this day continues to review every hire every week. There is a presence and an active presence from both of them that continues to be incredibly energizing because it's so great to work day-to-day with these people. So it's not a question of, don't assume because they're not on the earnings call that they're somewhere off and they're half checked out. They're here. We're on email with Larry. I couldn't believe, I sent something to Larry the other day and like an hour later, this was on Sunday morning, and then we're chatting away. That's the level of involvement these two founders are. And they're setting the direction of the company, leading the company. And in the areas where they really have their forte, they dig deep on an everyday basis.
Jonathan Rosenberg: And they still review every job offer.
Patrick Pichette: So that gives you a sense of perspective of their involvement. Thanks for asking that question because I think it is really—people kind of always question that but I think it's really at the heart of why Google is so special.
Maria Shim: Your next question comes from Jeffrey Lindsay - Sanford C. Bernstein.
Jeffrey Lindsay: How far off is the possibility of you [inaudible] targeting a Double Click.
Jonathan Rosenberg: We can take another question because I'm not going to comment on future direction there. It's not something we're currently working on.
Maria Shim: Your final question comes from Imran Khan - JP Morgan.
Imran Khan: Can you please give us some color on what kind of trends you are seeing in the U.K. Can you help us with play click and CPC trends in the U.K.?
Patrick Pichette: We can talk geographically about the U.K. We saw a decline year-over-year but you saw an increase, also, quarter-over-quarter for the U.K. Primarily due to FX because of the big changes, decline since last year. And then the same thing for quarter-over-quarter. I think that in general the U.K. continues to perform pretty well. In the grand scheme of things, given the tough economic environment that they have seen in the last little while, you would have thought that they would have been a major pullback. But the search continues to be there and the key verticals that are driving the U.K. continue to be doing relatively well. So I think that there are signs of increasing consumer confidence and you think of Q3, Q4, the travel vertical or the retail vertical, they did kind of okay. So it's not like the U.K. is in a nose dive. The U.K. is holding its own is the best way to portray it.
Maria Shim: Thanks everyone for joining us today. If you have any follow-ups please let us know. Thank you.
Operator: This concludes today’s conference call. | [
{
"speaker": "Operator",
"text": "Good day and welcome, everyone, to the Google Inc. conference call. Today's conference is being recorded. At this time, I would like to turn the call over to Maria Shim."
},
{
"speaker": "Maria Shim",
"text": "Good afternoon, everyone, and welcome Google's third quarter 2009 earnings follow up conference call. With us are Patrick Pichette, Chief Financial Officer, and Jonathan Rosenberg, Senior Vice President of Product Management. After we cover a few housekeeping items we will start taking questions from the moderator page, as we did on the last call. Also, this call is being Web cast from our Investor Relations Web site located at investor.google.com. Please refer to our Web site for important information, including our earnings press release and related slide deck. A replay of this call will also be available on our Web site in a few hours. Please note that we routinely post important information on our Investor Relations Web site located at investor.google.com and we encourage you to make use of that resource. As a reminder, the purpose of this follow-up call is to give participants the opportunity to ask more detailed financial and product questions in an efficient and Reg FD-compliant manner. Let me now quickly cover the safe harbor. Some of the statements we make today may be considered forward-looking and these statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings, including our annual report on Form 10-K for the year ended December 31, 2008, as well as our earnings press release for a more detailed description of the risk factors that may affect our results. Copies can be obtained from the SEC or by visiting the Investor Relations section of our Web site. Also, please note that certain financial measures we use on this call, such as operating profit and operating margin, are expressed on a non-GAAP basis and have been adjusted to exclude charges relating to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and GAAP to non-GAAP reconciliation can be found in our earnings press release. With that, we are going to take as many questions as we can accommodate."
},
{
"speaker": "Maria Shim",
"text": "We will start with a question from Mark Mahaney – Citigroup."
},
{
"speaker": "Mark Mahaney",
"text": "How can a company with $22.0 billion on the balance sheet in cash generate negative net interest income? How about cutting out the hedging program and buying back stock? That's a huge drag on your ROI."
},
{
"speaker": "Patrick Pichette",
"text": "It's obvious that the consequence of the last year is pulling through on OI&E. So just to give you how we're managing it is as soon as a couple of quarters ago, we were all in kind of very conservative portfolio in order to take the cash, given the economic situation. Since then, we have actually revised our investment strategy and have agreed to an investment portfolio for the long term. And we are in the process of actually moving out of that very conservative position we were, but there is an impact, obviously, because we're doing this on a gradual roll-out basis. We are not a money manager in the sense of moving money in and out of billions of dollars on a daily basis. That's not the business of Google, so our business is going to be to build a really good portfolio that ties back to the interests that our community and the board set, which is clearly much better than just staying on day-to-day sovereign-backed securities. So that is going to take a couple of quarters to roll out. In the meantime, we are on the operating income side, you are paying the price for it while we are migrating. We recognize that. But I would separate that. We will fix that, it's just going to take a couple of quarters and it's going to be fixed and then we will not be in the position we're in today. I think that overall I'm really pleased with the fact that we have protected our assets so well over the last year. On the flip side, on the hedging side, I think that our hedging is an insurance policy and if you look at, again, the last 12 months, it served us so incredibly well that there is a really good case to continue to invest the dollars we put there. And as volatility comes does, the costs are also going to come down. So hopefully that will also benefit us. So the net of these two things, I think that we have a very balanced strategy. I would love to be exactly where our target portfolio should be, but we have to do this in a disciplined manner so it's going to happen over a couple of quarters. And then from there we will be in a much more regular state. So from that perspective I think you are right, that the third quarter kind of illustrates a transition period. In terms of the last point of your question, I think Eric mentioned it very clearly on the call. So that's how we think of OI&E. And it's bound to change over the coming quarters."
},
{
"speaker": "Maria Shim",
"text": "The next question comes from Brian Pitz – UBS."
},
{
"speaker": "Brian Pitz",
"text": "Could you broadly discuss Google's strategy regarding search distribution deals? Do you think you have reached a scale in terms of distribution to not overpay for these deals?"
},
{
"speaker": "Patrick Pichette",
"text": "Let me talk about the first part because I think the first part of the question is the heart of the matter, which is we look at every distribution deal we can because it's good for the ecosystem. It's good for everybody; everybody makes money when you have a good distribution deal and in that context all we want to make sure is we have also discipline at making sure that when there is a deal it's a win-win. And I wouldn't comment that in the past anybody overpaid for anything. There may be deals that in hindsight didn't make sense and needed restructuring, but that doesn't mean that somebody overpaid. So in my mind right now we have a really good strategy of making sure that every partner we can bring onboard is a good partner and we have just got to make sure that everybody wins at it. So I'm actually quite pleased at the way that this is going and we hope to have even more partners in the future."
},
{
"speaker": "Maria Shim",
"text": "The next question is from Imran Khan - JP Morgan."
},
{
"speaker": "Imran Khan",
"text": "The tax rate was 21%. How should we think about the tax rate going forward?"
},
{
"speaker": "Patrick Pichette",
"text": "Tax continues to be quite elusive for many of the analysts that have models because of all of the factors that are at play in taxes. So FX is a big issue for our taxes and also the hedging program and how it flows through the tax effect. So we are pleased to have 21% but we really can't comment about the future because it's so dependent on these big variables and will affect us."
},
{
"speaker": "Maria Shim",
"text": "The next question comes from Heath Terry – FBR."
},
{
"speaker": "Heath Terry",
"text": "You mentioned that mobile search volumes grew 30% quarter-over-quarter. Can you give us a sense of monetization levels of mobile search queries versus a traditional search query and what kind of trends you're seeing in mobile search monetization?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "We don't really comment specifically on the monetization statistics of mobile versus desk top. I can certainly say that from a search traffic perspective, search traffic volume is being very nicely driven on mobile by smart phone adoption. In some markets, like in Japan, mobile searches are growing twice as fast as desk top searches over the last year or so. Eric mentioned that advertisers are seeing value and taking advantage of new Google ads products and I think in the long run mobile is really going to emerge as one of those. I think right now what we see is that advertisers are typically just extending their campaigns into mobile and they're not doing as much customization with the campaigns on the mobile side because there's not as much volume there, but as they start seeing more volume they'll customize the campaigns better, which will make the whole ad network work better. I think the other thing we're seeing is that display seems to work very well on some of these devices and I think that's because of the level of engagement that a user has when they're staring at a cell phone and actually seeing a display ad. They tend to notice it more, and unlike when they're on a desk top machine, they're less like to click away from it. So there's much more of a dynamic of forced engagement with display. So I think we're quite optimistic there about AdSense on the high-end mobile devices."
},
{
"speaker": "Maria Shim",
"text": "The next question comes from Scott Devitt – Morgan Stanley."
},
{
"speaker": "Scott Devitt",
"text": "How is Google managing to growth a vertical search platform, particularly in the retail category and should we expect more direct investment in vertical areas such as base product cards check out or a more horizontal approach?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "The strategy certainly depends a lot on verticals, so product search and shopping is certainly one where we are particularly focused at the moment. We are continuing to improve the shopping vertical. We launched the find-nearby store, which is the first local shopping feature recently. We are also trying to have a much more visual shopping-one-box. If you type in \"chrome toaster\" you will see the shopping-one-box and how that works. We are doing well with checkout, there's a payment platform there and I think we're starting to get more focused on some of the other verticals. We have always done well in images. You're certainly aware of the works that we're doing in books. We have made more progress with help. We just launched the poison-control-one-box. Real estate, finance, and travel are also other areas that we're going to get quite focused on and obviously we will also continue to improve Google horizontally."
},
{
"speaker": "Maria Shim",
"text": "The next question comes from Colin Gillis – Brigantine."
},
{
"speaker": "Colin Gillis",
"text": "Can you talk to the value of mobile clicks compared to desk top clicks and specific verticals where the value is much higher."
},
{
"speaker": "Jonathan Rosenberg",
"text": "I think that the dynamics are very different, if you think about it, and it all relates to the probability that the user is actually going to consummate a transaction. So if you're searching locally for a restaurant or a coffee shop, then the value of a click is different from a desk top and in some cases you don't get credit for the click because the user just walks in the store. And so I think we're still sorting some of that out."
},
{
"speaker": "Maria Shim",
"text": "The next question comes from Jeetil Patel - Deutsche Bank Securities."
},
{
"speaker": "Jeetil Patel",
"text": "It is quite commendable that Google is not micro managing its business based on margin percentages. That said, should we think about the business from the standpoint of a cash flow dollar target three, five, seven years out, or a sustainable cash flow growth rate?"
},
{
"speaker": "Patrick Pichette",
"text": "Let me just give a bit more comment to what I said on the previous call, which is obviously the focus of the company is on innovation, innovating products that actually serve users and benefit also our advertisers. And so from that perspective the only point we wanted to make on the previous call that is worth restating is that if there were an area where we needed to invest heavily in the short term in order to really fuel growth in a specific area we have the means to do it. And Google wouldn't kind of worry for a quarter, a couple of quarters, if it really was the right strategic decision, to kind of say what's going to be our percentage margin impact. We're here to build businesses and in that sense you have a positive mindset of instead of being stuck in margin land, which most companies live in, we can actually be in the land of capturing opportunities. And for us, that's so much more powerful. So just for an illustration, rather than to make the case for one, if Android continues to have all the runway that it's having right now, you know you go from one handset with one provider in one country to the stats that we shared with you a bit earlier, with like 25 countries and 30 handsets or whichever it was. Maybe the reversal. But it's so much more, if we had that kind of invest in those areas and the question became what's going to the percentage margin, we would never ask that question. And that's why I think we answer that question the way we do, I think that clearly Google is generating a healthy amount of cash and we are really pleased by that and that gives us the strategic to have the freedom to actually do the kinds of things that Eric talked about a bit earlier. So that's really how we think about the business. It's about growth, it's about users, and it's about partners or advertisers. And that's how we think about the business."
},
{
"speaker": "Maria Shim",
"text": "The next question comes from James Mitchell - Goldman Sachs."
},
{
"speaker": "James Mitchell",
"text": "Given the sharp sequential improvement in revenue, did Google also sharply increase bonus accruals?"
},
{
"speaker": "Patrick Pichette",
"text": "We had to do some additional accruals—James, I think that's a good catch. Many of you always ask us about these kind of bonus accruals. In Q3 the performance was such that we had to do a bit of catch-up on accruals and that's what we meant when we talked in our comments that part of the quarter-over-quarter increase in expenses went to that as well. But it also went to a couple of other items that I mentioned, like real estate and equipment. So, yes, absolutely we had to have some accrual impact."
},
{
"speaker": "Maria Shim",
"text": "The next question comes from Benjamin Schachter - Broadpoint Am Tech."
},
{
"speaker": "Benjamin Schachter",
"text": "When can we expect to see the CPA model more broadly deployed on Google.com?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "The conversion optimizer product is actually a CPA pricing model and we're using it pretty broadly. I think we announced this quarter that it's managing over a billion in annual spend and it's driving pretty good results for the advertisers. They use it to get more conversions and manage it to a lower CPA. We are running some experiments but I think some blogs may have picked up on CPA-based pricing models for some product-focused advertisement and these are generally running on the Google affiliate network on Google.com. I can't comment too much on how that's going until it launches a little bit more broadly."
},
{
"speaker": "Maria Shim",
"text": "The next question comes from Wayne Chang - Canaccord Adams."
},
{
"speaker": "Wayne Chang",
"text": "For the greater willingness to add more heads to staff and invest in the company, could you comment on how aggressive that ramp may look like in 2010 and are there distinct areas you are looking to pull talent?"
},
{
"speaker": "Patrick Pichette",
"text": "The bottleneck becomes finding great talent that fits with the culture. And so we have ramped up our hiring practices and our pipelines we hope, so we won't give you specific numbers. But what I can tell you is we are ramping up our pipelines to make sure that we have access. And we also think that in this kind of economic environment there is a great opportunity to actually get great talent as well, so we should capitalize on that as much as possible. Where we're going to invest them, I think Eric made the point that he hopes to have a 50% engineering and then 50% everything else. So it's just a rule of thumb that we use that because this is an engineering-driven company with innovation at its core, it's really important that the bulk of the hiring that we're looking for is in the engineering talent and they will be applied to all of our priority areas and they, yes, include mobile, video, but also search because search continues to be the next billion dollar business as well. And we have a such a healthy agenda on that one as well. So that's how to think about it."
},
{
"speaker": "Maria Shim",
"text": "Your next question comes from Heath Terry – FBR."
},
{
"speaker": "Heath Terry",
"text": "What kind of advantages does the Double Click ad exchange offer over other ad exchanges? How does it stand from a standpoint of advertisers and publishers?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "We are really focused more on our customer needs I think than a specific competitive set per se. We think there is a huge opportunity, as I think we have told you about, to create this open ecosystem where buyers and sellers can meet and transact. One of the exciting features is that we're actually able to do this and seamlessly integrate AdWords, advertisers, and AdSense publishers and all of the Double Click advertisers and publishers, which has been part of the vision from the acquisition at the beginning. We are also trying to get very, very fast in real time so you actually have real time bidding for buyers, real time yield management across all of the publisher channels and helping things clear properly, so we are very optimistic about how things are going there."
},
{
"speaker": "Maria Shim",
"text": "The next question comes from Sandeep Aggarwal - Collins Stewart."
},
{
"speaker": "Sandeep Aggarwal",
"text": "What were the trends for search spend by small- and medium-sized advertisers during the quarter?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I think in general we saw fewer macroeconomic effects with the small- and medium-sized advertisers, from the beginning of the recession than we saw with large advertisers. Larger advertisers, I think, were faster to cut as the recession began and they were stronger and faster to rebound as things came back. So the main trend that I think we saw that characterized the last quarter was the larger advertisers coming back. Patrick is that correct?"
},
{
"speaker": "Patrick Pichette",
"text": "That is correct. That's why we emphasized it because you will remember we discussed in Q1 and Q2 how the big advertiser had pulled back out and the small-medium businesses were kind of holding their own. And what really we saw in Q3 was the big advertisers depending on the verticals again and depending on the geographies. So not everything is the same everywhere, but these are the ones that made quite a significant difference in the quarter."
},
{
"speaker": "Maria Shim",
"text": "The next question comes from Richard Fetyko of Merriman Curhan Ford."
},
{
"speaker": "Richard Fetyko of Merriman Curhan Ford",
"text": "What are your intentions with the acquisition of [Antou]?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "[Antou] is a publicly traded company and the deal hasn't closed. So I don't think we can answer that."
},
{
"speaker": "Patrick Pichette",
"text": "That's right. So in Q4. Wait for the after the closing and ask us the question again."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yes, we'll keep improving video quality and delivery."
},
{
"speaker": "Maria Shim",
"text": "The next question comes from Mark May - Needham & Company."
},
{
"speaker": "Mark May",
"text": "Please provide more color on your hiring plans. What functional areas of geographies will be most impacted?"
},
{
"speaker": "Patrick Pichette",
"text": "Again, rather than to give you a specific answer, I think that if I were an analyst kind of thinking through our own models, the next billion dollars of revenue doesn't require linear hiring in finance. So it really is about innovation. So I think that you can think through our organization and think through, if we really want to focus in the areas of engineering and the areas of sales and support, then it tells you really where we're going to focus our hiring. And then obviously there are a number of other areas that we will continue to grow just because with more businesses you have the complexity of more businesses, so you do need the more lawyers, you need the more of this and the more of that, but the real bulk of it is really in the engineering community and in the sales and support community that really drive these ecosystems. That's how we're thinking about it."
},
{
"speaker": "Maria Shim",
"text": "The next question comes from Jeffrey Lindsay - Sanford C. Bernstein."
},
{
"speaker": "Jeffrey Lindsay",
"text": "Did you enter into a financial agreement with Verizon such as a rough sharing order to persuade to accept Android phones or did they elect to select Android without a financial incentive?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "What we announced was a strategic agreement to deliver mobile devices to consumers based on the wonderful open-source Android operating system we have which is going to be serviced and towered by Verizon's great nationwide network. We don't comment on specifics of the deal. But I think we certainly collect that we have the same goals of getting some of these great peer net connected smart phones into the hands of consumers."
},
{
"speaker": "Maria Shim",
"text": "Your next question comes from Jim Friedland – Cowen & Company."
},
{
"speaker": "Jim Friedland",
"text": "How will you be accounting for advertising revenues on the ad exchange?"
},
{
"speaker": "Patrick Pichette",
"text": "Why don't we get back to you? I'm pretty sure we're doing it on a gross basis, but why don't we get back to you."
},
{
"speaker": "Maria Shim",
"text": "The next question comes from Imran Khan - JP Morgan."
},
{
"speaker": "Imran Khan",
"text": "How much of your sequential growth was driven by Ad Auality improvement?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Again, we don't tend to break that out. We had a very good quarter from Ad Quality's perspective. I can tell you the significant things that we did. The biggest things, probably in order, or close to order, were the UI tweaks that we did for results pages. We changed the maximum width, decreasing the spacing between the search results and the right hand side ads on wide screen. With that it increased the click-through rate on the right hand side ads and I think we did that some time around the second week in August. We also had some significant ad improvements like site links that basically allow additional links to categorize and deeper advertisers of a site, which you can see if you run a query on something like Chevy, you'll see the Silverado, the Malibu, you will see more information there, which increased click-through rates. We also did some more work on showing more goods at good ads and expanded match. But we don't give a specific sense of exactly the percentage that that resulted in. The more significant of the changes occurred in mid-August."
},
{
"speaker": "Maria Shim",
"text": "The next question comes from Doug Anmuth - Barclays Capital."
},
{
"speaker": "Doug Anmuth",
"text": "As the dollar has weakened, how are you thinking about your hedging program? Will you scale it down going forward? Was the declining quarter cost of hedging in Q3 due to less volatility or less exposure?"
},
{
"speaker": "Patrick Pichette",
"text": "Let me answer your question in kind of two or three different ways. First is clearly there was less volatility in Q3 and we had taken, you'll remember in Q2 because there was so much more volatility in Q1 and Q2, we had taken a lot more because of FAS 133. Of these hedging costs through the P&L at that time, and therefore less volatility in Q3. With the combination of less volatility and already taken big write-downs, created less expenses for the quarter itself. That's on piece. Going forward, if international revenue continues to grow, it will create more exposure for us and in that sense we will require more attention on the hedging side. That's how to think about the second part of your question. And the question of are we scaling it back, will be scale it back, clearly not in the sense that when you look at all the benefits we gained last year from this program, it is seen as insurance. It's matters as insurance and therefore there is no plan on scaling it. Having said that, there is a plan for review of it on a constant basis and formally, annually, as we build our plan forward and we go back, if there are areas where we can actually be smarter in terms of more deductibles, if you have less volatility, like there's a science to this, it's not a blind exercise, and we are running an optimum curve where there's actually a specific point where we're trying to manage to. And you try to minimize the cost, obviously, for the maximum benefits. And that's how we're thinking about it and that's how we'll manage going forward. And then in general, about the dollar weakening, I think there may be, for anybody who has a perception that the dollar is going to continue to weaken over the coming two or three or four years, if you made that case, then you would say you don't need your hedging program. And that's the danger that every hedging program falls into, which is people will say why are you investing this much this quarter into a hedging program that has no benefit because I know the dollar is only going to weaken, and then the next thing you know you have a crisis like we had last year and then they say where's your hedging program. So it is insurance, it's part of doing business and in a business like ours, and I will refer you back to the very first two points I've made, which is it's about finding that optimal point, making sure that we're finding the best economic value for these hedging programs, and then it will be driven a lot by the market itself and the exposures we have. But we're putting a lot of science into this."
},
{
"speaker": "Maria Shim",
"text": "The next question comes from Wayne Chang - Canaccord Adams."
},
{
"speaker": "Wayne Chang",
"text": "Could you comment on the level of monetization changes to YouTube and future thoughts on aligning the strategicals for video to over the top distribution."
},
{
"speaker": "Jonathan Rosenberg",
"text": "I guess I don't know exactly what over the top distribution means but I certainly know a lot about what's going on from a monetization perspective on YouTube. So let me try to focus on that. I think we've said before we're monetizing more than a billion views every week and these monetizable views have increased more than three times in the last year. So the model there is making partners money and the success of content to idea over the course of the last several months has been a big part of that. Usage and traffic continues to be very, very strong and we are now doing a good job of monetizing across the four activities that Chad tends to refer to on the site. The home page ads are going great. We have sold out the U.S. YouTube home page over significant periods of time. We are making great progress on the search videos. If you look at the promoted videos on the right hand side, if you put in a query for something like soccer, the watch videos with the in-stream ads are going well, and we're getting some interesting videos uploaded and better engagement with the user community. If you take a look at the Quaker Oats contest that's running now on awakening your senses challenges, we're seeing a lot of interest there. So I think across the board things are going very well from a monetization perspective with YouTube."
},
{
"speaker": "Maria Shim",
"text": "Your next question comes from Jeetil Patel - Deutsche Bank Securities."
},
{
"speaker": "Jeetil Patel",
"text": "With the strong gains you are seeing in the display ad business, can you discuss whether these gains are a function of share gains and online display ads or do these dollars represent new dollars being allocated to the Internet from offline."
},
{
"speaker": "Jonathan Rosenberg",
"text": "We certainly talked about how happy we are with the growth of the display business. We don't typically comment on our market share. I do think display has a huge potential. I think our goal is to obviously help the overall pie grow and I think we have succeeded because we're offering great performance to advertisers and we are going to continue to grow revenue for our publishers. I think significant portions of dollars are coming offline to online."
},
{
"speaker": "Maria Shim",
"text": "Your next question comes from Jeffrey Lindsay - Sanford C. Bernstein."
},
{
"speaker": "Jeffrey Lindsay",
"text": "Is search on mobile devices cannibalistic to PC search or is it additive?"
},
{
"speaker": "Patrick Pichette",
"text": "I think that the most exciting thing about mobile is that even though there may be on the margin some stuff that is kind of overlap, it's essentially a new space. And because it's a new space and there has been a lot of research done on this, and there was one, for example, there was one research that I read not long ago where by the end of 2011 or the end of 2012 that the research talks about smart phones surpassing the global PC in sales. So you end up in a world where like it's an \"and\" world rather than an \"or\" world where you live very differently with your mobile device than the PC."
},
{
"speaker": "Jonathan Rosenberg",
"text": "I think that the intuitive way to think about it is really that it's largely non-cannibalistic because think about it, having search with you at all times basically opens up new opportunities no matter where you are at the time of day. So certainly a search that somebody was able to do because they had their mobile phone with them when they were away from their desktop is unlikely to be cannibalistic. The other thing that we can actually see in the data is the complimentary aspect of the usage patterns across time of day and day of week. You see mobile usage increase in the middle of the day at lunch, you see it increase after work, you see it increase over the weekend. So I think some of those dynamics suggest that it's largely not cannibalistic but we need to continue to gather data there to better understand it."
},
{
"speaker": "Maria Shim",
"text": "Your next question comes from Benjamin Schachter - Broadpoint Am Tech."
},
{
"speaker": "Benjamin Schachter",
"text": "Will we see more video ads within the Google search pages and how will the YouTube sales force work with the existing bidding system for Google.com?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "We are definitely show more videos on Google.com. Like we have that plus box now and you can see it on some queries. Typically the queries that you see it on today are limited to entertainment and movies. I think there are some good product demonstrations. Type in \"astro boy.\" I think that's an example that will generate one of the plus boxes. So I think we're pretty encourage by the user and the advertiser responses there and we're going to keep investing in expanding that some more. I think that we want those formats ultimately to merge with the YouTube efforts from a sales and product perspective, which we're working to do."
},
{
"speaker": "Maria Shim",
"text": "Your next question comes from Sandeep Aggarwal - Collins Stewart."
},
{
"speaker": "Sandeep Aggarwal",
"text": "What are the top three hurdles Google needs to cross to be a significant player in display advertising?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I think we covered some of those already. I think that we talked on the first call, you've got to make it easier for the advertisers to run their campaign. We've got to get the demand for the publisher ad inventory. I think publishers are mostly interested in forecasting, they want to extract the maximum value from the inventory that they have, they want to be able to use products like Network Builder much more easily to manage their inventory across all of their sites. On the other side, the advertisers basically want to use products like the ad planner product so they can get much better at targeting relative to specific audiences. We launched demographic data in Ad Planner for nine or ten markets this last quarter, adding the U.K., France, Japan, Brazil, Australia and others. So I think it's just basically an effort around fixing what historically has been a very fractured and complex ad ecosystem and making it easier for the advertisers and the publishers to engage and thereby grow the pie for everyone."
},
{
"speaker": "Patrick Pichette",
"text": "The way the question is written, I think that it is important to understand that in many ways Google is a very significant player in this play today. The question is, it is a model that is very fragmented. It's a model that really has a ton of inefficiencies and many people would like to participate in the model, if there were an exchange, if there were a place where a publisher could actually interact on an efficient basis. From that perspective. I think it really is a story about fixing an industry that is really cumbersome in a lot of upside rather than a story of are we catching up in some way, shape or form."
},
{
"speaker": "Maria Shim",
"text": "Your next question comes from Christa Quarles - Thomas Weisel Partners."
},
{
"speaker": "Christa Quarles",
"text": "On the display side we hear from marketers and agencies that they are interested in products that are not IAB standard, i.e. screen takeovers. How important is this business for you and how does it compliment what you're doing on the exchange?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Well, we're trying to build display products for all advertisers out there, both on the branded side and on the performance display side, so obviously we want to support creativity as part of our strategy in everything that we do. We have been working on a bunch of tools focused on this, within Double Click as well as within AdWords. The Double Click rich media studio basically being the main focus. So we are going to keep building and differentiating the products and trying to find ways to bring more accountability, showcase the ROI, and let the advertisers and publishers benefit from our innovations there. Exactly how that will manifest itself in terms of what may today may be non-IAB standard formats, I can't say."
},
{
"speaker": "Maria Shim",
"text": "Your next question comes from Youssef Squali - Jefferies & Co."
},
{
"speaker": "Youssef Squali",
"text": "How does the Google exchange differ from others like Right Media, and how does Google overcome the lack of Tier 1 inventory?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I believe that the exchange will have all types of inventory including Tier 1 inventory. It's plain and simple."
},
{
"speaker": "Maria Shim",
"text": "Your next question comes from Jim Friedland – Cowen & Company."
},
{
"speaker": "Jim Friedland",
"text": "Again, a follow-up to Jonathan's comment that display is compelling in the mobile environment. If mobile display is a material opportunity would the company consider monetizing Google products such as Gmail on mobile via display ads."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Would we consider something? Sure, we would consider something. I think that mail on mobile may be a little bit more difficult to aggressively monetize, again, because you're dealing with the small screen size there and it's a little bit more difficult to find adjacent room that doesn't get in the way of a mail message. Certainly we're open to better ways of doing display on the mobile devices. It's not immediately obvious to me, intuitively, that Gmail would me a more monetizable opportunity on mobile devices than it is on desktop devices. But we're certainly going to watch and see how mobile plays out. There are some good examples there with popular apps, Urban Spoon, Shazam, and other, where I think we can get a sense of how some ad formats work and see whether or not there are opportunities there. I would be hesitant to really launch functionality that significantly adverses people's ability to read their mail."
},
{
"speaker": "Maria Shim",
"text": "Your next question comes from Christa Quarles - Thomas Weisel Partners."
},
{
"speaker": "Christa Quarles",
"text": "Other cost of revenue, excluding depreciation, which was 5.7% of gross revenues which is quite a bit lower from a year ago. Can you provide an explanation? Is YouTube more efficient or are you reserving costs lower?"
},
{
"speaker": "Patrick Pichette",
"text": "The answer is yes. So, we are more efficient, and even depreciation, if you look at depreciation quarter-over-quarter and year-over-year, essentially when Eric talked a bit earlier about the fact that we really, over the last year from an architectural point of view, did a number of changes to be much more efficient, we got the benefits of that. And we get the benefits on the machine utilization but we also get it on the network side. So overall, you see it both in the opex side as well as the depreciation side. So it is part of the puzzle for that category, so I'm really happy that we're continuing to push hard in that area."
},
{
"speaker": "Maria Shim",
"text": "Your next question comes from Mark Mahaney – Citigroup."
},
{
"speaker": "Mark Mahaney",
"text": "Have Sergey and Larry's roles within the company changed materially over the past two years? Are they still as actively involved as in the past?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "They're still my boss. I guess really the most significant change, probably for you all, is that they're not on the earnings call, which they were in the past. But generally I think they're just as engaged and involved in the state of the business as they always have been. I think as a management team we're trying to do a better job of dividing and conquering across different products and different applications so I think many of the folks on Eric's management team are more specifically focused on particular areas. Sergey, for example, is diving deep on the social side. Larry is very involved in Chrome OS and Android. So I think they continue to be very, very much engaged. I think that all of us on the management team are trying to get focused on specific efforts within the business because the businesses now are so large that we can't all focus on everything."
},
{
"speaker": "Patrick Pichette",
"text": "But I think it's fair to say that they are incredibly involved. I mean, in my mind, these two founders, we see them daily, we see them through the week. On the areas where they are focused, they are incredibly focused. They are very present. I get—Larry to this day continues to review every hire every week. There is a presence and an active presence from both of them that continues to be incredibly energizing because it's so great to work day-to-day with these people. So it's not a question of, don't assume because they're not on the earnings call that they're somewhere off and they're half checked out. They're here. We're on email with Larry. I couldn't believe, I sent something to Larry the other day and like an hour later, this was on Sunday morning, and then we're chatting away. That's the level of involvement these two founders are. And they're setting the direction of the company, leading the company. And in the areas where they really have their forte, they dig deep on an everyday basis."
},
{
"speaker": "Jonathan Rosenberg",
"text": "And they still review every job offer."
},
{
"speaker": "Patrick Pichette",
"text": "So that gives you a sense of perspective of their involvement. Thanks for asking that question because I think it is really—people kind of always question that but I think it's really at the heart of why Google is so special."
},
{
"speaker": "Maria Shim",
"text": "Your next question comes from Jeffrey Lindsay - Sanford C. Bernstein."
},
{
"speaker": "Jeffrey Lindsay",
"text": "How far off is the possibility of you [inaudible] targeting a Double Click."
},
{
"speaker": "Jonathan Rosenberg",
"text": "We can take another question because I'm not going to comment on future direction there. It's not something we're currently working on."
},
{
"speaker": "Maria Shim",
"text": "Your final question comes from Imran Khan - JP Morgan."
},
{
"speaker": "Imran Khan",
"text": "Can you please give us some color on what kind of trends you are seeing in the U.K. Can you help us with play click and CPC trends in the U.K.?"
},
{
"speaker": "Patrick Pichette",
"text": "We can talk geographically about the U.K. We saw a decline year-over-year but you saw an increase, also, quarter-over-quarter for the U.K. Primarily due to FX because of the big changes, decline since last year. And then the same thing for quarter-over-quarter. I think that in general the U.K. continues to perform pretty well. In the grand scheme of things, given the tough economic environment that they have seen in the last little while, you would have thought that they would have been a major pullback. But the search continues to be there and the key verticals that are driving the U.K. continue to be doing relatively well. So I think that there are signs of increasing consumer confidence and you think of Q3, Q4, the travel vertical or the retail vertical, they did kind of okay. So it's not like the U.K. is in a nose dive. The U.K. is holding its own is the best way to portray it."
},
{
"speaker": "Maria Shim",
"text": "Thanks everyone for joining us today. If you have any follow-ups please let us know. Thank you."
},
{
"speaker": "Operator",
"text": "This concludes today’s conference call."
}
] | null | null |
GOOGL | 2 | 2,009 | 2009-07-17 16:30:00 | Operator: Good day and welcome, everyone, to the Google Inc. conference call. This call is being recorded. At this time I would like to turn the call over to Maria Shim. Please go ahead, ma'am.
Maria Shim: Good afternoon, everyone, and welcome Google's second quarter 2009 earnings follow up conference call. With us are Patrick Pichette, Chief Financial Officer, and Jonathan Rosenberg, Senior Vice President of Product Management. After we cover a few housekeeping items we'll open the call immediately to your questions. Please limit yourself to one question and one follow on. Also, this call is being webcast from our Investor Relations website located at Investor.Google.com. Please refer to our website for important information, including our earnings press release and related slide deck. A replay of this call will also be available on our website in a few hours. Please note that we routinely post important information on our Investor Relations website located at Investor.Google.com and we encourage you to make use of that resource. As a reminder, the purpose of this follow up call is to give participants the opportunity to ask more detailed financial and product questions in an efficient and Reg FD compliant manner. Let me now quickly cover the safe harbor. Some of the statements we make today may be considered forward-looking and these statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings, including our annual report on Form 10-K for the year ended December 31, 2008 as well as our earnings press release for a more detailed description of the risk factors that may affect our results. Copies can be obtained from the SEC or by visiting the Investor Relations section of our website. Also, please note that certain financial measures we use on this call, such as operating profit and operating margin, are expressed on a non-GAAP basis and have been adjusted to exclude charges relating to share-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and GAAP to non-GAAP reconciliation can be found in our earnings press release. With that, we are ready to take your questions. Operator?
Operator: Thank you. (Operator Instructions) Your first question comes from William Morrison - ThinkEquity Partners.
William Morrison: I have a follow up question on the Exchange. And, Jonathan, I think in the call you said that it's now essentially integrated with AdWords and AdSense. And I'm just curious, do you think the bigger opportunity in the Exchange is on the double-click network of publishers or Google content network? That's question number one. And question number two is, as I'm sure you're aware, Congress is once again looking at regulating behavioral advertising and it seems like at least the initial take is they're pushing for opt-in on third-party cookies, opt-out on first party. I'm just curious, I believe you guys have stated that you support that kind of environment and I'm curious what kind of impact that would have on the Exchange business and behavioral targeting you're doing in the Contact Google Network? Thanks.
Jonathan Rosenberg: I guess it's a little early for me to handicap the overall opportunity. You know, today we're happy with the progress on the ad exchange. We've integrated the existing double-click exchange with the AdWords and AdSense advertisers and it's all on the Google infrastructure at this point. Overall, I mean, the idea there is about creating the biggest pool we can of liquidity so advertisers will find opportunities where they can't today and be able to monetize inventory the most efficiently. I don't think I can give you any better insight into what the relative sizes might be. On the cookie side, we're already allowing users to edit preferences in the Manager in terms of opting in and opting out. I think that's a pretty positive sign because it means that you control the ads to a degree. But I don't really have a sense and I can't really speculate on what's going to happen based on different potential legislation that we haven't yet seen on how it's going to impact the market overall. I think people are very interested in the interest-based advertising efforts and I think probably a larger fraction of the opportunity is just in creating this open platform for both advertisers and publishers to buy and sell inventory. So I think that's probably relatively more important than just the modest incremental improvement in targeting that you might get from one particular component of the targeting.
Operator: Your next question comes from Marianne Wolk - Susquehanna Financial Group.
Marianne Wolk: You highlighted the strengths in the AdSense for content business this quarter. Can you talk about whether you're seeing a net increase in overall spending when advertisers use AFC or is this a more economical source of conversions for them and reduces net spending?
Patrick Pichette: I don't know if it reduces net spending, but it is a good, I mean, obviously there is, as Nikesh mentioned earlier on the call, there is a mix, if you think of the display space, there's clearly a mix between the branding side and then the performance side. And people are in these times really focusing on the performance side. And in consequence it really helped in that part of the business. I don't know, Jonathan, if you have more comment to give on it, but that's basically what we see.
Jonathan Rosenberg: Yes, the only other observation I have is I've certainly seen with some advertisers they're finding that display is really a great complement to search. And an advertisers starts a new display campaign on the content network and then they actually see some improvement in their search ads getting more effective. So I think that there's a positive dynamic between the two, but we're not really seeing a shift from search. We're seeing the substantive advertisers who are tapped out on search and still have budget to spend looking for incremental conversion and being aware of the fact that on an ROI basis they can get that from the content network and grow their total sales.
Marianne Wolk: Overall, you think this is an incremental source of revenue?
Jonathan Rosenberg: Yes.
Operator: Your next question comes from Ross Sandler - RBC Capital Markets.
Ross Sandler: First, on the partner sites versus Google sites, so partner sites revenue growth outpaced Google websites' growth on a quarter-over-quarter basis for the first time I think, ever, even with the 44 million quarter-over-quarter FX boost. So can you provide us with a little color on what's driving mix shift? Is it the display stuff you were just referring to?
Patrick Pichette: There's nothing really fundamental. In terms of percentages, if you look at how the mix is changing, it's not changing in any fundamental way. So this quarter, I mean, in fact, you know, Google properties have really delivered most of the growth in terms of revenue. So the AdSense network continues to grow, but in fact it grew at a slower pace, right 3.5% versus 2%. So I'm not exactly sure if I understand your question.
Jonathan Rosenberg: The only other big component that you might consider there maybe if you look at it relative to a year or so ago is the component that's coming from display.
Ross Sandler: Right, on a sequential basis I think was what I was - I think Google sites were down about 1% and the partner sites up 3%. That was what I was referring to, Patrick, I guess.
Patrick Pichette: Yes, on a quarterly basis, but on a quarterly basis. I mean, really it's very difficult for 90 days to make a trend. I know it sounds like - and given these numbers in terms of total revenue, I mean, that's how you have to think about it.
Ross Sandler: Okay, but there weren't any like real significant partner wins that may have kind of been a one-time incremental boost in the second quarter?
Patrick Pichette: No, not at all.
Ross Sandler: Okay. And then on the FX hedging issue, so you had a greater FX hit if we look year-over-year, the 497 versus last quarter 429, but your hedging revenue was $124 million this quarter versus the $154 million last quarter. So is that difference explained by some of the one-time gains that you had on the hedging side in 1Q and is this $124 million that you had in 2Q kind of the right, stable run rate to think about going forward?
Patrick Pichette: No. Again, FX is a complicated matter for two reasons. One is we started building our FX program last year roughly at this time. And at that time we had nothing for the GDP, for example, right? We actually only started setting up GDP hedges at the end of the third quarter, so kind of September/October timeframe. So if you think of the ladders of hedges that we've started building last year, they come at different times and then therefore they impact through this year in different magnitude. So be careful of using this quarter and the numbers you see as what should be the steady state for a certainly set of exposures. Second is where the currency was last year, depending on where you were Q1, Q2, or Q3, again, on a delta year-over-year basis gives very different sets of numbers. So you have to think of the puzzle in terms of those two factors. Unfortunately, you don't have all of this information to build, but that's how the mechanics really work from our FX desk. So that's why you end up with, you know, this quarter the delta between where the rates are today for Q2 versus the Q2 of last year give you these kind of sets of magnitudes. So that's the simplest way I can explain it. And I know it's frustrating. I acknowledge that. Let me acknowledge it, that it is a complex set of issues and so it's very tough to get a sense of.
Operator: Your next question comes from Sameet Sinha - JMP Securities.
Sameet Sinha: So you'd mentioned that CPCs in part have been impacted because of the increase in query volumes in countries like - low CPC countries like Brazil and China. If you were to think about if macro conditions were to improve in higher CPC geographies, do you think the momentum would be big enough to overcome the declining CPCs of Brazil and China or do you think declining CPCs we should start to expect as a secular trend from here on just because query growth from those markets would probably be higher than some of the more developed countries?
Patrick Pichette: Well, I think you're painting the puzzle the right way, which is international mix has a real affect on our CPC and it has it in two ways - which country it comes from, whether it be, you know, Germany versus India, the growth rates between these different countries, and then obviously there's all the currency issues and the FX issues that play into it as well. So, I mean, what we talked about, you know, it was down year-over-year and up quarter-over-quarter as a good illustration of what the combination of all these things do, right? And then you have seasonality on top of it. So these are the pieces at work. Jonathan, I don't know if you have additional comment?
Jonathan Rosenberg: Well, I mean, international growth will be a significant component in terms of what the blended average CPC will move towards. You know, we certainly expect growth in those developed markets as the economy rebounds, but the relative difference between the monetization in the U.S., Canada, Australia, Western European countries is quite significant relative to some of the more nascent markets. So as you add incremental clicks from those developing markets, that brings the blended average, everything else being constant, down.
Sameet Sinha: In terms of tax rate, Patrick, what tax rate should we be using for 2009?
Patrick Pichette: I can tell you that at the end of the second quarter 20% was a good one because that's where - I can't give you any forward - and, again, I think that the comment I made on the call was an important one, right? There are really two sets of kind of big dynamics in our tax rates. Obviously, remember, all of the mix between our international versus U.S. mix of revenues is a big component that will actually swing the tax rate. And then second is how the hedging program rolls out. And depending on the types of gains that we may have on hedging and the way that this flows through also has a significant impact on our tax rate. So if you remember in Q4, for example, where we had very large gains on FX, it drew a lot of tax implications. So these are the two big-ticket items that you have to consider as to the modeling.
Operator: Your next question comes from Trip Chowdhry - Global Equities Research.
Trip Chowdhry: First, regarding the new initiatives you have with app exchange and other product initiatives, it seems like we don’t have a business model sporting those initiatives. Do you think it will be still ad-supported or license-supported? And if you think it's more license-supported, how can investors feel confident that Google can execute on business models which are other than pure ad-driven?
Patrick Pichette: The ad exchange itself is actually - it has a business model today. And so it's driven by the volume of ads that are flowing through the exchange. And it's the same thing -
Trip Chowdhry: Well, I mean, [inaudible].
Jonathan Rosenberg: I think that Eric addressed that question when we talked about enterprise and apps earlier. And I think that there are certainly opportunities for other licensing models and other models in terms of garnering revenue, but I think that we're confident that with a lot of the functionality we're delivering to people, where they're running search both across their internal information and across their external information what we're doing is creating a better environment on the web, creating a better environment online, creating more applications for developers to produce, and the more people spend time on the web, the more they search, the better they can search over their own internal information, the more they run searches online. So I think we're pretty confident that in the long run from a strategic perspective that's positive for us.
Trip Chowdhry: And a follow up on that. I was investigating and trying to understand your developer programs and that stuff. It seems like, you know, between the competition, between Microsoft and Google, the race being played out, it is less of a competition more of a war of accretion. And why I say that is you're giving up a lot of OS and a lot of software for free and even before the industry matures. And [inaudible] immediately gets collapsed, in which I don't see any person as the winner. So who do you think - you create products where you grow the industry in terms of revenues rather than collapse the industry from Day 1? And obviously we have different points here regarding Android; even though Google claims it's very successful, I have a data point saying it hasn't been successful. And, again, the prime reason is it just couldn't gather the revenue mattresses for your developers. Developers are not making money on Android and they're making a lot of money on iPhone and that's the reason why one is successful. My next question is: How do you think about growing the industry rather than collapsing the industry from Day 1?
Jonathan Rosenberg: Okay, well I'm not sure I completely understand your premise about growing the industry versus collapsing it. I mean, the broad story from a developer perspective is we're trying to make the web the place to build, to deploy and experience what are becoming increasingly rich and exciting applications. And we're doing that in a few areas. We're making the browser more powerful with Chrome. We're trying to make connectivity pervasive and accessible and usable for developers. I disagree with some of the comments about the degree to which the Android market is robust; we've got a lot of applications that we're seeing there and a lot of users using them. And we're also trying to provide Google-level services to every developer, which is App Engine, and we're very optimistic that that's going to make for a much more exciting and richer web.
Operator: Your next question comes from Benjamin Schachter - Broadpoint Am Tech.
Benjamin Schachter: A few housekeeping questions: One, bonus accruals didn't come at all, I don't think, and that was sort of the issue last quarter, so I was wondering if you could talk about those turned in and how we should think about those. And then if we could dig a little bit deeper into G&A and if you could just remind us what were the big issues in Q1? I think you were sort of implying that there was nothing special about where the run rate was in Q2, so maybe we should think about that going forward. And then finally on the tax rate, my understanding previously it's always been the tax rate you put in the quarter is sort of what you expect is your best guess for the year, and so we should all sort of think about that as your best guess for the year. Is that correct?
Patrick Pichette: So let's start with the last one. In theory you're right that when we take tax provisions, you know, you can't just look backwards; you have to also kind of think through the full fiscal year. But, again, if you think of all the moving parts within it, it's a bit like OI&E with Sprint and the team in Treasury, right? They try to give you a number that reflects what they thinks going to happen, but then the currency takes off and then the world changes. So just a word of caution on that one. In the case of G&A, you're right that we have not had - you'll remember in Q1 we talked about kind of three items that really impacted our G&A or that we had noted, anyway - the legal settlements, which were kind of one-time in a few areas; then there was the restructuring of our sales and marketing group and then finally there was some bad debt. So these were the three that specifically we had documented and mentioned. We didn't have anything of any significance this quarter, so that's the essence of some of the delta. In the case of the bonus, you'll remember it was really a big issue between Q4, a year end issue, and starting the year. I mean, there's nothing special to report on the bonus accrual for this quarter.
Benjamin Schachter: Well, were the bonus accruals similar to what they were in Q1?
Patrick Pichette: We wouldn't comment on that. I mean, all I can tell you - let me tell you this way: We have our plan that's been approved with the Board, and that plan basically has a set of kind of indicators within it and we're tracking according to these indicators.
Benjamin Schachter: And then one other thing. You sort of very subtly were mentioning YouTube might be doing a bit better than it has in the past. The preroll issue is the first time you've sort of really embraced that on a public call. Do you think that's going to be the key modernization effort going forward or is it still kind of you're testing out new methods? Or are you kind of set on preroll in terms of how you're pushing your sales force?
Patrick Pichette: Let's give two answers on it. Let me give you the general answer and then I'll let Jonathan jump in on the details. I think that it is true that we are pleased with YouTube's trajectory. And in part the reason why we're communicating it to the Street is there's been so much press over the last quarter with all of these documentations of, you know, massive cost and no business models and all of the kind of negative press that we've read a lot about. And we just wanted to kind of reaffirm to the Street that this is a very credible business model and it's one that's got trajectory. So in that sense it's just to kind of tell everybody that we're on progress on the plan that we had made for it. I'll turn to Jonathan on the monetization pieces.
Jonathan Rosenberg: Yes, sure, Ben. There really isn't a simple answer there because there's sort of four main user activities on the site if you think about it broadly, right? They enter on the home page, they search for videos to watch, they watch videos, and they upload videos and engage with the community with comments, recommendations and that sort of thing. And the different types of modes really get different advertising models. And that's part of why I think it's taken us time to kind of triangulate towards what works, and I think some of the things that we have now are still in pretty nascent stages. If you look at the home page it's basically big brand display ads. You know, search can be good for promoting videos, kind of similar to maybe what AdWords does for Google. But if you look at where the big inventory is, the massive users are in more the watch pages. So that's what we're sort of trying to figure out. You know, is it overlays that are going to work? Is it the in-stream stuff? I think we're still testing all of these things and the answer's going to be different for the different areas on the site that the user's on.
Benjamin Schachter: But I think on the call you indicated much more - just being more open to the prerolls, and that seemed to be new to me. Were you not trying to indicate anything in particular there?
Jonathan Rosenberg: I would not say that our overall optimism that we expressed with respect to YouTube is primarily a function of one specific format. We've actually been testing prerolls, I think, for quite awhile. So if you interpreted that one single comment to prerolls to imply the broad conclusion with respect to optimism on YouTube, I think that's probably a mistake.
Operator: Your next question comes from James Mitchell - Goldman Sachs.
James Mitchell: If I was smarter this question would be simpler, so I kind of apologize in advance if it's confusing. But if I look back at the last year or so, it seems like [inaudible] growth sailed right through the financial crisis, where as price-per-click access [inaudible] dropped very sharply. And then this most recent quarter, [inaudible] growth slowed a little bit to up 15% year-on-year, while price-per-click seems to be stabilizing quarter-on-quarter. So when I think those trends, is it better to infer that [inaudible] just grow structurally over time but face the law of large numbers, while price-per-click is very sensitive to the economic cycle, or is it better to infer that Google's monetization initiatives tend to boost [inaudible] in some quarters and boost price-per-click in other quarters?
Jonathan Rosenberg: Well, maybe you're smarter than I am because I'm not sure I understand the entire question, but I think what you said is generally true. I think that in any give quarter the economic situation can impact the number of leads that are likely to convert. It can impact the number of commercial queries. I do think what Nikesh said is true, which is that advertisers don't constrain by their budgets; they manage to bids.
Patrick Pichette: I think the model, if you think of - go back and take a look at the relationship between click growth and then CPC, right? Click growth is driven by so many factors, so you have the growth of the Internet itself, then you have the seasonality within it, and then you have - there's so many factors that will drive the click growth. And then obviously, you know, if people are in recessionary environments, shopping even more for the better bargain, then they click even more because they move around a bit. So it is a complex hypothesis that you are tabling and to kind of say here, I've figured out the four dots that make it work, I mean, I don't think any of us around the table that live in this world would make it a simple puzzle.
Jonathan Rosenberg: The one thing I think we could say for sure is queries are less sensitive to the economy. There's more comparison shopping when the economy is not strong and potentially a little bit less buying. So you could still have high-paid - the paid clicks can be high even when the economy is bad and I think the CPCs would adjust if the users aren't converting and drop if that's consistent with the hypothesis that you're trying to articulate.
James Mitchell: The comparison shopping could have helped paid [inaudible] growth in the fourth quarter and first quarter while the weaker conversion sort of hurt PPC and now conditions have normalized a little bit. I mean, maybe it just is an extrapolation question. You mentioned there were 12 improvements to ad quality in the quarter and they had a bigger impact than usual on revenue. Would that impact be felt more on the paid [inaudible] or more on the PPC?
Jonathan Rosenberg: It would impact both, yes.
Operator: Your next question comes from Mark Mahaney - Citigroup.
Mark Mahaney: One question just on mobile. There's been some data points that - I think in the founders' letter about a third of queries in Japan coming off of mobile devices; that's obviously a very unique market. You don't quality unique, but that obviously is a very unique market. Any other markets where you think search queries are material - 5% - as a percentage of total queries and any thoughts on are there any particular reasons why Western Europe and the U.S. and other markets over time wouldn't reach levels that may be half of what you'd see in Japan's, call it over a two to three year period?
Jonathan Rosenberg: So are you specifically asking questions with respect to mobile search volume increasing in Japan?
Mark Mahaney: Just mobile search, yes, please.
Jonathan Rosenberg: Well, I mean, mobile search volume has increased quite a bit in the U.S., I think, as we mentioned, and that's largely a function of availability of phones with good browsers. And I think data plans are also an important dynamic. You know, generally I think mobile search volume is pretty high in Indonesia and in the Middle East, but we're starting to see mobile growth increase pretty well overall. You certainly see more interest in mobile search where the landline infrastructure is relatively poor, but I don't have any more specific thoughts beyond that.
Patrick Pichette: Eric said in the previous call and I think that the adoption of these high-end devices, which are getting more and more ubiquitous - the G phones, the Android platform, the iPhone - I mean, they really do drive a lot of living on the web because the web is so much more accessible and therefore a lot more searches as well. So there's a fundamental trend that's happening there as well that's clearly is more than just Japan. I mean, there's a whole ecosystem that's building right now.
Mark Mahaney: And one quick follow on; it has to do with paid search results. What's the latest thinking on the inclusion of broader formats within paid search results, i.e., allowing advertisers to respond to intentions with more than just text but to include display ads or video links or whatever in the paid search results, to apply universal search, that you've applied to organic search, to paid search results?
Jonathan Rosenberg: Yes, well I think Nikesh mentioned the video plus box. We're also working on much better ways of offering valuable information in ads with functionality like the product one box, where we're doing similar efforts. We're also I think going to make significant progress and we have made some progress in experimenting with local where it's easier to or we're getting better at determining where a user is and thereby being able to give them the appropriate local information. So I think that there's a lot of opportunity. And if you look over the course of the last year, I think that the search results have in many ways, with universal search, been outpacing the innovations on the ad side and we're really going to move forward with the experiments on things like products and video and local. We've, of course, got to do that in ways that are good for the user, but we think we're making progress there. I think we've made more progress on the search side.
Operator: Your next question comes from Youssef Squali - Jefferies & Co.
Youssef Squali: If I take the domestic business, which was sequentially down, and I take out some revenues from YouTube - so you talked a lot about how well YouTube did - I can very easily get to year-on-year decline in U.S. search business. So I'm trying to understand what this really means. I mean, why wouldn't that imply maybe the beginning of maturation of search? I know it's somewhat unbelievable, but what's the counterargument there?
Patrick Pichette: That the U.S. search business is not declining.
Youssef Squali: So that means YouTube -
Jonathan Rosenberg: Well, of course, I mean, it's not all static, right? We're going to continue to deliver to these advertisers much better ways to manage their bids, much better ways to optimize their campaign and manage their budgets. We actually didn't talk about it on the call, but we've rolled out a new advertiser interface for AdWords to a very large fraction of our advertisers. The previous question just asked about the opportunities to improve the quality of ads, and if you look at it today, the click-through rate on ads is still low relative to the search results. So I think there's lots and lots of opportunity there and there's still many verticals where we don't do a particularly good job with the searches. So I think there's lots of headroom in terms of monetization for search overall.
Youssef Squali: You know, that's helpful. I'm just looking at the domestic revenues last year versus this year and the delta is really only about $40 - $45 million, so the point there, if, just for the sake of argument, is YouTube was zero last year - which, obviously, it wasn’t - and if it's [$50] million this year - which, arguably, if it is or not - then your domestic revenues in search would be declining year-on-year. But your point is they're not. Okay, so I'll take that.
Jonathan Rosenberg: But there's also - I think there's another flaw in that logic, because YouTube is not U.S. only.
Youssef Squali: The majority of it is U.S., though.
Jonathan Rosenberg: It also wasn't zero last year.
Youssef Squali: Right, okay. Fair enough. And then if I look at growth in the network, it was up 2% versus negative 3% in Q1, right? So how much of that was driven by YouTube versus AdSense for content? In other words, is AdSense per search up as well year-on-year or is AdSense for content just growing faster because looking at AOL, traffic for AOL for ads for MySpace, the numbers don't just look too impressive to imply that AdSense for search would be that much higher.
Patrick Pichette: Yes, there's no doubt that AFC is up relative to AFS within that period, but also in general display as well has been up because Q1, if you'll remember, the comments we had made is on the display side there was some pullback in Q1 versus Q4 and now coming back into Q2.
Operator: Your next question comes from Christa Quarles - Thomas Weisel Partners.
Christa Quarles: You guys talked a little bit about the mobile advertising market being basically not a separate biddable marketplace. I was wondering if you could just give us rough sizes in percentages of advertisers who've opted out to the mobile piece, you know, more or less than half? So that's the first question. And then the second question is: Do you guys have any data around your developer community yet, you know, which are the most popular products that people - or that developers tend to be working, size of developer, community, you know, how many people went to the developer conference. So question two. And then the third question is just I found myself opening my wallet to Google last weekend to pay for storage because I'd been bumping up against my limits. I was wondering if you guys have actually said how many people pay for Google storage?
Jonathan Rosenberg: I think that we had 3,500 people at the developer conference sign up. Somebody can check on that and tell me what the -
Christa Quarles: Yes, but it included people like me.
Jonathan Rosenberg: I think it was 3,500 developers. We can specifically check on that. I believe on the mobile side that's generally a separately biddable marketplace.
Christa Quarles: I thought it was an opt-in. I mean, I think Eric's comment on the call was specifically that it's roughly the same CDC because it's embedded in the same PC marketplace but over time - I thought as of right now you basically have your queries basically for the PC and you have to opt out so as not to be included in the mobile results. Is that not -
Jonathan Rosenberg: Mobile is sort of tricky because there's the smart phones, which are more conventional browsers, and that's tied to the traditional experience, but then there's a separate set of mobile-only campaigns that you can also run.
Christa Quarles: Okay. I guess I'm talking about the smart phone side and those. I guess, you know, the question is manifesting out of the fact that I've talked to some mobile competitors who are sort of frustrated that you guys are embedding that and they were saying, you know, that the ad's quality may not be as good or whatever. So I guess what I'm trying to get a sense of from you is what percentage of advertisers have chosen to opt out of those mobile because they either don't feel like the quality's there or they're just not ready to measure it?
Jonathan Rosenberg: That I don't know. I know the default - I think the default is that you show on both but we give advertisers control and they can opt out, they can do just smart phone only capabilities.
Christa Quarles: Right. But you don't have any -
Jonathan Rosenberg: I think the number's pretty small, but I don't actually have it with me.
Christa Quarles: Small that has opted out?
Jonathan Rosenberg: Yes.
Christa Quarles: Okay. And then paying for storage?
Patrick Pichette: I don't think we've ever disclosed that.
Jonathan Rosenberg: Yes, it's not a significant - paid storage is not a significant portion of our revenue.
Operator: Your next question comes from Sandeep Aggarwal - Collins Stewart LLC.
Sandeep Aggarwal: Jonathan, it has been nearly six or seven weeks since Bing launched. Just a couple of questions to the extent you are willing to comment. What is your overall take on Bing? Are you seeing any changes of behavior by a typical Google user in terms of propensity to search at Google? And also, in terms of [inaudible] or blending search along with some [inaudible] of [inaudible] suggest travel, shopping, can really work here?
Jonathan Rosenberg: I think we said on the call that we think it's relatively early to call. We certainly haven't seen a large shift in share. I do think that there are opportunities to do a much better job with vertically oriented searches. And the question was asked on the call earlier - we talked about some verticals; I think I mentioned finance on the call earlier, where there's certainly an opportunity to do a much better job with ads. And certainly I think there's an opportunity to do a better job in shopping and in travel and in many verticals in time.
Sandeep Aggarwal: And, Patrick, if I may ask one question on the headcount, there was a 378 headcount reduction sequentially. What was [inaudible] you know, maybe job elimination was [inaudible] accretion.
Patrick Pichette: All right, let me give you the context on this again; I think it's important. We had announced at the end of Q1 a number of rationalizations in the sales and marketing program. And we continue to have a lot of job openings and we're hiring. So in the second quarter what you see is just a manifestation of, you know, if you can't hire fast enough in the job openings that you have, just for whatever reason, over the last 90 days, you end up in this position where you haven't started kind of catching up, if you wish. So it's just a timing issue. So the company continues to hire; it continues to have many recs open in many departments. And then some positions were eliminated in sales and marketing, as was discussed. So that's the net result of it, right? So if you go to the Google site for job posting, you'll see a lot of job postings today.
Operator: Your next question comes from Doug Anmuth - Barclays Capital.
Doug Anmuth: Two questions, I think pretty straightforward, the first one on cash flow. You net income was higher Q-to-Q, but your free cash flow was lower, so can you clarify what's going on in working capital and then also in income taxes? And then secondly, on TAC, it came in somewhat higher than we expected, at least, so I'm curious how much you're benefiting at this point from the Dell deal coming off? Are you still paying residuals there and are we likely to see sort of greater benefits from that going forward?
Patrick Pichette: So on the cash flow, I'll give you the most simple answer, which is in Q2 you have two tax payments, for the federal and the California state, and they occur April 15th and I think June 15th. So just those are not in Q1 and then you've got a big hit in Q2. And it's a big amount of money, like hundreds and hundreds and hundreds of millions - I think it's like $800 million or $900 million, in that range, right? So it's like a ton of money. So that will obviously impact, by far outweigh everything else, on the free cash flow calculation. Everything else actually is in pretty good shape. On the TAC side, I think there's, again, if you look at our TAC and it's been progressing, as I said on the previous call, you've just got moving pieces, but you wouldn't have kind of - there's no significant event that would have actually moved it in one way or another. You just have this effect between the Google and the non-Google and then you have the affect of the mix within the AdSense network between the smaller and the larger guys. And then that moves all the time and that's what you see in the reflection. I mean, obviously, so what we have seen in Q2 is, you know, a higher percentage of the smaller partners and slightly higher on the Google, and that's what you end up with.
Doug Anmuth: And just going back real quick on that TAC hit, as I look back at other second quarters, I mean, I assume that timing would be the same, but I don't see sort of a similar affect there in previous years.
Patrick Pichette: Yes, but I wouldn't worry about two years ago what happened in Q2 for TAC. I mean, two years ago to two years ago you would have had a very different mix of deals with very different payouts.
Doug Anmuth: I was referring to income taxes, actually.
Patrick Pichette: Oh, sorry.
Doug Anmuth: TAC, taxes - close.
Patrick Pichette: T-A-X.
Doug Anmuth: T-A-X, yes.
Patrick Pichette: Okay, yes. I thought it was TAC. Did everybody get TAC? Oh, sorry about that. On taxes, no, I mean, well, I'd have to go back. Every year we pay a lot, right?
Doug Anmuth: All right. We'll take it offline.
Patrick Pichette: Okay, we'll have the IR people come back to you on the details.
Operator: Your next question comes from Jeetil Patel - Deutsche Bank Securities.
Jeetil Patel: On the TAC, it's obviously been moving down, as Doug alluded to as well, but I'm curious, are you able to basically take down TAC on the search side, on the CPC front, and maybe reallocate it to more the lead gen side of the business in terms of CPA and CPM inside the network there? And second, as you look at your kind of display category developing, are you seeing the interest in YouTube develop among pure display-oriented advertisers or lead gen-oriented advertisers? And then lastly, Germany, last quarter I think you pointed out as a fairly strong market for you, I guess. Can you give us a sense of where Germany is and is that close to cracking the 10% mark in terms of contribution?
Patrick Pichette: I just need to understand better your first question.
Jeetil Patel: Yes. TAC's been moving down. Is there the possibility that you could take some of your TAC dollars that you pay out on a CPC basis, whether it be search or CSEs or others, and bring down those TAC payments and reallocate them to more of the display side of the business in terms of inside your AdSense for content network on a CPM basis?
Patrick Pichette: I mean, the different deals have just different characteristics and you can't just shift them; they're with each of the partners and they appear in the AdSense network; I mean, there's a certain structure. And then if you do a deal for Chrome or for Toolbars, you just have a completely different set of structures for those deals. So, I mean, we continue to manage each of these sets of partners and each of these streams of TAC with their own set of economics and, you know, every time we get a good deal we do it. And the mix is just a product of all that, no more, no less. We don't think okay, we'll reduce the dial on one to increase the dial on the other. Everything that makes sense we do.
Jonathan Rosenberg: I guess on the questions with respect to YouTube, I tried to address some of that in I think it was Ben's question. And, again, the type of advertiser really depends on which of the activities it is, right? There's the home page, there's searching for videos to watch, there's the watch pages. So it depends which activity you're talking about. The traditional Google advertisers are generally direct-response focused. The brand display advertisers - the people taking over the home page banners - are more display oriented. And I think you're starting to see some TV advertisers come online, but I don't think I can give you too much color on exactly to what degree that's playing in the equation. And what's the question - there was also, I think, a question about Germany?
Jeetil Patel: Yes, Germany. I think you highlighted it as a strong market last quarter, I guess. Can you just provide an update or commentary of how that progressed in Q2?
Patrick Pichette: I mean, it did well, but I wouldn't give any more information than that. You'll remember last quarter in Q1 there was a lot of macroeconomic events that people were asking about, you know, how is Europe doing given the meltdown of the economy in UK, and how was the rest of Continental, so we just used it as an illustration rather than a set of data points with a lot facts around it.
Operator: Your next question comes from Steve Weinstein - Pacific Crest Securities.
Steve Weinstein: Can you just help explain all the volatility in the interest and other income line, how we can get our hands around that, because it's swinging enough that it's affecting the numbers.
Patrick Pichette: Yes. OI&E will continue to be a real challenge. It's a real challenge for us as well, right, because there's been so much volatility in FX in the last little while when you think of the last three, four quarters. I mean, it is difficult to predict where FX is going. In fact, we were discussing as a team that some companies kind of right now stay at the margin level, right, and then after that they say it's really tough to give guidance anywhere below. Obviously, we don't give guidance, but the point is in general there's really two big drivers that affect it for us. One is obviously on the investment side we've been very conservative in the last year to make sure that we protect the capital of Google and by doing so obviously our yields have gone down quite dramatically to protect that. So all of our investment in our marketable securities that have been sovereign backed and that we've talked about, I mean, it has a pretty big impact in terms of trajectory. On the flip side of that, our hedging costs, you know, as volatility continues to be really high, the hedging costs, you know, we've benefited from it, but sometimes you just get the timings of the FAS 133 that hit you. And even though you're doing fine on your hedges per se, right, you end up at the end of a quarter and because of where the FX rates stand at the point and then you marked-to-market your options, you end up with having from an accounting point of view bringing a lot of these expenses back into a current quarter. It can have a big effect, right? These swings can be quite significant. So I sympathize with you because it in fact is really difficult to get some good semblance of where this thing's going on a quarter-to-quarter basis. I mean, I can tell you on the flip side of that is we manage this very responsibly, obviously, as you can see in the results of our FX program and then our investment program. We have to think through in the coming quarters as to how do we, given the economy stabilizing and the banking systems are stabilizing, right, how do we re-think our investment portfolio to kind of take advantage of kind of the stabilized environment.
Jonathan Rosenberg: Since I actually got a factual answer to one of the questions that was asked earlier over e-mail I said I would just share it. I answered Christa and said that there were 3,500 developers or I might have said attendees at the developer conference. There were 3,500 attendees, but 2,196 developers, so Christa must have been there with a lot of her friends. But the factual answer to your question is just under 2,200 developers.
Patrick Pichette: So, Steve, I hope that answers your question and the big pieces at work.
Operator: Your next question comes from Ross Sandler - RBC Capital Markets.
Ross Sandler: Just a couple follow ups, first on the CapEx. So, Patrick, you've said in the past - you've kind of thrown off the hypothetical example that up until, call it middle of last year, you guys were managing the CapEx program to always kind of stay ahead of capacity. So if you thought you needed 20 data centers in a given year, you'd invest in 22 or 23. How do we think about where we are today in terms of capacity utilization of all of Google's infrastructure and when does kind of a maintenance CapEx have to start kicking in? And then a follow up question on just the relative growth rates for U.S. versus Western Europe. Do you think those two markets through the second quarter are now moving closer in tandem, Western Europe starting to slow down a little bit later than the U.S. in terms of kind of where we've come from in the last four quarters? Do you think that we're not kind of at parity in terms of the deceleration in those markets? And then the last question is: When you talk about putting the content network on Ad Ex, the next version of the Exchange, how does Google think about sacrificing potentially more favorable web share deals with publishers that are on the content network today with potentially a lower rev share if they put their inventory on the exchange? I think the exchanges are closer to a 5% to 10% type rev share. How do you think about that dynamic when you start plugging in all the inventory from the content network?
Patrick Pichette: Let me start with the CapEx question. On CapEx, it has been every quarter - I've been here now for four quarters and every quarter everybody asks, Patrick, it's going down again, so is it bottoming out? And we've had a great benefit in the last two to three quarters of not only higher utilization rates but Moore's Law's been at work for us on top of that, and we have had really good planning of our capacity. So the combination of all these things has given us quite a boost in terms of managing our CapEx and that's just shown in the results. You'll remember, also, that I said we have a number of areas where we need to invest and we are making these investments. And I mentioned, you'll remember, one place which is in Scandinavia which the only time you could work on it is in the summer. So even if we had all our plans to start in March, the place was a deep freeze at the time and now they're kind of working hard at it. So we continue to invest. And they're lumpy and they're big and when you get a next generation of servers ready then you do a big overhaul and then at that point you get a lot of capital in. And that's just the nature of the business. So we're, one, very pleased with the way that the team has worked really hard to get this better utilization and better planning of the capacity, so they're smarter about it. So we got the benefits over the last three/four quarters and we're continuing to invest and we'll do so in the future. So that's on the CapEx side.
Jonathan Rosenberg: I don't think there's an easy answer on the Ad Exchange question. I mean, the idea is basically to create an open platform so advertisers and publishers can buy and sell inventory. I think there are going to be different optimization insights and different margins which are justified by different targeting technologies that different players bring to the table, but I think that what we're hoping to do is reduce a lot of the fragmentation that exists in the whole buying experience and if overall you can get more budget and more advertisers and more publishers flowing through there, in the end the economics are going to work across both sides.
Patrick Pichette: The last question you asked, which is U.S. versus Western Europe, we're really pleased with the growth in Western Europe. Obviously, in both of these markets the economy has had a lot of short-term affects that you can't discount; it's been true for the U.K. And also the FX has had a huge affect, as you can see through our results. So in both cases we're really pleased with the growth rates that we have and I don't think that I would correlate one with the other right now; I think they have their own sets of momentums and dynamics. We'll take one last question. Unfortunately, we're running out of time. So we'll take one last question, please.
Operator: Your final question comes from Colin Gillis - Brigantine.
Colin Gillis: I know every customer is important, but when we talk about slimming down the sales and marketing efforts could you give me a sense as to what is that customer base that needs an awful lot of direct handholding? Is it 1,000 customers? Is it 5,000 customers?
Jonathan Rosenberg: I don't think there's an easy answer to that question. I mean, basically the way we manage the sales and the support experience is on a bang for the buck basis we're providing support to the customers from whom we're going to garner the largest amount of revenue. I think that if you are able to support larger numbers of customers you'd be able to make incremental revenue, so I think there are many, many thousands of customers that could use utilization efforts from our support organization; there's only a subset that we're actually able to support at the level that we would like to. But on a bang-for-the-buck basis, we're prioritizing at the top of that funnel. The key there is really focus, I mean, what we're really trying to do there is create automated tools that make scaling these efforts easier and make it easier for customers to optimize on their own. Of course, we also partner with agencies who I think do a lot of the heavy lifting there for us and play an important component to the equation.
Colin Gillis: Absolutely. So just trying to get some sense, directionally would you say you're focusing in more on the larger customers at the top of the funnel?
Jonathan Rosenberg: Yes. Certainly, we allocate our sales time. I mean, the salespeople allocate their time on the basis of, you know, on a bang-for-the-buck basis where the money is for the most part.
Patrick Pichette: The direct sales force focuses essentially on these very large national accounts who are very large advertisers, whether they are agencies or they are big customers, and that's where they focus essentially their attention. And then we have a second category that, you know, you get some phone support, and then the third category that you just - sort of on the web. And so the reason why we do this, coming back to the original question, when we did the rationalization we grew so fast and then we made a number of acquisitions, and then you end up in a position when you kind of start adding all the bodies and you say okay, who's talking to whom, you end up with duplications in some places. And that's neither good nor bad; it was just the way it was and we set let's do a bit of rationalization. But we continue to, you know, we have all the headcount that we need in order to focus on the big accounts that we want to bid. We're not constrained in that sense, if you wish, right? And that's why we just did the cleanup in Q1.
Patrick Pichette: Okay, with that, Maria, we can close the call. Is that okay?
Maria Shim: Yes. Thank you everyone for your time. We'll talk to you next quarter.
Patrick Pichette: Thank you, everybody.
Operator: And this concludes today's conference. We thank you for your participation. | [
{
"speaker": "Operator",
"text": "Good day and welcome, everyone, to the Google Inc. conference call. This call is being recorded. At this time I would like to turn the call over to Maria Shim. Please go ahead, ma'am."
},
{
"speaker": "Maria Shim",
"text": "Good afternoon, everyone, and welcome Google's second quarter 2009 earnings follow up conference call. With us are Patrick Pichette, Chief Financial Officer, and Jonathan Rosenberg, Senior Vice President of Product Management. After we cover a few housekeeping items we'll open the call immediately to your questions. Please limit yourself to one question and one follow on. Also, this call is being webcast from our Investor Relations website located at Investor.Google.com. Please refer to our website for important information, including our earnings press release and related slide deck. A replay of this call will also be available on our website in a few hours. Please note that we routinely post important information on our Investor Relations website located at Investor.Google.com and we encourage you to make use of that resource. As a reminder, the purpose of this follow up call is to give participants the opportunity to ask more detailed financial and product questions in an efficient and Reg FD compliant manner. Let me now quickly cover the safe harbor. Some of the statements we make today may be considered forward-looking and these statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings, including our annual report on Form 10-K for the year ended December 31, 2008 as well as our earnings press release for a more detailed description of the risk factors that may affect our results. Copies can be obtained from the SEC or by visiting the Investor Relations section of our website. Also, please note that certain financial measures we use on this call, such as operating profit and operating margin, are expressed on a non-GAAP basis and have been adjusted to exclude charges relating to share-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and GAAP to non-GAAP reconciliation can be found in our earnings press release. With that, we are ready to take your questions. Operator?"
},
{
"speaker": "Operator",
"text": "Thank you. (Operator Instructions) Your first question comes from William Morrison - ThinkEquity Partners."
},
{
"speaker": "William Morrison",
"text": "I have a follow up question on the Exchange. And, Jonathan, I think in the call you said that it's now essentially integrated with AdWords and AdSense. And I'm just curious, do you think the bigger opportunity in the Exchange is on the double-click network of publishers or Google content network? That's question number one. And question number two is, as I'm sure you're aware, Congress is once again looking at regulating behavioral advertising and it seems like at least the initial take is they're pushing for opt-in on third-party cookies, opt-out on first party. I'm just curious, I believe you guys have stated that you support that kind of environment and I'm curious what kind of impact that would have on the Exchange business and behavioral targeting you're doing in the Contact Google Network? Thanks."
},
{
"speaker": "Jonathan Rosenberg",
"text": "I guess it's a little early for me to handicap the overall opportunity. You know, today we're happy with the progress on the ad exchange. We've integrated the existing double-click exchange with the AdWords and AdSense advertisers and it's all on the Google infrastructure at this point. Overall, I mean, the idea there is about creating the biggest pool we can of liquidity so advertisers will find opportunities where they can't today and be able to monetize inventory the most efficiently. I don't think I can give you any better insight into what the relative sizes might be. On the cookie side, we're already allowing users to edit preferences in the Manager in terms of opting in and opting out. I think that's a pretty positive sign because it means that you control the ads to a degree. But I don't really have a sense and I can't really speculate on what's going to happen based on different potential legislation that we haven't yet seen on how it's going to impact the market overall. I think people are very interested in the interest-based advertising efforts and I think probably a larger fraction of the opportunity is just in creating this open platform for both advertisers and publishers to buy and sell inventory. So I think that's probably relatively more important than just the modest incremental improvement in targeting that you might get from one particular component of the targeting."
},
{
"speaker": "Operator",
"text": "Your next question comes from Marianne Wolk - Susquehanna Financial Group."
},
{
"speaker": "Marianne Wolk",
"text": "You highlighted the strengths in the AdSense for content business this quarter. Can you talk about whether you're seeing a net increase in overall spending when advertisers use AFC or is this a more economical source of conversions for them and reduces net spending?"
},
{
"speaker": "Patrick Pichette",
"text": "I don't know if it reduces net spending, but it is a good, I mean, obviously there is, as Nikesh mentioned earlier on the call, there is a mix, if you think of the display space, there's clearly a mix between the branding side and then the performance side. And people are in these times really focusing on the performance side. And in consequence it really helped in that part of the business. I don't know, Jonathan, if you have more comment to give on it, but that's basically what we see."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yes, the only other observation I have is I've certainly seen with some advertisers they're finding that display is really a great complement to search. And an advertisers starts a new display campaign on the content network and then they actually see some improvement in their search ads getting more effective. So I think that there's a positive dynamic between the two, but we're not really seeing a shift from search. We're seeing the substantive advertisers who are tapped out on search and still have budget to spend looking for incremental conversion and being aware of the fact that on an ROI basis they can get that from the content network and grow their total sales."
},
{
"speaker": "Marianne Wolk",
"text": "Overall, you think this is an incremental source of revenue?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ross Sandler - RBC Capital Markets."
},
{
"speaker": "Ross Sandler",
"text": "First, on the partner sites versus Google sites, so partner sites revenue growth outpaced Google websites' growth on a quarter-over-quarter basis for the first time I think, ever, even with the 44 million quarter-over-quarter FX boost. So can you provide us with a little color on what's driving mix shift? Is it the display stuff you were just referring to?"
},
{
"speaker": "Patrick Pichette",
"text": "There's nothing really fundamental. In terms of percentages, if you look at how the mix is changing, it's not changing in any fundamental way. So this quarter, I mean, in fact, you know, Google properties have really delivered most of the growth in terms of revenue. So the AdSense network continues to grow, but in fact it grew at a slower pace, right 3.5% versus 2%. So I'm not exactly sure if I understand your question."
},
{
"speaker": "Jonathan Rosenberg",
"text": "The only other big component that you might consider there maybe if you look at it relative to a year or so ago is the component that's coming from display."
},
{
"speaker": "Ross Sandler",
"text": "Right, on a sequential basis I think was what I was - I think Google sites were down about 1% and the partner sites up 3%. That was what I was referring to, Patrick, I guess."
},
{
"speaker": "Patrick Pichette",
"text": "Yes, on a quarterly basis, but on a quarterly basis. I mean, really it's very difficult for 90 days to make a trend. I know it sounds like - and given these numbers in terms of total revenue, I mean, that's how you have to think about it."
},
{
"speaker": "Ross Sandler",
"text": "Okay, but there weren't any like real significant partner wins that may have kind of been a one-time incremental boost in the second quarter?"
},
{
"speaker": "Patrick Pichette",
"text": "No, not at all."
},
{
"speaker": "Ross Sandler",
"text": "Okay. And then on the FX hedging issue, so you had a greater FX hit if we look year-over-year, the 497 versus last quarter 429, but your hedging revenue was $124 million this quarter versus the $154 million last quarter. So is that difference explained by some of the one-time gains that you had on the hedging side in 1Q and is this $124 million that you had in 2Q kind of the right, stable run rate to think about going forward?"
},
{
"speaker": "Patrick Pichette",
"text": "No. Again, FX is a complicated matter for two reasons. One is we started building our FX program last year roughly at this time. And at that time we had nothing for the GDP, for example, right? We actually only started setting up GDP hedges at the end of the third quarter, so kind of September/October timeframe. So if you think of the ladders of hedges that we've started building last year, they come at different times and then therefore they impact through this year in different magnitude. So be careful of using this quarter and the numbers you see as what should be the steady state for a certainly set of exposures. Second is where the currency was last year, depending on where you were Q1, Q2, or Q3, again, on a delta year-over-year basis gives very different sets of numbers. So you have to think of the puzzle in terms of those two factors. Unfortunately, you don't have all of this information to build, but that's how the mechanics really work from our FX desk. So that's why you end up with, you know, this quarter the delta between where the rates are today for Q2 versus the Q2 of last year give you these kind of sets of magnitudes. So that's the simplest way I can explain it. And I know it's frustrating. I acknowledge that. Let me acknowledge it, that it is a complex set of issues and so it's very tough to get a sense of."
},
{
"speaker": "Operator",
"text": "Your next question comes from Sameet Sinha - JMP Securities."
},
{
"speaker": "Sameet Sinha",
"text": "So you'd mentioned that CPCs in part have been impacted because of the increase in query volumes in countries like - low CPC countries like Brazil and China. If you were to think about if macro conditions were to improve in higher CPC geographies, do you think the momentum would be big enough to overcome the declining CPCs of Brazil and China or do you think declining CPCs we should start to expect as a secular trend from here on just because query growth from those markets would probably be higher than some of the more developed countries?"
},
{
"speaker": "Patrick Pichette",
"text": "Well, I think you're painting the puzzle the right way, which is international mix has a real affect on our CPC and it has it in two ways - which country it comes from, whether it be, you know, Germany versus India, the growth rates between these different countries, and then obviously there's all the currency issues and the FX issues that play into it as well. So, I mean, what we talked about, you know, it was down year-over-year and up quarter-over-quarter as a good illustration of what the combination of all these things do, right? And then you have seasonality on top of it. So these are the pieces at work. Jonathan, I don't know if you have additional comment?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Well, I mean, international growth will be a significant component in terms of what the blended average CPC will move towards. You know, we certainly expect growth in those developed markets as the economy rebounds, but the relative difference between the monetization in the U.S., Canada, Australia, Western European countries is quite significant relative to some of the more nascent markets. So as you add incremental clicks from those developing markets, that brings the blended average, everything else being constant, down."
},
{
"speaker": "Sameet Sinha",
"text": "In terms of tax rate, Patrick, what tax rate should we be using for 2009?"
},
{
"speaker": "Patrick Pichette",
"text": "I can tell you that at the end of the second quarter 20% was a good one because that's where - I can't give you any forward - and, again, I think that the comment I made on the call was an important one, right? There are really two sets of kind of big dynamics in our tax rates. Obviously, remember, all of the mix between our international versus U.S. mix of revenues is a big component that will actually swing the tax rate. And then second is how the hedging program rolls out. And depending on the types of gains that we may have on hedging and the way that this flows through also has a significant impact on our tax rate. So if you remember in Q4, for example, where we had very large gains on FX, it drew a lot of tax implications. So these are the two big-ticket items that you have to consider as to the modeling."
},
{
"speaker": "Operator",
"text": "Your next question comes from Trip Chowdhry - Global Equities Research."
},
{
"speaker": "Trip Chowdhry",
"text": "First, regarding the new initiatives you have with app exchange and other product initiatives, it seems like we don’t have a business model sporting those initiatives. Do you think it will be still ad-supported or license-supported? And if you think it's more license-supported, how can investors feel confident that Google can execute on business models which are other than pure ad-driven?"
},
{
"speaker": "Patrick Pichette",
"text": "The ad exchange itself is actually - it has a business model today. And so it's driven by the volume of ads that are flowing through the exchange. And it's the same thing -"
},
{
"speaker": "Trip Chowdhry",
"text": "Well, I mean, [inaudible]."
},
{
"speaker": "Jonathan Rosenberg",
"text": "I think that Eric addressed that question when we talked about enterprise and apps earlier. And I think that there are certainly opportunities for other licensing models and other models in terms of garnering revenue, but I think that we're confident that with a lot of the functionality we're delivering to people, where they're running search both across their internal information and across their external information what we're doing is creating a better environment on the web, creating a better environment online, creating more applications for developers to produce, and the more people spend time on the web, the more they search, the better they can search over their own internal information, the more they run searches online. So I think we're pretty confident that in the long run from a strategic perspective that's positive for us."
},
{
"speaker": "Trip Chowdhry",
"text": "And a follow up on that. I was investigating and trying to understand your developer programs and that stuff. It seems like, you know, between the competition, between Microsoft and Google, the race being played out, it is less of a competition more of a war of accretion. And why I say that is you're giving up a lot of OS and a lot of software for free and even before the industry matures. And [inaudible] immediately gets collapsed, in which I don't see any person as the winner. So who do you think - you create products where you grow the industry in terms of revenues rather than collapse the industry from Day 1? And obviously we have different points here regarding Android; even though Google claims it's very successful, I have a data point saying it hasn't been successful. And, again, the prime reason is it just couldn't gather the revenue mattresses for your developers. Developers are not making money on Android and they're making a lot of money on iPhone and that's the reason why one is successful. My next question is: How do you think about growing the industry rather than collapsing the industry from Day 1?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Okay, well I'm not sure I completely understand your premise about growing the industry versus collapsing it. I mean, the broad story from a developer perspective is we're trying to make the web the place to build, to deploy and experience what are becoming increasingly rich and exciting applications. And we're doing that in a few areas. We're making the browser more powerful with Chrome. We're trying to make connectivity pervasive and accessible and usable for developers. I disagree with some of the comments about the degree to which the Android market is robust; we've got a lot of applications that we're seeing there and a lot of users using them. And we're also trying to provide Google-level services to every developer, which is App Engine, and we're very optimistic that that's going to make for a much more exciting and richer web."
},
{
"speaker": "Operator",
"text": "Your next question comes from Benjamin Schachter - Broadpoint Am Tech."
},
{
"speaker": "Benjamin Schachter",
"text": "A few housekeeping questions: One, bonus accruals didn't come at all, I don't think, and that was sort of the issue last quarter, so I was wondering if you could talk about those turned in and how we should think about those. And then if we could dig a little bit deeper into G&A and if you could just remind us what were the big issues in Q1? I think you were sort of implying that there was nothing special about where the run rate was in Q2, so maybe we should think about that going forward. And then finally on the tax rate, my understanding previously it's always been the tax rate you put in the quarter is sort of what you expect is your best guess for the year, and so we should all sort of think about that as your best guess for the year. Is that correct?"
},
{
"speaker": "Patrick Pichette",
"text": "So let's start with the last one. In theory you're right that when we take tax provisions, you know, you can't just look backwards; you have to also kind of think through the full fiscal year. But, again, if you think of all the moving parts within it, it's a bit like OI&E with Sprint and the team in Treasury, right? They try to give you a number that reflects what they thinks going to happen, but then the currency takes off and then the world changes. So just a word of caution on that one. In the case of G&A, you're right that we have not had - you'll remember in Q1 we talked about kind of three items that really impacted our G&A or that we had noted, anyway - the legal settlements, which were kind of one-time in a few areas; then there was the restructuring of our sales and marketing group and then finally there was some bad debt. So these were the three that specifically we had documented and mentioned. We didn't have anything of any significance this quarter, so that's the essence of some of the delta. In the case of the bonus, you'll remember it was really a big issue between Q4, a year end issue, and starting the year. I mean, there's nothing special to report on the bonus accrual for this quarter."
},
{
"speaker": "Benjamin Schachter",
"text": "Well, were the bonus accruals similar to what they were in Q1?"
},
{
"speaker": "Patrick Pichette",
"text": "We wouldn't comment on that. I mean, all I can tell you - let me tell you this way: We have our plan that's been approved with the Board, and that plan basically has a set of kind of indicators within it and we're tracking according to these indicators."
},
{
"speaker": "Benjamin Schachter",
"text": "And then one other thing. You sort of very subtly were mentioning YouTube might be doing a bit better than it has in the past. The preroll issue is the first time you've sort of really embraced that on a public call. Do you think that's going to be the key modernization effort going forward or is it still kind of you're testing out new methods? Or are you kind of set on preroll in terms of how you're pushing your sales force?"
},
{
"speaker": "Patrick Pichette",
"text": "Let's give two answers on it. Let me give you the general answer and then I'll let Jonathan jump in on the details. I think that it is true that we are pleased with YouTube's trajectory. And in part the reason why we're communicating it to the Street is there's been so much press over the last quarter with all of these documentations of, you know, massive cost and no business models and all of the kind of negative press that we've read a lot about. And we just wanted to kind of reaffirm to the Street that this is a very credible business model and it's one that's got trajectory. So in that sense it's just to kind of tell everybody that we're on progress on the plan that we had made for it. I'll turn to Jonathan on the monetization pieces."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yes, sure, Ben. There really isn't a simple answer there because there's sort of four main user activities on the site if you think about it broadly, right? They enter on the home page, they search for videos to watch, they watch videos, and they upload videos and engage with the community with comments, recommendations and that sort of thing. And the different types of modes really get different advertising models. And that's part of why I think it's taken us time to kind of triangulate towards what works, and I think some of the things that we have now are still in pretty nascent stages. If you look at the home page it's basically big brand display ads. You know, search can be good for promoting videos, kind of similar to maybe what AdWords does for Google. But if you look at where the big inventory is, the massive users are in more the watch pages. So that's what we're sort of trying to figure out. You know, is it overlays that are going to work? Is it the in-stream stuff? I think we're still testing all of these things and the answer's going to be different for the different areas on the site that the user's on."
},
{
"speaker": "Benjamin Schachter",
"text": "But I think on the call you indicated much more - just being more open to the prerolls, and that seemed to be new to me. Were you not trying to indicate anything in particular there?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I would not say that our overall optimism that we expressed with respect to YouTube is primarily a function of one specific format. We've actually been testing prerolls, I think, for quite awhile. So if you interpreted that one single comment to prerolls to imply the broad conclusion with respect to optimism on YouTube, I think that's probably a mistake."
},
{
"speaker": "Operator",
"text": "Your next question comes from James Mitchell - Goldman Sachs."
},
{
"speaker": "James Mitchell",
"text": "If I was smarter this question would be simpler, so I kind of apologize in advance if it's confusing. But if I look back at the last year or so, it seems like [inaudible] growth sailed right through the financial crisis, where as price-per-click access [inaudible] dropped very sharply. And then this most recent quarter, [inaudible] growth slowed a little bit to up 15% year-on-year, while price-per-click seems to be stabilizing quarter-on-quarter. So when I think those trends, is it better to infer that [inaudible] just grow structurally over time but face the law of large numbers, while price-per-click is very sensitive to the economic cycle, or is it better to infer that Google's monetization initiatives tend to boost [inaudible] in some quarters and boost price-per-click in other quarters?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Well, maybe you're smarter than I am because I'm not sure I understand the entire question, but I think what you said is generally true. I think that in any give quarter the economic situation can impact the number of leads that are likely to convert. It can impact the number of commercial queries. I do think what Nikesh said is true, which is that advertisers don't constrain by their budgets; they manage to bids."
},
{
"speaker": "Patrick Pichette",
"text": "I think the model, if you think of - go back and take a look at the relationship between click growth and then CPC, right? Click growth is driven by so many factors, so you have the growth of the Internet itself, then you have the seasonality within it, and then you have - there's so many factors that will drive the click growth. And then obviously, you know, if people are in recessionary environments, shopping even more for the better bargain, then they click even more because they move around a bit. So it is a complex hypothesis that you are tabling and to kind of say here, I've figured out the four dots that make it work, I mean, I don't think any of us around the table that live in this world would make it a simple puzzle."
},
{
"speaker": "Jonathan Rosenberg",
"text": "The one thing I think we could say for sure is queries are less sensitive to the economy. There's more comparison shopping when the economy is not strong and potentially a little bit less buying. So you could still have high-paid - the paid clicks can be high even when the economy is bad and I think the CPCs would adjust if the users aren't converting and drop if that's consistent with the hypothesis that you're trying to articulate."
},
{
"speaker": "James Mitchell",
"text": "The comparison shopping could have helped paid [inaudible] growth in the fourth quarter and first quarter while the weaker conversion sort of hurt PPC and now conditions have normalized a little bit. I mean, maybe it just is an extrapolation question. You mentioned there were 12 improvements to ad quality in the quarter and they had a bigger impact than usual on revenue. Would that impact be felt more on the paid [inaudible] or more on the PPC?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "It would impact both, yes."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mark Mahaney - Citigroup."
},
{
"speaker": "Mark Mahaney",
"text": "One question just on mobile. There's been some data points that - I think in the founders' letter about a third of queries in Japan coming off of mobile devices; that's obviously a very unique market. You don't quality unique, but that obviously is a very unique market. Any other markets where you think search queries are material - 5% - as a percentage of total queries and any thoughts on are there any particular reasons why Western Europe and the U.S. and other markets over time wouldn't reach levels that may be half of what you'd see in Japan's, call it over a two to three year period?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "So are you specifically asking questions with respect to mobile search volume increasing in Japan?"
},
{
"speaker": "Mark Mahaney",
"text": "Just mobile search, yes, please."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Well, I mean, mobile search volume has increased quite a bit in the U.S., I think, as we mentioned, and that's largely a function of availability of phones with good browsers. And I think data plans are also an important dynamic. You know, generally I think mobile search volume is pretty high in Indonesia and in the Middle East, but we're starting to see mobile growth increase pretty well overall. You certainly see more interest in mobile search where the landline infrastructure is relatively poor, but I don't have any more specific thoughts beyond that."
},
{
"speaker": "Patrick Pichette",
"text": "Eric said in the previous call and I think that the adoption of these high-end devices, which are getting more and more ubiquitous - the G phones, the Android platform, the iPhone - I mean, they really do drive a lot of living on the web because the web is so much more accessible and therefore a lot more searches as well. So there's a fundamental trend that's happening there as well that's clearly is more than just Japan. I mean, there's a whole ecosystem that's building right now."
},
{
"speaker": "Mark Mahaney",
"text": "And one quick follow on; it has to do with paid search results. What's the latest thinking on the inclusion of broader formats within paid search results, i.e., allowing advertisers to respond to intentions with more than just text but to include display ads or video links or whatever in the paid search results, to apply universal search, that you've applied to organic search, to paid search results?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yes, well I think Nikesh mentioned the video plus box. We're also working on much better ways of offering valuable information in ads with functionality like the product one box, where we're doing similar efforts. We're also I think going to make significant progress and we have made some progress in experimenting with local where it's easier to or we're getting better at determining where a user is and thereby being able to give them the appropriate local information. So I think that there's a lot of opportunity. And if you look over the course of the last year, I think that the search results have in many ways, with universal search, been outpacing the innovations on the ad side and we're really going to move forward with the experiments on things like products and video and local. We've, of course, got to do that in ways that are good for the user, but we think we're making progress there. I think we've made more progress on the search side."
},
{
"speaker": "Operator",
"text": "Your next question comes from Youssef Squali - Jefferies & Co."
},
{
"speaker": "Youssef Squali",
"text": "If I take the domestic business, which was sequentially down, and I take out some revenues from YouTube - so you talked a lot about how well YouTube did - I can very easily get to year-on-year decline in U.S. search business. So I'm trying to understand what this really means. I mean, why wouldn't that imply maybe the beginning of maturation of search? I know it's somewhat unbelievable, but what's the counterargument there?"
},
{
"speaker": "Patrick Pichette",
"text": "That the U.S. search business is not declining."
},
{
"speaker": "Youssef Squali",
"text": "So that means YouTube -"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Well, of course, I mean, it's not all static, right? We're going to continue to deliver to these advertisers much better ways to manage their bids, much better ways to optimize their campaign and manage their budgets. We actually didn't talk about it on the call, but we've rolled out a new advertiser interface for AdWords to a very large fraction of our advertisers. The previous question just asked about the opportunities to improve the quality of ads, and if you look at it today, the click-through rate on ads is still low relative to the search results. So I think there's lots and lots of opportunity there and there's still many verticals where we don't do a particularly good job with the searches. So I think there's lots of headroom in terms of monetization for search overall."
},
{
"speaker": "Youssef Squali",
"text": "You know, that's helpful. I'm just looking at the domestic revenues last year versus this year and the delta is really only about $40 - $45 million, so the point there, if, just for the sake of argument, is YouTube was zero last year - which, obviously, it wasn’t - and if it's [$50] million this year - which, arguably, if it is or not - then your domestic revenues in search would be declining year-on-year. But your point is they're not. Okay, so I'll take that."
},
{
"speaker": "Jonathan Rosenberg",
"text": "But there's also - I think there's another flaw in that logic, because YouTube is not U.S. only."
},
{
"speaker": "Youssef Squali",
"text": "The majority of it is U.S., though."
},
{
"speaker": "Jonathan Rosenberg",
"text": "It also wasn't zero last year."
},
{
"speaker": "Youssef Squali",
"text": "Right, okay. Fair enough. And then if I look at growth in the network, it was up 2% versus negative 3% in Q1, right? So how much of that was driven by YouTube versus AdSense for content? In other words, is AdSense per search up as well year-on-year or is AdSense for content just growing faster because looking at AOL, traffic for AOL for ads for MySpace, the numbers don't just look too impressive to imply that AdSense for search would be that much higher."
},
{
"speaker": "Patrick Pichette",
"text": "Yes, there's no doubt that AFC is up relative to AFS within that period, but also in general display as well has been up because Q1, if you'll remember, the comments we had made is on the display side there was some pullback in Q1 versus Q4 and now coming back into Q2."
},
{
"speaker": "Operator",
"text": "Your next question comes from Christa Quarles - Thomas Weisel Partners."
},
{
"speaker": "Christa Quarles",
"text": "You guys talked a little bit about the mobile advertising market being basically not a separate biddable marketplace. I was wondering if you could just give us rough sizes in percentages of advertisers who've opted out to the mobile piece, you know, more or less than half? So that's the first question. And then the second question is: Do you guys have any data around your developer community yet, you know, which are the most popular products that people - or that developers tend to be working, size of developer, community, you know, how many people went to the developer conference. So question two. And then the third question is just I found myself opening my wallet to Google last weekend to pay for storage because I'd been bumping up against my limits. I was wondering if you guys have actually said how many people pay for Google storage?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I think that we had 3,500 people at the developer conference sign up. Somebody can check on that and tell me what the -"
},
{
"speaker": "Christa Quarles",
"text": "Yes, but it included people like me."
},
{
"speaker": "Jonathan Rosenberg",
"text": "I think it was 3,500 developers. We can specifically check on that. I believe on the mobile side that's generally a separately biddable marketplace."
},
{
"speaker": "Christa Quarles",
"text": "I thought it was an opt-in. I mean, I think Eric's comment on the call was specifically that it's roughly the same CDC because it's embedded in the same PC marketplace but over time - I thought as of right now you basically have your queries basically for the PC and you have to opt out so as not to be included in the mobile results. Is that not -"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Mobile is sort of tricky because there's the smart phones, which are more conventional browsers, and that's tied to the traditional experience, but then there's a separate set of mobile-only campaigns that you can also run."
},
{
"speaker": "Christa Quarles",
"text": "Okay. I guess I'm talking about the smart phone side and those. I guess, you know, the question is manifesting out of the fact that I've talked to some mobile competitors who are sort of frustrated that you guys are embedding that and they were saying, you know, that the ad's quality may not be as good or whatever. So I guess what I'm trying to get a sense of from you is what percentage of advertisers have chosen to opt out of those mobile because they either don't feel like the quality's there or they're just not ready to measure it?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "That I don't know. I know the default - I think the default is that you show on both but we give advertisers control and they can opt out, they can do just smart phone only capabilities."
},
{
"speaker": "Christa Quarles",
"text": "Right. But you don't have any -"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I think the number's pretty small, but I don't actually have it with me."
},
{
"speaker": "Christa Quarles",
"text": "Small that has opted out?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yes."
},
{
"speaker": "Christa Quarles",
"text": "Okay. And then paying for storage?"
},
{
"speaker": "Patrick Pichette",
"text": "I don't think we've ever disclosed that."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yes, it's not a significant - paid storage is not a significant portion of our revenue."
},
{
"speaker": "Operator",
"text": "Your next question comes from Sandeep Aggarwal - Collins Stewart LLC."
},
{
"speaker": "Sandeep Aggarwal",
"text": "Jonathan, it has been nearly six or seven weeks since Bing launched. Just a couple of questions to the extent you are willing to comment. What is your overall take on Bing? Are you seeing any changes of behavior by a typical Google user in terms of propensity to search at Google? And also, in terms of [inaudible] or blending search along with some [inaudible] of [inaudible] suggest travel, shopping, can really work here?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I think we said on the call that we think it's relatively early to call. We certainly haven't seen a large shift in share. I do think that there are opportunities to do a much better job with vertically oriented searches. And the question was asked on the call earlier - we talked about some verticals; I think I mentioned finance on the call earlier, where there's certainly an opportunity to do a much better job with ads. And certainly I think there's an opportunity to do a better job in shopping and in travel and in many verticals in time."
},
{
"speaker": "Sandeep Aggarwal",
"text": "And, Patrick, if I may ask one question on the headcount, there was a 378 headcount reduction sequentially. What was [inaudible] you know, maybe job elimination was [inaudible] accretion."
},
{
"speaker": "Patrick Pichette",
"text": "All right, let me give you the context on this again; I think it's important. We had announced at the end of Q1 a number of rationalizations in the sales and marketing program. And we continue to have a lot of job openings and we're hiring. So in the second quarter what you see is just a manifestation of, you know, if you can't hire fast enough in the job openings that you have, just for whatever reason, over the last 90 days, you end up in this position where you haven't started kind of catching up, if you wish. So it's just a timing issue. So the company continues to hire; it continues to have many recs open in many departments. And then some positions were eliminated in sales and marketing, as was discussed. So that's the net result of it, right? So if you go to the Google site for job posting, you'll see a lot of job postings today."
},
{
"speaker": "Operator",
"text": "Your next question comes from Doug Anmuth - Barclays Capital."
},
{
"speaker": "Doug Anmuth",
"text": "Two questions, I think pretty straightforward, the first one on cash flow. You net income was higher Q-to-Q, but your free cash flow was lower, so can you clarify what's going on in working capital and then also in income taxes? And then secondly, on TAC, it came in somewhat higher than we expected, at least, so I'm curious how much you're benefiting at this point from the Dell deal coming off? Are you still paying residuals there and are we likely to see sort of greater benefits from that going forward?"
},
{
"speaker": "Patrick Pichette",
"text": "So on the cash flow, I'll give you the most simple answer, which is in Q2 you have two tax payments, for the federal and the California state, and they occur April 15th and I think June 15th. So just those are not in Q1 and then you've got a big hit in Q2. And it's a big amount of money, like hundreds and hundreds and hundreds of millions - I think it's like $800 million or $900 million, in that range, right? So it's like a ton of money. So that will obviously impact, by far outweigh everything else, on the free cash flow calculation. Everything else actually is in pretty good shape. On the TAC side, I think there's, again, if you look at our TAC and it's been progressing, as I said on the previous call, you've just got moving pieces, but you wouldn't have kind of - there's no significant event that would have actually moved it in one way or another. You just have this effect between the Google and the non-Google and then you have the affect of the mix within the AdSense network between the smaller and the larger guys. And then that moves all the time and that's what you see in the reflection. I mean, obviously, so what we have seen in Q2 is, you know, a higher percentage of the smaller partners and slightly higher on the Google, and that's what you end up with."
},
{
"speaker": "Doug Anmuth",
"text": "And just going back real quick on that TAC hit, as I look back at other second quarters, I mean, I assume that timing would be the same, but I don't see sort of a similar affect there in previous years."
},
{
"speaker": "Patrick Pichette",
"text": "Yes, but I wouldn't worry about two years ago what happened in Q2 for TAC. I mean, two years ago to two years ago you would have had a very different mix of deals with very different payouts."
},
{
"speaker": "Doug Anmuth",
"text": "I was referring to income taxes, actually."
},
{
"speaker": "Patrick Pichette",
"text": "Oh, sorry."
},
{
"speaker": "Doug Anmuth",
"text": "TAC, taxes - close."
},
{
"speaker": "Patrick Pichette",
"text": "T-A-X."
},
{
"speaker": "Doug Anmuth",
"text": "T-A-X, yes."
},
{
"speaker": "Patrick Pichette",
"text": "Okay, yes. I thought it was TAC. Did everybody get TAC? Oh, sorry about that. On taxes, no, I mean, well, I'd have to go back. Every year we pay a lot, right?"
},
{
"speaker": "Doug Anmuth",
"text": "All right. We'll take it offline."
},
{
"speaker": "Patrick Pichette",
"text": "Okay, we'll have the IR people come back to you on the details."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jeetil Patel - Deutsche Bank Securities."
},
{
"speaker": "Jeetil Patel",
"text": "On the TAC, it's obviously been moving down, as Doug alluded to as well, but I'm curious, are you able to basically take down TAC on the search side, on the CPC front, and maybe reallocate it to more the lead gen side of the business in terms of CPA and CPM inside the network there? And second, as you look at your kind of display category developing, are you seeing the interest in YouTube develop among pure display-oriented advertisers or lead gen-oriented advertisers? And then lastly, Germany, last quarter I think you pointed out as a fairly strong market for you, I guess. Can you give us a sense of where Germany is and is that close to cracking the 10% mark in terms of contribution?"
},
{
"speaker": "Patrick Pichette",
"text": "I just need to understand better your first question."
},
{
"speaker": "Jeetil Patel",
"text": "Yes. TAC's been moving down. Is there the possibility that you could take some of your TAC dollars that you pay out on a CPC basis, whether it be search or CSEs or others, and bring down those TAC payments and reallocate them to more of the display side of the business in terms of inside your AdSense for content network on a CPM basis?"
},
{
"speaker": "Patrick Pichette",
"text": "I mean, the different deals have just different characteristics and you can't just shift them; they're with each of the partners and they appear in the AdSense network; I mean, there's a certain structure. And then if you do a deal for Chrome or for Toolbars, you just have a completely different set of structures for those deals. So, I mean, we continue to manage each of these sets of partners and each of these streams of TAC with their own set of economics and, you know, every time we get a good deal we do it. And the mix is just a product of all that, no more, no less. We don't think okay, we'll reduce the dial on one to increase the dial on the other. Everything that makes sense we do."
},
{
"speaker": "Jonathan Rosenberg",
"text": "I guess on the questions with respect to YouTube, I tried to address some of that in I think it was Ben's question. And, again, the type of advertiser really depends on which of the activities it is, right? There's the home page, there's searching for videos to watch, there's the watch pages. So it depends which activity you're talking about. The traditional Google advertisers are generally direct-response focused. The brand display advertisers - the people taking over the home page banners - are more display oriented. And I think you're starting to see some TV advertisers come online, but I don't think I can give you too much color on exactly to what degree that's playing in the equation. And what's the question - there was also, I think, a question about Germany?"
},
{
"speaker": "Jeetil Patel",
"text": "Yes, Germany. I think you highlighted it as a strong market last quarter, I guess. Can you just provide an update or commentary of how that progressed in Q2?"
},
{
"speaker": "Patrick Pichette",
"text": "I mean, it did well, but I wouldn't give any more information than that. You'll remember last quarter in Q1 there was a lot of macroeconomic events that people were asking about, you know, how is Europe doing given the meltdown of the economy in UK, and how was the rest of Continental, so we just used it as an illustration rather than a set of data points with a lot facts around it."
},
{
"speaker": "Operator",
"text": "Your next question comes from Steve Weinstein - Pacific Crest Securities."
},
{
"speaker": "Steve Weinstein",
"text": "Can you just help explain all the volatility in the interest and other income line, how we can get our hands around that, because it's swinging enough that it's affecting the numbers."
},
{
"speaker": "Patrick Pichette",
"text": "Yes. OI&E will continue to be a real challenge. It's a real challenge for us as well, right, because there's been so much volatility in FX in the last little while when you think of the last three, four quarters. I mean, it is difficult to predict where FX is going. In fact, we were discussing as a team that some companies kind of right now stay at the margin level, right, and then after that they say it's really tough to give guidance anywhere below. Obviously, we don't give guidance, but the point is in general there's really two big drivers that affect it for us. One is obviously on the investment side we've been very conservative in the last year to make sure that we protect the capital of Google and by doing so obviously our yields have gone down quite dramatically to protect that. So all of our investment in our marketable securities that have been sovereign backed and that we've talked about, I mean, it has a pretty big impact in terms of trajectory. On the flip side of that, our hedging costs, you know, as volatility continues to be really high, the hedging costs, you know, we've benefited from it, but sometimes you just get the timings of the FAS 133 that hit you. And even though you're doing fine on your hedges per se, right, you end up at the end of a quarter and because of where the FX rates stand at the point and then you marked-to-market your options, you end up with having from an accounting point of view bringing a lot of these expenses back into a current quarter. It can have a big effect, right? These swings can be quite significant. So I sympathize with you because it in fact is really difficult to get some good semblance of where this thing's going on a quarter-to-quarter basis. I mean, I can tell you on the flip side of that is we manage this very responsibly, obviously, as you can see in the results of our FX program and then our investment program. We have to think through in the coming quarters as to how do we, given the economy stabilizing and the banking systems are stabilizing, right, how do we re-think our investment portfolio to kind of take advantage of kind of the stabilized environment."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Since I actually got a factual answer to one of the questions that was asked earlier over e-mail I said I would just share it. I answered Christa and said that there were 3,500 developers or I might have said attendees at the developer conference. There were 3,500 attendees, but 2,196 developers, so Christa must have been there with a lot of her friends. But the factual answer to your question is just under 2,200 developers."
},
{
"speaker": "Patrick Pichette",
"text": "So, Steve, I hope that answers your question and the big pieces at work."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ross Sandler - RBC Capital Markets."
},
{
"speaker": "Ross Sandler",
"text": "Just a couple follow ups, first on the CapEx. So, Patrick, you've said in the past - you've kind of thrown off the hypothetical example that up until, call it middle of last year, you guys were managing the CapEx program to always kind of stay ahead of capacity. So if you thought you needed 20 data centers in a given year, you'd invest in 22 or 23. How do we think about where we are today in terms of capacity utilization of all of Google's infrastructure and when does kind of a maintenance CapEx have to start kicking in? And then a follow up question on just the relative growth rates for U.S. versus Western Europe. Do you think those two markets through the second quarter are now moving closer in tandem, Western Europe starting to slow down a little bit later than the U.S. in terms of kind of where we've come from in the last four quarters? Do you think that we're not kind of at parity in terms of the deceleration in those markets? And then the last question is: When you talk about putting the content network on Ad Ex, the next version of the Exchange, how does Google think about sacrificing potentially more favorable web share deals with publishers that are on the content network today with potentially a lower rev share if they put their inventory on the exchange? I think the exchanges are closer to a 5% to 10% type rev share. How do you think about that dynamic when you start plugging in all the inventory from the content network?"
},
{
"speaker": "Patrick Pichette",
"text": "Let me start with the CapEx question. On CapEx, it has been every quarter - I've been here now for four quarters and every quarter everybody asks, Patrick, it's going down again, so is it bottoming out? And we've had a great benefit in the last two to three quarters of not only higher utilization rates but Moore's Law's been at work for us on top of that, and we have had really good planning of our capacity. So the combination of all these things has given us quite a boost in terms of managing our CapEx and that's just shown in the results. You'll remember, also, that I said we have a number of areas where we need to invest and we are making these investments. And I mentioned, you'll remember, one place which is in Scandinavia which the only time you could work on it is in the summer. So even if we had all our plans to start in March, the place was a deep freeze at the time and now they're kind of working hard at it. So we continue to invest. And they're lumpy and they're big and when you get a next generation of servers ready then you do a big overhaul and then at that point you get a lot of capital in. And that's just the nature of the business. So we're, one, very pleased with the way that the team has worked really hard to get this better utilization and better planning of the capacity, so they're smarter about it. So we got the benefits over the last three/four quarters and we're continuing to invest and we'll do so in the future. So that's on the CapEx side."
},
{
"speaker": "Jonathan Rosenberg",
"text": "I don't think there's an easy answer on the Ad Exchange question. I mean, the idea is basically to create an open platform so advertisers and publishers can buy and sell inventory. I think there are going to be different optimization insights and different margins which are justified by different targeting technologies that different players bring to the table, but I think that what we're hoping to do is reduce a lot of the fragmentation that exists in the whole buying experience and if overall you can get more budget and more advertisers and more publishers flowing through there, in the end the economics are going to work across both sides."
},
{
"speaker": "Patrick Pichette",
"text": "The last question you asked, which is U.S. versus Western Europe, we're really pleased with the growth in Western Europe. Obviously, in both of these markets the economy has had a lot of short-term affects that you can't discount; it's been true for the U.K. And also the FX has had a huge affect, as you can see through our results. So in both cases we're really pleased with the growth rates that we have and I don't think that I would correlate one with the other right now; I think they have their own sets of momentums and dynamics. We'll take one last question. Unfortunately, we're running out of time. So we'll take one last question, please."
},
{
"speaker": "Operator",
"text": "Your final question comes from Colin Gillis - Brigantine."
},
{
"speaker": "Colin Gillis",
"text": "I know every customer is important, but when we talk about slimming down the sales and marketing efforts could you give me a sense as to what is that customer base that needs an awful lot of direct handholding? Is it 1,000 customers? Is it 5,000 customers?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I don't think there's an easy answer to that question. I mean, basically the way we manage the sales and the support experience is on a bang for the buck basis we're providing support to the customers from whom we're going to garner the largest amount of revenue. I think that if you are able to support larger numbers of customers you'd be able to make incremental revenue, so I think there are many, many thousands of customers that could use utilization efforts from our support organization; there's only a subset that we're actually able to support at the level that we would like to. But on a bang-for-the-buck basis, we're prioritizing at the top of that funnel. The key there is really focus, I mean, what we're really trying to do there is create automated tools that make scaling these efforts easier and make it easier for customers to optimize on their own. Of course, we also partner with agencies who I think do a lot of the heavy lifting there for us and play an important component to the equation."
},
{
"speaker": "Colin Gillis",
"text": "Absolutely. So just trying to get some sense, directionally would you say you're focusing in more on the larger customers at the top of the funnel?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yes. Certainly, we allocate our sales time. I mean, the salespeople allocate their time on the basis of, you know, on a bang-for-the-buck basis where the money is for the most part."
},
{
"speaker": "Patrick Pichette",
"text": "The direct sales force focuses essentially on these very large national accounts who are very large advertisers, whether they are agencies or they are big customers, and that's where they focus essentially their attention. And then we have a second category that, you know, you get some phone support, and then the third category that you just - sort of on the web. And so the reason why we do this, coming back to the original question, when we did the rationalization we grew so fast and then we made a number of acquisitions, and then you end up in a position when you kind of start adding all the bodies and you say okay, who's talking to whom, you end up with duplications in some places. And that's neither good nor bad; it was just the way it was and we set let's do a bit of rationalization. But we continue to, you know, we have all the headcount that we need in order to focus on the big accounts that we want to bid. We're not constrained in that sense, if you wish, right? And that's why we just did the cleanup in Q1."
},
{
"speaker": "Patrick Pichette",
"text": "Okay, with that, Maria, we can close the call. Is that okay?"
},
{
"speaker": "Maria Shim",
"text": "Yes. Thank you everyone for your time. We'll talk to you next quarter."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, everybody."
},
{
"speaker": "Operator",
"text": "And this concludes today's conference. We thank you for your participation."
}
] | null | null |
GOOGL | 1 | 2,009 | 2009-04-18 16:30:00 | Operator: Good day and welcome everyone to the Google Inc. conference call. Today's call is being recorded. At this time I would like to turn the call over to Krista Bessinger, Director of Investor Relations. Please go ahead, ma'am.
Krista Bessinger: Great. Thank you. Good afternoon everyone and welcome to Google's first quarter 2009 earnings follow up conference call. With us are Patrick Pichette, Chief Financial Officer, and Jonathan Rosenberg, Senior Vice President of Product Management. I will quickly cover a few housekeeping items and then we'll open the call immediately to your questions. Please limit yourself to one question and one follow on. Also, please note that this call is being webcast on our Investor Relations website located at Investor.Google.com. Please refer to our website for information, including our earnings press release and the latest slide deck. And a replay of this call will be available on our website in a few hours. Please note that we routinely post important information on our Investor Relations website located at Investor.Google.com and we encourage you to make use of that resource. As a reminder, the purpose of this follow up call is to give participants the opportunity to ask more detailed financial and product questions in Reg FD compliant manner. Now I'll quickly cover the safe harbor statement. Some of the statements we make today may be considered forward-looking, and these statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings, including our annual report on Form 10-K for the year ended December 31, 2008 as well as our earnings press release for a more detailed description of the risk factors that may affect our results. Copies can be obtained from the SEC or by visiting the Investor Relations section of our website. Also, please note that certain financial measures we use on this call such as EPS, net income, operating margin, and operating income are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and GAAP to non-GAAP reconciliation can be found in our earnings press release. So with that, we're ready to take your questions. Operator?
Operator: (Operator Instructions) Your first question comes from Heath Terry - FBR Capital Markets & Co.
Heath Terry: I was just wondering, as we look at the operating expense lines, we obviously saw pretty big declines in R&D and sales and marketing. We know from the headcount number in those areas that there wasn't as much of a decline. Can you talk to us about how you're getting those kinds of cost savings without using headcount as a reduction? And then just, from the increase that we saw in G&A, is there anything outside of the charges related to the change in share-based compensation that's driving that up this quarter?
Patrick Pichette: I'll answer that question. Overall what you have seen, as we mentioned on the prior call, the biggest change from quarter to quarter, if you wish, in the trajectory of our cost, as we mentioned on the prior call, was this issue of the bonus accrual in Q4, which was higher than we had originally planned because our results were better and now we're resetting the plan as what is a typical plan for the year, so we're starting again fresh. And those bonus accruals, which are tied to labor, flow into different categories that do include R&D. It's also fair to say that across many of our categories of costs we've continued to be quite diligent about our trajectories and we see that also as part of our results in a number of categories. So we continue to be prudent and that is essentially the biggest element that would have flowed through from Q4 to Q1.
Heath Terry: And so just for the follow up side of that, is it fair to say that looking at the delta and the bonus accrual is a reasonable expectation of kind of what your plans are for the level business needs to be at for outperformance to happen and us to see the same thing that we saw in the fourth quarter last year for the necessary bonus accrual catch up?
Patrick Pichette: I'm not sure I understand the question. If your question is - we have now reset our plan at, let's say that it's 100%, right, whatever 100% is, so now we're running this year with the expectation of 100% and we hope to beat that - because you always hope to beat your plan - but that's what we're running with right. And if between now and the end of the year we see a big ramp up in our performance, right as we see that we will take appropriate accruals at that point.
Operator: Your next question comes from James Friedland - Cowan and Company.
James Friedland: I wanted to ask a question on Google Apps that was indicated in the last call as a key area for investment. At this point in the evolution, is the investment more on new features or are you starting to do more in terms of building up an enterprise sales force? And are you seeing additional enterprise wins, especially in this environment, on the cost savings and can you name any?
Jonathan Rosenberg: We had some pretty large deployments this quarter. Avago, which I think is the semiconductor division of HP, deployed the App suite to several thousand - maybe 5,000 or 6,000 users. We had some progress in one of the big states in Mexico, too, which we launched in early Q1. We also had quite a bit of progress on the .edu side, with I think 60 colleges and universities that we signed deals with. Some of them, I believe, were Cornell and Georgetown. I know we signed other significant deals with T-Mobile, Fujisoft, Euromaster - which I think is a subsidiary of Michelin - so I think there's significant progress there. The kind of functionality that we're working on are some of the big holes that I think we still had in the suite. Offline support was probably one of the more significant pieces, as was better synching with mobile devices. We're seeing pretty strong demand and traction in organizations in sort of the 3,000 to 15,000 size range. We're getting a lot of help with the reseller program that we launched. And I think your observation about what is the state in a cost challenging environment. I think we are seeing that we've got a number of customers who are using the paid Apps version. I think we're signing on more customers because of the cost savings relative to competitors. There's a big Forrester study that showed that we're a fraction of the price of the competition even relative to their cloud-based offering. So I think we're doing pretty well. There's one category, manufacturing, and spinoffs of large companies that seem to make a lot of sense, particularly when a company's building new infrastructure. And we've got some examples; I think the Avago example is one of those and I know there are more.
James Friedland: Are there particular industries where Apps are being better adopted at this point versus others where maybe it's a little bit more complex and harder to get into?
Jonathan Rosenberg: I'm not sure I can establish any correlation in terms of the categories of industries. I think it's more a function of how the users and the IT departments are set up. Certainly, the educational institutions have made relatively quick and robust progress, as have companies that I mentioned that have sort of spun out and are out to start from scratch and build and don't have the legacy dynamics that established companies do. But I think that's really the only broad observation that I could name. I think it's more a function of the size of the enterprise than it is the industry, so it's a few to several or 10 - even 15,000.
Operator: Your next question comes from Steve Weinstein - Pacific Crest Securities.
Steve Weinstein: I'm just trying to understand. You had almost a full quarter still benefit from the DoubleClick acquisition and so when I look at your U.S. business where you're reporting basically 3% growth, without DoubleClick, was the business in the U.S. basically flat year-over-year?
Patrick Pichette: I don't have those details so I won't answer it. It is true that we have - so if you think of the coming quarters, DoubleClick will be, like, we're finishing the first year of DoubleClick, so what I can say which is a factual statement is we had in Q1 we're finishing the first full year of recognizing revenues for DoubleClick, but now DoubleClick's integrated in all the display [inaudible]. So in Q2 you'll see the effect of that.
Steve Weinstein: So as a follow up, then, I hope you can clarify one more thing on the G&A expenses. If we back out basically the $46 million in expenses you kind of recognize sort of one-time, is that a fair run rate to work on right now? I guess I'm missing something about how the bonus accruals is going to change throughout the year.
Patrick Pichette: No, what I mentioned is that the bonus accrual that we took in Q4, that did not get moved into Q1 because we reset it, you know, much more than offset additional expense pressures that we talked about.
Operator: Your next question comes from Richard Fetyko - Merriman Curhan Ford & Co.
Richard Fetyko: Guys, if you were to compare the mobile and the display initiatives and if you include YouTube within the display, which one do you expect to be the bigger opportunity in the next two or three years? And then the follow up on that, could you elaborate more on the display ad strategy? You have the Ad Exchange, you have also the AdSense for display or for content that you're integrating display into. Could you give us a little more color on what sort of strategy or product you're emphasizing within that display initiative?
Jonathan Rosenberg: I guess I'm not - broadly, the story and the strategy is to address the issues and the challenges around the way display ads are bought and sold. We do fundamentally believe that those are going to change quite dramatically over the coming years and we're trying to bring much more measurability, the kind of efficiency that we had with search advertising to display and make it much more efficient for both advertisers and publishers to offer better ads for users. So, I mean, basically building the largest scale network that we can that's going to give the best ROI to advertisers on the one side and the best yield to publishers on the other. So if we get fully integration of DoubleClick and Google products, we're going to have the combination of this big leading platform for advertisers to create and manage the most effective campaign and publishers to on the other side manage and monetize their inventory. So I think it's the combination of being able to do both of those things we expect will be very, very powerful. It's hard for me to handicap whether or not the scope of overall revenue on the display side or the mobile side will be bigger. We're obviously very, very excited about both and making strong progress in both, so I don't have a sense of what the size of those industries will look like in two or three years.
Operator: Your next question comes from Doug Anmuth - Barclays Capital.
Doug Anmuth: Can you provide some color, Patrick, on the reasons for the sequential decline in other costs of revenues?
Patrick Pichette: Again, in other cost of revenue, if I just go through my notes, they are still tied mostly to payroll issues rather than equipment issues or machine utilization. So that's basically it.
Doug Anmuth: So, just to clarify, so you're saying more related to the bonus accrual than to depreciation?
Patrick Pichette: Yes, that's correct.
Operator: Your next question comes from George Askew - Stifel Nicolaus & Company, Inc.
George Askew: I'm going to address this bonus issue one more time. I'm just trying to get a sense of the size of the bonus accrual in the first quarter. If you look at it as a percentage of sales, for example, in the first quarter '09 compared to the year ago quarter, first quarter '08, was it materially different?
Patrick Pichette: I don't have the answer to that question. But I think again in general terms I think that if you think of your modeling, I think looking at run rates from a year ago may be useful to kind of get a sense of magnitude versus Q4 because Q4, as I said, was sufficiently different that actually it does make a difference between Q4 and Q1.
George Askew: And then secondly, as a follow up, there's media reports hitting late this afternoon here that YouTube is partnering to stream full-length movies, TV shows, etc., a redesign happening there. What can you tell us about this kind of news on YouTube and the redesign that appears to be imminent?
Jonathan Rosenberg: Certainly what we're hearing from both viewers and advertisers is that they want premium content and a premium viewing experience and we want YouTube to be as comprehensive as search there and we want, in fact, as much professional quality content as we can and advertisers as we can of all sizes and types. I believe there's a conference or some additional details on the Sony issues coming out directly from the folks at YouTube, so you might want to take a look and watch for that. They should have all of the details about the Sony relationship and dynamics from San Bruno.
Operator: Your next question comes from Mark Mahaney - Citigroup.
Mark Mahaney: Just one quick financial goals question. In past historic years I think there was a goal - and I know it was stated at Investor Days in the past - to simply expand pro forma operating income sequentially as long as possible. Is that still a goal within the company? That happened this quarter. But is the way you think about this, financial goals, just to expand that sequentially going forward, that non-GAAP operating income?
Patrick Pichette: Two points. I wasn't there in the old days when whoever would have said what, but certainly under my rule we don't give any guidance going forward on any of these dimensions. All I think it's important that people understand is we're demonstrating responsible management over our resources. You should consider, as you think of your modeling, the fact that we talked at length on the previous call that our revenues are seasonal and you've just got to think of our expenses much more of a kind of fixed cost. They're not seasonal in a way, right? So our labor is not seasonal and our expenses are not because we're still growing. So that's the mind-set that you should apply to your modeling.
Operator: Your next question comes from Sameet Sinha - JMP Securities.
Sameet Sinha: A couple of questions. If you can talk about the networks business. Understandably, you've undertaken some initiatives over the last couple of quarters to clean it out. When can we start to see improvement in that business and when will you end these initiatives?
Jonathan Rosenberg: Could you clarify - are you asking about AdSense or search? What exactly are you asking about?
Sameet Sinha: I mean the Google networks business. I'm just looking at that, trying to open it over here. It was down sequentially a little bigger than it was down last quarter, so I'm talking about. You were getting rid of some arbitrage layers, things like that. When are those activities - when do you think that ends?
Jonathan Rosenberg: Some of that relates to partner issues. Some of it is the network cleanup. I think that to date the cleanup has been largely successful, but it's kind of an ongoing cat and mouse game just like e-mail spam, so I don't think I would necessarily want to suggest that the cleanup issue has been fixed. I think we did start engaging pretty aggressively in those efforts last year and we've made great progress. I think the other piece that you may see is there are probably some FX issues in other partners that we have that are built in there that are seeing the same kind of economic issues that we have as well as having to sort of understand which partners are in the overall mix, which is a factor. We don't give you the full list of those dynamics.
Sameet Sinha: In terms of the follow up, can you talk about the correct share count to use? You had repriced some options. Would these become dilutive anytime during the year?
Patrick Pichette: Sorry, restate the question for me, please.
Sameet Sinha: You had repriced some options, some underwater options. Do they become part of the diluted share base now that they are in the money because they were priced, my sense is, about 306.
Patrick Pichette: No, not anytime soon is the answer. Very small. Very small. So you wouldn't count on them. Just to complement Jonathan on the - to come back to the issue of the network. I mean, there is a difference between obviously AdSense for search and AdSense for content and clearly two types of businesses with two different rationales if you think of behavior. And the content side, obviously, branding oriented, just like campaigns, as I mentioned a bit earlier. So on that side obviously remaining challenging in Q1 because those advertisers typically will shift to more relative - to their performance-based advertising if they have a chance and tighter budget. So really a tale of two cities between the AdSense for search and the AdSense for content. Just to complement Jonathan's point.
Jonathan Rosenberg: I agree. I think that's right.
Operator: Your next question comes from James Mitchell - Goldman Sachs.
James Mitchell: Could you talk about the impact of no longer providing rebates to agencies on your revenue growth in the international business?
Jonathan Rosenberg: So you're referring to the best practices funding which we phased out over the course of the last year. Patrick wasn't here for all of that.
Patrick Pichette: What would be specific, James, in your question? Like what would you like? We have done that.
James Mitchell: I was wondering whether it was something that materially impacted the first quarter or it's something, because it was phased in over the last year, it's been -
Patrick Pichette: No, it wouldn't have been. It wouldn't have been material.
Operator: Your next question comes from Youssef Squali - Jefferies & Co.
Youssef Squali: Just to reiterate on the BPF, so our understanding is that a number of agencies were still getting a fair amount of money, somewhere between 6% and 7% back, as of Q4, and starting January 1 that went down to zero. So you're saying that the year-on-year decline of 9%, call it, in the U.K., I guess, was not materially impacted by that?
Patrick Pichette: That's correct. For our total revenue, we may have had one agency for whom it would have mattered for that agency, but in the total of our revenues it wouldn't have been material.
Youssef Squali: And then a clarification. Why was DoubleClick revenues weaker this quarter? I think on the prior call you kind of talked about that, but you didn't kind of provide the reasons why.
Patrick Pichette: Well, I think there's two elements on it, right? One is seasonality, because if you think of DoubleClick in Q4, it's a very strong quarter for the display advertising related to the Christmas, certainly in North America, which is a big element of the DoubleClick. And then second is the entire economic environment right now is putting a lot of pressure on that business. So it's the combination of these two things that really we're seeing in the market.
Operator: Your next question comes from Christa Quarles - Thomas Weisel Partners.
Christa Quarles: I was wondering if you guys could dig into some of the mobile data a little bit more. I guess what I'm seeking is in this vaunted example that you have in Japan, do you have sort of RPS relative to what you're seeing in other markets in terms of increase? I've listened to your mobile webinars where you've guided advertisers to bid maybe 4x what they're bidding on the PC simply because there are fewer chances to be shown. Is there any quantification whatsoever that you can provide around how monetization is ultimately different on the mobile relative to the PC?
Jonathan Rosenberg: I think it's really too early to say. I think that we certainly see the promise, we think. I mean, are you're asking specifically about Japan?
Christa Quarles: Well, I guess what I'm trying to ultimately do is quantify. I thought Eric's comment was really interesting, that you guys are now, what was it, 8% mobile browsing share?
Jonathan Rosenberg: I think I said that.
Christa Quarles: Or you said it - somebody said it - which is the first time I'd seen this data out of you guys. So, again, it's trying to quantify what this opportunity could ultimately mean and if monetization all of sudden becomes even more intriguing, interesting in a mobile context relative to a PC one then, you know, people might get more excited.
Jonathan Rosenberg: Yes. I personally think mobile is going to be very significant. I talked in my prepared remarks about how powerful the phones are and the degree to which search traffic is up over five times in the last couple of years. It is the case that I think nearly 80% of our mobile search queries come from outside the U.S., so a lot of the lessons that we're still learning at this point are lessons that we're learning from markets like Japan, to some extent China and India. But I think the thing you really have to look at is if we've got 100 - 175 million smart phones shipping in 2009 and they all have this much, much different, very rich mobile browsing experience, you're basically talking about something that didn't exist on phones a couple of years ago. They didn't have the processing power, they didn't have the battery life, they didn't have the rich display, they didn't have an input mechanism that worked well, we didn't have the kind of vast networks that we have today, and we're now seeing many developers understand that the web is this wonderful platform for these mobile apps and they can be fast, they can be location aware, they can offer a rich experience and even work offline. And that I think is fundamentally going to change the whole value equation with these devices and you're going to see that users are much more likely in my opinion in the long run to consummate a transaction against an ad that they were served on a mobile phone because they're probably clicking on that ad or interested in that ad because they're out somewhere and ready to go consummate a transaction. So I think there's lots of reasons to think about where the business is going and where these phones are going which make us very excited. There's not a great deal of data yet on what the pace of revenue growth will be there other than what we're seeing in Japan, which is very promising.
Christa Quarles: I just want to follow up on the mobile side, you guys have an investment in Clearwire. Obviously, there's broad-based concerns there. Would you guys ante up further if they needed additional cash? Is there any plan around that investment?
Patrick Pichette: The lawyer across the table is telling me to tell you we don't comment on the future potential investments.
Jonathan Rosenberg: One thing I would actually urge you to think about when you look at some of these other markets like Japan is that in some of these markets there are many users who only access the web through their mobile devices and that makes the dynamic very, very different. And of course Japan is far ahead in terms of mobile consumption than other markets, so it's an interesting market to look at in terms of where I think the trends are going to be.
Operator: Your next question comes from Justin Post - BAS-ML.
Justin Post: I apologize if you've already addressed this, but one of the things I see really interesting on YouTube is the quantity of searches and it's becoming one of the leading search engines out there. And I think you've rolled out some new ads. What are the click through rates on some of those video advertisements that are showing up in sponsored search results? Are you happy with that? And do you see that as maybe one of the bigger opportunities on YouTube and, if not, what really is working right now?
Jonathan Rosenberg: I think we're really still in the experimental stage on a lot of this. I mean, there's no doubt that from a traffic perspective the whole YouTube phenomenon continues. We're definitely hitting on an ongoing basis new playback and upload highs. We're basically at this point looking at multiple different ad formats. We're certainly monetizing hundreds of millions of videos in the U.S. every month, which is more than the total of U.S. monthly views on any other online video site. We don't give you the specifics in terms of click through rate, but we've got a whole bunch of new form [break in audio] and new content. We just launched in-stream ads on long-form content, so if you do a query on YouTube for Star Trek Charlie X, which is one of the episodes, you'll see an example of some of the new ads that we have there. Omid mentioned the home page format ad that we have which we're very, very happy with the results on which basically is a masthead that goes across the top. I think today it's Crank 2 and yesterday it was Volvo. And we've also got the promoted videos which we launched last quarter which are doing pretty well. But I can't give you any more details on the click through rate.
Justin Post: And can you tell us how the engine's doing as far as profitability? Any thoughts on margins? Are they getting better or worse? And then just a follow up on DoubleClick, are all those revenues going on the licensing line and did display help your overall growth rate, the 6%? Was display something that grew faster than that and helped the overall growth rate?
Patrick Pichette: I think on the display side it does go right through to the licensing line, so it does. And then you can back out if it does make our - oh, DoubleClick, sorry. Yes, DoubleClick does go through that line.
Justin Post: So we can kind of back that out and kind of see how it's affecting the overall growth rate.
Patrick Pichette: I guess so.
Operator: Your next question comes from Jeffrey Lindsay - Sanford Bernstein.
Jeffrey Lindsay: I just want to ask about the large reduction in traffic acquisition cost. This was due to makeshift or is it that you're rolling off expensive deals? What I'm interested in is how sustainable is that trend? And then if you could just mention - I don't know if it's public or not - just how long you've got to run on the current AOL and ASK deals. Thanks.
Patrick Pichette: Okay. So the short answer is it is mix and we obviously don't comment on any deals that we have in our pipeline. I think it's also, if you look at our Q4 '08 versus Q1 '09, our Google [inaudible] versus Google total revenue on the [Google] side it's gone up slightly and that's, you know, if you think of - there's the mix within the category and then there's mix between categories and on the Google side, obviously, it reflects the growth in our revenue from toolbars and browser distribution agreements. So that's how I'd think about it.
Operator: Your next question comes from Jeetil Patel - Deutsche Bank Securities.
Jeetil Patel: A couple of questions and I guess broadly two different questions, but if you adjust for FX and you look at your CPCs, they look like they were still up or flattish on a year-on-year basis when adjusting for FX, but not as much as before. I guess can you talk about, I guess, conversion rate coming off and I guess in particular which regions are you seeing more pronounced changes in CPC or conversion rates out there that could fluctuate the overall CPC trend? And then second, I guess it looks like the U.K. obviously fell pretty quickly in terms of revenue constant currency and then came back. U.S. it was, it seems like, more of a kind of steady decline, but holding its own. And rest of world is kind of a mixed bag. I guess can you characterize where do you think we are in the rest of world camp in general in terms of kind of going through this recession and seeing that impact in some of your regions? Is it probably early stages similar to the U.S. trend or does look like it'll pace similar to the U.K.?
Jonathan Rosenberg: We don't really break out the components of the RPM equation, so I'm not sure I'm going to give you a whole lot of color here. You can't derive price directly from paid clicks growth in the total amount of information that we give you. I think I did say on the call that some of what we're seeing on CPC is mix issues. It's particularly mix issues for the smaller emerging markets; it's certainly an FX component. It's certainly the lower dollar items and the issue of conversion being relatively lower than they had in the past. And as Eric mentioned, the auction working and advertisers lowering their bid. So I think that those are components. We certainly have seen a lot of CPC growth in the quarters before the economy collapsed, but I can't give you any more detail than that.
Jeetil Patel: I guess in some of the nascent regions that are still ramping, if you open up more distribution or more coverage, are you seeing bid prices improve like you saw over the course of the last couple of years here or in some of the more mature markets or is it a different dynamic in some of these emerging markets?
Jonathan Rosenberg: Yes. Okay, so I think that what we're seeing there is different because a lot of those markets are sort of at the more nascent stages of the growth rate. So if you sort of map them against what we saw in the U.S. or the U.K., which was actually the leading market, and said, you know, they're N years behind us, many of them are on growth trajectories that are strong, just as we were a few years ago, but obviously that's being dampened by the economic dynamic just like things are here. And, of course, you also have the FX effects there, too.
Operator: Your next question comes from Ross Sandler - RBC Capital Markets.
Ross Sandler: One kind of high-level question then one or two accounting questions. To follow up on the pharma ads issue earlier, it looks like the FDA may actually require all these pharma advertisers to add all the disclosures to their ad creatives. Is that a fairly easy task for Google to increase the available character length on those particular ads or is that going to be a little bit more challenging given the complicated technology?
Jonathan Rosenberg: I'm not sure what we're actually going to do there. I'm not convinced that we won't be able to come to some agreement in terms of what the right solution is with respect to some of these issues. Certainly, it wouldn't be ideal if we had to modify the user interface to accommodate substantially more information. Can it be done? Yes. Is it easy? Maybe not. We're going to find a way with the advertisers to make this work in one way or another and you could do it within the existing creatives if you had to.
Ross Sandler: Just a quick follow up on that. Are the advertisers actually still doing stuff right now or are they completely on hold until this issue gets resolved or can you not comment on that?
Jonathan Rosenberg: I believe there's some things that have been shut off, but I don't know all of the details about what subset of the activity there has been shut off. And some of them are, I think, attempting to change relative to the new standards they need to try to address. It's not really as big a deal, I think, as folks are making it. I know that I said that health was a vertical that was doing particularly well and pharma is important, but it's really a pretty small segment of the whole vertical.
Ross Sandler: And then, Patrick, if we can just get a little more clarification on the accounting around the hedging program kind of going forward. The way it was explained before it was an 18 months kind of rolling forward of these contracts. So why did we see the one-time boost in the first quarter and are we to expect more of that? How do we think about the accounting around the hedging program?
Patrick Pichette: Okay, so the fundamental issue that you have is it's not one time. It just happens that as every quarter we set up another tranche of hedges, some for the immediate short term that we don't have covered yet but cover it more and all the way to 18 months out. Think of it as kind of you're building the equivalent of a ladder every quarter, kind of filling the pipeline as every quarter retires. And so in Q3 of '08 that's when we actually put originally the first set of pound hedges that we've built over a couple of quarters and that now will have, you know, a full 18-month ladder built over the coming quarter. So that will just be rolling, that entire set of hedges, every quarter going forward. But in Q3 we put in a bunch of them for the next quarter and the next quarter and the decreasing exposure levels all the way down to 18 months, and it happened that the ones we put in Q3, because of where the pound went, gave us a substantial gain for Q1. I mean, next quarter we'll have more hedges that will kind of come to fruition and we'll have to decide what to do with the options that we got. So it's not a one-time item. The real item that happened is the ones that we had put in September, because of the wild fluctuation and variability of the pound over the last six months, we just happened to gain a lot. Had we had - I'll give the extreme of a case where assume that the pound had gone nowhere, it'd been very stable through the entire period, right? We would have spent the money and we would have had no benefits because there's nothing to capture because there's no volatility. So it really was driven - the last six months - and in a way I really feel for the investment community and the analysts trying to run these models, I really do feel for everybody because you have such high volatility in the last kind of nine months and because that is compounded by the FAS 133 that says well, you know, if you're in or you're out, you've got to book it all or not the minute that you get a decent amount of volatility, it just swings the numbers all over the place. So what we have to think about from our perspective is we continue to have a very stable hedging program in place. It continues to deliver us the value when there's high volatility, which is what happened. And, you know, because of the forced marked-to-market you have a decent amount of numbers floating around, but you shouldn't worry about that too much.
Ross Sandler: And then one last question - I promise, the last one - on the bonus accrual issue, a couple years ago Google used to accrue for bonuses with kind of a progressive growth manner so 1Q the accrual was kind of the lowest and it ramped up throughout the year and 4Q was the highest. And then in Q2 '07 you kind of went to more of a flat quarterly accrual program. Are we now back to the progressive? Like how do we think about, you know, just take $100 and spread it out over the course of four quarters? Is that going to be $25, $25, $25, $25 or does it start at $10 and then go up higher on the bonus accrual issue?
Patrick Pichette: Yes. I mean, we try to, if you think about it, right, we try to - when you start the year you have a plan in place and in that plan you accrue according to what you think the year's going to unfold and that's all we do. And then as the year unfolds we would, if we had more information to raise the accrual, would do so, so that's how we plan the year. That's why the number has gone down relative to Q4 because, I mean, if there's a good proof of how uncertain an uncharted territory we live in, look at Q4 and our results in Q4 and the economic activity that was really - in all of the turmoil that was happening, we had a very strong revenue quarter in Q4. And that created a bonus accrual that, if you had thought even in September or August, we hadn't foreseen. So we were really happy with the results and therefore happy to take the accrual and celebrate with all the Googlers, and now we're back to our regular territory of here's the year and here's the plan and away we go. I mean, that's why variability because the world is very uncertain and we're living through it right now all of us together.
Operator: Your next question comes from Sandeep Aggarwal - Collins Stewart LLC.
Sandeep Aggarwal: Jonathan, one question is we are seeing a little bit higher traction for search engine optimization and the question to you is does that mean the ecosystem of paid search is expanding or does this mean there's some potential threat to the paid search campaign?
Jonathan Rosenberg: I guess I'm not sure what is the perceived threat that you're articulating as a result of search engine optimizers?
Sandeep Aggarwal: Well, I mean, you know, if I'm running a Google Adwords campaign and then I'm also running searching and optimization and instead of Google and saving the money I'm running model for [inaudible] and maybe optimizing my website, landing pages, etc. In that case, am I likely to cut my paid search budget and I look at some money for searching optimization?
Jonathan Rosenberg: I honestly don't have any idea. You're basically saying is there going to be a shift in Adwords spending, spending on [inaudible], and I don't know.
Sandeep Aggarwal: And just one question, Patrick. On the sales team side, just one thing, you know, I think [inaudible] just happened too quickly. I know Omid tried to address some of those things in the previous call you hosted, but is there any other [inaudible] - should we expect some more changes in the sales structure, sales channel or anything else of that sort?
Patrick Pichette: We have no plans right now. I think that the work that was done by the team was very well done and that's why, as you can imagine, for any organization the last thing you want is an announcement every two weeks of changes. That just drives everybody nuts. And so we had an opportunity in the sales group to do the things that we announced and so, you know, we did announce them a few weeks ago. And right now we have no more plan. I mean, it's obvious that the world continues to be quite uncertain, right? So in that kind of world you've got to stay flexible, but right now we have no other plan.
Sandeep Aggarwal: And just one thing about, is there going to be any future revenue contribution from that discontinued audio business?
Patrick Pichette: No.
Jonathan Rosenberg: Sandeep, I'm just thinking about your original question a little bit and I think the one comment that I could offer is I don't tend to think of these advertisers that we have as having fixed budgets. And I think it's kind of unlikely that someone who's running an Adwords campaign, where they're measuring the ROI on an incremental basis and experiencing positive ROI from each incremental Adwords click, it seems unlikely that they would throttle that budget back if they're making positive gross margin on each of the Adwords clicked. So what you're proposing seems unlikely to me, but plausible.
Operator: Your next question comes from [Brian Volen] - Sturtevant & Company.
Brian Volen: I want to touch back on the idea that Eric brought up, the ROIs moving more into Google's favor. As we look at the moving parts in there we just look at clicks and searches, the cost and conversions. With the market pretty much moving costs lower, isn't that going to be the major factor or what is really driving the ROIs up anything more than just the costs coming down as advertisers are moving out of the space? And is there anything that will, other than keeping the costs low, allow for advertisers to actually really stage up and spike into the market to push ROIs higher?
Jonathan Rosenberg: I think really the main thing that drives ROI is the degree to which we're able to develop better ads and ad systems that target more efficiently and deliver an ad such that if the user clicks on it they're more likely to consummate a transaction. I think the conversion rate is probably the most significant component and that's a function of targeting the ad and the creative on the ad. Also some of the tools that we offer with respect to optimizing users' websites, you know, analytics, the website optimizer, things that allow the advertiser to get higher conversion rates on their site. I think that's basically the kind of thing that we're going to do that will continue to improve ROI.
Brian Volen: You talked about the optimizer there. About what percent of customers are using the optimizer?
Jonathan Rosenberg: I don't think that we've said. You'd have to talk to customers directly yourself. There is a blog post if you type conversion optimizer [on Google] it describes some of the detail in the study that we ran with a bunch of advertisers for which I got the percentage of [inaudible] different pieces. But we don't release that number. A pretty large portion of our advertisers are using some subset of the various tools that I mentioned - the website optimizer, the keyword piece, the conversion optimizer with analytics.
Operator: Your next question comes from Robert Haley - Gabelli & Company.
Robert Haley: I wanted to just ask one question on your paid click growth and if you could talk about what's driving that growth, whether it's growth in the number of advertisers using Google or maybe talk about paid click growth on a per advertiser basis and how that's impacted by changes in budgets allocated to Google versus changes in consumer click through behavior.
Patrick Pichette: I'll make just a broad statement and then let Jonathan complement, if you wish. There is, I mean, our traffic continues to grow, so if you think of general principles of what's going in our favor, our traffic continues to grow and we continue to have paid clicks to our network. There are different effects within that which obviously at the macro level, if you're in a mature market like the U.S. versus an emerging market like India, you get mix issues, you get vertical issues and you get value issues and that's basically how kind of we think about it and manage it. And so I don't know if Jonathan you have additional information you want to share or if I've missed something big.
Jonathan Rosenberg: No, I think Patrick got the biggest thing. I mean, clearly query growth is the primary driver there and beyond that I don't think we really go into detail on the other components of the equation. I don't think that there's significant activity with advertisers withdrawing themselves from a budgeting perspective altogether. I would echo what Omid said there, that to the extent that we are impacted by budget reduction, it tends to be the larger organizations where a CFO, somebody in Patrick's role, basically says we want to cut budgets N% across the company and that impacts the CMO. That's much less a factor in the small and medium businesses and, interestingly, it's less a factor even in some very large companies that really understand the concept that Omid mentioned about Google being a sales channel as opposed to a marketing expense. And I would take to heart the comments about the auto industry, where I think you're otherwise seeing relative shrinkage in overall marketing budgets and yet some robust growth in paid search and online advertising. So I think there is still value. I think we're seeing a lot of value in terms of shift in markets like that one from a budget perspective. By the way the one other obvious area there is I don't think you're seeing much budge reduction at all in the pure play online companies who really understand and measure the metrics of a lot of this traffic. I think they're much less prone to adjusting their budget.
Krista Bessinger: Great. So thank you, everyone, for your time today. If you have any further follow up questions, please don't hesitate to contact either myself or [Rhea]; we're happy to answer your questions. And thanks again for your time.
Operator: And this concludes today's conference. We thank you for your participation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day and welcome everyone to the Google Inc. conference call. Today's call is being recorded. At this time I would like to turn the call over to Krista Bessinger, Director of Investor Relations. Please go ahead, ma'am."
},
{
"speaker": "Krista Bessinger",
"text": "Great. Thank you. Good afternoon everyone and welcome to Google's first quarter 2009 earnings follow up conference call. With us are Patrick Pichette, Chief Financial Officer, and Jonathan Rosenberg, Senior Vice President of Product Management. I will quickly cover a few housekeeping items and then we'll open the call immediately to your questions. Please limit yourself to one question and one follow on. Also, please note that this call is being webcast on our Investor Relations website located at Investor.Google.com. Please refer to our website for information, including our earnings press release and the latest slide deck. And a replay of this call will be available on our website in a few hours. Please note that we routinely post important information on our Investor Relations website located at Investor.Google.com and we encourage you to make use of that resource. As a reminder, the purpose of this follow up call is to give participants the opportunity to ask more detailed financial and product questions in Reg FD compliant manner. Now I'll quickly cover the safe harbor statement. Some of the statements we make today may be considered forward-looking, and these statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings, including our annual report on Form 10-K for the year ended December 31, 2008 as well as our earnings press release for a more detailed description of the risk factors that may affect our results. Copies can be obtained from the SEC or by visiting the Investor Relations section of our website. Also, please note that certain financial measures we use on this call such as EPS, net income, operating margin, and operating income are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and GAAP to non-GAAP reconciliation can be found in our earnings press release. So with that, we're ready to take your questions. Operator?"
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from Heath Terry - FBR Capital Markets & Co."
},
{
"speaker": "Heath Terry",
"text": "I was just wondering, as we look at the operating expense lines, we obviously saw pretty big declines in R&D and sales and marketing. We know from the headcount number in those areas that there wasn't as much of a decline. Can you talk to us about how you're getting those kinds of cost savings without using headcount as a reduction? And then just, from the increase that we saw in G&A, is there anything outside of the charges related to the change in share-based compensation that's driving that up this quarter?"
},
{
"speaker": "Patrick Pichette",
"text": "I'll answer that question. Overall what you have seen, as we mentioned on the prior call, the biggest change from quarter to quarter, if you wish, in the trajectory of our cost, as we mentioned on the prior call, was this issue of the bonus accrual in Q4, which was higher than we had originally planned because our results were better and now we're resetting the plan as what is a typical plan for the year, so we're starting again fresh. And those bonus accruals, which are tied to labor, flow into different categories that do include R&D. It's also fair to say that across many of our categories of costs we've continued to be quite diligent about our trajectories and we see that also as part of our results in a number of categories. So we continue to be prudent and that is essentially the biggest element that would have flowed through from Q4 to Q1."
},
{
"speaker": "Heath Terry",
"text": "And so just for the follow up side of that, is it fair to say that looking at the delta and the bonus accrual is a reasonable expectation of kind of what your plans are for the level business needs to be at for outperformance to happen and us to see the same thing that we saw in the fourth quarter last year for the necessary bonus accrual catch up?"
},
{
"speaker": "Patrick Pichette",
"text": "I'm not sure I understand the question. If your question is - we have now reset our plan at, let's say that it's 100%, right, whatever 100% is, so now we're running this year with the expectation of 100% and we hope to beat that - because you always hope to beat your plan - but that's what we're running with right. And if between now and the end of the year we see a big ramp up in our performance, right as we see that we will take appropriate accruals at that point."
},
{
"speaker": "Operator",
"text": "Your next question comes from James Friedland - Cowan and Company."
},
{
"speaker": "James Friedland",
"text": "I wanted to ask a question on Google Apps that was indicated in the last call as a key area for investment. At this point in the evolution, is the investment more on new features or are you starting to do more in terms of building up an enterprise sales force? And are you seeing additional enterprise wins, especially in this environment, on the cost savings and can you name any?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "We had some pretty large deployments this quarter. Avago, which I think is the semiconductor division of HP, deployed the App suite to several thousand - maybe 5,000 or 6,000 users. We had some progress in one of the big states in Mexico, too, which we launched in early Q1. We also had quite a bit of progress on the .edu side, with I think 60 colleges and universities that we signed deals with. Some of them, I believe, were Cornell and Georgetown. I know we signed other significant deals with T-Mobile, Fujisoft, Euromaster - which I think is a subsidiary of Michelin - so I think there's significant progress there. The kind of functionality that we're working on are some of the big holes that I think we still had in the suite. Offline support was probably one of the more significant pieces, as was better synching with mobile devices. We're seeing pretty strong demand and traction in organizations in sort of the 3,000 to 15,000 size range. We're getting a lot of help with the reseller program that we launched. And I think your observation about what is the state in a cost challenging environment. I think we are seeing that we've got a number of customers who are using the paid Apps version. I think we're signing on more customers because of the cost savings relative to competitors. There's a big Forrester study that showed that we're a fraction of the price of the competition even relative to their cloud-based offering. So I think we're doing pretty well. There's one category, manufacturing, and spinoffs of large companies that seem to make a lot of sense, particularly when a company's building new infrastructure. And we've got some examples; I think the Avago example is one of those and I know there are more."
},
{
"speaker": "James Friedland",
"text": "Are there particular industries where Apps are being better adopted at this point versus others where maybe it's a little bit more complex and harder to get into?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I'm not sure I can establish any correlation in terms of the categories of industries. I think it's more a function of how the users and the IT departments are set up. Certainly, the educational institutions have made relatively quick and robust progress, as have companies that I mentioned that have sort of spun out and are out to start from scratch and build and don't have the legacy dynamics that established companies do. But I think that's really the only broad observation that I could name. I think it's more a function of the size of the enterprise than it is the industry, so it's a few to several or 10 - even 15,000."
},
{
"speaker": "Operator",
"text": "Your next question comes from Steve Weinstein - Pacific Crest Securities."
},
{
"speaker": "Steve Weinstein",
"text": "I'm just trying to understand. You had almost a full quarter still benefit from the DoubleClick acquisition and so when I look at your U.S. business where you're reporting basically 3% growth, without DoubleClick, was the business in the U.S. basically flat year-over-year?"
},
{
"speaker": "Patrick Pichette",
"text": "I don't have those details so I won't answer it. It is true that we have - so if you think of the coming quarters, DoubleClick will be, like, we're finishing the first year of DoubleClick, so what I can say which is a factual statement is we had in Q1 we're finishing the first full year of recognizing revenues for DoubleClick, but now DoubleClick's integrated in all the display [inaudible]. So in Q2 you'll see the effect of that."
},
{
"speaker": "Steve Weinstein",
"text": "So as a follow up, then, I hope you can clarify one more thing on the G&A expenses. If we back out basically the $46 million in expenses you kind of recognize sort of one-time, is that a fair run rate to work on right now? I guess I'm missing something about how the bonus accruals is going to change throughout the year."
},
{
"speaker": "Patrick Pichette",
"text": "No, what I mentioned is that the bonus accrual that we took in Q4, that did not get moved into Q1 because we reset it, you know, much more than offset additional expense pressures that we talked about."
},
{
"speaker": "Operator",
"text": "Your next question comes from Richard Fetyko - Merriman Curhan Ford & Co."
},
{
"speaker": "Richard Fetyko",
"text": "Guys, if you were to compare the mobile and the display initiatives and if you include YouTube within the display, which one do you expect to be the bigger opportunity in the next two or three years? And then the follow up on that, could you elaborate more on the display ad strategy? You have the Ad Exchange, you have also the AdSense for display or for content that you're integrating display into. Could you give us a little more color on what sort of strategy or product you're emphasizing within that display initiative?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I guess I'm not - broadly, the story and the strategy is to address the issues and the challenges around the way display ads are bought and sold. We do fundamentally believe that those are going to change quite dramatically over the coming years and we're trying to bring much more measurability, the kind of efficiency that we had with search advertising to display and make it much more efficient for both advertisers and publishers to offer better ads for users. So, I mean, basically building the largest scale network that we can that's going to give the best ROI to advertisers on the one side and the best yield to publishers on the other. So if we get fully integration of DoubleClick and Google products, we're going to have the combination of this big leading platform for advertisers to create and manage the most effective campaign and publishers to on the other side manage and monetize their inventory. So I think it's the combination of being able to do both of those things we expect will be very, very powerful. It's hard for me to handicap whether or not the scope of overall revenue on the display side or the mobile side will be bigger. We're obviously very, very excited about both and making strong progress in both, so I don't have a sense of what the size of those industries will look like in two or three years."
},
{
"speaker": "Operator",
"text": "Your next question comes from Doug Anmuth - Barclays Capital."
},
{
"speaker": "Doug Anmuth",
"text": "Can you provide some color, Patrick, on the reasons for the sequential decline in other costs of revenues?"
},
{
"speaker": "Patrick Pichette",
"text": "Again, in other cost of revenue, if I just go through my notes, they are still tied mostly to payroll issues rather than equipment issues or machine utilization. So that's basically it."
},
{
"speaker": "Doug Anmuth",
"text": "So, just to clarify, so you're saying more related to the bonus accrual than to depreciation?"
},
{
"speaker": "Patrick Pichette",
"text": "Yes, that's correct."
},
{
"speaker": "Operator",
"text": "Your next question comes from George Askew - Stifel Nicolaus & Company, Inc."
},
{
"speaker": "George Askew",
"text": "I'm going to address this bonus issue one more time. I'm just trying to get a sense of the size of the bonus accrual in the first quarter. If you look at it as a percentage of sales, for example, in the first quarter '09 compared to the year ago quarter, first quarter '08, was it materially different?"
},
{
"speaker": "Patrick Pichette",
"text": "I don't have the answer to that question. But I think again in general terms I think that if you think of your modeling, I think looking at run rates from a year ago may be useful to kind of get a sense of magnitude versus Q4 because Q4, as I said, was sufficiently different that actually it does make a difference between Q4 and Q1."
},
{
"speaker": "George Askew",
"text": "And then secondly, as a follow up, there's media reports hitting late this afternoon here that YouTube is partnering to stream full-length movies, TV shows, etc., a redesign happening there. What can you tell us about this kind of news on YouTube and the redesign that appears to be imminent?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Certainly what we're hearing from both viewers and advertisers is that they want premium content and a premium viewing experience and we want YouTube to be as comprehensive as search there and we want, in fact, as much professional quality content as we can and advertisers as we can of all sizes and types. I believe there's a conference or some additional details on the Sony issues coming out directly from the folks at YouTube, so you might want to take a look and watch for that. They should have all of the details about the Sony relationship and dynamics from San Bruno."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mark Mahaney - Citigroup."
},
{
"speaker": "Mark Mahaney",
"text": "Just one quick financial goals question. In past historic years I think there was a goal - and I know it was stated at Investor Days in the past - to simply expand pro forma operating income sequentially as long as possible. Is that still a goal within the company? That happened this quarter. But is the way you think about this, financial goals, just to expand that sequentially going forward, that non-GAAP operating income?"
},
{
"speaker": "Patrick Pichette",
"text": "Two points. I wasn't there in the old days when whoever would have said what, but certainly under my rule we don't give any guidance going forward on any of these dimensions. All I think it's important that people understand is we're demonstrating responsible management over our resources. You should consider, as you think of your modeling, the fact that we talked at length on the previous call that our revenues are seasonal and you've just got to think of our expenses much more of a kind of fixed cost. They're not seasonal in a way, right? So our labor is not seasonal and our expenses are not because we're still growing. So that's the mind-set that you should apply to your modeling."
},
{
"speaker": "Operator",
"text": "Your next question comes from Sameet Sinha - JMP Securities."
},
{
"speaker": "Sameet Sinha",
"text": "A couple of questions. If you can talk about the networks business. Understandably, you've undertaken some initiatives over the last couple of quarters to clean it out. When can we start to see improvement in that business and when will you end these initiatives?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Could you clarify - are you asking about AdSense or search? What exactly are you asking about?"
},
{
"speaker": "Sameet Sinha",
"text": "I mean the Google networks business. I'm just looking at that, trying to open it over here. It was down sequentially a little bigger than it was down last quarter, so I'm talking about. You were getting rid of some arbitrage layers, things like that. When are those activities - when do you think that ends?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Some of that relates to partner issues. Some of it is the network cleanup. I think that to date the cleanup has been largely successful, but it's kind of an ongoing cat and mouse game just like e-mail spam, so I don't think I would necessarily want to suggest that the cleanup issue has been fixed. I think we did start engaging pretty aggressively in those efforts last year and we've made great progress. I think the other piece that you may see is there are probably some FX issues in other partners that we have that are built in there that are seeing the same kind of economic issues that we have as well as having to sort of understand which partners are in the overall mix, which is a factor. We don't give you the full list of those dynamics."
},
{
"speaker": "Sameet Sinha",
"text": "In terms of the follow up, can you talk about the correct share count to use? You had repriced some options. Would these become dilutive anytime during the year?"
},
{
"speaker": "Patrick Pichette",
"text": "Sorry, restate the question for me, please."
},
{
"speaker": "Sameet Sinha",
"text": "You had repriced some options, some underwater options. Do they become part of the diluted share base now that they are in the money because they were priced, my sense is, about 306."
},
{
"speaker": "Patrick Pichette",
"text": "No, not anytime soon is the answer. Very small. Very small. So you wouldn't count on them. Just to complement Jonathan on the - to come back to the issue of the network. I mean, there is a difference between obviously AdSense for search and AdSense for content and clearly two types of businesses with two different rationales if you think of behavior. And the content side, obviously, branding oriented, just like campaigns, as I mentioned a bit earlier. So on that side obviously remaining challenging in Q1 because those advertisers typically will shift to more relative - to their performance-based advertising if they have a chance and tighter budget. So really a tale of two cities between the AdSense for search and the AdSense for content. Just to complement Jonathan's point."
},
{
"speaker": "Jonathan Rosenberg",
"text": "I agree. I think that's right."
},
{
"speaker": "Operator",
"text": "Your next question comes from James Mitchell - Goldman Sachs."
},
{
"speaker": "James Mitchell",
"text": "Could you talk about the impact of no longer providing rebates to agencies on your revenue growth in the international business?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "So you're referring to the best practices funding which we phased out over the course of the last year. Patrick wasn't here for all of that."
},
{
"speaker": "Patrick Pichette",
"text": "What would be specific, James, in your question? Like what would you like? We have done that."
},
{
"speaker": "James Mitchell",
"text": "I was wondering whether it was something that materially impacted the first quarter or it's something, because it was phased in over the last year, it's been -"
},
{
"speaker": "Patrick Pichette",
"text": "No, it wouldn't have been. It wouldn't have been material."
},
{
"speaker": "Operator",
"text": "Your next question comes from Youssef Squali - Jefferies & Co."
},
{
"speaker": "Youssef Squali",
"text": "Just to reiterate on the BPF, so our understanding is that a number of agencies were still getting a fair amount of money, somewhere between 6% and 7% back, as of Q4, and starting January 1 that went down to zero. So you're saying that the year-on-year decline of 9%, call it, in the U.K., I guess, was not materially impacted by that?"
},
{
"speaker": "Patrick Pichette",
"text": "That's correct. For our total revenue, we may have had one agency for whom it would have mattered for that agency, but in the total of our revenues it wouldn't have been material."
},
{
"speaker": "Youssef Squali",
"text": "And then a clarification. Why was DoubleClick revenues weaker this quarter? I think on the prior call you kind of talked about that, but you didn't kind of provide the reasons why."
},
{
"speaker": "Patrick Pichette",
"text": "Well, I think there's two elements on it, right? One is seasonality, because if you think of DoubleClick in Q4, it's a very strong quarter for the display advertising related to the Christmas, certainly in North America, which is a big element of the DoubleClick. And then second is the entire economic environment right now is putting a lot of pressure on that business. So it's the combination of these two things that really we're seeing in the market."
},
{
"speaker": "Operator",
"text": "Your next question comes from Christa Quarles - Thomas Weisel Partners."
},
{
"speaker": "Christa Quarles",
"text": "I was wondering if you guys could dig into some of the mobile data a little bit more. I guess what I'm seeking is in this vaunted example that you have in Japan, do you have sort of RPS relative to what you're seeing in other markets in terms of increase? I've listened to your mobile webinars where you've guided advertisers to bid maybe 4x what they're bidding on the PC simply because there are fewer chances to be shown. Is there any quantification whatsoever that you can provide around how monetization is ultimately different on the mobile relative to the PC?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I think it's really too early to say. I think that we certainly see the promise, we think. I mean, are you're asking specifically about Japan?"
},
{
"speaker": "Christa Quarles",
"text": "Well, I guess what I'm trying to ultimately do is quantify. I thought Eric's comment was really interesting, that you guys are now, what was it, 8% mobile browsing share?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I think I said that."
},
{
"speaker": "Christa Quarles",
"text": "Or you said it - somebody said it - which is the first time I'd seen this data out of you guys. So, again, it's trying to quantify what this opportunity could ultimately mean and if monetization all of sudden becomes even more intriguing, interesting in a mobile context relative to a PC one then, you know, people might get more excited."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yes. I personally think mobile is going to be very significant. I talked in my prepared remarks about how powerful the phones are and the degree to which search traffic is up over five times in the last couple of years. It is the case that I think nearly 80% of our mobile search queries come from outside the U.S., so a lot of the lessons that we're still learning at this point are lessons that we're learning from markets like Japan, to some extent China and India. But I think the thing you really have to look at is if we've got 100 - 175 million smart phones shipping in 2009 and they all have this much, much different, very rich mobile browsing experience, you're basically talking about something that didn't exist on phones a couple of years ago. They didn't have the processing power, they didn't have the battery life, they didn't have the rich display, they didn't have an input mechanism that worked well, we didn't have the kind of vast networks that we have today, and we're now seeing many developers understand that the web is this wonderful platform for these mobile apps and they can be fast, they can be location aware, they can offer a rich experience and even work offline. And that I think is fundamentally going to change the whole value equation with these devices and you're going to see that users are much more likely in my opinion in the long run to consummate a transaction against an ad that they were served on a mobile phone because they're probably clicking on that ad or interested in that ad because they're out somewhere and ready to go consummate a transaction. So I think there's lots of reasons to think about where the business is going and where these phones are going which make us very excited. There's not a great deal of data yet on what the pace of revenue growth will be there other than what we're seeing in Japan, which is very promising."
},
{
"speaker": "Christa Quarles",
"text": "I just want to follow up on the mobile side, you guys have an investment in Clearwire. Obviously, there's broad-based concerns there. Would you guys ante up further if they needed additional cash? Is there any plan around that investment?"
},
{
"speaker": "Patrick Pichette",
"text": "The lawyer across the table is telling me to tell you we don't comment on the future potential investments."
},
{
"speaker": "Jonathan Rosenberg",
"text": "One thing I would actually urge you to think about when you look at some of these other markets like Japan is that in some of these markets there are many users who only access the web through their mobile devices and that makes the dynamic very, very different. And of course Japan is far ahead in terms of mobile consumption than other markets, so it's an interesting market to look at in terms of where I think the trends are going to be."
},
{
"speaker": "Operator",
"text": "Your next question comes from Justin Post - BAS-ML."
},
{
"speaker": "Justin Post",
"text": "I apologize if you've already addressed this, but one of the things I see really interesting on YouTube is the quantity of searches and it's becoming one of the leading search engines out there. And I think you've rolled out some new ads. What are the click through rates on some of those video advertisements that are showing up in sponsored search results? Are you happy with that? And do you see that as maybe one of the bigger opportunities on YouTube and, if not, what really is working right now?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I think we're really still in the experimental stage on a lot of this. I mean, there's no doubt that from a traffic perspective the whole YouTube phenomenon continues. We're definitely hitting on an ongoing basis new playback and upload highs. We're basically at this point looking at multiple different ad formats. We're certainly monetizing hundreds of millions of videos in the U.S. every month, which is more than the total of U.S. monthly views on any other online video site. We don't give you the specifics in terms of click through rate, but we've got a whole bunch of new form [break in audio] and new content. We just launched in-stream ads on long-form content, so if you do a query on YouTube for Star Trek Charlie X, which is one of the episodes, you'll see an example of some of the new ads that we have there. Omid mentioned the home page format ad that we have which we're very, very happy with the results on which basically is a masthead that goes across the top. I think today it's Crank 2 and yesterday it was Volvo. And we've also got the promoted videos which we launched last quarter which are doing pretty well. But I can't give you any more details on the click through rate."
},
{
"speaker": "Justin Post",
"text": "And can you tell us how the engine's doing as far as profitability? Any thoughts on margins? Are they getting better or worse? And then just a follow up on DoubleClick, are all those revenues going on the licensing line and did display help your overall growth rate, the 6%? Was display something that grew faster than that and helped the overall growth rate?"
},
{
"speaker": "Patrick Pichette",
"text": "I think on the display side it does go right through to the licensing line, so it does. And then you can back out if it does make our - oh, DoubleClick, sorry. Yes, DoubleClick does go through that line."
},
{
"speaker": "Justin Post",
"text": "So we can kind of back that out and kind of see how it's affecting the overall growth rate."
},
{
"speaker": "Patrick Pichette",
"text": "I guess so."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jeffrey Lindsay - Sanford Bernstein."
},
{
"speaker": "Jeffrey Lindsay",
"text": "I just want to ask about the large reduction in traffic acquisition cost. This was due to makeshift or is it that you're rolling off expensive deals? What I'm interested in is how sustainable is that trend? And then if you could just mention - I don't know if it's public or not - just how long you've got to run on the current AOL and ASK deals. Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Okay. So the short answer is it is mix and we obviously don't comment on any deals that we have in our pipeline. I think it's also, if you look at our Q4 '08 versus Q1 '09, our Google [inaudible] versus Google total revenue on the [Google] side it's gone up slightly and that's, you know, if you think of - there's the mix within the category and then there's mix between categories and on the Google side, obviously, it reflects the growth in our revenue from toolbars and browser distribution agreements. So that's how I'd think about it."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jeetil Patel - Deutsche Bank Securities."
},
{
"speaker": "Jeetil Patel",
"text": "A couple of questions and I guess broadly two different questions, but if you adjust for FX and you look at your CPCs, they look like they were still up or flattish on a year-on-year basis when adjusting for FX, but not as much as before. I guess can you talk about, I guess, conversion rate coming off and I guess in particular which regions are you seeing more pronounced changes in CPC or conversion rates out there that could fluctuate the overall CPC trend? And then second, I guess it looks like the U.K. obviously fell pretty quickly in terms of revenue constant currency and then came back. U.S. it was, it seems like, more of a kind of steady decline, but holding its own. And rest of world is kind of a mixed bag. I guess can you characterize where do you think we are in the rest of world camp in general in terms of kind of going through this recession and seeing that impact in some of your regions? Is it probably early stages similar to the U.S. trend or does look like it'll pace similar to the U.K.?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "We don't really break out the components of the RPM equation, so I'm not sure I'm going to give you a whole lot of color here. You can't derive price directly from paid clicks growth in the total amount of information that we give you. I think I did say on the call that some of what we're seeing on CPC is mix issues. It's particularly mix issues for the smaller emerging markets; it's certainly an FX component. It's certainly the lower dollar items and the issue of conversion being relatively lower than they had in the past. And as Eric mentioned, the auction working and advertisers lowering their bid. So I think that those are components. We certainly have seen a lot of CPC growth in the quarters before the economy collapsed, but I can't give you any more detail than that."
},
{
"speaker": "Jeetil Patel",
"text": "I guess in some of the nascent regions that are still ramping, if you open up more distribution or more coverage, are you seeing bid prices improve like you saw over the course of the last couple of years here or in some of the more mature markets or is it a different dynamic in some of these emerging markets?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yes. Okay, so I think that what we're seeing there is different because a lot of those markets are sort of at the more nascent stages of the growth rate. So if you sort of map them against what we saw in the U.S. or the U.K., which was actually the leading market, and said, you know, they're N years behind us, many of them are on growth trajectories that are strong, just as we were a few years ago, but obviously that's being dampened by the economic dynamic just like things are here. And, of course, you also have the FX effects there, too."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ross Sandler - RBC Capital Markets."
},
{
"speaker": "Ross Sandler",
"text": "One kind of high-level question then one or two accounting questions. To follow up on the pharma ads issue earlier, it looks like the FDA may actually require all these pharma advertisers to add all the disclosures to their ad creatives. Is that a fairly easy task for Google to increase the available character length on those particular ads or is that going to be a little bit more challenging given the complicated technology?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I'm not sure what we're actually going to do there. I'm not convinced that we won't be able to come to some agreement in terms of what the right solution is with respect to some of these issues. Certainly, it wouldn't be ideal if we had to modify the user interface to accommodate substantially more information. Can it be done? Yes. Is it easy? Maybe not. We're going to find a way with the advertisers to make this work in one way or another and you could do it within the existing creatives if you had to."
},
{
"speaker": "Ross Sandler",
"text": "Just a quick follow up on that. Are the advertisers actually still doing stuff right now or are they completely on hold until this issue gets resolved or can you not comment on that?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I believe there's some things that have been shut off, but I don't know all of the details about what subset of the activity there has been shut off. And some of them are, I think, attempting to change relative to the new standards they need to try to address. It's not really as big a deal, I think, as folks are making it. I know that I said that health was a vertical that was doing particularly well and pharma is important, but it's really a pretty small segment of the whole vertical."
},
{
"speaker": "Ross Sandler",
"text": "And then, Patrick, if we can just get a little more clarification on the accounting around the hedging program kind of going forward. The way it was explained before it was an 18 months kind of rolling forward of these contracts. So why did we see the one-time boost in the first quarter and are we to expect more of that? How do we think about the accounting around the hedging program?"
},
{
"speaker": "Patrick Pichette",
"text": "Okay, so the fundamental issue that you have is it's not one time. It just happens that as every quarter we set up another tranche of hedges, some for the immediate short term that we don't have covered yet but cover it more and all the way to 18 months out. Think of it as kind of you're building the equivalent of a ladder every quarter, kind of filling the pipeline as every quarter retires. And so in Q3 of '08 that's when we actually put originally the first set of pound hedges that we've built over a couple of quarters and that now will have, you know, a full 18-month ladder built over the coming quarter. So that will just be rolling, that entire set of hedges, every quarter going forward. But in Q3 we put in a bunch of them for the next quarter and the next quarter and the decreasing exposure levels all the way down to 18 months, and it happened that the ones we put in Q3, because of where the pound went, gave us a substantial gain for Q1. I mean, next quarter we'll have more hedges that will kind of come to fruition and we'll have to decide what to do with the options that we got. So it's not a one-time item. The real item that happened is the ones that we had put in September, because of the wild fluctuation and variability of the pound over the last six months, we just happened to gain a lot. Had we had - I'll give the extreme of a case where assume that the pound had gone nowhere, it'd been very stable through the entire period, right? We would have spent the money and we would have had no benefits because there's nothing to capture because there's no volatility. So it really was driven - the last six months - and in a way I really feel for the investment community and the analysts trying to run these models, I really do feel for everybody because you have such high volatility in the last kind of nine months and because that is compounded by the FAS 133 that says well, you know, if you're in or you're out, you've got to book it all or not the minute that you get a decent amount of volatility, it just swings the numbers all over the place. So what we have to think about from our perspective is we continue to have a very stable hedging program in place. It continues to deliver us the value when there's high volatility, which is what happened. And, you know, because of the forced marked-to-market you have a decent amount of numbers floating around, but you shouldn't worry about that too much."
},
{
"speaker": "Ross Sandler",
"text": "And then one last question - I promise, the last one - on the bonus accrual issue, a couple years ago Google used to accrue for bonuses with kind of a progressive growth manner so 1Q the accrual was kind of the lowest and it ramped up throughout the year and 4Q was the highest. And then in Q2 '07 you kind of went to more of a flat quarterly accrual program. Are we now back to the progressive? Like how do we think about, you know, just take $100 and spread it out over the course of four quarters? Is that going to be $25, $25, $25, $25 or does it start at $10 and then go up higher on the bonus accrual issue?"
},
{
"speaker": "Patrick Pichette",
"text": "Yes. I mean, we try to, if you think about it, right, we try to - when you start the year you have a plan in place and in that plan you accrue according to what you think the year's going to unfold and that's all we do. And then as the year unfolds we would, if we had more information to raise the accrual, would do so, so that's how we plan the year. That's why the number has gone down relative to Q4 because, I mean, if there's a good proof of how uncertain an uncharted territory we live in, look at Q4 and our results in Q4 and the economic activity that was really - in all of the turmoil that was happening, we had a very strong revenue quarter in Q4. And that created a bonus accrual that, if you had thought even in September or August, we hadn't foreseen. So we were really happy with the results and therefore happy to take the accrual and celebrate with all the Googlers, and now we're back to our regular territory of here's the year and here's the plan and away we go. I mean, that's why variability because the world is very uncertain and we're living through it right now all of us together."
},
{
"speaker": "Operator",
"text": "Your next question comes from Sandeep Aggarwal - Collins Stewart LLC."
},
{
"speaker": "Sandeep Aggarwal",
"text": "Jonathan, one question is we are seeing a little bit higher traction for search engine optimization and the question to you is does that mean the ecosystem of paid search is expanding or does this mean there's some potential threat to the paid search campaign?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I guess I'm not sure what is the perceived threat that you're articulating as a result of search engine optimizers?"
},
{
"speaker": "Sandeep Aggarwal",
"text": "Well, I mean, you know, if I'm running a Google Adwords campaign and then I'm also running searching and optimization and instead of Google and saving the money I'm running model for [inaudible] and maybe optimizing my website, landing pages, etc. In that case, am I likely to cut my paid search budget and I look at some money for searching optimization?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I honestly don't have any idea. You're basically saying is there going to be a shift in Adwords spending, spending on [inaudible], and I don't know."
},
{
"speaker": "Sandeep Aggarwal",
"text": "And just one question, Patrick. On the sales team side, just one thing, you know, I think [inaudible] just happened too quickly. I know Omid tried to address some of those things in the previous call you hosted, but is there any other [inaudible] - should we expect some more changes in the sales structure, sales channel or anything else of that sort?"
},
{
"speaker": "Patrick Pichette",
"text": "We have no plans right now. I think that the work that was done by the team was very well done and that's why, as you can imagine, for any organization the last thing you want is an announcement every two weeks of changes. That just drives everybody nuts. And so we had an opportunity in the sales group to do the things that we announced and so, you know, we did announce them a few weeks ago. And right now we have no more plan. I mean, it's obvious that the world continues to be quite uncertain, right? So in that kind of world you've got to stay flexible, but right now we have no other plan."
},
{
"speaker": "Sandeep Aggarwal",
"text": "And just one thing about, is there going to be any future revenue contribution from that discontinued audio business?"
},
{
"speaker": "Patrick Pichette",
"text": "No."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Sandeep, I'm just thinking about your original question a little bit and I think the one comment that I could offer is I don't tend to think of these advertisers that we have as having fixed budgets. And I think it's kind of unlikely that someone who's running an Adwords campaign, where they're measuring the ROI on an incremental basis and experiencing positive ROI from each incremental Adwords click, it seems unlikely that they would throttle that budget back if they're making positive gross margin on each of the Adwords clicked. So what you're proposing seems unlikely to me, but plausible."
},
{
"speaker": "Operator",
"text": "Your next question comes from [Brian Volen] - Sturtevant & Company."
},
{
"speaker": "Brian Volen",
"text": "I want to touch back on the idea that Eric brought up, the ROIs moving more into Google's favor. As we look at the moving parts in there we just look at clicks and searches, the cost and conversions. With the market pretty much moving costs lower, isn't that going to be the major factor or what is really driving the ROIs up anything more than just the costs coming down as advertisers are moving out of the space? And is there anything that will, other than keeping the costs low, allow for advertisers to actually really stage up and spike into the market to push ROIs higher?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I think really the main thing that drives ROI is the degree to which we're able to develop better ads and ad systems that target more efficiently and deliver an ad such that if the user clicks on it they're more likely to consummate a transaction. I think the conversion rate is probably the most significant component and that's a function of targeting the ad and the creative on the ad. Also some of the tools that we offer with respect to optimizing users' websites, you know, analytics, the website optimizer, things that allow the advertiser to get higher conversion rates on their site. I think that's basically the kind of thing that we're going to do that will continue to improve ROI."
},
{
"speaker": "Brian Volen",
"text": "You talked about the optimizer there. About what percent of customers are using the optimizer?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I don't think that we've said. You'd have to talk to customers directly yourself. There is a blog post if you type conversion optimizer [on Google] it describes some of the detail in the study that we ran with a bunch of advertisers for which I got the percentage of [inaudible] different pieces. But we don't release that number. A pretty large portion of our advertisers are using some subset of the various tools that I mentioned - the website optimizer, the keyword piece, the conversion optimizer with analytics."
},
{
"speaker": "Operator",
"text": "Your next question comes from Robert Haley - Gabelli & Company."
},
{
"speaker": "Robert Haley",
"text": "I wanted to just ask one question on your paid click growth and if you could talk about what's driving that growth, whether it's growth in the number of advertisers using Google or maybe talk about paid click growth on a per advertiser basis and how that's impacted by changes in budgets allocated to Google versus changes in consumer click through behavior."
},
{
"speaker": "Patrick Pichette",
"text": "I'll make just a broad statement and then let Jonathan complement, if you wish. There is, I mean, our traffic continues to grow, so if you think of general principles of what's going in our favor, our traffic continues to grow and we continue to have paid clicks to our network. There are different effects within that which obviously at the macro level, if you're in a mature market like the U.S. versus an emerging market like India, you get mix issues, you get vertical issues and you get value issues and that's basically how kind of we think about it and manage it. And so I don't know if Jonathan you have additional information you want to share or if I've missed something big."
},
{
"speaker": "Jonathan Rosenberg",
"text": "No, I think Patrick got the biggest thing. I mean, clearly query growth is the primary driver there and beyond that I don't think we really go into detail on the other components of the equation. I don't think that there's significant activity with advertisers withdrawing themselves from a budgeting perspective altogether. I would echo what Omid said there, that to the extent that we are impacted by budget reduction, it tends to be the larger organizations where a CFO, somebody in Patrick's role, basically says we want to cut budgets N% across the company and that impacts the CMO. That's much less a factor in the small and medium businesses and, interestingly, it's less a factor even in some very large companies that really understand the concept that Omid mentioned about Google being a sales channel as opposed to a marketing expense. And I would take to heart the comments about the auto industry, where I think you're otherwise seeing relative shrinkage in overall marketing budgets and yet some robust growth in paid search and online advertising. So I think there is still value. I think we're seeing a lot of value in terms of shift in markets like that one from a budget perspective. By the way the one other obvious area there is I don't think you're seeing much budge reduction at all in the pure play online companies who really understand and measure the metrics of a lot of this traffic. I think they're much less prone to adjusting their budget."
},
{
"speaker": "Krista Bessinger",
"text": "Great. So thank you, everyone, for your time today. If you have any further follow up questions, please don't hesitate to contact either myself or [Rhea]; we're happy to answer your questions. And thanks again for your time."
},
{
"speaker": "Operator",
"text": "And this concludes today's conference. We thank you for your participation. You may now disconnect."
}
] | null | null |
GOOGL | 4 | 2,012 | 2013-01-23 16:30:00 | Operator: Good day and welcome everyone to the Google Inc. fourth quarter 2012 earnings conference call. This call is being recorded. At this time, I would like to turn the call over to Willa Chalmers, Senior Manager of Investor Relations. Please go ahead.
Willa Chalmers: Great, thank you, Jennifer. Good afternoon, everyone and welcome to today's fourth quarter and fiscal year 2012 earnings conference call. With us are Larry Page, Chief Executive Officer; Patrick Pichette, Senior Vice President and Chief Financial Officer; Nikesh Arora, Senior Vice President and Chief Business Officer. Also, as you know, we distribute our earnings release through our Investor Relations website located at investor.google.com. So, please refer to our IR website for our earnings releases, as well as the supplementary slides that accompany the call. You can also visit our Google Plus Investor Relations page for the latest company news and updates. So, please check it out. This call is also being webcast from investor.google.com. A replay of the call will be available on our website later today. So, let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward-looking, including statements regarding Google's future investments, our long-term growth and innovation, the expected performance of our businesses and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on this call, such as operating income and operating margin, are also expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will turn the call over to Larry.
Larry Page: Happy New Year everyone and welcome to our earnings call. Thank you for joining us this afternoon. We ended 2012 with a strong quarter. Revenue was up 36% year-on-year and 8% quarter-on-quarter and we hit $50 billion in revenue for the first time last year, not a bad achievement in just a decade-and-a-half. We have talked a lot about excellence and velocity over the last year. While many claim it's my nature never to be satisfied, we've actually made real progress creating more beautiful and more intuitive products. Take Search. The perfect search engine would understand exactly what you mean and give you exactly what you want. Our Knowledge Graph brings that much closer. Search for Nikola Tesla and you will get information about this great inventor that is beautifully displayed right from the results page. His basic bio, books he wrote, his photo, no extra work needed, and we even recommend information about other inventors such as Edison and Marconi that you can easily browse through. Again, right from the results page. And last quarter, we launched the Knowledge Graph in seven new languages, including Spanish, Japanese and Russian. This is hard work. It's about way more than translating the words on the page. Google has to understand millions of different entities as well as their meaning and context. I'm also excited about the progress we’ve made with Voice Search. You're in your car, sadly it's still a car you have to drive and it’s not electric and you're running out of gas. Just pick up your phone and ask Google for directions to the nearest gas station and you'll be on your way immediately. It's a great example of how we can take the hassle right out of your life. Our long-term investments in Google Maps have really paid off. The team has worked tremendously hard to create the most accurate and comprehensive maps in the world. Driving country-by-country may have seemed crazy a few years back. Today, it’s totally obvious, because location is core to your search experience. And with Google Maps for iOS, we have reinvigorated our product. It's more intuitive and beautiful, and users love it. Google Maps for iOS was downloaded over 10 million times in the first 48 hours. In fact, six Google apps were included in Apple's App Store Best Free Apps of 2012, including YouTube, Chrome, Google Search and Gmail. I’ve always believed that computers should do the hard work, so you can get on with the things that matter in life living, learning and loving. So it’s exciting to see our progress with Google Now. Launched earlier in the year, it gives you information before you even have to ask. We’ll now proactively provide your flight times, or your boarding pass, or directions to your next appointment. We'll even suggest interesting places to visit nearby. As we discussed on the last earnings call, we now live in a multi-screen world. People carry a supercomputer in their pocket all the time. In fact, we feel naked without our smartphone and many users have more than one device, a laptop, a phone, and a tablet. We are living in unchartered territory. It's a new kind of computing environment. Everyone is really excited about the technology and are spending a lot of money on devices driving faster adoption than we have ever seen before. It's been a long time in computing since we had this rate of change. It probably hasn’t happened since the birth of personal computing. It's why we have put so much focus on devices. They have been one of our biggest bets in the last few years, along with software to go with these devices, Chrome and Android. Our goal here is to push the user experience forward, so you get the best of Google in one easy to use package. The Samsung Chromebook, which we launched in October at an amazing price of $249 was a holiday highlight. I love mine. It is super easy to use and almost maintains itself. Open a chrome tab on your phone and everything syncs on your laptop with no extra effort required. We also launched two new Nexus devices to rave reviews, Nexus 4 and Nexus 10. In six months after we first unveiled it, the Nexus 7 continues to define the 7 inch tablet category making many best of 2012 and holiday gift lists. Clearly there is work to be done in managing our supply better, as well as building a great customer experience and that is a priority for the teams. But considering all the excitement over the holidays for our devices, it is clear there is tremendous opportunity in delivering great value with amazing and simple user experience. Google Play, another big bet is on fire. The growth is tremendous. This quarter we signed deals with Time as well as Warner Music Group. So we now provide contents from all the top Hollywood film studios, music labels and magazine publishers. We have not even reached Google Play's first anniversary. Many of you have questions about Motorola, and Patrick will go into details of our accounting for the business so that you can do your models right. I am excited about the business. In today's multi-screen world the opportunities are endless. Think about your devices, battery life is a huge issue. You shouldn’t have to worry about constantly recharging your phone. When you drop your phone, it shouldn’t go splat. Everything should be ton faster and easier. There is real potential to invent new and better experiences. Our CEO of Motorola, Dennis, has built a world-class team and they are working on the opportunities. It is still early days but I am excited about the innovative ways they are approaching product development and speed of their execution and they recently signed and agreement to sell more Motorola's home division for $2.35 billion. 2012 was an amazing year for Google and we are all set for a great 2013. I am incredibly optimistic about the opportunities we have as a technology company focused on user benefits. Every day I come to work excited about more and bigger opportunities and every day we work to have more and better organized Googlers, those are employees, improving the execution and overall capabilities to deliver world the world changing products. I know it sounds funny but with the ambitious plans we have, we are only just getting started. Our biggest challenge in this area is focus. We face so many opportunities and so it is important to thoughtfully invest in the right areas where we can have the greatest impact. We don't want to describe ourselves too thin, but I am quite optimistic that as we get better and better in managing our product areas, we will be able to continue to grow our ambitions. That's why I am here and that's one reason why Google Earth, now working at Google. Google Earth remains our greatest asset and we are working hard to recruit and retain the best employees. We've had a great start to the year, by being in the Fortune Magazine's, the best company to work for in the U.S. for the fourth time. We worked hard to create a company, where everyone is part of the family and where the work is challenging and rewarding, so I'm really happy to get that recognition. I want to finish by thanking all the Googlers who made this possible, and now I'll turn it over to Patrick. Thank you.
Patrick Pichette: Thank you, Larry. Good afternoon, everyone, and thanks for joining us. So, let's dive in by reviewing the detail of our overall business financial performance. As we noted in a blog post last week, the Motorola Home business has been presented separately as discontinued operations in our financial tables. This makes typical quarter-on-quarter or year-on-year comparisons a little more challenging this quarter, but I will provide some color throughout my comments. So without further ado, here we go. Our gross total consolidated revenue grew 36% year-over-year to $14.4 billion, and 8% quarter-over-quarter. As I mentioned, this figure excludes the Motorola Home revenue. Had we included Motorola Home, gross total consolidated revenue would have been $15.2 billion, a growth rate of 44% year-over-year and 8% quarter-over-quarter. Google standalone gross revenue grew 22% year-over-year to $12.9 billion and 12% quarter-over-quarter. Our Google Website revenue was up 18% year-over-year to $8.6 billion and up 12% quarter-over-quarter with strengths across most geographies and industries. Our Google Network revenue grew 19% year-over-year to $3.4 billion and 10% quarter-over-quarter, finally, other revenue grew 102% year-over-year to $829 million and 24% quarter-over-quarter driven by Play hardware and content sales. And were it not for fluctuations in currencies Google standalone revenue would have in fact grown 24% year-over-year. Turning to Motorola Mobility, its gross revenue was $1.5 billion for the quarter. And once again had we included the Home business, the total gross revenue for the combined Motorola entities would have been $2.3 billion. As Larry mentioned, we are really pleased with the velocity of change at Motorola, but it's still at a very beginning of the Motorola Google story. No one should be surprised if results from this segment are a variable for quite a while as we restructure the business. And remember, we inherited a 12 to 18 months product pipeline that we are still working through. At Google Now, our global aggregate paid click growth was strong, up 24% year-over-year and up 9% quarter-over-quarter. As we said many times, there are several factors that impact the CPC click dynamics, including FX, geo mix, product changes et cetera, but this quarter specifically it's worth mentioning that we implemented some policy changes that lowered our paid click growth, improved our CPC growth and lowered network revenue for the quarter. Nikesh will speak more about this in a few minutes, but the bottom line is, that these policies are part of many constant changes that are focused on what's good for the user and advertisers, so we believe they are good for Google's business in the long-term too. Our aggregate cost per click was down 6% year-over-year and up 2% quarter-over-quarter. Once again remember that currency headwinds also had a moderate year-on-year negative impact on CPC in Q4. In fixed FX terms, in fact aggregate CPC would have been down only 4% year-over-year and up 1% quarter-over-quarter. Turning to geographic performance of Google's standalone business we continue to see strong performance in the U.S. and the U.K. while the economic situation of Southern Europe continues to impact our rest of world growth somewhat. In our earning slides, which you can find on our investor relations website, you will see that we have broken down our revenue by U.S., U.K., and rest of world to show the impact of FX and the benefits from our hedging programs. So please refer to those slides for the exact calculations. Revenue from the U.S. was up 20% year-over-year to $6 billion. The U.K. was up 23% year-over-year to $1.3 billion which includes [an immaterial] [ph] benefit from our hedging program. In fact in fixed FX terms the U.K. grew 22%. Non-U.S. Revenue, excluding the U.K., accounted for 44% of our total revenue or $5.6 billion, up 24% year-over-year and includes a $36 million benefit from our hedging program and in fixed FX terms rest of world grew 28%. So now if I come back to an aggregate level for the total consolidated business, our other cost of revenue was $3 billion in Q4, excluding SBC and Motorola restructuring, our non-GAAP operating expenses totaled $4.1 billion, which also exclude SBC and Motorola restructuring and our non-GAAP operating profit was $4.3 billion in Q4, resulting in a non-GAAP operating margin of 30%. For standalone Google, traffic acquisition costs were $3.1 billion or 25% of total advertising revenue. Our other cost of revenue was $1.8 billion excluding $101 million of stock-based compensation. The increase year-over-year was driven by equipment costs, including the cost associated with hardware sales on Play but also content acquisition costs and our data center costs. Non-GAAP operating expenses were $3.6 billion excluding stock-based compensation of $576 million. Finally, non-GAAP operating profit was $4.4 billion in Q4, resulting in a non-GAAP operating margin of 34%. One last note. Depreciation and amortization expense on property, plant and equipment for standalone Google was $493 million for this quarter. At Motorola Mobility, total non-GAAP operating expenses including cost of revenue were $1.7 billion and keep in mind that intangible amortization expense attributed to the standalone Google and Motorola mobility, they are included in these non-GAAP measures. Of the $289 million in intangible amortization expense this quarter, $153 million was a result of the acquisition of Motorola and of which $116 million is allocated to Google and $37 million allocated to Motorola Mobility. As a result, the non-GAAP operating loss on Motorola Mobility was $152 million in Q4, resulting in a non-GAAP operating margin of negative 10% for that segment. Let me turn to headcount. Headcount for the consolidated headcount increased by roughly 300 people in Q4. Keep in mind that consolidated headcount includes Motorola Home until it is divested and Home comprises roughly one third of the total Motorola headcount. Standalone Google added about 1,400 people and in total, the consolidated company ended the quarter at around 53,900 full-time employees. Our effective tax rate this quarter was 18%. The change from last quarter reflects the mix in shifts of earnings between domestic and international subsidiary and hedges. Now let me turn quickly to cash management. Other income and expense was 152 million for quarter, which reflects realized gains on investments and interest income offset by the continued impact of FAS 133 expense from our hedging program. For more details on OI&E, please again refer to the slides that accompany this call on our IR website. Our operating cash flow was very strong, $4.7 billion. CapEx for the quarter was $1 billion versus last quarter of $872 million. The majority of CapEx expense was related to production equipment, data center construction and facilities related purchases. We are very pleased with our free cash flow which was $3.7 billion and please note that cash flow and CapEx both include the Home business for now. So finally the success of our products and our continued strong performance, as portrayed by Larry's comments continues to give us the confidence to fund our strategic growth in areas such as search, YouTube, Android, Chrome as well as in our overall infrastructure with a view to the long-term. I will hand off now to Nikesh who will cover in more detail of our business performance in the quarter and after his remarks, we will open it up for the phone lines for any questions. Nikesh?
Nikesh Arora: Thank you, Patrick. As Larry and Patrick have mentioned, our business had a strong quarter with $12.9 billion revenue in Google standalone alone. We are very pleased with our year-on-year growth of 22%. I think our advertising business is firing on all cylinders. Companies of all sizes continue to embrace online advertising and our major players increasing their investments. In fact, here's an interesting tidbit. Across search display, YouTube and more, our top 25 advertisers are now spending average of over $150 million per year. Did I deliver that number? Our core business continues to be strong. Our investments in mobile shopping, our past holiday test with Flying Colors. As Larry mentioned, our vision is for search to understand exactly what you mean and give you exactly what you want in all devices that you live with throughout your day. Talking about the devices, our queries from wide ranging of new devices are continuing to power our overall growth in search volumes. Distinctions between devices, form factors are becoming less meaningful, particularly between desktop, laptops and tablets. Our Search performed very well last quarter during Black Friday and Cyber Monday. We still have greater proportion of queries with commercial intent and higher RPMs in areas like retail, computers and electronics. We launched a set of features to make shopping stress free and more fun. I don't know if you've had a chance to look at it, but there are some interesting things like 360 degree toy imagery and integrating retailers' promotions and discounts into our shopping product. Our investments in Search, particularly in mobile and shopping are really helping clients. Now, let me give you an example. Front End Audio. This is the company that offers recording and light sound equipment sales. Sometime in mid-September, the deployed product lifting ads, within weeks these ads were accounting for about 15% of the total sales. They also tripled their click through rates and also reduced their cost per conversion by 75% to 80%. This is great for us, because the product we believe is in the interest of the end users. It's a great product for Front End Audio improves their economics and improves our economy. Major retailers like RadioShack and Home Depot, they use our Mobile Apps 3 shoppers across devices, including click-to-call, click-to-map. For Home Depot, mobile commerce sales are quadrupled in a year. Patrick mentioned some changes in policy and enforcement. These enforcements had the effect of reducing ad clicks on the sites of certain AdSense for search partners. These policy updates are part of our ongoing work to improve user experiences on Google and on site in terms of using Google Search. Since these policies improve the experience of both users and advertisers, we firmly believe they are good for our business in the long-term. Switching gears to YouTube in display, we are continuing to make strong progress here, but there was a key language that brand speak, so it continues to be a key area of focus for us. Videos are baked into the core of all of our products whether it's search, display, mobile, and of course YouTube itself. YouTube is well positioned for the changing viewing habits of today's multi-screen world. The site's new redesign is focused on channels and that has led to major increase in engagement. In 2012, viewers watched over 4 billion hours of video on YouTube a month and it's now available across over 400 million mobile devices, gaming consoles and connector PDs in addition to your desktop. YouTube creators continue to vow and attract audiences. Outside estimate say that video on which I am sure all of you have seen of PSY, his hit song, Gangnam Style, now the most watched YouTube video for all times, it generated over $8 million in all-in advertising deal. YouTube Partner revenue has doubled for the fourth consecutive year and thousands of channels are now making six figures annually. YouTube is not only home for creators, but it's also home for major brand advisers. On YouTube, our top 100 global advertisers spent over 50% more in 2012 than they did in 2011. Clearly this is a strong signal of the power in YouTube to reach audiences. What's interesting is the significant factor into growth of YouTube has been our TrueView skippable ad format. Agencies and marketers are seeing real benefits. You only pay for the ad if viewers watch them. In fact, 70% of our in-stream ads are now TrueView formats and this quarter TrueView came to Xbox, the iPad, and the Wii. Putting all our advertiser solutions together, it is really helping us deliver greater returns and develop close relationships with major clients worldwide. Like McDonald's, who this quarter launched always on search in YouTube campaign to increase customer awareness and their ability towards their brands across all channels. In Q4, we signed a new global deal with L'Oreal, under which we worked to promote their brands using Google's digital offerings across the world in Display, Search, YouTube and more. While our complete solution for marketers not only applies to businesses, but we saw this in this quarter's 2012 election from the presidency to local races. Google's mobile search, video and measurement products were the center of a huge number of Democratic, Republican initiatives and campaigns. Our election advertising revenues increased by five times over the 2008 election. Here is an interesting statistic for you. In nine of the top 11 Senate races for the U.S., the candidates who spent more with Google, was elected. Well, 2012 was not just a big year for advertising, it was a big year for publisher business as well. Working closely with major publishers, from weather channel to timing, bringing the DoubleClick Google ad technology stack together is really helping our clients increase their direct, indirect and programmatic CPMs. Our solutions for media companies now (inaudible) be on advertising encompassing paid service, subscriptions and more. That was about our business, our ad revenue. Other highlights looking at the geographic breakdown of our ads business. Growth in Northern Europe was robust, with strength in Germany and the U.K. Asia performed steadily and other regions were very pleased that Americas maintain steady growth driven by strength in mobile and YouTube. Southern Europe was somewhat softer as it continues to face macroeconomic challenges. Our enterprise business continues to grow at an impressive pace. It's been gaining traction across some of the largest companies in the world. New customers this quarter include Nintendo, the Canadian Broadcasting Company, Shaw industries, Costco, Randstad and Hyundai to name a few. Also signing in May is the U.S. Department of Interior, moved more than 70,000 employees to the cloud during Q4 making it the largest federal agency to date using Google Apps. I think I solid, we have had a good quarter. Our revenues continue to grow. Clients continue to see value with us and value in online advertising. We have been able to build significant new revenue streams at mobile, YouTube and display and clearly arising one in enterprise. We have weathered various economic storms and are benefiting from the shift in advertising spend towards digital media plus there is continued strong execution and client relationships. I want to echo Larry's congratulations to our teams around the world for all their hard work in delivering a great quarter and stellar year in a tough environment. Thank you.
Patrick Pichette: Thank you, Nikesh. With that, I am going to turn it over to Jennifer who will open the lines for the Q&A. Jennifer, all yours.
Operator: (Operator Instructions) We will take our first question from Carlos Kirjner with Bernstein.
Carlos Kirjner: Two questions. Last quarter we saw a material sequential decline of Google websites' revenues growth rate of more than 400 basis points. Even after accounting for FX, this quarter we see another deceleration I think about 250 basis points on an FX neutral basis in the Google websites' revenue line. Of these, in the context where YouTube is growing really fast based on your comments, so what have been the major drivers of this continued deceleration of Google websites? Should we expect similar growth rate declines going forward? Secondly on TAC, it seems TAC for distribution as a percentage of Google websites' revenues grew less than what we had seen earlier in the last several quarters in 2012. What has driven the stabilization of this TAC, distribution TAC and how should we think about distribution TAC in the future? Thank you.
Larry Page: Well, thank you, Carlos for the detailed question. I am going to turn that over to Patrick for, hopefully, a good answer.
Patrick Pichette: Yes, thank you. So Carlos, on the first one, you are right that there is quite a bit of noise because of FX on the sites year-over-year between Q3 and Q4 but overall I think that we are very pleased with the growth around 20%. You are right that in the last quarter there was a bit more headwinds than this quarter but overall the core search business is doing well and driven really by the strength in mobile and we are obviously additionally pleased with the YouTube business, particularly the watch page. So, despite the fact that there is quite a bit of FX noise in there and that FX does carry over to sites, overall I think that we are very pleased with the overall growth. In terms of TAC I think that that’s the case where obviously our mobile revenue is growing and it is having impact on our mix shift. That’s really the fundamental trend that you see in TAC rather than change in the TAC rate of any particular partner. So that’s really what's going on there but I think as we said in the previous calls we think of TAC in the way, there is a really positive story in TAC, which is, it is distribution and it is worth paying for. This is the positive side of our business having much more distribution of our apps across and that’s true also for mobile. So we are really thrilled that all of the mobile is thriving to the extent that it is and remember that, finally, TAC is not a new phenomenon for us. We have always dealt with distribution partners and we'll continue to experience and manage it to make sure that it drives revenue and profit for both parties in a balanced way, so nothing new here but really excited by the trends. Thank you Carlos. We will go to our next question, please.
Operator: We will take our next question from Ben Schachter with Macquarie.
Ben Schachter: Two questions for Larry around the notion of Answers not linked. First on Knowledge Graph, can you just give us a high level view on where we are in terms of its implementation and how widely it's rolled out? And specifically, how if at all it impacts the economics of Google's businesses? And then second Google Shopping, the PLAs and the interface changes, I think significantly improve the user experience, but the consumer still needs to leave the site to transact. Do you anticipate a mechanism whereas users can actually transact on Google Shopping without having to leave? You know, as you said sort of no extra work needed? Thanks.
Larry Page: Well, Ben, thank you for the questions. I think we rolled out Knowledge Graph very recently and I think we are still in the early stages of that. I think that, I mentioned some of the internationalization work that we did which is hard work and I think we'll continue to do that. I mean it's still 1% or something where we should be, so I am really excited about what we can do in the future. I think the economics points, I think that the way we look at it is we provide much better answers for people really grow the business. We increased the number times that you might want information, because you know you are going to get correct answers or increasing it for modalities, you can get answers like Voice, or Mobile or so on, so I am somewhat excited about that and generally we monetize those things. So, I don’t have a comment on specifics of that, but it think we are quite excited about that. The Knowledge Graph does run on the right hand side where the ads also run. [I expect] [ph] there could be some short-term impacts on that, but I think the primary thing is getting people better answers is really good for our business. Google Shopping, I guess you are asking about product listing ads I think that we are also in the early stages of that. We just rolled out Google Shopping. We’ve seen tremendous uptake from merchants and from users and I expect that quality of the site, the ease of buying things will improve over time and I am really excited about that. I am not going to comment on details about that, but we’re always focused on making our user experience better. So, can we have our next question please?
Operator: We'll take our next question from Scott Devitt with Morgan Stanley.
Scott Devitt: Thanks. I guess, following up on Ben's comment regarding Answers versus Links. Larry, you recently quoted I think saying about the possibility of having a system that could basically vacation plan for you. And now that you own ITA and Frommer’s and Zagat and you've built out travel explorer or flight explorer and Hotel Finder. Can you talk a bit more about the strategy with travel in terms of the problem you are trying to solve there relative to this historic experience of Google sending you offsite for depth of experience. And then secondly, Patrick, I think last quarter you gave the FX neutral CPC down 8%. I wonder if you could give that same number for this quarter, thanks. For the fourth quarter?
Larry Page: Yes, Scott. That's a great question. I'll take the first part, and I think that we've always done a very good job of sending people to the right places and I don't think that being able to answer very complex information means necessarily that we wouldn't send people off to other sites, So I think the main thing for us is to be able to understand the complex problem. Like, I think, I gave some example like finding a hotel that's near (inaudible) logistics for the flight, for a vacation you might take and the hotel and the activities we wanted to do, kind of solving that all at once in a way a human assistant might be able to do. And, you still might use other parties to do that transaction, so I don’t necessarily believe the assumption of your question, but we are looking at those things. It was more of an example. I think Google’s aspiration is to be able to that for any area. Not just travel and we have been working with as many companies as we can and trying to organize the web’s information. And where we needed to acquire companies, we have done some of that or work with other companies or make deals or whatever we need to do. So we are trying to be practical about it and I think we do have some amazing assets in travel and mapping and so on. I think those things will pay off for us in the future providing great experience. So, Patrick?
Patrick Pichette: Yes, Scott, the answer to your specific question is, the CPCs have, on a year-over-year basis, they have gone down 4% and on a quarter-over-quarter basis, they are 1%. That is on a fixed FX adjusted and so that compares to the minus six and plus two that I mentioned a couple of minutes ago. Thanks for your questions, Scott. Jennifer, let's go to our next question please.
Operator: Our next question comes from Mark Mahaney with RBC.
Mark Mahaney: Great, thanks. Two questions. Could you talk broadly where you are on cash about Google Maps and where do you think the monetization of that is today versus where you think it potentially could be? Then, Larry, I think you were quoted recently with some comments on competitive products out in the market. Any comments, in particular, on graphical search as it has been announced and to what extent you think that’s complementary or competitive with Google's core search? Thank you very much.
Larry Page: Well, I can say a little bit about Maps. So this is Larry. I think that people are always focused on monetization of Maps but it's important to think about, for me, it’s the history of Maps. We started working on Maps a long, long time ago and because we thought it was critical to your search experience. It is actually finding what you are looking for and if we look at our component of queries that are geographically related, it’s a huge number and always has been. So again, to understand those queries we have to understand where things are in the real world. So that’s been always the core part of our main web search. We already make quite a bit of money on web search and I already told you that was a significant amount of queries. So we actually we already make quite a bit of money on Maps in that way as a part of our core business, and a significant part, which really allowed us to make those investments. We are in the early stages of monetization on the Maps themselves. I think we are doing some interesting things there. I think we will continue to do that. I think it is likely to be a great source of revenue but still in the early stages on the Maps, but on the search side, we have significant revenue already. I think you are asking about graph search, which was recently announced. I think that when leaving about search, our mission has been to organize the world's information and making it universally accessible and useful. We have been at that for quite a while and made investments in all sorts of areas, like Maps, as I just mentioned which turned out to be really important. That’s the way we think about. There is knowledge search, there is all sorts of investments we have made, gathering different kinds of data and making sure we have everyone's data and we will continue to do that. That business has change a lot. Only 10 years ago, what you though Google should do, is almost unrecognizable compared to what it does now and the number of things that it understands. So we see just tremendous opportunity to make better products for users that really understand their needs and really grow that opportunity and if you look at voice, for example, which we have also made huge investment in, the importance of that to mobile for finding things. I mentioned you can ask Google where the nearest gas station is on your phone while you are driving on your phones and it does all this work perfectly. So I think we see that as just all sorts of aspects on those problem and we have been very focused on that. Now there is another great example. There is tremendous innovation there. It is actually answering your question before you even think to have the question and that's pretty incredible. I am super excited about that, so I feel very confident of our core business of organizing things, finding things, getting people information. I couldn't be more excited about that. Our next question?
Operator: We'll take our next question from Anthony Diclemente with Barclays.
Anthony Diclemente: Hi. First for Patrick on Motorola in terms of the lawsuit which widened in the quarter, I am wondering if you could contextualize for us the financial direction of Motorola, both, in terms of the revenue declining and the growing expenses. I mean, I know this isn't something that Google typically does, but I think it would be helpful for investors if there's any way to kind of put a band or threshold around what the potential operating losses could be at Motorola. And then second question for Larry around the commercialization of driverless cars. I just wonder if you could give us an update on that and your test that you're doing in Nevada and I am wondering if you could talk about Android as part of that? It sounds like the automotive, electronics suppliers are recognizing the importance of Android for the infotainment systems in those cars and so maybe you can talk a little bit about that opportunity for Android as well? Thanks for the question.
Larry Page: I think maybe I'll take the second half of your question first. I think that, I would say also on Motorola and then I will let Patrick fill in. I mean we are so excited about them in this. I think that we're really in the early days of Motorola with respect to Google's acquisition of it, and I'll let him give you some details. I think that on driverless cars, I think obviously it's still early days to answer. Although I'm really excited about what the team has got done and what that can mean for ordinary people and really substantially improving mobility and potentially really reducing the land area that we have to devote for cars which is incredible amounts in cities. It can really reduce parking. We are looking at that. Even for Google just as a major cost to reduce our parking costs in our facilities by having automated cars parked more densely and serve more people. I think those things will be amazing deals. Android I think that we are still. That's little bit different than the automated cars I think, but Android won't be used in cars probably before we get automated cars into the mainstream. I think people are really excited about that due to the incredible success of Android and we are obviously working with those manufacturers to help them make that happen well. So, Patrick?
Patrick Pichette: Yes, just a bit of color on Motorola. Right? First just to remind everybody, we do care about profitability and that is our goal with every one of the areas where we invest, and we said that before and we are not in the business for losing money with Motorola or even cross subsiding it. But, we are really 180 days into this journey and we've made a ton of progress, including the sale of the Home business. And as I mentioned earlier also we are kind of outsourcing our manufacturing and so much more that has been done and the restructurings that you have heard earlier in the late summer and early fall. So, and I just want to remind everybody that we inherited kind of 12 to 18 months of product pipeline that we have to work through and that's the reality of the business, that's kind of overhaul and then kind of rebuild the new product pipeline where Dennis's team has kind of been really focused on in addition to the restructuring. It does take time before it shows up. Having said that finally on the financials themselves, Anthony, it's really worth noting that Motorola is also hindered by a portion of the amortization of intangibles due to the acquisition, so the losses that you see are somewhat inflated by this amortization of intangibles which we've decided to kind of put through the P&L on a non-GAAP basis. So, all-in-all, when we look at the losses like this quarter, a negative $150 million, you take out the amortization, these are not consequential losses relative to either Google or the kind of turnaround we are seeing and the kind of positive momentum. So, that's why Larry started by saying we are really optimistic, but it does take time and that's why I am also saying, be ready for a lot of fluctuations in our P&L over the coming quarters. It's just the nature of the bees when you reinvent business. Thank you for your question, Anthony. Let's go, Jennifer, to our next question.
Operator: Our next question comes from Justin Post with Merrill Lynch.
Justin Post: Thank you. Larry, I think on your last call, you mentioned that you are impatient with mobile CPCs, not that they were not bad place but you wanted to get them higher. Can you talk about progress made in the quarter and do you feel like you are really making a positive inflection there or is that still a few quarters away? Then as you as you look at your mobile business as far as the growth of queries or the growth of revenues and you look at it relative to maybe mcommerce growth, do you think you are gaining share of the market? Do you feel like your position in mobile is really secure and that you maybe even be gaining share in mobile or maybe the street doesn’t recognize it? Thank you.
Larry Page: Thank you for your question. Let's see, the mobile business, it has been going very well. We have tremendous growth with the Android. We are serving our users really well. We are building amazing products that are getting better at a rapid rate. The rate of improvement are obviously very high. So I feel pretty comfortable that my focus mostly on our products and assume that their usage will follow the great products. I think that in some sense, some of you may consider mobile an extension over the desktop usage too. I mean, we have built a lot of great products that people use for the desktops like Maps which was transferred very well. And I think that one thing I was amazed by Chrome on my Android phone, Chrome is just an amazing experience. So, using my Nexus phone or other more smartphones from the latest generation, those phones are almost like using a desktop of last year or something like that. So I think the experiences are improving a lot and very, very quickly. So I think we have hit some uncharted territory, because of the rapid rate of change in these things but I am very, very optimistic about it. I think that CPCs will improve as these devices are improving as well. Obviously, I mentioned that we are working to simplify our ad system for advertisers. In the light of all these changes and I am excited about our plans there. We don’t have anything to announce today but I am very excited about our efforts there. I think that we will make rapid progress in that area. So I think I answered both of your questions. So maybe we can have our next question.
Operator: We will take our next question from Stephen Ju with Credit Suisse.
Stephen Ju: Thanks, guys. So I guess the pace of your headcount increases is used to be moderating as we take a look back 2012 and the same goes for CapEx as well. So do you feel like you are now at an appropriate level to tackle your three major areas of investment focus? I guess another way to ask the question is, are there any other large scale opportunities you have identified that would entail acceleration in terms of your hiring or CapEx? Thank you.
Larry Page: I think we have run a number of different businesses and I think that they all have different needs and it's sort of like, we are looking at the sum of all those things. So I think it is a little bit hard to predict those things. I think you should ask us to do whatever is necessary to make the most business outcome. Having said that, I think we have some time in the past we have had a lot of people, we are growing at the edge of what's been the modest in terms of scaling. I think that’s still the case. We would say, that’s moderated but I would say that we have also slowed our international growth and products development a bit which is probably having some impact on that. So I guess, I will give it to Patrick for some more detail, perhaps.
Patrick Pichette: Okay, just the comment on the CapEx side. We have always said and I think if you go back the last couple of years on CapEx, it has been really lumpy. We have gone from really highs where we were above $1 billion and then it's come all the way down to a few hundred million dollars. Now it's kind of moved back up, so it's a real testimony that it is lumpy, because as you add, just to use the example of a data center, as you will see CapEx, because we fill with equipment at data center. But once the data center is full and then we have to put an extension to the data center or then you are into concrete again and power. So, it's just the nature of our business. Certainly on the core businesses are quite lumpy, so we without giving any guidance forward, we have been as you've seen in this quarter $1 billion of CapEx, really very much aligned with the excitement we have around our products, whether it be social, whether it be pictures, whether it be all of the areas that you have heard Larry talk about and so that's why we are fueled as I said in my comments. We are fueled by the positive momentum we have in many areas of the company and we believe now is the time to invest and that's why we are doing it with confidence, discipline with confidence.
Larry Page: Ross, I'll also just add briefly that when we run our business, we find that it works better if our hiring is reasonably smooth, so we have worked harder to manage that smoothness. We have recruiters in place and hiring staff in place for the long-term and make sure we'll provide a good consistent business growth there just makes us operationally run better and we've probably been managing that a bit more tightly.
Patrick Pichette: Thanks for your question, Steven. Let's go to our next question, please, Jennifer.
Operator: We'll take our next question from Ross Sandler with Deutsche Bank Securities.
Ross Sandler: Thanks guys. I have got two questions, first for Nikesh on Mobile and then one follow-up for Patrick on the Google sites TAC. So, Nikesh, what percent of your several million advertising clients are bidding on mobile key words today and what percentage do you think have mobile-specific websites enabled already? And then Patrick, the follow-up on TAC, the year-over-year growth rate for Google website's TAC decelerated from 45% to 43%, subtle but there is probably some organic items in there that are helping it. Is that a function of smartphone installation growth rolling over or any partnership agreements or something else? Can you just give us a little color on that deceleration? Thanks.
Nikesh Arora: Thanks for your question, Ross. On the mobile front, I think it's important to understand that a vast majority of our advertisers have opted into mobile from an advertising point of view. I think Larry said this a few quarters ago that we slowly have been working over time to try and make it feel like a common experience across multiple screens for advertisers, because advertisers are more interested in the business benefit of advertising with us as opposed to specifically which form factor, which device they invest with us on, so our teams have been working really hard in the last few quarters to try and get us to a point where we can make it simple for the advertiser where they come to us with a business problem and we are able to solve it for them irrespective of device, irrespective of form factor or property that they are going to have advertise on. So, from that perspective, I think things are going in the right direction. As far as specifically how many advertisers have mobile landing pages that they can send their users to? That number is not as much as we would like it. Obviously, we've had programs, we have talked about in the past earning calls like GoMo which help businesses go mobile, so those efforts are bearing fruit but broadly speaking, I think we are happy with the progress we have made both on getting advertisers to be more mobilized and also what we are doing from a campaign management perspective to get more and more campaigns that can run across all devices and form factors.
Larry Page: I'll just add on the mobile question. We don’t necessarily want them to have mobile sites some are too simple and I find I get kind of frustrated on my phone sometimes when I have these mobile specific sites because I am using a modern Nexus 4 that can actually view up the full site and I just find it confusing. So, I think as an industry, we need to improve these experiences and that will take a bit of time, but I'd almost say that we should be designing for mobile the kind of mobile phones that we had now the state-of-the-art or a little bit beyond and that those experiences should work on all devices pretty well, so I'd actually like to us go more in that direction perhaps, so Patrick?
Patrick Pichette: Just on my side, I need Ross, I need you to actually call us after this. Because, when I look at our TAC for the Google Web as a percentage of website revenue, it is pretty stable to us and every way we look at it is pretty stable. So I am not sure if there is anything you are looking into it that we are missing but don't hesitate to follow-up with the IR team afterwards. But we don’t see any deceleration in any meaningful way on the website side. Thanks, Ross.
Larry Page: Great, can we have our next question?
Operator: Yes, we will take our next question from Richard Kramer with Arete Research.
Richard Kramer: Thanks very much. Larry, a couple of quick questions. First of all, just to polish up this Mobile and CPC question, how many years do you think it's going to take before CPCs on Mobile and Desktop are roughly equal trading off location and display size? Another question, looking broadly at the business, there are a number of geographical markets like China where you are simply not able to operate. Do you see any prospect for being able to enter some of those markets in the medium term? Or do you think that the business is still going to be geographically constrained? Then a quick one for Patrick, will there be an impairment test coming up on Motorola especially with respect to the IPR given the FTC settlement around Standards-Essential Patent? Thanks.
Larry Page: Thanks, Richard, for all the questions. I think that's a threefer. The problem seems to be, and I am not going to make predictions about when they will be equal; I don't think they will be equal, I think probably one will always be bigger than the other, though, not clear which way but I don't think this is a long-term problem. I don't think this is a long time in coming, and I think as I have said before, there's a lot of advantages to mobile. You already know location quite clearly, you can call somebody easily, you have a camera, you can hangout with the business, you can be notified instantly. There's just a lot of things about mobile that are amazing opportunities for advertisers and for businesses. So I expect that to revolutionize how people do marketing and we are working hard on that. I expect that that will work a lot better for users and for advertisers and businesses, and therefore more money. We will be able to generate a lot more money than we do now. Okay, so maybe Nikesh can address China.
Nikesh Arora: I thought I was getting the mobile CPC question, Larry.
Larry Page: You can do the second one first, though.
Nikesh Arora: Okay, I think it is fair to say we do operate in China right now. We have an ad sales business. We have a display business in the market. We know there is many users who use Android devices in the market. I think what's important to understand is the reason we decided to not operate in China was because we believe that we wanted to make sure that users are able to have unfettered access to our products, and the products where we believe they have ability to access in an unfettered fashion we do operate in the market. It's only the ones where they aren't able to access in the way we would like to, in which case they are able to access it through our operations in Hong Kong. So we think we operate in China, not in the way you might perceive it, but users have access to our services and there is even a small revenue business that we have in China.
Larry Page: Oaky, so, Patrick, what might be an impairment to us for Motorola?
Patrick Pichette: Obviously, every time there is any formal kind of transactions or events that occur, we have to look at our balance sheet and if is any impairment test. In the case of Motorola, we don't think there is actually right now. We have no information even with the Standards-Essential Patent. There is no information right now that leads us to believe that we have to do an impairment test on any of it. Remember that the Standards-Essential Patent for Motorola is a very small portion of the entire portfolio pool of patents that we got out of Motorola. So, just put that in the context as well. So, thanks for your question, Richard. Why don’t we go to the next question, Jennifer.
Operator: We will take our next question from Neil Doshi with Citigroup.
Neil Doshi: Thanks. Can you provide more details around the policy changes that were implemented in the quarter, and whether they will continue to have an impact on CPCs and paid clicks in Q1? Then also we were recently at the NRF convention in New York and we saw a demo of the Google Zavers product where users can click coupons, and then use those coupons in the offline retail world. How big of an opportunity is really bridging the online ads with off-line transactions for Google and this is something that's a key initiative as we go into 2013? Thanks.
Larry Page: Thanks, Neil, for your question. So I think that Nikesh can give us some color on the policy.
Nikesh Arora: I think it's fair to say what we did was, we’ve always had a policy. The policy has been that we want to make sure that whatever ads are presented in whatever way our traffic is routed to ads, it is done in the best interest of the user and we began to notice that they were sites and pages whereas we had too many ads in a page, so it became more restrictive and updated our policies for better enforcement and that has resulted in higher quality results for end users, it has reduced in some cases the monetization that some of our partners are seeing as a result of this enforcement and hence you are seeing the impact on the numbers. We just announced this policy sometime early this quarter, in the past quarter that we just went through, so you are going to see the impact over the next few quarters. We've also implemented more stringent policies around downloadable apps, and that's why I think both those effects are going to stay with us for the year, but we think in the long-term is the right answer for us, it's the right answer for users and it's right answer for advertisers, so we think it's a good thing to do.
Larry Page: We've been doing things like that for a while just making sure we are focused on user experience in our advertising products and we found that that's been a very good long-term focus for our business that has really benefitted us. I think that's kind of the ordinary course of it there. You mentioned bridging online ads with offline transactions. As I said mobile will increase the value of these kind of businesses. That's an example of it, which can actually measure if somebody gets an offer that they redeemed it in a real store or they went in the store or whatever it is. And so, we are very excited about that, but we’re still in the early stages of really making those solutions work for consumers, advertisers and so on, but I think it's a great area that you highlighted that. So, can we go to our next question?
Operator: We'll take our next question from Heather Bellini with Goldman Sachs.
Heather Bellini: Hi, great. I had a question for Larry. I was just wondering if you could share with us your initial thoughts on the Google Fiber rollout. And also if you could outline for us your vision for the product if you look out over the next few years and how this might fit into your opening comments about multiple screens and unprecedented change in the consumer compute arena?
Larry Page: Well, I think it's been great to see the success there with the initial Fiber rollout. We are still in the very early stages of it. Obviously, we are going to a small number of people and so on, but we are excited about the possibilities there of getting people kind of give you the experience and really great Internet experience. Patrick, do you want to add anything there?
Patrick Pichette: Yes. We are really focused on Kansas City right now and you've probably seen in the press. It's called now the Silicon Prairie. It's got a lot of press, because we've started to roll out, we started the implementation and the installs. We are growing up in terms of installs weeks after week and people just love the product. So, you are absolutely right, Heather, that we are really excited about this product and it's been a great success overall. So, while we are going to continue and as we've said all along, and here is another great example of one where it's not a hobby, we really think that we should be making good business with this opportunity and we are going to continue to look at the possibility of expanding, but right now we just got to nail because we are in the early days. We just got to nail Kansas City. It's a perfect place for us to kind of debug all of the elements of the product and the experience for the users, but all-in-all, what a great opportunity to deliver kind of 100 times the average speed and that's what people are just dying to get everywhere. We have time for probably one last question.
Larry Page: Sorry I missed the second part of the question too, but it's a pretty big question, you wanted me to outline the vision for the products looking over the next few years. I guess the best way to predict the future is to make it, so that's what we are trying to do. I don't have anything specific to announce this time, but I couldn't be more excited about some of the things I mentioned on Google Now of really understanding what your question is before you have it. Wouldn't that be great at the earnings call if we just answered all of your questions without you asking them, because that will be less work for you all. So, I think some of those things could really be reality and I think if you look at knowledge panels and I recently asked like really obscure question I was looking at the height of a bridge. I was like what's the height of the bridge? And I typed into the Google and it just spit out the answer, and I was dumbfounded you know but I didn't have to go and research that. So, I think some of those things would seem kind of like science fiction where we are really getting to Google apps. Sergey has really taken on and he used to think that was science fiction and he is running around with it wearing it, as am I sometimes as well. So, I think we are just really excited about the future and I think the rate of innovation in the world is increasing, and also I think Google and that's just really exciting place to be.
Patrick Pichette: We actually saw Sergey in New York last weekend, in the subway with his plastic bags and all. So we have time for one last question.
Operator: We will take our last question from Douglas Anmuth with JPMorgan.
Douglas Anmuth: Great, thanks for taking the question. I just wanted to ask you about Display to start. I think in the last couple of years you have given a run rate in 4Q. I was hoping you could do that again for this past quarter and then also just talk about the early feedback and contribution from the YouTube App on iOS and then lastly any update on the features, timing and the process there? Thank you.
Patrick Pichette: So let me just jump on display. As we said many times in the past, we will give occasionally kind of numbers here and there just to give a sense of momentum, but we don't give them quarter-over-quarter or year-over-year. So that's exactly the case for display. And in the case of early feedback on the contribution for YouTube App on iOS, I will leave it to Nikesh.
Nikesh Arora: We are very excited about the iOS app that we put out there, not just for YouTube but also for Google Maps. We think they both have tremendous amount of success and it's an illustration of how, if you focus on the user and produce a great experience, it doesn't matter what platform it is. People will adopt it and adapt it and take to it. I think our partners and we both are excited about that fact that these apps are successful. I don't think it's just a unilateral view. Back to Patrick.
Patrick Pichette: Sorry, I just saw, Doug, your question on the C Shares. Look, as we said previously, this recapitalization is subject to (inaudible) pending litigation right now and once the litigation has been resolved, we expect our Board of Directors to determine the exact timing of issuing the dividend. So, we can't really predict it yet, because it's litigation, but we don't expect it to occur before the second quarter of this year. That's where we stand on that. With that, I just want to thank everybody who joining us today on the call. Wish everybody a really prosperous and happy new year. As Nikesh and Larry said, two-thumps up to all our Googlers for a phenomenal 2012 and making it a place of choice and look forward to an exciting 2013. With that Jennifer, I am going to let you close the call.
Operator: Alright, thank you. That does conclude toady's conference. Thank you for you participation. | [
{
"speaker": "Operator",
"text": "Good day and welcome everyone to the Google Inc. fourth quarter 2012 earnings conference call. This call is being recorded. At this time, I would like to turn the call over to Willa Chalmers, Senior Manager of Investor Relations. Please go ahead."
},
{
"speaker": "Willa Chalmers",
"text": "Great, thank you, Jennifer. Good afternoon, everyone and welcome to today's fourth quarter and fiscal year 2012 earnings conference call. With us are Larry Page, Chief Executive Officer; Patrick Pichette, Senior Vice President and Chief Financial Officer; Nikesh Arora, Senior Vice President and Chief Business Officer. Also, as you know, we distribute our earnings release through our Investor Relations website located at investor.google.com. So, please refer to our IR website for our earnings releases, as well as the supplementary slides that accompany the call. You can also visit our Google Plus Investor Relations page for the latest company news and updates. So, please check it out. This call is also being webcast from investor.google.com. A replay of the call will be available on our website later today. So, let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward-looking, including statements regarding Google's future investments, our long-term growth and innovation, the expected performance of our businesses and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on this call, such as operating income and operating margin, are also expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will turn the call over to Larry."
},
{
"speaker": "Larry Page",
"text": "Happy New Year everyone and welcome to our earnings call. Thank you for joining us this afternoon. We ended 2012 with a strong quarter. Revenue was up 36% year-on-year and 8% quarter-on-quarter and we hit $50 billion in revenue for the first time last year, not a bad achievement in just a decade-and-a-half. We have talked a lot about excellence and velocity over the last year. While many claim it's my nature never to be satisfied, we've actually made real progress creating more beautiful and more intuitive products. Take Search. The perfect search engine would understand exactly what you mean and give you exactly what you want. Our Knowledge Graph brings that much closer. Search for Nikola Tesla and you will get information about this great inventor that is beautifully displayed right from the results page. His basic bio, books he wrote, his photo, no extra work needed, and we even recommend information about other inventors such as Edison and Marconi that you can easily browse through. Again, right from the results page. And last quarter, we launched the Knowledge Graph in seven new languages, including Spanish, Japanese and Russian. This is hard work. It's about way more than translating the words on the page. Google has to understand millions of different entities as well as their meaning and context. I'm also excited about the progress we’ve made with Voice Search. You're in your car, sadly it's still a car you have to drive and it’s not electric and you're running out of gas. Just pick up your phone and ask Google for directions to the nearest gas station and you'll be on your way immediately. It's a great example of how we can take the hassle right out of your life. Our long-term investments in Google Maps have really paid off. The team has worked tremendously hard to create the most accurate and comprehensive maps in the world. Driving country-by-country may have seemed crazy a few years back. Today, it’s totally obvious, because location is core to your search experience. And with Google Maps for iOS, we have reinvigorated our product. It's more intuitive and beautiful, and users love it. Google Maps for iOS was downloaded over 10 million times in the first 48 hours. In fact, six Google apps were included in Apple's App Store Best Free Apps of 2012, including YouTube, Chrome, Google Search and Gmail. I’ve always believed that computers should do the hard work, so you can get on with the things that matter in life living, learning and loving. So it’s exciting to see our progress with Google Now. Launched earlier in the year, it gives you information before you even have to ask. We’ll now proactively provide your flight times, or your boarding pass, or directions to your next appointment. We'll even suggest interesting places to visit nearby. As we discussed on the last earnings call, we now live in a multi-screen world. People carry a supercomputer in their pocket all the time. In fact, we feel naked without our smartphone and many users have more than one device, a laptop, a phone, and a tablet. We are living in unchartered territory. It's a new kind of computing environment. Everyone is really excited about the technology and are spending a lot of money on devices driving faster adoption than we have ever seen before. It's been a long time in computing since we had this rate of change. It probably hasn’t happened since the birth of personal computing. It's why we have put so much focus on devices. They have been one of our biggest bets in the last few years, along with software to go with these devices, Chrome and Android. Our goal here is to push the user experience forward, so you get the best of Google in one easy to use package. The Samsung Chromebook, which we launched in October at an amazing price of $249 was a holiday highlight. I love mine. It is super easy to use and almost maintains itself. Open a chrome tab on your phone and everything syncs on your laptop with no extra effort required. We also launched two new Nexus devices to rave reviews, Nexus 4 and Nexus 10. In six months after we first unveiled it, the Nexus 7 continues to define the 7 inch tablet category making many best of 2012 and holiday gift lists. Clearly there is work to be done in managing our supply better, as well as building a great customer experience and that is a priority for the teams. But considering all the excitement over the holidays for our devices, it is clear there is tremendous opportunity in delivering great value with amazing and simple user experience. Google Play, another big bet is on fire. The growth is tremendous. This quarter we signed deals with Time as well as Warner Music Group. So we now provide contents from all the top Hollywood film studios, music labels and magazine publishers. We have not even reached Google Play's first anniversary. Many of you have questions about Motorola, and Patrick will go into details of our accounting for the business so that you can do your models right. I am excited about the business. In today's multi-screen world the opportunities are endless. Think about your devices, battery life is a huge issue. You shouldn’t have to worry about constantly recharging your phone. When you drop your phone, it shouldn’t go splat. Everything should be ton faster and easier. There is real potential to invent new and better experiences. Our CEO of Motorola, Dennis, has built a world-class team and they are working on the opportunities. It is still early days but I am excited about the innovative ways they are approaching product development and speed of their execution and they recently signed and agreement to sell more Motorola's home division for $2.35 billion. 2012 was an amazing year for Google and we are all set for a great 2013. I am incredibly optimistic about the opportunities we have as a technology company focused on user benefits. Every day I come to work excited about more and bigger opportunities and every day we work to have more and better organized Googlers, those are employees, improving the execution and overall capabilities to deliver world the world changing products. I know it sounds funny but with the ambitious plans we have, we are only just getting started. Our biggest challenge in this area is focus. We face so many opportunities and so it is important to thoughtfully invest in the right areas where we can have the greatest impact. We don't want to describe ourselves too thin, but I am quite optimistic that as we get better and better in managing our product areas, we will be able to continue to grow our ambitions. That's why I am here and that's one reason why Google Earth, now working at Google. Google Earth remains our greatest asset and we are working hard to recruit and retain the best employees. We've had a great start to the year, by being in the Fortune Magazine's, the best company to work for in the U.S. for the fourth time. We worked hard to create a company, where everyone is part of the family and where the work is challenging and rewarding, so I'm really happy to get that recognition. I want to finish by thanking all the Googlers who made this possible, and now I'll turn it over to Patrick. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Larry. Good afternoon, everyone, and thanks for joining us. So, let's dive in by reviewing the detail of our overall business financial performance. As we noted in a blog post last week, the Motorola Home business has been presented separately as discontinued operations in our financial tables. This makes typical quarter-on-quarter or year-on-year comparisons a little more challenging this quarter, but I will provide some color throughout my comments. So without further ado, here we go. Our gross total consolidated revenue grew 36% year-over-year to $14.4 billion, and 8% quarter-over-quarter. As I mentioned, this figure excludes the Motorola Home revenue. Had we included Motorola Home, gross total consolidated revenue would have been $15.2 billion, a growth rate of 44% year-over-year and 8% quarter-over-quarter. Google standalone gross revenue grew 22% year-over-year to $12.9 billion and 12% quarter-over-quarter. Our Google Website revenue was up 18% year-over-year to $8.6 billion and up 12% quarter-over-quarter with strengths across most geographies and industries. Our Google Network revenue grew 19% year-over-year to $3.4 billion and 10% quarter-over-quarter, finally, other revenue grew 102% year-over-year to $829 million and 24% quarter-over-quarter driven by Play hardware and content sales. And were it not for fluctuations in currencies Google standalone revenue would have in fact grown 24% year-over-year. Turning to Motorola Mobility, its gross revenue was $1.5 billion for the quarter. And once again had we included the Home business, the total gross revenue for the combined Motorola entities would have been $2.3 billion. As Larry mentioned, we are really pleased with the velocity of change at Motorola, but it's still at a very beginning of the Motorola Google story. No one should be surprised if results from this segment are a variable for quite a while as we restructure the business. And remember, we inherited a 12 to 18 months product pipeline that we are still working through. At Google Now, our global aggregate paid click growth was strong, up 24% year-over-year and up 9% quarter-over-quarter. As we said many times, there are several factors that impact the CPC click dynamics, including FX, geo mix, product changes et cetera, but this quarter specifically it's worth mentioning that we implemented some policy changes that lowered our paid click growth, improved our CPC growth and lowered network revenue for the quarter. Nikesh will speak more about this in a few minutes, but the bottom line is, that these policies are part of many constant changes that are focused on what's good for the user and advertisers, so we believe they are good for Google's business in the long-term too. Our aggregate cost per click was down 6% year-over-year and up 2% quarter-over-quarter. Once again remember that currency headwinds also had a moderate year-on-year negative impact on CPC in Q4. In fixed FX terms, in fact aggregate CPC would have been down only 4% year-over-year and up 1% quarter-over-quarter. Turning to geographic performance of Google's standalone business we continue to see strong performance in the U.S. and the U.K. while the economic situation of Southern Europe continues to impact our rest of world growth somewhat. In our earning slides, which you can find on our investor relations website, you will see that we have broken down our revenue by U.S., U.K., and rest of world to show the impact of FX and the benefits from our hedging programs. So please refer to those slides for the exact calculations. Revenue from the U.S. was up 20% year-over-year to $6 billion. The U.K. was up 23% year-over-year to $1.3 billion which includes [an immaterial] [ph] benefit from our hedging program. In fact in fixed FX terms the U.K. grew 22%. Non-U.S. Revenue, excluding the U.K., accounted for 44% of our total revenue or $5.6 billion, up 24% year-over-year and includes a $36 million benefit from our hedging program and in fixed FX terms rest of world grew 28%. So now if I come back to an aggregate level for the total consolidated business, our other cost of revenue was $3 billion in Q4, excluding SBC and Motorola restructuring, our non-GAAP operating expenses totaled $4.1 billion, which also exclude SBC and Motorola restructuring and our non-GAAP operating profit was $4.3 billion in Q4, resulting in a non-GAAP operating margin of 30%. For standalone Google, traffic acquisition costs were $3.1 billion or 25% of total advertising revenue. Our other cost of revenue was $1.8 billion excluding $101 million of stock-based compensation. The increase year-over-year was driven by equipment costs, including the cost associated with hardware sales on Play but also content acquisition costs and our data center costs. Non-GAAP operating expenses were $3.6 billion excluding stock-based compensation of $576 million. Finally, non-GAAP operating profit was $4.4 billion in Q4, resulting in a non-GAAP operating margin of 34%. One last note. Depreciation and amortization expense on property, plant and equipment for standalone Google was $493 million for this quarter. At Motorola Mobility, total non-GAAP operating expenses including cost of revenue were $1.7 billion and keep in mind that intangible amortization expense attributed to the standalone Google and Motorola mobility, they are included in these non-GAAP measures. Of the $289 million in intangible amortization expense this quarter, $153 million was a result of the acquisition of Motorola and of which $116 million is allocated to Google and $37 million allocated to Motorola Mobility. As a result, the non-GAAP operating loss on Motorola Mobility was $152 million in Q4, resulting in a non-GAAP operating margin of negative 10% for that segment. Let me turn to headcount. Headcount for the consolidated headcount increased by roughly 300 people in Q4. Keep in mind that consolidated headcount includes Motorola Home until it is divested and Home comprises roughly one third of the total Motorola headcount. Standalone Google added about 1,400 people and in total, the consolidated company ended the quarter at around 53,900 full-time employees. Our effective tax rate this quarter was 18%. The change from last quarter reflects the mix in shifts of earnings between domestic and international subsidiary and hedges. Now let me turn quickly to cash management. Other income and expense was 152 million for quarter, which reflects realized gains on investments and interest income offset by the continued impact of FAS 133 expense from our hedging program. For more details on OI&E, please again refer to the slides that accompany this call on our IR website. Our operating cash flow was very strong, $4.7 billion. CapEx for the quarter was $1 billion versus last quarter of $872 million. The majority of CapEx expense was related to production equipment, data center construction and facilities related purchases. We are very pleased with our free cash flow which was $3.7 billion and please note that cash flow and CapEx both include the Home business for now. So finally the success of our products and our continued strong performance, as portrayed by Larry's comments continues to give us the confidence to fund our strategic growth in areas such as search, YouTube, Android, Chrome as well as in our overall infrastructure with a view to the long-term. I will hand off now to Nikesh who will cover in more detail of our business performance in the quarter and after his remarks, we will open it up for the phone lines for any questions. Nikesh?"
},
{
"speaker": "Nikesh Arora",
"text": "Thank you, Patrick. As Larry and Patrick have mentioned, our business had a strong quarter with $12.9 billion revenue in Google standalone alone. We are very pleased with our year-on-year growth of 22%. I think our advertising business is firing on all cylinders. Companies of all sizes continue to embrace online advertising and our major players increasing their investments. In fact, here's an interesting tidbit. Across search display, YouTube and more, our top 25 advertisers are now spending average of over $150 million per year. Did I deliver that number? Our core business continues to be strong. Our investments in mobile shopping, our past holiday test with Flying Colors. As Larry mentioned, our vision is for search to understand exactly what you mean and give you exactly what you want in all devices that you live with throughout your day. Talking about the devices, our queries from wide ranging of new devices are continuing to power our overall growth in search volumes. Distinctions between devices, form factors are becoming less meaningful, particularly between desktop, laptops and tablets. Our Search performed very well last quarter during Black Friday and Cyber Monday. We still have greater proportion of queries with commercial intent and higher RPMs in areas like retail, computers and electronics. We launched a set of features to make shopping stress free and more fun. I don't know if you've had a chance to look at it, but there are some interesting things like 360 degree toy imagery and integrating retailers' promotions and discounts into our shopping product. Our investments in Search, particularly in mobile and shopping are really helping clients. Now, let me give you an example. Front End Audio. This is the company that offers recording and light sound equipment sales. Sometime in mid-September, the deployed product lifting ads, within weeks these ads were accounting for about 15% of the total sales. They also tripled their click through rates and also reduced their cost per conversion by 75% to 80%. This is great for us, because the product we believe is in the interest of the end users. It's a great product for Front End Audio improves their economics and improves our economy. Major retailers like RadioShack and Home Depot, they use our Mobile Apps 3 shoppers across devices, including click-to-call, click-to-map. For Home Depot, mobile commerce sales are quadrupled in a year. Patrick mentioned some changes in policy and enforcement. These enforcements had the effect of reducing ad clicks on the sites of certain AdSense for search partners. These policy updates are part of our ongoing work to improve user experiences on Google and on site in terms of using Google Search. Since these policies improve the experience of both users and advertisers, we firmly believe they are good for our business in the long-term. Switching gears to YouTube in display, we are continuing to make strong progress here, but there was a key language that brand speak, so it continues to be a key area of focus for us. Videos are baked into the core of all of our products whether it's search, display, mobile, and of course YouTube itself. YouTube is well positioned for the changing viewing habits of today's multi-screen world. The site's new redesign is focused on channels and that has led to major increase in engagement. In 2012, viewers watched over 4 billion hours of video on YouTube a month and it's now available across over 400 million mobile devices, gaming consoles and connector PDs in addition to your desktop. YouTube creators continue to vow and attract audiences. Outside estimate say that video on which I am sure all of you have seen of PSY, his hit song, Gangnam Style, now the most watched YouTube video for all times, it generated over $8 million in all-in advertising deal. YouTube Partner revenue has doubled for the fourth consecutive year and thousands of channels are now making six figures annually. YouTube is not only home for creators, but it's also home for major brand advisers. On YouTube, our top 100 global advertisers spent over 50% more in 2012 than they did in 2011. Clearly this is a strong signal of the power in YouTube to reach audiences. What's interesting is the significant factor into growth of YouTube has been our TrueView skippable ad format. Agencies and marketers are seeing real benefits. You only pay for the ad if viewers watch them. In fact, 70% of our in-stream ads are now TrueView formats and this quarter TrueView came to Xbox, the iPad, and the Wii. Putting all our advertiser solutions together, it is really helping us deliver greater returns and develop close relationships with major clients worldwide. Like McDonald's, who this quarter launched always on search in YouTube campaign to increase customer awareness and their ability towards their brands across all channels. In Q4, we signed a new global deal with L'Oreal, under which we worked to promote their brands using Google's digital offerings across the world in Display, Search, YouTube and more. While our complete solution for marketers not only applies to businesses, but we saw this in this quarter's 2012 election from the presidency to local races. Google's mobile search, video and measurement products were the center of a huge number of Democratic, Republican initiatives and campaigns. Our election advertising revenues increased by five times over the 2008 election. Here is an interesting statistic for you. In nine of the top 11 Senate races for the U.S., the candidates who spent more with Google, was elected. Well, 2012 was not just a big year for advertising, it was a big year for publisher business as well. Working closely with major publishers, from weather channel to timing, bringing the DoubleClick Google ad technology stack together is really helping our clients increase their direct, indirect and programmatic CPMs. Our solutions for media companies now (inaudible) be on advertising encompassing paid service, subscriptions and more. That was about our business, our ad revenue. Other highlights looking at the geographic breakdown of our ads business. Growth in Northern Europe was robust, with strength in Germany and the U.K. Asia performed steadily and other regions were very pleased that Americas maintain steady growth driven by strength in mobile and YouTube. Southern Europe was somewhat softer as it continues to face macroeconomic challenges. Our enterprise business continues to grow at an impressive pace. It's been gaining traction across some of the largest companies in the world. New customers this quarter include Nintendo, the Canadian Broadcasting Company, Shaw industries, Costco, Randstad and Hyundai to name a few. Also signing in May is the U.S. Department of Interior, moved more than 70,000 employees to the cloud during Q4 making it the largest federal agency to date using Google Apps. I think I solid, we have had a good quarter. Our revenues continue to grow. Clients continue to see value with us and value in online advertising. We have been able to build significant new revenue streams at mobile, YouTube and display and clearly arising one in enterprise. We have weathered various economic storms and are benefiting from the shift in advertising spend towards digital media plus there is continued strong execution and client relationships. I want to echo Larry's congratulations to our teams around the world for all their hard work in delivering a great quarter and stellar year in a tough environment. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Nikesh. With that, I am going to turn it over to Jennifer who will open the lines for the Q&A. Jennifer, all yours."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) We will take our first question from Carlos Kirjner with Bernstein."
},
{
"speaker": "Carlos Kirjner",
"text": "Two questions. Last quarter we saw a material sequential decline of Google websites' revenues growth rate of more than 400 basis points. Even after accounting for FX, this quarter we see another deceleration I think about 250 basis points on an FX neutral basis in the Google websites' revenue line. Of these, in the context where YouTube is growing really fast based on your comments, so what have been the major drivers of this continued deceleration of Google websites? Should we expect similar growth rate declines going forward? Secondly on TAC, it seems TAC for distribution as a percentage of Google websites' revenues grew less than what we had seen earlier in the last several quarters in 2012. What has driven the stabilization of this TAC, distribution TAC and how should we think about distribution TAC in the future? Thank you."
},
{
"speaker": "Larry Page",
"text": "Well, thank you, Carlos for the detailed question. I am going to turn that over to Patrick for, hopefully, a good answer."
},
{
"speaker": "Patrick Pichette",
"text": "Yes, thank you. So Carlos, on the first one, you are right that there is quite a bit of noise because of FX on the sites year-over-year between Q3 and Q4 but overall I think that we are very pleased with the growth around 20%. You are right that in the last quarter there was a bit more headwinds than this quarter but overall the core search business is doing well and driven really by the strength in mobile and we are obviously additionally pleased with the YouTube business, particularly the watch page. So, despite the fact that there is quite a bit of FX noise in there and that FX does carry over to sites, overall I think that we are very pleased with the overall growth. In terms of TAC I think that that’s the case where obviously our mobile revenue is growing and it is having impact on our mix shift. That’s really the fundamental trend that you see in TAC rather than change in the TAC rate of any particular partner. So that’s really what's going on there but I think as we said in the previous calls we think of TAC in the way, there is a really positive story in TAC, which is, it is distribution and it is worth paying for. This is the positive side of our business having much more distribution of our apps across and that’s true also for mobile. So we are really thrilled that all of the mobile is thriving to the extent that it is and remember that, finally, TAC is not a new phenomenon for us. We have always dealt with distribution partners and we'll continue to experience and manage it to make sure that it drives revenue and profit for both parties in a balanced way, so nothing new here but really excited by the trends. Thank you Carlos. We will go to our next question, please."
},
{
"speaker": "Operator",
"text": "We will take our next question from Ben Schachter with Macquarie."
},
{
"speaker": "Ben Schachter",
"text": "Two questions for Larry around the notion of Answers not linked. First on Knowledge Graph, can you just give us a high level view on where we are in terms of its implementation and how widely it's rolled out? And specifically, how if at all it impacts the economics of Google's businesses? And then second Google Shopping, the PLAs and the interface changes, I think significantly improve the user experience, but the consumer still needs to leave the site to transact. Do you anticipate a mechanism whereas users can actually transact on Google Shopping without having to leave? You know, as you said sort of no extra work needed? Thanks."
},
{
"speaker": "Larry Page",
"text": "Well, Ben, thank you for the questions. I think we rolled out Knowledge Graph very recently and I think we are still in the early stages of that. I think that, I mentioned some of the internationalization work that we did which is hard work and I think we'll continue to do that. I mean it's still 1% or something where we should be, so I am really excited about what we can do in the future. I think the economics points, I think that the way we look at it is we provide much better answers for people really grow the business. We increased the number times that you might want information, because you know you are going to get correct answers or increasing it for modalities, you can get answers like Voice, or Mobile or so on, so I am somewhat excited about that and generally we monetize those things. So, I don’t have a comment on specifics of that, but it think we are quite excited about that. The Knowledge Graph does run on the right hand side where the ads also run. [I expect] [ph] there could be some short-term impacts on that, but I think the primary thing is getting people better answers is really good for our business. Google Shopping, I guess you are asking about product listing ads I think that we are also in the early stages of that. We just rolled out Google Shopping. We’ve seen tremendous uptake from merchants and from users and I expect that quality of the site, the ease of buying things will improve over time and I am really excited about that. I am not going to comment on details about that, but we’re always focused on making our user experience better. So, can we have our next question please?"
},
{
"speaker": "Operator",
"text": "We'll take our next question from Scott Devitt with Morgan Stanley."
},
{
"speaker": "Scott Devitt",
"text": "Thanks. I guess, following up on Ben's comment regarding Answers versus Links. Larry, you recently quoted I think saying about the possibility of having a system that could basically vacation plan for you. And now that you own ITA and Frommer’s and Zagat and you've built out travel explorer or flight explorer and Hotel Finder. Can you talk a bit more about the strategy with travel in terms of the problem you are trying to solve there relative to this historic experience of Google sending you offsite for depth of experience. And then secondly, Patrick, I think last quarter you gave the FX neutral CPC down 8%. I wonder if you could give that same number for this quarter, thanks. For the fourth quarter?"
},
{
"speaker": "Larry Page",
"text": "Yes, Scott. That's a great question. I'll take the first part, and I think that we've always done a very good job of sending people to the right places and I don't think that being able to answer very complex information means necessarily that we wouldn't send people off to other sites, So I think the main thing for us is to be able to understand the complex problem. Like, I think, I gave some example like finding a hotel that's near (inaudible) logistics for the flight, for a vacation you might take and the hotel and the activities we wanted to do, kind of solving that all at once in a way a human assistant might be able to do. And, you still might use other parties to do that transaction, so I don’t necessarily believe the assumption of your question, but we are looking at those things. It was more of an example. I think Google’s aspiration is to be able to that for any area. Not just travel and we have been working with as many companies as we can and trying to organize the web’s information. And where we needed to acquire companies, we have done some of that or work with other companies or make deals or whatever we need to do. So we are trying to be practical about it and I think we do have some amazing assets in travel and mapping and so on. I think those things will pay off for us in the future providing great experience. So, Patrick?"
},
{
"speaker": "Patrick Pichette",
"text": "Yes, Scott, the answer to your specific question is, the CPCs have, on a year-over-year basis, they have gone down 4% and on a quarter-over-quarter basis, they are 1%. That is on a fixed FX adjusted and so that compares to the minus six and plus two that I mentioned a couple of minutes ago. Thanks for your questions, Scott. Jennifer, let's go to our next question please."
},
{
"speaker": "Operator",
"text": "Our next question comes from Mark Mahaney with RBC."
},
{
"speaker": "Mark Mahaney",
"text": "Great, thanks. Two questions. Could you talk broadly where you are on cash about Google Maps and where do you think the monetization of that is today versus where you think it potentially could be? Then, Larry, I think you were quoted recently with some comments on competitive products out in the market. Any comments, in particular, on graphical search as it has been announced and to what extent you think that’s complementary or competitive with Google's core search? Thank you very much."
},
{
"speaker": "Larry Page",
"text": "Well, I can say a little bit about Maps. So this is Larry. I think that people are always focused on monetization of Maps but it's important to think about, for me, it’s the history of Maps. We started working on Maps a long, long time ago and because we thought it was critical to your search experience. It is actually finding what you are looking for and if we look at our component of queries that are geographically related, it’s a huge number and always has been. So again, to understand those queries we have to understand where things are in the real world. So that’s been always the core part of our main web search. We already make quite a bit of money on web search and I already told you that was a significant amount of queries. So we actually we already make quite a bit of money on Maps in that way as a part of our core business, and a significant part, which really allowed us to make those investments. We are in the early stages of monetization on the Maps themselves. I think we are doing some interesting things there. I think we will continue to do that. I think it is likely to be a great source of revenue but still in the early stages on the Maps, but on the search side, we have significant revenue already. I think you are asking about graph search, which was recently announced. I think that when leaving about search, our mission has been to organize the world's information and making it universally accessible and useful. We have been at that for quite a while and made investments in all sorts of areas, like Maps, as I just mentioned which turned out to be really important. That’s the way we think about. There is knowledge search, there is all sorts of investments we have made, gathering different kinds of data and making sure we have everyone's data and we will continue to do that. That business has change a lot. Only 10 years ago, what you though Google should do, is almost unrecognizable compared to what it does now and the number of things that it understands. So we see just tremendous opportunity to make better products for users that really understand their needs and really grow that opportunity and if you look at voice, for example, which we have also made huge investment in, the importance of that to mobile for finding things. I mentioned you can ask Google where the nearest gas station is on your phone while you are driving on your phones and it does all this work perfectly. So I think we see that as just all sorts of aspects on those problem and we have been very focused on that. Now there is another great example. There is tremendous innovation there. It is actually answering your question before you even think to have the question and that's pretty incredible. I am super excited about that, so I feel very confident of our core business of organizing things, finding things, getting people information. I couldn't be more excited about that. Our next question?"
},
{
"speaker": "Operator",
"text": "We'll take our next question from Anthony Diclemente with Barclays."
},
{
"speaker": "Anthony Diclemente",
"text": "Hi. First for Patrick on Motorola in terms of the lawsuit which widened in the quarter, I am wondering if you could contextualize for us the financial direction of Motorola, both, in terms of the revenue declining and the growing expenses. I mean, I know this isn't something that Google typically does, but I think it would be helpful for investors if there's any way to kind of put a band or threshold around what the potential operating losses could be at Motorola. And then second question for Larry around the commercialization of driverless cars. I just wonder if you could give us an update on that and your test that you're doing in Nevada and I am wondering if you could talk about Android as part of that? It sounds like the automotive, electronics suppliers are recognizing the importance of Android for the infotainment systems in those cars and so maybe you can talk a little bit about that opportunity for Android as well? Thanks for the question."
},
{
"speaker": "Larry Page",
"text": "I think maybe I'll take the second half of your question first. I think that, I would say also on Motorola and then I will let Patrick fill in. I mean we are so excited about them in this. I think that we're really in the early days of Motorola with respect to Google's acquisition of it, and I'll let him give you some details. I think that on driverless cars, I think obviously it's still early days to answer. Although I'm really excited about what the team has got done and what that can mean for ordinary people and really substantially improving mobility and potentially really reducing the land area that we have to devote for cars which is incredible amounts in cities. It can really reduce parking. We are looking at that. Even for Google just as a major cost to reduce our parking costs in our facilities by having automated cars parked more densely and serve more people. I think those things will be amazing deals. Android I think that we are still. That's little bit different than the automated cars I think, but Android won't be used in cars probably before we get automated cars into the mainstream. I think people are really excited about that due to the incredible success of Android and we are obviously working with those manufacturers to help them make that happen well. So, Patrick?"
},
{
"speaker": "Patrick Pichette",
"text": "Yes, just a bit of color on Motorola. Right? First just to remind everybody, we do care about profitability and that is our goal with every one of the areas where we invest, and we said that before and we are not in the business for losing money with Motorola or even cross subsiding it. But, we are really 180 days into this journey and we've made a ton of progress, including the sale of the Home business. And as I mentioned earlier also we are kind of outsourcing our manufacturing and so much more that has been done and the restructurings that you have heard earlier in the late summer and early fall. So, and I just want to remind everybody that we inherited kind of 12 to 18 months of product pipeline that we have to work through and that's the reality of the business, that's kind of overhaul and then kind of rebuild the new product pipeline where Dennis's team has kind of been really focused on in addition to the restructuring. It does take time before it shows up. Having said that finally on the financials themselves, Anthony, it's really worth noting that Motorola is also hindered by a portion of the amortization of intangibles due to the acquisition, so the losses that you see are somewhat inflated by this amortization of intangibles which we've decided to kind of put through the P&L on a non-GAAP basis. So, all-in-all, when we look at the losses like this quarter, a negative $150 million, you take out the amortization, these are not consequential losses relative to either Google or the kind of turnaround we are seeing and the kind of positive momentum. So, that's why Larry started by saying we are really optimistic, but it does take time and that's why I am also saying, be ready for a lot of fluctuations in our P&L over the coming quarters. It's just the nature of the bees when you reinvent business. Thank you for your question, Anthony. Let's go, Jennifer, to our next question."
},
{
"speaker": "Operator",
"text": "Our next question comes from Justin Post with Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "Thank you. Larry, I think on your last call, you mentioned that you are impatient with mobile CPCs, not that they were not bad place but you wanted to get them higher. Can you talk about progress made in the quarter and do you feel like you are really making a positive inflection there or is that still a few quarters away? Then as you as you look at your mobile business as far as the growth of queries or the growth of revenues and you look at it relative to maybe mcommerce growth, do you think you are gaining share of the market? Do you feel like your position in mobile is really secure and that you maybe even be gaining share in mobile or maybe the street doesn’t recognize it? Thank you."
},
{
"speaker": "Larry Page",
"text": "Thank you for your question. Let's see, the mobile business, it has been going very well. We have tremendous growth with the Android. We are serving our users really well. We are building amazing products that are getting better at a rapid rate. The rate of improvement are obviously very high. So I feel pretty comfortable that my focus mostly on our products and assume that their usage will follow the great products. I think that in some sense, some of you may consider mobile an extension over the desktop usage too. I mean, we have built a lot of great products that people use for the desktops like Maps which was transferred very well. And I think that one thing I was amazed by Chrome on my Android phone, Chrome is just an amazing experience. So, using my Nexus phone or other more smartphones from the latest generation, those phones are almost like using a desktop of last year or something like that. So I think the experiences are improving a lot and very, very quickly. So I think we have hit some uncharted territory, because of the rapid rate of change in these things but I am very, very optimistic about it. I think that CPCs will improve as these devices are improving as well. Obviously, I mentioned that we are working to simplify our ad system for advertisers. In the light of all these changes and I am excited about our plans there. We don’t have anything to announce today but I am very excited about our efforts there. I think that we will make rapid progress in that area. So I think I answered both of your questions. So maybe we can have our next question."
},
{
"speaker": "Operator",
"text": "We will take our next question from Stephen Ju with Credit Suisse."
},
{
"speaker": "Stephen Ju",
"text": "Thanks, guys. So I guess the pace of your headcount increases is used to be moderating as we take a look back 2012 and the same goes for CapEx as well. So do you feel like you are now at an appropriate level to tackle your three major areas of investment focus? I guess another way to ask the question is, are there any other large scale opportunities you have identified that would entail acceleration in terms of your hiring or CapEx? Thank you."
},
{
"speaker": "Larry Page",
"text": "I think we have run a number of different businesses and I think that they all have different needs and it's sort of like, we are looking at the sum of all those things. So I think it is a little bit hard to predict those things. I think you should ask us to do whatever is necessary to make the most business outcome. Having said that, I think we have some time in the past we have had a lot of people, we are growing at the edge of what's been the modest in terms of scaling. I think that’s still the case. We would say, that’s moderated but I would say that we have also slowed our international growth and products development a bit which is probably having some impact on that. So I guess, I will give it to Patrick for some more detail, perhaps."
},
{
"speaker": "Patrick Pichette",
"text": "Okay, just the comment on the CapEx side. We have always said and I think if you go back the last couple of years on CapEx, it has been really lumpy. We have gone from really highs where we were above $1 billion and then it's come all the way down to a few hundred million dollars. Now it's kind of moved back up, so it's a real testimony that it is lumpy, because as you add, just to use the example of a data center, as you will see CapEx, because we fill with equipment at data center. But once the data center is full and then we have to put an extension to the data center or then you are into concrete again and power. So, it's just the nature of our business. Certainly on the core businesses are quite lumpy, so we without giving any guidance forward, we have been as you've seen in this quarter $1 billion of CapEx, really very much aligned with the excitement we have around our products, whether it be social, whether it be pictures, whether it be all of the areas that you have heard Larry talk about and so that's why we are fueled as I said in my comments. We are fueled by the positive momentum we have in many areas of the company and we believe now is the time to invest and that's why we are doing it with confidence, discipline with confidence."
},
{
"speaker": "Larry Page",
"text": "Ross, I'll also just add briefly that when we run our business, we find that it works better if our hiring is reasonably smooth, so we have worked harder to manage that smoothness. We have recruiters in place and hiring staff in place for the long-term and make sure we'll provide a good consistent business growth there just makes us operationally run better and we've probably been managing that a bit more tightly."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks for your question, Steven. Let's go to our next question, please, Jennifer."
},
{
"speaker": "Operator",
"text": "We'll take our next question from Ross Sandler with Deutsche Bank Securities."
},
{
"speaker": "Ross Sandler",
"text": "Thanks guys. I have got two questions, first for Nikesh on Mobile and then one follow-up for Patrick on the Google sites TAC. So, Nikesh, what percent of your several million advertising clients are bidding on mobile key words today and what percentage do you think have mobile-specific websites enabled already? And then Patrick, the follow-up on TAC, the year-over-year growth rate for Google website's TAC decelerated from 45% to 43%, subtle but there is probably some organic items in there that are helping it. Is that a function of smartphone installation growth rolling over or any partnership agreements or something else? Can you just give us a little color on that deceleration? Thanks."
},
{
"speaker": "Nikesh Arora",
"text": "Thanks for your question, Ross. On the mobile front, I think it's important to understand that a vast majority of our advertisers have opted into mobile from an advertising point of view. I think Larry said this a few quarters ago that we slowly have been working over time to try and make it feel like a common experience across multiple screens for advertisers, because advertisers are more interested in the business benefit of advertising with us as opposed to specifically which form factor, which device they invest with us on, so our teams have been working really hard in the last few quarters to try and get us to a point where we can make it simple for the advertiser where they come to us with a business problem and we are able to solve it for them irrespective of device, irrespective of form factor or property that they are going to have advertise on. So, from that perspective, I think things are going in the right direction. As far as specifically how many advertisers have mobile landing pages that they can send their users to? That number is not as much as we would like it. Obviously, we've had programs, we have talked about in the past earning calls like GoMo which help businesses go mobile, so those efforts are bearing fruit but broadly speaking, I think we are happy with the progress we have made both on getting advertisers to be more mobilized and also what we are doing from a campaign management perspective to get more and more campaigns that can run across all devices and form factors."
},
{
"speaker": "Larry Page",
"text": "I'll just add on the mobile question. We don’t necessarily want them to have mobile sites some are too simple and I find I get kind of frustrated on my phone sometimes when I have these mobile specific sites because I am using a modern Nexus 4 that can actually view up the full site and I just find it confusing. So, I think as an industry, we need to improve these experiences and that will take a bit of time, but I'd almost say that we should be designing for mobile the kind of mobile phones that we had now the state-of-the-art or a little bit beyond and that those experiences should work on all devices pretty well, so I'd actually like to us go more in that direction perhaps, so Patrick?"
},
{
"speaker": "Patrick Pichette",
"text": "Just on my side, I need Ross, I need you to actually call us after this. Because, when I look at our TAC for the Google Web as a percentage of website revenue, it is pretty stable to us and every way we look at it is pretty stable. So I am not sure if there is anything you are looking into it that we are missing but don't hesitate to follow-up with the IR team afterwards. But we don’t see any deceleration in any meaningful way on the website side. Thanks, Ross."
},
{
"speaker": "Larry Page",
"text": "Great, can we have our next question?"
},
{
"speaker": "Operator",
"text": "Yes, we will take our next question from Richard Kramer with Arete Research."
},
{
"speaker": "Richard Kramer",
"text": "Thanks very much. Larry, a couple of quick questions. First of all, just to polish up this Mobile and CPC question, how many years do you think it's going to take before CPCs on Mobile and Desktop are roughly equal trading off location and display size? Another question, looking broadly at the business, there are a number of geographical markets like China where you are simply not able to operate. Do you see any prospect for being able to enter some of those markets in the medium term? Or do you think that the business is still going to be geographically constrained? Then a quick one for Patrick, will there be an impairment test coming up on Motorola especially with respect to the IPR given the FTC settlement around Standards-Essential Patent? Thanks."
},
{
"speaker": "Larry Page",
"text": "Thanks, Richard, for all the questions. I think that's a threefer. The problem seems to be, and I am not going to make predictions about when they will be equal; I don't think they will be equal, I think probably one will always be bigger than the other, though, not clear which way but I don't think this is a long-term problem. I don't think this is a long time in coming, and I think as I have said before, there's a lot of advantages to mobile. You already know location quite clearly, you can call somebody easily, you have a camera, you can hangout with the business, you can be notified instantly. There's just a lot of things about mobile that are amazing opportunities for advertisers and for businesses. So I expect that to revolutionize how people do marketing and we are working hard on that. I expect that that will work a lot better for users and for advertisers and businesses, and therefore more money. We will be able to generate a lot more money than we do now. Okay, so maybe Nikesh can address China."
},
{
"speaker": "Nikesh Arora",
"text": "I thought I was getting the mobile CPC question, Larry."
},
{
"speaker": "Larry Page",
"text": "You can do the second one first, though."
},
{
"speaker": "Nikesh Arora",
"text": "Okay, I think it is fair to say we do operate in China right now. We have an ad sales business. We have a display business in the market. We know there is many users who use Android devices in the market. I think what's important to understand is the reason we decided to not operate in China was because we believe that we wanted to make sure that users are able to have unfettered access to our products, and the products where we believe they have ability to access in an unfettered fashion we do operate in the market. It's only the ones where they aren't able to access in the way we would like to, in which case they are able to access it through our operations in Hong Kong. So we think we operate in China, not in the way you might perceive it, but users have access to our services and there is even a small revenue business that we have in China."
},
{
"speaker": "Larry Page",
"text": "Oaky, so, Patrick, what might be an impairment to us for Motorola?"
},
{
"speaker": "Patrick Pichette",
"text": "Obviously, every time there is any formal kind of transactions or events that occur, we have to look at our balance sheet and if is any impairment test. In the case of Motorola, we don't think there is actually right now. We have no information even with the Standards-Essential Patent. There is no information right now that leads us to believe that we have to do an impairment test on any of it. Remember that the Standards-Essential Patent for Motorola is a very small portion of the entire portfolio pool of patents that we got out of Motorola. So, just put that in the context as well. So, thanks for your question, Richard. Why don’t we go to the next question, Jennifer."
},
{
"speaker": "Operator",
"text": "We will take our next question from Neil Doshi with Citigroup."
},
{
"speaker": "Neil Doshi",
"text": "Thanks. Can you provide more details around the policy changes that were implemented in the quarter, and whether they will continue to have an impact on CPCs and paid clicks in Q1? Then also we were recently at the NRF convention in New York and we saw a demo of the Google Zavers product where users can click coupons, and then use those coupons in the offline retail world. How big of an opportunity is really bridging the online ads with off-line transactions for Google and this is something that's a key initiative as we go into 2013? Thanks."
},
{
"speaker": "Larry Page",
"text": "Thanks, Neil, for your question. So I think that Nikesh can give us some color on the policy."
},
{
"speaker": "Nikesh Arora",
"text": "I think it's fair to say what we did was, we’ve always had a policy. The policy has been that we want to make sure that whatever ads are presented in whatever way our traffic is routed to ads, it is done in the best interest of the user and we began to notice that they were sites and pages whereas we had too many ads in a page, so it became more restrictive and updated our policies for better enforcement and that has resulted in higher quality results for end users, it has reduced in some cases the monetization that some of our partners are seeing as a result of this enforcement and hence you are seeing the impact on the numbers. We just announced this policy sometime early this quarter, in the past quarter that we just went through, so you are going to see the impact over the next few quarters. We've also implemented more stringent policies around downloadable apps, and that's why I think both those effects are going to stay with us for the year, but we think in the long-term is the right answer for us, it's the right answer for users and it's right answer for advertisers, so we think it's a good thing to do."
},
{
"speaker": "Larry Page",
"text": "We've been doing things like that for a while just making sure we are focused on user experience in our advertising products and we found that that's been a very good long-term focus for our business that has really benefitted us. I think that's kind of the ordinary course of it there. You mentioned bridging online ads with offline transactions. As I said mobile will increase the value of these kind of businesses. That's an example of it, which can actually measure if somebody gets an offer that they redeemed it in a real store or they went in the store or whatever it is. And so, we are very excited about that, but we’re still in the early stages of really making those solutions work for consumers, advertisers and so on, but I think it's a great area that you highlighted that. So, can we go to our next question?"
},
{
"speaker": "Operator",
"text": "We'll take our next question from Heather Bellini with Goldman Sachs."
},
{
"speaker": "Heather Bellini",
"text": "Hi, great. I had a question for Larry. I was just wondering if you could share with us your initial thoughts on the Google Fiber rollout. And also if you could outline for us your vision for the product if you look out over the next few years and how this might fit into your opening comments about multiple screens and unprecedented change in the consumer compute arena?"
},
{
"speaker": "Larry Page",
"text": "Well, I think it's been great to see the success there with the initial Fiber rollout. We are still in the very early stages of it. Obviously, we are going to a small number of people and so on, but we are excited about the possibilities there of getting people kind of give you the experience and really great Internet experience. Patrick, do you want to add anything there?"
},
{
"speaker": "Patrick Pichette",
"text": "Yes. We are really focused on Kansas City right now and you've probably seen in the press. It's called now the Silicon Prairie. It's got a lot of press, because we've started to roll out, we started the implementation and the installs. We are growing up in terms of installs weeks after week and people just love the product. So, you are absolutely right, Heather, that we are really excited about this product and it's been a great success overall. So, while we are going to continue and as we've said all along, and here is another great example of one where it's not a hobby, we really think that we should be making good business with this opportunity and we are going to continue to look at the possibility of expanding, but right now we just got to nail because we are in the early days. We just got to nail Kansas City. It's a perfect place for us to kind of debug all of the elements of the product and the experience for the users, but all-in-all, what a great opportunity to deliver kind of 100 times the average speed and that's what people are just dying to get everywhere. We have time for probably one last question."
},
{
"speaker": "Larry Page",
"text": "Sorry I missed the second part of the question too, but it's a pretty big question, you wanted me to outline the vision for the products looking over the next few years. I guess the best way to predict the future is to make it, so that's what we are trying to do. I don't have anything specific to announce this time, but I couldn't be more excited about some of the things I mentioned on Google Now of really understanding what your question is before you have it. Wouldn't that be great at the earnings call if we just answered all of your questions without you asking them, because that will be less work for you all. So, I think some of those things could really be reality and I think if you look at knowledge panels and I recently asked like really obscure question I was looking at the height of a bridge. I was like what's the height of the bridge? And I typed into the Google and it just spit out the answer, and I was dumbfounded you know but I didn't have to go and research that. So, I think some of those things would seem kind of like science fiction where we are really getting to Google apps. Sergey has really taken on and he used to think that was science fiction and he is running around with it wearing it, as am I sometimes as well. So, I think we are just really excited about the future and I think the rate of innovation in the world is increasing, and also I think Google and that's just really exciting place to be."
},
{
"speaker": "Patrick Pichette",
"text": "We actually saw Sergey in New York last weekend, in the subway with his plastic bags and all. So we have time for one last question."
},
{
"speaker": "Operator",
"text": "We will take our last question from Douglas Anmuth with JPMorgan."
},
{
"speaker": "Douglas Anmuth",
"text": "Great, thanks for taking the question. I just wanted to ask you about Display to start. I think in the last couple of years you have given a run rate in 4Q. I was hoping you could do that again for this past quarter and then also just talk about the early feedback and contribution from the YouTube App on iOS and then lastly any update on the features, timing and the process there? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "So let me just jump on display. As we said many times in the past, we will give occasionally kind of numbers here and there just to give a sense of momentum, but we don't give them quarter-over-quarter or year-over-year. So that's exactly the case for display. And in the case of early feedback on the contribution for YouTube App on iOS, I will leave it to Nikesh."
},
{
"speaker": "Nikesh Arora",
"text": "We are very excited about the iOS app that we put out there, not just for YouTube but also for Google Maps. We think they both have tremendous amount of success and it's an illustration of how, if you focus on the user and produce a great experience, it doesn't matter what platform it is. People will adopt it and adapt it and take to it. I think our partners and we both are excited about that fact that these apps are successful. I don't think it's just a unilateral view. Back to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Sorry, I just saw, Doug, your question on the C Shares. Look, as we said previously, this recapitalization is subject to (inaudible) pending litigation right now and once the litigation has been resolved, we expect our Board of Directors to determine the exact timing of issuing the dividend. So, we can't really predict it yet, because it's litigation, but we don't expect it to occur before the second quarter of this year. That's where we stand on that. With that, I just want to thank everybody who joining us today on the call. Wish everybody a really prosperous and happy new year. As Nikesh and Larry said, two-thumps up to all our Googlers for a phenomenal 2012 and making it a place of choice and look forward to an exciting 2013. With that Jennifer, I am going to let you close the call."
},
{
"speaker": "Operator",
"text": "Alright, thank you. That does conclude toady's conference. Thank you for you participation."
}
] | null | null |
GOOGL | 3 | 2,012 | 2012-10-18 04:30:00 | Operator: Good day, and welcome everyone to the Google, Inc. Third Quarter 2012 Earnings Conference Call. This call is being recorded. And at this time, I’d like to turn the call over to Jane Penner, Director of Investor Relations. Please go ahead.
Jane Penner: Good afternoon, everyone, and welcome to today’s third quarter 2012 earnings conference call. With us are Larry Page, Chief Executive Officer; Patrick Pichette, Senior Vice President and Chief Financial Officer; and Nikesh Arora, Senior Vice President and Chief Business Officer. Also, as you know, we distribute our earnings release through our Investor Relations website located at investor.google.com. So, please refer to our IR website for our earnings releases, as well as the supplementary slides that accompany the call. This call is also being webcast from investor.google.com. A replay of the call will be available on our website later today. Now, let me quickly cover the Safe Harbor. Some of the statements we make today may be considered forward-looking, including statements regarding Google’s future investments, our long-term growth and innovation, the expected performance of our businesses, and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on this call, such as operating income and operating margin are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will turn the call to Patrick.
Patrick Pichette: Hello, everybody. We’re going to invite Larry to give us the first round of commentary and then I’ll go through our financials and then Nikesh will have some comment before we turn to Q&A. So here you go, Larry.
Lawrence Page: Thank you, Patrick. Hello, everyone. Thanks for joining us. It’s great to be on the call today and to share our progress since we last spoke six months ago. As you can hear my voice is still hoarse, so I will keep my remarks reasonably short. I am sorry for the scramble earlier today. As our printers have said, they hit send on the release just a bit early. We had a strong quarter, I am really happy with our business. Revenue was up 45% year-on-year, and at just 14 years old, we cleared our first $14 billion revenue quarter. Not bad for a teenager. Today, we live in a world of abundance; abundant information and abundant computing. Most of us carry at least one device, all the time, every day. In fact many of us would feel naked without our smartphone. It’s hardly surprising mobile search queries and mobile commerce are growing dramatically across the world. And we use these devices interchangeably, depending on our situation. I switch between my Nexus phone, my Nexus 7 tablet and my new Chromebook that we just announced today many times a day. While this abundance causes disruption, it also creates amazing opportunity. And Google is super well-placed to take advantage of these disruptive opportunities. Why? Because our search query volumes have grown this quarter as measured year-over-year. And we are seeing tremendous innovation in advertising, which I believe, will help us monetize mobile queries more effectively than desktop today. Indeed, our mobile monetization per query is already a significant fraction compared to desktop. In short, as we transition from one screen to multiscreens, Google has enormous opportunities to innovate and drive ever higher monetization, just like Search in 2000. Now we took a big bet on Android back in 2005. We believed that aligning standards around an open source operating system would drive innovation across the industry. Most people thought we were nuts. Today, there are over half a billion Android devices, half a billion, with 1.3 million more being activated every day. You should all run out and buy the Nexus 7 tablet for $199. It’s had rave reviews and recently won Gadget of the Year from T3, the gadget experts. You’ll love the integration with Google Play. It is an amazing device. This time last year, I announced that our run-rate for mobile advertising hit $2.5 billion. That seemed like a pretty big number even for Google. But now we have built up additional mobile revenue from users paying for content and apps in Google Play. Including these new sources grossed up, I can announce our new run-rate for mobile is now over $8 billion. That’s quite a business. We have so many opportunities today, that unless we prioritize we spread ourselves too thin. Last month, we sunset another 19 products. We’ve now closed or have combined 60 products and features in the last year. And we’ve put a ton of energy into ensuring that our remaining products work really well together. Because as screens multiply, it’s more important than ever that we converge our services. Users want one consistent, beautiful and simple Google experience. Technology should do all the hard work, liberating users to get on with the important things that matter in their lives and this screen independence is at the core of our strategy. Take Chrome on Android, for example. We only launched in February, but the experience is already amazing. When you are using Chrome, switching devices is truly painless. All your tabs are there, ready to go. Search on your desktop and the result is right there on your smartphone. You can even click the back button, and it just works. And as more users upgrade to Google+, it’s now over 400 million, users are enjoying amazing experiences across devices like instant photo upload. In the same way, we want to make advertising super simple for customers. Online advertising has developed in very device specific ways, with separate campaigns for desktop and mobile. This makes arduous work for advertisers and agencies, and means mobile opportunities often get missed. So we’re working to significantly simplify the campaign experience, working very hard on that. Advertisers should be free to think about their audience, while we do the hard work of dynamically adapting their campaigns across devices. I’m very excited about this. I talked at the start about the abundance of information. In the early days of Google, you would type in a query, we’d return ten blue links, and you move on fairly happily. Today, you expect more. You expect Google to understand deeply and you expect us to turn your intentions into actions in the blink of an eye. If you search for Tom Hanks movies, chances are you want movies with Tom Hanks and thanks to our Knowledge Graph that’s what we show now, right from the results page: clean, fast, and organized. And if you’re shopping, say for Ugg boots, we now give you pictures, details about the different boots, prices and information about the local inventory, again right from the results page, clean, fast, and organized. There’s much more we can do to get you the right information at just the right time. You might have a really important event in the city perhaps a first date, and the traffic is bad. You need to leave early to avoid being late. Or maybe you’ve just landed in a new country and you’re at the airport ATM trying to figure out how much cash to withdraw? Google Now, which we launched on Android in June, gives you all that information and more automatically, with zero effort required on your part. It’s still early days, but these kinds of tips and recommendations are super powerful. They really save users time and hassle. This is why I’m incredibly excited about the opportunities ahead, given our expertise in Search and Mobile, and our track record monetizing high usage products. Everyday, I wake up and I’m delighted that our opportunities keep growing. And that we’re birthing to our users great products that are defining the future. It’s a truly exciting time to be at Google. And now, you will hear from Patrick some details about our quarter.
Patrick Pichette: Thanks, Larry. Good afternoon, everyone, and thank you for joining us. Overall, we are very pleased with the growth trajectory of our business this quarter and this in fact despite significant currency fluctuations in many of our international markets. So for example, if currencies had remained constant year-over-year, our consolidated revenue growth would actually have been 6% higher. On a positive note, our U.S. growth continues to be strong. And as Larry noted, we’ve got a great quarter on the product front gaining traction in a number of critical areas. So before I dive into the financials, I just want to give you a bit more detail on the new $8 billion annual mobile run rate that Larry mentioned. The new run rate is different from the one we gave you a year ago. And more specifically, last year, it included only our gross revenue from mobile ads, but this year, in this number we also added the gross revenue from the mobile sales of Google Play content. And finally, it also includes the consumer spending on the Play apps. So with that and now why don’t I just jump into our financial performance. Our total gross consolidated revenue grew 45% year-over-year to $14.1 billion and that’s also 15% quarter-over-quarter. Google’s Standalone revenue grew 19% year-over-year to $11.5 billion, 5% quarter-over-quarter. In that, our Google Website revenue was up 15% year-over-year to $7.7 billion, 2% quarter-over-quarter, with strengths across most major geographies and verticals. Our Google Network grew 21% year-over-year to $3.1 billion and 5% quarter-over-quarter. And our other revenue grew 73% year-over-year to $666 million, 52% quarter-over-quarter and this driven by the Nexus 7 sales. If it were not for these currency fluctuations, Google Standalone revenue would actually have grown 24% year-over-year. As Larry mentioned, Google Standalone business continues to perform very well. A dramatic growth in our new devices is driving mobiles queries and clicks. And although it’s early days, some of our existing ads have better monetization in desktop already today and we’re confident that this transition opens a whole new space for innovation and new format and future monetization. Turning to MMI, Motorola gross revenue was $2.6 billion. The mobile device division revenue for that period was $1.8 billion and the home division revenue was $797 million, but we’re really pleased with Motorola’s progress in its 150 days. As indicated in our public filings, our team has made a lot of operational changes, we harmonized and narrowed the product portfolio, there’s been streamlining of software operations and we scale back the markets in which we operate. But that said, we are just at the beginning of the Motorola Google story. And we should expect, as I mentioned before, results from this segment to be quite variable for quite a while yet. Remember that we inherited an entire product pipeline where hardware business cycles are typically in a 12 months to 18 months. At Google, our aggregate paid click growth was very strong again this quarter up 33% year-over-year, 6% quarter-over-quarter. Our aggregate CPC or cost-per-click was down 15% and down 3% quarter-over-quarter. But once again please remember that currency headwinds also had a significant negative impact on our CPCs in Q3. In fixed FX terms, aggregate CPC would have been down only 8% almost half of the 15% and down only 1% quarter-over-quarter. Turning to geographic performance of Google Standalone business, we continue to see robust performance in the U.S., the UK and Japan. On the other hand, we felt the continued impact of the economic situation in continental Europe, but we’ve seen pressure in sectors like travel and retail. In our earnings slides, which you can find in our Investor Relations website, you’ll see that we’ve broken down our revenue by U.S., UK and rest of world, to show the impact of FX and the benefits of our hedging program. So please refer to those slides for the exact calculations. Revenue from the U.S. was up 23% year-over-year to $5.4 billion. The UK was up 16% to $1.2 billion, which includes $6 million of benefit from our hedging program and in FX term; in fact the UK grew 20%. The non-U.S. revenue excluding the UK accounted for 42% of our total revenue or $4.9 billion, up 15% year-over-year, but in fixed terms, in fact was 26%. And all this includes a $56 million benefit from our hedging program. So let’s come back now to an aggregate level for total consolidated business. Our other cost of revenue was $3.6 billion in Q3 excluding our stock-based compensation. Non-GAAP operating expenses totaled $2.9 billion, which again excludes SBC and the restructuring and related charges recorded in our Motorola business. And our non-GAAP operating profit was therefore $3.8 billion in Q3, resulting in a non-GAAP operating margin of 27%. For Google Standalone, our traffic acquisition costs were $2.8 billion or 25.5% of total advertising revenue. Our other cost of revenue was $1.6 billion and that excludes $103 million of stock-based compensation. The increase year-over-year in this other cost of revenue was driven by data center costs, equipment costs and including costs associated with the sales of the Nexus 7, and finally, content acquisition costs. Non-GAAP operating expenses were $3.2 billion, excluding again SBC of $585 million. And finally, our non-GAAP operating profit was $4 billion in Q3 resulting in a non-GAAP operating margin of 34% for Google Standalone. Lastly many of you’ve asked for the depreciation and amortization expense on PPE for standalone Google, which was $465 million for this quarter. If we flip to Motorola, our total non-GAAP operating expenses including cost of revenue totaled $2.7 billion for the quarter. And keep in mind, that intangible amortization expenses attributed to the standalone Google and Motorola are included in these non-GAAP measures. And as a result, the non-GAAP operating loss of Motorola was $151 million for Q3, resulting in a non-GAAP operating margin of 6% for that segment. Let’s switch over to headcount. For the consolidated business, it decreased by roughly 1,000 in Q3. Standalone Google added about 1,800 people. And remember that historically, we often see some seasonal effects on the hiring in Q3 as folks that we hired in the spring and early summer actually start working in September. In total, the consolidated company ended up the quarter around 53,500 full-time employees. Our effective tax rate for this quarter was 22% in Q3, the changes from last quarter reflects the mix shift in earnings between the domestic and international subsidiaries and our hedges, but finally, fewer capital gains offsets versus last quarter. If you allow me to turn to cash management, OI&E or other income and expenses was $62 million, which reflect the continued impact of our FAS 133 expenses of our hedging program, but also fewer capital gains versus last quarter. For more detail on OI&E, again, please refer to the slides that accompany this call on our IR website. Operating cash flow was very strong, $4 billion. CapEx for the quarter was $872 million versus last quarter’s $774 million. The majority of our CapEx spent is in – continues to be related to production equipment and facilities related purchases. All this actually delivers us a free cash flow, which was $3.1 billion with which we’re quite pleased. The success of our product really gives us the confidence to continue to fund the strategic growth areas, areas that Larry talked about such as Search, YouTube, Android, Chrome, and as always we continue to show our discipline in making the touch calls on products that just don’t live up to our expectations. In Q3, we’ve seen a number of these decisions including the sunset of our Google TV Ad as an example. So with that, I will hand it off to Nikesh, who will cover more detail on our business performance in the quarter. And after his remarks, we’ll open up the phones for Q&A. Nikesh, here’s to you.
Nikesh Arora: Thank you, Patrick. I’d like to reiterate what Patrick said. Our business had a strong quarter with $11.5 billion in Google Standalone gross revenue. I want to talk to you about our focus and progress on four major trends that are actually helping to drive our business growth. First, a trend Larry already talked about, the rise of the multiscreen consumer. This is creating huge opportunities for us especially in our advertising business and focus on video and mobile. At the moment, everybody thinks about the online world is divided into desktops and mobile. Larry shared the amazing $8 billion run rate. And I believe in the medium-term, these screens will continue to diverge, but advertising opportunities will converge to allow our marketers to run common campaigns across all these screens. Our teams have been putting the same focus on mobile and video the last few quarters that we brought to display a few years ago. And it’s rewarding to see it bear fruit. We’ve intensified trading for our sales team across the globe, integrated sales tools, so we can really bring our customers’ mobile video, Search, Display as a cohesive solution. We're also educating our advertisers through initiatives like Go Mobile to ensure they have the right creators and landing pages to make mobile truly work for them. However, we feel the progress we’ve made is just the very first step in the journey of monetizing many screens Larry talked about. As we develop advertising that can take advantage of the context in which consumers use this many screens, we expect to continue to see better monetization. As we help marketers reach consumers closer to the point of purchase, the opportunities will only get bigger. We’re already seeing glimpses of this. Take T-Mobile, who use location based mobile ads to drive people nearby into their stores, and in their words, win the last 10 feet. They achieved a click-through rate of about 13%, in what is a very successful strategy. These rates are 3 to 4 times of what you would see without using some of these context. And our Click-to-Call ads work because consumers can respond by contacting an advertiser immediately from the ad, generating approximately 20 million phone calls per month for our clients through our various call products of advertising. The second trend, which I’m excited about is, it’s not just the context that matters, but also our ability to deliver more precise answers to consumers, something also that Larry talked about. We are working very hard in this. Larry talked Google Now and Knowledge Graph; it’s exciting to see how that even makes opportunities for us happen, as Search become smarter in a commercial environment. We can do a better job of connecting marketers with consumers in the moments that matter, irrespective of what device they are using. For example, we’re pleased that as of yesterday, Google Shopping completed its transition to a fully paid model based on product listing ads. Now we’re providing product information, pictures, pricing, local inventory information, over billion products from tens of thousands of merchants and over 100,000 sellers. So the new Google Shopping experience, Adorama, one of the US’s largest photo retailers and mail order suppliers saw their click-through rate jump by 176%. Their conversion rate went up by 100% in June as compared to near earlier. Using the same technology that powers our Knowledge Graph, we’re providing better answers with Google Shopping in other areas where users want to make a purchase. We’re going to reduce the number of steps from search to transaction, making the online experience even more valuable to consumers and marketers. The third trend, which I’m excited about is that we’re actually making real headway amplifying offline brand campaigns with online media. We have a unique approach that helps advertisers succeed across media. We allow them to use and leverage the attributes of each media and adapt their campaigns for online success. YouTube energized by new professional content and Display are the core of this business helping clients increase awareness, increase capability, and also drive engagement. In addition, we also continue to make progress in our end-to-end technology platform to help advertisers of all sizes succeed with display advertising. Today, our top partners in the agency world and very large advertisers and publishers, are using a consistent technology stack. The number of impressions that we’ve been able to pass through AdX and Invite platforms have doubled over the last year. We are also working on creating more video premium inventory without channel strategy in YouTube as more and more viewers move to online video, we expect more and more brands will do the same. Our brand business is actually creating quite a buzz in the industry because we have great media and our solutions really work. For example, on YouTube, we looked at about 92 different ad campaigns with sales impact, we found that an average spending on YouTube was approximately 2.4 times more efficient than the equivalent television spent. We have 200 times more video advertisers than the average U.S. television network. In our TrueView format, in which advertisers only pay for ads that users watch has really taken off. We have twice as many advertisers using TrueView since last year. That’s a very important statistic, but like any good brand marketer, the best way for me to show you – tell you a story is to actually show it. So let’s see what two of our leading brands have done this quarter. We launched the YouTube Gillette Football Club with Procter & Gamble in Europe, we’ve created global brand platform for Gillette that will reinvent the way people watch football online. The campaigns have generated about $30 million video views. We are working with Coca-Cola on their Vitaminwater branding effort. We’ve partnered to build a strategic music program leveraging YouTube as a platform to anchor, distribute and syndicate the video content. It’s particularly exciting to see that over 100 brands now have over 1 million followers in Google+ including ESPN, PlayStation, Ferrari, H&M, Burberry and Toyota. Last trend I want to talk about is the trend of cloud computing in the enterprise. Our enterprise business continues to thrive. We saw especially great traction in retail and education sectors this quarter with Dillard's, Kohl's, and Office Depot, all using Google Enterprise products. In education, there are over 20 million students, faculty and staff, non-Google apps, Princeton, Virginia Tech, and even the Philippines Department of Education which has over 600,000 users. With the recent launch of Google+ for enterprise customers, organizations of all size – sizes including capital and Banshee Wines are starting to use our Hangouts and other tools to work together and get things done from anywhere. In addition to all these trends, our marketing team continues to do an excellent job. We launched a global cross-product initiative to bring the 2012 Olympics to our users worldwide. YouTube streamed the games like to 64 countries. Also YouTube was the efficient live streaming provider with over 1 million hours of live content for the democratic and republic of national conventions. And we passed yet another milestone just this week and YouTube broke it’s own record to reach more than 8 million concurrent live streams of Felix Baumgartner’s recording breaking leap from space with the Red Bull Stratos mission. So with that as an update, I'm going to hang your back to Patrick.
Patrick Pichette: Thank you, Nikesh. So Jennifer, if you would like to tell us the rules we will just get on for the Q&A session.
Operator: (Operator Instructions) And we will take our first question from Ross Sandler with Deutsche Bank.
Ross A. Sandler: Thanks guys. Nikesh, one quick question on revenue and Patrick one on expenses. The international and rest of world organic growth was 26% pretty strong, but down from 29% last quarter. So is there any incremental weakness that you saw or was this just mostly from a tougher comp? And then Patrick, your sales and marketing expense was up 18% from last quarter that's a bit higher than the typical increase in 3Q, can you talk about what’s driving up those investments? Thanks guys.
Patrick Pichette: Okay, I’ll start, Nikesh and I are pointing at each other. Yeah, on the marketing expense listen, I think what you see is the impact of the support for the Nexus 7 that we launched in Q3. Otherwise everything was pretty much in line with what we would expect. We just got such a great review of the Nexus 7, we won the support of the market and that's the biggest delta you will see in that number. In terms of the market, I’ll hand it over to Nikesh for his commentary.
Nikesh Arora: I think it's fair to say that, our revenue growth internationally has been pretty strong. You are seeing some pockets of difference in performance partly because of seasonal reasons and partly because of the continuing economic effects you’re seeing in Europe. So our business is doing better than the economy in most markets in Europe, but it does get impacted a little bit with some of the fluctuations you see there. So from our perspective there is no any cause for concern.
Ross A. Sandler: Okay. Thanks, guys.
Patrick Pichette: Thanks, Ross. Jennifer, let’s go to the next caller please.
Operator: And we will take our next question from Scott Devitt with Morgan Stanley.
Scott W. Devitt: Hi, thanks. Just wondering if you could talk a little more about the strategy behind the decision to monetize product listing ads and then more broadly about the retail strategy for the company? And then secondly, Google website revenue net of distribution tax lowered to 13% from 20% last quarter, I was wondering if possible you could Patrick normalize that for currency to get a better understanding of FX neutral for website growth? Thank you.
Lawrence Page: Hello Scott, this is Larry. On this question about the strategy and product listings, I think we’re just really excited about providing a better experience for our customers. When they search for something I mention boots on the call, now you search for that, I think you'll see a well organized set of product information, ways to buy it and really have a great experience there. And we see, our ability to do that on the ads or monetized product listing side, it’s really helping us provide a better user experience and provide a better advertiser experience. So I’m very excited about that. I think we are still in the early stages of that. We just launched, I think yesterday really and we still got ways to go. So I'll let Nikesh or Patrick take the next question.
Patrick Pichette: On your question relative to our Google site and tech, I’m not – could you just repeat your question, I not sure, I understood what you meant?
Scott W. Devitt: I’m just trying to understand better the – you suggested the 600 basis point effect from currency and I was just wondering if there is a better way to understand the way that currency effected Google site revenue, if I should think of that any differently than the overall currency?
Patrick Pichette: I see, so no, it's even the, I mean we have – our network is slightly skewed to the US versus our Google site, so you’ll have some mixed effect there because our network is slightly skewed to the US, but overall I think that it still gives you a good sense of proportion as to what's going on in the market. So that’s the way I would kind of think about it from a model point of view.
Lawrence Page: Let me just add – now it’s on the first part of the question, I think we are really trying to provide answers to people and so, and the strategy for the company really looking at very detailed information and giving you the exact right answer, what we’re doing with knowledge [tides] [ph]. And in search, I wanted to do the same thing as with our advertising to make sure that we get you, as a user in the right answer. And I think that's a very exciting sort of a new strategy for us.
Scott W. Devitt: Thank you.
Patrick Pichette: Thanks Scott. Jennifer, let's go to the next question please.
Operator: Next question comes from Mark Mahaney with Citi.
Mark S. Mahaney: Great, thanks. Two questions please mobile searches are really strong, what’s happening with desktop searches. At some point it's probably reasonable to assume that they’re flat lined, we already reach that. And on the expense side if we just looked at the core Google it looks like the margins are coming down, but if you did roughly $200 million may be in Nexus revenue and if you really sold those devices at cost then margins are actually better than they have been in two year, which is the more accurate interpretation? Thanks.
Patrick Pichette: Actually, let me start with the margins and then I will answer your first question. On the margins you actually have a couple of effects this quarter, one of them, is clearly as you said the cost of the Nexus that will flow into our other cost of revenue, but also it's the first time that you have the full quarter effect of the amortization of intangibles from the Motorola transaction. So that is also another big kind levered that actually kicked in. and it should noted just for the financial community that the amortization of intangibles for Motorola flows to both the Google segment and the Motorola segment in different proportion. So again, it’s pretty tough, as I promised you that we’d have a lot of kind of noise in the data, I think that’s a good set of indication. And for the first one, why don’t I let Larry give a few comments on the issue of mobile.
Lawrence Page: So I guess, I feel like you are asking the wrong question a little bit. I think we are really starting to live in the new reality, one where the kind of ubiquity of the screens helps users really move from intent to action much faster and more seamlessly. So I think this will create a huge new universe of opportunities for advertisers where they can focus on platform. Focusing on platform specific queries won’t make us much sense because advertisers will be dynamically adopting across a whole bunch of different devices to reach the right audiences at the right time. And that’s kind of how we are thinking about it and I alluded to changes that we'll make – to our ads system to improve the advertiser experience and the user experience around that. And I also think that, we are just seeing tremendous growth in the Android, which really obviously we have tremendous ability to influence and to improve the user experience, to add location, to notify your things as I mentioned around different kinds of non-commercial experiences. We can notify you of commercial experiences as well. So I think that’s a really big and great opportunity for us. And as I’ve said, that monetization on mobile queries right now is a significant fraction of desktop. So we're kind of living the best of both worlds, we’re able to move our existing ads, our existing monetization over to mobile. And lastly in order to really innovate using Android and our strength of having ads on other mobile platforms and really move advertisers and consumers who into a new world. So I think we are uniquely positioned to get through the transition and it’s really profit from it. So I am just incredibly excited about that.
Mark S. Mahaney: Thanks for the correction Larry.
Lawrence Page: Thanks. Jennifer let’s got to our next question please.
Operator: Our next question comes from Carlos Kirjner with Sanford Bernstein.
Carlos Kirjner: Hi, two questions, if you run a website with proprietary high quality content today and have to choose a protocol to add, meta data about this content, why would the clear choice would be the Open Graph protocol instead of RDF or one of it’s variables and if that happens and the semantic web arises on the back of open graph doesn’t it place Google at a fundamental disadvantage to achieve the vision that Larry laid out in the beginning of the call. The second question is what do think is the future of vertical search and why is that there are sites that specialize in certain vertical such as travel and local, that seem to do a better job than Google today and if this is going to change over time and what happens with vertical search? Thank you.
Lawrence Page: Yeah, Carlos, I’ll take those questions. I think if you - I'm not an expert on the protocols you’re talking about, I think in general we made a huge investment in knowledge graph and really understanding in detail about everything. And that’s a major effort for us, and we’d obviously love to have other people help us with that. I think it’s been a little bit of a challenge in the past to get all the labeling aligned and all those things. I think we have a big part to play in that. We’re absolutely very excited about that and I think we’re going to do a lot work in that area. And I think we’re doing well in that space. Vertical searches, as you asked about, I think our goal has always been to get you to the right place, but we also – to do that we need to really understand in detail, your context, what you need, what’s really going on with that information, if it’s airline tickets, what are the flights between, what do they cost, products, some one selling we need to know how much they cost to get to know what the shipping is and so on. So I think any place we can get that information accurately, we can present it to our users. However we are very happy to do so. In general, we found that we knew it’s really, build more of that experience in order to provide a really high quality experience to our users. But again, we’re always open alsoto working with partners.
Carlos Kirjner: Thanks you.
Patrick Pichette: Thank you, Carlos, for your question. Jennifer, let’s go to our next question.
Operator: And we will take our next question from Ben Schachter with Macquarie.
Ben Schachter: One question for Larry and then a couple of housekeeping points on the Apple relationship for Patrick. Larry, there is a lot of this talk about internet use on mobile devices, but switching gears a little, I just wonder if you could talk about the potential for internet access on television screens and how Google might benefit from that? And then Patrick, just two quick housekeeping questions on Apple. One, is 100% of the TAC that you pay, Apple recognized in the Google.com TAC line, and then on iOS 6 there is a seemingly small change in the default search bar right now, says the word search where they used to say Google. How does if at all that change the economic relationship between Apple and Google? Thanks.
Lawrence Page: Okay, so Ben thanks for the question. I mean, obviously we were exited about television, television screens, displays and we have been for a while. We’ve had Google TV, it was a product for quite sometime, I’d just say, I love it and I think it’s a great time to have a real browser, mail on your television, easily access You Tube and all those kind of things. YouTube is integrated on many, many devices from DVD players and so on to game consoles and things like that. So we obviously are working hard to get distribution for YouTube, for Chrome and for the internet as a whole on television screens, as well as our own products, and we’re very excited about that. I think we are obviously still in the early stages of that, something we really has a great user experience, and we work hard to make that happen.
Patrick Pichette: On the – sorry, just want to talk about the TAC line and just to say that, yes, I mean obviously all the TAC that we paid to Apple, it is just another partner for distribution, so it all is tied to our – the TAC line that we have for Google.com. On your question of the default, I mean although there is – nothing is changed, right, I mean, when you use Google, we are a great partner with Apple, we’re a great partner with many of them, and in doing so, when you do search, I mean we have a great, we have the – the fact that they’ve changed from Google to search is still kind of run by our engines. So I hope that clarifies the point Ben.
Ben Schachter: Okay, thanks.
Patrick Pichette: Thanks, Ben. Jennifer let’s go to the next question please.
Operator: Next question come from Anthony Diclemente with Barclays.
Anthony Diclemente: Hi, thanks. I started to harp on the CPC question, but you mentioned them being down 8% XFS. Can you just Patrick, talk a little bit about the other drivers, I think everybody assumes that the bulk of the down 8% is mobile, but I know there are other factors driving that down 8%, so if you could just kind of give us order of magnitude in emerging markets and so forth if possible? And then secondly, on allocation of your sizable free cash flow and on your cash balance Patrick in the past you’ve talked about reviewing and considering capital returns at the Board level. And at the same time you’ve talked about your cash balance being a strategic asset for Google, just wondering if you could give us an update on yours, on Larry’s, Board’s thinking on allocation of capital and use of your cash balance? Thanks for the question.
Patrick Pichette: Yeah, listen, on the CPC trends nothing has changed from last two quarters. And in fact, I think people have a tendency just to harp and assuming that it’s automatically mobile…
Anthony Diclemente: Right.
Patrick Pichette: And if you look through our results, I just kind of point to a few areas, if you look at our mix between our Google properties and our network, right, our network grew quite a bit again this quarter and that would drive a lot of pack as well. So I and again that’s the reason why I kind of want to educate and tell and remind everybody that just all of these mix effects whether it would be mobile versus laptop versus desktop, but also emerging market versus developed markets and also our Google.com versus network. And then we haven’t even talked about the changes in our ads quality, which actually can change quite a bit as well. So I think that matters a lot, and I think that it’s really important now we understand that all these mix effects are actually playing or play there in the CPC. So and that’s what we don’t give, if we start giving down all the breakdown right, it’s just endless. So for us, the real issue for us is, but what really matters is, they are going down, but on the flip side of that, right, given all these mix issues, what we really see is our pay clicks going up at a pretty healthy rate at 33% again this quarter, which actually gives you a sense of people who are engaged, people are using our products, it’s really about this transformation of multi-devices and in fact that there is a little bit less CPC is not a concern compared to all the offside that we see on the other side. On the issue of our cash and capital balance, I think, you get the same answer and maybe Larry wants to kind of chime in if he wishes to, but we just review this on a constant basis. We ask ourselves the question, is there real options for us actually to use the cash from a strategic perspective and we’ve come to the conclusion that it is a real strategic asset for us right now with the ability to balance. And so we think it’s prudent to actually manage our capital structure to where it is as we speak.
Lawrence Page: We have nothing to announce at this time.
Anthony Diclemente: Okay. Thank you very much.
Lawrence Page: Thank you. Thanks, Anthony.
Patrick Pichette: Thanks, Anthony.
Lawrence Page: Can we have the next question?
Operator: Next question comes from Heather Bellini with Goldman Sachs.
Heather Bellini: Great. Thank you for the question. I have two for Patrick and then one for Larry. Patrick, I’ll start out with yours first. Can you give us an idea of the run rate that you are talking about, the $8 billion for mobile, can you give us an idea of what that is on a kind of same-store sales basis, you gave us the $2.5 billion run rate last year, what is the mobile advertising piece, I think that’s something people are really interested in, so extra stuff from Google Play? The follow-up question I had for you was, what’s the margin profile on the Google Play content revenue that you’re recognizing? And then the question for Larry is, I guess just in listening to Mark Mahaney’s question, I was wondering in this new reality you mentioned in response to his question, how does Google Fiber play into this vision to have your content and search capabilities go across multiple screens? Thank you.
Lawrence Page: Okay, I’ll let Patrick, take the first part.
Patrick Pichette: Okay. So on the $8 billion, so let me give you just a bit more information on it, but clearly we don’t breakdown each of the categories, we just wanted to kind of give you a sense of proportion. A point that’s important is, of the three categories I gave you, ads continues to be the bulk of it, the vast majority of it. And then on the case of the Google Play, it’s important to note from a modeling perspective that everything’s that’s content, that is whether a book, a movie content is actually booked on our books on a gross basis. Everything that is tied to apps is booked on a net basis, but it’s still a huge kind of number in all cases. So without giving you, I just want to give you that, so that you don’t start thinking that there is actually 8 billion that is book to revenue in our result that you see, but in fact, two of the three are there, the third one is done on a net basis, just because of our accounting rules. So and the vast majority is still ads.
Heather Bellini: And can you just give us a sense of the margin profile on the not ad piece?
Patrick Pichette: We don’t provide that. We don’t give any of the details of that. But clearly, it’s a different profile, because it’s content, so we have partnerships that we deal with.
Heather Bellini: Great.
Patrick Pichette: On the case of, why don’t I turn it over to Larry to talk about Google Fiber and Google TV.
Lawrence Page: Hi, Heather, it’s a great question. I think, Google Fiber I think we are in the early stages, right, it’s just rolling in out in one city or two cities that are one city. And we’re really excited about it and I’m excited about the user experience there. In fact, I think I’m about to go, went soon from my asked trials. But you control it with a Nexus 7 tablet actually, that’s the remote for it. I think it will be an amazing experience from a user standpoint, one that can really drive that industry forward. So are quite excited about that like said we are in the early stages, obviously rolling that up.
Patrick Pichette: It’s worth just to close on that. It’s worth kind of noting also that we are pushing for the next chapter of the internet in the U.S. with Google Fiber. People, there is such a demand for higher speed access at reasonable prices, I think that we got a great mouth trap with Google Fiber and we hope it excites everybody and promote the environment that will actually give us that kind of connectivity in the U.S. and elsewhere as well.
Heather Bellini: Thank you.
Patrick Pichette: Thanks. Jennifer, let’s go to a next question please.
Operator: Next question comes from Douglas Anmuth with JPMorgan
Douglas T. Anmuth: Great, thanks. Just want to ask two questions. First is just following up on Scott’s earlier question, we saw a deceleration in Google Properties and then an acceleration on network side. But hoping that you could talk about a little bit beyond the U.S. and the international mix, is there anything else that you would attribute those dynamics to. And then secondly, you talked a lot about multiple screens and ambiguity of devices, how concerned are you that in a mobile world, behavior is different and we’re living in more of an apps-based environment and Google might not be that starting point for people on mobile devices. Thanks.
Lawrence Page: Yeah, thanks. That was a great question, Doug, I’ll take the second one first. I think a lots been made on that note, I don’t think that’s really true, kind of apps versus search. We obviously have a great position in apps, we have the Android Play Star, which has a huge number of apps. And I think that those experiences are good experiences and there are some things that are better than them, but to us some things that are better than the web of the apps. I think over time, we do our jobs right, you have the same capabilities in both places, and we have such ability in apps, you built some more usually good apps, the same way you go to webpage and so on. So I think anyway I think those differences will emerge or where it is tenures over time. I think we obliviously have a strong position in both. So I’m not so worried about that. I think that there is obviously innovation that goes out of mobile and we talked a little bit about all the different context and location you could have on mobile, the fact they’re always carrying a device with you and those things are very powerful. So you want all that when you are on desktop seller on the web, you want that same information. And so we wanted a seamless experience that goes across both mobile and desktop and TV or whatever screens you have, and that’s what we are building. I think that we are going to see tremendous in these things. The other point I make is that, there is a small, relatively small number of people right now that have Chrome on their mobile devices. And I find Chrome on my mobile device like the same is having a desktop computer a year ago or something. And it’s an amazing experience. You can buy things. It remembers your credit card numbers and that means it’s a very, very easy great experience. That’s been, that’s rolled up to a relatively small number of people, but it will be increasing quickly. So I guess just seeing all those trends, I think it’s tremendous opportunity for us. And I don’t think people are really thinking about it correctly now. So Patrick, do you want the cover the detailed question?
Patrick Pichette: Yeah, with pleasure. Look just to reiterate that our Google website’s revenue was up and with strength across most geographies and most verticals. I mean obviously you’ve heard Nikesh talk about, Douglas, we can’t control the economy in the short term, so if there is a country that is slowing down a little bit then we clearly kind of see it in the result as well because Google is actually a pretty good protector of the present as far the economists are varying kind of reminds us. But then on the Google Network, I think we’re just really pleased with, it’s skewed slightly more to the U.S. but really pleased with the performance overall with all of our networks, that’s been performing well. So nothing additional to kind of highlight apart from just a good general trends.
Douglas Anmuth: Okay. Thank you.
Patrick Pichette: Jennifer, our next question please?
Operator: Next question comes from Richard Kramer with Arete.
Richard Kramer: Hi, thanks very much. I’ve got some, one question for each of you, if I may, for Larry if you could just expand a little bit more on YouTube and maybe provide not only some metrics, but really your may be three to five year vision of its rolling video distribution between Google TV and the fiber project and some of the other options. For Nikesh, could you talk a little bit about emerging markets and where Android really is the dominant not only in scale, mobile computing platforms, and what may drive that to show faster international growth, if its having sales force or purchasing power or something else and maybe Patrick, could you help us understand a little bit the FX headwind on the top line how it might have been expressed moving down the P&L especially in sort of net profit terms. Thanks very much.
Lawrence Page: Richard, that’s a great question on YouTube. I haven’t had, Nikesh mentioned Google TV for a while, I think recently kind of YouTube transition from maybe a year ago, to be really something that keeps me entertained for hours on the TV. It can play back, lots of really high quality, highly exciting things, they are now kind of tailored for me, my channels and so on and I think we have tremendously increasing YouTube usage, continues to grow like crazy. And we’ve head increasing monetization as well which causes people to put more content on it, and to monetize it worldwide, kind of in a blink of an eye you can put things up. So I was just, the recent video of horse dancing, came in style. I have been watching, its 400 million views now – 500 million. And that kind of thing to really just put the switch, turn it on, get a worldwide distribution and sort of – almost without doing any work, if you are a provider of this content is an amazing thing. And I think that’s how we see the future, we’re just kind of continue to grow that. It is going to be available everywhere on your mobile, on your TV, on your desktop wherever you want. It’s going to keep track of the kinds of things you’re interested in and really provides you an amazing experience, and provide a great experience for the advertisers, true view is exploding, which gives us high quality ads from an end user standpoint, because they can skip some if they want. So it encourages paths that are actually entertaining, not annoying, and that’s been working or making money over that and it’s coming like crazy as well. So I couldn’t be more excited about all that.
Nikesh Arora: Thanks Richard. As far as the emerging markets in Android, I mean I think we’re very excited about the fact that Android is becoming very successful platform in many markets, outside the U.S. not just the U.S. I think in terms of what drive, I am not sure if your question is about faster growth of Android or faster growth of monetization on Android platforms. I think on both of them, we’re seeing the adoption in various markets, there OEMS are producing Android devices on the bleeding edge and doing a phenomenal job of working with operators in those market and distributing them, so we think that will continue because and Android is providing to be a great platform for innovation for all the OEM. In addition to that as more and more people use mobile device, I think we’ve talked a lot in this call about have those mobile devices are being used, we are seeing an increasing in query growth and we are seeing our various new ad formats and ads where we bring context into account is actually helping us monetize. So I think both those trends are going in the right direction. Hopefully that provides more opportunity for us.
Patrick Pichette: Let me close on FX, so Richard, just two points, one is, it’s been interesting in Q3, the U.S. dollar has really weakened versus a whole host of currencies, so typically you have one currency that goes down another one is more stable, we’ve really seen it across-the-board, it just happens with the macro economic trend, again, it’s something you can’t predict. So it’s been across-the-board and without giving you the details of how it flows to margins, it is fair to say and we’ve already talked in the past that our operating expenses are skewed to the U.S. I mean Mountain View is the headquarter and so from that perspective it has some effect as well. So I think you can navigate through this. So it was definitely a significant impact for this quarter.
Anthony Diclemente: Okay. Thanks.
Patrick Pichette: Thanks, Richard. Jennifer, let’s go to our next question.
Operator: Our next question comes from Justin Post with Merrill Lynch.
Patrick Pichette: Justin, are you with us?
Justin Post: Can you hear me now?
Patrick Pichette: We can.
Justin Post: On a high level, I just want to know, if searches on mobile the same quality in your estimate as PC I mean are you still getting good high CPC travel and e-commerce searches on mobile? Second, maybe you could talk a little bit about the rollout of Google product search seeing those ads definitely in core search results and could that have an impact in Q4? And then maybe some detail on the hedging program, this is one of your worst year-over-year hedging, I’m sorry, one of your worst year-over-year FX impacts down $500 million and now you get a $62 million benefit and I think you disclosed the cost was 124. I guess there is there something you can do to kind of improve that the ratio is there and not spend so much and a get a better benefit win FX is negative thanks.
Lawrence Page: Yes, Justin thanks for the question. I don’t know the details of the particular queries on the Google Desktop, but I can tell you I think like for example in Travel we bought IT software for a sizable amount, we thought it was important to provide a better experience there, when you type cities and you want an airline ticket, you actually need that detailed information, and I think I’m not worried about any of that to the extend we provide great an amazing user experience for people. However they are looking for all types of different kinds of information as long as we’re providing again that very detailed, very organized customer results of people, I think that translates across all of your screen is just fine. Nikesh or Patrick, do you want to?
Patrick Pichette: Again jumping on to the FX issue if you don’t mind, look I think that it’s interesting your question Justin, but let’s remind ourselves of a couple of points, because I think our FX program has actually delivered amazing value to shareholders. One is, we don’t hedge revenue, we hedge profits. And we hedge a number of kind of major currencies like the Euro, the Pound, the Canadian Dollar, few others which is the core of our program, and not only but actually our hedge program is certainly designed for long-term kind of 18 months as a risk reduction strategy and doesn’t necessarily correlate in a way we should perform for three months kind of timeframe in our financial results. And it’s really also build to make sure, I guess you had a cost benefit ratio, thereof making sure that it’s set for bit dislocations. So if it’s just a smaller variance in the short-term, you are not going to get us much benefit as it is a big dislocation. So for all these reasons and then what I mentioned a bit earlier, which is we’ve seen actually FX across a whole slue of currencies this quarter, which these smaller currencies just added up and we don’t hedge for them today. That’s what kind of ended up in the puzzle. So we are constantly looking at our forecast and if it makes sense we will actually throw in new currencies going forward. So that’s been the story on FX, but I wouldn’t read in anyway (inaudible) performed that it hasn’t performed well, it’s performed very low. So why don’t I turn it back over to Nikesh for the last question.
Nikesh Arora: Yeah, in terms of the product listing ad as we talked about, we’re really excited that we actually went on a full rollout for product listing ads and as we’ve said we have 1 billion products that are in there. So as we’ve also, as Larry talked about getting more precise information. We believe that users when they search they come exploring on the web, when they have a better idea, what they are trying to buy. They start expressing intent by being more precise of what they ask for. And we believe being able to do product listing ads gets us closer to intent because if somebody types a Nikon D800 then we know they are looking to buy or looking to get more information about a specific product and the fact that we can show them reviews pictures and pricing information gets us closer to action. And we believe in the medium term that’s going to create more monetization and a better monetization for us as opposed to having just 10 blue links of ads we’d send them to other websites. So I think that’s going to have a good impact in the medium term, I don’t think I’m going to comment whether that has an impact in Q4 or not.
Justin Post: Great. Thank you.
Patrick Pichette: Thanks, Justin, for your question. We will go for one last question. Jennifer, please?
Operator: We will take our last question from Brian Pitz with Jefferies.
Brian Pitz: Great. Thanks. Larry, bigger picture question on your mobile comments, would you give us some rough sense of how long it could take to close the bulk of the gap between desktop and mobile monetization, is this a matter of quarters or years that will see that come together. And then maybe just you made a quick comment on travel weakness last quarter, I think you said travel was strong across the board. And then you came back today and said it sounds like that was a weaker category, just anymore color on the weakness of travel? Thanks.
Lawrence Page: Thanks Brian for the question. And we have kind of policy of not talking about the future, so I think it’s generally a good policy. I tend to be very impatient and I think, I kind of reiterate what I said that we are positioned well, very, very well, and uniquely well, because we have hardly very significant fraction to monetization on mobile and that’s a great start. And we’re working on changes, we do things we’ve been investing in this space for long, long time right, our mobile monetization is not zero, it’s a very significant number. As we try to end also with $8 billion number. And I think that it’s kind of good pace there and I don’t think that the things we need to do are that huge, to have us in a very good spot and I think we have opportunity to be higher monetization than where we are now. Put some innovation which we’re kind of doing, it looks like that I’m very impatient and I think that, another point I make I guess that I’ve made already, I think that, advertisers are ads still requires they spend some metric to deal with mobile in general. I think advertisers, mobile until very recently it’s been relatively small percentage of advertising spend from those advertisers. I think that’s starting to be in the long as the case, right, and that’s happening relatively quickly, and I think advertisers will also react to that, and you will see them invest, more efforts in targeting those users, running apps for them in phone which holds obviously benefit our monetization there. Actually we have a lot of trends working for us, so I am not worried about this in terms of our business at all. I think it’s more of an opportunity for us because we’re better positioned than most other companies. I guess (inaudible) estimate, short-term impact and I am quite impatient.
Patrick Pichette: If I can just close on just travel, I mean obviously there’s a couple of factors in there, one of them is clearly – there is seasonality in travel, so obviously that’s always an impact quarter-over-quarter, and then as we – the same news you read about Europe or other parts of the world that are in different economic situations. You will notice that if you kind of track Google Trends and you go and mine into the data, you will see that some sectors are performing better, others are not, and as I mentioned in my commentary, at the very beginning, travel and retail has been somewhat weak in Europe just given their situation, so no real surprises there Brian. Thank you for you questions. Just before we close, I just want to take a ten seconds on behalf of Nikesh, Larry and myself thanking in the amazing work of our Googlers, all our employees, all our partners, what an amazing last 90 days it’s been both at Motorola and Google. And I’ll let Larry close with the last words before we turn it over to Jennifer to close the call.
Lawrence Page: Yeah, I just want to thank all of you after spending so much time with us and following us and doing your analysis. And with that, I’ll close the call.
Patrick Pichette: Jennifer, we’ll let you close the call.
Operator: All right, thank you. And that does conclude today’s presentation, thank you for your participation. | [
{
"speaker": "Operator",
"text": "Good day, and welcome everyone to the Google, Inc. Third Quarter 2012 Earnings Conference Call. This call is being recorded. And at this time, I’d like to turn the call over to Jane Penner, Director of Investor Relations. Please go ahead."
},
{
"speaker": "Jane Penner",
"text": "Good afternoon, everyone, and welcome to today’s third quarter 2012 earnings conference call. With us are Larry Page, Chief Executive Officer; Patrick Pichette, Senior Vice President and Chief Financial Officer; and Nikesh Arora, Senior Vice President and Chief Business Officer. Also, as you know, we distribute our earnings release through our Investor Relations website located at investor.google.com. So, please refer to our IR website for our earnings releases, as well as the supplementary slides that accompany the call. This call is also being webcast from investor.google.com. A replay of the call will be available on our website later today. Now, let me quickly cover the Safe Harbor. Some of the statements we make today may be considered forward-looking, including statements regarding Google’s future investments, our long-term growth and innovation, the expected performance of our businesses, and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on this call, such as operating income and operating margin are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will turn the call to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Hello, everybody. We’re going to invite Larry to give us the first round of commentary and then I’ll go through our financials and then Nikesh will have some comment before we turn to Q&A. So here you go, Larry."
},
{
"speaker": "Lawrence Page",
"text": "Thank you, Patrick. Hello, everyone. Thanks for joining us. It’s great to be on the call today and to share our progress since we last spoke six months ago. As you can hear my voice is still hoarse, so I will keep my remarks reasonably short. I am sorry for the scramble earlier today. As our printers have said, they hit send on the release just a bit early. We had a strong quarter, I am really happy with our business. Revenue was up 45% year-on-year, and at just 14 years old, we cleared our first $14 billion revenue quarter. Not bad for a teenager. Today, we live in a world of abundance; abundant information and abundant computing. Most of us carry at least one device, all the time, every day. In fact many of us would feel naked without our smartphone. It’s hardly surprising mobile search queries and mobile commerce are growing dramatically across the world. And we use these devices interchangeably, depending on our situation. I switch between my Nexus phone, my Nexus 7 tablet and my new Chromebook that we just announced today many times a day. While this abundance causes disruption, it also creates amazing opportunity. And Google is super well-placed to take advantage of these disruptive opportunities. Why? Because our search query volumes have grown this quarter as measured year-over-year. And we are seeing tremendous innovation in advertising, which I believe, will help us monetize mobile queries more effectively than desktop today. Indeed, our mobile monetization per query is already a significant fraction compared to desktop. In short, as we transition from one screen to multiscreens, Google has enormous opportunities to innovate and drive ever higher monetization, just like Search in 2000. Now we took a big bet on Android back in 2005. We believed that aligning standards around an open source operating system would drive innovation across the industry. Most people thought we were nuts. Today, there are over half a billion Android devices, half a billion, with 1.3 million more being activated every day. You should all run out and buy the Nexus 7 tablet for $199. It’s had rave reviews and recently won Gadget of the Year from T3, the gadget experts. You’ll love the integration with Google Play. It is an amazing device. This time last year, I announced that our run-rate for mobile advertising hit $2.5 billion. That seemed like a pretty big number even for Google. But now we have built up additional mobile revenue from users paying for content and apps in Google Play. Including these new sources grossed up, I can announce our new run-rate for mobile is now over $8 billion. That’s quite a business. We have so many opportunities today, that unless we prioritize we spread ourselves too thin. Last month, we sunset another 19 products. We’ve now closed or have combined 60 products and features in the last year. And we’ve put a ton of energy into ensuring that our remaining products work really well together. Because as screens multiply, it’s more important than ever that we converge our services. Users want one consistent, beautiful and simple Google experience. Technology should do all the hard work, liberating users to get on with the important things that matter in their lives and this screen independence is at the core of our strategy. Take Chrome on Android, for example. We only launched in February, but the experience is already amazing. When you are using Chrome, switching devices is truly painless. All your tabs are there, ready to go. Search on your desktop and the result is right there on your smartphone. You can even click the back button, and it just works. And as more users upgrade to Google+, it’s now over 400 million, users are enjoying amazing experiences across devices like instant photo upload. In the same way, we want to make advertising super simple for customers. Online advertising has developed in very device specific ways, with separate campaigns for desktop and mobile. This makes arduous work for advertisers and agencies, and means mobile opportunities often get missed. So we’re working to significantly simplify the campaign experience, working very hard on that. Advertisers should be free to think about their audience, while we do the hard work of dynamically adapting their campaigns across devices. I’m very excited about this. I talked at the start about the abundance of information. In the early days of Google, you would type in a query, we’d return ten blue links, and you move on fairly happily. Today, you expect more. You expect Google to understand deeply and you expect us to turn your intentions into actions in the blink of an eye. If you search for Tom Hanks movies, chances are you want movies with Tom Hanks and thanks to our Knowledge Graph that’s what we show now, right from the results page: clean, fast, and organized. And if you’re shopping, say for Ugg boots, we now give you pictures, details about the different boots, prices and information about the local inventory, again right from the results page, clean, fast, and organized. There’s much more we can do to get you the right information at just the right time. You might have a really important event in the city perhaps a first date, and the traffic is bad. You need to leave early to avoid being late. Or maybe you’ve just landed in a new country and you’re at the airport ATM trying to figure out how much cash to withdraw? Google Now, which we launched on Android in June, gives you all that information and more automatically, with zero effort required on your part. It’s still early days, but these kinds of tips and recommendations are super powerful. They really save users time and hassle. This is why I’m incredibly excited about the opportunities ahead, given our expertise in Search and Mobile, and our track record monetizing high usage products. Everyday, I wake up and I’m delighted that our opportunities keep growing. And that we’re birthing to our users great products that are defining the future. It’s a truly exciting time to be at Google. And now, you will hear from Patrick some details about our quarter."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks, Larry. Good afternoon, everyone, and thank you for joining us. Overall, we are very pleased with the growth trajectory of our business this quarter and this in fact despite significant currency fluctuations in many of our international markets. So for example, if currencies had remained constant year-over-year, our consolidated revenue growth would actually have been 6% higher. On a positive note, our U.S. growth continues to be strong. And as Larry noted, we’ve got a great quarter on the product front gaining traction in a number of critical areas. So before I dive into the financials, I just want to give you a bit more detail on the new $8 billion annual mobile run rate that Larry mentioned. The new run rate is different from the one we gave you a year ago. And more specifically, last year, it included only our gross revenue from mobile ads, but this year, in this number we also added the gross revenue from the mobile sales of Google Play content. And finally, it also includes the consumer spending on the Play apps. So with that and now why don’t I just jump into our financial performance. Our total gross consolidated revenue grew 45% year-over-year to $14.1 billion and that’s also 15% quarter-over-quarter. Google’s Standalone revenue grew 19% year-over-year to $11.5 billion, 5% quarter-over-quarter. In that, our Google Website revenue was up 15% year-over-year to $7.7 billion, 2% quarter-over-quarter, with strengths across most major geographies and verticals. Our Google Network grew 21% year-over-year to $3.1 billion and 5% quarter-over-quarter. And our other revenue grew 73% year-over-year to $666 million, 52% quarter-over-quarter and this driven by the Nexus 7 sales. If it were not for these currency fluctuations, Google Standalone revenue would actually have grown 24% year-over-year. As Larry mentioned, Google Standalone business continues to perform very well. A dramatic growth in our new devices is driving mobiles queries and clicks. And although it’s early days, some of our existing ads have better monetization in desktop already today and we’re confident that this transition opens a whole new space for innovation and new format and future monetization. Turning to MMI, Motorola gross revenue was $2.6 billion. The mobile device division revenue for that period was $1.8 billion and the home division revenue was $797 million, but we’re really pleased with Motorola’s progress in its 150 days. As indicated in our public filings, our team has made a lot of operational changes, we harmonized and narrowed the product portfolio, there’s been streamlining of software operations and we scale back the markets in which we operate. But that said, we are just at the beginning of the Motorola Google story. And we should expect, as I mentioned before, results from this segment to be quite variable for quite a while yet. Remember that we inherited an entire product pipeline where hardware business cycles are typically in a 12 months to 18 months. At Google, our aggregate paid click growth was very strong again this quarter up 33% year-over-year, 6% quarter-over-quarter. Our aggregate CPC or cost-per-click was down 15% and down 3% quarter-over-quarter. But once again please remember that currency headwinds also had a significant negative impact on our CPCs in Q3. In fixed FX terms, aggregate CPC would have been down only 8% almost half of the 15% and down only 1% quarter-over-quarter. Turning to geographic performance of Google Standalone business, we continue to see robust performance in the U.S., the UK and Japan. On the other hand, we felt the continued impact of the economic situation in continental Europe, but we’ve seen pressure in sectors like travel and retail. In our earnings slides, which you can find in our Investor Relations website, you’ll see that we’ve broken down our revenue by U.S., UK and rest of world, to show the impact of FX and the benefits of our hedging program. So please refer to those slides for the exact calculations. Revenue from the U.S. was up 23% year-over-year to $5.4 billion. The UK was up 16% to $1.2 billion, which includes $6 million of benefit from our hedging program and in FX term; in fact the UK grew 20%. The non-U.S. revenue excluding the UK accounted for 42% of our total revenue or $4.9 billion, up 15% year-over-year, but in fixed terms, in fact was 26%. And all this includes a $56 million benefit from our hedging program. So let’s come back now to an aggregate level for total consolidated business. Our other cost of revenue was $3.6 billion in Q3 excluding our stock-based compensation. Non-GAAP operating expenses totaled $2.9 billion, which again excludes SBC and the restructuring and related charges recorded in our Motorola business. And our non-GAAP operating profit was therefore $3.8 billion in Q3, resulting in a non-GAAP operating margin of 27%. For Google Standalone, our traffic acquisition costs were $2.8 billion or 25.5% of total advertising revenue. Our other cost of revenue was $1.6 billion and that excludes $103 million of stock-based compensation. The increase year-over-year in this other cost of revenue was driven by data center costs, equipment costs and including costs associated with the sales of the Nexus 7, and finally, content acquisition costs. Non-GAAP operating expenses were $3.2 billion, excluding again SBC of $585 million. And finally, our non-GAAP operating profit was $4 billion in Q3 resulting in a non-GAAP operating margin of 34% for Google Standalone. Lastly many of you’ve asked for the depreciation and amortization expense on PPE for standalone Google, which was $465 million for this quarter. If we flip to Motorola, our total non-GAAP operating expenses including cost of revenue totaled $2.7 billion for the quarter. And keep in mind, that intangible amortization expenses attributed to the standalone Google and Motorola are included in these non-GAAP measures. And as a result, the non-GAAP operating loss of Motorola was $151 million for Q3, resulting in a non-GAAP operating margin of 6% for that segment. Let’s switch over to headcount. For the consolidated business, it decreased by roughly 1,000 in Q3. Standalone Google added about 1,800 people. And remember that historically, we often see some seasonal effects on the hiring in Q3 as folks that we hired in the spring and early summer actually start working in September. In total, the consolidated company ended up the quarter around 53,500 full-time employees. Our effective tax rate for this quarter was 22% in Q3, the changes from last quarter reflects the mix shift in earnings between the domestic and international subsidiaries and our hedges, but finally, fewer capital gains offsets versus last quarter. If you allow me to turn to cash management, OI&E or other income and expenses was $62 million, which reflect the continued impact of our FAS 133 expenses of our hedging program, but also fewer capital gains versus last quarter. For more detail on OI&E, again, please refer to the slides that accompany this call on our IR website. Operating cash flow was very strong, $4 billion. CapEx for the quarter was $872 million versus last quarter’s $774 million. The majority of our CapEx spent is in – continues to be related to production equipment and facilities related purchases. All this actually delivers us a free cash flow, which was $3.1 billion with which we’re quite pleased. The success of our product really gives us the confidence to continue to fund the strategic growth areas, areas that Larry talked about such as Search, YouTube, Android, Chrome, and as always we continue to show our discipline in making the touch calls on products that just don’t live up to our expectations. In Q3, we’ve seen a number of these decisions including the sunset of our Google TV Ad as an example. So with that, I will hand it off to Nikesh, who will cover more detail on our business performance in the quarter. And after his remarks, we’ll open up the phones for Q&A. Nikesh, here’s to you."
},
{
"speaker": "Nikesh Arora",
"text": "Thank you, Patrick. I’d like to reiterate what Patrick said. Our business had a strong quarter with $11.5 billion in Google Standalone gross revenue. I want to talk to you about our focus and progress on four major trends that are actually helping to drive our business growth. First, a trend Larry already talked about, the rise of the multiscreen consumer. This is creating huge opportunities for us especially in our advertising business and focus on video and mobile. At the moment, everybody thinks about the online world is divided into desktops and mobile. Larry shared the amazing $8 billion run rate. And I believe in the medium-term, these screens will continue to diverge, but advertising opportunities will converge to allow our marketers to run common campaigns across all these screens. Our teams have been putting the same focus on mobile and video the last few quarters that we brought to display a few years ago. And it’s rewarding to see it bear fruit. We’ve intensified trading for our sales team across the globe, integrated sales tools, so we can really bring our customers’ mobile video, Search, Display as a cohesive solution. We're also educating our advertisers through initiatives like Go Mobile to ensure they have the right creators and landing pages to make mobile truly work for them. However, we feel the progress we’ve made is just the very first step in the journey of monetizing many screens Larry talked about. As we develop advertising that can take advantage of the context in which consumers use this many screens, we expect to continue to see better monetization. As we help marketers reach consumers closer to the point of purchase, the opportunities will only get bigger. We’re already seeing glimpses of this. Take T-Mobile, who use location based mobile ads to drive people nearby into their stores, and in their words, win the last 10 feet. They achieved a click-through rate of about 13%, in what is a very successful strategy. These rates are 3 to 4 times of what you would see without using some of these context. And our Click-to-Call ads work because consumers can respond by contacting an advertiser immediately from the ad, generating approximately 20 million phone calls per month for our clients through our various call products of advertising. The second trend, which I’m excited about is, it’s not just the context that matters, but also our ability to deliver more precise answers to consumers, something also that Larry talked about. We are working very hard in this. Larry talked Google Now and Knowledge Graph; it’s exciting to see how that even makes opportunities for us happen, as Search become smarter in a commercial environment. We can do a better job of connecting marketers with consumers in the moments that matter, irrespective of what device they are using. For example, we’re pleased that as of yesterday, Google Shopping completed its transition to a fully paid model based on product listing ads. Now we’re providing product information, pictures, pricing, local inventory information, over billion products from tens of thousands of merchants and over 100,000 sellers. So the new Google Shopping experience, Adorama, one of the US’s largest photo retailers and mail order suppliers saw their click-through rate jump by 176%. Their conversion rate went up by 100% in June as compared to near earlier. Using the same technology that powers our Knowledge Graph, we’re providing better answers with Google Shopping in other areas where users want to make a purchase. We’re going to reduce the number of steps from search to transaction, making the online experience even more valuable to consumers and marketers. The third trend, which I’m excited about is that we’re actually making real headway amplifying offline brand campaigns with online media. We have a unique approach that helps advertisers succeed across media. We allow them to use and leverage the attributes of each media and adapt their campaigns for online success. YouTube energized by new professional content and Display are the core of this business helping clients increase awareness, increase capability, and also drive engagement. In addition, we also continue to make progress in our end-to-end technology platform to help advertisers of all sizes succeed with display advertising. Today, our top partners in the agency world and very large advertisers and publishers, are using a consistent technology stack. The number of impressions that we’ve been able to pass through AdX and Invite platforms have doubled over the last year. We are also working on creating more video premium inventory without channel strategy in YouTube as more and more viewers move to online video, we expect more and more brands will do the same. Our brand business is actually creating quite a buzz in the industry because we have great media and our solutions really work. For example, on YouTube, we looked at about 92 different ad campaigns with sales impact, we found that an average spending on YouTube was approximately 2.4 times more efficient than the equivalent television spent. We have 200 times more video advertisers than the average U.S. television network. In our TrueView format, in which advertisers only pay for ads that users watch has really taken off. We have twice as many advertisers using TrueView since last year. That’s a very important statistic, but like any good brand marketer, the best way for me to show you – tell you a story is to actually show it. So let’s see what two of our leading brands have done this quarter. We launched the YouTube Gillette Football Club with Procter & Gamble in Europe, we’ve created global brand platform for Gillette that will reinvent the way people watch football online. The campaigns have generated about $30 million video views. We are working with Coca-Cola on their Vitaminwater branding effort. We’ve partnered to build a strategic music program leveraging YouTube as a platform to anchor, distribute and syndicate the video content. It’s particularly exciting to see that over 100 brands now have over 1 million followers in Google+ including ESPN, PlayStation, Ferrari, H&M, Burberry and Toyota. Last trend I want to talk about is the trend of cloud computing in the enterprise. Our enterprise business continues to thrive. We saw especially great traction in retail and education sectors this quarter with Dillard's, Kohl's, and Office Depot, all using Google Enterprise products. In education, there are over 20 million students, faculty and staff, non-Google apps, Princeton, Virginia Tech, and even the Philippines Department of Education which has over 600,000 users. With the recent launch of Google+ for enterprise customers, organizations of all size – sizes including capital and Banshee Wines are starting to use our Hangouts and other tools to work together and get things done from anywhere. In addition to all these trends, our marketing team continues to do an excellent job. We launched a global cross-product initiative to bring the 2012 Olympics to our users worldwide. YouTube streamed the games like to 64 countries. Also YouTube was the efficient live streaming provider with over 1 million hours of live content for the democratic and republic of national conventions. And we passed yet another milestone just this week and YouTube broke it’s own record to reach more than 8 million concurrent live streams of Felix Baumgartner’s recording breaking leap from space with the Red Bull Stratos mission. So with that as an update, I'm going to hang your back to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Nikesh. So Jennifer, if you would like to tell us the rules we will just get on for the Q&A session."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) And we will take our first question from Ross Sandler with Deutsche Bank."
},
{
"speaker": "Ross A. Sandler",
"text": "Thanks guys. Nikesh, one quick question on revenue and Patrick one on expenses. The international and rest of world organic growth was 26% pretty strong, but down from 29% last quarter. So is there any incremental weakness that you saw or was this just mostly from a tougher comp? And then Patrick, your sales and marketing expense was up 18% from last quarter that's a bit higher than the typical increase in 3Q, can you talk about what’s driving up those investments? Thanks guys."
},
{
"speaker": "Patrick Pichette",
"text": "Okay, I’ll start, Nikesh and I are pointing at each other. Yeah, on the marketing expense listen, I think what you see is the impact of the support for the Nexus 7 that we launched in Q3. Otherwise everything was pretty much in line with what we would expect. We just got such a great review of the Nexus 7, we won the support of the market and that's the biggest delta you will see in that number. In terms of the market, I’ll hand it over to Nikesh for his commentary."
},
{
"speaker": "Nikesh Arora",
"text": "I think it's fair to say that, our revenue growth internationally has been pretty strong. You are seeing some pockets of difference in performance partly because of seasonal reasons and partly because of the continuing economic effects you’re seeing in Europe. So our business is doing better than the economy in most markets in Europe, but it does get impacted a little bit with some of the fluctuations you see there. So from our perspective there is no any cause for concern."
},
{
"speaker": "Ross A. Sandler",
"text": "Okay. Thanks, guys."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks, Ross. Jennifer, let’s go to the next caller please."
},
{
"speaker": "Operator",
"text": "And we will take our next question from Scott Devitt with Morgan Stanley."
},
{
"speaker": "Scott W. Devitt",
"text": "Hi, thanks. Just wondering if you could talk a little more about the strategy behind the decision to monetize product listing ads and then more broadly about the retail strategy for the company? And then secondly, Google website revenue net of distribution tax lowered to 13% from 20% last quarter, I was wondering if possible you could Patrick normalize that for currency to get a better understanding of FX neutral for website growth? Thank you."
},
{
"speaker": "Lawrence Page",
"text": "Hello Scott, this is Larry. On this question about the strategy and product listings, I think we’re just really excited about providing a better experience for our customers. When they search for something I mention boots on the call, now you search for that, I think you'll see a well organized set of product information, ways to buy it and really have a great experience there. And we see, our ability to do that on the ads or monetized product listing side, it’s really helping us provide a better user experience and provide a better advertiser experience. So I’m very excited about that. I think we are still in the early stages of that. We just launched, I think yesterday really and we still got ways to go. So I'll let Nikesh or Patrick take the next question."
},
{
"speaker": "Patrick Pichette",
"text": "On your question relative to our Google site and tech, I’m not – could you just repeat your question, I not sure, I understood what you meant?"
},
{
"speaker": "Scott W. Devitt",
"text": "I’m just trying to understand better the – you suggested the 600 basis point effect from currency and I was just wondering if there is a better way to understand the way that currency effected Google site revenue, if I should think of that any differently than the overall currency?"
},
{
"speaker": "Patrick Pichette",
"text": "I see, so no, it's even the, I mean we have – our network is slightly skewed to the US versus our Google site, so you’ll have some mixed effect there because our network is slightly skewed to the US, but overall I think that it still gives you a good sense of proportion as to what's going on in the market. So that’s the way I would kind of think about it from a model point of view."
},
{
"speaker": "Lawrence Page",
"text": "Let me just add – now it’s on the first part of the question, I think we are really trying to provide answers to people and so, and the strategy for the company really looking at very detailed information and giving you the exact right answer, what we’re doing with knowledge [tides] [ph]. And in search, I wanted to do the same thing as with our advertising to make sure that we get you, as a user in the right answer. And I think that's a very exciting sort of a new strategy for us."
},
{
"speaker": "Scott W. Devitt",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks Scott. Jennifer, let's go to the next question please."
},
{
"speaker": "Operator",
"text": "Next question comes from Mark Mahaney with Citi."
},
{
"speaker": "Mark S. Mahaney",
"text": "Great, thanks. Two questions please mobile searches are really strong, what’s happening with desktop searches. At some point it's probably reasonable to assume that they’re flat lined, we already reach that. And on the expense side if we just looked at the core Google it looks like the margins are coming down, but if you did roughly $200 million may be in Nexus revenue and if you really sold those devices at cost then margins are actually better than they have been in two year, which is the more accurate interpretation? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Actually, let me start with the margins and then I will answer your first question. On the margins you actually have a couple of effects this quarter, one of them, is clearly as you said the cost of the Nexus that will flow into our other cost of revenue, but also it's the first time that you have the full quarter effect of the amortization of intangibles from the Motorola transaction. So that is also another big kind levered that actually kicked in. and it should noted just for the financial community that the amortization of intangibles for Motorola flows to both the Google segment and the Motorola segment in different proportion. So again, it’s pretty tough, as I promised you that we’d have a lot of kind of noise in the data, I think that’s a good set of indication. And for the first one, why don’t I let Larry give a few comments on the issue of mobile."
},
{
"speaker": "Lawrence Page",
"text": "So I guess, I feel like you are asking the wrong question a little bit. I think we are really starting to live in the new reality, one where the kind of ubiquity of the screens helps users really move from intent to action much faster and more seamlessly. So I think this will create a huge new universe of opportunities for advertisers where they can focus on platform. Focusing on platform specific queries won’t make us much sense because advertisers will be dynamically adopting across a whole bunch of different devices to reach the right audiences at the right time. And that’s kind of how we are thinking about it and I alluded to changes that we'll make – to our ads system to improve the advertiser experience and the user experience around that. And I also think that, we are just seeing tremendous growth in the Android, which really obviously we have tremendous ability to influence and to improve the user experience, to add location, to notify your things as I mentioned around different kinds of non-commercial experiences. We can notify you of commercial experiences as well. So I think that’s a really big and great opportunity for us. And as I’ve said, that monetization on mobile queries right now is a significant fraction of desktop. So we're kind of living the best of both worlds, we’re able to move our existing ads, our existing monetization over to mobile. And lastly in order to really innovate using Android and our strength of having ads on other mobile platforms and really move advertisers and consumers who into a new world. So I think we are uniquely positioned to get through the transition and it’s really profit from it. So I am just incredibly excited about that."
},
{
"speaker": "Mark S. Mahaney",
"text": "Thanks for the correction Larry."
},
{
"speaker": "Lawrence Page",
"text": "Thanks. Jennifer let’s got to our next question please."
},
{
"speaker": "Operator",
"text": "Our next question comes from Carlos Kirjner with Sanford Bernstein."
},
{
"speaker": "Carlos Kirjner",
"text": "Hi, two questions, if you run a website with proprietary high quality content today and have to choose a protocol to add, meta data about this content, why would the clear choice would be the Open Graph protocol instead of RDF or one of it’s variables and if that happens and the semantic web arises on the back of open graph doesn’t it place Google at a fundamental disadvantage to achieve the vision that Larry laid out in the beginning of the call. The second question is what do think is the future of vertical search and why is that there are sites that specialize in certain vertical such as travel and local, that seem to do a better job than Google today and if this is going to change over time and what happens with vertical search? Thank you."
},
{
"speaker": "Lawrence Page",
"text": "Yeah, Carlos, I’ll take those questions. I think if you - I'm not an expert on the protocols you’re talking about, I think in general we made a huge investment in knowledge graph and really understanding in detail about everything. And that’s a major effort for us, and we’d obviously love to have other people help us with that. I think it’s been a little bit of a challenge in the past to get all the labeling aligned and all those things. I think we have a big part to play in that. We’re absolutely very excited about that and I think we’re going to do a lot work in that area. And I think we’re doing well in that space. Vertical searches, as you asked about, I think our goal has always been to get you to the right place, but we also – to do that we need to really understand in detail, your context, what you need, what’s really going on with that information, if it’s airline tickets, what are the flights between, what do they cost, products, some one selling we need to know how much they cost to get to know what the shipping is and so on. So I think any place we can get that information accurately, we can present it to our users. However we are very happy to do so. In general, we found that we knew it’s really, build more of that experience in order to provide a really high quality experience to our users. But again, we’re always open alsoto working with partners."
},
{
"speaker": "Carlos Kirjner",
"text": "Thanks you."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Carlos, for your question. Jennifer, let’s go to our next question."
},
{
"speaker": "Operator",
"text": "And we will take our next question from Ben Schachter with Macquarie."
},
{
"speaker": "Ben Schachter",
"text": "One question for Larry and then a couple of housekeeping points on the Apple relationship for Patrick. Larry, there is a lot of this talk about internet use on mobile devices, but switching gears a little, I just wonder if you could talk about the potential for internet access on television screens and how Google might benefit from that? And then Patrick, just two quick housekeeping questions on Apple. One, is 100% of the TAC that you pay, Apple recognized in the Google.com TAC line, and then on iOS 6 there is a seemingly small change in the default search bar right now, says the word search where they used to say Google. How does if at all that change the economic relationship between Apple and Google? Thanks."
},
{
"speaker": "Lawrence Page",
"text": "Okay, so Ben thanks for the question. I mean, obviously we were exited about television, television screens, displays and we have been for a while. We’ve had Google TV, it was a product for quite sometime, I’d just say, I love it and I think it’s a great time to have a real browser, mail on your television, easily access You Tube and all those kind of things. YouTube is integrated on many, many devices from DVD players and so on to game consoles and things like that. So we obviously are working hard to get distribution for YouTube, for Chrome and for the internet as a whole on television screens, as well as our own products, and we’re very excited about that. I think we are obviously still in the early stages of that, something we really has a great user experience, and we work hard to make that happen."
},
{
"speaker": "Patrick Pichette",
"text": "On the – sorry, just want to talk about the TAC line and just to say that, yes, I mean obviously all the TAC that we paid to Apple, it is just another partner for distribution, so it all is tied to our – the TAC line that we have for Google.com. On your question of the default, I mean although there is – nothing is changed, right, I mean, when you use Google, we are a great partner with Apple, we’re a great partner with many of them, and in doing so, when you do search, I mean we have a great, we have the – the fact that they’ve changed from Google to search is still kind of run by our engines. So I hope that clarifies the point Ben."
},
{
"speaker": "Ben Schachter",
"text": "Okay, thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks, Ben. Jennifer let’s go to the next question please."
},
{
"speaker": "Operator",
"text": "Next question come from Anthony Diclemente with Barclays."
},
{
"speaker": "Anthony Diclemente",
"text": "Hi, thanks. I started to harp on the CPC question, but you mentioned them being down 8% XFS. Can you just Patrick, talk a little bit about the other drivers, I think everybody assumes that the bulk of the down 8% is mobile, but I know there are other factors driving that down 8%, so if you could just kind of give us order of magnitude in emerging markets and so forth if possible? And then secondly, on allocation of your sizable free cash flow and on your cash balance Patrick in the past you’ve talked about reviewing and considering capital returns at the Board level. And at the same time you’ve talked about your cash balance being a strategic asset for Google, just wondering if you could give us an update on yours, on Larry’s, Board’s thinking on allocation of capital and use of your cash balance? Thanks for the question."
},
{
"speaker": "Patrick Pichette",
"text": "Yeah, listen, on the CPC trends nothing has changed from last two quarters. And in fact, I think people have a tendency just to harp and assuming that it’s automatically mobile…"
},
{
"speaker": "Anthony Diclemente",
"text": "Right."
},
{
"speaker": "Patrick Pichette",
"text": "And if you look through our results, I just kind of point to a few areas, if you look at our mix between our Google properties and our network, right, our network grew quite a bit again this quarter and that would drive a lot of pack as well. So I and again that’s the reason why I kind of want to educate and tell and remind everybody that just all of these mix effects whether it would be mobile versus laptop versus desktop, but also emerging market versus developed markets and also our Google.com versus network. And then we haven’t even talked about the changes in our ads quality, which actually can change quite a bit as well. So I think that matters a lot, and I think that it’s really important now we understand that all these mix effects are actually playing or play there in the CPC. So and that’s what we don’t give, if we start giving down all the breakdown right, it’s just endless. So for us, the real issue for us is, but what really matters is, they are going down, but on the flip side of that, right, given all these mix issues, what we really see is our pay clicks going up at a pretty healthy rate at 33% again this quarter, which actually gives you a sense of people who are engaged, people are using our products, it’s really about this transformation of multi-devices and in fact that there is a little bit less CPC is not a concern compared to all the offside that we see on the other side. On the issue of our cash and capital balance, I think, you get the same answer and maybe Larry wants to kind of chime in if he wishes to, but we just review this on a constant basis. We ask ourselves the question, is there real options for us actually to use the cash from a strategic perspective and we’ve come to the conclusion that it is a real strategic asset for us right now with the ability to balance. And so we think it’s prudent to actually manage our capital structure to where it is as we speak."
},
{
"speaker": "Lawrence Page",
"text": "We have nothing to announce at this time."
},
{
"speaker": "Anthony Diclemente",
"text": "Okay. Thank you very much."
},
{
"speaker": "Lawrence Page",
"text": "Thank you. Thanks, Anthony."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks, Anthony."
},
{
"speaker": "Lawrence Page",
"text": "Can we have the next question?"
},
{
"speaker": "Operator",
"text": "Next question comes from Heather Bellini with Goldman Sachs."
},
{
"speaker": "Heather Bellini",
"text": "Great. Thank you for the question. I have two for Patrick and then one for Larry. Patrick, I’ll start out with yours first. Can you give us an idea of the run rate that you are talking about, the $8 billion for mobile, can you give us an idea of what that is on a kind of same-store sales basis, you gave us the $2.5 billion run rate last year, what is the mobile advertising piece, I think that’s something people are really interested in, so extra stuff from Google Play? The follow-up question I had for you was, what’s the margin profile on the Google Play content revenue that you’re recognizing? And then the question for Larry is, I guess just in listening to Mark Mahaney’s question, I was wondering in this new reality you mentioned in response to his question, how does Google Fiber play into this vision to have your content and search capabilities go across multiple screens? Thank you."
},
{
"speaker": "Lawrence Page",
"text": "Okay, I’ll let Patrick, take the first part."
},
{
"speaker": "Patrick Pichette",
"text": "Okay. So on the $8 billion, so let me give you just a bit more information on it, but clearly we don’t breakdown each of the categories, we just wanted to kind of give you a sense of proportion. A point that’s important is, of the three categories I gave you, ads continues to be the bulk of it, the vast majority of it. And then on the case of the Google Play, it’s important to note from a modeling perspective that everything’s that’s content, that is whether a book, a movie content is actually booked on our books on a gross basis. Everything that is tied to apps is booked on a net basis, but it’s still a huge kind of number in all cases. So without giving you, I just want to give you that, so that you don’t start thinking that there is actually 8 billion that is book to revenue in our result that you see, but in fact, two of the three are there, the third one is done on a net basis, just because of our accounting rules. So and the vast majority is still ads."
},
{
"speaker": "Heather Bellini",
"text": "And can you just give us a sense of the margin profile on the not ad piece?"
},
{
"speaker": "Patrick Pichette",
"text": "We don’t provide that. We don’t give any of the details of that. But clearly, it’s a different profile, because it’s content, so we have partnerships that we deal with."
},
{
"speaker": "Heather Bellini",
"text": "Great."
},
{
"speaker": "Patrick Pichette",
"text": "On the case of, why don’t I turn it over to Larry to talk about Google Fiber and Google TV."
},
{
"speaker": "Lawrence Page",
"text": "Hi, Heather, it’s a great question. I think, Google Fiber I think we are in the early stages, right, it’s just rolling in out in one city or two cities that are one city. And we’re really excited about it and I’m excited about the user experience there. In fact, I think I’m about to go, went soon from my asked trials. But you control it with a Nexus 7 tablet actually, that’s the remote for it. I think it will be an amazing experience from a user standpoint, one that can really drive that industry forward. So are quite excited about that like said we are in the early stages, obviously rolling that up."
},
{
"speaker": "Patrick Pichette",
"text": "It’s worth just to close on that. It’s worth kind of noting also that we are pushing for the next chapter of the internet in the U.S. with Google Fiber. People, there is such a demand for higher speed access at reasonable prices, I think that we got a great mouth trap with Google Fiber and we hope it excites everybody and promote the environment that will actually give us that kind of connectivity in the U.S. and elsewhere as well."
},
{
"speaker": "Heather Bellini",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks. Jennifer, let’s go to a next question please."
},
{
"speaker": "Operator",
"text": "Next question comes from Douglas Anmuth with JPMorgan"
},
{
"speaker": "Douglas T. Anmuth",
"text": "Great, thanks. Just want to ask two questions. First is just following up on Scott’s earlier question, we saw a deceleration in Google Properties and then an acceleration on network side. But hoping that you could talk about a little bit beyond the U.S. and the international mix, is there anything else that you would attribute those dynamics to. And then secondly, you talked a lot about multiple screens and ambiguity of devices, how concerned are you that in a mobile world, behavior is different and we’re living in more of an apps-based environment and Google might not be that starting point for people on mobile devices. Thanks."
},
{
"speaker": "Lawrence Page",
"text": "Yeah, thanks. That was a great question, Doug, I’ll take the second one first. I think a lots been made on that note, I don’t think that’s really true, kind of apps versus search. We obviously have a great position in apps, we have the Android Play Star, which has a huge number of apps. And I think that those experiences are good experiences and there are some things that are better than them, but to us some things that are better than the web of the apps. I think over time, we do our jobs right, you have the same capabilities in both places, and we have such ability in apps, you built some more usually good apps, the same way you go to webpage and so on. So I think anyway I think those differences will emerge or where it is tenures over time. I think we obliviously have a strong position in both. So I’m not so worried about that. I think that there is obviously innovation that goes out of mobile and we talked a little bit about all the different context and location you could have on mobile, the fact they’re always carrying a device with you and those things are very powerful. So you want all that when you are on desktop seller on the web, you want that same information. And so we wanted a seamless experience that goes across both mobile and desktop and TV or whatever screens you have, and that’s what we are building. I think that we are going to see tremendous in these things. The other point I make is that, there is a small, relatively small number of people right now that have Chrome on their mobile devices. And I find Chrome on my mobile device like the same is having a desktop computer a year ago or something. And it’s an amazing experience. You can buy things. It remembers your credit card numbers and that means it’s a very, very easy great experience. That’s been, that’s rolled up to a relatively small number of people, but it will be increasing quickly. So I guess just seeing all those trends, I think it’s tremendous opportunity for us. And I don’t think people are really thinking about it correctly now. So Patrick, do you want the cover the detailed question?"
},
{
"speaker": "Patrick Pichette",
"text": "Yeah, with pleasure. Look just to reiterate that our Google website’s revenue was up and with strength across most geographies and most verticals. I mean obviously you’ve heard Nikesh talk about, Douglas, we can’t control the economy in the short term, so if there is a country that is slowing down a little bit then we clearly kind of see it in the result as well because Google is actually a pretty good protector of the present as far the economists are varying kind of reminds us. But then on the Google Network, I think we’re just really pleased with, it’s skewed slightly more to the U.S. but really pleased with the performance overall with all of our networks, that’s been performing well. So nothing additional to kind of highlight apart from just a good general trends."
},
{
"speaker": "Douglas Anmuth",
"text": "Okay. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Jennifer, our next question please?"
},
{
"speaker": "Operator",
"text": "Next question comes from Richard Kramer with Arete."
},
{
"speaker": "Richard Kramer",
"text": "Hi, thanks very much. I’ve got some, one question for each of you, if I may, for Larry if you could just expand a little bit more on YouTube and maybe provide not only some metrics, but really your may be three to five year vision of its rolling video distribution between Google TV and the fiber project and some of the other options. For Nikesh, could you talk a little bit about emerging markets and where Android really is the dominant not only in scale, mobile computing platforms, and what may drive that to show faster international growth, if its having sales force or purchasing power or something else and maybe Patrick, could you help us understand a little bit the FX headwind on the top line how it might have been expressed moving down the P&L especially in sort of net profit terms. Thanks very much."
},
{
"speaker": "Lawrence Page",
"text": "Richard, that’s a great question on YouTube. I haven’t had, Nikesh mentioned Google TV for a while, I think recently kind of YouTube transition from maybe a year ago, to be really something that keeps me entertained for hours on the TV. It can play back, lots of really high quality, highly exciting things, they are now kind of tailored for me, my channels and so on and I think we have tremendously increasing YouTube usage, continues to grow like crazy. And we’ve head increasing monetization as well which causes people to put more content on it, and to monetize it worldwide, kind of in a blink of an eye you can put things up. So I was just, the recent video of horse dancing, came in style. I have been watching, its 400 million views now – 500 million. And that kind of thing to really just put the switch, turn it on, get a worldwide distribution and sort of – almost without doing any work, if you are a provider of this content is an amazing thing. And I think that’s how we see the future, we’re just kind of continue to grow that. It is going to be available everywhere on your mobile, on your TV, on your desktop wherever you want. It’s going to keep track of the kinds of things you’re interested in and really provides you an amazing experience, and provide a great experience for the advertisers, true view is exploding, which gives us high quality ads from an end user standpoint, because they can skip some if they want. So it encourages paths that are actually entertaining, not annoying, and that’s been working or making money over that and it’s coming like crazy as well. So I couldn’t be more excited about all that."
},
{
"speaker": "Nikesh Arora",
"text": "Thanks Richard. As far as the emerging markets in Android, I mean I think we’re very excited about the fact that Android is becoming very successful platform in many markets, outside the U.S. not just the U.S. I think in terms of what drive, I am not sure if your question is about faster growth of Android or faster growth of monetization on Android platforms. I think on both of them, we’re seeing the adoption in various markets, there OEMS are producing Android devices on the bleeding edge and doing a phenomenal job of working with operators in those market and distributing them, so we think that will continue because and Android is providing to be a great platform for innovation for all the OEM. In addition to that as more and more people use mobile device, I think we’ve talked a lot in this call about have those mobile devices are being used, we are seeing an increasing in query growth and we are seeing our various new ad formats and ads where we bring context into account is actually helping us monetize. So I think both those trends are going in the right direction. Hopefully that provides more opportunity for us."
},
{
"speaker": "Patrick Pichette",
"text": "Let me close on FX, so Richard, just two points, one is, it’s been interesting in Q3, the U.S. dollar has really weakened versus a whole host of currencies, so typically you have one currency that goes down another one is more stable, we’ve really seen it across-the-board, it just happens with the macro economic trend, again, it’s something you can’t predict. So it’s been across-the-board and without giving you the details of how it flows to margins, it is fair to say and we’ve already talked in the past that our operating expenses are skewed to the U.S. I mean Mountain View is the headquarter and so from that perspective it has some effect as well. So I think you can navigate through this. So it was definitely a significant impact for this quarter."
},
{
"speaker": "Anthony Diclemente",
"text": "Okay. Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks, Richard. Jennifer, let’s go to our next question."
},
{
"speaker": "Operator",
"text": "Our next question comes from Justin Post with Merrill Lynch."
},
{
"speaker": "Patrick Pichette",
"text": "Justin, are you with us?"
},
{
"speaker": "Justin Post",
"text": "Can you hear me now?"
},
{
"speaker": "Patrick Pichette",
"text": "We can."
},
{
"speaker": "Justin Post",
"text": "On a high level, I just want to know, if searches on mobile the same quality in your estimate as PC I mean are you still getting good high CPC travel and e-commerce searches on mobile? Second, maybe you could talk a little bit about the rollout of Google product search seeing those ads definitely in core search results and could that have an impact in Q4? And then maybe some detail on the hedging program, this is one of your worst year-over-year hedging, I’m sorry, one of your worst year-over-year FX impacts down $500 million and now you get a $62 million benefit and I think you disclosed the cost was 124. I guess there is there something you can do to kind of improve that the ratio is there and not spend so much and a get a better benefit win FX is negative thanks."
},
{
"speaker": "Lawrence Page",
"text": "Yes, Justin thanks for the question. I don’t know the details of the particular queries on the Google Desktop, but I can tell you I think like for example in Travel we bought IT software for a sizable amount, we thought it was important to provide a better experience there, when you type cities and you want an airline ticket, you actually need that detailed information, and I think I’m not worried about any of that to the extend we provide great an amazing user experience for people. However they are looking for all types of different kinds of information as long as we’re providing again that very detailed, very organized customer results of people, I think that translates across all of your screen is just fine. Nikesh or Patrick, do you want to?"
},
{
"speaker": "Patrick Pichette",
"text": "Again jumping on to the FX issue if you don’t mind, look I think that it’s interesting your question Justin, but let’s remind ourselves of a couple of points, because I think our FX program has actually delivered amazing value to shareholders. One is, we don’t hedge revenue, we hedge profits. And we hedge a number of kind of major currencies like the Euro, the Pound, the Canadian Dollar, few others which is the core of our program, and not only but actually our hedge program is certainly designed for long-term kind of 18 months as a risk reduction strategy and doesn’t necessarily correlate in a way we should perform for three months kind of timeframe in our financial results. And it’s really also build to make sure, I guess you had a cost benefit ratio, thereof making sure that it’s set for bit dislocations. So if it’s just a smaller variance in the short-term, you are not going to get us much benefit as it is a big dislocation. So for all these reasons and then what I mentioned a bit earlier, which is we’ve seen actually FX across a whole slue of currencies this quarter, which these smaller currencies just added up and we don’t hedge for them today. That’s what kind of ended up in the puzzle. So we are constantly looking at our forecast and if it makes sense we will actually throw in new currencies going forward. So that’s been the story on FX, but I wouldn’t read in anyway (inaudible) performed that it hasn’t performed well, it’s performed very low. So why don’t I turn it back over to Nikesh for the last question."
},
{
"speaker": "Nikesh Arora",
"text": "Yeah, in terms of the product listing ad as we talked about, we’re really excited that we actually went on a full rollout for product listing ads and as we’ve said we have 1 billion products that are in there. So as we’ve also, as Larry talked about getting more precise information. We believe that users when they search they come exploring on the web, when they have a better idea, what they are trying to buy. They start expressing intent by being more precise of what they ask for. And we believe being able to do product listing ads gets us closer to intent because if somebody types a Nikon D800 then we know they are looking to buy or looking to get more information about a specific product and the fact that we can show them reviews pictures and pricing information gets us closer to action. And we believe in the medium term that’s going to create more monetization and a better monetization for us as opposed to having just 10 blue links of ads we’d send them to other websites. So I think that’s going to have a good impact in the medium term, I don’t think I’m going to comment whether that has an impact in Q4 or not."
},
{
"speaker": "Justin Post",
"text": "Great. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks, Justin, for your question. We will go for one last question. Jennifer, please?"
},
{
"speaker": "Operator",
"text": "We will take our last question from Brian Pitz with Jefferies."
},
{
"speaker": "Brian Pitz",
"text": "Great. Thanks. Larry, bigger picture question on your mobile comments, would you give us some rough sense of how long it could take to close the bulk of the gap between desktop and mobile monetization, is this a matter of quarters or years that will see that come together. And then maybe just you made a quick comment on travel weakness last quarter, I think you said travel was strong across the board. And then you came back today and said it sounds like that was a weaker category, just anymore color on the weakness of travel? Thanks."
},
{
"speaker": "Lawrence Page",
"text": "Thanks Brian for the question. And we have kind of policy of not talking about the future, so I think it’s generally a good policy. I tend to be very impatient and I think, I kind of reiterate what I said that we are positioned well, very, very well, and uniquely well, because we have hardly very significant fraction to monetization on mobile and that’s a great start. And we’re working on changes, we do things we’ve been investing in this space for long, long time right, our mobile monetization is not zero, it’s a very significant number. As we try to end also with $8 billion number. And I think that it’s kind of good pace there and I don’t think that the things we need to do are that huge, to have us in a very good spot and I think we have opportunity to be higher monetization than where we are now. Put some innovation which we’re kind of doing, it looks like that I’m very impatient and I think that, another point I make I guess that I’ve made already, I think that, advertisers are ads still requires they spend some metric to deal with mobile in general. I think advertisers, mobile until very recently it’s been relatively small percentage of advertising spend from those advertisers. I think that’s starting to be in the long as the case, right, and that’s happening relatively quickly, and I think advertisers will also react to that, and you will see them invest, more efforts in targeting those users, running apps for them in phone which holds obviously benefit our monetization there. Actually we have a lot of trends working for us, so I am not worried about this in terms of our business at all. I think it’s more of an opportunity for us because we’re better positioned than most other companies. I guess (inaudible) estimate, short-term impact and I am quite impatient."
},
{
"speaker": "Patrick Pichette",
"text": "If I can just close on just travel, I mean obviously there’s a couple of factors in there, one of them is clearly – there is seasonality in travel, so obviously that’s always an impact quarter-over-quarter, and then as we – the same news you read about Europe or other parts of the world that are in different economic situations. You will notice that if you kind of track Google Trends and you go and mine into the data, you will see that some sectors are performing better, others are not, and as I mentioned in my commentary, at the very beginning, travel and retail has been somewhat weak in Europe just given their situation, so no real surprises there Brian. Thank you for you questions. Just before we close, I just want to take a ten seconds on behalf of Nikesh, Larry and myself thanking in the amazing work of our Googlers, all our employees, all our partners, what an amazing last 90 days it’s been both at Motorola and Google. And I’ll let Larry close with the last words before we turn it over to Jennifer to close the call."
},
{
"speaker": "Lawrence Page",
"text": "Yeah, I just want to thank all of you after spending so much time with us and following us and doing your analysis. And with that, I’ll close the call."
},
{
"speaker": "Patrick Pichette",
"text": "Jennifer, we’ll let you close the call."
},
{
"speaker": "Operator",
"text": "All right, thank you. And that does conclude today’s presentation, thank you for your participation."
}
] | null | null |
GOOGL | 2 | 2,012 | 2012-07-19 16:30:00 | Operator: Good day, everyone and welcome to the Google Inc. Second Quarter 2012 Earnings Conference Call. Today’s call is being recorded. At this time, I’d like to turn the conference over to Willa Lo, Investor Relations Manager. Please go ahead, ma'am.
Willa Lo: Good afternoon, everyone, and welcome to today’s second quarter 2012 earnings conference call. With us are Pat Pichette, Senior Vice President and Chief Financial Officer; Nikesh Arora, Senior Vice President and Chief Business Officer; Susan Wojcicki, Senior Vice President, Advertising. Also, as you know, we distribute our earnings release through our Investor Relations website located at investor.google.com. So, please refer to our IR website for our earnings releases, as well as the supplementary slides that accompany the call. This call is also being webcast from investor.google.com. A replay of the call will be available on our website later today. Now, let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward-looking, including statements regarding Google’s future investments, our long-term growth and innovation, the expected performance of our businesses, and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on this call, such as operating income and operating margin, are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will now turn the call to Larry.
Patrick Pichette: Thank you, Willa, and good afternoon everyone. Thank you for joining us. So, well, this is a special call as we enter into a new chapter in our history at Google here with our recent acquisition of Motorola, and with it comes a new set of financial information for all you both at a consolidated, but also at the segment level. So speaking of Motorola, it’s worth noting that given the recent close of the transaction, we can expect this specific segment of our financials to continue to show some accounting variability. So for example, this quarter it’s a stub period, so meaning it only reflects the results since the acquisition dates rather than the full quarter. And as a result of the close, we did a number of accounting adjustments typical for such transactions. So we’ll try to do our best to answer your questions on this call. And our investor relations team will also continue to support the analyst and the investor community during this transition. So now, let’s quickly cover our consolidated result as well as segmented reporting for both Google and Motorola. Our gross total consolidated revenue grew 35% year-over-year to $12.2 billion and 15% quarter-over-quarter. So again, please remember that these total consolidated numbers include the stub period for Motorola. Additionally, there was a significant year-over-year currency headwind in Q2. In fixed FX, revenue would have grown to 39% year-over-year instead of 35%. Google on a standalone gross revenue grew 21% year-over-year to $11 billion and 3% quarter-over-quarter. Our Google website revenue was up 21% year-over-year to $7.5 billion and 3% quarter-over-quarter, which trends across most major geographies and verticals. Google network revenue grew 20% year-over-year to $3 billion, and 2% quarter-over-quarter. Our other revenue line grew by 42% year-over-year to $439 million and 5% quarter-over-quarter. It’s again worth noting that in fixed FX our revenue would have grown 25% year-over-year. Motorola grew revenue for the stub period since May 22 at $1.3 billion. Our mobile devices revenue for that period was $843 million, encouraged by the strength of the North American Verizon franchise driven by the RAZR MAXX sales. Although we’ve seen also weaker revenues that were driven by the declining international sales of feature phones and mid-tier smartphones; the home business, revenue was $407 million. So the core metrics of Google standalone business continue to perform very well against the backdrop of a somewhat difficult global economic environment. Our global aggregate paid-click growth was very strong, up 42% year-over-year, and also up 1% quarter-over-quarter. Our aggregate cost-per-click growth was down 16% year-over-year, and up 1% quarter-over-quarter. And please remember that the currency headwinds also obviously had a quite negative impact on the CPCs in Q2. Turning to geographic performance of Google standalone business, U.S., UK and rest of world are growing at a good pace as reflected in our results. In our earnings slides, which you’ll find in our Investor Relation website, you’ll see that we’ve broken down our revenue by U.S., UK and rest of world, to show the impact of FX and the benefits of our hedging program. So please refer to those slides for those exact calculation. Revenue from the U.S. was up 20% year-over-year to $5 billion. Our non-U.S. revenue accounted for 54% of our total revenue or $6 billion, and was up 22% year-over-year, which includes $81 million benefit from our hedging program. The UK was up 20% year-over-year to $1.2 billion, and then fixed FX term; in fact the UK grew 22%. Coming back to an aggregate level for the total consolidated business; other cost of revenue was $2.3 billion in Q2. Our non-GAAP operating expenses totaled $3.3 billion, which excludes stock-based compensation and charges related to the severance and benefit arrangements in connection with the Motorola acquisition of $652 million. Our non-GAAP operating profit was $4 billion in Q2, resulting in non-GAAP operating margin of 32.3%. For standalone Google, our traffic acquisition costs were $2.6 billion or 24.7% of total advertising revenue. Our other cost of revenue was $1.3 billion, and that's excluding SBC of $82 million. Our non-GAAP operating expenses were $3.1 billion, also excluding SBC of $470 million. Finally, non-GAAP operating profit was $4 billion in Q2, resulting in a non-GAAP operating margin of 36.4%. This continued strong margin in our standalone Google business segment gives us the confidence to continue to fully fund our many strategic growth areas, such as mobile, Android, YouTube and Chrome. Obviously, Susan and Nikesh will go into more details of our initiatives in a minute. At Motorola, our non-GAAP operating expenses including cost of revenue for the stub period were $1.3 billion. And keep in mind that, intangible amortization of expenses and the step-up cost attributed to standalone Google and Motorola are included in these non-GAAP measures. And as a result, the non-GAAP operating loss at Motorola was minus $38 million in Q2 resulting in a non-GAAP operating margin of minus 3% for that specific segment. Headcount increased roughly 21,500 in Q2, obviously Google itself added about 1200, while the remainder of this number includes the Motorola employees who joined in the acquisition. In total, the consolidated company ended the quarter at around 54,600 employees, full-time employees status. Our effective tax rate was 19% in Q2, and that reflects not only the mix of our earnings between domestic, international subsidiaries and our hedges, but also capital gains offset by carried over capital losses. Let me quickly turn to cash management. Other income and expenses was $254 million for the quarter, which reflects gains related to a divestiture of a business, offset somewhat by lower interest income and by the impact of our FAS 133 expenses from our hedging program. For more details [underway any], please again refer to the slides of the company or call on our IR website. Operating cash flow was very strong at $4.3 billion for the second quarter. CapEx for the quarter was $774 million versus last quarter at $607 million. The majority of our CapEx was spent really related to production equipment, facilities, and man purchases. And obviously, we're pleased with our free cash flow, which was $3.5 billion. So now, let me hand it over to Nikesh, who will cover more the details of our business performance in the quarter, then Susan will cover our product highlights. And then finally, we’ll open up the lines for your questions. And please note that Nikesh and Susan will discuss only the standalone Google business and not cover Motorola. So let me turn it over to Nikesh.
Nikesh Arora: Thank you, Patrick, and hello everyone. Our business had a very strong quarter as you’ve heard with over $11 billion in revenue. I’m going to talk about three broad themes today. First, how our recent big bets in the ad business are coming together into integrated platforms. I think digital advertising is really in defrag mode. secondly, we’ll take a look under the hood that how our investments and search advertising adds quality by helping our search business accelerate. And third, we’re going to talk a bit about our enterprise business, which I believe is reaching a real turning point, then I’ll discuss some ways for driving success for our customers and some marketing highlights. So first, our big bets. In about four years, DoubleClick has gone from strength to strength at Google. Now it is the foundation of our display business. this quarter, we announced DoubleClick digital marketing, the first modern ad platform for the modern digital world. This was the biggest ever overall for DoubleClick ad platform. It is used by thousands of agencies and marketers and we managed billions in marketing spend across the world on this platform. It now spans the best of display, rich media, exchange buying, surge and measurement. Some of our recent display acquisitions, Teracent and Invite Media, which both grew by over 50% last year, are also seamlessly integrated into this platform. At the same time, AdMeld, which we acquired, is helping provide publishers control, flexibility and more revenue opportunities. Our display platform helps direct response in brand marketers navigate the whole web. For brands, this quarter we unveiled the Brand Activate initiative. As seas of measurement and planning solutions baked directly into our platform, with our partners are building an online measurement for GRPs or gross rating points in a way to measure viewable impressions. Effectively what we want to do is we want to drive more and more advertising dollars in the brand space and this platform is going to be an effective way for us and we’ll do that. Recently InComm at a big advertising festival, creative agencies loved project [Rebif] this was one of our demos with the possibilities of how in modern digital marketing you can use multiple media formats to make advertising successful. That is quite a change from 2004 when our four line text ads weren’t quite as exciting. Another big bet as part of our integrated solutions is YouTube. I think in 2007 it was when newspapers frequently said YouTube is groping for an effective business model. I think we can declare we found our model. YouTube now unites the world through video from the Human Rights channel launched this quarter to a (inaudible) study confirming YouTube as a major global news platform. And for the first time, YouTube will be powering NBC’s live streaming of the Olympics in the U.S. while also live streaming the games in London to 64 territories around the world. Yearly account signups have doubled year-over-year and users are uploading over 72 hours of video every minute. This quarter we released a new YouTube app for Android helping users to find videos and follow channels from a mobile or tablet devices. We believe YouTube is now a proven winner for the whole video ecosystem. Thousands of partners are making six figures and we’re proud to work with major record labels in Hollywood studios on this platform. In fact, earlier in May, we saw an incredible digital upfront of it, Ban Car, highlighting our YouTube programming partners. Slightly over 13,000 clients attended, some of the worlds biggest advertisers were there and they’re making significant commitments on YouTube including people like Unilever, AT&T and American Express. If you’re counting that’s five successful acquisitions well integrated and helping us succeed in the advertising space. The sixth is Admob, which helps power our mobile ads, both across Android and IOS and other mobile platforms future. Admob was integrated this quarter into AdWords, this has further turbo charged our ability to provide in-house advertising. That’s more than a million advertisers with 300,000 mobile apps, 350 million devices at their finger tips. The growth in the businesses with mobile website is stunning. Last quarter we rolled out GoMo which is the short for go mobile, that initiative was rolled out in 8 new countries including Germany, Japan and Brazil. Mobile friendly website are vital modern businesses and very important for our mobile search business. In less than one year the number of advertisers with mobile sites has doubled. Other major upgrade to Google Analytics was made for mobile apps and the new AdMob SDK for developers turned out to an awesome quarter. For us mobile is like desktop was in 1999, smart marketers are getting great ROI and are developing native ad models that generate results for them. For example, we’ve had 15 million monthly calls for our click-to-call go format exclusively available in mobile devices in the US. Let’s talk about my second theme, the secret souls of search advertising. This quarter showed why we’re so optimistic about search’s continued growth. You know about some factors that drive search, the overall move to digital media and new search ad formats. Privacy, we often underestimate one factor that you don’t often read about. The amount of effort our product engineering teams put into the quality and precision for ads, that just keeps getting better. This quarter made 72 quality improvements and launched greater auctions transparency for search advertisers, effectively what results it improves the relevance of our add and making it more useful to consumers, it drives better results for our partners, clients and advertisers and it helps improve monetization. Imagine if every single search ad was a perfect answer that drove the conversion for the customer, I think that’s the objective that our teams are aiming for. In Q2, our improvements included better triggering of site links and ads and improved ad rotation system, better geographical targeting, expanded match for keyword variance and a whole host of other improvements. As an example of benefits of these changes, the advertisers taking advantages of new close variance feature and exact and phrase matching are seeing roughly a 2% increase in clicks in average. Let’s talk about the third theme, the technology, where we are in our enterprise business. I think it’s become clear for us that we have a serious small, but growing business, which is going to be a future growth engine for Google. I hope you read this week about a company, who said competition was 50% more expensive than Google, and not as cool. That company is now $200,000 a year Google apps customer. Companies, schools, governments worldwide are moving to the could faster than ever. More than 5 million businesses have now gone Google worldwide. The traction amongst large organizations even such as the U.S. Department of Interior, Fairfax Media in Australia, et cetera. I think it’s clear, you can’t fake a commitment to cloud computing, and we’ve invested to build and scale a business that has gone to upstart to upper crust. Thousands of businesses switch to Google apps from our competitors everyday. Recently, we’ve launch products like Google Drive, Google Maps Coordinate, as well as the ability to edit documents off-line and in a whole range of mobile devices and tablets. That just shows you the pace of innovation that Google is bringing to the business technology. With over 1 million active applicants of App Engine and the recent launch of Compute Engine, our Cloud Platform that makes Google’s infrastructure directly available to developers and businesses. Let’s change the gears. Let’s talk about countries and how our performance was across the world. Across all products, growth in the Americas and Asia was steady relative to the first quarter. The U.S. and Canada remains strong. Southern Europe slowed slightly as it was hampered by a poor macro economic in overall ad industry conditions notably Spain. On the other hand, performance accelerated in non-Europe driven by the UK. Our clients span a full range of industries that are making the web work for their business. Let's take a few examples. Take the hotel and travel sector; in France, we work with (inaudible) to revamp and improve the search investment allocation across 23 countries. In Denmark, top travel site, (inaudible) shifted some of their TV budgets to YouTube and other Google branding solutions. We’re particularly proud about our achievements in the automotive sector from Detroit to Bavaria. This quarter's highlights included a contract with Tesla, and a (inaudible) deal with Audi to embed Google Earth in all of their cars. In Canada, we partnered with Ford around online video content and GM and Toyota is investing significantly in YouTube. Switching gears to our agency partners, they are leading the charge in the digital era. I think we have the best relationships with agencies around the world than we’ve ever had before. And we are being able to more those relationships to real partnerships that allows them to work with their customers to make the web work for them. I’m particularly proud of the work this quarter with our agency partner Starcom MediaVest Group to develop a global joint account planning project across 50 top accounts. We lunched a digital training curriculum, covering Google products and digital trends, and we’re able to train over 8,000 people. (Inaudible) sectors are good examples, but our partnerships permit all the industries and across all countries. Spanish Health Insurance, Sanitas, made a major investment in search, and now that's become our most efficient channel from customer acquisition online accounting for about 25% to 30% of their new customers. In France, Denon is working with us on a global initiative across our display and YouTube products, as well as U.S. pharmaceutical manufacturer Shire, Intel in China chose AdMeld for a cross-platform campaign on Android and iOS because of the reach that AdMeld provides them and the seamless solutions we offer. And in Sweden, H&M is using Google+ social extensions for search addressing. Not only does it increase traffic, but it also gives them a large number of engaged followers. They’ve increased their (inaudible) in AdWords because of that by an average of 22%. Let’s talk briefly about marketing. Marketing is a key focus for our consumer products, and speaking about Google+, our marketing team continues to do a phenomenal job supporting our investments there. That's a Plus campaign is now in the U.S., U.K., Japan, France, and Germany and is helping to connect communities in Google+. Since this quarter, we organized hangouts with diverse groups, so it advances into the NBA to the UEFA. As I mentioned the Cannes Lions festival, I’m particularly proud not only are we providing great marketing solutions to our partners and our customers, our own marketing team received two Grand Prix awards, one for Project Re: Brief where we worked with Coca-Cola to take an old ad and make it relevant in the digital media space, and two for our U.K. voice search campaign. But not only that they brought back 25 additional awards, five golds, eight silvers, 12 bronze, our own min-Olympics. That’s our marketing team showing that innovation for everything we do. I’ll leave you with two final examples that show the diversity of Google’s partnerships. In France, this quarter, we move forward with the commercial relationship with SNE, which effectively represents French publishers, to put out of print books into Google Play for Android. This helps user more easily access this material and enables publishers to generate additional revenue for their continent. And second, from the sublime French literary tradition to even more sublime Doodle 4 Google contest. Our U.S. winner was Wisconsin second grader Dylan Hoffman, who in May compete a record 114,000 school children from 48 states. His school earned a $50,000 technology grand and Dylan’s Doodle grace to Google home page for a day. I think Dylan is not listening to this call, but if he is, he’s had a pretty successful second quarter as well. So congratulations and thanks to Dylan, his family and his school from Googlers all around the world, and thanks to all the Googlers that allowed us to have such a wonderful quarter. I’m going to handover to Susan now.
Susan Wojcicki: Thanks, Nikesh. We also had a busy and productive second quarter for all of our consumer products. Let me start with Search. Our goal is to deliver technology that just works. Larry has described the perfect search engine as something that understands exactly what you mean and gives you back exactly what you want. We’ve made a start for a more intelligent search, thanks to the Knowledge Graph which understands real world thing, their defining characteristics and their connections to one another. Our Knowledge Graph currently includes more than 500 million thing, people and places, more than 3.5 billion facts about them. This includes entities like landmarks, celebrities, sport team, works of art and a lot more. For a summarizing related content all at one place people not only find what they’re looking for, but they also make (inaudible). For example, I was checking [films] this weekend, so I searched for the movie The Dark Knight Rises, from the Knowledge Graph results that’s showed up on the right hand side of my search results, I was able to find out that the movie is coming on tomorrow, some information about the film and which actors star in it. Since, I didn’t recognize all the actors, I clicked on the photos displayed and I was able to see biographical information as well as other movies they’ve been in. The Knowledge Graph results also should need related movies that other people have searched for. I discovered a number of movies, including movies scheduled to come out later this year and next year that I also want to see. The Knowledge Graph also works great on mobile. If you voice search for Julia Roberts movies on your phone, you will see a list of her latest films in the search results. And if you are running an Android device with Jelly Bean, our latest Android release, Google will actually say the list of movies back to you, powered by the Knowledge Graph in addition to giving you the traditional search results. Also on Android, we introduced Google Now, a feature that intelligently brings you the right information at the right time, just for you even outward. For example, one morning last week, Google Now told me that (inaudible) 16 minutes longer than normal based on current traffic. All my schedules have been late or now gone. I didn’t have to do anything, the information just showed up as a notification. Google Now also shows me other things I may care about like weather, driving directions, my next appointment, cool places nearby, slide updates and scores for my sports. As you can see, we’re serious about providing more intelligent results. We’re moving beyond the search engine that just matches strings of words to one that understands the people, the world where people do. Just as a knowledge graph connects real-world thing; Google+ is a social spine that is starting to connect everything across Google. With a new Google+ local feature accessible from desktop and mobile on Maps, Search and Google+, the users can find and share nearly 100 million places and local businesses like restaurants and museums. You just can make decisions about where they want to go based on Zagat scores, summaries and reviews from friends and people they trust who are on Google+. Once they decided where to go, they can use the New Events tab in Google+ to plan their activity and to share photos and comments before, during, and after the event. We’ve also redesigned the Google+ app for both Android and iOS, and we’re recently announced a Google+ experience for Google, for Android tablets and the iPad. More users are now accessing Google+ from mobile devices than from desktops. Today, 250 million users have upgraded to Google+ meaning, they’ve signed up for Google+ and created a profile. we’re excited about this momentum, but we know, it’s still early days that people build a community on Google+. Moving on to shopping; this is another area where we’re helping people more quickly turn their intentions into actions. In May, we announced a new commercial model built on product listing app, it’s called Google Shopping and our transition to the new model will be complete in the fall in the U.S. By having a commercial relationship with merchants, we believe consumers will see more reliable and up-to-date information of our prices and product availability. A merchant should receive higher quality traffic to their site. We’re also experimenting with new commercial formats on Google.com that have product summaries and larger product images. These new formats are clearly labeled sponsors and they help shoppers more easily find and compare different products, or refine their searches by brand or product type. Try searching for camping tents to see an example of these new results. Users can find special offers and deals with Google Shopping, and can shop with confidence when they see a Google trusted store badge on retailer site. On the platform side, we had a lot of key announcements and launches at our Google I/O developer conference. Let me give a quick summary of the highlights. We announced 1 million new Android devices are being activated each day with more than 400 million devices now activated worldwide. We showed our Jelly Bean, our latest version of Android and the Nexus 7, a tablet that is build for Google Play. More than 20 billion apps have been downloaded from Google Play. We announced that Chrome has 310 million users worldwide, which is up from a 160 million last May. We brought Chrome for Android out of beta and we introduced Chrome for iOS which became the most popular free app in the Apple app store within hours of its availability. We launched our new infrastructure service product called Google Compute engine, which lets developers and businesses run Linux virtual machines on the same infrastructure that powers Google. Google documents became editable offline and we announced Google Drive for iOS. Drive is a place to create, share and store all your content that’s available even without an internet connection, and it functions across Windows, Mac, Android, Chrome OS and now iOS. We released 3D cityscapes in Google Earth for mobile, announced that travelers with an Android device can now access offline map of more than 150 countries. And expanded our Street View maps, our Street View feature in Google Maps to provide panoramic imagery in more than 3,000 cities, across 40 countries. And then of course there was Sergey surprise demo of Google Glass, with a live video hangout with skydivers wearing Google Glass and jumping out of an airship nearly a mile above downtown San Francisco, and then landing on the roof of the I/O Conference Center. To see this demo for yourself, you can search on Project Glass demo on YouTube. I definitely recommend this video. Thanks all for your time and now back to Patrick.
Patrick Pichette: Thank you, Susan. I’m never going to jump off with one of these balloon plane. So it was an absolutely unbelievable experience and thanks for Sergey’s innovation on that one. One more thing just before we turn to Q&A, just a couple of announcements, one, we have just launched our Google+ Investor Relations page, which is designed really to be a great source for Google products updates and company news relevant to investors and shareholders. So please be sure to check it out and let the IR team know what you think of it. So that’s just launched about an hour ago. And as we are about to open the lines, I just also want to invite David Drummond, our Chief Legal Officer, he will be joining Nikesh, Susan, and myself to answer any questions that you may have. So welcome David to the call as well. And we are going to turn on now Jamie to the Q&A section. So let us know how we want to operate.
Operator: Thank you, sir. (Operator Instructions) And we will take our first question from Mark Mahaney with Citi.
Mark S. Mahaney: Great. Thanks. Two questions please. First on Motorola, the comments at the time of the acquisition is that it would accretive, do you still feel that that asset can be in any thoughts would give us as to how you would make, what has been pretty consistently a loss leading asset that Motorola Mobile, how you make that accretive? And then a product on Search and what you find in terms of the appetite with the interest in voice search, Google has had a voice search capability for a while. But as you’ve noticed over time, people are more interested in using that less the quality of that versus whatever regular search. How interesting do you think that is as a growth area for Google in the future voice search? Thank you.
Patrick Pichette: So I’ll just answer the Motorola question, and then let Susan jump in on the Search. On the question of Motorola, look we’re totally excited about this opportunity that we have with Motorola, and our management team has been there only a few weeks. Clearly, everybody should expect some changes at Motorola that we have already talked about in the public domain and when we said, Dennis and the management team is there resetting and retooling it. but we have nothing really to announce right now. I think we have to let them do their work. but I can tell you that was a probable excitement in MMI for all the employees, but also for the clients. So I just want to come back, Mark to your point on accounting. If you actually took out the accounting issues that were related to closing the transaction where it’d be just upgrade, the amortization of intangibles, and some of the adjustments that were related to the acquisition, in fact on the mobile side, they didn’t have – they had a pretty stable and good quarter, and there’s a lot of accounting noise in the data. So I think it’s going to take one or two quarters before all that noise comes out. Susan, do you want to comment on the voice search?
Susan Wojcicki: Sure. Yeah, so I mean voice search has been an area that Google has been investing in for a number of years. we believe like we have really good technology here, because we’ve invested for so long on this. and as I mentioned in my – when I talked before hand, now with the Jelly Bean release, we have the ability not only to ask a question, but also to have the answers given back to you. And so, I definitely recommend that you test it out. it is very powerful and we think in the right circumstances, users will want to – some users will want to type and some users will want to have voice. And so in the circumstances where they do, was developed a really amazing technology that is leading edge on that.
Mark S. Mahaney: Thank you, Susan. Thank you, Patrick.
Patrick Pichette: Thanks for you questions, let’s go to the next question please.
Operator: We will take our next question from Spencer Wang with Credit Suisse.
Spencer Wang: Thanks, I guess one question and two parts for Patrick on Motorola. You talked a little bit about some of the accounting noise, Patrick, and it doesn’t sound like it’s finalized. Yeah, but, I was wondering if you could give us a rough sense of the purchase price allocation in terms of the hard assets, versus goodwill versus other intangibles so we can sort through some of that noise. And the second part is, I was wondering if you can just talk a little bit about the Motorola home business in terms of how that fits in, if you guys consider that strategic? Thanks.
Patrick Pichette: Okay, so on the details of the purchase price we haven’t given in terms of the asset and obviously the IR team can follow up with you on that, but I think in our disclosures the press release like, you will see like for example, intangibles was 30 some million in the case of Motorola and 32 I believe for Google. Just on the intangibles, so it gives you a sense of numbers for the step periods. As it relates to the home business, I mean, again a bit of the same story that I told Mark prior, which is, we’ve just got into the place and we’re in the process of evaluating every business of MMI, in every division of it. So it’s a little bit too early for us comment on big changes right now. So I just need a bit of patient for us to complete our home work as we’ve been there just for a few weeks.
Spencer Wang: Sure, thanks a lot Patrick.
Patrick Pichette: Thanks Spencer. Let’s go to the next question please.
Operator: And we will take our next question from Carlos Kirjner with Sanford Bernstein.
Carlos Kirjner: Hi thanks for taking my questions. I have two questions, one on mobile and one on YouTube. On mobile, have you conducted any studies on the impact of mobile adoption or search query demand by end users. And do you have a perspective on what portion of mobile queries are incremental versus cannibalistic for handsets and tablets. And on YouTube, I think one or two quarters ago, Nikesh referred to Google Analytics as the unsung hero of the business. Thinking about YouTube brand advertisers, how do you give them visibility into brand advertising ROI in YouTube, and do you think you will be able to do that to get the dollars to flow and overcome the obvious challenges that you may have there?
Patrick Pichette: So, Nikesh would answer the second question; Susan on cannibalization of mobile versus desktop.
Susan Wojcicki: Yeah, definitely; maybe we’ve spent a lot of time looking at that to trying to understand how those two different types of devices and how those searches are interactive with each other. And this is very complicated, but I will say we believe that mobile searches are mostly incremental. For example on weekend, when you – those are out and about, you usually see a raise in mobile activity. And then when users are back on Monday, we see a raise of desktop. So, although it’s not a one-for-one, we do believe that they are mostly incremental.
Carlos Kirjner: And does it value Susan between handsets and tablets.
Susan Wojcicki: In terms of queries?
Carlos Kirjner: No, on the incremental versus cannibalistic.
Susan Wojcicki: I mean we’d look – I think we’re still in the process of trying to have run our analysis and trying to figure that out. I mean I think that the thing that handsets and tablets have in common is they’re both on the go and people are willing to take their mobile, people use tablet certainly in the office environment as well. So, I would say, we’re still doing the analysis on that.
Carlos Kirjner: Okay. Yeah, so we have a clear view on the handsets and on the tablet there’s more analysis to be done; on YouTube, Nikesh?
Nikesh Arora: (Inaudible) Carlos, hi, so in YouTube there are two different issues. And if you’re talking about performance advertisers, they’re able to look at ROI on YouTube versus other performance media on the online space. I guess more interesting when you start talking about brand, because brand is not just about the online space, brand is also about the television space. And we’ve done very exciting things, with single source panels, where we worked in Germany with thousands of users and try to look at advertising effectiveness and efficiency, not just on YouTube and online video, but also compared to television and we’re incorporating data into our analytics and our sales pictures to show how the ROI is available on YouTube. We’ve noticed only doing at higher ROI, but we also get higher reach and higher frequency capabilities on YouTube, because you are looking at users on a very large online platform.
Patrick Pichette: Thanks for your question Carlos.
Carlos Kirjner: Thank you.
Patrick Pichette: Let’s jump to the next one please, Jamie?
Operator: We’ll take our next question from Ben Schachter with Macquarie.
Ben Schachter: And just two questions, I was wondering first, give an update us on Larry’s health situation and then I know it’s early, but can you update us on the usage of Chrome for iOS devices, and any comments you can give to help us understand the importance of that product and also how you plan to market it. And then also, historically you’ve talked about self driving cars and some of these other projects as relatively low investment, high media profile projects, but it seems with Google Glass and some others and they are taking more management time and focus, should we be thinking about those differently? Thanks.
Patrick Pichette: Yes, I want to let Nikesh talk about Larry situation, Susan can talk about the second question on iOS Chrome and then I’ll just take it to run, so Nikesh.
Nikesh Arora: There is no more new news on Larry. Larry has lost is voice and we said that means he cannot do any public speaking engagements for the time including today’s earnings call, but he continues to run the company and he is here and involves in all the strategic business decisions that we’re making.
Patrick Pichette: Susan.
Susan Wojcicki: And on Chrome for the iOS device from the moment we launched it was a very popular in the app store and we’ve seen this one of the top apps and it’s something we’ve invested for many years on Chrome. It’s got a lot of really compelling features, from security, being very fast and we continue to expect to see growth just because of the users using it for the different features that make it a really great product. From the other things, the self driving cars and Google+, I mean those continue to be projects that from a headcount perspective are very – are small, we’ve talked about them being they are small, but they have the potential to be very big. And I think they are also projects that – we sort of think about them as moon shops a lot of time, like projects that we think can have really amazing capabilities, but again, and they get the company excited, but in terms of actual resources, it is a very small number.
Patrick Pichette: Yeah, the fact that Sergey is actually leading the Glass project doesn’t change any of the strategy. So from that perspective just very exciting and fun to share it with people when we have such exciting demos. But I wouldn’t change any of the strategy in terms of the real focus of management and our capital intensity.
Nikesh Arora: Thanks, Ben. Let’s go to our next question please.
Operator: And we will go next to Scott Devitt with Morgan Stanley.
Scott Devitt: Thanks for taking my questions. I had two please. You’ve previously referenced the Talent or in last year increased the cash compensation by 10%. I was just wondering given the transition of a number of companies that you compete with for Talent into the public markets, could you just give an updated view on the cost and availability of the Talent in the Valley? And then secondly on a last 12 months basis, Google has generated $12.5 billion in unlevered free cash, so you now have an 8% unlevered free cash yield and you are generating cash at an run rate that equates to about 30% of the current cash positions. So I was wondering if you could just talk a bit about the way that you are currently thinking about capital allocation or specifically a share repurchase? Thanks.
Nikesh Arora: Okay. So let me start with the second one first. We continue, and I know that sound a bit like a broken record on this, but on a very regular basis, we actually debated with our board. In our – our cash position is really a strategic asset to us given all of the innovation that's happening, and all of the options that are available to us. I mean it has been such, and you just take Motorola, which we just closed, I mean it was a real strategic asset to us to actually be able to pounce. So we haven't changed our position in terms of share repurchases or dividends or any of the others for a time being, which does not mean we don't evaluate. We do take a good look at it. We just think that it continuous to be a strategic asset for us, and so that's why we haven't changed our position yet. In the case of the talent, I think that the Valley continues to be hot, I mean it's a hotbed of innovation. There's a lot of need for that talent, especially the very high, the engineering front, and we're delighted by our strategy. I mean we continue to see really benchmark levels for our retention purposes, and we continue to attract the very best talent. So for us, it is an absolute strategic asset again for the company. I mean, Googlers, the engineers that are here in the salespeople and they've really make a huge difference to the velocity of the company. So the Valley has not change, it content despite everything else is going on in the world out there are. The Valley continues to be absolutely hot, and we’re still pleased to have seen our strategy pay out so well. So thanks for your question Scott. Very good question. Let's go to our next question please Jamie.
Operator: And we'll go next to Heather Bellini with Goldman Sachs.
Heather Bellini: Hi, great, thank you. I had two questions. First, what are you seeing in terms of mobile CPC trend, and how do you see these trends playing out over the course of the next 12 months. And then, the second question is, with the Nexus 7 on the market, can you talk a little bit about your plan to accelerate content acquisition in particular in video and book? Thank you.
Patrick Pichette: I think Nikesh is perfectly suited for both.
Nikesh Arora: Hi, Heather. Thank you for your question. Well, I think the good news is that we’re seeing phenomenal growth in the mobile queries across the board, whether it’s tablets, whether it’s mobile phones, whether it’s geographical or whether we are seeing phenomenal amounts of mobile queries across the board. I think as I said, mobile is right now where Search was in 1999. we had a situation where Susan’s team was doing phenomenal product innovation to keep driving more and more efficiency for the advertisers. we were working with advertisers to get them to get better landing pages, better sites, get them to understand truly the opportunities on the mobile space for example. You can make phone calls, so we have a product called Click-to-Call. Now the Search takes on a whole different meaning, because there’s a better conversion and people actually click and make phone calls. So we are seeing mobile CPCs are healthy and we expect them the long-term that they will continue to be healthy and sort of follow this trajectory that Search has followed, more inventory, more effectiveness, more ROI for the advertisers, better pricing in the market. In terms of your second question on Nexus 7, I think we have made tremendous amounts of headway in the content space that we have a lot, lot of content on Google Play. we are working very closely with the music industry, with Hollywood studios et cetera, to get more and more content on the platforms, so I think given that there are models out there where other people are offering content to the platforms. it is becoming to the standards that you can have the ability to offer content to the end user and we are making tremendous amounts of progress across the board.
Patrick Pichette: Thanks for your question, Heather. Let’s go to our next question please.
Operator: And we’ll take our next question from Doug Anmuth with JPMorgan.
Doug Anmuth: Great, thanks for taking the question. I just wanted to ask two things, just first following up on the mobile CPC question, can you just give us some color on what percentage of advertisers are bidding on smartphone to N tablets in addition to the desktop? and then secondly, Patrick can you also just help us understand the accounting around the Nexus 7 tablet and how we should be thinking about that on a growth versus net basis and the impact it may have going forward? Thanks.
Patrick Pichette: Okay. So I will let Nikesh cover the CBC and I also come back after.
Nikesh Arora: Yeah, actually I think I already said that in my prepared remarks that we have over 1 million advertisers working with us in mobile advertising and it gets over 300,000 mobile apps. So I think it’s a substantive number in terms of number of advertisers are involved in mobile space. And I think usually people will get enrolled in mobile space don’t distinguish between smartphones and tablets, they actually, they want to find the most effective ROI they can get and they want to capture as many queries as you get on these device. Patrick?
Patrick Pichette: No, the issue for the Nexus S, Nexus 7, the – I mean we have two sets of accounting, obviously, it’s distributed on it’s own by others like, you can get it at Best Buy and otherwise when you use the Play Store to actually buy it right, we book the revenue and then we book the cost as well and the cost will be in other cost of revenue rather than CAC or TAC, they’re neither of them and that’s how the accounting is set.
Susan Wojcicki: Yeah, and this is Susan, just one more thing I would add Doug on your question about the mobile CBCs and the percentage that are bidding, is a lot of campaign structures are setup so that when an advertiser participates in a bid, they actually bid, they can instead of one campaign and it can run across everything. And we adjust those prices dynamically for them, we have – it’s called Smart Pricing. And so some advertisers do bid specifically on mobile and then some advertisers have bundled campaigns and we adjust those prices. So it’s not just advertiser that are bidding only for mobile that are participating in mobile.
Patrick Pichette: Thanks for your question, Doug. Let’s go to the next question please.
Operator: And we will go next to Justin Post with Merrill Lynch.
Justin Post: Great. When you look at your international result ex-FX, they actually were stable or even accelerated. Yeah, we are hearing a lot of issues over there. Can you talk about geographic mix, what countries are doing well or vertical mix and any product enhancements or new products you’ve launched that are really helping your revenue growth there. And then secondly, TAC to distribution partners was up about $40 million quarter-over-quarter and continues to be a bigger chunk of your Google website revenues. What drove the quarter-over-quarter increase, was that mostly mobile or are there other factors? Thank you.
Patrick Pichette: So, let me jump on TAC, and then let Nikesh answer to the first question. So TAC, it's really a mix, right, obviously TAC reflects a mix of the different distribution methods that include toolbars, chrome distribution, mobile distribution, and also obviously the AFS business as well. So there's a – if you look at our revenue mix between Google properties and network, right network will attach stronger, so that will drive TAC as well. And then, mobile is also one of these contributing factors. So we don't break down all these specifics, but it’s not only mobile. I mean, we have a number of factors that are at play here. On the first question, I’ll let Nikesh circle back to you.
Nikesh Arora: Yeah, I alluded to some of this in the prepared remarks. I think, as I said growth in the Americas and Asia has been steady this quarter. The U.S. and Canada have stayed strong, and as I mentioned, as you’ve said there have been some issues internationally. Southern Europe, we saw slide dip as we think it is hampered both by pure macro economic conditions and all ad industry concerns. Spain was a notable sort of lowlight or highlight depending on how you look at it in that conversation. On the other hand, performance accelerated for us in northern Europe driven by the UK and the UK has been a little depressed over the last few quarters. So it is finally coming back and sort of we are seeing strength there again. In terms of your question and on the sectors, I think travel has been strong pretty much across the board in the U.S. and the UK and around the world. Auto was strong in the U.S. for us, healthcare has been strong in the UK, and generally across the world, we've seen strong sort of performance both in finance and local, and we're seeing more and more sort of excitement and enthusiasm in sectors like CPG and entertainment given the shift to brand. But I’d say, this is the snapshot in time and these things change quarter-over-quarter.
Justin Post: Thank you.
Patrick Pichette: Thanks, Justin. Jamie, let’s go to our next caller please.
Operator: And we’ll go next to Anthony Diclemente with Barclays.
Anthony Diclemente: Hi, thanks. One, I think for Susan, just if you can help us with the order of the magnitude the drivers of the divergence that we continue to see between CPCs and volume. I think in the past you’ve talked about, of course mobile is one of those drivers, but then FX, we have a sense of that, property mix, emerging markets and add quality changes, all driving that. So I was wondering if you guys could give us like a ordered magnitude of how important each of those key drivers were in the quarter and then how we should think about those trending going forward, if we should expect that divergence to normalize or should we actually expect it to continue to diverge? It will be helpful. Thank you very much.
Patrick Pichette: Susan, do you want to give some comments on it or Nikesh.
Nikesh Arora: I think, I had the CPC (inaudible) on this quarter and you can’t have a good earnings call, if you don’t talk about CPC, so here we go. CPC is an important metric for us, but if you take that independently, it’s not necessarily a reflection of the fundamental health of our business. This quarter, I’d say the biggest impact on CPC was actually FX. We have four or five factors that impact CPC, but the biggest impact this quarter was FX. We have clearly an impact of mobile versus tablet versus desktop, we have an impact of emerging versus developed markets, and what’s happening from a macro economic point of view, that we’ve talked about, we have an impact on google.com versus network, so as you see the network playing a bigger role, it impacts CPC. And finally as quality changes, also impact CPC, but I’d say this quarter the impact has been felt because of FX, but from a positive perspective we see any time there was a change in CPC, which is more attractive for the advertiser that allows the advertiser get a bit of ROI, but for us it’s an opportunity for the advertising.
Patrick Pichette: Yeah, it’s important to know that the 16%, there was a big chunk of it, that was CPC versus the last quarter. I mean, as the euro kind of went down 9% year-over-year, I mean it obviously makes a big difference. So thanks for your question.
Anthony Diclemente: Okay, and that’s a nice one. Thank you.
Patrick Pichette: Cheers. Let’s go to the next question please, Jamie.
Operator: And we’ll take our next question from Ken Sena with Evercore Partners.
Ken Sena: Hi, thank you. Can you just maybe talk a little bit more about the Offers business and do you feel strongly about that business as you did in the past. And maybe how that business actually will come into play with Google+ or on payments or (inaudible)? Thank you.
Susan Wojcicki: Hi, Ken. So yeah Offers continues to be an area that we are investing in, we have, I mean we think that there is a lot of things that are really important about Offers the way it’s a local business and works with both small and large business it’s got, there is a lot of user interest in it. So it is an area that we are continuing to invest in. We’re also, as we continue to develop our business model continues to evolve. And for example, we are putting a little – we’re working with a lot of the different Offers and providing distribution for them in addition to generating our own Offers with our own sales team. So, but it continues to be an important area for us, and we’ll continue to invest in the cities that we’re currently operating in.
Ken Sena: Thank you.
Patrick Pichette: Sure.
Susan Wojcicki: Thank you, Ken.
Susan Wojcicki: Jamie, our next question please.
Operator: And we will take our next question from Ronald Josey with ThinkEquity.
Ronald Josey: Great, thanks for taking my question. Going back to mobile and the opportunity there, Nikesh I thought that might be interesting if you could talk a little bit about, perhaps what you are seeing in terms of the campaigns and there has been an acceleration, now that AdMob is fully integrated in AdWord, knowing that there is over a million advertisers and 300,000 apps. I’m wondering if there is been accelerations since that's happened? Thank you.
Nikesh Arora: Hi, thanks for the question. I think as I said, we are seeing phenomenal amount of growth in the mobile query space and it’s a consequence of more device, it’s a consequence of more adoption of tablets around the world. It's also comfortable with the devices and using them more often. So with the number of questions they asked on the AdMobs. so AdMobs just got completed in early June. So it’s a bit early to say, we're seeing acceleration. but generally, our performance throughout that integration has been very strong and we’ve effectively had a very, and what we’ve done about six months ago, as we took all of our sales efforts and we took our specialized mobile sales people, we had them trained all of our sales forces around the world. So that impact has even contributed more than just that integration part. but we think the integration is just going to turbocharge that effort and hopefully continue to help us drive mobile. and mobile is going to be here for a while. I think it’s a fact of life for us now. So we are mobile sort of becoming as core, as desktop search was, so we’re making sure that all of our sales people around the world are fully equipped and working with every advertiser, not just 1 million to make sure that people can see ROI in both mobile and desktop simultaneously.
Ronald Josey: Great, thank you.
Patrick Pichette: Thanks, Ron. Let's go to our next question, please.
Operator: And we'll go next to Jason Maynard with Wells Fargo.
Jason Maynard: Hey, good afternoon. I have one question just on the shifted mobile and specifically around this will be both Nexus as well as Motorola. How important do you think it is for ultimate mobile modernization to actually control the whole experience on the device and given that you’ve got all sorts of different competitors some who subsidize evidently, some obviously telling full price, hardware, software combos, what do you think the right mixes for Google and when do you think you’ll sort of sort this out and be a little bit more declarative in the market with your intentions? Thanks.
Nikesh Arora: I think, hi this is Nikesh again Jason. thanks again for your question. And as I said, mobile is very, very important. I think it’s better to go back and think about what’s happening in the marketplace. We said we’re very committed to mobile; it’s evident in our commitment to Android in our ecosystem as well as Motorola acquisition. So we believe that mobile us very and very important critical to the future. Now, I know it seems a little complicated when you look at the different competitors, and how you talked about subsidies et cetera. We simplify that by focusing on, how do we provide the best experience to the user. Now providing the best experience to user, is effectively working really hard with Andy Rubin, Stephen Android making sure he is getting the best experience for the end-user and in that process he works with the best OEMs in the marketplace to make sure that the combination of hardware and software allows for the best experience to be delivered. I think, for us what's important as to get that experience delivered and we will work with whatever the industry models that are out there, either we work direct with operators, trying to make sure that happens behind the end-user and more often they’ll not be work with OEMs, to see how we can get the best agreed experience in the hands of the end-user. I think that's what we're going to focus on. So, I think that's quite declarative in terms of intention.
Patrick Pichette: Yeah. I mean just to close, open is really important to Google and in that context you see our strategy is very focused on end-users and been open and we are going to get a lot of benefit that we already have and continue to get a lot of benefit out of that. So, it's a complex question, there is no doubt about it. Thank you, so much for your question. Let’s go for the next question please.
Operator: Now we’ll take our next question from Lloyd Walmsley with Deutsche Bank.
Lloyd Walmsley: Thanks, I'm wondering if you could tell us a little bit about the rollout of the shift to paid inclusion for Google shopping and when you expect it to be fully rolled out and kind of what you're seeing today in terms of Paid Clicks and CPCs, now that some of the shopping links have been moved to high end results and where do you think CPCs there can go relative to just core paid search?
Patrick Pichette: I’ll let Susan answer this one. Susan?
Susan Wojcicki: Yeah, so Lloyd, so we made this decision to move to a commercial model because we saw that ultimately this would drive a better experience for users and having more up to date information and more accurate price and inventory availability and so we are in the process of rolling that out. We think it will be rolled out. We expect probably completed around the Q4 timeframe. And we are working really hard with all the merchants to get them all on board, and again we think this is actually really good for both the merchants and the users. We actually don’t refer to this as feed inclusion, just because that actually is a term from the people who have been in the industry for a really long time meaning putting in, paid things into the search results, in a non-marked way. And we’re very, very clear when we show this, we do mark everything very clearly as sponsored, and again we believe that actually moving to this model is good for both the users and for the merchants and we’re really looking forward to this transition.
Lloyd Walmsley: Thank you.
Patrick Pichette: Thanks for your question, a very important piece for us. Let’s go to our next question please.
Operator: We will take our next question from Kevin Kopelman with Cowen and Company.
Kevin Kopelman: Hi, thanks. Could you give us a sense of how big your mobile search queries are, as a percentage of total search queries? And also on Motorola, I know you’re not giving us a business update, but could you give us what the Android unit growth was in the quarter on a pro forma basis? Thanks.
Patrick Pichette: Well, on the last one, on the mobile side, the non-home side, it’s all Android. And on the search queries, we don’t actually provide the details. We provide the geographics, but we don’t give the details of the other one. So, I am sorry Kevin if we can’t be more helpful on the granular details on this issue. Let’s see, we have time for one more question, let’s jump on one last question, Jamie?
Operator: Thank you, sir. We’ll take our last question from Jason Helfstein with Oppenheimer.
Jason Helfstein: Thanks for taking my question. I’ll ask you just two. One, can you just talk about the growth of Google+ number growth, are you happy? I think you alluded to how that's going. What can you do to drive faster member growth and is that kind of part of the strategy or you just led it organically evolve. So kind of a push versus, I guess the pull strategy there. And then second, can you give us the breakdown of depreciation between Motorola and MII for the quarter? Thanks.
Patrick Pichette: Well, you’ll have, in the segmented reporting you'll find that information. So, after the call, so this is for your second question, Jason. On the issue of depreciation, I think that the team can circle back which would give you the split, because we do the segmented reporting. On the first question, which is about Google growth and our success there, I’ll let Susan cover that one.
Susan Wojcicki: Sure. Yeah, so, overall we've been really pleased with the growth that we've seen, you’ve talked about the $250 million accounts that we have, Google+ accounts. And I do think it's also really important to remember that Google+ just celebrated its one-year anniversary. We actually celebrated that at IO. And so, we see that Google+ account growth has growing really well. We think that one of the most important things is that when you have a Google+ account you have the ability to share. And we've talked about Google+ being the social spine across all of our products ability to make all of our products better. Not just the stream, which is an important part, but also for example your search experience. So that if I have a friend, a friend went to hotel, and +1 that hotel, if I’m ongoing to that same location, I would you be able to see that information at the time that I'm doing that search. And so we have many, many use cases where we think being part of Google+ will be a better experience. And so we’re working across the board to make sure that our products are integrated, we have a number of integrations across the products, probably local with the most significant one that we did this quarter, and we find that having those integrations by making the products better, also tried to more usage of Google+. So yeah, so thank you Jason, that was an important question.
Jason Helfstein: Thank you.
Patrick Pichette: And with that with an eye on the clock, we’ve got to run. I just wanted to do couple of things; one is thank Nikesh and Susan as well as David for joining us for the call, and Q&A. I also thank all our Googlers, I mean these last 90 days and the great results that we are posting now and beginning of the collaboration and integration of Motorola, all these things are possible because our Googlers do a phenomenal jobs every single day. So I want to thank everybody and then as I close, remember to go and take a look at our Google+ website for investor relations. And I think you will find it pretty interesting. So with that Jamie, I’ll let you close the call, and I wish everybody a happy summer.
Operator: Thank you, sir. That does conclude today’s conference and we do appreciate everyone’s participation. | [
{
"speaker": "Operator",
"text": "Good day, everyone and welcome to the Google Inc. Second Quarter 2012 Earnings Conference Call. Today’s call is being recorded. At this time, I’d like to turn the conference over to Willa Lo, Investor Relations Manager. Please go ahead, ma'am."
},
{
"speaker": "Willa Lo",
"text": "Good afternoon, everyone, and welcome to today’s second quarter 2012 earnings conference call. With us are Pat Pichette, Senior Vice President and Chief Financial Officer; Nikesh Arora, Senior Vice President and Chief Business Officer; Susan Wojcicki, Senior Vice President, Advertising. Also, as you know, we distribute our earnings release through our Investor Relations website located at investor.google.com. So, please refer to our IR website for our earnings releases, as well as the supplementary slides that accompany the call. This call is also being webcast from investor.google.com. A replay of the call will be available on our website later today. Now, let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward-looking, including statements regarding Google’s future investments, our long-term growth and innovation, the expected performance of our businesses, and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on this call, such as operating income and operating margin, are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will now turn the call to Larry."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Willa, and good afternoon everyone. Thank you for joining us. So, well, this is a special call as we enter into a new chapter in our history at Google here with our recent acquisition of Motorola, and with it comes a new set of financial information for all you both at a consolidated, but also at the segment level. So speaking of Motorola, it’s worth noting that given the recent close of the transaction, we can expect this specific segment of our financials to continue to show some accounting variability. So for example, this quarter it’s a stub period, so meaning it only reflects the results since the acquisition dates rather than the full quarter. And as a result of the close, we did a number of accounting adjustments typical for such transactions. So we’ll try to do our best to answer your questions on this call. And our investor relations team will also continue to support the analyst and the investor community during this transition. So now, let’s quickly cover our consolidated result as well as segmented reporting for both Google and Motorola. Our gross total consolidated revenue grew 35% year-over-year to $12.2 billion and 15% quarter-over-quarter. So again, please remember that these total consolidated numbers include the stub period for Motorola. Additionally, there was a significant year-over-year currency headwind in Q2. In fixed FX, revenue would have grown to 39% year-over-year instead of 35%. Google on a standalone gross revenue grew 21% year-over-year to $11 billion and 3% quarter-over-quarter. Our Google website revenue was up 21% year-over-year to $7.5 billion and 3% quarter-over-quarter, which trends across most major geographies and verticals. Google network revenue grew 20% year-over-year to $3 billion, and 2% quarter-over-quarter. Our other revenue line grew by 42% year-over-year to $439 million and 5% quarter-over-quarter. It’s again worth noting that in fixed FX our revenue would have grown 25% year-over-year. Motorola grew revenue for the stub period since May 22 at $1.3 billion. Our mobile devices revenue for that period was $843 million, encouraged by the strength of the North American Verizon franchise driven by the RAZR MAXX sales. Although we’ve seen also weaker revenues that were driven by the declining international sales of feature phones and mid-tier smartphones; the home business, revenue was $407 million. So the core metrics of Google standalone business continue to perform very well against the backdrop of a somewhat difficult global economic environment. Our global aggregate paid-click growth was very strong, up 42% year-over-year, and also up 1% quarter-over-quarter. Our aggregate cost-per-click growth was down 16% year-over-year, and up 1% quarter-over-quarter. And please remember that the currency headwinds also obviously had a quite negative impact on the CPCs in Q2. Turning to geographic performance of Google standalone business, U.S., UK and rest of world are growing at a good pace as reflected in our results. In our earnings slides, which you’ll find in our Investor Relation website, you’ll see that we’ve broken down our revenue by U.S., UK and rest of world, to show the impact of FX and the benefits of our hedging program. So please refer to those slides for those exact calculation. Revenue from the U.S. was up 20% year-over-year to $5 billion. Our non-U.S. revenue accounted for 54% of our total revenue or $6 billion, and was up 22% year-over-year, which includes $81 million benefit from our hedging program. The UK was up 20% year-over-year to $1.2 billion, and then fixed FX term; in fact the UK grew 22%. Coming back to an aggregate level for the total consolidated business; other cost of revenue was $2.3 billion in Q2. Our non-GAAP operating expenses totaled $3.3 billion, which excludes stock-based compensation and charges related to the severance and benefit arrangements in connection with the Motorola acquisition of $652 million. Our non-GAAP operating profit was $4 billion in Q2, resulting in non-GAAP operating margin of 32.3%. For standalone Google, our traffic acquisition costs were $2.6 billion or 24.7% of total advertising revenue. Our other cost of revenue was $1.3 billion, and that's excluding SBC of $82 million. Our non-GAAP operating expenses were $3.1 billion, also excluding SBC of $470 million. Finally, non-GAAP operating profit was $4 billion in Q2, resulting in a non-GAAP operating margin of 36.4%. This continued strong margin in our standalone Google business segment gives us the confidence to continue to fully fund our many strategic growth areas, such as mobile, Android, YouTube and Chrome. Obviously, Susan and Nikesh will go into more details of our initiatives in a minute. At Motorola, our non-GAAP operating expenses including cost of revenue for the stub period were $1.3 billion. And keep in mind that, intangible amortization of expenses and the step-up cost attributed to standalone Google and Motorola are included in these non-GAAP measures. And as a result, the non-GAAP operating loss at Motorola was minus $38 million in Q2 resulting in a non-GAAP operating margin of minus 3% for that specific segment. Headcount increased roughly 21,500 in Q2, obviously Google itself added about 1200, while the remainder of this number includes the Motorola employees who joined in the acquisition. In total, the consolidated company ended the quarter at around 54,600 employees, full-time employees status. Our effective tax rate was 19% in Q2, and that reflects not only the mix of our earnings between domestic, international subsidiaries and our hedges, but also capital gains offset by carried over capital losses. Let me quickly turn to cash management. Other income and expenses was $254 million for the quarter, which reflects gains related to a divestiture of a business, offset somewhat by lower interest income and by the impact of our FAS 133 expenses from our hedging program. For more details [underway any], please again refer to the slides of the company or call on our IR website. Operating cash flow was very strong at $4.3 billion for the second quarter. CapEx for the quarter was $774 million versus last quarter at $607 million. The majority of our CapEx was spent really related to production equipment, facilities, and man purchases. And obviously, we're pleased with our free cash flow, which was $3.5 billion. So now, let me hand it over to Nikesh, who will cover more the details of our business performance in the quarter, then Susan will cover our product highlights. And then finally, we’ll open up the lines for your questions. And please note that Nikesh and Susan will discuss only the standalone Google business and not cover Motorola. So let me turn it over to Nikesh."
},
{
"speaker": "Nikesh Arora",
"text": "Thank you, Patrick, and hello everyone. Our business had a very strong quarter as you’ve heard with over $11 billion in revenue. I’m going to talk about three broad themes today. First, how our recent big bets in the ad business are coming together into integrated platforms. I think digital advertising is really in defrag mode. secondly, we’ll take a look under the hood that how our investments and search advertising adds quality by helping our search business accelerate. And third, we’re going to talk a bit about our enterprise business, which I believe is reaching a real turning point, then I’ll discuss some ways for driving success for our customers and some marketing highlights. So first, our big bets. In about four years, DoubleClick has gone from strength to strength at Google. Now it is the foundation of our display business. this quarter, we announced DoubleClick digital marketing, the first modern ad platform for the modern digital world. This was the biggest ever overall for DoubleClick ad platform. It is used by thousands of agencies and marketers and we managed billions in marketing spend across the world on this platform. It now spans the best of display, rich media, exchange buying, surge and measurement. Some of our recent display acquisitions, Teracent and Invite Media, which both grew by over 50% last year, are also seamlessly integrated into this platform. At the same time, AdMeld, which we acquired, is helping provide publishers control, flexibility and more revenue opportunities. Our display platform helps direct response in brand marketers navigate the whole web. For brands, this quarter we unveiled the Brand Activate initiative. As seas of measurement and planning solutions baked directly into our platform, with our partners are building an online measurement for GRPs or gross rating points in a way to measure viewable impressions. Effectively what we want to do is we want to drive more and more advertising dollars in the brand space and this platform is going to be an effective way for us and we’ll do that. Recently InComm at a big advertising festival, creative agencies loved project [Rebif] this was one of our demos with the possibilities of how in modern digital marketing you can use multiple media formats to make advertising successful. That is quite a change from 2004 when our four line text ads weren’t quite as exciting. Another big bet as part of our integrated solutions is YouTube. I think in 2007 it was when newspapers frequently said YouTube is groping for an effective business model. I think we can declare we found our model. YouTube now unites the world through video from the Human Rights channel launched this quarter to a (inaudible) study confirming YouTube as a major global news platform. And for the first time, YouTube will be powering NBC’s live streaming of the Olympics in the U.S. while also live streaming the games in London to 64 territories around the world. Yearly account signups have doubled year-over-year and users are uploading over 72 hours of video every minute. This quarter we released a new YouTube app for Android helping users to find videos and follow channels from a mobile or tablet devices. We believe YouTube is now a proven winner for the whole video ecosystem. Thousands of partners are making six figures and we’re proud to work with major record labels in Hollywood studios on this platform. In fact, earlier in May, we saw an incredible digital upfront of it, Ban Car, highlighting our YouTube programming partners. Slightly over 13,000 clients attended, some of the worlds biggest advertisers were there and they’re making significant commitments on YouTube including people like Unilever, AT&T and American Express. If you’re counting that’s five successful acquisitions well integrated and helping us succeed in the advertising space. The sixth is Admob, which helps power our mobile ads, both across Android and IOS and other mobile platforms future. Admob was integrated this quarter into AdWords, this has further turbo charged our ability to provide in-house advertising. That’s more than a million advertisers with 300,000 mobile apps, 350 million devices at their finger tips. The growth in the businesses with mobile website is stunning. Last quarter we rolled out GoMo which is the short for go mobile, that initiative was rolled out in 8 new countries including Germany, Japan and Brazil. Mobile friendly website are vital modern businesses and very important for our mobile search business. In less than one year the number of advertisers with mobile sites has doubled. Other major upgrade to Google Analytics was made for mobile apps and the new AdMob SDK for developers turned out to an awesome quarter. For us mobile is like desktop was in 1999, smart marketers are getting great ROI and are developing native ad models that generate results for them. For example, we’ve had 15 million monthly calls for our click-to-call go format exclusively available in mobile devices in the US. Let’s talk about my second theme, the secret souls of search advertising. This quarter showed why we’re so optimistic about search’s continued growth. You know about some factors that drive search, the overall move to digital media and new search ad formats. Privacy, we often underestimate one factor that you don’t often read about. The amount of effort our product engineering teams put into the quality and precision for ads, that just keeps getting better. This quarter made 72 quality improvements and launched greater auctions transparency for search advertisers, effectively what results it improves the relevance of our add and making it more useful to consumers, it drives better results for our partners, clients and advertisers and it helps improve monetization. Imagine if every single search ad was a perfect answer that drove the conversion for the customer, I think that’s the objective that our teams are aiming for. In Q2, our improvements included better triggering of site links and ads and improved ad rotation system, better geographical targeting, expanded match for keyword variance and a whole host of other improvements. As an example of benefits of these changes, the advertisers taking advantages of new close variance feature and exact and phrase matching are seeing roughly a 2% increase in clicks in average. Let’s talk about the third theme, the technology, where we are in our enterprise business. I think it’s become clear for us that we have a serious small, but growing business, which is going to be a future growth engine for Google. I hope you read this week about a company, who said competition was 50% more expensive than Google, and not as cool. That company is now $200,000 a year Google apps customer. Companies, schools, governments worldwide are moving to the could faster than ever. More than 5 million businesses have now gone Google worldwide. The traction amongst large organizations even such as the U.S. Department of Interior, Fairfax Media in Australia, et cetera. I think it’s clear, you can’t fake a commitment to cloud computing, and we’ve invested to build and scale a business that has gone to upstart to upper crust. Thousands of businesses switch to Google apps from our competitors everyday. Recently, we’ve launch products like Google Drive, Google Maps Coordinate, as well as the ability to edit documents off-line and in a whole range of mobile devices and tablets. That just shows you the pace of innovation that Google is bringing to the business technology. With over 1 million active applicants of App Engine and the recent launch of Compute Engine, our Cloud Platform that makes Google’s infrastructure directly available to developers and businesses. Let’s change the gears. Let’s talk about countries and how our performance was across the world. Across all products, growth in the Americas and Asia was steady relative to the first quarter. The U.S. and Canada remains strong. Southern Europe slowed slightly as it was hampered by a poor macro economic in overall ad industry conditions notably Spain. On the other hand, performance accelerated in non-Europe driven by the UK. Our clients span a full range of industries that are making the web work for their business. Let's take a few examples. Take the hotel and travel sector; in France, we work with (inaudible) to revamp and improve the search investment allocation across 23 countries. In Denmark, top travel site, (inaudible) shifted some of their TV budgets to YouTube and other Google branding solutions. We’re particularly proud about our achievements in the automotive sector from Detroit to Bavaria. This quarter's highlights included a contract with Tesla, and a (inaudible) deal with Audi to embed Google Earth in all of their cars. In Canada, we partnered with Ford around online video content and GM and Toyota is investing significantly in YouTube. Switching gears to our agency partners, they are leading the charge in the digital era. I think we have the best relationships with agencies around the world than we’ve ever had before. And we are being able to more those relationships to real partnerships that allows them to work with their customers to make the web work for them. I’m particularly proud of the work this quarter with our agency partner Starcom MediaVest Group to develop a global joint account planning project across 50 top accounts. We lunched a digital training curriculum, covering Google products and digital trends, and we’re able to train over 8,000 people. (Inaudible) sectors are good examples, but our partnerships permit all the industries and across all countries. Spanish Health Insurance, Sanitas, made a major investment in search, and now that's become our most efficient channel from customer acquisition online accounting for about 25% to 30% of their new customers. In France, Denon is working with us on a global initiative across our display and YouTube products, as well as U.S. pharmaceutical manufacturer Shire, Intel in China chose AdMeld for a cross-platform campaign on Android and iOS because of the reach that AdMeld provides them and the seamless solutions we offer. And in Sweden, H&M is using Google+ social extensions for search addressing. Not only does it increase traffic, but it also gives them a large number of engaged followers. They’ve increased their (inaudible) in AdWords because of that by an average of 22%. Let’s talk briefly about marketing. Marketing is a key focus for our consumer products, and speaking about Google+, our marketing team continues to do a phenomenal job supporting our investments there. That's a Plus campaign is now in the U.S., U.K., Japan, France, and Germany and is helping to connect communities in Google+. Since this quarter, we organized hangouts with diverse groups, so it advances into the NBA to the UEFA. As I mentioned the Cannes Lions festival, I’m particularly proud not only are we providing great marketing solutions to our partners and our customers, our own marketing team received two Grand Prix awards, one for Project Re: Brief where we worked with Coca-Cola to take an old ad and make it relevant in the digital media space, and two for our U.K. voice search campaign. But not only that they brought back 25 additional awards, five golds, eight silvers, 12 bronze, our own min-Olympics. That’s our marketing team showing that innovation for everything we do. I’ll leave you with two final examples that show the diversity of Google’s partnerships. In France, this quarter, we move forward with the commercial relationship with SNE, which effectively represents French publishers, to put out of print books into Google Play for Android. This helps user more easily access this material and enables publishers to generate additional revenue for their continent. And second, from the sublime French literary tradition to even more sublime Doodle 4 Google contest. Our U.S. winner was Wisconsin second grader Dylan Hoffman, who in May compete a record 114,000 school children from 48 states. His school earned a $50,000 technology grand and Dylan’s Doodle grace to Google home page for a day. I think Dylan is not listening to this call, but if he is, he’s had a pretty successful second quarter as well. So congratulations and thanks to Dylan, his family and his school from Googlers all around the world, and thanks to all the Googlers that allowed us to have such a wonderful quarter. I’m going to handover to Susan now."
},
{
"speaker": "Susan Wojcicki",
"text": "Thanks, Nikesh. We also had a busy and productive second quarter for all of our consumer products. Let me start with Search. Our goal is to deliver technology that just works. Larry has described the perfect search engine as something that understands exactly what you mean and gives you back exactly what you want. We’ve made a start for a more intelligent search, thanks to the Knowledge Graph which understands real world thing, their defining characteristics and their connections to one another. Our Knowledge Graph currently includes more than 500 million thing, people and places, more than 3.5 billion facts about them. This includes entities like landmarks, celebrities, sport team, works of art and a lot more. For a summarizing related content all at one place people not only find what they’re looking for, but they also make (inaudible). For example, I was checking [films] this weekend, so I searched for the movie The Dark Knight Rises, from the Knowledge Graph results that’s showed up on the right hand side of my search results, I was able to find out that the movie is coming on tomorrow, some information about the film and which actors star in it. Since, I didn’t recognize all the actors, I clicked on the photos displayed and I was able to see biographical information as well as other movies they’ve been in. The Knowledge Graph results also should need related movies that other people have searched for. I discovered a number of movies, including movies scheduled to come out later this year and next year that I also want to see. The Knowledge Graph also works great on mobile. If you voice search for Julia Roberts movies on your phone, you will see a list of her latest films in the search results. And if you are running an Android device with Jelly Bean, our latest Android release, Google will actually say the list of movies back to you, powered by the Knowledge Graph in addition to giving you the traditional search results. Also on Android, we introduced Google Now, a feature that intelligently brings you the right information at the right time, just for you even outward. For example, one morning last week, Google Now told me that (inaudible) 16 minutes longer than normal based on current traffic. All my schedules have been late or now gone. I didn’t have to do anything, the information just showed up as a notification. Google Now also shows me other things I may care about like weather, driving directions, my next appointment, cool places nearby, slide updates and scores for my sports. As you can see, we’re serious about providing more intelligent results. We’re moving beyond the search engine that just matches strings of words to one that understands the people, the world where people do. Just as a knowledge graph connects real-world thing; Google+ is a social spine that is starting to connect everything across Google. With a new Google+ local feature accessible from desktop and mobile on Maps, Search and Google+, the users can find and share nearly 100 million places and local businesses like restaurants and museums. You just can make decisions about where they want to go based on Zagat scores, summaries and reviews from friends and people they trust who are on Google+. Once they decided where to go, they can use the New Events tab in Google+ to plan their activity and to share photos and comments before, during, and after the event. We’ve also redesigned the Google+ app for both Android and iOS, and we’re recently announced a Google+ experience for Google, for Android tablets and the iPad. More users are now accessing Google+ from mobile devices than from desktops. Today, 250 million users have upgraded to Google+ meaning, they’ve signed up for Google+ and created a profile. we’re excited about this momentum, but we know, it’s still early days that people build a community on Google+. Moving on to shopping; this is another area where we’re helping people more quickly turn their intentions into actions. In May, we announced a new commercial model built on product listing app, it’s called Google Shopping and our transition to the new model will be complete in the fall in the U.S. By having a commercial relationship with merchants, we believe consumers will see more reliable and up-to-date information of our prices and product availability. A merchant should receive higher quality traffic to their site. We’re also experimenting with new commercial formats on Google.com that have product summaries and larger product images. These new formats are clearly labeled sponsors and they help shoppers more easily find and compare different products, or refine their searches by brand or product type. Try searching for camping tents to see an example of these new results. Users can find special offers and deals with Google Shopping, and can shop with confidence when they see a Google trusted store badge on retailer site. On the platform side, we had a lot of key announcements and launches at our Google I/O developer conference. Let me give a quick summary of the highlights. We announced 1 million new Android devices are being activated each day with more than 400 million devices now activated worldwide. We showed our Jelly Bean, our latest version of Android and the Nexus 7, a tablet that is build for Google Play. More than 20 billion apps have been downloaded from Google Play. We announced that Chrome has 310 million users worldwide, which is up from a 160 million last May. We brought Chrome for Android out of beta and we introduced Chrome for iOS which became the most popular free app in the Apple app store within hours of its availability. We launched our new infrastructure service product called Google Compute engine, which lets developers and businesses run Linux virtual machines on the same infrastructure that powers Google. Google documents became editable offline and we announced Google Drive for iOS. Drive is a place to create, share and store all your content that’s available even without an internet connection, and it functions across Windows, Mac, Android, Chrome OS and now iOS. We released 3D cityscapes in Google Earth for mobile, announced that travelers with an Android device can now access offline map of more than 150 countries. And expanded our Street View maps, our Street View feature in Google Maps to provide panoramic imagery in more than 3,000 cities, across 40 countries. And then of course there was Sergey surprise demo of Google Glass, with a live video hangout with skydivers wearing Google Glass and jumping out of an airship nearly a mile above downtown San Francisco, and then landing on the roof of the I/O Conference Center. To see this demo for yourself, you can search on Project Glass demo on YouTube. I definitely recommend this video. Thanks all for your time and now back to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, Susan. I’m never going to jump off with one of these balloon plane. So it was an absolutely unbelievable experience and thanks for Sergey’s innovation on that one. One more thing just before we turn to Q&A, just a couple of announcements, one, we have just launched our Google+ Investor Relations page, which is designed really to be a great source for Google products updates and company news relevant to investors and shareholders. So please be sure to check it out and let the IR team know what you think of it. So that’s just launched about an hour ago. And as we are about to open the lines, I just also want to invite David Drummond, our Chief Legal Officer, he will be joining Nikesh, Susan, and myself to answer any questions that you may have. So welcome David to the call as well. And we are going to turn on now Jamie to the Q&A section. So let us know how we want to operate."
},
{
"speaker": "Operator",
"text": "Thank you, sir. (Operator Instructions) And we will take our first question from Mark Mahaney with Citi."
},
{
"speaker": "Mark S. Mahaney",
"text": "Great. Thanks. Two questions please. First on Motorola, the comments at the time of the acquisition is that it would accretive, do you still feel that that asset can be in any thoughts would give us as to how you would make, what has been pretty consistently a loss leading asset that Motorola Mobile, how you make that accretive? And then a product on Search and what you find in terms of the appetite with the interest in voice search, Google has had a voice search capability for a while. But as you’ve noticed over time, people are more interested in using that less the quality of that versus whatever regular search. How interesting do you think that is as a growth area for Google in the future voice search? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "So I’ll just answer the Motorola question, and then let Susan jump in on the Search. On the question of Motorola, look we’re totally excited about this opportunity that we have with Motorola, and our management team has been there only a few weeks. Clearly, everybody should expect some changes at Motorola that we have already talked about in the public domain and when we said, Dennis and the management team is there resetting and retooling it. but we have nothing really to announce right now. I think we have to let them do their work. but I can tell you that was a probable excitement in MMI for all the employees, but also for the clients. So I just want to come back, Mark to your point on accounting. If you actually took out the accounting issues that were related to closing the transaction where it’d be just upgrade, the amortization of intangibles, and some of the adjustments that were related to the acquisition, in fact on the mobile side, they didn’t have – they had a pretty stable and good quarter, and there’s a lot of accounting noise in the data. So I think it’s going to take one or two quarters before all that noise comes out. Susan, do you want to comment on the voice search?"
},
{
"speaker": "Susan Wojcicki",
"text": "Sure. Yeah, so I mean voice search has been an area that Google has been investing in for a number of years. we believe like we have really good technology here, because we’ve invested for so long on this. and as I mentioned in my – when I talked before hand, now with the Jelly Bean release, we have the ability not only to ask a question, but also to have the answers given back to you. And so, I definitely recommend that you test it out. it is very powerful and we think in the right circumstances, users will want to – some users will want to type and some users will want to have voice. And so in the circumstances where they do, was developed a really amazing technology that is leading edge on that."
},
{
"speaker": "Mark S. Mahaney",
"text": "Thank you, Susan. Thank you, Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks for you questions, let’s go to the next question please."
},
{
"speaker": "Operator",
"text": "We will take our next question from Spencer Wang with Credit Suisse."
},
{
"speaker": "Spencer Wang",
"text": "Thanks, I guess one question and two parts for Patrick on Motorola. You talked a little bit about some of the accounting noise, Patrick, and it doesn’t sound like it’s finalized. Yeah, but, I was wondering if you could give us a rough sense of the purchase price allocation in terms of the hard assets, versus goodwill versus other intangibles so we can sort through some of that noise. And the second part is, I was wondering if you can just talk a little bit about the Motorola home business in terms of how that fits in, if you guys consider that strategic? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Okay, so on the details of the purchase price we haven’t given in terms of the asset and obviously the IR team can follow up with you on that, but I think in our disclosures the press release like, you will see like for example, intangibles was 30 some million in the case of Motorola and 32 I believe for Google. Just on the intangibles, so it gives you a sense of numbers for the step periods. As it relates to the home business, I mean, again a bit of the same story that I told Mark prior, which is, we’ve just got into the place and we’re in the process of evaluating every business of MMI, in every division of it. So it’s a little bit too early for us comment on big changes right now. So I just need a bit of patient for us to complete our home work as we’ve been there just for a few weeks."
},
{
"speaker": "Spencer Wang",
"text": "Sure, thanks a lot Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks Spencer. Let’s go to the next question please."
},
{
"speaker": "Operator",
"text": "And we will take our next question from Carlos Kirjner with Sanford Bernstein."
},
{
"speaker": "Carlos Kirjner",
"text": "Hi thanks for taking my questions. I have two questions, one on mobile and one on YouTube. On mobile, have you conducted any studies on the impact of mobile adoption or search query demand by end users. And do you have a perspective on what portion of mobile queries are incremental versus cannibalistic for handsets and tablets. And on YouTube, I think one or two quarters ago, Nikesh referred to Google Analytics as the unsung hero of the business. Thinking about YouTube brand advertisers, how do you give them visibility into brand advertising ROI in YouTube, and do you think you will be able to do that to get the dollars to flow and overcome the obvious challenges that you may have there?"
},
{
"speaker": "Patrick Pichette",
"text": "So, Nikesh would answer the second question; Susan on cannibalization of mobile versus desktop."
},
{
"speaker": "Susan Wojcicki",
"text": "Yeah, definitely; maybe we’ve spent a lot of time looking at that to trying to understand how those two different types of devices and how those searches are interactive with each other. And this is very complicated, but I will say we believe that mobile searches are mostly incremental. For example on weekend, when you – those are out and about, you usually see a raise in mobile activity. And then when users are back on Monday, we see a raise of desktop. So, although it’s not a one-for-one, we do believe that they are mostly incremental."
},
{
"speaker": "Carlos Kirjner",
"text": "And does it value Susan between handsets and tablets."
},
{
"speaker": "Susan Wojcicki",
"text": "In terms of queries?"
},
{
"speaker": "Carlos Kirjner",
"text": "No, on the incremental versus cannibalistic."
},
{
"speaker": "Susan Wojcicki",
"text": "I mean we’d look – I think we’re still in the process of trying to have run our analysis and trying to figure that out. I mean I think that the thing that handsets and tablets have in common is they’re both on the go and people are willing to take their mobile, people use tablet certainly in the office environment as well. So, I would say, we’re still doing the analysis on that."
},
{
"speaker": "Carlos Kirjner",
"text": "Okay. Yeah, so we have a clear view on the handsets and on the tablet there’s more analysis to be done; on YouTube, Nikesh?"
},
{
"speaker": "Nikesh Arora",
"text": "(Inaudible) Carlos, hi, so in YouTube there are two different issues. And if you’re talking about performance advertisers, they’re able to look at ROI on YouTube versus other performance media on the online space. I guess more interesting when you start talking about brand, because brand is not just about the online space, brand is also about the television space. And we’ve done very exciting things, with single source panels, where we worked in Germany with thousands of users and try to look at advertising effectiveness and efficiency, not just on YouTube and online video, but also compared to television and we’re incorporating data into our analytics and our sales pictures to show how the ROI is available on YouTube. We’ve noticed only doing at higher ROI, but we also get higher reach and higher frequency capabilities on YouTube, because you are looking at users on a very large online platform."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks for your question Carlos."
},
{
"speaker": "Carlos Kirjner",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Let’s jump to the next one please, Jamie?"
},
{
"speaker": "Operator",
"text": "We’ll take our next question from Ben Schachter with Macquarie."
},
{
"speaker": "Ben Schachter",
"text": "And just two questions, I was wondering first, give an update us on Larry’s health situation and then I know it’s early, but can you update us on the usage of Chrome for iOS devices, and any comments you can give to help us understand the importance of that product and also how you plan to market it. And then also, historically you’ve talked about self driving cars and some of these other projects as relatively low investment, high media profile projects, but it seems with Google Glass and some others and they are taking more management time and focus, should we be thinking about those differently? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Yes, I want to let Nikesh talk about Larry situation, Susan can talk about the second question on iOS Chrome and then I’ll just take it to run, so Nikesh."
},
{
"speaker": "Nikesh Arora",
"text": "There is no more new news on Larry. Larry has lost is voice and we said that means he cannot do any public speaking engagements for the time including today’s earnings call, but he continues to run the company and he is here and involves in all the strategic business decisions that we’re making."
},
{
"speaker": "Patrick Pichette",
"text": "Susan."
},
{
"speaker": "Susan Wojcicki",
"text": "And on Chrome for the iOS device from the moment we launched it was a very popular in the app store and we’ve seen this one of the top apps and it’s something we’ve invested for many years on Chrome. It’s got a lot of really compelling features, from security, being very fast and we continue to expect to see growth just because of the users using it for the different features that make it a really great product. From the other things, the self driving cars and Google+, I mean those continue to be projects that from a headcount perspective are very – are small, we’ve talked about them being they are small, but they have the potential to be very big. And I think they are also projects that – we sort of think about them as moon shops a lot of time, like projects that we think can have really amazing capabilities, but again, and they get the company excited, but in terms of actual resources, it is a very small number."
},
{
"speaker": "Patrick Pichette",
"text": "Yeah, the fact that Sergey is actually leading the Glass project doesn’t change any of the strategy. So from that perspective just very exciting and fun to share it with people when we have such exciting demos. But I wouldn’t change any of the strategy in terms of the real focus of management and our capital intensity."
},
{
"speaker": "Nikesh Arora",
"text": "Thanks, Ben. Let’s go to our next question please."
},
{
"speaker": "Operator",
"text": "And we will go next to Scott Devitt with Morgan Stanley."
},
{
"speaker": "Scott Devitt",
"text": "Thanks for taking my questions. I had two please. You’ve previously referenced the Talent or in last year increased the cash compensation by 10%. I was just wondering given the transition of a number of companies that you compete with for Talent into the public markets, could you just give an updated view on the cost and availability of the Talent in the Valley? And then secondly on a last 12 months basis, Google has generated $12.5 billion in unlevered free cash, so you now have an 8% unlevered free cash yield and you are generating cash at an run rate that equates to about 30% of the current cash positions. So I was wondering if you could just talk a bit about the way that you are currently thinking about capital allocation or specifically a share repurchase? Thanks."
},
{
"speaker": "Nikesh Arora",
"text": "Okay. So let me start with the second one first. We continue, and I know that sound a bit like a broken record on this, but on a very regular basis, we actually debated with our board. In our – our cash position is really a strategic asset to us given all of the innovation that's happening, and all of the options that are available to us. I mean it has been such, and you just take Motorola, which we just closed, I mean it was a real strategic asset to us to actually be able to pounce. So we haven't changed our position in terms of share repurchases or dividends or any of the others for a time being, which does not mean we don't evaluate. We do take a good look at it. We just think that it continuous to be a strategic asset for us, and so that's why we haven't changed our position yet. In the case of the talent, I think that the Valley continues to be hot, I mean it's a hotbed of innovation. There's a lot of need for that talent, especially the very high, the engineering front, and we're delighted by our strategy. I mean we continue to see really benchmark levels for our retention purposes, and we continue to attract the very best talent. So for us, it is an absolute strategic asset again for the company. I mean, Googlers, the engineers that are here in the salespeople and they've really make a huge difference to the velocity of the company. So the Valley has not change, it content despite everything else is going on in the world out there are. The Valley continues to be absolutely hot, and we’re still pleased to have seen our strategy pay out so well. So thanks for your question Scott. Very good question. Let's go to our next question please Jamie."
},
{
"speaker": "Operator",
"text": "And we'll go next to Heather Bellini with Goldman Sachs."
},
{
"speaker": "Heather Bellini",
"text": "Hi, great, thank you. I had two questions. First, what are you seeing in terms of mobile CPC trend, and how do you see these trends playing out over the course of the next 12 months. And then, the second question is, with the Nexus 7 on the market, can you talk a little bit about your plan to accelerate content acquisition in particular in video and book? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "I think Nikesh is perfectly suited for both."
},
{
"speaker": "Nikesh Arora",
"text": "Hi, Heather. Thank you for your question. Well, I think the good news is that we’re seeing phenomenal growth in the mobile queries across the board, whether it’s tablets, whether it’s mobile phones, whether it’s geographical or whether we are seeing phenomenal amounts of mobile queries across the board. I think as I said, mobile is right now where Search was in 1999. we had a situation where Susan’s team was doing phenomenal product innovation to keep driving more and more efficiency for the advertisers. we were working with advertisers to get them to get better landing pages, better sites, get them to understand truly the opportunities on the mobile space for example. You can make phone calls, so we have a product called Click-to-Call. Now the Search takes on a whole different meaning, because there’s a better conversion and people actually click and make phone calls. So we are seeing mobile CPCs are healthy and we expect them the long-term that they will continue to be healthy and sort of follow this trajectory that Search has followed, more inventory, more effectiveness, more ROI for the advertisers, better pricing in the market. In terms of your second question on Nexus 7, I think we have made tremendous amounts of headway in the content space that we have a lot, lot of content on Google Play. we are working very closely with the music industry, with Hollywood studios et cetera, to get more and more content on the platforms, so I think given that there are models out there where other people are offering content to the platforms. it is becoming to the standards that you can have the ability to offer content to the end user and we are making tremendous amounts of progress across the board."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks for your question, Heather. Let’s go to our next question please."
},
{
"speaker": "Operator",
"text": "And we’ll take our next question from Doug Anmuth with JPMorgan."
},
{
"speaker": "Doug Anmuth",
"text": "Great, thanks for taking the question. I just wanted to ask two things, just first following up on the mobile CPC question, can you just give us some color on what percentage of advertisers are bidding on smartphone to N tablets in addition to the desktop? and then secondly, Patrick can you also just help us understand the accounting around the Nexus 7 tablet and how we should be thinking about that on a growth versus net basis and the impact it may have going forward? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Okay. So I will let Nikesh cover the CBC and I also come back after."
},
{
"speaker": "Nikesh Arora",
"text": "Yeah, actually I think I already said that in my prepared remarks that we have over 1 million advertisers working with us in mobile advertising and it gets over 300,000 mobile apps. So I think it’s a substantive number in terms of number of advertisers are involved in mobile space. And I think usually people will get enrolled in mobile space don’t distinguish between smartphones and tablets, they actually, they want to find the most effective ROI they can get and they want to capture as many queries as you get on these device. Patrick?"
},
{
"speaker": "Patrick Pichette",
"text": "No, the issue for the Nexus S, Nexus 7, the – I mean we have two sets of accounting, obviously, it’s distributed on it’s own by others like, you can get it at Best Buy and otherwise when you use the Play Store to actually buy it right, we book the revenue and then we book the cost as well and the cost will be in other cost of revenue rather than CAC or TAC, they’re neither of them and that’s how the accounting is set."
},
{
"speaker": "Susan Wojcicki",
"text": "Yeah, and this is Susan, just one more thing I would add Doug on your question about the mobile CBCs and the percentage that are bidding, is a lot of campaign structures are setup so that when an advertiser participates in a bid, they actually bid, they can instead of one campaign and it can run across everything. And we adjust those prices dynamically for them, we have – it’s called Smart Pricing. And so some advertisers do bid specifically on mobile and then some advertisers have bundled campaigns and we adjust those prices. So it’s not just advertiser that are bidding only for mobile that are participating in mobile."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks for your question, Doug. Let’s go to the next question please."
},
{
"speaker": "Operator",
"text": "And we will go next to Justin Post with Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "Great. When you look at your international result ex-FX, they actually were stable or even accelerated. Yeah, we are hearing a lot of issues over there. Can you talk about geographic mix, what countries are doing well or vertical mix and any product enhancements or new products you’ve launched that are really helping your revenue growth there. And then secondly, TAC to distribution partners was up about $40 million quarter-over-quarter and continues to be a bigger chunk of your Google website revenues. What drove the quarter-over-quarter increase, was that mostly mobile or are there other factors? Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "So, let me jump on TAC, and then let Nikesh answer to the first question. So TAC, it's really a mix, right, obviously TAC reflects a mix of the different distribution methods that include toolbars, chrome distribution, mobile distribution, and also obviously the AFS business as well. So there's a – if you look at our revenue mix between Google properties and network, right network will attach stronger, so that will drive TAC as well. And then, mobile is also one of these contributing factors. So we don't break down all these specifics, but it’s not only mobile. I mean, we have a number of factors that are at play here. On the first question, I’ll let Nikesh circle back to you."
},
{
"speaker": "Nikesh Arora",
"text": "Yeah, I alluded to some of this in the prepared remarks. I think, as I said growth in the Americas and Asia has been steady this quarter. The U.S. and Canada have stayed strong, and as I mentioned, as you’ve said there have been some issues internationally. Southern Europe, we saw slide dip as we think it is hampered both by pure macro economic conditions and all ad industry concerns. Spain was a notable sort of lowlight or highlight depending on how you look at it in that conversation. On the other hand, performance accelerated for us in northern Europe driven by the UK and the UK has been a little depressed over the last few quarters. So it is finally coming back and sort of we are seeing strength there again. In terms of your question and on the sectors, I think travel has been strong pretty much across the board in the U.S. and the UK and around the world. Auto was strong in the U.S. for us, healthcare has been strong in the UK, and generally across the world, we've seen strong sort of performance both in finance and local, and we're seeing more and more sort of excitement and enthusiasm in sectors like CPG and entertainment given the shift to brand. But I’d say, this is the snapshot in time and these things change quarter-over-quarter."
},
{
"speaker": "Justin Post",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks, Justin. Jamie, let’s go to our next caller please."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Anthony Diclemente with Barclays."
},
{
"speaker": "Anthony Diclemente",
"text": "Hi, thanks. One, I think for Susan, just if you can help us with the order of the magnitude the drivers of the divergence that we continue to see between CPCs and volume. I think in the past you’ve talked about, of course mobile is one of those drivers, but then FX, we have a sense of that, property mix, emerging markets and add quality changes, all driving that. So I was wondering if you guys could give us like a ordered magnitude of how important each of those key drivers were in the quarter and then how we should think about those trending going forward, if we should expect that divergence to normalize or should we actually expect it to continue to diverge? It will be helpful. Thank you very much."
},
{
"speaker": "Patrick Pichette",
"text": "Susan, do you want to give some comments on it or Nikesh."
},
{
"speaker": "Nikesh Arora",
"text": "I think, I had the CPC (inaudible) on this quarter and you can’t have a good earnings call, if you don’t talk about CPC, so here we go. CPC is an important metric for us, but if you take that independently, it’s not necessarily a reflection of the fundamental health of our business. This quarter, I’d say the biggest impact on CPC was actually FX. We have four or five factors that impact CPC, but the biggest impact this quarter was FX. We have clearly an impact of mobile versus tablet versus desktop, we have an impact of emerging versus developed markets, and what’s happening from a macro economic point of view, that we’ve talked about, we have an impact on google.com versus network, so as you see the network playing a bigger role, it impacts CPC. And finally as quality changes, also impact CPC, but I’d say this quarter the impact has been felt because of FX, but from a positive perspective we see any time there was a change in CPC, which is more attractive for the advertiser that allows the advertiser get a bit of ROI, but for us it’s an opportunity for the advertising."
},
{
"speaker": "Patrick Pichette",
"text": "Yeah, it’s important to know that the 16%, there was a big chunk of it, that was CPC versus the last quarter. I mean, as the euro kind of went down 9% year-over-year, I mean it obviously makes a big difference. So thanks for your question."
},
{
"speaker": "Anthony Diclemente",
"text": "Okay, and that’s a nice one. Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Cheers. Let’s go to the next question please, Jamie."
},
{
"speaker": "Operator",
"text": "And we’ll take our next question from Ken Sena with Evercore Partners."
},
{
"speaker": "Ken Sena",
"text": "Hi, thank you. Can you just maybe talk a little bit more about the Offers business and do you feel strongly about that business as you did in the past. And maybe how that business actually will come into play with Google+ or on payments or (inaudible)? Thank you."
},
{
"speaker": "Susan Wojcicki",
"text": "Hi, Ken. So yeah Offers continues to be an area that we are investing in, we have, I mean we think that there is a lot of things that are really important about Offers the way it’s a local business and works with both small and large business it’s got, there is a lot of user interest in it. So it is an area that we are continuing to invest in. We’re also, as we continue to develop our business model continues to evolve. And for example, we are putting a little – we’re working with a lot of the different Offers and providing distribution for them in addition to generating our own Offers with our own sales team. So, but it continues to be an important area for us, and we’ll continue to invest in the cities that we’re currently operating in."
},
{
"speaker": "Ken Sena",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Sure."
},
{
"speaker": "Susan Wojcicki",
"text": "Thank you, Ken."
},
{
"speaker": "Susan Wojcicki",
"text": "Jamie, our next question please."
},
{
"speaker": "Operator",
"text": "And we will take our next question from Ronald Josey with ThinkEquity."
},
{
"speaker": "Ronald Josey",
"text": "Great, thanks for taking my question. Going back to mobile and the opportunity there, Nikesh I thought that might be interesting if you could talk a little bit about, perhaps what you are seeing in terms of the campaigns and there has been an acceleration, now that AdMob is fully integrated in AdWord, knowing that there is over a million advertisers and 300,000 apps. I’m wondering if there is been accelerations since that's happened? Thank you."
},
{
"speaker": "Nikesh Arora",
"text": "Hi, thanks for the question. I think as I said, we are seeing phenomenal amount of growth in the mobile query space and it’s a consequence of more device, it’s a consequence of more adoption of tablets around the world. It's also comfortable with the devices and using them more often. So with the number of questions they asked on the AdMobs. so AdMobs just got completed in early June. So it’s a bit early to say, we're seeing acceleration. but generally, our performance throughout that integration has been very strong and we’ve effectively had a very, and what we’ve done about six months ago, as we took all of our sales efforts and we took our specialized mobile sales people, we had them trained all of our sales forces around the world. So that impact has even contributed more than just that integration part. but we think the integration is just going to turbocharge that effort and hopefully continue to help us drive mobile. and mobile is going to be here for a while. I think it’s a fact of life for us now. So we are mobile sort of becoming as core, as desktop search was, so we’re making sure that all of our sales people around the world are fully equipped and working with every advertiser, not just 1 million to make sure that people can see ROI in both mobile and desktop simultaneously."
},
{
"speaker": "Ronald Josey",
"text": "Great, thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks, Ron. Let's go to our next question, please."
},
{
"speaker": "Operator",
"text": "And we'll go next to Jason Maynard with Wells Fargo."
},
{
"speaker": "Jason Maynard",
"text": "Hey, good afternoon. I have one question just on the shifted mobile and specifically around this will be both Nexus as well as Motorola. How important do you think it is for ultimate mobile modernization to actually control the whole experience on the device and given that you’ve got all sorts of different competitors some who subsidize evidently, some obviously telling full price, hardware, software combos, what do you think the right mixes for Google and when do you think you’ll sort of sort this out and be a little bit more declarative in the market with your intentions? Thanks."
},
{
"speaker": "Nikesh Arora",
"text": "I think, hi this is Nikesh again Jason. thanks again for your question. And as I said, mobile is very, very important. I think it’s better to go back and think about what’s happening in the marketplace. We said we’re very committed to mobile; it’s evident in our commitment to Android in our ecosystem as well as Motorola acquisition. So we believe that mobile us very and very important critical to the future. Now, I know it seems a little complicated when you look at the different competitors, and how you talked about subsidies et cetera. We simplify that by focusing on, how do we provide the best experience to the user. Now providing the best experience to user, is effectively working really hard with Andy Rubin, Stephen Android making sure he is getting the best experience for the end-user and in that process he works with the best OEMs in the marketplace to make sure that the combination of hardware and software allows for the best experience to be delivered. I think, for us what's important as to get that experience delivered and we will work with whatever the industry models that are out there, either we work direct with operators, trying to make sure that happens behind the end-user and more often they’ll not be work with OEMs, to see how we can get the best agreed experience in the hands of the end-user. I think that's what we're going to focus on. So, I think that's quite declarative in terms of intention."
},
{
"speaker": "Patrick Pichette",
"text": "Yeah. I mean just to close, open is really important to Google and in that context you see our strategy is very focused on end-users and been open and we are going to get a lot of benefit that we already have and continue to get a lot of benefit out of that. So, it's a complex question, there is no doubt about it. Thank you, so much for your question. Let’s go for the next question please."
},
{
"speaker": "Operator",
"text": "Now we’ll take our next question from Lloyd Walmsley with Deutsche Bank."
},
{
"speaker": "Lloyd Walmsley",
"text": "Thanks, I'm wondering if you could tell us a little bit about the rollout of the shift to paid inclusion for Google shopping and when you expect it to be fully rolled out and kind of what you're seeing today in terms of Paid Clicks and CPCs, now that some of the shopping links have been moved to high end results and where do you think CPCs there can go relative to just core paid search?"
},
{
"speaker": "Patrick Pichette",
"text": "I’ll let Susan answer this one. Susan?"
},
{
"speaker": "Susan Wojcicki",
"text": "Yeah, so Lloyd, so we made this decision to move to a commercial model because we saw that ultimately this would drive a better experience for users and having more up to date information and more accurate price and inventory availability and so we are in the process of rolling that out. We think it will be rolled out. We expect probably completed around the Q4 timeframe. And we are working really hard with all the merchants to get them all on board, and again we think this is actually really good for both the merchants and the users. We actually don’t refer to this as feed inclusion, just because that actually is a term from the people who have been in the industry for a really long time meaning putting in, paid things into the search results, in a non-marked way. And we’re very, very clear when we show this, we do mark everything very clearly as sponsored, and again we believe that actually moving to this model is good for both the users and for the merchants and we’re really looking forward to this transition."
},
{
"speaker": "Lloyd Walmsley",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "Thanks for your question, a very important piece for us. Let’s go to our next question please."
},
{
"speaker": "Operator",
"text": "We will take our next question from Kevin Kopelman with Cowen and Company."
},
{
"speaker": "Kevin Kopelman",
"text": "Hi, thanks. Could you give us a sense of how big your mobile search queries are, as a percentage of total search queries? And also on Motorola, I know you’re not giving us a business update, but could you give us what the Android unit growth was in the quarter on a pro forma basis? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Well, on the last one, on the mobile side, the non-home side, it’s all Android. And on the search queries, we don’t actually provide the details. We provide the geographics, but we don’t give the details of the other one. So, I am sorry Kevin if we can’t be more helpful on the granular details on this issue. Let’s see, we have time for one more question, let’s jump on one last question, Jamie?"
},
{
"speaker": "Operator",
"text": "Thank you, sir. We’ll take our last question from Jason Helfstein with Oppenheimer."
},
{
"speaker": "Jason Helfstein",
"text": "Thanks for taking my question. I’ll ask you just two. One, can you just talk about the growth of Google+ number growth, are you happy? I think you alluded to how that's going. What can you do to drive faster member growth and is that kind of part of the strategy or you just led it organically evolve. So kind of a push versus, I guess the pull strategy there. And then second, can you give us the breakdown of depreciation between Motorola and MII for the quarter? Thanks."
},
{
"speaker": "Patrick Pichette",
"text": "Well, you’ll have, in the segmented reporting you'll find that information. So, after the call, so this is for your second question, Jason. On the issue of depreciation, I think that the team can circle back which would give you the split, because we do the segmented reporting. On the first question, which is about Google growth and our success there, I’ll let Susan cover that one."
},
{
"speaker": "Susan Wojcicki",
"text": "Sure. Yeah, so, overall we've been really pleased with the growth that we've seen, you’ve talked about the $250 million accounts that we have, Google+ accounts. And I do think it's also really important to remember that Google+ just celebrated its one-year anniversary. We actually celebrated that at IO. And so, we see that Google+ account growth has growing really well. We think that one of the most important things is that when you have a Google+ account you have the ability to share. And we've talked about Google+ being the social spine across all of our products ability to make all of our products better. Not just the stream, which is an important part, but also for example your search experience. So that if I have a friend, a friend went to hotel, and +1 that hotel, if I’m ongoing to that same location, I would you be able to see that information at the time that I'm doing that search. And so we have many, many use cases where we think being part of Google+ will be a better experience. And so we’re working across the board to make sure that our products are integrated, we have a number of integrations across the products, probably local with the most significant one that we did this quarter, and we find that having those integrations by making the products better, also tried to more usage of Google+. So yeah, so thank you Jason, that was an important question."
},
{
"speaker": "Jason Helfstein",
"text": "Thank you."
},
{
"speaker": "Patrick Pichette",
"text": "And with that with an eye on the clock, we’ve got to run. I just wanted to do couple of things; one is thank Nikesh and Susan as well as David for joining us for the call, and Q&A. I also thank all our Googlers, I mean these last 90 days and the great results that we are posting now and beginning of the collaboration and integration of Motorola, all these things are possible because our Googlers do a phenomenal jobs every single day. So I want to thank everybody and then as I close, remember to go and take a look at our Google+ website for investor relations. And I think you will find it pretty interesting. So with that Jamie, I’ll let you close the call, and I wish everybody a happy summer."
},
{
"speaker": "Operator",
"text": "Thank you, sir. That does conclude today’s conference and we do appreciate everyone’s participation."
}
] | null | null |
GOOGL | 1 | 2,012 | 2012-04-13 16:30:00 | Operator: Good day, everyone, and welcome to the Google Inc. First Quarter 2012 Earnings Conference Call. Today's call is being recorded. At this time, I'd like to turn the conference over to your host, Director of Investor Relations, Ms. Jane Penner. Please go ahead, ma'am.
Jane Penner: Good afternoon, everyone, and welcome to today's first quarter 2012 earnings conference call. With us are Larry Page, Chief Executive Officer; David Drummond, Senior Vice President, Corporate Development, and Chief Legal Officer; Patrick Pichette, Senior Vice President and Chief Financial Officer; and Nikesh Arora, Senior Vice President and Chief Business Officer. Also, as you know, we distribute our earnings release through our Investor Relations website located at investor.google.com. So please refer to our IR website for our earnings releases, as well as the supplementary slides that accompany the call. This call is also being webcast from investor.google.com. A replay of the call will be available on our website in a few hours. Now let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward looking, including statements regarding Google's future investments, our long-term growth and innovation, the expected performance of our business and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on this call, such as operating income and operating margin, are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will now turn the call over to Larry.
Larry Page: Thank you. Hi, everyone, and thanks for joining the call today. It's great to be here with all of you. I'll talk about our new class of stock at the end of my remarks, but first, I want to focus on our performance. We had a very strong quarter with revenue up 24% year-on-year at $10.6 billion. Since becoming CEO again last April, I've pushed hard to increase our velocity, improve our execution and focus on the big bets that will make a difference in the world. Google is a large company now, but we'll achieve more and do it faster if we approach life with the passion and the soul of a startup. This has involved a lot of cleanups. We've given many of our products including Search a visual refresh. They now have a more consistent look and feel. When we've closed or combined over 30 products, we have so many opportunities that without hard choices we end up spreading ourselves too thin and don't have the impact that we strive for. Creating a simpler and more intuitive user experience across Google has been another important focus. I have always believed that technologies should do the hard work, but just takes scheduling and communications, so users can get on with what makes them happiest, life. Our products work seamlessly together so people don't have to navigate Google to get stuff done. Chrome for Android, which launched this quarter, is a great example of this kind of simplicity we're shooting for. It does mean switching between devices painless. All of your tabs are there across your desktop and Android, you can even click the back button on a different device and it just works. Just try it out, it's a great experience. It's the same with Google Play, which we also shipped this quarter. You can now access all your movies, your books and apps and games from the web or from your Android device, no cables, downloading or syncing required. We spent years working with partners to get all of this great content. So it's really exciting to see it brought together in a beautifully simply way that people can enjoy. Now Google+ is truly at the heart of our efforts to create a simpler, more intuitive experience for all of our users. You should think of it in 2 parts. One is just our social spine. Once you're logged in and have upgraded to Google+, you're just using one Google, not a series of disconnected products. It's still early days, but with over 120 Google integrations to date -- Google+ integrations to date, we're on the right track. And your user experience on Google just gets better. You can see friends' recommendations when you're using Google Play and you don't think about that as Google+, but it just comes from that infrastructure. And we're seeing a positive impact all across the web. Google users can now recommend search results they like, a goal we’ve had ever since we started the company. The other part is the social destination, which is accessed on your mobile client or on plus.google.com. This social destination part grew from a base of 0, not starting with all Google users like the part I was previously talking about, and is growing quickly. In fact, we see impressive engagement in fast growth here. It's just not all of Google. We are starting up a new community. We're excited about the amazing speed with which some people have amassed over 1 million followers, and I have just been lucky enough to pass 2 million. I get high-quality feedback on the public post I make, which I really enjoy. And every day we make Google+ better. Just yesterday, we took another big step forward with a beautiful new UI for Google+. And the new customizable navigation driven in that redesign makes it much easier to access your favorite apps. There's better discoverability for Hangouts and you'll love the larger images that you see across that interface. Now last time, there's a bit of confusion over the metrics I gave about Google+. I want to be clear about these 2 parts of Google+ and the fact that we have made great progress on both parts. As you would expect, the social spine is proportional to Google and all of the usage across Google. And Google’s pretty big. And well over 170 million people have now upgraded to Google+. So to summarize, there are 2 parts to the Google+ experience: the part that is the social spine, and the other part that's the social destination part of Google+ exclusively. Both of these are growing fast, but the social destination part of Google+ is growing as a new product with very healthy growth. I'm also excited by our big bets. We have some amazing new products that were seen as crazy when we launched them, but now have phenomenal usage. They can easily pass the toothbrush test. They're important enough that millions of people use them at least once or twice a day. Chrome has over 200 million users. Our Display business has reached an annualized run rate of over $5 billion and 850,000 Android devices are activated every day. And YouTube just keeps on growing. These are just staggering even by Google standard. They had over 800 million monthly users uploading over an hour of video per second. I'm incredibly proud of these achievements. They wouldn't have been possible without an amazing team of Googlers and the long-term focus with which we are able to run the company, which brings me to this afternoon's announcement about our stock. Now throughout our evolution from being privately held startup to a large publicly listed company, we have managed Google for the long term and enjoying tremendous success as a result, especially since our IPO in 2004. The founders, Sergey and I, really hoped but we did not expect that Google would have such significant impact. And that this progress has made us even more impatient to do important things that matter in the world. Our enduring love for Google comes from a strong desire to create technology products that enrich millions of people's lives in deep and meaningful ways. To fulfill these dreams, we need to ensure that Google remains a successful growing business that can generate significant returns for everyone involved. When we went public in 2004, we established some clear well-publicized expectations for investors around our governance. We wrote a couple of things in our original founder’s letter, I just want to read here. "New investors will fully share in Google's long-term economic future, but will have little ability to influence its strategic decisions through their voting rights. And we are creating a new corporate structure that is designed for stability over the long-time horizons. By investing in Google, you're placing an unusual long-term bet on a team, especially Sergey and me." I wanted to quote all that because these are the clear well-publicized expectations we established for investors. And while this decision was controversial at the time, we believe with hindsight it was absolutely the right thing to do. Eight years later, these still -- statements are still remarkably accurate and everyone involved has realized tremendous benefits. Given Google's success, it's unsurprising this type of dual-class governance structure is now somewhat standard among newer technology companies. In our experience, success is more likely if you concentrate on the long term. Technology products often require significant investment over many years to fulfill their potential. For example, it took 3 years just to ship our first Android handset and then another 3 years on top of that before the operating system truly reach critical mass. These kind of investments are not for the fainthearted. Long-term product investments like Chrome and YouTube, which now enjoy phenomenal usage, were made with a significant degree of independence. However, day-to-day dilution from routine equity-based employee compensation and other possible dilutions, such as stock-based acquisitions, will likely undermine this dual-class structure and our aspirations for Google over the very long term. We have put our hearts into Google and hope to do so for many years to come, so we want to ensure that our corporate structure can sustain these efforts and our desire to improve the world. Today, we announced plans to create a new class of nonvoting capital stock. These shares will be distributed via stock dividend to all existing stockholders. The owner of each existing share will receive one new share of the nonvoting stock, giving investors twice the number of shares they had before. Effectively, a 2-for-1 stock split, something many of our investors have long asked us for. These nonvoting shares will be available for corporate uses like equity-based employee compensation that might otherwise dilute our governance structure. In November 2009, Sergey and I published plans to sell a modest percentage of our overall stock ending in 2015. We are currently halfway through those plans and we don't expect any changes to that, certainly not as the result of this new potential class. We both remain very much committed to Google for the long term. It's important to bear in mind that this proposal will only have an effect on governance over the very long term. In fact, there's no particular urgency to make these changes now. We don't have an unusually big acquisition planned, in case you are wondering. Investors and others have always taken a big bet on Sergey and me, and that bet will likely last longer as a result of these changes. We are honored that so many of you have put your trust in us and recognize the tremendous responsibility that rests on our shoulders. We think this is a good thing because users rely on Google to produce and operate amazing technology products and to safely and responsibly store their data. That is our passion. Thank you very much, and I will now hand over to David to explain some of the more technical aspects of this proposal.
David C. Drummond: Thanks, Larry. So first of all, I wanted to say that we'll be filing a proxy statement soon, which will have more details about today's proposal. But for now, I want to give a few broad strokes. First off, as Larry said, what we announced today is basically a 2-for-1 stock split, and here's how it works. What we're doing is creating a new class of stock, Class C. That new stock will have equivalent rights to our existing Class A and Class B stock, except it will have no voting rights, and it will also be issued through a stock dividend on all Class A and Class B shares. So after the dividend, a stockholder who currently owns one share of Class A common stock with a single vote will continue to own that share plus one share of Class C capital stock that does not have a vote. Our existing Class A shares will continue to trade as they do now and the new class C shares will also be listed, so stockholders will be able to trade those shares, the class C, just as they can with the Class A shares today. Now one thing to emphasize, because all stockholders will be treated equally and will receive one share of Class C for every share they now hold, everyone, including Larry, Sergey and Eric, will retain the same voting interest they had immediately prior to the dividend. And it's also important to note that as part of this, Larry, Sergey and Eric have all agreed to subject their shares to a transfer restriction agreement. This agreement maintains the same link between their voting and economic interest that exist today. So if any of Larry, Sergey or Eric sell or transfer their nonvoting Class C shares, there's a stapling provision in the agreement that requires them to either sell an equal number of Class B shares or convert an equal number of Class B shares into Class A shares. Now the stapling requirement will end when their ownership levels fall below certain thresholds. So the basic thing to understand here is that the stapling provision is designed so that subject to these thresholds, the votes held by the founders and Eric will be reduced proportionally as their economic interest in the company declines. Now a word about the process we used. Our Board of Directors carefully considered this proposal to create a new class of stock before reaching a decision. The process the board followed was robust and the deliberations were extensive. Back in January 2011, the board established a special committee comprised of independent non-management board members to consider this new class of stock or other alternatives. The committee met on numerous occasions over the 15 months that the special committee considered the proposal and that, that was separately from the board. The committee recommended and the board unanimously approved today's proposal. In terms of next steps, the proposal’s subject to the approval of a majority of the voting power of Google's common stock and they'll vote together as a class that will happen at our Annual Meeting on June 21 of this year. Given that Larry, Sergey and Eric control the majority of voting power and support the proposal, we expect it to pass. Following that, the board will set a record date for the dividend to move the process forward. So for more detail on the proposal, you can find the Founder's Letter that Larry and Sergey issued this morning as well as a postscript from me on our Investor Relations site. And as I said, next week, we'll file a preliminary proxy statement with the SEC, so you'll have even more details about today's proposal. So with that, I'll turn it over to Patrick to talk about the quarter.
Patrick Pichette: Thank you, David. Good afternoon, everyone, and thank you for joining us. Well, closing this first year with Larry leading Google as CEO, all of us at Google feel a renewed sense of velocity, focus and optimism in our Q1 operating, but also financial results are a good reflection of this spirit. So let's jump right into the financials. Our gross revenue grew 24% year-over-year to $10.6 billion, 1% quarter-over-quarter, and our Google websites also grew. Revenue grew 24% to $7.3 billion, with strength across most major geographies and verticals. Google's Network revenue was up 20% year-over-year to $2.9 billion, 1% quarter-over-quarter. And Network revenue was still negatively impacted by the search quality changes we began to make a year ago in late February, otherwise known as Panda. Other revenue was up 56% year-over-year to $420 million and 2% quarter-over-quarter. Our aggregate paid-click growth was very strong, just shy of 40%, up 39% year-over-year, and up 7% quarter-over-quarter. Aggregate cost-per-click growth was down 12% and down 6% quarter-over-quarter. So given the recent trends in CPCs and clicks, allow me to spend a bit of time today addressing this. The most important thing for you to understand is that our business is healthy. We believe that shifts in CPC and paid clicks taken independently really do not reflect the fundamental health of our business. Now allow me some details on this. In general, we attribute these trends to a combination of really 5 core factors. Those include FX, and then there's 3 mix effects. For example, the mobile versus tablet versus desktop shifts, emerging markets versus developed markets shifts and even the basics of google.com versus our network. And then finally, ads quality changes which is also a huge factor. So as you can see, it's a complex set of dynamics with multiple variables at play. Many in the financial community have tried to isolate or often I hear pick one of these among these factors as the primary driver for CPC or click trends. Some even say it's about -- all about mobile. Others suggest that it indicates weakness in demand for Google advertising. Well, on the latter point, I want to be very clear that that's not the case. One important signal we have for advertiser demand is bidding behavior. And in fact, our advertisers’ bid continue to be very strong and are growing. So the dynamics around CPCs and paid clicks are just simply very complex because of all of these big factors and change continually. So trying to pick a horse, so to speak, just doesn't make sense. We internally track all these factors with the help of a number of statisticians, economists and engineers who dig into all these details on an ongoing basis. So we won't go into that level of detail every quarter, but again, the key thing to understand is that we believe that shifts in CPC, or paid clicks taken independently, simply don't reflect the fundamental health of our business, which we believe is actually very healthy. If anything, the recent lower CPCs present a great opportunity for advertisers to get an even better return on their ad spend. And lower cost, better ROI attract advertisers and thus, this is good for Google for the long term as well. So enough said on CPCs and paid clicks. Let's just turn to geographic performance. The U.S., U.K. and rest of world are growing still at good pace as reflected in our results. In our earnings slides, which you'll find on our Investor Relation website, you see that we've broken down our revenue by U.S., U.K. and rest of world that showed the impact of FX and the benefits from our hedging programs. So please refer to those slides for the exact calculations. Our revenue in the U.S. was up 22% year-over-year to $4.9 billion. Our non-U.S. revenue accounted for 54% of our total revenue or $5.8 billion, up 26% year-over-year, which includes modest $37 million benefits from our hedging program. The U.K. was up 19% year-over-year to $1.2 billion. Let me now turn to expenses. Our traffic acquisition costs were $2.5 billion or 24.5% of total advertising revenue. Our other cost of revenue was $1.2 billion, excluding stock-based compensation of $74 million. And finally, operating expenses excluding SBC again, totaled $3 billion. SBC totaled $482 million for the quarter, and the increase year-over-year in OpEx was primarily due to payroll, increased advertising and promotional spend and professional services. So as a result of all this, our non-GAAP operating profit was $3.9 billion for Q1, resulting in a non-GAAP operating margin slightly above 37%. These robust margins give us the confidence to continue to fully fund the strategic growth areas such as mobile, Android, YouTube, Chrome, all the areas that Larry talked about. And Nikesh will go into more details of these initiatives in a minute. Turning to headcount, which was approximately 610 for the quarter, and we ended up the quarter with roughly 33,077 employees, full time. Our effective tax rate was lower this quarter, 18%, and this reflects the mix of earnings between domestic and international subsidiaries and hedges and also some capital gains offset by carried over capital losses. So now let me turn to cash, cash management. Other OI&Es or other income and expenses was $156 million for the quarter, positive, and it reflects a higher realized gain on our investments, offset somewhat by lower interest income and by the impact of our FAS 133 expenses from our hedging program. For more details on OI&E, once again, I refer you to the slides that accompany us on our IR website. Operating cash flow was very strong, $3.7 billion. CapEx for the quarter was $607 million versus last quarter at $951 million. The majority of our CapEx spend was related to production equipment this quarter, as well as data center operations and facilities. And as a reminder, we will continue to make significant CapEx investments, and these have shown to be lumpy from quarter-to-quarter, mostly depending on when we're able to make these investments. So in total, very pleased with our free cash flow, $3.1 billion. Let me close with my usual reminder that our revenues typically exhibit seasonality in the first half of the year, while our expenses do less so. So it's just a forewarning for everybody who's kind of tuning their models. I'll hand off now to Nikesh who will cover in more detail our business performance in the quarter. Additionally, since Susan, who is typically on the call, is on a well-deserved spring break with her family this week, Nikesh will also cover some of the product highlights, primarily in Ads. With this, I'll turn it over to Nikesh.
Nikesh Arora: Thank you, Patrick. I will now give you an update on our business activities. As Larry and Patrick have mentioned, we had another quarter of excellent performance, resulting in $10.6 billion of revenue this quarter. Our results are actually reflective of 3 major trends that are happening in the online advertising space, so let me just touch upon those. First, we're seeing a big move to solutions. Our clients and partners more and more want complete solutions that work across all screens: desktop; mobile, tablet; and in the future, television. And also work with all kinds of formats, whether they're search, display or video ads. It's like having individual solutions for different devices and formats. So we're driving our teams to sell solutions across the entire marketing funnel. From building brand awareness to conversions, we are converging our teams of over 8,000 people to setting these complete solutions in 60 countries, making us one of the largest online solutions player. Secondly, the big trend is we're seeing a breakthrough on brands. More than at any point in the last decade of online advertising, we're at a point where major brand advertisers, from movie studios to CPG companies, are finally looking to digital media as a central part of their marketing efforts. We are making huge progress. YouTube has gone from an interesting ad buy to key buy for brands. In May, we'll be hosting our first upfront for brands and agencies, showcasing the latest channel content and opportunities for marketers, something television has been doing forever. We will do that for YouTube in New York. And third, we're beginning to see a trend on cross-media measurement. Social advertising has always been highly measurable, and we have been leading the industry in extending the measurability, not only in Search, but in Display, Mobile and live video. We are actually taking that one step further and trying to move that measurability into offline sales. Our experience is that businesses may allocate experimental budgets to new areas, but they invest serious money only when they can measure the results. We are rolling our best-of-breed measurement technologies so all clients can measure their ROI, whether their goals are online conversions, brand lifts or just the ability to compare offline and online media. Let's talk about some specific product areas. Search, our Desktop Search business has maintained robust growth with strong traction with our top partners around the world even in the face of economic uncertainties that we've been noticing in Europe. I think search advertising has broken through that sound barrier of being an online channel, which now finally proven to drive in-store sales. For example, we partnered with IKEA in Italy in a study showing that each click on a paid search ad generates $7.60 of revenue. And then interaction with paid search in conjunction with television drives 20% of contribution to sales. And there's a lot of room to improve on that, but it's a cut clear demonstration of how online advertising is no longer just restricted to online sales but also having a huge impact in the offline world. Last week, we launched a range of features to improve location targeting so that marketers can reach users by zip code or have their physical location show up more prominently in their ads. In sales, I want to highlight Google Analytics, which is an unsung hero. Over 10 million marketers and websites globally use Google Analytics to measure the effectiveness of their online presence in real time. From large e-commerce sites to small blogs, that means that our technology is at the heart of over 10 million businesses, helping them get the most out of the Web. Last quarter, we made several important improvements to Google Analytics, helping marketeers to measure the impact of the traffic from across over 400 social networks. I didn't even know there are 400 social networks. Let's talk about Display. On Display, we saw a robust revenue growth as our clients continue to see the value of integrated advertising solution in driving business results. For example, we signed a deal with Unilever in Brazil for a campaign that ran across all Google properties, including YouTube, Search, Google Display Network and Gmail. We also recently partnered with leading sportswear company, Reebok, to develop a global display campaign across YouTube, Mobile -- YouTube and AdMob -- and mobiles, YouTube as well. On the platform side in Display, we continue to make progress. We are now the leading platform provider for agencies and publishers to help drive their business using display advertising. We are focused in building unified buying and selling platform that helps them manage their advertising across all media much better than they have been able to in the past. Our good relationships with our clients are helped by rapid product development and innovation. Last quarter, we launched the Google Display Network app in AdWords, which makes it easy for all AdWords clients to build, monitor and find display campaigns across millions of sites in our network. This is helping bring the world of search and display even closer. Let's take a minute to talk about YouTube. As I mentioned, YouTube is an amazing success story. It's gone from an interesting buy to an obvious buy. Our watch paid sales have accelerated, particularly in key emerging countries, but also in mature ones. Today, most of our in-stream ads in YouTube are skippable, while our TrueView ad format, which is fast becoming an online video standard. It's great for users and it's great for advertisers. For example, the U.K. mobile operator O2 is actively now using YouTube to support their brand launch. They're using several YouTube products, including TrueView YouTube Mobile. They even live stream the New York -- sorry, the New Year Eve's concert from the O2 arena in London globally in YouTube. In addition to this, we're also rolling out our 100 new original channels in YouTube, featuring top talents like Jay-Z, Madonna, Tony Hawk, as well as innovative new media companies and YouTube's new own successful partners. We think YouTube is fast becoming the platform for the next generation of talents, which is great because we're also seeing initial success selling the sponsorship for these channels to large advertisers such as Toyota, Unilever, GM as all in anticipation of the big upfront event coming up in May. Let's change gears and talk about mobile. Mobile is quickly becoming a backbone of many clients overall advertising strategies and has huge headroom to grow. We continue to innovate with our product offerings with a number of new tools for advertisers. One development we're particularly excited about is our new enhanced click-to-download formats. This format in Search helps marketeers and developers promote apps. These things help improve ROI to provide users with more relevant download information about apps such as star rankings, pricing, et cetera, and all this happens right in the ad creator [ph]. So we keep actively working to help develop the mobile ecosystem from enabling mobile commerce to empowering local businesses. In Q1, we began to scale our GoMo campaign, which is our Go Mobile campaign. This initiative helps businesses get more and more assertive and set up great mobile websites so they can keep driving traffic to those websites and expand their businesses. We've done these efforts across the world in North and South America, in Europe, in Asia and Africa. Moving beyond advertising. Our Enterprise business also saw excellent progress as large organizations and small businesses continue to see the value of Google Apps as a cost-effective and feature-rich productivity suite. Some of our top customers to go Google in Q1 include global pharmaceutical company Roche, more than 90,000 users; the State of Colorado, which announced they intend to move 26,000 employees and users to Google; also the University of Pennsylvania and Rome have gone Google. Not only that, small business adoption of Google Apps is on fire, with SMB signups almost doubling in the past 6 months. So we're happy with the business and we're happy with the way Enterprise continues to progress. Let me go back and show some more color on the country performance, as Patrick also talked about. From a regional perspective, we saw generally stable performance in the Americas. We saw a sustained traction in most parts of Europe and we saw acceleration in Asia, all this was driven by strong performance from our long tail Sense sales channel. Growth in North America was steady and this certainly was boosted by seasonal events such as Super Bowl, Valentine's Day, tax season. Canada was a little slower. Of course, Western Europe was robust in spite of the macroeconomic conditions. We continued seeing good growth in the U.K. Germany, France and Italy grew slightly less quickly than before. We saw strong acceleration in Asia. Japan grew faster this quarter, led by successes again, in our small and medium client base. Let's talk about marketing and our partnerships business. Our marketing and partnership teams continue to support the fantastic growth we've seen this quarter across all of our business lines, products and services. We continue to roll out initiatives to support of Google+, which Larry talked about. We rolled out our That's the plus campaign with spots airing during the Grammys, the Oscars. Google+ and Hangouts are getting great traction. We have President Obama, we have Governor Romney, they both conducted very successful Hangouts in the platform. Even NASCAR held a Hangout ahead of the Daytona 500. But the most interesting was Seaview Survey, it had underwater Hangout live from the Great Barrier Reef. It's amazing to be able to see our great products like Hangouts be so successful. I recommend that all of you try Hangout soon. As Larry mentioned, we also launched Google Play, which provides users one place to find, enjoy and share apps, music, movies and books instantly anywhere across the Web and on the Android devices. To support the launch, we are on a 7 days to Play promotion, offering discounts and apps and media, and our YouTube video has received over 3 million viewers to date. Our partnership teams also kept its great work, supporting our products by being very close to our partners. For example, we launched Google Street View in Russia, which lets users walk around the historical centers of Moscow and St. Petersburg. And we are also thrilled that this quarter our Google Cultural Institute help bring Nelson Mandela's archives online. We expand our successful art project to include new museums from the Getty Museum in L.A. to the museums in Paris and Qatar. Project now provides access to more than 30,000 ultra-high resolution images, paintings, sculptures and photographs in 151 museums and other institutions in 40 countries. So in closing, I think Q1 was an excellent quarter. It has led us off to a very good start for 2012. We look forward to continuing to serve our users, customers and partners for the rest of 2012 and beyond. Also, I want to say thank you to all the Googlers and our global business team, all of our partners in the product and engineering teams that allow us to make these wonderful things happen and allow us to continue to drive the business. With that, thank you, and I'm going to hand you back to Patrick.
Patrick Pichette: Thank you. So Jamie, our operator, is going to give us the instructions to get to the Q&A. So Jamie, why don't we just jump right in?
Operator: [Operator Instructions] And we'll take our first question from Spencer Wang with Credit Suisse.
Spencer Wang: Two quick questions. First for Patrick. You mentioned the headcount growth was only about 600 this quarter. That's obviously slower than what you saw in 2011. Should we -- is this roughly the pace we should expect for 2012 or were there perhaps some timing factors? And then secondly for Larry, you talked about Google+ unifying the Google product. So when you think about things like Google Wallet and Offers, the mobile strategy maps, do you think of these as individual products or are they part of perhaps a broader local strategy? And if so, how do they fit together?
Patrick Pichette: Perhaps why don't I just jump on the technical question, then let Larry get to the second one. So look, I think that the headcount fluctuations, you'll remember last year when Larry said that we were at what was the kind of the edge of what was tolerable. And look, this short-term variability is actually the very best proof point that we don't manage kind of quarter-to-quarter and try to smooth things out. It just happens that in the first quarter, at this time of year, it's a bit different than when you come back in Q3 when you have all of the graduate students that actually start with us, so there's a bit of fluctuations there. So I wouldn't read that much into the numbers, but we're basically continuing to push on plan for hiring for this year.
Larry Page: And the question, I guess, about our products. I think we're working very hard, and I've talked a lot about this to make our Google experience be more unified and feel like one great experience for people. And many of the products you mentioned, Google Wallet, Offers, Maps, I mean, they apply kind of across many of the things we do. And so I think you'll see better integration of those products over -- through the rest of our products has already exist with Wallet, for example, across many different parts like Google Play and so on. And I think you'll see that increasingly happen over time just as we make these experiences better. They'll come up when you expect them to come up and when they make sense for users. I think that's definitely a big area of focus for us.
Operator: And we'll go next to Mark Mahaney with Citi.
Mark S. Mahaney: Two quick questions. First, in terms of appealing to major brands, and Nikesh I think you talked about how you're seeing major brands engage more with YouTube and other assets. Could you talk about how you're trying to go after those dollars? Are there new things that you're doing now that you weren't doing 2 years ago to kind of accelerate that momentum? And then just real quickly on the mobile CPC issue. Can you just comment again on over time, over what period of time you would expect mobile and desktop CPCs to merge or do you think that's a realistic expectation? What would cause that to happen or not?
Nikesh Arora: Let me take the first question quickly, then I'll give you a little color on the second one, then Patrick can jump in. In terms of what we're doing differently, as I mentioned, YouTube has gone from being an interesting place where brands to be to being a must-buy. So we're seeing tremendous demand for inventory, which is brand related. And for the most part, the online world in the past has been more performance related i.e., people wanted to get some transactions, they wanted to get more people to their website. Now they're seeing the benefit of using the Web for brand affiliation and for brand recognition. So we are beginning to have a different sales pitch with the large brands, which is oriented towards them coming and getting their brands seen a little bit, and YouTube is a phenomenal tool in that regard, which acts sort of like an anchor property. Then we're able to package our demographic base inventory around the Google Display Network, around YouTube and actually get the brands to engage in the large campaigns, which can run the millions of dollars. This was a capability we couldn't have a few years ago because the inventory didn't exist or the demographic tools didn't exist. So clearly, this is a new space and a new sort of pitch to our brand advertisers. As I said, we are trying to light this up across our sales force around the world in 60 countries.
Patrick Pichette: No, we just have -- let's go through the mobile CPC question. So Mark, I think that this one is -- think of it as so much upside for us because essentially mobile is exploding in query growth and the formats themselves are just adapting already a lot and from a relatively crude base to so much more in the future. So that you're absolutely right that right now they don't monetize as well because we're kind of in what search used to be in 2002, 2003, 2004. So as these formats kind of continue to get better and better, we'd expect much better performance on them.
Larry Page: This is Larry. I'll add something, Mark. I think the mobile CPCs -- I mean, people always spend their most effort on the major -- whatever the major source of traffic or revenue is, and those are growing really quickly, albeit currently, obviously, there's more on desktop. I think over time as a reverse, and I think that the ability to kind of on your mobile to do local kinds of transactions, to really easily communicate with people and to do the kind of capabilities you have on your mobile device. And the fact that you spend most of your money locally, I think that over time that may actually reverse and the CPCs action may get better. But I think we're very bullish about that. We're making a lot of investments in that area, in things like Offers and so on and Wallet. And we're very, very excited about the potential there, and also Click-to-Call and other things that we do. So I think, for example, it's a lot easier to call someone from your mobile than it is from your computer right now. And so if that's how you're relying for transactions, actually mobile CPC should be higher for that. So I think you just haven't seen the focus on it and we're moving more and more focused on to that, both on our sales side and our customers are moving focus onto that, but I'm very, very bullish on that.
Operator: And we'll go next to Ben Schachter with Macquarie.
Benjamin A. Schachter: Larry, in your 2012 update letter, you speak of all these notions of changing the world and ambitious goals on risky projects and having a healthy disregard for the impossible. Without getting into too much detail, at a high level, what types of projects is Google working on that would really surprise us? And are you remaining committed to the 70/20/10 rule where these noncore areas might get only 10% of the investment? And then separately, just on the google.com TAC, please, that continues to increase as a percentage of Google revenue. Is most of that coming from payments to mobile partners? And given the growth of mobile, should we expect that to continue to increase meaningfully?
Patrick Pichette: Do you mind, Larry, why don't I answer the last one first because it's really easy and then you can jump on the rest. Look, on TAC, if you look at our percentages -- as a percentage of revenue year-over-year, I mean it's basically stable. I mean, it moves a little bit here and there and you have partner mix and FX mix between mobile and others, but it's not actually changing in any dramatic way. So what you have to see in there is just the regular mix of both traffics and partners that come in and out all the time as well, so that I wouldn't read too much into that. I'll let Larry answer the real sexy question.
Larry Page: I think I didn't mention specifically the 70/20/10 in my letter. I should have, that's a good addition. So we definitely still see a -- most of our resources should be going to our core businesses, which really Search and Ads and a few of those things I mentioned that's really fallen to that core, I think. And then there's 20% kind of near things and maybe another 10% on the really speculative things. Through our whole history, we've really struggled this and have 10% kind of on the speculative things. Generally, it's much lower than that. I think the real thing that's needed on those projects is some management. Those take up bandwidth. You saw our announcements of Google Glass last week, which I was very excited to go out. You've seen the driver with his car kinds of things. And it does our take our executive time to deal with those things and so on, and so I think that's the real investment we make rather than being huge amounts of dollars on those kinds of things generally. We've got a limited number of things we can do. As I've been saying, we've been trying to focus. So trying to make sure that we have the right speculative bets as well as the right bets we're making on our core products and so on. And I'm pretty excited about our ability to do that. And I think it's hard coming from the outside because I mentioned in the letter I published today that Android took 3 years, plus 3 years kind of to really get to where it is today. That's 6 years, and you all haven't seen android, right, for those 6 years. We've seen it for those 6 years and we really invested in it. It's not so much money at the earlier stages, but attention. And that's an important, I think, discipline for the company to have.
Operator: And we'll take our next question from Brian Pitz with UBS.
Brian J. Pitz: Similar to detail on cost-per-click, would you discuss the key drivers of higher paid-click growth? Is it quality changes, Product Listing Ads or something else? And more broadly, maybe you can discuss how Product Listing Ads do impact results as we're tracking a substantially higher number of these ads on your site?
Patrick Pichette: Without giving -- look, the short answer is yes, and that's what the core answer of my message to the market was today. I think that you have a combination of international factors. You have a combination of new formats. Ad formats drive a lot in terms of paid clicks. If you think of even the sitelinks' extensions that we've -- like we have a new generation of sitelinks for this quarter, right? This is a perfect example of a product where by adding additional lines that are more targeted, so instead of having just kind of, trucks or -- and then you go down into the second layer, right, you have less CPC for that additional sitelinks. But if it's a better ad, people click a ton more on them. So it is really all of those 5 factors that actually drive them. And that's why we're continuing to kind of be pretty happy with the health of the net effect, which is real growth. Certainly, internationally, I mean it also -- you can see our mix between international and non-international. And that's driving it as well. So you have all these factors at play. And we're pretty happy with what we're doing there.
Operator: And we'll take our next question from Doug Anmuth with JPMorgan.
Douglas Anmuth: Two things. First, just want to follow up on the question on mobile and TAC. If you could help us understand beyond CPCs how the economics of mobile are different and perhaps a little bit more detail on how you're paying OEMs and carriers. And then secondly, any updated thoughts on the cash balance and an update perhaps on the split of U.S. and international cash?
Patrick Pichette: Let me start with the last one first. We don't give the breakdown of our U.S. cash. We do it kind of irregularly, so we haven't done so of late. We have -- we continue to have a very strong cash balance, both U.S. and international. You'll notice, if you go into the details of our cash balance and on our balance sheet, right, we have just slightly under $2 billion of sec lending programs. So when you really, really look at our net cash balance, you got to take that sec lending out because it's on both sides of the balance sheet. But for the rest of it, incredibly healthy cash balance, both domestic and international. And Nikesh, do you want to give a quick update on the mobile CPCs and their mix?
Nikesh Arora: Yes. I mean, again, I'm not going to talk about specific of the TAC on mobile. But as you know, we get people using our devices both organically as well as through our distribution partnerships with carriers and OEMs. And typically, the OEMs and carriers participate in some of the economics that are on the Android marketplace or Google Play and some of them participate in the economics around Google Search just the way we would do syndication on the Web platform, which you do with many partners around the world. We have similar deals on the mobile front. I think in the mix, it comes out. This sort of washes out and it sort of adds up into our number which we show in -- our total number of green desktop and mobile. But mobile is no different from the way the desktop business operates out there.
Patrick Pichette: And we benefit from the terrific growth.
Operator: And we'll go next to Carlos Kirjner with Bernstein.
Carlos Kirjner: Two questions, if I may. If you think of the future of Internet search 3 or 4 years out, how important will the social signal be and how important your personalization be? In other words, would the company with the best social signal be able to offer the best search? And if the answer to that question is no, why is Google investing so much in Google+? And second question, if I may, you probably end the year with about $50 billion in cash and marketable securities and that will give you quite a lot of strategic flexibility. Given that, what's the rationale to continue to increase that amount on market on cash to shareholders?
Larry Page: I'll take the first part, Carlos. I think the -- this is Larry, and I think it's a very good question. And I think one of the things actually had in my remarks when I took out was to talk a little bit about Search and just enough time to put it all in. And I actually covered the question you're asking. I think one of the most amazing things I think we can do today that we couldn't do even a few months ago is to really -- I have this friend Ben Smith, right, who's a person at Google. He has kind of a common name. Now when I do a search actually, it finds the right person and it puts him in the search box. So for the first time, the search box isn't really doing searching a string, just the sequence of letters. It's actually searching for that person that I know. Now it's not, obviously not all the searches you do, but being able to search for people well is important. And knowing -- having real feedback from users about what they like and don't like and things they're sharing and so on is very useful for search. And we have a lot of those signals already, but we can always use more signals. We can always use better relevance and we can always use more data to generate that. So I think it is very important. I think it's not -- think social data about identity and ability to easily share things with other people and comment on them and things like that is a basic utility for people in all of our products. And that's where I was talking about Google+ really working across all of Google for identity and sharing and notification and other things that it does really well. So that all applies to Search and I think it's important for Search. I think search is going to change a lot. We're going to make it a lot better over the next 5 or 10 years as it's changed a lot in the past. And it will include a bunch of those signals and a bunch of other things as well.
Patrick Pichette: Carlos, why don't I take the next one, the issue of our cash balance. We have a healthy cash balance, I had mentioned a minute ago, and we still believe that it's an incredible strategic asset for us. You saw it last year when we decided to make the purchase of MMI, and we continue to monitor this cash balance. And for the time being, we really believe that, that strategic asset has a ton of value. So we'll continue to monitor it and we have a process by which we actually review it on a regular basis with the board, and those questions are always asked. So we have a good governance process around it. But for now and the time being, we have nothing to announce on it.
Operator: And we'll take our next question from Heather Bellini with Goldman Sachs.
Heather Bellini: I was wondering, Larry, if you could walk us through your view on Google's tablet strategy via Android and the relative importance of having success with these devices in terms of achieving your long-term goal?
Larry Page: Heather, that's a good question. I think that we're very excited about tablets. I think there's a number of Android tablets out there and obviously, we have strong competition there as well. I think you've seen us really invest substantially also in things like Google Play, which really give you great access to entertainment, media, books and videos and so on, and as well as the apps. And we think that's an important component of what we're doing. I think there's also -- obviously, there's been a lot of success on some lower-priced tablets that run Android, maybe not the full Google version of Android. But we definitely believe that there's going to be a lot of success at the lower end of the market as well with lower-priced products that will be very significant. And it's definitely an area we think is important and we're quite focused on.
Operator: And we'll go next to Justin Post with Bank of America Merrill Lynch.
A. Justin Post: I have one for Larry and one for Patrick. Larry, Android is obviously a key focus. You talk about it a lot in your letters. Can you help us understand the strategic value for Google since you're not licensing it? Do you see more revenue per device if it runs on Android or lower TAC or what else can you tell us about what the real advantage to Google's advertising businesses? And then Patrick, obviously, higher in CapEx in Q1 this year, a lot lower than Q1 last year. Can you tell us if you factor in your revenue growth when you make that spending decision, your outlook? Does that -- give us any clues on your outlook for revenue growth over the next couple of years?
Patrick Pichette: Why don't I jump on the -- because mine again is not a very strategic one, it's more how we proceed. Look, it's lumpy because there's just timing decisions, right. We would -- there's probably a few areas where we would have like to actually make investments in Q1 and for a bunch of logistics reasons or otherwise, we couldn't. And so -- and you'll notice that's why there's kind of like $350 million difference between Q4 and Q1. And you should just expect it to be lumpy and that's just the nature of -- data centers are kind of big and clunky. And when you buy some piece of real estate, it's big and clunky. So there is quite a bit of variability into it. But we're -- again, I wouldn't take any one data point to start making a trend out of. So it's tough for, but I think that you can see we're committed to capital. If you look at the last couple of years, we've really made kind of significant investments and we'll continue to do them because it's a real strategic asset to us as well. So I'll let Larry answer the first question.
Larry Page: Justin, I think on your questions about Android, I think they're pretty short-term focus and I think it's good to think about the longer-term issues. We don't get very many new operating systems, kind of only a few in my lifetime, and I think they're pretty important. And I think Android's really about increasing the pace of innovation, usage of mobile devices and our ability to get a great user experiences out to our users, which I think we're doing a great job of. I mentioned over 850,000 devices per day are going out. And it's important to remember we're very early stages of that like we've only -- I'm amazed the computer that I'm carrying in my pocket is as good as the one I had a few years ago on my desktop. And I think we're only at the very, very early stages of what's possible with those devices. And I'm excited about a whole bunch of things we're doing in that area. We already mentioned kind of things like I said I'm very bullish about CPCs will improve on mobile over desktop due to all those capabilities. And so I think the benefits we get from Android are a lot. I mean, obviously, we have great integration with our products and Search and Google+ and photo uploading and there's a hundred things that we do really well on Android that benefit us across the board and across our users across the board and our products across the board. And I think that's going to continue to be the case. And I think it does lead to better economics for us too because we're providing amazing experiences for people that are well integrated and work well and they demand. So that's -- I'm very positive on all those things.
Operator: And we'll go next to Lloyd Walmsley with Deutsche Bank.
Lloyd Walmsley: Larry, just wondering as you look out on a very long term kind of 5-year view, do you see tablets taking perhaps the majority of home Internet usage? And if so, how strategically imperative is it for Android to have a big success in the tablet space given partner TAC could impose a high cost to the extent Android doesn't have a hit?
Larry Page: Yes, I mean, I think I've sort of already answered this question previously about tablets. I think the -- I mean, like I said, I think it's an important area. I think your computing experience, obviously, if you have an Android phone or use Google a lot online or you care about all those things in terms of your experience. And so I think you're thinking about your user experience. You're thinking about across all the devices use. I think people are going to get a lot more devices. We see kind of a convergence between all the services on those devices. And right now, I feel like each device you got is kind of a hassle the deal with and you're thinking about each individual device and all the issues with it. And I think that's not really right. I think you're going to have a pretty unified experience and a great experience from a user point of view and you won't have to manage all these devices. So I think you want to think about all these screens around you working seamlessly and working well for you. And I think, obviously, tablets are important. We have Google TV obviously. Big screens are important, computers are important, phones are important. Everything, all those devices are important. And I expect that they'll work well together. So I think that's kind of how we would think about it, and I think it's -- I don't think any single device there is going to drive all the usage or all the kind of convergence that needs to happen.
Operator: And we'll go next to Ross Sandler with RBC Capital Markets.
Ross Sandler: I had a question for Nikesh. Can you give us an update on the growth rate you're seeing today in your core Search business by small, medium and large advertiser tranches? I think you mentioned in the prepared remarks that Japan had strong growth, primarily due to smaller advertiser tranche. So how does that growth look in the various advertisers' size buckets across your GOs? And then is the speed of small advertiser adoption increasing right now versus prior periods given all the new local products that you have?
Nikesh Arora: Yes, I mean, I think the one way to think about it is that fundamentally we have one auction, and that auction every advertiser participates, whether it's the small advertiser or large advertiser. So they way we think about it is that we try and go ahead and get more and more advertisers to see the benefit of online advertising and the solutions that we offer. So as more and more advertisers come into the auction, it drives the price up of the auction for both large and small advertisers. And the way to think about it is that there's a price as we talked about CPCs and paid clicks, but it's really the third variable that goes into it, how many advertisers can we bring into the auction and how many various things can we get them interested in, whether it's mobile, whether it's YouTube, whether it's Display, whether it's Search. So there has been a lot of effort we have put in from our end, both to get more small business online. We've been adding GXBO campaigns around the world where we get small businesses online. We've also been cleaning up our signup flows for our adverts products, which is a self-served product where really small business can sign up. We have been working on getting people to have more mobile sites and getting people out in the mobile campaign. So effectively, it's a lot of effort towards getting more and more advertisers into the ecosystem. And as that happens around the world, you will see seasonal patterns or some sort of spikes when we work harder on small businesses in one quarter in certain parts of the world. But eventually, it all benefits the auction and we see the trend over time ends up working the same way for large and small advertisers.
Operator: That final question comes from Anthony DiClemente with Barclays.
Anthony J. DiClemente: Just one question for Nikesh or whomever wants to answer it. It seems like even though as you're shifting to mobile, you have this presumably double-digit pricing step down for CPCs. But in the Display world, certainly, that pricing difference could be even more dramatic. In some cases, by half or 2/3. Prices getting cut on that shift to mobile. And so you guys at Google have the unique ability to compare and contrast the difference in price between like Search and Display and how the 2 are monetizing relative to desktop. And so any color on that comparison would be appreciated because I think there are folks out there that have a view that actually Search, core Search, monetizes better on that shift to mobile than Display does, and I would love to just understand that better.
Nikesh Arora: Yes, I mean, I guess -- let me try to just explain to it from the advertiser perspective. So what we're striving towards is advertisers are interested in ROI. Advertisers actually are not interested in whether they're on the mobile product, the Display product, the Search product on the Web or the Search product on mobile. So what we are fast converging towards is we're basically sitting down and understanding ROI targets of our advertisers. And then we have immense amounts of inventory at our behest, whether it's mobile inventory, on Display or Search or desktop inventory or even inventory to our network. And what we are trying to work towards is being able to dynamically allocate across these various products, what allows them to get the maximum ROI. In that case, they are sort of -- they don't really care about whether they got that transaction to happen off one platform, one format or the other. So that's what we want to aspire, and that works really well in performance advertising because there is a specific objective the advertiser has. On Display, on brand, it works slightly differently, obviously, because you're talking about CPMs. But generally, that's the way to think about it. In the long term, we think mobile will monetize better. And we usually don't see the difference happening on Display and Search as you alluded to. Larry, you want to add something?
Larry Page: I'm just going to close the call here, and I really thank everyone for spending so much time with us today. And thank you all for spending time with us today and for being so interested in Google. And now, I'll turn it over to the operator.
Operator: Thank you. That does conclude today's conference. We do appreciate your participation. | [
{
"speaker": "Operator",
"text": "Good day, everyone, and welcome to the Google Inc. First Quarter 2012 Earnings Conference Call. Today's call is being recorded. At this time, I'd like to turn the conference over to your host, Director of Investor Relations, Ms. Jane Penner. Please go ahead, ma'am."
},
{
"speaker": "Jane Penner",
"text": "Good afternoon, everyone, and welcome to today's first quarter 2012 earnings conference call. With us are Larry Page, Chief Executive Officer; David Drummond, Senior Vice President, Corporate Development, and Chief Legal Officer; Patrick Pichette, Senior Vice President and Chief Financial Officer; and Nikesh Arora, Senior Vice President and Chief Business Officer. Also, as you know, we distribute our earnings release through our Investor Relations website located at investor.google.com. So please refer to our IR website for our earnings releases, as well as the supplementary slides that accompany the call. This call is also being webcast from investor.google.com. A replay of the call will be available on our website in a few hours. Now let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward looking, including statements regarding Google's future investments, our long-term growth and innovation, the expected performance of our business and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. Please refer to our SEC filings for a more detailed description of the risk factors that may affect our results. Please note that certain financial measures that we use on this call, such as operating income and operating margin, are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings press release. With that, I will now turn the call over to Larry."
},
{
"speaker": "Larry Page",
"text": "Thank you. Hi, everyone, and thanks for joining the call today. It's great to be here with all of you. I'll talk about our new class of stock at the end of my remarks, but first, I want to focus on our performance. We had a very strong quarter with revenue up 24% year-on-year at $10.6 billion. Since becoming CEO again last April, I've pushed hard to increase our velocity, improve our execution and focus on the big bets that will make a difference in the world. Google is a large company now, but we'll achieve more and do it faster if we approach life with the passion and the soul of a startup. This has involved a lot of cleanups. We've given many of our products including Search a visual refresh. They now have a more consistent look and feel. When we've closed or combined over 30 products, we have so many opportunities that without hard choices we end up spreading ourselves too thin and don't have the impact that we strive for. Creating a simpler and more intuitive user experience across Google has been another important focus. I have always believed that technologies should do the hard work, but just takes scheduling and communications, so users can get on with what makes them happiest, life. Our products work seamlessly together so people don't have to navigate Google to get stuff done. Chrome for Android, which launched this quarter, is a great example of this kind of simplicity we're shooting for. It does mean switching between devices painless. All of your tabs are there across your desktop and Android, you can even click the back button on a different device and it just works. Just try it out, it's a great experience. It's the same with Google Play, which we also shipped this quarter. You can now access all your movies, your books and apps and games from the web or from your Android device, no cables, downloading or syncing required. We spent years working with partners to get all of this great content. So it's really exciting to see it brought together in a beautifully simply way that people can enjoy. Now Google+ is truly at the heart of our efforts to create a simpler, more intuitive experience for all of our users. You should think of it in 2 parts. One is just our social spine. Once you're logged in and have upgraded to Google+, you're just using one Google, not a series of disconnected products. It's still early days, but with over 120 Google integrations to date -- Google+ integrations to date, we're on the right track. And your user experience on Google just gets better. You can see friends' recommendations when you're using Google Play and you don't think about that as Google+, but it just comes from that infrastructure. And we're seeing a positive impact all across the web. Google users can now recommend search results they like, a goal we’ve had ever since we started the company. The other part is the social destination, which is accessed on your mobile client or on plus.google.com. This social destination part grew from a base of 0, not starting with all Google users like the part I was previously talking about, and is growing quickly. In fact, we see impressive engagement in fast growth here. It's just not all of Google. We are starting up a new community. We're excited about the amazing speed with which some people have amassed over 1 million followers, and I have just been lucky enough to pass 2 million. I get high-quality feedback on the public post I make, which I really enjoy. And every day we make Google+ better. Just yesterday, we took another big step forward with a beautiful new UI for Google+. And the new customizable navigation driven in that redesign makes it much easier to access your favorite apps. There's better discoverability for Hangouts and you'll love the larger images that you see across that interface. Now last time, there's a bit of confusion over the metrics I gave about Google+. I want to be clear about these 2 parts of Google+ and the fact that we have made great progress on both parts. As you would expect, the social spine is proportional to Google and all of the usage across Google. And Google’s pretty big. And well over 170 million people have now upgraded to Google+. So to summarize, there are 2 parts to the Google+ experience: the part that is the social spine, and the other part that's the social destination part of Google+ exclusively. Both of these are growing fast, but the social destination part of Google+ is growing as a new product with very healthy growth. I'm also excited by our big bets. We have some amazing new products that were seen as crazy when we launched them, but now have phenomenal usage. They can easily pass the toothbrush test. They're important enough that millions of people use them at least once or twice a day. Chrome has over 200 million users. Our Display business has reached an annualized run rate of over $5 billion and 850,000 Android devices are activated every day. And YouTube just keeps on growing. These are just staggering even by Google standard. They had over 800 million monthly users uploading over an hour of video per second. I'm incredibly proud of these achievements. They wouldn't have been possible without an amazing team of Googlers and the long-term focus with which we are able to run the company, which brings me to this afternoon's announcement about our stock. Now throughout our evolution from being privately held startup to a large publicly listed company, we have managed Google for the long term and enjoying tremendous success as a result, especially since our IPO in 2004. The founders, Sergey and I, really hoped but we did not expect that Google would have such significant impact. And that this progress has made us even more impatient to do important things that matter in the world. Our enduring love for Google comes from a strong desire to create technology products that enrich millions of people's lives in deep and meaningful ways. To fulfill these dreams, we need to ensure that Google remains a successful growing business that can generate significant returns for everyone involved. When we went public in 2004, we established some clear well-publicized expectations for investors around our governance. We wrote a couple of things in our original founder’s letter, I just want to read here. \"New investors will fully share in Google's long-term economic future, but will have little ability to influence its strategic decisions through their voting rights. And we are creating a new corporate structure that is designed for stability over the long-time horizons. By investing in Google, you're placing an unusual long-term bet on a team, especially Sergey and me.\" I wanted to quote all that because these are the clear well-publicized expectations we established for investors. And while this decision was controversial at the time, we believe with hindsight it was absolutely the right thing to do. Eight years later, these still -- statements are still remarkably accurate and everyone involved has realized tremendous benefits. Given Google's success, it's unsurprising this type of dual-class governance structure is now somewhat standard among newer technology companies. In our experience, success is more likely if you concentrate on the long term. Technology products often require significant investment over many years to fulfill their potential. For example, it took 3 years just to ship our first Android handset and then another 3 years on top of that before the operating system truly reach critical mass. These kind of investments are not for the fainthearted. Long-term product investments like Chrome and YouTube, which now enjoy phenomenal usage, were made with a significant degree of independence. However, day-to-day dilution from routine equity-based employee compensation and other possible dilutions, such as stock-based acquisitions, will likely undermine this dual-class structure and our aspirations for Google over the very long term. We have put our hearts into Google and hope to do so for many years to come, so we want to ensure that our corporate structure can sustain these efforts and our desire to improve the world. Today, we announced plans to create a new class of nonvoting capital stock. These shares will be distributed via stock dividend to all existing stockholders. The owner of each existing share will receive one new share of the nonvoting stock, giving investors twice the number of shares they had before. Effectively, a 2-for-1 stock split, something many of our investors have long asked us for. These nonvoting shares will be available for corporate uses like equity-based employee compensation that might otherwise dilute our governance structure. In November 2009, Sergey and I published plans to sell a modest percentage of our overall stock ending in 2015. We are currently halfway through those plans and we don't expect any changes to that, certainly not as the result of this new potential class. We both remain very much committed to Google for the long term. It's important to bear in mind that this proposal will only have an effect on governance over the very long term. In fact, there's no particular urgency to make these changes now. We don't have an unusually big acquisition planned, in case you are wondering. Investors and others have always taken a big bet on Sergey and me, and that bet will likely last longer as a result of these changes. We are honored that so many of you have put your trust in us and recognize the tremendous responsibility that rests on our shoulders. We think this is a good thing because users rely on Google to produce and operate amazing technology products and to safely and responsibly store their data. That is our passion. Thank you very much, and I will now hand over to David to explain some of the more technical aspects of this proposal."
},
{
"speaker": "David C. Drummond",
"text": "Thanks, Larry. So first of all, I wanted to say that we'll be filing a proxy statement soon, which will have more details about today's proposal. But for now, I want to give a few broad strokes. First off, as Larry said, what we announced today is basically a 2-for-1 stock split, and here's how it works. What we're doing is creating a new class of stock, Class C. That new stock will have equivalent rights to our existing Class A and Class B stock, except it will have no voting rights, and it will also be issued through a stock dividend on all Class A and Class B shares. So after the dividend, a stockholder who currently owns one share of Class A common stock with a single vote will continue to own that share plus one share of Class C capital stock that does not have a vote. Our existing Class A shares will continue to trade as they do now and the new class C shares will also be listed, so stockholders will be able to trade those shares, the class C, just as they can with the Class A shares today. Now one thing to emphasize, because all stockholders will be treated equally and will receive one share of Class C for every share they now hold, everyone, including Larry, Sergey and Eric, will retain the same voting interest they had immediately prior to the dividend. And it's also important to note that as part of this, Larry, Sergey and Eric have all agreed to subject their shares to a transfer restriction agreement. This agreement maintains the same link between their voting and economic interest that exist today. So if any of Larry, Sergey or Eric sell or transfer their nonvoting Class C shares, there's a stapling provision in the agreement that requires them to either sell an equal number of Class B shares or convert an equal number of Class B shares into Class A shares. Now the stapling requirement will end when their ownership levels fall below certain thresholds. So the basic thing to understand here is that the stapling provision is designed so that subject to these thresholds, the votes held by the founders and Eric will be reduced proportionally as their economic interest in the company declines. Now a word about the process we used. Our Board of Directors carefully considered this proposal to create a new class of stock before reaching a decision. The process the board followed was robust and the deliberations were extensive. Back in January 2011, the board established a special committee comprised of independent non-management board members to consider this new class of stock or other alternatives. The committee met on numerous occasions over the 15 months that the special committee considered the proposal and that, that was separately from the board. The committee recommended and the board unanimously approved today's proposal. In terms of next steps, the proposal’s subject to the approval of a majority of the voting power of Google's common stock and they'll vote together as a class that will happen at our Annual Meeting on June 21 of this year. Given that Larry, Sergey and Eric control the majority of voting power and support the proposal, we expect it to pass. Following that, the board will set a record date for the dividend to move the process forward. So for more detail on the proposal, you can find the Founder's Letter that Larry and Sergey issued this morning as well as a postscript from me on our Investor Relations site. And as I said, next week, we'll file a preliminary proxy statement with the SEC, so you'll have even more details about today's proposal. So with that, I'll turn it over to Patrick to talk about the quarter."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you, David. Good afternoon, everyone, and thank you for joining us. Well, closing this first year with Larry leading Google as CEO, all of us at Google feel a renewed sense of velocity, focus and optimism in our Q1 operating, but also financial results are a good reflection of this spirit. So let's jump right into the financials. Our gross revenue grew 24% year-over-year to $10.6 billion, 1% quarter-over-quarter, and our Google websites also grew. Revenue grew 24% to $7.3 billion, with strength across most major geographies and verticals. Google's Network revenue was up 20% year-over-year to $2.9 billion, 1% quarter-over-quarter. And Network revenue was still negatively impacted by the search quality changes we began to make a year ago in late February, otherwise known as Panda. Other revenue was up 56% year-over-year to $420 million and 2% quarter-over-quarter. Our aggregate paid-click growth was very strong, just shy of 40%, up 39% year-over-year, and up 7% quarter-over-quarter. Aggregate cost-per-click growth was down 12% and down 6% quarter-over-quarter. So given the recent trends in CPCs and clicks, allow me to spend a bit of time today addressing this. The most important thing for you to understand is that our business is healthy. We believe that shifts in CPC and paid clicks taken independently really do not reflect the fundamental health of our business. Now allow me some details on this. In general, we attribute these trends to a combination of really 5 core factors. Those include FX, and then there's 3 mix effects. For example, the mobile versus tablet versus desktop shifts, emerging markets versus developed markets shifts and even the basics of google.com versus our network. And then finally, ads quality changes which is also a huge factor. So as you can see, it's a complex set of dynamics with multiple variables at play. Many in the financial community have tried to isolate or often I hear pick one of these among these factors as the primary driver for CPC or click trends. Some even say it's about -- all about mobile. Others suggest that it indicates weakness in demand for Google advertising. Well, on the latter point, I want to be very clear that that's not the case. One important signal we have for advertiser demand is bidding behavior. And in fact, our advertisers’ bid continue to be very strong and are growing. So the dynamics around CPCs and paid clicks are just simply very complex because of all of these big factors and change continually. So trying to pick a horse, so to speak, just doesn't make sense. We internally track all these factors with the help of a number of statisticians, economists and engineers who dig into all these details on an ongoing basis. So we won't go into that level of detail every quarter, but again, the key thing to understand is that we believe that shifts in CPC, or paid clicks taken independently, simply don't reflect the fundamental health of our business, which we believe is actually very healthy. If anything, the recent lower CPCs present a great opportunity for advertisers to get an even better return on their ad spend. And lower cost, better ROI attract advertisers and thus, this is good for Google for the long term as well. So enough said on CPCs and paid clicks. Let's just turn to geographic performance. The U.S., U.K. and rest of world are growing still at good pace as reflected in our results. In our earnings slides, which you'll find on our Investor Relation website, you see that we've broken down our revenue by U.S., U.K. and rest of world that showed the impact of FX and the benefits from our hedging programs. So please refer to those slides for the exact calculations. Our revenue in the U.S. was up 22% year-over-year to $4.9 billion. Our non-U.S. revenue accounted for 54% of our total revenue or $5.8 billion, up 26% year-over-year, which includes modest $37 million benefits from our hedging program. The U.K. was up 19% year-over-year to $1.2 billion. Let me now turn to expenses. Our traffic acquisition costs were $2.5 billion or 24.5% of total advertising revenue. Our other cost of revenue was $1.2 billion, excluding stock-based compensation of $74 million. And finally, operating expenses excluding SBC again, totaled $3 billion. SBC totaled $482 million for the quarter, and the increase year-over-year in OpEx was primarily due to payroll, increased advertising and promotional spend and professional services. So as a result of all this, our non-GAAP operating profit was $3.9 billion for Q1, resulting in a non-GAAP operating margin slightly above 37%. These robust margins give us the confidence to continue to fully fund the strategic growth areas such as mobile, Android, YouTube, Chrome, all the areas that Larry talked about. And Nikesh will go into more details of these initiatives in a minute. Turning to headcount, which was approximately 610 for the quarter, and we ended up the quarter with roughly 33,077 employees, full time. Our effective tax rate was lower this quarter, 18%, and this reflects the mix of earnings between domestic and international subsidiaries and hedges and also some capital gains offset by carried over capital losses. So now let me turn to cash, cash management. Other OI&Es or other income and expenses was $156 million for the quarter, positive, and it reflects a higher realized gain on our investments, offset somewhat by lower interest income and by the impact of our FAS 133 expenses from our hedging program. For more details on OI&E, once again, I refer you to the slides that accompany us on our IR website. Operating cash flow was very strong, $3.7 billion. CapEx for the quarter was $607 million versus last quarter at $951 million. The majority of our CapEx spend was related to production equipment this quarter, as well as data center operations and facilities. And as a reminder, we will continue to make significant CapEx investments, and these have shown to be lumpy from quarter-to-quarter, mostly depending on when we're able to make these investments. So in total, very pleased with our free cash flow, $3.1 billion. Let me close with my usual reminder that our revenues typically exhibit seasonality in the first half of the year, while our expenses do less so. So it's just a forewarning for everybody who's kind of tuning their models. I'll hand off now to Nikesh who will cover in more detail our business performance in the quarter. Additionally, since Susan, who is typically on the call, is on a well-deserved spring break with her family this week, Nikesh will also cover some of the product highlights, primarily in Ads. With this, I'll turn it over to Nikesh."
},
{
"speaker": "Nikesh Arora",
"text": "Thank you, Patrick. I will now give you an update on our business activities. As Larry and Patrick have mentioned, we had another quarter of excellent performance, resulting in $10.6 billion of revenue this quarter. Our results are actually reflective of 3 major trends that are happening in the online advertising space, so let me just touch upon those. First, we're seeing a big move to solutions. Our clients and partners more and more want complete solutions that work across all screens: desktop; mobile, tablet; and in the future, television. And also work with all kinds of formats, whether they're search, display or video ads. It's like having individual solutions for different devices and formats. So we're driving our teams to sell solutions across the entire marketing funnel. From building brand awareness to conversions, we are converging our teams of over 8,000 people to setting these complete solutions in 60 countries, making us one of the largest online solutions player. Secondly, the big trend is we're seeing a breakthrough on brands. More than at any point in the last decade of online advertising, we're at a point where major brand advertisers, from movie studios to CPG companies, are finally looking to digital media as a central part of their marketing efforts. We are making huge progress. YouTube has gone from an interesting ad buy to key buy for brands. In May, we'll be hosting our first upfront for brands and agencies, showcasing the latest channel content and opportunities for marketers, something television has been doing forever. We will do that for YouTube in New York. And third, we're beginning to see a trend on cross-media measurement. Social advertising has always been highly measurable, and we have been leading the industry in extending the measurability, not only in Search, but in Display, Mobile and live video. We are actually taking that one step further and trying to move that measurability into offline sales. Our experience is that businesses may allocate experimental budgets to new areas, but they invest serious money only when they can measure the results. We are rolling our best-of-breed measurement technologies so all clients can measure their ROI, whether their goals are online conversions, brand lifts or just the ability to compare offline and online media. Let's talk about some specific product areas. Search, our Desktop Search business has maintained robust growth with strong traction with our top partners around the world even in the face of economic uncertainties that we've been noticing in Europe. I think search advertising has broken through that sound barrier of being an online channel, which now finally proven to drive in-store sales. For example, we partnered with IKEA in Italy in a study showing that each click on a paid search ad generates $7.60 of revenue. And then interaction with paid search in conjunction with television drives 20% of contribution to sales. And there's a lot of room to improve on that, but it's a cut clear demonstration of how online advertising is no longer just restricted to online sales but also having a huge impact in the offline world. Last week, we launched a range of features to improve location targeting so that marketers can reach users by zip code or have their physical location show up more prominently in their ads. In sales, I want to highlight Google Analytics, which is an unsung hero. Over 10 million marketers and websites globally use Google Analytics to measure the effectiveness of their online presence in real time. From large e-commerce sites to small blogs, that means that our technology is at the heart of over 10 million businesses, helping them get the most out of the Web. Last quarter, we made several important improvements to Google Analytics, helping marketeers to measure the impact of the traffic from across over 400 social networks. I didn't even know there are 400 social networks. Let's talk about Display. On Display, we saw a robust revenue growth as our clients continue to see the value of integrated advertising solution in driving business results. For example, we signed a deal with Unilever in Brazil for a campaign that ran across all Google properties, including YouTube, Search, Google Display Network and Gmail. We also recently partnered with leading sportswear company, Reebok, to develop a global display campaign across YouTube, Mobile -- YouTube and AdMob -- and mobiles, YouTube as well. On the platform side in Display, we continue to make progress. We are now the leading platform provider for agencies and publishers to help drive their business using display advertising. We are focused in building unified buying and selling platform that helps them manage their advertising across all media much better than they have been able to in the past. Our good relationships with our clients are helped by rapid product development and innovation. Last quarter, we launched the Google Display Network app in AdWords, which makes it easy for all AdWords clients to build, monitor and find display campaigns across millions of sites in our network. This is helping bring the world of search and display even closer. Let's take a minute to talk about YouTube. As I mentioned, YouTube is an amazing success story. It's gone from an interesting buy to an obvious buy. Our watch paid sales have accelerated, particularly in key emerging countries, but also in mature ones. Today, most of our in-stream ads in YouTube are skippable, while our TrueView ad format, which is fast becoming an online video standard. It's great for users and it's great for advertisers. For example, the U.K. mobile operator O2 is actively now using YouTube to support their brand launch. They're using several YouTube products, including TrueView YouTube Mobile. They even live stream the New York -- sorry, the New Year Eve's concert from the O2 arena in London globally in YouTube. In addition to this, we're also rolling out our 100 new original channels in YouTube, featuring top talents like Jay-Z, Madonna, Tony Hawk, as well as innovative new media companies and YouTube's new own successful partners. We think YouTube is fast becoming the platform for the next generation of talents, which is great because we're also seeing initial success selling the sponsorship for these channels to large advertisers such as Toyota, Unilever, GM as all in anticipation of the big upfront event coming up in May. Let's change gears and talk about mobile. Mobile is quickly becoming a backbone of many clients overall advertising strategies and has huge headroom to grow. We continue to innovate with our product offerings with a number of new tools for advertisers. One development we're particularly excited about is our new enhanced click-to-download formats. This format in Search helps marketeers and developers promote apps. These things help improve ROI to provide users with more relevant download information about apps such as star rankings, pricing, et cetera, and all this happens right in the ad creator [ph]. So we keep actively working to help develop the mobile ecosystem from enabling mobile commerce to empowering local businesses. In Q1, we began to scale our GoMo campaign, which is our Go Mobile campaign. This initiative helps businesses get more and more assertive and set up great mobile websites so they can keep driving traffic to those websites and expand their businesses. We've done these efforts across the world in North and South America, in Europe, in Asia and Africa. Moving beyond advertising. Our Enterprise business also saw excellent progress as large organizations and small businesses continue to see the value of Google Apps as a cost-effective and feature-rich productivity suite. Some of our top customers to go Google in Q1 include global pharmaceutical company Roche, more than 90,000 users; the State of Colorado, which announced they intend to move 26,000 employees and users to Google; also the University of Pennsylvania and Rome have gone Google. Not only that, small business adoption of Google Apps is on fire, with SMB signups almost doubling in the past 6 months. So we're happy with the business and we're happy with the way Enterprise continues to progress. Let me go back and show some more color on the country performance, as Patrick also talked about. From a regional perspective, we saw generally stable performance in the Americas. We saw a sustained traction in most parts of Europe and we saw acceleration in Asia, all this was driven by strong performance from our long tail Sense sales channel. Growth in North America was steady and this certainly was boosted by seasonal events such as Super Bowl, Valentine's Day, tax season. Canada was a little slower. Of course, Western Europe was robust in spite of the macroeconomic conditions. We continued seeing good growth in the U.K. Germany, France and Italy grew slightly less quickly than before. We saw strong acceleration in Asia. Japan grew faster this quarter, led by successes again, in our small and medium client base. Let's talk about marketing and our partnerships business. Our marketing and partnership teams continue to support the fantastic growth we've seen this quarter across all of our business lines, products and services. We continue to roll out initiatives to support of Google+, which Larry talked about. We rolled out our That's the plus campaign with spots airing during the Grammys, the Oscars. Google+ and Hangouts are getting great traction. We have President Obama, we have Governor Romney, they both conducted very successful Hangouts in the platform. Even NASCAR held a Hangout ahead of the Daytona 500. But the most interesting was Seaview Survey, it had underwater Hangout live from the Great Barrier Reef. It's amazing to be able to see our great products like Hangouts be so successful. I recommend that all of you try Hangout soon. As Larry mentioned, we also launched Google Play, which provides users one place to find, enjoy and share apps, music, movies and books instantly anywhere across the Web and on the Android devices. To support the launch, we are on a 7 days to Play promotion, offering discounts and apps and media, and our YouTube video has received over 3 million viewers to date. Our partnership teams also kept its great work, supporting our products by being very close to our partners. For example, we launched Google Street View in Russia, which lets users walk around the historical centers of Moscow and St. Petersburg. And we are also thrilled that this quarter our Google Cultural Institute help bring Nelson Mandela's archives online. We expand our successful art project to include new museums from the Getty Museum in L.A. to the museums in Paris and Qatar. Project now provides access to more than 30,000 ultra-high resolution images, paintings, sculptures and photographs in 151 museums and other institutions in 40 countries. So in closing, I think Q1 was an excellent quarter. It has led us off to a very good start for 2012. We look forward to continuing to serve our users, customers and partners for the rest of 2012 and beyond. Also, I want to say thank you to all the Googlers and our global business team, all of our partners in the product and engineering teams that allow us to make these wonderful things happen and allow us to continue to drive the business. With that, thank you, and I'm going to hand you back to Patrick."
},
{
"speaker": "Patrick Pichette",
"text": "Thank you. So Jamie, our operator, is going to give us the instructions to get to the Q&A. So Jamie, why don't we just jump right in?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] And we'll take our first question from Spencer Wang with Credit Suisse."
},
{
"speaker": "Spencer Wang",
"text": "Two quick questions. First for Patrick. You mentioned the headcount growth was only about 600 this quarter. That's obviously slower than what you saw in 2011. Should we -- is this roughly the pace we should expect for 2012 or were there perhaps some timing factors? And then secondly for Larry, you talked about Google+ unifying the Google product. So when you think about things like Google Wallet and Offers, the mobile strategy maps, do you think of these as individual products or are they part of perhaps a broader local strategy? And if so, how do they fit together?"
},
{
"speaker": "Patrick Pichette",
"text": "Perhaps why don't I just jump on the technical question, then let Larry get to the second one. So look, I think that the headcount fluctuations, you'll remember last year when Larry said that we were at what was the kind of the edge of what was tolerable. And look, this short-term variability is actually the very best proof point that we don't manage kind of quarter-to-quarter and try to smooth things out. It just happens that in the first quarter, at this time of year, it's a bit different than when you come back in Q3 when you have all of the graduate students that actually start with us, so there's a bit of fluctuations there. So I wouldn't read that much into the numbers, but we're basically continuing to push on plan for hiring for this year."
},
{
"speaker": "Larry Page",
"text": "And the question, I guess, about our products. I think we're working very hard, and I've talked a lot about this to make our Google experience be more unified and feel like one great experience for people. And many of the products you mentioned, Google Wallet, Offers, Maps, I mean, they apply kind of across many of the things we do. And so I think you'll see better integration of those products over -- through the rest of our products has already exist with Wallet, for example, across many different parts like Google Play and so on. And I think you'll see that increasingly happen over time just as we make these experiences better. They'll come up when you expect them to come up and when they make sense for users. I think that's definitely a big area of focus for us."
},
{
"speaker": "Operator",
"text": "And we'll go next to Mark Mahaney with Citi."
},
{
"speaker": "Mark S. Mahaney",
"text": "Two quick questions. First, in terms of appealing to major brands, and Nikesh I think you talked about how you're seeing major brands engage more with YouTube and other assets. Could you talk about how you're trying to go after those dollars? Are there new things that you're doing now that you weren't doing 2 years ago to kind of accelerate that momentum? And then just real quickly on the mobile CPC issue. Can you just comment again on over time, over what period of time you would expect mobile and desktop CPCs to merge or do you think that's a realistic expectation? What would cause that to happen or not?"
},
{
"speaker": "Nikesh Arora",
"text": "Let me take the first question quickly, then I'll give you a little color on the second one, then Patrick can jump in. In terms of what we're doing differently, as I mentioned, YouTube has gone from being an interesting place where brands to be to being a must-buy. So we're seeing tremendous demand for inventory, which is brand related. And for the most part, the online world in the past has been more performance related i.e., people wanted to get some transactions, they wanted to get more people to their website. Now they're seeing the benefit of using the Web for brand affiliation and for brand recognition. So we are beginning to have a different sales pitch with the large brands, which is oriented towards them coming and getting their brands seen a little bit, and YouTube is a phenomenal tool in that regard, which acts sort of like an anchor property. Then we're able to package our demographic base inventory around the Google Display Network, around YouTube and actually get the brands to engage in the large campaigns, which can run the millions of dollars. This was a capability we couldn't have a few years ago because the inventory didn't exist or the demographic tools didn't exist. So clearly, this is a new space and a new sort of pitch to our brand advertisers. As I said, we are trying to light this up across our sales force around the world in 60 countries."
},
{
"speaker": "Patrick Pichette",
"text": "No, we just have -- let's go through the mobile CPC question. So Mark, I think that this one is -- think of it as so much upside for us because essentially mobile is exploding in query growth and the formats themselves are just adapting already a lot and from a relatively crude base to so much more in the future. So that you're absolutely right that right now they don't monetize as well because we're kind of in what search used to be in 2002, 2003, 2004. So as these formats kind of continue to get better and better, we'd expect much better performance on them."
},
{
"speaker": "Larry Page",
"text": "This is Larry. I'll add something, Mark. I think the mobile CPCs -- I mean, people always spend their most effort on the major -- whatever the major source of traffic or revenue is, and those are growing really quickly, albeit currently, obviously, there's more on desktop. I think over time as a reverse, and I think that the ability to kind of on your mobile to do local kinds of transactions, to really easily communicate with people and to do the kind of capabilities you have on your mobile device. And the fact that you spend most of your money locally, I think that over time that may actually reverse and the CPCs action may get better. But I think we're very bullish about that. We're making a lot of investments in that area, in things like Offers and so on and Wallet. And we're very, very excited about the potential there, and also Click-to-Call and other things that we do. So I think, for example, it's a lot easier to call someone from your mobile than it is from your computer right now. And so if that's how you're relying for transactions, actually mobile CPC should be higher for that. So I think you just haven't seen the focus on it and we're moving more and more focused on to that, both on our sales side and our customers are moving focus onto that, but I'm very, very bullish on that."
},
{
"speaker": "Operator",
"text": "And we'll go next to Ben Schachter with Macquarie."
},
{
"speaker": "Benjamin A. Schachter",
"text": "Larry, in your 2012 update letter, you speak of all these notions of changing the world and ambitious goals on risky projects and having a healthy disregard for the impossible. Without getting into too much detail, at a high level, what types of projects is Google working on that would really surprise us? And are you remaining committed to the 70/20/10 rule where these noncore areas might get only 10% of the investment? And then separately, just on the google.com TAC, please, that continues to increase as a percentage of Google revenue. Is most of that coming from payments to mobile partners? And given the growth of mobile, should we expect that to continue to increase meaningfully?"
},
{
"speaker": "Patrick Pichette",
"text": "Do you mind, Larry, why don't I answer the last one first because it's really easy and then you can jump on the rest. Look, on TAC, if you look at our percentages -- as a percentage of revenue year-over-year, I mean it's basically stable. I mean, it moves a little bit here and there and you have partner mix and FX mix between mobile and others, but it's not actually changing in any dramatic way. So what you have to see in there is just the regular mix of both traffics and partners that come in and out all the time as well, so that I wouldn't read too much into that. I'll let Larry answer the real sexy question."
},
{
"speaker": "Larry Page",
"text": "I think I didn't mention specifically the 70/20/10 in my letter. I should have, that's a good addition. So we definitely still see a -- most of our resources should be going to our core businesses, which really Search and Ads and a few of those things I mentioned that's really fallen to that core, I think. And then there's 20% kind of near things and maybe another 10% on the really speculative things. Through our whole history, we've really struggled this and have 10% kind of on the speculative things. Generally, it's much lower than that. I think the real thing that's needed on those projects is some management. Those take up bandwidth. You saw our announcements of Google Glass last week, which I was very excited to go out. You've seen the driver with his car kinds of things. And it does our take our executive time to deal with those things and so on, and so I think that's the real investment we make rather than being huge amounts of dollars on those kinds of things generally. We've got a limited number of things we can do. As I've been saying, we've been trying to focus. So trying to make sure that we have the right speculative bets as well as the right bets we're making on our core products and so on. And I'm pretty excited about our ability to do that. And I think it's hard coming from the outside because I mentioned in the letter I published today that Android took 3 years, plus 3 years kind of to really get to where it is today. That's 6 years, and you all haven't seen android, right, for those 6 years. We've seen it for those 6 years and we really invested in it. It's not so much money at the earlier stages, but attention. And that's an important, I think, discipline for the company to have."
},
{
"speaker": "Operator",
"text": "And we'll take our next question from Brian Pitz with UBS."
},
{
"speaker": "Brian J. Pitz",
"text": "Similar to detail on cost-per-click, would you discuss the key drivers of higher paid-click growth? Is it quality changes, Product Listing Ads or something else? And more broadly, maybe you can discuss how Product Listing Ads do impact results as we're tracking a substantially higher number of these ads on your site?"
},
{
"speaker": "Patrick Pichette",
"text": "Without giving -- look, the short answer is yes, and that's what the core answer of my message to the market was today. I think that you have a combination of international factors. You have a combination of new formats. Ad formats drive a lot in terms of paid clicks. If you think of even the sitelinks' extensions that we've -- like we have a new generation of sitelinks for this quarter, right? This is a perfect example of a product where by adding additional lines that are more targeted, so instead of having just kind of, trucks or -- and then you go down into the second layer, right, you have less CPC for that additional sitelinks. But if it's a better ad, people click a ton more on them. So it is really all of those 5 factors that actually drive them. And that's why we're continuing to kind of be pretty happy with the health of the net effect, which is real growth. Certainly, internationally, I mean it also -- you can see our mix between international and non-international. And that's driving it as well. So you have all these factors at play. And we're pretty happy with what we're doing there."
},
{
"speaker": "Operator",
"text": "And we'll take our next question from Doug Anmuth with JPMorgan."
},
{
"speaker": "Douglas Anmuth",
"text": "Two things. First, just want to follow up on the question on mobile and TAC. If you could help us understand beyond CPCs how the economics of mobile are different and perhaps a little bit more detail on how you're paying OEMs and carriers. And then secondly, any updated thoughts on the cash balance and an update perhaps on the split of U.S. and international cash?"
},
{
"speaker": "Patrick Pichette",
"text": "Let me start with the last one first. We don't give the breakdown of our U.S. cash. We do it kind of irregularly, so we haven't done so of late. We have -- we continue to have a very strong cash balance, both U.S. and international. You'll notice, if you go into the details of our cash balance and on our balance sheet, right, we have just slightly under $2 billion of sec lending programs. So when you really, really look at our net cash balance, you got to take that sec lending out because it's on both sides of the balance sheet. But for the rest of it, incredibly healthy cash balance, both domestic and international. And Nikesh, do you want to give a quick update on the mobile CPCs and their mix?"
},
{
"speaker": "Nikesh Arora",
"text": "Yes. I mean, again, I'm not going to talk about specific of the TAC on mobile. But as you know, we get people using our devices both organically as well as through our distribution partnerships with carriers and OEMs. And typically, the OEMs and carriers participate in some of the economics that are on the Android marketplace or Google Play and some of them participate in the economics around Google Search just the way we would do syndication on the Web platform, which you do with many partners around the world. We have similar deals on the mobile front. I think in the mix, it comes out. This sort of washes out and it sort of adds up into our number which we show in -- our total number of green desktop and mobile. But mobile is no different from the way the desktop business operates out there."
},
{
"speaker": "Patrick Pichette",
"text": "And we benefit from the terrific growth."
},
{
"speaker": "Operator",
"text": "And we'll go next to Carlos Kirjner with Bernstein."
},
{
"speaker": "Carlos Kirjner",
"text": "Two questions, if I may. If you think of the future of Internet search 3 or 4 years out, how important will the social signal be and how important your personalization be? In other words, would the company with the best social signal be able to offer the best search? And if the answer to that question is no, why is Google investing so much in Google+? And second question, if I may, you probably end the year with about $50 billion in cash and marketable securities and that will give you quite a lot of strategic flexibility. Given that, what's the rationale to continue to increase that amount on market on cash to shareholders?"
},
{
"speaker": "Larry Page",
"text": "I'll take the first part, Carlos. I think the -- this is Larry, and I think it's a very good question. And I think one of the things actually had in my remarks when I took out was to talk a little bit about Search and just enough time to put it all in. And I actually covered the question you're asking. I think one of the most amazing things I think we can do today that we couldn't do even a few months ago is to really -- I have this friend Ben Smith, right, who's a person at Google. He has kind of a common name. Now when I do a search actually, it finds the right person and it puts him in the search box. So for the first time, the search box isn't really doing searching a string, just the sequence of letters. It's actually searching for that person that I know. Now it's not, obviously not all the searches you do, but being able to search for people well is important. And knowing -- having real feedback from users about what they like and don't like and things they're sharing and so on is very useful for search. And we have a lot of those signals already, but we can always use more signals. We can always use better relevance and we can always use more data to generate that. So I think it is very important. I think it's not -- think social data about identity and ability to easily share things with other people and comment on them and things like that is a basic utility for people in all of our products. And that's where I was talking about Google+ really working across all of Google for identity and sharing and notification and other things that it does really well. So that all applies to Search and I think it's important for Search. I think search is going to change a lot. We're going to make it a lot better over the next 5 or 10 years as it's changed a lot in the past. And it will include a bunch of those signals and a bunch of other things as well."
},
{
"speaker": "Patrick Pichette",
"text": "Carlos, why don't I take the next one, the issue of our cash balance. We have a healthy cash balance, I had mentioned a minute ago, and we still believe that it's an incredible strategic asset for us. You saw it last year when we decided to make the purchase of MMI, and we continue to monitor this cash balance. And for the time being, we really believe that, that strategic asset has a ton of value. So we'll continue to monitor it and we have a process by which we actually review it on a regular basis with the board, and those questions are always asked. So we have a good governance process around it. But for now and the time being, we have nothing to announce on it."
},
{
"speaker": "Operator",
"text": "And we'll take our next question from Heather Bellini with Goldman Sachs."
},
{
"speaker": "Heather Bellini",
"text": "I was wondering, Larry, if you could walk us through your view on Google's tablet strategy via Android and the relative importance of having success with these devices in terms of achieving your long-term goal?"
},
{
"speaker": "Larry Page",
"text": "Heather, that's a good question. I think that we're very excited about tablets. I think there's a number of Android tablets out there and obviously, we have strong competition there as well. I think you've seen us really invest substantially also in things like Google Play, which really give you great access to entertainment, media, books and videos and so on, and as well as the apps. And we think that's an important component of what we're doing. I think there's also -- obviously, there's been a lot of success on some lower-priced tablets that run Android, maybe not the full Google version of Android. But we definitely believe that there's going to be a lot of success at the lower end of the market as well with lower-priced products that will be very significant. And it's definitely an area we think is important and we're quite focused on."
},
{
"speaker": "Operator",
"text": "And we'll go next to Justin Post with Bank of America Merrill Lynch."
},
{
"speaker": "A. Justin Post",
"text": "I have one for Larry and one for Patrick. Larry, Android is obviously a key focus. You talk about it a lot in your letters. Can you help us understand the strategic value for Google since you're not licensing it? Do you see more revenue per device if it runs on Android or lower TAC or what else can you tell us about what the real advantage to Google's advertising businesses? And then Patrick, obviously, higher in CapEx in Q1 this year, a lot lower than Q1 last year. Can you tell us if you factor in your revenue growth when you make that spending decision, your outlook? Does that -- give us any clues on your outlook for revenue growth over the next couple of years?"
},
{
"speaker": "Patrick Pichette",
"text": "Why don't I jump on the -- because mine again is not a very strategic one, it's more how we proceed. Look, it's lumpy because there's just timing decisions, right. We would -- there's probably a few areas where we would have like to actually make investments in Q1 and for a bunch of logistics reasons or otherwise, we couldn't. And so -- and you'll notice that's why there's kind of like $350 million difference between Q4 and Q1. And you should just expect it to be lumpy and that's just the nature of -- data centers are kind of big and clunky. And when you buy some piece of real estate, it's big and clunky. So there is quite a bit of variability into it. But we're -- again, I wouldn't take any one data point to start making a trend out of. So it's tough for, but I think that you can see we're committed to capital. If you look at the last couple of years, we've really made kind of significant investments and we'll continue to do them because it's a real strategic asset to us as well. So I'll let Larry answer the first question."
},
{
"speaker": "Larry Page",
"text": "Justin, I think on your questions about Android, I think they're pretty short-term focus and I think it's good to think about the longer-term issues. We don't get very many new operating systems, kind of only a few in my lifetime, and I think they're pretty important. And I think Android's really about increasing the pace of innovation, usage of mobile devices and our ability to get a great user experiences out to our users, which I think we're doing a great job of. I mentioned over 850,000 devices per day are going out. And it's important to remember we're very early stages of that like we've only -- I'm amazed the computer that I'm carrying in my pocket is as good as the one I had a few years ago on my desktop. And I think we're only at the very, very early stages of what's possible with those devices. And I'm excited about a whole bunch of things we're doing in that area. We already mentioned kind of things like I said I'm very bullish about CPCs will improve on mobile over desktop due to all those capabilities. And so I think the benefits we get from Android are a lot. I mean, obviously, we have great integration with our products and Search and Google+ and photo uploading and there's a hundred things that we do really well on Android that benefit us across the board and across our users across the board and our products across the board. And I think that's going to continue to be the case. And I think it does lead to better economics for us too because we're providing amazing experiences for people that are well integrated and work well and they demand. So that's -- I'm very positive on all those things."
},
{
"speaker": "Operator",
"text": "And we'll go next to Lloyd Walmsley with Deutsche Bank."
},
{
"speaker": "Lloyd Walmsley",
"text": "Larry, just wondering as you look out on a very long term kind of 5-year view, do you see tablets taking perhaps the majority of home Internet usage? And if so, how strategically imperative is it for Android to have a big success in the tablet space given partner TAC could impose a high cost to the extent Android doesn't have a hit?"
},
{
"speaker": "Larry Page",
"text": "Yes, I mean, I think I've sort of already answered this question previously about tablets. I think the -- I mean, like I said, I think it's an important area. I think your computing experience, obviously, if you have an Android phone or use Google a lot online or you care about all those things in terms of your experience. And so I think you're thinking about your user experience. You're thinking about across all the devices use. I think people are going to get a lot more devices. We see kind of a convergence between all the services on those devices. And right now, I feel like each device you got is kind of a hassle the deal with and you're thinking about each individual device and all the issues with it. And I think that's not really right. I think you're going to have a pretty unified experience and a great experience from a user point of view and you won't have to manage all these devices. So I think you want to think about all these screens around you working seamlessly and working well for you. And I think, obviously, tablets are important. We have Google TV obviously. Big screens are important, computers are important, phones are important. Everything, all those devices are important. And I expect that they'll work well together. So I think that's kind of how we would think about it, and I think it's -- I don't think any single device there is going to drive all the usage or all the kind of convergence that needs to happen."
},
{
"speaker": "Operator",
"text": "And we'll go next to Ross Sandler with RBC Capital Markets."
},
{
"speaker": "Ross Sandler",
"text": "I had a question for Nikesh. Can you give us an update on the growth rate you're seeing today in your core Search business by small, medium and large advertiser tranches? I think you mentioned in the prepared remarks that Japan had strong growth, primarily due to smaller advertiser tranche. So how does that growth look in the various advertisers' size buckets across your GOs? And then is the speed of small advertiser adoption increasing right now versus prior periods given all the new local products that you have?"
},
{
"speaker": "Nikesh Arora",
"text": "Yes, I mean, I think the one way to think about it is that fundamentally we have one auction, and that auction every advertiser participates, whether it's the small advertiser or large advertiser. So they way we think about it is that we try and go ahead and get more and more advertisers to see the benefit of online advertising and the solutions that we offer. So as more and more advertisers come into the auction, it drives the price up of the auction for both large and small advertisers. And the way to think about it is that there's a price as we talked about CPCs and paid clicks, but it's really the third variable that goes into it, how many advertisers can we bring into the auction and how many various things can we get them interested in, whether it's mobile, whether it's YouTube, whether it's Display, whether it's Search. So there has been a lot of effort we have put in from our end, both to get more small business online. We've been adding GXBO campaigns around the world where we get small businesses online. We've also been cleaning up our signup flows for our adverts products, which is a self-served product where really small business can sign up. We have been working on getting people to have more mobile sites and getting people out in the mobile campaign. So effectively, it's a lot of effort towards getting more and more advertisers into the ecosystem. And as that happens around the world, you will see seasonal patterns or some sort of spikes when we work harder on small businesses in one quarter in certain parts of the world. But eventually, it all benefits the auction and we see the trend over time ends up working the same way for large and small advertisers."
},
{
"speaker": "Operator",
"text": "That final question comes from Anthony DiClemente with Barclays."
},
{
"speaker": "Anthony J. DiClemente",
"text": "Just one question for Nikesh or whomever wants to answer it. It seems like even though as you're shifting to mobile, you have this presumably double-digit pricing step down for CPCs. But in the Display world, certainly, that pricing difference could be even more dramatic. In some cases, by half or 2/3. Prices getting cut on that shift to mobile. And so you guys at Google have the unique ability to compare and contrast the difference in price between like Search and Display and how the 2 are monetizing relative to desktop. And so any color on that comparison would be appreciated because I think there are folks out there that have a view that actually Search, core Search, monetizes better on that shift to mobile than Display does, and I would love to just understand that better."
},
{
"speaker": "Nikesh Arora",
"text": "Yes, I mean, I guess -- let me try to just explain to it from the advertiser perspective. So what we're striving towards is advertisers are interested in ROI. Advertisers actually are not interested in whether they're on the mobile product, the Display product, the Search product on the Web or the Search product on mobile. So what we are fast converging towards is we're basically sitting down and understanding ROI targets of our advertisers. And then we have immense amounts of inventory at our behest, whether it's mobile inventory, on Display or Search or desktop inventory or even inventory to our network. And what we are trying to work towards is being able to dynamically allocate across these various products, what allows them to get the maximum ROI. In that case, they are sort of -- they don't really care about whether they got that transaction to happen off one platform, one format or the other. So that's what we want to aspire, and that works really well in performance advertising because there is a specific objective the advertiser has. On Display, on brand, it works slightly differently, obviously, because you're talking about CPMs. But generally, that's the way to think about it. In the long term, we think mobile will monetize better. And we usually don't see the difference happening on Display and Search as you alluded to. Larry, you want to add something?"
},
{
"speaker": "Larry Page",
"text": "I'm just going to close the call here, and I really thank everyone for spending so much time with us today. And thank you all for spending time with us today and for being so interested in Google. And now, I'll turn it over to the operator."
},
{
"speaker": "Operator",
"text": "Thank you. That does conclude today's conference. We do appreciate your participation."
}
] | null | null |
GOOGL | 4 | 2,007 | 2008-02-01 08:00:00 | Operator: Good day and welcome, everyone, to the Google Inc. Conference call. Today’s call is being recorded. At this time, I would like to turn the call over to Ms. Krista Bessinger. Please go ahead, Madam.
Krista Bessinger: Good afternoon, everyone and welcome to today’s third quarter 2007 earnings conference call. With us are: Eric Schmidt, Chief Executive Officer; George Reyes, Chief Financial Officer; Larry Page, Founder and President of Products; Sergey Brin, Founder and President of Technology; Jonathan Rosenberg, Senior Vice President of Product Management; and Omid Kordestani, Senior Vice President of Global Sales and Operations. Eric, George, Larry, and Sergey will provide their thoughts on the quarter and then Jonathan and Omid will join us for Q&A. Please note that this call is being webcast from our investor relations website. Our press release, issued a few minutes ago, is also posted on the website, along with the slides that accompany today’s prepared remarks. A replay of this call will also be available on our investor relations website in a few hours. Now, let me quickly cover the Safe Harbor statement. Some of the statements we make today may be considered forward-looking, including statements regarding our investments, seasonality, traffic acquisition costs, increase in the cost of sales, international growth, operating margins, growth in headcount, and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings, including our quarterly report on Form 10-Q, for the quarter ended September 30, 2007, as well as our earnings press release posted a few minutes ago for a more detailed description of the risk factors that may affect our results. Copies can be obtained from the SEC or by visiting the investor relations section of our website. Also, please note that certain financial measures we use on this call, such as EPS, net income, operating margin, and operating income, are expressed on a non-GAAP basis and have been adjusted to exclude charges relating to stock-based compensation. We’ve also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and GAAP to non-GAAP reconciliation can be found in our earnings press release on our website. With that, it is my pleasure to turn the call over to Eric.
Eric E. Schmidt: Thank you very much, Krista and in looking at 2007, we are very, very pleased with our year and also with the quarter that’s just ended. If you look at 2007, a strong financial performance across the board, reflecting a performance and a focus here at Google on both growth and profitability, with of course very strong revenue, operating income, and earnings. I want to call out strong international growth. More than half of our search traffic is now outside the United States, more than 150 domains and still growing. The international market is still very nascent with tremendous potential for what we could do over time. And of course, the model at Google about product improvements and innovation continues. Hundreds of search quality launches, greater advertiser control and transparency, obviously higher ROI as a result, lots of new ads formats, YouTube video ads, from example, contests, branded channels. We’re working hard, by the way, to promote open mobile and developer platforms and we’re completing an application suite, [inaudible] integration, presentations, et cetera, and in concert with both product and international focus, we have a global team. We now have offices in more than 20 countries. We are working on having a local presence across global markets and this global local focus is reflected both in our organization and our products and in the way we run the company. Of course in Q4, a solid quarter without a question, pleased with traffic growth across the board even in the relatively mature markets which is always exciting. And obviously we are very happy with gross revenue on both google.com and on our AdSense partners. I think we are going to have Larry and Sergey take you through product highlights. My emphasis area is search, infrastructure investments, things we don’t talk that much about, leading to improved quality as seen by end users that we can measure, and of course giving advertisers more control as the product matures and obviously, as a result, improving their return on investment. The APP strategy, which we announced earlier in the year, now fully visible -- more innovation, data portability, all the apps now either in place or coming and mobile, which we are very excited with Android, the My Location service as part of Maps and many other new features that are both out and coming. So we are optimistic about 2008. We have growing revenue streams across a broad range of verticals and markets. As I mentioned, this international market which is central to our global rule, still relatively nascent with a tremendous potential. Ad dollars continuing to move from offline to online, a trend which is not going to reverse, and of course our ability to use our strong position in markets in order to essentially offer more services to end users and get people even more to see the new benefits of the new Internet world. So with that, rather than me talking about more of the details, why don’t we hear from George and then Larry and Sergey on some of the amazing things that have been happening. George.
George Reyes: Thanks, Eric and good afternoon, everyone. At a high level, we had another strong quarter, with gross revenue increasing 51% over Q4 of 2006 to $4.8 billion. Our google.com properties increased 58% year over year, reflecting strong traffic growth during the holiday retail season and, to a lesser extent, monetization growth. AdSense revenue grew 37% over Q4 of 2006, driven by particularly solid performance among our AdSense research partners, including e-commerce and search partners. Offsetting this growth was the impact of a quality improvement to AdSense for content. This changed the clickable area around the text-based ads to only the title and URL, reducing the number of accidental clicks and increasing advertiser ROI. Now let’s look at aggregate paid clicks growth. Aggregate paid clicks includes clicks related to ads served on Google properties, as well as ads served on partner sits. Aggregate paid clicks grew approximately 30% over Q4 of 2006 and approximately 9% over Q3. Let me now discuss our international performance. International revenue increased to $2.3 billion, or 48% of revenue in Q4. Revenue in the U.K. grew 5% this quarter to $692 million, reflecting the usual Q4 seasonal slowdown in the finance and travel verticals. Revenue growth in EMEA was primarily driven by a strong performance in France and Germany, where gains were made in the retail, technology, and finance verticals. We also saw solid gains in relatively smaller markets, such as Canada, Ireland, Spain, and the Nordics. Asia and Latin America continue to show impressive growth rates as well, with Brazil, Mexico, Argentina, and China being notable performers in the quarter. Now turning to expenses, traffic acquisition costs were $1.4 billion, or roughly 30.3% of total advertising revenue, down 40 basis points year over year but up from 29.1% in Q3. The increase in overall TAC rate was primarily related to the performance of a few AdSense partner sites, for which we are required to make guaranteed payments. We have found that social networking inventory is not monetizing as well as expected. AdSense TAC was $1.3 billion, while TAC related to distribution partners and others who direct traffic to our websites totaled $125 million in the quarter. Turning to other costs of revenue, which includes $6 million in stock-based compensation, increased $75 million over Q3 to $516 million. The largest driver of the increase was the increase in costs related to our data centers, including depreciation, equipment, and operations. We continue to anticipate that other cost of sales could increase going forward. Other than cost of revenues, operating expenses in Q4 totaled $1.4 billion, including approximately $239 million stock-based compensation. Expenses related to payroll and facilities increased $97 million to $756 million. At the end of the quarter, we had a full-time employee base of 16,805 employees. We added 889 employees in Q4, with over half the new hires being in engineering, followed by sales and marketing. We have implemented and continue to follow a disciplined hiring process in all areas of our organization. Hiring in Q4 tends to be slower due to the holidays but as we’ve indicated in the past, we will continue to invest in our core business, both in the U.S. and internationally. Turning to non-GAAP operating income, which excludes stock-based compensation, increased to $1.7 billion in Q4, with non-GAAP operating margins of 35%, compared to 36% in Q3. The sequential decrease in margins was driven primarily by the increase in overall TAC, as discussed earlier. As we have said before, margins may decline in the future as we continue to make ongoing investments in our business. Turning to tax, our effective tax rate for Q4 was 25%. Our Q4 rate was more favorably impacted by an R&D tax credit in Q4 compared to Q3 as a result of stock option activity. This was the primary driver of the difference in tax rates between Q3 and Q4. And finally, turning to cash, operating cash flow remained strong at $1.7 billion, with CapEx for the quarter of $678 million. As in previous quarters, the majority of our CapEx was related to IT infrastructure investments, including data center construction, production of servers, and networking equipment. We expect to continue to make these significant investments in CapEx in future quarters. Free cash flow, a non-GAAP measure which we define as cash flow from operations less CapEx, was also strong at $1 billion. So in summary, we believe our results reflect the strength of our core business across our three primary initiatives -- search, ads, and apps, with disciplined investments that position us very well to capitalize on the long-term opportunities we see for Google. With that, I would like to turn the conversation over to Larry.
Lawrence Page: Thank you, George. I’m really excited to tell you about some key new things that we did in both search and advertising. So to begin with in search, we had over 100 launches in Q4 with focus on our internationalization and investing in our quality. One of those was universal search, which is now available in 15 languages, up six in Q4. We also launched the universal navigation bar in all languages, which gives our users easier access to all of our Google properties. And book results are now blended in all domains. We also made some behind the scenes infrastructure improvements to improve our quality, and the biggest of those was increased index size, which really improved relevancy, especially for non-English results. We also had substantial improvements in latency and freshness, particularly in Europe, Middle East, and Asia-Pacific. Now, we also made it easier for webmasters to make their site searchable. There’s two things there. The first was webmaster tools. We have several million sites now using and actually doubled our user base over last year, and that basically lets webmasters easily tell what’s being crawled from their site and what’s being indexed and so forth. And we added a bunch of new features to that in Q4. We also have our site maps product, which is another tool to let webmasters make their sites easier to crawl and we added Florida, District of Columbia, and U.K. National Archives, among many other sites, and added many, many thousands of pages there. Now in ads, that’s obviously where we get a large portion of our revenue. We launched some key features there that really drove performance for advertisers and really helped us gain traction. First of those in AdWords was call the AdWords Conversion Optimizer, which we launched in early January and that lets customers big by specifying a cost per acquisition rather than a cost per click. So for example, you could pay only when someone actually buys something rather than just when someone clicks on your ads. AdWords actually, the system actually optimizes their click-based bids to approximate that cost per acquisition for each auction, and that’s really gotten strong adoption, particularly among our larger clients and we’re really excited about that. That really improves the advertiser return on investment. That gives them more conversions which is really what they care about when they actually make money at a lower cost per conversion. In AdSense, we also launched cost-per-click on placement targeted campaigns, such as campaigns that are on a particular website. And this got really strong adoption and it really helped drive better performance and increased spend for our [directory] advertisers, so we are really excited about that too. Now I’m going to turn it over to Sergey.
Sergey Brin: Thanks, Larry. I want to talk to you about some of our relatively newer initiatives. I want to start with Google Apps and related products. G-mail -- G-mail launched an important new infrastructure in Q4 and this has really increased performance. For those of you who are G-mail users, you may have noticed how it loads a little bit snappier, you can switch between conversations a little bit faster. It’s really improved my productivity and I hope you see that as well. In addition to that, this new infrastructure has really made development easier and in fact, we were able after that to launch eight new features within a span of eight weeks. A couple of new features that also makes G-mail more open, we’ve added IMAP support, so you can use all of your favorite e-mail clients, including, of course, devices like the iPhone and you don’t have to use POP3 anymore, you can now use IMAP, which is the better way to go, if you have the choice. You can also now chat with AOL instant messaging users, so this is great now in the Google chat little screen in G-mail. You can connect not just to other Google Talk users but also AIM users, which is a really large population. I want to jump now from G-mail to YouTube. YouTube has continued to have a really strong user growth. In fact, we had a few special events that just demonstrate this. We hosted the CNN Republican debate together with CNN and in fact, almost as many people saw it on YouTube as did on CNN. We consider this a great milestone and we hope to continue to do great partnerships with CNN and others to jointly grow audience for events. We also, I should mention that YouTube is now available in 17 languages, eight more than last quarter, and so we are seeing a lot of international growth. We are really excited about that. In enterprise, we’ve gotten a lot of increased interest, trial, and adoption of Google Apps in larger companies. First of all, we’ve signed an agreement with Taylor Woodrow, which is the construction services division of Taylor Wimpey, a FTSE 100 company in the U.K. We are also finalizing an agreement to deploy Google Apps at Genentech, and those are just a couple of the really big ones we have. We are talking to many, many companies and many are adopting it all the time. In addition, the universities that have deployed this quarter includes the University of Southern California, the North Carolina Greensboro, Florida International, and Clemson. Now jumping a little bit aside in mobile, we’ve really been revving the Google Maps for mobile, among other applications, and Google Maps is just really useful on your cell-phone now. Some of you might have seen our launch of the My Location, which allows you to see where you are on your cell-phone even if you do not have a GPS-enabled phone, and that’s really amazing. In fact, even if you have a GPS in your phone, the My Location can give you a first cut much faster than you can usually get a GPS signal, and it will work indoors. I was just using this, I was at a conference in Switzerland, I was able to find a really small hotel and then even switch over to the satellite view on my phone to figure out that I needed to take a vernicular to get up there. It was just a really amazing experience and we continue to add features and reliability to it all the time. I should mention My Location is available now in 21 countries and it works on four different platforms altogether. We also launched a new rev of apps for the iPhone. We call it Grand Prix internally, but basically you get access that’s really fast and integrated to the major Google products, including search, G-mail, calendar reader, and others. And it’s really had great uptake. I use it personally myself. Many people have really been enjoying this product. It’s growing very rapidly. Last but not least, I’m going to do a shout out to Android, which is the operating system that we are developing for mobile phones, and it’s completely open, of course. It’s going to really solve a lot of the challenges the company’s in the mobile industry have. We’ve released the SDK for it. We formed the Open Handset Alliance, which has now 34 industry leaders in it, and we really think that this is going to make Internet on mobile hopefully as frictionless as it is on your desktop normal Internet experience. This is going to spawn lots more activity and what we love, it’s to see lots of great, open access to the Internet wherever and whenever you are. Anyway, that’s what we’ve been doing on those fronts and now, back to you, Eric.
Eric E. Schmidt: Well, thank you very much, George, Larry, Sergey. As you can see, not only did we have a very good 2007 but we are quite optimistic about ’08 and our model continues to work very well. Why don’t we go ahead and move to your questions and I would also like to bring in Omid and Jonathan, previously introduced, to help us answer your questions on this or anything else. So could we go ahead and get our first question?
Operator: (Operator Instructions) We’ll take our first question from Imran Khan from J.P. Morgan.
Imran Khan: Two questions; first of all, paid click growth rate declined 15 percentage points sequentially year over year, growth rate, so I’m trying to understand how much of that growth rate decline was due to the changes you made and if you see any improvement in the price-per-click because of increased customers return on investment, because your year-over-year revenue growth rate decelerated 10 points as well on your website, so to better understand the relationship between price-per-click and paid clicks growth rate. And secondly, social network monetization is difficult. You talked about that and I believe it’s with News Corp that you signed a long-term contract, so how should we think about that contract and what does that mean for your TAC rate going forward? Thank you.
Eric E. Schmidt: Why don’t we start with Jonathan? Why don’t you take the first part of Imran’s question?
Jonathan Rosenberg: Sure, Imran. Basically paid click growth, which you referred to, tracks the traffic growth rate and the traffic growth rate did decelerate. The number of search ads basically grew faster than the number of content ads, so I think one of the things that you have to look at there is what is the mix issue. And then I think there were probably some secondary factors there. Some factors would include things like the focus that we’ve had on weeding out the low CPC, high click-thru rate low quality advertiser, so that’s probably a component. The other thing that we did was there was probably some impact from the non-clickable backgrounds which we launched on AdSense for content, so those were probably the biggest things. I think there was also a little bit of an issue with the timing of the holiday. Monday and Tuesday were Christmas and Christmas Eve, which are conventionally our biggest days, so that was probably a component. On the CPC side, generally CPCs have been going up, click-thru rates have been going up, and coverage has been going down. I’m not sure I could add much more there.
Sergey Brin: I just wanted to follow-up on the social networking question. We don’t talk about individual partners’ performance or anything like that. Now I do want to highlight though, we have had a challenge in Q4 with social networking inventory as a whole and some of the monetization work we were doing there didn’t pan out as well as we had hoped. But we are continuing the efforts and we are still optimistic about future quarters.
Operator: We’ll take our next question from Douglas Anmuth from Lehman Brothers.
Douglas Anmuth: Thank you. My question is regarding the U.K. it looks like your growth Q2 was about 5% in the U.K. and that compares to about 11% in the fourth quarter of last year. Could you talk about what you are seeing there beyond the usual categories that you may see weakness in typically during 4Q and what you are seeing there from a macro perspective as well? Thank you.
Eric E. Schmidt: Omid, do you want to go ahead and handle that?
Omid Kordestani: In general, we are very pleased with our performance in Europe. And actually, I know you asked about the U.K., but very quickly we are seeing great results in France and Germany as well in the retail category. I think in the U.K., we saw the typical seasonal patterns but we were -- there are certain categories that we believe the auction is in effect fully sold out and we are working on clever ideas and conversion analysis for our partners to really improve their understanding of how they should spend and how they should price their bids. But overall, we are very satisfied with the penetration we have with the major accounts. We are at CEOCM tables. I was there throughout Q4 and overall, we’ve seen a lot of strength in the market.
Douglas Anmuth: And are those two categories, travel and financial, that are typically seasonally weak? I mean, do you feel like there is an additional macro impact there?
Omid Kordestani: No, those two were the primary ones.
Eric E. Schmidt: Jonathan, do you want to add anything to that?
Jonathan Rosenberg: I was just going to add that it was finance and travel. Maybe the only other point to look at there is if you look at the total percentage of advertising spend in the U.K., some of the public data says that it’s roughly 15%, 16%, 17% on search, whereas in the United States it’s more like 6%. So one of the things that you see there is that the seasonality, particularly in those two verticals, is much more marked because they are spending a disproportionately greater amount of money in total on search engine efforts.
Eric E. Schmidt: Let’s go to our next question.
Operator: We’ll go next to Jennifer Watson with Goldman Sachs.
Jennifer Watson: Thank you. Can you give us a little bit more detail on the feedback that you are getting from both advertisers and consumers on the YouTube advertisements that you guys rolled out?
Eric E. Schmidt: Omid.
Omid Kordestani: We were doing what I can best characterize as just a lot of touch points with our -- both publisher partners as well as advertisers. We are trying different formats. The in-video ads have been very successful. We’ve had a number of campaigns and the way we are also approaching this which I think is unique for Google is really from an integrated and scalable fashion. In the case of -- for example, if I may name some clients, General Motors, for example, Chevrolet Europe, we did what I think is a really truly possible with the advantage that Google has, you know, running the campaigns across multiple countries, delivering large numbers of impressions from YouTube to the content network to the search campaigns. Adobe, for example, ran one of the biggest homepage campaigns we’ve had in the history of YouTube. So all in all, we are doing a lot of experimentation. We are starting to do it globally and we are doing it in every integrated fashion and by adding the other key assets that we have.
Eric E. Schmidt: Let me add a couple of other things. YouTube is doing extremely well, growing very, very quickly and doing so internationally as well as in the United States. There’s been an issue around standardizing ad formats for advertisers who would like to be able to do industry buys and so forth. So as these new ad formats are being developed, we are also looking to make sure they get standardized into a common buying pool and pattern so that people feel comfortable that they can get real value. The next generation of projects are actually very, very sophisticated ad products and it looks like they are going to do extremely well. Next question.
Operator: We’ll go next --
Krista Bessinger: Operator?
Operator: We’ll go next to Mark Mahaney from Citigroup.
Mark Mahaney: Thank you. I wanted to ask a question about mobile, particularly for you, Eric. You’ve got a very interesting perspective from two companies on what’s happening with mobile Internet usage, particularly off the iPhones. How much of a ramp are you seeing? Is there any way you could quantify it and is there a way you think about how mobile search as a percentage of overall search could be in two to three years? Thank you.
Eric E. Schmidt: It’s very difficult to estimate the percentage in a few years. We have already said in a number of public statements that it is growing significantly faster on a percentage basis than other categories, and as you mentioned, iPhone is the first of a whole generation of products that will be much more search intensive, and so there’s much more likely to be many more search opportunities and with those search opportunities comes ad monetization. We have done a number of deals for mobile devices already, KTTI and DoCoMo, for example. DoCoMo just announced by Omid in Japan, which are very, very strategic for us. It’s difficult to estimate what percentage it could ultimately be long term, and when I say long term, I mean perhaps 10 or 20 years. It’s reasonable to assume that a majority of searches would be on mobile or personal devices, simply because over a long enough period of time, they will take on the tremendous power that’s represented in the PC and Mac platform. And the wireless networks are getting to the point where they can offer performance similar to the wireline. Jonathan, do you want to add anything?
Jonathan Rosenberg: We’ve been tracking the data very carefully. We are particularly interested in looking at the iPhone, particularly because the experience on web browsing is so good and because of the optimization efforts which we did. We saw a very significant spike in December with the optimization that we did on both the iPhone and it was well over double I think within about a month in terms of increased usage.
Mark Mahaney: If I can do a quick follow-up on macro trends -- to the extent that you would see weakness related to a softening consumer, do you think you would see it more on the supply or the demand side -- i.e. ad budgets being trimmed or less consumer commercially oriented searches? Thank you.
Eric E. Schmidt: Sergey.
Sergey Brin: We’ve been really studying these questions really in depth and near as we can tell, we just offer such a great ROI for advertisers that they can directly see and measures that advertisers in maybe even difficult markets and what not just have great incentive to get as much profitable inventory as they can from Google and the other different kinds of ROI advertising that we offer. So we have not been able to detect any such effects from macroeconomic trends.
Eric E. Schmidt: Jonathan.
Jonathan Rosenberg: I think some of you have observed that direct marketing tends to be less affected by economic downturns than brand marketing, given a time measurability. I think that’s been true in past recessions. I think we’ll probably see that again. I think one thing we may see is consumers comparison shopping more and that would certainly create more clicks. It might create modestly lower conversion rates but we think overall, if people are doing more comparison shopping and looking for bargains, that’s probably positive. Clearly if there’s less overall commerce in the economy in general, then that could adversely impact overall demand, but we really think that relative to most organizations, we are pretty much tracking the diversity of the overall economy and search-based efforts will fare pretty well.
Eric E. Schmidt: Let’s move to our next question.
Operator: We’ll go next to Christa Quarles from Thomas Weisel Partners.
Christa Sober Quarles: The main question I guess is on the C-block I guess passed the reserve price today. Obviously you can’t mention whether or not you are bidding, but can you just talk about what those open access measures ultimately mean for you, and especially with Verizon moving toward open access toward the end of 2008? And also, if you can kind of highlight your WiMax stance. And then a total separate quick question -- I was just wondering if you could give the impact on checkout to COGS in Q4. Thanks.
Eric E. Schmidt: On the first part of the question, we’ve concluded we cannot answer any questions in that category because of legislative rules with respect to how the auction is working, so I’m afraid we’re going to only be able to answer the second question, so could you repeat it again?
Christa Sober Quarles: Well, can you make any comment on WiMax at all, with a separate --
Eric E. Schmidt: As I indicated, I think it’s best practice for us just to move to the second question.
Christa Sober Quarles: The second question was just on Checkout and whether it had a big impact on the COGS in Q4.
Eric E. Schmidt: Jonathan.
Jonathan Rosenberg: I think it’s the same answer that we’ve given in the previous calls -- the impact was immaterial. I think one of the strongest observations that I could give you there is that the organic growth in terms of Checkout overtook the promotion efforts this quarter, so I think that’s a good sign in terms of the general traction that we are getting. The other things that we are seeing there, that the click-thru rates on the [badge] are up as much as 10%, so I think that’s going pretty well.
Sergey Brin: If I may, also in addition to the click-thru rates, I think we are starting to get some anecdotal and some actual real studies that demonstrate that the conversions are also up, very substantially and hopefully we’ll be able to share more of that with you in the coming weeks. But there is really good evidence now that Checkout is able to get consumers through the process more quickly and more reliably.
Christa Sober Quarles: Okay. Thanks.
Eric E. Schmidt: Why don’t we go ahead to our next question?
Operator: We’ll go next to Robert Peck from Bear Stearns.
Robert Peck: As we think about the margin levels this quarter, should analysts be thinking that based on what you are seeing as far as the social networking side, is this more of a new run-rate level, or do you think the margins were somewhat suppressed by the MySpace relationship in Q4? And then number two, could you also talk to us about timing of a DoubleClick closing and any sort of impact you can see to the numbers for 2008?
Eric E. Schmidt: Let me do the DoubleClick question. So everybody knows, we had FTC clearance in the United States in December, which is great, and we are working with the European Commission. We are obviously very hopeful that they will clear as well and that’s probably all we can really say about DoubleClick at this time, but we are certainly hopeful that it will get cleared. We are working with them pretty closely. George, did you want to answer the first question?
George Reyes: Bob, could you repeat the question again?
Robert Peck: It’s really more of was the impact of social a one-time impact for 4Q or should we think about this as being more of a normalized EBITDA margin run-rate going forward, particularly as other projects continue to build --
George Reyes: We’re still in the learning stages of how we monetize social networking and this is going to evolve over a period of months, so this is sort of early stage at this point.
Robert Peck: Any idea on a replacement for CFO?
George Reyes: Maybe.
Eric E. Schmidt: We’ve got a number of very good candidates and we are very happy to have George is still doing the job here and has agreed to continue to do this until we find the right replacement and it’s a hard position to replace, given George’s incredible performance. Let’s go to our next question.
Operator: We’ll go next to Benjamin Schachter from UBS.
Benjamin Schachter: A few questions; I was wondering if you could go into a little more detail on the social networking issues and specifically maybe talk about differences you are seeing with your non-text-based ads versus your text-based ads on social networking. And then another question on TAC associated with Google.com revenue. It continues to move higher, it’s about 4% now. I was wondering if you could talk about the key drivers and if there is a target rate internally for where that may go. And then finally, on healthcare, in the past, Sergey, I think you’ve specifically said that you don’t really think about Google's efforts in healthcare as really a driver for P&L and Eric, I know you are speaking at a healthcare conference in February. Any updates to that? Any change in how you are thinking about healthcare, how it might be a business opportunity? Thanks.
Eric E. Schmidt: On the healthcare side, we don’t have any products to announce at this time, so why don’t we answer the first part of your question, Jonathan and Sergey -- social networking and TAC.
Sergey Brin: I’m afraid I’m not sure off the bat what the stats were on the image versus text ads. We did have some changes relating to allowing certain kinds of CPC ads, which were only allowed to be bid on a CPM previously, which may have contributed to some cannibalization, or at least for now. But as I said, on the whole I’m not sure what the data is for image versus text.
Jonathan Rosenberg: I don’t have too much to add. We’ve certainly seen adoption of both the text and the image ads on social. I think the thing we have to figure out there is how to optimize the look and feel of the ads against the inventory that we have, how to slice the inventory up in alternative ways to try to figure out how to make it work and we’ve got some demos that we’ve just developed that are going to change the way we are doing some of the targeting, so I think we are basically going to have to look at that and try to figure out how do you find people of particular demographics that are comparable to what you might find in the New York Times or in a particular publication that you might have been previously familiar with.
Sergey Brin: If I may summarize on the whole, we have a huge amount of social networking inventory, including the MySpace relationship, including of course Orkut, our own network, which is very, very successful and probably like 20 others, or something like that. I don’t know the exact number. But we have an incredible amount of this inventory and in fact, it varies quite a bit in how it all monetizes, based on a number of factors, some of which we understand, some of which we don’t. I don’t think we have the killer best way to advertise and monetize the social networks yet. We’re running lots of experiments. We had some significant improvements but as I said, some of the things we were working on in Q4 didn’t really pan out and there were some disappointments there. I hope to be able to report more progress in the future but it’s a big opportunity because it’s so much inventory.
Eric E. Schmidt: Why don’t we move to our next question?
Operator: We’ll go next to Mary Meeker from Morgan Stanley.
Mary Meeker: Thanks. Dave and I wanted to revisit Imran’s question from the beginning of the call. Our worry going into the fourth quarter about Google was related to monetization levels, or cost-per-click growth, given what was going on in financial services, retail, and travel. We weren’t worried about query growth. Now you’ve reported your numbers and by our math, the cost-per-click growth was about 16%, so very robust, the highest we’ve seen in a long time, but by your math, the paid click growth was only about 9% sequentially in what is typically a seasonally strong quarter. And as we were thinking about it, just as we read in the press release before the call started, we thought issues might relate to the fact that it’s tougher to gain share, given how high your share already is, given there might be some share loss, issues about a recession, something geographic, or much slower market growth. And George mentioned then changes in the algorithm impacted, reduced accidental clicks. So our question, and it may be for George, is 9% sequential growth the kind of growth to potentially think about in the December quarter, or did the algorithm have a really material effect on the sequential query growth, or was it something else?
Eric E. Schmidt: Again, we have to be very careful here not to project any guidance here with all the math, so Sergey, do you want to try to describe what you thought the components of all of this were?
Sergey Brin: I should mention that we were reluctant to even start reporting that particular metric and it’s because unfortunately, there’s just a lot of complexity in our business and as we try to get the best possible, most useful ads to our end users, and hence get the most promising customers to our advertisers, we trade off a lot of things. So one example is the one that George mentioned, the one that you just talked about -- for example, getting rid of the clickable backgrounds. But there are also factors like we might want to reduce the number of low cost clicks, or perhaps low likelihood to convert clicks, in favor of a smaller number of higher quality clicks. There are many, many trade-offs that we make. So I just -- I would hesitate in inferring too much from just that one metric alone.
Mary Meeker: But was some of the -- was the change or some of the unusual things that happened that related to what you just mentioned and what George mentioned, were they global and did they take place through most of the quarter, or were they U.S. based? And then I’m done. Thanks.
Eric E. Schmidt: Jonathan.
Jonathan Rosenberg: I’m not sure to what degree I can separate out the international component. It certainly is true that prices rise as advertisers get higher conversion rates, particularly over the holidays, and Hal Varian posted a blog that sort of takes you through some of that. The other thing which I think you said which I’m pretty clear is not the case, we’re generally doing very well from a market share perspective domestically and internationally, so the trend there is almost uniformly a gain in market share.
Mary Meeker: I guess the one last observation is given that the changes probably had impact throughout most of the quarter and were perhaps global, that potential slowdown could be -- it could be a blip.
Eric E. Schmidt: Again, you’re using the term potential slowdown, which is not a term we have used on this call, so again that’s your view, not necessarily ours.
Jonathan Rosenberg: Mary, the click growth in the quarter beat our internal forecast.
Mary Meeker: Yeah, and it was certainly strong.
Eric E. Schmidt: Why don’t we move on? Thank you very much. Next question.
Operator: We’ll go next to Sandeep Aggarwal from Oppenheimer.
Sandeep Aggarwal: Thanks. Two questions; one is can you talk about how you are viewing the partnerships you have with some of the big AdSense partners? And basically, it’s clear that you did see some impact in that -- acquisition cost because of the minimum guarantees. I just wanted to know how would you hedge that kind of situation going forward? And secondly, George mentioned about investments which may drive down the margins. I just wanted to hear from you or get some sense of where these investments will be made -- will this be more of enhancing your existing products and infrastructure, or some new initiatives? Thank you.
Eric E. Schmidt: Omid.
Omid Kordestani: I’ll take the first part of the question. I think in relation to partnerships, we enter all of these with a view to having very successful [inaudible] before going to the partner, as well as ourselves. We would like to have very profitable deals. I think in certain areas, as we’ve been talking about social networking, we make bigger bets to be able to understand that space. We think that’s an important category. We have our own products in that space and we want to understand the monetization, which is again more challenging area for us to figure out, but we are confident given the innovation model that we have and the roadmap that we have that we’ll be able to perform better there. So our goal in all of these deals is to again make the proper levels of investment, proper levels of guarantees and over time, in areas that are newer to us, to understand them better and have better products.
Lawrence Page: I was going to add we’ve had I think in many of these areas with great partners, we’ve had very significant improvements in monetization and social networking in different areas. And like Sergey mentioned, I think there’s large opportunities still there. There’s tremendous amounts of inventory and the monetization levels are relatively low compared to other things. And we’ve seen the ability to make significant gains, so we are very optimistic about those areas still.
Sandeep Aggarwal: I’m sorry, what about the investments, future investments?
Eric E. Schmidt: You might want to repeat your question, because I’m not sure I agreed with the premise of your question. Go ahead.
Sandeep Aggarwal: I just wanted to hear basically in terms of I -- basically if you can provide some color in terms of future investments. Are they going to be more focused in terms of the enhancements to the existing product portfolio and improving your infrastructure versus some of the new initiatives?
Eric E. Schmidt: Well, the general answer is that’s where we see big opportunities and our primary focus on investments is in fact in our core business, and you see the success we had in 2007 and in Q4, the vast majority of that was actually not in all the things that generates all the exciting new announcements that we are happy to talk about, but in investments in core search and core advertising globally, which I’m incredibly proud of. George, do you want to add anything on this?
George Reyes: So in terms of your comments around margins going forward, as you know we don’t give guidance. We are going to continue to higher the talented people that we always have. We are going to continue our investments in CapEx and we are going to be very careful around how we proceed with making investments.
Sandeep Aggarwal: Thank you.
Operator: We’ll take our next question from Brian Pitz from Bank of America.
Brian Pitz: Can you provide some additional color on why we observed more of a deceleration in Google AdWords versus AdSense? And maybe this is a point of clarification but I think we heard you say that quality changes were made to AdSense and in addition, our assumption is that it was the social networking revenue also falls in the AdSense bucket. And then just a quick second question to Larry on licensing revenue -- should we assume most of the increase is due to the Postini acquisition? And that’s it. Thanks.
Eric E. Schmidt: Jonathan, AdSense and --
Jonathan Rosenberg: I think we’ve pretty much answered that with the discussion that we had earlier on the mix issues. I’m not sure I can offer you anymore color. We said that the Google.com traffic was stronger than our own internal expectations. We also -- if you look back at Q3, which I think we talked about on the call then, Q3 was a very, very good quarter, so if you are looking at the sequential growth rate, you are comparing it to a quarter in which we did disproportionately well, relative to what we’ve done in the past but I’m not sure how much color I can really give you there.
Lawrence Page: Perhaps it is worth mentioning, I do believe that we include the social networking revenue within the AdSense for content bucket, which is within AdSense as a whole. And perhaps it’s worth [also a note on the side], it’s not necessarily a financial metric, but we have had great partnerships with these social networks now. We’ve now launched Open Social and we have now at least 20 partners on that. We have applications being developed so we have networks who are participating, so we are really excited about all the progress innovation there and even though Q4 for us was a little bit of a disappointment in terms of the kinds of improvements in monetization we were able to generate, that’s -- Q3 was fine for us in that light, as was Q2 and we are optimistic about the future.
Eric E. Schmidt: And remember that the Google model is one of experimentation. We keep trying and we keep trying new ideas until we find the ones that really generate phenomenal ROI and not only do we go with them but they grow very quickly.
Jonathan Rosenberg: I didn’t want to miss your second question, it was about enterprise growth and Postini?
Brian Pitz: Yes.
Jonathan Rosenberg: And what specifically were you looking for?
Brian Pitz: Well, should we assume that most of the growth in licensing was due to the Postini acquisition in the quarter?
Jonathan Rosenberg: I think we’ve had a lot of success to date with small businesses. We added a lot of ISPs, which tend to drive a lot of the traffic. We also pushed a lot of the education efforts, which I think had a pretty significant component. Beyond that, it’s hard to --
Eric E. Schmidt: The answer to your question is yes. It’s easier that way. Why don’t we go to our next question?
Operator: We’ll go next to Marianne Wolk from Susquehanna.
Marianne Wolk: Thanks. I wanted to focus back on the economy. Can I confirm that when you called the weakness in the U.K. related to travel and finance seasonal, that you have already seen the normal seasonal rebound here in January? And then as a follow-up, a few retailers we actually spoke to in Q4 said that they increased their spending in online advertising as a way to bolster the slower offline sales. Have you noticed any counter-cyclicality in the business? Could a weaker economy actually accelerate the shift in ad dollars online?
Eric E. Schmidt: Again, you have a thesis here which we don’t necessarily agree with and in any case, we are not going to talk about the current quarter. We are talking about the quarter that ended in December. I’m happy to say that we have not yet seen any negative impact from the rumors of future recessions. We’ll see what happens.
Sergey Brin: But if I may add, I do think that certainly like you’ve seen from several of your contacts, it makes a lot of sense for advertisers if they want to be careful about their spending and they want to make sure they are getting a good ROI, to use the exact kind of advertising that we are offering. I think that makes a lot of sense and I think lots of advertisers recognize that.
Operator: We’ll go next to Justin Post from Merrill Lynch.
Justin Post: Thank you. Most of my questions have been asked, but one about your future -- when you think about revenue sources beyond search, what do you think your biggest opportunity is among software as a service -- video or display? Do you prioritize those? And do you think any of them could be material within the next two years?
Lawrence Page: I think it’s hard to prioritize the exact ones. I think we are making tremendous strides in apps, as we talked about. There’s tremendous -- those are of tremendous importance to people and we are also getting revenue from multiple sources there from advertising and from people paying for the service itself. And we’ve obviously seen tremendous growth in YouTube, which we already mentioned, which is great. I think we’ll be -- there’s going to be significant amounts of advertising there also. I’m pretty optimistic about all the new areas we are pursuing and the opportunities there will take -- you tend to underestimate the long term and overestimate the short term for any new thing and I think you want to be careful about that, but I’m very optimistic long-term.
Eric E. Schmidt: There’s reasons to be optimistic about all the categories that you described. The display business is literally right in front of us and the DoubleClick acquisition is an essential part of that strategy, so we’ll see. But of course, we have a sales force that is perfectly capable of selling those, customers are purchasing those already, and it’s a market that would benefit from the kind of technology that Google can bring to market. In the case of YouTube, you have a huge forward opportunity just because of the scale of the audience, globalization and so forth, so to the degree that we can develop the ad formats that we describe, it again should become very significant -- exactly when is very difficult to predict. Some more questions?
Operator: We’ll take our next question from Heath Terry from Credit Suisse.
Heath Terry: I was wondering if first you could update us on the local business and exactly where you are in continuing to try and attract advertisers to monetize the tremendous traffic that you’ve built within Google Maps, particularly what kind of progress that you’ve seen out of the local business referral model?
Eric E. Schmidt: Jonathan.
Jonathan Rosenberg: I guess the biggest thing that happened this last quarter was the Local Plus Box, which we launched I think in late November. Basically that was an improvement to the local ads on Google.com. I think it’s only available for the top ads but basically what happens is we show a plus box for the local ads and it expands and basically gives you the advertiser’s address, the phone number, a map, and this is the kind of thing that you’ll see us moving more towards as we try to make our efforts there and our ads more consistent with what is going on with universal search, convey as much information as we possibly can in the ad related to what happens if you click through to it and try to figure out how to capture the local opportunity.
Heath Terry: Great, and on the local business referral program?
Omid Kordestani: We’re not breaking any of those components out now. We are right now really focused on getting the right content, as Jonathan mentioned. A lot of the success of these areas will depend on having the most comprehensive listings and the right format and we are experimenting with all that, building the right relationships, and it’s still kind of early for us to break it out and really talk about the revenue performance.
Jonathan Rosenberg: The one other thing that you could look at is I also believe that we have pretty much completely revamped the regional targeting system and how that works for the advertisers, and I would expect that there will be significant improvement from that as well.
Krista Bessinger: We have time for just one more question.
Operator: We’ll go next to Jeffrey Lindsay from Sanford Bernstein.
Jeffrey Lindsay: We’d like to ask two things. First of all, could you give us any breakdown of the 889 new staff, geographically and/or by function? And then second, it looks like the TAC rate increased in the fourth quarter to 88%. Why did the TAC rate go up? What were the drivers behind this and were they one-off factors or were they factors that you expect would continue? Thank you.
Eric E. Schmidt: On the hiring question, the first part of your question, you’ll remember that we hired a little ahead of ourselves maybe six months ago, so we’ve returned to our normal hiring process -- more international over time, a balance -- maybe 50-50, or close to it, technical and non-technical. We are a very difficult place to get a job at and so we continue to look to the very, very top talent in each and every position, and we do that worldwide and it’s working very well. And I don’t think any of that is going to change. I think that model for hiring and building the organization has worked for us for many years and I think it will continue.
George Reyes: Our TAC rate is not 88%. We are looking at TAC as if it were a percentage of advertising revenue, which is roughly 30%. So as we’ve said, primarily this is all related to our AdSense partner sites and that’s -- which is where we are required to make the guaranteed payments and social networking is also something that is coming online pretty strongly.
Eric E. Schmidt: So with that, I want to thank everybody. Thank you, Krista, thank the Operator and thank all of you for spending so much time once again on your afternoon/evening covering Google and we look forward to talking to you in our next quarterly earnings call. Thank you very much.
Operator: This concludes today’s conference. We thank you for your participation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day and welcome, everyone, to the Google Inc. Conference call. Today’s call is being recorded. At this time, I would like to turn the call over to Ms. Krista Bessinger. Please go ahead, Madam."
},
{
"speaker": "Krista Bessinger",
"text": "Good afternoon, everyone and welcome to today’s third quarter 2007 earnings conference call. With us are: Eric Schmidt, Chief Executive Officer; George Reyes, Chief Financial Officer; Larry Page, Founder and President of Products; Sergey Brin, Founder and President of Technology; Jonathan Rosenberg, Senior Vice President of Product Management; and Omid Kordestani, Senior Vice President of Global Sales and Operations. Eric, George, Larry, and Sergey will provide their thoughts on the quarter and then Jonathan and Omid will join us for Q&A. Please note that this call is being webcast from our investor relations website. Our press release, issued a few minutes ago, is also posted on the website, along with the slides that accompany today’s prepared remarks. A replay of this call will also be available on our investor relations website in a few hours. Now, let me quickly cover the Safe Harbor statement. Some of the statements we make today may be considered forward-looking, including statements regarding our investments, seasonality, traffic acquisition costs, increase in the cost of sales, international growth, operating margins, growth in headcount, and our expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings, including our quarterly report on Form 10-Q, for the quarter ended September 30, 2007, as well as our earnings press release posted a few minutes ago for a more detailed description of the risk factors that may affect our results. Copies can be obtained from the SEC or by visiting the investor relations section of our website. Also, please note that certain financial measures we use on this call, such as EPS, net income, operating margin, and operating income, are expressed on a non-GAAP basis and have been adjusted to exclude charges relating to stock-based compensation. We’ve also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. Our GAAP results and GAAP to non-GAAP reconciliation can be found in our earnings press release on our website. With that, it is my pleasure to turn the call over to Eric."
},
{
"speaker": "Eric E. Schmidt",
"text": "Thank you very much, Krista and in looking at 2007, we are very, very pleased with our year and also with the quarter that’s just ended. If you look at 2007, a strong financial performance across the board, reflecting a performance and a focus here at Google on both growth and profitability, with of course very strong revenue, operating income, and earnings. I want to call out strong international growth. More than half of our search traffic is now outside the United States, more than 150 domains and still growing. The international market is still very nascent with tremendous potential for what we could do over time. And of course, the model at Google about product improvements and innovation continues. Hundreds of search quality launches, greater advertiser control and transparency, obviously higher ROI as a result, lots of new ads formats, YouTube video ads, from example, contests, branded channels. We’re working hard, by the way, to promote open mobile and developer platforms and we’re completing an application suite, [inaudible] integration, presentations, et cetera, and in concert with both product and international focus, we have a global team. We now have offices in more than 20 countries. We are working on having a local presence across global markets and this global local focus is reflected both in our organization and our products and in the way we run the company. Of course in Q4, a solid quarter without a question, pleased with traffic growth across the board even in the relatively mature markets which is always exciting. And obviously we are very happy with gross revenue on both google.com and on our AdSense partners. I think we are going to have Larry and Sergey take you through product highlights. My emphasis area is search, infrastructure investments, things we don’t talk that much about, leading to improved quality as seen by end users that we can measure, and of course giving advertisers more control as the product matures and obviously, as a result, improving their return on investment. The APP strategy, which we announced earlier in the year, now fully visible -- more innovation, data portability, all the apps now either in place or coming and mobile, which we are very excited with Android, the My Location service as part of Maps and many other new features that are both out and coming. So we are optimistic about 2008. We have growing revenue streams across a broad range of verticals and markets. As I mentioned, this international market which is central to our global rule, still relatively nascent with a tremendous potential. Ad dollars continuing to move from offline to online, a trend which is not going to reverse, and of course our ability to use our strong position in markets in order to essentially offer more services to end users and get people even more to see the new benefits of the new Internet world. So with that, rather than me talking about more of the details, why don’t we hear from George and then Larry and Sergey on some of the amazing things that have been happening. George."
},
{
"speaker": "George Reyes",
"text": "Thanks, Eric and good afternoon, everyone. At a high level, we had another strong quarter, with gross revenue increasing 51% over Q4 of 2006 to $4.8 billion. Our google.com properties increased 58% year over year, reflecting strong traffic growth during the holiday retail season and, to a lesser extent, monetization growth. AdSense revenue grew 37% over Q4 of 2006, driven by particularly solid performance among our AdSense research partners, including e-commerce and search partners. Offsetting this growth was the impact of a quality improvement to AdSense for content. This changed the clickable area around the text-based ads to only the title and URL, reducing the number of accidental clicks and increasing advertiser ROI. Now let’s look at aggregate paid clicks growth. Aggregate paid clicks includes clicks related to ads served on Google properties, as well as ads served on partner sits. Aggregate paid clicks grew approximately 30% over Q4 of 2006 and approximately 9% over Q3. Let me now discuss our international performance. International revenue increased to $2.3 billion, or 48% of revenue in Q4. Revenue in the U.K. grew 5% this quarter to $692 million, reflecting the usual Q4 seasonal slowdown in the finance and travel verticals. Revenue growth in EMEA was primarily driven by a strong performance in France and Germany, where gains were made in the retail, technology, and finance verticals. We also saw solid gains in relatively smaller markets, such as Canada, Ireland, Spain, and the Nordics. Asia and Latin America continue to show impressive growth rates as well, with Brazil, Mexico, Argentina, and China being notable performers in the quarter. Now turning to expenses, traffic acquisition costs were $1.4 billion, or roughly 30.3% of total advertising revenue, down 40 basis points year over year but up from 29.1% in Q3. The increase in overall TAC rate was primarily related to the performance of a few AdSense partner sites, for which we are required to make guaranteed payments. We have found that social networking inventory is not monetizing as well as expected. AdSense TAC was $1.3 billion, while TAC related to distribution partners and others who direct traffic to our websites totaled $125 million in the quarter. Turning to other costs of revenue, which includes $6 million in stock-based compensation, increased $75 million over Q3 to $516 million. The largest driver of the increase was the increase in costs related to our data centers, including depreciation, equipment, and operations. We continue to anticipate that other cost of sales could increase going forward. Other than cost of revenues, operating expenses in Q4 totaled $1.4 billion, including approximately $239 million stock-based compensation. Expenses related to payroll and facilities increased $97 million to $756 million. At the end of the quarter, we had a full-time employee base of 16,805 employees. We added 889 employees in Q4, with over half the new hires being in engineering, followed by sales and marketing. We have implemented and continue to follow a disciplined hiring process in all areas of our organization. Hiring in Q4 tends to be slower due to the holidays but as we’ve indicated in the past, we will continue to invest in our core business, both in the U.S. and internationally. Turning to non-GAAP operating income, which excludes stock-based compensation, increased to $1.7 billion in Q4, with non-GAAP operating margins of 35%, compared to 36% in Q3. The sequential decrease in margins was driven primarily by the increase in overall TAC, as discussed earlier. As we have said before, margins may decline in the future as we continue to make ongoing investments in our business. Turning to tax, our effective tax rate for Q4 was 25%. Our Q4 rate was more favorably impacted by an R&D tax credit in Q4 compared to Q3 as a result of stock option activity. This was the primary driver of the difference in tax rates between Q3 and Q4. And finally, turning to cash, operating cash flow remained strong at $1.7 billion, with CapEx for the quarter of $678 million. As in previous quarters, the majority of our CapEx was related to IT infrastructure investments, including data center construction, production of servers, and networking equipment. We expect to continue to make these significant investments in CapEx in future quarters. Free cash flow, a non-GAAP measure which we define as cash flow from operations less CapEx, was also strong at $1 billion. So in summary, we believe our results reflect the strength of our core business across our three primary initiatives -- search, ads, and apps, with disciplined investments that position us very well to capitalize on the long-term opportunities we see for Google. With that, I would like to turn the conversation over to Larry."
},
{
"speaker": "Lawrence Page",
"text": "Thank you, George. I’m really excited to tell you about some key new things that we did in both search and advertising. So to begin with in search, we had over 100 launches in Q4 with focus on our internationalization and investing in our quality. One of those was universal search, which is now available in 15 languages, up six in Q4. We also launched the universal navigation bar in all languages, which gives our users easier access to all of our Google properties. And book results are now blended in all domains. We also made some behind the scenes infrastructure improvements to improve our quality, and the biggest of those was increased index size, which really improved relevancy, especially for non-English results. We also had substantial improvements in latency and freshness, particularly in Europe, Middle East, and Asia-Pacific. Now, we also made it easier for webmasters to make their site searchable. There’s two things there. The first was webmaster tools. We have several million sites now using and actually doubled our user base over last year, and that basically lets webmasters easily tell what’s being crawled from their site and what’s being indexed and so forth. And we added a bunch of new features to that in Q4. We also have our site maps product, which is another tool to let webmasters make their sites easier to crawl and we added Florida, District of Columbia, and U.K. National Archives, among many other sites, and added many, many thousands of pages there. Now in ads, that’s obviously where we get a large portion of our revenue. We launched some key features there that really drove performance for advertisers and really helped us gain traction. First of those in AdWords was call the AdWords Conversion Optimizer, which we launched in early January and that lets customers big by specifying a cost per acquisition rather than a cost per click. So for example, you could pay only when someone actually buys something rather than just when someone clicks on your ads. AdWords actually, the system actually optimizes their click-based bids to approximate that cost per acquisition for each auction, and that’s really gotten strong adoption, particularly among our larger clients and we’re really excited about that. That really improves the advertiser return on investment. That gives them more conversions which is really what they care about when they actually make money at a lower cost per conversion. In AdSense, we also launched cost-per-click on placement targeted campaigns, such as campaigns that are on a particular website. And this got really strong adoption and it really helped drive better performance and increased spend for our [directory] advertisers, so we are really excited about that too. Now I’m going to turn it over to Sergey."
},
{
"speaker": "Sergey Brin",
"text": "Thanks, Larry. I want to talk to you about some of our relatively newer initiatives. I want to start with Google Apps and related products. G-mail -- G-mail launched an important new infrastructure in Q4 and this has really increased performance. For those of you who are G-mail users, you may have noticed how it loads a little bit snappier, you can switch between conversations a little bit faster. It’s really improved my productivity and I hope you see that as well. In addition to that, this new infrastructure has really made development easier and in fact, we were able after that to launch eight new features within a span of eight weeks. A couple of new features that also makes G-mail more open, we’ve added IMAP support, so you can use all of your favorite e-mail clients, including, of course, devices like the iPhone and you don’t have to use POP3 anymore, you can now use IMAP, which is the better way to go, if you have the choice. You can also now chat with AOL instant messaging users, so this is great now in the Google chat little screen in G-mail. You can connect not just to other Google Talk users but also AIM users, which is a really large population. I want to jump now from G-mail to YouTube. YouTube has continued to have a really strong user growth. In fact, we had a few special events that just demonstrate this. We hosted the CNN Republican debate together with CNN and in fact, almost as many people saw it on YouTube as did on CNN. We consider this a great milestone and we hope to continue to do great partnerships with CNN and others to jointly grow audience for events. We also, I should mention that YouTube is now available in 17 languages, eight more than last quarter, and so we are seeing a lot of international growth. We are really excited about that. In enterprise, we’ve gotten a lot of increased interest, trial, and adoption of Google Apps in larger companies. First of all, we’ve signed an agreement with Taylor Woodrow, which is the construction services division of Taylor Wimpey, a FTSE 100 company in the U.K. We are also finalizing an agreement to deploy Google Apps at Genentech, and those are just a couple of the really big ones we have. We are talking to many, many companies and many are adopting it all the time. In addition, the universities that have deployed this quarter includes the University of Southern California, the North Carolina Greensboro, Florida International, and Clemson. Now jumping a little bit aside in mobile, we’ve really been revving the Google Maps for mobile, among other applications, and Google Maps is just really useful on your cell-phone now. Some of you might have seen our launch of the My Location, which allows you to see where you are on your cell-phone even if you do not have a GPS-enabled phone, and that’s really amazing. In fact, even if you have a GPS in your phone, the My Location can give you a first cut much faster than you can usually get a GPS signal, and it will work indoors. I was just using this, I was at a conference in Switzerland, I was able to find a really small hotel and then even switch over to the satellite view on my phone to figure out that I needed to take a vernicular to get up there. It was just a really amazing experience and we continue to add features and reliability to it all the time. I should mention My Location is available now in 21 countries and it works on four different platforms altogether. We also launched a new rev of apps for the iPhone. We call it Grand Prix internally, but basically you get access that’s really fast and integrated to the major Google products, including search, G-mail, calendar reader, and others. And it’s really had great uptake. I use it personally myself. Many people have really been enjoying this product. It’s growing very rapidly. Last but not least, I’m going to do a shout out to Android, which is the operating system that we are developing for mobile phones, and it’s completely open, of course. It’s going to really solve a lot of the challenges the company’s in the mobile industry have. We’ve released the SDK for it. We formed the Open Handset Alliance, which has now 34 industry leaders in it, and we really think that this is going to make Internet on mobile hopefully as frictionless as it is on your desktop normal Internet experience. This is going to spawn lots more activity and what we love, it’s to see lots of great, open access to the Internet wherever and whenever you are. Anyway, that’s what we’ve been doing on those fronts and now, back to you, Eric."
},
{
"speaker": "Eric E. Schmidt",
"text": "Well, thank you very much, George, Larry, Sergey. As you can see, not only did we have a very good 2007 but we are quite optimistic about ’08 and our model continues to work very well. Why don’t we go ahead and move to your questions and I would also like to bring in Omid and Jonathan, previously introduced, to help us answer your questions on this or anything else. So could we go ahead and get our first question?"
},
{
"speaker": "Operator",
"text": "(Operator Instructions) We’ll take our first question from Imran Khan from J.P. Morgan."
},
{
"speaker": "Imran Khan",
"text": "Two questions; first of all, paid click growth rate declined 15 percentage points sequentially year over year, growth rate, so I’m trying to understand how much of that growth rate decline was due to the changes you made and if you see any improvement in the price-per-click because of increased customers return on investment, because your year-over-year revenue growth rate decelerated 10 points as well on your website, so to better understand the relationship between price-per-click and paid clicks growth rate. And secondly, social network monetization is difficult. You talked about that and I believe it’s with News Corp that you signed a long-term contract, so how should we think about that contract and what does that mean for your TAC rate going forward? Thank you."
},
{
"speaker": "Eric E. Schmidt",
"text": "Why don’t we start with Jonathan? Why don’t you take the first part of Imran’s question?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Sure, Imran. Basically paid click growth, which you referred to, tracks the traffic growth rate and the traffic growth rate did decelerate. The number of search ads basically grew faster than the number of content ads, so I think one of the things that you have to look at there is what is the mix issue. And then I think there were probably some secondary factors there. Some factors would include things like the focus that we’ve had on weeding out the low CPC, high click-thru rate low quality advertiser, so that’s probably a component. The other thing that we did was there was probably some impact from the non-clickable backgrounds which we launched on AdSense for content, so those were probably the biggest things. I think there was also a little bit of an issue with the timing of the holiday. Monday and Tuesday were Christmas and Christmas Eve, which are conventionally our biggest days, so that was probably a component. On the CPC side, generally CPCs have been going up, click-thru rates have been going up, and coverage has been going down. I’m not sure I could add much more there."
},
{
"speaker": "Sergey Brin",
"text": "I just wanted to follow-up on the social networking question. We don’t talk about individual partners’ performance or anything like that. Now I do want to highlight though, we have had a challenge in Q4 with social networking inventory as a whole and some of the monetization work we were doing there didn’t pan out as well as we had hoped. But we are continuing the efforts and we are still optimistic about future quarters."
},
{
"speaker": "Operator",
"text": "We’ll take our next question from Douglas Anmuth from Lehman Brothers."
},
{
"speaker": "Douglas Anmuth",
"text": "Thank you. My question is regarding the U.K. it looks like your growth Q2 was about 5% in the U.K. and that compares to about 11% in the fourth quarter of last year. Could you talk about what you are seeing there beyond the usual categories that you may see weakness in typically during 4Q and what you are seeing there from a macro perspective as well? Thank you."
},
{
"speaker": "Eric E. Schmidt",
"text": "Omid, do you want to go ahead and handle that?"
},
{
"speaker": "Omid Kordestani",
"text": "In general, we are very pleased with our performance in Europe. And actually, I know you asked about the U.K., but very quickly we are seeing great results in France and Germany as well in the retail category. I think in the U.K., we saw the typical seasonal patterns but we were -- there are certain categories that we believe the auction is in effect fully sold out and we are working on clever ideas and conversion analysis for our partners to really improve their understanding of how they should spend and how they should price their bids. But overall, we are very satisfied with the penetration we have with the major accounts. We are at CEOCM tables. I was there throughout Q4 and overall, we’ve seen a lot of strength in the market."
},
{
"speaker": "Douglas Anmuth",
"text": "And are those two categories, travel and financial, that are typically seasonally weak? I mean, do you feel like there is an additional macro impact there?"
},
{
"speaker": "Omid Kordestani",
"text": "No, those two were the primary ones."
},
{
"speaker": "Eric E. Schmidt",
"text": "Jonathan, do you want to add anything to that?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I was just going to add that it was finance and travel. Maybe the only other point to look at there is if you look at the total percentage of advertising spend in the U.K., some of the public data says that it’s roughly 15%, 16%, 17% on search, whereas in the United States it’s more like 6%. So one of the things that you see there is that the seasonality, particularly in those two verticals, is much more marked because they are spending a disproportionately greater amount of money in total on search engine efforts."
},
{
"speaker": "Eric E. Schmidt",
"text": "Let’s go to our next question."
},
{
"speaker": "Operator",
"text": "We’ll go next to Jennifer Watson with Goldman Sachs."
},
{
"speaker": "Jennifer Watson",
"text": "Thank you. Can you give us a little bit more detail on the feedback that you are getting from both advertisers and consumers on the YouTube advertisements that you guys rolled out?"
},
{
"speaker": "Eric E. Schmidt",
"text": "Omid."
},
{
"speaker": "Omid Kordestani",
"text": "We were doing what I can best characterize as just a lot of touch points with our -- both publisher partners as well as advertisers. We are trying different formats. The in-video ads have been very successful. We’ve had a number of campaigns and the way we are also approaching this which I think is unique for Google is really from an integrated and scalable fashion. In the case of -- for example, if I may name some clients, General Motors, for example, Chevrolet Europe, we did what I think is a really truly possible with the advantage that Google has, you know, running the campaigns across multiple countries, delivering large numbers of impressions from YouTube to the content network to the search campaigns. Adobe, for example, ran one of the biggest homepage campaigns we’ve had in the history of YouTube. So all in all, we are doing a lot of experimentation. We are starting to do it globally and we are doing it in every integrated fashion and by adding the other key assets that we have."
},
{
"speaker": "Eric E. Schmidt",
"text": "Let me add a couple of other things. YouTube is doing extremely well, growing very, very quickly and doing so internationally as well as in the United States. There’s been an issue around standardizing ad formats for advertisers who would like to be able to do industry buys and so forth. So as these new ad formats are being developed, we are also looking to make sure they get standardized into a common buying pool and pattern so that people feel comfortable that they can get real value. The next generation of projects are actually very, very sophisticated ad products and it looks like they are going to do extremely well. Next question."
},
{
"speaker": "Operator",
"text": "We’ll go next --"
},
{
"speaker": "Krista Bessinger",
"text": "Operator?"
},
{
"speaker": "Operator",
"text": "We’ll go next to Mark Mahaney from Citigroup."
},
{
"speaker": "Mark Mahaney",
"text": "Thank you. I wanted to ask a question about mobile, particularly for you, Eric. You’ve got a very interesting perspective from two companies on what’s happening with mobile Internet usage, particularly off the iPhones. How much of a ramp are you seeing? Is there any way you could quantify it and is there a way you think about how mobile search as a percentage of overall search could be in two to three years? Thank you."
},
{
"speaker": "Eric E. Schmidt",
"text": "It’s very difficult to estimate the percentage in a few years. We have already said in a number of public statements that it is growing significantly faster on a percentage basis than other categories, and as you mentioned, iPhone is the first of a whole generation of products that will be much more search intensive, and so there’s much more likely to be many more search opportunities and with those search opportunities comes ad monetization. We have done a number of deals for mobile devices already, KTTI and DoCoMo, for example. DoCoMo just announced by Omid in Japan, which are very, very strategic for us. It’s difficult to estimate what percentage it could ultimately be long term, and when I say long term, I mean perhaps 10 or 20 years. It’s reasonable to assume that a majority of searches would be on mobile or personal devices, simply because over a long enough period of time, they will take on the tremendous power that’s represented in the PC and Mac platform. And the wireless networks are getting to the point where they can offer performance similar to the wireline. Jonathan, do you want to add anything?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "We’ve been tracking the data very carefully. We are particularly interested in looking at the iPhone, particularly because the experience on web browsing is so good and because of the optimization efforts which we did. We saw a very significant spike in December with the optimization that we did on both the iPhone and it was well over double I think within about a month in terms of increased usage."
},
{
"speaker": "Mark Mahaney",
"text": "If I can do a quick follow-up on macro trends -- to the extent that you would see weakness related to a softening consumer, do you think you would see it more on the supply or the demand side -- i.e. ad budgets being trimmed or less consumer commercially oriented searches? Thank you."
},
{
"speaker": "Eric E. Schmidt",
"text": "Sergey."
},
{
"speaker": "Sergey Brin",
"text": "We’ve been really studying these questions really in depth and near as we can tell, we just offer such a great ROI for advertisers that they can directly see and measures that advertisers in maybe even difficult markets and what not just have great incentive to get as much profitable inventory as they can from Google and the other different kinds of ROI advertising that we offer. So we have not been able to detect any such effects from macroeconomic trends."
},
{
"speaker": "Eric E. Schmidt",
"text": "Jonathan."
},
{
"speaker": "Jonathan Rosenberg",
"text": "I think some of you have observed that direct marketing tends to be less affected by economic downturns than brand marketing, given a time measurability. I think that’s been true in past recessions. I think we’ll probably see that again. I think one thing we may see is consumers comparison shopping more and that would certainly create more clicks. It might create modestly lower conversion rates but we think overall, if people are doing more comparison shopping and looking for bargains, that’s probably positive. Clearly if there’s less overall commerce in the economy in general, then that could adversely impact overall demand, but we really think that relative to most organizations, we are pretty much tracking the diversity of the overall economy and search-based efforts will fare pretty well."
},
{
"speaker": "Eric E. Schmidt",
"text": "Let’s move to our next question."
},
{
"speaker": "Operator",
"text": "We’ll go next to Christa Quarles from Thomas Weisel Partners."
},
{
"speaker": "Christa Sober Quarles",
"text": "The main question I guess is on the C-block I guess passed the reserve price today. Obviously you can’t mention whether or not you are bidding, but can you just talk about what those open access measures ultimately mean for you, and especially with Verizon moving toward open access toward the end of 2008? And also, if you can kind of highlight your WiMax stance. And then a total separate quick question -- I was just wondering if you could give the impact on checkout to COGS in Q4. Thanks."
},
{
"speaker": "Eric E. Schmidt",
"text": "On the first part of the question, we’ve concluded we cannot answer any questions in that category because of legislative rules with respect to how the auction is working, so I’m afraid we’re going to only be able to answer the second question, so could you repeat it again?"
},
{
"speaker": "Christa Sober Quarles",
"text": "Well, can you make any comment on WiMax at all, with a separate --"
},
{
"speaker": "Eric E. Schmidt",
"text": "As I indicated, I think it’s best practice for us just to move to the second question."
},
{
"speaker": "Christa Sober Quarles",
"text": "The second question was just on Checkout and whether it had a big impact on the COGS in Q4."
},
{
"speaker": "Eric E. Schmidt",
"text": "Jonathan."
},
{
"speaker": "Jonathan Rosenberg",
"text": "I think it’s the same answer that we’ve given in the previous calls -- the impact was immaterial. I think one of the strongest observations that I could give you there is that the organic growth in terms of Checkout overtook the promotion efforts this quarter, so I think that’s a good sign in terms of the general traction that we are getting. The other things that we are seeing there, that the click-thru rates on the [badge] are up as much as 10%, so I think that’s going pretty well."
},
{
"speaker": "Sergey Brin",
"text": "If I may, also in addition to the click-thru rates, I think we are starting to get some anecdotal and some actual real studies that demonstrate that the conversions are also up, very substantially and hopefully we’ll be able to share more of that with you in the coming weeks. But there is really good evidence now that Checkout is able to get consumers through the process more quickly and more reliably."
},
{
"speaker": "Christa Sober Quarles",
"text": "Okay. Thanks."
},
{
"speaker": "Eric E. Schmidt",
"text": "Why don’t we go ahead to our next question?"
},
{
"speaker": "Operator",
"text": "We’ll go next to Robert Peck from Bear Stearns."
},
{
"speaker": "Robert Peck",
"text": "As we think about the margin levels this quarter, should analysts be thinking that based on what you are seeing as far as the social networking side, is this more of a new run-rate level, or do you think the margins were somewhat suppressed by the MySpace relationship in Q4? And then number two, could you also talk to us about timing of a DoubleClick closing and any sort of impact you can see to the numbers for 2008?"
},
{
"speaker": "Eric E. Schmidt",
"text": "Let me do the DoubleClick question. So everybody knows, we had FTC clearance in the United States in December, which is great, and we are working with the European Commission. We are obviously very hopeful that they will clear as well and that’s probably all we can really say about DoubleClick at this time, but we are certainly hopeful that it will get cleared. We are working with them pretty closely. George, did you want to answer the first question?"
},
{
"speaker": "George Reyes",
"text": "Bob, could you repeat the question again?"
},
{
"speaker": "Robert Peck",
"text": "It’s really more of was the impact of social a one-time impact for 4Q or should we think about this as being more of a normalized EBITDA margin run-rate going forward, particularly as other projects continue to build --"
},
{
"speaker": "George Reyes",
"text": "We’re still in the learning stages of how we monetize social networking and this is going to evolve over a period of months, so this is sort of early stage at this point."
},
{
"speaker": "Robert Peck",
"text": "Any idea on a replacement for CFO?"
},
{
"speaker": "George Reyes",
"text": "Maybe."
},
{
"speaker": "Eric E. Schmidt",
"text": "We’ve got a number of very good candidates and we are very happy to have George is still doing the job here and has agreed to continue to do this until we find the right replacement and it’s a hard position to replace, given George’s incredible performance. Let’s go to our next question."
},
{
"speaker": "Operator",
"text": "We’ll go next to Benjamin Schachter from UBS."
},
{
"speaker": "Benjamin Schachter",
"text": "A few questions; I was wondering if you could go into a little more detail on the social networking issues and specifically maybe talk about differences you are seeing with your non-text-based ads versus your text-based ads on social networking. And then another question on TAC associated with Google.com revenue. It continues to move higher, it’s about 4% now. I was wondering if you could talk about the key drivers and if there is a target rate internally for where that may go. And then finally, on healthcare, in the past, Sergey, I think you’ve specifically said that you don’t really think about Google's efforts in healthcare as really a driver for P&L and Eric, I know you are speaking at a healthcare conference in February. Any updates to that? Any change in how you are thinking about healthcare, how it might be a business opportunity? Thanks."
},
{
"speaker": "Eric E. Schmidt",
"text": "On the healthcare side, we don’t have any products to announce at this time, so why don’t we answer the first part of your question, Jonathan and Sergey -- social networking and TAC."
},
{
"speaker": "Sergey Brin",
"text": "I’m afraid I’m not sure off the bat what the stats were on the image versus text ads. We did have some changes relating to allowing certain kinds of CPC ads, which were only allowed to be bid on a CPM previously, which may have contributed to some cannibalization, or at least for now. But as I said, on the whole I’m not sure what the data is for image versus text."
},
{
"speaker": "Jonathan Rosenberg",
"text": "I don’t have too much to add. We’ve certainly seen adoption of both the text and the image ads on social. I think the thing we have to figure out there is how to optimize the look and feel of the ads against the inventory that we have, how to slice the inventory up in alternative ways to try to figure out how to make it work and we’ve got some demos that we’ve just developed that are going to change the way we are doing some of the targeting, so I think we are basically going to have to look at that and try to figure out how do you find people of particular demographics that are comparable to what you might find in the New York Times or in a particular publication that you might have been previously familiar with."
},
{
"speaker": "Sergey Brin",
"text": "If I may summarize on the whole, we have a huge amount of social networking inventory, including the MySpace relationship, including of course Orkut, our own network, which is very, very successful and probably like 20 others, or something like that. I don’t know the exact number. But we have an incredible amount of this inventory and in fact, it varies quite a bit in how it all monetizes, based on a number of factors, some of which we understand, some of which we don’t. I don’t think we have the killer best way to advertise and monetize the social networks yet. We’re running lots of experiments. We had some significant improvements but as I said, some of the things we were working on in Q4 didn’t really pan out and there were some disappointments there. I hope to be able to report more progress in the future but it’s a big opportunity because it’s so much inventory."
},
{
"speaker": "Eric E. Schmidt",
"text": "Why don’t we move to our next question?"
},
{
"speaker": "Operator",
"text": "We’ll go next to Mary Meeker from Morgan Stanley."
},
{
"speaker": "Mary Meeker",
"text": "Thanks. Dave and I wanted to revisit Imran’s question from the beginning of the call. Our worry going into the fourth quarter about Google was related to monetization levels, or cost-per-click growth, given what was going on in financial services, retail, and travel. We weren’t worried about query growth. Now you’ve reported your numbers and by our math, the cost-per-click growth was about 16%, so very robust, the highest we’ve seen in a long time, but by your math, the paid click growth was only about 9% sequentially in what is typically a seasonally strong quarter. And as we were thinking about it, just as we read in the press release before the call started, we thought issues might relate to the fact that it’s tougher to gain share, given how high your share already is, given there might be some share loss, issues about a recession, something geographic, or much slower market growth. And George mentioned then changes in the algorithm impacted, reduced accidental clicks. So our question, and it may be for George, is 9% sequential growth the kind of growth to potentially think about in the December quarter, or did the algorithm have a really material effect on the sequential query growth, or was it something else?"
},
{
"speaker": "Eric E. Schmidt",
"text": "Again, we have to be very careful here not to project any guidance here with all the math, so Sergey, do you want to try to describe what you thought the components of all of this were?"
},
{
"speaker": "Sergey Brin",
"text": "I should mention that we were reluctant to even start reporting that particular metric and it’s because unfortunately, there’s just a lot of complexity in our business and as we try to get the best possible, most useful ads to our end users, and hence get the most promising customers to our advertisers, we trade off a lot of things. So one example is the one that George mentioned, the one that you just talked about -- for example, getting rid of the clickable backgrounds. But there are also factors like we might want to reduce the number of low cost clicks, or perhaps low likelihood to convert clicks, in favor of a smaller number of higher quality clicks. There are many, many trade-offs that we make. So I just -- I would hesitate in inferring too much from just that one metric alone."
},
{
"speaker": "Mary Meeker",
"text": "But was some of the -- was the change or some of the unusual things that happened that related to what you just mentioned and what George mentioned, were they global and did they take place through most of the quarter, or were they U.S. based? And then I’m done. Thanks."
},
{
"speaker": "Eric E. Schmidt",
"text": "Jonathan."
},
{
"speaker": "Jonathan Rosenberg",
"text": "I’m not sure to what degree I can separate out the international component. It certainly is true that prices rise as advertisers get higher conversion rates, particularly over the holidays, and Hal Varian posted a blog that sort of takes you through some of that. The other thing which I think you said which I’m pretty clear is not the case, we’re generally doing very well from a market share perspective domestically and internationally, so the trend there is almost uniformly a gain in market share."
},
{
"speaker": "Mary Meeker",
"text": "I guess the one last observation is given that the changes probably had impact throughout most of the quarter and were perhaps global, that potential slowdown could be -- it could be a blip."
},
{
"speaker": "Eric E. Schmidt",
"text": "Again, you’re using the term potential slowdown, which is not a term we have used on this call, so again that’s your view, not necessarily ours."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Mary, the click growth in the quarter beat our internal forecast."
},
{
"speaker": "Mary Meeker",
"text": "Yeah, and it was certainly strong."
},
{
"speaker": "Eric E. Schmidt",
"text": "Why don’t we move on? Thank you very much. Next question."
},
{
"speaker": "Operator",
"text": "We’ll go next to Sandeep Aggarwal from Oppenheimer."
},
{
"speaker": "Sandeep Aggarwal",
"text": "Thanks. Two questions; one is can you talk about how you are viewing the partnerships you have with some of the big AdSense partners? And basically, it’s clear that you did see some impact in that -- acquisition cost because of the minimum guarantees. I just wanted to know how would you hedge that kind of situation going forward? And secondly, George mentioned about investments which may drive down the margins. I just wanted to hear from you or get some sense of where these investments will be made -- will this be more of enhancing your existing products and infrastructure, or some new initiatives? Thank you."
},
{
"speaker": "Eric E. Schmidt",
"text": "Omid."
},
{
"speaker": "Omid Kordestani",
"text": "I’ll take the first part of the question. I think in relation to partnerships, we enter all of these with a view to having very successful [inaudible] before going to the partner, as well as ourselves. We would like to have very profitable deals. I think in certain areas, as we’ve been talking about social networking, we make bigger bets to be able to understand that space. We think that’s an important category. We have our own products in that space and we want to understand the monetization, which is again more challenging area for us to figure out, but we are confident given the innovation model that we have and the roadmap that we have that we’ll be able to perform better there. So our goal in all of these deals is to again make the proper levels of investment, proper levels of guarantees and over time, in areas that are newer to us, to understand them better and have better products."
},
{
"speaker": "Lawrence Page",
"text": "I was going to add we’ve had I think in many of these areas with great partners, we’ve had very significant improvements in monetization and social networking in different areas. And like Sergey mentioned, I think there’s large opportunities still there. There’s tremendous amounts of inventory and the monetization levels are relatively low compared to other things. And we’ve seen the ability to make significant gains, so we are very optimistic about those areas still."
},
{
"speaker": "Sandeep Aggarwal",
"text": "I’m sorry, what about the investments, future investments?"
},
{
"speaker": "Eric E. Schmidt",
"text": "You might want to repeat your question, because I’m not sure I agreed with the premise of your question. Go ahead."
},
{
"speaker": "Sandeep Aggarwal",
"text": "I just wanted to hear basically in terms of I -- basically if you can provide some color in terms of future investments. Are they going to be more focused in terms of the enhancements to the existing product portfolio and improving your infrastructure versus some of the new initiatives?"
},
{
"speaker": "Eric E. Schmidt",
"text": "Well, the general answer is that’s where we see big opportunities and our primary focus on investments is in fact in our core business, and you see the success we had in 2007 and in Q4, the vast majority of that was actually not in all the things that generates all the exciting new announcements that we are happy to talk about, but in investments in core search and core advertising globally, which I’m incredibly proud of. George, do you want to add anything on this?"
},
{
"speaker": "George Reyes",
"text": "So in terms of your comments around margins going forward, as you know we don’t give guidance. We are going to continue to higher the talented people that we always have. We are going to continue our investments in CapEx and we are going to be very careful around how we proceed with making investments."
},
{
"speaker": "Sandeep Aggarwal",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "We’ll take our next question from Brian Pitz from Bank of America."
},
{
"speaker": "Brian Pitz",
"text": "Can you provide some additional color on why we observed more of a deceleration in Google AdWords versus AdSense? And maybe this is a point of clarification but I think we heard you say that quality changes were made to AdSense and in addition, our assumption is that it was the social networking revenue also falls in the AdSense bucket. And then just a quick second question to Larry on licensing revenue -- should we assume most of the increase is due to the Postini acquisition? And that’s it. Thanks."
},
{
"speaker": "Eric E. Schmidt",
"text": "Jonathan, AdSense and --"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I think we’ve pretty much answered that with the discussion that we had earlier on the mix issues. I’m not sure I can offer you anymore color. We said that the Google.com traffic was stronger than our own internal expectations. We also -- if you look back at Q3, which I think we talked about on the call then, Q3 was a very, very good quarter, so if you are looking at the sequential growth rate, you are comparing it to a quarter in which we did disproportionately well, relative to what we’ve done in the past but I’m not sure how much color I can really give you there."
},
{
"speaker": "Lawrence Page",
"text": "Perhaps it is worth mentioning, I do believe that we include the social networking revenue within the AdSense for content bucket, which is within AdSense as a whole. And perhaps it’s worth [also a note on the side], it’s not necessarily a financial metric, but we have had great partnerships with these social networks now. We’ve now launched Open Social and we have now at least 20 partners on that. We have applications being developed so we have networks who are participating, so we are really excited about all the progress innovation there and even though Q4 for us was a little bit of a disappointment in terms of the kinds of improvements in monetization we were able to generate, that’s -- Q3 was fine for us in that light, as was Q2 and we are optimistic about the future."
},
{
"speaker": "Eric E. Schmidt",
"text": "And remember that the Google model is one of experimentation. We keep trying and we keep trying new ideas until we find the ones that really generate phenomenal ROI and not only do we go with them but they grow very quickly."
},
{
"speaker": "Jonathan Rosenberg",
"text": "I didn’t want to miss your second question, it was about enterprise growth and Postini?"
},
{
"speaker": "Brian Pitz",
"text": "Yes."
},
{
"speaker": "Jonathan Rosenberg",
"text": "And what specifically were you looking for?"
},
{
"speaker": "Brian Pitz",
"text": "Well, should we assume that most of the growth in licensing was due to the Postini acquisition in the quarter?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I think we’ve had a lot of success to date with small businesses. We added a lot of ISPs, which tend to drive a lot of the traffic. We also pushed a lot of the education efforts, which I think had a pretty significant component. Beyond that, it’s hard to --"
},
{
"speaker": "Eric E. Schmidt",
"text": "The answer to your question is yes. It’s easier that way. Why don’t we go to our next question?"
},
{
"speaker": "Operator",
"text": "We’ll go next to Marianne Wolk from Susquehanna."
},
{
"speaker": "Marianne Wolk",
"text": "Thanks. I wanted to focus back on the economy. Can I confirm that when you called the weakness in the U.K. related to travel and finance seasonal, that you have already seen the normal seasonal rebound here in January? And then as a follow-up, a few retailers we actually spoke to in Q4 said that they increased their spending in online advertising as a way to bolster the slower offline sales. Have you noticed any counter-cyclicality in the business? Could a weaker economy actually accelerate the shift in ad dollars online?"
},
{
"speaker": "Eric E. Schmidt",
"text": "Again, you have a thesis here which we don’t necessarily agree with and in any case, we are not going to talk about the current quarter. We are talking about the quarter that ended in December. I’m happy to say that we have not yet seen any negative impact from the rumors of future recessions. We’ll see what happens."
},
{
"speaker": "Sergey Brin",
"text": "But if I may add, I do think that certainly like you’ve seen from several of your contacts, it makes a lot of sense for advertisers if they want to be careful about their spending and they want to make sure they are getting a good ROI, to use the exact kind of advertising that we are offering. I think that makes a lot of sense and I think lots of advertisers recognize that."
},
{
"speaker": "Operator",
"text": "We’ll go next to Justin Post from Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "Thank you. Most of my questions have been asked, but one about your future -- when you think about revenue sources beyond search, what do you think your biggest opportunity is among software as a service -- video or display? Do you prioritize those? And do you think any of them could be material within the next two years?"
},
{
"speaker": "Lawrence Page",
"text": "I think it’s hard to prioritize the exact ones. I think we are making tremendous strides in apps, as we talked about. There’s tremendous -- those are of tremendous importance to people and we are also getting revenue from multiple sources there from advertising and from people paying for the service itself. And we’ve obviously seen tremendous growth in YouTube, which we already mentioned, which is great. I think we’ll be -- there’s going to be significant amounts of advertising there also. I’m pretty optimistic about all the new areas we are pursuing and the opportunities there will take -- you tend to underestimate the long term and overestimate the short term for any new thing and I think you want to be careful about that, but I’m very optimistic long-term."
},
{
"speaker": "Eric E. Schmidt",
"text": "There’s reasons to be optimistic about all the categories that you described. The display business is literally right in front of us and the DoubleClick acquisition is an essential part of that strategy, so we’ll see. But of course, we have a sales force that is perfectly capable of selling those, customers are purchasing those already, and it’s a market that would benefit from the kind of technology that Google can bring to market. In the case of YouTube, you have a huge forward opportunity just because of the scale of the audience, globalization and so forth, so to the degree that we can develop the ad formats that we describe, it again should become very significant -- exactly when is very difficult to predict. Some more questions?"
},
{
"speaker": "Operator",
"text": "We’ll take our next question from Heath Terry from Credit Suisse."
},
{
"speaker": "Heath Terry",
"text": "I was wondering if first you could update us on the local business and exactly where you are in continuing to try and attract advertisers to monetize the tremendous traffic that you’ve built within Google Maps, particularly what kind of progress that you’ve seen out of the local business referral model?"
},
{
"speaker": "Eric E. Schmidt",
"text": "Jonathan."
},
{
"speaker": "Jonathan Rosenberg",
"text": "I guess the biggest thing that happened this last quarter was the Local Plus Box, which we launched I think in late November. Basically that was an improvement to the local ads on Google.com. I think it’s only available for the top ads but basically what happens is we show a plus box for the local ads and it expands and basically gives you the advertiser’s address, the phone number, a map, and this is the kind of thing that you’ll see us moving more towards as we try to make our efforts there and our ads more consistent with what is going on with universal search, convey as much information as we possibly can in the ad related to what happens if you click through to it and try to figure out how to capture the local opportunity."
},
{
"speaker": "Heath Terry",
"text": "Great, and on the local business referral program?"
},
{
"speaker": "Omid Kordestani",
"text": "We’re not breaking any of those components out now. We are right now really focused on getting the right content, as Jonathan mentioned. A lot of the success of these areas will depend on having the most comprehensive listings and the right format and we are experimenting with all that, building the right relationships, and it’s still kind of early for us to break it out and really talk about the revenue performance."
},
{
"speaker": "Jonathan Rosenberg",
"text": "The one other thing that you could look at is I also believe that we have pretty much completely revamped the regional targeting system and how that works for the advertisers, and I would expect that there will be significant improvement from that as well."
},
{
"speaker": "Krista Bessinger",
"text": "We have time for just one more question."
},
{
"speaker": "Operator",
"text": "We’ll go next to Jeffrey Lindsay from Sanford Bernstein."
},
{
"speaker": "Jeffrey Lindsay",
"text": "We’d like to ask two things. First of all, could you give us any breakdown of the 889 new staff, geographically and/or by function? And then second, it looks like the TAC rate increased in the fourth quarter to 88%. Why did the TAC rate go up? What were the drivers behind this and were they one-off factors or were they factors that you expect would continue? Thank you."
},
{
"speaker": "Eric E. Schmidt",
"text": "On the hiring question, the first part of your question, you’ll remember that we hired a little ahead of ourselves maybe six months ago, so we’ve returned to our normal hiring process -- more international over time, a balance -- maybe 50-50, or close to it, technical and non-technical. We are a very difficult place to get a job at and so we continue to look to the very, very top talent in each and every position, and we do that worldwide and it’s working very well. And I don’t think any of that is going to change. I think that model for hiring and building the organization has worked for us for many years and I think it will continue."
},
{
"speaker": "George Reyes",
"text": "Our TAC rate is not 88%. We are looking at TAC as if it were a percentage of advertising revenue, which is roughly 30%. So as we’ve said, primarily this is all related to our AdSense partner sites and that’s -- which is where we are required to make the guaranteed payments and social networking is also something that is coming online pretty strongly."
},
{
"speaker": "Eric E. Schmidt",
"text": "So with that, I want to thank everybody. Thank you, Krista, thank the Operator and thank all of you for spending so much time once again on your afternoon/evening covering Google and we look forward to talking to you in our next quarterly earnings call. Thank you very much."
},
{
"speaker": "Operator",
"text": "This concludes today’s conference. We thank you for your participation. You may now disconnect."
}
] | null | null |
GOOGL | 3 | 2,007 | 2007-10-19 16:30:00 | Operator: Good day and welcome, everyone, to the Google Inc.Conference call. Today’s call is being recorded. At this time, I would like toturn the call over to Ms. Krista Bessinger. Please go ahead.
Krista Bessinger: Good afternoon, everyone and welcome to today’s thirdquarter 2007 earnings conference call. With me today are: Eric Schmidt, ChiefExecutive Officer; George Reyes, Chief Financial Officer; Larry Page, Founderand President of Products; Sergey Brin, Founder and President of Technology; JonathanRosenberg, Senior Vice President ofProduct Management; and Omid Kordestani, Senior Vice President of Global Sales andOperations. Eric, George, Larry, and Sergey will provide some thoughtson the quarter and then Jonathan and Omid will join us for Q&A. This call is being webcast from our investor relationswebsite and our press release, issued a few minutes ago, is now also posted onour website, as well as the slides that accompany today’s prepared remarks. Please note that a replay of this call will be available onour investor relations website in just a few hours. Now, let me quickly cover the Safe Harbor statement. Some ofthe statements we make today may be considered forward-looking, includingstatements regarding our investments, seasonality, traffic acquisition costs,increase in the cost of sales, plans to continue to invest in personalization,international growth, growth in headcount, and our expected level of capital expenditures. These statements involve a number of risk and uncertaintiesthat could cause actual results to differ materially. Please note that theseforward-looking statements reflect our opinions only as of the date of thispresentation and we undertake no obligation to revise or publicly release theresults of any revision to these forward-looking statements in light of newinformation or future events. Please refer to our SEC filings, including our quarterlyreport on Form 10-Q, for the quarter ended June 30, 2007, as well as ourearnings release posted a few minutes ago for a more detailed description ofthe risk factors that may affect our results. Copies of these documents can be obtained from the SEC or byvisiting the investor relations section of our website. Also, please note thatcertain financial measures we will use on this call, such as EPS, net income,operating margin, and operating income, are expressed on a non-GAAP basis andhave been adjusted to exclude charges relating to stock-based compensation.We’ve also adjusted our net cash provided by operating activities to removecapital expenditures, which we refer to as free cash flow. We report our GAAP results as well as provide a GAAP tonon-GAAP reconciliation in our earnings press release. With that, it is my pleasure to turn the call over to Eric.
Eric E. Schmidt: Thank you very much, Krista and thank you all again forjoining us. We are very pleased with such strong results in what is seasonallyone of our weaker quarters. When we look at it, revenue growth of course very healthy,both in google.com and also in our AdSense businesses. And the seasonalweakness in traffic was milder than we expected on google.com, which was a verypleasant surprise from our perspective. It is obvious to us that the searchquality investments that we are making are paying off, particularlyinternationally, as we do better and better in almost every country. Along with that, of course, we are working on expanding ourbreadth of ads offering with all sorts of new types of ads -- gadget ads, videoads, others coming -- and each of these initiatives gives advertisers new andinteresting ways to build relationships with their customers. So by building these deeper ad solutions, we really candeliver more value, especially in markets and industries where they’ve notreally had these kinds of tools before. These are highly measurable and ROIdriven campaigns and Sergey is going to talk a little bit more about this interms of the steps we are taking in ads. Looking at it as search, ads, and apps, on the apps side, weare now seeing a massive transition to web-based cloud computing at a consumerand enterprise level. We talked about this for a while and we now see not onlythe progress but also the future products, both from Google and from the otherfolks in the industry to make this really happen. In our case, of course, we launched the presentation productas well as closing Postini, which is central to our enterprise push. We are really on the cusp of a world where everyone cancreate, share, collaborate and find their content in the cloud anytime andanywhere. Before I turn it over to George for all I think the goodnews, let me say something about George. George announced his retirement. I’vehad the privilege of working with him from almost 20 years. I’m going toembarrass him now. And everything that I can think of financially that’shappened at Google has really had George in the middle, whether it’s goingpublic, building the infrastructure of a multi-billion corporation, our largecash position, the secondaries, the financing, very, very good investorrelationships, the openness that we are now seeking, the financial disciplinethat exists in the company and also amazingly, our ability to deal with Section404 and Sarbanes-Oxley -- all driven not just by George but people he broughtinto the company. With that, George, and hopefully an even better introductionto come -- go ahead, George.
George Reyes: Thanks, Erik and good afternoon, everyone. We had a verystrong quarter across the board, with continued impressive growth in ourbusiness. Gross revenue increased 57% over last year to $4.2 billion. OurGoogle.com performance was strong at $2.7 billion, representing year-over-yearrevenue growth of 68% and a 10% increase over last quarter. As was the case in Q2, Google.com traffic was stronger thanexpected, reflecting a milder, seasonal affect than we’ve experiencedhistorically. Consistent with past summers, we also saw strong growth inmonetization, supported in part by healthy pipeline quality improvements. We are particularly pleased with our AdSense performance,which grew 8% over the second quarter and 40% over last year to $1.5 billion.Both the AdSense for content and AdSense for search businesses were strong aswe experienced continued increases in traffic and improved our ability tomonetize our newer partner relationships. Let’s now take a look at aggregate paid clicks growth.Aggregate paid clicks include clicks related to ads served on Googleproperties, as well as ads served on our partner sites. Aggregate paid clicksgrew approximately 45% over Q3 of last year, and increased approximately 5%over Q2. Let me now discuss our international performance.International revenue grew to just over $2 billion, or 48% of revenue. The U.K.reported revenues of $661 million, and 10% sequential growth, led by thestrength in the finance vertical. The region consisting of Belgium, TheNetherlands, and Luxembourg also experienced notable growth in Q3. The travel vertical was a contributor of growth acrossFrance, Italy, Spain and Portugal, and helped drive monetization growth. And in Asia and Latin America, where we are still buildingour presence and investing heavily, we continued to experience strong growthrates in countries such as Brazil, China, and Korea. Let’s now turn to operating expenses. Traffic acquisitioncosts were $1.2 billion and 29% of total advertising revenue, down from 30% inQ2. AdSense TAC was $1.1 billion, while TAC related to distribution partnersand others who direct traffic to our website totaled $105 million in thequarter. As we have discussed previously, as we grow our AdSensepartner network and embark upon new initiatives, we may see pressure on TACrates going forward. Turning to other costs of revenue, other costs of revenueincreased $29 million over the prior quarter, primarily as a result ofincreases in costs related to our data centers, including depreciation,equipment, operations, content acquisition costs, data licensing fees, andamortization. We anticipate that our cost of sales will continue toincrease going forward. Let’s now turn to operating expenses. Operating expenses inQ3 other than cost of revenue included approximately $200 million ofstock-based compensation and totaled $1.3 billion. Expenses related to payroll and facilities increased $34million to $659 million. During the quarter, we added 2,130 employees, themajority in engineering and sales and marketing. At the end of the quarter, wehad a full-time employee base of 15,916. Consistent with previous years, a large portion of ourstarts in the third quarter were related to university hires. Approximately1,000 employees had accepted offers earlier in the year but started in Q3,after the end of the academic year. Included also are approximately 300 employees from thePostini acquisition which closed in September. As we have previously discussed,we are continuing to take a careful look at how we can more efficientlyallocate resources across functions and globally. Let’s now turn to non-GAAP operating profit, which excludesstock-based compensation. This was $1.5billion with non-GAAP operating margins of 36%, up from 35% in Q2. As we havestated previously, margins may decline as we continue to make investments inour business. Now, turning to cash, operating cash flow was $1.6 billionand CapEx for the quarter declined to $553 million. The majority of our CapExwas again related to IT infrastructure investments, including data center, construction,production of servers, and networking equipment. We intend to make similarinvestments going forward as we continue to build a global infrastructure andresources necessary to serve and improve our product for our users and ouradvertisers. Lastly, free cash flow, a non-GAAP measure which we defineas cash flow from operations less CapEx, increased to $1.1 billion. Now, we will turn it over to Larry for more comments on thequarter.
Lawrence Page: Thank you, George. I am really excited to talk to you alittle bit about search and our improving search quality this quarter. We had alot of improvements we made to search quality for users and markets outside ofNorth America and I am very excited about that. It’s a big part of our trafficand we launched several dozen search quality improvements in specificparticular international markets and we are especially happy with the resultsthat we had in Russia, Thailand, Japan and Arabic speaking markets. In mobile search, our search traffic there increased bothdomestically and internationally and the mobile apps traffic is growing well,particularly in maps. YouTube also launched their public site to stream selectYouTube content to mobile devices, of course, sporting the [inaudible] edition,which we launched last quarter. Mobile ads are really doing well, especially in Japan wherewe had strong revenue growth and we also launched mobile ads in Korea. Let me tell you a little bit about our user experienceworldwide, and especially about personalization and some new features. iGoogle,which has just been growing tremendously, expanded up to 43 domains now. We’rereally excited about that. We also made it easier for users to set up their homepage oniGoogle, and that increased retention and usage. I love looking at some ofthese -- the weather, even though in California isn’t such an issue for us,still good to know what’s happening, and I can very easily get that on myhomepage now. The number of available gadgets are increasing significantlyand the developer ecosystem there is really growing. Now in book search, we really increased funding of relevantbook results a lot this quarter, and we think that has a significant effect onimproving quality. Our book search index is also huge now. It’s over a millionbooks. You think about trying to stack those up on your desk, it would takequite a bit of space. We also added several new partners there with a total of 27partners now involved in that product, and we introduced a number of newfeatures. Now, let me switch gears and talk to you a little bit aboutmaps and Earth, our geographic products. In maps, we really opened up an [outlookAPI] that makes maps a developmentplatform and it makes it easy for people to put their own functionality intomaps. For example, you can get real estate listings just when youare looking at maps, or real time updates to gas prices or ski and snow reportsright on your Google maps provided by third parties. In street view, which is a feature that lets you see a viewof a particular street or house or business, we added five cities in Q3 and sixmore just in the last week, so we are very excited about that. There’s a totalof now 15 major cities where you can see street level views of almost anywherein the city. In Earth, last week we actually launched a YouTube videolayer on Earth. You can go to different areas and see videos users have postedabout that area, and I looked at a few from Brazil that are very interesting.And companies like the Hidden Bay Lodge in Ontario posted a fishing video aboutgoing fishing there, so we are very excited about too. So I will turn it over to Sergey now to talk to us aboutprogress in ads and apps.
Sergey Brin: Thanks, Larry. I am really excited to tell you today whatwe’ve done over the past quarter in ads and apps. As you all know foradvertising, our real philosophy is to create win-win between advertisers andcustomers by presenting users with really relevant information which isinteresting to them that’s likely cause a transaction to commence, we arereally helping out both. But it is also important that it is not just what we say,but we can actually prove it, and so measurements of our return on investmentand the ability to optimize the investment is really important for advertisers. We have a lot of tools now available for advertisers to dothat but I want to highlight a couple of new ones and a couple of updates forthis quarter. In beta testing right now, we have the conversion optimizerand this lets advertisers adopt an ROI driven financial model even more easilythan just going straight with a kind of a cost-per-click type bidding.Basically, clients specify, advertisers specify how much they want to pay for acustomer and then we automatically optimize for them in each auction how muchthey ought to be bidding in order to accomplish that goal. We’ve also launched a new release of our website optimizer,and this is where advertisers can run and create these AB kind of splitexperiments. You know, they can change their website layouts, they canrearrange their content, and this is very important because there is tremendousvariance, even once you get a user on your website how likely are they toreally understand what they are seeing, how likely or how easy is it for themto use, and ultimately what percentage of those users do actually perform atransaction? And this was a really great way to optimize that, to make a reallybig difference in the business. Next I want to talk about some new app formats that I amquite excited about. And this does not mean that really flashy, in-your-facestuff. For example, we’ve launched our gadget ads and this is a global betathat we are running now. And for gadget ads, you can actually put functionalityinto the advertisement so it is more than just something to look at and clickbut something you can really interact with. We have a Nissan gadget ad running right now that lets youpunch in your zip code, you get local traffic. It’s fun for users, it helpsNissan build brand. We also have gadgets that are actually really function towhat the company does. For example, if you are trying to book a flight or whatnot, you can punch where you are flying from and to directly into the ad.Anyway, we really are excited about these. Of course, you’ve probably heard about our in-video ads, aswell as the AdSense video units. So basically, instead of trying to dosomething, say a pre-rollout for video where you would have to watch acommercial before watching the video, that would really not make sense,especially the kinds of several minute type videos we typically show onproperties such as YouTube. It would be very distracting. Instead, we have a really nice ad that shows up in thebottom 20% of the video that just overlays for a few seconds after the videostarts playing and in fact, the initial user response rates have -- well, theuser responses and feedback have been positive and we’ve had betterclick-through rates than we anticipated. So I’m very optimistic about this adformat and this is the kind of thing that we have to do when we develop new adprograms. You have to experiment with different kinds of things until you canactually find formats that really work for users and for advertisers. The AdSense video units of course are -- the YouTube videoscan be embedded on sites in the AdSense network, and this certainly providesmore distribution for the videos. They allow us to have contextually targetedads in the video player and this creates this three-way revenue share, which isreally a win-win-win between the publisher, the video’s producer, and Google. I also want to, just while on the subject of video ads, justmention TV ads, which we of course have been running now for a while. We’vereally been getting a lot of interest and bookings from advertisers. And theremarkable thing about television is, it’s surprising, but in fact of theoffline advertising, it’s the one that’s closest to Internet levelaccountability and we feel we can bring much greater ROI type accountability totelevision advertising, much as we’ve done online. Let me take a moment to talk about apps and what we’ve beendoing there. We’ve been growing. We’ve been seeing a lot of adoption of certainapps for your domain, apps for your university. The University of Phoenix, which is up to about250,000 accounts now, students, faculty, employees and so forth; Northwesternis now offering it to all students, that’s on the educational front. For companies, we have a partnership now with Capgemini,which integrates Google apps into their suite of offerings and then Capgeminiprovides the systems integration support. And we are really excited aboutworking with third parties like this because there are just so many greatcompanies in the enterprise space that really know how to work with thecustomers and can plug our technologies in where it makes the most sense. We also closed the Postini acquisition and not only did weclose it, but we already have deployed some of the Postini functionality onGoogle apps for domain and this was just an automatic upgrade for our appscustomers. Now, in the apps suite, we now have rounded it out a bit.For example, we launched Presentations, so you can create a presentation, youcan import one, edit them and share them, and what this basically means now,for my usage, whenever I get e-mails or I need to work with somebody onsomething, I don’t really have to leave the web browser. And for Presentations,it’s great because you want to collaborate on a presentation. If there’ssomething you’re presenting, you want to get ready ahead of time. You can also,as you are even watching a presentation, you can make comments on it and whatnot. You can even just go to the URL of the presentation as you are beingpresented to and page through it forward or backward without having to havereceived a large attachment or having a big printout or something like that. It is really convenient and I think has the potential tochange how people really work together. Now, these apps support a total of 27 languages now. Weadded six more this quarter, so it is a very international product and we aregetting adoption worldwide. An important piece that we are working on has to do withoffline functionality because of course, you don’t want to just have access tothese things when you are on -- if you want it in an airplane, you want itsomewhere where you just don’t have Internet or your Internet connection goesdown or is flaky. And the Google Gears was launched in Q2 to address that. Ourreader, as you all know, is our first geared application, as we call it, andthe fact that it is very nice. I encourage all of you to try this product. Itis very fast. It obviously downloads all the items, so they are pre-fetched.They show up quickly. But you can expect more and more of Google's applications toshow up in geared versions so that you can work untethered. Anyhow, I’m very excited about the progress we’ve made onboth fronts. Thanks for your time and now back to Eric.
Eric E. Schmidt: Thanks a lot, Sergey and looking back at the quarter, it isobvious to us that our model continues to work very well. It is a systematicapproach that we have to innovation and the way in which the company isexecuting speaks for itself. The strategy of search, ads, and apps seems to resonateperfectly with this worldwide transition, if you will, to the use of theInternet on many, many difference devices, so all very exciting from a Googleperspective and again, thank you for listening so long to us. Why don’t we go ahead and get your questions and see whatpeople think? Krista.
Krista Bessinger: Operator, we would like to go ahead and poll for questions.
Operator: (Operator Instructions) We’ll take our first question fromImran Khan from J.P. Morgan.
Imran Khan: Thank you for taking my questions. Two questions; numberone, if I look at your network revenue, Google network website revenue, thatimproved significantly in Q3 after being roughly flat in Q2. I was trying tobetter understand what is driving that growth. Secondly, you have been working with MySpace for a while andto get a better sense of what you have learned, how monetizable these socialnetworking sites are out there and as these social networking sites engagementsare growing so quickly, are you concerned that that could be a point of entryon the web?
Eric E. Schmidt: Thank you very much for your question. When we look at thenetwork revenue, a lot of the benefit we think is simply coming from greatertraffic to our partners and then also strong monetization gains and the way ourad networks work. Omid, can you give us some color on how the partners viewthis?
Omid Kordestani: Sure, Eric. We look at basically both seasonality of thepartners and their distribution strategy. Some of our partners benefited lastquarter from having greater distribution of their services through their ownefforts of syndicating their search and advertising or using our services, andwe have been ramping up partnerships in the UGC space and we’ve seen nicegrowth in that space from partners, like MySpace. I’ll let Sergey maybe add to the monetization angle here.
Sergey Brin: We’ve been very pleased with our partnership with MySpace.We’ve been pleased with the advertising performance. It has been a lot of workand innovation, actually. I know you might not see it from kind of a the userinterface point of view that you see, but we are developing really newtechnologies and I think these social networks are going to require a differentkind of targeting technologies, difference concepts of advertising. We’ve already made big strides. It’s obviously a challengebecause there is so much inventory, people can be distracted by very manydifferent things and it is very personal, so there are a lot of things thatmake it hard. But our technology, our targeting, all those things areactually coming along very well and we are really happy. We view it as a greatopportunity. I mean, it is just so much more inventory that if done correctlycan create that kind of win-win I was talking about between advertisers andusers.
Operator: We’ll go next to Anthony Noto from Goldman Sachs.
Anthony Noto -Goldman Sachs: Thank you very much. You talked on the call about iGoogleand the positive feedback you’ve gotten from user metrics and I was wonderingif you could comment a little bit about improving that product even further.It’s a great application to allow me to more efficiently use Google. I don’thave to enter in searches for all the information I want to have on a dailybasis. And there’s two things I think that could make it a lotbetter, and the real root of my question is, is there a technology limitationto doing the following two things, or a legal limitation -- the first is other,pulling in other applications that are popular on in the Internet, specificallythose that have been written to Facebook and others. Second, you’ve also talkedabout advertising being a form of content and in many of the verticals that Ihave on iGoogle in my account, such as movies, would really benefit fromdisplay advertising as an additional form of information. So is there atechnology and/or legal or other considerations that have limited you puttingdisplay ads on a the page or pulling in other applications? Thank you.
Eric E. Schmidt: Thanks very much, Anthony, for your good productsuggestions. There are some legal limits as to what we could do. We obviouslyhave to get permission of the partner and content in so forth and so on. Thereis no intrinsic reason why the vision that you painted can’t occur and in fact,part of our developer strategy is to get people to build what we call iGoogleGadgets, and we encourage the site that you name and others to make themavailable. We need to work with them. We obviously can’t do it withouttheir permission. Jonathon, do you want to talk a little bit about the displayads?
Jonathan Rosenberg: In particular with respect to gadgets, Anthony, we arecertainly going to be offering a lot more functionality through the gadgets.The current focus with them really is the user experience. We’ve done somethings with themes which we think have been a pretty big success, but reallywhat we are trying to do is figure out how to integrate much of what we aredoing with iGoogle and also the concept of these gadget ads, which Sergeymentioned. What is so powerful there is that the gadget ads just don’tserve up your simple brand impression. What they do is they get people toengage with the brand and then we can actually empirically measure the level ofengagement, which is much more powerful than the things people havetraditionally done with display. One of the things that I would suggest you do, Sergeymentioned one of the gadget ads, the Nissan ad, I think if you type into Googleeither Honda gadget ad campaign or the Six Flags gadget ad campaign, you’ll getsome examples of some campaigns that have leveraged this technology to reallydeliver.
Eric E. Schmidt: Our next question.
Operator: We’ll go next to Benjamin Schachter from UBS.
Benjamin Schachter -UBS: If I’m reading the TAC rates right, it looks like thepartner TAC went down pretty meaningfully, and then the TAC associated withGoogle.com went up as a percentage of revenue. I’m wondering if you couldcomment on those trends. Also, you mentioned in the prepared comments about the levelof accountability on TV ads. At a high level, can you talk about the learningsthat you are getting from targeting ads on the search side, how those will workwith both video and display, possibly offline and on? Thanks.
Eric E. Schmidt: Jonathon, do you want to talk about TV ads first?
Jonathan Rosenberg: Sure. I think TV ads could actually really beunderappreciated for the reason that you mentioned, in terms of our offlineefforts. This is really one of the few places where you can bring the same typeof Internet level accountability to offline advertising, so with searchadvertising, obviously our customers see real-time how their ads performed. The same thing is really true with the feedback mechanismthat we get with set-top boxes. We are bringing the same level of granularityto the offline TV format. The trials that we have right now are with EchoStarand Astound Cable. And what we are able to do there is we are able to show theadvertisers when their spot is playing and look at the viewing levels of usersactually during the course of the spot, so we are very excited about how thatis playing out and we think it bodes very, very well for our progress in TV.
Eric E. Schmidt: Why don’t we talk about TAC rates? George, do you want tostart that?
George Reyes: So our AdSense TAC went down slightly, but on the otherhand, Google.com TAC went up, and primarily driven by the partner mix.
Eric E. Schmidt: Our next question.
Operator: We’ll go next to Robert Peck from Bear Stearns.
Robert Peck: I had a question on future use of capital here, and as Ithink of any large expenditures going forward -- first of all, I was wonderingif maybe you could comment on Google's desire to maybe put a large investmentin Facebook or a large social network? And then I was wondering if maybe Larrycould talk about the importance of 700-megahertz going forward. I mean, itdoesn’t look like [inaudible] will probably codify what Google wants for the700-megahertz, so does it come to a point where Google has no choice to notonly put a token bid in but to also sort of bid to win, whether it be with aconsortium or what not?
Eric E. Schmidt: On the question about specific investments, as you know, Ican’t really comment on any specific investments. I want to assure you all thatthe cash isn’t -- it’s not burning a hole in our pockets. We don’t feel somegreat need to spend it right now for any particular reason. We would do aninvestment that is capitaled if we thought it was incredibly strategic. Many ofthe partners we’ve been able to work with, we’ve not needed to do such aninvestment. They are happy partnering with us simply because of our technologyand our ability to monetize. Larry, do you want to comment about 700-megahertz?
Lawrence Page: Sure. I think we’ve been actually quite happy with theopenness provisions that have been put into the 700-megahertz auction, so Idisagree with your assertion there. I think we have many, many different options available to usas a company, in terms of spectrum and connectivity for people in wireless andso forth, so I don’t think we feel like there’s any desperate need for us tohave to bid to win or anything like that. And again, the money is not burning ahole in our pockets.
Eric E. Schmidt: Next question.
Operator: We’ll go next to Christa Sober Quarles from Thomas Weisel.
Christa Sober Quarles- Thomas Weisel Partners: First question is just around in the mobile side, we’restarting to see sort of a convergence among hardware, software and services,you know, a la Nokia’s bid for NAVTEQ. I was just wondering, do you feelcomfortable with your current position on just having applications and theubiquity that you can achieve in the distribution of those applications? Secondly, I was just wondering if you could give us anupdate on when you think DoubleClick might get some clarification on when thatmight close. I guess the EU decision begins next week, but just an update therewould be great. Thanks.
Eric E. Schmidt: On the DoubleClick side, we are following all of theappropriate steps that are needed to get worldwide approval and we arecertainly optimistic. It would be I think premature for me to suggest anyparticular timing. I can tell you we have a pretty close working relationshipwith all the people who I think in my view responsibly are checking on doesthis make sense and so forth. But we believe it will ultimately result in avery good outcome for us. On the mobile side, we have talked at some length about ourmobile application strategy. We are very happy with it. Mobile applications,there’s some evidence that we are becoming the leading mobile applicationsprovider, at least in certain segments, and the mobile story is a very strong onefor Google. It is also a great one for the world. You see over and over again one company after anotherannouncing a new interesting mobile platform. We want to make sure that Googleand its technology is a part of each and every one of those platforms. Next question.
Operator: We’ll go next to Mark Mahaney from Citigroup.
Mark Mahaney -Citigroup: First, congratulations to George for a job extremely welldone. Just to keep going on mobile, what I’m trying to figure out is how muchof the future investment requirements success for Google in mobile couldentail? And the setup here is you’ve obviously achieved a leading position as aPC search service without the need to develop a Google PC or a PC operatingsystem or an Internet access service with all the infrastructure requirementsthat that would entail. Is there any reason that your success in the mobile Internetworld would require any similar type developments -- a Google phone, a mobilephone operating system, or a wireless access infrastructure with all of therequirements that that would entail?
Lawrence Page: I don’t think again that there’s a requirement to do anythings like that. I think Google, obviously we’ve grown a lot since we enteredthe search business and the opportunities that are available to us aredifferent, and there are opportunities for us available in those kinds ofspaces. And we would also love to get even greater numbers of people and wideraccess to our applications that we provide. So I think that it is more of an opportunity for us then acost. We have tremendous usage of our current mobile applications and we havedeals with very, very many different wireless carriers and so on, and manyother types of carriers. I think those things will all continue.
Eric E. Schmidt: Next question.
Operator: We’ll go next to Douglas Anmuth from Lehman Brothers.
Douglas Anmuth -Lehman Brothers: It looks like you added more than 2100 net headcount adds inthe quarter, which is significantly more than you added in Q2, despite beingmore focused on headcount. So even ex Postini, it looks like it is more than1800. So can you give us some color on the timing of your hires during 3Q andalso how we should think about this in relation to margins going forward? Thankyou.
Eric E. Schmidt: Obviously can’t talk about margins going forward. What wesaid last quarter, as you know, is that this is an area where we needed tospend some more time and focus more on what is the appropriate rate. And thegood news is we have done that. The numbers that you are seeing are essentiallyan overhang and they are an overhang from hiring that had been agreed to many,many months earlier. June, of course, is a major college hiring, universityhiring, professor hiring kind of a cycle, so I don’t know that that will berepeated. The important thing here is that we did in fact correct andI think going forward, you should be comfortable that we are paying a lot ofattention to the headcount.
Douglas Anmuth -Lehman Brothers: Thank you.
Operator: We’ll go next to Justin Post from Merrill Lynch.
Justin Post: Thank you. The gap between your revenue growth, 57%, andyour sponsored click growth, has been maintained around 12%. Could you talkabout the drivers there, where you are in your monetization cycle? Do you havea pretty good pipeline of things coming forward? And do you think things like YouTube and AdSense for contentcould actually grow that gap as we look out to next year?
Jonathan Rosenberg: I can maybe cover some of the monetization issues. We arecertainly very happy with the product upside that we achieved this quarter. Itwas really -- it really came out of over 20 quality and UI improvements that welaunched. There were two very big things that we’ve talked aboutpublicly. The first was the reserve base promotion, and actually we onlylaunched that in late August, so it only had part of the quarter to manifestitself in terms of improvements, and that was basically the change to theformula which determines which ads are shown above the search results, so thatwas certainly significant. We’ve also been doing some things like previous query basedad targeting, which is pretty significant. We’re looking at the previous queryto try to figure out what to do on the next query. So we’re pretty confidentthat we’ve got many, many more ad quality improvements like these. We’re also launching them internationally prettyexpeditiously, so from that standpoint we think there is a very healthypipeline in ads improvements.
Eric E. Schmidt: Next question.
Operator: We’ll go next to Brian Pitz from Bank of America.
Brian Pitz: Your CPC growth rate accelerated from 7% last quarter to 8%this quarter. Can you provide any commentary on this, including is this drivenby your recent algorithm change? Secondly, with respect to your ability to monetizesignificantly better than competitors, is there the possibility for TAC ratesto continue to come down, especially with respect to the upcoming renewal ofAsk.com? Thanks.
Eric E. Schmidt: Jonathan and Omid.
Jonathan Rosenberg: I’ll let Omid handle the Ask.com comment. Basically you aretalking about a 1% difference. CPC, as we’ve talked about in the past, islargely driven by mix, so I think if you looked at the monetization improvementsthat I mentioned, that is certainly a component of it but a large part of it isalso a mix issue. Summer does tend to be modestly higher from a CPCperspective. One of the things that we see is that there is a lot less academictraffic, which Google has disproportionate to most of the other players in themarket. So with less non-monetizable traffic and modestly moremonetizable traffic, that is a mix that actually does play a role.
Omid Kordestani: We are going to I think enter a period where you will see alot of these fluctuations so it will be hard to predict. One is driven bypartner renewals, like the ones you mentioned where we obviously focus onpreserving our relationships with as many of our partners as possible,including Ask. But the other thing that is going in parallel with thatobviously is increasing the quality of our network and our partners are alsoactively involved with distribution strategy of their services, like we are. I think the mix of those effects is really hard to predict.We are trying to improve the quality overall, which will I think actuallyeliminate some growth in terms of distribution in the network. That’sunhealthy, in our opinion, for the network. On the other hand, the renewal and improvements in monetizationreally drive up the monetization [efforts]. So that makes it hard to predict atthis point.
Jonathan Rosenberg: The one other thing I would add is that all of the adsquality efforts are very, very focused on eliminating a lot of the bad ads, andin particular, it’s a lot of the very bad ads which are low CPC, so one of thethings you will see is that as we improve ad quality, reducing coverage whichin general is what we’re doing, you will see the CPC increase because thoselousy ads are generally the nickel or thereabouts types of ads.
Brian Pitz: Thank you.
Eric E. Schmidt: Our next question.
Operator: We’ll go next to Jeffrey Lindsay from Sanford Bernstein.
Jeffrey Lindsay -Sanford Bernstein: We would like to ask a little bit more about the 2100 newhires, or the 1800 after Postini. We noticed that a high proportion came insales. Could you possibly give us an indication of the geographic split forthese new hires, overseas versus domestic? And then, could you give us an indicationfor the rationale for the expansion of the sales force? And given that a lot ofyour sales are automated, wouldn’t expansion of the sales force be taking yourcost structure in the wrong direction?
Omid Kordestani: A couple of important factors in that, some of them youmentioned. First, we have been very focused in having the proper level ofpresence in every country that makes sense for us to have, both our partnershipteams as well as advertising sales teams that directly work with customers. As you can imagine, in some of the emerging markets, forexample, both in Asia and in Europe, we’ve had actually early success withadvertisers working directly with our system through our online channel.However, you reach a point where local education are helping the efforts onmonetization with the clients. It requires the presence and what our focus hasbeen is to really push our field sales forces, our direct sales forces, toreally spend their time on the named accounts and also represent the full suiteof products that we have. So one of the things we are trying to avoid is havingmultiple sales forces for the different products and services we have. Forexample, the YouTube activity; one of the great efforts we have done, both inNorth America and other regions, is to actually train the sales force andcombine effort so that our customers receive one voice and one representationfrom the company covering the majority of the products. At the same time, what we are doing is paying a lot ofattention to cost per revenue dollar metrics and sales force productivity andputting the right customers in the right channels and mapping that with oursales organization where again, we balance the direct sales force that is inthe field versus the operations team and sales efforts that go on in our bigoperation centers in Dublin and in Argentina, in local countries in Asia and inIndia, which we have a major presence in.
Eric E. Schmidt: Next question.
Operator: We’ll go next to Youssef Squali from Jefferies.
Youssef Squali -Jefferies & Co.: Thank you very much. Can you talk about monetization on thevideo side and YouTube in particular? You’ve started syndicating that contentacross the ad network. When do you turn up the monetization dial on that? Is itan ’08 event? What’s preventing you from doing it now? And secondly, I guess for Sergey, is it fair to assume thatyou’ve decided to go with ad overlays over a pre-roll and potentiallypost-rolls? Thanks.
Sergey Brin: Let me just take both of those. We’re certainly progressingon monetization for YouTube and what not, but that’s not the number onepriority for that property right now. We continue to grow the traffic andimprove the user experience. We continue to really improve the publisherexperience and also, we are working on things like the fingerprinting, which weannounced recently, which we have just really fantastic technology for. On the advertising UI, we are very pleased with the overlaybut I don’t think we are ever going to say this is it from now on. We are goingto continue to test a variety of different formats. When we started in UIs for advertising on search, were bythe way the little text ads, we were considered really crazy. I mean, it took along time to really perfect that to get advertisers to really understand it,learn it, and ramp the monetization. Here also I think we are in for along-term investment.
Youssef Squali -Jefferies & Co.: Thanks.
Eric E. Schmidt: Next question.
Operator: We’ll go next to Heath Terry from Credit Suisse.
Heath Terry: Thank you. As you start broadening out your advertisingformats with your television relationships, YouTube, to what degree are yoursearch advertisers starting to manage these mediums from a single point ofcontact for you? And how far along are the more traditional branded advertisersin beginning to look at their Internet and traditional forms of advertisingalongside of each other when they are trying to evaluate the effectiveness ofthat advertising?
Omid Kordestani: We are actually spending a lot of time -- that’s a very goodquestion -- in terms of how we should focus on the core business and help alladvertisers, including the major Fortune companies and companies across theworld, really take advantage of search. That’s a proven model for us. We reallyunderstand a lot about it and that is something we -- the sales force spendsthe majority of their time doing at this point. In these other areas, as Sergey mentioned, for example, weare really prioritizing in the case of YouTube the user experience but at thesame time, we are having great demand and interest in advertisers trying thesenew formats and working with us. So in the case of radio, TV, print, all ofthese are new initiatives. We are seeing a lot of interest. We are spendingtime on it and really trying to balance not losing focus on the core businessthat we really understand well and clearly works with the advertisers, as wellas getting interesting trials going, trying different formats. So I think we are very confident in terms of the future ofthese formats, and especially the video, which is a great area of focus for us,as well as TV. I would say those two areas, you will see a lot of progress fromus in the coming quarters and search will continue to remain a very, verystrong focus.
Eric E. Schmidt: Next question.
Operator: We’ll go next to James Friedland from Cowen and Co.
James Friedland -Cowen and Co.: Thanks. I didn’t hear any comments on the call about GoogleCheckout, and now that we are heading into the holiday season, I just wanted tosee if we could get some commentary on what you are seeing in terms ofadoption, especially in the U.K. where you just launched. Secondly, CapEx, while we expect it to continue to growquickly, has gone down sequentially and I was just wondering if you can commenton how it has been trending in the core search business in terms of ROIC. Onthat incremental dollar spend, are you getting better returns on your searchCapEx today than you were say 12 months ago? Thanks.
Sergey Brin: On Google Checkout, Google Checkout is continuing to grow.We are very excited about it. I personally use it all the time. We’ve beenadding a number of great merchants. Most recently, we added B&H, which happensto be my favorite camera equipment store. But we are adding many others aswell. We are excited going into Q4 because we have -- it’s afairly young product and this time, we get to develop it further into theholiday season, so we are really excited about that one. On your other question, I am going to turn it over to --
Jonathan Rosenberg: This is Jonathan. I caught the checkout part of thequestion. Maybe we can follow-up and get the second half. I just wanted tomention Sergey’s shopping experiences are too limited. We’ve got a big chunk oftop 500 merchants. In Q3, we launched PetSmart, Drugstore.com, Shoebuy.com, andthe NHL Store. I think the real story that is important there is that manyof the advertisers that we are working with, such as Jockey, are reporting much,much higher click-through rates. They achieved as much as 60% higher withCheckout and they decreased the cost-per-click by over 31% with Google AdWordsand Google Checkout. So we are seeing much more significant volumes in terms ofsome of these advertisers and the performance with the advertisers. I’m not sure I got the other half of your question.
James Friedland -Cowen and Co.: The other half was on the returns on invested capital onsearch CapEx, because CapEx has been trending down a little bit. It’s stillexpected to grow quickly but for that dollar spend on search CapEx a year agoversus today, are you seeing improved returns on your business?
Eric E. Schmidt: That’s a good question. We don’t actually use that metric inthe way you phrase it. What we are really trying to do is to invest the capitalof our shareholders as wisely as possible. As you know, we have built large andvery powerful data centers that are largely custom designed. Those data centersdo more than just search; they do advertising, they host apps, they do GoogleEarth and maps and so forth and so on. We are quite comfortable that that investment, which wemonitor incredibly closely because it is, you know, millions of dollarsinvolved, really does translate into superior financial returns. One way to think about this is that a year ago, people wouldask us about capital, why we were spending on this money on capital, and we’dsay we’ll get it. We’ll get it back in scale and in systems and so forth. Andyou are seeing the benefit of the investment a year ago. Hopefully you’ll seethe same investment return in the year for what we are doing today.
James Friedland -Cowen and Co.: Thank you.
Eric E. Schmidt: Thank you. Next question.
Operator: We’ll go next to Sandeep Aggarwal from Oppenheimer & Co.
Sandeep Aggarwal -Oppenheimer & Co.: Thank you. Two questions and one, sorry, again, asking aquestion on mobile search, but I wanted to know if you can share what kind ofmix are you seeing in terms of a search query initiated by [mobile] versus PC,and if there is basically a trend you can share versus last year? Secondly, you have completed one quarter with universalsearch. If you can make any comment in terms of what kind of improvement theend user has seen and what kind of benefits advertisers have realized? Thankyou.
Eric E. Schmidt: On the mobile search side, our mobile searches areincreasing rapidly compared to a year ago. They are growing more quickly thannon-mobile searches. They are still a very small percentage of total searches,which is of great frustration to us and we are working very, very hard withsome mobile operators to get Google Search to be as standard as possible onevery phone -- very quick and very responsive. Because we think the peopleusing phones really want to use Google to solve interesting informationproblems. Jonathan, do you want to handle the second question?
Jonathan Rosenberg: The second question specifically on universal search, Ithink as you know we launched at the Searchology event back in around themiddle of May. We are very pleased with the increases in traffic which we sawthis summer, relative to the traditional seasonality. I am not sure that I canstatistically attribute the causality to universal search but certainly what weare seeing is very, very favorable feedback from users. We are seeing goodclick-through rates particularly, as Larry mentioned, with the betterintegration of pieces from different data sets like book search. So as we addmore books into the index and make it blend better, we certainly see higherclick-throughs. So in terms of revealed user activity, what we are seeing isvery strong. Whether or not that is actually what drove growth is unclear. Ithink it is certainly a component.
Eric E. Schmidt: Our next question.
Operator: We’ll go next to Mark May from Needham & Company.
Mark May: Thanks for taking my question. It is increasingly clear thatin order to succeed long-term in the online marketing services space, that it’sbest to have a broad set of ad format capabilities. The question is can youprovide us with some data points that illustrate Google's current position inwhat I think is the largest of those, or one of the largest, which is brand ordisplay ads? And what are you doing to better your position there?
Omid Kordestani: I think at this point it is still early for us to be able toreally put any markers. What we are very busy with is just engaging thecustomers, training the sales force, trying these new formats, understandingwhich ones work best. It is clear that the engagement model is of great interest,things like the gadget ads that we mentioned. The accountability and themeasurements, the kinds of things we are doing in TV that we discussed earlier-- all of those is very meaningful to the advertiser and there is greatinterest from them to participate in these trials we are doing and these testswe are doing. I think we should be in a position to share more informationwith you in 2008 as we get more of these services out of beta, as well as signup more partners, more inventory and get the advertisers to have more spendingin these. I think you’ll, as I mentioned earlier, I think you will seethat primarily happen initially in both TV and the video space for us.
Krista Bessinger: I think we have time for just one more question, please.
Operator: We’ll go next to Jason Helfstein from CIBC World Markets. JasonHelfstein - CIBC World Markets Thanks. Two questions, one quick one and then fairly longer;are there any market share numbers or growth rates you can provide for Chinaand India? And then my second question relates to the consolidation weare seeing of network guys by AOL and Yahoo!. It seems to us that that’s kindof a play on behavioral marketing. Do you have any concerns if they are notcareful, it might trigger privacy concerns for the industry and legislation orsomething we obviously don’t want to happen? And are there any discussions thatare going on perhaps at the industry or IAB level, so everyone is careful inthat regard? Thanks.
Eric E. Schmidt: On the growth rates in China and India, we are starting froma relatively smaller base in a number of other countries, and so the growthrates are quite significant. We would expect that to continue until they get tosome reasonably stable growth pattern. Both markets are growing quickly. Bothmarkets are under-penetrated in the Internet as a whole. In China, as you know, we have a local competitor who hasmajority share. In India, it appears as though we have majority share. But inboth cases, it’s essentially an open field for all the players. On the question of consolidation and some of the privacyconcerns, this is something that we spend a lot of time on and we are veryconcerned that the actions of the industry as a whole, people who are concernedabout what happens on the Internet could somehow affect us or really hurtconsumers. From a Google perspective, we had done a number of things tothat respect. We have announced a whole bunch of policies around cookies andlog retention, which are innovative in the industry. As best we can tell, wehave the most aggressive privacy policy of any of the key players in theindustry today. But we are also working very hard with government relationsteams all around the world to try to get people to understand what it reallymeans to have people using the Internet all day and the various conflicts thatare inherent there. From a Google perspective, our ultimate success is based onthe happiness, satisfaction and excitement of end users. I can tell you that anend user is not going to come to Google if they don’t trust us. To the ultimatecheck, if you will, on a company like Google, is the fact that we are aconsumer company, primarily, and the consumers are free to choose and if theybelieve that Google is a poor quality company with respect to their privacy,they are not going to use Google. They are going to use somebody else. So it is very much a fundamental part of our businessstrategy not only to promote privacy but also to encourage everyone to take itvery seriously. With that, it looks like we’ve run out of time. I wanted tomake sure that everybody knew that we are having our financial analyst meetingnext week and we are looking forward to all of you who can attend in personcoming, and of course, you’re invited. And those of you who cannot attend inperson, of course there will be a full webcast and everything will be availableonline, as you would expect. So with that, thank very much, Krista. Thank you, everyone,for joining us.
Krista Bessinger: Thank you all for joining.
Operator: And this concludes today’s conference. We thank you for yourparticipation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day and welcome, everyone, to the Google Inc.Conference call. Today’s call is being recorded. At this time, I would like toturn the call over to Ms. Krista Bessinger. Please go ahead."
},
{
"speaker": "Krista Bessinger",
"text": "Good afternoon, everyone and welcome to today’s thirdquarter 2007 earnings conference call. With me today are: Eric Schmidt, ChiefExecutive Officer; George Reyes, Chief Financial Officer; Larry Page, Founderand President of Products; Sergey Brin, Founder and President of Technology; JonathanRosenberg, Senior Vice President ofProduct Management; and Omid Kordestani, Senior Vice President of Global Sales andOperations. Eric, George, Larry, and Sergey will provide some thoughtson the quarter and then Jonathan and Omid will join us for Q&A. This call is being webcast from our investor relationswebsite and our press release, issued a few minutes ago, is now also posted onour website, as well as the slides that accompany today’s prepared remarks. Please note that a replay of this call will be available onour investor relations website in just a few hours. Now, let me quickly cover the Safe Harbor statement. Some ofthe statements we make today may be considered forward-looking, includingstatements regarding our investments, seasonality, traffic acquisition costs,increase in the cost of sales, plans to continue to invest in personalization,international growth, growth in headcount, and our expected level of capital expenditures. These statements involve a number of risk and uncertaintiesthat could cause actual results to differ materially. Please note that theseforward-looking statements reflect our opinions only as of the date of thispresentation and we undertake no obligation to revise or publicly release theresults of any revision to these forward-looking statements in light of newinformation or future events. Please refer to our SEC filings, including our quarterlyreport on Form 10-Q, for the quarter ended June 30, 2007, as well as ourearnings release posted a few minutes ago for a more detailed description ofthe risk factors that may affect our results. Copies of these documents can be obtained from the SEC or byvisiting the investor relations section of our website. Also, please note thatcertain financial measures we will use on this call, such as EPS, net income,operating margin, and operating income, are expressed on a non-GAAP basis andhave been adjusted to exclude charges relating to stock-based compensation.We’ve also adjusted our net cash provided by operating activities to removecapital expenditures, which we refer to as free cash flow. We report our GAAP results as well as provide a GAAP tonon-GAAP reconciliation in our earnings press release. With that, it is my pleasure to turn the call over to Eric."
},
{
"speaker": "Eric E. Schmidt",
"text": "Thank you very much, Krista and thank you all again forjoining us. We are very pleased with such strong results in what is seasonallyone of our weaker quarters. When we look at it, revenue growth of course very healthy,both in google.com and also in our AdSense businesses. And the seasonalweakness in traffic was milder than we expected on google.com, which was a verypleasant surprise from our perspective. It is obvious to us that the searchquality investments that we are making are paying off, particularlyinternationally, as we do better and better in almost every country. Along with that, of course, we are working on expanding ourbreadth of ads offering with all sorts of new types of ads -- gadget ads, videoads, others coming -- and each of these initiatives gives advertisers new andinteresting ways to build relationships with their customers. So by building these deeper ad solutions, we really candeliver more value, especially in markets and industries where they’ve notreally had these kinds of tools before. These are highly measurable and ROIdriven campaigns and Sergey is going to talk a little bit more about this interms of the steps we are taking in ads. Looking at it as search, ads, and apps, on the apps side, weare now seeing a massive transition to web-based cloud computing at a consumerand enterprise level. We talked about this for a while and we now see not onlythe progress but also the future products, both from Google and from the otherfolks in the industry to make this really happen. In our case, of course, we launched the presentation productas well as closing Postini, which is central to our enterprise push. We are really on the cusp of a world where everyone cancreate, share, collaborate and find their content in the cloud anytime andanywhere. Before I turn it over to George for all I think the goodnews, let me say something about George. George announced his retirement. I’vehad the privilege of working with him from almost 20 years. I’m going toembarrass him now. And everything that I can think of financially that’shappened at Google has really had George in the middle, whether it’s goingpublic, building the infrastructure of a multi-billion corporation, our largecash position, the secondaries, the financing, very, very good investorrelationships, the openness that we are now seeking, the financial disciplinethat exists in the company and also amazingly, our ability to deal with Section404 and Sarbanes-Oxley -- all driven not just by George but people he broughtinto the company. With that, George, and hopefully an even better introductionto come -- go ahead, George."
},
{
"speaker": "George Reyes",
"text": "Thanks, Erik and good afternoon, everyone. We had a verystrong quarter across the board, with continued impressive growth in ourbusiness. Gross revenue increased 57% over last year to $4.2 billion. OurGoogle.com performance was strong at $2.7 billion, representing year-over-yearrevenue growth of 68% and a 10% increase over last quarter. As was the case in Q2, Google.com traffic was stronger thanexpected, reflecting a milder, seasonal affect than we’ve experiencedhistorically. Consistent with past summers, we also saw strong growth inmonetization, supported in part by healthy pipeline quality improvements. We are particularly pleased with our AdSense performance,which grew 8% over the second quarter and 40% over last year to $1.5 billion.Both the AdSense for content and AdSense for search businesses were strong aswe experienced continued increases in traffic and improved our ability tomonetize our newer partner relationships. Let’s now take a look at aggregate paid clicks growth.Aggregate paid clicks include clicks related to ads served on Googleproperties, as well as ads served on our partner sites. Aggregate paid clicksgrew approximately 45% over Q3 of last year, and increased approximately 5%over Q2. Let me now discuss our international performance.International revenue grew to just over $2 billion, or 48% of revenue. The U.K.reported revenues of $661 million, and 10% sequential growth, led by thestrength in the finance vertical. The region consisting of Belgium, TheNetherlands, and Luxembourg also experienced notable growth in Q3. The travel vertical was a contributor of growth acrossFrance, Italy, Spain and Portugal, and helped drive monetization growth. And in Asia and Latin America, where we are still buildingour presence and investing heavily, we continued to experience strong growthrates in countries such as Brazil, China, and Korea. Let’s now turn to operating expenses. Traffic acquisitioncosts were $1.2 billion and 29% of total advertising revenue, down from 30% inQ2. AdSense TAC was $1.1 billion, while TAC related to distribution partnersand others who direct traffic to our website totaled $105 million in thequarter. As we have discussed previously, as we grow our AdSensepartner network and embark upon new initiatives, we may see pressure on TACrates going forward. Turning to other costs of revenue, other costs of revenueincreased $29 million over the prior quarter, primarily as a result ofincreases in costs related to our data centers, including depreciation,equipment, operations, content acquisition costs, data licensing fees, andamortization. We anticipate that our cost of sales will continue toincrease going forward. Let’s now turn to operating expenses. Operating expenses inQ3 other than cost of revenue included approximately $200 million ofstock-based compensation and totaled $1.3 billion. Expenses related to payroll and facilities increased $34million to $659 million. During the quarter, we added 2,130 employees, themajority in engineering and sales and marketing. At the end of the quarter, wehad a full-time employee base of 15,916. Consistent with previous years, a large portion of ourstarts in the third quarter were related to university hires. Approximately1,000 employees had accepted offers earlier in the year but started in Q3,after the end of the academic year. Included also are approximately 300 employees from thePostini acquisition which closed in September. As we have previously discussed,we are continuing to take a careful look at how we can more efficientlyallocate resources across functions and globally. Let’s now turn to non-GAAP operating profit, which excludesstock-based compensation. This was $1.5billion with non-GAAP operating margins of 36%, up from 35% in Q2. As we havestated previously, margins may decline as we continue to make investments inour business. Now, turning to cash, operating cash flow was $1.6 billionand CapEx for the quarter declined to $553 million. The majority of our CapExwas again related to IT infrastructure investments, including data center, construction,production of servers, and networking equipment. We intend to make similarinvestments going forward as we continue to build a global infrastructure andresources necessary to serve and improve our product for our users and ouradvertisers. Lastly, free cash flow, a non-GAAP measure which we defineas cash flow from operations less CapEx, increased to $1.1 billion. Now, we will turn it over to Larry for more comments on thequarter."
},
{
"speaker": "Lawrence Page",
"text": "Thank you, George. I am really excited to talk to you alittle bit about search and our improving search quality this quarter. We had alot of improvements we made to search quality for users and markets outside ofNorth America and I am very excited about that. It’s a big part of our trafficand we launched several dozen search quality improvements in specificparticular international markets and we are especially happy with the resultsthat we had in Russia, Thailand, Japan and Arabic speaking markets. In mobile search, our search traffic there increased bothdomestically and internationally and the mobile apps traffic is growing well,particularly in maps. YouTube also launched their public site to stream selectYouTube content to mobile devices, of course, sporting the [inaudible] edition,which we launched last quarter. Mobile ads are really doing well, especially in Japan wherewe had strong revenue growth and we also launched mobile ads in Korea. Let me tell you a little bit about our user experienceworldwide, and especially about personalization and some new features. iGoogle,which has just been growing tremendously, expanded up to 43 domains now. We’rereally excited about that. We also made it easier for users to set up their homepage oniGoogle, and that increased retention and usage. I love looking at some ofthese -- the weather, even though in California isn’t such an issue for us,still good to know what’s happening, and I can very easily get that on myhomepage now. The number of available gadgets are increasing significantlyand the developer ecosystem there is really growing. Now in book search, we really increased funding of relevantbook results a lot this quarter, and we think that has a significant effect onimproving quality. Our book search index is also huge now. It’s over a millionbooks. You think about trying to stack those up on your desk, it would takequite a bit of space. We also added several new partners there with a total of 27partners now involved in that product, and we introduced a number of newfeatures. Now, let me switch gears and talk to you a little bit aboutmaps and Earth, our geographic products. In maps, we really opened up an [outlookAPI] that makes maps a developmentplatform and it makes it easy for people to put their own functionality intomaps. For example, you can get real estate listings just when youare looking at maps, or real time updates to gas prices or ski and snow reportsright on your Google maps provided by third parties. In street view, which is a feature that lets you see a viewof a particular street or house or business, we added five cities in Q3 and sixmore just in the last week, so we are very excited about that. There’s a totalof now 15 major cities where you can see street level views of almost anywherein the city. In Earth, last week we actually launched a YouTube videolayer on Earth. You can go to different areas and see videos users have postedabout that area, and I looked at a few from Brazil that are very interesting.And companies like the Hidden Bay Lodge in Ontario posted a fishing video aboutgoing fishing there, so we are very excited about too. So I will turn it over to Sergey now to talk to us aboutprogress in ads and apps."
},
{
"speaker": "Sergey Brin",
"text": "Thanks, Larry. I am really excited to tell you today whatwe’ve done over the past quarter in ads and apps. As you all know foradvertising, our real philosophy is to create win-win between advertisers andcustomers by presenting users with really relevant information which isinteresting to them that’s likely cause a transaction to commence, we arereally helping out both. But it is also important that it is not just what we say,but we can actually prove it, and so measurements of our return on investmentand the ability to optimize the investment is really important for advertisers. We have a lot of tools now available for advertisers to dothat but I want to highlight a couple of new ones and a couple of updates forthis quarter. In beta testing right now, we have the conversion optimizerand this lets advertisers adopt an ROI driven financial model even more easilythan just going straight with a kind of a cost-per-click type bidding.Basically, clients specify, advertisers specify how much they want to pay for acustomer and then we automatically optimize for them in each auction how muchthey ought to be bidding in order to accomplish that goal. We’ve also launched a new release of our website optimizer,and this is where advertisers can run and create these AB kind of splitexperiments. You know, they can change their website layouts, they canrearrange their content, and this is very important because there is tremendousvariance, even once you get a user on your website how likely are they toreally understand what they are seeing, how likely or how easy is it for themto use, and ultimately what percentage of those users do actually perform atransaction? And this was a really great way to optimize that, to make a reallybig difference in the business. Next I want to talk about some new app formats that I amquite excited about. And this does not mean that really flashy, in-your-facestuff. For example, we’ve launched our gadget ads and this is a global betathat we are running now. And for gadget ads, you can actually put functionalityinto the advertisement so it is more than just something to look at and clickbut something you can really interact with. We have a Nissan gadget ad running right now that lets youpunch in your zip code, you get local traffic. It’s fun for users, it helpsNissan build brand. We also have gadgets that are actually really function towhat the company does. For example, if you are trying to book a flight or whatnot, you can punch where you are flying from and to directly into the ad.Anyway, we really are excited about these. Of course, you’ve probably heard about our in-video ads, aswell as the AdSense video units. So basically, instead of trying to dosomething, say a pre-rollout for video where you would have to watch acommercial before watching the video, that would really not make sense,especially the kinds of several minute type videos we typically show onproperties such as YouTube. It would be very distracting. Instead, we have a really nice ad that shows up in thebottom 20% of the video that just overlays for a few seconds after the videostarts playing and in fact, the initial user response rates have -- well, theuser responses and feedback have been positive and we’ve had betterclick-through rates than we anticipated. So I’m very optimistic about this adformat and this is the kind of thing that we have to do when we develop new adprograms. You have to experiment with different kinds of things until you canactually find formats that really work for users and for advertisers. The AdSense video units of course are -- the YouTube videoscan be embedded on sites in the AdSense network, and this certainly providesmore distribution for the videos. They allow us to have contextually targetedads in the video player and this creates this three-way revenue share, which isreally a win-win-win between the publisher, the video’s producer, and Google. I also want to, just while on the subject of video ads, justmention TV ads, which we of course have been running now for a while. We’vereally been getting a lot of interest and bookings from advertisers. And theremarkable thing about television is, it’s surprising, but in fact of theoffline advertising, it’s the one that’s closest to Internet levelaccountability and we feel we can bring much greater ROI type accountability totelevision advertising, much as we’ve done online. Let me take a moment to talk about apps and what we’ve beendoing there. We’ve been growing. We’ve been seeing a lot of adoption of certainapps for your domain, apps for your university. The University of Phoenix, which is up to about250,000 accounts now, students, faculty, employees and so forth; Northwesternis now offering it to all students, that’s on the educational front. For companies, we have a partnership now with Capgemini,which integrates Google apps into their suite of offerings and then Capgeminiprovides the systems integration support. And we are really excited aboutworking with third parties like this because there are just so many greatcompanies in the enterprise space that really know how to work with thecustomers and can plug our technologies in where it makes the most sense. We also closed the Postini acquisition and not only did weclose it, but we already have deployed some of the Postini functionality onGoogle apps for domain and this was just an automatic upgrade for our appscustomers. Now, in the apps suite, we now have rounded it out a bit.For example, we launched Presentations, so you can create a presentation, youcan import one, edit them and share them, and what this basically means now,for my usage, whenever I get e-mails or I need to work with somebody onsomething, I don’t really have to leave the web browser. And for Presentations,it’s great because you want to collaborate on a presentation. If there’ssomething you’re presenting, you want to get ready ahead of time. You can also,as you are even watching a presentation, you can make comments on it and whatnot. You can even just go to the URL of the presentation as you are beingpresented to and page through it forward or backward without having to havereceived a large attachment or having a big printout or something like that. It is really convenient and I think has the potential tochange how people really work together. Now, these apps support a total of 27 languages now. Weadded six more this quarter, so it is a very international product and we aregetting adoption worldwide. An important piece that we are working on has to do withoffline functionality because of course, you don’t want to just have access tothese things when you are on -- if you want it in an airplane, you want itsomewhere where you just don’t have Internet or your Internet connection goesdown or is flaky. And the Google Gears was launched in Q2 to address that. Ourreader, as you all know, is our first geared application, as we call it, andthe fact that it is very nice. I encourage all of you to try this product. Itis very fast. It obviously downloads all the items, so they are pre-fetched.They show up quickly. But you can expect more and more of Google's applications toshow up in geared versions so that you can work untethered. Anyhow, I’m very excited about the progress we’ve made onboth fronts. Thanks for your time and now back to Eric."
},
{
"speaker": "Eric E. Schmidt",
"text": "Thanks a lot, Sergey and looking back at the quarter, it isobvious to us that our model continues to work very well. It is a systematicapproach that we have to innovation and the way in which the company isexecuting speaks for itself. The strategy of search, ads, and apps seems to resonateperfectly with this worldwide transition, if you will, to the use of theInternet on many, many difference devices, so all very exciting from a Googleperspective and again, thank you for listening so long to us. Why don’t we go ahead and get your questions and see whatpeople think? Krista."
},
{
"speaker": "Krista Bessinger",
"text": "Operator, we would like to go ahead and poll for questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) We’ll take our first question fromImran Khan from J.P. Morgan."
},
{
"speaker": "Imran Khan",
"text": "Thank you for taking my questions. Two questions; numberone, if I look at your network revenue, Google network website revenue, thatimproved significantly in Q3 after being roughly flat in Q2. I was trying tobetter understand what is driving that growth. Secondly, you have been working with MySpace for a while andto get a better sense of what you have learned, how monetizable these socialnetworking sites are out there and as these social networking sites engagementsare growing so quickly, are you concerned that that could be a point of entryon the web?"
},
{
"speaker": "Eric E. Schmidt",
"text": "Thank you very much for your question. When we look at thenetwork revenue, a lot of the benefit we think is simply coming from greatertraffic to our partners and then also strong monetization gains and the way ourad networks work. Omid, can you give us some color on how the partners viewthis?"
},
{
"speaker": "Omid Kordestani",
"text": "Sure, Eric. We look at basically both seasonality of thepartners and their distribution strategy. Some of our partners benefited lastquarter from having greater distribution of their services through their ownefforts of syndicating their search and advertising or using our services, andwe have been ramping up partnerships in the UGC space and we’ve seen nicegrowth in that space from partners, like MySpace. I’ll let Sergey maybe add to the monetization angle here."
},
{
"speaker": "Sergey Brin",
"text": "We’ve been very pleased with our partnership with MySpace.We’ve been pleased with the advertising performance. It has been a lot of workand innovation, actually. I know you might not see it from kind of a the userinterface point of view that you see, but we are developing really newtechnologies and I think these social networks are going to require a differentkind of targeting technologies, difference concepts of advertising. We’ve already made big strides. It’s obviously a challengebecause there is so much inventory, people can be distracted by very manydifferent things and it is very personal, so there are a lot of things thatmake it hard. But our technology, our targeting, all those things areactually coming along very well and we are really happy. We view it as a greatopportunity. I mean, it is just so much more inventory that if done correctlycan create that kind of win-win I was talking about between advertisers andusers."
},
{
"speaker": "Operator",
"text": "We’ll go next to Anthony Noto from Goldman Sachs."
},
{
"speaker": "Anthony Noto -Goldman Sachs",
"text": "Thank you very much. You talked on the call about iGoogleand the positive feedback you’ve gotten from user metrics and I was wonderingif you could comment a little bit about improving that product even further.It’s a great application to allow me to more efficiently use Google. I don’thave to enter in searches for all the information I want to have on a dailybasis. And there’s two things I think that could make it a lotbetter, and the real root of my question is, is there a technology limitationto doing the following two things, or a legal limitation -- the first is other,pulling in other applications that are popular on in the Internet, specificallythose that have been written to Facebook and others. Second, you’ve also talkedabout advertising being a form of content and in many of the verticals that Ihave on iGoogle in my account, such as movies, would really benefit fromdisplay advertising as an additional form of information. So is there atechnology and/or legal or other considerations that have limited you puttingdisplay ads on a the page or pulling in other applications? Thank you."
},
{
"speaker": "Eric E. Schmidt",
"text": "Thanks very much, Anthony, for your good productsuggestions. There are some legal limits as to what we could do. We obviouslyhave to get permission of the partner and content in so forth and so on. Thereis no intrinsic reason why the vision that you painted can’t occur and in fact,part of our developer strategy is to get people to build what we call iGoogleGadgets, and we encourage the site that you name and others to make themavailable. We need to work with them. We obviously can’t do it withouttheir permission. Jonathon, do you want to talk a little bit about the displayads?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "In particular with respect to gadgets, Anthony, we arecertainly going to be offering a lot more functionality through the gadgets.The current focus with them really is the user experience. We’ve done somethings with themes which we think have been a pretty big success, but reallywhat we are trying to do is figure out how to integrate much of what we aredoing with iGoogle and also the concept of these gadget ads, which Sergeymentioned. What is so powerful there is that the gadget ads just don’tserve up your simple brand impression. What they do is they get people toengage with the brand and then we can actually empirically measure the level ofengagement, which is much more powerful than the things people havetraditionally done with display. One of the things that I would suggest you do, Sergeymentioned one of the gadget ads, the Nissan ad, I think if you type into Googleeither Honda gadget ad campaign or the Six Flags gadget ad campaign, you’ll getsome examples of some campaigns that have leveraged this technology to reallydeliver."
},
{
"speaker": "Eric E. Schmidt",
"text": "Our next question."
},
{
"speaker": "Operator",
"text": "We’ll go next to Benjamin Schachter from UBS."
},
{
"speaker": "Benjamin Schachter -UBS",
"text": "If I’m reading the TAC rates right, it looks like thepartner TAC went down pretty meaningfully, and then the TAC associated withGoogle.com went up as a percentage of revenue. I’m wondering if you couldcomment on those trends. Also, you mentioned in the prepared comments about the levelof accountability on TV ads. At a high level, can you talk about the learningsthat you are getting from targeting ads on the search side, how those will workwith both video and display, possibly offline and on? Thanks."
},
{
"speaker": "Eric E. Schmidt",
"text": "Jonathon, do you want to talk about TV ads first?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Sure. I think TV ads could actually really beunderappreciated for the reason that you mentioned, in terms of our offlineefforts. This is really one of the few places where you can bring the same typeof Internet level accountability to offline advertising, so with searchadvertising, obviously our customers see real-time how their ads performed. The same thing is really true with the feedback mechanismthat we get with set-top boxes. We are bringing the same level of granularityto the offline TV format. The trials that we have right now are with EchoStarand Astound Cable. And what we are able to do there is we are able to show theadvertisers when their spot is playing and look at the viewing levels of usersactually during the course of the spot, so we are very excited about how thatis playing out and we think it bodes very, very well for our progress in TV."
},
{
"speaker": "Eric E. Schmidt",
"text": "Why don’t we talk about TAC rates? George, do you want tostart that?"
},
{
"speaker": "George Reyes",
"text": "So our AdSense TAC went down slightly, but on the otherhand, Google.com TAC went up, and primarily driven by the partner mix."
},
{
"speaker": "Eric E. Schmidt",
"text": "Our next question."
},
{
"speaker": "Operator",
"text": "We’ll go next to Robert Peck from Bear Stearns."
},
{
"speaker": "Robert Peck",
"text": "I had a question on future use of capital here, and as Ithink of any large expenditures going forward -- first of all, I was wonderingif maybe you could comment on Google's desire to maybe put a large investmentin Facebook or a large social network? And then I was wondering if maybe Larrycould talk about the importance of 700-megahertz going forward. I mean, itdoesn’t look like [inaudible] will probably codify what Google wants for the700-megahertz, so does it come to a point where Google has no choice to notonly put a token bid in but to also sort of bid to win, whether it be with aconsortium or what not?"
},
{
"speaker": "Eric E. Schmidt",
"text": "On the question about specific investments, as you know, Ican’t really comment on any specific investments. I want to assure you all thatthe cash isn’t -- it’s not burning a hole in our pockets. We don’t feel somegreat need to spend it right now for any particular reason. We would do aninvestment that is capitaled if we thought it was incredibly strategic. Many ofthe partners we’ve been able to work with, we’ve not needed to do such aninvestment. They are happy partnering with us simply because of our technologyand our ability to monetize. Larry, do you want to comment about 700-megahertz?"
},
{
"speaker": "Lawrence Page",
"text": "Sure. I think we’ve been actually quite happy with theopenness provisions that have been put into the 700-megahertz auction, so Idisagree with your assertion there. I think we have many, many different options available to usas a company, in terms of spectrum and connectivity for people in wireless andso forth, so I don’t think we feel like there’s any desperate need for us tohave to bid to win or anything like that. And again, the money is not burning ahole in our pockets."
},
{
"speaker": "Eric E. Schmidt",
"text": "Next question."
},
{
"speaker": "Operator",
"text": "We’ll go next to Christa Sober Quarles from Thomas Weisel."
},
{
"speaker": "Christa Sober Quarles- Thomas Weisel Partners",
"text": "First question is just around in the mobile side, we’restarting to see sort of a convergence among hardware, software and services,you know, a la Nokia’s bid for NAVTEQ. I was just wondering, do you feelcomfortable with your current position on just having applications and theubiquity that you can achieve in the distribution of those applications? Secondly, I was just wondering if you could give us anupdate on when you think DoubleClick might get some clarification on when thatmight close. I guess the EU decision begins next week, but just an update therewould be great. Thanks."
},
{
"speaker": "Eric E. Schmidt",
"text": "On the DoubleClick side, we are following all of theappropriate steps that are needed to get worldwide approval and we arecertainly optimistic. It would be I think premature for me to suggest anyparticular timing. I can tell you we have a pretty close working relationshipwith all the people who I think in my view responsibly are checking on doesthis make sense and so forth. But we believe it will ultimately result in avery good outcome for us. On the mobile side, we have talked at some length about ourmobile application strategy. We are very happy with it. Mobile applications,there’s some evidence that we are becoming the leading mobile applicationsprovider, at least in certain segments, and the mobile story is a very strong onefor Google. It is also a great one for the world. You see over and over again one company after anotherannouncing a new interesting mobile platform. We want to make sure that Googleand its technology is a part of each and every one of those platforms. Next question."
},
{
"speaker": "Operator",
"text": "We’ll go next to Mark Mahaney from Citigroup."
},
{
"speaker": "Mark Mahaney -Citigroup",
"text": "First, congratulations to George for a job extremely welldone. Just to keep going on mobile, what I’m trying to figure out is how muchof the future investment requirements success for Google in mobile couldentail? And the setup here is you’ve obviously achieved a leading position as aPC search service without the need to develop a Google PC or a PC operatingsystem or an Internet access service with all the infrastructure requirementsthat that would entail. Is there any reason that your success in the mobile Internetworld would require any similar type developments -- a Google phone, a mobilephone operating system, or a wireless access infrastructure with all of therequirements that that would entail?"
},
{
"speaker": "Lawrence Page",
"text": "I don’t think again that there’s a requirement to do anythings like that. I think Google, obviously we’ve grown a lot since we enteredthe search business and the opportunities that are available to us aredifferent, and there are opportunities for us available in those kinds ofspaces. And we would also love to get even greater numbers of people and wideraccess to our applications that we provide. So I think that it is more of an opportunity for us then acost. We have tremendous usage of our current mobile applications and we havedeals with very, very many different wireless carriers and so on, and manyother types of carriers. I think those things will all continue."
},
{
"speaker": "Eric E. Schmidt",
"text": "Next question."
},
{
"speaker": "Operator",
"text": "We’ll go next to Douglas Anmuth from Lehman Brothers."
},
{
"speaker": "Douglas Anmuth -Lehman Brothers",
"text": "It looks like you added more than 2100 net headcount adds inthe quarter, which is significantly more than you added in Q2, despite beingmore focused on headcount. So even ex Postini, it looks like it is more than1800. So can you give us some color on the timing of your hires during 3Q andalso how we should think about this in relation to margins going forward? Thankyou."
},
{
"speaker": "Eric E. Schmidt",
"text": "Obviously can’t talk about margins going forward. What wesaid last quarter, as you know, is that this is an area where we needed tospend some more time and focus more on what is the appropriate rate. And thegood news is we have done that. The numbers that you are seeing are essentiallyan overhang and they are an overhang from hiring that had been agreed to many,many months earlier. June, of course, is a major college hiring, universityhiring, professor hiring kind of a cycle, so I don’t know that that will berepeated. The important thing here is that we did in fact correct andI think going forward, you should be comfortable that we are paying a lot ofattention to the headcount."
},
{
"speaker": "Douglas Anmuth -Lehman Brothers",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "We’ll go next to Justin Post from Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "Thank you. The gap between your revenue growth, 57%, andyour sponsored click growth, has been maintained around 12%. Could you talkabout the drivers there, where you are in your monetization cycle? Do you havea pretty good pipeline of things coming forward? And do you think things like YouTube and AdSense for contentcould actually grow that gap as we look out to next year?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I can maybe cover some of the monetization issues. We arecertainly very happy with the product upside that we achieved this quarter. Itwas really -- it really came out of over 20 quality and UI improvements that welaunched. There were two very big things that we’ve talked aboutpublicly. The first was the reserve base promotion, and actually we onlylaunched that in late August, so it only had part of the quarter to manifestitself in terms of improvements, and that was basically the change to theformula which determines which ads are shown above the search results, so thatwas certainly significant. We’ve also been doing some things like previous query basedad targeting, which is pretty significant. We’re looking at the previous queryto try to figure out what to do on the next query. So we’re pretty confidentthat we’ve got many, many more ad quality improvements like these. We’re also launching them internationally prettyexpeditiously, so from that standpoint we think there is a very healthypipeline in ads improvements."
},
{
"speaker": "Eric E. Schmidt",
"text": "Next question."
},
{
"speaker": "Operator",
"text": "We’ll go next to Brian Pitz from Bank of America."
},
{
"speaker": "Brian Pitz",
"text": "Your CPC growth rate accelerated from 7% last quarter to 8%this quarter. Can you provide any commentary on this, including is this drivenby your recent algorithm change? Secondly, with respect to your ability to monetizesignificantly better than competitors, is there the possibility for TAC ratesto continue to come down, especially with respect to the upcoming renewal ofAsk.com? Thanks."
},
{
"speaker": "Eric E. Schmidt",
"text": "Jonathan and Omid."
},
{
"speaker": "Jonathan Rosenberg",
"text": "I’ll let Omid handle the Ask.com comment. Basically you aretalking about a 1% difference. CPC, as we’ve talked about in the past, islargely driven by mix, so I think if you looked at the monetization improvementsthat I mentioned, that is certainly a component of it but a large part of it isalso a mix issue. Summer does tend to be modestly higher from a CPCperspective. One of the things that we see is that there is a lot less academictraffic, which Google has disproportionate to most of the other players in themarket. So with less non-monetizable traffic and modestly moremonetizable traffic, that is a mix that actually does play a role."
},
{
"speaker": "Omid Kordestani",
"text": "We are going to I think enter a period where you will see alot of these fluctuations so it will be hard to predict. One is driven bypartner renewals, like the ones you mentioned where we obviously focus onpreserving our relationships with as many of our partners as possible,including Ask. But the other thing that is going in parallel with thatobviously is increasing the quality of our network and our partners are alsoactively involved with distribution strategy of their services, like we are. I think the mix of those effects is really hard to predict.We are trying to improve the quality overall, which will I think actuallyeliminate some growth in terms of distribution in the network. That’sunhealthy, in our opinion, for the network. On the other hand, the renewal and improvements in monetizationreally drive up the monetization [efforts]. So that makes it hard to predict atthis point."
},
{
"speaker": "Jonathan Rosenberg",
"text": "The one other thing I would add is that all of the adsquality efforts are very, very focused on eliminating a lot of the bad ads, andin particular, it’s a lot of the very bad ads which are low CPC, so one of thethings you will see is that as we improve ad quality, reducing coverage whichin general is what we’re doing, you will see the CPC increase because thoselousy ads are generally the nickel or thereabouts types of ads."
},
{
"speaker": "Brian Pitz",
"text": "Thank you."
},
{
"speaker": "Eric E. Schmidt",
"text": "Our next question."
},
{
"speaker": "Operator",
"text": "We’ll go next to Jeffrey Lindsay from Sanford Bernstein."
},
{
"speaker": "Jeffrey Lindsay -Sanford Bernstein",
"text": "We would like to ask a little bit more about the 2100 newhires, or the 1800 after Postini. We noticed that a high proportion came insales. Could you possibly give us an indication of the geographic split forthese new hires, overseas versus domestic? And then, could you give us an indicationfor the rationale for the expansion of the sales force? And given that a lot ofyour sales are automated, wouldn’t expansion of the sales force be taking yourcost structure in the wrong direction?"
},
{
"speaker": "Omid Kordestani",
"text": "A couple of important factors in that, some of them youmentioned. First, we have been very focused in having the proper level ofpresence in every country that makes sense for us to have, both our partnershipteams as well as advertising sales teams that directly work with customers. As you can imagine, in some of the emerging markets, forexample, both in Asia and in Europe, we’ve had actually early success withadvertisers working directly with our system through our online channel.However, you reach a point where local education are helping the efforts onmonetization with the clients. It requires the presence and what our focus hasbeen is to really push our field sales forces, our direct sales forces, toreally spend their time on the named accounts and also represent the full suiteof products that we have. So one of the things we are trying to avoid is havingmultiple sales forces for the different products and services we have. Forexample, the YouTube activity; one of the great efforts we have done, both inNorth America and other regions, is to actually train the sales force andcombine effort so that our customers receive one voice and one representationfrom the company covering the majority of the products. At the same time, what we are doing is paying a lot ofattention to cost per revenue dollar metrics and sales force productivity andputting the right customers in the right channels and mapping that with oursales organization where again, we balance the direct sales force that is inthe field versus the operations team and sales efforts that go on in our bigoperation centers in Dublin and in Argentina, in local countries in Asia and inIndia, which we have a major presence in."
},
{
"speaker": "Eric E. Schmidt",
"text": "Next question."
},
{
"speaker": "Operator",
"text": "We’ll go next to Youssef Squali from Jefferies."
},
{
"speaker": "Youssef Squali -Jefferies & Co.",
"text": "Thank you very much. Can you talk about monetization on thevideo side and YouTube in particular? You’ve started syndicating that contentacross the ad network. When do you turn up the monetization dial on that? Is itan ’08 event? What’s preventing you from doing it now? And secondly, I guess for Sergey, is it fair to assume thatyou’ve decided to go with ad overlays over a pre-roll and potentiallypost-rolls? Thanks."
},
{
"speaker": "Sergey Brin",
"text": "Let me just take both of those. We’re certainly progressingon monetization for YouTube and what not, but that’s not the number onepriority for that property right now. We continue to grow the traffic andimprove the user experience. We continue to really improve the publisherexperience and also, we are working on things like the fingerprinting, which weannounced recently, which we have just really fantastic technology for. On the advertising UI, we are very pleased with the overlaybut I don’t think we are ever going to say this is it from now on. We are goingto continue to test a variety of different formats. When we started in UIs for advertising on search, were bythe way the little text ads, we were considered really crazy. I mean, it took along time to really perfect that to get advertisers to really understand it,learn it, and ramp the monetization. Here also I think we are in for along-term investment."
},
{
"speaker": "Youssef Squali -Jefferies & Co.",
"text": "Thanks."
},
{
"speaker": "Eric E. Schmidt",
"text": "Next question."
},
{
"speaker": "Operator",
"text": "We’ll go next to Heath Terry from Credit Suisse."
},
{
"speaker": "Heath Terry",
"text": "Thank you. As you start broadening out your advertisingformats with your television relationships, YouTube, to what degree are yoursearch advertisers starting to manage these mediums from a single point ofcontact for you? And how far along are the more traditional branded advertisersin beginning to look at their Internet and traditional forms of advertisingalongside of each other when they are trying to evaluate the effectiveness ofthat advertising?"
},
{
"speaker": "Omid Kordestani",
"text": "We are actually spending a lot of time -- that’s a very goodquestion -- in terms of how we should focus on the core business and help alladvertisers, including the major Fortune companies and companies across theworld, really take advantage of search. That’s a proven model for us. We reallyunderstand a lot about it and that is something we -- the sales force spendsthe majority of their time doing at this point. In these other areas, as Sergey mentioned, for example, weare really prioritizing in the case of YouTube the user experience but at thesame time, we are having great demand and interest in advertisers trying thesenew formats and working with us. So in the case of radio, TV, print, all ofthese are new initiatives. We are seeing a lot of interest. We are spendingtime on it and really trying to balance not losing focus on the core businessthat we really understand well and clearly works with the advertisers, as wellas getting interesting trials going, trying different formats. So I think we are very confident in terms of the future ofthese formats, and especially the video, which is a great area of focus for us,as well as TV. I would say those two areas, you will see a lot of progress fromus in the coming quarters and search will continue to remain a very, verystrong focus."
},
{
"speaker": "Eric E. Schmidt",
"text": "Next question."
},
{
"speaker": "Operator",
"text": "We’ll go next to James Friedland from Cowen and Co."
},
{
"speaker": "James Friedland -Cowen and Co.",
"text": "Thanks. I didn’t hear any comments on the call about GoogleCheckout, and now that we are heading into the holiday season, I just wanted tosee if we could get some commentary on what you are seeing in terms ofadoption, especially in the U.K. where you just launched. Secondly, CapEx, while we expect it to continue to growquickly, has gone down sequentially and I was just wondering if you can commenton how it has been trending in the core search business in terms of ROIC. Onthat incremental dollar spend, are you getting better returns on your searchCapEx today than you were say 12 months ago? Thanks."
},
{
"speaker": "Sergey Brin",
"text": "On Google Checkout, Google Checkout is continuing to grow.We are very excited about it. I personally use it all the time. We’ve beenadding a number of great merchants. Most recently, we added B&H, which happensto be my favorite camera equipment store. But we are adding many others aswell. We are excited going into Q4 because we have -- it’s afairly young product and this time, we get to develop it further into theholiday season, so we are really excited about that one. On your other question, I am going to turn it over to --"
},
{
"speaker": "Jonathan Rosenberg",
"text": "This is Jonathan. I caught the checkout part of thequestion. Maybe we can follow-up and get the second half. I just wanted tomention Sergey’s shopping experiences are too limited. We’ve got a big chunk oftop 500 merchants. In Q3, we launched PetSmart, Drugstore.com, Shoebuy.com, andthe NHL Store. I think the real story that is important there is that manyof the advertisers that we are working with, such as Jockey, are reporting much,much higher click-through rates. They achieved as much as 60% higher withCheckout and they decreased the cost-per-click by over 31% with Google AdWordsand Google Checkout. So we are seeing much more significant volumes in terms ofsome of these advertisers and the performance with the advertisers. I’m not sure I got the other half of your question."
},
{
"speaker": "James Friedland -Cowen and Co.",
"text": "The other half was on the returns on invested capital onsearch CapEx, because CapEx has been trending down a little bit. It’s stillexpected to grow quickly but for that dollar spend on search CapEx a year agoversus today, are you seeing improved returns on your business?"
},
{
"speaker": "Eric E. Schmidt",
"text": "That’s a good question. We don’t actually use that metric inthe way you phrase it. What we are really trying to do is to invest the capitalof our shareholders as wisely as possible. As you know, we have built large andvery powerful data centers that are largely custom designed. Those data centersdo more than just search; they do advertising, they host apps, they do GoogleEarth and maps and so forth and so on. We are quite comfortable that that investment, which wemonitor incredibly closely because it is, you know, millions of dollarsinvolved, really does translate into superior financial returns. One way to think about this is that a year ago, people wouldask us about capital, why we were spending on this money on capital, and we’dsay we’ll get it. We’ll get it back in scale and in systems and so forth. Andyou are seeing the benefit of the investment a year ago. Hopefully you’ll seethe same investment return in the year for what we are doing today."
},
{
"speaker": "James Friedland -Cowen and Co.",
"text": "Thank you."
},
{
"speaker": "Eric E. Schmidt",
"text": "Thank you. Next question."
},
{
"speaker": "Operator",
"text": "We’ll go next to Sandeep Aggarwal from Oppenheimer & Co."
},
{
"speaker": "Sandeep Aggarwal -Oppenheimer & Co.",
"text": "Thank you. Two questions and one, sorry, again, asking aquestion on mobile search, but I wanted to know if you can share what kind ofmix are you seeing in terms of a search query initiated by [mobile] versus PC,and if there is basically a trend you can share versus last year? Secondly, you have completed one quarter with universalsearch. If you can make any comment in terms of what kind of improvement theend user has seen and what kind of benefits advertisers have realized? Thankyou."
},
{
"speaker": "Eric E. Schmidt",
"text": "On the mobile search side, our mobile searches areincreasing rapidly compared to a year ago. They are growing more quickly thannon-mobile searches. They are still a very small percentage of total searches,which is of great frustration to us and we are working very, very hard withsome mobile operators to get Google Search to be as standard as possible onevery phone -- very quick and very responsive. Because we think the peopleusing phones really want to use Google to solve interesting informationproblems. Jonathan, do you want to handle the second question?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "The second question specifically on universal search, Ithink as you know we launched at the Searchology event back in around themiddle of May. We are very pleased with the increases in traffic which we sawthis summer, relative to the traditional seasonality. I am not sure that I canstatistically attribute the causality to universal search but certainly what weare seeing is very, very favorable feedback from users. We are seeing goodclick-through rates particularly, as Larry mentioned, with the betterintegration of pieces from different data sets like book search. So as we addmore books into the index and make it blend better, we certainly see higherclick-throughs. So in terms of revealed user activity, what we are seeing isvery strong. Whether or not that is actually what drove growth is unclear. Ithink it is certainly a component."
},
{
"speaker": "Eric E. Schmidt",
"text": "Our next question."
},
{
"speaker": "Operator",
"text": "We’ll go next to Mark May from Needham & Company."
},
{
"speaker": "Mark May",
"text": "Thanks for taking my question. It is increasingly clear thatin order to succeed long-term in the online marketing services space, that it’sbest to have a broad set of ad format capabilities. The question is can youprovide us with some data points that illustrate Google's current position inwhat I think is the largest of those, or one of the largest, which is brand ordisplay ads? And what are you doing to better your position there?"
},
{
"speaker": "Omid Kordestani",
"text": "I think at this point it is still early for us to be able toreally put any markers. What we are very busy with is just engaging thecustomers, training the sales force, trying these new formats, understandingwhich ones work best. It is clear that the engagement model is of great interest,things like the gadget ads that we mentioned. The accountability and themeasurements, the kinds of things we are doing in TV that we discussed earlier-- all of those is very meaningful to the advertiser and there is greatinterest from them to participate in these trials we are doing and these testswe are doing. I think we should be in a position to share more informationwith you in 2008 as we get more of these services out of beta, as well as signup more partners, more inventory and get the advertisers to have more spendingin these. I think you’ll, as I mentioned earlier, I think you will seethat primarily happen initially in both TV and the video space for us."
},
{
"speaker": "Krista Bessinger",
"text": "I think we have time for just one more question, please."
},
{
"speaker": "Operator",
"text": "We’ll go next to Jason Helfstein from CIBC World Markets. JasonHelfstein - CIBC World Markets Thanks. Two questions, one quick one and then fairly longer;are there any market share numbers or growth rates you can provide for Chinaand India? And then my second question relates to the consolidation weare seeing of network guys by AOL and Yahoo!. It seems to us that that’s kindof a play on behavioral marketing. Do you have any concerns if they are notcareful, it might trigger privacy concerns for the industry and legislation orsomething we obviously don’t want to happen? And are there any discussions thatare going on perhaps at the industry or IAB level, so everyone is careful inthat regard? Thanks."
},
{
"speaker": "Eric E. Schmidt",
"text": "On the growth rates in China and India, we are starting froma relatively smaller base in a number of other countries, and so the growthrates are quite significant. We would expect that to continue until they get tosome reasonably stable growth pattern. Both markets are growing quickly. Bothmarkets are under-penetrated in the Internet as a whole. In China, as you know, we have a local competitor who hasmajority share. In India, it appears as though we have majority share. But inboth cases, it’s essentially an open field for all the players. On the question of consolidation and some of the privacyconcerns, this is something that we spend a lot of time on and we are veryconcerned that the actions of the industry as a whole, people who are concernedabout what happens on the Internet could somehow affect us or really hurtconsumers. From a Google perspective, we had done a number of things tothat respect. We have announced a whole bunch of policies around cookies andlog retention, which are innovative in the industry. As best we can tell, wehave the most aggressive privacy policy of any of the key players in theindustry today. But we are also working very hard with government relationsteams all around the world to try to get people to understand what it reallymeans to have people using the Internet all day and the various conflicts thatare inherent there. From a Google perspective, our ultimate success is based onthe happiness, satisfaction and excitement of end users. I can tell you that anend user is not going to come to Google if they don’t trust us. To the ultimatecheck, if you will, on a company like Google, is the fact that we are aconsumer company, primarily, and the consumers are free to choose and if theybelieve that Google is a poor quality company with respect to their privacy,they are not going to use Google. They are going to use somebody else. So it is very much a fundamental part of our businessstrategy not only to promote privacy but also to encourage everyone to take itvery seriously. With that, it looks like we’ve run out of time. I wanted tomake sure that everybody knew that we are having our financial analyst meetingnext week and we are looking forward to all of you who can attend in personcoming, and of course, you’re invited. And those of you who cannot attend inperson, of course there will be a full webcast and everything will be availableonline, as you would expect. So with that, thank very much, Krista. Thank you, everyone,for joining us."
},
{
"speaker": "Krista Bessinger",
"text": "Thank you all for joining."
},
{
"speaker": "Operator",
"text": "And this concludes today’s conference. We thank you for yourparticipation. You may now disconnect."
}
] | null | null |
GOOGL | 2 | 2,007 | 2007-07-20 08:00:00 | Operator: Good day, everyone and welcome to the Google Inc. conference call. This call is being recorded. At this time, I would like to turn the call over to Maria Shim, Investor Relations Manager. Please go ahead.
Maria Shim: Good afternoon. Welcome to our second quarter 2007 earnings call. On the call with us today are Eric Schmidt, Chief Executive Officer; George Reyes, Chief Financial Officer; Larry Page, Founder and President of Products; Sergey Brin, Founder and President of Technology; Jonathan Rosenberg, Senior Vice President of Product Management, and Omid Kordestani, Senior Vice President of Global Sales and Operations. Eric, George, Larry and Sergey will provide some thoughts on the quarter, and then we will have Jonathan and Omid join us for your questions. This call is being webcast from our investor relations website. Our press release, issued a few minutes ago, is now posted on our website, as well as presentation slides that will accompany today's prepared remarks. A replay of this call will be available within a few hours. Some of the comments we will make today are forward looking, including statements regarding our investments in our business; seasonality; our traffic acquisition costs (NYSE:TAC); increases in cost of sales; plans to continue to invest in personalization; international growth; growth in our headcount and expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially from those anticipated by these forward-looking statements. These forward-looking statements speak as of today, and you should not rely on them as representing our views in the future, and we undertake no obligation to update these statements after this call. Please refer to our SEC filings, including our quarterly report on Form 10-Q for the quarter ended March 31, 2007, as well as our earnings release posted a few minutes ago on our website, for a more detailed description of the risk factors that may affect our results. Copies of these documents may be obtained from the SEC or by visiting the investor relations section of our website. Also, please note that certain financial measures we use on this call such as EPS, net income, operating margin and operating income are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. We report our GAAP results, as well as provide reconciliations of these non-GAAP measures to GAAP financial measures, in our earnings release. With that, I would like to turn the call over to Eric.
Eric Schmidt: Well thank you very much, and thank you all for joining us in your busy day. We have once again delivered strong revenue performance, particularly on core Google.com search and strong cash flow in our seasonally weak quarter. We're obviously very pleased with that. Traffic was stronger than we expected on Google.com both domestically and internationally, with annual traffic growth actually increasing over time, which is a very positive surprise. We are clearly doing the right things to attract and retain users. You can see this in the success of our many products. We're very focused now on people spending their time searching, using information online and doing it in a global way. The summer seasonality that we always talk about does appear to be milder than we expected, which is also good news. We are improving our ability to monetize searches, as we do every quarter, with another strong quarter of ads quality improvements. We are still continuing to see strength in revenue per query and click-through rate, and the pace of ads quality innovation is strong as we continue to scale up this effort and build up on our expertise. It is a big area of investment for us and an important one. So we have continued to make significant investments, as we have previously discussed. We are growing rapidly, building the best infrastructure, hiring the best to extend our footprint internationally, all the things that we talked about. Building better and better products and invest in doing so in the model that we've talked about: 70/20/10, 20% of the time, and that sort of thing. The data center is reducing latency, increasing search indices, et cetera. Network effects are driven by scale, and Google is the beneficiary of that. By focusing on the best talent -- and we have talked about this as well -- we have a growing percentage of international hires and international offices contributing to our global product set. We are building now localized products for each of these markets and we are seeing significant gains in terms of our role and our impact in each of these languages and cultures in ways that matter to end users. Of course, we are still applying the kind of discipline that we have always talked about with respect to making strategic long-term investments and short-term profits. So we are busy executing on our search, ads and apps strategy at scale all around the world. It is a focused strategy with these three pillars that will really grow the Google ecosystem. From a Google perspective, when we look at the quarter, one area we exceeded over our expense plan was headcount. We are very pleased with the talent that we've brought on board, but going forward we will watch this area very closely. So when I look at the quarter, we are very pleased with what we're delivering. The product model is working, our global growth strategy is working, our innovation model is working, and we continue to be an innovator at scale, and we certainly expect that to continue. I do want to mention -- as I have before -- that the second quarter which we just completed and the third quarter that we are in are seasonally weaker in traffic than the first and fourth and we would, of course, expect that to be true for many, many years to come. Let me turn it over to George for his comments and then I will join you at the end. Go ahead, George.
George Reyes: Thanks, Eric and good afternoon, everyone. I will go through a discussion of the quarter quickly so that we can allow more time for your questions. Gross revenue increased to $3.9 billion, representing 58% growth over last year. Despite expected seasonal weakness, we experienced particular strength in our Google.com properties, driven primarily by stronger than expected traffic growth globally, as well as continued improvements in ads quality. As Eric mentioned earlier, the pace of ads quality innovation was strong, with the aggregate of these improvements positively impacting Google.com revenue. Revenue from Google.com properties was $2.5 billion, representing a year-over-year growth of 74% and sequential growth of 9%. Now I will turn AdSense revenue, which grew 36% over last year and was approximately flat at $1.35 billion. Growth in AdSense was affected by several factors, including typical seasonality that we see in our network during Q2 and to a lesser extent changes to the AdSense implementation of certain AdSense research partners that were less favorable to revenue. We also implemented changes that improve the user experience on our network, as well as provide more value to advertisers. For instance, AdSense for Content revenue was affected by policy changes such as termination of publishers who were not meeting our quality thresholds, partially offset by strong revenue growth from other AdSense for Content partners. Let's now look at aggregate paid clicks growth. To remind you, aggregate paid clicks include clicks related to ads served on Google properties, as well as ads served on our partner sites. Aggregate paid clicks grew approximately 47% over Q2 of last year and were roughly flat with Q1 levels, reflecting the typical seasonal pattern we see in Q2. Let me now discuss our international performance. We continue to make significant international investments, and we're seeing the benefits of this strategy. International revenue increased to 48% of total revenue, or roughly $1.8 billion, driven primarily by strong growth in Europe, despite weaker seasonal traffic trends. Spain, Italy and France in particular outperformed in Q2, while Germany, along with the UK, were significant drivers of revenue growth. The UK came in with revenues of $600 million and 4% sequential growth. Our substantial investments in R&D, sales and marketing, as well as infrastructure, are benefiting our smaller markets as well, with healthy growth rates in markets like Brazil, China and Korea. Now turning to expenses, traffic acquisition costs were $1.15 billion and 30% of total advertising revenue, down from 31% in Q1. AdSense TAC was just over $1 billion, while TAC related to distribution partners and others who direct traffic to our websites totaled $87 million in the quarter. As we grow our AdSense partner network and embark upon new initiatives, we may see additional pressure on TAC rates going forward. Other costs of revenue increased $67 million over the prior quarter primarily as a result of increases in costs related to datacenters, included depreciation, equipment and operations. We anticipate that other costs of sales will continue to increase going forward. Looking at operating expenses, operating expenses in Q2 other than cost of revenue included $234 million in stock-based compensation and totaled $1.2 billion. The growth in OpEx was primarily driven by increases in expenses related to payroll and facilities, which was $625 million in the quarter. One of the larger drivers of payroll expense was the company bonus plan. This was due in part to a revision of our bonus accrual methodology that will allow us to more proportionately recognize the related expenses each quarter. This all led to a higher bonus accrual in Q2, which includes a catch-up from Q1, and affected all expense line items. A second factor driving expenses was headcount growth, which led to higher payroll expenses. We added 1,548 employees in Q2, the majority in sales and marketing and engineering. At the end of the quarter, we had a full-time employee base of 13,786. The percentage of our international hires, new hires, also continued to rise, demonstrating our commitment to further scale the business internationally. We have grown quickly to address strategic opportunities, and as we grow we're applying increased discipline when making investments and taking a careful look at how we allocate resources efficiently across the world. Turning to operating profit, non-GAAP operating profit which excludes stock-based compensation, was $1.3 billion, with non-GAAP operating margins of 35%, a decline from 38% in Q1. Now turning to cash flow, operating cash flow was strong at $1.2 billion and CapEx for the quarter declined to $575 million. The majority of our CapEx was again related to IT infrastructure investments, including production of servers, datacenter construction and networking equipment. We will continue to make these investments going forward as our infrastructure and resources make possible such innovations as universal search, and will further our leadership position in the industry. Free cash flow, a non-GAAP measure, which we define as cash flow from operations less CapEx, increased to $655 million. So in summary, we believe our results reflect the strength of our core search and ads business, while our significant but disciplined investment positions going forward will allow us to leverage everything that we have been doing at Google. Now I will turn it over to Sergey.
Sergey Brin: Thanks, George. I am really excited to tell you about what we have accomplished in the past quarter, especially with respect to search. And of course, search remains the heart of what we do. We had a big launch this past quarter in particular with universal search. This means now when you search on Google.com -- and soon it will be available on our international domains -- you are going to get results from both the web as well as image, video, news, maps and books all together. This may seem simple, but in fact it has taken a lot of infrastructure work just to be able to do all the computation across all those corpuses, as well as the algorithms that allow us to rank those disparate types of information together. Just a couple days ago, I was researching an old IBM mainframe system from the 1960s I had created on Google, and it never occurred to me to search for videos on that kind of query. But in fact, there were great videos and they popped up, and I watched both IBM's promotional videos from the '60s as well as a fantastic kind of looking back research history video about that particular computer. It turned out to be very useful to me. I expect that other users also find this useful, along with all the other corpuses I mentioned, not just video. It is just amazing where you don't think to search for something you are looking for where the information could just be fantastic. On the international front, we have been making great strides. We are actually now experimenting with trying new kinds of home pages, for example in Korea, Taiwan and Hong Kong, that are completely different types than we have tried before on our U.S. sites, as well as our European sites. We think it will be more appropriate for the local cultures and their contexts and their broadband connections, which for example in Korea are extraordinarily fast. The initial results, by the way, have been coming back quite positive, so we are optimistic about that. A big launch that maybe we don't appreciate so much in the U.S. is the cross-language information retrieval. What that means is that if you run your query in one language -- and by the way, don't forget many users out there, if they don't speak English, they can only get in their language about a tenth of the information that is available on the web as in English, so it is a much smaller set. But now, when they do their query, we will actually run that query in other languages, including English, and get back the results and translate them back. This is just really phenomenal. This is really opening the true power of the web to people who don't speak necessarily English. By the way, it works in English, too so occasionally, when you get stuff and it is only in French or Italian or whatnot, you'll get it back. I am very excited about this particular one. Now in addition to search, of course, we have been working on our iGoogle page, the personalized home page, as we used to call it. It is launched in 18 new domains. It is one of our fastest-growing products. We have been effecting fantastic gadgets for them, the little modules that you plug in. I have about 20 on my home page. It is really a good way to be able to see a bunch of information at once, not to have to navigate to disparate sites. We launched GadgetMaker, which lets people who aren't JavaScript and Ajax wizards in their own right to actually create gadgets that are going to be useful for things like sharing photos, planning events and whatnot. This is just one aspect in the way that we are personalizing the web. I think we are going to continue to invest lots of resources in this area. Now, jumping ahead, while there are so many things I would like to tell you about some of our web efforts, I only have limited time here. On ads, we have been doing a lot of work on ads, as always. Our goal is to connect advertisers with people who really care about their advertisements, who are really interested in their products. So the most important thing is the quality of our ad system. Q2 was a really strong quarter. We had lots of launches of different ad quality improvements, improvements in the algorithms. We had good results with our advertisers and with the publishers as well. We also enhanced the feedback system that allows users to give us feedback on the ads. It also better connects users with the advertisers that they would be best served by. Now, advertisers obviously want to get traffic to their websites, but ultimately they are interested in getting sales or leads or whatnot. So we want to make the whole process for the advertisers' marketing spend as effective as possible. Starting first off with the launch of the redesigned Google Analytics, it's got new visualization tools and custom dashboards. It really lets marketers and advertisers and people who just really care about their websites get great information and understand about how people are actually using those websites. That allows them to in turn optimize their websites. We added ten new languages, that is up to 17 languages supported now. We actually have had as a result, great growth in both new customers for Analytics, as well as people linking their AdWords account to their Google Analytics account, which is the most powerful combination. We've also added very important placement performance as well as search query information. So now, advertisers know where in our network precisely their ads are running. This obviously gives them better control over the ads too, and also which search queries are generating the best results. It is very useful information. We have obviously had a lot of demand for that and we finally have it out. Now lastly, I just wanted to mention our continuing work, we mentioned this before, but the pay-per-action advertising. Ultimately, as I said, the advertisers want not clicks, but they want something to happen like a purchase and whatnot. The pay-per-action advertising is now available to all advertisers and on all publisher sites. We have been having lots of advertisers move to this model. It is such a no-brainer. Then you don't have to figure out for yourself; well, I don't know how much a click is worth to me and whatnot. It really ties it directly to the action. Anyhow, all told, I am very excited about the progress we have been making on both search and ads, and for apps, I would love to turn it over to Larry.
Larry Page: Well, thank you, Sergey. We continue to really invest in building simple web-based applications to help all of our users organize their information and create new content. As Sergey already mentioned with that mainframe example about video, we have been really excited about video. The best example of this is really YouTube. We made very strong progress this quarter, YouTube did, in many different areas. We added local support in nine new countries, and also, local users can now enjoy locally generated content, new features there, and new features on featured videos, directors and promotions. We have gotten great response to all of those things, which has resulted in increased usage. We also added many new partners on YouTube, several of them in newly added markets like Hearst Argyle Television, National Geographic and Global de Brazil. We also broadened our distribution through other partnerships, for example, Motorola, Telecom Italia and Apple on the iPhone and Apple TV. The iPhone, of course, has an amazing user experience in looking at YouTube. You can waste very many hours, and also enjoy useful content like mainframe videos on your iPhone. So Google Apps also had a very successful quarter overall. We were named number one product of the year by PC World magazine, which we were very excited about. We launched our apps premiere partner edition for ISPs to offer co-branded apps to their subscribers. And we signed a new deal with several new partners, including Virgin Media, a UK ISP. We also launched a tool in apps to enable easy migration of large numbers of email accounts to Gmail. This does things like preserves the header information, threads all the conversations, makes your email searchable. For example, just one customer migrated 30,000 users with 3 million emails in just 24 hours. So we have a lot of excitement around that. We also announced our intent to acquire Postini for $625 million. What that lets large enterprises do is really give them with some of the complex issues that they have like their business rules, their security mandates and legal compliance, and really let them do that easily over an email solution. So we are really excited about that, and it lets us add web-hosted security and corporate compliance for email, IM and other communications. Postini was actually one of our first partners in Google Apps. Again, we are really excited about this and I think that many of our customers are as well. Let me switch gears for a second and talk a little bit about developers. Really to support our efforts across all of the areas of the company -- search, advertising and applications -- we're really supporting a growing community of developers. As part of that effort, we had our first worldwide Developer Day to reach out to that community. We had over 5,000 developers participate in over ten countries and online, and we got a great response from them. We also at that time delivered several new tools and APIs for the developers to work with. One was called Google Gears, which is an open source project that enables web-based applications to run offline. We also launched Maplets, which lets people extend Google Maps, and there's examples like real estate search and embedded photographs that developers are implementing now. So all of these developers are really helping us to create new and interesting information and applications and content which helps us build our whole ecosystem and makes the user experience better for everybody. I was really excited by our progress in this quarter, and now I will turn it over to Eric.
Eric Schmidt: Thank you. As I reflect on the quarter, I am really struck by our ability to operate and move forward at this scale. Normally, innovation at our size and growth begins to slow but here, it seems to be accelerating. We are producing more products with many more users, more languages, in more countries in the ways that we have talked about. I think it is because our model is working so well that we are so optimistic about the future. When we talk about products, and Sergey talked, for example, about iGoogle, you can see something which goes from almost no users when it is introduced to many, many, many millions of users very, very quickly. So we know this model will continue to scale, and we know that we are focused on our primary mission, which is around search, ads and apps. That focus is going to continue, with many good things to come in the future. So with that, maybe we should get some questions and comments. Maria?
Maria Shim: Operator, could we start taking questions, please?
Operator: (Operator Instructions) Your first question comes from Anthony Noto - Goldman Sachs.
Anthony Noto: Eric, one question for you. I think you have said previously that it was your goal to grow operating income each quarter on a sequential basis. This quarter, obviously, it was down. I was wondering if that was completely due to the bonus accrual that you had mentioned, given the number of employees you hired was lower than we thought, D&A was lower than we thought and revenue was higher, because I am trying to get to that underlying difference. If you could explain in a little bit more detail how much that incremental bonus accrual was. Thanks.
Eric Schmidt: In general, we don't break out all the puts and takes on the changes in the accrual. What I would tell you is that we overspent against our own plan in the area of headcount, and some of it was related to this bonus accrual that I talked about; and some, because we hired a little faster than we had planned. In looking at it we thought, was this a mistake or not? We decided it was not a mistake, that in fact the kind of people we brought in are so good that we're happy we did this. As I said earlier, we will continue to watch this very carefully in the future.
Anthony Noto: Thank you.
Operator: Your next question comes from Imran Khan – JP Morgan.
Imran Khan: Hi, thank you for taking my question. One clarification question and then a follow-up. For clarification, when you said that you will closely look at headcount, should we assume that headcount growth will slow down? Secondly, Eric, you talked about how your traffic growth rate is actually accelerating. If we look at the paid click volume it is flat sequentially, considering traffic growth rate is accelerating and you're getting into new countries. Why is paid click volume flat sequentially? Thank you.
Eric Schmidt: With respect to the headcount, as I said, we ended up somewhat higher on our headcount expenses than we planned, which is the issue that Anthony asked about as well. We will watch it, we will adjust, we will be opportunistic but we are going to be careful about that. Jonathan, do you want to talk about paid clicks?
Jonathan Rosenberg: Typically, this is a slow quarter for paid click growth. It is basically the lowest in the year from a seasonality perspective. If you look at it on a year-over-year growth rate, paid clicks is very healthy and consistent with the trends that we have been seeing. Really, I would characterize the quarter as one of very strong traffic growth domestically and internationally in what typically we see as a somewhat weaker quarter from a traffic perspective.
Sergey Brin: Actually, if I can add one more thing on the paid clicks. As we develop improved algorithms for showing our ads and as a result we're able to achieve better click-throughs, better monetization and whatnot, we usually like to split the benefit of that between both able to generate more revenue for other publishers than ourselves; but also, we like to improve the user experience, which in some cases means we try to show fewer ads in certain locations where we think they are less likely to get clicked on. That has a significant effect.
Imran Khan: Thank you. That's very helpful.
Operator: Your next question comes from Mark Mahaney - Citigroup.
Mark Mahaney: I wanted to follow up with Sergey on that last point. If you are making the ads more targeted and qualified -- which is what we think is happening -- at the end, advertisers should see more qualified leads and be willing to pay for that. We have seen an acceleration in your CPC growth the last two quarters and I know there's a lot of things that feed into that. But do you think that that actually is what's happening, or do you think that that kind of growth driver; that is, that CPC inflection point, growing because of increased advertiser interest and being willing to pay for more qualified leads? Do you think that is still to come?
Sergey Brin: I think it is a combination of factors. On the CPC, for example, the international mix changes, the nature of queries from season to season changes, and whatnot. On the whole, as you said, I do think that advertisers are seeing really good returns, and therefore they do bid higher. The other effect, as I mentioned, is that we tend to, when we have the opportunity, we feel like maybe we would be better off displacing some of the ads to show more search results higher on the page or taking more of the page especially as we improve the ad systems; therefore, we're still making equal or greater revenue. We do take that opportunity to increase the barriers to getting some ads up there. So that also has significant effects.
Jonathan Rosenberg: In general, we have talked about this in the past, but we definitely believe there is plenty of room to grow pricing. We know that advertisers watch their ROI very carefully and they monitor their budgets accordingly. Sergey alluded to the general dynamic of improving the quality of ads and what you can expect the dynamic there is with respect to click-through rates rising while the number of ads declines. Basically what we are seeing is when you try to parse out the average CPC, the growth rates in emerging markets versus developed markets impacts this a lot, because the new markets have lower prices and the faster growth in new markets tends to put downward pressure on CPC. The other big thing that you saw this quarter was, as Eric mentioned, traffic growth on Google.com. When Google.com grows faster, that positively impacts CPC significantly. We did, as Eric mentioned, see very strong traffic growth there. So a lot of it is the distribution piece.
Operator: Your next question comes from Mary Meeker - Morgan Stanley.
Mary Meeker: Thanks. I just want a couple clarifications. Eric, you've talked about the heads and basically the headcount and the operating expense changes and said you are going to watch it and you feel great about the people you've hired. But if could indicate if a portion of those were sales heads and a portion were international heads. I guess our translation would be that you feel comfortable that there will be related revenue commensurate to the hires in the next two to three quarters. If we could drill down on the bonus accrual a little bit, should we expect to see it play out on a more normalized basis on a go-forward basis? Is it fair to say that half of the difference between what you might have been expecting in OpEx and half of what you got for the quarter was related to the accrual? A third question if we may, just for a little clarification, any thoughts on how we should think about cost of goods sold as a percent of revenue on a go-forward basis? If you could answer any of those three, we will be happy because we know we went over our quota. Thank you.
Eric Schmidt: Thank you, Mary. I will let George answer the second two. With respect to productivity of our headcount, our headcount, especially in sales, is productive very, very quickly. Omid talks and says that it's maybe even with the same quarter which they are hired is a model that is scaleable.
Omid Kordestani: Again, the sales force name at Google means different things. It is the field forces which are calling on new Fortune companies, for example, as well as operational people that manage our online advertisers and the optimizations that go into the improvements. All of our analysis actually shows excellent productivity across the board. Some of the emerging markets obviously have different rates of productivity, and it is an investment we're making for the future there. But all in all, we've actually been going through a very thorough process of figuring out how best to take the sales force and reorganize them to represent all the various products we have today, from the core search products to the brand name products and monitor our productivity really carefully as we add resources both domestically and internationally.
George Reyes: Mary, going forward it should be a more normalized bonus accrual process. This was just sort of a one-time inflection that we tried to do to true-up the bonus.
Operator: Your next question comes from Ben Schachter - UBS.
Ben Schachter: There's a lot of litigation and regulatory issues around both the company and the industry, some established and some potential. What are the top two or three that you think potentially pose both the greatest risks for the company and the greatest opportunity? Separately, at a very high level the success of text-based search ads have really shown how valuable advertisers find highly-targeted ads. What do you think are the key barriers and opportunities to better targeting on the display and video side, both online and off? Thanks.
Eric Schmidt: Ben, on your first question about litigation, we have already disclosed two major areas of litigation for Google; the first being in the book area, the book scanning and Library Project, and the second involving Viacom. Both of those are very important from the standpoint of principle. It would be great if those would go away or somehow would be resolved by technology or so forth. But we take those very seriously because we were sued by people who were unhappy with what we believed we were doing was right. With respect to broader litigation issues, Google is in the information business. There's always a potential that governments will decide that some of the things that we're doing are appropriate or inappropriate in ways that make our business harder. However, there are no short-term threats in that regard, and in fact in many cases the opening up of markets, the opening up of the Internet -- especially in countries outside the United States -- is really putting pressure on governments to have a broader information access approach, make information more broadly available, open up their Internet borders in a good way. So we are very optimistic about that sort of thing. On your second question, we will have Omid answer that.
Omid Kordestani: There's two fronts really, two thrusts of work going on in the core business and there is continual work on ads improvement. There are all kinds of algorithms that continue to improve the targetability of the ads and the efficiency and accountability for advertisers and marketers. The interplay that was interesting between display and brand advertising and our core business, where we're seeing great success. This last quarter, we saw Pepsi in the U.S.; we saw Coke in France and Heinz in the U.S. really try to take advantage of both sides of the equation here. So advertisers are looking for ways to interact with our users online and have a two-way conversation about their brands really are starting to use YouTube very effectively and advertise on the content network, which allows them this targeted reach. It's also possible to have this two-way conversation, really an engagement with the users that the advertisers are really interested in. So we see great submissions of video or contests that then create that brand affinity, as well as then the ability to reach the audience and targetability that search provides. So we are really experimenting with all of that, and the core innovation is driving the core targetability and we're trying to learn a lot on how to best leverage the network as well as the properties like YouTube to have a comprehensive solution for the advertisers.
Operator: Your next question comes from Robert Peck - Bear Stearns.
Robert Peck: I was wondering if you could give us a little more color or clarity on the current impact of your other endeavors, monetization on YouTube, the radio side, TV and print. When do you think it may start to become more material? You've recently rolled out site authentication as well as the unavailable after tag. I guess our thoughts there are, when should we see any sort of impact on either search volumes or click-through rates or CPCs going forward? Thanks.
Omid Kordestani: On all the new initiative from TV to print, again we have moved from the beta phase where we tested a few advertisers and a few publishers and really expand beyond that. We're seeing really excellent adoption. What we're seeing is the advertisers are really pleased, and the partners are really pleased with the type of monetization they are experiencing. Again, it is going to be too early for us to really see a material impact, given the scale of the other sides of the business. The mantra I'm following right now is that we really need to first prove this model for both the advertisers and the publishers before we really scale it and scale it both in specific geographies as well as internationally. I think hopefully in the next few quarters we can shed more light on this. But at this point, we are seeing, as I said, great success with the early results and we hope to be able to scaled these models.
Operator: Your next question comes from Justin Post - Merrill Lynch.
Justin Post: Thanks for taking the question. When I look at the advertising revenues up 73% on Google websites, was there anything non-search-related really driving that number? Long term, could you discuss your outlook for display or video advertising for Google? Do you think it can be a meaningful percentage of your total revenues?
Eric Schmidt: It certainly will eventually be a significant and meaningful percentage. Jonathan or Omid, do you want to talk a little bit about that?
Omid Kordestani: I think I just spoke to that earlier, is that on all these fronts we're seeing great success both in the advertiser front and the publisher front in the context of the beta test that we're doing. We have reorganized the sales force, for example, in the U.S., which is the most advanced, most mature market for us so that they can represent all the products. So every sales force and sales group now within the U.S. structure is going through a lot of training and has just been reorganized so that they don't just represent search, but they represent all the products. They have supporting expertise for the specific areas from YouTube to television to print advertising. What you will see from us is, again, a lot of effort to take this beyond the beta phase and engage more advertisers, more publishers. Once we prove that model, extend that internationally as quickly as possible. Again, I'm putting a lot of emphasis on this, there is great hiring behind it and great innovation so that we can have it be a significant portion of our revenues. We just have to see it develop.
Justin Post: Was there an impact in the quarter at all?
Omid Kordestani: Not this quarter.
Jonathan Rosenberg: Just in terms of the basic underlying numbers, the story really is, as we talked about, is clearly a combination of strong traffic growth and ads quality. Eric mentioned the traffic growth increasing over time and the increase in the rate there, which is very substantial. Larry and Sergey also talked about the big investment that we have been making in the user experience and search quality and the universal search launch. What I think we are really seeing there is that users are engaging in more searches by virtue of our improving the search experience.
Justin Post: Thank you.
Operator: Your next question comes from Brian Pitz - Banc of America Securities.
Brian Pitz: Thank you. A two-part question on eBay. Any color on the impact you've seen in the quarter on volume and cost per click from the pullback in advertising on your site? Any commentary on the acceleration of revenue that eBay noted yesterday on its call that is associated with your international partnership? Thank you.
Eric Schmidt: eBay has been a long-term partner for Google. While it is true that they adjusted their mix in our advertising model, they continue to be a very significant advertiser. We did not see an impact on Google for many of the changes that they talked about that they made. Part of that is because Google is capable of choosing very much the best ad. When ads priority shift and people move advertising around, we can still take advantage of the highest-quality ad as produced in the auction. So far, the answer is no, no impact whatsoever. Our international business is very, very strong as you heard, and as a percentage of gross revenue it is growing especially strong in Europe; again, also noted in the eBay report. But that is not primarily because of our eBay-Google partnership, it is just because our international business is just strong overall.
Brian Pitz: Thank you.
Operator: Your next question comes from Christa Quarles - Thomas Weisel Partners.
Christa Quarles: First if you could highlight what the theoretical limit for TAC rates would be, you are close to 85%. Second, a broader question. I'm just very curious about what you're doing with regard to the spectrum. I was wondering if you could articulate what your telecom strategy is or what you are willing to articulate to this point, especially in light of some of the Google phone rumors out there. Thanks.
Eric Schmidt: Let me do the second part, and I'll have George talk a little about TAC rates. First, we don't comment on rumors, and there's lots and lots of rumors which is always very exciting. We have looked pretty carefully at wireless, and we are thinking about what we want to do there. From a Google perspective, the most important thing is that there be an open network. We define that in the sense that people can go to a store or however they are going to get it and get a device, plug that device into a wireless network and be able to use the full capability of the Internet. In the course of using that full capability of the Internet, which is going to be delivered on these mini-devices that have come out in this space globally, they're also going to become very significant Google advertising users. So there's really a direct connection between the open interoperable network that we are now arguing for in SEC filings and so forth and the ultimate usage of Google services and applications, and of course, advertiser satisfaction.
George Reyes: On the TAC rate, on an absolute basis TAC increased. It was basically just a fundamental of more AdSense partnerships. Going forward, the future trend will depend basically on the relative growth of large AdSense partnerships and Google.com.
Christa Quarles: Is there a theoretical, I mean will you strike a deal? I mean, obviously you do minimum guarantees, but will you regularly start striking deals at 95%?
Eric Schmidt: We prefer to do profitable deals. We are happy to give the majority of the revenue to the partners, which is what this is doing. There is no particular rule that we follow. We have as a business taken the position that we do want to have growing operating income to the bottom line. Basically growing operating income on a quarter-over-quarter basis. Although we did not achieve that this past quarter, it is certainly our goal. So all of the business decisions that we do are in the context of growing operating income on a quarter-over-quarter basis on an absolute basis, as well as building a strong cash flow-based business.
Christa Quarles: Thanks.
Operator: Your next question comes from Douglas Anmuth - Lehman Brothers.
Douglas Anmuth: Can you provide an update on your efforts around digital fingerprinting and content identification? Just one last question to try to wrap up the bonus accrual thing. Can you just clarify how you were accounting for your bonus accruals in 2006 and how that is changing, if it is, in 2007 in terms of the calendar basis? Thank you.
Eric Schmidt: This is really a question about Claim Your Content. Larry and Sergey?
Sergey Brin: I should probably have Chad do an update of that. But as far as I know, we have experiments that are running and actually working quite well. So we are optimistic to be able to deploy that live in the near future. I haven't heard of any significant impediments. Obviously, this will present a new capability to content owners which they haven't had in the past with any other sites or mediums to be able to just detect in such a scaleable way easily, just in an automated way. So we are very excited about it.
George Reyes: A portion of the increase in the OpEx is a function of the change in the bonus accrual. That methodology includes a piece that relates to the catch-up of related Q1 charges. So that would be one angle on it. We also expect our bonus expenses to be more normalized or proportional going forward and less of a ramp-up throughout the year.
Douglas Anmuth: So is it reasonable to think that, for example, in the fourth quarter this year that you will have less bonus accrual on a relative basis will be in the fourth quarter this year than it was last year?
George Reyes: It will be normalized throughout the year going forward.
Operator: Your next question comes from Heath Terry - Credit Suisse.
Heath Terry: Thank you. I'm just wondering if you could just give us an update on Google Local, what you see as being the barriers in terms of really filling out the business directory there, as well as starting to bring monetization of the impressive level of traffic that you have gotten for that site up to where monetization in your core search product is?
Larry Page: I think we have been really excited about our efforts on local and business listings and apps, which are all interrelated. From a user experience, I think there's still a long ways to go to make those things work even better. We have done experiments with things like having businesses listed on maps so you can see where they are and things like that. I see all those things as interrelated. Also improved targetability of advertising for local advertisers or locally targeted businesses. I think we are in the quite early stages of those products. The user experiences are improving rapidly, and I think they will continue to. Also, the advertising capabilities of advertisers to target particular local needs is also improving really rapidly. I think we are really excited about that. It is sort of like the other areas people have been asking about, I think there is a lot of initial progress which we are very excited about, and we expect to have a lot more going forward.
Jonathan Rosenberg: On some specific efforts this quarter, I think one of the things we did particularly with respect to Local Business Center was focus on making it easier and faster for businesses to submit their information. We launched a business ownership verification via phone and SMS in a bunch of international locales. I think we're up to about eight countries which replaces some of the more cumbersome processes that we had for verification efforts which previously could take days or longer. We have got that down to a few minutes. Some of the other thing that we did were better capabilities just in terms of bulk uploading of lists of business locations that cater to large chains of businesses. We've got a much, much more robust UI for doing that. So as we build out all of that underlying functionality, we are going to be able to do a whole lot more here with Local.
Operator: Your next question comes from Youssef Squali - Jefferies.
Youssef Squali: Thank you very much. George, I want to go back to the comments you made about a more normalized bonus accrual level starting in Q3. Any reason to believe then that margins could decline further from their Q2 levels? Doesn't sound like it, but I was wondering if you can comment. Larry, on your foray into the enterprise market, you started with search appliances in '02. Now you are going after hosted applications. Can you speak to the logic of going after that market, which looks very different to us from your core search market? Looking at the margin characteristics of other companies, it looks like it may be very dilutive to your overall margins.
Eric Schmidt: Larry, do you want to do the second part?
Larry Page: I think one thing to keep in mind, we have Gmail, for example, has been a very successful product. We're really excited about it. There's many people within companies who need different kinds of functionality in order to use Gmail, and they are among the heaviest users. We don't really think about it in that way, I guess. I think that we have a tremendous amount of usage with Gmail and other hosted apps within Enterprises, and we are going to do just fine making money. I think the other kind of businesses you've seen there have a very different structure than what we have. I am not concerned about that applying to us, those businesses necessarily being very low margin.
George Reyes: On your other question we're just not going to comment on forward-looking margins. We just don't do that.
Operator: Your final question comes from Gene Munster - Piper Jaffray.
Gene Munster: Good afternoon. It looks like you guys have been a little bit more aggressive in China, specifically inking a deal with Sina. It sounds like you've strengthened your brand there. Any thoughts on how your efforts in China are going specifically?
Eric Schmidt: When we entered China, we entered under a set of restrictions that have been well publicized. We decided to invest heavily in China. We now have quite a talented engineering team, strong marketing, strong sales; very, very good connectivity and very low latency. The combination of that and a set of very good Chinese language products for search, advertising and some new ones they just launched seem to be accelerating our market share. Although it does not appear that we are number one in the market, it looks like we are now in a situation where we are quite competitive. In many areas, users tell us that our products are better. So it is a very good start. Although we don't think that this will result in an immediate, huge success, we think that the tenacity of Google, the many strengths that Google brings to the party will bring significant victories in China over the next few years. With that, what I would like to do is let's finish up. Thank you all again for spending so much time with us. When I think about what we have done and the set of networks that we have created: the network of users, the network of advertisers, the network of publishers. Google is doing a particularly good job of using these networks and tying them together in clever and new and innovative ways to provide real value to users, of course, especially in advertising, but also real value in terms of economics. It is the sum of that that I think is perhaps the least understood part of Google. It is the fact that we can link publishers and advertisers and users in new solutions that really do solve their problems. They solve their problems in ways that they have never been solved before, and we do it on a global scale. So with that, thank you very, very much. | [
{
"speaker": "Operator",
"text": "Good day, everyone and welcome to the Google Inc. conference call. This call is being recorded. At this time, I would like to turn the call over to Maria Shim, Investor Relations Manager. Please go ahead."
},
{
"speaker": "Maria Shim",
"text": "Good afternoon. Welcome to our second quarter 2007 earnings call. On the call with us today are Eric Schmidt, Chief Executive Officer; George Reyes, Chief Financial Officer; Larry Page, Founder and President of Products; Sergey Brin, Founder and President of Technology; Jonathan Rosenberg, Senior Vice President of Product Management, and Omid Kordestani, Senior Vice President of Global Sales and Operations. Eric, George, Larry and Sergey will provide some thoughts on the quarter, and then we will have Jonathan and Omid join us for your questions. This call is being webcast from our investor relations website. Our press release, issued a few minutes ago, is now posted on our website, as well as presentation slides that will accompany today's prepared remarks. A replay of this call will be available within a few hours. Some of the comments we will make today are forward looking, including statements regarding our investments in our business; seasonality; our traffic acquisition costs (NYSE:TAC); increases in cost of sales; plans to continue to invest in personalization; international growth; growth in our headcount and expected level of capital expenditures. These statements involve a number of risks and uncertainties that could cause actual results to differ materially from those anticipated by these forward-looking statements. These forward-looking statements speak as of today, and you should not rely on them as representing our views in the future, and we undertake no obligation to update these statements after this call. Please refer to our SEC filings, including our quarterly report on Form 10-Q for the quarter ended March 31, 2007, as well as our earnings release posted a few minutes ago on our website, for a more detailed description of the risk factors that may affect our results. Copies of these documents may be obtained from the SEC or by visiting the investor relations section of our website. Also, please note that certain financial measures we use on this call such as EPS, net income, operating margin and operating income are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation. We have also adjusted our net cash provided by operating activities to remove capital expenditures, which we refer to as free cash flow. We report our GAAP results, as well as provide reconciliations of these non-GAAP measures to GAAP financial measures, in our earnings release. With that, I would like to turn the call over to Eric."
},
{
"speaker": "Eric Schmidt",
"text": "Well thank you very much, and thank you all for joining us in your busy day. We have once again delivered strong revenue performance, particularly on core Google.com search and strong cash flow in our seasonally weak quarter. We're obviously very pleased with that. Traffic was stronger than we expected on Google.com both domestically and internationally, with annual traffic growth actually increasing over time, which is a very positive surprise. We are clearly doing the right things to attract and retain users. You can see this in the success of our many products. We're very focused now on people spending their time searching, using information online and doing it in a global way. The summer seasonality that we always talk about does appear to be milder than we expected, which is also good news. We are improving our ability to monetize searches, as we do every quarter, with another strong quarter of ads quality improvements. We are still continuing to see strength in revenue per query and click-through rate, and the pace of ads quality innovation is strong as we continue to scale up this effort and build up on our expertise. It is a big area of investment for us and an important one. So we have continued to make significant investments, as we have previously discussed. We are growing rapidly, building the best infrastructure, hiring the best to extend our footprint internationally, all the things that we talked about. Building better and better products and invest in doing so in the model that we've talked about: 70/20/10, 20% of the time, and that sort of thing. The data center is reducing latency, increasing search indices, et cetera. Network effects are driven by scale, and Google is the beneficiary of that. By focusing on the best talent -- and we have talked about this as well -- we have a growing percentage of international hires and international offices contributing to our global product set. We are building now localized products for each of these markets and we are seeing significant gains in terms of our role and our impact in each of these languages and cultures in ways that matter to end users. Of course, we are still applying the kind of discipline that we have always talked about with respect to making strategic long-term investments and short-term profits. So we are busy executing on our search, ads and apps strategy at scale all around the world. It is a focused strategy with these three pillars that will really grow the Google ecosystem. From a Google perspective, when we look at the quarter, one area we exceeded over our expense plan was headcount. We are very pleased with the talent that we've brought on board, but going forward we will watch this area very closely. So when I look at the quarter, we are very pleased with what we're delivering. The product model is working, our global growth strategy is working, our innovation model is working, and we continue to be an innovator at scale, and we certainly expect that to continue. I do want to mention -- as I have before -- that the second quarter which we just completed and the third quarter that we are in are seasonally weaker in traffic than the first and fourth and we would, of course, expect that to be true for many, many years to come. Let me turn it over to George for his comments and then I will join you at the end. Go ahead, George."
},
{
"speaker": "George Reyes",
"text": "Thanks, Eric and good afternoon, everyone. I will go through a discussion of the quarter quickly so that we can allow more time for your questions. Gross revenue increased to $3.9 billion, representing 58% growth over last year. Despite expected seasonal weakness, we experienced particular strength in our Google.com properties, driven primarily by stronger than expected traffic growth globally, as well as continued improvements in ads quality. As Eric mentioned earlier, the pace of ads quality innovation was strong, with the aggregate of these improvements positively impacting Google.com revenue. Revenue from Google.com properties was $2.5 billion, representing a year-over-year growth of 74% and sequential growth of 9%. Now I will turn AdSense revenue, which grew 36% over last year and was approximately flat at $1.35 billion. Growth in AdSense was affected by several factors, including typical seasonality that we see in our network during Q2 and to a lesser extent changes to the AdSense implementation of certain AdSense research partners that were less favorable to revenue. We also implemented changes that improve the user experience on our network, as well as provide more value to advertisers. For instance, AdSense for Content revenue was affected by policy changes such as termination of publishers who were not meeting our quality thresholds, partially offset by strong revenue growth from other AdSense for Content partners. Let's now look at aggregate paid clicks growth. To remind you, aggregate paid clicks include clicks related to ads served on Google properties, as well as ads served on our partner sites. Aggregate paid clicks grew approximately 47% over Q2 of last year and were roughly flat with Q1 levels, reflecting the typical seasonal pattern we see in Q2. Let me now discuss our international performance. We continue to make significant international investments, and we're seeing the benefits of this strategy. International revenue increased to 48% of total revenue, or roughly $1.8 billion, driven primarily by strong growth in Europe, despite weaker seasonal traffic trends. Spain, Italy and France in particular outperformed in Q2, while Germany, along with the UK, were significant drivers of revenue growth. The UK came in with revenues of $600 million and 4% sequential growth. Our substantial investments in R&D, sales and marketing, as well as infrastructure, are benefiting our smaller markets as well, with healthy growth rates in markets like Brazil, China and Korea. Now turning to expenses, traffic acquisition costs were $1.15 billion and 30% of total advertising revenue, down from 31% in Q1. AdSense TAC was just over $1 billion, while TAC related to distribution partners and others who direct traffic to our websites totaled $87 million in the quarter. As we grow our AdSense partner network and embark upon new initiatives, we may see additional pressure on TAC rates going forward. Other costs of revenue increased $67 million over the prior quarter primarily as a result of increases in costs related to datacenters, included depreciation, equipment and operations. We anticipate that other costs of sales will continue to increase going forward. Looking at operating expenses, operating expenses in Q2 other than cost of revenue included $234 million in stock-based compensation and totaled $1.2 billion. The growth in OpEx was primarily driven by increases in expenses related to payroll and facilities, which was $625 million in the quarter. One of the larger drivers of payroll expense was the company bonus plan. This was due in part to a revision of our bonus accrual methodology that will allow us to more proportionately recognize the related expenses each quarter. This all led to a higher bonus accrual in Q2, which includes a catch-up from Q1, and affected all expense line items. A second factor driving expenses was headcount growth, which led to higher payroll expenses. We added 1,548 employees in Q2, the majority in sales and marketing and engineering. At the end of the quarter, we had a full-time employee base of 13,786. The percentage of our international hires, new hires, also continued to rise, demonstrating our commitment to further scale the business internationally. We have grown quickly to address strategic opportunities, and as we grow we're applying increased discipline when making investments and taking a careful look at how we allocate resources efficiently across the world. Turning to operating profit, non-GAAP operating profit which excludes stock-based compensation, was $1.3 billion, with non-GAAP operating margins of 35%, a decline from 38% in Q1. Now turning to cash flow, operating cash flow was strong at $1.2 billion and CapEx for the quarter declined to $575 million. The majority of our CapEx was again related to IT infrastructure investments, including production of servers, datacenter construction and networking equipment. We will continue to make these investments going forward as our infrastructure and resources make possible such innovations as universal search, and will further our leadership position in the industry. Free cash flow, a non-GAAP measure, which we define as cash flow from operations less CapEx, increased to $655 million. So in summary, we believe our results reflect the strength of our core search and ads business, while our significant but disciplined investment positions going forward will allow us to leverage everything that we have been doing at Google. Now I will turn it over to Sergey."
},
{
"speaker": "Sergey Brin",
"text": "Thanks, George. I am really excited to tell you about what we have accomplished in the past quarter, especially with respect to search. And of course, search remains the heart of what we do. We had a big launch this past quarter in particular with universal search. This means now when you search on Google.com -- and soon it will be available on our international domains -- you are going to get results from both the web as well as image, video, news, maps and books all together. This may seem simple, but in fact it has taken a lot of infrastructure work just to be able to do all the computation across all those corpuses, as well as the algorithms that allow us to rank those disparate types of information together. Just a couple days ago, I was researching an old IBM mainframe system from the 1960s I had created on Google, and it never occurred to me to search for videos on that kind of query. But in fact, there were great videos and they popped up, and I watched both IBM's promotional videos from the '60s as well as a fantastic kind of looking back research history video about that particular computer. It turned out to be very useful to me. I expect that other users also find this useful, along with all the other corpuses I mentioned, not just video. It is just amazing where you don't think to search for something you are looking for where the information could just be fantastic. On the international front, we have been making great strides. We are actually now experimenting with trying new kinds of home pages, for example in Korea, Taiwan and Hong Kong, that are completely different types than we have tried before on our U.S. sites, as well as our European sites. We think it will be more appropriate for the local cultures and their contexts and their broadband connections, which for example in Korea are extraordinarily fast. The initial results, by the way, have been coming back quite positive, so we are optimistic about that. A big launch that maybe we don't appreciate so much in the U.S. is the cross-language information retrieval. What that means is that if you run your query in one language -- and by the way, don't forget many users out there, if they don't speak English, they can only get in their language about a tenth of the information that is available on the web as in English, so it is a much smaller set. But now, when they do their query, we will actually run that query in other languages, including English, and get back the results and translate them back. This is just really phenomenal. This is really opening the true power of the web to people who don't speak necessarily English. By the way, it works in English, too so occasionally, when you get stuff and it is only in French or Italian or whatnot, you'll get it back. I am very excited about this particular one. Now in addition to search, of course, we have been working on our iGoogle page, the personalized home page, as we used to call it. It is launched in 18 new domains. It is one of our fastest-growing products. We have been effecting fantastic gadgets for them, the little modules that you plug in. I have about 20 on my home page. It is really a good way to be able to see a bunch of information at once, not to have to navigate to disparate sites. We launched GadgetMaker, which lets people who aren't JavaScript and Ajax wizards in their own right to actually create gadgets that are going to be useful for things like sharing photos, planning events and whatnot. This is just one aspect in the way that we are personalizing the web. I think we are going to continue to invest lots of resources in this area. Now, jumping ahead, while there are so many things I would like to tell you about some of our web efforts, I only have limited time here. On ads, we have been doing a lot of work on ads, as always. Our goal is to connect advertisers with people who really care about their advertisements, who are really interested in their products. So the most important thing is the quality of our ad system. Q2 was a really strong quarter. We had lots of launches of different ad quality improvements, improvements in the algorithms. We had good results with our advertisers and with the publishers as well. We also enhanced the feedback system that allows users to give us feedback on the ads. It also better connects users with the advertisers that they would be best served by. Now, advertisers obviously want to get traffic to their websites, but ultimately they are interested in getting sales or leads or whatnot. So we want to make the whole process for the advertisers' marketing spend as effective as possible. Starting first off with the launch of the redesigned Google Analytics, it's got new visualization tools and custom dashboards. It really lets marketers and advertisers and people who just really care about their websites get great information and understand about how people are actually using those websites. That allows them to in turn optimize their websites. We added ten new languages, that is up to 17 languages supported now. We actually have had as a result, great growth in both new customers for Analytics, as well as people linking their AdWords account to their Google Analytics account, which is the most powerful combination. We've also added very important placement performance as well as search query information. So now, advertisers know where in our network precisely their ads are running. This obviously gives them better control over the ads too, and also which search queries are generating the best results. It is very useful information. We have obviously had a lot of demand for that and we finally have it out. Now lastly, I just wanted to mention our continuing work, we mentioned this before, but the pay-per-action advertising. Ultimately, as I said, the advertisers want not clicks, but they want something to happen like a purchase and whatnot. The pay-per-action advertising is now available to all advertisers and on all publisher sites. We have been having lots of advertisers move to this model. It is such a no-brainer. Then you don't have to figure out for yourself; well, I don't know how much a click is worth to me and whatnot. It really ties it directly to the action. Anyhow, all told, I am very excited about the progress we have been making on both search and ads, and for apps, I would love to turn it over to Larry."
},
{
"speaker": "Larry Page",
"text": "Well, thank you, Sergey. We continue to really invest in building simple web-based applications to help all of our users organize their information and create new content. As Sergey already mentioned with that mainframe example about video, we have been really excited about video. The best example of this is really YouTube. We made very strong progress this quarter, YouTube did, in many different areas. We added local support in nine new countries, and also, local users can now enjoy locally generated content, new features there, and new features on featured videos, directors and promotions. We have gotten great response to all of those things, which has resulted in increased usage. We also added many new partners on YouTube, several of them in newly added markets like Hearst Argyle Television, National Geographic and Global de Brazil. We also broadened our distribution through other partnerships, for example, Motorola, Telecom Italia and Apple on the iPhone and Apple TV. The iPhone, of course, has an amazing user experience in looking at YouTube. You can waste very many hours, and also enjoy useful content like mainframe videos on your iPhone. So Google Apps also had a very successful quarter overall. We were named number one product of the year by PC World magazine, which we were very excited about. We launched our apps premiere partner edition for ISPs to offer co-branded apps to their subscribers. And we signed a new deal with several new partners, including Virgin Media, a UK ISP. We also launched a tool in apps to enable easy migration of large numbers of email accounts to Gmail. This does things like preserves the header information, threads all the conversations, makes your email searchable. For example, just one customer migrated 30,000 users with 3 million emails in just 24 hours. So we have a lot of excitement around that. We also announced our intent to acquire Postini for $625 million. What that lets large enterprises do is really give them with some of the complex issues that they have like their business rules, their security mandates and legal compliance, and really let them do that easily over an email solution. So we are really excited about that, and it lets us add web-hosted security and corporate compliance for email, IM and other communications. Postini was actually one of our first partners in Google Apps. Again, we are really excited about this and I think that many of our customers are as well. Let me switch gears for a second and talk a little bit about developers. Really to support our efforts across all of the areas of the company -- search, advertising and applications -- we're really supporting a growing community of developers. As part of that effort, we had our first worldwide Developer Day to reach out to that community. We had over 5,000 developers participate in over ten countries and online, and we got a great response from them. We also at that time delivered several new tools and APIs for the developers to work with. One was called Google Gears, which is an open source project that enables web-based applications to run offline. We also launched Maplets, which lets people extend Google Maps, and there's examples like real estate search and embedded photographs that developers are implementing now. So all of these developers are really helping us to create new and interesting information and applications and content which helps us build our whole ecosystem and makes the user experience better for everybody. I was really excited by our progress in this quarter, and now I will turn it over to Eric."
},
{
"speaker": "Eric Schmidt",
"text": "Thank you. As I reflect on the quarter, I am really struck by our ability to operate and move forward at this scale. Normally, innovation at our size and growth begins to slow but here, it seems to be accelerating. We are producing more products with many more users, more languages, in more countries in the ways that we have talked about. I think it is because our model is working so well that we are so optimistic about the future. When we talk about products, and Sergey talked, for example, about iGoogle, you can see something which goes from almost no users when it is introduced to many, many, many millions of users very, very quickly. So we know this model will continue to scale, and we know that we are focused on our primary mission, which is around search, ads and apps. That focus is going to continue, with many good things to come in the future. So with that, maybe we should get some questions and comments. Maria?"
},
{
"speaker": "Maria Shim",
"text": "Operator, could we start taking questions, please?"
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from Anthony Noto - Goldman Sachs."
},
{
"speaker": "Anthony Noto",
"text": "Eric, one question for you. I think you have said previously that it was your goal to grow operating income each quarter on a sequential basis. This quarter, obviously, it was down. I was wondering if that was completely due to the bonus accrual that you had mentioned, given the number of employees you hired was lower than we thought, D&A was lower than we thought and revenue was higher, because I am trying to get to that underlying difference. If you could explain in a little bit more detail how much that incremental bonus accrual was. Thanks."
},
{
"speaker": "Eric Schmidt",
"text": "In general, we don't break out all the puts and takes on the changes in the accrual. What I would tell you is that we overspent against our own plan in the area of headcount, and some of it was related to this bonus accrual that I talked about; and some, because we hired a little faster than we had planned. In looking at it we thought, was this a mistake or not? We decided it was not a mistake, that in fact the kind of people we brought in are so good that we're happy we did this. As I said earlier, we will continue to watch this very carefully in the future."
},
{
"speaker": "Anthony Noto",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Imran Khan – JP Morgan."
},
{
"speaker": "Imran Khan",
"text": "Hi, thank you for taking my question. One clarification question and then a follow-up. For clarification, when you said that you will closely look at headcount, should we assume that headcount growth will slow down? Secondly, Eric, you talked about how your traffic growth rate is actually accelerating. If we look at the paid click volume it is flat sequentially, considering traffic growth rate is accelerating and you're getting into new countries. Why is paid click volume flat sequentially? Thank you."
},
{
"speaker": "Eric Schmidt",
"text": "With respect to the headcount, as I said, we ended up somewhat higher on our headcount expenses than we planned, which is the issue that Anthony asked about as well. We will watch it, we will adjust, we will be opportunistic but we are going to be careful about that. Jonathan, do you want to talk about paid clicks?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Typically, this is a slow quarter for paid click growth. It is basically the lowest in the year from a seasonality perspective. If you look at it on a year-over-year growth rate, paid clicks is very healthy and consistent with the trends that we have been seeing. Really, I would characterize the quarter as one of very strong traffic growth domestically and internationally in what typically we see as a somewhat weaker quarter from a traffic perspective."
},
{
"speaker": "Sergey Brin",
"text": "Actually, if I can add one more thing on the paid clicks. As we develop improved algorithms for showing our ads and as a result we're able to achieve better click-throughs, better monetization and whatnot, we usually like to split the benefit of that between both able to generate more revenue for other publishers than ourselves; but also, we like to improve the user experience, which in some cases means we try to show fewer ads in certain locations where we think they are less likely to get clicked on. That has a significant effect."
},
{
"speaker": "Imran Khan",
"text": "Thank you. That's very helpful."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mark Mahaney - Citigroup."
},
{
"speaker": "Mark Mahaney",
"text": "I wanted to follow up with Sergey on that last point. If you are making the ads more targeted and qualified -- which is what we think is happening -- at the end, advertisers should see more qualified leads and be willing to pay for that. We have seen an acceleration in your CPC growth the last two quarters and I know there's a lot of things that feed into that. But do you think that that actually is what's happening, or do you think that that kind of growth driver; that is, that CPC inflection point, growing because of increased advertiser interest and being willing to pay for more qualified leads? Do you think that is still to come?"
},
{
"speaker": "Sergey Brin",
"text": "I think it is a combination of factors. On the CPC, for example, the international mix changes, the nature of queries from season to season changes, and whatnot. On the whole, as you said, I do think that advertisers are seeing really good returns, and therefore they do bid higher. The other effect, as I mentioned, is that we tend to, when we have the opportunity, we feel like maybe we would be better off displacing some of the ads to show more search results higher on the page or taking more of the page especially as we improve the ad systems; therefore, we're still making equal or greater revenue. We do take that opportunity to increase the barriers to getting some ads up there. So that also has significant effects."
},
{
"speaker": "Jonathan Rosenberg",
"text": "In general, we have talked about this in the past, but we definitely believe there is plenty of room to grow pricing. We know that advertisers watch their ROI very carefully and they monitor their budgets accordingly. Sergey alluded to the general dynamic of improving the quality of ads and what you can expect the dynamic there is with respect to click-through rates rising while the number of ads declines. Basically what we are seeing is when you try to parse out the average CPC, the growth rates in emerging markets versus developed markets impacts this a lot, because the new markets have lower prices and the faster growth in new markets tends to put downward pressure on CPC. The other big thing that you saw this quarter was, as Eric mentioned, traffic growth on Google.com. When Google.com grows faster, that positively impacts CPC significantly. We did, as Eric mentioned, see very strong traffic growth there. So a lot of it is the distribution piece."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mary Meeker - Morgan Stanley."
},
{
"speaker": "Mary Meeker",
"text": "Thanks. I just want a couple clarifications. Eric, you've talked about the heads and basically the headcount and the operating expense changes and said you are going to watch it and you feel great about the people you've hired. But if could indicate if a portion of those were sales heads and a portion were international heads. I guess our translation would be that you feel comfortable that there will be related revenue commensurate to the hires in the next two to three quarters. If we could drill down on the bonus accrual a little bit, should we expect to see it play out on a more normalized basis on a go-forward basis? Is it fair to say that half of the difference between what you might have been expecting in OpEx and half of what you got for the quarter was related to the accrual? A third question if we may, just for a little clarification, any thoughts on how we should think about cost of goods sold as a percent of revenue on a go-forward basis? If you could answer any of those three, we will be happy because we know we went over our quota. Thank you."
},
{
"speaker": "Eric Schmidt",
"text": "Thank you, Mary. I will let George answer the second two. With respect to productivity of our headcount, our headcount, especially in sales, is productive very, very quickly. Omid talks and says that it's maybe even with the same quarter which they are hired is a model that is scaleable."
},
{
"speaker": "Omid Kordestani",
"text": "Again, the sales force name at Google means different things. It is the field forces which are calling on new Fortune companies, for example, as well as operational people that manage our online advertisers and the optimizations that go into the improvements. All of our analysis actually shows excellent productivity across the board. Some of the emerging markets obviously have different rates of productivity, and it is an investment we're making for the future there. But all in all, we've actually been going through a very thorough process of figuring out how best to take the sales force and reorganize them to represent all the various products we have today, from the core search products to the brand name products and monitor our productivity really carefully as we add resources both domestically and internationally."
},
{
"speaker": "George Reyes",
"text": "Mary, going forward it should be a more normalized bonus accrual process. This was just sort of a one-time inflection that we tried to do to true-up the bonus."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ben Schachter - UBS."
},
{
"speaker": "Ben Schachter",
"text": "There's a lot of litigation and regulatory issues around both the company and the industry, some established and some potential. What are the top two or three that you think potentially pose both the greatest risks for the company and the greatest opportunity? Separately, at a very high level the success of text-based search ads have really shown how valuable advertisers find highly-targeted ads. What do you think are the key barriers and opportunities to better targeting on the display and video side, both online and off? Thanks."
},
{
"speaker": "Eric Schmidt",
"text": "Ben, on your first question about litigation, we have already disclosed two major areas of litigation for Google; the first being in the book area, the book scanning and Library Project, and the second involving Viacom. Both of those are very important from the standpoint of principle. It would be great if those would go away or somehow would be resolved by technology or so forth. But we take those very seriously because we were sued by people who were unhappy with what we believed we were doing was right. With respect to broader litigation issues, Google is in the information business. There's always a potential that governments will decide that some of the things that we're doing are appropriate or inappropriate in ways that make our business harder. However, there are no short-term threats in that regard, and in fact in many cases the opening up of markets, the opening up of the Internet -- especially in countries outside the United States -- is really putting pressure on governments to have a broader information access approach, make information more broadly available, open up their Internet borders in a good way. So we are very optimistic about that sort of thing. On your second question, we will have Omid answer that."
},
{
"speaker": "Omid Kordestani",
"text": "There's two fronts really, two thrusts of work going on in the core business and there is continual work on ads improvement. There are all kinds of algorithms that continue to improve the targetability of the ads and the efficiency and accountability for advertisers and marketers. The interplay that was interesting between display and brand advertising and our core business, where we're seeing great success. This last quarter, we saw Pepsi in the U.S.; we saw Coke in France and Heinz in the U.S. really try to take advantage of both sides of the equation here. So advertisers are looking for ways to interact with our users online and have a two-way conversation about their brands really are starting to use YouTube very effectively and advertise on the content network, which allows them this targeted reach. It's also possible to have this two-way conversation, really an engagement with the users that the advertisers are really interested in. So we see great submissions of video or contests that then create that brand affinity, as well as then the ability to reach the audience and targetability that search provides. So we are really experimenting with all of that, and the core innovation is driving the core targetability and we're trying to learn a lot on how to best leverage the network as well as the properties like YouTube to have a comprehensive solution for the advertisers."
},
{
"speaker": "Operator",
"text": "Your next question comes from Robert Peck - Bear Stearns."
},
{
"speaker": "Robert Peck",
"text": "I was wondering if you could give us a little more color or clarity on the current impact of your other endeavors, monetization on YouTube, the radio side, TV and print. When do you think it may start to become more material? You've recently rolled out site authentication as well as the unavailable after tag. I guess our thoughts there are, when should we see any sort of impact on either search volumes or click-through rates or CPCs going forward? Thanks."
},
{
"speaker": "Omid Kordestani",
"text": "On all the new initiative from TV to print, again we have moved from the beta phase where we tested a few advertisers and a few publishers and really expand beyond that. We're seeing really excellent adoption. What we're seeing is the advertisers are really pleased, and the partners are really pleased with the type of monetization they are experiencing. Again, it is going to be too early for us to really see a material impact, given the scale of the other sides of the business. The mantra I'm following right now is that we really need to first prove this model for both the advertisers and the publishers before we really scale it and scale it both in specific geographies as well as internationally. I think hopefully in the next few quarters we can shed more light on this. But at this point, we are seeing, as I said, great success with the early results and we hope to be able to scaled these models."
},
{
"speaker": "Operator",
"text": "Your next question comes from Justin Post - Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "Thanks for taking the question. When I look at the advertising revenues up 73% on Google websites, was there anything non-search-related really driving that number? Long term, could you discuss your outlook for display or video advertising for Google? Do you think it can be a meaningful percentage of your total revenues?"
},
{
"speaker": "Eric Schmidt",
"text": "It certainly will eventually be a significant and meaningful percentage. Jonathan or Omid, do you want to talk a little bit about that?"
},
{
"speaker": "Omid Kordestani",
"text": "I think I just spoke to that earlier, is that on all these fronts we're seeing great success both in the advertiser front and the publisher front in the context of the beta test that we're doing. We have reorganized the sales force, for example, in the U.S., which is the most advanced, most mature market for us so that they can represent all the products. So every sales force and sales group now within the U.S. structure is going through a lot of training and has just been reorganized so that they don't just represent search, but they represent all the products. They have supporting expertise for the specific areas from YouTube to television to print advertising. What you will see from us is, again, a lot of effort to take this beyond the beta phase and engage more advertisers, more publishers. Once we prove that model, extend that internationally as quickly as possible. Again, I'm putting a lot of emphasis on this, there is great hiring behind it and great innovation so that we can have it be a significant portion of our revenues. We just have to see it develop."
},
{
"speaker": "Justin Post",
"text": "Was there an impact in the quarter at all?"
},
{
"speaker": "Omid Kordestani",
"text": "Not this quarter."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Just in terms of the basic underlying numbers, the story really is, as we talked about, is clearly a combination of strong traffic growth and ads quality. Eric mentioned the traffic growth increasing over time and the increase in the rate there, which is very substantial. Larry and Sergey also talked about the big investment that we have been making in the user experience and search quality and the universal search launch. What I think we are really seeing there is that users are engaging in more searches by virtue of our improving the search experience."
},
{
"speaker": "Justin Post",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Brian Pitz - Banc of America Securities."
},
{
"speaker": "Brian Pitz",
"text": "Thank you. A two-part question on eBay. Any color on the impact you've seen in the quarter on volume and cost per click from the pullback in advertising on your site? Any commentary on the acceleration of revenue that eBay noted yesterday on its call that is associated with your international partnership? Thank you."
},
{
"speaker": "Eric Schmidt",
"text": "eBay has been a long-term partner for Google. While it is true that they adjusted their mix in our advertising model, they continue to be a very significant advertiser. We did not see an impact on Google for many of the changes that they talked about that they made. Part of that is because Google is capable of choosing very much the best ad. When ads priority shift and people move advertising around, we can still take advantage of the highest-quality ad as produced in the auction. So far, the answer is no, no impact whatsoever. Our international business is very, very strong as you heard, and as a percentage of gross revenue it is growing especially strong in Europe; again, also noted in the eBay report. But that is not primarily because of our eBay-Google partnership, it is just because our international business is just strong overall."
},
{
"speaker": "Brian Pitz",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Christa Quarles - Thomas Weisel Partners."
},
{
"speaker": "Christa Quarles",
"text": "First if you could highlight what the theoretical limit for TAC rates would be, you are close to 85%. Second, a broader question. I'm just very curious about what you're doing with regard to the spectrum. I was wondering if you could articulate what your telecom strategy is or what you are willing to articulate to this point, especially in light of some of the Google phone rumors out there. Thanks."
},
{
"speaker": "Eric Schmidt",
"text": "Let me do the second part, and I'll have George talk a little about TAC rates. First, we don't comment on rumors, and there's lots and lots of rumors which is always very exciting. We have looked pretty carefully at wireless, and we are thinking about what we want to do there. From a Google perspective, the most important thing is that there be an open network. We define that in the sense that people can go to a store or however they are going to get it and get a device, plug that device into a wireless network and be able to use the full capability of the Internet. In the course of using that full capability of the Internet, which is going to be delivered on these mini-devices that have come out in this space globally, they're also going to become very significant Google advertising users. So there's really a direct connection between the open interoperable network that we are now arguing for in SEC filings and so forth and the ultimate usage of Google services and applications, and of course, advertiser satisfaction."
},
{
"speaker": "George Reyes",
"text": "On the TAC rate, on an absolute basis TAC increased. It was basically just a fundamental of more AdSense partnerships. Going forward, the future trend will depend basically on the relative growth of large AdSense partnerships and Google.com."
},
{
"speaker": "Christa Quarles",
"text": "Is there a theoretical, I mean will you strike a deal? I mean, obviously you do minimum guarantees, but will you regularly start striking deals at 95%?"
},
{
"speaker": "Eric Schmidt",
"text": "We prefer to do profitable deals. We are happy to give the majority of the revenue to the partners, which is what this is doing. There is no particular rule that we follow. We have as a business taken the position that we do want to have growing operating income to the bottom line. Basically growing operating income on a quarter-over-quarter basis. Although we did not achieve that this past quarter, it is certainly our goal. So all of the business decisions that we do are in the context of growing operating income on a quarter-over-quarter basis on an absolute basis, as well as building a strong cash flow-based business."
},
{
"speaker": "Christa Quarles",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Your next question comes from Douglas Anmuth - Lehman Brothers."
},
{
"speaker": "Douglas Anmuth",
"text": "Can you provide an update on your efforts around digital fingerprinting and content identification? Just one last question to try to wrap up the bonus accrual thing. Can you just clarify how you were accounting for your bonus accruals in 2006 and how that is changing, if it is, in 2007 in terms of the calendar basis? Thank you."
},
{
"speaker": "Eric Schmidt",
"text": "This is really a question about Claim Your Content. Larry and Sergey?"
},
{
"speaker": "Sergey Brin",
"text": "I should probably have Chad do an update of that. But as far as I know, we have experiments that are running and actually working quite well. So we are optimistic to be able to deploy that live in the near future. I haven't heard of any significant impediments. Obviously, this will present a new capability to content owners which they haven't had in the past with any other sites or mediums to be able to just detect in such a scaleable way easily, just in an automated way. So we are very excited about it."
},
{
"speaker": "George Reyes",
"text": "A portion of the increase in the OpEx is a function of the change in the bonus accrual. That methodology includes a piece that relates to the catch-up of related Q1 charges. So that would be one angle on it. We also expect our bonus expenses to be more normalized or proportional going forward and less of a ramp-up throughout the year."
},
{
"speaker": "Douglas Anmuth",
"text": "So is it reasonable to think that, for example, in the fourth quarter this year that you will have less bonus accrual on a relative basis will be in the fourth quarter this year than it was last year?"
},
{
"speaker": "George Reyes",
"text": "It will be normalized throughout the year going forward."
},
{
"speaker": "Operator",
"text": "Your next question comes from Heath Terry - Credit Suisse."
},
{
"speaker": "Heath Terry",
"text": "Thank you. I'm just wondering if you could just give us an update on Google Local, what you see as being the barriers in terms of really filling out the business directory there, as well as starting to bring monetization of the impressive level of traffic that you have gotten for that site up to where monetization in your core search product is?"
},
{
"speaker": "Larry Page",
"text": "I think we have been really excited about our efforts on local and business listings and apps, which are all interrelated. From a user experience, I think there's still a long ways to go to make those things work even better. We have done experiments with things like having businesses listed on maps so you can see where they are and things like that. I see all those things as interrelated. Also improved targetability of advertising for local advertisers or locally targeted businesses. I think we are in the quite early stages of those products. The user experiences are improving rapidly, and I think they will continue to. Also, the advertising capabilities of advertisers to target particular local needs is also improving really rapidly. I think we are really excited about that. It is sort of like the other areas people have been asking about, I think there is a lot of initial progress which we are very excited about, and we expect to have a lot more going forward."
},
{
"speaker": "Jonathan Rosenberg",
"text": "On some specific efforts this quarter, I think one of the things we did particularly with respect to Local Business Center was focus on making it easier and faster for businesses to submit their information. We launched a business ownership verification via phone and SMS in a bunch of international locales. I think we're up to about eight countries which replaces some of the more cumbersome processes that we had for verification efforts which previously could take days or longer. We have got that down to a few minutes. Some of the other thing that we did were better capabilities just in terms of bulk uploading of lists of business locations that cater to large chains of businesses. We've got a much, much more robust UI for doing that. So as we build out all of that underlying functionality, we are going to be able to do a whole lot more here with Local."
},
{
"speaker": "Operator",
"text": "Your next question comes from Youssef Squali - Jefferies."
},
{
"speaker": "Youssef Squali",
"text": "Thank you very much. George, I want to go back to the comments you made about a more normalized bonus accrual level starting in Q3. Any reason to believe then that margins could decline further from their Q2 levels? Doesn't sound like it, but I was wondering if you can comment. Larry, on your foray into the enterprise market, you started with search appliances in '02. Now you are going after hosted applications. Can you speak to the logic of going after that market, which looks very different to us from your core search market? Looking at the margin characteristics of other companies, it looks like it may be very dilutive to your overall margins."
},
{
"speaker": "Eric Schmidt",
"text": "Larry, do you want to do the second part?"
},
{
"speaker": "Larry Page",
"text": "I think one thing to keep in mind, we have Gmail, for example, has been a very successful product. We're really excited about it. There's many people within companies who need different kinds of functionality in order to use Gmail, and they are among the heaviest users. We don't really think about it in that way, I guess. I think that we have a tremendous amount of usage with Gmail and other hosted apps within Enterprises, and we are going to do just fine making money. I think the other kind of businesses you've seen there have a very different structure than what we have. I am not concerned about that applying to us, those businesses necessarily being very low margin."
},
{
"speaker": "George Reyes",
"text": "On your other question we're just not going to comment on forward-looking margins. We just don't do that."
},
{
"speaker": "Operator",
"text": "Your final question comes from Gene Munster - Piper Jaffray."
},
{
"speaker": "Gene Munster",
"text": "Good afternoon. It looks like you guys have been a little bit more aggressive in China, specifically inking a deal with Sina. It sounds like you've strengthened your brand there. Any thoughts on how your efforts in China are going specifically?"
},
{
"speaker": "Eric Schmidt",
"text": "When we entered China, we entered under a set of restrictions that have been well publicized. We decided to invest heavily in China. We now have quite a talented engineering team, strong marketing, strong sales; very, very good connectivity and very low latency. The combination of that and a set of very good Chinese language products for search, advertising and some new ones they just launched seem to be accelerating our market share. Although it does not appear that we are number one in the market, it looks like we are now in a situation where we are quite competitive. In many areas, users tell us that our products are better. So it is a very good start. Although we don't think that this will result in an immediate, huge success, we think that the tenacity of Google, the many strengths that Google brings to the party will bring significant victories in China over the next few years. With that, what I would like to do is let's finish up. Thank you all again for spending so much time with us. When I think about what we have done and the set of networks that we have created: the network of users, the network of advertisers, the network of publishers. Google is doing a particularly good job of using these networks and tying them together in clever and new and innovative ways to provide real value to users, of course, especially in advertising, but also real value in terms of economics. It is the sum of that that I think is perhaps the least understood part of Google. It is the fact that we can link publishers and advertisers and users in new solutions that really do solve their problems. They solve their problems in ways that they have never been solved before, and we do it on a global scale. So with that, thank you very, very much."
}
] | null | null |
GOOGL | 1 | 2,007 | 2007-04-19 08:00:00 | Operator: Good day and welcome to the Google Inc. conference call. This call is being recorded. At this time I would like to turn the call over to Ms. Kim Jabal, Director of Investor Relations. Please go ahead.
Kim Jabal: Hello, everyone. Welcome to our first quarter 2007 earnings call. On the call with us today are Eric Schmidt, Chief Executive Officer; George Reyes, Chief Financial Officer; Larry Page, Founder and President of Products; Sergey Brin, Founder and President of Technology; Jonathan Rosenberg, Senior Vice President of Product Management; and Omid Kordestani, Senior Vice President of Global Sales and Operations. Eric, George, Larry and Sergey will provide some thoughts on the quarter, and then we will have Jonathan and Omid join us for your questions. This call is being webcast from our Investor Relations website. Our press release issued a few minutes ago is now posted on our website, as well as presentation slides that will accompany today's prepared remarks. A replay of this call will be available within a few hours. Some of the comments we will make today are forward looking, including statements regarding international growth; possible future benefits from our partner deals; growth in our headcount; future investments in partnerships, distribution and content; future product innovation; our expected operating expenses; our expected level of capital expenditures; our expected margins; charges associated with stock-based compensation and possible future pressure on traffic acquisition cost rates. These statements involve a number of risks and uncertainties that could cause actual results to differ materially from those anticipated by these forward-looking statements. These risks and uncertainties include a variety of factors, some of which are beyond our control. These forward-looking statements speak as of today, and you should not rely on them as representing our views in the future, and we undertake no obligation to update these statements after this call. Please refer to our SEC filings, including our annual report on Form 10-K for the year ended December 31, 2006, as well as our earnings release posted on our website for a more detailed description of the risk factors that may affect our results. Copies of these documents may be obtained from the SEC or by visiting the Investor Relations section of our website. Also, please note that certain financial measures we use on this call such as EPS, net income, operating margin, operating income and our effective tax rate are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation. In addition, in the fourth quarter of 2006, we removed certain discrete tax items from non-GAAP net income and EPS. Finally, we adjusted our net cash provided by operating activities to remove capital expenditures, a measure we refer to as free cash flow. We report our GAAP results, as well as provide reconciliations of these non-GAAP measures to GAAP financial measures in our earnings release. You can obtain a copy of our earnings release by visiting the Investor Relations section of our website. Now with that, I will turn the call over to Eric. Well, thank you very much, Kim. As everybody can see from the press release, we are ecstatic about our financial results this past quarter. Before I start talking about how well we did this quarter, I would like to remind everybody as I have each year at this time, that we are about to enter our seasonally slower summer growth period, and make sure you factor that in when thinking about how our business will grow. Our core business at Google remains very strong and continues to grow. We have seen excellent performance in the U.S.; performance internationally is even better. International growth across many markets confirms the validity of our business model: build the market, monetization will follow. What is different now is that everyone is thinking more creatively about monetization opportunities, simply because they have learned about our successes and failures in past rollouts. So we're getting a benefit from that. We are continuing to make significant investments in our core business. Data centers, of course, primarily for speed, comprehensiveness and usefulness and engineering to preserve our 70/20/10 model that you have heard many times before. In sales and support -- and I should say this globally by the way -- to attract and retain users and advertisers. And in partnerships of course. Our AdSense partners, content partners, distribution partners, offline partners. Sometimes I worry that we spend so much time talking about all the new things that we don't focus as much on the core business, especially in our marketing and messaging. In looking at the quarter, the most important message is that our core business is very strong. It is the core business that is driving our success. Core services are as vital and vibrant and innovative as they could possibly be. The success of our core business continues to let us take calculated risks in new markets and expand in new products. Geographic, for example, committing to our European expansion, committed to Asia. China, of course, is very important to us, but only one market of many that are now receiving great focus at Google. Expanding our business to multiple platforms and formats. In display advertising, DoubleClick, which of course was the subject of our call last week which all of you participated in. In video, YouTube, hugely successful for us; video syndication now working well for us. The BBC deal, a historic deal for us this quarter. In mobile, LG and Samsung deals this quarter driving mobile adoption for the Internet and for Google in many, many good ways; many partnerships already in place. In the enterprise business, a premier version this quarter including now Docs & Spreadsheets. We are also expanding our business to offline media, again the subject of a lot of discussion. Radio, the Clear Channel deal that we announced on Monday, again drives the definitive deal to make that business hugely successful for us. In TV, the EchoStar deal similarly announced very recently, which allows us to do targeted advertising in the television world. In print, the test that we announced a couple months ago is doing extremely well and being expanded as we learn what really works and what does not. Each of these strategies involves creating solutions that benefit both advertisers and users, and it is the synergy between them that we have been able to harness. Targeted, useful, effective advertising will continue to be our mantra; you all know that, of course. Technology and efficiency is the core of our technology approach, and it really does benefit end users. In fact, if you think about it, user benefit is the most important thing that we focus on as to how we make these decisions. Our past experiences and our failures, if you will, the learnings that we get show us what works and what does not. From our perspective, and I think the forward challenge for the company, is simply making these learnings scale globally so very, very quickly. This is why we are so excited not just about the quarter, but for the quarters that lie ahead. Now rather than me talking, maybe George, you could take everybody through the financials and a lot of the details, which are very impressive.
George Reyes: So let's go ahead and get started. Thank you very much, Eric, for that introduction. As you can tell, Q1 was a very strong quarter for us with truly impressive growth driven by our continued leadership in both search and advertising. Gross revenue increased 63% over Q1 of last year to $3.7 billion. Revenue from Google properties was $2.3 billion, representing strong year-over-year growth of 76%. We experienced healthy traffic growth in our Google.com business both domestically and internationally. Monetization continues to be strong, positively impacted by improvements in our ads in Q1, as well as in prior quarters. As we have discussed in previous quarters, we are constantly innovating to show our users more relevant and targeted ads, which in turn leads to benefits for our advertisers and strengthens our business. The investments in our extensive network of partnerships were also contributing meaningfully to our growth. AdSense revenues increased 45% over last year to $1.3 billion, driven by strong growth across our existing partners, as well as launching a few new partners. As on Google.com, our AdSense business experienced very strong traffic gains in the quarter, particularly internationally. I will go into more detail about our international performance in a moment. Beginning last quarter we began to disclose the growth in paid clicks. This number includes clicks related to ads served on Google properties, as well ads served on our partner sites. Aggregate paid clicks grew approximately 52% over Q1 of last year and approximately 13% over Q4. Now I will turn to the geographic discussion. We are continuing to see significant momentum in our international business as we invest in the infrastructure to address our global opportunity. International revenue was 47% of total revenue, or $1.7 billion. As is typical in the first quarter, the UK was particularly strong with revenues of $578 million and 23% sequential growth as the travel and finance verticals rebounded as we expected from Q4. Other markets that contributed meaningfully to growth were Germany, France and Spain, as well as some of our Asian markets like Japan and also Australia. In addition, it is important to note that some of our smaller markets are also performing very well, including Ireland, Brazil and Korea, which benefited from our partnership with Daum. This demonstrates the diversity of our business and the potential to grow our business even more significantly outside the United States. Turning to TAC, traffic acquisition costs were $1.1 billion. The majority of TAC is related to the amounts paid to our AdSense partners, which totaled just over $1 billion. The increase is due primarily to growth of more significant AdSense partnerships. As we grow our distribution in AdSense partner network and embark upon new initiatives, we may see additional pressure on TAC rates going forward. TAC related to distribution partners totaled $73 million in Q1. The increase in these traffic acquisition costs is associated with some of our largest distribution deals ramping up. Other costs of revenue increased $38 million over the prior quarter, primarily as a result of increases in depreciation related to data centers, bandwidth costs and content acquisition costs. Going forward, we anticipate that other cost of sales will increase as each of these line items grow. Turning to operating expenses, OpEx included $184 million in stock-based compensation and totaled $972 million. These included $506 million in payroll-related and facilities expenses, an increase of $13 million over the prior quarter. R&D decreased as a percentage of revenue, primarily due to lower expenses related to company bonuses in the first quarter relative to the fourth quarter, while sales and marketing and G&A were relatively flat as a percentage of revenue. Non-GAAP operating profit, which excludes stock-based compensation, rose to $1.4 billion with non-GAAP operating margins of 38%, up from 37% in Q4. As we have said in the past, margins may decline as we continue to invest heavily in our business. You should expect continued growth in headcount, across functions and across the world. We also expect continued investments in AdSense partnerships, distribution partners and content. Capital expenditures for the quarter totaled $597 million. While there were some real estate-related expenditures as in prior quarters, the majority of our CapEx was related to IT infrastructure investments, including data centers, servers and networking equipment. As we have discussed previously, we expect to make continued significant capital expenditure investments to drive the growth of our business as these investments have contributed tremendously to our success to date. Now turning to cash flow, operating cash flow was strong at just over $1.2 billion. Free cash flow, a non-GAAP measure which we define as cash flow from operations less CapEx, increased to $623 million. With that, I will turn it over to Larry.
Larry Page: Thanks, George. I'm not only excited about our financial performance, but also our product performance in the quarter, and that's what I am going to tell you a little bit about. Now remember, we keep about 70% of our resources focused on our core business which is search and ads, and the rest of that, which is probably the other 30%, is probably primarily what you hear about. But we work tremendously hard to improve our core relevance and our focus on search, and we made many improvements this quarter in many, many different markets on just basic quality and relevance in our search. We've also made user experience improvements which are easier to see, and those are on things like when you do a search, you can actually get maps and reviews of businesses right in your search results and also in very, very many countries. We released a bunch of new ones this quarter. We are also looking a lot more at content. So things like personalized search where the results are tailored to you specifically are things we also made great strides in. Now we have also, I think, made great strides in moving people towards web computing, and things like Gmail we opened up sign-ups this quarter and had very healthy growth there, which for us we are really excited about. We also improved our Docs & Spreadsheets product, releasing 15 new languages, and we also had tremendous growth there. We also released Google Apps Premier, which is a product for companies and universities we launched this quarter. It lets you have Gmail for your own domain, and you can even use your own existing login process for your users to log in to Gmail and use Docs & Spreadsheets and all of our great products. We have a lot of great customers there, Northwestern; even customers in Kenya and Rwanda, and we have pilots with GE and P&G, and we're very excited also about the prospects there. In YouTube, we have had tremendous uptake of YouTube, and I would say the growth is accelerating even more. We have made many improvements to those sites, which increased usage of community features of people talking about videos, rating them and so on, and just generally improving the experience there and going gangbusters there. In the personalized home page on Google, we released a new, improved version of that with things like themes so you can have your personalized home page on the beach or at the bus station and see a little bit of the weather that is going on, and we had tremendous uptake with huge numbers of our users adopting that on the first day. We also released things like the Google Talk, which lets you see your friends on your Google personalized home page, and we look forward to improving those products even more. Our user experience is still a tremendous focus for us, and new products also. With that, I would like to turn it over to Sergey and have him talk a little bit about the other part of our ecosystem, which is partners and advertisers.
Sergey Brin: Thanks, Larry. I'm very excited to talk to you today and to echo a lot of the sentiments that Eric already shared with you: how key partnerships are to Google and how much we care about making our partners successful. First off, we noted some of the improvements we made to YouTube, and we also have a number of more partners there. In the past quarter we announced the BBC, the NBA, the Sundance Channel. We even have a partnership with a number of the presidential candidates this year, their video clips which we call You Choose '08. YouTube continues to grow both user-wise, as Larry mentioned, and in terms of partners. In the mobile space, we had a number of new partners sign up and a number of announcements, including Nokia and Vodafone, both two very large announcements. I want to spend most of the time, however, talking about advertising, both what we have done to help out our most numerous partners, our advertisers, as well as the other kinds of partnerships we have struck within the advertising space. First of all, we have launched Pay-Per-Action in beta, and that is the easiest way for an advertiser, in many cases, to decide how much they should pay for advertising, which is just to specify an action like a purchase and say, this is how much I am willing to pay for each purchase. We're very excited about that. Clearly it definitely speaks to what advertisers want to get most. We also have helped them out in getting more of those actions, conversions, purchases and what not with the introduction of the Website Optimizer. This lets you automatically test and refine your website to optimize adoption or conversion or whatever that may be. Another thing that will really help that is to make it easier for customers to actually transact. To spend money without fear of their credit card being stolen, without just a lot of hassle of entering the same information over and over, and we have done that with Google Checkout. In this past quarter, we announced a number of new partners for Google Checkout. We launched CompUSA and Blue Nile, and we also signed RadioShack, as well as B&H. Now we have been talking here mostly about search and certainly online advertising. Within online, we have expanded quite a bit. You are familiar with our AdSense for Content network. We have signed Daum up for that. That is the very large Korean site. In fact, now we have 75% of the top 20 social networks also in our AdSense network. The big news you have no doubt heard by now is our intent to acquire DoubleClick, and we're very excited about that because of the possibility to make it even easier for our advertisers to launch and manage their search and display campaigns, which they can now do -- or will be able to do -- in an integrated fashion. That is the Internet portion of our advertising. Of course, we also have been trying to make it easier for advertisers to advertise on other media, offline media. In television, for example, we have a partnership with EchoStar over at that DISH Network and that way we can deliver advertisements to DISH Network viewers. In radio more recently, we have signed a partnership with Clear Channel, which opens up a lot of great inventory to our advertisers who want to use the radio medium. Ultimately, as Eric said, it really comes down to end users or viewers to be consumers of this advertising. Some people feel that advertising is a zero sum game, and they shrug when they hear about all these new advertising products and the progress and what not; but that has not been our experience. In fact, fundamentally our vision is that we can make advertising better across the board, better for everyone. We don't have to have intrusive advertising to be effective. In fact, quite on the contrary, it is the interesting, relevant, sometimes entertaining advertising that is most effective for both advertisers and makes it the best possible world for the users and viewers alike. So, on that note, I would like to turn it back over to Eric.
Eric Schmidt: Well, thank you very much, Sergey. As I listen to this, I am very impressed that the global growth strategy of Google continues to work very, very well. Our innovation model is clearly working; lots and lots of new products coming out and no end in sight. The partnerships that we reviewed, in particular the ones that Sergey and Larry just highlighted, are now really working, they are really running globally. The core business in search and ads, we're still at the beginning of that business. A lot of people have said that well maybe this is not such a big business. It is a huge business, and we have a lot of room to grow there. The complementary strategies, things like offline ads, some of the new ad initiatives, YouTube again complements our core search and ads business. There are other examples, obviously our enterprise business. They are working, too. I'm personally impressed with the way in which the management team and employees of the company have managed the growth from an operations perspective. You can imagine the dials and everything else that has to be tuned here, and yet we have been able to take advantage of the opportunity before us, and I believe we will be able to do that for the foreseeable future. So with that, why don't we go directly to your questions? We are going to add Jonathan and Omid as previously announced, because they do such a good job with Q&A. Operator, are you ready for the first question?
Operator: Absolutely. (Operator Instructions) Your first question comes from Mark Mahaney - Citigroup.
Mark Mahaney: Great, thanks. Two quick questions, please. A housekeeping question: it looks like the change of the lowered tax yield on stock-based comp maybe added $0.03 to $0.05 to the number. Could you just walk through that math a little bit? Secondly, a broader question just on display advertising. Larry and Sergey, when you started search, you clearly had something different in mind, something more targeted than the normal advertising that was out there. What generally changed in your thinking that made you think either that the display advertising market was big enough or that you had a targetable solution that was good enough to make you want to make the moves you made, like buy DoubleClick?
Eric Schmidt: Let's have Larry and Sergey answer the second question while they are figuring out the answer to the first.
Sergey Brin: There were a number of things that made us excited about this area. First of all, of course, the success of our own products within the broader advertising space, not just search but for example, AdSense for Content and more recently even including image ads and things like site targeting. I think we realized how much inefficiency there really was in online advertising. Because at the face of it, you would think well, how complicated can it be? You just pick a good site for your ads and you just run them, what could be inefficient about that? But, in fact, it turns out there are many different websites. There are many different users who use those websites in their different situations. Advertisers, in many cases, don't have all the metrics information they need to decide which ads to run where. So we have seen good success with that, and we think we can expand that more to broader kinds of media, not just static images and what not. Of course, with this intent to acquire DoubleClick, we think we can make more advertisers much more efficient.
Eric Schmidt: Larry and Omid and Jonathan, do you want to add a little bit more to that?
Omid Kordestani: The other thing I would add is that we are, as we have said in the previous quarters, very busy actually with all these initiatives, including display advertising. In the last couple of quarters, we've had a lot of customer success stories where they are taking advantage of the content network, the different formats we already support, the targetability. Customers include companies like REI that, for example, use Google's display network to promote new store openings. They utilize geographic and site targeting functionality to reach both mass media sites like NewYorkTimes.com, as well as niche audiences like specialty sites like rockclimbing.com. This has proven so effective for them in driving in-store traffic that they are really going to utilize it as part of their ongoing marketing initiatives. So based on what we saw here, we just know that the same principle we applied to search targeting can really extend to these new initiatives and that we are going to place a lot of emphasis on that.
Larry Page: I was just going to add that we are still in the very early stages of display ads and branding ads and that whole area. Much of the technology we have already developed for our search ads and AdSense for content and so on can be used for those markets. People do very sophisticated things around time of day and types of users with these things, and also the sites already with our AdSense network, the sites where you just choose to run your ad or not and so on, the content of those pages, all of those things apply to the kind of spaces we are now going after.
Eric Schmidt: Could you ask the first part of your question again, the housekeeping question?
Mark Mahaney: Yes, just on the tax, it sounds like there may have been a little bit of a change in the tax rate you are applying to determine the shield on the stock-based compensation; or maybe there wasn’t a change, but it looks like there was. It looked like it was a very modest change. Could you walk through that, or you can just say there was no change.
George Reyes: It was a very, very modest change from the 134 to the 183 here.
Mark Mahaney: Thank you very much.
Operator: Your next question comes from Robert Peck - Bear Stearns.
Robert Peck: Eric, I wondered if you could comment a little bit about some of the tweaks to the algorithm during the quarter. In particular, do you take something like the words Bear Stearns and you type them into Google versus typing them into Yahoo!, you notice that you're not monetizing as much as you did. You go back a year or so ago, there was a lot of buzz around a third link. I think you have made some of these changes maybe in the middle of the quarter. Could you talk about what you saw as far as impacts on CPC, pricing, as you sort of scale back your inventory on keywords you were selling, click through rates and ultimately revenue. Part of that as well is, you also reduced some of the minimum CPC pricing to more tail-like turns. If you could quantify how you see those changes impacting maybe a more full Q in Q2 and going forward?
Eric Schmidt: Jonathan, why don't you handle it?
Jonathan Rosenberg: I'm not sure I can quantify it too much for you, but I can try to give you a sense philosophically of what we have been doing and some of the changes that we actually implemented. As you know, we have been upgrading the quality component into ads from the start, and we have been building on that with fairly robust quality improvements almost every quarter since. This quarter was obviously no exception. Some of the type of changes that you're talking about, specifically the ones that we implemented in mid-February which we announced, were the quality-based bidding changes. Basically what those did was improve the quality score algorithm that generates more accurate quality scores and predictions, particularly in some of the cases where we have limited data. So there are a lot of situations maybe a lot of people don't search a lot on Bear Stearns. We have done a better job of figuring out for some subset of those words how to tweak the quality-based scores. That was certainly significant. One of the things that made it even more significant was that we added to the front end of AdWords the ability to give advertisers transparency into their quality so that they could see whether or not particular words were poor, okay or great. That actually allowed the results to improve pretty substantially. That certainly had a real impact during the quarter, although it was only implemented midway through the quarter in February. There are just a couple of others which I can touch on real quickly. We also announced that we changed the background color on the top ads to yellow. We also changed the area in which people click so that people are less likely to click if they are not actually trying to click on the ad. These types of things are also important. Landing page quality I think is another thing we have been working on. Beyond that, it is basically just many changes to the ad systems. You can derive the CPCs to the extent that you want by looking at the paid click number which George announced.
Operator: Your next question comes from Anthony Noto – Goldman Sachs.
Anthony Noto: Thank you very much. Eric, I was wondering if you could comment at the management level as you make investments, what measurement do you look at holistically for the company as a return-based measurement to ensure that the overall business and overall shareholders are seeing an aggregated return from each of the individual investments? The reason for my question is I know that you have launched a lot of initiatives: Google Checkout, Gmail, Google Finance, that may not necessarily have a unique revenue stream tied to them that is large, but does provide ancillary benefits to the overall platform. Are you incented on that return metric? The second question is, we tracked your revenue per employee on a gross basis. Up until the fourth quarter of 2005, gross revenue per employee had been growing in the single-digit range. Since then it has been declining, in fact down 12% year-over-year this quarter. I recognize that is because you're adding more new employees that are not productive. At what point do you think your existing employee base is large enough that your new employees do not cause your gross revenue per employee to decline?
Eric Schmidt: An interesting series of questions. We don't approach the questions quite the same way that you phrased them. Our primary focus is on end user happiness, end user traffic, end user growth. So what we look at is we look at what will drive even more end users using our product globally. So, for example, if we could bring out a product that will cause people to use Google and its various applications that much more and they spend more and more of their day using Google services, that allows us to eventually monetize that. So we do not insist on a direct link from say a product that does not get revenue to one that does. In the cases that you cited, we look at the revenue contribution. But the primary focus and the primary management focus is around end user happiness, end user growth, end user everything. With respect to the revenue per headcount, again we are not very focused on that. We are much more focused in total growth of the platform, total growth of the number of advertisers, total growth of the monetization. It is easy enough for us to dial any particular metric like employees per gross revenue up or down as we see fit. It is more important to focus on end user happiness. A lot of the people we are talking about are, for example, coming in for customer service globally. We are also way, way investing in engineering because we believe this is a time where our model is scaling that products that we are going to bring out in a year or two are going to have huge impacts to the investments we're making in data centers, and we need the engineers to build the great products to do so.
Operator: Your next question comes from Douglas Anmuth - Lehman Brothers.
Doug Anmuth: I was hoping you could comment on toolbar activity. If we look at third-party data, it suggests that toolbar growth is driving north of 40% of total growth in search queries, which clearly validates your distribution strategy. But I'm wondering what you're seeing in terms of the behavior pattern for users with downloaded toolbars, not just right after they get the toolbar but over a little bit of time. Does it make you concerned at all that we could be seeing sort of a one-time spike from this initial bigger distribution of toolbars? Thank you.
Jonathan Rosenberg: Certainly a big story in the quarter is traffic, and a component of the traffic performance is certainly toolbar. No question toolbar users search more than non-toolbar users. I can’t really comment on the degree to which the growth rates would be dependent on the number of remaining users out there who could also use toolbar, but we can certainly say that your hypothesis is correct, that toolbar users search significantly more.
Larry Page: I was just going to add, we have been distributing toolbars for a long time and have had a very successful product there for a long time. I don't think there has been any huge changes over the last quarter or two in people's behavior or those mechanisms.
Operator: Your next question comes from Mary Meeker - Morgan Stanley.
Mary Meeker: Thanks. One of the things that we are seeing in the market right now is it feels as though we are seeing an acceleration in the migration from offline advertising to online advertising. Eric, you talked in your opening remarks about your deal with Clear Channel, your deal with EchoStar; obviously others. Obviously they are early stage. But we are frankly surprised that you're able to announce such large deals as quickly as you have been able to do that. Do you think that we will see a lot more of those in the next six months? When we add them all up at the end of 2008 and we look at the financial impact to Google, do you think it could be at a level where it is actually material as quickly as the end of 2008? Thanks.
Omid Kordestani: Your observation is correct. We are very busy in the partnership area and very much so also globally. I think what we are seeing is that again the power of the platform and the interest in tapping into, depending on what kind of partner you are, both the advertiser network and the publishing network is very, very interesting for people. That again, this push to a more efficient measurability is of great interest to everyone, be it in the print sector, audio or TV. I think what everybody is really trying to figure out is where do their put their own resources, just like Google did awhile back where we focused our field operations on more Fortune companies. I think the TV companies, print companies, they are all trying to apply their resources to their area of their own expertise and then utilize our ability to drive a lot of revenue and targetability and measurability. So we're finding great interest. It is very competitive, the market is very competitive, and on a global basis, we're just again doing the best we can to staff up both partnerships with legal and finance to be able to model these deals and be able to have the right partnerships in place. So yes, I would say you are going to see us be very much focused on this space.
Operator: Your next question comes from Ben Schachter - UBS.
Ben Schachter: Congratulations on a nice quarter. Can you talk at a high level on Google's view of cookie data and third-party ad serving? Now that you own DoubleClick, do you think it is more likely that you will open up the network to third-party ad serving? Thanks.
Eric Schmidt: I will let Larry and Sergey.
Larry Page: I think that in general we are really excited about opportunities to improve some of the practices that are in place there with regards to people's privacy, but also while improving targetability and the kinds of information you need to really provide good information to everybody involved in the process. So I think we're excited about our ability, our technological strength and how it can be applied to some of those issues. We're not ready to go into any specifics on that yet.
Operator: Your next question comes from Justin Post - Merrill Lynch.
Justin Post: Could you talk a little bit about TAC? Obviously you saw the percentage or the percent of network increase quarter over quarter. Is the mix of who your partners are changing a lot? Did a couple of partners ramp up, and how do you see that going forward? A little more comment on that. And then on the distribution partner side, is that fully in your numbers now, or are there still more partners ramping up there for future quarters?
George Reyes: The answer is that we're doing a lot more deals and the deals are, in fact, carrying a disproportionate amount of TAC. So, at the end of the day and I think I suggested that in my earlier comments, TAC as a percentage of revenue is likely to increase given the deals that we're doing these days.
Justin Post: Was there a partner that specifically ramped up in the quarter?
George Reyes: I can’t comment on that. Generally I think the TAC rates are going up directionally.
Operator: Your next question comes from Imran Khan – JP Morgan.
Imran Khan: Thank you very much for taking my question. Your paid click growth rate in Q1 was 52%. I think it was down from 61% in the fourth quarter. Can you please help us to understand if that growth rate decline was due to query volume growth rate decline or click-through improvement? Also, do you have any contra revenue from Google Checkout?
Eric Schmidt: George could specifically answer the contra-revenue question with respect to Checkout. From a marketing perspective, Q4 was seasonally more significant in terms of the marketing efforts that we were doing. He can give you the specific accounting implications. The other specific question relates to paid clicks and click-throughs?
Imran Khan: Yes, so basically paid click growth rate declined from 61% to 52%. Is it driven by query volume growth decline, or there was an anniversary of click-through improvement that you made in the past?
Eric Schmidt: Query volume was very healthy. I think we already mentioned that. Q1 is typically a somewhat weaker seasonal quarter from a monetization perspective, although George mentioned in his prepared remarks that there are some exceptions internationally, particularly in the UK. Beyond that, I would not be too much into an aggregate CPC measure as we have talked about in the past. Country mix, property mix as the previous question alluded to, had significant impact on how that shakes out. Clicks are extremely healthy as well.
George Reyes: On the Checkout question, you have to sort of stand back. We really peaked seasonally in the Christmas season and right now the business is going, but it is not going at a seasonally strong rate at this point in time. So we are bullish on Checkout, and the contra revenue range will probably be somewhere around 1% of revenues or thereabouts.
Operator: Your next question comes from Brian Pitz - Bank of America.
Brian Pitz: Thank you. First, a broader industry question. When you look at the UK market, a lot of data suggests that market is growing very substantially and north of 40%, and now represents about 11% of total ad spend is now online versus the U.S., we estimate about 5.5%. Can you talk about what is fundamentally different about that market or what is going on there that is driving those higher growth rates? Just a quick follow-up: you mentioned earlier on the call growth and investment in content. Any sense there what type of content or areas you may be interested in? Thanks.
Omid Kordestani: In terms of the UK question, we're definitely seeing very strong performance there. I think it is driven by our leadership team and having put a lot of focus in both reaching out to our clients, as well as advertising agencies, focus on named accounts. We're seeing increases in average spend, significant increases in that focusing on the different vertical strategies and making sure we understand the seasonality of those just as we mentioned earlier. Probably saw finance and travel bounce back, and in Q4, for example, we very much paid attention to how to deal with that seasonality and that helped us in Q4 as well. So we just think again the economy is very strong there. The sales team and the leadership is very strong, and just our ability to execute our strategy is working well. There is also strong interest in the new ad formats and also, as we mentioned, deals like BBC, were some of the very interesting deals we were able to establish. In terms of content, I think in general some of the spending we're doing is improving our product areas. For example, spending in mapping services and mapping data and some of the partnerships we established. But I don't think there is anything unusual there other than just our focus in improving both the products and expanding partnerships.
Jonathan Rosenberg: Just adding to Omid's comments, the two other things that I have noticed in the UK are that early on the agencies were particularly aggressive with the online medium, and that really helped spur the early growth when it was in its more nascent stages which has carried over. I think some of the other observations that I have seen just in the marketing literature are that there is a relative lack of TV advertising there because the BBC is so popular. And so they were much quicker to move their spending to other outlets and try things more quickly and then discovered that the ROI was high.
Eric Schmidt: And George, you wanted to add something, didn't you?
George Reyes: I just wanted to clarify that comment on Checkout. On Google Checkout basically we are less than 1% of where we were in the holiday quarter.
Operator: Your next question comes from Christa Quarles - Thomas Weisel.
Christa Quarles: I was wondering if you could discuss some of these offline ad partnerships with regard to your view as to whether or not you can get beyond remnant? Clearly the Clear Channel deal was less than 5% of their inventory. Or it is a really just about redefining remnant for some of these markets? Clearly we have also seen the eBay upfront auction not working very well. So I was just wondering if you could discuss that. And then also I think last quarter you indicated that coverage rates were down. I was wondering if you could comment on them this quarter.
Eric Schmidt: One thing to clarify is that the Clear Channel deal includes a lot of premium inventory. It is not a remnant deal. That is a misperception. Maybe we did not communicate that very well. The EchoStar, similarly, those our primary spots. That is why those two deals are so important. It launches these two new initiatives right in front of the primetime viewer.
Omid Kordestani: I would add that we really look for also how the partnerships would like to start with us. I think we are confident that we are very good at monetization given the diversity of our network and the ability of targetability. So each partnership is different, depending on their own sales capabilities and how they like to work with us. We really want to be flexible and find where we can add value to these partnerships.
Eric Schmidt: I'm sorry, what is the other question?
Christa Quarles: I think you guys indicated that coverage was actually down in Q4, and I was just wondering if you could characterize what it looked like in Q1?
Jonathan Rosenberg: Coverage of what?
Christa Quarles: Ad coverage on the site. It sounded like you were reducing the coverage as a whole.
Eric Schmidt: Sure. We're showing fewer ads, and those fewer ads are worth more because they are better targeted. Jonathan?
Jonathan Rosenberg: Yes, I think what Eric said is correct. Many of the improvements that you are seeing from a quality perspective are improvements that are basically reducing the total number of ads and increasing the click-through rates. That has really been the hallmark of the ad's quality initiative. We have been layering them on, as I have said each quarter, quarter after quarter. So the improvements that we came out with in quarters past are further implemented in future quarters and then again this quarter, as I mentioned, we implemented a number primarily in the middle of the quarter.
Operator: Your next question comes from Heath Terry - Credit Suisse.
Heath Terry: I was wondering if you could give us an idea -- to the extent that you have this data and can share it -- of your search users, what percentage are actually using multiple Google products? Using Mail, using Froogle, using Orkut, one of the other offerings that you have got? How much, when you look at usage of that entire Google universe as a whole, what percentage of it at this point would you qualify as being non-search?
Jonathan Rosenberg: Probably the most significant change that we have seen there is that we have done a much better job recently of providing a unified login across all of the Google properties. So now what we're seeing is that users who log in tend to use their Google login regardless of which property they are logging in with, and that has manifested itself in terms of one experience that lets us really add a lot of value with personalization, which Larry mentioned, we're doing significantly. So we're seeing much, much better integration. In terms of actual percentages of use on different products, we really don't separate the data out that way. But we're starting to see much, much better integration and we are also starting a number of efforts that will make things like one box show up more frequently, as Larry mentioned, so that you will see the information in context and sharing of things like addresses and other functionality across all of the products to make it a much more seamless and integrated experience.
Operator: Your next question comes from Jordan Rohan - RBC Capital Markets.
Jordan Rohan: Great, thank you. Reports out of the National Association of Broadcasters Conference indicates that Google was supposedly very close to introducing a content filtering system, perhaps called Claim Your Content for use on YouTube and Google Video. Does this keep copyrighted content from being posted or make it easier to remove? How might major studios or content producers prove ownership of intellectual property? Thank you.
Eric Schmidt: Those reports did not quite get the gist of what we -- and in particular I -- said. Google is building a tool which is called Claim Your Content, and it allows publishers to somewhat automate the takedown process. It is not a filtering system. The technology does not block uploads. It makes it much, much more effective and much quicker to download, essentially to get us to remove inappropriately uploaded content. It is very much compliant with the DMCA, and we believe we will address many of the operational complaints people are making about the workload that the DMCA has put on them. So we're trying to make that work, and we think it addresses the vast majority of all those complaints.
Jordan Rohan: How do studios prove ownership of the intellectual property?
Eric Schmidt: There is a mechanism where they work with us to show that, and again these tools are just beginning and over the next year, those mechanisms will get better and better.
Operator: Due to time constraints we have time for one final question. Your final question comes from Youssef Squali - Jefferies & Co.
Youssef Squali: Thank you very much. I was wondering if you could speak to the disparity in monetization between domestic and international, outside of the UK? You may not want to quantify it, but if you can just look at the disparity that you had last year versus this year, by how much has it shrunk, if it has? I'm assuming that it hasn’t. Can you get to parity over time? Because if that is the case then you guys may be in position to actually show revenue growth – [inaudible], sorry.
Eric Schmidt: I'm not sure I completely agree with some of the premise of that. We do expect that the international percentage of our global revenue will eventually be greater than 50%. International is getting close already, and that has been one of our strategic goals. It is fundamentally a function of the distribution of worldwide ad dollars, and there is only so much of a percentage in any particular market of worldwide ad spending that we can get. Do you want to characterize, Jonathan, the difference in international between leading markets like the UK and some of the other ones, is the gap getting closer?
Jonathan Rosenberg: Yes, I think the way I would look at it is I would look at the strength of revenue in the U.S. and the UK as a proxy for the opportunity set in each of those other countries. The next best thing to look at is the total amount of e-commerce which exists in any individual country. Obviously the more e-commerce, the more likely you're going to see significant monetization opportunities. We have done a lot of effort looking at the correlation between GDP, Internet host, number of computers. My impression is it is generally driven by the big macroeconomic factors and that is where you're going to see the highest correlations. Some of the much more nascent countries still do have very, very low monetization rates.
Eric Schmidt: It is time to finish up. So let me end first by saying thank you all for spending so much time listening to what we are up to, covering us and helping us get the message out. Again, as I reflect on the quarter and as I reflect on what we have talked about today, Google is very much benefiting from the growth rate of the industry and the model that we are using to grow with it or ahead of it. The industry is large. It is growing quickly. All of the players are doing a great job of making the Internet and the online and offline experiences even more effective. We have also benefited from the very, very hard work of an awful lot of publishers, agencies and advertisers who are using tools that can be improved over time. We are investing a lot of money and time to build better platforms, better communities for them. All of this is in pursuit of our goal around end users, making the information that people want accessible to them exactly when and where they want it on the device and in whatever country and language that they choose to be in or that they just care about. So the model is working, and this is a scale business and the scale looks very, very good to us. So with that, thank you very, very much for all your time and let's go ahead and we will talk to you in three months.
Operator: That does conclude today's conference. You may disconnect your lines at anytime. | [
{
"speaker": "Operator",
"text": "Good day and welcome to the Google Inc. conference call. This call is being recorded. At this time I would like to turn the call over to Ms. Kim Jabal, Director of Investor Relations. Please go ahead."
},
{
"speaker": "Kim Jabal",
"text": "Hello, everyone. Welcome to our first quarter 2007 earnings call. On the call with us today are Eric Schmidt, Chief Executive Officer; George Reyes, Chief Financial Officer; Larry Page, Founder and President of Products; Sergey Brin, Founder and President of Technology; Jonathan Rosenberg, Senior Vice President of Product Management; and Omid Kordestani, Senior Vice President of Global Sales and Operations. Eric, George, Larry and Sergey will provide some thoughts on the quarter, and then we will have Jonathan and Omid join us for your questions. This call is being webcast from our Investor Relations website. Our press release issued a few minutes ago is now posted on our website, as well as presentation slides that will accompany today's prepared remarks. A replay of this call will be available within a few hours. Some of the comments we will make today are forward looking, including statements regarding international growth; possible future benefits from our partner deals; growth in our headcount; future investments in partnerships, distribution and content; future product innovation; our expected operating expenses; our expected level of capital expenditures; our expected margins; charges associated with stock-based compensation and possible future pressure on traffic acquisition cost rates. These statements involve a number of risks and uncertainties that could cause actual results to differ materially from those anticipated by these forward-looking statements. These risks and uncertainties include a variety of factors, some of which are beyond our control. These forward-looking statements speak as of today, and you should not rely on them as representing our views in the future, and we undertake no obligation to update these statements after this call. Please refer to our SEC filings, including our annual report on Form 10-K for the year ended December 31, 2006, as well as our earnings release posted on our website for a more detailed description of the risk factors that may affect our results. Copies of these documents may be obtained from the SEC or by visiting the Investor Relations section of our website. Also, please note that certain financial measures we use on this call such as EPS, net income, operating margin, operating income and our effective tax rate are expressed on a non-GAAP basis and have been adjusted to exclude charges related to stock-based compensation. In addition, in the fourth quarter of 2006, we removed certain discrete tax items from non-GAAP net income and EPS. Finally, we adjusted our net cash provided by operating activities to remove capital expenditures, a measure we refer to as free cash flow. We report our GAAP results, as well as provide reconciliations of these non-GAAP measures to GAAP financial measures in our earnings release. You can obtain a copy of our earnings release by visiting the Investor Relations section of our website. Now with that, I will turn the call over to Eric. Well, thank you very much, Kim. As everybody can see from the press release, we are ecstatic about our financial results this past quarter. Before I start talking about how well we did this quarter, I would like to remind everybody as I have each year at this time, that we are about to enter our seasonally slower summer growth period, and make sure you factor that in when thinking about how our business will grow. Our core business at Google remains very strong and continues to grow. We have seen excellent performance in the U.S.; performance internationally is even better. International growth across many markets confirms the validity of our business model: build the market, monetization will follow. What is different now is that everyone is thinking more creatively about monetization opportunities, simply because they have learned about our successes and failures in past rollouts. So we're getting a benefit from that. We are continuing to make significant investments in our core business. Data centers, of course, primarily for speed, comprehensiveness and usefulness and engineering to preserve our 70/20/10 model that you have heard many times before. In sales and support -- and I should say this globally by the way -- to attract and retain users and advertisers. And in partnerships of course. Our AdSense partners, content partners, distribution partners, offline partners. Sometimes I worry that we spend so much time talking about all the new things that we don't focus as much on the core business, especially in our marketing and messaging. In looking at the quarter, the most important message is that our core business is very strong. It is the core business that is driving our success. Core services are as vital and vibrant and innovative as they could possibly be. The success of our core business continues to let us take calculated risks in new markets and expand in new products. Geographic, for example, committing to our European expansion, committed to Asia. China, of course, is very important to us, but only one market of many that are now receiving great focus at Google. Expanding our business to multiple platforms and formats. In display advertising, DoubleClick, which of course was the subject of our call last week which all of you participated in. In video, YouTube, hugely successful for us; video syndication now working well for us. The BBC deal, a historic deal for us this quarter. In mobile, LG and Samsung deals this quarter driving mobile adoption for the Internet and for Google in many, many good ways; many partnerships already in place. In the enterprise business, a premier version this quarter including now Docs & Spreadsheets. We are also expanding our business to offline media, again the subject of a lot of discussion. Radio, the Clear Channel deal that we announced on Monday, again drives the definitive deal to make that business hugely successful for us. In TV, the EchoStar deal similarly announced very recently, which allows us to do targeted advertising in the television world. In print, the test that we announced a couple months ago is doing extremely well and being expanded as we learn what really works and what does not. Each of these strategies involves creating solutions that benefit both advertisers and users, and it is the synergy between them that we have been able to harness. Targeted, useful, effective advertising will continue to be our mantra; you all know that, of course. Technology and efficiency is the core of our technology approach, and it really does benefit end users. In fact, if you think about it, user benefit is the most important thing that we focus on as to how we make these decisions. Our past experiences and our failures, if you will, the learnings that we get show us what works and what does not. From our perspective, and I think the forward challenge for the company, is simply making these learnings scale globally so very, very quickly. This is why we are so excited not just about the quarter, but for the quarters that lie ahead. Now rather than me talking, maybe George, you could take everybody through the financials and a lot of the details, which are very impressive."
},
{
"speaker": "George Reyes",
"text": "So let's go ahead and get started. Thank you very much, Eric, for that introduction. As you can tell, Q1 was a very strong quarter for us with truly impressive growth driven by our continued leadership in both search and advertising. Gross revenue increased 63% over Q1 of last year to $3.7 billion. Revenue from Google properties was $2.3 billion, representing strong year-over-year growth of 76%. We experienced healthy traffic growth in our Google.com business both domestically and internationally. Monetization continues to be strong, positively impacted by improvements in our ads in Q1, as well as in prior quarters. As we have discussed in previous quarters, we are constantly innovating to show our users more relevant and targeted ads, which in turn leads to benefits for our advertisers and strengthens our business. The investments in our extensive network of partnerships were also contributing meaningfully to our growth. AdSense revenues increased 45% over last year to $1.3 billion, driven by strong growth across our existing partners, as well as launching a few new partners. As on Google.com, our AdSense business experienced very strong traffic gains in the quarter, particularly internationally. I will go into more detail about our international performance in a moment. Beginning last quarter we began to disclose the growth in paid clicks. This number includes clicks related to ads served on Google properties, as well ads served on our partner sites. Aggregate paid clicks grew approximately 52% over Q1 of last year and approximately 13% over Q4. Now I will turn to the geographic discussion. We are continuing to see significant momentum in our international business as we invest in the infrastructure to address our global opportunity. International revenue was 47% of total revenue, or $1.7 billion. As is typical in the first quarter, the UK was particularly strong with revenues of $578 million and 23% sequential growth as the travel and finance verticals rebounded as we expected from Q4. Other markets that contributed meaningfully to growth were Germany, France and Spain, as well as some of our Asian markets like Japan and also Australia. In addition, it is important to note that some of our smaller markets are also performing very well, including Ireland, Brazil and Korea, which benefited from our partnership with Daum. This demonstrates the diversity of our business and the potential to grow our business even more significantly outside the United States. Turning to TAC, traffic acquisition costs were $1.1 billion. The majority of TAC is related to the amounts paid to our AdSense partners, which totaled just over $1 billion. The increase is due primarily to growth of more significant AdSense partnerships. As we grow our distribution in AdSense partner network and embark upon new initiatives, we may see additional pressure on TAC rates going forward. TAC related to distribution partners totaled $73 million in Q1. The increase in these traffic acquisition costs is associated with some of our largest distribution deals ramping up. Other costs of revenue increased $38 million over the prior quarter, primarily as a result of increases in depreciation related to data centers, bandwidth costs and content acquisition costs. Going forward, we anticipate that other cost of sales will increase as each of these line items grow. Turning to operating expenses, OpEx included $184 million in stock-based compensation and totaled $972 million. These included $506 million in payroll-related and facilities expenses, an increase of $13 million over the prior quarter. R&D decreased as a percentage of revenue, primarily due to lower expenses related to company bonuses in the first quarter relative to the fourth quarter, while sales and marketing and G&A were relatively flat as a percentage of revenue. Non-GAAP operating profit, which excludes stock-based compensation, rose to $1.4 billion with non-GAAP operating margins of 38%, up from 37% in Q4. As we have said in the past, margins may decline as we continue to invest heavily in our business. You should expect continued growth in headcount, across functions and across the world. We also expect continued investments in AdSense partnerships, distribution partners and content. Capital expenditures for the quarter totaled $597 million. While there were some real estate-related expenditures as in prior quarters, the majority of our CapEx was related to IT infrastructure investments, including data centers, servers and networking equipment. As we have discussed previously, we expect to make continued significant capital expenditure investments to drive the growth of our business as these investments have contributed tremendously to our success to date. Now turning to cash flow, operating cash flow was strong at just over $1.2 billion. Free cash flow, a non-GAAP measure which we define as cash flow from operations less CapEx, increased to $623 million. With that, I will turn it over to Larry."
},
{
"speaker": "Larry Page",
"text": "Thanks, George. I'm not only excited about our financial performance, but also our product performance in the quarter, and that's what I am going to tell you a little bit about. Now remember, we keep about 70% of our resources focused on our core business which is search and ads, and the rest of that, which is probably the other 30%, is probably primarily what you hear about. But we work tremendously hard to improve our core relevance and our focus on search, and we made many improvements this quarter in many, many different markets on just basic quality and relevance in our search. We've also made user experience improvements which are easier to see, and those are on things like when you do a search, you can actually get maps and reviews of businesses right in your search results and also in very, very many countries. We released a bunch of new ones this quarter. We are also looking a lot more at content. So things like personalized search where the results are tailored to you specifically are things we also made great strides in. Now we have also, I think, made great strides in moving people towards web computing, and things like Gmail we opened up sign-ups this quarter and had very healthy growth there, which for us we are really excited about. We also improved our Docs & Spreadsheets product, releasing 15 new languages, and we also had tremendous growth there. We also released Google Apps Premier, which is a product for companies and universities we launched this quarter. It lets you have Gmail for your own domain, and you can even use your own existing login process for your users to log in to Gmail and use Docs & Spreadsheets and all of our great products. We have a lot of great customers there, Northwestern; even customers in Kenya and Rwanda, and we have pilots with GE and P&G, and we're very excited also about the prospects there. In YouTube, we have had tremendous uptake of YouTube, and I would say the growth is accelerating even more. We have made many improvements to those sites, which increased usage of community features of people talking about videos, rating them and so on, and just generally improving the experience there and going gangbusters there. In the personalized home page on Google, we released a new, improved version of that with things like themes so you can have your personalized home page on the beach or at the bus station and see a little bit of the weather that is going on, and we had tremendous uptake with huge numbers of our users adopting that on the first day. We also released things like the Google Talk, which lets you see your friends on your Google personalized home page, and we look forward to improving those products even more. Our user experience is still a tremendous focus for us, and new products also. With that, I would like to turn it over to Sergey and have him talk a little bit about the other part of our ecosystem, which is partners and advertisers."
},
{
"speaker": "Sergey Brin",
"text": "Thanks, Larry. I'm very excited to talk to you today and to echo a lot of the sentiments that Eric already shared with you: how key partnerships are to Google and how much we care about making our partners successful. First off, we noted some of the improvements we made to YouTube, and we also have a number of more partners there. In the past quarter we announced the BBC, the NBA, the Sundance Channel. We even have a partnership with a number of the presidential candidates this year, their video clips which we call You Choose '08. YouTube continues to grow both user-wise, as Larry mentioned, and in terms of partners. In the mobile space, we had a number of new partners sign up and a number of announcements, including Nokia and Vodafone, both two very large announcements. I want to spend most of the time, however, talking about advertising, both what we have done to help out our most numerous partners, our advertisers, as well as the other kinds of partnerships we have struck within the advertising space. First of all, we have launched Pay-Per-Action in beta, and that is the easiest way for an advertiser, in many cases, to decide how much they should pay for advertising, which is just to specify an action like a purchase and say, this is how much I am willing to pay for each purchase. We're very excited about that. Clearly it definitely speaks to what advertisers want to get most. We also have helped them out in getting more of those actions, conversions, purchases and what not with the introduction of the Website Optimizer. This lets you automatically test and refine your website to optimize adoption or conversion or whatever that may be. Another thing that will really help that is to make it easier for customers to actually transact. To spend money without fear of their credit card being stolen, without just a lot of hassle of entering the same information over and over, and we have done that with Google Checkout. In this past quarter, we announced a number of new partners for Google Checkout. We launched CompUSA and Blue Nile, and we also signed RadioShack, as well as B&H. Now we have been talking here mostly about search and certainly online advertising. Within online, we have expanded quite a bit. You are familiar with our AdSense for Content network. We have signed Daum up for that. That is the very large Korean site. In fact, now we have 75% of the top 20 social networks also in our AdSense network. The big news you have no doubt heard by now is our intent to acquire DoubleClick, and we're very excited about that because of the possibility to make it even easier for our advertisers to launch and manage their search and display campaigns, which they can now do -- or will be able to do -- in an integrated fashion. That is the Internet portion of our advertising. Of course, we also have been trying to make it easier for advertisers to advertise on other media, offline media. In television, for example, we have a partnership with EchoStar over at that DISH Network and that way we can deliver advertisements to DISH Network viewers. In radio more recently, we have signed a partnership with Clear Channel, which opens up a lot of great inventory to our advertisers who want to use the radio medium. Ultimately, as Eric said, it really comes down to end users or viewers to be consumers of this advertising. Some people feel that advertising is a zero sum game, and they shrug when they hear about all these new advertising products and the progress and what not; but that has not been our experience. In fact, fundamentally our vision is that we can make advertising better across the board, better for everyone. We don't have to have intrusive advertising to be effective. In fact, quite on the contrary, it is the interesting, relevant, sometimes entertaining advertising that is most effective for both advertisers and makes it the best possible world for the users and viewers alike. So, on that note, I would like to turn it back over to Eric."
},
{
"speaker": "Eric Schmidt",
"text": "Well, thank you very much, Sergey. As I listen to this, I am very impressed that the global growth strategy of Google continues to work very, very well. Our innovation model is clearly working; lots and lots of new products coming out and no end in sight. The partnerships that we reviewed, in particular the ones that Sergey and Larry just highlighted, are now really working, they are really running globally. The core business in search and ads, we're still at the beginning of that business. A lot of people have said that well maybe this is not such a big business. It is a huge business, and we have a lot of room to grow there. The complementary strategies, things like offline ads, some of the new ad initiatives, YouTube again complements our core search and ads business. There are other examples, obviously our enterprise business. They are working, too. I'm personally impressed with the way in which the management team and employees of the company have managed the growth from an operations perspective. You can imagine the dials and everything else that has to be tuned here, and yet we have been able to take advantage of the opportunity before us, and I believe we will be able to do that for the foreseeable future. So with that, why don't we go directly to your questions? We are going to add Jonathan and Omid as previously announced, because they do such a good job with Q&A. Operator, are you ready for the first question?"
},
{
"speaker": "Operator",
"text": "Absolutely. (Operator Instructions) Your first question comes from Mark Mahaney - Citigroup."
},
{
"speaker": "Mark Mahaney",
"text": "Great, thanks. Two quick questions, please. A housekeeping question: it looks like the change of the lowered tax yield on stock-based comp maybe added $0.03 to $0.05 to the number. Could you just walk through that math a little bit? Secondly, a broader question just on display advertising. Larry and Sergey, when you started search, you clearly had something different in mind, something more targeted than the normal advertising that was out there. What generally changed in your thinking that made you think either that the display advertising market was big enough or that you had a targetable solution that was good enough to make you want to make the moves you made, like buy DoubleClick?"
},
{
"speaker": "Eric Schmidt",
"text": "Let's have Larry and Sergey answer the second question while they are figuring out the answer to the first."
},
{
"speaker": "Sergey Brin",
"text": "There were a number of things that made us excited about this area. First of all, of course, the success of our own products within the broader advertising space, not just search but for example, AdSense for Content and more recently even including image ads and things like site targeting. I think we realized how much inefficiency there really was in online advertising. Because at the face of it, you would think well, how complicated can it be? You just pick a good site for your ads and you just run them, what could be inefficient about that? But, in fact, it turns out there are many different websites. There are many different users who use those websites in their different situations. Advertisers, in many cases, don't have all the metrics information they need to decide which ads to run where. So we have seen good success with that, and we think we can expand that more to broader kinds of media, not just static images and what not. Of course, with this intent to acquire DoubleClick, we think we can make more advertisers much more efficient."
},
{
"speaker": "Eric Schmidt",
"text": "Larry and Omid and Jonathan, do you want to add a little bit more to that?"
},
{
"speaker": "Omid Kordestani",
"text": "The other thing I would add is that we are, as we have said in the previous quarters, very busy actually with all these initiatives, including display advertising. In the last couple of quarters, we've had a lot of customer success stories where they are taking advantage of the content network, the different formats we already support, the targetability. Customers include companies like REI that, for example, use Google's display network to promote new store openings. They utilize geographic and site targeting functionality to reach both mass media sites like NewYorkTimes.com, as well as niche audiences like specialty sites like rockclimbing.com. This has proven so effective for them in driving in-store traffic that they are really going to utilize it as part of their ongoing marketing initiatives. So based on what we saw here, we just know that the same principle we applied to search targeting can really extend to these new initiatives and that we are going to place a lot of emphasis on that."
},
{
"speaker": "Larry Page",
"text": "I was just going to add that we are still in the very early stages of display ads and branding ads and that whole area. Much of the technology we have already developed for our search ads and AdSense for content and so on can be used for those markets. People do very sophisticated things around time of day and types of users with these things, and also the sites already with our AdSense network, the sites where you just choose to run your ad or not and so on, the content of those pages, all of those things apply to the kind of spaces we are now going after."
},
{
"speaker": "Eric Schmidt",
"text": "Could you ask the first part of your question again, the housekeeping question?"
},
{
"speaker": "Mark Mahaney",
"text": "Yes, just on the tax, it sounds like there may have been a little bit of a change in the tax rate you are applying to determine the shield on the stock-based compensation; or maybe there wasn’t a change, but it looks like there was. It looked like it was a very modest change. Could you walk through that, or you can just say there was no change."
},
{
"speaker": "George Reyes",
"text": "It was a very, very modest change from the 134 to the 183 here."
},
{
"speaker": "Mark Mahaney",
"text": "Thank you very much."
},
{
"speaker": "Operator",
"text": "Your next question comes from Robert Peck - Bear Stearns."
},
{
"speaker": "Robert Peck",
"text": "Eric, I wondered if you could comment a little bit about some of the tweaks to the algorithm during the quarter. In particular, do you take something like the words Bear Stearns and you type them into Google versus typing them into Yahoo!, you notice that you're not monetizing as much as you did. You go back a year or so ago, there was a lot of buzz around a third link. I think you have made some of these changes maybe in the middle of the quarter. Could you talk about what you saw as far as impacts on CPC, pricing, as you sort of scale back your inventory on keywords you were selling, click through rates and ultimately revenue. Part of that as well is, you also reduced some of the minimum CPC pricing to more tail-like turns. If you could quantify how you see those changes impacting maybe a more full Q in Q2 and going forward?"
},
{
"speaker": "Eric Schmidt",
"text": "Jonathan, why don't you handle it?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "I'm not sure I can quantify it too much for you, but I can try to give you a sense philosophically of what we have been doing and some of the changes that we actually implemented. As you know, we have been upgrading the quality component into ads from the start, and we have been building on that with fairly robust quality improvements almost every quarter since. This quarter was obviously no exception. Some of the type of changes that you're talking about, specifically the ones that we implemented in mid-February which we announced, were the quality-based bidding changes. Basically what those did was improve the quality score algorithm that generates more accurate quality scores and predictions, particularly in some of the cases where we have limited data. So there are a lot of situations maybe a lot of people don't search a lot on Bear Stearns. We have done a better job of figuring out for some subset of those words how to tweak the quality-based scores. That was certainly significant. One of the things that made it even more significant was that we added to the front end of AdWords the ability to give advertisers transparency into their quality so that they could see whether or not particular words were poor, okay or great. That actually allowed the results to improve pretty substantially. That certainly had a real impact during the quarter, although it was only implemented midway through the quarter in February. There are just a couple of others which I can touch on real quickly. We also announced that we changed the background color on the top ads to yellow. We also changed the area in which people click so that people are less likely to click if they are not actually trying to click on the ad. These types of things are also important. Landing page quality I think is another thing we have been working on. Beyond that, it is basically just many changes to the ad systems. You can derive the CPCs to the extent that you want by looking at the paid click number which George announced."
},
{
"speaker": "Operator",
"text": "Your next question comes from Anthony Noto – Goldman Sachs."
},
{
"speaker": "Anthony Noto",
"text": "Thank you very much. Eric, I was wondering if you could comment at the management level as you make investments, what measurement do you look at holistically for the company as a return-based measurement to ensure that the overall business and overall shareholders are seeing an aggregated return from each of the individual investments? The reason for my question is I know that you have launched a lot of initiatives: Google Checkout, Gmail, Google Finance, that may not necessarily have a unique revenue stream tied to them that is large, but does provide ancillary benefits to the overall platform. Are you incented on that return metric? The second question is, we tracked your revenue per employee on a gross basis. Up until the fourth quarter of 2005, gross revenue per employee had been growing in the single-digit range. Since then it has been declining, in fact down 12% year-over-year this quarter. I recognize that is because you're adding more new employees that are not productive. At what point do you think your existing employee base is large enough that your new employees do not cause your gross revenue per employee to decline?"
},
{
"speaker": "Eric Schmidt",
"text": "An interesting series of questions. We don't approach the questions quite the same way that you phrased them. Our primary focus is on end user happiness, end user traffic, end user growth. So what we look at is we look at what will drive even more end users using our product globally. So, for example, if we could bring out a product that will cause people to use Google and its various applications that much more and they spend more and more of their day using Google services, that allows us to eventually monetize that. So we do not insist on a direct link from say a product that does not get revenue to one that does. In the cases that you cited, we look at the revenue contribution. But the primary focus and the primary management focus is around end user happiness, end user growth, end user everything. With respect to the revenue per headcount, again we are not very focused on that. We are much more focused in total growth of the platform, total growth of the number of advertisers, total growth of the monetization. It is easy enough for us to dial any particular metric like employees per gross revenue up or down as we see fit. It is more important to focus on end user happiness. A lot of the people we are talking about are, for example, coming in for customer service globally. We are also way, way investing in engineering because we believe this is a time where our model is scaling that products that we are going to bring out in a year or two are going to have huge impacts to the investments we're making in data centers, and we need the engineers to build the great products to do so."
},
{
"speaker": "Operator",
"text": "Your next question comes from Douglas Anmuth - Lehman Brothers."
},
{
"speaker": "Doug Anmuth",
"text": "I was hoping you could comment on toolbar activity. If we look at third-party data, it suggests that toolbar growth is driving north of 40% of total growth in search queries, which clearly validates your distribution strategy. But I'm wondering what you're seeing in terms of the behavior pattern for users with downloaded toolbars, not just right after they get the toolbar but over a little bit of time. Does it make you concerned at all that we could be seeing sort of a one-time spike from this initial bigger distribution of toolbars? Thank you."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Certainly a big story in the quarter is traffic, and a component of the traffic performance is certainly toolbar. No question toolbar users search more than non-toolbar users. I can’t really comment on the degree to which the growth rates would be dependent on the number of remaining users out there who could also use toolbar, but we can certainly say that your hypothesis is correct, that toolbar users search significantly more."
},
{
"speaker": "Larry Page",
"text": "I was just going to add, we have been distributing toolbars for a long time and have had a very successful product there for a long time. I don't think there has been any huge changes over the last quarter or two in people's behavior or those mechanisms."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mary Meeker - Morgan Stanley."
},
{
"speaker": "Mary Meeker",
"text": "Thanks. One of the things that we are seeing in the market right now is it feels as though we are seeing an acceleration in the migration from offline advertising to online advertising. Eric, you talked in your opening remarks about your deal with Clear Channel, your deal with EchoStar; obviously others. Obviously they are early stage. But we are frankly surprised that you're able to announce such large deals as quickly as you have been able to do that. Do you think that we will see a lot more of those in the next six months? When we add them all up at the end of 2008 and we look at the financial impact to Google, do you think it could be at a level where it is actually material as quickly as the end of 2008? Thanks."
},
{
"speaker": "Omid Kordestani",
"text": "Your observation is correct. We are very busy in the partnership area and very much so also globally. I think what we are seeing is that again the power of the platform and the interest in tapping into, depending on what kind of partner you are, both the advertiser network and the publishing network is very, very interesting for people. That again, this push to a more efficient measurability is of great interest to everyone, be it in the print sector, audio or TV. I think what everybody is really trying to figure out is where do their put their own resources, just like Google did awhile back where we focused our field operations on more Fortune companies. I think the TV companies, print companies, they are all trying to apply their resources to their area of their own expertise and then utilize our ability to drive a lot of revenue and targetability and measurability. So we're finding great interest. It is very competitive, the market is very competitive, and on a global basis, we're just again doing the best we can to staff up both partnerships with legal and finance to be able to model these deals and be able to have the right partnerships in place. So yes, I would say you are going to see us be very much focused on this space."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ben Schachter - UBS."
},
{
"speaker": "Ben Schachter",
"text": "Congratulations on a nice quarter. Can you talk at a high level on Google's view of cookie data and third-party ad serving? Now that you own DoubleClick, do you think it is more likely that you will open up the network to third-party ad serving? Thanks."
},
{
"speaker": "Eric Schmidt",
"text": "I will let Larry and Sergey."
},
{
"speaker": "Larry Page",
"text": "I think that in general we are really excited about opportunities to improve some of the practices that are in place there with regards to people's privacy, but also while improving targetability and the kinds of information you need to really provide good information to everybody involved in the process. So I think we're excited about our ability, our technological strength and how it can be applied to some of those issues. We're not ready to go into any specifics on that yet."
},
{
"speaker": "Operator",
"text": "Your next question comes from Justin Post - Merrill Lynch."
},
{
"speaker": "Justin Post",
"text": "Could you talk a little bit about TAC? Obviously you saw the percentage or the percent of network increase quarter over quarter. Is the mix of who your partners are changing a lot? Did a couple of partners ramp up, and how do you see that going forward? A little more comment on that. And then on the distribution partner side, is that fully in your numbers now, or are there still more partners ramping up there for future quarters?"
},
{
"speaker": "George Reyes",
"text": "The answer is that we're doing a lot more deals and the deals are, in fact, carrying a disproportionate amount of TAC. So, at the end of the day and I think I suggested that in my earlier comments, TAC as a percentage of revenue is likely to increase given the deals that we're doing these days."
},
{
"speaker": "Justin Post",
"text": "Was there a partner that specifically ramped up in the quarter?"
},
{
"speaker": "George Reyes",
"text": "I can’t comment on that. Generally I think the TAC rates are going up directionally."
},
{
"speaker": "Operator",
"text": "Your next question comes from Imran Khan – JP Morgan."
},
{
"speaker": "Imran Khan",
"text": "Thank you very much for taking my question. Your paid click growth rate in Q1 was 52%. I think it was down from 61% in the fourth quarter. Can you please help us to understand if that growth rate decline was due to query volume growth rate decline or click-through improvement? Also, do you have any contra revenue from Google Checkout?"
},
{
"speaker": "Eric Schmidt",
"text": "George could specifically answer the contra-revenue question with respect to Checkout. From a marketing perspective, Q4 was seasonally more significant in terms of the marketing efforts that we were doing. He can give you the specific accounting implications. The other specific question relates to paid clicks and click-throughs?"
},
{
"speaker": "Imran Khan",
"text": "Yes, so basically paid click growth rate declined from 61% to 52%. Is it driven by query volume growth decline, or there was an anniversary of click-through improvement that you made in the past?"
},
{
"speaker": "Eric Schmidt",
"text": "Query volume was very healthy. I think we already mentioned that. Q1 is typically a somewhat weaker seasonal quarter from a monetization perspective, although George mentioned in his prepared remarks that there are some exceptions internationally, particularly in the UK. Beyond that, I would not be too much into an aggregate CPC measure as we have talked about in the past. Country mix, property mix as the previous question alluded to, had significant impact on how that shakes out. Clicks are extremely healthy as well."
},
{
"speaker": "George Reyes",
"text": "On the Checkout question, you have to sort of stand back. We really peaked seasonally in the Christmas season and right now the business is going, but it is not going at a seasonally strong rate at this point in time. So we are bullish on Checkout, and the contra revenue range will probably be somewhere around 1% of revenues or thereabouts."
},
{
"speaker": "Operator",
"text": "Your next question comes from Brian Pitz - Bank of America."
},
{
"speaker": "Brian Pitz",
"text": "Thank you. First, a broader industry question. When you look at the UK market, a lot of data suggests that market is growing very substantially and north of 40%, and now represents about 11% of total ad spend is now online versus the U.S., we estimate about 5.5%. Can you talk about what is fundamentally different about that market or what is going on there that is driving those higher growth rates? Just a quick follow-up: you mentioned earlier on the call growth and investment in content. Any sense there what type of content or areas you may be interested in? Thanks."
},
{
"speaker": "Omid Kordestani",
"text": "In terms of the UK question, we're definitely seeing very strong performance there. I think it is driven by our leadership team and having put a lot of focus in both reaching out to our clients, as well as advertising agencies, focus on named accounts. We're seeing increases in average spend, significant increases in that focusing on the different vertical strategies and making sure we understand the seasonality of those just as we mentioned earlier. Probably saw finance and travel bounce back, and in Q4, for example, we very much paid attention to how to deal with that seasonality and that helped us in Q4 as well. So we just think again the economy is very strong there. The sales team and the leadership is very strong, and just our ability to execute our strategy is working well. There is also strong interest in the new ad formats and also, as we mentioned, deals like BBC, were some of the very interesting deals we were able to establish. In terms of content, I think in general some of the spending we're doing is improving our product areas. For example, spending in mapping services and mapping data and some of the partnerships we established. But I don't think there is anything unusual there other than just our focus in improving both the products and expanding partnerships."
},
{
"speaker": "Jonathan Rosenberg",
"text": "Just adding to Omid's comments, the two other things that I have noticed in the UK are that early on the agencies were particularly aggressive with the online medium, and that really helped spur the early growth when it was in its more nascent stages which has carried over. I think some of the other observations that I have seen just in the marketing literature are that there is a relative lack of TV advertising there because the BBC is so popular. And so they were much quicker to move their spending to other outlets and try things more quickly and then discovered that the ROI was high."
},
{
"speaker": "Eric Schmidt",
"text": "And George, you wanted to add something, didn't you?"
},
{
"speaker": "George Reyes",
"text": "I just wanted to clarify that comment on Checkout. On Google Checkout basically we are less than 1% of where we were in the holiday quarter."
},
{
"speaker": "Operator",
"text": "Your next question comes from Christa Quarles - Thomas Weisel."
},
{
"speaker": "Christa Quarles",
"text": "I was wondering if you could discuss some of these offline ad partnerships with regard to your view as to whether or not you can get beyond remnant? Clearly the Clear Channel deal was less than 5% of their inventory. Or it is a really just about redefining remnant for some of these markets? Clearly we have also seen the eBay upfront auction not working very well. So I was just wondering if you could discuss that. And then also I think last quarter you indicated that coverage rates were down. I was wondering if you could comment on them this quarter."
},
{
"speaker": "Eric Schmidt",
"text": "One thing to clarify is that the Clear Channel deal includes a lot of premium inventory. It is not a remnant deal. That is a misperception. Maybe we did not communicate that very well. The EchoStar, similarly, those our primary spots. That is why those two deals are so important. It launches these two new initiatives right in front of the primetime viewer."
},
{
"speaker": "Omid Kordestani",
"text": "I would add that we really look for also how the partnerships would like to start with us. I think we are confident that we are very good at monetization given the diversity of our network and the ability of targetability. So each partnership is different, depending on their own sales capabilities and how they like to work with us. We really want to be flexible and find where we can add value to these partnerships."
},
{
"speaker": "Eric Schmidt",
"text": "I'm sorry, what is the other question?"
},
{
"speaker": "Christa Quarles",
"text": "I think you guys indicated that coverage was actually down in Q4, and I was just wondering if you could characterize what it looked like in Q1?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Coverage of what?"
},
{
"speaker": "Christa Quarles",
"text": "Ad coverage on the site. It sounded like you were reducing the coverage as a whole."
},
{
"speaker": "Eric Schmidt",
"text": "Sure. We're showing fewer ads, and those fewer ads are worth more because they are better targeted. Jonathan?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yes, I think what Eric said is correct. Many of the improvements that you are seeing from a quality perspective are improvements that are basically reducing the total number of ads and increasing the click-through rates. That has really been the hallmark of the ad's quality initiative. We have been layering them on, as I have said each quarter, quarter after quarter. So the improvements that we came out with in quarters past are further implemented in future quarters and then again this quarter, as I mentioned, we implemented a number primarily in the middle of the quarter."
},
{
"speaker": "Operator",
"text": "Your next question comes from Heath Terry - Credit Suisse."
},
{
"speaker": "Heath Terry",
"text": "I was wondering if you could give us an idea -- to the extent that you have this data and can share it -- of your search users, what percentage are actually using multiple Google products? Using Mail, using Froogle, using Orkut, one of the other offerings that you have got? How much, when you look at usage of that entire Google universe as a whole, what percentage of it at this point would you qualify as being non-search?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Probably the most significant change that we have seen there is that we have done a much better job recently of providing a unified login across all of the Google properties. So now what we're seeing is that users who log in tend to use their Google login regardless of which property they are logging in with, and that has manifested itself in terms of one experience that lets us really add a lot of value with personalization, which Larry mentioned, we're doing significantly. So we're seeing much, much better integration. In terms of actual percentages of use on different products, we really don't separate the data out that way. But we're starting to see much, much better integration and we are also starting a number of efforts that will make things like one box show up more frequently, as Larry mentioned, so that you will see the information in context and sharing of things like addresses and other functionality across all of the products to make it a much more seamless and integrated experience."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jordan Rohan - RBC Capital Markets."
},
{
"speaker": "Jordan Rohan",
"text": "Great, thank you. Reports out of the National Association of Broadcasters Conference indicates that Google was supposedly very close to introducing a content filtering system, perhaps called Claim Your Content for use on YouTube and Google Video. Does this keep copyrighted content from being posted or make it easier to remove? How might major studios or content producers prove ownership of intellectual property? Thank you."
},
{
"speaker": "Eric Schmidt",
"text": "Those reports did not quite get the gist of what we -- and in particular I -- said. Google is building a tool which is called Claim Your Content, and it allows publishers to somewhat automate the takedown process. It is not a filtering system. The technology does not block uploads. It makes it much, much more effective and much quicker to download, essentially to get us to remove inappropriately uploaded content. It is very much compliant with the DMCA, and we believe we will address many of the operational complaints people are making about the workload that the DMCA has put on them. So we're trying to make that work, and we think it addresses the vast majority of all those complaints."
},
{
"speaker": "Jordan Rohan",
"text": "How do studios prove ownership of the intellectual property?"
},
{
"speaker": "Eric Schmidt",
"text": "There is a mechanism where they work with us to show that, and again these tools are just beginning and over the next year, those mechanisms will get better and better."
},
{
"speaker": "Operator",
"text": "Due to time constraints we have time for one final question. Your final question comes from Youssef Squali - Jefferies & Co."
},
{
"speaker": "Youssef Squali",
"text": "Thank you very much. I was wondering if you could speak to the disparity in monetization between domestic and international, outside of the UK? You may not want to quantify it, but if you can just look at the disparity that you had last year versus this year, by how much has it shrunk, if it has? I'm assuming that it hasn’t. Can you get to parity over time? Because if that is the case then you guys may be in position to actually show revenue growth – [inaudible], sorry."
},
{
"speaker": "Eric Schmidt",
"text": "I'm not sure I completely agree with some of the premise of that. We do expect that the international percentage of our global revenue will eventually be greater than 50%. International is getting close already, and that has been one of our strategic goals. It is fundamentally a function of the distribution of worldwide ad dollars, and there is only so much of a percentage in any particular market of worldwide ad spending that we can get. Do you want to characterize, Jonathan, the difference in international between leading markets like the UK and some of the other ones, is the gap getting closer?"
},
{
"speaker": "Jonathan Rosenberg",
"text": "Yes, I think the way I would look at it is I would look at the strength of revenue in the U.S. and the UK as a proxy for the opportunity set in each of those other countries. The next best thing to look at is the total amount of e-commerce which exists in any individual country. Obviously the more e-commerce, the more likely you're going to see significant monetization opportunities. We have done a lot of effort looking at the correlation between GDP, Internet host, number of computers. My impression is it is generally driven by the big macroeconomic factors and that is where you're going to see the highest correlations. Some of the much more nascent countries still do have very, very low monetization rates."
},
{
"speaker": "Eric Schmidt",
"text": "It is time to finish up. So let me end first by saying thank you all for spending so much time listening to what we are up to, covering us and helping us get the message out. Again, as I reflect on the quarter and as I reflect on what we have talked about today, Google is very much benefiting from the growth rate of the industry and the model that we are using to grow with it or ahead of it. The industry is large. It is growing quickly. All of the players are doing a great job of making the Internet and the online and offline experiences even more effective. We have also benefited from the very, very hard work of an awful lot of publishers, agencies and advertisers who are using tools that can be improved over time. We are investing a lot of money and time to build better platforms, better communities for them. All of this is in pursuit of our goal around end users, making the information that people want accessible to them exactly when and where they want it on the device and in whatever country and language that they choose to be in or that they just care about. So the model is working, and this is a scale business and the scale looks very, very good to us. So with that, thank you very, very much for all your time and let's go ahead and we will talk to you in three months."
},
{
"speaker": "Operator",
"text": "That does conclude today's conference. You may disconnect your lines at anytime."
}
] | null | null |
CVX | 4 | 2,008 | 2009-01-30 11:00:00 | Operator: Good morning. Welcome to Chevron's Fourth Quarter 2008 Earnings Conference Call. (Operator Instructions). I will now turn the conference call over to the Chairman and Chief Executive Officer of Chevron Corporation, Mr. Dave O'Reilly, please go ahead, sir.
Dave O'Reilly: Thank you, operator, and welcome to the Chevron's fourth quarter earnings conference call and webcast. On the call with me today are Pat Yarrington, Vice President and Chief Financial Officer, and Jim Aleveras, General Manager Investor Relations. Pat took over as CFO from Steve Crowe who retired last month and as extensive experience in all aspects of Chevron's financial operations. Most recently Pat has been our Vice President and Treasurer and prior to that was Vice President of Government and Public Affairs and before that Vice President of Strategic Planning. You'll have an opportunity to meet her at our meeting in New York on March 10th. Pat, I'll turn the meeting over to you.
Patricia Yarrington: Thanks, Dave. Let's turn now to Chevron's financial and operating results for the fourth quarter of 2008. We'll refer to the slides that are available on the Web. Before we get started please remember that this presentation contains estimates, projections, and other forward looking statements. We ask that you review the cautionary statement on slide two. I'll begin with slide three which provides an overview of our financial performance. The company's fourth quarter earnings were $4.9 billion or $2.44 per diluted share. Our total fourth quarter 2008 earnings were about the same as fourth quarter 2007. Earnings per share, however, were up about 5% due to our share repurchase program. Comparing the fourth quarter 2008 to the same period a year earlier, lower crude oil and natural gas prices reduced upstream results while falling prices improved profits in the downstream segment. To recap the balance of slide three, return on capital employed for the year was nearly 27%, under scoring Chevron's financial strength the debt ratio was below 10% at the end of the year and cash balances exceeded debt by $700 million. Share repurchases were $8 billion for the year. Our latest share repurchase program was authorized by the Board in September 2007 for up to $15 billion over a period of up to three years. We have now repurchased $10.1 billion of the $15 billion authorized. We do not anticipate repurchasing shares in the first quarter of 2009. Finally Chevron's 2008 TSR of negative 18% compares favorably to the S&P 500s return of negative 37% and a 37% decline in the MX oil index. Turning to slide four, our total capital spend for 2008 was $22.8 billion compared with our budget of $22.9 billion. Upstream spending accounted for $17.5 billion of that total. Our cash C&E which excludes our equity share of affiliate outlays was $20.5 billion. Our announced capital program for 2009 of $22.8 billion is unchanged from 2008 expenditures. However, about 10% of the total 2009 budget relates to large one-time payments for concessions in the partition neutral zone and Jong Dong Bay (ph) gas field. Excluding these items underlying spending in the upstream segment is budgeted to be lower than last year. Of the overall 2009 capital program 77% is for upstream activities reflecting the capital intensive phase of some of our long term growth projects. Another 19% is earmarked for the downstream for a number of investments to upgrade our refining network. Jim will now take us through the quarterly comparisons. So Jim over to you.
James Aleveras: Thanks, Pat. My remarks compare results of the fourth quarter 2008 with the third quarter 2008. As a reminder our earnings release compared fourth quarter 2008 with the same quarter a year earlier. Turning to slide five, fourth quarter net income was about $3 billion lower than the third quarter. Starting with the left side of the chart lower crude oil and natural gas prices caused (inaudible) to decline by more than $3 billion. Similar to the prior quarter falling commodity prices benefited the downstream segment in the fourth quarter. The variants in the other bar reflects lower chemical earnings and higher corporate charges. Slide six summarizes the results for our U.S. upstream operations. Lower crude oil and natural gas prices reduced earnings by $1.6 billion. Chevron's average U.S. crude oil realization was down about $61 per barrel between quarters similar to the average WTI change of about $59 per barrel between the periods. Production (inaudible) were down 4% mainly due to the full quarter impact of September hurricane shut-ins. The violent impact reduced fourth quarter earnings by $100 million. As mentioned in the interim update lower charges related to the hurricanes benefited earnings by about $350 million in the fourth quarter compared to the third. The fourth quarter included a gain of about $600 million from an exchange transaction which included the company's interest in a producing property in Utah. For comparison asset sales added about $350 million to third quarter profits. This difference of $250 million is shown on the chart. The other bar is comprised of a number of items. The largest of which was related to a change in natural gas inventories. Turning to slide seven, international upstream earnings for the fourth quarter fell nearly $2 billion from the third quarter's results. Lower oil and gas prices reduced earnings by $2.8 billion. Our average realization per liquids fell about $56 per barrel between sequential quarters compared to the $59 per barrel decline in the average (inaudible) price. Higher liftings benefited fourth quarter earnings by $430 million. Liftings were higher in Kazakhstan due to the ramp up of the Tengiz expansion and completion of the third quarter facilities turnaround there. The ramp up of Agbami in Nigeria was also a significant factor. The $210 million favorable variance in tax items shown in the slide reflect various issues in several countries. Exploration expense was higher between quarters reducing earnings by $140 million. This is a result of several well write-offs along with higher geological and geophysical expenditures. The other bar is primarily an increase in foreign currency gains. Slide eight summarizes the quarterly change in the worldwide oil equivalent production including volumes produced from oil sands in Canada. Production increased by 97, 000 barrels per day or 4% between periods. Though our fourth quarter prices benefited buy-in by 73,000 barrels per day primarily due to production strain contracts and variable royalties. External constraints such as mandated curtailments by opaque member host governments and lower natural gas demand reduced production by 51, 000 barrels per day. As mentioned earlier the fourth quarter was impacted by the September hurricanes in the Gulf of Mexico. The volume metric effect was an adverse variance of 27,000 barrels per day. Base business declines of 17,000 barrels per day were more than offset by the ramp up of production from the Tengiz expansion, Agbami, Blind Faith, and the Northwest Shoal on G-Train 5. Slide nine compares full year 2008 OEG production including volumes produced from oil sands in Canada to that of 2007. Price impacts on production sharing contracts and variable royalties reduced production by 72,000 barrels per day. WTI prices averaged $72 per barrel in 2007 in contrast to $100 per barrel in 2008. For the year 2008 external constraints such as mandated curtailments by opaque member host governments and lower natural gas demand reduced production by 13,000 barrels per day. The full year impact of Gulf of Mexico hurricanes was 35,000 barrels per day. Our base business decline was 78,000 barrels per day, a drop of about 3%. I'll discuss our outlook for the base business decline in a moment. Finally our major projects, primarily the Tengiz expansion, Agbami, and the further ramp up of our 2007 Bibyana (ph ) in Banglodesh added 109,000 barrels per day to 2008 production. Blind faith come on extremely late in 2008 and did not have a large impact the full year. 2008 production of 2.5 free million barrels per day came in at 120,000 barrels per day lower than the element we provided at the beginning of the year. The original 2008 outlook of 2.65 million barrels per day assumed crude prices for the year would average $70 per barrel, instead of the $100 average that actually occurred. Price effects along with external constraints and then September hurricanes noted here were the primary reasons for the difference. Our base business performed solidly better than we assumed, offsetting this we experience a six-month delay in the in the (inaudible). The rest of our projects started on time but some ramped up more slowly than originally planned. Slide ten shows our production outlook for 2009. We had previously provided (inaudible) for 2008 that each dollar change in crude prices would inversely change our production by about 2,000 barrels per day due to effect of production sharing and variable (inaudible) agreements. Because of certain thresholds have been reached under these agreements, our rule of thumb for 2009 is each dollar change in crude prices affects production by roughly 1,200 barrels per day. As before, I caution you that this rule of thumb is very approximate and actually results will differ each of the underlying contracts as different. On this basis comparing 2009 at an assumed price of $50 per barrel, which this is based on last week's future prices, and 2008 at $100 per barrel, the price effects would increase production by 60,000 barrels per day as shown on the chart. External constraints again for (inaudible) member, most Governments and market factors are assumed to reduce production by 80,000 barrels per day. Base business declines and the impact of lower investment in the base business are expected to reduce production by 188,000 barrels per day. This amount is an implied 7% decline rate in contrast to our previous 4 to 5% base decline guidance due to lower expected oil and gas prices, spending on our base business and mitigating natural fuel declines, will be reduced in 2009. We're still investing to mitigate these declines but at a lower level reflecting the lower level of oil and gas prices. The big (inaudible) that we do not produce in 2009 will still be there to produce when market conditions are more attractive. Because of the temporarily higher base decline rate and market driven investment deferrals, we do not expect to achieve our full 3% compound annual production growth between 2005 and 2010. We'll update you further at our annual security analysts meeting in New York on March 10th. Finally, 2009 will benefit from the continued ramp up and full year production in a more recent major capital projects and from the (inaudible) that come on line for later this year including (inaudible) and Brazil, Tahiti in the Gulf of Mexico, and Gonzale Luni (ph) in Angola. Turning to slide 11, U.S. downstream operation turned to just over $1 billion essentially flat with the previous quarter. Indicator margins reduces earnings by $260 million. Our marketing margins improved lowering refinery margins on the West and Gulf Coast were a large factor. The change in the company's realized margins tracked the change in indicator margins. WHI prices fell more than $56 per barrel from the end of the third quarter to the end of fourth quarter. This exceeded the $39 per barrel drop that occurred during the prior quarter. The sharply falling prices caused the downstream to have a large favorable timing effect in both quarters. Timing effects were $80 million more favorable in the fourth quarter than the third. On an absolute basis, timing effects in the fourth quarter were about $700 million. The largest factor was provisionally priced or improved which was $370 million in the fourth quarter, about the same it was in the third quarter. In the previous conference call, I mentioned that the company revised their primary long haul crude supply agreement to the West Coast refineries starting in October. However, August and September liftings were still final (inaudible) in October and November, and prices were about $35 per barrels lower than at the end of the third quarter. We do not expect a material timing effects for provisionally appraised crude in the first quarter for U.S. operations. The balance of the timing effects was primarily due to inventory, derivative gains associated with shale refined products, a favorable lag in aviation pricing, and other supply related factors. Finally operating expenses declined largely from lower fuel costs. Turning to slide 12, international downstream earnings improved by $230 million and more than $1 billion. Defining margins were lower in the fourth quarter. Our marketing margins were mixed. Overall our realized margins fell $205 million between the sequential quarters. Volumes were simply lower during the fourth quarter partly reflecting planned maintenance and a (inaudible 00:16:45) refinery in the UK. The volume effect was an average strand of $30 million. Timing effects added $525 million to the fourth quarter earnings, compared third quarter earnings. The absolute amount of timing effects in the fourth quarter was roughly $850 million. Nearly half of the increase between sequential quarters was related to derivative gains and long haul crude new refined products such as PMJ crude, templar exports, and crude sales to equity affiliated refineries. As I mentioned during the last few quarters, we often use derivatives to lock in a margin above the cost of transportation which result in gains when prices decrease and vice versa. The balance of the timing effects between quarters resulted in gains in derivatives used to convert crude pricing to the time of refinery run. And a favorable lag in aviation pricing as well as other supply related timing factors. The other burr on this chart reflects an adverse change of $50 million between quarters. Lower operating expense was more than offset by an adverse swing in point price index. On slide 13 shows that earnings from chemical operations were $28 million the fourth quarter, compared to $70 million in the third quarter. Results for all (inaudible) due to lower volumes in prices. (inaudible) range fell primarily because of a one time impairment charge. The other bar reflects higher additive range. On slide 14 covers all other net charges. Before the quarter results, net charges of $365 million, comparable to net charges at $190 million in the third quarter. $310 million of the swing reflects higher corporate charges across a number of areas, $70 million of the change stems from a favorable variance of two tax items. The other bar on slide 14 includes the net of many unrelated items which were $65 million payroll variance between the sequential quarters. Before turning it over to Dave, I'd just like to briefly recap the fourth quarter. Upstream earnings fell significantly in line with the interim updates. Downstream continues to benefit from sizable derivative gains due to the declining prices, also noted in the interim update. And last as projected chemical earnings were lower and all of these charges exceeded the guidance range. Dave O'Reilly will now summarize our 2008 strategic progress and provide some thoughts about 2009. Dave?
Dave O'Reilly: Well, thank you, Jim. And turning to slide 15, in 2008, we focused on execution and succeeded across the board. For several years, we’ve made improvements on our safety performance and were among the best in class. In our upstream business, we committed starting to on three major Chevron operated projects, adding significantly to our long-term production. The Tengiz expansion like Agbami and Blind Faith are all online and performing well. We also started the first phrase of the North Duri steam flood in Indonesia and achieved first production at five partner operated projects. We've talked about our exploration success for many years in a row and 2008 was another banner year for exploration, which we'll discuss further at the March Security Analysts Meeting. WE told the investment community that our reserve replacement ratio would improve and on a preliminary basis, we estimate that we replaced 146% of our production in 2008. Now our downstream business we placed to improve refinery reliability. We delivered on that pledge in 2008 and we had our best fuelization rates on record. 2008 represented a 6.5% improvement in refinery utilization over the base year of 2005. Our downstream portfolio rationalization has continued in 2008 as we exited a number of non-strategic markets. Finally, we rewarded our shareholders with another double digit increase in our dividends and repurchased $8 billion of our shares. We did so while funding our robust capital program and maintain the balance sheet with more cash than debt at the end of the year. So we enter these challenging times with the financial strength and flexibility to succeed in the years ahead. Turning to slide 16, let's just look at 2009 briefly. In our upstream business we're on track to start up three more Chevron operated projects further demonstrating our organic growth potential. We are also focused on the work needed to continue to advance in our strategically important projects in core areas such as Australia and the deep water Gulf of Mexico. In the downstream business, we're maintaining our focus on refinery utilization to capture the most margin that the market will permit. And we're continuing to rationalize our portfolio to focus on our strongest markets and those with the most potential for long-term value creation. Across the enterprise we're focused on managing our costs in the same world class process as we used to manage costs when they are rising are now critical to realizing maximum savings on materials and services in a softening market. Combined with capital discipline, our attention to every element of our cost structure will ensure us success during this economic slowdown. Rewarding our share holders, continuing our disciplined growth, and maintaining our financial strength are all objectives we have been pursuing and will continue to pursue in 2009. Meeting our commitments to our investors, our communities and a world that has long-term need for our products and services has been and will continue to be our priority. I look forward to discussing the challenges and opportunities of 2009 and the years ahead at our meeting on March 10th in New York City. That concludes our prepared remarks. We'll now take your questions. So that everyone has an opportunity to participate, please try to limit your follow up questions to one or two. So, operator, please open the lines for questions.
Operator: Thank you. (Operator instructions). And our first question comes from Mark Flatery from Credit Swiss. Your question please.
Mark Flathery -Credit Swiss: Thank you. My question is on the reserve replacement and I know you have only preliminary numbers and you'll give more details in March but can you give us an early feel for how much the net pricing impact was on these India reserve replacement and whether it was net positive, net negative roughly how big?
Dave O'Reilly: Well Mark, thank you. We've had a great success with our reserves replacement this year in a number of areas. Some of the projects that we started up where we had conservatively booked reserves, we were able to rebuy numbers because we now demonstrated through production more confidence in the reservoirs. We've also had some additions from contract extensions such as the PNZ and those will be disclosed in somewhat more detail when we get to our March meeting. We did benefit, obviously, from price and my recollection is that we're in the 80 – the organic replacement for one year was above 80% or around 80%. The balance comes from price. So we've gained back in price some of what we lost – a lot of what we lost over the last few years as the numbers went in the other direction, as price went upwards and reduced those reserves. So now that I look over the last ten years it's very gratifying to see that we are at greater than 100% reserve replacement over that long spread of time. So I feel good about where we are and we'll be covering that in more detail obviously in March. And you'll see a lot more disclosure in the 10-K as well. So thank you for the question.
Unidentified Analyst: Great, thank you.
Operator: Our next question is from Robert Kessler from Simmons and Company, your questions please.
Robert Kessler: Good morning and Pat welcome to your new role. My question relates to your production guidance for 2009. Looking at the new implied base business decline rate of 7% and comparing that to your recent experience of 3 to 4% I recognize you said there was a gap associated with lower spending. And if I look at your CapEx plan it looks like excluding the one time payments it would have been down about $2.8 billion. Is that the order of magnitude spending that you estimate would be required to flatten our mitigate that decline rate down to the 4% figure you typically experience? And why given, I would assume you would expect resilence in your portfolio down to $50 a barrel at least, why would you not go ahead and spend that amount in a deflationary oil field service environment?
Dave O'Reilly: Okay a lot of questions there but let me – generally your observations are on the right track. But let me give you a reason why I think the primary reason why and maybe even an example of why we think it's unwise to chase after barrels in this environment. We have – we're clearly pursuing our long term strategic projects that require continued investment over the long term and I cited a number of examples of those. But let me talk about a very specific example of where we have consciously slowed down and that's in the Peonce (ph). And there are two reasons for it, one is Colorado has instituted some pretty onerous environmental regulations that have made it a lot more difficult to get permits in a timely manner. So we’ve reduced – we were planning – we were in the process of reducing our plans just from an environmental permitting stand point. Also the pricing outlook is looking a little tenuous in that area so we've slowed it down. In the meantime we expect – we do expect costs to come down in the good and services and supplies and oil field services area. And as those costs come down we'll obviously have a chance to re-evaluate our portfolio and make decisions to add more investment if we think it's appropriate. But in this environment we think we're doing the right thing to back off the particularly the opportunities that we can come back to later because they're in this case on fee land. And we're conscious here of the capital discipline that we need to exercise in order to make the right value decision. So there are a number of those decisions that we've taken. We think they're the right thing to do in this market and we expect as prices -- as costs come down that we'll be – and permitting requirements are met that we'll be able to reevaluate our position in the future. But I think in current circumstances this is the right thing to do.
Robert Kessler: Thank you for the color.
Dave O'Reilly: Thank you.
Operator: Our next question is from Erik Mielke from Merrill Lynch. Your question please.
Erik Mielke: Yes, good morning. I'd also like to congratulate Pat on her new role and welcome to the quarterly conference circus. I'd like to ask a question on the production outlook, as well. Given the experience you've had in 2008 are you being more conservative in your guidance in 2009? Particularly with respect to the ramp up from the major capital projects out on execution? And is there anything on the external factors that you can help us understand that number at least a little bit better? Is that 60,000 barrels per day based on the current run rate or is that project for the contract by opaque?
Dave O'Reilly: Well I think we are taking, I think, a realistic view as best we can of what is happening in the market place with Opaque and some market impacts. We show an 80,000 barrels per day negative on what we call external factors, and basically that’s roughly what we see. About half of that’s market effects. Half of it is OPEC, but the OPEC impact’s primarily in Venezuela and some in Angola and a little bit in Nigeria. The balance is market effects in gas in Asia. We saw a deterioration in gas demand in Thailand, for example, late in the year. And we just think that it’s not wise for us to count on those markets bouncing back very quickly. They’re still good for the long-term, but in the near-term in ’09, I think what we’ve done is give you the most realistic assessment that we can of what we call external factors. It’s very hard to predict this with accuracy. But that’s our best shot at it as we see it today.
Erik Mielke: Okay, thanks. Can I ask a follow-up on foreign exchange? There was quite a bit of noise in the quarter from foreign exchange. Are there any handy rules of thumb that you can give us that we can use to try predict some of the overall exposure for group?
Jim Aleveras: Erik, I’m afraid that’s a very, very difficult challenge for us. Obviously, different factors come into play depending on the timing on our acquisition of goods and services, depending on the net monetary asset and liability positions in different parts of the company. In general, what we saw overall, the benefit in the fourth quarter was the strengthening dollar. But obviously it hit different segments in different ways. I wish I could provide better guidance in that, but again, because of the mix of components that goes into that, both what we buy, what we sell, as well as the assets and liabilities in our different international businesses, it’s very, very difficult to give anything other than guidance that suggests that strengthening or weakening dollar would help or hurt our clients exchange rates.
Erik Mielke: Okay, and finally, was there any significant over or under-lift in international upstream in the fourth quarter?
Jim Aleveras: In the fourth quarter we had a under-lift relative to our production of about %. For the year as a whole, we were essentially in balance.
Erik Mielke: Thanks very much.
Dave O’Reilly: You’re welcome.
Operator: Your next question’s from Michael LaMotte with JPMorgan. Your question please.
Michael LaMotte: Thank you. Good morning. The question I have is for Dave. The ministry of petroleum in Iraq seems pretty committed to moving forward with MSEs and awards in June of ’09. I was wondering if you could give us your thoughts on what that might mean for Chevron this year.
Dave O’Reilly: Well, I have just been in the Middle East this month, and there is certainly motivation on their part to move to some agreements, I think, in this year. So there’s been a pick-up in the pace. It’s very hard to predict. Despite the good intentions by the government there to move prospects forward, there are limitations in the capacity of the ministries that just handle the volume of activity. So this could be a year in which some opportunities will get firmed up, but I don’t know how to predict it really. I would hate to go on record and say yes something will happen this year, but we’re clearly interested as many others are. We’re clearly interested as many others are and we’re clearly buying the appropriate packages and ready to move forward and make the appropriate proposals as the opportunities arise.
Michael LaMotte: Thank you for that. I understand that it is difficult to predict, but just the fact that you are staying close to it is (inaudible).
Dave O’Reilly: We are staying close to it. I can assure you of that.
Michael LaMotte: Very good, thank you.
Operator: Your next question’s from Neil McMahon with Sanford Bernstein. Your question please.
Neil McMahon: Hi, just a few of them (inaudible) just a question on projects. Could you give us any update on Jack and St. Malo and the current challenging times? I’m just wondering if you’re doing the sensible thing and renegotiating any potential engineering contracts that you’ve awarded on those projects in terms of feed and rig contracts and also an update on where you are with the Reliance Petroleum option for John Negara (ph)?
Dave O’Reilly: Let me start with the Jack and St. Malo and the lower tertiary in the deep water Gulf of Mexico. This is a very, very important trend and one that we’re really focused on. We had a lot of success in the leasing rounds that just happened this year in the Gulf of Mexico and we have a fine portfolio of prospects in that trend. We are continuing to move forward with Jack and St. Malo and we’re just now at the very early end of the front end engineering works, so this is an ideal time, we think, to be moving into the market as the cost of goods and services are coming down. This is a great opportunity for us and we’ll certainly talk more about it in-depth at the March analyst meeting, but let me assure you, this is one of our top priorities for the long-term and one that’s getting a lot of our attention and we think it’s a good time for us to be starting to move into the market on these opportunities. On Reliance, we are discussing with Reliance the opportunity there at the John Negara Refinery. These are sensitive commercial discussion and I’d prefer not to comment on the at the present time. But this is a year which the situation there will clearly become clarified as we’ve been predicting for some time.
Neil McMahon: Just a quick follow-up on Jack and St. Malo, too, given the fact that you’re entering this, it seems, in a very logical, sensible manner, are we to presume then middle of the decade before we see any significant production coming on from any of those lower tertiary developments?
Neil McMahon: Well, it will be in the next decade since we’re almost there. I would hope that we would have production before the middle of the decade at this point. This year, though, will be clearly one with a lot of engineering work and I think we’ve come very close to selecting the optimum conceptual development plan. So I would hope that by the middle of the decade we would have good production there, but I think we’ll try to predict that a little better for you in March when we see you all.
Neil McMahon: Thanks. Operator Your next question is from Arjun Murti with Goldman Sachs. Your question please.
Arjun Murti: Thank you. Perhaps it’s a little bit of a follow-up on the question on the base declines and the decision to spend less there, and I appreciate part of it’s the environmental regs, but also service costs are still high and oil prices have come down. You still have, otherwise, a very robust capital program and it seems like costs have been inflated in industry across the board. Perhaps some of those major development projects you can’t stop at this point because you’re already in the middle of them, but if there’s perhaps cost concerns in going through with the base business, wouldn’t that also be true of the growth projects that you’re not really slowing those down? I’m just trying to reconcile those two things.
Dave O’Reilly: Well, thank Arjun, let me comment on that. We sanctioned very few projects in 2007 and 2008. Many of the projects that came on stream in 2008 and are coming on in 2009 were sanctioned and most of the expenditures and commitments to spend were made in the 2003, 4, 5 period. So while yes, there has clearly been some cost escalation, none of these projects were launched and made major commitments to at the peak of cost. So we are in fact, I think, in a very good position because the next projects that we sanctioned in our queue will be going out for repress for proposal in ’09 and in 2010. And this, we think is a good window for that because costs are clearly softening. There’s a little bit of a lag, but on the other hand we’ve seen costs come down quite a bit faster than they have in the past, which tells you that we could be hitting a sweet spot here for some of these projects. It’s hard to predict, but clearly that’s going to be part of our thinking, and we believe that these major projects that are good for our long-term will be cost-competitive in this environment. Now, obviously if we are wrong about that, we have the flexibility to go back to investing more into the base business if those costs justify. But we think we’re making the right, balanced decision here. And given the slack in the market, I think it's good timing.
Arjun Murti: Dave, that’s actually really helpful comment and I really appreciate that. Are you confident that you’ll be able to sanction these and that the negations and in this very uncertain environment can get done to then be able to sanction them and move forward or is the ’09 budget perhaps a higher than likely level of spending and as you get through these negotiations and sanction the products, it’s more the ’10 and ’11 CapEx that will be more robust? If it is still a very high level of CapEx, I don’t have an issue with it. I hear you, but we are still spending a decent amount in ’09.
Dave O’Reilly: Well, yes, look, clearly if we can’t justify and don’t feel comfortable with the costs relative to the outlook for the business, we would wait; I think is the best way of putting it. We have some flexibility on some of these major projects, but I think the reality that we see in the market place right now is we think this is a good time to be going back in the market. So if we’re wrong, well then obviously these numbers are too high and we’ll back off. But I think we’re seeing signs that this market is changing more rapidly than it has in the past. I think the suppliers of goods and services to our industry realize that they’re in a different environment as well. The ones that are in it for the long-term clearly want our business and they’ll be modifying their pricing appropriately, so I think some of that’s going to occur.
Arjun Murti: Thank you very much. I appreciate it.
Dave O’Reilly: You’re welcome Arjun.
Operator: Your next question is from Paul Cheng from Barclays Capital. Your question please. Paul Cheng – Barclays Capital Thank you. Good morning, guys. When you’re talking about the cost reduction that you’re expecting, how has is that so far with your negotiation with your wind men ? Are they receptive and recognize that that change is coming down? And how quickly do you think that the lower cost may start to flow through and to benefit you guys and from that aspect when you’re talking about lower treasury, I’m wondering if you can talk about the (inaudible) George was thinking about extending it potentially in the second half of 2009 and if the market conditions may have changed that expectation at this point.
Dave O’Reilly: I think I’ve commented on the lower tertiary already, but let me just talk about Australia and Gorgon for a moment. We are on track to sanctioning that project late in the year. Again, we think this is good timing. We are currently in the market with our FPs. The Australian dollar has weakened significantly. There’s a lot of capacity now in the labor force in Australia as many of the resource industries have deferred activity in mining and other activities. So there’s a lot of interest in this project and I think this is a good time for us to be out in the market beginning to assess and call for prices for equipment and for services and construction. So how it will turn out will remain to be seen, but we’re bullish on Gorgon and believe that’s one that we hope we’ll be able to tie up and create something long-term for the company sometime late in the year. Paul Cheng – Barclays Capital Can I have a follow-up Dave? In the last three years, rightfully, after your Unicom acquisition, the company has been focusing on organic projects and not really looked that much on the M&A markets. I’m wondering if the wheel had changed now the market condition had changed (inaudible) and sometimes people will say that you want to be a cognizant buyer. Nothing specific, I just wanted to see what is the management’s view about that subject?
Dave O’Reilly: Well, two answers to that question. First of all, we clearly have a great organic queue of projects here that we’re continuing to pursue and invest in and we believe that, certainly compared to our size, we are among the best in the industry in that area. And then we’re fueling that in the background with continued success in our explorations program. Look we’re not blind to what’s going on in the world around us, and we make assessments of the opportunities. But those are hard to predict and I prefer not to comment on them, but clearly we’re not blind to looking for other opportunities as well. But our priority in 2009, I think, is going to be on advancing these projects and bringing them to market as well as starting up the ones that are in the commissioning phase that Jim referred to in his remarks a few minutes ago. Paul Cheng – Barclays Capital Thank you.
Dave O’Reilly: Thank you.
Operator: Your next question is from Jason Gammel from Macquarie. Your question please.
Jason Gammel: Thank you. I’d like to add my congratulations to Pat on your new role. Dave, you’ve had a lot of specific questions today relative to some of the projects you have captured, and I think you just marked your ninth anniversary as CEO, so let me just ask a little broader question. How would you assess the state of your investment opportunities now relative to where it’s been over the course of your tenure? Dave O’ Reilly Well, thanks Jason. I think the depth and quality of our queue of opportunities is stronger than any time it’s been in that nine years. And I say that not just based on the projects we’ve been talking about very specifically and that we’ve had a number of questions on this morning, but also the success we’re continuing to have with our exploration program that tells me that that’s going to lead to future developments in the next decade that will be value creating for the company for the long-term. So I see us in a very, very strong position and I feel very good about the opportunities that we have in the years ahead.
Jason Gammel: That’s appreciated. Maybe as a follow-up I could ask another open-ended one. What do you see as the two or three biggest challenges facing the company over the next two to three years? Dave O’Reilly Well, clearly managing through this uncertain period, which is something we’ve done before a number of times as a company and as an industry. We are clearly in a more challenging environment with lower demand. I think we have to go back to the early 80s to see two years of back-to-back oil demand decline. So we had a modest decline globally last year. It’s projected that there’ll be another one this year. So managing out costs and staying focused on the long-term is clearly our objective here. And clearly we’re in a good position to do it because of our strong balance sheet and because we delivered during the good times so that we have that flexibility during the tougher times. The second item I think is the whole issue of carbon management over the next five years or so as the world tries to struggle with how to value carbon and how that affects the business. So I see those as two challenges over the next couple of years, one we’ve been through before a number of times and we’re used to it—the cyclical activity. But I think we’re moving into an area where we’ll be dealing with this new issue. And I don’t mean new in the European sense where we’re already managing it quite well, but I mean in a global sense as more and more countries sign up for carbon management and the impacts on business will clearly be there. And the people who manage successfully will do better than those that don’t.
Jason Gammel: I appreciate that context. Thanks Dave.
Dave O’Reilly: You’re welcome. Thank you, Jason. Operator Your next question is from Paul Sankey from Deutsche Bank. Your question please.
Paul Sankey: Hello everyone. I would just like to carry on a little bit on the CapEx question if I could, sort of related to what Arjun was asking. I understood that you had quite a significant ForEx benefit from a stronger dollar, perhaps as much as a 10 to 20% implied benefit given that a lot of your spending obviously is abroad, which again would have led me to think your CapEx number would come down. You’ve also, as we’ve covered, said you stepped back in the US spending. Could you just help me rationalize that particular part of the balance? Thanks.
Dave O’Reilly: I don’t think we saw a significant benefit CapEx on the strengthening dollar in ’08. A lot of that dollar strengthening occurred very, very late in the year. And so basically the ’08 numbers certainly reflect an average year. As Jim said, it’s very hard to predict this. We’re in uncharted waters. The dollar has been a safe haven at the moment and some other currencies have declined, but clearly some of these numbers could change if there were more dramatic changes in relative valuations of currencies, but I just don’t think I feel comfortable about trying to predict that 2009. But I do feel comfortable telling you that 2008 did not see significant benefit.
Paul Sankey: David, I was really thinking about 2009 relative to 2008 and all things equal with the move that we had in foreign currencies, we would have thought your CapEx would step down, especially when you then add on a somewhat lower level of spending in the US.
Dave O’Reilly: Well, there’s perhaps a little bit of a step down in a few areas, but remember that when you look at the budget here, about 10% of that budget is for one time payments for concession extension. So the budget has come down by about 10%. And part of that is built into that 10%, our current assessment of that. But it’s a prediction and nobody really, truly knows how the relative exchange rates are going to turn out. It’s a fool’s game to try to over guess it.
Paul Sankey: Great, thanks. And then just briefly on the buy back, I believe you said that you would not be buying back shares in Q1. Could you talk a little bit about that decision relative to obviously what we’ve said about CapEx and what we’ve said perhaps about M&A as well? Thanks.
Dave O’Reilly: I’m going to turn it over to Pat to talk about our financial priorities. She’s been sitting here patiently and you’ve all been congratulating her, but she needs to chime in here on this subject as the keeper of the balance sheet. So pat?
Pat Yarrington: Okay, well thanks Dave. I was feeling like I was turning into a potted plant here for a moment. But thanks for the question. Our financial priorities really are from a cash standpoint sustaining and growing the dividend, then funding the capital program that we have where we’ve got projects that bring good returns over a viable vast range of commodity prices, and then maintaining our financial strength and flexibility. So we’ve always seen the share repurchase program as sort of the discretionary part of that. And we’re just indicating certainly for the first quarter of 2009 that we’re not going to have a continuation of that repurchase program.
Paul Sankey: I guess you’d expect debt to rise even so in Q1.
Pat Yarrington: I think that that’s a reasonable expectation. As Dave said, we de-levered when the times were right giving us that flexibility now. When revenue stream has come down and our cost structure obviously is adjusting but perhaps not quite as rapidly, so I think you could expect to see a modest increase in the debt balance in the first quarter. We’re very well positioned though to, even at low, sustained prices, have a very strong balance sheet.
Paul Sankey: Okay, Pat I didn’t congratulate you, so I will. Congratulations.
Pat Yarrington: Well, thank you.
Dave O’Reilly: Thanks for the questions Paul.
Operator: Your next question is from Mike Mathis from Merrill Lynch. Your question please.
Dave O’Reilly: Hello Mike?
Mike Mathis: I’m sorry, it’s been answered. Thank you.
Dave O’Reilly: Okay, you’re welcome.
Operator: Your next question is from Mark Gilman from Benchmark. Your question please.
Mark Gilman: Folks, good morning. I have a couple of things if I could please. Was there any change in the fiscal terms that was agreed upon associated with the extension of the concession of the MZ, Dave? .
Dave O’Reilly: No, the fundamental terms are the same Mark. Okay, and the production outlook for 2009 and the price effect therein, are there any thresholds that are included in that under the $50 a barrel assumption?
Dave O’ Reilly: Well, the $50 a barrel we picked from the stripped price. We did hit some thresholds when the prices were high back in—you’re talking about production sharing thresholds?
Mark Gilman: Yes, cumulative capital costs recovery or rate of return or cumulative production, any of the things that went into Jim’s comments regarding the change in the sensitivity.
Dave O’Reilly: Yes, Jim, why don’t you deal with that one for me?
Jim Aleveras: Mark, the changes that we saw in 2008—and we did hit some thresholds in 2008—were why we had a higher volume impact per dollar per barrel of change in price in crude. Looking ahead to 2009, since we’ve already crossed those thresholds, we feel lower volume impact per dollar change in crude prices.
Mark Gilman: Yes, Jim, but what I’m asking is, are any threshold impacts built into the 60,000 a day price effect as part of your 2009 forecast?
Jim Aleveras: Not many, most of them are behind us, which is why the number has come down.
Mark Gilman: Okay, Dave can I infer from Jack St. Malo comments that the appraisal wells had been or have been drilling were successful?
Dave O’Reilly: Well, I think we’re going to report on the appraisal in March, but I think you can infer that we’re on the right track and we’ll give you a lot more detail in March.
Mark Gilman: Okay, just one final clarification Dave, regarding the 80% organic reserve replacement in ’08, does that include the reserves associated with the concession extension at the NZ? Dave O’Reilly Yes. And you’ll see more detail in the K.
Mark Gilman: Thank you.
Dave O’Reilly: You’re welcome.
Operator: Our next question is from Erik Mielke from Merrill Lynch. Your question.
Erik Mielke: I’m sorry fellows for another question, I just thought I’d ask for an update on (inaudible) and you’ve been running through the other key projects. In your CapEx statement, you said you had an initial payment but the bonus payment also has some initial development. If you could, give us some guidance on where you expect to take that in 2009.
Dave O’Reilly: Well, yes, thanks Erik. We are progressing with the construction work in (inaudible). So it’s actively moving forward and the appropriate capital is included in our program. You view that as another long-term project that will benefit the company for many decades to come. So yes, that one is on track compared to what we told you last year. And again, we’ll be updating you in the March meeting, but thank you for the question.
Erik Mielke: Was it part of your reserve bookings for ’08?
Dave O’Reilly: You’ll see the details in the K. I can’t answer that right now.
Erik Mielke: Thank you.
Operator: Our final question is from Mark Gilman from Benchmark. Your question please.
Mark Gilman: Guys, the exploration/spend component, the 2009 capital budget versus 2008, give me an idea of what it is.
Jim Aleveras: It’s about flat between 2009 and 2008.
Mark Gilman: Level, Jim?
Jim Aleveras: Pretty much so, yes Mark.
Dave O’Reilly: A little bit more appraisal in balance between appraisals versus pure exploration, but we’re going to go through a very detailed review of our exploration program and our plans for ’09 very specifically in the analyst meeting.
Mark Gilman: Okay, thanks folks.
Dave O’Reilly: You’re very welcome. I think it’s time to wind it up Matt unless there are other questions.
Operator: At this time I show no further questions.
Dave O’Reilly: Well, thank you very much for listening. We appreciate everyone’s participation in the call. I want to thank you for your questions this morning and look forward to seeing many of you in March in New York. So, Matt, thank you.
Operator: Ladies and gentlemen, this concludes Chevron’s fourth quarter 2008 earnings conference call. Thank you for your participation. (Operator Instructions) Good day. | [
{
"speaker": "Operator",
"text": "Good morning. Welcome to Chevron's Fourth Quarter 2008 Earnings Conference Call. (Operator Instructions). I will now turn the conference call over to the Chairman and Chief Executive Officer of Chevron Corporation, Mr. Dave O'Reilly, please go ahead, sir."
},
{
"speaker": "Dave O'Reilly",
"text": "Thank you, operator, and welcome to the Chevron's fourth quarter earnings conference call and webcast. On the call with me today are Pat Yarrington, Vice President and Chief Financial Officer, and Jim Aleveras, General Manager Investor Relations. Pat took over as CFO from Steve Crowe who retired last month and as extensive experience in all aspects of Chevron's financial operations. Most recently Pat has been our Vice President and Treasurer and prior to that was Vice President of Government and Public Affairs and before that Vice President of Strategic Planning. You'll have an opportunity to meet her at our meeting in New York on March 10th. Pat, I'll turn the meeting over to you."
},
{
"speaker": "Patricia Yarrington",
"text": "Thanks, Dave. Let's turn now to Chevron's financial and operating results for the fourth quarter of 2008. We'll refer to the slides that are available on the Web. Before we get started please remember that this presentation contains estimates, projections, and other forward looking statements. We ask that you review the cautionary statement on slide two. I'll begin with slide three which provides an overview of our financial performance. The company's fourth quarter earnings were $4.9 billion or $2.44 per diluted share. Our total fourth quarter 2008 earnings were about the same as fourth quarter 2007. Earnings per share, however, were up about 5% due to our share repurchase program. Comparing the fourth quarter 2008 to the same period a year earlier, lower crude oil and natural gas prices reduced upstream results while falling prices improved profits in the downstream segment. To recap the balance of slide three, return on capital employed for the year was nearly 27%, under scoring Chevron's financial strength the debt ratio was below 10% at the end of the year and cash balances exceeded debt by $700 million. Share repurchases were $8 billion for the year. Our latest share repurchase program was authorized by the Board in September 2007 for up to $15 billion over a period of up to three years. We have now repurchased $10.1 billion of the $15 billion authorized. We do not anticipate repurchasing shares in the first quarter of 2009. Finally Chevron's 2008 TSR of negative 18% compares favorably to the S&P 500s return of negative 37% and a 37% decline in the MX oil index. Turning to slide four, our total capital spend for 2008 was $22.8 billion compared with our budget of $22.9 billion. Upstream spending accounted for $17.5 billion of that total. Our cash C&E which excludes our equity share of affiliate outlays was $20.5 billion. Our announced capital program for 2009 of $22.8 billion is unchanged from 2008 expenditures. However, about 10% of the total 2009 budget relates to large one-time payments for concessions in the partition neutral zone and Jong Dong Bay (ph) gas field. Excluding these items underlying spending in the upstream segment is budgeted to be lower than last year. Of the overall 2009 capital program 77% is for upstream activities reflecting the capital intensive phase of some of our long term growth projects. Another 19% is earmarked for the downstream for a number of investments to upgrade our refining network. Jim will now take us through the quarterly comparisons. So Jim over to you."
},
{
"speaker": "James Aleveras",
"text": "Thanks, Pat. My remarks compare results of the fourth quarter 2008 with the third quarter 2008. As a reminder our earnings release compared fourth quarter 2008 with the same quarter a year earlier. Turning to slide five, fourth quarter net income was about $3 billion lower than the third quarter. Starting with the left side of the chart lower crude oil and natural gas prices caused (inaudible) to decline by more than $3 billion. Similar to the prior quarter falling commodity prices benefited the downstream segment in the fourth quarter. The variants in the other bar reflects lower chemical earnings and higher corporate charges. Slide six summarizes the results for our U.S. upstream operations. Lower crude oil and natural gas prices reduced earnings by $1.6 billion. Chevron's average U.S. crude oil realization was down about $61 per barrel between quarters similar to the average WTI change of about $59 per barrel between the periods. Production (inaudible) were down 4% mainly due to the full quarter impact of September hurricane shut-ins. The violent impact reduced fourth quarter earnings by $100 million. As mentioned in the interim update lower charges related to the hurricanes benefited earnings by about $350 million in the fourth quarter compared to the third. The fourth quarter included a gain of about $600 million from an exchange transaction which included the company's interest in a producing property in Utah. For comparison asset sales added about $350 million to third quarter profits. This difference of $250 million is shown on the chart. The other bar is comprised of a number of items. The largest of which was related to a change in natural gas inventories. Turning to slide seven, international upstream earnings for the fourth quarter fell nearly $2 billion from the third quarter's results. Lower oil and gas prices reduced earnings by $2.8 billion. Our average realization per liquids fell about $56 per barrel between sequential quarters compared to the $59 per barrel decline in the average (inaudible) price. Higher liftings benefited fourth quarter earnings by $430 million. Liftings were higher in Kazakhstan due to the ramp up of the Tengiz expansion and completion of the third quarter facilities turnaround there. The ramp up of Agbami in Nigeria was also a significant factor. The $210 million favorable variance in tax items shown in the slide reflect various issues in several countries. Exploration expense was higher between quarters reducing earnings by $140 million. This is a result of several well write-offs along with higher geological and geophysical expenditures. The other bar is primarily an increase in foreign currency gains. Slide eight summarizes the quarterly change in the worldwide oil equivalent production including volumes produced from oil sands in Canada. Production increased by 97, 000 barrels per day or 4% between periods. Though our fourth quarter prices benefited buy-in by 73,000 barrels per day primarily due to production strain contracts and variable royalties. External constraints such as mandated curtailments by opaque member host governments and lower natural gas demand reduced production by 51, 000 barrels per day. As mentioned earlier the fourth quarter was impacted by the September hurricanes in the Gulf of Mexico. The volume metric effect was an adverse variance of 27,000 barrels per day. Base business declines of 17,000 barrels per day were more than offset by the ramp up of production from the Tengiz expansion, Agbami, Blind Faith, and the Northwest Shoal on G-Train 5. Slide nine compares full year 2008 OEG production including volumes produced from oil sands in Canada to that of 2007. Price impacts on production sharing contracts and variable royalties reduced production by 72,000 barrels per day. WTI prices averaged $72 per barrel in 2007 in contrast to $100 per barrel in 2008. For the year 2008 external constraints such as mandated curtailments by opaque member host governments and lower natural gas demand reduced production by 13,000 barrels per day. The full year impact of Gulf of Mexico hurricanes was 35,000 barrels per day. Our base business decline was 78,000 barrels per day, a drop of about 3%. I'll discuss our outlook for the base business decline in a moment. Finally our major projects, primarily the Tengiz expansion, Agbami, and the further ramp up of our 2007 Bibyana (ph ) in Banglodesh added 109,000 barrels per day to 2008 production. Blind faith come on extremely late in 2008 and did not have a large impact the full year. 2008 production of 2.5 free million barrels per day came in at 120,000 barrels per day lower than the element we provided at the beginning of the year. The original 2008 outlook of 2.65 million barrels per day assumed crude prices for the year would average $70 per barrel, instead of the $100 average that actually occurred. Price effects along with external constraints and then September hurricanes noted here were the primary reasons for the difference. Our base business performed solidly better than we assumed, offsetting this we experience a six-month delay in the in the (inaudible). The rest of our projects started on time but some ramped up more slowly than originally planned. Slide ten shows our production outlook for 2009. We had previously provided (inaudible) for 2008 that each dollar change in crude prices would inversely change our production by about 2,000 barrels per day due to effect of production sharing and variable (inaudible) agreements. Because of certain thresholds have been reached under these agreements, our rule of thumb for 2009 is each dollar change in crude prices affects production by roughly 1,200 barrels per day. As before, I caution you that this rule of thumb is very approximate and actually results will differ each of the underlying contracts as different. On this basis comparing 2009 at an assumed price of $50 per barrel, which this is based on last week's future prices, and 2008 at $100 per barrel, the price effects would increase production by 60,000 barrels per day as shown on the chart. External constraints again for (inaudible) member, most Governments and market factors are assumed to reduce production by 80,000 barrels per day. Base business declines and the impact of lower investment in the base business are expected to reduce production by 188,000 barrels per day. This amount is an implied 7% decline rate in contrast to our previous 4 to 5% base decline guidance due to lower expected oil and gas prices, spending on our base business and mitigating natural fuel declines, will be reduced in 2009. We're still investing to mitigate these declines but at a lower level reflecting the lower level of oil and gas prices. The big (inaudible) that we do not produce in 2009 will still be there to produce when market conditions are more attractive. Because of the temporarily higher base decline rate and market driven investment deferrals, we do not expect to achieve our full 3% compound annual production growth between 2005 and 2010. We'll update you further at our annual security analysts meeting in New York on March 10th. Finally, 2009 will benefit from the continued ramp up and full year production in a more recent major capital projects and from the (inaudible) that come on line for later this year including (inaudible) and Brazil, Tahiti in the Gulf of Mexico, and Gonzale Luni (ph) in Angola. Turning to slide 11, U.S. downstream operation turned to just over $1 billion essentially flat with the previous quarter. Indicator margins reduces earnings by $260 million. Our marketing margins improved lowering refinery margins on the West and Gulf Coast were a large factor. The change in the company's realized margins tracked the change in indicator margins. WHI prices fell more than $56 per barrel from the end of the third quarter to the end of fourth quarter. This exceeded the $39 per barrel drop that occurred during the prior quarter. The sharply falling prices caused the downstream to have a large favorable timing effect in both quarters. Timing effects were $80 million more favorable in the fourth quarter than the third. On an absolute basis, timing effects in the fourth quarter were about $700 million. The largest factor was provisionally priced or improved which was $370 million in the fourth quarter, about the same it was in the third quarter. In the previous conference call, I mentioned that the company revised their primary long haul crude supply agreement to the West Coast refineries starting in October. However, August and September liftings were still final (inaudible) in October and November, and prices were about $35 per barrels lower than at the end of the third quarter. We do not expect a material timing effects for provisionally appraised crude in the first quarter for U.S. operations. The balance of the timing effects was primarily due to inventory, derivative gains associated with shale refined products, a favorable lag in aviation pricing, and other supply related factors. Finally operating expenses declined largely from lower fuel costs. Turning to slide 12, international downstream earnings improved by $230 million and more than $1 billion. Defining margins were lower in the fourth quarter. Our marketing margins were mixed. Overall our realized margins fell $205 million between the sequential quarters. Volumes were simply lower during the fourth quarter partly reflecting planned maintenance and a (inaudible 00:16:45) refinery in the UK. The volume effect was an average strand of $30 million. Timing effects added $525 million to the fourth quarter earnings, compared third quarter earnings. The absolute amount of timing effects in the fourth quarter was roughly $850 million. Nearly half of the increase between sequential quarters was related to derivative gains and long haul crude new refined products such as PMJ crude, templar exports, and crude sales to equity affiliated refineries. As I mentioned during the last few quarters, we often use derivatives to lock in a margin above the cost of transportation which result in gains when prices decrease and vice versa. The balance of the timing effects between quarters resulted in gains in derivatives used to convert crude pricing to the time of refinery run. And a favorable lag in aviation pricing as well as other supply related timing factors. The other burr on this chart reflects an adverse change of $50 million between quarters. Lower operating expense was more than offset by an adverse swing in point price index. On slide 13 shows that earnings from chemical operations were $28 million the fourth quarter, compared to $70 million in the third quarter. Results for all (inaudible) due to lower volumes in prices. (inaudible) range fell primarily because of a one time impairment charge. The other bar reflects higher additive range. On slide 14 covers all other net charges. Before the quarter results, net charges of $365 million, comparable to net charges at $190 million in the third quarter. $310 million of the swing reflects higher corporate charges across a number of areas, $70 million of the change stems from a favorable variance of two tax items. The other bar on slide 14 includes the net of many unrelated items which were $65 million payroll variance between the sequential quarters. Before turning it over to Dave, I'd just like to briefly recap the fourth quarter. Upstream earnings fell significantly in line with the interim updates. Downstream continues to benefit from sizable derivative gains due to the declining prices, also noted in the interim update. And last as projected chemical earnings were lower and all of these charges exceeded the guidance range. Dave O'Reilly will now summarize our 2008 strategic progress and provide some thoughts about 2009. Dave?"
},
{
"speaker": "Dave O'Reilly",
"text": "Well, thank you, Jim. And turning to slide 15, in 2008, we focused on execution and succeeded across the board. For several years, we’ve made improvements on our safety performance and were among the best in class. In our upstream business, we committed starting to on three major Chevron operated projects, adding significantly to our long-term production. The Tengiz expansion like Agbami and Blind Faith are all online and performing well. We also started the first phrase of the North Duri steam flood in Indonesia and achieved first production at five partner operated projects. We've talked about our exploration success for many years in a row and 2008 was another banner year for exploration, which we'll discuss further at the March Security Analysts Meeting. WE told the investment community that our reserve replacement ratio would improve and on a preliminary basis, we estimate that we replaced 146% of our production in 2008. Now our downstream business we placed to improve refinery reliability. We delivered on that pledge in 2008 and we had our best fuelization rates on record. 2008 represented a 6.5% improvement in refinery utilization over the base year of 2005. Our downstream portfolio rationalization has continued in 2008 as we exited a number of non-strategic markets. Finally, we rewarded our shareholders with another double digit increase in our dividends and repurchased $8 billion of our shares. We did so while funding our robust capital program and maintain the balance sheet with more cash than debt at the end of the year. So we enter these challenging times with the financial strength and flexibility to succeed in the years ahead. Turning to slide 16, let's just look at 2009 briefly. In our upstream business we're on track to start up three more Chevron operated projects further demonstrating our organic growth potential. We are also focused on the work needed to continue to advance in our strategically important projects in core areas such as Australia and the deep water Gulf of Mexico. In the downstream business, we're maintaining our focus on refinery utilization to capture the most margin that the market will permit. And we're continuing to rationalize our portfolio to focus on our strongest markets and those with the most potential for long-term value creation. Across the enterprise we're focused on managing our costs in the same world class process as we used to manage costs when they are rising are now critical to realizing maximum savings on materials and services in a softening market. Combined with capital discipline, our attention to every element of our cost structure will ensure us success during this economic slowdown. Rewarding our share holders, continuing our disciplined growth, and maintaining our financial strength are all objectives we have been pursuing and will continue to pursue in 2009. Meeting our commitments to our investors, our communities and a world that has long-term need for our products and services has been and will continue to be our priority. I look forward to discussing the challenges and opportunities of 2009 and the years ahead at our meeting on March 10th in New York City. That concludes our prepared remarks. We'll now take your questions. So that everyone has an opportunity to participate, please try to limit your follow up questions to one or two. So, operator, please open the lines for questions."
},
{
"speaker": "Operator",
"text": "Thank you. (Operator instructions). And our first question comes from Mark Flatery from Credit Swiss. Your question please."
},
{
"speaker": "Mark Flathery -Credit Swiss",
"text": "Thank you. My question is on the reserve replacement and I know you have only preliminary numbers and you'll give more details in March but can you give us an early feel for how much the net pricing impact was on these India reserve replacement and whether it was net positive, net negative roughly how big?"
},
{
"speaker": "Dave O'Reilly",
"text": "Well Mark, thank you. We've had a great success with our reserves replacement this year in a number of areas. Some of the projects that we started up where we had conservatively booked reserves, we were able to rebuy numbers because we now demonstrated through production more confidence in the reservoirs. We've also had some additions from contract extensions such as the PNZ and those will be disclosed in somewhat more detail when we get to our March meeting. We did benefit, obviously, from price and my recollection is that we're in the 80 – the organic replacement for one year was above 80% or around 80%. The balance comes from price. So we've gained back in price some of what we lost – a lot of what we lost over the last few years as the numbers went in the other direction, as price went upwards and reduced those reserves. So now that I look over the last ten years it's very gratifying to see that we are at greater than 100% reserve replacement over that long spread of time. So I feel good about where we are and we'll be covering that in more detail obviously in March. And you'll see a lot more disclosure in the 10-K as well. So thank you for the question."
},
{
"speaker": "Unidentified Analyst",
"text": "Great, thank you."
},
{
"speaker": "Operator",
"text": "Our next question is from Robert Kessler from Simmons and Company, your questions please."
},
{
"speaker": "Robert Kessler",
"text": "Good morning and Pat welcome to your new role. My question relates to your production guidance for 2009. Looking at the new implied base business decline rate of 7% and comparing that to your recent experience of 3 to 4% I recognize you said there was a gap associated with lower spending. And if I look at your CapEx plan it looks like excluding the one time payments it would have been down about $2.8 billion. Is that the order of magnitude spending that you estimate would be required to flatten our mitigate that decline rate down to the 4% figure you typically experience? And why given, I would assume you would expect resilence in your portfolio down to $50 a barrel at least, why would you not go ahead and spend that amount in a deflationary oil field service environment?"
},
{
"speaker": "Dave O'Reilly",
"text": "Okay a lot of questions there but let me – generally your observations are on the right track. But let me give you a reason why I think the primary reason why and maybe even an example of why we think it's unwise to chase after barrels in this environment. We have – we're clearly pursuing our long term strategic projects that require continued investment over the long term and I cited a number of examples of those. But let me talk about a very specific example of where we have consciously slowed down and that's in the Peonce (ph). And there are two reasons for it, one is Colorado has instituted some pretty onerous environmental regulations that have made it a lot more difficult to get permits in a timely manner. So we’ve reduced – we were planning – we were in the process of reducing our plans just from an environmental permitting stand point. Also the pricing outlook is looking a little tenuous in that area so we've slowed it down. In the meantime we expect – we do expect costs to come down in the good and services and supplies and oil field services area. And as those costs come down we'll obviously have a chance to re-evaluate our portfolio and make decisions to add more investment if we think it's appropriate. But in this environment we think we're doing the right thing to back off the particularly the opportunities that we can come back to later because they're in this case on fee land. And we're conscious here of the capital discipline that we need to exercise in order to make the right value decision. So there are a number of those decisions that we've taken. We think they're the right thing to do in this market and we expect as prices -- as costs come down that we'll be – and permitting requirements are met that we'll be able to reevaluate our position in the future. But I think in current circumstances this is the right thing to do."
},
{
"speaker": "Robert Kessler",
"text": "Thank you for the color."
},
{
"speaker": "Dave O'Reilly",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question is from Erik Mielke from Merrill Lynch. Your question please."
},
{
"speaker": "Erik Mielke",
"text": "Yes, good morning. I'd also like to congratulate Pat on her new role and welcome to the quarterly conference circus. I'd like to ask a question on the production outlook, as well. Given the experience you've had in 2008 are you being more conservative in your guidance in 2009? Particularly with respect to the ramp up from the major capital projects out on execution? And is there anything on the external factors that you can help us understand that number at least a little bit better? Is that 60,000 barrels per day based on the current run rate or is that project for the contract by opaque?"
},
{
"speaker": "Dave O'Reilly",
"text": "Well I think we are taking, I think, a realistic view as best we can of what is happening in the market place with Opaque and some market impacts. We show an 80,000 barrels per day negative on what we call external factors, and basically that’s roughly what we see. About half of that’s market effects. Half of it is OPEC, but the OPEC impact’s primarily in Venezuela and some in Angola and a little bit in Nigeria. The balance is market effects in gas in Asia. We saw a deterioration in gas demand in Thailand, for example, late in the year. And we just think that it’s not wise for us to count on those markets bouncing back very quickly. They’re still good for the long-term, but in the near-term in ’09, I think what we’ve done is give you the most realistic assessment that we can of what we call external factors. It’s very hard to predict this with accuracy. But that’s our best shot at it as we see it today."
},
{
"speaker": "Erik Mielke",
"text": "Okay, thanks. Can I ask a follow-up on foreign exchange? There was quite a bit of noise in the quarter from foreign exchange. Are there any handy rules of thumb that you can give us that we can use to try predict some of the overall exposure for group?"
},
{
"speaker": "Jim Aleveras",
"text": "Erik, I’m afraid that’s a very, very difficult challenge for us. Obviously, different factors come into play depending on the timing on our acquisition of goods and services, depending on the net monetary asset and liability positions in different parts of the company. In general, what we saw overall, the benefit in the fourth quarter was the strengthening dollar. But obviously it hit different segments in different ways. I wish I could provide better guidance in that, but again, because of the mix of components that goes into that, both what we buy, what we sell, as well as the assets and liabilities in our different international businesses, it’s very, very difficult to give anything other than guidance that suggests that strengthening or weakening dollar would help or hurt our clients exchange rates."
},
{
"speaker": "Erik Mielke",
"text": "Okay, and finally, was there any significant over or under-lift in international upstream in the fourth quarter?"
},
{
"speaker": "Jim Aleveras",
"text": "In the fourth quarter we had a under-lift relative to our production of about %. For the year as a whole, we were essentially in balance."
},
{
"speaker": "Erik Mielke",
"text": "Thanks very much."
},
{
"speaker": "Dave O’Reilly",
"text": "You’re welcome."
},
{
"speaker": "Operator",
"text": "Your next question’s from Michael LaMotte with JPMorgan. Your question please."
},
{
"speaker": "Michael LaMotte",
"text": "Thank you. Good morning. The question I have is for Dave. The ministry of petroleum in Iraq seems pretty committed to moving forward with MSEs and awards in June of ’09. I was wondering if you could give us your thoughts on what that might mean for Chevron this year."
},
{
"speaker": "Dave O’Reilly",
"text": "Well, I have just been in the Middle East this month, and there is certainly motivation on their part to move to some agreements, I think, in this year. So there’s been a pick-up in the pace. It’s very hard to predict. Despite the good intentions by the government there to move prospects forward, there are limitations in the capacity of the ministries that just handle the volume of activity. So this could be a year in which some opportunities will get firmed up, but I don’t know how to predict it really. I would hate to go on record and say yes something will happen this year, but we’re clearly interested as many others are. We’re clearly interested as many others are and we’re clearly buying the appropriate packages and ready to move forward and make the appropriate proposals as the opportunities arise."
},
{
"speaker": "Michael LaMotte",
"text": "Thank you for that. I understand that it is difficult to predict, but just the fact that you are staying close to it is (inaudible)."
},
{
"speaker": "Dave O’Reilly",
"text": "We are staying close to it. I can assure you of that."
},
{
"speaker": "Michael LaMotte",
"text": "Very good, thank you."
},
{
"speaker": "Operator",
"text": "Your next question’s from Neil McMahon with Sanford Bernstein. Your question please."
},
{
"speaker": "Neil McMahon",
"text": "Hi, just a few of them (inaudible) just a question on projects. Could you give us any update on Jack and St. Malo and the current challenging times? I’m just wondering if you’re doing the sensible thing and renegotiating any potential engineering contracts that you’ve awarded on those projects in terms of feed and rig contracts and also an update on where you are with the Reliance Petroleum option for John Negara (ph)?"
},
{
"speaker": "Dave O’Reilly",
"text": "Let me start with the Jack and St. Malo and the lower tertiary in the deep water Gulf of Mexico. This is a very, very important trend and one that we’re really focused on. We had a lot of success in the leasing rounds that just happened this year in the Gulf of Mexico and we have a fine portfolio of prospects in that trend. We are continuing to move forward with Jack and St. Malo and we’re just now at the very early end of the front end engineering works, so this is an ideal time, we think, to be moving into the market as the cost of goods and services are coming down. This is a great opportunity for us and we’ll certainly talk more about it in-depth at the March analyst meeting, but let me assure you, this is one of our top priorities for the long-term and one that’s getting a lot of our attention and we think it’s a good time for us to be starting to move into the market on these opportunities. On Reliance, we are discussing with Reliance the opportunity there at the John Negara Refinery. These are sensitive commercial discussion and I’d prefer not to comment on the at the present time. But this is a year which the situation there will clearly become clarified as we’ve been predicting for some time."
},
{
"speaker": "Neil McMahon",
"text": "Just a quick follow-up on Jack and St. Malo, too, given the fact that you’re entering this, it seems, in a very logical, sensible manner, are we to presume then middle of the decade before we see any significant production coming on from any of those lower tertiary developments?"
},
{
"speaker": "Neil McMahon",
"text": "Well, it will be in the next decade since we’re almost there. I would hope that we would have production before the middle of the decade at this point. This year, though, will be clearly one with a lot of engineering work and I think we’ve come very close to selecting the optimum conceptual development plan. So I would hope that by the middle of the decade we would have good production there, but I think we’ll try to predict that a little better for you in March when we see you all."
},
{
"speaker": "Neil McMahon",
"text": "Thanks. Operator Your next question is from Arjun Murti with Goldman Sachs. Your question please."
},
{
"speaker": "Arjun Murti",
"text": "Thank you. Perhaps it’s a little bit of a follow-up on the question on the base declines and the decision to spend less there, and I appreciate part of it’s the environmental regs, but also service costs are still high and oil prices have come down. You still have, otherwise, a very robust capital program and it seems like costs have been inflated in industry across the board. Perhaps some of those major development projects you can’t stop at this point because you’re already in the middle of them, but if there’s perhaps cost concerns in going through with the base business, wouldn’t that also be true of the growth projects that you’re not really slowing those down? I’m just trying to reconcile those two things."
},
{
"speaker": "Dave O’Reilly",
"text": "Well, thank Arjun, let me comment on that. We sanctioned very few projects in 2007 and 2008. Many of the projects that came on stream in 2008 and are coming on in 2009 were sanctioned and most of the expenditures and commitments to spend were made in the 2003, 4, 5 period. So while yes, there has clearly been some cost escalation, none of these projects were launched and made major commitments to at the peak of cost. So we are in fact, I think, in a very good position because the next projects that we sanctioned in our queue will be going out for repress for proposal in ’09 and in 2010. And this, we think is a good window for that because costs are clearly softening. There’s a little bit of a lag, but on the other hand we’ve seen costs come down quite a bit faster than they have in the past, which tells you that we could be hitting a sweet spot here for some of these projects. It’s hard to predict, but clearly that’s going to be part of our thinking, and we believe that these major projects that are good for our long-term will be cost-competitive in this environment. Now, obviously if we are wrong about that, we have the flexibility to go back to investing more into the base business if those costs justify. But we think we’re making the right, balanced decision here. And given the slack in the market, I think it's good timing."
},
{
"speaker": "Arjun Murti",
"text": "Dave, that’s actually really helpful comment and I really appreciate that. Are you confident that you’ll be able to sanction these and that the negations and in this very uncertain environment can get done to then be able to sanction them and move forward or is the ’09 budget perhaps a higher than likely level of spending and as you get through these negotiations and sanction the products, it’s more the ’10 and ’11 CapEx that will be more robust? If it is still a very high level of CapEx, I don’t have an issue with it. I hear you, but we are still spending a decent amount in ’09."
},
{
"speaker": "Dave O’Reilly",
"text": "Well, yes, look, clearly if we can’t justify and don’t feel comfortable with the costs relative to the outlook for the business, we would wait; I think is the best way of putting it. We have some flexibility on some of these major projects, but I think the reality that we see in the market place right now is we think this is a good time to be going back in the market. So if we’re wrong, well then obviously these numbers are too high and we’ll back off. But I think we’re seeing signs that this market is changing more rapidly than it has in the past. I think the suppliers of goods and services to our industry realize that they’re in a different environment as well. The ones that are in it for the long-term clearly want our business and they’ll be modifying their pricing appropriately, so I think some of that’s going to occur."
},
{
"speaker": "Arjun Murti",
"text": "Thank you very much. I appreciate it."
},
{
"speaker": "Dave O’Reilly",
"text": "You’re welcome Arjun."
},
{
"speaker": "Operator",
"text": "Your next question is from Paul Cheng from Barclays Capital. Your question please. Paul Cheng – Barclays Capital Thank you. Good morning, guys. When you’re talking about the cost reduction that you’re expecting, how has is that so far with your negotiation with your wind men ? Are they receptive and recognize that that change is coming down? And how quickly do you think that the lower cost may start to flow through and to benefit you guys and from that aspect when you’re talking about lower treasury, I’m wondering if you can talk about the (inaudible) George was thinking about extending it potentially in the second half of 2009 and if the market conditions may have changed that expectation at this point."
},
{
"speaker": "Dave O’Reilly",
"text": "I think I’ve commented on the lower tertiary already, but let me just talk about Australia and Gorgon for a moment. We are on track to sanctioning that project late in the year. Again, we think this is good timing. We are currently in the market with our FPs. The Australian dollar has weakened significantly. There’s a lot of capacity now in the labor force in Australia as many of the resource industries have deferred activity in mining and other activities. So there’s a lot of interest in this project and I think this is a good time for us to be out in the market beginning to assess and call for prices for equipment and for services and construction. So how it will turn out will remain to be seen, but we’re bullish on Gorgon and believe that’s one that we hope we’ll be able to tie up and create something long-term for the company sometime late in the year. Paul Cheng – Barclays Capital Can I have a follow-up Dave? In the last three years, rightfully, after your Unicom acquisition, the company has been focusing on organic projects and not really looked that much on the M&A markets. I’m wondering if the wheel had changed now the market condition had changed (inaudible) and sometimes people will say that you want to be a cognizant buyer. Nothing specific, I just wanted to see what is the management’s view about that subject?"
},
{
"speaker": "Dave O’Reilly",
"text": "Well, two answers to that question. First of all, we clearly have a great organic queue of projects here that we’re continuing to pursue and invest in and we believe that, certainly compared to our size, we are among the best in the industry in that area. And then we’re fueling that in the background with continued success in our explorations program. Look we’re not blind to what’s going on in the world around us, and we make assessments of the opportunities. But those are hard to predict and I prefer not to comment on them, but clearly we’re not blind to looking for other opportunities as well. But our priority in 2009, I think, is going to be on advancing these projects and bringing them to market as well as starting up the ones that are in the commissioning phase that Jim referred to in his remarks a few minutes ago. Paul Cheng – Barclays Capital Thank you."
},
{
"speaker": "Dave O’Reilly",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question is from Jason Gammel from Macquarie. Your question please."
},
{
"speaker": "Jason Gammel",
"text": "Thank you. I’d like to add my congratulations to Pat on your new role. Dave, you’ve had a lot of specific questions today relative to some of the projects you have captured, and I think you just marked your ninth anniversary as CEO, so let me just ask a little broader question. How would you assess the state of your investment opportunities now relative to where it’s been over the course of your tenure? Dave O’ Reilly Well, thanks Jason. I think the depth and quality of our queue of opportunities is stronger than any time it’s been in that nine years. And I say that not just based on the projects we’ve been talking about very specifically and that we’ve had a number of questions on this morning, but also the success we’re continuing to have with our exploration program that tells me that that’s going to lead to future developments in the next decade that will be value creating for the company for the long-term. So I see us in a very, very strong position and I feel very good about the opportunities that we have in the years ahead."
},
{
"speaker": "Jason Gammel",
"text": "That’s appreciated. Maybe as a follow-up I could ask another open-ended one. What do you see as the two or three biggest challenges facing the company over the next two to three years? Dave O’Reilly Well, clearly managing through this uncertain period, which is something we’ve done before a number of times as a company and as an industry. We are clearly in a more challenging environment with lower demand. I think we have to go back to the early 80s to see two years of back-to-back oil demand decline. So we had a modest decline globally last year. It’s projected that there’ll be another one this year. So managing out costs and staying focused on the long-term is clearly our objective here. And clearly we’re in a good position to do it because of our strong balance sheet and because we delivered during the good times so that we have that flexibility during the tougher times. The second item I think is the whole issue of carbon management over the next five years or so as the world tries to struggle with how to value carbon and how that affects the business. So I see those as two challenges over the next couple of years, one we’ve been through before a number of times and we’re used to it—the cyclical activity. But I think we’re moving into an area where we’ll be dealing with this new issue. And I don’t mean new in the European sense where we’re already managing it quite well, but I mean in a global sense as more and more countries sign up for carbon management and the impacts on business will clearly be there. And the people who manage successfully will do better than those that don’t."
},
{
"speaker": "Jason Gammel",
"text": "I appreciate that context. Thanks Dave."
},
{
"speaker": "Dave O’Reilly",
"text": "You’re welcome. Thank you, Jason. Operator Your next question is from Paul Sankey from Deutsche Bank. Your question please."
},
{
"speaker": "Paul Sankey",
"text": "Hello everyone. I would just like to carry on a little bit on the CapEx question if I could, sort of related to what Arjun was asking. I understood that you had quite a significant ForEx benefit from a stronger dollar, perhaps as much as a 10 to 20% implied benefit given that a lot of your spending obviously is abroad, which again would have led me to think your CapEx number would come down. You’ve also, as we’ve covered, said you stepped back in the US spending. Could you just help me rationalize that particular part of the balance? Thanks."
},
{
"speaker": "Dave O’Reilly",
"text": "I don’t think we saw a significant benefit CapEx on the strengthening dollar in ’08. A lot of that dollar strengthening occurred very, very late in the year. And so basically the ’08 numbers certainly reflect an average year. As Jim said, it’s very hard to predict this. We’re in uncharted waters. The dollar has been a safe haven at the moment and some other currencies have declined, but clearly some of these numbers could change if there were more dramatic changes in relative valuations of currencies, but I just don’t think I feel comfortable about trying to predict that 2009. But I do feel comfortable telling you that 2008 did not see significant benefit."
},
{
"speaker": "Paul Sankey",
"text": "David, I was really thinking about 2009 relative to 2008 and all things equal with the move that we had in foreign currencies, we would have thought your CapEx would step down, especially when you then add on a somewhat lower level of spending in the US."
},
{
"speaker": "Dave O’Reilly",
"text": "Well, there’s perhaps a little bit of a step down in a few areas, but remember that when you look at the budget here, about 10% of that budget is for one time payments for concession extension. So the budget has come down by about 10%. And part of that is built into that 10%, our current assessment of that. But it’s a prediction and nobody really, truly knows how the relative exchange rates are going to turn out. It’s a fool’s game to try to over guess it."
},
{
"speaker": "Paul Sankey",
"text": "Great, thanks. And then just briefly on the buy back, I believe you said that you would not be buying back shares in Q1. Could you talk a little bit about that decision relative to obviously what we’ve said about CapEx and what we’ve said perhaps about M&A as well? Thanks."
},
{
"speaker": "Dave O’Reilly",
"text": "I’m going to turn it over to Pat to talk about our financial priorities. She’s been sitting here patiently and you’ve all been congratulating her, but she needs to chime in here on this subject as the keeper of the balance sheet. So pat?"
},
{
"speaker": "Pat Yarrington",
"text": "Okay, well thanks Dave. I was feeling like I was turning into a potted plant here for a moment. But thanks for the question. Our financial priorities really are from a cash standpoint sustaining and growing the dividend, then funding the capital program that we have where we’ve got projects that bring good returns over a viable vast range of commodity prices, and then maintaining our financial strength and flexibility. So we’ve always seen the share repurchase program as sort of the discretionary part of that. And we’re just indicating certainly for the first quarter of 2009 that we’re not going to have a continuation of that repurchase program."
},
{
"speaker": "Paul Sankey",
"text": "I guess you’d expect debt to rise even so in Q1."
},
{
"speaker": "Pat Yarrington",
"text": "I think that that’s a reasonable expectation. As Dave said, we de-levered when the times were right giving us that flexibility now. When revenue stream has come down and our cost structure obviously is adjusting but perhaps not quite as rapidly, so I think you could expect to see a modest increase in the debt balance in the first quarter. We’re very well positioned though to, even at low, sustained prices, have a very strong balance sheet."
},
{
"speaker": "Paul Sankey",
"text": "Okay, Pat I didn’t congratulate you, so I will. Congratulations."
},
{
"speaker": "Pat Yarrington",
"text": "Well, thank you."
},
{
"speaker": "Dave O’Reilly",
"text": "Thanks for the questions Paul."
},
{
"speaker": "Operator",
"text": "Your next question is from Mike Mathis from Merrill Lynch. Your question please."
},
{
"speaker": "Dave O’Reilly",
"text": "Hello Mike?"
},
{
"speaker": "Mike Mathis",
"text": "I’m sorry, it’s been answered. Thank you."
},
{
"speaker": "Dave O’Reilly",
"text": "Okay, you’re welcome."
},
{
"speaker": "Operator",
"text": "Your next question is from Mark Gilman from Benchmark. Your question please."
},
{
"speaker": "Mark Gilman",
"text": "Folks, good morning. I have a couple of things if I could please. Was there any change in the fiscal terms that was agreed upon associated with the extension of the concession of the MZ, Dave? ."
},
{
"speaker": "Dave O’Reilly",
"text": "No, the fundamental terms are the same Mark. Okay, and the production outlook for 2009 and the price effect therein, are there any thresholds that are included in that under the $50 a barrel assumption?"
},
{
"speaker": "Dave O’ Reilly",
"text": "Well, the $50 a barrel we picked from the stripped price. We did hit some thresholds when the prices were high back in—you’re talking about production sharing thresholds?"
},
{
"speaker": "Mark Gilman",
"text": "Yes, cumulative capital costs recovery or rate of return or cumulative production, any of the things that went into Jim’s comments regarding the change in the sensitivity."
},
{
"speaker": "Dave O’Reilly",
"text": "Yes, Jim, why don’t you deal with that one for me?"
},
{
"speaker": "Jim Aleveras",
"text": "Mark, the changes that we saw in 2008—and we did hit some thresholds in 2008—were why we had a higher volume impact per dollar per barrel of change in price in crude. Looking ahead to 2009, since we’ve already crossed those thresholds, we feel lower volume impact per dollar change in crude prices."
},
{
"speaker": "Mark Gilman",
"text": "Yes, Jim, but what I’m asking is, are any threshold impacts built into the 60,000 a day price effect as part of your 2009 forecast?"
},
{
"speaker": "Jim Aleveras",
"text": "Not many, most of them are behind us, which is why the number has come down."
},
{
"speaker": "Mark Gilman",
"text": "Okay, Dave can I infer from Jack St. Malo comments that the appraisal wells had been or have been drilling were successful?"
},
{
"speaker": "Dave O’Reilly",
"text": "Well, I think we’re going to report on the appraisal in March, but I think you can infer that we’re on the right track and we’ll give you a lot more detail in March."
},
{
"speaker": "Mark Gilman",
"text": "Okay, just one final clarification Dave, regarding the 80% organic reserve replacement in ’08, does that include the reserves associated with the concession extension at the NZ? Dave O’Reilly Yes. And you’ll see more detail in the K."
},
{
"speaker": "Mark Gilman",
"text": "Thank you."
},
{
"speaker": "Dave O’Reilly",
"text": "You’re welcome."
},
{
"speaker": "Operator",
"text": "Our next question is from Erik Mielke from Merrill Lynch. Your question."
},
{
"speaker": "Erik Mielke",
"text": "I’m sorry fellows for another question, I just thought I’d ask for an update on (inaudible) and you’ve been running through the other key projects. In your CapEx statement, you said you had an initial payment but the bonus payment also has some initial development. If you could, give us some guidance on where you expect to take that in 2009."
},
{
"speaker": "Dave O’Reilly",
"text": "Well, yes, thanks Erik. We are progressing with the construction work in (inaudible). So it’s actively moving forward and the appropriate capital is included in our program. You view that as another long-term project that will benefit the company for many decades to come. So yes, that one is on track compared to what we told you last year. And again, we’ll be updating you in the March meeting, but thank you for the question."
},
{
"speaker": "Erik Mielke",
"text": "Was it part of your reserve bookings for ’08?"
},
{
"speaker": "Dave O’Reilly",
"text": "You’ll see the details in the K. I can’t answer that right now."
},
{
"speaker": "Erik Mielke",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our final question is from Mark Gilman from Benchmark. Your question please."
},
{
"speaker": "Mark Gilman",
"text": "Guys, the exploration/spend component, the 2009 capital budget versus 2008, give me an idea of what it is."
},
{
"speaker": "Jim Aleveras",
"text": "It’s about flat between 2009 and 2008."
},
{
"speaker": "Mark Gilman",
"text": "Level, Jim?"
},
{
"speaker": "Jim Aleveras",
"text": "Pretty much so, yes Mark."
},
{
"speaker": "Dave O’Reilly",
"text": "A little bit more appraisal in balance between appraisals versus pure exploration, but we’re going to go through a very detailed review of our exploration program and our plans for ’09 very specifically in the analyst meeting."
},
{
"speaker": "Mark Gilman",
"text": "Okay, thanks folks."
},
{
"speaker": "Dave O’Reilly",
"text": "You’re very welcome. I think it’s time to wind it up Matt unless there are other questions."
},
{
"speaker": "Operator",
"text": "At this time I show no further questions."
},
{
"speaker": "Dave O’Reilly",
"text": "Well, thank you very much for listening. We appreciate everyone’s participation in the call. I want to thank you for your questions this morning and look forward to seeing many of you in March in New York. So, Matt, thank you."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes Chevron’s fourth quarter 2008 earnings conference call. Thank you for your participation. (Operator Instructions) Good day."
}
] | null | null |
CVX | 3 | 2,008 | 2008-10-31 10:00:00 | Operator: Good Morning. My name is Matt and I will be your conference facilitator today. Welcome to Chevron's third quarter 2008 Earnings Call. (Operator Instructions) I will now turn the conference over to the Vice President and Chief Financial Officer of Chevron Corporation, Mr. Steve Crowe. Please go ahead, sir.
Steve Crowe: Thanks, Matt. Welcome to Chevron's third quarter earning conference call and webcast. On the call with me today are George Kirkland, Executive Vice President, Global Upstream & Gas; and Jim Aleveras, General Manager, Investor Relations. Our focus today is on Chevron’s financial and operating results for the third quarter of 2008. We’ll refer to the slides that are available on the web. Before we get started, please be reminded that this presentation contains estimates, projections, and other forward-looking statements. We ask that you review the cautionary statement on Slide 2. I’ll begin with Slide 3, which provides an overview of our financial performance. The company’s third quarter earnings were a record $7.9 billion, or $3.85 per diluted share. Our third quarter 2008 results were more than double our third quarter 2007 earnings. Higher crude oil and natural gas prices contributed to our upstream performance. Our downstream operations benefited from improved margins, strong refinement utilization, and from timing effects related to the substantial drop in the price of oil during the third quarter. Third quarter 2008 earnings rose over 30% compared with the second quarter 2008, which Jim will discuss shortly. To recap the balance of slide 3: Return on capital employed for the trailing 12 months was 27%. Capital and exploratory spending was $5.5 billion for quarter. Stock buybacks were $2 billion during the period. Underscoring Chevron’s financial strength the debt ratio was below 8% at the end of the quarter and cash balances exceeded debt by $4 billion. Jim will now take us through the quarterly comparisons. Jim?
Jim Aleveras: Thanks, Steve. My remarks compare the results of the third quarter 2008 with the second quarter 2008. As a reminder, our earnings release compared third quarter 2008 with the same quarter a year ago. Turning to slide 4, third quarter net income was $1.9 billion higher than the second quarter. Starting with the left side of the chart, lower crude oil and natural gas realizations and lower volumes reduced worldwide upstream results by more than $1 billion. At the same time, the significant decrease in crude oil prices during the quarter benefited the downstream segments, which improved nearly $2.6 billion in the second quarter’s loss position. The variance in the residual other bar largely reflects the absence of charges at the corporate level that were taken in the prior quarter. Slide 5 summarizes the results of our U.S. upstream operations, which were essentially unchanged between quarters. Lower crude oil and natural gas realizations reduced earnings by $130 million. Chevron’s average U.S. crude oil realization was down $1.75 per barrel between consecutive quarters. This was less than the roughly $5.50 per barrel decline in WTI spot prices between quarters since much of our Gulf of Mexico crude oil production is priced on a lagged basis. Production volumes were down 8% between quarters, primarily due to hurricane related shut-ins during September, these reduced earnings by $195 million. Additionally, as we mentioned in the interim update, expenses related to the hurricanes reduced earnings by roughly $400 million. These included incremental cost to abandon toppled platforms, asset write-offs and initial repairs. George will discuss our hurricane recovery efforts in more detail in a few minutes. Asset sales added about $350 million to third quarter profits. These included a non-operated interest and a K2 property along with other smaller property sales. The other bar on this chart is the net of everything else. The largest single item was higher earnings in our natural gas marketing division including gains and derivatives related to gas contracts. The magnitude of these gains was directly related to the drop in natural gas prices during the quarter. Turning to slide 6, international up stream earnings for the third quarter fell about $1.1 billion from the second quarter's results. Lower oil and natural gas prices reduced earnings by $250 million. Our average unit realizations for liquids fell about $7.70 per barrel between sequential quarters. Roughly, $1.50 per barrel more than the average brand spot price decline. Lower liftings had a $635 million adverse impact on the third quarter earrings. The largest reduction was in Kazakhstan reflecting lower production, which I'll cover in the next slide. Liftings were also lower in Azerbaijan, Angola, Congo, and China. Overall, third quarter liftings were about 2% less than production, while we were slightly over lifted in the second quarter. Through the nine months liftings in production were roughly in balance. More than half of the adverse change in the DD&A and OpEx bar on the chart reflected impairments of several matured fields in the North Sea. Operating expense was higher due to labor and transportation costs and start up costs of our Agbami project. The bar is the net of the foreign exchange effects partly offset by the absence of favorable prior quarter tax items and numerous unrelated matters. Slide 7 summarizes the quarterly change in worldwide oil equivalent production, including volumes produced from oil sands in Canada. Production fell by 94,000 barrels per day or nearly 4% between periods. U.S. production declined 55,000 barrels per day chiefly as a result of shut-ins during September for hurricanes Gustav and Ike. Outside the US, overall production dropped 39,000 barrels per day in the third quarter. In Kazakhstan most of the 55,000 barrel per day reduction reflected completion of TCO's second generation plant and concurrent annual facility maintenance. These had a larger impact than we had expected at the time of last quarter's call. Lower production at Karachaganak was also a factor. The increase in Nigerian volumes was due to the start up of our Agbami project in late July. George will provide the outlook for production in the fourth quarter and full year 2008 shortly. Turning to slide 8, U.S. downstream operations moved from a $680 million loss in the second quarter to a $1 billion profit in the third quarter. Industry margins reduced earnings by $180 million. Chevron’s actual margin capture and higher volumes in the third quarter increased earnings by $100 million and partly offset the decline in industry indicator margins. Due to significantly less planned refinery downtime in the third quarter, earnings improved by $380 million. Chevron’s U.S. refineries operated with minimal downtime. Given the extraordinary volatility of crude oil and refined product prices, and their impact on our downstream earnings, we've highlighted timing effects during the last few quarterly calls. [West Texas] immediate prices fell more than $39 per barrel from the end of the second quarter to the end of the third quarter. This compares to an increase of over $38 per barrel during the previous quarter. The unprecedented swing in prices during each period resulted in an earnings changes of $1.3 billion between sequential quarters. Of this $1.3 billion favorable variance shown in the bar about $700 million reflected the impact of provisionally priced foreign crudes, which lowered second quarter earnings on an absolute basis by $340 million, and increased third quarter earnings by $360 million. About $200 million of the $1.3 billion total was the swing from losses to gains in mark-to-market derivatives related to a long-term fixed price crude purchase contract. Over $120 million of the $1.3 billion reflected the absence of second quarter derivative losses related to converting crudes from the acquisition price to the price at the time we were on. We discontinued most of our derivative use for crude price conversion in the U.S. in early June. The balance of the timing effects primarily resulted from a favorable change in derivative impacts related to the sales of refine products and from gains due to the timing of aviation fuel pricing and all other supply related timing effects. We have revised our primary long haul crude supply agreement for our West Coast refineries. Beginning with October liftings all barrels will be priced at the average price during the month of lifting rather than at the time of discharge. This change will eliminate provisional pricing on these crudes and we expected to significantly reduce the timing effects in our U.S. downstream earnings. However, fourth quarter earnings will include the impacts of final pricing adjustments for October and November deliveries that were lifted during the third quarter. Returning to the chart, the other bar is largely due to better lubricant margins and the absence of pipeline impairments, I mentioned last quarter. Turning to slide 9, international downstream earnings improved to $817 million in the second quarter's loss. Margins were a minor favorable item, as improved marketing margins overcame weaker refining margins. Volumes benefited slightly following completion of repairs at our Pembroke Refinery in the U.K. As in the U.S., international downstream timing effects were major factor in the favorable change between quarters, as the price of crude and petroleum products fell significantly. Of the $860 million favorable timing effects shown in the bar, more than half was related to derivative gains on sales of long-haul equity crude and refined products, such as, partitioned neutral zone crude and Pembroke product exports. As I mentioned last quarter, we often use derivatives to lock in a margin above the cost of transportation, which can result in gains when prices decrease and vice versa. More than $100 million of the 860 million total shown in the bar reflected gains in the third quarter as compared to losses in the second quarter and derivatives used to convert crude pricing to the time of refinery run. The balance of the timing effects is primarily due to favorable inventory impacts, gains due to the timing of aviation fuel pricing, and all other supply-related timing effects. Going forward, we're taking actions as appropriate, to reduce the volatility of this segment, the price fluctuations. The other bar on the slide shows a $51 million adverse variance between quarters. This is the net of foreign exchange gains, offset by operating cost and tax items. Slide 10 shows that earnings from chemical operations were $70 million in the third quarter compared to $41 million in the second quarter. Results for olefins improved on higher margins along with lower operating expense. Aromatics results fell somewhat, due to startup costs, for the Jubail Chevron Phillips Styrene operation. The other bar reflects lower additive earnings. Slide 11 covers all other. Third quarter results were net charges of $190 million compared to net charges of $580 million in the second quarter. $190 million of the swing reflects lower environmental charges, and $110 million stems from a favorable variance in tax items. The other bar on slide 11 includes the net of many unrelated items which were favorable variants between sequential quarters. In total, the third quarter net charge was less than our standard guidance of $250 million to $300 million. For the various reasons stated in the interim update. Before turning it over to George, I'd just like to briefly recap the third quarter. Upstream earnings and volumes were down somewhat inline with the interim update. We experienced a strong improvement in downstream performance, due to timing effects rising from sharper declining crude and product prices and less refinery downtime also as outlined in the interim update. Fine line, as projected chemical results benefited from higher margins. George Kirkland is now going to provide an update on our production outlook for 2008, our hurricane recovery plans, and our upstream projects status through 2009. George?
George Kirkland: Thanks, Jim. Before I update you on the major capital projects, I'd like to review our production. Please turn to slide 13. This graph compares net OEG production through the first nine months of 2008; first is the first nine months of last year. Total OEG production through the third quarter was 2.53 million barrels per day. Although production is down 95,000 barrels per day about 80,000 barrels per day of this loss is attributable to price effects on the net entitlement barrels and 17,000 barrels a day is attributable to the disruptions from hurricanes Gustav and Ike in the Gulf of Mexico. I’ll discuss the hurricane impacts in just a few moments. Despite these losses, we have been very successful in managing our base business declines and capturing gains for major capital projects that have recently come online. The low base business decline is a positive indicator of our base business efforts, where we have experienced improved reliability across the enterprise. Adjusting for favorable gas market conditions in the Asia-Pacific region, and the Indonesian unitization settlement, our base business decline rate is approaching the low end of our 4% to 5% decline guidance. Now, I'll update you on the production outlook for the remainder of the year. Please turn to slide 14. Assuming fourth quarter prices will average approximately $70 a barrel, and thereby, approximately $100 a barrel for the whole year. Our 2008 production outlook is estimated at 2.55 million barrels of oil equivalent per day. This graph compares the 2008 outlook to year-to-date third quarter actuals, and our fourth quarter production outlook. The last bar on the right shows the 2008 guidance provided last January. Absent the yearly price effects of about 60,000 barrels per day and hurricane disruptions, which we estimate to be about 35,000 barrels per day, the full year net production would be in line with the prior guidance. The fourth quarter production forecast is estimated at 2.62 million barrels per day, significantly higher than year-to-date actuals. This is driven by two factors; the continued ramp up of our major capital projects, principally, Agbami and the Tengiz expansion and lower prices. Project ramp ups are estimated to add approximately 170,000 barrels per day during the quarter. The impact of lower prices on net entitlement barrels, associated with production sharing contracts will likely increase production by about 45,000 barrels per day during the quarter. Offsetting these gains are hurricane disruptions, which are estimated at 65,000 barrels per day for the quarter and the continued base business declines which includes ongoing operational difficulties in Azerbaijan. I would like to now spend a few moments to provide additional details on the hurricanes. Please turn to slide 15. This slide shows the trajectory of hurricanes Gustav and Ike with respect to Chevron leases in the Gulf of Mexico. The leases are shown in yellow. The wind field for hurricane Gustav is shown in red and for hurricane Ike in green. We are pleased to report that there were zero safety incidence associated with the evacuation of personnel from our offshore facilities. 3500 personnel were safely evacuated for Gustav and 1500 for Ike. We did sustain damage from the storms. Overall, there were 13 toppled structures, four leaning structures and three missing well heads. The long term impact of this damage on production is not great. It is estimated that between 6,000 to 10,000 barrels a day will be permanently lost. In the deepwater areas there were some minor damages sustained at Petronius and Genesis where production is now being restored. There was no damage to the Blind Faith facility and only minor damage to Tahiti. I'd now like to share an update on the current restoration effort and forecast, if you would please turn to slide 16. This chart shows the anticipated net OEG production restoration profile by month. The actual restored production to date is shown on the solid blue line and the outlook is in the dash line. Pre-Gustav production from the Gulf of Mexico averaged about 190,000 barrels of oil equivalent per day. As of this week, total restored production is 55% of pre-storm levels. Of the remaining production to be restored, about three quarters is dependent on the timing of third party pipeline repairs. Let me assure you that we have a dedicated team of professionals actively working with our partners and stakeholders to keep our restoration efforts on track. I'd like now to provide an update on our major capital projects. Please turn to slide 17. Chevron has reached some critical major capital project milestones in 2008. So far this year six projects have started up. It is also anticipated that another two will start up in the fourth quarter, North Duri Area 12 in Indonesia and Blind Faith in the Gulf of Mexico. On July 29, our Nigerian affiliate commenced crude oil production from the Agbami field, this is a significant accomplishment. Agbami initial gross oil equivalent production has ramped up to more than 110,000 barrels per day. We anticipate the ramp up to continue reaching 250,000 barrels per day by the end of 2009. Well, September 22, our Tengizchevroil affiliate completed a major expansion at the Tengiz field in Kazakhstan that has nearly doubled production capacity to 540,000 barrels per day. Remember that the first phase of this expansion started up during the fourth quarter of 2007. All phases are now complete and commissioned. In Western Australia on the September 1, the fifth Train at the North West Shelf’s Venture liquefied natural gas facility became operational. This production facility is expected to increase the joint venture’s export capacity by about four million metric tons of LNG annually to 16.3 million metric tons. During the second quarter, in conjunction with our joint venture partners, first oil was achieved from the Moho-Bilondo field in the Republic of Congo. Please turn to slide 18. Other projects that have achieved first production during the first three quarters of 2008 are ACG Phase III in Azerbaijan and Brodgar-Callanish in United Kingdom. I’ll now touch on the remaining project startups for 2008. In the Gulf of Mexico, the last stages of commissioning are taking place at the Blind Faith facility, and first oil is anticipated in November. There was no damage to the facility during Hurricane Ike, but it did disrupt commissioning activities. In Indonesia, the next phase development at the heavy oil Duri field remains on schedule; it is also expected to start up in November. Now, let’s turn to slide 19. Looking forward to 2009, I’d like to provide you with a status on the major capital project milestones that are anticipated next year. Let’s start in the Gulf of Mexico deepwater with our Tahiti project. The project is progressing on schedule. The spar hole was installed during the first quarter and the topside modules during the third quarter of this year. The facility sustained minor damage during hurricane Ike and will be repaired during ongoing hookup and commissioning activities. However, this will not delay the projects and we still anticipate first oil by the third quarter of 2009. In Brazil, at the Frade field construction of the FPSO is 85% complete with a sail-away from Dubai expected in late December. First oil is expected during the second quarter of 2009. In Angola, the Tombua Landana project remains on schedule, to meet first oil during the second half of 2009. The hurricanes in the Gulf of Mexico, did not significantly impact the schedule for sail-away of the various compliant pile tower components. The Large Scale Steam Pilot in the Partitioned Neutral Zone also remains on schedule. If this pilot is successful, it will lead to a full-field development at Wafra. First steam injection is expected during early 2009. Finally, I would like to provide a summary of other key 2008 upstream highlights. Please turn to slide 20. For September 10, we announced the extension and amendment of the Partitioned Neutral Zone operating agreement with the Kingdom of Saudi Arabia. This agreement extends the existing arrangement for 30 years through 2039. In Canada, at the Hebron field, formal binding agreements were signed in August between Hebron project proponents and the government of Newfoundland and Labrador. These agreements paved the way for the project to proceed. During the third quarter, Chevron transferred operatorship to ExxonMobil following ratification by co-venture partners. In Australia, our LNG projects are progressing toward key milestones. At Gorgon, the joint venture is pursuing a project scope of 3-5 million metric tons per annum LNG trains. A final investment decision is expected after environmental approvals have been provided by the State and Commonwealth for the third train proposal and following the completion of engineering and design. Wheatstone, which represents a tremendous growth opportunity for Chevron Australia is progressing towards FEED. It builds on our extensive natural gas resources in Western Australia and is expected to make our company a leading natural gas supplier and operator of LNG facilities in the Asia-Pacific region. We announced our attention during the first quarter to develop Wheatstone as a grain field onshore LNG and domestic gas project. And finally at Chuandongbei, we expect the initial FID by the end of this year. The appropriate engineering and design work required to sanction the project work. The project is on track. We assumed operational control of the existing operations in August. This concludes the project update and now I will turn it back over to Steve.
Steve J. Crowe: Thank you, George. That concludes our prepared remarks. We will now take your questions; one question and one follow-up per caller, please. Matt, open the lines for questions. Thanks.
Operator: Thank you, sir. (Operator Instructions). Our first question is from Mark Flannery from Credit Suisse. Your question please?
Mark Flannery: Thanks. Yes, just a question for George, while coming into budgeting season, things are looking very different on the commodity side. Nobody really knows what’s going to happen in 2009 of course, but given what’s happened to oil prices. Could you tell me what you’re thinking about when you think about the ’09 CapEx budgets for the upstream, particularly with regards to the more capital intensive end of the spectrum? I’m not looking for a number, because I know we won’t get one, but just what’s your thought process around that right now?
George Kirkland: Let’s just first start off that we haven’t finished our budgeting process we’re going through the approval process, we’ve been working through that. Our thought processes on any project that has already moved into construction of past FID, those projects will move very much through their cycle would never slow those down. And we anticipate trying to hold our capital spending pretty much in line of where we’ve been this year. We don’t like fluctuating our capital spend up and down. Our long-term view on pricing has not changed. So I would look at this point at capital spending very similar between years and recognize if we have something different, we want to change. We have flexibility on near-term projects not our long-term projects. We really can’t back-off for long-term projects.
Steve Crowe: Mark, let me just expand a little bit on just the mechanics that George alluded to. We're right in the middle now of finalizing our business plans and the capital spending for 2009, and per our normal practice it would be our intention to have a release and provide the 2009 capital program sometime around the middle of December. So, about six weeks from now, I think, would be the approximate time you'll hear our final program for next year. Do you have a follow-up question?
Mark Flannery: I do and it's on the same topic. I wondered, George, could you characterize the capital expenditure program that you have or you are putting together for 2009. How much of that would you describe as fully discretionary i.e. not part of projects that have gone through FID, not part of projects about to meet FID, that kind of thing. What's the wiggle room would you think in the budget?
George Kirkland: Just an estimate without numbers in front of me and recognizing that probably 75%, 80% of our project expenditures are related to projects that are post FID, so, those are pretty far along at this point. So there is not a lot of wiggle room in the first year. Our wiggle room in capital spending is much greater in the second year of our budget cycle, and of course, very large amount in our third year of our budget cycle.
Mark Flannery: That's very helpful. Thank you very much.
Steve Crowe: Thanks, Mark. May we have the next questioner please?
Operator: Our next question is from Paul Cheng of Barclays Capital. Your question please?
Paul Cheng: Hi, gentlemen.
George Kirkland: Hi.
Steve Crowe: Hi, Paul.
Paul Cheng: My question is related to the CapEx. I know you are not going to talk on numbers, so I am not asking that. But, George when you are looking at with potentiality, oil surfaces cost and the raw material cost [next year] everything are coming down. Is that a trade-off, there is certain project, if you delay it even if they are already FID delayed, you may be able to get a much lower cost structure. So, want to see that, I mean, how you view on that?
George Kirkland: Well, there is no doubt for projects that have not reached FID where you don't have contracts with and what we are expecting is we are expecting that the cost of goods and services are going to come down. So, we would I think look very strongly at slight movements on projects that made sense. From the cost of building them, if it's going to come down we would look at sliding those a little bit. I actually see this as a real opportunity for companies like Chevron. I do expect the cost of goods and services to come down. I think the financing is going to hurt others to move projects forward. So my expectation is shipyards and equipment manufacturers, there'll be less pressure on them than there has been. So, I think, there is going to some benefit for some of our future big projects with cost reductions.
Steve Crowe: Paul, do you have a follow up question?
Paul Cheng: Yes, if I could. Yes, actually, somewhat unrelated Tengizchevroil now you said 540,000 barrel per a day. I think there is a long time objective, when they get to a 700,000 barrel per day plus. I want to see if George has any update on where we are in that process?
George Kirkland: Well let me deal with the expansion. Our expansion, the name plate on it was 540. We've reached that and we don't yet know if we can get a few more barrels out of it, but my expectation is we are probably going to be able to get a few more barrels, and maybe by our March meeting with the analysts that we'll have a little more word on that to see if we’ve been able to increase the capacity further. I believe, I mentioned that our Analyst Meeting earlier in March this year that we were looking at the next expansion for Tengiz. We’d like to move that engineering work forward as fast as we can. We’ve learned an awful lot about what we can do on big, big projects in the Kazakhstan area of where we operate Tengiz. So, it's a good time to be ready to move forward with the next expansion, and I know a little more information about the performance, of course, on the gas injection as the year plays on out. So, I think, all of those things line up for us to want to move the next expansion forward, of course, we have to get all of our partners on board with that.
Paul Cheng: George, can I put in a quick question in here? For 10-Q with the [SEC], you guys will be able to put more reserve this year?
George Kirkland: I think it's a little premature to talk about reserves; we’re just in the process of going through our reserve reviews around the world, and I’d really rather wait to talk about reserve bookings preferably actually to the March meeting, when by that time we’ve done all our work.
Steve Crowe: Thanks, Paul. And I would just add that the current SEC rules are still in place, although they’ve come out with a proposal for modification of the definition, but it’s still using prices at a point in time at the end of 2008. And as George mentioned, we may have some preliminary numbers that we can share with you in terms of reserves in the January call, but we don't really finalize all of our work until February and have it available then for the 10-K and then further discussion at the March '09 Analyst Meeting.
Paul Cheng: Thank you.
Steve Crowe: Thanks, Paul. May we have the next questioner please?
Operator: Your next question is from Neil McMahon from Sanford Bernstein. Your question please?
Neil McMahon: Hi, I've got questions related to your project timing. Just moving on to some of your previous answers, George, you mentioned that Gorgon, you're not planning 3 million - 5 million ton trains and one presumes since it hasn't gone to FID, yet. But there is scope to discuss materials costs and contractor costs. Do you have any rough idea, what timing you would expect Gorgon to come on and at? And if the current credit markets or falling prices for products and services may delay that a little bit?
George Kirkland: I think may be in a earlier question, I was trying to foreshadow that I actually see a potential advantage for big LNG projects that have not reached FID. The cost reduction of goods and services is really I think, very, very good news for those kind of projects, so, very positive from that point of view. Our long-term view of prices of oil and gas, have not changed, which is how we always looked at our economics. So in some ways with cost of goods and services, I think potentially coming down, it's a benefit to those large projects. And once again it reinforces this financial crisis, reinforces the advantages that companies like Chevron have, we have very, very strong balance sheets and are not, I think, held hostage or to getting loans to do our projects. So, from that perspective, I think, it may actually be a benefit for us in some of our very, very large projects.
Steve Crowe: I'll just add. We have the advantage of having a very strong balance sheet and we got to this point because we look a long-term view of the commodity price cycle, strengthened our balance sheet when commodity prices were rising, so as to whether a downturn or advantage ourselves of opportunities. We also have the other aspect that George mentioned, and that is, we have a great project queue. So, tremendous strength, but also tremendous opportunities. Neil, do you have a follow-up?
Neil McMahon: Yes, Steve and I appreciate all of that, and that's good to hear. It was really, again on Gorgan, just a rough timing on when that project would be coming on, I am presuming the second half of the next decade? And then, as we are talking about projects, maybe George could give an update on Jack and St. Malo, as well?
George Kirkland: Let me deal with Gorgan saying our target is FID in the second half of 2009. So, sometime mid-year or little bit after we would like to be the FID. I would then like to come out as we approach FID and then give a definitive date. I don't think it's quite as long as what you mentioned, I'd pull it back a little bit from there. But, I would much rather talk about that in detail once we get closer to the FID point. Okay, and then on Jack and St. Malo. We still have appraisal wells to complete on both Jack and St. Malo and until we get those appraisal wells drilled and evaluated, we really can't comment on further timing. I would anticipate that we would be able to make pretty strong views on timing for Jack and St. Malo, between the analyst call in late January to the time we get together in March; somewhere in that timeframe, we should have a pretty good idea of our path forward.
Neil McMahon: Right, thanks.
George Kirkland: Thanks, Neil. May we have the next questioner, please?
Operator: The next question is from Paul Sankey of Deutsche Bank. Your question please?
Paul Sankey: Hi, guys. Just one on upstream, and one on finance, if I could, I’ll slip in a few thoughts to it. Firstly, George you mentioned 2650 would be your production level for 2008 at $70 oil. Could you indicate what level you would expect for 2009, given the impressive list of projects you’ve listed? Secondly, the decline rate towards 4% is what you said. Would that be sensitive to the oil price being lower in terms of how hard you defend that number? And finally, on the upstream side, if you could talk about exploration and any highlights that you’ve got coming up over the coming year? Thanks.
George Kirkland: It’s a long list there. Let me…
Paul Sankey: That was one question, George.
George Kirkland: Very well strung together. The 2009 production number, I’m much preferred to talk about that at the January or have Steve or others talk about it at the January meeting. And I hope everyone recognize that there’s an awful lot of moving parts going on right now. Hurricane restoration has potential significant swings, and as I mentioned in my comments today, three-quarters of the remaining barrels that we have off there are not dependent on what we do; they’re dependent on third-party pipelines. So we have that concern. We have all these projects coming on, and including Tahiti and the timing of all these big projects when they come on, one quarter, one month, all of these make a significant difference. A lot of these points will be nailed down by the end of the year. We are going to know an awful lot about where we are on hurricanes, we're going to know ramp up on Agbami to a much better extent. Blind Faith was going to be owned by then, so we'll have some performance data on it and we'll have a pretty good idea of exact timing of Tahiti, which is a bunch of big barrels for us, so another project where we have high working interest. So from that perspective, we typically give our guidance for 2000 or that year in the January meeting. So we're going to hold with that and we'll give that guidance at the next quarter's call.
Steve Crowe: I'd just add on top of George's comments for all the reasons that he cited. As we've done year, when we give the guidance for 2009, net of O&G production, we'll ping it off a specific crude price recognized in the workings of various contract agreements overseas can affect net production. I think you had another question on…
Paul Sankey: Yes, sorry. You mentioned that you implied that it was close to 4% decline rate based on higher activity levels in defending the base. I just wondered if with the lower oil that’s going to be still defendable, I guess it's really a follow-up to the CapEx question in some ways.
George Kirkland: Well, we've tried to take the price effects out our decline rate analysis and give you numbers that really don’t reflect the price itself. We try to pull the price effects out of there to the best we can.
Paul Sankey: No, I'm thinking more about activity levels, George? You know are you going to do less, because fuel price is lower?
George Kirkland: Once again you got to remember, a lot of contracts for rigs you're already set for a year and six months. So there is limited change that you are going to make in a short-term program. And I would tell you, typically, the very strongest returned projects, when you look at rate of returns on your investment tend to be those projects that are off of current infrastructure and tie-ins, so those development wells and workovers tend to have the very, very best economics. I would tell you that we will make decisions during the year for certain contracts as they are coming up if it looks to be advantageous for us to decide to go out to the market and bid for a rig in lieu of doing a contract extension we will do that to make sure we attract the best prices to do our work. So we will make some choices like that, very tactical choices during the year. I can't at this point in time speculate how that will play out, it could have some minor effect on our base decline. But it is just way too early to speculate.
Steve Crowe: George, the third part of…
Paul Sankey: Third part of one…
Steve Crowe: Third part of the first question (inaudible)…
George Kirkland: Our exploration focus is still very much, in those focus areas I've talked about, we have been drilling wells in Australia, we haven’t made any announcements, but we have been doing quite a bit of work in Australia. And I expect we will cover that later through some announcements. We are just starting several wells in the lower tertiary, in the deepwater Gulf of Mexico, it's too early to make anything of a report expect the wells have been spuded. And we’re continuing to drill some expiration wells in the focus area of West Africa, but I don’t really have any specific updates beyond that. We’ll give a very broad update and I’d say detailed update once again in our analyst meeting in March.
Paul Sankey: But the development here, it feels like a quiet year for expiration.
George Kirkland: Our exploration program, I will tell you, we try to keep it very consistent. We try not to yo-yo it up and down, that’s my expectation again for next year. We always like to drill anywhere from 15 to 20 high impact wells around the world and then of course our large number of appraisal wells and delineation wells. So my expectation would be a program similar to what we’ve done in the last few years. Once again, we don’t like to yo-yo them up and down. We’ve got rig contracts, we plan for the long-term and we try to maintain even this in those programs.
Steve Crowe: Paul, you had one more question.
Paul Sankey: Yes, very quickly, one for you Steve, and that would be pension, anything to say about pension funding and the outlook there. Thanks, so I’ll leave it there. Thank you.
Steve Crowe: Thanks, Paul. Certainly the market value of our Pension Trust Fund obviously has gone down with the market in the last several months. We don’t have any required funding requirements under the PPA or [RISSA]. As you may recall, particularly earlier in this decade, we have an approach towards funding that we call opportunistic funding. When we have sufficient cash or cash flows and can assure ourselves of tax deductibility and making a contribution. I guess, I would say at this juncture the disclosures that Chevron’s made in its 10-K and 10-Q still pertain, including our ongoing economic review to fund more than we have there, indicated in our SEC filings. So keeping in mind that the PBO obligation under PPA discount rules results in higher discount rates. The magnitude of the funding is better than you might think just looking at the reduction in the asset values. So I guess, I’d take you back to our disclosures that we have made in earlier 10-Qs and the one that you will see in our 10-Q next week. May we have the next questioner please?
Operator: The next question is from Michael LaMotte of JPMorgan. Your question please?
Michael LaMotte: Thanks. Good Morning, guys. I’d like to follow-up on this base decline number George, if I could quickly. In slide 13, 55,000 barrel a day number implies a 2.1% rate, at the analyst meeting in March, the same slide showing ’07 versus ’06 was about 1% decline. And I know a 1.6%, I guess. In your remarks you mentioned operating challenges in Azerbaijan is one of the reasons for the base decline. The question I am asking is, is it all Azerbaijan? Are there issues related to that, that explain that whole delta and can 2% hold?
George Kirkland: I keep going back and we track this base business very closely, because we have good success, it has been lower for now, I think probably 4-5 quarters less than the 4% to 5%. I would tell everybody, remember those barrels are in the bank, moved our production up and held our production. So that’s a real positive, but I tried to also give a little color on this 55 that there were other things going on in there, that benefited our base and reduced that decline. One of those was a unitization agreement in Indonesia that we highlighted in an earlier call; I believe that was a first quarter call.
Steve Crowe: It was first quarter.
George Kirkland: First quarter call and that had an impact, and we've also had better marketing results, gas sales in the Asia-Pacific region that in effect has raised the amount of base production we've had there. So, it's not really a fair comparison on base decline without taking that into effect, and when you add those pieces back, it gets back to the low end of this. It gets back in the 4% range, approximately. So, we feel good for planning purposes. We're going to continue to hold this 4% to 5% as kind of our planning model. But then, when we look at our actuals and the processes we put in place, we're hopeful that we're going to continue to see, that we're able to do a little bit better than that. So, we're going to look back at performance and we're going to plan forward, at least for some period of time, still in this 4% to 5% range.
Steve Crowe: Mike, do you have a follow-up?
Michael LaMotte: I do. Thank you for that color, George. If you wouldn't mind expanding a bit on the impairment to North Sea assets, as well?
Steve Crowe: Jim, do you want to feel that one?
Jim Aleveras: Yes. We had impairment of number of very small fields in the Dutch North Sea, as well as the U.K. North Sea, these are mature fields, and they are very small partially, in terms of production. So, those are not tremendously material to us.
Steve Crowe: They were all reaching the end of their productive lives. So, we took the asset values down.
Michael LaMotte: Okay. Very good. Thank you.
Steve Crowe: You bet. May we have our next questioner, please?
Operator: Your next question is from Erik Mielke from Merrill Lynch. Your question please?
Erik Mielke: Good morning, gentlemen. I have two questions, the first one for George, and the second one for Steve, probably. Firstly, on the partition neutral zone in Saudi, and I understand that you are not willing to get into a huge reserve discussion at this point. But can you clarify whether the extension of the contract would automatically lead to additional reserves being bookable for you?
George Kirkland: Our normal reserve process only allows us to book reserves through the existing contract life; the contract life without the extension would have been ending in February of 2009, and now it will go to 2039. So, with that extended period, there will be proved reserves that will be booked as a part of that extension.
Erik Mielke: It's very clear. Thanks.
Steve Crowe: And do you have another?
Erik Mielke: Yes. My second question is more on cash management. If I hear you correctly, it sounds like CapEx is something that you intend to keep at current levels, and even if prices were to go let's say $10 lower than where they are today. And for the rest of your cash management, how do you balance between holding cash, accelerating buybacks, or scaling back buybacks, and potentially increasing dividends? And then also, can you clarify where are you going to keep your cash?
George Kirkland: Thanks, Erik. Well, I'll begin on a short-term issue. It's our intention here in the fourth quarter to maintain the share buyback pace at $2 billion in the fourth quarter, just as we've done for the last five quarters. In terms of cash management and balancing, I think first and foremost, we want to make sure we fund the capital program that we feel is such a robust program with a very deep queue. So that's our first and foremost use of operating cash. Secondly, we are mindful of our 21, 22 year record of increasing annual payouts and our dividend, and would fully want to maintain that progress overtime. Thirdly, as I had alluded before, we do want to maintain a strong balance sheet through the commodity price cycle and I think we're in enviable position, right now, as having one of the strongest balance sheets in the industry. As to share buybacks, we take all of the other considerations into account and make a determination as to whether or not there is enough of a cash flywheel to fund further buybacks. We take a look at economic conditions, market conditions going forward and would plan on giving guidance to the investment community, just as we're doing now at the call each quarter, for at least, one quarter, ahead. But as for right now, we're coming off two quarters of consecutive record earnings, a very, very strong balance sheet, strong cash flows, more cash than debt and we see another $2 billion here in the buybacks, in the fourth quarter. Can we have the next question, please?
Operator: Our next question is from Peter McNally from Galleon. Your question please?
Peter McNally: My question has been answered. Thank you.
Steve Crowe: Thanks, Peter. Can we have the next questioner please?
Operator: Our next question is from Mark Gilman from Benchmark. Your question please?
Mark Gilman: Guys, good morning, good afternoon. George, I am wondering if you could tell me associated with the new concession of the partition neutral zone, did you benefit or would you benefit from any change in fiscal terms, should you decide to proceed with the full field steam flood there?
George Kirkland: Mark, first off, it's an extension of the existing contract there and at this point in time, I will not discuss the terms of a future full field steam development. I would rather hold that off until we get closure to that decision point.
Mark Gilman: Okay. Let me turn to my follow-up. I believe you received approval to proceed with them across a straight development project or with respect to some of the resources that [UNICCO] had identified years ago. I am curious as to whether that gas is to go to Bontang or to be dedicated to the domestic market and is there an agreement to allow for [protomania] to participate as an equity partner.
George Kirkland: Mark, that agreement to develop and the plan of development there has not been fully approved. So, we don't have all the approvals yet on that. So, at this point, I really can't talk about it because we don't have all the approvals. It has been reported in the press a couple of times but all the pieces have not been put together, so it has not been reported correctly.
Mark Gilman: Okay. Since I got two strikes, let me try one more quickly. George with respect to the production sharing contract impacts that you'd cited in several of your slides. Can you segment that between those losses that would be considered permanent associated with threshold return and/or full capital cost recovery versus those reductions that are associated more with operating cost and continuing capital cost recovery?
George Kirkland: Mark, I can't do that at this time. That's a lot of detail. I will tell you, some of it has been related to triggers, in other words, return triggers that will change the distribution in effect of profit oil. So, we have that. We have some that is royalty pieces, which reach triggers with higher royalty rates. But, first off, I don't think we ever would try to share that kind of detail, that's an awful lot of detail. We'd rather try to give you each year kind of a guideline that kind of matches what we think is going to happen for the year at a price scenario or a price range. This last year, we've been telling you it's been about $2 for every dollar a barrel impact on price, it's about 2000 barrels per day change and that's kind of been what it has, we will update that again for the year 2009, which we will be once again looking-forward and look at price impacts and production impacts together.
Steve Crowe: Mark, what we will try to do on the January call then is, when we give our guidance for 2009 production at a specified price. Based on that specified price, we'll try to give the investment community a rule a thumb to use to know how to adjust that if prices are above or below that amount.
Mark Gilman: Okay, guys thanks. I'm taking my back and going back to the dugout.
Steve Crowe: Okay, Mark. May we have the next questioner please?
Operator: Our final question today is from Neil McMahon of Sanford Bernstein. Your question please?
Neil McMahon: Hi. Just not really a follow-up, something a bit different for you, Steve. What was the tax rate difference between the second quarter and the third quarter?
Steve Crowe: Of this year?
Neil McMahon: Of this year, yes.
Steve Crowe: In the third quarter our tax rate was just about 45%. And in the second quarter it was about 49% and below a rate for the third quarter of this year was associated with a greater proportion of income being earned in tax jurisdictions with lower tax rates. But we also have an impact in the second quarter of a reduction in the tax rate in Bangladesh. So, on an ongoing basis, as we have guided in the past, allowing for the different taxing jurisdictions and being an integrative company, our guidance would be to use sort of an average rate of about 45% or in that neighborhood at least.
Neil McMahon: Okay, that’s great. Thank you.
Steve Crowe: Thanks, Neil. Mark or Matt, are there any other questioners in line?
Operator: We have no further question as this time.
Steve Crowe: Okay. Well, thank you, Matt. In closing, let me say that we appreciate everybody’s participation on today’s call. And I especially want to thank each of these analysts on behalf of all the participants for their questions during this morning session. Matt, back to you.
Operator: Ladies and gentlemen, this concludes Chevron’s third quarter 2008 earnings conference call. You may now disconnect. Good day. | [
{
"speaker": "Operator",
"text": "Good Morning. My name is Matt and I will be your conference facilitator today. Welcome to Chevron's third quarter 2008 Earnings Call. (Operator Instructions) I will now turn the conference over to the Vice President and Chief Financial Officer of Chevron Corporation, Mr. Steve Crowe. Please go ahead, sir."
},
{
"speaker": "Steve Crowe",
"text": "Thanks, Matt. Welcome to Chevron's third quarter earning conference call and webcast. On the call with me today are George Kirkland, Executive Vice President, Global Upstream & Gas; and Jim Aleveras, General Manager, Investor Relations. Our focus today is on Chevron’s financial and operating results for the third quarter of 2008. We’ll refer to the slides that are available on the web. Before we get started, please be reminded that this presentation contains estimates, projections, and other forward-looking statements. We ask that you review the cautionary statement on Slide 2. I’ll begin with Slide 3, which provides an overview of our financial performance. The company’s third quarter earnings were a record $7.9 billion, or $3.85 per diluted share. Our third quarter 2008 results were more than double our third quarter 2007 earnings. Higher crude oil and natural gas prices contributed to our upstream performance. Our downstream operations benefited from improved margins, strong refinement utilization, and from timing effects related to the substantial drop in the price of oil during the third quarter. Third quarter 2008 earnings rose over 30% compared with the second quarter 2008, which Jim will discuss shortly. To recap the balance of slide 3: Return on capital employed for the trailing 12 months was 27%. Capital and exploratory spending was $5.5 billion for quarter. Stock buybacks were $2 billion during the period. Underscoring Chevron’s financial strength the debt ratio was below 8% at the end of the quarter and cash balances exceeded debt by $4 billion. Jim will now take us through the quarterly comparisons. Jim?"
},
{
"speaker": "Jim Aleveras",
"text": "Thanks, Steve. My remarks compare the results of the third quarter 2008 with the second quarter 2008. As a reminder, our earnings release compared third quarter 2008 with the same quarter a year ago. Turning to slide 4, third quarter net income was $1.9 billion higher than the second quarter. Starting with the left side of the chart, lower crude oil and natural gas realizations and lower volumes reduced worldwide upstream results by more than $1 billion. At the same time, the significant decrease in crude oil prices during the quarter benefited the downstream segments, which improved nearly $2.6 billion in the second quarter’s loss position. The variance in the residual other bar largely reflects the absence of charges at the corporate level that were taken in the prior quarter. Slide 5 summarizes the results of our U.S. upstream operations, which were essentially unchanged between quarters. Lower crude oil and natural gas realizations reduced earnings by $130 million. Chevron’s average U.S. crude oil realization was down $1.75 per barrel between consecutive quarters. This was less than the roughly $5.50 per barrel decline in WTI spot prices between quarters since much of our Gulf of Mexico crude oil production is priced on a lagged basis. Production volumes were down 8% between quarters, primarily due to hurricane related shut-ins during September, these reduced earnings by $195 million. Additionally, as we mentioned in the interim update, expenses related to the hurricanes reduced earnings by roughly $400 million. These included incremental cost to abandon toppled platforms, asset write-offs and initial repairs. George will discuss our hurricane recovery efforts in more detail in a few minutes. Asset sales added about $350 million to third quarter profits. These included a non-operated interest and a K2 property along with other smaller property sales. The other bar on this chart is the net of everything else. The largest single item was higher earnings in our natural gas marketing division including gains and derivatives related to gas contracts. The magnitude of these gains was directly related to the drop in natural gas prices during the quarter. Turning to slide 6, international up stream earnings for the third quarter fell about $1.1 billion from the second quarter's results. Lower oil and natural gas prices reduced earnings by $250 million. Our average unit realizations for liquids fell about $7.70 per barrel between sequential quarters. Roughly, $1.50 per barrel more than the average brand spot price decline. Lower liftings had a $635 million adverse impact on the third quarter earrings. The largest reduction was in Kazakhstan reflecting lower production, which I'll cover in the next slide. Liftings were also lower in Azerbaijan, Angola, Congo, and China. Overall, third quarter liftings were about 2% less than production, while we were slightly over lifted in the second quarter. Through the nine months liftings in production were roughly in balance. More than half of the adverse change in the DD&A and OpEx bar on the chart reflected impairments of several matured fields in the North Sea. Operating expense was higher due to labor and transportation costs and start up costs of our Agbami project. The bar is the net of the foreign exchange effects partly offset by the absence of favorable prior quarter tax items and numerous unrelated matters. Slide 7 summarizes the quarterly change in worldwide oil equivalent production, including volumes produced from oil sands in Canada. Production fell by 94,000 barrels per day or nearly 4% between periods. U.S. production declined 55,000 barrels per day chiefly as a result of shut-ins during September for hurricanes Gustav and Ike. Outside the US, overall production dropped 39,000 barrels per day in the third quarter. In Kazakhstan most of the 55,000 barrel per day reduction reflected completion of TCO's second generation plant and concurrent annual facility maintenance. These had a larger impact than we had expected at the time of last quarter's call. Lower production at Karachaganak was also a factor. The increase in Nigerian volumes was due to the start up of our Agbami project in late July. George will provide the outlook for production in the fourth quarter and full year 2008 shortly. Turning to slide 8, U.S. downstream operations moved from a $680 million loss in the second quarter to a $1 billion profit in the third quarter. Industry margins reduced earnings by $180 million. Chevron’s actual margin capture and higher volumes in the third quarter increased earnings by $100 million and partly offset the decline in industry indicator margins. Due to significantly less planned refinery downtime in the third quarter, earnings improved by $380 million. Chevron’s U.S. refineries operated with minimal downtime. Given the extraordinary volatility of crude oil and refined product prices, and their impact on our downstream earnings, we've highlighted timing effects during the last few quarterly calls. [West Texas] immediate prices fell more than $39 per barrel from the end of the second quarter to the end of the third quarter. This compares to an increase of over $38 per barrel during the previous quarter. The unprecedented swing in prices during each period resulted in an earnings changes of $1.3 billion between sequential quarters. Of this $1.3 billion favorable variance shown in the bar about $700 million reflected the impact of provisionally priced foreign crudes, which lowered second quarter earnings on an absolute basis by $340 million, and increased third quarter earnings by $360 million. About $200 million of the $1.3 billion total was the swing from losses to gains in mark-to-market derivatives related to a long-term fixed price crude purchase contract. Over $120 million of the $1.3 billion reflected the absence of second quarter derivative losses related to converting crudes from the acquisition price to the price at the time we were on. We discontinued most of our derivative use for crude price conversion in the U.S. in early June. The balance of the timing effects primarily resulted from a favorable change in derivative impacts related to the sales of refine products and from gains due to the timing of aviation fuel pricing and all other supply related timing effects. We have revised our primary long haul crude supply agreement for our West Coast refineries. Beginning with October liftings all barrels will be priced at the average price during the month of lifting rather than at the time of discharge. This change will eliminate provisional pricing on these crudes and we expected to significantly reduce the timing effects in our U.S. downstream earnings. However, fourth quarter earnings will include the impacts of final pricing adjustments for October and November deliveries that were lifted during the third quarter. Returning to the chart, the other bar is largely due to better lubricant margins and the absence of pipeline impairments, I mentioned last quarter. Turning to slide 9, international downstream earnings improved to $817 million in the second quarter's loss. Margins were a minor favorable item, as improved marketing margins overcame weaker refining margins. Volumes benefited slightly following completion of repairs at our Pembroke Refinery in the U.K. As in the U.S., international downstream timing effects were major factor in the favorable change between quarters, as the price of crude and petroleum products fell significantly. Of the $860 million favorable timing effects shown in the bar, more than half was related to derivative gains on sales of long-haul equity crude and refined products, such as, partitioned neutral zone crude and Pembroke product exports. As I mentioned last quarter, we often use derivatives to lock in a margin above the cost of transportation, which can result in gains when prices decrease and vice versa. More than $100 million of the 860 million total shown in the bar reflected gains in the third quarter as compared to losses in the second quarter and derivatives used to convert crude pricing to the time of refinery run. The balance of the timing effects is primarily due to favorable inventory impacts, gains due to the timing of aviation fuel pricing, and all other supply-related timing effects. Going forward, we're taking actions as appropriate, to reduce the volatility of this segment, the price fluctuations. The other bar on the slide shows a $51 million adverse variance between quarters. This is the net of foreign exchange gains, offset by operating cost and tax items. Slide 10 shows that earnings from chemical operations were $70 million in the third quarter compared to $41 million in the second quarter. Results for olefins improved on higher margins along with lower operating expense. Aromatics results fell somewhat, due to startup costs, for the Jubail Chevron Phillips Styrene operation. The other bar reflects lower additive earnings. Slide 11 covers all other. Third quarter results were net charges of $190 million compared to net charges of $580 million in the second quarter. $190 million of the swing reflects lower environmental charges, and $110 million stems from a favorable variance in tax items. The other bar on slide 11 includes the net of many unrelated items which were favorable variants between sequential quarters. In total, the third quarter net charge was less than our standard guidance of $250 million to $300 million. For the various reasons stated in the interim update. Before turning it over to George, I'd just like to briefly recap the third quarter. Upstream earnings and volumes were down somewhat inline with the interim update. We experienced a strong improvement in downstream performance, due to timing effects rising from sharper declining crude and product prices and less refinery downtime also as outlined in the interim update. Fine line, as projected chemical results benefited from higher margins. George Kirkland is now going to provide an update on our production outlook for 2008, our hurricane recovery plans, and our upstream projects status through 2009. George?"
},
{
"speaker": "George Kirkland",
"text": "Thanks, Jim. Before I update you on the major capital projects, I'd like to review our production. Please turn to slide 13. This graph compares net OEG production through the first nine months of 2008; first is the first nine months of last year. Total OEG production through the third quarter was 2.53 million barrels per day. Although production is down 95,000 barrels per day about 80,000 barrels per day of this loss is attributable to price effects on the net entitlement barrels and 17,000 barrels a day is attributable to the disruptions from hurricanes Gustav and Ike in the Gulf of Mexico. I’ll discuss the hurricane impacts in just a few moments. Despite these losses, we have been very successful in managing our base business declines and capturing gains for major capital projects that have recently come online. The low base business decline is a positive indicator of our base business efforts, where we have experienced improved reliability across the enterprise. Adjusting for favorable gas market conditions in the Asia-Pacific region, and the Indonesian unitization settlement, our base business decline rate is approaching the low end of our 4% to 5% decline guidance. Now, I'll update you on the production outlook for the remainder of the year. Please turn to slide 14. Assuming fourth quarter prices will average approximately $70 a barrel, and thereby, approximately $100 a barrel for the whole year. Our 2008 production outlook is estimated at 2.55 million barrels of oil equivalent per day. This graph compares the 2008 outlook to year-to-date third quarter actuals, and our fourth quarter production outlook. The last bar on the right shows the 2008 guidance provided last January. Absent the yearly price effects of about 60,000 barrels per day and hurricane disruptions, which we estimate to be about 35,000 barrels per day, the full year net production would be in line with the prior guidance. The fourth quarter production forecast is estimated at 2.62 million barrels per day, significantly higher than year-to-date actuals. This is driven by two factors; the continued ramp up of our major capital projects, principally, Agbami and the Tengiz expansion and lower prices. Project ramp ups are estimated to add approximately 170,000 barrels per day during the quarter. The impact of lower prices on net entitlement barrels, associated with production sharing contracts will likely increase production by about 45,000 barrels per day during the quarter. Offsetting these gains are hurricane disruptions, which are estimated at 65,000 barrels per day for the quarter and the continued base business declines which includes ongoing operational difficulties in Azerbaijan. I would like to now spend a few moments to provide additional details on the hurricanes. Please turn to slide 15. This slide shows the trajectory of hurricanes Gustav and Ike with respect to Chevron leases in the Gulf of Mexico. The leases are shown in yellow. The wind field for hurricane Gustav is shown in red and for hurricane Ike in green. We are pleased to report that there were zero safety incidence associated with the evacuation of personnel from our offshore facilities. 3500 personnel were safely evacuated for Gustav and 1500 for Ike. We did sustain damage from the storms. Overall, there were 13 toppled structures, four leaning structures and three missing well heads. The long term impact of this damage on production is not great. It is estimated that between 6,000 to 10,000 barrels a day will be permanently lost. In the deepwater areas there were some minor damages sustained at Petronius and Genesis where production is now being restored. There was no damage to the Blind Faith facility and only minor damage to Tahiti. I'd now like to share an update on the current restoration effort and forecast, if you would please turn to slide 16. This chart shows the anticipated net OEG production restoration profile by month. The actual restored production to date is shown on the solid blue line and the outlook is in the dash line. Pre-Gustav production from the Gulf of Mexico averaged about 190,000 barrels of oil equivalent per day. As of this week, total restored production is 55% of pre-storm levels. Of the remaining production to be restored, about three quarters is dependent on the timing of third party pipeline repairs. Let me assure you that we have a dedicated team of professionals actively working with our partners and stakeholders to keep our restoration efforts on track. I'd like now to provide an update on our major capital projects. Please turn to slide 17. Chevron has reached some critical major capital project milestones in 2008. So far this year six projects have started up. It is also anticipated that another two will start up in the fourth quarter, North Duri Area 12 in Indonesia and Blind Faith in the Gulf of Mexico. On July 29, our Nigerian affiliate commenced crude oil production from the Agbami field, this is a significant accomplishment. Agbami initial gross oil equivalent production has ramped up to more than 110,000 barrels per day. We anticipate the ramp up to continue reaching 250,000 barrels per day by the end of 2009. Well, September 22, our Tengizchevroil affiliate completed a major expansion at the Tengiz field in Kazakhstan that has nearly doubled production capacity to 540,000 barrels per day. Remember that the first phase of this expansion started up during the fourth quarter of 2007. All phases are now complete and commissioned. In Western Australia on the September 1, the fifth Train at the North West Shelf’s Venture liquefied natural gas facility became operational. This production facility is expected to increase the joint venture’s export capacity by about four million metric tons of LNG annually to 16.3 million metric tons. During the second quarter, in conjunction with our joint venture partners, first oil was achieved from the Moho-Bilondo field in the Republic of Congo. Please turn to slide 18. Other projects that have achieved first production during the first three quarters of 2008 are ACG Phase III in Azerbaijan and Brodgar-Callanish in United Kingdom. I’ll now touch on the remaining project startups for 2008. In the Gulf of Mexico, the last stages of commissioning are taking place at the Blind Faith facility, and first oil is anticipated in November. There was no damage to the facility during Hurricane Ike, but it did disrupt commissioning activities. In Indonesia, the next phase development at the heavy oil Duri field remains on schedule; it is also expected to start up in November. Now, let’s turn to slide 19. Looking forward to 2009, I’d like to provide you with a status on the major capital project milestones that are anticipated next year. Let’s start in the Gulf of Mexico deepwater with our Tahiti project. The project is progressing on schedule. The spar hole was installed during the first quarter and the topside modules during the third quarter of this year. The facility sustained minor damage during hurricane Ike and will be repaired during ongoing hookup and commissioning activities. However, this will not delay the projects and we still anticipate first oil by the third quarter of 2009. In Brazil, at the Frade field construction of the FPSO is 85% complete with a sail-away from Dubai expected in late December. First oil is expected during the second quarter of 2009. In Angola, the Tombua Landana project remains on schedule, to meet first oil during the second half of 2009. The hurricanes in the Gulf of Mexico, did not significantly impact the schedule for sail-away of the various compliant pile tower components. The Large Scale Steam Pilot in the Partitioned Neutral Zone also remains on schedule. If this pilot is successful, it will lead to a full-field development at Wafra. First steam injection is expected during early 2009. Finally, I would like to provide a summary of other key 2008 upstream highlights. Please turn to slide 20. For September 10, we announced the extension and amendment of the Partitioned Neutral Zone operating agreement with the Kingdom of Saudi Arabia. This agreement extends the existing arrangement for 30 years through 2039. In Canada, at the Hebron field, formal binding agreements were signed in August between Hebron project proponents and the government of Newfoundland and Labrador. These agreements paved the way for the project to proceed. During the third quarter, Chevron transferred operatorship to ExxonMobil following ratification by co-venture partners. In Australia, our LNG projects are progressing toward key milestones. At Gorgon, the joint venture is pursuing a project scope of 3-5 million metric tons per annum LNG trains. A final investment decision is expected after environmental approvals have been provided by the State and Commonwealth for the third train proposal and following the completion of engineering and design. Wheatstone, which represents a tremendous growth opportunity for Chevron Australia is progressing towards FEED. It builds on our extensive natural gas resources in Western Australia and is expected to make our company a leading natural gas supplier and operator of LNG facilities in the Asia-Pacific region. We announced our attention during the first quarter to develop Wheatstone as a grain field onshore LNG and domestic gas project. And finally at Chuandongbei, we expect the initial FID by the end of this year. The appropriate engineering and design work required to sanction the project work. The project is on track. We assumed operational control of the existing operations in August. This concludes the project update and now I will turn it back over to Steve."
},
{
"speaker": "Steve J. Crowe",
"text": "Thank you, George. That concludes our prepared remarks. We will now take your questions; one question and one follow-up per caller, please. Matt, open the lines for questions. Thanks."
},
{
"speaker": "Operator",
"text": "Thank you, sir. (Operator Instructions). Our first question is from Mark Flannery from Credit Suisse. Your question please?"
},
{
"speaker": "Mark Flannery",
"text": "Thanks. Yes, just a question for George, while coming into budgeting season, things are looking very different on the commodity side. Nobody really knows what’s going to happen in 2009 of course, but given what’s happened to oil prices. Could you tell me what you’re thinking about when you think about the ’09 CapEx budgets for the upstream, particularly with regards to the more capital intensive end of the spectrum? I’m not looking for a number, because I know we won’t get one, but just what’s your thought process around that right now?"
},
{
"speaker": "George Kirkland",
"text": "Let’s just first start off that we haven’t finished our budgeting process we’re going through the approval process, we’ve been working through that. Our thought processes on any project that has already moved into construction of past FID, those projects will move very much through their cycle would never slow those down. And we anticipate trying to hold our capital spending pretty much in line of where we’ve been this year. We don’t like fluctuating our capital spend up and down. Our long-term view on pricing has not changed. So I would look at this point at capital spending very similar between years and recognize if we have something different, we want to change. We have flexibility on near-term projects not our long-term projects. We really can’t back-off for long-term projects."
},
{
"speaker": "Steve Crowe",
"text": "Mark, let me just expand a little bit on just the mechanics that George alluded to. We're right in the middle now of finalizing our business plans and the capital spending for 2009, and per our normal practice it would be our intention to have a release and provide the 2009 capital program sometime around the middle of December. So, about six weeks from now, I think, would be the approximate time you'll hear our final program for next year. Do you have a follow-up question?"
},
{
"speaker": "Mark Flannery",
"text": "I do and it's on the same topic. I wondered, George, could you characterize the capital expenditure program that you have or you are putting together for 2009. How much of that would you describe as fully discretionary i.e. not part of projects that have gone through FID, not part of projects about to meet FID, that kind of thing. What's the wiggle room would you think in the budget?"
},
{
"speaker": "George Kirkland",
"text": "Just an estimate without numbers in front of me and recognizing that probably 75%, 80% of our project expenditures are related to projects that are post FID, so, those are pretty far along at this point. So there is not a lot of wiggle room in the first year. Our wiggle room in capital spending is much greater in the second year of our budget cycle, and of course, very large amount in our third year of our budget cycle."
},
{
"speaker": "Mark Flannery",
"text": "That's very helpful. Thank you very much."
},
{
"speaker": "Steve Crowe",
"text": "Thanks, Mark. May we have the next questioner please?"
},
{
"speaker": "Operator",
"text": "Our next question is from Paul Cheng of Barclays Capital. Your question please?"
},
{
"speaker": "Paul Cheng",
"text": "Hi, gentlemen."
},
{
"speaker": "George Kirkland",
"text": "Hi."
},
{
"speaker": "Steve Crowe",
"text": "Hi, Paul."
},
{
"speaker": "Paul Cheng",
"text": "My question is related to the CapEx. I know you are not going to talk on numbers, so I am not asking that. But, George when you are looking at with potentiality, oil surfaces cost and the raw material cost [next year] everything are coming down. Is that a trade-off, there is certain project, if you delay it even if they are already FID delayed, you may be able to get a much lower cost structure. So, want to see that, I mean, how you view on that?"
},
{
"speaker": "George Kirkland",
"text": "Well, there is no doubt for projects that have not reached FID where you don't have contracts with and what we are expecting is we are expecting that the cost of goods and services are going to come down. So, we would I think look very strongly at slight movements on projects that made sense. From the cost of building them, if it's going to come down we would look at sliding those a little bit. I actually see this as a real opportunity for companies like Chevron. I do expect the cost of goods and services to come down. I think the financing is going to hurt others to move projects forward. So my expectation is shipyards and equipment manufacturers, there'll be less pressure on them than there has been. So, I think, there is going to some benefit for some of our future big projects with cost reductions."
},
{
"speaker": "Steve Crowe",
"text": "Paul, do you have a follow up question?"
},
{
"speaker": "Paul Cheng",
"text": "Yes, if I could. Yes, actually, somewhat unrelated Tengizchevroil now you said 540,000 barrel per a day. I think there is a long time objective, when they get to a 700,000 barrel per day plus. I want to see if George has any update on where we are in that process?"
},
{
"speaker": "George Kirkland",
"text": "Well let me deal with the expansion. Our expansion, the name plate on it was 540. We've reached that and we don't yet know if we can get a few more barrels out of it, but my expectation is we are probably going to be able to get a few more barrels, and maybe by our March meeting with the analysts that we'll have a little more word on that to see if we’ve been able to increase the capacity further. I believe, I mentioned that our Analyst Meeting earlier in March this year that we were looking at the next expansion for Tengiz. We’d like to move that engineering work forward as fast as we can. We’ve learned an awful lot about what we can do on big, big projects in the Kazakhstan area of where we operate Tengiz. So, it's a good time to be ready to move forward with the next expansion, and I know a little more information about the performance, of course, on the gas injection as the year plays on out. So, I think, all of those things line up for us to want to move the next expansion forward, of course, we have to get all of our partners on board with that."
},
{
"speaker": "Paul Cheng",
"text": "George, can I put in a quick question in here? For 10-Q with the [SEC], you guys will be able to put more reserve this year?"
},
{
"speaker": "George Kirkland",
"text": "I think it's a little premature to talk about reserves; we’re just in the process of going through our reserve reviews around the world, and I’d really rather wait to talk about reserve bookings preferably actually to the March meeting, when by that time we’ve done all our work."
},
{
"speaker": "Steve Crowe",
"text": "Thanks, Paul. And I would just add that the current SEC rules are still in place, although they’ve come out with a proposal for modification of the definition, but it’s still using prices at a point in time at the end of 2008. And as George mentioned, we may have some preliminary numbers that we can share with you in terms of reserves in the January call, but we don't really finalize all of our work until February and have it available then for the 10-K and then further discussion at the March '09 Analyst Meeting."
},
{
"speaker": "Paul Cheng",
"text": "Thank you."
},
{
"speaker": "Steve Crowe",
"text": "Thanks, Paul. May we have the next questioner please?"
},
{
"speaker": "Operator",
"text": "Your next question is from Neil McMahon from Sanford Bernstein. Your question please?"
},
{
"speaker": "Neil McMahon",
"text": "Hi, I've got questions related to your project timing. Just moving on to some of your previous answers, George, you mentioned that Gorgon, you're not planning 3 million - 5 million ton trains and one presumes since it hasn't gone to FID, yet. But there is scope to discuss materials costs and contractor costs. Do you have any rough idea, what timing you would expect Gorgon to come on and at? And if the current credit markets or falling prices for products and services may delay that a little bit?"
},
{
"speaker": "George Kirkland",
"text": "I think may be in a earlier question, I was trying to foreshadow that I actually see a potential advantage for big LNG projects that have not reached FID. The cost reduction of goods and services is really I think, very, very good news for those kind of projects, so, very positive from that point of view. Our long-term view of prices of oil and gas, have not changed, which is how we always looked at our economics. So in some ways with cost of goods and services, I think potentially coming down, it's a benefit to those large projects. And once again it reinforces this financial crisis, reinforces the advantages that companies like Chevron have, we have very, very strong balance sheets and are not, I think, held hostage or to getting loans to do our projects. So, from that perspective, I think, it may actually be a benefit for us in some of our very, very large projects."
},
{
"speaker": "Steve Crowe",
"text": "I'll just add. We have the advantage of having a very strong balance sheet and we got to this point because we look a long-term view of the commodity price cycle, strengthened our balance sheet when commodity prices were rising, so as to whether a downturn or advantage ourselves of opportunities. We also have the other aspect that George mentioned, and that is, we have a great project queue. So, tremendous strength, but also tremendous opportunities. Neil, do you have a follow-up?"
},
{
"speaker": "Neil McMahon",
"text": "Yes, Steve and I appreciate all of that, and that's good to hear. It was really, again on Gorgan, just a rough timing on when that project would be coming on, I am presuming the second half of the next decade? And then, as we are talking about projects, maybe George could give an update on Jack and St. Malo, as well?"
},
{
"speaker": "George Kirkland",
"text": "Let me deal with Gorgan saying our target is FID in the second half of 2009. So, sometime mid-year or little bit after we would like to be the FID. I would then like to come out as we approach FID and then give a definitive date. I don't think it's quite as long as what you mentioned, I'd pull it back a little bit from there. But, I would much rather talk about that in detail once we get closer to the FID point. Okay, and then on Jack and St. Malo. We still have appraisal wells to complete on both Jack and St. Malo and until we get those appraisal wells drilled and evaluated, we really can't comment on further timing. I would anticipate that we would be able to make pretty strong views on timing for Jack and St. Malo, between the analyst call in late January to the time we get together in March; somewhere in that timeframe, we should have a pretty good idea of our path forward."
},
{
"speaker": "Neil McMahon",
"text": "Right, thanks."
},
{
"speaker": "George Kirkland",
"text": "Thanks, Neil. May we have the next questioner, please?"
},
{
"speaker": "Operator",
"text": "The next question is from Paul Sankey of Deutsche Bank. Your question please?"
},
{
"speaker": "Paul Sankey",
"text": "Hi, guys. Just one on upstream, and one on finance, if I could, I’ll slip in a few thoughts to it. Firstly, George you mentioned 2650 would be your production level for 2008 at $70 oil. Could you indicate what level you would expect for 2009, given the impressive list of projects you’ve listed? Secondly, the decline rate towards 4% is what you said. Would that be sensitive to the oil price being lower in terms of how hard you defend that number? And finally, on the upstream side, if you could talk about exploration and any highlights that you’ve got coming up over the coming year? Thanks."
},
{
"speaker": "George Kirkland",
"text": "It’s a long list there. Let me…"
},
{
"speaker": "Paul Sankey",
"text": "That was one question, George."
},
{
"speaker": "George Kirkland",
"text": "Very well strung together. The 2009 production number, I’m much preferred to talk about that at the January or have Steve or others talk about it at the January meeting. And I hope everyone recognize that there’s an awful lot of moving parts going on right now. Hurricane restoration has potential significant swings, and as I mentioned in my comments today, three-quarters of the remaining barrels that we have off there are not dependent on what we do; they’re dependent on third-party pipelines. So we have that concern. We have all these projects coming on, and including Tahiti and the timing of all these big projects when they come on, one quarter, one month, all of these make a significant difference. A lot of these points will be nailed down by the end of the year. We are going to know an awful lot about where we are on hurricanes, we're going to know ramp up on Agbami to a much better extent. Blind Faith was going to be owned by then, so we'll have some performance data on it and we'll have a pretty good idea of exact timing of Tahiti, which is a bunch of big barrels for us, so another project where we have high working interest. So from that perspective, we typically give our guidance for 2000 or that year in the January meeting. So we're going to hold with that and we'll give that guidance at the next quarter's call."
},
{
"speaker": "Steve Crowe",
"text": "I'd just add on top of George's comments for all the reasons that he cited. As we've done year, when we give the guidance for 2009, net of O&G production, we'll ping it off a specific crude price recognized in the workings of various contract agreements overseas can affect net production. I think you had another question on…"
},
{
"speaker": "Paul Sankey",
"text": "Yes, sorry. You mentioned that you implied that it was close to 4% decline rate based on higher activity levels in defending the base. I just wondered if with the lower oil that’s going to be still defendable, I guess it's really a follow-up to the CapEx question in some ways."
},
{
"speaker": "George Kirkland",
"text": "Well, we've tried to take the price effects out our decline rate analysis and give you numbers that really don’t reflect the price itself. We try to pull the price effects out of there to the best we can."
},
{
"speaker": "Paul Sankey",
"text": "No, I'm thinking more about activity levels, George? You know are you going to do less, because fuel price is lower?"
},
{
"speaker": "George Kirkland",
"text": "Once again you got to remember, a lot of contracts for rigs you're already set for a year and six months. So there is limited change that you are going to make in a short-term program. And I would tell you, typically, the very strongest returned projects, when you look at rate of returns on your investment tend to be those projects that are off of current infrastructure and tie-ins, so those development wells and workovers tend to have the very, very best economics. I would tell you that we will make decisions during the year for certain contracts as they are coming up if it looks to be advantageous for us to decide to go out to the market and bid for a rig in lieu of doing a contract extension we will do that to make sure we attract the best prices to do our work. So we will make some choices like that, very tactical choices during the year. I can't at this point in time speculate how that will play out, it could have some minor effect on our base decline. But it is just way too early to speculate."
},
{
"speaker": "Steve Crowe",
"text": "George, the third part of…"
},
{
"speaker": "Paul Sankey",
"text": "Third part of one…"
},
{
"speaker": "Steve Crowe",
"text": "Third part of the first question (inaudible)…"
},
{
"speaker": "George Kirkland",
"text": "Our exploration focus is still very much, in those focus areas I've talked about, we have been drilling wells in Australia, we haven’t made any announcements, but we have been doing quite a bit of work in Australia. And I expect we will cover that later through some announcements. We are just starting several wells in the lower tertiary, in the deepwater Gulf of Mexico, it's too early to make anything of a report expect the wells have been spuded. And we’re continuing to drill some expiration wells in the focus area of West Africa, but I don’t really have any specific updates beyond that. We’ll give a very broad update and I’d say detailed update once again in our analyst meeting in March."
},
{
"speaker": "Paul Sankey",
"text": "But the development here, it feels like a quiet year for expiration."
},
{
"speaker": "George Kirkland",
"text": "Our exploration program, I will tell you, we try to keep it very consistent. We try not to yo-yo it up and down, that’s my expectation again for next year. We always like to drill anywhere from 15 to 20 high impact wells around the world and then of course our large number of appraisal wells and delineation wells. So my expectation would be a program similar to what we’ve done in the last few years. Once again, we don’t like to yo-yo them up and down. We’ve got rig contracts, we plan for the long-term and we try to maintain even this in those programs."
},
{
"speaker": "Steve Crowe",
"text": "Paul, you had one more question."
},
{
"speaker": "Paul Sankey",
"text": "Yes, very quickly, one for you Steve, and that would be pension, anything to say about pension funding and the outlook there. Thanks, so I’ll leave it there. Thank you."
},
{
"speaker": "Steve Crowe",
"text": "Thanks, Paul. Certainly the market value of our Pension Trust Fund obviously has gone down with the market in the last several months. We don’t have any required funding requirements under the PPA or [RISSA]. As you may recall, particularly earlier in this decade, we have an approach towards funding that we call opportunistic funding. When we have sufficient cash or cash flows and can assure ourselves of tax deductibility and making a contribution. I guess, I would say at this juncture the disclosures that Chevron’s made in its 10-K and 10-Q still pertain, including our ongoing economic review to fund more than we have there, indicated in our SEC filings. So keeping in mind that the PBO obligation under PPA discount rules results in higher discount rates. The magnitude of the funding is better than you might think just looking at the reduction in the asset values. So I guess, I’d take you back to our disclosures that we have made in earlier 10-Qs and the one that you will see in our 10-Q next week. May we have the next questioner please?"
},
{
"speaker": "Operator",
"text": "The next question is from Michael LaMotte of JPMorgan. Your question please?"
},
{
"speaker": "Michael LaMotte",
"text": "Thanks. Good Morning, guys. I’d like to follow-up on this base decline number George, if I could quickly. In slide 13, 55,000 barrel a day number implies a 2.1% rate, at the analyst meeting in March, the same slide showing ’07 versus ’06 was about 1% decline. And I know a 1.6%, I guess. In your remarks you mentioned operating challenges in Azerbaijan is one of the reasons for the base decline. The question I am asking is, is it all Azerbaijan? Are there issues related to that, that explain that whole delta and can 2% hold?"
},
{
"speaker": "George Kirkland",
"text": "I keep going back and we track this base business very closely, because we have good success, it has been lower for now, I think probably 4-5 quarters less than the 4% to 5%. I would tell everybody, remember those barrels are in the bank, moved our production up and held our production. So that’s a real positive, but I tried to also give a little color on this 55 that there were other things going on in there, that benefited our base and reduced that decline. One of those was a unitization agreement in Indonesia that we highlighted in an earlier call; I believe that was a first quarter call."
},
{
"speaker": "Steve Crowe",
"text": "It was first quarter."
},
{
"speaker": "George Kirkland",
"text": "First quarter call and that had an impact, and we've also had better marketing results, gas sales in the Asia-Pacific region that in effect has raised the amount of base production we've had there. So, it's not really a fair comparison on base decline without taking that into effect, and when you add those pieces back, it gets back to the low end of this. It gets back in the 4% range, approximately. So, we feel good for planning purposes. We're going to continue to hold this 4% to 5% as kind of our planning model. But then, when we look at our actuals and the processes we put in place, we're hopeful that we're going to continue to see, that we're able to do a little bit better than that. So, we're going to look back at performance and we're going to plan forward, at least for some period of time, still in this 4% to 5% range."
},
{
"speaker": "Steve Crowe",
"text": "Mike, do you have a follow-up?"
},
{
"speaker": "Michael LaMotte",
"text": "I do. Thank you for that color, George. If you wouldn't mind expanding a bit on the impairment to North Sea assets, as well?"
},
{
"speaker": "Steve Crowe",
"text": "Jim, do you want to feel that one?"
},
{
"speaker": "Jim Aleveras",
"text": "Yes. We had impairment of number of very small fields in the Dutch North Sea, as well as the U.K. North Sea, these are mature fields, and they are very small partially, in terms of production. So, those are not tremendously material to us."
},
{
"speaker": "Steve Crowe",
"text": "They were all reaching the end of their productive lives. So, we took the asset values down."
},
{
"speaker": "Michael LaMotte",
"text": "Okay. Very good. Thank you."
},
{
"speaker": "Steve Crowe",
"text": "You bet. May we have our next questioner, please?"
},
{
"speaker": "Operator",
"text": "Your next question is from Erik Mielke from Merrill Lynch. Your question please?"
},
{
"speaker": "Erik Mielke",
"text": "Good morning, gentlemen. I have two questions, the first one for George, and the second one for Steve, probably. Firstly, on the partition neutral zone in Saudi, and I understand that you are not willing to get into a huge reserve discussion at this point. But can you clarify whether the extension of the contract would automatically lead to additional reserves being bookable for you?"
},
{
"speaker": "George Kirkland",
"text": "Our normal reserve process only allows us to book reserves through the existing contract life; the contract life without the extension would have been ending in February of 2009, and now it will go to 2039. So, with that extended period, there will be proved reserves that will be booked as a part of that extension."
},
{
"speaker": "Erik Mielke",
"text": "It's very clear. Thanks."
},
{
"speaker": "Steve Crowe",
"text": "And do you have another?"
},
{
"speaker": "Erik Mielke",
"text": "Yes. My second question is more on cash management. If I hear you correctly, it sounds like CapEx is something that you intend to keep at current levels, and even if prices were to go let's say $10 lower than where they are today. And for the rest of your cash management, how do you balance between holding cash, accelerating buybacks, or scaling back buybacks, and potentially increasing dividends? And then also, can you clarify where are you going to keep your cash?"
},
{
"speaker": "George Kirkland",
"text": "Thanks, Erik. Well, I'll begin on a short-term issue. It's our intention here in the fourth quarter to maintain the share buyback pace at $2 billion in the fourth quarter, just as we've done for the last five quarters. In terms of cash management and balancing, I think first and foremost, we want to make sure we fund the capital program that we feel is such a robust program with a very deep queue. So that's our first and foremost use of operating cash. Secondly, we are mindful of our 21, 22 year record of increasing annual payouts and our dividend, and would fully want to maintain that progress overtime. Thirdly, as I had alluded before, we do want to maintain a strong balance sheet through the commodity price cycle and I think we're in enviable position, right now, as having one of the strongest balance sheets in the industry. As to share buybacks, we take all of the other considerations into account and make a determination as to whether or not there is enough of a cash flywheel to fund further buybacks. We take a look at economic conditions, market conditions going forward and would plan on giving guidance to the investment community, just as we're doing now at the call each quarter, for at least, one quarter, ahead. But as for right now, we're coming off two quarters of consecutive record earnings, a very, very strong balance sheet, strong cash flows, more cash than debt and we see another $2 billion here in the buybacks, in the fourth quarter. Can we have the next question, please?"
},
{
"speaker": "Operator",
"text": "Our next question is from Peter McNally from Galleon. Your question please?"
},
{
"speaker": "Peter McNally",
"text": "My question has been answered. Thank you."
},
{
"speaker": "Steve Crowe",
"text": "Thanks, Peter. Can we have the next questioner please?"
},
{
"speaker": "Operator",
"text": "Our next question is from Mark Gilman from Benchmark. Your question please?"
},
{
"speaker": "Mark Gilman",
"text": "Guys, good morning, good afternoon. George, I am wondering if you could tell me associated with the new concession of the partition neutral zone, did you benefit or would you benefit from any change in fiscal terms, should you decide to proceed with the full field steam flood there?"
},
{
"speaker": "George Kirkland",
"text": "Mark, first off, it's an extension of the existing contract there and at this point in time, I will not discuss the terms of a future full field steam development. I would rather hold that off until we get closure to that decision point."
},
{
"speaker": "Mark Gilman",
"text": "Okay. Let me turn to my follow-up. I believe you received approval to proceed with them across a straight development project or with respect to some of the resources that [UNICCO] had identified years ago. I am curious as to whether that gas is to go to Bontang or to be dedicated to the domestic market and is there an agreement to allow for [protomania] to participate as an equity partner."
},
{
"speaker": "George Kirkland",
"text": "Mark, that agreement to develop and the plan of development there has not been fully approved. So, we don't have all the approvals yet on that. So, at this point, I really can't talk about it because we don't have all the approvals. It has been reported in the press a couple of times but all the pieces have not been put together, so it has not been reported correctly."
},
{
"speaker": "Mark Gilman",
"text": "Okay. Since I got two strikes, let me try one more quickly. George with respect to the production sharing contract impacts that you'd cited in several of your slides. Can you segment that between those losses that would be considered permanent associated with threshold return and/or full capital cost recovery versus those reductions that are associated more with operating cost and continuing capital cost recovery?"
},
{
"speaker": "George Kirkland",
"text": "Mark, I can't do that at this time. That's a lot of detail. I will tell you, some of it has been related to triggers, in other words, return triggers that will change the distribution in effect of profit oil. So, we have that. We have some that is royalty pieces, which reach triggers with higher royalty rates. But, first off, I don't think we ever would try to share that kind of detail, that's an awful lot of detail. We'd rather try to give you each year kind of a guideline that kind of matches what we think is going to happen for the year at a price scenario or a price range. This last year, we've been telling you it's been about $2 for every dollar a barrel impact on price, it's about 2000 barrels per day change and that's kind of been what it has, we will update that again for the year 2009, which we will be once again looking-forward and look at price impacts and production impacts together."
},
{
"speaker": "Steve Crowe",
"text": "Mark, what we will try to do on the January call then is, when we give our guidance for 2009 production at a specified price. Based on that specified price, we'll try to give the investment community a rule a thumb to use to know how to adjust that if prices are above or below that amount."
},
{
"speaker": "Mark Gilman",
"text": "Okay, guys thanks. I'm taking my back and going back to the dugout."
},
{
"speaker": "Steve Crowe",
"text": "Okay, Mark. May we have the next questioner please?"
},
{
"speaker": "Operator",
"text": "Our final question today is from Neil McMahon of Sanford Bernstein. Your question please?"
},
{
"speaker": "Neil McMahon",
"text": "Hi. Just not really a follow-up, something a bit different for you, Steve. What was the tax rate difference between the second quarter and the third quarter?"
},
{
"speaker": "Steve Crowe",
"text": "Of this year?"
},
{
"speaker": "Neil McMahon",
"text": "Of this year, yes."
},
{
"speaker": "Steve Crowe",
"text": "In the third quarter our tax rate was just about 45%. And in the second quarter it was about 49% and below a rate for the third quarter of this year was associated with a greater proportion of income being earned in tax jurisdictions with lower tax rates. But we also have an impact in the second quarter of a reduction in the tax rate in Bangladesh. So, on an ongoing basis, as we have guided in the past, allowing for the different taxing jurisdictions and being an integrative company, our guidance would be to use sort of an average rate of about 45% or in that neighborhood at least."
},
{
"speaker": "Neil McMahon",
"text": "Okay, that’s great. Thank you."
},
{
"speaker": "Steve Crowe",
"text": "Thanks, Neil. Mark or Matt, are there any other questioners in line?"
},
{
"speaker": "Operator",
"text": "We have no further question as this time."
},
{
"speaker": "Steve Crowe",
"text": "Okay. Well, thank you, Matt. In closing, let me say that we appreciate everybody’s participation on today’s call. And I especially want to thank each of these analysts on behalf of all the participants for their questions during this morning session. Matt, back to you."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes Chevron’s third quarter 2008 earnings conference call. You may now disconnect. Good day."
}
] | null | null |
CVX | 2 | 2,008 | 2008-08-02 10:00:00 | Operator: Good morning. My name is Matt and I will be your conference facilitator today. Welcome to Chevron's second quarter 2008 earnings conference call. (Operator Instructions) I will now turn the conference over to the Vice President and Chief Financial Officer of Chevron Corporation, Mr. Steve Crowe. Please go ahead, sir.
Steve J. Crowe: Thanks, Matt. Welcome to Chevron's second quarter earnings conference call and webcast. Jim Aleveras, General Manager of Investor Relations, is on the call with me. Our focus today is on Chevron's financial and operating results for the second quarter of 2008. We will refer to the slides that are available on the web. Before we get started, please be reminded that this presentation contains estimates, projections, and other forward-looking statements. We ask that you review the cautionary statement on slide 2. I’ll begin with slide 3, which provides an overview of our financial performance. The company’s second quarter earnings were a record $6 billion, or $2.90 per diluted share. Our second quarter 2008 results were up 11% from the second quarter 2007. Higher crude oil prices benefited our upstream performance but had a negative impact on our downstream business. The second quarter of last year included a $500 million net gain on the sale of an investment and redemption of debt. Second quarter 2008 earnings rose over 15% compared with the first quarter of 2008, which Jim will discuss shortly. Return on capital employed for the trailing 12 months was 23%. The debt ratio was below 8% at the end of June. Capital and exploratory spending was $5.2 billion for the quarter. In addition to the $2 billion of stock buy-backs, we increased the second quarter dividend 12%. Jim will now take us through the quarterly comparisons. Jim.
Jim Aleveras: Thanks, Steve. My remarks compare results of the second quarter 2008 with the first quarter 2008. As a reminder, our earnings release compared second quarter 2008 with the same quarter a year ago. Turning to slide 4, second quarter net income was $800 million higher than the first quarter. Starting with the left side of the chart, higher crude oil and natural gas realizations benefited the company’s worldwide upstream results. At the same time, the significant increase in crude oil prices adversely affected the downstream segment. The variance in the residual other bar primarily reflects higher charges at the corporate level for environmental remediation and tax adjustments. Slide 5 summarizes the results of our U.S. upstream operations, which improved by about $590 million between quarters. Higher crude oil and natural gas realizations benefited earnings by $775 million. Chevron's average U.S. crude oil realization was up about $24.30 per barrel between consecutive quarters. This was less than the nearly $26 increase in WTI’s spot prices between quarters, since much of our Gulf of Mexico crude oil production is priced on a lagged basis. Production volumes were down 2% between quarters, largely due to operational downtime and normal fuel declines. This reduced earnings by $30 million. Higher operating expenses reduced earnings by $70 million. Fuel, steam, and utility costs increased, as did maintenance expenses. The other bar is the net of everything else, including various gas marketing effects. Turning to slide 6, international upstream earnings for the second quarter were about $1.5 billion higher than the first quarter’s results. Higher oil and gas prices increased earnings by nearly $1.3 billion. Our average unit realization for liquids rose by $24.30 per barrel between sequential quarters, about the same as the average brent spot price increase. An increase in liftings contributed $130 million to the second quarter. Liftings were up primarily in Tengiz, the U.K., and China. Overall liftings were roughly in balance for the first half of the year after our under-lifted position in the first quarter. Operating expense reduced earnings by $90 million, mainly in the U.K., Kazakhstan and Indonesia. The other bar reflects the net of many unrelated items. The largest item was a favorable swing in foreign exchange effects. Among the offsetting items, exploration expense was higher in the second quarter. Slide 7 summarizes the change in worldwide oil equivalent production, including volumes produced from oil sands in Canada. Production fell by 62,000 barrels per day, or 2% between quarters. U.S. production declined 13,000 barrels per day due to operational down time and normal field declines that I mentioned. Outside the U.S., overall production dropped 49,000 barrels per day in the second quarter. However, we estimate that the impact of higher prices reduced production by about 75,000 barrels per day between sequential quarters. So absent price effects, volumes would have been up between quarters. I’ll elaborate on this in a moment. Indonesia production was impacted by prices but the largest effect was the absence of the one-time benefit of a favorable gas unitization agreement that we discussed on the conference call last quarter. While gross production at Tengiz continued to ramp up with our expansion project, both Tengiz and Karachaganak net volumes were affected by higher prices. Turning to our production outlook for 2008, total OEG production for the first six months of 2008 was 2.57 million barrels per day. During this period, WTI prices averaged just over $110 per barrel. Our production target for 2008, which assumed $70 per barrel WTI, was 2.65 million barrels per day. Absent the price effects under production sharing and variable royalty agreements, our production for the first half would have been on track with our full year production target of $2.65 million barrels per day. This production level reflected strong base business performance without significant contributions from several 2008 major project start-ups. Our project start-ups will increase production during the second half of the year and, adjusting for price effects, we expect to meet or exceed our volume target for the year. Steve will provide a brief update on our major projects at the end of our presentation. We reviewed our rule of thumb as prices have moved far above $70 per barrel, and we believe the rule of thumb is still applicable at the current price level. That is to say, a $1 per barrel increase in prices leads to about a 2,000 barrel per day reduction in our net production volumes for the year. However, I would like to reemphasize the caveats we’ve given you about this rule of thumb. The calculation of price impacts includes many variables, including the interaction of prices and costs, very specific contract thresholds and terms and so forth. The rule of thumb is our best estimate of the impact for 2008, but results will vary when making comparisons between periods. For example, because certain thresholds were met in the second quarter, the rule of thumb does not work when comparing the first and second quarters of 2008. Each dollar change in price had an impact of over 3,000 barrels per day in this particular comparison. We’ll continue to update you as we move through this very volatile environment. Turning to slide 8, our U.S. downstream operations moved from break even to a loss of about $680 million in the second quarter. Industry refining margins improved in the second quarter, although marketing indicator margins weakened, particularly on the west coast. On balance, indicator margins suggest a $305 million benefit. WTI prices rose more than $38 per barrel from the end of the first quarter to the end of the second quarter. This compares to an increase of less than $6 per barrel during the first quarter. This truly extraordinary crude price spike in the second quarter reduced the U.S. downstream earnings by $490 million between quarters. The $490 million is shown on the bar labeled timing effects. Of the $490 million, about $280 million reflected the impact of provisionally priced foreign crude. This crude is priced on a delivered basis, although we take title to it when it is lifted. We typically have about 13 million to 15 million barrels of provisionally priced crude in transit to the U.S. west coast. These barrels are effectively marked to market at the end of each period. A second timing effect accounted for $110 million of the $490 million change between quarters. We used derivatives to convert crudes, including crudes that are not provisionally priced, from the acquisition price to the price at the time they are run. As prices went up dramatically during the second quarter, this resulted in derivative losses. The balance of timing effects between quarters reflected a number of supply related activities, including mark-to-market losses on derivatives related to a long-term contract. Moving to the next bar, we had an unfavorable variance of $300 million between quarters, due to refinery shut-down effects. Almost all of these were planned shutdowns and we previously cautioned that 2008 would be a heavy planned shutdown period for us. The adverse $300 million variance reflects both the direct operating expense and the lost margin capture as we purchased more expensive feed stocks and intermediates during the refinery shutdowns. Most of the difference between quarters was due to our Pascagoula refinery, where both the number one crude unit and coker were down during the second quarter. Planned shutdowns at El Segundo and [Hawaii] were much smaller factors. Our 2008 maintenance schedule indicates that essentially all of our major U.S. planned shutdowns were completed in the first half of 2008. Excluding the operating expense related to refinery shutdowns, other OpEx was $145 million higher in the second quarter. Many factors were involved here, including higher fuel costs. The other bar on the chart is an unfavorable variance of $56 million, which primarily reflects minor pipeline impairments. Turning to slide 9, international downstream earnings fell $300 million from the first quarter’s results. Refining indicator margins improved while marketing margins were mixed across our international geographic areas. On balance, company margins were a $185 million benefit between quarters. Volumetric effects were a $25 million adverse variance. This primarily reflected the unplanned shutdowns at the Pembroke refinery in Wales. We estimate the overall impact of all international refinery downtime between quarters to be an unfavorable variance of $32 million, which reflects OpEx as well as volume and feedstock impacts. As we saw in the United States, international downstream timing effects were a major factor in the adverse change between quarters, as the price of crude and petroleum products increased very significantly over the course of the second quarter. Two-thirds of the $225 million shown as timing effects was related to long haul sales of equity crude and refined products. For select cargos, we often use derivatives to lock in a margin above the cost of transportation. During periods of rapidly increasing prices, this can lead to derivative losses. The majority of this timing effect is related to delivered sales of partition neutral zone equity crude and exports of refined products from our Pembroke refinery to third parties. The balance of the timing effect is primarily due to losses on derivatives used to convert crude pricing to the time of refinery run. There was also a factor involved here regarding the changes in inventory. The next bar shows operating expense was a $140 million unfavorable variance between quarters. A number of different items affected the various geographic regions. There was not a pattern to the components of the $140 million change. The other bar shows a $95 million reduction between quarters, and this primarily reflects lower foreign exchange gains, as well as an adverse swing in tax items. Slide 10 shows that earnings from chemical operations were $41 million in the second quarter, compared with $43 million in the first quarter. Results for olefins fell on lower margins and volumes, as well as higher expense. Aromatics results were also affected by lower volumes and higher operating expenses. Additionally, shutdown activity reduce aromatics results. The other bar on this chart shows a favorable $26 million variance between quarters. This reflects the absence of a $40 million environmental provision we mentioned on last quarter’s conference call, partly offset by lower additive margins. Turning to slide 11, which covers all other, second quarter results were net charges of $580 million compared to net charges of $255 million in the first quarter. The $210 million variance reflects environmental provisions related to legacy Texaco and Unocal downstream assets. Since these assets were sold prior to Chevron acquiring their parent companies, the impact was included here rather than in the downstream segment. Tax items were an $80 million unfavorable variance. The other bar reflects the net of many unrelated items. Before I turn things back over to Steve, I would just like to briefly recap the second quarter’s results. First, upstream results were very strong, in line with the indicators in our July 10th interim update. Second, we experienced a sharp decline in downstream performance due to timing effects and refinery downtime, as we discussed in the interim update. Finally, as we projected, chemical results were flat between sequential quarters and our all other charges were significantly higher than the standard guidance range due to environmental remediation charges. That completes my variance analysis for the quarter. Back over to you, Steve.
Steve J. Crowe: Thanks, Jim. Before opening the call to questions, I would like to highlight the significant progress we’ve made on some of our major capital projects. Please turn to slide 12. First up is our Agbami project, offshore Nigeria. Yesterday, we announced that Agbami had begun production. Chevron is the operator with a 68% interest in this world class deepwater project. Agbami’s initial gross OEG production is expected to quickly ramp up to more than 100,000 barrels per day. We anticipate this reach 250,000 barrels per day by the end of 2009. In the U.K., our partner recently announced first production for the Callanish-Brodgar fields, also known as the Brittania satellite development. At the Tengiz field in Kazakhstan, our phased expansion remains on schedule for full facility start-up this quarter. The first phase, which began late last year, added nearly 90,000 barrels per day of total production during the second quarter. The second phase of production is now complete and we’re doing the major turnaround, final tie-ins, and commissioning. As a result, there will be a brief drop in production of about 25,000 barrels a day in the third quarter. With full facility start-up, we anticipate the project will add 240,000 barrels a day of production, increasing Tengiz’s total capacity from 300,000 to 540,000 barrels per day. In the Gulf of Mexico, we completed our plan to retrofit and tension all eight mooring lines on our Blind Faith facility. We are continuing with commissioning work, having installed all four of the risers. We expect start-up later this year. It’s difficult to be more specific about the timing as weather could impact our commissioning efforts. In Australia, the Northwest Shelf fifth train, fifth LNG train is in the midst of commissioning with an anticipated first cargo in the fourth quarter. In Brazil, our Frade project is on track for a 2009 start-up. At our Tahiti facility in the Gulf of Mexico, the production spar has been moored, the installation of sub-sea flow lines and risers is nearly complete, and the first of three major topside modules was installed last week. We expect to install the other two topside modules this quarter. The Tahiti project remains on schedule for first production in the third quarter 2009. In Angola, our Tombua Landana project is also on schedule for first production next year. In summary, our major projects are on track to deliver significant new volumes. That concludes our prepared remarks. We’ll now take you questions. One question and one follow-up per caller, please. Matt, would you open up the lines for questions?
Operator: (Operator Instructions) Our first question is from Arjun Murti of Goldman Sachs.
Arjun Murti: Thank you. Thanks for the project update. I was wondering if you could provide a similar update on some of your exploration plans, I guess in particular the status of some of the key lower tertiary projects, Jack in particular, St. Malo. If you could provide an update on exploration in general but most notably the lower tertiary, that would be helpful. Thank you.
Steve J. Crowe: Well, we’re looking at Jack and St. Malo presently. We have another well that will be completed later in the year. We’re giving consideration as to whether or not we can tie back those two projects, Jack and St. Malo, one of which came from Unocal and one of which is a legacy Chevron one, and consider developing the two of them in tandem. We’ll have more to say about the progress of the lower tertiary as we get a little deeper in the year and can probably give you a more definitive update on our next conference call. Arjun, did you have a follow-up question?
Arjun Murti: Are those expected to be sanctioned this year, and does the fact that you are considering a joint development speak to any disappointment or update in terms of the resource potential of either or both together?
Steve J. Crowe: I think the consideration of joining those two projects together really speaks to the opportunity to reduce costs in the current environment and produce them in tandem as a more efficient way of developing the resource.
Arjun Murti: It’s an efficiency consideration?
Steve J. Crowe: Primarily.
Arjun Murti: And I’m sorry, do you think we’ll be expecting a sanction decision this year or is that an ’09 or later kind of a thing?
Steve J. Crowe: That will be outside of 2008.
Arjun Murti: Thank you very much.
Operator: Our next question is from Neil McMahon of Sanford Bernstein.
Neil McMahon: Just really on some of the numbers in today’s call that Jim ran through on the variance analysis; looking at the OpEx reduction both in the U.S. but more importantly in international, which is a bit strange, given higher royalties and an inflation environment. I was wondering to what extent -- well, first of all really why that OpEx reduction took place from the first quarter to second quarter, and in particular related to what’s going on in Kazakhstan with some of your partners in the Karachaganak field seeing increased charges associated with changes in the fiscal terms in that country.
Steve J. Crowe: Well, let me give a first correction, I think, Neil. As Jim was going through the variance analyses say on the U.S. upstream, we indicated on our, on slide five that operating expense was higher in the second quarter in comparison to the first quarter by about $70 million after tax, mainly reflecting, as you would expect, higher fuel costs and utility costs, along with higher maintenance. So actually the costs were higher in the second than in the first quarter.
Jim Aleveras: Neil, with regard to the international upstream, you will see OpEx down a little bit but the biggest factor there was simply a number of different things in our various U.K., Kazakhstan, and Indonesia operations.
Neil McMahon: I’m just sort of struggling why it’s dropped, given the fact that BG on their conference call were talking about the fact that under duress, or -- maybe that wasn’t the word they used but they were paying new taxes associated with the fiscal change in Kazakhstan. That’s all. It seems strange that you have gone down whereas they went up.
Jim Aleveras: Neil, perhaps it’s a semantic issue here. When we’re showing OpEx as a negative, what we’re saying is it’s a negative to P&L. We start with our income from the first quarter and we end with our income in the second quarter, so when OpEx is a negative, what it means is it’s a detraction from our earnings in the second quarter.
Neil McMahon: Right, I understand that but you did say that it went down. That’s all.
Jim Aleveras: No, we said OpEx was a negative. If you look at the international upstream chart, it’s a negative $90 million to earnings, so that’s OpEx actually going up. It’s reducing earnings by $90 million.
Neil McMahon: Okay, I thought you said a few minutes ago that things got better in Kazakhstan, but that’s fine. Maybe as a follow-up then, just on the environmental charge under corporate, maybe you could just walk through that, since you did say you had disposed of those assets, or maybe my hearing has completely gone.
Steve J. Crowe: Well, as we had foreshadowed in the interim update on July 10th, certain of the environment provisions or obligations that we have that are connected with legacy operations of Texaco or Unocal, we still are obliged per certain of the contractual arrangements to effect the environment clean-up or remediation. It so happened that here in the second quarter, for primarily the Unocal but also Texaco operations that are no longer operating, they’ve been disposed of, certain events have occurred where we thought it was appropriate for the accounting rules to recognize the increased liability. So that was the fundamental driver for that increase of $210 million between the first and second quarters of this year.
Neil McMahon: Steve, can you tell us where they are or what the chances are that this sort of thing is going to happen again on some of those assets?
Steve J. Crowe: Well, there were a variety of things, some of which were marketing related. Operations that Unocal had that have since been sold twice. Some of them are connected with refinery and terminal locations, both legacy -- primarily legacy Texaco. And those things occur driven by events, but you will have noticed I think over the last year or so that our recognition of environment expenses, whether it be for currently owned and operated operations or those previously disposed of are a bit more -- occur more regularly during the course of the year. But it’s very hard to give you a prediction as to what the ratable pace would be because it’s driven by events and they tend to come based on the situation.
Neil McMahon: Okay, thanks.
Operator: Our next question is from Paul Sankey of Deutsche Bank.
Paul Sankey: Good morning, gentlemen. I got a little bit confused regarding your overall statements about volumes for the year. You said you at 2537, 2.5 million and that you would otherwise have been at your target but for the PSC and other effects of 2650. You then subsequently said that you expect still to meet the target by the end of the year, was it, or could you just clarify? I didn’t quite understand what you were saying. Do you mean that you are going to still be at 2537 by the end of the year, or are you going to hit --
Steve J. Crowe: I’ll let Jim cover that.
Jim Aleveras: Paul, what we are saying is that we expect to meet or exceed the 2.65 that we talked about at $70 a barrel oil at our March meeting, but that’s adjusted for prices. Right now, we’re in a very volatile pricing environment so if prices stay above $70, we’ll come in below that but we’ll give you a reconciliation back to that that will explain the PSC effects that cause it.
Paul Sankey: But the point I was making was that you said that at the current level, effectively but for those effects, the 2.5 level but for those effects amount to the 2.6, if you like, which would then to me suggest that there’s no growth in the second half.
Jim Aleveras: No, we expect to meet or exceed, and I’ll put exceed in italics, if that helps, Paul.
Paul Sankey: Okay, I’ve got you, I think.
Steve J. Crowe: So what we’re saying again, for those on the phone, is we are reaffirming our production guidance earlier in the year that we’ll have net production of 2.65 at a $70 per barrel average price for the year. And Jim also mentioned that it still looks appropriate as you make those adjustments because of higher print prices, a two-to-one ration, such that for every dollar increase above the $70, you could anticipate roughly a 2,000 barrel a day reduction in net production.
Paul Sankey: Okay, if I could take my follow-up, you were very clear on Agbami. On Tengiz, you mentioned that you will be down in 3Q. Could you just give us the overall levels? You mentioned you’d be down I think 25,000 a day. Could you just give us the overall levels, even at the Kazakhstan level, that would be fine. And then if you could also just clarify the exit rate for ’08, because you said there the capacity I think is 240 a day. But if you could just clarify where you think you’ll be by the end of the year, that’s great. Thank you.
Jim Aleveras: Well, let’s take the first one first. Paul, we mentioned the 25,000 barrel a day reduction in the current quarter simply to alert people that as we tie in the facilities and we bring the second generation plan on stream, we will have to reduce production a little bit as we are tying everything back together.
Paul Sankey: And that will be down to what level, Jim?
Jim Aleveras: Right now, we’re running close to 400,000 barrels day on a gross 100% basis.
Paul Sankey: And that’s pre the 25, right?
Jim Aleveras: Yes, that’s correct. So there will be a slight reduction in overall production just as we tie everything together and get the plant up and running. In terms of the exit rate from 2008, going into 2009 it’s a little too early to tell yet. We certainly have achieved, as we promised, the 90,000 barrel a day improvement from the first phase of the project, the sour gas injection.
Steve J. Crowe: But it will be ramping up to the expected 540,000 barrels a day on a total project -- just don’t want to quote an exact number as we exit out 2008 and go into 2009.
Jim Aleveras: But we’re certainly going to expect a pretty prompt increase once we get out of the third quarter into the fourth quarter.
Steve J. Crowe: That’s correct. Thanks very much, Paul.
Operator: Our next question is from Paul Cheng of Lehman Brothers.
Paul Cheng: With Agbami coming on stream and also a number of projects, can you maybe share with us the kind of return and profitability on those new projects compared to your existing one? It looked like Agbami should be extremely profitable, so I’m wondering if you can shed some light.
Steve J. Crowe: Well, we typically wouldn’t talk about the economics of a specific project, which obviously get into a lot of the fiscal terms that we have in each of those operations, but Agbami will be a very profitable project for us. It will be returning cash to us on a prompt basis. As you know, it’s a light oil condensate project and ought to have a very handsome rate of return. Our expectation, sort of harkening back to an earlier question on ramp-up is that we probably will see as the wells come on production reaching 100,000 barrels a day in the early part of next year, and then as we mentioned before, moving up to the 250,000 barrels a day by the end of 2009. But I think a takeaway from that last chart that I showed in the prepared remarks is we’ve got a long and healthy list of projects, some of which have come on, some of which are right in the midst of being commissioned, and some are coming on and right on schedule for 2009. So I think our production, which of course net production will be influenced by prices and the way variable royalty mechanisms work and production sharing agreements, but these large projects are all lined up and as you can see, it’s quite a long list and probably will differentiate Chevron versus a lot of our competitors. I think it’s a major difference. We’ve been talking about it for a couple of years now, but they’re ready.
Paul Cheng: Steve, what’s your current production in Agbami at this point?
Steve J. Crowe: Well, Agbami started up literally on Tuesday of this week, as I recall, and so as the wells come on it will be ramping up. The last I saw, and it changes all the time, Paul, but the last I saw was a day or so ago and it was about 20,000 barrels a day. But it ramps up over time, so don’t put any specific number -- it’s a function of when the wells come on. But as I mentioned, as they do come on, we anticipate about 100,000 barrels a day in early 2009.
Paul Cheng: Can I ask a follow-up and maybe conceptual question about the timing effect losses in your downstream operation?
Steve J. Crowe: Sure.
Paul Cheng: I understand the price finalization impact related to long haul crude supply in Saudi Arabia and -- so that’s really no big deal on that. What I’m not quite sure I understand why we even use a derivative for -- let’s say if your own equity crude oil you sell, I think -- based on what you guys describe is that you use derivative to hedge whatever is the price during that journey, that shipping time, whether it’s 20 days or 40 days, given that no one really can foresee what is the price direction for the next 20, 40 days, so arguably you have 50% of the time you make money; 50% of the time, you lose money in that derivative trade. And given Chevron has no concern about liquidity or anything, why we even bother to do that?
Jim Aleveras: The reason we did that was to match the cost of crude that we purchased to the time that it’s run in the refinery to get the margins for the day.
Paul Cheng: But why do we even bother, Jim? That’s my question.
Jim Aleveras: Well --
Paul Cheng: I mean, over time, it makes no difference.
Jim Aleveras: But Paul, what we are trying to do there is just lock in a refining margin, which historically refining margins have fluctuated and we want to get refining margin of the day. As we have done this, especially in the second quarter during a period of very, very rapid price changes, we’ve seen that this added volatility to our earnings. That volatility is something that we don’t find acceptable and we have curtailed that program to a considerable extent in the second quarter. So going forward, you can expect to see much smaller effects from this.
Paul Cheng: Okay. Thank you.
Steve J. Crowe: Let me just reiterate a couple of points; in as much of the timing effects were significant in looking at our results, in light of our second quarter results, we’re looking at everything that impacts our downstream performance. But let me make it clear -- our strategy for the downstream business hasn’t changed. We are continuing to work on rationalizing our portfolio to eliminate less profitable assets and to reduce the capital employed in our marketing network, while maintaining our brand uplift. We are absolutely focused on refinery reliability and selective investments to improve refinery performance. But we are also looking at the tactical issues, as Jim mentioned, like the use of derivatives and other factors that sometimes add perhaps unnecessary volatility to our reported results. Thanks for your call and questions, Paul. May we have the next question?
Operator: Our next question is from Kate Lucas of J.P. Morgan.
Kate Lucas: Good morning, gentlemen. Can you just comment a little bit on how, on the progress of the steam flood technology that you are using or implementing in the neutral zone? Specifically, any challenges with the steam flood or the carbonate reservoir? And then, can you comment on whether you are able to source the natural gas and water without any issues?
Steve J. Crowe: Thanks, Kate. As you know, we are in a pilot project in the PNZ to see if the technology would be applicable to carbonate formation. As far as I’m aware, good progress is being made and as you’re also aware, we’re doing that early pilot in the partition neutral zone, which has its concession ending in the early part of 2009. This is a 60-year concession and we’re very optimistic that that concession will be extended but it’s too early at this point on the call to confirm it definitively. But all indications are from the pilot steam project that things are progressing as we had anticipated.
Operator: Our next question is from Erik Mielke of Merrill Lynch.
Erik Mielke: We’ve been through most of my questions; just a couple of quick follow-ups. In the discussion earlier with Neil on international operating costs during the second quarter, I recognize that there was an increase during the quarter but the rate of increase was perhaps less than we would have expected. Is that because of the volume mix effect or is it part of underlying cost improvements that you’ve previously discussed?
Jim Aleveras: It’s a combination of a number of things, Erik. If we look at our operating expense, what we are seeing is higher costs in a lot of areas, but we did have some work over costs in West Africa that affected the prior period that are not in the current period.
Steve J. Crowe: Hope that helps.
Erik Mielke: It does indeed. And then finally, just looking at politics and the fact that by the time we have the next call, we’ll be right in the middle of the elections, we’ve had an announcement today from one of the two candidates that they are considering windfall taxes to finance a so-called energy rebate. What are you hearing from your contacts in Washington when it comes to the outlook for taxation on U.S. oil companies? And if you have any comment on what the impact will be for the different proposals on CO2 cap and trade for your business.
Steve J. Crowe: Well, it’s again very early with respect to the measurement of the impact of the various CO2 proposals that have been floated around for the last year or so. As far as windfall profits tax is concerned, we have over the last year seen a number of proposals tabled, some were windfall profit tax, some were related to use of foreign tax credits, some were connected with the sustained usability of LIFO. At this juncture up to this point, those have all not passed muster but again, it depends on the nature and terms of any legislation that might be forthcoming in a new administration down the road, so it really much depends on the form of any additional taxation. Hard to speculate until you know all the details. Erik, do you have any other questions?
Erik Mielke: No, that’s it for me. Thank you.
Operator: Our next question is from Jason Gammel of Macquarie.
Jason Gammel: Thank you. Good morning, guys. I just wanted to ask a question about the timing of the Pascagoula coker turnaround. From an historic margin capture standpoint, the second quarter would seem to be counterintuitive for planning a two-month turnaround on a coker. Can you shed any light into that decision-making process?
Jim Aleveras: Let me take a swipe at that. The whole issue of bringing a coker down is a very, very complex issue that we’re very conscious the timing is important in terms of scheduling a turnaround because of the impact on margins. If we look at the light heavy differential as a key proxy for coker profitability we don’t find that it follows a consistent pattern between the first and second quarter. So in the 2003, 2005 period, light heavy differentials were actually higher in the first quarter than the second quarter. You just can’t change a major refinery turnaround once you see actual margins coming through the market on a weekly or a monthly basis. In Pascagoula, for example, the crude unit and coker shutdowns during the second quarter were very major undertakings involving thousands of temporary workers. And the Pascagoula coker had run five years since its last scheduled turnaround. We simply were not in the position to second-guess the market as the market evolved in 2008 to get the timing exactly where you would have liked to have gotten it in hindsight to capture the best margins.
Steve J. Crowe: I think I would add as well two other points, Jason; one, there was a lot of activity with respect to bringing back the other crude unit in the first quarter, so there really wasn’t an opportunity to accelerate it by a quarter or two if you had perceived a different light heavy differential in the short-term. But the other point that I would make is, as Jim had alluded to, almost all of our schedule maintenance here in the U.S. for 2008 is behind us, so we would expect to have increased refinery availability during the second half of the year.
Jason Gammel: Okay, that’s very helpful, guys. Maybe as a follow-up, I could ask about the decline in branded gasoline sales? It looks to be down about 5% year over year. Is that purely a demand function or are there some divestitures that played a role in that as well?
Jim Aleveras: It’s largely a demand function, Jason. What we are seeing is a higher amount of demand decrease in the U.S. West Coast than we are seeing in other parts of the country, and of course Chevron is disproportionately exposed to the U.S. West Coast. We’ve seen this in prior periods as well when California was disproportionately hit in the early 1990s as the defense contractors exited the state, and in the late 1990s as the dot.com bubble burst. In each case, we’ve seen California rebound. Right now, California is being disproportionately hit by the housing and credit crisis, and this has created what we feel is a negative consumer sentiment that’s causing people to do less discretionary driving. Long-term, we’re very bullish about California. We’ve seen California knocked down twice in the last decade. The exit of the defense contractors was a huge impact on California. The dot.com bubble was a huge impact on California, and California unemployment rates had run 1.5 times the national average. So there’s a lot of consumer sentiment going on here and we’re just in the midst of this for a short period of time. We don’t know what the future holds but in the past, California has wobbled around more than the country has but it’s always come back. So we’re optimistic about the future but for the moment, we are being disproportionately affected by our exposure to the U.S. West Coast.
Steve J. Crowe: Jason, just to close that off, we really don’t have any divestments that are impacting the lower branded gas sales. It’s all a function of industry market demand.
Jason Gammel: Very helpful. Thanks, guys.
Operator: Our next question is from [Wasim Khalil] of HSBC.
Wasim Khalil: I was just wondering if you could perhaps give us a little bit more information on the partition neutral -- I believe the lady earlier from J.P. Morgan was cut off and I was just wondering if you could just perhaps give us some more information on any updates that are going on regarding that.
Steve J. Crowe: Well, I really don’t have a lot of additional information to offer up. I had commented on the status and successful progress of our steam flood in the carbonate rock, and also had mentioned that we’ve been having ongoing discussions with the Kingdom for an extension of the concession agreement, which is progressing and against which we’re very optimistic that we’ll have a successful resolution. Beyond that, I really don’t have any additional information to provide to you on the call here today.
Wasim Khalil: Right, okay. I guess then if there’s no additional information, there’s no additional questions. Thank you very much.
Operator: Our next question is from Doug Leggate of Quandrum.
Doug Leggate: This is becoming a bit of a theme here -- on this partition neutral zone, I’m just curious; in the event that the concession is extended, can you give any kind of rough approximation as to what the period that you would expect it to be? Because I’m expecting you would be able to book the reserves here, right, if it gets extended?
Steve J. Crowe: If the concession is extended, we would be able to book reserves. As you know, under current accounting rules, we’re only able to book reserves to the extent that production would occur under the existing contract. As far as any of the commercial terms that are in the midst of being finalized and negotiated, I’m clearly not at liberty to discuss those now but your fundamental premise about being able to book reserves is correct, Doug.
Doug Leggate: I guess as a related follow-up, would this be as long as the original concession, or would there be much shorter -- just, you know, ballpark would be really useful.
Steve J. Crowe: Well, the existing concession was for 60 years and I am really not at liberty to talk about the terms of the successor, if it is concluded. We’ll give the investment community full detail, or as much detail as we can at the point of our announcement.
Doug Leggate: Great. Thanks, Steve.
Operator: (Operator Instructions)
Steve J. Crowe: Matt, it looks like we’ve gone through the lists of analysts who had questions for us. I think in closing, let me say how much I appreciate all of the analysts participation, particularly asking questions on behalf of all of those listening, and thank you very much. Matt, back to you.
Operator: Ladies and gentlemen, this concludes Chevron's second quarter 2008 earnings conference call. Thank you for participating. You may now disconnect. Good day. | [
{
"speaker": "Operator",
"text": "Good morning. My name is Matt and I will be your conference facilitator today. Welcome to Chevron's second quarter 2008 earnings conference call. (Operator Instructions) I will now turn the conference over to the Vice President and Chief Financial Officer of Chevron Corporation, Mr. Steve Crowe. Please go ahead, sir."
},
{
"speaker": "Steve J. Crowe",
"text": "Thanks, Matt. Welcome to Chevron's second quarter earnings conference call and webcast. Jim Aleveras, General Manager of Investor Relations, is on the call with me. Our focus today is on Chevron's financial and operating results for the second quarter of 2008. We will refer to the slides that are available on the web. Before we get started, please be reminded that this presentation contains estimates, projections, and other forward-looking statements. We ask that you review the cautionary statement on slide 2. I’ll begin with slide 3, which provides an overview of our financial performance. The company’s second quarter earnings were a record $6 billion, or $2.90 per diluted share. Our second quarter 2008 results were up 11% from the second quarter 2007. Higher crude oil prices benefited our upstream performance but had a negative impact on our downstream business. The second quarter of last year included a $500 million net gain on the sale of an investment and redemption of debt. Second quarter 2008 earnings rose over 15% compared with the first quarter of 2008, which Jim will discuss shortly. Return on capital employed for the trailing 12 months was 23%. The debt ratio was below 8% at the end of June. Capital and exploratory spending was $5.2 billion for the quarter. In addition to the $2 billion of stock buy-backs, we increased the second quarter dividend 12%. Jim will now take us through the quarterly comparisons. Jim."
},
{
"speaker": "Jim Aleveras",
"text": "Thanks, Steve. My remarks compare results of the second quarter 2008 with the first quarter 2008. As a reminder, our earnings release compared second quarter 2008 with the same quarter a year ago. Turning to slide 4, second quarter net income was $800 million higher than the first quarter. Starting with the left side of the chart, higher crude oil and natural gas realizations benefited the company’s worldwide upstream results. At the same time, the significant increase in crude oil prices adversely affected the downstream segment. The variance in the residual other bar primarily reflects higher charges at the corporate level for environmental remediation and tax adjustments. Slide 5 summarizes the results of our U.S. upstream operations, which improved by about $590 million between quarters. Higher crude oil and natural gas realizations benefited earnings by $775 million. Chevron's average U.S. crude oil realization was up about $24.30 per barrel between consecutive quarters. This was less than the nearly $26 increase in WTI’s spot prices between quarters, since much of our Gulf of Mexico crude oil production is priced on a lagged basis. Production volumes were down 2% between quarters, largely due to operational downtime and normal fuel declines. This reduced earnings by $30 million. Higher operating expenses reduced earnings by $70 million. Fuel, steam, and utility costs increased, as did maintenance expenses. The other bar is the net of everything else, including various gas marketing effects. Turning to slide 6, international upstream earnings for the second quarter were about $1.5 billion higher than the first quarter’s results. Higher oil and gas prices increased earnings by nearly $1.3 billion. Our average unit realization for liquids rose by $24.30 per barrel between sequential quarters, about the same as the average brent spot price increase. An increase in liftings contributed $130 million to the second quarter. Liftings were up primarily in Tengiz, the U.K., and China. Overall liftings were roughly in balance for the first half of the year after our under-lifted position in the first quarter. Operating expense reduced earnings by $90 million, mainly in the U.K., Kazakhstan and Indonesia. The other bar reflects the net of many unrelated items. The largest item was a favorable swing in foreign exchange effects. Among the offsetting items, exploration expense was higher in the second quarter. Slide 7 summarizes the change in worldwide oil equivalent production, including volumes produced from oil sands in Canada. Production fell by 62,000 barrels per day, or 2% between quarters. U.S. production declined 13,000 barrels per day due to operational down time and normal field declines that I mentioned. Outside the U.S., overall production dropped 49,000 barrels per day in the second quarter. However, we estimate that the impact of higher prices reduced production by about 75,000 barrels per day between sequential quarters. So absent price effects, volumes would have been up between quarters. I’ll elaborate on this in a moment. Indonesia production was impacted by prices but the largest effect was the absence of the one-time benefit of a favorable gas unitization agreement that we discussed on the conference call last quarter. While gross production at Tengiz continued to ramp up with our expansion project, both Tengiz and Karachaganak net volumes were affected by higher prices. Turning to our production outlook for 2008, total OEG production for the first six months of 2008 was 2.57 million barrels per day. During this period, WTI prices averaged just over $110 per barrel. Our production target for 2008, which assumed $70 per barrel WTI, was 2.65 million barrels per day. Absent the price effects under production sharing and variable royalty agreements, our production for the first half would have been on track with our full year production target of $2.65 million barrels per day. This production level reflected strong base business performance without significant contributions from several 2008 major project start-ups. Our project start-ups will increase production during the second half of the year and, adjusting for price effects, we expect to meet or exceed our volume target for the year. Steve will provide a brief update on our major projects at the end of our presentation. We reviewed our rule of thumb as prices have moved far above $70 per barrel, and we believe the rule of thumb is still applicable at the current price level. That is to say, a $1 per barrel increase in prices leads to about a 2,000 barrel per day reduction in our net production volumes for the year. However, I would like to reemphasize the caveats we’ve given you about this rule of thumb. The calculation of price impacts includes many variables, including the interaction of prices and costs, very specific contract thresholds and terms and so forth. The rule of thumb is our best estimate of the impact for 2008, but results will vary when making comparisons between periods. For example, because certain thresholds were met in the second quarter, the rule of thumb does not work when comparing the first and second quarters of 2008. Each dollar change in price had an impact of over 3,000 barrels per day in this particular comparison. We’ll continue to update you as we move through this very volatile environment. Turning to slide 8, our U.S. downstream operations moved from break even to a loss of about $680 million in the second quarter. Industry refining margins improved in the second quarter, although marketing indicator margins weakened, particularly on the west coast. On balance, indicator margins suggest a $305 million benefit. WTI prices rose more than $38 per barrel from the end of the first quarter to the end of the second quarter. This compares to an increase of less than $6 per barrel during the first quarter. This truly extraordinary crude price spike in the second quarter reduced the U.S. downstream earnings by $490 million between quarters. The $490 million is shown on the bar labeled timing effects. Of the $490 million, about $280 million reflected the impact of provisionally priced foreign crude. This crude is priced on a delivered basis, although we take title to it when it is lifted. We typically have about 13 million to 15 million barrels of provisionally priced crude in transit to the U.S. west coast. These barrels are effectively marked to market at the end of each period. A second timing effect accounted for $110 million of the $490 million change between quarters. We used derivatives to convert crudes, including crudes that are not provisionally priced, from the acquisition price to the price at the time they are run. As prices went up dramatically during the second quarter, this resulted in derivative losses. The balance of timing effects between quarters reflected a number of supply related activities, including mark-to-market losses on derivatives related to a long-term contract. Moving to the next bar, we had an unfavorable variance of $300 million between quarters, due to refinery shut-down effects. Almost all of these were planned shutdowns and we previously cautioned that 2008 would be a heavy planned shutdown period for us. The adverse $300 million variance reflects both the direct operating expense and the lost margin capture as we purchased more expensive feed stocks and intermediates during the refinery shutdowns. Most of the difference between quarters was due to our Pascagoula refinery, where both the number one crude unit and coker were down during the second quarter. Planned shutdowns at El Segundo and [Hawaii] were much smaller factors. Our 2008 maintenance schedule indicates that essentially all of our major U.S. planned shutdowns were completed in the first half of 2008. Excluding the operating expense related to refinery shutdowns, other OpEx was $145 million higher in the second quarter. Many factors were involved here, including higher fuel costs. The other bar on the chart is an unfavorable variance of $56 million, which primarily reflects minor pipeline impairments. Turning to slide 9, international downstream earnings fell $300 million from the first quarter’s results. Refining indicator margins improved while marketing margins were mixed across our international geographic areas. On balance, company margins were a $185 million benefit between quarters. Volumetric effects were a $25 million adverse variance. This primarily reflected the unplanned shutdowns at the Pembroke refinery in Wales. We estimate the overall impact of all international refinery downtime between quarters to be an unfavorable variance of $32 million, which reflects OpEx as well as volume and feedstock impacts. As we saw in the United States, international downstream timing effects were a major factor in the adverse change between quarters, as the price of crude and petroleum products increased very significantly over the course of the second quarter. Two-thirds of the $225 million shown as timing effects was related to long haul sales of equity crude and refined products. For select cargos, we often use derivatives to lock in a margin above the cost of transportation. During periods of rapidly increasing prices, this can lead to derivative losses. The majority of this timing effect is related to delivered sales of partition neutral zone equity crude and exports of refined products from our Pembroke refinery to third parties. The balance of the timing effect is primarily due to losses on derivatives used to convert crude pricing to the time of refinery run. There was also a factor involved here regarding the changes in inventory. The next bar shows operating expense was a $140 million unfavorable variance between quarters. A number of different items affected the various geographic regions. There was not a pattern to the components of the $140 million change. The other bar shows a $95 million reduction between quarters, and this primarily reflects lower foreign exchange gains, as well as an adverse swing in tax items. Slide 10 shows that earnings from chemical operations were $41 million in the second quarter, compared with $43 million in the first quarter. Results for olefins fell on lower margins and volumes, as well as higher expense. Aromatics results were also affected by lower volumes and higher operating expenses. Additionally, shutdown activity reduce aromatics results. The other bar on this chart shows a favorable $26 million variance between quarters. This reflects the absence of a $40 million environmental provision we mentioned on last quarter’s conference call, partly offset by lower additive margins. Turning to slide 11, which covers all other, second quarter results were net charges of $580 million compared to net charges of $255 million in the first quarter. The $210 million variance reflects environmental provisions related to legacy Texaco and Unocal downstream assets. Since these assets were sold prior to Chevron acquiring their parent companies, the impact was included here rather than in the downstream segment. Tax items were an $80 million unfavorable variance. The other bar reflects the net of many unrelated items. Before I turn things back over to Steve, I would just like to briefly recap the second quarter’s results. First, upstream results were very strong, in line with the indicators in our July 10th interim update. Second, we experienced a sharp decline in downstream performance due to timing effects and refinery downtime, as we discussed in the interim update. Finally, as we projected, chemical results were flat between sequential quarters and our all other charges were significantly higher than the standard guidance range due to environmental remediation charges. That completes my variance analysis for the quarter. Back over to you, Steve."
},
{
"speaker": "Steve J. Crowe",
"text": "Thanks, Jim. Before opening the call to questions, I would like to highlight the significant progress we’ve made on some of our major capital projects. Please turn to slide 12. First up is our Agbami project, offshore Nigeria. Yesterday, we announced that Agbami had begun production. Chevron is the operator with a 68% interest in this world class deepwater project. Agbami’s initial gross OEG production is expected to quickly ramp up to more than 100,000 barrels per day. We anticipate this reach 250,000 barrels per day by the end of 2009. In the U.K., our partner recently announced first production for the Callanish-Brodgar fields, also known as the Brittania satellite development. At the Tengiz field in Kazakhstan, our phased expansion remains on schedule for full facility start-up this quarter. The first phase, which began late last year, added nearly 90,000 barrels per day of total production during the second quarter. The second phase of production is now complete and we’re doing the major turnaround, final tie-ins, and commissioning. As a result, there will be a brief drop in production of about 25,000 barrels a day in the third quarter. With full facility start-up, we anticipate the project will add 240,000 barrels a day of production, increasing Tengiz’s total capacity from 300,000 to 540,000 barrels per day. In the Gulf of Mexico, we completed our plan to retrofit and tension all eight mooring lines on our Blind Faith facility. We are continuing with commissioning work, having installed all four of the risers. We expect start-up later this year. It’s difficult to be more specific about the timing as weather could impact our commissioning efforts. In Australia, the Northwest Shelf fifth train, fifth LNG train is in the midst of commissioning with an anticipated first cargo in the fourth quarter. In Brazil, our Frade project is on track for a 2009 start-up. At our Tahiti facility in the Gulf of Mexico, the production spar has been moored, the installation of sub-sea flow lines and risers is nearly complete, and the first of three major topside modules was installed last week. We expect to install the other two topside modules this quarter. The Tahiti project remains on schedule for first production in the third quarter 2009. In Angola, our Tombua Landana project is also on schedule for first production next year. In summary, our major projects are on track to deliver significant new volumes. That concludes our prepared remarks. We’ll now take you questions. One question and one follow-up per caller, please. Matt, would you open up the lines for questions?"
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Our first question is from Arjun Murti of Goldman Sachs."
},
{
"speaker": "Arjun Murti",
"text": "Thank you. Thanks for the project update. I was wondering if you could provide a similar update on some of your exploration plans, I guess in particular the status of some of the key lower tertiary projects, Jack in particular, St. Malo. If you could provide an update on exploration in general but most notably the lower tertiary, that would be helpful. Thank you."
},
{
"speaker": "Steve J. Crowe",
"text": "Well, we’re looking at Jack and St. Malo presently. We have another well that will be completed later in the year. We’re giving consideration as to whether or not we can tie back those two projects, Jack and St. Malo, one of which came from Unocal and one of which is a legacy Chevron one, and consider developing the two of them in tandem. We’ll have more to say about the progress of the lower tertiary as we get a little deeper in the year and can probably give you a more definitive update on our next conference call. Arjun, did you have a follow-up question?"
},
{
"speaker": "Arjun Murti",
"text": "Are those expected to be sanctioned this year, and does the fact that you are considering a joint development speak to any disappointment or update in terms of the resource potential of either or both together?"
},
{
"speaker": "Steve J. Crowe",
"text": "I think the consideration of joining those two projects together really speaks to the opportunity to reduce costs in the current environment and produce them in tandem as a more efficient way of developing the resource."
},
{
"speaker": "Arjun Murti",
"text": "It’s an efficiency consideration?"
},
{
"speaker": "Steve J. Crowe",
"text": "Primarily."
},
{
"speaker": "Arjun Murti",
"text": "And I’m sorry, do you think we’ll be expecting a sanction decision this year or is that an ’09 or later kind of a thing?"
},
{
"speaker": "Steve J. Crowe",
"text": "That will be outside of 2008."
},
{
"speaker": "Arjun Murti",
"text": "Thank you very much."
},
{
"speaker": "Operator",
"text": "Our next question is from Neil McMahon of Sanford Bernstein."
},
{
"speaker": "Neil McMahon",
"text": "Just really on some of the numbers in today’s call that Jim ran through on the variance analysis; looking at the OpEx reduction both in the U.S. but more importantly in international, which is a bit strange, given higher royalties and an inflation environment. I was wondering to what extent -- well, first of all really why that OpEx reduction took place from the first quarter to second quarter, and in particular related to what’s going on in Kazakhstan with some of your partners in the Karachaganak field seeing increased charges associated with changes in the fiscal terms in that country."
},
{
"speaker": "Steve J. Crowe",
"text": "Well, let me give a first correction, I think, Neil. As Jim was going through the variance analyses say on the U.S. upstream, we indicated on our, on slide five that operating expense was higher in the second quarter in comparison to the first quarter by about $70 million after tax, mainly reflecting, as you would expect, higher fuel costs and utility costs, along with higher maintenance. So actually the costs were higher in the second than in the first quarter."
},
{
"speaker": "Jim Aleveras",
"text": "Neil, with regard to the international upstream, you will see OpEx down a little bit but the biggest factor there was simply a number of different things in our various U.K., Kazakhstan, and Indonesia operations."
},
{
"speaker": "Neil McMahon",
"text": "I’m just sort of struggling why it’s dropped, given the fact that BG on their conference call were talking about the fact that under duress, or -- maybe that wasn’t the word they used but they were paying new taxes associated with the fiscal change in Kazakhstan. That’s all. It seems strange that you have gone down whereas they went up."
},
{
"speaker": "Jim Aleveras",
"text": "Neil, perhaps it’s a semantic issue here. When we’re showing OpEx as a negative, what we’re saying is it’s a negative to P&L. We start with our income from the first quarter and we end with our income in the second quarter, so when OpEx is a negative, what it means is it’s a detraction from our earnings in the second quarter."
},
{
"speaker": "Neil McMahon",
"text": "Right, I understand that but you did say that it went down. That’s all."
},
{
"speaker": "Jim Aleveras",
"text": "No, we said OpEx was a negative. If you look at the international upstream chart, it’s a negative $90 million to earnings, so that’s OpEx actually going up. It’s reducing earnings by $90 million."
},
{
"speaker": "Neil McMahon",
"text": "Okay, I thought you said a few minutes ago that things got better in Kazakhstan, but that’s fine. Maybe as a follow-up then, just on the environmental charge under corporate, maybe you could just walk through that, since you did say you had disposed of those assets, or maybe my hearing has completely gone."
},
{
"speaker": "Steve J. Crowe",
"text": "Well, as we had foreshadowed in the interim update on July 10th, certain of the environment provisions or obligations that we have that are connected with legacy operations of Texaco or Unocal, we still are obliged per certain of the contractual arrangements to effect the environment clean-up or remediation. It so happened that here in the second quarter, for primarily the Unocal but also Texaco operations that are no longer operating, they’ve been disposed of, certain events have occurred where we thought it was appropriate for the accounting rules to recognize the increased liability. So that was the fundamental driver for that increase of $210 million between the first and second quarters of this year."
},
{
"speaker": "Neil McMahon",
"text": "Steve, can you tell us where they are or what the chances are that this sort of thing is going to happen again on some of those assets?"
},
{
"speaker": "Steve J. Crowe",
"text": "Well, there were a variety of things, some of which were marketing related. Operations that Unocal had that have since been sold twice. Some of them are connected with refinery and terminal locations, both legacy -- primarily legacy Texaco. And those things occur driven by events, but you will have noticed I think over the last year or so that our recognition of environment expenses, whether it be for currently owned and operated operations or those previously disposed of are a bit more -- occur more regularly during the course of the year. But it’s very hard to give you a prediction as to what the ratable pace would be because it’s driven by events and they tend to come based on the situation."
},
{
"speaker": "Neil McMahon",
"text": "Okay, thanks."
},
{
"speaker": "Operator",
"text": "Our next question is from Paul Sankey of Deutsche Bank."
},
{
"speaker": "Paul Sankey",
"text": "Good morning, gentlemen. I got a little bit confused regarding your overall statements about volumes for the year. You said you at 2537, 2.5 million and that you would otherwise have been at your target but for the PSC and other effects of 2650. You then subsequently said that you expect still to meet the target by the end of the year, was it, or could you just clarify? I didn’t quite understand what you were saying. Do you mean that you are going to still be at 2537 by the end of the year, or are you going to hit --"
},
{
"speaker": "Steve J. Crowe",
"text": "I’ll let Jim cover that."
},
{
"speaker": "Jim Aleveras",
"text": "Paul, what we are saying is that we expect to meet or exceed the 2.65 that we talked about at $70 a barrel oil at our March meeting, but that’s adjusted for prices. Right now, we’re in a very volatile pricing environment so if prices stay above $70, we’ll come in below that but we’ll give you a reconciliation back to that that will explain the PSC effects that cause it."
},
{
"speaker": "Paul Sankey",
"text": "But the point I was making was that you said that at the current level, effectively but for those effects, the 2.5 level but for those effects amount to the 2.6, if you like, which would then to me suggest that there’s no growth in the second half."
},
{
"speaker": "Jim Aleveras",
"text": "No, we expect to meet or exceed, and I’ll put exceed in italics, if that helps, Paul."
},
{
"speaker": "Paul Sankey",
"text": "Okay, I’ve got you, I think."
},
{
"speaker": "Steve J. Crowe",
"text": "So what we’re saying again, for those on the phone, is we are reaffirming our production guidance earlier in the year that we’ll have net production of 2.65 at a $70 per barrel average price for the year. And Jim also mentioned that it still looks appropriate as you make those adjustments because of higher print prices, a two-to-one ration, such that for every dollar increase above the $70, you could anticipate roughly a 2,000 barrel a day reduction in net production."
},
{
"speaker": "Paul Sankey",
"text": "Okay, if I could take my follow-up, you were very clear on Agbami. On Tengiz, you mentioned that you will be down in 3Q. Could you just give us the overall levels? You mentioned you’d be down I think 25,000 a day. Could you just give us the overall levels, even at the Kazakhstan level, that would be fine. And then if you could also just clarify the exit rate for ’08, because you said there the capacity I think is 240 a day. But if you could just clarify where you think you’ll be by the end of the year, that’s great. Thank you."
},
{
"speaker": "Jim Aleveras",
"text": "Well, let’s take the first one first. Paul, we mentioned the 25,000 barrel a day reduction in the current quarter simply to alert people that as we tie in the facilities and we bring the second generation plan on stream, we will have to reduce production a little bit as we are tying everything back together."
},
{
"speaker": "Paul Sankey",
"text": "And that will be down to what level, Jim?"
},
{
"speaker": "Jim Aleveras",
"text": "Right now, we’re running close to 400,000 barrels day on a gross 100% basis."
},
{
"speaker": "Paul Sankey",
"text": "And that’s pre the 25, right?"
},
{
"speaker": "Jim Aleveras",
"text": "Yes, that’s correct. So there will be a slight reduction in overall production just as we tie everything together and get the plant up and running. In terms of the exit rate from 2008, going into 2009 it’s a little too early to tell yet. We certainly have achieved, as we promised, the 90,000 barrel a day improvement from the first phase of the project, the sour gas injection."
},
{
"speaker": "Steve J. Crowe",
"text": "But it will be ramping up to the expected 540,000 barrels a day on a total project -- just don’t want to quote an exact number as we exit out 2008 and go into 2009."
},
{
"speaker": "Jim Aleveras",
"text": "But we’re certainly going to expect a pretty prompt increase once we get out of the third quarter into the fourth quarter."
},
{
"speaker": "Steve J. Crowe",
"text": "That’s correct. Thanks very much, Paul."
},
{
"speaker": "Operator",
"text": "Our next question is from Paul Cheng of Lehman Brothers."
},
{
"speaker": "Paul Cheng",
"text": "With Agbami coming on stream and also a number of projects, can you maybe share with us the kind of return and profitability on those new projects compared to your existing one? It looked like Agbami should be extremely profitable, so I’m wondering if you can shed some light."
},
{
"speaker": "Steve J. Crowe",
"text": "Well, we typically wouldn’t talk about the economics of a specific project, which obviously get into a lot of the fiscal terms that we have in each of those operations, but Agbami will be a very profitable project for us. It will be returning cash to us on a prompt basis. As you know, it’s a light oil condensate project and ought to have a very handsome rate of return. Our expectation, sort of harkening back to an earlier question on ramp-up is that we probably will see as the wells come on production reaching 100,000 barrels a day in the early part of next year, and then as we mentioned before, moving up to the 250,000 barrels a day by the end of 2009. But I think a takeaway from that last chart that I showed in the prepared remarks is we’ve got a long and healthy list of projects, some of which have come on, some of which are right in the midst of being commissioned, and some are coming on and right on schedule for 2009. So I think our production, which of course net production will be influenced by prices and the way variable royalty mechanisms work and production sharing agreements, but these large projects are all lined up and as you can see, it’s quite a long list and probably will differentiate Chevron versus a lot of our competitors. I think it’s a major difference. We’ve been talking about it for a couple of years now, but they’re ready."
},
{
"speaker": "Paul Cheng",
"text": "Steve, what’s your current production in Agbami at this point?"
},
{
"speaker": "Steve J. Crowe",
"text": "Well, Agbami started up literally on Tuesday of this week, as I recall, and so as the wells come on it will be ramping up. The last I saw, and it changes all the time, Paul, but the last I saw was a day or so ago and it was about 20,000 barrels a day. But it ramps up over time, so don’t put any specific number -- it’s a function of when the wells come on. But as I mentioned, as they do come on, we anticipate about 100,000 barrels a day in early 2009."
},
{
"speaker": "Paul Cheng",
"text": "Can I ask a follow-up and maybe conceptual question about the timing effect losses in your downstream operation?"
},
{
"speaker": "Steve J. Crowe",
"text": "Sure."
},
{
"speaker": "Paul Cheng",
"text": "I understand the price finalization impact related to long haul crude supply in Saudi Arabia and -- so that’s really no big deal on that. What I’m not quite sure I understand why we even use a derivative for -- let’s say if your own equity crude oil you sell, I think -- based on what you guys describe is that you use derivative to hedge whatever is the price during that journey, that shipping time, whether it’s 20 days or 40 days, given that no one really can foresee what is the price direction for the next 20, 40 days, so arguably you have 50% of the time you make money; 50% of the time, you lose money in that derivative trade. And given Chevron has no concern about liquidity or anything, why we even bother to do that?"
},
{
"speaker": "Jim Aleveras",
"text": "The reason we did that was to match the cost of crude that we purchased to the time that it’s run in the refinery to get the margins for the day."
},
{
"speaker": "Paul Cheng",
"text": "But why do we even bother, Jim? That’s my question."
},
{
"speaker": "Jim Aleveras",
"text": "Well --"
},
{
"speaker": "Paul Cheng",
"text": "I mean, over time, it makes no difference."
},
{
"speaker": "Jim Aleveras",
"text": "But Paul, what we are trying to do there is just lock in a refining margin, which historically refining margins have fluctuated and we want to get refining margin of the day. As we have done this, especially in the second quarter during a period of very, very rapid price changes, we’ve seen that this added volatility to our earnings. That volatility is something that we don’t find acceptable and we have curtailed that program to a considerable extent in the second quarter. So going forward, you can expect to see much smaller effects from this."
},
{
"speaker": "Paul Cheng",
"text": "Okay. Thank you."
},
{
"speaker": "Steve J. Crowe",
"text": "Let me just reiterate a couple of points; in as much of the timing effects were significant in looking at our results, in light of our second quarter results, we’re looking at everything that impacts our downstream performance. But let me make it clear -- our strategy for the downstream business hasn’t changed. We are continuing to work on rationalizing our portfolio to eliminate less profitable assets and to reduce the capital employed in our marketing network, while maintaining our brand uplift. We are absolutely focused on refinery reliability and selective investments to improve refinery performance. But we are also looking at the tactical issues, as Jim mentioned, like the use of derivatives and other factors that sometimes add perhaps unnecessary volatility to our reported results. Thanks for your call and questions, Paul. May we have the next question?"
},
{
"speaker": "Operator",
"text": "Our next question is from Kate Lucas of J.P. Morgan."
},
{
"speaker": "Kate Lucas",
"text": "Good morning, gentlemen. Can you just comment a little bit on how, on the progress of the steam flood technology that you are using or implementing in the neutral zone? Specifically, any challenges with the steam flood or the carbonate reservoir? And then, can you comment on whether you are able to source the natural gas and water without any issues?"
},
{
"speaker": "Steve J. Crowe",
"text": "Thanks, Kate. As you know, we are in a pilot project in the PNZ to see if the technology would be applicable to carbonate formation. As far as I’m aware, good progress is being made and as you’re also aware, we’re doing that early pilot in the partition neutral zone, which has its concession ending in the early part of 2009. This is a 60-year concession and we’re very optimistic that that concession will be extended but it’s too early at this point on the call to confirm it definitively. But all indications are from the pilot steam project that things are progressing as we had anticipated."
},
{
"speaker": "Operator",
"text": "Our next question is from Erik Mielke of Merrill Lynch."
},
{
"speaker": "Erik Mielke",
"text": "We’ve been through most of my questions; just a couple of quick follow-ups. In the discussion earlier with Neil on international operating costs during the second quarter, I recognize that there was an increase during the quarter but the rate of increase was perhaps less than we would have expected. Is that because of the volume mix effect or is it part of underlying cost improvements that you’ve previously discussed?"
},
{
"speaker": "Jim Aleveras",
"text": "It’s a combination of a number of things, Erik. If we look at our operating expense, what we are seeing is higher costs in a lot of areas, but we did have some work over costs in West Africa that affected the prior period that are not in the current period."
},
{
"speaker": "Steve J. Crowe",
"text": "Hope that helps."
},
{
"speaker": "Erik Mielke",
"text": "It does indeed. And then finally, just looking at politics and the fact that by the time we have the next call, we’ll be right in the middle of the elections, we’ve had an announcement today from one of the two candidates that they are considering windfall taxes to finance a so-called energy rebate. What are you hearing from your contacts in Washington when it comes to the outlook for taxation on U.S. oil companies? And if you have any comment on what the impact will be for the different proposals on CO2 cap and trade for your business."
},
{
"speaker": "Steve J. Crowe",
"text": "Well, it’s again very early with respect to the measurement of the impact of the various CO2 proposals that have been floated around for the last year or so. As far as windfall profits tax is concerned, we have over the last year seen a number of proposals tabled, some were windfall profit tax, some were related to use of foreign tax credits, some were connected with the sustained usability of LIFO. At this juncture up to this point, those have all not passed muster but again, it depends on the nature and terms of any legislation that might be forthcoming in a new administration down the road, so it really much depends on the form of any additional taxation. Hard to speculate until you know all the details. Erik, do you have any other questions?"
},
{
"speaker": "Erik Mielke",
"text": "No, that’s it for me. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question is from Jason Gammel of Macquarie."
},
{
"speaker": "Jason Gammel",
"text": "Thank you. Good morning, guys. I just wanted to ask a question about the timing of the Pascagoula coker turnaround. From an historic margin capture standpoint, the second quarter would seem to be counterintuitive for planning a two-month turnaround on a coker. Can you shed any light into that decision-making process?"
},
{
"speaker": "Jim Aleveras",
"text": "Let me take a swipe at that. The whole issue of bringing a coker down is a very, very complex issue that we’re very conscious the timing is important in terms of scheduling a turnaround because of the impact on margins. If we look at the light heavy differential as a key proxy for coker profitability we don’t find that it follows a consistent pattern between the first and second quarter. So in the 2003, 2005 period, light heavy differentials were actually higher in the first quarter than the second quarter. You just can’t change a major refinery turnaround once you see actual margins coming through the market on a weekly or a monthly basis. In Pascagoula, for example, the crude unit and coker shutdowns during the second quarter were very major undertakings involving thousands of temporary workers. And the Pascagoula coker had run five years since its last scheduled turnaround. We simply were not in the position to second-guess the market as the market evolved in 2008 to get the timing exactly where you would have liked to have gotten it in hindsight to capture the best margins."
},
{
"speaker": "Steve J. Crowe",
"text": "I think I would add as well two other points, Jason; one, there was a lot of activity with respect to bringing back the other crude unit in the first quarter, so there really wasn’t an opportunity to accelerate it by a quarter or two if you had perceived a different light heavy differential in the short-term. But the other point that I would make is, as Jim had alluded to, almost all of our schedule maintenance here in the U.S. for 2008 is behind us, so we would expect to have increased refinery availability during the second half of the year."
},
{
"speaker": "Jason Gammel",
"text": "Okay, that’s very helpful, guys. Maybe as a follow-up, I could ask about the decline in branded gasoline sales? It looks to be down about 5% year over year. Is that purely a demand function or are there some divestitures that played a role in that as well?"
},
{
"speaker": "Jim Aleveras",
"text": "It’s largely a demand function, Jason. What we are seeing is a higher amount of demand decrease in the U.S. West Coast than we are seeing in other parts of the country, and of course Chevron is disproportionately exposed to the U.S. West Coast. We’ve seen this in prior periods as well when California was disproportionately hit in the early 1990s as the defense contractors exited the state, and in the late 1990s as the dot.com bubble burst. In each case, we’ve seen California rebound. Right now, California is being disproportionately hit by the housing and credit crisis, and this has created what we feel is a negative consumer sentiment that’s causing people to do less discretionary driving. Long-term, we’re very bullish about California. We’ve seen California knocked down twice in the last decade. The exit of the defense contractors was a huge impact on California. The dot.com bubble was a huge impact on California, and California unemployment rates had run 1.5 times the national average. So there’s a lot of consumer sentiment going on here and we’re just in the midst of this for a short period of time. We don’t know what the future holds but in the past, California has wobbled around more than the country has but it’s always come back. So we’re optimistic about the future but for the moment, we are being disproportionately affected by our exposure to the U.S. West Coast."
},
{
"speaker": "Steve J. Crowe",
"text": "Jason, just to close that off, we really don’t have any divestments that are impacting the lower branded gas sales. It’s all a function of industry market demand."
},
{
"speaker": "Jason Gammel",
"text": "Very helpful. Thanks, guys."
},
{
"speaker": "Operator",
"text": "Our next question is from [Wasim Khalil] of HSBC."
},
{
"speaker": "Wasim Khalil",
"text": "I was just wondering if you could perhaps give us a little bit more information on the partition neutral -- I believe the lady earlier from J.P. Morgan was cut off and I was just wondering if you could just perhaps give us some more information on any updates that are going on regarding that."
},
{
"speaker": "Steve J. Crowe",
"text": "Well, I really don’t have a lot of additional information to offer up. I had commented on the status and successful progress of our steam flood in the carbonate rock, and also had mentioned that we’ve been having ongoing discussions with the Kingdom for an extension of the concession agreement, which is progressing and against which we’re very optimistic that we’ll have a successful resolution. Beyond that, I really don’t have any additional information to provide to you on the call here today."
},
{
"speaker": "Wasim Khalil",
"text": "Right, okay. I guess then if there’s no additional information, there’s no additional questions. Thank you very much."
},
{
"speaker": "Operator",
"text": "Our next question is from Doug Leggate of Quandrum."
},
{
"speaker": "Doug Leggate",
"text": "This is becoming a bit of a theme here -- on this partition neutral zone, I’m just curious; in the event that the concession is extended, can you give any kind of rough approximation as to what the period that you would expect it to be? Because I’m expecting you would be able to book the reserves here, right, if it gets extended?"
},
{
"speaker": "Steve J. Crowe",
"text": "If the concession is extended, we would be able to book reserves. As you know, under current accounting rules, we’re only able to book reserves to the extent that production would occur under the existing contract. As far as any of the commercial terms that are in the midst of being finalized and negotiated, I’m clearly not at liberty to discuss those now but your fundamental premise about being able to book reserves is correct, Doug."
},
{
"speaker": "Doug Leggate",
"text": "I guess as a related follow-up, would this be as long as the original concession, or would there be much shorter -- just, you know, ballpark would be really useful."
},
{
"speaker": "Steve J. Crowe",
"text": "Well, the existing concession was for 60 years and I am really not at liberty to talk about the terms of the successor, if it is concluded. We’ll give the investment community full detail, or as much detail as we can at the point of our announcement."
},
{
"speaker": "Doug Leggate",
"text": "Great. Thanks, Steve."
},
{
"speaker": "Operator",
"text": "(Operator Instructions)"
},
{
"speaker": "Steve J. Crowe",
"text": "Matt, it looks like we’ve gone through the lists of analysts who had questions for us. I think in closing, let me say how much I appreciate all of the analysts participation, particularly asking questions on behalf of all of those listening, and thank you very much. Matt, back to you."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes Chevron's second quarter 2008 earnings conference call. Thank you for participating. You may now disconnect. Good day."
}
] | null | null |
CVX | 1 | 2,008 | 2008-05-02 10:00:00 | Operator: Good morning. My name is Matt and I will be your conference facilitator today. Welcome to Chevron's first quarter 2008 earnings conference call. (Operator Instructions) I will now turn the conference over to the Vice President and Chief Financial Officer of Chevron Corporation, Mr. Steve Crowe. Please go ahead, sir.
Steve J. Crowe: Thanks, Matt. Welcome to Chevron's first quarter earnings conference call and webcast. Jim Aleveras, General Manager of Investor Relations is on the call with me today. Our focus is on Chevron's financial and operating results for the first quarter of 2008. We will refer to the slides that are available on the web. Before we get started, please be reminded that this presentation contains estimates, projections, and other forward-looking statements. We ask that you review the cautionary statement on slide 2. I’ll begin with slide 3, which provides an overview of our financial performance. The company’s first quarter earnings were $5.2 billion, or $2.48 per diluted share. Our first quarter 2008 earnings were up nearly 10% from the first quarter 2007, reflecting higher crude oil and natural gas prices, which more than offset weaker downstream results. The first quarter of last year included a $700 million gain on the sale of our interest in a refinery in The Netherlands. First quarter 2008 earnings rose 6% compared to the fourth quarter 2007, which Jim will discuss shortly. Return on capital employed for the trailing 12 months was 23%. The debt ratio was about 8% at the end of the quarter. As we announced Wednesday, we increased our quarterly dividend by $0.07 per share, or 12.1%. This marks the fourth consecutive year we’ve raised the second quarter dividend by a double-digit amount. Stock buy-backs were $2 billion in the quarter. Jim will now take us through the quarterly comparisons. Jim.
Jim Aleveras: Thanks, Steve. My remarks compare results of the first quarter 2008 with the fourth quarter 2007. As a reminder, our earnings release compared the first quarter 2008 with the same quarter a year ago. Turning to slide 4, first quarter net income was almost $300 million higher than the fourth quarter. Starting with the left side of the chart, higher crude oil and natural gas realizations benefited the company’s worldwide upstream results. Partly offsetting this was the impact of lower upstream volumes. The largest component here was international liftings. Liftings were lower than production in the first quarter. Downstream results were up slightly from the fourth quarter, reflecting improved refinery operations in the United States. The variance in the residual other bar is the net of everything else. Slide 5 summarizes the results of our U.S. upstream operations, which improved by about $220 million between quarters. Higher crude oil and natural gas realizations benefited earnings by $335 million. Chevron's average U.S. crude oil realization was up about $8 per barrel between consecutive quarters. This is more than the $7.25 per barrel increase in WTI’s spot prices, since much of our Gulf of Mexico crude oil production is priced on a lagged basis. Production volumes were down 2% between quarters, largely due to operational and weather related downtime, as well as normal fuel declines. This impact reduced earnings by $85 million. The $85 million DD&A reflects higher rates and higher accretion charges for abandonment. Exploration expense fell $90 million between periods. The primary factor was lower well write-offs in the first quarter. The other bar reflects miscellaneous gas marketing and income tax items. Let’s turn to slide 6. International upstream earnings for the first quarter were about $70 million higher than the fourth quarter’s results. Higher oil and gas prices increased earnings by $370 million. Our unit realization for liquids rose by $5.70 per barrel, significantly less than the $9.30 per barrel increase in brent spot prices. Comparing average prices for the first and fourth quarters, we found that worldwide benchmark crudes did not move consistently. For example, Malaysia’s light sweet tapas crude was up $3.20 per barrel between quarter and Sumatra Light rose $7.70 per barrel. WTI’s spot prices increased $7.25 per barrel, $2 less than the change in brent. Our realizations therefore reflected geographic market prices which were not in line with brent movements during this particular comparison period. Lower first quarter liftings, particularly in Azerbaijan, the U.K., Nigeria, and Australia, reduced earnings by $195 million. As I noted earlier, we were under-lifted in the first quarter, an issue we referenced in the interim update. Partially offsetting this under-lift is a one-time benefit from the retroactive effect of the unitization agreement in Indonesia we also mentioned in the interim update. Tax items reduced earnings by $230 million between quarters. These were spread among several countries and included the absence of favorable fourth quarter items we discussed on our last conference call. Operating expense was down $130 million from the fourth quarter due to lower seasonal activity levels in several international areas. The other bar reflects the net of many unrelated items. The largest components were adverse foreign exchange effects, offset by lower exploration expense. Slide 7 summarizes the change in worldwide oil equivalent production, including volumes produced from oil sands in Canada. Production fell by 14,000 barrels per day, or about half of 1% between consecutive quarters. United States production fell 15,000 barrels per day, about 2% due to operational down time and normal field declines. Outside the United States, overall production was flat between quarters. Kazakhstan benefited from the ramp-up of staged oil from the TCO expansion project. Offsetting this were reduced entitlements in Azerbaijan. Comparing the fourth and first quarters, the increase in international liquids realizations reduced our volumes by about 25,000 barrels per day, due to cost recovery and variable royalty provisions of certain production contracts. As we noted at our March analyst meeting in New York City, each contract is different and there are non-linear points when certain thresholds are reached. Looking at our 2008 production guidance, our general rule of thumb is unchanged. A $1 per barrel increase in crude oil prices will reduce our production entitlement by roughly 2,000 barrels per day. We caution that this is only an estimate and results will vary, especially for individual quarterly comparisons. In the context of our production, I would like to briefly summarize our upstream project status. As we discussed at our March meeting, the Tengiz expansion is on track with the first phase of staged oil meeting all of its targets and full facility start-up on schedule for the third quarter of this year. First oil at Blind Faith, our Gulf of Mexico project, forecasted for the late second quarter is now projected to occur in the second half of 2008 due to an issue with the mooring lines. The exact timing of startup is dependent on weather in the Gulf. As we mentioned at the March meeting, a fourth well was added to the initial development plan for Blind Faith. The acceleration of the fourth well reflects higher than anticipated reservoir quality. This well has now been drilled, completed, and is ready for production at the time of facility startup later this year. As indicated in March, gross peak production for Blind Faith is now expected to be 70,000 barrels of oil equivalent per day. Also in March, we said we expected first oil from Moho Bilondo offshore of the Republic of Congo in the second half of this year. This project has now started up ahead of schedule. In Nigeria, we expect our Agbami project to remain on track for a third quarter start-up. Overall, our upstream projects are moving forward. While we will provide an update later in the year, we are optimistic that when adjusted for price effects, our 2008 production will be on track with the guidance we provided in march that was based on $70 oil prices. Let’s turn to slide 8 -- our U.S. downstream operations moved from a loss position in the fourth quarter to break-even results in the first quarter. Industry refining and marketing indicator margins on the west coast weakened in the first quarter. Although refining margins improved somewhat on the Gulf Coast, marketing margins declined. On balance, especially given Chevron's west coast weighting, industry margins were an adverse $55 million impact between quarters. With the completion of our El Segundo refinery upgrade project at the end of 2007, the coker was back in operation and we were able to run heavier crudes. That helped to improve first quarter results by roughly $100 million. The swing in timing effects, such as the impact of provisionally priced foreign crudes, was $50 million better in the first quarter, since crude prices did not rise as much from the beginning to the end of the first quarter as they did in the fourth quarter. Sales of motor gasoline and jet fuel were down by 2% and 3% respectively. While diesel fuel sales strengthened between quarters, lower first quarter volumes resulted in an adverse impact of $50 million. Turning to slide 9, international downstream earnings fell about $10 million from the fourth quarter’s results. Refining indicator margins were lower while marketing margins were mixed across our international geographic areas. On balance, margins reduced earnings by about $30 million between quarters. Volumetric effects were a $70 million adverse variance. This reflected planned shutdowns at refineries in Canada, South Africa, Singapore, and South Korea. Additionally, marketing volumes were affected by seasonal factors in Asia and Africa. Higher charter rates resulted in a $70 million increase in international shipping earnings. The $19 million benefit in the other bar is the net of many items, including adverse tax effects and favorable OpEx variance. Slide 10 shows that earnings from chemical operations were $43 million in the first quarter compared with $69 million in the fourth quarter. Results for olefins improved on higher margins and volumes, especially for polyethylene. Aromatics were essentially unchanged as volumes and margins were mixed. Included in the other bar here is an approximately $40 million environmental provision we mentioned in the interim update, as well as the absence of favorable tax items we discussed on last quarter’s conference call. Slide 11 covers all other. First quarter results were net charges of $255 million compared to net charges of $237 million in the fourth quarter. Corporate tax adjustments had a $100 million adverse impact between quarters. Corporate charges shown were a favorable variance of $85 million. This largely reflects lower advertising and employee related expense. As we mentioned in the interim update, our current guidance for all other activities is a charge of $250 million to $300 million. Because of irregularly occurring accruals and other charges that affect corporate and other activities, we continue to expect volatility in this area and the possibility that actual results will lie outside the guidance range. That completes our brief analysis of the quarter. Back over to you, Steve.
Steve J. Crowe: Thanks, Jim. And now a brief recap of our strategic progress in recent months. Please turn to slide 12. Jim touched on the Moho Bilondo deepwater project in the Republic of the Congo. We confirmed start-up ahead of schedule of this 31% owned partner operated project. It is expected to reach maximum total crude oil production of 90,000 barrels per day in 2010. With our partners, we made the final investment decision to construct Platong Gas II natural gas project in Thailand. The $3.1 billion project will add 420 million cubic feet a day of processing capacity. Chevron is the operator and holds a 70% interest. Start-up is anticipated in 2011. We began front-end engineering and design work to develop an LNG project at our 100% owned Wheatstone discovery in Australia. We estimate that Wheatstone holds 4.5 trillion cubic feet of natural gas resource. In Nigeria, along with our partners, we made the final investment decision to develop the deepwater Usan Field. Chevron Nigeria Limited holds a 30% interest in this partner operated project. Usan is expected to have first production in late 2011 with peak production of 180,000 barrels of oil per day. Finally, as I mentioned, earlier in the week our board approved a 12% increase in the quarterly dividend. We’ve raised our quarterly dividend by a double-digit amount in each of the last four years and our shareholders have benefited from 21 consecutive years of higher annual dividend payouts. That concludes our prepared remarks. We will now take your questions, one question and one follow-up per caller, please. Matt, please open the lines for questions. Thanks.
Operator: (Operator Instructions) Your first question is from Paul Sankey of Deutsche Bank.
Paul Sankey: A couple of things; firstly a high level question, if I could, and then secondly a more detailed one. In terms of the cash management, Steve, if you could just talk about firstly your expectations for CapEx this year, given what we’ve seen so far in Q1. I guess you are still on target for your original guidance. And secondly, the sensitivity to buy-backs -- should we just keep with a ratable $2 billion? Thanks.
Steve J. Crowe: Thanks, Paul. At this point, we confirm that our capital expenditures for 2008 are still at the budgeted amount, which is just shy of $23 billion. As far as our cash management, I think under the current conditions you can expect a buy-back pace comparable to what you’ve seen in the first quarter. We’ve had a $2 billion per quarter buy-back pace in the third and fourth quarters of last year and now again in the first quarter of 2008. So I think that’s a reasonable expectation at this point in time. We certainly have worked into our cash management the higher dividend that was announced a couple of days ago.
Paul Sankey: Great, and if I could on the detail question, it didn’t come up on the slide but in Indonesia, you are down quite hard in oil and up in gas. Is there something going on on the oil side that we should know about? And if you could make any other observations about the dynamics of Indonesian growth, that would be great. And a cheeky follow-up -- is Bangladesh, is that peeking now in terms of its volumes or is there more growth to come? Thanks.
Steve J. Crowe: With respect to Indonesia, one of the things that we had noted in the interim update is in the first quarter gas, as it affects OEG production, was benefited by a unitization and the retroactive benefit of that unitization. As far as liquids production in Indonesia, I am not aware of anything that is systemic, Paul, that would result in the change in terms of our longer term profile. As regards Bangladesh, that operation has been running very well and there’s been increased demand on the Bangladesh operation so I don’t see any change in the intermediate term here. Thanks very much for your questions. May we have the next question, please?
Operator: Our next question is from Paul Cheng with Lehman Brothers.
Paul Cheng: Steve, in the past, you were talking about the underlying decline curve I think in your assumption that you are using 4.5% for the whole corporation. In the first quarter, is the number showing any substantial difference from that?
Steve J. Crowe: Paul, I don’t have a number for the first quarter for that short a period as to what the decline rate is for our base operations, but as George Kirkland mentioned at the analyst meeting in March, we did have a lot of success in 2007 with a decline rate much below the guidance that we are still confirming in that 4.5% to 5% range. As George mentioned, one point doesn’t make a trend and while we were very pleased and optimistic as to the success in 2007, at this stage we’d still advise the analyst community to use the guidance of 4.5% to 5%. Paul, did you have a follow-up question?
Paul Cheng: Yeah, somewhat unrelated, I think Jim talked about the underlifting in the quarter. How much has the underlifting in the quarter actually cost you in terms of earnings? And at the end of the first quarter, are we from an inventory standpoint already balanced or are we still underlifted?
Jim Aleveras: We were underlifted by about 5% in the first quarter, so that’s about 50,000 barrels, a little over 50,000 barrels a day.
Paul Cheng: Jim, do you have how much it cost you?
Jim Aleveras: The impact of a 50,000 barrel a day reduction is shown in our international upstream volumes because it is lifting, not production, that affects earnings.
Paul Cheng: Okay, so it is $195 million.
Jim Aleveras: If you look at our international upstream income, that $195 million or roughly $200 million impact is largely because liftings in the first quarter were lower than in the fourth quarter. In the fourth quarter, we were about balanced. We were about 1% underlifted.
Paul Cheng: Okay, so we are, as of the end of the first quarter, we are underlifted so in theory, we should see an overlifting in the second quarter?
Jim Aleveras: Not necessarily in the second quarter but over time. These things are related to the timing of cargos but we don’t always see them come back each quarter, but over time that is a good item. I would like to emphasize that the volume, the $195 million on slide 6 for international upstream income reflects not just the liquids underlift but also affects the favorable impact of the gas unitization agreement that we mentioned.
Steve J. Crowe: Paul, the only other thing that I would mention to you, when you look at the quantification of the OEG barrel underlift, is that not all barrels carry with them the same degree of profitability. So there can be circumstances where you have comparable underlifts in two periods but the P&L effect would be very different because it depends on where those underlifts occur.
Paul Cheng: Certainly. Very good. Thank you.
Steve J. Crowe: Thanks, Paul. May we have the next question?
Operator: Our next question is from Doug Leggate of Citigroup.
Doug Leggate: Thank you. Thanks for taking my question. First question is a follow-up to Paul -- the 50,000 barrels per day that Jim mentioned as the underlift from the international upstream, can you quantify the gas unitization benefit? What was the volumetric effect of that, is my first one.
Steve J. Crowe: As I recall, the effect of the unitization was about 25,000 barrels a day in terms of OEG production. Again, that will get ratably smaller as you take it out through all four quarters of this year.
Doug Leggate: Okay, great, thanks. The second one is actually a downstream question -- Jim mentioned the $100 million impact on earnings as a result of the coker being back up and now you are running heavy oil. Can you give us some idea -- that’s an earnings impact; give us some idea of what the margin benefit was, or perhaps to put it another way -- what kind of volumes and what kind of [grade] of crude are you now running there and how has that changed relative to let’s say before the project was completed?
Jim Aleveras: Doug, the volumes in crude we are running are not substantially different. What is different is that we are no longer running lighter sweeter crudes. We are running less expensive heavier crudes. I don’t have the exact split-out of what our crude slate was, and we wouldn’t disclose that, for the first quarter relative to the fourth quarter but you can see the financial impact in the bar there.
Steve J. Crowe: And Doug, I would point out that the magnitude of that impact again is influenced by the fact that while the coker was down in the fourth quarter, we were by necessity buying lighter, sweeter, and more expensive crudes and feedstocks.
Doug Leggate: So not all of the $100 million was margin benefit -- some was lower cost?
Jim Aleveras: It’s primarily lower cost.
Doug Leggate: Sorry, I mean operating costs as opposed to costs accrued, because you were not buying the other products in the fourth quarter.
Jim Aleveras: Well, it’s primarily the cost of feedstock, which is more expensive crude. There were some intermediates purchased but it was primarily in the fourth quarter we purchased lighter, sweeter crudes.
Doug Leggate: Okay, that’s great. Thanks very much.
Steve J. Crowe: Thanks, Doug. Did you have another follow-up? Okay, may we have the next question, please?
Operator: Our next question is from Mark Flannery of Credit Suisse.
Mark Flannery: I’ve got two questions; the first one is can you give us an idea of what’s going on same-store sales just on the west coast in terms of volumes? I know you mentioned a couple of numbers there during the call, about 2% drop in gasoline and distillate doing well. But could you just run through them again and include a number for diesel? And then I have a follow-up.
Steve J. Crowe: Mark, I don’t have a Chevron same-store sales comparing first quarter ’08 say to first quarter of ’07 in front of me, but I can tell you that if you look at motor gasoline demand industry wide in the United States using DOE implied demand data, through April demand is down about seven-tenths of a percent. But the interesting component from a portfolio perspective is in pad five, we’re down nearly 7% whereas in pads one through four, we’re up about a half a percent during that four month period. So we are seeing a greater demand impact here out on the west coast where Chevron's portfolio is proportionately larger than some of our competitors. Now on the distillate side, and covering all the distillates, U.S. demand for the first four months is down a little less than 3% compared to the comparable period a year ago.
Mark Flannery: Just specifically on your own operations, are you exporting distillate right now, either from the west coast or the Gulf?
Steve J. Crowe: Not that I’m aware of at this juncture.
Mark Flannery: Okay. Maybe I could just jam this one in as the follow-up --
Steve J. Crowe: And in fact, we’ll try to get back to you with the specifics on that if we have any different information.
Mark Flannery: Okay, I’ll call Jim later but I guess the follow-up, which is not really a follow-up, is do you have any update on Gorgon maybe to give us right now?
Steve J. Crowe: Nothing different than what George and Dave would have described to you at the March analyst meeting. We are pressing ahead with revised compliance for the environmental permit to reflect three rather than two trains on barrel island, but we are committed to the project. We are looking for ways to make it economic and take out costs, but the three partners are aligned with respect to the strategy, so it’s essentially a confirmation of the information that was provided back in mid-March. Thanks very much. May we have the next question, please?
Operator: Our next question is from Mark Gillman of Benchmark. Your question, please.
Mark Gillman: Good morning. Guys, I’m having trouble understanding the overseas downstream earnings. It almost looks to me, and perhaps you guys can clarify it, as if there was some kind of step-down that occurred about mid-year in ’07, impacted both the fourth quarter and first quarter. If you were to try to reconcile first quarter against year-ago first quarter, just looking at the margin comparisons you wouldn’t get anywhere near close. And I guess I am further puzzled by the comment Jim made regarding the shipping component of such earnings, which up significantly in the first quarter versus the fourth, where it would appear to me tanker rates were down sharply 4Q versus 1. Any help? And I’ve got a follow-up.
Jim Aleveras: Well, let’s take the first part of your question with regard to margins. The margins that we are quoting are very specific to Chevron's marketing areas internationally, so Mark, as you are familiar with, we are marketing in certain areas and we use the indicator margins to try to match where we are located. And margins have been a little weaker but have been mixed overall. You’ll recall that last year in this quarter, we had the benefit of the sale of our interest in a refinery in The Netherlands --
Mark Gillman: I took that out, Jim. That’s not a factor.
Jim Aleveras: -- and later in the year, we had the benefit of the sale of our refining and marketing assets in the Benelux countries. But if you remove those, yes, margins have been a little bit weaker and volumes have been a little weaker in the second half of the year than they were in the first half. But as to your comment about shipping, we’re just looking at the freight rates that are charged for the particular routes and the particular vessels that we use. And of course, shipping charges are an expense to the rest of the downstream. We broke it out here partly because we wanted to show from a transparency standpoint what the components were.
Mark Gillman: Okay, let me try my follow-up, if I could please; the comment in the U.S. upstream regarding DD&A, I did some rough math, probably not very good at this point in the week but nonetheless, I’m coming up with about 2 to 2.50 an equivalent barrel increase in the DD&A rate in order to justify that variance. Given the absence of any negative year-end ’07 U.S. reserve data, I don’t quite understand what it is with virtually no change in producing projects, if you will, could generate a DD&A increase of that magnitude and I’m interested in whether it is sustainable going forward.
Steve J. Crowe: Mark, that’s a good question. One of the things that we did in the latter part of 2007 was a full review of the abandonment provision for all of our operations, the so-called ARO liability. And we accrued at year-end 2007 an additional abandonment provision that through the workings of the ARO get accreted as part of the DD&A charge as production occurs through those fields that are so affected. So there would be some discontinuity as you look at fourth quarter on into the first quarter of this year as a result of that, and I suspect, Mark, that’s the missing piece that you can’t find.
Mark Gillman: Is that sustainable, Steve?
Steve J. Crowe: Well, it’s sustainable to the extent that we’ve increased the abandonment provision for those fields and that higher charge will be taken through DD&A over the life of the fields, and that abandonment provision will be higher then in 2008 than it would have been in earlier periods.
Mark Gillman: Okay. Thanks very much.
Steve J. Crowe: You’re welcome, Mark. May we have the next question, please?
Operator: Our next question is from Erik Mielke of Merrill Lynch.
Erik Mielke: Good morning, gentlemen. I have a couple of questions on the upstream production. Firstly on Asian gas, which was stronger for Bangladesh, Indonesia, and Thailand than what we’d model. I know you already touched on this but I just want to make sure we understand what we should expect for the remainder of 2008, whether the first quarter production level is a good guide for those three specific countries on natural gas.
Steve J. Crowe: I don’t have any information to suggest they aren’t other than the item that I alluded to with respect to the unitization of our gas field in Indonesia. That obviously would have a -- because of the retroactivity would have a greater affect in the first quarter than the other three quarters of the year. Jim, do you have anything else to add to that?
Jim Aleveras: No, I don’t.
Steve J. Crowe: Erik, do you have a follow-up?
Erik Mielke: I do. I have two follow-ups, if I’m able. Let me try one first -- first in Kazakhstan, you mentioned that Tengiz will be the next step change for Tengiz is in the third quarter. Should we expect a further increase in the second quarter? Is there an element of ramp-up taking place there? And is there any maintenance at Karachaganak that we need to be aware of?
Jim Aleveras: Well, let’s take Kazakhstan -- we’re seeing about a 90,000 barrel a day improvement in production as a result of the first phase, the sour gas injection. That was ramping up in the first quarter and is now fully ramped up, you see 34, which is half of a 70 mbd increase reflecting our 50% share. That increase ought to be a little higher in the second quarter but you won’t see a substantial change until we get into the third quarter and we have full production facilities. Erik, you asked about another location?
Steve J. Crowe: Karachaganak.
Jim Aleveras: Oh, Karachaganak.
Erik Mielke: Whether there is maintenance in Karachaganak.
Jim Aleveras: I don’t have anything on that of substance that I am looking at here. If there was, it was not something that was terribly dramatic.
Steve J. Crowe: Erik, did you have one more question?
Erik Mielke: If I can try a cheeky one, just on Nigeria with the outages that other operators have had there, have you had any impact on your second quarter volumes that we need to be aware of?
Steve J. Crowe: No, in talking to our operational folks in Nigeria, the impacts that some of the others have faced in the first quarter and here in the early second quarter, we haven’t experienced to the same degree. We’ve had very, very nominal shut-ins for very short durations in our operations. I would also point out, Erik, too as Jim and I have mentioned, we’ve got a Agbami coming on here in the third quarter and Agbami, unlike some of the other operations that are on-shore, is a deepwater project and it is 70 miles offshore, so it is quite a ways away from where some of the unrest has occurred. So we expect that the Agbami project will come on as advertised in the third quarter. Thanks very much, Erik, for your questions.
Erik Mielke: That’s great. Thank you.
Operator: Our next question is from Neil McMahon of Sanford Bernstein.
Neil McMahon: Just a quick question on the exploration wells that are sort of the high profile ones that are getting drilled -- any update on the Jack and Saint Malo appraisal wells? And also, could you give us some sort of guidance as to when the drilling of the Orphan Basin well is going to take place?
Steve J. Crowe: With respect to the Orphan Basin, I recall that the next well would be drilled in 2009 and as far as the follow-up wells for Jack and Saint Malo, they are -- one is underway now, as I recall, and another a little bit later in the year. And then decisions will be made following those evaluations as to whether or not Jack and Saint Malo will be kept as separate projects or conceivably combined.
Neil McMahon: Okay, maybe as a loose follow-up in the upstream, just in terms of the whole Caspian Basin and the CPC pipeline, how much are you guys involved in looking at a bosphoros bypass pipeline in Turkey as a way of making sure that the increase Tengiz volumes, especially as we go forward over time, can find a decent route to market?
Jim Aleveras: Neil, all I can say is that we are looking at all of our options because obviously optionality is very important to us in terms of expansion of our existing pipeline. But right now we have rail capacity to handle all of the exports in addition to the pipeline capacity that would result from an expansion of the Tengiz project. But in terms of what specifics we are looking at over and above rail, we’d rather not discuss that.
Steve J. Crowe: I would say that the discussions with the partners to expand the capacity of CPC is as it has been is ongoing and there are various conditions that each party has tabled that we are looking at but we will still continue with the negotiations for the expansion of CPC. As Jim said, we otherwise have mechanisms to move Tengiz crude and just as we had done before the CPC pipeline was completed, we are using rail and other means to move the crude. Thanks very much for your question.
Operator: Our next question is from Jerry Gunn of BlackRock.
Steve J. Crowe: Hello, Jerry?
Operator: Jerry, did you have a question? You may want to check your mute button.
Steve J. Crowe: Okay, let’s try the next question, please.
Operator: Our next question is a follow-up from Mark Gillman of Benchmark.
Mark Gillman: Steve and Jim, are there any rate of return or cumulative production thresholds on block 14 that would be encountered -- block 14 in Angola -- that would be encountered this year at current price levels?
Steve J. Crowe: Not that I’m aware of. Hang on one sec here, I’ll see if I can see anything. In terms of price levels, looking at objective -- no, there is nothing substantive that is associated with the African operations.
Mark Gillman: Okay, if I could just sneak a follow-up; Steve, I wasn’t clear what you meant by that roughly 25,000 a day characterization of the impact of the Indonesian unitization on the gas side. I thought that there was a one-time retroactive element which is benefiting the first quarter and then a considerably smaller positive impact going forward. What was the 25 equivalents a day supposed to represent?
Steve J. Crowe: That was the retroactivity piece that I was alluding to that would be non-recurring obviously in other quarters. So your understanding is correct, Mark.
Mark Gillman: Okay, fine. Thank you.
Jim Aleveras: Matt, do we have other callers?
Operator: At this time, I am showing no further questions.
Steve J. Crowe: Thank you. I am presuming that we’ve been able to cover your questions in the time allotted and I think in large measure because our interim update provided a lot of information that’s proved to be consistent with the earnings release that you saw today. So in closing, I want to express my appreciation to everyone’s participation on the call and I especially want to thank each of the analysts on behalf of the participants for their questions during this morning’s session. Matt, I’ll turn it back to you.
Operator: Ladies and gentlemen, this concludes today’s 2008 earnings conference call. You may now disconnect. Good day. | [
{
"speaker": "Operator",
"text": "Good morning. My name is Matt and I will be your conference facilitator today. Welcome to Chevron's first quarter 2008 earnings conference call. (Operator Instructions) I will now turn the conference over to the Vice President and Chief Financial Officer of Chevron Corporation, Mr. Steve Crowe. Please go ahead, sir."
},
{
"speaker": "Steve J. Crowe",
"text": "Thanks, Matt. Welcome to Chevron's first quarter earnings conference call and webcast. Jim Aleveras, General Manager of Investor Relations is on the call with me today. Our focus is on Chevron's financial and operating results for the first quarter of 2008. We will refer to the slides that are available on the web. Before we get started, please be reminded that this presentation contains estimates, projections, and other forward-looking statements. We ask that you review the cautionary statement on slide 2. I’ll begin with slide 3, which provides an overview of our financial performance. The company’s first quarter earnings were $5.2 billion, or $2.48 per diluted share. Our first quarter 2008 earnings were up nearly 10% from the first quarter 2007, reflecting higher crude oil and natural gas prices, which more than offset weaker downstream results. The first quarter of last year included a $700 million gain on the sale of our interest in a refinery in The Netherlands. First quarter 2008 earnings rose 6% compared to the fourth quarter 2007, which Jim will discuss shortly. Return on capital employed for the trailing 12 months was 23%. The debt ratio was about 8% at the end of the quarter. As we announced Wednesday, we increased our quarterly dividend by $0.07 per share, or 12.1%. This marks the fourth consecutive year we’ve raised the second quarter dividend by a double-digit amount. Stock buy-backs were $2 billion in the quarter. Jim will now take us through the quarterly comparisons. Jim."
},
{
"speaker": "Jim Aleveras",
"text": "Thanks, Steve. My remarks compare results of the first quarter 2008 with the fourth quarter 2007. As a reminder, our earnings release compared the first quarter 2008 with the same quarter a year ago. Turning to slide 4, first quarter net income was almost $300 million higher than the fourth quarter. Starting with the left side of the chart, higher crude oil and natural gas realizations benefited the company’s worldwide upstream results. Partly offsetting this was the impact of lower upstream volumes. The largest component here was international liftings. Liftings were lower than production in the first quarter. Downstream results were up slightly from the fourth quarter, reflecting improved refinery operations in the United States. The variance in the residual other bar is the net of everything else. Slide 5 summarizes the results of our U.S. upstream operations, which improved by about $220 million between quarters. Higher crude oil and natural gas realizations benefited earnings by $335 million. Chevron's average U.S. crude oil realization was up about $8 per barrel between consecutive quarters. This is more than the $7.25 per barrel increase in WTI’s spot prices, since much of our Gulf of Mexico crude oil production is priced on a lagged basis. Production volumes were down 2% between quarters, largely due to operational and weather related downtime, as well as normal fuel declines. This impact reduced earnings by $85 million. The $85 million DD&A reflects higher rates and higher accretion charges for abandonment. Exploration expense fell $90 million between periods. The primary factor was lower well write-offs in the first quarter. The other bar reflects miscellaneous gas marketing and income tax items. Let’s turn to slide 6. International upstream earnings for the first quarter were about $70 million higher than the fourth quarter’s results. Higher oil and gas prices increased earnings by $370 million. Our unit realization for liquids rose by $5.70 per barrel, significantly less than the $9.30 per barrel increase in brent spot prices. Comparing average prices for the first and fourth quarters, we found that worldwide benchmark crudes did not move consistently. For example, Malaysia’s light sweet tapas crude was up $3.20 per barrel between quarter and Sumatra Light rose $7.70 per barrel. WTI’s spot prices increased $7.25 per barrel, $2 less than the change in brent. Our realizations therefore reflected geographic market prices which were not in line with brent movements during this particular comparison period. Lower first quarter liftings, particularly in Azerbaijan, the U.K., Nigeria, and Australia, reduced earnings by $195 million. As I noted earlier, we were under-lifted in the first quarter, an issue we referenced in the interim update. Partially offsetting this under-lift is a one-time benefit from the retroactive effect of the unitization agreement in Indonesia we also mentioned in the interim update. Tax items reduced earnings by $230 million between quarters. These were spread among several countries and included the absence of favorable fourth quarter items we discussed on our last conference call. Operating expense was down $130 million from the fourth quarter due to lower seasonal activity levels in several international areas. The other bar reflects the net of many unrelated items. The largest components were adverse foreign exchange effects, offset by lower exploration expense. Slide 7 summarizes the change in worldwide oil equivalent production, including volumes produced from oil sands in Canada. Production fell by 14,000 barrels per day, or about half of 1% between consecutive quarters. United States production fell 15,000 barrels per day, about 2% due to operational down time and normal field declines. Outside the United States, overall production was flat between quarters. Kazakhstan benefited from the ramp-up of staged oil from the TCO expansion project. Offsetting this were reduced entitlements in Azerbaijan. Comparing the fourth and first quarters, the increase in international liquids realizations reduced our volumes by about 25,000 barrels per day, due to cost recovery and variable royalty provisions of certain production contracts. As we noted at our March analyst meeting in New York City, each contract is different and there are non-linear points when certain thresholds are reached. Looking at our 2008 production guidance, our general rule of thumb is unchanged. A $1 per barrel increase in crude oil prices will reduce our production entitlement by roughly 2,000 barrels per day. We caution that this is only an estimate and results will vary, especially for individual quarterly comparisons. In the context of our production, I would like to briefly summarize our upstream project status. As we discussed at our March meeting, the Tengiz expansion is on track with the first phase of staged oil meeting all of its targets and full facility start-up on schedule for the third quarter of this year. First oil at Blind Faith, our Gulf of Mexico project, forecasted for the late second quarter is now projected to occur in the second half of 2008 due to an issue with the mooring lines. The exact timing of startup is dependent on weather in the Gulf. As we mentioned at the March meeting, a fourth well was added to the initial development plan for Blind Faith. The acceleration of the fourth well reflects higher than anticipated reservoir quality. This well has now been drilled, completed, and is ready for production at the time of facility startup later this year. As indicated in March, gross peak production for Blind Faith is now expected to be 70,000 barrels of oil equivalent per day. Also in March, we said we expected first oil from Moho Bilondo offshore of the Republic of Congo in the second half of this year. This project has now started up ahead of schedule. In Nigeria, we expect our Agbami project to remain on track for a third quarter start-up. Overall, our upstream projects are moving forward. While we will provide an update later in the year, we are optimistic that when adjusted for price effects, our 2008 production will be on track with the guidance we provided in march that was based on $70 oil prices. Let’s turn to slide 8 -- our U.S. downstream operations moved from a loss position in the fourth quarter to break-even results in the first quarter. Industry refining and marketing indicator margins on the west coast weakened in the first quarter. Although refining margins improved somewhat on the Gulf Coast, marketing margins declined. On balance, especially given Chevron's west coast weighting, industry margins were an adverse $55 million impact between quarters. With the completion of our El Segundo refinery upgrade project at the end of 2007, the coker was back in operation and we were able to run heavier crudes. That helped to improve first quarter results by roughly $100 million. The swing in timing effects, such as the impact of provisionally priced foreign crudes, was $50 million better in the first quarter, since crude prices did not rise as much from the beginning to the end of the first quarter as they did in the fourth quarter. Sales of motor gasoline and jet fuel were down by 2% and 3% respectively. While diesel fuel sales strengthened between quarters, lower first quarter volumes resulted in an adverse impact of $50 million. Turning to slide 9, international downstream earnings fell about $10 million from the fourth quarter’s results. Refining indicator margins were lower while marketing margins were mixed across our international geographic areas. On balance, margins reduced earnings by about $30 million between quarters. Volumetric effects were a $70 million adverse variance. This reflected planned shutdowns at refineries in Canada, South Africa, Singapore, and South Korea. Additionally, marketing volumes were affected by seasonal factors in Asia and Africa. Higher charter rates resulted in a $70 million increase in international shipping earnings. The $19 million benefit in the other bar is the net of many items, including adverse tax effects and favorable OpEx variance. Slide 10 shows that earnings from chemical operations were $43 million in the first quarter compared with $69 million in the fourth quarter. Results for olefins improved on higher margins and volumes, especially for polyethylene. Aromatics were essentially unchanged as volumes and margins were mixed. Included in the other bar here is an approximately $40 million environmental provision we mentioned in the interim update, as well as the absence of favorable tax items we discussed on last quarter’s conference call. Slide 11 covers all other. First quarter results were net charges of $255 million compared to net charges of $237 million in the fourth quarter. Corporate tax adjustments had a $100 million adverse impact between quarters. Corporate charges shown were a favorable variance of $85 million. This largely reflects lower advertising and employee related expense. As we mentioned in the interim update, our current guidance for all other activities is a charge of $250 million to $300 million. Because of irregularly occurring accruals and other charges that affect corporate and other activities, we continue to expect volatility in this area and the possibility that actual results will lie outside the guidance range. That completes our brief analysis of the quarter. Back over to you, Steve."
},
{
"speaker": "Steve J. Crowe",
"text": "Thanks, Jim. And now a brief recap of our strategic progress in recent months. Please turn to slide 12. Jim touched on the Moho Bilondo deepwater project in the Republic of the Congo. We confirmed start-up ahead of schedule of this 31% owned partner operated project. It is expected to reach maximum total crude oil production of 90,000 barrels per day in 2010. With our partners, we made the final investment decision to construct Platong Gas II natural gas project in Thailand. The $3.1 billion project will add 420 million cubic feet a day of processing capacity. Chevron is the operator and holds a 70% interest. Start-up is anticipated in 2011. We began front-end engineering and design work to develop an LNG project at our 100% owned Wheatstone discovery in Australia. We estimate that Wheatstone holds 4.5 trillion cubic feet of natural gas resource. In Nigeria, along with our partners, we made the final investment decision to develop the deepwater Usan Field. Chevron Nigeria Limited holds a 30% interest in this partner operated project. Usan is expected to have first production in late 2011 with peak production of 180,000 barrels of oil per day. Finally, as I mentioned, earlier in the week our board approved a 12% increase in the quarterly dividend. We’ve raised our quarterly dividend by a double-digit amount in each of the last four years and our shareholders have benefited from 21 consecutive years of higher annual dividend payouts. That concludes our prepared remarks. We will now take your questions, one question and one follow-up per caller, please. Matt, please open the lines for questions. Thanks."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question is from Paul Sankey of Deutsche Bank."
},
{
"speaker": "Paul Sankey",
"text": "A couple of things; firstly a high level question, if I could, and then secondly a more detailed one. In terms of the cash management, Steve, if you could just talk about firstly your expectations for CapEx this year, given what we’ve seen so far in Q1. I guess you are still on target for your original guidance. And secondly, the sensitivity to buy-backs -- should we just keep with a ratable $2 billion? Thanks."
},
{
"speaker": "Steve J. Crowe",
"text": "Thanks, Paul. At this point, we confirm that our capital expenditures for 2008 are still at the budgeted amount, which is just shy of $23 billion. As far as our cash management, I think under the current conditions you can expect a buy-back pace comparable to what you’ve seen in the first quarter. We’ve had a $2 billion per quarter buy-back pace in the third and fourth quarters of last year and now again in the first quarter of 2008. So I think that’s a reasonable expectation at this point in time. We certainly have worked into our cash management the higher dividend that was announced a couple of days ago."
},
{
"speaker": "Paul Sankey",
"text": "Great, and if I could on the detail question, it didn’t come up on the slide but in Indonesia, you are down quite hard in oil and up in gas. Is there something going on on the oil side that we should know about? And if you could make any other observations about the dynamics of Indonesian growth, that would be great. And a cheeky follow-up -- is Bangladesh, is that peeking now in terms of its volumes or is there more growth to come? Thanks."
},
{
"speaker": "Steve J. Crowe",
"text": "With respect to Indonesia, one of the things that we had noted in the interim update is in the first quarter gas, as it affects OEG production, was benefited by a unitization and the retroactive benefit of that unitization. As far as liquids production in Indonesia, I am not aware of anything that is systemic, Paul, that would result in the change in terms of our longer term profile. As regards Bangladesh, that operation has been running very well and there’s been increased demand on the Bangladesh operation so I don’t see any change in the intermediate term here. Thanks very much for your questions. May we have the next question, please?"
},
{
"speaker": "Operator",
"text": "Our next question is from Paul Cheng with Lehman Brothers."
},
{
"speaker": "Paul Cheng",
"text": "Steve, in the past, you were talking about the underlying decline curve I think in your assumption that you are using 4.5% for the whole corporation. In the first quarter, is the number showing any substantial difference from that?"
},
{
"speaker": "Steve J. Crowe",
"text": "Paul, I don’t have a number for the first quarter for that short a period as to what the decline rate is for our base operations, but as George Kirkland mentioned at the analyst meeting in March, we did have a lot of success in 2007 with a decline rate much below the guidance that we are still confirming in that 4.5% to 5% range. As George mentioned, one point doesn’t make a trend and while we were very pleased and optimistic as to the success in 2007, at this stage we’d still advise the analyst community to use the guidance of 4.5% to 5%. Paul, did you have a follow-up question?"
},
{
"speaker": "Paul Cheng",
"text": "Yeah, somewhat unrelated, I think Jim talked about the underlifting in the quarter. How much has the underlifting in the quarter actually cost you in terms of earnings? And at the end of the first quarter, are we from an inventory standpoint already balanced or are we still underlifted?"
},
{
"speaker": "Jim Aleveras",
"text": "We were underlifted by about 5% in the first quarter, so that’s about 50,000 barrels, a little over 50,000 barrels a day."
},
{
"speaker": "Paul Cheng",
"text": "Jim, do you have how much it cost you?"
},
{
"speaker": "Jim Aleveras",
"text": "The impact of a 50,000 barrel a day reduction is shown in our international upstream volumes because it is lifting, not production, that affects earnings."
},
{
"speaker": "Paul Cheng",
"text": "Okay, so it is $195 million."
},
{
"speaker": "Jim Aleveras",
"text": "If you look at our international upstream income, that $195 million or roughly $200 million impact is largely because liftings in the first quarter were lower than in the fourth quarter. In the fourth quarter, we were about balanced. We were about 1% underlifted."
},
{
"speaker": "Paul Cheng",
"text": "Okay, so we are, as of the end of the first quarter, we are underlifted so in theory, we should see an overlifting in the second quarter?"
},
{
"speaker": "Jim Aleveras",
"text": "Not necessarily in the second quarter but over time. These things are related to the timing of cargos but we don’t always see them come back each quarter, but over time that is a good item. I would like to emphasize that the volume, the $195 million on slide 6 for international upstream income reflects not just the liquids underlift but also affects the favorable impact of the gas unitization agreement that we mentioned."
},
{
"speaker": "Steve J. Crowe",
"text": "Paul, the only other thing that I would mention to you, when you look at the quantification of the OEG barrel underlift, is that not all barrels carry with them the same degree of profitability. So there can be circumstances where you have comparable underlifts in two periods but the P&L effect would be very different because it depends on where those underlifts occur."
},
{
"speaker": "Paul Cheng",
"text": "Certainly. Very good. Thank you."
},
{
"speaker": "Steve J. Crowe",
"text": "Thanks, Paul. May we have the next question?"
},
{
"speaker": "Operator",
"text": "Our next question is from Doug Leggate of Citigroup."
},
{
"speaker": "Doug Leggate",
"text": "Thank you. Thanks for taking my question. First question is a follow-up to Paul -- the 50,000 barrels per day that Jim mentioned as the underlift from the international upstream, can you quantify the gas unitization benefit? What was the volumetric effect of that, is my first one."
},
{
"speaker": "Steve J. Crowe",
"text": "As I recall, the effect of the unitization was about 25,000 barrels a day in terms of OEG production. Again, that will get ratably smaller as you take it out through all four quarters of this year."
},
{
"speaker": "Doug Leggate",
"text": "Okay, great, thanks. The second one is actually a downstream question -- Jim mentioned the $100 million impact on earnings as a result of the coker being back up and now you are running heavy oil. Can you give us some idea -- that’s an earnings impact; give us some idea of what the margin benefit was, or perhaps to put it another way -- what kind of volumes and what kind of [grade] of crude are you now running there and how has that changed relative to let’s say before the project was completed?"
},
{
"speaker": "Jim Aleveras",
"text": "Doug, the volumes in crude we are running are not substantially different. What is different is that we are no longer running lighter sweeter crudes. We are running less expensive heavier crudes. I don’t have the exact split-out of what our crude slate was, and we wouldn’t disclose that, for the first quarter relative to the fourth quarter but you can see the financial impact in the bar there."
},
{
"speaker": "Steve J. Crowe",
"text": "And Doug, I would point out that the magnitude of that impact again is influenced by the fact that while the coker was down in the fourth quarter, we were by necessity buying lighter, sweeter, and more expensive crudes and feedstocks."
},
{
"speaker": "Doug Leggate",
"text": "So not all of the $100 million was margin benefit -- some was lower cost?"
},
{
"speaker": "Jim Aleveras",
"text": "It’s primarily lower cost."
},
{
"speaker": "Doug Leggate",
"text": "Sorry, I mean operating costs as opposed to costs accrued, because you were not buying the other products in the fourth quarter."
},
{
"speaker": "Jim Aleveras",
"text": "Well, it’s primarily the cost of feedstock, which is more expensive crude. There were some intermediates purchased but it was primarily in the fourth quarter we purchased lighter, sweeter crudes."
},
{
"speaker": "Doug Leggate",
"text": "Okay, that’s great. Thanks very much."
},
{
"speaker": "Steve J. Crowe",
"text": "Thanks, Doug. Did you have another follow-up? Okay, may we have the next question, please?"
},
{
"speaker": "Operator",
"text": "Our next question is from Mark Flannery of Credit Suisse."
},
{
"speaker": "Mark Flannery",
"text": "I’ve got two questions; the first one is can you give us an idea of what’s going on same-store sales just on the west coast in terms of volumes? I know you mentioned a couple of numbers there during the call, about 2% drop in gasoline and distillate doing well. But could you just run through them again and include a number for diesel? And then I have a follow-up."
},
{
"speaker": "Steve J. Crowe",
"text": "Mark, I don’t have a Chevron same-store sales comparing first quarter ’08 say to first quarter of ’07 in front of me, but I can tell you that if you look at motor gasoline demand industry wide in the United States using DOE implied demand data, through April demand is down about seven-tenths of a percent. But the interesting component from a portfolio perspective is in pad five, we’re down nearly 7% whereas in pads one through four, we’re up about a half a percent during that four month period. So we are seeing a greater demand impact here out on the west coast where Chevron's portfolio is proportionately larger than some of our competitors. Now on the distillate side, and covering all the distillates, U.S. demand for the first four months is down a little less than 3% compared to the comparable period a year ago."
},
{
"speaker": "Mark Flannery",
"text": "Just specifically on your own operations, are you exporting distillate right now, either from the west coast or the Gulf?"
},
{
"speaker": "Steve J. Crowe",
"text": "Not that I’m aware of at this juncture."
},
{
"speaker": "Mark Flannery",
"text": "Okay. Maybe I could just jam this one in as the follow-up --"
},
{
"speaker": "Steve J. Crowe",
"text": "And in fact, we’ll try to get back to you with the specifics on that if we have any different information."
},
{
"speaker": "Mark Flannery",
"text": "Okay, I’ll call Jim later but I guess the follow-up, which is not really a follow-up, is do you have any update on Gorgon maybe to give us right now?"
},
{
"speaker": "Steve J. Crowe",
"text": "Nothing different than what George and Dave would have described to you at the March analyst meeting. We are pressing ahead with revised compliance for the environmental permit to reflect three rather than two trains on barrel island, but we are committed to the project. We are looking for ways to make it economic and take out costs, but the three partners are aligned with respect to the strategy, so it’s essentially a confirmation of the information that was provided back in mid-March. Thanks very much. May we have the next question, please?"
},
{
"speaker": "Operator",
"text": "Our next question is from Mark Gillman of Benchmark. Your question, please."
},
{
"speaker": "Mark Gillman",
"text": "Good morning. Guys, I’m having trouble understanding the overseas downstream earnings. It almost looks to me, and perhaps you guys can clarify it, as if there was some kind of step-down that occurred about mid-year in ’07, impacted both the fourth quarter and first quarter. If you were to try to reconcile first quarter against year-ago first quarter, just looking at the margin comparisons you wouldn’t get anywhere near close. And I guess I am further puzzled by the comment Jim made regarding the shipping component of such earnings, which up significantly in the first quarter versus the fourth, where it would appear to me tanker rates were down sharply 4Q versus 1. Any help? And I’ve got a follow-up."
},
{
"speaker": "Jim Aleveras",
"text": "Well, let’s take the first part of your question with regard to margins. The margins that we are quoting are very specific to Chevron's marketing areas internationally, so Mark, as you are familiar with, we are marketing in certain areas and we use the indicator margins to try to match where we are located. And margins have been a little weaker but have been mixed overall. You’ll recall that last year in this quarter, we had the benefit of the sale of our interest in a refinery in The Netherlands --"
},
{
"speaker": "Mark Gillman",
"text": "I took that out, Jim. That’s not a factor."
},
{
"speaker": "Jim Aleveras",
"text": "-- and later in the year, we had the benefit of the sale of our refining and marketing assets in the Benelux countries. But if you remove those, yes, margins have been a little bit weaker and volumes have been a little weaker in the second half of the year than they were in the first half. But as to your comment about shipping, we’re just looking at the freight rates that are charged for the particular routes and the particular vessels that we use. And of course, shipping charges are an expense to the rest of the downstream. We broke it out here partly because we wanted to show from a transparency standpoint what the components were."
},
{
"speaker": "Mark Gillman",
"text": "Okay, let me try my follow-up, if I could please; the comment in the U.S. upstream regarding DD&A, I did some rough math, probably not very good at this point in the week but nonetheless, I’m coming up with about 2 to 2.50 an equivalent barrel increase in the DD&A rate in order to justify that variance. Given the absence of any negative year-end ’07 U.S. reserve data, I don’t quite understand what it is with virtually no change in producing projects, if you will, could generate a DD&A increase of that magnitude and I’m interested in whether it is sustainable going forward."
},
{
"speaker": "Steve J. Crowe",
"text": "Mark, that’s a good question. One of the things that we did in the latter part of 2007 was a full review of the abandonment provision for all of our operations, the so-called ARO liability. And we accrued at year-end 2007 an additional abandonment provision that through the workings of the ARO get accreted as part of the DD&A charge as production occurs through those fields that are so affected. So there would be some discontinuity as you look at fourth quarter on into the first quarter of this year as a result of that, and I suspect, Mark, that’s the missing piece that you can’t find."
},
{
"speaker": "Mark Gillman",
"text": "Is that sustainable, Steve?"
},
{
"speaker": "Steve J. Crowe",
"text": "Well, it’s sustainable to the extent that we’ve increased the abandonment provision for those fields and that higher charge will be taken through DD&A over the life of the fields, and that abandonment provision will be higher then in 2008 than it would have been in earlier periods."
},
{
"speaker": "Mark Gillman",
"text": "Okay. Thanks very much."
},
{
"speaker": "Steve J. Crowe",
"text": "You’re welcome, Mark. May we have the next question, please?"
},
{
"speaker": "Operator",
"text": "Our next question is from Erik Mielke of Merrill Lynch."
},
{
"speaker": "Erik Mielke",
"text": "Good morning, gentlemen. I have a couple of questions on the upstream production. Firstly on Asian gas, which was stronger for Bangladesh, Indonesia, and Thailand than what we’d model. I know you already touched on this but I just want to make sure we understand what we should expect for the remainder of 2008, whether the first quarter production level is a good guide for those three specific countries on natural gas."
},
{
"speaker": "Steve J. Crowe",
"text": "I don’t have any information to suggest they aren’t other than the item that I alluded to with respect to the unitization of our gas field in Indonesia. That obviously would have a -- because of the retroactivity would have a greater affect in the first quarter than the other three quarters of the year. Jim, do you have anything else to add to that?"
},
{
"speaker": "Jim Aleveras",
"text": "No, I don’t."
},
{
"speaker": "Steve J. Crowe",
"text": "Erik, do you have a follow-up?"
},
{
"speaker": "Erik Mielke",
"text": "I do. I have two follow-ups, if I’m able. Let me try one first -- first in Kazakhstan, you mentioned that Tengiz will be the next step change for Tengiz is in the third quarter. Should we expect a further increase in the second quarter? Is there an element of ramp-up taking place there? And is there any maintenance at Karachaganak that we need to be aware of?"
},
{
"speaker": "Jim Aleveras",
"text": "Well, let’s take Kazakhstan -- we’re seeing about a 90,000 barrel a day improvement in production as a result of the first phase, the sour gas injection. That was ramping up in the first quarter and is now fully ramped up, you see 34, which is half of a 70 mbd increase reflecting our 50% share. That increase ought to be a little higher in the second quarter but you won’t see a substantial change until we get into the third quarter and we have full production facilities. Erik, you asked about another location?"
},
{
"speaker": "Steve J. Crowe",
"text": "Karachaganak."
},
{
"speaker": "Jim Aleveras",
"text": "Oh, Karachaganak."
},
{
"speaker": "Erik Mielke",
"text": "Whether there is maintenance in Karachaganak."
},
{
"speaker": "Jim Aleveras",
"text": "I don’t have anything on that of substance that I am looking at here. If there was, it was not something that was terribly dramatic."
},
{
"speaker": "Steve J. Crowe",
"text": "Erik, did you have one more question?"
},
{
"speaker": "Erik Mielke",
"text": "If I can try a cheeky one, just on Nigeria with the outages that other operators have had there, have you had any impact on your second quarter volumes that we need to be aware of?"
},
{
"speaker": "Steve J. Crowe",
"text": "No, in talking to our operational folks in Nigeria, the impacts that some of the others have faced in the first quarter and here in the early second quarter, we haven’t experienced to the same degree. We’ve had very, very nominal shut-ins for very short durations in our operations. I would also point out, Erik, too as Jim and I have mentioned, we’ve got a Agbami coming on here in the third quarter and Agbami, unlike some of the other operations that are on-shore, is a deepwater project and it is 70 miles offshore, so it is quite a ways away from where some of the unrest has occurred. So we expect that the Agbami project will come on as advertised in the third quarter. Thanks very much, Erik, for your questions."
},
{
"speaker": "Erik Mielke",
"text": "That’s great. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question is from Neil McMahon of Sanford Bernstein."
},
{
"speaker": "Neil McMahon",
"text": "Just a quick question on the exploration wells that are sort of the high profile ones that are getting drilled -- any update on the Jack and Saint Malo appraisal wells? And also, could you give us some sort of guidance as to when the drilling of the Orphan Basin well is going to take place?"
},
{
"speaker": "Steve J. Crowe",
"text": "With respect to the Orphan Basin, I recall that the next well would be drilled in 2009 and as far as the follow-up wells for Jack and Saint Malo, they are -- one is underway now, as I recall, and another a little bit later in the year. And then decisions will be made following those evaluations as to whether or not Jack and Saint Malo will be kept as separate projects or conceivably combined."
},
{
"speaker": "Neil McMahon",
"text": "Okay, maybe as a loose follow-up in the upstream, just in terms of the whole Caspian Basin and the CPC pipeline, how much are you guys involved in looking at a bosphoros bypass pipeline in Turkey as a way of making sure that the increase Tengiz volumes, especially as we go forward over time, can find a decent route to market?"
},
{
"speaker": "Jim Aleveras",
"text": "Neil, all I can say is that we are looking at all of our options because obviously optionality is very important to us in terms of expansion of our existing pipeline. But right now we have rail capacity to handle all of the exports in addition to the pipeline capacity that would result from an expansion of the Tengiz project. But in terms of what specifics we are looking at over and above rail, we’d rather not discuss that."
},
{
"speaker": "Steve J. Crowe",
"text": "I would say that the discussions with the partners to expand the capacity of CPC is as it has been is ongoing and there are various conditions that each party has tabled that we are looking at but we will still continue with the negotiations for the expansion of CPC. As Jim said, we otherwise have mechanisms to move Tengiz crude and just as we had done before the CPC pipeline was completed, we are using rail and other means to move the crude. Thanks very much for your question."
},
{
"speaker": "Operator",
"text": "Our next question is from Jerry Gunn of BlackRock."
},
{
"speaker": "Steve J. Crowe",
"text": "Hello, Jerry?"
},
{
"speaker": "Operator",
"text": "Jerry, did you have a question? You may want to check your mute button."
},
{
"speaker": "Steve J. Crowe",
"text": "Okay, let’s try the next question, please."
},
{
"speaker": "Operator",
"text": "Our next question is a follow-up from Mark Gillman of Benchmark."
},
{
"speaker": "Mark Gillman",
"text": "Steve and Jim, are there any rate of return or cumulative production thresholds on block 14 that would be encountered -- block 14 in Angola -- that would be encountered this year at current price levels?"
},
{
"speaker": "Steve J. Crowe",
"text": "Not that I’m aware of. Hang on one sec here, I’ll see if I can see anything. In terms of price levels, looking at objective -- no, there is nothing substantive that is associated with the African operations."
},
{
"speaker": "Mark Gillman",
"text": "Okay, if I could just sneak a follow-up; Steve, I wasn’t clear what you meant by that roughly 25,000 a day characterization of the impact of the Indonesian unitization on the gas side. I thought that there was a one-time retroactive element which is benefiting the first quarter and then a considerably smaller positive impact going forward. What was the 25 equivalents a day supposed to represent?"
},
{
"speaker": "Steve J. Crowe",
"text": "That was the retroactivity piece that I was alluding to that would be non-recurring obviously in other quarters. So your understanding is correct, Mark."
},
{
"speaker": "Mark Gillman",
"text": "Okay, fine. Thank you."
},
{
"speaker": "Jim Aleveras",
"text": "Matt, do we have other callers?"
},
{
"speaker": "Operator",
"text": "At this time, I am showing no further questions."
},
{
"speaker": "Steve J. Crowe",
"text": "Thank you. I am presuming that we’ve been able to cover your questions in the time allotted and I think in large measure because our interim update provided a lot of information that’s proved to be consistent with the earnings release that you saw today. So in closing, I want to express my appreciation to everyone’s participation on the call and I especially want to thank each of the analysts on behalf of the participants for their questions during this morning’s session. Matt, I’ll turn it back to you."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today’s 2008 earnings conference call. You may now disconnect. Good day."
}
] | null | null |
CVX | 4 | 2,007 | 2008-02-01 11:00:00 | Operator: Welcome to Chevron's fourth quarter 2007 earnings conference call. (Operator Instructions) I will now turn the conference call over to the Chairman and Chief Executive Officer of Chevron Corporation, Mr. Dave O'Reilly. Please go ahead, sir.
David O'Reilly: Thank you, Matt, and welcome to Chevron's fourth quarter earnings conference call and webcast. I am joined by today Steve Crowe, our Chief Financial Officer; and Jim Aleveras, General Manager, Investor Relations. Our focus today is on Chevron's financial and operating results for the fourth quarter and will refer to the slides that are available on the web. Turning to slide 2, before we start, please be reminded that this presentation contains estimates, projections and other forward-looking statements. I ask you to review the cautionary statement on this slide. I'll begin with slide 3, which provides an overview of our financial performance. The company's fourth quarter earnings were $4.9 billion or $2.32 per diluted share. Full year results of $18.7 billion mark the fourth consecutive year of record earnings. Our fourth quarter earnings were 29% higher than the fourth quarter of 2006, reflecting higher crude prices, which more than offset weaker downstream results. Fourth quarter earnings rose 31% compared to the third quarter of 2007, which Steve will discuss in detail shortly. Return on capital employed for the year was 23% and our debt ratio at yearend was 8.6%. Stock buybacks during the quarter were $2 billion and $7 billion for the year in total. Total shareholder return for the year was over 30%. Turning to slide 4, our total capital spending for 2007 was $20 billion. Upstream spending accounted for $15.5 billion or 78% of the total. Our cash C&E, which excludes our share of equity share of affiliate outlets totaled $17.7 billion for the year. Our announced capital program for 2008 of $22.9 billion represents an increase of $2.9 billion over 2007 expenditures. About $2 billion of the increase is earmarked for upstream, reflecting the capital-intensive phase of some of our long-term growth projects. The change in downstream spending is due to a number of investments to operate our refining network. Steve will now take us through the quarterly comparisons. Steve?
Steve Crowe: Thanks, Dave. My remarks compare results of the fourth quarter 2007 to the third quarter. As a reminder, our earnings release compared fourth quarter 2007 to the same quarter a year ago. Turning to slide 5. Fourth quarter net income was almost $1.2 billion higher than the third quarter. Starting with the left side of this chart, significantly higher oil prices and slightly higher natural gas prices benefited the company's upstream results worldwide. Higher international liftings were also a factor. Downstream results fell from the prior quarter. The third quarter included a $265 million gain on the sale of our fuels marketing assets in Belgium, Luxembourg and the Netherlands. The variance in the residual "Other" bar is the net of everything else. Slide 6 summarizes the results of our US upstream earnings, which improved by about $240 million between quarters. Higher realizations, primarily for liquids, benefited earnings by $400 million. Chevron's US crude oil realizations were up roughly $13 per barrel. While the average quarterly price of WTI increased more than $15 per barrel between quarters, much of our Gulf of Mexico crude oil production is priced on a lagged basis and rose about $11 per barrel. Production volumes fell 1.5% between quarters largely due to operational downtime and field declines in the Gulf of Mexico. The $90 million DD&A benefit primarily reflects the absence of the third quarter's provision for asset retirement obligations. Exploration and operating expense increased about $165 million between quarters. Exploration expense was up about $90 million mostly on higher well write-offs. Operating expense was $75 million higher due to higher production taxes and maintenance costs. "Other" primarily reflects lower gas marketing margins. Turning to slide 7. International upstream earnings for the fourth quarter were almost $1.2 billion higher than the third quarters' results. Higher oil and gas prices increased earnings by about $700 million. Unit realizations for liquids rose by $13 per barrel, in line with the percentage change in Brent spot prices. Higher liftings during the quarter, particularly in Azerbaijan, Kazakhstan, Australia and Nigeria, improved earnings by $280 million. Tax items benefited earnings by $210 million between quarters. This mainly reflects the absence of adverse tax adjustments last quarter along with net favorable adjustments spread across a number of countries in the current period. The variance in "Other" reflects the absence of asset impairment charges recorded in the third quarter, which were offset by higher operating expenses. Slide 8 summarizes the change in worldwide oil equivalent production, including volumes produced from oilsands in Canada. Production rose by 22,000 barrels per day between quarters. During the fourth quarter, US production decreased 11,000 barrels per day compared to the prior period, mainly due to operational downtime and field declines in the Gulf of Mexico. Outside of the US, oil and gas production increased 33,000 barrels per day between quarters. The increase reflected the absence of third quarter shutdowns in the UK and Azerbaijan. The Tengiz expansion project in Kazakhstan came on stream late in the fourth quarter and was gradually ramping up. Partially offsetting was a drop in Canadian volumes due to the November fire at the Athabasca upgrader and lower Hibernia production. Turning to slide 9, we'll now briefly discuss our 2008 production outlook. As a reminder, during our fourth quarter 2006 conference call a year ago, we estimated that total 2007 production would be about 2.6 million barrels a day. That estimate assumed an oil price of about $60 per barrel. Despite the impact of higher crude oil prices on net production, we were able to exceed our estimate by 19,000 barrels a day. The increased volumes came from major capital projects, fewer storm-related shut-ins and lower base business decline rates. As we look to 2008 production in a $70 per barrel price environment, we are estimating a production increase of a little more than 1%. If prices were to remain at the current $90 level, production would be on the order of 50,000 to 60,000 barrels a day lower. As noted in the slide, the 2008 production reflects an overall base business decline rate of 4.5%, which is consistent with our historical experience. We anticipate that the start-up of major capital projects in 2008 and the ramp-up of volumes from projects begun in earlier years will had about 150,000 barrels a day. These projects include the Tengiz expansion in Kazakhstan, Agbami in Nigeria and Blind Faith in the Gulf of Mexico. We also anticipate continued production growth from our Bibiana field in Bangladesh. Looking beyond 2008 production, we reaffirm our objective to grow production volumes from 2005 to 2010 by an annual rate of 3%. Before moving on to the downstream, I'd like to briefly address our reserves replacement for 2007. At the end of February, we'll file our Form 10-K with the SEC, which will have considerable detail on our oil and gas reserves. We haven't yet completed all of our governance reviews, but I can tell you today that we anticipate the 2007 reserves replacement ratio on an oil equivalent basis will be in the 10% to 15% range. This low replacement rate was affected by three primary factors. First, SEC rules require that reserves be calculated using yearend prices. The price of WTI increased $35 per barrel from the end of 2006 to the end of 2007. This large rise in commodity prices reduced our reported reserves under production sharing contracts and variable royalty arrangements that are common in international operations. We estimate the impact of higher prices reduced our replacement ratio by about 30%. Second, sales and acquisitions during the year reduced the replacement ratio by about 10%. And third, although we made a great deal of progress on our major development projects, the timing and circumstances were such that we were unable to book large reserves additions for these projects or for contract extensions in 2007. The timing of reserve recognition for these types of events vary significantly from year-to-year. Given the number of major projects in development, we anticipate a meaningful impact on reserve additions in the years ahead. Besides the information that will be presented on reserves in the 10-K, George Kirkland will discuss this topic and our outlook in more depth at the meeting with security analysts and it's webcast on March 11. He will discuss not only reserves, but also the success we've had in adding resources last year. Moving to the downstream on slide 10. US downstream operations posted a loss for the second consecutive quarter. Refining and marketing indicator margins on the West Coast improved slightly in the fourth quarter, while there was small declines on the Gulf Coast. On balance, this effect was a favorable $35 million between quarters. Higher volumes on like product for refinery production benefited the fourth quarter earnings by $50 million compared to the prior quarter. In our conference call last quarter, we mentioned the adverse impact of timing effects, such as provisionally priced foreign crude as crude prices increased $11 per barrel during the third quarter. Over the fourth quarter, the average price of WTI increased by $15 per barrel, adding to the adverse impact of this timing effects as shown on the chart. The other variance reflects higher operating expenses partly stemming from shutdowns of the Pascagoula and El Segundo refineries. Also included in this amount are the costs for provisions for litigation offset by a gain on the sale of our proprietary credit card businesses. While this slide accounts for the change in earnings between quarters, the fact remains that our US downstream business operations lost money in the fourth quarter. On an absolute basis, two major factors cause this. First, our Pascagoula refinery's crude unit was down and our El Segundo refinery was undergoing a coker upgrade to process heavier crude. This raised our feedstock costs, so our actual margins were less than the indicator margins. It also increased our operating expenses. The second factor was the sharp rise in crude oil prices. This caused us to incur loses on provisionally priced crude and to have derivative loses under mark-to-market accounting along with inventory effects in the period. These combined effects amounted to roughly $400 million in the fourth quarter. Turning to slide 11. International downstream earnings fell $228 million from the third quarter's results. Refining indicator margins were generally higher, while marketing margins were mixed across our internationally geographic areas. On balance, higher overall fourth quarter margins offset a small adverse volume effect to produce the $40 million favorable variance shown on the chart. Most of the timing effects, which reduced earnings by $80 million, were associated with inventory accounting. The third quarter included a $265 million gain on the sale of our Benelux fuels marketing operations. The $77 million benefit shown in the "Other" bar includes favorable variances in foreign exchange as well as other items that were mostly offsetting. Slide 12 shows earnings from chemical operations were $69 million in the fourth quarter compared with $103 million in the third quarter. Results for olefins declined during the quarter primarily due to lower ethylene and polyethylene sales volumes and margins. The decline in aromatics was also largely due to lower volumes and margins. Included in the "Other" bar are tax benefits and the absence of the third quarter environmental provision, partly offset by lower additive earnings. Slide 13 covers all other. Fourth quarter results were net charges of $237 million compared to net charges of $193 million in the third quarter. The absence of third quarter environmental provisions was largely offset by a decrease in net interest income. The "Other" bar includes the impact of tax benefits offset by higher yearend corporate expenses. Fourth quarter net charges for this segment fell above our standard guidance range of $160 million to $200 million as we had indicated in our interim update. That concludes our brief analysis of the quarter. So Dave, back to you.
Dave O'Reilly: Okay. Thank you, Steve. And before I get to your questions, let's have a brief recap of our strategic progress in recent months. So please turn to slide 14. With our partners, we made the final investment decision to construct a $.2 million metric ton LNG plant in Angola, in which Chevron holds a 36% interest. We signed a 30-year production sharing contract with China National Petroleum Corporation to assume operatorship and hold a 49% interest in the development of the Chuandongbei natural gas area in Central China. As Steve mentioned, we initiated production from the first phase of expansion at our 50% owned Tengiz field. And although this phase did not add significantly to fourth quarter production, earlier this week we announced the milestone of increasing daily crude oil production capacity by 90,000 barrels to about 400,000 barrels per day. The addition of full facilities in the second half of 2008 is expected to further increase daily crude production capacity to 540,000 barrels per day. We signed an agreement to increase daily sales of natural gas in Thailand by 500 million cubic feet to 1.2 billion cubic feet by 2012 from company-operated offshore blocks 10 through 13, and in late October we had received 10-year extensions for these concessions to the year 2022. Our 50% owned Yosu refinery in South Korea completed its major upgrade to process heavier crude into light products. And in December we completed the second phase of modifications at our refinery in El Segundo, California, also enabling the processing of heavier crude oils into light products. In summary, 2007 was a very successful year for Chevron and our shareholders. We achieved record earnings, investors are in excellent queue of capital projects, increased our annual dividend payment for the 20th consecutive year, and repurchased $7 billion of shares, and our total shareholders return was the best among our peer group. As we enter 2008, we look forward to the completion of several major growth projects and further progress on our strategic goal. So that concludes my prepared remarks and Steve's as well, and we'll now take your questions. One question and one follow-up per caller please, and Matt, please open the lines for questions. Thank you.
Operator: (Operator Instructions) Our first question comes from Paul Cheng of Lehman Brothers. Your question please.
Paul Cheng: Hi, good morning guys.
Steve Crowe: Good morning, Paul.
Paul Cheng: This is either for Steve or Dave. You talked briefly on the reserve replacement, and you're saying that you have not been able to book any reserve from the major project. Just your sense on the Angola LNG, and you have a contract extension in Thailand, Gulf. You also started with Tengiz, none of those that has been able to allow you to book any reserve in 2007?
Dave O'Reilly: Thank you, Paul. That's a good question and a fair question to ask. For the Angola LNG, we are very confident in the resource base as the plant owners have the rights to virtually all the associated gas in offshore Angola. However, before booking reserves from properties owned by others, we are securing third-party certifications. We anticipate those reserve adds in 2008 and in future years as the offshore Angola properties are developed. With respect to Thailand, we're also very confident of 1 billion barrel probable reserve base. We'll move into the P1 reserves as we delineate the field and the projects mature. But at this point at the time of signing the concessions, we don't meet the requirements for P1 for the SEC definition. Do you have a follow-up question Paul?
Paul Cheng: How about the Tengiz that the solid gas [re-injection] presume that that would improve the recoverable rate?
Dave O'Reilly: I think where you see our 10-K, you'll find that we have a lot more detail, Paul, on increased recoveries where they are appropriate. But I think getting back to the year, I would like to emphasize the point that the reserves are there, the resources are there, but because of the fact that we have to go through a certification process because of the complexity of the Angola situation as well, technical reasons. We booked reserves in Thailand on an incremental basis because these are multiple small fields and small compartmentalized resources that you must actually develop a plan to drill and have the drillbit involved before you book the reserves. So we're confident that the resources are there. But it's a matter of timing for booking these reserves. Thank you.
Paul Cheng: Thank you.
Steve Crowe: Paul, I'd also mentioned that in about five weeks when we have our Analyst Meeting and webcast in New York, George Kirkland, our EVP of Upstream, will talk more about the reserves booking, but he will also talk a good deal about the success we've had with the drillbit and the resource adds that we've had in 2007. So, you and others will be able to get a lot more detail on this subject at that point. Thanks very much for your question though, Paul.
Paul Cheng: Thank you.
Operator: Our next question is from Arjun Murti of Goldman Sachs. Your question, please.
Arjun Murti: Thank you. I had another question on the reserves. I think we certainly appreciate that Chevron does have a sizeable resource base that we call 3P reserves, and in any one year there can be volatility and one of these get booked to crude reserves. We understand the SEC pricing effects and we appreciate those disclosure, we appreciate the asset sales. But I guess it's now four years we're decently below 100%, and Chevron especially, both as a merged company or legacy, had such a long track record of exceeding 100% that something has meaningfully changed here in the last four years, despite you all actually having very good exploration success in signing a number of contracts. Is it just that, in the old days the legacy assets, North Sea, US and so forth, Indonesia, you were more predictably able to book the reserves in crude year-in, year-out, and we're in a transition to these new reserves, were the timings is more extended or has something else changed that's just causing now so many years of sub 100% even if we make some of the pricing adjustments in the asset sale adjustments?
Dave O'Reilly: Arjun, this is Dave. I'll take that question. First of all, I think, well, your observations are good one, but I think that if you go back, say, to the '90s, back over the last 20 years or so, the configuration of our portfolio has changed quite a bit. In those days, we were adding multiple, multiple small amounts of reserves over a multiple, multiple smaller fields when we get thousands of fields and thousands of developments. Our portfolio has deliberately shifted, of course, over the last 10 years or more, and now we are looking at significantly bigger projects that are much more lumpy. So you will see choppiness here in the reserves bookings. Now having said that even over the transition period over the last 10 years, our reserve replacement has been in excess of 100%. But, you're right. In the last few years, it has been much more choppy. So I expect you are going to see years when we are significantly above 100% on a one-year basis as things come together, but you're also going to find years when we're below it. And of course, all of that has been exacerbated by the pricing effects that you've talked about. I think if we look over the last few years alone, 600 million or 700 million barrels of oil have just disappeared. Actually it's a result of a fairly good thing and that is higher prices, higher earnings and higher cash flow. So you are going to see a more choppy period ahead some years when we're below, some years when we're substantially above, and it's a matter of timing. But we are adding the resources. And the examples that we cited in our response to Paul Cheng's question, I think are very good examples of projects that are complicated, particularly in the case of Angola. That required third-party certification because we don't actually, in the case of Angola, own all of those reserves. But we are entitled to them and we are entitled to book them as we are certified and following SEC rules. So thank you for the question.
Steve Crowe: Did you have any follow-up you'd like?
Arjun Murti: That's a very full answer, I appreciate it.
Dave O'Reilly: You're very welcome. Thanks very much for your question.
Operator: Our next question is from Robert Kessler of Simmons & Company. Your question, please.
Robert Kessler: Good morning, gentlemen. I wanted to see if we could look a little bit more closely at your 2008 updated production outlook. If I go back to what you were expecting in the March 2007 Analyst Meeting, I want to say the number was closer to 2.8 million barrels a day, so roughly 150,000 barrels a day higher than what you've got in your slide today. I know a lot has changed since then. Prices have certainly increased, Tahiti has slipped, but I wanted to see if you could provide some sort of reconciliation between those two figures?
Steve Crowe: Thank you, Robert. In our Analyst Meeting back in March of last year, you could interpolate from the bar chart that our anticipated production for 2008 would be on the order of 2.8. And as we had mentioned today at a $70 price environment, we were guiding you folks that it's 2.65. So your math, Robert, is about right. It looks to be about 150,000 barrels a day difference. We describe in the neighborhood of 95,000 to 100,000 barrels of that to a major capital project delays. As you pointed out, it's Tahiti slipping out of 2008, and it's a little slower ramp-up particularly for our TCO expansion this year. The other big component that's on the order of about 40,000 barrels a day or thereabouts would be attributable to higher prices that we're basing our production profile on this year versus the information that we showed at the Analyst Meeting. So that accounts for the lions share. But I would tell you that, as we go forward, we still expect that between 2005 and 2010, our standing guidance of increasing our production by an annual rate of 3% still holds. This timeframe will have that production more backend loaded, but we're very confident that over the next couple of years we're going be able to increase production and achieve that production growth rate. I hope that helps you, Robert. Do you have follow up on that?
Robert Kessler: That helps. Thank you very much.
Steve Crowe: You are very welcome.
Operator: Our next question is from Doug Leggate of Citigroup. Your question, please.
Doug Leggate: Thanks. Good morning, gentlemen.
Dave O'Reilly: Good morning, Doug.
Doug Leggate: If I could just get some clarity on that last answer, Steve, if you don't mind, because the implication of the original target was about 400,000 barrel per day increase over the five-year period. The price tag has obviously moved up. So, just to be clear, is this your consistency with that guidance even though we've had a substantially higher move in the oil price?
Steve Crowe: That is correct. The guidance that we're giving still pins off now a $70 price tag. You recall though, Doug, back at the time that we first gave the guidance, we said our production profile from '05 to '10 would be in excess of 3%. So we think we still have some ability to accommodate the higher prices.
Dave O'Reilly: But I think, Doug, just following up on Steve's point, if prices were to go to $90 or $100 and stay there then we have to reevaluate, I think, at least at the margins some of those assumptions. But our assumption here is we're just using $70 at the moment. The reason we pick $70 on this chart that you're seeing is that it was about $70 in 2007. So we're trying to take out the impact of prices in this analysis.
Steve Crowe: Doug, I also mentioned when I also mentioned when I was talking about our outlook for 2008, I kind of gave you some manner by which you could adjust when I commented that if prices for 2008 would be, say, in the $90 per barrel level that the production would be on the order of $50,000 to $60,000 barrels a day lower. So I have to tell you though that the price effect associated with our various contracts overseas is it varies with the price range and which those changes occur. So it's not totally linear. So the guidance that I gave you was moving, say, from a $70 per barrel environment to that of, say, a $90 per barrel environment.
Doug Leggate: Great.
Steve Crowe: Doug, did you have another question?
Doug Leggate: Thank you. I've got just a short follow-up, it's on the decline rate guidance or I think you've kind of declared that for everyone to see. A lot of the projects you have, however, are coming on are arguably quite long life. Would you expect that decline rate to moderate as these new barrels come on stream?
Steve Crowe: Yes, we would, Doug. Now, we actually did better than 4.5% during 2007, and while we're not confident enough yet in the certainty of what we're accomplishing to forecast that that's a permanent shift. But you're correct. As you move forward with longer life projects, we expect that that will make a transition at some point in the future. And that's something we'll address when we feel confident that we can forecast something that's better than 4.5%. So, at the moment we're sticking with our 4.5% guidance. Thank you.
Doug Leggate: Thank you very much.
Steve Crowe: Next question, please.
Operator: Our next question is from Mark Gilman of Benchmark. Your question, please.
Mark Gilman: Dave, Steve and Jim, good morning.
Steve Crowe: Good morning.
Doug O'Reilly: Good morning, Mark.
Mark Gilman: I want to see if I could just try to get a better understanding of the economic structure of the Angola LNG project. I mean I think I hear what you're just saying that because you have "rights to the gas" it allows you to book the reserves. But it's my understanding that you are still buying the gas from Sonangol, and therefore this is not a typical integrated West African LNG project. Can you share any light on this issue at all?
Dave O'Reilly: Let me just put it this way. The plant owners are entitled to this gas under Angolan legislation. So this is legislated, but it's not all coming from one field. There are multiple fields involved. So, there is legislation in place. All of it has been fully vetted through the government. So there are other rights to this gas, and under SEC rules, we will be able to book those gases. But because not all of them fall into our gas fields, if you will, our gas production, these have to be certified, and that's what underway right now. Other than that, that's about as far as I can go in answering your question, Mark.
Mark Gilman: But Dave, aren't you buying the gas from Sonangol even in those fields where you have a working interest and an applicable production sharing timeframe?
Dave O'Reilly: It's not a purchase arrangement. It's a dedication to the plan arrangement. And that's about as far as I can go.
Mark Gilman: Thank you very much.
Dave O'Reilly: Thanks, Mark.
Operator: Our next question is from William Ferrer of WH Reeves. Your question, please.
William Ferrer: Yes. Good morning, gentlemen.
Steve Crowe: Good morning, Bill.
William Ferrer: Couple of questions for Steve -- excuse me -- a question and a follow-up on the general issue of accounting. You mentioned that the US downstream, if I got this correctly, was burdened by $400 million in the fourth quarter roughly of inventory and derivative effects. Is that related to, say, foreign oil pricing effects, or is this different and would that go away in the first quarter, for example, or how permanent might that be? And my follow-up is also an accounting question. Without getting into the nuance of timing of reserve adds, does the formality of what you will have to report at yearend influence your book DD&A as we go forward? Thank you.
Steve Crowe: Thank you, Bill. Let me start off with the comments regarding the US downstream. As I had mentioned, in an absolute sense, we estimate that the fourth quarter US downstream results were adversely affected by about $400 million in the quarter, and there are main areas that account for this. Firstly is the downtime at our refineries. Order of magnitude, that's about $250 million impact. That reflects both planned downtime, as was the case in our El Segundo refinery when we have the coker down, as well as unplanned downtime that we had at Pascagoula as a result of the crude unit fire that occurred back in August. The components of those are both sort of a lost opportunity profit in the margin because we had to acquire more expensive feedstocks such as light, sweet crudes to input to the refineries. It also reflects that we have higher operating expense while those refineries were down. Roughly speaking, that impact of the refineries being down was about split equally between planned downtime and unplanned downtime. Now the balance of that $400 million or roughly $150 we would ascribe to, say, call timing differences, really driven by the rapid escalation in the price of crude oil from the beginning to the end of the fourth quarter. And as you pointed out, Bill, that affects both our contractual arrangements for the purchase of provisionally priced foreign crude, but also some of our derivatives that we have, which are mark-to-market at the end of each period whereas the physicals associated with that would be recognized in a different period. The inventory impacts for the fourth quarter in the US weren't all that great. There was a bigger impact overseas. So I hope that gives you and the another analysts a fix on trying to adjust to normalize, if you will, our fourth quarter US results, which are attributable, one, to the rapid rise in crude prices, and two, to the downtime that we have in our refineries. Now the second question I think you had was with respect to the impact on our DD&A rates as a result of reserve additions. And of course, that gets into the calculation for determining the DD&A rates. So it depends on where the reserve additions occur and where the decrements might occur, but it certainly influences the rate. The other item, Bill, that I'd mentioned to you is that, as we go forward, we'll be providing information in our 10-K that will address changes in our abandonment as well, and that will have impact prospectively on our DD&A rates going forward. So I don't want to go into a full accounting lesson on all of that. But your question is a good one and it will impact future years. Thanks very much for your question and your follow-up.
Operator: Our next question is from Neil McMahon of Sanford Bernstein. Your question, please.
Neil McMahon: I have a got an umbrella question on Nigeria, I guess it's the best way to put it. First of all, just after Shell's comments, about what's happening on the delta, obviously you've got a big position there as well and you have been affected by the outages. They suggested that potentially Olokola LNG will be significantly delayed. I just wanted to get an update from yourselves and also your Escravos GTL plant and how things are going there. Thanks.
Dave O'Reilly: First of all, our total performance in the delta has not been that significantly affected on a current basis. I think my recollection is that the impacts of disturbances there in the swamp areas onshore is less than 20,000 barrels a day net to Chevron. And we've made some significant progress over the last few years in steadily improving our situation there from two or three years ago. Secondly, I think it's too early to predict the schedule for Olokola. We have a new administration. There is a new government. There is a restructuring going on in the petroleum sector to separate NNPC and make it a commercial entity, and put the regulatory function back on the government with a number of distinct compartments, kind of an upstream sector of the government regulatory sector and a downstream sector, and then there is whole new look being given to the gas business. So in light of all of the changes in the government and the policies around how this whole area is going to be managed, I think it would be unrealistic. I haven't heard what Shell has said, but I think anyone associated with something that's brand new there would take the same position that we've got to reassess the timing of this. And wait until we understand how these policies and regulations are going to impact the business before we move forward, and I think we're in that zone right now. Hopefully, some clarity will come this as we more through 2008. Now, having said that, our main focus in 2008 will be brining the Agbami on stream. And Agbami, the FPSO is now on-site, it's been hooked up. We're continuing to complete wells, and we expect that sometime in the middle of the year or so that Agbami will be coming on stream. So, that's a kind of a long winded answer to your question, Neil, but it's probably, I think, a realistic assessment of the situation there.
Neil McMahon: Maybe just a follow-up on that, I'm just wondering if your comments are the same for the GTL plant. And just also on Agbami, I'm surprised that when yourself and Steve mentioned about reserve replacement rate, you didn't have a bit more to add on Agbami. Have you effectively booked all of the Agbami volumes already because one presumes it's going to be on in the next few months?
Dave O'Reilly: First of all, absolutely not, but let me remind you that that the regulations there. We've booked an initial quantity but the regulations there are very specific. You have to book the most conservative end of the range on a project like that until you actually have demonstrated oil flowing and production, and that, of course, you can't do until you start it up. So there will be more bookings on Agbami. It's an enormous resource base. But we've only booked the initial quantities there so far. Now on EGTL, it's under construction. It is still progressing and we'll give you an update on the timing for that in the March meeting. But it's still actively under construction.
Neil McMahon: Thank you.
Dave O'Reilly: Thank you, Neil. Operator Our next question is from [Eric Wilke] of Merrill Lynch. Your question, please.
Eric Wilke: Good morning. Thank you for taking my question. My question relates to TCO. It's good to see that you're making progress on the expansion. You mentioned the second phase of the expansion. Can you give us some guidance on the ramp-up profile, perhaps the average contribution to second half or the anticipated exit for 2008?
Dave O'Reilly: Eric, I'd like to hold that back until March. We are making progress month-by-month there. The SGI plant, the first phase of that is up and running and has been ramping up. So, we'll have a much better handle on this as we come out of the winter month. Winter months are difficult months from a construction perspective. The temperatures there went 30 below in recent weeks. So, if you'll hang on to that question until March, we'll have, I think, a better handle on where we think we will be on the second phase of expansion there.
Eric Wilke: Okay. Fair enough. Can I ask the second expansion though on the back evacuation route, I think you made progress on CPC expansion?
Dave O'Reilly: Absolutely. Let me just, first of all, tell we have restructured the CPC arrangements to put the pipeline on a much more financially sound footing. And we're now in the phase of negotiating the terms for expansion of the pipeline. However, we're not depending on that expansion to move oil out of Tengiz. Then if you will recall that we had a long history of being able to move oil from Tengiz before there ever was a CPC pipeline from 1993 until about the year 2000. So, we have multiple options for movement of Tengiz oil. We have a very skilled and accomplished group that are capable of doing that by a number of different routes. While we obviously desire to expand CPC and believe it will be expanded, we are confident in our ability to continue to move the crude, even the additional crude from Tengiz even without the CPC expansion being in place. Thank you.
Steve Crowe: Thank you. Can we have the next caller or question please?
Operator: Our next question is from Mark Gilman of Benchmark. Your question, please.
Mark Gilman: Dave and Steve, I'm wondering if I can possibly get a little bit better handle on the base US capital spending '08 versus '07. If we take out of each year the major project elements, in other words, Tahiti and Blind Faith, what would that comparison look like?
Dave O'Reilly: I think it would be rather flat, Mark, and in round numbers. It's a subtlety that isn't right at my fingertips right now, but I think it would be rather flat and it reflects the fact that we have a big resource base. We are continuing to see a lot of progress in other areas, which tend to skate on to the radar screen, for example, San Joaquin Valley, where we are continuing to make great gains in expanding our production there or at least moderating the decline. The Mid Continent area where we are beginning, of course, we've got plans to grow in the Piceance and expect to have production starting there around the end of the year. As to the specific numbers, let me call in Steve to kind of give you a little bit of a highlight.
Steve Crowe: Mark, I think Dave's response is right on, but let me give you kind of directionally on some of the big projects. If I take a look at, say, 2007 and compare it to 2008, the spending for Blind Faith will actually be lower in '08 than it was in '07. A little bit more money will be spent for say the Great White, Silvertip, Tobago area. In the case of Tahiti, our spending in '08 will be somewhat less than it was in '07. But as Dave pointed out in the Piceance area, we see spending ramping up there in ''08 versus ''07. And while I haven't racked up all the pieces, I think the underline comment that Dave made was right. If you pulled out the big projects that are sort of identifiable in both years, the underlying spending is probably fairly flat.
Mark Gilman: So Dave and Steve, if we allow for inflation, it's actually down a little bit.
Dave O'Reilly: Well, we're not seeing as much inflation there as you say. I mean the inflation in things like deepwater and that type of thing. But land rigs and some of the other things we're doing onshore, we're not seeing quite the same rate of inflation. So I don't think you can draw that conclusion that easily. We'll try to put more depth behind that in our March meeting, Mark, and see if we can get a better handle on it for you, okay.
Mark Gilman: Dave, one more quasi-related follow-up if I could. Without regard to the timing of the ramp-up on the Tengiz expansion, are you in a position yet to be able to assess reservoir response to the injections? I noticed, Dave, when you characterize the project in your summary comments that instead of using the range of potential increase in production, you really focused on numbers at the high end with your 540,000 a day comment.
Dave O'Reilly: Well, the high end of the range, Mark, has to do with our belief in the capacity of the plant and the facilities. The reservoir response I think we're already demonstrating, because remember we've had a experience now with sweet gas injection dating over a year before we ever gone to injecting sour gas, which we've been doing now for a numbers of months. So we've already demonstrated that the reservoir is performing and we're confident that that part of it is well underway. And with time and with further expansion of facilities, we would probably be able to add further to our reserves. But the 540 is a reflection of our belief that that capacity is now demonstrably within reach. I think that's probably the best way to put it.
Mark Gilman: Okay, Dave. Thanks a lot.
Dave O'Reilly: Thank you. Thanks, Mark.
Operator: Our next question is from Jason Gammel of Macquarie. Your question, please.
Jason Gammel: Good morning, gentlemen. I wanted to inquire about what you're seeing for refined product demand right now in the United States, maybe particularly in California, in light of the weak refining margin conditions that we've been seeing recently.
Dave O'Reilly: Jason, let me take that. If I look back on the year, I think we're seeing a year-over-year gasoline demand actually '06 to '07 is slightly up and distillate demand up by about more than a 0.5%. Now having said that, there has been a downward year-over-year trend quarter-by-quarter during the year 2007. In the first quarter, we had year-over-year gains, in the second quarter they were somewhat less, in the third quarter -- and I am talking about nationwide -- we were seeing flat, and in the fourth quarter nationwide there was a decline in the demand, I think in the order of 0.5% to 1% with the comparable period the year before. And the West Coast [Pet 5] is no exception to that. We're seeing those same trends occur in the West as we're seeing throughout the nation. So there is no question there's been a softening industry-wide throughout '07. And I think as we start '08, its early days here, but we are probably experiencing a similar softness as we saw in the fourth quarter.
Jason Gammel: Okay. Thanks, Dave. And then, maybe as a follow-up, would you mind commenting on what you're seeing in the Asian markets that you're currently marketing in?
Dave O'Reilly: The Asian markets are still doing very well. I was in 14 developing countries during the second half of '07, and I couldn't find any one of them that was growing at less than 7% GDP. So the markets, overall, there have been performing well. They may become off a little bit at these higher prices, but many of them have subsidized oil and gas prices, and you are not seeing the sort of demand impacts there that we have seen in the rest. If I take a macro view now and bring you right back up to 40,000 feet, if you look over the last few years, I think you'll see that aggregate demand in OECD has been relatively flat and the global growth that we're seeing has been driven essentially by the developing world. Developing Asia is a big, big engine here, and the Middle East itself, where a lot of the oil and gas demand is heavily subsidized, and there doesn't seem to be any real significant slowdown occurring there. So, that's it in a nutshell.
Jason Gammel: Thank you.
Steve Crowe: Thank you, Jason.
Operator: Our next question is from Eric Wilke of Merrill Lynch. Your question, please.
Eric Wilke: Thank you. Mine is just a quick follow-up on the fourth quarter US exploration expense. You mentioned that these remaining will write-off, if you can bit a more color on that that would be great.
Dave O'Reilly: There were a few in the Gulf of Mexico. And I don't have all of the specifics at hand, but they were generally in the Gulf of Mexico. I just don't have all of that at my fingertips.
Steve Crowe: Eric, you can, after the call, give a Jim a call and he'll give you a little color commentary on that to the extent that we can talk about.
Eric Wilke: Okay, thanks.
Steve Crowe: Thanks very much.
Dave O'Reilly: Okay. Well, I think it's coming up to the top of the hour. So I think it's a good time for us to wrap-up. I want to thank you all for participating in the call today, and I'll look forward to seeing many of you at our March Security Analyst Meeting in New York. So, thank you all again, and thank you, Matt, for hosting the call.
Operator: Ladies and gentlemen, this concludes today's fourth quarter 2007 earnings conference call. You may now disconnect. Good day. | [
{
"speaker": "Operator",
"text": "Welcome to Chevron's fourth quarter 2007 earnings conference call. (Operator Instructions) I will now turn the conference call over to the Chairman and Chief Executive Officer of Chevron Corporation, Mr. Dave O'Reilly. Please go ahead, sir."
},
{
"speaker": "David O'Reilly",
"text": "Thank you, Matt, and welcome to Chevron's fourth quarter earnings conference call and webcast. I am joined by today Steve Crowe, our Chief Financial Officer; and Jim Aleveras, General Manager, Investor Relations. Our focus today is on Chevron's financial and operating results for the fourth quarter and will refer to the slides that are available on the web. Turning to slide 2, before we start, please be reminded that this presentation contains estimates, projections and other forward-looking statements. I ask you to review the cautionary statement on this slide. I'll begin with slide 3, which provides an overview of our financial performance. The company's fourth quarter earnings were $4.9 billion or $2.32 per diluted share. Full year results of $18.7 billion mark the fourth consecutive year of record earnings. Our fourth quarter earnings were 29% higher than the fourth quarter of 2006, reflecting higher crude prices, which more than offset weaker downstream results. Fourth quarter earnings rose 31% compared to the third quarter of 2007, which Steve will discuss in detail shortly. Return on capital employed for the year was 23% and our debt ratio at yearend was 8.6%. Stock buybacks during the quarter were $2 billion and $7 billion for the year in total. Total shareholder return for the year was over 30%. Turning to slide 4, our total capital spending for 2007 was $20 billion. Upstream spending accounted for $15.5 billion or 78% of the total. Our cash C&E, which excludes our share of equity share of affiliate outlets totaled $17.7 billion for the year. Our announced capital program for 2008 of $22.9 billion represents an increase of $2.9 billion over 2007 expenditures. About $2 billion of the increase is earmarked for upstream, reflecting the capital-intensive phase of some of our long-term growth projects. The change in downstream spending is due to a number of investments to operate our refining network. Steve will now take us through the quarterly comparisons. Steve?"
},
{
"speaker": "Steve Crowe",
"text": "Thanks, Dave. My remarks compare results of the fourth quarter 2007 to the third quarter. As a reminder, our earnings release compared fourth quarter 2007 to the same quarter a year ago. Turning to slide 5. Fourth quarter net income was almost $1.2 billion higher than the third quarter. Starting with the left side of this chart, significantly higher oil prices and slightly higher natural gas prices benefited the company's upstream results worldwide. Higher international liftings were also a factor. Downstream results fell from the prior quarter. The third quarter included a $265 million gain on the sale of our fuels marketing assets in Belgium, Luxembourg and the Netherlands. The variance in the residual \"Other\" bar is the net of everything else. Slide 6 summarizes the results of our US upstream earnings, which improved by about $240 million between quarters. Higher realizations, primarily for liquids, benefited earnings by $400 million. Chevron's US crude oil realizations were up roughly $13 per barrel. While the average quarterly price of WTI increased more than $15 per barrel between quarters, much of our Gulf of Mexico crude oil production is priced on a lagged basis and rose about $11 per barrel. Production volumes fell 1.5% between quarters largely due to operational downtime and field declines in the Gulf of Mexico. The $90 million DD&A benefit primarily reflects the absence of the third quarter's provision for asset retirement obligations. Exploration and operating expense increased about $165 million between quarters. Exploration expense was up about $90 million mostly on higher well write-offs. Operating expense was $75 million higher due to higher production taxes and maintenance costs. \"Other\" primarily reflects lower gas marketing margins. Turning to slide 7. International upstream earnings for the fourth quarter were almost $1.2 billion higher than the third quarters' results. Higher oil and gas prices increased earnings by about $700 million. Unit realizations for liquids rose by $13 per barrel, in line with the percentage change in Brent spot prices. Higher liftings during the quarter, particularly in Azerbaijan, Kazakhstan, Australia and Nigeria, improved earnings by $280 million. Tax items benefited earnings by $210 million between quarters. This mainly reflects the absence of adverse tax adjustments last quarter along with net favorable adjustments spread across a number of countries in the current period. The variance in \"Other\" reflects the absence of asset impairment charges recorded in the third quarter, which were offset by higher operating expenses. Slide 8 summarizes the change in worldwide oil equivalent production, including volumes produced from oilsands in Canada. Production rose by 22,000 barrels per day between quarters. During the fourth quarter, US production decreased 11,000 barrels per day compared to the prior period, mainly due to operational downtime and field declines in the Gulf of Mexico. Outside of the US, oil and gas production increased 33,000 barrels per day between quarters. The increase reflected the absence of third quarter shutdowns in the UK and Azerbaijan. The Tengiz expansion project in Kazakhstan came on stream late in the fourth quarter and was gradually ramping up. Partially offsetting was a drop in Canadian volumes due to the November fire at the Athabasca upgrader and lower Hibernia production. Turning to slide 9, we'll now briefly discuss our 2008 production outlook. As a reminder, during our fourth quarter 2006 conference call a year ago, we estimated that total 2007 production would be about 2.6 million barrels a day. That estimate assumed an oil price of about $60 per barrel. Despite the impact of higher crude oil prices on net production, we were able to exceed our estimate by 19,000 barrels a day. The increased volumes came from major capital projects, fewer storm-related shut-ins and lower base business decline rates. As we look to 2008 production in a $70 per barrel price environment, we are estimating a production increase of a little more than 1%. If prices were to remain at the current $90 level, production would be on the order of 50,000 to 60,000 barrels a day lower. As noted in the slide, the 2008 production reflects an overall base business decline rate of 4.5%, which is consistent with our historical experience. We anticipate that the start-up of major capital projects in 2008 and the ramp-up of volumes from projects begun in earlier years will had about 150,000 barrels a day. These projects include the Tengiz expansion in Kazakhstan, Agbami in Nigeria and Blind Faith in the Gulf of Mexico. We also anticipate continued production growth from our Bibiana field in Bangladesh. Looking beyond 2008 production, we reaffirm our objective to grow production volumes from 2005 to 2010 by an annual rate of 3%. Before moving on to the downstream, I'd like to briefly address our reserves replacement for 2007. At the end of February, we'll file our Form 10-K with the SEC, which will have considerable detail on our oil and gas reserves. We haven't yet completed all of our governance reviews, but I can tell you today that we anticipate the 2007 reserves replacement ratio on an oil equivalent basis will be in the 10% to 15% range. This low replacement rate was affected by three primary factors. First, SEC rules require that reserves be calculated using yearend prices. The price of WTI increased $35 per barrel from the end of 2006 to the end of 2007. This large rise in commodity prices reduced our reported reserves under production sharing contracts and variable royalty arrangements that are common in international operations. We estimate the impact of higher prices reduced our replacement ratio by about 30%. Second, sales and acquisitions during the year reduced the replacement ratio by about 10%. And third, although we made a great deal of progress on our major development projects, the timing and circumstances were such that we were unable to book large reserves additions for these projects or for contract extensions in 2007. The timing of reserve recognition for these types of events vary significantly from year-to-year. Given the number of major projects in development, we anticipate a meaningful impact on reserve additions in the years ahead. Besides the information that will be presented on reserves in the 10-K, George Kirkland will discuss this topic and our outlook in more depth at the meeting with security analysts and it's webcast on March 11. He will discuss not only reserves, but also the success we've had in adding resources last year. Moving to the downstream on slide 10. US downstream operations posted a loss for the second consecutive quarter. Refining and marketing indicator margins on the West Coast improved slightly in the fourth quarter, while there was small declines on the Gulf Coast. On balance, this effect was a favorable $35 million between quarters. Higher volumes on like product for refinery production benefited the fourth quarter earnings by $50 million compared to the prior quarter. In our conference call last quarter, we mentioned the adverse impact of timing effects, such as provisionally priced foreign crude as crude prices increased $11 per barrel during the third quarter. Over the fourth quarter, the average price of WTI increased by $15 per barrel, adding to the adverse impact of this timing effects as shown on the chart. The other variance reflects higher operating expenses partly stemming from shutdowns of the Pascagoula and El Segundo refineries. Also included in this amount are the costs for provisions for litigation offset by a gain on the sale of our proprietary credit card businesses. While this slide accounts for the change in earnings between quarters, the fact remains that our US downstream business operations lost money in the fourth quarter. On an absolute basis, two major factors cause this. First, our Pascagoula refinery's crude unit was down and our El Segundo refinery was undergoing a coker upgrade to process heavier crude. This raised our feedstock costs, so our actual margins were less than the indicator margins. It also increased our operating expenses. The second factor was the sharp rise in crude oil prices. This caused us to incur loses on provisionally priced crude and to have derivative loses under mark-to-market accounting along with inventory effects in the period. These combined effects amounted to roughly $400 million in the fourth quarter. Turning to slide 11. International downstream earnings fell $228 million from the third quarter's results. Refining indicator margins were generally higher, while marketing margins were mixed across our internationally geographic areas. On balance, higher overall fourth quarter margins offset a small adverse volume effect to produce the $40 million favorable variance shown on the chart. Most of the timing effects, which reduced earnings by $80 million, were associated with inventory accounting. The third quarter included a $265 million gain on the sale of our Benelux fuels marketing operations. The $77 million benefit shown in the \"Other\" bar includes favorable variances in foreign exchange as well as other items that were mostly offsetting. Slide 12 shows earnings from chemical operations were $69 million in the fourth quarter compared with $103 million in the third quarter. Results for olefins declined during the quarter primarily due to lower ethylene and polyethylene sales volumes and margins. The decline in aromatics was also largely due to lower volumes and margins. Included in the \"Other\" bar are tax benefits and the absence of the third quarter environmental provision, partly offset by lower additive earnings. Slide 13 covers all other. Fourth quarter results were net charges of $237 million compared to net charges of $193 million in the third quarter. The absence of third quarter environmental provisions was largely offset by a decrease in net interest income. The \"Other\" bar includes the impact of tax benefits offset by higher yearend corporate expenses. Fourth quarter net charges for this segment fell above our standard guidance range of $160 million to $200 million as we had indicated in our interim update. That concludes our brief analysis of the quarter. So Dave, back to you."
},
{
"speaker": "Dave O'Reilly",
"text": "Okay. Thank you, Steve. And before I get to your questions, let's have a brief recap of our strategic progress in recent months. So please turn to slide 14. With our partners, we made the final investment decision to construct a $.2 million metric ton LNG plant in Angola, in which Chevron holds a 36% interest. We signed a 30-year production sharing contract with China National Petroleum Corporation to assume operatorship and hold a 49% interest in the development of the Chuandongbei natural gas area in Central China. As Steve mentioned, we initiated production from the first phase of expansion at our 50% owned Tengiz field. And although this phase did not add significantly to fourth quarter production, earlier this week we announced the milestone of increasing daily crude oil production capacity by 90,000 barrels to about 400,000 barrels per day. The addition of full facilities in the second half of 2008 is expected to further increase daily crude production capacity to 540,000 barrels per day. We signed an agreement to increase daily sales of natural gas in Thailand by 500 million cubic feet to 1.2 billion cubic feet by 2012 from company-operated offshore blocks 10 through 13, and in late October we had received 10-year extensions for these concessions to the year 2022. Our 50% owned Yosu refinery in South Korea completed its major upgrade to process heavier crude into light products. And in December we completed the second phase of modifications at our refinery in El Segundo, California, also enabling the processing of heavier crude oils into light products. In summary, 2007 was a very successful year for Chevron and our shareholders. We achieved record earnings, investors are in excellent queue of capital projects, increased our annual dividend payment for the 20th consecutive year, and repurchased $7 billion of shares, and our total shareholders return was the best among our peer group. As we enter 2008, we look forward to the completion of several major growth projects and further progress on our strategic goal. So that concludes my prepared remarks and Steve's as well, and we'll now take your questions. One question and one follow-up per caller please, and Matt, please open the lines for questions. Thank you."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Our first question comes from Paul Cheng of Lehman Brothers. Your question please."
},
{
"speaker": "Paul Cheng",
"text": "Hi, good morning guys."
},
{
"speaker": "Steve Crowe",
"text": "Good morning, Paul."
},
{
"speaker": "Paul Cheng",
"text": "This is either for Steve or Dave. You talked briefly on the reserve replacement, and you're saying that you have not been able to book any reserve from the major project. Just your sense on the Angola LNG, and you have a contract extension in Thailand, Gulf. You also started with Tengiz, none of those that has been able to allow you to book any reserve in 2007?"
},
{
"speaker": "Dave O'Reilly",
"text": "Thank you, Paul. That's a good question and a fair question to ask. For the Angola LNG, we are very confident in the resource base as the plant owners have the rights to virtually all the associated gas in offshore Angola. However, before booking reserves from properties owned by others, we are securing third-party certifications. We anticipate those reserve adds in 2008 and in future years as the offshore Angola properties are developed. With respect to Thailand, we're also very confident of 1 billion barrel probable reserve base. We'll move into the P1 reserves as we delineate the field and the projects mature. But at this point at the time of signing the concessions, we don't meet the requirements for P1 for the SEC definition. Do you have a follow-up question Paul?"
},
{
"speaker": "Paul Cheng",
"text": "How about the Tengiz that the solid gas [re-injection] presume that that would improve the recoverable rate?"
},
{
"speaker": "Dave O'Reilly",
"text": "I think where you see our 10-K, you'll find that we have a lot more detail, Paul, on increased recoveries where they are appropriate. But I think getting back to the year, I would like to emphasize the point that the reserves are there, the resources are there, but because of the fact that we have to go through a certification process because of the complexity of the Angola situation as well, technical reasons. We booked reserves in Thailand on an incremental basis because these are multiple small fields and small compartmentalized resources that you must actually develop a plan to drill and have the drillbit involved before you book the reserves. So we're confident that the resources are there. But it's a matter of timing for booking these reserves. Thank you."
},
{
"speaker": "Paul Cheng",
"text": "Thank you."
},
{
"speaker": "Steve Crowe",
"text": "Paul, I'd also mentioned that in about five weeks when we have our Analyst Meeting and webcast in New York, George Kirkland, our EVP of Upstream, will talk more about the reserves booking, but he will also talk a good deal about the success we've had with the drillbit and the resource adds that we've had in 2007. So, you and others will be able to get a lot more detail on this subject at that point. Thanks very much for your question though, Paul."
},
{
"speaker": "Paul Cheng",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question is from Arjun Murti of Goldman Sachs. Your question, please."
},
{
"speaker": "Arjun Murti",
"text": "Thank you. I had another question on the reserves. I think we certainly appreciate that Chevron does have a sizeable resource base that we call 3P reserves, and in any one year there can be volatility and one of these get booked to crude reserves. We understand the SEC pricing effects and we appreciate those disclosure, we appreciate the asset sales. But I guess it's now four years we're decently below 100%, and Chevron especially, both as a merged company or legacy, had such a long track record of exceeding 100% that something has meaningfully changed here in the last four years, despite you all actually having very good exploration success in signing a number of contracts. Is it just that, in the old days the legacy assets, North Sea, US and so forth, Indonesia, you were more predictably able to book the reserves in crude year-in, year-out, and we're in a transition to these new reserves, were the timings is more extended or has something else changed that's just causing now so many years of sub 100% even if we make some of the pricing adjustments in the asset sale adjustments?"
},
{
"speaker": "Dave O'Reilly",
"text": "Arjun, this is Dave. I'll take that question. First of all, I think, well, your observations are good one, but I think that if you go back, say, to the '90s, back over the last 20 years or so, the configuration of our portfolio has changed quite a bit. In those days, we were adding multiple, multiple small amounts of reserves over a multiple, multiple smaller fields when we get thousands of fields and thousands of developments. Our portfolio has deliberately shifted, of course, over the last 10 years or more, and now we are looking at significantly bigger projects that are much more lumpy. So you will see choppiness here in the reserves bookings. Now having said that even over the transition period over the last 10 years, our reserve replacement has been in excess of 100%. But, you're right. In the last few years, it has been much more choppy. So I expect you are going to see years when we are significantly above 100% on a one-year basis as things come together, but you're also going to find years when we're below it. And of course, all of that has been exacerbated by the pricing effects that you've talked about. I think if we look over the last few years alone, 600 million or 700 million barrels of oil have just disappeared. Actually it's a result of a fairly good thing and that is higher prices, higher earnings and higher cash flow. So you are going to see a more choppy period ahead some years when we're below, some years when we're substantially above, and it's a matter of timing. But we are adding the resources. And the examples that we cited in our response to Paul Cheng's question, I think are very good examples of projects that are complicated, particularly in the case of Angola. That required third-party certification because we don't actually, in the case of Angola, own all of those reserves. But we are entitled to them and we are entitled to book them as we are certified and following SEC rules. So thank you for the question."
},
{
"speaker": "Steve Crowe",
"text": "Did you have any follow-up you'd like?"
},
{
"speaker": "Arjun Murti",
"text": "That's a very full answer, I appreciate it."
},
{
"speaker": "Dave O'Reilly",
"text": "You're very welcome. Thanks very much for your question."
},
{
"speaker": "Operator",
"text": "Our next question is from Robert Kessler of Simmons & Company. Your question, please."
},
{
"speaker": "Robert Kessler",
"text": "Good morning, gentlemen. I wanted to see if we could look a little bit more closely at your 2008 updated production outlook. If I go back to what you were expecting in the March 2007 Analyst Meeting, I want to say the number was closer to 2.8 million barrels a day, so roughly 150,000 barrels a day higher than what you've got in your slide today. I know a lot has changed since then. Prices have certainly increased, Tahiti has slipped, but I wanted to see if you could provide some sort of reconciliation between those two figures?"
},
{
"speaker": "Steve Crowe",
"text": "Thank you, Robert. In our Analyst Meeting back in March of last year, you could interpolate from the bar chart that our anticipated production for 2008 would be on the order of 2.8. And as we had mentioned today at a $70 price environment, we were guiding you folks that it's 2.65. So your math, Robert, is about right. It looks to be about 150,000 barrels a day difference. We describe in the neighborhood of 95,000 to 100,000 barrels of that to a major capital project delays. As you pointed out, it's Tahiti slipping out of 2008, and it's a little slower ramp-up particularly for our TCO expansion this year. The other big component that's on the order of about 40,000 barrels a day or thereabouts would be attributable to higher prices that we're basing our production profile on this year versus the information that we showed at the Analyst Meeting. So that accounts for the lions share. But I would tell you that, as we go forward, we still expect that between 2005 and 2010, our standing guidance of increasing our production by an annual rate of 3% still holds. This timeframe will have that production more backend loaded, but we're very confident that over the next couple of years we're going be able to increase production and achieve that production growth rate. I hope that helps you, Robert. Do you have follow up on that?"
},
{
"speaker": "Robert Kessler",
"text": "That helps. Thank you very much."
},
{
"speaker": "Steve Crowe",
"text": "You are very welcome."
},
{
"speaker": "Operator",
"text": "Our next question is from Doug Leggate of Citigroup. Your question, please."
},
{
"speaker": "Doug Leggate",
"text": "Thanks. Good morning, gentlemen."
},
{
"speaker": "Dave O'Reilly",
"text": "Good morning, Doug."
},
{
"speaker": "Doug Leggate",
"text": "If I could just get some clarity on that last answer, Steve, if you don't mind, because the implication of the original target was about 400,000 barrel per day increase over the five-year period. The price tag has obviously moved up. So, just to be clear, is this your consistency with that guidance even though we've had a substantially higher move in the oil price?"
},
{
"speaker": "Steve Crowe",
"text": "That is correct. The guidance that we're giving still pins off now a $70 price tag. You recall though, Doug, back at the time that we first gave the guidance, we said our production profile from '05 to '10 would be in excess of 3%. So we think we still have some ability to accommodate the higher prices."
},
{
"speaker": "Dave O'Reilly",
"text": "But I think, Doug, just following up on Steve's point, if prices were to go to $90 or $100 and stay there then we have to reevaluate, I think, at least at the margins some of those assumptions. But our assumption here is we're just using $70 at the moment. The reason we pick $70 on this chart that you're seeing is that it was about $70 in 2007. So we're trying to take out the impact of prices in this analysis."
},
{
"speaker": "Steve Crowe",
"text": "Doug, I also mentioned when I also mentioned when I was talking about our outlook for 2008, I kind of gave you some manner by which you could adjust when I commented that if prices for 2008 would be, say, in the $90 per barrel level that the production would be on the order of $50,000 to $60,000 barrels a day lower. So I have to tell you though that the price effect associated with our various contracts overseas is it varies with the price range and which those changes occur. So it's not totally linear. So the guidance that I gave you was moving, say, from a $70 per barrel environment to that of, say, a $90 per barrel environment."
},
{
"speaker": "Doug Leggate",
"text": "Great."
},
{
"speaker": "Steve Crowe",
"text": "Doug, did you have another question?"
},
{
"speaker": "Doug Leggate",
"text": "Thank you. I've got just a short follow-up, it's on the decline rate guidance or I think you've kind of declared that for everyone to see. A lot of the projects you have, however, are coming on are arguably quite long life. Would you expect that decline rate to moderate as these new barrels come on stream?"
},
{
"speaker": "Steve Crowe",
"text": "Yes, we would, Doug. Now, we actually did better than 4.5% during 2007, and while we're not confident enough yet in the certainty of what we're accomplishing to forecast that that's a permanent shift. But you're correct. As you move forward with longer life projects, we expect that that will make a transition at some point in the future. And that's something we'll address when we feel confident that we can forecast something that's better than 4.5%. So, at the moment we're sticking with our 4.5% guidance. Thank you."
},
{
"speaker": "Doug Leggate",
"text": "Thank you very much."
},
{
"speaker": "Steve Crowe",
"text": "Next question, please."
},
{
"speaker": "Operator",
"text": "Our next question is from Mark Gilman of Benchmark. Your question, please."
},
{
"speaker": "Mark Gilman",
"text": "Dave, Steve and Jim, good morning."
},
{
"speaker": "Steve Crowe",
"text": "Good morning."
},
{
"speaker": "Doug O'Reilly",
"text": "Good morning, Mark."
},
{
"speaker": "Mark Gilman",
"text": "I want to see if I could just try to get a better understanding of the economic structure of the Angola LNG project. I mean I think I hear what you're just saying that because you have \"rights to the gas\" it allows you to book the reserves. But it's my understanding that you are still buying the gas from Sonangol, and therefore this is not a typical integrated West African LNG project. Can you share any light on this issue at all?"
},
{
"speaker": "Dave O'Reilly",
"text": "Let me just put it this way. The plant owners are entitled to this gas under Angolan legislation. So this is legislated, but it's not all coming from one field. There are multiple fields involved. So, there is legislation in place. All of it has been fully vetted through the government. So there are other rights to this gas, and under SEC rules, we will be able to book those gases. But because not all of them fall into our gas fields, if you will, our gas production, these have to be certified, and that's what underway right now. Other than that, that's about as far as I can go in answering your question, Mark."
},
{
"speaker": "Mark Gilman",
"text": "But Dave, aren't you buying the gas from Sonangol even in those fields where you have a working interest and an applicable production sharing timeframe?"
},
{
"speaker": "Dave O'Reilly",
"text": "It's not a purchase arrangement. It's a dedication to the plan arrangement. And that's about as far as I can go."
},
{
"speaker": "Mark Gilman",
"text": "Thank you very much."
},
{
"speaker": "Dave O'Reilly",
"text": "Thanks, Mark."
},
{
"speaker": "Operator",
"text": "Our next question is from William Ferrer of WH Reeves. Your question, please."
},
{
"speaker": "William Ferrer",
"text": "Yes. Good morning, gentlemen."
},
{
"speaker": "Steve Crowe",
"text": "Good morning, Bill."
},
{
"speaker": "William Ferrer",
"text": "Couple of questions for Steve -- excuse me -- a question and a follow-up on the general issue of accounting. You mentioned that the US downstream, if I got this correctly, was burdened by $400 million in the fourth quarter roughly of inventory and derivative effects. Is that related to, say, foreign oil pricing effects, or is this different and would that go away in the first quarter, for example, or how permanent might that be? And my follow-up is also an accounting question. Without getting into the nuance of timing of reserve adds, does the formality of what you will have to report at yearend influence your book DD&A as we go forward? Thank you."
},
{
"speaker": "Steve Crowe",
"text": "Thank you, Bill. Let me start off with the comments regarding the US downstream. As I had mentioned, in an absolute sense, we estimate that the fourth quarter US downstream results were adversely affected by about $400 million in the quarter, and there are main areas that account for this. Firstly is the downtime at our refineries. Order of magnitude, that's about $250 million impact. That reflects both planned downtime, as was the case in our El Segundo refinery when we have the coker down, as well as unplanned downtime that we had at Pascagoula as a result of the crude unit fire that occurred back in August. The components of those are both sort of a lost opportunity profit in the margin because we had to acquire more expensive feedstocks such as light, sweet crudes to input to the refineries. It also reflects that we have higher operating expense while those refineries were down. Roughly speaking, that impact of the refineries being down was about split equally between planned downtime and unplanned downtime. Now the balance of that $400 million or roughly $150 we would ascribe to, say, call timing differences, really driven by the rapid escalation in the price of crude oil from the beginning to the end of the fourth quarter. And as you pointed out, Bill, that affects both our contractual arrangements for the purchase of provisionally priced foreign crude, but also some of our derivatives that we have, which are mark-to-market at the end of each period whereas the physicals associated with that would be recognized in a different period. The inventory impacts for the fourth quarter in the US weren't all that great. There was a bigger impact overseas. So I hope that gives you and the another analysts a fix on trying to adjust to normalize, if you will, our fourth quarter US results, which are attributable, one, to the rapid rise in crude prices, and two, to the downtime that we have in our refineries. Now the second question I think you had was with respect to the impact on our DD&A rates as a result of reserve additions. And of course, that gets into the calculation for determining the DD&A rates. So it depends on where the reserve additions occur and where the decrements might occur, but it certainly influences the rate. The other item, Bill, that I'd mentioned to you is that, as we go forward, we'll be providing information in our 10-K that will address changes in our abandonment as well, and that will have impact prospectively on our DD&A rates going forward. So I don't want to go into a full accounting lesson on all of that. But your question is a good one and it will impact future years. Thanks very much for your question and your follow-up."
},
{
"speaker": "Operator",
"text": "Our next question is from Neil McMahon of Sanford Bernstein. Your question, please."
},
{
"speaker": "Neil McMahon",
"text": "I have a got an umbrella question on Nigeria, I guess it's the best way to put it. First of all, just after Shell's comments, about what's happening on the delta, obviously you've got a big position there as well and you have been affected by the outages. They suggested that potentially Olokola LNG will be significantly delayed. I just wanted to get an update from yourselves and also your Escravos GTL plant and how things are going there. Thanks."
},
{
"speaker": "Dave O'Reilly",
"text": "First of all, our total performance in the delta has not been that significantly affected on a current basis. I think my recollection is that the impacts of disturbances there in the swamp areas onshore is less than 20,000 barrels a day net to Chevron. And we've made some significant progress over the last few years in steadily improving our situation there from two or three years ago. Secondly, I think it's too early to predict the schedule for Olokola. We have a new administration. There is a new government. There is a restructuring going on in the petroleum sector to separate NNPC and make it a commercial entity, and put the regulatory function back on the government with a number of distinct compartments, kind of an upstream sector of the government regulatory sector and a downstream sector, and then there is whole new look being given to the gas business. So in light of all of the changes in the government and the policies around how this whole area is going to be managed, I think it would be unrealistic. I haven't heard what Shell has said, but I think anyone associated with something that's brand new there would take the same position that we've got to reassess the timing of this. And wait until we understand how these policies and regulations are going to impact the business before we move forward, and I think we're in that zone right now. Hopefully, some clarity will come this as we more through 2008. Now, having said that, our main focus in 2008 will be brining the Agbami on stream. And Agbami, the FPSO is now on-site, it's been hooked up. We're continuing to complete wells, and we expect that sometime in the middle of the year or so that Agbami will be coming on stream. So, that's a kind of a long winded answer to your question, Neil, but it's probably, I think, a realistic assessment of the situation there."
},
{
"speaker": "Neil McMahon",
"text": "Maybe just a follow-up on that, I'm just wondering if your comments are the same for the GTL plant. And just also on Agbami, I'm surprised that when yourself and Steve mentioned about reserve replacement rate, you didn't have a bit more to add on Agbami. Have you effectively booked all of the Agbami volumes already because one presumes it's going to be on in the next few months?"
},
{
"speaker": "Dave O'Reilly",
"text": "First of all, absolutely not, but let me remind you that that the regulations there. We've booked an initial quantity but the regulations there are very specific. You have to book the most conservative end of the range on a project like that until you actually have demonstrated oil flowing and production, and that, of course, you can't do until you start it up. So there will be more bookings on Agbami. It's an enormous resource base. But we've only booked the initial quantities there so far. Now on EGTL, it's under construction. It is still progressing and we'll give you an update on the timing for that in the March meeting. But it's still actively under construction."
},
{
"speaker": "Neil McMahon",
"text": "Thank you."
},
{
"speaker": "Dave O'Reilly",
"text": "Thank you, Neil. Operator Our next question is from [Eric Wilke] of Merrill Lynch. Your question, please."
},
{
"speaker": "Eric Wilke",
"text": "Good morning. Thank you for taking my question. My question relates to TCO. It's good to see that you're making progress on the expansion. You mentioned the second phase of the expansion. Can you give us some guidance on the ramp-up profile, perhaps the average contribution to second half or the anticipated exit for 2008?"
},
{
"speaker": "Dave O'Reilly",
"text": "Eric, I'd like to hold that back until March. We are making progress month-by-month there. The SGI plant, the first phase of that is up and running and has been ramping up. So, we'll have a much better handle on this as we come out of the winter month. Winter months are difficult months from a construction perspective. The temperatures there went 30 below in recent weeks. So, if you'll hang on to that question until March, we'll have, I think, a better handle on where we think we will be on the second phase of expansion there."
},
{
"speaker": "Eric Wilke",
"text": "Okay. Fair enough. Can I ask the second expansion though on the back evacuation route, I think you made progress on CPC expansion?"
},
{
"speaker": "Dave O'Reilly",
"text": "Absolutely. Let me just, first of all, tell we have restructured the CPC arrangements to put the pipeline on a much more financially sound footing. And we're now in the phase of negotiating the terms for expansion of the pipeline. However, we're not depending on that expansion to move oil out of Tengiz. Then if you will recall that we had a long history of being able to move oil from Tengiz before there ever was a CPC pipeline from 1993 until about the year 2000. So, we have multiple options for movement of Tengiz oil. We have a very skilled and accomplished group that are capable of doing that by a number of different routes. While we obviously desire to expand CPC and believe it will be expanded, we are confident in our ability to continue to move the crude, even the additional crude from Tengiz even without the CPC expansion being in place. Thank you."
},
{
"speaker": "Steve Crowe",
"text": "Thank you. Can we have the next caller or question please?"
},
{
"speaker": "Operator",
"text": "Our next question is from Mark Gilman of Benchmark. Your question, please."
},
{
"speaker": "Mark Gilman",
"text": "Dave and Steve, I'm wondering if I can possibly get a little bit better handle on the base US capital spending '08 versus '07. If we take out of each year the major project elements, in other words, Tahiti and Blind Faith, what would that comparison look like?"
},
{
"speaker": "Dave O'Reilly",
"text": "I think it would be rather flat, Mark, and in round numbers. It's a subtlety that isn't right at my fingertips right now, but I think it would be rather flat and it reflects the fact that we have a big resource base. We are continuing to see a lot of progress in other areas, which tend to skate on to the radar screen, for example, San Joaquin Valley, where we are continuing to make great gains in expanding our production there or at least moderating the decline. The Mid Continent area where we are beginning, of course, we've got plans to grow in the Piceance and expect to have production starting there around the end of the year. As to the specific numbers, let me call in Steve to kind of give you a little bit of a highlight."
},
{
"speaker": "Steve Crowe",
"text": "Mark, I think Dave's response is right on, but let me give you kind of directionally on some of the big projects. If I take a look at, say, 2007 and compare it to 2008, the spending for Blind Faith will actually be lower in '08 than it was in '07. A little bit more money will be spent for say the Great White, Silvertip, Tobago area. In the case of Tahiti, our spending in '08 will be somewhat less than it was in '07. But as Dave pointed out in the Piceance area, we see spending ramping up there in ''08 versus ''07. And while I haven't racked up all the pieces, I think the underline comment that Dave made was right. If you pulled out the big projects that are sort of identifiable in both years, the underlying spending is probably fairly flat."
},
{
"speaker": "Mark Gilman",
"text": "So Dave and Steve, if we allow for inflation, it's actually down a little bit."
},
{
"speaker": "Dave O'Reilly",
"text": "Well, we're not seeing as much inflation there as you say. I mean the inflation in things like deepwater and that type of thing. But land rigs and some of the other things we're doing onshore, we're not seeing quite the same rate of inflation. So I don't think you can draw that conclusion that easily. We'll try to put more depth behind that in our March meeting, Mark, and see if we can get a better handle on it for you, okay."
},
{
"speaker": "Mark Gilman",
"text": "Dave, one more quasi-related follow-up if I could. Without regard to the timing of the ramp-up on the Tengiz expansion, are you in a position yet to be able to assess reservoir response to the injections? I noticed, Dave, when you characterize the project in your summary comments that instead of using the range of potential increase in production, you really focused on numbers at the high end with your 540,000 a day comment."
},
{
"speaker": "Dave O'Reilly",
"text": "Well, the high end of the range, Mark, has to do with our belief in the capacity of the plant and the facilities. The reservoir response I think we're already demonstrating, because remember we've had a experience now with sweet gas injection dating over a year before we ever gone to injecting sour gas, which we've been doing now for a numbers of months. So we've already demonstrated that the reservoir is performing and we're confident that that part of it is well underway. And with time and with further expansion of facilities, we would probably be able to add further to our reserves. But the 540 is a reflection of our belief that that capacity is now demonstrably within reach. I think that's probably the best way to put it."
},
{
"speaker": "Mark Gilman",
"text": "Okay, Dave. Thanks a lot."
},
{
"speaker": "Dave O'Reilly",
"text": "Thank you. Thanks, Mark."
},
{
"speaker": "Operator",
"text": "Our next question is from Jason Gammel of Macquarie. Your question, please."
},
{
"speaker": "Jason Gammel",
"text": "Good morning, gentlemen. I wanted to inquire about what you're seeing for refined product demand right now in the United States, maybe particularly in California, in light of the weak refining margin conditions that we've been seeing recently."
},
{
"speaker": "Dave O'Reilly",
"text": "Jason, let me take that. If I look back on the year, I think we're seeing a year-over-year gasoline demand actually '06 to '07 is slightly up and distillate demand up by about more than a 0.5%. Now having said that, there has been a downward year-over-year trend quarter-by-quarter during the year 2007. In the first quarter, we had year-over-year gains, in the second quarter they were somewhat less, in the third quarter -- and I am talking about nationwide -- we were seeing flat, and in the fourth quarter nationwide there was a decline in the demand, I think in the order of 0.5% to 1% with the comparable period the year before. And the West Coast [Pet 5] is no exception to that. We're seeing those same trends occur in the West as we're seeing throughout the nation. So there is no question there's been a softening industry-wide throughout '07. And I think as we start '08, its early days here, but we are probably experiencing a similar softness as we saw in the fourth quarter."
},
{
"speaker": "Jason Gammel",
"text": "Okay. Thanks, Dave. And then, maybe as a follow-up, would you mind commenting on what you're seeing in the Asian markets that you're currently marketing in?"
},
{
"speaker": "Dave O'Reilly",
"text": "The Asian markets are still doing very well. I was in 14 developing countries during the second half of '07, and I couldn't find any one of them that was growing at less than 7% GDP. So the markets, overall, there have been performing well. They may become off a little bit at these higher prices, but many of them have subsidized oil and gas prices, and you are not seeing the sort of demand impacts there that we have seen in the rest. If I take a macro view now and bring you right back up to 40,000 feet, if you look over the last few years, I think you'll see that aggregate demand in OECD has been relatively flat and the global growth that we're seeing has been driven essentially by the developing world. Developing Asia is a big, big engine here, and the Middle East itself, where a lot of the oil and gas demand is heavily subsidized, and there doesn't seem to be any real significant slowdown occurring there. So, that's it in a nutshell."
},
{
"speaker": "Jason Gammel",
"text": "Thank you."
},
{
"speaker": "Steve Crowe",
"text": "Thank you, Jason."
},
{
"speaker": "Operator",
"text": "Our next question is from Eric Wilke of Merrill Lynch. Your question, please."
},
{
"speaker": "Eric Wilke",
"text": "Thank you. Mine is just a quick follow-up on the fourth quarter US exploration expense. You mentioned that these remaining will write-off, if you can bit a more color on that that would be great."
},
{
"speaker": "Dave O'Reilly",
"text": "There were a few in the Gulf of Mexico. And I don't have all of the specifics at hand, but they were generally in the Gulf of Mexico. I just don't have all of that at my fingertips."
},
{
"speaker": "Steve Crowe",
"text": "Eric, you can, after the call, give a Jim a call and he'll give you a little color commentary on that to the extent that we can talk about."
},
{
"speaker": "Eric Wilke",
"text": "Okay, thanks."
},
{
"speaker": "Steve Crowe",
"text": "Thanks very much."
},
{
"speaker": "Dave O'Reilly",
"text": "Okay. Well, I think it's coming up to the top of the hour. So I think it's a good time for us to wrap-up. I want to thank you all for participating in the call today, and I'll look forward to seeing many of you at our March Security Analyst Meeting in New York. So, thank you all again, and thank you, Matt, for hosting the call."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's fourth quarter 2007 earnings conference call. You may now disconnect. Good day."
}
] | null | null |
CVX | 3 | 2,007 | 2007-11-02 16:15:00 | Operator: Welcome to Chevron’s third quarter 2007 earnings conferencecall. (Operator Instructions) I will now turn the conference over to theVice President and Chief Financial Officer of Chevron Corporation, Mr. SteveCrowe. Please go ahead, sir.
Stephen J. Crowe: Thank you, Matt. Welcome to Chevron’s third quarter earnings conference call. Today on the call I’m joined by GeorgeKirkland, EVP, Upstream and Gas; Mike Worth, EVP, Global Downstream, and JimAleveras, General Manager, Investor Relations. Our focus today is on Chevron’sfinancial and operating results for the third quarter of 2007. We’ll refer to the slides that are availableon the web. I remind you that today’s presentation contains estimates,projections and other forward-looking statements and ask that you review the Safe Harbor statement on slide 2. Turning to slide 3, the company reported earnings of $3.7billion in the third quarter compared with $5 billion in the third quarter2006. Earnings of $1.75 per dilutedshare were down from $2.29 per share reported for the same quarter last year. Both periods reflected about $400 million or approximately$0.19 per share of net chargesassociated with non-recurring items. Themain driver for the earnings change was a decline of over $1 billion indownstream profits. Escalating costs forcrude oil feedstocks could not be fully recovered in the market. This impact was global, but it was especiallysignificant on the USwest coast. Overall, third quarter results were $1.7 billion lower than ourrecord second quarter 2007, which Jim will discuss shortly. Return on capital employed for the trailing four quarterswas 22%. During the quarter, we retiredabout $2 billion of debt, reducing the debt ratio to about 7.5% at quarter end. Third quarter share repurchases totaled $2 billion,reflecting an accelerated buyback pace. As we projected in last quarter’s conference call, we completed theDecember 2006 buyback program during the third quarter. In September, we announced and initiated anew repurchase program of up to $15 billion over a period of up to three years. Jim will now take us through the quarterly comparisons.
Jim Aleveras: Thanks, Steve. Myremarks compare third quarter results to those of the second quarter 2007. As a reminder, our earnings press releasecompared third quarter 2007 with the same quarter a year ago. Turning to slide 4, third quarter net income was $1.7billion lower than the record level of the second quarter. Lower downstream margins were the mostsignificant component of the change. Upstream realizations increased, but the benefit was partly offset bylower international liftings due to the timing of cargoes. Additionally, the second quarter included the $680 milliongain on the sale of Chevron’s investment in Dynegy, while the third quarterreflects a smaller, $265 million gain on the sale of the company’s BeneluxFuels marketing assets. Separate from these major asset sales, there was a further$300 million adverse effect between the sequential quarters due to netnon-recurring charges. The mostsignificant factor was the difference in tax items, contributing to a $230million variance between quarters. Addition non-recurring items, along with other factors in the aggregate,were responsible for a negative variance of about $130 million as shown on thisslide. Except for large discrete items, it has not been ourpractice to identify smaller non-recurring charges and credits. We did so this quarter because of the largeswing in these smaller items between the second and third quarters. Just to recap, the third quarter included $415 million lessin gains on major asset sales and $300 million more in smaller, non-recurringnet charges than did the second quarter. This amounts to an adverse swing of more than $700 million betweensequential quarters of more than $0.33 per share. Turning to slide 5. Slide 5 summarizes the results of our USupstream earnings which fell by about $90 million between quarters. Higher realizations benefited earnings byabout $135 million between quarters. Higher liquids prices contributed $250 million to earnings, but lowernatural gas realization had a $115 million offsetting impact. Chevron’s domestic crude oil realizations were up about$9.80 per barrel between quarters, around $0.50 per barrel less than theincrease in average WTI spot prices. This partly reflects Gulf of Mexico productionthat is priced on a lagged basis. This isa benefit when prices are falling, but a headwind when prices are rising. Our natural gas realization fell by a little over $1.10 perthousand cubic feet, which is in line with the average changes in bid weekpricing at Henry Hub in Californiaand in the Rockies. Our volumes were slightly lower due to storm-related shutdownsin the Gulf, maintenance work and natural field declines. These were partly offset by one moreproducing day in the third quarter. Asset retirement obligations were higher by $60 millionmainly due to an adjustment to the abandonment provision for offshore Californiaproperties that were previously sold. The other bar on this slide reflects higher exploration expense, assetimpairment and the absence of gains on some small operations we sold in thesecond quarter. Turning to slide 6, this slide compares upstreaminternational earnings, which fell about $120 million between the second andthird quarters. Stronger liquidsrealizations benefited earnings by almost all of the $285 million impact shownon this slide. Natural gas effects,while positive, were essentially negligible. Liquids realizations improved by about $5.80 per barrel, in line withthe rise in spot BRENT prices. Lower liftings spread across multiple countries reflectedthe timing of cargos and reduced earnings by $240 million. We were in a net under-lifted position in thethird quarter, which brings the year 2007 to a balance liftings position. Tax adjustments reduced earnings by about $80 millionbetween periods. The variance in theother bar includes asset impairment charges. Turning to slide 7, slide 7 summarizes the change inworldwide oil equivalent production including volumes produced from oil sandsin Canada. Daily volumes were down by 39,000 barrelsbetween quarters. Maintenance-relatedshutdowns in the UK North Sea were the largest factor in this change. George Kirkland will discuss productionvolumes in more detail in a moment. Turning to slide 8, our USdownstream results in the third quarter fell nearly $900 million from the priorquarter. Margins were down $680million. Both refining and marketingmargins fell, but the decline was particularly large for west coast refiningmargins. Breaking out the $680 million,over 90% of that amount was refining margins, and over two-thirds of thatamount, in turn, was related to the west coast. Crude prices rose more rapidly than product prices during a period whenproduct inventories were ample. West coast margins also include an unfavorable variance infinal pricing adjustments for long haul crude. Lower refining volumes reduced third quarter earnings by $90 million,primarily due to a fire at our Pascagoula, Mississippirefinery in mid-August as well as other planned maintenance there. The unfavorablevariance in the other bar on this chart includes employee termination benefitsand provisions for litigation. Both thesecond quarter and third quarter included environmental remediation charges inthis segment. Turning to slide 9, international downstream earnings of $487million were $30 million lower than the second quarter. Released downstream margins dropped by about$275 million, in line with the change in indicator margins. Asian refining margin indicators fell byone-third and indicator margins were sharply lower in Europeas well. As was the case in the US;the price of crude rose more rapidly than the price of refined products duringthe quarter. These lower margins fullyoffset the gain on the sale of our fuels marketing business in the Beneluxcountries. The other bar on this slide includes asset impairment charges, lowershipping earnings and employee termination benefits. Looking at slide 10, this slide shows the chemicaloperations earnings in the quarter were $103 million, essentially unchangedfrom the prior quarter. The results foroil sands improved due to higher ethylene margins and reduced utilitycosts. Aromatics benefited from improvedstyrene earnings reflecting higher margins and increased volumes. Aromatics also benefited from the absence ofan asset writedown we mentioned in the second quarter. The other bar includesan environment reserve provision in the third quarter. Slide 11 covers all other. Second quarter results included the $680 million gain on the sale of ourinterest in Dynegy, which was partly offset by $160 million of charges relatedto the early redemption of Texaco capital bonds. Similar to the second quarterthis segment includes about $70 million of environmental remediation expensesfor legacy Texaco and Unocal sites that have been closed or sold. Third quarter net charges for this segmentfell at the high end of our standard guidance range of $160 million to $200million as we advised in our interim update. That completes a brief analysis of the quarter. Back over to you Steve.
Stephen J. Crowe: Thanks, Jim. Wewanted to use a portion of today’s teleconference to give George Kirkland andMike Worth and opportunity to update you on our upstream and downstreambusiness developments respectively. We’ll start with George. He’llturn things over to Mike and then we’ll open it up for your questions.
George Kirkland: Thank you, Steve. I’ll start on slide 13. Before Iprovide you with an update of our major capital projects, I would like to reviewour 2007 production results. This slidecompares our net OEG production through the first nine months of 2007 versusthe first nine months of last year. Although we are down 50,000 barrels a day this year, we can point out90,000 barrels of losses in 2007 that are attributable to our contractualchange in OPEC curtailments in Venezuela. Our production efforts this year have been focused onmanaging our base business declines and capturing gains from major capitalprojects that have recently come online. The low base business decline is a positive indicator of our basebusiness efforts. However, there are many moving parts in the base business --workovers, development wells, reliability and so on -- and it’s too early to say that our typical4% to 5% base decline rate has changed. Now I’ll update you on some of our key projects. Please turn to slide 14. Let’s start in the Gulf of Mexicodeepwater with our Tahiti project, where we have a 58%net working interest. As a reminder, Tahitiis designed to have a production capacity of 125,000 barrels of oil per day and70 million cubic feet of gas per day. We have continued to progress this project by completinginstallation of export pipelines, completing five of the six development wells,and installing a significant portion of the sub sea production system and flowlines. The spar hole is complete and thetop sides are near completion. The holeand top sides will be ready for offshore installation once replacement mooringshackles and components are delivered and the rescheduling of the installationis finalized. A metallurgical problem with the original shackles wasidentified in June and installation activities were deferred in order to insurethat the facilities would be put in a safe and reliable operation. Installation of the truss spar is now scheduled to begin inthe first quarter of 2008. The top sideinstallation, the mating with the spar, is targeted for the third quarter of2008. First production is now expectedby the third quarter of 2009, approximately 12 months later than originallyplanned due to the shackle replacement and the installation rescheduling. Now let’s turn to slide 15. We also continue to progress our Blind Faith project, located in the deepwaterGulf of Mexico. In July we purchased an additional 12.5% working interest in thisproject, bringing our total interest up to a 75% share. The top sides have been lifted onto the holeand all three development wells have been drilled. Positive results from the developmentdrilling supports the future drilling of a fourth well by 2009. Off shore installation and well completions are scheduled tocommence in November of this year, with first production expected by the secondquarter of 2008. Blind Faith has aproduction capacity of 45,000 barrels of oil per day and 45 million cubic feetof gas per day. Now onto slide 16 where I will update the status of theAgbami Deepwater Nigeria project. It’sfloating production, storage and off-loading vessel has left the fabricationyard in South Koreaand is being towed to the offshore Nigerialocation. This FPSO is the largest ofits type in the world and will be moored and ready for hook-up in the firstquarter of 2008. It has a processingcapacity of 250,000 barrels of oil per day and a storage capacity of 2.1million barrels of oil. We have already drilled 11 producers and seven injectors. We have two rigs working on the completionsof these wells. We are on-track forfirst oil by the third quarter of 2008. We expect to be at full capacity within one year of start up. As a reminder, Chevron has a 68% interest inthis project. Now turning to slide 17, I’ll cover the Tengiz SGI/SGPproject. We anticipate that sour gasinjection and the first production will begin in the fourth quarter of2007. As a reminder, Chevron has a 50%working interest in TCO and the expansion start up, which we call Staged Oil,will enable us to increase production by about 90,000 barrels a day gross. The second generation plant which is picturedhere should be fully operational by the second half of 2008. This will add another 160,000 barrels ofproduction per day. The labor disruption of 2006 extended the constructionperiod but we have made great strides in keeping this project moving forward. The combined SGI/SGP project has been one ofthe most complex and challenging, multi-billion dollar projects that Chevronhas ever led, and we are glad to see this project nearing its completion andstart-up. In the interim period between project start-up and theCaspian pipeline expansion, alternative rail export routes ensure we can exportthe full plant output. Now let’s turn to slide 18. Production growth in the near term is all about the start-up and ramp-upof these highlighted major capital projects. Before I finish this morning, I wanted to cover other key milestonesthat occurred during the third quarter. The first two bullets further illustrate that our largequeue of opportunities are moving forward. Gorgon has passed a couple of very important milestones recently. We received environmental approval from theWestern Australian Minister for the Environment in September, and FederalMinister for the Environment in October. Our engineering efforts are focusing on the permit conditions,modularization opportunities and execution planning. In Indonesiawe started up the DarajatIII geothermal project in July. This facility adds 110 megawatts to the West Javapower grid. The Darajat facility now hasa total capacity of 260 megawatts. The next two items are examples of how we replenish ourdevelopment queue. In August weannounced the Malange oil discovery in block 14 deepwater offshore Angola.This well encountered more than 200 net feet of oil sands. The well was tested at a rate of over 7,500barrels of oil per day of high quality crude. Future drilling is planned to assess potential reserves and assist inthe development design. In July, we reported the successful prevention test of theRosebank appraisal well, located some 100 miles Northwest of the Shetland Islands. This well, in approximately 3,700 feet of water, flow-tested37 degree API light oil at restricted rates of 6,000 barrels of oil perday. The appraisal and evaluationprogram should be completed by November of this year and will allow us todetermine the future work program and development of this discovery. We also recently announced our extension of the productionperiod for Thailandblocks 10 through 13. By securing thisproduction extension we will now be able to move major investments forward onthe Platong II project. Platong II isthe planned expansion of the existing Platong assets, which are currentlyproducing 250 million cubic feet a day and 40,000 barrels a day of hydrocarbideliquids. Platong II will add gasprocessing capacity and enable our oil and gas projects to beaccelerating. Now I’ll turn it over to Mike.
Mike Worth: Thanks, George. Moving to slide 19, I would now like to update you on key downstreaminitiatives beginning with operational excellence. Improved reliabilitycontinues to be our top priority. We have resolved many high-risk conditionswhich have caused unplanned downtime. Despite these improvements, weexperienced significant crude unit fires this year at Richmondand Pascagoula. These incidentsremind us that we still have work to do, and have further strengthened ourresolve to improve reliability to enhance capabilities, processes andequipment. While the fire at Pascagoula was unfortunate, our incidentresponse was swift and effective, limiting the impact and preventing anyinjuries. We expect to complete repairs during the first quarter 2008. Thedemolition phase is proceeding safely. Critical equipment orders have beenplaced, and delivery is scheduled. We’re taking steps to optimize conversionunit utilization while the crude unit is offline. As the left chart shows, lost utilization from unplanneddowntime this year has been slightly greater than in 2006, due to the two fires.However, we continue to drive down the number of unplanned outages, as shown onthe right. Incidents per quarter at our largest operated refineries have fallenmore than 50% since 2005. Since the first quarter turnaround, crude unit utilizationat Richmond has been consistentlystrong, averaging 101%. Our UK refinery has also operated very well the entireyear, also averaging 100% crude utilization. Conversion unit utilization atthese facilities has also been very strong. Turning to capital projects on slide 20, we are progressingwell in terms of achieving the major milestones we committed to earlier thisyear. During the quarter, our South Korean joint venture refinery completedconstruction of its [reside] upgrade project ahead of schedule and on budget.We expect the upgrade to lower crude costs by about $1 per barrel, increaselight product yield by 33,000 barrels per day, and add 15,000 barrels per dayof new lubricant base oil production. A new vacuum column, among the largest inthe world, and a new hydrocracker, lubricants base oil plant, and otherconversion units have begun commercial operations. On the west coast, we are currently modifying our El Segundocoker during a planned turnaround, to enable a shift to heavier and highersulfur crudes and to improve coker reliability. We expect to meet our productsupply commitments during the turnaround and to have the heavy crudeenhancements online by year end. We completed the Caspian blend integration product at our UKrefinery ahead of schedule and on budget. We now have the ability to feedCaspian blend crude at rates up to 40% of total feed. This will provide an economic outlet forgrowing equity production. Finally, we announced sanctioning of the ContinuousCatalytic Reforming project at Pascagoula. The new CCR will improve utilization andoptimize product yields. Gasolineproduction at the refinery is expected to increases about 10% with completionanticipated by mid-2010. In summary, weare ahead of schedule, or on track to complete the significant capital projectswe committed to bringing online this year. Moving to slide 21, we are also making significant progressin high grading our portfolio. As youcan see from the map, we have made a number of divestments in the past twoyears on top of ongoing efforts to reduce the capital intensity of our brandedretail network. As you recall, back in March we announced our intent topursue divestments in Europe and Latin America. We have followedthrough and succeeded in monetizing assets in businesses we no longer consideredstrategic. In March, we sold our 31%interest in the Nerefco Refinery in the Netherlandsand other assets there, generating $1.1 billion in after-tax proceeds. Duringthe third quarter, we closed the sale of our fuels marketing business in Belgium,the Netherlandsand Luxembourgfor about $500 million in proceeds excluding a final adjustment expected byyear end. We also reached agreements to sell our proprietary, consumerand commercial credit card businesses. We believe these arrangements will enhance the payment products we offerour customers, while enabling us to maintain the strong brand loyaltyassociated with our cards. More portfolio improvement opportunities are being evaluatedand we’ll share progress on these in the future. We are working to create a more focusedfootprint for our marketing businesses. Fewer markets, but stronger positions in those markets will help usreduce costs and further improve returns on divested capital. Now I will turn it back over to Steve.
Stephen J. Crowe: Thanks, Mike. Thatconcludes our prepared remarks. We’llnow take your questions, one question per caller, please. Matt, please open the lines for questions.
Operator: Our first question comes from Dan Barcelo - Banc Of AmericaSecurities.
Dan Barcelo: Good morning, gentlemen. Thank you for the update,particularly on the projects, it was quite useful. I wonder if you could spenda little bit on Gorgon. Having received a lot of the environmental approvals,could you talk a little bit about maybe the costs you are looking at now? Iknow it may be premature as you’re still trying to cost and phase that, but anythoughts about how you’d phase the development, and particularly on the costs forGorgon? Thank you.
George Kirkland: Dan, let me start off. I think you’ve highlighted a lot ofthe points that we’ve still got to address. In my comments I mentioned that weneed to go back and look at the permit conditions. We have a significant numberof permit conditions that we’ve got to have mitigations fully vetted andunderstood how we would handle where we don’t get into a cost issue during theconstruction stage. So we are presently back looking at all those conditions,and I would add one other area that we’re really spending a lot of time on is themodularization. Remember we’re building this on Barrow Island. We’ve got theability to do a lot of modules and bring them in to minimize the actual work onthe island. That in many ways helps us, because the situation at the island,the constraints we have about moving equipment in there. We need to have areally good plan, and modularization will really help us there. Those are the items that we’re really focusing on at thispoint in time. I expect I’ll be able to talk quite a bit more about scheduleand where we are at our March analyst meeting, and at that point in time I willtry to really give a lot more details around the plan forward on Gorgon.
Operator: Your next question comes from Doug Leggate - Citigroup.
Doug Leggate -Citigroup: Steve, the one-off items this quarter, I guess I’m thinkingspecifically about refining marketing. You’ve given us some breakdown on thelarger items, environmental mediation and so on, but it seems that there were quitea number of fairly significant items, particularly on the USdownstream. Could you go into a little bit more detail if you can on just toquantify that?
Stephen J. Crowe: Sure, I’ll ask Jim to handle that. We anticipated that mightbe a question, since we kind of foreshadowed on our October 9th interim updatethat there would be a fair number of non-recurring items that affected theresults this quarter. So Jim?
Jim Aleveras: Doug, your question was with respect to the USdownstream?
Doug Leggate -Citigroup: Well clearly across the businesses would be useful, but thatwas the one specifically where we saw a bit of a gap.
Jim Aleveras: Well in the USdownstream again, the effects were primarily margin-related. If we look at the non-recurring chargesbetween the second and third quarter, there was not a significant difference inthat particular segment, in the US downstream segment.
Doug Leggate -Citigroup: Then the absolute number this quarter is what I’m trying toget, the absolute impact.
Jim Aleveras: The absolute number in the third quarter was about $50million negative.
Doug Leggate -Citigroup: Okay. Do you havethat for the other divisions?
Jim Aleveras: In terms of our segments?
Doug Leggate -Citigroup: Yes.
Jim Aleveras: For the third quarter the USupstream, the non-recurring charges in aggregate were about $100 millionnegative. For the internationaldownstream, the net non-recurring charges were about $250 millionnegative. As I mentioned, for USdownstream it was about $50 million negative. For the international downstream, because of the gain on theBenelux assets, the change or the impact was a favorable$165 million. I should point out that’s$100 million less than the gain on the Beneluxassets. So there was the gain on the Beneluxassets of plus $265 million and there were net non-recurring charges ofnegative $100 million. In the chemical segment, the impact was negative $40 million;and in the all other segment, the impact was about $100 million for a total of$400 million that we quoted in our earnings press release.
Doug Leggate -Citigroup: The 121 employee termination and litigation, you’re notterming that a one-off item in the U.S.?
Stephen J. Crowe: Yes we are, Doug, and it’s not a large item but theseverances that were recognized in third quarter results were both in the United States as well as international. Thanks very much for your question. May we have the next question please?
Operator: The next question is from Paul Sankey - Deutsche Bank. Your question, please?
Paul Sankey -Deutsche Bank: I want to ask a question about Indiabut if I could just make an observation further to Doug’s point -- I’ll not phrase it as a question -- youhave in the earnings supplement a table of special items and other adjustmentsby quarter with nothing in it; but you’re identifying $400 million ofspecials. Again, I don’t want to use up my question on that but I dofind it slightly odd that there’s zero reported within that table and I waswondering why that is, but if we could just...
Jim Aleveras: We won’t count that as a question. So in the post Reg Gworld we live in, which goes back a few years now about making pro formaadjustments to GAAP earnings, these items were properly recognized in the thirdquarter. They’re event-driven as in thecase of sales or the recognition of impairments or severances and thelike. We don’t view them, these happen for all large companies invarying degrees from period to period. We just felt there were enough of them that occurred in the quarter thatwe should highlight it for the analyst community in the interim update and inthe press release. It’s really, then, left up to the individual analyst todetermine whether or not those should be taken out in order to get more of aclean earnings from your perspective. So, it’s only that, Paul.
Paul Sankey -Deutsche Bank: I just found it strange that. In terms of India, could you just update usplease, in that you haven’t mentioned it here amongst your major initiatives,could you just talk a little bit about the status of the expansion that you’vegot going on there, firstly? Secondly, the timing and potential for you to expand yourposition. Finally, a progress update onhow you’re getting on with the upstream elements of that whole move that youmade there. Thanks.
Stephen J. Crowe: Thank you, Paul. Ithink I’ll ask Mike to talk a little bit about the progress that we’re seeingon the downstream side.
Mike Worth: I think there were three parts. I’ll take the first two and I’ll hand theupstream one off to George. The refineryconstruction is progressing very well. Over 97% of the engineering work is done and the construction is wellunderway. I think the announced startdate for that refinery is 2008, and I fully expect that start-up to occur nextyear. Relative to our investment position, as you know we have a5% stake and subject to a number of other agreements being negotiated, theopportunity to increase that to 29%. Wehave not concluded those other agreements and no decisions have been made as tothe ultimate decision relative to our equity share in that refinery. I’ll ask George to comment on the upstream.
Paul Sankey -Deutsche Bank: Could I just ask you the timing next year -- you mentioned ‘08 obviously for therefinery -- that’s presumably afirst-half event. Secondly the timing,if you could just remind us on the increase on the stake when we’ll get ananswer on that would also be interesting. Sorry to interrupt. Thanks.
Mike Worth: I think the announced start date for the refinery isactually second half ‘08. The timing forour final decision on our investment position is subsequent to the refinerystart-up.
Paul Sankey -Deutsche Bank: Thanks.
George Kirkland: On the upstream issue, I would say we still have interest inthe KG Basin. But, Paul, there’s reallynot been much progress in really developing that opportunity. So really it’s nothing really to report atthis point in time.
Paul Sankey -Deutsche Bank: Are there any initiatives that there might be something,George, that you could talk about? Or wecan have more of an idea? Thanks.
George Kirkland: Really nothing to talk about at this point in time. Paul, it’s just not ready and there’s a lotof other people besides us that are interested in that. So I really don’t have anything to report.
Operator: Ournext question is from Mark Flannery - Credit Suisse.
Mark Flannery: Yes. My question isto George, and it concerns the decline rates. You said that it’s too early to say whether or not the base decline of 4%to 5% is to be changed. Could you justexpand a little on that, and tell us what kind of things specifically you’redoing presumably to get that rate down obviously? When do you think it would be appropriate totalk about a new decline rate in the upstream?
George Kirkland: I’ll answer the last part of that question first. I want some run time to see exactly how weare influencing it. Specifically we’vegot I think great processes where we in effect do base business audits aroundthe world and we audit from the reservoir through all the facilities. We look at reliability. We look at reservoir performance. We look at the interactions between thesurface facilities and the subsurface facilities to make sure we don’t have anybottlenecks. We’ve been on that process,for now about three years. It continues to turn up opportunities for us to optimize ourproduction around the world. We areseeing some influence. This first ninemonths of this year we’ve had some great successes in South Texas with somedevelopment wells, which we used good seismic technology there, and had somegood results there. We’ve got some otherplaces where we’ve focused on our water floods and we’ve seen some declinerates shallow out. We’ve got a lot of history of multiple years where this 4%to 5% decline rate is what we’ve been typically seeing. So I’m encouraged by the first nine months,but I want a lot more run time and I am confident that the processes that we’veput in place are going to help us for the long period improve our recovery andreduce our decline rates in greatest sense, but I think it’s a little bit tooearly and that’s why I made those comments that way.
Mark Flannery: George, would you characterize this as mostly EOR typestuff, or I mean are you spending more money on enhanced oil recovery or is asort of mix of things?
George Kirkland: It’s a mix of things. It is not one focus. We have fourto five areas that we really focus on; and in some places, we get it out ofjust system reliability, raising the reliability, the run times. Some places it’s hey, we find a facility thatwe can push more barrels through and we see that we’ve got reservoir capabilityto match to it and not have to spend a lot of monies on facilities. So we’re doing all those type things like, once again, fromthe reservoir through the sales point to try to optimize the system in all ourbusiness units around the world.
Operator: Your next question comes from Mark Gilman - Benchmark.
Mark Gilman -Benchmark: Relating to Pascagoula,could you give an idea as to the size of the crude unit that is down? More generally, I guess I was a little surprised to see thesanctioning of the CCR project, and I’m assuming that in having done so thedistillation expansion at Pascagoula which had been under evaluation is now nolonger on the table. Could you commenton the validity of that observation?
Mike Worth: Yes, on the crude unit it’s about 160,000 barrels per dayand on the CCR, that is an independent project. We’ve got old fixed-bed reformers that need to have the catalystregenerated so we’ve got to pull reformers offline for catalyst regeneration,and it significantly impacts our ability to get the utilization at the facilityup. So this is a reliability projectthat has a very strong economic pay out, and frankly, there are not many ofthese fixed-bed reformers still in operation in the industry. So it’s really upgrading the technology tothe current state-of-the-art. The evaluation of other alternatives for Pascagoulacontinues. I think I’ve indicated thatwe would reach a final decision on that next year. Certainly, you’re seeing project economicschallenged in the refining sector on the Gulf Coast as well as the rest of theworld by the cost environment, by the questions about the margin environment,uncertainty about biofuels penetration and future demand, etcetera. So we’re factoring all those into our evaluationof alternatives, and we’ll have more to say about that next year as that workis complete.
Mark Gilman -Benchmark: Mike, if I could just follow up on that. If you’reconsidering an expansion, I don’t know how you go about properly sizing whatthe replacement reforming capacity ought to be.
Mike Worth: Well on the reforming, it fits into a refinery that isconfigured with a number of other facilities that has streams that create feedfor the reformer. What we’re doing is taking existing intermediate streams andwe are installing facilities that essentially you can look at as ade-bottleneck or a capacity creep kind of a project that enables us to morefully utilize the streams available within the refinery and increase theutilization.
Operator: Your next question comes from Neil McMahon - SanfordBernstein.
Neil McMahon: Maybe this is a quick one you don’t have many answers for,but most of the impact on the refining in the US,the negative impact as you said was on the west coast. Just wanted to go intomaybe walking through some reasons for that, and did you have hedges in placesthere that could have caused some of those losses?
Mike Worth: As Jim showed earlier, when you compare the third quarter tothe second quarter, our USearnings were down nearly $900 million. More than two-thirds of that declinewas due to industry margins, and really the balance for the USwas due to lower volumes, and that is primarilyPascagoula. So I think the quarter-to-quarter comparison is prettystraightforward on those two pieces. We have some pricing effects on our crudeoil into the refining system that we see most acutely at times of rapid changein crude prices, and our foreign crude that we purchase that is long-haul crudegets provisionally price while it’s on the water, and so we’ll see the effectof those increases before we actually capture the margin for running thatcrude. So we do have some paper effects that you see in anenvironment like this that are exacerbated by the amount of long-haul crudethat we run and the way that we price crude into our system.
Neil McMahon: So you don’t really do hedge accounting then on thoselong-haul crudes or in the west coast?
Mike Worth: We mark the pricing to current period pricing, and we runour refineries to capture the margin of the day, so we convert the pricing torun-month pricing, and so what that does result in is some open paper that is priceconversion off the feed stock to the run month.
Jim Aleveras: Let me just add on that point, again, as Mike said, thoseare part of the contractual provisions. They’re not hedging, per se, so when a cargo is lifted it has acontractual term as to when it’ll be priced so many days after lifting. In a rising market, as we’ve seen here in thethird quarter, that works adversely against us. Thank you very much for the question and the follow-up.
Operator: Your next question comes from Paul Cheng - LehmanBrothers.
Paul Cheng: Mike, if I look at the third quarter market conditions, GulfCoast 3 to 1 crack spread is roughly in the $11 to $12 per barrel and the Californiacrack is probably about $13, $14. Whilethey advanced sharply from the second quarter, but they are really not that badfrom a historical standards standpoint. If you look at your earnings, I meanadjusting for the $50 million in environmental remediation charges and also the$90 million loss related to Pascagoula,you earned $30 million. Is there astructural problem with your asset there then that your hardware just needs tobe revised sharply in order for them to be more sustainable in a more normalpricing environment?
Mike Worth: No, I don’t think there is a structural problem in themarket or in the refinery. I think theindicator margins did decline more sharply on the west coast than on the Gulf coastand with a skew to our downstream where we have more than half of our USrefining capacity on the west coast, that sharper decline will affect us to agreater degree.
Paul Cheng: Mike, I’m talking about on an absolute level that the crackis still topping out in the $10 to $15, which is not really that bad.
Mike Worth: Let me take another shot at building on the question thatNeil was asking. We have these non-ratablepricing effects related to the change in crude prices which are most significantbecause the amount of long-haul crude that we bring into the west coast. And so if you look at 3Q07 versus 3Q06 youwould see that the margin declines are not especially severe and the absolutelevel of margins, as you say, are not as extreme as the earnings delta mightindicate; but if you look at 3Q06, we saw crude prices drop by about $11 abarrel over the quarter. In 3Q07 we saw crude prices increase by $11 per barrelin the quarter, and so those non-ratable pricing effects have significantknock-on accounting effects that get unwound subsequently as we actually runthe crude, but in the quarter they create pronounced effects on our west coastdownstream performance.
Paul Cheng: Mike can you quantify it for us?
Mike Worth: I don’t have the numbers in front of me to quantify that,Paul.
Jim Aleveras: You know, Paul, you’re talking on average maybe 15 millionbarrels of long-haul crude on the water, and as Mike said in the earlier perioda year ago, we saw crude prices from beginning to end of the quarter drop by$11 a barrel, and just the reverse effect that occurred here in the thirdquarter. That is going to be a material impact on the comparison betweenadjacent years on a variance. it’s one of the reasons why sometimes theindicative margin doesn’t become realized for our company. Thanks for yourquestion.
Operator: Your next question comes from John Herrlin - Merrill Lynch.
John Herrlin: With Thailandyou said that you extended the contract. Are the terms still similar, or arethey higher for the country?
Stephen J. Crowe: Do we have similar terms? It’s still the Taiwanterms. We do have some issues with related to how we extended it, but overallthe terms are basically the same.
John Herrlin -Merrill Lynch: You were pretty active at the last Central Gulf sale. Could you give us asense on how many of the leases were Miocene versus, say Paleocene?
Stephen J. Crowe: I think my memory of the major targeted prospects, I believeit was nine or 11 intotal that we really captured major new prospects. All of them but one was thelower tertiary.
Operator: Your next question comes from Mark Gilman - Benchmark.
Mark Gilman: George, if you could, on Block 14 in Angola,could you tell me whether or not there are separate PSCs for each of thefields, and the extent to which there are rate of return thresholds built intothose production-sharing contracts, pursuant to which profit barrels and profitpercentages would step down once the threshold was reached?
George Kirkland: Mark, I’m going to limit my comments a little bit, I willtell you that we have different development areas around each field. Our development areas have typically in block14, been larger than what we had seen in the past and in some cases, they havebeen more or less brought together to allow cost recovery to be moved from onedevelopment to another. So we have hadlarger development areas than in the past. I’m not going to speak about the contractual pieces beyond that.
Operator: Your final question comes from Michael LaMotte - JP Morgan.
Michael LaMotte: A question related to upstream cost pressures, as yourspending is shifting more towards completion and production, are you seeing anychanges in the rate of change of cost there? I would think that completion inflation is probably not as high asdrilling in rigs, offshore rigs in particular.
George Kirkland: Let me take a shot at this one in a couple of ways. First off, remember we are operating in 25 to30 countries around the world, we’ve got a whole portfolio of projects that arein anything from the early phase, engineering to just about to start up andactually a lot of them in start up. The ones that are late in phase, we know contractual costsvery, very well. Those projects are notseeing and have not seen the same movement in costs as projects in the earlyphases. I would tell you whether a project is an onshore project in North America or if it is an offshore project or a deepwater project,all of those in effect, change the outcome of the cost increases. I’ll give you a couple of examples of what we’ve seen andmaybe that will help you get a little bit of context. We had a project in Angola, we brought onlinein deepwater project in Angola that we brought online a little over a year ago,we’re doing a very similar project that’s in the fabrication stage at thispoint, so we understand contractually what the cost is going to be fordrilling, for building of all the facilities, the installation, so we have gotthe contracts really nailed down. There’s a five to seven-year difference in the life cycle ofthe two projects and when you compare project A to project B, we see almost a100% increase in the cost of doing the similar work. So that’s very typical in the deepwater whereyou’ve seen rig rates go up. Deepwaterrig rates have gone up two to threetimes over a five-year period. Other areas we are not seeing the same, and once again everyproject we look at individually because you’ve got a different mix of contractsthat are either in place, and we have some period at a different rate than whatwe see in the future so we look at everything on a specific project-by-projectbasis. I would tell you one of the best areas to look at, maybe togive you a view of what the cost in the general industry what’s happened therein the last probably five to seven years, is to look at the CERA, the CambridgeEnergy Research report that was published, I believe in the last year. What it basically shows is over the periodfrom early 2000 to late ‘06, about 180% to 190% increase in their index. So they’ve shown a significant move in thatindex, and I think it’s very indicative of the general industry.
Michael LaMotte: Is there anything in the component cost that is leading youto think about redirecting capital on the margin? Anything inflationary in the components sidethat would lead you to rethink project or redirect capital to better return?
George Kirkland: We do that. I wouldtell you the one that’s probably been impacted the most is shelf Gulf of Mexicowhere we made some decisions on changing how much capital we were spending onsome of our delineation and development wells there. Rig rates had moved way, way up veryquickly. If you look at the pricing sideof Henry Hub gas and you see the gas price has not moved; as a matter of fact,gas has moved down and oil has moved up. So we would have a bias there at this point in time to be oilier if wehave a choice. We’ve got some projectsbecause of the cost run-up on the services and the downturn on the gas price,that they are not really projects that are viable. So they are put back on the shelf.
Jim Aleveras: In closing, let me say that we appreciate everyone’sparticipation on today’s call. I especially want to thank each of theanalysts on behalf of all the participants for their questions during thismorning’s session. Matt, back to you.
Operator: Ladies and gentlemen, this concludes today’s third quarter2007 earnings conference call. | [
{
"speaker": "Operator",
"text": "Welcome to Chevron’s third quarter 2007 earnings conferencecall. (Operator Instructions) I will now turn the conference over to theVice President and Chief Financial Officer of Chevron Corporation, Mr. SteveCrowe. Please go ahead, sir."
},
{
"speaker": "Stephen J. Crowe",
"text": "Thank you, Matt. Welcome to Chevron’s third quarter earnings conference call. Today on the call I’m joined by GeorgeKirkland, EVP, Upstream and Gas; Mike Worth, EVP, Global Downstream, and JimAleveras, General Manager, Investor Relations. Our focus today is on Chevron’sfinancial and operating results for the third quarter of 2007. We’ll refer to the slides that are availableon the web. I remind you that today’s presentation contains estimates,projections and other forward-looking statements and ask that you review the Safe Harbor statement on slide 2. Turning to slide 3, the company reported earnings of $3.7billion in the third quarter compared with $5 billion in the third quarter2006. Earnings of $1.75 per dilutedshare were down from $2.29 per share reported for the same quarter last year. Both periods reflected about $400 million or approximately$0.19 per share of net chargesassociated with non-recurring items. Themain driver for the earnings change was a decline of over $1 billion indownstream profits. Escalating costs forcrude oil feedstocks could not be fully recovered in the market. This impact was global, but it was especiallysignificant on the USwest coast. Overall, third quarter results were $1.7 billion lower than ourrecord second quarter 2007, which Jim will discuss shortly. Return on capital employed for the trailing four quarterswas 22%. During the quarter, we retiredabout $2 billion of debt, reducing the debt ratio to about 7.5% at quarter end. Third quarter share repurchases totaled $2 billion,reflecting an accelerated buyback pace. As we projected in last quarter’s conference call, we completed theDecember 2006 buyback program during the third quarter. In September, we announced and initiated anew repurchase program of up to $15 billion over a period of up to three years. Jim will now take us through the quarterly comparisons."
},
{
"speaker": "Jim Aleveras",
"text": "Thanks, Steve. Myremarks compare third quarter results to those of the second quarter 2007. As a reminder, our earnings press releasecompared third quarter 2007 with the same quarter a year ago. Turning to slide 4, third quarter net income was $1.7billion lower than the record level of the second quarter. Lower downstream margins were the mostsignificant component of the change. Upstream realizations increased, but the benefit was partly offset bylower international liftings due to the timing of cargoes. Additionally, the second quarter included the $680 milliongain on the sale of Chevron’s investment in Dynegy, while the third quarterreflects a smaller, $265 million gain on the sale of the company’s BeneluxFuels marketing assets. Separate from these major asset sales, there was a further$300 million adverse effect between the sequential quarters due to netnon-recurring charges. The mostsignificant factor was the difference in tax items, contributing to a $230million variance between quarters. Addition non-recurring items, along with other factors in the aggregate,were responsible for a negative variance of about $130 million as shown on thisslide. Except for large discrete items, it has not been ourpractice to identify smaller non-recurring charges and credits. We did so this quarter because of the largeswing in these smaller items between the second and third quarters. Just to recap, the third quarter included $415 million lessin gains on major asset sales and $300 million more in smaller, non-recurringnet charges than did the second quarter. This amounts to an adverse swing of more than $700 million betweensequential quarters of more than $0.33 per share. Turning to slide 5. Slide 5 summarizes the results of our USupstream earnings which fell by about $90 million between quarters. Higher realizations benefited earnings byabout $135 million between quarters. Higher liquids prices contributed $250 million to earnings, but lowernatural gas realization had a $115 million offsetting impact. Chevron’s domestic crude oil realizations were up about$9.80 per barrel between quarters, around $0.50 per barrel less than theincrease in average WTI spot prices. This partly reflects Gulf of Mexico productionthat is priced on a lagged basis. This isa benefit when prices are falling, but a headwind when prices are rising. Our natural gas realization fell by a little over $1.10 perthousand cubic feet, which is in line with the average changes in bid weekpricing at Henry Hub in Californiaand in the Rockies. Our volumes were slightly lower due to storm-related shutdownsin the Gulf, maintenance work and natural field declines. These were partly offset by one moreproducing day in the third quarter. Asset retirement obligations were higher by $60 millionmainly due to an adjustment to the abandonment provision for offshore Californiaproperties that were previously sold. The other bar on this slide reflects higher exploration expense, assetimpairment and the absence of gains on some small operations we sold in thesecond quarter. Turning to slide 6, this slide compares upstreaminternational earnings, which fell about $120 million between the second andthird quarters. Stronger liquidsrealizations benefited earnings by almost all of the $285 million impact shownon this slide. Natural gas effects,while positive, were essentially negligible. Liquids realizations improved by about $5.80 per barrel, in line withthe rise in spot BRENT prices. Lower liftings spread across multiple countries reflectedthe timing of cargos and reduced earnings by $240 million. We were in a net under-lifted position in thethird quarter, which brings the year 2007 to a balance liftings position. Tax adjustments reduced earnings by about $80 millionbetween periods. The variance in theother bar includes asset impairment charges. Turning to slide 7, slide 7 summarizes the change inworldwide oil equivalent production including volumes produced from oil sandsin Canada. Daily volumes were down by 39,000 barrelsbetween quarters. Maintenance-relatedshutdowns in the UK North Sea were the largest factor in this change. George Kirkland will discuss productionvolumes in more detail in a moment. Turning to slide 8, our USdownstream results in the third quarter fell nearly $900 million from the priorquarter. Margins were down $680million. Both refining and marketingmargins fell, but the decline was particularly large for west coast refiningmargins. Breaking out the $680 million,over 90% of that amount was refining margins, and over two-thirds of thatamount, in turn, was related to the west coast. Crude prices rose more rapidly than product prices during a period whenproduct inventories were ample. West coast margins also include an unfavorable variance infinal pricing adjustments for long haul crude. Lower refining volumes reduced third quarter earnings by $90 million,primarily due to a fire at our Pascagoula, Mississippirefinery in mid-August as well as other planned maintenance there. The unfavorablevariance in the other bar on this chart includes employee termination benefitsand provisions for litigation. Both thesecond quarter and third quarter included environmental remediation charges inthis segment. Turning to slide 9, international downstream earnings of $487million were $30 million lower than the second quarter. Released downstream margins dropped by about$275 million, in line with the change in indicator margins. Asian refining margin indicators fell byone-third and indicator margins were sharply lower in Europeas well. As was the case in the US;the price of crude rose more rapidly than the price of refined products duringthe quarter. These lower margins fullyoffset the gain on the sale of our fuels marketing business in the Beneluxcountries. The other bar on this slide includes asset impairment charges, lowershipping earnings and employee termination benefits. Looking at slide 10, this slide shows the chemicaloperations earnings in the quarter were $103 million, essentially unchangedfrom the prior quarter. The results foroil sands improved due to higher ethylene margins and reduced utilitycosts. Aromatics benefited from improvedstyrene earnings reflecting higher margins and increased volumes. Aromatics also benefited from the absence ofan asset writedown we mentioned in the second quarter. The other bar includesan environment reserve provision in the third quarter. Slide 11 covers all other. Second quarter results included the $680 million gain on the sale of ourinterest in Dynegy, which was partly offset by $160 million of charges relatedto the early redemption of Texaco capital bonds. Similar to the second quarterthis segment includes about $70 million of environmental remediation expensesfor legacy Texaco and Unocal sites that have been closed or sold. Third quarter net charges for this segmentfell at the high end of our standard guidance range of $160 million to $200million as we advised in our interim update. That completes a brief analysis of the quarter. Back over to you Steve."
},
{
"speaker": "Stephen J. Crowe",
"text": "Thanks, Jim. Wewanted to use a portion of today’s teleconference to give George Kirkland andMike Worth and opportunity to update you on our upstream and downstreambusiness developments respectively. We’ll start with George. He’llturn things over to Mike and then we’ll open it up for your questions."
},
{
"speaker": "George Kirkland",
"text": "Thank you, Steve. I’ll start on slide 13. Before Iprovide you with an update of our major capital projects, I would like to reviewour 2007 production results. This slidecompares our net OEG production through the first nine months of 2007 versusthe first nine months of last year. Although we are down 50,000 barrels a day this year, we can point out90,000 barrels of losses in 2007 that are attributable to our contractualchange in OPEC curtailments in Venezuela. Our production efforts this year have been focused onmanaging our base business declines and capturing gains from major capitalprojects that have recently come online. The low base business decline is a positive indicator of our basebusiness efforts. However, there are many moving parts in the base business --workovers, development wells, reliability and so on -- and it’s too early to say that our typical4% to 5% base decline rate has changed. Now I’ll update you on some of our key projects. Please turn to slide 14. Let’s start in the Gulf of Mexicodeepwater with our Tahiti project, where we have a 58%net working interest. As a reminder, Tahitiis designed to have a production capacity of 125,000 barrels of oil per day and70 million cubic feet of gas per day. We have continued to progress this project by completinginstallation of export pipelines, completing five of the six development wells,and installing a significant portion of the sub sea production system and flowlines. The spar hole is complete and thetop sides are near completion. The holeand top sides will be ready for offshore installation once replacement mooringshackles and components are delivered and the rescheduling of the installationis finalized. A metallurgical problem with the original shackles wasidentified in June and installation activities were deferred in order to insurethat the facilities would be put in a safe and reliable operation. Installation of the truss spar is now scheduled to begin inthe first quarter of 2008. The top sideinstallation, the mating with the spar, is targeted for the third quarter of2008. First production is now expectedby the third quarter of 2009, approximately 12 months later than originallyplanned due to the shackle replacement and the installation rescheduling. Now let’s turn to slide 15. We also continue to progress our Blind Faith project, located in the deepwaterGulf of Mexico. In July we purchased an additional 12.5% working interest in thisproject, bringing our total interest up to a 75% share. The top sides have been lifted onto the holeand all three development wells have been drilled. Positive results from the developmentdrilling supports the future drilling of a fourth well by 2009. Off shore installation and well completions are scheduled tocommence in November of this year, with first production expected by the secondquarter of 2008. Blind Faith has aproduction capacity of 45,000 barrels of oil per day and 45 million cubic feetof gas per day. Now onto slide 16 where I will update the status of theAgbami Deepwater Nigeria project. It’sfloating production, storage and off-loading vessel has left the fabricationyard in South Koreaand is being towed to the offshore Nigerialocation. This FPSO is the largest ofits type in the world and will be moored and ready for hook-up in the firstquarter of 2008. It has a processingcapacity of 250,000 barrels of oil per day and a storage capacity of 2.1million barrels of oil. We have already drilled 11 producers and seven injectors. We have two rigs working on the completionsof these wells. We are on-track forfirst oil by the third quarter of 2008. We expect to be at full capacity within one year of start up. As a reminder, Chevron has a 68% interest inthis project. Now turning to slide 17, I’ll cover the Tengiz SGI/SGPproject. We anticipate that sour gasinjection and the first production will begin in the fourth quarter of2007. As a reminder, Chevron has a 50%working interest in TCO and the expansion start up, which we call Staged Oil,will enable us to increase production by about 90,000 barrels a day gross. The second generation plant which is picturedhere should be fully operational by the second half of 2008. This will add another 160,000 barrels ofproduction per day. The labor disruption of 2006 extended the constructionperiod but we have made great strides in keeping this project moving forward. The combined SGI/SGP project has been one ofthe most complex and challenging, multi-billion dollar projects that Chevronhas ever led, and we are glad to see this project nearing its completion andstart-up. In the interim period between project start-up and theCaspian pipeline expansion, alternative rail export routes ensure we can exportthe full plant output. Now let’s turn to slide 18. Production growth in the near term is all about the start-up and ramp-upof these highlighted major capital projects. Before I finish this morning, I wanted to cover other key milestonesthat occurred during the third quarter. The first two bullets further illustrate that our largequeue of opportunities are moving forward. Gorgon has passed a couple of very important milestones recently. We received environmental approval from theWestern Australian Minister for the Environment in September, and FederalMinister for the Environment in October. Our engineering efforts are focusing on the permit conditions,modularization opportunities and execution planning. In Indonesiawe started up the DarajatIII geothermal project in July. This facility adds 110 megawatts to the West Javapower grid. The Darajat facility now hasa total capacity of 260 megawatts. The next two items are examples of how we replenish ourdevelopment queue. In August weannounced the Malange oil discovery in block 14 deepwater offshore Angola.This well encountered more than 200 net feet of oil sands. The well was tested at a rate of over 7,500barrels of oil per day of high quality crude. Future drilling is planned to assess potential reserves and assist inthe development design. In July, we reported the successful prevention test of theRosebank appraisal well, located some 100 miles Northwest of the Shetland Islands. This well, in approximately 3,700 feet of water, flow-tested37 degree API light oil at restricted rates of 6,000 barrels of oil perday. The appraisal and evaluationprogram should be completed by November of this year and will allow us todetermine the future work program and development of this discovery. We also recently announced our extension of the productionperiod for Thailandblocks 10 through 13. By securing thisproduction extension we will now be able to move major investments forward onthe Platong II project. Platong II isthe planned expansion of the existing Platong assets, which are currentlyproducing 250 million cubic feet a day and 40,000 barrels a day of hydrocarbideliquids. Platong II will add gasprocessing capacity and enable our oil and gas projects to beaccelerating. Now I’ll turn it over to Mike."
},
{
"speaker": "Mike Worth",
"text": "Thanks, George. Moving to slide 19, I would now like to update you on key downstreaminitiatives beginning with operational excellence. Improved reliabilitycontinues to be our top priority. We have resolved many high-risk conditionswhich have caused unplanned downtime. Despite these improvements, weexperienced significant crude unit fires this year at Richmondand Pascagoula. These incidentsremind us that we still have work to do, and have further strengthened ourresolve to improve reliability to enhance capabilities, processes andequipment. While the fire at Pascagoula was unfortunate, our incidentresponse was swift and effective, limiting the impact and preventing anyinjuries. We expect to complete repairs during the first quarter 2008. Thedemolition phase is proceeding safely. Critical equipment orders have beenplaced, and delivery is scheduled. We’re taking steps to optimize conversionunit utilization while the crude unit is offline. As the left chart shows, lost utilization from unplanneddowntime this year has been slightly greater than in 2006, due to the two fires.However, we continue to drive down the number of unplanned outages, as shown onthe right. Incidents per quarter at our largest operated refineries have fallenmore than 50% since 2005. Since the first quarter turnaround, crude unit utilizationat Richmond has been consistentlystrong, averaging 101%. Our UK refinery has also operated very well the entireyear, also averaging 100% crude utilization. Conversion unit utilization atthese facilities has also been very strong. Turning to capital projects on slide 20, we are progressingwell in terms of achieving the major milestones we committed to earlier thisyear. During the quarter, our South Korean joint venture refinery completedconstruction of its [reside] upgrade project ahead of schedule and on budget.We expect the upgrade to lower crude costs by about $1 per barrel, increaselight product yield by 33,000 barrels per day, and add 15,000 barrels per dayof new lubricant base oil production. A new vacuum column, among the largest inthe world, and a new hydrocracker, lubricants base oil plant, and otherconversion units have begun commercial operations. On the west coast, we are currently modifying our El Segundocoker during a planned turnaround, to enable a shift to heavier and highersulfur crudes and to improve coker reliability. We expect to meet our productsupply commitments during the turnaround and to have the heavy crudeenhancements online by year end. We completed the Caspian blend integration product at our UKrefinery ahead of schedule and on budget. We now have the ability to feedCaspian blend crude at rates up to 40% of total feed. This will provide an economic outlet forgrowing equity production. Finally, we announced sanctioning of the ContinuousCatalytic Reforming project at Pascagoula. The new CCR will improve utilization andoptimize product yields. Gasolineproduction at the refinery is expected to increases about 10% with completionanticipated by mid-2010. In summary, weare ahead of schedule, or on track to complete the significant capital projectswe committed to bringing online this year. Moving to slide 21, we are also making significant progressin high grading our portfolio. As youcan see from the map, we have made a number of divestments in the past twoyears on top of ongoing efforts to reduce the capital intensity of our brandedretail network. As you recall, back in March we announced our intent topursue divestments in Europe and Latin America. We have followedthrough and succeeded in monetizing assets in businesses we no longer consideredstrategic. In March, we sold our 31%interest in the Nerefco Refinery in the Netherlandsand other assets there, generating $1.1 billion in after-tax proceeds. Duringthe third quarter, we closed the sale of our fuels marketing business in Belgium,the Netherlandsand Luxembourgfor about $500 million in proceeds excluding a final adjustment expected byyear end. We also reached agreements to sell our proprietary, consumerand commercial credit card businesses. We believe these arrangements will enhance the payment products we offerour customers, while enabling us to maintain the strong brand loyaltyassociated with our cards. More portfolio improvement opportunities are being evaluatedand we’ll share progress on these in the future. We are working to create a more focusedfootprint for our marketing businesses. Fewer markets, but stronger positions in those markets will help usreduce costs and further improve returns on divested capital. Now I will turn it back over to Steve."
},
{
"speaker": "Stephen J. Crowe",
"text": "Thanks, Mike. Thatconcludes our prepared remarks. We’llnow take your questions, one question per caller, please. Matt, please open the lines for questions."
},
{
"speaker": "Operator",
"text": "Our first question comes from Dan Barcelo - Banc Of AmericaSecurities."
},
{
"speaker": "Dan Barcelo",
"text": "Good morning, gentlemen. Thank you for the update,particularly on the projects, it was quite useful. I wonder if you could spenda little bit on Gorgon. Having received a lot of the environmental approvals,could you talk a little bit about maybe the costs you are looking at now? Iknow it may be premature as you’re still trying to cost and phase that, but anythoughts about how you’d phase the development, and particularly on the costs forGorgon? Thank you."
},
{
"speaker": "George Kirkland",
"text": "Dan, let me start off. I think you’ve highlighted a lot ofthe points that we’ve still got to address. In my comments I mentioned that weneed to go back and look at the permit conditions. We have a significant numberof permit conditions that we’ve got to have mitigations fully vetted andunderstood how we would handle where we don’t get into a cost issue during theconstruction stage. So we are presently back looking at all those conditions,and I would add one other area that we’re really spending a lot of time on is themodularization. Remember we’re building this on Barrow Island. We’ve got theability to do a lot of modules and bring them in to minimize the actual work onthe island. That in many ways helps us, because the situation at the island,the constraints we have about moving equipment in there. We need to have areally good plan, and modularization will really help us there. Those are the items that we’re really focusing on at thispoint in time. I expect I’ll be able to talk quite a bit more about scheduleand where we are at our March analyst meeting, and at that point in time I willtry to really give a lot more details around the plan forward on Gorgon."
},
{
"speaker": "Operator",
"text": "Your next question comes from Doug Leggate - Citigroup."
},
{
"speaker": "Doug Leggate -Citigroup",
"text": "Steve, the one-off items this quarter, I guess I’m thinkingspecifically about refining marketing. You’ve given us some breakdown on thelarger items, environmental mediation and so on, but it seems that there were quitea number of fairly significant items, particularly on the USdownstream. Could you go into a little bit more detail if you can on just toquantify that?"
},
{
"speaker": "Stephen J. Crowe",
"text": "Sure, I’ll ask Jim to handle that. We anticipated that mightbe a question, since we kind of foreshadowed on our October 9th interim updatethat there would be a fair number of non-recurring items that affected theresults this quarter. So Jim?"
},
{
"speaker": "Jim Aleveras",
"text": "Doug, your question was with respect to the USdownstream?"
},
{
"speaker": "Doug Leggate -Citigroup",
"text": "Well clearly across the businesses would be useful, but thatwas the one specifically where we saw a bit of a gap."
},
{
"speaker": "Jim Aleveras",
"text": "Well in the USdownstream again, the effects were primarily margin-related. If we look at the non-recurring chargesbetween the second and third quarter, there was not a significant difference inthat particular segment, in the US downstream segment."
},
{
"speaker": "Doug Leggate -Citigroup",
"text": "Then the absolute number this quarter is what I’m trying toget, the absolute impact."
},
{
"speaker": "Jim Aleveras",
"text": "The absolute number in the third quarter was about $50million negative."
},
{
"speaker": "Doug Leggate -Citigroup",
"text": "Okay. Do you havethat for the other divisions?"
},
{
"speaker": "Jim Aleveras",
"text": "In terms of our segments?"
},
{
"speaker": "Doug Leggate -Citigroup",
"text": "Yes."
},
{
"speaker": "Jim Aleveras",
"text": "For the third quarter the USupstream, the non-recurring charges in aggregate were about $100 millionnegative. For the internationaldownstream, the net non-recurring charges were about $250 millionnegative. As I mentioned, for USdownstream it was about $50 million negative. For the international downstream, because of the gain on theBenelux assets, the change or the impact was a favorable$165 million. I should point out that’s$100 million less than the gain on the Beneluxassets. So there was the gain on the Beneluxassets of plus $265 million and there were net non-recurring charges ofnegative $100 million. In the chemical segment, the impact was negative $40 million;and in the all other segment, the impact was about $100 million for a total of$400 million that we quoted in our earnings press release."
},
{
"speaker": "Doug Leggate -Citigroup",
"text": "The 121 employee termination and litigation, you’re notterming that a one-off item in the U.S.?"
},
{
"speaker": "Stephen J. Crowe",
"text": "Yes we are, Doug, and it’s not a large item but theseverances that were recognized in third quarter results were both in the United States as well as international. Thanks very much for your question. May we have the next question please?"
},
{
"speaker": "Operator",
"text": "The next question is from Paul Sankey - Deutsche Bank. Your question, please?"
},
{
"speaker": "Paul Sankey -Deutsche Bank",
"text": "I want to ask a question about Indiabut if I could just make an observation further to Doug’s point -- I’ll not phrase it as a question -- youhave in the earnings supplement a table of special items and other adjustmentsby quarter with nothing in it; but you’re identifying $400 million ofspecials. Again, I don’t want to use up my question on that but I dofind it slightly odd that there’s zero reported within that table and I waswondering why that is, but if we could just..."
},
{
"speaker": "Jim Aleveras",
"text": "We won’t count that as a question. So in the post Reg Gworld we live in, which goes back a few years now about making pro formaadjustments to GAAP earnings, these items were properly recognized in the thirdquarter. They’re event-driven as in thecase of sales or the recognition of impairments or severances and thelike. We don’t view them, these happen for all large companies invarying degrees from period to period. We just felt there were enough of them that occurred in the quarter thatwe should highlight it for the analyst community in the interim update and inthe press release. It’s really, then, left up to the individual analyst todetermine whether or not those should be taken out in order to get more of aclean earnings from your perspective. So, it’s only that, Paul."
},
{
"speaker": "Paul Sankey -Deutsche Bank",
"text": "I just found it strange that. In terms of India, could you just update usplease, in that you haven’t mentioned it here amongst your major initiatives,could you just talk a little bit about the status of the expansion that you’vegot going on there, firstly? Secondly, the timing and potential for you to expand yourposition. Finally, a progress update onhow you’re getting on with the upstream elements of that whole move that youmade there. Thanks."
},
{
"speaker": "Stephen J. Crowe",
"text": "Thank you, Paul. Ithink I’ll ask Mike to talk a little bit about the progress that we’re seeingon the downstream side."
},
{
"speaker": "Mike Worth",
"text": "I think there were three parts. I’ll take the first two and I’ll hand theupstream one off to George. The refineryconstruction is progressing very well. Over 97% of the engineering work is done and the construction is wellunderway. I think the announced startdate for that refinery is 2008, and I fully expect that start-up to occur nextyear. Relative to our investment position, as you know we have a5% stake and subject to a number of other agreements being negotiated, theopportunity to increase that to 29%. Wehave not concluded those other agreements and no decisions have been made as tothe ultimate decision relative to our equity share in that refinery. I’ll ask George to comment on the upstream."
},
{
"speaker": "Paul Sankey -Deutsche Bank",
"text": "Could I just ask you the timing next year -- you mentioned ‘08 obviously for therefinery -- that’s presumably afirst-half event. Secondly the timing,if you could just remind us on the increase on the stake when we’ll get ananswer on that would also be interesting. Sorry to interrupt. Thanks."
},
{
"speaker": "Mike Worth",
"text": "I think the announced start date for the refinery isactually second half ‘08. The timing forour final decision on our investment position is subsequent to the refinerystart-up."
},
{
"speaker": "Paul Sankey -Deutsche Bank",
"text": "Thanks."
},
{
"speaker": "George Kirkland",
"text": "On the upstream issue, I would say we still have interest inthe KG Basin. But, Paul, there’s reallynot been much progress in really developing that opportunity. So really it’s nothing really to report atthis point in time."
},
{
"speaker": "Paul Sankey -Deutsche Bank",
"text": "Are there any initiatives that there might be something,George, that you could talk about? Or wecan have more of an idea? Thanks."
},
{
"speaker": "George Kirkland",
"text": "Really nothing to talk about at this point in time. Paul, it’s just not ready and there’s a lotof other people besides us that are interested in that. So I really don’t have anything to report."
},
{
"speaker": "Operator",
"text": "Ournext question is from Mark Flannery - Credit Suisse."
},
{
"speaker": "Mark Flannery",
"text": "Yes. My question isto George, and it concerns the decline rates. You said that it’s too early to say whether or not the base decline of 4%to 5% is to be changed. Could you justexpand a little on that, and tell us what kind of things specifically you’redoing presumably to get that rate down obviously? When do you think it would be appropriate totalk about a new decline rate in the upstream?"
},
{
"speaker": "George Kirkland",
"text": "I’ll answer the last part of that question first. I want some run time to see exactly how weare influencing it. Specifically we’vegot I think great processes where we in effect do base business audits aroundthe world and we audit from the reservoir through all the facilities. We look at reliability. We look at reservoir performance. We look at the interactions between thesurface facilities and the subsurface facilities to make sure we don’t have anybottlenecks. We’ve been on that process,for now about three years. It continues to turn up opportunities for us to optimize ourproduction around the world. We areseeing some influence. This first ninemonths of this year we’ve had some great successes in South Texas with somedevelopment wells, which we used good seismic technology there, and had somegood results there. We’ve got some otherplaces where we’ve focused on our water floods and we’ve seen some declinerates shallow out. We’ve got a lot of history of multiple years where this 4%to 5% decline rate is what we’ve been typically seeing. So I’m encouraged by the first nine months,but I want a lot more run time and I am confident that the processes that we’veput in place are going to help us for the long period improve our recovery andreduce our decline rates in greatest sense, but I think it’s a little bit tooearly and that’s why I made those comments that way."
},
{
"speaker": "Mark Flannery",
"text": "George, would you characterize this as mostly EOR typestuff, or I mean are you spending more money on enhanced oil recovery or is asort of mix of things?"
},
{
"speaker": "George Kirkland",
"text": "It’s a mix of things. It is not one focus. We have fourto five areas that we really focus on; and in some places, we get it out ofjust system reliability, raising the reliability, the run times. Some places it’s hey, we find a facility thatwe can push more barrels through and we see that we’ve got reservoir capabilityto match to it and not have to spend a lot of monies on facilities. So we’re doing all those type things like, once again, fromthe reservoir through the sales point to try to optimize the system in all ourbusiness units around the world."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mark Gilman - Benchmark."
},
{
"speaker": "Mark Gilman -Benchmark",
"text": "Relating to Pascagoula,could you give an idea as to the size of the crude unit that is down? More generally, I guess I was a little surprised to see thesanctioning of the CCR project, and I’m assuming that in having done so thedistillation expansion at Pascagoula which had been under evaluation is now nolonger on the table. Could you commenton the validity of that observation?"
},
{
"speaker": "Mike Worth",
"text": "Yes, on the crude unit it’s about 160,000 barrels per dayand on the CCR, that is an independent project. We’ve got old fixed-bed reformers that need to have the catalystregenerated so we’ve got to pull reformers offline for catalyst regeneration,and it significantly impacts our ability to get the utilization at the facilityup. So this is a reliability projectthat has a very strong economic pay out, and frankly, there are not many ofthese fixed-bed reformers still in operation in the industry. So it’s really upgrading the technology tothe current state-of-the-art. The evaluation of other alternatives for Pascagoulacontinues. I think I’ve indicated thatwe would reach a final decision on that next year. Certainly, you’re seeing project economicschallenged in the refining sector on the Gulf Coast as well as the rest of theworld by the cost environment, by the questions about the margin environment,uncertainty about biofuels penetration and future demand, etcetera. So we’re factoring all those into our evaluationof alternatives, and we’ll have more to say about that next year as that workis complete."
},
{
"speaker": "Mark Gilman -Benchmark",
"text": "Mike, if I could just follow up on that. If you’reconsidering an expansion, I don’t know how you go about properly sizing whatthe replacement reforming capacity ought to be."
},
{
"speaker": "Mike Worth",
"text": "Well on the reforming, it fits into a refinery that isconfigured with a number of other facilities that has streams that create feedfor the reformer. What we’re doing is taking existing intermediate streams andwe are installing facilities that essentially you can look at as ade-bottleneck or a capacity creep kind of a project that enables us to morefully utilize the streams available within the refinery and increase theutilization."
},
{
"speaker": "Operator",
"text": "Your next question comes from Neil McMahon - SanfordBernstein."
},
{
"speaker": "Neil McMahon",
"text": "Maybe this is a quick one you don’t have many answers for,but most of the impact on the refining in the US,the negative impact as you said was on the west coast. Just wanted to go intomaybe walking through some reasons for that, and did you have hedges in placesthere that could have caused some of those losses?"
},
{
"speaker": "Mike Worth",
"text": "As Jim showed earlier, when you compare the third quarter tothe second quarter, our USearnings were down nearly $900 million. More than two-thirds of that declinewas due to industry margins, and really the balance for the USwas due to lower volumes, and that is primarilyPascagoula. So I think the quarter-to-quarter comparison is prettystraightforward on those two pieces. We have some pricing effects on our crudeoil into the refining system that we see most acutely at times of rapid changein crude prices, and our foreign crude that we purchase that is long-haul crudegets provisionally price while it’s on the water, and so we’ll see the effectof those increases before we actually capture the margin for running thatcrude. So we do have some paper effects that you see in anenvironment like this that are exacerbated by the amount of long-haul crudethat we run and the way that we price crude into our system."
},
{
"speaker": "Neil McMahon",
"text": "So you don’t really do hedge accounting then on thoselong-haul crudes or in the west coast?"
},
{
"speaker": "Mike Worth",
"text": "We mark the pricing to current period pricing, and we runour refineries to capture the margin of the day, so we convert the pricing torun-month pricing, and so what that does result in is some open paper that is priceconversion off the feed stock to the run month."
},
{
"speaker": "Jim Aleveras",
"text": "Let me just add on that point, again, as Mike said, thoseare part of the contractual provisions. They’re not hedging, per se, so when a cargo is lifted it has acontractual term as to when it’ll be priced so many days after lifting. In a rising market, as we’ve seen here in thethird quarter, that works adversely against us. Thank you very much for the question and the follow-up."
},
{
"speaker": "Operator",
"text": "Your next question comes from Paul Cheng - LehmanBrothers."
},
{
"speaker": "Paul Cheng",
"text": "Mike, if I look at the third quarter market conditions, GulfCoast 3 to 1 crack spread is roughly in the $11 to $12 per barrel and the Californiacrack is probably about $13, $14. Whilethey advanced sharply from the second quarter, but they are really not that badfrom a historical standards standpoint. If you look at your earnings, I meanadjusting for the $50 million in environmental remediation charges and also the$90 million loss related to Pascagoula,you earned $30 million. Is there astructural problem with your asset there then that your hardware just needs tobe revised sharply in order for them to be more sustainable in a more normalpricing environment?"
},
{
"speaker": "Mike Worth",
"text": "No, I don’t think there is a structural problem in themarket or in the refinery. I think theindicator margins did decline more sharply on the west coast than on the Gulf coastand with a skew to our downstream where we have more than half of our USrefining capacity on the west coast, that sharper decline will affect us to agreater degree."
},
{
"speaker": "Paul Cheng",
"text": "Mike, I’m talking about on an absolute level that the crackis still topping out in the $10 to $15, which is not really that bad."
},
{
"speaker": "Mike Worth",
"text": "Let me take another shot at building on the question thatNeil was asking. We have these non-ratablepricing effects related to the change in crude prices which are most significantbecause the amount of long-haul crude that we bring into the west coast. And so if you look at 3Q07 versus 3Q06 youwould see that the margin declines are not especially severe and the absolutelevel of margins, as you say, are not as extreme as the earnings delta mightindicate; but if you look at 3Q06, we saw crude prices drop by about $11 abarrel over the quarter. In 3Q07 we saw crude prices increase by $11 per barrelin the quarter, and so those non-ratable pricing effects have significantknock-on accounting effects that get unwound subsequently as we actually runthe crude, but in the quarter they create pronounced effects on our west coastdownstream performance."
},
{
"speaker": "Paul Cheng",
"text": "Mike can you quantify it for us?"
},
{
"speaker": "Mike Worth",
"text": "I don’t have the numbers in front of me to quantify that,Paul."
},
{
"speaker": "Jim Aleveras",
"text": "You know, Paul, you’re talking on average maybe 15 millionbarrels of long-haul crude on the water, and as Mike said in the earlier perioda year ago, we saw crude prices from beginning to end of the quarter drop by$11 a barrel, and just the reverse effect that occurred here in the thirdquarter. That is going to be a material impact on the comparison betweenadjacent years on a variance. it’s one of the reasons why sometimes theindicative margin doesn’t become realized for our company. Thanks for yourquestion."
},
{
"speaker": "Operator",
"text": "Your next question comes from John Herrlin - Merrill Lynch."
},
{
"speaker": "John Herrlin",
"text": "With Thailandyou said that you extended the contract. Are the terms still similar, or arethey higher for the country?"
},
{
"speaker": "Stephen J. Crowe",
"text": "Do we have similar terms? It’s still the Taiwanterms. We do have some issues with related to how we extended it, but overallthe terms are basically the same."
},
{
"speaker": "John Herrlin -Merrill Lynch",
"text": "You were pretty active at the last Central Gulf sale. Could you give us asense on how many of the leases were Miocene versus, say Paleocene?"
},
{
"speaker": "Stephen J. Crowe",
"text": "I think my memory of the major targeted prospects, I believeit was nine or 11 intotal that we really captured major new prospects. All of them but one was thelower tertiary."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mark Gilman - Benchmark."
},
{
"speaker": "Mark Gilman",
"text": "George, if you could, on Block 14 in Angola,could you tell me whether or not there are separate PSCs for each of thefields, and the extent to which there are rate of return thresholds built intothose production-sharing contracts, pursuant to which profit barrels and profitpercentages would step down once the threshold was reached?"
},
{
"speaker": "George Kirkland",
"text": "Mark, I’m going to limit my comments a little bit, I willtell you that we have different development areas around each field. Our development areas have typically in block14, been larger than what we had seen in the past and in some cases, they havebeen more or less brought together to allow cost recovery to be moved from onedevelopment to another. So we have hadlarger development areas than in the past. I’m not going to speak about the contractual pieces beyond that."
},
{
"speaker": "Operator",
"text": "Your final question comes from Michael LaMotte - JP Morgan."
},
{
"speaker": "Michael LaMotte",
"text": "A question related to upstream cost pressures, as yourspending is shifting more towards completion and production, are you seeing anychanges in the rate of change of cost there? I would think that completion inflation is probably not as high asdrilling in rigs, offshore rigs in particular."
},
{
"speaker": "George Kirkland",
"text": "Let me take a shot at this one in a couple of ways. First off, remember we are operating in 25 to30 countries around the world, we’ve got a whole portfolio of projects that arein anything from the early phase, engineering to just about to start up andactually a lot of them in start up. The ones that are late in phase, we know contractual costsvery, very well. Those projects are notseeing and have not seen the same movement in costs as projects in the earlyphases. I would tell you whether a project is an onshore project in North America or if it is an offshore project or a deepwater project,all of those in effect, change the outcome of the cost increases. I’ll give you a couple of examples of what we’ve seen andmaybe that will help you get a little bit of context. We had a project in Angola, we brought onlinein deepwater project in Angola that we brought online a little over a year ago,we’re doing a very similar project that’s in the fabrication stage at thispoint, so we understand contractually what the cost is going to be fordrilling, for building of all the facilities, the installation, so we have gotthe contracts really nailed down. There’s a five to seven-year difference in the life cycle ofthe two projects and when you compare project A to project B, we see almost a100% increase in the cost of doing the similar work. So that’s very typical in the deepwater whereyou’ve seen rig rates go up. Deepwaterrig rates have gone up two to threetimes over a five-year period. Other areas we are not seeing the same, and once again everyproject we look at individually because you’ve got a different mix of contractsthat are either in place, and we have some period at a different rate than whatwe see in the future so we look at everything on a specific project-by-projectbasis. I would tell you one of the best areas to look at, maybe togive you a view of what the cost in the general industry what’s happened therein the last probably five to seven years, is to look at the CERA, the CambridgeEnergy Research report that was published, I believe in the last year. What it basically shows is over the periodfrom early 2000 to late ‘06, about 180% to 190% increase in their index. So they’ve shown a significant move in thatindex, and I think it’s very indicative of the general industry."
},
{
"speaker": "Michael LaMotte",
"text": "Is there anything in the component cost that is leading youto think about redirecting capital on the margin? Anything inflationary in the components sidethat would lead you to rethink project or redirect capital to better return?"
},
{
"speaker": "George Kirkland",
"text": "We do that. I wouldtell you the one that’s probably been impacted the most is shelf Gulf of Mexicowhere we made some decisions on changing how much capital we were spending onsome of our delineation and development wells there. Rig rates had moved way, way up veryquickly. If you look at the pricing sideof Henry Hub gas and you see the gas price has not moved; as a matter of fact,gas has moved down and oil has moved up. So we would have a bias there at this point in time to be oilier if wehave a choice. We’ve got some projectsbecause of the cost run-up on the services and the downturn on the gas price,that they are not really projects that are viable. So they are put back on the shelf."
},
{
"speaker": "Jim Aleveras",
"text": "In closing, let me say that we appreciate everyone’sparticipation on today’s call. I especially want to thank each of theanalysts on behalf of all the participants for their questions during thismorning’s session. Matt, back to you."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today’s third quarter2007 earnings conference call."
}
] | null | null |
CVX | 2 | 2,007 | 2007-07-27 11:00:00 | Operator: Welcome to Chevron’s second quarter 2007 earnings conference call. (Operator Instructions) I will now turn the conference over to the Chairman and CEO of Chevron Corporation, Mr. Dave O’Reilly. Please go ahead sir.
Dave O’Reilly: Welcome to Chevron’s second quarter earnings conference call. Today I’m joined by Steve Crowe, Chief Financial Officer and Irene Melitas, Manager of Investor Relations. Our focus today is on Chevron’s financial and operating results for the second quarter of 2007 and I’ll refer to the slides that are available on the web. I’ll remind you that today’s presentation contains estimates, projections and other forward-looking statements and ask that you review the Safe Harbor statement on slide 2. Turning to slide 3. The company reported earnings of $5.4 billion in the second quarter, up 24% from the second quarter of 2006. Earnings of $2.52 per diluted share were up 28% from a year ago. The main drivers for the increase were first, a $680 million after-tax gain on the sale of our interest in Dynegy, partially offset by costs of $160 million from retiring on economic debt. Second, the absence of hurricane related charges for uninsured costs incurred in the second quarter of 2006; and thirdly, higher margins for refined products. Second quarter results were 14% higher than the first quarter, which Steve will discuss shortly. Return on capital employed for the trailing four quarters was 24% and the debt ratio was about 10% at quarter end. Share repurchases totaled $1.75 billion, reflecting a higher buy back pace, which Steve foreshadowed at last quarters conference call. We now expect to complete the current buy back program in the third quarter. Steve will now take us through the quarterly comparisons.
Steve Crowe: Thanks, Dave. My remarks compare second quarter results to those of the first quarter 2007. As a reminder, our earnings release compared second quarter 2007 to the same quarter a year ago. Turning to slide 4; second quarter net income was $665 million higher than the first quarter’s result, driven by stronger commodity prices in the upstream and higher realized margins in downstream, particularly in refining. An increase in environmental remediation charges and a charge for the early redemption of Texaco capital bonds contributed negatively to the quarters results. Both items were highlighted in our interim update. The other bar reflects a negative variance in tax-related items and a net of everything else. Both periods had like-sized asset sales gains, the Nerefco sale in the first quarter and Dynegy in the second largely offsetting one another. Slide 5 summarizes the results of our U.S. substream earnings, which improved by about $425 million between quarters. Higher realizations particularly for liquids benefited earnings by $220 million between quarters. The $7.29 per barrel increase in crude realizations was generally in line with the increase on a composite of industry benchmark prices and contributed to a favorable $200 million variance between quarters. Improved natural gas realizations resulted in a $20 million profit effect. Though Henry Hub bid prices increased by $0.76 per 1,000 cubic feet, our average realizations rose $0.16 per 1,000 cubic feet reflecting our regional production mix and spot sales. Volumes including one additional producing day increased earnings by $30 million. Other primarily reflects a favorable variance in FAS 133 effects, lower exploration expenses and a gain on the sale of a couple of small operations. Turning to slide 6, international upstream earnings were $305 million higher than the first quarter’s. Stronger oil prices benefited earnings by about $560 million and were partly offset by lower gas realizations. Unit Liquids realizations improved $10.17 per barrel, in line with the rise in spot Brent prices. Higher liftings in Canada, Bangladesh and Azerbaijani and other international locations resulted in a positive earnings variance of $120 million. The negative $70 million for litigation represents the absence of a favorable litigation settlement in the first quarter. The variance in other includes an unfavorable swing in tax-related items as well as higher operating and depreciation expense. Slide 7 summarizes the change in worldwide oil equivalent production, including volumes produced from oil sands in Canada. Daily volumes were down by 13,000 barrels per day between quarters with the larger changes by country noted on the slide. For the first six months of the year, our worldwide oil equivalent production averaged 2.640m barrels per day. We expect production for the second half of the year to be in line with the first. Turning to slide 8, U.S. downstream results in the second quarter exceeded the prior quarters by about $430 million. Higher realized margins benefited earnings by $390 million relative to the first quarter, reflecting stronger industry margins, particularly refining. Refining margins were partially dampened by inventory-related effects and an unfavorable variance in final pricing adjustments for long-haul crude. Marketing margins also improved the quarter’s results. Refining volumes increased results by $135 million between quarters primarily due to the completion of the first quarter Richmond Refinery crude unit turnaround. The unfavorable variance in other largely reflects an increase in costs for environmental remediation as highlights in our interim update. Turning to slide 9, international downstream results of $517 million were lower than the first quarter’s. Absent the first quarter’s $700 million gain on the sale of our interest in the Nerefco Refinery, results were $56 million lower between quarters. Realized downstream margins improved earnings by about $150 million, primarily led by higher refining margins in most regions, in line with the rise in indicator margins. Lower volumes resulted in a decline of about $45 million between quarters reflecting, the fourth quarter Nerefco sale. Included in other is an swing in foreign exchange effects along with higher operating expenses reflecting increased maintenance and labor costs. Slide 10 shows earnings from chemicals were $104 million in the second quarter compared with $120 million in the first quarter. Results for olefins improved during the quarter due to higher ethylene and polyethylene margins and increased ethylene volumes. This was more than offset by an asset writedown in aromatics. Slide 11 covers all other. Second quarter results show a positive variance from the prior quarter arising from a gain on the sale of our interest in Dynegy which was partially offset by a charge related to the early redemption of Texaco capitol bonds, both of which were highlighted in our interim update. The variance in the other bar reflects and increase in environmental remediation expense for legacy Texaco and Unocal sites that have been closed or sold, tax related and other miscellaneous items. Absent the Dynegy gain and charge related to debt redemption, net charges for this segment fell within the guidance range of $160 million to $200 million provided in our interim update. That completes our brief analysis for the quarter. Back over to you, Dave.
Dave O’Reilly: Thanks, Steve. Turning to slide 12, we highlight some of the recent developments of the last few months starting with upstream. Last month we announced delay in our Gulf of Mexico Tahiti project due to some problems discovered in the facilities shackles. New shackles have been ordered and the timing of their installation is currently under review. At this time we have no further updates to provide regarding the completion date for these activities but will keep you apprised once we have a firm defined recovery plan in place. We have also signed a memorandum of understanding with the Venezuelan Government for the retention of our 30% interest in Hamaca. The MOU established the basic terms of the conversion and governance of the new joint venture company. Final conversion steps, including the National Assembly’s approval and the issuance of a Presidential Transfer Decree, are expected later this year. In Europe, we successfully completed a production test of the Rosebank Appraisal well west of Shetland. Chevron holds a 40% interest in the Rosebank discovery and is the operator. A third appraisal well is expected to be completed later this year and the resulting data will determine a future work program for the discovery. On the downstream side, earlier in the quarter we disclosed that an extensive plan turnaround of our major crude distillation unit in the El Segundo Refinery was underway. That turnaround is now mechanically complete and the unit start up is under way. During the down time, certain work was performed to progress the heavy crude project which remains on track for year end completion. We also completed the sale of our fuels marketing assets in Uruguay and announced an agreement for the sale of the Benelux marketing assets in Europe. That transaction is expected to close during this third quarter and both transactions are part of our portfolio rationalization efforts highlighted during our March analyst meeting. Finally in May, as we mentioned earlier, we sold our interest in Dynegy. Our decision was driven by Dynegy’s exits from oil and gas activities and the company’s increasing focus on power generation, thereby minimizing the strategic fit with Chevron. That concludes our prepared remarks. We’ll now take your questions, and one caller and one question per caller at a time, please. We’ll try to wrap up at or before the top of the hour. So, Matt, please open the lines for questions.
Operator: Our first question comes from Dan Barcelo - Banc Of America.
Dan Barcelo: Regarding U.S. natural gas production, you mentioned in your press release that it’s down about 7% year on year due to base decline. However, if I look over the last three quarters sequentially it seems the decline is a lot less. I don’t know if you could give any further guidance on base declines for natural gas and even for oil which has actually been pretty flat, especially given the pull back for natural gas prices?
Irene Melitas: We don’t really assign a declined value to natural gas versus liquids. The guidance we’ve previously issued is that overall our decline rate worldwide is about 4% to 5%, and in the U.S. it is higher, somewhere in the neighborhood of about 7%. But we don’t otherwise provide a split between liquids and gas.
Operator: Our next question is from Doug Leggate of Citigroup. Your question please.
Doug Leggate: Production guidance for the balance of this year, perhaps looking ahead, can you just bring us up to date with where you see things. Just to be clear, Venezuela is not I guess really out of the equation in terms of the present mix, but do you see any other changes taking place in Venezuela that might impact your production that way, over the balance of this year in particular?
Dave O’Reilly: Thanks, Doug. You know as I had mentioned in the aggregate for the enterprise, we see second half production largely the same as we had in the first; that is 2.640 million barrels a day or thereabouts. In the second half of the year we do anticipate some declines here in the United States as a result of normal field declines, particularly in the Gulf of Mexico. But, internationally, we expect to see some pick-up in Eurasia as a result of our TCO expansion that will be coming on later in the year, as well as a full six months of Bibiyana, where it came on line at the end of the first quarter this year. As far as the specifics on Venezuela are concerned for Hamaca right at this juncture the terms have not been made public so we won’t comment on that particularly. But our projects are largely on track and as I said, we expect to be about the same for the full year.
Operator: Our next question is from Arjun Murti - Goldman Sachs. Your question please.
Arjun Murti: Thanks. My question is on some of the tax claims that have been filed by Russia related to the CPC that’s at least been in the press. I realize the nature of these things are difficult to forecast outcomes and so forth, but just given the importance of your Tengiz project in Kazakhstan production, to the extent that you’re not able to come to some sort of settlement with Russia do they have any reasonable recourse or actions that they can take or should we feel that since it is a separate country from Kazakhstan we shouldn’t feel that the Tengiz or Kazak production is at risk for any reason related to these tax claims.
Steve Crowe: Arjun, there have been some tax claims. By the way, these are not unusual; we get them all over the world, United States included, but let me just put them in perspective. The very first tax claim that we appealed, it went to the higher court. The higher court kicked it back down to the lower court. These are kind of I would say legitimate questions for tax authorities to ask that we need to resolve so that was an encouraging sign. So I expect that we’re going to resolve these tax claims just like we do in other jurisdictions and it’s a matter of interpretation of the tax code and sitting down and understanding one another and getting a resolution. Now having said that, with Tengiz of course we are also looking at other options; we’re not solely dependent on CPC. We have a significant rail program, export program that we’ve exercised in the past. As you remember, we operated Tengiz for five or six years without any CPC pipeline but we have many other options. We are also developing a southern route to take advantage of our participation in the Baku line so there are multiple options for exports here but I wouldn’t get hung up on this tax case because I think it’s just an example of something we have to work our way through.
Operator: Your next question is from Paul Chang of Lehman Brothers. Your question please.
Paul Chang: Dave, can you give an update on the status of our Gorgon, Agbami, and also the neutral zone contract expansion?
Dave O’Reilly: Okay, Gorgon, Agbami and neutral zone; let me start with Gorgon. You’ll recall that one of the big issues last year was getting government approval from the environmental perspective from the Western Australia government and the Western Australian government EPA had filed an objection. We worked our way through that and at the end of last year we were able to resolve those issues and objections from the EPA and gain the approval of the Western Australian government to go ahead with the project. Then there were two other issues remaining which we talked about in the spring at our March analyst meeting. The first was getting federal government approval or the commonwealth government technically, approval for the environmental permits there. That process is still underway and is not complete but I am confident that we’re going to get completion there and we’re working hard to get it there. The other issue was the question of costs and the cost escalation that we’re seeking in the whole L&G supply chain: Fabrication, contractors, construction, and et cetera. That led us to go back and work with our partners late last year and we’re continuing that work, although we should be wrapping it up this year. It caused us to go back with our partners and look at trying to come up with alternatives and optimization for the construction plan and facilities; different configurations. That work is underway. We’re working with our partners. This is an enormously big project. It’s very important from a capital storage perspective to get it right. So we’re looking at a facility that’s going to be on the ground for decades and producing very, very copious quantities of gas. We want to get it right, we’re working our way through it. When we get it right, we’ll move forward with it. But that work is still underway. That’s Gorgon. You asked two other questions, although you were supposed to ask one.
Paul Chang: It’s all in one question.
Dave O’Reilly: I know, yes. Agbami; Next month I’ll be in Korea visiting the FPSO, which is nearing completion. It’s one of the largest ever built, the size of an aircraft carrier I’ve been told. So I’m looking forward to seeing it. It’s going to sail later this quarter, early in the fourth quarter. So everything is online with Agbami. The third question you asked was the neutral zone. We are in the process of renegotiating or negotiating an extension or amendment to the neutral zone agreement, which has been in place from 1949 and through different successor companies and it’s too early to predict the outcome, other than to say that we are currently engaged and over the next year or so we hope to get that issue resolved. But it’s too early to say yet. It’s early days of the negotiation. Thank you. I will take the next question please.
Operator: Our next question is from Nicole Decker of Bear Stearns. Your question please.
Nicole Decker: Good morning. My question is on the share buyback program given that you aim to complete your authorization next quarter I am interested in hearing your thoughts on the likelihood of an extension or a renewal?
Steve Crowe: As Dave mentioned we anticipate completing the currently $5 billion authorized program in the third quarter. That would amount to $1.9 billion and we fully expect that our board will authorize a follow-on program right behind it. As indicated, we’ve been ramping up the repurchase program given the current market conditions and our debt profile with $1.75 billion here in the second quarter and as I mentioned 1.9 billion in the third quarter. So thanks very much, but that can be your expectation. May we have the next question?
Operator: Our next question is from Bruce Lanni of AG Edwards. Your question please.
Bruce Lanni: Just a follow-up question somewhat dealing with Paul Chang. Gulf of Mexico; I tuned in a little bit late, you may have covered it. But can you give us an update on the sanctioning there as well as any status or comments on Jack and Bob North?
Dave O’Reilly: Let me just kind of give you an overview of the Gulf of Mexico in general. I covered the Tahiti issue earlier in my opening remarks and we have no firm plan yet for recovery other than we’ve ordered replacement shackles and we’re still working on a recovery plan there. Blind Faith; the hull has been delivered to the Gulf. By the way the Tahiti hull is in the Gulf. So it’s not a question of the hull, it’s a question of getting the shackles manufactured and coming up with a new program for installation. It’s much too early to predict what timeframe that can occur. On Blind Faith the hull has been delivered into the Gulf of Mexico and that’s looking on track. Jack and St. Malo, you recall last year, we completed a extensive record setting test on Jack and we have an appraisal program planned for both St. Malo on a continuation of the appraisal of Jack during 2008;, not during 2007, so you will not hear more from us this year, other than to say there’s more appraisal underway and that will lead to a much better understanding in ‘08 and beyond that, who knows. We’ll be developing some sort of a development plan to move forward, but that is the timeframe for those two. On Tubular Bells, we’re still working with the operator on that to develop further appraisal and it’s too early to predict yet, but the ultimate development is there, but I’ll refer you to the operator on that one. Was there another question?
Bruce Lanni: Bob North.
Dave O’Reilly: I believe we have a well in our program currently with Bob North and so we’ll perhaps have more to say about Bob North later this year.
Operator: Our next question is from Neil McMahon of Sanford Bernstein. Your question please.
Neil McMahon: Just on Jack again, actually, it looked like there was a delay on the next appraisal well on Jack, and I believe at the investor presentation earlier in the year, you were not planning to test that appraisal well, but given the fact that it’s been delayed into 2008, are you now going to test that next appraisal well and maybe you could provide sort of an ongoing description of how you’re finding the reservoir characteristics based on the work you’ve done so far.
Dave O’Reilly: Let me go back and be very precise because we were very careful about what we said. We said we do our next appraisal well at Jack either late this year or early next year. What I’m saying now is it’s going to be early next year, not late this year. It is unlikely that we’ll need to test that well, but it will help us characterize the scope of the reservoir, and beyond that I’m not prepared to make any other predictions. St. Malo, I don’t know we’ve made a decision yet as to whether we’re going to test the St. Malo well, a lot of it depends on what we find in the next appraisal well, so it’s too early to tell what we’ll do there. One of the great advantages here is now we’ve merged our predevelopment teams because this is the benefit of a merger between Chevron and Unocal because Unocal was the operator at St. Malo, we’re the operator at Jack. Now we’ll be able to merge the technical teams that are working on this and I think we’re trying to optimize our plans here so that we transfer learning things from one to the other and take the most efficient approach to developing this new trend in an economic way. So early days yet, more work to come, but we’re very satisfied with the progress we’ve made to date.
Operator: Your next question is from Mark Gilman - Benchmark Company. Your question please.
Mark Gilman: I was wondering if you could provide just a little bit more clarity and granularity on the heavy crew projects in El Segundo and Yeosu in Korea in terms of what units in particular you’re putting in, the size, the cost and what the yield implications will be?
Dave O’Reilly: Let me just give you a general review on El Segundo first. We tried to cover some of this in the March meeting. The El Segundo work really requires a lot of work in two areas. It requires a facility to be installed in our major crude unit, which is currently underway and actually just about wrapped up as I mentioned in my formal remarks. The second phase of the construction work revolves around the coker because we need more coking capacity and more efficient coking capacity and construction work is already underway but it will be conducted and completed during the coker turnaround that we had scheduled in the fourth quarter this year. So the plan is to have it all wrapped up. In the case of Yeosu, it is actually so that the El Segundo is in the hundreds of millions sort of range. Now the Yeosu project is a $1.5 billion and that involves some new facilities, dehydrogenation facilities, as well as at the back end of it, a new base oil plant, the ability of the plant and the capacity of the plant to convert heavier crudes, that will complete by the end of the year and that’s on track. The lube oil plant is expected to start up in the second quarter of next year. It lags behind the basic plan itself. So that’s generally the scope of the 2 projects. The one in Yeosu is quite much more significant and we’ll be covering that in more detail in one of our upcoming calls or perhaps in our big analyst meeting early next year. Thank you.
Operator: Our next question is from Robert Kessler - Simmons, your question please.
Robert Kessler: Dave, I don’t really expect you to speak on behalf of other oil companies but any reason as to why you’re sticking around in Venezuela despite Exxon and Conoco having taking Chavez to court effectively.
Dave O’Reilly: Well, first of all we’ve been there a long time. Since the 1940s originally, but first let me mention a couple of things. We were able to successfully convert our Boscan operation to a joint-ventured company last year and in the process of doing that, preserve value and come out of it in what we think was a satisfactory conclusion. We believe that we have the same opportunity here at Hamaca, and I can’t speak for other companies other than to say that we wouldn’t be making this choice if we didn’t think it was the right choice for Chevron, and we are confident that under the circumstances we can complete, well the negotiations are complete, but get approved by the authorities so we can continue to operate there. But I think in your question you almost implied part of the answer. You should put that question to some of the others as well.
Robert Kessler: Any thoughts about a future heavy oil project, in addition to Hamaca at this point?
Dave O’Reilly: No, I think our focus right now is on restructuring our current operations there, and we just have to see how we’re treated there, what the opportunities are in the future and our decisions to go further there are entirely dependent on our experience with the operations that we’ve already converted and are in the process of converting. Thank you.
Operator: The next question is from Mark Gilman - Benchmark, your question please.
Mark Gilman: I’m having an awful lot of difficulty with the transparency in the release, regarding there are indicated to be no special items, but as we go through the discussion there seems to be quite a number. I was hoping you could quantify the asset sales in U.S. E&P, the environmental provisions, and refining and marketing, and to what extent those provisions are included in the $150 million number that is indicated in the waterfall chart regarding overall earnings, and also the asset writedown in foreign E&P?
Steve Crowe: Thank you, Mark. We don’t disclose special items, because we no longer view it as special items given the size of our firm. But the things that we’ve disclosed in the press release and foreshadowed in the interim update are I think some of the key things if you were making some adjustments you could take into account. Certainly the largest among those would be the gain connected with our sale of the Dynegy shares. Similarly in the same segment we indicated that there was a charge in connection of the redemption of some uneconomic Texaco capital bonds, which we reacquired here in the second quarter. Those two might be things you could pull from our report of results.
Dave O’Reilly: I would like to build a little bit on it, Steve is right on the mark, you know, we are not going to dig into the ups and downs, because every quarter there are ups and downs, let me give you one example. We see environment charges come pretty much every year, now they come in lumps; some quarters there are fewer and some quarters there more, this quarter they are some what more than we’d experience, for example, in the first quarter. But it varies and I think you’ve go to expect that these things are ongoing, so we treat them as a part of our ongoing business. I think from an analyst perspective the best way to view our earnings is to look at them and then if we see things we truly believe are unique and that do not belong in routine business, such as the two items that Steve cited, I think those we will continue to highlight. But others I think you’ve got to take into the ongoing business environment and they are lumpy, slightly up sometimes, down other times. If there is something that we believe is a significant factor, that we think you ought to take into account, we are going to tell you about it. And that is why we highlighted these two items that we did in the second quarter. I think we are about ready to wrap up, so I would like to thank you all for participating in the call. Please let Irene or our team know if you have any follow-up questions. I look forward to talking to you in future quarters or future meetings. Thank you for your interest in the company. Good bye. | [
{
"speaker": "Operator",
"text": "Welcome to Chevron’s second quarter 2007 earnings conference call. (Operator Instructions) I will now turn the conference over to the Chairman and CEO of Chevron Corporation, Mr. Dave O’Reilly. Please go ahead sir."
},
{
"speaker": "Dave O’Reilly",
"text": "Welcome to Chevron’s second quarter earnings conference call. Today I’m joined by Steve Crowe, Chief Financial Officer and Irene Melitas, Manager of Investor Relations. Our focus today is on Chevron’s financial and operating results for the second quarter of 2007 and I’ll refer to the slides that are available on the web. I’ll remind you that today’s presentation contains estimates, projections and other forward-looking statements and ask that you review the Safe Harbor statement on slide 2. Turning to slide 3. The company reported earnings of $5.4 billion in the second quarter, up 24% from the second quarter of 2006. Earnings of $2.52 per diluted share were up 28% from a year ago. The main drivers for the increase were first, a $680 million after-tax gain on the sale of our interest in Dynegy, partially offset by costs of $160 million from retiring on economic debt. Second, the absence of hurricane related charges for uninsured costs incurred in the second quarter of 2006; and thirdly, higher margins for refined products. Second quarter results were 14% higher than the first quarter, which Steve will discuss shortly. Return on capital employed for the trailing four quarters was 24% and the debt ratio was about 10% at quarter end. Share repurchases totaled $1.75 billion, reflecting a higher buy back pace, which Steve foreshadowed at last quarters conference call. We now expect to complete the current buy back program in the third quarter. Steve will now take us through the quarterly comparisons."
},
{
"speaker": "Steve Crowe",
"text": "Thanks, Dave. My remarks compare second quarter results to those of the first quarter 2007. As a reminder, our earnings release compared second quarter 2007 to the same quarter a year ago. Turning to slide 4; second quarter net income was $665 million higher than the first quarter’s result, driven by stronger commodity prices in the upstream and higher realized margins in downstream, particularly in refining. An increase in environmental remediation charges and a charge for the early redemption of Texaco capital bonds contributed negatively to the quarters results. Both items were highlighted in our interim update. The other bar reflects a negative variance in tax-related items and a net of everything else. Both periods had like-sized asset sales gains, the Nerefco sale in the first quarter and Dynegy in the second largely offsetting one another. Slide 5 summarizes the results of our U.S. substream earnings, which improved by about $425 million between quarters. Higher realizations particularly for liquids benefited earnings by $220 million between quarters. The $7.29 per barrel increase in crude realizations was generally in line with the increase on a composite of industry benchmark prices and contributed to a favorable $200 million variance between quarters. Improved natural gas realizations resulted in a $20 million profit effect. Though Henry Hub bid prices increased by $0.76 per 1,000 cubic feet, our average realizations rose $0.16 per 1,000 cubic feet reflecting our regional production mix and spot sales. Volumes including one additional producing day increased earnings by $30 million. Other primarily reflects a favorable variance in FAS 133 effects, lower exploration expenses and a gain on the sale of a couple of small operations. Turning to slide 6, international upstream earnings were $305 million higher than the first quarter’s. Stronger oil prices benefited earnings by about $560 million and were partly offset by lower gas realizations. Unit Liquids realizations improved $10.17 per barrel, in line with the rise in spot Brent prices. Higher liftings in Canada, Bangladesh and Azerbaijani and other international locations resulted in a positive earnings variance of $120 million. The negative $70 million for litigation represents the absence of a favorable litigation settlement in the first quarter. The variance in other includes an unfavorable swing in tax-related items as well as higher operating and depreciation expense. Slide 7 summarizes the change in worldwide oil equivalent production, including volumes produced from oil sands in Canada. Daily volumes were down by 13,000 barrels per day between quarters with the larger changes by country noted on the slide. For the first six months of the year, our worldwide oil equivalent production averaged 2.640m barrels per day. We expect production for the second half of the year to be in line with the first. Turning to slide 8, U.S. downstream results in the second quarter exceeded the prior quarters by about $430 million. Higher realized margins benefited earnings by $390 million relative to the first quarter, reflecting stronger industry margins, particularly refining. Refining margins were partially dampened by inventory-related effects and an unfavorable variance in final pricing adjustments for long-haul crude. Marketing margins also improved the quarter’s results. Refining volumes increased results by $135 million between quarters primarily due to the completion of the first quarter Richmond Refinery crude unit turnaround. The unfavorable variance in other largely reflects an increase in costs for environmental remediation as highlights in our interim update. Turning to slide 9, international downstream results of $517 million were lower than the first quarter’s. Absent the first quarter’s $700 million gain on the sale of our interest in the Nerefco Refinery, results were $56 million lower between quarters. Realized downstream margins improved earnings by about $150 million, primarily led by higher refining margins in most regions, in line with the rise in indicator margins. Lower volumes resulted in a decline of about $45 million between quarters reflecting, the fourth quarter Nerefco sale. Included in other is an swing in foreign exchange effects along with higher operating expenses reflecting increased maintenance and labor costs. Slide 10 shows earnings from chemicals were $104 million in the second quarter compared with $120 million in the first quarter. Results for olefins improved during the quarter due to higher ethylene and polyethylene margins and increased ethylene volumes. This was more than offset by an asset writedown in aromatics. Slide 11 covers all other. Second quarter results show a positive variance from the prior quarter arising from a gain on the sale of our interest in Dynegy which was partially offset by a charge related to the early redemption of Texaco capitol bonds, both of which were highlighted in our interim update. The variance in the other bar reflects and increase in environmental remediation expense for legacy Texaco and Unocal sites that have been closed or sold, tax related and other miscellaneous items. Absent the Dynegy gain and charge related to debt redemption, net charges for this segment fell within the guidance range of $160 million to $200 million provided in our interim update. That completes our brief analysis for the quarter. Back over to you, Dave."
},
{
"speaker": "Dave O’Reilly",
"text": "Thanks, Steve. Turning to slide 12, we highlight some of the recent developments of the last few months starting with upstream. Last month we announced delay in our Gulf of Mexico Tahiti project due to some problems discovered in the facilities shackles. New shackles have been ordered and the timing of their installation is currently under review. At this time we have no further updates to provide regarding the completion date for these activities but will keep you apprised once we have a firm defined recovery plan in place. We have also signed a memorandum of understanding with the Venezuelan Government for the retention of our 30% interest in Hamaca. The MOU established the basic terms of the conversion and governance of the new joint venture company. Final conversion steps, including the National Assembly’s approval and the issuance of a Presidential Transfer Decree, are expected later this year. In Europe, we successfully completed a production test of the Rosebank Appraisal well west of Shetland. Chevron holds a 40% interest in the Rosebank discovery and is the operator. A third appraisal well is expected to be completed later this year and the resulting data will determine a future work program for the discovery. On the downstream side, earlier in the quarter we disclosed that an extensive plan turnaround of our major crude distillation unit in the El Segundo Refinery was underway. That turnaround is now mechanically complete and the unit start up is under way. During the down time, certain work was performed to progress the heavy crude project which remains on track for year end completion. We also completed the sale of our fuels marketing assets in Uruguay and announced an agreement for the sale of the Benelux marketing assets in Europe. That transaction is expected to close during this third quarter and both transactions are part of our portfolio rationalization efforts highlighted during our March analyst meeting. Finally in May, as we mentioned earlier, we sold our interest in Dynegy. Our decision was driven by Dynegy’s exits from oil and gas activities and the company’s increasing focus on power generation, thereby minimizing the strategic fit with Chevron. That concludes our prepared remarks. We’ll now take your questions, and one caller and one question per caller at a time, please. We’ll try to wrap up at or before the top of the hour. So, Matt, please open the lines for questions."
},
{
"speaker": "Operator",
"text": "Our first question comes from Dan Barcelo - Banc Of America."
},
{
"speaker": "Dan Barcelo",
"text": "Regarding U.S. natural gas production, you mentioned in your press release that it’s down about 7% year on year due to base decline. However, if I look over the last three quarters sequentially it seems the decline is a lot less. I don’t know if you could give any further guidance on base declines for natural gas and even for oil which has actually been pretty flat, especially given the pull back for natural gas prices?"
},
{
"speaker": "Irene Melitas",
"text": "We don’t really assign a declined value to natural gas versus liquids. The guidance we’ve previously issued is that overall our decline rate worldwide is about 4% to 5%, and in the U.S. it is higher, somewhere in the neighborhood of about 7%. But we don’t otherwise provide a split between liquids and gas."
},
{
"speaker": "Operator",
"text": "Our next question is from Doug Leggate of Citigroup. Your question please."
},
{
"speaker": "Doug Leggate",
"text": "Production guidance for the balance of this year, perhaps looking ahead, can you just bring us up to date with where you see things. Just to be clear, Venezuela is not I guess really out of the equation in terms of the present mix, but do you see any other changes taking place in Venezuela that might impact your production that way, over the balance of this year in particular?"
},
{
"speaker": "Dave O’Reilly",
"text": "Thanks, Doug. You know as I had mentioned in the aggregate for the enterprise, we see second half production largely the same as we had in the first; that is 2.640 million barrels a day or thereabouts. In the second half of the year we do anticipate some declines here in the United States as a result of normal field declines, particularly in the Gulf of Mexico. But, internationally, we expect to see some pick-up in Eurasia as a result of our TCO expansion that will be coming on later in the year, as well as a full six months of Bibiyana, where it came on line at the end of the first quarter this year. As far as the specifics on Venezuela are concerned for Hamaca right at this juncture the terms have not been made public so we won’t comment on that particularly. But our projects are largely on track and as I said, we expect to be about the same for the full year."
},
{
"speaker": "Operator",
"text": "Our next question is from Arjun Murti - Goldman Sachs. Your question please."
},
{
"speaker": "Arjun Murti",
"text": "Thanks. My question is on some of the tax claims that have been filed by Russia related to the CPC that’s at least been in the press. I realize the nature of these things are difficult to forecast outcomes and so forth, but just given the importance of your Tengiz project in Kazakhstan production, to the extent that you’re not able to come to some sort of settlement with Russia do they have any reasonable recourse or actions that they can take or should we feel that since it is a separate country from Kazakhstan we shouldn’t feel that the Tengiz or Kazak production is at risk for any reason related to these tax claims."
},
{
"speaker": "Steve Crowe",
"text": "Arjun, there have been some tax claims. By the way, these are not unusual; we get them all over the world, United States included, but let me just put them in perspective. The very first tax claim that we appealed, it went to the higher court. The higher court kicked it back down to the lower court. These are kind of I would say legitimate questions for tax authorities to ask that we need to resolve so that was an encouraging sign. So I expect that we’re going to resolve these tax claims just like we do in other jurisdictions and it’s a matter of interpretation of the tax code and sitting down and understanding one another and getting a resolution. Now having said that, with Tengiz of course we are also looking at other options; we’re not solely dependent on CPC. We have a significant rail program, export program that we’ve exercised in the past. As you remember, we operated Tengiz for five or six years without any CPC pipeline but we have many other options. We are also developing a southern route to take advantage of our participation in the Baku line so there are multiple options for exports here but I wouldn’t get hung up on this tax case because I think it’s just an example of something we have to work our way through."
},
{
"speaker": "Operator",
"text": "Your next question is from Paul Chang of Lehman Brothers. Your question please."
},
{
"speaker": "Paul Chang",
"text": "Dave, can you give an update on the status of our Gorgon, Agbami, and also the neutral zone contract expansion?"
},
{
"speaker": "Dave O’Reilly",
"text": "Okay, Gorgon, Agbami and neutral zone; let me start with Gorgon. You’ll recall that one of the big issues last year was getting government approval from the environmental perspective from the Western Australia government and the Western Australian government EPA had filed an objection. We worked our way through that and at the end of last year we were able to resolve those issues and objections from the EPA and gain the approval of the Western Australian government to go ahead with the project. Then there were two other issues remaining which we talked about in the spring at our March analyst meeting. The first was getting federal government approval or the commonwealth government technically, approval for the environmental permits there. That process is still underway and is not complete but I am confident that we’re going to get completion there and we’re working hard to get it there. The other issue was the question of costs and the cost escalation that we’re seeking in the whole L&G supply chain: Fabrication, contractors, construction, and et cetera. That led us to go back and work with our partners late last year and we’re continuing that work, although we should be wrapping it up this year. It caused us to go back with our partners and look at trying to come up with alternatives and optimization for the construction plan and facilities; different configurations. That work is underway. We’re working with our partners. This is an enormously big project. It’s very important from a capital storage perspective to get it right. So we’re looking at a facility that’s going to be on the ground for decades and producing very, very copious quantities of gas. We want to get it right, we’re working our way through it. When we get it right, we’ll move forward with it. But that work is still underway. That’s Gorgon. You asked two other questions, although you were supposed to ask one."
},
{
"speaker": "Paul Chang",
"text": "It’s all in one question."
},
{
"speaker": "Dave O’Reilly",
"text": "I know, yes. Agbami; Next month I’ll be in Korea visiting the FPSO, which is nearing completion. It’s one of the largest ever built, the size of an aircraft carrier I’ve been told. So I’m looking forward to seeing it. It’s going to sail later this quarter, early in the fourth quarter. So everything is online with Agbami. The third question you asked was the neutral zone. We are in the process of renegotiating or negotiating an extension or amendment to the neutral zone agreement, which has been in place from 1949 and through different successor companies and it’s too early to predict the outcome, other than to say that we are currently engaged and over the next year or so we hope to get that issue resolved. But it’s too early to say yet. It’s early days of the negotiation. Thank you. I will take the next question please."
},
{
"speaker": "Operator",
"text": "Our next question is from Nicole Decker of Bear Stearns. Your question please."
},
{
"speaker": "Nicole Decker",
"text": "Good morning. My question is on the share buyback program given that you aim to complete your authorization next quarter I am interested in hearing your thoughts on the likelihood of an extension or a renewal?"
},
{
"speaker": "Steve Crowe",
"text": "As Dave mentioned we anticipate completing the currently $5 billion authorized program in the third quarter. That would amount to $1.9 billion and we fully expect that our board will authorize a follow-on program right behind it. As indicated, we’ve been ramping up the repurchase program given the current market conditions and our debt profile with $1.75 billion here in the second quarter and as I mentioned 1.9 billion in the third quarter. So thanks very much, but that can be your expectation. May we have the next question?"
},
{
"speaker": "Operator",
"text": "Our next question is from Bruce Lanni of AG Edwards. Your question please."
},
{
"speaker": "Bruce Lanni",
"text": "Just a follow-up question somewhat dealing with Paul Chang. Gulf of Mexico; I tuned in a little bit late, you may have covered it. But can you give us an update on the sanctioning there as well as any status or comments on Jack and Bob North?"
},
{
"speaker": "Dave O’Reilly",
"text": "Let me just kind of give you an overview of the Gulf of Mexico in general. I covered the Tahiti issue earlier in my opening remarks and we have no firm plan yet for recovery other than we’ve ordered replacement shackles and we’re still working on a recovery plan there. Blind Faith; the hull has been delivered to the Gulf. By the way the Tahiti hull is in the Gulf. So it’s not a question of the hull, it’s a question of getting the shackles manufactured and coming up with a new program for installation. It’s much too early to predict what timeframe that can occur. On Blind Faith the hull has been delivered into the Gulf of Mexico and that’s looking on track. Jack and St. Malo, you recall last year, we completed a extensive record setting test on Jack and we have an appraisal program planned for both St. Malo on a continuation of the appraisal of Jack during 2008;, not during 2007, so you will not hear more from us this year, other than to say there’s more appraisal underway and that will lead to a much better understanding in ‘08 and beyond that, who knows. We’ll be developing some sort of a development plan to move forward, but that is the timeframe for those two. On Tubular Bells, we’re still working with the operator on that to develop further appraisal and it’s too early to predict yet, but the ultimate development is there, but I’ll refer you to the operator on that one. Was there another question?"
},
{
"speaker": "Bruce Lanni",
"text": "Bob North."
},
{
"speaker": "Dave O’Reilly",
"text": "I believe we have a well in our program currently with Bob North and so we’ll perhaps have more to say about Bob North later this year."
},
{
"speaker": "Operator",
"text": "Our next question is from Neil McMahon of Sanford Bernstein. Your question please."
},
{
"speaker": "Neil McMahon",
"text": "Just on Jack again, actually, it looked like there was a delay on the next appraisal well on Jack, and I believe at the investor presentation earlier in the year, you were not planning to test that appraisal well, but given the fact that it’s been delayed into 2008, are you now going to test that next appraisal well and maybe you could provide sort of an ongoing description of how you’re finding the reservoir characteristics based on the work you’ve done so far."
},
{
"speaker": "Dave O’Reilly",
"text": "Let me go back and be very precise because we were very careful about what we said. We said we do our next appraisal well at Jack either late this year or early next year. What I’m saying now is it’s going to be early next year, not late this year. It is unlikely that we’ll need to test that well, but it will help us characterize the scope of the reservoir, and beyond that I’m not prepared to make any other predictions. St. Malo, I don’t know we’ve made a decision yet as to whether we’re going to test the St. Malo well, a lot of it depends on what we find in the next appraisal well, so it’s too early to tell what we’ll do there. One of the great advantages here is now we’ve merged our predevelopment teams because this is the benefit of a merger between Chevron and Unocal because Unocal was the operator at St. Malo, we’re the operator at Jack. Now we’ll be able to merge the technical teams that are working on this and I think we’re trying to optimize our plans here so that we transfer learning things from one to the other and take the most efficient approach to developing this new trend in an economic way. So early days yet, more work to come, but we’re very satisfied with the progress we’ve made to date."
},
{
"speaker": "Operator",
"text": "Your next question is from Mark Gilman - Benchmark Company. Your question please."
},
{
"speaker": "Mark Gilman",
"text": "I was wondering if you could provide just a little bit more clarity and granularity on the heavy crew projects in El Segundo and Yeosu in Korea in terms of what units in particular you’re putting in, the size, the cost and what the yield implications will be?"
},
{
"speaker": "Dave O’Reilly",
"text": "Let me just give you a general review on El Segundo first. We tried to cover some of this in the March meeting. The El Segundo work really requires a lot of work in two areas. It requires a facility to be installed in our major crude unit, which is currently underway and actually just about wrapped up as I mentioned in my formal remarks. The second phase of the construction work revolves around the coker because we need more coking capacity and more efficient coking capacity and construction work is already underway but it will be conducted and completed during the coker turnaround that we had scheduled in the fourth quarter this year. So the plan is to have it all wrapped up. In the case of Yeosu, it is actually so that the El Segundo is in the hundreds of millions sort of range. Now the Yeosu project is a $1.5 billion and that involves some new facilities, dehydrogenation facilities, as well as at the back end of it, a new base oil plant, the ability of the plant and the capacity of the plant to convert heavier crudes, that will complete by the end of the year and that’s on track. The lube oil plant is expected to start up in the second quarter of next year. It lags behind the basic plan itself. So that’s generally the scope of the 2 projects. The one in Yeosu is quite much more significant and we’ll be covering that in more detail in one of our upcoming calls or perhaps in our big analyst meeting early next year. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question is from Robert Kessler - Simmons, your question please."
},
{
"speaker": "Robert Kessler",
"text": "Dave, I don’t really expect you to speak on behalf of other oil companies but any reason as to why you’re sticking around in Venezuela despite Exxon and Conoco having taking Chavez to court effectively."
},
{
"speaker": "Dave O’Reilly",
"text": "Well, first of all we’ve been there a long time. Since the 1940s originally, but first let me mention a couple of things. We were able to successfully convert our Boscan operation to a joint-ventured company last year and in the process of doing that, preserve value and come out of it in what we think was a satisfactory conclusion. We believe that we have the same opportunity here at Hamaca, and I can’t speak for other companies other than to say that we wouldn’t be making this choice if we didn’t think it was the right choice for Chevron, and we are confident that under the circumstances we can complete, well the negotiations are complete, but get approved by the authorities so we can continue to operate there. But I think in your question you almost implied part of the answer. You should put that question to some of the others as well."
},
{
"speaker": "Robert Kessler",
"text": "Any thoughts about a future heavy oil project, in addition to Hamaca at this point?"
},
{
"speaker": "Dave O’Reilly",
"text": "No, I think our focus right now is on restructuring our current operations there, and we just have to see how we’re treated there, what the opportunities are in the future and our decisions to go further there are entirely dependent on our experience with the operations that we’ve already converted and are in the process of converting. Thank you."
},
{
"speaker": "Operator",
"text": "The next question is from Mark Gilman - Benchmark, your question please."
},
{
"speaker": "Mark Gilman",
"text": "I’m having an awful lot of difficulty with the transparency in the release, regarding there are indicated to be no special items, but as we go through the discussion there seems to be quite a number. I was hoping you could quantify the asset sales in U.S. E&P, the environmental provisions, and refining and marketing, and to what extent those provisions are included in the $150 million number that is indicated in the waterfall chart regarding overall earnings, and also the asset writedown in foreign E&P?"
},
{
"speaker": "Steve Crowe",
"text": "Thank you, Mark. We don’t disclose special items, because we no longer view it as special items given the size of our firm. But the things that we’ve disclosed in the press release and foreshadowed in the interim update are I think some of the key things if you were making some adjustments you could take into account. Certainly the largest among those would be the gain connected with our sale of the Dynegy shares. Similarly in the same segment we indicated that there was a charge in connection of the redemption of some uneconomic Texaco capital bonds, which we reacquired here in the second quarter. Those two might be things you could pull from our report of results."
},
{
"speaker": "Dave O’Reilly",
"text": "I would like to build a little bit on it, Steve is right on the mark, you know, we are not going to dig into the ups and downs, because every quarter there are ups and downs, let me give you one example. We see environment charges come pretty much every year, now they come in lumps; some quarters there are fewer and some quarters there more, this quarter they are some what more than we’d experience, for example, in the first quarter. But it varies and I think you’ve go to expect that these things are ongoing, so we treat them as a part of our ongoing business. I think from an analyst perspective the best way to view our earnings is to look at them and then if we see things we truly believe are unique and that do not belong in routine business, such as the two items that Steve cited, I think those we will continue to highlight. But others I think you’ve got to take into the ongoing business environment and they are lumpy, slightly up sometimes, down other times. If there is something that we believe is a significant factor, that we think you ought to take into account, we are going to tell you about it. And that is why we highlighted these two items that we did in the second quarter. I think we are about ready to wrap up, so I would like to thank you all for participating in the call. Please let Irene or our team know if you have any follow-up questions. I look forward to talking to you in future quarters or future meetings. Thank you for your interest in the company. Good bye."
}
] | null | null |
CVX | 1 | 2,007 | 2007-04-27 11:00:00 | Operator: Good morning. My name is Matt, and I will be your conference facilitator today. Welcome to Chevron's First Quarter 2007 Earnings Call. At this time, all participants are in a listen-only mode. After the speakers' remarks, there will be a question-and-answer session and instructions will be given at that time. (Operator Instructions). As a reminder, this conference call is being recorded. I would now like to turn the conference over to Vice President and Chief Financial Officer of Chevron Corporation, Mr. Steve Crowe. Please go ahead, sir.
Steve Crowe: Thank you, Matt. Welcome to Chevron's first quarter earnings conference call. Today, on the call, I am joined by Irene Melitas, Manager of Investor Relations. Our focus today is on Chevron's financial and operating results for the first quarter of 2007. We'll refer to the slides that are available on the web. I remind you that today's presentation contains estimates, projections and other forward-looking statements and ask that you review the Safe Harbor statement on slide two. I'll begin with slide 3, which provides an overview of our financial performance. The company reported earnings of $4.7 billion for the quarter or $2.18 per diluted share. Earnings were up 18% from the first quarter a year ago, reflecting a $700 million after-tax gain on the sale of our interest in the Nerefco Refinery in the Netherlands and higher margins on refined products worldwide. These benefits were partially offset by the effect of lower prices for crude oil and natural gas on upstream profits. First quarter results were 25% higher than the fourth quarter of 2006, which Irene will discuss shortly. Return on capital employed for the trailing four quarters was 23%. And the debt ratio was about 12% at quarter end. Earlier this week, we announced an 11.5% dividend increase raising our quarterly dividend to $0.58 per share. 2007 marks the 20th consecutive year that the company has increased its annual dividend payout. Share repurchases totaled $1.25 billion, the same quarterly pace as in 2006. Slide 4 highlights some of the milestones we achieved in recent months, starting with upstream. Last month, we announced the start-up of our Bibiyana natural gas field in Bangladesh. The field is initially expected to produce 200 million cubic feet of natural gas per day rising to 500 million cubic feet per day by 2010. This exploration success continues with the announcement of two deepwater oil accumulations in the northern part of the Republic of Congo Moho-Bilondo permit. Chevron's non-operated interest is 31.5%. Evaluation and development options studies are underway. In the downstream, we announced the sale of our 31% interest in the Nerefco Refinery in the Netherlands. The transaction closed at the end of March, and was part of our portfolio rationalization efforts highlighted during the March analyst meeting. Irene, will now take us through the quarterly comparisons. Irene?
Irene Melitas: Thanks, Steve. My remarks compare first quarter results to those of the fourth quarter 2006. As a reminder, our earnings release compared first quarter 2007 to the same quarter a year ago. Turning to slide 5; first quarter net income was about $940 million higher than the fourth quarter results. First quarter earnings benefited by $700 million from the sale of our interest in the Nerefco Refinery in Europe, as indicated in our interim update for the quarter. Volume effects reduced earnings by $175 million and were primarily attributable to lower liftings in Canada and production in the US. A decrease in exploration expense contributed favorably to the quarters results. The other bar reflects a positive swing in tax related items, lower operating expenses, and the net of everything else. Slide 6, summarizes the results of our US upstream earnings, which declined by $90 million between quarters. The benefit of higher natural gas realizations were partially offset by lower liquids realizations, and netted to a $20 million improvement in earnings. The $1.38 per barrel decrease in crude realizations was generally smaller than the decrease in industry benchmark prices. While the average price for WTI declined by $1.89 per barrel between quarters. The Gulf of Mexico benchmark trade month price, which is on a lagged basis, declined by about $0.95 per barrel Higher natural gas realizations resulted in a $50 million profit improvement. Though Henry Hub bid-week prices improved by $0.24 per thousand cubic feet, our average realizations improved $0.50 per thousand cubic feet, reflecting our regional production mix and spot sales. Volume effects associated with third-party pipeline disruptions in the Gulf of Mexico and San Joaquin Valley and two fewer producing days reduced earnings by $65 million. Other primarily reflects an unfavorable variance in FAS 133 effects, which was partially offset by lower exploration expenses and other items. Turning to slide 7; international upstream earnings were about $90 million higher than the fourth quarter. Lower oil prices reduced earnings by about $35 million, and were partially offset by higher gas realizations. Unit liquids realizations declined by $0.62 per barrel, less than the drop in spot brand prices due to country mix effects. Lower liftings in Canada resulted in a negative earnings variance of $100 million. A decrease in exploration expenses benefited earnings by $155 million. The variance in other includes lower operating expenses between quarters. Slide 8, summarizes the change in worldwide oil equivalent production including volumes produced from oil sands in Canada. Daily volumes were down by 12,000 barrels between the quarters. During the first quarter, US production declined 14,000 barrels per day due to third-party pipeline disruptions affecting the Gulf of Mexico and San Joaquin Valley and natural field declines. Outside the US, oil and gas production was relatively flat between quarters. Production increases in the United Kingdom reflect the absence of downtime at Britannia during the fourth quarter. This increase was offset by lower production in Canada due to unplanned downtime at Hibernia. Turning to slide 9, US downstream results in the first quarter were slightly higher than the prior quarters. Lower realized margin effects of about $85 million adversely impacted earnings relative to the fourth quarter. This was primarily due to the affects of the Richmond refinery crude unit turnaround, which was extended by repairs associated with the fire. The unit was down for most of the quarter, which prevented the company from capturing the improved West Coast refining margins. Refining margins were also dampened by supply effects during the quarter. Marketing margins were lower on the West Coast. Weaker asphalt and lubricants margins also affected the quarter's results. Somewhat offsetting these lower margin affects were improved refining and marketing margins in the East. The other variance includes lower expenses at the Pascagoula refinery following the fourth quarter's FCC shutdown and expansion project and other miscellaneous items. Turning to slide 10, international downstream earnings of about $1.3 billion were substantially higher than the fourth quarter. The sale of our interest in the Nerefco refinery, and associated assets in the Netherlands resulted in an after-tax gain of $700 million. Absence the sale, results were about $40 million lower between quarters. Realized downstream margins improved earnings by about $50 million led by higher refining margins in most regions, in line with the rise in indicator margins. An unfavorable swing in foreign exchange effects reduced earnings by $90 million and drove the variance in other. Slide 11 shows earnings from chemicals were $120 million in the first quarter compared with $124 million in the fourth quarter. Results for olefins declined during the quarter, primarily due to lower ethylene margins and higher manufacturing costs related to plant turnarounds. The improvement in additives earnings reflects the combination of higher margins, and lower non-manufacturing expenses. Slide 12 covers all other. First quarter results show a positive variance from the prior quarter due to higher earnings associated with the company's investment in Dynegy, included in the P&L business' bar and as mentioned in our interim update guidance, favorable corporate tax items included in other. Largely as a result of the variance in tax items, net charges for segment Other were lower than our standard quarterly guidance for this segment at a range of $160 million to $200 million excluding Dynegy. That completes our brief analysis for the quarter. Back over to you, Steve.
Steve Crowe: Thanks, Irene. That concludes our prepared remarks. We'll now take your questions, one question per caller, please. We'll wrap up at or before the top of the hour. Matt, please open the lines for questions. Thanks.
Operator: Thank you. (Operator Instructions). Our first question is from Dan Barcelo of Banc of America. Your question please.
Dan Barcelo: Yes. Good morning.
Steve Crowe: Hey, Dan.
Dan Barcelo: Regarding to me, you had an impact obviously in the first quarter from Richmond. I didn't know, if you could just further quantify for us a bit some of the non-recurring operational impacts for first quarter for the downstream relative to just the refining margin impacts or other environment impacts?
Steve Crowe: Sure. Thanks, Dan. Just for a little bit of background, as Irene mentioned, we had a fire that occurred at the Richmond refinery in mid January at the crude unit. Just as that was being brought down for schedule maintenance. We had a failure of a swing out [wash oil pipe spool]. But as I mentioned, there was a plant turnaround being readied and so our supply position already anticipated the unit being out of service. The fire itself extended the shutdown by about a month and the refinery was back by the end of the first quarter. From an analytical perspective, if you try to get an estimate of the cost of the incident including the lost profit opportunity as well as the additional repair costs, then it's probably on the order of about $150 million or so. Thank you. Next question please.
Operator: Our next question is from Doug Leggate of Citigroup. Your question, please.
Doug Leggate: Thanks. Good morning, Steve and Irene.
Steve Crowe: Good morning, Doug.
Irene Melitas: Good morning.
Doug Leggate: The tax in the quarters, Steve, I think Irene alluded a little bit there in the comments. But it was obviously a bit lower than your guidance, I guess. Can you just walk us through some of the major items there and just reiterate perhaps what you expect the run rate to be for the balance of the year?
Steve Crowe: Sure. Thank you, Doug. The first quarter effective tax rate was 37.6% and if you look at the average effective tax rate for full year 2006, it was more on the order of 46%. So Doug as you pointed out, it was considerably lower than last year. And looking at the components as to why our average effective tax rate is lower in the first quarter for a 90-day period, I'd point to three things. Number one, we had a lower tax rate associated with the Nerefco sale, certainly a non-recurring item from a run rate perspective. Number two, we have some favorable adjustments for prior periods resulting from the completion of tax audits. And number three, in the first quarter, proportionately more income was earned in lower tax rate jurisdictions. Clearly, we operate in many taxing jurisdictions. So, as they shift from location to location, you can get some noise on that score. With respect to the favorable adjustments for prior periods as Irene mentioned, we try to at least reference this in the April 10th interim update. In that interim update, we spoke about all other segment. We said, for the first quarter, favorable tax-related effects at the corporate level are expected to substantially offset corporate charges for the period. So, given the earlier guidance that should have given some indication that we were going to be getting a favorable tax benefit. But those three components explain roughly the 10% decline or 9% decline from sort of an average run rate. As to your question, what might be an average rate? I think, the rate that we saw in 2006, is pretty representative. Again, there will be noise that occurs when we have adjustments as a result of completion of tax audits. And there will be noise to the extent that you have transactions that result in tax rates different than that average. Thanks very much for you question, Doug. I hope that helps.
Operator: Our next question is from Ron Oster of A.G. Edwards. Your question please.
Ron Oster: Good morning Steve. Had a quick question on Gorgon, I was wondering if you could give us an update in terms of any progress that's been made there regarding the development type or any contract sales? If you could just kind go over some of the major hurdles that need to be overcome before it to be sanctioned? And any timeframe on sanction would be helpful?
Steve Crowe: Thank Ron. We covered this at last months New York, Analyst Meeting. But for the benefit of those who may not have heard that, let me give a little bit of background. Gorgon is a project of great scale and complexity. And certainly, we're dealing with increasing market-related costs. Gorgon is presently in the engineering and design phase. You may recall, last December, we received concurrence on the environmental framework for two-train LNG facility on Barrow Island, which was given by the Western Australian government. We are now awaiting the final environmental permits from the Western Australia government and the Common Wealth. Which we expect will occur around mid-year. During the last several months, we've undertaken additional studies to reduce costs, consider appropriate production capacities, and try to mitigate any uncertainty with respect to the execution before we make a final investment decision. But the project is moving forward, and the first hurdle that we need to get past is the environmental permit, which I mentioned we hope to see in the not too distant future. As was indicated in the slides, that we showed at the Analysts Meeting last month, start-up is expected after 2010. It's difficult for me to give anything more precise at this stage of the game until some of these milestones are completed. But I thank you for your question, Ron.
Operator: Our next question is from Mark Flannery of Credit Suisse, your question please.
Mark Flannery: Yes, thanks. My question is on Kazakhstan and Tengiz, in particular. Can you just update us what we expect to see from that project as we go through the year? Any maintenance or ramp ups, ramp downs that kind of things?
Steve Crowe: Thank you, Mark. Again, this was a project that George Kirkland discussed at last months Analysts Meeting. But, let me give just a little bit of a backdrop here on this phased expansion at TCO. The sweet gas injection came on in the latter part of 2006. This year, we've tested it and established the sustained injection rates and pressures, and the mechanical operation of the facilities. Later in 2007, we expect the Sour Gas Injection to commence and staged oil will increase. Once fully online in 2008 as the project ramps up, we see Tengiz gross production capacity increasing from levels in the neighborhood of 285,000 barrels a day to a range of 460,000 to 550,000 barrels a day, once it is fully online. So, it’s moving ahead, and we will continue to update you with respect to the project as information becomes available. Thanks very much, Mark.
Operator: Our next question is from Paul Cheng of Lehman Brothers, your question please.
Paul Cheng: Hi Steve and Irene. Good morning.
Steve Crowe: Hi, Paul.
Irene Melitas: Good morning, Paul.
Paul Cheng: Just a quick one, it seems that you update Gorgon. Can you give us an update on Nigeria and Angola on the LNG project to see where we are in terms of sanctioning those projects? Thank you.
Steve Crowe: Thank you, Paul. Those projects are earlier in their development. The Angola LNG project in which we own about 36% equity is still in feed that is the engineering and the front-end engineering and design phase. It is progressing with the collaboration of our partners, and we expect FID, later this year. As to the Nigeria LNG project, the Olokola I, it too was in feed with engineering and design work underway. It’s a little bit further back than the Angola I. But we will keep you apprise as it progresses. That's the current status Paul. Thank you very much.
Operator: Our next question is from Mark Gilman of Benchmark, your question please.
Mark Gilman: Guys, good morning.
Steve Crowe: Good morning, Mark.
Irene Melitas: Good morning, Mark.
Mark Gilman: Wondering to see if I could get a little bit more clarification on the international downstream earnings, knowing that, that segment contains a number of what I would consider to be non-refining and marketing activities including shipping, including CPC, including the petrochemical interest in Korea with LG. I also noticed in that variance analysis, there was no mention one way or the other of the potential absence of the fourth quarter LIFO benefit that favorably impacted those results. So, if you could clarify that first quarter result in that segment, drill down a little bit, I would appreciate it?
Irene Melitas: Thanks Mark. You asked about some of the other contributing factors to our international downstream earnings, for example, shipping and so forth. Shipping was actually down between quarters on account of fewer liftings and lower freight rates. The earnings contributed from the Sasol JV were positive between quarters. Trading margins were higher between quarters, and clearly the biggest driver as far as other items relates to foreign exchange, which was a negative variance between the two quarters. Inventory related effects, I do not have that specifically isolated at this time. We can certainly get back to you after the call.
Steve Crowe: Thanks Mark, you are quite right to say, it’s a very large business with lots of components in it. And making it simplified for these bar charts, we do take a lot of things that get netted together. Thank you very much. May we have the next call please?
Operator: Your next question is from Bernie Picchi of Wall Street Access. Your question please.
Bernie Picchi: Yes. Good morning, Steve and Irene. It was interesting and pleasing to see that you had a 5% increase in branded gasoline sales in the US in the quarter. I was a little surprised by that given kind of what's happened to gasoline prices. Can you give us any color on what may or how it should be happening region by region and also within the quarter and if you can go out into the beginning of the second quarter? Are you seeing a continuation of that trend? Is it going to falling-off on acceleration or what's going on?
Steve Crowe: Thank you, Bernie. The main driver that we've seen in our increase in volumes associated with branded gasoline here in the United States has been the expansion associated with the Texaco brand. As we got a full use of that, we've expanded the brand both in the Southeast and now more recently on the West Coast. So, that's been a key contributor for the increasing sales of branded gasoline that we've seen here in the United States. And as you can imagine, that's a very favorable development from our perspective. As far as I know, Bernie, we don't see any thing that suggests that will not continue. Thanks very much. May we have the next call?
Operator: The next question is from Oswald Clint of Sanford Bernstein. Your question please.
Oswald Clint: Hi. Good morning, guys. Just one question on exploration please. Given, there are very successful exploration discoveries quarter today than actually over the last couple of years, is there any potential for the rest of the year for a step up in drilling activity or some extra exploration wells to be drilled over the course of 2007?
Steve Crowe: Well, as we had talked about at our January call, we see the exploration activity essentially on par with that of last year. We've just had tremendous success with exploration, as you know. And over the last five years, our success rate has been industry leading at 45%. I don't have any specific new information with regards to the exploration program, but it is something that we are very proud of and it had a tremendous track record on. Perhaps, we can get you some more detail if you follow up with Irene a little later.
Irene Melitas: I would actually also recommend that you refer to the presentation by Bobby Ryan back in March and in one of the slides, it actually provides in great detail what our program is for 2007.
Steve Crowe: Thank you, Irene. May we have the next call?
Operator: Our next question is from of John Herrlin of Merrill Lynch. Your question please.
John Herrlin: Yeah. Hi. Looking upstream at your CapEx, you are up 26% versus first quarter of last year, but down 21% versus fourth quarter. I am just trying to get a sense of what you are spending on there? Are these lumpy changes because of all the development stuff you are doing with things like at (inaudible) and Tahiti or is it because of exploration activity?
Steve Crowe: Thank you, John. Certainly, our C&E pattern is influenced by the timing of these large projects that you've heard so much about. We monitor the capital program very, very closely. Sort of on a naive basis, if you look back for several years for Chevron, our spending tends to be backend loaded to the second half of the year. The $4.1 billion spend through the first quarter in the aggregate that includes R&M and other as well, is right in line with our historical pattern of spending about 20% to 21% of the full C&E amount in the first quarter. So, I think your perception is correct. It's driven largely by the timing of these projects.
John Herrlin: Thanks.
Steve Crowe: Thanks very much, John.
Operator: Our next is from Jason Gammel of Prudential. Your question please.
Jason Gammel: Good morning, Steve and Irene.
Steve Crowe: Good morning, Jason.
Irene Melitas: Good morning, Jason.
Jason Gammel: With the Richmond incident now largely behind you, can you provide us with any guidance about the progress on capturing the reliability refinery within the system, maybe in terms of utilization ranges that we could expect to see for the remainder of the year based on what you know about scheduled maintenance?
Steve Crowe: Well, as we would have mentioned at last month's analyst meeting, we are spending a lot of time on process and equipment and people in trying to create that reliability refinery. Running the refineries with excellence is a very cost effective way of increasing earnings for our shareholders. As Mike would have mentioned last month, 2007 has a particularly heavy turnaround. As I mentioned, there was a turnaround at the first plant turnaround in the first quarter at Richmond, and we have other plant turnarounds that occur here in the United States and overseas. For competitive reasons and commercial reasons, we don't describe the timing of those things until they are completed. But they will influence the metrics when you look at crude utilization. However, they are well planned for and the downstream units are up and running. And so, we will continue to progress our efforts towards improving reliability. It is a key focus for our downstream business and we expect to see continued progress just as we had done in 2006. But thanks for the question very much, Jason.
Irene Melitas: And Jason, if I may add one more thing, just a data point here. The number of outages for the last six months was about 40% lower than the prior six months. So, I think that speaks to our ongoing progress and the reliability arena.
Steve Crowe: Thank you. May we have the next question please?
Operator: Our next question comes from Paul Cheng of Lehman Brothers, your question please.
Paul Cheng: Hi, Steve and Irene. I just had a follow-up. When I was looking at your share buyback, it's about $1.25 billion a quarter and if you are looking at your cash flow generating capability and your cash on hand. Is there any reason that company do not want to increase the run rate to a more substantial?
Steve Crowe: Thanks Paul. The cash on hand at the end of the first quarter included the proceeds from the Nerefco sale which were received as the clock struck midnight on March 31st. Absent of that, the cash balances at the end of March relative to the end of the year were nearly the same. As I pointed out, we spent $1.25 billion for share repurchases in the first quarter. Given the cash balances that we have now and our cash generation capacity, along with the strengthening of commodity prices, it's highly likely that we'll increase the pace of our repurchase program here in the second quarter. But we look at the repurchase program as an appropriate use of our cash in excess of operating needs and our capital program. But first and foremost, we have such a wonderful queue of projects we want to make sure we fund the growth for our shareholders by making sure that those projects are well funded. Over the last three years or so, we've used the share repurchase program as a way of balanced capital realignment as we've reduced debt and reacquired equity. It is however, even from an investment point of view quite apart from capital structure, an attractive investment for excess cash for our shareholders, as we're purchasing reserves at rates that are under $10 a barrel. So, I think you can expect a step up in the repurchase rate in the second quarter. Thanks very much, Paul
Paul Cheng: Steve. Can I stay in with additional question?
Steve Crowe: Sure.
Paul Cheng: You talked about the branded sales gasoline sale up because of Texaco. Can you share with us some market intelligence, in your network, what is the same store sales you offered here for those stores that have open more than 12 months?
Steve Crowe: Thanks Paul. I don't have the information for the change in volumes for same store sales year-to-year. If you give us some time we may be able to get that information for you. Thanks so much.
Paul Cheng: Thank you.
Operator: Our next question is from Mark Gilman of Benchmark, your question please.
Mark Gilman: Steve and Irene, I wonder if we could talk in a little bit greater detail about the West African production numbers. Which in this particular quarter and frankly in some quarters previously, seem to be running below that, which I would expect given the development inventory and progress on projects? Could you alert us to any specific entitlement and production sharing contract effects regarding Angola and Block 14 in particular or ultimately if the first quarter is associated either or would decline from 4Q is associated either with Chad, Nigeria or elsewhere. If you could highlight that as well please?
Irene Melitas: Yes, Mark thanks for your question. The variance in West Africa is largely driven by Nigeria. Last quarter, we had most of the variance in our Africa production, primarily in liquids, reflected an incremental production that was allocable to us under terms of one of our agreements that were completed in the quarter. These types of allocations occur periodically and are somewhat similar to cost recovery barrels. So what you are seeing 4Q, 1Q is the absence of that allocation, if you will. In Angola, actually the story is quite positive for the quarter. We did show a positive variance and it reflects primarily strong performance of our fields out there, and the addition of one more producing well at BBLT during the first quarter.
Steve Crowe: Thanks very much, Mark. I think at this juncture, we'll wrap it up. In closing, let me say that we appreciate everybody's participation on today's call. And I especially want to thank each of the analysts on behalf of all the participants for their questions during this morning session. So, Matt back to you.
Operator: Ladies and gentlemen, this concludes today's first quarter 2007 earnings conference call. You may now disconnect. Good day. | [
{
"speaker": "Operator",
"text": "Good morning. My name is Matt, and I will be your conference facilitator today. Welcome to Chevron's First Quarter 2007 Earnings Call. At this time, all participants are in a listen-only mode. After the speakers' remarks, there will be a question-and-answer session and instructions will be given at that time. (Operator Instructions). As a reminder, this conference call is being recorded. I would now like to turn the conference over to Vice President and Chief Financial Officer of Chevron Corporation, Mr. Steve Crowe. Please go ahead, sir."
},
{
"speaker": "Steve Crowe",
"text": "Thank you, Matt. Welcome to Chevron's first quarter earnings conference call. Today, on the call, I am joined by Irene Melitas, Manager of Investor Relations. Our focus today is on Chevron's financial and operating results for the first quarter of 2007. We'll refer to the slides that are available on the web. I remind you that today's presentation contains estimates, projections and other forward-looking statements and ask that you review the Safe Harbor statement on slide two. I'll begin with slide 3, which provides an overview of our financial performance. The company reported earnings of $4.7 billion for the quarter or $2.18 per diluted share. Earnings were up 18% from the first quarter a year ago, reflecting a $700 million after-tax gain on the sale of our interest in the Nerefco Refinery in the Netherlands and higher margins on refined products worldwide. These benefits were partially offset by the effect of lower prices for crude oil and natural gas on upstream profits. First quarter results were 25% higher than the fourth quarter of 2006, which Irene will discuss shortly. Return on capital employed for the trailing four quarters was 23%. And the debt ratio was about 12% at quarter end. Earlier this week, we announced an 11.5% dividend increase raising our quarterly dividend to $0.58 per share. 2007 marks the 20th consecutive year that the company has increased its annual dividend payout. Share repurchases totaled $1.25 billion, the same quarterly pace as in 2006. Slide 4 highlights some of the milestones we achieved in recent months, starting with upstream. Last month, we announced the start-up of our Bibiyana natural gas field in Bangladesh. The field is initially expected to produce 200 million cubic feet of natural gas per day rising to 500 million cubic feet per day by 2010. This exploration success continues with the announcement of two deepwater oil accumulations in the northern part of the Republic of Congo Moho-Bilondo permit. Chevron's non-operated interest is 31.5%. Evaluation and development options studies are underway. In the downstream, we announced the sale of our 31% interest in the Nerefco Refinery in the Netherlands. The transaction closed at the end of March, and was part of our portfolio rationalization efforts highlighted during the March analyst meeting. Irene, will now take us through the quarterly comparisons. Irene?"
},
{
"speaker": "Irene Melitas",
"text": "Thanks, Steve. My remarks compare first quarter results to those of the fourth quarter 2006. As a reminder, our earnings release compared first quarter 2007 to the same quarter a year ago. Turning to slide 5; first quarter net income was about $940 million higher than the fourth quarter results. First quarter earnings benefited by $700 million from the sale of our interest in the Nerefco Refinery in Europe, as indicated in our interim update for the quarter. Volume effects reduced earnings by $175 million and were primarily attributable to lower liftings in Canada and production in the US. A decrease in exploration expense contributed favorably to the quarters results. The other bar reflects a positive swing in tax related items, lower operating expenses, and the net of everything else. Slide 6, summarizes the results of our US upstream earnings, which declined by $90 million between quarters. The benefit of higher natural gas realizations were partially offset by lower liquids realizations, and netted to a $20 million improvement in earnings. The $1.38 per barrel decrease in crude realizations was generally smaller than the decrease in industry benchmark prices. While the average price for WTI declined by $1.89 per barrel between quarters. The Gulf of Mexico benchmark trade month price, which is on a lagged basis, declined by about $0.95 per barrel Higher natural gas realizations resulted in a $50 million profit improvement. Though Henry Hub bid-week prices improved by $0.24 per thousand cubic feet, our average realizations improved $0.50 per thousand cubic feet, reflecting our regional production mix and spot sales. Volume effects associated with third-party pipeline disruptions in the Gulf of Mexico and San Joaquin Valley and two fewer producing days reduced earnings by $65 million. Other primarily reflects an unfavorable variance in FAS 133 effects, which was partially offset by lower exploration expenses and other items. Turning to slide 7; international upstream earnings were about $90 million higher than the fourth quarter. Lower oil prices reduced earnings by about $35 million, and were partially offset by higher gas realizations. Unit liquids realizations declined by $0.62 per barrel, less than the drop in spot brand prices due to country mix effects. Lower liftings in Canada resulted in a negative earnings variance of $100 million. A decrease in exploration expenses benefited earnings by $155 million. The variance in other includes lower operating expenses between quarters. Slide 8, summarizes the change in worldwide oil equivalent production including volumes produced from oil sands in Canada. Daily volumes were down by 12,000 barrels between the quarters. During the first quarter, US production declined 14,000 barrels per day due to third-party pipeline disruptions affecting the Gulf of Mexico and San Joaquin Valley and natural field declines. Outside the US, oil and gas production was relatively flat between quarters. Production increases in the United Kingdom reflect the absence of downtime at Britannia during the fourth quarter. This increase was offset by lower production in Canada due to unplanned downtime at Hibernia. Turning to slide 9, US downstream results in the first quarter were slightly higher than the prior quarters. Lower realized margin effects of about $85 million adversely impacted earnings relative to the fourth quarter. This was primarily due to the affects of the Richmond refinery crude unit turnaround, which was extended by repairs associated with the fire. The unit was down for most of the quarter, which prevented the company from capturing the improved West Coast refining margins. Refining margins were also dampened by supply effects during the quarter. Marketing margins were lower on the West Coast. Weaker asphalt and lubricants margins also affected the quarter's results. Somewhat offsetting these lower margin affects were improved refining and marketing margins in the East. The other variance includes lower expenses at the Pascagoula refinery following the fourth quarter's FCC shutdown and expansion project and other miscellaneous items. Turning to slide 10, international downstream earnings of about $1.3 billion were substantially higher than the fourth quarter. The sale of our interest in the Nerefco refinery, and associated assets in the Netherlands resulted in an after-tax gain of $700 million. Absence the sale, results were about $40 million lower between quarters. Realized downstream margins improved earnings by about $50 million led by higher refining margins in most regions, in line with the rise in indicator margins. An unfavorable swing in foreign exchange effects reduced earnings by $90 million and drove the variance in other. Slide 11 shows earnings from chemicals were $120 million in the first quarter compared with $124 million in the fourth quarter. Results for olefins declined during the quarter, primarily due to lower ethylene margins and higher manufacturing costs related to plant turnarounds. The improvement in additives earnings reflects the combination of higher margins, and lower non-manufacturing expenses. Slide 12 covers all other. First quarter results show a positive variance from the prior quarter due to higher earnings associated with the company's investment in Dynegy, included in the P&L business' bar and as mentioned in our interim update guidance, favorable corporate tax items included in other. Largely as a result of the variance in tax items, net charges for segment Other were lower than our standard quarterly guidance for this segment at a range of $160 million to $200 million excluding Dynegy. That completes our brief analysis for the quarter. Back over to you, Steve."
},
{
"speaker": "Steve Crowe",
"text": "Thanks, Irene. That concludes our prepared remarks. We'll now take your questions, one question per caller, please. We'll wrap up at or before the top of the hour. Matt, please open the lines for questions. Thanks."
},
{
"speaker": "Operator",
"text": "Thank you. (Operator Instructions). Our first question is from Dan Barcelo of Banc of America. Your question please."
},
{
"speaker": "Dan Barcelo",
"text": "Yes. Good morning."
},
{
"speaker": "Steve Crowe",
"text": "Hey, Dan."
},
{
"speaker": "Dan Barcelo",
"text": "Regarding to me, you had an impact obviously in the first quarter from Richmond. I didn't know, if you could just further quantify for us a bit some of the non-recurring operational impacts for first quarter for the downstream relative to just the refining margin impacts or other environment impacts?"
},
{
"speaker": "Steve Crowe",
"text": "Sure. Thanks, Dan. Just for a little bit of background, as Irene mentioned, we had a fire that occurred at the Richmond refinery in mid January at the crude unit. Just as that was being brought down for schedule maintenance. We had a failure of a swing out [wash oil pipe spool]. But as I mentioned, there was a plant turnaround being readied and so our supply position already anticipated the unit being out of service. The fire itself extended the shutdown by about a month and the refinery was back by the end of the first quarter. From an analytical perspective, if you try to get an estimate of the cost of the incident including the lost profit opportunity as well as the additional repair costs, then it's probably on the order of about $150 million or so. Thank you. Next question please."
},
{
"speaker": "Operator",
"text": "Our next question is from Doug Leggate of Citigroup. Your question, please."
},
{
"speaker": "Doug Leggate",
"text": "Thanks. Good morning, Steve and Irene."
},
{
"speaker": "Steve Crowe",
"text": "Good morning, Doug."
},
{
"speaker": "Irene Melitas",
"text": "Good morning."
},
{
"speaker": "Doug Leggate",
"text": "The tax in the quarters, Steve, I think Irene alluded a little bit there in the comments. But it was obviously a bit lower than your guidance, I guess. Can you just walk us through some of the major items there and just reiterate perhaps what you expect the run rate to be for the balance of the year?"
},
{
"speaker": "Steve Crowe",
"text": "Sure. Thank you, Doug. The first quarter effective tax rate was 37.6% and if you look at the average effective tax rate for full year 2006, it was more on the order of 46%. So Doug as you pointed out, it was considerably lower than last year. And looking at the components as to why our average effective tax rate is lower in the first quarter for a 90-day period, I'd point to three things. Number one, we had a lower tax rate associated with the Nerefco sale, certainly a non-recurring item from a run rate perspective. Number two, we have some favorable adjustments for prior periods resulting from the completion of tax audits. And number three, in the first quarter, proportionately more income was earned in lower tax rate jurisdictions. Clearly, we operate in many taxing jurisdictions. So, as they shift from location to location, you can get some noise on that score. With respect to the favorable adjustments for prior periods as Irene mentioned, we try to at least reference this in the April 10th interim update. In that interim update, we spoke about all other segment. We said, for the first quarter, favorable tax-related effects at the corporate level are expected to substantially offset corporate charges for the period. So, given the earlier guidance that should have given some indication that we were going to be getting a favorable tax benefit. But those three components explain roughly the 10% decline or 9% decline from sort of an average run rate. As to your question, what might be an average rate? I think, the rate that we saw in 2006, is pretty representative. Again, there will be noise that occurs when we have adjustments as a result of completion of tax audits. And there will be noise to the extent that you have transactions that result in tax rates different than that average. Thanks very much for you question, Doug. I hope that helps."
},
{
"speaker": "Operator",
"text": "Our next question is from Ron Oster of A.G. Edwards. Your question please."
},
{
"speaker": "Ron Oster",
"text": "Good morning Steve. Had a quick question on Gorgon, I was wondering if you could give us an update in terms of any progress that's been made there regarding the development type or any contract sales? If you could just kind go over some of the major hurdles that need to be overcome before it to be sanctioned? And any timeframe on sanction would be helpful?"
},
{
"speaker": "Steve Crowe",
"text": "Thank Ron. We covered this at last months New York, Analyst Meeting. But for the benefit of those who may not have heard that, let me give a little bit of background. Gorgon is a project of great scale and complexity. And certainly, we're dealing with increasing market-related costs. Gorgon is presently in the engineering and design phase. You may recall, last December, we received concurrence on the environmental framework for two-train LNG facility on Barrow Island, which was given by the Western Australian government. We are now awaiting the final environmental permits from the Western Australia government and the Common Wealth. Which we expect will occur around mid-year. During the last several months, we've undertaken additional studies to reduce costs, consider appropriate production capacities, and try to mitigate any uncertainty with respect to the execution before we make a final investment decision. But the project is moving forward, and the first hurdle that we need to get past is the environmental permit, which I mentioned we hope to see in the not too distant future. As was indicated in the slides, that we showed at the Analysts Meeting last month, start-up is expected after 2010. It's difficult for me to give anything more precise at this stage of the game until some of these milestones are completed. But I thank you for your question, Ron."
},
{
"speaker": "Operator",
"text": "Our next question is from Mark Flannery of Credit Suisse, your question please."
},
{
"speaker": "Mark Flannery",
"text": "Yes, thanks. My question is on Kazakhstan and Tengiz, in particular. Can you just update us what we expect to see from that project as we go through the year? Any maintenance or ramp ups, ramp downs that kind of things?"
},
{
"speaker": "Steve Crowe",
"text": "Thank you, Mark. Again, this was a project that George Kirkland discussed at last months Analysts Meeting. But, let me give just a little bit of a backdrop here on this phased expansion at TCO. The sweet gas injection came on in the latter part of 2006. This year, we've tested it and established the sustained injection rates and pressures, and the mechanical operation of the facilities. Later in 2007, we expect the Sour Gas Injection to commence and staged oil will increase. Once fully online in 2008 as the project ramps up, we see Tengiz gross production capacity increasing from levels in the neighborhood of 285,000 barrels a day to a range of 460,000 to 550,000 barrels a day, once it is fully online. So, it’s moving ahead, and we will continue to update you with respect to the project as information becomes available. Thanks very much, Mark."
},
{
"speaker": "Operator",
"text": "Our next question is from Paul Cheng of Lehman Brothers, your question please."
},
{
"speaker": "Paul Cheng",
"text": "Hi Steve and Irene. Good morning."
},
{
"speaker": "Steve Crowe",
"text": "Hi, Paul."
},
{
"speaker": "Irene Melitas",
"text": "Good morning, Paul."
},
{
"speaker": "Paul Cheng",
"text": "Just a quick one, it seems that you update Gorgon. Can you give us an update on Nigeria and Angola on the LNG project to see where we are in terms of sanctioning those projects? Thank you."
},
{
"speaker": "Steve Crowe",
"text": "Thank you, Paul. Those projects are earlier in their development. The Angola LNG project in which we own about 36% equity is still in feed that is the engineering and the front-end engineering and design phase. It is progressing with the collaboration of our partners, and we expect FID, later this year. As to the Nigeria LNG project, the Olokola I, it too was in feed with engineering and design work underway. It’s a little bit further back than the Angola I. But we will keep you apprise as it progresses. That's the current status Paul. Thank you very much."
},
{
"speaker": "Operator",
"text": "Our next question is from Mark Gilman of Benchmark, your question please."
},
{
"speaker": "Mark Gilman",
"text": "Guys, good morning."
},
{
"speaker": "Steve Crowe",
"text": "Good morning, Mark."
},
{
"speaker": "Irene Melitas",
"text": "Good morning, Mark."
},
{
"speaker": "Mark Gilman",
"text": "Wondering to see if I could get a little bit more clarification on the international downstream earnings, knowing that, that segment contains a number of what I would consider to be non-refining and marketing activities including shipping, including CPC, including the petrochemical interest in Korea with LG. I also noticed in that variance analysis, there was no mention one way or the other of the potential absence of the fourth quarter LIFO benefit that favorably impacted those results. So, if you could clarify that first quarter result in that segment, drill down a little bit, I would appreciate it?"
},
{
"speaker": "Irene Melitas",
"text": "Thanks Mark. You asked about some of the other contributing factors to our international downstream earnings, for example, shipping and so forth. Shipping was actually down between quarters on account of fewer liftings and lower freight rates. The earnings contributed from the Sasol JV were positive between quarters. Trading margins were higher between quarters, and clearly the biggest driver as far as other items relates to foreign exchange, which was a negative variance between the two quarters. Inventory related effects, I do not have that specifically isolated at this time. We can certainly get back to you after the call."
},
{
"speaker": "Steve Crowe",
"text": "Thanks Mark, you are quite right to say, it’s a very large business with lots of components in it. And making it simplified for these bar charts, we do take a lot of things that get netted together. Thank you very much. May we have the next call please?"
},
{
"speaker": "Operator",
"text": "Your next question is from Bernie Picchi of Wall Street Access. Your question please."
},
{
"speaker": "Bernie Picchi",
"text": "Yes. Good morning, Steve and Irene. It was interesting and pleasing to see that you had a 5% increase in branded gasoline sales in the US in the quarter. I was a little surprised by that given kind of what's happened to gasoline prices. Can you give us any color on what may or how it should be happening region by region and also within the quarter and if you can go out into the beginning of the second quarter? Are you seeing a continuation of that trend? Is it going to falling-off on acceleration or what's going on?"
},
{
"speaker": "Steve Crowe",
"text": "Thank you, Bernie. The main driver that we've seen in our increase in volumes associated with branded gasoline here in the United States has been the expansion associated with the Texaco brand. As we got a full use of that, we've expanded the brand both in the Southeast and now more recently on the West Coast. So, that's been a key contributor for the increasing sales of branded gasoline that we've seen here in the United States. And as you can imagine, that's a very favorable development from our perspective. As far as I know, Bernie, we don't see any thing that suggests that will not continue. Thanks very much. May we have the next call?"
},
{
"speaker": "Operator",
"text": "The next question is from Oswald Clint of Sanford Bernstein. Your question please."
},
{
"speaker": "Oswald Clint",
"text": "Hi. Good morning, guys. Just one question on exploration please. Given, there are very successful exploration discoveries quarter today than actually over the last couple of years, is there any potential for the rest of the year for a step up in drilling activity or some extra exploration wells to be drilled over the course of 2007?"
},
{
"speaker": "Steve Crowe",
"text": "Well, as we had talked about at our January call, we see the exploration activity essentially on par with that of last year. We've just had tremendous success with exploration, as you know. And over the last five years, our success rate has been industry leading at 45%. I don't have any specific new information with regards to the exploration program, but it is something that we are very proud of and it had a tremendous track record on. Perhaps, we can get you some more detail if you follow up with Irene a little later."
},
{
"speaker": "Irene Melitas",
"text": "I would actually also recommend that you refer to the presentation by Bobby Ryan back in March and in one of the slides, it actually provides in great detail what our program is for 2007."
},
{
"speaker": "Steve Crowe",
"text": "Thank you, Irene. May we have the next call?"
},
{
"speaker": "Operator",
"text": "Our next question is from of John Herrlin of Merrill Lynch. Your question please."
},
{
"speaker": "John Herrlin",
"text": "Yeah. Hi. Looking upstream at your CapEx, you are up 26% versus first quarter of last year, but down 21% versus fourth quarter. I am just trying to get a sense of what you are spending on there? Are these lumpy changes because of all the development stuff you are doing with things like at (inaudible) and Tahiti or is it because of exploration activity?"
},
{
"speaker": "Steve Crowe",
"text": "Thank you, John. Certainly, our C&E pattern is influenced by the timing of these large projects that you've heard so much about. We monitor the capital program very, very closely. Sort of on a naive basis, if you look back for several years for Chevron, our spending tends to be backend loaded to the second half of the year. The $4.1 billion spend through the first quarter in the aggregate that includes R&M and other as well, is right in line with our historical pattern of spending about 20% to 21% of the full C&E amount in the first quarter. So, I think your perception is correct. It's driven largely by the timing of these projects."
},
{
"speaker": "John Herrlin",
"text": "Thanks."
},
{
"speaker": "Steve Crowe",
"text": "Thanks very much, John."
},
{
"speaker": "Operator",
"text": "Our next is from Jason Gammel of Prudential. Your question please."
},
{
"speaker": "Jason Gammel",
"text": "Good morning, Steve and Irene."
},
{
"speaker": "Steve Crowe",
"text": "Good morning, Jason."
},
{
"speaker": "Irene Melitas",
"text": "Good morning, Jason."
},
{
"speaker": "Jason Gammel",
"text": "With the Richmond incident now largely behind you, can you provide us with any guidance about the progress on capturing the reliability refinery within the system, maybe in terms of utilization ranges that we could expect to see for the remainder of the year based on what you know about scheduled maintenance?"
},
{
"speaker": "Steve Crowe",
"text": "Well, as we would have mentioned at last month's analyst meeting, we are spending a lot of time on process and equipment and people in trying to create that reliability refinery. Running the refineries with excellence is a very cost effective way of increasing earnings for our shareholders. As Mike would have mentioned last month, 2007 has a particularly heavy turnaround. As I mentioned, there was a turnaround at the first plant turnaround in the first quarter at Richmond, and we have other plant turnarounds that occur here in the United States and overseas. For competitive reasons and commercial reasons, we don't describe the timing of those things until they are completed. But they will influence the metrics when you look at crude utilization. However, they are well planned for and the downstream units are up and running. And so, we will continue to progress our efforts towards improving reliability. It is a key focus for our downstream business and we expect to see continued progress just as we had done in 2006. But thanks for the question very much, Jason."
},
{
"speaker": "Irene Melitas",
"text": "And Jason, if I may add one more thing, just a data point here. The number of outages for the last six months was about 40% lower than the prior six months. So, I think that speaks to our ongoing progress and the reliability arena."
},
{
"speaker": "Steve Crowe",
"text": "Thank you. May we have the next question please?"
},
{
"speaker": "Operator",
"text": "Our next question comes from Paul Cheng of Lehman Brothers, your question please."
},
{
"speaker": "Paul Cheng",
"text": "Hi, Steve and Irene. I just had a follow-up. When I was looking at your share buyback, it's about $1.25 billion a quarter and if you are looking at your cash flow generating capability and your cash on hand. Is there any reason that company do not want to increase the run rate to a more substantial?"
},
{
"speaker": "Steve Crowe",
"text": "Thanks Paul. The cash on hand at the end of the first quarter included the proceeds from the Nerefco sale which were received as the clock struck midnight on March 31st. Absent of that, the cash balances at the end of March relative to the end of the year were nearly the same. As I pointed out, we spent $1.25 billion for share repurchases in the first quarter. Given the cash balances that we have now and our cash generation capacity, along with the strengthening of commodity prices, it's highly likely that we'll increase the pace of our repurchase program here in the second quarter. But we look at the repurchase program as an appropriate use of our cash in excess of operating needs and our capital program. But first and foremost, we have such a wonderful queue of projects we want to make sure we fund the growth for our shareholders by making sure that those projects are well funded. Over the last three years or so, we've used the share repurchase program as a way of balanced capital realignment as we've reduced debt and reacquired equity. It is however, even from an investment point of view quite apart from capital structure, an attractive investment for excess cash for our shareholders, as we're purchasing reserves at rates that are under $10 a barrel. So, I think you can expect a step up in the repurchase rate in the second quarter. Thanks very much, Paul"
},
{
"speaker": "Paul Cheng",
"text": "Steve. Can I stay in with additional question?"
},
{
"speaker": "Steve Crowe",
"text": "Sure."
},
{
"speaker": "Paul Cheng",
"text": "You talked about the branded sales gasoline sale up because of Texaco. Can you share with us some market intelligence, in your network, what is the same store sales you offered here for those stores that have open more than 12 months?"
},
{
"speaker": "Steve Crowe",
"text": "Thanks Paul. I don't have the information for the change in volumes for same store sales year-to-year. If you give us some time we may be able to get that information for you. Thanks so much."
},
{
"speaker": "Paul Cheng",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question is from Mark Gilman of Benchmark, your question please."
},
{
"speaker": "Mark Gilman",
"text": "Steve and Irene, I wonder if we could talk in a little bit greater detail about the West African production numbers. Which in this particular quarter and frankly in some quarters previously, seem to be running below that, which I would expect given the development inventory and progress on projects? Could you alert us to any specific entitlement and production sharing contract effects regarding Angola and Block 14 in particular or ultimately if the first quarter is associated either or would decline from 4Q is associated either with Chad, Nigeria or elsewhere. If you could highlight that as well please?"
},
{
"speaker": "Irene Melitas",
"text": "Yes, Mark thanks for your question. The variance in West Africa is largely driven by Nigeria. Last quarter, we had most of the variance in our Africa production, primarily in liquids, reflected an incremental production that was allocable to us under terms of one of our agreements that were completed in the quarter. These types of allocations occur periodically and are somewhat similar to cost recovery barrels. So what you are seeing 4Q, 1Q is the absence of that allocation, if you will. In Angola, actually the story is quite positive for the quarter. We did show a positive variance and it reflects primarily strong performance of our fields out there, and the addition of one more producing well at BBLT during the first quarter."
},
{
"speaker": "Steve Crowe",
"text": "Thanks very much, Mark. I think at this juncture, we'll wrap it up. In closing, let me say that we appreciate everybody's participation on today's call. And I especially want to thank each of the analysts on behalf of all the participants for their questions during this morning session. So, Matt back to you."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's first quarter 2007 earnings conference call. You may now disconnect. Good day."
}
] | null | null |
HD | 4 | 2,008 | 2009-02-24 09:00:00 | Executives: Diane Dayhoff - Senior Vice President, Investor Relations Frank Blake - Chairman, Chief Executive Officer Craig Menear - Senior Vice President, Merchandising Carol B. Tome - Chief Financial Officer, Executive Vice President Corporate Services Mark Holifield - Senior Vice President, Supply Chain Matt Carey - Executive Vice President, Chief Information Officer
Analysts: Deborah Weinswig - Citigroup Colin McGranahan - Sanford C. Bernstein Matthew Fassler - Goldman Sachs Michael Lasser - Barclays Capital Gregory Melich - Morgan Stanley Budd Bugatch - Raymond James John Zolidis - Buckingham Research Maggie Gilliam - Gilliam & Company Wayne Hood - BMO Capital Markets Brian Nagel - UBS Shannon Joseph - Wachovia Capital Markets Eric Bosshard - Cleveland Research Christopher Horvers - J.P. Morgan
Operator: Good day, everyone and welcome to today’s Home Depot fourth quarter earnings conference call. Today’s conference is being recorded. (Operator Instructions) Beginning today’s discussion is Ms. Diane Dayhoff, Vice President of Investor Relations. Please go ahead, Madam.
Diane Dayhoff: Thank you, Augusta and good morning to everyone. Welcome to the Home Depot third quarter -- fourth quarter earnings conference call. Joining us on our call today are Frank Blake, Chairman and CEO of The Home Depot; Craig Menear, Executive Vice President, Merchandising; and Carol Tome, Chief Financial Officer and Executive Vice President, Corporate Services. Following our prepared remarks, the call will be open for analysts’ questions. Questions will be limited to analysts and investors and as a reminder, we would appreciate it if the participants would limit themselves to one question with one follow-up, please. This conference call is being broadcast real-time on the Internet at homedepot.com with links on both our homepage and the investor relations section. The replay will also be available on our site. If we are unable to get to your question during the call, please call our investor relations department at 770-384-2387. Before I turn the call over to Frank, let me remind you that today’s press release and the presentations made by our executives include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties. These risks and uncertainties include, but are not limited to, those factors identified in the release and in our filings with the Securities and Exchange Commission. Now let me turn the call over to Frank Blake.
Frank Blake: Thank you, Diane and good morning, everyone. Sales for the fourth quarter were $14.6 billion. Comp sales were negative 13%. When adjusted for the seasonal shift caused by having 53 weeks in our fiscal 2007, our comp sales were negative 11.5%. At the end of January, we announced several actions that we are taking in light of current market conditions. These included shutting down our expo businesses, restructuring support positions, and writing down our equity interest in HD Supply. Those actions resulted in $550 million of charges in the fourth quarter. Excluding those charges, diluted earnings per share from continuing operations were $0.19. Carol will give you more detail in a few minutes on both our fourth quarter and fiscal year numbers. As a general comment, we anticipated a difficult quarter and year and they were all that and more. The issues impacting us are familiar to you all -- the housing market is still depressed, the percent of GDP now spent on housing related construction is at 3.1%. This is the lowest that it has ever been in 60 years of recorded data and we anticipate further deterioration. The credit markets are still stressed for consumers and businesses alike and unemployment continues to increase. We have seen some improvement in our California and Florida markets in the sense that the rate of decline has slowed but these relative improvements are more than offset by declines elsewhere in the country. Our Canadian business started the year strong but deteriorated in the second half as the global economy began to weaken. Also, the implementation of the bulk of our core retail pilot occurred in the second half in Canada and that caused some additional distraction in a difficult time. For the year, Canada posted mid-single-digit negative comps. China, while small, had positive comps, and our business in Mexico had another great year, with double-digit positive comps. There were some very positive signs of improved business performance during 2008. We said at the start of the year that we would maintain a flat to slightly positive gross margin rate for the year. We did that and we did it at the same time we launched a new lower price campaign. This is indicative of better control and coordination within our merchandising organization and our effective focus on everyday pricing. We also reduced our inventory by over $1 billion while at the same time maintaining the best in-stock rate we’ve had in several years. Again, this reflects planning, focus, and execution across the business from merchandising to store operations to supply chain to finance, and we continue to see improvement in customer satisfaction as measured by our voice-of-the-customer surveys and by independent third parties. We also gained market share in key categories, as Craig will describe. For 2009, we anticipate another difficult year. We are expecting sales to decline approximately 9% and earnings per share to decline by about 7%. Excluding the impacts of our strategic actions from this January and the store rationalization charges of earlier in 2008, we expect earnings per share to decline approximately 26%. Let me add a note of caution here -- last year at this time, we provided guidance in terms of a range of performance for 2008. This year, we are not providing a range. That doesn’t mean that we are more certain about 2009 than we were about 2008 -- in fact, 2009 is an even more uncertain planning horizon. Housing inventory remains high; consumer demand remains soft, and the impact of government stimulus is uncertain. But rather than giving a very broad range, which would not provide you much of an understanding of how we think about the business, we thought it better to provide our working estimate. Carol will outline for you the key assumptions underlying this estimate. Our intent is to provide a reasonably transparent framework for thinking about our business without implying a certainty that would be misplaced in the current environment. And while we are anticipating a tough year in 2009, we will continue to make progress in improving our business. Over the last two years, we have become a simpler company, which is a good thing. We have exited non-core businesses; we have restructured support staff; we have stopped applying significant capital to building new square footage; and we have renegotiated our private label credit agreement. These actions will make us a better business. They also allow us to focus in 2009 on the steps we know we have to take for long-term success. We have to improve our supply chain. With the opening of our fifth RDC in January, RDCs now serve approximately 500 of our stores. By the end of 2009, we expect that they will serve over 1,000 stores. We are pleased with the results we have seen to date with RDCs and we anticipate additional improvement as we get closer to critical mass on the number of stores served, vendors [on board], and percent of cost of goods flowing through the facilities. We have to improve our merchandising tools. We have made progress over the last two years on this and 2008’s performance on margin rate and inventory would not have been possible without the improved tools and disciplines we have already put in place. Matt Carey and our IT team, along with Craig and the merchandising team, have additional improvements in process for 2009. We are not contemplating any significant spend on a U.S. based enterprise wide system in 2009. We have the advantage of being able to assess the benefits of putting such a program in place in Canada in 2008 and we’ll be in a good position at the end of 2009 to assess whether such an investment for the U.S. would make sense. And we have to continue to improve our customer service. Marvin and the store operations team have applied the same concept of simplification to our stores. Last year, we re-invested over $250 million annualized in hours to the floor of the store, our Aprons-on-the-Floor initiative. This year, Marvin and Tim [Pro], our Head of HR, and their teams will focus on improving our training so that we enhance our associates’ effectiveness. We are going into 2009 conscious that we have to preserve the momentum in improving our business and also conscious that we have to be more disciplined than ever in our use of cash. Our capital spending is back-end weighted and we’ll be prepared to adjust if circumstances require, and we’ll continue to carefully control our discretionary spending. I want to thank our associates for all their hard work and dedication during a very tough year and their commitment for the year ahead. Our associates carry the culture of our company to our customers every day and I am very proud that even in these difficult times, we had a record number of stores participate in our success sharing program for hourly associates. Now let me turn the call over to Craig.
Craig Menear: Thanks, Frank and good morning, everyone. Our sales reflect the ongoing softness in the home improvement market. For the quarter and full year, our remerchandising department experienced negative comp sales growth compared to 2007. In the fourth quarter, the departments that outperformed the company’s average comp were building materials, plumbing, seasonal, paint, and hardware. Flooring performed at the company’s average comp. From a regional perspective, sales trends were mixed. In the areas that first experienced the housing downturn, there are some signs of stabilization. For example, markets such as Miami, San Francisco, and San Diego are still posting negative comps but have shown a significant improvement in comps in the fourth quarter versus last year. However, in areas that previously showed some resilience, like Cleveland, Seattle, and Pittsburgh, we are seeing greater softness. We also saw strong comps for regions that had been affected by severe weather. The Gulf Region posted positive comps in the fourth quarter as communities continued to rebuild following last summer’s hurricanes. Additionally, we saw increased sales in chemicals, flashlights, chainsaws, portable generators, shovels, and snow blowers as a result of ice storms that spread across the Midwest and Kentucky. I want to take a moment to thank our store associates, merchants, and logistics teams for coordinating the efforts during those ice storms to ensure that we had the right products in the stores to take care of our customers. It was a tremendous collaboration and they executed very well. During the quarter, we continued to experience softness in big ticket projects. We define these projects as those transactions over $500. In this average ticket tier, we saw double-digit declines during the quarter. Contrast this with transactions with tickets under $20 where the decline was just 2.7%. In total, average ticket for the fourth quarter on a comparable 13-week basis was down 7.5% to $50.87. We continued to see relative strength in basic repair and remodel as evidence of our plumbing, hardware, and paint department results. We also were pleased with our better execution and performance in our holiday and seasonal gift merchandise. While there are several economic factors affecting our results that we cannot control, we continue to focus on those areas we can control. We are executing on our merchandising transformation to provide a great, everyday value to our customers and will continue to do so in 2009. At the heart of our merchandising transformation is our portfolio strategy. This defines the role and intent of our merchandise categories to capture the full basket on project sales, driving sales and gross margin productivity. Our new lower price campaign is a major component of our portfolio strategy, where we shout out value on key products and project starters across the store. An example of this is in interior paint, where we have lowered prices on items such as Behr’s Flat Premium Plus. Unit sales are increasing and at the same time, our attachment sales of related items are going up. Overall, we are pleased with the results of this campaign and can already see that our customers are responding to this program. Despite the deterioration we saw in the fourth quarter sales as a result of the worsening economy, we were very pleased that our comp transactions did not decline sharply in the fourth quarter. Comp transactions were a negative 5.8% compared to the full year at negative 5.5%. Our enhanced assortment planning and forecasting tools allowed our merchants to make faster decisions in this business environment. Enhanced forecasting is particularly important in our seasonal businesses. We knew it was going to be a difficult holiday season, so in the U.S., we assorted accordingly and planned for less inventory in these categories. This result in better sell-through and fewer markdowns. To put this in perspective, our special buy, seasonal merchandise, we purchased fewer goods, had better than 90% sell-through while reducing markdowns nearly 10%. This was also a quarter of unprecedented swings in commodities like I’ve never seen. Framing lumber reached its lowest level since 1990 and copper and oil prices fell over 50% from the beginning of the quarter. Despite this and the softer sales, our new processes and tools allowed us to better manage the business, deliver a solid gross margin and inventory performance in the U.S. We are confident that our merchandising strategy is working, as evidenced by our unit share gains in nine out of our 13 departments during the quarter. Based on independent third-party tracking of our consumer activity, we saw strong unit share gains in several key merchandising classes -- carpet, hand tools, power tools, blinds, windows and doors, to name a few. We feel good as we head into the spring in this challenging environment. We utilized our assortment of management tools to refine our seasonal assortments and to strengthen our value segments at the opening and middle price points. In the fourth quarter, we saw some customers purchase top-of-the-line snow removal product as they traded in their third-party service contracts and opted to do it themselves. We are prepared to provide customers with the necessary products in lawn equipment, chemicals, and fertilizer categories should this trend continue into the spring businesses. 2009 is going to be another tough year, but we are focused on merchandising fundamentals and we are well-positioned to execute. And now I would like to turn the call over to Carol.
Carol B. Tome: Thank you, Craig and hello, everyone. Our financial results for the quarter and year are distorted by a few factors that I would like to discuss and get out of the way before I cover our results. For the fourth quarter and the year, we will be comparing our results against an extra week, as fiscal 2007 was a 53-week year. The extra week in 2007 added approximately $1.1 billion to sales and approximately $0.04 to earnings per share. We had several strategic charges in fiscal 2008, which we have highlighted on an exhibit to our press release. For the year, the charges totaled $951 million, representing a $564 million store rationalization charge related to the closing of 15 under-performing stores and the removal of 50 stores from our new store opening pipeline, and a $387 million charge taken in the fourth quarter in connection with the closing of our expo businesses and support staff reductions. For the purpose of this call, we will refer to these charges as the business rationalization charge. Finally, earnings from continuing operations were impacted by a $163 million write-down of our investment in HD Supply, which is reflected in other expense, and we reported a $52 million loss net of taxes from discontinued operations related to the settlement of an HD Supply working capital matter. So with that, in the fourth quarter, sales were $14.6 billion, a 17.3% decrease from last year. For the year, our sales declined by 7.8% to $71.3 billion. Excluding last year’s extra week, sales were down 12% for the quarter and 6.5% for the year. Comp or same-store sales were negative 13% for the quarter, with negative comps up 12.6% in November, negative 17.4% in December, and negative 9.2% in January. The monthly comps are distorted because last year’s extra week shifted our fiscal calendar. On a like-for-like basis, for the fourth quarter comps were negative 11.5%. Now like-for-like comps for our U.S. stores were a negative 9.2%. Roughly 10% of our sales are from outside of the U.S. In the fourth quarter, we saw significant strengthening of the U.S. dollar against all currencies. Foreign exchange rate fluctuations negatively impacted total company comps by 190 basis points in the quarter. For the year, comp sales were negative 8.7%. Neither the calendar shift or foreign exchange had a meaningful impact to comps for the year. Excluding the fourth quarter business rationalization charge and the HD Supply write-downs, adjusted earnings per share from continuing operations were $0.19 for the fourth quarter. For the year, earnings per share from continuing operations were $1.37. On an adjusted basis, earnings per share from continuing operations were $1.78, down 21.6%, slightly better than our most recent guidance. In the fourth quarter, our gross margin was 34%, a decrease of 32 basis points from last year, reflecting the following factors. First, our U.S. retail business reported five basis points of margin expansion in the quarter, due primarily to better shrink results than last year. Through our focused [inaudible] portfolio approach, our merchants are driving new lower prices while maintaining overall gross margin. This gross margin expansion was offset by 14 basis points, or $20 million, related to markdowns taken in connection with the closing of the expo businesses. Second, we realized 23 basis points of margin contraction, primarily related to our Canadian business, reflecting the impact of a weaker Canadian dollar, a promotional December, and inventory adjustments related to our score or SAP conversion. For the year, our gross margin was 33.7%, up four basis points from last year. Excluding the markdowns associated with the business rationalization charge, our gross margin increased by eight basis points from last year. In the fourth quarter, operating expenses increased by 493 basis points to 32.1% of sales. Excluding the business rationalization charge, operating expense increased by 241 basis points to 29.6%. Our expense deleverage reflects the impact of negative sales, where we expect to deleverage expenses for every point of negative comp by about 20 basis points. In the fourth quarter, our expense deleverage per point of negative comp was about 18 basis points, including the cost of private label credit. Throughout the year, we had been experiencing additional expense deleverage due to rising costs associated with our private label credit program. In the fourth quarter, and as expected, the expense pressure from our private label credit card moderated. For the year, operating expenses increased by 329 basis points to 27.5% of sales. Excluding the business rationalization charge, operating expenses increased by 200 basis points to 26.2% of sales. Net interest and other expense was $297 million in the fourth quarter, an increase of $105 million. For the year, net interest and other expense was $769 million, an increase of $147 million from last year. Both the quarter and year reflect a $163 million charge due to a 50% write-down of our investment in HD Supply. Now moving to our operational metrics, during the fourth quarter we opened six net new stores, including one relocation, for an ending store count of 2,274. At the end of the fourth quarter, selling square footage was $238 million, a 1.3% increase from last year. Reflecting the sales environment and excluding last year’s extra week, total sales per square foot for fiscal 2008 were $298, down roughly 9%. Now turning to the balance sheet, our team has done an excellent job of controlling inventory in this sales environment and the quality of our inventory has never been better. At the end of the quarter, retail inventory was $10.7 billion, down 9% from last year. On a per-store basis, inventory was down 10.6% to last year. Inventory turns were four times, compared to 4.2 times last year. We ended the quarter with $41 billion in assets, including $525 million in cash and short-term investments. This is an increase of approximately $68 million in cash and short-term investments from the end of fiscal 2007, reflecting cash generated by the business of approximately $5.3 billion, offset by $1.8 billion of capital expenditures, $2 billion used to repay outstanding commercial paper and other debt obligations, and $1.5 billion of dividends. As a reminder, we have a $3.25 billion A2P2 commercial paper program that is 100% back-stopped by a committed long-term bank line of credit. As of the end of the year, we had no outstanding commercial paper. Computed on the average of beginning and ending long-term debt and equity for the trailing four quarters, and excluding the business rationalization charge, return on invested capital was approximately 11.4%. As Frank mentioned, we expect 2009 to be challenging. Our guidance reflects our best thinking at this point. We have detailed our guidance in our press release, so let me just hit the high points. First, let me remind you that we guide off of GAAP. We have based our working estimate on a number of external factors, including GDP, where our view is that nominal GDP will fall by 2.5% in the first half, and fall by 1.1% in the second half. Now our view on GDP does not include any potential lift from the economic stimulus package, which could be positive, or any impact if there were to be a significant increase in the personal savings rate, which could be negative. As of today, we expect fiscal 2009 sales to decline by 9%, with negative comps in the high-single-digit area. We expect the first half to be softer than the back half of the year. For fiscal 2009, we expect earnings per share from continuing operations to decline by 7%. On an adjusted basis, we expect earnings per share to decline approximately 26%. Included in our earnings per share guidance is our view that gross margin expansion will be flat to slightly positive for the year, and expenses as a percent of sales should be flat year over year, but clearly this is distorted by the business rationalization charge. On an adjusted basis, we expect to deleverage expenses by about 13 basis points per point of negative comp, and this reflects the benefit of our support staff reductions, a lower cost of private label credit, and the exit of the expo businesses. Now moving to capital allocations, our capital spending plan for 2009 is $1 billion, reflecting $175 million for new stores, $577 million for our existing U.S. stores and supply chain, $200 million for core IT and other corporate initiatives, and $72 million for our non-U.S. businesses. We expect to open 12 stores this year, with about half of those openings in Canada and Mexico. We have approximately $11.4 million of long-term debt, of which $1.8 billion comes due in the latter part of 2009. At this point, it is our intent to repay the debt maturities as they come due using cash generated by the business. Finally, I want to give you our latest thinking on our recapitalization plan. In 2007, we completed almost 50% of our $22.5 billion recapitalization plan. Shortly after, we put the recap on pause given market conditions and it will stay on pause until we see stabilization in our business and the credit markets. So thank you for your participation in today’s call and August, we’re now ready for questions.
Operator: (Operator Instructions) Our first question will come from Deborah Weinswig with Citigroup.
Deborah Weinswig - Citigroup: Good morning. Throughout the call today we heard about the newly improved assortment management tools. How much more opportunity is there to improve the processes?
Frank Blake: Deborah, I would say we’re really in the early innings of that, so just starting but Craig, why don’t you address that?
Craig Menear: Yeah, Deborah, I think it would be fair to say that we are probably at this stage maybe a quarter of the way through the process, or even maybe slightly just a little less than that. So we have a lot of work to still do.
Deborah Weinswig - Citigroup: Okay, and then we’ll sneak one more question in -- on the RDCs, I think it was said on the call it was the best [in-stock] rate that you had experienced in five years. Can you compare your RDC [serve stores] and non-RDC [serve stores]?
Frank Blake: So at this point, Deborah, they are roughly the same. We have seen a little bit better performance from our RDC supported stores but to tell you the truth, the supply chain as a whole, along with our store operations team and our merchandise team, have just done an excellent job on the in-stock rate, so that improvement reflects improvement across the company, not just in the RDC supported stores.
Deborah Weinswig - Citigroup: Great. Thanks so much. Keep up the great work and best of luck.
Operator: Our next question will come from Colin McGranahan with Bernstein.
Colin McGranahan - Sanford C. Bernstein: Good morning. Focusing back on the RDCs for a second here, it sounds like that by the end of next year, or nearly half of the store base will be served by an RDC. I know Mark had talked about initially some obviously inventory benefits, some supply chain cost benefits, operating margin benefits. I think it was 30 or 40 basis points. How are you thinking about those benefits now that you have five of these open, and how is that impacting your outlook for inventory at the end of next year, inventory turnover and the potential margin benefits that could accrue in ’09 from the supply chain improvements?
Frank Blake: I would say first, and then Mark is here and he’ll address your question in more detail, Colin, but I would say we are still very pleased with the results and counting on those results as we go forward. In 2009, it’s not yet at critical mass in terms of whether we see the benefit on inventory turnover. We are immediately seeing the benefit on transportation on the freight cost but less so on the in-stock and inventory turn. Mark, do you want to --
Mark Holifield: Sure, just a bit more detail on RDC -- as Frank said, we opened our fifth this quarter. That opened in Allentown, Pennsylvania. We had about five weeks of operation there and all of our KPIs -- key performance indicators -- are looking good there and meeting our expectations. The four other RDCs are progressing well against their KPIs as well, and we are on track to achieve the original business case for the RDCs. We expect to be serving about half of our stores by the end of 2009, and by the end of 2010 serving all of them.
Colin McGranahan - Sanford C. Bernstein: Okay, and then just a quick follow-up for Carol -- you know, it looks like the free cash flow should be up nicely in 2009. I understand you have $1.8 billion in maturities but are you -- do you plan maybe to just keep excess cash on the balance sheet at this point? And do you have a specific outlook for what you expect on free cash flow?
Carol B. Tome: Well, we expect it will generate more than enough cash to meet all of our obligations, including our dividend, which is $1.5 billion; our CapEx, which is $1 billion, to repay our debt maturities, which is $1.8 billion, and the additional cash that is generated will be held in the bank.
Colin McGranahan - Sanford C. Bernstein: Okay. Thank you.
Operator: Our next question will come from Matthew Fassler with Goldman Sachs.
Matthew Fassler - Goldman Sachs: Thanks a lot. If we could get a little more color on the progression of your business through the quarter -- you had that dip in December and I’m not sure if there was calendar distortion behind that but I would like to get just kind of quantitative color there and also how you experienced holiday this year, given the promotional environment and any particular merchandising efforts you brought to bear.
Frank Blake: Matt, why don’t -- I think probably it would help if Carol gave you the adjusted comps through those months and then both she and Craig can comment on the holiday season.
Matthew Fassler - Goldman Sachs: That would be great.
Carol B. Tome: Hey, Matt. We saw some real distortion because of the calendar shift, so first let me give you the adjusted comps for total company and then I’ll give you the adjusted comps for U.S. store. So the adjusted comps for total company in the month of November were at negative 11.7%; in the month of December, negative 10.8%; and in the month of January, negative 11.9%. For the U.S. stores, the adjusted comp was negative 9.5% in November, negative 8.6% in December, and negative 9.4% in January.
Matthew Fassler - Goldman Sachs: And when you give us total company, that is not local currency but U.S. dollar comps for -- as they’re impacted by Canada?
Carol B. Tome: That is the total company comps in U.S. dollars reflecting exchange rate impacts, yes.
Matthew Fassler - Goldman Sachs: Okay, good.
Frank Blake: And Craig, do you want to comment on the holiday season?
Craig Menear: Yes, overall on the holiday season, we were pretty pleased, Matt, with the overall performance when we looked at where we gained share, hand tools, power tools, holiday, decorating. You know, we felt pretty good about the end result. It was a tough environment, obviously, in the market but at the same time, we gained share and we came out as clean as we have ever come out, so we feel pretty positive about it.
Matthew Fassler - Goldman Sachs: Gotcha, and then one quick follow-up -- you talked about Florida and California showing smaller declines. We’ve heard that from different companies at different times over the past two years, so I guess how consistently have you seen the comp decline moderation in those markets?
Frank Blake: So it’s been pretty consistent for the last few quarters, Matt, that California and Florida are -- the rate of comp decline is improving.
Matthew Fassler - Goldman Sachs: How do they compare with the total company level?
Carol B. Tome: Just a data point -- if you look at -- and this is what we reported, you know, we reported negative comp of 13%. If you back out California and Florida, the comp would have been negative 13.5%.
Matthew Fassler - Goldman Sachs: Gotcha -- okay, thank you so much.
Operator: Our next question will come from Michael Lasser with Barclays Capital.
Michael Lasser - Barclays Capital: Good morning, thanks. If you start to see competitors become more aggressive from a promotional perspective in the upcoming year, what’s your sense for how you are going to respond, particularly because you will have some gross margin cushion from your enhanced inventory assortment efforts?
Frank Blake: So Michael, I mean, the -- one of the things that really lies behind the portfolio approach is that we try to articulate pretty clearly for ourselves what the role is of each category and where it’s critical to set the right price impression, where it may not be, where we have some opportunities. And so we’re trying to set the path to provide the most value for the customer and then the response is really going to be dictated by what’s our overall portfolio strategy. Craig, do you want to elaborate on that?
Craig Menear: For about the last year-and-a-half, we’ve been really focused on trying to work hard to eliminate promotional activity in our business. You know, we’re not 100% there, obviously but that is the strategy to get back to providing great value for our customers every single day. And I think we’ve shared with you on past calls that promotional activity that we had out there in the past wasn’t really nutritive to the business and we are simply converting that type of spend into driving our portfolio strategy and really focusing on the project business. And so we’re conscious, obviously, of the market that we compete in. We have to be because that’s at the heart of driving value to our customers. But we’re going to really react based on our portfolio strategy approach.
Michael Lasser - Barclays Capital: Maybe I’ll ask it a little bit differently then -- how much of the flat to slightly up gross margin guidance for the year is a result of the focus bay approach, and how much is inherent, you know, are you assuming that the promotional environment in the upcoming year is going to become more [intense]? And then what is the risk that there’s a structural change in the home improvement sub-sector that gross margins are structurally lower because everyone else is just chasing traffic? Thanks.
Frank Blake: Well, again, Michael, the way we look at it is our job is to provide the compelling value to our customers and that’s what sets the strategy, so I -- it’s -- we don’t start with an assumption of hey, here’s how we see all the different potentials on the competitive environment. We start from the -- where do we know we have to go to provide great value to our customer and build from there?
Michael Lasser - Barclays Capital: Okay. Thank you for your comments.
Operator: Our next question will come from Gregory Melich with Morgan Stanley.
Gregory Melich - Morgan Stanley: Thanks. I have two questions -- one on credit and then on CapEx. On credit, we know how much it helps the SG&A, Carol -- have you guys thought about how much it could impact the top line in terms of the percentage of your sales that would be on credit, or reduced credit lines for some of your private label card customers?
Carol B. Tome: Well, today we are approving 76% of all new applications and in 2008, we opened up $3.2 million accounts. Now, the approval line, if you will, is dropped by about 6% so the average line that’s been approved is $6,850. The through-the-door FICO scores are 705, so we still think that credit is going to be an important value proposition going forward. As a penetration of total sales, it was down slightly from last year at about 28%. We’re really focused on just asking our customers every time they shop with us if they would like to use their private label credit card. We’re not going to push credit at them but we certainly encourage them to use it and we have factored in our best thinking as it relates to credit in the guidance that we’ve given.
Gregory Melich - Morgan Stanley: Okay, great, so you expect to see that could drop a little bit in terms of percentage, like it did last year?
Carol B. Tome: I think that’s actually very reasonable, yeah.
Gregory Melich - Morgan Stanley: Okay, great. And then on CapEx, for anyone there, if you think about it longer term, the billing that you are doing this year, which makes I guess a lot of sense given where we are in, on a five-year view, what do you think that needs to be or should be, if we were thinking out longer term?
Frank Blake: Well, I think we’ve said in the past in terms of applying CapEx to new stores that we see a constrained opportunity but there’s still some opportunity, so I think we’ve talked about average -- over time, a little over 1% growth in new square footage, around 1.5%, 1.4% growth in new square footage. So as you go forward, as communities shift, as you have to follow different geographies, they will -- we’ll continue to put in some new square footage but it is going to be significantly less, obviously, than it has been in the past. And there are other things that we obviously are looking at closely. We’ll continue to spend CapEx on our building out our new supply chain on the IT side, as I said in my comments, we’re going to be spending this year, observing how, what the results are in Canada with the new enterprise wide system that they have in place, because if we were to decide to do that, that would obviously require some resources as well.
Carol B. Tome: And as we look out, we can’t imagine a scenario where our capital spending would ever exceed our annual depreciation and amortization expense. And as a reminder, the RDCs are not capital intensive. In 2009, we’ll be spending about $89 million in support of our RDC investment.
Gregory Melich - Morgan Stanley: That’s great. Thanks.
Operator: Our next question will come from Budd Bugatch with Raymond James.
Budd Bugatch - Raymond James: Thank you for taking my question. Good morning. Can you talk, Carol, the linearity of that basis point of deleverage for every comp point of deleverage? At 13 basis points, how linear is that as that moves up and down? Obviously the comps are a big number now.
Carol B. Tome: Right -- well, we feel pretty good about that. Budd, you know, this is an art, not a science. Could it move a couple of basis points if the comps were worse than we thought? Sure, but we feel pretty good about that.
Budd Bugatch - Raymond James: And on the upside?
Carol B. Tome: We should start to see leverage as soon as we hit a 0% comp.
Budd Bugatch - Raymond James: Okay. Secondly, the 12 net new stores, off of what base are we looking at? Because we still have yard birds and expo and the store count -- I’m just making sure I understand.
Carol B. Tome: Yeah, we have -- yeah, expo is still in there, so it’s just add 12 and subtract 34.
Budd Bugatch - Raymond James: Okay, and the same for yard birds too? I mean, it’s 12 net off of the --
Carol B. Tome: Yes, it’s 12 net off -- subtract from the 2,274 that we ended the year, subtract 41 and add 12.
Budd Bugatch - Raymond James: Gotcha. Okay, and finally on the CapEx, it’s about -- what, about $250,000 per store, if my math is right, right now excluding what you are going to spend on the supply chain? Is that number look like a number that will be constant over a couple of years?
Carol B. Tome: Well, there are a couple of things to remember -- first, we did some catch-up spending that we don’t need to repeat in 2009. We also have a lot of expense dollars that we spend on just maintaining our stores. In fact, over $500 million of expense dollars go into maintaining our stores. So if we look at what we are spending on a per square footage base, just maintaining the stores, it’s a little less than $3 a square foot and we feel pretty good about that.
Budd Bugatch - Raymond James: Okay. Thanks, Carol. Thank you very much.
Operator: Our next question will come from John [Zolidis] with Buckingham Research.
John Zolidis - Buckingham Research: Good morning. Just a clean-up question on the foreign currency -- can you tell us what the total impact to sales was in the fourth quarter, and if there was any material impact to the bottom line? And then what is anticipated in the guidance for foreign currency impact in 2009? Thank you.
Carol B. Tome: The impact to sales is about $320 million in the fourth quarter. There was no material impact to the bottom line and as we look out for 2009, included in our guidance is our view that the currencies will stay where they are, so we’re not assuming further strengthening of the U.S. dollar or any weakening as a point, so there is a year-over-year impact to ourselves because of where the currencies are today and that’s included in the guidance.
John Zolidis - Buckingham Research: Can you give us some help on what that might be and since you report the comps in U.S. dollars, is there maybe a 100 basis points impact from FX in that?
Carol B. Tome: That’s right -- there’s about 100 basis points.
John Zolidis - Buckingham Research: Okay. Thank you.
Carol B. Tome: You’re welcome.
Operator: Our next question will come from Maggie Gilliam with Gilliam & Company.
Maggie Gilliam - Gilliam & Company: Could you comment on what is the status of the SAP system in Canada and what are your plans for implementing it in the U.S.? I know there has been a little bit of talk about simplifying it or making some modifications going forward. Thank you.
Frank Blake: Sure. Good morning, Maggie. First, great credit to the Canadian team and our IT team for the implementation of the system. I mean, you look at major efforts like this and a lot of times, you run into some significant unanticipated issues. This was done on time and the Canadian team really did just an excellent job of getting it in place. Now, going forward, we have the opportunity to figure out okay, what are the benefits, who do those benefits compare to our ongoing efforts to improve our infrastructure here in the U.S., and then assess kind of towards the end of 2009, what’s the best path forward for the United States? Matt Carey, our IT leader, is here in the room and so I -- Matt, if you want to add some comments to that.
Matt Carey: Absolutely. We intend on measuring the impact and the return that we’ve gotten or are going to get in this system and we’ll assess it throughout the year and go through a few seasonal cycles and make sure that it meets our expectations before we make a call.
Frank Blake: Thanks.
Diane Dayhoff: Augusta, I think we’re ready for the next question.
Operator: Our next question will come from Wayne Hood with BMO Capital Markets.
Wayne Hood - BMO Capital Markets: Good morning. I guess on Canada again, Carol specifically to you, I guess as you look at their implementation there, there was some inventory adjustments and as you look at that, what do you see there that might mean or imply inventory adjustments that might be needed in the U.S. if you rolled out SAP and how much is their inventory down up there since that rollout -- about 5% or 10% or can you put some parameters around that?
Carol B. Tome: Well Wayne, we haven’t done the analysis in the United States to be able to quantify what it could mean but anytime you convert, and I think you know we converted from retail method of inventory to cost and there was an inventory adjustment that took place, so that impacted the gross margin performance in the fourth quarter. We also had some shrinkage and that was really because of the disruption associated with the implementation. So I can tell you what it meant to Canada, which we called out in this overall impact to the company gross margin up in Canada -- it was about 23 basis points. The inventory piece related to the score or SAP implementation was about 12 basis points. So I can’t tell you what it means for the U.S.
Wayne Hood - BMO Capital Markets: Okay, and then I just had a quick question for Craig; Craig, you indicated some increase in units you are employing in some of these other areas. I am just wondering, when you think about fully allocating expenses back to these labor intensive departments, what level of profitability are you seeing year over year, even though your share may be up?
Craig Menear: When we look at our flooring business -- for example, soft flooring has been a very strong business for us, where we’ve been gaining share and when we look at the overall profitability of that product category, we’re actually very pleased with our results.
Wayne Hood - BMO Capital Markets: So it’s up year over year, fully allocated?
Craig Menear: All in, when you look at everything, yeah, we’re very happy with where we are at.
Wayne Hood - BMO Capital Markets: Thank you.
Operator: Our next question will come from Brian Nagel with UBS.
Brian Nagel - UBS: Good morning. I wanted to just follow-up; you commented in your prepared remarks about California and Florida, and seeing some signs of stabilization there and some weakness, some incremental weakness in other markets. I guess as we think about the trend of business throughout the country and how the trend is likely to change potentially as we go through 2009, are there regions of the country that are still uncharacteristically strong, that are helping to support comps? That’s one question. And then the second, going back to California and Florida, as you’ve seen maybe signs of stabilization there, do you think that reflects, or to what degree does that reflect sales of foreclosed homes?
Frank Blake: Brian, a couple of comments -- the first would be, just so that everybody is clear, they are still declining, so -- I mean, it’s not stabilization in the sense of oh, okay, well, we’ve actually bottomed. This is just a rate of decline that is slowing. The second, in terms of areas that are positive, as Craig called out in the weather-impacted areas, we’ve seen positive comps, so we’ve seen positive comps in our Gulf area, for example.
Brian Nagel - UBS: And then as far as foreclosures, are those helping to drive better -- or I guess less bad results?
Frank Blake: Yeah, I mean there is an advantage to existing housing turnover. That’s something clearly that is relevant to our business and clearly a lot of the turnover in those areas has been from foreclosed housing.
Craig Menear: We also see when you look at product categories, things like vinyl flooring, cleaning, in-stock carpet -- all of those businesses and compared to the total company are relatively strong businesses and we think that that’s a combination of people that are beginning to fix up some of these homes but also the fact that there is high rent impact out there, where more people are renting.
Brian Nagel - UBS: Okay. Thank you very much.
Operator: Our next question will come from Shannon Joseph with Wachovia.
Shannon Joseph - Wachovia Capital Markets: Actually, my questions have already been answered. Thanks.
Operator: Our next question will come from Eric Bosshard with Cleveland Research.
Eric Bosshard - Cleveland Research: Good morning. Two things as we think about 2009 -- first of all, I guess one for Craig, and that is as you think about the merchandising strategy in response to the consumer, can you just give us a little detail on categories or areas or price points or what you are thinking about proactively and how you are going to position merchandising? And then secondly for Marvin, if he’s in the room, just a similar question for how you are thinking about staffing stores and service levels in anticipation of what you are looking at for 2009.
Frank Blake: Okay. Marvin is in the room, so he’ll respond to the second part of your question, Eric. Craig.
Craig Menear: Eric, as it relates to kind of how we are looking at the merchandising piece, using our assortment planning tools, we are actually expanding the variety or clusters, if you will, of assortments that we are putting out there, trying to be more granular to approach specific customer needs and specific types of stores. So we have an improvement in, for example, in our seasonal areas of things like patio grills, power equipment, and so on, where we have put more clusters to be more granular. Also, the other thing that we have focused on is really making the adjustments where we feel it was necessary and potentially shifting to stronger opening price point and mid-price points, and we have assorted accordingly as we move into 2009 to make those types of adjustments. And then as I mentioned, we are also watching, because we think that there is potential upside where customers will in fact potentially opt out of services that they have around their home today and elect to do it themselves, and what we saw in snow equipment in the fourth quarter was that actually -- that translated into our better product selling at the top end of the line and we’ll be prepared to make those type of adjustments to fulfill those customers’ needs as well.
Unidentified Participant: Eric, good morning. This is Marvin. The second half of your question, we’re really going to keep it very basic. We have spent a lot of time simplifying the stores, removing task and making sure that we are positioning associates in the customer facing areas of the business. So for ’09, it’s going to be a focus on training, as Frank mentioned earlier. We are going to re-orient and re-train every single associate on the fundamentals of customer service. We’ve never done that before and we are going to focus on that in the first quarter. We are also going to make sure that we have our associates in the parts of the store during the times of the day that we have our greatest customer traffic and we are going to just focus on customer service. Our goal is going to be to execute well so that we can bring some of the merchandising events and new products to life with better service and just better associate know-how, so really taking [inaudible], customer service, and associate know-how will be the plan for 2009.
Eric Bosshard - Cleveland Research: And in terms of staffing levels relative to sales, is there any adjustment being made in the model?
Unidentified Participant: No, it’s not -- I mean, we have an activity based system that is staffed based on departments, so an example would be when we have a department that is performing well, like our repair maintenance categories, you will see more associates in that area because sales are up. And when we have some [inaudible] that may be slightly down, you will see less associates based on the number of customers. So department by department, store by store, and we feel like that has served us well and we’ll continue that for 2009.
Eric Bosshard - Cleveland Research: And then lastly on that, is there any change in the minimum staffing target as the sales continue to contract?
Unidentified Participant: No, because we staff based on departments, we don’t look at minimum staffing by store. We focus on a department-by-department basis. If you look at our store, we are a store made up of many different, smaller stores. A hardware store, plumbing store, so we think a department-by-department focus is the best method for us to serve our customers.
Eric Bosshard - Cleveland Research: Great. Thank you.
Diane Dayhoff: Augusta, we have time for one more question.
Operator: That question will come from Chris Horvers with J.P. Morgan.
Christopher Horvers - J.P. Morgan: Yes, made it in. I was going to say best for last, but -- so first to clarify, we’ve received a number of questions about guidance, so it’s $1.37, down 7% -- that’s $1.27. Should we think about adjusting for that $132 million of one-time expenses in 4Q as well?
Carol B. Tome: Yes, when we said on an adjusted basis, EPS would be down around 26%, we’re adjusting out the expenses in 2008 and 2009, related to the business rationalization.
Christopher Horvers - J.P. Morgan: Right, so the point forecast is like $1.32-ish, something like that.
Carol B. Tome: On an adjusted basis.
Christopher Horvers - J.P. Morgan: Right, yes, on an adjusted basis. Okay, that’s perfect. And then can you talk of a follow-up question on the promotional environment -- you know, Lowe’s results last week caused a lot of concern out there. Have you seen Sears pull back? What is Menards doing? Has Lowe's changed their pricing strategy? And then broadly on inventory, it seems like you guys are very clean. How do you think the channel looks and your other big retail competitors?
Frank Blake: Well first, look, it’s always a competitive market. I mean, we’re always responding to customers, we’re always out there trying every day to have the best pricing for our customers, so that’s going to be the same in 2009 as it was in 2008. And in terms of our competitors inventory positions, I guess I’m not really in a position to comment.
Christopher Horvers - J.P. Morgan: From what you are seeing in the channel and the suppliers, do you think they are clean, so it’s not like there’s a lot of inventory that needs to be cleared out?
Frank Blake: In our channel?
Christopher Horvers - J.P. Morgan: Yeah, your vendors.
Craig Menear: I really -- you mean from the vendor standpoint, Chris?
Christopher Horvers - J.P. Morgan: Yes.
Craig Menear: Yeah, I mean, I think our vendors are probably in pretty good shape as we talk to them. You know, everybody in this environment is trying to watch how they manage their business, so I’m not hearing anything from our vendor community that has them with dire concern over inventory position. You know, and just one other comment as it relates to kind of how we are approaching the environment -- it is the job of our merchants to understand and anticipate where they think the market will go as they build their assortments for a given year, and we take into account what we think will happen the best we can and then assort accordingly, which is why we’ve made some of the adjustments that we’ve made within the line structures as we move into 2009.
Christopher Horvers - J.P. Morgan: Okay, and then just one final one -- so then Craig, how have you ordered Spring on a year-over-year inventory basis?
Craig Menear: We have --
Frank Blake: You know, Chris, I think that’s probably not --
Craig Menear: More competitive information than I want to give out.
Christopher Horvers - J.P. Morgan: Okay, fair enough. Thank you.
Frank Blake: Thank you, Chris.
Diane Dayhoff: Thank you all for joining us and we look forward to talking to you at the end of next quarter.
Operator: This does conclude our call. We would like to thank everyone for their participation. Have a great day. | [
{
"speaker": "Executives",
"text": "Diane Dayhoff - Senior Vice President, Investor Relations Frank Blake - Chairman, Chief Executive Officer Craig Menear - Senior Vice President, Merchandising Carol B. Tome - Chief Financial Officer, Executive Vice President Corporate Services Mark Holifield - Senior Vice President, Supply Chain Matt Carey - Executive Vice President, Chief Information Officer"
},
{
"speaker": "Analysts",
"text": "Deborah Weinswig - Citigroup Colin McGranahan - Sanford C. Bernstein Matthew Fassler - Goldman Sachs Michael Lasser - Barclays Capital Gregory Melich - Morgan Stanley Budd Bugatch - Raymond James John Zolidis - Buckingham Research Maggie Gilliam - Gilliam & Company Wayne Hood - BMO Capital Markets Brian Nagel - UBS Shannon Joseph - Wachovia Capital Markets Eric Bosshard - Cleveland Research Christopher Horvers - J.P. Morgan"
},
{
"speaker": "Operator",
"text": "Good day, everyone and welcome to today’s Home Depot fourth quarter earnings conference call. Today’s conference is being recorded. (Operator Instructions) Beginning today’s discussion is Ms. Diane Dayhoff, Vice President of Investor Relations. Please go ahead, Madam."
},
{
"speaker": "Diane Dayhoff",
"text": "Thank you, Augusta and good morning to everyone. Welcome to the Home Depot third quarter -- fourth quarter earnings conference call. Joining us on our call today are Frank Blake, Chairman and CEO of The Home Depot; Craig Menear, Executive Vice President, Merchandising; and Carol Tome, Chief Financial Officer and Executive Vice President, Corporate Services. Following our prepared remarks, the call will be open for analysts’ questions. Questions will be limited to analysts and investors and as a reminder, we would appreciate it if the participants would limit themselves to one question with one follow-up, please. This conference call is being broadcast real-time on the Internet at homedepot.com with links on both our homepage and the investor relations section. The replay will also be available on our site. If we are unable to get to your question during the call, please call our investor relations department at 770-384-2387. Before I turn the call over to Frank, let me remind you that today’s press release and the presentations made by our executives include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties. These risks and uncertainties include, but are not limited to, those factors identified in the release and in our filings with the Securities and Exchange Commission. Now let me turn the call over to Frank Blake."
},
{
"speaker": "Frank Blake",
"text": "Thank you, Diane and good morning, everyone. Sales for the fourth quarter were $14.6 billion. Comp sales were negative 13%. When adjusted for the seasonal shift caused by having 53 weeks in our fiscal 2007, our comp sales were negative 11.5%. At the end of January, we announced several actions that we are taking in light of current market conditions. These included shutting down our expo businesses, restructuring support positions, and writing down our equity interest in HD Supply. Those actions resulted in $550 million of charges in the fourth quarter. Excluding those charges, diluted earnings per share from continuing operations were $0.19. Carol will give you more detail in a few minutes on both our fourth quarter and fiscal year numbers. As a general comment, we anticipated a difficult quarter and year and they were all that and more. The issues impacting us are familiar to you all -- the housing market is still depressed, the percent of GDP now spent on housing related construction is at 3.1%. This is the lowest that it has ever been in 60 years of recorded data and we anticipate further deterioration. The credit markets are still stressed for consumers and businesses alike and unemployment continues to increase. We have seen some improvement in our California and Florida markets in the sense that the rate of decline has slowed but these relative improvements are more than offset by declines elsewhere in the country. Our Canadian business started the year strong but deteriorated in the second half as the global economy began to weaken. Also, the implementation of the bulk of our core retail pilot occurred in the second half in Canada and that caused some additional distraction in a difficult time. For the year, Canada posted mid-single-digit negative comps. China, while small, had positive comps, and our business in Mexico had another great year, with double-digit positive comps. There were some very positive signs of improved business performance during 2008. We said at the start of the year that we would maintain a flat to slightly positive gross margin rate for the year. We did that and we did it at the same time we launched a new lower price campaign. This is indicative of better control and coordination within our merchandising organization and our effective focus on everyday pricing. We also reduced our inventory by over $1 billion while at the same time maintaining the best in-stock rate we’ve had in several years. Again, this reflects planning, focus, and execution across the business from merchandising to store operations to supply chain to finance, and we continue to see improvement in customer satisfaction as measured by our voice-of-the-customer surveys and by independent third parties. We also gained market share in key categories, as Craig will describe. For 2009, we anticipate another difficult year. We are expecting sales to decline approximately 9% and earnings per share to decline by about 7%. Excluding the impacts of our strategic actions from this January and the store rationalization charges of earlier in 2008, we expect earnings per share to decline approximately 26%. Let me add a note of caution here -- last year at this time, we provided guidance in terms of a range of performance for 2008. This year, we are not providing a range. That doesn’t mean that we are more certain about 2009 than we were about 2008 -- in fact, 2009 is an even more uncertain planning horizon. Housing inventory remains high; consumer demand remains soft, and the impact of government stimulus is uncertain. But rather than giving a very broad range, which would not provide you much of an understanding of how we think about the business, we thought it better to provide our working estimate. Carol will outline for you the key assumptions underlying this estimate. Our intent is to provide a reasonably transparent framework for thinking about our business without implying a certainty that would be misplaced in the current environment. And while we are anticipating a tough year in 2009, we will continue to make progress in improving our business. Over the last two years, we have become a simpler company, which is a good thing. We have exited non-core businesses; we have restructured support staff; we have stopped applying significant capital to building new square footage; and we have renegotiated our private label credit agreement. These actions will make us a better business. They also allow us to focus in 2009 on the steps we know we have to take for long-term success. We have to improve our supply chain. With the opening of our fifth RDC in January, RDCs now serve approximately 500 of our stores. By the end of 2009, we expect that they will serve over 1,000 stores. We are pleased with the results we have seen to date with RDCs and we anticipate additional improvement as we get closer to critical mass on the number of stores served, vendors [on board], and percent of cost of goods flowing through the facilities. We have to improve our merchandising tools. We have made progress over the last two years on this and 2008’s performance on margin rate and inventory would not have been possible without the improved tools and disciplines we have already put in place. Matt Carey and our IT team, along with Craig and the merchandising team, have additional improvements in process for 2009. We are not contemplating any significant spend on a U.S. based enterprise wide system in 2009. We have the advantage of being able to assess the benefits of putting such a program in place in Canada in 2008 and we’ll be in a good position at the end of 2009 to assess whether such an investment for the U.S. would make sense. And we have to continue to improve our customer service. Marvin and the store operations team have applied the same concept of simplification to our stores. Last year, we re-invested over $250 million annualized in hours to the floor of the store, our Aprons-on-the-Floor initiative. This year, Marvin and Tim [Pro], our Head of HR, and their teams will focus on improving our training so that we enhance our associates’ effectiveness. We are going into 2009 conscious that we have to preserve the momentum in improving our business and also conscious that we have to be more disciplined than ever in our use of cash. Our capital spending is back-end weighted and we’ll be prepared to adjust if circumstances require, and we’ll continue to carefully control our discretionary spending. I want to thank our associates for all their hard work and dedication during a very tough year and their commitment for the year ahead. Our associates carry the culture of our company to our customers every day and I am very proud that even in these difficult times, we had a record number of stores participate in our success sharing program for hourly associates. Now let me turn the call over to Craig."
},
{
"speaker": "Craig Menear",
"text": "Thanks, Frank and good morning, everyone. Our sales reflect the ongoing softness in the home improvement market. For the quarter and full year, our remerchandising department experienced negative comp sales growth compared to 2007. In the fourth quarter, the departments that outperformed the company’s average comp were building materials, plumbing, seasonal, paint, and hardware. Flooring performed at the company’s average comp. From a regional perspective, sales trends were mixed. In the areas that first experienced the housing downturn, there are some signs of stabilization. For example, markets such as Miami, San Francisco, and San Diego are still posting negative comps but have shown a significant improvement in comps in the fourth quarter versus last year. However, in areas that previously showed some resilience, like Cleveland, Seattle, and Pittsburgh, we are seeing greater softness. We also saw strong comps for regions that had been affected by severe weather. The Gulf Region posted positive comps in the fourth quarter as communities continued to rebuild following last summer’s hurricanes. Additionally, we saw increased sales in chemicals, flashlights, chainsaws, portable generators, shovels, and snow blowers as a result of ice storms that spread across the Midwest and Kentucky. I want to take a moment to thank our store associates, merchants, and logistics teams for coordinating the efforts during those ice storms to ensure that we had the right products in the stores to take care of our customers. It was a tremendous collaboration and they executed very well. During the quarter, we continued to experience softness in big ticket projects. We define these projects as those transactions over $500. In this average ticket tier, we saw double-digit declines during the quarter. Contrast this with transactions with tickets under $20 where the decline was just 2.7%. In total, average ticket for the fourth quarter on a comparable 13-week basis was down 7.5% to $50.87. We continued to see relative strength in basic repair and remodel as evidence of our plumbing, hardware, and paint department results. We also were pleased with our better execution and performance in our holiday and seasonal gift merchandise. While there are several economic factors affecting our results that we cannot control, we continue to focus on those areas we can control. We are executing on our merchandising transformation to provide a great, everyday value to our customers and will continue to do so in 2009. At the heart of our merchandising transformation is our portfolio strategy. This defines the role and intent of our merchandise categories to capture the full basket on project sales, driving sales and gross margin productivity. Our new lower price campaign is a major component of our portfolio strategy, where we shout out value on key products and project starters across the store. An example of this is in interior paint, where we have lowered prices on items such as Behr’s Flat Premium Plus. Unit sales are increasing and at the same time, our attachment sales of related items are going up. Overall, we are pleased with the results of this campaign and can already see that our customers are responding to this program. Despite the deterioration we saw in the fourth quarter sales as a result of the worsening economy, we were very pleased that our comp transactions did not decline sharply in the fourth quarter. Comp transactions were a negative 5.8% compared to the full year at negative 5.5%. Our enhanced assortment planning and forecasting tools allowed our merchants to make faster decisions in this business environment. Enhanced forecasting is particularly important in our seasonal businesses. We knew it was going to be a difficult holiday season, so in the U.S., we assorted accordingly and planned for less inventory in these categories. This result in better sell-through and fewer markdowns. To put this in perspective, our special buy, seasonal merchandise, we purchased fewer goods, had better than 90% sell-through while reducing markdowns nearly 10%. This was also a quarter of unprecedented swings in commodities like I’ve never seen. Framing lumber reached its lowest level since 1990 and copper and oil prices fell over 50% from the beginning of the quarter. Despite this and the softer sales, our new processes and tools allowed us to better manage the business, deliver a solid gross margin and inventory performance in the U.S. We are confident that our merchandising strategy is working, as evidenced by our unit share gains in nine out of our 13 departments during the quarter. Based on independent third-party tracking of our consumer activity, we saw strong unit share gains in several key merchandising classes -- carpet, hand tools, power tools, blinds, windows and doors, to name a few. We feel good as we head into the spring in this challenging environment. We utilized our assortment of management tools to refine our seasonal assortments and to strengthen our value segments at the opening and middle price points. In the fourth quarter, we saw some customers purchase top-of-the-line snow removal product as they traded in their third-party service contracts and opted to do it themselves. We are prepared to provide customers with the necessary products in lawn equipment, chemicals, and fertilizer categories should this trend continue into the spring businesses. 2009 is going to be another tough year, but we are focused on merchandising fundamentals and we are well-positioned to execute. And now I would like to turn the call over to Carol."
},
{
"speaker": "Carol B. Tome",
"text": "Thank you, Craig and hello, everyone. Our financial results for the quarter and year are distorted by a few factors that I would like to discuss and get out of the way before I cover our results. For the fourth quarter and the year, we will be comparing our results against an extra week, as fiscal 2007 was a 53-week year. The extra week in 2007 added approximately $1.1 billion to sales and approximately $0.04 to earnings per share. We had several strategic charges in fiscal 2008, which we have highlighted on an exhibit to our press release. For the year, the charges totaled $951 million, representing a $564 million store rationalization charge related to the closing of 15 under-performing stores and the removal of 50 stores from our new store opening pipeline, and a $387 million charge taken in the fourth quarter in connection with the closing of our expo businesses and support staff reductions. For the purpose of this call, we will refer to these charges as the business rationalization charge. Finally, earnings from continuing operations were impacted by a $163 million write-down of our investment in HD Supply, which is reflected in other expense, and we reported a $52 million loss net of taxes from discontinued operations related to the settlement of an HD Supply working capital matter. So with that, in the fourth quarter, sales were $14.6 billion, a 17.3% decrease from last year. For the year, our sales declined by 7.8% to $71.3 billion. Excluding last year’s extra week, sales were down 12% for the quarter and 6.5% for the year. Comp or same-store sales were negative 13% for the quarter, with negative comps up 12.6% in November, negative 17.4% in December, and negative 9.2% in January. The monthly comps are distorted because last year’s extra week shifted our fiscal calendar. On a like-for-like basis, for the fourth quarter comps were negative 11.5%. Now like-for-like comps for our U.S. stores were a negative 9.2%. Roughly 10% of our sales are from outside of the U.S. In the fourth quarter, we saw significant strengthening of the U.S. dollar against all currencies. Foreign exchange rate fluctuations negatively impacted total company comps by 190 basis points in the quarter. For the year, comp sales were negative 8.7%. Neither the calendar shift or foreign exchange had a meaningful impact to comps for the year. Excluding the fourth quarter business rationalization charge and the HD Supply write-downs, adjusted earnings per share from continuing operations were $0.19 for the fourth quarter. For the year, earnings per share from continuing operations were $1.37. On an adjusted basis, earnings per share from continuing operations were $1.78, down 21.6%, slightly better than our most recent guidance. In the fourth quarter, our gross margin was 34%, a decrease of 32 basis points from last year, reflecting the following factors. First, our U.S. retail business reported five basis points of margin expansion in the quarter, due primarily to better shrink results than last year. Through our focused [inaudible] portfolio approach, our merchants are driving new lower prices while maintaining overall gross margin. This gross margin expansion was offset by 14 basis points, or $20 million, related to markdowns taken in connection with the closing of the expo businesses. Second, we realized 23 basis points of margin contraction, primarily related to our Canadian business, reflecting the impact of a weaker Canadian dollar, a promotional December, and inventory adjustments related to our score or SAP conversion. For the year, our gross margin was 33.7%, up four basis points from last year. Excluding the markdowns associated with the business rationalization charge, our gross margin increased by eight basis points from last year. In the fourth quarter, operating expenses increased by 493 basis points to 32.1% of sales. Excluding the business rationalization charge, operating expense increased by 241 basis points to 29.6%. Our expense deleverage reflects the impact of negative sales, where we expect to deleverage expenses for every point of negative comp by about 20 basis points. In the fourth quarter, our expense deleverage per point of negative comp was about 18 basis points, including the cost of private label credit. Throughout the year, we had been experiencing additional expense deleverage due to rising costs associated with our private label credit program. In the fourth quarter, and as expected, the expense pressure from our private label credit card moderated. For the year, operating expenses increased by 329 basis points to 27.5% of sales. Excluding the business rationalization charge, operating expenses increased by 200 basis points to 26.2% of sales. Net interest and other expense was $297 million in the fourth quarter, an increase of $105 million. For the year, net interest and other expense was $769 million, an increase of $147 million from last year. Both the quarter and year reflect a $163 million charge due to a 50% write-down of our investment in HD Supply. Now moving to our operational metrics, during the fourth quarter we opened six net new stores, including one relocation, for an ending store count of 2,274. At the end of the fourth quarter, selling square footage was $238 million, a 1.3% increase from last year. Reflecting the sales environment and excluding last year’s extra week, total sales per square foot for fiscal 2008 were $298, down roughly 9%. Now turning to the balance sheet, our team has done an excellent job of controlling inventory in this sales environment and the quality of our inventory has never been better. At the end of the quarter, retail inventory was $10.7 billion, down 9% from last year. On a per-store basis, inventory was down 10.6% to last year. Inventory turns were four times, compared to 4.2 times last year. We ended the quarter with $41 billion in assets, including $525 million in cash and short-term investments. This is an increase of approximately $68 million in cash and short-term investments from the end of fiscal 2007, reflecting cash generated by the business of approximately $5.3 billion, offset by $1.8 billion of capital expenditures, $2 billion used to repay outstanding commercial paper and other debt obligations, and $1.5 billion of dividends. As a reminder, we have a $3.25 billion A2P2 commercial paper program that is 100% back-stopped by a committed long-term bank line of credit. As of the end of the year, we had no outstanding commercial paper. Computed on the average of beginning and ending long-term debt and equity for the trailing four quarters, and excluding the business rationalization charge, return on invested capital was approximately 11.4%. As Frank mentioned, we expect 2009 to be challenging. Our guidance reflects our best thinking at this point. We have detailed our guidance in our press release, so let me just hit the high points. First, let me remind you that we guide off of GAAP. We have based our working estimate on a number of external factors, including GDP, where our view is that nominal GDP will fall by 2.5% in the first half, and fall by 1.1% in the second half. Now our view on GDP does not include any potential lift from the economic stimulus package, which could be positive, or any impact if there were to be a significant increase in the personal savings rate, which could be negative. As of today, we expect fiscal 2009 sales to decline by 9%, with negative comps in the high-single-digit area. We expect the first half to be softer than the back half of the year. For fiscal 2009, we expect earnings per share from continuing operations to decline by 7%. On an adjusted basis, we expect earnings per share to decline approximately 26%. Included in our earnings per share guidance is our view that gross margin expansion will be flat to slightly positive for the year, and expenses as a percent of sales should be flat year over year, but clearly this is distorted by the business rationalization charge. On an adjusted basis, we expect to deleverage expenses by about 13 basis points per point of negative comp, and this reflects the benefit of our support staff reductions, a lower cost of private label credit, and the exit of the expo businesses. Now moving to capital allocations, our capital spending plan for 2009 is $1 billion, reflecting $175 million for new stores, $577 million for our existing U.S. stores and supply chain, $200 million for core IT and other corporate initiatives, and $72 million for our non-U.S. businesses. We expect to open 12 stores this year, with about half of those openings in Canada and Mexico. We have approximately $11.4 million of long-term debt, of which $1.8 billion comes due in the latter part of 2009. At this point, it is our intent to repay the debt maturities as they come due using cash generated by the business. Finally, I want to give you our latest thinking on our recapitalization plan. In 2007, we completed almost 50% of our $22.5 billion recapitalization plan. Shortly after, we put the recap on pause given market conditions and it will stay on pause until we see stabilization in our business and the credit markets. So thank you for your participation in today’s call and August, we’re now ready for questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Our first question will come from Deborah Weinswig with Citigroup."
},
{
"speaker": "Deborah Weinswig - Citigroup",
"text": "Good morning. Throughout the call today we heard about the newly improved assortment management tools. How much more opportunity is there to improve the processes?"
},
{
"speaker": "Frank Blake",
"text": "Deborah, I would say we’re really in the early innings of that, so just starting but Craig, why don’t you address that?"
},
{
"speaker": "Craig Menear",
"text": "Yeah, Deborah, I think it would be fair to say that we are probably at this stage maybe a quarter of the way through the process, or even maybe slightly just a little less than that. So we have a lot of work to still do."
},
{
"speaker": "Deborah Weinswig - Citigroup",
"text": "Okay, and then we’ll sneak one more question in -- on the RDCs, I think it was said on the call it was the best [in-stock] rate that you had experienced in five years. Can you compare your RDC [serve stores] and non-RDC [serve stores]?"
},
{
"speaker": "Frank Blake",
"text": "So at this point, Deborah, they are roughly the same. We have seen a little bit better performance from our RDC supported stores but to tell you the truth, the supply chain as a whole, along with our store operations team and our merchandise team, have just done an excellent job on the in-stock rate, so that improvement reflects improvement across the company, not just in the RDC supported stores."
},
{
"speaker": "Deborah Weinswig - Citigroup",
"text": "Great. Thanks so much. Keep up the great work and best of luck."
},
{
"speaker": "Operator",
"text": "Our next question will come from Colin McGranahan with Bernstein."
},
{
"speaker": "Colin McGranahan - Sanford C. Bernstein",
"text": "Good morning. Focusing back on the RDCs for a second here, it sounds like that by the end of next year, or nearly half of the store base will be served by an RDC. I know Mark had talked about initially some obviously inventory benefits, some supply chain cost benefits, operating margin benefits. I think it was 30 or 40 basis points. How are you thinking about those benefits now that you have five of these open, and how is that impacting your outlook for inventory at the end of next year, inventory turnover and the potential margin benefits that could accrue in ’09 from the supply chain improvements?"
},
{
"speaker": "Frank Blake",
"text": "I would say first, and then Mark is here and he’ll address your question in more detail, Colin, but I would say we are still very pleased with the results and counting on those results as we go forward. In 2009, it’s not yet at critical mass in terms of whether we see the benefit on inventory turnover. We are immediately seeing the benefit on transportation on the freight cost but less so on the in-stock and inventory turn. Mark, do you want to --"
},
{
"speaker": "Mark Holifield",
"text": "Sure, just a bit more detail on RDC -- as Frank said, we opened our fifth this quarter. That opened in Allentown, Pennsylvania. We had about five weeks of operation there and all of our KPIs -- key performance indicators -- are looking good there and meeting our expectations. The four other RDCs are progressing well against their KPIs as well, and we are on track to achieve the original business case for the RDCs. We expect to be serving about half of our stores by the end of 2009, and by the end of 2010 serving all of them."
},
{
"speaker": "Colin McGranahan - Sanford C. Bernstein",
"text": "Okay, and then just a quick follow-up for Carol -- you know, it looks like the free cash flow should be up nicely in 2009. I understand you have $1.8 billion in maturities but are you -- do you plan maybe to just keep excess cash on the balance sheet at this point? And do you have a specific outlook for what you expect on free cash flow?"
},
{
"speaker": "Carol B. Tome",
"text": "Well, we expect it will generate more than enough cash to meet all of our obligations, including our dividend, which is $1.5 billion; our CapEx, which is $1 billion, to repay our debt maturities, which is $1.8 billion, and the additional cash that is generated will be held in the bank."
},
{
"speaker": "Colin McGranahan - Sanford C. Bernstein",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question will come from Matthew Fassler with Goldman Sachs."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "Thanks a lot. If we could get a little more color on the progression of your business through the quarter -- you had that dip in December and I’m not sure if there was calendar distortion behind that but I would like to get just kind of quantitative color there and also how you experienced holiday this year, given the promotional environment and any particular merchandising efforts you brought to bear."
},
{
"speaker": "Frank Blake",
"text": "Matt, why don’t -- I think probably it would help if Carol gave you the adjusted comps through those months and then both she and Craig can comment on the holiday season."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "That would be great."
},
{
"speaker": "Carol B. Tome",
"text": "Hey, Matt. We saw some real distortion because of the calendar shift, so first let me give you the adjusted comps for total company and then I’ll give you the adjusted comps for U.S. store. So the adjusted comps for total company in the month of November were at negative 11.7%; in the month of December, negative 10.8%; and in the month of January, negative 11.9%. For the U.S. stores, the adjusted comp was negative 9.5% in November, negative 8.6% in December, and negative 9.4% in January."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "And when you give us total company, that is not local currency but U.S. dollar comps for -- as they’re impacted by Canada?"
},
{
"speaker": "Carol B. Tome",
"text": "That is the total company comps in U.S. dollars reflecting exchange rate impacts, yes."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "Okay, good."
},
{
"speaker": "Frank Blake",
"text": "And Craig, do you want to comment on the holiday season?"
},
{
"speaker": "Craig Menear",
"text": "Yes, overall on the holiday season, we were pretty pleased, Matt, with the overall performance when we looked at where we gained share, hand tools, power tools, holiday, decorating. You know, we felt pretty good about the end result. It was a tough environment, obviously, in the market but at the same time, we gained share and we came out as clean as we have ever come out, so we feel pretty positive about it."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "Gotcha, and then one quick follow-up -- you talked about Florida and California showing smaller declines. We’ve heard that from different companies at different times over the past two years, so I guess how consistently have you seen the comp decline moderation in those markets?"
},
{
"speaker": "Frank Blake",
"text": "So it’s been pretty consistent for the last few quarters, Matt, that California and Florida are -- the rate of comp decline is improving."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "How do they compare with the total company level?"
},
{
"speaker": "Carol B. Tome",
"text": "Just a data point -- if you look at -- and this is what we reported, you know, we reported negative comp of 13%. If you back out California and Florida, the comp would have been negative 13.5%."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "Gotcha -- okay, thank you so much."
},
{
"speaker": "Operator",
"text": "Our next question will come from Michael Lasser with Barclays Capital."
},
{
"speaker": "Michael Lasser - Barclays Capital",
"text": "Good morning, thanks. If you start to see competitors become more aggressive from a promotional perspective in the upcoming year, what’s your sense for how you are going to respond, particularly because you will have some gross margin cushion from your enhanced inventory assortment efforts?"
},
{
"speaker": "Frank Blake",
"text": "So Michael, I mean, the -- one of the things that really lies behind the portfolio approach is that we try to articulate pretty clearly for ourselves what the role is of each category and where it’s critical to set the right price impression, where it may not be, where we have some opportunities. And so we’re trying to set the path to provide the most value for the customer and then the response is really going to be dictated by what’s our overall portfolio strategy. Craig, do you want to elaborate on that?"
},
{
"speaker": "Craig Menear",
"text": "For about the last year-and-a-half, we’ve been really focused on trying to work hard to eliminate promotional activity in our business. You know, we’re not 100% there, obviously but that is the strategy to get back to providing great value for our customers every single day. And I think we’ve shared with you on past calls that promotional activity that we had out there in the past wasn’t really nutritive to the business and we are simply converting that type of spend into driving our portfolio strategy and really focusing on the project business. And so we’re conscious, obviously, of the market that we compete in. We have to be because that’s at the heart of driving value to our customers. But we’re going to really react based on our portfolio strategy approach."
},
{
"speaker": "Michael Lasser - Barclays Capital",
"text": "Maybe I’ll ask it a little bit differently then -- how much of the flat to slightly up gross margin guidance for the year is a result of the focus bay approach, and how much is inherent, you know, are you assuming that the promotional environment in the upcoming year is going to become more [intense]? And then what is the risk that there’s a structural change in the home improvement sub-sector that gross margins are structurally lower because everyone else is just chasing traffic? Thanks."
},
{
"speaker": "Frank Blake",
"text": "Well, again, Michael, the way we look at it is our job is to provide the compelling value to our customers and that’s what sets the strategy, so I -- it’s -- we don’t start with an assumption of hey, here’s how we see all the different potentials on the competitive environment. We start from the -- where do we know we have to go to provide great value to our customer and build from there?"
},
{
"speaker": "Michael Lasser - Barclays Capital",
"text": "Okay. Thank you for your comments."
},
{
"speaker": "Operator",
"text": "Our next question will come from Gregory Melich with Morgan Stanley."
},
{
"speaker": "Gregory Melich - Morgan Stanley",
"text": "Thanks. I have two questions -- one on credit and then on CapEx. On credit, we know how much it helps the SG&A, Carol -- have you guys thought about how much it could impact the top line in terms of the percentage of your sales that would be on credit, or reduced credit lines for some of your private label card customers?"
},
{
"speaker": "Carol B. Tome",
"text": "Well, today we are approving 76% of all new applications and in 2008, we opened up $3.2 million accounts. Now, the approval line, if you will, is dropped by about 6% so the average line that’s been approved is $6,850. The through-the-door FICO scores are 705, so we still think that credit is going to be an important value proposition going forward. As a penetration of total sales, it was down slightly from last year at about 28%. We’re really focused on just asking our customers every time they shop with us if they would like to use their private label credit card. We’re not going to push credit at them but we certainly encourage them to use it and we have factored in our best thinking as it relates to credit in the guidance that we’ve given."
},
{
"speaker": "Gregory Melich - Morgan Stanley",
"text": "Okay, great, so you expect to see that could drop a little bit in terms of percentage, like it did last year?"
},
{
"speaker": "Carol B. Tome",
"text": "I think that’s actually very reasonable, yeah."
},
{
"speaker": "Gregory Melich - Morgan Stanley",
"text": "Okay, great. And then on CapEx, for anyone there, if you think about it longer term, the billing that you are doing this year, which makes I guess a lot of sense given where we are in, on a five-year view, what do you think that needs to be or should be, if we were thinking out longer term?"
},
{
"speaker": "Frank Blake",
"text": "Well, I think we’ve said in the past in terms of applying CapEx to new stores that we see a constrained opportunity but there’s still some opportunity, so I think we’ve talked about average -- over time, a little over 1% growth in new square footage, around 1.5%, 1.4% growth in new square footage. So as you go forward, as communities shift, as you have to follow different geographies, they will -- we’ll continue to put in some new square footage but it is going to be significantly less, obviously, than it has been in the past. And there are other things that we obviously are looking at closely. We’ll continue to spend CapEx on our building out our new supply chain on the IT side, as I said in my comments, we’re going to be spending this year, observing how, what the results are in Canada with the new enterprise wide system that they have in place, because if we were to decide to do that, that would obviously require some resources as well."
},
{
"speaker": "Carol B. Tome",
"text": "And as we look out, we can’t imagine a scenario where our capital spending would ever exceed our annual depreciation and amortization expense. And as a reminder, the RDCs are not capital intensive. In 2009, we’ll be spending about $89 million in support of our RDC investment."
},
{
"speaker": "Gregory Melich - Morgan Stanley",
"text": "That’s great. Thanks."
},
{
"speaker": "Operator",
"text": "Our next question will come from Budd Bugatch with Raymond James."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "Thank you for taking my question. Good morning. Can you talk, Carol, the linearity of that basis point of deleverage for every comp point of deleverage? At 13 basis points, how linear is that as that moves up and down? Obviously the comps are a big number now."
},
{
"speaker": "Carol B. Tome",
"text": "Right -- well, we feel pretty good about that. Budd, you know, this is an art, not a science. Could it move a couple of basis points if the comps were worse than we thought? Sure, but we feel pretty good about that."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "And on the upside?"
},
{
"speaker": "Carol B. Tome",
"text": "We should start to see leverage as soon as we hit a 0% comp."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "Okay. Secondly, the 12 net new stores, off of what base are we looking at? Because we still have yard birds and expo and the store count -- I’m just making sure I understand."
},
{
"speaker": "Carol B. Tome",
"text": "Yeah, we have -- yeah, expo is still in there, so it’s just add 12 and subtract 34."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "Okay, and the same for yard birds too? I mean, it’s 12 net off of the --"
},
{
"speaker": "Carol B. Tome",
"text": "Yes, it’s 12 net off -- subtract from the 2,274 that we ended the year, subtract 41 and add 12."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "Gotcha. Okay, and finally on the CapEx, it’s about -- what, about $250,000 per store, if my math is right, right now excluding what you are going to spend on the supply chain? Is that number look like a number that will be constant over a couple of years?"
},
{
"speaker": "Carol B. Tome",
"text": "Well, there are a couple of things to remember -- first, we did some catch-up spending that we don’t need to repeat in 2009. We also have a lot of expense dollars that we spend on just maintaining our stores. In fact, over $500 million of expense dollars go into maintaining our stores. So if we look at what we are spending on a per square footage base, just maintaining the stores, it’s a little less than $3 a square foot and we feel pretty good about that."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "Okay. Thanks, Carol. Thank you very much."
},
{
"speaker": "Operator",
"text": "Our next question will come from John [Zolidis] with Buckingham Research."
},
{
"speaker": "John Zolidis - Buckingham Research",
"text": "Good morning. Just a clean-up question on the foreign currency -- can you tell us what the total impact to sales was in the fourth quarter, and if there was any material impact to the bottom line? And then what is anticipated in the guidance for foreign currency impact in 2009? Thank you."
},
{
"speaker": "Carol B. Tome",
"text": "The impact to sales is about $320 million in the fourth quarter. There was no material impact to the bottom line and as we look out for 2009, included in our guidance is our view that the currencies will stay where they are, so we’re not assuming further strengthening of the U.S. dollar or any weakening as a point, so there is a year-over-year impact to ourselves because of where the currencies are today and that’s included in the guidance."
},
{
"speaker": "John Zolidis - Buckingham Research",
"text": "Can you give us some help on what that might be and since you report the comps in U.S. dollars, is there maybe a 100 basis points impact from FX in that?"
},
{
"speaker": "Carol B. Tome",
"text": "That’s right -- there’s about 100 basis points."
},
{
"speaker": "John Zolidis - Buckingham Research",
"text": "Okay. Thank you."
},
{
"speaker": "Carol B. Tome",
"text": "You’re welcome."
},
{
"speaker": "Operator",
"text": "Our next question will come from Maggie Gilliam with Gilliam & Company."
},
{
"speaker": "Maggie Gilliam - Gilliam & Company",
"text": "Could you comment on what is the status of the SAP system in Canada and what are your plans for implementing it in the U.S.? I know there has been a little bit of talk about simplifying it or making some modifications going forward. Thank you."
},
{
"speaker": "Frank Blake",
"text": "Sure. Good morning, Maggie. First, great credit to the Canadian team and our IT team for the implementation of the system. I mean, you look at major efforts like this and a lot of times, you run into some significant unanticipated issues. This was done on time and the Canadian team really did just an excellent job of getting it in place. Now, going forward, we have the opportunity to figure out okay, what are the benefits, who do those benefits compare to our ongoing efforts to improve our infrastructure here in the U.S., and then assess kind of towards the end of 2009, what’s the best path forward for the United States? Matt Carey, our IT leader, is here in the room and so I -- Matt, if you want to add some comments to that."
},
{
"speaker": "Matt Carey",
"text": "Absolutely. We intend on measuring the impact and the return that we’ve gotten or are going to get in this system and we’ll assess it throughout the year and go through a few seasonal cycles and make sure that it meets our expectations before we make a call."
},
{
"speaker": "Frank Blake",
"text": "Thanks."
},
{
"speaker": "Diane Dayhoff",
"text": "Augusta, I think we’re ready for the next question."
},
{
"speaker": "Operator",
"text": "Our next question will come from Wayne Hood with BMO Capital Markets."
},
{
"speaker": "Wayne Hood - BMO Capital Markets",
"text": "Good morning. I guess on Canada again, Carol specifically to you, I guess as you look at their implementation there, there was some inventory adjustments and as you look at that, what do you see there that might mean or imply inventory adjustments that might be needed in the U.S. if you rolled out SAP and how much is their inventory down up there since that rollout -- about 5% or 10% or can you put some parameters around that?"
},
{
"speaker": "Carol B. Tome",
"text": "Well Wayne, we haven’t done the analysis in the United States to be able to quantify what it could mean but anytime you convert, and I think you know we converted from retail method of inventory to cost and there was an inventory adjustment that took place, so that impacted the gross margin performance in the fourth quarter. We also had some shrinkage and that was really because of the disruption associated with the implementation. So I can tell you what it meant to Canada, which we called out in this overall impact to the company gross margin up in Canada -- it was about 23 basis points. The inventory piece related to the score or SAP implementation was about 12 basis points. So I can’t tell you what it means for the U.S."
},
{
"speaker": "Wayne Hood - BMO Capital Markets",
"text": "Okay, and then I just had a quick question for Craig; Craig, you indicated some increase in units you are employing in some of these other areas. I am just wondering, when you think about fully allocating expenses back to these labor intensive departments, what level of profitability are you seeing year over year, even though your share may be up?"
},
{
"speaker": "Craig Menear",
"text": "When we look at our flooring business -- for example, soft flooring has been a very strong business for us, where we’ve been gaining share and when we look at the overall profitability of that product category, we’re actually very pleased with our results."
},
{
"speaker": "Wayne Hood - BMO Capital Markets",
"text": "So it’s up year over year, fully allocated?"
},
{
"speaker": "Craig Menear",
"text": "All in, when you look at everything, yeah, we’re very happy with where we are at."
},
{
"speaker": "Wayne Hood - BMO Capital Markets",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question will come from Brian Nagel with UBS."
},
{
"speaker": "Brian Nagel - UBS",
"text": "Good morning. I wanted to just follow-up; you commented in your prepared remarks about California and Florida, and seeing some signs of stabilization there and some weakness, some incremental weakness in other markets. I guess as we think about the trend of business throughout the country and how the trend is likely to change potentially as we go through 2009, are there regions of the country that are still uncharacteristically strong, that are helping to support comps? That’s one question. And then the second, going back to California and Florida, as you’ve seen maybe signs of stabilization there, do you think that reflects, or to what degree does that reflect sales of foreclosed homes?"
},
{
"speaker": "Frank Blake",
"text": "Brian, a couple of comments -- the first would be, just so that everybody is clear, they are still declining, so -- I mean, it’s not stabilization in the sense of oh, okay, well, we’ve actually bottomed. This is just a rate of decline that is slowing. The second, in terms of areas that are positive, as Craig called out in the weather-impacted areas, we’ve seen positive comps, so we’ve seen positive comps in our Gulf area, for example."
},
{
"speaker": "Brian Nagel - UBS",
"text": "And then as far as foreclosures, are those helping to drive better -- or I guess less bad results?"
},
{
"speaker": "Frank Blake",
"text": "Yeah, I mean there is an advantage to existing housing turnover. That’s something clearly that is relevant to our business and clearly a lot of the turnover in those areas has been from foreclosed housing."
},
{
"speaker": "Craig Menear",
"text": "We also see when you look at product categories, things like vinyl flooring, cleaning, in-stock carpet -- all of those businesses and compared to the total company are relatively strong businesses and we think that that’s a combination of people that are beginning to fix up some of these homes but also the fact that there is high rent impact out there, where more people are renting."
},
{
"speaker": "Brian Nagel - UBS",
"text": "Okay. Thank you very much."
},
{
"speaker": "Operator",
"text": "Our next question will come from Shannon Joseph with Wachovia."
},
{
"speaker": "Shannon Joseph - Wachovia Capital Markets",
"text": "Actually, my questions have already been answered. Thanks."
},
{
"speaker": "Operator",
"text": "Our next question will come from Eric Bosshard with Cleveland Research."
},
{
"speaker": "Eric Bosshard - Cleveland Research",
"text": "Good morning. Two things as we think about 2009 -- first of all, I guess one for Craig, and that is as you think about the merchandising strategy in response to the consumer, can you just give us a little detail on categories or areas or price points or what you are thinking about proactively and how you are going to position merchandising? And then secondly for Marvin, if he’s in the room, just a similar question for how you are thinking about staffing stores and service levels in anticipation of what you are looking at for 2009."
},
{
"speaker": "Frank Blake",
"text": "Okay. Marvin is in the room, so he’ll respond to the second part of your question, Eric. Craig."
},
{
"speaker": "Craig Menear",
"text": "Eric, as it relates to kind of how we are looking at the merchandising piece, using our assortment planning tools, we are actually expanding the variety or clusters, if you will, of assortments that we are putting out there, trying to be more granular to approach specific customer needs and specific types of stores. So we have an improvement in, for example, in our seasonal areas of things like patio grills, power equipment, and so on, where we have put more clusters to be more granular. Also, the other thing that we have focused on is really making the adjustments where we feel it was necessary and potentially shifting to stronger opening price point and mid-price points, and we have assorted accordingly as we move into 2009 to make those types of adjustments. And then as I mentioned, we are also watching, because we think that there is potential upside where customers will in fact potentially opt out of services that they have around their home today and elect to do it themselves, and what we saw in snow equipment in the fourth quarter was that actually -- that translated into our better product selling at the top end of the line and we’ll be prepared to make those type of adjustments to fulfill those customers’ needs as well."
},
{
"speaker": "Unidentified Participant",
"text": "Eric, good morning. This is Marvin. The second half of your question, we’re really going to keep it very basic. We have spent a lot of time simplifying the stores, removing task and making sure that we are positioning associates in the customer facing areas of the business. So for ’09, it’s going to be a focus on training, as Frank mentioned earlier. We are going to re-orient and re-train every single associate on the fundamentals of customer service. We’ve never done that before and we are going to focus on that in the first quarter. We are also going to make sure that we have our associates in the parts of the store during the times of the day that we have our greatest customer traffic and we are going to just focus on customer service. Our goal is going to be to execute well so that we can bring some of the merchandising events and new products to life with better service and just better associate know-how, so really taking [inaudible], customer service, and associate know-how will be the plan for 2009."
},
{
"speaker": "Eric Bosshard - Cleveland Research",
"text": "And in terms of staffing levels relative to sales, is there any adjustment being made in the model?"
},
{
"speaker": "Unidentified Participant",
"text": "No, it’s not -- I mean, we have an activity based system that is staffed based on departments, so an example would be when we have a department that is performing well, like our repair maintenance categories, you will see more associates in that area because sales are up. And when we have some [inaudible] that may be slightly down, you will see less associates based on the number of customers. So department by department, store by store, and we feel like that has served us well and we’ll continue that for 2009."
},
{
"speaker": "Eric Bosshard - Cleveland Research",
"text": "And then lastly on that, is there any change in the minimum staffing target as the sales continue to contract?"
},
{
"speaker": "Unidentified Participant",
"text": "No, because we staff based on departments, we don’t look at minimum staffing by store. We focus on a department-by-department basis. If you look at our store, we are a store made up of many different, smaller stores. A hardware store, plumbing store, so we think a department-by-department focus is the best method for us to serve our customers."
},
{
"speaker": "Eric Bosshard - Cleveland Research",
"text": "Great. Thank you."
},
{
"speaker": "Diane Dayhoff",
"text": "Augusta, we have time for one more question."
},
{
"speaker": "Operator",
"text": "That question will come from Chris Horvers with J.P. Morgan."
},
{
"speaker": "Christopher Horvers - J.P. Morgan",
"text": "Yes, made it in. I was going to say best for last, but -- so first to clarify, we’ve received a number of questions about guidance, so it’s $1.37, down 7% -- that’s $1.27. Should we think about adjusting for that $132 million of one-time expenses in 4Q as well?"
},
{
"speaker": "Carol B. Tome",
"text": "Yes, when we said on an adjusted basis, EPS would be down around 26%, we’re adjusting out the expenses in 2008 and 2009, related to the business rationalization."
},
{
"speaker": "Christopher Horvers - J.P. Morgan",
"text": "Right, so the point forecast is like $1.32-ish, something like that."
},
{
"speaker": "Carol B. Tome",
"text": "On an adjusted basis."
},
{
"speaker": "Christopher Horvers - J.P. Morgan",
"text": "Right, yes, on an adjusted basis. Okay, that’s perfect. And then can you talk of a follow-up question on the promotional environment -- you know, Lowe’s results last week caused a lot of concern out there. Have you seen Sears pull back? What is Menards doing? Has Lowe's changed their pricing strategy? And then broadly on inventory, it seems like you guys are very clean. How do you think the channel looks and your other big retail competitors?"
},
{
"speaker": "Frank Blake",
"text": "Well first, look, it’s always a competitive market. I mean, we’re always responding to customers, we’re always out there trying every day to have the best pricing for our customers, so that’s going to be the same in 2009 as it was in 2008. And in terms of our competitors inventory positions, I guess I’m not really in a position to comment."
},
{
"speaker": "Christopher Horvers - J.P. Morgan",
"text": "From what you are seeing in the channel and the suppliers, do you think they are clean, so it’s not like there’s a lot of inventory that needs to be cleared out?"
},
{
"speaker": "Frank Blake",
"text": "In our channel?"
},
{
"speaker": "Christopher Horvers - J.P. Morgan",
"text": "Yeah, your vendors."
},
{
"speaker": "Craig Menear",
"text": "I really -- you mean from the vendor standpoint, Chris?"
},
{
"speaker": "Christopher Horvers - J.P. Morgan",
"text": "Yes."
},
{
"speaker": "Craig Menear",
"text": "Yeah, I mean, I think our vendors are probably in pretty good shape as we talk to them. You know, everybody in this environment is trying to watch how they manage their business, so I’m not hearing anything from our vendor community that has them with dire concern over inventory position. You know, and just one other comment as it relates to kind of how we are approaching the environment -- it is the job of our merchants to understand and anticipate where they think the market will go as they build their assortments for a given year, and we take into account what we think will happen the best we can and then assort accordingly, which is why we’ve made some of the adjustments that we’ve made within the line structures as we move into 2009."
},
{
"speaker": "Christopher Horvers - J.P. Morgan",
"text": "Okay, and then just one final one -- so then Craig, how have you ordered Spring on a year-over-year inventory basis?"
},
{
"speaker": "Craig Menear",
"text": "We have --"
},
{
"speaker": "Frank Blake",
"text": "You know, Chris, I think that’s probably not --"
},
{
"speaker": "Craig Menear",
"text": "More competitive information than I want to give out."
},
{
"speaker": "Christopher Horvers - J.P. Morgan",
"text": "Okay, fair enough. Thank you."
},
{
"speaker": "Frank Blake",
"text": "Thank you, Chris."
},
{
"speaker": "Diane Dayhoff",
"text": "Thank you all for joining us and we look forward to talking to you at the end of next quarter."
},
{
"speaker": "Operator",
"text": "This does conclude our call. We would like to thank everyone for their participation. Have a great day."
}
] | null | null |
HD | 3 | 2,008 | 2008-11-18 09:00:00 | Executives: Diane Dayhoff - Senior Vice President, Investor Relations Frank Blake - Chairman and Chief Executive Officer Craig Menear - Executive Vice President, Merchandising Carol B. Tome - Chief Financial Officer and Executive Vice President, Corporate Services Matt Carey - Executive Vice President, Chief Information Officer Mark Holifield - Senior Vice President, Supply Chain Marvin Ellison - Executive Vice President, U.S. Stores
Analysts: Colin McGranahan - Sanford C. Bernstein & Co. Peter Benedict - Wachovia Capital Markets, LLC David Strasser - Banc of America Securities Michael Baker - Deutsche Bank Securities Scot Ciccarelli - RBC Capital Markets Christopher Horvers - J.P. Morgan Deborah Weinswig - Citigroup Alan Rifkin - Merrill Lynch T.J. McConville - Raymond James Matthew Fassler - Goldman Sachs Michael Lasser - Barclays Capital
Operator: Good day, everyone, and welcome to today's Home Depot third quarter earnings conference call. (Operator Instructions) Beginning today's discussion is Diane Dayhoff, Senior Vice President of Investor Relations. Please go ahead, ma'am.
Diane Dayhoff: Thank you, [Augusta], and good morning to everyone. Welcome to The Home Depot third quarter earnings conference call. Joining us on our call today are Frank Blake, Chairman and CEO of The Home Depot, Craig Menear, Executive Vice President, Merchandising, and Carol Tome, Chief Financial Officer and Executive Vice President, Corporate Services. Following our prepared remarks, the call will be opened for analyst's questions. Questions will be limited to analysts and investors and, as a reminder, we would appreciate it if the participants would limit themselves to one question and one follow up, please. If we are unable to get to your question during the call, please call our Investor Relations Department at 770-384-2387. Before I turn the call over to Frank, let me remind you that today's press release and the presentations made by our executives include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties. These risks and uncertainties include, but are not limited to, those factors identified in the release and in our filings with the Securities and Exchange Commission. Now let me turn the call over to Frank Blake.
Frank Blake: Thank you, Diane, and good morning, everyone. Sales for the third quarter were $17.8 billion, down 6.2%. Comp sales were negative 8.3%. As Carol will describe, sales for the quarter were negatively impacted by approximately $225 million because of the seasonal shift associated with 53 weeks in fiscal 2007. Adjusting for that, comp sales were negative 7.1%. Diluted earnings per share were $0.45. You all obviously know that this is a difficult environment in the housing and home improvement markets. The view we had at the start of the quarter, that we might be nearing a bottom - our August was actually better than we'd planned - gave way to the financial crisis in September and beyond. We've seen the kinds of pressure you'd expect in this environment. Our big ticket sales are down significantly, as Craig will describe. Our customers are finding credit harder to come by, as Carol will discuss, and we're generally seeing continued softness in tough markets and erosion in previously strong markets. Let me give you some specifics. Since the mid-September and forward time period is the most relevant, we look at the rolling six-week comp performance of our top 40 markets versus Q3 2007. Of those top 40 markets, only 15 are performing better now. So we are not seeing the improvement that we thought we'd see as we cycled against the soft comparisons from last year. And where we are seeing better performance, frequently there's only fractional improvement. So, for example, Miami is performing better, but is still mid-teens negative comping. We've seen some improvement in California and New England but, again, these markets remain under pressure. At the same time, previously strong markets have eroded. Last year the Northwest was a relatively strong area for us. Now Seattle, Portland, and Spokane have negative double-digit comps. We expect that these pressures will continue into the fourth quarter and 2009. In many respects the difficult market is obscuring the progress that our associates are making. Our customer service levels as reflected in our Voice of the Customer surveys continued to improve. Marvin Ellison, our Executive Vice President, U.S. Stores, has implemented significant changes in our store operations, making our approach simpler, more consistent, and more customer-focused. On the merchandising side, you can already see some of the improvements Craig and his team have accomplished. It's an enormous challenge to operate a business our size in a declining market with rapidly changing commodity prices and achieve price leadership, margin stability, and inventory control. For the quarter, we launched a strong new lower-priced campaign, achieved significantly better markdown control, and lowered per-store inventory by 7.5%. I believe we have better execution in our business across merchandising, operations, supply chain and our supporting functions than we have had in quite awhile. At the end of October we opened our fourth Rapid Deployment Center or RDC in Winchester, Virginia. RDCs now serve approximately 400 of our stores. We remain committed to enhancing our supply chain and are pleased to be back on the track of opening facilities. This year we have one more facility that we will open in the fourth quarter. Our International businesses, particularly Canada, have started to feel some of the economic pressures that we've had in the U.S. Canada had mid single-digit negative comps and saw a similar pattern of accelerated declining sales in the quarter. In addition, our Canadian team tackled a major business system implementation with SAP Core Retail, which is now live in all our Canadian stores - a substantial undertaking in the midst of very difficult market conditions. The rest of our business will now benefit from the learnings we can gain from the Canadian effort, and I'm very excited to have Matt Carey, who has over 20 years of experience with WalMart and eBay, on board as our new EVP and CIO to help us in that effort. China also reported negative comps, driven in large part by the impact of the Olympics in China in August. But Mexico continued its strong performance with another quarter of double-digit positive comps. Across our entire business, we are making the adjustments necessary to respond to a tough market environment. We are carefully controlling our discretionary spending, scrutinizing every dollar of capital, and, most importantly, intensifying our focus on our customers. The culture at Home Depot is our strength, and I want to thank our associates for responding well in a tough time. Now let turn the call over to Craig.
Craig Menear: Thanks, Frank, and good morning, everyone. In the third quarter we experienced negative comp sales growth in all departments except building materials, which was driven by strong sales in roofing and insulation. Both categories increased in the number of units sold, though it should be noted that some of the comp dollar gain in roofing was driven by higher prices due to increased petroleum costs. Additional departments that outperformed the company's average comp were plumbing, hardware and garden. The departments that underperformed the company average comp were kitchen and bath, millwork, electrical, lumber and flooring. And paint performed at the company's average comp. Average ticket was down $1.62 or 2.8% from last year to $55.86. We saw a decline in two areas. First, big ticket sales continued to suffer. For example, [special] kitchens were down nearly 30% versus last year. And second, we saw that approximately 40% of the decline in average ticket was due to lower average spending per basket. From a regional perspective, areas of the North, particularly the Northern Plains and Ohio Valley, performed above the company's average comp in the third quarter. The same is true for parts of the South, like Texas, Oklahoma and Louisiana. The positive results along the Gulf are attributed primarily to hurricane-related sales. Hurricanes Gustav and Ike added approximately $125 million in incremental sales in the quarter; however, we did not realize any benefit to the bottom line as those sales were low margin sales and margin dollars were offset by additional expenses such as freight, store damage and associate cost. I am proud of the cross-functional team's efforts before, during and after the storms to ensure our products and associates were in place to help our customers and their communities. As Frank has said, in this challenging environment, we need to remain focused on executing and improving those things that we can control. We have discussed for several quarters the implementation of our portfolio strategy, and while we still have a long ways to go, we're starting to see the deliberative results. One such result was reflected in our transactions. While total company transactions of $315 million were down 3.4% year-over-year, we saw an improving trend during the last six weeks of the quarter. One of our ongoing initiatives has been to reduce promotions and refocus our efforts on being an everyday value provider as part of our portfolio strategy. By the third quarter, we felt that we had accomplished enough in this transition to effectively communicate our progress to our customers. Our marketing campaign supporting our new lower price reinforces the everyday value message. Our new lower price program increased transactions and drove attachment sales. Another metric supporting the initial success of our portfolio strategy and overall merchandising transformation was our gross margin results. The third quarter presented the most volatile commodity market I've ever seen; however, we worked through it and we saw a 27 basis point improvement in gross margin over the third quarter last year. Early this year we introduced new tools to our merchants to better plan, assort and react to changes in the market by forecasting at a more granular level. The clarity that these tools provided drove gross margin and inventory productivity, particularly in our seasonal categories. In the third quarter alone, we saw a 200 basis point gross margin improvement in our U.S. garden category due to lower markdowns. All the merchandising initiatives that I've described so far are also driving the results in market share. In the U.S., 6 out of 13 departments gained unit share in the third quarter, and 10 out of 13 showed share improvements from where they ended the second quarter. Based on independent third-party tracking of consumer activity, we saw strong share gains in several key merchandising classes. For example, insulation, carpet, ceramic tile, power tools, toilets, faucets, grills and molding all gained share in the quarter, to name a few. Many of these classes received concentrated merchandising focus and investment, utilizing our portfolio strategy. For example, in molding we updated the assortments regionally, refined the merchandising sets, improved the value proposition, and added point of sale information, making it easier for our customers to shop and make a selection. As we look to the fourth quarter, we expect that we will continue to see relative strength in energy efficient and basic repair products. We have a compelling selection of value conscious and energy efficient products. We are positioned well in holiday products, including our expanded assortment of LED lighting, our gift centers have strong values in hand tool sets and power tools across varying price points, and we're ready to serve the storage and organization needs of our customers following the holidays. In this difficult environment, we are focused on things that we can control and executing on them. We will continue to execute our portfolio strategy, make assortment and pricing adjustments, implement resets, and drive project sales by the way we position merchandise in our stores. We believe these actions improve the value proposition for our customers and simplify their shopping experience. And now I'd like to turn the call over to Carol.
Carol B. Tome: Thank you, Craig, and hello, everyone. In the third quarter, sales were $17.8 billion, a 6.2% decrease from last year, reflecting negative same-store sales of 8.3%, offset in part by sales from new stores. Net earnings were $756 million compared to $1.1 billion last year. Earnings per diluted share from continuing operations were $0.45 versus $0.59 last year. Comp store same-store sales were negative 8.3% for the quarter, with negative comps of 6.5% in August, negative 7.4% in September, and negative 10.5% in October. The last three weeks in October were particularly weak. In fiscal 2007 we had 53 weeks in the year. This shifted our 2008 fiscal calendar. Because of this shift and given the seasonal nature of our business, third quarter sales on a like-for-like calendar basis were negatively impacted by approximately $225 million. Excluding the calendar shift, our likeforlike comp for the quarter was negative 7.1%. Roughly 10% of our sales are outside of the United States. Late in the third quarter we saw significant strengthening of the U.S. dollar against all currencies. The impact to total sales was about $40 million. And similarly, from an earnings perspective, the strengthening of the U.S. dollar did not have a material impact in the quarter. In the third quarter our gross margin was 33.7%, an increase of 27 basis points from last year, and reflects the benefits arising from our focused-based portfolio approach as well as a shift in the mix of products sold. Specifically, our gross margin expansion was driven by the following factors: First, lower markdowns coupled with a smarter approach to promotions covered the cost of our new lower price program and drove 23 basis points of margin expansion. Second, a decline in the penetration of our lower-margin kitchen and appliance category drove 14 basis points of margin expansion. And finally, we experienced a contraction in our gross margin of 10 basis points resulting from clearance activities taken in connection with the one-time conversion of our Canadian stores to their SAP Core Retail platform. In the third quarter, operating expenses increased by 214 basis points to 26.3% of sales. Our expense deleverage reflects for the most part the impact of negative sales. Generally, we expect to deleverage expenses by about 20 basis points for every point of negative comp. In the third quarter, our expense deleverage per point of negative comp was approximately 17 basis points for a total of 144 basis points of deleverage. Further, as expected, in the quarter we experienced an additional 70 basis points of expense deleverage due to a higher cost of credit associated with our private label credit card. In the third quarter, our total cost of credit as a percent of private label credit sales was approximately 2.2%. Looking forward, our new private label credit card contract with Citi begins in January of 2009 and at that time the cost of credit will be capped at 1.5% of private label credit sales. As you know, a great deal of pressure has been placed on consumers and therefore retail sales due to tightening of consumer credit. Sales under our private label credit card made up 28% of our total sales compared to 30% one year ago. Today, over 70% of our new account applications are granted credit lines, but the average approval limit has decreased by 5% from last year. Further, in some cases existing credit lines have been reduced. So as we look out, continuing pressure on credit availability could potentially impact sales. Our operating margin was 7.4% in the third quarter, down 186 basis points from last year. Net interest expense was $151 million, an increase of $26 million from last year, reflecting a decline in interest income due to the lower interest rate environment and lower investable cash balances. In the third quarter our income tax provision rate was 35.5%. We expect our tax rate to be approximately 36.1% for the year. Diluted shares were 1.69 billion shares compared to 1.82 billion shares last year. The reduction in outstanding shares is due to our share repurchase program and includes the tender offer we completed in September of 2007. At the beginning of the third quarter, we repurchased 2.4 million shares for $70 million. When the financial markets shut down, we put our recapitalization program back on pause and it will remain on pause until further notice. Now moving to our operational metrics, during the third quarter we opened 11 net new stores for an ending store count of 2,268. Today, 257 stores representing approximately 11% of our store base operate in Canada, Mexico and China. At the end of the quarter, selling square footage was 238 million, a 2.1% increase from last year. Reflecting the sales environment, total sales per square foot were approximately $296 for the quarter, down 8.5% from last year. Sales per square foot for our new stores were up 2.1% from last year. Now turning to the balance sheet, our balance sheet and our cash position remain strong. At the end of the quarter we had $874 million in cash and no outstanding commercial paper. As a reminder, we have a $3.25 billion A2/P2 commercial paper program that is 100% backstopped by a committed long-term bank line of credit. We do not foresee the need to access the commercial paper market during the remainder of the fourth quarter; however, if we need to issue commercial paper, we believe the market is open to us at this time. We have approximately $11 billion of long-term debt of which $1.7 billion comes due in 2009. The average duration of our long-term debt portfolio is approximately 11 years. We ended the quarter with $44.2 billion in assets. Since the end of the year, our cash position has increased by approximately $400 million, reflecting cash flow generated by the business of approximately $4.9 billion offset by $1.4 billion of capital expenditures, $1.1 billion of dividends paid, and $2 billion used to repay outstanding commercial paper and an operating lease obligation. At the end of the quarter, retail inventory was $11.9 billion, down 5.7% from last year. On a perstore basis, inventory was down 7.5%. Our operators and merchants have done an excellent job of controlling inventory in this sales environment. The quality of our inventory has never been better and clearance inventory is at a record low. Further, our in-stock level is at a record high. Reflecting the sales environment, however, inventory turnover was 4.2 times compared to 4.4 times last year. Computed on the average of beginning and ending long-term debt and equity for the trailing four quarters, return on invested capital for continuing operations was approximately 11.6%. Excluding the store rationalization charge earlier this year, our return on invested capital was approximately 12.7%. As we look forward we continue to project a challenging sales environment. We've been controlling what we can control, but November comps to date are about the same as October. Based on our year-to-date results, the stronger U.S. dollar, and our view that the consumer could be very challenged in the fourth quarter, we now believe that fiscal 2008 sales could be down as much as 8% for the year. We continue to project that our earnings per share from continuing operations excluding the store rationalization charge will be down approximately 24% from last year. We will share our 2009 guidance with you during our fourth quarter earnings conference call, which is scheduled for February 24. So thank you for your participation in today's call and Augusta, we are now ready for questions.
Operator: (Operator Instructions) Your first question comes from Colin McGranahan - Sanford C. Bernstein & Co.
Colin McGranahan - Sanford C. Bernstein & Co.: Craig, you said that 40% of the decline in ticket was due to lower spending per basket. I'm assuming the remaining 60% decline in average ticket, then, was due to mix - fewer large ticket purchases. Can you comment maybe how that compares over the course of the last, I don't know, year or two and what that implies in terms of how the mix impact is working on the average ticket?
Colin McGranahan - Sanford C. Bernstein & Co.: Yes, Colin. The balance was in fact the decline in average ticket. We're continuing to see pressure in big-ticket categories like kitchen and millwork that is impacting the overall average ticket. And I would tell you that in the third quarter, as we looked at those larger transactions above $500 or $1,000 - they took a step down to double-digit.
Carol B. Tome: I'll just jump in on the appliance side, because I think this is important. If you look back in 2007 and 2006, we saw average ticket growth because of an increasing penetration of our appliances. In the third quarter we lost $0.17 in our ticket just due to appliance.
Colin McGranahan - Sanford C. Bernstein & Co.: And then the second question, I don't know if Matt Carey is actually on the call, but if he is -= and if he's not, maybe someone else can jump in - just in terms of what are the initial experiences with SAP in Canada, what you've learned and how you're thinking about those learnings in terms of U.S. IT implementation.
Frank Blake: Colin, Matt is here so Matt, why don't you address it.
Matt Carey: Sure. You know, it's early days. We are just in the very end of the rollout. The team's been focused very hard in completing the rollout, and we'll be assessing the performance of those stores and that business in the coming year and learning as much as we can such that we can help the U.S. business as well.
Frank Blake: And Colin, the one thing I'd say is we entered this with a number of questions and one of the first questions was could we do it? I mean, could we implement this without just a dramatic impact on the business because, frankly, you look at other big implementations like this and there have been some significant - beyond divots - huge potholes. And I think credit to the Canadian team and to Matt's team, you know, the implementation as an implementation, it's gone pretty well.
Colin McGranahan - Sanford C. Bernstein & Co.: It seems like you converted all the stores. There were no major snafus.
Frank Blake: Right.
Colin McGranahan - Sanford C. Bernstein & Co.: Up and running. And you're probably already seeing some initial benefits, I would imagine.
Frank Blake: Well, again, tough as I outlined, Canada is seeing - you know, if you think about Canada, they've got some of the same issues in terms of impact from the auto industry, oil and gas. So it's way too early yet for us to be able to tease out what the benefits are as they wrestle with a tough market.
Operator: Your next question comes from Peter Benedict - Wachovia Capital Markets, LLC.
Peter Benedict - Wachovia Capital Markets, LLC: Again on the average ticket, it's been down the last nine quarters and I think the third quarter number puts us basically back to where we were in about the third quarter of 2004. When you look at the mix of your business and the stores today, what period would you say it's most similar to over the past several years? Is it like 2004 or is there some other year that we can look back to that would be more representative of what you're seeing in the stores today?
Craig Menear: I would tell you that as we look at the current decline in the big ticket, the change in our business from 2004 to now as it relates to appliances, I don't think you can really compare it to - I think the mix is different. So we've grown our appliance business significantly since 2004, and on the flip side, you know, in this current environment, the categories like kitchen cabinets are down significantly. So I'm not sure it's a fair comparison.
Frank Blake: Peter, it really is tough because, as both Carol and Craig said, you've got to look at categories. I mean, I think of things like countertops that we were barely in in 2004 versus now.
Carol B. Tome: More kitchen, flooring, the whole emphasis on specialties is very different. And that's our business model; it's just being impacted by the economic environment.
Frank Blake: Correct.
Operator: Your next question comes from David Strasser - Banc of America Securities.
David Strasser - Banc of America Securities: So, quickly, when you look at the mix of stores around the country - the Northeast now is about 17% of stores; the Midwest, 10% of stores - you can make a good argument that those areas, based on what's happening in the economy, are going to get worse. When you look at some of the mistakes or some of the positive things you were able to do in areas like Southern California, Nevada, Florida, what have you learned that you can use to anticipate slowdowns as some of the things that are going on in those areas start to materialize.
Frank Blake: So, David, I'd say - and this is more anticipation than direct experience at this point - I would expect that the dynamics are going to be different. So when you look at California, Florida, Nevada, you had just a lot of speculative homebuilding. You had strong employment, strong underlying GDP growth, but a housing bubble that had a direct impact on us as that bubble collapsed. I suspect we're going to be seeing a different dynamic play out going forward where it's less a housing bubble unwinding than it is a region dealing with basic difficulties on economic growth and employment. So just on your premise, we're not anticipating that it will be same-same and we can have hypotheses on how that will play out in our stores, but I think we're going to see a very different unfolding.
David Strasser - Banc of America Securities: Just as a follow up, at the beginning of the call you had said the Northeast. Could you just repeat what you had mentioned, how the business had trended there?
Frank Blake: Yes. The comment on New England was that it's better than it was, which is good, but I want to be very cautious in saying better is truly a relative term and that it's still under pressure.
Operator: Your next question comes from Michael Baker - Deutsche Bank Securities.
Michael Baker - Deutsche Bank Securities: So you said November was about where it was in October. Is that that 10.5% that you said for October? It sounds like the end of October was worse than the total October of 10.5%, so I just wanted to clarify where November was relative to that.
Carol B. Tome: It's around the negative 10.5% area.
Michael Baker - Deutsche Bank Securities: I think the sales guidance, the full year sales guidance, down 8% seems to imply down 18% for the fourth quarter. You have one fewer weeks so; you adjust that, maybe down 12% or 13%. You get a percent or two from square footage, so it sounds like the guidance for the comp, at least, is a little bit worse than down 10%, if my math is even close to right. So is that just being conservative, thinking things might drop off, or is my math just completely off?
Carol B. Tome: Your math is right. What's included in our guidance is our view of the U.S. dollar's impact to our fourth quarter sales. You know, the U.S. dollar strengthened at the end of the third quarter so it didn't have a big impact to our third quarter, but we assume that the dollar will remain strong in the fourth quarter and that will have an impact to our sales outside the United States.
Michael Baker - Deutsche Bank Securities: By a percent or two or something along those lines?
Carol B. Tome: We're thinking about almost a couple percent.
Operator: Your next question comes from Scot Ciccarelli - RBC Capital Markets.
Scot Ciccarelli - RBC Capital Markets: What has been the big change in terms of the sales trends in October/November? I'm sure it's just a continuation, but are we seeing incremental pressure on traffic or is it incremental pressure on ticket or is it both?
Frank Blake: Well, I think I'll turn it to Craig, but as Craig was outlining, we actually feel like we're gaining some traction on the transactions, but just seeing continued pressure on ticket.
Craig Menear: Yes, that is correct. We looked at transactions actually in October. We actually saw a significant change and improvement in transactions. But when you look at ticket in the month of October, that fell significantly. Ticket above $500 was double-digit off.
Operator: Your next question comes from Christopher Horvers - J.P. Morgan.
Christopher Horvers - J.P. Morgan: I want to understand, you know, maybe how we should read the stat trend or the trend in the business as you enter the fourth quarter and try to get our arms around A) how do compares ease as you go from November to January, and B) how much should we read into or ascribe the shift down in comps to the fact that the seasonal and the maintenance categories, well, they just don't do as well when everybody's holed up in the winter, with the windows shut and the heat on.
Carol B. Tome: Well, let me answer the first part of your question if I could. In terms of comparisons, looking at last year - and remember, there's a calendar shift that distorts some of this - but last year our comps were negative 6 - 6 in November, negative 7 - 2 in December, and negative 10 - 8 in January. So from a comparison, it would appear that January is the easiest compare.
Frank Blake: In terms of your comment on the product assortment and what sells, the mix, it's going to be roughly the same year-over-year, that same shift away. Obviously, there are a lot of things like kitchen remodels and new flooring and the like that really slow down pretty significantly once you're past, frankly, this period, once you're past the Thanksgiving Day period.
Craig Menear: And when you look at the seasonal impact of, like, the garden department, the big shift obviously comes from Q2 to Q3. It's much less significant Q3 to Q4.
Christopher Horvers - J.P. Morgan: So maybe coming at it from a different angle, how much would you say because of that mix shift away from outdoor and from seasonal, how much of this is just a dip down because we're entering that time of year and how much might maybe we recover in the first half next year when you get into a better seasonal period?
Frank Blake: Well, again, on the comp perspective, you're comparing same dip to same dip, and then obviously our business does pick up. January is our lowest month.
Carol B. Tome: If you look at just total sales dollars, you should [inaudible] just because of the seasonal nature, and then it picks right back up when spring comes.
Christopher Horvers - J.P. Morgan: And a follow up question on SG&A trends. You've been basically keeping SG&A per foot flattish here in the first three quarters of 2008. How should we think about your ability to keep it flattish into 2009, either from a maintenance SG&A spend perspective or from stores on minimum staffing level?
Carol B. Tome: Well, let me first talk about the fourth quarter. For the fourth quarter we expect our expenses per average store to be down from what they were a year ago. Two reasons for that, primarily lower advertising spending in the fourth quarter this year versus last year, and then last fourth quarter you may recall that we had some write-offs associated with stores that we elected not to open. There was a big write-off for a store in San Francisco, if you remember that. We won't be repeating that in the fourth quarter, so expenses should be down on a per square foot basis. And as we come back to you at the end of the fourth quarter, we'll give you the guidance for 2009 and we'll let you know what we think about expenses on a per store basis. But clearly, this is an area of real focus.
Operator: Your next question comes from Deborah Weinswig - Citigroup.
Deborah Weinswig - Citigroup: So, Carol, originally or last quarter you had given guidance of sales to decline 5% for fiscal '08. Now you're saying potentially an 8% decline, but we're keeping earnings guidance kind of down 24%. Is the major difference on the gross margin side or how should we think through that?
Carol B. Tome: Well, we had a good earnings quarter in the third quarter; our earnings were better than our plan. So we're able to take that into the fourth quarter. And then as we look at the fourth quarter, you know, Craig's talked to you about the new tools that we're using that allow us to forecast sales margin and inventory now for 200 classes on a weekly basis. That's giving us better visibility on what we think the margin will do in the fourth quarter and that's giving us comfort for the guidance that we gave.
Deborah Weinswig - Citigroup: And then also can you talk about your inventory performance in the quarter? Certainly very impressive, especially in light of the environment.
Frank Blake: This is a joint effort of everybody on the team. I mean, it starts with Craig and his merchandising team and Carol and her finance team working with them on the planning process and Marvin on the store execution side and supply chain. I mean, it really is just - it's connecting a lot of - this isn't a very fancy answer, but it's just connecting a lot of dots within the business in a more effective way.
Craig Menear: It's really the new tools are giving us great visibility and has changed how we manage the business. And quite honestly, when we look at the inventory overall, it was widespread. It wasn't concentrated in a significant or one area; it was widespread across all our merchandising departments.
Deborah Weinswig - Citigroup: So, Frank, would you say it's a much more collaborative effort?
Frank Blake: Again, yes. I mean, I think there are lots of opportunities for us to improve our operations, and these are the kinds of time periods that force us to get those. And as Craig said, you know, develop the new tools that help us communicate better within the organization.
Deborah Weinswig - Citigroup: What are you seeing with regards to stores that are being serviced by the RDC network and, in terms of the RDC network, how shall we think about 2009?
Frank Blake: Well, one of our - and Mark is here and he can address that as well - but when we put this on pause we had a series of benchmarks that we wanted to hit before we would start again, and one of them was how are we performing with the stores in terms of accuracy of shipments and how are the stores performing in terms of out-of-stocks, and we hit those targets, which is what gave us confidence to restart the rollout process. And our plan is to continue through 2009 and 2010. Mark, if you want?
Mark Holifield: Yes, just that we had opened our Winchester facility. We're in our fourth week of operations there. We're experiencing no significant issues and pleased with the progress there. As Frank said, the main things we're looking at from a store perspective is the in-stock in the store and our RDC stores perform better than our other stores. We're looking at our ability to service the stores with very accurate loads and timely delivery. So we believe we're on track to achieve our ultimate targeted levels over time, so we're pleased with that progress. In terms of 2009, we want to continue until we can serve 100% of our stores and we're targeting 2010 for that completion, so you'll see openings in 2009 against that target.
Operator: Your next question comes from Alan Rifkin - Merrill Lynch.
Alan Rifkin - Merrill Lynch: Certainly it sounds like the price rationalization program has been pretty successful in driving transactions and units and revenues. My question is, though, taken together with the incremental marketing spend, has it been accretive to net income and, if so, what is your proclivity going forward to expand the program?
Frank Blake: First of all, there wasn't an incremental marketing spend per se. It was a shift of how we were using our dollars to communicate to the customer. And overall, I think that as we look at the program, part of our portfolio strategy is to drive to an everyday great value for our customer, and we've been doing that by eliminating promotional activity that was non-nutritive. And so we see this as an ongoing program. It's focused on our customer. It's focused on driving value to our customer every day and, as we look at this program, it's built in our guidance as we move forward.
Alan Rifkin - Merrill Lynch: When you say it's an ongoing program, will it maintain the same level or will it be intensified?
Frank Blake: As we look at the market and we look at implementation of our portfolio strategy, I certainly would not see it going backwards. As the market bears, we'll look at whether or not that intensifies.
Alan Rifkin - Merrill Lynch: Where are you, Carol, with respect to minimum staffing levels at the store level? And going forward, if we continue to see a decelerating revenue environment, what is the opportunity to further reduce payroll at the store level?
Carol B. Tome: Well, Alan, we staff by department, not by store. And Marvin Ellison is here, our Executive Vice President of Stores, and I'll let him address your question.
Marvin Ellison: As Carol said, we staff by department and not by total store, and really it's based on the rate of sales in that department. So if we have a department like plumbing, where sales is increasing, then we will beef up staffing. If a department has sales declining, we'll pull back staffing. The other thing we've done is that we've looked at customer shopping traffic patterns, and we focus our service during those timeframes. So we've been able to take the same number of associates and increase our service levels just based on when customers shop. So we think that that works for us and we're going to continue to strive with that model for the rest of the year.
Alan Rifkin - Merrill Lynch: Okay, but at the departmental level, for departments that, going forward, let's say, come in below your plan, is there opportunity to further reduce labor within those departments or are you pretty much at the lowest staffing levels today?
Marvin Ellison: We look at it case by case. And as it stands right now, I mean, we're not at any minimum staffing levels. We just try to maintain a certain level of service in our stores, and the reason why departments work is because it allows us to be granular and we can look at it department by department and make sure that we are flexing the necessary sources in areas where we need to to provide service.
Operator: Your next question comes from T.J. McConville - Raymond James.
T.J. McConville - Raymond James: The first question I had was a follow up to a previous question on the call. Craig, I think you said that ticket above $500 was off double-digit in October. I was wondering if maybe we could get a sense for where that was in the beginning parts of the quarter or maybe where it was last year?
Craig Menear: In the beginning parts of the quarter it was mid single-digit. We believe that there was some impact of that, particularly in September, as a result of hurricane sales and the repair that was happening in those particular parts of the country, but mid single-digits. And prior to that it ranged pretty much double-digit negative.
T.J. McConville - Raymond James: And the second question I had was on the geographical regions. I know Frank gave us a pretty nice update at the beginning of the call on how things were looking. I was wondering if we could get a sense for the progression of decline throughout the quarter. Maybe a better way to ask would be did the bad markets sort of flatten out as things got worse and the good markets just got that much more bad or was it just an across-the-board deterioration for you?
Frank Blake: I'll be honest, T.J., I don't have the time lapsed photography on that to tell you exactly how it played out, so I'd be guessing if I gave you an answer on that. And, again, you'd see a lot of variation from within the market. Some markets impacted more dramatically through the quarter than others. But honestly, I just don't have that in my head.
Operator: Your next question comes from Matthew Fassler - Goldman Sachs.
Matthew Fassler - Goldman Sachs: As you disclosed the monthly comp numbers, are those impacted by the calendar shift as well or are those monthly progressions distorted or are they pretty clean?
Carol B. Tome: The monthly comps that we gave you were the reported comps. I'd be happy to give you the likeforlike comps.
Matthew Fassler - Goldman Sachs: That'd be great.
Carol B. Tome: Okay. So we reported a negative 6.5 for August. The like-for-like was negative 6.2. We reported a negative 7.4 for September. The like-for-like was negative 5.3. And we reported a negative 10.5 for October. The like-for-like was negative 9.4.
Matthew Fassler - Goldman Sachs: So negative 9.4 would kind of be the comparable number as you left the quarter?
Carol B. Tome: Yeah.
Frank Blake: Right.
Matthew Fassler - Goldman Sachs: Secondly, can you try to quantify the impact that International had on the business and maybe put that in the context of what you had seen year-to-date, I guess both overall and then currency, I think, probably hurt you at least a little bit in the third quarter, having helped you prior to that, so if you could help us understand that as well.
Carol B. Tome: Yes. Our reported comp for the quarter was negative 8.3%. Our U.S. comp was negative 8.4%. So that gives you some sense of the positive impact that we've seen from our nonU.S. businesses has diminished.
Matthew Fassler - Goldman Sachs: And then obviously make the calendar adjustments comparably.
Carol B. Tome: That's right.
Matthew Fassler - Goldman Sachs: And then the comment that you made at the outset, Frank, of 15 of 40 markets having gotten better, just to make sure I understand, you're actually seeing some sequential improvement in a number of markets, it's just not as many markets as you thought you might as the compares get easier and probably by a lesser magnitude where you saw that improvement.
Frank Blake: That's correct, both statements. It's fewer than we thought and it's not as much as we thought.
Matthew Fassler - Goldman Sachs: And then finally, the payables ratio looked like it was down a bit year-on-year. If you could share with us whether there's any rhyme or reason to that movement and what we should look for over the course of the year?
Carol B. Tome: Yes. Our payables ratio was 57% compared to 60% a year ago. Last year you may recall we outsourced all of our payables processing to India. And candidly, we had some disruption. The 57% is where we think we should be. Now remember that at the end of each year there's always a low point in that ratio, so in the fourth quarter I would expect it to be around, call it 49%, something like that, and then it will build back up.
Matthew Fassler - Goldman Sachs: Your aggregate market share numbers, you talked about having gained share in a number of categories. As you look at that third-party source, is there an aggregate share gain or loss that they gave you and, if they did, how has that moved versus the year-to-date trend?
Frank Blake: I don't think they do an aggregate.
Craig Menear: They don't. They don't do an aggregate.
Diane Dayhoff: Augusta, we have time for one more question.
Operator: Your last question comes from Michael Lasser - Barclays Capital.
Michael Lasser - Barclays Capital: Frank, at the outset you said you expect these pressures will continue into the fourth quarter of 2009. Maybe you could expand a little bit more on that comment and, if that is the case, will it necessitate a greater store rationalization program that you occurred earlier this year?
Frank Blake: We expect it to be to the fourth quarter and into 2009, as I said. And, you know, look, we look every quarter at our stores and try to make sure we're doing the right thing in terms of the stores that we have open. And I would say as we look at our orange box stores, we don't see a dramatic change from what we saw in the first quarter in terms of the long-term value of those stores.
Michael Lasser - Barclays Capital: And a follow up for Carol. You mentioned that the leverage or deleverage per point of comp is now down to about 17 basis points. Will there be an asymmetric leverage profile such that you'll get much better leverage once the comp turns positive and how are you thinking about that?
Carol B. Tome: I'm looking for the day when that comp turns positive and, yes, there is an asymmetrical relationship as things start to move up.
Michael Lasser - Barclays Capital: But it's hard to quantify at this point?
Carol B. Tome: It is. We're working through that right now. And as you can appreciate, Michael, all our focus has been on running the business in this very challenging sales environment. As we look out, planning for positive comps - and that day will come - we'll come back and tell you what the leverage looks like.
Michael Lasser - Barclays Capital: What has caused the downshift from the 20 basis points to 17 basis points?
Carol B. Tome: Our 20 basis point rule is a rule of thumb. It's going to be around 20. I don't think it'll ever be exactly 20.
Diane Dayhoff: Well, thank you, everyone, for joining us today, and we look forward to talking to you when we release our fourth quarter earnings on February 24.
Operator: Thank you. This does conclude our call. We'd like to thank everyone for their participation. Have a great day. | [
{
"speaker": "Executives",
"text": "Diane Dayhoff - Senior Vice President, Investor Relations Frank Blake - Chairman and Chief Executive Officer Craig Menear - Executive Vice President, Merchandising Carol B. Tome - Chief Financial Officer and Executive Vice President, Corporate Services Matt Carey - Executive Vice President, Chief Information Officer Mark Holifield - Senior Vice President, Supply Chain Marvin Ellison - Executive Vice President, U.S. Stores"
},
{
"speaker": "Analysts",
"text": "Colin McGranahan - Sanford C. Bernstein & Co. Peter Benedict - Wachovia Capital Markets, LLC David Strasser - Banc of America Securities Michael Baker - Deutsche Bank Securities Scot Ciccarelli - RBC Capital Markets Christopher Horvers - J.P. Morgan Deborah Weinswig - Citigroup Alan Rifkin - Merrill Lynch T.J. McConville - Raymond James Matthew Fassler - Goldman Sachs Michael Lasser - Barclays Capital"
},
{
"speaker": "Operator",
"text": "Good day, everyone, and welcome to today's Home Depot third quarter earnings conference call. (Operator Instructions) Beginning today's discussion is Diane Dayhoff, Senior Vice President of Investor Relations. Please go ahead, ma'am."
},
{
"speaker": "Diane Dayhoff",
"text": "Thank you, [Augusta], and good morning to everyone. Welcome to The Home Depot third quarter earnings conference call. Joining us on our call today are Frank Blake, Chairman and CEO of The Home Depot, Craig Menear, Executive Vice President, Merchandising, and Carol Tome, Chief Financial Officer and Executive Vice President, Corporate Services. Following our prepared remarks, the call will be opened for analyst's questions. Questions will be limited to analysts and investors and, as a reminder, we would appreciate it if the participants would limit themselves to one question and one follow up, please. If we are unable to get to your question during the call, please call our Investor Relations Department at 770-384-2387. Before I turn the call over to Frank, let me remind you that today's press release and the presentations made by our executives include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties. These risks and uncertainties include, but are not limited to, those factors identified in the release and in our filings with the Securities and Exchange Commission. Now let me turn the call over to Frank Blake."
},
{
"speaker": "Frank Blake",
"text": "Thank you, Diane, and good morning, everyone. Sales for the third quarter were $17.8 billion, down 6.2%. Comp sales were negative 8.3%. As Carol will describe, sales for the quarter were negatively impacted by approximately $225 million because of the seasonal shift associated with 53 weeks in fiscal 2007. Adjusting for that, comp sales were negative 7.1%. Diluted earnings per share were $0.45. You all obviously know that this is a difficult environment in the housing and home improvement markets. The view we had at the start of the quarter, that we might be nearing a bottom - our August was actually better than we'd planned - gave way to the financial crisis in September and beyond. We've seen the kinds of pressure you'd expect in this environment. Our big ticket sales are down significantly, as Craig will describe. Our customers are finding credit harder to come by, as Carol will discuss, and we're generally seeing continued softness in tough markets and erosion in previously strong markets. Let me give you some specifics. Since the mid-September and forward time period is the most relevant, we look at the rolling six-week comp performance of our top 40 markets versus Q3 2007. Of those top 40 markets, only 15 are performing better now. So we are not seeing the improvement that we thought we'd see as we cycled against the soft comparisons from last year. And where we are seeing better performance, frequently there's only fractional improvement. So, for example, Miami is performing better, but is still mid-teens negative comping. We've seen some improvement in California and New England but, again, these markets remain under pressure. At the same time, previously strong markets have eroded. Last year the Northwest was a relatively strong area for us. Now Seattle, Portland, and Spokane have negative double-digit comps. We expect that these pressures will continue into the fourth quarter and 2009. In many respects the difficult market is obscuring the progress that our associates are making. Our customer service levels as reflected in our Voice of the Customer surveys continued to improve. Marvin Ellison, our Executive Vice President, U.S. Stores, has implemented significant changes in our store operations, making our approach simpler, more consistent, and more customer-focused. On the merchandising side, you can already see some of the improvements Craig and his team have accomplished. It's an enormous challenge to operate a business our size in a declining market with rapidly changing commodity prices and achieve price leadership, margin stability, and inventory control. For the quarter, we launched a strong new lower-priced campaign, achieved significantly better markdown control, and lowered per-store inventory by 7.5%. I believe we have better execution in our business across merchandising, operations, supply chain and our supporting functions than we have had in quite awhile. At the end of October we opened our fourth Rapid Deployment Center or RDC in Winchester, Virginia. RDCs now serve approximately 400 of our stores. We remain committed to enhancing our supply chain and are pleased to be back on the track of opening facilities. This year we have one more facility that we will open in the fourth quarter. Our International businesses, particularly Canada, have started to feel some of the economic pressures that we've had in the U.S. Canada had mid single-digit negative comps and saw a similar pattern of accelerated declining sales in the quarter. In addition, our Canadian team tackled a major business system implementation with SAP Core Retail, which is now live in all our Canadian stores - a substantial undertaking in the midst of very difficult market conditions. The rest of our business will now benefit from the learnings we can gain from the Canadian effort, and I'm very excited to have Matt Carey, who has over 20 years of experience with WalMart and eBay, on board as our new EVP and CIO to help us in that effort. China also reported negative comps, driven in large part by the impact of the Olympics in China in August. But Mexico continued its strong performance with another quarter of double-digit positive comps. Across our entire business, we are making the adjustments necessary to respond to a tough market environment. We are carefully controlling our discretionary spending, scrutinizing every dollar of capital, and, most importantly, intensifying our focus on our customers. The culture at Home Depot is our strength, and I want to thank our associates for responding well in a tough time. Now let turn the call over to Craig."
},
{
"speaker": "Craig Menear",
"text": "Thanks, Frank, and good morning, everyone. In the third quarter we experienced negative comp sales growth in all departments except building materials, which was driven by strong sales in roofing and insulation. Both categories increased in the number of units sold, though it should be noted that some of the comp dollar gain in roofing was driven by higher prices due to increased petroleum costs. Additional departments that outperformed the company's average comp were plumbing, hardware and garden. The departments that underperformed the company average comp were kitchen and bath, millwork, electrical, lumber and flooring. And paint performed at the company's average comp. Average ticket was down $1.62 or 2.8% from last year to $55.86. We saw a decline in two areas. First, big ticket sales continued to suffer. For example, [special] kitchens were down nearly 30% versus last year. And second, we saw that approximately 40% of the decline in average ticket was due to lower average spending per basket. From a regional perspective, areas of the North, particularly the Northern Plains and Ohio Valley, performed above the company's average comp in the third quarter. The same is true for parts of the South, like Texas, Oklahoma and Louisiana. The positive results along the Gulf are attributed primarily to hurricane-related sales. Hurricanes Gustav and Ike added approximately $125 million in incremental sales in the quarter; however, we did not realize any benefit to the bottom line as those sales were low margin sales and margin dollars were offset by additional expenses such as freight, store damage and associate cost. I am proud of the cross-functional team's efforts before, during and after the storms to ensure our products and associates were in place to help our customers and their communities. As Frank has said, in this challenging environment, we need to remain focused on executing and improving those things that we can control. We have discussed for several quarters the implementation of our portfolio strategy, and while we still have a long ways to go, we're starting to see the deliberative results. One such result was reflected in our transactions. While total company transactions of $315 million were down 3.4% year-over-year, we saw an improving trend during the last six weeks of the quarter. One of our ongoing initiatives has been to reduce promotions and refocus our efforts on being an everyday value provider as part of our portfolio strategy. By the third quarter, we felt that we had accomplished enough in this transition to effectively communicate our progress to our customers. Our marketing campaign supporting our new lower price reinforces the everyday value message. Our new lower price program increased transactions and drove attachment sales. Another metric supporting the initial success of our portfolio strategy and overall merchandising transformation was our gross margin results. The third quarter presented the most volatile commodity market I've ever seen; however, we worked through it and we saw a 27 basis point improvement in gross margin over the third quarter last year. Early this year we introduced new tools to our merchants to better plan, assort and react to changes in the market by forecasting at a more granular level. The clarity that these tools provided drove gross margin and inventory productivity, particularly in our seasonal categories. In the third quarter alone, we saw a 200 basis point gross margin improvement in our U.S. garden category due to lower markdowns. All the merchandising initiatives that I've described so far are also driving the results in market share. In the U.S., 6 out of 13 departments gained unit share in the third quarter, and 10 out of 13 showed share improvements from where they ended the second quarter. Based on independent third-party tracking of consumer activity, we saw strong share gains in several key merchandising classes. For example, insulation, carpet, ceramic tile, power tools, toilets, faucets, grills and molding all gained share in the quarter, to name a few. Many of these classes received concentrated merchandising focus and investment, utilizing our portfolio strategy. For example, in molding we updated the assortments regionally, refined the merchandising sets, improved the value proposition, and added point of sale information, making it easier for our customers to shop and make a selection. As we look to the fourth quarter, we expect that we will continue to see relative strength in energy efficient and basic repair products. We have a compelling selection of value conscious and energy efficient products. We are positioned well in holiday products, including our expanded assortment of LED lighting, our gift centers have strong values in hand tool sets and power tools across varying price points, and we're ready to serve the storage and organization needs of our customers following the holidays. In this difficult environment, we are focused on things that we can control and executing on them. We will continue to execute our portfolio strategy, make assortment and pricing adjustments, implement resets, and drive project sales by the way we position merchandise in our stores. We believe these actions improve the value proposition for our customers and simplify their shopping experience. And now I'd like to turn the call over to Carol."
},
{
"speaker": "Carol B. Tome",
"text": "Thank you, Craig, and hello, everyone. In the third quarter, sales were $17.8 billion, a 6.2% decrease from last year, reflecting negative same-store sales of 8.3%, offset in part by sales from new stores. Net earnings were $756 million compared to $1.1 billion last year. Earnings per diluted share from continuing operations were $0.45 versus $0.59 last year. Comp store same-store sales were negative 8.3% for the quarter, with negative comps of 6.5% in August, negative 7.4% in September, and negative 10.5% in October. The last three weeks in October were particularly weak. In fiscal 2007 we had 53 weeks in the year. This shifted our 2008 fiscal calendar. Because of this shift and given the seasonal nature of our business, third quarter sales on a like-for-like calendar basis were negatively impacted by approximately $225 million. Excluding the calendar shift, our likeforlike comp for the quarter was negative 7.1%. Roughly 10% of our sales are outside of the United States. Late in the third quarter we saw significant strengthening of the U.S. dollar against all currencies. The impact to total sales was about $40 million. And similarly, from an earnings perspective, the strengthening of the U.S. dollar did not have a material impact in the quarter. In the third quarter our gross margin was 33.7%, an increase of 27 basis points from last year, and reflects the benefits arising from our focused-based portfolio approach as well as a shift in the mix of products sold. Specifically, our gross margin expansion was driven by the following factors: First, lower markdowns coupled with a smarter approach to promotions covered the cost of our new lower price program and drove 23 basis points of margin expansion. Second, a decline in the penetration of our lower-margin kitchen and appliance category drove 14 basis points of margin expansion. And finally, we experienced a contraction in our gross margin of 10 basis points resulting from clearance activities taken in connection with the one-time conversion of our Canadian stores to their SAP Core Retail platform. In the third quarter, operating expenses increased by 214 basis points to 26.3% of sales. Our expense deleverage reflects for the most part the impact of negative sales. Generally, we expect to deleverage expenses by about 20 basis points for every point of negative comp. In the third quarter, our expense deleverage per point of negative comp was approximately 17 basis points for a total of 144 basis points of deleverage. Further, as expected, in the quarter we experienced an additional 70 basis points of expense deleverage due to a higher cost of credit associated with our private label credit card. In the third quarter, our total cost of credit as a percent of private label credit sales was approximately 2.2%. Looking forward, our new private label credit card contract with Citi begins in January of 2009 and at that time the cost of credit will be capped at 1.5% of private label credit sales. As you know, a great deal of pressure has been placed on consumers and therefore retail sales due to tightening of consumer credit. Sales under our private label credit card made up 28% of our total sales compared to 30% one year ago. Today, over 70% of our new account applications are granted credit lines, but the average approval limit has decreased by 5% from last year. Further, in some cases existing credit lines have been reduced. So as we look out, continuing pressure on credit availability could potentially impact sales. Our operating margin was 7.4% in the third quarter, down 186 basis points from last year. Net interest expense was $151 million, an increase of $26 million from last year, reflecting a decline in interest income due to the lower interest rate environment and lower investable cash balances. In the third quarter our income tax provision rate was 35.5%. We expect our tax rate to be approximately 36.1% for the year. Diluted shares were 1.69 billion shares compared to 1.82 billion shares last year. The reduction in outstanding shares is due to our share repurchase program and includes the tender offer we completed in September of 2007. At the beginning of the third quarter, we repurchased 2.4 million shares for $70 million. When the financial markets shut down, we put our recapitalization program back on pause and it will remain on pause until further notice. Now moving to our operational metrics, during the third quarter we opened 11 net new stores for an ending store count of 2,268. Today, 257 stores representing approximately 11% of our store base operate in Canada, Mexico and China. At the end of the quarter, selling square footage was 238 million, a 2.1% increase from last year. Reflecting the sales environment, total sales per square foot were approximately $296 for the quarter, down 8.5% from last year. Sales per square foot for our new stores were up 2.1% from last year. Now turning to the balance sheet, our balance sheet and our cash position remain strong. At the end of the quarter we had $874 million in cash and no outstanding commercial paper. As a reminder, we have a $3.25 billion A2/P2 commercial paper program that is 100% backstopped by a committed long-term bank line of credit. We do not foresee the need to access the commercial paper market during the remainder of the fourth quarter; however, if we need to issue commercial paper, we believe the market is open to us at this time. We have approximately $11 billion of long-term debt of which $1.7 billion comes due in 2009. The average duration of our long-term debt portfolio is approximately 11 years. We ended the quarter with $44.2 billion in assets. Since the end of the year, our cash position has increased by approximately $400 million, reflecting cash flow generated by the business of approximately $4.9 billion offset by $1.4 billion of capital expenditures, $1.1 billion of dividends paid, and $2 billion used to repay outstanding commercial paper and an operating lease obligation. At the end of the quarter, retail inventory was $11.9 billion, down 5.7% from last year. On a perstore basis, inventory was down 7.5%. Our operators and merchants have done an excellent job of controlling inventory in this sales environment. The quality of our inventory has never been better and clearance inventory is at a record low. Further, our in-stock level is at a record high. Reflecting the sales environment, however, inventory turnover was 4.2 times compared to 4.4 times last year. Computed on the average of beginning and ending long-term debt and equity for the trailing four quarters, return on invested capital for continuing operations was approximately 11.6%. Excluding the store rationalization charge earlier this year, our return on invested capital was approximately 12.7%. As we look forward we continue to project a challenging sales environment. We've been controlling what we can control, but November comps to date are about the same as October. Based on our year-to-date results, the stronger U.S. dollar, and our view that the consumer could be very challenged in the fourth quarter, we now believe that fiscal 2008 sales could be down as much as 8% for the year. We continue to project that our earnings per share from continuing operations excluding the store rationalization charge will be down approximately 24% from last year. We will share our 2009 guidance with you during our fourth quarter earnings conference call, which is scheduled for February 24. So thank you for your participation in today's call and Augusta, we are now ready for questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from Colin McGranahan - Sanford C. Bernstein & Co."
},
{
"speaker": "Colin McGranahan - Sanford C. Bernstein & Co.",
"text": "Craig, you said that 40% of the decline in ticket was due to lower spending per basket. I'm assuming the remaining 60% decline in average ticket, then, was due to mix - fewer large ticket purchases. Can you comment maybe how that compares over the course of the last, I don't know, year or two and what that implies in terms of how the mix impact is working on the average ticket?"
},
{
"speaker": "Colin McGranahan - Sanford C. Bernstein & Co.",
"text": "Yes, Colin. The balance was in fact the decline in average ticket. We're continuing to see pressure in big-ticket categories like kitchen and millwork that is impacting the overall average ticket. And I would tell you that in the third quarter, as we looked at those larger transactions above $500 or $1,000 - they took a step down to double-digit."
},
{
"speaker": "Carol B. Tome",
"text": "I'll just jump in on the appliance side, because I think this is important. If you look back in 2007 and 2006, we saw average ticket growth because of an increasing penetration of our appliances. In the third quarter we lost $0.17 in our ticket just due to appliance."
},
{
"speaker": "Colin McGranahan - Sanford C. Bernstein & Co.",
"text": "And then the second question, I don't know if Matt Carey is actually on the call, but if he is -= and if he's not, maybe someone else can jump in - just in terms of what are the initial experiences with SAP in Canada, what you've learned and how you're thinking about those learnings in terms of U.S. IT implementation."
},
{
"speaker": "Frank Blake",
"text": "Colin, Matt is here so Matt, why don't you address it."
},
{
"speaker": "Matt Carey",
"text": "Sure. You know, it's early days. We are just in the very end of the rollout. The team's been focused very hard in completing the rollout, and we'll be assessing the performance of those stores and that business in the coming year and learning as much as we can such that we can help the U.S. business as well."
},
{
"speaker": "Frank Blake",
"text": "And Colin, the one thing I'd say is we entered this with a number of questions and one of the first questions was could we do it? I mean, could we implement this without just a dramatic impact on the business because, frankly, you look at other big implementations like this and there have been some significant - beyond divots - huge potholes. And I think credit to the Canadian team and to Matt's team, you know, the implementation as an implementation, it's gone pretty well."
},
{
"speaker": "Colin McGranahan - Sanford C. Bernstein & Co.",
"text": "It seems like you converted all the stores. There were no major snafus."
},
{
"speaker": "Frank Blake",
"text": "Right."
},
{
"speaker": "Colin McGranahan - Sanford C. Bernstein & Co.",
"text": "Up and running. And you're probably already seeing some initial benefits, I would imagine."
},
{
"speaker": "Frank Blake",
"text": "Well, again, tough as I outlined, Canada is seeing - you know, if you think about Canada, they've got some of the same issues in terms of impact from the auto industry, oil and gas. So it's way too early yet for us to be able to tease out what the benefits are as they wrestle with a tough market."
},
{
"speaker": "Operator",
"text": "Your next question comes from Peter Benedict - Wachovia Capital Markets, LLC."
},
{
"speaker": "Peter Benedict - Wachovia Capital Markets, LLC",
"text": "Again on the average ticket, it's been down the last nine quarters and I think the third quarter number puts us basically back to where we were in about the third quarter of 2004. When you look at the mix of your business and the stores today, what period would you say it's most similar to over the past several years? Is it like 2004 or is there some other year that we can look back to that would be more representative of what you're seeing in the stores today?"
},
{
"speaker": "Craig Menear",
"text": "I would tell you that as we look at the current decline in the big ticket, the change in our business from 2004 to now as it relates to appliances, I don't think you can really compare it to - I think the mix is different. So we've grown our appliance business significantly since 2004, and on the flip side, you know, in this current environment, the categories like kitchen cabinets are down significantly. So I'm not sure it's a fair comparison."
},
{
"speaker": "Frank Blake",
"text": "Peter, it really is tough because, as both Carol and Craig said, you've got to look at categories. I mean, I think of things like countertops that we were barely in in 2004 versus now."
},
{
"speaker": "Carol B. Tome",
"text": "More kitchen, flooring, the whole emphasis on specialties is very different. And that's our business model; it's just being impacted by the economic environment."
},
{
"speaker": "Frank Blake",
"text": "Correct."
},
{
"speaker": "Operator",
"text": "Your next question comes from David Strasser - Banc of America Securities."
},
{
"speaker": "David Strasser - Banc of America Securities",
"text": "So, quickly, when you look at the mix of stores around the country - the Northeast now is about 17% of stores; the Midwest, 10% of stores - you can make a good argument that those areas, based on what's happening in the economy, are going to get worse. When you look at some of the mistakes or some of the positive things you were able to do in areas like Southern California, Nevada, Florida, what have you learned that you can use to anticipate slowdowns as some of the things that are going on in those areas start to materialize."
},
{
"speaker": "Frank Blake",
"text": "So, David, I'd say - and this is more anticipation than direct experience at this point - I would expect that the dynamics are going to be different. So when you look at California, Florida, Nevada, you had just a lot of speculative homebuilding. You had strong employment, strong underlying GDP growth, but a housing bubble that had a direct impact on us as that bubble collapsed. I suspect we're going to be seeing a different dynamic play out going forward where it's less a housing bubble unwinding than it is a region dealing with basic difficulties on economic growth and employment. So just on your premise, we're not anticipating that it will be same-same and we can have hypotheses on how that will play out in our stores, but I think we're going to see a very different unfolding."
},
{
"speaker": "David Strasser - Banc of America Securities",
"text": "Just as a follow up, at the beginning of the call you had said the Northeast. Could you just repeat what you had mentioned, how the business had trended there?"
},
{
"speaker": "Frank Blake",
"text": "Yes. The comment on New England was that it's better than it was, which is good, but I want to be very cautious in saying better is truly a relative term and that it's still under pressure."
},
{
"speaker": "Operator",
"text": "Your next question comes from Michael Baker - Deutsche Bank Securities."
},
{
"speaker": "Michael Baker - Deutsche Bank Securities",
"text": "So you said November was about where it was in October. Is that that 10.5% that you said for October? It sounds like the end of October was worse than the total October of 10.5%, so I just wanted to clarify where November was relative to that."
},
{
"speaker": "Carol B. Tome",
"text": "It's around the negative 10.5% area."
},
{
"speaker": "Michael Baker - Deutsche Bank Securities",
"text": "I think the sales guidance, the full year sales guidance, down 8% seems to imply down 18% for the fourth quarter. You have one fewer weeks so; you adjust that, maybe down 12% or 13%. You get a percent or two from square footage, so it sounds like the guidance for the comp, at least, is a little bit worse than down 10%, if my math is even close to right. So is that just being conservative, thinking things might drop off, or is my math just completely off?"
},
{
"speaker": "Carol B. Tome",
"text": "Your math is right. What's included in our guidance is our view of the U.S. dollar's impact to our fourth quarter sales. You know, the U.S. dollar strengthened at the end of the third quarter so it didn't have a big impact to our third quarter, but we assume that the dollar will remain strong in the fourth quarter and that will have an impact to our sales outside the United States."
},
{
"speaker": "Michael Baker - Deutsche Bank Securities",
"text": "By a percent or two or something along those lines?"
},
{
"speaker": "Carol B. Tome",
"text": "We're thinking about almost a couple percent."
},
{
"speaker": "Operator",
"text": "Your next question comes from Scot Ciccarelli - RBC Capital Markets."
},
{
"speaker": "Scot Ciccarelli - RBC Capital Markets",
"text": "What has been the big change in terms of the sales trends in October/November? I'm sure it's just a continuation, but are we seeing incremental pressure on traffic or is it incremental pressure on ticket or is it both?"
},
{
"speaker": "Frank Blake",
"text": "Well, I think I'll turn it to Craig, but as Craig was outlining, we actually feel like we're gaining some traction on the transactions, but just seeing continued pressure on ticket."
},
{
"speaker": "Craig Menear",
"text": "Yes, that is correct. We looked at transactions actually in October. We actually saw a significant change and improvement in transactions. But when you look at ticket in the month of October, that fell significantly. Ticket above $500 was double-digit off."
},
{
"speaker": "Operator",
"text": "Your next question comes from Christopher Horvers - J.P. Morgan."
},
{
"speaker": "Christopher Horvers - J.P. Morgan",
"text": "I want to understand, you know, maybe how we should read the stat trend or the trend in the business as you enter the fourth quarter and try to get our arms around A) how do compares ease as you go from November to January, and B) how much should we read into or ascribe the shift down in comps to the fact that the seasonal and the maintenance categories, well, they just don't do as well when everybody's holed up in the winter, with the windows shut and the heat on."
},
{
"speaker": "Carol B. Tome",
"text": "Well, let me answer the first part of your question if I could. In terms of comparisons, looking at last year - and remember, there's a calendar shift that distorts some of this - but last year our comps were negative 6 - 6 in November, negative 7 - 2 in December, and negative 10 - 8 in January. So from a comparison, it would appear that January is the easiest compare."
},
{
"speaker": "Frank Blake",
"text": "In terms of your comment on the product assortment and what sells, the mix, it's going to be roughly the same year-over-year, that same shift away. Obviously, there are a lot of things like kitchen remodels and new flooring and the like that really slow down pretty significantly once you're past, frankly, this period, once you're past the Thanksgiving Day period."
},
{
"speaker": "Craig Menear",
"text": "And when you look at the seasonal impact of, like, the garden department, the big shift obviously comes from Q2 to Q3. It's much less significant Q3 to Q4."
},
{
"speaker": "Christopher Horvers - J.P. Morgan",
"text": "So maybe coming at it from a different angle, how much would you say because of that mix shift away from outdoor and from seasonal, how much of this is just a dip down because we're entering that time of year and how much might maybe we recover in the first half next year when you get into a better seasonal period?"
},
{
"speaker": "Frank Blake",
"text": "Well, again, on the comp perspective, you're comparing same dip to same dip, and then obviously our business does pick up. January is our lowest month."
},
{
"speaker": "Carol B. Tome",
"text": "If you look at just total sales dollars, you should [inaudible] just because of the seasonal nature, and then it picks right back up when spring comes."
},
{
"speaker": "Christopher Horvers - J.P. Morgan",
"text": "And a follow up question on SG&A trends. You've been basically keeping SG&A per foot flattish here in the first three quarters of 2008. How should we think about your ability to keep it flattish into 2009, either from a maintenance SG&A spend perspective or from stores on minimum staffing level?"
},
{
"speaker": "Carol B. Tome",
"text": "Well, let me first talk about the fourth quarter. For the fourth quarter we expect our expenses per average store to be down from what they were a year ago. Two reasons for that, primarily lower advertising spending in the fourth quarter this year versus last year, and then last fourth quarter you may recall that we had some write-offs associated with stores that we elected not to open. There was a big write-off for a store in San Francisco, if you remember that. We won't be repeating that in the fourth quarter, so expenses should be down on a per square foot basis. And as we come back to you at the end of the fourth quarter, we'll give you the guidance for 2009 and we'll let you know what we think about expenses on a per store basis. But clearly, this is an area of real focus."
},
{
"speaker": "Operator",
"text": "Your next question comes from Deborah Weinswig - Citigroup."
},
{
"speaker": "Deborah Weinswig - Citigroup",
"text": "So, Carol, originally or last quarter you had given guidance of sales to decline 5% for fiscal '08. Now you're saying potentially an 8% decline, but we're keeping earnings guidance kind of down 24%. Is the major difference on the gross margin side or how should we think through that?"
},
{
"speaker": "Carol B. Tome",
"text": "Well, we had a good earnings quarter in the third quarter; our earnings were better than our plan. So we're able to take that into the fourth quarter. And then as we look at the fourth quarter, you know, Craig's talked to you about the new tools that we're using that allow us to forecast sales margin and inventory now for 200 classes on a weekly basis. That's giving us better visibility on what we think the margin will do in the fourth quarter and that's giving us comfort for the guidance that we gave."
},
{
"speaker": "Deborah Weinswig - Citigroup",
"text": "And then also can you talk about your inventory performance in the quarter? Certainly very impressive, especially in light of the environment."
},
{
"speaker": "Frank Blake",
"text": "This is a joint effort of everybody on the team. I mean, it starts with Craig and his merchandising team and Carol and her finance team working with them on the planning process and Marvin on the store execution side and supply chain. I mean, it really is just - it's connecting a lot of - this isn't a very fancy answer, but it's just connecting a lot of dots within the business in a more effective way."
},
{
"speaker": "Craig Menear",
"text": "It's really the new tools are giving us great visibility and has changed how we manage the business. And quite honestly, when we look at the inventory overall, it was widespread. It wasn't concentrated in a significant or one area; it was widespread across all our merchandising departments."
},
{
"speaker": "Deborah Weinswig - Citigroup",
"text": "So, Frank, would you say it's a much more collaborative effort?"
},
{
"speaker": "Frank Blake",
"text": "Again, yes. I mean, I think there are lots of opportunities for us to improve our operations, and these are the kinds of time periods that force us to get those. And as Craig said, you know, develop the new tools that help us communicate better within the organization."
},
{
"speaker": "Deborah Weinswig - Citigroup",
"text": "What are you seeing with regards to stores that are being serviced by the RDC network and, in terms of the RDC network, how shall we think about 2009?"
},
{
"speaker": "Frank Blake",
"text": "Well, one of our - and Mark is here and he can address that as well - but when we put this on pause we had a series of benchmarks that we wanted to hit before we would start again, and one of them was how are we performing with the stores in terms of accuracy of shipments and how are the stores performing in terms of out-of-stocks, and we hit those targets, which is what gave us confidence to restart the rollout process. And our plan is to continue through 2009 and 2010. Mark, if you want?"
},
{
"speaker": "Mark Holifield",
"text": "Yes, just that we had opened our Winchester facility. We're in our fourth week of operations there. We're experiencing no significant issues and pleased with the progress there. As Frank said, the main things we're looking at from a store perspective is the in-stock in the store and our RDC stores perform better than our other stores. We're looking at our ability to service the stores with very accurate loads and timely delivery. So we believe we're on track to achieve our ultimate targeted levels over time, so we're pleased with that progress. In terms of 2009, we want to continue until we can serve 100% of our stores and we're targeting 2010 for that completion, so you'll see openings in 2009 against that target."
},
{
"speaker": "Operator",
"text": "Your next question comes from Alan Rifkin - Merrill Lynch."
},
{
"speaker": "Alan Rifkin - Merrill Lynch",
"text": "Certainly it sounds like the price rationalization program has been pretty successful in driving transactions and units and revenues. My question is, though, taken together with the incremental marketing spend, has it been accretive to net income and, if so, what is your proclivity going forward to expand the program?"
},
{
"speaker": "Frank Blake",
"text": "First of all, there wasn't an incremental marketing spend per se. It was a shift of how we were using our dollars to communicate to the customer. And overall, I think that as we look at the program, part of our portfolio strategy is to drive to an everyday great value for our customer, and we've been doing that by eliminating promotional activity that was non-nutritive. And so we see this as an ongoing program. It's focused on our customer. It's focused on driving value to our customer every day and, as we look at this program, it's built in our guidance as we move forward."
},
{
"speaker": "Alan Rifkin - Merrill Lynch",
"text": "When you say it's an ongoing program, will it maintain the same level or will it be intensified?"
},
{
"speaker": "Frank Blake",
"text": "As we look at the market and we look at implementation of our portfolio strategy, I certainly would not see it going backwards. As the market bears, we'll look at whether or not that intensifies."
},
{
"speaker": "Alan Rifkin - Merrill Lynch",
"text": "Where are you, Carol, with respect to minimum staffing levels at the store level? And going forward, if we continue to see a decelerating revenue environment, what is the opportunity to further reduce payroll at the store level?"
},
{
"speaker": "Carol B. Tome",
"text": "Well, Alan, we staff by department, not by store. And Marvin Ellison is here, our Executive Vice President of Stores, and I'll let him address your question."
},
{
"speaker": "Marvin Ellison",
"text": "As Carol said, we staff by department and not by total store, and really it's based on the rate of sales in that department. So if we have a department like plumbing, where sales is increasing, then we will beef up staffing. If a department has sales declining, we'll pull back staffing. The other thing we've done is that we've looked at customer shopping traffic patterns, and we focus our service during those timeframes. So we've been able to take the same number of associates and increase our service levels just based on when customers shop. So we think that that works for us and we're going to continue to strive with that model for the rest of the year."
},
{
"speaker": "Alan Rifkin - Merrill Lynch",
"text": "Okay, but at the departmental level, for departments that, going forward, let's say, come in below your plan, is there opportunity to further reduce labor within those departments or are you pretty much at the lowest staffing levels today?"
},
{
"speaker": "Marvin Ellison",
"text": "We look at it case by case. And as it stands right now, I mean, we're not at any minimum staffing levels. We just try to maintain a certain level of service in our stores, and the reason why departments work is because it allows us to be granular and we can look at it department by department and make sure that we are flexing the necessary sources in areas where we need to to provide service."
},
{
"speaker": "Operator",
"text": "Your next question comes from T.J. McConville - Raymond James."
},
{
"speaker": "T.J. McConville - Raymond James",
"text": "The first question I had was a follow up to a previous question on the call. Craig, I think you said that ticket above $500 was off double-digit in October. I was wondering if maybe we could get a sense for where that was in the beginning parts of the quarter or maybe where it was last year?"
},
{
"speaker": "Craig Menear",
"text": "In the beginning parts of the quarter it was mid single-digit. We believe that there was some impact of that, particularly in September, as a result of hurricane sales and the repair that was happening in those particular parts of the country, but mid single-digits. And prior to that it ranged pretty much double-digit negative."
},
{
"speaker": "T.J. McConville - Raymond James",
"text": "And the second question I had was on the geographical regions. I know Frank gave us a pretty nice update at the beginning of the call on how things were looking. I was wondering if we could get a sense for the progression of decline throughout the quarter. Maybe a better way to ask would be did the bad markets sort of flatten out as things got worse and the good markets just got that much more bad or was it just an across-the-board deterioration for you?"
},
{
"speaker": "Frank Blake",
"text": "I'll be honest, T.J., I don't have the time lapsed photography on that to tell you exactly how it played out, so I'd be guessing if I gave you an answer on that. And, again, you'd see a lot of variation from within the market. Some markets impacted more dramatically through the quarter than others. But honestly, I just don't have that in my head."
},
{
"speaker": "Operator",
"text": "Your next question comes from Matthew Fassler - Goldman Sachs."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "As you disclosed the monthly comp numbers, are those impacted by the calendar shift as well or are those monthly progressions distorted or are they pretty clean?"
},
{
"speaker": "Carol B. Tome",
"text": "The monthly comps that we gave you were the reported comps. I'd be happy to give you the likeforlike comps."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "That'd be great."
},
{
"speaker": "Carol B. Tome",
"text": "Okay. So we reported a negative 6.5 for August. The like-for-like was negative 6.2. We reported a negative 7.4 for September. The like-for-like was negative 5.3. And we reported a negative 10.5 for October. The like-for-like was negative 9.4."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "So negative 9.4 would kind of be the comparable number as you left the quarter?"
},
{
"speaker": "Carol B. Tome",
"text": "Yeah."
},
{
"speaker": "Frank Blake",
"text": "Right."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "Secondly, can you try to quantify the impact that International had on the business and maybe put that in the context of what you had seen year-to-date, I guess both overall and then currency, I think, probably hurt you at least a little bit in the third quarter, having helped you prior to that, so if you could help us understand that as well."
},
{
"speaker": "Carol B. Tome",
"text": "Yes. Our reported comp for the quarter was negative 8.3%. Our U.S. comp was negative 8.4%. So that gives you some sense of the positive impact that we've seen from our nonU.S. businesses has diminished."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "And then obviously make the calendar adjustments comparably."
},
{
"speaker": "Carol B. Tome",
"text": "That's right."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "And then the comment that you made at the outset, Frank, of 15 of 40 markets having gotten better, just to make sure I understand, you're actually seeing some sequential improvement in a number of markets, it's just not as many markets as you thought you might as the compares get easier and probably by a lesser magnitude where you saw that improvement."
},
{
"speaker": "Frank Blake",
"text": "That's correct, both statements. It's fewer than we thought and it's not as much as we thought."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "And then finally, the payables ratio looked like it was down a bit year-on-year. If you could share with us whether there's any rhyme or reason to that movement and what we should look for over the course of the year?"
},
{
"speaker": "Carol B. Tome",
"text": "Yes. Our payables ratio was 57% compared to 60% a year ago. Last year you may recall we outsourced all of our payables processing to India. And candidly, we had some disruption. The 57% is where we think we should be. Now remember that at the end of each year there's always a low point in that ratio, so in the fourth quarter I would expect it to be around, call it 49%, something like that, and then it will build back up."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "Your aggregate market share numbers, you talked about having gained share in a number of categories. As you look at that third-party source, is there an aggregate share gain or loss that they gave you and, if they did, how has that moved versus the year-to-date trend?"
},
{
"speaker": "Frank Blake",
"text": "I don't think they do an aggregate."
},
{
"speaker": "Craig Menear",
"text": "They don't. They don't do an aggregate."
},
{
"speaker": "Diane Dayhoff",
"text": "Augusta, we have time for one more question."
},
{
"speaker": "Operator",
"text": "Your last question comes from Michael Lasser - Barclays Capital."
},
{
"speaker": "Michael Lasser - Barclays Capital",
"text": "Frank, at the outset you said you expect these pressures will continue into the fourth quarter of 2009. Maybe you could expand a little bit more on that comment and, if that is the case, will it necessitate a greater store rationalization program that you occurred earlier this year?"
},
{
"speaker": "Frank Blake",
"text": "We expect it to be to the fourth quarter and into 2009, as I said. And, you know, look, we look every quarter at our stores and try to make sure we're doing the right thing in terms of the stores that we have open. And I would say as we look at our orange box stores, we don't see a dramatic change from what we saw in the first quarter in terms of the long-term value of those stores."
},
{
"speaker": "Michael Lasser - Barclays Capital",
"text": "And a follow up for Carol. You mentioned that the leverage or deleverage per point of comp is now down to about 17 basis points. Will there be an asymmetric leverage profile such that you'll get much better leverage once the comp turns positive and how are you thinking about that?"
},
{
"speaker": "Carol B. Tome",
"text": "I'm looking for the day when that comp turns positive and, yes, there is an asymmetrical relationship as things start to move up."
},
{
"speaker": "Michael Lasser - Barclays Capital",
"text": "But it's hard to quantify at this point?"
},
{
"speaker": "Carol B. Tome",
"text": "It is. We're working through that right now. And as you can appreciate, Michael, all our focus has been on running the business in this very challenging sales environment. As we look out, planning for positive comps - and that day will come - we'll come back and tell you what the leverage looks like."
},
{
"speaker": "Michael Lasser - Barclays Capital",
"text": "What has caused the downshift from the 20 basis points to 17 basis points?"
},
{
"speaker": "Carol B. Tome",
"text": "Our 20 basis point rule is a rule of thumb. It's going to be around 20. I don't think it'll ever be exactly 20."
},
{
"speaker": "Diane Dayhoff",
"text": "Well, thank you, everyone, for joining us today, and we look forward to talking to you when we release our fourth quarter earnings on February 24."
},
{
"speaker": "Operator",
"text": "Thank you. This does conclude our call. We'd like to thank everyone for their participation. Have a great day."
}
] | null | null |
HD | 2 | 2,008 | 2008-08-19 09:00:00 | Executives: Diane Dayhoff - Senior Vice President, Investor Relations Frank Blake - Chairman, Chief Executive Officer Craig Menear - Senior Vice President, Merchandising Carol B. Tome - Chief Financial Officer, Executive Vice President Corporate Services Mark Holifield - Senior Vice President, Supply Chain
Analysts: Daniel Binder - Jefferies Christopher Horvers - J.P. Morgan Mitchell Kaiser - Piper Jaffray Budd Bugatch - Raymond James Matthew Fassler - Goldman Sachs Colin McGranahan - Sanford C. Bernstein Michael Lasser - Lehman Brothers David Strasser - Banc of America Securities Eric Bosshard - Cleveland Research Gregory Melich - Morgan Stanley
Operator: Good day, everyone and welcome to today’s Home Depot second quarter earnings conference call. As a reminder, today’s call is being recorded. Beginning today’s discussion is Ms. Diane Dayhoff, Senior Vice President of Investor Relations. Please go ahead, Madam.
Diane Dayhoff: Thank you, Augusta and good morning to everyone. Joining us on our call today are Frank Blake, Chairman and CEO of The Home Depot; Craig Menear, Executive Vice President of Merchandising; and Carol Tome, Chief Financial Officer and Executive Vice President, Corporate Services. Following our prepared remarks, the call will be open for analyst questions. Questions will be limited to analysts and investors and as a reminder, we would appreciate it if the participants would limit themselves to one question with one follow-up, please. This conference call is being broadcast real-time on the Internet at homedepot.com with links on both our homepage and the investor relations section. The replay will also be available on our site. If we are unable to get to your question this morning during the call, please call our investor relations department at 770-384-2387. Before I turn the call over to Frank, let me remind you that today’s press release and the presentations made by our executives include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties. These risks and uncertainties include, but are not limited to, those factors identified in the release and in our filings with the Securities and Exchange Commission. Now let me turn the call over to Frank Blake.
Frank Blake: Thank you, Diane and good morning, everyone. Sales for the second quarter were $21 billion, down 5.4%. Comp sales were negative 7.9%. As Carol will describe, sales for the quarter were negatively impacted by about $160 million because of the seasonal shift associated with 53 weeks in fiscal 2007. Adjusting for that, comp sales were negative 7.2%. Diluted earnings per share were $0.71. I think you all are well aware of the difficult environment in the housing and home improvement markets, so what I would like to do is discuss the areas where we are focused on for execution and give you a sense of the progress we are making and the ground we still have to cover. For the past 18 months, we’ve been working on our five key priorities -- associate engagement, shopping environment, product excitement, product availability, and own the pro. I won’t go through each of these but I’ll highlight some of the key items. On the product and merchandising side of the business, we have made significant progress. We have had better execution across the board. Craig and his team are implementing a portfolio approach to our merchandising efforts and this is already providing significant benefits. In a time of increasing price pressure, they are managing through the areas where we need to protect critical price points for our customers and at the same time, they are addressing areas where we need to recognize the cost increases that some of our vendors are facing. We are also managing our seasonal business more effectively. This allows us to redirect funds that would have been used in margin dollar eroding promotions and instead drive more coherent, better price points for our customers. On product availability or supply chain, we have three rapid deployment centers or RDCs serving 300 stores. Although our current RDCs are meeting or beating most of the measurements of performance that we set out for them, we believe that full rollout will be more effective when we’ve improved some of the key processes in the facilities. That is what we have been focused on over the last 90 days. Obviously we’d have preferred to keep to our initial rollout plan and to have hit no bumps in the road but this is a bump, not a detour. It impacts the timing in 2008 but not our overall timing. We remain committed to our RDC rollout strategy. Our core retail pilot in Canada is now live in 36 stores with 20 coming online yesterday. It is going well and remains on track to be completed in all Canadian stores by year-end. Most important, we continue to make progress with customer satisfaction, whether we measure that through our voice of the customer surveys or through other third-party measurements. One additional indicator that we’ve looked at is something known as the net promoter score. The net promoter score looks at the percentage of customers who rate their shopping experience as nine or a 10 and subtracts from that the percent of customers who rate the experience as a six or worse. The theory behind this is that the best way to grow is to get more customers who are promoters and fewer who are detractors. Our net promoter score has improved 480 basis points year over year and is now at 52.9%. Industry benchmarks say the best-in-class retailers have net promoter scores of over 50%. We still have a great deal of room to improve but it is encouraging that the investments we are making in the business are starting to make a discernible impact with our customers. On share performance, we have stabilized our share loss rate but we have not yet turned the corner on total share gain. Of the 13 major categories we look at, we believe we gained share in five but in some of the categories where we lost share, flooring, for example, we believe that we will reverse that loss in the remainder of the year. Long-term, we believe there’s a benefit to our customers and our shareholders in driving to a compelling everyday value proposition, even if there are short-term share fluctuations. As we look forward into the second half of the year, we see continued pressure in our markets. Housing and home improvement spend as a percent of GDP is now at 3.5% versus a 60-year historical average of 4.75%. From this data point on its own, you could foresee a near-term bottoming of the housing market but there are also pressures on the consumer from constriction of credit availability and increased costs of basic goods, so we remain cautious about our market in the back half of this year and into the first half of 2009. From our own results, we see modest improvement in some of our markets. For example, we look at the percent of our top 40 markets that have positively comped in the quarter. In the third quarter of 2007, 20% of our top 40 markets positively comped. In the fourth quarter of last year, that percentage was 12.5%. In the first quarter of this year, the number was zero. This past quarter, the number improved to 7.5% and two-thirds of our top 40 markets had better comp performance in the second quarter than the first. That is good news directionally. But some of that is undoubtedly due to the economic stimulus in the second quarter and may not be sustainable. It’s also important to bear in mind that our guidance assumes modest improved comp performance though still negative through the back half of the year, if only because of the easier comparisons from the back half of 2007 and 2006. One of the positives we see in 2009, as Carol will discuss shortly, is the renegotiation of our credit contract. We have finalized a new deal with Citi that will reduce the volatility in our cost of credit. On the international side of our business, Mexico remains very strong. It has posted double-digit positive comps for the 15th straight quarter. That is an outstanding record and is a testament to Ricardo Saldivar and our great associates in Mexico. Canada’s performance was also solid though some of the economic ills of the United States have impacted them and they have posted low-single-digit negative comps. They were particularly affected in the areas impacted by the auto industry and the slowing economy in the Western provinces. In China, we saw positive double-digit comp growth. In that context, I would like to recognize our 37 associates competing in the Olympic and Paralympic Games this summer. We have men and women from across the business competing in everything from track and field to rowing and cycling. We are very proud of these associates, as we are very proud and grateful to all of our associates. We are transforming this business in the midst of a very difficult environment. We are investing in the core, betting controlling our operational and merchandising processes, and seeing significant improvement in customer service, all through the hard work and focus of our 300,000 plus associates. We recognize our associates through a program called success sharing. At the end of the first half, 75% of our stores were eligible for success sharing and I am very pleased that we will be issuing success sharing checks in excess of $40 million, both company records. Now let me turn the call over to Craig.
Craig Menear: Thanks, Frank and good morning, everyone. In the second quarter, all selling departments reported negative comps. Plumbing outperformed the company’s average comp and seasonal and kitchen and bath were at the company’s average comp. Lumber, building materials, hardware, flooring, paint, electrical, and millwork were all below the company’s average comp and with the softness in these project businesses, average ticket was down 1.2% from last year to $57.58. Total company transactions were $361 million, down 4.2% from last year. Transactions in the $600-plus range comped down double-digit while transactions of less than $25 were down single digits. Regionally, we saw positive comp sales in the Southwest region, with every department in that region outperforming the company average. The Northern Plains region, while still negative, outperformed the company average comp in part due to the floods that affected the Midwest in July. While these areas are performing well, we continue to see double-digit negative comps in California and Florida markets for the fifth consecutive quarter. Despite the challenging environment in the second quarter, I am particularly proud of our execution. We focused on controlling what we could control. We managed our business by continuing to implement our focus bay approach, where every category has a specific role and intent, driving assortment, pricing, and marketing decisions. This, along with the better tools that we developed this year allowed us to tightly manage inventory and gross margin dollars during the quarter. For example, with our forecasting tool, we’ve gone from forecasting sales, margin and inventory for 13 departments on a monthly basis to forecasting 200 classes on a weekly basis. This type of insight helps us make better decisions with greater speed, which is invaluable when every dollar counts during these challenging times. In addition, this quarter we continued to reduce promotions. We were less promotional overall compared to last year and consciously focused on eliminating margin eroding promotions. This is important as our customers are looking for great value every day and we want to simplify their shopping experience. We have continued to see cost pressure in the quarter from price inflation in products that are metal and petroleum based. Our approach in dealing with this remains consistent. Each request is being handled individually with each supplier, since every situation is unique. Our pricing philosophy is to provide everyday great value and our retail pricing is set based on what the market will bear in conjunction with our focus bay approach, not cost. Our improved execution through our merchandising transformation helped us offset the impact from cost pressure in the market during the quarter. Despite the calendar shift, we saw solid sales in inventory performance in our seasonal businesses as a result of enhanced assortment planning at store level and tighter inventory management. Working with our new merchandising tools and our logistics partners, we planned and executed well in these businesses. For example, our home comfort categories experienced double-digit positive comp growth. Sales of air conditioning units and fans were up significantly as a result of the early hot summer experienced across much of the United States and we were able to respond effectively. To put this in perspective, for the first half of the year our top seasonal classes, sales, gross margin dollars, and inventory productivity each performed two times better than the company average. An area of relative strength remains basic repair. Customers are spending to maintain their homes. For example, in plumbing every major repair class in that department performed above the company average. We saw unit share gains against the market in several categories, including roofing, toilets, hardware, power tools and accessories, and electrical on a rolling 12 months, and all of these categories are essential to basic repair. Additionally, we know that customers are value conscious and some customers are shifting their buying patterns to more opening price point products. We benefited by responding to our customers’ needs and added more opening price point products to our assortments during the quarter. Energy efficient products also performed well this quarter. In anticipation of high energy costs later this year, consumers are focused on energy conservation and we are already seeing customers begin to respond to these challenges by preparing their homes with these products. This is a trend we expect to continue in the third quarter. Products such as weather stripping, caulk, CFL light-bulbs, air circulation, pipe insulation, all performed well and in the Northeast, we are already seeing strong sales in our fireplace category as customers are stocking up on pellet fuel before the cold weather arrives. As we head into the back half of the year, we are going to continue to pay attention to the trends in energy conservation as consumers further prepare to offset rising energy costs. We are introducing several new products, including the exclusive EcoSmart dimmable CFL light bulbs, water sense water saving faucets and toilets, and an innovative wall flush mount programmable thermostat from [Right Town]. In addition, we will continue to relevant Energy Star products, such as appliances, windows, furnaces, and water heaters. 2008 is going to continue to be challenging but the merchandising organization will remain focused on driving everyday great value for our customers using our enhanced merchandising tools and our focus bay approach. And now I would like to turn the call over to Carol.
Carol B. Tome: Thank you, Craig and good morning. In the second quarter, sales were $21 billion, a 5.4% decrease from last year, reflecting negative same-store sales of 7.9%, offset in part by sales from new stores. Earnings were $1.2 billion compared to $1.6 billion last year. Earnings per diluted share from continuing operations were $0.71 versus $0.77 last year. Comps or same-store sales were a negative 7.9% for the quarter, with negative comps up 7.3% in May and negative 8.1% in each of June and July. Our comp sales were slightly higher than our plan, reflecting we believe some benefit arising from the economic stimulus package. In 2007, we had 53 weeks in the year. This shifted our 2008 fiscal calendar. Because of this shift, and given the seasonal nature of our business, second quarter sales on a like-for-like calendar basis were negatively impacted by approximately $160 million. Excluding the calendar shift, our like-for-like comp for the quarter was negative 7.2%. In the second quarter, our gross margin was 33.2%, an increase of nine basis points from last year. Our gross margin reflects higher supply chain costs that negatively impacted gross margin by 18 basis points. As Craig mentioned, our gross margin expansion reflects better merchandising execution across all stores and this drove 23 basis points of margin expansion. And we had some benefit from running fewer credit promotions in the quarter, and that added four basis points to our gross margin. In the second quarter, operating expenses increased by 188 basis points to 23.4% of sales. In the second quarter, we recorded an $18 million charge related to the store rationalization decisions that we announced in the first quarter. Excluding the store rationalization charge, we deleveraged expenses by 179 basis points in the quarter. Our expense deleverage reflects for the most part the impact of negative sales. Generally, we expect to deleverage expenses by about 20 basis points for every point of negative comp. In the second quarter, our expense deleverage per point of negative comp was closer to 13 basis points as we experienced favorability in expense categories like advertising, medical, and workers compensation, among others. Further, as expected, in the second quarter we experienced about 73 basis points of expense deleverage due to a higher cost of credit associated with our private label credit card. And while we are on credit, let me comment on our private label agreement. Last week, we executed a new contract with Citi, our third party service provider. The contract will go into effect on January 1st of 2009 and run through January 2017. We are very pleased with the terms and conditions of this agreement. We are moving from a profit sharing agreement to a fixed fee agreement with some upside opportunity . Effectively, the new agreement removes the volatility in our cost of credit and puts a cap on our cost. We are estimating that our future cost of credit as a percent of private label credit sales will be in the 1% area and in no event will it exceed 1.5% in any one year. We will also receive an up-front cash payment of $220 million, which will be recognized as income over the life of the contract. Now, our operating margin was 9.7% in the second quarter, down 180 basis points from last year. Net interest expense was $157 million in the second quarter, up $12 million from last year, reflecting a decline in interest income due to lower investable cash balances, offset in part by lower interest expense arising from a favorable tax settlement. In the second quarter, we had a favorable settlement with the Province of Quebec, the result of which reduced interest expense by $20 million and tax expense by $8 million. In the second quarter, our income tax provision rate was 36.2%, due primarily do the favorable tax settlement, as well as lower state and foreign effective tax rates. We expect our tax rate to be approximately 36.4% for the year. Diluted shares for the second quarter were 1.69 billion shares, compared to 1.97 billion shares last year. The reduction in our outstanding shares is due to our share repurchase program and includes the tender offer we completed last September. We didn’t repurchase any shares during the second quarter, and as we have discussed, we plan to complete our debt financed recap once the market stabilizes but in the meantime, we may use excess liquidity to repurchase shares. Now, moving to our operational metrics, during the second quarter we opened 15 new stores, including one relocation and as planned, closed 15 stores for an ending store count of 2,257. Today, 251 stores, representing approximately 11% of our store base, operate in Canada, Mexico, and China. At the end of the second quarter, selling square footage was 237 million, a 3% increase from last year. Reflecting the sales environment, total sales per square foot were approximately $350 for the quarter, down 8.6% from last year. Now, turning to the balance sheet, at the end of the quarter, retail inventory was $11.9 billion, down 3.4% from last year. On a per store basis, inventory was down 5.9%. Our merchandising, supply chain, and operating groups have all worked hard to manage inventory while maintaining high in-stock rates and their efforts paid off. But based on the sales environment, our inventory turnover was 4.3 times compared to 4.6 times last year. Computed on the average of beginning and ending long-term debt and equity for the trailing four quarters, return on invested capital for continuing operations was approximately 10.7% but excluding the store rationalization charge, return on invested capital was 11.6%, down 210 basis points from last year. We ended the quarter with $45.1 billion in assets, including $1.1 billion in cash and short-term investments. This is an increase of approximately $605 million in cash and short-term investments from the end of fiscal 2007, and it reflects cash flow generated by the business of approximately $4 billion, offset by $960 million of capital expenditures, $760 million of dividends paid, and $1.7 billion used to repay outstanding commercial paper. In June, we told you that our 2008 capital spending plan was $2.2 billion. We now believe that 2008 capital expenditures will be $2 billion, primarily as a result of the timing of 2009 new store openings. As of the first half of 2008, we have spent 48% of our $2 billion forecast. Relative to our plan, we had a solid second quarter. Our financial results reflect a company that is managing its business in a difficult environment. The economic environment remains very challenging. Based on our first half results and our view of the back half, we believe that fiscal 2008 sales will decline by approximately 5% and fiscal 2008 earnings per share from continuing operations will decline by approximately 24%, consistent with the low end of our previous guidance. Now please note that our 2008 earnings per share guidance does not include the store rationalization charge. Thank you for your participation in today’s call and Augusta, we are now ready for questions.
Operator: (Operator Instructions) Daniel Binder with Jefferies has our first question.
Daniel Binder - Jefferies: I was wondering -- could you give us a rough idea of what you think the tax rebate stimulus may have done for your sales in the quarter, either in dollars or on a growth rate basis? And then also, if you could quantify the benefits you think you may have seen from the Midwest recovery efforts due to the floods.
Frank Blake: First on the tax rebates, this is -- we don’t have a clear line of sight into it but I will give you kind of the ballpark of how we look at it, and this is -- we look at the $500 million plus shift in the first quarter, the $160 million shift in the second quarter, one to the negative, one to the positive, go okay, there’s $400 million there and we think about three-quarters of it, so $300 million is probably related to the stimulus package. And in terms of the impact on the Midwest, that’s really -- it’s at a level of immateriality, probably around $10 million.
Daniel Binder - Jefferies: Okay, and then two other questions -- what was the contribution from international on the total comp store sales? And then, can you just remind us, Carol, what the cost of credit is this year so we can kind of figure out what the year-over-year benefit should be next year when you come down to something closer to 1%?
Frank Blake: So international was around 140 basis points. Carol, on the credit.
Carol B. Tome: And the cost of credit we estimate this year will be in the 2% area.
Daniel Binder - Jefferies: And do you think next year will be closer to the 1 or the 1.5?
Carol B. Tome: We’ll give you a better idea as we get into the year.
Daniel Binder - Jefferies: Okay. Thanks, I appreciate it.
Operator: Our next question will come from Christopher Horvers of J.P. Morgan.
Christopher Horvers - J.P. Morgan: Thank you and good morning. Can you talk about -- you know, it seems like it was a really good seasonal year here. You had stimulus checks, you had the weather drought recovery. Is there a way to look at your comps and say well, in the third quarter, if every category comped the same, how would your total comp change, given the mix change, ballpark?
Frank Blake: Every quarter has a different profile in terms of some categories go down, obviously seasonal goes down a little bit in the third quarter and other categories go up. So I’m not quite sure how to get a handle on your question of what -- Craig, do you want to give a shot at how that might look?
Craig Menear: If you think about just the garden business, for example, there the penetration actually shifts from slightly over 21% to slightly over 13% but at the same time, then you have things like fireplace that comes up, other seasonal businesses that actually kick in. So I don’t know that I can give you an exact number but there is certainly a change as a result of just the penetration of our garden business in the back half of the year.
Frank Blake: Is that helpful to you? I’m not sure we’re answering your question.
Christopher Horvers - J.P. Morgan: Yeah, it is. I mean, maybe if you could say -- if you think about everything you do in your backyard in the early Spring to early Summer, any sense on how those categories comped relative to the rest of the mix?
Craig Menear: Those categories actually performed above the company average in the quarter. Overall, as I mentioned, when we look at our core seasonal businesses for the entire season, the first half, if you will, they actually were two times better than the company average and we were certainly above what we anticipated in the quarter for those businesses. We actually exceeded our plans.
Christopher Horvers - J.P. Morgan: Okay, that’s very helpful. And then just one follow-up -- Carol, how should we think about the rest of the shift unwinding, the -- what was it, 290 basis points in 1Q, saw about 70 basis points in 2Q -- how does that play out in the back half, do you think?
Carol B. Tome: It should be negligible. Most of the shift is behind us, just because of the nature of our seasons, as you were just pointing out.
Christopher Horvers - J.P. Morgan: Okay. Thank you very much.
Operator: Mitch Kaiser with Piper Jaffray has our next question.
Mitchell Kaiser - Piper Jaffray: Good morning. I was hoping you could give us a little more detail on what you are going to do on the processes around the RDC, and then maybe what we need to see before -- I think overall you were taking that to 20 over time. If you could just give us a little more color on that, that would be helpful. Thanks.
Frank Blake: Sure, you bet, and we’ve got Mark Holifield here in the room, so I’ll turn that question over to Mark to address.
Mark Holifield: Good morning, everyone. Yes, we are slowing our 2008 openings but we feel we are on track for a 2010 completion where we would serve 100% of our stores. Our focus at this point is really ensuring a seamless rollout going forward, doing the right thing for our stores and our customers. The key things that we are focused on -- improving the in-stock at the stores, we’re pleased with where we are there. The RDCs have improved the in-stock for the SKUs that are covered by RDC. We’re improving our accuracy of shipments, the quality of timeliness -- and quality and timeliness of loads delivered to our stores and then our throughput productivity, and those are the things we are focused on as we go forward. I would expect to see one or two openings between now and the end of our fiscal year.
Mitchell Kaiser - Piper Jaffray: Okay, and I think you’ve said a goal that 75% of your COGS will go through either the lumber DCs, stocking DCs, or RDCs -- is that still consistent with that you are looking for over time?
Mark Holifield: Yes, our end goal is to have 70% to 80% of goods covered through central distribution. Keep in mind though that that includes, as you’ve said, other DCs besides RDCs to get there.
Mitchell Kaiser - Piper Jaffray: Okay. Thanks, guys. Good luck.
Operator: Thank you. We’ll go next to Budd Bugatch with Raymond James.
Budd Bugatch - Raymond James: Good morning, everyone. Carol, you’ve said that the second quarter relative to your plan was solid. Can you give us maybe a little bit more color on that and hopefully quantify some of that? Did you beat your own internal forecast in the second quarter and if so, at what line items?
Carol B. Tome: Budd, we did beat our internal forecast. We beat our sales forecast, we beat our earnings forecast. Now, we did get a benefit from the Quebec settlement that I pointed out, which was $0.01 of earnings better than our plan but we were -- we had a solid quarter. And it’s not just on the income statement. We were very pleased with the performance of inventory. We’re managing inventory in a very difficult environment.
Budd Bugatch - Raymond James: So ex the Quebec settlement, can you give us an idea of how much you may have beaten your plan by?
Diane Dayhoff: We don’t give that type of information.
Budd Bugatch - Raymond James: I know you don’t give quarterly guidance. I was just trying to get to where you were on a look-backward basis. Okay, one other question I have is just Craig, when you mentioned the performance to the comp average on all of the categories, you only had one that was above the company average in the quarter. Can you elucidate on that, maybe how much above or how that could work mathematically?
Craig Menear: Again, plumbing was the one that was above the company average and seasonal and our kitchen and bath businesses were performing at the company overall. And when you look at the balance, we continue to see challenges in the project businesses and around those projects that are significant discretionary spend in particular or large projects, so that the reference that I made as it related to transactions above $600, you know, that’s where we still continue to see the significant amount of challenge.
Frank Blake: And I think just on the math, you’ve got the higher penetration on our outdoor business, so when that’s at the company average, that’s how the math works.
Budd Bugatch - Raymond James: Okay. Thank you, Frank. Thank you, Craig.
Operator: We’ll go next to Matthew Fassler with Goldman Sachs.
Matthew Fassler - Goldman Sachs: Thanks a lot and good morning. I want to get a little bit of color, Frank and Carol, on the comments you made about what you expect for the rest of the year. I think you said that your expectation is that comps will be a bit better in the second half of the year than they were in the second quarter. If you flow that through the P&L, I believe that the operating margin has to come under a little bit of incremental pressure versus what you saw in the quarter, so I guess given your macro caution, I’m a bit surprised that you are as optimistic as you are on sales at the same time and wondering why the operating margin wouldn’t improve a little bit from the implied guidance.
Carol B. Tome: Well, Matt, as you pointed out, we do believe our comps will be slightly better in the back half than they were in the first half. And on the margin side, there are components of margins, first starting with gross profit. We said our gross profit margin would be flat to slightly positive for the year. For the first six months, I think we are up 14 basis points. I wouldn’t anticipate that we would repeat that in the back half. And from an operating expense perspective, we did have some expense favorability in the second quarter that we don’t think we’ll repeat in the back half of the year. So when we added it all together, we thought a realistic view of our business for the back half was consistent with the guidance that we had previously given, which is sales down approximately 5% and earnings per share down approximately [24%].
Matthew Fassler - Goldman Sachs: And just to amplify those a bit, Carol, is the gross margin -- expectation of some gross margin erosion a function of product price inflation or is there something else impacting that outlook?
Carol B. Tome: It’s a function of a number of factors, including mix changes.
Matthew Fassler - Goldman Sachs: And in terms of expense favorability, are there any call-outs that would get in the way in the second half of the year?
Carol B. Tome: Nothing that’s material, Matt -- it’s a lot of one, two basis point type of activities.
Matthew Fassler - Goldman Sachs: The second question that I have tries to dig a bit deeper into the distribution question. It sounds like the facilities that you have are doing okay versus your plan. You spoke about where you are going to focus your work in the existing DCs. I guess what was it that you saw that led you to slow down the rollout? There must have been something in performance or in your analytics that suggested you needed to do some more work here.
Frank Blake: I’ll give you my view on that, Matt, and also invite Mark to add his comments. As we have talked about before, when we opened the Dallas RDC, we saw that that had some significant operational issues in terms of what we had planned. And then we go back and you look at our pilot project in Braselton, the rollout in Chicago and Dallas, and you go gee, there are some significant process improvements that it would be good to make. And you have a choice -- you can say I want to make those significant process improvements as we go and keep to the original schedule or you go gee, this would be a good time to pause, get the operational improvements in now, and then roll. And to be candid, we had a lot of discussion about that amongst our senior leadership team and the advantage of a rollout like this in my view is we’ve got three RDCs up. It’s kind of a perfect time to have that pause, get things really the way you want them before you continue the rollout. And Mark can comment on this and we’ve said it before -- this is a big undertaking. I mean, we are trying to do in a very short period of time what other retailers would take 2X or 3X the amount of time to do. It’s valuable to -- the more you can replicate what you are doing and not have to make improvements on the run, the better off we think we’ll be in the rollout and the easier the integration with the store side of this and the merchandising side. So that was the thought process and I’ll ask Mark if he’s got some additional comments to add.
Mark Holifield: I think Frank has summed it up very well. I think we are sure the concept is sound based on what we’ve seen and we’ve been pleased with some of the initial indications of success. The work we are doing right now is really to ensure that we can do a fast rollout and achieve our 2010 objective.
Matthew Fassler - Goldman Sachs: I didn’t mean to cut you off, Mark, but are there any financial consequences, positive or negative, in the short-run from the changing of timing here?
Carol B. Tome: Not included in the guidance that we’ve given. Clearly we’ve secured some real estate that we’re not optimizing. It’s empty right now but that’s factored into the guidance that we gave.
Matthew Fassler - Goldman Sachs: Understood. Thanks so much.
Operator: We’ll go next to Colin McGranahan with Sanford Bernstein.
Colin McGranahan - Sanford C. Bernstein: Good morning. First, just on market share, it sounds like maybe a little bit of the improvement in momentum you had has stabilized here. It sounded to me like maybe the flooring category. Do you think that was just a function of some of the promotions that were run in the space? And if you could comment just a little bit more broadly on the general market share direction, especially relative to some of the competitive closings that we’re starting to see from the independents and just your general outlook on where you think market share goes from here.
Frank Blake: I think first, your comment on flooring, that is how we look at it and we see that in some other categories. Again, I’d emphasize that one of the things Craig and the merchandising team are doing is really putting some discipline around driving to every day compelling value propositions, trying to pull ourselves off of a lot of the promotional activity that we were doing. And that’s going to drive some short-term fluctuations in share but we think the long-term direction is right. I think versus some of our competitors, we look obviously at there are differences by quarter and we are particularly pleased in the second quarter, if you kind of look at historically where we’ve been in the second quarter, we think we’ve picked up ground from where we’ve typically been.
Colin McGranahan - Sanford C. Bernstein: Okay. And then just second, briefly on the cost of credit, assuming that you are down to 1% next year, my math would say that’s like about a 30 basis point positive impact for next year. And then how did you -- that’s excluding the three bps of the $200 million -- how did you possibly get a $200 million cash payment out of Citi at this point?
Frank Blake: I think both sides, Colin, this is -- I think this is an instance where we’ve had a good partnership with Citi over the last several years and we both sat down and worked out a new agreement that I think hit a lot of the concerns that they had, frankly, with our prior deal and addressed some of the concerns that we have. And Carol and her team did just an excellent job on I think setting the right path for the company on our credit agreement over the next -- you know, from 2009 through ’17.
Colin McGranahan - Sanford C. Bernstein: And did you shop that competitively then?
Carol B. Tome: We didn’t shop it competitively but we utilized a third-party advisor who is an expert in this field to assure that the terms and conditions of our agreement are market or better, and as Frank pointed out, we really had the benefit of an open book with Citi over the past five years, which allowed us to mutually come to agreements that work really well for both of us.
Colin McGranahan - Sanford C. Bernstein: Okay. Thank you.
Operator: Our next question will come from Michael Lasser with Lehman Brothers.
Michael Lasser - Lehman Brothers: Good morning. Thanks a lot for taking my questions. As you look at it today, what percent of sales are related to basic repair items? You’ve talked about relative strength in those areas for the last few quarters, so I’m curious -- if you trend that relative strength out for the foreseeable future, at what point does the mix shift towards those categories drive overall growth in the total sales? Because at some point, you comp negative on top of negative and the basic repair items will continue or non-discretionary items will continue and that should drive positive growth as some point.
Craig Menear: Michael, I can’t give you an exact percentage as it relates to our business in total because these repair categories cut across several of our reporting departments. But certainly our focus, our main focus is to continue to certainly drive the project business overall, which drives attachment sales and as a result right now, we’re seeing the consumer is certainly under these circumstances that they are facing with cost pressure in their own lives, basically focusing on doing things that they need to do to maintain their home, so whether it’s replacing water heaters or replacing a roof our patching a roof when something happens to their home, they are certainly making those kind of decisions. But over the long haul, it is about driving the project business, which is what will then achieve attachment sales and drive comp performance over time.
Michael Lasser - Lehman Brothers: Thank you. As a quick follow-up, as part of the new credit agreement, will any of the terms for new or existing cardholders be changed such that the availability of consumer credit under your private label program will be reduced next year?
Carol B. Tome: Not per the terms of our new agreement but I will tell you that this year, we have made some changes -- we being the collective we. For example, where we saw delinquencies in the past, we had not reduced the credit line. This year, we reduced the credit line to the amount of the outstanding because we thought that was prudent in the current environment. Further, we saw significant erosion in FICO scores and Citi pulls a credit report every month. There was significant erosion. There were some credit line reductions. But the more important aspect of all of this I believe is that we approve 68% of all credit card applications, so that continues to show us that the portfolio is robust.
Michael Lasser - Lehman Brothers: Can you quantify in any way what sort of impact the change in terms or the change in philosophy might have had on either the sales result or the portfolio?
Carol B. Tome: We don’t think the change in terms has had a material impact to the portfolio other than it helps a bit on the profitability side. We are being more selective in the type of promotions that we offer. Our everyday value proposition is if you use our private label credit card and you spend $299 on the card, it’s no interest, no payments for six months. From time to time, we offer 12 months no interest, no payment programs and we’ve cut back on those programs a little bit. Have they had an impact on sales? We can’t tell but we have cut back on the programs a bit.
Michael Lasser - Lehman Brothers: Sounds great. Thanks for the commentary. Best of luck.
Operator: We’ll go next to David Strasser with Banc of America.
David Strasser - Banc of America Securities: Thank you. I know you had talked about the impact of gross margin on inflation and so on with vendors, but just from a bigger picture, not so much numbers, what are you seeing with your customer and your ability to pass that through? And what is -- and where are you with your vendors? And as you sort of look out into the back half of next -- early ’09, do you think that gets to be a bigger issue for you guys, or do you think you are seeing kind of most of it now?
Frank Blake: Let me make a couple of general comments and then turn it to Craig. So what we’ve seen so far is you really almost have to take it category by category and vendor by vendor. So that’s both in terms of how Craig and the merchants approach the vendor requests, as well as what we see on the customer reaction. And one of the things I think Craig and team are doing a very good job at is, as he indicated, focusing on opening price points and also focusing as there are necessary price increases and trying to add value in the product, along with the price increases. Craig, maybe you want to add some commentary to that.
Craig Menear: I think what we are really trying to do is obviously work, as Frank said, individually with our suppliers because each situation is unique but at the same time, really trying to apply our focus bay approach in terms of how and where we might pass on retail. And it’s important to understand that from a merchandising direction that we’re giving in our team, is your retails aren’t linked to your cost. Retails are linked to what’s happening in the marketplace and what our portfolio strategy says that we want to get done. And then we work the balance of that. Cost obviously is independent of that. So right now, as we look forward, again certain things seem to be making moves. Lumber is starting to stabilize, it appears at this point. Framing lumber is not significantly different than last year, copper is pretty much flat to last year. Still obviously when you look at comparatives as it relates to steel or petroleum, there’s certainly pressure against last year, and I think that pressure will continue as we go through the back half. I’m not seeing anything right now that would indicate that we’ll see a dramatic fall-off in that.
David Strasser - Banc of America Securities: And just along those lines, I mean, looking at lumber, it’s a good one. Not only is it stabilizing, it actually seems to be going up in price, just from when we look at it, as a lot of other commodities seem to be declining in value. Any thoughts to why that would be happening? Is there anything you are seeing from a demand standpoint that would be driving that?
Craig Menear: Well, demand in the market overall with the current housing environment is down, so it is -- you know, it’s kind of a -- it’s strictly a supply/demand type of issue. So folks out there are trying to get what they can for the product that they are producing, so you are right. I mean, you are seeing sheet goods actually at a higher rate than the previous quarter. Dimensional lumber hasn’t quite reached that point but it’s close.
David Strasser - Banc of America Securities: It’s just surprising to see that, I guess, in this environment where you see housing, so I just figured I’d see. Anyway, thanks a lot.
Operator: Our next question will come from Eric Bosshard with Cleveland Research.
Eric Bosshard - Cleveland Research: Good morning. Two questions, I guess the first for Craig; on the EDLP focus you talked about or the comment was made that you gained share in five of 13 categories, or I guess lost share in eight of 13. Can you just talk about the rational benefit payback and commitment to continuing with this strategy and how you think that’s going to play out in that market share performance as we move forward?
Craig Menear: Again, we feel pretty strongly that listening to what our customers are saying through various research that we do, the customer is looking for us to simplify their shopping experience. The promotional activity complicates that for them. It focuses them into periods of time where they need to buy to feel like they’ve got the best deal. It also puts pressure up through the supply chain, through our suppliers when you have that kind of activity. So we feel pretty strongly that over the long-term, by providing a great value to our customer every day and having them understand that we have that great value every day, it will drive the confidence level for them to shop with us. And so I think over the long haul, that should in fact pay out in share for the Home Depot.
Eric Bosshard - Cleveland Research: And how long is the long haul, do you feel? How long does it take until this process starts to really incrementally create value for you?
Craig Menear: It’s a journey, Eric. I don’t know that I can fix a date out there. As we really work our focus bay approach and recognize that we have both assortment marketing, pricing elements to fix as we put those in place -- you know, this is a journey that we are going to take over the next probably couple of years.
Eric Bosshard - Cleveland Research: Okay, and then second question on SAP, understand that you had 20 stores put up and running but I guess prior to yesterday, you still had 16 up and running. It seems like the rollout in Canada has been more deliberate, which makes sense but understanding how deliberate it’s been up until yesterday, what gives you the confidence that you get through all of Canada by the end of the year and are there any experiences that have caused you to move at such a measured pace to this point?
Frank Blake: So it’s actually pretty consistent with what we had planned. I mean, the way the pilot was -- you know, it’s kind of the geography of the pilot was you do a couple of stores, do a dwell time, do a limited number of stores, have a dwell time, and the you start hitting a more rapid rollout pace of 20 to 25 stores that have clipped, and that was always the way it was laid out, so -- and again, it’s not that dissimilar from the RDC in terms of how you structure your pilot and initial rollout. There’s a little bit of pause at the start as you shake out the bugs and make sure you’ve got something that can really withstand a 20-store clip. Now, we just turned those 20 stores on on Monday, so that’s yesterday, so we’re so far, so good. And if you can do 20 at a clip, then you can move it up to 20, 25 and easily make the end of the year.
Eric Bosshard - Cleveland Research: And through the first 16, has the feedback or implementation been basically where you thought it would be?
Frank Blake: Yes.
Eric Bosshard - Cleveland Research: Okay. Thank you.
Diane Dayhoff: Augusta, we have time for one more question.
Operator: Thank you. That will come from Gregory Melich with Morgan Stanley.
Gregory Melich - Morgan Stanley: Thanks. Carol, you mentioned before that there were a few things in SG&A that were favorable this quarter that you didn’t see sticking in the back half. Could you sort of call those out or another way, look at the 3% growth in SG&A dollars -- is that a rate that we can maintain or is it going to go back to that more sort of 5% or 6%?
Carol B. Tome: Well, we talked about favorability in a number of expense categories like advertising, medical, workers’ compensation. I don’t see that favorability continuing into the back half, for example.
Gregory Melich - Morgan Stanley: Okay, and if we were to look at the growth from a dollar perspective, do you think the first quarter was more representative or is there -- because I mean, a 3% growth in dollars is impressive. We should be thinking about it is the fact that they grew a couple hundred bps more would be more normalized?
Carol B. Tome: I think the first quarter is more representative than the second quarter.
Gregory Melich - Morgan Stanley: Okay, great. And then a second question is the payables year over year -- I mean, the inventory looks nicely controlled. Also saw the payables come down. Is there something that was driving that uniquely or is it just the timing at the end of the -- or just fewer receipts? I mean, how should we look at that drop in payables?
Carol B. Tome: Sure. The way you should look at it, and our payables ratio at the end of the second quarter was 60%, so that’s pretty good but it is down from about 63% a year ago. And that’s actually because of some transition disruptions we had a year ago. We outsourced all of our payable functions to India and ran into a bit of disruption as a result, which we don’t like. We’re back in line now in terms of our service level agreements with a third party, in terms of our on-time payments with our suppliers. And that 60% ratio is the one that we would like to maintain. Of course, there’s a seasonal element to that, as you know -- it will always drop off at year-end but then it should come back up to the 60% range.
Gregory Melich - Morgan Stanley: Okay, great. And just one last, just as a follow-up to the first question -- if you talk about that 20 bps of deleverage that you’ve used historically, as you go into next year, if it is another down year, do you think that that’s still the right number or do you think that could end up being higher?
Carol B. Tome: We just started our 2009 planning activities, as you can appreciate, and we are working off of that same 20 basis point rule of thumb. And as we get closer to the end of the year and we firm up our plans, we’ll give you some more color.
Gregory Melich - Morgan Stanley: Okay, great. Thanks.
Diane Dayhoff: Well, thank you to everyone for joining us today and we look forward to talking to you next quarter.
Operator: That does conclude our call. We’d like to thank everyone for their participation. Have a great day. | [
{
"speaker": "Executives",
"text": "Diane Dayhoff - Senior Vice President, Investor Relations Frank Blake - Chairman, Chief Executive Officer Craig Menear - Senior Vice President, Merchandising Carol B. Tome - Chief Financial Officer, Executive Vice President Corporate Services Mark Holifield - Senior Vice President, Supply Chain"
},
{
"speaker": "Analysts",
"text": "Daniel Binder - Jefferies Christopher Horvers - J.P. Morgan Mitchell Kaiser - Piper Jaffray Budd Bugatch - Raymond James Matthew Fassler - Goldman Sachs Colin McGranahan - Sanford C. Bernstein Michael Lasser - Lehman Brothers David Strasser - Banc of America Securities Eric Bosshard - Cleveland Research Gregory Melich - Morgan Stanley"
},
{
"speaker": "Operator",
"text": "Good day, everyone and welcome to today’s Home Depot second quarter earnings conference call. As a reminder, today’s call is being recorded. Beginning today’s discussion is Ms. Diane Dayhoff, Senior Vice President of Investor Relations. Please go ahead, Madam."
},
{
"speaker": "Diane Dayhoff",
"text": "Thank you, Augusta and good morning to everyone. Joining us on our call today are Frank Blake, Chairman and CEO of The Home Depot; Craig Menear, Executive Vice President of Merchandising; and Carol Tome, Chief Financial Officer and Executive Vice President, Corporate Services. Following our prepared remarks, the call will be open for analyst questions. Questions will be limited to analysts and investors and as a reminder, we would appreciate it if the participants would limit themselves to one question with one follow-up, please. This conference call is being broadcast real-time on the Internet at homedepot.com with links on both our homepage and the investor relations section. The replay will also be available on our site. If we are unable to get to your question this morning during the call, please call our investor relations department at 770-384-2387. Before I turn the call over to Frank, let me remind you that today’s press release and the presentations made by our executives include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties. These risks and uncertainties include, but are not limited to, those factors identified in the release and in our filings with the Securities and Exchange Commission. Now let me turn the call over to Frank Blake."
},
{
"speaker": "Frank Blake",
"text": "Thank you, Diane and good morning, everyone. Sales for the second quarter were $21 billion, down 5.4%. Comp sales were negative 7.9%. As Carol will describe, sales for the quarter were negatively impacted by about $160 million because of the seasonal shift associated with 53 weeks in fiscal 2007. Adjusting for that, comp sales were negative 7.2%. Diluted earnings per share were $0.71. I think you all are well aware of the difficult environment in the housing and home improvement markets, so what I would like to do is discuss the areas where we are focused on for execution and give you a sense of the progress we are making and the ground we still have to cover. For the past 18 months, we’ve been working on our five key priorities -- associate engagement, shopping environment, product excitement, product availability, and own the pro. I won’t go through each of these but I’ll highlight some of the key items. On the product and merchandising side of the business, we have made significant progress. We have had better execution across the board. Craig and his team are implementing a portfolio approach to our merchandising efforts and this is already providing significant benefits. In a time of increasing price pressure, they are managing through the areas where we need to protect critical price points for our customers and at the same time, they are addressing areas where we need to recognize the cost increases that some of our vendors are facing. We are also managing our seasonal business more effectively. This allows us to redirect funds that would have been used in margin dollar eroding promotions and instead drive more coherent, better price points for our customers. On product availability or supply chain, we have three rapid deployment centers or RDCs serving 300 stores. Although our current RDCs are meeting or beating most of the measurements of performance that we set out for them, we believe that full rollout will be more effective when we’ve improved some of the key processes in the facilities. That is what we have been focused on over the last 90 days. Obviously we’d have preferred to keep to our initial rollout plan and to have hit no bumps in the road but this is a bump, not a detour. It impacts the timing in 2008 but not our overall timing. We remain committed to our RDC rollout strategy. Our core retail pilot in Canada is now live in 36 stores with 20 coming online yesterday. It is going well and remains on track to be completed in all Canadian stores by year-end. Most important, we continue to make progress with customer satisfaction, whether we measure that through our voice of the customer surveys or through other third-party measurements. One additional indicator that we’ve looked at is something known as the net promoter score. The net promoter score looks at the percentage of customers who rate their shopping experience as nine or a 10 and subtracts from that the percent of customers who rate the experience as a six or worse. The theory behind this is that the best way to grow is to get more customers who are promoters and fewer who are detractors. Our net promoter score has improved 480 basis points year over year and is now at 52.9%. Industry benchmarks say the best-in-class retailers have net promoter scores of over 50%. We still have a great deal of room to improve but it is encouraging that the investments we are making in the business are starting to make a discernible impact with our customers. On share performance, we have stabilized our share loss rate but we have not yet turned the corner on total share gain. Of the 13 major categories we look at, we believe we gained share in five but in some of the categories where we lost share, flooring, for example, we believe that we will reverse that loss in the remainder of the year. Long-term, we believe there’s a benefit to our customers and our shareholders in driving to a compelling everyday value proposition, even if there are short-term share fluctuations. As we look forward into the second half of the year, we see continued pressure in our markets. Housing and home improvement spend as a percent of GDP is now at 3.5% versus a 60-year historical average of 4.75%. From this data point on its own, you could foresee a near-term bottoming of the housing market but there are also pressures on the consumer from constriction of credit availability and increased costs of basic goods, so we remain cautious about our market in the back half of this year and into the first half of 2009. From our own results, we see modest improvement in some of our markets. For example, we look at the percent of our top 40 markets that have positively comped in the quarter. In the third quarter of 2007, 20% of our top 40 markets positively comped. In the fourth quarter of last year, that percentage was 12.5%. In the first quarter of this year, the number was zero. This past quarter, the number improved to 7.5% and two-thirds of our top 40 markets had better comp performance in the second quarter than the first. That is good news directionally. But some of that is undoubtedly due to the economic stimulus in the second quarter and may not be sustainable. It’s also important to bear in mind that our guidance assumes modest improved comp performance though still negative through the back half of the year, if only because of the easier comparisons from the back half of 2007 and 2006. One of the positives we see in 2009, as Carol will discuss shortly, is the renegotiation of our credit contract. We have finalized a new deal with Citi that will reduce the volatility in our cost of credit. On the international side of our business, Mexico remains very strong. It has posted double-digit positive comps for the 15th straight quarter. That is an outstanding record and is a testament to Ricardo Saldivar and our great associates in Mexico. Canada’s performance was also solid though some of the economic ills of the United States have impacted them and they have posted low-single-digit negative comps. They were particularly affected in the areas impacted by the auto industry and the slowing economy in the Western provinces. In China, we saw positive double-digit comp growth. In that context, I would like to recognize our 37 associates competing in the Olympic and Paralympic Games this summer. We have men and women from across the business competing in everything from track and field to rowing and cycling. We are very proud of these associates, as we are very proud and grateful to all of our associates. We are transforming this business in the midst of a very difficult environment. We are investing in the core, betting controlling our operational and merchandising processes, and seeing significant improvement in customer service, all through the hard work and focus of our 300,000 plus associates. We recognize our associates through a program called success sharing. At the end of the first half, 75% of our stores were eligible for success sharing and I am very pleased that we will be issuing success sharing checks in excess of $40 million, both company records. Now let me turn the call over to Craig."
},
{
"speaker": "Craig Menear",
"text": "Thanks, Frank and good morning, everyone. In the second quarter, all selling departments reported negative comps. Plumbing outperformed the company’s average comp and seasonal and kitchen and bath were at the company’s average comp. Lumber, building materials, hardware, flooring, paint, electrical, and millwork were all below the company’s average comp and with the softness in these project businesses, average ticket was down 1.2% from last year to $57.58. Total company transactions were $361 million, down 4.2% from last year. Transactions in the $600-plus range comped down double-digit while transactions of less than $25 were down single digits. Regionally, we saw positive comp sales in the Southwest region, with every department in that region outperforming the company average. The Northern Plains region, while still negative, outperformed the company average comp in part due to the floods that affected the Midwest in July. While these areas are performing well, we continue to see double-digit negative comps in California and Florida markets for the fifth consecutive quarter. Despite the challenging environment in the second quarter, I am particularly proud of our execution. We focused on controlling what we could control. We managed our business by continuing to implement our focus bay approach, where every category has a specific role and intent, driving assortment, pricing, and marketing decisions. This, along with the better tools that we developed this year allowed us to tightly manage inventory and gross margin dollars during the quarter. For example, with our forecasting tool, we’ve gone from forecasting sales, margin and inventory for 13 departments on a monthly basis to forecasting 200 classes on a weekly basis. This type of insight helps us make better decisions with greater speed, which is invaluable when every dollar counts during these challenging times. In addition, this quarter we continued to reduce promotions. We were less promotional overall compared to last year and consciously focused on eliminating margin eroding promotions. This is important as our customers are looking for great value every day and we want to simplify their shopping experience. We have continued to see cost pressure in the quarter from price inflation in products that are metal and petroleum based. Our approach in dealing with this remains consistent. Each request is being handled individually with each supplier, since every situation is unique. Our pricing philosophy is to provide everyday great value and our retail pricing is set based on what the market will bear in conjunction with our focus bay approach, not cost. Our improved execution through our merchandising transformation helped us offset the impact from cost pressure in the market during the quarter. Despite the calendar shift, we saw solid sales in inventory performance in our seasonal businesses as a result of enhanced assortment planning at store level and tighter inventory management. Working with our new merchandising tools and our logistics partners, we planned and executed well in these businesses. For example, our home comfort categories experienced double-digit positive comp growth. Sales of air conditioning units and fans were up significantly as a result of the early hot summer experienced across much of the United States and we were able to respond effectively. To put this in perspective, for the first half of the year our top seasonal classes, sales, gross margin dollars, and inventory productivity each performed two times better than the company average. An area of relative strength remains basic repair. Customers are spending to maintain their homes. For example, in plumbing every major repair class in that department performed above the company average. We saw unit share gains against the market in several categories, including roofing, toilets, hardware, power tools and accessories, and electrical on a rolling 12 months, and all of these categories are essential to basic repair. Additionally, we know that customers are value conscious and some customers are shifting their buying patterns to more opening price point products. We benefited by responding to our customers’ needs and added more opening price point products to our assortments during the quarter. Energy efficient products also performed well this quarter. In anticipation of high energy costs later this year, consumers are focused on energy conservation and we are already seeing customers begin to respond to these challenges by preparing their homes with these products. This is a trend we expect to continue in the third quarter. Products such as weather stripping, caulk, CFL light-bulbs, air circulation, pipe insulation, all performed well and in the Northeast, we are already seeing strong sales in our fireplace category as customers are stocking up on pellet fuel before the cold weather arrives. As we head into the back half of the year, we are going to continue to pay attention to the trends in energy conservation as consumers further prepare to offset rising energy costs. We are introducing several new products, including the exclusive EcoSmart dimmable CFL light bulbs, water sense water saving faucets and toilets, and an innovative wall flush mount programmable thermostat from [Right Town]. In addition, we will continue to relevant Energy Star products, such as appliances, windows, furnaces, and water heaters. 2008 is going to continue to be challenging but the merchandising organization will remain focused on driving everyday great value for our customers using our enhanced merchandising tools and our focus bay approach. And now I would like to turn the call over to Carol."
},
{
"speaker": "Carol B. Tome",
"text": "Thank you, Craig and good morning. In the second quarter, sales were $21 billion, a 5.4% decrease from last year, reflecting negative same-store sales of 7.9%, offset in part by sales from new stores. Earnings were $1.2 billion compared to $1.6 billion last year. Earnings per diluted share from continuing operations were $0.71 versus $0.77 last year. Comps or same-store sales were a negative 7.9% for the quarter, with negative comps up 7.3% in May and negative 8.1% in each of June and July. Our comp sales were slightly higher than our plan, reflecting we believe some benefit arising from the economic stimulus package. In 2007, we had 53 weeks in the year. This shifted our 2008 fiscal calendar. Because of this shift, and given the seasonal nature of our business, second quarter sales on a like-for-like calendar basis were negatively impacted by approximately $160 million. Excluding the calendar shift, our like-for-like comp for the quarter was negative 7.2%. In the second quarter, our gross margin was 33.2%, an increase of nine basis points from last year. Our gross margin reflects higher supply chain costs that negatively impacted gross margin by 18 basis points. As Craig mentioned, our gross margin expansion reflects better merchandising execution across all stores and this drove 23 basis points of margin expansion. And we had some benefit from running fewer credit promotions in the quarter, and that added four basis points to our gross margin. In the second quarter, operating expenses increased by 188 basis points to 23.4% of sales. In the second quarter, we recorded an $18 million charge related to the store rationalization decisions that we announced in the first quarter. Excluding the store rationalization charge, we deleveraged expenses by 179 basis points in the quarter. Our expense deleverage reflects for the most part the impact of negative sales. Generally, we expect to deleverage expenses by about 20 basis points for every point of negative comp. In the second quarter, our expense deleverage per point of negative comp was closer to 13 basis points as we experienced favorability in expense categories like advertising, medical, and workers compensation, among others. Further, as expected, in the second quarter we experienced about 73 basis points of expense deleverage due to a higher cost of credit associated with our private label credit card. And while we are on credit, let me comment on our private label agreement. Last week, we executed a new contract with Citi, our third party service provider. The contract will go into effect on January 1st of 2009 and run through January 2017. We are very pleased with the terms and conditions of this agreement. We are moving from a profit sharing agreement to a fixed fee agreement with some upside opportunity . Effectively, the new agreement removes the volatility in our cost of credit and puts a cap on our cost. We are estimating that our future cost of credit as a percent of private label credit sales will be in the 1% area and in no event will it exceed 1.5% in any one year. We will also receive an up-front cash payment of $220 million, which will be recognized as income over the life of the contract. Now, our operating margin was 9.7% in the second quarter, down 180 basis points from last year. Net interest expense was $157 million in the second quarter, up $12 million from last year, reflecting a decline in interest income due to lower investable cash balances, offset in part by lower interest expense arising from a favorable tax settlement. In the second quarter, we had a favorable settlement with the Province of Quebec, the result of which reduced interest expense by $20 million and tax expense by $8 million. In the second quarter, our income tax provision rate was 36.2%, due primarily do the favorable tax settlement, as well as lower state and foreign effective tax rates. We expect our tax rate to be approximately 36.4% for the year. Diluted shares for the second quarter were 1.69 billion shares, compared to 1.97 billion shares last year. The reduction in our outstanding shares is due to our share repurchase program and includes the tender offer we completed last September. We didn’t repurchase any shares during the second quarter, and as we have discussed, we plan to complete our debt financed recap once the market stabilizes but in the meantime, we may use excess liquidity to repurchase shares. Now, moving to our operational metrics, during the second quarter we opened 15 new stores, including one relocation and as planned, closed 15 stores for an ending store count of 2,257. Today, 251 stores, representing approximately 11% of our store base, operate in Canada, Mexico, and China. At the end of the second quarter, selling square footage was 237 million, a 3% increase from last year. Reflecting the sales environment, total sales per square foot were approximately $350 for the quarter, down 8.6% from last year. Now, turning to the balance sheet, at the end of the quarter, retail inventory was $11.9 billion, down 3.4% from last year. On a per store basis, inventory was down 5.9%. Our merchandising, supply chain, and operating groups have all worked hard to manage inventory while maintaining high in-stock rates and their efforts paid off. But based on the sales environment, our inventory turnover was 4.3 times compared to 4.6 times last year. Computed on the average of beginning and ending long-term debt and equity for the trailing four quarters, return on invested capital for continuing operations was approximately 10.7% but excluding the store rationalization charge, return on invested capital was 11.6%, down 210 basis points from last year. We ended the quarter with $45.1 billion in assets, including $1.1 billion in cash and short-term investments. This is an increase of approximately $605 million in cash and short-term investments from the end of fiscal 2007, and it reflects cash flow generated by the business of approximately $4 billion, offset by $960 million of capital expenditures, $760 million of dividends paid, and $1.7 billion used to repay outstanding commercial paper. In June, we told you that our 2008 capital spending plan was $2.2 billion. We now believe that 2008 capital expenditures will be $2 billion, primarily as a result of the timing of 2009 new store openings. As of the first half of 2008, we have spent 48% of our $2 billion forecast. Relative to our plan, we had a solid second quarter. Our financial results reflect a company that is managing its business in a difficult environment. The economic environment remains very challenging. Based on our first half results and our view of the back half, we believe that fiscal 2008 sales will decline by approximately 5% and fiscal 2008 earnings per share from continuing operations will decline by approximately 24%, consistent with the low end of our previous guidance. Now please note that our 2008 earnings per share guidance does not include the store rationalization charge. Thank you for your participation in today’s call and Augusta, we are now ready for questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Daniel Binder with Jefferies has our first question."
},
{
"speaker": "Daniel Binder - Jefferies",
"text": "I was wondering -- could you give us a rough idea of what you think the tax rebate stimulus may have done for your sales in the quarter, either in dollars or on a growth rate basis? And then also, if you could quantify the benefits you think you may have seen from the Midwest recovery efforts due to the floods."
},
{
"speaker": "Frank Blake",
"text": "First on the tax rebates, this is -- we don’t have a clear line of sight into it but I will give you kind of the ballpark of how we look at it, and this is -- we look at the $500 million plus shift in the first quarter, the $160 million shift in the second quarter, one to the negative, one to the positive, go okay, there’s $400 million there and we think about three-quarters of it, so $300 million is probably related to the stimulus package. And in terms of the impact on the Midwest, that’s really -- it’s at a level of immateriality, probably around $10 million."
},
{
"speaker": "Daniel Binder - Jefferies",
"text": "Okay, and then two other questions -- what was the contribution from international on the total comp store sales? And then, can you just remind us, Carol, what the cost of credit is this year so we can kind of figure out what the year-over-year benefit should be next year when you come down to something closer to 1%?"
},
{
"speaker": "Frank Blake",
"text": "So international was around 140 basis points. Carol, on the credit."
},
{
"speaker": "Carol B. Tome",
"text": "And the cost of credit we estimate this year will be in the 2% area."
},
{
"speaker": "Daniel Binder - Jefferies",
"text": "And do you think next year will be closer to the 1 or the 1.5?"
},
{
"speaker": "Carol B. Tome",
"text": "We’ll give you a better idea as we get into the year."
},
{
"speaker": "Daniel Binder - Jefferies",
"text": "Okay. Thanks, I appreciate it."
},
{
"speaker": "Operator",
"text": "Our next question will come from Christopher Horvers of J.P. Morgan."
},
{
"speaker": "Christopher Horvers - J.P. Morgan",
"text": "Thank you and good morning. Can you talk about -- you know, it seems like it was a really good seasonal year here. You had stimulus checks, you had the weather drought recovery. Is there a way to look at your comps and say well, in the third quarter, if every category comped the same, how would your total comp change, given the mix change, ballpark?"
},
{
"speaker": "Frank Blake",
"text": "Every quarter has a different profile in terms of some categories go down, obviously seasonal goes down a little bit in the third quarter and other categories go up. So I’m not quite sure how to get a handle on your question of what -- Craig, do you want to give a shot at how that might look?"
},
{
"speaker": "Craig Menear",
"text": "If you think about just the garden business, for example, there the penetration actually shifts from slightly over 21% to slightly over 13% but at the same time, then you have things like fireplace that comes up, other seasonal businesses that actually kick in. So I don’t know that I can give you an exact number but there is certainly a change as a result of just the penetration of our garden business in the back half of the year."
},
{
"speaker": "Frank Blake",
"text": "Is that helpful to you? I’m not sure we’re answering your question."
},
{
"speaker": "Christopher Horvers - J.P. Morgan",
"text": "Yeah, it is. I mean, maybe if you could say -- if you think about everything you do in your backyard in the early Spring to early Summer, any sense on how those categories comped relative to the rest of the mix?"
},
{
"speaker": "Craig Menear",
"text": "Those categories actually performed above the company average in the quarter. Overall, as I mentioned, when we look at our core seasonal businesses for the entire season, the first half, if you will, they actually were two times better than the company average and we were certainly above what we anticipated in the quarter for those businesses. We actually exceeded our plans."
},
{
"speaker": "Christopher Horvers - J.P. Morgan",
"text": "Okay, that’s very helpful. And then just one follow-up -- Carol, how should we think about the rest of the shift unwinding, the -- what was it, 290 basis points in 1Q, saw about 70 basis points in 2Q -- how does that play out in the back half, do you think?"
},
{
"speaker": "Carol B. Tome",
"text": "It should be negligible. Most of the shift is behind us, just because of the nature of our seasons, as you were just pointing out."
},
{
"speaker": "Christopher Horvers - J.P. Morgan",
"text": "Okay. Thank you very much."
},
{
"speaker": "Operator",
"text": "Mitch Kaiser with Piper Jaffray has our next question."
},
{
"speaker": "Mitchell Kaiser - Piper Jaffray",
"text": "Good morning. I was hoping you could give us a little more detail on what you are going to do on the processes around the RDC, and then maybe what we need to see before -- I think overall you were taking that to 20 over time. If you could just give us a little more color on that, that would be helpful. Thanks."
},
{
"speaker": "Frank Blake",
"text": "Sure, you bet, and we’ve got Mark Holifield here in the room, so I’ll turn that question over to Mark to address."
},
{
"speaker": "Mark Holifield",
"text": "Good morning, everyone. Yes, we are slowing our 2008 openings but we feel we are on track for a 2010 completion where we would serve 100% of our stores. Our focus at this point is really ensuring a seamless rollout going forward, doing the right thing for our stores and our customers. The key things that we are focused on -- improving the in-stock at the stores, we’re pleased with where we are there. The RDCs have improved the in-stock for the SKUs that are covered by RDC. We’re improving our accuracy of shipments, the quality of timeliness -- and quality and timeliness of loads delivered to our stores and then our throughput productivity, and those are the things we are focused on as we go forward. I would expect to see one or two openings between now and the end of our fiscal year."
},
{
"speaker": "Mitchell Kaiser - Piper Jaffray",
"text": "Okay, and I think you’ve said a goal that 75% of your COGS will go through either the lumber DCs, stocking DCs, or RDCs -- is that still consistent with that you are looking for over time?"
},
{
"speaker": "Mark Holifield",
"text": "Yes, our end goal is to have 70% to 80% of goods covered through central distribution. Keep in mind though that that includes, as you’ve said, other DCs besides RDCs to get there."
},
{
"speaker": "Mitchell Kaiser - Piper Jaffray",
"text": "Okay. Thanks, guys. Good luck."
},
{
"speaker": "Operator",
"text": "Thank you. We’ll go next to Budd Bugatch with Raymond James."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "Good morning, everyone. Carol, you’ve said that the second quarter relative to your plan was solid. Can you give us maybe a little bit more color on that and hopefully quantify some of that? Did you beat your own internal forecast in the second quarter and if so, at what line items?"
},
{
"speaker": "Carol B. Tome",
"text": "Budd, we did beat our internal forecast. We beat our sales forecast, we beat our earnings forecast. Now, we did get a benefit from the Quebec settlement that I pointed out, which was $0.01 of earnings better than our plan but we were -- we had a solid quarter. And it’s not just on the income statement. We were very pleased with the performance of inventory. We’re managing inventory in a very difficult environment."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "So ex the Quebec settlement, can you give us an idea of how much you may have beaten your plan by?"
},
{
"speaker": "Diane Dayhoff",
"text": "We don’t give that type of information."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "I know you don’t give quarterly guidance. I was just trying to get to where you were on a look-backward basis. Okay, one other question I have is just Craig, when you mentioned the performance to the comp average on all of the categories, you only had one that was above the company average in the quarter. Can you elucidate on that, maybe how much above or how that could work mathematically?"
},
{
"speaker": "Craig Menear",
"text": "Again, plumbing was the one that was above the company average and seasonal and our kitchen and bath businesses were performing at the company overall. And when you look at the balance, we continue to see challenges in the project businesses and around those projects that are significant discretionary spend in particular or large projects, so that the reference that I made as it related to transactions above $600, you know, that’s where we still continue to see the significant amount of challenge."
},
{
"speaker": "Frank Blake",
"text": "And I think just on the math, you’ve got the higher penetration on our outdoor business, so when that’s at the company average, that’s how the math works."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "Okay. Thank you, Frank. Thank you, Craig."
},
{
"speaker": "Operator",
"text": "We’ll go next to Matthew Fassler with Goldman Sachs."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "Thanks a lot and good morning. I want to get a little bit of color, Frank and Carol, on the comments you made about what you expect for the rest of the year. I think you said that your expectation is that comps will be a bit better in the second half of the year than they were in the second quarter. If you flow that through the P&L, I believe that the operating margin has to come under a little bit of incremental pressure versus what you saw in the quarter, so I guess given your macro caution, I’m a bit surprised that you are as optimistic as you are on sales at the same time and wondering why the operating margin wouldn’t improve a little bit from the implied guidance."
},
{
"speaker": "Carol B. Tome",
"text": "Well, Matt, as you pointed out, we do believe our comps will be slightly better in the back half than they were in the first half. And on the margin side, there are components of margins, first starting with gross profit. We said our gross profit margin would be flat to slightly positive for the year. For the first six months, I think we are up 14 basis points. I wouldn’t anticipate that we would repeat that in the back half. And from an operating expense perspective, we did have some expense favorability in the second quarter that we don’t think we’ll repeat in the back half of the year. So when we added it all together, we thought a realistic view of our business for the back half was consistent with the guidance that we had previously given, which is sales down approximately 5% and earnings per share down approximately [24%]."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "And just to amplify those a bit, Carol, is the gross margin -- expectation of some gross margin erosion a function of product price inflation or is there something else impacting that outlook?"
},
{
"speaker": "Carol B. Tome",
"text": "It’s a function of a number of factors, including mix changes."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "And in terms of expense favorability, are there any call-outs that would get in the way in the second half of the year?"
},
{
"speaker": "Carol B. Tome",
"text": "Nothing that’s material, Matt -- it’s a lot of one, two basis point type of activities."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "The second question that I have tries to dig a bit deeper into the distribution question. It sounds like the facilities that you have are doing okay versus your plan. You spoke about where you are going to focus your work in the existing DCs. I guess what was it that you saw that led you to slow down the rollout? There must have been something in performance or in your analytics that suggested you needed to do some more work here."
},
{
"speaker": "Frank Blake",
"text": "I’ll give you my view on that, Matt, and also invite Mark to add his comments. As we have talked about before, when we opened the Dallas RDC, we saw that that had some significant operational issues in terms of what we had planned. And then we go back and you look at our pilot project in Braselton, the rollout in Chicago and Dallas, and you go gee, there are some significant process improvements that it would be good to make. And you have a choice -- you can say I want to make those significant process improvements as we go and keep to the original schedule or you go gee, this would be a good time to pause, get the operational improvements in now, and then roll. And to be candid, we had a lot of discussion about that amongst our senior leadership team and the advantage of a rollout like this in my view is we’ve got three RDCs up. It’s kind of a perfect time to have that pause, get things really the way you want them before you continue the rollout. And Mark can comment on this and we’ve said it before -- this is a big undertaking. I mean, we are trying to do in a very short period of time what other retailers would take 2X or 3X the amount of time to do. It’s valuable to -- the more you can replicate what you are doing and not have to make improvements on the run, the better off we think we’ll be in the rollout and the easier the integration with the store side of this and the merchandising side. So that was the thought process and I’ll ask Mark if he’s got some additional comments to add."
},
{
"speaker": "Mark Holifield",
"text": "I think Frank has summed it up very well. I think we are sure the concept is sound based on what we’ve seen and we’ve been pleased with some of the initial indications of success. The work we are doing right now is really to ensure that we can do a fast rollout and achieve our 2010 objective."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "I didn’t mean to cut you off, Mark, but are there any financial consequences, positive or negative, in the short-run from the changing of timing here?"
},
{
"speaker": "Carol B. Tome",
"text": "Not included in the guidance that we’ve given. Clearly we’ve secured some real estate that we’re not optimizing. It’s empty right now but that’s factored into the guidance that we gave."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "Understood. Thanks so much."
},
{
"speaker": "Operator",
"text": "We’ll go next to Colin McGranahan with Sanford Bernstein."
},
{
"speaker": "Colin McGranahan - Sanford C. Bernstein",
"text": "Good morning. First, just on market share, it sounds like maybe a little bit of the improvement in momentum you had has stabilized here. It sounded to me like maybe the flooring category. Do you think that was just a function of some of the promotions that were run in the space? And if you could comment just a little bit more broadly on the general market share direction, especially relative to some of the competitive closings that we’re starting to see from the independents and just your general outlook on where you think market share goes from here."
},
{
"speaker": "Frank Blake",
"text": "I think first, your comment on flooring, that is how we look at it and we see that in some other categories. Again, I’d emphasize that one of the things Craig and the merchandising team are doing is really putting some discipline around driving to every day compelling value propositions, trying to pull ourselves off of a lot of the promotional activity that we were doing. And that’s going to drive some short-term fluctuations in share but we think the long-term direction is right. I think versus some of our competitors, we look obviously at there are differences by quarter and we are particularly pleased in the second quarter, if you kind of look at historically where we’ve been in the second quarter, we think we’ve picked up ground from where we’ve typically been."
},
{
"speaker": "Colin McGranahan - Sanford C. Bernstein",
"text": "Okay. And then just second, briefly on the cost of credit, assuming that you are down to 1% next year, my math would say that’s like about a 30 basis point positive impact for next year. And then how did you -- that’s excluding the three bps of the $200 million -- how did you possibly get a $200 million cash payment out of Citi at this point?"
},
{
"speaker": "Frank Blake",
"text": "I think both sides, Colin, this is -- I think this is an instance where we’ve had a good partnership with Citi over the last several years and we both sat down and worked out a new agreement that I think hit a lot of the concerns that they had, frankly, with our prior deal and addressed some of the concerns that we have. And Carol and her team did just an excellent job on I think setting the right path for the company on our credit agreement over the next -- you know, from 2009 through ’17."
},
{
"speaker": "Colin McGranahan - Sanford C. Bernstein",
"text": "And did you shop that competitively then?"
},
{
"speaker": "Carol B. Tome",
"text": "We didn’t shop it competitively but we utilized a third-party advisor who is an expert in this field to assure that the terms and conditions of our agreement are market or better, and as Frank pointed out, we really had the benefit of an open book with Citi over the past five years, which allowed us to mutually come to agreements that work really well for both of us."
},
{
"speaker": "Colin McGranahan - Sanford C. Bernstein",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question will come from Michael Lasser with Lehman Brothers."
},
{
"speaker": "Michael Lasser - Lehman Brothers",
"text": "Good morning. Thanks a lot for taking my questions. As you look at it today, what percent of sales are related to basic repair items? You’ve talked about relative strength in those areas for the last few quarters, so I’m curious -- if you trend that relative strength out for the foreseeable future, at what point does the mix shift towards those categories drive overall growth in the total sales? Because at some point, you comp negative on top of negative and the basic repair items will continue or non-discretionary items will continue and that should drive positive growth as some point."
},
{
"speaker": "Craig Menear",
"text": "Michael, I can’t give you an exact percentage as it relates to our business in total because these repair categories cut across several of our reporting departments. But certainly our focus, our main focus is to continue to certainly drive the project business overall, which drives attachment sales and as a result right now, we’re seeing the consumer is certainly under these circumstances that they are facing with cost pressure in their own lives, basically focusing on doing things that they need to do to maintain their home, so whether it’s replacing water heaters or replacing a roof our patching a roof when something happens to their home, they are certainly making those kind of decisions. But over the long haul, it is about driving the project business, which is what will then achieve attachment sales and drive comp performance over time."
},
{
"speaker": "Michael Lasser - Lehman Brothers",
"text": "Thank you. As a quick follow-up, as part of the new credit agreement, will any of the terms for new or existing cardholders be changed such that the availability of consumer credit under your private label program will be reduced next year?"
},
{
"speaker": "Carol B. Tome",
"text": "Not per the terms of our new agreement but I will tell you that this year, we have made some changes -- we being the collective we. For example, where we saw delinquencies in the past, we had not reduced the credit line. This year, we reduced the credit line to the amount of the outstanding because we thought that was prudent in the current environment. Further, we saw significant erosion in FICO scores and Citi pulls a credit report every month. There was significant erosion. There were some credit line reductions. But the more important aspect of all of this I believe is that we approve 68% of all credit card applications, so that continues to show us that the portfolio is robust."
},
{
"speaker": "Michael Lasser - Lehman Brothers",
"text": "Can you quantify in any way what sort of impact the change in terms or the change in philosophy might have had on either the sales result or the portfolio?"
},
{
"speaker": "Carol B. Tome",
"text": "We don’t think the change in terms has had a material impact to the portfolio other than it helps a bit on the profitability side. We are being more selective in the type of promotions that we offer. Our everyday value proposition is if you use our private label credit card and you spend $299 on the card, it’s no interest, no payments for six months. From time to time, we offer 12 months no interest, no payment programs and we’ve cut back on those programs a little bit. Have they had an impact on sales? We can’t tell but we have cut back on the programs a bit."
},
{
"speaker": "Michael Lasser - Lehman Brothers",
"text": "Sounds great. Thanks for the commentary. Best of luck."
},
{
"speaker": "Operator",
"text": "We’ll go next to David Strasser with Banc of America."
},
{
"speaker": "David Strasser - Banc of America Securities",
"text": "Thank you. I know you had talked about the impact of gross margin on inflation and so on with vendors, but just from a bigger picture, not so much numbers, what are you seeing with your customer and your ability to pass that through? And what is -- and where are you with your vendors? And as you sort of look out into the back half of next -- early ’09, do you think that gets to be a bigger issue for you guys, or do you think you are seeing kind of most of it now?"
},
{
"speaker": "Frank Blake",
"text": "Let me make a couple of general comments and then turn it to Craig. So what we’ve seen so far is you really almost have to take it category by category and vendor by vendor. So that’s both in terms of how Craig and the merchants approach the vendor requests, as well as what we see on the customer reaction. And one of the things I think Craig and team are doing a very good job at is, as he indicated, focusing on opening price points and also focusing as there are necessary price increases and trying to add value in the product, along with the price increases. Craig, maybe you want to add some commentary to that."
},
{
"speaker": "Craig Menear",
"text": "I think what we are really trying to do is obviously work, as Frank said, individually with our suppliers because each situation is unique but at the same time, really trying to apply our focus bay approach in terms of how and where we might pass on retail. And it’s important to understand that from a merchandising direction that we’re giving in our team, is your retails aren’t linked to your cost. Retails are linked to what’s happening in the marketplace and what our portfolio strategy says that we want to get done. And then we work the balance of that. Cost obviously is independent of that. So right now, as we look forward, again certain things seem to be making moves. Lumber is starting to stabilize, it appears at this point. Framing lumber is not significantly different than last year, copper is pretty much flat to last year. Still obviously when you look at comparatives as it relates to steel or petroleum, there’s certainly pressure against last year, and I think that pressure will continue as we go through the back half. I’m not seeing anything right now that would indicate that we’ll see a dramatic fall-off in that."
},
{
"speaker": "David Strasser - Banc of America Securities",
"text": "And just along those lines, I mean, looking at lumber, it’s a good one. Not only is it stabilizing, it actually seems to be going up in price, just from when we look at it, as a lot of other commodities seem to be declining in value. Any thoughts to why that would be happening? Is there anything you are seeing from a demand standpoint that would be driving that?"
},
{
"speaker": "Craig Menear",
"text": "Well, demand in the market overall with the current housing environment is down, so it is -- you know, it’s kind of a -- it’s strictly a supply/demand type of issue. So folks out there are trying to get what they can for the product that they are producing, so you are right. I mean, you are seeing sheet goods actually at a higher rate than the previous quarter. Dimensional lumber hasn’t quite reached that point but it’s close."
},
{
"speaker": "David Strasser - Banc of America Securities",
"text": "It’s just surprising to see that, I guess, in this environment where you see housing, so I just figured I’d see. Anyway, thanks a lot."
},
{
"speaker": "Operator",
"text": "Our next question will come from Eric Bosshard with Cleveland Research."
},
{
"speaker": "Eric Bosshard - Cleveland Research",
"text": "Good morning. Two questions, I guess the first for Craig; on the EDLP focus you talked about or the comment was made that you gained share in five of 13 categories, or I guess lost share in eight of 13. Can you just talk about the rational benefit payback and commitment to continuing with this strategy and how you think that’s going to play out in that market share performance as we move forward?"
},
{
"speaker": "Craig Menear",
"text": "Again, we feel pretty strongly that listening to what our customers are saying through various research that we do, the customer is looking for us to simplify their shopping experience. The promotional activity complicates that for them. It focuses them into periods of time where they need to buy to feel like they’ve got the best deal. It also puts pressure up through the supply chain, through our suppliers when you have that kind of activity. So we feel pretty strongly that over the long-term, by providing a great value to our customer every day and having them understand that we have that great value every day, it will drive the confidence level for them to shop with us. And so I think over the long haul, that should in fact pay out in share for the Home Depot."
},
{
"speaker": "Eric Bosshard - Cleveland Research",
"text": "And how long is the long haul, do you feel? How long does it take until this process starts to really incrementally create value for you?"
},
{
"speaker": "Craig Menear",
"text": "It’s a journey, Eric. I don’t know that I can fix a date out there. As we really work our focus bay approach and recognize that we have both assortment marketing, pricing elements to fix as we put those in place -- you know, this is a journey that we are going to take over the next probably couple of years."
},
{
"speaker": "Eric Bosshard - Cleveland Research",
"text": "Okay, and then second question on SAP, understand that you had 20 stores put up and running but I guess prior to yesterday, you still had 16 up and running. It seems like the rollout in Canada has been more deliberate, which makes sense but understanding how deliberate it’s been up until yesterday, what gives you the confidence that you get through all of Canada by the end of the year and are there any experiences that have caused you to move at such a measured pace to this point?"
},
{
"speaker": "Frank Blake",
"text": "So it’s actually pretty consistent with what we had planned. I mean, the way the pilot was -- you know, it’s kind of the geography of the pilot was you do a couple of stores, do a dwell time, do a limited number of stores, have a dwell time, and the you start hitting a more rapid rollout pace of 20 to 25 stores that have clipped, and that was always the way it was laid out, so -- and again, it’s not that dissimilar from the RDC in terms of how you structure your pilot and initial rollout. There’s a little bit of pause at the start as you shake out the bugs and make sure you’ve got something that can really withstand a 20-store clip. Now, we just turned those 20 stores on on Monday, so that’s yesterday, so we’re so far, so good. And if you can do 20 at a clip, then you can move it up to 20, 25 and easily make the end of the year."
},
{
"speaker": "Eric Bosshard - Cleveland Research",
"text": "And through the first 16, has the feedback or implementation been basically where you thought it would be?"
},
{
"speaker": "Frank Blake",
"text": "Yes."
},
{
"speaker": "Eric Bosshard - Cleveland Research",
"text": "Okay. Thank you."
},
{
"speaker": "Diane Dayhoff",
"text": "Augusta, we have time for one more question."
},
{
"speaker": "Operator",
"text": "Thank you. That will come from Gregory Melich with Morgan Stanley."
},
{
"speaker": "Gregory Melich - Morgan Stanley",
"text": "Thanks. Carol, you mentioned before that there were a few things in SG&A that were favorable this quarter that you didn’t see sticking in the back half. Could you sort of call those out or another way, look at the 3% growth in SG&A dollars -- is that a rate that we can maintain or is it going to go back to that more sort of 5% or 6%?"
},
{
"speaker": "Carol B. Tome",
"text": "Well, we talked about favorability in a number of expense categories like advertising, medical, workers’ compensation. I don’t see that favorability continuing into the back half, for example."
},
{
"speaker": "Gregory Melich - Morgan Stanley",
"text": "Okay, and if we were to look at the growth from a dollar perspective, do you think the first quarter was more representative or is there -- because I mean, a 3% growth in dollars is impressive. We should be thinking about it is the fact that they grew a couple hundred bps more would be more normalized?"
},
{
"speaker": "Carol B. Tome",
"text": "I think the first quarter is more representative than the second quarter."
},
{
"speaker": "Gregory Melich - Morgan Stanley",
"text": "Okay, great. And then a second question is the payables year over year -- I mean, the inventory looks nicely controlled. Also saw the payables come down. Is there something that was driving that uniquely or is it just the timing at the end of the -- or just fewer receipts? I mean, how should we look at that drop in payables?"
},
{
"speaker": "Carol B. Tome",
"text": "Sure. The way you should look at it, and our payables ratio at the end of the second quarter was 60%, so that’s pretty good but it is down from about 63% a year ago. And that’s actually because of some transition disruptions we had a year ago. We outsourced all of our payable functions to India and ran into a bit of disruption as a result, which we don’t like. We’re back in line now in terms of our service level agreements with a third party, in terms of our on-time payments with our suppliers. And that 60% ratio is the one that we would like to maintain. Of course, there’s a seasonal element to that, as you know -- it will always drop off at year-end but then it should come back up to the 60% range."
},
{
"speaker": "Gregory Melich - Morgan Stanley",
"text": "Okay, great. And just one last, just as a follow-up to the first question -- if you talk about that 20 bps of deleverage that you’ve used historically, as you go into next year, if it is another down year, do you think that that’s still the right number or do you think that could end up being higher?"
},
{
"speaker": "Carol B. Tome",
"text": "We just started our 2009 planning activities, as you can appreciate, and we are working off of that same 20 basis point rule of thumb. And as we get closer to the end of the year and we firm up our plans, we’ll give you some more color."
},
{
"speaker": "Gregory Melich - Morgan Stanley",
"text": "Okay, great. Thanks."
},
{
"speaker": "Diane Dayhoff",
"text": "Well, thank you to everyone for joining us today and we look forward to talking to you next quarter."
},
{
"speaker": "Operator",
"text": "That does conclude our call. We’d like to thank everyone for their participation. Have a great day."
}
] | null | null |
HD | 1 | 2,008 | 2008-05-20 09:00:00 | Executives: Diane Dayhoff - Senior Vice President, Investor Relations Frank Blake - Chairman, Chief Executive Officer Craig Menear - Senior Vice President, Merchandising Paul Raines - Executive Vice President of U.S. Stores Carol B. Tome - Chief Financial Officer, Executive Vice President Corporate Services Mark Holifield - Senior Vice President, Supply Chain
Analysts: Deborah Weinswig - Citigroup Wayne Hood - BMO Capital Markets David Strasser - Banc of America Securities Michael Lasseter - Lehman Brothers Colin McGranahan - Sanford C. Bernstein Matthew Fassler - Goldman Sachs Budd Bugatch - Raymond James Gregory Melich - Morgan Stanley Michael Baker - Deutsche Bank Daniel Binder - Jefferies
Operator: Good day, everyone and welcome to today’s Home Depot first quarter earnings conference call. As a reminder, today’s call is being recorded. Beginning today’s discussion is Ms. Diane Dayhoff, Senior Vice President of Investor Relations. Please go ahead.
Diane Dayhoff: Thank you, Connie, and good morning to everyone. Welcome to the Home Depot first quarter earnings conference call. Joining us on our call today are Frank Blake, Chairman and CEO of The Home Depot; Craig Menear, Executive Vice President of Merchandising; Paul Raines, Executive Vice President of U.S. Stores; and Carol Tome, Chief Financial Officer. Following our prepared remarks, the call will be open for analyst questions. Questions will be limited to analysts and investors and as a reminder, we would really appreciate it if the participants would limit themselves to one question with one follow-up, please. This conference call is being broadcast real-time on the Internet at homedepot.com with links on both our homepage and the investor relations section. The replay will also be available on our site. If we are unable to get to your question during the call, please call our investor relations department at 770-384-2387. Before I turn the call over to Frank, let me remind you that today’s press release and the presentations made by our executives include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties. These risks and uncertainties include, but are not limited to, those factors identified in the release and in our filings with the Securities and Exchange Commission. Now let me turn the call over to Frank Blake.
Frank Blake: Thank you, Diane and good morning, everyone. Sales for the first quarter were $17.9 billion, down 3.4%. Comp sales were negative 6.5%. As Carol will describe, sales and comps for the quarter reflect a benefit in seasonal timing due to the 14th week in the fourth quarter of 2007. Diluted earnings per share were $0.21. That includes a $0.20 charge related to our decision to rationalize square footage growth in existing stores. I would like to summarize what I see as the positives for the quarter and then talk about some concerns. First on the positive side, we showed significant improvement in the disciplines around our merchandising, as Craig will describe. We had better execution in our seasonal business and had better focus on moving away from promotional activity that confused our customers and undermined our brand. We also took significant steps to restructure our workforce to provide more customer facing hours. Paul will go through some of these actions. We shut down call centers, we rolled out day freight receiving, we restructured our HR field team, and in each instance, we redeployed hours to customer facing activities. So a source of great pride that our 300,000 plus associates could take on so much change in such a short period of time in such difficult conditions and yet continue to drive improvements in customer service, as we are seeing in our voice of customers scores. These changes were necessary to adapt to current market conditions but they will also position us well for the future. As we announced a few weeks ago, we took a significant step to rationalize our new store growth. The stores we are taking out of our pipeline weren’t expected to meet our targeted returns. They would have diverted investment from our existing stores and negatively impacted our overall return to shareholders. By not building them, we’ll free up approximately $1 billion in cash over the next three years to invest in maintenance, merchandising resets, and other areas within our existing stores. We’ll continue to open new stores in the future but we’ll do so in locations that offer the best opportunity for long-term growth and profitability. We will be very disciplined in our capital allocation and very focused on the customer experience. We continued in the first quarter to invest in our five key priorities -- associate engagement, shopping environment, product excitement, product availability, and own the pro. We have now opened three rapid deployment centers, or RDCs, and expect to roll out an additional five by year-end. We began piloting core retail in two Canadian stores at the end of March and remain on track to complete the rollout by year’s end. Our agenda for transforming the business is aggressive but measured. We are going to take some risks. We have to but we are also going to respond quickly to any issues we see. And it’s encouraging that we continue to see positive trends on our overall market share. We also continue to see strong performance from our international businesses. Mexico posted positive double-digit comps for the 14th straight quarter. Canada had positive comps, and we are very pleased that China posted positive double-digit comps. We feel that we have the right strategy there, start small and build up through success, and it’s encouraging to see those stores performing well. Now on the concerned side, we are still seeing relatively weakly demand for our non-seasonal products. And housing turnover, which is down over 30% from the highs in 2005, remains a concern. There’s a significant inventory of homes to work through and the latest national association of realtors data shows home prices down 7.7%, with some areas of the country down substantially more than that. So the housing and home improvement markets remain very difficult. At the same time, we are seeing significant pressure on the cost side as the price of basic commodities goes up and our customers are also facing pressure as they see the price of gasoline and food increase. There isn’t a well-worn path guiding us on what all these pressures will do to our business, but we certainly see on the general market side more risk than opportunities through the remainder of the year. So we are approaching the second quarter and the second half by focusing on those things we can control. We will continue to invest to improve the customer experience and we will show the discipline necessary to stop doing those things that aren’t related to our key priorities. One of our vendors said it well the other day -- it’s time for those who are serious about this business to get serious about the business. That’s a good description of Home Depot now. We are serious about the business and we are taking the serious actions necessary to position us for the long-term success. Now let me turn the call over to Craig.
Craig Menear: Thanks, Frank and good morning, everyone. In the first quarter, we experienced a negative sales growth in all departments except garden. Plumbing, while negative, outperformed the company average comp. As expected, the significant weakness in the quarter came from continued softness in big ticket and construction departments. Building materials, electrical, millwork, and kitchens all had double-digit comp declines. With softness in these project businesses, among others, average ticket was down 2.8% from last year to $57.36. Regionally in markets where home prices have declined approximately 15%, we are continuing to see double-digit negative comps. This was reflected in our results in California and in Florida. Even garden, which posted a positive comp for the company reported negative comps in those areas. While these two regions remain weak, there are a few areas of the country, such as the Ohio Valley and the Southwest region, as well as our international businesses that are helping to offset some of those declines. We are also seeing pressure from commodity price inflation and deflation in the market, although pricing for wood products has stabilized, including dimensional lumber and sheet goods, which are now on par with pricing from last year, we continue to see pressure from gypsum deflation. Copper pricing is up year over year and higher than we had anticipated. Additionally, we are seeing inflationary pressure from petroleum and metals, which is leading to cost pressure. As we shared with you last quarter, we continue to see strength in the basic repair categories, with comps less negative than the company average. We know that during difficult times, customers will continue to make essential repairs in their home. As a result, we focused our activity on improving our line structures and understanding customers’ repair needs. A good example is assortment adjustments that we’ve made in hand tools, power tools, and plumbing fixtures, all which resulted in share gains in the quarter. Another area of strength this quarter stemmed from our execution in our seasonal business. We are pleased with the results of our spring seasonal categories which posted positive comps for the quarter. Live goods, handheld power, chemicals, fertilizers, and landscape performed well and seed and lawn décor posted double-digit positive comps. These results were driven by continued line structure improvements and new innovative products such as Pennington’s Smart Seed, which requires 30% less water and Vigoro’s Super Green, a slow release fertilizer that will last up to five months. Large contributors to the comp increase in live goods were the expanded offerings of the proven winners brand and growth of our eco-options products, which include vegetable and herbs in plantable, biodegradable pea pods. While we’ve made progress, we continue to have opportunities to improve line structures and product offerings. For example, in the second quarter we will invest in several categories where we have lost share, particularly ceramic tile, bath faucets, and bath fixtures. We will reset ceramic tile and bath faucets and we will enhance our assortment of bath fixtures. We continue to drive merchandising transformation, and while it is still early, we are starting to see a difference in our business when we align the right people, processes, and tools. Investments made in our associates, both in the field and the store support center, are starting to pay off. With the team in place, we made significant progress in improving, and in some cases creating crucial processes. We remain committed to implementing our focused approach to finding the role and intent of each category which drives our assortment, pricing, and marketing strategy. In addition, we have also provided our merchants with improved tools that deliver significant benefits and time savings for the merchandising team, maximizing assortment and forecasting visibility. These investments are beginning to show results and for the last rolling 12 months, we have experienced unit share growth in several categories, including patio, paint, hand tools, and carpet. In patio, we provided great brands at exceptional values, as seen with our exclusive Thomasville and Hampton Bay lines, and our share gains in paint are all about new product innovation and execution at store level. Last year we started down the long-term path to return to our merchandising roots, providing everyday compelling values to our customers. By focusing in on our merchandising fundamentals with this objective in mind, we were able to better manage our gross margin dollars. Our gross margin productivity in the first quarter was the result of better assortment planning, visibility created by our new tools, a change in promotional strategy, and improve seasonal inventory management. As we head into the summer, we are pleased with our seasonal lineup and feel that we are well-positioned in patio, grills, mowers, and power equipment. We feel that the merchants have captured the change in customer preference in our air movement category with our new portable air conditioning units and diverse assortment of environmentally friendly products under our eco-options line. And we continue to provide great values and innovation in emerging products, like fresh air paint, the only true odorless and VOC, or volatile organic compound free paint in the market. Before I turn the call over to Paul, I would like to welcome Frank Bifulco, our new Chief Marketing Officer, to the merchandising team. Frank brings 30 years of marketing experience to the Home Depot and a strong consumer brand management background from his years at Hasbro, Timberland, and the Coca-Cola Company. 2008 is going to be another tough year but we have a strong merchandising team focused on our fundamentals who will continue our promise of delivering everyday value to our customer. And now I would like to turn the call over to Paul.
Paul Raines: Thank you, Craig. As Frank mentioned, we are focused in in-store execution and improving customer service. We executed a number of transformational changes in the first quarter. In the past, the types of changes we made this quarter would have taken years. It is a shift in philosophy that has allowed us to increase the rate of change and improve execution. I would like to take a few minutes to share this philosophy. Our approach is to seek out best practices from those who are closest to the customer, our stores. As we identify opportunities, we assign a field leader to develop the concept and implement this in their region with support from our corporate staff. Once proven in the field, we implement across our entire chain, with field leaders taking ownership for success in their area. We have found that our approach is highly efficient and can be implemented at a high rate of speed. In this environment, moving with velocity to transform our stores and better service customers is vital. One of our main initiatives is aprons on the floor. This program is geared at investing in our stores by adding more selling hours to the floor through better expense allocation. Our goal in 2008 is to reallocated $180 million to add more sales hours to the stores. There are several areas where we have redeployed resources. Let me take you through a few of the more significant changes we have made. Based on a recommendation from our field teams, in February we rolled out our day freight initiative to over 1,100 stores. The purpose of this was two-fold; to increase associate availability during our peak selling hours and provide more ownership of inventory management to our department supervisors. This initiative changed our receiving and recovery time from overnight to early morning and evening shifts to allow us to have more associates on the floor assisting customers. This was heavy lifting but we were able to accomplish it with little noise because of the personal involvement of the field team. Along with the change in receiving, we also empowered our department supervisors. We returned inventory management responsibilities to department supervisors who have greater visibility and knowledge about product needs. This is the most significant change to our operating model since the SPI, or service performance initiative, in 2000. During the past five years, the Home Depot has standardized and institutionalized our human resources function across the organization. In April, we told you that we were going to restructure our field human resources function and as of May 1st, we replaced our in-store human resources manager with district-based human resources teams. Sometimes we need to restructure to reinvest. We are committed to prudently managing our expenses and taking action where we can to hit our $180 million goal to reinvest in associates. We know motivation and engagement of our more than 300,000 associates make a huge impact on customer satisfaction and on sales. We continue to focus on recognizing and rewarding associates. Despite the difficult environment, we are continuing to reward associates through our success sharing and Homer Badge programs. We have not given out over 410,000 Homer badges. We are also proud to say that we now have 3,000 master trade specialists, all licensed plumbers or electricians, in our stores. As you know, we have taken steps in the past year to refocus our training efforts back to hands-on, in-the-aisle learning. During the quarter, we introduced a product knowledge badge. This new badge rewards associates through cash compensation for completing 100% of the product knowledge training in their departments and adjacent departments. Associates that complete this training are better able to help our customers with projects that cut across multiple product categories. Our associates are reacting positively to the changes they are seeing. We know that taking care of our customers and each other by investing in our stores and associates is the right thing to do. Our voluntary turnover continues to decline at a double-digit rate year over year and our store associate tenure continues to increase. In terms of shopping environment, we are pleased with our progress. As most of you know, the average age of our stores is around eight years old, a time when you really need to refurbish the stores to continue to drive sales. We have adopted a programmatic approach to maintenance and will continue to spend significantly more in 2008 than the historical trend. We are operating a large complex organization. In a business this size, driving changes requires simplification and consistency in our approach. As a result of our investments, we are seeing results. We continue to see improvements in our VOC survey, where we hear from more than 115,000 customers a week. We know 2008 is going to be a difficult year. We remain committed to executing the fundamentals, our key priorities, and to investing in our associates and customers. Now I would like to turn the call over to Carol.
Carol B. Tome: Thank you, Paul and hello, everyone. In the first quarter, sales were $17.9 billion, a 3.4% decrease from last year, reflecting negative same-store sales of 6.5%, offset in part by sales from new stores. We reported earnings per share of $0.21 in the quarter, which reflect a charge of $543 million, due to the recently announced closing of 15 stores and removal of 50 stores from our future growth pipeline. For the purpose of today’s call, we are going to refer to this charge as the store rationalization charge. Excluding the store rationalization charge, earnings per share from continuing operations were $0.41, down 14.6% from last year. Our first quarter comp sales decline was slightly worse than our plan. Comps or same-store sales were negative 6.5% for the quarter, with negative comps of 6.4% in February, negative 8.7% in March, and negative 4.9% in April. Comp sales remain negative in May but are running in line with our expectation. In 2007, we had 53 weeks in the year. This shifted our 2008 fiscal calendar. Because of this shift, and given the seasonal nature of our business, first quarter sales benefited from a seasonal timing change. The calendar shift added about $524 million to first quarter comp sales. Adjusting for this, comps would have been negative 9.2% for the quarter. In the first quarter, our gross margin was 33.9%, an increase of 14 basis points from last year. Our gross margin expansion is due principally to lower markdowns than last year. While it isn’t material, our gross margin expansion is net of a five basis point, or $10 million impact of markdowns associated with inventory in our 15 closing stores. The calendar shift did not impact the gross margin rate but drove gross margin dollars. For the quarter, the calendar shift resulted in approximately $0.04 of year-over-year earnings per share growth. In the first quarter, operating expenses increased by 508 basis points to 29.8% of sales. Excluding the charge of $533 million related to our store rationalization, operating expense increased by 211 basis points to 26.9%. Our expense deleverage reflects the impact of negative sales, where for every point of negative comp we expect to deleverage expenses by about 20 basis points. The negative comps in the first quarter resulted in expense deleverage of approximately 115 basis points. Further, as expected, in the first quarter we experienced an additional 96 basis points of expense deleverage due to a higher cost of credit associated with our private label credit card. Operating margin was 4.1% in the first quarter, down 495 basis points from last year. Excluding the store rationalization charge, operating margin was 7.1% in the first quarter, down 192 basis points from last year and in line with our plan. Net interest expense was $164 million in the first quarter, up $4 million from last year. In the first quarter, our income tax provision rate was 36.9%, reflecting the impact of the store rationalization charge. We expect our tax rate to be approximately 37% for the year. Diluted shares for the first quarter were 1.68 billion shares, compared to 1.97 billion shares last year. The reduction in outstanding shares is due to our share repurchase program and includes the tender offer we completed last September. We did not repurchase any shares during the first quarter and the completion of our recapitalization plan remains on pause as we are waiting for stability, both in our business and the credit markets. Now moving to our operational metrics, during the first quarter we opened 26 new stores, including two relocations for an ending store count of 2,258. Today, 247 stores representing approximately 11% of our store base operate in Canada, Mexico, and China. At the end of the first quarter, selling square footage was $237 million, a 3.9% increase from last year. Reflecting the sales environment, total sales per square foot were approximately $305 for the quarter, down 7.4% from last year. Now turning to the balance sheet, at the end of the quarter, retail inventory was $12.6 billion, down from $12.7 billion last year. On a per store basis, inventory was down 4.6%. As you heard from Craig, this year we instituted a new seasonal inventory planning process and as a result, our seasonal inventory levels are in good shape relative to the sales environment. But based on the sales environment, our inventory turnover was 3.9 times compared to 4.2 times last year. Computed on the average of beginning and ending long-term debt and equity for the trailing four quarters, return on invested capital for continuing operations was approximately 12%, down 240 basis points from last year due to the decline in our operating profit and the store rationalization charge. Excluding the store rationalization charge, our return on invested capital was approximately 13%. We ended the quarter with $45.6 billion in assets, including $779 million in cash and short-term investments. This is an increase of approximately $322 million in cash and short-term investments from the end of fiscal 2007, reflecting cash flow generated by the business of approximately $2.4 billion, offset by $530 million of capital expenditures, $379 million of dividends paid, and a $1.2 billion repayment of outstanding commercial paper. First quarter earnings were in line with our expectations. As Frank mentioned, we do see certain headwinds ahead. While it is early in the year, today we are more comfortable with the low-end of our EPS from continuing operations guidance of down 24% from fiscal 2007. This guidance does not include the store rationalization charge. We are holding our investor conference on June 5th and look forward to covering our business performance and prospects with you at that time. Thank you for your participation in today’s call and Connie, we are now ready for questions.
Operator: (Operator Instructions) We’ll take our first question from Deborah Weinswig from Citigroup.
Deborah Weinswig - Citigroup: Good morning. Craig, you talked about providing the merchants with improved tools and how these tools helped improve visibility. Can you go into that in a little bit more detail? And also compare what they were using a year ago with what they are using now?
Craig Menear: Sure. What we’ve done is we’ve provided some new assortment planning tools to the merchants that really helps them in terms of the difficulty it was to plan below a market level, so we were able to plan really down to a store level in several of our categories, and that’s a pretty big significant enhancement for them. At the same time, one of the other new tools we updated or upgraded a forecasting tool that our merchant and finance teams use, and that provided greater visibility to overall forecasting and actual results that allows us to act faster.
Deborah Weinswig - Citigroup: Great, and then as a follow-up, Frank, it sounds like between the hiring of Frank and also adding Brian Cornell to the board that there’s an increased focus on advertising and marketing. Can you talk about what we should expect going forward with regard to these two initiatives?
Frank Blake: Well, as Craig said, we are very happy to have Frank come on board and he just brings a lot of experience, and clearly for a company like ours, marketing, which broadly defined is a deep understanding of our customer, is absolutely critical and we are looking at that -- we are looking to be best in class in that. And we also have some strength on the board to give us advice and counsel -- Brian Cornell, Al Carey, and Bonnie Hill and others who really have good, strong marketing backgrounds. So it is -- again, I hope this company will be characterized by the extent to which we understand our customers’ needs and fulfill them.
Deborah Weinswig - Citigroup: Thanks so much and congratulations.
Operator: We’ll take our next question from Wayne Hood from BMO Capital.
Wayne Hood - BMO Capital Markets: I’m not sure you want to talk about this, but could you discuss a little bit how you are getting your hands around the disruptions at the regional distribution centers, particularly Dallas as we come up on the Memorial Day weekend and in light of the rollout that you expect by the end of the year? And then Craig, could you talk about your market share in flooring, the changes you made a year ago and has that really resulted in an increase in share in flooring?
Frank Blake: So on the first one, we’re happy to talk about the issues. We have had some issues in a number of our initiatives as we have rolled them out, and as I tried to say in the overall comment, look, we know we are moving quick and we are asking the organization to change a lot. We know we will stub our toe occasionally but we also are committed to responding rapidly What I would is Mark Holifield and then Paul Raines too to comment on the situation in the Dallas RDC, and then Craig, you should address the back half of Wayne’s question.
Mark Holifield: Just to refresh everybody’s memory, we are moving very quickly from about 20% central distribution penetration to about 75%, so it’s a very aggressive supply chain transformation. Our target for this year is to end up serving about 40% of our stores with about 30% of their cost of goods sold. And with any major transformation like that, you do encounter some bumps in the road. We did encounter some with [Bradenton], we encountered some with our Chicago opening, which we did January. We opened up Dallas in March. It was the most aggressive opening that we’ve done so far, with about 180 stores served, going right into our spring peak. So we did see some more disruption than we desired there but we do feel we are getting our hands around that. We are on the road to recovery there and we expect that we will have that back on track. Don’t see any major issues for the Memorial Day selling period and we do see ourselves as on track for the 40% of stores and 30% of cost of goods sold targets by the end of the year, so we are working it and expect to see that behind us soon.
Paul Raines: And Wayne, this is Paul. On the store side, we know that transforming our supply chain is vital to our success, so we’ve been preparing our stores in advance of the rollout. Specific to the RDC situation, Mark and I are in touch and working very closely on this on a day-to-day basis and there is a significant amount of support from our stores team with that RDC team really integrated on the ground, working through the issues together. As Mark says, this is a company with a high rate of velocity, so anything we do has a lot of complexity with it and I am really pleased with what our team in the Southwest has done to support the supply chain organization.
Craig Menear: On flooring, I have shared with you in the past that we were losing share. That really started in the flooring business somewhere around the mid part of 2005. We were losing as much as 300 to 400 basis points to the market. We’ve been able to turn that in Q1 and actually have a positive share growth for the category in total, and for a few quarters now, we’ve actually been able to see positive growth in carpet, ceramic tile, and laminate.
Diane Dayhoff: Connie, next question.
Operator: We’ll go next to David Strasser for Banc of America Securities.
David Strasser - Banc of America Securities: Thank you very much. So after the store closures, 15 of them, as you continue to look at that, how should we be thinking over the next say one or three years about the store base? Are there more to come as you look out?
Frank Blake: David, we did a very thorough review of our stores, and maybe Carol will describe it a bit, but we were focused on trying to get at one time all the stores that we didn’t think made economic sense for the company to be operating. So it’s not as though there are a whole series of other stores that are on the bubble, or where action is imminent. We really think throughout our 2000-plus chain, these were the 15 stores that needed to close, and that’s -- it’s not a huge percentage on that kind of a store base and we feel pretty good about that number.
Carol B. Tome: We went store by store, started by looking at our stores that are older than three years, because those are stores that are mature, but we decided to look at every store. So in fact of the 15 stores that we are closing, three of those stores are younger than three years old, so it was a very thorough analysis.
Frank Blake: Now having said that, obviously things can change but we’ve taken as good a swing as we could at the time.
David Strasser - Banc of America Securities: And I guess on a related basis, I guess one of the things that seem to be changing is there seems to be just a lot of independent store closures. I guess Lowe’s talked about that yesterday, you guys have talked about it. How does that -- do you have any sense of what percent of the market has gone away over the last 12 months? I don’t know how you would judge that, and if so, does that change how you would sort of think about opening stores even going forward?
Frank Blake: First off, no, we don’t -- I mean, we don’t have a good number on what that might be and it really doesn’t change what our view is on future store openings. I mean, the best that we get is anecdotal data, so probably the same as others get.
David Strasser - Banc of America Securities: And do you know exactly what day the housing market is going to bottom?
Carol B. Tome: Oh, please tell us.
David Strasser - Banc of America Securities: Because if you know, it would be -- that’s the question we get, so --
Frank Blake: It’s August 8th.
David Strasser - Banc of America Securities: Excellent.
Frank Blake: Of what year --
David Strasser - Banc of America Securities: Thank you very much.
Operator: We’ll take our next question from Michael Lasseter from Lehman Brothers.
Michael Lasseter - Lehman Brothers: Good morning and thanks for taking my questions, and as long as we are on the subject, perhaps you could us if we are going to win the Triple Crown or not. But two questions -- first, how are you thinking about the balance between preserving financial flexibility in this time by targeting certain leverage ratios, such as lease adjusted debt to EBITDAR and the other end of the spectrum of stewarding capital to the highest return investments? Because there could be an opportunity or a disconnect between the period when perhaps the financials haven’t caught up but yet the stock price has rallied and there is a window of opportunity to purchase the shares at an attractive level.
Frank Blake: I’ll ask Carol to answer that in more detail but obviously that’s something we focus quite a bit on and hope -- you know, in the first instance, that is, we look at our business and look at all of the underlying signals that we get between geographic signals and signals in particular kinds of classes and sub-classes of product that we can build up a confidence level on what the market is doing and do that in a timely fashion. Carol, you may want to comment as well.
Carol B. Tome: Last year we completed a thorough analysis on the question of financial flexibility and determined that our capital structure based on the maturity of our company needed to change from one that facilitated growth to one that facilitated capital distribution. And we determined that we wanted to measure that through an adjusted debt to EBITDAR ratio of 2.5 times, and that is our target. Today we are at 2.1 times if you look at it on a trailing 12-month basis. Part of our capital structure strategy, of course, was to recapitalize our company and we announced a $22.5 billion recapitalization plan, of which we’ve completed about 50%. The remaining recapitalization plan is on pause just because of the instability of our business and the instability of the credit markets. But obviously we are looking at this very closely every day.
Michael Lasseter - Lehman Brothers: Okay, and as a quick follow-up, can you reconcile the commentary that in the press release that many areas of the country worsened during the period and then perhaps on the call you mentioned that May was running in line with plan?
Frank Blake: Well, we have planned for some negative performance, so what we are seeing is roughly what we anticipated.
Michael Lasseter - Lehman Brothers: Okay. Is there any -- I guess is there some of the regions that had been stronger, are they starting to experience weakness due to perhaps economic factors?
Frank Blake: Yeah, I’d say -- I mean, generally, because it’s obviously something we look at very closely in terms of the different regional performance, areas that have been hit hard in the past, Florida and California come immediately to mind, continue -- I mean, it’s hard to see a lot of improvement there. We’ve got other areas that had been relatively strong that have declined a bit, and then as Craig called out, we’ve got some areas of strength, like the Southwest and some areas in the Midwest where there wasn’t -- where both there’s stronger economic activity now, like in the Southwest there’s not so much speculative activity in the past, like the Midwest.
Michael Lasseter - Lehman Brothers: Okay. Thank you for taking my questions, best of luck.
Operator: We’ll take our next question from Colin McGranahan from Bernstein.
Colin McGranahan - Sanford C. Bernstein: Good morning. I just have two brief ones today -- first, Carol, I may not have heard you right about the impact of the credit card business? I thought I heard you say 96 basis points. Is that correct?
Carol B. Tome: That’s correct.
Colin McGranahan - Sanford C. Bernstein: So that seems substantially higher than I think what your expectation was for the full year. Is there any kind of seasonality or can you talk a little bit more about how the delinquency trends are and the credit contribution is flowing relative to your prior expectations?
Carol B. Tome: There is a bit of seasonality but I will say that only as it relates to the profitability of the portfolio in that a year ago, we were enjoying excess profits from our gain sharing arrangement and we had none of those excess profits in the first quarter of this year. So the year-over-year comparisons are going to be tougher in the first half of the year than they will be in the back half of the year, so hopefully that helps you.
Colin McGranahan - Sanford C. Bernstein: Yeah, that makes sense. Obviously those profits deteriorated through the years, the delinquency rate stepped up sequentially. So was the overall delinquency or charge-off rates largely in line with your expectation to date?
Carol B. Tome: It’s running a little heavier actually, or a little higher. The good news, if there is good news in this environment, it seems to have stabilized.
Colin McGranahan - Sanford C. Bernstein: Okay, and you -- that, just so I understand that correctly, once your gain sharing is zero, it’s zero, right? You can’t actually have negative gain sharing?
Carol B. Tome: Our arrangement is a profit sharing arrangement. In excess, we share in the profits in excess of a targeted return. If the targeted return is not achieved, then we could have to pay more for the cost of the credit.
Colin McGranahan - Sanford C. Bernstein: Okay. And then just again, a brief question, seasonal impact through the year -- what should we expect in the coming quarters in terms of impact on sales 2Q, 3Q, 4Q, roughly? And operating margins?
Carol B. Tome: Well, the good news is that by the end of the year, there won’t be any impact. It will all work out but clearly if you have an extra week of spring in the first quarter, you are going to have one less week of spring in the second quarter.
Colin McGranahan - Sanford C. Bernstein: And then just a -- so the same 13-weeks, whether you started in the February week or ended in the April week, that was that roughly negative 9.2 comp?
Carol B. Tome: If you do a like-for-like comp, that’s correct.
Colin McGranahan - Sanford C. Bernstein: Okay. Great. Thank you so much.
Operator: We’ll take our next question from Matthew Fassler from Goldman Sachs.
Matthew Fassler - Goldman Sachs: Thanks a lot. Good morning, guys. A couple of questions, if I could -- on the comp store sales, if you could talk both about your U.S. only comps excluding China, Mexico, and Canada, and also if you could talk on the comp store sales side about whether the monthly numbers were distorted by either the calendar shift or by Easter.
Frank Blake: Well, I’ll let Carol give the specifics but there were -- I mean, there was an Easter impact but obviously over the course of the quarter, that eased out and there would also have been some shifting impacts on the month. I don’t know that we actually kind of broke that out for you, but we gave you the overall number.
Carol B. Tome: I’m sorry for jumping in, but Matt, the way we look at it is relative to our plan.
Matthew Fassler - Goldman Sachs: I guess the reason I ask is because your competitor was out with numbers yesterday that were more volatile month to month with April showing a much bigger improvement. I’m wondering if your business was more consistent through the quarter or whether it was actually, when you put aside the calendar shift, a little more volatile than it looks on a reported basis?
Craig Menear: Maybe I can add a little bit of light to that. As we looked at the numbers in April last year, remember we had a couple of really horrendous weeks with weather. Our numbers in those weeks were sub-double-digit negatives, so we were nowhere near as down as much as what our competitor reported yesterday in those two weeks, which we think is what really is the difference in April in our performance versus theirs.
Matthew Fassler - Goldman Sachs: Understood. And one quick follow-up -- on the expense line, as we measured it, your retail expenses per foot or per store excluding the charges were essentially flat, maybe up a little but I guess we could do the credit card work on our own and kind of back it out, but if you look at that at the store level excluding the credit card impact, is that down kind of low to mid-singles, or low singles in your view?
Carol B. Tome: It is.
Matthew Fassler - Goldman Sachs: And is that consistent with where you’ve been or perhaps a little more of a pull-back on SG&A?
Carol B. Tome: It’s a reflection of the store count, the expenses that we have associated with store count. You know, we are only opening 55 stores this year.
Matthew Fassler - Goldman Sachs: Understood. And the payroll, if you look at store payroll per se and you look at the either dollars per foot or leverage versus say last quarter, do you know what direction that moved in?
Carol B. Tome: It was flat to slightly up.
Matthew Fassler - Goldman Sachs: The dollars or the ratio?
Carol B. Tome: The ratio.
Matthew Fassler - Goldman Sachs: Great. Thanks so much, guys.
Carol B. Tome: Matt, we didn’t answer your question on U.S. only comps, and we’re happy to do that. If you look at the contribution from our businesses outside of the United States, as Frank pointed out we had positive comps everywhere outside the United States. The contribution in the first quarter was 1.9%, about the same as it was in the fourth quarter.
Matthew Fassler - Goldman Sachs: So it’s basically unchanged from where it’s been. Thank you so much.
Operator: We’ll take our next question from Budd Bugatch from Raymond James.
Budd Bugatch - Raymond James: Good morning and thank you for taking my question. As you think about the business, Frank and Carol, you are kind of describing a leaner, and a lot of the announcements that we’ve seen, a leaner and a meaner Home Depot that is more in touch with the customer at the store level. Can you talk a little bit about what expense difference that means, maybe from the store service support center? I know there have been some actions taken there and obviously you talked about the call centers as well. How should we think about the overall overhead going forward and when does that show up in the numbers?
Frank Blake: Well, the first thing, Budd, to point out is as we were going through a number of the actions that we’ve taken like the call centers, like restructuring our field HR teams, like the day freight, we actually put those savings or hours back into the store. We reallocated back to customer-facing activity. So as a leadership team, we looked at this and said we know we need to address as one of our first priorities and key priorities associate engagement and this is -- that’s one of the sets of activities we are going to be taking to address the need to improve our coverage on the floor. And that’s going to be an ongoing effort. So Paul and his team, he’s got a whole group that is focused around what we call aprons on the floor where people come up with ideas on things we can do better, cheaper, faster, whatever it is and then how we redeploy that into hours on the store. We will always have opportunities, I suspect, in terms of our SSC here in getting our organization sized correctly to support the business. We took a very significant action a few months ago and look, all of our jobs here is to figure out how best to support the stores and how to do a better job tomorrow, which means being able to do it for faster and cheaper than we are doing today.
Budd Bugatch - Raymond James: Okay. And as you described what was going on with the field leaders, it almost sounded like a store Kaizen events, if I can put it in that term. How many field leaders are there? How many of those kinds of initiatives and events are there going on? Can you quantify a little bit of that for us?
Frank Blake: Let me ask Paul to discuss that.
Paul Raines: Sure, Budd. I think what’s going on in this aprons on the floor, and we’ll add some color to it at the investor conference but this is our own continuous improvement. Kaizen is a good term. This is our own program to generate thinking around how do we find solutions for customer service. So our team literally is receiving hundreds of ideas on a weekly basis. We are taking action on those. The large ones you’ve heard about -- underneath those, there are several others that are smaller -- method improvements, process improvements, et cetera. But as Frank said, this is part of a multi-year framework to reallocated and reinvest in our customer service levels on the floor. So you will hear us at the investor conference talk about that multi-year game plan to continue this process.
Budd Bugatch - Raymond James: Well, you and I have talked about that in another venue and I am all for that. I think that is a great thing to do. My last question, if I could, is just piggy-backing a little bit on Colin’s question about the 96 basis points of higher credit. Carol, if you could maybe talk a little bit about that, how that played out month by month over the quarter -- I know you may not want to give us the actual granularity on it, but was the -- did that increase or decrease as the quarter unfolded?
Carol B. Tome: Well, we actually account for the profit sharing at the end of the month. We don’t do it each month.
Budd Bugatch - Raymond James: So you do it at the end of the quarter, not just at the end of the --
Carol B. Tome: Yes, at the end of each quarter, yes.
Budd Bugatch - Raymond James: Okay. All right, thank you very much.
Diane Dayhoff: Connie, we’re ready for the next question.
Operator: We’ll go next to Gregory Melich from Morgan Stanley.
Gregory Melich - Morgan Stanley: A couple of questions; one, Carol, you said it was $0.04 is what the week shift implied. Am I backing into that right, that’s it about a 20% variable margin, those sales?
Carol B. Tome: That’s right.
Gregory Melich - Morgan Stanley: Okay. And is it fair then to say that that’s what you see in the second quarter the other way, or how does that play out towards the end of the second quarter?
Carol B. Tome: We’ll explain it to you when we get done with the second quarter. We’ve got to see how the numbers come in. It really depends on the top line.
Diane Dayhoff: But yes, there is a change, yes, you are right.
Carol B. Tome: Of course, yeah.
Gregory Melich - Morgan Stanley: Okay, great. And then, not to beat credit like a dead horse, but we’ll try -- if the gain share goes away and then you don’t take losses from that, but if you start paying it say in a few, 2% or 3% as opposed to 1%, does that then show up in gross margin? Is that the way the accounting works?
Carol B. Tome: No, it’s a little bit more complicated than that, I’m sorry. There are three components of our cost of credit. There’s the deferred interest component, which is the fee we pay for our no interest, no payment programs, and our everyday value proposition is if you use the card and you spend 299, it’s no interest, no payments for six months. That deferred interest is accounted for as a cost of goods sold. Then there are two other components. There is the gain share, which is a profit back to us and an interchange fee, which is a charge to us. And when you add it all up, the gain share and the interchange is in our selling and store operating expenses and when you add it all up, the deferred interest, the gain share, and the interchange, you get a cost of credit. In 2007, our cost of credit as a percent of credit sales -- and remember, credit sales are about 30% of our total sales, our cost of credit in 2007 was less than 50 basis points. In 2008, our plan is that it will be 200 basis points or 2%. And we stress tested this and we don’t think it would be any higher than 4%. So hopefully that’s helpful.
Gregory Melich - Morgan Stanley: That is and at some point though, you could see some of that showing up in another line but that overall number is helpful.
Carol B. Tome: It’s going to be in the same line, deferred interest, which is in cost of goods and then selling and store operating. Deferred interest isn’t going to move. That’s a fixed fee, if that’s helpful. It’s really how profitable is the portfolio. That’s where you could see movement and it would be in our selling and operating expenses.
Gregory Melich - Morgan Stanley: Got it, perfect. And then third was rising fuel costs -- where does that show up? Is it SG&A or is it in cost of goods sold?
Carol B. Tome: It’s in both. It’s in both. Obviously it’s in our cost of goods but we also within SG&A, we have delivery expense. Delivery expense would be a factor of fuel expense, so it’s in both lines.
Gregory Melich - Morgan Stanley: Okay, great. Thanks.
Operator: We’ll go next to Michael Baker from Deutsche Bank.
Michael Baker - Deutsche Bank: Thanks. So first question on gross margin -- so it was better this quarter because of being less promotional. Any expectation on the trend going forward? I think, correct me if I’m wrong, but a year ago you were a little bit more promotional in the first quarter and then you did back off on that throughout the year, so should we expect that same kind of gross margin gain going forward or is that going to change?
Craig Menear: In terms of the promotional activity, we went in and we really took a hard look at the promotional activity itself and what we were getting from that. And when we looked at about 10% of the promotions driving about 80% of the lift, that wasn’t a great return on the other 90%. So that’s where we became much more rational in terms of what we were doing with the promotions themselves and we obviously benefited from that. As we look at what’s going on with overall inflation, particularly as it relates to fuel, that’s where we are seeing pressure and we think that will certainly translate into some pressure overall in our margin but we are going to do our best to offset that for the customer, obviously.
Michael Baker - Deutsche Bank: Okay, thanks. And then if I could ask one more question just on May, you said it’s in line with plan. I think your previous plan at the beginning of the year was for comps to get better throughout the year. Does that include the second quarter -- but then, of course, you have the negative calendar shift, which was apparently within your plan, so that would make the second quarter plan worse than the first quarter. Just wondering if you can help us there, put that into context. Should the second quarter, plan to be better or worse than the first quarter?
Carol B. Tome: Sure. Because of the calendar shift, our second quarter should be our worst comping quarter of the year.
Michael Baker - Deutsche Bank: Okay. Thank you very much.
Diane Dayhoff: Connie, we have time for one more question.
Operator: We’ll take our final question from Daniel Binder from Jefferies.
Daniel Binder - Jefferies: Appreciating the fact that the quality of the labor is changing, I was wondering if you can maybe quantify, either on a comp basis or a total hour basis, what the increase or decrease in hours, labor hours has been year over year? And the second question was related to store-wide market share; could you give us any comments on that? And then lastly, just wondering if you are pleased with the consistency of the in-aisle training and whether or not the loss of the HR function at the store level will be disruptive in that.
Frank Blake: Let me take those in reverse order. On the consistency of the in-aisle training, and whether we will lose something from the loss of the HR imposition in our stores, the first thing I would acknowledge is we will lose something. I mean, these are trade-offs that we make in terms of some of the operational benefits in the store versus our belief that we do need to reallocate labor and do some restructuring on our workforce to provide better service for our customers. As Paul indicated, we are very focused on training. We’ve got a new program we are rolling out in terms of product knowledge badges, rewarding associates for -- so the question is a very fair question. It’s one we focus on and as I said, every time you do these decisions there are downsides and the best we do is address the downside as well as we can. On your second question, if I understood that, that was kind of our general market share -- was that your question?
Daniel Binder - Jefferies: Yes, just if you look at unit market share across all categories for the whole store, are you losing or gaining share.
Frank Blake: So I’d say the way we look at it, there are roughly 13 -- we look at 13 categories and we are gaining or holding our own in half of them. And we see that as improvement. We know we’ve got a hill to climb here, so we see that as improvement. Craig and his team, along with everybody else on the senior leadership team, we’ve identified areas where we think we can gain market share, turn that around and we feel good about our plans to do that over the remainder of the year. And then your last question on sales per hour, I’m not sure.
Daniel Binder - Jefferies: Well, I was trying to just understand quantitatively, if you were to look at labor hours per store, are they going up at this point on a comp basis or are they just declining less than comps?
Frank Blake: Yeah, they -- and for sure again, and it varies, and Paul can discuss the labor model but there’s a -- or maybe will take you to a level of detail none of you wants to go, but it obviously varies store by store on what the sales are in the particular store, but it could be just exactly as you said, that what’s happening is just the hours are declining at a lower rate than the sales.
Paul Raines: In a negative comp environment, if you are in a store that’s negative comping, you know, the actual store customer traffic is decreasing. That store will have less associates in it. But when we talk about our aprons on the floor campaign, that $180 million that I referenced is we are -- our goal is to add the equivalent of three full-time employees selling hours to each store. Some of that will be a reallocation of tasking that we have made more efficient. Some of that will be incremental spend in the store based on the cost reductions of the call centers in HR, et cetera. So it’s all a combination of efforts to put more selling hours in front of each customer than we would have had otherwise.
Daniel Binder - Jefferies: And are you making the progress you had hoped to on the master trades hires? Is that still a top priority and where do you expect that to be this year?
Frank Blake: I think it’s a very exciting program for us. As Paul indicated, we’ve got over 3,000 master trades specialists. As you would expect, and as we would expect, this is not an investment that you see an immediate return on but we are very pleased with how that program is going and we think it relates very directly to the foundation of Home Depot, that knowledge, that deep knowledge in the store, so we are pleased with the program.
Daniel Binder - Jefferies: Okay, great. Thanks.
Diane Dayhoff: Thank you, Connie, and thank you, everyone, for joining us today. We look forward to our speaking with you if you are coming to Atlanta for our conference in early June, otherwise we’ll talk to you in August. Thank you.
Operator: And this concludes today’s conference. We thank you for your participation and you may now disconnect. | [
{
"speaker": "Executives",
"text": "Diane Dayhoff - Senior Vice President, Investor Relations Frank Blake - Chairman, Chief Executive Officer Craig Menear - Senior Vice President, Merchandising Paul Raines - Executive Vice President of U.S. Stores Carol B. Tome - Chief Financial Officer, Executive Vice President Corporate Services Mark Holifield - Senior Vice President, Supply Chain"
},
{
"speaker": "Analysts",
"text": "Deborah Weinswig - Citigroup Wayne Hood - BMO Capital Markets David Strasser - Banc of America Securities Michael Lasseter - Lehman Brothers Colin McGranahan - Sanford C. Bernstein Matthew Fassler - Goldman Sachs Budd Bugatch - Raymond James Gregory Melich - Morgan Stanley Michael Baker - Deutsche Bank Daniel Binder - Jefferies"
},
{
"speaker": "Operator",
"text": "Good day, everyone and welcome to today’s Home Depot first quarter earnings conference call. As a reminder, today’s call is being recorded. Beginning today’s discussion is Ms. Diane Dayhoff, Senior Vice President of Investor Relations. Please go ahead."
},
{
"speaker": "Diane Dayhoff",
"text": "Thank you, Connie, and good morning to everyone. Welcome to the Home Depot first quarter earnings conference call. Joining us on our call today are Frank Blake, Chairman and CEO of The Home Depot; Craig Menear, Executive Vice President of Merchandising; Paul Raines, Executive Vice President of U.S. Stores; and Carol Tome, Chief Financial Officer. Following our prepared remarks, the call will be open for analyst questions. Questions will be limited to analysts and investors and as a reminder, we would really appreciate it if the participants would limit themselves to one question with one follow-up, please. This conference call is being broadcast real-time on the Internet at homedepot.com with links on both our homepage and the investor relations section. The replay will also be available on our site. If we are unable to get to your question during the call, please call our investor relations department at 770-384-2387. Before I turn the call over to Frank, let me remind you that today’s press release and the presentations made by our executives include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties. These risks and uncertainties include, but are not limited to, those factors identified in the release and in our filings with the Securities and Exchange Commission. Now let me turn the call over to Frank Blake."
},
{
"speaker": "Frank Blake",
"text": "Thank you, Diane and good morning, everyone. Sales for the first quarter were $17.9 billion, down 3.4%. Comp sales were negative 6.5%. As Carol will describe, sales and comps for the quarter reflect a benefit in seasonal timing due to the 14th week in the fourth quarter of 2007. Diluted earnings per share were $0.21. That includes a $0.20 charge related to our decision to rationalize square footage growth in existing stores. I would like to summarize what I see as the positives for the quarter and then talk about some concerns. First on the positive side, we showed significant improvement in the disciplines around our merchandising, as Craig will describe. We had better execution in our seasonal business and had better focus on moving away from promotional activity that confused our customers and undermined our brand. We also took significant steps to restructure our workforce to provide more customer facing hours. Paul will go through some of these actions. We shut down call centers, we rolled out day freight receiving, we restructured our HR field team, and in each instance, we redeployed hours to customer facing activities. So a source of great pride that our 300,000 plus associates could take on so much change in such a short period of time in such difficult conditions and yet continue to drive improvements in customer service, as we are seeing in our voice of customers scores. These changes were necessary to adapt to current market conditions but they will also position us well for the future. As we announced a few weeks ago, we took a significant step to rationalize our new store growth. The stores we are taking out of our pipeline weren’t expected to meet our targeted returns. They would have diverted investment from our existing stores and negatively impacted our overall return to shareholders. By not building them, we’ll free up approximately $1 billion in cash over the next three years to invest in maintenance, merchandising resets, and other areas within our existing stores. We’ll continue to open new stores in the future but we’ll do so in locations that offer the best opportunity for long-term growth and profitability. We will be very disciplined in our capital allocation and very focused on the customer experience. We continued in the first quarter to invest in our five key priorities -- associate engagement, shopping environment, product excitement, product availability, and own the pro. We have now opened three rapid deployment centers, or RDCs, and expect to roll out an additional five by year-end. We began piloting core retail in two Canadian stores at the end of March and remain on track to complete the rollout by year’s end. Our agenda for transforming the business is aggressive but measured. We are going to take some risks. We have to but we are also going to respond quickly to any issues we see. And it’s encouraging that we continue to see positive trends on our overall market share. We also continue to see strong performance from our international businesses. Mexico posted positive double-digit comps for the 14th straight quarter. Canada had positive comps, and we are very pleased that China posted positive double-digit comps. We feel that we have the right strategy there, start small and build up through success, and it’s encouraging to see those stores performing well. Now on the concerned side, we are still seeing relatively weakly demand for our non-seasonal products. And housing turnover, which is down over 30% from the highs in 2005, remains a concern. There’s a significant inventory of homes to work through and the latest national association of realtors data shows home prices down 7.7%, with some areas of the country down substantially more than that. So the housing and home improvement markets remain very difficult. At the same time, we are seeing significant pressure on the cost side as the price of basic commodities goes up and our customers are also facing pressure as they see the price of gasoline and food increase. There isn’t a well-worn path guiding us on what all these pressures will do to our business, but we certainly see on the general market side more risk than opportunities through the remainder of the year. So we are approaching the second quarter and the second half by focusing on those things we can control. We will continue to invest to improve the customer experience and we will show the discipline necessary to stop doing those things that aren’t related to our key priorities. One of our vendors said it well the other day -- it’s time for those who are serious about this business to get serious about the business. That’s a good description of Home Depot now. We are serious about the business and we are taking the serious actions necessary to position us for the long-term success. Now let me turn the call over to Craig."
},
{
"speaker": "Craig Menear",
"text": "Thanks, Frank and good morning, everyone. In the first quarter, we experienced a negative sales growth in all departments except garden. Plumbing, while negative, outperformed the company average comp. As expected, the significant weakness in the quarter came from continued softness in big ticket and construction departments. Building materials, electrical, millwork, and kitchens all had double-digit comp declines. With softness in these project businesses, among others, average ticket was down 2.8% from last year to $57.36. Regionally in markets where home prices have declined approximately 15%, we are continuing to see double-digit negative comps. This was reflected in our results in California and in Florida. Even garden, which posted a positive comp for the company reported negative comps in those areas. While these two regions remain weak, there are a few areas of the country, such as the Ohio Valley and the Southwest region, as well as our international businesses that are helping to offset some of those declines. We are also seeing pressure from commodity price inflation and deflation in the market, although pricing for wood products has stabilized, including dimensional lumber and sheet goods, which are now on par with pricing from last year, we continue to see pressure from gypsum deflation. Copper pricing is up year over year and higher than we had anticipated. Additionally, we are seeing inflationary pressure from petroleum and metals, which is leading to cost pressure. As we shared with you last quarter, we continue to see strength in the basic repair categories, with comps less negative than the company average. We know that during difficult times, customers will continue to make essential repairs in their home. As a result, we focused our activity on improving our line structures and understanding customers’ repair needs. A good example is assortment adjustments that we’ve made in hand tools, power tools, and plumbing fixtures, all which resulted in share gains in the quarter. Another area of strength this quarter stemmed from our execution in our seasonal business. We are pleased with the results of our spring seasonal categories which posted positive comps for the quarter. Live goods, handheld power, chemicals, fertilizers, and landscape performed well and seed and lawn décor posted double-digit positive comps. These results were driven by continued line structure improvements and new innovative products such as Pennington’s Smart Seed, which requires 30% less water and Vigoro’s Super Green, a slow release fertilizer that will last up to five months. Large contributors to the comp increase in live goods were the expanded offerings of the proven winners brand and growth of our eco-options products, which include vegetable and herbs in plantable, biodegradable pea pods. While we’ve made progress, we continue to have opportunities to improve line structures and product offerings. For example, in the second quarter we will invest in several categories where we have lost share, particularly ceramic tile, bath faucets, and bath fixtures. We will reset ceramic tile and bath faucets and we will enhance our assortment of bath fixtures. We continue to drive merchandising transformation, and while it is still early, we are starting to see a difference in our business when we align the right people, processes, and tools. Investments made in our associates, both in the field and the store support center, are starting to pay off. With the team in place, we made significant progress in improving, and in some cases creating crucial processes. We remain committed to implementing our focused approach to finding the role and intent of each category which drives our assortment, pricing, and marketing strategy. In addition, we have also provided our merchants with improved tools that deliver significant benefits and time savings for the merchandising team, maximizing assortment and forecasting visibility. These investments are beginning to show results and for the last rolling 12 months, we have experienced unit share growth in several categories, including patio, paint, hand tools, and carpet. In patio, we provided great brands at exceptional values, as seen with our exclusive Thomasville and Hampton Bay lines, and our share gains in paint are all about new product innovation and execution at store level. Last year we started down the long-term path to return to our merchandising roots, providing everyday compelling values to our customers. By focusing in on our merchandising fundamentals with this objective in mind, we were able to better manage our gross margin dollars. Our gross margin productivity in the first quarter was the result of better assortment planning, visibility created by our new tools, a change in promotional strategy, and improve seasonal inventory management. As we head into the summer, we are pleased with our seasonal lineup and feel that we are well-positioned in patio, grills, mowers, and power equipment. We feel that the merchants have captured the change in customer preference in our air movement category with our new portable air conditioning units and diverse assortment of environmentally friendly products under our eco-options line. And we continue to provide great values and innovation in emerging products, like fresh air paint, the only true odorless and VOC, or volatile organic compound free paint in the market. Before I turn the call over to Paul, I would like to welcome Frank Bifulco, our new Chief Marketing Officer, to the merchandising team. Frank brings 30 years of marketing experience to the Home Depot and a strong consumer brand management background from his years at Hasbro, Timberland, and the Coca-Cola Company. 2008 is going to be another tough year but we have a strong merchandising team focused on our fundamentals who will continue our promise of delivering everyday value to our customer. And now I would like to turn the call over to Paul."
},
{
"speaker": "Paul Raines",
"text": "Thank you, Craig. As Frank mentioned, we are focused in in-store execution and improving customer service. We executed a number of transformational changes in the first quarter. In the past, the types of changes we made this quarter would have taken years. It is a shift in philosophy that has allowed us to increase the rate of change and improve execution. I would like to take a few minutes to share this philosophy. Our approach is to seek out best practices from those who are closest to the customer, our stores. As we identify opportunities, we assign a field leader to develop the concept and implement this in their region with support from our corporate staff. Once proven in the field, we implement across our entire chain, with field leaders taking ownership for success in their area. We have found that our approach is highly efficient and can be implemented at a high rate of speed. In this environment, moving with velocity to transform our stores and better service customers is vital. One of our main initiatives is aprons on the floor. This program is geared at investing in our stores by adding more selling hours to the floor through better expense allocation. Our goal in 2008 is to reallocated $180 million to add more sales hours to the stores. There are several areas where we have redeployed resources. Let me take you through a few of the more significant changes we have made. Based on a recommendation from our field teams, in February we rolled out our day freight initiative to over 1,100 stores. The purpose of this was two-fold; to increase associate availability during our peak selling hours and provide more ownership of inventory management to our department supervisors. This initiative changed our receiving and recovery time from overnight to early morning and evening shifts to allow us to have more associates on the floor assisting customers. This was heavy lifting but we were able to accomplish it with little noise because of the personal involvement of the field team. Along with the change in receiving, we also empowered our department supervisors. We returned inventory management responsibilities to department supervisors who have greater visibility and knowledge about product needs. This is the most significant change to our operating model since the SPI, or service performance initiative, in 2000. During the past five years, the Home Depot has standardized and institutionalized our human resources function across the organization. In April, we told you that we were going to restructure our field human resources function and as of May 1st, we replaced our in-store human resources manager with district-based human resources teams. Sometimes we need to restructure to reinvest. We are committed to prudently managing our expenses and taking action where we can to hit our $180 million goal to reinvest in associates. We know motivation and engagement of our more than 300,000 associates make a huge impact on customer satisfaction and on sales. We continue to focus on recognizing and rewarding associates. Despite the difficult environment, we are continuing to reward associates through our success sharing and Homer Badge programs. We have not given out over 410,000 Homer badges. We are also proud to say that we now have 3,000 master trade specialists, all licensed plumbers or electricians, in our stores. As you know, we have taken steps in the past year to refocus our training efforts back to hands-on, in-the-aisle learning. During the quarter, we introduced a product knowledge badge. This new badge rewards associates through cash compensation for completing 100% of the product knowledge training in their departments and adjacent departments. Associates that complete this training are better able to help our customers with projects that cut across multiple product categories. Our associates are reacting positively to the changes they are seeing. We know that taking care of our customers and each other by investing in our stores and associates is the right thing to do. Our voluntary turnover continues to decline at a double-digit rate year over year and our store associate tenure continues to increase. In terms of shopping environment, we are pleased with our progress. As most of you know, the average age of our stores is around eight years old, a time when you really need to refurbish the stores to continue to drive sales. We have adopted a programmatic approach to maintenance and will continue to spend significantly more in 2008 than the historical trend. We are operating a large complex organization. In a business this size, driving changes requires simplification and consistency in our approach. As a result of our investments, we are seeing results. We continue to see improvements in our VOC survey, where we hear from more than 115,000 customers a week. We know 2008 is going to be a difficult year. We remain committed to executing the fundamentals, our key priorities, and to investing in our associates and customers. Now I would like to turn the call over to Carol."
},
{
"speaker": "Carol B. Tome",
"text": "Thank you, Paul and hello, everyone. In the first quarter, sales were $17.9 billion, a 3.4% decrease from last year, reflecting negative same-store sales of 6.5%, offset in part by sales from new stores. We reported earnings per share of $0.21 in the quarter, which reflect a charge of $543 million, due to the recently announced closing of 15 stores and removal of 50 stores from our future growth pipeline. For the purpose of today’s call, we are going to refer to this charge as the store rationalization charge. Excluding the store rationalization charge, earnings per share from continuing operations were $0.41, down 14.6% from last year. Our first quarter comp sales decline was slightly worse than our plan. Comps or same-store sales were negative 6.5% for the quarter, with negative comps of 6.4% in February, negative 8.7% in March, and negative 4.9% in April. Comp sales remain negative in May but are running in line with our expectation. In 2007, we had 53 weeks in the year. This shifted our 2008 fiscal calendar. Because of this shift, and given the seasonal nature of our business, first quarter sales benefited from a seasonal timing change. The calendar shift added about $524 million to first quarter comp sales. Adjusting for this, comps would have been negative 9.2% for the quarter. In the first quarter, our gross margin was 33.9%, an increase of 14 basis points from last year. Our gross margin expansion is due principally to lower markdowns than last year. While it isn’t material, our gross margin expansion is net of a five basis point, or $10 million impact of markdowns associated with inventory in our 15 closing stores. The calendar shift did not impact the gross margin rate but drove gross margin dollars. For the quarter, the calendar shift resulted in approximately $0.04 of year-over-year earnings per share growth. In the first quarter, operating expenses increased by 508 basis points to 29.8% of sales. Excluding the charge of $533 million related to our store rationalization, operating expense increased by 211 basis points to 26.9%. Our expense deleverage reflects the impact of negative sales, where for every point of negative comp we expect to deleverage expenses by about 20 basis points. The negative comps in the first quarter resulted in expense deleverage of approximately 115 basis points. Further, as expected, in the first quarter we experienced an additional 96 basis points of expense deleverage due to a higher cost of credit associated with our private label credit card. Operating margin was 4.1% in the first quarter, down 495 basis points from last year. Excluding the store rationalization charge, operating margin was 7.1% in the first quarter, down 192 basis points from last year and in line with our plan. Net interest expense was $164 million in the first quarter, up $4 million from last year. In the first quarter, our income tax provision rate was 36.9%, reflecting the impact of the store rationalization charge. We expect our tax rate to be approximately 37% for the year. Diluted shares for the first quarter were 1.68 billion shares, compared to 1.97 billion shares last year. The reduction in outstanding shares is due to our share repurchase program and includes the tender offer we completed last September. We did not repurchase any shares during the first quarter and the completion of our recapitalization plan remains on pause as we are waiting for stability, both in our business and the credit markets. Now moving to our operational metrics, during the first quarter we opened 26 new stores, including two relocations for an ending store count of 2,258. Today, 247 stores representing approximately 11% of our store base operate in Canada, Mexico, and China. At the end of the first quarter, selling square footage was $237 million, a 3.9% increase from last year. Reflecting the sales environment, total sales per square foot were approximately $305 for the quarter, down 7.4% from last year. Now turning to the balance sheet, at the end of the quarter, retail inventory was $12.6 billion, down from $12.7 billion last year. On a per store basis, inventory was down 4.6%. As you heard from Craig, this year we instituted a new seasonal inventory planning process and as a result, our seasonal inventory levels are in good shape relative to the sales environment. But based on the sales environment, our inventory turnover was 3.9 times compared to 4.2 times last year. Computed on the average of beginning and ending long-term debt and equity for the trailing four quarters, return on invested capital for continuing operations was approximately 12%, down 240 basis points from last year due to the decline in our operating profit and the store rationalization charge. Excluding the store rationalization charge, our return on invested capital was approximately 13%. We ended the quarter with $45.6 billion in assets, including $779 million in cash and short-term investments. This is an increase of approximately $322 million in cash and short-term investments from the end of fiscal 2007, reflecting cash flow generated by the business of approximately $2.4 billion, offset by $530 million of capital expenditures, $379 million of dividends paid, and a $1.2 billion repayment of outstanding commercial paper. First quarter earnings were in line with our expectations. As Frank mentioned, we do see certain headwinds ahead. While it is early in the year, today we are more comfortable with the low-end of our EPS from continuing operations guidance of down 24% from fiscal 2007. This guidance does not include the store rationalization charge. We are holding our investor conference on June 5th and look forward to covering our business performance and prospects with you at that time. Thank you for your participation in today’s call and Connie, we are now ready for questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) We’ll take our first question from Deborah Weinswig from Citigroup."
},
{
"speaker": "Deborah Weinswig - Citigroup",
"text": "Good morning. Craig, you talked about providing the merchants with improved tools and how these tools helped improve visibility. Can you go into that in a little bit more detail? And also compare what they were using a year ago with what they are using now?"
},
{
"speaker": "Craig Menear",
"text": "Sure. What we’ve done is we’ve provided some new assortment planning tools to the merchants that really helps them in terms of the difficulty it was to plan below a market level, so we were able to plan really down to a store level in several of our categories, and that’s a pretty big significant enhancement for them. At the same time, one of the other new tools we updated or upgraded a forecasting tool that our merchant and finance teams use, and that provided greater visibility to overall forecasting and actual results that allows us to act faster."
},
{
"speaker": "Deborah Weinswig - Citigroup",
"text": "Great, and then as a follow-up, Frank, it sounds like between the hiring of Frank and also adding Brian Cornell to the board that there’s an increased focus on advertising and marketing. Can you talk about what we should expect going forward with regard to these two initiatives?"
},
{
"speaker": "Frank Blake",
"text": "Well, as Craig said, we are very happy to have Frank come on board and he just brings a lot of experience, and clearly for a company like ours, marketing, which broadly defined is a deep understanding of our customer, is absolutely critical and we are looking at that -- we are looking to be best in class in that. And we also have some strength on the board to give us advice and counsel -- Brian Cornell, Al Carey, and Bonnie Hill and others who really have good, strong marketing backgrounds. So it is -- again, I hope this company will be characterized by the extent to which we understand our customers’ needs and fulfill them."
},
{
"speaker": "Deborah Weinswig - Citigroup",
"text": "Thanks so much and congratulations."
},
{
"speaker": "Operator",
"text": "We’ll take our next question from Wayne Hood from BMO Capital."
},
{
"speaker": "Wayne Hood - BMO Capital Markets",
"text": "I’m not sure you want to talk about this, but could you discuss a little bit how you are getting your hands around the disruptions at the regional distribution centers, particularly Dallas as we come up on the Memorial Day weekend and in light of the rollout that you expect by the end of the year? And then Craig, could you talk about your market share in flooring, the changes you made a year ago and has that really resulted in an increase in share in flooring?"
},
{
"speaker": "Frank Blake",
"text": "So on the first one, we’re happy to talk about the issues. We have had some issues in a number of our initiatives as we have rolled them out, and as I tried to say in the overall comment, look, we know we are moving quick and we are asking the organization to change a lot. We know we will stub our toe occasionally but we also are committed to responding rapidly What I would is Mark Holifield and then Paul Raines too to comment on the situation in the Dallas RDC, and then Craig, you should address the back half of Wayne’s question."
},
{
"speaker": "Mark Holifield",
"text": "Just to refresh everybody’s memory, we are moving very quickly from about 20% central distribution penetration to about 75%, so it’s a very aggressive supply chain transformation. Our target for this year is to end up serving about 40% of our stores with about 30% of their cost of goods sold. And with any major transformation like that, you do encounter some bumps in the road. We did encounter some with [Bradenton], we encountered some with our Chicago opening, which we did January. We opened up Dallas in March. It was the most aggressive opening that we’ve done so far, with about 180 stores served, going right into our spring peak. So we did see some more disruption than we desired there but we do feel we are getting our hands around that. We are on the road to recovery there and we expect that we will have that back on track. Don’t see any major issues for the Memorial Day selling period and we do see ourselves as on track for the 40% of stores and 30% of cost of goods sold targets by the end of the year, so we are working it and expect to see that behind us soon."
},
{
"speaker": "Paul Raines",
"text": "And Wayne, this is Paul. On the store side, we know that transforming our supply chain is vital to our success, so we’ve been preparing our stores in advance of the rollout. Specific to the RDC situation, Mark and I are in touch and working very closely on this on a day-to-day basis and there is a significant amount of support from our stores team with that RDC team really integrated on the ground, working through the issues together. As Mark says, this is a company with a high rate of velocity, so anything we do has a lot of complexity with it and I am really pleased with what our team in the Southwest has done to support the supply chain organization."
},
{
"speaker": "Craig Menear",
"text": "On flooring, I have shared with you in the past that we were losing share. That really started in the flooring business somewhere around the mid part of 2005. We were losing as much as 300 to 400 basis points to the market. We’ve been able to turn that in Q1 and actually have a positive share growth for the category in total, and for a few quarters now, we’ve actually been able to see positive growth in carpet, ceramic tile, and laminate."
},
{
"speaker": "Diane Dayhoff",
"text": "Connie, next question."
},
{
"speaker": "Operator",
"text": "We’ll go next to David Strasser for Banc of America Securities."
},
{
"speaker": "David Strasser - Banc of America Securities",
"text": "Thank you very much. So after the store closures, 15 of them, as you continue to look at that, how should we be thinking over the next say one or three years about the store base? Are there more to come as you look out?"
},
{
"speaker": "Frank Blake",
"text": "David, we did a very thorough review of our stores, and maybe Carol will describe it a bit, but we were focused on trying to get at one time all the stores that we didn’t think made economic sense for the company to be operating. So it’s not as though there are a whole series of other stores that are on the bubble, or where action is imminent. We really think throughout our 2000-plus chain, these were the 15 stores that needed to close, and that’s -- it’s not a huge percentage on that kind of a store base and we feel pretty good about that number."
},
{
"speaker": "Carol B. Tome",
"text": "We went store by store, started by looking at our stores that are older than three years, because those are stores that are mature, but we decided to look at every store. So in fact of the 15 stores that we are closing, three of those stores are younger than three years old, so it was a very thorough analysis."
},
{
"speaker": "Frank Blake",
"text": "Now having said that, obviously things can change but we’ve taken as good a swing as we could at the time."
},
{
"speaker": "David Strasser - Banc of America Securities",
"text": "And I guess on a related basis, I guess one of the things that seem to be changing is there seems to be just a lot of independent store closures. I guess Lowe’s talked about that yesterday, you guys have talked about it. How does that -- do you have any sense of what percent of the market has gone away over the last 12 months? I don’t know how you would judge that, and if so, does that change how you would sort of think about opening stores even going forward?"
},
{
"speaker": "Frank Blake",
"text": "First off, no, we don’t -- I mean, we don’t have a good number on what that might be and it really doesn’t change what our view is on future store openings. I mean, the best that we get is anecdotal data, so probably the same as others get."
},
{
"speaker": "David Strasser - Banc of America Securities",
"text": "And do you know exactly what day the housing market is going to bottom?"
},
{
"speaker": "Carol B. Tome",
"text": "Oh, please tell us."
},
{
"speaker": "David Strasser - Banc of America Securities",
"text": "Because if you know, it would be -- that’s the question we get, so --"
},
{
"speaker": "Frank Blake",
"text": "It’s August 8th."
},
{
"speaker": "David Strasser - Banc of America Securities",
"text": "Excellent."
},
{
"speaker": "Frank Blake",
"text": "Of what year --"
},
{
"speaker": "David Strasser - Banc of America Securities",
"text": "Thank you very much."
},
{
"speaker": "Operator",
"text": "We’ll take our next question from Michael Lasseter from Lehman Brothers."
},
{
"speaker": "Michael Lasseter - Lehman Brothers",
"text": "Good morning and thanks for taking my questions, and as long as we are on the subject, perhaps you could us if we are going to win the Triple Crown or not. But two questions -- first, how are you thinking about the balance between preserving financial flexibility in this time by targeting certain leverage ratios, such as lease adjusted debt to EBITDAR and the other end of the spectrum of stewarding capital to the highest return investments? Because there could be an opportunity or a disconnect between the period when perhaps the financials haven’t caught up but yet the stock price has rallied and there is a window of opportunity to purchase the shares at an attractive level."
},
{
"speaker": "Frank Blake",
"text": "I’ll ask Carol to answer that in more detail but obviously that’s something we focus quite a bit on and hope -- you know, in the first instance, that is, we look at our business and look at all of the underlying signals that we get between geographic signals and signals in particular kinds of classes and sub-classes of product that we can build up a confidence level on what the market is doing and do that in a timely fashion. Carol, you may want to comment as well."
},
{
"speaker": "Carol B. Tome",
"text": "Last year we completed a thorough analysis on the question of financial flexibility and determined that our capital structure based on the maturity of our company needed to change from one that facilitated growth to one that facilitated capital distribution. And we determined that we wanted to measure that through an adjusted debt to EBITDAR ratio of 2.5 times, and that is our target. Today we are at 2.1 times if you look at it on a trailing 12-month basis. Part of our capital structure strategy, of course, was to recapitalize our company and we announced a $22.5 billion recapitalization plan, of which we’ve completed about 50%. The remaining recapitalization plan is on pause just because of the instability of our business and the instability of the credit markets. But obviously we are looking at this very closely every day."
},
{
"speaker": "Michael Lasseter - Lehman Brothers",
"text": "Okay, and as a quick follow-up, can you reconcile the commentary that in the press release that many areas of the country worsened during the period and then perhaps on the call you mentioned that May was running in line with plan?"
},
{
"speaker": "Frank Blake",
"text": "Well, we have planned for some negative performance, so what we are seeing is roughly what we anticipated."
},
{
"speaker": "Michael Lasseter - Lehman Brothers",
"text": "Okay. Is there any -- I guess is there some of the regions that had been stronger, are they starting to experience weakness due to perhaps economic factors?"
},
{
"speaker": "Frank Blake",
"text": "Yeah, I’d say -- I mean, generally, because it’s obviously something we look at very closely in terms of the different regional performance, areas that have been hit hard in the past, Florida and California come immediately to mind, continue -- I mean, it’s hard to see a lot of improvement there. We’ve got other areas that had been relatively strong that have declined a bit, and then as Craig called out, we’ve got some areas of strength, like the Southwest and some areas in the Midwest where there wasn’t -- where both there’s stronger economic activity now, like in the Southwest there’s not so much speculative activity in the past, like the Midwest."
},
{
"speaker": "Michael Lasseter - Lehman Brothers",
"text": "Okay. Thank you for taking my questions, best of luck."
},
{
"speaker": "Operator",
"text": "We’ll take our next question from Colin McGranahan from Bernstein."
},
{
"speaker": "Colin McGranahan - Sanford C. Bernstein",
"text": "Good morning. I just have two brief ones today -- first, Carol, I may not have heard you right about the impact of the credit card business? I thought I heard you say 96 basis points. Is that correct?"
},
{
"speaker": "Carol B. Tome",
"text": "That’s correct."
},
{
"speaker": "Colin McGranahan - Sanford C. Bernstein",
"text": "So that seems substantially higher than I think what your expectation was for the full year. Is there any kind of seasonality or can you talk a little bit more about how the delinquency trends are and the credit contribution is flowing relative to your prior expectations?"
},
{
"speaker": "Carol B. Tome",
"text": "There is a bit of seasonality but I will say that only as it relates to the profitability of the portfolio in that a year ago, we were enjoying excess profits from our gain sharing arrangement and we had none of those excess profits in the first quarter of this year. So the year-over-year comparisons are going to be tougher in the first half of the year than they will be in the back half of the year, so hopefully that helps you."
},
{
"speaker": "Colin McGranahan - Sanford C. Bernstein",
"text": "Yeah, that makes sense. Obviously those profits deteriorated through the years, the delinquency rate stepped up sequentially. So was the overall delinquency or charge-off rates largely in line with your expectation to date?"
},
{
"speaker": "Carol B. Tome",
"text": "It’s running a little heavier actually, or a little higher. The good news, if there is good news in this environment, it seems to have stabilized."
},
{
"speaker": "Colin McGranahan - Sanford C. Bernstein",
"text": "Okay, and you -- that, just so I understand that correctly, once your gain sharing is zero, it’s zero, right? You can’t actually have negative gain sharing?"
},
{
"speaker": "Carol B. Tome",
"text": "Our arrangement is a profit sharing arrangement. In excess, we share in the profits in excess of a targeted return. If the targeted return is not achieved, then we could have to pay more for the cost of the credit."
},
{
"speaker": "Colin McGranahan - Sanford C. Bernstein",
"text": "Okay. And then just again, a brief question, seasonal impact through the year -- what should we expect in the coming quarters in terms of impact on sales 2Q, 3Q, 4Q, roughly? And operating margins?"
},
{
"speaker": "Carol B. Tome",
"text": "Well, the good news is that by the end of the year, there won’t be any impact. It will all work out but clearly if you have an extra week of spring in the first quarter, you are going to have one less week of spring in the second quarter."
},
{
"speaker": "Colin McGranahan - Sanford C. Bernstein",
"text": "And then just a -- so the same 13-weeks, whether you started in the February week or ended in the April week, that was that roughly negative 9.2 comp?"
},
{
"speaker": "Carol B. Tome",
"text": "If you do a like-for-like comp, that’s correct."
},
{
"speaker": "Colin McGranahan - Sanford C. Bernstein",
"text": "Okay. Great. Thank you so much."
},
{
"speaker": "Operator",
"text": "We’ll take our next question from Matthew Fassler from Goldman Sachs."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "Thanks a lot. Good morning, guys. A couple of questions, if I could -- on the comp store sales, if you could talk both about your U.S. only comps excluding China, Mexico, and Canada, and also if you could talk on the comp store sales side about whether the monthly numbers were distorted by either the calendar shift or by Easter."
},
{
"speaker": "Frank Blake",
"text": "Well, I’ll let Carol give the specifics but there were -- I mean, there was an Easter impact but obviously over the course of the quarter, that eased out and there would also have been some shifting impacts on the month. I don’t know that we actually kind of broke that out for you, but we gave you the overall number."
},
{
"speaker": "Carol B. Tome",
"text": "I’m sorry for jumping in, but Matt, the way we look at it is relative to our plan."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "I guess the reason I ask is because your competitor was out with numbers yesterday that were more volatile month to month with April showing a much bigger improvement. I’m wondering if your business was more consistent through the quarter or whether it was actually, when you put aside the calendar shift, a little more volatile than it looks on a reported basis?"
},
{
"speaker": "Craig Menear",
"text": "Maybe I can add a little bit of light to that. As we looked at the numbers in April last year, remember we had a couple of really horrendous weeks with weather. Our numbers in those weeks were sub-double-digit negatives, so we were nowhere near as down as much as what our competitor reported yesterday in those two weeks, which we think is what really is the difference in April in our performance versus theirs."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "Understood. And one quick follow-up -- on the expense line, as we measured it, your retail expenses per foot or per store excluding the charges were essentially flat, maybe up a little but I guess we could do the credit card work on our own and kind of back it out, but if you look at that at the store level excluding the credit card impact, is that down kind of low to mid-singles, or low singles in your view?"
},
{
"speaker": "Carol B. Tome",
"text": "It is."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "And is that consistent with where you’ve been or perhaps a little more of a pull-back on SG&A?"
},
{
"speaker": "Carol B. Tome",
"text": "It’s a reflection of the store count, the expenses that we have associated with store count. You know, we are only opening 55 stores this year."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "Understood. And the payroll, if you look at store payroll per se and you look at the either dollars per foot or leverage versus say last quarter, do you know what direction that moved in?"
},
{
"speaker": "Carol B. Tome",
"text": "It was flat to slightly up."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "The dollars or the ratio?"
},
{
"speaker": "Carol B. Tome",
"text": "The ratio."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "Great. Thanks so much, guys."
},
{
"speaker": "Carol B. Tome",
"text": "Matt, we didn’t answer your question on U.S. only comps, and we’re happy to do that. If you look at the contribution from our businesses outside of the United States, as Frank pointed out we had positive comps everywhere outside the United States. The contribution in the first quarter was 1.9%, about the same as it was in the fourth quarter."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "So it’s basically unchanged from where it’s been. Thank you so much."
},
{
"speaker": "Operator",
"text": "We’ll take our next question from Budd Bugatch from Raymond James."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "Good morning and thank you for taking my question. As you think about the business, Frank and Carol, you are kind of describing a leaner, and a lot of the announcements that we’ve seen, a leaner and a meaner Home Depot that is more in touch with the customer at the store level. Can you talk a little bit about what expense difference that means, maybe from the store service support center? I know there have been some actions taken there and obviously you talked about the call centers as well. How should we think about the overall overhead going forward and when does that show up in the numbers?"
},
{
"speaker": "Frank Blake",
"text": "Well, the first thing, Budd, to point out is as we were going through a number of the actions that we’ve taken like the call centers, like restructuring our field HR teams, like the day freight, we actually put those savings or hours back into the store. We reallocated back to customer-facing activity. So as a leadership team, we looked at this and said we know we need to address as one of our first priorities and key priorities associate engagement and this is -- that’s one of the sets of activities we are going to be taking to address the need to improve our coverage on the floor. And that’s going to be an ongoing effort. So Paul and his team, he’s got a whole group that is focused around what we call aprons on the floor where people come up with ideas on things we can do better, cheaper, faster, whatever it is and then how we redeploy that into hours on the store. We will always have opportunities, I suspect, in terms of our SSC here in getting our organization sized correctly to support the business. We took a very significant action a few months ago and look, all of our jobs here is to figure out how best to support the stores and how to do a better job tomorrow, which means being able to do it for faster and cheaper than we are doing today."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "Okay. And as you described what was going on with the field leaders, it almost sounded like a store Kaizen events, if I can put it in that term. How many field leaders are there? How many of those kinds of initiatives and events are there going on? Can you quantify a little bit of that for us?"
},
{
"speaker": "Frank Blake",
"text": "Let me ask Paul to discuss that."
},
{
"speaker": "Paul Raines",
"text": "Sure, Budd. I think what’s going on in this aprons on the floor, and we’ll add some color to it at the investor conference but this is our own continuous improvement. Kaizen is a good term. This is our own program to generate thinking around how do we find solutions for customer service. So our team literally is receiving hundreds of ideas on a weekly basis. We are taking action on those. The large ones you’ve heard about -- underneath those, there are several others that are smaller -- method improvements, process improvements, et cetera. But as Frank said, this is part of a multi-year framework to reallocated and reinvest in our customer service levels on the floor. So you will hear us at the investor conference talk about that multi-year game plan to continue this process."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "Well, you and I have talked about that in another venue and I am all for that. I think that is a great thing to do. My last question, if I could, is just piggy-backing a little bit on Colin’s question about the 96 basis points of higher credit. Carol, if you could maybe talk a little bit about that, how that played out month by month over the quarter -- I know you may not want to give us the actual granularity on it, but was the -- did that increase or decrease as the quarter unfolded?"
},
{
"speaker": "Carol B. Tome",
"text": "Well, we actually account for the profit sharing at the end of the month. We don’t do it each month."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "So you do it at the end of the quarter, not just at the end of the --"
},
{
"speaker": "Carol B. Tome",
"text": "Yes, at the end of each quarter, yes."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "Okay. All right, thank you very much."
},
{
"speaker": "Diane Dayhoff",
"text": "Connie, we’re ready for the next question."
},
{
"speaker": "Operator",
"text": "We’ll go next to Gregory Melich from Morgan Stanley."
},
{
"speaker": "Gregory Melich - Morgan Stanley",
"text": "A couple of questions; one, Carol, you said it was $0.04 is what the week shift implied. Am I backing into that right, that’s it about a 20% variable margin, those sales?"
},
{
"speaker": "Carol B. Tome",
"text": "That’s right."
},
{
"speaker": "Gregory Melich - Morgan Stanley",
"text": "Okay. And is it fair then to say that that’s what you see in the second quarter the other way, or how does that play out towards the end of the second quarter?"
},
{
"speaker": "Carol B. Tome",
"text": "We’ll explain it to you when we get done with the second quarter. We’ve got to see how the numbers come in. It really depends on the top line."
},
{
"speaker": "Diane Dayhoff",
"text": "But yes, there is a change, yes, you are right."
},
{
"speaker": "Carol B. Tome",
"text": "Of course, yeah."
},
{
"speaker": "Gregory Melich - Morgan Stanley",
"text": "Okay, great. And then, not to beat credit like a dead horse, but we’ll try -- if the gain share goes away and then you don’t take losses from that, but if you start paying it say in a few, 2% or 3% as opposed to 1%, does that then show up in gross margin? Is that the way the accounting works?"
},
{
"speaker": "Carol B. Tome",
"text": "No, it’s a little bit more complicated than that, I’m sorry. There are three components of our cost of credit. There’s the deferred interest component, which is the fee we pay for our no interest, no payment programs, and our everyday value proposition is if you use the card and you spend 299, it’s no interest, no payments for six months. That deferred interest is accounted for as a cost of goods sold. Then there are two other components. There is the gain share, which is a profit back to us and an interchange fee, which is a charge to us. And when you add it all up, the gain share and the interchange is in our selling and store operating expenses and when you add it all up, the deferred interest, the gain share, and the interchange, you get a cost of credit. In 2007, our cost of credit as a percent of credit sales -- and remember, credit sales are about 30% of our total sales, our cost of credit in 2007 was less than 50 basis points. In 2008, our plan is that it will be 200 basis points or 2%. And we stress tested this and we don’t think it would be any higher than 4%. So hopefully that’s helpful."
},
{
"speaker": "Gregory Melich - Morgan Stanley",
"text": "That is and at some point though, you could see some of that showing up in another line but that overall number is helpful."
},
{
"speaker": "Carol B. Tome",
"text": "It’s going to be in the same line, deferred interest, which is in cost of goods and then selling and store operating. Deferred interest isn’t going to move. That’s a fixed fee, if that’s helpful. It’s really how profitable is the portfolio. That’s where you could see movement and it would be in our selling and operating expenses."
},
{
"speaker": "Gregory Melich - Morgan Stanley",
"text": "Got it, perfect. And then third was rising fuel costs -- where does that show up? Is it SG&A or is it in cost of goods sold?"
},
{
"speaker": "Carol B. Tome",
"text": "It’s in both. It’s in both. Obviously it’s in our cost of goods but we also within SG&A, we have delivery expense. Delivery expense would be a factor of fuel expense, so it’s in both lines."
},
{
"speaker": "Gregory Melich - Morgan Stanley",
"text": "Okay, great. Thanks."
},
{
"speaker": "Operator",
"text": "We’ll go next to Michael Baker from Deutsche Bank."
},
{
"speaker": "Michael Baker - Deutsche Bank",
"text": "Thanks. So first question on gross margin -- so it was better this quarter because of being less promotional. Any expectation on the trend going forward? I think, correct me if I’m wrong, but a year ago you were a little bit more promotional in the first quarter and then you did back off on that throughout the year, so should we expect that same kind of gross margin gain going forward or is that going to change?"
},
{
"speaker": "Craig Menear",
"text": "In terms of the promotional activity, we went in and we really took a hard look at the promotional activity itself and what we were getting from that. And when we looked at about 10% of the promotions driving about 80% of the lift, that wasn’t a great return on the other 90%. So that’s where we became much more rational in terms of what we were doing with the promotions themselves and we obviously benefited from that. As we look at what’s going on with overall inflation, particularly as it relates to fuel, that’s where we are seeing pressure and we think that will certainly translate into some pressure overall in our margin but we are going to do our best to offset that for the customer, obviously."
},
{
"speaker": "Michael Baker - Deutsche Bank",
"text": "Okay, thanks. And then if I could ask one more question just on May, you said it’s in line with plan. I think your previous plan at the beginning of the year was for comps to get better throughout the year. Does that include the second quarter -- but then, of course, you have the negative calendar shift, which was apparently within your plan, so that would make the second quarter plan worse than the first quarter. Just wondering if you can help us there, put that into context. Should the second quarter, plan to be better or worse than the first quarter?"
},
{
"speaker": "Carol B. Tome",
"text": "Sure. Because of the calendar shift, our second quarter should be our worst comping quarter of the year."
},
{
"speaker": "Michael Baker - Deutsche Bank",
"text": "Okay. Thank you very much."
},
{
"speaker": "Diane Dayhoff",
"text": "Connie, we have time for one more question."
},
{
"speaker": "Operator",
"text": "We’ll take our final question from Daniel Binder from Jefferies."
},
{
"speaker": "Daniel Binder - Jefferies",
"text": "Appreciating the fact that the quality of the labor is changing, I was wondering if you can maybe quantify, either on a comp basis or a total hour basis, what the increase or decrease in hours, labor hours has been year over year? And the second question was related to store-wide market share; could you give us any comments on that? And then lastly, just wondering if you are pleased with the consistency of the in-aisle training and whether or not the loss of the HR function at the store level will be disruptive in that."
},
{
"speaker": "Frank Blake",
"text": "Let me take those in reverse order. On the consistency of the in-aisle training, and whether we will lose something from the loss of the HR imposition in our stores, the first thing I would acknowledge is we will lose something. I mean, these are trade-offs that we make in terms of some of the operational benefits in the store versus our belief that we do need to reallocate labor and do some restructuring on our workforce to provide better service for our customers. As Paul indicated, we are very focused on training. We’ve got a new program we are rolling out in terms of product knowledge badges, rewarding associates for -- so the question is a very fair question. It’s one we focus on and as I said, every time you do these decisions there are downsides and the best we do is address the downside as well as we can. On your second question, if I understood that, that was kind of our general market share -- was that your question?"
},
{
"speaker": "Daniel Binder - Jefferies",
"text": "Yes, just if you look at unit market share across all categories for the whole store, are you losing or gaining share."
},
{
"speaker": "Frank Blake",
"text": "So I’d say the way we look at it, there are roughly 13 -- we look at 13 categories and we are gaining or holding our own in half of them. And we see that as improvement. We know we’ve got a hill to climb here, so we see that as improvement. Craig and his team, along with everybody else on the senior leadership team, we’ve identified areas where we think we can gain market share, turn that around and we feel good about our plans to do that over the remainder of the year. And then your last question on sales per hour, I’m not sure."
},
{
"speaker": "Daniel Binder - Jefferies",
"text": "Well, I was trying to just understand quantitatively, if you were to look at labor hours per store, are they going up at this point on a comp basis or are they just declining less than comps?"
},
{
"speaker": "Frank Blake",
"text": "Yeah, they -- and for sure again, and it varies, and Paul can discuss the labor model but there’s a -- or maybe will take you to a level of detail none of you wants to go, but it obviously varies store by store on what the sales are in the particular store, but it could be just exactly as you said, that what’s happening is just the hours are declining at a lower rate than the sales."
},
{
"speaker": "Paul Raines",
"text": "In a negative comp environment, if you are in a store that’s negative comping, you know, the actual store customer traffic is decreasing. That store will have less associates in it. But when we talk about our aprons on the floor campaign, that $180 million that I referenced is we are -- our goal is to add the equivalent of three full-time employees selling hours to each store. Some of that will be a reallocation of tasking that we have made more efficient. Some of that will be incremental spend in the store based on the cost reductions of the call centers in HR, et cetera. So it’s all a combination of efforts to put more selling hours in front of each customer than we would have had otherwise."
},
{
"speaker": "Daniel Binder - Jefferies",
"text": "And are you making the progress you had hoped to on the master trades hires? Is that still a top priority and where do you expect that to be this year?"
},
{
"speaker": "Frank Blake",
"text": "I think it’s a very exciting program for us. As Paul indicated, we’ve got over 3,000 master trades specialists. As you would expect, and as we would expect, this is not an investment that you see an immediate return on but we are very pleased with how that program is going and we think it relates very directly to the foundation of Home Depot, that knowledge, that deep knowledge in the store, so we are pleased with the program."
},
{
"speaker": "Daniel Binder - Jefferies",
"text": "Okay, great. Thanks."
},
{
"speaker": "Diane Dayhoff",
"text": "Thank you, Connie, and thank you, everyone, for joining us today. We look forward to our speaking with you if you are coming to Atlanta for our conference in early June, otherwise we’ll talk to you in August. Thank you."
},
{
"speaker": "Operator",
"text": "And this concludes today’s conference. We thank you for your participation and you may now disconnect."
}
] | null | null |
HD | 4 | 2,007 | 2008-02-26 09:00:00 | Executives: Diane Dayhoff - Senior Vice President of Investor Relations Frank Blake - Chairman, Chief Executive Officer Craig Menear - Executive Vice President Merchandising Mark Holifield, Senior Vice President Supply Chain Carol B. Tome - Chief Financial Officer
Analysts: Steve Chick - J.P. Morgan Matthew Fassler - Goldman, Sachs & Co. Eric Bosshard - Cleveland Research Danielle Fox - Merrill Lynch Todd Duvick - Bank of America David Schick - Stifel Nicolaus & Company Budd Bugatch - Raymond James Chris Horvers - Bear Stearns Gregory Melich - Morgan Stanley
Operator: Good day, everyone, and welcome to today's Home Depot fourth quarter earnings conference call. As a reminder, today's call is being recorded. Beginning today's discussion is Ms. Diane Dayhoff, Senior Vice President of Investor Relations. Please go ahead, ma'am.
Diane Dayhoff - Senior Vice President of Investor Relations: Thank you, [Matt], and good morning to everyone. Welcome to the Home Depot fourth quarter earnings conference call. Joining us on our call today are Frank Blake, Chairman and CEO of The Home Depot, Craig Menear, Executive Vice President, Merchandising, Mark Holifield, Senior Vice President, Supply Chain, and Carol Tome, Chief Financial Officer. Following our prepared remarks, the call will be opened for analysts' questions. Questions will be limited to analysts and investors, and as a reminder, we would appreciate it if the participants would limit themselves to one question with one follow up, please. This conference call is being broadcast real time on the Internet at HomeDepot.com, with links on both our home page and the Investor Relations section. The replay also will be available on our site. If we are unable to get to your question during the call, please call our Investor Relations Department at 7703842387. Before I turn the call over to Frank, let me remind you that today's press release and the presentations made by our executives include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties. These risks and uncertainties include but are not limited to those factors identified in the release and in our filings with the Securities and Exchange Commission. Now let me turn the call over to Frank.
Frank Blake - Chairman, Chief Executive Officer: Thank you, Diane, and good morning, everyone. I believe we'll look back on 2007 as one of the most difficult years ever for The Home Depot ever financially, but I also believe we'll look back on it as one of the most important years for the long-term health of the business. On the financial side for the year, consolidated earnings per share declined 15% to $2.37. For our continuing operations, earnings per share were down 11% for the year. Our comp sales were negative 6.7%. When we set our plan in the beginning of 2007, we thought that we'd see an improvement in the market by the fourth quarter. In fact, we saw conditions worsen. Markets that had been soft, like California, Florida and the Northeast, stayed soft, and markets that had been relatively strong, like the Southwest and Midwest, weakened. The fourth quarter was our worst comp performance this year at negative 8.3%. But despite the difficulties in our market and the tough environment, I also believe 2007 has set the stage for the long-term health of the business. We are focused exclusively on our retail business. We set out our five priorities for investment in the retail business and committed resources to them, and they are the same priorities for 2008 and beyond - associate engagement, shopping environment, product availability, product excitement and Own the Pro. We have made significant progress on each. On associate engagement, we realigned compensation and reward programs to ensure that our associates are being appropriately recognized. For example, despite the difficult second half, we had 50% more associates in success sharing than in 2006 and increased the average payout by almost 40%. Our objective is to once again set the standard for associate knowledge and customer service. It won't happen overnight, but we're taking the right steps. In 2007, we hired over 2,500 master trade specialists - licensed plumbers and electricians - to work in our stores. We reintroduced Homer Badges to reward associates for great customer service. In 2008, we will be introducing a new TK Badge that will reward associates for developing enhanced product knowledge. In 2008, we will also focus redeploying noncustomer facing expenses to selling hours, an initiative we call Aprons on the Floor. An example of this is that we are changing the way we handle freight in our lower-volume stores. In more than 1,100 stores, we are moving today receiving and inventory stocking in the early morning and late evening hours while the store is open. This increases our ability to staff more customer-facing hours and shift full-time associates to busier selling periods. Paul Raines and his Store Operations team have piloted and rolled out this major initiative in a fraction of the time that it would have taken in the past, a sign of both increased velocity of decision making and greater focus on regional implementation and ownership. On shopping environment, in 2007 we completed an aggressive list of maintenance projects, with new lighting and basic cleanup activities for over half our stores, as well as more complex repair and maintenance activities for hundreds of other stores. In 2008, we will continue to invest at levels significantly above prior years. We now have an established programmatic maintenance cadence for our stores. We have also set out new store standards across the company that address the clutter we had allowed to develop over the years. On product availability, Mark Holifield will discuss the progress we've made on our supply chain transformation. In 2007 we piloted a new distribution concept. We're pleased with the results, and in 2008 through 2010, we will roll out new distribution centers. It is our number one initiative for 2008 and will help us lower costs, increase asset efficiency and improve the customer experience. On product excitement, Craig will discuss some of the new products and activities that he and the Merchandising team are driving, but I'd like to give you a point of view on our merchandising organization that we haven't much discussed before. Those of you who followed The Home Depot for awhile know that the company made a significant move several years ago to centralize all of our Merchandising functions. At one point we had nine divisions, each with its own merchandising organization. Then a few years ago we consolidated all those organizations into one in Atlanta. That centralization had a number of very positive impacts, but it also created some issues and gaps in strategy and execution as merchants lost direct touch with their markets. Throughout 2007, Craig and his team, along with Store Operations and supply chain, have worked to build basic processes to fill the gaps and fix the issues created by the centralization. We're well along in the process. We'll continue in 2008. This work is critical for our performance in 2008 and will also position us for successful implementation of core retail. On that point, we begin to pilot our new ERP system in Canada this spring. Once out of pilot, we will roll the new platform to all Canadian stores and expect to be fully operational there with the new system by the end of the year. On our Own the Pro initiative, we have grown our bid room volume by over 200% this year, and in 2008 we will continue to leverage our customer analytics to drive a deeper relationship with these valuable customers. Finally, our international businesses performed very well in 2007. We are the market leader in both Mexico and Canada. Mexico posted double-digit comps for the year, Canada had positive comps, and China has posted positive comps since we re-branded our stores last summer. On all of our initiatives, we are proud of what we have accomplished but realistic about all the work we have left to do. We have improved our voice of customer scores, but we are still too often perceived as lagging in customer service, and we know that in a down market, we have to work all the harder to earn our customers' confidence. So as we look at 2008, we know that we have to continue to make investments in our business to drive our key priorities. We also know that we have to stop doing some things. We should be judged by the discipline we bring to executing on our key priorities and the discipline we bring to stepping away from activities that aren't priorities. Chief among the activities we are downsizing is new store growth. We will open about 55 new stores in 2008, of which only about 35 will be in the United States. We expect 2008 to be another challenging year in terms of the housing and home improvement markets. There is a substantial inventory of houses for sale, continued pressure on housing prices, uncertainties around credit availability, and concerns around the overall economy beyond the housing sector. Throughout this year I have referenced the data on private residential construction as a percent of GDP. At this time last year it had fallen from 6.3% at the beginning of 2006 to 5.3%. The 60year average is 4.8%, which suggested that there was still room for the market to fall, and it did. It dropped another 110 basis points and now stands at 4.2%. So we are now below the historic mean. We probably still have room to go, and the historic troughs in this indicator suggest that is the case. But this gives us at least some cause for cautious optimism as we look out through 2008 and into 2009. Carol will cover our 2008 guidance in more detail in a few minutes, but in summary, we expect continued negative comps in 2008, with sales decreasing 4% to 5% as compared to last year. We also expect negative comps in the mid to high single-digit range. Since, as Carol has described, every point of negative comp drives about 20 basis points in operating profit deterioration and since we expect continued cost impacts from our private label credit card, our earnings per share will decline by approximately 19% to 24%. I'd like to go back to a comment I made on my first earnings call a year ago. The Home Depot is a company built on a strong set of core values. We have hundreds of thousands of associates who understand those values, believe them and live them. They make a difference for our customers, for our communities and for each other every day. They love solving problems. They are passionate about helping others. I want to thank them for their dedication and hard work. They make this a truly special company. Now let me turn the call over to Craig.
Craig Menear - Executive Vice President Merchandising: Thanks, Frank, and good morning, everyone. Our Merchandising departmental sales reflect the softness in the home improvement market. For the year, every department experienced flat to negative sales growth compared to 2006, with those categories most closely associated with construction - like lumber, building materials, electrical and millwork - posting double-digit negative declines. In the fourth quarter, we experienced negative sales growth in all departments except one. The department that outperformed the company's average comp were Seasonal, Plumbing, Paint and Hardware. The one department that experienced positive comp sales was Seasonal, driven by strong performance in Holiday, Fireplace, and Chemicals. Flooring performed at the company average. The weakness in the quarter came from continued softness in big-ticket and construction categories. January was particularly soft. The pros went home for the holiday and didn't come back until the latter part of the month. Special order Kitchens, Windows, Roofing and Madic Fasteners all had double-digit sales declines across all regions in the country except the Southwest. Additionally, we saw continued commodity deflation which impacted Lumber and Building Material categories like Dimensional Lumber and Gypsum. The combination of softness in the big ticket and commodity deflation negatively impacted average ticket, which was down 2.3% from last year to $54.96. While we saw pressure across the store, there was relative strength in Repair and Remodel categories. Fasteners, builder's hardware, plumbing repair, pipe, along with the associated tools needed to make repairs, performed above the company's average comp in all regions except the hardest hit areas of California, Florida and portions of the Northeast. We saw strength in seasonal categories. Fireplace, Heaters, Power Equipment posted positive comps for the quarter in every region of the country except the more temperate climates such as in California and Florida. Additionally, Holiday posted double-digit comps across the country as a result of our enhanced assortment and increased values for our customers. I've shared with you throughout the year that we're focused on merchandising fundamentals. While some of my comments will seem obvious, let me tell you what's been done in 2007 and what my senior leadership team and I will continue to focus on in 2008. First, to ensure that we are in touch with our customer's needs, every merchant is required to walk our stores at least one day a week. The objective is for our merchants to use this time to speak with customers and associates to get direct feedback on their assortments and merchandising opportunities. Second, we have constructed a weekly meeting where merchandising leadership and our regional merchants, together with Operations and supply chain leadership discuss upcoming events and operational issues. This creates a sense of urgency, quickly resolving issues normally by the end of the day, and it creates a collaborative ownership of results. Third, we asked our IT and finance teams to provide improved tools to help merchants more effectively do their job. We don't have time to wait for core retail, a multi-year initiative, to provide these merchandising tools. Our technology team delivered an enhanced assortment tool that makes it easier for our merchants to assort to a market and even down to a specific store. They also provided a new forecasting tool. The new forecasting tool is essential because speed in decision making is more critical than ever in this business environment. Enhanced forecasting is particularly important in our seasonal businesses. We used this improved forecasting for spring planning and feel good about having the right amount of product in our stores for our customers at the right time. Fourth, I've asked our merchants to accelerate implementation of our focused bay approach, our belief that not all bays are created equal, which drives our investment decisions. In 2007, we exited Consumer Electronics. This year we plan to exit Pet and Halloween categories. My team knows that they need to make the tough calls in driving resources back to core home improvement categories. Even within core home improvement categories, we need to accelerate decisions on line structure, introduction of innovative products, and communicating the value proposition to improve our assortment productivity. These actions, along with other investments, have allowed us to narrow our share loss in 2007. Specifically, these actions have helped us drive improvements in several product categories, such as Power Tools, Soft Flooring, Paint and Seasonal. While we have made progress in many product categories, there are still others where we continue to lose share, and this represents an opportunity for us going forward. For example, in 2008 we are confident that we will improve our business results in Lighting, Kitchens, Bath Fixtures and Hand Tools by focusing on the fundamentals and leveraging these new tools. Our suppliers are key partners and I know that we will always negotiate over price, but we are in this to drive business together and we are driving a more collaborative planning process, doing a better job of sharing information, and working together on product innovation. These merchandising processes and stronger, better partnerships better equip our merchants so that they can leverage our regional merchandising teams in the field and sharpen our local merchandising efforts. For spring, I have some great products that I'm really excited about. We have a new exclusive charbroil grill with infrared technology ensuring even cooking and the ability to sear or slow cook with a range of temperatures from 250 to 800 degrees. It's also energy efficient and self-cleaning, with a touch of a button. We are introducing new patio sets that bring affordable luxury to our customers. This year we introduced Thomasville to our line up, complimenting Hampton Bay, both of which are exclusive programs. Our sets start at $399 and include everything from rust-proof aluminium frames with hard surface tops to wicker and cast aluminium sets and indoor/outdoor wood. We are also introducing an electric start gas trimmer under our exclusive Ryobi brand. The new touch-start trimmer is a very innovative product, and it's the only gas trimmer sold in the United States that can be started with the push of a button as opposed to the standard pull cord. Finally, I want to highlight our new fresh air paint from ICI, which is the only true VOC - or volatile organic compound - free paint in the market. It is a trend-forward color palette of 65 colors inspired from nature, and it is the one of the only paint products that is Greenguard certified. It's truly odor free, which makes painting a much more pleasant experience. 2008 is going to be tough, but we have a strong merchandising team that will remain focused on merchandising fundamentals and delivering long-term value for our customers. And now I'd like to turn the call over to Mark.
Mark Holifield, Senior Vice President Supply Chain: Thanks, Craig. Good morning, everyone. First, I'll walk you through our supply chain accomplishments this year and then I'll outline our plans for 2008. In 2007, we started transforming our supply chain so we could deliver on the priority of improved product availability or better in-stock for our customers. One of our first objectives was to complete a comprehensive review of our supply chain, its capabilities and its limitations. In terms of capabilities, not too surprisingly we discovered that our biggest opportunity is to radically increase our central distribution penetration. This will allow us to manage our inventory much more effectively both for our regular replenishment inventory and for our seasonal and promotional products. The existing Home Depot supply chain worked great for high-volume stores, which had no trouble making frequent orders to vendors for direct-store delivery to allow them good in-stocks and inventory turnover. But in lower-volume stores, without an effective central distribution network, our store associates are forced every day to make the tough choice of being out of stock or overstocked due to vendor minimum order quantities, long lead times, and unreliable replenishment. Given this need for much more central distribution, we developed an end-state vision for what an ideal network would look like for The Home Depot in the United States. This distribution network strategy effort employed industry standard techniques to map and analyze all of our existing and forecasted network product flows all the way upstream from our suppliers and downstream to our stores and customers. Through this effort, we developed an optimal distribution center network strategy model that we will continue to use to guide all of our network development decisions in the future. A few of the highlights about the optimal network strategy: Our goals are first, to move from a central distribution penetration of about 20% of product flow measured by cost of goods sold to about 75% of product flow. Second, to operate fast-flow distribution centers, with the capability to process faster-moving goods which we will call rapid-deployment centers or RDCs. The optimal distribution center, or DC network, would include more than 20 of these fast-flow RDC facilities. Optimally, more volume will pass through these fast-flow RDCs than through traditional DCs. Third, to operate lumber in bulk DCs along with traditional stockandpick DCs as we do today. So the biggest opportunity in front of us was to develop these RDCs and to move quickly as the gap from 20% of central distribution to 75% is obviously quite large. Concurrent with our supply chain strategy efforts, having a general idea of where the end-state supply chain strategy would take us, we began to pilot these fast-flow capabilities in our existing distribution network. In late March of 2007 we kicked off an RDC pilot in Atlanta that included 67 Atlanta area stores and 20 vendors, converting part of an existing Home Depot operated DC in Braselton, Georgia to these fast-flow or RDC capabilities. The results of the RDC pilot were better in-stock at the stores, reduced lead times, improved shipment integrity, and improved inventory turnover. We ramped up more stores and more vendors, and today the Atlanta area RDC served 99 stores and processes almost 100 Home Depot vendors' products through it. We continue to add vendors to the mix weekly. So we now have a DC network strategy, a proven concept of operations as its cornerstone, and we have begun to roll it out. Our second RDC was opened in Chicago in January, and we are ramping up volume there now. When we open an RDC, if there is a transit facility nearby - as in Chicago we will close it and incorporate those existing processes and freight flows into the new RDC. The keys to executing this strategy are getting more RDC buildings open and operating effectively and on-boarding vendors to the program. We will have several more openings in 2008, and we have a major push on getting vendors on board. Our target is complete 2008 and enter 2009 with 40% of our U.S. stores receiving RDC service and 30% of those stores' product flow measured in cost of goods sold on the RDC program. To get to the 40% of stores targeted this corresponds to opening about six additional facilities this year, ending 2008 with about eight RDCs given that each facility will serve about 100 stores. Beyond 2008 we will continue to open RDCs until we have reached 100% of our U.S. stores. We will also continue to ramp up vendors through the RDCs, making progress toward the in-state goal of 75% central distribution. Keep in mind that while RDCs will ultimately make up about half of the total product flow, the 75% distribution target includes the existing lumber DCs and the traditional stockandpick DCs. We expect to complete our RDC rollout in 2010. At this point we estimate the required capital investment to be about $260 million through 2010. We will keep you posted as we progress on this very exciting initiative. We think that long term it means lower supply chain cost, better in-stocks and higher inventory turns. Another important objective in supply chain was to establish a world class team of supply chain professionals. I've been very pleased with the supply chain talent we have on board here at The Home Depot, and we have augmented that talent with some key leaders who will help us to deliver on our commitments. In addition to Mark Huffman, Vice President of Inventory Planning and Replenishment, and John Deaton, Vice President of Supply Chain Development, let me highlight a couple of leaders who have joined us recently and are already making big impacts. Charlie Armstrong is our VP of Distribution and joined us in October. Charlie has years of transformation experience in retail supply chain, working with Ward's, Melville, GARR Consulting Group, and others. Charlie is accountable for all DCs and their operations as we radically increase our central distribution capabilities and roll out the RDCs. Additionally, we hired a new VP of Transportation, Michelle Livingston, who also joined in October. Michelle is a lifelong transportation professional. She came to us from C&S Wholesale Grocers, a large distributor to over 2,000 retail stores. Prior to C&S, Michelle worked with J.C. Penny as Vice President of Transportation and was there during their retail transformation, so she also has experience with the scope of our effort. So in closing, we are very pleased with our progress and excited about 2008 and the future as we transform our supply chain to the benefit of our customers, associates and shareholders. And now I'll turn the call over to Carol.
Carol B. Tome - Chief Financial Officer: Thank you, Mark, and hello, everyone. There are a couple of items I'd like to mention before I cover our results. First, our fiscal year consisted of 53 weeks, so our fourth quarter results reflect 14 weeks of operations compared to 13 weeks last year. Second, fiscal 2007 results include seven months of HD Supply as a discontinued operation. HD Supply operating results, including the impact of the sale of the business, are found on a line item entitled Earnings from Discontinued Operations. In the fourth quarter, sales were $17.7 billion, a 1.5% increase from last year. For the year, our sales declined by 2.1% to $77.3 billion. The 14th week in the fourth quarter added approximately $1.1 billion in sales to the quarter and the year. Excluding the sales impacts of the extra week, our fourth quarter sales declined by 4.7% and our fiscal year sales declined by 3.5%. We reported earnings per share from continuing operations of $0.40 in the quarter, down 4.8% from last year and for fiscal 2007, earnings per share from continuing operations were $2.27, down 11% from last year. The extra week increased earnings per share by approximately $.04 for the quarter and the year. Consistent with our guidance, the slowing housing environment significantly impacted our comp sales, which were a negative 8.3% for the quarter. Consolidated same-store sales were negative 6.6% in November, negative 7.2% in December, and negative 10.8% in January. We do not include the extra week in our comp calculation. For the year, comp sales were negative 6.7%. In the fourth quarter, our gross margin was 34.3%, an increase of 67 basis points from last year, reflecting 47 basis points of margin expansion due to lower deferred interest associated with our private label credit card, and 20 basis points of margin expansion due to a number of factors, including a change in the mix of products sold and less promotions in the quarter. For the year, our gross margin was 33.6% flat to last year. In the fourth quarter, operating expenses increased by 197 basis points to 27.2% of sales. Our expense deleverage reflects the impact of negative sales, where for every point of negative comp we expect to deleverage expenses by about 20 basis points. With a negative comp of roughly 8%, we would expect to report expense deleverage of 160 basis points. In the fourth quarter, we experienced an additional 37 basis points of expense deleverage due to several strategic business decisions, including the closing of our Tampa call center and write-offs associated with certain future store locations that we determined we will not open. Further, as we anticipated, the gain share from our private label credit card program was less in the fourth quarter than last year. The year-over-year decline in gain share is about equal to severance we paid out in the fourth quarter of 2006. For the year, operating expenses increased by 188 basis points to 24.3% of sales. Operating margin was 7.1% in the fourth quarter, down 130 basis points from last year. For fiscal 2007, operating margin was 9.4%, down 186 basis points compared to last year. Diluted shares for the fourth quarter were 1.68 billion shares compared to 2 billion shares last year. The reduction in outstanding shares is due to our share repurchase program and includes the tender offer we completed in September. Since our share repurchase program began in 2002, we have repurchased a total of 743 million shares or 31% of our outstanding shares. Moving to our operational metrics, during the fourth quarter we opened 26 new stores, including five relocations, for an ending store count of 2,234. At the end of the fourth quarter, selling square footage was 235 million, a 4.9% increase from last year. Reflecting the sales environment, total sales per square foot on a 14week basis were approximately $279 for the quarter, down 8.7% from last year, and for the year were $332, down roughly 7% from fiscal 2006. Now turning to the balance sheet, at the end of the quarter retail inventory was $11.7 billion, up 4% from last year. On a per-store basis, inventory was flat to last year. Inventory turns were 4.2 times compared to 4.5 last year. Computed on the average of beginning and ending, long-term debt and equity for the trailing four quarters, return on invested capital was approximately 14%, down 290 basis points from last year due to the decline in our operating profits. We ended the quarter with $44.3 billion in assets, including $457 million in cash and short-term investments. This is a decrease of approximately $160 million in cash and short-term investments from the end of fiscal 2006, reflecting cash generated by the business of approximately $6.2 billion, net proceeds from the sale of HD Supply of $8 billion, and commercial paper issuances of $1.7 billion offset by $10.8 billion paid for share repurchases, $3.6 billion of capital expenditures, and $1.7 billion of dividends. As Frank mentioned, the home improvement market is very soft and it's difficult for us to know just where it will go in 2008. Our guidance reflects our best thinking at this point, and it's important to note that we have not factored into our thinking the impact of the economic stimulus package. We're going after our fair share, but we really don't know how the consumer is going to react in this environment. We've detailed our guidance in our press release, so let me just hit the high points. From fiscal 2007 reported results, we expect fiscal 2008 sales to decline by 4% to 5%, with negative comps in the mid to high single digit area. In the first three weeks of fiscal 2008, we are seeing mid single-digit negative comps, consistent with our plan. For the year, we expect to open 55 new stores. For fiscal 2008, we expect earnings per share from continuing operations to decline by 19% to 24%. Included in our earnings per share guidance is our view that gross margin expansion will be flat to slightly positive and that our operating margin will decline by 170 to 210 basis points as we expect expense deleverage due to negative comp sales and expense pressure from our private label credit card program. Let me take a minute and comment on our private label credit card program. By way of background, we currently offer six products as part of our private label credit card portfolio which range from three consumer-oriented cards to three cards that serve our professional contractors. As of the end of fiscal 2007, almost 30% of all sales tendered were tendered through the use of our private label cards. The cards are offered and administrated by a third party in a program that includes a profit sharing provision. There are three main components of the program that impact the earnings statement. First, deferred interest - we are charged a flat fee which we call deferred interest every time a customer uses one of our deferred financing programs like No Interest, No Payment for Six Months. This flat fee is treated by us as a cost of goods sold. Second, interchange - we are charged a fee each time our pros use their card. It's like an interchange fee for VISA or American Express, and we treat this charge as an operating expense. Third, gain share - this is our share of any profits in excess of a targeted turn. The portfolio has been much more profitable than the targeted return, so we've been enjoying a gain share which is treated as a reduction in operating expenses. The sum of all three totals the total cost of credit. Since 2004, the total cost of credit as a percent of credit sales has dropped by over 100 basis points, and in 2007 was less than 1% of private label credit sales. Under our credit agreement, the cost of credit can increase if the portfolio decreases in profitability. In fact, we project that the cost of credit will increase in 2008 and a major factor to this increase is less gain share due to higher losses in the portfolio. We believe the total cost of credit will reach 2% in 2008. While the year-over-year increase is large, 2% is in line with the cost of credit for traditional bank cards. Now moving to capital allocation, our capital spending plan for 2008 is $2.3 billion, down 32% from what we spent in the retail business last year, primarily due to lower new store openings. Approximately 50% of our capital spending plan is for new stores and the remainder will be used to invest in our existing stores in support of our key initiatives. Given that this is a transition year for our supply chain, we are not planning for any inventory turnover improvement, and given the sales environment, we may see slight deterioration in our turns. Finally, I want to give you our latest thinking on our recapitalization plan. In 2007, we completed almost 50% of our $22.5 billion recapitalization plan. Late last year, we put the recap on pause given market conditions. 2008 is going to be another challenging year, and we think the prudent thing to do is to keep the program on pause until we see stabilization in our business and the credit markets. So thank you for your participation in today's call, and Matt, we're ready and we'll be happy to take your questions.
Steve Chick - J.P. Morgan: Hi, thanks. Hey, I guess, Carol, first off, just in terms of the credit card, the 2% that the private label card will cost you in '08, I'm calculating that that's about $440 million or so. And I know you gave us what the numbers were for the second half of '07. Can you just give us what the - well, confirm if that absolute number is right and what the total increase will be year-over-year that you're projecting at this point?
Carol B. Tome - Chief Financial Officer: Steve, you're a little bit high on your analysis, and let me give you a bit more color on how to think about our private label credit card. There are three aspects of the program that impact the earnings statement. If you think about deferred interest, that is treated by us as a cost of goods sold. Your year-over change is going to be very little. In fact, we'll have fewer credit promotions days in 2008, and we expect very little change in the cost of deferred interest. As you come, then, to the selling and store operating expense line, clearly we'll have a lot less gain share than we had in 2007. I'm thinking that the amount of deleverage that we'll get year-over-year because of lower gain share is the amount of about 50 basis points.
Steve Chick - J.P. Morgan: Okay. Okay, so I just - so 50 basis points will be the portion within your selling and administrative expenses?
Carol B. Tome - Chief Financial Officer: Yeah. In the operating margin decline guidance that we gave of 170 to 210, there's as much as 50 related to the gain share.
Steve Chick - J.P. Morgan: Oh, okay. All right. Great, that helps. Now the second thing, you know, this quarter, you know, your comp gap with your competitor narrowed pretty nicely, and it looks like it was in the months - the last two months of the quarter. You know, are you - can you speak to that a little? I mean, is it, you know, maybe this quarter might have been kind of an anomaly, or do you really think that, you know, some of the cultural things and the things you're implementing at the store level are starting to gain traction relative to the marketplace?
Frank Blake - Chairman, Chief Executive Officer: You know, Steve, we - I guess the right way for us to think about it is not with respect to any one particular competitor but to think about it in terms of the market as a whole. As Craig said, we were pleased in some of the areas where we think we picked up share, but there are lots more opportunities out there for us to continue to gain share.
Steve Chick - J.P. Morgan: Okay, thanks. And last, a clarification point, if I could. Carol, the guidance for D&A, which I think you said is $1.9 billion, is that the D&A that's on the face of the P&L or is it the total depreciation and amortization that you disclose separately?
Carol B. Tome - Chief Financial Officer: It's the total depreciation and amortization that we disclose separately.
Steve Chick - J.P. Morgan: Okay, so that's $1.9 billion compared with 1.82?
Carol B. Tome - Chief Financial Officer: That's correct.
Steve Chick - J.P. Morgan: Okay. All right, great. Thank you.
Carol B. Tome - Chief Financial Officer: You're welcome.
Operator: We'll go next to Matthew Fassler with Goldman Sachs.
Matthew Fassler - Goldman, Sachs & Co.: Thanks a lot and good morning. I'd like to focus today primarily on distribution. If you could talk about the decision to go with the RDCs versus other distribution alternatives, the stock and fixed DCs specifically, what the cost difference is, and just sort of the thought process beyond that call.
Mark Holifield, Senior Vice President Supply Chain: Yeah, Matt, it's Mark Holifield. On the decision to go to fast-flow as opposed to stock-and-pick, what I would point out is that we do have stock-and-pick distribution centers today that we use primarily for import products but also for domestic products. So we had capabilities in that arena already. Given our gap of 20% to 75%, where we want to go, these fast-flow facilities are much simpler to set up, much smaller in general and much lower in capital investment, so we felt that this was the fastest way to make that acceleration from 20% to 75% central distribution penetration.
Matthew Fassler - Goldman, Sachs & Co.: And just one follow up - thank you for that, Mark - you know, Carol, you talked about the quarter-to-date same-store sales trends, you know, down mid-singles is a pretty sharp improvement from the numbers that you saw in January. How would you characterize or what would you attribute it to, and how do you think about that in the context of your expectations for the rest of the year?
Carol B. Tome - Chief Financial Officer: Well, clearly we think the first half is going to be softer than the back half, as you can appreciate given the comps that we're up against. We did have a very, very strong President's Day weekend, and so that's obviously contributing to our year-to-date performance. But as Craig pointed out in his comments, in January the pros - they went home for the holidays, and they just didn't come back. But we're starting to see them come back in our stores.
Matthew Fassler - Goldman, Sachs & Co.: Fair enough. Thanks so much.
Operator: We'll go next to Eric Bosshard with Cleveland Research.
Eric Bosshard - Cleveland Research: Good morning.
Frank Blake - Chairman, Chief Executive Officer: Morning.
Eric Bosshard - Cleveland Research: Two things I'd love to get some guidance on. First of all, in terms of the delta in Capex, Frank or Carol, can you talk about where the investment is changing in '08 relative to '07? I know you that indicated that store openings is an important [inaudible] with that, but where else is there delta taking place there?
Carol B. Tome - Chief Financial Officer: Sure. In 2008 we decided to spend $2.3 billion, which is down $1.1 billion from what we spent in the retail business in 2007. $900 million of that is directly related to new store openings, so that's the biggest change. The remainder decline is in areas where we spent money that we don't need to spend in 2008. For example, we put radio call boxes in our stores in 2007. We don't need to repeat that in 2008. We're being very judicious on our merchandising resets. As Craig mentioned, we are accelerating merchandising resets that assist the product line review process, but for those major transformation resets, we're pulling back on those a bit because we think that makes the most sense for the business.
Eric Bosshard - Cleveland Research: Great. And then secondly, for Craig, can you comment about what you're seeing in terms of sourcing costs, specifically your direct import program - if you're seeing the influence of Chinese inflation and how you can react or respond to that?
Craig Menear - Executive Vice President Merchandising: Yeah, certainly, Eric. No question that there is cost pressure in the market as a result of the taxation change in China. We're working hard with our suppliers to try to offset those costs wherever possible. We have, you know, taken some and in other cases we've been able to work with them to offset costs and forego that. So there is pressure there, but at this point it's not something that we don't feel is unmanageable.
Eric Bosshard - Cleveland Research: Great. Very good. Thank you.
Operator: We'll go to Danielle Fox with Merrill Lynch.
Danielle Fox - Merrill Lynch: Thanks. Good morning. Could you talk a little bit more about the financial impact from the rollout of this optimal supply chain strategy? Should it be earnings dilutive, neutral or accretive over, you know, the next few years? And on a related note, how do you manage the potential for disruption as you make major changes to your distribution network? Thanks.
Carol B. Tome - Chief Financial Officer: Danielle, on the financial impact, as you can appreciate, as we're rolling this out it will be earnings dilutive, and it's included in the guidance that we gave you for 2008. As Mark mentioned, we expect to be fully functioning in 2010, and that's when we'll see the economic benefit starting to flow through in terms of lower supply chain costs and higher inventory turns. On the disruption, we are planning for that. Mark, you might want to comment.
Mark Holifield, Senior Vice President Supply Chain: Yeah. I think we roll these out over the course of about three or four months as they open up and get to full volume. We have learned a lot from the Braselton test, and we learn each time we're going. You know, we're working very closely with the stores to ensure that our store partners understand the process. And, you know, I won't say we've perfected the program, but through the Braselton pilot, we've stumbled across just about everything we can stumble across and we believe we'll have a good rollout going forward.
Danielle Fox - Merrill Lynch: Okay. Thank you.
Operator: We'll go next to Todd Duvick with Bank of America.
Todd Duvick - Bank of America: Good morning. I had a quick question for you, and I appreciate the comments on the recapitalization program. I'm just wondering if you can tell us if that precludes any opportunistic share repurchases as we go throughout the year until you do feel the time is right for the recapitalization program?
Carol B. Tome - Chief Financial Officer: Well, what we've said all along is that we will use our excess cash to return capital to our shareholders through share repurchases. As you can see by looking at our balance sheet, we don't have any. We have $1.7 billion of outstanding commercial paper, and we need to run the business with about $500 to $1 billion of cash. So we anticipate based on the guidance that we gave that we will be in the commercial paper market in 2008.
Todd Duvick - Bank of America: Okay. But in terms of any large debt issuance, you're just going to kind of wait and see when the business improves, and following that, you're going to plan to finish the transformation program?
Carol B. Tome - Chief Financial Officer: Yeah, we are committed to the recapitalization program, but given our business as well as the conditions of the credit markets, we think it's prudent to pause.
Todd Duvick - Bank of America: Okay. Thank you very much.
Carol B. Tome - Chief Financial Officer: You're welcome.
Operator: We'll go to David Schick with Stifel Nicolaus.
David Schick - Stifel Nicolaus & Company: Hi. Good morning. A question, really, I guess for Mark. If you think out maybe five years - and I know it's just 90 days of data on Braselton and Chicago - but you think about product costs and gross margin versus sort of inventory turns or driving comps or product availability, can you rank order that opportunity or at least, you know, talk about what's bigger and what's smaller in those opportunities?
Mark Holifield, Senior Vice President Supply Chain: Yeah. I would point out that we have almost a year of experience with the Braselton RDC. As I said, we opened that in late March of '07 so we've got a fair amount of information on that and experience with that. In terms of the business case for RDC, it's really based upon logistics costs, which we expect to lower through improved transportation and handling, improve inventory turnover through a better allocation process and lowering the lead time and the amount of time it takes for products to travel to stores from the vendors, and improved in-stocks leading to greater sales through the process of lowering the lead time and improving the responsiveness to inventory changes in the store. In rank order, it's kind of tough, I think. Logistics cost is very clear. You can measure that very clearly. Inventory turns, there's a whole lot of things that impact inventory turns, so it's a little bit tougher to point to a specific benefit there because there's a lot of moving parts; same thing with in-stock. But we do expect all three of those to improve greatly as we roll these out.
Carol B. Tome - Chief Financial Officer: But if you love cash, one full turn improvement in inventory is over $1.5 billion of cash. So Mark, I don't know about you, but I'd put that high on the priority list.
Mark Holifield, Senior Vice President Supply Chain: Yes.
David Schick - Stifel Nicolaus & Company: Thanks a lot.
Operator: We'll go to Budd Bugatch with Raymond James.
Budd Bugatch - Raymond James: Good morning. Just a couple of quick questions. Carol, in the past you've given us the 5% change in sales begets a 10% change in EPS and the 20 basis points to operating margin for every 100 basis points of change in comps. Do those still hold? Do those still hold for the long term, with the exception of the credit cost issue that you had this year?
Carol B. Tome - Chief Financial Officer: Right. Excluding the private label card portfolio, we think our rule of thumb of 20 basis points of deleverage for every point of negative comp holds. I think that would change in an environment if we were at pro-loan double-digit negative. We're not there. But clearly, we have minimum staffing levels in our stores that we need to be sensitive to. But we've modeled this, and we're comfortable with the guidance that we've given.
Budd Bugatch - Raymond James: Okay. And Mark, for you, I'm just a little confused on the difference between the fast-flow facilities of Braselton and what you had - I think you had 10 transit facilities that also served about 100 stores each, if I remember right - and can you give us a difference of what's - what's the difference between those two physically and maybe operationally?
Mark Holifield, Senior Vice President Supply Chain: Sure, Budd. The transit facilities, the easiest way to think about those is they're really more of an in-house LTL dock - a less than truckload freight handling dock. We place an order that's a store-level order direct to the store, and it simply passes through the transit facility where it's aggregated with other store-level orders going direct to the store. So it's really - the easiest way to think about it is in-house LTL dock.
Budd Bugatch - Raymond James: Right.
Mark Holifield, Senior Vice President Supply Chain: An RDC is different than that. We place a DC-level order, a single order, for the 100 stores, so we reduce the number of purchase orders that we send to the vendor by 99%, we reduce the number of orders that he has to pick by 99%, and we reduce the number of shipments by the same amount. So it's a single bulk shipment into the RDC, and at the RDC, then, we break that down by store and use the information we have on inventory at that point - what's needed in each store - to allocate what's needed to the store. So it's more handling in the RDC, but we gain benefit in terms of the in-stock and inventory turn. And as we roll vendors on this, we work with them to take the costs out that they're saving in terms of fewer orders to process.
Budd Bugatch - Raymond James: Got you. Okay, thank you very much.
Operator: We'll go to Chris Horvers with Bear Stearns.
Chris Horvers - Bear Stearns: Chris Horvers from Bear Stearns.
Carol B. Tome - Chief Financial Officer: Hi, Chris.
Chris Horvers - Bear Stearns: Stepping back on square footage growth, you cut back the growth this year. Can you talk about how you're thinking about longer term - what your longer-term square footage growth be, how many stores you might think about in 2009 and 2010, domestic versus international?
Frank Blake - Chairman, Chief Executive Officer: Well, first let me take the domestic side, Chris. You know, we've said for awhile that you should look at our new square footage growth as pretty much matching the market. And so obviously, as the market growth has come down, then our plans going forward on new square footage growth is coming down. So I would not expect, you know, at least within our planning horizon much change from what we're going to do in 2008 and if there were a change, it would probably be slightly decremented, not going up. Internationally, we continue to see opportunities in Mexico. You know, we really haven't even started to roll out China. We've stayed with the initial dozen stores from a year ago, just working through that business model. So we haven't really even put on the table yet what's a new store growth plan for China.
Chris Horvers - Bear Stearns: Okay. That's very helpful. Frank, in prior conference calls you've talked about your relative market share gain or loss versus the market and how you saw some improvement. I'm not sure if I missed it. Could you review that?
Frank Blake - Chairman, Chief Executive Officer: Yeah, and I think Craig mentioned it just in passing. The way we look at is we think we've still lost share to the market. We think we've I don't want to do a double negative here, but we've reversed the rate of our decline, so it's improving. But we don't see in our performance now that we're picking up share to the market yet. We feel like we're on that trajectory, but we're not there yet.
Chris Horvers - Bear Stearns: Do you have the '07 versus '06, what the numbers were by chance?
Frank Blake - Chairman, Chief Executive Officer: I don't off the top of my head. And truly - we can get that back to you - ballpark, I'm remembering we've kind of cut it in half, the rate of decline, something like that.
Diane Dayhoff - Senior Vice President of Investor Relations: Chris, this is Diane. I'll get back to you with that.
Chris Horvers - Bear Stearns: Okay. And then finally, Craig, can you talk a little bit about trends in the Appliance category? You didn't really call it out. How do you feel you're making progress there, and how do you look at that from a market share perspective?
Craig Menear - Executive Vice President Merchandising: We improved our share in the quarter again from 10.8% to 11.8%. So we had a positive gain in the quarter. The industry in total is contracting, but we still feel that, you know, based on the share information, that our assortment and line up is something that the customer's responding very positively to.
Chris Horvers - Bear Stearns: Excellent. Thank you very much.
Diane Dayhoff - Senior Vice President of Investor Relations: Matt, we have time for one more question.
Operator: We'll take our final question from Gregory Melich with Morgan Stanley.
Gregory Melich - Morgan Stanley: Hi, thanks. I had a couple questions. One, on the credit, Carol, you mentioned that you thought it was 50 bps of hit this year. Now is that where essentially it's no longer making money for you, or in '09, if credit continued to deteriorate, could it go further? In other words, how profit making is this credit overall? And then a follow up on distribution.
Carol B. Tome - Chief Financial Officer: Well, remember, there's always a cost to credit. While we share in the profitability of credit, when you add it all up there's always a cost. The cost has been declining. It's now less than 1% of sales. It will increase, we believe, to 2% of sales. It all depends on the profitability of the portfolio. Could it go higher? Yes. It really depends on what happens within the portfolio. We have stress tested this and put it through the wringer, and we don't think it could get any higher than 4%. And we're certainly not predicting that. But, you know, we said bankruptcies jump and delinquencies increase and we stressed it and went into a prolonged recession scenario, and that's the output of that analysis.
Gregory Melich - Morgan Stanley: And that compares to the 2% you talked about this year?
Carol B. Tome - Chief Financial Officer: Yeah, 2% for 2008, yeah.
Gregory Melich - Morgan Stanley: Right. And then the second is on distribution. Like, Mark, you gave the number of $200-some million for Capex. I assume you're - are you leasing these DCs, and if you are, what is the cost for that? What would be the implied cost?
Mark Holifield, Senior Vice President Supply Chain: Yeah. The number's $260 million. That does not include the land and equipment - excuse me, the land and building; we lease those. That includes our leasehold improvements and our systems that go into it.
Carol B. Tome - Chief Financial Officer: The lease costs are included in the guidance that we gave you. As you can appreciate, the locations of these facilities are not the same as our stores, where we seek for A-related real estate. These are in C locations, so the rent expense is very reasonable.
Gregory Melich - Morgan Stanley: Okay. So the number, you would say, if you were to add all those lease costs, it's not billions?
Carol B. Tome - Chief Financial Officer: Oh, no, sir. No.
Gregory Melich - Morgan Stanley: Okay. And on that, as you get these DCs rolled out, does it increase your likelihood and Frank, in terms of doing the stores three or four years from now to go into more rural markets or to do more in-fills, or is that really not the purpose of the exercise?
Frank Blake - Chairman, Chief Executive Officer: That isn't really the purpose of the exercise, but for sure it could be the case that our improved distribution network could facilitate different stores than we have now. But that really isn't the purpose, and that's not what we're looking to it to do.
Gregory Melich - Morgan Stanley: Great. Thanks.
Diane Dayhoff - Senior Vice President of Investor Relations: Well, thank you, everyone, for joining us today. We look forward to talking to you next quarter.
Operator: And that does conclude today's call. Again, thank you for your participation. Have a good day. | [
{
"speaker": "Executives",
"text": "Diane Dayhoff - Senior Vice President of Investor Relations Frank Blake - Chairman, Chief Executive Officer Craig Menear - Executive Vice President Merchandising Mark Holifield, Senior Vice President Supply Chain Carol B. Tome - Chief Financial Officer"
},
{
"speaker": "Analysts",
"text": "Steve Chick - J.P. Morgan Matthew Fassler - Goldman, Sachs & Co. Eric Bosshard - Cleveland Research Danielle Fox - Merrill Lynch Todd Duvick - Bank of America David Schick - Stifel Nicolaus & Company Budd Bugatch - Raymond James Chris Horvers - Bear Stearns Gregory Melich - Morgan Stanley"
},
{
"speaker": "Operator",
"text": "Good day, everyone, and welcome to today's Home Depot fourth quarter earnings conference call. As a reminder, today's call is being recorded. Beginning today's discussion is Ms. Diane Dayhoff, Senior Vice President of Investor Relations. Please go ahead, ma'am."
},
{
"speaker": "Diane Dayhoff - Senior Vice President of Investor Relations",
"text": "Thank you, [Matt], and good morning to everyone. Welcome to the Home Depot fourth quarter earnings conference call. Joining us on our call today are Frank Blake, Chairman and CEO of The Home Depot, Craig Menear, Executive Vice President, Merchandising, Mark Holifield, Senior Vice President, Supply Chain, and Carol Tome, Chief Financial Officer. Following our prepared remarks, the call will be opened for analysts' questions. Questions will be limited to analysts and investors, and as a reminder, we would appreciate it if the participants would limit themselves to one question with one follow up, please. This conference call is being broadcast real time on the Internet at HomeDepot.com, with links on both our home page and the Investor Relations section. The replay also will be available on our site. If we are unable to get to your question during the call, please call our Investor Relations Department at 7703842387. Before I turn the call over to Frank, let me remind you that today's press release and the presentations made by our executives include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties. These risks and uncertainties include but are not limited to those factors identified in the release and in our filings with the Securities and Exchange Commission. Now let me turn the call over to Frank."
},
{
"speaker": "Frank Blake - Chairman, Chief Executive Officer",
"text": "Thank you, Diane, and good morning, everyone. I believe we'll look back on 2007 as one of the most difficult years ever for The Home Depot ever financially, but I also believe we'll look back on it as one of the most important years for the long-term health of the business. On the financial side for the year, consolidated earnings per share declined 15% to $2.37. For our continuing operations, earnings per share were down 11% for the year. Our comp sales were negative 6.7%. When we set our plan in the beginning of 2007, we thought that we'd see an improvement in the market by the fourth quarter. In fact, we saw conditions worsen. Markets that had been soft, like California, Florida and the Northeast, stayed soft, and markets that had been relatively strong, like the Southwest and Midwest, weakened. The fourth quarter was our worst comp performance this year at negative 8.3%. But despite the difficulties in our market and the tough environment, I also believe 2007 has set the stage for the long-term health of the business. We are focused exclusively on our retail business. We set out our five priorities for investment in the retail business and committed resources to them, and they are the same priorities for 2008 and beyond - associate engagement, shopping environment, product availability, product excitement and Own the Pro. We have made significant progress on each. On associate engagement, we realigned compensation and reward programs to ensure that our associates are being appropriately recognized. For example, despite the difficult second half, we had 50% more associates in success sharing than in 2006 and increased the average payout by almost 40%. Our objective is to once again set the standard for associate knowledge and customer service. It won't happen overnight, but we're taking the right steps. In 2007, we hired over 2,500 master trade specialists - licensed plumbers and electricians - to work in our stores. We reintroduced Homer Badges to reward associates for great customer service. In 2008, we will be introducing a new TK Badge that will reward associates for developing enhanced product knowledge. In 2008, we will also focus redeploying noncustomer facing expenses to selling hours, an initiative we call Aprons on the Floor. An example of this is that we are changing the way we handle freight in our lower-volume stores. In more than 1,100 stores, we are moving today receiving and inventory stocking in the early morning and late evening hours while the store is open. This increases our ability to staff more customer-facing hours and shift full-time associates to busier selling periods. Paul Raines and his Store Operations team have piloted and rolled out this major initiative in a fraction of the time that it would have taken in the past, a sign of both increased velocity of decision making and greater focus on regional implementation and ownership. On shopping environment, in 2007 we completed an aggressive list of maintenance projects, with new lighting and basic cleanup activities for over half our stores, as well as more complex repair and maintenance activities for hundreds of other stores. In 2008, we will continue to invest at levels significantly above prior years. We now have an established programmatic maintenance cadence for our stores. We have also set out new store standards across the company that address the clutter we had allowed to develop over the years. On product availability, Mark Holifield will discuss the progress we've made on our supply chain transformation. In 2007 we piloted a new distribution concept. We're pleased with the results, and in 2008 through 2010, we will roll out new distribution centers. It is our number one initiative for 2008 and will help us lower costs, increase asset efficiency and improve the customer experience. On product excitement, Craig will discuss some of the new products and activities that he and the Merchandising team are driving, but I'd like to give you a point of view on our merchandising organization that we haven't much discussed before. Those of you who followed The Home Depot for awhile know that the company made a significant move several years ago to centralize all of our Merchandising functions. At one point we had nine divisions, each with its own merchandising organization. Then a few years ago we consolidated all those organizations into one in Atlanta. That centralization had a number of very positive impacts, but it also created some issues and gaps in strategy and execution as merchants lost direct touch with their markets. Throughout 2007, Craig and his team, along with Store Operations and supply chain, have worked to build basic processes to fill the gaps and fix the issues created by the centralization. We're well along in the process. We'll continue in 2008. This work is critical for our performance in 2008 and will also position us for successful implementation of core retail. On that point, we begin to pilot our new ERP system in Canada this spring. Once out of pilot, we will roll the new platform to all Canadian stores and expect to be fully operational there with the new system by the end of the year. On our Own the Pro initiative, we have grown our bid room volume by over 200% this year, and in 2008 we will continue to leverage our customer analytics to drive a deeper relationship with these valuable customers. Finally, our international businesses performed very well in 2007. We are the market leader in both Mexico and Canada. Mexico posted double-digit comps for the year, Canada had positive comps, and China has posted positive comps since we re-branded our stores last summer. On all of our initiatives, we are proud of what we have accomplished but realistic about all the work we have left to do. We have improved our voice of customer scores, but we are still too often perceived as lagging in customer service, and we know that in a down market, we have to work all the harder to earn our customers' confidence. So as we look at 2008, we know that we have to continue to make investments in our business to drive our key priorities. We also know that we have to stop doing some things. We should be judged by the discipline we bring to executing on our key priorities and the discipline we bring to stepping away from activities that aren't priorities. Chief among the activities we are downsizing is new store growth. We will open about 55 new stores in 2008, of which only about 35 will be in the United States. We expect 2008 to be another challenging year in terms of the housing and home improvement markets. There is a substantial inventory of houses for sale, continued pressure on housing prices, uncertainties around credit availability, and concerns around the overall economy beyond the housing sector. Throughout this year I have referenced the data on private residential construction as a percent of GDP. At this time last year it had fallen from 6.3% at the beginning of 2006 to 5.3%. The 60year average is 4.8%, which suggested that there was still room for the market to fall, and it did. It dropped another 110 basis points and now stands at 4.2%. So we are now below the historic mean. We probably still have room to go, and the historic troughs in this indicator suggest that is the case. But this gives us at least some cause for cautious optimism as we look out through 2008 and into 2009. Carol will cover our 2008 guidance in more detail in a few minutes, but in summary, we expect continued negative comps in 2008, with sales decreasing 4% to 5% as compared to last year. We also expect negative comps in the mid to high single-digit range. Since, as Carol has described, every point of negative comp drives about 20 basis points in operating profit deterioration and since we expect continued cost impacts from our private label credit card, our earnings per share will decline by approximately 19% to 24%. I'd like to go back to a comment I made on my first earnings call a year ago. The Home Depot is a company built on a strong set of core values. We have hundreds of thousands of associates who understand those values, believe them and live them. They make a difference for our customers, for our communities and for each other every day. They love solving problems. They are passionate about helping others. I want to thank them for their dedication and hard work. They make this a truly special company. Now let me turn the call over to Craig."
},
{
"speaker": "Craig Menear - Executive Vice President Merchandising",
"text": "Thanks, Frank, and good morning, everyone. Our Merchandising departmental sales reflect the softness in the home improvement market. For the year, every department experienced flat to negative sales growth compared to 2006, with those categories most closely associated with construction - like lumber, building materials, electrical and millwork - posting double-digit negative declines. In the fourth quarter, we experienced negative sales growth in all departments except one. The department that outperformed the company's average comp were Seasonal, Plumbing, Paint and Hardware. The one department that experienced positive comp sales was Seasonal, driven by strong performance in Holiday, Fireplace, and Chemicals. Flooring performed at the company average. The weakness in the quarter came from continued softness in big-ticket and construction categories. January was particularly soft. The pros went home for the holiday and didn't come back until the latter part of the month. Special order Kitchens, Windows, Roofing and Madic Fasteners all had double-digit sales declines across all regions in the country except the Southwest. Additionally, we saw continued commodity deflation which impacted Lumber and Building Material categories like Dimensional Lumber and Gypsum. The combination of softness in the big ticket and commodity deflation negatively impacted average ticket, which was down 2.3% from last year to $54.96. While we saw pressure across the store, there was relative strength in Repair and Remodel categories. Fasteners, builder's hardware, plumbing repair, pipe, along with the associated tools needed to make repairs, performed above the company's average comp in all regions except the hardest hit areas of California, Florida and portions of the Northeast. We saw strength in seasonal categories. Fireplace, Heaters, Power Equipment posted positive comps for the quarter in every region of the country except the more temperate climates such as in California and Florida. Additionally, Holiday posted double-digit comps across the country as a result of our enhanced assortment and increased values for our customers. I've shared with you throughout the year that we're focused on merchandising fundamentals. While some of my comments will seem obvious, let me tell you what's been done in 2007 and what my senior leadership team and I will continue to focus on in 2008. First, to ensure that we are in touch with our customer's needs, every merchant is required to walk our stores at least one day a week. The objective is for our merchants to use this time to speak with customers and associates to get direct feedback on their assortments and merchandising opportunities. Second, we have constructed a weekly meeting where merchandising leadership and our regional merchants, together with Operations and supply chain leadership discuss upcoming events and operational issues. This creates a sense of urgency, quickly resolving issues normally by the end of the day, and it creates a collaborative ownership of results. Third, we asked our IT and finance teams to provide improved tools to help merchants more effectively do their job. We don't have time to wait for core retail, a multi-year initiative, to provide these merchandising tools. Our technology team delivered an enhanced assortment tool that makes it easier for our merchants to assort to a market and even down to a specific store. They also provided a new forecasting tool. The new forecasting tool is essential because speed in decision making is more critical than ever in this business environment. Enhanced forecasting is particularly important in our seasonal businesses. We used this improved forecasting for spring planning and feel good about having the right amount of product in our stores for our customers at the right time. Fourth, I've asked our merchants to accelerate implementation of our focused bay approach, our belief that not all bays are created equal, which drives our investment decisions. In 2007, we exited Consumer Electronics. This year we plan to exit Pet and Halloween categories. My team knows that they need to make the tough calls in driving resources back to core home improvement categories. Even within core home improvement categories, we need to accelerate decisions on line structure, introduction of innovative products, and communicating the value proposition to improve our assortment productivity. These actions, along with other investments, have allowed us to narrow our share loss in 2007. Specifically, these actions have helped us drive improvements in several product categories, such as Power Tools, Soft Flooring, Paint and Seasonal. While we have made progress in many product categories, there are still others where we continue to lose share, and this represents an opportunity for us going forward. For example, in 2008 we are confident that we will improve our business results in Lighting, Kitchens, Bath Fixtures and Hand Tools by focusing on the fundamentals and leveraging these new tools. Our suppliers are key partners and I know that we will always negotiate over price, but we are in this to drive business together and we are driving a more collaborative planning process, doing a better job of sharing information, and working together on product innovation. These merchandising processes and stronger, better partnerships better equip our merchants so that they can leverage our regional merchandising teams in the field and sharpen our local merchandising efforts. For spring, I have some great products that I'm really excited about. We have a new exclusive charbroil grill with infrared technology ensuring even cooking and the ability to sear or slow cook with a range of temperatures from 250 to 800 degrees. It's also energy efficient and self-cleaning, with a touch of a button. We are introducing new patio sets that bring affordable luxury to our customers. This year we introduced Thomasville to our line up, complimenting Hampton Bay, both of which are exclusive programs. Our sets start at $399 and include everything from rust-proof aluminium frames with hard surface tops to wicker and cast aluminium sets and indoor/outdoor wood. We are also introducing an electric start gas trimmer under our exclusive Ryobi brand. The new touch-start trimmer is a very innovative product, and it's the only gas trimmer sold in the United States that can be started with the push of a button as opposed to the standard pull cord. Finally, I want to highlight our new fresh air paint from ICI, which is the only true VOC - or volatile organic compound - free paint in the market. It is a trend-forward color palette of 65 colors inspired from nature, and it is the one of the only paint products that is Greenguard certified. It's truly odor free, which makes painting a much more pleasant experience. 2008 is going to be tough, but we have a strong merchandising team that will remain focused on merchandising fundamentals and delivering long-term value for our customers. And now I'd like to turn the call over to Mark."
},
{
"speaker": "Mark Holifield, Senior Vice President Supply Chain",
"text": "Thanks, Craig. Good morning, everyone. First, I'll walk you through our supply chain accomplishments this year and then I'll outline our plans for 2008. In 2007, we started transforming our supply chain so we could deliver on the priority of improved product availability or better in-stock for our customers. One of our first objectives was to complete a comprehensive review of our supply chain, its capabilities and its limitations. In terms of capabilities, not too surprisingly we discovered that our biggest opportunity is to radically increase our central distribution penetration. This will allow us to manage our inventory much more effectively both for our regular replenishment inventory and for our seasonal and promotional products. The existing Home Depot supply chain worked great for high-volume stores, which had no trouble making frequent orders to vendors for direct-store delivery to allow them good in-stocks and inventory turnover. But in lower-volume stores, without an effective central distribution network, our store associates are forced every day to make the tough choice of being out of stock or overstocked due to vendor minimum order quantities, long lead times, and unreliable replenishment. Given this need for much more central distribution, we developed an end-state vision for what an ideal network would look like for The Home Depot in the United States. This distribution network strategy effort employed industry standard techniques to map and analyze all of our existing and forecasted network product flows all the way upstream from our suppliers and downstream to our stores and customers. Through this effort, we developed an optimal distribution center network strategy model that we will continue to use to guide all of our network development decisions in the future. A few of the highlights about the optimal network strategy: Our goals are first, to move from a central distribution penetration of about 20% of product flow measured by cost of goods sold to about 75% of product flow. Second, to operate fast-flow distribution centers, with the capability to process faster-moving goods which we will call rapid-deployment centers or RDCs. The optimal distribution center, or DC network, would include more than 20 of these fast-flow RDC facilities. Optimally, more volume will pass through these fast-flow RDCs than through traditional DCs. Third, to operate lumber in bulk DCs along with traditional stockandpick DCs as we do today. So the biggest opportunity in front of us was to develop these RDCs and to move quickly as the gap from 20% of central distribution to 75% is obviously quite large. Concurrent with our supply chain strategy efforts, having a general idea of where the end-state supply chain strategy would take us, we began to pilot these fast-flow capabilities in our existing distribution network. In late March of 2007 we kicked off an RDC pilot in Atlanta that included 67 Atlanta area stores and 20 vendors, converting part of an existing Home Depot operated DC in Braselton, Georgia to these fast-flow or RDC capabilities. The results of the RDC pilot were better in-stock at the stores, reduced lead times, improved shipment integrity, and improved inventory turnover. We ramped up more stores and more vendors, and today the Atlanta area RDC served 99 stores and processes almost 100 Home Depot vendors' products through it. We continue to add vendors to the mix weekly. So we now have a DC network strategy, a proven concept of operations as its cornerstone, and we have begun to roll it out. Our second RDC was opened in Chicago in January, and we are ramping up volume there now. When we open an RDC, if there is a transit facility nearby - as in Chicago we will close it and incorporate those existing processes and freight flows into the new RDC. The keys to executing this strategy are getting more RDC buildings open and operating effectively and on-boarding vendors to the program. We will have several more openings in 2008, and we have a major push on getting vendors on board. Our target is complete 2008 and enter 2009 with 40% of our U.S. stores receiving RDC service and 30% of those stores' product flow measured in cost of goods sold on the RDC program. To get to the 40% of stores targeted this corresponds to opening about six additional facilities this year, ending 2008 with about eight RDCs given that each facility will serve about 100 stores. Beyond 2008 we will continue to open RDCs until we have reached 100% of our U.S. stores. We will also continue to ramp up vendors through the RDCs, making progress toward the in-state goal of 75% central distribution. Keep in mind that while RDCs will ultimately make up about half of the total product flow, the 75% distribution target includes the existing lumber DCs and the traditional stockandpick DCs. We expect to complete our RDC rollout in 2010. At this point we estimate the required capital investment to be about $260 million through 2010. We will keep you posted as we progress on this very exciting initiative. We think that long term it means lower supply chain cost, better in-stocks and higher inventory turns. Another important objective in supply chain was to establish a world class team of supply chain professionals. I've been very pleased with the supply chain talent we have on board here at The Home Depot, and we have augmented that talent with some key leaders who will help us to deliver on our commitments. In addition to Mark Huffman, Vice President of Inventory Planning and Replenishment, and John Deaton, Vice President of Supply Chain Development, let me highlight a couple of leaders who have joined us recently and are already making big impacts. Charlie Armstrong is our VP of Distribution and joined us in October. Charlie has years of transformation experience in retail supply chain, working with Ward's, Melville, GARR Consulting Group, and others. Charlie is accountable for all DCs and their operations as we radically increase our central distribution capabilities and roll out the RDCs. Additionally, we hired a new VP of Transportation, Michelle Livingston, who also joined in October. Michelle is a lifelong transportation professional. She came to us from C&S Wholesale Grocers, a large distributor to over 2,000 retail stores. Prior to C&S, Michelle worked with J.C. Penny as Vice President of Transportation and was there during their retail transformation, so she also has experience with the scope of our effort. So in closing, we are very pleased with our progress and excited about 2008 and the future as we transform our supply chain to the benefit of our customers, associates and shareholders. And now I'll turn the call over to Carol."
},
{
"speaker": "Carol B. Tome - Chief Financial Officer",
"text": "Thank you, Mark, and hello, everyone. There are a couple of items I'd like to mention before I cover our results. First, our fiscal year consisted of 53 weeks, so our fourth quarter results reflect 14 weeks of operations compared to 13 weeks last year. Second, fiscal 2007 results include seven months of HD Supply as a discontinued operation. HD Supply operating results, including the impact of the sale of the business, are found on a line item entitled Earnings from Discontinued Operations. In the fourth quarter, sales were $17.7 billion, a 1.5% increase from last year. For the year, our sales declined by 2.1% to $77.3 billion. The 14th week in the fourth quarter added approximately $1.1 billion in sales to the quarter and the year. Excluding the sales impacts of the extra week, our fourth quarter sales declined by 4.7% and our fiscal year sales declined by 3.5%. We reported earnings per share from continuing operations of $0.40 in the quarter, down 4.8% from last year and for fiscal 2007, earnings per share from continuing operations were $2.27, down 11% from last year. The extra week increased earnings per share by approximately $.04 for the quarter and the year. Consistent with our guidance, the slowing housing environment significantly impacted our comp sales, which were a negative 8.3% for the quarter. Consolidated same-store sales were negative 6.6% in November, negative 7.2% in December, and negative 10.8% in January. We do not include the extra week in our comp calculation. For the year, comp sales were negative 6.7%. In the fourth quarter, our gross margin was 34.3%, an increase of 67 basis points from last year, reflecting 47 basis points of margin expansion due to lower deferred interest associated with our private label credit card, and 20 basis points of margin expansion due to a number of factors, including a change in the mix of products sold and less promotions in the quarter. For the year, our gross margin was 33.6% flat to last year. In the fourth quarter, operating expenses increased by 197 basis points to 27.2% of sales. Our expense deleverage reflects the impact of negative sales, where for every point of negative comp we expect to deleverage expenses by about 20 basis points. With a negative comp of roughly 8%, we would expect to report expense deleverage of 160 basis points. In the fourth quarter, we experienced an additional 37 basis points of expense deleverage due to several strategic business decisions, including the closing of our Tampa call center and write-offs associated with certain future store locations that we determined we will not open. Further, as we anticipated, the gain share from our private label credit card program was less in the fourth quarter than last year. The year-over-year decline in gain share is about equal to severance we paid out in the fourth quarter of 2006. For the year, operating expenses increased by 188 basis points to 24.3% of sales. Operating margin was 7.1% in the fourth quarter, down 130 basis points from last year. For fiscal 2007, operating margin was 9.4%, down 186 basis points compared to last year. Diluted shares for the fourth quarter were 1.68 billion shares compared to 2 billion shares last year. The reduction in outstanding shares is due to our share repurchase program and includes the tender offer we completed in September. Since our share repurchase program began in 2002, we have repurchased a total of 743 million shares or 31% of our outstanding shares. Moving to our operational metrics, during the fourth quarter we opened 26 new stores, including five relocations, for an ending store count of 2,234. At the end of the fourth quarter, selling square footage was 235 million, a 4.9% increase from last year. Reflecting the sales environment, total sales per square foot on a 14week basis were approximately $279 for the quarter, down 8.7% from last year, and for the year were $332, down roughly 7% from fiscal 2006. Now turning to the balance sheet, at the end of the quarter retail inventory was $11.7 billion, up 4% from last year. On a per-store basis, inventory was flat to last year. Inventory turns were 4.2 times compared to 4.5 last year. Computed on the average of beginning and ending, long-term debt and equity for the trailing four quarters, return on invested capital was approximately 14%, down 290 basis points from last year due to the decline in our operating profits. We ended the quarter with $44.3 billion in assets, including $457 million in cash and short-term investments. This is a decrease of approximately $160 million in cash and short-term investments from the end of fiscal 2006, reflecting cash generated by the business of approximately $6.2 billion, net proceeds from the sale of HD Supply of $8 billion, and commercial paper issuances of $1.7 billion offset by $10.8 billion paid for share repurchases, $3.6 billion of capital expenditures, and $1.7 billion of dividends. As Frank mentioned, the home improvement market is very soft and it's difficult for us to know just where it will go in 2008. Our guidance reflects our best thinking at this point, and it's important to note that we have not factored into our thinking the impact of the economic stimulus package. We're going after our fair share, but we really don't know how the consumer is going to react in this environment. We've detailed our guidance in our press release, so let me just hit the high points. From fiscal 2007 reported results, we expect fiscal 2008 sales to decline by 4% to 5%, with negative comps in the mid to high single digit area. In the first three weeks of fiscal 2008, we are seeing mid single-digit negative comps, consistent with our plan. For the year, we expect to open 55 new stores. For fiscal 2008, we expect earnings per share from continuing operations to decline by 19% to 24%. Included in our earnings per share guidance is our view that gross margin expansion will be flat to slightly positive and that our operating margin will decline by 170 to 210 basis points as we expect expense deleverage due to negative comp sales and expense pressure from our private label credit card program. Let me take a minute and comment on our private label credit card program. By way of background, we currently offer six products as part of our private label credit card portfolio which range from three consumer-oriented cards to three cards that serve our professional contractors. As of the end of fiscal 2007, almost 30% of all sales tendered were tendered through the use of our private label cards. The cards are offered and administrated by a third party in a program that includes a profit sharing provision. There are three main components of the program that impact the earnings statement. First, deferred interest - we are charged a flat fee which we call deferred interest every time a customer uses one of our deferred financing programs like No Interest, No Payment for Six Months. This flat fee is treated by us as a cost of goods sold. Second, interchange - we are charged a fee each time our pros use their card. It's like an interchange fee for VISA or American Express, and we treat this charge as an operating expense. Third, gain share - this is our share of any profits in excess of a targeted turn. The portfolio has been much more profitable than the targeted return, so we've been enjoying a gain share which is treated as a reduction in operating expenses. The sum of all three totals the total cost of credit. Since 2004, the total cost of credit as a percent of credit sales has dropped by over 100 basis points, and in 2007 was less than 1% of private label credit sales. Under our credit agreement, the cost of credit can increase if the portfolio decreases in profitability. In fact, we project that the cost of credit will increase in 2008 and a major factor to this increase is less gain share due to higher losses in the portfolio. We believe the total cost of credit will reach 2% in 2008. While the year-over-year increase is large, 2% is in line with the cost of credit for traditional bank cards. Now moving to capital allocation, our capital spending plan for 2008 is $2.3 billion, down 32% from what we spent in the retail business last year, primarily due to lower new store openings. Approximately 50% of our capital spending plan is for new stores and the remainder will be used to invest in our existing stores in support of our key initiatives. Given that this is a transition year for our supply chain, we are not planning for any inventory turnover improvement, and given the sales environment, we may see slight deterioration in our turns. Finally, I want to give you our latest thinking on our recapitalization plan. In 2007, we completed almost 50% of our $22.5 billion recapitalization plan. Late last year, we put the recap on pause given market conditions. 2008 is going to be another challenging year, and we think the prudent thing to do is to keep the program on pause until we see stabilization in our business and the credit markets. So thank you for your participation in today's call, and Matt, we're ready and we'll be happy to take your questions."
},
{
"speaker": "Steve Chick - J.P. Morgan",
"text": "Hi, thanks. Hey, I guess, Carol, first off, just in terms of the credit card, the 2% that the private label card will cost you in '08, I'm calculating that that's about $440 million or so. And I know you gave us what the numbers were for the second half of '07. Can you just give us what the - well, confirm if that absolute number is right and what the total increase will be year-over-year that you're projecting at this point?"
},
{
"speaker": "Carol B. Tome - Chief Financial Officer",
"text": "Steve, you're a little bit high on your analysis, and let me give you a bit more color on how to think about our private label credit card. There are three aspects of the program that impact the earnings statement. If you think about deferred interest, that is treated by us as a cost of goods sold. Your year-over change is going to be very little. In fact, we'll have fewer credit promotions days in 2008, and we expect very little change in the cost of deferred interest. As you come, then, to the selling and store operating expense line, clearly we'll have a lot less gain share than we had in 2007. I'm thinking that the amount of deleverage that we'll get year-over-year because of lower gain share is the amount of about 50 basis points."
},
{
"speaker": "Steve Chick - J.P. Morgan",
"text": "Okay. Okay, so I just - so 50 basis points will be the portion within your selling and administrative expenses?"
},
{
"speaker": "Carol B. Tome - Chief Financial Officer",
"text": "Yeah. In the operating margin decline guidance that we gave of 170 to 210, there's as much as 50 related to the gain share."
},
{
"speaker": "Steve Chick - J.P. Morgan",
"text": "Oh, okay. All right. Great, that helps. Now the second thing, you know, this quarter, you know, your comp gap with your competitor narrowed pretty nicely, and it looks like it was in the months - the last two months of the quarter. You know, are you - can you speak to that a little? I mean, is it, you know, maybe this quarter might have been kind of an anomaly, or do you really think that, you know, some of the cultural things and the things you're implementing at the store level are starting to gain traction relative to the marketplace?"
},
{
"speaker": "Frank Blake - Chairman, Chief Executive Officer",
"text": "You know, Steve, we - I guess the right way for us to think about it is not with respect to any one particular competitor but to think about it in terms of the market as a whole. As Craig said, we were pleased in some of the areas where we think we picked up share, but there are lots more opportunities out there for us to continue to gain share."
},
{
"speaker": "Steve Chick - J.P. Morgan",
"text": "Okay, thanks. And last, a clarification point, if I could. Carol, the guidance for D&A, which I think you said is $1.9 billion, is that the D&A that's on the face of the P&L or is it the total depreciation and amortization that you disclose separately?"
},
{
"speaker": "Carol B. Tome - Chief Financial Officer",
"text": "It's the total depreciation and amortization that we disclose separately."
},
{
"speaker": "Steve Chick - J.P. Morgan",
"text": "Okay, so that's $1.9 billion compared with 1.82?"
},
{
"speaker": "Carol B. Tome - Chief Financial Officer",
"text": "That's correct."
},
{
"speaker": "Steve Chick - J.P. Morgan",
"text": "Okay. All right, great. Thank you."
},
{
"speaker": "Carol B. Tome - Chief Financial Officer",
"text": "You're welcome."
},
{
"speaker": "Operator",
"text": "We'll go next to Matthew Fassler with Goldman Sachs."
},
{
"speaker": "Matthew Fassler - Goldman, Sachs & Co.",
"text": "Thanks a lot and good morning. I'd like to focus today primarily on distribution. If you could talk about the decision to go with the RDCs versus other distribution alternatives, the stock and fixed DCs specifically, what the cost difference is, and just sort of the thought process beyond that call."
},
{
"speaker": "Mark Holifield, Senior Vice President Supply Chain",
"text": "Yeah, Matt, it's Mark Holifield. On the decision to go to fast-flow as opposed to stock-and-pick, what I would point out is that we do have stock-and-pick distribution centers today that we use primarily for import products but also for domestic products. So we had capabilities in that arena already. Given our gap of 20% to 75%, where we want to go, these fast-flow facilities are much simpler to set up, much smaller in general and much lower in capital investment, so we felt that this was the fastest way to make that acceleration from 20% to 75% central distribution penetration."
},
{
"speaker": "Matthew Fassler - Goldman, Sachs & Co.",
"text": "And just one follow up - thank you for that, Mark - you know, Carol, you talked about the quarter-to-date same-store sales trends, you know, down mid-singles is a pretty sharp improvement from the numbers that you saw in January. How would you characterize or what would you attribute it to, and how do you think about that in the context of your expectations for the rest of the year?"
},
{
"speaker": "Carol B. Tome - Chief Financial Officer",
"text": "Well, clearly we think the first half is going to be softer than the back half, as you can appreciate given the comps that we're up against. We did have a very, very strong President's Day weekend, and so that's obviously contributing to our year-to-date performance. But as Craig pointed out in his comments, in January the pros - they went home for the holidays, and they just didn't come back. But we're starting to see them come back in our stores."
},
{
"speaker": "Matthew Fassler - Goldman, Sachs & Co.",
"text": "Fair enough. Thanks so much."
},
{
"speaker": "Operator",
"text": "We'll go next to Eric Bosshard with Cleveland Research."
},
{
"speaker": "Eric Bosshard - Cleveland Research",
"text": "Good morning."
},
{
"speaker": "Frank Blake - Chairman, Chief Executive Officer",
"text": "Morning."
},
{
"speaker": "Eric Bosshard - Cleveland Research",
"text": "Two things I'd love to get some guidance on. First of all, in terms of the delta in Capex, Frank or Carol, can you talk about where the investment is changing in '08 relative to '07? I know you that indicated that store openings is an important [inaudible] with that, but where else is there delta taking place there?"
},
{
"speaker": "Carol B. Tome - Chief Financial Officer",
"text": "Sure. In 2008 we decided to spend $2.3 billion, which is down $1.1 billion from what we spent in the retail business in 2007. $900 million of that is directly related to new store openings, so that's the biggest change. The remainder decline is in areas where we spent money that we don't need to spend in 2008. For example, we put radio call boxes in our stores in 2007. We don't need to repeat that in 2008. We're being very judicious on our merchandising resets. As Craig mentioned, we are accelerating merchandising resets that assist the product line review process, but for those major transformation resets, we're pulling back on those a bit because we think that makes the most sense for the business."
},
{
"speaker": "Eric Bosshard - Cleveland Research",
"text": "Great. And then secondly, for Craig, can you comment about what you're seeing in terms of sourcing costs, specifically your direct import program - if you're seeing the influence of Chinese inflation and how you can react or respond to that?"
},
{
"speaker": "Craig Menear - Executive Vice President Merchandising",
"text": "Yeah, certainly, Eric. No question that there is cost pressure in the market as a result of the taxation change in China. We're working hard with our suppliers to try to offset those costs wherever possible. We have, you know, taken some and in other cases we've been able to work with them to offset costs and forego that. So there is pressure there, but at this point it's not something that we don't feel is unmanageable."
},
{
"speaker": "Eric Bosshard - Cleveland Research",
"text": "Great. Very good. Thank you."
},
{
"speaker": "Operator",
"text": "We'll go to Danielle Fox with Merrill Lynch."
},
{
"speaker": "Danielle Fox - Merrill Lynch",
"text": "Thanks. Good morning. Could you talk a little bit more about the financial impact from the rollout of this optimal supply chain strategy? Should it be earnings dilutive, neutral or accretive over, you know, the next few years? And on a related note, how do you manage the potential for disruption as you make major changes to your distribution network? Thanks."
},
{
"speaker": "Carol B. Tome - Chief Financial Officer",
"text": "Danielle, on the financial impact, as you can appreciate, as we're rolling this out it will be earnings dilutive, and it's included in the guidance that we gave you for 2008. As Mark mentioned, we expect to be fully functioning in 2010, and that's when we'll see the economic benefit starting to flow through in terms of lower supply chain costs and higher inventory turns. On the disruption, we are planning for that. Mark, you might want to comment."
},
{
"speaker": "Mark Holifield, Senior Vice President Supply Chain",
"text": "Yeah. I think we roll these out over the course of about three or four months as they open up and get to full volume. We have learned a lot from the Braselton test, and we learn each time we're going. You know, we're working very closely with the stores to ensure that our store partners understand the process. And, you know, I won't say we've perfected the program, but through the Braselton pilot, we've stumbled across just about everything we can stumble across and we believe we'll have a good rollout going forward."
},
{
"speaker": "Danielle Fox - Merrill Lynch",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "We'll go next to Todd Duvick with Bank of America."
},
{
"speaker": "Todd Duvick - Bank of America",
"text": "Good morning. I had a quick question for you, and I appreciate the comments on the recapitalization program. I'm just wondering if you can tell us if that precludes any opportunistic share repurchases as we go throughout the year until you do feel the time is right for the recapitalization program?"
},
{
"speaker": "Carol B. Tome - Chief Financial Officer",
"text": "Well, what we've said all along is that we will use our excess cash to return capital to our shareholders through share repurchases. As you can see by looking at our balance sheet, we don't have any. We have $1.7 billion of outstanding commercial paper, and we need to run the business with about $500 to $1 billion of cash. So we anticipate based on the guidance that we gave that we will be in the commercial paper market in 2008."
},
{
"speaker": "Todd Duvick - Bank of America",
"text": "Okay. But in terms of any large debt issuance, you're just going to kind of wait and see when the business improves, and following that, you're going to plan to finish the transformation program?"
},
{
"speaker": "Carol B. Tome - Chief Financial Officer",
"text": "Yeah, we are committed to the recapitalization program, but given our business as well as the conditions of the credit markets, we think it's prudent to pause."
},
{
"speaker": "Todd Duvick - Bank of America",
"text": "Okay. Thank you very much."
},
{
"speaker": "Carol B. Tome - Chief Financial Officer",
"text": "You're welcome."
},
{
"speaker": "Operator",
"text": "We'll go to David Schick with Stifel Nicolaus."
},
{
"speaker": "David Schick - Stifel Nicolaus & Company",
"text": "Hi. Good morning. A question, really, I guess for Mark. If you think out maybe five years - and I know it's just 90 days of data on Braselton and Chicago - but you think about product costs and gross margin versus sort of inventory turns or driving comps or product availability, can you rank order that opportunity or at least, you know, talk about what's bigger and what's smaller in those opportunities?"
},
{
"speaker": "Mark Holifield, Senior Vice President Supply Chain",
"text": "Yeah. I would point out that we have almost a year of experience with the Braselton RDC. As I said, we opened that in late March of '07 so we've got a fair amount of information on that and experience with that. In terms of the business case for RDC, it's really based upon logistics costs, which we expect to lower through improved transportation and handling, improve inventory turnover through a better allocation process and lowering the lead time and the amount of time it takes for products to travel to stores from the vendors, and improved in-stocks leading to greater sales through the process of lowering the lead time and improving the responsiveness to inventory changes in the store. In rank order, it's kind of tough, I think. Logistics cost is very clear. You can measure that very clearly. Inventory turns, there's a whole lot of things that impact inventory turns, so it's a little bit tougher to point to a specific benefit there because there's a lot of moving parts; same thing with in-stock. But we do expect all three of those to improve greatly as we roll these out."
},
{
"speaker": "Carol B. Tome - Chief Financial Officer",
"text": "But if you love cash, one full turn improvement in inventory is over $1.5 billion of cash. So Mark, I don't know about you, but I'd put that high on the priority list."
},
{
"speaker": "Mark Holifield, Senior Vice President Supply Chain",
"text": "Yes."
},
{
"speaker": "David Schick - Stifel Nicolaus & Company",
"text": "Thanks a lot."
},
{
"speaker": "Operator",
"text": "We'll go to Budd Bugatch with Raymond James."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "Good morning. Just a couple of quick questions. Carol, in the past you've given us the 5% change in sales begets a 10% change in EPS and the 20 basis points to operating margin for every 100 basis points of change in comps. Do those still hold? Do those still hold for the long term, with the exception of the credit cost issue that you had this year?"
},
{
"speaker": "Carol B. Tome - Chief Financial Officer",
"text": "Right. Excluding the private label card portfolio, we think our rule of thumb of 20 basis points of deleverage for every point of negative comp holds. I think that would change in an environment if we were at pro-loan double-digit negative. We're not there. But clearly, we have minimum staffing levels in our stores that we need to be sensitive to. But we've modeled this, and we're comfortable with the guidance that we've given."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "Okay. And Mark, for you, I'm just a little confused on the difference between the fast-flow facilities of Braselton and what you had - I think you had 10 transit facilities that also served about 100 stores each, if I remember right - and can you give us a difference of what's - what's the difference between those two physically and maybe operationally?"
},
{
"speaker": "Mark Holifield, Senior Vice President Supply Chain",
"text": "Sure, Budd. The transit facilities, the easiest way to think about those is they're really more of an in-house LTL dock - a less than truckload freight handling dock. We place an order that's a store-level order direct to the store, and it simply passes through the transit facility where it's aggregated with other store-level orders going direct to the store. So it's really - the easiest way to think about it is in-house LTL dock."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "Right."
},
{
"speaker": "Mark Holifield, Senior Vice President Supply Chain",
"text": "An RDC is different than that. We place a DC-level order, a single order, for the 100 stores, so we reduce the number of purchase orders that we send to the vendor by 99%, we reduce the number of orders that he has to pick by 99%, and we reduce the number of shipments by the same amount. So it's a single bulk shipment into the RDC, and at the RDC, then, we break that down by store and use the information we have on inventory at that point - what's needed in each store - to allocate what's needed to the store. So it's more handling in the RDC, but we gain benefit in terms of the in-stock and inventory turn. And as we roll vendors on this, we work with them to take the costs out that they're saving in terms of fewer orders to process."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "Got you. Okay, thank you very much."
},
{
"speaker": "Operator",
"text": "We'll go to Chris Horvers with Bear Stearns."
},
{
"speaker": "Chris Horvers - Bear Stearns",
"text": "Chris Horvers from Bear Stearns."
},
{
"speaker": "Carol B. Tome - Chief Financial Officer",
"text": "Hi, Chris."
},
{
"speaker": "Chris Horvers - Bear Stearns",
"text": "Stepping back on square footage growth, you cut back the growth this year. Can you talk about how you're thinking about longer term - what your longer-term square footage growth be, how many stores you might think about in 2009 and 2010, domestic versus international?"
},
{
"speaker": "Frank Blake - Chairman, Chief Executive Officer",
"text": "Well, first let me take the domestic side, Chris. You know, we've said for awhile that you should look at our new square footage growth as pretty much matching the market. And so obviously, as the market growth has come down, then our plans going forward on new square footage growth is coming down. So I would not expect, you know, at least within our planning horizon much change from what we're going to do in 2008 and if there were a change, it would probably be slightly decremented, not going up. Internationally, we continue to see opportunities in Mexico. You know, we really haven't even started to roll out China. We've stayed with the initial dozen stores from a year ago, just working through that business model. So we haven't really even put on the table yet what's a new store growth plan for China."
},
{
"speaker": "Chris Horvers - Bear Stearns",
"text": "Okay. That's very helpful. Frank, in prior conference calls you've talked about your relative market share gain or loss versus the market and how you saw some improvement. I'm not sure if I missed it. Could you review that?"
},
{
"speaker": "Frank Blake - Chairman, Chief Executive Officer",
"text": "Yeah, and I think Craig mentioned it just in passing. The way we look at is we think we've still lost share to the market. We think we've I don't want to do a double negative here, but we've reversed the rate of our decline, so it's improving. But we don't see in our performance now that we're picking up share to the market yet. We feel like we're on that trajectory, but we're not there yet."
},
{
"speaker": "Chris Horvers - Bear Stearns",
"text": "Do you have the '07 versus '06, what the numbers were by chance?"
},
{
"speaker": "Frank Blake - Chairman, Chief Executive Officer",
"text": "I don't off the top of my head. And truly - we can get that back to you - ballpark, I'm remembering we've kind of cut it in half, the rate of decline, something like that."
},
{
"speaker": "Diane Dayhoff - Senior Vice President of Investor Relations",
"text": "Chris, this is Diane. I'll get back to you with that."
},
{
"speaker": "Chris Horvers - Bear Stearns",
"text": "Okay. And then finally, Craig, can you talk a little bit about trends in the Appliance category? You didn't really call it out. How do you feel you're making progress there, and how do you look at that from a market share perspective?"
},
{
"speaker": "Craig Menear - Executive Vice President Merchandising",
"text": "We improved our share in the quarter again from 10.8% to 11.8%. So we had a positive gain in the quarter. The industry in total is contracting, but we still feel that, you know, based on the share information, that our assortment and line up is something that the customer's responding very positively to."
},
{
"speaker": "Chris Horvers - Bear Stearns",
"text": "Excellent. Thank you very much."
},
{
"speaker": "Diane Dayhoff - Senior Vice President of Investor Relations",
"text": "Matt, we have time for one more question."
},
{
"speaker": "Operator",
"text": "We'll take our final question from Gregory Melich with Morgan Stanley."
},
{
"speaker": "Gregory Melich - Morgan Stanley",
"text": "Hi, thanks. I had a couple questions. One, on the credit, Carol, you mentioned that you thought it was 50 bps of hit this year. Now is that where essentially it's no longer making money for you, or in '09, if credit continued to deteriorate, could it go further? In other words, how profit making is this credit overall? And then a follow up on distribution."
},
{
"speaker": "Carol B. Tome - Chief Financial Officer",
"text": "Well, remember, there's always a cost to credit. While we share in the profitability of credit, when you add it all up there's always a cost. The cost has been declining. It's now less than 1% of sales. It will increase, we believe, to 2% of sales. It all depends on the profitability of the portfolio. Could it go higher? Yes. It really depends on what happens within the portfolio. We have stress tested this and put it through the wringer, and we don't think it could get any higher than 4%. And we're certainly not predicting that. But, you know, we said bankruptcies jump and delinquencies increase and we stressed it and went into a prolonged recession scenario, and that's the output of that analysis."
},
{
"speaker": "Gregory Melich - Morgan Stanley",
"text": "And that compares to the 2% you talked about this year?"
},
{
"speaker": "Carol B. Tome - Chief Financial Officer",
"text": "Yeah, 2% for 2008, yeah."
},
{
"speaker": "Gregory Melich - Morgan Stanley",
"text": "Right. And then the second is on distribution. Like, Mark, you gave the number of $200-some million for Capex. I assume you're - are you leasing these DCs, and if you are, what is the cost for that? What would be the implied cost?"
},
{
"speaker": "Mark Holifield, Senior Vice President Supply Chain",
"text": "Yeah. The number's $260 million. That does not include the land and equipment - excuse me, the land and building; we lease those. That includes our leasehold improvements and our systems that go into it."
},
{
"speaker": "Carol B. Tome - Chief Financial Officer",
"text": "The lease costs are included in the guidance that we gave you. As you can appreciate, the locations of these facilities are not the same as our stores, where we seek for A-related real estate. These are in C locations, so the rent expense is very reasonable."
},
{
"speaker": "Gregory Melich - Morgan Stanley",
"text": "Okay. So the number, you would say, if you were to add all those lease costs, it's not billions?"
},
{
"speaker": "Carol B. Tome - Chief Financial Officer",
"text": "Oh, no, sir. No."
},
{
"speaker": "Gregory Melich - Morgan Stanley",
"text": "Okay. And on that, as you get these DCs rolled out, does it increase your likelihood and Frank, in terms of doing the stores three or four years from now to go into more rural markets or to do more in-fills, or is that really not the purpose of the exercise?"
},
{
"speaker": "Frank Blake - Chairman, Chief Executive Officer",
"text": "That isn't really the purpose of the exercise, but for sure it could be the case that our improved distribution network could facilitate different stores than we have now. But that really isn't the purpose, and that's not what we're looking to it to do."
},
{
"speaker": "Gregory Melich - Morgan Stanley",
"text": "Great. Thanks."
},
{
"speaker": "Diane Dayhoff - Senior Vice President of Investor Relations",
"text": "Well, thank you, everyone, for joining us today. We look forward to talking to you next quarter."
},
{
"speaker": "Operator",
"text": "And that does conclude today's call. Again, thank you for your participation. Have a good day."
}
] | null | null |
HD | 3 | 2,007 | 2007-11-13 02:56:00 | Executives: Diane Dayhoff - Senior - Vice President of InvestorRelations Frank Blake - Chairman, Chief Executive Officer Craig Menear - Senior Vice President, Merchandising Paul Raines - Executive Vice President of U.S. Stores Carol B. Tome - Chief Financial Officer, Executive VicePresident Corporate Services
Analysts: Chris Horvers - Bear Stearns Deborah Weinswig - Citigroup Jeff Wimmer - J.P. Morgan Budd Bugatch - Raymond James Matthew Fassler - Goldman Sachs Danielle Fox - Merrill Lynch Gregory Melich - Morgan Stanley Eric Bosshard - Cleveland Research Shannon Coyne - Credit Suisse Colin McGranahan - Sanford Bernstein Brian Nagel - UBS
Operator: Good day, everyone and welcome to today’s Home Depot third quarter earningsconference call. As a reminder, today’s call is being recorded. Beginningtoday’s discussion is Ms. Diane Dayhoff, Senior Vice President of InvestorRelations. Please go ahead.
Diane Dayhoff: Thank you and good morning to everyone. Welcome to the HomeDepot third quarter earnings conference call. Joining us on our call today areFrank Blake, Chairman and CEO of The Home Depot; Craig Menear, Executive VicePresident of Merchandising; Paul Raines, Executive Vice President of U.S.Stores; and Carol Tome, Chief Financial Officer and Executive Vice PresidentCorporate Services. Following our prepared remarks, the call will be open foranalyst questions. Questions will be limited to analysts and investors and as areminder, we would appreciate it if participants would limit themselves to onequestion with one follow-up, please. This conference call is being broadcast real-time on theInternet at homedepot.com with links on both our homepage and the investorrelations section. The replay will also be available on our site. If we areunable to get to your question during the call, please call our investorrelations department at 770-384-2387. Before I turn the call over to Frank, let me remind you thattoday’s press release and the presentations made by our executives includeforward-looking statements as defined in the Private Securities LitigationReform Act of 1995. These statements are subject to risks and uncertainties.These risks and uncertainties include, but are not limited to, those factorsidentified in the release and in our filings with the Securities and ExchangeCommission. Now let me turn the call over to Frank Blake.
Frank Blake: Thank you, Diane and good morning, everyone. Our marketcontinues to face into significant headwinds. We started the year with a fairlypessimistic view of the housing and home improvement markets. It turns out weweren’t pessimistic enough. We had expected some market improvement by thethird quarter. That didn’t occur and our results reflect the difficult market. Sales for the third quarter were $19 billion, down 3.5%.Comp sales were negative 6.2% and diluted earnings per share from our retailbusiness were down 9% at $0.59. We expect continued difficult conditions for the remainderof 2007 and into 2008. We have consistently used as a guidepost to marketconditions the ratio of residential construction spend to GDP. The 60-yearaverage is 4.8%. At the height of our market in 2005, the ratio was 6.25%. Themarket is now corrected to 4.5%. When you consider the GDP is approximately $14trillion, this represents a market contraction of over $240 billion. While we are now close to the average, we don’t expect themarket do decline to the average and then pivot back up. We expect that thesoft market will continue, as reflected in the current overhang of housinginventory and the difficulties in the sub-prime mortgage [market]. As painful as the correction has been and will probablycontinue to be, we are now on the underside of this 60-year average. The valueof a time tested average is that it gives you confidence in the marketpotential ahead. For the Home Depot, it reinforces the importance of investingin our business and fixing our core operations. What most distinguishes the Home Depot is the culture of ourassociates, their passion for the company and customer service. As difficult asthe market is, it is great to see that passion reignited. We are achievingprogress from our investments in each of our five key priorities -- associateengagement, store environment, product availability, product excitement, andOwn the Pro. I’ll provide a quick summary on each, but before doing that, let’slook at overall market performance. We recognize that Home Depot's issues are not only marketrelated. We have also lost share through our own performance. One of our keyobjectives has been to reverse that market share loss. The latest data shows uslosing about 385 basis points to the market on a rolling 12-month basis. Thatis a significant improvement over last year’s number of 760 basis points. Also, as Paul will detail, in the markets where the housingand home improvement markets have been more stable, we are seeing positive compperformance. On associate engagement, Paul will take you through what we’vedone on our success sharing program, master trade specialists, and otherinitiatives. A good sign that we are seeing results here is that voluntaryhourly attrition is down 24%. We will continue to invest in our associatesbecause they are at the heart of our customer experience. On our shopping environment, we are rolling out new storestandards for cleanliness and appearance and we’ve already seen significantimprovement in our voice of customer VOC scores. On product availability, with Mark Hollifield and team wehave improved our in-stock position in our stores and this is also reflected inour VOC results, which show an improved score in our find-and-buy metric. We also have a distribution pilot well underway. We took anexisting facility in Georgia, introduced new processes in technology and areseeing shortened lead times and better in-stock positions in the servicestores. Building out our new supply chain will be one of our most importantinitiatives through the remainder of 2007 and 2008. On product excitement, Craig will discuss the areas wherewe’ve made significant share gains. We are also putting additional resourcesinto our regional merchandising efforts and adding talent to our merchandisingorganization. On our Own the Pro initiative, we are using the analyticsfrom Dunnhumby to gain better insights into the 2% of our customers who drivenearly 30% of our sales. Through these analytics, we are gaining a betterunderstanding of who these customers are and what their unique buying patternsarea. The analysis is being used to drive targeted direct mail pieces tooptimize our job lock quantity SKU lists, and to generate customer contactlists for our pro desk sales associates. I would also like to make a brief comment on core retail.We’ve launched a program to transform our merchandising systems and processesand we are on track to deliver the first phase in Canada next year. Our international business remains strong. Mexico posteddouble-digit comps in the quarter, Canada had positive comps, and China ismaking good progress. Our international stores now contribute 9% of sales and11% of operating profit, an impressive record of performance for thesebusinesses. Finally, let me make a few comments about our sale of HDSupply and our recapitalization plan. We closed the sale on August 30th and weare now focused exclusively on our retail business. We used the proceeds fromthe supply sale to fund the bulk of our $10.7 billion tender offer, which wecompleted in early September. That completes about 50% of our recapitalization. Given the market environment now, both in the housing andhome improvement market and the credit market, we don’t think it’s prudent torush to execute the remainder of the recapitalization, so this is not somethingthat will happen in the remainder of 2007. The basic principals behind the recapitalization that wewill be disciplined in our capital allocation and benchmark our use of capitalagainst returning dollars to our shareholders remain in place, as does ouroverall goal. We will provide a more complete view of our perspective on thisin 2008 inFebruary. In a meeting last week, one of our vendors made a greatcomment -- a downturn is a terrible opportunity to waste. This market downturnis an opportunity for the Home Depot to focus our resources and attention onthe things that matter and to bring greater customer focus to the business.That is what we are doing. Now let me turn the call over to Craig.
Craig Menear: Thank you, Frank and good morning, everyone. In the thirdquarter, we experienced negative sales growth in all of our departments exceptkitchens, which was driven by appliances. The departments that outperformed thecompany average comps were plumbing, kitchen and bath, garden, paint, andhardware. The departments that underperformed the company average comp werelumber, millwork, lighting, and building materials, and flooring performed at thecompany average. First let’s talk about what negatively impacted us duringthe quarter, including regional differences in performance and later, we’llhighlight some of the wins that we had in the quarter. A large driver of our weak sales performance in the quarterwas due to the softness in our building materials and related businesses. Lowerdemand, as well as commodity deflation in building material categories, such asdimensional lumber and drywall, impacted average ticket, which was down 1.5% fromlast year to $57.48. As you would expect, we are seeing double-digit declines inmarkets like South Florida, California, and portions of the Northeast. However,a few regions showed positive comps in these commodity related businesses, suchas the Southwest and Ohio Valley. The category where we lost share in the quarter waslighting. This is a product category that we have opportunity to enhance ourmerchandise offering and simplify the selection process for our customers. Herewe have promoted our top expo merchant, Lisa McLelland, to Merchandising VicePresident to lead this category going forward. She is leveraging the learningsfrom expo in fashion and design as the assortment is retooled for the spring of2008. Our kitchen category also remains challenged. In marketsfacing significant home price depreciation, such as Phoenix, Sacramento, andTampa, we are experiencing double-digit negative comps. Despite the headwindsthat we face in this big ticket category, we remain focused on improving our shareloss. We completed the rollout of our assembled kitchen cabinet program that wementioned last quarter and we are pleased with the early results. As we move into the fourth quarter, we are taking thelearnings from our success in the flooring department to our kitchen departmentand we will simplify the purchase process and increase the value propositionfor our customers. We are upgrading the shopping experience by resetting showrooms and enhancing the capability of our associates through additional trainingand technology upgrades. Now let’s talk about some of the areas where we’ve seenshare gains in the quarter -- paint, appliances, and power tools. Despite increasing competitive dynamics in the paintbusiness, our market share of paint grew again this quarter. We have a greatpartner in Masco with Behr Paint, which has been consistently rated number onein independent product testing for the past five years. Sales were particularly strong in our exterior paint andstain categories and customers are responding to the market-leading innovationand products such as our exclusive nano-guard exterior paint that requires nopriming. In a shrinking appliance market, we continued to gain sharethis quarter, building on the gains that we’ve seen for the past few years. Wesaw significant strength in this category throughout the country. Our successhas been driven by our ability to stay relevant to our customers by providingthem with the latest features and benefits at great values. Customers continue to be pleased with the innovation, style,and design we are offering in appliances in products like the GE café and theLG kitchen series, both high-end suites of kitchen appliances. Another area that is beginning to show positive shareresults is our hardware department. In power tools and accessories, we gainedshare in a shrinking market and extended our leadership in this category. Wesaw a strong performance across the country, including markets such as LosAngeles, Washington D.C., Chicago, San Francisco and Denver. We drove these share gains by staying relevant to both thepro and the do-it-yourself customer, providing them with tools that have thelatest functionality at great value. An example of this was our October launchof the new Ryobi One Plus lithium products, which offers professional featuresat affordable prices. A final comment on areas that we were pleased with in thethird quarter would be our merchandising resets. Where we have completed ourresets and implemented change from our product line review process,collectively these categories are outperforming the store sales performance inline with our expectations. There is no question that we are operating in challengingtimes, and as we look forward, we remain focused on our merchandisingfundamentals, enhancing our processes and strengthening our team. I have talkedto you in the past about our focused bay approach. The company transactionswere down 1.8% for the quarter. However, where we have applied our strategyagainst our specific category roles, we are beginning to see positive results.For example, in toolsets, whose intent is to drive traffic, we have seen thiscategory turn from a negative to a positive comp performance in the quarter. We are also partnering with our suppliers to bring value toour customers. Two weeks ago, we met with all of our top suppliers. We spent alot of time developing actions to more collaboratively solve customer problemsand drive sales for both of our companies. As we look forward to the fourth quarter, we are pleasedwith the early sales of our holiday program and gift oriented products. Thisyear, we expanded and refined our assortment and expect to be the number fourretailer in U.S. holiday décor sales, with double-digit year-over-year growth. We are also focused on managing our seasonal categories,such as heating, snow removal, and organization. Before I turn it over to Paul, I want to mention someexciting changes in our merchandising organization. During the past quarter, wehave invested to add talent within the merchandising team at our senior level.Bruce Marino, a 23-year veteran of the Home Depot has come back tomerchandising after spending eight years as the Western Division President.Bruce is leading our field merchandising teams, merchandise serviceorganization, store environment, and new concepts. We also have three Senior Vice Presidents that areresponsible for our merchandising categories. Another former division Presidentand merchant, Eric Pederson, is our SVP running our building materialsbusinesses. Giles Bowman, who has held various merchandising positionsthroughout the organization, is our SVP for hard lines. And lastly, we are pleased that Gordie Erickson has joinedus as our SVP of Décor. He brings a strong background of merchandising with 32years of experience in home center mass and specialty retailing. Now I would like to turn the call over to Paul.
Paul Raines: Thank you, Craig. As Frank mentioned, we have seensignificant differences in regional performance, driven by macroeconomic trendsand housing indicators. In those markets with favorable housing trends andstrong disposable income, we are seeing positive comp performance. For example,in the Southwest, our Dallas, Austin, and San Antonio markets had positivecomps for the quarter. In those areas that have been the hardest hit by housingturnover and new home sales, we continue to feel significant pressure. It is nosurprise that Sacramento, Las Vegas, and Fort Myers, Naples fall in thiscategory, with Fort Myers Naples posting negative comps in excess of 20%. Our business displays significant variation acrossgeographies and that underscores the importance of having a local focus. Forexample, within our Ohio Valley region, we have relatively stable housingmarkets as well as markets with deteriorating housing indicators, both postingpositive comps for the third quarter. We believe that our performance in these markets is beingdriven by share gains, as well as our focus on our five priorities. Now let’s talk about some of our progress on thosepriorities. This year, we have made a lot of progress on our associateengagement priority and despite the difficult business environment, we aredriving positive changes around our associate reward and recognition programs.We know that the motivation and engagement of our more than 300,000 associatesmake a huge impact on customer satisfaction and on sales. In our second quarter earnings call, we spoke a lot aboutcompensation enhancements. The changes in our success sharing program, anincentive program for hourly associates driven by individual store performance,allowed us to increase our associates participation in success sharing byalmost 40 points year over year for the first half. The largest check an hourlyassociated received was $1,855 and the average check was around $200. The issuance of restricted stock grants have more closelyaligned assistant store managers with the company’s goals. We have also seenpositive results from the reinstitution of our Homer Badge program, whereassociates get rewarded with merit badges for outstanding customer service,which they can submit for cash compensation. To date, over 78,000 Homer Badges have been awarded,including seven gold level badges and two platinum level badges. We have also seen a big impact from our master tradespecialist program. As of last week, we had over 2,000 master trade specialistsin our stores, all being either licensed plumbers or electricians. We areextremely pleased with this program. These specialists are better able to helpcustomers with their plumbing and electrical projects, help train associates,and help us better assort stores to comply with local building codes andrequirements. Our merchant team is also leveraging these specialists byhaving regular conference calls to ensure we are adopting and changing ouroffering in stores to reflect the regional needs of the business. While we view this as an investment in the short-term, weare confident that longer term, we will see a return on this investment. We are seeing the impact of our focus on associateengagement through reduced turnover and our employer of choice survey. As Frankmentioned, voluntary hourly turnover in our stores is down 24% from last year.EOC results indicate that our initiatives in associate engagement are making ameaningful difference. Earlier this year, we surveyed almost 300,000 of ourassociates at both the stores and the store support centers. Our highest scoreswere in those areas that are the most difficult to change -- meaningful andchallenging work, inclusive culture, and work environment. We definitely have room for improvement, particularly inareas like communication and work schedule. We are pleased with the results andfeel we can make progress in the areas that need our attention the most. In terms of shopping environment, we are very pleased withour progress. As most of you know, the average age of our stores is aroundseven years old, a time when you really need to refurbish the stores tocontinue to drive sales. Therefore this year, we increased our maintenancebudget by 2.5 times our 2005 spend, geared at making the stores clean anduncluttered and inviting to our customers. We have integrated our field and store support center teamsto better align ourselves around the needs of the business, as well as adopteda programmatic approach to maintenance. To date, we have polished or spiffed 473 floors, striped1,038 parking lots, remodeled 172 restrooms and now have T5 lighting in 1,765stores. In addition to programmatic maintenance, our integratedfield and support center teams have rolled out store standards to all stores.Through a cross-functional approach, we developed and piloted our basicexpectations for stores and our goal is to drive a foundational level of storeappearance that is agreed upon by our merchants, operators and support teams. To do this, we’ve set common guidelines on appearance andshopability and have created discipline around how the store support center directlyimpacts a store’s environment. The standards provide guidance on things such as front apronmerchandising, wing stack usage, signage presentation, fixturing, and off-shelfproduct. This initiative helps reduce the amount of time our store manages spendon navigating some of these issues, removes unnecessary clutter from the aislesand implements a basic, consistent approach in terms of store appearance. Finally, on our Own the Pro initiative, you’ve heard fromFrank that 2% of our customers drive almost 30% of our sales. Through Dunnhumbyand our credit card programs, we have good information about what this superpremium customer spends in our stores. Over the last quarter, this customer whotypically spends twice to three times as much as a regular customer, hascontinued to shop with us. We are now taking the next steps, building betterrelationships with them, communicating our value proposition, and staying relevant to them through our bid roomand job lot quantities programs, to continue to connect with them and gain agreater share of their wallet going forward. We know these initiatives are making a difference becauseour customers are telling us. Through our voice of customer survey, where wehear from over 200,000 customers a week, we see improvements in likelihood torecommend, find and buy, and our clean and uncluttered metrics. Clean anduncluttered, which measures the shopping environment, is improving faster thanall other metrics. Although we see good progress on our associate engagement,shopping environment, and Own the Pro initiatives, we know that continue toface market headwinds and challenges. Our success will be defined by ourability to remain focused on the fundamentals of the business during thisdifficult environment. I want to make a brief comment on the stores organization.Although Craig was able to lure veteran Western Division President Bruce Marinoaway to merchandising, we could not be happier for Bruce and look forward toworking with him closely going forward. We have replaced Bruce with Joe McFarland, who is our newPresident for the Western Division. Joe is a 16-year veteran with the HomeDepot, who has held various operating positions, including regional vicepresident, district manager, and store manager. I am very excited about havingJoe in this leadership position. One last comment before I turn it over to Carol; it isunfortunate when we face natural disasters but it is during times like thesethat our associates and customers need us the most. Taking care of thecommunity and each other in a disaster is one of the things Home Depot doesbest. During the recent wildfires in California, we saw thousandsof customers and associates evacuated from their homes and many lost theirhomes or sustained significant damage to them. In order to assist ourassociates and customers in need, the Home Depot kept stores open longer thanany other retailer in the area and donated palettes of water, flashlights andbatteries, air purifiers, gloves, and more. Beyond providing the necessaryproducts during this disaster relief effort, our associates also donated theirtime to help in any way needed -- at evacuation centers, building sifters,providing shelter for animals and hosting kids workshops. You can always count on Home Depot to stand tall in times ofneed for our customers and associates. I want to thank each and every one ofour associates for your commitment and sacrifice. You make us proud to wear theorange apron. Now I would like to turn the call over to Carol.
Carol B. Tome: Thank you, Paul and hello, everyone. Before I discuss theresults of the quarter, let me remind you that our third quarter resultsinclude one month of HD Supply as a discontinued operation. As you review ourfinancial statements, please note that the operating results and earningsimpact of the sale of HD Supply are found in a one-line item on our incomestatement entitled earnings from discontinued operations. In the third quarter, sales were $18.96 billion, a 3.5%decrease from last year, reflecting negative same-store sales of 6.2%, offsetin part by sales from new and non-comp stores. Consolidated same-store saleswere negative 5% in August, negative 7.3% in September, and negative 6.3% inOctober. In the third quarter, our gross margin was 33.4%, a decreaseof 18 basis points from the same period last year. Contributing to theyear-over-year decrease in our gross margin rate were the following factors. As expected, our gross margin benefited from lower interestcosts associated with our private label credit card financing program. In thethird quarter, we realized 36 basis points of margin expansion due to lowerinterest costs. We gave up roughly 54 basis points of margin due to a higherpenetration of lower margin products like appliances, as well as markdownstaken to clear through some seasonal items like outdoor power equipment andgrills, and allow us to transition into new products, like assembled cabinetsand kitchen accessories. As a percent of sales, total expenses grew by 183 basispoints to 24.1%. Our expense deleverage reflects the impact of negative sales,where for every point of negative comp, we expect to deleverage expenses byabout 20 basis points. So with a negative comp of roughly 6%, we would expect toreport expense deleverage of 120 basis points. In the third quarter, weexperienced an additional roughly 60 basis points of expense deleverage due totwo main factors. First, during the quarter, we announced our plans to closeour 11 landscape supply locations. We recognized $25 million of expenseassociated with the store closings during the quarter. Second, we share in the profitability of our private labelcredit card portfolio through a gain share program. Private label credit salesmake up about 30% of our total sales. The portfolio remains very profitable butlosses within the portfolio are higher than they were one year ago. As aresult, our gain share was approximately $82 million less than last year. Our expenses reflect investments we are making in support ofour five key priorities. We continue to view payroll as an investment. As apercent of sales, total payroll increased by 51 basis points over last year,which includes investments in our master trade specialist program, as well asexpense associated with employee bonus programs like success sharing.Currently, 57% of our stores are eligible for success sharing compared to 22%last year. As a result of the factors I just mentioned, our operatingmargin declined from last year. Our operating margin for the third quarter was9.3% as compared to 11.3% last year. Net interest expense was $125 million inthe third quarter, up $33 million from last year, reflecting higher levels ofoutstanding indebtedness. In the third quarter, our income tax provision rate forcontinuing operations was 34.7% compared to 37.4% last year. In the thirdquarter, we reached agreement with tax authorities on several state and federaltax audits. As a result, we recognized a $35 million tax benefit in thequarter, as well as some related interest expense benefits. Earnings from continuing operations were $1.1 billion, ascompared to $1.3 billion last year, and continuing earnings per diluted sharewere $0.59, down 9.2% from last year. Diluted shares for the third quarter were1.815 billion shares compared to 2.05 billion shares last year. The reduction in outstanding shares is due to the sharerepurchase program we began in 2002, including the 289 million shares werepurchased in our recent tender offer. Through the end of the third quarter,we had repurchased a total of 743 million shares. Earnings for our discontinued operation, HD Supply, were $20million. Included in this quarter’s results are the net after tax financialresults for the month of August, as well as the impact of the sale of HDSupply. After expenses and taxes, we recognized a $4 million loss on the saleof the business. Moving to our operational metrics, during the third quarterwe opened 25 new stores, including one relocated store, for an ending storecount of 2,224. Today, 236 stores representing approximately 11% of our storebase, operate in Canada, Mexico, and China. At the end of the third quarter, selling square footage was233 million, a 5.4% increase from last year. The average square footage perstore was 105,000 square feet, the same as last year. Reflecting the sales environment, total sales per squarefoot were approximately $323 for the quarter, down 7.8% from last year. Whilethe year-over-year trends for our new stores were also negative, sales persquare foot for our new stores had their best year-over-year performance sincethe fourth quarter of 2006. At the end of the quarter, retail inventory was $12.6billion, an increase of 3.7% from last year. On a per store basis, inventorywas down 1.9% from last year. Inventory turns were 4.4 times, slightly lowerthan last year. Computed on the average of beginning and ending long-termdebt and equity for the trailing four quarters, return on invested capital forour retail business was 15%, reflecting a 130 basis point improvement from thesecond quarter of 2007. We ended the quarter with $45.5 billion in assets, including$550 million in cash and short-term investments. This is a decrease ofapproximately $64 million in cash from the end of fiscal 2006, reflecting cashgenerated by the business of approximately $5.8 billion, net proceeds from thesale of HD Supply of $8.3 billion, along with commercial paper issuances of$748 million, offset by $2.5 billion of capital expenditures, $325 million paidfor a minority interest in HD Supply, $1.3 billion of dividends paid, and $10.8billion paid for share repurchases. For the year, we now estimate our total capital spendingwill be approximately $3.9 billion. Given our performance to date and the softness we continueto project for the rest of 2007, we think our comps for the year will benegative 6% to 7%, and earnings per share from continuing operations on a52-week basis will be down as much as 11% from last year. Finally, I want to give you our latest thinking on thecompletion of our $22.5 billion recapitalization plan. As Frank mentioned,since we announced the plan in June, we have completed about 50% of our recap.As you know, both the credit market and the housing market have become moredifficult since June. We believe it is prudent to take a cautious stance withregard to the completion of the recap. We will move forward when we seeimprovement in both the home improvement and credit market, which we believewill not occur until some time in 2008. We will keep you appraised of our plans and during ourfourth quarter conference call, we will provide you with sales, earnings, andcapital spending guidance for fiscal 2008. Thank you for your participation in today’s call and we arenow ready for questions.
Operator: (Operator Instructions) We’ll go first to Chris Horvers atBear Stearns.
Chris Horvers - BearStearns: Thank you and good morning, everybody. First question on therecap program, I think when we are out here speaking with investors and weunderstand being pushed back because of the credit market aspect but pushing itback because of the home improvement market, what do you say to people who turnand say well, if they are not interested in buying our stock, why should I?
Frank Blake: I think again, as we’ve said, it is looking at both marketsand saying what is the prudent thing for us to do for our shareholders. If yousaid all other things being equal, we were planning to go forward at the end ofthis year and then take another step in the spring, but all things reallyaren’t equal, both in terms of the credit market and we do think it makes senseto look at the housing market and see what’s happening in the housing marketbefore making another major commitment.
Chris Horvers - BearStearns: Could you just expand on that last part? Why would you belooking at the housing market?
Frank Blake: I think again for us, we look at both what our projectionwas for the year, where it turned out, and we want to get a better sense of2008 and we are frankly just in the middle of the planning process around 2008.
Carol B. Tome: Chris, you’ll recall that from a capital strategyperspective, we have targeted an adjusted debt to EBITDAR leverage ratio of 2.5times, and so clearly the housing market will impact our adjusted EBITDAR, andso we are just working through our plans for 2008 and looking at that relativeto our financing plans.
Chris Horvers - BearStearns: One follow-up question, Carol; as we think about 2008, andunderstand you haven’t given guidance yet, we know sales -- it’s going to be atough environment and we had the second downturn in the housing. As we thinkabout the deleverage that might occur in ’08, does the accelerated maintenanceand the additional store investment this year make the potential deleverageless next year for every 100 basis points of comp?
Carol B. Tome: Well, it’s a great question. We had some catch-up spendingin 2007, as we’ve talked to you about. Again, we are not giving guidance todayfor 2008 because we are just building our plans. But as we look at our businessmodel, we believe that we will still, for every negative point of comp sales,deleverage expenses by 20 basis points. Then there will be some other goes-insand goes-outs that we’ll talk to you about.
Chris Horvers - BearStearns: Thank you very much.
Operator: Next we’ll move to Deborah Weinswig at Citigroup.
Deborah Weinswig -Citigroup: Good morning. Frank, I believe Carol had highlighted thefact that 57% of stores this year are eligible for success sharing versus 22% ayear ago. I would assume that that’s very important for employee morale. Canyou talk about if you’ve changed the target or how you’ve gotten to a highernumber year over year, and just what it means for the employees?
Frank Blake: Yes, we did change the targets, so previously we tended tohave a stretched target in order to get into success sharing, and then you hadto hit 100% of the target. So for this year, we changed that approach and madeit a percent of target and at the time, we were thinking the target we set outwas a very reasonable target, with again, the basic principal being we wantedour associates to feel the benefit of success sharing and then earn their wayup into additional dollars, rather than feeling demotivated from the start at atough plan that they didn’t think they could achieve.
Deborah Weinswig -Citigroup: Okay, and then last question, in terms of helping theassociates in a tough environment, are there any additional tools that you areproviding them with in store to help serve customers or help them upsell?
Paul Raines: I’ll take that one. There is a series of activities in thestores around learning that are very important. We’ve spent a lot of timerefocusing in the first half of this year around in-the-aisle learning andemphasizing project and product knowledge versus the heavily e-learning focusthat we’ve had previously. So that’s one of the tools we’ve given them. At the same time, we are doing a tremendous amount of focuson our VOC activities and giving them a lot of feedback and metrics around whatcustomers are saying about the business. So we feel that we are giving ourassociates a lot more tools around the customer and around product knowledgeand helping customers do projects in their homes through this first half.
Deborah Weinswig -Citigroup: Great. Thank you very much.
Operator: And next we’ll move to Stephen Chick with J.P. Morgan.
Jeff Wimmer - J.P.Morgan: This is actually Jeff Wimmer on behalf of Stephen Chick. Ihave a question about your guidance, if you could delve in a little bit moreabout that. It looks like sales remain relatively the same, in that high,mid-single digit range, but could you talk about the split between growth andSG&A deleverage? Are you still looking for up gross margins year over year?
Carol B. Tome: Yes, year over year we are projecting slight marginexpansion. On the expense side, the expense deleverage that we saw in the thirdquarter will continue into the fourth quarter.
Jeff Wimmer - J.P.Morgan: Okay, and then I might have missed this because I got on thecall a little late, but did you give intra-quarter sales yet?
Carol B. Tome: From a comp perspective?
Jeff Wimmer - J.P.Morgan: From a comp perspective, yes.
Carol B. Tome: We sure did, and let me just tell you negative 5 in August, negative 7.3 in September, negative 6.3 in October.
Jeff Wimmer - J.P.Morgan: Okay, and then also, just thinking about going forward, youhave the $600 million reinvestment plan. Is this going to be somethingreoccurring next year? Will there be additional incremental investment as welook into ’08?
Carol B. Tome: At the beginning of the year, we said that we were investing$2.2 billion in support of our five key priorities, $1.6 billion for capital,$600 million of expense. Some of that expense was catch-up spending. We willcontinue to invest in the key priorities in 2008. Just to update the capital bit, we are going to spend thisyear we project about 1.3 against the original 1.6 target, but that’s reallybecause of the sale of HD Supply.
Jeff Wimmer - J.P.Morgan: Okay. Thank you.
Operator: Next we’ll move to Budd Bugatch at Raymond James.
Budd Bugatch -Raymond James: Good morning. Let me ask you a question -- my first questionreally goes to appliances. Can you update us where you are on share onappliances? I noticed in some stores maybe some additional square footagethrough the use of mezzanines. Is that prevalent in a number of stores?
Frank Blake: Budd, that’s a very limited pilot that we were running and Iwould not expect to see a lot more of those, but let me turn it over to Craigfor general comments on appliances.
Craig Menear: For appliances overall, again we were pleased with theperformance there. We’ve achieved a 12.4% penetration in terms of market shareversus 10.7 ayear ago, up again from Q2, which was at 11.7, so the customer really continuesto respond to the offering that the team has put together.
Budd Bugatch -Raymond James: And Craig, those are unit shares?
Craig Menear: Yes.
Budd Bugatch -Raymond James: Okay, and if we could also, my last question is to talk alittle bit about any additional talent or what you see in the merchandisingorganization with Gordie’s coming on board, or can you talk about maybe whatother needs you might have?
Craig Menear: Well again, very excited to not only have Gordie on boardbut also to have Bruce join us, coming in from the field to help us reallycoordinate and connect with our regional team as we continue to try to drivethe regional assortment variations that we need across our business and getthat executed for the stores. And with Gordie joining us, again great retail talent. Ithink well respected in terms of his knowledge, both in mass discount andspecialty retailing and it’s a super addition to our team. We feel very good about the overall team that we have inplace right now and looking forward to driving the business.
Budd Bugatch -Raymond James: Okay, and Carol, could you just give us what the tax rate isgoing forward? Any more tax issues?
Carol B. Tome: We project that the provision rate for the year will be36.5%.
Budd Bugatch -Raymond James: Okay, that helps.
Operator: We’ll go next to Matthew Fassler at Goldman Sachs.
Matthew Fassler - GoldmanSachs: Thanks a lot. Just a couple of quick questions here. Firstof all, the average ticket decline seemed to moderate a bit. If you could giveus any color on why you think that happened, be it mix or other factors. And then just by way of follow-up, Carol, on the recap,would you continue to expect to deploy free cash against buy-backs or would youhold off on that as well?
Frank Blake: Craig, why don’t you comment on the average ticket.
Craig Menear: On average ticket overall, again what we saw there was someshift in mix that is impacting that business. When you look at what happened tothe lumber and building materials categories, as that relates to a largerrepair/remodel project overall, that certainly had an impact on the category. We did see some shifting and we are seeing withincategories, for example, in a little more discretionary spend categories likeoutdoor power equipment, we saw some shift down in the line, which impacted theticket in that category as well.
Carol B. Tome: Just another comment on the ticket, if you look at just thesequential performance, Q3 to Q2, in Q3 we picked up $0.22 of average ticketgrowth because of an increased appliance penetration. We didn’t have that samebenefit in the second quarter, so that’s part of what you are seeing. And on the recap question, as Frank said in his comments, weremain committed to our capital allocation strategy where we will alwayscompare the use of excess cash, returning that to our shareholders versussomething else, and so yes, we’ll remain committed to that.
Matthew Fassler -Goldman Sachs: But just to clarify, to the extent that you are talkingabout holding off on the recap, you’re talking about holding off borrowing moremoney to buy back stock, not the repurchase of stock in and of itself?
Carol B. Tome: Right. Now remember, we have $748 million of outstandingcommercial paper, so we don’t have excess cash as we are sitting today.
Matthew Fassler -Goldman Sachs: Fair enough. Okay, thank you.
Operator: Next we’ll go to Danielle Fox at Merrill Lynch.
Danielle Fox -Merrill Lynch: Thanks. Good morning. I guess just looking backhistorically, the retail business has had an operating margin as high as 11.8%,which is about 200 basis points above where you are tracking this year. I’mwondering what needs to happen to get back up to those levels. Presumably youneed to return to positive comps, but do some of these supply chainenhancements that you are beginning also need to work out in order to return tothe 11.8%?
Frank Blake: I think first, clearly positive comps, because that leverspositively versus the negative, the deleverage that we see now. And thensecond, you are exactly right in terms of improving. What we see is thesubstantial investment that we are going to make in our supply chain will helpus improve our operating margins, as will the merchandising transformationthat’s really at the heart of core retail.
Danielle Fox -Merrill Lynch: You don’t see anything as having changed in the underlyingcost structure that would prevent you from returning to those levels, giventhat you did need to step up the P&L investing beginning in the second halfof ’06?
Frank Blake: No, I would say 11.8 is a long ways away, but we think thereis significant improvement from where we are.
Danielle Fox -Merrill Lynch: Okay. Thank you.
Operator: Next we’ll go to Gregory Melich at Morgan Stanley.
Gregory Melich -Morgan Stanley: Thanks. I have two questions; Frank, did we start on theCanadian rollout of the merchandising system that was mentioned as somethingthat will happen next year? Is that a pilot or is that across all the stores or-- just fill us in on the timing there.
Frank Blake: The timing is around the end of March, the pilots will -- Imean, the way the actual rollout works is it starts with a set of pilot storesand you pilot that for several weeks and then fix any bumps that occurredduring the pilot process and then we expect to have it rolled out to everystore in Canada by the end of 2008.
Gregory Melich - MorganStanley: And if I remember correctly, there was a plan to maybeaccelerate the U.S. following that. Is that still the case? Or that will be a’09 business?
Frank Blake: The way we are setting this up, and I think the tremendousadvantage that we have with Canada as our laboratory, in effect, is that we aregoing to look very closely at what the results are from Canada, both pilot androllout, and that’s going to determine the pace that we take on the U.S. side.
Gregory Melich -Morgan Stanley: Okay, so stay tuned, basically.
Frank Blake: Yes.
Gregory Melich -Morgan Stanley: Okay, and the second question, Carol, is a follow-up on theearnings share of the credit business. I think you said it was $83 million. DidI get that number right?
Carol B. Tome: It’s $82 million year over year.
Gregory Melich -Morgan Stanley: So was that -- but it was still profitable in the quarter?
Carol B. Tome: Yes, it certainly is -- very profitable.
Gregory Melich -Morgan Stanley: And was that swing -- would you call that an ongoing --
Carol B. Tome: Yes, you know --
Gregory Melich -Morgan Stanley: -- provision that you [unwound], effectively.
Carol B. Tome: It’s a good question. It’s the loss piece of the portfolio.The portfolio is really a good portfolio. The losses have been running in the4%, 4.5% range. They’ve popped up. We’re now projecting they’ll be in the 6%range which, relative to other credit card portfolios is not bad, but it’shigher so it means the profitability isn’t as large as it was, so we didn’t getas much of a share gain in the quarter. And that pressure will continue intothe fourth quarter.
Gregory Melich -Morgan Stanley: Okay, so we think that 6% is now a good ongoing number thatwe should use?
Carol B. Tome: Well, we’re going to be watching it very, very carefully.Some other stats, just for your information, 65% of the portfolio has FICOscores greater than 650, so that’s very high quality. But 17% of the portfoliohas FICO scores of less than 600, so we are going to be watching this verycarefully. I mean, the credit market is interesting in today’s environment.
Gregory Melich -Morgan Stanley: And are you -- on the downside there, is there like astop-loss so to speak, that you share profits but is there a cap on that or no?
Carol B. Tome: The profits that are share is over a threshold, over anearnings threshold. We’ve got a long way to go before that would happen.
Gregory Melich -Morgan Stanley: Okay, great. Thanks.
Operator: Our next question comes from Eric Bosshard at ClevelandResearch.
Eric Bosshard -Cleveland Research: Good morning. Two questions -- first of all, on the recap,is the -- waiting to see what you are going to do next year, is that based asmuch on uncertainty about the EBITDA of the business next year? Is that theprimary driver to how you are rethinking the pace of which you are going tomove on that?
Frank Blake: Well, as both Carol and I said in our comments, it is boththings, both the credit markets and the underlying housing market. As Carolindicated, obviously the underlying housing market impacts our performance,which impacts our EBITDA which impacts our coverage. And for where we are now, I think it’s worth pausing andrealizing look, the window has been closed on us, so we could not have been buyingeven if we had wanted to. The window is now open and you would say -- we’d saylooking at our business and looking at the credit market that this is a time topause and make sure we’ve got a pretty firm idea going forward before makingthat second and third steps in the recapitalization plan, which again, as Isaid in the initial comments, we remain committed to. It’s really just aquestion of figuring out the right timing.
Carol B. Tome: And we certainly have debt capacity. If you look at ouradjusted debt-to-EBITDA ratio for the trailing 12 months, it’s 1.9 times, sowe’ve got debt capacity.
Eric Bosshard -Cleveland Research: Okay, and then secondly, understanding the uncertainty,you’ve made the decision to move slower on the repurchase. I understand thatbut in terms of the capital and the sales investment that you are going to makein the business for next year, how are you thinking differently about that? Isthat a wait and see how sales are until you determine what you are going toinvest in the business? Or are you going to continue to make the investmentregardless of the sales environment?
Frank Blake: We are continuing to make the investment in the business tomake the customer experience the best possible customer experience. I’d saywhere there’s an impact and where you’ve already seen an impact this year is inour new store opening and taking down our new store opening, both for 2007, asCarol indicated, that reduced our CapEx for 2007 and into 2008.
Carol B. Tome: And you’ll recall, Eric, at the beginning of the year, wesaid we would spend $4.5 billion in capital. We are going to spend 3.9. Thatincludes about $200 million at supply, so in the retail business about 3.7 andthe delta from the beginning of the year is really new store capital.
Eric Bosshard -Cleveland Research: Thank you.
Operator: We’ll go next to Gary Balter at Credit Suisse.
Shannon Coyne -Credit Suisse: This is actually Shannon Coyne for Gary. I just had onequestion -- how much of the lower guidance is due to the reinvestment in thestores, or minimum labor standards that you’ve put in place versus theworsening housing markets?
Carol B. Tome: For the fourth quarter and full year, Shannon?
Shannon Coyne -Credit Suisse: Yes.
Carol B. Tome: If we’re looking at comps of negative 67%, earnings fromcontinuing operations, EPS down 11%, implied in that is expense deleveragealong the lines of what you saw in the third quarter, and gross marginexpansion. And the expense deleverage is just a factor of the negative compsthat we are projecting, the investment, and some continued pressure on credit.
Shannon Coyne -Credit Suisse: Okay, thanks.
Operator: Next we’ll take a question from Colin McGranahan atBernstein.
Colin McGranahan -Sanford Bernstein: Good morning. I wanted to focus first on the expense line alittle bit. As I look at the expense dollars, year over year the growth rate ofthose dollars is about 4.1%, which is -- looks like a deceleration of about 100basis points from roughly 5% growth rate in the first half of the year. Givensuccess sharing dollars look like they were probably pretty consistent, youhave this $82 million negative year-over-year delta in the credit portfolio,square footage growth is pretty much the same at 5.4%, what was it that causedthe expense dollars to decelerate and where did you realize some expensesavings in the business?
Carol B. Tome: We didn’t call it out in our prepared remarks, but just likethe second quarter, we were actually under our expense plan in the third quarter.Every day we wake up and look at sales, we look at cash, and we look at wherewe control expenses so it doesn’t impact the customer experience. And we’ve hadgood expense control in areas like advertising. We might want to talk about payroll, it’s our biggestexpense. On the payroll side, wages are up year over year. That’s reflectingthe investments that we are making but as you would expect, we’ve got anactivity-based labor model and the hours in the stores are actually lower thanthey were a year ago, as you would expect, because we have less activity in thestores. On the G&A side, we’ve got unbelievable expense control.We’re investing where we need to invest but where we can cut costs, we are.
Colin McGranahan -Sanford Bernstein: So were labor dollars then growing at a slower rate in thethird quarter than they were in the first half of the year?
Carol B. Tome: They were.
Colin McGranahan -Sanford Bernstein: Okay, so that was a savings, then advertising is a savingsand just tightening the nuts on the G&A.
Carol B. Tome: Yes. And still there are lots of other small goes-ins andgoes-outs, but yes, those are the big buckets.
Colin McGranahan -Sanford Bernstein: Okay, and is that 4% a reasonable pace going forward?Because it looks like that $82 million credit delta is probably recurring andgiven probably some stress levels of some of your larger pros that are sittingon those credit cards, that may actually be getting worse, not better.
Carol B. Tome: Well, I think we’ve given you pretty good guidance for theyear, so you can do the math.
Colin McGranahan -Sanford Bernstein: Okay, and then my second question just on traffic. Obviouslyticket improved sequentially a little bit. It looks like there was a prettysignificant deceleration in traffic. Would you peg any of that to kind ofseasonal variances and the drought conditions and thinks like that? Or was itjust general housing market?
Craig Menear: Not really -- as we looked at the traffic, just let meaddress the drought question. We saw some impact in categories like live goods,pressure washers, and power equipment in the southeast area of the country. Itwasn’t material overall in the quarter. We did take the opportunity to movesome power equipment into the southwest region of the country, which wasperforming extremely strong, and to make sure that we continued to leverage theopportunity in that business. But overall, I wouldn’t say that weather was the impact tothe average ticket.
Colin McGranahan -Sanford Bernstein: To the traffic?
Craig Menear: Or traffic, I’m sorry, yes.
Colin McGranahan -Sanford Bernstein: Okay, great. Good luck, guys. Thanks.
Diane Dayhoff: We have time for one more question.
Operator: Okay, and we’ll go to Brian Nagel at UBS.
Brian Nagel - UBS: Good morning. A question on -- as we see the weakness in theU.S. dollar here, and [you are presumably] sourcing more products overseas,what impact has that or could that have upon your business or specific grossmargins in the coming quarters?
Craig Menear: When we look at what’s going on with the dollar right now,certainly there is some pressure out there but we are working hard with oursuppliers to really work through that pressure with them to find other waysthat we can work together to take mutual costs that we have out of our businessand really not let that impact the retail environment whatsoever, so we’re notseeing a significant change overall.
Brian Nagel - UBS: That’s helpful, and then one very quick question; I noticedin the guidance, it seems like the benefit of that extra week from an EPSperspective change this time in your guidance. What explains that?
Carol B. Tome: We tightened up our forecasts. We had carried over somecosts into that extra week that we didn’t need to, and so we just have a betterforecast.
Brian Nagel - UBS: Okay, fair enough. Thank you very much and good luck nextquarter.
Frank Blake: Thank you all very much.
Diane Dayhoff: Thank you for joining us and we look forward to the callnext quarter.
Operator: And that does conclude today’s conference. Again, thank youfor your participation. | [
{
"speaker": "Executives",
"text": "Diane Dayhoff - Senior - Vice President of InvestorRelations Frank Blake - Chairman, Chief Executive Officer Craig Menear - Senior Vice President, Merchandising Paul Raines - Executive Vice President of U.S. Stores Carol B. Tome - Chief Financial Officer, Executive VicePresident Corporate Services"
},
{
"speaker": "Analysts",
"text": "Chris Horvers - Bear Stearns Deborah Weinswig - Citigroup Jeff Wimmer - J.P. Morgan Budd Bugatch - Raymond James Matthew Fassler - Goldman Sachs Danielle Fox - Merrill Lynch Gregory Melich - Morgan Stanley Eric Bosshard - Cleveland Research Shannon Coyne - Credit Suisse Colin McGranahan - Sanford Bernstein Brian Nagel - UBS"
},
{
"speaker": "Operator",
"text": "Good day, everyone and welcome to today’s Home Depot third quarter earningsconference call. As a reminder, today’s call is being recorded. Beginningtoday’s discussion is Ms. Diane Dayhoff, Senior Vice President of InvestorRelations. Please go ahead."
},
{
"speaker": "Diane Dayhoff",
"text": "Thank you and good morning to everyone. Welcome to the HomeDepot third quarter earnings conference call. Joining us on our call today areFrank Blake, Chairman and CEO of The Home Depot; Craig Menear, Executive VicePresident of Merchandising; Paul Raines, Executive Vice President of U.S.Stores; and Carol Tome, Chief Financial Officer and Executive Vice PresidentCorporate Services. Following our prepared remarks, the call will be open foranalyst questions. Questions will be limited to analysts and investors and as areminder, we would appreciate it if participants would limit themselves to onequestion with one follow-up, please. This conference call is being broadcast real-time on theInternet at homedepot.com with links on both our homepage and the investorrelations section. The replay will also be available on our site. If we areunable to get to your question during the call, please call our investorrelations department at 770-384-2387. Before I turn the call over to Frank, let me remind you thattoday’s press release and the presentations made by our executives includeforward-looking statements as defined in the Private Securities LitigationReform Act of 1995. These statements are subject to risks and uncertainties.These risks and uncertainties include, but are not limited to, those factorsidentified in the release and in our filings with the Securities and ExchangeCommission. Now let me turn the call over to Frank Blake."
},
{
"speaker": "Frank Blake",
"text": "Thank you, Diane and good morning, everyone. Our marketcontinues to face into significant headwinds. We started the year with a fairlypessimistic view of the housing and home improvement markets. It turns out weweren’t pessimistic enough. We had expected some market improvement by thethird quarter. That didn’t occur and our results reflect the difficult market. Sales for the third quarter were $19 billion, down 3.5%.Comp sales were negative 6.2% and diluted earnings per share from our retailbusiness were down 9% at $0.59. We expect continued difficult conditions for the remainderof 2007 and into 2008. We have consistently used as a guidepost to marketconditions the ratio of residential construction spend to GDP. The 60-yearaverage is 4.8%. At the height of our market in 2005, the ratio was 6.25%. Themarket is now corrected to 4.5%. When you consider the GDP is approximately $14trillion, this represents a market contraction of over $240 billion. While we are now close to the average, we don’t expect themarket do decline to the average and then pivot back up. We expect that thesoft market will continue, as reflected in the current overhang of housinginventory and the difficulties in the sub-prime mortgage [market]. As painful as the correction has been and will probablycontinue to be, we are now on the underside of this 60-year average. The valueof a time tested average is that it gives you confidence in the marketpotential ahead. For the Home Depot, it reinforces the importance of investingin our business and fixing our core operations. What most distinguishes the Home Depot is the culture of ourassociates, their passion for the company and customer service. As difficult asthe market is, it is great to see that passion reignited. We are achievingprogress from our investments in each of our five key priorities -- associateengagement, store environment, product availability, product excitement, andOwn the Pro. I’ll provide a quick summary on each, but before doing that, let’slook at overall market performance. We recognize that Home Depot's issues are not only marketrelated. We have also lost share through our own performance. One of our keyobjectives has been to reverse that market share loss. The latest data shows uslosing about 385 basis points to the market on a rolling 12-month basis. Thatis a significant improvement over last year’s number of 760 basis points. Also, as Paul will detail, in the markets where the housingand home improvement markets have been more stable, we are seeing positive compperformance. On associate engagement, Paul will take you through what we’vedone on our success sharing program, master trade specialists, and otherinitiatives. A good sign that we are seeing results here is that voluntaryhourly attrition is down 24%. We will continue to invest in our associatesbecause they are at the heart of our customer experience. On our shopping environment, we are rolling out new storestandards for cleanliness and appearance and we’ve already seen significantimprovement in our voice of customer VOC scores. On product availability, with Mark Hollifield and team wehave improved our in-stock position in our stores and this is also reflected inour VOC results, which show an improved score in our find-and-buy metric. We also have a distribution pilot well underway. We took anexisting facility in Georgia, introduced new processes in technology and areseeing shortened lead times and better in-stock positions in the servicestores. Building out our new supply chain will be one of our most importantinitiatives through the remainder of 2007 and 2008. On product excitement, Craig will discuss the areas wherewe’ve made significant share gains. We are also putting additional resourcesinto our regional merchandising efforts and adding talent to our merchandisingorganization. On our Own the Pro initiative, we are using the analyticsfrom Dunnhumby to gain better insights into the 2% of our customers who drivenearly 30% of our sales. Through these analytics, we are gaining a betterunderstanding of who these customers are and what their unique buying patternsarea. The analysis is being used to drive targeted direct mail pieces tooptimize our job lock quantity SKU lists, and to generate customer contactlists for our pro desk sales associates. I would also like to make a brief comment on core retail.We’ve launched a program to transform our merchandising systems and processesand we are on track to deliver the first phase in Canada next year. Our international business remains strong. Mexico posteddouble-digit comps in the quarter, Canada had positive comps, and China ismaking good progress. Our international stores now contribute 9% of sales and11% of operating profit, an impressive record of performance for thesebusinesses. Finally, let me make a few comments about our sale of HDSupply and our recapitalization plan. We closed the sale on August 30th and weare now focused exclusively on our retail business. We used the proceeds fromthe supply sale to fund the bulk of our $10.7 billion tender offer, which wecompleted in early September. That completes about 50% of our recapitalization. Given the market environment now, both in the housing andhome improvement market and the credit market, we don’t think it’s prudent torush to execute the remainder of the recapitalization, so this is not somethingthat will happen in the remainder of 2007. The basic principals behind the recapitalization that wewill be disciplined in our capital allocation and benchmark our use of capitalagainst returning dollars to our shareholders remain in place, as does ouroverall goal. We will provide a more complete view of our perspective on thisin 2008 inFebruary. In a meeting last week, one of our vendors made a greatcomment -- a downturn is a terrible opportunity to waste. This market downturnis an opportunity for the Home Depot to focus our resources and attention onthe things that matter and to bring greater customer focus to the business.That is what we are doing. Now let me turn the call over to Craig."
},
{
"speaker": "Craig Menear",
"text": "Thank you, Frank and good morning, everyone. In the thirdquarter, we experienced negative sales growth in all of our departments exceptkitchens, which was driven by appliances. The departments that outperformed thecompany average comps were plumbing, kitchen and bath, garden, paint, andhardware. The departments that underperformed the company average comp werelumber, millwork, lighting, and building materials, and flooring performed at thecompany average. First let’s talk about what negatively impacted us duringthe quarter, including regional differences in performance and later, we’llhighlight some of the wins that we had in the quarter. A large driver of our weak sales performance in the quarterwas due to the softness in our building materials and related businesses. Lowerdemand, as well as commodity deflation in building material categories, such asdimensional lumber and drywall, impacted average ticket, which was down 1.5% fromlast year to $57.48. As you would expect, we are seeing double-digit declines inmarkets like South Florida, California, and portions of the Northeast. However,a few regions showed positive comps in these commodity related businesses, suchas the Southwest and Ohio Valley. The category where we lost share in the quarter waslighting. This is a product category that we have opportunity to enhance ourmerchandise offering and simplify the selection process for our customers. Herewe have promoted our top expo merchant, Lisa McLelland, to Merchandising VicePresident to lead this category going forward. She is leveraging the learningsfrom expo in fashion and design as the assortment is retooled for the spring of2008. Our kitchen category also remains challenged. In marketsfacing significant home price depreciation, such as Phoenix, Sacramento, andTampa, we are experiencing double-digit negative comps. Despite the headwindsthat we face in this big ticket category, we remain focused on improving our shareloss. We completed the rollout of our assembled kitchen cabinet program that wementioned last quarter and we are pleased with the early results. As we move into the fourth quarter, we are taking thelearnings from our success in the flooring department to our kitchen departmentand we will simplify the purchase process and increase the value propositionfor our customers. We are upgrading the shopping experience by resetting showrooms and enhancing the capability of our associates through additional trainingand technology upgrades. Now let’s talk about some of the areas where we’ve seenshare gains in the quarter -- paint, appliances, and power tools. Despite increasing competitive dynamics in the paintbusiness, our market share of paint grew again this quarter. We have a greatpartner in Masco with Behr Paint, which has been consistently rated number onein independent product testing for the past five years. Sales were particularly strong in our exterior paint andstain categories and customers are responding to the market-leading innovationand products such as our exclusive nano-guard exterior paint that requires nopriming. In a shrinking appliance market, we continued to gain sharethis quarter, building on the gains that we’ve seen for the past few years. Wesaw significant strength in this category throughout the country. Our successhas been driven by our ability to stay relevant to our customers by providingthem with the latest features and benefits at great values. Customers continue to be pleased with the innovation, style,and design we are offering in appliances in products like the GE café and theLG kitchen series, both high-end suites of kitchen appliances. Another area that is beginning to show positive shareresults is our hardware department. In power tools and accessories, we gainedshare in a shrinking market and extended our leadership in this category. Wesaw a strong performance across the country, including markets such as LosAngeles, Washington D.C., Chicago, San Francisco and Denver. We drove these share gains by staying relevant to both thepro and the do-it-yourself customer, providing them with tools that have thelatest functionality at great value. An example of this was our October launchof the new Ryobi One Plus lithium products, which offers professional featuresat affordable prices. A final comment on areas that we were pleased with in thethird quarter would be our merchandising resets. Where we have completed ourresets and implemented change from our product line review process,collectively these categories are outperforming the store sales performance inline with our expectations. There is no question that we are operating in challengingtimes, and as we look forward, we remain focused on our merchandisingfundamentals, enhancing our processes and strengthening our team. I have talkedto you in the past about our focused bay approach. The company transactionswere down 1.8% for the quarter. However, where we have applied our strategyagainst our specific category roles, we are beginning to see positive results.For example, in toolsets, whose intent is to drive traffic, we have seen thiscategory turn from a negative to a positive comp performance in the quarter. We are also partnering with our suppliers to bring value toour customers. Two weeks ago, we met with all of our top suppliers. We spent alot of time developing actions to more collaboratively solve customer problemsand drive sales for both of our companies. As we look forward to the fourth quarter, we are pleasedwith the early sales of our holiday program and gift oriented products. Thisyear, we expanded and refined our assortment and expect to be the number fourretailer in U.S. holiday décor sales, with double-digit year-over-year growth. We are also focused on managing our seasonal categories,such as heating, snow removal, and organization. Before I turn it over to Paul, I want to mention someexciting changes in our merchandising organization. During the past quarter, wehave invested to add talent within the merchandising team at our senior level.Bruce Marino, a 23-year veteran of the Home Depot has come back tomerchandising after spending eight years as the Western Division President.Bruce is leading our field merchandising teams, merchandise serviceorganization, store environment, and new concepts. We also have three Senior Vice Presidents that areresponsible for our merchandising categories. Another former division Presidentand merchant, Eric Pederson, is our SVP running our building materialsbusinesses. Giles Bowman, who has held various merchandising positionsthroughout the organization, is our SVP for hard lines. And lastly, we are pleased that Gordie Erickson has joinedus as our SVP of Décor. He brings a strong background of merchandising with 32years of experience in home center mass and specialty retailing. Now I would like to turn the call over to Paul."
},
{
"speaker": "Paul Raines",
"text": "Thank you, Craig. As Frank mentioned, we have seensignificant differences in regional performance, driven by macroeconomic trendsand housing indicators. In those markets with favorable housing trends andstrong disposable income, we are seeing positive comp performance. For example,in the Southwest, our Dallas, Austin, and San Antonio markets had positivecomps for the quarter. In those areas that have been the hardest hit by housingturnover and new home sales, we continue to feel significant pressure. It is nosurprise that Sacramento, Las Vegas, and Fort Myers, Naples fall in thiscategory, with Fort Myers Naples posting negative comps in excess of 20%. Our business displays significant variation acrossgeographies and that underscores the importance of having a local focus. Forexample, within our Ohio Valley region, we have relatively stable housingmarkets as well as markets with deteriorating housing indicators, both postingpositive comps for the third quarter. We believe that our performance in these markets is beingdriven by share gains, as well as our focus on our five priorities. Now let’s talk about some of our progress on thosepriorities. This year, we have made a lot of progress on our associateengagement priority and despite the difficult business environment, we aredriving positive changes around our associate reward and recognition programs.We know that the motivation and engagement of our more than 300,000 associatesmake a huge impact on customer satisfaction and on sales. In our second quarter earnings call, we spoke a lot aboutcompensation enhancements. The changes in our success sharing program, anincentive program for hourly associates driven by individual store performance,allowed us to increase our associates participation in success sharing byalmost 40 points year over year for the first half. The largest check an hourlyassociated received was $1,855 and the average check was around $200. The issuance of restricted stock grants have more closelyaligned assistant store managers with the company’s goals. We have also seenpositive results from the reinstitution of our Homer Badge program, whereassociates get rewarded with merit badges for outstanding customer service,which they can submit for cash compensation. To date, over 78,000 Homer Badges have been awarded,including seven gold level badges and two platinum level badges. We have also seen a big impact from our master tradespecialist program. As of last week, we had over 2,000 master trade specialistsin our stores, all being either licensed plumbers or electricians. We areextremely pleased with this program. These specialists are better able to helpcustomers with their plumbing and electrical projects, help train associates,and help us better assort stores to comply with local building codes andrequirements. Our merchant team is also leveraging these specialists byhaving regular conference calls to ensure we are adopting and changing ouroffering in stores to reflect the regional needs of the business. While we view this as an investment in the short-term, weare confident that longer term, we will see a return on this investment. We are seeing the impact of our focus on associateengagement through reduced turnover and our employer of choice survey. As Frankmentioned, voluntary hourly turnover in our stores is down 24% from last year.EOC results indicate that our initiatives in associate engagement are making ameaningful difference. Earlier this year, we surveyed almost 300,000 of ourassociates at both the stores and the store support centers. Our highest scoreswere in those areas that are the most difficult to change -- meaningful andchallenging work, inclusive culture, and work environment. We definitely have room for improvement, particularly inareas like communication and work schedule. We are pleased with the results andfeel we can make progress in the areas that need our attention the most. In terms of shopping environment, we are very pleased withour progress. As most of you know, the average age of our stores is aroundseven years old, a time when you really need to refurbish the stores tocontinue to drive sales. Therefore this year, we increased our maintenancebudget by 2.5 times our 2005 spend, geared at making the stores clean anduncluttered and inviting to our customers. We have integrated our field and store support center teamsto better align ourselves around the needs of the business, as well as adopteda programmatic approach to maintenance. To date, we have polished or spiffed 473 floors, striped1,038 parking lots, remodeled 172 restrooms and now have T5 lighting in 1,765stores. In addition to programmatic maintenance, our integratedfield and support center teams have rolled out store standards to all stores.Through a cross-functional approach, we developed and piloted our basicexpectations for stores and our goal is to drive a foundational level of storeappearance that is agreed upon by our merchants, operators and support teams. To do this, we’ve set common guidelines on appearance andshopability and have created discipline around how the store support center directlyimpacts a store’s environment. The standards provide guidance on things such as front apronmerchandising, wing stack usage, signage presentation, fixturing, and off-shelfproduct. This initiative helps reduce the amount of time our store manages spendon navigating some of these issues, removes unnecessary clutter from the aislesand implements a basic, consistent approach in terms of store appearance. Finally, on our Own the Pro initiative, you’ve heard fromFrank that 2% of our customers drive almost 30% of our sales. Through Dunnhumbyand our credit card programs, we have good information about what this superpremium customer spends in our stores. Over the last quarter, this customer whotypically spends twice to three times as much as a regular customer, hascontinued to shop with us. We are now taking the next steps, building betterrelationships with them, communicating our value proposition, and staying relevant to them through our bid roomand job lot quantities programs, to continue to connect with them and gain agreater share of their wallet going forward. We know these initiatives are making a difference becauseour customers are telling us. Through our voice of customer survey, where wehear from over 200,000 customers a week, we see improvements in likelihood torecommend, find and buy, and our clean and uncluttered metrics. Clean anduncluttered, which measures the shopping environment, is improving faster thanall other metrics. Although we see good progress on our associate engagement,shopping environment, and Own the Pro initiatives, we know that continue toface market headwinds and challenges. Our success will be defined by ourability to remain focused on the fundamentals of the business during thisdifficult environment. I want to make a brief comment on the stores organization.Although Craig was able to lure veteran Western Division President Bruce Marinoaway to merchandising, we could not be happier for Bruce and look forward toworking with him closely going forward. We have replaced Bruce with Joe McFarland, who is our newPresident for the Western Division. Joe is a 16-year veteran with the HomeDepot, who has held various operating positions, including regional vicepresident, district manager, and store manager. I am very excited about havingJoe in this leadership position. One last comment before I turn it over to Carol; it isunfortunate when we face natural disasters but it is during times like thesethat our associates and customers need us the most. Taking care of thecommunity and each other in a disaster is one of the things Home Depot doesbest. During the recent wildfires in California, we saw thousandsof customers and associates evacuated from their homes and many lost theirhomes or sustained significant damage to them. In order to assist ourassociates and customers in need, the Home Depot kept stores open longer thanany other retailer in the area and donated palettes of water, flashlights andbatteries, air purifiers, gloves, and more. Beyond providing the necessaryproducts during this disaster relief effort, our associates also donated theirtime to help in any way needed -- at evacuation centers, building sifters,providing shelter for animals and hosting kids workshops. You can always count on Home Depot to stand tall in times ofneed for our customers and associates. I want to thank each and every one ofour associates for your commitment and sacrifice. You make us proud to wear theorange apron. Now I would like to turn the call over to Carol."
},
{
"speaker": "Carol B. Tome",
"text": "Thank you, Paul and hello, everyone. Before I discuss theresults of the quarter, let me remind you that our third quarter resultsinclude one month of HD Supply as a discontinued operation. As you review ourfinancial statements, please note that the operating results and earningsimpact of the sale of HD Supply are found in a one-line item on our incomestatement entitled earnings from discontinued operations. In the third quarter, sales were $18.96 billion, a 3.5%decrease from last year, reflecting negative same-store sales of 6.2%, offsetin part by sales from new and non-comp stores. Consolidated same-store saleswere negative 5% in August, negative 7.3% in September, and negative 6.3% inOctober. In the third quarter, our gross margin was 33.4%, a decreaseof 18 basis points from the same period last year. Contributing to theyear-over-year decrease in our gross margin rate were the following factors. As expected, our gross margin benefited from lower interestcosts associated with our private label credit card financing program. In thethird quarter, we realized 36 basis points of margin expansion due to lowerinterest costs. We gave up roughly 54 basis points of margin due to a higherpenetration of lower margin products like appliances, as well as markdownstaken to clear through some seasonal items like outdoor power equipment andgrills, and allow us to transition into new products, like assembled cabinetsand kitchen accessories. As a percent of sales, total expenses grew by 183 basispoints to 24.1%. Our expense deleverage reflects the impact of negative sales,where for every point of negative comp, we expect to deleverage expenses byabout 20 basis points. So with a negative comp of roughly 6%, we would expect toreport expense deleverage of 120 basis points. In the third quarter, weexperienced an additional roughly 60 basis points of expense deleverage due totwo main factors. First, during the quarter, we announced our plans to closeour 11 landscape supply locations. We recognized $25 million of expenseassociated with the store closings during the quarter. Second, we share in the profitability of our private labelcredit card portfolio through a gain share program. Private label credit salesmake up about 30% of our total sales. The portfolio remains very profitable butlosses within the portfolio are higher than they were one year ago. As aresult, our gain share was approximately $82 million less than last year. Our expenses reflect investments we are making in support ofour five key priorities. We continue to view payroll as an investment. As apercent of sales, total payroll increased by 51 basis points over last year,which includes investments in our master trade specialist program, as well asexpense associated with employee bonus programs like success sharing.Currently, 57% of our stores are eligible for success sharing compared to 22%last year. As a result of the factors I just mentioned, our operatingmargin declined from last year. Our operating margin for the third quarter was9.3% as compared to 11.3% last year. Net interest expense was $125 million inthe third quarter, up $33 million from last year, reflecting higher levels ofoutstanding indebtedness. In the third quarter, our income tax provision rate forcontinuing operations was 34.7% compared to 37.4% last year. In the thirdquarter, we reached agreement with tax authorities on several state and federaltax audits. As a result, we recognized a $35 million tax benefit in thequarter, as well as some related interest expense benefits. Earnings from continuing operations were $1.1 billion, ascompared to $1.3 billion last year, and continuing earnings per diluted sharewere $0.59, down 9.2% from last year. Diluted shares for the third quarter were1.815 billion shares compared to 2.05 billion shares last year. The reduction in outstanding shares is due to the sharerepurchase program we began in 2002, including the 289 million shares werepurchased in our recent tender offer. Through the end of the third quarter,we had repurchased a total of 743 million shares. Earnings for our discontinued operation, HD Supply, were $20million. Included in this quarter’s results are the net after tax financialresults for the month of August, as well as the impact of the sale of HDSupply. After expenses and taxes, we recognized a $4 million loss on the saleof the business. Moving to our operational metrics, during the third quarterwe opened 25 new stores, including one relocated store, for an ending storecount of 2,224. Today, 236 stores representing approximately 11% of our storebase, operate in Canada, Mexico, and China. At the end of the third quarter, selling square footage was233 million, a 5.4% increase from last year. The average square footage perstore was 105,000 square feet, the same as last year. Reflecting the sales environment, total sales per squarefoot were approximately $323 for the quarter, down 7.8% from last year. Whilethe year-over-year trends for our new stores were also negative, sales persquare foot for our new stores had their best year-over-year performance sincethe fourth quarter of 2006. At the end of the quarter, retail inventory was $12.6billion, an increase of 3.7% from last year. On a per store basis, inventorywas down 1.9% from last year. Inventory turns were 4.4 times, slightly lowerthan last year. Computed on the average of beginning and ending long-termdebt and equity for the trailing four quarters, return on invested capital forour retail business was 15%, reflecting a 130 basis point improvement from thesecond quarter of 2007. We ended the quarter with $45.5 billion in assets, including$550 million in cash and short-term investments. This is a decrease ofapproximately $64 million in cash from the end of fiscal 2006, reflecting cashgenerated by the business of approximately $5.8 billion, net proceeds from thesale of HD Supply of $8.3 billion, along with commercial paper issuances of$748 million, offset by $2.5 billion of capital expenditures, $325 million paidfor a minority interest in HD Supply, $1.3 billion of dividends paid, and $10.8billion paid for share repurchases. For the year, we now estimate our total capital spendingwill be approximately $3.9 billion. Given our performance to date and the softness we continueto project for the rest of 2007, we think our comps for the year will benegative 6% to 7%, and earnings per share from continuing operations on a52-week basis will be down as much as 11% from last year. Finally, I want to give you our latest thinking on thecompletion of our $22.5 billion recapitalization plan. As Frank mentioned,since we announced the plan in June, we have completed about 50% of our recap.As you know, both the credit market and the housing market have become moredifficult since June. We believe it is prudent to take a cautious stance withregard to the completion of the recap. We will move forward when we seeimprovement in both the home improvement and credit market, which we believewill not occur until some time in 2008. We will keep you appraised of our plans and during ourfourth quarter conference call, we will provide you with sales, earnings, andcapital spending guidance for fiscal 2008. Thank you for your participation in today’s call and we arenow ready for questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) We’ll go first to Chris Horvers atBear Stearns."
},
{
"speaker": "Chris Horvers - BearStearns",
"text": "Thank you and good morning, everybody. First question on therecap program, I think when we are out here speaking with investors and weunderstand being pushed back because of the credit market aspect but pushing itback because of the home improvement market, what do you say to people who turnand say well, if they are not interested in buying our stock, why should I?"
},
{
"speaker": "Frank Blake",
"text": "I think again, as we’ve said, it is looking at both marketsand saying what is the prudent thing for us to do for our shareholders. If yousaid all other things being equal, we were planning to go forward at the end ofthis year and then take another step in the spring, but all things reallyaren’t equal, both in terms of the credit market and we do think it makes senseto look at the housing market and see what’s happening in the housing marketbefore making another major commitment."
},
{
"speaker": "Chris Horvers - BearStearns",
"text": "Could you just expand on that last part? Why would you belooking at the housing market?"
},
{
"speaker": "Frank Blake",
"text": "I think again for us, we look at both what our projectionwas for the year, where it turned out, and we want to get a better sense of2008 and we are frankly just in the middle of the planning process around 2008."
},
{
"speaker": "Carol B. Tome",
"text": "Chris, you’ll recall that from a capital strategyperspective, we have targeted an adjusted debt to EBITDAR leverage ratio of 2.5times, and so clearly the housing market will impact our adjusted EBITDAR, andso we are just working through our plans for 2008 and looking at that relativeto our financing plans."
},
{
"speaker": "Chris Horvers - BearStearns",
"text": "One follow-up question, Carol; as we think about 2008, andunderstand you haven’t given guidance yet, we know sales -- it’s going to be atough environment and we had the second downturn in the housing. As we thinkabout the deleverage that might occur in ’08, does the accelerated maintenanceand the additional store investment this year make the potential deleverageless next year for every 100 basis points of comp?"
},
{
"speaker": "Carol B. Tome",
"text": "Well, it’s a great question. We had some catch-up spendingin 2007, as we’ve talked to you about. Again, we are not giving guidance todayfor 2008 because we are just building our plans. But as we look at our businessmodel, we believe that we will still, for every negative point of comp sales,deleverage expenses by 20 basis points. Then there will be some other goes-insand goes-outs that we’ll talk to you about."
},
{
"speaker": "Chris Horvers - BearStearns",
"text": "Thank you very much."
},
{
"speaker": "Operator",
"text": "Next we’ll move to Deborah Weinswig at Citigroup."
},
{
"speaker": "Deborah Weinswig -Citigroup",
"text": "Good morning. Frank, I believe Carol had highlighted thefact that 57% of stores this year are eligible for success sharing versus 22% ayear ago. I would assume that that’s very important for employee morale. Canyou talk about if you’ve changed the target or how you’ve gotten to a highernumber year over year, and just what it means for the employees?"
},
{
"speaker": "Frank Blake",
"text": "Yes, we did change the targets, so previously we tended tohave a stretched target in order to get into success sharing, and then you hadto hit 100% of the target. So for this year, we changed that approach and madeit a percent of target and at the time, we were thinking the target we set outwas a very reasonable target, with again, the basic principal being we wantedour associates to feel the benefit of success sharing and then earn their wayup into additional dollars, rather than feeling demotivated from the start at atough plan that they didn’t think they could achieve."
},
{
"speaker": "Deborah Weinswig -Citigroup",
"text": "Okay, and then last question, in terms of helping theassociates in a tough environment, are there any additional tools that you areproviding them with in store to help serve customers or help them upsell?"
},
{
"speaker": "Paul Raines",
"text": "I’ll take that one. There is a series of activities in thestores around learning that are very important. We’ve spent a lot of timerefocusing in the first half of this year around in-the-aisle learning andemphasizing project and product knowledge versus the heavily e-learning focusthat we’ve had previously. So that’s one of the tools we’ve given them. At the same time, we are doing a tremendous amount of focuson our VOC activities and giving them a lot of feedback and metrics around whatcustomers are saying about the business. So we feel that we are giving ourassociates a lot more tools around the customer and around product knowledgeand helping customers do projects in their homes through this first half."
},
{
"speaker": "Deborah Weinswig -Citigroup",
"text": "Great. Thank you very much."
},
{
"speaker": "Operator",
"text": "And next we’ll move to Stephen Chick with J.P. Morgan."
},
{
"speaker": "Jeff Wimmer - J.P.Morgan",
"text": "This is actually Jeff Wimmer on behalf of Stephen Chick. Ihave a question about your guidance, if you could delve in a little bit moreabout that. It looks like sales remain relatively the same, in that high,mid-single digit range, but could you talk about the split between growth andSG&A deleverage? Are you still looking for up gross margins year over year?"
},
{
"speaker": "Carol B. Tome",
"text": "Yes, year over year we are projecting slight marginexpansion. On the expense side, the expense deleverage that we saw in the thirdquarter will continue into the fourth quarter."
},
{
"speaker": "Jeff Wimmer - J.P.Morgan",
"text": "Okay, and then I might have missed this because I got on thecall a little late, but did you give intra-quarter sales yet?"
},
{
"speaker": "Carol B. Tome",
"text": "From a comp perspective?"
},
{
"speaker": "Jeff Wimmer - J.P.Morgan",
"text": "From a comp perspective, yes."
},
{
"speaker": "Carol B. Tome",
"text": "We sure did, and let me just tell you negative 5 in August, negative 7.3 in September, negative 6.3 in October."
},
{
"speaker": "Jeff Wimmer - J.P.Morgan",
"text": "Okay, and then also, just thinking about going forward, youhave the $600 million reinvestment plan. Is this going to be somethingreoccurring next year? Will there be additional incremental investment as welook into ’08?"
},
{
"speaker": "Carol B. Tome",
"text": "At the beginning of the year, we said that we were investing$2.2 billion in support of our five key priorities, $1.6 billion for capital,$600 million of expense. Some of that expense was catch-up spending. We willcontinue to invest in the key priorities in 2008. Just to update the capital bit, we are going to spend thisyear we project about 1.3 against the original 1.6 target, but that’s reallybecause of the sale of HD Supply."
},
{
"speaker": "Jeff Wimmer - J.P.Morgan",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Next we’ll move to Budd Bugatch at Raymond James."
},
{
"speaker": "Budd Bugatch -Raymond James",
"text": "Good morning. Let me ask you a question -- my first questionreally goes to appliances. Can you update us where you are on share onappliances? I noticed in some stores maybe some additional square footagethrough the use of mezzanines. Is that prevalent in a number of stores?"
},
{
"speaker": "Frank Blake",
"text": "Budd, that’s a very limited pilot that we were running and Iwould not expect to see a lot more of those, but let me turn it over to Craigfor general comments on appliances."
},
{
"speaker": "Craig Menear",
"text": "For appliances overall, again we were pleased with theperformance there. We’ve achieved a 12.4% penetration in terms of market shareversus 10.7 ayear ago, up again from Q2, which was at 11.7, so the customer really continuesto respond to the offering that the team has put together."
},
{
"speaker": "Budd Bugatch -Raymond James",
"text": "And Craig, those are unit shares?"
},
{
"speaker": "Craig Menear",
"text": "Yes."
},
{
"speaker": "Budd Bugatch -Raymond James",
"text": "Okay, and if we could also, my last question is to talk alittle bit about any additional talent or what you see in the merchandisingorganization with Gordie’s coming on board, or can you talk about maybe whatother needs you might have?"
},
{
"speaker": "Craig Menear",
"text": "Well again, very excited to not only have Gordie on boardbut also to have Bruce join us, coming in from the field to help us reallycoordinate and connect with our regional team as we continue to try to drivethe regional assortment variations that we need across our business and getthat executed for the stores. And with Gordie joining us, again great retail talent. Ithink well respected in terms of his knowledge, both in mass discount andspecialty retailing and it’s a super addition to our team. We feel very good about the overall team that we have inplace right now and looking forward to driving the business."
},
{
"speaker": "Budd Bugatch -Raymond James",
"text": "Okay, and Carol, could you just give us what the tax rate isgoing forward? Any more tax issues?"
},
{
"speaker": "Carol B. Tome",
"text": "We project that the provision rate for the year will be36.5%."
},
{
"speaker": "Budd Bugatch -Raymond James",
"text": "Okay, that helps."
},
{
"speaker": "Operator",
"text": "We’ll go next to Matthew Fassler at Goldman Sachs."
},
{
"speaker": "Matthew Fassler - GoldmanSachs",
"text": "Thanks a lot. Just a couple of quick questions here. Firstof all, the average ticket decline seemed to moderate a bit. If you could giveus any color on why you think that happened, be it mix or other factors. And then just by way of follow-up, Carol, on the recap,would you continue to expect to deploy free cash against buy-backs or would youhold off on that as well?"
},
{
"speaker": "Frank Blake",
"text": "Craig, why don’t you comment on the average ticket."
},
{
"speaker": "Craig Menear",
"text": "On average ticket overall, again what we saw there was someshift in mix that is impacting that business. When you look at what happened tothe lumber and building materials categories, as that relates to a largerrepair/remodel project overall, that certainly had an impact on the category. We did see some shifting and we are seeing withincategories, for example, in a little more discretionary spend categories likeoutdoor power equipment, we saw some shift down in the line, which impacted theticket in that category as well."
},
{
"speaker": "Carol B. Tome",
"text": "Just another comment on the ticket, if you look at just thesequential performance, Q3 to Q2, in Q3 we picked up $0.22 of average ticketgrowth because of an increased appliance penetration. We didn’t have that samebenefit in the second quarter, so that’s part of what you are seeing. And on the recap question, as Frank said in his comments, weremain committed to our capital allocation strategy where we will alwayscompare the use of excess cash, returning that to our shareholders versussomething else, and so yes, we’ll remain committed to that."
},
{
"speaker": "Matthew Fassler -Goldman Sachs",
"text": "But just to clarify, to the extent that you are talkingabout holding off on the recap, you’re talking about holding off borrowing moremoney to buy back stock, not the repurchase of stock in and of itself?"
},
{
"speaker": "Carol B. Tome",
"text": "Right. Now remember, we have $748 million of outstandingcommercial paper, so we don’t have excess cash as we are sitting today."
},
{
"speaker": "Matthew Fassler -Goldman Sachs",
"text": "Fair enough. Okay, thank you."
},
{
"speaker": "Operator",
"text": "Next we’ll go to Danielle Fox at Merrill Lynch."
},
{
"speaker": "Danielle Fox -Merrill Lynch",
"text": "Thanks. Good morning. I guess just looking backhistorically, the retail business has had an operating margin as high as 11.8%,which is about 200 basis points above where you are tracking this year. I’mwondering what needs to happen to get back up to those levels. Presumably youneed to return to positive comps, but do some of these supply chainenhancements that you are beginning also need to work out in order to return tothe 11.8%?"
},
{
"speaker": "Frank Blake",
"text": "I think first, clearly positive comps, because that leverspositively versus the negative, the deleverage that we see now. And thensecond, you are exactly right in terms of improving. What we see is thesubstantial investment that we are going to make in our supply chain will helpus improve our operating margins, as will the merchandising transformationthat’s really at the heart of core retail."
},
{
"speaker": "Danielle Fox -Merrill Lynch",
"text": "You don’t see anything as having changed in the underlyingcost structure that would prevent you from returning to those levels, giventhat you did need to step up the P&L investing beginning in the second halfof ’06?"
},
{
"speaker": "Frank Blake",
"text": "No, I would say 11.8 is a long ways away, but we think thereis significant improvement from where we are."
},
{
"speaker": "Danielle Fox -Merrill Lynch",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Next we’ll go to Gregory Melich at Morgan Stanley."
},
{
"speaker": "Gregory Melich -Morgan Stanley",
"text": "Thanks. I have two questions; Frank, did we start on theCanadian rollout of the merchandising system that was mentioned as somethingthat will happen next year? Is that a pilot or is that across all the stores or-- just fill us in on the timing there."
},
{
"speaker": "Frank Blake",
"text": "The timing is around the end of March, the pilots will -- Imean, the way the actual rollout works is it starts with a set of pilot storesand you pilot that for several weeks and then fix any bumps that occurredduring the pilot process and then we expect to have it rolled out to everystore in Canada by the end of 2008."
},
{
"speaker": "Gregory Melich - MorganStanley",
"text": "And if I remember correctly, there was a plan to maybeaccelerate the U.S. following that. Is that still the case? Or that will be a’09 business?"
},
{
"speaker": "Frank Blake",
"text": "The way we are setting this up, and I think the tremendousadvantage that we have with Canada as our laboratory, in effect, is that we aregoing to look very closely at what the results are from Canada, both pilot androllout, and that’s going to determine the pace that we take on the U.S. side."
},
{
"speaker": "Gregory Melich -Morgan Stanley",
"text": "Okay, so stay tuned, basically."
},
{
"speaker": "Frank Blake",
"text": "Yes."
},
{
"speaker": "Gregory Melich -Morgan Stanley",
"text": "Okay, and the second question, Carol, is a follow-up on theearnings share of the credit business. I think you said it was $83 million. DidI get that number right?"
},
{
"speaker": "Carol B. Tome",
"text": "It’s $82 million year over year."
},
{
"speaker": "Gregory Melich -Morgan Stanley",
"text": "So was that -- but it was still profitable in the quarter?"
},
{
"speaker": "Carol B. Tome",
"text": "Yes, it certainly is -- very profitable."
},
{
"speaker": "Gregory Melich -Morgan Stanley",
"text": "And was that swing -- would you call that an ongoing --"
},
{
"speaker": "Carol B. Tome",
"text": "Yes, you know --"
},
{
"speaker": "Gregory Melich -Morgan Stanley",
"text": "-- provision that you [unwound], effectively."
},
{
"speaker": "Carol B. Tome",
"text": "It’s a good question. It’s the loss piece of the portfolio.The portfolio is really a good portfolio. The losses have been running in the4%, 4.5% range. They’ve popped up. We’re now projecting they’ll be in the 6%range which, relative to other credit card portfolios is not bad, but it’shigher so it means the profitability isn’t as large as it was, so we didn’t getas much of a share gain in the quarter. And that pressure will continue intothe fourth quarter."
},
{
"speaker": "Gregory Melich -Morgan Stanley",
"text": "Okay, so we think that 6% is now a good ongoing number thatwe should use?"
},
{
"speaker": "Carol B. Tome",
"text": "Well, we’re going to be watching it very, very carefully.Some other stats, just for your information, 65% of the portfolio has FICOscores greater than 650, so that’s very high quality. But 17% of the portfoliohas FICO scores of less than 600, so we are going to be watching this verycarefully. I mean, the credit market is interesting in today’s environment."
},
{
"speaker": "Gregory Melich -Morgan Stanley",
"text": "And are you -- on the downside there, is there like astop-loss so to speak, that you share profits but is there a cap on that or no?"
},
{
"speaker": "Carol B. Tome",
"text": "The profits that are share is over a threshold, over anearnings threshold. We’ve got a long way to go before that would happen."
},
{
"speaker": "Gregory Melich -Morgan Stanley",
"text": "Okay, great. Thanks."
},
{
"speaker": "Operator",
"text": "Our next question comes from Eric Bosshard at ClevelandResearch."
},
{
"speaker": "Eric Bosshard -Cleveland Research",
"text": "Good morning. Two questions -- first of all, on the recap,is the -- waiting to see what you are going to do next year, is that based asmuch on uncertainty about the EBITDA of the business next year? Is that theprimary driver to how you are rethinking the pace of which you are going tomove on that?"
},
{
"speaker": "Frank Blake",
"text": "Well, as both Carol and I said in our comments, it is boththings, both the credit markets and the underlying housing market. As Carolindicated, obviously the underlying housing market impacts our performance,which impacts our EBITDA which impacts our coverage. And for where we are now, I think it’s worth pausing andrealizing look, the window has been closed on us, so we could not have been buyingeven if we had wanted to. The window is now open and you would say -- we’d saylooking at our business and looking at the credit market that this is a time topause and make sure we’ve got a pretty firm idea going forward before makingthat second and third steps in the recapitalization plan, which again, as Isaid in the initial comments, we remain committed to. It’s really just aquestion of figuring out the right timing."
},
{
"speaker": "Carol B. Tome",
"text": "And we certainly have debt capacity. If you look at ouradjusted debt-to-EBITDA ratio for the trailing 12 months, it’s 1.9 times, sowe’ve got debt capacity."
},
{
"speaker": "Eric Bosshard -Cleveland Research",
"text": "Okay, and then secondly, understanding the uncertainty,you’ve made the decision to move slower on the repurchase. I understand thatbut in terms of the capital and the sales investment that you are going to makein the business for next year, how are you thinking differently about that? Isthat a wait and see how sales are until you determine what you are going toinvest in the business? Or are you going to continue to make the investmentregardless of the sales environment?"
},
{
"speaker": "Frank Blake",
"text": "We are continuing to make the investment in the business tomake the customer experience the best possible customer experience. I’d saywhere there’s an impact and where you’ve already seen an impact this year is inour new store opening and taking down our new store opening, both for 2007, asCarol indicated, that reduced our CapEx for 2007 and into 2008."
},
{
"speaker": "Carol B. Tome",
"text": "And you’ll recall, Eric, at the beginning of the year, wesaid we would spend $4.5 billion in capital. We are going to spend 3.9. Thatincludes about $200 million at supply, so in the retail business about 3.7 andthe delta from the beginning of the year is really new store capital."
},
{
"speaker": "Eric Bosshard -Cleveland Research",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "We’ll go next to Gary Balter at Credit Suisse."
},
{
"speaker": "Shannon Coyne -Credit Suisse",
"text": "This is actually Shannon Coyne for Gary. I just had onequestion -- how much of the lower guidance is due to the reinvestment in thestores, or minimum labor standards that you’ve put in place versus theworsening housing markets?"
},
{
"speaker": "Carol B. Tome",
"text": "For the fourth quarter and full year, Shannon?"
},
{
"speaker": "Shannon Coyne -Credit Suisse",
"text": "Yes."
},
{
"speaker": "Carol B. Tome",
"text": "If we’re looking at comps of negative 67%, earnings fromcontinuing operations, EPS down 11%, implied in that is expense deleveragealong the lines of what you saw in the third quarter, and gross marginexpansion. And the expense deleverage is just a factor of the negative compsthat we are projecting, the investment, and some continued pressure on credit."
},
{
"speaker": "Shannon Coyne -Credit Suisse",
"text": "Okay, thanks."
},
{
"speaker": "Operator",
"text": "Next we’ll take a question from Colin McGranahan atBernstein."
},
{
"speaker": "Colin McGranahan -Sanford Bernstein",
"text": "Good morning. I wanted to focus first on the expense line alittle bit. As I look at the expense dollars, year over year the growth rate ofthose dollars is about 4.1%, which is -- looks like a deceleration of about 100basis points from roughly 5% growth rate in the first half of the year. Givensuccess sharing dollars look like they were probably pretty consistent, youhave this $82 million negative year-over-year delta in the credit portfolio,square footage growth is pretty much the same at 5.4%, what was it that causedthe expense dollars to decelerate and where did you realize some expensesavings in the business?"
},
{
"speaker": "Carol B. Tome",
"text": "We didn’t call it out in our prepared remarks, but just likethe second quarter, we were actually under our expense plan in the third quarter.Every day we wake up and look at sales, we look at cash, and we look at wherewe control expenses so it doesn’t impact the customer experience. And we’ve hadgood expense control in areas like advertising. We might want to talk about payroll, it’s our biggestexpense. On the payroll side, wages are up year over year. That’s reflectingthe investments that we are making but as you would expect, we’ve got anactivity-based labor model and the hours in the stores are actually lower thanthey were a year ago, as you would expect, because we have less activity in thestores. On the G&A side, we’ve got unbelievable expense control.We’re investing where we need to invest but where we can cut costs, we are."
},
{
"speaker": "Colin McGranahan -Sanford Bernstein",
"text": "So were labor dollars then growing at a slower rate in thethird quarter than they were in the first half of the year?"
},
{
"speaker": "Carol B. Tome",
"text": "They were."
},
{
"speaker": "Colin McGranahan -Sanford Bernstein",
"text": "Okay, so that was a savings, then advertising is a savingsand just tightening the nuts on the G&A."
},
{
"speaker": "Carol B. Tome",
"text": "Yes. And still there are lots of other small goes-ins andgoes-outs, but yes, those are the big buckets."
},
{
"speaker": "Colin McGranahan -Sanford Bernstein",
"text": "Okay, and is that 4% a reasonable pace going forward?Because it looks like that $82 million credit delta is probably recurring andgiven probably some stress levels of some of your larger pros that are sittingon those credit cards, that may actually be getting worse, not better."
},
{
"speaker": "Carol B. Tome",
"text": "Well, I think we’ve given you pretty good guidance for theyear, so you can do the math."
},
{
"speaker": "Colin McGranahan -Sanford Bernstein",
"text": "Okay, and then my second question just on traffic. Obviouslyticket improved sequentially a little bit. It looks like there was a prettysignificant deceleration in traffic. Would you peg any of that to kind ofseasonal variances and the drought conditions and thinks like that? Or was itjust general housing market?"
},
{
"speaker": "Craig Menear",
"text": "Not really -- as we looked at the traffic, just let meaddress the drought question. We saw some impact in categories like live goods,pressure washers, and power equipment in the southeast area of the country. Itwasn’t material overall in the quarter. We did take the opportunity to movesome power equipment into the southwest region of the country, which wasperforming extremely strong, and to make sure that we continued to leverage theopportunity in that business. But overall, I wouldn’t say that weather was the impact tothe average ticket."
},
{
"speaker": "Colin McGranahan -Sanford Bernstein",
"text": "To the traffic?"
},
{
"speaker": "Craig Menear",
"text": "Or traffic, I’m sorry, yes."
},
{
"speaker": "Colin McGranahan -Sanford Bernstein",
"text": "Okay, great. Good luck, guys. Thanks."
},
{
"speaker": "Diane Dayhoff",
"text": "We have time for one more question."
},
{
"speaker": "Operator",
"text": "Okay, and we’ll go to Brian Nagel at UBS."
},
{
"speaker": "Brian Nagel - UBS",
"text": "Good morning. A question on -- as we see the weakness in theU.S. dollar here, and [you are presumably] sourcing more products overseas,what impact has that or could that have upon your business or specific grossmargins in the coming quarters?"
},
{
"speaker": "Craig Menear",
"text": "When we look at what’s going on with the dollar right now,certainly there is some pressure out there but we are working hard with oursuppliers to really work through that pressure with them to find other waysthat we can work together to take mutual costs that we have out of our businessand really not let that impact the retail environment whatsoever, so we’re notseeing a significant change overall."
},
{
"speaker": "Brian Nagel - UBS",
"text": "That’s helpful, and then one very quick question; I noticedin the guidance, it seems like the benefit of that extra week from an EPSperspective change this time in your guidance. What explains that?"
},
{
"speaker": "Carol B. Tome",
"text": "We tightened up our forecasts. We had carried over somecosts into that extra week that we didn’t need to, and so we just have a betterforecast."
},
{
"speaker": "Brian Nagel - UBS",
"text": "Okay, fair enough. Thank you very much and good luck nextquarter."
},
{
"speaker": "Frank Blake",
"text": "Thank you all very much."
},
{
"speaker": "Diane Dayhoff",
"text": "Thank you for joining us and we look forward to the callnext quarter."
},
{
"speaker": "Operator",
"text": "And that does conclude today’s conference. Again, thank youfor your participation."
}
] | null | null |
HD | 2 | 2,007 | 2007-08-14 09:00:00 | Executives: Diane Dayhoff - IR Frank Blake - Chairman, CEO Craig Menear – SVP, Merchandising Carol Tome - CFO Mark Holifield – VP, Supply Chain
Analysts: Matthew Fassler - Goldman Sachs Budd Bugatch - Raymond James Seth Basham - Credit Suisse Steve Chick – JP Morgan Colin McGranahan - Bernstein Mike Baker - Deutsche Bank Parham Behrooz - Evergreen Investments Frank Gallagher - Catalyst Funds David Schick - Stifel Nicolaus Eric Bosshard - Cleveland Research Susan Hutman - Alliance Bernstein Danielle Fox - Merrill Lynch
Operator: Good day, everyone and welcome to today's Home Depot second quarter earnings conference call. As a reminder today's call is being recorded. Beginning today's discussion is Ms. Diane Dayhoff, Senior Vice President of Investor Relations. Please go ahead, ma'am.
Diane Dayhoff: Good morning to everyone. Welcome to the Home Depot second quarter earnings conference call. Joining us on our call today are Frank Blake, Chairman and CEO of the Home Depot; Craig Menear, Executive Vice President, Merchandising; and Carol Tome, Chief Financial Officer and Executive Vice President, Corporate Services. Following our prepared remarks the call will be open for analyst questions. Questions will be limited to analysts and investors, and as a reminder, we would appreciate it if the participants would limit themselves to one question with one follow-up please. This conference call is being broadcast real time on the Internet at HomeDepot.com with links on both our homepage and the investor relations section. The replay will also be available on our site. If we are unable to get to your question during the call, please call our Investor Relations department at 770-384 -2387. Before I turn the call over to Frank, let me remind you that today's press release and the presentations made by executives include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties. These risks and uncertainties include, but are not limited to, those factors identified in the release and in our filings with the Securities and Exchange Commission. Now, let me turn the call over to Frank Blake.
Frank Blake: Thank you, Diane and good morning, everyone. Let me start by saying that I realize that many of you want to know where we stand on the sale of our HD Supply business. Unfortunately, I have no new details to add. We remain in discussions with the buyers and I'm not in a position to answer the very reasonable questions you may have about what is the likely outcome. What I can talk about this morning is the performance of our core retail business. Our market continues to be a challenging one. You are familiar with the statistics: housing starts are down 22%, existing home sales are down 12%, inventory of homes for sale is at 8.7 months -- a 15-year high -- and the home builder index is at 24%, a 16-year low. In addition, the issues around the subprime market continue to intensify and this is an important concern both for the financial markets generally and for housing specifically, since subprime mortgages accounted for 24% of the dollar volume in the mortgage market last year. So this is a difficult time and our performance reflects that. Sales were $22.2 billion, down about 2% for the quarter. Comp sales were a negative 5.2%. Diluted earnings per share from continuing operations were down 6% at $0.77. Despite the difficulties, there were some positive signs for us. First, on the comp sales side, we did see strength in regions of the country with our Southwestern and Ohio Valley markets posting positive comps. The second positive sign is that our transactions grew year-over-year. While we still had negative comp transactions, this was our best comp transaction performance in awhile. As Craig will review with you, we also believe that we gained share in some key product categories and for our overall market, we have reversed our market share loss; or in other words, we're not losing market share as fast as we were. But as that last phrase indicates, we have a long way to go to get to where we need to be. We don't want to be losing less share; we want to be gaining share and outperforming our market, so we will continue to invest in our stores and in our associates to improve customer service. In addition, we'll continue to look for more cost effective and productive ways to manage non-customer facing activities. Here is a quick update on the progress we've made on our five key priorities: We are restructuring the way our associates are compensated, recognized and rewarded to make it clear that taking care of our associates is one of the core values of the company. As an example, one program we restructured was success sharing, an incentive sharing for our hourly store associates driven by individual store performance. 74% of our stores or over 200,000 of our associates will receive a success sharing payout for the first half which compares to 33% of our stores or about 86,000 associates in the first half of last year. The payout on success sharing is nearly three times what it was last year. We want to recognize and reward our associates for the hard work they're doing and we believe this is contributing to the improvement we are seeing in associate retention. We have picked up considerable momentum in our Master Trade Specialist Program and we now have over 700 licensed electricians and plumbers in our aisles. We've reallocated our resources, putting more at the division and regional levels and have pushed more decision-making closer to the customer to take greater advantage of unique regional opportunities across the country. In our merchandising organization, we have created three new Senior Vice President positions reporting to Craig and have staffed two positions with Home Depot veterans and are conducting an internal and external search for a third, as well as another Senior Vice President position that's open in merchandising. In our supply chain organization, Mark Holifield has added leaders with experience developing and implementing large scale retail systems and comprehensive retail supply chain strategies. We have dedicated a regional Vice President, a Merchandising Vice President, and a Logistics Vice President to our U.S. core retail project team to ensure this effort gets the focus that's required for successful implementation. We are past the halfway mark for the year on planned maintenance projects such as restroom remodels, floor polishing, relamping and lot striping and these efforts are reflected in higher voice of customer scores compared to last year. For example, we've seen year-over-year improvement in our store environment, clear and uncluttered aisles as well as associate availability and likelihood to recommend scores. Now let me address our international business. Our international businesses -- Canada, Mexico, and China -- performed well during the quarter. Our Canadian stores posted positive comps and our Mexican stores posted double-digit positive comps in the quarter. We've been in China less than a year and we continue to be excited about the opportunities this market presents. Let me finish with this comment: the second quarter was more difficult than disappointing. As Carol will go through, our results for the most part were in line with our expectations. We expect continued difficult conditions in the back half of the year but our investments are not for the short term, they are for the long term health and growth of the business and we believe we are seeing signs of progress. Now, let me turn the call over to Craig.
Craig Menear: Thank you, Frank and good morning, everyone. While comp sales in the second quarter continued to be negatively impacted by the current housing environment, we have made progress in executing our merchandise strategy resulting in sequential year-over-year improvements in sales growth, gross margin expansion, and inventory velocity. In the second quarter, four departments outperformed the company's comp: garden, flooring, paint and plumbing. Six departments performed below the company's comp: hardware, lumber, kitchen/bath, lighting, building materials and millwork. Commodity deflation of lumber as well as softness in certain big ticket categories impacted average ticket which was down 2.8% from last year to $58.30. Over the past several years, we have seen a benefit from the sale of appliances in our average ticket. This quarter the average ticket benefit from appliances remained the same as last year. Despite the challenging selling environment we made progress this quarter. Our comp transactions while down 2% were better than we've seen many years. Our total transactions were up 1%. We saw market share improvements in key areas resulting from the merchandise actions we've been taking in the most recent quarters. We have shared with you that we've been taking action to turn around our flooring business. Our merchandising team’s efforts have started to gain traction as we saw market share gains in both hard and soft flooring in the second quarter. For example, carpeting is an area where we gain share in a flat market by accelerating our product line review process and improving our assortment with the addition of 40 new styles, each offering 12 color choices. We also improve the overall shopping experience by enhancing our merchandising displays. Our investment in flooring displays and resets have made a positive impact on the customer’s ability to shop this category. Finally, by creating a tighter association between our install services program, our merchandise and marketing we simplified the installation offers to our customers which drove sales and positive gross margin results. Our market share of paint sales grew this quarter, primarily driven by innovation, seasonally relevant products like our exclusive Behr Nanoguard exterior paint that requires no priming. We believe this quarter’s paint performance was supported by the positive customer response to the Behr Challenge marketing campaign where our customers were invited into our stores to compare Behr’s outstanding performance and value to other brands. Behr has been consistently rated number one in independent product testing for the past four years. As customers expand their homes into the backyard, outdoor living continues to be a major trend with patio and grills leading the way in bringing customers affordable luxury. We saw significant gains in grills this quarter driven by the success of the Charmglow brand. In patio, we expanded our assortment to focus alternative, casual seating groups, our selection in seating and tabletop dining sets helped cement our success this season. We gained significant market share in patio furniture and further extended our leadership in this category. In a shrinking appliance market, we continue to gain share this quarter, building on the gains that we've seen for the last few years. Customers continue to be pleased with the innovation, style, and design we offer in appliances. Second quarter results were driven by sales of innovative washers, dryers and refrigerators such as the Maytag Bravo high efficiency top-load washers and matching dryers and the GE Adora refreshment center side by side refrigerator, both found exclusively at the Home Depot. The professional customer remains a key focus for us. We're pleased with the quarter’s market share results in areas like gypsum, windows, and power tools. Gains in the power tools are driven in part by the products such as the new Makita magnesium lightweight more powerful circular saw which was well received by our professional customers. Our execution this spring led to good results in seasonal categories with particularly strong results in live goods. We're also pleased with our performance over key holidays like Memorial Day, 4th of July, and Father's Day where we had strong weekends. We're making progress but we still have a lot of areas where we have opportunity. In the second quarter we lost share in kitchen and millwork and let me share with you some of the actions we're taking in these areas. We are in the midst of replacing the ready to assemble kitchen cabinets in most markets that we have carried this product for over 20 years. We accelerated the exit of this category by taking markdowns in the second quarter to bring a new line of assembled cabinets into the majority of our stores by the end of the third quarter. This product offering better address the needs of our pro and serious do-it-yourself customers than ready to assemble product. We will continue to offer ready to assemble cabinets in those markets where it remains important to our customers. In millwork, we updated our door program by introducing new products at great prices and enhancing our regional mix. During the quarter we introduced a number of new wood grain collections and glass styles in our Feather River fiberglass door program. These additions continue to expand and update our fiberglass offering to show the latest trends and styles in decorative exterior doors. Looking to the third quarter I'm really excited about the new products that you'll see in our stores. First, we'll continue to bring affordable luxury to our customers by introducing products such as our exclusive line of Arietta designer range hoods which offers the style and quality of premium brand designer hoods at half the price. In addition we're excited about our new LG Kitchen Series tat's being introduced right now. This is a high end suite of Kitchen Appliances that includes a steam dishwasher. Second, we'll introduce several products that will bring Pro features to the do-it-yourselfers such as Home Life’s lightweight backpack leaf blower. In door locks we'll introduce Kwikset smart key door locks that makes rekeying simple and easy for our homeowner. This exclusive launch will be great for our DIY and our Pro repair and maintenance customers. In power tools, we will enhance our current line up of lithium ion products with new Black and Decker and Ryobi tool lines. The Black & Decker BDX lithium ion line offers great design features and value to the eco boomers who are just buying their first set of tools. Our current Ryobi One Plus assortment will be enhanced with lithium products that offer professional performance at outstanding values. With products like these and our focus on executing merchandising fundamentals, we bring excitement to our stores and deliver greater value to our customers. Now I'd like to turn the call over to Carol.
Carol Tome: Thank you, Craig and hello, everyone. Before I discuss the results of the quarter, let me remind you that we are now reporting the results of HD Supply as a discontinued operation. Any reference we make to continuing operations is a reference to our retail business only, and as you review our financial statements, please note that the operating results of HD Supply are found in a one line item on the income statement entitled earnings from discontinued operations and HD Supply assets and liabilities are noted on our balance sheet as assets and liabilities of discontinued operations. In the second quarter, sales were $22.2 billion, a 1.8% decrease from last year, reflecting negative same-store sales of 5.2% offset in part by sales from new and non-comp stores. Consolidated store sales were a negative 3.1% in May, negative 5.4% in June, and negative 6.8% in July, as we did not repeat last years highly promotional activity in July. Now, given the state of the home improvement market, we had planned for negative comp sales in the U.S. and our actual results were, for the most part, in line with our expectations. For our stores outside of the U.S., comps were positive. Now, one last comment about comps. For the first two weeks of August, our comps are running in the negative 3% area. In the second quarter, our gross margin was 33.1%, an increase of 9 basis points from the same period last year. Contributing to the year-over-year increase in our gross margin were the following factors: first, as expected, our gross margin benefited from lower interest costs associated with our private label credit card financing program. In the second quarter, we realized 38 basis points of margin expansion due to lower interest cost. Second, on a net basis, we gave up roughly 16 basis points of this expansion due to a change in mix of products sold and markdowns taken to allow us to transition into new products, including the kitchen cabinet program that Craig mentioned. Finally, we experienced higher shrinkage than one year ago and this negatively impacted gross margin by about 13 basis points. While shrink was higher in the second quarter, it has since returned to the levels we experienced last year. As a percent of sales, total expenses grew by 147 basis points to 21.6%. Our expense deleverage reflects the impact of negative sales where for every point of negative comp we expect to deleverage expenses by about 20 basis points. Our expenses also reflect investments we are making in support of our five key priorities. We continue to view payroll as an investment. As a percent of sales, total payroll increased by 79 basis points over last year. This reflects investment in store labor as well as the impact of our success sharing and other store bonus plans. One last comment about expenses. While we are committed to our five key priorities, it doesn't mean we aren't taking action to control costs in this negative comp sales environment. In the second quarter, our expenses were approximately $140 million less than our plan. As a result of the factors I just mentioned, our operating margin for the second quarter was 11.5%, down 137 basis points from last year. Net interest expense was $145 million in the second quarter, up $47 million from last year, reflecting higher levels of outstanding indebtedness. Our long term debt to equity ratio at the end of the second quarter was approximately 43% compared to approximately 25% last year. In the second quarter, our income tax provision rate for continuing operations was 36.9% compared to 39.6% last year. Last year’s tax provision rate reflects the impact of an assessment we received from the Province of Quebec. Earnings from continuing operations were $1.5 billion as compared to $1.7 billion last year and continuing earnings per diluted share were $0.77 down 6.1% from last year. Diluted shares for the second quarter were 1.97 billion shares compared to 2.1 billion shares last year. The reduction in outstanding shares is due to the share repurchase program we began in 2002. Through the end of the second quarter of 2007, we had repurchased a total of 454 million shares. Earnings for our discontinued operation, HD Supply, were $66 million compared to $161 million last year. Included in this quarter’s earnings is a discrete tax item of approximately $60 million arising from the timing of the sale of HD Supply. Excluding this discrete item, earnings from discontinued operations were approximately $126 million. The discrete tax item should reverse itself in the third quarter. Moving to our operational metrics, during the second quarter we opened 33 new stores, including three relocations for an ending store count of 2,200 stores. Today, 232 stores representing approximately 11% of our store base operate in Canada, Mexico and China. At the end of the second quarter, selling square footage was 230 million, a 5% increase from last year. The average square footage per store was 105,000 square feet, the same as last year. Reflecting the sales environment, total sales per square foot were approximately $383 for the quarter, down 6.9% from last year. Now, turning to the balance sheet. At the end of the quarter, retail inventory was $12.3 billion, an increase of $200 million or 1.6% from last year. On a per store basis, inventory was down 4% from last year. Inventory turns were 4.6 times, slightly lower than last year. Computed on the average of beginning and ending long term debt and equity for the trailing four quarters, return on invested capital was 15% as compared to 20.7% last year. We ended the quarter with $56.9 billion in assets, including $3 billion in cash and short-term investments. This is an increase of approximately $2.4 billion in cash and short-term investments from the end of fiscal 2006, reflecting generated by the business of approximately $5 billion offset by $1.6 billion of consolidated capital expenditures, $886 million of dividends paid, and $91 million paid for share repurchases. In closing, we believe that residential construction and the home improvement market will remain soft throughout 2007 and into 2008. We are committed to our reinvestment plans for the long term health of the business, understanding that it will put short-term pressure on earnings. We think our earnings per share from continuing operations on a 52 week basis will decline by 12% to 15% in fiscal 2007 with consolidated earnings per share down 15% to 18%. Our earnings per share guidance does not include the impact of the 53rd week, the impact of the sale of HD Supply or the impact of our outstanding tender offer. Thank you for your participation in today's call. We are now ready for questions.
Operator: Your first question comes from Matthew Fassler - Goldman Sachs.
Matthew Fassler - Goldman Sachs : I want to focus on the capital structure if I can. I know that you're not inclined to comment on the specifics about the sale of Supply, but you still have I would think a range of opportunities, perhaps depending on market conditions, perhaps not. Can you talk about your view and the board’s view about the recap in general given the range of outcomes that you might see on Supply?
Frank Blake: What I'd say, Matt, is we remain committed to the recap strategy. Obviously, this is something we're going to do with our eyes open looking at the market conditions that we're facing in terms of timing, size, and the rest.
Matthew Fassler - Goldman Sachs : If the Supply deal were not to get done or not to get done in a timely fashion, would you be willing to do the tender?
Frank Blake: Well, I'm cautious on answering kind of hypothetical questions on this, as just to put the connection, maybe the easiest way is to give one overview comment. To put the connection between the Supply transaction and our recap and tender in perspective, what I'd say -- and this is an obvious comment and of course you all know it -- is that the $22.5 billion included $10.3 billion from Supply in it. So if you take the Supply transaction out, you've got a different recapitalization size and then you have to look at the tender as it relates to a portion of your recap strategy and that's basically what we would be weighing.
Carol Tome: From a liquidity perspective, as you know we ended the quarter with $3 billion in cash, we have access to the A2 P2 commercial paper market and we do have a $10 billion bridge financing facility.
Matthew Fassler - Goldman Sachs : You talked about August comps to date, just looking at your last year’s third quarter performance, August was actually your toughest compare. How should we think about the fact that business is tracking somewhat better in August? Any color you could give us there?
Carol Tome: Actually, Matt, let me just call out the comps last year by month. August was a negative 1.1, September was a negative 4.3, and October was a negative 8.7.
Matthew Fassler - Goldman Sachs : So to the extent that August is your toughest compare and you're doing somewhat better in the first couple weeks, it would sound like a pretty impressive performance.
Frank Blake: Matt, I just would add a caution that you have to look at last year’s comp numbers because they were compared to the prior year’s numbers which were so influenced by the hurricane impacts. So I'd like to reach exactly the same conclusion you're reaching but we're cautious on that as we see this unfold.
Carol Tome: Yes, let's look at the third quarter comps, negative 5.1 last year, positive 3.6 the prior year, a positive 4.5 the year before that.
Operator: Your next question comes from Budd Bugatch - Raymond James.
Budd Bugatch - Raymond James: Good morning as well. I'd like to just ask a question about gross margin. Carol, in your remarks you had talked about the July comparison being down 6.8 because you did not repeat the last year’s promotional activity and yet when you went through the gross margin activity, gross margin results you were down 16 basis points for a combination of mix and markdowns and I would have thought if you had less promotional activity you might have actually seen a lift from that. Can you maybe parse out mix and markdowns and give us a feel of how that works out?
Craig Menear: There's two things. As Carol mentioned number one, we were less aggressive in July from a promotional standpoint. We shared with you that in first quarter we were too aggressive and that we would relook at that in second quarter which we did. Secondly, as we continued to work our assortment strategies and continue to focus on our line structure, we are aggressively moving product out that isn't performing to the standard that we would like to see. Like we shared with you on the cabinet program, we made a decision to move quickly on that and accelerate the pace of the introduction of new product.
Budd Bugatch - Raymond James: In cabinets you had made a comment, Craig, between assembled and RGA, and that the overall cabinet business looked like it was down and under performing. How did assembled do versus RGA?
Craig Menear: The assembled cabinets are performing very well as we get that into our stores.
Budd Bugatch - Raymond James: Frank, for you, my last question is talk about if -- and this is a hypothetical and I know you're going to love it -- if HD Supply is not sold for whatever reason, you had previously said that you wanted to integrate that into the stores as opposed to the silo type of strategy that was being employed before. Is that still your view or would you relook at that original thought process?
Frank Blake: The strategy, what I'd say, Budd is it is very important to me strategically that we think of ourselves as a retail business because the value in this business is the retail company. So assuming a world with Supply, we'll adjust but it will still be within the framework of the dominant focus of our company is going to be retail.
Operator: Your next question comes from Seth Basham - Credit Suisse.
Seth Basham - Credit Suisse: On the gross margin front again, is your guidance for the year still intact?
Carol Tome: Our guidance for slight margin expansion is still intact.
Seth Basham - Credit Suisse: The reset cadence going forward, are you expecting less of a negative hit from markdowns related to resets?
Carol Tome: I think that as we look at our reset program going forward, we plan as part of that process for the change over and liquidation of inventory in that process and we expect that to be as we had planned it going forward.
Seth Basham - Credit Suisse: Finally just related to the expenses in the quarter, can you give us some more color as to what beat your plan this quarter? I think you mentioned $140 million in difference?
Carol Tome: Yes, I can give you some color. We were laser focused on how we spend our advertising dollars and our advertising dollars came in under plan and our -- I'll call it our operations expense category -- lots of categories from the cost of the bags that you use when you check out at the register, and if you go line by line by line we were just really, really controlled. When you added it all up, it was about $140 million. I should point out in that $140 million that it was about $20 million less in depreciation and amortization than we had planned.
Operator: Your next question comes from Steve Chick – JP Morgan.
Steve Chick - JP Morgan: Good quarter under the circumstances. If I could ask some follow-up questions on Supply. Based upon the data you gave, which was a little limited, I think EBIT for that business looks like it was about down year-over-year say $60 million and I was wondering if you could speak to what the sales trends were there and if it was margin versus sales? Secondly, as it relates to your willingness to restructure the terms potentially, is it the performance of the business or is it the credit market that are factors there?
Frank Blake: Well, let me ask Carol to address the first and not surprisingly I'll pass on the second.
Carol Tome: Regarding HD Supply as you know, their business is heavily focused on residential construction and you know what's going on in the residential construction market. For the quarter, sales for HD Supply were down almost 7%, organic growth was down about 10%. Their gross margin did suffer some contraction in the quarter. They did a great job of controlling expenses in this environment but when you add it all up there was operating margin contraction. I should point out, as we look at it from a market share perspective, we see that they continue to do a very good job in share gains. It's just a tough market out there.
Steve Chick - JP Morgan: Can you speak to maybe, Frank, what the timing would be in terms of when we might hear what the resolution is on that process?
Frank Blake: Everything is better off with a fuller, freer discussion than we can have, but just genuinely these are issues in negotiation and I just wouldn't be comfortable talking about it.
Steve Chick - JP Morgan: A second question if I could. CapEx guidance, it looks like you're back half weighted again this year for your cap spending. Is that still on track? I think your target is -- refresh my memory -- $4.5 billion and do you still planned on hitting that in the second half?
Carol Tome: Thank you for asking the question. This is the perfect opportunity to give clarity and update that guidance. We were looking at $4.5 billion at the beginning of the year, we're now looking at $4 billion. The delta is in two big buckets. The first bucket is HD Supply. We spent some capital for HD Supply for the first half but we're not planning to spend any capital for HD Supply in the back half so that's about $100 million. The rest all is related to the timing of new store capital. As we've looked at when we were going to pay for the purchase price of land, et cetera, some of that has gotten pushed off into 2008. So as it relates to the capital for our five key initiatives, we are spending and in the stores taking care of those five key priorities as we speak.
Operator: Your next question comes from Colin McGranahan - Bernstein.
Colin McGranahan - Bernstein: I was going to ask you what your reserve price on Supply was but I'm afraid I wouldn't get an answer to that. Seriously, I would like to focus on maybe the core retail implementation, and if I understand you're probably fairly close to the Canadian implementation. Could you give us a quick update on where you are in Canada, any changes versus the timeline you've laid out and just a general update on core retail?
Frank Blake: Absolutely, Colin, and actually Mark Holifield is in the room here so I will turn this over to Mark.
Mark Holifield: Thanks, Frank. I'd say core retail is going very well with Score being our Canadian implementation there. In Canada we're in the very heavy lifting phase of this right now where we're really deep into the implementation process. We do still expect to pilot some stores in Canada this year and then rollout throughout 2008. We've accelerated since our business plan in 2007 originally did not include U.S. core retail. We've actually accelerated our efforts there and we're in the process of planning our U.S. core retail implementation with the folks that Frank talked about earlier. Our EVP from Stores and Merchandise Vice President and Logistics Vice President all working together to make the plan for U.S. Core retail which will launch shortly after the heavy lifting efforts there.
Colin McGranahan - Bernstein: So Mark in Canada you're piloting a few stores this year. When would you expect to have Canada completely switched over to SAP?
Mark Holifield: In 2008.
Colin McGranahan - Bernstein: Just some time in 2008?
Mark Holifield: Yes.
Colin McGranahan - Bernstein: So if we can't find any hammers in Toronto at some point, we know it's switched?
Frank Blake: You'll find exactly the hammer you're looking for.
Colin McGranahan - Bernstein: Okay, good luck with that. Actually, Mark since I've got you on the line, can you talk at all about the logistics plan and any change there on how your strategy there is evolving as well?
Mark Holifield: We're working against the plan that we've laid out previously and we're pleased with progress there. We've successfully hit some key milestones there on new systems and processes around Warehouse Management Systems and new distribution techniques, so we've hit key milestones also on our network planning effort and we've got the plans for the new DC facility openings through 2008 consistent with that plan.
Operator: Your next question comes from Mike Baker - Deutsche Bank.
Mike Baker - Deutsche Bank: Your SG&A sounds like you're in line with your plan but your SG&A was better than planned, so was there areas where you were disappointed, was it just the comps? Although it sounded like that was about what you expected.
Carol Tome: The comment about our performance in line with the most of our expectations starts with the sales. Our sales were very close to our plan. We continue to see weakness in areas like South Florida and in California. That's weaker than what we planned. You back those areas out and we would have been right on our plan, so that's really where my comments rested, I think as you go down the rest of the income statement we did a pretty good job as well.
Mike Baker - Deutsche Bank: Is there more SG&A opportunity for some of the belt tightening that you talked about or is that something we should continue to expect?
Frank Blake: Look, we're always looking for opportunities to do things more effectively and more productively and we have those opportunities, so we'll continue to work on that.
Mike Baker - Deutsche Bank: I'll take my shot at Home Depot Supply question. So in my mind, a tender in the Home Depot Supply were linked to the extent now that you can do the tender, you can buy the same number of shares for less amount of money. Does that make it easier for you to be able to accept less for the Home Depot Supply because again, in my mind, it was essentially trading Home Depot Supply for 250 million shares; or is that just too simple?
Frank Blake: It's not exactly how I'd say certainly I look at it. I look at Supply, as we've said right from the start, we're taking a look at creating shareholder value with our Supply transaction and what's the best way to do that. The linkage to how does that tie into the share price on the tender offer, I mean it's there but that is not what's in our line of sight.
Carol Tome: Supply was linked to the size of the recapitalization plan.
Operator: Next we'll move to Parham Behrooz - Evergreen Investments.
Parham Behrooz - Evergreen Investments: I have a question on your debt funding. You seemed very confident you were going to be able to place a lot of debt after you placed a lot of debt last year, and then hit everybody with a four notch downgrade. Can you expand on how you're planning on placing debt, when you're planning on placing it, and any changes to the terms of existing debtholders?
Carol Tome: Well, it sounds like you may be a fixed income investor or an analyst and you know the debt capital markets better than we. They're extraordinary turbulent today. We're watching them very carefully. Our approach to raising capital is to be prudent and to be practical with everybody's interests at heart, so we have not clearly determined nor articulated when we will go to market, how we will go to market. We're looking at all of our opportunities.
Parham Behrooz - Evergreen Investments: So you don't want to expand on any of that today?
Carol Tome: I do not. As Frank said, there are some things we'll talk about today and some things we aren't.
Parham Behrooz - Evergreen Investments: When can we look for you to put a plan together? Because it seems like you have a plan together for the stockholders but you really don't for the debtholders.
Carol Tome: We are thinking about our debtholders as stakeholders, very important to our company and our overall capital structure and as we continue to refine our plans we will certainly be articulating those plans.
Operator: Your next question comes from David Schick - Stifel Nicolaus.
David Schick - Stifel Nicolaus: As we think about the existing home sales and obviously the pressure on the business and the way the consumer thinks about things differently and in the meantime, you've affected gross margin with some of the resets, et cetera. Forget this year, even maybe forget '08. Is the consumer, do you think, coming out or is this business coming out with anything different on what it should support from a gross margin perspective as you think about the elasticity that you see as you work some of these things through?
Frank Blake: Well, if I understand the question, let me take a general comment to that and then turn it to Craig. I think if you look at how our stores reflect some of the trends in the market and how people think about their homes, you can see it in things like the outdoor living that Craig was referencing, so now when you go into our stores you see an assortment around outdoor living for the home that frankly has opportunities for us on the gross margin side and I think is addressing what customers are interested in doing with their homes. I think you'll see that in other areas of the store as we build out our product mix.
Craig Menear: Two other things that I would add-on and number one is as we continue to drive innovation, that certainly should help us drive not only top line sales but then the resulting gross margin dollars and then the second key thing that we have to stay focused on to continue to drive the gross margin dollars for the business is project selling, and as we stay focused on the overall line structure and selling projects, we can have a positive impact to the gross margin dollar generation.
David Schick - Stifel Nicolaus: With the pressure you're seeing, there's nothing with the pressure we're seeing in the consumer to make you think five years from now gross margin should be lower in this industry than it is today, in fact perhaps higher based on things you can do?
Carol Tome: Oh, goodness if I could just jump in, if you think about what we're doing with core retail and logistics, our margins should grow through a cost out perspective.
David Schick - Stifel Nicolaus: I'm just trying to clarify sensitivity and elasticity. Great. Thank you.
Operator: Your next question comes from Eric Bosshard - Cleveland Research.
Eric Bosshard - Cleveland Research : The retail profit looked like it was down around 18% and your guidance for the full year suggests that you don't expect much of a change in the profit degradation in retail in the second half on a year-over-year basis, in other words down 18% first half, down 15% or 18% second half. The comparisons are a lot easier in the second half. Can you talk a little bit about why the rate of decline in retail is expected to continue to be at that level in the second half?
Frank Blake: Well, I think as I said, we continue to see some pressure ahead for us. If you were to ask in kind of a general perspective, the year-to-date in terms of the market I'd say has played out pretty close to our expectation. The first quarter we had some weather impacts but it was pretty close to what we expected. The second quarter has been pretty close to what we expected. In terms of how we had developed our plans, we've had to adjust the third and fourth quarter are going to be more difficult, and frankly we're reflecting that additional difficulty that we see in the back half of the year, particularly as compared to last year.
Eric Bosshard - Cleveland Research : Is that reflective of concern with sales or with spending or with gross margin?
Frank Blake: Sales. I think the key point there would be sales.
Eric Bosshard - Cleveland Research : Secondly, you talk about this is the year where you are spending more money to drive share progress which you've done successfully. Can you talk about how you're thinking about balancing controlling expenses to generate earnings and with that investment, how are you thinking about that?
Frank Blake: First the general point of view is we're investing in our stores. We want to see share gain because we think as the number one home improvement retailer we should be performing at our market and from where we are now, that implies improved share performance. But we're investing in our stores because our stores really require the investment to meet the customer expectation, and we start from that before we go to the is it a share gain play? Is it an expense improvement play? We've done a lot of work around what our customer expectations are and we know we just have to improve the shopability of our store and we know we have to invest to achieve that.
Eric Bosshard - Cleveland Research : As you look at the second half plans at $140 million reduction in expenses in Q2, are we likely to see that follow through in the second half? Have you lowered the planned spending in the second half already at this point?
Carol Tome: We're looking at every expense item that we can control, but not diluting our focus on our five key priorities. I think what I'd ask you to do is just look at the guidance that we've given and expect us to deliver along that guidance.
Eric Bosshard - Cleveland Research : Last question, Carol, on Supply. You've talked about your performance versus plan on a lot of categories. Can you talk about the Supply profit performance in the second quarter and how that related to the plan you had for the second quarter?
Carol Tome: I could, but given where we are, it's a discontinued operation and I think we've given enough color on the business.
Operator: We'll go next to Susan Hutman - Alliance Bernstein.
Susan Hutman - Alliance Bernstein: My question is really for Carol. I just want to clarify an answer you gave to an earlier question. It was about whether the full tender would be completed even if Supply weren't sold and you made a strong point to note that you have CP access and bank availability. By my calculation, if you actually did completely debt finance the full $22.5 billion, your lease adjusted leverage would be four times which is way above your 2.5 times target. At the recent Analyst meeting you stated your commitment to strong investment grade ratings and I would doubt at four times that you could hold your current high BBB which is already four notches below. Would you say that your view on ratings has changed relative to your strong view relating to the recap?
Carol Tome: No. Our view of ratings has not changed. We have a targeted adjusted debt to EBITDA ratio of 2.5 times. It's our intent to stay true to that ratio. Now it will go up and down each time you measure it every quarter but nothing is changed on the rating. My comment on the size of the recap at HD Supply is simply that we sized our recap based on $10.3 billion of anticipated proceeds from Supply and $12 billion of debt finance to be raised as soon as practical. If HD Supply, if we have no proceeds from HD Supply and I'm not saying that's the case but if that were to happen our recap would be reduced to $12 billion.
Operator: Your final question comes from Danielle Fox - Merrill Lynch.
Danielle Fox - Merrill Lynch : Thanks, good morning. Could you talk a little bit more about what drove the sequential improvement in transactions and should we be reading transaction as the equivalent to traffic? It was a little bit surprising given that Carol, you mentioned one of the things, one of the areas where you found some savings was in advertising, so I'm wondering what you think drove the sequential improvement in the transaction count?
Frank Blake: Danielle, first as an overall comment for the company and then turn to Craig and Carol, we had very strong performance in our garden and live goods, so when you think about transaction count and if you saw some of our stores, I think if you had the chance to walk them, I think you'd be very, very impressed this year with what we did in our D28 and I think that accounted for a lot of the transaction growth, just the performance of garden and live goods.
Craig Menear: As we shared with you early on in the year, we were really focused on our focused bay approach and we had a roll on ten categories and we've been working hard to implement that and part of that as we shared with you there were traffic driving categories and certainly in our lawn and garden area that was one of them. I think the other piece of it is as we continue to work the merchandising strategy from our end, we're working very closely with Paul Reines and the operations team to make sure that we're doing everything we can to communicate to our store associates the advantages that we have in the marketplace and try to communicate that to our customers both through our marketing and through our associates on the floor, and I certainly think that's having a benefit as well.
Danielle Fox - Merrill Lynch : I know you mentioned where you were tracking in August. Carol, did you give us the monthly comps for this quarter? If I missed it I'll just go back through the transcript but I don't have that in my notes.
Carol Tome: For this quarter I did. I think I kind of stumbled through that description. Let me go through it one more time. May was negative 3.1%, June was a negative 5.4% and July was a negative 6.8%.
Diane Dayhoff: Thank you to everyone who has joined us today and we look forward to talking to you next quarter. | [
{
"speaker": "Executives",
"text": "Diane Dayhoff - IR Frank Blake - Chairman, CEO Craig Menear – SVP, Merchandising Carol Tome - CFO Mark Holifield – VP, Supply Chain"
},
{
"speaker": "Analysts",
"text": "Matthew Fassler - Goldman Sachs Budd Bugatch - Raymond James Seth Basham - Credit Suisse Steve Chick – JP Morgan Colin McGranahan - Bernstein Mike Baker - Deutsche Bank Parham Behrooz - Evergreen Investments Frank Gallagher - Catalyst Funds David Schick - Stifel Nicolaus Eric Bosshard - Cleveland Research Susan Hutman - Alliance Bernstein Danielle Fox - Merrill Lynch"
},
{
"speaker": "Operator",
"text": "Good day, everyone and welcome to today's Home Depot second quarter earnings conference call. As a reminder today's call is being recorded. Beginning today's discussion is Ms. Diane Dayhoff, Senior Vice President of Investor Relations. Please go ahead, ma'am."
},
{
"speaker": "Diane Dayhoff",
"text": "Good morning to everyone. Welcome to the Home Depot second quarter earnings conference call. Joining us on our call today are Frank Blake, Chairman and CEO of the Home Depot; Craig Menear, Executive Vice President, Merchandising; and Carol Tome, Chief Financial Officer and Executive Vice President, Corporate Services. Following our prepared remarks the call will be open for analyst questions. Questions will be limited to analysts and investors, and as a reminder, we would appreciate it if the participants would limit themselves to one question with one follow-up please. This conference call is being broadcast real time on the Internet at HomeDepot.com with links on both our homepage and the investor relations section. The replay will also be available on our site. If we are unable to get to your question during the call, please call our Investor Relations department at 770-384 -2387. Before I turn the call over to Frank, let me remind you that today's press release and the presentations made by executives include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties. These risks and uncertainties include, but are not limited to, those factors identified in the release and in our filings with the Securities and Exchange Commission. Now, let me turn the call over to Frank Blake."
},
{
"speaker": "Frank Blake",
"text": "Thank you, Diane and good morning, everyone. Let me start by saying that I realize that many of you want to know where we stand on the sale of our HD Supply business. Unfortunately, I have no new details to add. We remain in discussions with the buyers and I'm not in a position to answer the very reasonable questions you may have about what is the likely outcome. What I can talk about this morning is the performance of our core retail business. Our market continues to be a challenging one. You are familiar with the statistics: housing starts are down 22%, existing home sales are down 12%, inventory of homes for sale is at 8.7 months -- a 15-year high -- and the home builder index is at 24%, a 16-year low. In addition, the issues around the subprime market continue to intensify and this is an important concern both for the financial markets generally and for housing specifically, since subprime mortgages accounted for 24% of the dollar volume in the mortgage market last year. So this is a difficult time and our performance reflects that. Sales were $22.2 billion, down about 2% for the quarter. Comp sales were a negative 5.2%. Diluted earnings per share from continuing operations were down 6% at $0.77. Despite the difficulties, there were some positive signs for us. First, on the comp sales side, we did see strength in regions of the country with our Southwestern and Ohio Valley markets posting positive comps. The second positive sign is that our transactions grew year-over-year. While we still had negative comp transactions, this was our best comp transaction performance in awhile. As Craig will review with you, we also believe that we gained share in some key product categories and for our overall market, we have reversed our market share loss; or in other words, we're not losing market share as fast as we were. But as that last phrase indicates, we have a long way to go to get to where we need to be. We don't want to be losing less share; we want to be gaining share and outperforming our market, so we will continue to invest in our stores and in our associates to improve customer service. In addition, we'll continue to look for more cost effective and productive ways to manage non-customer facing activities. Here is a quick update on the progress we've made on our five key priorities: We are restructuring the way our associates are compensated, recognized and rewarded to make it clear that taking care of our associates is one of the core values of the company. As an example, one program we restructured was success sharing, an incentive sharing for our hourly store associates driven by individual store performance. 74% of our stores or over 200,000 of our associates will receive a success sharing payout for the first half which compares to 33% of our stores or about 86,000 associates in the first half of last year. The payout on success sharing is nearly three times what it was last year. We want to recognize and reward our associates for the hard work they're doing and we believe this is contributing to the improvement we are seeing in associate retention. We have picked up considerable momentum in our Master Trade Specialist Program and we now have over 700 licensed electricians and plumbers in our aisles. We've reallocated our resources, putting more at the division and regional levels and have pushed more decision-making closer to the customer to take greater advantage of unique regional opportunities across the country. In our merchandising organization, we have created three new Senior Vice President positions reporting to Craig and have staffed two positions with Home Depot veterans and are conducting an internal and external search for a third, as well as another Senior Vice President position that's open in merchandising. In our supply chain organization, Mark Holifield has added leaders with experience developing and implementing large scale retail systems and comprehensive retail supply chain strategies. We have dedicated a regional Vice President, a Merchandising Vice President, and a Logistics Vice President to our U.S. core retail project team to ensure this effort gets the focus that's required for successful implementation. We are past the halfway mark for the year on planned maintenance projects such as restroom remodels, floor polishing, relamping and lot striping and these efforts are reflected in higher voice of customer scores compared to last year. For example, we've seen year-over-year improvement in our store environment, clear and uncluttered aisles as well as associate availability and likelihood to recommend scores. Now let me address our international business. Our international businesses -- Canada, Mexico, and China -- performed well during the quarter. Our Canadian stores posted positive comps and our Mexican stores posted double-digit positive comps in the quarter. We've been in China less than a year and we continue to be excited about the opportunities this market presents. Let me finish with this comment: the second quarter was more difficult than disappointing. As Carol will go through, our results for the most part were in line with our expectations. We expect continued difficult conditions in the back half of the year but our investments are not for the short term, they are for the long term health and growth of the business and we believe we are seeing signs of progress. Now, let me turn the call over to Craig."
},
{
"speaker": "Craig Menear",
"text": "Thank you, Frank and good morning, everyone. While comp sales in the second quarter continued to be negatively impacted by the current housing environment, we have made progress in executing our merchandise strategy resulting in sequential year-over-year improvements in sales growth, gross margin expansion, and inventory velocity. In the second quarter, four departments outperformed the company's comp: garden, flooring, paint and plumbing. Six departments performed below the company's comp: hardware, lumber, kitchen/bath, lighting, building materials and millwork. Commodity deflation of lumber as well as softness in certain big ticket categories impacted average ticket which was down 2.8% from last year to $58.30. Over the past several years, we have seen a benefit from the sale of appliances in our average ticket. This quarter the average ticket benefit from appliances remained the same as last year. Despite the challenging selling environment we made progress this quarter. Our comp transactions while down 2% were better than we've seen many years. Our total transactions were up 1%. We saw market share improvements in key areas resulting from the merchandise actions we've been taking in the most recent quarters. We have shared with you that we've been taking action to turn around our flooring business. Our merchandising team’s efforts have started to gain traction as we saw market share gains in both hard and soft flooring in the second quarter. For example, carpeting is an area where we gain share in a flat market by accelerating our product line review process and improving our assortment with the addition of 40 new styles, each offering 12 color choices. We also improve the overall shopping experience by enhancing our merchandising displays. Our investment in flooring displays and resets have made a positive impact on the customer’s ability to shop this category. Finally, by creating a tighter association between our install services program, our merchandise and marketing we simplified the installation offers to our customers which drove sales and positive gross margin results. Our market share of paint sales grew this quarter, primarily driven by innovation, seasonally relevant products like our exclusive Behr Nanoguard exterior paint that requires no priming. We believe this quarter’s paint performance was supported by the positive customer response to the Behr Challenge marketing campaign where our customers were invited into our stores to compare Behr’s outstanding performance and value to other brands. Behr has been consistently rated number one in independent product testing for the past four years. As customers expand their homes into the backyard, outdoor living continues to be a major trend with patio and grills leading the way in bringing customers affordable luxury. We saw significant gains in grills this quarter driven by the success of the Charmglow brand. In patio, we expanded our assortment to focus alternative, casual seating groups, our selection in seating and tabletop dining sets helped cement our success this season. We gained significant market share in patio furniture and further extended our leadership in this category. In a shrinking appliance market, we continue to gain share this quarter, building on the gains that we've seen for the last few years. Customers continue to be pleased with the innovation, style, and design we offer in appliances. Second quarter results were driven by sales of innovative washers, dryers and refrigerators such as the Maytag Bravo high efficiency top-load washers and matching dryers and the GE Adora refreshment center side by side refrigerator, both found exclusively at the Home Depot. The professional customer remains a key focus for us. We're pleased with the quarter’s market share results in areas like gypsum, windows, and power tools. Gains in the power tools are driven in part by the products such as the new Makita magnesium lightweight more powerful circular saw which was well received by our professional customers. Our execution this spring led to good results in seasonal categories with particularly strong results in live goods. We're also pleased with our performance over key holidays like Memorial Day, 4th of July, and Father's Day where we had strong weekends. We're making progress but we still have a lot of areas where we have opportunity. In the second quarter we lost share in kitchen and millwork and let me share with you some of the actions we're taking in these areas. We are in the midst of replacing the ready to assemble kitchen cabinets in most markets that we have carried this product for over 20 years. We accelerated the exit of this category by taking markdowns in the second quarter to bring a new line of assembled cabinets into the majority of our stores by the end of the third quarter. This product offering better address the needs of our pro and serious do-it-yourself customers than ready to assemble product. We will continue to offer ready to assemble cabinets in those markets where it remains important to our customers. In millwork, we updated our door program by introducing new products at great prices and enhancing our regional mix. During the quarter we introduced a number of new wood grain collections and glass styles in our Feather River fiberglass door program. These additions continue to expand and update our fiberglass offering to show the latest trends and styles in decorative exterior doors. Looking to the third quarter I'm really excited about the new products that you'll see in our stores. First, we'll continue to bring affordable luxury to our customers by introducing products such as our exclusive line of Arietta designer range hoods which offers the style and quality of premium brand designer hoods at half the price. In addition we're excited about our new LG Kitchen Series tat's being introduced right now. This is a high end suite of Kitchen Appliances that includes a steam dishwasher. Second, we'll introduce several products that will bring Pro features to the do-it-yourselfers such as Home Life’s lightweight backpack leaf blower. In door locks we'll introduce Kwikset smart key door locks that makes rekeying simple and easy for our homeowner. This exclusive launch will be great for our DIY and our Pro repair and maintenance customers. In power tools, we will enhance our current line up of lithium ion products with new Black and Decker and Ryobi tool lines. The Black & Decker BDX lithium ion line offers great design features and value to the eco boomers who are just buying their first set of tools. Our current Ryobi One Plus assortment will be enhanced with lithium products that offer professional performance at outstanding values. With products like these and our focus on executing merchandising fundamentals, we bring excitement to our stores and deliver greater value to our customers. Now I'd like to turn the call over to Carol."
},
{
"speaker": "Carol Tome",
"text": "Thank you, Craig and hello, everyone. Before I discuss the results of the quarter, let me remind you that we are now reporting the results of HD Supply as a discontinued operation. Any reference we make to continuing operations is a reference to our retail business only, and as you review our financial statements, please note that the operating results of HD Supply are found in a one line item on the income statement entitled earnings from discontinued operations and HD Supply assets and liabilities are noted on our balance sheet as assets and liabilities of discontinued operations. In the second quarter, sales were $22.2 billion, a 1.8% decrease from last year, reflecting negative same-store sales of 5.2% offset in part by sales from new and non-comp stores. Consolidated store sales were a negative 3.1% in May, negative 5.4% in June, and negative 6.8% in July, as we did not repeat last years highly promotional activity in July. Now, given the state of the home improvement market, we had planned for negative comp sales in the U.S. and our actual results were, for the most part, in line with our expectations. For our stores outside of the U.S., comps were positive. Now, one last comment about comps. For the first two weeks of August, our comps are running in the negative 3% area. In the second quarter, our gross margin was 33.1%, an increase of 9 basis points from the same period last year. Contributing to the year-over-year increase in our gross margin were the following factors: first, as expected, our gross margin benefited from lower interest costs associated with our private label credit card financing program. In the second quarter, we realized 38 basis points of margin expansion due to lower interest cost. Second, on a net basis, we gave up roughly 16 basis points of this expansion due to a change in mix of products sold and markdowns taken to allow us to transition into new products, including the kitchen cabinet program that Craig mentioned. Finally, we experienced higher shrinkage than one year ago and this negatively impacted gross margin by about 13 basis points. While shrink was higher in the second quarter, it has since returned to the levels we experienced last year. As a percent of sales, total expenses grew by 147 basis points to 21.6%. Our expense deleverage reflects the impact of negative sales where for every point of negative comp we expect to deleverage expenses by about 20 basis points. Our expenses also reflect investments we are making in support of our five key priorities. We continue to view payroll as an investment. As a percent of sales, total payroll increased by 79 basis points over last year. This reflects investment in store labor as well as the impact of our success sharing and other store bonus plans. One last comment about expenses. While we are committed to our five key priorities, it doesn't mean we aren't taking action to control costs in this negative comp sales environment. In the second quarter, our expenses were approximately $140 million less than our plan. As a result of the factors I just mentioned, our operating margin for the second quarter was 11.5%, down 137 basis points from last year. Net interest expense was $145 million in the second quarter, up $47 million from last year, reflecting higher levels of outstanding indebtedness. Our long term debt to equity ratio at the end of the second quarter was approximately 43% compared to approximately 25% last year. In the second quarter, our income tax provision rate for continuing operations was 36.9% compared to 39.6% last year. Last year’s tax provision rate reflects the impact of an assessment we received from the Province of Quebec. Earnings from continuing operations were $1.5 billion as compared to $1.7 billion last year and continuing earnings per diluted share were $0.77 down 6.1% from last year. Diluted shares for the second quarter were 1.97 billion shares compared to 2.1 billion shares last year. The reduction in outstanding shares is due to the share repurchase program we began in 2002. Through the end of the second quarter of 2007, we had repurchased a total of 454 million shares. Earnings for our discontinued operation, HD Supply, were $66 million compared to $161 million last year. Included in this quarter’s earnings is a discrete tax item of approximately $60 million arising from the timing of the sale of HD Supply. Excluding this discrete item, earnings from discontinued operations were approximately $126 million. The discrete tax item should reverse itself in the third quarter. Moving to our operational metrics, during the second quarter we opened 33 new stores, including three relocations for an ending store count of 2,200 stores. Today, 232 stores representing approximately 11% of our store base operate in Canada, Mexico and China. At the end of the second quarter, selling square footage was 230 million, a 5% increase from last year. The average square footage per store was 105,000 square feet, the same as last year. Reflecting the sales environment, total sales per square foot were approximately $383 for the quarter, down 6.9% from last year. Now, turning to the balance sheet. At the end of the quarter, retail inventory was $12.3 billion, an increase of $200 million or 1.6% from last year. On a per store basis, inventory was down 4% from last year. Inventory turns were 4.6 times, slightly lower than last year. Computed on the average of beginning and ending long term debt and equity for the trailing four quarters, return on invested capital was 15% as compared to 20.7% last year. We ended the quarter with $56.9 billion in assets, including $3 billion in cash and short-term investments. This is an increase of approximately $2.4 billion in cash and short-term investments from the end of fiscal 2006, reflecting generated by the business of approximately $5 billion offset by $1.6 billion of consolidated capital expenditures, $886 million of dividends paid, and $91 million paid for share repurchases. In closing, we believe that residential construction and the home improvement market will remain soft throughout 2007 and into 2008. We are committed to our reinvestment plans for the long term health of the business, understanding that it will put short-term pressure on earnings. We think our earnings per share from continuing operations on a 52 week basis will decline by 12% to 15% in fiscal 2007 with consolidated earnings per share down 15% to 18%. Our earnings per share guidance does not include the impact of the 53rd week, the impact of the sale of HD Supply or the impact of our outstanding tender offer. Thank you for your participation in today's call. We are now ready for questions."
},
{
"speaker": "Operator",
"text": "Your first question comes from Matthew Fassler - Goldman Sachs."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "I want to focus on the capital structure if I can. I know that you're not inclined to comment on the specifics about the sale of Supply, but you still have I would think a range of opportunities, perhaps depending on market conditions, perhaps not. Can you talk about your view and the board’s view about the recap in general given the range of outcomes that you might see on Supply?"
},
{
"speaker": "Frank Blake",
"text": "What I'd say, Matt, is we remain committed to the recap strategy. Obviously, this is something we're going to do with our eyes open looking at the market conditions that we're facing in terms of timing, size, and the rest."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "If the Supply deal were not to get done or not to get done in a timely fashion, would you be willing to do the tender?"
},
{
"speaker": "Frank Blake",
"text": "Well, I'm cautious on answering kind of hypothetical questions on this, as just to put the connection, maybe the easiest way is to give one overview comment. To put the connection between the Supply transaction and our recap and tender in perspective, what I'd say -- and this is an obvious comment and of course you all know it -- is that the $22.5 billion included $10.3 billion from Supply in it. So if you take the Supply transaction out, you've got a different recapitalization size and then you have to look at the tender as it relates to a portion of your recap strategy and that's basically what we would be weighing."
},
{
"speaker": "Carol Tome",
"text": "From a liquidity perspective, as you know we ended the quarter with $3 billion in cash, we have access to the A2 P2 commercial paper market and we do have a $10 billion bridge financing facility."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "You talked about August comps to date, just looking at your last year’s third quarter performance, August was actually your toughest compare. How should we think about the fact that business is tracking somewhat better in August? Any color you could give us there?"
},
{
"speaker": "Carol Tome",
"text": "Actually, Matt, let me just call out the comps last year by month. August was a negative 1.1, September was a negative 4.3, and October was a negative 8.7."
},
{
"speaker": "Matthew Fassler - Goldman Sachs",
"text": "So to the extent that August is your toughest compare and you're doing somewhat better in the first couple weeks, it would sound like a pretty impressive performance."
},
{
"speaker": "Frank Blake",
"text": "Matt, I just would add a caution that you have to look at last year’s comp numbers because they were compared to the prior year’s numbers which were so influenced by the hurricane impacts. So I'd like to reach exactly the same conclusion you're reaching but we're cautious on that as we see this unfold."
},
{
"speaker": "Carol Tome",
"text": "Yes, let's look at the third quarter comps, negative 5.1 last year, positive 3.6 the prior year, a positive 4.5 the year before that."
},
{
"speaker": "Operator",
"text": "Your next question comes from Budd Bugatch - Raymond James."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "Good morning as well. I'd like to just ask a question about gross margin. Carol, in your remarks you had talked about the July comparison being down 6.8 because you did not repeat the last year’s promotional activity and yet when you went through the gross margin activity, gross margin results you were down 16 basis points for a combination of mix and markdowns and I would have thought if you had less promotional activity you might have actually seen a lift from that. Can you maybe parse out mix and markdowns and give us a feel of how that works out?"
},
{
"speaker": "Craig Menear",
"text": "There's two things. As Carol mentioned number one, we were less aggressive in July from a promotional standpoint. We shared with you that in first quarter we were too aggressive and that we would relook at that in second quarter which we did. Secondly, as we continued to work our assortment strategies and continue to focus on our line structure, we are aggressively moving product out that isn't performing to the standard that we would like to see. Like we shared with you on the cabinet program, we made a decision to move quickly on that and accelerate the pace of the introduction of new product."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "In cabinets you had made a comment, Craig, between assembled and RGA, and that the overall cabinet business looked like it was down and under performing. How did assembled do versus RGA?"
},
{
"speaker": "Craig Menear",
"text": "The assembled cabinets are performing very well as we get that into our stores."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "Frank, for you, my last question is talk about if -- and this is a hypothetical and I know you're going to love it -- if HD Supply is not sold for whatever reason, you had previously said that you wanted to integrate that into the stores as opposed to the silo type of strategy that was being employed before. Is that still your view or would you relook at that original thought process?"
},
{
"speaker": "Frank Blake",
"text": "The strategy, what I'd say, Budd is it is very important to me strategically that we think of ourselves as a retail business because the value in this business is the retail company. So assuming a world with Supply, we'll adjust but it will still be within the framework of the dominant focus of our company is going to be retail."
},
{
"speaker": "Operator",
"text": "Your next question comes from Seth Basham - Credit Suisse."
},
{
"speaker": "Seth Basham - Credit Suisse",
"text": "On the gross margin front again, is your guidance for the year still intact?"
},
{
"speaker": "Carol Tome",
"text": "Our guidance for slight margin expansion is still intact."
},
{
"speaker": "Seth Basham - Credit Suisse",
"text": "The reset cadence going forward, are you expecting less of a negative hit from markdowns related to resets?"
},
{
"speaker": "Carol Tome",
"text": "I think that as we look at our reset program going forward, we plan as part of that process for the change over and liquidation of inventory in that process and we expect that to be as we had planned it going forward."
},
{
"speaker": "Seth Basham - Credit Suisse",
"text": "Finally just related to the expenses in the quarter, can you give us some more color as to what beat your plan this quarter? I think you mentioned $140 million in difference?"
},
{
"speaker": "Carol Tome",
"text": "Yes, I can give you some color. We were laser focused on how we spend our advertising dollars and our advertising dollars came in under plan and our -- I'll call it our operations expense category -- lots of categories from the cost of the bags that you use when you check out at the register, and if you go line by line by line we were just really, really controlled. When you added it all up, it was about $140 million. I should point out in that $140 million that it was about $20 million less in depreciation and amortization than we had planned."
},
{
"speaker": "Operator",
"text": "Your next question comes from Steve Chick – JP Morgan."
},
{
"speaker": "Steve Chick - JP Morgan",
"text": "Good quarter under the circumstances. If I could ask some follow-up questions on Supply. Based upon the data you gave, which was a little limited, I think EBIT for that business looks like it was about down year-over-year say $60 million and I was wondering if you could speak to what the sales trends were there and if it was margin versus sales? Secondly, as it relates to your willingness to restructure the terms potentially, is it the performance of the business or is it the credit market that are factors there?"
},
{
"speaker": "Frank Blake",
"text": "Well, let me ask Carol to address the first and not surprisingly I'll pass on the second."
},
{
"speaker": "Carol Tome",
"text": "Regarding HD Supply as you know, their business is heavily focused on residential construction and you know what's going on in the residential construction market. For the quarter, sales for HD Supply were down almost 7%, organic growth was down about 10%. Their gross margin did suffer some contraction in the quarter. They did a great job of controlling expenses in this environment but when you add it all up there was operating margin contraction. I should point out, as we look at it from a market share perspective, we see that they continue to do a very good job in share gains. It's just a tough market out there."
},
{
"speaker": "Steve Chick - JP Morgan",
"text": "Can you speak to maybe, Frank, what the timing would be in terms of when we might hear what the resolution is on that process?"
},
{
"speaker": "Frank Blake",
"text": "Everything is better off with a fuller, freer discussion than we can have, but just genuinely these are issues in negotiation and I just wouldn't be comfortable talking about it."
},
{
"speaker": "Steve Chick - JP Morgan",
"text": "A second question if I could. CapEx guidance, it looks like you're back half weighted again this year for your cap spending. Is that still on track? I think your target is -- refresh my memory -- $4.5 billion and do you still planned on hitting that in the second half?"
},
{
"speaker": "Carol Tome",
"text": "Thank you for asking the question. This is the perfect opportunity to give clarity and update that guidance. We were looking at $4.5 billion at the beginning of the year, we're now looking at $4 billion. The delta is in two big buckets. The first bucket is HD Supply. We spent some capital for HD Supply for the first half but we're not planning to spend any capital for HD Supply in the back half so that's about $100 million. The rest all is related to the timing of new store capital. As we've looked at when we were going to pay for the purchase price of land, et cetera, some of that has gotten pushed off into 2008. So as it relates to the capital for our five key initiatives, we are spending and in the stores taking care of those five key priorities as we speak."
},
{
"speaker": "Operator",
"text": "Your next question comes from Colin McGranahan - Bernstein."
},
{
"speaker": "Colin McGranahan - Bernstein",
"text": "I was going to ask you what your reserve price on Supply was but I'm afraid I wouldn't get an answer to that. Seriously, I would like to focus on maybe the core retail implementation, and if I understand you're probably fairly close to the Canadian implementation. Could you give us a quick update on where you are in Canada, any changes versus the timeline you've laid out and just a general update on core retail?"
},
{
"speaker": "Frank Blake",
"text": "Absolutely, Colin, and actually Mark Holifield is in the room here so I will turn this over to Mark."
},
{
"speaker": "Mark Holifield",
"text": "Thanks, Frank. I'd say core retail is going very well with Score being our Canadian implementation there. In Canada we're in the very heavy lifting phase of this right now where we're really deep into the implementation process. We do still expect to pilot some stores in Canada this year and then rollout throughout 2008. We've accelerated since our business plan in 2007 originally did not include U.S. core retail. We've actually accelerated our efforts there and we're in the process of planning our U.S. core retail implementation with the folks that Frank talked about earlier. Our EVP from Stores and Merchandise Vice President and Logistics Vice President all working together to make the plan for U.S. Core retail which will launch shortly after the heavy lifting efforts there."
},
{
"speaker": "Colin McGranahan - Bernstein",
"text": "So Mark in Canada you're piloting a few stores this year. When would you expect to have Canada completely switched over to SAP?"
},
{
"speaker": "Mark Holifield",
"text": "In 2008."
},
{
"speaker": "Colin McGranahan - Bernstein",
"text": "Just some time in 2008?"
},
{
"speaker": "Mark Holifield",
"text": "Yes."
},
{
"speaker": "Colin McGranahan - Bernstein",
"text": "So if we can't find any hammers in Toronto at some point, we know it's switched?"
},
{
"speaker": "Frank Blake",
"text": "You'll find exactly the hammer you're looking for."
},
{
"speaker": "Colin McGranahan - Bernstein",
"text": "Okay, good luck with that. Actually, Mark since I've got you on the line, can you talk at all about the logistics plan and any change there on how your strategy there is evolving as well?"
},
{
"speaker": "Mark Holifield",
"text": "We're working against the plan that we've laid out previously and we're pleased with progress there. We've successfully hit some key milestones there on new systems and processes around Warehouse Management Systems and new distribution techniques, so we've hit key milestones also on our network planning effort and we've got the plans for the new DC facility openings through 2008 consistent with that plan."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mike Baker - Deutsche Bank."
},
{
"speaker": "Mike Baker - Deutsche Bank",
"text": "Your SG&A sounds like you're in line with your plan but your SG&A was better than planned, so was there areas where you were disappointed, was it just the comps? Although it sounded like that was about what you expected."
},
{
"speaker": "Carol Tome",
"text": "The comment about our performance in line with the most of our expectations starts with the sales. Our sales were very close to our plan. We continue to see weakness in areas like South Florida and in California. That's weaker than what we planned. You back those areas out and we would have been right on our plan, so that's really where my comments rested, I think as you go down the rest of the income statement we did a pretty good job as well."
},
{
"speaker": "Mike Baker - Deutsche Bank",
"text": "Is there more SG&A opportunity for some of the belt tightening that you talked about or is that something we should continue to expect?"
},
{
"speaker": "Frank Blake",
"text": "Look, we're always looking for opportunities to do things more effectively and more productively and we have those opportunities, so we'll continue to work on that."
},
{
"speaker": "Mike Baker - Deutsche Bank",
"text": "I'll take my shot at Home Depot Supply question. So in my mind, a tender in the Home Depot Supply were linked to the extent now that you can do the tender, you can buy the same number of shares for less amount of money. Does that make it easier for you to be able to accept less for the Home Depot Supply because again, in my mind, it was essentially trading Home Depot Supply for 250 million shares; or is that just too simple?"
},
{
"speaker": "Frank Blake",
"text": "It's not exactly how I'd say certainly I look at it. I look at Supply, as we've said right from the start, we're taking a look at creating shareholder value with our Supply transaction and what's the best way to do that. The linkage to how does that tie into the share price on the tender offer, I mean it's there but that is not what's in our line of sight."
},
{
"speaker": "Carol Tome",
"text": "Supply was linked to the size of the recapitalization plan."
},
{
"speaker": "Operator",
"text": "Next we'll move to Parham Behrooz - Evergreen Investments."
},
{
"speaker": "Parham Behrooz - Evergreen Investments",
"text": "I have a question on your debt funding. You seemed very confident you were going to be able to place a lot of debt after you placed a lot of debt last year, and then hit everybody with a four notch downgrade. Can you expand on how you're planning on placing debt, when you're planning on placing it, and any changes to the terms of existing debtholders?"
},
{
"speaker": "Carol Tome",
"text": "Well, it sounds like you may be a fixed income investor or an analyst and you know the debt capital markets better than we. They're extraordinary turbulent today. We're watching them very carefully. Our approach to raising capital is to be prudent and to be practical with everybody's interests at heart, so we have not clearly determined nor articulated when we will go to market, how we will go to market. We're looking at all of our opportunities."
},
{
"speaker": "Parham Behrooz - Evergreen Investments",
"text": "So you don't want to expand on any of that today?"
},
{
"speaker": "Carol Tome",
"text": "I do not. As Frank said, there are some things we'll talk about today and some things we aren't."
},
{
"speaker": "Parham Behrooz - Evergreen Investments",
"text": "When can we look for you to put a plan together? Because it seems like you have a plan together for the stockholders but you really don't for the debtholders."
},
{
"speaker": "Carol Tome",
"text": "We are thinking about our debtholders as stakeholders, very important to our company and our overall capital structure and as we continue to refine our plans we will certainly be articulating those plans."
},
{
"speaker": "Operator",
"text": "Your next question comes from David Schick - Stifel Nicolaus."
},
{
"speaker": "David Schick - Stifel Nicolaus",
"text": "As we think about the existing home sales and obviously the pressure on the business and the way the consumer thinks about things differently and in the meantime, you've affected gross margin with some of the resets, et cetera. Forget this year, even maybe forget '08. Is the consumer, do you think, coming out or is this business coming out with anything different on what it should support from a gross margin perspective as you think about the elasticity that you see as you work some of these things through?"
},
{
"speaker": "Frank Blake",
"text": "Well, if I understand the question, let me take a general comment to that and then turn it to Craig. I think if you look at how our stores reflect some of the trends in the market and how people think about their homes, you can see it in things like the outdoor living that Craig was referencing, so now when you go into our stores you see an assortment around outdoor living for the home that frankly has opportunities for us on the gross margin side and I think is addressing what customers are interested in doing with their homes. I think you'll see that in other areas of the store as we build out our product mix."
},
{
"speaker": "Craig Menear",
"text": "Two other things that I would add-on and number one is as we continue to drive innovation, that certainly should help us drive not only top line sales but then the resulting gross margin dollars and then the second key thing that we have to stay focused on to continue to drive the gross margin dollars for the business is project selling, and as we stay focused on the overall line structure and selling projects, we can have a positive impact to the gross margin dollar generation."
},
{
"speaker": "David Schick - Stifel Nicolaus",
"text": "With the pressure you're seeing, there's nothing with the pressure we're seeing in the consumer to make you think five years from now gross margin should be lower in this industry than it is today, in fact perhaps higher based on things you can do?"
},
{
"speaker": "Carol Tome",
"text": "Oh, goodness if I could just jump in, if you think about what we're doing with core retail and logistics, our margins should grow through a cost out perspective."
},
{
"speaker": "David Schick - Stifel Nicolaus",
"text": "I'm just trying to clarify sensitivity and elasticity. Great. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Eric Bosshard - Cleveland Research."
},
{
"speaker": "Eric Bosshard - Cleveland Research",
"text": "The retail profit looked like it was down around 18% and your guidance for the full year suggests that you don't expect much of a change in the profit degradation in retail in the second half on a year-over-year basis, in other words down 18% first half, down 15% or 18% second half. The comparisons are a lot easier in the second half. Can you talk a little bit about why the rate of decline in retail is expected to continue to be at that level in the second half?"
},
{
"speaker": "Frank Blake",
"text": "Well, I think as I said, we continue to see some pressure ahead for us. If you were to ask in kind of a general perspective, the year-to-date in terms of the market I'd say has played out pretty close to our expectation. The first quarter we had some weather impacts but it was pretty close to what we expected. The second quarter has been pretty close to what we expected. In terms of how we had developed our plans, we've had to adjust the third and fourth quarter are going to be more difficult, and frankly we're reflecting that additional difficulty that we see in the back half of the year, particularly as compared to last year."
},
{
"speaker": "Eric Bosshard - Cleveland Research",
"text": "Is that reflective of concern with sales or with spending or with gross margin?"
},
{
"speaker": "Frank Blake",
"text": "Sales. I think the key point there would be sales."
},
{
"speaker": "Eric Bosshard - Cleveland Research",
"text": "Secondly, you talk about this is the year where you are spending more money to drive share progress which you've done successfully. Can you talk about how you're thinking about balancing controlling expenses to generate earnings and with that investment, how are you thinking about that?"
},
{
"speaker": "Frank Blake",
"text": "First the general point of view is we're investing in our stores. We want to see share gain because we think as the number one home improvement retailer we should be performing at our market and from where we are now, that implies improved share performance. But we're investing in our stores because our stores really require the investment to meet the customer expectation, and we start from that before we go to the is it a share gain play? Is it an expense improvement play? We've done a lot of work around what our customer expectations are and we know we just have to improve the shopability of our store and we know we have to invest to achieve that."
},
{
"speaker": "Eric Bosshard - Cleveland Research",
"text": "As you look at the second half plans at $140 million reduction in expenses in Q2, are we likely to see that follow through in the second half? Have you lowered the planned spending in the second half already at this point?"
},
{
"speaker": "Carol Tome",
"text": "We're looking at every expense item that we can control, but not diluting our focus on our five key priorities. I think what I'd ask you to do is just look at the guidance that we've given and expect us to deliver along that guidance."
},
{
"speaker": "Eric Bosshard - Cleveland Research",
"text": "Last question, Carol, on Supply. You've talked about your performance versus plan on a lot of categories. Can you talk about the Supply profit performance in the second quarter and how that related to the plan you had for the second quarter?"
},
{
"speaker": "Carol Tome",
"text": "I could, but given where we are, it's a discontinued operation and I think we've given enough color on the business."
},
{
"speaker": "Operator",
"text": "We'll go next to Susan Hutman - Alliance Bernstein."
},
{
"speaker": "Susan Hutman - Alliance Bernstein",
"text": "My question is really for Carol. I just want to clarify an answer you gave to an earlier question. It was about whether the full tender would be completed even if Supply weren't sold and you made a strong point to note that you have CP access and bank availability. By my calculation, if you actually did completely debt finance the full $22.5 billion, your lease adjusted leverage would be four times which is way above your 2.5 times target. At the recent Analyst meeting you stated your commitment to strong investment grade ratings and I would doubt at four times that you could hold your current high BBB which is already four notches below. Would you say that your view on ratings has changed relative to your strong view relating to the recap?"
},
{
"speaker": "Carol Tome",
"text": "No. Our view of ratings has not changed. We have a targeted adjusted debt to EBITDA ratio of 2.5 times. It's our intent to stay true to that ratio. Now it will go up and down each time you measure it every quarter but nothing is changed on the rating. My comment on the size of the recap at HD Supply is simply that we sized our recap based on $10.3 billion of anticipated proceeds from Supply and $12 billion of debt finance to be raised as soon as practical. If HD Supply, if we have no proceeds from HD Supply and I'm not saying that's the case but if that were to happen our recap would be reduced to $12 billion."
},
{
"speaker": "Operator",
"text": "Your final question comes from Danielle Fox - Merrill Lynch."
},
{
"speaker": "Danielle Fox - Merrill Lynch",
"text": "Thanks, good morning. Could you talk a little bit more about what drove the sequential improvement in transactions and should we be reading transaction as the equivalent to traffic? It was a little bit surprising given that Carol, you mentioned one of the things, one of the areas where you found some savings was in advertising, so I'm wondering what you think drove the sequential improvement in the transaction count?"
},
{
"speaker": "Frank Blake",
"text": "Danielle, first as an overall comment for the company and then turn to Craig and Carol, we had very strong performance in our garden and live goods, so when you think about transaction count and if you saw some of our stores, I think if you had the chance to walk them, I think you'd be very, very impressed this year with what we did in our D28 and I think that accounted for a lot of the transaction growth, just the performance of garden and live goods."
},
{
"speaker": "Craig Menear",
"text": "As we shared with you early on in the year, we were really focused on our focused bay approach and we had a roll on ten categories and we've been working hard to implement that and part of that as we shared with you there were traffic driving categories and certainly in our lawn and garden area that was one of them. I think the other piece of it is as we continue to work the merchandising strategy from our end, we're working very closely with Paul Reines and the operations team to make sure that we're doing everything we can to communicate to our store associates the advantages that we have in the marketplace and try to communicate that to our customers both through our marketing and through our associates on the floor, and I certainly think that's having a benefit as well."
},
{
"speaker": "Danielle Fox - Merrill Lynch",
"text": "I know you mentioned where you were tracking in August. Carol, did you give us the monthly comps for this quarter? If I missed it I'll just go back through the transcript but I don't have that in my notes."
},
{
"speaker": "Carol Tome",
"text": "For this quarter I did. I think I kind of stumbled through that description. Let me go through it one more time. May was negative 3.1%, June was a negative 5.4% and July was a negative 6.8%."
},
{
"speaker": "Diane Dayhoff",
"text": "Thank you to everyone who has joined us today and we look forward to talking to you next quarter."
}
] | null | null |
HD | 1 | 2,007 | 2007-05-15 09:00:00 | Executives: Diane Dayhoff - Vice President, Investor Relations Frank Blake - Chairman of the Board, Chief Executive Officer Craig Menear - Executive Vice President, Merchandising Paul Raines - Executive Vice President, U.S. Stores Carol B. Tomé - Chief Financial Officer and Executive Vice President - Corporate Services Mark Holifield - Senior Vice President, Supply Chain
Analysts: Matthew J. Fassler - Goldman Sachs Gary Balter - Credit Suisse Colin McGranahan - Bernstein Budd Bugatch - Raymond James Steve Chick - J.P. Morgan Eric Bosshard - Cleveland Research Chris Horvers - Bear Stearns
Operator: Good day, everyone and welcome to today’s Home Depot first quarter earnings conference call. As a reminder, today’s call is being recorded. Beginning today’s discussion is Miss Diane Dayhoff, Senior Vice President of Investor Relations. Please go ahead.
Diane Dayhoff: Thank you and good morning to everyone. Welcome to the Home Depot first quarter earnings conference call. Joining us on our call today are Frank Blake, Chairman and CEO of The Home Depot; Craig Menear, Executive Vice President, Merchandising; Paul Raines, Executive Vice President, U.S. Stores; and Carol Tomé, Chief Financial Officer and Executive Vice President, Corporate Services. Following our prepared remarks, the call will be open for analysts’ questions. Questions will be limited to analysts and investors and as a reminder, we would appreciate it if the participants would limit themselves to one question with one follow-up please. This conference call is being broadcast real-time on the Internet at homedepot.com, with links on both our homepage and the investor relations section. The replay will also be available on our site. If we are unable to get to your question during the call, please call our investor relations department at 770-384-2387. Before I turn the call over to Frank, let me remind you that today’s press release and the presentations made by our executives include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1955. These statements are subject to risks and uncertainties. These risks and uncertainties include, but are not limited to, those factors identified in the release and in our filings with the Securities and Exchange Commission. Now, let me turn the call over to Frank Blake.
Frank Blake: Thank you, Diane and good morning, everyone. This was a difficult first quarter for us. Consolidated sales were $21.6 billion, up about 1%, but diluted earnings per share were down 24% at $0.53. Our retail business had a negative comp of 7.6% for the quarter and while we expected a tough quarter, this was worse than we anticipated. There were a number of factors that contributed to our poor performance. The housing and home improvement markets were soft, and especially so in some of our traditionally strong markets in Florida and the Northeast. The weather was challenging as we had one of the coldest Aprils in more than a decade and finally, we continue to work through our own issues on performance and execution. Let me give you a summary assessment of what has gone well in this first quarter and where some of our major opportunities and issues remain. First, our associates have responded quickly and enthusiastically to the basic message that we are focusing on our retail business and reconnecting with the core values that are the foundation of the company. If anything, this has happened more rapidly than I anticipated and is a testament to the strength of the culture of this company and how deep-seated it is in our associates. As Paul will describe, we have taken a number of actions to change the way our associates are compensated, recognized and rewarded to make it clear that taking care of our associates is one of the core values of the company. We have also invested in associate hours on the store floor with a significant increase in payroll as a percent of sales. With this, we have rededicated ourselves to excellence in customer service and I hope you have seen some of that in our stores. We remain committed to our strategy of investing in the retail business despite the challenging environment. We know that this put additional pressure on our earnings in this quarter but believe it was important for the long-term strength of our business. Carol will take you through some of the specific drivers of the declines in our gross margin and operating profit performance. As a point of reference, we saw comp transaction declines of 15% to 20%-plus in our northern division and in parts of our southern division during two key weeks in April. It is difficult to make a timely adjustment for that level of decline. We did, however, see positive comp transactions of a similar magnitude this last week as spring arrived in the North. We are making good progress on our programmatic maintenance efforts and are well on our way on planned projects such as restroom remodels, floor polishing, re-lamping and lot striping. Over 20% of our projects are in progress or complete. We accelerated clearance mark-downs in the quarter in support of merchandising reset activities. We are revamping our processes for connecting with smaller vendors with innovative products who in the past have found it difficult to deal with some of our bureaucracy and procedures. We have taken early steps forward in our supply chain transformation. We have implemented enhancements to our replenishment systems. We successfully went live with our first distribution center conversion to the Manhattan Warehouse Management System, which will be our single state-of-the-art platform, and we have begun to pilot our new central distribution concepts. We have also made significant improvements in the services we provide to our pro customers, particularly through our bid room. We have nearly tripled the volume of business that we do through our bid room. We believe we have narrowed the gap between our performance and our market’s performance, but we still have significant room to improve. Craig will describe for you some of the areas where we are seeing market share gains, as well as some of the areas where we continue to struggle. We need to bring to every effort we undertake a consistent customer-based and store-based focus. This may sound obvious but there are worlds of differences between a program that works well in Atlanta and one that works well in the store, and we still have too many programs that aren’t designed for effective implementation in our stores. Now let me address our international retail business. Our international businesses, Canada, Mexico and China, performed well during the quarter. Canada’s comps were above the U.S.’ and the sales growth there was consistent with Canadian home improvement markets growth. Our Mexican stores continued to outperform the market, posting double-digit comps in the quarter, and our China stores are performing consistent with our integration plan. Leaving retail and turning now to our supply business, sales were $3.1 billion, up 46% and operating profit was $163 million, up 9% for the quarter. Like our retail business, supplies results were impacted by the slowdown in the housing market during the quarter. As a result, organic sales declined 6.5%. We continue to analyze strategic alternatives for the supply business. We are working as diligently as possible on this and we will update you as soon as the review is complete. For the quarter ahead and the remainder of the year, we expect the U.S. home improvement market to remain challenging. One simple benchmark that we’ve used is the percent of gross domestic product, GDP, represented by private residential investment. This number was as high as 6.3% in late 2005. It ended the first quarter of 2007 at 5%. The historic mean is around 4.8%. Active mortgage equity withdrawals have declined significantly and housing inventory continues to build. So we continue to see headwinds in our market and are not planning for any near-term market improvement. We will, however, stay on strategy and invest in our five key priorities: associate engagement; product excitement; shopping environment; product availability; and own the pro. At the end of this call, Carol will give you an update on our earnings guidance. Now let me turn the call over to Craig. Craig.
Craig Menear: Thank you, Frank and good morning, everybody. Comps in the first quarter were disappointing and less than what we had planned. Four departments performed above the company average -- electrical lighting, plumbing, garden, and appliances. Two departments performed around the company average -- paint and hardware. Five departments were below the average -- lumber, building materials, millwork, flooring, and kitchen and bath. As Frank mentioned, there were some notable factors in this quarter that impacted our performance. Weather, commodity deflation, and a tough housing market, particularly in certain regional areas where we have significant business. This was partially offset by sharper focus on merchandising fundamentals and implementation. We began the year in February with poor weather but bounced back with inline performance in March. However, the first two weeks of April brought with it unusually cold, snowy and wet weather that negatively impacted key seasonal and pro categories, particularly in the North. These two weeks of April happened to be some of the largest run-rate increase weeks in the quarter, so the timing of this weather impact was particularly difficult. Falling lumber prices continued to negatively impact results. In the first quarter, lumber price deflation negatively impacted comps by 95 basis points. Lumber prices are at their lowest point in five years. Existing and new home sales continued to be negative year over year, with some regions being affected more than others. For example, we experienced double-digit negative comps in South Florida and Boston due to slower sales in construction categories like windows and roofing. Soft housing along with the weather negatively impacted customer transactions. Additionally, these conditions impacted our big ticket items such as soft flooring and special order kitchens. Consequently, the average ticket was down 2.9% from last year to $59.01. Our gross margin rate in the first quarter reflects the acceleration of our merchandise strategy that we launched at the beginning of the year. We cleared out products to make room for new merchandising as we launched our enhanced product line review process. As an example, we accelerated the clearance in our wood and laminate categories as our stores implemented new resets in this area. Additionally, our gross margin rate reflects an increase in sales penetration of lower margin items such as appliances, power equipment, water heaters and wire. Finally, with the current market environment and severe weather impact, we created three significant sales driving events in an effort to support top line sales in certain categories. As part of our merchandise strategy, we told you that we would measure ourselves by our performance in market share improvement. We are seeing positive improvement in many of our product categories but we have a lot of work to do in others where we continue to lose share. An example of where we are continuing to lose share is bath. To address this, we have begun to roll out bath showrooms in new stores and smaller showroom resets in existing stores. These design showrooms and resets improve product visibility, making it easier for our customers to shop. Additionally, we are adding exciting new bath products under our Pegasus brand name to all of our stores. Other underperforming categories will be addressed throughout the year as we keep on our merchandise strategy. We have shared with you in the past that we have challenges in flooring. While we continue to work on soft flooring, we have seen improvement in hard surface flooring, led by strong performance in wood flooring and ceramic tile, driven primarily by reset activity and new product assortments. Both of these categories saw an increase in market share. We did see market share improvement on a rolling 12 month basis in several additional categories as we implemented our focused approach in assortment, presentation and value. These include categories of patio, outdoor power equipment, appliances, nursery, landscape, power tools and accessories. In patio, we enhanced our offerings to reflect the changing trends in outdoor living. Customers also responded to the breadth of brand offering and the value in power tools and outdoor power equipment. Through our strong vendor partnerships, we have improved our execution, product quality and value proposition in landscape and nursery products. Finally, we continued to have success in appliances during the quarter, gaining share for the fourth quarter in a row. I am proud that we were once again named Energy Star Retailer of the Year. This award was due in part to the Eco-Options program that we launched in the fourth quarter of last year. We continued our success of this program in the first quarter. Eco-Options is intended to educate our customers on ways to be more energy efficient. We gave away 1 million CFL bulbs on Earth Day, and the additional sales of CFLs led to strong positive comps in light bulbs. Overall, customers responded positively to our 2,500 plus environmentally friendly Eco-Options products. We will continue to work on enhancing this program with additional products to drive sales throughout the year. As we look to the second quarter, despite the tough market we believe our performance relative to the market will continue to improve as we proceed to execute our merchandise strategy. We are well-positioned in key seasonal categories, such as tractors, mowers, grills, patio and air conditioners, and we have new programs and products in place for key holidays, such as Memorial Day, Father’s Day and the Fourth of July. With that, I would now like to turn the call over to Paul.
Paul Raines: Thank you, Craig and good morning, everyone. As many of you know, one of our key priorities is associate engagement. The store experience starts with how our associates are feeling about themselves and the company. This business has a high emotional content and morale and the emotional engagement with customers is vital to our success. With over 364,000 associates, this is a challenge we continually face but in a short period of time, we’ve made notable progress in associate morale. I am getting a lot more e-mails from customers wanting to tell me about their great experience at The Home Depot. It is evident that our associates are energized. At our investor conference, we told you that we were going to make several investments. One was to deleverage payroll expense as a result of our associate engagement initiatives. We stayed true to that commitment in the first quarter. We also shared with you that we reduced the number of metrics we hold store managers accountable for from 35 to eight. This has allowed store managers to remain focused on what’s most important -- our customers. We gave the stores a fun fund -- $3,000 that could be used at the store manager’s discretion to pump up their associates. Since then, we have also done a number of other things. During the first quarter, we launched a program to hire master trade specialists, particularly certified plumbers and electricians. These specialists not only bring their experience and know-how to the store but they also transfer knowledge to other associates and help boost morale. While it is still early, we are pleased with this program. We have changed our associates’ compensation structure. One of the ways we reward our hourly associates for great performance is through success sharing, which was historically based on a store achieving 100% of its goals. This is not the market design so like many other retailers, we changed the threshold to 95%. Now, associates feel more empowered and motivated to reach these goals. I am pleased to say that for the first quarter, over 65% of our stores are on target to achieve success sharing. We also continued our Orange Juiced program and reintroduced merit badges, which we call the Homer badge. Our Homer badge program rewards associates for good performance or exceptional customer service. Once you attain three badges, you can exchange them for cash. You will soon begin to see the Homer badges on the aprons of your favorite associates across the country. We have strengthened the role of the regional merchandise manager, or RMM, in the merchandising process to ensure we are meeting the local product needs of our customers. Before this change, the majority of merchandising decisions were centralized but today, RMMs are able to adapt to the needs of customers by regionally allocating inventory. One of Home Depot's traditional strengths has been our ability to adapt to local needs and drive regional differentiation. We are returning to that core competence. To own the pro, we are focused on a number of different initiatives to better service pros, drive sales and build loyalty. One which I am really excited about is the pro bid room. The pro bid room, which is now available in all of our stores, allows us to leverage the buying power of The Home Depot for the benefit of our pro customers. Our direct ship program allows us to have large orders delivered from our vendors to the customer’s job site directly. This reduces handling, lead time and cost and builds loyalty with this important customer. The pro bid room brings the power of The Home Depot to our customer’s job site. Another initiative that I’m particularly excited about are managed accounts. We have identified our super premium customers, that 2% of customers that represents 30% of our sales. To better service these customers, we have begun adding more pro sales managers to strategic markets. Even though we are just starting to expand this program, accounts that are managed by a dedicated Home Depot pro sales manager spend 50% more than unmanaged accounts. As Frank mentioned, we have also continued to invest in programmatic store maintenance. Year over year, our spending on maintenance for general repairs, lighting, painting and lot striping has more than doubled. And with all of these investments, we are starting to see results. Through our voice of the customer surveys, we hear from approximately 200,000 customers a week. Our latest results show that we are tracking above the year-ago period for all of our metrics, indicating increased satisfaction from those customers that shop in our stores and make a purchase. We also know some customers have not shopped us recently so we are working hard to make their next experience a great one. Although the progress we are making in the stores is not evident in our financial results today, our attrition rates are down. The morale in the stores has improved significantly and our voice of the customer scores tell us we are doing the right things for our associates and our customers. I believe I have a good perspective on this. I have worked in the store support center and have also had key operational roles as RVP and Division President. I have a good understanding of the role that the store support center can play and the needs of the field, and can bridge those two. The Home Depot is a large enterprise and our reputation has been built through millions of customer experiences on the floor of our stores. I am pleased to say that we are committed to enhancing that legacy one customer at a time. I would now like to turn it over to Carol Tomé.
Carol B. Tomé: Thank you, Paul and hello, everyone. In the first quarter, our total company sales grew by 0.6% to $21.6 billion. We experienced sales growth of $977 million in our supply segment but a sales decline of $830 million in our retail segment. Sales in the retail segment were $18.5 billion, a 4.3% decrease from last year, reflecting the impact of negative same-store sales of 7.6%, offset in part by sales from new stores. Based on the slowing housing environment and tough year-over-year comparisons, we had planned for a negative comp of slightly over 5% for the quarter. What we didn’t plan for was unseasonably cold and wet weather in April. The two coldest weeks in April accounted for two-thirds of the comp miss to our plan, and the miss was found in the Northern and Southern part of the country. Out west, where the sun was shining, our Western Division beat its sales plan for the quarter. Same-store sales were negative 7.4% in February, negative 5% in March, and negative 9.3% in April. Now, while still negative, same-store sales have rebounded and for the first two weeks of the second quarter are in line with our expectation. One more comment about retail sales -- while we missed our comp plan by more than 200 basis points, the market growth was down from what we expected by approximately 300 basis points, so we believe we performed better than the market in the first quarter. As you heard from Frank, sales in the supply segment were $3.1 billion, up 45.8% from last year. We look at sales growth in this segment from an organic and an acquired perspective. Given the challenging residential construction market, organic sales declined by 6.5% in the first quarter. Consolidated gross margin was 32.9%, a decrease of 80 basis points from the same period last year. Given the growth in our supply segment, we are experiencing a higher penetration of lower supply gross margin dollars. In the first quarter, approximately 12% of our gross margin dollars came from supply, as compared to 8% last year. 38 basis points of the consolidated gross margin decline in the first quarter was a result of a higher penetration of supply. Supply’s gross margin for the first quarter was 26.8%, down 94 basis points from the first quarter last year, the majority of which reflects a change in mix of businesses owned, namely Hughes Supply. The remaining 42 basis points of contraction in our consolidated gross margin came from a decline in the retail gross margin. Retail’s gross margin in the first quarter was 33.8%, down 47 basis points from last year. At our February investor conference, we told you that we anticipated a gross margin benefit this year arising from lower interest costs associated with our private label credit card financing program. In the first quarter, we realized about 37 basis points of margin expansion from lower interest costs. This benefit was offset by two main factors. First, as Frank and Craig mentioned, we elected to accelerate clearance mark-downs in support of our reset activity and our product line review. Clearance mark-downs costs us about 54 basis points in the quarter. Second, we had a higher penetration of lower margin categories like appliances. This change in mix, along with the promotional activity that Craig mentioned, drove approximately 30 basis points of the year-over-year decline. In the first quarter, consolidated operating expenses as a percent of sales increased by 199 basis points to 24.4%, consistent with our plan. We experienced expense deleverage in both the retail and supply segments. As a percent of sales, total expenses in the retail segment grew by 217 basis points to 24.7%. This deleverage occurred across every major expense category in support of our five key priorities. For example, in addition to our recognition programs, we elected to keep associates on the floor of the store even though sales were softer than our plan. In the first quarter, total payroll as a percent of sales increased by 76 basis points from the prior year. One last comment about expenses; while we will control expenses where we can, in a negative comp environment, it is very hard to leverage expenses. We believe that for every point of negative comp, we will deleverage expenses by about 20 basis points. As a result of the factors I just mentioned, the operating margin in both our retail and supply segments declined from last year. On a consolidated basis, our operating margin for the first quarter was 8.5%, down 279 basis points from last year. Net interest expense was $161 million in the first quarter, up $109 million from last year, reflecting higher levels of outstanding indebtedness. Our long-term debt-to-equity ratio at the end of the first quarter was approximately 45% compared to approximately 24% one year ago. In the first quarter, our income tax provision rate was 37.5%. Diluted shares for the first quarter were 2 billion shares compared to 2.1 billion shares last year. The reduction in outstanding shares is due to our share repurchase program. In the first quarter, we repurchased 3.4 million shares and cumulatively since 2002 when our share repurchase program began, we have repurchased 454 million shares and spent $16.5 billion under our $17.5 billion authorization. Now, moving to our operational metrics, during the first quarter we opened 26 new stores, closed two floor stores, and relocated one store for an ending store count of 2,170 stores. Today, 230 stores representing approximately 11% of our store base, operate in Canada, Mexico and China. At the end of the first quarter, selling retail square footage was $228 million, a 5.6% increase from last year. The average square footage per store was 105,000 square feet, the same as last year. Reflecting the sales environment, total sales per square foot were approximately $329 for the quarter, down 9.4% from last year. In the first quarter, our new stores were 64% as productive as our comp stores, down from 66% last year and this reflects our changing store base. Of the new stores that we opened over the last year, approximately 28% were in Canada, Mexico and China. Generally, these stores are less productive than U.S. stores. Now, turning to the balance sheet, at the end of the quarter, total inventory was $14.4 billion, an increase of $1 billion, or 7.6%, from the first quarter last year. In the retail segment on a per store basis, retail inventory was up 0.2% from last year. Inventory is higher than we planned but that is because of the sales softness in April. Our inventory lumps are in seasonal categories and we have already seen inventory drop as seasonal sales have strengthened in May. Consolidated inventory turns were 4.3 times, down from 4.6 times last year. Beginning long-term debt and equity for the trailing four quarters, return on invested capital was 16.5%, reflecting our retail operating performance and lower returns in our supply business. We ended the quarter with $56 billion in assets, including $2.1 billion in cash and short-term investments. This is an increase of approximately $1.5 billion in cash and short-term investments from the end of fiscal 2006, reflecting cash flow generated by the business of approximately $2.8 billion, offset by $696 million of capital expenditure, $443 million in dividends paid, $91 million spent for share repurchases, and $31 million paid for acquisitions. As Frank mentioned, we believe the home improvement market will remain soft throughout 2007. We intend to continue our reinvestment plans for the long-term health of the business, understanding that it will put short-term pressure on earnings. At the beginning of the year, we provided earnings guidance and said that our earnings per share on a 52-week basis would decline by 4% to 9% in fiscal 2007. Based on the drivers of our first quarter performance, we now believe we will be at the low end of our earnings guidance for the year. Thank you for listening to today’s call and we are now ready to take your questions. We are ready for questions. Thank you.
Operator: (Operator Instructions) We’ll go first to Matthew Fassler with Goldman Sachs.
Matthew J. Fassler - Goldman Sachs: Thanks a lot and good morning. I want to focus first on supply margins, if you would. I think you spoke at your analyst meeting to slight operating margin expansion for that business for the year. I realize that Hughes had a dilutive impact on the margins but you did own it for part of the first quarter last year, so as you think about the earnings outlook for that piece of the business, would you say that it has perhaps come down from where you were at the outset of the year?
Carol B. Tomé: Good morning, Matt. Supply’s gross margin dropped 94 basis points in the first quarter from last year. 75 basis points of that was directly attributable to Hughes Supply. Last year, we had Hughes in for one month of the quarter. This year we had Hughes in for three months of the quarter. Based on the guidance that we gave at our February investor conference, despite the fact that the residential construction market is challenging, we still feel comfortable about the guidance that we’ve given.
Matthew J. Fassler - Goldman Sachs: And that has, that performance is not an issue as you look at the strategic review? Does the first quarter number if you will from supply impact the progress of that process?
Frank Blake: I think we are pleased with the performance of the supply business, again recognizing that they face some of the same issues in the housing market that you are all familiar with.
Matthew J. Fassler - Goldman Sachs: And just for a quick follow-up, the share repurchase number I guess was a much slower run-rate than we have typically seen, though obviously we are still early in the year. How should we think about that $90 million spent on repurchases and think about the outlook for buy-backs for the rest of the year?
Frank Blake: I think generally, we’ve said we are going to wait until the end of our strategic review process with supply and then come out with a more general framework around what we are going to do on capital and our share repurchases.
Matthew J. Fassler - Goldman Sachs: Fair enough. Thank you so much.
Operator: We’ll go now to Gary Balter with Credit Suisse.
Gary Balter - Credit Suisse: Thank you. Frank, first of all, I just want to say that just visiting stores, you see such a difference in the employees so whatever you are doing, keep it up.
Frank Blake: Thank you, Gary. It’s a lot of people other than I, obviously.
Gary Balter - Credit Suisse: Yes, it’s the whole team but you can see the difference. A question for you -- that wasn’t a question, so I still get my two, but a question for you; at the conference in February, you talked about operating margins going from 11.4 to 11.9 at retail between ’06 and 2010. It looks like this year is going to come in maybe 10-ish, 10.2, somewhere in that range. Are you still comfortable as you look out to 2010 that you could turn it around that rapidly, given the investments you need and given what you are seeing already?
Frank Blake: I think, as we talked about at the conference, we see such enormous opportunities around our supply chain. Mark is actually here in the room and he’s -- we’re starting to -- we’re very, very early in that process but that was really the bulk of where we saw the potential for operational efficiency and improvement and we remain very optimistic about that.
Gary Balter - Credit Suisse: As part of that, how dependent is the supply chain on getting the SAP system working effectively?
Frank Blake: That’s highly dependent on that. Mark, you might want to comment on it.
Mark Holifield: Yes, as you know, we have the core retail SAP implementation going forward in Canada and we are just at the early stages of beginning the plans to get that going in the U.S., but we are on track pretty much with our plans in Canada and expect a pilot with our first stores later this year.
Gary Balter - Credit Suisse: And then the second question is appliances obviously has a lower gross margin. That’s been an area you’ve been focusing on. Could you walk us through the operating margin difference between selling products such as appliances versus your core products?
Carol B. Tomé: From an operating margin perspective?
Gary Balter - Credit Suisse: Is there a dedicated labor force -- do you make it back, in other words, on the operating margin line or is this just something that is going to drive down margins as you grow in those businesses?
Craig Menear: We do have a dedicated team that from a labor standpoint that is involved with our appliance business but in total, we look at our sales in the appliance category and the growth in that business as part of driving overall top line sales productivity. We are looking for a margin mix in total that would bring the bottom line in conjunction with where our plans would project them to be. So we are not necessarily looking for an individual category look. We are looking at a total mix look.
Carol B. Tomé: But it’s fair to say we make money on appliances.
Gary Balter - Credit Suisse: Thank you.
Operator: We’ll go now to Colin McGranahan with Bernstein.
Colin McGranahan - Bernstein: Good morning. I wanted to focus a little bit on the gross margin line, and understanding obviously the first quarter was a difficult quarter from a clearance event and a seasonal event, but I just want to try to understand the tradeoff that you are looking at between comp growth and driving traffic, driving the excitement, which I know is one of the five major initiatives. I just want to try to get a little bit more understanding of how you are thinking about promotional events and whether given the clearance activity in the first quarter you still would expect gross margins in the retail business to be up for the year.
Frank Blake: First, I’ll make a comment on that and then turn it to Craig. As he commented, we did some promotional events in the first quarter frankly, I take this on myself, in response to the sales environment that didn’t pay out, that weren’t the smartest thing to do. I think as we go forward, the way we are thinking of our promotional events is to make sure they are more impactful and make more sense in terms of driving transactions in our store and yielding gross margin dollars.
Craig Menear: In terms of when you look at the margin impacts, we made a conscious decision to accelerate clearance in the first quarter, really looking to take advantage of some of the peak traffic time that we have in our store. Obviously didn’t anticipate the weather impact of the first couple of weeks of April, which also put a little bit more of a negative spin on our clearance plan in the quarter. We will be less promotional, as Frank said, moving forward. I think that it is fair to say mix is difficult for us to predict as we move forward.
Carol B. Tomé: If I could just jump in from a guidance perspective, based on the drivers of the first quarter performance, we are comfortable with the guidance that we gave on sales for the year, which was mid-single digit negative comp. We did have gross margin guidance as well. We are comfortable with the low-end of that gross margin guidance, which is the 20 basis point range.
Colin McGranahan - Bernstein: Okay, and then Carol while I’ve got you, just a quick follow-up, CapEx in the first quarter seemed a little bit light versus our expectations. Is that still on track for the year?
Carol B. Tomé: The thing about our capital spending program, as you can appreciate, this is the busiest time of the year for us and so we don’t want to put a lot of activity inside the stores when our customers are there. So you will see the capital start to really take off in the second, third and fourth quarters.
Colin McGranahan - Bernstein: Great, thanks.
Operator: We’ll go now to Budd Bugatch with Raymond James & Associates.
Budd Bugatch - Raymond James: Thank you and good morning. Payroll to sales you said went up 70 basis points in Q1. Could you reflect that versus what the plan might have been, and maybe tell us how we should think about payroll to sales for the rest of the year?
Carol B. Tomé: I’ll start and Paul, you might want to jump in, but we were actually over hours in the first quarter, so relative to our plan, the expense deleverage was a little bit more than we anticipated but we’re okay with that. We want to keep people on the floor of the store and we are not coming off the guidance that we gave, that we’ll keep the associates on the floor of the store.
Paul Raines: As you know, we’ve made a significant commitment beginning the back-half of last year to our voice of the customer projects and service, and we remain committed to that and we continue to see it through the rest of this year.
Budd Bugatch - Raymond James: I understand and appreciate that, I just wonder whether 76 basis points is a proper run-rate to expect for the rest of the year, or maybe just two-thirds of that, or somehow you can give us a feel for that.
Carol B. Tomé: Sure, Budd. I think that’s a very fair question. The sales were soft, I mean, clearly down almost 8% on a comp store basis, so that deleverage that we experienced in the first quarter is not what we expect to have going forward because we are not expecting a negative 8 comp for the balance of the year.
Budd Bugatch - Raymond James: Okay, two other areas just quickly; soft flooring has been very weak for a long time and I think the comp performance in the first quarter was maybe amongst the poorest in the stores, if our suppliers are telling us right. What are you doing to fix that? And did I hear you right that you closed both floor stores in the quarter?
Frank Blake: We did, Budd. We did not think that that pilot was particularly a good idea, or yielded the results that we expected. We are doing a number of things across soft flooring in the stores, and as you can appreciate -- and again, I’ll let Craig comment to some of the specifics -- but as you can appreciate, this is one of those items that goes from what the appearance of the store because it’s a décor kind of sale, the product that we carry in the store, and then the connection to our installers because such a large percentage of that product we install. So getting the right coordination from sale through to installation is a key part of getting that business right. Craig, do you want to make a couple of additional --
Craig Menear: Budd, I think if you look at our key actions that are taking place in the soft flooring market, we are focused on assortment. There are several assortment changes that are coming forward and are being implemented in the store really as we speak. As Frank mentioned, presentation, so we will begin to have some showroom upgrades in this category as well, and then of course we are focused on trying to simplify the offering for our customer from an installation standpoint. So all three of those are key action areas that we are focused on right now.
Budd Bugatch - Raymond James: When do you expect some positive comps in that particular area?
Craig Menear: We are seeing improvement begin in the category. We are a long ways from the category being where we want it to be.
Carol B. Tomé: I think we should just go ahead and tell you what flooring was, because it wasn’t one of the worst comp departments in the store. Flooring for the quarter was down 8.7%.
Budd Bugatch - Raymond James: I understand that, Carol, but that included the hard as well. I was just thinking about soft being that area.
Frank Blake: The other think I would add, Budd, in terms of your question of when this turns around, one of the areas where we have achieved the most success is frankly having more intensive training for our associates on the floor, so if you looked across the whole range of things that we’ve done, and we’ve been working on this -- this isn’t a first quarter issue, this has been a multi-year issue. That’s been one of the ones that’s had the most encouraging performance in terms of turning it around to positive comps, so we are now looking at okay, how do we take those pilots and extend them more broadly?
Budd Bugatch - Raymond James: That is exciting, Frank. My last question, Carol, for you is did I understand you have a -- the quality of the inventory is in good shape, that you’ve now with the better weather, the quality is okay and the amount of clearance should be therefore reduced in upcoming quarters?
Carol B. Tomé: The inventory lumps are in the seasonal categories. It’s patio, grill, tractors -- just good stuff and we are starting to see the inventory come down as the sales improve.
Budd Bugatch - Raymond James: Thank you very much.
Operator: We’ll go now to Steve Chick with J.P. Morgan.
Steve Chick - J.P. Morgan: Thank you. Just a couple of questions. Paul, you had outlined a projection of $200 million of payroll deleverage I think for 2007 back at the analyst presentation. I was wondering if you could speak to the payroll deleverage in terms of that target for the year. Secondly to that, with that and the $100 million investment that you made at the end of the second half, are you seeing improved customer service levels and sales related to the dollars that you are allocating to that investment?
Paul Raines: Maybe I’ll start with talking about the second piece of that and I’ll let Carol answer the first piece. I think we are seeing improved results. If you see our BOC metrics, we are clearly ahead on year over year on all of those metrics. We are seeing a significant improvement in the customer experience on all of those metrics. We also have a significant morale improvement in our stores, which as you know our associates, the ability to take care of customers is a big driver of their own morale, so we are pleased with that and we think that’s part of it. In terms of the deleverage, I think the main issue for us is we are going to continue to fund the activities in the store based on what our service model is and we don’t expect to see the kind of impact top line that we saw in the first quarter. Carol, I don’t know what you want to say about the deleverage.
Carol B. Tomé: That’s right. We’re on track.
Paul Raines: We’re on track.
Steve Chick - J.P. Morgan: But I guess -- for the $200 million, if I just simplistically take 76 basis points of deleverage this quarter and look at it relative to retail sales, I don’t know if it’s too simplistic to look at it that way but that’s about $140 million of deleverage. Is it too simplistic to look at it that way?
Carol B. Tomé: The payroll number I shared was total payroll inside the store. What Paul is referring to is hourly payroll, so I think we need to back that out. Hourly payroll we deleveraged by about 36 basis points in the first quarter, so maybe that’s helpful.
Steve Chick - J.P. Morgan: Okay, so the target that you’ve set out, you think that’s the right type of investment you need to make with hours in the stores?
Frank Blake: I would also say, Steve, it’s not as though we started this and said it’s a $200 million bucket and where are we on the $200 million bucket. It’s much more, as Paul said, what do we need on the floor of our store to adequately serve our customers? Look what happened to us on the first quarter was we kept to that despite some pressure on the sales. So if the bucket is slightly more or slightly less than the $200 million, that’s going to float a bit with what the sales are.
Steve Chick - J.P. Morgan: Second question, if I could, Frank, just in terms of the process with Home Depot Supply. I understand the sensitivities around speaking to it, but it was February 12th I think that you mentioned you were evaluating the review. I guess we are all anxious to hear the end of that evaluation but it is a little surprising that you haven’t decided yet. Can you speak to what the delay is, so to speak and how things are going with the process?
Frank Blake: Sure, I’d be happy to. I guess just so you know my mindset, I have to say I don’t see this at all as a delay. We are 90 days, give or take, 90 days into the process and truly, as you can well imagine, this wasn’t something that we had been thinking about 90 days before or 120 days before, so we are 90 days into the process and I think if you ask most folks what this kind of process takes, something between 90 and 180 -- I mean, 90 days would almost be unheard of. 180 days is probably more the norm. We are I think going to be a lot more expeditious in this but I don’t see this as a delay at all.
Steve Chick - J.P. Morgan: Okay, but are you pretty encouraged by the process in terms of feedback and interest level and things like that, in the event you go that route?
Frank Blake: I think -- look, there’s a lot of things we think about on a strategic evaluation process. One is the interest from other people in the assets and I think we’ve got some strong interest in the assets and then the other part is our own internal evaluation of what is the best thing for our shareholders with these assets.
Steve Chick - J.P. Morgan: Will we hear a conclusion by the end of next quarter, do you think?
Frank Blake: This is what I wouldn’t comment on.
Steve Chick - J.P. Morgan: Okay. Thanks.
Operator: We’ll go now to Eric Bosshard with Cleveland Research.
Eric Bosshard - Cleveland Research: Good morning. Can you talk a little bit about how you are going to get customers back into the store? It seemed like Craig commented that from a promotional spend, that you would be less promotional in 2Q. I’m just curious how you are going to get, how you expect to get customers back into the store to see the improved morale, improved energy in the store, improved execution.
Frank Blake: First, I’ll give a general comment on that, but offering -- to my mind, there’s a difference between promotional activity and offering compelling values. The compelling values will drive footsteps into our stores and that’s what we have to be focused and never lose that proposition to our customers. Then, I would also say if you look at where we are in the market, probably one of our biggest opportunities is conversion -- converting the customers who come into our stores as it is now. We are the top-of-mind home improvement retailer, so fortunately we are not faced with just an issue of gee, do I want to go into Home Depot? but when I’m in Home Depot looking at this category, do I see the compelling value? Do they have the product that I want? Craig, I don’t know if you want to add to that.
Craig Menear: Eric, it’s really continuing to work the merchandising strategy that I laid out at the conference. We have to continue to focus on improving our offering, as Frank has mentioned, as it relates to not only the value proposition but the line structure, and then really making sure that we communicate those values to our customers properly through our marketing efforts.
Eric Bosshard - Cleveland Research: And then just a follow-up for Carol, if I could. In terms of the guidance, Carol, you said that you are now at the low-end of the earnings guidance but maintaining what sounds like the same comp guidance. Is the deviation for the year just reflective of what happened in 1Q, or do you have a different perspective of how the rest of the year will lay out versus what your prior expectations were?
Carol B. Tomé: Well, clearly there’s the impact of the first quarter because we were below our earnings plan for the first quarter. As we look out for the remaining quarters, the change in our guidance really is on the gross margin line, where we believe we will have margin expansion but it won’t be on the high-end of the margin expansion that we had guided to earlier in the year.
Eric Bosshard - Cleveland Research: Thank you.
Diane Dayhoff: We have time for one more question.
Operator: We will take our final question from Chris Horvers with Bear Stearns.
Chris Horvers - Bear Stearns: Thank you. Good morning. Can you talk about the bay reset program for the year and how deep you are into that and how we should think about clearance activities looking forward?
Craig Menear: In terms of our merchandising resets, we are on track to continue driving change within our stores through multiple categories. You will see that begin to ramp up a little bit more heavily as we move towards the back-half of the second quarter. As Carol mentioned earlier, we do try to purposefully keep some of the activity out of this high-traffic timeframe so that we don’t disrupt the stores.
Chris Horvers - Bear Stearns: So should we expect clearance activity to also pick up in line with that?
Craig Menear: We accelerated clearance in the first quarter and we’ll see a more normalized clearance approach going through the balance of the year.
Chris Horvers - Bear Stearns: Okay, and on a related question as we think about the payroll and the maintenance spend on the stores, the cadence of that spending as we look throughout the year, how do you look at that and does the fact that you really started some of these programs in the back-half of last year make it less of a drag in the back-half?
Carol B. Tomé: As we mentioned at our investor conference, in support of our five key priorities, we are spending about $1.6 billion in capital, about $600 million in expense, so you are going to see that drag, if you will, in every quarter. We are investing for the long-term.
Chris Horvers - Bear Stearns: But the fact that you spent $500 million or so in the back-half of last year, you are going to spend the incremental on top of that?
Frank Blake: Again, it’s important that while we spend, we also -- in the back-half of ’06 we also know that just programmatically, there are improvements we have to be making in our stores.
Chris Horvers - Bear Stearns: Finally, as you think about the big ticket categories like kitchen and bath, clearly I expected that to be a drag on the comp perspective. How is that versus your expectations? Was it worse and did April have an impact and maybe saw some marginal or sequential improvement in May?
Craig Menear: I would say that it is fair to say in some of the big ticket category spending it was a little bit more difficult than what we had anticipated.
Chris Horvers - Bear Stearns: Any improvement in the back-half of the quarter or May?
Frank Blake: I’d say it’s still a little early.
Carol B. Tomé: We’re two weeks into May.
Chris Horvers - Bear Stearns: Okay. Thank you.
Frank Blake: Thank you all very much.
Diane Dayhoff: Thanks for joining us.
Operator: That does conclude our conference for today. Thank you all for your participation and have a great day. | [
{
"speaker": "Executives",
"text": "Diane Dayhoff - Vice President, Investor Relations Frank Blake - Chairman of the Board, Chief Executive Officer Craig Menear - Executive Vice President, Merchandising Paul Raines - Executive Vice President, U.S. Stores Carol B. Tomé - Chief Financial Officer and Executive Vice President - Corporate Services Mark Holifield - Senior Vice President, Supply Chain"
},
{
"speaker": "Analysts",
"text": "Matthew J. Fassler - Goldman Sachs Gary Balter - Credit Suisse Colin McGranahan - Bernstein Budd Bugatch - Raymond James Steve Chick - J.P. Morgan Eric Bosshard - Cleveland Research Chris Horvers - Bear Stearns"
},
{
"speaker": "Operator",
"text": "Good day, everyone and welcome to today’s Home Depot first quarter earnings conference call. As a reminder, today’s call is being recorded. Beginning today’s discussion is Miss Diane Dayhoff, Senior Vice President of Investor Relations. Please go ahead."
},
{
"speaker": "Diane Dayhoff",
"text": "Thank you and good morning to everyone. Welcome to the Home Depot first quarter earnings conference call. Joining us on our call today are Frank Blake, Chairman and CEO of The Home Depot; Craig Menear, Executive Vice President, Merchandising; Paul Raines, Executive Vice President, U.S. Stores; and Carol Tomé, Chief Financial Officer and Executive Vice President, Corporate Services. Following our prepared remarks, the call will be open for analysts’ questions. Questions will be limited to analysts and investors and as a reminder, we would appreciate it if the participants would limit themselves to one question with one follow-up please. This conference call is being broadcast real-time on the Internet at homedepot.com, with links on both our homepage and the investor relations section. The replay will also be available on our site. If we are unable to get to your question during the call, please call our investor relations department at 770-384-2387. Before I turn the call over to Frank, let me remind you that today’s press release and the presentations made by our executives include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1955. These statements are subject to risks and uncertainties. These risks and uncertainties include, but are not limited to, those factors identified in the release and in our filings with the Securities and Exchange Commission. Now, let me turn the call over to Frank Blake."
},
{
"speaker": "Frank Blake",
"text": "Thank you, Diane and good morning, everyone. This was a difficult first quarter for us. Consolidated sales were $21.6 billion, up about 1%, but diluted earnings per share were down 24% at $0.53. Our retail business had a negative comp of 7.6% for the quarter and while we expected a tough quarter, this was worse than we anticipated. There were a number of factors that contributed to our poor performance. The housing and home improvement markets were soft, and especially so in some of our traditionally strong markets in Florida and the Northeast. The weather was challenging as we had one of the coldest Aprils in more than a decade and finally, we continue to work through our own issues on performance and execution. Let me give you a summary assessment of what has gone well in this first quarter and where some of our major opportunities and issues remain. First, our associates have responded quickly and enthusiastically to the basic message that we are focusing on our retail business and reconnecting with the core values that are the foundation of the company. If anything, this has happened more rapidly than I anticipated and is a testament to the strength of the culture of this company and how deep-seated it is in our associates. As Paul will describe, we have taken a number of actions to change the way our associates are compensated, recognized and rewarded to make it clear that taking care of our associates is one of the core values of the company. We have also invested in associate hours on the store floor with a significant increase in payroll as a percent of sales. With this, we have rededicated ourselves to excellence in customer service and I hope you have seen some of that in our stores. We remain committed to our strategy of investing in the retail business despite the challenging environment. We know that this put additional pressure on our earnings in this quarter but believe it was important for the long-term strength of our business. Carol will take you through some of the specific drivers of the declines in our gross margin and operating profit performance. As a point of reference, we saw comp transaction declines of 15% to 20%-plus in our northern division and in parts of our southern division during two key weeks in April. It is difficult to make a timely adjustment for that level of decline. We did, however, see positive comp transactions of a similar magnitude this last week as spring arrived in the North. We are making good progress on our programmatic maintenance efforts and are well on our way on planned projects such as restroom remodels, floor polishing, re-lamping and lot striping. Over 20% of our projects are in progress or complete. We accelerated clearance mark-downs in the quarter in support of merchandising reset activities. We are revamping our processes for connecting with smaller vendors with innovative products who in the past have found it difficult to deal with some of our bureaucracy and procedures. We have taken early steps forward in our supply chain transformation. We have implemented enhancements to our replenishment systems. We successfully went live with our first distribution center conversion to the Manhattan Warehouse Management System, which will be our single state-of-the-art platform, and we have begun to pilot our new central distribution concepts. We have also made significant improvements in the services we provide to our pro customers, particularly through our bid room. We have nearly tripled the volume of business that we do through our bid room. We believe we have narrowed the gap between our performance and our market’s performance, but we still have significant room to improve. Craig will describe for you some of the areas where we are seeing market share gains, as well as some of the areas where we continue to struggle. We need to bring to every effort we undertake a consistent customer-based and store-based focus. This may sound obvious but there are worlds of differences between a program that works well in Atlanta and one that works well in the store, and we still have too many programs that aren’t designed for effective implementation in our stores. Now let me address our international retail business. Our international businesses, Canada, Mexico and China, performed well during the quarter. Canada’s comps were above the U.S.’ and the sales growth there was consistent with Canadian home improvement markets growth. Our Mexican stores continued to outperform the market, posting double-digit comps in the quarter, and our China stores are performing consistent with our integration plan. Leaving retail and turning now to our supply business, sales were $3.1 billion, up 46% and operating profit was $163 million, up 9% for the quarter. Like our retail business, supplies results were impacted by the slowdown in the housing market during the quarter. As a result, organic sales declined 6.5%. We continue to analyze strategic alternatives for the supply business. We are working as diligently as possible on this and we will update you as soon as the review is complete. For the quarter ahead and the remainder of the year, we expect the U.S. home improvement market to remain challenging. One simple benchmark that we’ve used is the percent of gross domestic product, GDP, represented by private residential investment. This number was as high as 6.3% in late 2005. It ended the first quarter of 2007 at 5%. The historic mean is around 4.8%. Active mortgage equity withdrawals have declined significantly and housing inventory continues to build. So we continue to see headwinds in our market and are not planning for any near-term market improvement. We will, however, stay on strategy and invest in our five key priorities: associate engagement; product excitement; shopping environment; product availability; and own the pro. At the end of this call, Carol will give you an update on our earnings guidance. Now let me turn the call over to Craig. Craig."
},
{
"speaker": "Craig Menear",
"text": "Thank you, Frank and good morning, everybody. Comps in the first quarter were disappointing and less than what we had planned. Four departments performed above the company average -- electrical lighting, plumbing, garden, and appliances. Two departments performed around the company average -- paint and hardware. Five departments were below the average -- lumber, building materials, millwork, flooring, and kitchen and bath. As Frank mentioned, there were some notable factors in this quarter that impacted our performance. Weather, commodity deflation, and a tough housing market, particularly in certain regional areas where we have significant business. This was partially offset by sharper focus on merchandising fundamentals and implementation. We began the year in February with poor weather but bounced back with inline performance in March. However, the first two weeks of April brought with it unusually cold, snowy and wet weather that negatively impacted key seasonal and pro categories, particularly in the North. These two weeks of April happened to be some of the largest run-rate increase weeks in the quarter, so the timing of this weather impact was particularly difficult. Falling lumber prices continued to negatively impact results. In the first quarter, lumber price deflation negatively impacted comps by 95 basis points. Lumber prices are at their lowest point in five years. Existing and new home sales continued to be negative year over year, with some regions being affected more than others. For example, we experienced double-digit negative comps in South Florida and Boston due to slower sales in construction categories like windows and roofing. Soft housing along with the weather negatively impacted customer transactions. Additionally, these conditions impacted our big ticket items such as soft flooring and special order kitchens. Consequently, the average ticket was down 2.9% from last year to $59.01. Our gross margin rate in the first quarter reflects the acceleration of our merchandise strategy that we launched at the beginning of the year. We cleared out products to make room for new merchandising as we launched our enhanced product line review process. As an example, we accelerated the clearance in our wood and laminate categories as our stores implemented new resets in this area. Additionally, our gross margin rate reflects an increase in sales penetration of lower margin items such as appliances, power equipment, water heaters and wire. Finally, with the current market environment and severe weather impact, we created three significant sales driving events in an effort to support top line sales in certain categories. As part of our merchandise strategy, we told you that we would measure ourselves by our performance in market share improvement. We are seeing positive improvement in many of our product categories but we have a lot of work to do in others where we continue to lose share. An example of where we are continuing to lose share is bath. To address this, we have begun to roll out bath showrooms in new stores and smaller showroom resets in existing stores. These design showrooms and resets improve product visibility, making it easier for our customers to shop. Additionally, we are adding exciting new bath products under our Pegasus brand name to all of our stores. Other underperforming categories will be addressed throughout the year as we keep on our merchandise strategy. We have shared with you in the past that we have challenges in flooring. While we continue to work on soft flooring, we have seen improvement in hard surface flooring, led by strong performance in wood flooring and ceramic tile, driven primarily by reset activity and new product assortments. Both of these categories saw an increase in market share. We did see market share improvement on a rolling 12 month basis in several additional categories as we implemented our focused approach in assortment, presentation and value. These include categories of patio, outdoor power equipment, appliances, nursery, landscape, power tools and accessories. In patio, we enhanced our offerings to reflect the changing trends in outdoor living. Customers also responded to the breadth of brand offering and the value in power tools and outdoor power equipment. Through our strong vendor partnerships, we have improved our execution, product quality and value proposition in landscape and nursery products. Finally, we continued to have success in appliances during the quarter, gaining share for the fourth quarter in a row. I am proud that we were once again named Energy Star Retailer of the Year. This award was due in part to the Eco-Options program that we launched in the fourth quarter of last year. We continued our success of this program in the first quarter. Eco-Options is intended to educate our customers on ways to be more energy efficient. We gave away 1 million CFL bulbs on Earth Day, and the additional sales of CFLs led to strong positive comps in light bulbs. Overall, customers responded positively to our 2,500 plus environmentally friendly Eco-Options products. We will continue to work on enhancing this program with additional products to drive sales throughout the year. As we look to the second quarter, despite the tough market we believe our performance relative to the market will continue to improve as we proceed to execute our merchandise strategy. We are well-positioned in key seasonal categories, such as tractors, mowers, grills, patio and air conditioners, and we have new programs and products in place for key holidays, such as Memorial Day, Father’s Day and the Fourth of July. With that, I would now like to turn the call over to Paul."
},
{
"speaker": "Paul Raines",
"text": "Thank you, Craig and good morning, everyone. As many of you know, one of our key priorities is associate engagement. The store experience starts with how our associates are feeling about themselves and the company. This business has a high emotional content and morale and the emotional engagement with customers is vital to our success. With over 364,000 associates, this is a challenge we continually face but in a short period of time, we’ve made notable progress in associate morale. I am getting a lot more e-mails from customers wanting to tell me about their great experience at The Home Depot. It is evident that our associates are energized. At our investor conference, we told you that we were going to make several investments. One was to deleverage payroll expense as a result of our associate engagement initiatives. We stayed true to that commitment in the first quarter. We also shared with you that we reduced the number of metrics we hold store managers accountable for from 35 to eight. This has allowed store managers to remain focused on what’s most important -- our customers. We gave the stores a fun fund -- $3,000 that could be used at the store manager’s discretion to pump up their associates. Since then, we have also done a number of other things. During the first quarter, we launched a program to hire master trade specialists, particularly certified plumbers and electricians. These specialists not only bring their experience and know-how to the store but they also transfer knowledge to other associates and help boost morale. While it is still early, we are pleased with this program. We have changed our associates’ compensation structure. One of the ways we reward our hourly associates for great performance is through success sharing, which was historically based on a store achieving 100% of its goals. This is not the market design so like many other retailers, we changed the threshold to 95%. Now, associates feel more empowered and motivated to reach these goals. I am pleased to say that for the first quarter, over 65% of our stores are on target to achieve success sharing. We also continued our Orange Juiced program and reintroduced merit badges, which we call the Homer badge. Our Homer badge program rewards associates for good performance or exceptional customer service. Once you attain three badges, you can exchange them for cash. You will soon begin to see the Homer badges on the aprons of your favorite associates across the country. We have strengthened the role of the regional merchandise manager, or RMM, in the merchandising process to ensure we are meeting the local product needs of our customers. Before this change, the majority of merchandising decisions were centralized but today, RMMs are able to adapt to the needs of customers by regionally allocating inventory. One of Home Depot's traditional strengths has been our ability to adapt to local needs and drive regional differentiation. We are returning to that core competence. To own the pro, we are focused on a number of different initiatives to better service pros, drive sales and build loyalty. One which I am really excited about is the pro bid room. The pro bid room, which is now available in all of our stores, allows us to leverage the buying power of The Home Depot for the benefit of our pro customers. Our direct ship program allows us to have large orders delivered from our vendors to the customer’s job site directly. This reduces handling, lead time and cost and builds loyalty with this important customer. The pro bid room brings the power of The Home Depot to our customer’s job site. Another initiative that I’m particularly excited about are managed accounts. We have identified our super premium customers, that 2% of customers that represents 30% of our sales. To better service these customers, we have begun adding more pro sales managers to strategic markets. Even though we are just starting to expand this program, accounts that are managed by a dedicated Home Depot pro sales manager spend 50% more than unmanaged accounts. As Frank mentioned, we have also continued to invest in programmatic store maintenance. Year over year, our spending on maintenance for general repairs, lighting, painting and lot striping has more than doubled. And with all of these investments, we are starting to see results. Through our voice of the customer surveys, we hear from approximately 200,000 customers a week. Our latest results show that we are tracking above the year-ago period for all of our metrics, indicating increased satisfaction from those customers that shop in our stores and make a purchase. We also know some customers have not shopped us recently so we are working hard to make their next experience a great one. Although the progress we are making in the stores is not evident in our financial results today, our attrition rates are down. The morale in the stores has improved significantly and our voice of the customer scores tell us we are doing the right things for our associates and our customers. I believe I have a good perspective on this. I have worked in the store support center and have also had key operational roles as RVP and Division President. I have a good understanding of the role that the store support center can play and the needs of the field, and can bridge those two. The Home Depot is a large enterprise and our reputation has been built through millions of customer experiences on the floor of our stores. I am pleased to say that we are committed to enhancing that legacy one customer at a time. I would now like to turn it over to Carol Tomé."
},
{
"speaker": "Carol B. Tomé",
"text": "Thank you, Paul and hello, everyone. In the first quarter, our total company sales grew by 0.6% to $21.6 billion. We experienced sales growth of $977 million in our supply segment but a sales decline of $830 million in our retail segment. Sales in the retail segment were $18.5 billion, a 4.3% decrease from last year, reflecting the impact of negative same-store sales of 7.6%, offset in part by sales from new stores. Based on the slowing housing environment and tough year-over-year comparisons, we had planned for a negative comp of slightly over 5% for the quarter. What we didn’t plan for was unseasonably cold and wet weather in April. The two coldest weeks in April accounted for two-thirds of the comp miss to our plan, and the miss was found in the Northern and Southern part of the country. Out west, where the sun was shining, our Western Division beat its sales plan for the quarter. Same-store sales were negative 7.4% in February, negative 5% in March, and negative 9.3% in April. Now, while still negative, same-store sales have rebounded and for the first two weeks of the second quarter are in line with our expectation. One more comment about retail sales -- while we missed our comp plan by more than 200 basis points, the market growth was down from what we expected by approximately 300 basis points, so we believe we performed better than the market in the first quarter. As you heard from Frank, sales in the supply segment were $3.1 billion, up 45.8% from last year. We look at sales growth in this segment from an organic and an acquired perspective. Given the challenging residential construction market, organic sales declined by 6.5% in the first quarter. Consolidated gross margin was 32.9%, a decrease of 80 basis points from the same period last year. Given the growth in our supply segment, we are experiencing a higher penetration of lower supply gross margin dollars. In the first quarter, approximately 12% of our gross margin dollars came from supply, as compared to 8% last year. 38 basis points of the consolidated gross margin decline in the first quarter was a result of a higher penetration of supply. Supply’s gross margin for the first quarter was 26.8%, down 94 basis points from the first quarter last year, the majority of which reflects a change in mix of businesses owned, namely Hughes Supply. The remaining 42 basis points of contraction in our consolidated gross margin came from a decline in the retail gross margin. Retail’s gross margin in the first quarter was 33.8%, down 47 basis points from last year. At our February investor conference, we told you that we anticipated a gross margin benefit this year arising from lower interest costs associated with our private label credit card financing program. In the first quarter, we realized about 37 basis points of margin expansion from lower interest costs. This benefit was offset by two main factors. First, as Frank and Craig mentioned, we elected to accelerate clearance mark-downs in support of our reset activity and our product line review. Clearance mark-downs costs us about 54 basis points in the quarter. Second, we had a higher penetration of lower margin categories like appliances. This change in mix, along with the promotional activity that Craig mentioned, drove approximately 30 basis points of the year-over-year decline. In the first quarter, consolidated operating expenses as a percent of sales increased by 199 basis points to 24.4%, consistent with our plan. We experienced expense deleverage in both the retail and supply segments. As a percent of sales, total expenses in the retail segment grew by 217 basis points to 24.7%. This deleverage occurred across every major expense category in support of our five key priorities. For example, in addition to our recognition programs, we elected to keep associates on the floor of the store even though sales were softer than our plan. In the first quarter, total payroll as a percent of sales increased by 76 basis points from the prior year. One last comment about expenses; while we will control expenses where we can, in a negative comp environment, it is very hard to leverage expenses. We believe that for every point of negative comp, we will deleverage expenses by about 20 basis points. As a result of the factors I just mentioned, the operating margin in both our retail and supply segments declined from last year. On a consolidated basis, our operating margin for the first quarter was 8.5%, down 279 basis points from last year. Net interest expense was $161 million in the first quarter, up $109 million from last year, reflecting higher levels of outstanding indebtedness. Our long-term debt-to-equity ratio at the end of the first quarter was approximately 45% compared to approximately 24% one year ago. In the first quarter, our income tax provision rate was 37.5%. Diluted shares for the first quarter were 2 billion shares compared to 2.1 billion shares last year. The reduction in outstanding shares is due to our share repurchase program. In the first quarter, we repurchased 3.4 million shares and cumulatively since 2002 when our share repurchase program began, we have repurchased 454 million shares and spent $16.5 billion under our $17.5 billion authorization. Now, moving to our operational metrics, during the first quarter we opened 26 new stores, closed two floor stores, and relocated one store for an ending store count of 2,170 stores. Today, 230 stores representing approximately 11% of our store base, operate in Canada, Mexico and China. At the end of the first quarter, selling retail square footage was $228 million, a 5.6% increase from last year. The average square footage per store was 105,000 square feet, the same as last year. Reflecting the sales environment, total sales per square foot were approximately $329 for the quarter, down 9.4% from last year. In the first quarter, our new stores were 64% as productive as our comp stores, down from 66% last year and this reflects our changing store base. Of the new stores that we opened over the last year, approximately 28% were in Canada, Mexico and China. Generally, these stores are less productive than U.S. stores. Now, turning to the balance sheet, at the end of the quarter, total inventory was $14.4 billion, an increase of $1 billion, or 7.6%, from the first quarter last year. In the retail segment on a per store basis, retail inventory was up 0.2% from last year. Inventory is higher than we planned but that is because of the sales softness in April. Our inventory lumps are in seasonal categories and we have already seen inventory drop as seasonal sales have strengthened in May. Consolidated inventory turns were 4.3 times, down from 4.6 times last year. Beginning long-term debt and equity for the trailing four quarters, return on invested capital was 16.5%, reflecting our retail operating performance and lower returns in our supply business. We ended the quarter with $56 billion in assets, including $2.1 billion in cash and short-term investments. This is an increase of approximately $1.5 billion in cash and short-term investments from the end of fiscal 2006, reflecting cash flow generated by the business of approximately $2.8 billion, offset by $696 million of capital expenditure, $443 million in dividends paid, $91 million spent for share repurchases, and $31 million paid for acquisitions. As Frank mentioned, we believe the home improvement market will remain soft throughout 2007. We intend to continue our reinvestment plans for the long-term health of the business, understanding that it will put short-term pressure on earnings. At the beginning of the year, we provided earnings guidance and said that our earnings per share on a 52-week basis would decline by 4% to 9% in fiscal 2007. Based on the drivers of our first quarter performance, we now believe we will be at the low end of our earnings guidance for the year. Thank you for listening to today’s call and we are now ready to take your questions. We are ready for questions. Thank you."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) We’ll go first to Matthew Fassler with Goldman Sachs."
},
{
"speaker": "Matthew J. Fassler - Goldman Sachs",
"text": "Thanks a lot and good morning. I want to focus first on supply margins, if you would. I think you spoke at your analyst meeting to slight operating margin expansion for that business for the year. I realize that Hughes had a dilutive impact on the margins but you did own it for part of the first quarter last year, so as you think about the earnings outlook for that piece of the business, would you say that it has perhaps come down from where you were at the outset of the year?"
},
{
"speaker": "Carol B. Tomé",
"text": "Good morning, Matt. Supply’s gross margin dropped 94 basis points in the first quarter from last year. 75 basis points of that was directly attributable to Hughes Supply. Last year, we had Hughes in for one month of the quarter. This year we had Hughes in for three months of the quarter. Based on the guidance that we gave at our February investor conference, despite the fact that the residential construction market is challenging, we still feel comfortable about the guidance that we’ve given."
},
{
"speaker": "Matthew J. Fassler - Goldman Sachs",
"text": "And that has, that performance is not an issue as you look at the strategic review? Does the first quarter number if you will from supply impact the progress of that process?"
},
{
"speaker": "Frank Blake",
"text": "I think we are pleased with the performance of the supply business, again recognizing that they face some of the same issues in the housing market that you are all familiar with."
},
{
"speaker": "Matthew J. Fassler - Goldman Sachs",
"text": "And just for a quick follow-up, the share repurchase number I guess was a much slower run-rate than we have typically seen, though obviously we are still early in the year. How should we think about that $90 million spent on repurchases and think about the outlook for buy-backs for the rest of the year?"
},
{
"speaker": "Frank Blake",
"text": "I think generally, we’ve said we are going to wait until the end of our strategic review process with supply and then come out with a more general framework around what we are going to do on capital and our share repurchases."
},
{
"speaker": "Matthew J. Fassler - Goldman Sachs",
"text": "Fair enough. Thank you so much."
},
{
"speaker": "Operator",
"text": "We’ll go now to Gary Balter with Credit Suisse."
},
{
"speaker": "Gary Balter - Credit Suisse",
"text": "Thank you. Frank, first of all, I just want to say that just visiting stores, you see such a difference in the employees so whatever you are doing, keep it up."
},
{
"speaker": "Frank Blake",
"text": "Thank you, Gary. It’s a lot of people other than I, obviously."
},
{
"speaker": "Gary Balter - Credit Suisse",
"text": "Yes, it’s the whole team but you can see the difference. A question for you -- that wasn’t a question, so I still get my two, but a question for you; at the conference in February, you talked about operating margins going from 11.4 to 11.9 at retail between ’06 and 2010. It looks like this year is going to come in maybe 10-ish, 10.2, somewhere in that range. Are you still comfortable as you look out to 2010 that you could turn it around that rapidly, given the investments you need and given what you are seeing already?"
},
{
"speaker": "Frank Blake",
"text": "I think, as we talked about at the conference, we see such enormous opportunities around our supply chain. Mark is actually here in the room and he’s -- we’re starting to -- we’re very, very early in that process but that was really the bulk of where we saw the potential for operational efficiency and improvement and we remain very optimistic about that."
},
{
"speaker": "Gary Balter - Credit Suisse",
"text": "As part of that, how dependent is the supply chain on getting the SAP system working effectively?"
},
{
"speaker": "Frank Blake",
"text": "That’s highly dependent on that. Mark, you might want to comment on it."
},
{
"speaker": "Mark Holifield",
"text": "Yes, as you know, we have the core retail SAP implementation going forward in Canada and we are just at the early stages of beginning the plans to get that going in the U.S., but we are on track pretty much with our plans in Canada and expect a pilot with our first stores later this year."
},
{
"speaker": "Gary Balter - Credit Suisse",
"text": "And then the second question is appliances obviously has a lower gross margin. That’s been an area you’ve been focusing on. Could you walk us through the operating margin difference between selling products such as appliances versus your core products?"
},
{
"speaker": "Carol B. Tomé",
"text": "From an operating margin perspective?"
},
{
"speaker": "Gary Balter - Credit Suisse",
"text": "Is there a dedicated labor force -- do you make it back, in other words, on the operating margin line or is this just something that is going to drive down margins as you grow in those businesses?"
},
{
"speaker": "Craig Menear",
"text": "We do have a dedicated team that from a labor standpoint that is involved with our appliance business but in total, we look at our sales in the appliance category and the growth in that business as part of driving overall top line sales productivity. We are looking for a margin mix in total that would bring the bottom line in conjunction with where our plans would project them to be. So we are not necessarily looking for an individual category look. We are looking at a total mix look."
},
{
"speaker": "Carol B. Tomé",
"text": "But it’s fair to say we make money on appliances."
},
{
"speaker": "Gary Balter - Credit Suisse",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "We’ll go now to Colin McGranahan with Bernstein."
},
{
"speaker": "Colin McGranahan - Bernstein",
"text": "Good morning. I wanted to focus a little bit on the gross margin line, and understanding obviously the first quarter was a difficult quarter from a clearance event and a seasonal event, but I just want to try to understand the tradeoff that you are looking at between comp growth and driving traffic, driving the excitement, which I know is one of the five major initiatives. I just want to try to get a little bit more understanding of how you are thinking about promotional events and whether given the clearance activity in the first quarter you still would expect gross margins in the retail business to be up for the year."
},
{
"speaker": "Frank Blake",
"text": "First, I’ll make a comment on that and then turn it to Craig. As he commented, we did some promotional events in the first quarter frankly, I take this on myself, in response to the sales environment that didn’t pay out, that weren’t the smartest thing to do. I think as we go forward, the way we are thinking of our promotional events is to make sure they are more impactful and make more sense in terms of driving transactions in our store and yielding gross margin dollars."
},
{
"speaker": "Craig Menear",
"text": "In terms of when you look at the margin impacts, we made a conscious decision to accelerate clearance in the first quarter, really looking to take advantage of some of the peak traffic time that we have in our store. Obviously didn’t anticipate the weather impact of the first couple of weeks of April, which also put a little bit more of a negative spin on our clearance plan in the quarter. We will be less promotional, as Frank said, moving forward. I think that it is fair to say mix is difficult for us to predict as we move forward."
},
{
"speaker": "Carol B. Tomé",
"text": "If I could just jump in from a guidance perspective, based on the drivers of the first quarter performance, we are comfortable with the guidance that we gave on sales for the year, which was mid-single digit negative comp. We did have gross margin guidance as well. We are comfortable with the low-end of that gross margin guidance, which is the 20 basis point range."
},
{
"speaker": "Colin McGranahan - Bernstein",
"text": "Okay, and then Carol while I’ve got you, just a quick follow-up, CapEx in the first quarter seemed a little bit light versus our expectations. Is that still on track for the year?"
},
{
"speaker": "Carol B. Tomé",
"text": "The thing about our capital spending program, as you can appreciate, this is the busiest time of the year for us and so we don’t want to put a lot of activity inside the stores when our customers are there. So you will see the capital start to really take off in the second, third and fourth quarters."
},
{
"speaker": "Colin McGranahan - Bernstein",
"text": "Great, thanks."
},
{
"speaker": "Operator",
"text": "We’ll go now to Budd Bugatch with Raymond James & Associates."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "Thank you and good morning. Payroll to sales you said went up 70 basis points in Q1. Could you reflect that versus what the plan might have been, and maybe tell us how we should think about payroll to sales for the rest of the year?"
},
{
"speaker": "Carol B. Tomé",
"text": "I’ll start and Paul, you might want to jump in, but we were actually over hours in the first quarter, so relative to our plan, the expense deleverage was a little bit more than we anticipated but we’re okay with that. We want to keep people on the floor of the store and we are not coming off the guidance that we gave, that we’ll keep the associates on the floor of the store."
},
{
"speaker": "Paul Raines",
"text": "As you know, we’ve made a significant commitment beginning the back-half of last year to our voice of the customer projects and service, and we remain committed to that and we continue to see it through the rest of this year."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "I understand and appreciate that, I just wonder whether 76 basis points is a proper run-rate to expect for the rest of the year, or maybe just two-thirds of that, or somehow you can give us a feel for that."
},
{
"speaker": "Carol B. Tomé",
"text": "Sure, Budd. I think that’s a very fair question. The sales were soft, I mean, clearly down almost 8% on a comp store basis, so that deleverage that we experienced in the first quarter is not what we expect to have going forward because we are not expecting a negative 8 comp for the balance of the year."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "Okay, two other areas just quickly; soft flooring has been very weak for a long time and I think the comp performance in the first quarter was maybe amongst the poorest in the stores, if our suppliers are telling us right. What are you doing to fix that? And did I hear you right that you closed both floor stores in the quarter?"
},
{
"speaker": "Frank Blake",
"text": "We did, Budd. We did not think that that pilot was particularly a good idea, or yielded the results that we expected. We are doing a number of things across soft flooring in the stores, and as you can appreciate -- and again, I’ll let Craig comment to some of the specifics -- but as you can appreciate, this is one of those items that goes from what the appearance of the store because it’s a décor kind of sale, the product that we carry in the store, and then the connection to our installers because such a large percentage of that product we install. So getting the right coordination from sale through to installation is a key part of getting that business right. Craig, do you want to make a couple of additional --"
},
{
"speaker": "Craig Menear",
"text": "Budd, I think if you look at our key actions that are taking place in the soft flooring market, we are focused on assortment. There are several assortment changes that are coming forward and are being implemented in the store really as we speak. As Frank mentioned, presentation, so we will begin to have some showroom upgrades in this category as well, and then of course we are focused on trying to simplify the offering for our customer from an installation standpoint. So all three of those are key action areas that we are focused on right now."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "When do you expect some positive comps in that particular area?"
},
{
"speaker": "Craig Menear",
"text": "We are seeing improvement begin in the category. We are a long ways from the category being where we want it to be."
},
{
"speaker": "Carol B. Tomé",
"text": "I think we should just go ahead and tell you what flooring was, because it wasn’t one of the worst comp departments in the store. Flooring for the quarter was down 8.7%."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "I understand that, Carol, but that included the hard as well. I was just thinking about soft being that area."
},
{
"speaker": "Frank Blake",
"text": "The other think I would add, Budd, in terms of your question of when this turns around, one of the areas where we have achieved the most success is frankly having more intensive training for our associates on the floor, so if you looked across the whole range of things that we’ve done, and we’ve been working on this -- this isn’t a first quarter issue, this has been a multi-year issue. That’s been one of the ones that’s had the most encouraging performance in terms of turning it around to positive comps, so we are now looking at okay, how do we take those pilots and extend them more broadly?"
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "That is exciting, Frank. My last question, Carol, for you is did I understand you have a -- the quality of the inventory is in good shape, that you’ve now with the better weather, the quality is okay and the amount of clearance should be therefore reduced in upcoming quarters?"
},
{
"speaker": "Carol B. Tomé",
"text": "The inventory lumps are in the seasonal categories. It’s patio, grill, tractors -- just good stuff and we are starting to see the inventory come down as the sales improve."
},
{
"speaker": "Budd Bugatch - Raymond James",
"text": "Thank you very much."
},
{
"speaker": "Operator",
"text": "We’ll go now to Steve Chick with J.P. Morgan."
},
{
"speaker": "Steve Chick - J.P. Morgan",
"text": "Thank you. Just a couple of questions. Paul, you had outlined a projection of $200 million of payroll deleverage I think for 2007 back at the analyst presentation. I was wondering if you could speak to the payroll deleverage in terms of that target for the year. Secondly to that, with that and the $100 million investment that you made at the end of the second half, are you seeing improved customer service levels and sales related to the dollars that you are allocating to that investment?"
},
{
"speaker": "Paul Raines",
"text": "Maybe I’ll start with talking about the second piece of that and I’ll let Carol answer the first piece. I think we are seeing improved results. If you see our BOC metrics, we are clearly ahead on year over year on all of those metrics. We are seeing a significant improvement in the customer experience on all of those metrics. We also have a significant morale improvement in our stores, which as you know our associates, the ability to take care of customers is a big driver of their own morale, so we are pleased with that and we think that’s part of it. In terms of the deleverage, I think the main issue for us is we are going to continue to fund the activities in the store based on what our service model is and we don’t expect to see the kind of impact top line that we saw in the first quarter. Carol, I don’t know what you want to say about the deleverage."
},
{
"speaker": "Carol B. Tomé",
"text": "That’s right. We’re on track."
},
{
"speaker": "Paul Raines",
"text": "We’re on track."
},
{
"speaker": "Steve Chick - J.P. Morgan",
"text": "But I guess -- for the $200 million, if I just simplistically take 76 basis points of deleverage this quarter and look at it relative to retail sales, I don’t know if it’s too simplistic to look at it that way but that’s about $140 million of deleverage. Is it too simplistic to look at it that way?"
},
{
"speaker": "Carol B. Tomé",
"text": "The payroll number I shared was total payroll inside the store. What Paul is referring to is hourly payroll, so I think we need to back that out. Hourly payroll we deleveraged by about 36 basis points in the first quarter, so maybe that’s helpful."
},
{
"speaker": "Steve Chick - J.P. Morgan",
"text": "Okay, so the target that you’ve set out, you think that’s the right type of investment you need to make with hours in the stores?"
},
{
"speaker": "Frank Blake",
"text": "I would also say, Steve, it’s not as though we started this and said it’s a $200 million bucket and where are we on the $200 million bucket. It’s much more, as Paul said, what do we need on the floor of our store to adequately serve our customers? Look what happened to us on the first quarter was we kept to that despite some pressure on the sales. So if the bucket is slightly more or slightly less than the $200 million, that’s going to float a bit with what the sales are."
},
{
"speaker": "Steve Chick - J.P. Morgan",
"text": "Second question, if I could, Frank, just in terms of the process with Home Depot Supply. I understand the sensitivities around speaking to it, but it was February 12th I think that you mentioned you were evaluating the review. I guess we are all anxious to hear the end of that evaluation but it is a little surprising that you haven’t decided yet. Can you speak to what the delay is, so to speak and how things are going with the process?"
},
{
"speaker": "Frank Blake",
"text": "Sure, I’d be happy to. I guess just so you know my mindset, I have to say I don’t see this at all as a delay. We are 90 days, give or take, 90 days into the process and truly, as you can well imagine, this wasn’t something that we had been thinking about 90 days before or 120 days before, so we are 90 days into the process and I think if you ask most folks what this kind of process takes, something between 90 and 180 -- I mean, 90 days would almost be unheard of. 180 days is probably more the norm. We are I think going to be a lot more expeditious in this but I don’t see this as a delay at all."
},
{
"speaker": "Steve Chick - J.P. Morgan",
"text": "Okay, but are you pretty encouraged by the process in terms of feedback and interest level and things like that, in the event you go that route?"
},
{
"speaker": "Frank Blake",
"text": "I think -- look, there’s a lot of things we think about on a strategic evaluation process. One is the interest from other people in the assets and I think we’ve got some strong interest in the assets and then the other part is our own internal evaluation of what is the best thing for our shareholders with these assets."
},
{
"speaker": "Steve Chick - J.P. Morgan",
"text": "Will we hear a conclusion by the end of next quarter, do you think?"
},
{
"speaker": "Frank Blake",
"text": "This is what I wouldn’t comment on."
},
{
"speaker": "Steve Chick - J.P. Morgan",
"text": "Okay. Thanks."
},
{
"speaker": "Operator",
"text": "We’ll go now to Eric Bosshard with Cleveland Research."
},
{
"speaker": "Eric Bosshard - Cleveland Research",
"text": "Good morning. Can you talk a little bit about how you are going to get customers back into the store? It seemed like Craig commented that from a promotional spend, that you would be less promotional in 2Q. I’m just curious how you are going to get, how you expect to get customers back into the store to see the improved morale, improved energy in the store, improved execution."
},
{
"speaker": "Frank Blake",
"text": "First, I’ll give a general comment on that, but offering -- to my mind, there’s a difference between promotional activity and offering compelling values. The compelling values will drive footsteps into our stores and that’s what we have to be focused and never lose that proposition to our customers. Then, I would also say if you look at where we are in the market, probably one of our biggest opportunities is conversion -- converting the customers who come into our stores as it is now. We are the top-of-mind home improvement retailer, so fortunately we are not faced with just an issue of gee, do I want to go into Home Depot? but when I’m in Home Depot looking at this category, do I see the compelling value? Do they have the product that I want? Craig, I don’t know if you want to add to that."
},
{
"speaker": "Craig Menear",
"text": "Eric, it’s really continuing to work the merchandising strategy that I laid out at the conference. We have to continue to focus on improving our offering, as Frank has mentioned, as it relates to not only the value proposition but the line structure, and then really making sure that we communicate those values to our customers properly through our marketing efforts."
},
{
"speaker": "Eric Bosshard - Cleveland Research",
"text": "And then just a follow-up for Carol, if I could. In terms of the guidance, Carol, you said that you are now at the low-end of the earnings guidance but maintaining what sounds like the same comp guidance. Is the deviation for the year just reflective of what happened in 1Q, or do you have a different perspective of how the rest of the year will lay out versus what your prior expectations were?"
},
{
"speaker": "Carol B. Tomé",
"text": "Well, clearly there’s the impact of the first quarter because we were below our earnings plan for the first quarter. As we look out for the remaining quarters, the change in our guidance really is on the gross margin line, where we believe we will have margin expansion but it won’t be on the high-end of the margin expansion that we had guided to earlier in the year."
},
{
"speaker": "Eric Bosshard - Cleveland Research",
"text": "Thank you."
},
{
"speaker": "Diane Dayhoff",
"text": "We have time for one more question."
},
{
"speaker": "Operator",
"text": "We will take our final question from Chris Horvers with Bear Stearns."
},
{
"speaker": "Chris Horvers - Bear Stearns",
"text": "Thank you. Good morning. Can you talk about the bay reset program for the year and how deep you are into that and how we should think about clearance activities looking forward?"
},
{
"speaker": "Craig Menear",
"text": "In terms of our merchandising resets, we are on track to continue driving change within our stores through multiple categories. You will see that begin to ramp up a little bit more heavily as we move towards the back-half of the second quarter. As Carol mentioned earlier, we do try to purposefully keep some of the activity out of this high-traffic timeframe so that we don’t disrupt the stores."
},
{
"speaker": "Chris Horvers - Bear Stearns",
"text": "So should we expect clearance activity to also pick up in line with that?"
},
{
"speaker": "Craig Menear",
"text": "We accelerated clearance in the first quarter and we’ll see a more normalized clearance approach going through the balance of the year."
},
{
"speaker": "Chris Horvers - Bear Stearns",
"text": "Okay, and on a related question as we think about the payroll and the maintenance spend on the stores, the cadence of that spending as we look throughout the year, how do you look at that and does the fact that you really started some of these programs in the back-half of last year make it less of a drag in the back-half?"
},
{
"speaker": "Carol B. Tomé",
"text": "As we mentioned at our investor conference, in support of our five key priorities, we are spending about $1.6 billion in capital, about $600 million in expense, so you are going to see that drag, if you will, in every quarter. We are investing for the long-term."
},
{
"speaker": "Chris Horvers - Bear Stearns",
"text": "But the fact that you spent $500 million or so in the back-half of last year, you are going to spend the incremental on top of that?"
},
{
"speaker": "Frank Blake",
"text": "Again, it’s important that while we spend, we also -- in the back-half of ’06 we also know that just programmatically, there are improvements we have to be making in our stores."
},
{
"speaker": "Chris Horvers - Bear Stearns",
"text": "Finally, as you think about the big ticket categories like kitchen and bath, clearly I expected that to be a drag on the comp perspective. How is that versus your expectations? Was it worse and did April have an impact and maybe saw some marginal or sequential improvement in May?"
},
{
"speaker": "Craig Menear",
"text": "I would say that it is fair to say in some of the big ticket category spending it was a little bit more difficult than what we had anticipated."
},
{
"speaker": "Chris Horvers - Bear Stearns",
"text": "Any improvement in the back-half of the quarter or May?"
},
{
"speaker": "Frank Blake",
"text": "I’d say it’s still a little early."
},
{
"speaker": "Carol B. Tomé",
"text": "We’re two weeks into May."
},
{
"speaker": "Chris Horvers - Bear Stearns",
"text": "Okay. Thank you."
},
{
"speaker": "Frank Blake",
"text": "Thank you all very much."
},
{
"speaker": "Diane Dayhoff",
"text": "Thanks for joining us."
},
{
"speaker": "Operator",
"text": "That does conclude our conference for today. Thank you all for your participation and have a great day."
}
] | null | null |
HD | 4 | 2,005 | 2006-02-21 13:45:00 | Analysts: Matthew Fassler - Goldman Sachs David Schick - Stifel Nicolaus Michael Baker - Deutsche Bank Deborah Weinswig - Citigroup Dave Tractor - Banc of America Securities Alan Rifkin - Lehman Brothers
Operator: Good day everyone and welcome to today's Home Depot fourth quarter earnings conference call. As a reminder today's call is being recorded. Beginning today's discussion is Ms. Diane Dayhoff, VP of Investor Relations. Please go ahead.
Diane Dayhoff: Thank you, Gwen, and good morning to everyone. Welcome to the Home Depot fourth quarter earnings conference call. Joining us on our call today are Bob Nardelli, Chairman, President and CEO of The Home Depot; Carol Tome, EVP and Chief Financial Officer; and Tom Taylor, EVP of Merchandising and Marketing. At our investor and analyst conference last month, we discussed our vision of The Home Depot business through the year 2010. A replay of those comments as well as the accompanying slides are available on our website under the investor relations section. With that in mind, today's discussion will focus on our accomplishments for fiscal year 2005 and more specifically on the fourth quarter. Bob will begin with a review of our business. Tom will then provide insight into our merchandising efforts and Carol will complete our prepared statements with a discussion of our financial results. Following our prepared statements we will open the line for questions. Questions will be limited to analysts and investors. As a reminder, we would appreciate it if the participants would limit themselves to one question with one follow-up, please. This conference call is being broadcast real time on the Internet at HomeDepot.com with links on both our home page and the investor relations section. A replay will also be available on our site. Before I turn the call over to Bob, let me remind you that today's press release and the presentations made by our executives include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties. These risks and uncertainties include, but are not limited to, those factors identified in the release and in our filings with the Securities and Exchange Commission. Now, let me turn the call over to Bob Nardelli.
Bob Nardelli: Thanks, Diane and good morning, everyone. This year was another year of company records, demonstrating that the strategy we laid out five years ago is working, and is delivering profitable growth. We continued to solidify our leadership position in the markets that we serve. As a result of the hard work and dedication of our associates, we achieved several records for the fourth quarter and year, including: sales, average ticket, gross margin, operating margin and net income. This success will be shared with our hourly and our non-management eligible associates. We will be distributing $44 million in success-sharing checks to them at the end of this quarter. For the year, sales were $81.5 billion; $8.4 billion or 11.5% higher than last year. Earnings per share were $2.72, over 20% higher than last year. Now this is the fourth consecutive year of earnings growth in excess of 20%. We continued to return value to our shareholders, and in 2005 we returned approximately 67% of earnings through dividends and share repurchases. Since the inception of our share repurchase program in late 2002, we've spent $9.7 billion of our $11 billion share repurchase authorization, repurchasing 277 million shares, or over 12% of our outstanding shares. During this same period, we have more than doubled the dividends paid to our shareholders. Last month we announced a 50% increase in our annual dividends to $0.60 per share, which equates to a 20% payout among the best-in-class in retail. By staying on strategy, we reported exceptional results in 2005, delivering on our commitment to provide sustainable, predictable and profitable growth. Carol Tome will take you through our financial results in more detail later. Our strategy of enhancing the core is a foundation of our business and our financial results reflect our continued focus on our customers. By consistently listening to our customers and introducing a stream of innovative and distinctive products throughout the store, we reported a record average ticket of almost $58, the highest average annual ticket in our Company's history. Tom Taylor will discuss how we are well-positioned to continue our momentum in 2006, through our exciting assortment of distinctive, innovative and new merchandise. In 2005, using technology as an enabler, we made significant IT enhancements that allowed us to improve our operational efficiency, drive expense productivity and improve our customer experience. When you add it all up, we spent over $1 billion in technology and infrastructure this year. I could not be more proud of the accomplishments we've made through initiatives such as the continuation of self-checkout, the completion of our back end automated and re-engineering, or BEAR. The progress with certified auto replenishment and our in-store special order service initiative called SOSE. Our store operation group continues to focus on putting the customer first. We get quantitative, measurable feedback from 250,000 customers each week and have seen improvements across every key attribute we measure, including: associate engagement, speed of checkout, associate know-how, and the merchandising selection. These voice-of-customer results tell us that our strategy is working. Our services businesses showed continued growth this year, with sales up 21% and currently represents 5% of our total sales. Throughout the year, we saw strength in installation categories such as: countertops, roofing, gutter, kitchen, windows and HVAC. Services is an important growth business for us and represents $110 billion market opportunity. As the largest segment of our population -- the baby boomers -- age, we see a definite and growing trend from this group towards more Do-It-For-Me services. To better position us for the continued growth, we launched a dedicated 300-person field organization focused specifically on customer service and installer performance during the fourth quarter. Our acquisition of Chem-Dry in the fourth quarter provides us with a solid franchise business model. This gives us two clear benefits. We will learn about the franchise approach to home services, which could lend itself to future expansion. In addition, through our Chem-Dry, Home Depot is represented in 10,000 additional homes every day, giving us the ability to expand our offerings to the customers, increasing our market share of services. When this is combined with our 11,000 installs a day, we touch more than 20,000 homes and have a significant opportunity to grow through adjacent products and services. We are now the largest retailer, installer and cleaner of soft flooring in the world. In 2005 we responded to our changing consumer trends by expanding the assortment in our stores through Home Depot Direct, which allows our customers to shop from the convenience of their homes. In addition, customers can shop through their catalogs like 10 Crescent Lane, Paces Trading Company, that offer an expanded assortment extending what we offer in our stores. While still in a start-up mode, Home Depot Direct has doubled in size over the last year. The next time you are on our website, I invite you to browse our new interactive appliance, grill and tractor selections. You will see why we are excited about this shopping platform. Last week, we invited customers to participate in selecting one of three different advertisements showing our new tractor line-up. In two days we had 1 million visitors, more visibility than any traditional form of media, demonstrating the power of our brand. I would now like to turn to Home Depot Supply. This business represents 5% of our total Company sales. In 2005, it experienced triple-digit growth. It's core business posted solid gains and we added to these businesses by completing and integrating 18 acquisitions. The acquisition of National Waterworks and USA Bluebook solidified our positions as the premier provider for water and waste water transmission products and services. Our national water infrastructure is aging rapidly. In fact, based on government and industry estimates, in 15 years more than 50% of our country's water infrastructure will be outdated and will need significant replacement and repair. National Waterworks now has 137 branches in 36 states. Creative Touch Interiors, a leading design center partner to the home builder, grew significantly through the year and now has 37 branches in 14 states. During the year we expanded our offering to home builders through the acquisition of William Brothers, a leading supplier of lumber and building materials. White Cap expanded its presence through double-digit organic growth and six strategic acquisitions. It now has over 103 locations, nearly doubling its presence in the U.S. since we acquired it in May of 2004. We acquired Contractors' Warehouse, which serves the small professional contractor and repair and remodeler. Contractors' Warehouse is a highly productive format with sales per square foot considerably above the Company average. Contractors' Warehouse has eight locations. As we look across the country, we think there are another 150 to 250 potential locations. Finally, our pending acquisition of Hughes Supply is truly a defining moment in The Home Depot's history. With Hughes Supply, we'll be positioned as the number one U.S. diversified wholesale distributor, with fiscal 2006 sales approaching $12 billion. Home Depot Supply will continue to be an important growth driver for us. We will focus on integrating the companies within Home Depot Supply, ensuring we capture the synergies we've identified, and continue to expand using a disciplined approach to develop or to acquire businesses that build off our strength, scale and core competencies. As we grow, we believe each new business has the potential to be a $1 billion plus business. When I reflect on 2005, it's clear that our commitment to creating shareholder value extends into the communities in which we live and work, and is a fundamental core value. I'm proud of the extraordinary efforts we made to look after our customers and our associates in 2005. Now I would like to say a few words on the Olympics. For Home Depot, these Olympic Games represent the culmination of all the hard work and dedication of our Olympic and Paralympic athletes. We are honored to have 35 Home Depot athletes, more than any other company competing in Torino for Olympic medals. We could not be more proud of the associates and our support as they strive to make their Olympic dreams come true. We would like to congratulate all of those medal winners to date, including Steve Elm, Danielle Goyette, Tricia Dunn-Luoma, Katie King and Jennifer Potter. So in closing, it's evident that the strategy we laid out five years ago is working. As we enter the next five years we feel confident that we are positioned for predictable, sustainable and profitable growth in support of our 2010 vision. And now, I would like to turn the call over to Tom Taylor. Tom.
Tom Taylor: Thanks, Bob, and good morning, everybody. As Bob mentioned, 2005 was a solid year. Our initiatives to create a compelling shopping experience paid off as exhibited by strong growth in the core. In the fourth quarter, we saw strength across the store. Kitchen and bath, including appliances, building materials and paint, were particularly strong. As Bob mentioned, our average ticket for the quarter and year were Company records. For the year the average ticket was $57.98, representing a 5.6% increase. For the quarter, average ticket was $57.20, a 5.7% increase over the previous year. This was driven by our relentless focus on improving the customer shopping experience through store modernization, the introduction of distinctive and innovative products, and our commitment to provide a value to our customers. In the fourth quarter, organizational categories are important to our customers. In January, people put away their holiday decorations, so we expanded our storage and organization selection, carrying everything from totes to full closet solutions. For the first time with our home organization, we did an exceptional job of coordinating our consumer advertising, including a fully integrated communications approach that took advantage of heavy Internet use, print and TV during the holiday season. This, combined with in-store information we provided associates, helped drive sales and ensure good customer service. In Decor our kitchen and countertop business realized double-digit comps in the quarter, as a result of the introduction of our Countertop Solution Center and innovative products, such as Silestone MICROBAN and Silestone leather-look countertops, featuring a number of new colors. The introduction of MICROBAN technology is now incorporated into every Silestone quartz countertop as a value-added feature. MICROBAN's antibacterial protection helps to fight the growth of odors causing bacteria, mold and mildew. The Silestone leather-look countertop offers a unique texture and the feel of fine leather with colors that are inspired by rivers around the world. The Countertop Solution Center is currently in 452 stores and we will continue to roll it out to an additional 250 stores in 2006. In kitchens, Thomasville's new cabinet finish and door styles were popular with our customers. Thomasville's reputation for fine furniture has been incorporated into unique furniture-inspired cabinet designs that are available only at The Home Depot. Our momentum in appliances continued in the quarter as we gained market share. Our core market share on a 12-month rolling basis grew by 160 basis points to 9.7% for the quarter and we captured the most market share in the period, versus our competitors. We also saw significant improvement in our close rate compared to other retailers, confirming that our approach of having dedicated staff as well as unique, innovative products is working. We maintained our momentum by continuously introducing new distinctive products, like our GE Smart Dispense dishwasher, which holds an entire bottle of liquid automatic dishwasher detergent, dispensing the right amount based on soil levels. Maytag Ice2O refrigerator, the first French door refrigerator with filtered water and ice on the door. Maytag Blue Metallic laundry set, GE Adora front loaders and our full set of LG appliances. We plan to continue this momentum by listening to our customers and responding to their needs. In professional categories, we saw strength in hardware, electrical, plumbing and builder materials across the country. This is not new. We've seen strength in our professional business throughout the year as a result of some initiatives we implemented in early 2005. Our professional customers told us they wanted dedicated sales associates and an easier way to order products. We listened and we responded. We set up a process and procedures to improve operations, enhanced our credit and loan services, created a 200-person outside sales force and set up a website to better service our professional customers. As a result of our improved customer service, we are gaining more loyalty, share of wallet and have more satisfied customers. In fact, loyalty in this segment is critical due to the frequency with which our professional customers shop. In the fourth quarter, we wowed our customers with a number of new and innovative products. Our new line of exclusive 28-volt Makita and 18-volt Makita lithium ion powered tools for the pro and serious Do-It-Yourselfers were a big hit. Customers have responded to the unique features and added functionality. Our Ralph Lauren metallic and suede paint, Bellagio Faux paint and Colores Origenes palette from Behr, featuring over 70 colors have also appealed to our customer base. Let me give you some examples of other exciting products that we introduced this year. The Ryobi MultiTask laser level, the Ryobi log splitter, RIDGID wet/dry vacs and Pegasus door locks also brought excitement to our stores. The excitement is going to continue. We believe we've done an excellent job of creating differentiation for Spring. Let me give you some examples. In our garden area, we are going to offer everything from mulch with weed protector to mulch that doesn't fade for a year, to a new exclusive masonry wall block with the look of genuine stack stone at a fraction of the price. We will also have the first ever full sun, full heat Impatiens, that we like to refer to as Sunpatiens; and a new shrub Crape Myrtle series called Razzle Dazzle, which is the perfect size for borders, beds, containers and hanging baskets. You will also see an exclusive premium rose program that will enhance our premium flower line of Viva Plants, featuring bilingual, informative packaging. In the outdoor power area, we have seen tremendous success with our new expanded tractor offerings. Earlier this month we rolled out our new tractor line-up, including Cub Cadet Series 100, Toros Time Cutters Z Zero Turn, and several other models to augment our John Deere lineup. Now, not only do we have the top brands under one roof, but because we have the most home improvement stores we provide the most convenience to our customers. This makes us the clear destination in power equipment and if people want to shop at home, 90% of our power equipment is available on line at TheHomeDepot.com. To better service our customers, by the end of the first quarter we will have a power equipment specialist in stores available to answer any questions on features and functionalities of all of our power equipment, including tractors and mowers. Finally, we will continue to expand our assortment of patio furniture, offering fashion-forward styles to suit every customer, from cast aluminum bistro sets to weather-treated teak sets. We plan to roll out a new line-up of outdoor cooking, providing all the functionality of indoor cooking. We will have everything from sleek outdoor kitchens to new grills. Our kitchens are modular, have a stacked-stone look and come with a stainless steel grill and the option of a stainless steel refrigerator. The best part about it is, at The Home Depot you will find that at a compelling value proposition. In addition to the tremendous line-up of innovative products for Spring, our capital investment into the existing stores will continue to pay dividends for the Company. As I previously mentioned, our Countertop Solution Center is outperforming our expectations and we will continue to roll it out in 2006. Additionally, because of strong initial results, we are increasing the number of pilot stores for home organization, millwork and our Lighting Cloud. We are testing other initiatives and will continue to explore different concepts as we strive to ensure we are providing innovative products, broadening our assortment, and making the environment easier to shop. With our lineup of products for the Spring and the introduction of new innovative products, our average ticket momentum will continue and we are sure we will create excitement in our stores for our customers. I would now like to turn the call over to Carol.
Carol Tome: Thank you, Tom. Hello, everyone. I am very proud of our 2005 financial performance and add my thanks to all of our orange-blooded associates for delivering on our strategic and operational objectives. As you heard from Bob and Tom, this was a year of many Company records. In the fourth quarter, our sales grew 15.9% to $19.5 billion. Comp, or same-store sales, for the fourth quarter were 5.5%. We experienced our best retail comp of the year in the fourth quarter, with a retail comp of 4.6%. The remaining 90 basis points of total Company comp growth was contributed by Home Depot Supply. Sales from stores that have been open less than one year and sales from our newly acquired businesses contributed 10.4% to our top-line growth in the fourth quarter. For the year, sales grew by $8.4 billion, or 11.5%, to $81.5 billion. Comp sales for the year were 3.8%, with 80 basis points contributed by Home Depot Supply. Consolidated net income totaled $1.3 billion for the quarter and $5.8 billion for the year. In the fourth quarter, earnings per share increased by 27.7% to $0.60. For the fiscal year, earnings per share were $2.72, a 20.4% increase from 2004. Gross margin was 33.8% for the fourth quarter, a decrease of 37 basis points from the same period last year; 21 basis points of this decline was due to an increased penetration of Home Depot Supply. As we have told you, today this business has a lower gross margin rate than our retail business. We expect the gross margin rate for Home Depot Supply to increase over time as we utilize our purchasing power to drive synergies throughout the enterprise. Also contributing to the year-over-year decline was a change in the mix of products sold. Reflecting consumer demand, in the fourth quarter we sold a higher percentage of lower margin categories, like appliances and electrical wire, than we did last year. For the year our gross margin rate was 33.5%, a modest increase of 10 basis points from last year, consistent with our guidance. Going forward, we expect modest gross margin expansion. During the fourth quarter, we opened 70 net new stores, including 11 stores in Canada and five in Mexico. More than 9% of our store base is now found in Canada and Mexico and we are the market leader in those two countries. This year we added 174 new stores, net of five relocations, and closed 22 stores, bringing the total number of stores at the end of the year to 2,042. Today we own 87% of our stores and believe our real estate ownership strategy is a competitive advantage. As you know, we strategically cannibalize our stores in order to grow market demand and top-line sales. In the fourth quarter, we cannibalized 19.5% of our stores, which had a negative impact on comp of 2.6%. Excluding the impact of cannibalization, comp sales would have been 8.1% for the quarter. For the year, cannibalization negatively impacted comp sales by 1.8%. Excluding the impact of cannibalization, comp sales would have been 5.6% for the year. For fiscal 2005, customer transactions were $1.3 billion, an increase of 2.7% over the last year. For the fourth quarter, customer transactions increased by 4.1%. For the year, selling square footage was 215 million, a 7% increase from last year. The average square footage per store was 105,000 square feet, down slightly from last year, reflecting the changing mix in our store format as we expand into new geographies and size our stores to meet the needs of the markets. For the fourth quarter, weighted average weekly store sales were $676,000 up 1.3% compared to the same period last year. For fiscal 2005, weighted average weekly store sales were $763,000 flat compared to last year. Sales per square foot were approximately $334 for the quarter, up 2.2% over last year. In the fourth quarter, our new store productivity was the best it has been since 2001, both from a sales per square foot perspective as well as year-over-year change. In the fourth quarter, sales per square foot for our new stores increased by approximately 7%. For the year, total sales per square foot were $377, up slightly from last year. In the fourth quarter, we continued to drive expense productivity as total operating expenses decreased 96 basis points from last year to 23.3% of sales. During the quarter, we drove expense leverage in most of our major expense categories and we did that by focusing on productivity, not by sacrificing our commitment to customer service. As you know, we have been redeploying tasking hours to selling hours and as of the end of fiscal 2005, 81% of our hours were committed to selling activities, as compared to 79% last year. For the year, total operating expenses as a percent of sales was 22%, a decrease of 55 basis points from last year. Operating margin for the fourth quarter was 10.5% and for fiscal 2005, 11.5%. This is our fifth consecutive year of operating margin expansion. Our income tax provision rate dropped to 36.4% in the fourth quarter from 37.1% last year. The majority of this reduction was due to the reversal of a $22 million evaluation allowance, as we are now able to recognize a state net operating loss for which no previous benefit had been recorded. For the year, our income tax provision rate was 37.1%. Diluted shares for both the fourth quarter and fiscal year 2005 were 2.1 billion shares, compared to 2.2 billion shares in both fourth quarter and fiscal 2004. The reduction in outstanding shares is due to our share repurchase program. In 2005, we repurchased 76.5 million shares and cumulatively, since 2002 when the program began, we have repurchased 276.9 million shares and spent $9.7 billion under our $11 billion authorization. Now turning to the balance sheet. At the end of the year total inventory was $11.4 billion, an increase of 13.2% from last year. Earlier in the year, we told you that our inventory was growing faster than our sales growth due to our acquisition activity and because we increased our inventory in support of the rebuilding efforts in hurricane-affected areas. We are selling through this inventory and as a result, our year-over-year increase is dropping in line with our sales growth. We look to leverage inventory growth in fiscal 2006. For the year, inventory turns were 4.8X, down slightly from 4.9X last year. Computed on beginning long-term debt and equity for the trailing four quarters, fiscal 2005 return on invested capital was 22.4%, an increase of 90 basis points from last year. We are a financial powerhouse and are using our strong cash flow to invest in the business and return cash to our shareholders. During the year, the business generated approximately $7 billion of cash and used that cash, coupled with the net proceeds of a $1 billion bond offering, to fund $3.9 billion of capital expenditures, $3 billion of share repurchases, $2.5 billion of acquisitions and $857 million in dividends. We ended the year with $807 million in cash and short-term investments. As you would expect, we hold cash in short-term investments and operating accounts in the United States, as well as Canada, Mexico and China. For cash management flexibility purposes, we issued $900 million in commercial paper at year end, most of which has since been repaid. As we discussed at our January investor conference, our fiscal 2006 growth guidance is aligned with our 2010 vision to grow ourselves by 9% to 12% and to grow our earnings per share by 10% to 14% on a compounded annual growth rate over the next five years. It now looks like the acquisition of Hughes Supply will close in April. Given that, we believe our 2006 sales will grow in the range of 14% to 17% and our earnings per share will grow in the range of 10% to 14%. Based on our business momentum, we are highly confident of our ability to deliver upon our growth targets in 2006 and beyond. So thank you for your participation in today's call and, Gwen, we are now ready for questions.
Operator: Thank you. (Operator Instructions) We'll go first to Matthew Fassler with Goldman Sachs.
Matthew Fassler, Goldman Sachs: Thanks a lot. Good morning and congratulations on a good quarter. I would like to ask one question and one follow up, of course. I would like to start with the gross margin issue. Ex-supply, margins were down a bit still. I'm curious how different the mix trends were in the fourth quarter versus where they were year-to-date when the core retail business was able to generate gross margin increases? And, whether the inventory reduction might have played a role in some of the gross margin erosion that you saw as well.
Carol Tome: Matt, good morning and let me respond to your question. The mix change was very considerable. As Tom talked about, we saw a significant increase in market share as it relates to appliance growth. In fact, the comps for appliances in the fourth quarter were 29%. Appliances have a lower margin than our core business, so as you can appreciate, that was dilutive to the gross margin overall. It costs us about 13 basis points of margin dilution in the fourth quarter. If you compare that to the fourth quarter of 2004, where we had considerable gross margin expansion, 30 basis points of the gross margin expansion a year ago was related to shrink. While we continue to see improvement in shrink, we are anniversaring a pretty big number this year; so we didn't have that expansion this year.
Matthew Fassler, Goldman Sachs: The appliance comp was an acceleration from what you have done previous?
Carol Tome: Absolutely.
Matthew Fassler, Goldman Sachs: Great. My follow-up question relates to traffic. It looks like if you just take your retail comp and you subtract your ticket growth, comp traffic was down only very slightly, which was a big improvement from where you were. I'm curious, given that January was so temperate and the weather was probably a positive for your business overall; whether that contributed inordinately to the traffic trends? Or whether in fact you saw traffic at that level through the quarter?
Bob Nardelli: Matt, this is Bob. I think I would respond two ways. I mean, there's no question, you use the word 'inordinate'. I certainly would not say it was inordinately contributed to the weather. I think we all know in retail that January was the warmest January on record. I go back to the fundamentals that Tom talked about. If you look at the momentum -- November, December, January -- I think it speaks volumes about what Tom and Carl have done in-store. I think it again supports what Carol said in her closing comments about 2006: that we enter the year with more momentum than we had any previous year.
Matthew Fassler, Goldman Sachs: Understood. Just to recap, it sounds like the traffic trends -- to the extent that they were better -- were probably better throughout the quarter, not just at the end.
Bob Nardelli: That's a correct statement, Matt.
Matthew Fassler, Goldman Sachs: Thank you so much.
Bob Nardelli: Thank you.
Operator: We will go next to David Schick with Stifel Nicolaus.
David Schick, Stifel Nicolaus: Hi, good morning.
Bob Nardelli: Good morning, David.
David Schick, Stifel Nicolaus: Add my congratulations. I wanted to drill into Matt's second question again. If you are saying that weather was additive but it wasn't the story; traffic was the story and traffic was better throughout the quarter. What can you tell us about what you think traffic should look like for '06 or beyond? You said that you are pleased with, essentially momentum now, but how do you think that plays out for '06?
Bob Nardelli: Let me just again -- I think it would be a misrepresentation to not say retail in general got a lift out of January's warm weather, but I would come back -- and I will ask Tom to comment -- David, let me just say again, as evidenced in the comp numbers for the fourth quarter, the continual flow of new and innovative merchandise, particularly that that is exclusive to the Home Depot, I think -- Tom relative to a merchandising standpoint, Carl, relative to operations -- we are feeling very good about the momentum coming out of '05 and going into '06. Tom, wouldn't you --?
Tom Taylor: I think I would say that certainly we will learn from the things we do that help in driving traffic to our stores and continue to repeat them. As I mentioned in my comments, an important customer to us is the pro customer. We are seeing strength in our pro categories and there is a high-frequency of shop with the pro customers. We are going to continue our efforts along that line. We have a good, aggressive plan to make sure that we are satisfying our customer to increase their visits to the store. While at the same time, we are going to continue to have differentiation in our stores. We are going to have new products in our stores. We are going to try to create excitement. I think some of what we did in the fourth quarter will, as I mentioned in my comments, I am excited about some of the differentiation we are going to bring in the Spring. We are going to do all we can.
Bob Nardelli: David, I am going to pile on to that because we had the entire senior leadership team walk our outdoor garden, department 28, in one of our stores and that is a new process Tom has introduced. I will tell you, you come away with unbelievable excitement about not only our power line-up, which certainly offers the most commanding brands under one roof -- Tom's comment. But if you look at the line-up of live goods for this year again, and all of the accessories from mulch and playground mulch exclusive to us, we are really looking forward to a good strong summer. We just need the weather to cooperate and we are well prepared.
David Schick, Stifel Nicolaus: Great, well I would follow up -- I guess with Tom. Tom, you talked about power equipment, you were just talking about the live goods and the outdoor kitchen. Could you talk about in the Spring selling season in aggregate -- or even break it down -- should we be looking for average ticket increases for the offerings that you've outlined?
Tom Taylor: Sure. I mean, we are seeing customers step up and buy; take themselves up the ladder in our assortment. I don't see a reason why that wouldn't continue. We are continuing to add higher end products to the stores. We think we should see average ticket growth across the categories you mentioned. We should see average ticket growth continue in growth because we are adding new things. This modular kitchen that I referenced, it's an inexpensive way for people to have a built-in grill -- a real, built-in, good-looking grill on the outside of their house. That will certainly help our momentum, so I would say that it will continue.
Bob Nardelli: You will see the most commanding line-up of outdoor living that this Company has ever put out there, both in-store and on catalog.
David Schick, Stifel Nicolaus: Do you think average ticket growth will accelerate in '06?
Bob Nardelli: David do you mean, will we continue to get year-over-year improvement as we have over the last few years?
David Schick, Stifel Nicolaus: Would the year-over-year accelerate in what your Spring offering looks like? I'm not asking you to predict what the customer is going to do. Just in terms of what you are putting in front of the customer.
Carol Tome: David, the average ticket growth as well as the transactions are all implied with the sales growth guidance that we have provided for you for 2006. Which, with Hughes, is to grow our sales by 14% to 17%. So hopefully that will help you build your model.
David Schick, Stifel Nicolaus: Fair enough. Okay, thanks.
Operator: We will go next to Michael Baker with Deutsche Bank.
Michael Baker, Deutsche Bank: Thanks. I wanted to touch on The Home Depot Supply business. Carol, you had mentioned that through synergies and the like, you expected to grow margins in those businesses. You have a number of acquisitions that you have made throughout the year and several years ago. So in fact, are you seeing better operating margins already in the businesses that you have acquired and have owned for some time? If so, can you try to quantify that a little bit?
Bob Nardelli: Joe DeAngelo is in the room and Joe I think shared some of that at our recent analyst meeting so let's let Joe reconfirm what basically he laid out there. Joe DeAngelo Certainly this year our operating margin growth was north of 200 basis points across the board with Home Depot Supply. Every business that we have acquired has grown faster after we've acquired them than before; and, we continue to see operating leverage down through the businesses. There is not a business that has not enhanced their operating margins since we have acquired them or that have been in our portfolio for a while that we didn't increase this year. We will grow that going forward.
Carol Tome: If you look at our 2010 vision, slides that are on our website, we actually show the margin growth that we expect in Home Depot Supply.
Michael Baker, Deutsche Bank: Okay, good, I appreciate that. Thanks for the clarity. The follow-up, just some housekeeping. The $44 million in success sharing, Bob, that you talked about earlier; is that in the fourth quarter earnings already? And then last, that guidance, Carol, that you had touched on, the 10% to 14% in '06. I believe -- and just to confirm -- that excludes share buyback?
Bob Nardelli: The $44 million is in the fourth quarter, to be clear. Again, that goes to recognize the fantastic performance of our hourly associates in the store and our non-eligible managers here at SSE and around the country. We are very proud. We are really pleased to be able to pay out $44 million to the associates that have helped earned the success of this Company. Carol.
Carol Tome: Regarding the earnings per share growth guidance, it does not include additional share repurchases.
Michael Baker, Deutsche Bank: Great, thank you very much.
Carol Tome: You're welcome.
Operator: We will take our next question from Deborah Weinswig with Citigroup.
Deborah Weinswig, Citigroup:
Carol Tome: Well clearly the benefits of global sourcing will help to drive margin expansion in our retail business. We do have some pressure with an increasing penetration of Home Depot Supply, so it's a balanced view as we look at gross margin going forward. That is why we are saying modest at this point.
Deborah Weinswig, Citigroup: Okay. In terms of a follow-up, from a technology perspective can you talk about what inning we are in? Especially as it relates to automated replenishment?
Bob Nardelli: Let me do two things. Again, I hate to use the inning example. If I can maybe provide a different perspective, because in a baseball game, 10 innings and it's over.
Deborah Weinswig, Citigroup: Do a double-header.
Bob Nardelli: That would be better. I think the more we reinvest to digitize our Company, the more benefit that we are seeing. Carol talked about a dramatic shift in selling hours, for example, as we digitized tasking, which allowed Carl to put more on consultative selling. If you just look at kitchens and appliances then you would say that is clearly gaining a return on that investment. So we will continue to invest. , Bob DeRodes and the team are doing a fabulous job. We talked about continuation of self-checkout; we talked about BEAR, we talked about SOSE and I am going to let Tom talk about CAR because again -- Tom, did you want to cover it? I think we have 20% enrolment.
Tom Taylor: We are at 20% of our product is being replenished automatically, with the goal to get to 50% by the end of the year; 50% of the product will be replenished automatically.
Deborah Weinswig, Citigroup: Tom, that will be at the end of 2006. What about longer term?
Tom Taylor: We will continue to evaluate it. The goal would be to get as much as we can, certainly there are some commodities, but that will be difficult to do. I can't give you an ending number to that. We hit our first milestone. We want to hit 50% and then we will see where we take it from more. There is no reason that it shouldn't go up more than 50%.
Deborah Weinswig, Citigroup: Obviously, I think Bob you had spoke about at the analyst meeting how important in-stock position is to the customers. Obviously, this should significantly drive that metric.
Bob Nardelli: I think there are two things: CAR you referenced, clearly will do that. the other bit of technology that Carl and Bob DeRodes put in is our new mobile ordering cart. I spent a good part of a Saturday going through that in-store and I would tell you, the Windows-based technology and our inventory management associates have embraced this technology and are using it. As a result of that, Carl, you may want to just provide some guidance that we really are seeing an increased benefit from this technology of in-stock and order replenishment. Carl, did you want to --
Carl Liebert : Hi, Deborah. This is Carl. A couple of things. We talked about Mobile Floor Walk at the analyst conference. It's been a terrific technology for us, because it gave us visibility to inventory that's in the store, that we can make sure it's at the right eye level so the customer can grab it. We've seen improved metrics for our ability to fill holes on the shelf within 24 hours, to pack down smarter and better; as well as our ability to order products on a much more frequency and use auto-replenishment that Tom talked about. But also to leverage the inventory that we've had in our box to begin with. We are six weeks into using this new tool and we've seen a significant improvement. It is the number one customer satisfaction metric for our customers, in-stock. We are pretty pleased with what we are seeing and we know that's going to continue to drive conversion in our stores.
Deborah Weinswig, Citigroup: Great. Thank you so much.
Operator: We will take our next question from Dave Tractor with Banc of America Securities.
Dave Tractor, Banc of America Securities: You talked about 10 Crescent Lane earlier in the beginning of the call as well. Where is the end game there? Or, where do you think that can be? Are we going to start seeing it beyond the New York stores? From a merchandising standpoint, how much of that can be incorporated?
Bob Nardelli: Let me say that I think online has always been a legitimate channel to market, and only within the last probably 12 to 18 months have we really, I think embraced that technology in a meaningful way. If you look at -- and we've talked about 3 million visits a week, again significantly above any traditional media circulation that's out there. The million visitors in two days. We are seeing that business has, as I said, doubled year-over-year. Harvey Seegers is in the room and Harvey can comment on, but we are very pleased with the start-up of both of those catalogs. We will be expanding that not only online, but you certainly have heard from Harvey recently. There have been some articles about how we will expand that in-store. Harvey, did you want to comment at all about that?
Harvey Seegers: Bob, I would simply mention that 10 Crescent Lane represents the result of market segmentation. In particular, we are going after aspirational merchandise, the high-end customer. We will continue to pursue those market segments in the future. So you will see 10 Crescent Lane become the bigger part of Home Depot Direct and you may see other brands introduced as well.
Bob Nardelli: Tom, did you want to add to that?
Tom Taylor: I just want to comment on New York. I think it's an excellent point. If you look at the Paces Trading Catalog, a lot of the light fixtures that you see there are hanging in the Manhattan stores that you referenced. But as we look at some of our resets and as we are investing capital back in the store, our Lighting Cloud pilot that we have going incorporates a lot of what you see in Manhattan across into other markets. So as we roll that out, you will see the learnings from Paces Trading, the learnings from the Manhattan store with the higher offering of Depot Direct products.
Dave Tractor, Banc of America Securities: Thanks.
Diane Dayhoff: We have time for one more question.
Operator: We will take our last question from Alan Rifkin with Lehman Brothers.
Alan Rifkin, Lehman Brothers : Thank you very much. Just a follow-up question with respect to Home Depot Supply. Now that you have said that you experienced triple-digit growth and that within White Cap you saw double-digit organic growth, I was wondering if maybe you could provide a little bit more color as to how some of the other businesses are doing from an organic perspective? Joe, I know you mentioned that operating margins are up 200 basis points on The Home Depot Supply business. I'm wondering if you could provide a little bit of color with respect to what types of returns on invested capital you are seeing. Thank you.
Joe DeAngelo: In terms of the organic growth in aggregate cross Home Depot Supply, we were 20%. But certainly everyone was double-digit growth across the board. Relative to the return on invested capital we ended return on invested capital, including goodwill, at 13%.
Carol Tome: So that is consistent with what we've been talking to you about, Alan and as we look to the future, we see increasing returns coming off both the Home Depot Supply business as well as the retail business. Alan Rifkin with Lehman Brothers Thank you very much.
Bob Nardelli: Thanks, Alan.
Diane Dayhoff: Well, thank you everyone for joining us and we look forward to talking to you next quarter. | [
{
"speaker": "Analysts",
"text": "Matthew Fassler - Goldman Sachs David Schick - Stifel Nicolaus Michael Baker - Deutsche Bank Deborah Weinswig - Citigroup Dave Tractor - Banc of America Securities Alan Rifkin - Lehman Brothers"
},
{
"speaker": "Operator",
"text": "Good day everyone and welcome to today's Home Depot fourth quarter earnings conference call. As a reminder today's call is being recorded. Beginning today's discussion is Ms. Diane Dayhoff, VP of Investor Relations. Please go ahead."
},
{
"speaker": "Diane Dayhoff",
"text": "Thank you, Gwen, and good morning to everyone. Welcome to the Home Depot fourth quarter earnings conference call. Joining us on our call today are Bob Nardelli, Chairman, President and CEO of The Home Depot; Carol Tome, EVP and Chief Financial Officer; and Tom Taylor, EVP of Merchandising and Marketing. At our investor and analyst conference last month, we discussed our vision of The Home Depot business through the year 2010. A replay of those comments as well as the accompanying slides are available on our website under the investor relations section. With that in mind, today's discussion will focus on our accomplishments for fiscal year 2005 and more specifically on the fourth quarter. Bob will begin with a review of our business. Tom will then provide insight into our merchandising efforts and Carol will complete our prepared statements with a discussion of our financial results. Following our prepared statements we will open the line for questions. Questions will be limited to analysts and investors. As a reminder, we would appreciate it if the participants would limit themselves to one question with one follow-up, please. This conference call is being broadcast real time on the Internet at HomeDepot.com with links on both our home page and the investor relations section. A replay will also be available on our site. Before I turn the call over to Bob, let me remind you that today's press release and the presentations made by our executives include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties. These risks and uncertainties include, but are not limited to, those factors identified in the release and in our filings with the Securities and Exchange Commission. Now, let me turn the call over to Bob Nardelli."
},
{
"speaker": "Bob Nardelli",
"text": "Thanks, Diane and good morning, everyone. This year was another year of company records, demonstrating that the strategy we laid out five years ago is working, and is delivering profitable growth. We continued to solidify our leadership position in the markets that we serve. As a result of the hard work and dedication of our associates, we achieved several records for the fourth quarter and year, including: sales, average ticket, gross margin, operating margin and net income. This success will be shared with our hourly and our non-management eligible associates. We will be distributing $44 million in success-sharing checks to them at the end of this quarter. For the year, sales were $81.5 billion; $8.4 billion or 11.5% higher than last year. Earnings per share were $2.72, over 20% higher than last year. Now this is the fourth consecutive year of earnings growth in excess of 20%. We continued to return value to our shareholders, and in 2005 we returned approximately 67% of earnings through dividends and share repurchases. Since the inception of our share repurchase program in late 2002, we've spent $9.7 billion of our $11 billion share repurchase authorization, repurchasing 277 million shares, or over 12% of our outstanding shares. During this same period, we have more than doubled the dividends paid to our shareholders. Last month we announced a 50% increase in our annual dividends to $0.60 per share, which equates to a 20% payout among the best-in-class in retail. By staying on strategy, we reported exceptional results in 2005, delivering on our commitment to provide sustainable, predictable and profitable growth. Carol Tome will take you through our financial results in more detail later. Our strategy of enhancing the core is a foundation of our business and our financial results reflect our continued focus on our customers. By consistently listening to our customers and introducing a stream of innovative and distinctive products throughout the store, we reported a record average ticket of almost $58, the highest average annual ticket in our Company's history. Tom Taylor will discuss how we are well-positioned to continue our momentum in 2006, through our exciting assortment of distinctive, innovative and new merchandise. In 2005, using technology as an enabler, we made significant IT enhancements that allowed us to improve our operational efficiency, drive expense productivity and improve our customer experience. When you add it all up, we spent over $1 billion in technology and infrastructure this year. I could not be more proud of the accomplishments we've made through initiatives such as the continuation of self-checkout, the completion of our back end automated and re-engineering, or BEAR. The progress with certified auto replenishment and our in-store special order service initiative called SOSE. Our store operation group continues to focus on putting the customer first. We get quantitative, measurable feedback from 250,000 customers each week and have seen improvements across every key attribute we measure, including: associate engagement, speed of checkout, associate know-how, and the merchandising selection. These voice-of-customer results tell us that our strategy is working. Our services businesses showed continued growth this year, with sales up 21% and currently represents 5% of our total sales. Throughout the year, we saw strength in installation categories such as: countertops, roofing, gutter, kitchen, windows and HVAC. Services is an important growth business for us and represents $110 billion market opportunity. As the largest segment of our population -- the baby boomers -- age, we see a definite and growing trend from this group towards more Do-It-For-Me services. To better position us for the continued growth, we launched a dedicated 300-person field organization focused specifically on customer service and installer performance during the fourth quarter. Our acquisition of Chem-Dry in the fourth quarter provides us with a solid franchise business model. This gives us two clear benefits. We will learn about the franchise approach to home services, which could lend itself to future expansion. In addition, through our Chem-Dry, Home Depot is represented in 10,000 additional homes every day, giving us the ability to expand our offerings to the customers, increasing our market share of services. When this is combined with our 11,000 installs a day, we touch more than 20,000 homes and have a significant opportunity to grow through adjacent products and services. We are now the largest retailer, installer and cleaner of soft flooring in the world. In 2005 we responded to our changing consumer trends by expanding the assortment in our stores through Home Depot Direct, which allows our customers to shop from the convenience of their homes. In addition, customers can shop through their catalogs like 10 Crescent Lane, Paces Trading Company, that offer an expanded assortment extending what we offer in our stores. While still in a start-up mode, Home Depot Direct has doubled in size over the last year. The next time you are on our website, I invite you to browse our new interactive appliance, grill and tractor selections. You will see why we are excited about this shopping platform. Last week, we invited customers to participate in selecting one of three different advertisements showing our new tractor line-up. In two days we had 1 million visitors, more visibility than any traditional form of media, demonstrating the power of our brand. I would now like to turn to Home Depot Supply. This business represents 5% of our total Company sales. In 2005, it experienced triple-digit growth. It's core business posted solid gains and we added to these businesses by completing and integrating 18 acquisitions. The acquisition of National Waterworks and USA Bluebook solidified our positions as the premier provider for water and waste water transmission products and services. Our national water infrastructure is aging rapidly. In fact, based on government and industry estimates, in 15 years more than 50% of our country's water infrastructure will be outdated and will need significant replacement and repair. National Waterworks now has 137 branches in 36 states. Creative Touch Interiors, a leading design center partner to the home builder, grew significantly through the year and now has 37 branches in 14 states. During the year we expanded our offering to home builders through the acquisition of William Brothers, a leading supplier of lumber and building materials. White Cap expanded its presence through double-digit organic growth and six strategic acquisitions. It now has over 103 locations, nearly doubling its presence in the U.S. since we acquired it in May of 2004. We acquired Contractors' Warehouse, which serves the small professional contractor and repair and remodeler. Contractors' Warehouse is a highly productive format with sales per square foot considerably above the Company average. Contractors' Warehouse has eight locations. As we look across the country, we think there are another 150 to 250 potential locations. Finally, our pending acquisition of Hughes Supply is truly a defining moment in The Home Depot's history. With Hughes Supply, we'll be positioned as the number one U.S. diversified wholesale distributor, with fiscal 2006 sales approaching $12 billion. Home Depot Supply will continue to be an important growth driver for us. We will focus on integrating the companies within Home Depot Supply, ensuring we capture the synergies we've identified, and continue to expand using a disciplined approach to develop or to acquire businesses that build off our strength, scale and core competencies. As we grow, we believe each new business has the potential to be a $1 billion plus business. When I reflect on 2005, it's clear that our commitment to creating shareholder value extends into the communities in which we live and work, and is a fundamental core value. I'm proud of the extraordinary efforts we made to look after our customers and our associates in 2005. Now I would like to say a few words on the Olympics. For Home Depot, these Olympic Games represent the culmination of all the hard work and dedication of our Olympic and Paralympic athletes. We are honored to have 35 Home Depot athletes, more than any other company competing in Torino for Olympic medals. We could not be more proud of the associates and our support as they strive to make their Olympic dreams come true. We would like to congratulate all of those medal winners to date, including Steve Elm, Danielle Goyette, Tricia Dunn-Luoma, Katie King and Jennifer Potter. So in closing, it's evident that the strategy we laid out five years ago is working. As we enter the next five years we feel confident that we are positioned for predictable, sustainable and profitable growth in support of our 2010 vision. And now, I would like to turn the call over to Tom Taylor. Tom."
},
{
"speaker": "Tom Taylor",
"text": "Thanks, Bob, and good morning, everybody. As Bob mentioned, 2005 was a solid year. Our initiatives to create a compelling shopping experience paid off as exhibited by strong growth in the core. In the fourth quarter, we saw strength across the store. Kitchen and bath, including appliances, building materials and paint, were particularly strong. As Bob mentioned, our average ticket for the quarter and year were Company records. For the year the average ticket was $57.98, representing a 5.6% increase. For the quarter, average ticket was $57.20, a 5.7% increase over the previous year. This was driven by our relentless focus on improving the customer shopping experience through store modernization, the introduction of distinctive and innovative products, and our commitment to provide a value to our customers. In the fourth quarter, organizational categories are important to our customers. In January, people put away their holiday decorations, so we expanded our storage and organization selection, carrying everything from totes to full closet solutions. For the first time with our home organization, we did an exceptional job of coordinating our consumer advertising, including a fully integrated communications approach that took advantage of heavy Internet use, print and TV during the holiday season. This, combined with in-store information we provided associates, helped drive sales and ensure good customer service. In Decor our kitchen and countertop business realized double-digit comps in the quarter, as a result of the introduction of our Countertop Solution Center and innovative products, such as Silestone MICROBAN and Silestone leather-look countertops, featuring a number of new colors. The introduction of MICROBAN technology is now incorporated into every Silestone quartz countertop as a value-added feature. MICROBAN's antibacterial protection helps to fight the growth of odors causing bacteria, mold and mildew. The Silestone leather-look countertop offers a unique texture and the feel of fine leather with colors that are inspired by rivers around the world. The Countertop Solution Center is currently in 452 stores and we will continue to roll it out to an additional 250 stores in 2006. In kitchens, Thomasville's new cabinet finish and door styles were popular with our customers. Thomasville's reputation for fine furniture has been incorporated into unique furniture-inspired cabinet designs that are available only at The Home Depot. Our momentum in appliances continued in the quarter as we gained market share. Our core market share on a 12-month rolling basis grew by 160 basis points to 9.7% for the quarter and we captured the most market share in the period, versus our competitors. We also saw significant improvement in our close rate compared to other retailers, confirming that our approach of having dedicated staff as well as unique, innovative products is working. We maintained our momentum by continuously introducing new distinctive products, like our GE Smart Dispense dishwasher, which holds an entire bottle of liquid automatic dishwasher detergent, dispensing the right amount based on soil levels. Maytag Ice2O refrigerator, the first French door refrigerator with filtered water and ice on the door. Maytag Blue Metallic laundry set, GE Adora front loaders and our full set of LG appliances. We plan to continue this momentum by listening to our customers and responding to their needs. In professional categories, we saw strength in hardware, electrical, plumbing and builder materials across the country. This is not new. We've seen strength in our professional business throughout the year as a result of some initiatives we implemented in early 2005. Our professional customers told us they wanted dedicated sales associates and an easier way to order products. We listened and we responded. We set up a process and procedures to improve operations, enhanced our credit and loan services, created a 200-person outside sales force and set up a website to better service our professional customers. As a result of our improved customer service, we are gaining more loyalty, share of wallet and have more satisfied customers. In fact, loyalty in this segment is critical due to the frequency with which our professional customers shop. In the fourth quarter, we wowed our customers with a number of new and innovative products. Our new line of exclusive 28-volt Makita and 18-volt Makita lithium ion powered tools for the pro and serious Do-It-Yourselfers were a big hit. Customers have responded to the unique features and added functionality. Our Ralph Lauren metallic and suede paint, Bellagio Faux paint and Colores Origenes palette from Behr, featuring over 70 colors have also appealed to our customer base. Let me give you some examples of other exciting products that we introduced this year. The Ryobi MultiTask laser level, the Ryobi log splitter, RIDGID wet/dry vacs and Pegasus door locks also brought excitement to our stores. The excitement is going to continue. We believe we've done an excellent job of creating differentiation for Spring. Let me give you some examples. In our garden area, we are going to offer everything from mulch with weed protector to mulch that doesn't fade for a year, to a new exclusive masonry wall block with the look of genuine stack stone at a fraction of the price. We will also have the first ever full sun, full heat Impatiens, that we like to refer to as Sunpatiens; and a new shrub Crape Myrtle series called Razzle Dazzle, which is the perfect size for borders, beds, containers and hanging baskets. You will also see an exclusive premium rose program that will enhance our premium flower line of Viva Plants, featuring bilingual, informative packaging. In the outdoor power area, we have seen tremendous success with our new expanded tractor offerings. Earlier this month we rolled out our new tractor line-up, including Cub Cadet Series 100, Toros Time Cutters Z Zero Turn, and several other models to augment our John Deere lineup. Now, not only do we have the top brands under one roof, but because we have the most home improvement stores we provide the most convenience to our customers. This makes us the clear destination in power equipment and if people want to shop at home, 90% of our power equipment is available on line at TheHomeDepot.com. To better service our customers, by the end of the first quarter we will have a power equipment specialist in stores available to answer any questions on features and functionalities of all of our power equipment, including tractors and mowers. Finally, we will continue to expand our assortment of patio furniture, offering fashion-forward styles to suit every customer, from cast aluminum bistro sets to weather-treated teak sets. We plan to roll out a new line-up of outdoor cooking, providing all the functionality of indoor cooking. We will have everything from sleek outdoor kitchens to new grills. Our kitchens are modular, have a stacked-stone look and come with a stainless steel grill and the option of a stainless steel refrigerator. The best part about it is, at The Home Depot you will find that at a compelling value proposition. In addition to the tremendous line-up of innovative products for Spring, our capital investment into the existing stores will continue to pay dividends for the Company. As I previously mentioned, our Countertop Solution Center is outperforming our expectations and we will continue to roll it out in 2006. Additionally, because of strong initial results, we are increasing the number of pilot stores for home organization, millwork and our Lighting Cloud. We are testing other initiatives and will continue to explore different concepts as we strive to ensure we are providing innovative products, broadening our assortment, and making the environment easier to shop. With our lineup of products for the Spring and the introduction of new innovative products, our average ticket momentum will continue and we are sure we will create excitement in our stores for our customers. I would now like to turn the call over to Carol."
},
{
"speaker": "Carol Tome",
"text": "Thank you, Tom. Hello, everyone. I am very proud of our 2005 financial performance and add my thanks to all of our orange-blooded associates for delivering on our strategic and operational objectives. As you heard from Bob and Tom, this was a year of many Company records. In the fourth quarter, our sales grew 15.9% to $19.5 billion. Comp, or same-store sales, for the fourth quarter were 5.5%. We experienced our best retail comp of the year in the fourth quarter, with a retail comp of 4.6%. The remaining 90 basis points of total Company comp growth was contributed by Home Depot Supply. Sales from stores that have been open less than one year and sales from our newly acquired businesses contributed 10.4% to our top-line growth in the fourth quarter. For the year, sales grew by $8.4 billion, or 11.5%, to $81.5 billion. Comp sales for the year were 3.8%, with 80 basis points contributed by Home Depot Supply. Consolidated net income totaled $1.3 billion for the quarter and $5.8 billion for the year. In the fourth quarter, earnings per share increased by 27.7% to $0.60. For the fiscal year, earnings per share were $2.72, a 20.4% increase from 2004. Gross margin was 33.8% for the fourth quarter, a decrease of 37 basis points from the same period last year; 21 basis points of this decline was due to an increased penetration of Home Depot Supply. As we have told you, today this business has a lower gross margin rate than our retail business. We expect the gross margin rate for Home Depot Supply to increase over time as we utilize our purchasing power to drive synergies throughout the enterprise. Also contributing to the year-over-year decline was a change in the mix of products sold. Reflecting consumer demand, in the fourth quarter we sold a higher percentage of lower margin categories, like appliances and electrical wire, than we did last year. For the year our gross margin rate was 33.5%, a modest increase of 10 basis points from last year, consistent with our guidance. Going forward, we expect modest gross margin expansion. During the fourth quarter, we opened 70 net new stores, including 11 stores in Canada and five in Mexico. More than 9% of our store base is now found in Canada and Mexico and we are the market leader in those two countries. This year we added 174 new stores, net of five relocations, and closed 22 stores, bringing the total number of stores at the end of the year to 2,042. Today we own 87% of our stores and believe our real estate ownership strategy is a competitive advantage. As you know, we strategically cannibalize our stores in order to grow market demand and top-line sales. In the fourth quarter, we cannibalized 19.5% of our stores, which had a negative impact on comp of 2.6%. Excluding the impact of cannibalization, comp sales would have been 8.1% for the quarter. For the year, cannibalization negatively impacted comp sales by 1.8%. Excluding the impact of cannibalization, comp sales would have been 5.6% for the year. For fiscal 2005, customer transactions were $1.3 billion, an increase of 2.7% over the last year. For the fourth quarter, customer transactions increased by 4.1%. For the year, selling square footage was 215 million, a 7% increase from last year. The average square footage per store was 105,000 square feet, down slightly from last year, reflecting the changing mix in our store format as we expand into new geographies and size our stores to meet the needs of the markets. For the fourth quarter, weighted average weekly store sales were $676,000 up 1.3% compared to the same period last year. For fiscal 2005, weighted average weekly store sales were $763,000 flat compared to last year. Sales per square foot were approximately $334 for the quarter, up 2.2% over last year. In the fourth quarter, our new store productivity was the best it has been since 2001, both from a sales per square foot perspective as well as year-over-year change. In the fourth quarter, sales per square foot for our new stores increased by approximately 7%. For the year, total sales per square foot were $377, up slightly from last year. In the fourth quarter, we continued to drive expense productivity as total operating expenses decreased 96 basis points from last year to 23.3% of sales. During the quarter, we drove expense leverage in most of our major expense categories and we did that by focusing on productivity, not by sacrificing our commitment to customer service. As you know, we have been redeploying tasking hours to selling hours and as of the end of fiscal 2005, 81% of our hours were committed to selling activities, as compared to 79% last year. For the year, total operating expenses as a percent of sales was 22%, a decrease of 55 basis points from last year. Operating margin for the fourth quarter was 10.5% and for fiscal 2005, 11.5%. This is our fifth consecutive year of operating margin expansion. Our income tax provision rate dropped to 36.4% in the fourth quarter from 37.1% last year. The majority of this reduction was due to the reversal of a $22 million evaluation allowance, as we are now able to recognize a state net operating loss for which no previous benefit had been recorded. For the year, our income tax provision rate was 37.1%. Diluted shares for both the fourth quarter and fiscal year 2005 were 2.1 billion shares, compared to 2.2 billion shares in both fourth quarter and fiscal 2004. The reduction in outstanding shares is due to our share repurchase program. In 2005, we repurchased 76.5 million shares and cumulatively, since 2002 when the program began, we have repurchased 276.9 million shares and spent $9.7 billion under our $11 billion authorization. Now turning to the balance sheet. At the end of the year total inventory was $11.4 billion, an increase of 13.2% from last year. Earlier in the year, we told you that our inventory was growing faster than our sales growth due to our acquisition activity and because we increased our inventory in support of the rebuilding efforts in hurricane-affected areas. We are selling through this inventory and as a result, our year-over-year increase is dropping in line with our sales growth. We look to leverage inventory growth in fiscal 2006. For the year, inventory turns were 4.8X, down slightly from 4.9X last year. Computed on beginning long-term debt and equity for the trailing four quarters, fiscal 2005 return on invested capital was 22.4%, an increase of 90 basis points from last year. We are a financial powerhouse and are using our strong cash flow to invest in the business and return cash to our shareholders. During the year, the business generated approximately $7 billion of cash and used that cash, coupled with the net proceeds of a $1 billion bond offering, to fund $3.9 billion of capital expenditures, $3 billion of share repurchases, $2.5 billion of acquisitions and $857 million in dividends. We ended the year with $807 million in cash and short-term investments. As you would expect, we hold cash in short-term investments and operating accounts in the United States, as well as Canada, Mexico and China. For cash management flexibility purposes, we issued $900 million in commercial paper at year end, most of which has since been repaid. As we discussed at our January investor conference, our fiscal 2006 growth guidance is aligned with our 2010 vision to grow ourselves by 9% to 12% and to grow our earnings per share by 10% to 14% on a compounded annual growth rate over the next five years. It now looks like the acquisition of Hughes Supply will close in April. Given that, we believe our 2006 sales will grow in the range of 14% to 17% and our earnings per share will grow in the range of 10% to 14%. Based on our business momentum, we are highly confident of our ability to deliver upon our growth targets in 2006 and beyond. So thank you for your participation in today's call and, Gwen, we are now ready for questions."
},
{
"speaker": "Operator",
"text": "Thank you. (Operator Instructions) We'll go first to Matthew Fassler with Goldman Sachs."
},
{
"speaker": "Matthew Fassler, Goldman Sachs",
"text": "Thanks a lot. Good morning and congratulations on a good quarter. I would like to ask one question and one follow up, of course. I would like to start with the gross margin issue. Ex-supply, margins were down a bit still. I'm curious how different the mix trends were in the fourth quarter versus where they were year-to-date when the core retail business was able to generate gross margin increases? And, whether the inventory reduction might have played a role in some of the gross margin erosion that you saw as well."
},
{
"speaker": "Carol Tome",
"text": "Matt, good morning and let me respond to your question. The mix change was very considerable. As Tom talked about, we saw a significant increase in market share as it relates to appliance growth. In fact, the comps for appliances in the fourth quarter were 29%. Appliances have a lower margin than our core business, so as you can appreciate, that was dilutive to the gross margin overall. It costs us about 13 basis points of margin dilution in the fourth quarter. If you compare that to the fourth quarter of 2004, where we had considerable gross margin expansion, 30 basis points of the gross margin expansion a year ago was related to shrink. While we continue to see improvement in shrink, we are anniversaring a pretty big number this year; so we didn't have that expansion this year."
},
{
"speaker": "Matthew Fassler, Goldman Sachs",
"text": "The appliance comp was an acceleration from what you have done previous?"
},
{
"speaker": "Carol Tome",
"text": "Absolutely."
},
{
"speaker": "Matthew Fassler, Goldman Sachs",
"text": "Great. My follow-up question relates to traffic. It looks like if you just take your retail comp and you subtract your ticket growth, comp traffic was down only very slightly, which was a big improvement from where you were. I'm curious, given that January was so temperate and the weather was probably a positive for your business overall; whether that contributed inordinately to the traffic trends? Or whether in fact you saw traffic at that level through the quarter?"
},
{
"speaker": "Bob Nardelli",
"text": "Matt, this is Bob. I think I would respond two ways. I mean, there's no question, you use the word 'inordinate'. I certainly would not say it was inordinately contributed to the weather. I think we all know in retail that January was the warmest January on record. I go back to the fundamentals that Tom talked about. If you look at the momentum -- November, December, January -- I think it speaks volumes about what Tom and Carl have done in-store. I think it again supports what Carol said in her closing comments about 2006: that we enter the year with more momentum than we had any previous year."
},
{
"speaker": "Matthew Fassler, Goldman Sachs",
"text": "Understood. Just to recap, it sounds like the traffic trends -- to the extent that they were better -- were probably better throughout the quarter, not just at the end."
},
{
"speaker": "Bob Nardelli",
"text": "That's a correct statement, Matt."
},
{
"speaker": "Matthew Fassler, Goldman Sachs",
"text": "Thank you so much."
},
{
"speaker": "Bob Nardelli",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "We will go next to David Schick with Stifel Nicolaus."
},
{
"speaker": "David Schick, Stifel Nicolaus",
"text": "Hi, good morning."
},
{
"speaker": "Bob Nardelli",
"text": "Good morning, David."
},
{
"speaker": "David Schick, Stifel Nicolaus",
"text": "Add my congratulations. I wanted to drill into Matt's second question again. If you are saying that weather was additive but it wasn't the story; traffic was the story and traffic was better throughout the quarter. What can you tell us about what you think traffic should look like for '06 or beyond? You said that you are pleased with, essentially momentum now, but how do you think that plays out for '06?"
},
{
"speaker": "Bob Nardelli",
"text": "Let me just again -- I think it would be a misrepresentation to not say retail in general got a lift out of January's warm weather, but I would come back -- and I will ask Tom to comment -- David, let me just say again, as evidenced in the comp numbers for the fourth quarter, the continual flow of new and innovative merchandise, particularly that that is exclusive to the Home Depot, I think -- Tom relative to a merchandising standpoint, Carl, relative to operations -- we are feeling very good about the momentum coming out of '05 and going into '06. Tom, wouldn't you --?"
},
{
"speaker": "Tom Taylor",
"text": "I think I would say that certainly we will learn from the things we do that help in driving traffic to our stores and continue to repeat them. As I mentioned in my comments, an important customer to us is the pro customer. We are seeing strength in our pro categories and there is a high-frequency of shop with the pro customers. We are going to continue our efforts along that line. We have a good, aggressive plan to make sure that we are satisfying our customer to increase their visits to the store. While at the same time, we are going to continue to have differentiation in our stores. We are going to have new products in our stores. We are going to try to create excitement. I think some of what we did in the fourth quarter will, as I mentioned in my comments, I am excited about some of the differentiation we are going to bring in the Spring. We are going to do all we can."
},
{
"speaker": "Bob Nardelli",
"text": "David, I am going to pile on to that because we had the entire senior leadership team walk our outdoor garden, department 28, in one of our stores and that is a new process Tom has introduced. I will tell you, you come away with unbelievable excitement about not only our power line-up, which certainly offers the most commanding brands under one roof -- Tom's comment. But if you look at the line-up of live goods for this year again, and all of the accessories from mulch and playground mulch exclusive to us, we are really looking forward to a good strong summer. We just need the weather to cooperate and we are well prepared."
},
{
"speaker": "David Schick, Stifel Nicolaus",
"text": "Great, well I would follow up -- I guess with Tom. Tom, you talked about power equipment, you were just talking about the live goods and the outdoor kitchen. Could you talk about in the Spring selling season in aggregate -- or even break it down -- should we be looking for average ticket increases for the offerings that you've outlined?"
},
{
"speaker": "Tom Taylor",
"text": "Sure. I mean, we are seeing customers step up and buy; take themselves up the ladder in our assortment. I don't see a reason why that wouldn't continue. We are continuing to add higher end products to the stores. We think we should see average ticket growth across the categories you mentioned. We should see average ticket growth continue in growth because we are adding new things. This modular kitchen that I referenced, it's an inexpensive way for people to have a built-in grill -- a real, built-in, good-looking grill on the outside of their house. That will certainly help our momentum, so I would say that it will continue."
},
{
"speaker": "Bob Nardelli",
"text": "You will see the most commanding line-up of outdoor living that this Company has ever put out there, both in-store and on catalog."
},
{
"speaker": "David Schick, Stifel Nicolaus",
"text": "Do you think average ticket growth will accelerate in '06?"
},
{
"speaker": "Bob Nardelli",
"text": "David do you mean, will we continue to get year-over-year improvement as we have over the last few years?"
},
{
"speaker": "David Schick, Stifel Nicolaus",
"text": "Would the year-over-year accelerate in what your Spring offering looks like? I'm not asking you to predict what the customer is going to do. Just in terms of what you are putting in front of the customer."
},
{
"speaker": "Carol Tome",
"text": "David, the average ticket growth as well as the transactions are all implied with the sales growth guidance that we have provided for you for 2006. Which, with Hughes, is to grow our sales by 14% to 17%. So hopefully that will help you build your model."
},
{
"speaker": "David Schick, Stifel Nicolaus",
"text": "Fair enough. Okay, thanks."
},
{
"speaker": "Operator",
"text": "We will go next to Michael Baker with Deutsche Bank."
},
{
"speaker": "Michael Baker, Deutsche Bank",
"text": "Thanks. I wanted to touch on The Home Depot Supply business. Carol, you had mentioned that through synergies and the like, you expected to grow margins in those businesses. You have a number of acquisitions that you have made throughout the year and several years ago. So in fact, are you seeing better operating margins already in the businesses that you have acquired and have owned for some time? If so, can you try to quantify that a little bit?"
},
{
"speaker": "Bob Nardelli",
"text": "Joe DeAngelo is in the room and Joe I think shared some of that at our recent analyst meeting so let's let Joe reconfirm what basically he laid out there. Joe DeAngelo Certainly this year our operating margin growth was north of 200 basis points across the board with Home Depot Supply. Every business that we have acquired has grown faster after we've acquired them than before; and, we continue to see operating leverage down through the businesses. There is not a business that has not enhanced their operating margins since we have acquired them or that have been in our portfolio for a while that we didn't increase this year. We will grow that going forward."
},
{
"speaker": "Carol Tome",
"text": "If you look at our 2010 vision, slides that are on our website, we actually show the margin growth that we expect in Home Depot Supply."
},
{
"speaker": "Michael Baker, Deutsche Bank",
"text": "Okay, good, I appreciate that. Thanks for the clarity. The follow-up, just some housekeeping. The $44 million in success sharing, Bob, that you talked about earlier; is that in the fourth quarter earnings already? And then last, that guidance, Carol, that you had touched on, the 10% to 14% in '06. I believe -- and just to confirm -- that excludes share buyback?"
},
{
"speaker": "Bob Nardelli",
"text": "The $44 million is in the fourth quarter, to be clear. Again, that goes to recognize the fantastic performance of our hourly associates in the store and our non-eligible managers here at SSE and around the country. We are very proud. We are really pleased to be able to pay out $44 million to the associates that have helped earned the success of this Company. Carol."
},
{
"speaker": "Carol Tome",
"text": "Regarding the earnings per share growth guidance, it does not include additional share repurchases."
},
{
"speaker": "Michael Baker, Deutsche Bank",
"text": "Great, thank you very much."
},
{
"speaker": "Carol Tome",
"text": "You're welcome."
},
{
"speaker": "Operator",
"text": "We will take our next question from Deborah Weinswig with Citigroup."
},
{
"speaker": "Deborah Weinswig, Citigroup",
"text": ""
},
{
"speaker": "Carol Tome",
"text": "Well clearly the benefits of global sourcing will help to drive margin expansion in our retail business. We do have some pressure with an increasing penetration of Home Depot Supply, so it's a balanced view as we look at gross margin going forward. That is why we are saying modest at this point."
},
{
"speaker": "Deborah Weinswig, Citigroup",
"text": "Okay. In terms of a follow-up, from a technology perspective can you talk about what inning we are in? Especially as it relates to automated replenishment?"
},
{
"speaker": "Bob Nardelli",
"text": "Let me do two things. Again, I hate to use the inning example. If I can maybe provide a different perspective, because in a baseball game, 10 innings and it's over."
},
{
"speaker": "Deborah Weinswig, Citigroup",
"text": "Do a double-header."
},
{
"speaker": "Bob Nardelli",
"text": "That would be better. I think the more we reinvest to digitize our Company, the more benefit that we are seeing. Carol talked about a dramatic shift in selling hours, for example, as we digitized tasking, which allowed Carl to put more on consultative selling. If you just look at kitchens and appliances then you would say that is clearly gaining a return on that investment. So we will continue to invest. , Bob DeRodes and the team are doing a fabulous job. We talked about continuation of self-checkout; we talked about BEAR, we talked about SOSE and I am going to let Tom talk about CAR because again -- Tom, did you want to cover it? I think we have 20% enrolment."
},
{
"speaker": "Tom Taylor",
"text": "We are at 20% of our product is being replenished automatically, with the goal to get to 50% by the end of the year; 50% of the product will be replenished automatically."
},
{
"speaker": "Deborah Weinswig, Citigroup",
"text": "Tom, that will be at the end of 2006. What about longer term?"
},
{
"speaker": "Tom Taylor",
"text": "We will continue to evaluate it. The goal would be to get as much as we can, certainly there are some commodities, but that will be difficult to do. I can't give you an ending number to that. We hit our first milestone. We want to hit 50% and then we will see where we take it from more. There is no reason that it shouldn't go up more than 50%."
},
{
"speaker": "Deborah Weinswig, Citigroup",
"text": "Obviously, I think Bob you had spoke about at the analyst meeting how important in-stock position is to the customers. Obviously, this should significantly drive that metric."
},
{
"speaker": "Bob Nardelli",
"text": "I think there are two things: CAR you referenced, clearly will do that. the other bit of technology that Carl and Bob DeRodes put in is our new mobile ordering cart. I spent a good part of a Saturday going through that in-store and I would tell you, the Windows-based technology and our inventory management associates have embraced this technology and are using it. As a result of that, Carl, you may want to just provide some guidance that we really are seeing an increased benefit from this technology of in-stock and order replenishment. Carl, did you want to --"
},
{
"speaker": "Carl Liebert",
"text": "Hi, Deborah. This is Carl. A couple of things. We talked about Mobile Floor Walk at the analyst conference. It's been a terrific technology for us, because it gave us visibility to inventory that's in the store, that we can make sure it's at the right eye level so the customer can grab it. We've seen improved metrics for our ability to fill holes on the shelf within 24 hours, to pack down smarter and better; as well as our ability to order products on a much more frequency and use auto-replenishment that Tom talked about. But also to leverage the inventory that we've had in our box to begin with. We are six weeks into using this new tool and we've seen a significant improvement. It is the number one customer satisfaction metric for our customers, in-stock. We are pretty pleased with what we are seeing and we know that's going to continue to drive conversion in our stores."
},
{
"speaker": "Deborah Weinswig, Citigroup",
"text": "Great. Thank you so much."
},
{
"speaker": "Operator",
"text": "We will take our next question from Dave Tractor with Banc of America Securities."
},
{
"speaker": "Dave Tractor, Banc of America Securities",
"text": "You talked about 10 Crescent Lane earlier in the beginning of the call as well. Where is the end game there? Or, where do you think that can be? Are we going to start seeing it beyond the New York stores? From a merchandising standpoint, how much of that can be incorporated?"
},
{
"speaker": "Bob Nardelli",
"text": "Let me say that I think online has always been a legitimate channel to market, and only within the last probably 12 to 18 months have we really, I think embraced that technology in a meaningful way. If you look at -- and we've talked about 3 million visits a week, again significantly above any traditional media circulation that's out there. The million visitors in two days. We are seeing that business has, as I said, doubled year-over-year. Harvey Seegers is in the room and Harvey can comment on, but we are very pleased with the start-up of both of those catalogs. We will be expanding that not only online, but you certainly have heard from Harvey recently. There have been some articles about how we will expand that in-store. Harvey, did you want to comment at all about that?"
},
{
"speaker": "Harvey Seegers",
"text": "Bob, I would simply mention that 10 Crescent Lane represents the result of market segmentation. In particular, we are going after aspirational merchandise, the high-end customer. We will continue to pursue those market segments in the future. So you will see 10 Crescent Lane become the bigger part of Home Depot Direct and you may see other brands introduced as well."
},
{
"speaker": "Bob Nardelli",
"text": "Tom, did you want to add to that?"
},
{
"speaker": "Tom Taylor",
"text": "I just want to comment on New York. I think it's an excellent point. If you look at the Paces Trading Catalog, a lot of the light fixtures that you see there are hanging in the Manhattan stores that you referenced. But as we look at some of our resets and as we are investing capital back in the store, our Lighting Cloud pilot that we have going incorporates a lot of what you see in Manhattan across into other markets. So as we roll that out, you will see the learnings from Paces Trading, the learnings from the Manhattan store with the higher offering of Depot Direct products."
},
{
"speaker": "Dave Tractor, Banc of America Securities",
"text": "Thanks."
},
{
"speaker": "Diane Dayhoff",
"text": "We have time for one more question."
},
{
"speaker": "Operator",
"text": "We will take our last question from Alan Rifkin with Lehman Brothers."
},
{
"speaker": "Alan Rifkin, Lehman Brothers",
"text": "Thank you very much. Just a follow-up question with respect to Home Depot Supply. Now that you have said that you experienced triple-digit growth and that within White Cap you saw double-digit organic growth, I was wondering if maybe you could provide a little bit more color as to how some of the other businesses are doing from an organic perspective? Joe, I know you mentioned that operating margins are up 200 basis points on The Home Depot Supply business. I'm wondering if you could provide a little bit of color with respect to what types of returns on invested capital you are seeing. Thank you."
},
{
"speaker": "Joe DeAngelo",
"text": "In terms of the organic growth in aggregate cross Home Depot Supply, we were 20%. But certainly everyone was double-digit growth across the board. Relative to the return on invested capital we ended return on invested capital, including goodwill, at 13%."
},
{
"speaker": "Carol Tome",
"text": "So that is consistent with what we've been talking to you about, Alan and as we look to the future, we see increasing returns coming off both the Home Depot Supply business as well as the retail business. Alan Rifkin with Lehman Brothers Thank you very much."
},
{
"speaker": "Bob Nardelli",
"text": "Thanks, Alan."
},
{
"speaker": "Diane Dayhoff",
"text": "Well, thank you everyone for joining us and we look forward to talking to you next quarter."
}
] | null | null |
JNJ | 4 | 2,008 | 2009-01-20 08:30:00 | Executives: Louise Mehrotra - Vice President, Investor Relations Bill Weldon – Chairman and Chief Executive Officer Dominic Caruso - Vice President, Finance and Chief Financial Officer
Analysts: Larry Biegelsen - Wachovia Catherine Arnold - Credit Suisse Mike Weinstein - JP Morgan David Roman – Morgan Stanley Bob Hopkins - Banc of America-Merrill Lynch Rick Wise - Leerink Swann Matt Dodds - Citigroup Glenn Novarro – RBC Bruce Nudell - UBS
Louise Mehrotra: Welcome, I’m Louise Mehrotra, Vice President of Investor Relations for Johnson & Johnson and it is my pleasure this morning to review our business results for the fourth quarter of 2008 and full year 2008. Joining me on the podium today are our host for today’s meeting Bill Weldon, Chairman of the Board of Directors and Chief Executive Officer of Johnson & Johnson, and Dominic Caruso, Vice President, Finance and Chief Financial Officer. A few logistics before we get into the details, the audio and visuals from this presentation are being made available to a broader audience via a webcast accessible through the Investor Relations section of the Johnson & Johnson website. I’ll begin by briefly reviewing highlights of the fourth quarter for the corporation and highlights for our three business segments. Following my remarks, Bill Weldon will comment on the 2008 results and provide a strategic outlook for the company. At the completion of Bill’s remarks Dominic Caruso will provide additional commentary on the 2008 financial results and guidance for 2009. We will then open the floor to your questions. We will conclude our formal presentation at approximately 9:30 am and following Q&A with some final remarks by Bill we’ll conclude the meeting around 10:00 am. Distributed with the copy of the press release that you just received is a schedule with actual revenues for major products and/or business franchises. For the listening audience these are available on the Johnson & Johnson website as is a copy of the press release. Before I get into the results, let me remind you that some of the statements made during this presentation may be considered forward looking statements. The 10-K for the fiscal year 2007 identifies certain factors that could cause the company’s actual results to differ materially from those projected in any forward looking statements made this morning. The company does not undertake to update any forward looking statements as a result of new information or future events or developments. The 10-K is available through the company or online. Last item, during the call, non-GAAP financial measures may be used to provide information pertinent to ongoing business performance. These measures are reconciled to the GAAP measures and are available on the Johnson & Johnson website. Now I would like to review our results for the fourth quarter of 2008. If you would refer to your copy of the press release, let’s begin with the schedule titled supplementary sales data by geographic area. Worldwide sales to customers were $15.2 billion for the fourth quarter of 2008 down 4.9% as compared to the fourth quarter of 2007. On an operational basis sales were down 1% and currency had a negative impact of 3.9%. In the US sales declined 6.9%. In regions outside the US our operational growth was 5.4% while affect of currency exchange rates negatively impacted our reported results by 8.1 points. Our strongest performing region was the Asia/Pacific/Africa region which grew 9.9% on an operational basis. The Western Hemisphere excluding the US grew by 6% operationally while Europe grew 2.7% operationally. If you’ll now turn to the consolidated statements of earnings net earnings on a reported basis were $2.7 billion and earnings per share were $0.97. This compares to $2.4 billion and $0.82 in the same period in 2007. Please direct your attention the boxed section of the schedule where we have provided adjusted earnings information. As referenced in the footnote fourth quarter 2008 results were adjusted to exclude special items including charges for in process research and development and the after tax net gain from several litigation matters. In the fourth quarter of 2007 results were adjusted to exclude the write down of the intangible asset related to Natrecor and a tax gain associated with the restructuring of certain international subsidiaries. Net earnings on an adjusted basis were $2.6 billion and earnings per share were $0.94 up 3.1% and 6.8% respectively versus the fourth quarter of 2007. I would now like to make some additional comments relative to the components leading to earnings before we move on to the segment highlights. Cost of goods sold at 28.8% of sales was 90 basis points less than the same period in 2007. In 2007 the results were impacted by one time charges. The 2008 results had some favorable impact of one time items which were substantially offset by charges in other income and expense. Excluding one time items, cost of goods sold would have increased approximately 30 basis points due to the ongoing changing mix of the business. Selling, marking and administrative expenses at 37.3% of sales were up 150 basis points versus last year. As we discussed last quarter we planned some investment spending in the fourth quarter. The increase in selling, marketing and administration is a combination of this investment spending and the change in the mix of our business driven by the growth in the consumer business and the lower sales in the pharmaceutical business. Our investment in research and development as a percent to sales was 13.9%, 70 basis points less than the fourth quarter of 2007 due to a combination of a change of mix of businesses and lower spending in our pharmaceutical business. Interest expense net of interest income of $17 million compares to $35 million of net interest income in the fourth quarter of 2007. This change in net expense was due to lower interest income resulting from lower rates on invested cash and higher interest expense due to a higher average debt position in the quarter versus the same period last year as we continue buying back shares as part of the repurchase program. Other income net of other expense was $638 million in the fourth quarter 2008 compared to $877 million of net other expense in the same period last year. During the fourth quarter of 2008 we closed on the sale of the Professional Wound Care business. The resulting gain as well as the net gain from litigation settlement that I mentioned earlier are included in this account. In the fourth quarter of 2007 the write down of the intangible asset related to Natrecor was recorded in this account. With regard to taxes please direct your attention the affective tax rate excluding special charges shown in the boxed section of the schedule. Taxes were 19.9% in the fourth quarter 2008 versus 15.3% in the fourth quarter 2007. Dominic will provide additional commentary on both other income and expense and taxes in his remarks. Looking at full year data, consolidated sales to customers for 2008 were $63.7 billion an increase of 4.3% as compared to 2007. On an operational basis growth was 1.9% and currency had a positive impact of 2.4 points. On the consolidated statement of year to date earnings I’d first like to draw your attention to the boxed section. In 2008 and 2007 net income and earnings per share have been adjusted for special items. In both years charges for in process research and development have been excluded. Additionally, in 2008 the after tax net litigation gains have been excluded. In 2007 the after tax costs associated with the restructuring program, the non cash charge related to Natrecor write down and the one time gain associated with the restructuring of certain international subsidiaries have been excluded. With these adjustments net earnings for the 12 months of 2008 were $12.9 billion or $4.55 per share up 6.8% and 9.6% respectively as compared to the same period in 2007. Turning now to business segment highlights please refer to the supplementary sales schedule highlighting major products or business franchises. I’ll begin with the consumer segment. Worldwide consumer segment sales for the fourth quarter 2008 of $3.9 billion increased 1.2% as compared to the same period last year. Operational growth was 6.9% while the impact of currency was -5.7 points. US sales were up 1.8% while international sales grew 10.6% on an operational basis. For the fourth quarter of 2008 sales for the over the counter pharmaceutical and nutritionals increased 8.5% on an operational basis compared to the same period in 2007. Sales in the US were up 4.7% due to the successful US launch of Zyrtec, partially offset by lower sales of cough and cold products due to the slower start to the season versus last year. Sales outside the US were up 12.6% operationally driven by strong growth of adult Tylenol, Nicorette, upper respiratory products and nutritionals. Our skin care business achieved operational sales growth of 11.5% in the fourth quarter of 2008 with sales in the US growing at 6.2% and sales outside the US up 15.3% on an operational basis. Strong growth was driven by the newly acquired products from Dabao, the leading moisturizer in China. Johnson’s Adult, Aveeno, Neutrogena also made significant contributions to the growth in the quarter. Baby care products achieved operational growth of 3.2% when compared to the fourth quarter 2007. Sales in the US were down 6% primarily due to the lower sales for BabyCenter.com. Solid growth across most product lines resulted in an operational increase from sales outside the US of 5.7%. Women’s health achieved operational growth of 1.1%. Sales in the US were flat, while sales outside the US were up on an operational basis by 1.6%. Solid growth in external sanitary protection was partially offset by sales declines in other products. Operational sales growth in the oral care franchise was 10.5% with US sales up 1.6%. In the US strong growth in Rembrandt products has been partially offset by slower sales in floss and mouth fresheners. Sales outside the US increased 19.3% operationally driven by very strong growth for Listerine across the major regions. Sales in the wound care other category were down 6.1% on an operational basis with the US down 17.2% and the business outside the US up 7%. The lower sales in the US were due to increased competition and a reduction to the trade inventory levels. That completes our review of the consumer segment and I’ll now review highlights for the Pharmaceutical segment. Worldwide net sales for the fourth quarter of $5.7 billion were down 11.1% versus the same period last year. On an operational basis sales were down 7.8% with a currency impact of -3.3 points. Sales in the US decreased 13% while sales outside the US increased on an operational basis by 0.5%. Our results continue to be impacted by generic competition on some of our products namely Duragesic, Razadyne, and Risperdal Oral. The patent for Risperdal expired in the US at the end of June, 2008, and there are generic competitors for Risperdal in most markets. Generic competitors for Razadyne entered the US market in the latter half of the year. The combined impact of these three products has reduced the fourth quarter worldwide pharmaceutical operational growth rate by approximately 9.5 points, with the US impact estimated at approximately 13% and the impact outside the US estimated at 4%. Excluding the impact of generic competition, operational sales growth was approximately 1.5%. Now reviewing the major products. AcipHex as its known in the US market and Pariet outside the US is a proton pump inhibitor, or PPI that we co-market with Eisai. On an operational basis sales were down 15.6% with similar results both in and outside the US. In the US script share has been negatively impacted by additional generic launches in the PPI category. Sales have also been impacted by the market entry in Canada of generic Rabeprazole, the active ingredient in Pariet. Concerta, a product for attention deficit hyperactivity disorder grew 3.1% operationally in the fourth quarter as compared to the same period last year with sales in the US down 6.3%. In the US market growth has been offset by lower market share. The FDA approval earlier this year of the adult indication for Concerta will enable us to compete in the broader ADHD market. Sales outside the US were up 34% operationally with strong growth seen across the major regions. Sales of Levaquin our anti infective were down 4.2% on an operational basis when compared to the same period a year ago due to lower prescription share. Share was negatively impacted by generics in the category. Procrit/Eprex declined operationally by 5.9% during the quarter as compared to the same period last year with Procrit down 3.9% and Eprex down 8.2% operationally. New competition and a softening of the market have contributed to the lower sales results for Eprex. Procrit results have been impacted by a decline in the market versus the fourth quarter of 2007 estimated at 13% partially offset by an increase in overall market share. Procrit aggregate share across all markets was approximately 49% in the fourth quarter 2008 up four points versus the same period last year. Sales of Remicade, a biologic approved for the treatment of a number of immune mediated inflammatory diseases were down 2.4% when compared to the fourth quarter 2007. Sales growth in the US was 1.7%. Sales were impacted by lower customer inventory levels as well as a lower market share due to increased competition. Sales to our customers for markets outside the US were down 15% due to the timing of shipments related to production scheduling due to maintenance. Excluding this impact sales outside the US are estimated to have grown over 20%. Risperdal Consta, our long acting injectable formulation achieved fourth quarter sales growth of 16.3% on an operational basis. US sales growth was 8.3% while sales outside the US were up 20.9% operationally with continued positive momentum in share. Sales of Topamax which is approved for the treatment of epilepsy and migraine prophylaxis increased operationally by 6.4%. Sales in the US were up 7.7% while sales outside the US were up 0.9% on an operational basis. In the US market share in the migraine category increased versus the same period last year. Outside the US strong growth was achieved in many market offset by generic entries in certain other markets. Velcade, a treatment for the relapse multiple myeloma is being co-developed with Millennium Pharmaceuticals. We have commercialization rights in Europe and the rest of the world outside the US. Operational sales growth was 33.5% with very strong results achieved across the regions. Wrapping up the review of the Pharmaceutical segment, after careful consideration, all research and commercial activities related to Ionsis have been stopped. Technical challenges with Ionsis led to this decision. We remain committed to exploring novel delivery technologies and believe strongly in the potential that innovative drug device combinations may offer. Additionally regarding TMC 207 a compound for the treatment of tuberculosis, the planned filing is now projected for the 2011 timeframe. The compound looks very promising; however, patient enrollment in the clinical trials is taking longer than anticipated. Regarding Ustekinumab we have submitted our response to the FDA complete response letter. I’ll now review the medical devices and diagnostic segment results. Worldwide medical devices and diagnostic segment sales of $5.6 billion grew 1.6% operationally as compared to the same period in 2007. Currency had a negative impact of 3.5 points resulting in total sales decline of 1.9%. Sales in the US were down 3% while sales outside the US increased on an operational basis by 5.6%. Results have been impacted by lower sales of drug eluting stents. Sales excluding the impact of lower sales of drug eluting stents grew nearly 4.5% operationally. Now turning to the franchises starting with Cordis. Cordis sales were down 15.5% operationally with the US down 35.8% and sales outside the US up 1.3%. Cordis results were impacted by lower sales of Cypher, our Sirolimus-eluting stent, and endovascular products partially offset by the solid growth in our Biosense Webster business. Cypher sales were approximately $270 million down 34% on an operational basis versus the prior year. Sales in the US of approximately $70 million were down 63%. In comparison to the fourth quarter of 2007 the US drug eluting stent market growth is estimated at 17%. Penetration rates are estimated at 73% up from 61% a year ago while PCI procedures are up approximately 4% in the quarter versus the same period last year. The estimated price for Cypher in the US is down approximately 6% versus the fourth quarter of 2007. Estimated share in the US of 15% was down eight points sequentially and down 32 points from the fourth quarter of 2007 due to the market entry of two new competitors in 2008. Sales outside the US of approximately $200 million declined 10% operationally. The estimated market share in the quarter of 32% was up two points on a sequential basis and down four points from the fourth quarter 2007. Increased competition has impacted the share outside the US. Cypher estimated worldwide share for the quarter was 25% down three points sequentially and down 15 points from the fourth quarter 2007. Endovascular sales were impacted by the recall of a reentry catheter. Biosense Webster, our electro physiology business achieved solid operational growth in the quarter driven by disposable catheter products. Our DePuy franchise had operational sales growth of 8.3% when compared to the same period in 2007 with the US growing 10% and the business outside the US growing by 6.2% operationally. Hip growth on a worldwide basis was 11% operational, outpacing the market growth in both the US and international businesses. On an operational basis worldwide knee growth was 6% while spine grew 8%. The rate of growth in our spine business has accelerated throughout the year due to the successful launch of a number of products. Mitek, our sports medicine business, grew 12% operationally outpacing the estimated market growth. The Diabetes franchise was down 6.1% operationally in the fourth quarter of 2008 with the US business down 18.4%. The US results were impacted by an adjustment to prior period estimates of sales rebate reserves. Excluding this adjustment US sales in the quarter would have been down approximately 2%. Positive momentum in share has been offset by pricing pressure and slower category growth. Outside the US sales increased 7.5% operationally due to the successful launch of a number of new products. Animas, our insulin pump business grew 40% on an operational basis due to new product launches and continued development of the international market. Ethicon Endo-Surgery achieved operational growth of 9% in the fourth quarter of 2008 with the US sales growing 7.1% and sales outside the US growing on an operational basis by 11.6%. The Harmonic technology business achieved strong double digit operational growth due to the global success of recently launched products and the underlying strength of this platform. Also contributing to growth in the quarter was the realized gastric band launched earlier this year in the US and the strong performance of the endoscope products in the international markets driven by increased awareness of the benefits on minimally invasive procedures as well as the metabolic benefits of obesity surgery. Ethicon worldwide sales grew operationally by 3.3% with the US up 2.8% and sales outside the US up 3.5%. Slower growth in sutures due to lower distributor inventory levels and the divestiture of the Professional Wound Care business in December impacted growth in the quarter. This impact has been offset by strong double digit growth in homeostasis, meshes and bio-surgical. Ortho clinical diagnostic achieved operational growth of 1.7% in the fourth quarter. Sales growth in the US was 1.2% while sales outside the US were up 2.3% on an operational basis. Results have been impacted by order timing and lower sales and donor screening. Rounding out the review of the medical devices and diagnostic segment our vision care franchise achieved operational sales growth of 5.7% in the fourth quarter compared to the same period last year. Sales in the US increased 5.8%. Sales outside the US grew 5.5% on an operational basis. The rate of growth has been impacted by the softness in the lens category overall and competitive launches. Acuvue Oasys, One-Day Acuvue Moist, and the Acuvue Oasys for Astigmatism were major growth drivers in the quarter. That completes highlights for the medical devices and diagnostic segment and concludes the segment highlights for Johnson & Johnson fourth quarter 2008. It is now my pleasure to introduce Bill Weldon.
Bill Weldon: Many of us are going to remember 2008 as a year of extraordinary economic events that shook our financial markets and global economy. With that backdrop as context I’m extremely proud of Johnson & Johnson’s accomplishments in 2008 and the way our people met our commitments with continued sales and earnings growth with significant progress in our pipelines and product launches and with continued investments in the future growth of our business. We faced and will continue to face challenges but our people, our products, our pipelines and our financial strength give me confidence that we are well positioned for the future. This morning I’ll briefly review Johnson & Johnson’s 2008 business and financial results and provide an update on how we are executing against our strategic plans for leadership and growth in the healthcare industry. I will also explain how we are preparing to deal with recent economic events and seize new growth opportunities. I’d like to leave you today with a deeper understanding of what we have done to prepare our business for 2009 and the longer term. From this, you’ll see why I am confident that Johnson & Johnson will emerge from the period stronger and even better positioned for growth as the economy and healthcare markets recover. In 2008 we delivered on our financial commitments despite the near term pressures on our business and non-foreseen shifts in the economic climate. We strengthened our core businesses and made significant progress in launching new products and line extensions and advancing our pipelines. In addition to the growth that comes from our internal R&D we also pursued licensing agreements and acquisitions that provided us new capabilities in medical devices and diagnostics and a stronger consumer presence in markets like China. In 2008 we have largely implemented the major cost structure improvements we outlines for our pharmaceuticals and Cordis business in mid 2007 and we have realized approximately $1.6 billion in annual savings from these actions which is at the higher end of our earlier guidance. Meanwhile the integration of the Pfizer consumer healthcare business is on track. We are comfortable that we will achieve cost synergies at the higher end of our previously disclosed range of $500 to $600 million by the end of 2009. We still expect this transaction to be break even or modestly accretive this year, one year ahead of schedule of the original schedule. We also continued throughout the year with our $10 billion share repurchase program. As of the end of December we had purchased approximately $8.1 billion of stock. Our business, driven by committed financial discipline continued to deliver strong adjusted earnings growth and solid sales growth when considering the generic challenges we faced. Our broad base of consumer pharmaceutical and medical device and diagnostics businesses increases sales to $63.7 billion despite the loss of exclusivity of Risperdal Oral for half the year, continuing pressures on our drug eluting stent and Procrit business and the additional impact of the economic decline. We achieved strong adjusted earnings growth of 6.8% and adjusted EPS growth of 9.6% which was higher than earnings due to our share repurchase program. We also generated a strong free cash flow of approximately $12.2 billion. I’d like to remind you of the expectations we set at this meeting last January. We said we expected operational sales in 2008 to increase 1% to 2% as we faced the patent expiration and business pressures I mentioned a moment ago. We delivered 1.9%. This is a significant achievement when you take into account the additional economic challenges that arose later in the year. In January we projected an adjusted EPS range of $4.39 to $4.44. At the end of the year we generated an adjusted EPS of $4.55 and 9.6% increase. In terms of sales by segment, consumer generated approximately $16 billion in revenue or 25% of our total. Pharmaceuticals approximately $24.6 billion or 39% of our total. MD&D generated $23.1 billion or 36% of our total. Our consumer business once again provided the premier consumer healthcare company in the world. With its science based innovations and iconic global brands consumer segment sales grew 8.3% operationally year over year. In the OTC nutritional business the successful launches of Zyrtec as an over the counter allergy medicine was a major contributor to this growth. Strong sales of other consumer products like Neutrogena, Aveeno, Listerine and our international baby care brands helped drive significant growth in our other franchises. The pharmaceutical segment saw an operational sales decline of 3.1% for the year. Excluding the impact of generic competition and continued declines in Procrit, pharmaceutical sales would have grown by 6% operationally. Nine products had sales of more than $1 billion including Remicade, Risperdal Consta, and Topamax. In addition, we saw strong sales growth from newer promising products like Prezista, Velcade and Invega. With these newer drugs and promising compounds and our late stage pipeline we see positive momentum building for the longer term. Our medical device and diagnostic business is the largest medical technology business in the world with sales of $23 billion. More than 80% of MD&D sales were derived from businesses where we hold the number one or number two market position. We continue to see solid growth and performance in six of our seven franchises in the face of tough competition. MD&D sales grew by 3.5% operationally. Excluding the impact of lower drug eluting stent sales operational growth would have been a healthy 6%. Some of the key growth drivers included vision care with products like Acuvue Oasys and One-Day Acuvue Moist, Ethicon Endo-Surgery harmonic technology and realized adjustable gastric band and the DePuy orthopedic and Mitek sports medicine products. Our Cordis business continued to see the impact of new entrants in the drug eluting stent market but it succeeded in broadening the strength of the cardiovascular franchise by continuing to build momentum in Biosense Webster and neurovascular business. Operating profit for 2008 was $17.3 billion and 27% to sales. That compares to $15.9 billion or 26% in 2007. This 110 basis point increase can be attributed to the excellent job our leadership team did in managing their businesses and containing costs during the year, even as the volatile economic climate began driving increases in commodity costs and shifts in consumer and patient behaviors. Thanks to the people at Johnson & Johnson we have managed through difficult economic cycles many times throughout our history. The past year presented its own extraordinary challenges. Some we anticipated and planned for, others could not be foreseen and required decisive actions during the year. Despite these challenges we continued a legacy of performance that few if any companies can claim. During 2008 stock indices like the Dow Jones Industrial Average and S&P 500 were down more than 30%. Other drug and healthcare indices were down about 20% to 30% in terms of total return to shareholders. Comparatively Johnson & Johnson’s total return to shareholders declined just 8%. While we’re never pleased with declines in our returns we were the third best performer in the Dow for 2008. When you look at our total shareholder returns over three, five and 10 year periods we beat and consistently beat the major indices that we compare to. I’d like to spend the rest of my time talking to you about how we plan to execute against our strategies for leadership and growth in healthcare. This chart will be familiar to most of you; it sizes the global healthcare market for 2007 at $4.1 trillion and breaks out those areas where we compete today and the areas of healthcare where we have not yet entered. About $1.3 trillion of that figure includes a variety of healthcare product areas where we do compete. Consumer, pharmaceutical, medical devices and diagnostics and where we hold about 5% market share. The remaining $2.8 trillion consists of healthcare markets that include providers, payers, administration, fitness, health information and many others. There is plenty of opportunity for Johnson & Johnson in the global healthcare market as we grow share in our existing markets and move into fertile grounds for expansion. I’d now like to turn a discussion of four major factors that will influence our business performance in 2009. These are the general healthcare environment and trends that are shaping the future, our own near term business pressures, the macro economic factors that every business is facing and the volatility of currency. To begin, there are many forces shaping healthcare environment that we have considered in our planning. For instance, an aging world population is creating incredible demand. In fact, every three and a half seconds somewhere in the world is turning 65. People are becoming increasingly interested in knowing about and managing their own health, not just their illnesses. As the movement to wellness and prevention gains more momentum even medical practitioners are more concerned with keeping patients healthy rather than just treating them when they become ill. Chronic diseases such as diabetes, cardiovascular disease and obesity are on the rise, driving up the cost of healthcare. Significant changes in healthcare systems and reimbursement models are being considered in the United States and elsewhere. These and other trends are putting more pressure than ever on healthcare systems to meet demands for innovation, quality healthcare and do that in more effective cost efficient ways. The second factor for discussion includes a near term business pressures that we have known about and been preparing for. These include a well understood and during the past year our companies made adjustments to their business plans to address the conditions we anticipated. Generic competition for some pharmaceutical products, aggressive new competitors in some of our surgical and comprehensive care businesses and low cost brands fighting for market share with our consumer products. We have made modifications where and when appropriate. These included streamlining our infrastructure to reduce our cost basis, prioritizing our R&D investments to ensure the success of the most promising products, continuing our investment in new product launches, focusing on emerging markets and expanding our presence in new and adjacent markets. While some of these actions have been difficult, all were necessary to ensure the strength of our business. We should see the full year benefits of a number of these actions in 2009. The third factor we must consider in 2009 is the macro economic environment that every business is facing. Over the past several months we have experienced a global financial and business slowdown unlike anything we have seen during our lifetimes. Much has already been written or reported about the early affects the economic slowdown is having on healthcare spending and behaviors. IMS projects a slowing growth in the US prescription drug market down 1% to 2% a year from 4.2% in 2007. According to the Kaiser Family Foundation with unemployment on the rise people have begun avoiding healthcare treatment or cutting back even for serious conditions. Many analysts have reported that surgeries, especially elective procedures are being postponed. Hospitals and healthcare providers are tightening their inventory levels and budgets while consumers are watching their spending more closely. In Johnson & Johnson we are seeing early affects in a few parts of our business. For example, while growth is still strong in an area like sports medicine we have recently seen slight declines in growth rates in the market. Also in markets that require more out of pocket spending like diabetes test strips and contact lenses we are seeing some signs that consumers and patients are becoming more frugal. Thanks to the strength of our leadership team our broad base of businesses and our fiscal discipline I remain very optimistic about our ability to adjust to the evolving economic conditions. I’m also very excited about the new products and strong pipelines that position us well for the future. The fourth factor that could have a significant impact on our business in 2009 is currency. The fluctuation in exchange rates over the last six months has been dramatic. These fluctuations could have a significant impact on our future financial results. Dominic will discuss the potential impact of currency in more detail during his remarks. Every challenging period brings with it a corresponding opportunity for growth and this one is no exception. By working in a disciplined way Johnson & Johnson will emerge stronger than ever remaining the worlds leading company in addressing human health and well being. I believe this for several reasons. As always, success starts with leadership and we are fortunate to have an experience management team in place with the right skills to capitalize on market conditions and build businesses for the long term growth. We are strengthening our core franchises, advancing our pipelines and introducing new products that will replenish and grow our revenue streams. We are building our market leadership positions and venturing into new growth spaces for Johnson & Johnson. We are maintaining our financial strength and flexibility with a combination of strong cash flows and a AAA credit rating which gives us access to credit at favorable rates. We have implemented cost structure improvements that should reap benefits for the bottom line and help us operate more efficiently. We are actively participating in the dialogues on public policy that will shape our business environment for years to come. In the meantime we continue to implement our strategic plan which will strengthen our company for long term growth. In addition, we are looking for new opportunities that may exist for our businesses under today’s unique market conditions. Whenever the economy and healthcare markets return to a more robust growth we will be stronger and better positioned for leadership in the markets where we choose to compete. Now I would like to spend my remaining time discussing the progress we have made on the four business priorities that we outlined last year. At the foundation of Johnson & Johnson’s business is a fundamental commitment to our credo which provides the common set of values for our approximately 120,000 employees around the globe. The four tenants of our credo provide a clear focus and mindset for how we approach every decision. Patients and customers first then our employees, our communities and our shareholders. We also work under an operating model that has served us well for decades. Its four elements are being broadly based in human healthcare, managing our businesses for the long term, taking a decentralized management approach, and focusing on our people and values. Last year I introduced four enterprise wide business priorities that continue to be critical to achieving our long term growth plans. They are winning in healthcare, capitalizing on convergence, accelerating growth in emerging markets, and developing leadership and talent. Let me begin by discussing what we mean by winning in healthcare. There are three major elements to winning in healthcare. First is growing our existing businesses. This encompasses advancing the pipeline, launching new products and extensions and enhancing our core strengths and franchises. Second is building new platforms for growth. These include making acquisitions and executing licensing agreements and also building new businesses in healthcare markets where we do not currently compete. Third is actively participating in the dialogue around public policy that will help shape the healthcare landscape for the future. Developing our own products and technologies within the Johnson & Johnson family of companies is the most efficient way to grow our existing businesses. We have continued to make significant investments in R&D across the business with approximate spending of $7.6 billion in 2008. As planned, our R&D investments began leveling off last year because we had substantially increased investments over the past several years to accommodate progress in our late stage pipeline. At our investor meeting in 2007 we set new goals for our pharmaceutical pipeline. We said we would file seven to 10 new products for approval between the beginning of 2008 and the end of 2010. Despite some setbacks we remain on course with that commitment. We have eight new compounds currently in registration and five of those were filed with the FDA in 2008. Tapentadol, an immediate release tablet for the relief of moderate to severe pain was also approved later in the year. We plan to file several more compounds by the end of 2010. At our investor meeting in June we briefed you on many of the exciting developments in our medical devices and diagnostics businesses. We have robust pipelines in both our surgical care and comprehensive care groups. Here’s an updated look at our surgical care pipeline. There are many projects on this comprehensive list worth highlighting but in the interest of time let me just mentioned just two. In surgical care we have developed the first computer assisted personalized sedation system called Sedasys. The device which is currently under review by the FDA will make it earlier for a physician and nurse teams to deliver propofol to patients undergoing screening and diagnostic procedures for colorectal cancer and disorders of the upper GI tract. By integrating drug deliver and patient monitoring the Sedasys system has the potential to change the way sedation is delivered. We talked in June about the Prineo skin closure system. Prineo will be used in surgical applications that require significant inter-dermal suturing time like body contouring procedures. This time saving system allows for a significant reduction in OR time for the hospital and a reduction in general anesthesia time for patients which should improve patient outcomes. Prineo is currently used in Europe and is expected to launch in the United States this year. In the comprehensive care pipeline we are also seeing good progress on several fronts. Again, in the interest of time let me mention just a few. In 2008 we received approval for two new diagnostic systems. Vitros 5600 integrated system shown here which is uniquely designed to integrate clinical chemistry and immunoassay testing to increase laboratory productivity. The Vitros 3600 a high through put system used for immunoassay and infectious diseases. Both of these next generation platforms can simultaneously run more than 100 tests and are designed to run innovative high impact diagnostic tests in the future. We feel very positive about the progress we are making on clinical trials for our Nevo Sirolimus-eluting stent. This cobalt chromium stent features a bio absorbable polymer and a unique reservoir technology. The first clinical trial for Nevo resolution one completed patent enrollment ahead of schedule and we plan to present six month primary end point data from this trial at the Euro PCR conference in May. We expect to file Nevo for CE mark approval in Europe in 2009. Within our Biosense Webster business we are awaiting FDA approval for an atrial fibrillation indication for the Navistar Thermocool Ablation Catheter. In December an FDA advisory panel unanimously recommended approval for this indication which will make Biosense Webster the first and only company in the United States with an approved A-Fib indication opening up a market with a penetration rate of less than 2%. The foundation of our consumer product success has always been based on superior science and technology. With recent development like helioplex technology for sunscreens or rapid release gel technology for OTC medications. We feature a wide array of scientific research competencies in areas like skin biology, pharmaco kinetics, drug delivery and microbiology to name a few. We have built a significant portfolio of proprietary technologies including dissolvable strips and taste masking for oral care and OTC drug delivery. Active naturals and fragrances used in skin care and cellular resuscitation and advanced adhesives for wound care and healing. We also continue to enhance our clinical trial expertise and expand our R&D capabilities around the world, developing products for emerging markets where our business has grown considerably. Now let’s turn to our existing and new products that result from our investments as well as our acquisition and licensing activities. Our existing franchises make up the broadest space of healthcare businesses in the world and are well known leaders across our three segments, holding the number one or number two market leadership positions in various markets. In 2008 approximately 70% of our revenues came from products with these market leading positions. Last year across all three of our businesses we launched hundreds of new products and line extensions some of which are highlighted on the screen. In addition to the products we developed internally we have made several acquisitions to add technology platforms, brands and market presence in areas where we saw opportunities. We acquired Dabao cosmetics in China which brings with it the countries number one moisturizer and a brand that is well known and respected among Chinese consumers. This acquisition also opens up opportunities to do more business in mid tier markets expanding the base of consumers we can serve in this region. In late 2008 we announced several other acquisitions in our surgical care business. We acquired Omrix Biopharmaceuticals, a company we knew well through existing partnerships and distribution agreements. Omrix develops and markets bio-surgical immunotherapy products. It will strengthen our presence in active biologic based homeostasis as well as convergent products for surgical procedures like the fibrin pad which is in clinical trials. Another is Mentor Corporation, a highly respected market leader for breast augmentation and reconstructive procedures. Once completed this acquisition will establish a major presence for Johnson & Johnson in aesthetics medicine. We also acquired SurgRx whose end seal products complement our harmonic technology and broaden the energy franchise in our ethicon endo-surgery business. In comprehensive care we acquired two companies, Immunicon and Amic for new diagnostic capabilities. Last year I introduced the office of strategy and growth as a new organization that would be looking at the white spaces in healthcare for Johnson & Johnson. Places where we envision building new businesses. We have defined the area of wellness and prevention as one of those opportunities and we have taken initial actions to establish this new business platform. In late 2008 we made two acquisitions to begin laying the groundwork for this new business. HealthMedia is a provider of web based behavioral interventions that emulate a health coaching session without the human intervention. The Human Performance Institute is developing science based training programs to improve employee engagement and productivity. We expect this new business to contribute to the performance of workforces through products and services that are designed to keep employees healthy, engaged and productive. Lastly, it is more important than ever that Johnson & Johnson be an active participant in the dialogues that are taking place around the world to improve healthcare. We are invited to participate in these discussions because of our well established reputation as a healthcare leader and the unique perspective we can provide based on the diverse set of businesses we manage. We’ve been willing to experiment and innovate new ways to address the problems inherent in today’s healthcare systems. We believe any discussion of healthcare policy reform must put the needs of the patients and consumers first. Now let’s turn to our second priority which is capitalizing on convergence. This is an area where we can leverage the breadth and combination of our businesses for a unique competitive advantage. We look at convergence in three ways, the combination of products and technologies, the development of patient centric solutions and the collective power and breadth of the Johnson & Johnson enterprise. The most conventional view of convergence is in the combination of products and technologies across the non-traditional boundaries. Drugs delivered on a stent using a reservoir technology like Nevo, medication delivered on a contact lens to treat allergic systems in the eye, or Sedasys and the fibrin pad which I mentioned earlier. When we established our comprehensive care group last year we talked about convergence in the form of patient centric solutions that ignored product silos and looked at a patient’s continuous cycle of diagnosis, treatment and recovery. We asked what were the needs we could serve or gaps in this cycle we could fill with our products, expertise and knowledge of diseases and healthcare. Let me give you just one example in this area. Last year we mentioned the role that ortho clinical diagnostics is playing in convergence as it works with our other businesses on the use of companion diagnostics in areas like oncology, metabolics and cardiovascular disease. By identifying mile markers and patients who will benefit most from cancer drug or by targeting early indications that occur before the first signs of heart failure we are uniquely positioned to assist patients from the moment of diagnosis through monitoring and on to therapeutic intervention or treatment with our full range of products. Finally, we look at convergence in the way we leverage the power of our enterprise across business segments for unique insights and solutions. Our launch of Zyrtec was a powerful example of how we used experience and knowledge in both our pharmaceuticals and consumer businesses to help with the largest prescription to over the counter switch in our history. It was sighted in the tan sheet as a model for any OTC switch. McNeil Consumer Healthcare worked with our pharmaceutical business to educate and inform healthcare plans, pharmacy benefits managers, national retailers and employers about the switch. Thanks to these efforts millions of consumers received Zyrtec switch information from their healthcare plans while many more received similar communication from their employers. This tremendous collaboration enabled Zyrtec to achieve 26% market share since its launch in 2008. A decentralized management approached is fundamental to the success of our operating model. Our operating companies and local management teams know their markets the best and they execute their business strategies with great autonomy. There are many common functions where standardization can benefit Johnson & Johnson with greater efficiency, faster processes, better use of our talent and more leverage to the bottom line. We must increasingly use our scale as an advantage and we are in the midst of efforts to build more standardized approaches in areas like finance, human resources, procurement and information technology. These are not changes that can be implemented overnight in a global enterprise like Johnson & Johnson but we have the resources committed to ensure we reap the benefits of the work we have already begun. Our third priority is accelerating growth in emerging markets. Johnson & Johnson has been a global company since the 1920s when we established our first international affiliate in Canada and first overseas affiliate in Great Britain. We have continued since then to build businesses throughout the world. Today we have facilities in 57 countries and almost half our revenues come from outside of the United States. The emerging markets look to provide the most robust healthcare opportunities over the next decade and we are preparing our businesses to capitalize on this growth. We define high growth emerging markets on a business by business basis. We typically include countries like Brazil, Russia, India and China usually called the BRIC countries along with other important growth areas such as Turkey and Mexico. While the current economic crisis might temper these markets growth rates from the high shown here the opportunities remain significant. Over the next five years Russia, India, China, and Turkey are now projected to grow at the high single digit rates while more developed markets are seeming to grow even slower. This growth and maturity of these markets will globally impact healthcare through the products and medicines being developed, where and how clinical trials are being carried out and the way we run our businesses. Our business in the BRIC countries grew 19% operationally in 2008 and we continue to build our local capabilities and presence to strengthen these efforts. We are not new comers to these countries. We have a significant presence and well established roots. For instance, we began operations in Brazil and India in the 30s and 40s and China and Russia in the 80s and 90s. Our commitment to these markets continues to grow. I mentioned the Dabao cosmetic acquisition in China earlier. In 2007 we opened the emerging markets innovation center in Shanghai to develop new and affordable products addressing the consumer needs of emerging markets. One of the centers first successes was the launch of Johnson’s Baby Long Protecting Cream in 2008 which addressed the dry skin that babies can experience in cold weather. The team used local market research, natural ingredients and a competitively priced $25,000 package to meet the need of China’s emerging market. We also continue to invest in professional education in these and other markets to help teach physicians how to use our medical technology and to prepare markets for the introduction of new healthcare practices. Our MD&D businesses have more than 20 training centers outside the United States and are dedicated to just this type of work. Our vision care business for example has been using this approach establishing training centers in the US and around the world to train more than 30,000 practitioners and introduce them to the latest breakthroughs in contact lenses and eye care research. Finally, our most important priority is developing leadership and talent because none of our other strategies and priorities can succeed without the talented and dedicated people at Johnson & Johnson. When you look at our credo our operating model and our business priorities people are the common thread. It is because of them that I am confident in our ability to continue meeting our patients and customer needs while furthering our excellent track record in performance. With more than 250 operating companies around the world we have the capability to develop leaders by exposing them to a wide variety of businesses with ever increasing responsibilities. We look for people who can work in a decentralized environment, develop winning strategies and execute the plans that lead to success across our business segments. We allow them to take prudent risks as they enhance their own judgment and business building capabilities. Ultimately my confidence in our future stems from the talents of our people and their individual commitments to living our credo responsibilities in their daily work. In closing, I would like to reinforce for you our commitment to growth. For us this means competing in the most attractive spaces in healthcare. It means building and sustaining leadership positions through our pipelines, people and strategic acquisitions and licensing agreements. Finally, it means growing our sales faster than the markets where we compete and growing our earnings faster than sales through a thoughtful disciplined management approach. Johnson & Johnson has delivered a strong track record of performance over time. We have managed through difficult economic cycles in the past and we are confident that our people, our products, our pipelines and our financial strength position us well for continued leadership and growth in healthcare. I’d like to thank you for your attention. Now I’d like to turn podium over to Dominic for some additional comments and then we’ll have Q&A.
Dominic Caruso: To wrap up our formal presentation I would like to touch briefly on our results for 2008 and then provide some comments for you to consider as you refine your models for 2009. As Bill indicated we are pleased with our solid financial results for 2008. While we recognize there are challenging factors in today’s economic environment such as currency volatility and uncertainty surrounding the depth and length of the current recession, we are positioned well for long term profitable growth. Our sales results for 2008 reflected solid performances across many of our businesses. As I am sure you are aware we experienced significant volatility in currency exchange rates during the year. In fact, currency positively impacted our sales results by 2.4% for the year but negatively impacted our sales results by 3.9% for the fourth quarter. Similarly, regarding EPS, changes in currency positively impacted our full year EPS results by 1.9% but negatively impacted our fourth quarter EPS results by 3.4%. Our strong earnings performance demonstrated again our ability to continue managing costs and improving margins all the while continuing to invest to advance our pipeline of new products or enter into new markets through licensing and acquisitions. Before we discuss 2009 I’d like to point out some items in our fourth quarter results. Our adjusted earnings per share results in the fourth quarter exclude special items such as in process research and development charges related to the acquisitions we made in the fourth quarter and several litigation matters. The most significant of these litigation matters is related to the judgment in our favor of long standing stent litigation with Medtronic which was previously announced. The receipt of the payment related to this litigation judgment of approximately $520 million was partially offset by amounts related to several other litigation matters. This net impact has been reflected in other income and expense but has been excluded from the adjusted earnings results. Additionally, during the fourth quarter we closed on the sale of the professional wound care business to OneEquity Partners. You will remember that during my discussion of our third quarter results this transaction was not included in my guidance for 2008. Since we view this transaction as in essence a decision to reshape our portfolio we expected then that any gain from this divestiture would be used to make additional investments or other business decisions that would enhance our long term growth. During the fourth quarter we took these actions. You will note that our other income and expense line item reflects net higher other income than my previous guidance as it now includes the gain from this divestiture of approximately $500 million as well as some offsetting items of approximately half that amount. Additionally you will note some higher level selling, marketing and administrative expenses in the fourth quarter which reflect the use of the remaining half of this gain to make the investments and other business decisions as we had expected. Now I’d like to provide some guidance for you to consider as you refine your models for 2009. This guidance takes into consideration the addition of Omrix Biopharmaceuticals and other acquisitions made in 2008, the divestiture of Professional Wound Care business which was completed in 2008 as well as the pending acquisition of Mentor Corporation which is expected to close later this month. As previously disclosed the Mentor acquisition is expected to be dilutive to 2009 EPS by approximately $0.03 to $0.05 per share. This dilutive affect includes the transaction costs which are now expensed according to the new accounting guidelines related to business combinations. Let’s start with a discussion of cash and interest income and expense. During 2008 we continued to generate strong cash flows. In fact, as Bill pointed out earlier we generated free cash flow or cash flow after necessary capital expenditures of approximately $12.2 billion. At the end of 2008 we had approximately $1 billion of net cash. This consists of approximately $12.8 billion of cash and investments and $11.8 billion of debt. This is an improvement of $1.2 billion in our overall net cash position from year end 2007. Our financial position remains strong and we continue to have good access to the credit markets for our financing needs at reasonable rates. For purposes of your models assuming no major acquisitions and assuming the completion of the share repurchase program during the early part of 2009 I’d suggest you consider modeling net interest expense of between $150 and $250 million. Turning to other income and expense, as a reminder this is the account where we record royalty income as well as one time gains and losses arising from such items as litigation, investments by our development corporation and asset sales or write offs. This account is difficult to forecast but assuming no major one times gains or losses I would recommend that you consider modeling other income and expense for 2009 as a net gain ranging from approximately $150 to $250 million. Now a word on taxes. For 2008 the company’s effective tax rate excluding special items was 22.9%. We suggest that you model our effective tax rate for 2009 in the range of 24% to 25%. This rate takes into consideration changes in the mix of our business for 2009 as well as the extension of the R&D tax credit for 2009. As always we will continue to pursue opportunities in this area to improve upon this rate throughout the year. Now turning to sales and earnings. As I previously mentioned we experienced significant volatility in terms of currency exchange rates especially late in the year. As you can see from this chart it is very difficult to predict movements in currency exchange rates especially given the current economic conditions and the resulting monetary policy changes that governments around the world are employing to address the situation. Some of these actions have had an impact on interest rates and a resulting impact on the volatility of currency exchange rates. It appears that additional actions are likely to be taken that may continue to impact the volatility of exchange rates even further. Therefore, our guidance for 2009 will be based first on a constant currency basis reflecting our results from operations assuming that average currency rates for 2009 will be the same as they were for 2008. This is the way we manage our business and we believe this provides a good understanding of the underlying performance of the business. I will then provide an estimate of our sales and EPS results for 2009 with the impact at current exchange rates could have showing the Euro as an example. Of course the actual impact is dependent upon many currencies but the Euro represents about 50% of this impact. I believe this will provide you with some helpful insight for your modeling purposes. Turning to sales, the mean of the analysts estimate as published by First Call indicates sales of $63.7 billion for 2009. As we looked at the various models it appears that not all the analysts have updated for currency fluctuations and some of those that have, have not fully reflected what the impact could be at current exchange rates. Taking into consideration the loss of US Patent exclusivity of both Risperdal Oral and Topamax which have about a 4% to 5% impact to our overall sales growth rate, we would be comfortable with your models reflecting operational sales change on a constant currency basis of between -1% and 1%. This would result in sales for 2009 on a constant currency basis of between $63 and $64 billion. While we are not predicting the impact of currency movements, to give you an idea of the potential impact if currency exchange rates for all of 2009 were to remain where they were as of last week that our sales growth rate would be negatively impacted by approximately 4% or approximately $2.4 billion. Thus under this scenario we would the expect reported sales to decline to a range between 3% and -5%, for a total expected level of reported sales of between $61 and $62 billion. Now turning to earnings. When I last checked, the First Call mean estimate for our EPS for full year 2009 was $4.61 per share which excludes the dilutive impact of the Mentor acquisition. It appears that many of the analyst models include a 2009 tax rate that is lower than the guidance I just provided. As I noted earlier it does not appear that all the models have been updated to reflect the potential impact of currency at current rates. I suggest you consider full year 2009 EPS estimates excluding the impact of special items of between $4.60 and $4.70 per share on an operational basis that is assuming same average exchange rates for 2009 as we saw in 2008. This represents an operational growth rate of 1% to 3%. While we are not predicting the impact of currency movements to give you an idea of the potential impact on EPS if currency exchange rates for all of 2009 were to remain where they were as of last week then our EPS growth rate would be negatively impacted by approximately 3% or approximately $0.15 per share. Thus under this scenario we would then expect total reported EPS excluding special items of between $4.45 and $4.55 per share. Throughout 2009 we will provide you with the operational growth rates for our actual sales and EPS results in order to give you the visibility to the underlying performance of the business. We will also provide the impact of currency on our actual results. As you refine your models for 2009 I want to remind you to consider the impact to our results from the loss of US Patent exclusivity of Risperdal Oral at the end of June 2008 and the loss of US Patent exclusivity of Topamax at the end of March 2009. These events will obviously have significant impacts to comparisons. As you work through the guidance I provided a few minutes ago we would be comfortable with your models reflecting an improvement in pre-tax operating margins for 2009. While operating margins may vary by business segment year to year, may be impacted from time to time by short term dilutive impact of acquisitions, improving the overall pre-tax operating margin by growing income faster than sales over time is a fundamental discipline we use in managing our business. In closing, I’d like to offer these final thoughts. Johnson & Johnson is a company that is financially strong. We continue to be committed to growth as Bill has pointed out. I am very proud of the financial performance we delivered in 2008 and I look forward to updating you on our progress for 2009 throughout the year. Louise back to you.
Louise Mehrotra: We’ll now begin the Q&A session. Please wait for the microphone before asking your question as this meeting is being webcast. As we have Bill Weldon with us today please keep your questions more strategic.
Larry Biegelsen – Wachovia: On the Pharma side many of your competitors have reevaluated their strategy in this difficult environment, could you by focusing for example on specialty markets or certain therapeutic categories could you articulate J&J’s strategy in the Pharmaceutical business? Second in services the other area that you’re targeting the pace that we saw in 2008 in terms of two small acquisitions is that what we can expect going forward or something more accelerated? Do you see 2009 as a one time event in terms of EPS growth? In other words, do you expect to return to historical EPS growth rates in 2010?
Bill Weldon: The first one is really the strategy around our Pharm business, we’ve historically been very focused on the specialty markets so when you look at the impacts we have much less of the impact but like everyone else really assessed our sales force, different ways of going to market but we have identified the specific therapeutic areas where we continue to focus on continue to develop our products where we think there is high potential whether its here in the United States or around the world. I would say that we modified our strategy but haven’t really changed it other than some of the ways we go to market with sales organization and new ways of looking at promoting our products that we think make us more efficient. As far as the specialty area it’s been an area that we’ve historically been focused on and will continue to be focused on. We think it gives us a lot of leverage and a lot of strength. The second question was really around acquisitions?
Larry Biegelsen – Wachovia: The areas you don’t participate in today this year and last year you showed us that pie chart. You had two small acquisitions I’m just wondering if that’s the pace that we can expect going forward in terms of penetrating that segment.
Bill Weldon: Let me comment on the wellness and prevention area and what has really driven us into that because I think with the new administration and truly the focus on obesity around the world and diabetes and the problems that are there that more and more people are getting focused on taking care of their own health and I think the administrations are starting to look at how do we reimburse and treat these people and keep people healthy which is really the answer to the long term healthcare costs that we have to deal with. We took last year really and tried to look across the landscape, we looked at health information technology for example. We zeroed in on prevention and wellness and the two acquisitions we have coupled with the experiences we’ve had over the last two decades at Johnson & Johnson. We think there’s a very strong business model looking at that in that today we pay about $400 less per employee for our healthcare costs than the normal company would pay. The reason for that is for two decades now we have 4% tobacco users at J&J where a normal population is about 20%. We have a focus on obesity and weight loss; we have a focus on cholesterol, hypertension and the areas that really many of the co-morbidities associated with obesity and keeping people healthy and well. We think that will also drive to engagement, absenteeism. We know, we’ve documented it in our own programs. By looking at the behavior modification technology that HealthMedia has coupled with the Human Performance Institute which looks at nutrition, exercise, recovery and the critical pieces. Putting it together with the facts we have we think we have a very strong model to go to governments and other businesses with to improve the health of their employees. I wouldn’t expect you’d see us going into large acquisitions trying to move things forward but build from the base that we have in wellness and prevention as we continue to assess other opportunities.
Dominic Caruso: Your question was really related to the level of EPS growth that our guidance for 2009 versus what could happen in 2010 or how that might change. I think 2009 is a year that’s very well understood by everyone. We know the business pressures we are facing in 2009 and in fact that’s now coupled with some economic pressures that we’re beginning to see as well. I would say that we’ve been able to manage through that very well both in 2008 where you saw increase in pre-tax operating margins and my guidance indicates an increase again in 2009 in pre-tax operating margins obviously impacts our EPS growth. Moving into 2010 I think a few things will change. One is that our comparisons obviously be a little easier when the business pressures are a little bit further behind us. More importantly than that we have a great deal of confidence in our new platforms for growth; our products, our pipeline and our leadership in terms of their ability to manage through these difficult times while at the same time preparing ourselves for continued growth in the future. When we look at managing our business although its very difficult to manage pre-tax operating margin increases in difficult times like 2008 and 2009 we did that and I guess that’s the way we manage our business and I’d see that we would continue doing that going forward. I can’t give you a specific outlook for 2010 but we’re confident with our products, we’re confident with our ability to manage our business appropriately.
Catherine Arnold - Credit Suisse: I was wondering with a lot of your competitors talking about going down the path of bio-similars or bio-betters as some of them like to call it, if you would have a similar interest given your capabilities and expertise in that area and how you might see that changing the landscape of your participation in biologics in general. Secondly, you mentioned that we should expect operating margin improvement in ’09 clearly that’s at the same time that you’re undergoing a significant amount of cash cow loss particularly in the pharmaceutical business and the med device business. Could you give us a little bit more color around that? As I look at your gross margin for instance in the quarter there may have been some currency noise and so forth but it’s surprisingly higher than we would have expected. SG&A you still are pretty robust and to me it seems like you have an opportunity to contract there?
Bill Weldon: We continue to assess whether its generics, bio-similar or anything else we’ll continue to assess it. We don’t see it as a real opportunity at the moment and part of that is because with bio-similars you’re probably going to still have to show because of the size of the molecule and everything else the way it forms, the way it shapes, the way it fits into the receptor there is going to have to be clinical trials so its going to require a significant investment. Our belief is we need to keep focused on creating new opportunities in the marketplace, driving them forward through the products that we can. As far as getting into the bio-similar area we don’t see any opportunity for us at this point in time.
Dominic Caruso: With respect to improving operating margins in ’09, you’re right, the ’08 fourth quarter in particular cogs number had some one time items as did the fourth quarter ’07 as Louise pointed out those items in ’08 were essentially offset by some other items in other income. That level is not the level we would expect going into 2009. We’d expect gross margin to be under pressure in 2009 as compared to 2008. Offsetting that we do have these various programs in place which Bill has talked about and I’ve talked about in the past which is our standardization efforts. We also have the general notion that our business leaders run the business in an appropriate way considering economic times. We would expect that both our SG&A and R&D costs as a percent of sales would be lower in ’09 versus ’08 which is in fact one of the major drivers of the pre-tax operating margin improvements.
Bill Weldon: Dominic has talked about the standardization initiatives and we’ve been investing in these over time and I think we’re starting to implement now we’re going to start to see the benefits of these through 2009 and beyond because it’s really been the investment phase we’ve been going through and we’ll continue to go through. I think we’re getting to the point we’re starting to execute and really implement some of these programs that are going to start to yield some of the benefits as we go forward.
Mike Weinstein - JP Morgan: Do you have the plan in place to achieve operating margin expansion in 2009 and the face of the fundamental pressures you’ll have? Is everything already in place to make that happen? The tax rate guidance for 2009 is that a function of decline in sales in pharmaceutical products manufactured out of Puerto Rico is that what’s driving that? The company is in a great position financially ’09 is going to be a tough year but financially you’re in great position you manage the company for the long term. Should we be thinking about 2009 as we model impact of events in 2009 should we assume that J&J is likely to be an acquirer over the course of 2009 taking advantage of your financial strength when a lot of companies are going to be relatively weak.
Dominic Caruso: Yes, the plans are in place for 2009 operating performance that would improve pre-tax operating margins over 2008. As a reminder, we started on this path back in 2007 where we conducted the restructuring of the pharmaceutical business and the Cordis business. Again, 2009 was not a surprise for us, we knew about this for some time. To put the plans in place now as Bill said we’re executing on a number of those plans we’re very happy we’re able to achieve the higher end of our cost improvement guidance that we provided earlier. We have of course the higher level of the PCH integration synergies happening in 2009 so those plans are in place, we feel comfortable with that. The tax rate increase from year over year is primarily due to the fact with lower pharmaceutical sales revenues especially products like Risperdal and Topamax we lose some tax benefit there that we’ve enjoyed over the last couple years so that’s the primary driver of that change.
Bill Weldon: We’re always looking for the right opportunities and we think that the pressures in the economy right now are going to create very unique opportunities for us. We have our list of candidates that we think would be good opportunities and other ones are going to be popping up and coming to us as the year progresses. We are very focused on the unique opportunities that will be presented to us based on the market conditions that we see today.
David Roman – Morgan Stanley: One of the areas you highlighted on the slides where you’re not currently participating is disease management. Can you talk a little bit about the avenues you might use to enter that a little more whether its IT services or diagnostics? On the guidance there are clearly a lot of moving parts in 2009 there’s probably some contribution from new pharmaceutical products, some slowing you mentioned in elective procedures. Could you talk to us a little bit more about the drivers of the 200 to 400 basis point deceleration in operational top line growth outside of the obvious being Topamax and Risperdal. On the buy back that probably will be completed shortly what’s in the assumption on share count for 2009?
Bill Weldon: Disease management is kind of a bad word to be using these days because a lot of the programs that have been run have not been successful. The way we’re trying to look at it is basically looking at a patient and saying how do we deal with that patient in taking the resources that J&J has and putting them against it. When we look at the management of the patient we’re talking about the area of diabetes for example and metabolic disease. Part of it goes to what we were talking about before this wellness and prevention. If you look at obesity here in the United States or around the world its one of the biggest drivers of problems. If you extrapolate that out to the co-morbidities associated with obesity if we can get obesity under control and that may be through surgical intervention which could be bypass or realized gastric band, it could be through some of the behavior modification programs and diet and exercise. Those are the things that we’re thinking about in that area. As far as diabetes specifically we have the onemous pump now, the glucose strips but we also have, if you look at Splenda, we look at surgical intervention, we look at the behavior modification programs so we’re actually looking at how do we approach the patient in a way that offers them the comprehensive treatment and bringing that out to further looking at bio-markers in earlier indicators through our ortho-clinical diagnostics programs, it will allow for a treatment of an individual and the management of an individual throughout the whole continuum of care as opposed to just trying to put a piece together here. We think that it’s not really disease management its really patient management and the behavior that we can influence in effect through our products or resources.
Dominic Caruso: I think you were referring to the operational sales guidance excluding any impact on currency. As you know, both Risperdal and Topamax together impact our growth rate 4% to 5% year over year. In addition to that just a couple factors that we considered. One is that we’ve seen some impact in several franchises that are impacted by consumer behavior. For example, in our consumer business or in businesses where consumer discretionary spending is a major factor such as diabetes test strips or in vision care with contact lenses. We’ve seen some impact there that we’ve taken into consideration. We’ve also seen some greater pricing pressure especially in countries outside the US as countries tend to look for ways to balance their budgets or improve their budgets by reducing the price or the cost of healthcare. Also in medical devices and diagnostics we mentioned before we’ve seen some impact already in elective procedures or procedures where there are some higher out of pocket expenditures. Finally, in the pharmaceuticals business I think the way to best characterize it is until we see the FDA approvals come forward for some of the products that are waiting FDA approval we generally are fairly conservative in the way we model those new products. We think that’s a prudent way for us to manage the business going into the year.
Bill Weldon: Let me add two more comments to that that I think are really important. Dominic talked about the elective surgery and some of the disposable income that individuals may have, the consumer have. I think you also have to look at the pharmaceutical business where we are seeing a slowing down in the rate of growth. You go back earlier in the year where people are saying prescriptions were actually declining but we think that’s kind of reversed itself and there’s a 1% to 2% growth I think IMS is forecasting for the coming year. There’s a slowdown there. The one element that we all have to, we kind of talk around it but it’s the whole economic environment. If you just take unemployment here in the United States I don’t know what the numbers are going to be but we know they’re going to get greater, we know there’s going to be an impact and we know that many of the people that will become unemployed are people that have insurance today. Those people are going to stop going to the doctor, they’re going to stop getting their prescriptions filled, and they’re going to stop having elective surgery. There’s going to be downward pressure on all of these areas so I think the economic conditions that we’re dealing with today are going to create downward pressure in lots of areas in healthcare but in other areas also. I think we have to be realistic about the impact that that can have on the whole healthcare market here in the United States. I think it’s also you can take it Venezuela or to Russia when you look at the price of oil. We have an economic decline around the world that is going to affect the total healthcare expenditures.
Dominic Caruso: On the buyback question we assume that we’ll complete the $2 billion left of the $10 billion share buyback in the early part of 2009 so our share count estimates reflect that and they do not reflect any assumption of any additional buyback in 2009.
Bob Hopkins - Banc of America-Merrill Lynch: On the consumer side I know you don’t give line item guidance but I’m just curious from a 50,000 foot perspective you expect that business to be a growth business in 2009. You talked a lot about policy in Washington DC and I think it’s a critically important topic. Specifically for 2009 what major changes do you anticipate happening if any? Beyond 2009 what emphasis on any major changes that you as CEO of J&J are anticipating beyond 2009 to the way healthcare policy is formed in this country?
Dominic Caruso: On the consumer business we don’t give guidance by sector but generally speaking we still look at our consumer business as a growth business. Just to reminder that in 2008 obviously we had the fantastic launch of Zyrtec in our ’08 results so that will be a tougher comparison for the consumer business in ’09.
Bill Weldon: When you look at policy in Washington we’ve used the term access and affordability for a long time. I think that the administration is talking about coverage and costs and they really mean the same thing. We do believe that we have to look at how do people gain more access at more affordable prices. There are lots of different ways to look at it and I think we’ll wait and see what the administration has to do here. We’ll work closely with them and try and support and work in ways that is going to allow patients to get better healthcare. I think the critical thing right now though is addressing the economic situation that we have. I think that’s going to be first and foremost so when you look at 2009 there are lots of things that could be done to have short term impacts. You can look at negotiating the pricing; you can look at all of these things and can have some short term. They’ll be some changes and some affects in those areas. As you look out further I think we’re all going to have to get together and really look at how do we get better healthcare. The one area that I think is a unique opportunity for J&J today and I keep going back to this is the whole area of dealing with, I was at a group in Washington where they asked a group of us to get together and look at some of the challenges whether it’s the economy, trade, energy or healthcare. The single largest issue that has to be dealt with is obesity. When you start looking at prevention and wellness and dealing with obesity, if we don’t get childhood obesity under control, if we don’t start dealing with this they say today one out of three children born today will have diabetes. The healthcare costs of today will be nothing compared to what they’re going to be. I think there will be a real focus on this area of prevention and keeping people healthy rather than letting them get sick and treating them. I think there will be a focus on that but I think the first and foremost the administration is going to have to address the economic conditions. I think that will have a positive impact but I do believe whether you want to call it coverage and costs, if you want to call it access and affordability. I think you have to also look at the whole area in health and prevention.
Rick Wise - Leerink Swann: You highlighted the customer inventory draw downs do you think there’s a lot further to go and maybe you could quantify the impact if you had on the fourth quarter?
Bill Weldon: Most of the, whether they be hospitals or major companies like Wal-Mart or others I think they’ve all been very tightly looking at their inventories as we’ve looked at ours. I think its just prudent today in the environment we’re in to try and get your inventories down and manage your capital. We’re doing that and everyone else is. I think that the draw down has taken place significantly but I think it’s hard to tell if there’s more to come and there may be ways of doing business that may change. I think there’s been a significant drawn down in many areas of inventories.
Dominic Caruso: I can’t quantify it for the fourth quarter. We do expect it to continue throughout 2009. The impact that we saw in the fourth quarter other than currency was really the impact of not shipping some Remicade at the end of the year due to our production scheduling and maintenance schedule which of course is not a significant impact, significant in the quarter but not a sign of anything other than the timing of that.
Rick Wise - Leerink Swann: Let me come with the strategic issue on the cash use a little differently. Clearly you have the cash, maybe your and the Board’s priorities is it continuing with share buyback, is it making acquisitions? Do you think Pharma growth will be positive in 2010? I’m not looking for a precise forecast?
Bill Weldon: Our Pharma or Pharma in general?
Rick Wise - Leerink Swann: Your Pharma business will it have positive year over year growth?
Bill Weldon: You know I’m not going to answer that question. The priorities for us have never changed. They’re simple. Our first priority is to make sure we have the money to pay our dividends. That’s 40% of what we have available. When you start to look at what we then want to do with the money it’s invest in the business. If we had an opportunity to make an acquisition or to do something that would be really positive for the business that would take precedence even over completing the share buyback. Our intent is to ensure that we continue to look at opportunities that are going to bring strategic value to the business and growing. I was mentioning this earlier to a couple people; I think the opportunities this year are going to be extraordinary. I think it’s a matter of sitting on what we have, making sure we understand where our priorities are and what opportunities might be there. If they present themselves then we’ll be in a great position to move on them. Absolutely this economic environment creates opportunities that we may never see again so we need to be positioned to capitalize on them if they present themselves.
Matt Dodds - Citigroup: When you look at the R&D even though you spent less in Pharma this year you’re still spending more than the average. I’m wondering as you’ve moved through ’08 how are you thinking about the cost benefit of those dollars first in the US how much harder is it going to get a return. Does the worldwide potential offset that, how you’re viewing that? On Sedasys you highlight that a lot is that a capital spend product and is the potential for that lower now given the environment?
Bill Weldon: As far as the R&D goes probably two or three years ago we actually increased our percent of sales up into 20% plus range, the industry is around 16%, 15%. We did that because we had what we really believe and still believe is such a rich pipeline. As products started to mature we made early investments six or seven years ago in early stage discovery and early products. They came to fruition and of course the cost of bringing a product to market is much greater. We’ve moved a lot of our clinical trials outside of the country so we’re getting a lot bigger bang for the buck today then we’ve ever gotten before. We’re starting to see a leveling off now because we think we’re going to get to a steady state which will be pretty much the same as an industry norm in the ability to invest in the products and its not that we don’t have confidence in our pipeline going forward and don’t need the investment its that we’ve been able to really be more efficient in the way we manage our clinical trials and the way we manage our go to market. Yes, we’ll see a leveling off of the expenses, we’ll see it more normalize against what the industry norms would be but the increase as we said for the last few years has really been because of the strength of the late stage development in our pipeline. You talked about the returns in the US, our feeling and belief and we hope this strongly is that we will get a strong person in charge of the FDA. We do hope its science will progress and be able to make scientific decisions for approval of products. It puts more pressure on the industry to do better research and to make sure we’re doing really good research that’s going to pay us the scrutiny of this. We think that’s an advantage to us. It’s an advantage to the industry to have a really strong regulatory body. Then we will reap the benefits of the products that we have coming. I think there’s going to be a lot more pressure on both pricing as well as the cost of brining the products to market. I think we’ll see more and more reviews and discussions about additional work that may be required. The benefit of innovation and bringing better products to market will more than offset the incremental costs if there are any that we’re going to have to deal with both here in the US. As you mentioned the emerging markets in some of these areas are making significant investments in healthcare in their countries and we think that we’re able to not only bring the products we have but modifications and the innovation center we have in China to bring better products there. You’ll see a leveling off but we’ll continue to work in that area. As far as Sedasys yes there is some capital equipment in that area but its not huge capital equipment cost and we have some unique ways of helping to move that to the consumer that will allow them to pay, we’re not going to be a bank but to buy these things over time or usage upon the product that will pay for itself in a short period of time. We’re looking at unique ways to help offset some of the costs for the consumer or the doctor.
Glenn Novarro – RBC: Another question on M&A and particularly on the Pharma side. It dovetails a little bit with your comment you just made. In the past you’ve talked about a challenging FDA and a challenging regulatory body. If you look over the last couple years your deals have been more outside the Pharma side on consumer and devices. I’m wondering is the reason why we haven’t seen something on the Pharma side in recent years is it because the company has made a strategic decision to diversify away from Pharma or is it more because the price wasn’t right or the culture of the company that you may have been looking at didn’t fit. I’m curious why we haven’t seen more on the Pharma side on the M&A.
Bill Weldon: It’s a bit of all of the above. If you look at the balance we were becoming way out of balance in the Pharma area and the PCH acquisition really helped balance our portfolio in that way. The regulatory bodies in many parts of the world especially here in the US have been struggling. They’ve been struggling to make decisions to approve products and with some of the adverse events they had they became risk diverse. It was very hard and it continues to be difficult getting products approved. The strategy that we have is if we have whether its in pharm, medical devices, diagnostics, consumer or any place else if it’s the right acquisition or the right license that will afford us the opportunity to advance the long term and create shareholder value we’re going to do it. We haven’t shied away from it we’ve just seen the prices have been very high. You have to look at where the products in their life cycle and where is the pipeline and do you gain access to something that’s going to bring real value, vis-à-vis what you already have in your investments. If you buy something there’s going to be lots of biotech companies. Everyone talks about biotech companies are going to come up right? The quest for the biotech company isn’t the important thing, it’s the cost of the investment to bring the product to market and is it going to bring value that’s going to be important. We have to look at the total investment and make sure that whether its pharmaceuticals, medical devices, diagnostics or consumer that we’re making the right investment that’s going to bring the benefit to our shareholders. We haven’t shied away from it we’ve just recognized that there were challenges that maybe made it more difficult.
Bruce Nudell - UBS: Structurally a decent chunk of your cash is ex-US does that create relative advantages for acquisition versus share buyback? I wanted to clarify with regard to Remicade the scale of the de-stocking and from what I thought I just heard it was more internal timing as to manufacture rather than credit issues or share issues in the marketplace.
Dominic Caruso: With respect to our capital structure and ex-US versus in US cash I would say generally speaking we’re comfortable with the level of cash we have and obviously we’re also very comfortable today given our strong financial position on our access to credit markets at reasonable rates. The cash location isn’t that much of a factor for us because of our ability to access capital when we need it at very reasonable rates. The Remicade issue was in the several hundred million dollar range of sales that due to scheduling issues in the production plan due to maintenance in the plan was simply deferred due to the timing of completing those events and it had nothing to do with any credit issues or any other issues with respect to the product.
Bill Weldon: I’d like to first of all thank you all for coming today I know it’s a very important day for a lot of reasons but we do appreciate your interest and your support of J&J. I also want to say in parting that I was asked a question earlier and that is about the morale of the people at J&J because a lot of things are going on around the world. I want to tell you that the people at J&J look at this year as an extraordinary opportunity and an opportunity that if we stay true to what we believe in, stay true to our plans and stay focused on our business that we can come out of 2009 in a much strong way than we’ve ever gone into it and we’ve gone into it in a very strong way. I want to let you all know that the people of J&J are very committed and that’s what makes me feel so optimistic about the year. Thanks very much and we’ll see you later. | [
{
"speaker": "Executives",
"text": "Louise Mehrotra - Vice President, Investor Relations Bill Weldon – Chairman and Chief Executive Officer Dominic Caruso - Vice President, Finance and Chief Financial Officer"
},
{
"speaker": "Analysts",
"text": "Larry Biegelsen - Wachovia Catherine Arnold - Credit Suisse Mike Weinstein - JP Morgan David Roman – Morgan Stanley Bob Hopkins - Banc of America-Merrill Lynch Rick Wise - Leerink Swann Matt Dodds - Citigroup Glenn Novarro – RBC Bruce Nudell - UBS"
},
{
"speaker": "Louise Mehrotra",
"text": "Welcome, I’m Louise Mehrotra, Vice President of Investor Relations for Johnson & Johnson and it is my pleasure this morning to review our business results for the fourth quarter of 2008 and full year 2008. Joining me on the podium today are our host for today’s meeting Bill Weldon, Chairman of the Board of Directors and Chief Executive Officer of Johnson & Johnson, and Dominic Caruso, Vice President, Finance and Chief Financial Officer. A few logistics before we get into the details, the audio and visuals from this presentation are being made available to a broader audience via a webcast accessible through the Investor Relations section of the Johnson & Johnson website. I’ll begin by briefly reviewing highlights of the fourth quarter for the corporation and highlights for our three business segments. Following my remarks, Bill Weldon will comment on the 2008 results and provide a strategic outlook for the company. At the completion of Bill’s remarks Dominic Caruso will provide additional commentary on the 2008 financial results and guidance for 2009. We will then open the floor to your questions. We will conclude our formal presentation at approximately 9:30 am and following Q&A with some final remarks by Bill we’ll conclude the meeting around 10:00 am. Distributed with the copy of the press release that you just received is a schedule with actual revenues for major products and/or business franchises. For the listening audience these are available on the Johnson & Johnson website as is a copy of the press release. Before I get into the results, let me remind you that some of the statements made during this presentation may be considered forward looking statements. The 10-K for the fiscal year 2007 identifies certain factors that could cause the company’s actual results to differ materially from those projected in any forward looking statements made this morning. The company does not undertake to update any forward looking statements as a result of new information or future events or developments. The 10-K is available through the company or online. Last item, during the call, non-GAAP financial measures may be used to provide information pertinent to ongoing business performance. These measures are reconciled to the GAAP measures and are available on the Johnson & Johnson website. Now I would like to review our results for the fourth quarter of 2008. If you would refer to your copy of the press release, let’s begin with the schedule titled supplementary sales data by geographic area. Worldwide sales to customers were $15.2 billion for the fourth quarter of 2008 down 4.9% as compared to the fourth quarter of 2007. On an operational basis sales were down 1% and currency had a negative impact of 3.9%. In the US sales declined 6.9%. In regions outside the US our operational growth was 5.4% while affect of currency exchange rates negatively impacted our reported results by 8.1 points. Our strongest performing region was the Asia/Pacific/Africa region which grew 9.9% on an operational basis. The Western Hemisphere excluding the US grew by 6% operationally while Europe grew 2.7% operationally. If you’ll now turn to the consolidated statements of earnings net earnings on a reported basis were $2.7 billion and earnings per share were $0.97. This compares to $2.4 billion and $0.82 in the same period in 2007. Please direct your attention the boxed section of the schedule where we have provided adjusted earnings information. As referenced in the footnote fourth quarter 2008 results were adjusted to exclude special items including charges for in process research and development and the after tax net gain from several litigation matters. In the fourth quarter of 2007 results were adjusted to exclude the write down of the intangible asset related to Natrecor and a tax gain associated with the restructuring of certain international subsidiaries. Net earnings on an adjusted basis were $2.6 billion and earnings per share were $0.94 up 3.1% and 6.8% respectively versus the fourth quarter of 2007. I would now like to make some additional comments relative to the components leading to earnings before we move on to the segment highlights. Cost of goods sold at 28.8% of sales was 90 basis points less than the same period in 2007. In 2007 the results were impacted by one time charges. The 2008 results had some favorable impact of one time items which were substantially offset by charges in other income and expense. Excluding one time items, cost of goods sold would have increased approximately 30 basis points due to the ongoing changing mix of the business. Selling, marking and administrative expenses at 37.3% of sales were up 150 basis points versus last year. As we discussed last quarter we planned some investment spending in the fourth quarter. The increase in selling, marketing and administration is a combination of this investment spending and the change in the mix of our business driven by the growth in the consumer business and the lower sales in the pharmaceutical business. Our investment in research and development as a percent to sales was 13.9%, 70 basis points less than the fourth quarter of 2007 due to a combination of a change of mix of businesses and lower spending in our pharmaceutical business. Interest expense net of interest income of $17 million compares to $35 million of net interest income in the fourth quarter of 2007. This change in net expense was due to lower interest income resulting from lower rates on invested cash and higher interest expense due to a higher average debt position in the quarter versus the same period last year as we continue buying back shares as part of the repurchase program. Other income net of other expense was $638 million in the fourth quarter 2008 compared to $877 million of net other expense in the same period last year. During the fourth quarter of 2008 we closed on the sale of the Professional Wound Care business. The resulting gain as well as the net gain from litigation settlement that I mentioned earlier are included in this account. In the fourth quarter of 2007 the write down of the intangible asset related to Natrecor was recorded in this account. With regard to taxes please direct your attention the affective tax rate excluding special charges shown in the boxed section of the schedule. Taxes were 19.9% in the fourth quarter 2008 versus 15.3% in the fourth quarter 2007. Dominic will provide additional commentary on both other income and expense and taxes in his remarks. Looking at full year data, consolidated sales to customers for 2008 were $63.7 billion an increase of 4.3% as compared to 2007. On an operational basis growth was 1.9% and currency had a positive impact of 2.4 points. On the consolidated statement of year to date earnings I’d first like to draw your attention to the boxed section. In 2008 and 2007 net income and earnings per share have been adjusted for special items. In both years charges for in process research and development have been excluded. Additionally, in 2008 the after tax net litigation gains have been excluded. In 2007 the after tax costs associated with the restructuring program, the non cash charge related to Natrecor write down and the one time gain associated with the restructuring of certain international subsidiaries have been excluded. With these adjustments net earnings for the 12 months of 2008 were $12.9 billion or $4.55 per share up 6.8% and 9.6% respectively as compared to the same period in 2007. Turning now to business segment highlights please refer to the supplementary sales schedule highlighting major products or business franchises. I’ll begin with the consumer segment. Worldwide consumer segment sales for the fourth quarter 2008 of $3.9 billion increased 1.2% as compared to the same period last year. Operational growth was 6.9% while the impact of currency was -5.7 points. US sales were up 1.8% while international sales grew 10.6% on an operational basis. For the fourth quarter of 2008 sales for the over the counter pharmaceutical and nutritionals increased 8.5% on an operational basis compared to the same period in 2007. Sales in the US were up 4.7% due to the successful US launch of Zyrtec, partially offset by lower sales of cough and cold products due to the slower start to the season versus last year. Sales outside the US were up 12.6% operationally driven by strong growth of adult Tylenol, Nicorette, upper respiratory products and nutritionals. Our skin care business achieved operational sales growth of 11.5% in the fourth quarter of 2008 with sales in the US growing at 6.2% and sales outside the US up 15.3% on an operational basis. Strong growth was driven by the newly acquired products from Dabao, the leading moisturizer in China. Johnson’s Adult, Aveeno, Neutrogena also made significant contributions to the growth in the quarter. Baby care products achieved operational growth of 3.2% when compared to the fourth quarter 2007. Sales in the US were down 6% primarily due to the lower sales for BabyCenter.com. Solid growth across most product lines resulted in an operational increase from sales outside the US of 5.7%. Women’s health achieved operational growth of 1.1%. Sales in the US were flat, while sales outside the US were up on an operational basis by 1.6%. Solid growth in external sanitary protection was partially offset by sales declines in other products. Operational sales growth in the oral care franchise was 10.5% with US sales up 1.6%. In the US strong growth in Rembrandt products has been partially offset by slower sales in floss and mouth fresheners. Sales outside the US increased 19.3% operationally driven by very strong growth for Listerine across the major regions. Sales in the wound care other category were down 6.1% on an operational basis with the US down 17.2% and the business outside the US up 7%. The lower sales in the US were due to increased competition and a reduction to the trade inventory levels. That completes our review of the consumer segment and I’ll now review highlights for the Pharmaceutical segment. Worldwide net sales for the fourth quarter of $5.7 billion were down 11.1% versus the same period last year. On an operational basis sales were down 7.8% with a currency impact of -3.3 points. Sales in the US decreased 13% while sales outside the US increased on an operational basis by 0.5%. Our results continue to be impacted by generic competition on some of our products namely Duragesic, Razadyne, and Risperdal Oral. The patent for Risperdal expired in the US at the end of June, 2008, and there are generic competitors for Risperdal in most markets. Generic competitors for Razadyne entered the US market in the latter half of the year. The combined impact of these three products has reduced the fourth quarter worldwide pharmaceutical operational growth rate by approximately 9.5 points, with the US impact estimated at approximately 13% and the impact outside the US estimated at 4%. Excluding the impact of generic competition, operational sales growth was approximately 1.5%. Now reviewing the major products. AcipHex as its known in the US market and Pariet outside the US is a proton pump inhibitor, or PPI that we co-market with Eisai. On an operational basis sales were down 15.6% with similar results both in and outside the US. In the US script share has been negatively impacted by additional generic launches in the PPI category. Sales have also been impacted by the market entry in Canada of generic Rabeprazole, the active ingredient in Pariet. Concerta, a product for attention deficit hyperactivity disorder grew 3.1% operationally in the fourth quarter as compared to the same period last year with sales in the US down 6.3%. In the US market growth has been offset by lower market share. The FDA approval earlier this year of the adult indication for Concerta will enable us to compete in the broader ADHD market. Sales outside the US were up 34% operationally with strong growth seen across the major regions. Sales of Levaquin our anti infective were down 4.2% on an operational basis when compared to the same period a year ago due to lower prescription share. Share was negatively impacted by generics in the category. Procrit/Eprex declined operationally by 5.9% during the quarter as compared to the same period last year with Procrit down 3.9% and Eprex down 8.2% operationally. New competition and a softening of the market have contributed to the lower sales results for Eprex. Procrit results have been impacted by a decline in the market versus the fourth quarter of 2007 estimated at 13% partially offset by an increase in overall market share. Procrit aggregate share across all markets was approximately 49% in the fourth quarter 2008 up four points versus the same period last year. Sales of Remicade, a biologic approved for the treatment of a number of immune mediated inflammatory diseases were down 2.4% when compared to the fourth quarter 2007. Sales growth in the US was 1.7%. Sales were impacted by lower customer inventory levels as well as a lower market share due to increased competition. Sales to our customers for markets outside the US were down 15% due to the timing of shipments related to production scheduling due to maintenance. Excluding this impact sales outside the US are estimated to have grown over 20%. Risperdal Consta, our long acting injectable formulation achieved fourth quarter sales growth of 16.3% on an operational basis. US sales growth was 8.3% while sales outside the US were up 20.9% operationally with continued positive momentum in share. Sales of Topamax which is approved for the treatment of epilepsy and migraine prophylaxis increased operationally by 6.4%. Sales in the US were up 7.7% while sales outside the US were up 0.9% on an operational basis. In the US market share in the migraine category increased versus the same period last year. Outside the US strong growth was achieved in many market offset by generic entries in certain other markets. Velcade, a treatment for the relapse multiple myeloma is being co-developed with Millennium Pharmaceuticals. We have commercialization rights in Europe and the rest of the world outside the US. Operational sales growth was 33.5% with very strong results achieved across the regions. Wrapping up the review of the Pharmaceutical segment, after careful consideration, all research and commercial activities related to Ionsis have been stopped. Technical challenges with Ionsis led to this decision. We remain committed to exploring novel delivery technologies and believe strongly in the potential that innovative drug device combinations may offer. Additionally regarding TMC 207 a compound for the treatment of tuberculosis, the planned filing is now projected for the 2011 timeframe. The compound looks very promising; however, patient enrollment in the clinical trials is taking longer than anticipated. Regarding Ustekinumab we have submitted our response to the FDA complete response letter. I’ll now review the medical devices and diagnostic segment results. Worldwide medical devices and diagnostic segment sales of $5.6 billion grew 1.6% operationally as compared to the same period in 2007. Currency had a negative impact of 3.5 points resulting in total sales decline of 1.9%. Sales in the US were down 3% while sales outside the US increased on an operational basis by 5.6%. Results have been impacted by lower sales of drug eluting stents. Sales excluding the impact of lower sales of drug eluting stents grew nearly 4.5% operationally. Now turning to the franchises starting with Cordis. Cordis sales were down 15.5% operationally with the US down 35.8% and sales outside the US up 1.3%. Cordis results were impacted by lower sales of Cypher, our Sirolimus-eluting stent, and endovascular products partially offset by the solid growth in our Biosense Webster business. Cypher sales were approximately $270 million down 34% on an operational basis versus the prior year. Sales in the US of approximately $70 million were down 63%. In comparison to the fourth quarter of 2007 the US drug eluting stent market growth is estimated at 17%. Penetration rates are estimated at 73% up from 61% a year ago while PCI procedures are up approximately 4% in the quarter versus the same period last year. The estimated price for Cypher in the US is down approximately 6% versus the fourth quarter of 2007. Estimated share in the US of 15% was down eight points sequentially and down 32 points from the fourth quarter of 2007 due to the market entry of two new competitors in 2008. Sales outside the US of approximately $200 million declined 10% operationally. The estimated market share in the quarter of 32% was up two points on a sequential basis and down four points from the fourth quarter 2007. Increased competition has impacted the share outside the US. Cypher estimated worldwide share for the quarter was 25% down three points sequentially and down 15 points from the fourth quarter 2007. Endovascular sales were impacted by the recall of a reentry catheter. Biosense Webster, our electro physiology business achieved solid operational growth in the quarter driven by disposable catheter products. Our DePuy franchise had operational sales growth of 8.3% when compared to the same period in 2007 with the US growing 10% and the business outside the US growing by 6.2% operationally. Hip growth on a worldwide basis was 11% operational, outpacing the market growth in both the US and international businesses. On an operational basis worldwide knee growth was 6% while spine grew 8%. The rate of growth in our spine business has accelerated throughout the year due to the successful launch of a number of products. Mitek, our sports medicine business, grew 12% operationally outpacing the estimated market growth. The Diabetes franchise was down 6.1% operationally in the fourth quarter of 2008 with the US business down 18.4%. The US results were impacted by an adjustment to prior period estimates of sales rebate reserves. Excluding this adjustment US sales in the quarter would have been down approximately 2%. Positive momentum in share has been offset by pricing pressure and slower category growth. Outside the US sales increased 7.5% operationally due to the successful launch of a number of new products. Animas, our insulin pump business grew 40% on an operational basis due to new product launches and continued development of the international market. Ethicon Endo-Surgery achieved operational growth of 9% in the fourth quarter of 2008 with the US sales growing 7.1% and sales outside the US growing on an operational basis by 11.6%. The Harmonic technology business achieved strong double digit operational growth due to the global success of recently launched products and the underlying strength of this platform. Also contributing to growth in the quarter was the realized gastric band launched earlier this year in the US and the strong performance of the endoscope products in the international markets driven by increased awareness of the benefits on minimally invasive procedures as well as the metabolic benefits of obesity surgery. Ethicon worldwide sales grew operationally by 3.3% with the US up 2.8% and sales outside the US up 3.5%. Slower growth in sutures due to lower distributor inventory levels and the divestiture of the Professional Wound Care business in December impacted growth in the quarter. This impact has been offset by strong double digit growth in homeostasis, meshes and bio-surgical. Ortho clinical diagnostic achieved operational growth of 1.7% in the fourth quarter. Sales growth in the US was 1.2% while sales outside the US were up 2.3% on an operational basis. Results have been impacted by order timing and lower sales and donor screening. Rounding out the review of the medical devices and diagnostic segment our vision care franchise achieved operational sales growth of 5.7% in the fourth quarter compared to the same period last year. Sales in the US increased 5.8%. Sales outside the US grew 5.5% on an operational basis. The rate of growth has been impacted by the softness in the lens category overall and competitive launches. Acuvue Oasys, One-Day Acuvue Moist, and the Acuvue Oasys for Astigmatism were major growth drivers in the quarter. That completes highlights for the medical devices and diagnostic segment and concludes the segment highlights for Johnson & Johnson fourth quarter 2008. It is now my pleasure to introduce Bill Weldon."
},
{
"speaker": "Bill Weldon",
"text": "Many of us are going to remember 2008 as a year of extraordinary economic events that shook our financial markets and global economy. With that backdrop as context I’m extremely proud of Johnson & Johnson’s accomplishments in 2008 and the way our people met our commitments with continued sales and earnings growth with significant progress in our pipelines and product launches and with continued investments in the future growth of our business. We faced and will continue to face challenges but our people, our products, our pipelines and our financial strength give me confidence that we are well positioned for the future. This morning I’ll briefly review Johnson & Johnson’s 2008 business and financial results and provide an update on how we are executing against our strategic plans for leadership and growth in the healthcare industry. I will also explain how we are preparing to deal with recent economic events and seize new growth opportunities. I’d like to leave you today with a deeper understanding of what we have done to prepare our business for 2009 and the longer term. From this, you’ll see why I am confident that Johnson & Johnson will emerge from the period stronger and even better positioned for growth as the economy and healthcare markets recover. In 2008 we delivered on our financial commitments despite the near term pressures on our business and non-foreseen shifts in the economic climate. We strengthened our core businesses and made significant progress in launching new products and line extensions and advancing our pipelines. In addition to the growth that comes from our internal R&D we also pursued licensing agreements and acquisitions that provided us new capabilities in medical devices and diagnostics and a stronger consumer presence in markets like China. In 2008 we have largely implemented the major cost structure improvements we outlines for our pharmaceuticals and Cordis business in mid 2007 and we have realized approximately $1.6 billion in annual savings from these actions which is at the higher end of our earlier guidance. Meanwhile the integration of the Pfizer consumer healthcare business is on track. We are comfortable that we will achieve cost synergies at the higher end of our previously disclosed range of $500 to $600 million by the end of 2009. We still expect this transaction to be break even or modestly accretive this year, one year ahead of schedule of the original schedule. We also continued throughout the year with our $10 billion share repurchase program. As of the end of December we had purchased approximately $8.1 billion of stock. Our business, driven by committed financial discipline continued to deliver strong adjusted earnings growth and solid sales growth when considering the generic challenges we faced. Our broad base of consumer pharmaceutical and medical device and diagnostics businesses increases sales to $63.7 billion despite the loss of exclusivity of Risperdal Oral for half the year, continuing pressures on our drug eluting stent and Procrit business and the additional impact of the economic decline. We achieved strong adjusted earnings growth of 6.8% and adjusted EPS growth of 9.6% which was higher than earnings due to our share repurchase program. We also generated a strong free cash flow of approximately $12.2 billion. I’d like to remind you of the expectations we set at this meeting last January. We said we expected operational sales in 2008 to increase 1% to 2% as we faced the patent expiration and business pressures I mentioned a moment ago. We delivered 1.9%. This is a significant achievement when you take into account the additional economic challenges that arose later in the year. In January we projected an adjusted EPS range of $4.39 to $4.44. At the end of the year we generated an adjusted EPS of $4.55 and 9.6% increase. In terms of sales by segment, consumer generated approximately $16 billion in revenue or 25% of our total. Pharmaceuticals approximately $24.6 billion or 39% of our total. MD&D generated $23.1 billion or 36% of our total. Our consumer business once again provided the premier consumer healthcare company in the world. With its science based innovations and iconic global brands consumer segment sales grew 8.3% operationally year over year. In the OTC nutritional business the successful launches of Zyrtec as an over the counter allergy medicine was a major contributor to this growth. Strong sales of other consumer products like Neutrogena, Aveeno, Listerine and our international baby care brands helped drive significant growth in our other franchises. The pharmaceutical segment saw an operational sales decline of 3.1% for the year. Excluding the impact of generic competition and continued declines in Procrit, pharmaceutical sales would have grown by 6% operationally. Nine products had sales of more than $1 billion including Remicade, Risperdal Consta, and Topamax. In addition, we saw strong sales growth from newer promising products like Prezista, Velcade and Invega. With these newer drugs and promising compounds and our late stage pipeline we see positive momentum building for the longer term. Our medical device and diagnostic business is the largest medical technology business in the world with sales of $23 billion. More than 80% of MD&D sales were derived from businesses where we hold the number one or number two market position. We continue to see solid growth and performance in six of our seven franchises in the face of tough competition. MD&D sales grew by 3.5% operationally. Excluding the impact of lower drug eluting stent sales operational growth would have been a healthy 6%. Some of the key growth drivers included vision care with products like Acuvue Oasys and One-Day Acuvue Moist, Ethicon Endo-Surgery harmonic technology and realized adjustable gastric band and the DePuy orthopedic and Mitek sports medicine products. Our Cordis business continued to see the impact of new entrants in the drug eluting stent market but it succeeded in broadening the strength of the cardiovascular franchise by continuing to build momentum in Biosense Webster and neurovascular business. Operating profit for 2008 was $17.3 billion and 27% to sales. That compares to $15.9 billion or 26% in 2007. This 110 basis point increase can be attributed to the excellent job our leadership team did in managing their businesses and containing costs during the year, even as the volatile economic climate began driving increases in commodity costs and shifts in consumer and patient behaviors. Thanks to the people at Johnson & Johnson we have managed through difficult economic cycles many times throughout our history. The past year presented its own extraordinary challenges. Some we anticipated and planned for, others could not be foreseen and required decisive actions during the year. Despite these challenges we continued a legacy of performance that few if any companies can claim. During 2008 stock indices like the Dow Jones Industrial Average and S&P 500 were down more than 30%. Other drug and healthcare indices were down about 20% to 30% in terms of total return to shareholders. Comparatively Johnson & Johnson’s total return to shareholders declined just 8%. While we’re never pleased with declines in our returns we were the third best performer in the Dow for 2008. When you look at our total shareholder returns over three, five and 10 year periods we beat and consistently beat the major indices that we compare to. I’d like to spend the rest of my time talking to you about how we plan to execute against our strategies for leadership and growth in healthcare. This chart will be familiar to most of you; it sizes the global healthcare market for 2007 at $4.1 trillion and breaks out those areas where we compete today and the areas of healthcare where we have not yet entered. About $1.3 trillion of that figure includes a variety of healthcare product areas where we do compete. Consumer, pharmaceutical, medical devices and diagnostics and where we hold about 5% market share. The remaining $2.8 trillion consists of healthcare markets that include providers, payers, administration, fitness, health information and many others. There is plenty of opportunity for Johnson & Johnson in the global healthcare market as we grow share in our existing markets and move into fertile grounds for expansion. I’d now like to turn a discussion of four major factors that will influence our business performance in 2009. These are the general healthcare environment and trends that are shaping the future, our own near term business pressures, the macro economic factors that every business is facing and the volatility of currency. To begin, there are many forces shaping healthcare environment that we have considered in our planning. For instance, an aging world population is creating incredible demand. In fact, every three and a half seconds somewhere in the world is turning 65. People are becoming increasingly interested in knowing about and managing their own health, not just their illnesses. As the movement to wellness and prevention gains more momentum even medical practitioners are more concerned with keeping patients healthy rather than just treating them when they become ill. Chronic diseases such as diabetes, cardiovascular disease and obesity are on the rise, driving up the cost of healthcare. Significant changes in healthcare systems and reimbursement models are being considered in the United States and elsewhere. These and other trends are putting more pressure than ever on healthcare systems to meet demands for innovation, quality healthcare and do that in more effective cost efficient ways. The second factor for discussion includes a near term business pressures that we have known about and been preparing for. These include a well understood and during the past year our companies made adjustments to their business plans to address the conditions we anticipated. Generic competition for some pharmaceutical products, aggressive new competitors in some of our surgical and comprehensive care businesses and low cost brands fighting for market share with our consumer products. We have made modifications where and when appropriate. These included streamlining our infrastructure to reduce our cost basis, prioritizing our R&D investments to ensure the success of the most promising products, continuing our investment in new product launches, focusing on emerging markets and expanding our presence in new and adjacent markets. While some of these actions have been difficult, all were necessary to ensure the strength of our business. We should see the full year benefits of a number of these actions in 2009. The third factor we must consider in 2009 is the macro economic environment that every business is facing. Over the past several months we have experienced a global financial and business slowdown unlike anything we have seen during our lifetimes. Much has already been written or reported about the early affects the economic slowdown is having on healthcare spending and behaviors. IMS projects a slowing growth in the US prescription drug market down 1% to 2% a year from 4.2% in 2007. According to the Kaiser Family Foundation with unemployment on the rise people have begun avoiding healthcare treatment or cutting back even for serious conditions. Many analysts have reported that surgeries, especially elective procedures are being postponed. Hospitals and healthcare providers are tightening their inventory levels and budgets while consumers are watching their spending more closely. In Johnson & Johnson we are seeing early affects in a few parts of our business. For example, while growth is still strong in an area like sports medicine we have recently seen slight declines in growth rates in the market. Also in markets that require more out of pocket spending like diabetes test strips and contact lenses we are seeing some signs that consumers and patients are becoming more frugal. Thanks to the strength of our leadership team our broad base of businesses and our fiscal discipline I remain very optimistic about our ability to adjust to the evolving economic conditions. I’m also very excited about the new products and strong pipelines that position us well for the future. The fourth factor that could have a significant impact on our business in 2009 is currency. The fluctuation in exchange rates over the last six months has been dramatic. These fluctuations could have a significant impact on our future financial results. Dominic will discuss the potential impact of currency in more detail during his remarks. Every challenging period brings with it a corresponding opportunity for growth and this one is no exception. By working in a disciplined way Johnson & Johnson will emerge stronger than ever remaining the worlds leading company in addressing human health and well being. I believe this for several reasons. As always, success starts with leadership and we are fortunate to have an experience management team in place with the right skills to capitalize on market conditions and build businesses for the long term growth. We are strengthening our core franchises, advancing our pipelines and introducing new products that will replenish and grow our revenue streams. We are building our market leadership positions and venturing into new growth spaces for Johnson & Johnson. We are maintaining our financial strength and flexibility with a combination of strong cash flows and a AAA credit rating which gives us access to credit at favorable rates. We have implemented cost structure improvements that should reap benefits for the bottom line and help us operate more efficiently. We are actively participating in the dialogues on public policy that will shape our business environment for years to come. In the meantime we continue to implement our strategic plan which will strengthen our company for long term growth. In addition, we are looking for new opportunities that may exist for our businesses under today’s unique market conditions. Whenever the economy and healthcare markets return to a more robust growth we will be stronger and better positioned for leadership in the markets where we choose to compete. Now I would like to spend my remaining time discussing the progress we have made on the four business priorities that we outlined last year. At the foundation of Johnson & Johnson’s business is a fundamental commitment to our credo which provides the common set of values for our approximately 120,000 employees around the globe. The four tenants of our credo provide a clear focus and mindset for how we approach every decision. Patients and customers first then our employees, our communities and our shareholders. We also work under an operating model that has served us well for decades. Its four elements are being broadly based in human healthcare, managing our businesses for the long term, taking a decentralized management approach, and focusing on our people and values. Last year I introduced four enterprise wide business priorities that continue to be critical to achieving our long term growth plans. They are winning in healthcare, capitalizing on convergence, accelerating growth in emerging markets, and developing leadership and talent. Let me begin by discussing what we mean by winning in healthcare. There are three major elements to winning in healthcare. First is growing our existing businesses. This encompasses advancing the pipeline, launching new products and extensions and enhancing our core strengths and franchises. Second is building new platforms for growth. These include making acquisitions and executing licensing agreements and also building new businesses in healthcare markets where we do not currently compete. Third is actively participating in the dialogue around public policy that will help shape the healthcare landscape for the future. Developing our own products and technologies within the Johnson & Johnson family of companies is the most efficient way to grow our existing businesses. We have continued to make significant investments in R&D across the business with approximate spending of $7.6 billion in 2008. As planned, our R&D investments began leveling off last year because we had substantially increased investments over the past several years to accommodate progress in our late stage pipeline. At our investor meeting in 2007 we set new goals for our pharmaceutical pipeline. We said we would file seven to 10 new products for approval between the beginning of 2008 and the end of 2010. Despite some setbacks we remain on course with that commitment. We have eight new compounds currently in registration and five of those were filed with the FDA in 2008. Tapentadol, an immediate release tablet for the relief of moderate to severe pain was also approved later in the year. We plan to file several more compounds by the end of 2010. At our investor meeting in June we briefed you on many of the exciting developments in our medical devices and diagnostics businesses. We have robust pipelines in both our surgical care and comprehensive care groups. Here’s an updated look at our surgical care pipeline. There are many projects on this comprehensive list worth highlighting but in the interest of time let me just mentioned just two. In surgical care we have developed the first computer assisted personalized sedation system called Sedasys. The device which is currently under review by the FDA will make it earlier for a physician and nurse teams to deliver propofol to patients undergoing screening and diagnostic procedures for colorectal cancer and disorders of the upper GI tract. By integrating drug deliver and patient monitoring the Sedasys system has the potential to change the way sedation is delivered. We talked in June about the Prineo skin closure system. Prineo will be used in surgical applications that require significant inter-dermal suturing time like body contouring procedures. This time saving system allows for a significant reduction in OR time for the hospital and a reduction in general anesthesia time for patients which should improve patient outcomes. Prineo is currently used in Europe and is expected to launch in the United States this year. In the comprehensive care pipeline we are also seeing good progress on several fronts. Again, in the interest of time let me mention just a few. In 2008 we received approval for two new diagnostic systems. Vitros 5600 integrated system shown here which is uniquely designed to integrate clinical chemistry and immunoassay testing to increase laboratory productivity. The Vitros 3600 a high through put system used for immunoassay and infectious diseases. Both of these next generation platforms can simultaneously run more than 100 tests and are designed to run innovative high impact diagnostic tests in the future. We feel very positive about the progress we are making on clinical trials for our Nevo Sirolimus-eluting stent. This cobalt chromium stent features a bio absorbable polymer and a unique reservoir technology. The first clinical trial for Nevo resolution one completed patent enrollment ahead of schedule and we plan to present six month primary end point data from this trial at the Euro PCR conference in May. We expect to file Nevo for CE mark approval in Europe in 2009. Within our Biosense Webster business we are awaiting FDA approval for an atrial fibrillation indication for the Navistar Thermocool Ablation Catheter. In December an FDA advisory panel unanimously recommended approval for this indication which will make Biosense Webster the first and only company in the United States with an approved A-Fib indication opening up a market with a penetration rate of less than 2%. The foundation of our consumer product success has always been based on superior science and technology. With recent development like helioplex technology for sunscreens or rapid release gel technology for OTC medications. We feature a wide array of scientific research competencies in areas like skin biology, pharmaco kinetics, drug delivery and microbiology to name a few. We have built a significant portfolio of proprietary technologies including dissolvable strips and taste masking for oral care and OTC drug delivery. Active naturals and fragrances used in skin care and cellular resuscitation and advanced adhesives for wound care and healing. We also continue to enhance our clinical trial expertise and expand our R&D capabilities around the world, developing products for emerging markets where our business has grown considerably. Now let’s turn to our existing and new products that result from our investments as well as our acquisition and licensing activities. Our existing franchises make up the broadest space of healthcare businesses in the world and are well known leaders across our three segments, holding the number one or number two market leadership positions in various markets. In 2008 approximately 70% of our revenues came from products with these market leading positions. Last year across all three of our businesses we launched hundreds of new products and line extensions some of which are highlighted on the screen. In addition to the products we developed internally we have made several acquisitions to add technology platforms, brands and market presence in areas where we saw opportunities. We acquired Dabao cosmetics in China which brings with it the countries number one moisturizer and a brand that is well known and respected among Chinese consumers. This acquisition also opens up opportunities to do more business in mid tier markets expanding the base of consumers we can serve in this region. In late 2008 we announced several other acquisitions in our surgical care business. We acquired Omrix Biopharmaceuticals, a company we knew well through existing partnerships and distribution agreements. Omrix develops and markets bio-surgical immunotherapy products. It will strengthen our presence in active biologic based homeostasis as well as convergent products for surgical procedures like the fibrin pad which is in clinical trials. Another is Mentor Corporation, a highly respected market leader for breast augmentation and reconstructive procedures. Once completed this acquisition will establish a major presence for Johnson & Johnson in aesthetics medicine. We also acquired SurgRx whose end seal products complement our harmonic technology and broaden the energy franchise in our ethicon endo-surgery business. In comprehensive care we acquired two companies, Immunicon and Amic for new diagnostic capabilities. Last year I introduced the office of strategy and growth as a new organization that would be looking at the white spaces in healthcare for Johnson & Johnson. Places where we envision building new businesses. We have defined the area of wellness and prevention as one of those opportunities and we have taken initial actions to establish this new business platform. In late 2008 we made two acquisitions to begin laying the groundwork for this new business. HealthMedia is a provider of web based behavioral interventions that emulate a health coaching session without the human intervention. The Human Performance Institute is developing science based training programs to improve employee engagement and productivity. We expect this new business to contribute to the performance of workforces through products and services that are designed to keep employees healthy, engaged and productive. Lastly, it is more important than ever that Johnson & Johnson be an active participant in the dialogues that are taking place around the world to improve healthcare. We are invited to participate in these discussions because of our well established reputation as a healthcare leader and the unique perspective we can provide based on the diverse set of businesses we manage. We’ve been willing to experiment and innovate new ways to address the problems inherent in today’s healthcare systems. We believe any discussion of healthcare policy reform must put the needs of the patients and consumers first. Now let’s turn to our second priority which is capitalizing on convergence. This is an area where we can leverage the breadth and combination of our businesses for a unique competitive advantage. We look at convergence in three ways, the combination of products and technologies, the development of patient centric solutions and the collective power and breadth of the Johnson & Johnson enterprise. The most conventional view of convergence is in the combination of products and technologies across the non-traditional boundaries. Drugs delivered on a stent using a reservoir technology like Nevo, medication delivered on a contact lens to treat allergic systems in the eye, or Sedasys and the fibrin pad which I mentioned earlier. When we established our comprehensive care group last year we talked about convergence in the form of patient centric solutions that ignored product silos and looked at a patient’s continuous cycle of diagnosis, treatment and recovery. We asked what were the needs we could serve or gaps in this cycle we could fill with our products, expertise and knowledge of diseases and healthcare. Let me give you just one example in this area. Last year we mentioned the role that ortho clinical diagnostics is playing in convergence as it works with our other businesses on the use of companion diagnostics in areas like oncology, metabolics and cardiovascular disease. By identifying mile markers and patients who will benefit most from cancer drug or by targeting early indications that occur before the first signs of heart failure we are uniquely positioned to assist patients from the moment of diagnosis through monitoring and on to therapeutic intervention or treatment with our full range of products. Finally, we look at convergence in the way we leverage the power of our enterprise across business segments for unique insights and solutions. Our launch of Zyrtec was a powerful example of how we used experience and knowledge in both our pharmaceuticals and consumer businesses to help with the largest prescription to over the counter switch in our history. It was sighted in the tan sheet as a model for any OTC switch. McNeil Consumer Healthcare worked with our pharmaceutical business to educate and inform healthcare plans, pharmacy benefits managers, national retailers and employers about the switch. Thanks to these efforts millions of consumers received Zyrtec switch information from their healthcare plans while many more received similar communication from their employers. This tremendous collaboration enabled Zyrtec to achieve 26% market share since its launch in 2008. A decentralized management approached is fundamental to the success of our operating model. Our operating companies and local management teams know their markets the best and they execute their business strategies with great autonomy. There are many common functions where standardization can benefit Johnson & Johnson with greater efficiency, faster processes, better use of our talent and more leverage to the bottom line. We must increasingly use our scale as an advantage and we are in the midst of efforts to build more standardized approaches in areas like finance, human resources, procurement and information technology. These are not changes that can be implemented overnight in a global enterprise like Johnson & Johnson but we have the resources committed to ensure we reap the benefits of the work we have already begun. Our third priority is accelerating growth in emerging markets. Johnson & Johnson has been a global company since the 1920s when we established our first international affiliate in Canada and first overseas affiliate in Great Britain. We have continued since then to build businesses throughout the world. Today we have facilities in 57 countries and almost half our revenues come from outside of the United States. The emerging markets look to provide the most robust healthcare opportunities over the next decade and we are preparing our businesses to capitalize on this growth. We define high growth emerging markets on a business by business basis. We typically include countries like Brazil, Russia, India and China usually called the BRIC countries along with other important growth areas such as Turkey and Mexico. While the current economic crisis might temper these markets growth rates from the high shown here the opportunities remain significant. Over the next five years Russia, India, China, and Turkey are now projected to grow at the high single digit rates while more developed markets are seeming to grow even slower. This growth and maturity of these markets will globally impact healthcare through the products and medicines being developed, where and how clinical trials are being carried out and the way we run our businesses. Our business in the BRIC countries grew 19% operationally in 2008 and we continue to build our local capabilities and presence to strengthen these efforts. We are not new comers to these countries. We have a significant presence and well established roots. For instance, we began operations in Brazil and India in the 30s and 40s and China and Russia in the 80s and 90s. Our commitment to these markets continues to grow. I mentioned the Dabao cosmetic acquisition in China earlier. In 2007 we opened the emerging markets innovation center in Shanghai to develop new and affordable products addressing the consumer needs of emerging markets. One of the centers first successes was the launch of Johnson’s Baby Long Protecting Cream in 2008 which addressed the dry skin that babies can experience in cold weather. The team used local market research, natural ingredients and a competitively priced $25,000 package to meet the need of China’s emerging market. We also continue to invest in professional education in these and other markets to help teach physicians how to use our medical technology and to prepare markets for the introduction of new healthcare practices. Our MD&D businesses have more than 20 training centers outside the United States and are dedicated to just this type of work. Our vision care business for example has been using this approach establishing training centers in the US and around the world to train more than 30,000 practitioners and introduce them to the latest breakthroughs in contact lenses and eye care research. Finally, our most important priority is developing leadership and talent because none of our other strategies and priorities can succeed without the talented and dedicated people at Johnson & Johnson. When you look at our credo our operating model and our business priorities people are the common thread. It is because of them that I am confident in our ability to continue meeting our patients and customer needs while furthering our excellent track record in performance. With more than 250 operating companies around the world we have the capability to develop leaders by exposing them to a wide variety of businesses with ever increasing responsibilities. We look for people who can work in a decentralized environment, develop winning strategies and execute the plans that lead to success across our business segments. We allow them to take prudent risks as they enhance their own judgment and business building capabilities. Ultimately my confidence in our future stems from the talents of our people and their individual commitments to living our credo responsibilities in their daily work. In closing, I would like to reinforce for you our commitment to growth. For us this means competing in the most attractive spaces in healthcare. It means building and sustaining leadership positions through our pipelines, people and strategic acquisitions and licensing agreements. Finally, it means growing our sales faster than the markets where we compete and growing our earnings faster than sales through a thoughtful disciplined management approach. Johnson & Johnson has delivered a strong track record of performance over time. We have managed through difficult economic cycles in the past and we are confident that our people, our products, our pipelines and our financial strength position us well for continued leadership and growth in healthcare. I’d like to thank you for your attention. Now I’d like to turn podium over to Dominic for some additional comments and then we’ll have Q&A."
},
{
"speaker": "Dominic Caruso",
"text": "To wrap up our formal presentation I would like to touch briefly on our results for 2008 and then provide some comments for you to consider as you refine your models for 2009. As Bill indicated we are pleased with our solid financial results for 2008. While we recognize there are challenging factors in today’s economic environment such as currency volatility and uncertainty surrounding the depth and length of the current recession, we are positioned well for long term profitable growth. Our sales results for 2008 reflected solid performances across many of our businesses. As I am sure you are aware we experienced significant volatility in currency exchange rates during the year. In fact, currency positively impacted our sales results by 2.4% for the year but negatively impacted our sales results by 3.9% for the fourth quarter. Similarly, regarding EPS, changes in currency positively impacted our full year EPS results by 1.9% but negatively impacted our fourth quarter EPS results by 3.4%. Our strong earnings performance demonstrated again our ability to continue managing costs and improving margins all the while continuing to invest to advance our pipeline of new products or enter into new markets through licensing and acquisitions. Before we discuss 2009 I’d like to point out some items in our fourth quarter results. Our adjusted earnings per share results in the fourth quarter exclude special items such as in process research and development charges related to the acquisitions we made in the fourth quarter and several litigation matters. The most significant of these litigation matters is related to the judgment in our favor of long standing stent litigation with Medtronic which was previously announced. The receipt of the payment related to this litigation judgment of approximately $520 million was partially offset by amounts related to several other litigation matters. This net impact has been reflected in other income and expense but has been excluded from the adjusted earnings results. Additionally, during the fourth quarter we closed on the sale of the professional wound care business to OneEquity Partners. You will remember that during my discussion of our third quarter results this transaction was not included in my guidance for 2008. Since we view this transaction as in essence a decision to reshape our portfolio we expected then that any gain from this divestiture would be used to make additional investments or other business decisions that would enhance our long term growth. During the fourth quarter we took these actions. You will note that our other income and expense line item reflects net higher other income than my previous guidance as it now includes the gain from this divestiture of approximately $500 million as well as some offsetting items of approximately half that amount. Additionally you will note some higher level selling, marketing and administrative expenses in the fourth quarter which reflect the use of the remaining half of this gain to make the investments and other business decisions as we had expected. Now I’d like to provide some guidance for you to consider as you refine your models for 2009. This guidance takes into consideration the addition of Omrix Biopharmaceuticals and other acquisitions made in 2008, the divestiture of Professional Wound Care business which was completed in 2008 as well as the pending acquisition of Mentor Corporation which is expected to close later this month. As previously disclosed the Mentor acquisition is expected to be dilutive to 2009 EPS by approximately $0.03 to $0.05 per share. This dilutive affect includes the transaction costs which are now expensed according to the new accounting guidelines related to business combinations. Let’s start with a discussion of cash and interest income and expense. During 2008 we continued to generate strong cash flows. In fact, as Bill pointed out earlier we generated free cash flow or cash flow after necessary capital expenditures of approximately $12.2 billion. At the end of 2008 we had approximately $1 billion of net cash. This consists of approximately $12.8 billion of cash and investments and $11.8 billion of debt. This is an improvement of $1.2 billion in our overall net cash position from year end 2007. Our financial position remains strong and we continue to have good access to the credit markets for our financing needs at reasonable rates. For purposes of your models assuming no major acquisitions and assuming the completion of the share repurchase program during the early part of 2009 I’d suggest you consider modeling net interest expense of between $150 and $250 million. Turning to other income and expense, as a reminder this is the account where we record royalty income as well as one time gains and losses arising from such items as litigation, investments by our development corporation and asset sales or write offs. This account is difficult to forecast but assuming no major one times gains or losses I would recommend that you consider modeling other income and expense for 2009 as a net gain ranging from approximately $150 to $250 million. Now a word on taxes. For 2008 the company’s effective tax rate excluding special items was 22.9%. We suggest that you model our effective tax rate for 2009 in the range of 24% to 25%. This rate takes into consideration changes in the mix of our business for 2009 as well as the extension of the R&D tax credit for 2009. As always we will continue to pursue opportunities in this area to improve upon this rate throughout the year. Now turning to sales and earnings. As I previously mentioned we experienced significant volatility in terms of currency exchange rates especially late in the year. As you can see from this chart it is very difficult to predict movements in currency exchange rates especially given the current economic conditions and the resulting monetary policy changes that governments around the world are employing to address the situation. Some of these actions have had an impact on interest rates and a resulting impact on the volatility of currency exchange rates. It appears that additional actions are likely to be taken that may continue to impact the volatility of exchange rates even further. Therefore, our guidance for 2009 will be based first on a constant currency basis reflecting our results from operations assuming that average currency rates for 2009 will be the same as they were for 2008. This is the way we manage our business and we believe this provides a good understanding of the underlying performance of the business. I will then provide an estimate of our sales and EPS results for 2009 with the impact at current exchange rates could have showing the Euro as an example. Of course the actual impact is dependent upon many currencies but the Euro represents about 50% of this impact. I believe this will provide you with some helpful insight for your modeling purposes. Turning to sales, the mean of the analysts estimate as published by First Call indicates sales of $63.7 billion for 2009. As we looked at the various models it appears that not all the analysts have updated for currency fluctuations and some of those that have, have not fully reflected what the impact could be at current exchange rates. Taking into consideration the loss of US Patent exclusivity of both Risperdal Oral and Topamax which have about a 4% to 5% impact to our overall sales growth rate, we would be comfortable with your models reflecting operational sales change on a constant currency basis of between -1% and 1%. This would result in sales for 2009 on a constant currency basis of between $63 and $64 billion. While we are not predicting the impact of currency movements, to give you an idea of the potential impact if currency exchange rates for all of 2009 were to remain where they were as of last week that our sales growth rate would be negatively impacted by approximately 4% or approximately $2.4 billion. Thus under this scenario we would the expect reported sales to decline to a range between 3% and -5%, for a total expected level of reported sales of between $61 and $62 billion. Now turning to earnings. When I last checked, the First Call mean estimate for our EPS for full year 2009 was $4.61 per share which excludes the dilutive impact of the Mentor acquisition. It appears that many of the analyst models include a 2009 tax rate that is lower than the guidance I just provided. As I noted earlier it does not appear that all the models have been updated to reflect the potential impact of currency at current rates. I suggest you consider full year 2009 EPS estimates excluding the impact of special items of between $4.60 and $4.70 per share on an operational basis that is assuming same average exchange rates for 2009 as we saw in 2008. This represents an operational growth rate of 1% to 3%. While we are not predicting the impact of currency movements to give you an idea of the potential impact on EPS if currency exchange rates for all of 2009 were to remain where they were as of last week then our EPS growth rate would be negatively impacted by approximately 3% or approximately $0.15 per share. Thus under this scenario we would then expect total reported EPS excluding special items of between $4.45 and $4.55 per share. Throughout 2009 we will provide you with the operational growth rates for our actual sales and EPS results in order to give you the visibility to the underlying performance of the business. We will also provide the impact of currency on our actual results. As you refine your models for 2009 I want to remind you to consider the impact to our results from the loss of US Patent exclusivity of Risperdal Oral at the end of June 2008 and the loss of US Patent exclusivity of Topamax at the end of March 2009. These events will obviously have significant impacts to comparisons. As you work through the guidance I provided a few minutes ago we would be comfortable with your models reflecting an improvement in pre-tax operating margins for 2009. While operating margins may vary by business segment year to year, may be impacted from time to time by short term dilutive impact of acquisitions, improving the overall pre-tax operating margin by growing income faster than sales over time is a fundamental discipline we use in managing our business. In closing, I’d like to offer these final thoughts. Johnson & Johnson is a company that is financially strong. We continue to be committed to growth as Bill has pointed out. I am very proud of the financial performance we delivered in 2008 and I look forward to updating you on our progress for 2009 throughout the year. Louise back to you."
},
{
"speaker": "Louise Mehrotra",
"text": "We’ll now begin the Q&A session. Please wait for the microphone before asking your question as this meeting is being webcast. As we have Bill Weldon with us today please keep your questions more strategic."
},
{
"speaker": "Larry Biegelsen – Wachovia",
"text": "On the Pharma side many of your competitors have reevaluated their strategy in this difficult environment, could you by focusing for example on specialty markets or certain therapeutic categories could you articulate J&J’s strategy in the Pharmaceutical business? Second in services the other area that you’re targeting the pace that we saw in 2008 in terms of two small acquisitions is that what we can expect going forward or something more accelerated? Do you see 2009 as a one time event in terms of EPS growth? In other words, do you expect to return to historical EPS growth rates in 2010?"
},
{
"speaker": "Bill Weldon",
"text": "The first one is really the strategy around our Pharm business, we’ve historically been very focused on the specialty markets so when you look at the impacts we have much less of the impact but like everyone else really assessed our sales force, different ways of going to market but we have identified the specific therapeutic areas where we continue to focus on continue to develop our products where we think there is high potential whether its here in the United States or around the world. I would say that we modified our strategy but haven’t really changed it other than some of the ways we go to market with sales organization and new ways of looking at promoting our products that we think make us more efficient. As far as the specialty area it’s been an area that we’ve historically been focused on and will continue to be focused on. We think it gives us a lot of leverage and a lot of strength. The second question was really around acquisitions?"
},
{
"speaker": "Larry Biegelsen – Wachovia",
"text": "The areas you don’t participate in today this year and last year you showed us that pie chart. You had two small acquisitions I’m just wondering if that’s the pace that we can expect going forward in terms of penetrating that segment."
},
{
"speaker": "Bill Weldon",
"text": "Let me comment on the wellness and prevention area and what has really driven us into that because I think with the new administration and truly the focus on obesity around the world and diabetes and the problems that are there that more and more people are getting focused on taking care of their own health and I think the administrations are starting to look at how do we reimburse and treat these people and keep people healthy which is really the answer to the long term healthcare costs that we have to deal with. We took last year really and tried to look across the landscape, we looked at health information technology for example. We zeroed in on prevention and wellness and the two acquisitions we have coupled with the experiences we’ve had over the last two decades at Johnson & Johnson. We think there’s a very strong business model looking at that in that today we pay about $400 less per employee for our healthcare costs than the normal company would pay. The reason for that is for two decades now we have 4% tobacco users at J&J where a normal population is about 20%. We have a focus on obesity and weight loss; we have a focus on cholesterol, hypertension and the areas that really many of the co-morbidities associated with obesity and keeping people healthy and well. We think that will also drive to engagement, absenteeism. We know, we’ve documented it in our own programs. By looking at the behavior modification technology that HealthMedia has coupled with the Human Performance Institute which looks at nutrition, exercise, recovery and the critical pieces. Putting it together with the facts we have we think we have a very strong model to go to governments and other businesses with to improve the health of their employees. I wouldn’t expect you’d see us going into large acquisitions trying to move things forward but build from the base that we have in wellness and prevention as we continue to assess other opportunities."
},
{
"speaker": "Dominic Caruso",
"text": "Your question was really related to the level of EPS growth that our guidance for 2009 versus what could happen in 2010 or how that might change. I think 2009 is a year that’s very well understood by everyone. We know the business pressures we are facing in 2009 and in fact that’s now coupled with some economic pressures that we’re beginning to see as well. I would say that we’ve been able to manage through that very well both in 2008 where you saw increase in pre-tax operating margins and my guidance indicates an increase again in 2009 in pre-tax operating margins obviously impacts our EPS growth. Moving into 2010 I think a few things will change. One is that our comparisons obviously be a little easier when the business pressures are a little bit further behind us. More importantly than that we have a great deal of confidence in our new platforms for growth; our products, our pipeline and our leadership in terms of their ability to manage through these difficult times while at the same time preparing ourselves for continued growth in the future. When we look at managing our business although its very difficult to manage pre-tax operating margin increases in difficult times like 2008 and 2009 we did that and I guess that’s the way we manage our business and I’d see that we would continue doing that going forward. I can’t give you a specific outlook for 2010 but we’re confident with our products, we’re confident with our ability to manage our business appropriately."
},
{
"speaker": "Catherine Arnold - Credit Suisse",
"text": "I was wondering with a lot of your competitors talking about going down the path of bio-similars or bio-betters as some of them like to call it, if you would have a similar interest given your capabilities and expertise in that area and how you might see that changing the landscape of your participation in biologics in general. Secondly, you mentioned that we should expect operating margin improvement in ’09 clearly that’s at the same time that you’re undergoing a significant amount of cash cow loss particularly in the pharmaceutical business and the med device business. Could you give us a little bit more color around that? As I look at your gross margin for instance in the quarter there may have been some currency noise and so forth but it’s surprisingly higher than we would have expected. SG&A you still are pretty robust and to me it seems like you have an opportunity to contract there?"
},
{
"speaker": "Bill Weldon",
"text": "We continue to assess whether its generics, bio-similar or anything else we’ll continue to assess it. We don’t see it as a real opportunity at the moment and part of that is because with bio-similars you’re probably going to still have to show because of the size of the molecule and everything else the way it forms, the way it shapes, the way it fits into the receptor there is going to have to be clinical trials so its going to require a significant investment. Our belief is we need to keep focused on creating new opportunities in the marketplace, driving them forward through the products that we can. As far as getting into the bio-similar area we don’t see any opportunity for us at this point in time."
},
{
"speaker": "Dominic Caruso",
"text": "With respect to improving operating margins in ’09, you’re right, the ’08 fourth quarter in particular cogs number had some one time items as did the fourth quarter ’07 as Louise pointed out those items in ’08 were essentially offset by some other items in other income. That level is not the level we would expect going into 2009. We’d expect gross margin to be under pressure in 2009 as compared to 2008. Offsetting that we do have these various programs in place which Bill has talked about and I’ve talked about in the past which is our standardization efforts. We also have the general notion that our business leaders run the business in an appropriate way considering economic times. We would expect that both our SG&A and R&D costs as a percent of sales would be lower in ’09 versus ’08 which is in fact one of the major drivers of the pre-tax operating margin improvements."
},
{
"speaker": "Bill Weldon",
"text": "Dominic has talked about the standardization initiatives and we’ve been investing in these over time and I think we’re starting to implement now we’re going to start to see the benefits of these through 2009 and beyond because it’s really been the investment phase we’ve been going through and we’ll continue to go through. I think we’re getting to the point we’re starting to execute and really implement some of these programs that are going to start to yield some of the benefits as we go forward."
},
{
"speaker": "Mike Weinstein - JP Morgan",
"text": "Do you have the plan in place to achieve operating margin expansion in 2009 and the face of the fundamental pressures you’ll have? Is everything already in place to make that happen? The tax rate guidance for 2009 is that a function of decline in sales in pharmaceutical products manufactured out of Puerto Rico is that what’s driving that? The company is in a great position financially ’09 is going to be a tough year but financially you’re in great position you manage the company for the long term. Should we be thinking about 2009 as we model impact of events in 2009 should we assume that J&J is likely to be an acquirer over the course of 2009 taking advantage of your financial strength when a lot of companies are going to be relatively weak."
},
{
"speaker": "Dominic Caruso",
"text": "Yes, the plans are in place for 2009 operating performance that would improve pre-tax operating margins over 2008. As a reminder, we started on this path back in 2007 where we conducted the restructuring of the pharmaceutical business and the Cordis business. Again, 2009 was not a surprise for us, we knew about this for some time. To put the plans in place now as Bill said we’re executing on a number of those plans we’re very happy we’re able to achieve the higher end of our cost improvement guidance that we provided earlier. We have of course the higher level of the PCH integration synergies happening in 2009 so those plans are in place, we feel comfortable with that. The tax rate increase from year over year is primarily due to the fact with lower pharmaceutical sales revenues especially products like Risperdal and Topamax we lose some tax benefit there that we’ve enjoyed over the last couple years so that’s the primary driver of that change."
},
{
"speaker": "Bill Weldon",
"text": "We’re always looking for the right opportunities and we think that the pressures in the economy right now are going to create very unique opportunities for us. We have our list of candidates that we think would be good opportunities and other ones are going to be popping up and coming to us as the year progresses. We are very focused on the unique opportunities that will be presented to us based on the market conditions that we see today."
},
{
"speaker": "David Roman – Morgan Stanley",
"text": "One of the areas you highlighted on the slides where you’re not currently participating is disease management. Can you talk a little bit about the avenues you might use to enter that a little more whether its IT services or diagnostics? On the guidance there are clearly a lot of moving parts in 2009 there’s probably some contribution from new pharmaceutical products, some slowing you mentioned in elective procedures. Could you talk to us a little bit more about the drivers of the 200 to 400 basis point deceleration in operational top line growth outside of the obvious being Topamax and Risperdal. On the buy back that probably will be completed shortly what’s in the assumption on share count for 2009?"
},
{
"speaker": "Bill Weldon",
"text": "Disease management is kind of a bad word to be using these days because a lot of the programs that have been run have not been successful. The way we’re trying to look at it is basically looking at a patient and saying how do we deal with that patient in taking the resources that J&J has and putting them against it. When we look at the management of the patient we’re talking about the area of diabetes for example and metabolic disease. Part of it goes to what we were talking about before this wellness and prevention. If you look at obesity here in the United States or around the world its one of the biggest drivers of problems. If you extrapolate that out to the co-morbidities associated with obesity if we can get obesity under control and that may be through surgical intervention which could be bypass or realized gastric band, it could be through some of the behavior modification programs and diet and exercise. Those are the things that we’re thinking about in that area. As far as diabetes specifically we have the onemous pump now, the glucose strips but we also have, if you look at Splenda, we look at surgical intervention, we look at the behavior modification programs so we’re actually looking at how do we approach the patient in a way that offers them the comprehensive treatment and bringing that out to further looking at bio-markers in earlier indicators through our ortho-clinical diagnostics programs, it will allow for a treatment of an individual and the management of an individual throughout the whole continuum of care as opposed to just trying to put a piece together here. We think that it’s not really disease management its really patient management and the behavior that we can influence in effect through our products or resources."
},
{
"speaker": "Dominic Caruso",
"text": "I think you were referring to the operational sales guidance excluding any impact on currency. As you know, both Risperdal and Topamax together impact our growth rate 4% to 5% year over year. In addition to that just a couple factors that we considered. One is that we’ve seen some impact in several franchises that are impacted by consumer behavior. For example, in our consumer business or in businesses where consumer discretionary spending is a major factor such as diabetes test strips or in vision care with contact lenses. We’ve seen some impact there that we’ve taken into consideration. We’ve also seen some greater pricing pressure especially in countries outside the US as countries tend to look for ways to balance their budgets or improve their budgets by reducing the price or the cost of healthcare. Also in medical devices and diagnostics we mentioned before we’ve seen some impact already in elective procedures or procedures where there are some higher out of pocket expenditures. Finally, in the pharmaceuticals business I think the way to best characterize it is until we see the FDA approvals come forward for some of the products that are waiting FDA approval we generally are fairly conservative in the way we model those new products. We think that’s a prudent way for us to manage the business going into the year."
},
{
"speaker": "Bill Weldon",
"text": "Let me add two more comments to that that I think are really important. Dominic talked about the elective surgery and some of the disposable income that individuals may have, the consumer have. I think you also have to look at the pharmaceutical business where we are seeing a slowing down in the rate of growth. You go back earlier in the year where people are saying prescriptions were actually declining but we think that’s kind of reversed itself and there’s a 1% to 2% growth I think IMS is forecasting for the coming year. There’s a slowdown there. The one element that we all have to, we kind of talk around it but it’s the whole economic environment. If you just take unemployment here in the United States I don’t know what the numbers are going to be but we know they’re going to get greater, we know there’s going to be an impact and we know that many of the people that will become unemployed are people that have insurance today. Those people are going to stop going to the doctor, they’re going to stop getting their prescriptions filled, and they’re going to stop having elective surgery. There’s going to be downward pressure on all of these areas so I think the economic conditions that we’re dealing with today are going to create downward pressure in lots of areas in healthcare but in other areas also. I think we have to be realistic about the impact that that can have on the whole healthcare market here in the United States. I think it’s also you can take it Venezuela or to Russia when you look at the price of oil. We have an economic decline around the world that is going to affect the total healthcare expenditures."
},
{
"speaker": "Dominic Caruso",
"text": "On the buyback question we assume that we’ll complete the $2 billion left of the $10 billion share buyback in the early part of 2009 so our share count estimates reflect that and they do not reflect any assumption of any additional buyback in 2009."
},
{
"speaker": "Bob Hopkins - Banc of America-Merrill Lynch",
"text": "On the consumer side I know you don’t give line item guidance but I’m just curious from a 50,000 foot perspective you expect that business to be a growth business in 2009. You talked a lot about policy in Washington DC and I think it’s a critically important topic. Specifically for 2009 what major changes do you anticipate happening if any? Beyond 2009 what emphasis on any major changes that you as CEO of J&J are anticipating beyond 2009 to the way healthcare policy is formed in this country?"
},
{
"speaker": "Dominic Caruso",
"text": "On the consumer business we don’t give guidance by sector but generally speaking we still look at our consumer business as a growth business. Just to reminder that in 2008 obviously we had the fantastic launch of Zyrtec in our ’08 results so that will be a tougher comparison for the consumer business in ’09."
},
{
"speaker": "Bill Weldon",
"text": "When you look at policy in Washington we’ve used the term access and affordability for a long time. I think that the administration is talking about coverage and costs and they really mean the same thing. We do believe that we have to look at how do people gain more access at more affordable prices. There are lots of different ways to look at it and I think we’ll wait and see what the administration has to do here. We’ll work closely with them and try and support and work in ways that is going to allow patients to get better healthcare. I think the critical thing right now though is addressing the economic situation that we have. I think that’s going to be first and foremost so when you look at 2009 there are lots of things that could be done to have short term impacts. You can look at negotiating the pricing; you can look at all of these things and can have some short term. They’ll be some changes and some affects in those areas. As you look out further I think we’re all going to have to get together and really look at how do we get better healthcare. The one area that I think is a unique opportunity for J&J today and I keep going back to this is the whole area of dealing with, I was at a group in Washington where they asked a group of us to get together and look at some of the challenges whether it’s the economy, trade, energy or healthcare. The single largest issue that has to be dealt with is obesity. When you start looking at prevention and wellness and dealing with obesity, if we don’t get childhood obesity under control, if we don’t start dealing with this they say today one out of three children born today will have diabetes. The healthcare costs of today will be nothing compared to what they’re going to be. I think there will be a real focus on this area of prevention and keeping people healthy rather than letting them get sick and treating them. I think there will be a focus on that but I think the first and foremost the administration is going to have to address the economic conditions. I think that will have a positive impact but I do believe whether you want to call it coverage and costs, if you want to call it access and affordability. I think you have to also look at the whole area in health and prevention."
},
{
"speaker": "Rick Wise - Leerink Swann",
"text": "You highlighted the customer inventory draw downs do you think there’s a lot further to go and maybe you could quantify the impact if you had on the fourth quarter?"
},
{
"speaker": "Bill Weldon",
"text": "Most of the, whether they be hospitals or major companies like Wal-Mart or others I think they’ve all been very tightly looking at their inventories as we’ve looked at ours. I think its just prudent today in the environment we’re in to try and get your inventories down and manage your capital. We’re doing that and everyone else is. I think that the draw down has taken place significantly but I think it’s hard to tell if there’s more to come and there may be ways of doing business that may change. I think there’s been a significant drawn down in many areas of inventories."
},
{
"speaker": "Dominic Caruso",
"text": "I can’t quantify it for the fourth quarter. We do expect it to continue throughout 2009. The impact that we saw in the fourth quarter other than currency was really the impact of not shipping some Remicade at the end of the year due to our production scheduling and maintenance schedule which of course is not a significant impact, significant in the quarter but not a sign of anything other than the timing of that."
},
{
"speaker": "Rick Wise - Leerink Swann",
"text": "Let me come with the strategic issue on the cash use a little differently. Clearly you have the cash, maybe your and the Board’s priorities is it continuing with share buyback, is it making acquisitions? Do you think Pharma growth will be positive in 2010? I’m not looking for a precise forecast?"
},
{
"speaker": "Bill Weldon",
"text": "Our Pharma or Pharma in general?"
},
{
"speaker": "Rick Wise - Leerink Swann",
"text": "Your Pharma business will it have positive year over year growth?"
},
{
"speaker": "Bill Weldon",
"text": "You know I’m not going to answer that question. The priorities for us have never changed. They’re simple. Our first priority is to make sure we have the money to pay our dividends. That’s 40% of what we have available. When you start to look at what we then want to do with the money it’s invest in the business. If we had an opportunity to make an acquisition or to do something that would be really positive for the business that would take precedence even over completing the share buyback. Our intent is to ensure that we continue to look at opportunities that are going to bring strategic value to the business and growing. I was mentioning this earlier to a couple people; I think the opportunities this year are going to be extraordinary. I think it’s a matter of sitting on what we have, making sure we understand where our priorities are and what opportunities might be there. If they present themselves then we’ll be in a great position to move on them. Absolutely this economic environment creates opportunities that we may never see again so we need to be positioned to capitalize on them if they present themselves."
},
{
"speaker": "Matt Dodds - Citigroup",
"text": "When you look at the R&D even though you spent less in Pharma this year you’re still spending more than the average. I’m wondering as you’ve moved through ’08 how are you thinking about the cost benefit of those dollars first in the US how much harder is it going to get a return. Does the worldwide potential offset that, how you’re viewing that? On Sedasys you highlight that a lot is that a capital spend product and is the potential for that lower now given the environment?"
},
{
"speaker": "Bill Weldon",
"text": "As far as the R&D goes probably two or three years ago we actually increased our percent of sales up into 20% plus range, the industry is around 16%, 15%. We did that because we had what we really believe and still believe is such a rich pipeline. As products started to mature we made early investments six or seven years ago in early stage discovery and early products. They came to fruition and of course the cost of bringing a product to market is much greater. We’ve moved a lot of our clinical trials outside of the country so we’re getting a lot bigger bang for the buck today then we’ve ever gotten before. We’re starting to see a leveling off now because we think we’re going to get to a steady state which will be pretty much the same as an industry norm in the ability to invest in the products and its not that we don’t have confidence in our pipeline going forward and don’t need the investment its that we’ve been able to really be more efficient in the way we manage our clinical trials and the way we manage our go to market. Yes, we’ll see a leveling off of the expenses, we’ll see it more normalize against what the industry norms would be but the increase as we said for the last few years has really been because of the strength of the late stage development in our pipeline. You talked about the returns in the US, our feeling and belief and we hope this strongly is that we will get a strong person in charge of the FDA. We do hope its science will progress and be able to make scientific decisions for approval of products. It puts more pressure on the industry to do better research and to make sure we’re doing really good research that’s going to pay us the scrutiny of this. We think that’s an advantage to us. It’s an advantage to the industry to have a really strong regulatory body. Then we will reap the benefits of the products that we have coming. I think there’s going to be a lot more pressure on both pricing as well as the cost of brining the products to market. I think we’ll see more and more reviews and discussions about additional work that may be required. The benefit of innovation and bringing better products to market will more than offset the incremental costs if there are any that we’re going to have to deal with both here in the US. As you mentioned the emerging markets in some of these areas are making significant investments in healthcare in their countries and we think that we’re able to not only bring the products we have but modifications and the innovation center we have in China to bring better products there. You’ll see a leveling off but we’ll continue to work in that area. As far as Sedasys yes there is some capital equipment in that area but its not huge capital equipment cost and we have some unique ways of helping to move that to the consumer that will allow them to pay, we’re not going to be a bank but to buy these things over time or usage upon the product that will pay for itself in a short period of time. We’re looking at unique ways to help offset some of the costs for the consumer or the doctor."
},
{
"speaker": "Glenn Novarro – RBC",
"text": "Another question on M&A and particularly on the Pharma side. It dovetails a little bit with your comment you just made. In the past you’ve talked about a challenging FDA and a challenging regulatory body. If you look over the last couple years your deals have been more outside the Pharma side on consumer and devices. I’m wondering is the reason why we haven’t seen something on the Pharma side in recent years is it because the company has made a strategic decision to diversify away from Pharma or is it more because the price wasn’t right or the culture of the company that you may have been looking at didn’t fit. I’m curious why we haven’t seen more on the Pharma side on the M&A."
},
{
"speaker": "Bill Weldon",
"text": "It’s a bit of all of the above. If you look at the balance we were becoming way out of balance in the Pharma area and the PCH acquisition really helped balance our portfolio in that way. The regulatory bodies in many parts of the world especially here in the US have been struggling. They’ve been struggling to make decisions to approve products and with some of the adverse events they had they became risk diverse. It was very hard and it continues to be difficult getting products approved. The strategy that we have is if we have whether its in pharm, medical devices, diagnostics, consumer or any place else if it’s the right acquisition or the right license that will afford us the opportunity to advance the long term and create shareholder value we’re going to do it. We haven’t shied away from it we’ve just seen the prices have been very high. You have to look at where the products in their life cycle and where is the pipeline and do you gain access to something that’s going to bring real value, vis-à-vis what you already have in your investments. If you buy something there’s going to be lots of biotech companies. Everyone talks about biotech companies are going to come up right? The quest for the biotech company isn’t the important thing, it’s the cost of the investment to bring the product to market and is it going to bring value that’s going to be important. We have to look at the total investment and make sure that whether its pharmaceuticals, medical devices, diagnostics or consumer that we’re making the right investment that’s going to bring the benefit to our shareholders. We haven’t shied away from it we’ve just recognized that there were challenges that maybe made it more difficult."
},
{
"speaker": "Bruce Nudell - UBS",
"text": "Structurally a decent chunk of your cash is ex-US does that create relative advantages for acquisition versus share buyback? I wanted to clarify with regard to Remicade the scale of the de-stocking and from what I thought I just heard it was more internal timing as to manufacture rather than credit issues or share issues in the marketplace."
},
{
"speaker": "Dominic Caruso",
"text": "With respect to our capital structure and ex-US versus in US cash I would say generally speaking we’re comfortable with the level of cash we have and obviously we’re also very comfortable today given our strong financial position on our access to credit markets at reasonable rates. The cash location isn’t that much of a factor for us because of our ability to access capital when we need it at very reasonable rates. The Remicade issue was in the several hundred million dollar range of sales that due to scheduling issues in the production plan due to maintenance in the plan was simply deferred due to the timing of completing those events and it had nothing to do with any credit issues or any other issues with respect to the product."
},
{
"speaker": "Bill Weldon",
"text": "I’d like to first of all thank you all for coming today I know it’s a very important day for a lot of reasons but we do appreciate your interest and your support of J&J. I also want to say in parting that I was asked a question earlier and that is about the morale of the people at J&J because a lot of things are going on around the world. I want to tell you that the people at J&J look at this year as an extraordinary opportunity and an opportunity that if we stay true to what we believe in, stay true to our plans and stay focused on our business that we can come out of 2009 in a much strong way than we’ve ever gone into it and we’ve gone into it in a very strong way. I want to let you all know that the people of J&J are very committed and that’s what makes me feel so optimistic about the year. Thanks very much and we’ll see you later."
}
] | null | null |
JNJ | 3 | 2,008 | 2008-10-14 08:30:00 | Executives: Louise Mehrotra - Vice President, Investor Relations Dominic Caruso - Vice President, Finance and Chief Financial Officer Chris Poon - Vice Chairman, Board of Directors and Worldwide Chairman Pharmaceuticals Group Paul Stoffels - Company Group Chairman, Global Research and Development Pharmaceuticals Group
Analysts: Rick Wise - Leerink Swann Matt Dodds - Citigroup Seth [Diverga] – Deutsche Bank David Roman – Morgan Stanley Catherine Arnold - Credit Suisse
Louise Mehrotra: Welcome, I’m Louise Mehrotra, Vice President of Investor Relations for Johnson & Johnson and it is my pleasure this morning to review our business results for the third quarter of 2008. Joining me on the podium today are Chris Poon, Vice Chairman, Board of Directors and Worldwide Chairman, Pharmaceuticals Group, Paul Stoffels, Company Group Chairman, Global Research and Development Pharmaceuticals Group and Dominic Caruso, Vice President, Finance and Chief Financial Officer. Also joining us today in the audience is Sheri McCoy, Worldwide Chairman, Surgical Care Group. As we announced last week, effective January 1, 2009, Sheri will assume the role of Worldwide Chairman, Pharmaceuticals Group. A few logistics before we get into the details, the audio and visuals from these presentations are being made available to a broader audience via a webcast accessible through the Investor Relations section of the Johnson & Johnson website. I’ll begin by briefly reviewing highlights of the third quarter for the corporation and highlights for our three business segments. Following my remarks, Dominic will provide additional commentary on the results for the quarter and guidance for the year. Chris and Paul will then provide an update on our Pharmaceuticals Business. We will then open the floor to your questions. We will conclude our formal presentation at approximately 9:30 am and following Q&A with some final remarks by Dominic we’ll conclude the meeting around 10:00 am. Distributed with the copy of the press release that you just received is a schedule with actual revenues for major products and/or business franchises. For the listening audience these are available on the Johnson & Johnson website as is a copy of the press release. Before I get into the results, let me remind you that some of the statements made during this presentation may be considered forward looking statements. The 10-K for the fiscal year 2007 identifies certain factors that could cause the company’s actual results to differ materially from those projected in any forward looking statements made this morning. The company does not undertake to update any forward looking statements as a result of new information or future events or developments. The 10-K is available through the company or online. The Pharmaceutical Group presentation contains statements about new molecular entities or NMEs and other medicines or line extensions in various stages of development. These presentations are based on the company’s current knowledge of the status of development of the NMEs, medicines and line extensions and are subject to the challenges and difficulties inherent in product development. Not every compound highlighted today will make it to the market. In Biopharmaceuticals there are higher possibilities of encountering infringement claims by competitors with respect to patents or other intellectual property rights. The company does not undertake to update any forward looking statements as the result of new information or future development. Last item, during the call, non-GAAP financial measures may be used to provide information pertinent to ongoing business performance. These measures are reconciled to the GAAP measures and are available on the Johnson & Johnson website. Now I would like to review our results for the third quarter of 2008. If you would refer to your copy of the press release, let’s begin with the schedule titled supplementary sales data by segment of business. Worldwide sales to customers were $15.9 billion for the third quarter of 2008, up 6.4% as compared to the third quarter of 2007. Our operational growth was 3.3% and currency added 3.1 points. If you turn to the schedule showing sales by geographic area, you will see that we achieved growth of 0.4% in the US. In regions outside the US our operational growth was 6.5%, while the effect of currency exchange rates positively impacted our reported results by 6.6 points. Our strongest performing region was the Western Hemisphere excluding the US which grew 15.3% on an operational basis. The Asia/Pacific/Africa region grew by 11.3% operationally while Europe grew 1% operationally. If you will now turn to the consolidated statement of earnings, net earnings on a reported basis were $3.3 billion and earnings per share were $1.17. This compares to $2.5 billion and $0.88 in the same period in 2007. Please direct your attention to the box section of the schedule where we have provided adjusted earnings information. As referenced in the footnote, third quarter 2007 were adjusted to exclude the after-tax impact of the cost associated with the restructuring program of $528 million. There were no adjustments to the 2008 results in the quarter. Net earnings on an adjusted basis and earnings per share were up 7.6% and 10.4% respectively versus the third quarter of 2007. I would now like to make some additional comments relative to the components leading to the adjusted earnings before we move on to the segment highlights. Cost of goods sold at 30% was up 150 basis points versus the same period in 2007. Approximately half of the increase is due to changing mix within our businesses while the remaining half is due to additional costs incurred in our manufacturing operation. Selling, marketing, and administrative expenses of 32.6% of sales were down 10 basis points versus last year. Cost containment efforts more than offset the impact of the change in mix of our business driven by the strong growth of the consumer business. Our investment in research and development as a percent to sales was 11.7%, 60 basis points less than the third quarter of 2007 due to a combination of the change of mix of businesses and the timing of expenditures. Interest expense net of interest income of $25 million compares to $52 million of net interest income in the third quarter of 2007. This increase in expense was due to a higher average debt position in the quarter versus the same period last year as we continue buying back shares as part of our repurchase program. Other income net of other expense was $224 million in the third quarter of 2008 compared to $2 million of net other expense in the same period last year. As discussed last quarter, we received a settlement payment Amgen for $200 million which is reflected in this account. With regard to taxes please direct your attention to the effective tax rate excluding special charges shown in the box section of the schedule. Taxes were 22.8% in the third quarter of 2008 versus 23.3% in the third quarter of 2007. Dominic will provide more commentary on taxes in his remarks. Looking at year to date data consolidated sales to customers for the nine months of 2008 were $48.6 billion an increase of 7.6% as compared to the same period a year ago. On a year to date basis operational growth was 3% and currency had a positive impact of 4.6 points. On the consolidated statement of year to date earnings I’d first like to draw your attention to the box section. In both 2008 and 2007 charges for in process research and development have been excluded. Additionally, in 2007 the costs associated with the restructuring program have been excluded. With these adjustments net earnings for the nine months of 2008 were $10.3 billion or $3.61 per share up 7.7% and 10.4% respectively as compared to the same period in 2007. Turning now to business segment highlights, I’ll begin with the consumer segment. Worldwide consumer segment sales of $4.1 billion increased 13.1% as compared to the third quarter of 2007. Operational growth was 9.4% while currency added 3.7 points. US sales were up 11.2% while international sales grew 8.1% on an operational basis. For the third quarter of 2008, sales for the over the counter pharmaceuticals and nutritionals increased 11% on an operational basis compared to the same period in 2007. Sales in the US were up 19% while sales outside the US were up 3% operationally. The successful US launch this year of Zyrtec was a major contributor to this increase. Our skin care business achieved operational sales growth of 12% in the third quarter of 2008 with sales in the US growing at 15% and sales outside the US up 10% on an operational basis. Strong growth was driven by Neutrogena, Clean & Clear, Aveeno and Johnson’s Adult, due to a combination of new product launches and strength in the core businesses. Also contributing to the strong growth in the quarter were the newly acquired products from Dabao the leading moisturizer in China. Baby care products achieved operational growth of 9% when compared to the third quarter of 2007. Sales in the US grew by 1% with some softness in category growth. Strong growth across most product lines resulted in an operational increase in sales outside the US of 12%. Women’s health achieved operational growth of 6%. Sales in the US were up 10% due to the successful launch of the new products in our KY line. Sales outside the US were up on an operational basis by 3%. Operational sales growth in the oral care franchise was 7% with US sales down 3%. A significant new product launch in the third quarter 2007 impacted the US growth comparisons for the quarter. Sales outside the US increased 18% operationally driven by very strong growth for Listerine across the major regions. That completes our review of the Consumer segment and I’ll now review highlights for the Pharmaceuticals segment. Worldwide net sales for the third quarter of $6.1 billion were up 0.2% versus the same period last year. On an operational basis, sales were down 2.5% with positive currency adding 2.7 points. Sales in the US decreased 6% while sales outside the US increased on an operational basis by 3.3%. Our results continue to be impacted by generic competition on some of our products, namely Duragesic, and Risperdal Oral. The combined effect of this generic competition has reduced the third quarter Worldwide Pharmaceutical operational sales growth rate by approximately 11 points with the US impact estimated at 13.5% and the impact outside the US estimated at nearly 8%. As we have previously reported we saw a continued retraction in the US market for Erythropoietin Stimulating Agents or ESAs. This retraction has impacted the overall Pharmaceutical growth rate by approximately 2 points. Additionally, in the third quarter sales results outside the US were favorably impacted by a reduction to a reserve for sales of approximately $135 million related to Concerta. The majority of the reserve had been recorded as a reduction to sales in prior years. Excluding the negative impact of generics and the lower sales of Procrit and the positive impact of the reserve reduction the underlying operational sales growth was estimated at 8%. Now reviewing the major products, both Procrit and Eprex declined operationally by 12% during the quarter as compared to the same quarter last year. New competition and softening of the market due to ongoing labor reviews have contributed to the lower sales results for Eprex. Procrit results have been impacted by a decline in the market versus the third quarter of 2007, estimated at 18%, partially offset by an increase in overall market share. Procrit aggregate share across all markets was approximately 48% in the third quarter of 2008, up 3 points versus the same period last year. Sales of Levaquin our anti-infective were down 10% on an operational basis when compared to the same period a year ago. The script volume in the market was down approximately 5% versus the third quarter of 2007 attributable to a lower incident of respiratory illnesses. Market share was negatively impacted by generics in the category. Risperdal Oral had an operational decline of 63% when compared to the same period a year ago. Sales in the US were down 77% while sales outside the US declined 38% operationally. With the patent expiration in the US at the end of June this year there are now generic competitors for Risperdal in most markets. AcipHex, as it’s known in the US market, and Pariet outside the US is a proton pump inhibitor, or PPI, that we co-market with Eisai. On an operational basis, sales were down 19%. US sales were down 18% and the sales outside the US were down 20% operationally. In the US, script share has been negatively impacted by additional generic launches in the PPI category. Similar market dynamics impacted sales outside the US, compounded by the impact of market entry in Canada of generic Rabeprazole, the active ingredient in Pariet. Now moving on to our growth drivers, Remicade, a biologic approved for the treatment of a number of immune mediated inflammatory diseases, grew by 19% when compared to the third quarter of 2007. Sales growth in the US was 20%. Market growth in the Anti-TNF category continued to be strong. Sales to our customers for markets outside the US were up 16%. As we reported in the first quarter there was a significant increase in sales outside the US due to timing of shipments reflecting inventory planning on our customer’s part. Both the second and the third quarter sales were impacted as the majority of the inventory build was depleted. Excluding the estimated change in inventory levels, sales outside the US were more in line with estimated increase in demand of approximately 30%. Sales of Topamax, which is approved for the treatment of epilepsy and migraine prophylaxis, increased operationally by 18%. Sales in the US were up 22% while sales outside the US were flat on an operational basis. In the US, market share in the migraine category increased versus the same period last year. Outside the US, strong growth was achieved in many markets, offset by generic entries in certain other markets. Risperdal Consta, our long acting injectable formulation, achieved third quarter sales growth of 10% on an operational basis. US sales growth was 6% ahead of the estimated market growth. Sales outside the US were up 12% operationally with continued positive momentum and share. Concerta, a product for attention deficit hyperactivity disorder, grew 66% operationally in the third quarter as compared to the same period last year. As mentioned, sales results outside the US included a reduction to a reserve for sales of approximately $135 million related to Concerta. Excluding this reserve sales were up approximately 12% operationally, with sales in the US were up 7% and sales outside the US up 28% operationally. In the US continued solid market growth has been partially offset by lower market share. The approval earlier this year of the Adult Indication for Concerta will enable us to compete in the broader ADHD market. Velcade, a treatment for relapsed multiple myeloma, is being co-developed with Millennium Pharmaceuticals. We have commercialization rights in Europe and the rest of the world outside the US. Operational sales growth was 37%, with very strong results achieved across the regions. Wrapping up the review of the pharmaceutical segment, a manufacturing supplement SNDA for [Iopsis] previously submitted to the FDA did not gain approval. We are continuing the evaluation of a next generational system. Additionally, in the quarter the EU filing for Invega for Bipolar mania was submitted. I’ll now review the medical devices and diagnostic segment results. Worldwide medical devices and diagnostic segment sales of $5.7 billion grew 5.6% operationally as compared to the same period in 2007. Currency added 3.2 points to the sales growth to bring total growth to 8.8%. Sales in the US grew 3.1% while sales outside the US increased on an operational basis by 8%. Results have been impacted by lower sales of drug eluting stents. Sales excluding the impact of lower sales of drug eluting stents grew nearly 8% operationally. Now turning to the franchises, starting with Cordis; Cordis sales were down 10% operationally with the US down 26% and sales outside the US up 4%. Cordis results were impacted by lower sales of Cypher, our Sirolimus-eluting stent, and endovascular products partially offset by strong growth in our Biosense Webster business. Cypher sales were approximately $290 million down 26% on an operational basis versus the prior year. Sales in the US of approximately $100 million were down 47%. In comparison to the third quarter of 2007 the US drug eluting stent market growth is estimated at 15%. Penetration rates are estimated at 70% up from 63% a year ago while PCI procedures are up approximately 8% in the quarter versus the same period last year. These gains have been partially offset by a reduction in price. Estimated share in the US of 22% was down 15 points sequentially and down 22 points from the third quarter of 2007 due to the market entry of two new competitors in 2008. Sales outside the US of approximately $190 million declined 6% operationally. The estimated market share in the quarter of 30% was flat on a sequential basis and down 4 point from the third quarter of 2007. Increased competition has impacted the share outside the US. Cypher estimated worldwide share for the quarter was 27%, down 6 points sequentially and down 11 points from the third quarter of 2007. Endovascular sales declined due to a combination of the recall of a reentry catheter and increased competition in multiple segments. Now, turning to growth drivers within the Cordis franchise, the Biosense Webster business, our electro-physiology business, achieved double digit operational growth in the quarter driven by increased system placements as well as growth in catheter products. Our DePuy franchise operational growth of 8% when compared to the same period in 2007 with the US growing 7% and the business outside the US growing by 10% operationally. Hip growth on a worldwide basis was 12% operational, with strong growth in both the US and International businesses. On an operational basis, worldwide knee growth was 4% while spine grew 7%. Mitech, our sports medicine business, grew 12% operationally. Ethicon Endo-Surgery achieved operational growth of 10% in the third quarter of 2008, with the US sales growing 8% and sales outside the US growing on an operational basis by 11%. The Harmonic business achieved operational growth of nearly 20% due to the global success of the recently launched products and the underlying strength of this platform. Also contributing to the growth in the quarter was the realized gastric band launched earlier this year in the US and the strong performance of the endoscopy products and the strong performance of the endoscopy products in the international markets driven by increased awareness of the benefits of minimally invasive procedures as well as the metabolic benefits of obesity surgery. Ethicon worldwide sales grew operationally by 5% with similar results both in and outside the US. Solid growth in sutures and strong double digit growth in homeostasis and bio-surgical were the major contributors to growth in the quarter. The diabetes franchise grew operationally by 10% in the third quarter of 2008. The US business grew by 9% while sales outside the US grew 12% on an operational basis. The success of the One-Touch Ultra line has been the major contributor to growth. Additionally, the Animas business achieved operational growth of over 30% driven by continued market share gains in the pump business. Our Vision Care franchise achieved operational sales growth of 9% in the third quarter compared to the same period last year. Sales in the US increased 10%. Sales outside the US grew 8% on an operational basis. Acuvue Oasys, One-Day Acuvue Moist and Acuvue Lens for were the major growth drivers in the quarter. Rounding out the review of the medical devices and diagnostic segment, Ortho-Clinical Diagnostics achieved operational growth of 9% in the third quarter. Sales growth in the US was 11% while sales outside the US were up 6% on an operational basis. Immunohematology and immunodiagnostics products achieved double digit results. That completes highlights for the medical devices and diagnostic segment and concludes the segment highlights for Johnson & Johnson's third quarter of 2008. I’ll now turn the discussion over to Dominic Caruso for some additional comments.
Dominic Caruso: I’d like to add my own welcome to members of the investment community who have joined us here today and to those who are listening via the webcast and conference call. We are very pleased today to report solid financial results for the third quarter. Our performance once again demonstrates how we are successfully managing the business through some short term business pressures while continuing to advance our key growth initiatives. In the face of the recent financial market volatility we remain confident in our ability to continue investing in the future growth of our business while maintaining a strong balance sheet and generating strong cash flows. Louise has already reviewed the segments results for you so I will mention some financial updates, highlight a few of the recent business developments in the quarter and discuss our financial guidance for the year before handing things over for a more detailed pharmaceutical update. Our sales results for the quarter were above the mean of the analysts estimate thus published by First Call. We also delivered another strong earnings performance for the quarter also above the mean of the analysts estimates published by First Call. We continue to implement the cost restructuring program that we announced last year and as I noted on our second quarter call we are on track to achieve annual cost savings of approximately $1.6 billion for 2008 which is at the higher end of our previous guidance. Now a brief update on our share repurchase program. This $10 billion share repurchase program as you recall began in August 2007 and as of the end of September we have purchased approximately $7.4 billion of our stock. Our share repurchase program along with our dividends continue to illustrate our commitment to returning value to our share owners while maintaining a strong financial position that provides the flexibility to invest in business building activities. This quarter we continue to make investments and take actions to drive the future growth of our business. Chris and Paul will provide highlights for our Pharma business so I’ll just mention some highlights for MD&D and Consumer. In our Medical Devices and Diagnostics business we saw strong performances across six of our seven franchises driven by solid sales in our DePuy, Ethicon Endo-Surgery and Ethicon Surgical businesses as well as the Ortho-Clinical Diagnostic, Vision Care and Diabetes Care businesses. With new competitors in the US Drug-eluting stent market the Cordis business has seen a negative impact to sales of Cypher as we expected. Meanwhile progress in other parts of the Cordis business looks promising. The development of the Nevo Sirolimus-eluting Coronary Stent is ongoing and the Biosense Webster continues to grow at double digit rates. In the Consumer segment this quarter and as part of our focus on emerging markets we acquired Beijing Dabao Cosmetics, one of the most trusted skin care brands in China. Johnson & Johnson has been doing business in China since 1985 and Dabao marks our first acquisition in this market. Our work with Dabao and its employees has already enhanced our knowledge of this critical marketplace and we look forward to further developing this brand for the future. Our Consumer business continued to see strong results from our allergy treatment Zyrtec which first became available without a prescription in stores across the US in January of this year. By the end of June, Zyrtec had captured approximately 26% of the US allergy market since its launch. Meanwhile, the integration of the Pfizer Consumer Healthcare business and brands continues to be on track to meet or exceed our target of $500 to $600 million of cost synergies by 2009 and we still expect this transaction to be break even or modestly accretive by 2009 one year ahead of the original schedule. I’d like to update you where we are with a few brief items related to some recent activities. First, I’m pleased to inform you that Ethicon has now entered into a definitive agreement to sell its Professional Wound Care business to One Equity Partners. We have previously announced the receipt of One Equities offer in July and have been working through the process since that time. The guidance that I will discuss today does not reflect any gain from the divestiture of this business which is expected to close in the fourth quarter pending satisfaction of all closing conditions. This divestiture is en essence a decision to reshape our portfolio. We expect any gain from this sale to be largely offset by increased investment spending or other actions. This anticipated gain affords us an opportunity to make additional investments and to consider other business decisions to enhance our longer term performance and financial condition. We also received good news recently regarding long standing patent litigation between our Cordis business and both Boston Scientific and Medtronic. On September 30, the US District Court in Delaware entered a final judgment of about $1.2 billion including accrued interest. It is too early to say when we will receive these payments given the possibility of appeals. Interest will continue to accrue until paid. As has been our practice we will not record any gain from these judgments until the cash is received and we expect to record such gains as special items. Any potential impact is not reflected in today’s guidance. I would like to provide you some comments for you to consider as you refine your models. Let’s start with a discussion of cash and debt as well as interest income and expense. During the third quarter of 2008 the company continued to generate strong cash flows. At the end of the third quarter we had approximately $150 million of net cash. This consists of approximately $14.8 billion of cash in investments and $14.6 billion of debt. This is an increase of approximately $400 million in our overall net cash position from year end 2007. This reflects our strong operating cash flow and the use of approximately $3.8 billion to repurchase our stock so far this year. Given the recent developments in the financial markets I’d like to share with you some important points about Johnson & Johnson. In our Corporate Investment Portfolio we had no exposure to sub-prime market or the financial services companies that have failed as a result of the recent credit crisis. We continue to have ready access to the Commercial paper market at attractive rates. At the end of September we renewed our expiring 364 day credit facility for $6.3 billion and signed a new five year credit facility for $1.4 billion to replace an existing one, both of which has Triple A credit ratings affirmed. These facilities are part of our continuous effort to maintain our financial strength and flexibility. Regarding interest income and expense, for purposes of your models, assuming no major acquisitions and considering the continuation but not full completion of the share repurchase program during 2008, I would suggest you consider modeling net interest expense between $50 and $100 million of net interest expense consistent with our previous guidance. Turning to other income and expense, as a reminder, this is the account where we record royalty income as well as one time gains and losses resulting from such items as litigation, gains or losses from investments by our development corporation or asset sales. The gain associated with the Amgen settlement is recorded in this account. Assuming no other major one time gains or losses I would recommend that you consider modeling other income and expense for 2008 as a net gain ranging from approximately $350 to $400 million. This is higher than our previous guidance but the impact will be more than offset by higher expenses in other line items as you saw some of this, this past quarter, due to actions taken or investments made with such funds. Now a word on taxes, year to date the company’s effective tax rate was 23.6% reflecting adjustments made in the third quarter resulting from the finalization of our federal return. As you are aware, the R&D tax credit extension was passed by Congress earlier this month. Our guidance has been updated to reflect this. The full impact of the R&D tax credit for 2008 will be recorded in the fourth quarter. Therefore we would suggest that you model our effective tax rate for 2008 in the range of 23% to 23.5% would not include any in process research and development charges or other special items. As always, we will continue to pursue opportunities in this area to improve upon this rate for the balance of the year. Turning to sales, we would be comfortable with your models reflecting operational sales growth for the full year 2008 at the higher end of our previous guidance of 1% and 2% or even slightly higher. As you know currency rates are difficult to forecast. While we are not predicting the impact of currency movements on our sales to give you an idea of the potential impact of currency rates were to stay where they are today through the end of this year then our sales growth would be favorably impacted by approximately 3%, resulting in total reported sales growth for the year of approximately 5% versus our prior guidance of 5.5% and 6.5%. This reflects stronger operational sales growth which is more than offset by the negative impact of currency. This is a significant change in currency from our previous guidance. For example, at current rates the fourth quarter impact of currency would reduce sales by approximately 1.5%. That’s compared to an implied 3.5% of growth based on currency at the time of our second quarter earnings call. This 5 point swing in currency would obviously have a resulting negative impact to earnings in the fourth quarter. Although we don’t normally comment on the following year with respect to guidance the impact of the stronger dollar could have on our results is something I would like to highlight for you as you refine your models. If the Dollar/Euro rates were to remain the same as today for all of 2009 the impact to next years sales due solely to currency would be a reduction to sales of approximately 3% to 3.5%. Now for earnings, when I last checked the first call mean estimate for our EPS for full year 2008 was $4.51 per share. Despite the potential impact of currency in the fourth quarter that I just outlined and taking into consideration the strength of our operating performance this past quarter and the items I have outlined for you we would be comfortable with your models reflecting full year 2008 earnings per share excluding in process research and development charges or other special items of between $4.50 and $4.53 per share, an increase from our previous EPS guidance range. That concludes my update on our operating performance this quarter and guidance for 2008. Let’s move on now to the next portion of our program today. Last year many of you joined us in New Brunswick for a full day review of our Pharmaceutical and Consumer businesses. Today we look forward to providing you with an update on our Pharmaceutical business and some of the pipeline highlights we described for you then. We typically provide these brief business updates every October as part of our ongoing effort to keep you informed about our long term strategy and prospects for growth. We have the most robust pipeline in our history and continue to see progress on several of our lead space compounds which will be discussed today. I’m very pleased this morning to have Chris Poon with us, my colleague on the Executive Committee of Johnson & Johnson. As you know, Chris is Vice Chairman of Johnson & Johnson and Worldwide Chairman of our Pharmaceutical Group. Chris and the Pharmaceutical leadership team have been continuing to invest in key pipeline compounds and major line extensions that will drive our long term growth while creating a more efficient and cost effective operation that addresses short term pressures. Joining Chris today is Paul Stoffels; Paul is Company Group Chairman of Global Research and Development for the Pharmaceutical Group. He will speak to you today about some of the latest developments in some of our promising pipeline compounds, Rivaroxaban, Paliperidone Palmitate, Golimumab, and Ustekinumab. At the end of Chris and Paul’s presentations we look forward to taking your questions. Before I hand over the podium to Chris, I would like to thank her on behalf of Johnson & Johnson for her dedication and commitment to bringing health and wellbeing to people around the world. Chris recently announced her plans to retire from Johnson & Johnson in March 2009. We will miss her leadership as we move forward with the business platforms, pipeline and talent she has fostered across the organization. Few in healthcare today have so successfully combined a passion for business with a mission of transforming patient’s lives as Chris has. We wish her the best of luck in the next chapter of her life. Now for the Pharmaceutical update.
Chris Poon: It’s going to be a pleasure to discuss our Pharmaceutical business with you. We’re going to talk about our existing and exciting pipeline and our research and development strategy that underlies our success. As Dominic and Louise mentioned, Paul will also be here and he’s going to also give us progress not only on some of our pipeline compounds but also give you a glimpse of some of the compounds in earlier development. First let me set the stage, the Johnson & Johnson Pharmaceuticals Group is a leader among the worldwide pharmaceuticals companies ranking 6th based on annual sales. The ranking in size and growth has been achieved through a combination of organic internal growth as well as selective licensing areas of strategic interest. It’s also important to note that at the end of 2007 Johnson & Johnson ranked third largest among biotech companies. This biotech market continues to be an important source of growth for us. Biotech expertise in the industry is driven because of our capabilities through the entire value chain. Our R&D capabilities in monocle antibodies pioneered at Centocor are significant and are transferable to the next generation biologics. We have unmatched bio-manufacturing expertise and capacity actually dating back to the very early years of biotech and Centocor’s first plant in the Netherlands 25 years ago. Throughout 2008 there have been several key compounds providing strong sales growth in our inline portfolio of medicines. The strong growth of these compounds continued in the third quarter fueled in some cases by new indications and in others by approvals in additional markets. Let me touch on a few of these; first Velcade. It continues its high sales growth and tremendous success with a 44% increase year to date versus prior year. Your call that Velcade was granted approval in June of this year for front line use in multiple myeloma in the EU. More approvals of multiple myeloma front line during the third quarter bring the total number of countries to 47 that’s up from less than 20 at the end of the second quarter. Our anti-psychotic franchise consists now of two growth products. Risperdal Consta continues its strong performance with sales growth of 11% versus the third quarter 2007 year to date and for Consta we’re pursuing additional indications in bipolar disorder and we expect to hear more about these indications next year. In addition, Invega contributed growth of 135% year to date. Remicade continues its strong sales growth after 10 years on the market delivering 18% growth and maintaining market share of about a third of the anti-TNF market. Concerta’s new adult indication just received in July has helped Concerta to continue its strong sales growth for the year to date figure of 10%. Prezista continues it’s success fueled by the availability of Intelence which received marketing approval in January of this year in the US and recently in the EU. With this breadth and depth of our growth products has enabled us to lessen the impact of generic competition and the slower sales of Procrit while our newer products that are still in launch mode continue to gain footing in their respective markets. Not only do we think about products we also think about markets and so let me give you a glimpse of some of our performance in our emerging markets. This focus on emerging markets what we call the brick countries; we continue to see considerable growth in the third quarter. This is the result of several launches of new products, new indications and of course increased investments to expand our sales forces in these selective markets. We continue to maximize our current portfolio and pursue new indications for our existing products. A few of the major line extensions that we have either filed or received approval for thus far in 2008 are shown here. I’ve already mentioned Concerta an adult ADHD. Topamax’s pediatric exclusivity approval this now extends the marketing exclusivity of Topamax until March 2009. Doribax we received approval in the EU for urinary tract infections, intra-abdominal infections and NP infections. I just mentioned Velcade for front line approval in the EU for multiple myeloma and just last Wednesday we received approval for a new injection site for Risperdal Consta a deltoid injection site. You can see how busy we’ve been this first half of this year with the major line extension approvals but also with some additional filings. We filed Risperdal Consta and bipolar mania, Invega for bipolar mania in the EU, Doxil for metastatic breast cancer and Prezista for early experience patients in the EU. I think you can see why we’re optimistic about our short and long term prospects for end market products and our pipeline. This slide shows some of the key strategic drivers we believe position us well into the future. To summarize, here are some of the key attributes of our pharmaceutical group. We have an experienced leadership team. As Louise mentioned, Sheri McCoy will be assuming the role of Worldwide Chairman for the Pharmaceuticals business. Sheri is a demonstrated leader, a close colleague and her breadth of experience helps position Johnson & Johnson well for the future. Sheri inherits a leadership team that is one of the most highly experienced, dedicated with impressive track records and I do believe that our Pharmaceutical group is in fantastic hands with Sheri’s leadership. As you’ve seen we have a diverse well balanced portfolio that includes a broad range of therapeutic areas with high end met needs and we have a robust late stage pipeline and are poised for several key product launches. Our early state pipeline is also promising. It’s important we continue to take actions to address the short term pressures in our business. These include the cost improvement programs that Dominic mentioned as well as organizing our R&D, our operations and our commercial organizations for growth, continuing to invest in our pipeline and ensuring that we have disciplined M&A and L&A. Let me just take a few moments to discuss our research and development strategy and to paint a picture for you of our strong capabilities and what makes us unique as an organization. We have research being conducted in seven therapeutic areas in both large and small molecule platforms. We have established global operations with end to end capabilities and we are pursuing innovative platforms and technologies in the context of a regulatory environment that is increasingly demanding, outcomes based development. This slide shows the seven therapeutic areas that are our strategic areas of interest. We are sharpening our focus in R&D on these therapeutic areas where we feel we can best play to win because we already lead in that market and/or because there continues to be a significant unmet medical need in that area. In order to accomplish our goal of a sustainable productive R&D organization we have evolved to a hybrid decentralized standardized model. The responsibility for research and early development each of the therapeutic areas remains decentralized as we believe this is the model and environment that fosters innovation and entrepreneurship. At the same time we continue to standardize or centralize certain key functions such as clinical operations, bio statistics, pharmacology, these centers of excellence or shared services provide support for the research and development activities of each of the therapeutic areas in order to reduce duplication and to leverage our scale. We believe that we’re already seeing the early results of this R&D operating model and Paul will give you a glimpse into some of the new compounds moving through the early development pipeline. We believe that sustain R&D productivity is the key to our future and we believe, therefore that our long term future remains very bright. As we’ve discussed in prior meetings here with you we expect to file between seven and 10 new products for approval between the beginning of 2008 and the end of 2010. We’re on track. Paul will talk to you today about four of these Paliperidone Palmitate, Ustekinumab, Golimumab and Rivaroxaban. In 2008 thus far we have already received marketing approval for Intelence for HIV both in the US and in the EU and we have filed in the immediate release formulation of Tapentadol for pain. Additionally, we have received an approval letter from the FDA for Ceftobiprole and have submitted complete response back to the agency. For the remainder of 2008 we remain on track to file Carisbamate for the treatment of Epilepsy and Yondelis in an oncology indication. In 2009 and 2010 we anticipate further filings for several other compounds. Now let me turn the stage over to my colleague and friend, Paul Stoffels.
Paul Stoffels: It’s my pleasure today to discuss in more detail a few compounds in our late stage pipeline that we are excited about. Today’s I’ll focus on Rivaroxaban, the first oral Factor Xa inhibitor, Paliperidone Palmitate, a novel long acting anti-psychotic, Golimumab human anti-TNF therapy that holds a lot of promise and Ustekinumab a first in class mechanism of action for moderate to severe plack psoriasis. I’ll also spend a few minutes highlighting a few key compounds in our early development pipeline. Let me begin with Rivaroxaban, our once daily oral direct Factor Xa Inhibitor. We are very excited about this compound which we are co-developing with Bayer. Rivaroxaban is initially being developed for prevention of VTE in patients undergoing hip or knee replacement surgery. A larger opportunity is with additional indications for VTE treatment, for SPAF and secondary prevention in patients with ACS. For VTE prevention we filed for approval with the FDA in July based on outstanding data from the Records Clinical Program in which more than 12,500 orthopedic patients have been investigated. This is the largest program ever conducted in VTE prevention in patients undergoing knee or hip replacement surgery. It comprised four pivotal phase three clinical trials that compared Rivaroxaban with Enoxaparin the current standard of care. Rivaroxaban demonstrated superior efficacy in the record program. This included head to head comparisons with Enoxaparin and a comparison of extended duration Rivaroxaban with short duration Enoxaparin. In each of the four trials Rivaroxaban and Enoxaparin demonstrated similar safety profiles and low rates of major bleeding. Details about all of these trial designs are available on ClinicalTrials.gov. Last month, Bayer Healthcare announced that Health Canada was the first country to approve the drug for VTE prevention. In addition, earlier this month, Bayer Healthcare announced the European Commission granted approval to market Rivaroxaban for VTE prevention in adult patients who have undergone elective total hip and knee replacement surgery. We will be presenting our Phase II dose finding results from our studies of Rivaroxaban in ACS at the American Heart Association meeting in November. In addition, we plan to present our pooled Record 1-4 data at the ASH meeting in December. This slide summarized the results of the Record 4 study which we presented in May. This was the first head to head study comparing Rivaroxaban at 10 mg once daily dose with Enoxaparin at 30 mg twice daily which is the FDA approved dosing regiment for Enoxaparin in this patient population. By contrast, the Record 1, 2 and 3 studies compared Rivaroxaban against Enoxaparin dosed once daily at 40 mg. In this study Rivaroxaban was superior to Enoxaparin in preventing VTE in patients who underwent total knee replacement surgery. Patients showed a statistical significance 31% reduction in relative risk of total VTE events compared to Enoxaparin. Total VTE events which was the primary end point was defined in the study as the composite of all deep vein thrombosis non-fatal pulmonary embolism and all cost mortality. Rates of major bleeding, the main safety end point while numerically greater in the Rivaroxaban treated patients were low in both treatment groups. Rivaroxaban was initially being developed for VTE prevention and there is a robust development program evaluating Rivaroxaban in several critical underserved areas where a drug with these properties can have a positive benefit to patients. In the trials show on this slide as well as in early completed studies approximately 50,000 patients are expected to be enrolled in the Rivaroxaban clinical development program. This includes trials in the prevention and treatment of a broad range of clotting disorders. These trails, done in collaboration between Bayer and J&J include four Phase III clinical programs in VTE prevention in orthopedic surgery, VTE treatment, stroke prevention in patients with atrial fibrillation, VTE prevention in hospitalized medically ill patients and a Phase II study in secondary prevention in patients with acute coronary syndrome. In summary, we are very excited about Rivaroxaban. We believe that Rivaroxaban’s combination of an exceptional efficacy and balanced safety provides a compelling and positive risk benefit profile that can help improve patient’s outcome. Let’s now look at Paliperidone Palmitate which represents the first atypical long acting injectable antipsychotic with monthly dosing. Paliperidone Palmitate uses a novel technology to deliver daily medication over a one month period. We believe this is a significant advantage in antipsychotic therapy. The monthly dosing schedule may enhance compliance and provide pharmical economic value by reducing the number of patient visits, hospitalization and recurrence which the drivers of increased healthcare costs. The advanced particle formulation allows storage at room temperature while the pre-filled syringes with smaller gauged needs can be administered through deltoid and gluteal injections. Palmitate is initially being developed for schizophrenia and we are considering a bipolar program in early 2009. We filed the US NDA for Palmitate for treatment of schizophrenia at the end of 2007. We presented data from those pivotal studies at the APA meeting in May and we have conducted comparative trials between Consta and Paliperidone Palmitate one of which is completed and one ongoing. As I mentioned, Palmitate uses a novel delivery technology and as with the lobe of novel technologies you learn as you conduct more clinical trials about how best to use this technology. One of the things we have learned from the first comparative trial with Consta is that we can get much more consistent efficacy with Paliperidone Palmitate across broad populations of patients with higher initiation dose. We used this higher initiation dose in a placebo controlled study and found that this dosing regiment demonstrated strong efficacy and excellent tolerability. We are now using this dosing regiment in a second comparative trial with Risperdal Consta which is ongoing. We have submitted data from the first comparative trial against Consta with a lower initiation dose as well as the data from the placebo controlled study with the higher initiation dose for presentation at ACNP a major medical meeting in December. We anticipate results from the final comparative clinical trial with the higher initiation dose of Paliperidone Palmitate versus Consta next year. As I previous indicated we filed an NDA for Palmitate in Schizophrenia late last year and received a complete response from the FDA in August regarding our NDA. The complete response outlined additional information needed before FDA would approve the application including a re-analysis of a subset of the data. No additional studies were requested. Given what we have learned about a higher initiation dosing providing an optimal level of patient outcome we plan to include this new dosing in a response submission to the FDA. We are in the process of preparing that data and anticipate the data will be ready to submit in the first half of 2009. Based on the new information to be submitted we believe that this will be a six month review. Let me now turn to Golimumab, the first human anti-TNF therapy currently filed in the European Union and the United States. We believe that Golimumab will offer excellent efficacy and best class dosing. The subcutaneous dosing will be single monthly injection. This compares favorable to competitor regiments ranging from two injections each week to one every two weeks. Our state of the art auto-injector is also a differentiating factor and Golimumab had a very low rate of injection site reactions in the clinical trials. We have filed for three indications simultaneously enabling us to efficiently and rapidly build a safety data base in support of Golimumab. We filed an MAA in Europe in the first quarter of 2008 and submitted a US filing in June 2008 for subcutaneous therapy for signs and symptoms of Rheumatoid Arthritis, Ankylosing Spondylitis, and Psoriatic Arthritis. In June we presented Phase 3 data in RA for the first time at the EULAR meeting in Paris. Findings showed the efficacy of Golimumab in several important populations. First in methotrexate naive patients, second in patients with active RA despite ongoing treatment methotrexate and third in patients previously treating with anti-TNF biologic agents. We have ongoing studies for all the potential findings including claims regarding impact on structural damage in RA and intravenous therapy for RA and for ulcerative colitis both intravenous and subcutaneous. Let’s take a look at the data for our studies of Golimumab in combination with Methotrexate in patients with active RA despite ongoing treatment with Methotrexate. In this trial called Go Forward adult patients were randomly assigned to four arms. Placebo plus Methotrexate, 50 mg and 100 mg Golimumab in combination with Methotrexate, 100 mg Golimumab alone administered subcutaneously every four weeks. Data was assessed at weeks 14 and 24 the co-primary end points where percentage of patients achieving ACR 20 response at week 14 and improvement from baseline and health assistant questionnaire or at week 24. Patients on the Golimumab 50 mg and 100 mg plus Methotrexate experienced significant improvements in the signs and symptoms of RA. Improvements were seen as early as the first clinical assessment which was four weeks after the first Golimumab injection and generally continued to improve over time. Patients with RA receiving Golimumab also demonstrated significant improvement in physical function as assessed by the hack. This slide shows results from the first prospective double blind placebo controlled Phase 3 clinical trial to analyze the efficacy of an anti-TNF therapy in patients previously treated with at least one anti-TNF agent. In the study 461 patients with active RA were randomized to receive either subcutaneous placebo or Golimumab at 50 mg or 100 mg every four weeks. The primary end point for this study was the proportion of patients in each group that achieved ACR 20 response rates at week 14. Patient responses were assessed through week 24 and improvements within hack were also recorded at week 24. Golimumab therapy significantly reduced the signs and symptoms of RA. At week 14 35% and 38% of patients receiving Golimumab 50 mg and 100 mg respectively achieve a primary end point of ACR 20. This compares with only 18% of patients receiving placebo achieving ACR 20. These results were maintained through six months. Golimumab was generally well tolerated across clinical trials and was associated with a low rate of injection site reactions compared with patients receiving placebo. We believe Golimumab holds great promise in various RA patient populations including Methotrexate naïve patients, patients with active RA despite Methotrexate and patients who have previously discontinued all TNF inhibitors. Golimumab may provide an appropriate treatment option to many people facing this debilitating disease. Now I would like to discuss Ustekinumab formerly know as CNTO 1275 a human mono-clonal anti-body which binds to the P40 sub unit shared by IL-20 and IL-23 and neutralizes both kinds. It has been initially developed for subcutaneous delivery for treatment of moderate to severe psoriasis. We believe Ustekinumab will transform the convenience of therapy requiring maintenance dosing only once every three months after two initiation doses at the zero and week four to achieve a very high response rates. We believe this will be a significant competitive advantage. Psoriasis will be the first indication but we are also developing the drug in Crohn’s disease and have other indications under consideration. The BLA and MAA were filed at the end of last year. On June 17 the FDA dermatologic and ophthalmic advisory committee unanimously recommended Ustekinumab for approval. The FDA has formally extended the review for our application by three months and we now anticipate a response at the end of the year. We recently presented the results of a comparative trial of Ustekinumab versus Etanercept. This was the first time a head to head trial has been done between two biologics in psoriasis. This was a Phase 3 multicenter randomized head to head study comparing Ustekinumab and Etanercept for the treatment of moderate to severe psoriasis. The study included three arms. Patients received either Etanercept twice weekly or 45 mg Ustekinumab at the zero and week four or 90 mg Ustekinumab at zero and week four. Over the 12 week period this amounts to 24 doses of Etanercept in comparison to two doses in both Ustekinumab arms. The primary end point of the trial was the percentage of participants achieving at least a 75% reduction in psoriasis at week 12 as measured by the psoriasis area and severity index of PASI 75. This study was presented by investigators at the 17th Congress of the European Academy of Dermatology and Venereology in Paris, France in September. At week 12, 68% of patients receiving 45 mg of Ustekinumab and 74% of patients receiving 90 mg of Ustekinumab achieved the PASI 75. This compared with 57% of patients receiving 24 50 mg doses of Etanercept over 12 weeks. Need less to say, we are excited about Ustekinumab which represents a first in class therapy for patients with psoriasis. In the allotted time today I also wanted to share with you a glimpse of our advancing early development pipeline. We are extremely excited by the opportunities represented here which are for compounds that are now in Phase 2 development. Let me go over each of them briefly. The first is SGLT-2 inhibitor. This compound has the potential to be a novel treatment for Type 2 diabetes and obesity. It has a novel mechanism of actions and works by inducing a significant increase in urine glucose excretion. It is well tolerated without associated hypoglycemia or weight gain. It represents a potential novel agent for weight loss. It is currently in Phase 2b and it has show positive proven concept. The second is an MTP inhibitor which has the potential to be a different shade of treatment for obesity. This compound acts in the gut which is different from other MTP compounds that may be systemically absorbed. For both these compounds we are currently evaluating the Phase 2b data and anticipate making decisions on plans for Phase 3 studies early next year. Finally, we have TMC435 which is a once daily organ protease inhibitor for treatment of Hepatitis C which has demonstrated good efficacy and safety in its initial proven concept. We are scheduled to present preliminary data on this compound at the American Association for the Study of Liver Disease meeting in San Francisco starting October 31st. We believe that sustained R&D productivity is the key to our future. We believe we have one of the most robust late stage pipelines in the industry. As we have already discussed we also expect to file between seven and 10 new products for approval between the beginning of 2008 and the end of 2010. This concludes our look at the Pharm pipeline so let me leave you with a few key take aways. We have an experienced leadership team that positions Johnson & Johnson well for the future. We have a diverse well balanced portfolio that spans a broad range of therapeutic areas. We have a robust late stage pipeline as well as promising early stage pipeline that will provide growth opportunities for the future. Thank you very much now I would like to turn it over to Louise.
Louise Mehrotra: We’ll now open the floor to your questions. If you could wait for a microphone as the meeting is being webcast.
Rick Wise - Leerink Swann: Given the turmoil in the US and OUS economies credit markets maybe you could talk just to start us off broadly about the likely economic impact on your business planning, impact on the P&L maybe just broadly how it’s going to change your investment priorities, how you’re going to use the cash as we look ahead?
Dominic Caruso: Recently we have seen some impact of the current economic conditions but just in a few pockets of our business. To date as you’ve seen from our results it hasn’t really resulted in any significant impact to our overall broad based business performance. I’d like to point out that our business leaders have over time been able to make the appropriate adjustments in response to changing market conditions and I certainly expect that they’ll be able to do so in the future. When we do that we’ll take a long term view of how to keep our business healthy for the long term. So far we’ve seen small pockets, a few pockets of impact but nothing that’s impacted our overall business performance.
Rick Wise - Leerink Swann: You highlighted the compelling growth you’ve seen in countries for example do you think that can continue given the global turmoil?
Dominic Caruso: We have, as a priority for the corporation we have accelerating growth in emerging markets as a key priority for all of our businesses because we believe that that is a great opportunity for us. We’ve already been present in many of those markets and as you saw we’re seeing significant up take and we’re continuing to invest in those markets. When we accelerate our investments these emerging markets tend to get a high priority.
Rick Wise - Leerink Swann: You highlighted the increased investments offsetting the gain maybe you could be more concrete with us about the investments where they’re going, what you expect to draw from it and maybe the longer term impact?
Dominic Caruso: I’d rather not be so specific about where the investments would be but whenever we have some one time gains like the Amgen gain or the gain from the divestiture of the Ethicon Wound Care business and we look at that gain as actually just a reshuffling of priorities. We want to take the opportunity to invest in a long term growth of our business. Our businesses have great growth opportunities that they present to us all the time. It’s our desire to help fund those investment opportunities and they span across all three of the major business segments. I’d rather not be specific at this time.
Matt Dodds - Citigroup: You didn’t highlight the pain franchise although you did have a little comment earlier. Can you just tell us what happened to Ionsis and where the next technology may be in timing? Also on tapentadol which you didn’t highlight can you just remind us do you expect the approval by year end and file in early ’09 for the extended release?
Paul Stoffels: First on Ionsis we recalled the product from the market because of the technical problem. We are planning on working on solving that and reintroducing whenever possible. On tapentadol the product was filed in January, our FDFA date is at the end of November but we are expected that this product will be a scheduled product and so typically that will take a DA review afterwards. We expect that will be a 60 to 90 day additional review. At this moment we are in active discussion with the FDA on tapentadol.
Chris Poon: You know that is for the acute indication immediate release. We’re still on track for the chronic program and extended release program.
Seth [Diverga] – Deutsche Bank: First on Concerta the reversal of the reserve of $135 million that’s I guess about two quarters of historical sales so can you give a little more color on that and also does that drop straight to the bottom line?
Dominic Caruso: This quarter we reversed our reserve for the anticipated pricing of Concerta in Canada. There was a ruling in Canada which increased the price of Concerta and we had estimated that perhaps that wouldn’t occur that did occur so that was favorable for us. The impact in the quarter of about $135 million in sales is roughly $0.02 or $0.03 to the bottom line.
Seth [Diverga] – Deutsche Bank: On the HIV franchise now that you’ve had a couple product approvals and another in Phase 3 have you considered a combination pill?
Paul Stoffels: The two first products Prezista and TMC125 so Intelence now are two products which are used mainly which are indicated for advanced patients. They are used in separate pills. We are developing TMC278 which is a very small dose which is a very combinable product with a number of different products. The product is now in Phase 3. Two Phase 3 studies are ongoing and we are looking for partnerships on how can we combine this product with different HIV especially in first line where they are desirable.
David Roman – Morgan Stanley: On the guidance it looks like for the full year your raised guidance by $0.03 to $0.05 relative to where you were previously. By my math the tax rate does that include the R&D tax credit? By my math the tax rate gets you probably $0.03 to $0.04. The fourth quarter relative to where the first call consensus it looks like guidance is implicitly below that number. Could you walk us through the moving parts there operationally, how much is FX hit the bottom line in the fourth quarter?
Dominic Caruso: Yes, the impact to FX, our guidance has in fact increases versus the previous guidance due most net net because of the R&D tax credit because the stronger performance we’ve seen in the business thus far we believe may be offset by negative impact of currency in the fourth quarter. I tried to give you an indication of the impact and we can’t predict currency so I’m just using currency at today’s rates the Euro today. If that stayed where it was throughout the entire fourth quarter sales would decrease due to currency by 1.5 points whereas my prior guidance at the end for the second quarter based on rates then we expected sales to increase by 3.5 point in the fourth quarter. That delta of five points on our fourth quarter sales is the pressure we’ll face with earnings in the fourth quarter. We’ll overcome that but that obviously offset some of the earlier gains this year. Currency may not end up there but we think that’s prudent to give you that kind of expectation.
David Roman – Morgan Stanley: You said previously that of the contribution of currency growth or decline two thirds of that falls to the bottom line of the growth?
Dominic Caruso: That’s right. It varies by where it happens in each currency and in each country. Not 100% of the change in top line falls through to bottom line. It’s always historically been at least two thirds. So two thirds we can count on coming through to bottom line. Sometimes it’s as high as 80% to 85% but definitely two thirds would.
David Roman – Morgan Stanley: On the economy we’ve seen preannouncement from Advance Medical Optics and Nobel Biocare so far can you maybe be a little more specific about which pockets of the business you’re seeing an impact from the economy either in the third quarter and then specifically some of your competitors and other have commented specifically about the month of September can you maybe give us a sense of the trend throughout the quarter in those businesses.
Dominic Caruso: We don’t typically comment on monthly sales trends and we just finished the quarter so we don’t really have a lot of data to hang our hat on. We did see some, as I mentioned, some pockets, these were mostly in what I would call elective type procedures so either in sports medicine or in women’s health procedures but not a broad base decline. In fact, you saw results for the quarter were actually pretty strong across our surgery businesses. In our Consumer business we’ve seen just a slight decline in the growth of those markets year over year. They’re still growing but just subsiding a little bit in growth.
Catherine Arnold - Credit Suisse: Obviously the world events have made balance sheets back in fashion and so as a result of that I’d like to probe a little bit on things like cash conversion. You’re actually above peers from our analysis in terms of your cash conversion but can you push that further as far as things like working capital and accounts receivable we may actually see some benefits on your top line as well as your free cash flow. If the cost of debt remains unchanged from current levels over the next 12 months would you reconsider your capital allocation priorities and I would put specifically out there repurchase as a question?
Dominic Caruso: With respect to balance sheet management one thing that I’m very proud to point out is that our businesses have managed the business well throughout up and down cycles and in fact you’re right, strong balance sheets are now in favor more broadly but they’ve always been in favor at Johnson & Johnson. It’s just the way we manage the business. I think that our free cash flow right now represents about 100% of our net income so our businesses do a pretty good job of managing receivables and inventory levels. I think we might consider a little bit of caution on capital expenditure if times get a little bit tougher. Overall our businesses are able to manage this consistently through economic times and they’re used to this so this is not a major undertaking for them. With respect to capital allocation and share repurchases it’s our policy to really complete the share repurchase that we’re undergoing before we make any other decision on how to use our capital allocation for things like share repurchases. As I mentioned before our priority is obviously the first pay our dividend, we have a 45 or 46 year history of paying a dividend and that right now is about a 40% payout ratio and a very nice yield at these lower prices. After that we would prefer to build the business with our cash but lastly if we don’t think there’s value creating business building activities we always look to the next use of cash to do something else to return value to shareholders like share repurchases but I can’t tell you what our plans would be until we exhaust current plan then see what the outlook is for the future.
Catherine Arnold - Credit Suisse: I’d like to ask you about your Hepatitis franchise and for Telaprevir could you comment on if you’re filing strategy in terms of treatment duration and approach and the timing of that versus the United States and Vertex plans and then your follow on product obviously the one today benefit is something that would be very attractive versus Telaprevir. Is there going to be a similar back bone therapy there, anything else unique about that molecule that we should know about?
Paul Stoffels: With regard to Telaprevir everything is on track there and in line with what Vertex is telling. We have a common development program together with Vertex and it will be based on similar data in Europe and the US. With regard to the TMC435 this phase of Hepatitis C protease inhibitors is going to be a tremendously big new market. These drugs work very well and we believe very much that there is space for more of these drugs, and 435 is a very attractive opportunity although it’s still in early development. We just finished Phase 2 data you will see them at the end of the month and we have to confirm efficacy and safety in next stages. We’ll continue with both drugs until further notice.
Catherine Arnold - Credit Suisse: Phase 2b is in the works now?
Paul Stoffels: Phase 2b is in the works for 435. We anticipate similar background therapies will continue to go for at least for a certain while. You know that there are also [noniclazides] and [niglazide] analogs in development for hepatitis C and you might anticipate that over time the background therapy for Hepatitis C might change like in HIV you will see new very potent drugs coming out of research and interferon’s they’re not that well tolerated so is any benefit of growing to highly effective combination therapy for Hepatitis C I think it will happen but it will take time.
Catherine Arnold - Credit Suisse: In the Phase 2b program do you have a lead in strategy as part of that program for [peg and rogriviran]?
Paul Stoffels: That is not yet, I will come back to you about that.
Rick Wise - Leerink Swann: Can you talk a little bit about the step pricing I think you mentioned prices were down?
Louise Mehrotra: In the US price in the quarter was $1,885 it’s down 3% sequentially and about 9% on year over year basis.
Rick Wise - Leerink Swann: You talked about cost of goods mix obviously I’m sure stents are a factor more consumer is factor. Is that all there is in the mix side? Maybe more specifics on the additional manufacturing costs is this a one quarter phenomenon you said half of it is it one quarter because at 70% again we’re sort of at a pretty low level of gross margin how should we think about gross margin going forward?
Dominic Caruso: In the quarter we did experience significant mix change and just as a reminder we obviously lost exclusivity for Risperdal in the US so that obviously impacted the quarter margin and the growth of the Consumer business obviously impacts the margin comparison. We had some manufacturing costs matters in the third quarter. They may continue a little bit in the fourth quarter through the rest of the year. We’ll handle these matter, our teams know what to do but they may be a little bit more costly to us and that’ why we’ve indicated that some of the gains we’ve experienced may be offset not only investment opportunities but other actions we have to take to shore up operations.
Rick Wise - Leerink Swann: Can you be more specific about where?
Dominic Caruso: No, I’d rather not be more specific now.
Rick Wise - Leerink Swann: You highlighted the new credit facilities did rates change does that occur because of the environment or you’re renewing it similar rates?
Dominic Caruso: The credit facilities I referred to are back up credit facilities to our Commercial paper line so we’ve not actually used these credit facilities we’ve actually just accessed Commercial paper and as I said we continue to have access to Commercial paper in the market and I would call the rates today very, very attractive.
David Roman – Morgan Stanley: On the Pharma business could you give us an update on Velcade and non-Hodgkin’s where we are, I think you already got positive recommendation from the European agency and then secondly on Ceftobiprole Theravance and RP announced this morning that they would expect panels for their hospital based drugs.
Chris Poon: On Velcade we’re still underway with pursuing more indications for Velcade; non-Hodgkin’s is one of them. We don’t have any more update other than that. We did get an approval for front line multiple myeloma that might be what you’re thinking about.
Paul Stoffels: On Ceftobiprole we anticipate that today with all the new NCEs and important additional indications that we will get advisory panels at the FDA so we anticipate that Ceftobiprole will have an advisory panel although we don’t know yet.
David Roman – Morgan Stanley: On spine the 7% reported growth could you tell us what that was in the US, it actually looks like that’s getting a little better is that confidence that’s driving the growth there or is there something else in the numbers?
Louise Mehrotra: For the spine growth in the US was 5% and OUS was 12% to come up to the 7%.
David Roman – Morgan Stanley: That 5% is an acceleration over last quarter is the driver confidence?
Louise Mehrotra: Some of it would be the confidence as well as strength in the business as well.
Operator: There are no further calls.
Dominic Caruso: Before we close the meeting I would like to thank Chris and Paul for the overview of some of the exciting opportunities in our Pharmaceutical business today. I think they outlined very well how some of our compounds are progressing in our pipeline. We continue to execute against these and other key priorities that are critical to improving patient care and meeting customers needs across our broad base of healthcare businesses. We’re also innovating and building leadership positions across our businesses while continuing to grow profitably all the while managing our costs and improving our operating margins. These successes are realized thanks to the excellent work and dedication of the extraordinary people across the Johnson & Johnson family of companies. Thank you for your continued support of Johnson & Johnson and I look forward to updating you in January on our full year 2008 results. Thanks and have a great day. | [
{
"speaker": "Executives",
"text": "Louise Mehrotra - Vice President, Investor Relations Dominic Caruso - Vice President, Finance and Chief Financial Officer Chris Poon - Vice Chairman, Board of Directors and Worldwide Chairman Pharmaceuticals Group Paul Stoffels - Company Group Chairman, Global Research and Development Pharmaceuticals Group"
},
{
"speaker": "Analysts",
"text": "Rick Wise - Leerink Swann Matt Dodds - Citigroup Seth [Diverga] – Deutsche Bank David Roman – Morgan Stanley Catherine Arnold - Credit Suisse"
},
{
"speaker": "Louise Mehrotra",
"text": "Welcome, I’m Louise Mehrotra, Vice President of Investor Relations for Johnson & Johnson and it is my pleasure this morning to review our business results for the third quarter of 2008. Joining me on the podium today are Chris Poon, Vice Chairman, Board of Directors and Worldwide Chairman, Pharmaceuticals Group, Paul Stoffels, Company Group Chairman, Global Research and Development Pharmaceuticals Group and Dominic Caruso, Vice President, Finance and Chief Financial Officer. Also joining us today in the audience is Sheri McCoy, Worldwide Chairman, Surgical Care Group. As we announced last week, effective January 1, 2009, Sheri will assume the role of Worldwide Chairman, Pharmaceuticals Group. A few logistics before we get into the details, the audio and visuals from these presentations are being made available to a broader audience via a webcast accessible through the Investor Relations section of the Johnson & Johnson website. I’ll begin by briefly reviewing highlights of the third quarter for the corporation and highlights for our three business segments. Following my remarks, Dominic will provide additional commentary on the results for the quarter and guidance for the year. Chris and Paul will then provide an update on our Pharmaceuticals Business. We will then open the floor to your questions. We will conclude our formal presentation at approximately 9:30 am and following Q&A with some final remarks by Dominic we’ll conclude the meeting around 10:00 am. Distributed with the copy of the press release that you just received is a schedule with actual revenues for major products and/or business franchises. For the listening audience these are available on the Johnson & Johnson website as is a copy of the press release. Before I get into the results, let me remind you that some of the statements made during this presentation may be considered forward looking statements. The 10-K for the fiscal year 2007 identifies certain factors that could cause the company’s actual results to differ materially from those projected in any forward looking statements made this morning. The company does not undertake to update any forward looking statements as a result of new information or future events or developments. The 10-K is available through the company or online. The Pharmaceutical Group presentation contains statements about new molecular entities or NMEs and other medicines or line extensions in various stages of development. These presentations are based on the company’s current knowledge of the status of development of the NMEs, medicines and line extensions and are subject to the challenges and difficulties inherent in product development. Not every compound highlighted today will make it to the market. In Biopharmaceuticals there are higher possibilities of encountering infringement claims by competitors with respect to patents or other intellectual property rights. The company does not undertake to update any forward looking statements as the result of new information or future development. Last item, during the call, non-GAAP financial measures may be used to provide information pertinent to ongoing business performance. These measures are reconciled to the GAAP measures and are available on the Johnson & Johnson website. Now I would like to review our results for the third quarter of 2008. If you would refer to your copy of the press release, let’s begin with the schedule titled supplementary sales data by segment of business. Worldwide sales to customers were $15.9 billion for the third quarter of 2008, up 6.4% as compared to the third quarter of 2007. Our operational growth was 3.3% and currency added 3.1 points. If you turn to the schedule showing sales by geographic area, you will see that we achieved growth of 0.4% in the US. In regions outside the US our operational growth was 6.5%, while the effect of currency exchange rates positively impacted our reported results by 6.6 points. Our strongest performing region was the Western Hemisphere excluding the US which grew 15.3% on an operational basis. The Asia/Pacific/Africa region grew by 11.3% operationally while Europe grew 1% operationally. If you will now turn to the consolidated statement of earnings, net earnings on a reported basis were $3.3 billion and earnings per share were $1.17. This compares to $2.5 billion and $0.88 in the same period in 2007. Please direct your attention to the box section of the schedule where we have provided adjusted earnings information. As referenced in the footnote, third quarter 2007 were adjusted to exclude the after-tax impact of the cost associated with the restructuring program of $528 million. There were no adjustments to the 2008 results in the quarter. Net earnings on an adjusted basis and earnings per share were up 7.6% and 10.4% respectively versus the third quarter of 2007. I would now like to make some additional comments relative to the components leading to the adjusted earnings before we move on to the segment highlights. Cost of goods sold at 30% was up 150 basis points versus the same period in 2007. Approximately half of the increase is due to changing mix within our businesses while the remaining half is due to additional costs incurred in our manufacturing operation. Selling, marketing, and administrative expenses of 32.6% of sales were down 10 basis points versus last year. Cost containment efforts more than offset the impact of the change in mix of our business driven by the strong growth of the consumer business. Our investment in research and development as a percent to sales was 11.7%, 60 basis points less than the third quarter of 2007 due to a combination of the change of mix of businesses and the timing of expenditures. Interest expense net of interest income of $25 million compares to $52 million of net interest income in the third quarter of 2007. This increase in expense was due to a higher average debt position in the quarter versus the same period last year as we continue buying back shares as part of our repurchase program. Other income net of other expense was $224 million in the third quarter of 2008 compared to $2 million of net other expense in the same period last year. As discussed last quarter, we received a settlement payment Amgen for $200 million which is reflected in this account. With regard to taxes please direct your attention to the effective tax rate excluding special charges shown in the box section of the schedule. Taxes were 22.8% in the third quarter of 2008 versus 23.3% in the third quarter of 2007. Dominic will provide more commentary on taxes in his remarks. Looking at year to date data consolidated sales to customers for the nine months of 2008 were $48.6 billion an increase of 7.6% as compared to the same period a year ago. On a year to date basis operational growth was 3% and currency had a positive impact of 4.6 points. On the consolidated statement of year to date earnings I’d first like to draw your attention to the box section. In both 2008 and 2007 charges for in process research and development have been excluded. Additionally, in 2007 the costs associated with the restructuring program have been excluded. With these adjustments net earnings for the nine months of 2008 were $10.3 billion or $3.61 per share up 7.7% and 10.4% respectively as compared to the same period in 2007. Turning now to business segment highlights, I’ll begin with the consumer segment. Worldwide consumer segment sales of $4.1 billion increased 13.1% as compared to the third quarter of 2007. Operational growth was 9.4% while currency added 3.7 points. US sales were up 11.2% while international sales grew 8.1% on an operational basis. For the third quarter of 2008, sales for the over the counter pharmaceuticals and nutritionals increased 11% on an operational basis compared to the same period in 2007. Sales in the US were up 19% while sales outside the US were up 3% operationally. The successful US launch this year of Zyrtec was a major contributor to this increase. Our skin care business achieved operational sales growth of 12% in the third quarter of 2008 with sales in the US growing at 15% and sales outside the US up 10% on an operational basis. Strong growth was driven by Neutrogena, Clean & Clear, Aveeno and Johnson’s Adult, due to a combination of new product launches and strength in the core businesses. Also contributing to the strong growth in the quarter were the newly acquired products from Dabao the leading moisturizer in China. Baby care products achieved operational growth of 9% when compared to the third quarter of 2007. Sales in the US grew by 1% with some softness in category growth. Strong growth across most product lines resulted in an operational increase in sales outside the US of 12%. Women’s health achieved operational growth of 6%. Sales in the US were up 10% due to the successful launch of the new products in our KY line. Sales outside the US were up on an operational basis by 3%. Operational sales growth in the oral care franchise was 7% with US sales down 3%. A significant new product launch in the third quarter 2007 impacted the US growth comparisons for the quarter. Sales outside the US increased 18% operationally driven by very strong growth for Listerine across the major regions. That completes our review of the Consumer segment and I’ll now review highlights for the Pharmaceuticals segment. Worldwide net sales for the third quarter of $6.1 billion were up 0.2% versus the same period last year. On an operational basis, sales were down 2.5% with positive currency adding 2.7 points. Sales in the US decreased 6% while sales outside the US increased on an operational basis by 3.3%. Our results continue to be impacted by generic competition on some of our products, namely Duragesic, and Risperdal Oral. The combined effect of this generic competition has reduced the third quarter Worldwide Pharmaceutical operational sales growth rate by approximately 11 points with the US impact estimated at 13.5% and the impact outside the US estimated at nearly 8%. As we have previously reported we saw a continued retraction in the US market for Erythropoietin Stimulating Agents or ESAs. This retraction has impacted the overall Pharmaceutical growth rate by approximately 2 points. Additionally, in the third quarter sales results outside the US were favorably impacted by a reduction to a reserve for sales of approximately $135 million related to Concerta. The majority of the reserve had been recorded as a reduction to sales in prior years. Excluding the negative impact of generics and the lower sales of Procrit and the positive impact of the reserve reduction the underlying operational sales growth was estimated at 8%. Now reviewing the major products, both Procrit and Eprex declined operationally by 12% during the quarter as compared to the same quarter last year. New competition and softening of the market due to ongoing labor reviews have contributed to the lower sales results for Eprex. Procrit results have been impacted by a decline in the market versus the third quarter of 2007, estimated at 18%, partially offset by an increase in overall market share. Procrit aggregate share across all markets was approximately 48% in the third quarter of 2008, up 3 points versus the same period last year. Sales of Levaquin our anti-infective were down 10% on an operational basis when compared to the same period a year ago. The script volume in the market was down approximately 5% versus the third quarter of 2007 attributable to a lower incident of respiratory illnesses. Market share was negatively impacted by generics in the category. Risperdal Oral had an operational decline of 63% when compared to the same period a year ago. Sales in the US were down 77% while sales outside the US declined 38% operationally. With the patent expiration in the US at the end of June this year there are now generic competitors for Risperdal in most markets. AcipHex, as it’s known in the US market, and Pariet outside the US is a proton pump inhibitor, or PPI, that we co-market with Eisai. On an operational basis, sales were down 19%. US sales were down 18% and the sales outside the US were down 20% operationally. In the US, script share has been negatively impacted by additional generic launches in the PPI category. Similar market dynamics impacted sales outside the US, compounded by the impact of market entry in Canada of generic Rabeprazole, the active ingredient in Pariet. Now moving on to our growth drivers, Remicade, a biologic approved for the treatment of a number of immune mediated inflammatory diseases, grew by 19% when compared to the third quarter of 2007. Sales growth in the US was 20%. Market growth in the Anti-TNF category continued to be strong. Sales to our customers for markets outside the US were up 16%. As we reported in the first quarter there was a significant increase in sales outside the US due to timing of shipments reflecting inventory planning on our customer’s part. Both the second and the third quarter sales were impacted as the majority of the inventory build was depleted. Excluding the estimated change in inventory levels, sales outside the US were more in line with estimated increase in demand of approximately 30%. Sales of Topamax, which is approved for the treatment of epilepsy and migraine prophylaxis, increased operationally by 18%. Sales in the US were up 22% while sales outside the US were flat on an operational basis. In the US, market share in the migraine category increased versus the same period last year. Outside the US, strong growth was achieved in many markets, offset by generic entries in certain other markets. Risperdal Consta, our long acting injectable formulation, achieved third quarter sales growth of 10% on an operational basis. US sales growth was 6% ahead of the estimated market growth. Sales outside the US were up 12% operationally with continued positive momentum and share. Concerta, a product for attention deficit hyperactivity disorder, grew 66% operationally in the third quarter as compared to the same period last year. As mentioned, sales results outside the US included a reduction to a reserve for sales of approximately $135 million related to Concerta. Excluding this reserve sales were up approximately 12% operationally, with sales in the US were up 7% and sales outside the US up 28% operationally. In the US continued solid market growth has been partially offset by lower market share. The approval earlier this year of the Adult Indication for Concerta will enable us to compete in the broader ADHD market. Velcade, a treatment for relapsed multiple myeloma, is being co-developed with Millennium Pharmaceuticals. We have commercialization rights in Europe and the rest of the world outside the US. Operational sales growth was 37%, with very strong results achieved across the regions. Wrapping up the review of the pharmaceutical segment, a manufacturing supplement SNDA for [Iopsis] previously submitted to the FDA did not gain approval. We are continuing the evaluation of a next generational system. Additionally, in the quarter the EU filing for Invega for Bipolar mania was submitted. I’ll now review the medical devices and diagnostic segment results. Worldwide medical devices and diagnostic segment sales of $5.7 billion grew 5.6% operationally as compared to the same period in 2007. Currency added 3.2 points to the sales growth to bring total growth to 8.8%. Sales in the US grew 3.1% while sales outside the US increased on an operational basis by 8%. Results have been impacted by lower sales of drug eluting stents. Sales excluding the impact of lower sales of drug eluting stents grew nearly 8% operationally. Now turning to the franchises, starting with Cordis; Cordis sales were down 10% operationally with the US down 26% and sales outside the US up 4%. Cordis results were impacted by lower sales of Cypher, our Sirolimus-eluting stent, and endovascular products partially offset by strong growth in our Biosense Webster business. Cypher sales were approximately $290 million down 26% on an operational basis versus the prior year. Sales in the US of approximately $100 million were down 47%. In comparison to the third quarter of 2007 the US drug eluting stent market growth is estimated at 15%. Penetration rates are estimated at 70% up from 63% a year ago while PCI procedures are up approximately 8% in the quarter versus the same period last year. These gains have been partially offset by a reduction in price. Estimated share in the US of 22% was down 15 points sequentially and down 22 points from the third quarter of 2007 due to the market entry of two new competitors in 2008. Sales outside the US of approximately $190 million declined 6% operationally. The estimated market share in the quarter of 30% was flat on a sequential basis and down 4 point from the third quarter of 2007. Increased competition has impacted the share outside the US. Cypher estimated worldwide share for the quarter was 27%, down 6 points sequentially and down 11 points from the third quarter of 2007. Endovascular sales declined due to a combination of the recall of a reentry catheter and increased competition in multiple segments. Now, turning to growth drivers within the Cordis franchise, the Biosense Webster business, our electro-physiology business, achieved double digit operational growth in the quarter driven by increased system placements as well as growth in catheter products. Our DePuy franchise operational growth of 8% when compared to the same period in 2007 with the US growing 7% and the business outside the US growing by 10% operationally. Hip growth on a worldwide basis was 12% operational, with strong growth in both the US and International businesses. On an operational basis, worldwide knee growth was 4% while spine grew 7%. Mitech, our sports medicine business, grew 12% operationally. Ethicon Endo-Surgery achieved operational growth of 10% in the third quarter of 2008, with the US sales growing 8% and sales outside the US growing on an operational basis by 11%. The Harmonic business achieved operational growth of nearly 20% due to the global success of the recently launched products and the underlying strength of this platform. Also contributing to the growth in the quarter was the realized gastric band launched earlier this year in the US and the strong performance of the endoscopy products and the strong performance of the endoscopy products in the international markets driven by increased awareness of the benefits of minimally invasive procedures as well as the metabolic benefits of obesity surgery. Ethicon worldwide sales grew operationally by 5% with similar results both in and outside the US. Solid growth in sutures and strong double digit growth in homeostasis and bio-surgical were the major contributors to growth in the quarter. The diabetes franchise grew operationally by 10% in the third quarter of 2008. The US business grew by 9% while sales outside the US grew 12% on an operational basis. The success of the One-Touch Ultra line has been the major contributor to growth. Additionally, the Animas business achieved operational growth of over 30% driven by continued market share gains in the pump business. Our Vision Care franchise achieved operational sales growth of 9% in the third quarter compared to the same period last year. Sales in the US increased 10%. Sales outside the US grew 8% on an operational basis. Acuvue Oasys, One-Day Acuvue Moist and Acuvue Lens for were the major growth drivers in the quarter. Rounding out the review of the medical devices and diagnostic segment, Ortho-Clinical Diagnostics achieved operational growth of 9% in the third quarter. Sales growth in the US was 11% while sales outside the US were up 6% on an operational basis. Immunohematology and immunodiagnostics products achieved double digit results. That completes highlights for the medical devices and diagnostic segment and concludes the segment highlights for Johnson & Johnson's third quarter of 2008. I’ll now turn the discussion over to Dominic Caruso for some additional comments."
},
{
"speaker": "Dominic Caruso",
"text": "I’d like to add my own welcome to members of the investment community who have joined us here today and to those who are listening via the webcast and conference call. We are very pleased today to report solid financial results for the third quarter. Our performance once again demonstrates how we are successfully managing the business through some short term business pressures while continuing to advance our key growth initiatives. In the face of the recent financial market volatility we remain confident in our ability to continue investing in the future growth of our business while maintaining a strong balance sheet and generating strong cash flows. Louise has already reviewed the segments results for you so I will mention some financial updates, highlight a few of the recent business developments in the quarter and discuss our financial guidance for the year before handing things over for a more detailed pharmaceutical update. Our sales results for the quarter were above the mean of the analysts estimate thus published by First Call. We also delivered another strong earnings performance for the quarter also above the mean of the analysts estimates published by First Call. We continue to implement the cost restructuring program that we announced last year and as I noted on our second quarter call we are on track to achieve annual cost savings of approximately $1.6 billion for 2008 which is at the higher end of our previous guidance. Now a brief update on our share repurchase program. This $10 billion share repurchase program as you recall began in August 2007 and as of the end of September we have purchased approximately $7.4 billion of our stock. Our share repurchase program along with our dividends continue to illustrate our commitment to returning value to our share owners while maintaining a strong financial position that provides the flexibility to invest in business building activities. This quarter we continue to make investments and take actions to drive the future growth of our business. Chris and Paul will provide highlights for our Pharma business so I’ll just mention some highlights for MD&D and Consumer. In our Medical Devices and Diagnostics business we saw strong performances across six of our seven franchises driven by solid sales in our DePuy, Ethicon Endo-Surgery and Ethicon Surgical businesses as well as the Ortho-Clinical Diagnostic, Vision Care and Diabetes Care businesses. With new competitors in the US Drug-eluting stent market the Cordis business has seen a negative impact to sales of Cypher as we expected. Meanwhile progress in other parts of the Cordis business looks promising. The development of the Nevo Sirolimus-eluting Coronary Stent is ongoing and the Biosense Webster continues to grow at double digit rates. In the Consumer segment this quarter and as part of our focus on emerging markets we acquired Beijing Dabao Cosmetics, one of the most trusted skin care brands in China. Johnson & Johnson has been doing business in China since 1985 and Dabao marks our first acquisition in this market. Our work with Dabao and its employees has already enhanced our knowledge of this critical marketplace and we look forward to further developing this brand for the future. Our Consumer business continued to see strong results from our allergy treatment Zyrtec which first became available without a prescription in stores across the US in January of this year. By the end of June, Zyrtec had captured approximately 26% of the US allergy market since its launch. Meanwhile, the integration of the Pfizer Consumer Healthcare business and brands continues to be on track to meet or exceed our target of $500 to $600 million of cost synergies by 2009 and we still expect this transaction to be break even or modestly accretive by 2009 one year ahead of the original schedule. I’d like to update you where we are with a few brief items related to some recent activities. First, I’m pleased to inform you that Ethicon has now entered into a definitive agreement to sell its Professional Wound Care business to One Equity Partners. We have previously announced the receipt of One Equities offer in July and have been working through the process since that time. The guidance that I will discuss today does not reflect any gain from the divestiture of this business which is expected to close in the fourth quarter pending satisfaction of all closing conditions. This divestiture is en essence a decision to reshape our portfolio. We expect any gain from this sale to be largely offset by increased investment spending or other actions. This anticipated gain affords us an opportunity to make additional investments and to consider other business decisions to enhance our longer term performance and financial condition. We also received good news recently regarding long standing patent litigation between our Cordis business and both Boston Scientific and Medtronic. On September 30, the US District Court in Delaware entered a final judgment of about $1.2 billion including accrued interest. It is too early to say when we will receive these payments given the possibility of appeals. Interest will continue to accrue until paid. As has been our practice we will not record any gain from these judgments until the cash is received and we expect to record such gains as special items. Any potential impact is not reflected in today’s guidance. I would like to provide you some comments for you to consider as you refine your models. Let’s start with a discussion of cash and debt as well as interest income and expense. During the third quarter of 2008 the company continued to generate strong cash flows. At the end of the third quarter we had approximately $150 million of net cash. This consists of approximately $14.8 billion of cash in investments and $14.6 billion of debt. This is an increase of approximately $400 million in our overall net cash position from year end 2007. This reflects our strong operating cash flow and the use of approximately $3.8 billion to repurchase our stock so far this year. Given the recent developments in the financial markets I’d like to share with you some important points about Johnson & Johnson. In our Corporate Investment Portfolio we had no exposure to sub-prime market or the financial services companies that have failed as a result of the recent credit crisis. We continue to have ready access to the Commercial paper market at attractive rates. At the end of September we renewed our expiring 364 day credit facility for $6.3 billion and signed a new five year credit facility for $1.4 billion to replace an existing one, both of which has Triple A credit ratings affirmed. These facilities are part of our continuous effort to maintain our financial strength and flexibility. Regarding interest income and expense, for purposes of your models, assuming no major acquisitions and considering the continuation but not full completion of the share repurchase program during 2008, I would suggest you consider modeling net interest expense between $50 and $100 million of net interest expense consistent with our previous guidance. Turning to other income and expense, as a reminder, this is the account where we record royalty income as well as one time gains and losses resulting from such items as litigation, gains or losses from investments by our development corporation or asset sales. The gain associated with the Amgen settlement is recorded in this account. Assuming no other major one time gains or losses I would recommend that you consider modeling other income and expense for 2008 as a net gain ranging from approximately $350 to $400 million. This is higher than our previous guidance but the impact will be more than offset by higher expenses in other line items as you saw some of this, this past quarter, due to actions taken or investments made with such funds. Now a word on taxes, year to date the company’s effective tax rate was 23.6% reflecting adjustments made in the third quarter resulting from the finalization of our federal return. As you are aware, the R&D tax credit extension was passed by Congress earlier this month. Our guidance has been updated to reflect this. The full impact of the R&D tax credit for 2008 will be recorded in the fourth quarter. Therefore we would suggest that you model our effective tax rate for 2008 in the range of 23% to 23.5% would not include any in process research and development charges or other special items. As always, we will continue to pursue opportunities in this area to improve upon this rate for the balance of the year. Turning to sales, we would be comfortable with your models reflecting operational sales growth for the full year 2008 at the higher end of our previous guidance of 1% and 2% or even slightly higher. As you know currency rates are difficult to forecast. While we are not predicting the impact of currency movements on our sales to give you an idea of the potential impact of currency rates were to stay where they are today through the end of this year then our sales growth would be favorably impacted by approximately 3%, resulting in total reported sales growth for the year of approximately 5% versus our prior guidance of 5.5% and 6.5%. This reflects stronger operational sales growth which is more than offset by the negative impact of currency. This is a significant change in currency from our previous guidance. For example, at current rates the fourth quarter impact of currency would reduce sales by approximately 1.5%. That’s compared to an implied 3.5% of growth based on currency at the time of our second quarter earnings call. This 5 point swing in currency would obviously have a resulting negative impact to earnings in the fourth quarter. Although we don’t normally comment on the following year with respect to guidance the impact of the stronger dollar could have on our results is something I would like to highlight for you as you refine your models. If the Dollar/Euro rates were to remain the same as today for all of 2009 the impact to next years sales due solely to currency would be a reduction to sales of approximately 3% to 3.5%. Now for earnings, when I last checked the first call mean estimate for our EPS for full year 2008 was $4.51 per share. Despite the potential impact of currency in the fourth quarter that I just outlined and taking into consideration the strength of our operating performance this past quarter and the items I have outlined for you we would be comfortable with your models reflecting full year 2008 earnings per share excluding in process research and development charges or other special items of between $4.50 and $4.53 per share, an increase from our previous EPS guidance range. That concludes my update on our operating performance this quarter and guidance for 2008. Let’s move on now to the next portion of our program today. Last year many of you joined us in New Brunswick for a full day review of our Pharmaceutical and Consumer businesses. Today we look forward to providing you with an update on our Pharmaceutical business and some of the pipeline highlights we described for you then. We typically provide these brief business updates every October as part of our ongoing effort to keep you informed about our long term strategy and prospects for growth. We have the most robust pipeline in our history and continue to see progress on several of our lead space compounds which will be discussed today. I’m very pleased this morning to have Chris Poon with us, my colleague on the Executive Committee of Johnson & Johnson. As you know, Chris is Vice Chairman of Johnson & Johnson and Worldwide Chairman of our Pharmaceutical Group. Chris and the Pharmaceutical leadership team have been continuing to invest in key pipeline compounds and major line extensions that will drive our long term growth while creating a more efficient and cost effective operation that addresses short term pressures. Joining Chris today is Paul Stoffels; Paul is Company Group Chairman of Global Research and Development for the Pharmaceutical Group. He will speak to you today about some of the latest developments in some of our promising pipeline compounds, Rivaroxaban, Paliperidone Palmitate, Golimumab, and Ustekinumab. At the end of Chris and Paul’s presentations we look forward to taking your questions. Before I hand over the podium to Chris, I would like to thank her on behalf of Johnson & Johnson for her dedication and commitment to bringing health and wellbeing to people around the world. Chris recently announced her plans to retire from Johnson & Johnson in March 2009. We will miss her leadership as we move forward with the business platforms, pipeline and talent she has fostered across the organization. Few in healthcare today have so successfully combined a passion for business with a mission of transforming patient’s lives as Chris has. We wish her the best of luck in the next chapter of her life. Now for the Pharmaceutical update."
},
{
"speaker": "Chris Poon",
"text": "It’s going to be a pleasure to discuss our Pharmaceutical business with you. We’re going to talk about our existing and exciting pipeline and our research and development strategy that underlies our success. As Dominic and Louise mentioned, Paul will also be here and he’s going to also give us progress not only on some of our pipeline compounds but also give you a glimpse of some of the compounds in earlier development. First let me set the stage, the Johnson & Johnson Pharmaceuticals Group is a leader among the worldwide pharmaceuticals companies ranking 6th based on annual sales. The ranking in size and growth has been achieved through a combination of organic internal growth as well as selective licensing areas of strategic interest. It’s also important to note that at the end of 2007 Johnson & Johnson ranked third largest among biotech companies. This biotech market continues to be an important source of growth for us. Biotech expertise in the industry is driven because of our capabilities through the entire value chain. Our R&D capabilities in monocle antibodies pioneered at Centocor are significant and are transferable to the next generation biologics. We have unmatched bio-manufacturing expertise and capacity actually dating back to the very early years of biotech and Centocor’s first plant in the Netherlands 25 years ago. Throughout 2008 there have been several key compounds providing strong sales growth in our inline portfolio of medicines. The strong growth of these compounds continued in the third quarter fueled in some cases by new indications and in others by approvals in additional markets. Let me touch on a few of these; first Velcade. It continues its high sales growth and tremendous success with a 44% increase year to date versus prior year. Your call that Velcade was granted approval in June of this year for front line use in multiple myeloma in the EU. More approvals of multiple myeloma front line during the third quarter bring the total number of countries to 47 that’s up from less than 20 at the end of the second quarter. Our anti-psychotic franchise consists now of two growth products. Risperdal Consta continues its strong performance with sales growth of 11% versus the third quarter 2007 year to date and for Consta we’re pursuing additional indications in bipolar disorder and we expect to hear more about these indications next year. In addition, Invega contributed growth of 135% year to date. Remicade continues its strong sales growth after 10 years on the market delivering 18% growth and maintaining market share of about a third of the anti-TNF market. Concerta’s new adult indication just received in July has helped Concerta to continue its strong sales growth for the year to date figure of 10%. Prezista continues it’s success fueled by the availability of Intelence which received marketing approval in January of this year in the US and recently in the EU. With this breadth and depth of our growth products has enabled us to lessen the impact of generic competition and the slower sales of Procrit while our newer products that are still in launch mode continue to gain footing in their respective markets. Not only do we think about products we also think about markets and so let me give you a glimpse of some of our performance in our emerging markets. This focus on emerging markets what we call the brick countries; we continue to see considerable growth in the third quarter. This is the result of several launches of new products, new indications and of course increased investments to expand our sales forces in these selective markets. We continue to maximize our current portfolio and pursue new indications for our existing products. A few of the major line extensions that we have either filed or received approval for thus far in 2008 are shown here. I’ve already mentioned Concerta an adult ADHD. Topamax’s pediatric exclusivity approval this now extends the marketing exclusivity of Topamax until March 2009. Doribax we received approval in the EU for urinary tract infections, intra-abdominal infections and NP infections. I just mentioned Velcade for front line approval in the EU for multiple myeloma and just last Wednesday we received approval for a new injection site for Risperdal Consta a deltoid injection site. You can see how busy we’ve been this first half of this year with the major line extension approvals but also with some additional filings. We filed Risperdal Consta and bipolar mania, Invega for bipolar mania in the EU, Doxil for metastatic breast cancer and Prezista for early experience patients in the EU. I think you can see why we’re optimistic about our short and long term prospects for end market products and our pipeline. This slide shows some of the key strategic drivers we believe position us well into the future. To summarize, here are some of the key attributes of our pharmaceutical group. We have an experienced leadership team. As Louise mentioned, Sheri McCoy will be assuming the role of Worldwide Chairman for the Pharmaceuticals business. Sheri is a demonstrated leader, a close colleague and her breadth of experience helps position Johnson & Johnson well for the future. Sheri inherits a leadership team that is one of the most highly experienced, dedicated with impressive track records and I do believe that our Pharmaceutical group is in fantastic hands with Sheri’s leadership. As you’ve seen we have a diverse well balanced portfolio that includes a broad range of therapeutic areas with high end met needs and we have a robust late stage pipeline and are poised for several key product launches. Our early state pipeline is also promising. It’s important we continue to take actions to address the short term pressures in our business. These include the cost improvement programs that Dominic mentioned as well as organizing our R&D, our operations and our commercial organizations for growth, continuing to invest in our pipeline and ensuring that we have disciplined M&A and L&A. Let me just take a few moments to discuss our research and development strategy and to paint a picture for you of our strong capabilities and what makes us unique as an organization. We have research being conducted in seven therapeutic areas in both large and small molecule platforms. We have established global operations with end to end capabilities and we are pursuing innovative platforms and technologies in the context of a regulatory environment that is increasingly demanding, outcomes based development. This slide shows the seven therapeutic areas that are our strategic areas of interest. We are sharpening our focus in R&D on these therapeutic areas where we feel we can best play to win because we already lead in that market and/or because there continues to be a significant unmet medical need in that area. In order to accomplish our goal of a sustainable productive R&D organization we have evolved to a hybrid decentralized standardized model. The responsibility for research and early development each of the therapeutic areas remains decentralized as we believe this is the model and environment that fosters innovation and entrepreneurship. At the same time we continue to standardize or centralize certain key functions such as clinical operations, bio statistics, pharmacology, these centers of excellence or shared services provide support for the research and development activities of each of the therapeutic areas in order to reduce duplication and to leverage our scale. We believe that we’re already seeing the early results of this R&D operating model and Paul will give you a glimpse into some of the new compounds moving through the early development pipeline. We believe that sustain R&D productivity is the key to our future and we believe, therefore that our long term future remains very bright. As we’ve discussed in prior meetings here with you we expect to file between seven and 10 new products for approval between the beginning of 2008 and the end of 2010. We’re on track. Paul will talk to you today about four of these Paliperidone Palmitate, Ustekinumab, Golimumab and Rivaroxaban. In 2008 thus far we have already received marketing approval for Intelence for HIV both in the US and in the EU and we have filed in the immediate release formulation of Tapentadol for pain. Additionally, we have received an approval letter from the FDA for Ceftobiprole and have submitted complete response back to the agency. For the remainder of 2008 we remain on track to file Carisbamate for the treatment of Epilepsy and Yondelis in an oncology indication. In 2009 and 2010 we anticipate further filings for several other compounds. Now let me turn the stage over to my colleague and friend, Paul Stoffels."
},
{
"speaker": "Paul Stoffels",
"text": "It’s my pleasure today to discuss in more detail a few compounds in our late stage pipeline that we are excited about. Today’s I’ll focus on Rivaroxaban, the first oral Factor Xa inhibitor, Paliperidone Palmitate, a novel long acting anti-psychotic, Golimumab human anti-TNF therapy that holds a lot of promise and Ustekinumab a first in class mechanism of action for moderate to severe plack psoriasis. I’ll also spend a few minutes highlighting a few key compounds in our early development pipeline. Let me begin with Rivaroxaban, our once daily oral direct Factor Xa Inhibitor. We are very excited about this compound which we are co-developing with Bayer. Rivaroxaban is initially being developed for prevention of VTE in patients undergoing hip or knee replacement surgery. A larger opportunity is with additional indications for VTE treatment, for SPAF and secondary prevention in patients with ACS. For VTE prevention we filed for approval with the FDA in July based on outstanding data from the Records Clinical Program in which more than 12,500 orthopedic patients have been investigated. This is the largest program ever conducted in VTE prevention in patients undergoing knee or hip replacement surgery. It comprised four pivotal phase three clinical trials that compared Rivaroxaban with Enoxaparin the current standard of care. Rivaroxaban demonstrated superior efficacy in the record program. This included head to head comparisons with Enoxaparin and a comparison of extended duration Rivaroxaban with short duration Enoxaparin. In each of the four trials Rivaroxaban and Enoxaparin demonstrated similar safety profiles and low rates of major bleeding. Details about all of these trial designs are available on ClinicalTrials.gov. Last month, Bayer Healthcare announced that Health Canada was the first country to approve the drug for VTE prevention. In addition, earlier this month, Bayer Healthcare announced the European Commission granted approval to market Rivaroxaban for VTE prevention in adult patients who have undergone elective total hip and knee replacement surgery. We will be presenting our Phase II dose finding results from our studies of Rivaroxaban in ACS at the American Heart Association meeting in November. In addition, we plan to present our pooled Record 1-4 data at the ASH meeting in December. This slide summarized the results of the Record 4 study which we presented in May. This was the first head to head study comparing Rivaroxaban at 10 mg once daily dose with Enoxaparin at 30 mg twice daily which is the FDA approved dosing regiment for Enoxaparin in this patient population. By contrast, the Record 1, 2 and 3 studies compared Rivaroxaban against Enoxaparin dosed once daily at 40 mg. In this study Rivaroxaban was superior to Enoxaparin in preventing VTE in patients who underwent total knee replacement surgery. Patients showed a statistical significance 31% reduction in relative risk of total VTE events compared to Enoxaparin. Total VTE events which was the primary end point was defined in the study as the composite of all deep vein thrombosis non-fatal pulmonary embolism and all cost mortality. Rates of major bleeding, the main safety end point while numerically greater in the Rivaroxaban treated patients were low in both treatment groups. Rivaroxaban was initially being developed for VTE prevention and there is a robust development program evaluating Rivaroxaban in several critical underserved areas where a drug with these properties can have a positive benefit to patients. In the trials show on this slide as well as in early completed studies approximately 50,000 patients are expected to be enrolled in the Rivaroxaban clinical development program. This includes trials in the prevention and treatment of a broad range of clotting disorders. These trails, done in collaboration between Bayer and J&J include four Phase III clinical programs in VTE prevention in orthopedic surgery, VTE treatment, stroke prevention in patients with atrial fibrillation, VTE prevention in hospitalized medically ill patients and a Phase II study in secondary prevention in patients with acute coronary syndrome. In summary, we are very excited about Rivaroxaban. We believe that Rivaroxaban’s combination of an exceptional efficacy and balanced safety provides a compelling and positive risk benefit profile that can help improve patient’s outcome. Let’s now look at Paliperidone Palmitate which represents the first atypical long acting injectable antipsychotic with monthly dosing. Paliperidone Palmitate uses a novel technology to deliver daily medication over a one month period. We believe this is a significant advantage in antipsychotic therapy. The monthly dosing schedule may enhance compliance and provide pharmical economic value by reducing the number of patient visits, hospitalization and recurrence which the drivers of increased healthcare costs. The advanced particle formulation allows storage at room temperature while the pre-filled syringes with smaller gauged needs can be administered through deltoid and gluteal injections. Palmitate is initially being developed for schizophrenia and we are considering a bipolar program in early 2009. We filed the US NDA for Palmitate for treatment of schizophrenia at the end of 2007. We presented data from those pivotal studies at the APA meeting in May and we have conducted comparative trials between Consta and Paliperidone Palmitate one of which is completed and one ongoing. As I mentioned, Palmitate uses a novel delivery technology and as with the lobe of novel technologies you learn as you conduct more clinical trials about how best to use this technology. One of the things we have learned from the first comparative trial with Consta is that we can get much more consistent efficacy with Paliperidone Palmitate across broad populations of patients with higher initiation dose. We used this higher initiation dose in a placebo controlled study and found that this dosing regiment demonstrated strong efficacy and excellent tolerability. We are now using this dosing regiment in a second comparative trial with Risperdal Consta which is ongoing. We have submitted data from the first comparative trial against Consta with a lower initiation dose as well as the data from the placebo controlled study with the higher initiation dose for presentation at ACNP a major medical meeting in December. We anticipate results from the final comparative clinical trial with the higher initiation dose of Paliperidone Palmitate versus Consta next year. As I previous indicated we filed an NDA for Palmitate in Schizophrenia late last year and received a complete response from the FDA in August regarding our NDA. The complete response outlined additional information needed before FDA would approve the application including a re-analysis of a subset of the data. No additional studies were requested. Given what we have learned about a higher initiation dosing providing an optimal level of patient outcome we plan to include this new dosing in a response submission to the FDA. We are in the process of preparing that data and anticipate the data will be ready to submit in the first half of 2009. Based on the new information to be submitted we believe that this will be a six month review. Let me now turn to Golimumab, the first human anti-TNF therapy currently filed in the European Union and the United States. We believe that Golimumab will offer excellent efficacy and best class dosing. The subcutaneous dosing will be single monthly injection. This compares favorable to competitor regiments ranging from two injections each week to one every two weeks. Our state of the art auto-injector is also a differentiating factor and Golimumab had a very low rate of injection site reactions in the clinical trials. We have filed for three indications simultaneously enabling us to efficiently and rapidly build a safety data base in support of Golimumab. We filed an MAA in Europe in the first quarter of 2008 and submitted a US filing in June 2008 for subcutaneous therapy for signs and symptoms of Rheumatoid Arthritis, Ankylosing Spondylitis, and Psoriatic Arthritis. In June we presented Phase 3 data in RA for the first time at the EULAR meeting in Paris. Findings showed the efficacy of Golimumab in several important populations. First in methotrexate naive patients, second in patients with active RA despite ongoing treatment methotrexate and third in patients previously treating with anti-TNF biologic agents. We have ongoing studies for all the potential findings including claims regarding impact on structural damage in RA and intravenous therapy for RA and for ulcerative colitis both intravenous and subcutaneous. Let’s take a look at the data for our studies of Golimumab in combination with Methotrexate in patients with active RA despite ongoing treatment with Methotrexate. In this trial called Go Forward adult patients were randomly assigned to four arms. Placebo plus Methotrexate, 50 mg and 100 mg Golimumab in combination with Methotrexate, 100 mg Golimumab alone administered subcutaneously every four weeks. Data was assessed at weeks 14 and 24 the co-primary end points where percentage of patients achieving ACR 20 response at week 14 and improvement from baseline and health assistant questionnaire or at week 24. Patients on the Golimumab 50 mg and 100 mg plus Methotrexate experienced significant improvements in the signs and symptoms of RA. Improvements were seen as early as the first clinical assessment which was four weeks after the first Golimumab injection and generally continued to improve over time. Patients with RA receiving Golimumab also demonstrated significant improvement in physical function as assessed by the hack. This slide shows results from the first prospective double blind placebo controlled Phase 3 clinical trial to analyze the efficacy of an anti-TNF therapy in patients previously treated with at least one anti-TNF agent. In the study 461 patients with active RA were randomized to receive either subcutaneous placebo or Golimumab at 50 mg or 100 mg every four weeks. The primary end point for this study was the proportion of patients in each group that achieved ACR 20 response rates at week 14. Patient responses were assessed through week 24 and improvements within hack were also recorded at week 24. Golimumab therapy significantly reduced the signs and symptoms of RA. At week 14 35% and 38% of patients receiving Golimumab 50 mg and 100 mg respectively achieve a primary end point of ACR 20. This compares with only 18% of patients receiving placebo achieving ACR 20. These results were maintained through six months. Golimumab was generally well tolerated across clinical trials and was associated with a low rate of injection site reactions compared with patients receiving placebo. We believe Golimumab holds great promise in various RA patient populations including Methotrexate naïve patients, patients with active RA despite Methotrexate and patients who have previously discontinued all TNF inhibitors. Golimumab may provide an appropriate treatment option to many people facing this debilitating disease. Now I would like to discuss Ustekinumab formerly know as CNTO 1275 a human mono-clonal anti-body which binds to the P40 sub unit shared by IL-20 and IL-23 and neutralizes both kinds. It has been initially developed for subcutaneous delivery for treatment of moderate to severe psoriasis. We believe Ustekinumab will transform the convenience of therapy requiring maintenance dosing only once every three months after two initiation doses at the zero and week four to achieve a very high response rates. We believe this will be a significant competitive advantage. Psoriasis will be the first indication but we are also developing the drug in Crohn’s disease and have other indications under consideration. The BLA and MAA were filed at the end of last year. On June 17 the FDA dermatologic and ophthalmic advisory committee unanimously recommended Ustekinumab for approval. The FDA has formally extended the review for our application by three months and we now anticipate a response at the end of the year. We recently presented the results of a comparative trial of Ustekinumab versus Etanercept. This was the first time a head to head trial has been done between two biologics in psoriasis. This was a Phase 3 multicenter randomized head to head study comparing Ustekinumab and Etanercept for the treatment of moderate to severe psoriasis. The study included three arms. Patients received either Etanercept twice weekly or 45 mg Ustekinumab at the zero and week four or 90 mg Ustekinumab at zero and week four. Over the 12 week period this amounts to 24 doses of Etanercept in comparison to two doses in both Ustekinumab arms. The primary end point of the trial was the percentage of participants achieving at least a 75% reduction in psoriasis at week 12 as measured by the psoriasis area and severity index of PASI 75. This study was presented by investigators at the 17th Congress of the European Academy of Dermatology and Venereology in Paris, France in September. At week 12, 68% of patients receiving 45 mg of Ustekinumab and 74% of patients receiving 90 mg of Ustekinumab achieved the PASI 75. This compared with 57% of patients receiving 24 50 mg doses of Etanercept over 12 weeks. Need less to say, we are excited about Ustekinumab which represents a first in class therapy for patients with psoriasis. In the allotted time today I also wanted to share with you a glimpse of our advancing early development pipeline. We are extremely excited by the opportunities represented here which are for compounds that are now in Phase 2 development. Let me go over each of them briefly. The first is SGLT-2 inhibitor. This compound has the potential to be a novel treatment for Type 2 diabetes and obesity. It has a novel mechanism of actions and works by inducing a significant increase in urine glucose excretion. It is well tolerated without associated hypoglycemia or weight gain. It represents a potential novel agent for weight loss. It is currently in Phase 2b and it has show positive proven concept. The second is an MTP inhibitor which has the potential to be a different shade of treatment for obesity. This compound acts in the gut which is different from other MTP compounds that may be systemically absorbed. For both these compounds we are currently evaluating the Phase 2b data and anticipate making decisions on plans for Phase 3 studies early next year. Finally, we have TMC435 which is a once daily organ protease inhibitor for treatment of Hepatitis C which has demonstrated good efficacy and safety in its initial proven concept. We are scheduled to present preliminary data on this compound at the American Association for the Study of Liver Disease meeting in San Francisco starting October 31st. We believe that sustained R&D productivity is the key to our future. We believe we have one of the most robust late stage pipelines in the industry. As we have already discussed we also expect to file between seven and 10 new products for approval between the beginning of 2008 and the end of 2010. This concludes our look at the Pharm pipeline so let me leave you with a few key take aways. We have an experienced leadership team that positions Johnson & Johnson well for the future. We have a diverse well balanced portfolio that spans a broad range of therapeutic areas. We have a robust late stage pipeline as well as promising early stage pipeline that will provide growth opportunities for the future. Thank you very much now I would like to turn it over to Louise."
},
{
"speaker": "Louise Mehrotra",
"text": "We’ll now open the floor to your questions. If you could wait for a microphone as the meeting is being webcast."
},
{
"speaker": "Rick Wise - Leerink Swann",
"text": "Given the turmoil in the US and OUS economies credit markets maybe you could talk just to start us off broadly about the likely economic impact on your business planning, impact on the P&L maybe just broadly how it’s going to change your investment priorities, how you’re going to use the cash as we look ahead?"
},
{
"speaker": "Dominic Caruso",
"text": "Recently we have seen some impact of the current economic conditions but just in a few pockets of our business. To date as you’ve seen from our results it hasn’t really resulted in any significant impact to our overall broad based business performance. I’d like to point out that our business leaders have over time been able to make the appropriate adjustments in response to changing market conditions and I certainly expect that they’ll be able to do so in the future. When we do that we’ll take a long term view of how to keep our business healthy for the long term. So far we’ve seen small pockets, a few pockets of impact but nothing that’s impacted our overall business performance."
},
{
"speaker": "Rick Wise - Leerink Swann",
"text": "You highlighted the compelling growth you’ve seen in countries for example do you think that can continue given the global turmoil?"
},
{
"speaker": "Dominic Caruso",
"text": "We have, as a priority for the corporation we have accelerating growth in emerging markets as a key priority for all of our businesses because we believe that that is a great opportunity for us. We’ve already been present in many of those markets and as you saw we’re seeing significant up take and we’re continuing to invest in those markets. When we accelerate our investments these emerging markets tend to get a high priority."
},
{
"speaker": "Rick Wise - Leerink Swann",
"text": "You highlighted the increased investments offsetting the gain maybe you could be more concrete with us about the investments where they’re going, what you expect to draw from it and maybe the longer term impact?"
},
{
"speaker": "Dominic Caruso",
"text": "I’d rather not be so specific about where the investments would be but whenever we have some one time gains like the Amgen gain or the gain from the divestiture of the Ethicon Wound Care business and we look at that gain as actually just a reshuffling of priorities. We want to take the opportunity to invest in a long term growth of our business. Our businesses have great growth opportunities that they present to us all the time. It’s our desire to help fund those investment opportunities and they span across all three of the major business segments. I’d rather not be specific at this time."
},
{
"speaker": "Matt Dodds - Citigroup",
"text": "You didn’t highlight the pain franchise although you did have a little comment earlier. Can you just tell us what happened to Ionsis and where the next technology may be in timing? Also on tapentadol which you didn’t highlight can you just remind us do you expect the approval by year end and file in early ’09 for the extended release?"
},
{
"speaker": "Paul Stoffels",
"text": "First on Ionsis we recalled the product from the market because of the technical problem. We are planning on working on solving that and reintroducing whenever possible. On tapentadol the product was filed in January, our FDFA date is at the end of November but we are expected that this product will be a scheduled product and so typically that will take a DA review afterwards. We expect that will be a 60 to 90 day additional review. At this moment we are in active discussion with the FDA on tapentadol."
},
{
"speaker": "Chris Poon",
"text": "You know that is for the acute indication immediate release. We’re still on track for the chronic program and extended release program."
},
{
"speaker": "Seth [Diverga] – Deutsche Bank",
"text": "First on Concerta the reversal of the reserve of $135 million that’s I guess about two quarters of historical sales so can you give a little more color on that and also does that drop straight to the bottom line?"
},
{
"speaker": "Dominic Caruso",
"text": "This quarter we reversed our reserve for the anticipated pricing of Concerta in Canada. There was a ruling in Canada which increased the price of Concerta and we had estimated that perhaps that wouldn’t occur that did occur so that was favorable for us. The impact in the quarter of about $135 million in sales is roughly $0.02 or $0.03 to the bottom line."
},
{
"speaker": "Seth [Diverga] – Deutsche Bank",
"text": "On the HIV franchise now that you’ve had a couple product approvals and another in Phase 3 have you considered a combination pill?"
},
{
"speaker": "Paul Stoffels",
"text": "The two first products Prezista and TMC125 so Intelence now are two products which are used mainly which are indicated for advanced patients. They are used in separate pills. We are developing TMC278 which is a very small dose which is a very combinable product with a number of different products. The product is now in Phase 3. Two Phase 3 studies are ongoing and we are looking for partnerships on how can we combine this product with different HIV especially in first line where they are desirable."
},
{
"speaker": "David Roman – Morgan Stanley",
"text": "On the guidance it looks like for the full year your raised guidance by $0.03 to $0.05 relative to where you were previously. By my math the tax rate does that include the R&D tax credit? By my math the tax rate gets you probably $0.03 to $0.04. The fourth quarter relative to where the first call consensus it looks like guidance is implicitly below that number. Could you walk us through the moving parts there operationally, how much is FX hit the bottom line in the fourth quarter?"
},
{
"speaker": "Dominic Caruso",
"text": "Yes, the impact to FX, our guidance has in fact increases versus the previous guidance due most net net because of the R&D tax credit because the stronger performance we’ve seen in the business thus far we believe may be offset by negative impact of currency in the fourth quarter. I tried to give you an indication of the impact and we can’t predict currency so I’m just using currency at today’s rates the Euro today. If that stayed where it was throughout the entire fourth quarter sales would decrease due to currency by 1.5 points whereas my prior guidance at the end for the second quarter based on rates then we expected sales to increase by 3.5 point in the fourth quarter. That delta of five points on our fourth quarter sales is the pressure we’ll face with earnings in the fourth quarter. We’ll overcome that but that obviously offset some of the earlier gains this year. Currency may not end up there but we think that’s prudent to give you that kind of expectation."
},
{
"speaker": "David Roman – Morgan Stanley",
"text": "You said previously that of the contribution of currency growth or decline two thirds of that falls to the bottom line of the growth?"
},
{
"speaker": "Dominic Caruso",
"text": "That’s right. It varies by where it happens in each currency and in each country. Not 100% of the change in top line falls through to bottom line. It’s always historically been at least two thirds. So two thirds we can count on coming through to bottom line. Sometimes it’s as high as 80% to 85% but definitely two thirds would."
},
{
"speaker": "David Roman – Morgan Stanley",
"text": "On the economy we’ve seen preannouncement from Advance Medical Optics and Nobel Biocare so far can you maybe be a little more specific about which pockets of the business you’re seeing an impact from the economy either in the third quarter and then specifically some of your competitors and other have commented specifically about the month of September can you maybe give us a sense of the trend throughout the quarter in those businesses."
},
{
"speaker": "Dominic Caruso",
"text": "We don’t typically comment on monthly sales trends and we just finished the quarter so we don’t really have a lot of data to hang our hat on. We did see some, as I mentioned, some pockets, these were mostly in what I would call elective type procedures so either in sports medicine or in women’s health procedures but not a broad base decline. In fact, you saw results for the quarter were actually pretty strong across our surgery businesses. In our Consumer business we’ve seen just a slight decline in the growth of those markets year over year. They’re still growing but just subsiding a little bit in growth."
},
{
"speaker": "Catherine Arnold - Credit Suisse",
"text": "Obviously the world events have made balance sheets back in fashion and so as a result of that I’d like to probe a little bit on things like cash conversion. You’re actually above peers from our analysis in terms of your cash conversion but can you push that further as far as things like working capital and accounts receivable we may actually see some benefits on your top line as well as your free cash flow. If the cost of debt remains unchanged from current levels over the next 12 months would you reconsider your capital allocation priorities and I would put specifically out there repurchase as a question?"
},
{
"speaker": "Dominic Caruso",
"text": "With respect to balance sheet management one thing that I’m very proud to point out is that our businesses have managed the business well throughout up and down cycles and in fact you’re right, strong balance sheets are now in favor more broadly but they’ve always been in favor at Johnson & Johnson. It’s just the way we manage the business. I think that our free cash flow right now represents about 100% of our net income so our businesses do a pretty good job of managing receivables and inventory levels. I think we might consider a little bit of caution on capital expenditure if times get a little bit tougher. Overall our businesses are able to manage this consistently through economic times and they’re used to this so this is not a major undertaking for them. With respect to capital allocation and share repurchases it’s our policy to really complete the share repurchase that we’re undergoing before we make any other decision on how to use our capital allocation for things like share repurchases. As I mentioned before our priority is obviously the first pay our dividend, we have a 45 or 46 year history of paying a dividend and that right now is about a 40% payout ratio and a very nice yield at these lower prices. After that we would prefer to build the business with our cash but lastly if we don’t think there’s value creating business building activities we always look to the next use of cash to do something else to return value to shareholders like share repurchases but I can’t tell you what our plans would be until we exhaust current plan then see what the outlook is for the future."
},
{
"speaker": "Catherine Arnold - Credit Suisse",
"text": "I’d like to ask you about your Hepatitis franchise and for Telaprevir could you comment on if you’re filing strategy in terms of treatment duration and approach and the timing of that versus the United States and Vertex plans and then your follow on product obviously the one today benefit is something that would be very attractive versus Telaprevir. Is there going to be a similar back bone therapy there, anything else unique about that molecule that we should know about?"
},
{
"speaker": "Paul Stoffels",
"text": "With regard to Telaprevir everything is on track there and in line with what Vertex is telling. We have a common development program together with Vertex and it will be based on similar data in Europe and the US. With regard to the TMC435 this phase of Hepatitis C protease inhibitors is going to be a tremendously big new market. These drugs work very well and we believe very much that there is space for more of these drugs, and 435 is a very attractive opportunity although it’s still in early development. We just finished Phase 2 data you will see them at the end of the month and we have to confirm efficacy and safety in next stages. We’ll continue with both drugs until further notice."
},
{
"speaker": "Catherine Arnold - Credit Suisse",
"text": "Phase 2b is in the works now?"
},
{
"speaker": "Paul Stoffels",
"text": "Phase 2b is in the works for 435. We anticipate similar background therapies will continue to go for at least for a certain while. You know that there are also [noniclazides] and [niglazide] analogs in development for hepatitis C and you might anticipate that over time the background therapy for Hepatitis C might change like in HIV you will see new very potent drugs coming out of research and interferon’s they’re not that well tolerated so is any benefit of growing to highly effective combination therapy for Hepatitis C I think it will happen but it will take time."
},
{
"speaker": "Catherine Arnold - Credit Suisse",
"text": "In the Phase 2b program do you have a lead in strategy as part of that program for [peg and rogriviran]?"
},
{
"speaker": "Paul Stoffels",
"text": "That is not yet, I will come back to you about that."
},
{
"speaker": "Rick Wise - Leerink Swann",
"text": "Can you talk a little bit about the step pricing I think you mentioned prices were down?"
},
{
"speaker": "Louise Mehrotra",
"text": "In the US price in the quarter was $1,885 it’s down 3% sequentially and about 9% on year over year basis."
},
{
"speaker": "Rick Wise - Leerink Swann",
"text": "You talked about cost of goods mix obviously I’m sure stents are a factor more consumer is factor. Is that all there is in the mix side? Maybe more specifics on the additional manufacturing costs is this a one quarter phenomenon you said half of it is it one quarter because at 70% again we’re sort of at a pretty low level of gross margin how should we think about gross margin going forward?"
},
{
"speaker": "Dominic Caruso",
"text": "In the quarter we did experience significant mix change and just as a reminder we obviously lost exclusivity for Risperdal in the US so that obviously impacted the quarter margin and the growth of the Consumer business obviously impacts the margin comparison. We had some manufacturing costs matters in the third quarter. They may continue a little bit in the fourth quarter through the rest of the year. We’ll handle these matter, our teams know what to do but they may be a little bit more costly to us and that’ why we’ve indicated that some of the gains we’ve experienced may be offset not only investment opportunities but other actions we have to take to shore up operations."
},
{
"speaker": "Rick Wise - Leerink Swann",
"text": "Can you be more specific about where?"
},
{
"speaker": "Dominic Caruso",
"text": "No, I’d rather not be more specific now."
},
{
"speaker": "Rick Wise - Leerink Swann",
"text": "You highlighted the new credit facilities did rates change does that occur because of the environment or you’re renewing it similar rates?"
},
{
"speaker": "Dominic Caruso",
"text": "The credit facilities I referred to are back up credit facilities to our Commercial paper line so we’ve not actually used these credit facilities we’ve actually just accessed Commercial paper and as I said we continue to have access to Commercial paper in the market and I would call the rates today very, very attractive."
},
{
"speaker": "David Roman – Morgan Stanley",
"text": "On the Pharma business could you give us an update on Velcade and non-Hodgkin’s where we are, I think you already got positive recommendation from the European agency and then secondly on Ceftobiprole Theravance and RP announced this morning that they would expect panels for their hospital based drugs."
},
{
"speaker": "Chris Poon",
"text": "On Velcade we’re still underway with pursuing more indications for Velcade; non-Hodgkin’s is one of them. We don’t have any more update other than that. We did get an approval for front line multiple myeloma that might be what you’re thinking about."
},
{
"speaker": "Paul Stoffels",
"text": "On Ceftobiprole we anticipate that today with all the new NCEs and important additional indications that we will get advisory panels at the FDA so we anticipate that Ceftobiprole will have an advisory panel although we don’t know yet."
},
{
"speaker": "David Roman – Morgan Stanley",
"text": "On spine the 7% reported growth could you tell us what that was in the US, it actually looks like that’s getting a little better is that confidence that’s driving the growth there or is there something else in the numbers?"
},
{
"speaker": "Louise Mehrotra",
"text": "For the spine growth in the US was 5% and OUS was 12% to come up to the 7%."
},
{
"speaker": "David Roman – Morgan Stanley",
"text": "That 5% is an acceleration over last quarter is the driver confidence?"
},
{
"speaker": "Louise Mehrotra",
"text": "Some of it would be the confidence as well as strength in the business as well."
},
{
"speaker": "Operator",
"text": "There are no further calls."
},
{
"speaker": "Dominic Caruso",
"text": "Before we close the meeting I would like to thank Chris and Paul for the overview of some of the exciting opportunities in our Pharmaceutical business today. I think they outlined very well how some of our compounds are progressing in our pipeline. We continue to execute against these and other key priorities that are critical to improving patient care and meeting customers needs across our broad base of healthcare businesses. We’re also innovating and building leadership positions across our businesses while continuing to grow profitably all the while managing our costs and improving our operating margins. These successes are realized thanks to the excellent work and dedication of the extraordinary people across the Johnson & Johnson family of companies. Thank you for your continued support of Johnson & Johnson and I look forward to updating you in January on our full year 2008 results. Thanks and have a great day."
}
] | null | null |
JNJ | 2 | 2,008 | 2008-07-15 08:30:00 | Executives: Louise Mehrotra - Vice President, Investor Relations Dominic Caruso - Vice President, Finance and Chief Financial Officer
Analysts: Rick Wise - Leerink Swann Tao Levy - Deutsche Bank Larry Biegelsen - Wachovia Mike Weinstein - JP Morgan Matthew Dodds - Citigroup Michael Jungling - Merrill Lynch Bob Hopkins - Banc of America Bruce Nudell - UBS Catherine Arnold - Credit Suisse Sara Michelmore - Cowen Larry Keusch - Goldman Sachs David Roman – Morgan Stanley
Operator: Welcome to the Johnson & Johnson second quarter 2008 earnings conference call. (Operator Instructions) I would now like to turn the conference call over to Johnson & Johnson.
Louise Mehrotra: Welcome, I’m Louise Mehrotra, Vice President of Investor Relations for Johnson & Johnson and it is my pleasure this morning to review our business results for the second quarter of 2008. With me on the call today is Dominic Caruso, Vice President of Finance and Chief Financial Officer. A few logistics before we get into the details, this review is being made available to a broader audience via a webcast accessible through the investor relations section of the Johnson & Johnson website. The press release that was sent to the investment community earlier this morning includes the schedule showing sales for major products and/or business franchises to facilitate updating your models. The press release is also available on the Johnson & Johnson website. I will review highlights of the second quarter 2008 results for the corporation and for our three business segments. Following additional remarks from Dominic, we will open the call to your questions. We expect the total call to last approximately one hour. Before I get into the results, let me remind you that some of the statements made during this call may be considered forward looking statements. The 10-K for the fiscal year 2007 identifies certain factors that could cause the company’s actual results to differ materially from those projected in any forward looking statements made this morning. The company does not undertake to update any forward looking statements as a result of new information or future events or developments. The 10-K is available through the company or online. Last item, during the call, non-GAAP financial measures may be used to provide information pertinent to ongoing business performance. These measures are reconciled to the GAAP measures and are available on the Johnson & Johnson website. Now I would like to review our results for the second quarter of 2008. If you would refer to your copy of the press release, let’s begin with the schedule titled supplementary sales data by segment of business. Worldwide sales to customers were a record $16.5 billion for the second quarter of 2008, up 8.7% as compared to the second quarter of 2007. Our operational growth was 3.1% and currency added 5.6 points. If you turn to the schedule showing sales by geographic area, you will see that we achieved growth of 2.1% in the US. In regions outside the US our operational growth was 4.3%, while the effect of currency exchange rates positively impacted our reported results by 11.9 points. Our strongest performing region was the Asia/Pacific/Africa region growing 8.5% on an operational basis. The Western Hemisphere excluding the US grew by 3.3% operationally while Europe grew 2.4% operationally. If you will now turn to the consolidated statement of earnings, net earnings on a reported basis were $3.3 billion and earnings per share were $1.17. This compares to $3.1 billion and $1.05 in the same period in 2007. Please direct your attention to the box section of the schedule where we have provided adjusted earnings information. As referenced in the footnote, the 2008 results had been adjusted to exclude the after-tax impact of the in-process research and development charge of $40 million associated with the acquisition of Amic a privately held developer of in vitro diagnostic. There were no adjustments to the results for the second quarter of 2007. Net earnings on an adjusted basis of $3.4 billion were up 9.3% and adjusted earnings per share of $1.18 were up 12.4%. I would now like to make some additional comments relative to the components leading to the adjusted earnings before we move on to the segment highlights. Cost of goods sold at 28.9% was up 10 basis points versus the same period in 2007, due to the change in mix of the businesses with higher growth in the consumer business and lower growth in the pharmaceutical business. Selling, marketing, and administrative expenses of 33.5% of sales were up 20 basis points due primarily to costs associated with new product launches in our MD&D business. Our investment in research and development as a percent to sales was 11.5%, 80 basis points less than the second quarter of 2007. Approximately half of the leverage was due to the mix of businesses and the remaining half was due to timing of expenditures. Interest expense net of interest income of $16 million compares to $36 million of net interest income in the second quarter of 2007. This increase in expense was due to a higher average debt position in the quarter versus the same period last year as we continue buying back shares as part of the repurchase program. Other income net of other expense was $135 million in the second quarter of 2008 compared to $117 million in the same period last year. With regard to taxes please direct your attention to the effective tax rate excluding special charges shown in the box section of the schedule. Taxes were 23.7% in the second quarter of 2008 comparable to the 2007 rate. Looking at year to date data consolidated sales to customers for the first half of 2008 were $32.6 billion an increase of 8.2% as compared to the same period a year ago. On a year to date basis operational growth was 2.8% and currency had a positive impact of 5.4 points. On the consolidated statement of year to date earnings I’d first like to draw your attention to the box section. In both 2008 and 2007 charges for in process research and development have been excluded. With these adjustments net earnings for the first half of 2008 were $7 billion or $2.44 per share up 7.8% and 10.4% respectively as compared to the same period in 2007. Turning now to business segment highlights, I’ll begin with the consumer segment. Worldwide consumer segment sales of $4 billion increased 13.2% as compared to the second quarter of 2007. Operational growth was 6.8% while currency added 6.4 points. US sales were up 8.5% while international sales grew 5.6% on an operational basis. For the second quarter of 2008, sales for the over the counter pharmaceuticals and nutritionals increased 11% on an operational basis compared to the same period in 2007. Sales in the US were up 16% while sales outside the US were up 5% operationally. The successful launch of Zyrtec in the US in January of this year is the major contributor to this increase. Adult Tylenol achieved strong growth in the quarter driven by the sales outside the US. Additionally outside the US nutritionals achieved strong double digit growth led by the growing demand for Splenda. Our skin care business achieved operational sales growth of 5% in the second quarter of 2008 with sales in the US growing at 12% and sales outside the US down 1% on an operational basis. Strong growth was driven by Neutrogena, Aveeno and Clean & Clear, due to a combination of new product launches and strength in the core businesses due to innovative technologies, like Helioplex. These gains were partially offset by lower sales of rock products and in Europe the discontinuation of Evian Facial Refresher. Baby care products achieved operational growth of 9% when compared to the second quarter of 2007. Sales growth in the US was 5% due to increased sales of cleansers and babycenter.com. Sales outside the US grew 11% on an operational basis, driven by the double digit growth of hair care, wipes, lotion, and oil. Women’s health achieved operational growth of 1%. In the increasingly competitive US market sales were down 3% while sales outside the US were up on an operational basis by 3% with solid growth in the internal sanitary protection line. Operational sales growth in the oral care franchise was 10% with US sales down 1% and sales outside the US up 21%. The Listerine product line achieved sales growth of over 20% operationally due to whitening strips launched in the third quarter of 2007 and the strong performance of Listerine mouthwash. Sales declines in Reach toothbrushes and Rembrandt products partially offset this growth. That completes our review of the consumer segment and I’ll now review highlights for the pharmaceutical segment. Worldwide net sales for the second quarter of $6.3 billion were up 3.1% versus the same period last year. On an operational basis, sales were down 1.3% with positive currency adding 4.4 points. Sales in the US decreased 1.7% while sales outside the US decreased on an operational basis by 0.6%. Our results continue to be impacted by generic competition on some of our products, namely Duragesic, and outside the US, Risperdal Oral in many countries. The combined effect of this generic competition has reduced the second quarter worldwide pharmaceutical operational sales growth rate by approximately 2.5 percentage points with the US impact estimated at approximately 0.5% and the impact outside the US estimated at nearly 7%. Additionally, we saw a retraction in the US market for ESAs following the ODAC discussions, the label changes, and changes to reimbursement. The resulting decline in Procrit sales impacted the worldwide pharmaceutical operational growth by approximately two points. Excluding both the impact of generics and declining Procrit sales, the underlying operational growth for pharmaceutical products was approximately 3.5%. Procrit/Eprex had a combined operational decline of 19% with Procrit down 23% and Eprex down 13% on an operational basis. New competition and a softening of the market due to ongoing label reviews have contributed to the lower sales results for Eprex. Procrit results have been impacted by a decline in the market versus the second quarter of 2007, estimated at approximately 25%, and partially offset by an increase in overall market share. Procrit aggregate share across all markets was approximately 44% in the second quarter of 2008, up one point versus the same period last year. Increased share in the hospital and retail markets was partially offset by lower share in the oncology clinics. Risperdal Oral had an operational decline of 19% when compared to the same period a year ago. Sales in the US were down 9% due primarily to the lowering of inventory levels as wholesales and retailers prepare for the third quarter entry of the generic product. Sales outside the US declined 37% on an operational basis due to generic competition for Risperdal Oral in most markets. Sales of Levaquin our anti-infective were down 4% on an operational basis when compared to the same period a year ago. Market share was negatively impacted by generics in the category. AcipHex, as it’s known in the US market, and Pariet outside the US is a proton pump inhibitor, or PPI, that we co-market with Eisai. On an operational basis, sales were down 9%. US sales were down 5% and sales outside the US were down 12% operationally. In the US, market share has been negatively impacted by additional generic launches in the PPI category. Similar market dynamics impacted sales outside the US, compounded by the impact of market entry in Canada of generic Rabeprazole, the active ingredient in Pariet. Now moving on to our growth drivers, Remicade, a biologic approved for the treatment of a number of immune mediated inflammatory diseases, grew by 2% when compared to the second quarter of 2007. Sales growth in the US was 9%. Market growth in the Anti-TNF category continued to be strong and the competitive dynamics intensified with new competitors in the market and current competitors receiving new indications. Sales to our customers for markets outside the US were down 18%. As we reported in the first quarter there was a significant increase in sales outside the US due to timing of shipments reflecting inventory planning on our customer’s part. The second quarter sales were impacted as a significant portion of the inventory build was depleted. Excluding the estimated changes in inventory levels, demand outside the US was up over 30%. Sales of Topamax, which is approved for the treatment of epilepsy and migraine prophylaxis, increased operationally by 15%. Sales in the US were up 16% while sales outside the US grew by 9% operationally. In the US, market share in the migraine category increased versus the same period last year. Outside the US, strong growth was achieved in many markets, partially offset by generic entries in certain other markets. Risperdal Consta, our long acting injectable formulation, achieved second quarter sales growth of 14% on an operational basis. US sales growth was 18% due to higher market share and market growth. Sales outside the US were up 12% operationally due to the positive shift form oral to injectable therapies. Concerta, a product for attention deficit hyperactivity disorder, grew 6% operationally in the second quarter as compared to the same period last year. Sales in the US were up 5% with continued strong market growth offset by a lower market share. The recent approval of the adult indication for Concerta will enable us to compete in the broader ADHD market. Sales outside the US grew 13% on an operational basis with strong growth achieved in many regions. Velcade, a treatment for relapsed multiple myeloma, is being co-developed with Millennium Pharmaceuticals. We have commercialization rights in Europe and the rest of the world outside the US. Operational sales growth was 47%, with very strong results achieved at all regions. Wrapping up the review of the pharmaceutical segment, as an update on the status of the complete response [Receptabipral] we have been working with the FDA on issues related to the approvable letter and are actively engaged in preparing our response. Once filed our complete response will likely be considered a Class two resubmission. A Class two resubmission has a six month review clause. Additionally regarding Dacogen we will not submit the EU marketing authorization application in 2008. The Phase three data did not demonstrate a statistically significant advantage of Dacogen treatment on median overall survival. However, the preliminary analysis of the data indicated response rates similar to those observed in other clinical trials of Dacogen in patients with NDS. We continue to analyze the data and later this year we will meet with the regulators to discuss the comprehensive findings from the study. I’ll now review the medical devices and diagnostic segment results. Worldwide medical devices and diagnostic segment sales of $6.1 billion grew 5.7% operationally as compared to the same period in 2007. Currency added 6.4 points to the sales growth to bring total growth to 12.1%. Sales in the US grew 4% while sales outside the US increased on an operational basis by 7.3%. Results have been impacted by lower sales of drug eluting stents. Sales excluding the impact of lower sales of drug eluting stents grew nearly 8% operationally. Now turning to the franchises, starting with Cordis; Cordis sales were down 6% operationally with the US down 12% and sales outside the US down 1%. Cordis results were impacted by lower sales of Cypher, our Sirolimus-eluting stent, partially offset by the results of Biosense Webster business. Cypher sales were approximately $395 million down 18% on an operational basis versus the prior year. Sales in the US of approximately $165 million were down 20%. In comparison to the second quarter of 2007 the US market has stabilized with PCI procedures increasing slightly and penetration rates estimated at 66%, similar to the 2007 level offset by a reduction in prices. Estimated share in the US of 36% was down 7 points sequentially and down 10 points from the second quarter of 2007 due to the market entry of a new competitor in the first quarter of 2008. Sales outside the US of approximately $230 million declined 16% operationally. The estimated market share in the quarter of 34% was down two points on a sequential basis and down four points from the second quarter of 2007. Increased competition has impacted the share outside the US. Cypher estimated worldwide share for the quarter was 35%, down four points sequentially and down six points from the second quarter of 2007. Now, turning to growth drivers within the Cordis franchise, the Biosense Webster business, our electro-physiology business, achieved double digit operational growth in the quarter driven by increased system placements as well as growth in irrigation, ultrasound and bi-directional catheters. Our DePuy franchise operational growth of 9% when compared to the same period in 2007 with the US growing 6% and the business outside the US growing by 12% operationally. Hip growth on a worldwide basis was 14% operational, with similar strong results both in and outside the US. On an operational basis, worldwide knee growth was 6% while spine grew 4%. Mitech, our sports medicine business, grew 15% operationally. Ethicon Endo-Surgery achieved operational growth of 10% in the second quarter of 2008, with the US sales growing 7% and sales outside the US growing on an operational basis by 13%. The Harmonic business achieved operational growth of more than 20% due to the success of the recently launched products and the underlying strength of this platform. In addition, the Endocutter, a key product in performing bariatric procedures, the realized gastric band and advanced sterilization products also contributed to the growth in the quarter. Ethicon worldwide sales grew operationally by 6% with US up 7% and sales outside the US growing operationally by 5%. Solid growth in sutures and double digit growth in homeostasis and mesh products were the major contributors to growth in the quarter. The diabetes franchise grew operationally by 7% in the second quarter of 2008. The US business grew by 9% while sales outside the US grew 4% on an operational basis. The Animas business achieved operational growth of nearly 40% driven by continued market share gains. Additionally the success of the One-Touch Ultra line has been a major contributor to the growth. Our Vision Care franchise achieved operational sales growth of 8% in the second quarter compared to the same period last year. Sales in the US increased 7%. The rate of growth has been impacted by the softness in the lens category overall and competitive launches. Additionally, as a quarterly comparison was impacted by the very strong growth in the second quarter of 2007 due to significant new product launches earlier in that year. Sales outside the US grew 10% on an operational basis. Acuvue Oasys, One-Day Acuvue Moist, and Acuvue Advanced for Astigmatism were the major contributors to the growth in the quarter. Additionally, outside the US One-Day Acuvue Define made a strong contribution to growth in the quarter. Rounding out the review of the medical devices and diagnostic segment, Ortho-Clinical Diagnostics achieved operational growth of 7% in the second quarter. Sales growth in the US was 8% while sales outside the US were up 6% on an operational basis. Immunohematology products achieving double digit results. That completes highlights for the medical devices and diagnostic segment and concludes the segment highlights for Johnson & Johnson's second quarter of 2008. Before we open the call to your questions, I’ll turn the discussion over to Dominic Caruso for some additional comments.
Dominic Caruso: We are very pleased today to report solid financial results for the second quarter of 2008. Our performance this past quarter demonstrates how we are successfully managing the business through some short term pressures while continuing to advance some of our key growth initiatives. Louise has already highlighted segment results for you, so I will mention some financial updates, highlight a few of the recent pipeline and product developments in the quarter and discuss our financial guidance for the year. Our sales results for the quarter were above the mean of the analyst estimates as published by First Call. We also delivered another strong earnings performance for the quarter also above the mean of the analyst estimates published by First Call which reflects our ability to continue managing our costs and improving our margins. In fact, pre-tax operating profit margin increased 50 basis points to 26.1% this past quarter as compared to 25.6% in the same quarter last year. We now have substantially implemented the cost restructuring program that we announced last year and we are on track to achieve the higher end of the annual cost savings of approximately $1.3 to $1.6 billion for 2008. Now a brief update on the progress of our $10 billion share repurchase program. As you’ll recall we began purchasing shares in August 2007 and as of the end of June we have purchased approximately $6.5 billion of our stock. We also announced our 46th consecutive year of dividend increases this quarter increasing our quarterly dividend by 10.8%. Our share repurchase program along with our dividends continue to illustrate our commitment to returning value to our shareowners while maintaining a strong financial position that provides the flexibility to invest in business building activities. We continue to make the investments and take the actions to drive the future growth of our business. This quarter we demonstrated our progress with several new product introductions and pipeline developments. In pharmaceuticals the FDA Advisory Committee unanimously recommended the approval of Ustekinumab or CNTO 1275 for the treatment of moderate to severe plaque psoriasis. We submitted an application to the FDA requesting approval of Golimumab or CNTO 148 as a subcutaneous injection for the treatment of rheumatoid arthritis, psoriatic arthritis and ankylosing spondylitis. The FDA approved our Concerta extended release tablets for treatment of attention deficit hyperactivity disorder or ADHD in adults. This approval expands the Concerta indication from children and adolescents into adults with ADHD and offers these patients a patented once daily formulation. We also filed an application with the FDA requesting pediatric exclusivity for Topamax which if granted would extend the market exclusivity for Topamax by six months to March of 2009. We’ve also recently announced positive clinical trial data for many of our compounds including Rivaroxaban, Tapentadol and Golimumab. In other pharmaceutical developments our anti-psychotic drug Risperdal Oral lost marketing exclusivity on June 29th and our affiliate [Yonson] launched an authorized generic version of Risperdal Oral on June 30th. The branded version of Risperdal Oral will continue to be available for patients. On June 5th we hosted many of you for a review of our medical devices and diagnostics and consumer businesses. As you know these types of meetings are part of our continuous effort to inform the investment community about our plans to continue our track record of growth. I trust you saw in our business leaders how excited they are about the future growth opportunities they discussed with you that day. Since June 5th our medical devices and diagnostic business has continued to advance the products and technologies that were mentioned that day. In the US Histacon introduced Acuvue Oasys brand contact lenses for astigmatism which combined unique stabilization technology with a new generation of silicone hydrogel material. The One-Touch ping glucose management system which is the first full featured insulin pump that wirelessly communicates what a blood glucose meter remote was cleared by the FDA. This system integrates technologies from both our animus and life scan businesses and it gives patients more freedom and flexibility in using their insulin pump. Consistent with our long standing approach to growing our business profitably we continue to take steps to strengthen our portfolio and ensure we are competing in the highest growth segments of health care. This quarter we announced the acquisition of Amic a privately held Swedish developer of in vitro diagnostic technologies. This acquisition complements our Ortho Clinical diagnostics business and provides ODC with new technologies and development for use in point of care and near patient setting. These technologies will allow us to deliver information to health care professionals where and when they need it. We also announced that Ethicon has received an offer from One Equity Partners to purchase our professional wound care business. This business includes both advanced wound care and general wound care products which generated annual net sales of approximately $270 million in 2007. We had been exploring a potential sale of this business as part of a continuous review of our business priorities. If the offer is accepted and the closing conditions are satisfied the proposed transaction will be expected to close later in 2008. It would be premature to say anything more about this pending transaction at this time. In the consumer segment this quarter we announced FDA approval of Evolence and new advanced collagen based structural dermal filler that corrects moderate to deep facial wrinkles and folds. Evolence is the first all natural dermal filler using naturally sourced collagen to replace the bodies lost collagen and adding volume and structural support in depleted areas for a more naturally youthful appearance. We have begun training health care professionals in the administration of Evolence and we will be introducing it throughout the second half of 2008. Our consumer business continued to see strong results from our allergy treatment Zyrtec which became first available without prescription in stores across the US in January of this year. By the end of June Zyrtec had captured 27% of the US allergy market. Meanwhile the integration of the Pfizer consumer health care business and brands continues to be on track to meet our target of $500 to $600 million in cost synergies by 2009 and we still expect this transaction to be break even or modestly accretive by 2009 one year ahead of the original schedule. I would now like to provide some comments for you to consider as you refine your models for 2008. Let’s start with a discussion of cash an interest in common expense. During the second quarter of 2008 the company continued to generate strong cash flows. At the end of the second quarter we had approximately $900 million of net debt. This consists of approximately $13 billion of cash in investments and $13.9 billion of debt. This is an increase of approximately $650 million in our overall net debt position from year end 2007 largely due to the continuation of our share repurchase program. We also issued $1.6 billion of long term debt in the US this past quarter. This issuance was principally used to convert short term borrowings to long term not an increase in overall debt levels. As is our practice we are always monitoring financial markets and the markets presented us with a good opportunity to issue long term debt at reasonable rates and with significant participation from investors. For purposes of your models assuming no major acquisitions and considering the continuation but not full completion of the share repurchase program during 2008 I would suggest you consider modeling net interest expense of between $50 and $100 million. This is a change from our previous guidance reflecting the additional costs from the conversion of some short term debt to long term. Turning to other income and expense as a reminder this account is where we record royalty income as well as one time gains and losses arising from such items as litigation, gains or losses from investments by our development corporation or asset sales. As announced this past Friday we have reached a settlement with Amgen concerning litigation regarding their contracting practices that have had an impact on our sales or Procrit in certain market segments. The settlement includes the payment by Amgen to us of $200 million which we expect to record in this account in the third quarter. This account is difficult to forecast but considering the Amgen settlement payment as well as some other partially offsetting items and assuming no other major one time gains or losses I would recommend that you consider modeling other income and expense for 2008 as a net gain ranging from approximately $250 to $300 million. Now a word on taxes, year to date through the second quarter of 2008 the company’s effective tax rate was 24%. Consistent with our earlier guidance we would suggest that you model our effective tax rate for 2008 in the range of 24% to 24.5% which would not include any in process research and development charges or other special items. Additionally, this guidance does not assume the reenactment of the R&D tax credit for 2008. As always we will continue to pursue opportunities in this area to improve upon this rate throughout the year. Turning to sales, we would be comfortable with your models reflecting operational sales growth for the full year 2008 of between 1% and 2% consistent with our earlier guidance. As you know currency rates are difficult to forecast. While we are not predicting the impact of currency movements on our sales to give you an idea of the potential impact of currency rates were to stay where they are today through the end of this year that our sales growth would be favorably impacted by approximately 4.5 points, resulting in total reported sales growth for the year of between 5.5% and 6.5%. Now for earnings, when I last checked the first call mean estimate for our EPS for full year 2008 was $4.45 per share. Considering the strength of our operating performance this past quarter and taking into consideration the items I have outlined for you, I would also take into consideration opportunities to invest in future growth we would be comfortable with your models reflecting full year 2008 earnings per share excluding in process research and development charges or other special items of between $4.45 and $4.50 per share or an increase of $0.05 from our previous earnings per share guidance. That concludes my comments on our operating performance this quarter and our guidance with respect to your models. I look forward to updating you throughout the remainder of the year on our quarterly earnings calls. Thank you and now back to you Louise.
Louise Mehrotra: Operator could you provide some instructions on the Q&A session?
Operator: (Operator Instructions) Your first question comes from Rick Wise - Leerink Swann.
Rick Wise - Leerink Swann: Let me start with sales projections, you’re guiding to 1% to 2% organic sales growth and yet first quarter looking at my numbers was nearly 3% the second quarter was 3% plus remind us what’s in your mind that it’s going to slower, is the generics and the stent loss likely in the second half?
Dominic Caruso: Risperdal lost its market exclusivity in the end of June so we had expected that and we also had expected additional competition in the drug eluting stent market and additionally as you saw we’ve seen a decline in the market for Procrit continuing from the prior year. We had thought this would be the case at the beginning of the year when we commented on our sales guidance and taking all of our sales performance into consideration year to date some positives as well as some negatives and looking out the future we feel comfortable with the original guidance we gave of 1% to 2% operationally of course then impacted by currency movements. We tried to give you an impact of what that might be.
Rick Wise - Leerink Swann: The first quarter there seemed to be some economic impact on procedures perhaps you can talk specifically from the top line perspective Ethicon-Endo seem to be rebounding nicely after a softer first quarter. Are you seeing any economic impact on procedures generally and maybe on the cost side of that as well if you could touch on the impact of rising commodity costs and energy costs and how that affects the outlook for cost of goods or gross margins through the rest of the year?
Dominic Caruso: With respect to procedures and let’s just talk about the first quarter. You’re right; we did see some softening in both the Ethicon and Ethicon-Endo business in the first quarter. Our comments then talked about the fact that there was some lower inventory patterns and ordering patterns by our distributors and that it might have been a sign of some lower procedures and as it turned out it really wasn’t the case there weren’t lower procedure volumes it was simply inventory adjustments by our distributors and in fact as you saw we had a nice rebound in the second quarter. We did not see any indication of any slow down in procedures in the second quarter across the businesses and in fact our DePuy business in the first quarter seemed to be impacted by the holiday as many of our competitors commented on as well and we are happy to see that that was also limited to that particular situation in the quarter and not at all a trend as we did not see any other procedural slow down of any nature in the quarter. With respect to energy and commodity prices and the like, it’s a great question. Many companies are facing into this. We have a mix of businesses as you know. The commodity prices and energy prices impact our consumer business more than they do our other businesses, as more direct material costs are a percentage of the total cost for products in that business compared to either medical devices or pharma. Our team has managed through that reasonably well. We’ve put in cost improvement programs to try to offset those cost increases as much as possible but we’ve also announced to our partners that we’ll be taking some price increase throughout the remainder of the year. Not in all product lines but across products that are most affected by commodity price increases.
Operator: Your next question comes from Tao Levy - Deutsche Bank.
Tao Levy - Deutsche Bank: On the settlement that you announced with Amgen how do you think that affects the business over the back half of the year? Are they no longer able to do what they were doing in the past?
Dominic Caruso: Comments about their activity I would ask that you ask them directly those comments. We’re satisfied with the settlement. We’re happy with the fact that we came to a reasonable settlement on our claims against them in their marketing practices. As we said in the press release we’re pleased with the settlement and we’ll just move on.
Tao Levy - Deutsche Bank: Should the expectation be that the oncology business for J&J on the Procrit side improve?
Dominic Caruso: As you know, we don’t provide any specific outlook for any specific products but I can tell you that our guidance for the full year takes all these matters into consideration.
Tao Levy - Deutsche Bank: You mentioned the decline in prices on drug eluting stents do you have some sort of magnitude in the second quarter given the entry of the new competitor?
Louise Mehrotra: In the US the price in the quarter was about $19.40 and that’s down about 2% versus the first quarter and down about 11% versus the second quarter of ’07.
Tao Levy - Deutsche Bank: Anything internationally?
Louise Mehrotra: Internationally the prices were flat in US dollars but that is also impacted by the currency. They were down about 10% in local currencies in Europe and that has been offset by the gains in the currency rates.
Operator: Your next question comes from Larry Biegelsen – Wachovia.
Larry Biegelsen - Wachovia: Could you remind us of the Rivaroxaban filings date in the US and also I don’t think I heard did you say when you were going to be responding to the FDA on Receptabipral?
Louise Mehrotra: Rivaroxaban in the United States we expect to file in the third quarter of ’08. Regarding Receptabipral and the complete response we are anticipating it will happen in the third quarter.
Larry Biegelsen - Wachovia: Could you help us understand the potential impact of the recent EMEA warning for Eprex? Is it reasonable to assume that about 40% of Eprex sales are in oncology and about 40% of the oncology use is in symptomatic patients with curative intent? How do those numbers compare to the US does oncology still represent about 70% of Procrit sales and do you expect the upcoming Procit label revision to be similar to the EME warning and lastly the timing of the US label revision.
Dominic Caruso: It’s probably premature for us to comment on what we expect the actual label to be. This is a recommendation on potential labeling and of course the various countries have to work through the recommendations. I really don’t think we should comment now prematurely on what the ultimate labeling might be. With respect to the actual facts on the percentage of sales I’ve given Louise now a few minutes to look that up.
Louise Mehrotra: For Procit in the United States it’s about half oncology and if you define curative as non-medistatics stage one to three it would be about half of that is curative. In terms of the EME Eprex it’s about 55% oncology and at this point there’s no clear definition OUS of what curative means. We’re not going to provide that information but you could probably use the US as a benchmark.
Operator: Your next question comes from Mike Weinstein - JP Morgan.
Mike Weinstein - JP Morgan: Let me start with just a couple clean up items. Ustekinumab you did get a positive panel vote and I would like to hear if you had any dialog with the agency on what might be needed to get that product approved post panel and what you think the timing might be.
Dominic Caruso: It was a unanimous recommendation for approval of Ustekinumab and we are in discussions with the FDA. I probably can’t give you too much detail on what those discussions are and I think the PADUFA date if I’m not mistaken is some time in September this year.
Louise Mehrotra: We actually filed November 29th so assuming it’s a 10 month review you’re correct.
Mike Weinstein - JP Morgan: We should be looking still to that date as a legitimate action date. With that in mind I’m thinking about Paliperidone palmitate which I’m not sure if you commented on but if you could give us your thoughts about the timing of that product.
Dominic Caruso: That PADUFA date for Pali is August.
Louise Mehrotra: We filed October 29, 2007.
Dominic Caruso: So it’s August ’08. This is an area of the agency as we’ve commented on before has not typically given approvals on first response. We’re in dialog with the agency; it’d probably be premature to comment on what they might do but that date is upcoming now in August.
Mike Weinstein - JP Morgan: Let me ask a broader financial question, it looks like you’re on track for very low single digit organic growth this year but because of the company’s discipline you’re going to be able to deliver what looks like it’s going to be at least high single digit earnings as high as 10%. Can you talk a little bit about how we should be thinking about 2009 without actually giving guidance at this point? I think everybody is thinking that ’09 will be the company’s toughest year in a long time because of the generic competition issues. You’re showing really strong resilience in 2008 and managing income statement should we be expecting the same as we move to ’09?
Dominic Caruso: It’s a great observation. We’re used to managing our P&L well as you know we have a strong track record of profitable growth and recently with the various challenges we faced and short term pressures with market declines and other matters and new competition. I think our management teams have responded very well and they’re accustomed to managing the business solidly anyway. I think in these tougher times where there are some short term pressures or some unexpected pressures they’ve certainly risen to the occasion and are demonstrating the ability to manage the business well. Our long term view of our business as you know is we aim to grow our business in a way that’s faster than the markets that we compete. We ultimately also aim to grow our profits faster than our sales. You’ve seen us improve operating margins this year. We’ve taken actions to do that and we certainly expect that that trend will continue into ’09. We’ve managed the business to grow our earnings at a rate that’s faster than our sales. We just think that’s good sound discipline while still keeping an eye on investing for the future.
Operator: Your next question comes from Matthew Dodds – Citigroup.
Matthew Dodds - Citigroup: If you look at the P&L and how this year’s done so far the one thing that I’m surprised about is the SG&A is actually grown along with the sales, it’s the R&D that’s dropped a bit more. I’m wondering on the SG&A side is that mix or foreign exchange keeping it at those rates and can we expect that to start dropping at a growth rate below sales as we move through this year?
Dominic Caruso: It’s a good observation. On thing to point out about the SG&A there are two factors. One is mix, as you mentioned. As we launch products for example in our consumer business or the consumer business grows a bit faster in any one quarter that’s a more SG&A intensive business. Also in some of our other businesses for example MD&D business as I pointed out earlier we did launch some new products. Occasionally you will see some up tick in SG&A expense either related to the mix of the business or related to new launches. In this particular quarter if I back out just launch expenses associated with some new meters from LifeScan etc. we did see leveraging in the SG&A line. It’s just a particular timing issues related to launch of new products. Overall we intend to leverage SG&A expense.
Matthew Dodds - Citigroup: On Levaquin should we not think of that product as no longer a growth driver, this isn’t just one soft quarter that really not a growth driver going forward?
Dominic Caruso: There are two ways to look at it; one of course the warning that’s been recommended for Levaquin is actually not a new warning, it’s the warning that was already on the label regarding tendon ruptures. It now is more pronounced because it will be a black box bolded warning. Obviously that should have some impact. I think it’s already well known the reaction those quinolones in that particular side effect. We’ve seen some competition. We’re still happy with the product obviously we have a good presence in the anti-infective arena with that product and we’re happy with its performance. There is a bit of change in character in the sense that the warning will be a little bit stronger than it was before and there’s some additional competition.
Operator: Your next question comes from Michael Jungling - Merrill Lynch.
Michael Jungling - Merrill Lynch: On consumer, I realize you had a very strong concentration in your organic growth rate but I’m curious whether you’re seeing a negative mix shift towards cheaper alternatives within your division. Secondly, on your cost rationalization program of $1.5 to $1.6 billion could you please comment on what the run rate is in the second quarter? The third question is on M&A, most of the sub-sectors of medical devices are now trading evaluation is 25% below the five year average. I’m just curious whether this is something which would perhaps accelerate J&J’s intent of doing more M&A?
Dominic Caruso: We have not seen in the consumer business a trend to cheaper alternatives. I think our consumer business appeals to a certain consumer class, if you will, if I could use that word. It’s a class of consumers that value professionally endorsed and scientifically based innovations in consumer products and we haven’t seen any shift to cheaper alternatives in our business. I’m glad to report that. With respect to the cost savings of the restructuring program I think it’s probably best to just comment on the overall cost restructuring savings we had anticipated. We had anticipated $1.3 to $1.6 billion so I just wanted to correct what you said earlier. The range was $1.3 to $1.6 billion and as I said earlier in my discussion now that we substantially implemented the program we’re very comfortable at the high end of that range. Approaching $1.6 billion in total cost savings is the annual cost savings in ’08. These are projects that are implemented at various times throughout the year but we’re comfortable at the high end of our range that we’ve substantially implanted on those projects. With respect to M&A as you know we’re always looking at M&A opportunities and with our primary criteria being that they create value for shareholders. I don’t think it necessarily accelerates our efforts. We’ve been involved in looking at M&A opportunities all the time and obviously if there’s an opportunity that we think would generate significant shareholder value then we would obviously move forward on that. You’re right lower prices could make that easier to do but I think its just part of our normal discipline of looking at acquisitions and determining whether they can generate value and then moving at the appropriate time.
Operator: Your next question comes from Bob Hopkins - Banc of America.
Bob Hopkins - Banc of America : On your comments about price increases, you mentioned that some of your businesses have been more affected by cost pressures than others. I was wondering if you could go into a little more detail there and just give us a sense as to which business have been most affected?
Dominic Caruso: What I meant to say is the consumer businesses in general have a higher percentage of their costs comprised of direct raw materials and in some of those product lines those direct materials are derivatives of oil or they’re other commodities that have accelerated in price or in cost to us. It’s basically the consumer business and those product lines within consumer that have resin based or other commodity based components.
Bob Hopkins - Banc of America : In the devise division has there been anything that really sticks out from a cost perspective?
Dominic Caruso: Not really across the overall devise business.
Bob Hopkins - Banc of America : Is it safe to say that basically what we’re hearing here today of J&J relative to the economy is that you’re seeing no meaningful impact on revenue growth for J&J as a result of the worldwide economy and the US economy?
Dominic Caruso: I think that’s a reasonable characterization. I think we’ve seen over multiple economic cycles that health care is generally not relatively correlated to economic cycles. Our business in particular has not been correlated with economic cycles in the past and it looks like so far this year our guidance for the year and our expectations for the year are holding up midway through the year and we feel confident about our outlook for the remainder of the year.
Bob Hopkins - Banc of America : One final quick one on DePuy obviously some strong results there it looks like the Hip number was especially strong. I was wondering if you got any comments back from DePuy relative to that Hip growth because obviously there’s a couple of your key competitors that are struggling a bit in Hips and I was wondering if you had any commentary about whether maybe some of the outsize growth was due to competitive wins versus just a healthy market.
Dominic Caruso: As you know we’re very pleased with our Hip portfolio and our folks have done a fantastic job with Hips. I think through the last share data that we looked at for Hips we had a slight increase in Hip share.
Louise Mehrotra: We are number one in Hips in the United States and if I looked at the market information first quarter we don’t have second quarter at this point, we think the US market was up about 7% and we grew better than that. We’re very pleased with our Hip performance.
Bob Hopkins - Banc of America : In terms of the units do you get any feedback from the division that you feel like you’re gaining unit share from the competitors as a result of some of these issues or you don’t have that level of detail now.
Louise Mehrotra: I can tell you we have very very modest price so that would indicate the rest is units.
Operator: Your next question comes from Bruce Nudell – UBS.
Bruce Nudell - UBS: I have a couple pipeline questions, one of the areas that you’re feeling competitive pressure in the anti-inflammatory is inflammatory Val disease and I was just looking at your pipeline I didn’t see a lot of activity for either CNTO 148 or 1275 in Crones. I was wondering what your plans might be there. My second question pertains to Rivaroxaban which is potentially a very big chart for you folks. When might we really get a glimpse as to its effectiveness in more chronic applications such as DVT or AF?
Dominic Caruso: With respect to AF for Rivaroxaban that study is ongoing so we won’t probably see that data for a while, nothing this year on Riva and AF.
Louise Mehrotra: Filing on that is anticipated to be 2010.
Dominic Caruso: So we should see hopefully some data next year on Riva and AF. With respect to Crones disease and our future plans are also colitis I think you referred to. Our plans with respect to either CNTO 148 or 1275 at the moment CNTO 1275 is being studied in psoriasis and that’s of course our first indication but for 148 talk about the future planned filings fort those.
Louise Mehrotra: For CNTO 1275 or Ustekinumab we’re also in Phase two for Crones disease so we are looking at it and for CNTO 148 or Golimumab we are in Phase two B for ulcer discolitis.
Operator: Your next question comes from Catherine Arnold - Credit Suisse.
Catherine Arnold - Credit Suisse: On Ustekinumab there has been some speculation periodically that there are competitive patents that may get in the way of you marketing the drug or may require you to add incremental royalty arrangements to the drug. Could you comment on if there are any material patents that you think would fit that description or is that incorrect? Secondly, I wondered if you could just reconcile your interest in Paliperidone palmitate with an opportunity to work with [El Khamis] to make a once monthly Risperdal.
Dominic Caruso: With Ustekinumab typically we’ll not comment on others patents. We feel very comfortable that our own patent position. With respect to working El Khamis on Risperdal Consta there is a potential formulation that I believe El Khamis believes is useful for a once month dosing of Risperdal Consta and we are studying that particular formulation for Risperdal Consta.
Catherine Arnold - Credit Suisse: If that formulation does prove successful would you put more emphasis and energy behind that program than and is there, I think El Khamis mentioned a 2020 patent cycle for the Consta formulation I’m not sure how that triangulates with your patent protection on palmitate, because I think Paliperidone goes quite early I think it’s actually 2011 if that’s correct.
Louise Mehrotra: For Risperdal Consta we have a patent expiration of 2014 but there also is formulation patents that do go out to 2020 so those should be considered but we’re right not communicating 2014. As far as Paliperidone palmitate it’s in the 2013 range and OUS is I think 2017.
Dominic Caruso: We would just have to wait to see the results before we could comment on which direction we would move.
Catherine Arnold - Credit Suisse: Do you know what the timing is on that?
Dominic Caruso: Next year we’ll know something about the new formulation.
Operator: Your next question comes from Sara Michelmore – Cowen.
Sara Michelmore - Cowen: Just a few clean up items. Could you comment on the share dynamics of the Cypher program in Japan?
Louise Mehrotra: We actually are not giving out Japan share any longer. We stopped doing that about a year and a half ago.
Dominic Caruso: It has rebounded nicely in Japan if I could add. We’re pleased with its performance in Japan.
Sara Michelmore - Cowen: With the Oran Risperdal generic competition in the US could you just comment on Invega and if there’s been any improvements in the momentum of that product heading into the generic launches of Risperdal.
Dominic Caruso: Invega is continuing to improve quarter after quarter but I would say consistent with our prior comments it’s not where we had expected it to be. It’s not the launch we had hoped for as we had commented before but we do see steady improvement with Invega. We believe it’s a viable alternative for patients and when used physicians comment very favorably about the effect with patients.
Sara Michelmore - Cowen: Are you willing to comment on a few of the drugs in the HIV franchise; Prezista and Intelence?
Dominic Caruso: We’re not going to comment on sales sizes other than to point out that we did launch Intelence earlier this year it seems to be well received by the community and Prezista is continuing to grow and of course what will be an important development would be the approval for Front line or First line therapy for Prezista which is expected later perhaps this year because we filed last year for that.
Sara Michelmore - Cowen: Last question on Evolence, you mentioned the new product approval and I’m just wondering if you could just give us the sense, is that a new sales force that you’re investing in to launch that product and how big of an incremental investment are you making in that area.
Dominic Caruso: Not a very big incremental investment as you know we have an ortho dermatological business and that’s the group that’s responsible for the launch of Evolence. We have made some obviously incremental investments to get ready for the launch. I wouldn’t call it significant.
Operator: Your next question comes from Larry Keusch - Goldman Sachs.
Larry Keusch - Goldman Sachs: Some of the comments that you made around the Vision Care franchise; two things struck me there and I’m wondering if you could add some thoughts around it. Number one are you suggesting that perhaps you are losing some market share to some of these new product launches is part of that. The other part is you also mentioned that you feel like you’re seeing softness in the contact lens market and are you again suggesting that that is perhaps somewhat economically sensitive?
Dominic Caruso: Let’s just clarify a few things. One of the comments that Louise made in her discussion of that Vistacom businesses that this quarters comps were difficult because the second quarter of 2007 included two matters; one was some product withdrawals by our competitors plus some product launches for us. We had a reasonably very strong second quarter of ’07 which made this quarters comp more challenging. With respect to share, even though the market was soft Louise correct me if I’m wrong I think the last share data is we are still gaining share with that business.
Louise Mehrotra: That is correct, we have first quarter data and we actually have picked up significant share points.
Larry Keusch - Goldman Sachs: So you are seeing some actual softness in contact lens?
Dominic Caruso: That’s apparently because we’re gaining share but we’re seeing just a slight softness in the market right now.
Louise Mehrotra: We don’t have second quarter data this is all first quarter that would be the logical thought process.
Larry Keusch - Goldman Sachs: I don’t know if you guys have the details around this but a couple weeks ago there was a release from PharmaMar indicating that J&J will no longer be involved in the development and marketing of Yondelis in Japan. I was just wondering if you had any comments around why perhaps you’re not going to be involved with Japan with that product.
Dominic Caruso: What I can tell you about that is that the clinical development of that product in Japan will take some time and in making our priority choices for the future we opted to essentially return the product back to PharmaMar and I understand they are proceeding with the development.
Larry Keusch - Goldman Sachs: Coming back to DePuy and primarily the large joint side of the business now it’s been some time since the settlement took place that was back in the fall. Could you just comment on how business now is running, is that distraction now behind the organization and it’s really all about new product launches or is the field of play still evolving?
Dominic Caruso: I think it’s partly still evolving in general in the industry. I would say for our business many of the changes that were agreed to in the settlement we had already had implemented well in advance of that settlement. It wasn’t as if at the time of the settlement we began new procedures, we had already implemented them. In fact I remember the settlement discussion that was commented on by the regulators that they were pleased to see that the items that they wanted to have in place we had already put in place. I think it’s not something that I would characterize as a huge distraction for the business at all.
Operator: Your last question comes from David Roman – Morgan Stanley.
David Roman – Morgan Stanley: Could you just remind us of $135 million of other income was for?
Dominic Caruso: That account, other income and expense has a variety of items in it. The most prominent item in that account is our royalty income. We’ve commented before that that’s in the $100 million a quarter range. The rest of it is a variety of items, a list longer than I could actually read off.
David Roman – Morgan Stanley: Asset sales or other settlements and things like that?
Dominic Caruso: Absolutely, there are always miscellaneous items like that that go into that account.
David Roman – Morgan Stanley: On the DePuy side, can you break down US and International growth for us?
Louise Mehrotra: This is all on an operational basis. The Hips in the US grew 14%, outside the US grew 14% for a total 14%. Knees grew 4%, outside the US they grew 8% for a total of 6% and Spine was flat in the US, up 14% OUS and 4% in total.
David Roman – Morgan Stanley: On the Knee number in the US, that appears to be little bit below market, is that more a share issues or are you seeing anything on the market side there?
Louise Mehrotra: What I have is first quarter market data for knee and it was about 9% in the US so yes we grew slower than the market. If that trend in the first quarter continues into the second in the market. We don’t have second quarter market data yet.
David Roman – Morgan Stanley: If you expect on MD&D day and on Cordis in particular it appears that most of the new product launches at least on the stent side in the US are in the post 2010 timeframe which I guess would suggest that most of the R&D investment will go on over the next 18 months. Could you talk about balancing investing in those programs with maintaining margins in overall medical devices with the declines in Cypher? Can we expect to see MD&D margins continue to be healthy year over year or will those be pressured?
Dominic Caruso: As you know we don’t comment on individual margin improvement plans but overall for the business we certainly expect to have margin improvement year over year. The only thing I would refer you to is last year it was a pretty significant decline in drug-eluting stents and you can see that our MD&D margins as reported for 2007 did deteriorate slightly from the 2006 levels and that’s basically the way we manage the business where other parts of the MD&D business need to step up given softness in certain parts of the business. I won’t comment on individual margin by segment going forward just reiterate that we manage the business to improve margins overall as an enterprise year over year.
Louise Mehrotra: Some final remarks from Dominic.
Dominic Caruso: Before we end this call I’d like to share some final thoughts on this quarters results and our confidence in our ability to continue our strong track record of profitable growth. We continue to execute against the key priorities and development opportunities that are crucial to improving patient care and meeting customer needs across our health care businesses. We are innovating and building leadership positions across our businesses while continuing to grow profitably managing our costs and improving our margins. We continue to invest in growth opportunities that are critical to our future as demonstrated by our progress while new products and new filings thanks to the excellent work and dedication of the extraordinary people across the Johnson & Johnson family of companies. We look forward to giving you a more detailed update on our Pharmaceutical business when we meet again in October. For now thank you for your continued support of Johnson & Johnson and have a great day. | [
{
"speaker": "Executives",
"text": "Louise Mehrotra - Vice President, Investor Relations Dominic Caruso - Vice President, Finance and Chief Financial Officer"
},
{
"speaker": "Analysts",
"text": "Rick Wise - Leerink Swann Tao Levy - Deutsche Bank Larry Biegelsen - Wachovia Mike Weinstein - JP Morgan Matthew Dodds - Citigroup Michael Jungling - Merrill Lynch Bob Hopkins - Banc of America Bruce Nudell - UBS Catherine Arnold - Credit Suisse Sara Michelmore - Cowen Larry Keusch - Goldman Sachs David Roman – Morgan Stanley"
},
{
"speaker": "Operator",
"text": "Welcome to the Johnson & Johnson second quarter 2008 earnings conference call. (Operator Instructions) I would now like to turn the conference call over to Johnson & Johnson."
},
{
"speaker": "Louise Mehrotra",
"text": "Welcome, I’m Louise Mehrotra, Vice President of Investor Relations for Johnson & Johnson and it is my pleasure this morning to review our business results for the second quarter of 2008. With me on the call today is Dominic Caruso, Vice President of Finance and Chief Financial Officer. A few logistics before we get into the details, this review is being made available to a broader audience via a webcast accessible through the investor relations section of the Johnson & Johnson website. The press release that was sent to the investment community earlier this morning includes the schedule showing sales for major products and/or business franchises to facilitate updating your models. The press release is also available on the Johnson & Johnson website. I will review highlights of the second quarter 2008 results for the corporation and for our three business segments. Following additional remarks from Dominic, we will open the call to your questions. We expect the total call to last approximately one hour. Before I get into the results, let me remind you that some of the statements made during this call may be considered forward looking statements. The 10-K for the fiscal year 2007 identifies certain factors that could cause the company’s actual results to differ materially from those projected in any forward looking statements made this morning. The company does not undertake to update any forward looking statements as a result of new information or future events or developments. The 10-K is available through the company or online. Last item, during the call, non-GAAP financial measures may be used to provide information pertinent to ongoing business performance. These measures are reconciled to the GAAP measures and are available on the Johnson & Johnson website. Now I would like to review our results for the second quarter of 2008. If you would refer to your copy of the press release, let’s begin with the schedule titled supplementary sales data by segment of business. Worldwide sales to customers were a record $16.5 billion for the second quarter of 2008, up 8.7% as compared to the second quarter of 2007. Our operational growth was 3.1% and currency added 5.6 points. If you turn to the schedule showing sales by geographic area, you will see that we achieved growth of 2.1% in the US. In regions outside the US our operational growth was 4.3%, while the effect of currency exchange rates positively impacted our reported results by 11.9 points. Our strongest performing region was the Asia/Pacific/Africa region growing 8.5% on an operational basis. The Western Hemisphere excluding the US grew by 3.3% operationally while Europe grew 2.4% operationally. If you will now turn to the consolidated statement of earnings, net earnings on a reported basis were $3.3 billion and earnings per share were $1.17. This compares to $3.1 billion and $1.05 in the same period in 2007. Please direct your attention to the box section of the schedule where we have provided adjusted earnings information. As referenced in the footnote, the 2008 results had been adjusted to exclude the after-tax impact of the in-process research and development charge of $40 million associated with the acquisition of Amic a privately held developer of in vitro diagnostic. There were no adjustments to the results for the second quarter of 2007. Net earnings on an adjusted basis of $3.4 billion were up 9.3% and adjusted earnings per share of $1.18 were up 12.4%. I would now like to make some additional comments relative to the components leading to the adjusted earnings before we move on to the segment highlights. Cost of goods sold at 28.9% was up 10 basis points versus the same period in 2007, due to the change in mix of the businesses with higher growth in the consumer business and lower growth in the pharmaceutical business. Selling, marketing, and administrative expenses of 33.5% of sales were up 20 basis points due primarily to costs associated with new product launches in our MD&D business. Our investment in research and development as a percent to sales was 11.5%, 80 basis points less than the second quarter of 2007. Approximately half of the leverage was due to the mix of businesses and the remaining half was due to timing of expenditures. Interest expense net of interest income of $16 million compares to $36 million of net interest income in the second quarter of 2007. This increase in expense was due to a higher average debt position in the quarter versus the same period last year as we continue buying back shares as part of the repurchase program. Other income net of other expense was $135 million in the second quarter of 2008 compared to $117 million in the same period last year. With regard to taxes please direct your attention to the effective tax rate excluding special charges shown in the box section of the schedule. Taxes were 23.7% in the second quarter of 2008 comparable to the 2007 rate. Looking at year to date data consolidated sales to customers for the first half of 2008 were $32.6 billion an increase of 8.2% as compared to the same period a year ago. On a year to date basis operational growth was 2.8% and currency had a positive impact of 5.4 points. On the consolidated statement of year to date earnings I’d first like to draw your attention to the box section. In both 2008 and 2007 charges for in process research and development have been excluded. With these adjustments net earnings for the first half of 2008 were $7 billion or $2.44 per share up 7.8% and 10.4% respectively as compared to the same period in 2007. Turning now to business segment highlights, I’ll begin with the consumer segment. Worldwide consumer segment sales of $4 billion increased 13.2% as compared to the second quarter of 2007. Operational growth was 6.8% while currency added 6.4 points. US sales were up 8.5% while international sales grew 5.6% on an operational basis. For the second quarter of 2008, sales for the over the counter pharmaceuticals and nutritionals increased 11% on an operational basis compared to the same period in 2007. Sales in the US were up 16% while sales outside the US were up 5% operationally. The successful launch of Zyrtec in the US in January of this year is the major contributor to this increase. Adult Tylenol achieved strong growth in the quarter driven by the sales outside the US. Additionally outside the US nutritionals achieved strong double digit growth led by the growing demand for Splenda. Our skin care business achieved operational sales growth of 5% in the second quarter of 2008 with sales in the US growing at 12% and sales outside the US down 1% on an operational basis. Strong growth was driven by Neutrogena, Aveeno and Clean & Clear, due to a combination of new product launches and strength in the core businesses due to innovative technologies, like Helioplex. These gains were partially offset by lower sales of rock products and in Europe the discontinuation of Evian Facial Refresher. Baby care products achieved operational growth of 9% when compared to the second quarter of 2007. Sales growth in the US was 5% due to increased sales of cleansers and babycenter.com. Sales outside the US grew 11% on an operational basis, driven by the double digit growth of hair care, wipes, lotion, and oil. Women’s health achieved operational growth of 1%. In the increasingly competitive US market sales were down 3% while sales outside the US were up on an operational basis by 3% with solid growth in the internal sanitary protection line. Operational sales growth in the oral care franchise was 10% with US sales down 1% and sales outside the US up 21%. The Listerine product line achieved sales growth of over 20% operationally due to whitening strips launched in the third quarter of 2007 and the strong performance of Listerine mouthwash. Sales declines in Reach toothbrushes and Rembrandt products partially offset this growth. That completes our review of the consumer segment and I’ll now review highlights for the pharmaceutical segment. Worldwide net sales for the second quarter of $6.3 billion were up 3.1% versus the same period last year. On an operational basis, sales were down 1.3% with positive currency adding 4.4 points. Sales in the US decreased 1.7% while sales outside the US decreased on an operational basis by 0.6%. Our results continue to be impacted by generic competition on some of our products, namely Duragesic, and outside the US, Risperdal Oral in many countries. The combined effect of this generic competition has reduced the second quarter worldwide pharmaceutical operational sales growth rate by approximately 2.5 percentage points with the US impact estimated at approximately 0.5% and the impact outside the US estimated at nearly 7%. Additionally, we saw a retraction in the US market for ESAs following the ODAC discussions, the label changes, and changes to reimbursement. The resulting decline in Procrit sales impacted the worldwide pharmaceutical operational growth by approximately two points. Excluding both the impact of generics and declining Procrit sales, the underlying operational growth for pharmaceutical products was approximately 3.5%. Procrit/Eprex had a combined operational decline of 19% with Procrit down 23% and Eprex down 13% on an operational basis. New competition and a softening of the market due to ongoing label reviews have contributed to the lower sales results for Eprex. Procrit results have been impacted by a decline in the market versus the second quarter of 2007, estimated at approximately 25%, and partially offset by an increase in overall market share. Procrit aggregate share across all markets was approximately 44% in the second quarter of 2008, up one point versus the same period last year. Increased share in the hospital and retail markets was partially offset by lower share in the oncology clinics. Risperdal Oral had an operational decline of 19% when compared to the same period a year ago. Sales in the US were down 9% due primarily to the lowering of inventory levels as wholesales and retailers prepare for the third quarter entry of the generic product. Sales outside the US declined 37% on an operational basis due to generic competition for Risperdal Oral in most markets. Sales of Levaquin our anti-infective were down 4% on an operational basis when compared to the same period a year ago. Market share was negatively impacted by generics in the category. AcipHex, as it’s known in the US market, and Pariet outside the US is a proton pump inhibitor, or PPI, that we co-market with Eisai. On an operational basis, sales were down 9%. US sales were down 5% and sales outside the US were down 12% operationally. In the US, market share has been negatively impacted by additional generic launches in the PPI category. Similar market dynamics impacted sales outside the US, compounded by the impact of market entry in Canada of generic Rabeprazole, the active ingredient in Pariet. Now moving on to our growth drivers, Remicade, a biologic approved for the treatment of a number of immune mediated inflammatory diseases, grew by 2% when compared to the second quarter of 2007. Sales growth in the US was 9%. Market growth in the Anti-TNF category continued to be strong and the competitive dynamics intensified with new competitors in the market and current competitors receiving new indications. Sales to our customers for markets outside the US were down 18%. As we reported in the first quarter there was a significant increase in sales outside the US due to timing of shipments reflecting inventory planning on our customer’s part. The second quarter sales were impacted as a significant portion of the inventory build was depleted. Excluding the estimated changes in inventory levels, demand outside the US was up over 30%. Sales of Topamax, which is approved for the treatment of epilepsy and migraine prophylaxis, increased operationally by 15%. Sales in the US were up 16% while sales outside the US grew by 9% operationally. In the US, market share in the migraine category increased versus the same period last year. Outside the US, strong growth was achieved in many markets, partially offset by generic entries in certain other markets. Risperdal Consta, our long acting injectable formulation, achieved second quarter sales growth of 14% on an operational basis. US sales growth was 18% due to higher market share and market growth. Sales outside the US were up 12% operationally due to the positive shift form oral to injectable therapies. Concerta, a product for attention deficit hyperactivity disorder, grew 6% operationally in the second quarter as compared to the same period last year. Sales in the US were up 5% with continued strong market growth offset by a lower market share. The recent approval of the adult indication for Concerta will enable us to compete in the broader ADHD market. Sales outside the US grew 13% on an operational basis with strong growth achieved in many regions. Velcade, a treatment for relapsed multiple myeloma, is being co-developed with Millennium Pharmaceuticals. We have commercialization rights in Europe and the rest of the world outside the US. Operational sales growth was 47%, with very strong results achieved at all regions. Wrapping up the review of the pharmaceutical segment, as an update on the status of the complete response [Receptabipral] we have been working with the FDA on issues related to the approvable letter and are actively engaged in preparing our response. Once filed our complete response will likely be considered a Class two resubmission. A Class two resubmission has a six month review clause. Additionally regarding Dacogen we will not submit the EU marketing authorization application in 2008. The Phase three data did not demonstrate a statistically significant advantage of Dacogen treatment on median overall survival. However, the preliminary analysis of the data indicated response rates similar to those observed in other clinical trials of Dacogen in patients with NDS. We continue to analyze the data and later this year we will meet with the regulators to discuss the comprehensive findings from the study. I’ll now review the medical devices and diagnostic segment results. Worldwide medical devices and diagnostic segment sales of $6.1 billion grew 5.7% operationally as compared to the same period in 2007. Currency added 6.4 points to the sales growth to bring total growth to 12.1%. Sales in the US grew 4% while sales outside the US increased on an operational basis by 7.3%. Results have been impacted by lower sales of drug eluting stents. Sales excluding the impact of lower sales of drug eluting stents grew nearly 8% operationally. Now turning to the franchises, starting with Cordis; Cordis sales were down 6% operationally with the US down 12% and sales outside the US down 1%. Cordis results were impacted by lower sales of Cypher, our Sirolimus-eluting stent, partially offset by the results of Biosense Webster business. Cypher sales were approximately $395 million down 18% on an operational basis versus the prior year. Sales in the US of approximately $165 million were down 20%. In comparison to the second quarter of 2007 the US market has stabilized with PCI procedures increasing slightly and penetration rates estimated at 66%, similar to the 2007 level offset by a reduction in prices. Estimated share in the US of 36% was down 7 points sequentially and down 10 points from the second quarter of 2007 due to the market entry of a new competitor in the first quarter of 2008. Sales outside the US of approximately $230 million declined 16% operationally. The estimated market share in the quarter of 34% was down two points on a sequential basis and down four points from the second quarter of 2007. Increased competition has impacted the share outside the US. Cypher estimated worldwide share for the quarter was 35%, down four points sequentially and down six points from the second quarter of 2007. Now, turning to growth drivers within the Cordis franchise, the Biosense Webster business, our electro-physiology business, achieved double digit operational growth in the quarter driven by increased system placements as well as growth in irrigation, ultrasound and bi-directional catheters. Our DePuy franchise operational growth of 9% when compared to the same period in 2007 with the US growing 6% and the business outside the US growing by 12% operationally. Hip growth on a worldwide basis was 14% operational, with similar strong results both in and outside the US. On an operational basis, worldwide knee growth was 6% while spine grew 4%. Mitech, our sports medicine business, grew 15% operationally. Ethicon Endo-Surgery achieved operational growth of 10% in the second quarter of 2008, with the US sales growing 7% and sales outside the US growing on an operational basis by 13%. The Harmonic business achieved operational growth of more than 20% due to the success of the recently launched products and the underlying strength of this platform. In addition, the Endocutter, a key product in performing bariatric procedures, the realized gastric band and advanced sterilization products also contributed to the growth in the quarter. Ethicon worldwide sales grew operationally by 6% with US up 7% and sales outside the US growing operationally by 5%. Solid growth in sutures and double digit growth in homeostasis and mesh products were the major contributors to growth in the quarter. The diabetes franchise grew operationally by 7% in the second quarter of 2008. The US business grew by 9% while sales outside the US grew 4% on an operational basis. The Animas business achieved operational growth of nearly 40% driven by continued market share gains. Additionally the success of the One-Touch Ultra line has been a major contributor to the growth. Our Vision Care franchise achieved operational sales growth of 8% in the second quarter compared to the same period last year. Sales in the US increased 7%. The rate of growth has been impacted by the softness in the lens category overall and competitive launches. Additionally, as a quarterly comparison was impacted by the very strong growth in the second quarter of 2007 due to significant new product launches earlier in that year. Sales outside the US grew 10% on an operational basis. Acuvue Oasys, One-Day Acuvue Moist, and Acuvue Advanced for Astigmatism were the major contributors to the growth in the quarter. Additionally, outside the US One-Day Acuvue Define made a strong contribution to growth in the quarter. Rounding out the review of the medical devices and diagnostic segment, Ortho-Clinical Diagnostics achieved operational growth of 7% in the second quarter. Sales growth in the US was 8% while sales outside the US were up 6% on an operational basis. Immunohematology products achieving double digit results. That completes highlights for the medical devices and diagnostic segment and concludes the segment highlights for Johnson & Johnson's second quarter of 2008. Before we open the call to your questions, I’ll turn the discussion over to Dominic Caruso for some additional comments."
},
{
"speaker": "Dominic Caruso",
"text": "We are very pleased today to report solid financial results for the second quarter of 2008. Our performance this past quarter demonstrates how we are successfully managing the business through some short term pressures while continuing to advance some of our key growth initiatives. Louise has already highlighted segment results for you, so I will mention some financial updates, highlight a few of the recent pipeline and product developments in the quarter and discuss our financial guidance for the year. Our sales results for the quarter were above the mean of the analyst estimates as published by First Call. We also delivered another strong earnings performance for the quarter also above the mean of the analyst estimates published by First Call which reflects our ability to continue managing our costs and improving our margins. In fact, pre-tax operating profit margin increased 50 basis points to 26.1% this past quarter as compared to 25.6% in the same quarter last year. We now have substantially implemented the cost restructuring program that we announced last year and we are on track to achieve the higher end of the annual cost savings of approximately $1.3 to $1.6 billion for 2008. Now a brief update on the progress of our $10 billion share repurchase program. As you’ll recall we began purchasing shares in August 2007 and as of the end of June we have purchased approximately $6.5 billion of our stock. We also announced our 46th consecutive year of dividend increases this quarter increasing our quarterly dividend by 10.8%. Our share repurchase program along with our dividends continue to illustrate our commitment to returning value to our shareowners while maintaining a strong financial position that provides the flexibility to invest in business building activities. We continue to make the investments and take the actions to drive the future growth of our business. This quarter we demonstrated our progress with several new product introductions and pipeline developments. In pharmaceuticals the FDA Advisory Committee unanimously recommended the approval of Ustekinumab or CNTO 1275 for the treatment of moderate to severe plaque psoriasis. We submitted an application to the FDA requesting approval of Golimumab or CNTO 148 as a subcutaneous injection for the treatment of rheumatoid arthritis, psoriatic arthritis and ankylosing spondylitis. The FDA approved our Concerta extended release tablets for treatment of attention deficit hyperactivity disorder or ADHD in adults. This approval expands the Concerta indication from children and adolescents into adults with ADHD and offers these patients a patented once daily formulation. We also filed an application with the FDA requesting pediatric exclusivity for Topamax which if granted would extend the market exclusivity for Topamax by six months to March of 2009. We’ve also recently announced positive clinical trial data for many of our compounds including Rivaroxaban, Tapentadol and Golimumab. In other pharmaceutical developments our anti-psychotic drug Risperdal Oral lost marketing exclusivity on June 29th and our affiliate [Yonson] launched an authorized generic version of Risperdal Oral on June 30th. The branded version of Risperdal Oral will continue to be available for patients. On June 5th we hosted many of you for a review of our medical devices and diagnostics and consumer businesses. As you know these types of meetings are part of our continuous effort to inform the investment community about our plans to continue our track record of growth. I trust you saw in our business leaders how excited they are about the future growth opportunities they discussed with you that day. Since June 5th our medical devices and diagnostic business has continued to advance the products and technologies that were mentioned that day. In the US Histacon introduced Acuvue Oasys brand contact lenses for astigmatism which combined unique stabilization technology with a new generation of silicone hydrogel material. The One-Touch ping glucose management system which is the first full featured insulin pump that wirelessly communicates what a blood glucose meter remote was cleared by the FDA. This system integrates technologies from both our animus and life scan businesses and it gives patients more freedom and flexibility in using their insulin pump. Consistent with our long standing approach to growing our business profitably we continue to take steps to strengthen our portfolio and ensure we are competing in the highest growth segments of health care. This quarter we announced the acquisition of Amic a privately held Swedish developer of in vitro diagnostic technologies. This acquisition complements our Ortho Clinical diagnostics business and provides ODC with new technologies and development for use in point of care and near patient setting. These technologies will allow us to deliver information to health care professionals where and when they need it. We also announced that Ethicon has received an offer from One Equity Partners to purchase our professional wound care business. This business includes both advanced wound care and general wound care products which generated annual net sales of approximately $270 million in 2007. We had been exploring a potential sale of this business as part of a continuous review of our business priorities. If the offer is accepted and the closing conditions are satisfied the proposed transaction will be expected to close later in 2008. It would be premature to say anything more about this pending transaction at this time. In the consumer segment this quarter we announced FDA approval of Evolence and new advanced collagen based structural dermal filler that corrects moderate to deep facial wrinkles and folds. Evolence is the first all natural dermal filler using naturally sourced collagen to replace the bodies lost collagen and adding volume and structural support in depleted areas for a more naturally youthful appearance. We have begun training health care professionals in the administration of Evolence and we will be introducing it throughout the second half of 2008. Our consumer business continued to see strong results from our allergy treatment Zyrtec which became first available without prescription in stores across the US in January of this year. By the end of June Zyrtec had captured 27% of the US allergy market. Meanwhile the integration of the Pfizer consumer health care business and brands continues to be on track to meet our target of $500 to $600 million in cost synergies by 2009 and we still expect this transaction to be break even or modestly accretive by 2009 one year ahead of the original schedule. I would now like to provide some comments for you to consider as you refine your models for 2008. Let’s start with a discussion of cash an interest in common expense. During the second quarter of 2008 the company continued to generate strong cash flows. At the end of the second quarter we had approximately $900 million of net debt. This consists of approximately $13 billion of cash in investments and $13.9 billion of debt. This is an increase of approximately $650 million in our overall net debt position from year end 2007 largely due to the continuation of our share repurchase program. We also issued $1.6 billion of long term debt in the US this past quarter. This issuance was principally used to convert short term borrowings to long term not an increase in overall debt levels. As is our practice we are always monitoring financial markets and the markets presented us with a good opportunity to issue long term debt at reasonable rates and with significant participation from investors. For purposes of your models assuming no major acquisitions and considering the continuation but not full completion of the share repurchase program during 2008 I would suggest you consider modeling net interest expense of between $50 and $100 million. This is a change from our previous guidance reflecting the additional costs from the conversion of some short term debt to long term. Turning to other income and expense as a reminder this account is where we record royalty income as well as one time gains and losses arising from such items as litigation, gains or losses from investments by our development corporation or asset sales. As announced this past Friday we have reached a settlement with Amgen concerning litigation regarding their contracting practices that have had an impact on our sales or Procrit in certain market segments. The settlement includes the payment by Amgen to us of $200 million which we expect to record in this account in the third quarter. This account is difficult to forecast but considering the Amgen settlement payment as well as some other partially offsetting items and assuming no other major one time gains or losses I would recommend that you consider modeling other income and expense for 2008 as a net gain ranging from approximately $250 to $300 million. Now a word on taxes, year to date through the second quarter of 2008 the company’s effective tax rate was 24%. Consistent with our earlier guidance we would suggest that you model our effective tax rate for 2008 in the range of 24% to 24.5% which would not include any in process research and development charges or other special items. Additionally, this guidance does not assume the reenactment of the R&D tax credit for 2008. As always we will continue to pursue opportunities in this area to improve upon this rate throughout the year. Turning to sales, we would be comfortable with your models reflecting operational sales growth for the full year 2008 of between 1% and 2% consistent with our earlier guidance. As you know currency rates are difficult to forecast. While we are not predicting the impact of currency movements on our sales to give you an idea of the potential impact of currency rates were to stay where they are today through the end of this year that our sales growth would be favorably impacted by approximately 4.5 points, resulting in total reported sales growth for the year of between 5.5% and 6.5%. Now for earnings, when I last checked the first call mean estimate for our EPS for full year 2008 was $4.45 per share. Considering the strength of our operating performance this past quarter and taking into consideration the items I have outlined for you, I would also take into consideration opportunities to invest in future growth we would be comfortable with your models reflecting full year 2008 earnings per share excluding in process research and development charges or other special items of between $4.45 and $4.50 per share or an increase of $0.05 from our previous earnings per share guidance. That concludes my comments on our operating performance this quarter and our guidance with respect to your models. I look forward to updating you throughout the remainder of the year on our quarterly earnings calls. Thank you and now back to you Louise."
},
{
"speaker": "Louise Mehrotra",
"text": "Operator could you provide some instructions on the Q&A session?"
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from Rick Wise - Leerink Swann."
},
{
"speaker": "Rick Wise - Leerink Swann",
"text": "Let me start with sales projections, you’re guiding to 1% to 2% organic sales growth and yet first quarter looking at my numbers was nearly 3% the second quarter was 3% plus remind us what’s in your mind that it’s going to slower, is the generics and the stent loss likely in the second half?"
},
{
"speaker": "Dominic Caruso",
"text": "Risperdal lost its market exclusivity in the end of June so we had expected that and we also had expected additional competition in the drug eluting stent market and additionally as you saw we’ve seen a decline in the market for Procrit continuing from the prior year. We had thought this would be the case at the beginning of the year when we commented on our sales guidance and taking all of our sales performance into consideration year to date some positives as well as some negatives and looking out the future we feel comfortable with the original guidance we gave of 1% to 2% operationally of course then impacted by currency movements. We tried to give you an impact of what that might be."
},
{
"speaker": "Rick Wise - Leerink Swann",
"text": "The first quarter there seemed to be some economic impact on procedures perhaps you can talk specifically from the top line perspective Ethicon-Endo seem to be rebounding nicely after a softer first quarter. Are you seeing any economic impact on procedures generally and maybe on the cost side of that as well if you could touch on the impact of rising commodity costs and energy costs and how that affects the outlook for cost of goods or gross margins through the rest of the year?"
},
{
"speaker": "Dominic Caruso",
"text": "With respect to procedures and let’s just talk about the first quarter. You’re right; we did see some softening in both the Ethicon and Ethicon-Endo business in the first quarter. Our comments then talked about the fact that there was some lower inventory patterns and ordering patterns by our distributors and that it might have been a sign of some lower procedures and as it turned out it really wasn’t the case there weren’t lower procedure volumes it was simply inventory adjustments by our distributors and in fact as you saw we had a nice rebound in the second quarter. We did not see any indication of any slow down in procedures in the second quarter across the businesses and in fact our DePuy business in the first quarter seemed to be impacted by the holiday as many of our competitors commented on as well and we are happy to see that that was also limited to that particular situation in the quarter and not at all a trend as we did not see any other procedural slow down of any nature in the quarter. With respect to energy and commodity prices and the like, it’s a great question. Many companies are facing into this. We have a mix of businesses as you know. The commodity prices and energy prices impact our consumer business more than they do our other businesses, as more direct material costs are a percentage of the total cost for products in that business compared to either medical devices or pharma. Our team has managed through that reasonably well. We’ve put in cost improvement programs to try to offset those cost increases as much as possible but we’ve also announced to our partners that we’ll be taking some price increase throughout the remainder of the year. Not in all product lines but across products that are most affected by commodity price increases."
},
{
"speaker": "Operator",
"text": "Your next question comes from Tao Levy - Deutsche Bank."
},
{
"speaker": "Tao Levy - Deutsche Bank",
"text": "On the settlement that you announced with Amgen how do you think that affects the business over the back half of the year? Are they no longer able to do what they were doing in the past?"
},
{
"speaker": "Dominic Caruso",
"text": "Comments about their activity I would ask that you ask them directly those comments. We’re satisfied with the settlement. We’re happy with the fact that we came to a reasonable settlement on our claims against them in their marketing practices. As we said in the press release we’re pleased with the settlement and we’ll just move on."
},
{
"speaker": "Tao Levy - Deutsche Bank",
"text": "Should the expectation be that the oncology business for J&J on the Procrit side improve?"
},
{
"speaker": "Dominic Caruso",
"text": "As you know, we don’t provide any specific outlook for any specific products but I can tell you that our guidance for the full year takes all these matters into consideration."
},
{
"speaker": "Tao Levy - Deutsche Bank",
"text": "You mentioned the decline in prices on drug eluting stents do you have some sort of magnitude in the second quarter given the entry of the new competitor?"
},
{
"speaker": "Louise Mehrotra",
"text": "In the US the price in the quarter was about $19.40 and that’s down about 2% versus the first quarter and down about 11% versus the second quarter of ’07."
},
{
"speaker": "Tao Levy - Deutsche Bank",
"text": "Anything internationally?"
},
{
"speaker": "Louise Mehrotra",
"text": "Internationally the prices were flat in US dollars but that is also impacted by the currency. They were down about 10% in local currencies in Europe and that has been offset by the gains in the currency rates."
},
{
"speaker": "Operator",
"text": "Your next question comes from Larry Biegelsen – Wachovia."
},
{
"speaker": "Larry Biegelsen - Wachovia",
"text": "Could you remind us of the Rivaroxaban filings date in the US and also I don’t think I heard did you say when you were going to be responding to the FDA on Receptabipral?"
},
{
"speaker": "Louise Mehrotra",
"text": "Rivaroxaban in the United States we expect to file in the third quarter of ’08. Regarding Receptabipral and the complete response we are anticipating it will happen in the third quarter."
},
{
"speaker": "Larry Biegelsen - Wachovia",
"text": "Could you help us understand the potential impact of the recent EMEA warning for Eprex? Is it reasonable to assume that about 40% of Eprex sales are in oncology and about 40% of the oncology use is in symptomatic patients with curative intent? How do those numbers compare to the US does oncology still represent about 70% of Procrit sales and do you expect the upcoming Procit label revision to be similar to the EME warning and lastly the timing of the US label revision."
},
{
"speaker": "Dominic Caruso",
"text": "It’s probably premature for us to comment on what we expect the actual label to be. This is a recommendation on potential labeling and of course the various countries have to work through the recommendations. I really don’t think we should comment now prematurely on what the ultimate labeling might be. With respect to the actual facts on the percentage of sales I’ve given Louise now a few minutes to look that up."
},
{
"speaker": "Louise Mehrotra",
"text": "For Procit in the United States it’s about half oncology and if you define curative as non-medistatics stage one to three it would be about half of that is curative. In terms of the EME Eprex it’s about 55% oncology and at this point there’s no clear definition OUS of what curative means. We’re not going to provide that information but you could probably use the US as a benchmark."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mike Weinstein - JP Morgan."
},
{
"speaker": "Mike Weinstein - JP Morgan",
"text": "Let me start with just a couple clean up items. Ustekinumab you did get a positive panel vote and I would like to hear if you had any dialog with the agency on what might be needed to get that product approved post panel and what you think the timing might be."
},
{
"speaker": "Dominic Caruso",
"text": "It was a unanimous recommendation for approval of Ustekinumab and we are in discussions with the FDA. I probably can’t give you too much detail on what those discussions are and I think the PADUFA date if I’m not mistaken is some time in September this year."
},
{
"speaker": "Louise Mehrotra",
"text": "We actually filed November 29th so assuming it’s a 10 month review you’re correct."
},
{
"speaker": "Mike Weinstein - JP Morgan",
"text": "We should be looking still to that date as a legitimate action date. With that in mind I’m thinking about Paliperidone palmitate which I’m not sure if you commented on but if you could give us your thoughts about the timing of that product."
},
{
"speaker": "Dominic Caruso",
"text": "That PADUFA date for Pali is August."
},
{
"speaker": "Louise Mehrotra",
"text": "We filed October 29, 2007."
},
{
"speaker": "Dominic Caruso",
"text": "So it’s August ’08. This is an area of the agency as we’ve commented on before has not typically given approvals on first response. We’re in dialog with the agency; it’d probably be premature to comment on what they might do but that date is upcoming now in August."
},
{
"speaker": "Mike Weinstein - JP Morgan",
"text": "Let me ask a broader financial question, it looks like you’re on track for very low single digit organic growth this year but because of the company’s discipline you’re going to be able to deliver what looks like it’s going to be at least high single digit earnings as high as 10%. Can you talk a little bit about how we should be thinking about 2009 without actually giving guidance at this point? I think everybody is thinking that ’09 will be the company’s toughest year in a long time because of the generic competition issues. You’re showing really strong resilience in 2008 and managing income statement should we be expecting the same as we move to ’09?"
},
{
"speaker": "Dominic Caruso",
"text": "It’s a great observation. We’re used to managing our P&L well as you know we have a strong track record of profitable growth and recently with the various challenges we faced and short term pressures with market declines and other matters and new competition. I think our management teams have responded very well and they’re accustomed to managing the business solidly anyway. I think in these tougher times where there are some short term pressures or some unexpected pressures they’ve certainly risen to the occasion and are demonstrating the ability to manage the business well. Our long term view of our business as you know is we aim to grow our business in a way that’s faster than the markets that we compete. We ultimately also aim to grow our profits faster than our sales. You’ve seen us improve operating margins this year. We’ve taken actions to do that and we certainly expect that that trend will continue into ’09. We’ve managed the business to grow our earnings at a rate that’s faster than our sales. We just think that’s good sound discipline while still keeping an eye on investing for the future."
},
{
"speaker": "Operator",
"text": "Your next question comes from Matthew Dodds – Citigroup."
},
{
"speaker": "Matthew Dodds - Citigroup",
"text": "If you look at the P&L and how this year’s done so far the one thing that I’m surprised about is the SG&A is actually grown along with the sales, it’s the R&D that’s dropped a bit more. I’m wondering on the SG&A side is that mix or foreign exchange keeping it at those rates and can we expect that to start dropping at a growth rate below sales as we move through this year?"
},
{
"speaker": "Dominic Caruso",
"text": "It’s a good observation. On thing to point out about the SG&A there are two factors. One is mix, as you mentioned. As we launch products for example in our consumer business or the consumer business grows a bit faster in any one quarter that’s a more SG&A intensive business. Also in some of our other businesses for example MD&D business as I pointed out earlier we did launch some new products. Occasionally you will see some up tick in SG&A expense either related to the mix of the business or related to new launches. In this particular quarter if I back out just launch expenses associated with some new meters from LifeScan etc. we did see leveraging in the SG&A line. It’s just a particular timing issues related to launch of new products. Overall we intend to leverage SG&A expense."
},
{
"speaker": "Matthew Dodds - Citigroup",
"text": "On Levaquin should we not think of that product as no longer a growth driver, this isn’t just one soft quarter that really not a growth driver going forward?"
},
{
"speaker": "Dominic Caruso",
"text": "There are two ways to look at it; one of course the warning that’s been recommended for Levaquin is actually not a new warning, it’s the warning that was already on the label regarding tendon ruptures. It now is more pronounced because it will be a black box bolded warning. Obviously that should have some impact. I think it’s already well known the reaction those quinolones in that particular side effect. We’ve seen some competition. We’re still happy with the product obviously we have a good presence in the anti-infective arena with that product and we’re happy with its performance. There is a bit of change in character in the sense that the warning will be a little bit stronger than it was before and there’s some additional competition."
},
{
"speaker": "Operator",
"text": "Your next question comes from Michael Jungling - Merrill Lynch."
},
{
"speaker": "Michael Jungling - Merrill Lynch",
"text": "On consumer, I realize you had a very strong concentration in your organic growth rate but I’m curious whether you’re seeing a negative mix shift towards cheaper alternatives within your division. Secondly, on your cost rationalization program of $1.5 to $1.6 billion could you please comment on what the run rate is in the second quarter? The third question is on M&A, most of the sub-sectors of medical devices are now trading evaluation is 25% below the five year average. I’m just curious whether this is something which would perhaps accelerate J&J’s intent of doing more M&A?"
},
{
"speaker": "Dominic Caruso",
"text": "We have not seen in the consumer business a trend to cheaper alternatives. I think our consumer business appeals to a certain consumer class, if you will, if I could use that word. It’s a class of consumers that value professionally endorsed and scientifically based innovations in consumer products and we haven’t seen any shift to cheaper alternatives in our business. I’m glad to report that. With respect to the cost savings of the restructuring program I think it’s probably best to just comment on the overall cost restructuring savings we had anticipated. We had anticipated $1.3 to $1.6 billion so I just wanted to correct what you said earlier. The range was $1.3 to $1.6 billion and as I said earlier in my discussion now that we substantially implemented the program we’re very comfortable at the high end of that range. Approaching $1.6 billion in total cost savings is the annual cost savings in ’08. These are projects that are implemented at various times throughout the year but we’re comfortable at the high end of our range that we’ve substantially implanted on those projects. With respect to M&A as you know we’re always looking at M&A opportunities and with our primary criteria being that they create value for shareholders. I don’t think it necessarily accelerates our efforts. We’ve been involved in looking at M&A opportunities all the time and obviously if there’s an opportunity that we think would generate significant shareholder value then we would obviously move forward on that. You’re right lower prices could make that easier to do but I think its just part of our normal discipline of looking at acquisitions and determining whether they can generate value and then moving at the appropriate time."
},
{
"speaker": "Operator",
"text": "Your next question comes from Bob Hopkins - Banc of America."
},
{
"speaker": "Bob Hopkins - Banc of America",
"text": "On your comments about price increases, you mentioned that some of your businesses have been more affected by cost pressures than others. I was wondering if you could go into a little more detail there and just give us a sense as to which business have been most affected?"
},
{
"speaker": "Dominic Caruso",
"text": "What I meant to say is the consumer businesses in general have a higher percentage of their costs comprised of direct raw materials and in some of those product lines those direct materials are derivatives of oil or they’re other commodities that have accelerated in price or in cost to us. It’s basically the consumer business and those product lines within consumer that have resin based or other commodity based components."
},
{
"speaker": "Bob Hopkins - Banc of America",
"text": "In the devise division has there been anything that really sticks out from a cost perspective?"
},
{
"speaker": "Dominic Caruso",
"text": "Not really across the overall devise business."
},
{
"speaker": "Bob Hopkins - Banc of America",
"text": "Is it safe to say that basically what we’re hearing here today of J&J relative to the economy is that you’re seeing no meaningful impact on revenue growth for J&J as a result of the worldwide economy and the US economy?"
},
{
"speaker": "Dominic Caruso",
"text": "I think that’s a reasonable characterization. I think we’ve seen over multiple economic cycles that health care is generally not relatively correlated to economic cycles. Our business in particular has not been correlated with economic cycles in the past and it looks like so far this year our guidance for the year and our expectations for the year are holding up midway through the year and we feel confident about our outlook for the remainder of the year."
},
{
"speaker": "Bob Hopkins - Banc of America",
"text": "One final quick one on DePuy obviously some strong results there it looks like the Hip number was especially strong. I was wondering if you got any comments back from DePuy relative to that Hip growth because obviously there’s a couple of your key competitors that are struggling a bit in Hips and I was wondering if you had any commentary about whether maybe some of the outsize growth was due to competitive wins versus just a healthy market."
},
{
"speaker": "Dominic Caruso",
"text": "As you know we’re very pleased with our Hip portfolio and our folks have done a fantastic job with Hips. I think through the last share data that we looked at for Hips we had a slight increase in Hip share."
},
{
"speaker": "Louise Mehrotra",
"text": "We are number one in Hips in the United States and if I looked at the market information first quarter we don’t have second quarter at this point, we think the US market was up about 7% and we grew better than that. We’re very pleased with our Hip performance."
},
{
"speaker": "Bob Hopkins - Banc of America",
"text": "In terms of the units do you get any feedback from the division that you feel like you’re gaining unit share from the competitors as a result of some of these issues or you don’t have that level of detail now."
},
{
"speaker": "Louise Mehrotra",
"text": "I can tell you we have very very modest price so that would indicate the rest is units."
},
{
"speaker": "Operator",
"text": "Your next question comes from Bruce Nudell – UBS."
},
{
"speaker": "Bruce Nudell - UBS",
"text": "I have a couple pipeline questions, one of the areas that you’re feeling competitive pressure in the anti-inflammatory is inflammatory Val disease and I was just looking at your pipeline I didn’t see a lot of activity for either CNTO 148 or 1275 in Crones. I was wondering what your plans might be there. My second question pertains to Rivaroxaban which is potentially a very big chart for you folks. When might we really get a glimpse as to its effectiveness in more chronic applications such as DVT or AF?"
},
{
"speaker": "Dominic Caruso",
"text": "With respect to AF for Rivaroxaban that study is ongoing so we won’t probably see that data for a while, nothing this year on Riva and AF."
},
{
"speaker": "Louise Mehrotra",
"text": "Filing on that is anticipated to be 2010."
},
{
"speaker": "Dominic Caruso",
"text": "So we should see hopefully some data next year on Riva and AF. With respect to Crones disease and our future plans are also colitis I think you referred to. Our plans with respect to either CNTO 148 or 1275 at the moment CNTO 1275 is being studied in psoriasis and that’s of course our first indication but for 148 talk about the future planned filings fort those."
},
{
"speaker": "Louise Mehrotra",
"text": "For CNTO 1275 or Ustekinumab we’re also in Phase two for Crones disease so we are looking at it and for CNTO 148 or Golimumab we are in Phase two B for ulcer discolitis."
},
{
"speaker": "Operator",
"text": "Your next question comes from Catherine Arnold - Credit Suisse."
},
{
"speaker": "Catherine Arnold - Credit Suisse",
"text": "On Ustekinumab there has been some speculation periodically that there are competitive patents that may get in the way of you marketing the drug or may require you to add incremental royalty arrangements to the drug. Could you comment on if there are any material patents that you think would fit that description or is that incorrect? Secondly, I wondered if you could just reconcile your interest in Paliperidone palmitate with an opportunity to work with [El Khamis] to make a once monthly Risperdal."
},
{
"speaker": "Dominic Caruso",
"text": "With Ustekinumab typically we’ll not comment on others patents. We feel very comfortable that our own patent position. With respect to working El Khamis on Risperdal Consta there is a potential formulation that I believe El Khamis believes is useful for a once month dosing of Risperdal Consta and we are studying that particular formulation for Risperdal Consta."
},
{
"speaker": "Catherine Arnold - Credit Suisse",
"text": "If that formulation does prove successful would you put more emphasis and energy behind that program than and is there, I think El Khamis mentioned a 2020 patent cycle for the Consta formulation I’m not sure how that triangulates with your patent protection on palmitate, because I think Paliperidone goes quite early I think it’s actually 2011 if that’s correct."
},
{
"speaker": "Louise Mehrotra",
"text": "For Risperdal Consta we have a patent expiration of 2014 but there also is formulation patents that do go out to 2020 so those should be considered but we’re right not communicating 2014. As far as Paliperidone palmitate it’s in the 2013 range and OUS is I think 2017."
},
{
"speaker": "Dominic Caruso",
"text": "We would just have to wait to see the results before we could comment on which direction we would move."
},
{
"speaker": "Catherine Arnold - Credit Suisse",
"text": "Do you know what the timing is on that?"
},
{
"speaker": "Dominic Caruso",
"text": "Next year we’ll know something about the new formulation."
},
{
"speaker": "Operator",
"text": "Your next question comes from Sara Michelmore – Cowen."
},
{
"speaker": "Sara Michelmore - Cowen",
"text": "Just a few clean up items. Could you comment on the share dynamics of the Cypher program in Japan?"
},
{
"speaker": "Louise Mehrotra",
"text": "We actually are not giving out Japan share any longer. We stopped doing that about a year and a half ago."
},
{
"speaker": "Dominic Caruso",
"text": "It has rebounded nicely in Japan if I could add. We’re pleased with its performance in Japan."
},
{
"speaker": "Sara Michelmore - Cowen",
"text": "With the Oran Risperdal generic competition in the US could you just comment on Invega and if there’s been any improvements in the momentum of that product heading into the generic launches of Risperdal."
},
{
"speaker": "Dominic Caruso",
"text": "Invega is continuing to improve quarter after quarter but I would say consistent with our prior comments it’s not where we had expected it to be. It’s not the launch we had hoped for as we had commented before but we do see steady improvement with Invega. We believe it’s a viable alternative for patients and when used physicians comment very favorably about the effect with patients."
},
{
"speaker": "Sara Michelmore - Cowen",
"text": "Are you willing to comment on a few of the drugs in the HIV franchise; Prezista and Intelence?"
},
{
"speaker": "Dominic Caruso",
"text": "We’re not going to comment on sales sizes other than to point out that we did launch Intelence earlier this year it seems to be well received by the community and Prezista is continuing to grow and of course what will be an important development would be the approval for Front line or First line therapy for Prezista which is expected later perhaps this year because we filed last year for that."
},
{
"speaker": "Sara Michelmore - Cowen",
"text": "Last question on Evolence, you mentioned the new product approval and I’m just wondering if you could just give us the sense, is that a new sales force that you’re investing in to launch that product and how big of an incremental investment are you making in that area."
},
{
"speaker": "Dominic Caruso",
"text": "Not a very big incremental investment as you know we have an ortho dermatological business and that’s the group that’s responsible for the launch of Evolence. We have made some obviously incremental investments to get ready for the launch. I wouldn’t call it significant."
},
{
"speaker": "Operator",
"text": "Your next question comes from Larry Keusch - Goldman Sachs."
},
{
"speaker": "Larry Keusch - Goldman Sachs",
"text": "Some of the comments that you made around the Vision Care franchise; two things struck me there and I’m wondering if you could add some thoughts around it. Number one are you suggesting that perhaps you are losing some market share to some of these new product launches is part of that. The other part is you also mentioned that you feel like you’re seeing softness in the contact lens market and are you again suggesting that that is perhaps somewhat economically sensitive?"
},
{
"speaker": "Dominic Caruso",
"text": "Let’s just clarify a few things. One of the comments that Louise made in her discussion of that Vistacom businesses that this quarters comps were difficult because the second quarter of 2007 included two matters; one was some product withdrawals by our competitors plus some product launches for us. We had a reasonably very strong second quarter of ’07 which made this quarters comp more challenging. With respect to share, even though the market was soft Louise correct me if I’m wrong I think the last share data is we are still gaining share with that business."
},
{
"speaker": "Louise Mehrotra",
"text": "That is correct, we have first quarter data and we actually have picked up significant share points."
},
{
"speaker": "Larry Keusch - Goldman Sachs",
"text": "So you are seeing some actual softness in contact lens?"
},
{
"speaker": "Dominic Caruso",
"text": "That’s apparently because we’re gaining share but we’re seeing just a slight softness in the market right now."
},
{
"speaker": "Louise Mehrotra",
"text": "We don’t have second quarter data this is all first quarter that would be the logical thought process."
},
{
"speaker": "Larry Keusch - Goldman Sachs",
"text": "I don’t know if you guys have the details around this but a couple weeks ago there was a release from PharmaMar indicating that J&J will no longer be involved in the development and marketing of Yondelis in Japan. I was just wondering if you had any comments around why perhaps you’re not going to be involved with Japan with that product."
},
{
"speaker": "Dominic Caruso",
"text": "What I can tell you about that is that the clinical development of that product in Japan will take some time and in making our priority choices for the future we opted to essentially return the product back to PharmaMar and I understand they are proceeding with the development."
},
{
"speaker": "Larry Keusch - Goldman Sachs",
"text": "Coming back to DePuy and primarily the large joint side of the business now it’s been some time since the settlement took place that was back in the fall. Could you just comment on how business now is running, is that distraction now behind the organization and it’s really all about new product launches or is the field of play still evolving?"
},
{
"speaker": "Dominic Caruso",
"text": "I think it’s partly still evolving in general in the industry. I would say for our business many of the changes that were agreed to in the settlement we had already had implemented well in advance of that settlement. It wasn’t as if at the time of the settlement we began new procedures, we had already implemented them. In fact I remember the settlement discussion that was commented on by the regulators that they were pleased to see that the items that they wanted to have in place we had already put in place. I think it’s not something that I would characterize as a huge distraction for the business at all."
},
{
"speaker": "Operator",
"text": "Your last question comes from David Roman – Morgan Stanley."
},
{
"speaker": "David Roman – Morgan Stanley",
"text": "Could you just remind us of $135 million of other income was for?"
},
{
"speaker": "Dominic Caruso",
"text": "That account, other income and expense has a variety of items in it. The most prominent item in that account is our royalty income. We’ve commented before that that’s in the $100 million a quarter range. The rest of it is a variety of items, a list longer than I could actually read off."
},
{
"speaker": "David Roman – Morgan Stanley",
"text": "Asset sales or other settlements and things like that?"
},
{
"speaker": "Dominic Caruso",
"text": "Absolutely, there are always miscellaneous items like that that go into that account."
},
{
"speaker": "David Roman – Morgan Stanley",
"text": "On the DePuy side, can you break down US and International growth for us?"
},
{
"speaker": "Louise Mehrotra",
"text": "This is all on an operational basis. The Hips in the US grew 14%, outside the US grew 14% for a total 14%. Knees grew 4%, outside the US they grew 8% for a total of 6% and Spine was flat in the US, up 14% OUS and 4% in total."
},
{
"speaker": "David Roman – Morgan Stanley",
"text": "On the Knee number in the US, that appears to be little bit below market, is that more a share issues or are you seeing anything on the market side there?"
},
{
"speaker": "Louise Mehrotra",
"text": "What I have is first quarter market data for knee and it was about 9% in the US so yes we grew slower than the market. If that trend in the first quarter continues into the second in the market. We don’t have second quarter market data yet."
},
{
"speaker": "David Roman – Morgan Stanley",
"text": "If you expect on MD&D day and on Cordis in particular it appears that most of the new product launches at least on the stent side in the US are in the post 2010 timeframe which I guess would suggest that most of the R&D investment will go on over the next 18 months. Could you talk about balancing investing in those programs with maintaining margins in overall medical devices with the declines in Cypher? Can we expect to see MD&D margins continue to be healthy year over year or will those be pressured?"
},
{
"speaker": "Dominic Caruso",
"text": "As you know we don’t comment on individual margin improvement plans but overall for the business we certainly expect to have margin improvement year over year. The only thing I would refer you to is last year it was a pretty significant decline in drug-eluting stents and you can see that our MD&D margins as reported for 2007 did deteriorate slightly from the 2006 levels and that’s basically the way we manage the business where other parts of the MD&D business need to step up given softness in certain parts of the business. I won’t comment on individual margin by segment going forward just reiterate that we manage the business to improve margins overall as an enterprise year over year."
},
{
"speaker": "Louise Mehrotra",
"text": "Some final remarks from Dominic."
},
{
"speaker": "Dominic Caruso",
"text": "Before we end this call I’d like to share some final thoughts on this quarters results and our confidence in our ability to continue our strong track record of profitable growth. We continue to execute against the key priorities and development opportunities that are crucial to improving patient care and meeting customer needs across our health care businesses. We are innovating and building leadership positions across our businesses while continuing to grow profitably managing our costs and improving our margins. We continue to invest in growth opportunities that are critical to our future as demonstrated by our progress while new products and new filings thanks to the excellent work and dedication of the extraordinary people across the Johnson & Johnson family of companies. We look forward to giving you a more detailed update on our Pharmaceutical business when we meet again in October. For now thank you for your continued support of Johnson & Johnson and have a great day."
}
] | null | null |
JNJ | 1 | 2,008 | 2008-04-15 08:30:00 | Executives: Louise Mehrotra - Vice President of Investor Relations Dominic J. Caruso - Chief Financial Officer, Vice President - Finance
Analysts: Michael Weinstein - J.P. Morgan Glenn Reicin - Morgan Stanley Tao Levy - Deutsche Bank Bob Hopkins - Lehman Brothers Lawrence Keusch - Goldman Sachs Michael Jungling - Merrill Lynch Matthew Dodds - Citigroup Larry Biegelsen - Wachovia Sara Michelmore - Cowen & Company Bruce Nudell - UBS
Operator: Good morning and welcome to the Johnson & Johnson first quarter 2008 earnings conference call. (Operator Instructions) I would now like to turn the conference over to Johnson & Johnson. You may begin.
Louise Mehrotra: Good morning and welcome. I’m Louise Mehrotra, Vice President of Investor Relations for Johnson & Johnson and it is my pleasure this morning to review our business results for the first quarter of 2008. With me on the call today is Dominic Caruso, Vice President of Finance and Chief Financial Officer. A few logistics before we get into the details -- this review is being made available to a broader audience via a webcast accessible through the investor relations section of the Johnson & Johnson website. Included with the copy of the press release that was sent to the investment community earlier this morning is the schedule showing sales for major products and/or business franchises to facilitate updating your models. These are also available on the Johnson & Johnson website, as is the press release. I will review highlights of the first quarter 2008 results for the corporation and for our three business segments. Following additional remarks from Dominic, we will open the call to your questions. We expect the total call to last approximately one hour. Before I get into the results, let me remind you that some of the statements made during this call may be considered forward-looking statements. The 10-K for the fiscal year 2007 identifies certain factors that could cause the company’s actual results to differ materially from those projected in any forward-looking statements made this morning. The company does not undertake to update any forward-looking statements as a result of new information or future events or developments. The 10-K is available through the company or online. Last item -- during the call, non-GAAP financial measures may be used to provide information pertinent to ongoing business performance. These measures are reconciled to the GAAP measures and are available on the Johnson & Johnson website. Now I would like to review our results for the first quarter of 2008. If you would refer to your copy of the press release, let’s begin with the schedule titled supplementary sales data by segment of business. Worldwide sales to customers were a record $16.2 billion for the first quarter of 2008, up 7.7% as compared to the first quarter of 2007. Our operational growth was 2.6% and currency contributed 5.1 points. If you turn to the schedule showing sales by geographic area, you will see that we achieved growth of 2.8% in the U.S. In regions outside the U.S., our operational growth was 2.4%, while the effect of currency exchange rates positively impacted our reported results by 11.3 points. Our strongest performing region was the Western Hemisphere excluding the U.S., growing 6.2% on an operational basis. Asia-Pacific/Africa region grew by 3.2% operationally while Europe grew 0.8% operationally. If you will now turn to the consolidated statement of earnings, net earnings on a reported basis were $3.6 billion and earnings per share were $1.26. This compares to $2.6 billion and $0.88 in the same period in 2007. Please direct your attention to the box section of the schedule where we have provided adjusted earnings information. As a reference in the footnote, the 2007 results had been adjusted for the after-tax impact of the in-process research and development charge of $807 million associated with the acquisition of Conor Medsystems. Net earnings on an adjusted basis were up 6.4% and adjusted earnings per share were up 8.6%. I would now like to make some additional comments relative to the components leading to the adjusted earnings before we move on to the segment highlights. Cost of goods sold at 28.5% is down 60 basis points as compared to the same period in 2007, with reductions seen across all three segments. Selling, marketing, and administrative expenses of 31.6% of sales are down 30 basis points as compared to 2007. This leverage is due to reductions primarily in our pharmaceutical business. Our investment in research and development as a percent of sales was 10.6%, 40 basis points less than the first quarter of 2007. Research and development spending is up nearly 4% in the quarter. Interest expense net of interest income of $16 million compares to $33 million of net interest income in the first quarter of 2007. This increase in expense is due to a higher average debt position in the quarter versus the same period last year, as we continue buying back shares as part of our repurchase program. Other income net of other expense was $18 million in the first quarter of 2008 compared to $228 million in the same period last year. The 2007 results included the gain related to the divestitures of certain brands in connection with the acquisition of Pfizer Consumer Healthcare. With regard to taxes, please direct your attention to the effective tax rate excluding special charges shown in the box section of the schedule. In the first quarter of both 2007 and 2008, taxes were 24.2%. Turning now to business highlights, I’ll begin with the consumer segment. Worldwide consumer segment sales of $4.1 billion increased 16.2% as compared to the first quarter of 2007. Operational growth was 9.9% while currency contributed 6.3%. U.S. sales were up 11.7% while international sales grew 8.3% on an operational basis. For the first quarter of 2008, sales for the over-the-counter pharmaceuticals and nutritionals increased 21% on an operational basis compared to the same period in 2007. Sales in the U.S. were up 29% while sales outside the U.S. were up 12% operationally. The successful launch of ZYRTEC in the U.S. in January of this year is the major contributor to this increase. Additionally, both the adult and pediatric analgesics achieved strong growth, driven by an increased uptake in the rapid release gels and the later start to the winter flu season. Our skin care business achieved operational sales growth of 4% in the first quarter of 2008 with sales in the U.S. growing at 7% and sales outside the U.S. up 2% on an operational basis. Strong growth was driven by Clean and Clear, Aveeno, and Nutrogena, due to a combination of new product launches and strength in the core businesses due to innovative technologies, like Helioplex. These gains were partially offset by the discontinuation of a small line of facial refreshers. Baby care products achieved operational growth of 11% when compared to the first quarter of 2007. Sales growth in the U.S. was 6% due to increased babycenter.com sales. Sales outside the U.S. grew 13% on an operational basis, driven by the strong double-digit growth of wipes, hair care, powder, and oil. Women’s health achieved operational growth of 2%. Sales in the U.S. were down 9% due to increased competition, while sales outside the U.S. were up on an operational basis by 9% with strong growth in both the internal and external sanitary protection lines. Operational sales growth in the oral care franchise was 3% with U.S. sales down 2% and sales outside the U.S. up 9%. Strong growth was achieved for the Listerine product line due to whitening strips launched in the third quarter of 2007 and the strong performance of Listerine mouthwash. Sales declines in Reach toothbrushes and Rembrandt products partially offset this growth. That completes our review of the consumer segment and I’ll now review highlights for the pharmaceutical segment. Worldwide net sales for the first quarter of $6.4 billion were up 3.3% versus the same period last year. On an operational basis, sales were down 0.6% with positive currency contributing 3.9 points. Sales in the U.S. increased 0.9% while sales outside the U.S. decreased on an operational basis by 3.1%. Our results continue to be impacted by generic competition on some of our products, namely DURAGESIC, and outside the U.S. RISPERDAL ORAL in many countries. The combined effect of this generic competition has reduced the first quarter worldwide pharmaceutical operational sales growth by approximately 3.5 percentage points with the U.S. impact estimated at approximately 1% and the impact outside the U.S. estimated at nearly 8%. Additionally, we saw a retraction in the U.S. market for ESAs following the ODAC discussions, the label changes, and changes to reimbursement. The resulting decline in PROCRIT sales impacted the worldwide pharmaceutical operational sales growth by approximately 4 points. Excluding both the impact of generics and declining PROCRIT sales, the underlying operational growth for pharmaceutical products was approximately 7%. PROCRIT/EPREX had a combined operational decline of 27% with PROCRIT down 37% and EPREX down 9% on an operational basis. New competition and label reviews have contributed to the lower sales results for EPREX. PROCRIT results have been impacted by a decline in the market versus the first quarter of 2007, estimated at approximately 37%, and partially offset by an increase in overall market share. PROCRIT aggregate share across all markets was approximately 45% in the first quarter of 2008, up one point versus the same period last year. Increased share in the hospital and retail markets was partially offset by lower share in the oncology clinics due to our competitors’ anti-competitive contracting strategies. RISPERDAL Oral had an operational decline of 9% when compared to the same period a year ago. Sales in the U.S. grew 4% with market growth of approximately 6% offset by a slight decline in market share. Sales outside the U.S. declined 34% on an operational basis due to generic competition for RISPERDAL Oral in many markets. ACIPHEX, as it’s known in the U.S. market, and PARIET outside the U.S. is a proton pump inhibitor, or PPI, that we co-market with Eisai. On an operational basis, sales were down 23%. U.S. sales were down 27% and sales outside the U.S. were down 19% operationally. In the U.S., market share has been negatively impacted by additional generic launches of competitor PPIs. Similar market dynamics impacted sales outside the U.S., compounded by the impact of market entry in Canada of generic Rabeprazole, the active ingredient in PARIET. Now moving on to our growth drivers -- REMICADE, a biologic approved for the treatment of a number of immune mediated inflammatory diseases, grew by 37% when compared to the first quarter of 2007. Sales growth in the U.S. was 13%. Market growth in the Anti-TNF category continued to be strong and the competitive dynamics intensified with the new competitors in the market and current competitors receiving new indications. Sales to our customers for markets outside the U.S. more than doubled due to a combination of the timing of shipments, strong market demand, and the positive impact of currency. The timing of shipments reflects inventory planning on our customer’s part and was estimated to contribute approximately two-thirds of the increase in sales outside the U.S. versus the same period last year. We expect the resulting build in inventory levels held by our customer will be reduced over the balance of the year. Sales of TOPOMAX, which is approved for the treatment of epilepsy and migraine prophylaxis, increased operationally by 4% with similar results both in and outside the U.S. In the U.S., market share in the migraine category increased versus the same period last year; however, market growth was flat. Outside the U.S., strong growth was achieved in many markets, partially offset by generic entries in certain other markets. Sales of LEVAQUIN, our anti-infective, were up 3% on an operational basis when compared to the same period a year ago. Growth has been tempered by increased competition. RISPERDAL CONSTA, our long-acting injectable formulation, achieved first quarter sales growth of 10% on an operational basis. U.S. sales growth was flat and was impacted by a reduction in the wholesaler inventory levels. Excluding this impact, growth was estimated to be double-digit. Sales outside the U.S. were up 16% operationally due to a positive shift form oral to injectable therapies. CONCERTA, a product for attention deficit hyperactivity disorder, grew 13% operationally in the first quarter as compared to the same period last year. Sales in the U.S. were up 12% with continued strong market growth. Sales outside the U.S. grew 15% on an operational basis with strong growth seen in most regions; however, competitive dynamics continued to intensify. VELCADE, a treatment for relapsed multiple myeloma, is being co-developed with Millennium Pharmaceuticals. We have commercialization rights in Europe and the rest of the world. Operational sales growth was very strong at 49%, with strong momentum due to the predictable safety profile and a favorable benefit risk ratio. With the potential acquisition of Millennium by Takeda, our ex-U.S. rights under the collaboration, distribution, and licensing agreement with Millennium concerning VELCADE will not change. Wrapping up the review of the pharmaceutical segment, last week we submitted to the FDA the manufacturing supplement sNDA for IONSYS and the sNDA for RISPERDAL CONSTA for adjunctive maintenance treatment to delay the occurrence of mood episodes in patients with frequently relapsing bipolar disorder. I will now review the medical devices and diagnostic segment results. Worldwide medical devices and diagnostic segment sales of $5.7 billion grew 1.4% operationally as compared to the same period in 2007. Currency contributed 5.8 points to the sales growth to bring total growth to 7.2%. Sales in the U.S. grew 0.2% while sales outside the U.S. increased on an operational basis by 2.6%. Results have been impacted by lower sales of drug eluting stents. Sales excluding the impact of lower sales of drug eluting stents grew nearly 5% operationally. Now turning to the franchises, starting with Cordis; Cordis sales were down 15% operationally with similar results in and outside the U.S. Cordis results were impacted by lower sales of Cypher, our Sirolimus-eluting stent, partially offset by the results of our Biosense Webster business and our neurovascular business. Cypher sales were approximately $400 million, down 27% on an operational basis versus the prior year. Sales in the U.S. of approximately $170 million were down 28%. A reduction in PCI procedures, a lower penetration rate of drug eluting stents, and lower prices resulted in an estimated market decline in the U.S. of approximately 25% versus the first quarter of 2007. Estimated share in the U.S. of 43% was down three points sequentially and down two points from the first quarter of 2007 due to the market entry of a new competitor during the quarter. Sales outside the U.S. of approximately $230 million declined 27% operationally. The estimated market share in the quarter of 39% was down one point on a sequential basis and down from 52% in the first quarter of 2007. Increased competition has impacted the share outside the U.S. CYPHER estimated worldwide share for the quarter was 41%, down one point sequentially and down 7 points from the first quarter of 2007. Now, turning to growth drivers within the Cordis franchise, the Biosense Webster business, our electro-physiology business, achieved double-digit operational growth in the quarter with the ultrasound products continuing to be strong contributors. The neurovascular business also achieved strong growth in the quarter due to the relaunch of the TRUFILL DCS Orbit Coil system and the enterprise stent in 2007. Our Depuy franchise had operational growth of 4% when compared to the same period in 2007, with the U.S. growing 2% and the business outside the U.S. growing by 6% operationally. Hip growth on a worldwide basis was 9% operational, led by the strong results in the U.S. where we hold the number one market position. On an operational basis, worldwide knee growth was 2% while spine was flat. Mitech, our sports medicine business, grew 11% operationally. Ethicon Endo-Surgery achieved operational growth of 6% in the first quarter of 2008, with U.S. sales growing 3% and sales outside the U.S. growing on an operational basis by 9%. Strong results were achieve in the energy business due to the success with the harmonic scalpel. In addition, the Endocutter, a key product in performing bariatric procedures and advanced sterilization products also contributed to the growth in the quarter. Ethicon worldwide sales grew operationally by 1% with U.S. down 1% and sales outside the U.S. growing operationally by 3%. On an operational basis, sales of sutures and women’s health were flat while meshes and hemostasis achieved solid growth. The diabetes franchise grew operationally by 6% in the first quarter of 2008. The U.S. business grew by 4% while sales outside the U.S. grew 8% on an operational basis. Growth in the U.S. was driven by the strong double-digit growth of the Animas pump business. The success of the one-touch ultra line has been the major driver of growth outside the U.S. Our Vision Care franchise achieved operational sales growth of 12% with sales in the U.S. growing at 16% and sales outside the U.S. growing 9% on an operational basis. Growth for the franchise was driven by the global success of Acuvue Oasis, One-Day Acuvue Moist, and Acuvue Advanced for Astigmatism. Additionally, outside the U.S. One-Day Acuvue Define made a strong contribution to growth in the quarter. Rounding out the review of the medical devices and diagnostic segment, Ortho-Clinical Diagnostics achieved operational growth of 4% in the first quarter. Sales outside the U.S. were up 5% on an operational basis due to increased sales in clinical chemistry. Sales growth in the U.S. was 2% with donor screening and immunohematology products achieving double-digit results. Partially offsetting this growth was lower sales in clinical chemistry due to shipment timing. With the launch of the Chagas assay in 2007, 85% of the U.S. blood supply is now screened for this disease. That completes highlights for the medical devices and diagnostic segment and concludes the segment highlights for Johnson & Johnson's first quarter of 2008. Before we open the call to your questions, I’ll turn the discussion over to Dominic Caruso for some additional comments. Dominic.
Dominic J. Caruso: Thank you, Louise. We are very pleased today to report solid financial results for the first quarter of 2008, which Louise has already highlighted for you. As we expected, our first quarter results reflected the continued impact of generic competition, the softening of the market for ESAs, some additional competition in drug eluting stents, and the implementation of our cost restructuring program announced last year. Our sales results for the quarter were above the mean of the analyst estimates as published by First Call. In the first quarter of this year, we have benefited from the successful launch of ZYRTEC, which included some initial inventory build in the trade, as well as the timing of shipments of REMICADE to our partner for distribution outside the U.S., reflecting inventory planning on their part. Additionally, in some of our MD&D businesses in the U.S., we saw slower ordering patterns from our distributors, which is due partly to timing of shipments and which may also be an early sign that procedure volumes may have slowed somewhat, at least in the first quarter. We delivered another solid earnings performance for the quarter as well, which reflects our ability to continue managing our cost and improving our margins. We have largely implemented the cost restructuring program that we announced last year and we remain on track to achieve annual cost savings of approximately $1.3 billion to $1.6 billion for 2008. As you can see, our operating margins have improved across each major category of the earnings statement. Our solid earnings performance exceeded the mean of analyst estimates as published by First Call. Now a brief update on the progress of our $10 billion share repurchase program. As you’ll recall, we began purchasing shares in August of 2007 and to date, we have purchased approximately $5.1 billion of our stock, or approximately 80 million shares. This share repurchase program, along with our dividends, continues to demonstrate our commitment to returning value to our shareowners while maintaining a strong financial position that provides the flexibility to invest in business building activities for future growth. This quarter we continued to show progress on new product introductions and pipeline developments that will fuel our growth going forward. In consumer, as I mentioned, our allergy treatment ZYRTEC became available without a prescription in stores across the U.S. for the first time. As the number one prescribed allergy treatment in the U.S., ZYRTEC’s availability over the counter has been highly anticipated and its launch has gone very well. Based on the data so far, we’ve reached 90% of U.S. stores in our first three months and we are very encouraged by the response. Our launch plans are on schedule, the marketing campaign is going well and we continue to view ZYRTEC’s switch as an important growth contributor for our consumer business. Meanwhile, the integration of the Pfizer Consumer Healthcare business and brands continues to be on track to meet or exceed our target of $500 million to $600 million in cost synergies by 2009, and we still expect this transaction to be break-even or modestly accretive by 2009, one year ahead of the original schedule. We’ve also seen significant progress in our medical device pipeline this quarter. Our Cordis and Conor Medsystems businesses have begun a randomized clinical trial comparing the [Nevo] Sirolimus-eluting coronary stent to Taxus Liberte Paclitaxel-eluting coronary stent. [Nevo] is the brand name for our new Conor Sirolimus product. We look forward to the results of this trial and remain excited by the prospect of combining a Sirolimus drug, which is used in Cordis’ CYPHER drug eluting stent, with Conner Medsystems unique reservoir technology for drug delivery. At our analyst meeting last October, we also discussed the development of the first computerized personalized sedation system, or CAPS. Ethicon Endo-Surgery has recently submitted a pre-market approval application to the FDA for this system. Turning to our pharmaceutical pipeline, we received good news on the virology front. The FDA in January granted accelerated approval to Tibotec pharmaceutical’s HIV medicine, INTELENCE, which was previously known as TMC125. This is the first new drug in its class to be approved in 10 years and its accelerated approval is a tribute to the breakthrough research and development that our virology teams have been doing. Meanwhile, in the area of pain management, we submitted a new drug application to the FDA for tapentadol, an investigational oral analgesic for the relief of moderate to severe acute pain. In addition, Centocor submitted a Marketing Authorization Application in Europe this quarter for the approval of golimumab, or CNTO148. Golimumab is a monthly subcutaneous treatment for adults with rheumatoid arthritis, psoriatic arthritis and ankylosing spondylitis. As a reminder, we have several new compounds currently under review with health authorities. These include Ustekinumab in the U.S. and the E.U.; paliperidone palmitate in the U.S.; [hipoxitene] in select countries in Europe; and ceftobiprole in the U.S. and the E.U. I would now like to provide some comments for you to consider as you refine your models for 2008. Let’s start with a discussion of cash and interest income and expense. During the first quarter of 2008, the company continued to generate strong cash flows. At the end of the first quarter, we had approximately $400 million of net debt. This consists of approximately $11 billion of cash and investments and $11.4 billion of debt. This is a slight increase in our overall net debt position from year-end 2007 as we have used approximately $1.5 billion in the first quarter of this year to continue buying our stock under our share repurchase program. For purposes of your models, assuming no major acquisitions, and considering the continuation but not full completion of the share repurchase program during 2008, I would suggest you consider modeling net interest income of between zero and a minor level of interest income consistent with our guidance in January. Turning to other income and expense, as a reminder this account is where we record royalty income as well as one-time gains and losses arising from such items as litigation, gains or losses from investments by our development corporation, or asset sales. This account is difficult to forecast but assuming no major one-time gains or losses, I would recommend that you consider modeling other income and expense for 2008 as a net gain ranging from approximately $100 million to $150 million, or a somewhat lower level of other non-operating net gains as compared to our earlier guidance. And now a word on taxes; for the first quarter of 2008, the company’s effective tax rate was 24.2%. We would suggest that you model our effective tax rate for 2008 in the range of 24% to 24.5%, which would not include any special items and is consistent with our earlier guidance. Additionally, this guidance does not assume the reenactment of the R&D tax credit for 2008. As always, we will continue to pursue opportunities in this area to improve upon this rate throughout the year. Turning to sales, we would be comfortable with your models reflecting operational sales growth for the full year 2008 of between 1% and 2%, consistent with our earlier guidance. As you know, currency impacts are difficult to predict and while we cannot predict the impact of currency movements, to give you an idea of the potential impact if currency rates were to stay where they are today through the end of this year, our sales growth would be favorably impacted by approximately 4.5%, resulting in total reported sales growth for the year of between 5.5% and 6.5%. Now for earnings -- when I last checked, the First Call mean estimate for our EPS for full year 2008 was $4.44 per share. Considering the strength of our first quarter earnings performance, the impact of the launch of ZYRTEC, and the timing of shipments for REMICADE as I mentioned earlier, but not losing sight of the loss of U.S. market exclusivity for RISPERDAL in the second half of the year, we suggest that you model our EPS for 2008 excluding any special items between $4.40 and $4.45 per share, slightly higher than our guidance in January. That concludes my comments on our operating performance this quarter and our guidance with respect to your models. I look forward to updating you throughout the year on our quarterly earnings calls. Thank you and now back to you, Louise.
Louise Mehrotra: Thank you, Dominic. Elizabeth, can you please give the instructions for the questions?
Operator: (Operator Instructions) Your first question comes from the line of Mike Weinstein with J.P. Morgan.
Michael Weinstein - J.P. Morgan: Good morning. First question, Dominic, you had a strong quarter here particularly with regard to consensus expectations. I think the consensus for the quarter was $1.20. You reported $1.26 adjusted, so you had a $0.06 beat but relative to your prior guidance, you only raised expectations for the year it looks like by $0.01. So maybe you can just comment on that. Thanks.
Dominic J. Caruso: Sure, Mike. The -- as I commented on throughout the discussion and Louise did in her discussion as well, we mentioned that we benefited in the first quarter from a number of items, particularly the successful launch of ZYRTEC, which included some inventory stocking in the trade. Of course, that will then bleed off a bit in the remaining quarters of the year. Our launch plans are consistent with our annual guidance but we did see some significant build in the first quarter and that impacted our first quarter number. I don’t think that the -- when I looked at the various estimates throughout the analyst community, it didn’t seem like those were built in to those estimates. And secondly, we mentioned that the O-U.S. shipments for REMICADE to our partner were significant in the first quarter, reflecting also inventory build on their part. As you may remember, we shipped bulk to our partner outside the U.S. and they finish the product for distribution outside the U.S. and through their inventory planning process, they ordered much more earlier in the year than perhaps we would have anticipated. So we think that will obviously bleed off as well. So taking that into consideration, those two items into consideration, and also looking at the fact that we expect a little bit lower non-operating gains, as I mentioned, and other income and expense, we thought it would be prudent to review our annual results again with you and slightly increase our expectations for the year.
Michael Weinstein - J.P. Morgan: Okay. You made a couple of other interesting comments that look at the performance of the business, as the consumer business was very strong, obviously helped by ZYRTEC but was still strong across the board. And then you made a comment about the really your U.S. MD&D business. You had a number of businesses that decelerated this quarter versus what we had seen last quarter and you made a comment about procedure volumes. Ethicon was surprisingly light this quarter. Ethicon Endo was I think 3% and Life Scan was slower and it was a little bit slower. So the commentary there about the distributor ordering patterns and procedure volumes, can you just flesh that out a little bit in terms of what you think you are seeing across the MD&D business?
Dominic J. Caruso: Sure. What we’ve seen early on in the year is that as I mentioned, distributors softened their ordering a little bit in the early part of the year. Our field checks tell us that’s a little bit of an inventory burn on their part, which is okay as you might expect that to happen. But also there may be early -- these are very early signs that at least in the first quarter, we did see some lower procedure volumes across the surgical suites in the U.S. We don’t -- we’re not sure whether that is going to be an impact for the full year or not but we definitely think it had some impact in our first quarter.
Michael Weinstein - J.P. Morgan: Okay, great. Last question and then I’ll let someone else jump in here -- ceftobiprole which became approvable later on during the quarter, what is your expectation there for timing?
Dominic J. Caruso: Well, the timing is obviously we have to work through with the FDA their completion of the review. You may remember that the reason -- in the approvable letter, the FDA cited completion of site inspections on their part and review of some additional information that we have provided. There’s been no indication of any safety or any other manufacturing issues of any sort, so I don’t want to predict how long it will take the FDA to complete their review and we would just like to wait and make sure that they are thoroughly complete with their review and then get back to us on their findings.
Michael Weinstein - J.P. Morgan: Great. Thank you, Dominic.
Louise Mehrotra: Next question, please.
Operator: Your next question comes from the line of Glenn Reicin with Morgan Stanley.
Glenn Reicin - Morgan Stanley: A couple of housekeeping questions -- you brought up the REMICADE stocking issue. You said it’s two-thirds of growth so that comes out to about $125 million. Is that about right?
Louise Mehrotra: Your math is good.
Glenn Reicin - Morgan Stanley: Okay, and then on ZYRTEC, can you at all quantify what you think the initial stocking was? And then you said it’s going to be a great growth driver for the year. Can you quantify what your expectations are for ZYRTEC for the year?
Dominic J. Caruso: We won’t -- Glenn, as you know we won’t give individual estimates for a product growth. ZYRTEC is included in our overall sales growth estimates for the year. As far as the first quarter is concerned, that OTC category which grew in excess of 25%, if we were to exclude ZYRTEC from that category of sales, we would see low to mid-single-digit growth in that category.
Glenn Reicin - Morgan Stanley: Okay then, how much of that growth do you think was stocking versus underlying usage?
Dominic J. Caruso: Well, probably a good two-thirds of the initial sales in the first quarter were attributed -- we believe are attributed to stocking.
Glenn Reicin - Morgan Stanley: That’s very helpful. Okay, and then also just two other quick questions -- INVEGA, is that included in the RISPERDAL number or is that separate now?
Dominic J. Caruso: That’s separate now in Other.
Glenn Reicin - Morgan Stanley: Okay, and you are not going to tell us what that number is?
Louise Mehrotra: No, not right now.
Glenn Reicin - Morgan Stanley: Okay, so all the other numbers you’ve given us in the past are going to be restated for that change?
Louise Mehrotra: The numbers that you have in the schedule have your comparables for prior year.
Glenn Reicin - Morgan Stanley: In prior quarters did INVEGA, was that included under the anti-psychotic number?
Louise Mehrotra: Yes, it was. And the numbers --
Glenn Reicin - Morgan Stanley: Okay, so we’re going to get restated schedules for all of the quarters going back or no?
Louise Mehrotra: What we have given you here is 2007 restated to take INVEGA out. We certainly could give you -- break out the RISPERDAL Oral and we could put that up.
Glenn Reicin - Morgan Stanley: Okay, we’ll do that later. And then R&D was only up around 4%. What do you expect growth in R&D to be up this year and why only 4%?
Dominic J. Caruso: Well, again Glenn, we won’t comment on individual line items like that because we manage the business throughout the 250 operating companies around the world and let them decide the proper level of spending in each of their categories, but generally speaking R&D growth will not be as pronounced as it has been in prior years. It will most likely be closer to the sales growth as opposed to the increased level of R&D spending you saw in prior years, as we now have built the pipeline as you saw and the products are now beginning to move through the regulatory process and off into the market.
Glenn Reicin - Morgan Stanley: So you’re actually saying that pharma spending moderates during the next couple of years on an R&D --
Dominic J. Caruso: That’s probably -- that’s a good -- it will definitely moderate a bit from our prior several years growth in R&D, that’s right.
Glenn Reicin - Morgan Stanley: Okay. Thank you very much.
Louise Mehrotra: Thank you. Next question, please.
Operator: Your next question comes from the line of Tao Levy with Deutsche Bank.
Tao Levy - Deutsche Bank: Good morning. You did comment briefly on the procedures that you were seeing sort of at hospitals being maybe a tad lighter in Q1. I was just wondering if you could provide any commentary around sort of more capital equipment spending that you might detect. I know you guys don’t do too much of that but I would love to get any thoughts there.
Dominic J. Caruso: Actually, Tao, we -- as you know, our business is not capital intensive at all and so it would be not appropriate for me to comment on that part of the business, which we really don’t participate much in.
Tao Levy - Deutsche Bank: Okay. And you also mentioned on drug eluting stents lower prices affecting you here in the U.S. I was just wondering if you could quantify that change.
Dominic J. Caruso: Sure and maybe Louise has it more readily available. If you look at price in drug eluting stents in this quarter versus last quarter of last year, it’s a decline on average of about 6%.
Tao Levy - Deutsche Bank: Great, thanks. And then just lastly, any general thoughts on the recent district court decision in favor of Teva on generic RISPERDAL and whether -- how that impacts how you are thinking about RISPERDAL going generic in the back half of the year.
Dominic J. Caruso: Right. Well, we are obviously aware of the court decision that is favorable to Teva to grant them a 180-day exclusivity period. We would prefer to wait for the FDA to actually act because the FDA has not yet granted Teva that exclusivity period so I would prefer to wait and see how the FDA acts and then we’ll plan accordingly.
Tao Levy - Deutsche Bank: But is it fair to -- I mean, if the FDA agrees with the courts, then that’s sort of a net positive for you guys versus your prior thinking?
Dominic J. Caruso: Sure, well, it’s always positive when you have less competitors in the market.
Tao Levy - Deutsche Bank: Okay, great. Thanks.
Louise Mehrotra: Thank you. Next question, please.
Operator: Your next question comes from the line of Bob Hopkins with Lehman Brothers.
Bob Hopkins - Lehman Brothers : Thanks and good morning. A couple of quick questions; first, Dominic, to go back to your comments about procedure growth during the quarter, was that spread evenly across Ethicon and Depuy or was that, your comments more focused on one versus the other, especially your comments on distributor inventory issues versus just overall slowdown? I was wondering if there was any further level of granularity you could provide there.
Dominic J. Caruso: Yeah, I think we saw lower procedure growth in general but I think probably in our Ethicon business more so than in the other businesses.
Bob Hopkins - Lehman Brothers : Okay, so the inventory issue you are talking about is related more to Depuy than Ethicon than?
Dominic J. Caruso: Well, it’s been across the board, Bob, so we have to do some additional field checks but I think in terms of the overall growth or slower growth in procedures probably more in the general surgery are that we saw in our Ethicon business.
Bob Hopkins - Lehman Brothers : Okay, thank you. That’s very helpful. And then on VELCADE and Millennium in light of the deal, I just want to be clear here -- should we expect the structure of your relationship with Millennium to change in any way as a result of this deal?
Dominic J. Caruso: Well, let’s break down the structure of the deal for you, that we -- hopefully this will be helpful. Outside the U.S., we have a broad arrangement with Millennium and as you know, we were the sole exclusive marketing partner outside the U.S. With respect to the current deal with Takeda that may take place, that deal will not be impacted in any way. In the U.S., we actually co-promote VELCADE along with Millennium. That particular co-promote arrangement has various expiration dates. They are generally annual and then they can be renewed by either party on an annual basis, so we will have to wait and see what -- if the transaction goes through what the new thinking is on the part of our partner. We would be happy to continue co-promoting the product with Millennium or the new entity, as the case may be.
Bob Hopkins - Lehman Brothers : Okay. Thank you. That’s helpful and then one final question -- given the launch of INTELENCE, I was wondering if you could provide any qualitative or quantitative thoughts on how we should think about that launch throughout the course of the rest of ’08 and into 2009.
Dominic J. Caruso: It’s probably too early, Bob, to give you any indication. We just launched it just a few months ago so I’d prefer to wait and see as we get more experience under our belt. I would say that the initial reaction by the medical community has been very positive, so we look forward to updating you more throughout the year.
Bob Hopkins - Lehman Brothers : Thank you, Dominic. Appreciate it.
Louise Mehrotra: Next question, please.
Operator: Your next question comes from the line of Larry Keusch with Goldman Sachs.
Lawrence Keusch - Goldman Sachs: Good morning. Dominic, I’m wondering if you could just review for us now where things stand with IONSYS, both in the U.S. and Europe. You obviously made some indications on the filing but I just want to kind of get an understanding where we stand.
Dominic J. Caruso: Sure. Well, IONSYS in Europe, we filed a manufacturing adjustment already, as you know, and it’s already been launched in Europe in seven countries, so it’s in the market in Europe. In the U.S., we just recently filed a manufacturing adjustment application with the FDA and we’ll have to wait for the FDA to take a look at that and we expect to hear back from them later this year.
Lawrence Keusch - Goldman Sachs: Okay, so it is possible that it could launch in the U.S. this year?
Dominic J. Caruso: Yeah, let’s just wait and see what the -- we work very closely with the FDA on it. Let’s just wait and see what the FDA has to say about our application.
Lawrence Keusch - Goldman Sachs: Okay, and then two other quick ones -- you certainly made some comments in the past, I think you’ve done some analysis around this where your consumer portfolio tends to do well during periods of economic challenges. But I just want to see how that was tracking in the first quarter and maybe you could take into account some of the comments about the decline in sales of Rembrandt as well as In-Reach toothbrushes. That’s question one. And then question two, I know you are going to get a lot of questions about the procedure volume that you mentioned but just anecdotally as you speak to the business managers, any sense of why you might be seeing any change in procedure volumes this early in the year and again, early in the economic cycle?
Dominic J. Caruso: Okay, well first with respect to our consumer business, you are right. As we looked over the years at various economic cycles, our consumer business did not -- really did not correlate at all with any economic cycles, either up or down. So the business does not seem to be impacted by major trends in the economy. You had asked about Rembrandt and Reach. We did have some slower growth in Rembrandt and Reach toothbrushes, which offset the very strong growth that we had in Listerine. Listerine is really the driver in our oral care business right now. It’s doing remarkably well for us, as we expected, bringing in a product of that heritage into our portfolio is very, very promising, so we are pleased with the outlook and the progress that we are making with Listerine. With respect to procedure volumes, it is a little early to comment on it, Larry. I think there’s a number of factors going on here. The holiday schedule, for example, in the first quarter of this year was different than the first quarter of last year, so scheduling procedures may be a little different than it was year over year. There isn’t anything that stands out to us in terms of one particular category or one particular factor impacting procedure growth. We just saw a little bit slower procedure growth this quarter than we had seen in the first quarter of prior years. So a little too early to tell. We’ll have to wait and see what others report and we’ll get a better sense for the overall market after we see that.
Lawrence Keusch - Goldman Sachs: Okay, great. Thanks for the comments, guys.
Louise Mehrotra: Thank you. Next question, please.
Operator: Your next question comes from the line of Michael Jungling with Merrill Lynch.
Michael Jungling - Merrill Lynch: Good morning, everyone. I have three questions. Firstly, can you give us the division EBIT for consumer, pharma, medical devices? Secondly, were you invited to make an offer for Alcon? And then thirdly, a question; if you did make another large acquisition, what is the upper limit that you are willing to go on a net debt to EBITDA? That would be great. Thank you.
Dominic J. Caruso: Michael, as you know we don’t really discuss the individual operating performance of the businesses. Rather, we give you an overall perspective on the enterprise and as you saw, we had very strong EBIT or pretax operating margins for the enterprise in the first quarter and we are pleased to see that the restructuring program we put in place last year has now been largely implemented and we see that in the operating margins for the entire business. No comment on the -- on whether or not we were invited in any particular situation. And lastly, with respect to acquisitions, the way we think about it, Michael, is in evaluating any limits, we don’t use the -- our Triple A credit rating, for example, as a limitation to our ability to make an appropriate offer for any acquisition that we would find attractive. Our primary criteria is whether or not the acquisition will generate significant shareholder value and in evaluating that, we take a look at whether or not the acquisition, proposed acquisition would generate a return sufficiently in excess of our cost of capital to compensate our shareholders for the risk. That’s our entire focus is on creating shareholder value and not necessarily on maintaining a particular level of debt or debt to equity ratio.
Michael Jungling - Merrill Lynch: And then just one final follow-up; if you look at the slow down in procedure growth that you’ve seen in the first quarter, how much of that could be the results of perhaps having less selling days in the first quarter?
Dominic J. Caruso: Well, that’s a great question, Michael and I was just commenting to Larry in the prior question that that did have some impact, that there were several days less shipping days in the quarter just because of the holiday schedule so that obviously had some impact. I can’t quantify it for you, however.
Michael Jungling - Merrill Lynch: Okay. Thank you.
Louise Mehrotra: Next question, please.
Operator: Your next question comes from the line of Matthew Dodds with Citigroup.
Matthew Dodds - Citigroup: Thanks. Good morning. A couple of questions. First, on the gross margin, you were up pretty good year over year and Dominic, I just wanted to see if you could comment at all how much of that might have been related to foreign exchange and how much was related to the restructuring program. And then the second question is on ACIPHEX/PARIET, that had a pretty big drop from what we even saw last year in the fourth quarter. So I guess my question there is was there any reversal in stocking in that kind of decline and is that the kind of run-rate we should expect, or is this a one-time drop of that magnitude?
Dominic J. Caruso: Okay, well with the gross margin, as you saw we did have a very favorable up-tick in gross margin this quarter versus the first quarter of last year. It’s really two items that impact that. One is that you may remember last year we brought in the Pfizer consumer healthcare business and in recording the acquisition price, there’s obviously some inventory step-up to fair market values. That was -- that negatively impacted first quarter gross margins, so the cost of those products were higher then. Obviously they have all now been sold through and so that accounting treatment has been fully taken into account by now, as we enter the first quarter of ’08. And then secondly, the other part of the benefit is the cost restructuring program that we announced last year across most of our businesses. We’ve taken a hard look at some of the cost structure, as you know, and we’ve seen a benefit across all our businesses.
Matthew Dodds - Citigroup: And then how about ACIPHEX?
Dominic J. Caruso: ACIPHEX -- Louise, can you comment on ACIPHEX and the entry of generics into the marketplace?
Louise Mehrotra: So the ACIPHEX in the U.S. is down about 27% and was your question regarding the inventory -- inventory differences is about half of that decline.
Matthew Dodds - Citigroup: Well, yeah because last -- I mean, even last year in the fourth quarter, you grew both in the U.S. and O-U.S. and then you had a huge drop down, so I guess globally is this the kind of -- is this a new level of decline we should expect or was there some reversals in inventory?
Louise Mehrotra: Well, about half of the decline, as I said, is due to reversals in the inventory or changes in the inventory level but there is new competition in the PPI market in the U.S. in terms of a generic and we are seeing that same dynamic outside the U.S. Also in Canada, the PARIET, there is a generic of PARIET on the market now.
Matthew Dodds - Citigroup: Thanks, Louise. Thanks, Dominic.
Louise Mehrotra: Next question, please.
Operator: Your next question comes from the line of Larry Biegelsen with Wachovia.
Larry Biegelsen - Wachovia: Thanks for taking my questions. Louise, drug eluting stent pricing in Europe on a constant currency basis, I think you gave the U.S. earlier.
Louise Mehrotra: On an operational basis, O-U.S. is about 7% down.
Larry Biegelsen - Wachovia: Thanks, and could you tell us what you think your share of the gastric banding market was in the quarter in the U.S. and how broadly you’ve rolled out the Realize brand? And then I have one question after that.
Dominic J. Caruso: Larry, as you know we are in the early stages of that launch so I -- we are probably not going to comment right now on market share there. In terms of how broadly it’s been rolled out, we have been undergoing physician training with respect to this launch. We’ve included in the launch plans a significant amount of physician training and education to ensure that the product is used appropriately, so we are just about through that now and then obviously we will continue to see further penetration of the product. It’s early though to give you any indication of share.
Larry Biegelsen - Wachovia: And the U.S. filing for Rivaroxaban and Golimumab, could you just remind us of the dates on those two please? Thanks.
Dominic J. Caruso: Louise, why don’t you comment on those?
Louise Mehrotra: Okay, so for Golimumab, it will be in the second quarter in the U.S. and for Rivaroxaban in the third quarter in the U.S.
Larry Biegelsen - Wachovia: Thank you.
Louise Mehrotra: Next question, please.
Operator: Your next question comes from the line of Sara Michelmore with Cowen.
Sara Michelmore - Cowen & Company : Good morning. Can you talk about the environment for price increases in your pharmaceutical business? I know recently you did take a price increase on REMICADE in the U.S. Can you just talk about the environment in general and if there are any other product lines where you’ve been able to pass through price increases recently?
Dominic J. Caruso: Right. Well Sara, as you know this environment in general is a difficult environment to take price increases in. And really the area that you can take prices in is when you obviously show significant benefit or differentiation from other products in the market. So we believe to the extent that we have such differentiation and we believe many of our products do demonstrate value to the healthcare system, we’ll continue to look for price increases where appropriate. But I would say the environment is not really conducive to price increases at all.
Sara Michelmore - Cowen & Company : Okay, and any other major product lines besides REMICADE in which you’ve been able to raise price recently?
Dominic J. Caruso: I don’t have the data in front of me, Sara, but we probably won’t comment on individual products.
Sara Michelmore - Cowen & Company : Okay. And in terms of CYPHER, I just wanted to clarify the U.S. market commentary there in particular, in terms of DDS utilization and PTCA volume declines. Could you just on a sequential basis give us a sense of what the trend there -- I know it was down significantly year over year but I’m just wondering if from your standpoint if that environment has stabilized or improved or deteriorated quarter to quarter.
Dominic J. Caruso: Right, so let me give you some insight into our estimate of the penetration rate in the U.S. for the first quarter is about 64%, and although that is significantly lower than the first quarter of ’07, we think it’s about a point higher than the fourth quarter of ’07. So that’s a good sign. It looks like the penetration rate sequentially now has stabilized. And in terms of the overall procedure volume, I don’t have that information handy right now.
Louise Mehrotra: Rough estimate is between the 10% and 15% range down in the quarter.
Sara Michelmore - Cowen & Company : Okay, okay and I guess we heading into the May medical meeting season. Any big data dissemination we should be paying attention to coming up at ASCO, DDW, APA -- any other meetings? I know specifically if you could comment on paliperidone palmitate and if we are going to see that Phase III data in the next couple of months.
Louise Mehrotra: At APA, you will see a poster on Phase III data at APA. We’ve also got REMICADE -- sorry, Golimumab Phase III data RA at ULAR, and that’s in June in Paris. And that’s -- we’ve got some Tapentadol data also coming out later on in the quarter as well at APS in Tampa.
Dominic J. Caruso: I think a little further out, Sara, I think in September we’ll see Ustekinumab at a Durham meeting in comparison to [Embro] I think, right?
Louise Mehrotra: Correct.
Sara Michelmore - Cowen & Company : Great. Thank you.
Louise Mehrotra: Okay, and last question.
Operator: Your last question comes from the line of Bruce Nudell with UBS.
Bruce Nudell - UBS: Good morning. Ex-ZYRTEC stocking, what would you estimate the operational growth of consumer might have been?
Dominic J. Caruso: For the entire consumer sector, I just don’t have it handy but as we mentioned earlier in the OTC arena, that growth of 25 or some percent was obviously -- obviously benefited from the ZYRTEC launch and that growth would have been in the low to mid single digits.
Bruce Nudell - UBS: Okay, thank you. And with regard to the procedure slow down in surgery, general surgery I think you said, in prior periods of economic slow down have you seen that sort of effect before?
Dominic J. Caruso: Actually no. On a big picture perspective, all of our businesses actually have had very little correlation to economic trends. I would say we are in a little bit of a unique environment though today, so it’s hard to predict based on past practices but we are a little bit in a unique environment with this particular economic slowdown, so to predict what impact that would have now would be a little premature. It’s just early in the quarter and we just saw some early signs.
Bruce Nudell - UBS: I guess just to follow-up on that, why -- in what manner is this particularly unique?
Dominic J. Caruso: Well, you mean the overall economic slow down?
Bruce Nudell - UBS: Yes, from --
Dominic J. Caruso: Well, I think from my perspective, Bruce, what I see is the uncertainty in the credit markets being somewhat of an area of -- well, quite frankly uncertainty and then economic growth is a question mark as a result of that. We’ve seen this before in other economic cycles but I think you’d agree this one is a little bit more pronounced than we’ve seen in at least more recent economic cycles.
Bruce Nudell - UBS: But it wouldn’t necessarily tie to general surgical procedures or --
Dominic J. Caruso: Well, no, that’s what I -- that’s right and that’s what I mentioned. It’s not necessarily something that we have seen in the past and I’m not sure whether it’s something we are seeing now but it’s just early in the year and we’re giving you some insight into some early indicators that we saw in the first part of this year.
Bruce Nudell - UBS: I guess my final question is you know, you guys clearly have enormous financial resources and capacity to buy back shares, tighten the belt. But looking forward 1.5% to 2.5% operational growth is going to be problematic for stock progression. From your point of view, what are the organic growth drivers for the top line that you folks are most excited about? Thank you.
Dominic J. Caruso: Sure, Bruce and of course, the 1% to 2% you mentioned going forward, the 1% to 2% of course is this year’s operational growth rate. We’re not going to comment on what it would be going forward but we are excited about the overall robustness of the pipeline. And as we mentioned earlier in the call today, we’ve made very, very good progress on all fronts -- the medical device business is filing for new products, exciting products like the CAP system. We’ve begun the Sirolimus on the Conor stent clinical trial, which I think is an exciting new growth platform for us going forward. And as you know the pharma pipeline is not only robust, it’s progressing according to schedule and we are making the filings and dialoging with the health authority. And so we have a number of potential growth drivers already moving forward, consistent with our plans. And having said all that, during a time of some slow growth in the short-term period, we obviously feel like we took the appropriate disciplined actions for the business overall to account for that.
Bruce Nudell - UBS: Thanks so much.
Dominic J. Caruso: Okay. Great, well, thank you, everyone and thank you, Louise. Before we end this call, I would like to share some final thoughts on this quarter’s results. We are continuing to execute against the key priorities and pipeline opportunities we have recently outlined for you. Our progress on new products and new filings is moving along, thanks to the hard work and dedication of the extraordinary people across the Johnson & Johnson family of companies. We continue to invest in growth opportunities that are critical to our future while continuing to manage our costs and improve our operating margins. I look forward to speaking with you again at our meeting on June 5th where we will focus on our medical devices and diagnostics businesses and also provide an update on the consumer business. Thank you for your continued support of Johnson & Johnson and have a great day.
Operator: Thank you. This concludes today’s Johnson & Johnson first quarter 2008 earnings conference call. You may now disconnect. | [
{
"speaker": "Executives",
"text": "Louise Mehrotra - Vice President of Investor Relations Dominic J. Caruso - Chief Financial Officer, Vice President - Finance"
},
{
"speaker": "Analysts",
"text": "Michael Weinstein - J.P. Morgan Glenn Reicin - Morgan Stanley Tao Levy - Deutsche Bank Bob Hopkins - Lehman Brothers Lawrence Keusch - Goldman Sachs Michael Jungling - Merrill Lynch Matthew Dodds - Citigroup Larry Biegelsen - Wachovia Sara Michelmore - Cowen & Company Bruce Nudell - UBS"
},
{
"speaker": "Operator",
"text": "Good morning and welcome to the Johnson & Johnson first quarter 2008 earnings conference call. (Operator Instructions) I would now like to turn the conference over to Johnson & Johnson. You may begin."
},
{
"speaker": "Louise Mehrotra",
"text": "Good morning and welcome. I’m Louise Mehrotra, Vice President of Investor Relations for Johnson & Johnson and it is my pleasure this morning to review our business results for the first quarter of 2008. With me on the call today is Dominic Caruso, Vice President of Finance and Chief Financial Officer. A few logistics before we get into the details -- this review is being made available to a broader audience via a webcast accessible through the investor relations section of the Johnson & Johnson website. Included with the copy of the press release that was sent to the investment community earlier this morning is the schedule showing sales for major products and/or business franchises to facilitate updating your models. These are also available on the Johnson & Johnson website, as is the press release. I will review highlights of the first quarter 2008 results for the corporation and for our three business segments. Following additional remarks from Dominic, we will open the call to your questions. We expect the total call to last approximately one hour. Before I get into the results, let me remind you that some of the statements made during this call may be considered forward-looking statements. The 10-K for the fiscal year 2007 identifies certain factors that could cause the company’s actual results to differ materially from those projected in any forward-looking statements made this morning. The company does not undertake to update any forward-looking statements as a result of new information or future events or developments. The 10-K is available through the company or online. Last item -- during the call, non-GAAP financial measures may be used to provide information pertinent to ongoing business performance. These measures are reconciled to the GAAP measures and are available on the Johnson & Johnson website. Now I would like to review our results for the first quarter of 2008. If you would refer to your copy of the press release, let’s begin with the schedule titled supplementary sales data by segment of business. Worldwide sales to customers were a record $16.2 billion for the first quarter of 2008, up 7.7% as compared to the first quarter of 2007. Our operational growth was 2.6% and currency contributed 5.1 points. If you turn to the schedule showing sales by geographic area, you will see that we achieved growth of 2.8% in the U.S. In regions outside the U.S., our operational growth was 2.4%, while the effect of currency exchange rates positively impacted our reported results by 11.3 points. Our strongest performing region was the Western Hemisphere excluding the U.S., growing 6.2% on an operational basis. Asia-Pacific/Africa region grew by 3.2% operationally while Europe grew 0.8% operationally. If you will now turn to the consolidated statement of earnings, net earnings on a reported basis were $3.6 billion and earnings per share were $1.26. This compares to $2.6 billion and $0.88 in the same period in 2007. Please direct your attention to the box section of the schedule where we have provided adjusted earnings information. As a reference in the footnote, the 2007 results had been adjusted for the after-tax impact of the in-process research and development charge of $807 million associated with the acquisition of Conor Medsystems. Net earnings on an adjusted basis were up 6.4% and adjusted earnings per share were up 8.6%. I would now like to make some additional comments relative to the components leading to the adjusted earnings before we move on to the segment highlights. Cost of goods sold at 28.5% is down 60 basis points as compared to the same period in 2007, with reductions seen across all three segments. Selling, marketing, and administrative expenses of 31.6% of sales are down 30 basis points as compared to 2007. This leverage is due to reductions primarily in our pharmaceutical business. Our investment in research and development as a percent of sales was 10.6%, 40 basis points less than the first quarter of 2007. Research and development spending is up nearly 4% in the quarter. Interest expense net of interest income of $16 million compares to $33 million of net interest income in the first quarter of 2007. This increase in expense is due to a higher average debt position in the quarter versus the same period last year, as we continue buying back shares as part of our repurchase program. Other income net of other expense was $18 million in the first quarter of 2008 compared to $228 million in the same period last year. The 2007 results included the gain related to the divestitures of certain brands in connection with the acquisition of Pfizer Consumer Healthcare. With regard to taxes, please direct your attention to the effective tax rate excluding special charges shown in the box section of the schedule. In the first quarter of both 2007 and 2008, taxes were 24.2%. Turning now to business highlights, I’ll begin with the consumer segment. Worldwide consumer segment sales of $4.1 billion increased 16.2% as compared to the first quarter of 2007. Operational growth was 9.9% while currency contributed 6.3%. U.S. sales were up 11.7% while international sales grew 8.3% on an operational basis. For the first quarter of 2008, sales for the over-the-counter pharmaceuticals and nutritionals increased 21% on an operational basis compared to the same period in 2007. Sales in the U.S. were up 29% while sales outside the U.S. were up 12% operationally. The successful launch of ZYRTEC in the U.S. in January of this year is the major contributor to this increase. Additionally, both the adult and pediatric analgesics achieved strong growth, driven by an increased uptake in the rapid release gels and the later start to the winter flu season. Our skin care business achieved operational sales growth of 4% in the first quarter of 2008 with sales in the U.S. growing at 7% and sales outside the U.S. up 2% on an operational basis. Strong growth was driven by Clean and Clear, Aveeno, and Nutrogena, due to a combination of new product launches and strength in the core businesses due to innovative technologies, like Helioplex. These gains were partially offset by the discontinuation of a small line of facial refreshers. Baby care products achieved operational growth of 11% when compared to the first quarter of 2007. Sales growth in the U.S. was 6% due to increased babycenter.com sales. Sales outside the U.S. grew 13% on an operational basis, driven by the strong double-digit growth of wipes, hair care, powder, and oil. Women’s health achieved operational growth of 2%. Sales in the U.S. were down 9% due to increased competition, while sales outside the U.S. were up on an operational basis by 9% with strong growth in both the internal and external sanitary protection lines. Operational sales growth in the oral care franchise was 3% with U.S. sales down 2% and sales outside the U.S. up 9%. Strong growth was achieved for the Listerine product line due to whitening strips launched in the third quarter of 2007 and the strong performance of Listerine mouthwash. Sales declines in Reach toothbrushes and Rembrandt products partially offset this growth. That completes our review of the consumer segment and I’ll now review highlights for the pharmaceutical segment. Worldwide net sales for the first quarter of $6.4 billion were up 3.3% versus the same period last year. On an operational basis, sales were down 0.6% with positive currency contributing 3.9 points. Sales in the U.S. increased 0.9% while sales outside the U.S. decreased on an operational basis by 3.1%. Our results continue to be impacted by generic competition on some of our products, namely DURAGESIC, and outside the U.S. RISPERDAL ORAL in many countries. The combined effect of this generic competition has reduced the first quarter worldwide pharmaceutical operational sales growth by approximately 3.5 percentage points with the U.S. impact estimated at approximately 1% and the impact outside the U.S. estimated at nearly 8%. Additionally, we saw a retraction in the U.S. market for ESAs following the ODAC discussions, the label changes, and changes to reimbursement. The resulting decline in PROCRIT sales impacted the worldwide pharmaceutical operational sales growth by approximately 4 points. Excluding both the impact of generics and declining PROCRIT sales, the underlying operational growth for pharmaceutical products was approximately 7%. PROCRIT/EPREX had a combined operational decline of 27% with PROCRIT down 37% and EPREX down 9% on an operational basis. New competition and label reviews have contributed to the lower sales results for EPREX. PROCRIT results have been impacted by a decline in the market versus the first quarter of 2007, estimated at approximately 37%, and partially offset by an increase in overall market share. PROCRIT aggregate share across all markets was approximately 45% in the first quarter of 2008, up one point versus the same period last year. Increased share in the hospital and retail markets was partially offset by lower share in the oncology clinics due to our competitors’ anti-competitive contracting strategies. RISPERDAL Oral had an operational decline of 9% when compared to the same period a year ago. Sales in the U.S. grew 4% with market growth of approximately 6% offset by a slight decline in market share. Sales outside the U.S. declined 34% on an operational basis due to generic competition for RISPERDAL Oral in many markets. ACIPHEX, as it’s known in the U.S. market, and PARIET outside the U.S. is a proton pump inhibitor, or PPI, that we co-market with Eisai. On an operational basis, sales were down 23%. U.S. sales were down 27% and sales outside the U.S. were down 19% operationally. In the U.S., market share has been negatively impacted by additional generic launches of competitor PPIs. Similar market dynamics impacted sales outside the U.S., compounded by the impact of market entry in Canada of generic Rabeprazole, the active ingredient in PARIET. Now moving on to our growth drivers -- REMICADE, a biologic approved for the treatment of a number of immune mediated inflammatory diseases, grew by 37% when compared to the first quarter of 2007. Sales growth in the U.S. was 13%. Market growth in the Anti-TNF category continued to be strong and the competitive dynamics intensified with the new competitors in the market and current competitors receiving new indications. Sales to our customers for markets outside the U.S. more than doubled due to a combination of the timing of shipments, strong market demand, and the positive impact of currency. The timing of shipments reflects inventory planning on our customer’s part and was estimated to contribute approximately two-thirds of the increase in sales outside the U.S. versus the same period last year. We expect the resulting build in inventory levels held by our customer will be reduced over the balance of the year. Sales of TOPOMAX, which is approved for the treatment of epilepsy and migraine prophylaxis, increased operationally by 4% with similar results both in and outside the U.S. In the U.S., market share in the migraine category increased versus the same period last year; however, market growth was flat. Outside the U.S., strong growth was achieved in many markets, partially offset by generic entries in certain other markets. Sales of LEVAQUIN, our anti-infective, were up 3% on an operational basis when compared to the same period a year ago. Growth has been tempered by increased competition. RISPERDAL CONSTA, our long-acting injectable formulation, achieved first quarter sales growth of 10% on an operational basis. U.S. sales growth was flat and was impacted by a reduction in the wholesaler inventory levels. Excluding this impact, growth was estimated to be double-digit. Sales outside the U.S. were up 16% operationally due to a positive shift form oral to injectable therapies. CONCERTA, a product for attention deficit hyperactivity disorder, grew 13% operationally in the first quarter as compared to the same period last year. Sales in the U.S. were up 12% with continued strong market growth. Sales outside the U.S. grew 15% on an operational basis with strong growth seen in most regions; however, competitive dynamics continued to intensify. VELCADE, a treatment for relapsed multiple myeloma, is being co-developed with Millennium Pharmaceuticals. We have commercialization rights in Europe and the rest of the world. Operational sales growth was very strong at 49%, with strong momentum due to the predictable safety profile and a favorable benefit risk ratio. With the potential acquisition of Millennium by Takeda, our ex-U.S. rights under the collaboration, distribution, and licensing agreement with Millennium concerning VELCADE will not change. Wrapping up the review of the pharmaceutical segment, last week we submitted to the FDA the manufacturing supplement sNDA for IONSYS and the sNDA for RISPERDAL CONSTA for adjunctive maintenance treatment to delay the occurrence of mood episodes in patients with frequently relapsing bipolar disorder. I will now review the medical devices and diagnostic segment results. Worldwide medical devices and diagnostic segment sales of $5.7 billion grew 1.4% operationally as compared to the same period in 2007. Currency contributed 5.8 points to the sales growth to bring total growth to 7.2%. Sales in the U.S. grew 0.2% while sales outside the U.S. increased on an operational basis by 2.6%. Results have been impacted by lower sales of drug eluting stents. Sales excluding the impact of lower sales of drug eluting stents grew nearly 5% operationally. Now turning to the franchises, starting with Cordis; Cordis sales were down 15% operationally with similar results in and outside the U.S. Cordis results were impacted by lower sales of Cypher, our Sirolimus-eluting stent, partially offset by the results of our Biosense Webster business and our neurovascular business. Cypher sales were approximately $400 million, down 27% on an operational basis versus the prior year. Sales in the U.S. of approximately $170 million were down 28%. A reduction in PCI procedures, a lower penetration rate of drug eluting stents, and lower prices resulted in an estimated market decline in the U.S. of approximately 25% versus the first quarter of 2007. Estimated share in the U.S. of 43% was down three points sequentially and down two points from the first quarter of 2007 due to the market entry of a new competitor during the quarter. Sales outside the U.S. of approximately $230 million declined 27% operationally. The estimated market share in the quarter of 39% was down one point on a sequential basis and down from 52% in the first quarter of 2007. Increased competition has impacted the share outside the U.S. CYPHER estimated worldwide share for the quarter was 41%, down one point sequentially and down 7 points from the first quarter of 2007. Now, turning to growth drivers within the Cordis franchise, the Biosense Webster business, our electro-physiology business, achieved double-digit operational growth in the quarter with the ultrasound products continuing to be strong contributors. The neurovascular business also achieved strong growth in the quarter due to the relaunch of the TRUFILL DCS Orbit Coil system and the enterprise stent in 2007. Our Depuy franchise had operational growth of 4% when compared to the same period in 2007, with the U.S. growing 2% and the business outside the U.S. growing by 6% operationally. Hip growth on a worldwide basis was 9% operational, led by the strong results in the U.S. where we hold the number one market position. On an operational basis, worldwide knee growth was 2% while spine was flat. Mitech, our sports medicine business, grew 11% operationally. Ethicon Endo-Surgery achieved operational growth of 6% in the first quarter of 2008, with U.S. sales growing 3% and sales outside the U.S. growing on an operational basis by 9%. Strong results were achieve in the energy business due to the success with the harmonic scalpel. In addition, the Endocutter, a key product in performing bariatric procedures and advanced sterilization products also contributed to the growth in the quarter. Ethicon worldwide sales grew operationally by 1% with U.S. down 1% and sales outside the U.S. growing operationally by 3%. On an operational basis, sales of sutures and women’s health were flat while meshes and hemostasis achieved solid growth. The diabetes franchise grew operationally by 6% in the first quarter of 2008. The U.S. business grew by 4% while sales outside the U.S. grew 8% on an operational basis. Growth in the U.S. was driven by the strong double-digit growth of the Animas pump business. The success of the one-touch ultra line has been the major driver of growth outside the U.S. Our Vision Care franchise achieved operational sales growth of 12% with sales in the U.S. growing at 16% and sales outside the U.S. growing 9% on an operational basis. Growth for the franchise was driven by the global success of Acuvue Oasis, One-Day Acuvue Moist, and Acuvue Advanced for Astigmatism. Additionally, outside the U.S. One-Day Acuvue Define made a strong contribution to growth in the quarter. Rounding out the review of the medical devices and diagnostic segment, Ortho-Clinical Diagnostics achieved operational growth of 4% in the first quarter. Sales outside the U.S. were up 5% on an operational basis due to increased sales in clinical chemistry. Sales growth in the U.S. was 2% with donor screening and immunohematology products achieving double-digit results. Partially offsetting this growth was lower sales in clinical chemistry due to shipment timing. With the launch of the Chagas assay in 2007, 85% of the U.S. blood supply is now screened for this disease. That completes highlights for the medical devices and diagnostic segment and concludes the segment highlights for Johnson & Johnson's first quarter of 2008. Before we open the call to your questions, I’ll turn the discussion over to Dominic Caruso for some additional comments. Dominic."
},
{
"speaker": "Dominic J. Caruso",
"text": "Thank you, Louise. We are very pleased today to report solid financial results for the first quarter of 2008, which Louise has already highlighted for you. As we expected, our first quarter results reflected the continued impact of generic competition, the softening of the market for ESAs, some additional competition in drug eluting stents, and the implementation of our cost restructuring program announced last year. Our sales results for the quarter were above the mean of the analyst estimates as published by First Call. In the first quarter of this year, we have benefited from the successful launch of ZYRTEC, which included some initial inventory build in the trade, as well as the timing of shipments of REMICADE to our partner for distribution outside the U.S., reflecting inventory planning on their part. Additionally, in some of our MD&D businesses in the U.S., we saw slower ordering patterns from our distributors, which is due partly to timing of shipments and which may also be an early sign that procedure volumes may have slowed somewhat, at least in the first quarter. We delivered another solid earnings performance for the quarter as well, which reflects our ability to continue managing our cost and improving our margins. We have largely implemented the cost restructuring program that we announced last year and we remain on track to achieve annual cost savings of approximately $1.3 billion to $1.6 billion for 2008. As you can see, our operating margins have improved across each major category of the earnings statement. Our solid earnings performance exceeded the mean of analyst estimates as published by First Call. Now a brief update on the progress of our $10 billion share repurchase program. As you’ll recall, we began purchasing shares in August of 2007 and to date, we have purchased approximately $5.1 billion of our stock, or approximately 80 million shares. This share repurchase program, along with our dividends, continues to demonstrate our commitment to returning value to our shareowners while maintaining a strong financial position that provides the flexibility to invest in business building activities for future growth. This quarter we continued to show progress on new product introductions and pipeline developments that will fuel our growth going forward. In consumer, as I mentioned, our allergy treatment ZYRTEC became available without a prescription in stores across the U.S. for the first time. As the number one prescribed allergy treatment in the U.S., ZYRTEC’s availability over the counter has been highly anticipated and its launch has gone very well. Based on the data so far, we’ve reached 90% of U.S. stores in our first three months and we are very encouraged by the response. Our launch plans are on schedule, the marketing campaign is going well and we continue to view ZYRTEC’s switch as an important growth contributor for our consumer business. Meanwhile, the integration of the Pfizer Consumer Healthcare business and brands continues to be on track to meet or exceed our target of $500 million to $600 million in cost synergies by 2009, and we still expect this transaction to be break-even or modestly accretive by 2009, one year ahead of the original schedule. We’ve also seen significant progress in our medical device pipeline this quarter. Our Cordis and Conor Medsystems businesses have begun a randomized clinical trial comparing the [Nevo] Sirolimus-eluting coronary stent to Taxus Liberte Paclitaxel-eluting coronary stent. [Nevo] is the brand name for our new Conor Sirolimus product. We look forward to the results of this trial and remain excited by the prospect of combining a Sirolimus drug, which is used in Cordis’ CYPHER drug eluting stent, with Conner Medsystems unique reservoir technology for drug delivery. At our analyst meeting last October, we also discussed the development of the first computerized personalized sedation system, or CAPS. Ethicon Endo-Surgery has recently submitted a pre-market approval application to the FDA for this system. Turning to our pharmaceutical pipeline, we received good news on the virology front. The FDA in January granted accelerated approval to Tibotec pharmaceutical’s HIV medicine, INTELENCE, which was previously known as TMC125. This is the first new drug in its class to be approved in 10 years and its accelerated approval is a tribute to the breakthrough research and development that our virology teams have been doing. Meanwhile, in the area of pain management, we submitted a new drug application to the FDA for tapentadol, an investigational oral analgesic for the relief of moderate to severe acute pain. In addition, Centocor submitted a Marketing Authorization Application in Europe this quarter for the approval of golimumab, or CNTO148. Golimumab is a monthly subcutaneous treatment for adults with rheumatoid arthritis, psoriatic arthritis and ankylosing spondylitis. As a reminder, we have several new compounds currently under review with health authorities. These include Ustekinumab in the U.S. and the E.U.; paliperidone palmitate in the U.S.; [hipoxitene] in select countries in Europe; and ceftobiprole in the U.S. and the E.U. I would now like to provide some comments for you to consider as you refine your models for 2008. Let’s start with a discussion of cash and interest income and expense. During the first quarter of 2008, the company continued to generate strong cash flows. At the end of the first quarter, we had approximately $400 million of net debt. This consists of approximately $11 billion of cash and investments and $11.4 billion of debt. This is a slight increase in our overall net debt position from year-end 2007 as we have used approximately $1.5 billion in the first quarter of this year to continue buying our stock under our share repurchase program. For purposes of your models, assuming no major acquisitions, and considering the continuation but not full completion of the share repurchase program during 2008, I would suggest you consider modeling net interest income of between zero and a minor level of interest income consistent with our guidance in January. Turning to other income and expense, as a reminder this account is where we record royalty income as well as one-time gains and losses arising from such items as litigation, gains or losses from investments by our development corporation, or asset sales. This account is difficult to forecast but assuming no major one-time gains or losses, I would recommend that you consider modeling other income and expense for 2008 as a net gain ranging from approximately $100 million to $150 million, or a somewhat lower level of other non-operating net gains as compared to our earlier guidance. And now a word on taxes; for the first quarter of 2008, the company’s effective tax rate was 24.2%. We would suggest that you model our effective tax rate for 2008 in the range of 24% to 24.5%, which would not include any special items and is consistent with our earlier guidance. Additionally, this guidance does not assume the reenactment of the R&D tax credit for 2008. As always, we will continue to pursue opportunities in this area to improve upon this rate throughout the year. Turning to sales, we would be comfortable with your models reflecting operational sales growth for the full year 2008 of between 1% and 2%, consistent with our earlier guidance. As you know, currency impacts are difficult to predict and while we cannot predict the impact of currency movements, to give you an idea of the potential impact if currency rates were to stay where they are today through the end of this year, our sales growth would be favorably impacted by approximately 4.5%, resulting in total reported sales growth for the year of between 5.5% and 6.5%. Now for earnings -- when I last checked, the First Call mean estimate for our EPS for full year 2008 was $4.44 per share. Considering the strength of our first quarter earnings performance, the impact of the launch of ZYRTEC, and the timing of shipments for REMICADE as I mentioned earlier, but not losing sight of the loss of U.S. market exclusivity for RISPERDAL in the second half of the year, we suggest that you model our EPS for 2008 excluding any special items between $4.40 and $4.45 per share, slightly higher than our guidance in January. That concludes my comments on our operating performance this quarter and our guidance with respect to your models. I look forward to updating you throughout the year on our quarterly earnings calls. Thank you and now back to you, Louise."
},
{
"speaker": "Louise Mehrotra",
"text": "Thank you, Dominic. Elizabeth, can you please give the instructions for the questions?"
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from the line of Mike Weinstein with J.P. Morgan."
},
{
"speaker": "Michael Weinstein - J.P. Morgan",
"text": "Good morning. First question, Dominic, you had a strong quarter here particularly with regard to consensus expectations. I think the consensus for the quarter was $1.20. You reported $1.26 adjusted, so you had a $0.06 beat but relative to your prior guidance, you only raised expectations for the year it looks like by $0.01. So maybe you can just comment on that. Thanks."
},
{
"speaker": "Dominic J. Caruso",
"text": "Sure, Mike. The -- as I commented on throughout the discussion and Louise did in her discussion as well, we mentioned that we benefited in the first quarter from a number of items, particularly the successful launch of ZYRTEC, which included some inventory stocking in the trade. Of course, that will then bleed off a bit in the remaining quarters of the year. Our launch plans are consistent with our annual guidance but we did see some significant build in the first quarter and that impacted our first quarter number. I don’t think that the -- when I looked at the various estimates throughout the analyst community, it didn’t seem like those were built in to those estimates. And secondly, we mentioned that the O-U.S. shipments for REMICADE to our partner were significant in the first quarter, reflecting also inventory build on their part. As you may remember, we shipped bulk to our partner outside the U.S. and they finish the product for distribution outside the U.S. and through their inventory planning process, they ordered much more earlier in the year than perhaps we would have anticipated. So we think that will obviously bleed off as well. So taking that into consideration, those two items into consideration, and also looking at the fact that we expect a little bit lower non-operating gains, as I mentioned, and other income and expense, we thought it would be prudent to review our annual results again with you and slightly increase our expectations for the year."
},
{
"speaker": "Michael Weinstein - J.P. Morgan",
"text": "Okay. You made a couple of other interesting comments that look at the performance of the business, as the consumer business was very strong, obviously helped by ZYRTEC but was still strong across the board. And then you made a comment about the really your U.S. MD&D business. You had a number of businesses that decelerated this quarter versus what we had seen last quarter and you made a comment about procedure volumes. Ethicon was surprisingly light this quarter. Ethicon Endo was I think 3% and Life Scan was slower and it was a little bit slower. So the commentary there about the distributor ordering patterns and procedure volumes, can you just flesh that out a little bit in terms of what you think you are seeing across the MD&D business?"
},
{
"speaker": "Dominic J. Caruso",
"text": "Sure. What we’ve seen early on in the year is that as I mentioned, distributors softened their ordering a little bit in the early part of the year. Our field checks tell us that’s a little bit of an inventory burn on their part, which is okay as you might expect that to happen. But also there may be early -- these are very early signs that at least in the first quarter, we did see some lower procedure volumes across the surgical suites in the U.S. We don’t -- we’re not sure whether that is going to be an impact for the full year or not but we definitely think it had some impact in our first quarter."
},
{
"speaker": "Michael Weinstein - J.P. Morgan",
"text": "Okay, great. Last question and then I’ll let someone else jump in here -- ceftobiprole which became approvable later on during the quarter, what is your expectation there for timing?"
},
{
"speaker": "Dominic J. Caruso",
"text": "Well, the timing is obviously we have to work through with the FDA their completion of the review. You may remember that the reason -- in the approvable letter, the FDA cited completion of site inspections on their part and review of some additional information that we have provided. There’s been no indication of any safety or any other manufacturing issues of any sort, so I don’t want to predict how long it will take the FDA to complete their review and we would just like to wait and make sure that they are thoroughly complete with their review and then get back to us on their findings."
},
{
"speaker": "Michael Weinstein - J.P. Morgan",
"text": "Great. Thank you, Dominic."
},
{
"speaker": "Louise Mehrotra",
"text": "Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Glenn Reicin with Morgan Stanley."
},
{
"speaker": "Glenn Reicin - Morgan Stanley",
"text": "A couple of housekeeping questions -- you brought up the REMICADE stocking issue. You said it’s two-thirds of growth so that comes out to about $125 million. Is that about right?"
},
{
"speaker": "Louise Mehrotra",
"text": "Your math is good."
},
{
"speaker": "Glenn Reicin - Morgan Stanley",
"text": "Okay, and then on ZYRTEC, can you at all quantify what you think the initial stocking was? And then you said it’s going to be a great growth driver for the year. Can you quantify what your expectations are for ZYRTEC for the year?"
},
{
"speaker": "Dominic J. Caruso",
"text": "We won’t -- Glenn, as you know we won’t give individual estimates for a product growth. ZYRTEC is included in our overall sales growth estimates for the year. As far as the first quarter is concerned, that OTC category which grew in excess of 25%, if we were to exclude ZYRTEC from that category of sales, we would see low to mid-single-digit growth in that category."
},
{
"speaker": "Glenn Reicin - Morgan Stanley",
"text": "Okay then, how much of that growth do you think was stocking versus underlying usage?"
},
{
"speaker": "Dominic J. Caruso",
"text": "Well, probably a good two-thirds of the initial sales in the first quarter were attributed -- we believe are attributed to stocking."
},
{
"speaker": "Glenn Reicin - Morgan Stanley",
"text": "That’s very helpful. Okay, and then also just two other quick questions -- INVEGA, is that included in the RISPERDAL number or is that separate now?"
},
{
"speaker": "Dominic J. Caruso",
"text": "That’s separate now in Other."
},
{
"speaker": "Glenn Reicin - Morgan Stanley",
"text": "Okay, and you are not going to tell us what that number is?"
},
{
"speaker": "Louise Mehrotra",
"text": "No, not right now."
},
{
"speaker": "Glenn Reicin - Morgan Stanley",
"text": "Okay, so all the other numbers you’ve given us in the past are going to be restated for that change?"
},
{
"speaker": "Louise Mehrotra",
"text": "The numbers that you have in the schedule have your comparables for prior year."
},
{
"speaker": "Glenn Reicin - Morgan Stanley",
"text": "In prior quarters did INVEGA, was that included under the anti-psychotic number?"
},
{
"speaker": "Louise Mehrotra",
"text": "Yes, it was. And the numbers --"
},
{
"speaker": "Glenn Reicin - Morgan Stanley",
"text": "Okay, so we’re going to get restated schedules for all of the quarters going back or no?"
},
{
"speaker": "Louise Mehrotra",
"text": "What we have given you here is 2007 restated to take INVEGA out. We certainly could give you -- break out the RISPERDAL Oral and we could put that up."
},
{
"speaker": "Glenn Reicin - Morgan Stanley",
"text": "Okay, we’ll do that later. And then R&D was only up around 4%. What do you expect growth in R&D to be up this year and why only 4%?"
},
{
"speaker": "Dominic J. Caruso",
"text": "Well, again Glenn, we won’t comment on individual line items like that because we manage the business throughout the 250 operating companies around the world and let them decide the proper level of spending in each of their categories, but generally speaking R&D growth will not be as pronounced as it has been in prior years. It will most likely be closer to the sales growth as opposed to the increased level of R&D spending you saw in prior years, as we now have built the pipeline as you saw and the products are now beginning to move through the regulatory process and off into the market."
},
{
"speaker": "Glenn Reicin - Morgan Stanley",
"text": "So you’re actually saying that pharma spending moderates during the next couple of years on an R&D --"
},
{
"speaker": "Dominic J. Caruso",
"text": "That’s probably -- that’s a good -- it will definitely moderate a bit from our prior several years growth in R&D, that’s right."
},
{
"speaker": "Glenn Reicin - Morgan Stanley",
"text": "Okay. Thank you very much."
},
{
"speaker": "Louise Mehrotra",
"text": "Thank you. Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Tao Levy with Deutsche Bank."
},
{
"speaker": "Tao Levy - Deutsche Bank",
"text": "Good morning. You did comment briefly on the procedures that you were seeing sort of at hospitals being maybe a tad lighter in Q1. I was just wondering if you could provide any commentary around sort of more capital equipment spending that you might detect. I know you guys don’t do too much of that but I would love to get any thoughts there."
},
{
"speaker": "Dominic J. Caruso",
"text": "Actually, Tao, we -- as you know, our business is not capital intensive at all and so it would be not appropriate for me to comment on that part of the business, which we really don’t participate much in."
},
{
"speaker": "Tao Levy - Deutsche Bank",
"text": "Okay. And you also mentioned on drug eluting stents lower prices affecting you here in the U.S. I was just wondering if you could quantify that change."
},
{
"speaker": "Dominic J. Caruso",
"text": "Sure and maybe Louise has it more readily available. If you look at price in drug eluting stents in this quarter versus last quarter of last year, it’s a decline on average of about 6%."
},
{
"speaker": "Tao Levy - Deutsche Bank",
"text": "Great, thanks. And then just lastly, any general thoughts on the recent district court decision in favor of Teva on generic RISPERDAL and whether -- how that impacts how you are thinking about RISPERDAL going generic in the back half of the year."
},
{
"speaker": "Dominic J. Caruso",
"text": "Right. Well, we are obviously aware of the court decision that is favorable to Teva to grant them a 180-day exclusivity period. We would prefer to wait for the FDA to actually act because the FDA has not yet granted Teva that exclusivity period so I would prefer to wait and see how the FDA acts and then we’ll plan accordingly."
},
{
"speaker": "Tao Levy - Deutsche Bank",
"text": "But is it fair to -- I mean, if the FDA agrees with the courts, then that’s sort of a net positive for you guys versus your prior thinking?"
},
{
"speaker": "Dominic J. Caruso",
"text": "Sure, well, it’s always positive when you have less competitors in the market."
},
{
"speaker": "Tao Levy - Deutsche Bank",
"text": "Okay, great. Thanks."
},
{
"speaker": "Louise Mehrotra",
"text": "Thank you. Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Bob Hopkins with Lehman Brothers."
},
{
"speaker": "Bob Hopkins - Lehman Brothers",
"text": "Thanks and good morning. A couple of quick questions; first, Dominic, to go back to your comments about procedure growth during the quarter, was that spread evenly across Ethicon and Depuy or was that, your comments more focused on one versus the other, especially your comments on distributor inventory issues versus just overall slowdown? I was wondering if there was any further level of granularity you could provide there."
},
{
"speaker": "Dominic J. Caruso",
"text": "Yeah, I think we saw lower procedure growth in general but I think probably in our Ethicon business more so than in the other businesses."
},
{
"speaker": "Bob Hopkins - Lehman Brothers",
"text": "Okay, so the inventory issue you are talking about is related more to Depuy than Ethicon than?"
},
{
"speaker": "Dominic J. Caruso",
"text": "Well, it’s been across the board, Bob, so we have to do some additional field checks but I think in terms of the overall growth or slower growth in procedures probably more in the general surgery are that we saw in our Ethicon business."
},
{
"speaker": "Bob Hopkins - Lehman Brothers",
"text": "Okay, thank you. That’s very helpful. And then on VELCADE and Millennium in light of the deal, I just want to be clear here -- should we expect the structure of your relationship with Millennium to change in any way as a result of this deal?"
},
{
"speaker": "Dominic J. Caruso",
"text": "Well, let’s break down the structure of the deal for you, that we -- hopefully this will be helpful. Outside the U.S., we have a broad arrangement with Millennium and as you know, we were the sole exclusive marketing partner outside the U.S. With respect to the current deal with Takeda that may take place, that deal will not be impacted in any way. In the U.S., we actually co-promote VELCADE along with Millennium. That particular co-promote arrangement has various expiration dates. They are generally annual and then they can be renewed by either party on an annual basis, so we will have to wait and see what -- if the transaction goes through what the new thinking is on the part of our partner. We would be happy to continue co-promoting the product with Millennium or the new entity, as the case may be."
},
{
"speaker": "Bob Hopkins - Lehman Brothers",
"text": "Okay. Thank you. That’s helpful and then one final question -- given the launch of INTELENCE, I was wondering if you could provide any qualitative or quantitative thoughts on how we should think about that launch throughout the course of the rest of ’08 and into 2009."
},
{
"speaker": "Dominic J. Caruso",
"text": "It’s probably too early, Bob, to give you any indication. We just launched it just a few months ago so I’d prefer to wait and see as we get more experience under our belt. I would say that the initial reaction by the medical community has been very positive, so we look forward to updating you more throughout the year."
},
{
"speaker": "Bob Hopkins - Lehman Brothers",
"text": "Thank you, Dominic. Appreciate it."
},
{
"speaker": "Louise Mehrotra",
"text": "Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Larry Keusch with Goldman Sachs."
},
{
"speaker": "Lawrence Keusch - Goldman Sachs",
"text": "Good morning. Dominic, I’m wondering if you could just review for us now where things stand with IONSYS, both in the U.S. and Europe. You obviously made some indications on the filing but I just want to kind of get an understanding where we stand."
},
{
"speaker": "Dominic J. Caruso",
"text": "Sure. Well, IONSYS in Europe, we filed a manufacturing adjustment already, as you know, and it’s already been launched in Europe in seven countries, so it’s in the market in Europe. In the U.S., we just recently filed a manufacturing adjustment application with the FDA and we’ll have to wait for the FDA to take a look at that and we expect to hear back from them later this year."
},
{
"speaker": "Lawrence Keusch - Goldman Sachs",
"text": "Okay, so it is possible that it could launch in the U.S. this year?"
},
{
"speaker": "Dominic J. Caruso",
"text": "Yeah, let’s just wait and see what the -- we work very closely with the FDA on it. Let’s just wait and see what the FDA has to say about our application."
},
{
"speaker": "Lawrence Keusch - Goldman Sachs",
"text": "Okay, and then two other quick ones -- you certainly made some comments in the past, I think you’ve done some analysis around this where your consumer portfolio tends to do well during periods of economic challenges. But I just want to see how that was tracking in the first quarter and maybe you could take into account some of the comments about the decline in sales of Rembrandt as well as In-Reach toothbrushes. That’s question one. And then question two, I know you are going to get a lot of questions about the procedure volume that you mentioned but just anecdotally as you speak to the business managers, any sense of why you might be seeing any change in procedure volumes this early in the year and again, early in the economic cycle?"
},
{
"speaker": "Dominic J. Caruso",
"text": "Okay, well first with respect to our consumer business, you are right. As we looked over the years at various economic cycles, our consumer business did not -- really did not correlate at all with any economic cycles, either up or down. So the business does not seem to be impacted by major trends in the economy. You had asked about Rembrandt and Reach. We did have some slower growth in Rembrandt and Reach toothbrushes, which offset the very strong growth that we had in Listerine. Listerine is really the driver in our oral care business right now. It’s doing remarkably well for us, as we expected, bringing in a product of that heritage into our portfolio is very, very promising, so we are pleased with the outlook and the progress that we are making with Listerine. With respect to procedure volumes, it is a little early to comment on it, Larry. I think there’s a number of factors going on here. The holiday schedule, for example, in the first quarter of this year was different than the first quarter of last year, so scheduling procedures may be a little different than it was year over year. There isn’t anything that stands out to us in terms of one particular category or one particular factor impacting procedure growth. We just saw a little bit slower procedure growth this quarter than we had seen in the first quarter of prior years. So a little too early to tell. We’ll have to wait and see what others report and we’ll get a better sense for the overall market after we see that."
},
{
"speaker": "Lawrence Keusch - Goldman Sachs",
"text": "Okay, great. Thanks for the comments, guys."
},
{
"speaker": "Louise Mehrotra",
"text": "Thank you. Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Michael Jungling with Merrill Lynch."
},
{
"speaker": "Michael Jungling - Merrill Lynch",
"text": "Good morning, everyone. I have three questions. Firstly, can you give us the division EBIT for consumer, pharma, medical devices? Secondly, were you invited to make an offer for Alcon? And then thirdly, a question; if you did make another large acquisition, what is the upper limit that you are willing to go on a net debt to EBITDA? That would be great. Thank you."
},
{
"speaker": "Dominic J. Caruso",
"text": "Michael, as you know we don’t really discuss the individual operating performance of the businesses. Rather, we give you an overall perspective on the enterprise and as you saw, we had very strong EBIT or pretax operating margins for the enterprise in the first quarter and we are pleased to see that the restructuring program we put in place last year has now been largely implemented and we see that in the operating margins for the entire business. No comment on the -- on whether or not we were invited in any particular situation. And lastly, with respect to acquisitions, the way we think about it, Michael, is in evaluating any limits, we don’t use the -- our Triple A credit rating, for example, as a limitation to our ability to make an appropriate offer for any acquisition that we would find attractive. Our primary criteria is whether or not the acquisition will generate significant shareholder value and in evaluating that, we take a look at whether or not the acquisition, proposed acquisition would generate a return sufficiently in excess of our cost of capital to compensate our shareholders for the risk. That’s our entire focus is on creating shareholder value and not necessarily on maintaining a particular level of debt or debt to equity ratio."
},
{
"speaker": "Michael Jungling - Merrill Lynch",
"text": "And then just one final follow-up; if you look at the slow down in procedure growth that you’ve seen in the first quarter, how much of that could be the results of perhaps having less selling days in the first quarter?"
},
{
"speaker": "Dominic J. Caruso",
"text": "Well, that’s a great question, Michael and I was just commenting to Larry in the prior question that that did have some impact, that there were several days less shipping days in the quarter just because of the holiday schedule so that obviously had some impact. I can’t quantify it for you, however."
},
{
"speaker": "Michael Jungling - Merrill Lynch",
"text": "Okay. Thank you."
},
{
"speaker": "Louise Mehrotra",
"text": "Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Matthew Dodds with Citigroup."
},
{
"speaker": "Matthew Dodds - Citigroup",
"text": "Thanks. Good morning. A couple of questions. First, on the gross margin, you were up pretty good year over year and Dominic, I just wanted to see if you could comment at all how much of that might have been related to foreign exchange and how much was related to the restructuring program. And then the second question is on ACIPHEX/PARIET, that had a pretty big drop from what we even saw last year in the fourth quarter. So I guess my question there is was there any reversal in stocking in that kind of decline and is that the kind of run-rate we should expect, or is this a one-time drop of that magnitude?"
},
{
"speaker": "Dominic J. Caruso",
"text": "Okay, well with the gross margin, as you saw we did have a very favorable up-tick in gross margin this quarter versus the first quarter of last year. It’s really two items that impact that. One is that you may remember last year we brought in the Pfizer consumer healthcare business and in recording the acquisition price, there’s obviously some inventory step-up to fair market values. That was -- that negatively impacted first quarter gross margins, so the cost of those products were higher then. Obviously they have all now been sold through and so that accounting treatment has been fully taken into account by now, as we enter the first quarter of ’08. And then secondly, the other part of the benefit is the cost restructuring program that we announced last year across most of our businesses. We’ve taken a hard look at some of the cost structure, as you know, and we’ve seen a benefit across all our businesses."
},
{
"speaker": "Matthew Dodds - Citigroup",
"text": "And then how about ACIPHEX?"
},
{
"speaker": "Dominic J. Caruso",
"text": "ACIPHEX -- Louise, can you comment on ACIPHEX and the entry of generics into the marketplace?"
},
{
"speaker": "Louise Mehrotra",
"text": "So the ACIPHEX in the U.S. is down about 27% and was your question regarding the inventory -- inventory differences is about half of that decline."
},
{
"speaker": "Matthew Dodds - Citigroup",
"text": "Well, yeah because last -- I mean, even last year in the fourth quarter, you grew both in the U.S. and O-U.S. and then you had a huge drop down, so I guess globally is this the kind of -- is this a new level of decline we should expect or was there some reversals in inventory?"
},
{
"speaker": "Louise Mehrotra",
"text": "Well, about half of the decline, as I said, is due to reversals in the inventory or changes in the inventory level but there is new competition in the PPI market in the U.S. in terms of a generic and we are seeing that same dynamic outside the U.S. Also in Canada, the PARIET, there is a generic of PARIET on the market now."
},
{
"speaker": "Matthew Dodds - Citigroup",
"text": "Thanks, Louise. Thanks, Dominic."
},
{
"speaker": "Louise Mehrotra",
"text": "Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Larry Biegelsen with Wachovia."
},
{
"speaker": "Larry Biegelsen - Wachovia",
"text": "Thanks for taking my questions. Louise, drug eluting stent pricing in Europe on a constant currency basis, I think you gave the U.S. earlier."
},
{
"speaker": "Louise Mehrotra",
"text": "On an operational basis, O-U.S. is about 7% down."
},
{
"speaker": "Larry Biegelsen - Wachovia",
"text": "Thanks, and could you tell us what you think your share of the gastric banding market was in the quarter in the U.S. and how broadly you’ve rolled out the Realize brand? And then I have one question after that."
},
{
"speaker": "Dominic J. Caruso",
"text": "Larry, as you know we are in the early stages of that launch so I -- we are probably not going to comment right now on market share there. In terms of how broadly it’s been rolled out, we have been undergoing physician training with respect to this launch. We’ve included in the launch plans a significant amount of physician training and education to ensure that the product is used appropriately, so we are just about through that now and then obviously we will continue to see further penetration of the product. It’s early though to give you any indication of share."
},
{
"speaker": "Larry Biegelsen - Wachovia",
"text": "And the U.S. filing for Rivaroxaban and Golimumab, could you just remind us of the dates on those two please? Thanks."
},
{
"speaker": "Dominic J. Caruso",
"text": "Louise, why don’t you comment on those?"
},
{
"speaker": "Louise Mehrotra",
"text": "Okay, so for Golimumab, it will be in the second quarter in the U.S. and for Rivaroxaban in the third quarter in the U.S."
},
{
"speaker": "Larry Biegelsen - Wachovia",
"text": "Thank you."
},
{
"speaker": "Louise Mehrotra",
"text": "Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Sara Michelmore with Cowen."
},
{
"speaker": "Sara Michelmore - Cowen & Company",
"text": "Good morning. Can you talk about the environment for price increases in your pharmaceutical business? I know recently you did take a price increase on REMICADE in the U.S. Can you just talk about the environment in general and if there are any other product lines where you’ve been able to pass through price increases recently?"
},
{
"speaker": "Dominic J. Caruso",
"text": "Right. Well Sara, as you know this environment in general is a difficult environment to take price increases in. And really the area that you can take prices in is when you obviously show significant benefit or differentiation from other products in the market. So we believe to the extent that we have such differentiation and we believe many of our products do demonstrate value to the healthcare system, we’ll continue to look for price increases where appropriate. But I would say the environment is not really conducive to price increases at all."
},
{
"speaker": "Sara Michelmore - Cowen & Company",
"text": "Okay, and any other major product lines besides REMICADE in which you’ve been able to raise price recently?"
},
{
"speaker": "Dominic J. Caruso",
"text": "I don’t have the data in front of me, Sara, but we probably won’t comment on individual products."
},
{
"speaker": "Sara Michelmore - Cowen & Company",
"text": "Okay. And in terms of CYPHER, I just wanted to clarify the U.S. market commentary there in particular, in terms of DDS utilization and PTCA volume declines. Could you just on a sequential basis give us a sense of what the trend there -- I know it was down significantly year over year but I’m just wondering if from your standpoint if that environment has stabilized or improved or deteriorated quarter to quarter."
},
{
"speaker": "Dominic J. Caruso",
"text": "Right, so let me give you some insight into our estimate of the penetration rate in the U.S. for the first quarter is about 64%, and although that is significantly lower than the first quarter of ’07, we think it’s about a point higher than the fourth quarter of ’07. So that’s a good sign. It looks like the penetration rate sequentially now has stabilized. And in terms of the overall procedure volume, I don’t have that information handy right now."
},
{
"speaker": "Louise Mehrotra",
"text": "Rough estimate is between the 10% and 15% range down in the quarter."
},
{
"speaker": "Sara Michelmore - Cowen & Company",
"text": "Okay, okay and I guess we heading into the May medical meeting season. Any big data dissemination we should be paying attention to coming up at ASCO, DDW, APA -- any other meetings? I know specifically if you could comment on paliperidone palmitate and if we are going to see that Phase III data in the next couple of months."
},
{
"speaker": "Louise Mehrotra",
"text": "At APA, you will see a poster on Phase III data at APA. We’ve also got REMICADE -- sorry, Golimumab Phase III data RA at ULAR, and that’s in June in Paris. And that’s -- we’ve got some Tapentadol data also coming out later on in the quarter as well at APS in Tampa."
},
{
"speaker": "Dominic J. Caruso",
"text": "I think a little further out, Sara, I think in September we’ll see Ustekinumab at a Durham meeting in comparison to [Embro] I think, right?"
},
{
"speaker": "Louise Mehrotra",
"text": "Correct."
},
{
"speaker": "Sara Michelmore - Cowen & Company",
"text": "Great. Thank you."
},
{
"speaker": "Louise Mehrotra",
"text": "Okay, and last question."
},
{
"speaker": "Operator",
"text": "Your last question comes from the line of Bruce Nudell with UBS."
},
{
"speaker": "Bruce Nudell - UBS",
"text": "Good morning. Ex-ZYRTEC stocking, what would you estimate the operational growth of consumer might have been?"
},
{
"speaker": "Dominic J. Caruso",
"text": "For the entire consumer sector, I just don’t have it handy but as we mentioned earlier in the OTC arena, that growth of 25 or some percent was obviously -- obviously benefited from the ZYRTEC launch and that growth would have been in the low to mid single digits."
},
{
"speaker": "Bruce Nudell - UBS",
"text": "Okay, thank you. And with regard to the procedure slow down in surgery, general surgery I think you said, in prior periods of economic slow down have you seen that sort of effect before?"
},
{
"speaker": "Dominic J. Caruso",
"text": "Actually no. On a big picture perspective, all of our businesses actually have had very little correlation to economic trends. I would say we are in a little bit of a unique environment though today, so it’s hard to predict based on past practices but we are a little bit in a unique environment with this particular economic slowdown, so to predict what impact that would have now would be a little premature. It’s just early in the quarter and we just saw some early signs."
},
{
"speaker": "Bruce Nudell - UBS",
"text": "I guess just to follow-up on that, why -- in what manner is this particularly unique?"
},
{
"speaker": "Dominic J. Caruso",
"text": "Well, you mean the overall economic slow down?"
},
{
"speaker": "Bruce Nudell - UBS",
"text": "Yes, from --"
},
{
"speaker": "Dominic J. Caruso",
"text": "Well, I think from my perspective, Bruce, what I see is the uncertainty in the credit markets being somewhat of an area of -- well, quite frankly uncertainty and then economic growth is a question mark as a result of that. We’ve seen this before in other economic cycles but I think you’d agree this one is a little bit more pronounced than we’ve seen in at least more recent economic cycles."
},
{
"speaker": "Bruce Nudell - UBS",
"text": "But it wouldn’t necessarily tie to general surgical procedures or --"
},
{
"speaker": "Dominic J. Caruso",
"text": "Well, no, that’s what I -- that’s right and that’s what I mentioned. It’s not necessarily something that we have seen in the past and I’m not sure whether it’s something we are seeing now but it’s just early in the year and we’re giving you some insight into some early indicators that we saw in the first part of this year."
},
{
"speaker": "Bruce Nudell - UBS",
"text": "I guess my final question is you know, you guys clearly have enormous financial resources and capacity to buy back shares, tighten the belt. But looking forward 1.5% to 2.5% operational growth is going to be problematic for stock progression. From your point of view, what are the organic growth drivers for the top line that you folks are most excited about? Thank you."
},
{
"speaker": "Dominic J. Caruso",
"text": "Sure, Bruce and of course, the 1% to 2% you mentioned going forward, the 1% to 2% of course is this year’s operational growth rate. We’re not going to comment on what it would be going forward but we are excited about the overall robustness of the pipeline. And as we mentioned earlier in the call today, we’ve made very, very good progress on all fronts -- the medical device business is filing for new products, exciting products like the CAP system. We’ve begun the Sirolimus on the Conor stent clinical trial, which I think is an exciting new growth platform for us going forward. And as you know the pharma pipeline is not only robust, it’s progressing according to schedule and we are making the filings and dialoging with the health authority. And so we have a number of potential growth drivers already moving forward, consistent with our plans. And having said all that, during a time of some slow growth in the short-term period, we obviously feel like we took the appropriate disciplined actions for the business overall to account for that."
},
{
"speaker": "Bruce Nudell - UBS",
"text": "Thanks so much."
},
{
"speaker": "Dominic J. Caruso",
"text": "Okay. Great, well, thank you, everyone and thank you, Louise. Before we end this call, I would like to share some final thoughts on this quarter’s results. We are continuing to execute against the key priorities and pipeline opportunities we have recently outlined for you. Our progress on new products and new filings is moving along, thanks to the hard work and dedication of the extraordinary people across the Johnson & Johnson family of companies. We continue to invest in growth opportunities that are critical to our future while continuing to manage our costs and improve our operating margins. I look forward to speaking with you again at our meeting on June 5th where we will focus on our medical devices and diagnostics businesses and also provide an update on the consumer business. Thank you for your continued support of Johnson & Johnson and have a great day."
},
{
"speaker": "Operator",
"text": "Thank you. This concludes today’s Johnson & Johnson first quarter 2008 earnings conference call. You may now disconnect."
}
] | null | null |
JPM | 4 | 2,008 | 2009-01-21 07:45:00 | Executives: Michael Cavanagh – CFO James Dimon – President & CEO
Analysts: Glenn Schorr - UBS John McDonald - Sanford C. Bernstein Betsy Graseck - Morgan Stanley Mike Mayo - Deutsche Bank Meredith Whitney - Oppenheimer Nancy Bush – NAB Research
Operator: Good morning ladies and gentlemen. Welcome to the JPMorgan Chase fourth quarter 2008 earnings call. Today's presentation may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are based upon the current beliefs and expectations of JPMorgan Chase’s management and are subject to significant risk and uncertainties. Factors that could cause JPMorgan Chase’s actual results to differ materially from those described in the forward-looking statements can be found in the firm’s filings which could differ materially from those described in the forward-looking statements that can be found in the firm’s filing with the Securities and Exchange Commission and you can refer to these fillings. These filings are available on both JPMorgan Chase’s and Securities and Exchange Commission websites. JPMorgan Chase does not undertake to update the forward-looking statements to reflect the impact of circumstances or events that may arise after the date of the forward-looking statements. Please also note that today’s presentation may include references non-GAAP financial measures, and you should refer to the information contained in the written slides accompanying this presentation for information about the calculation. The slides are available at JPMorgan Chase’s website. (Operator Instructions) At this time I'd like to turn the call over to JPMorgan Chase's Chairman and Chief Executive Officer, James Dimon, and Chief Financial Officer, Michael Cavanagh; Mr. Cavanagh please go ahead sir.
Michael Cavanagh: Good morning everybody thanks for joining us early this morning. We simply wanted to get our results out as soon as they were ready so appreciate your patience in us moving the time on this. As usual we’re going to do the presentation but I’m going to cover it pretty quickly since there’s a lot of material in here but slow down on certain slides to really make sure I’m very clear about what’s in them and then we’ll take some Q&A at the end. So if you start on the presentation just quickly on the first slide, you see that our full year profits for 2008 were $5.6 billion or $1.37 a share driven down substantially from the prior year by higher credit costs of $22 billion but really the point here is absorbing that substantial increase was the very high and strong pre-provision profits that you can see, the $73 billion of revenues less the $43 billion of expenses to give you $30 billion pre-tax pre-provision profitability which is obviously a big part of the story as well across all the businesses. If you go to the next slide, slide two, I’ll only point out here that for the quarter $702 million of net income or $0.07 of EPS. Rather then spend time here as usual it’s best to go through this business by business which I’ll do but first let’s just hit slide three and let me spend a minute just to flag for you what are the big items that are imbedded in that $0.07 of results. And so here on slide three fourth quarter significant items, you see a variety of negatives and positives which are baked in there so let’s just walk down them from the top. So first one, $4 billion pre-tax increase to our loan loss reserves for $2.5 billion after-tax. That brings our total loan loss reserves to $24 billion from $10 billion a year ago. Next item is $2.9 billion pre-tax of net markdowns on leveraged loans and mortgage exposures. The exposures we’ve been talking to you about for the last several quarters now and that’s in the investment bank. The next item, merger-related items that really reflects a gain related to the net positive impact of a variety of refinements to the purchase accounting estimates for WaMu which as we said last quarter would get refined in the first quarter given that we did the deal five days before the end of last quarter so it’s negative goodwill, that flows through the income statement as a gain of $1.1 billion after-tax. Next MSR risk management results of $1.4 billion pre-tax, $900 million after-tax. We just point this out because the bigger then usual number and this is the money we made taking some risk in the way we manage and hedge the change in value of the MSR asset in the mortgage banking part of retail. Next is $1.1 billion pre-tax of private equity write-downs shown in corporate and lastly as you saw in our 10-Q because this happened very early in the quarter the $600 million after-tax Paymentech gain on sale. So with all those items just flagged for you and the businesses over to the right in which they appear, I won’t harp on those again, so now let’s just start with the investment bank on slide four. So let me start you up on the upper right side of the page in the box, so you see net loss for the quarter of $2.4 billion in the investment bank and this table is its own sort of significant items table for the investment bank. So the leverage lending markdowns and the mortgage-related markdowns flagged for you on the prior page and I’ll show you where we stand on those positions in a second. Credit costs, this is additions to reserves shown on the prior page, total $4 billion pre-tax for the firm, $700 million pre-tax in the investment bank in the quarter and then the last item is the impact of spread tightening on structured liabilities, an item we’ve been talking about over the past several quarters for $700 million pre-tax. Those items come down to, if you tax effect them but not comp effect just to be clear what I did here, that’s $2.7 billion after-tax impact in the quarter where there wasn’t a comp accrual is the way I did that. I just make one additional point that typically we see when our spread tightens and we have a reduction in value of our structured liabilities on the liability side, our counterparty payables on the asset side of the balance sheet tend to increase in value and have an offset. In this quarter the spreads didn’t behave in the same relationship so actually what’s known as CVA, the value of our counterparty receivables adjustment actually was a meaningful negative number as well. So now if you just walk down the bullets and the P&L, aside from those items that are in the box above you see investment banking fees of $1.4 billion revenue, that’s down 17% from a year ago but you see on the next slide, I’ll show you the continued leading market position that we have in corporate finance across all categories is very substantial. Next line the $1.7 billion fixed income markets negative revenue for the quarter. If you net out the DVA leverage loan marks and mortgage marks from above, that brings you back to $1.6 billion positive revenue and really the story there is weak trading in the credit related products offset again by continued very strong and record performance in rates and currencies and continued strength in commodities and emerging markets which has been a story for the last several quarters. Moving down to equity markets, negative revenues of $94 million in total. You net out the impact of spread tightening and that’s $260 million positive so that’s again weak trading particularly, weak trading results offset in part by strong client revenues particularly in the prime service businesses. Next is credit costs driving the P&L, $765 million, a little bit of charge-offs in the quarter but again the bulk of that is the nearly $700 million addition to loan loss reserves that brings, you can see in the table to the left, the allowance to total loans in the investment bank of 4.71%, up substantially from last quarter and last year as you can see for yourself, 1.93% a year ago to 4.71% now. So while credit is degrading we think we’re doing what we should be doing to bolster the loan loss reserves through the P&L. Lastly expenses down 9%, lower compensation expense 63% comp to revenue ratio for the year trued up in the fourth quarter and all that brings you down to the $2.4 billion bottom line loss that you see here in the investment bank. Next slide, slide five, you see the standing of the investment bank and the client franchise and you can look for yourself at this and see how strong the franchise position is and understand why despite the challenging environment that we’re in we’re very confident about the ability to deliver in the investment banking business, strong results looking ahead. Slide six, don’t need to spend much time on. You’ve seen this before but when you take the $1.8 billion of markdowns, now I’m on leveraged lending, it’s the $1.8 billion of markdowns takes us down to $12.6 billion of [notional] commitments remaining that have a total markdown cumulative of $5.7 billion or 45% so the carrying value of $6.9 billion of market exposure is where we currently have our remaining legacy leverage loans at $0.55 on the $1 on average but obviously that goes loan by loan, name by name, piece by piece. Slide seven is then the last page on the investment bank and it’s just a recap of again what we’ve shown you last quarter. If you start in the box in the upper left, it’s the aggregate exposures we have in these various residential and commercial mortgage exposures. So last quarter we ended the quarter with $18.6 billion worth of exposure. You see in the middle column $3.9 billion reduction in the quarter to end at $14.7 billion. Obviously the marks came down, that was $1.1 billion of markdowns embedded in the $3.9 billion of exposure reduction. The bulk of that against the commercial exposure there where you see $9.3 billion of exposure at the end of last quarter, total reduction of $1.6 billion and then ending just under $8 billion. So moving past the investment bank, slide eight I just wanted to show you how we are now for the first quarter including the operating results of Washington Mutual in the particularly the remaining businesses here and so what I’ve shown you and you’ll see this in our supplement as well, is the top half is the way JPMorgan Chase was reporting its businesses that were effected previously, and so at the bottom is how we’ve revamped some of our disclosures and I’ll walk across that across the bottom. So the first two buckets are going to be the two new segments of disclosure within retail financial services, so retail financial services will still be one of our six business units but we’ll break those results down in to retail banking which is going to be really the branch banking business as well as business banking and the related loans in business banking and WaMu branches will go into that business. Moving over its consumer lending and then for all the remaining lending activities aside from business banking, all the origination and balance activities, so that’s home lending, education, auto etc., will be shown and reported in this business as well as mortgage production and servicing and again related WaMu activities reported beginning this quarter in there. And then over on the right side of the page you see card services and commercial bank, disclosure exactly the same as before but as we get to those businesses you can look at the supplement and see we’re just enhancing some of the disclosure items that are embedded in these businesses to help you understand what we picked up from WaMu, where it’s relevant. Slide nine, I won’t spend a lot of time on, but we just break down now the key statistics that drive the P&L for both retail banking on the top half of the page and consumer lending at the bottom the way we always do. So just at the top half I’d just point out the healthy underlying trends. We feel good about them, average deposits of $340 billion, up a bit year-over-year ex WaMu and then in the case of WaMu deposits have been stabilizing and have stabilized and that’s reflective of the fact that we’ve been adjusting pricing and have not seen a run off in deposits there which we think is a very good sign and very good for the business. And branch production stats very strong as well. Obviously at the bottom you see origination activities down and that’s driven by generally speaking the tighter underwriting standards that we’ve been talking about across the various portfolios. Slide 10 now the retail overall P&L, so retail top few lines is just the consolidated retail financial services business earned $624 million for the quarter. But going to the pieces the second bullet and middle of the page on the left, it’s retail banking, $1,040 million of profit in the quarter, up 85%. Obviously that includes WaMu with total revenue of $4.5 billion for the quarter. That billion dollar number just stare at that for a second, that is a powerful source of ongoing earnings that we are going to continue to invest in and grow so we feel very good about the profit line in this business. Next you go down to consumer lending, which I described what that is and you see the net income loss of $416 million and that obviously includes to the negative the additional higher credit costs, $3.3 billion which is higher losses as well as the addition of loan loss reserves which related to the residential real estate portfolio is $1.6 billion of the $4 billion of additions to reserves running through that $3.3 billion of credit costs and then on the revenue line, noninterest revenues of $2.1 billion includes that positive MSR risk management result I talked about earlier. Next slide, slide 11 I just wanted before going through the stats on the key portfolios, just to show you a page that shows you how WaMu balances coming into our credit reporting is going to have an effect on our credit stats as you try to think about them versus the past and compare them to others. So I’ll just quickly run down the page, so first row of numbers is Chase so that’s legacy Chase consumer lending $205 billion of balances, $1.5 billion of charge-offs, 2.98% charge-off rate for the quarter and allowance against that of $7.4 billion or 3.62% coverage. When you add in the portion of the WaMu balances that we didn’t impair obviously that’s a selection of loans that are performing really well, so that’s $58 billion with zero charge-offs in the quarter. That will obviously grow over time and obviously has the conforming loan loss allowance will be put against but that’s at a lower level then Chase so when you blend those two together the charge-off rate comes down to 2.32% and coverage to 3.16%. But that is the row, the blue line, the blue shading you will see that row hence forward in our supplemental disclosures and we really think that that is the relevant line looking at the credit stats related to our non-credit impaired consumer-lending portfolio. We’ll also show you the total including the impaired portfolio which you see on the next line which is $89 billion but obviously we marked that so that doesn’t reflect charge-offs in it so it further dilutes down charge-off rates and allowance coverage ratios. I’ll quickly hit the next few slides, you’ve seen these before, the main point if you look at the delinquency trends on the upper left is that delinquencies continue to go higher. If you move over to the upper right box you see that dollar charge-offs in our home equity portfolio which were $770 million in the quarter, charge-off rate of 2.67% and that’s all in. When you look at just the portion of $95 billion or so that’s heritage JPMorgan you see that same $770 million drives a charge-off rate against the legacy portfolio of 3.24% so obviously the loss trend up more dramatically then when you look at it on a blended basis. And the key points at the bottom, last bullet, that we do see continued deterioration. We expect that that $770 million of quarterly charge-offs could progress towards a billion dollars plus or minus per quarter over the next several quarters hence the addition to loan loss reserves in the quarter. Next slide, same thing on prime, $195 million charge-offs in the quarter, 1.20% charge-off rate, 1.97% charge-off rate for heritage JPMorgan only and that our quarterly loss outlook, bottom bullet again could be as high as $400 million per quarter looking out over the next several quarters. And then on slide 14, subprime portfolio, $319 million of net charge-offs in the quarter, 8.08% charge-off rate all in, 9.76% for heritage JPMorgan and the quarterly losses here could be as high as $375 million to $425 million a quarter over the course of 2009. Similar guidance here to what we had before, nonetheless some addition to reserve there. Now slide 15 is important updates so let me take a second on this. We talked to you when we acquired the WaMu portfolio about some scenarios of expected lifetime losses, so if you go to the table here, let me just refresh you. The first two columns you see per prior presentation, we had said in our last presentation to you that our base estimate reflected US peak to trough HPI of down 25% that that reflected working down the page $36 billion of remaining life losses from the beginning of 2008 which then had imbedded in it $30.7 billion remaining after the close. We also told you in the next column over that if we got to a deeper recession which we approximated could reflect a 28% peak to trough HPI that the losses could go up by $6 billion and $42 billion and $36.7 billion, we’re going to stop talking about from the beginning of the year, so if you just look at that bottom line, $31 billion up to $36.7 billion. Now moving over to the right, current outlook and this is market outlook because we haven’t really recranked every number in here but the current markets forecast [case shield] or whatever you want to look at, economy.com, which suggests that the peak to trough may go to something more like 31%. We’ve refined or triangulated what our implied losses could be having had another quarter’s worth of work to do, that against that kind of market outlook the implied range of where losses could be, could be as high as $32 billion to $36 billion to give you a freshened up view on that. Going down the bullets, the next important point is the second bullet, as we’ve also refined our accounting on the balance sheet our current marks reflect $32.5 billion of remainder of life losses so that puts us marked and accounted for at the bottom end but inside that range of where current market expectation is. Next important point is that losses that we’ve actually taken thus far, its been very early, are actually inline with losses and delinquencies inline with what was imbedded in our valuation so far. And then the last point is how to think about this is that when you would have future additions to loan loss reserves, that would happen if and when the actual delinquencies and losses start to exceed what was imbedded in our initial expectations. So I’ll leave it at that. You will hear more in Investor Day but it’s very early but we know this is an important topic so we want to just give you a freshened up view on that. Moving on to card services, slide 16, I’ll pick up the pace a little bit, here you have, I’ll just make the point if you look at the key stats on the left side of the page, the P&L, it is all in. This is what’s in our disclosure supplement. This includes the WaMu portfolio imbedded in all the P&L data, revenue, credit costs, expense and profit, but for the key stats in order to give you all a better trend of what’s going on in the larger Chase business, we’re going to show you stats excluding WaMu as well and for the most part those will be the stats that I try to refer to in terms of how trends are behaving across the business. So working down some of these bullets here you see the loss for the quarter of $371 million. That was really driven by the $4 billion of pre-tax credit costs up substantially year-over-year and that’s both due to higher credit costs as well as an addition to loan loss reserves of $1.1 billion in the quarter. You see the charge-off rate circled at the bottom of the table of 5.29% in the fourth quarter which is basically inline with our last outlook but now looking ahead we do see that loss rate for 2009 beginning the year at something more like 7% and progressing across the year through to something more like 8%. Again that is on an ex WaMu type of basis so consistent with the guidance that we’ve talked about before. I won’t run through the rest of the stats on the page but you can see them for yourselves there. Moving on next slide, 17, commercial bank, $480 million of net income is a record quarterly number for this business and that would be the case without the inclusion of WaMu so continued strong results in the business here. That’s on record revenue for a quarter of $1.5 billion, up substantially year-on-year and you can just look at the balance sheet stats, second bullet describes them to you, but the liability balances up 17%, loan growth up 11% so that’s $117 billion of loans, $114 billion of liability balances, a very well funded business. And of that loan growth you see 11% year-over-year that’s imbedded in that is 37% growth in the government and not for profit business so James is going to talk a bit about the lending we’ve been doing but you can see it really here in this business. And then credit costs of $190 million some signs of weakening of credit stats here so a little bit of increased charge-off, 40 basis points as well as some loan loss addition here. Treasury and securities services on slide 18, $533 million worth of record profits, up 26% from a year ago. That’s on record revenue again in both treasury services and worldwide security services in the quarter, $2.2 billion total revenue, up 17%. And again the big drivers of that is growth in the balance sheet here. So you see $336 billion of liability balances, up 34% and we’re seeing tremendous influx of balances in this kind of environment which obviously could abate looking ahead, we’ll see. And also just looking ahead we’re conscious of a lower rate environment which could also put some pressures on spreads in this business as well as in the commercial bank on their liability balances. Last business, slide 19, asset management quarterly profits of $255 million, down 52% year-over-year, obviously driven by what’s going on in assets under management so you see assets under management down 5% with $211 billion of market related declines offset in part by continued strong inflows, $61 billion for the quarter, $151 billion of inflows over the past year but most of that obviously in liquidity products, lower margin hence the impact on revenues, so quarterly revenues of $1.7 billion down 31% year-over-year. Slide 20, corporate/private equity, so just walking down the table I’ve hit these numbers before for you so $1.1 billion of private equity losses, write-downs on the $6.9 billion of carrying value, that translates into $700 million after-tax loss. Corporate is slightly over $1 billion of profit, big piece of that is the Paymentech gain running through that line and then the last piece of corporate is the merger-related items which includes the extraordinary gain on WaMu offset in part by the Bear Stearns related and WaMu related merger expense. I’ll just make a comment here, the merger related items, this number probably plus or minus $600 million after-tax in 2009 blending together WaMu and Bear Stearns which is consistent with what we’ve talked about before. And lastly before I hand it over to James, capital management slide 21, it’s important to note that we continue to maintain an extremely strong capital position. So you see Tier 1 capital $136 billion, up from $89 billion a year ago and $112 billion last quarter. That translates on a regulatory basis into a Tier 1 capital ratio of 10.8%, up from 8.4% a year ago and 8.9% last quarter. And looking further down those ratios in the table, I’d also just point out very strong tangible capital ratios aside from the regulatory capital ratios. Just a few more points here, in the bottom left side, I wanted you to realize we’re talking Tier 1 capital under a Basel I regime, and while we’re not on it yet we’re working towards it and understand that Basel II would be higher for us if we reported on that basis. Second point is that really maintain this capital strength while managing the other part of balance sheet strength which is the credit reserve side, that’s up to $24 billion as I said earlier from $10 billion of one year ago. And all that ran through the P&L so to maintain a capital account the way we did goes back to the wide pre-tax margins we have pre-provision. And then lastly I just wanted to flag for people because there’s been a lot of concern around the off balance sheet accounting rule changes, so FAS 140 and FIN46R, so while these aren’t yet released we’ve put a little table here in the bottom right so you can look at it yourself to give you an estimate of what it might mean to us. The point for us is that we look at this all the time and on a forward basis are managing capital with this stuff in mind and you see we’ve [inaudible] to the 10-Q balances that a lot of people see of what’s off balance sheet, walk that across to what the GAAP asset impact might be, these are our best estimates and then translate that into RWA under Basel I so it could be something like 80 basis points, maybe plus or minus, but obviously that will depend on what the final rules actually look like and when they get implemented. So with that let me hand it off to James to fill in any outlook comments that I missed.
James Dimon: Thank you very much, and I just have a few comments and then we’ll open it up to questions. On the investment bank, there are two things I’d like to talk about. One is the results on the client side have really been exceptional, the market share gains, I think that’s true on investment banking and on trading. We see a lot more client flow and we think we’re going to do very well servicing investor and corporate clients. We get asked a lot about Bear Stearns and the impact of Bear Stearns. I hesitate to say this a little bit, we still expect to get $1 billion of earnings from Bear Stearns late in 2009 predominantly prime brokerage is doing well and energy and commodities but it also helped and aided our business in equities, fixed income and really across the board we got some terrific bankers in the deal. However it’s hard to separate out positions that we inherited that we decided to keep or we didn’t hedge right or something like that but when we took on Bear, we did take on a lot more risk assets and we got them down substantially, we probably lost several billion dollars more then we would have in the year had we not done Bear and again, it’s hard to really separate what was our responsibility and what we inherited because we could have sold some of the things we inherited. The retail business we’re working hard on WaMu. We’re still very excited about it, we think it’s still approximately what we told you last time what its going to do for this company. We’re very excited about the ability to build small business, private banking, asset management, and middle market on top of the retail [inaudible] platform there. We hope to consolidate all of WaMu systems by the end of the year. That’s the point where we get very comfortable about how we can grow it. We will be changing the brand in California at the end of March because I think it’s important to start using the new name in California. You might have saw that yesterday we closed a mortgage in the mortgage business which we are obviously a very big player and we still think we’re going to be, get very good at it, and though we don’t know the real ongoing profitability of all the mortgage business, we did close the remaining broker business that we did mostly in the prime side and we just think it’s a smart thing to do because a lot of business that came through that side was just not our kind of quality. Card, Michael gave you some numbers where losses will be higher. Now we don’t totally see that yet but we’re just kind of assuming that unemployment is going to go up and obviously that’s going to drive card. We also owe you, we’re not going to do it now, some comments on the new [you dap] so when I think we have Investor Day about what that might mean for the business and how we might adopt a chain into [you dap]. Suffice it to say here, it probably will drive profits lower and reduce the amount of credit that you can make availability and the way you can make it available to consumers, but we think we could adjust to it over time in a fairly reasonable way. Commercial bank, all I can say is just really great results and, into reserves and MPLs and credit loss haven’t gone up that much. They have to go up. You cannot have an environment like this where you don’t see a lot of stress and strain on middle markets, so we do expect losses to go up there. Treasury and security services kind of gangbusters. I think one of the important things there to keep in mind is we also didn’t have any of the pitfalls so we feel really good how we run that business. Asset management, results down, obviously because assets under management are down but I think the important thing here also is we’ve grown the business, more bankers, more net inflows and we also stayed away from a lot of pitfalls that have beset some other folks in that business. Michael mentioned the balance sheet, we think we’re in very good shape. I should add that we did add and you see in the supplement, but our investment portfolio, the parent, have gone from $116 billion to over $160 billion as we try to invest on this excess liquidity we have etc. so it drives those ratios down but it’s completely discretion on our part how we use that and in the short run it drives slightly higher income in corporate as we buy some of those portfolios. I want to mention two other things, report on one other thing, which is we started this [way forward] campaign about all the things that JPMorgan is doing to help the system, to help our clients, the small business, middle market, investment banking, and there’s going to be a lot more coming about that and you’ve seen, I think we’ve been at the forefront of mortgage modifications. We have some more information about that coming up in a day or so because we think there are more things we can do to help keep people in their homes and do a better job for the consumer. And we’re also, in the press release we announced also that in the quarter we extended new credit of over $100 billion because there have been a lot of questions out there about whether banks are making loans. I think we’re speaking for lots of banks here, people are out making loans. This quarter alone I think we did four million new credit cards, so we extended credit card loans, corporate loans, middle market loans, we bought $1.4 billion bond issue when no one else would bid on it from Illinois. So we’re in business. Some businesses the loan demand is actually dropping rather dramatically. We’ve also in the interbank market we have had on average $40 billion or $50 billion out and into bank market, that is also a form of lending. So people ask are banks lending to each other, well I think some are and trying to help the system that way. And all of this is helped by the TARP so we think it’s a valid question people to ask what are doing with the TARP money and we do say it’s hard to separate exactly what is TARP money because remember we’re making loans all the time but we are trying to follow the intent and spirit of TARP which is to help the economy of the United States recover and make sure we’re financing people. We even have done some major large syndicated leveraged finance loans and I’ll mention two, [Imbev and Mars] but there’s several others. So we’re still in business. Obviously the cost of money is higher for clients and people have tightened up some of the underwriting standards, but we’re still in business, we’re still trying to do the best we can both for our shareholders and the country. So we will stop there and open for questions.
Operator: (Operator Instructions) Your first question comes from the line of Glenn Schorr - UBS
Glenn Schorr - UBS: Curious to get your thoughts on a lot of talk going back and forth on the loan remodification laws and the potential principal reductions, so you’ve done a lot of loan remods on your own, but I don’t know if there’s been a lot of principal reduction involved, just thoughts for you but really for the industry in general on what potential impact that could have on both acceleration of losses but also just the state of the securitization markets.
James Dimon: We are really trying to figure that out and all I’m going to say at this point is its legislation and we don’t know it’s going to get passed or not get passed. I do think it could have a pretty chilling effect on consumer lending in general and drive up bankruptcies in general, people go to the bankruptcy courts more but you really have to wait until the specific things come out to see what the GSE’s do, FHA and all the real specifics around it. So we’re kind of reserving final judgment on how that would work. In the meantime we’re going forward what we think is a very good program to modify mortgages. Sometimes they include principal reduction, remember the really important thing for consumers is much more affordability and cash flows. Principal is an artificial concept when you talk about cash over a long period of time so people can afford a home, that’s what you really want to do. It’s also very important in mortgage modification to re-underwrite. To do real income verification, real appraisals, to make sure the people can and want to live there and to do the second time around, maybe it wasn’t done so well the first time around.
Glenn Schorr - UBS: What kind of timeframe can the system, so let’s say we have some sort of new mantra going forward or let’s say everybody adapt to JPMorgan’s efforts, doing it one at a time like this seems difficult whether you go direct or through a bankruptcy judge, what kind of timeframe can we get there whatever there means.
James Dimon: I think most of the companies are doing it, have really staffed up a lot to be able to handle these kind of things. In any event no matter how you do it you’re going to do it one by one and that is the right way to do it. It’s a lot of work but obviously when home prices stabilize the foreclosures will start to go down a little bit and we’ll get through it.
Glenn Schorr - UBS: A numbers questions, [inaudible] margin up like 50 basis points, net interest income like 80% of revenues, obviously a weak revenue quarter but most of it comes on the liability side, you mentioned in the remarks a little bit but at what point do lower interest rates start to turn that around and start to actually be a hindrance.
Michael Cavanagh: It’s tough to say. We’re trying to manage our way through that as we speak. The best visibility we have would be that margin ex what goes on in the investment bank I hope would be stable percentage wise looking ahead, but we have to see how we do managing to operate around this very, very low interest rate environment.
Glenn Schorr - UBS: You grew the corporate portfolios, what you buying there. I did notice a bunch of CLOs being purchased in the fourth quarter, I’m assuming that’s part of it.
Michael Cavanagh: Right, remember we got a lot of new deposits in and so we bought a lot of mortgages. We’ve been doing a little bit of CLOs, a little bit of other credit related product. You’re going to see us do that. We’re getting some enormous spreads. We think some of them are very, very safe and sound. And we want to make money in that portfolio but we’re being cautious about how we do it and we don’t have to do all of this at once. We’re not making any big bet for the company.
Operator: Your next question comes from the line of John McDonald - Sanford C. Bernstein
John McDonald - Sanford C. Bernstein: In card, the outlook for the first quarter, almost a 200 basis point increase and the net charge-offs in your outlook, just wondering are you seeing that in the delinquencies yet, did you see a sharp acceleration in December in the delinquencies?
Michael Cavanagh: We did not see a sharp increase in delinquencies in December and I think I mentioned we don’t have full visibility of why we’ll go to 7%, that is a little bit of a guess that the economy is worse and unemployment is going to hit the 7.5% or 8% number. So we’re just saying if that happens unemployment, credit card loss will simply go up. We don’t know for a fact that’s going to happen.
John McDonald - Sanford C. Bernstein: So it’s more driven by your unemployment outlook.
Michael Cavanagh: Yes.
John McDonald - Sanford C. Bernstein: In the card business as well, does margin get any benefit from the improvement in [inaudible] spreads over the past couple of weeks and what would be your outlook on that card margin.
Michael Cavanagh: The answer, it does, what really happened is it had a big negative in the third quarter and a little bit of recovery in the fourth quarter and I think we did say, I think we did say the number that it cost us, at one point it’s costing $100 million a month, that’s disappearing so it doesn’t really benefit us next year, it’s just the extra cost disappears. Some of that cost by the way ends up as a benefit in corporate because we get the benefit on the other side, that other place as a company.
John McDonald - Sanford C. Bernstein: In terms of the outlook on consumer balances, card balances and consumers are delevering and you worry about adverse selection, do you expect to grow card balances or are you looking to grow card balances in this environment.
James Dimon: It’s very hard to tell because what we see is that the consumer is spending less so card spend was down a fairly dramatic 8% in the fourth quarter. Payments are way down too so balances, we don’t know how those two are going to intercept but what we do know and I believe is that our share is going up. Remember we’re very prime so we think we’re in the kind of the more secure part of the segment and we’ve added a lot of clients so we continue to market, it’s just very hard to tell what’s going to happen to balances next year.
John McDonald - Sanford C. Bernstein: On WaMu if you put together everything that you talked about, did you get roughly $0.10 as you expected this quarter contribution from WaMu in your estimate?
Michael Cavanagh: I think ex the extraordinary gain I think it was a little bit better then $0.10.
James Dimon: Track what we kind of talked about for next year, the $0.50 type of number.
Michael Cavanagh: Which is still out outlook there.
John McDonald - Sanford C. Bernstein: And no change on the Bear, as James said, right.
Michael Cavanagh: The thing about that is that it takes time to ramp up but we talked about the fourth quarter exit rate of 2009 being the incremental profitability of about a billion dollars after-tax.
John McDonald - Sanford C. Bernstein: And is Bear a positive contribution to overall JPMorgan in this quarter?
James Dimon: No, I think we already said, and I’m not going to talk about the quarter specifically, and it’s hard to separate because we took on Bear, we consolidated the risk positions, we obviously started making decisions what to buy, what to sell, what to hedge, not to hedge, but it did add a lot of risk position to our company in areas where we already had risk like securitized product, leveraged loans, some credit, and it did cost us net, net however you look at it several billion dollars this year. And that several billion unlike other things didn’t really have the offset of comp because we’re not punishing everyone in the investment bank for the fact that Bear cost our investment bank and I think our people in investment bank just did an exceptional job assimilating the people of Bear, the systems of Bear, and trying to really manage and de-risk and what turned out to be a terrible environment.
Operator: Your next question comes from the line of Betsy Graseck - Morgan Stanley
Betsy Graseck - Morgan Stanley: You talked quite a bit about the loan growth that you’ve been generating and you gave some examples, could you also give us a sense as to generally speaking how much of the growth is line extension on previous [inaudible] versus new relationships.
James Dimon: We’re not going to do that right now, but I think we are going to try to give more information about new credit, renewals of credit, but renewals of credit are credit and I don’t want to get into the game to act like we’re obligated to renew credit all the time. So but we are going to do that and the reason we said 100 plus is because we want to make sure we get the right numbers out there. But you will see us give some numbers like that, in middle market, large corporate, even our investment portfolio and as I mentioned we added $50 or $60 billion but remember that is extending credit too. We’ve probably bought more mortgage securities then the government did this quarter.
Betsy Graseck - Morgan Stanley: And then can you give us your updated thoughts as to how you’re thinking about the dividend given the outlook for continued difficult environment.
James Dimon: You know we never, we’re exuberant raising the dividend and this company has enormous earnings power so and we felt obligation to pay the dividend so we feel pretty good about it, so we’re not that concerned about it.
Betsy Graseck - Morgan Stanley: Is there anything with regard to how you’re thinking about the dividend relative to having the TARP and how you think through returning TARP money versus paying the dividend out, is that at all part of the thought process?
James Dimon: I guess one is a, we feel, one is an obligation to your shareholders that you tell then when you raise the dividend and you intend to pay it. It should be consistent and steady and like I said we never raised it to exorbitant numbers so it wasn’t something that is a yoke around our necks. The TARP is a depending on how you look at it, a three or five year preferred or something like that and so they’re not directly comparable and we’ll eventually repay the TARP and move on when we get through all this and right now you can’t repay the TARP because part of the agreement was that it wasn’t repayable without being replaced. And you can’t replace that kind of thing in today’s market.
Operator: Your next question comes from the line of Mike Mayo - Deutsche Bank
Mike Mayo - Deutsche Bank: Can you talk about the investment bank strategy, are you looking to kind of contract, maintain or expand in absolute terms and relative to peer, are you looking for big market share and the reason I ask it looks like your compensation is only down a little bit year-over-year so are you willing to pay a little bit more to get better talent and get better share.
James Dimon: I think part of the compensation does relate to about what I mentioned about Bear Stearns but, we hope to gain share. But there will always be tough competitors in the investment banking business so I think that the investor side, trading, client trading, we have, it’s hard to tell if we’ve gained share but if you look at surveys in Greenwich and other things and anecdotally it looks like we have. We certainly have in equity trading so we hope to gain share there. And the investment banking side, covering corporate clients, ECM, DCM, M&A and stuff like that, we’ve gained share. But as you know this is a tough business so we don’t assume that it will be easy going forward. And we’ll keep investing in the parts of the business that we think will grow and obviously there are parts of the business which have changed and you kind of disinvest a little bit and that would be in areas you know about, parts of the securitized products, some structured products, etc. where you’re just not going to have the volumes you had before.
Operator: Your next question comes from the line of Meredith Whitney - Oppenheimer
Meredith Whitney - Oppenheimer: Just to make sure I’m clear, your unemployment expectation now is 7.5 to 8%?
James Dimon: I mentioned that relative to card. But I think it’s fair to say in my opinion is the minimum you’re going to see. That’s an opinion though, that’s not built into every number we do. So that’s just an opinion.
Meredith Whitney - Oppenheimer: But do you have a number like you clearly went through in terms of your severity expectations, do you have a number embedded generally in your assumptions for loss reserves?
James Dimon: I think the answer is, well loss reserve is a different thing which is looking forward and projecting forward and yes, we do assume some deterioration in that which assumes higher in general, home prices going down, unemployment going up. But it is not a direct correlation. I agree with you it will drive those things, but these are just estimates and models so common sense tells you it’s going to get worse and we should be prepared for that.
Meredith Whitney - Oppenheimer: Getting back to expenses and highlighting on the stuff that you talked about with the investment bank, given the fact that it is such a large percentage of your overall cost structure and the environment is so different and the business is going in such a different direction, how do you resize that business and a larger question is you guys are the poster children for realigning so many businesses, integrating so many businesses, how long do you imagine the restructuring of the core expense structure within the banking industry takes and that’s important to relending of course.
James Dimon: So the investment bank, obviously a lot of the change you see taking place in the investment bank, I think Steve Black and Bill Winters have been pretty aggressive in resizing and responding to the environment. What we don’t want to do is over react and not do a good job servicing our clients. So job number one is to make sure that we’re in the market servicing the client, trading, calling on clients, and so we’re not going to over react to that, we don’t think those businesses are going to go away. Like I said, I think we think some of them are. I think the way you look at it and I don’t have the headcount numbers in front of me, but when we added Bear Stearns, we said it would add about 6,000 people to the IB net. I think the headcount looking forward is going to be more like as if you didn’t add Bear Stearns at all. So we’ve probably eliminated some how in all the things we do another 6,000 jobs and that will come also down during the course of the year as some of the plans we put in place are implemented.
Meredith Whitney - Oppenheimer: Given change, given the fact that obviously everyone is looking to monetize and get as much capital to their core franchise as possible, do you have additional spare parts divestitures, and conversely do you have appetite for spare parts acquisitions, meaning a prime broker that comes available, I’m just throwing out situations, but can you comment on that?
James Dimon: Acquisitions, we would never say never, but obviously we’re busy with Bear Stearns and WaMu, both of which we think are important to do and to do right so the hurdle rate would be really high to do an acquisition. The price would have to be really good, the ability to execute unquestionable, and the business logic unquestionable. So we’re not out there looking, if that happens obviously we’ll think about it over time and the second one, divestitures, there’s nothing on the table that we plan to divest.
Operator: Your next question comes from the line of Nancy Bush – NAB Research
Nancy Bush – NAB Research: You spoke about bringing down deposit costs in the WaMu franchise, can you just tell us sort of how generally you’re doing that, are you doing it by product, or by region and what has the reaction been?
Michael Cavanagh: I think we’ll get deeper into it in terms of Investor Day but as you know the need to hold deposits was causing WaMu to be a price leader on particularly time deposits but really across the board so as we’ve modeled the deal and as Charlie and team are actually executing, we’re looking to just bring pricing, state by state, region by region, into better line with the way we would do it in Chase markets in terms of the company’s overall cost of money with a view to the local market conditions. So anywhere state by state we both look at overall cost of money to the company together with franchise value when we price money.
James Dimon: Hot money, we’re attracting some hot money. We don’t need it.
Michael Cavanagh: So despite that we’re doing an okay, but keeping total balances pretty flat to where they were with some churn away from fast money.
Nancy Bush – NAB Research: Can you just give us your very rough impression in the quarter of whether the pricing reductions at WaMu, how much they kicked in to NIM or took away from NIM?
Michael Cavanagh: What I would point you to is on the retail side, you can see it’s imbedded in here but it’s part of the impact of overall deposit margin in the retail business which stayed around a 3% type of level.
James Dimon: And within what we kind of expected because we knew we were going to do some of that and obviously the changes in the rate curve and the deposit costs, but net net is all probably a wash.
Operator: There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments.
Michael Cavanagh: Thank you very much everybody, look forward to talking to you next quarter. | [
{
"speaker": "Executives",
"text": "Michael Cavanagh – CFO James Dimon – President & CEO"
},
{
"speaker": "Analysts",
"text": "Glenn Schorr - UBS John McDonald - Sanford C. Bernstein Betsy Graseck - Morgan Stanley Mike Mayo - Deutsche Bank Meredith Whitney - Oppenheimer Nancy Bush – NAB Research"
},
{
"speaker": "Operator",
"text": "Good morning ladies and gentlemen. Welcome to the JPMorgan Chase fourth quarter 2008 earnings call. Today's presentation may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are based upon the current beliefs and expectations of JPMorgan Chase’s management and are subject to significant risk and uncertainties. Factors that could cause JPMorgan Chase’s actual results to differ materially from those described in the forward-looking statements can be found in the firm’s filings which could differ materially from those described in the forward-looking statements that can be found in the firm’s filing with the Securities and Exchange Commission and you can refer to these fillings. These filings are available on both JPMorgan Chase’s and Securities and Exchange Commission websites. JPMorgan Chase does not undertake to update the forward-looking statements to reflect the impact of circumstances or events that may arise after the date of the forward-looking statements. Please also note that today’s presentation may include references non-GAAP financial measures, and you should refer to the information contained in the written slides accompanying this presentation for information about the calculation. The slides are available at JPMorgan Chase’s website. (Operator Instructions) At this time I'd like to turn the call over to JPMorgan Chase's Chairman and Chief Executive Officer, James Dimon, and Chief Financial Officer, Michael Cavanagh; Mr. Cavanagh please go ahead sir."
},
{
"speaker": "Michael Cavanagh",
"text": "Good morning everybody thanks for joining us early this morning. We simply wanted to get our results out as soon as they were ready so appreciate your patience in us moving the time on this. As usual we’re going to do the presentation but I’m going to cover it pretty quickly since there’s a lot of material in here but slow down on certain slides to really make sure I’m very clear about what’s in them and then we’ll take some Q&A at the end. So if you start on the presentation just quickly on the first slide, you see that our full year profits for 2008 were $5.6 billion or $1.37 a share driven down substantially from the prior year by higher credit costs of $22 billion but really the point here is absorbing that substantial increase was the very high and strong pre-provision profits that you can see, the $73 billion of revenues less the $43 billion of expenses to give you $30 billion pre-tax pre-provision profitability which is obviously a big part of the story as well across all the businesses. If you go to the next slide, slide two, I’ll only point out here that for the quarter $702 million of net income or $0.07 of EPS. Rather then spend time here as usual it’s best to go through this business by business which I’ll do but first let’s just hit slide three and let me spend a minute just to flag for you what are the big items that are imbedded in that $0.07 of results. And so here on slide three fourth quarter significant items, you see a variety of negatives and positives which are baked in there so let’s just walk down them from the top. So first one, $4 billion pre-tax increase to our loan loss reserves for $2.5 billion after-tax. That brings our total loan loss reserves to $24 billion from $10 billion a year ago. Next item is $2.9 billion pre-tax of net markdowns on leveraged loans and mortgage exposures. The exposures we’ve been talking to you about for the last several quarters now and that’s in the investment bank. The next item, merger-related items that really reflects a gain related to the net positive impact of a variety of refinements to the purchase accounting estimates for WaMu which as we said last quarter would get refined in the first quarter given that we did the deal five days before the end of last quarter so it’s negative goodwill, that flows through the income statement as a gain of $1.1 billion after-tax. Next MSR risk management results of $1.4 billion pre-tax, $900 million after-tax. We just point this out because the bigger then usual number and this is the money we made taking some risk in the way we manage and hedge the change in value of the MSR asset in the mortgage banking part of retail. Next is $1.1 billion pre-tax of private equity write-downs shown in corporate and lastly as you saw in our 10-Q because this happened very early in the quarter the $600 million after-tax Paymentech gain on sale. So with all those items just flagged for you and the businesses over to the right in which they appear, I won’t harp on those again, so now let’s just start with the investment bank on slide four. So let me start you up on the upper right side of the page in the box, so you see net loss for the quarter of $2.4 billion in the investment bank and this table is its own sort of significant items table for the investment bank. So the leverage lending markdowns and the mortgage-related markdowns flagged for you on the prior page and I’ll show you where we stand on those positions in a second. Credit costs, this is additions to reserves shown on the prior page, total $4 billion pre-tax for the firm, $700 million pre-tax in the investment bank in the quarter and then the last item is the impact of spread tightening on structured liabilities, an item we’ve been talking about over the past several quarters for $700 million pre-tax. Those items come down to, if you tax effect them but not comp effect just to be clear what I did here, that’s $2.7 billion after-tax impact in the quarter where there wasn’t a comp accrual is the way I did that. I just make one additional point that typically we see when our spread tightens and we have a reduction in value of our structured liabilities on the liability side, our counterparty payables on the asset side of the balance sheet tend to increase in value and have an offset. In this quarter the spreads didn’t behave in the same relationship so actually what’s known as CVA, the value of our counterparty receivables adjustment actually was a meaningful negative number as well. So now if you just walk down the bullets and the P&L, aside from those items that are in the box above you see investment banking fees of $1.4 billion revenue, that’s down 17% from a year ago but you see on the next slide, I’ll show you the continued leading market position that we have in corporate finance across all categories is very substantial. Next line the $1.7 billion fixed income markets negative revenue for the quarter. If you net out the DVA leverage loan marks and mortgage marks from above, that brings you back to $1.6 billion positive revenue and really the story there is weak trading in the credit related products offset again by continued very strong and record performance in rates and currencies and continued strength in commodities and emerging markets which has been a story for the last several quarters. Moving down to equity markets, negative revenues of $94 million in total. You net out the impact of spread tightening and that’s $260 million positive so that’s again weak trading particularly, weak trading results offset in part by strong client revenues particularly in the prime service businesses. Next is credit costs driving the P&L, $765 million, a little bit of charge-offs in the quarter but again the bulk of that is the nearly $700 million addition to loan loss reserves that brings, you can see in the table to the left, the allowance to total loans in the investment bank of 4.71%, up substantially from last quarter and last year as you can see for yourself, 1.93% a year ago to 4.71% now. So while credit is degrading we think we’re doing what we should be doing to bolster the loan loss reserves through the P&L. Lastly expenses down 9%, lower compensation expense 63% comp to revenue ratio for the year trued up in the fourth quarter and all that brings you down to the $2.4 billion bottom line loss that you see here in the investment bank. Next slide, slide five, you see the standing of the investment bank and the client franchise and you can look for yourself at this and see how strong the franchise position is and understand why despite the challenging environment that we’re in we’re very confident about the ability to deliver in the investment banking business, strong results looking ahead. Slide six, don’t need to spend much time on. You’ve seen this before but when you take the $1.8 billion of markdowns, now I’m on leveraged lending, it’s the $1.8 billion of markdowns takes us down to $12.6 billion of [notional] commitments remaining that have a total markdown cumulative of $5.7 billion or 45% so the carrying value of $6.9 billion of market exposure is where we currently have our remaining legacy leverage loans at $0.55 on the $1 on average but obviously that goes loan by loan, name by name, piece by piece. Slide seven is then the last page on the investment bank and it’s just a recap of again what we’ve shown you last quarter. If you start in the box in the upper left, it’s the aggregate exposures we have in these various residential and commercial mortgage exposures. So last quarter we ended the quarter with $18.6 billion worth of exposure. You see in the middle column $3.9 billion reduction in the quarter to end at $14.7 billion. Obviously the marks came down, that was $1.1 billion of markdowns embedded in the $3.9 billion of exposure reduction. The bulk of that against the commercial exposure there where you see $9.3 billion of exposure at the end of last quarter, total reduction of $1.6 billion and then ending just under $8 billion. So moving past the investment bank, slide eight I just wanted to show you how we are now for the first quarter including the operating results of Washington Mutual in the particularly the remaining businesses here and so what I’ve shown you and you’ll see this in our supplement as well, is the top half is the way JPMorgan Chase was reporting its businesses that were effected previously, and so at the bottom is how we’ve revamped some of our disclosures and I’ll walk across that across the bottom. So the first two buckets are going to be the two new segments of disclosure within retail financial services, so retail financial services will still be one of our six business units but we’ll break those results down in to retail banking which is going to be really the branch banking business as well as business banking and the related loans in business banking and WaMu branches will go into that business. Moving over its consumer lending and then for all the remaining lending activities aside from business banking, all the origination and balance activities, so that’s home lending, education, auto etc., will be shown and reported in this business as well as mortgage production and servicing and again related WaMu activities reported beginning this quarter in there. And then over on the right side of the page you see card services and commercial bank, disclosure exactly the same as before but as we get to those businesses you can look at the supplement and see we’re just enhancing some of the disclosure items that are embedded in these businesses to help you understand what we picked up from WaMu, where it’s relevant. Slide nine, I won’t spend a lot of time on, but we just break down now the key statistics that drive the P&L for both retail banking on the top half of the page and consumer lending at the bottom the way we always do. So just at the top half I’d just point out the healthy underlying trends. We feel good about them, average deposits of $340 billion, up a bit year-over-year ex WaMu and then in the case of WaMu deposits have been stabilizing and have stabilized and that’s reflective of the fact that we’ve been adjusting pricing and have not seen a run off in deposits there which we think is a very good sign and very good for the business. And branch production stats very strong as well. Obviously at the bottom you see origination activities down and that’s driven by generally speaking the tighter underwriting standards that we’ve been talking about across the various portfolios. Slide 10 now the retail overall P&L, so retail top few lines is just the consolidated retail financial services business earned $624 million for the quarter. But going to the pieces the second bullet and middle of the page on the left, it’s retail banking, $1,040 million of profit in the quarter, up 85%. Obviously that includes WaMu with total revenue of $4.5 billion for the quarter. That billion dollar number just stare at that for a second, that is a powerful source of ongoing earnings that we are going to continue to invest in and grow so we feel very good about the profit line in this business. Next you go down to consumer lending, which I described what that is and you see the net income loss of $416 million and that obviously includes to the negative the additional higher credit costs, $3.3 billion which is higher losses as well as the addition of loan loss reserves which related to the residential real estate portfolio is $1.6 billion of the $4 billion of additions to reserves running through that $3.3 billion of credit costs and then on the revenue line, noninterest revenues of $2.1 billion includes that positive MSR risk management result I talked about earlier. Next slide, slide 11 I just wanted before going through the stats on the key portfolios, just to show you a page that shows you how WaMu balances coming into our credit reporting is going to have an effect on our credit stats as you try to think about them versus the past and compare them to others. So I’ll just quickly run down the page, so first row of numbers is Chase so that’s legacy Chase consumer lending $205 billion of balances, $1.5 billion of charge-offs, 2.98% charge-off rate for the quarter and allowance against that of $7.4 billion or 3.62% coverage. When you add in the portion of the WaMu balances that we didn’t impair obviously that’s a selection of loans that are performing really well, so that’s $58 billion with zero charge-offs in the quarter. That will obviously grow over time and obviously has the conforming loan loss allowance will be put against but that’s at a lower level then Chase so when you blend those two together the charge-off rate comes down to 2.32% and coverage to 3.16%. But that is the row, the blue line, the blue shading you will see that row hence forward in our supplemental disclosures and we really think that that is the relevant line looking at the credit stats related to our non-credit impaired consumer-lending portfolio. We’ll also show you the total including the impaired portfolio which you see on the next line which is $89 billion but obviously we marked that so that doesn’t reflect charge-offs in it so it further dilutes down charge-off rates and allowance coverage ratios. I’ll quickly hit the next few slides, you’ve seen these before, the main point if you look at the delinquency trends on the upper left is that delinquencies continue to go higher. If you move over to the upper right box you see that dollar charge-offs in our home equity portfolio which were $770 million in the quarter, charge-off rate of 2.67% and that’s all in. When you look at just the portion of $95 billion or so that’s heritage JPMorgan you see that same $770 million drives a charge-off rate against the legacy portfolio of 3.24% so obviously the loss trend up more dramatically then when you look at it on a blended basis. And the key points at the bottom, last bullet, that we do see continued deterioration. We expect that that $770 million of quarterly charge-offs could progress towards a billion dollars plus or minus per quarter over the next several quarters hence the addition to loan loss reserves in the quarter. Next slide, same thing on prime, $195 million charge-offs in the quarter, 1.20% charge-off rate, 1.97% charge-off rate for heritage JPMorgan only and that our quarterly loss outlook, bottom bullet again could be as high as $400 million per quarter looking out over the next several quarters. And then on slide 14, subprime portfolio, $319 million of net charge-offs in the quarter, 8.08% charge-off rate all in, 9.76% for heritage JPMorgan and the quarterly losses here could be as high as $375 million to $425 million a quarter over the course of 2009. Similar guidance here to what we had before, nonetheless some addition to reserve there. Now slide 15 is important updates so let me take a second on this. We talked to you when we acquired the WaMu portfolio about some scenarios of expected lifetime losses, so if you go to the table here, let me just refresh you. The first two columns you see per prior presentation, we had said in our last presentation to you that our base estimate reflected US peak to trough HPI of down 25% that that reflected working down the page $36 billion of remaining life losses from the beginning of 2008 which then had imbedded in it $30.7 billion remaining after the close. We also told you in the next column over that if we got to a deeper recession which we approximated could reflect a 28% peak to trough HPI that the losses could go up by $6 billion and $42 billion and $36.7 billion, we’re going to stop talking about from the beginning of the year, so if you just look at that bottom line, $31 billion up to $36.7 billion. Now moving over to the right, current outlook and this is market outlook because we haven’t really recranked every number in here but the current markets forecast [case shield] or whatever you want to look at, economy.com, which suggests that the peak to trough may go to something more like 31%. We’ve refined or triangulated what our implied losses could be having had another quarter’s worth of work to do, that against that kind of market outlook the implied range of where losses could be, could be as high as $32 billion to $36 billion to give you a freshened up view on that. Going down the bullets, the next important point is the second bullet, as we’ve also refined our accounting on the balance sheet our current marks reflect $32.5 billion of remainder of life losses so that puts us marked and accounted for at the bottom end but inside that range of where current market expectation is. Next important point is that losses that we’ve actually taken thus far, its been very early, are actually inline with losses and delinquencies inline with what was imbedded in our valuation so far. And then the last point is how to think about this is that when you would have future additions to loan loss reserves, that would happen if and when the actual delinquencies and losses start to exceed what was imbedded in our initial expectations. So I’ll leave it at that. You will hear more in Investor Day but it’s very early but we know this is an important topic so we want to just give you a freshened up view on that. Moving on to card services, slide 16, I’ll pick up the pace a little bit, here you have, I’ll just make the point if you look at the key stats on the left side of the page, the P&L, it is all in. This is what’s in our disclosure supplement. This includes the WaMu portfolio imbedded in all the P&L data, revenue, credit costs, expense and profit, but for the key stats in order to give you all a better trend of what’s going on in the larger Chase business, we’re going to show you stats excluding WaMu as well and for the most part those will be the stats that I try to refer to in terms of how trends are behaving across the business. So working down some of these bullets here you see the loss for the quarter of $371 million. That was really driven by the $4 billion of pre-tax credit costs up substantially year-over-year and that’s both due to higher credit costs as well as an addition to loan loss reserves of $1.1 billion in the quarter. You see the charge-off rate circled at the bottom of the table of 5.29% in the fourth quarter which is basically inline with our last outlook but now looking ahead we do see that loss rate for 2009 beginning the year at something more like 7% and progressing across the year through to something more like 8%. Again that is on an ex WaMu type of basis so consistent with the guidance that we’ve talked about before. I won’t run through the rest of the stats on the page but you can see them for yourselves there. Moving on next slide, 17, commercial bank, $480 million of net income is a record quarterly number for this business and that would be the case without the inclusion of WaMu so continued strong results in the business here. That’s on record revenue for a quarter of $1.5 billion, up substantially year-on-year and you can just look at the balance sheet stats, second bullet describes them to you, but the liability balances up 17%, loan growth up 11% so that’s $117 billion of loans, $114 billion of liability balances, a very well funded business. And of that loan growth you see 11% year-over-year that’s imbedded in that is 37% growth in the government and not for profit business so James is going to talk a bit about the lending we’ve been doing but you can see it really here in this business. And then credit costs of $190 million some signs of weakening of credit stats here so a little bit of increased charge-off, 40 basis points as well as some loan loss addition here. Treasury and securities services on slide 18, $533 million worth of record profits, up 26% from a year ago. That’s on record revenue again in both treasury services and worldwide security services in the quarter, $2.2 billion total revenue, up 17%. And again the big drivers of that is growth in the balance sheet here. So you see $336 billion of liability balances, up 34% and we’re seeing tremendous influx of balances in this kind of environment which obviously could abate looking ahead, we’ll see. And also just looking ahead we’re conscious of a lower rate environment which could also put some pressures on spreads in this business as well as in the commercial bank on their liability balances. Last business, slide 19, asset management quarterly profits of $255 million, down 52% year-over-year, obviously driven by what’s going on in assets under management so you see assets under management down 5% with $211 billion of market related declines offset in part by continued strong inflows, $61 billion for the quarter, $151 billion of inflows over the past year but most of that obviously in liquidity products, lower margin hence the impact on revenues, so quarterly revenues of $1.7 billion down 31% year-over-year. Slide 20, corporate/private equity, so just walking down the table I’ve hit these numbers before for you so $1.1 billion of private equity losses, write-downs on the $6.9 billion of carrying value, that translates into $700 million after-tax loss. Corporate is slightly over $1 billion of profit, big piece of that is the Paymentech gain running through that line and then the last piece of corporate is the merger-related items which includes the extraordinary gain on WaMu offset in part by the Bear Stearns related and WaMu related merger expense. I’ll just make a comment here, the merger related items, this number probably plus or minus $600 million after-tax in 2009 blending together WaMu and Bear Stearns which is consistent with what we’ve talked about before. And lastly before I hand it over to James, capital management slide 21, it’s important to note that we continue to maintain an extremely strong capital position. So you see Tier 1 capital $136 billion, up from $89 billion a year ago and $112 billion last quarter. That translates on a regulatory basis into a Tier 1 capital ratio of 10.8%, up from 8.4% a year ago and 8.9% last quarter. And looking further down those ratios in the table, I’d also just point out very strong tangible capital ratios aside from the regulatory capital ratios. Just a few more points here, in the bottom left side, I wanted you to realize we’re talking Tier 1 capital under a Basel I regime, and while we’re not on it yet we’re working towards it and understand that Basel II would be higher for us if we reported on that basis. Second point is that really maintain this capital strength while managing the other part of balance sheet strength which is the credit reserve side, that’s up to $24 billion as I said earlier from $10 billion of one year ago. And all that ran through the P&L so to maintain a capital account the way we did goes back to the wide pre-tax margins we have pre-provision. And then lastly I just wanted to flag for people because there’s been a lot of concern around the off balance sheet accounting rule changes, so FAS 140 and FIN46R, so while these aren’t yet released we’ve put a little table here in the bottom right so you can look at it yourself to give you an estimate of what it might mean to us. The point for us is that we look at this all the time and on a forward basis are managing capital with this stuff in mind and you see we’ve [inaudible] to the 10-Q balances that a lot of people see of what’s off balance sheet, walk that across to what the GAAP asset impact might be, these are our best estimates and then translate that into RWA under Basel I so it could be something like 80 basis points, maybe plus or minus, but obviously that will depend on what the final rules actually look like and when they get implemented. So with that let me hand it off to James to fill in any outlook comments that I missed."
},
{
"speaker": "James Dimon",
"text": "Thank you very much, and I just have a few comments and then we’ll open it up to questions. On the investment bank, there are two things I’d like to talk about. One is the results on the client side have really been exceptional, the market share gains, I think that’s true on investment banking and on trading. We see a lot more client flow and we think we’re going to do very well servicing investor and corporate clients. We get asked a lot about Bear Stearns and the impact of Bear Stearns. I hesitate to say this a little bit, we still expect to get $1 billion of earnings from Bear Stearns late in 2009 predominantly prime brokerage is doing well and energy and commodities but it also helped and aided our business in equities, fixed income and really across the board we got some terrific bankers in the deal. However it’s hard to separate out positions that we inherited that we decided to keep or we didn’t hedge right or something like that but when we took on Bear, we did take on a lot more risk assets and we got them down substantially, we probably lost several billion dollars more then we would have in the year had we not done Bear and again, it’s hard to really separate what was our responsibility and what we inherited because we could have sold some of the things we inherited. The retail business we’re working hard on WaMu. We’re still very excited about it, we think it’s still approximately what we told you last time what its going to do for this company. We’re very excited about the ability to build small business, private banking, asset management, and middle market on top of the retail [inaudible] platform there. We hope to consolidate all of WaMu systems by the end of the year. That’s the point where we get very comfortable about how we can grow it. We will be changing the brand in California at the end of March because I think it’s important to start using the new name in California. You might have saw that yesterday we closed a mortgage in the mortgage business which we are obviously a very big player and we still think we’re going to be, get very good at it, and though we don’t know the real ongoing profitability of all the mortgage business, we did close the remaining broker business that we did mostly in the prime side and we just think it’s a smart thing to do because a lot of business that came through that side was just not our kind of quality. Card, Michael gave you some numbers where losses will be higher. Now we don’t totally see that yet but we’re just kind of assuming that unemployment is going to go up and obviously that’s going to drive card. We also owe you, we’re not going to do it now, some comments on the new [you dap] so when I think we have Investor Day about what that might mean for the business and how we might adopt a chain into [you dap]. Suffice it to say here, it probably will drive profits lower and reduce the amount of credit that you can make availability and the way you can make it available to consumers, but we think we could adjust to it over time in a fairly reasonable way. Commercial bank, all I can say is just really great results and, into reserves and MPLs and credit loss haven’t gone up that much. They have to go up. You cannot have an environment like this where you don’t see a lot of stress and strain on middle markets, so we do expect losses to go up there. Treasury and security services kind of gangbusters. I think one of the important things there to keep in mind is we also didn’t have any of the pitfalls so we feel really good how we run that business. Asset management, results down, obviously because assets under management are down but I think the important thing here also is we’ve grown the business, more bankers, more net inflows and we also stayed away from a lot of pitfalls that have beset some other folks in that business. Michael mentioned the balance sheet, we think we’re in very good shape. I should add that we did add and you see in the supplement, but our investment portfolio, the parent, have gone from $116 billion to over $160 billion as we try to invest on this excess liquidity we have etc. so it drives those ratios down but it’s completely discretion on our part how we use that and in the short run it drives slightly higher income in corporate as we buy some of those portfolios. I want to mention two other things, report on one other thing, which is we started this [way forward] campaign about all the things that JPMorgan is doing to help the system, to help our clients, the small business, middle market, investment banking, and there’s going to be a lot more coming about that and you’ve seen, I think we’ve been at the forefront of mortgage modifications. We have some more information about that coming up in a day or so because we think there are more things we can do to help keep people in their homes and do a better job for the consumer. And we’re also, in the press release we announced also that in the quarter we extended new credit of over $100 billion because there have been a lot of questions out there about whether banks are making loans. I think we’re speaking for lots of banks here, people are out making loans. This quarter alone I think we did four million new credit cards, so we extended credit card loans, corporate loans, middle market loans, we bought $1.4 billion bond issue when no one else would bid on it from Illinois. So we’re in business. Some businesses the loan demand is actually dropping rather dramatically. We’ve also in the interbank market we have had on average $40 billion or $50 billion out and into bank market, that is also a form of lending. So people ask are banks lending to each other, well I think some are and trying to help the system that way. And all of this is helped by the TARP so we think it’s a valid question people to ask what are doing with the TARP money and we do say it’s hard to separate exactly what is TARP money because remember we’re making loans all the time but we are trying to follow the intent and spirit of TARP which is to help the economy of the United States recover and make sure we’re financing people. We even have done some major large syndicated leveraged finance loans and I’ll mention two, [Imbev and Mars] but there’s several others. So we’re still in business. Obviously the cost of money is higher for clients and people have tightened up some of the underwriting standards, but we’re still in business, we’re still trying to do the best we can both for our shareholders and the country. So we will stop there and open for questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from the line of Glenn Schorr - UBS"
},
{
"speaker": "Glenn Schorr - UBS",
"text": "Curious to get your thoughts on a lot of talk going back and forth on the loan remodification laws and the potential principal reductions, so you’ve done a lot of loan remods on your own, but I don’t know if there’s been a lot of principal reduction involved, just thoughts for you but really for the industry in general on what potential impact that could have on both acceleration of losses but also just the state of the securitization markets."
},
{
"speaker": "James Dimon",
"text": "We are really trying to figure that out and all I’m going to say at this point is its legislation and we don’t know it’s going to get passed or not get passed. I do think it could have a pretty chilling effect on consumer lending in general and drive up bankruptcies in general, people go to the bankruptcy courts more but you really have to wait until the specific things come out to see what the GSE’s do, FHA and all the real specifics around it. So we’re kind of reserving final judgment on how that would work. In the meantime we’re going forward what we think is a very good program to modify mortgages. Sometimes they include principal reduction, remember the really important thing for consumers is much more affordability and cash flows. Principal is an artificial concept when you talk about cash over a long period of time so people can afford a home, that’s what you really want to do. It’s also very important in mortgage modification to re-underwrite. To do real income verification, real appraisals, to make sure the people can and want to live there and to do the second time around, maybe it wasn’t done so well the first time around."
},
{
"speaker": "Glenn Schorr - UBS",
"text": "What kind of timeframe can the system, so let’s say we have some sort of new mantra going forward or let’s say everybody adapt to JPMorgan’s efforts, doing it one at a time like this seems difficult whether you go direct or through a bankruptcy judge, what kind of timeframe can we get there whatever there means."
},
{
"speaker": "James Dimon",
"text": "I think most of the companies are doing it, have really staffed up a lot to be able to handle these kind of things. In any event no matter how you do it you’re going to do it one by one and that is the right way to do it. It’s a lot of work but obviously when home prices stabilize the foreclosures will start to go down a little bit and we’ll get through it."
},
{
"speaker": "Glenn Schorr - UBS",
"text": "A numbers questions, [inaudible] margin up like 50 basis points, net interest income like 80% of revenues, obviously a weak revenue quarter but most of it comes on the liability side, you mentioned in the remarks a little bit but at what point do lower interest rates start to turn that around and start to actually be a hindrance."
},
{
"speaker": "Michael Cavanagh",
"text": "It’s tough to say. We’re trying to manage our way through that as we speak. The best visibility we have would be that margin ex what goes on in the investment bank I hope would be stable percentage wise looking ahead, but we have to see how we do managing to operate around this very, very low interest rate environment."
},
{
"speaker": "Glenn Schorr - UBS",
"text": "You grew the corporate portfolios, what you buying there. I did notice a bunch of CLOs being purchased in the fourth quarter, I’m assuming that’s part of it."
},
{
"speaker": "Michael Cavanagh",
"text": "Right, remember we got a lot of new deposits in and so we bought a lot of mortgages. We’ve been doing a little bit of CLOs, a little bit of other credit related product. You’re going to see us do that. We’re getting some enormous spreads. We think some of them are very, very safe and sound. And we want to make money in that portfolio but we’re being cautious about how we do it and we don’t have to do all of this at once. We’re not making any big bet for the company."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of John McDonald - Sanford C. Bernstein"
},
{
"speaker": "John McDonald - Sanford C. Bernstein",
"text": "In card, the outlook for the first quarter, almost a 200 basis point increase and the net charge-offs in your outlook, just wondering are you seeing that in the delinquencies yet, did you see a sharp acceleration in December in the delinquencies?"
},
{
"speaker": "Michael Cavanagh",
"text": "We did not see a sharp increase in delinquencies in December and I think I mentioned we don’t have full visibility of why we’ll go to 7%, that is a little bit of a guess that the economy is worse and unemployment is going to hit the 7.5% or 8% number. So we’re just saying if that happens unemployment, credit card loss will simply go up. We don’t know for a fact that’s going to happen."
},
{
"speaker": "John McDonald - Sanford C. Bernstein",
"text": "So it’s more driven by your unemployment outlook."
},
{
"speaker": "Michael Cavanagh",
"text": "Yes."
},
{
"speaker": "John McDonald - Sanford C. Bernstein",
"text": "In the card business as well, does margin get any benefit from the improvement in [inaudible] spreads over the past couple of weeks and what would be your outlook on that card margin."
},
{
"speaker": "Michael Cavanagh",
"text": "The answer, it does, what really happened is it had a big negative in the third quarter and a little bit of recovery in the fourth quarter and I think we did say, I think we did say the number that it cost us, at one point it’s costing $100 million a month, that’s disappearing so it doesn’t really benefit us next year, it’s just the extra cost disappears. Some of that cost by the way ends up as a benefit in corporate because we get the benefit on the other side, that other place as a company."
},
{
"speaker": "John McDonald - Sanford C. Bernstein",
"text": "In terms of the outlook on consumer balances, card balances and consumers are delevering and you worry about adverse selection, do you expect to grow card balances or are you looking to grow card balances in this environment."
},
{
"speaker": "James Dimon",
"text": "It’s very hard to tell because what we see is that the consumer is spending less so card spend was down a fairly dramatic 8% in the fourth quarter. Payments are way down too so balances, we don’t know how those two are going to intercept but what we do know and I believe is that our share is going up. Remember we’re very prime so we think we’re in the kind of the more secure part of the segment and we’ve added a lot of clients so we continue to market, it’s just very hard to tell what’s going to happen to balances next year."
},
{
"speaker": "John McDonald - Sanford C. Bernstein",
"text": "On WaMu if you put together everything that you talked about, did you get roughly $0.10 as you expected this quarter contribution from WaMu in your estimate?"
},
{
"speaker": "Michael Cavanagh",
"text": "I think ex the extraordinary gain I think it was a little bit better then $0.10."
},
{
"speaker": "James Dimon",
"text": "Track what we kind of talked about for next year, the $0.50 type of number."
},
{
"speaker": "Michael Cavanagh",
"text": "Which is still out outlook there."
},
{
"speaker": "John McDonald - Sanford C. Bernstein",
"text": "And no change on the Bear, as James said, right."
},
{
"speaker": "Michael Cavanagh",
"text": "The thing about that is that it takes time to ramp up but we talked about the fourth quarter exit rate of 2009 being the incremental profitability of about a billion dollars after-tax."
},
{
"speaker": "John McDonald - Sanford C. Bernstein",
"text": "And is Bear a positive contribution to overall JPMorgan in this quarter?"
},
{
"speaker": "James Dimon",
"text": "No, I think we already said, and I’m not going to talk about the quarter specifically, and it’s hard to separate because we took on Bear, we consolidated the risk positions, we obviously started making decisions what to buy, what to sell, what to hedge, not to hedge, but it did add a lot of risk position to our company in areas where we already had risk like securitized product, leveraged loans, some credit, and it did cost us net, net however you look at it several billion dollars this year. And that several billion unlike other things didn’t really have the offset of comp because we’re not punishing everyone in the investment bank for the fact that Bear cost our investment bank and I think our people in investment bank just did an exceptional job assimilating the people of Bear, the systems of Bear, and trying to really manage and de-risk and what turned out to be a terrible environment."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Betsy Graseck - Morgan Stanley"
},
{
"speaker": "Betsy Graseck - Morgan Stanley",
"text": "You talked quite a bit about the loan growth that you’ve been generating and you gave some examples, could you also give us a sense as to generally speaking how much of the growth is line extension on previous [inaudible] versus new relationships."
},
{
"speaker": "James Dimon",
"text": "We’re not going to do that right now, but I think we are going to try to give more information about new credit, renewals of credit, but renewals of credit are credit and I don’t want to get into the game to act like we’re obligated to renew credit all the time. So but we are going to do that and the reason we said 100 plus is because we want to make sure we get the right numbers out there. But you will see us give some numbers like that, in middle market, large corporate, even our investment portfolio and as I mentioned we added $50 or $60 billion but remember that is extending credit too. We’ve probably bought more mortgage securities then the government did this quarter."
},
{
"speaker": "Betsy Graseck - Morgan Stanley",
"text": "And then can you give us your updated thoughts as to how you’re thinking about the dividend given the outlook for continued difficult environment."
},
{
"speaker": "James Dimon",
"text": "You know we never, we’re exuberant raising the dividend and this company has enormous earnings power so and we felt obligation to pay the dividend so we feel pretty good about it, so we’re not that concerned about it."
},
{
"speaker": "Betsy Graseck - Morgan Stanley",
"text": "Is there anything with regard to how you’re thinking about the dividend relative to having the TARP and how you think through returning TARP money versus paying the dividend out, is that at all part of the thought process?"
},
{
"speaker": "James Dimon",
"text": "I guess one is a, we feel, one is an obligation to your shareholders that you tell then when you raise the dividend and you intend to pay it. It should be consistent and steady and like I said we never raised it to exorbitant numbers so it wasn’t something that is a yoke around our necks. The TARP is a depending on how you look at it, a three or five year preferred or something like that and so they’re not directly comparable and we’ll eventually repay the TARP and move on when we get through all this and right now you can’t repay the TARP because part of the agreement was that it wasn’t repayable without being replaced. And you can’t replace that kind of thing in today’s market."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Mike Mayo - Deutsche Bank"
},
{
"speaker": "Mike Mayo - Deutsche Bank",
"text": "Can you talk about the investment bank strategy, are you looking to kind of contract, maintain or expand in absolute terms and relative to peer, are you looking for big market share and the reason I ask it looks like your compensation is only down a little bit year-over-year so are you willing to pay a little bit more to get better talent and get better share."
},
{
"speaker": "James Dimon",
"text": "I think part of the compensation does relate to about what I mentioned about Bear Stearns but, we hope to gain share. But there will always be tough competitors in the investment banking business so I think that the investor side, trading, client trading, we have, it’s hard to tell if we’ve gained share but if you look at surveys in Greenwich and other things and anecdotally it looks like we have. We certainly have in equity trading so we hope to gain share there. And the investment banking side, covering corporate clients, ECM, DCM, M&A and stuff like that, we’ve gained share. But as you know this is a tough business so we don’t assume that it will be easy going forward. And we’ll keep investing in the parts of the business that we think will grow and obviously there are parts of the business which have changed and you kind of disinvest a little bit and that would be in areas you know about, parts of the securitized products, some structured products, etc. where you’re just not going to have the volumes you had before."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Meredith Whitney - Oppenheimer"
},
{
"speaker": "Meredith Whitney - Oppenheimer",
"text": "Just to make sure I’m clear, your unemployment expectation now is 7.5 to 8%?"
},
{
"speaker": "James Dimon",
"text": "I mentioned that relative to card. But I think it’s fair to say in my opinion is the minimum you’re going to see. That’s an opinion though, that’s not built into every number we do. So that’s just an opinion."
},
{
"speaker": "Meredith Whitney - Oppenheimer",
"text": "But do you have a number like you clearly went through in terms of your severity expectations, do you have a number embedded generally in your assumptions for loss reserves?"
},
{
"speaker": "James Dimon",
"text": "I think the answer is, well loss reserve is a different thing which is looking forward and projecting forward and yes, we do assume some deterioration in that which assumes higher in general, home prices going down, unemployment going up. But it is not a direct correlation. I agree with you it will drive those things, but these are just estimates and models so common sense tells you it’s going to get worse and we should be prepared for that."
},
{
"speaker": "Meredith Whitney - Oppenheimer",
"text": "Getting back to expenses and highlighting on the stuff that you talked about with the investment bank, given the fact that it is such a large percentage of your overall cost structure and the environment is so different and the business is going in such a different direction, how do you resize that business and a larger question is you guys are the poster children for realigning so many businesses, integrating so many businesses, how long do you imagine the restructuring of the core expense structure within the banking industry takes and that’s important to relending of course."
},
{
"speaker": "James Dimon",
"text": "So the investment bank, obviously a lot of the change you see taking place in the investment bank, I think Steve Black and Bill Winters have been pretty aggressive in resizing and responding to the environment. What we don’t want to do is over react and not do a good job servicing our clients. So job number one is to make sure that we’re in the market servicing the client, trading, calling on clients, and so we’re not going to over react to that, we don’t think those businesses are going to go away. Like I said, I think we think some of them are. I think the way you look at it and I don’t have the headcount numbers in front of me, but when we added Bear Stearns, we said it would add about 6,000 people to the IB net. I think the headcount looking forward is going to be more like as if you didn’t add Bear Stearns at all. So we’ve probably eliminated some how in all the things we do another 6,000 jobs and that will come also down during the course of the year as some of the plans we put in place are implemented."
},
{
"speaker": "Meredith Whitney - Oppenheimer",
"text": "Given change, given the fact that obviously everyone is looking to monetize and get as much capital to their core franchise as possible, do you have additional spare parts divestitures, and conversely do you have appetite for spare parts acquisitions, meaning a prime broker that comes available, I’m just throwing out situations, but can you comment on that?"
},
{
"speaker": "James Dimon",
"text": "Acquisitions, we would never say never, but obviously we’re busy with Bear Stearns and WaMu, both of which we think are important to do and to do right so the hurdle rate would be really high to do an acquisition. The price would have to be really good, the ability to execute unquestionable, and the business logic unquestionable. So we’re not out there looking, if that happens obviously we’ll think about it over time and the second one, divestitures, there’s nothing on the table that we plan to divest."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Nancy Bush – NAB Research"
},
{
"speaker": "Nancy Bush – NAB Research",
"text": "You spoke about bringing down deposit costs in the WaMu franchise, can you just tell us sort of how generally you’re doing that, are you doing it by product, or by region and what has the reaction been?"
},
{
"speaker": "Michael Cavanagh",
"text": "I think we’ll get deeper into it in terms of Investor Day but as you know the need to hold deposits was causing WaMu to be a price leader on particularly time deposits but really across the board so as we’ve modeled the deal and as Charlie and team are actually executing, we’re looking to just bring pricing, state by state, region by region, into better line with the way we would do it in Chase markets in terms of the company’s overall cost of money with a view to the local market conditions. So anywhere state by state we both look at overall cost of money to the company together with franchise value when we price money."
},
{
"speaker": "James Dimon",
"text": "Hot money, we’re attracting some hot money. We don’t need it."
},
{
"speaker": "Michael Cavanagh",
"text": "So despite that we’re doing an okay, but keeping total balances pretty flat to where they were with some churn away from fast money."
},
{
"speaker": "Nancy Bush – NAB Research",
"text": "Can you just give us your very rough impression in the quarter of whether the pricing reductions at WaMu, how much they kicked in to NIM or took away from NIM?"
},
{
"speaker": "Michael Cavanagh",
"text": "What I would point you to is on the retail side, you can see it’s imbedded in here but it’s part of the impact of overall deposit margin in the retail business which stayed around a 3% type of level."
},
{
"speaker": "James Dimon",
"text": "And within what we kind of expected because we knew we were going to do some of that and obviously the changes in the rate curve and the deposit costs, but net net is all probably a wash."
},
{
"speaker": "Operator",
"text": "There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments."
},
{
"speaker": "Michael Cavanagh",
"text": "Thank you very much everybody, look forward to talking to you next quarter."
}
] | null | null |
JPM | 3 | 2,008 | 2008-10-15 09:00:00 | Executives: Michael Cavanagh – CFO James Dimon – President & CEO
Analysts: John McDonald - Sanford C. Bernstein Guy Moszkowski - Merrill Lynch Mike Mayo - Deutsche Bank Betsy Graseck - Morgan Stanley Jeff Harte - Sandler O’Neill Meredith Whitney - Oppenheimer William Tanona - Goldman Sachs Jim Mitchell - Buckingham Research Glenn Schorr - UBS Ron Mandel – GIC Nancy Bush – NAB Research
Operator: Good morning ladies and gentlemen. Welcome to the JPMorgan Chase third quarter 2008 earnings call. Today's presentation may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are based on the current beliefs and expectations of JPMorgan Chase’s management and are subject to significant risk and uncertainties. Actual results may differ from those set forth in the forward-looking statements. Factors that could cause JPMorgan Chase’s actual results to differ materially from those described in the forward-looking statements can be found in JPMorgan Chase’s current report on Form 8-K dated September 26, 2008, its Quarterly Reports on Form-Q for the quarters ended June 30, 2008 and March 31, 2008 and its Annual Report on Form-K for the year ended December 31, 2007 each of which has been filed with the Securities and Exchange Commission and is available on JPMorgan Chase’s website, www.jpmchase.com and on the Securities and Exchange Commission website. JPMorgan Chase does not undertake to update the forward-looking statements to reflect the impact of circumstances or events that may arise after the date of the forward-looking statements. Today’s presentation may also reference non-GAAP financial measures, and you should refer to the information contained in the written slides accompanying this presentation for information about their calculation. The slides are available at JPMorgan Chase’s website. (Operator Instructions) At this time I'd like to turn the call over to JPMorgan Chase's Chairman and Chief Executive Officer, James Dimon, and Chief Financial Officer, Michael Cavanagh; Mr. Cavanagh please go ahead sir.
Michael Cavanagh: Good morning everybody thanks for joining James and I. So we’re going to go through as usual a slide presentation that is available on our website. If you have that in front of you I hope, let me first like I did last quarter with Bear Stearns just describe upfront the impact in the quarter of the Washington Mutual transaction that closed during the quarter to clear that up before we start talking about what went on in the JPMorgan businesses for the full quarter. The first point I’d make here is the italicized comment up top that the numbers, its only been less then three weeks since we announced and closed the Washington Mutual transaction so take the numbers that I’ll talk about here on this page related to Washington Mutual as our best estimates at this stage and do expect us to be working on future refinements if and as needed. But with that if you go into the table you see that we reported firm-wide net income including Washington Mutual impact of $527 million or $0.11 per share. Then you see the WaMu related merger items which you’re going to see in our corporate segment for the quarter. A conforming loan loss reserve adjustment of $1.221 billion; a little higher then what we said on the WaMu call a couple of weeks back and then an extraordinary gain of $581 million which is actually zero at the time of the call. Those two together are about $0.18 negative so bring you down to results before WaMu of $1.167 or about $0.28 per share. Moving down to some of the bullets at the bottom, just to give you a sense for what’s coming in the future, merger-related items ongoing from this point forward, so in the fourth quarter and beyond, will again be booked in corporate the same way you’re going to see what happened with the non-operating results of Bear Stearns. That’s going to include whatever merger costs there are that flow in the future. We’re giving you an estimate that that could be after-tax about $100 million plus or minus in the fourth quarter and cumulatively as much as $500 million plus or minus over the next several years. In addition the refinements that I talked about to the purchase accounting to the extent that they occur are going to run through P&L and that’s related to the fact that there’s a negative goodwill situation and to the accounting [inaudible] you can follow-up after the call on what all that means. But any refinements will run through P&L but we will count them in this merger-related items line that we’ll show you and talk about in the corporate segment. Lastly beginning next quarter we’ll obviously show the ongoing operating results as appropriate in our relevant business segments, retail, card services and commercial banking and we’ll be spending time to improve and refine the reporting methodology we have to capture all the details we want to give you. Just a high level comment, on the earnings impact we still feel comfortable that about a $0.50 incremental EPS for 2009 is a reasonable expectation and as far as the fourth quarter goes you can pretty much expect our best guess would be pro rata portion of that $0.10, $0.12 of EPS in the fourth quarter related to WaMu. Moving along to slide two, I won’t comment on the first several items on the page here because we’re going to hit them in the businesses but just some firm-wide items, down toward the middle of the page, you see the results include overall results include, now this is JPMorgan Chase away from Washington Mutual after-tax items that include the slightly larger benefit from reduction of deferred tax liabilities and what I talked about on the WaMu call a couple of weeks ago its $927 million after-tax. Its spread across our business units, the bulk of it in the investment bank and then the next two items auction rate and Fannie Mae and Freddie Mac write-downs you’re going to see in our corporate segment. On credit reserves firm-wide we increased credit reserves through the P&L by $1.3 billion in the quarter bringing the total to $15.3 billion of loan loss allowance and that’s strong coverage ratios that you’ll see here I’ll show you a final slide that gives you that across the full firm and that’s before Washington Mutual again. As you know in addition we brought over and then added to the reserves Washington Mutual had for its non-market portfolios to the tune of $4.5 billion added to the $15.3 billion that we had. And lastly we maintained very strong Tier 1 capital, $112 billion or 8.9% Tier 1 ratio on the back of the successful capital raise of $11.5 billion of common equity that we did a couple of weeks ago. I’m going to skip now slide three and go right to getting into the results for the investment bank on slide four. So here you see the investment bank had $882 million of net income on pre-tax income of $16 million so that’s really the flow-through of the deferred tax liability benefit that I talked about on the prior page largely going to the investment bank. If you now work down the P&L for the business, $4 billion of overall revenues, piece of that included $1.6 billion of investment banking fee revenues, up 20% year-over-year and you’ll see on the next slide that we continue to be leading market share across the league tables as well as the top, this $1.6 billion for the year-to-date equivalent is actually the top fee earner on the street. So I feel very good about the investment banking fee franchise. Moving along to fixed income markets you see we had on the revenue side a total of $815 million of revenues. That includes $2.6 billion of write-downs related to our mortgage positions that we’ve been talking about before as well as $1 billion related to leverage lending. I’ll show you a slide on each of those so we won’t go into that in more detail right now. And then underlying that in fixed income it was a very strong results in a bunch of other areas, record results in rates and currencies, credit trading very strong emerging markets and commodities. On the equity market side, you see $1.650 billion of revenues, up strongly year-over-year and that’s on strong client revenue and on the trading side. And then lastly you see credit portfolio down a lot from a year ago but that’s really related to derivative receivables, the widening of our counter party credit spreads obviously driving the values lower there and the negative revenues which in large part offset the benefit that you see in the bullets in fixed income markets and equity markets related to the benefit we get on our own credit spread widening. On the credit cost line you see $234 million of credit costs, actually the preponderance of that is additions to loan loss allowance, only $13 million of actual charge-offs in the quarter that brings the allowance for loan losses in the investment bank to $2.7 billion for the 3.85% reserves to loans ratio. And then the last point I’ll make here is you see at the bottom the end of period equity, $33 billion. I’ll comment on the back of how we arrived at that but we really spent time in the quarter looking to refine our capital allocation methodologies to our businesses and you can think of this as a common equity equivalent for the investment bank. Moving along to slide five, I’m going to skip it, but you won’t go through it here, but you can see for yourself the strong rankings we have in the league tables on the fee side. So moving to slide six, I’ll just quickly comment on the legacy leverage lending positions. So you see we had net markdowns as I said of $1 billion for the quarter. That brings our gross markdowns to $3.8 billion on the remaining $12.9 billion of commitments that we have for a 29% markdown to a carrying value on the balance sheet of $9.1 billion. And that is a reduction of $3.4 billion or 21% from last quarter. Moving on to slide seven you see on the mortgage related side, same numbers we’ve been showing you in prior periods. I’ll start in the table, if you go to the left, you see the bottom line of the table $33 billion of mortgage exposure across the products shown here both residential and commercial reduced by $14.4 billion to end this past quarter at $18.6 billion for the investment bank. If you look at the first bullet below the table, that reduction in two parts, $2.6 billion of write-downs as I talked about in the P&L, running through the P&L, as well as $11.8 billion worth of sales including $4.3 billion of which was moved over to our corporate investment portfolio which is the real buyer of these type of assets. I’ll skip going through the details because you can read them for yourself of what comprises the different buckets that we have on the page, you see in the next couple of bullets, but obviously we feel well marked here but when you go down to the final bullet, just to explain how we think about the remaining $18.6 billion, we would think about that in two ways. There’s a natural level of inventory that you need to support the ongoing trading and client activity in normal times. That could be anywhere from $12 billion to $15 billion and so you see $12 billion right now of that would be assets of that very nature that you expect to be business as usual and flowing in and out the door. On top of that though we do have $6.6 billion worth of remaining positions from what we’ve been through obviously marked down and we’re just going to manage that on a mark-to-market basis in a liquidating portfolio in the investment bank under [Bill and Steve] but remain, leave our trading debt focused on facilitating client business and put that in the hands of a special team to deal with. Moving on to retail now on slide eight you see again the main drivers as we always go through of what’s going on in the P&L so you see the growth in the branch stats, checking accounts up 10% you can read for yourself the growth in branches and ATMs, etc. Average deposits up 2% year-over-year and flattish versus last quarter but do feel good about the strength of this franchise. Mortgages obviously originations on the mortgage loan side down some. Most of what we’re originating is conforming to government guarantee standards there and holding the market share gains that we’ve had there. Home equity originations down 77% year-over-year. When you translate that on slide nine into the P&L for the retail business, we end up with the $4.9 billion worth of revenue in the retail business overall which is up 16% year-over-year. That drops down to $247 million of net income which is down from the year ago and prior quarter and the big reason for that is credit. So you see credit costs circled there of $1.678 billion. Obviously charge-offs are higher and you can see the charge-off rate overall down below at 244 basis points up from prior year and prior quarter but also included in that $1.7 billion of credit costs is $450 million of additions to loan loss reserves part of the firm-wide $1.3 billion increase. In addition we added $250 million of loan loss reserves related to prime mortgages held in corporate. So I’m going to show you a couple of slides in a second on what’s going on in the major portfolios. Lastly at the bottom of the page same thing as the investment bank, you see the equity allocated to the business taking into account the WaMu acquisition increasing from $17 billion to $25 billion in the quarter. Moving on to slide 10, I’ll talk you through the same slides we’ve seen before on our major residential mortgage portfolios. So slide 10 is home equity. I’ll just take you to the upper right box, the key stats, focus on the net charge-offs dollar line, so you see $663 million of net charge-offs, up from $511 million last quarter. I’ll just take you right down to our outlook from here on this is that we had talked about last quarter the pace of deterioration slowing off of what we had given to you earlier in the year. It has slowed but nonetheless it continues to deteriorate so our best outlook for the near-term is that quarterly loss that $663 million could trend as high as $725 million per quarter to $800 million a quarter over the next several quarters or so. When you move on to subprime, a little more severe degradation so you see $192 million of net charge-offs last quarter going up to $273 million and our outlook again down at the bottom bullet could be as high as $375 million to $425 million over the coming quarters by early 2009. Here was a major component of our $450 million reserve increase in the retail business was related to subprime. On slide 12 prime mortgage, remember I said earlier that we carry some of the balances here in our retail business but many in the corporate segment and in the investment portfolio, overall the charge-offs on this portfolio of $177 million in the quarter or 1.51%, that’s going to trend as high as $300 million by early 2009 and just to remind people, we talked about this last quarter, the increase in prime. Just to clarity a bit, this portfolio we have, mix drives a lot of what’s going on here. You see that 80% of our losses in the quarter came from California and Florida which represented 37% of the portfolio. The more important portion of why the charge-off rates are higher then you might expect is that this is not a well balanced portfolio by vintage so of the $47 billion you see in balances, about 50% are ‘06, ‘07 vintages which drive 90% plus of the losses related to this portfolio. Moving on to card, slide 13, here you see we had profits of $292 million in the quarter down substantially from a year ago. Main driver again credit costs, $2.2 billion up substantially from the prior year, charge-off rate of 5%, pretty much on what we previously expected up from 4.98% last quarter but essentially flat. In addition on top of charge-offs we added $250 million to the allowance for loan loss reserves in the quarter. On the revenue side we had outstandings grow by 6% from a year ago to about $158 billion and charge volume growth of 5% when you translate that into, its modest revenue growth basically flat to a year ago. And lastly same points at the bottom, $15 billion of capital and I’ll just tell you that’s with the view to where the business is going to go once card securitizations come on balance sheet and more under Basel II, so a good number for capital allocation to the card business. Moving onto commercial bank on slide 14, here we had profits of $312 million, up 21% from a year ago and that’s on record revenue so the $1.125 billion is up 11% from the prior year. That’s on the back of loan growth of 18% from a year ago and deposit or liability balances up 13% from a year ago and that revenue growth is really coming across all products in the business. Here credit costs of $126 million actually again, very modest charge-offs. You see the 22 basis point net charge-off rate in the quarter so all in all, below normalized levels for credit costs and as we’ll comment later expect this to worsen. It will worsen from these levels given the economy but so far so good for this business. On slide 15, treasury and security services, you see profits of $406 million up from the year ago. Again liability balance up 10% helping translate to revenues up 12% from a year ago including two segments here, treasury services, the cash management businesses and security services, the custody business. On the treasury services side the $897 million of revenues were a record quarterly revenue level. WSS benefited from the market we’re in but obviously faces challenges as the market has come off in what we’ve seen in this month so far. Overall liability balances you see of $260 billion. Moving on to asset management, $351 million worth of net income, down from a year ago and down from last quarter. Story here again as I mentioned with treasury and security services is market levels impact this so our assets under management are down by $133 billion solely due to market declines. On the other side of that over the past 12 months we’ve continued to have inflows, $123 billion for the past year and $46 billion in for the quarter helping offset some of that. Nonetheless it translates into revenues down 11% given lower market level effect as well as performance fees. Finally moving on the P&L to corporate, slide 17, I’ll just walk through the pieces here, private equity we have been talking about weaker conditions for liquidations and valuations on private equity so we got it this quarter. Negative revenues on unrealized losses of $206 million translates into after-tax losses of $164 million. Moving down a row you see corporate, $1.64 billion negative so this is where you see in the bullets to the bottom right, inside that number some of the big numbers are the write-down of the Fannie and Freddie preferred securities that we owned $642 million after-tax. Also the $400 million pre-tax estimated charge related to auction rate security settlement, $248 million after-tax and lastly I commented earlier the prime loans that we hold in corporate, both the $250 million increase in loan loss allowance as well as actually charge-offs in the quarter translate into $234 million of after-tax costs in all running through that $1.64 billion negative for corporate. Outlook for there continues to be $50 million to $100 million negative in a quarter but you’re going to have volatility around the investment portfolio as well as the credit costs related to that prime portfolio and then the last piece is the $735 million after-tax of merger-related items. This as I said earlier is where we’re going to continue to show you the impact in future quarters of Washington Mutual and Bear Stearns related items. So here for the quarter you see the $1.2 billion conforming loan loss reserve for WaMu as well as the $600 million extraordinary gain as well as about $95 million after-tax of Bear Stearns merger-related costs, kind of in line with what we had expected. Moving on to capital, so slide 18, you see the firm-wide view of capital, obviously came in a bit better then what we talked about a couple of weeks ago on the Washington Mutual call so you see about five rows down, Tier 1 capital ratio is a Basel I basis, 8.9% for the quarter, again that includes taking on the Washington Mutual balance sheet and the $11.5 billion of common equity we raised in closing the quarter. And again that’s on a Basel I basis, on a Basel II basis our best estimate is that there’s substantial, maybe 100 basis points spread between the two to the positive going to Basel II. And then just the points down at the bottom, the capital allocation and funding costs, so capital allocation we spent a lot of time in this environment and thinking about what’s going on in our industry, making sure we have capital allocated properly in the businesses so we have people making good decisions as our industry obviously faces a lot of different challenges. And what we did in trying to arrive at that is take a couple of things into mind, two of those are that Basel II will be in effect for us January of 2010 or thereabouts, as well as the off-balance sheet accounting rules that bring on in particular the credit card off-balance sheet securitization. So we tried to take a forward view of where we’re going as we thought about allocating capital to the businesses. And then the final point is that obviously with credit spreads where they are, the cost of money, the cost of goods sold in our company period is obviously much higher and we’ve been regularly passing through higher cost of money to our businesses so they can again make good economic decisions for the shareholders on a day to day basis. Moving on to slide 19 now I’ll just recap the numbers or let you read them yourselves, these are just refreshes of the pages we showed you the night of the Washington Mutual announcement. The top table on page 19 just shows you the $31 billion of tangible assets acquired from WaMu as booked on their books net of our write-downs and purchase accounting and the consideration we paid gets you to the estimated after-tax gain of $581 million for the quarter as well as the conforming loan loss reserve adjustments you see at the bottom. I’ll make the same caveat on this page that these are our best estimates as we sit here now and to expect some future refinements to these numbers if necessary. One last slide on WaMu is page 20, think of this as a preamble to the disclosure we’re going to be giving you in future quarters which really goes to the loan balances and the reserves associated with those since obviously we took a lot of loans and marked them down. I just want you to understand how it’s going to flow through our numbers, so over to the left you see the first three columns is just JPMorgan standalone before WaMu. You see our loan balances in the first blue row if you follow your eye across there the next column is our loan loss allowance, $14.5 billion related to loan coverage and that’s 2.72% loan loss reserve coverage. When you move to the middle you see WaMu but first I’ll point you over to the side, remember that we took $108 billion worth of WaMu loans that are credit impaired the bad stuff. We wrote that down by the $30 billion to get to the $78 billion carrying value on our books now related to these loans for a markdown of just around 28%. What remains then is in the middle of the page under the green column for Washington Mutual loan balances, the remainder, the good stuff, that wasn’t marked down is $131 billion that needs normal loan loss reserves against it. So including the additional conforming loan accounting entry we booked we have $4.5 billion of loan loss reserve related to the Washington Mutual loans that have reserves and then those two columns, two sets of columns add over to JPMorgan consolidated. So again there are things moving through these numbers that we’re going to be very clear when we get to our fourth quarter results on how it flows through the numbers. Washington Mutual integration on page 21 will just say that it’s progressing well. Important point is that the deposit base is really stabilizing and growing since September 30 with positive net inflows on seven out of the past nine days. And then finally our outlook, I think I’ve hit all the comments here. I’ll just say one or two things in addition that in really across retail, really across all the businesses you see our comment that you can generally be expecting higher credit costs and the worse economic conditions get, the more likely it is, or it is likely if economic conditions worsen that we’ll continue adding to our loan loss reserves in coming quarters. But in card in particular if you see down there on the left side of the page, you can expect losses of the 5% or so range in the fourth quarter which is in line with what we previously said, but given what we’re seeing in the economy its reasonable at this stage to up the expectations for losses in card for 2009. So we say here that you can expect something more to the tune of 6% loan losses at the beginning of the year growing to something more like 7% at the end of the year, but again highly dependent upon the economy. In asset management, TSS, subject to market conditions, corporate the $50 million to $100 million I already described, and Washington Mutual the $0.50 of EPS incremental next year with a pro rata piece of that coming in the fourth quarter as I said earlier. So with all that one other item is paymentech gains from the dissolution of our merchant services business with First Data, that will be about an after-tax gain assuming it goes through in early November on schedule of $800 million, so after-tax but obviously given expectations for loan loss reserving, we’ll see what, don’t expect that to be dropping to the bottom line is what I’d say. So with that, let me wrap that up and James and I can take some questions.
James Dimon: Let me just give a couple of overall comments before we take some questions, obviously we necessarily need to be prepared for a bad environment. We don’t know what the environment is going to be and Michael took you through all the credit numbers. If you look at them, other then home lending which we think is far worse then we would have expected, we’re actually not that bad, non-performers, delinquencies, in card etc. but when you see this kind of unemployment, this kind of uncertainty, the reduced consumer spend, we are getting braced for increasing loan loss reserves going forward. So its reasonable as a shareholder for you to expect that trading results can be very tough going forward, that charge-offs are going to be going up, the loan loss reserve will be added at least the next couple of quarters but we’re going into the environment with extremely strong balance sheet; 8.9% Tier 1 before the government’s addition to that, very strong loan loss reserve, we think among the strongest in the industry which probably be strengthening going forward. And I think of note when you go through this press release there is real growth. In some areas it’s in market share like investment banking and mortgages even though it’s a tough business, in other areas its really raw growth. In deposits and loans and you see that in TSS, private bank, commercial, and so we feel pretty good about it. Even in the card business where we have low expectations for spend, our spend is up 5% and from what we know VISA numbers are more like zero so we seem to be gaining a little bit of share there too. I also want to point out that in the investment bank, on of the things, if you back out those losses which we don’t think you always should do, but the trading results were pretty good but another way to view that is that based on what we just went through in September and obviously for the whole quarter but September in particular, you have to feel pretty good with the violent swings in volatility that we’re able to manage through that process across all of our products globally and not be highly surprised. That goes from the Lehman bankruptcy to the AIG issues to swings in certain securities of 25% in a day and you could imagine what its like to manage through that process and I think for our people here, I think its very important to note it was an unbelievable thing to watch the people accomplish the WaMu acquisition, managing the portfolios, a lot of people were dealing with clients and mortgages and issues trying to do the right thing for the clients everyday so it makes you really proud to watch what the people here are able to accomplish and I think it also portends very well what could be accomplished in the future. I’ll also mention on the treasury package because I know it’s in the back of your minds, we were presented with a package from the government and the way, this is the way that JPMorgan saw it. The United States government is trying to do some very powerful things to fix the situation and a lot of people can cover the whole bunch of different programs but they had one and I think what they’re doing in this package plus all the prior things that have been done is very powerful and you will start to see some effect. So we really saw this as doing something which is very good for the system. It is equally true if you said, well they’re asymmetric benefits for, it could be a negative for JPMorgan versus competition. That may very well be true but we did not think that JPMorgan should be selfish or parochial and try to stop what’s good for the system because it might be mildly bad for us relative to some of our competitors. So we hope it will work. There’s $25 billion of capital if it comes in the door. We hope to be able to find ways to use it, to benefit our shareholders and continue to be there for our clients. I do want to point out that we are there for our clients, commercial loans are up 18%, the investment banking loans were way up, and a lot of the things we do every day we’re trying to do the best we can to be in business for our clients even in some categories where if you asked the question, if you borrowed at today’s marginal costs, and lent out at today’s yields in home equity, auto, you’re probably losing money. But we still try to stay in business in the right way for people who walk into our branches or deal with our bankers so we will stop there and open the floor to any questions you may have.
Operator: (Operator Instructions) Your first question comes from the line of John McDonald - Sanford C. Bernstein
John McDonald - Sanford C. Bernstein : In the equity trading could you comment on share gains in prime brokerage and also the contribution of the Bear Stearns business this quarter versus last quarter?
James Dimon: We’ve had some gain in prime broker and I’m going to say if you look at total downs there able to go something like 25% over the quarter so Bear is performing kind of the way we expect but I don’t remember the specific numbers of what it did, the equity--
Michael Cavanagh: It’s definitely an improvement in P&L over the last quarter but not yet and I would still say we’re tracking towards the incremental profits we expected to get by the 2009, health in the business but not a dramatic change in P&L just yet.
John McDonald - Sanford C. Bernstein: So it’s not yet a net positive but it should be still towards the $250 million per quarter by the end of next year?
James Dimon: It’s a small net positive but not a good net positive.
John McDonald - Sanford C. Bernstein: In the credit card business the margin was up quarter to quarter was wondering if the prime LIBOR spread was something that started to hurt towards the end of the quarter and do you expect that to impact you more going forward?
James Dimon: That number alone if it stayed where it is today could cost us $100 million a month in that business. We don’t expect it to stay there and obviously there are actions we can take to reduce it over time.
James Dimon: And you’re right it wasn’t a significant factor in the third quarter.
John McDonald - Sanford C. Bernstein: On the card, any changes toward the end of the quarter in payment rates and behavior as the market fell apart in terms of just revolve and payment rates?
James Dimon: Yes, so spend numbers dropped from a year ago and they’re now running on the consumer side plus 3%, 4%, 5% a week. I think the industry is closer, at least we know the VISA numbers are around zero. Payment rates came down a little bit which you expect to see in an environment like this and obviously the losses are kind of trending upward in a nice steady fashion like we told you to expect.
John McDonald - Sanford C. Bernstein: On the government’s plan with the preferred, do you expect them to be restrictive on how banks deploy the capital or pretty much free reign for the banks to use their discretion subject to--?
James Dimon: It’s a non-voting preferred so we don’t expect the government to get involved in our business. But it’s clear that the government would like us to use the capital to facilitate clients, to make loans and stuff like that and we want to do that too so I think we have a common interest in this.
Operator: Your next question comes from the line of Guy Moszkowski - Merrill Lynch
Guy Moszkowski - Merrill Lynch: I just wanted to follow-up on the use of the government capital, would you think its reasonably leveragable especially given the availability of the debt guarantee or is the government actually do you think expecting you to maintain Tier 1 close to 12%?
James Dimon: I don’t think the government is telling us what to do with the capital, and when you say leveragable I think you can use it. We fully expect to use some of it to do a good job for our shareholders and the government guarantee on the debt side just makes it easier for banks to rollover their liabilities and some banks are having trouble doing that; JPMorgan was not.
Guy Moszkowski - Merrill Lynch: But presumably given that you’ll be receiving an injection of $25 billion of Tier 1 capital if you leveraged it even a few times over an used the fact that you can borrow at basically treasuries plus 75, given the 75 basis point cost of the guarantee, it would seem like it could actually be an interesting opportunity or am I looking at it wrong?
James Dimon: No, I think if you are a bank that’s [filling a hole], obviously you can’t do that. If you were a bank that’s not [filling a hole] obviously you can do some of that. But we just got it so we haven’t, we haven’t even got it yet so we’re just sitting here making sure we do it right and obviously it will relate to the environment you see going ahead. It’s very important for us just I think it’s very important for the government that all these institutions be able to weather whatever happens coming forward.
Guy Moszkowski - Merrill Lynch: And do you plan to use the TARP asset sale facility to reduce some of those mortgage exposures that you talked about?
James Dimon: Look I don’t think it’s highly relevant to us honestly and we’re down to smaller numbers now and so the answer is probably not but we’ll see how the details come out and we’ll figure it out then. I think the TARP facility when it comes out may very well help the markets and that will help anyone who wants to trade in those markets because you have real prices and real discovery and real ability to how you manage your own assets and capital.
Guy Moszkowski - Merrill Lynch: On Bear Stearns, given what you paid for the company versus the book value that they stated at the time of the merger, and the fact that you didn’t record an extraordinary gain there you would essentially be carrying maybe $10 billion of reserves and you talked about a variety of the things that those were set up for, but largely it would be for securities valuation and I was wondering have you burned through all those reserves at this point and would some of the securities losses that you showed this quarter have been from the Bear Stearns portfolio or do you still have some of those valuation reserves available?
James Dimon: I think we’ve been clear right from the beginning there are no valuation reserves ever in the Bear Stearns deal. All those assets came over and were marked at fair value. There were reserves for litigation, severance, a whole bunch of stuff like that, but they were our best estimate. There is nothing left over from Bear Stearns. If you said what would your losses have been in mortgages this quarter had you not done the Bear Stearns deal, my guess is about 40% of that came from Bear Stearns.
Operator: Your next question comes from the line of Mike Mayo - Deutsche Bank
Mike Mayo - Deutsche Bank: So when do you get the $25 billion in preferred?
James Dimon: I don’t know. I think the paperwork is not finished on that and obviously we’re going to read that very carefully.
Mike Mayo - Deutsche Bank: Would you be willing to use that $25 billion for new acquisitions?
James Dimon: I would be willing to use it for anything that made sense for JPMorgan shareholders.
Mike Mayo - Deutsche Bank: And Bear Stearns, how much of the Fed’s backup has been eaten into?
James Dimon: There’s no Fed backup. The Fed is financing $30 billion of assets and we’re taking the first $1.1 billion or whatever the number is of loss there and again we’ve been very consistent. We think the Fed is going to get all their money back and we expect to get a little bit of our first loss note back too. But I don’t know. They’re managing that. It’s up to them and it depends how they manage it over time. They make their own reports by the way what they think the market value of that is and the last report I saw said it’s about what it started at and obviously its bounced all over the place in the last month.
Mike Mayo - Deutsche Bank: Have you made any changes to mark-to-market accounting? I guess there’s been a lot of noise in the SEC and there’s and IASB proposal for European banks that would allow them to move assets from fair value accounting to more loan type accounting, any views on all of this, any changes ahead or any changes already made?
James Dimon: We have made no changes to our accounting. I think with the SEC guidelines set out is that in markets where there’s kind of no trading you’ve got to use your judgment and models and stuff like that. We’ve made no change in ours. I think the European banks, we are already allowed if we want to move from a trading account to a held to maturity account and we took you all through that last time, we did do that with a little bit of stuff and put up a lot more reserves, not less when we did that because, the matter of fact we wanted more reserves. They said the banks can do that themselves in Europe now.
Mike Mayo - Deutsche Bank: As far as your outlook you mentioned the Lehman bankruptcy risk remain, and I guess that relates to CDS, but can you elaborate and how important are these risks?
James Dimon: We think we’re going to be fine on those risks but we just want it pointed out, it’s really two things to simplify it a little bit, one is trading. And honestly all of us thought that if you ever saw a mutual called the major dealer exit that it would be very tough on trading, it was. But I think it was, I think the street, it was able to get through that rather quickly and easily but there’s still some open issues relating to that, but not big. And the second is we were a huge financing tri party agent and we have collateral against that and some of that collateral we have to liquidate and some of that collateral belongs to some other people. We think that all will sort out.
Operator: Your next question comes from the line of Betsy Graseck - Morgan Stanley
Betsy Graseck - Morgan Stanley: Could you talk a little bit about the card business? We realize that the House had passed some legislation that potentially will make its way to the Senate in the beginning of the year and you’ve got the Fed regulators looking at a proposal [inaudible], what are you doing in the card business to prepare yourself for the potential that these legislation changes?
James Dimon: First of all keep in mind that we already had eliminated double cycle billing and we had already eliminated [off us] pricing. This is where we changed your pricing because of FICO score change or something like that. So two of the biggest things that people complain about we already don’t do. So put them to the side and that cost us money. It was like $300 or $400 million--
Michael Cavanagh: It was [$700] million, it was going back about a year, [three quarters of a year].
James Dimon: So the other stuff and there’s a whole bunch of stuff out there, I would put in the category it could be significant so any one change on its own could be hundreds of millions of dollars or something like that. In total they could be well over a billion but there are actions that would take place that would change a lot of that. So for example if you can’t re-price your loans, you’re not going to make certain types of loans. If you have to have people pay off teaser rate loans last on a series of loans, we’re not going to make teaser rate loans. So a lot of that stuff I think competitively will cause changes in profits in the short-run but not in the long-run. It will change your pricing, if you cannot price for risk, you’re going to charge everybody else more, that’s what’s going to happen.
Betsy Graseck - Morgan Stanley: I know in your comments to the Fed you indicated that the industry or your portfolio in particular would be smaller, can you give us any sense of the degree to which you think you might need to pull back on your outstandings?
James Dimon: Yes, we already have but honestly like some of the teaser outstandings that we pulled back on worked out profitable anyway. We’re going to run the business for profit. If outstandings go down $10 million so be it.
Betsy Graseck - Morgan Stanley: When you did the WaMu announcement you indicated a slide where you had your home lending loss severity expectations based on current estimates, deeper recessions, severe recession, based on what you were saying earlier it seems like you might be triangulating more towards a deeper recession in your outlook, is that fair to say or not?
James Dimon: Our outlook is kind of what we see with a little twist that we expect it to get worse. And so we don’t really know but I think you know what, we have to be prepared that it gets a lot worse. And we are.
Operator: Your next question comes from the line of Jeff Harte - Sandler O’Neill
Jeff Harte - Sandler O’Neill: In the mortgage related exposures and the investment bank you showed the decline and I think you said $4.3 billion of it went into corporate, of the total decline going back beyond just the third quarter how much has gone into corporate do you know?
James Dimon: Just that piece. So corporate has $100 billion portfolio and that portfolio is for interest rate exposures, for collateral reasons, to manage the balance sheet of the company, we are moving some of that portfolio slowly and carefully into higher yielding assets. Because remember we’re here for shareholders and some of these assets we think are going to give great returns to shareholders over time. So it’s not in a great rush but those assets will include a little bit of AAA CLO, a little bit of bank preferred, a little bit of Alt-A, a little bit of CMBS, and we’re not going to do it ad hoc, we’re just going to do it over time. So those assets that they move were the same type of assets they were buying. And they were moved at fair value so there was no benefit to anyone in it.
Jeff Harte - Sandler O’Neill: Are they mark-to-market?
James Dimon: Yes, most of those will continue to be mark-to-market in the treasury portfolio. So you will see a little more volatility in corporate because more of the assets there are being held in a trading portfolio because they have to be, but again we’re here for shareholder results and if we have to take a little bit more risk to do a good thing for shareholders we’re willing to take a little more volatility.
Jeff Harte - Sandler O’Neill: I know there’s no way to normalize trading revenues but if we back out the big marked downs of $3.6 billion in the quarter trading revenues looked really, really good.
James Dimon: They were really, really good.
Jeff Harte - Sandler O’Neill: Is that kind of wow that was fantastic, we’ll never see that again or, I’m just surprised given how much volatility there was in the quarter?
James Dimon: Honestly it was an exceptional performance. Some areas I think the rising tide lifted all boats so I think you’ll see a lot of trading desk in certain currencies and certain rates and other areas, and other areas our people just did an exceptional job. Emerging markets, we were hedged for a downturn on the equity side, we were prepared and positioned for markets going down so we benefited from that and it, we’re not taking big bets on it but it was pretty good performance. We don’t expect that to repeat though.
Jeff Harte - Sandler O’Neill: From a deposit standpoint almost $970 billion on the balance sheet is more then I was expecting combining you with Washington Mutual, can you talk at all about, are you gaining more market share there is there any pricing pressure changes on the deposit side?
James Dimon: We think in the market share side and the wholesale side, yes. And you see that in TSS. And we think in private bank the answer would be yes. Retail the answer is no and part of the reason we weren’t competing aggressively for funds nor are we in areas we had this big flight to quality. So I think if you were in California or Florida and you were strong, you had a big inflow. We weren’t in California and Florida so we weren’t the beneficiary of flight to quality but we think we’re probably gaining a little bit of share and I think the deposits in the last month were up $100 billion in total.
Operator: Your next question comes from the line of Meredith Whitney - Oppenheimer
Meredith Whitney – Oppenheimer: You didn’t quantify how many of your businesses are impacted by the prime LIBOR inversion and I want to be clear in terms of the decline in originations on your mortgage portfolio, was that more credit based or in terms of tightening underwriting standards or prime LIBOR--?
James Dimon: Prime LIBOR has a huge negative effect on card; it has a modest beneficial effect across some other businesses. So that’s not a big deal and it doesn’t affect, directly effect the origination business. The origination business and I think this is true for a lot of people in the industry, people have gone back to old fashioned 80% LTV, real verified income, more disciplined appraisals, and in some areas they won’t even go to 85% LTV because of expected home decreases. So we are not at 80% in California, Nevada, or Florida, we’re at 65%. That’s why its down and I think that’s true for us and everybody else, almost everything being originated is eligible for Fannie Mae, Freddie Mac, or FHA and so therefore you have this great reduction for us and for other people in origination. Obviously the quality of that stuff is going to be much higher.
Meredith Whitney – Oppenheimer: Given the fact that the industry is pulling back credit across the board, are you seeing areas where you’ve pulled back credit deteriorating much further obviously the states, the sand states are experiencing the most credit deterioration but have you given a test example of pulling back credit in one area and seeing all your competitors in that being a catalyst for chronic increase in deteriorating credit?
James Dimon: No I think the answer is probably yes but we’ll never really know so if everyone pulls out of credit out of California obviously it will accelerate the depreciation in homes in California make it harder, scarier to provide credit and let me just make a general comment about a crisis like this. One of the things that happens which I think the government is focusing on is a lot of individual actors, I’m talking about you as investors, banks as providers of credit, individuals, small businesses, large businesses, all start to take actions that are rational for them as an individual or a corporation but in total can cause exactly what you’re talking about. And that’s one of the things that the government is trying to reverse. It’s not just the banks. It’s the individuals who invest in banks, its people who provide capital to other financial institutions or moving the money back overseas and so you do see a little bit of that and they’re trying to arrest that. That is the one thing that’s got people most scared and they’re trying to stop it and I think what the government is doing is pretty powerful medicine. I’d say the governments around the world is pretty powerful medicine and I think you will start to see some beneficial effect of that in the next couple of weeks.
Meredith Whitney – Oppenheimer: If you really believed that you’d be gunning credit card lines, right because you believe that the inversion would abate?
James Dimon: We’re not speculators. But we are buying slightly more risky assets and we’re growing our businesses everywhere so we’re not panicking. Credit cards were up, credit card receivables were up. We’re not pulling out of California. We’re still going there. We’re still marketing. Obviously we’re trying to modify what’s going on. We’re not going to say, yahoo, this is over, extend credit like we did without fear. If you’re not fearful, you’re crazy.
Operator: Your next question comes from the line of William Tanona - Goldman Sachs
William Tanona - Goldman Sachs : Some of the other investment banks provided some pretty good color in terms of where they have certain assets marked within their investment bank, just wondering if you would be willing to provide that same level of detail across prime, Alt-A, subprime, CMBS, you give the exposure reductions but we don’t really know where those things are marked.
James Dimon: So leverage loans we did and I’ll give you some numbers right now, ready? Prime loans is not really applicable, securities high 50s, Alt-A performing about mid 70s, non-performing 40s, that’s loans. Alt-A securities high 20s, subprime mid 30s, CMBS loans mid 80s, securities mid 70s, that’s all we’re going to give you because its competitive information.
William Tanona - Goldman Sachs : In terms of the retail financial services, if I look at the charge-off rates for the prime loans that are retail financial services, it looks like its about 96 basis points this quarter versus the charge-offs for corporate which are about 30, what’s the difference between those prime mortgages held in RFS versus corporate?
James Dimon: It’s mostly vintage. We may change the reporting of them; combine it so we don’t cause this confusion going forward. One of the things I should mention, when you look at the mortgage business that we kind of looked at the $12 billion ongoing is trading, its moving, that’s what we need to do to service clients, properly marked, you shouldn’t see huge, obviously there’s risk in trading, but it should be back to more normal risk and there’s $6 billion, its marked, but put it in as liquidating very hard to trade, you can’t trade it all. Its marked down to we’re going to get, I would believe, we’re going to get very substantial returns, from 10% to 20% as we liquidate it using fairly bad assumptions. We don’t like it but it’s not that big a deal anymore.
William Tanona - Goldman Sachs : The commentary in terms of your outlook you talked about basically expecting or having lower expectations for earnings within the investment banking results, is that just relative to this quarter or is that just in general what we should be expecting?
James Dimon: I just think you should be very cautious. I’m guessing what the environment is going to be so this crisis isn’t over so we’re just guessing like you can guess on your own. We don’t know anything that you don’t know. We’re just guessing that it still could be pretty tough out there for awhile. We might have some more markdowns that, we have really healthy loan loss reserves, like $77 billion of loans, we have almost 4% up against that. That’s historically high but it’s very idiosyncratic. If one big company fails that could be a huge loss for us so we’re just prepared to be a little bit tougher in the investment bank. We hope to make some money but we’re not going to count on it for now. I [would] be shocked if we make a lot of money one of these quarters either by the way.
Operator: Your next question comes from the line of Jim Mitchell - Buckingham Research
Jim Mitchell - Buckingham Research: In the mortgage market with the TARP are you seeing any impact on stabilizing pricing there which could help reduce the risk of write-downs going forward?
James Dimon: A little bit in Alt-A and maybe a little bit in some of the CMBS stuff. Remember TARP hasn’t started yet but just the anticipation might cause some of that. Surprisingly we haven’t really seen anything in agencies, agency MBS which the spreads are still damn near the highs and we think those are probably very good buys. And I would expect one day we’re going to wake up those [inaudible] in dramatically.
Michael Cavanagh: Then the buying that was announced last weekend by the agencies monthly, $20 billion each is going to be helpful as well.
James Dimon: We were up to Fannie Mae and Freddie Mac preferreds, but whatever they are, I think we can get real value for that back one day too. I just think it could be years from now.
Jim Mitchell - Buckingham Research : Maybe that dovetails into the securities gains that you had this quarter was that realized in the available for sale portfolio or was it mark-to-market in your corporate trading book or is it hedges, where were those gains?
James Dimon: It was realized in the AFS portfolio. There was some trading losses in there that—
Michael Cavanagh: Some trading losses on some non-interest rate products and on just changing [coupon] trades in some of the mortgages on there that were realized gains.
Operator: Your next question comes from the line of Glenn Schorr - UBS
Glenn Schorr – UBS: On the [inaudible] temporary liquidity guarantee program, did you know round about how much you have coming due through June 30 and is there any reason why you wouldn’t max out on that issuance?
Michael Cavanagh: I don’t have the number handy and we haven’t really thought through it exactly.
James Dimon: Remember it includes, the way we understand it it includes CP, promissory notes, maturing debt, all unsecured, holding company and bank, so it’s a pretty big number and its 125% of that.
Glenn Schorr – UBS: It seems like well worth it not that your balance sheet was in that rough of a spot, it just seems like a--
James Dimon: So you guys basically just want to stick all the money and leverage up and go for it.
Glenn Schorr – UBS: Hunker down in the bunkers sounds pretty good to me these days. On the balance sheet on slide four you saw other assets double from $90 billion to $180 billion, is that anything in particular?
Michael Cavanagh: You mean the supplement. Let me come back to you on that, it may just be all the cash that’s coming in going into, it’s got to be WaMu.
Glenn Schorr – UBS: What are the signs you do look for in terms of when the boosting of the reserves stops because you’re at obviously extremely high levels as you pointed out of the loan loss reserves, is it the pace of increase on the both delinquencies, unemployment and charge-offs?
James Dimon: I think the second you see a levelization of charge-offs, with some certainly going forward that you don’t need any additions to reserves.
Operator: Your next question comes from the line of Ron Mandel – GIC
Ron Mandel – GIC: On the treasury program if you think over the longer term there’s some incentives to buyback the preferred stock that the treasury is taking the number of warrants, the higher coupon, I’m wondering if you could maybe elaborate on how you think about, you may want to issue stock to buyback the preferred and also just maybe how many warrants you think are going to be issued under the program?
James Dimon: Once we decide to go into the program I was thinking could we have $50 billion. So think of it this way obviously by the time you get to the 9% you’ll probably want to have paid it off and the warrants are equal to the value you gain. So in our case they’re going to get warrants if the way it’s currently written, 10 year warrants on $3.75 billion of stock, those warrants are worth, you can estimate it at $1.2 billion, which is an additional cost on the $25 billion. So it’s 5% plus the way I look at it, a year plus another 5% for the full term. You just monetize the cost of the warrants. So it’s not bad money that way. There is a way if you refinance it sooner, you’re going to refinance it with real Tier 1 capital that you can eliminate half the warrants and we’ll deal with that in due course. That to me becomes a truly financial decision. You do that or not do that, but the government made this part of it not an unattractive thing so that people can get the capital, use the capital and hopefully do some good with the capital.
Ron Mandel – GIC: How many warrants, warrants for how many shares and--?
James Dimon: It’s not the shares, its warrants for $3.75 billion worth of stock; you could do your own share calculation. The market value of those warrants would be something like $1.2 billion or $1.3 billion use your own model.
Michael Cavanagh: The strike is based on a trailing 20 day price.
James Dimon: I’m simply saying think of that, of the whole $25 billion it’s under 5%, maybe 6% so if you spread it over the first five years of the 5% of money, your money is costing you 6.5%. Its still cheaper then most companies can raise money at today. And it’s real Tier 1 so it’s very cheap Tier 1. So to that extent it’s not a bad economic transaction.
Ron Mandel – GIC: And then you could even reduce the warrants as you mentioned by--
James Dimon: There’s a way to reduce them, but you could argue that a lot of people wouldn’t want to because that’s cheaper capital then they could otherwise get.
Ron Mandel – GIC: So on your balance sheet this is additional Tier 1 capital?
James Dimon: It’s all Tier 1 capital.
Ron Mandel – GIC: Not the preferred part, the warrants part.
James Dimon: The warrants are not Tier 1 capital; they are just a dilution on the balance sheet.
Michael Cavanagh: It would be $25 billion on top of the $112 billion in Tier 1 capital we currently have.
Ron Mandel – GIC: The other part of the FDIC program besides the debt guarantee was a checking account guarantee, are you going to opt in to that and if so what will the cost be--?
James Dimon: I think what they said is 10 basis points in that and think of that as an operating account guarantee. I think the real point of that wasn’t for JPMorgan, its really for smaller community banks and stuff that do a lot of small business middle market and they don’t want those people to be afraid that they’re operating accounts are at risk.
Ron Mandel – GIC: And then the 10 basis point cost--
James Dimon: It doesn’t mean anything to us either way whether we do it or don’t.
Operator: Your final question comes from the line of Nancy Bush – NAB Research
Nancy Bush – NAB Research: This is sort of a philosophical question; this treasury program that was announced yesterday I think came as a bit of a surprise to everybody. It seems to have been done with a few days thought and mostly as a result of what happened in Europe but what is your feeling about how this has changed the dynamic for capital raising going forward? Is it going to make it more expensive for the banking industry to raise capital beyond this period of treasury investment? Can you give me your philosophical thoughts about it?
James Dimon: I don’t really think so; I think that one day everything will have normalized again. That might be three or five years out. I think what they really wanted to do; I don’t know how long they worked on this, so I wouldn’t assume it was just three days. I do think they had to do something relative to the rest of the world so if you were in their shoes you would look at it and say well the rest of the world is guaranteeing deposits, United States is not and the rest of the world, you might create other consequences so but I agree with you. Making policy on the run is a very hard thing to do and it always has these huge unintended consequences which is really hard to forecast ahead of time or have any foresight on at all. But I think one day it will normalize and will make raising capital more expensive for banks. We’ll go back to a more normal world and people will probably spend a lot more attention on credit, which they should.
Nancy Bush – NAB Research : You have been a huge beneficiary of basically institutional failures in this environment, is it your sense that this treasury program will slow that process, is it intended to slow the process, is it intended to prop up banks that should probably fail? Is that one of the unintended consequences?
James Dimon: I think that one of the consequences is, is that this program obviously helps the weaker more then it helps the strong. And I think I mentioned that if you don’t want to be parochial or selfish, as long as it really materially helping the system, we all should be in favor of it. So you can sit around the table and argue all day long where we would have been better off and sure, but you’re not better off if the system goes down. But I don’t think the intent on the treasury, I think they’re very conscious of, they don’t intend to hold up failing banks and you haven’t seen them do that. What you’ve seen them do is be pretty aggressive to try to get failing banks in the hands of good owners. So they’re going to have to throughout this program, the devil will be in the details how they manage it. So you will be looking at how they really manage it going forward and we’ll be second guessing them too at one point.
Operator: There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments.
James Dimon: Thank you very much and we’ll talk to you soon. | [
{
"speaker": "Executives",
"text": "Michael Cavanagh – CFO James Dimon – President & CEO"
},
{
"speaker": "Analysts",
"text": "John McDonald - Sanford C. Bernstein Guy Moszkowski - Merrill Lynch Mike Mayo - Deutsche Bank Betsy Graseck - Morgan Stanley Jeff Harte - Sandler O’Neill Meredith Whitney - Oppenheimer William Tanona - Goldman Sachs Jim Mitchell - Buckingham Research Glenn Schorr - UBS Ron Mandel – GIC Nancy Bush – NAB Research"
},
{
"speaker": "Operator",
"text": "Good morning ladies and gentlemen. Welcome to the JPMorgan Chase third quarter 2008 earnings call. Today's presentation may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are based on the current beliefs and expectations of JPMorgan Chase’s management and are subject to significant risk and uncertainties. Actual results may differ from those set forth in the forward-looking statements. Factors that could cause JPMorgan Chase’s actual results to differ materially from those described in the forward-looking statements can be found in JPMorgan Chase’s current report on Form 8-K dated September 26, 2008, its Quarterly Reports on Form-Q for the quarters ended June 30, 2008 and March 31, 2008 and its Annual Report on Form-K for the year ended December 31, 2007 each of which has been filed with the Securities and Exchange Commission and is available on JPMorgan Chase’s website, www.jpmchase.com and on the Securities and Exchange Commission website. JPMorgan Chase does not undertake to update the forward-looking statements to reflect the impact of circumstances or events that may arise after the date of the forward-looking statements. Today’s presentation may also reference non-GAAP financial measures, and you should refer to the information contained in the written slides accompanying this presentation for information about their calculation. The slides are available at JPMorgan Chase’s website. (Operator Instructions) At this time I'd like to turn the call over to JPMorgan Chase's Chairman and Chief Executive Officer, James Dimon, and Chief Financial Officer, Michael Cavanagh; Mr. Cavanagh please go ahead sir."
},
{
"speaker": "Michael Cavanagh",
"text": "Good morning everybody thanks for joining James and I. So we’re going to go through as usual a slide presentation that is available on our website. If you have that in front of you I hope, let me first like I did last quarter with Bear Stearns just describe upfront the impact in the quarter of the Washington Mutual transaction that closed during the quarter to clear that up before we start talking about what went on in the JPMorgan businesses for the full quarter. The first point I’d make here is the italicized comment up top that the numbers, its only been less then three weeks since we announced and closed the Washington Mutual transaction so take the numbers that I’ll talk about here on this page related to Washington Mutual as our best estimates at this stage and do expect us to be working on future refinements if and as needed. But with that if you go into the table you see that we reported firm-wide net income including Washington Mutual impact of $527 million or $0.11 per share. Then you see the WaMu related merger items which you’re going to see in our corporate segment for the quarter. A conforming loan loss reserve adjustment of $1.221 billion; a little higher then what we said on the WaMu call a couple of weeks back and then an extraordinary gain of $581 million which is actually zero at the time of the call. Those two together are about $0.18 negative so bring you down to results before WaMu of $1.167 or about $0.28 per share. Moving down to some of the bullets at the bottom, just to give you a sense for what’s coming in the future, merger-related items ongoing from this point forward, so in the fourth quarter and beyond, will again be booked in corporate the same way you’re going to see what happened with the non-operating results of Bear Stearns. That’s going to include whatever merger costs there are that flow in the future. We’re giving you an estimate that that could be after-tax about $100 million plus or minus in the fourth quarter and cumulatively as much as $500 million plus or minus over the next several years. In addition the refinements that I talked about to the purchase accounting to the extent that they occur are going to run through P&L and that’s related to the fact that there’s a negative goodwill situation and to the accounting [inaudible] you can follow-up after the call on what all that means. But any refinements will run through P&L but we will count them in this merger-related items line that we’ll show you and talk about in the corporate segment. Lastly beginning next quarter we’ll obviously show the ongoing operating results as appropriate in our relevant business segments, retail, card services and commercial banking and we’ll be spending time to improve and refine the reporting methodology we have to capture all the details we want to give you. Just a high level comment, on the earnings impact we still feel comfortable that about a $0.50 incremental EPS for 2009 is a reasonable expectation and as far as the fourth quarter goes you can pretty much expect our best guess would be pro rata portion of that $0.10, $0.12 of EPS in the fourth quarter related to WaMu. Moving along to slide two, I won’t comment on the first several items on the page here because we’re going to hit them in the businesses but just some firm-wide items, down toward the middle of the page, you see the results include overall results include, now this is JPMorgan Chase away from Washington Mutual after-tax items that include the slightly larger benefit from reduction of deferred tax liabilities and what I talked about on the WaMu call a couple of weeks ago its $927 million after-tax. Its spread across our business units, the bulk of it in the investment bank and then the next two items auction rate and Fannie Mae and Freddie Mac write-downs you’re going to see in our corporate segment. On credit reserves firm-wide we increased credit reserves through the P&L by $1.3 billion in the quarter bringing the total to $15.3 billion of loan loss allowance and that’s strong coverage ratios that you’ll see here I’ll show you a final slide that gives you that across the full firm and that’s before Washington Mutual again. As you know in addition we brought over and then added to the reserves Washington Mutual had for its non-market portfolios to the tune of $4.5 billion added to the $15.3 billion that we had. And lastly we maintained very strong Tier 1 capital, $112 billion or 8.9% Tier 1 ratio on the back of the successful capital raise of $11.5 billion of common equity that we did a couple of weeks ago. I’m going to skip now slide three and go right to getting into the results for the investment bank on slide four. So here you see the investment bank had $882 million of net income on pre-tax income of $16 million so that’s really the flow-through of the deferred tax liability benefit that I talked about on the prior page largely going to the investment bank. If you now work down the P&L for the business, $4 billion of overall revenues, piece of that included $1.6 billion of investment banking fee revenues, up 20% year-over-year and you’ll see on the next slide that we continue to be leading market share across the league tables as well as the top, this $1.6 billion for the year-to-date equivalent is actually the top fee earner on the street. So I feel very good about the investment banking fee franchise. Moving along to fixed income markets you see we had on the revenue side a total of $815 million of revenues. That includes $2.6 billion of write-downs related to our mortgage positions that we’ve been talking about before as well as $1 billion related to leverage lending. I’ll show you a slide on each of those so we won’t go into that in more detail right now. And then underlying that in fixed income it was a very strong results in a bunch of other areas, record results in rates and currencies, credit trading very strong emerging markets and commodities. On the equity market side, you see $1.650 billion of revenues, up strongly year-over-year and that’s on strong client revenue and on the trading side. And then lastly you see credit portfolio down a lot from a year ago but that’s really related to derivative receivables, the widening of our counter party credit spreads obviously driving the values lower there and the negative revenues which in large part offset the benefit that you see in the bullets in fixed income markets and equity markets related to the benefit we get on our own credit spread widening. On the credit cost line you see $234 million of credit costs, actually the preponderance of that is additions to loan loss allowance, only $13 million of actual charge-offs in the quarter that brings the allowance for loan losses in the investment bank to $2.7 billion for the 3.85% reserves to loans ratio. And then the last point I’ll make here is you see at the bottom the end of period equity, $33 billion. I’ll comment on the back of how we arrived at that but we really spent time in the quarter looking to refine our capital allocation methodologies to our businesses and you can think of this as a common equity equivalent for the investment bank. Moving along to slide five, I’m going to skip it, but you won’t go through it here, but you can see for yourself the strong rankings we have in the league tables on the fee side. So moving to slide six, I’ll just quickly comment on the legacy leverage lending positions. So you see we had net markdowns as I said of $1 billion for the quarter. That brings our gross markdowns to $3.8 billion on the remaining $12.9 billion of commitments that we have for a 29% markdown to a carrying value on the balance sheet of $9.1 billion. And that is a reduction of $3.4 billion or 21% from last quarter. Moving on to slide seven you see on the mortgage related side, same numbers we’ve been showing you in prior periods. I’ll start in the table, if you go to the left, you see the bottom line of the table $33 billion of mortgage exposure across the products shown here both residential and commercial reduced by $14.4 billion to end this past quarter at $18.6 billion for the investment bank. If you look at the first bullet below the table, that reduction in two parts, $2.6 billion of write-downs as I talked about in the P&L, running through the P&L, as well as $11.8 billion worth of sales including $4.3 billion of which was moved over to our corporate investment portfolio which is the real buyer of these type of assets. I’ll skip going through the details because you can read them for yourself of what comprises the different buckets that we have on the page, you see in the next couple of bullets, but obviously we feel well marked here but when you go down to the final bullet, just to explain how we think about the remaining $18.6 billion, we would think about that in two ways. There’s a natural level of inventory that you need to support the ongoing trading and client activity in normal times. That could be anywhere from $12 billion to $15 billion and so you see $12 billion right now of that would be assets of that very nature that you expect to be business as usual and flowing in and out the door. On top of that though we do have $6.6 billion worth of remaining positions from what we’ve been through obviously marked down and we’re just going to manage that on a mark-to-market basis in a liquidating portfolio in the investment bank under [Bill and Steve] but remain, leave our trading debt focused on facilitating client business and put that in the hands of a special team to deal with. Moving on to retail now on slide eight you see again the main drivers as we always go through of what’s going on in the P&L so you see the growth in the branch stats, checking accounts up 10% you can read for yourself the growth in branches and ATMs, etc. Average deposits up 2% year-over-year and flattish versus last quarter but do feel good about the strength of this franchise. Mortgages obviously originations on the mortgage loan side down some. Most of what we’re originating is conforming to government guarantee standards there and holding the market share gains that we’ve had there. Home equity originations down 77% year-over-year. When you translate that on slide nine into the P&L for the retail business, we end up with the $4.9 billion worth of revenue in the retail business overall which is up 16% year-over-year. That drops down to $247 million of net income which is down from the year ago and prior quarter and the big reason for that is credit. So you see credit costs circled there of $1.678 billion. Obviously charge-offs are higher and you can see the charge-off rate overall down below at 244 basis points up from prior year and prior quarter but also included in that $1.7 billion of credit costs is $450 million of additions to loan loss reserves part of the firm-wide $1.3 billion increase. In addition we added $250 million of loan loss reserves related to prime mortgages held in corporate. So I’m going to show you a couple of slides in a second on what’s going on in the major portfolios. Lastly at the bottom of the page same thing as the investment bank, you see the equity allocated to the business taking into account the WaMu acquisition increasing from $17 billion to $25 billion in the quarter. Moving on to slide 10, I’ll talk you through the same slides we’ve seen before on our major residential mortgage portfolios. So slide 10 is home equity. I’ll just take you to the upper right box, the key stats, focus on the net charge-offs dollar line, so you see $663 million of net charge-offs, up from $511 million last quarter. I’ll just take you right down to our outlook from here on this is that we had talked about last quarter the pace of deterioration slowing off of what we had given to you earlier in the year. It has slowed but nonetheless it continues to deteriorate so our best outlook for the near-term is that quarterly loss that $663 million could trend as high as $725 million per quarter to $800 million a quarter over the next several quarters or so. When you move on to subprime, a little more severe degradation so you see $192 million of net charge-offs last quarter going up to $273 million and our outlook again down at the bottom bullet could be as high as $375 million to $425 million over the coming quarters by early 2009. Here was a major component of our $450 million reserve increase in the retail business was related to subprime. On slide 12 prime mortgage, remember I said earlier that we carry some of the balances here in our retail business but many in the corporate segment and in the investment portfolio, overall the charge-offs on this portfolio of $177 million in the quarter or 1.51%, that’s going to trend as high as $300 million by early 2009 and just to remind people, we talked about this last quarter, the increase in prime. Just to clarity a bit, this portfolio we have, mix drives a lot of what’s going on here. You see that 80% of our losses in the quarter came from California and Florida which represented 37% of the portfolio. The more important portion of why the charge-off rates are higher then you might expect is that this is not a well balanced portfolio by vintage so of the $47 billion you see in balances, about 50% are ‘06, ‘07 vintages which drive 90% plus of the losses related to this portfolio. Moving on to card, slide 13, here you see we had profits of $292 million in the quarter down substantially from a year ago. Main driver again credit costs, $2.2 billion up substantially from the prior year, charge-off rate of 5%, pretty much on what we previously expected up from 4.98% last quarter but essentially flat. In addition on top of charge-offs we added $250 million to the allowance for loan loss reserves in the quarter. On the revenue side we had outstandings grow by 6% from a year ago to about $158 billion and charge volume growth of 5% when you translate that into, its modest revenue growth basically flat to a year ago. And lastly same points at the bottom, $15 billion of capital and I’ll just tell you that’s with the view to where the business is going to go once card securitizations come on balance sheet and more under Basel II, so a good number for capital allocation to the card business. Moving onto commercial bank on slide 14, here we had profits of $312 million, up 21% from a year ago and that’s on record revenue so the $1.125 billion is up 11% from the prior year. That’s on the back of loan growth of 18% from a year ago and deposit or liability balances up 13% from a year ago and that revenue growth is really coming across all products in the business. Here credit costs of $126 million actually again, very modest charge-offs. You see the 22 basis point net charge-off rate in the quarter so all in all, below normalized levels for credit costs and as we’ll comment later expect this to worsen. It will worsen from these levels given the economy but so far so good for this business. On slide 15, treasury and security services, you see profits of $406 million up from the year ago. Again liability balance up 10% helping translate to revenues up 12% from a year ago including two segments here, treasury services, the cash management businesses and security services, the custody business. On the treasury services side the $897 million of revenues were a record quarterly revenue level. WSS benefited from the market we’re in but obviously faces challenges as the market has come off in what we’ve seen in this month so far. Overall liability balances you see of $260 billion. Moving on to asset management, $351 million worth of net income, down from a year ago and down from last quarter. Story here again as I mentioned with treasury and security services is market levels impact this so our assets under management are down by $133 billion solely due to market declines. On the other side of that over the past 12 months we’ve continued to have inflows, $123 billion for the past year and $46 billion in for the quarter helping offset some of that. Nonetheless it translates into revenues down 11% given lower market level effect as well as performance fees. Finally moving on the P&L to corporate, slide 17, I’ll just walk through the pieces here, private equity we have been talking about weaker conditions for liquidations and valuations on private equity so we got it this quarter. Negative revenues on unrealized losses of $206 million translates into after-tax losses of $164 million. Moving down a row you see corporate, $1.64 billion negative so this is where you see in the bullets to the bottom right, inside that number some of the big numbers are the write-down of the Fannie and Freddie preferred securities that we owned $642 million after-tax. Also the $400 million pre-tax estimated charge related to auction rate security settlement, $248 million after-tax and lastly I commented earlier the prime loans that we hold in corporate, both the $250 million increase in loan loss allowance as well as actually charge-offs in the quarter translate into $234 million of after-tax costs in all running through that $1.64 billion negative for corporate. Outlook for there continues to be $50 million to $100 million negative in a quarter but you’re going to have volatility around the investment portfolio as well as the credit costs related to that prime portfolio and then the last piece is the $735 million after-tax of merger-related items. This as I said earlier is where we’re going to continue to show you the impact in future quarters of Washington Mutual and Bear Stearns related items. So here for the quarter you see the $1.2 billion conforming loan loss reserve for WaMu as well as the $600 million extraordinary gain as well as about $95 million after-tax of Bear Stearns merger-related costs, kind of in line with what we had expected. Moving on to capital, so slide 18, you see the firm-wide view of capital, obviously came in a bit better then what we talked about a couple of weeks ago on the Washington Mutual call so you see about five rows down, Tier 1 capital ratio is a Basel I basis, 8.9% for the quarter, again that includes taking on the Washington Mutual balance sheet and the $11.5 billion of common equity we raised in closing the quarter. And again that’s on a Basel I basis, on a Basel II basis our best estimate is that there’s substantial, maybe 100 basis points spread between the two to the positive going to Basel II. And then just the points down at the bottom, the capital allocation and funding costs, so capital allocation we spent a lot of time in this environment and thinking about what’s going on in our industry, making sure we have capital allocated properly in the businesses so we have people making good decisions as our industry obviously faces a lot of different challenges. And what we did in trying to arrive at that is take a couple of things into mind, two of those are that Basel II will be in effect for us January of 2010 or thereabouts, as well as the off-balance sheet accounting rules that bring on in particular the credit card off-balance sheet securitization. So we tried to take a forward view of where we’re going as we thought about allocating capital to the businesses. And then the final point is that obviously with credit spreads where they are, the cost of money, the cost of goods sold in our company period is obviously much higher and we’ve been regularly passing through higher cost of money to our businesses so they can again make good economic decisions for the shareholders on a day to day basis. Moving on to slide 19 now I’ll just recap the numbers or let you read them yourselves, these are just refreshes of the pages we showed you the night of the Washington Mutual announcement. The top table on page 19 just shows you the $31 billion of tangible assets acquired from WaMu as booked on their books net of our write-downs and purchase accounting and the consideration we paid gets you to the estimated after-tax gain of $581 million for the quarter as well as the conforming loan loss reserve adjustments you see at the bottom. I’ll make the same caveat on this page that these are our best estimates as we sit here now and to expect some future refinements to these numbers if necessary. One last slide on WaMu is page 20, think of this as a preamble to the disclosure we’re going to be giving you in future quarters which really goes to the loan balances and the reserves associated with those since obviously we took a lot of loans and marked them down. I just want you to understand how it’s going to flow through our numbers, so over to the left you see the first three columns is just JPMorgan standalone before WaMu. You see our loan balances in the first blue row if you follow your eye across there the next column is our loan loss allowance, $14.5 billion related to loan coverage and that’s 2.72% loan loss reserve coverage. When you move to the middle you see WaMu but first I’ll point you over to the side, remember that we took $108 billion worth of WaMu loans that are credit impaired the bad stuff. We wrote that down by the $30 billion to get to the $78 billion carrying value on our books now related to these loans for a markdown of just around 28%. What remains then is in the middle of the page under the green column for Washington Mutual loan balances, the remainder, the good stuff, that wasn’t marked down is $131 billion that needs normal loan loss reserves against it. So including the additional conforming loan accounting entry we booked we have $4.5 billion of loan loss reserve related to the Washington Mutual loans that have reserves and then those two columns, two sets of columns add over to JPMorgan consolidated. So again there are things moving through these numbers that we’re going to be very clear when we get to our fourth quarter results on how it flows through the numbers. Washington Mutual integration on page 21 will just say that it’s progressing well. Important point is that the deposit base is really stabilizing and growing since September 30 with positive net inflows on seven out of the past nine days. And then finally our outlook, I think I’ve hit all the comments here. I’ll just say one or two things in addition that in really across retail, really across all the businesses you see our comment that you can generally be expecting higher credit costs and the worse economic conditions get, the more likely it is, or it is likely if economic conditions worsen that we’ll continue adding to our loan loss reserves in coming quarters. But in card in particular if you see down there on the left side of the page, you can expect losses of the 5% or so range in the fourth quarter which is in line with what we previously said, but given what we’re seeing in the economy its reasonable at this stage to up the expectations for losses in card for 2009. So we say here that you can expect something more to the tune of 6% loan losses at the beginning of the year growing to something more like 7% at the end of the year, but again highly dependent upon the economy. In asset management, TSS, subject to market conditions, corporate the $50 million to $100 million I already described, and Washington Mutual the $0.50 of EPS incremental next year with a pro rata piece of that coming in the fourth quarter as I said earlier. So with all that one other item is paymentech gains from the dissolution of our merchant services business with First Data, that will be about an after-tax gain assuming it goes through in early November on schedule of $800 million, so after-tax but obviously given expectations for loan loss reserving, we’ll see what, don’t expect that to be dropping to the bottom line is what I’d say. So with that, let me wrap that up and James and I can take some questions."
},
{
"speaker": "James Dimon",
"text": "Let me just give a couple of overall comments before we take some questions, obviously we necessarily need to be prepared for a bad environment. We don’t know what the environment is going to be and Michael took you through all the credit numbers. If you look at them, other then home lending which we think is far worse then we would have expected, we’re actually not that bad, non-performers, delinquencies, in card etc. but when you see this kind of unemployment, this kind of uncertainty, the reduced consumer spend, we are getting braced for increasing loan loss reserves going forward. So its reasonable as a shareholder for you to expect that trading results can be very tough going forward, that charge-offs are going to be going up, the loan loss reserve will be added at least the next couple of quarters but we’re going into the environment with extremely strong balance sheet; 8.9% Tier 1 before the government’s addition to that, very strong loan loss reserve, we think among the strongest in the industry which probably be strengthening going forward. And I think of note when you go through this press release there is real growth. In some areas it’s in market share like investment banking and mortgages even though it’s a tough business, in other areas its really raw growth. In deposits and loans and you see that in TSS, private bank, commercial, and so we feel pretty good about it. Even in the card business where we have low expectations for spend, our spend is up 5% and from what we know VISA numbers are more like zero so we seem to be gaining a little bit of share there too. I also want to point out that in the investment bank, on of the things, if you back out those losses which we don’t think you always should do, but the trading results were pretty good but another way to view that is that based on what we just went through in September and obviously for the whole quarter but September in particular, you have to feel pretty good with the violent swings in volatility that we’re able to manage through that process across all of our products globally and not be highly surprised. That goes from the Lehman bankruptcy to the AIG issues to swings in certain securities of 25% in a day and you could imagine what its like to manage through that process and I think for our people here, I think its very important to note it was an unbelievable thing to watch the people accomplish the WaMu acquisition, managing the portfolios, a lot of people were dealing with clients and mortgages and issues trying to do the right thing for the clients everyday so it makes you really proud to watch what the people here are able to accomplish and I think it also portends very well what could be accomplished in the future. I’ll also mention on the treasury package because I know it’s in the back of your minds, we were presented with a package from the government and the way, this is the way that JPMorgan saw it. The United States government is trying to do some very powerful things to fix the situation and a lot of people can cover the whole bunch of different programs but they had one and I think what they’re doing in this package plus all the prior things that have been done is very powerful and you will start to see some effect. So we really saw this as doing something which is very good for the system. It is equally true if you said, well they’re asymmetric benefits for, it could be a negative for JPMorgan versus competition. That may very well be true but we did not think that JPMorgan should be selfish or parochial and try to stop what’s good for the system because it might be mildly bad for us relative to some of our competitors. So we hope it will work. There’s $25 billion of capital if it comes in the door. We hope to be able to find ways to use it, to benefit our shareholders and continue to be there for our clients. I do want to point out that we are there for our clients, commercial loans are up 18%, the investment banking loans were way up, and a lot of the things we do every day we’re trying to do the best we can to be in business for our clients even in some categories where if you asked the question, if you borrowed at today’s marginal costs, and lent out at today’s yields in home equity, auto, you’re probably losing money. But we still try to stay in business in the right way for people who walk into our branches or deal with our bankers so we will stop there and open the floor to any questions you may have."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from the line of John McDonald - Sanford C. Bernstein"
},
{
"speaker": "John McDonald - Sanford C. Bernstein",
"text": "In the equity trading could you comment on share gains in prime brokerage and also the contribution of the Bear Stearns business this quarter versus last quarter?"
},
{
"speaker": "James Dimon",
"text": "We’ve had some gain in prime broker and I’m going to say if you look at total downs there able to go something like 25% over the quarter so Bear is performing kind of the way we expect but I don’t remember the specific numbers of what it did, the equity--"
},
{
"speaker": "Michael Cavanagh",
"text": "It’s definitely an improvement in P&L over the last quarter but not yet and I would still say we’re tracking towards the incremental profits we expected to get by the 2009, health in the business but not a dramatic change in P&L just yet."
},
{
"speaker": "John McDonald - Sanford C. Bernstein",
"text": "So it’s not yet a net positive but it should be still towards the $250 million per quarter by the end of next year?"
},
{
"speaker": "James Dimon",
"text": "It’s a small net positive but not a good net positive."
},
{
"speaker": "John McDonald - Sanford C. Bernstein",
"text": "In the credit card business the margin was up quarter to quarter was wondering if the prime LIBOR spread was something that started to hurt towards the end of the quarter and do you expect that to impact you more going forward?"
},
{
"speaker": "James Dimon",
"text": "That number alone if it stayed where it is today could cost us $100 million a month in that business. We don’t expect it to stay there and obviously there are actions we can take to reduce it over time."
},
{
"speaker": "James Dimon",
"text": "And you’re right it wasn’t a significant factor in the third quarter."
},
{
"speaker": "John McDonald - Sanford C. Bernstein",
"text": "On the card, any changes toward the end of the quarter in payment rates and behavior as the market fell apart in terms of just revolve and payment rates?"
},
{
"speaker": "James Dimon",
"text": "Yes, so spend numbers dropped from a year ago and they’re now running on the consumer side plus 3%, 4%, 5% a week. I think the industry is closer, at least we know the VISA numbers are around zero. Payment rates came down a little bit which you expect to see in an environment like this and obviously the losses are kind of trending upward in a nice steady fashion like we told you to expect."
},
{
"speaker": "John McDonald - Sanford C. Bernstein",
"text": "On the government’s plan with the preferred, do you expect them to be restrictive on how banks deploy the capital or pretty much free reign for the banks to use their discretion subject to--?"
},
{
"speaker": "James Dimon",
"text": "It’s a non-voting preferred so we don’t expect the government to get involved in our business. But it’s clear that the government would like us to use the capital to facilitate clients, to make loans and stuff like that and we want to do that too so I think we have a common interest in this."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Guy Moszkowski - Merrill Lynch"
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "I just wanted to follow-up on the use of the government capital, would you think its reasonably leveragable especially given the availability of the debt guarantee or is the government actually do you think expecting you to maintain Tier 1 close to 12%?"
},
{
"speaker": "James Dimon",
"text": "I don’t think the government is telling us what to do with the capital, and when you say leveragable I think you can use it. We fully expect to use some of it to do a good job for our shareholders and the government guarantee on the debt side just makes it easier for banks to rollover their liabilities and some banks are having trouble doing that; JPMorgan was not."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "But presumably given that you’ll be receiving an injection of $25 billion of Tier 1 capital if you leveraged it even a few times over an used the fact that you can borrow at basically treasuries plus 75, given the 75 basis point cost of the guarantee, it would seem like it could actually be an interesting opportunity or am I looking at it wrong?"
},
{
"speaker": "James Dimon",
"text": "No, I think if you are a bank that’s [filling a hole], obviously you can’t do that. If you were a bank that’s not [filling a hole] obviously you can do some of that. But we just got it so we haven’t, we haven’t even got it yet so we’re just sitting here making sure we do it right and obviously it will relate to the environment you see going ahead. It’s very important for us just I think it’s very important for the government that all these institutions be able to weather whatever happens coming forward."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "And do you plan to use the TARP asset sale facility to reduce some of those mortgage exposures that you talked about?"
},
{
"speaker": "James Dimon",
"text": "Look I don’t think it’s highly relevant to us honestly and we’re down to smaller numbers now and so the answer is probably not but we’ll see how the details come out and we’ll figure it out then. I think the TARP facility when it comes out may very well help the markets and that will help anyone who wants to trade in those markets because you have real prices and real discovery and real ability to how you manage your own assets and capital."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "On Bear Stearns, given what you paid for the company versus the book value that they stated at the time of the merger, and the fact that you didn’t record an extraordinary gain there you would essentially be carrying maybe $10 billion of reserves and you talked about a variety of the things that those were set up for, but largely it would be for securities valuation and I was wondering have you burned through all those reserves at this point and would some of the securities losses that you showed this quarter have been from the Bear Stearns portfolio or do you still have some of those valuation reserves available?"
},
{
"speaker": "James Dimon",
"text": "I think we’ve been clear right from the beginning there are no valuation reserves ever in the Bear Stearns deal. All those assets came over and were marked at fair value. There were reserves for litigation, severance, a whole bunch of stuff like that, but they were our best estimate. There is nothing left over from Bear Stearns. If you said what would your losses have been in mortgages this quarter had you not done the Bear Stearns deal, my guess is about 40% of that came from Bear Stearns."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Mike Mayo - Deutsche Bank"
},
{
"speaker": "Mike Mayo - Deutsche Bank",
"text": "So when do you get the $25 billion in preferred?"
},
{
"speaker": "James Dimon",
"text": "I don’t know. I think the paperwork is not finished on that and obviously we’re going to read that very carefully."
},
{
"speaker": "Mike Mayo - Deutsche Bank",
"text": "Would you be willing to use that $25 billion for new acquisitions?"
},
{
"speaker": "James Dimon",
"text": "I would be willing to use it for anything that made sense for JPMorgan shareholders."
},
{
"speaker": "Mike Mayo - Deutsche Bank",
"text": "And Bear Stearns, how much of the Fed’s backup has been eaten into?"
},
{
"speaker": "James Dimon",
"text": "There’s no Fed backup. The Fed is financing $30 billion of assets and we’re taking the first $1.1 billion or whatever the number is of loss there and again we’ve been very consistent. We think the Fed is going to get all their money back and we expect to get a little bit of our first loss note back too. But I don’t know. They’re managing that. It’s up to them and it depends how they manage it over time. They make their own reports by the way what they think the market value of that is and the last report I saw said it’s about what it started at and obviously its bounced all over the place in the last month."
},
{
"speaker": "Mike Mayo - Deutsche Bank",
"text": "Have you made any changes to mark-to-market accounting? I guess there’s been a lot of noise in the SEC and there’s and IASB proposal for European banks that would allow them to move assets from fair value accounting to more loan type accounting, any views on all of this, any changes ahead or any changes already made?"
},
{
"speaker": "James Dimon",
"text": "We have made no changes to our accounting. I think with the SEC guidelines set out is that in markets where there’s kind of no trading you’ve got to use your judgment and models and stuff like that. We’ve made no change in ours. I think the European banks, we are already allowed if we want to move from a trading account to a held to maturity account and we took you all through that last time, we did do that with a little bit of stuff and put up a lot more reserves, not less when we did that because, the matter of fact we wanted more reserves. They said the banks can do that themselves in Europe now."
},
{
"speaker": "Mike Mayo - Deutsche Bank",
"text": "As far as your outlook you mentioned the Lehman bankruptcy risk remain, and I guess that relates to CDS, but can you elaborate and how important are these risks?"
},
{
"speaker": "James Dimon",
"text": "We think we’re going to be fine on those risks but we just want it pointed out, it’s really two things to simplify it a little bit, one is trading. And honestly all of us thought that if you ever saw a mutual called the major dealer exit that it would be very tough on trading, it was. But I think it was, I think the street, it was able to get through that rather quickly and easily but there’s still some open issues relating to that, but not big. And the second is we were a huge financing tri party agent and we have collateral against that and some of that collateral we have to liquidate and some of that collateral belongs to some other people. We think that all will sort out."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Betsy Graseck - Morgan Stanley"
},
{
"speaker": "Betsy Graseck - Morgan Stanley",
"text": "Could you talk a little bit about the card business? We realize that the House had passed some legislation that potentially will make its way to the Senate in the beginning of the year and you’ve got the Fed regulators looking at a proposal [inaudible], what are you doing in the card business to prepare yourself for the potential that these legislation changes?"
},
{
"speaker": "James Dimon",
"text": "First of all keep in mind that we already had eliminated double cycle billing and we had already eliminated [off us] pricing. This is where we changed your pricing because of FICO score change or something like that. So two of the biggest things that people complain about we already don’t do. So put them to the side and that cost us money. It was like $300 or $400 million--"
},
{
"speaker": "Michael Cavanagh",
"text": "It was [$700] million, it was going back about a year, [three quarters of a year]."
},
{
"speaker": "James Dimon",
"text": "So the other stuff and there’s a whole bunch of stuff out there, I would put in the category it could be significant so any one change on its own could be hundreds of millions of dollars or something like that. In total they could be well over a billion but there are actions that would take place that would change a lot of that. So for example if you can’t re-price your loans, you’re not going to make certain types of loans. If you have to have people pay off teaser rate loans last on a series of loans, we’re not going to make teaser rate loans. So a lot of that stuff I think competitively will cause changes in profits in the short-run but not in the long-run. It will change your pricing, if you cannot price for risk, you’re going to charge everybody else more, that’s what’s going to happen."
},
{
"speaker": "Betsy Graseck - Morgan Stanley",
"text": "I know in your comments to the Fed you indicated that the industry or your portfolio in particular would be smaller, can you give us any sense of the degree to which you think you might need to pull back on your outstandings?"
},
{
"speaker": "James Dimon",
"text": "Yes, we already have but honestly like some of the teaser outstandings that we pulled back on worked out profitable anyway. We’re going to run the business for profit. If outstandings go down $10 million so be it."
},
{
"speaker": "Betsy Graseck - Morgan Stanley",
"text": "When you did the WaMu announcement you indicated a slide where you had your home lending loss severity expectations based on current estimates, deeper recessions, severe recession, based on what you were saying earlier it seems like you might be triangulating more towards a deeper recession in your outlook, is that fair to say or not?"
},
{
"speaker": "James Dimon",
"text": "Our outlook is kind of what we see with a little twist that we expect it to get worse. And so we don’t really know but I think you know what, we have to be prepared that it gets a lot worse. And we are."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Jeff Harte - Sandler O’Neill"
},
{
"speaker": "Jeff Harte - Sandler O’Neill",
"text": "In the mortgage related exposures and the investment bank you showed the decline and I think you said $4.3 billion of it went into corporate, of the total decline going back beyond just the third quarter how much has gone into corporate do you know?"
},
{
"speaker": "James Dimon",
"text": "Just that piece. So corporate has $100 billion portfolio and that portfolio is for interest rate exposures, for collateral reasons, to manage the balance sheet of the company, we are moving some of that portfolio slowly and carefully into higher yielding assets. Because remember we’re here for shareholders and some of these assets we think are going to give great returns to shareholders over time. So it’s not in a great rush but those assets will include a little bit of AAA CLO, a little bit of bank preferred, a little bit of Alt-A, a little bit of CMBS, and we’re not going to do it ad hoc, we’re just going to do it over time. So those assets that they move were the same type of assets they were buying. And they were moved at fair value so there was no benefit to anyone in it."
},
{
"speaker": "Jeff Harte - Sandler O’Neill",
"text": "Are they mark-to-market?"
},
{
"speaker": "James Dimon",
"text": "Yes, most of those will continue to be mark-to-market in the treasury portfolio. So you will see a little more volatility in corporate because more of the assets there are being held in a trading portfolio because they have to be, but again we’re here for shareholder results and if we have to take a little bit more risk to do a good thing for shareholders we’re willing to take a little more volatility."
},
{
"speaker": "Jeff Harte - Sandler O’Neill",
"text": "I know there’s no way to normalize trading revenues but if we back out the big marked downs of $3.6 billion in the quarter trading revenues looked really, really good."
},
{
"speaker": "James Dimon",
"text": "They were really, really good."
},
{
"speaker": "Jeff Harte - Sandler O’Neill",
"text": "Is that kind of wow that was fantastic, we’ll never see that again or, I’m just surprised given how much volatility there was in the quarter?"
},
{
"speaker": "James Dimon",
"text": "Honestly it was an exceptional performance. Some areas I think the rising tide lifted all boats so I think you’ll see a lot of trading desk in certain currencies and certain rates and other areas, and other areas our people just did an exceptional job. Emerging markets, we were hedged for a downturn on the equity side, we were prepared and positioned for markets going down so we benefited from that and it, we’re not taking big bets on it but it was pretty good performance. We don’t expect that to repeat though."
},
{
"speaker": "Jeff Harte - Sandler O’Neill",
"text": "From a deposit standpoint almost $970 billion on the balance sheet is more then I was expecting combining you with Washington Mutual, can you talk at all about, are you gaining more market share there is there any pricing pressure changes on the deposit side?"
},
{
"speaker": "James Dimon",
"text": "We think in the market share side and the wholesale side, yes. And you see that in TSS. And we think in private bank the answer would be yes. Retail the answer is no and part of the reason we weren’t competing aggressively for funds nor are we in areas we had this big flight to quality. So I think if you were in California or Florida and you were strong, you had a big inflow. We weren’t in California and Florida so we weren’t the beneficiary of flight to quality but we think we’re probably gaining a little bit of share and I think the deposits in the last month were up $100 billion in total."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Meredith Whitney - Oppenheimer"
},
{
"speaker": "Meredith Whitney – Oppenheimer",
"text": "You didn’t quantify how many of your businesses are impacted by the prime LIBOR inversion and I want to be clear in terms of the decline in originations on your mortgage portfolio, was that more credit based or in terms of tightening underwriting standards or prime LIBOR--?"
},
{
"speaker": "James Dimon",
"text": "Prime LIBOR has a huge negative effect on card; it has a modest beneficial effect across some other businesses. So that’s not a big deal and it doesn’t affect, directly effect the origination business. The origination business and I think this is true for a lot of people in the industry, people have gone back to old fashioned 80% LTV, real verified income, more disciplined appraisals, and in some areas they won’t even go to 85% LTV because of expected home decreases. So we are not at 80% in California, Nevada, or Florida, we’re at 65%. That’s why its down and I think that’s true for us and everybody else, almost everything being originated is eligible for Fannie Mae, Freddie Mac, or FHA and so therefore you have this great reduction for us and for other people in origination. Obviously the quality of that stuff is going to be much higher."
},
{
"speaker": "Meredith Whitney – Oppenheimer",
"text": "Given the fact that the industry is pulling back credit across the board, are you seeing areas where you’ve pulled back credit deteriorating much further obviously the states, the sand states are experiencing the most credit deterioration but have you given a test example of pulling back credit in one area and seeing all your competitors in that being a catalyst for chronic increase in deteriorating credit?"
},
{
"speaker": "James Dimon",
"text": "No I think the answer is probably yes but we’ll never really know so if everyone pulls out of credit out of California obviously it will accelerate the depreciation in homes in California make it harder, scarier to provide credit and let me just make a general comment about a crisis like this. One of the things that happens which I think the government is focusing on is a lot of individual actors, I’m talking about you as investors, banks as providers of credit, individuals, small businesses, large businesses, all start to take actions that are rational for them as an individual or a corporation but in total can cause exactly what you’re talking about. And that’s one of the things that the government is trying to reverse. It’s not just the banks. It’s the individuals who invest in banks, its people who provide capital to other financial institutions or moving the money back overseas and so you do see a little bit of that and they’re trying to arrest that. That is the one thing that’s got people most scared and they’re trying to stop it and I think what the government is doing is pretty powerful medicine. I’d say the governments around the world is pretty powerful medicine and I think you will start to see some beneficial effect of that in the next couple of weeks."
},
{
"speaker": "Meredith Whitney – Oppenheimer",
"text": "If you really believed that you’d be gunning credit card lines, right because you believe that the inversion would abate?"
},
{
"speaker": "James Dimon",
"text": "We’re not speculators. But we are buying slightly more risky assets and we’re growing our businesses everywhere so we’re not panicking. Credit cards were up, credit card receivables were up. We’re not pulling out of California. We’re still going there. We’re still marketing. Obviously we’re trying to modify what’s going on. We’re not going to say, yahoo, this is over, extend credit like we did without fear. If you’re not fearful, you’re crazy."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of William Tanona - Goldman Sachs"
},
{
"speaker": "William Tanona - Goldman Sachs",
"text": "Some of the other investment banks provided some pretty good color in terms of where they have certain assets marked within their investment bank, just wondering if you would be willing to provide that same level of detail across prime, Alt-A, subprime, CMBS, you give the exposure reductions but we don’t really know where those things are marked."
},
{
"speaker": "James Dimon",
"text": "So leverage loans we did and I’ll give you some numbers right now, ready? Prime loans is not really applicable, securities high 50s, Alt-A performing about mid 70s, non-performing 40s, that’s loans. Alt-A securities high 20s, subprime mid 30s, CMBS loans mid 80s, securities mid 70s, that’s all we’re going to give you because its competitive information."
},
{
"speaker": "William Tanona - Goldman Sachs",
"text": "In terms of the retail financial services, if I look at the charge-off rates for the prime loans that are retail financial services, it looks like its about 96 basis points this quarter versus the charge-offs for corporate which are about 30, what’s the difference between those prime mortgages held in RFS versus corporate?"
},
{
"speaker": "James Dimon",
"text": "It’s mostly vintage. We may change the reporting of them; combine it so we don’t cause this confusion going forward. One of the things I should mention, when you look at the mortgage business that we kind of looked at the $12 billion ongoing is trading, its moving, that’s what we need to do to service clients, properly marked, you shouldn’t see huge, obviously there’s risk in trading, but it should be back to more normal risk and there’s $6 billion, its marked, but put it in as liquidating very hard to trade, you can’t trade it all. Its marked down to we’re going to get, I would believe, we’re going to get very substantial returns, from 10% to 20% as we liquidate it using fairly bad assumptions. We don’t like it but it’s not that big a deal anymore."
},
{
"speaker": "William Tanona - Goldman Sachs",
"text": "The commentary in terms of your outlook you talked about basically expecting or having lower expectations for earnings within the investment banking results, is that just relative to this quarter or is that just in general what we should be expecting?"
},
{
"speaker": "James Dimon",
"text": "I just think you should be very cautious. I’m guessing what the environment is going to be so this crisis isn’t over so we’re just guessing like you can guess on your own. We don’t know anything that you don’t know. We’re just guessing that it still could be pretty tough out there for awhile. We might have some more markdowns that, we have really healthy loan loss reserves, like $77 billion of loans, we have almost 4% up against that. That’s historically high but it’s very idiosyncratic. If one big company fails that could be a huge loss for us so we’re just prepared to be a little bit tougher in the investment bank. We hope to make some money but we’re not going to count on it for now. I [would] be shocked if we make a lot of money one of these quarters either by the way."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Jim Mitchell - Buckingham Research"
},
{
"speaker": "Jim Mitchell - Buckingham Research",
"text": "In the mortgage market with the TARP are you seeing any impact on stabilizing pricing there which could help reduce the risk of write-downs going forward?"
},
{
"speaker": "James Dimon",
"text": "A little bit in Alt-A and maybe a little bit in some of the CMBS stuff. Remember TARP hasn’t started yet but just the anticipation might cause some of that. Surprisingly we haven’t really seen anything in agencies, agency MBS which the spreads are still damn near the highs and we think those are probably very good buys. And I would expect one day we’re going to wake up those [inaudible] in dramatically."
},
{
"speaker": "Michael Cavanagh",
"text": "Then the buying that was announced last weekend by the agencies monthly, $20 billion each is going to be helpful as well."
},
{
"speaker": "James Dimon",
"text": "We were up to Fannie Mae and Freddie Mac preferreds, but whatever they are, I think we can get real value for that back one day too. I just think it could be years from now."
},
{
"speaker": "Jim Mitchell - Buckingham Research",
"text": "Maybe that dovetails into the securities gains that you had this quarter was that realized in the available for sale portfolio or was it mark-to-market in your corporate trading book or is it hedges, where were those gains?"
},
{
"speaker": "James Dimon",
"text": "It was realized in the AFS portfolio. There was some trading losses in there that—"
},
{
"speaker": "Michael Cavanagh",
"text": "Some trading losses on some non-interest rate products and on just changing [coupon] trades in some of the mortgages on there that were realized gains."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Glenn Schorr - UBS"
},
{
"speaker": "Glenn Schorr – UBS",
"text": "On the [inaudible] temporary liquidity guarantee program, did you know round about how much you have coming due through June 30 and is there any reason why you wouldn’t max out on that issuance?"
},
{
"speaker": "Michael Cavanagh",
"text": "I don’t have the number handy and we haven’t really thought through it exactly."
},
{
"speaker": "James Dimon",
"text": "Remember it includes, the way we understand it it includes CP, promissory notes, maturing debt, all unsecured, holding company and bank, so it’s a pretty big number and its 125% of that."
},
{
"speaker": "Glenn Schorr – UBS",
"text": "It seems like well worth it not that your balance sheet was in that rough of a spot, it just seems like a--"
},
{
"speaker": "James Dimon",
"text": "So you guys basically just want to stick all the money and leverage up and go for it."
},
{
"speaker": "Glenn Schorr – UBS",
"text": "Hunker down in the bunkers sounds pretty good to me these days. On the balance sheet on slide four you saw other assets double from $90 billion to $180 billion, is that anything in particular?"
},
{
"speaker": "Michael Cavanagh",
"text": "You mean the supplement. Let me come back to you on that, it may just be all the cash that’s coming in going into, it’s got to be WaMu."
},
{
"speaker": "Glenn Schorr – UBS",
"text": "What are the signs you do look for in terms of when the boosting of the reserves stops because you’re at obviously extremely high levels as you pointed out of the loan loss reserves, is it the pace of increase on the both delinquencies, unemployment and charge-offs?"
},
{
"speaker": "James Dimon",
"text": "I think the second you see a levelization of charge-offs, with some certainly going forward that you don’t need any additions to reserves."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ron Mandel – GIC"
},
{
"speaker": "Ron Mandel – GIC",
"text": "On the treasury program if you think over the longer term there’s some incentives to buyback the preferred stock that the treasury is taking the number of warrants, the higher coupon, I’m wondering if you could maybe elaborate on how you think about, you may want to issue stock to buyback the preferred and also just maybe how many warrants you think are going to be issued under the program?"
},
{
"speaker": "James Dimon",
"text": "Once we decide to go into the program I was thinking could we have $50 billion. So think of it this way obviously by the time you get to the 9% you’ll probably want to have paid it off and the warrants are equal to the value you gain. So in our case they’re going to get warrants if the way it’s currently written, 10 year warrants on $3.75 billion of stock, those warrants are worth, you can estimate it at $1.2 billion, which is an additional cost on the $25 billion. So it’s 5% plus the way I look at it, a year plus another 5% for the full term. You just monetize the cost of the warrants. So it’s not bad money that way. There is a way if you refinance it sooner, you’re going to refinance it with real Tier 1 capital that you can eliminate half the warrants and we’ll deal with that in due course. That to me becomes a truly financial decision. You do that or not do that, but the government made this part of it not an unattractive thing so that people can get the capital, use the capital and hopefully do some good with the capital."
},
{
"speaker": "Ron Mandel – GIC",
"text": "How many warrants, warrants for how many shares and--?"
},
{
"speaker": "James Dimon",
"text": "It’s not the shares, its warrants for $3.75 billion worth of stock; you could do your own share calculation. The market value of those warrants would be something like $1.2 billion or $1.3 billion use your own model."
},
{
"speaker": "Michael Cavanagh",
"text": "The strike is based on a trailing 20 day price."
},
{
"speaker": "James Dimon",
"text": "I’m simply saying think of that, of the whole $25 billion it’s under 5%, maybe 6% so if you spread it over the first five years of the 5% of money, your money is costing you 6.5%. Its still cheaper then most companies can raise money at today. And it’s real Tier 1 so it’s very cheap Tier 1. So to that extent it’s not a bad economic transaction."
},
{
"speaker": "Ron Mandel – GIC",
"text": "And then you could even reduce the warrants as you mentioned by--"
},
{
"speaker": "James Dimon",
"text": "There’s a way to reduce them, but you could argue that a lot of people wouldn’t want to because that’s cheaper capital then they could otherwise get."
},
{
"speaker": "Ron Mandel – GIC",
"text": "So on your balance sheet this is additional Tier 1 capital?"
},
{
"speaker": "James Dimon",
"text": "It’s all Tier 1 capital."
},
{
"speaker": "Ron Mandel – GIC",
"text": "Not the preferred part, the warrants part."
},
{
"speaker": "James Dimon",
"text": "The warrants are not Tier 1 capital; they are just a dilution on the balance sheet."
},
{
"speaker": "Michael Cavanagh",
"text": "It would be $25 billion on top of the $112 billion in Tier 1 capital we currently have."
},
{
"speaker": "Ron Mandel – GIC",
"text": "The other part of the FDIC program besides the debt guarantee was a checking account guarantee, are you going to opt in to that and if so what will the cost be--?"
},
{
"speaker": "James Dimon",
"text": "I think what they said is 10 basis points in that and think of that as an operating account guarantee. I think the real point of that wasn’t for JPMorgan, its really for smaller community banks and stuff that do a lot of small business middle market and they don’t want those people to be afraid that they’re operating accounts are at risk."
},
{
"speaker": "Ron Mandel – GIC",
"text": "And then the 10 basis point cost--"
},
{
"speaker": "James Dimon",
"text": "It doesn’t mean anything to us either way whether we do it or don’t."
},
{
"speaker": "Operator",
"text": "Your final question comes from the line of Nancy Bush – NAB Research"
},
{
"speaker": "Nancy Bush – NAB Research",
"text": "This is sort of a philosophical question; this treasury program that was announced yesterday I think came as a bit of a surprise to everybody. It seems to have been done with a few days thought and mostly as a result of what happened in Europe but what is your feeling about how this has changed the dynamic for capital raising going forward? Is it going to make it more expensive for the banking industry to raise capital beyond this period of treasury investment? Can you give me your philosophical thoughts about it?"
},
{
"speaker": "James Dimon",
"text": "I don’t really think so; I think that one day everything will have normalized again. That might be three or five years out. I think what they really wanted to do; I don’t know how long they worked on this, so I wouldn’t assume it was just three days. I do think they had to do something relative to the rest of the world so if you were in their shoes you would look at it and say well the rest of the world is guaranteeing deposits, United States is not and the rest of the world, you might create other consequences so but I agree with you. Making policy on the run is a very hard thing to do and it always has these huge unintended consequences which is really hard to forecast ahead of time or have any foresight on at all. But I think one day it will normalize and will make raising capital more expensive for banks. We’ll go back to a more normal world and people will probably spend a lot more attention on credit, which they should."
},
{
"speaker": "Nancy Bush – NAB Research",
"text": "You have been a huge beneficiary of basically institutional failures in this environment, is it your sense that this treasury program will slow that process, is it intended to slow the process, is it intended to prop up banks that should probably fail? Is that one of the unintended consequences?"
},
{
"speaker": "James Dimon",
"text": "I think that one of the consequences is, is that this program obviously helps the weaker more then it helps the strong. And I think I mentioned that if you don’t want to be parochial or selfish, as long as it really materially helping the system, we all should be in favor of it. So you can sit around the table and argue all day long where we would have been better off and sure, but you’re not better off if the system goes down. But I don’t think the intent on the treasury, I think they’re very conscious of, they don’t intend to hold up failing banks and you haven’t seen them do that. What you’ve seen them do is be pretty aggressive to try to get failing banks in the hands of good owners. So they’re going to have to throughout this program, the devil will be in the details how they manage it. So you will be looking at how they really manage it going forward and we’ll be second guessing them too at one point."
},
{
"speaker": "Operator",
"text": "There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments."
},
{
"speaker": "James Dimon",
"text": "Thank you very much and we’ll talk to you soon."
}
] | null | null |
JPM | 2 | 2,008 | 2008-07-17 08:00:00 | Executives: Michael J. Cavanagh - Chief Financial Officer James Dimon - Chairman of the Board, President, Chief Executive Officer
Analysts: Glenn Schorr - UBS Guy Moszkowski - Merrill Lynch Mike Mayo - Deutsche Bank Betsy Graseck - Morgan Stanley William Tanona - Goldman Sachs Jeff Hart - Sandler O’Neill Meredith Whitney - Oppenheimer John McDonald - AllianceBernstein Ron Mandel - GIC
Operator:
:
:
:
:
:
:
:
:
: Mr. Cavanagh, please go ahead, sir.
Michael J:
Cavanagh:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
: Working down the revenue components of the Investment Bank you see we had $1.7 billion of investment banking fees, the circled number over there, which is our second-highest quarterly performance of all time, so obviously we feel very, very pleased with the continued strength of our investment banking, corporate finance and advisory franchise, and you'll see some of the rankings on the next page.
: Equity Markets, $1.1 billion, down a bit from a year ago total revenues and also in there about $150 million of benefit from widening of credit spread.
: Equity Markets, $1.1 billion, down a bit from a year ago total revenues and also in there about $150 million of benefit from widening of credit spread.
:
:
:
:
:
:
:
:
:
:
:
:
:
: Level III assets, no major change; slight uptick from 6% overall to 7% or so, which you'll see more when we file our Q.
: Level III assets, no major change; slight uptick from 6% overall to 7% or so, which you'll see more when we file our Q.
: Level III assets, no major change; slight uptick from 6% overall to 7% or so, which you'll see more when we file our Q.
:
:
:
:
:
:
:
:
: And at the bottom of the page, a repeat of some of the details of the de-risking that I talked about upfront.
: And at the bottom of the page, a repeat of some of the details of the de-risking that I talked about upfront.
: And at the bottom of the page, a repeat of some of the details of the de-risking that I talked about upfront.
: And at the bottom of the page, a repeat of some of the details of the de-risking that I talked about upfront.
: And at the bottom of the page, a repeat of some of the details of the de-risking that I talked about upfront.
: And at the bottom of the page, a repeat of some of the details of the de-risking that I talked about upfront.
: And at the bottom of the page, a repeat of some of the details of the de-risking that I talked about upfront.
:
:
:
: And lastly 15% growth in the servicing book.
: And lastly 15% growth in the servicing book.
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
: In particular on the revenue side, I just want to point out, remember we talked about at the time of the Bank One merger the opportunity here to grow annualized investment banking revenues delivered to this customer base from something like $400 or $500 million annualized to $1 billion was our goal? This quarter we set a record there and with $270 million per quarter of investment banking revenues have exceeded that target for the first time.
: In particular on the revenue side, I just want to point out, remember we talked about at the time of the Bank One merger the opportunity here to grow annualized investment banking revenues delivered to this customer base from something like $400 or $500 million annualized to $1 billion was our goal? This quarter we set a record there and with $270 million per quarter of investment banking revenues have exceeded that target for the first time.
: In particular on the revenue side, I just want to point out, remember we talked about at the time of the Bank One merger the opportunity here to grow annualized investment banking revenues delivered to this customer base from something like $400 or $500 million annualized to $1 billion was our goal? This quarter we set a record there and with $270 million per quarter of investment banking revenues have exceeded that target for the first time.
:
:
:
:
:
:
:
: Private Bank revenues up very strongly, and we've continued to do what we need to do to continue to build what we think is a great business here.
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
:
: Bear Stearns, as I said upfront, $500 million of after-tax merger costs remain to be booked could run up to $150 a quarter after tax in the third and fourth quarter and trend down from there.
: So with that I wrap up the comments here, and Jamie and I will just take some questions.
: So with that I wrap up the comments here, and Jamie and I will just take some questions.
: So with that I wrap up the comments here, and Jamie and I will just take some questions.
: So with that I wrap up the comments here, and Jamie and I will just take some questions.
Operator:
:
Glenn Schorr - UBS: I think you mentioned in the comments that Bear was a slight drag on the Investment Bank. I'm assuming you meant some form of P&L comment, but can you talk about the strength in investment banking and then particularly in FIC trading on JPMorgan versus Bear, and then maybe a little bit more on the color commentary by product?
Michael J. Cavanagh: You know, we don't get - I mean, I flagged some of the - let's take it in two pieces. A little bit of drag means that just for the month of June, the Bear Stearns ongoing activities contributed somewhat to the marks we took in leveraged loans and mortgages as well as, you know, we basically have taken on expenses ahead of revenues, so a little bit of drag after tax related to that. All that's saying is the $400 million of after-tax profits in our Investment Bank could have been a couple of hundred million higher had it not been for including the Bear Stearns results in the second quarter. But, as we said, those results are going to trend to the positive. Beginning in the second half of the year, they'll be incrementally positive. And as we said, the areas of strength, as you'd expect, very strong results in rates, currencies, emerging markets, credit trading, so some areas really with standout performance.
Glenn Schorr - UBS: But you can't help us with the breakdown of what was - it's going to be impossible going forward, but the breakdown between JPMorgan and Bear's contribution to the FIC line in the quarter?
Michael J. Cavanagh: Oh, yeah. No, I wouldn't even think of it that way. I mean, we -
James Dimon: There was no contribution - very - almost no contribution to FIC in Bear in this quarter.
Glenn Schorr - UBS: That's a great quarter then. And then maybe, you both touched on a drop but maybe as a follow up, is how'd you balance, Jamie, your outlook commentary in the text, which is realistic, I think, and then how you grow, because I never know what to root for in terms of growth in Cards and Retail at a time when credit's starting to break down. Obviously, you try to price for it, but maybe just comment on that.
James Dimon: When you look at the growth numbers in Retail, you know, the revenues are up 15%, and almost all categories are growing. Deposit accounts, investments - our mortgage share is up to 11%, and while right now that isn't very profitable, I would have pretty good hopes that that will be far more profitable down the road. And that's just opening branches and hiring salespeople and doing the things you always do. You know, some of the credit costs are - you could almost look at them as a sunk cost at this point. And Card, where actually spend is up 7% - but the way to look at it a little bit is we're gaining share in consumer and small business, albeit obviously, you know, sales themselves are down a little bit. So we're continuing to invest in marketing in that business just like any other business. We're not going to stop doing that because you have credit losses.
Operator: Your next question comes from Guy Moszkowski - Merrill Lynch.
Guy Moszkowski - Merrill Lynch: I guess my first question is, as you think of kind of a waterfall where you're looking at initially $11 or $12 billion of book value in Bear Stearns, and you pay $1 billion and change for that. I know you've got a page that looks a little bit like this in your Appendix, I guess, Page 23. And you try to work down to the extraordinary gain of zero, within all of these transaction-related costs that add up to the difference between what their capital initially was and the lack of the gain or negative goodwill, how much of these transaction-related costs that you're talking about here are essentially reserved, hung up on the balance sheet, which over time, if not used, could work their way into earnings?
James Dimon: I think, Guy, the way to look at it is very little. That, you know, there are some reserves for litigation and taxes and things like that, but those are best estimates in the ordinary course now. They'll be changed over time if the expectations change, and most of the severance and real estate and stuff like that really is actual cost. We know the cost at this point. And then all the things related to the balance sheet, de-risking, deleveraging, conforming accounting, think of that as gone.
Michael J. Cavanagh: Yes. And those operating losses are already spent.
James Dimon: Yes, there's nothing else there.
Guy Moszkowski - Merrill Lynch: So de-risking and deleveraging costs essentially are realized losses on disposition of the portfolio?
James Dimon: Realized or just marked down.
Michael J. Cavanagh: To appropriate values.
James Dimon: As at the rest of the company.
Guy Moszkowski - Merrill Lynch: Okay, so you don't want us to think that some portion of this is essentially like traditional purchase accounting?
James Dimon: Absolutely not.
Guy Moszkowski - Merrill Lynch: Well, on the home equity side, changing topics here completely, it sounds like you've lowered the guidance of what we might expect the loss rate to look like by year end to about $700 a quarter from $900 million a quarter, and I was wondering if you could elaborate a little bit on what trend lines it is that are giving you a little bit more comfort there?
James Dimon: Right. So one of the things Mike mentioned is that that number's come down a couple hundred million, but the expected loss of the subprime and prime is up by a couple hundred million, so it's kind of a wash in our eyes. It's just that you look at the latest numbers of delinquencies and roll rates, you know, people go from 30 days to 60 days to 90 days, it looks like it might be a little bit lower than it was before. It is very early. We do not know. It's June, and a lot of people could argue there's some seasonality in that, so - but it's a little ray of sunshine which, you know, it's okay to grab onto for now.
Guy Moszkowski - Merrill Lynch: Right. But like you said, there's other clouds in a couple of other portfolios.
James Dimon: That's absolutely correct.
Guy Moszkowski - Merrill Lynch: The point you made about actively hedging when you were talking on Page 7 about some of the various mortgage exposures, could you remind us what your monoline exposure looks like there and whether any of your actions this quarter included any write-downs to that?
James Dimon: There were no write-downs this quarter to monoline. There may have been some modest marks or something like that. I want to point out we've only showed the gross exposures. Some are hedged and some aren't hedged because we've always acknowledged that there are risks on both sides of that, and there is no real perfect hedge, as you well know. And some things like Alt-A really can't be hedged. And the monolines, you know, we took on some - I think we told you in the past that for JPMorgan alone, you know, unless there's an actual default, the risks are not high. We took on some additional risk from Bear Stearns. I would still make that statement, that the risks, you know, you're talking about, unless there's a major default of one of the major ones, that they're really not that high. There could be marks up or down a couple hundred million dollars, but we're not relying - we're relying a little bit more than we used to on the monolines for some of the things because Bear Stearns had some, but it's really not a major thing for us. I mean, put it this way, the worst case isn't that bad.
Guy Moszkowski - Merrill Lynch: In the Investment Bank you mentioned the comp levels and comp ratio, and they do seem quite high, especially given that your result was actually quite strong, even with your charges. Your year-over-year fixed income results, for example, were actually up a little bit or, sorry, modestly down. But, I mean, really in very good shape. And so when I look at a 57% or so comp ratio, it just seems very, very high. Maybe you can give us a sense for what's driving that that's not recurring and where we ought to think about that ratio for the full year.
James Dimon: That ratio obviously is high, and I think it was a very healthy reserve relative to results. Ongoing, it should probably look a little bit more normal, and it's just reflective of how we think we need to pay people, etc., but, you know, obviously it was a fairly healthy addition this quarter. We don't want our people getting depressed, put it that way. We want to keep morale up.
Guy Moszkowski - Merrill Lynch: Well, I certainly applaud that sentiment.
James Dimon: Exactly.
Guy Moszkowski - Merrill Lynch: And then the final thing I'll ask you is on Basel II, obviously the pure investment banks are showing us TSE Basel II ratios at this point obviously very difficult to compare. What's your timetable for beginning to show us Basel II?
Michael J. Cavanagh: Guy, we're working on that now. As you know, we're under the different regulatory regime for Basel II and examination of the investment banks, and we're hoping to be the first major bank to be approved to go into parallel run potentially as early as the fourth quarter of this year.
James Dimon: And our Basel II number as we currently see it would be very strong. And I think if we use the same rules and requirements that the investment banks use, it'd be even stronger than that.
Guy Moszkowski - Merrill Lynch: And maybe you can give us a sense for how it would compare to those, you know, 12 percentage numbers that we're seeing from those guys.
James Dimon: I challenge those numbers, okay? I'm not sure that those investment banks are using true Basel II-type numbers, but we don't know the detail. Ours would be very strong, too. So we've just got to wait until it sorts out. Now you saw recently the Fed and the SEC have an agreement to be sharing stuff like that so there'll be some commonality down the road in how people do Basel II. I would question whether those Basel II numbers are the same as ours.
Guy Moszkowski - Merrill Lynch: Any particular area in which you would question that?
James Dimon: No, but you just do your analysis of the facts.
Operator: Your next question comes from Mike Mayo - Deutsche Bank.
Mike Mayo - Deutsche Bank: Can you elaborate more, you mentioned home equity might be a little bit better than you expected. You talked a lot about that at your Investor Day. But prime mortgage going from 48 basis points up to 91 basis points linked quarter, can you just elaborate more on what you're seeing there and why?
James Dimon: Mike, it's exactly the same risk factors and all the other things. It's high CLTV, high LTV, it's stated income, it's California, Florida, Arizona. And I agree with you, they're staggering numbers. You know, it might be higher because, you know, we have all the politicians telling people it's okay not to pay your mortgages. It's just really hard for us to tell. Our current expectation is those losses could triple from here. And we're prepared for that, and we will reserve for that appropriately going forward.
Mike Mayo - Deutsche Bank: I'm sorry. Prime mortgage losses could go from 91 basis points to 270 basis points?
Michael J. Cavanagh: Yes.
James Dimon: Yes, that's what I said. We had $100 million a quarter, and we could go up to $300 million a quarter. We don't [expect it to] happen next quarter, but if you look at current trends - and maybe we're being a little overly conservative - that could be $300 million a quarter some time in '09. For awhile, not forever.
Mike Mayo - Deutsche Bank: That's a lot worse than you expected before, and now you're expecting home equity to be a little bit better, so how do you reconcile those two?
James Dimon: Mike, we don't. We can't.
Mike Mayo - Deutsche Bank: And then unrealized securities losses, what are those or how much non-agency MBS do you have?
Michael J. Cavanagh: So our total OCI, you know, deteriorated by about a billion dollars in the quarter to be - if that's the question, Mike.
James Dimon: Non-agency MBS where?
Mike Mayo - Deutsche Bank: Firm wide, just because of the decline in value.
James Dimon: Okay, I think if you looked at non-agency MBS, that is the number we're talking about at prime, which is held both in Retail and in Corporate, that is non-agency [whole] loans, most jumbo whole loans.
Mike Mayo - Deutsche Bank: How about securities?
James Dimon: Very little. Very little other securities which are non-agency. There's some. You know, we buy and sell securities all the time. I mean, we bought some credit card BBB loans, and we've bought some CLOs and, you know, we have a huge portfolio we try to manage for total return.
Mike Mayo - Deutsche Bank: And just to reconcile two other comments. You said continued lower investment banking results, but on the other hand Bear's contribution should get a lot better. So what are you thinking about going forward that might be a drag?
James Dimon: Yeah, so Bear, what we hope to see is that, you know, it'll be a positive contribution next quarter and build up to, you know, some time in '09 to $250 million a quarter. And the underlying results are outstanding. I mean, the trading results, the investment banking results, I mean, really outstanding. And if you talk to clients, I think they'd be very happy with us across the board. But you have to look at the environment today and just assume it's going to continue for awhile. There are still assets we want to get down. There's a lot of risk in holding syndicated loans and mortgages. You know, the values are much better because they're already been written down so much. You know, Mike mentioned the average leveraged loan is now $0.80 on the dollar. But in an environment like this, we assume that as we sell stuff, hedge stuff, that it, you know, we will probably have to pay a little bit more going forward. Eventually that will end, and you'll get the real underlying results. And the only other thing in there, because we do have a lot of credit exposure, which is very idiosyncratic. You have rate reserves, but, you know, you have some big surprise in a credit loan somewhere, you know, that could cost us. And we should be prepared for that, too.
Mike Mayo - Deutsche Bank: Last question, mergers? I think you've been waiting your whole life for this environment or planning for it, so what is the impediment to you pursuing a merger right now in the Retail Banking side? Is it lack of willingness of sellers and boards? Is it the mark-to-market accounting? Is it the lack of your willingness?
James Dimon: I think the mark-to-market accounting makes it harder for a bank to buy a bank because you have to, you know, basically write the loans to a market value, but it does not make it impossible, certainly not for us because under the right circumstances we're sure we could raise the capital we need to do it, but it does make it harder. And, you know, this is a good environment. I would expect - I'm speaking generically now - that this will lead to more mergers over time. Nothing is impeding us, but it's not just up to us, as you pointed out.
Mike Mayo - Deutsche Bank: If you close a deal by year end, do you still have to do the mark-to-market accounting on the loan book?
Michael J. Cavanagh: Yes. That's effective immediately, right? That's not a -
James Dimon: I believe so, Mike.
Michael J. Cavanagh: Effectively immediately and it's effective from now going forward, unless it gets changed. And we don't know if it'll be changed or not.
James Dimon: We wouldn't do a deal or not do a deal based upon pure accounting like that. We would do a deal or not do a deal based upon how much value we thought it added to shareholders. It just makes it harder, that's all.
Operator: Your next question comes from Betsy Graseck - Morgan Stanley.
Betsy Graseck - Morgan Stanley : Just two questions, one on the Bear Stearns assets. You did sell down a dramatic amount relative to prior expectations. How much more do you anticipate reducing from here?
James Dimon: Well, it's not, you know, I wouldn't look at it like they're Bear Stearns assets anymore because these books are combined and run by a consolidated management team at this point, but I think if you look at the assets that Mike spoke about - mortgages, leveraged finance, and obviously some other categories that we didn't spend time on they'll be coming down over time.
Betsy Graseck - Morgan Stanley : And as you executed that selldown of assets, did that at all help the trading line? I mean, I know you indicated that there wasn't much in Bear Stearns' operating business in your trading line, but I'm wondering if there was any, gain on sale given where rates had gone during the quarter that may have helped out that line at all.
Michael J. Cavanagh: No. I would think of that as, you know, liquidation is a large contributor to consuming the book value that we were talking about earlier between write-downs and operating losses as we deleveraged.
Betsy Graseck - Morgan Stanley : And then lastly I just wonder how you're thinking about the dividend policy given the very strong capital ratio that you ended the quarter at and well above, I think expectations.
James Dimon: Well, we applaud our friends at Wells Fargo, but we don't have quite that much guts going forward. We bear some more risk and, you know, we're not going to create the dividend until we see clear daylight.
Operator: Your next question comes from William Tanona - Goldman Sachs.
William Tanona - Goldman Sachs: Just help me understand the kind of decision to increase the equity in the Investment Bank by $4 billion. If you looked at Bear Stearns, you know, prior to this deal, the equity was at $11.5 billion, and we all know that they were far greater levered. And, you know, looking at how much it took risk-weighted assets down, it's about 45%. If you just keep the same kind of leverage ratio, it kind of implies $6.5 billion of equity. So just trying to understand why you only allocated the $4 billion to the Investment Bank.
Michael J. Cavanagh: Well, remember we took, Bill, we took equity up in anticipation somewhat of all this by $1 billion in the first quarter from $21 to $22. Remember also that our allocated equity is really just allocated common equity, so when you look at, you know, pure comparisons you've got to add a share of the non-common equity component to the firm's capital to get to the real kind of denominator when you do some of the calculations that are often done. So we go through all that. And I guess the one last thing to remember is that, when we do our own internal compares of capitalization to get to sort of stand-alone single A type of ratings, you've got to parse through versus our competitors that hold asset management businesses, private equity businesses, etc., inside their overall units. When doing a comparison of our Investment Banking unit to those, you have some parsing to do to arrive at what real pure comparisons look like. So on all that kind of basis, I think we get to a place that we feel like is appropriate, and we continue to watch it and look beyond just the nominal levels and look at some risk weightings and our sense of where risk really sits and compare to economic capital calculations internally as well.
James Dimon: I think it's good to point out [inaudible] capital buy because Mike mentioned, you know, our Tier 1 has a much higher component of common equity, which you could say is higher quality Tier 1. But across the board, you know, we try to be conservative. I always talk about quality of capital, which is maybe a peculiar concept, but loan loss reserves are very strong. You know, our BOLI/COLI is very strong. We're massively over reserved by a couple of billion dollars in our pension plans. We got out of the auto leasing business. Our card IO is very small. So it's really across the board. You know, you can look at all these things and call us pretty conservative. And we really believe in maintaining a strong balance sheet on all counts, not just [drawing] Tier 1 but all these other things I just mentioned.
William Tanona - Goldman Sachs: And then I guess the follow-up question - and I've got to go back to it because I can't let you off that easy but helping us reconcile the commentary in terms of prime mortgages versus home equity. I mean, what is it precisely I know you can't obviously comment about the industry as a whole or choose not to - but in terms of our individual portfolio, what is it about your prime mortgage portfolio that you expect losses could potentially triple from here? You know, is it just the segments that you're in? Just trying to understand and reconcile that as well as, you know, the commentary between the home equity.
James Dimon: You know, you saw subprime go first, and then, on a slight lag, you saw home equity, and now in the lag you're seeing prime go. And it's exactly the same lost factors. But remember, the components of where we are in the states and all the stuff like this, it's very different. And we started doing more jumbos in '07, so a lot of that is - part of that's '07 vintage, which I think I told you at the time we're going to do and grow a balance sheet and gain share. And we were wrong. You know, we obviously wish we hadn't done it. So when you adjust for all of those things - vintages, CLTV, stated income, where it's done - that's what we're seeing. You know, it's very early in the loss curves, so the 300's just - it's just kind of rolling forward and projecting. You know, we hope it doesn't to there but it easily could.
Michael J. Cavanagh: It's the same as our guidance on home equity was. It's where things could go depending on a set of views internally.
William Tanona - Goldman Sachs: Yes, I mean, I guess I understand that. I just, you know, as you think about them potentially going up to 3 or 250 or whatever it may be and, you know, given your new guidance on home equity, which would also put that at 3, I guess it's just tough to imagine how home equity, given everything that's going on there with housing prices that that number could be as low if you do really expect prime to potentially double or triple from here.
James Dimon: At different locations, different vintages, different - but we understand your point. We disagree. It's that prime looks terrible, and we're sorry. There's nothing - we could say it eight times, but it looks terrible.
Operator: Your next question comes from Jeff Hart - Sandler O’Neill.
Jeff Hart - Sandler O’Neill: Sticking with the prime mortgage for a second, when you talk about deterioration, I look at your prime mortgage portfolio and it's dominated by jumbo and Alt-A. Can you give us any color as to how the jumbo bucket's performing versus the Alt-A versus what I'll guess I'll call other prime mortgages that don't make up as big a part of your portfolio?
James Dimon: You know, I think - I don't know the number offhand. Mike, do you know the number?
Michael J. Cavanagh: No. I mean, the way I might explain it, Jeff, is we've significant ratcheted back our underwriting standards in prime to be fundamentally much more of a traditional underwriting standards, much less stated income, LTVs from here that are targeted to not be in excess of the expected home price in given areas. So we're in some parts of the country max LTV currently at 65%, etc., etc. So when you layer that through and look at our portfolio split between the balances that we would continue to underwrite on our given standards and those that we wouldn't, for what we would continue to underwrite the existing credit performance is substantially lower than its overall level of 91 basis points of loss. So we feel confident that our current underwriting is wholly different than sort of the pig and the snake that we have just working through of what has been already underwritten with the risk factors that Jamie described. And I think one of the real drivers is home prices in some of the areas where we put on loans has come down so substantially that, you know, where we were in situations of, you know, relying on - rather, because it was prime, not relying on mortgage insurance and home values have dropped even below 80% original LTVs, we're taking losses. So that's, you know, those are some of the dynamics.
James Dimon: And I should just point out, though, what we see is if home equity goes we're going to be north of 3 by a little bit, and that the prime will be 220, 230, 240. You know, it may be temporary. It may just - it may hit that and then come down fairly quickly.
Jeff Hart - Sandler O'Neill: But is prime going to that level a function of over three-quarters of your portfolio being jumbo and Alt-A versus just kind of the overall what you'd call housing market?
James Dimon: It may be. You know, I mean, that's all we have so that's - we don't have a great compare point, you know, because that's the preponderance of what we have in portfolio.
Jeff Hart - Sandler O'Neill: Are you seeing better - I mean, from what you have in portfolio, are you seeing better performance away from jumbos?
James Dimon: We mostly have jumbos so -
Michael J. Cavanagh: That's my point, Jeff. I don't have a good compare point inside of the portfolio because that's the preponderance of what we have actually on balance sheet. Conforming stuff obviously goes straight out the door to the agencies and doesn't stay on balance sheet.
James Dimon: I think the jumbos are more proportionately California, too, so that probably has a lot to do with it.
Jeff Hart - Sandler O'Neill: And on the Commercial side of the business, we're seeing what's still pretty good loan growth. It's very nice loan growth. We're seeing really good credit quality as far as charge-offs go, but we're seeing you build reserves. Can you talk a little bit about whether that reserve build is in anticipation of troubles in commercial or just a function of how quickly you're growing your balances?
Michael J. Cavanagh: I'd say it's two pieces. You know, there's a - we've been cautious related to commercial real estate, as we've talked about the Commercial Bank. But when you look at some small portions of the portfolio related to homebuilders, you saw in the first quarter really the more significant additions to reserves in the quarter. And that's really, you know, as time goes by and certain portions of the portfolio go under stress, they get downgraded and require incremental reserves. In aggregate, we feel confident about where we're putting on growth from here, but it's just the dynamics of degradation in certain sectors, particularly anything related to homebuilders.
James Dimon: By the way, the portfolio - and thanks for pointing it out - is very strong. I would think you should expect nonperformers to go up. We have never seen environments like this where that doesn't happen, even in a strong portfolio. And all of the growth, we really are comfortable. We see enormous opportunities to grow it and feel kind of like Wells felt about it, that there are a lot of clients, they need loans, they want to grow. There are a lot of municipalities - a lot of the growth is coming from government and not-for-profit, which is generally very secure, so we feel pretty good about it. But it almost has to deteriorate in an environment like this.
Operator: Your next question comes from Meredith Whitney - Oppenheimer.
Meredith Whitney - Oppenheimer: I'm out of gas in terms of home equity and prime questions, but I just wanted to ask a separate question, which is on uninsured deposits and any type of market share moves and obviously important moves within that sector - you know, $2.5 trillion sector - and your thoughts on visuals of IndyMac and what's going on there, please.
James Dimon: Well, again, thanks for pointing out that our deposits in asset under management are like up 25% and TSS up 15% and Commercial Bank up 19%, which shows you, you know, kind of the power of this franchise over time. And, you know, we worry about us. You know, some - I think there are going to be issues. I think you've heard a lot of regulators talk about some of the issues with banks out there which may have more problems in their commercial real estate, and that'll cause, obviously, some depositors to be concerned about it. But we think we'll be a beneficiary of all that.
Meredith Whitney - Oppenheimer: Anything in terms of just an industry comment?
James Dimon: You know, it's different all over the place, the competition for deposits right now. And we're not really chasing it, so you're not seeing growth in our deposits because we're chasing them. I think some of the people have really raised rates, not just uninsured but have raised rates because they need them.
Meredith Whitney - Oppenheimer: What do you see in terms of, you know, any type of Northern Rock issue, where people are actively splitting accounts or anything like that so you're starting to see - I mean, how long would the line be where we'd start to see real market share moves?
James Dimon: Honestly, we don't know the answer to that question.
Operator: Your next question comes from John McDonald - AllianceBernstein.
John McDonald - AllianceBernstein: Just two questions on potential accounting changes. I was wondering how much of a concern the potential changes in the QSPEs might be in terms of impact on capital ratios, and then also the potential changes in the credit card billing practices.
Michael J. Cavanagh: Yes. So, I mean, just, first of all, we don't think the change in accounting - you know, remember you're talking about '09 and 2010 - would be consequential at all, though it'll could put hundreds of billions of dollars back on the balance sheet, the risk-weighted assets may be different. It's really not clear. But I think - and we may show you a lot more of this next time because it's come up many times, but we analyzed it, we don't think it's that big a deal for us. And we understand the regulator's points, but it's putting too much fear in people's eyes that is a little bit unjustified, particularly in our case. And the credit card changes, you know, it really depends. You know, we already got rid of double-cycle billing and we already got rid of [offers] default pricing or [offers] repricing at all. So the new changes coming up, depending on [how it] gets rolled out, could have an impact. It could be fairly material. A lot of it will be one shot, just one time, it'll hurt you for a year or something like that. But it really remains to be seen how it gets implemented and really how competitors react. Remember, you change price or something like that, everyone's going to - all the competitors react and do something bad in the first place. The interchange thing could also be [dramatic] though I would be surprised if you have pricing controls like that in the United States of America.
John McDonald - AllianceBernstein: And the margin hit that you saw in credit card this quarter, you mentioned, you know, the credit quality is impacting it, but do you have any flexibility? You know, typically card issuers have some flexibility to raise pricing. Should that flow through over the next couple of quarters as you [reprice] folks?
Michael J. Cavanagh: That would be some of our hope, John. You know, that potentially some response on our part to what we're seeing could be a factor in the second half of the year.
Operator: Your last question comes from Ron Mandel - GIC.
Ron Mandel - GIC: In regard to FAS 140, I just saw your comment about not being that worried. You know, you have $75 billion or so of off balance sheet managed credit card loans. If that came back on, that would be about - which is, I think, is highly likely - would be about, you know, 50 basis points or so of capital.
James Dimon: It would be $50 billion of risk-weighted assets.
Michael J. Cavanagh: Correct. So, you know, clearly, Ron, just remember, that is the accounting effect; that we would agree that that's probably likely, that credit card QSPs come on. So that $70 billion and maybe something less than $50 billion of RWA, I think, being conservative, come on, which obviously will eat into Tier 1 capital ratio. But the regulators get to take their view themselves and not necessarily follow accounting on how they're going to handle all that when they - and we just don't know enough yet on how that's all going to play out. If that were the outcome, we could handle it, obviously.
James Dimon: But also remember, Ron, we're retaining a lot of capital. Our dividend is low. We're retaining capital even at these low earning numbers. You know, we kind of expect that to continue. [inaudible] we're retaining capital. And you're talking about, you know, '09, 2010, 2011. So we'd be in very good shape for that.
Ron Mandel - GIC: Have your conversations with regulators indicated that they will take a different approach than the accountants?
Michael J. Cavanagh: It's too early to tell.
James Dimon: It's too early to tell, which is why I'm saying if you go through what I would consider almost the worst case, it's still not that big a deal. So, you know, so it hurts your Tier 1 ratio by 50 basis points, other ratios, who cares? It's just, you know, at one point it's just another number on a piece of paper. And, you know, we've got plenty of ways to raise capital or add preferred stock or reduce asset growth or something like that -
Michael J. Cavanagh: Or recalibrate our capital targets because nothing fundamentally is changing as accounting changes, right?
Ron Mandel - GIC: Right. And are there any third-party vehicles that you manage or otherwise that might - third-party related assets where you manage the conduit that might come on the balance sheet.
James Dimon: The conduit can go on the balance sheet, but that would barely impact capital because it's already included in capital
Michael J. Cavanagh: On a risk-rated basis. And then there's a couple hundred billion of other forms of securitizations, VIEs, you know, totaling up. But like Jamie said, we can take you through at a future time. But there's plenty of business actions that we would see taking to make adjustments to likely make any impact from any of that very manageable.
James Dimon: Some of that would be irrational. We have absolutely no risk. We've got to put it in your balance sheet. So but even when I say it wouldn't matter, but remember we have a very, very forward-looking view of capital, so we already project our capital throughout '09, and we already know that we can handle all that stuff easily. It might change what we do elsewhere, but we already know we can handle that easily.
Ron Mandel - GIC: And then I just had one last question. I guess I can't let go of the home equity, and that was at one point you indicated the amount of home equity loans as a percentage that was over 90% current loan to value. I think you said it was 22%, and I'm wondering if you have an updated figure.
James Dimon: That was over 100%. That was like they would go into negative equity, and I think the number - that was a forecast, right, to the end of the year?
Michael J. Cavanagh: I think it was 10 and negative equity at the beginning, you know, on a forecasted - on a current basis going to potentially 20. So we're somewhere along that spectrum of 10 going to 20 in negative equity, I would say, Ron. But we can confirm that for you.
James Dimon: And what we really don't know, which is - you know, we can't really project - is how will people act who go negative equity who've been living in a home for three or four years, because you're hitting different vintages now. People who've actually been there, their kids are going to school. So it's a very different thing than maybe people who bought their homes on a 100% LTV in, you know, 2006 or 2007. That's possibly why you're seeing some improvement here.
Ron Mandel - GIC: So you don't really have enough data to see how the people with no equity are going to act?
James Dimon: No, we're assuming they won't act well.
Michael J. Cavanagh: But it's possible that they aren't as bad as we might expect. Thank you, everybody, for joining us. Look forward to next quarter. Take care. | [
{
"speaker": "Executives",
"text": "Michael J. Cavanagh - Chief Financial Officer James Dimon - Chairman of the Board, President, Chief Executive Officer"
},
{
"speaker": "Analysts",
"text": "Glenn Schorr - UBS Guy Moszkowski - Merrill Lynch Mike Mayo - Deutsche Bank Betsy Graseck - Morgan Stanley William Tanona - Goldman Sachs Jeff Hart - Sandler O’Neill Meredith Whitney - Oppenheimer John McDonald - AllianceBernstein Ron Mandel - GIC"
},
{
"speaker": "Operator",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": "Mr. Cavanagh, please go ahead, sir."
},
{
"speaker": "Michael J",
"text": ""
},
{
"speaker": "Cavanagh",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": "Working down the revenue components of the Investment Bank you see we had $1.7 billion of investment banking fees, the circled number over there, which is our second-highest quarterly performance of all time, so obviously we feel very, very pleased with the continued strength of our investment banking, corporate finance and advisory franchise, and you'll see some of the rankings on the next page."
},
{
"speaker": "",
"text": "Equity Markets, $1.1 billion, down a bit from a year ago total revenues and also in there about $150 million of benefit from widening of credit spread."
},
{
"speaker": "",
"text": "Equity Markets, $1.1 billion, down a bit from a year ago total revenues and also in there about $150 million of benefit from widening of credit spread."
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": "Level III assets, no major change; slight uptick from 6% overall to 7% or so, which you'll see more when we file our Q."
},
{
"speaker": "",
"text": "Level III assets, no major change; slight uptick from 6% overall to 7% or so, which you'll see more when we file our Q."
},
{
"speaker": "",
"text": "Level III assets, no major change; slight uptick from 6% overall to 7% or so, which you'll see more when we file our Q."
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": "And at the bottom of the page, a repeat of some of the details of the de-risking that I talked about upfront."
},
{
"speaker": "",
"text": "And at the bottom of the page, a repeat of some of the details of the de-risking that I talked about upfront."
},
{
"speaker": "",
"text": "And at the bottom of the page, a repeat of some of the details of the de-risking that I talked about upfront."
},
{
"speaker": "",
"text": "And at the bottom of the page, a repeat of some of the details of the de-risking that I talked about upfront."
},
{
"speaker": "",
"text": "And at the bottom of the page, a repeat of some of the details of the de-risking that I talked about upfront."
},
{
"speaker": "",
"text": "And at the bottom of the page, a repeat of some of the details of the de-risking that I talked about upfront."
},
{
"speaker": "",
"text": "And at the bottom of the page, a repeat of some of the details of the de-risking that I talked about upfront."
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": "And lastly 15% growth in the servicing book."
},
{
"speaker": "",
"text": "And lastly 15% growth in the servicing book."
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": "In particular on the revenue side, I just want to point out, remember we talked about at the time of the Bank One merger the opportunity here to grow annualized investment banking revenues delivered to this customer base from something like $400 or $500 million annualized to $1 billion was our goal? This quarter we set a record there and with $270 million per quarter of investment banking revenues have exceeded that target for the first time."
},
{
"speaker": "",
"text": "In particular on the revenue side, I just want to point out, remember we talked about at the time of the Bank One merger the opportunity here to grow annualized investment banking revenues delivered to this customer base from something like $400 or $500 million annualized to $1 billion was our goal? This quarter we set a record there and with $270 million per quarter of investment banking revenues have exceeded that target for the first time."
},
{
"speaker": "",
"text": "In particular on the revenue side, I just want to point out, remember we talked about at the time of the Bank One merger the opportunity here to grow annualized investment banking revenues delivered to this customer base from something like $400 or $500 million annualized to $1 billion was our goal? This quarter we set a record there and with $270 million per quarter of investment banking revenues have exceeded that target for the first time."
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": "Private Bank revenues up very strongly, and we've continued to do what we need to do to continue to build what we think is a great business here."
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "",
"text": "Bear Stearns, as I said upfront, $500 million of after-tax merger costs remain to be booked could run up to $150 a quarter after tax in the third and fourth quarter and trend down from there."
},
{
"speaker": "",
"text": "So with that I wrap up the comments here, and Jamie and I will just take some questions."
},
{
"speaker": "",
"text": "So with that I wrap up the comments here, and Jamie and I will just take some questions."
},
{
"speaker": "",
"text": "So with that I wrap up the comments here, and Jamie and I will just take some questions."
},
{
"speaker": "",
"text": "So with that I wrap up the comments here, and Jamie and I will just take some questions."
},
{
"speaker": "Operator",
"text": ""
},
{
"speaker": "",
"text": ""
},
{
"speaker": "Glenn Schorr - UBS",
"text": "I think you mentioned in the comments that Bear was a slight drag on the Investment Bank. I'm assuming you meant some form of P&L comment, but can you talk about the strength in investment banking and then particularly in FIC trading on JPMorgan versus Bear, and then maybe a little bit more on the color commentary by product?"
},
{
"speaker": "Michael J. Cavanagh",
"text": "You know, we don't get - I mean, I flagged some of the - let's take it in two pieces. A little bit of drag means that just for the month of June, the Bear Stearns ongoing activities contributed somewhat to the marks we took in leveraged loans and mortgages as well as, you know, we basically have taken on expenses ahead of revenues, so a little bit of drag after tax related to that. All that's saying is the $400 million of after-tax profits in our Investment Bank could have been a couple of hundred million higher had it not been for including the Bear Stearns results in the second quarter. But, as we said, those results are going to trend to the positive. Beginning in the second half of the year, they'll be incrementally positive. And as we said, the areas of strength, as you'd expect, very strong results in rates, currencies, emerging markets, credit trading, so some areas really with standout performance."
},
{
"speaker": "Glenn Schorr - UBS",
"text": "But you can't help us with the breakdown of what was - it's going to be impossible going forward, but the breakdown between JPMorgan and Bear's contribution to the FIC line in the quarter?"
},
{
"speaker": "Michael J. Cavanagh",
"text": "Oh, yeah. No, I wouldn't even think of it that way. I mean, we -"
},
{
"speaker": "James Dimon",
"text": "There was no contribution - very - almost no contribution to FIC in Bear in this quarter."
},
{
"speaker": "Glenn Schorr - UBS",
"text": "That's a great quarter then. And then maybe, you both touched on a drop but maybe as a follow up, is how'd you balance, Jamie, your outlook commentary in the text, which is realistic, I think, and then how you grow, because I never know what to root for in terms of growth in Cards and Retail at a time when credit's starting to break down. Obviously, you try to price for it, but maybe just comment on that."
},
{
"speaker": "James Dimon",
"text": "When you look at the growth numbers in Retail, you know, the revenues are up 15%, and almost all categories are growing. Deposit accounts, investments - our mortgage share is up to 11%, and while right now that isn't very profitable, I would have pretty good hopes that that will be far more profitable down the road. And that's just opening branches and hiring salespeople and doing the things you always do. You know, some of the credit costs are - you could almost look at them as a sunk cost at this point. And Card, where actually spend is up 7% - but the way to look at it a little bit is we're gaining share in consumer and small business, albeit obviously, you know, sales themselves are down a little bit. So we're continuing to invest in marketing in that business just like any other business. We're not going to stop doing that because you have credit losses."
},
{
"speaker": "Operator",
"text": "Your next question comes from Guy Moszkowski - Merrill Lynch."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "I guess my first question is, as you think of kind of a waterfall where you're looking at initially $11 or $12 billion of book value in Bear Stearns, and you pay $1 billion and change for that. I know you've got a page that looks a little bit like this in your Appendix, I guess, Page 23. And you try to work down to the extraordinary gain of zero, within all of these transaction-related costs that add up to the difference between what their capital initially was and the lack of the gain or negative goodwill, how much of these transaction-related costs that you're talking about here are essentially reserved, hung up on the balance sheet, which over time, if not used, could work their way into earnings?"
},
{
"speaker": "James Dimon",
"text": "I think, Guy, the way to look at it is very little. That, you know, there are some reserves for litigation and taxes and things like that, but those are best estimates in the ordinary course now. They'll be changed over time if the expectations change, and most of the severance and real estate and stuff like that really is actual cost. We know the cost at this point. And then all the things related to the balance sheet, de-risking, deleveraging, conforming accounting, think of that as gone."
},
{
"speaker": "Michael J. Cavanagh",
"text": "Yes. And those operating losses are already spent."
},
{
"speaker": "James Dimon",
"text": "Yes, there's nothing else there."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "So de-risking and deleveraging costs essentially are realized losses on disposition of the portfolio?"
},
{
"speaker": "James Dimon",
"text": "Realized or just marked down."
},
{
"speaker": "Michael J. Cavanagh",
"text": "To appropriate values."
},
{
"speaker": "James Dimon",
"text": "As at the rest of the company."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "Okay, so you don't want us to think that some portion of this is essentially like traditional purchase accounting?"
},
{
"speaker": "James Dimon",
"text": "Absolutely not."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "Well, on the home equity side, changing topics here completely, it sounds like you've lowered the guidance of what we might expect the loss rate to look like by year end to about $700 a quarter from $900 million a quarter, and I was wondering if you could elaborate a little bit on what trend lines it is that are giving you a little bit more comfort there?"
},
{
"speaker": "James Dimon",
"text": "Right. So one of the things Mike mentioned is that that number's come down a couple hundred million, but the expected loss of the subprime and prime is up by a couple hundred million, so it's kind of a wash in our eyes. It's just that you look at the latest numbers of delinquencies and roll rates, you know, people go from 30 days to 60 days to 90 days, it looks like it might be a little bit lower than it was before. It is very early. We do not know. It's June, and a lot of people could argue there's some seasonality in that, so - but it's a little ray of sunshine which, you know, it's okay to grab onto for now."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "Right. But like you said, there's other clouds in a couple of other portfolios."
},
{
"speaker": "James Dimon",
"text": "That's absolutely correct."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "The point you made about actively hedging when you were talking on Page 7 about some of the various mortgage exposures, could you remind us what your monoline exposure looks like there and whether any of your actions this quarter included any write-downs to that?"
},
{
"speaker": "James Dimon",
"text": "There were no write-downs this quarter to monoline. There may have been some modest marks or something like that. I want to point out we've only showed the gross exposures. Some are hedged and some aren't hedged because we've always acknowledged that there are risks on both sides of that, and there is no real perfect hedge, as you well know. And some things like Alt-A really can't be hedged. And the monolines, you know, we took on some - I think we told you in the past that for JPMorgan alone, you know, unless there's an actual default, the risks are not high. We took on some additional risk from Bear Stearns. I would still make that statement, that the risks, you know, you're talking about, unless there's a major default of one of the major ones, that they're really not that high. There could be marks up or down a couple hundred million dollars, but we're not relying - we're relying a little bit more than we used to on the monolines for some of the things because Bear Stearns had some, but it's really not a major thing for us. I mean, put it this way, the worst case isn't that bad."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "In the Investment Bank you mentioned the comp levels and comp ratio, and they do seem quite high, especially given that your result was actually quite strong, even with your charges. Your year-over-year fixed income results, for example, were actually up a little bit or, sorry, modestly down. But, I mean, really in very good shape. And so when I look at a 57% or so comp ratio, it just seems very, very high. Maybe you can give us a sense for what's driving that that's not recurring and where we ought to think about that ratio for the full year."
},
{
"speaker": "James Dimon",
"text": "That ratio obviously is high, and I think it was a very healthy reserve relative to results. Ongoing, it should probably look a little bit more normal, and it's just reflective of how we think we need to pay people, etc., but, you know, obviously it was a fairly healthy addition this quarter. We don't want our people getting depressed, put it that way. We want to keep morale up."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "Well, I certainly applaud that sentiment."
},
{
"speaker": "James Dimon",
"text": "Exactly."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "And then the final thing I'll ask you is on Basel II, obviously the pure investment banks are showing us TSE Basel II ratios at this point obviously very difficult to compare. What's your timetable for beginning to show us Basel II?"
},
{
"speaker": "Michael J. Cavanagh",
"text": "Guy, we're working on that now. As you know, we're under the different regulatory regime for Basel II and examination of the investment banks, and we're hoping to be the first major bank to be approved to go into parallel run potentially as early as the fourth quarter of this year."
},
{
"speaker": "James Dimon",
"text": "And our Basel II number as we currently see it would be very strong. And I think if we use the same rules and requirements that the investment banks use, it'd be even stronger than that."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "And maybe you can give us a sense for how it would compare to those, you know, 12 percentage numbers that we're seeing from those guys."
},
{
"speaker": "James Dimon",
"text": "I challenge those numbers, okay? I'm not sure that those investment banks are using true Basel II-type numbers, but we don't know the detail. Ours would be very strong, too. So we've just got to wait until it sorts out. Now you saw recently the Fed and the SEC have an agreement to be sharing stuff like that so there'll be some commonality down the road in how people do Basel II. I would question whether those Basel II numbers are the same as ours."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "Any particular area in which you would question that?"
},
{
"speaker": "James Dimon",
"text": "No, but you just do your analysis of the facts."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mike Mayo - Deutsche Bank."
},
{
"speaker": "Mike Mayo - Deutsche Bank",
"text": "Can you elaborate more, you mentioned home equity might be a little bit better than you expected. You talked a lot about that at your Investor Day. But prime mortgage going from 48 basis points up to 91 basis points linked quarter, can you just elaborate more on what you're seeing there and why?"
},
{
"speaker": "James Dimon",
"text": "Mike, it's exactly the same risk factors and all the other things. It's high CLTV, high LTV, it's stated income, it's California, Florida, Arizona. And I agree with you, they're staggering numbers. You know, it might be higher because, you know, we have all the politicians telling people it's okay not to pay your mortgages. It's just really hard for us to tell. Our current expectation is those losses could triple from here. And we're prepared for that, and we will reserve for that appropriately going forward."
},
{
"speaker": "Mike Mayo - Deutsche Bank",
"text": "I'm sorry. Prime mortgage losses could go from 91 basis points to 270 basis points?"
},
{
"speaker": "Michael J. Cavanagh",
"text": "Yes."
},
{
"speaker": "James Dimon",
"text": "Yes, that's what I said. We had $100 million a quarter, and we could go up to $300 million a quarter. We don't [expect it to] happen next quarter, but if you look at current trends - and maybe we're being a little overly conservative - that could be $300 million a quarter some time in '09. For awhile, not forever."
},
{
"speaker": "Mike Mayo - Deutsche Bank",
"text": "That's a lot worse than you expected before, and now you're expecting home equity to be a little bit better, so how do you reconcile those two?"
},
{
"speaker": "James Dimon",
"text": "Mike, we don't. We can't."
},
{
"speaker": "Mike Mayo - Deutsche Bank",
"text": "And then unrealized securities losses, what are those or how much non-agency MBS do you have?"
},
{
"speaker": "Michael J. Cavanagh",
"text": "So our total OCI, you know, deteriorated by about a billion dollars in the quarter to be - if that's the question, Mike."
},
{
"speaker": "James Dimon",
"text": "Non-agency MBS where?"
},
{
"speaker": "Mike Mayo - Deutsche Bank",
"text": "Firm wide, just because of the decline in value."
},
{
"speaker": "James Dimon",
"text": "Okay, I think if you looked at non-agency MBS, that is the number we're talking about at prime, which is held both in Retail and in Corporate, that is non-agency [whole] loans, most jumbo whole loans."
},
{
"speaker": "Mike Mayo - Deutsche Bank",
"text": "How about securities?"
},
{
"speaker": "James Dimon",
"text": "Very little. Very little other securities which are non-agency. There's some. You know, we buy and sell securities all the time. I mean, we bought some credit card BBB loans, and we've bought some CLOs and, you know, we have a huge portfolio we try to manage for total return."
},
{
"speaker": "Mike Mayo - Deutsche Bank",
"text": "And just to reconcile two other comments. You said continued lower investment banking results, but on the other hand Bear's contribution should get a lot better. So what are you thinking about going forward that might be a drag?"
},
{
"speaker": "James Dimon",
"text": "Yeah, so Bear, what we hope to see is that, you know, it'll be a positive contribution next quarter and build up to, you know, some time in '09 to $250 million a quarter. And the underlying results are outstanding. I mean, the trading results, the investment banking results, I mean, really outstanding. And if you talk to clients, I think they'd be very happy with us across the board. But you have to look at the environment today and just assume it's going to continue for awhile. There are still assets we want to get down. There's a lot of risk in holding syndicated loans and mortgages. You know, the values are much better because they're already been written down so much. You know, Mike mentioned the average leveraged loan is now $0.80 on the dollar. But in an environment like this, we assume that as we sell stuff, hedge stuff, that it, you know, we will probably have to pay a little bit more going forward. Eventually that will end, and you'll get the real underlying results. And the only other thing in there, because we do have a lot of credit exposure, which is very idiosyncratic. You have rate reserves, but, you know, you have some big surprise in a credit loan somewhere, you know, that could cost us. And we should be prepared for that, too."
},
{
"speaker": "Mike Mayo - Deutsche Bank",
"text": "Last question, mergers? I think you've been waiting your whole life for this environment or planning for it, so what is the impediment to you pursuing a merger right now in the Retail Banking side? Is it lack of willingness of sellers and boards? Is it the mark-to-market accounting? Is it the lack of your willingness?"
},
{
"speaker": "James Dimon",
"text": "I think the mark-to-market accounting makes it harder for a bank to buy a bank because you have to, you know, basically write the loans to a market value, but it does not make it impossible, certainly not for us because under the right circumstances we're sure we could raise the capital we need to do it, but it does make it harder. And, you know, this is a good environment. I would expect - I'm speaking generically now - that this will lead to more mergers over time. Nothing is impeding us, but it's not just up to us, as you pointed out."
},
{
"speaker": "Mike Mayo - Deutsche Bank",
"text": "If you close a deal by year end, do you still have to do the mark-to-market accounting on the loan book?"
},
{
"speaker": "Michael J. Cavanagh",
"text": "Yes. That's effective immediately, right? That's not a -"
},
{
"speaker": "James Dimon",
"text": "I believe so, Mike."
},
{
"speaker": "Michael J. Cavanagh",
"text": "Effectively immediately and it's effective from now going forward, unless it gets changed. And we don't know if it'll be changed or not."
},
{
"speaker": "James Dimon",
"text": "We wouldn't do a deal or not do a deal based upon pure accounting like that. We would do a deal or not do a deal based upon how much value we thought it added to shareholders. It just makes it harder, that's all."
},
{
"speaker": "Operator",
"text": "Your next question comes from Betsy Graseck - Morgan Stanley."
},
{
"speaker": "Betsy Graseck - Morgan Stanley",
"text": "Just two questions, one on the Bear Stearns assets. You did sell down a dramatic amount relative to prior expectations. How much more do you anticipate reducing from here?"
},
{
"speaker": "James Dimon",
"text": "Well, it's not, you know, I wouldn't look at it like they're Bear Stearns assets anymore because these books are combined and run by a consolidated management team at this point, but I think if you look at the assets that Mike spoke about - mortgages, leveraged finance, and obviously some other categories that we didn't spend time on they'll be coming down over time."
},
{
"speaker": "Betsy Graseck - Morgan Stanley",
"text": "And as you executed that selldown of assets, did that at all help the trading line? I mean, I know you indicated that there wasn't much in Bear Stearns' operating business in your trading line, but I'm wondering if there was any, gain on sale given where rates had gone during the quarter that may have helped out that line at all."
},
{
"speaker": "Michael J. Cavanagh",
"text": "No. I would think of that as, you know, liquidation is a large contributor to consuming the book value that we were talking about earlier between write-downs and operating losses as we deleveraged."
},
{
"speaker": "Betsy Graseck - Morgan Stanley",
"text": "And then lastly I just wonder how you're thinking about the dividend policy given the very strong capital ratio that you ended the quarter at and well above, I think expectations."
},
{
"speaker": "James Dimon",
"text": "Well, we applaud our friends at Wells Fargo, but we don't have quite that much guts going forward. We bear some more risk and, you know, we're not going to create the dividend until we see clear daylight."
},
{
"speaker": "Operator",
"text": "Your next question comes from William Tanona - Goldman Sachs."
},
{
"speaker": "William Tanona - Goldman Sachs",
"text": "Just help me understand the kind of decision to increase the equity in the Investment Bank by $4 billion. If you looked at Bear Stearns, you know, prior to this deal, the equity was at $11.5 billion, and we all know that they were far greater levered. And, you know, looking at how much it took risk-weighted assets down, it's about 45%. If you just keep the same kind of leverage ratio, it kind of implies $6.5 billion of equity. So just trying to understand why you only allocated the $4 billion to the Investment Bank."
},
{
"speaker": "Michael J. Cavanagh",
"text": "Well, remember we took, Bill, we took equity up in anticipation somewhat of all this by $1 billion in the first quarter from $21 to $22. Remember also that our allocated equity is really just allocated common equity, so when you look at, you know, pure comparisons you've got to add a share of the non-common equity component to the firm's capital to get to the real kind of denominator when you do some of the calculations that are often done. So we go through all that. And I guess the one last thing to remember is that, when we do our own internal compares of capitalization to get to sort of stand-alone single A type of ratings, you've got to parse through versus our competitors that hold asset management businesses, private equity businesses, etc., inside their overall units. When doing a comparison of our Investment Banking unit to those, you have some parsing to do to arrive at what real pure comparisons look like. So on all that kind of basis, I think we get to a place that we feel like is appropriate, and we continue to watch it and look beyond just the nominal levels and look at some risk weightings and our sense of where risk really sits and compare to economic capital calculations internally as well."
},
{
"speaker": "James Dimon",
"text": "I think it's good to point out [inaudible] capital buy because Mike mentioned, you know, our Tier 1 has a much higher component of common equity, which you could say is higher quality Tier 1. But across the board, you know, we try to be conservative. I always talk about quality of capital, which is maybe a peculiar concept, but loan loss reserves are very strong. You know, our BOLI/COLI is very strong. We're massively over reserved by a couple of billion dollars in our pension plans. We got out of the auto leasing business. Our card IO is very small. So it's really across the board. You know, you can look at all these things and call us pretty conservative. And we really believe in maintaining a strong balance sheet on all counts, not just [drawing] Tier 1 but all these other things I just mentioned."
},
{
"speaker": "William Tanona - Goldman Sachs",
"text": "And then I guess the follow-up question - and I've got to go back to it because I can't let you off that easy but helping us reconcile the commentary in terms of prime mortgages versus home equity. I mean, what is it precisely I know you can't obviously comment about the industry as a whole or choose not to - but in terms of our individual portfolio, what is it about your prime mortgage portfolio that you expect losses could potentially triple from here? You know, is it just the segments that you're in? Just trying to understand and reconcile that as well as, you know, the commentary between the home equity."
},
{
"speaker": "James Dimon",
"text": "You know, you saw subprime go first, and then, on a slight lag, you saw home equity, and now in the lag you're seeing prime go. And it's exactly the same lost factors. But remember, the components of where we are in the states and all the stuff like this, it's very different. And we started doing more jumbos in '07, so a lot of that is - part of that's '07 vintage, which I think I told you at the time we're going to do and grow a balance sheet and gain share. And we were wrong. You know, we obviously wish we hadn't done it. So when you adjust for all of those things - vintages, CLTV, stated income, where it's done - that's what we're seeing. You know, it's very early in the loss curves, so the 300's just - it's just kind of rolling forward and projecting. You know, we hope it doesn't to there but it easily could."
},
{
"speaker": "Michael J. Cavanagh",
"text": "It's the same as our guidance on home equity was. It's where things could go depending on a set of views internally."
},
{
"speaker": "William Tanona - Goldman Sachs",
"text": "Yes, I mean, I guess I understand that. I just, you know, as you think about them potentially going up to 3 or 250 or whatever it may be and, you know, given your new guidance on home equity, which would also put that at 3, I guess it's just tough to imagine how home equity, given everything that's going on there with housing prices that that number could be as low if you do really expect prime to potentially double or triple from here."
},
{
"speaker": "James Dimon",
"text": "At different locations, different vintages, different - but we understand your point. We disagree. It's that prime looks terrible, and we're sorry. There's nothing - we could say it eight times, but it looks terrible."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jeff Hart - Sandler O’Neill."
},
{
"speaker": "Jeff Hart - Sandler O’Neill",
"text": "Sticking with the prime mortgage for a second, when you talk about deterioration, I look at your prime mortgage portfolio and it's dominated by jumbo and Alt-A. Can you give us any color as to how the jumbo bucket's performing versus the Alt-A versus what I'll guess I'll call other prime mortgages that don't make up as big a part of your portfolio?"
},
{
"speaker": "James Dimon",
"text": "You know, I think - I don't know the number offhand. Mike, do you know the number?"
},
{
"speaker": "Michael J. Cavanagh",
"text": "No. I mean, the way I might explain it, Jeff, is we've significant ratcheted back our underwriting standards in prime to be fundamentally much more of a traditional underwriting standards, much less stated income, LTVs from here that are targeted to not be in excess of the expected home price in given areas. So we're in some parts of the country max LTV currently at 65%, etc., etc. So when you layer that through and look at our portfolio split between the balances that we would continue to underwrite on our given standards and those that we wouldn't, for what we would continue to underwrite the existing credit performance is substantially lower than its overall level of 91 basis points of loss. So we feel confident that our current underwriting is wholly different than sort of the pig and the snake that we have just working through of what has been already underwritten with the risk factors that Jamie described. And I think one of the real drivers is home prices in some of the areas where we put on loans has come down so substantially that, you know, where we were in situations of, you know, relying on - rather, because it was prime, not relying on mortgage insurance and home values have dropped even below 80% original LTVs, we're taking losses. So that's, you know, those are some of the dynamics."
},
{
"speaker": "James Dimon",
"text": "And I should just point out, though, what we see is if home equity goes we're going to be north of 3 by a little bit, and that the prime will be 220, 230, 240. You know, it may be temporary. It may just - it may hit that and then come down fairly quickly."
},
{
"speaker": "Jeff Hart - Sandler O'Neill",
"text": "But is prime going to that level a function of over three-quarters of your portfolio being jumbo and Alt-A versus just kind of the overall what you'd call housing market?"
},
{
"speaker": "James Dimon",
"text": "It may be. You know, I mean, that's all we have so that's - we don't have a great compare point, you know, because that's the preponderance of what we have in portfolio."
},
{
"speaker": "Jeff Hart - Sandler O'Neill",
"text": "Are you seeing better - I mean, from what you have in portfolio, are you seeing better performance away from jumbos?"
},
{
"speaker": "James Dimon",
"text": "We mostly have jumbos so -"
},
{
"speaker": "Michael J. Cavanagh",
"text": "That's my point, Jeff. I don't have a good compare point inside of the portfolio because that's the preponderance of what we have actually on balance sheet. Conforming stuff obviously goes straight out the door to the agencies and doesn't stay on balance sheet."
},
{
"speaker": "James Dimon",
"text": "I think the jumbos are more proportionately California, too, so that probably has a lot to do with it."
},
{
"speaker": "Jeff Hart - Sandler O'Neill",
"text": "And on the Commercial side of the business, we're seeing what's still pretty good loan growth. It's very nice loan growth. We're seeing really good credit quality as far as charge-offs go, but we're seeing you build reserves. Can you talk a little bit about whether that reserve build is in anticipation of troubles in commercial or just a function of how quickly you're growing your balances?"
},
{
"speaker": "Michael J. Cavanagh",
"text": "I'd say it's two pieces. You know, there's a - we've been cautious related to commercial real estate, as we've talked about the Commercial Bank. But when you look at some small portions of the portfolio related to homebuilders, you saw in the first quarter really the more significant additions to reserves in the quarter. And that's really, you know, as time goes by and certain portions of the portfolio go under stress, they get downgraded and require incremental reserves. In aggregate, we feel confident about where we're putting on growth from here, but it's just the dynamics of degradation in certain sectors, particularly anything related to homebuilders."
},
{
"speaker": "James Dimon",
"text": "By the way, the portfolio - and thanks for pointing it out - is very strong. I would think you should expect nonperformers to go up. We have never seen environments like this where that doesn't happen, even in a strong portfolio. And all of the growth, we really are comfortable. We see enormous opportunities to grow it and feel kind of like Wells felt about it, that there are a lot of clients, they need loans, they want to grow. There are a lot of municipalities - a lot of the growth is coming from government and not-for-profit, which is generally very secure, so we feel pretty good about it. But it almost has to deteriorate in an environment like this."
},
{
"speaker": "Operator",
"text": "Your next question comes from Meredith Whitney - Oppenheimer."
},
{
"speaker": "Meredith Whitney - Oppenheimer",
"text": "I'm out of gas in terms of home equity and prime questions, but I just wanted to ask a separate question, which is on uninsured deposits and any type of market share moves and obviously important moves within that sector - you know, $2.5 trillion sector - and your thoughts on visuals of IndyMac and what's going on there, please."
},
{
"speaker": "James Dimon",
"text": "Well, again, thanks for pointing out that our deposits in asset under management are like up 25% and TSS up 15% and Commercial Bank up 19%, which shows you, you know, kind of the power of this franchise over time. And, you know, we worry about us. You know, some - I think there are going to be issues. I think you've heard a lot of regulators talk about some of the issues with banks out there which may have more problems in their commercial real estate, and that'll cause, obviously, some depositors to be concerned about it. But we think we'll be a beneficiary of all that."
},
{
"speaker": "Meredith Whitney - Oppenheimer",
"text": "Anything in terms of just an industry comment?"
},
{
"speaker": "James Dimon",
"text": "You know, it's different all over the place, the competition for deposits right now. And we're not really chasing it, so you're not seeing growth in our deposits because we're chasing them. I think some of the people have really raised rates, not just uninsured but have raised rates because they need them."
},
{
"speaker": "Meredith Whitney - Oppenheimer",
"text": "What do you see in terms of, you know, any type of Northern Rock issue, where people are actively splitting accounts or anything like that so you're starting to see - I mean, how long would the line be where we'd start to see real market share moves?"
},
{
"speaker": "James Dimon",
"text": "Honestly, we don't know the answer to that question."
},
{
"speaker": "Operator",
"text": "Your next question comes from John McDonald - AllianceBernstein."
},
{
"speaker": "John McDonald - AllianceBernstein",
"text": "Just two questions on potential accounting changes. I was wondering how much of a concern the potential changes in the QSPEs might be in terms of impact on capital ratios, and then also the potential changes in the credit card billing practices."
},
{
"speaker": "Michael J. Cavanagh",
"text": "Yes. So, I mean, just, first of all, we don't think the change in accounting - you know, remember you're talking about '09 and 2010 - would be consequential at all, though it'll could put hundreds of billions of dollars back on the balance sheet, the risk-weighted assets may be different. It's really not clear. But I think - and we may show you a lot more of this next time because it's come up many times, but we analyzed it, we don't think it's that big a deal for us. And we understand the regulator's points, but it's putting too much fear in people's eyes that is a little bit unjustified, particularly in our case. And the credit card changes, you know, it really depends. You know, we already got rid of double-cycle billing and we already got rid of [offers] default pricing or [offers] repricing at all. So the new changes coming up, depending on [how it] gets rolled out, could have an impact. It could be fairly material. A lot of it will be one shot, just one time, it'll hurt you for a year or something like that. But it really remains to be seen how it gets implemented and really how competitors react. Remember, you change price or something like that, everyone's going to - all the competitors react and do something bad in the first place. The interchange thing could also be [dramatic] though I would be surprised if you have pricing controls like that in the United States of America."
},
{
"speaker": "John McDonald - AllianceBernstein",
"text": "And the margin hit that you saw in credit card this quarter, you mentioned, you know, the credit quality is impacting it, but do you have any flexibility? You know, typically card issuers have some flexibility to raise pricing. Should that flow through over the next couple of quarters as you [reprice] folks?"
},
{
"speaker": "Michael J. Cavanagh",
"text": "That would be some of our hope, John. You know, that potentially some response on our part to what we're seeing could be a factor in the second half of the year."
},
{
"speaker": "Operator",
"text": "Your last question comes from Ron Mandel - GIC."
},
{
"speaker": "Ron Mandel - GIC",
"text": "In regard to FAS 140, I just saw your comment about not being that worried. You know, you have $75 billion or so of off balance sheet managed credit card loans. If that came back on, that would be about - which is, I think, is highly likely - would be about, you know, 50 basis points or so of capital."
},
{
"speaker": "James Dimon",
"text": "It would be $50 billion of risk-weighted assets."
},
{
"speaker": "Michael J. Cavanagh",
"text": "Correct. So, you know, clearly, Ron, just remember, that is the accounting effect; that we would agree that that's probably likely, that credit card QSPs come on. So that $70 billion and maybe something less than $50 billion of RWA, I think, being conservative, come on, which obviously will eat into Tier 1 capital ratio. But the regulators get to take their view themselves and not necessarily follow accounting on how they're going to handle all that when they - and we just don't know enough yet on how that's all going to play out. If that were the outcome, we could handle it, obviously."
},
{
"speaker": "James Dimon",
"text": "But also remember, Ron, we're retaining a lot of capital. Our dividend is low. We're retaining capital even at these low earning numbers. You know, we kind of expect that to continue. [inaudible] we're retaining capital. And you're talking about, you know, '09, 2010, 2011. So we'd be in very good shape for that."
},
{
"speaker": "Ron Mandel - GIC",
"text": "Have your conversations with regulators indicated that they will take a different approach than the accountants?"
},
{
"speaker": "Michael J. Cavanagh",
"text": "It's too early to tell."
},
{
"speaker": "James Dimon",
"text": "It's too early to tell, which is why I'm saying if you go through what I would consider almost the worst case, it's still not that big a deal. So, you know, so it hurts your Tier 1 ratio by 50 basis points, other ratios, who cares? It's just, you know, at one point it's just another number on a piece of paper. And, you know, we've got plenty of ways to raise capital or add preferred stock or reduce asset growth or something like that -"
},
{
"speaker": "Michael J. Cavanagh",
"text": "Or recalibrate our capital targets because nothing fundamentally is changing as accounting changes, right?"
},
{
"speaker": "Ron Mandel - GIC",
"text": "Right. And are there any third-party vehicles that you manage or otherwise that might - third-party related assets where you manage the conduit that might come on the balance sheet."
},
{
"speaker": "James Dimon",
"text": "The conduit can go on the balance sheet, but that would barely impact capital because it's already included in capital"
},
{
"speaker": "Michael J. Cavanagh",
"text": "On a risk-rated basis. And then there's a couple hundred billion of other forms of securitizations, VIEs, you know, totaling up. But like Jamie said, we can take you through at a future time. But there's plenty of business actions that we would see taking to make adjustments to likely make any impact from any of that very manageable."
},
{
"speaker": "James Dimon",
"text": "Some of that would be irrational. We have absolutely no risk. We've got to put it in your balance sheet. So but even when I say it wouldn't matter, but remember we have a very, very forward-looking view of capital, so we already project our capital throughout '09, and we already know that we can handle all that stuff easily. It might change what we do elsewhere, but we already know we can handle that easily."
},
{
"speaker": "Ron Mandel - GIC",
"text": "And then I just had one last question. I guess I can't let go of the home equity, and that was at one point you indicated the amount of home equity loans as a percentage that was over 90% current loan to value. I think you said it was 22%, and I'm wondering if you have an updated figure."
},
{
"speaker": "James Dimon",
"text": "That was over 100%. That was like they would go into negative equity, and I think the number - that was a forecast, right, to the end of the year?"
},
{
"speaker": "Michael J. Cavanagh",
"text": "I think it was 10 and negative equity at the beginning, you know, on a forecasted - on a current basis going to potentially 20. So we're somewhere along that spectrum of 10 going to 20 in negative equity, I would say, Ron. But we can confirm that for you."
},
{
"speaker": "James Dimon",
"text": "And what we really don't know, which is - you know, we can't really project - is how will people act who go negative equity who've been living in a home for three or four years, because you're hitting different vintages now. People who've actually been there, their kids are going to school. So it's a very different thing than maybe people who bought their homes on a 100% LTV in, you know, 2006 or 2007. That's possibly why you're seeing some improvement here."
},
{
"speaker": "Ron Mandel - GIC",
"text": "So you don't really have enough data to see how the people with no equity are going to act?"
},
{
"speaker": "James Dimon",
"text": "No, we're assuming they won't act well."
},
{
"speaker": "Michael J. Cavanagh",
"text": "But it's possible that they aren't as bad as we might expect. Thank you, everybody, for joining us. Look forward to next quarter. Take care."
}
] | null | null |
JPM | 1 | 2,008 | 2008-04-16 09:00:00 | Executives: Michael J. Cavanagh - Chief Financial Officer James Dimon - Chairman of the Board, President, Chief Executive Officer
Analysts: Guy Moszkowski - Merrill Lynch Glenn Schorr - UBS Michael Mayo - Deutsche Bank Betsy Graseck - Morgan Stanley Jeffrey Harte - Sandler O'Neill & Partners L.P. Meredith Whitney - Oppenheimer
Operator: Good morning, ladies and gentlemen. Welcome to the JPMorgan Chase first quarter 2008 earnings call. This call is being recorded. Today's presentation may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements speak only as of the date hereof and reflect management's current beliefs. These statements are by their nature subject to significant risks and uncertainties, and the firm's actual returns could differ materially from those described in the forward-looking statements. Please refer to JPMorgan Chase's filings with the Securities and Exchange Commission, including its most recent Form 10K and Forms 10Q for a description of the risk and factors that could cause the firm's results to differ materially from those described in the forward-looking statements. At the conclusion of the presentation, you'll have an opportunity to ask questions. (Operator Instructions) And at this time, I'd like to turn the call over to JPMorgan Chase's Chairman and Chief Executive Officer Jamie Dimon and Chief Financial Officer Mike Cavanagh. Mr. Cavanagh, please go ahead, sir.
Michael J. Cavanagh: Great. Good morning. Thank you, Operator. Good morning, everyone. You've got Mike here and Jamie as well. As usual, we'll run through a presentation that you can pull off the web to run through. I'll run through the numbers and Jamie will make some comments, and then we'll take Q&A for a bit. So hopefully you have the presentation in front of you. If you go to the first page, Financial Highlights, this is the highlights exactly as - yeah, headlines from our press release - so I'm not going to sit here and read it verbatim for you. But I guess I would just make the general couple of comments that you do see from the diverse earnings sources that we've got, resulting in $2.4 billion of earnings for the quarter inclusive of the $2.6 billion in markdowns in the investment bank that I'll get to, as well as the strengthening of credit reserves by $2.5 billion in the quarter on top of the higher level of actual credit losses in the quarter, net of the benefit of the $1.5 billion, all that washing through given the broader sources of earnings we have to create the positive earnings of $2.4 billion. Which really gets to my next point, which is really that the earnings helped build and strengthen capital, with Tier 1 capital actually increasing again in the quarter to just around $90 billion. It maintains our 8.3% Tier 1 ratio, which we feel very good about. But more broadly in light of - and that's with some growth in the balance sheet - so meeting the franchise needs of our clients as we operate through these tougher times along with the strength and the liquidity [in] place and the $12.6 billion in overall credit reserves, I feel like the balance sheet and capital position is all in good shape and proud of how we managed through the difficult couple of quarters we had in a row and maintain strength there. And then I guess the last point I'd make here is that we are dealing in tough times, but it's been very important to the team here that we maintain our focus on the underlying business momentum. And you really see it across the businesses. You can see a summary of it down here at the bottom, that revenue growth of 15% in Retail, the strong rankings we maintain in investment banking fee side and the market share gains we've taken there, and really in many of our other businesses and the strong profit growth in TSS. So we spend a lot of time focused on it and feel very good about the continued ability to drive underlying growth there. Flipping now to the second slide, not much to add versus the first page but you do see at a high level the firm's kind of GAAP P&L, the $2.4 billion of reported net income and EPS of $0.68, obviously down substantially from the very strong conditions we operated in and the record results of the first quarter last year. You can see on a net basis, revenues and expenses down together, and the substantial story is obviously the big increase to $5.1 billion worth of credit costs which, as I said, is about $2.5 billion of increase in allowance in the quarter along with charge-offs ticking higher through prior year quarter and last quarter into this quarter. So now if we - we'll move to the businesses; I'll start with the Investment Bank on Page 3. So here you see, starting with profits, we had a loss of $87 million in the quarter inclusive of a very tough month of March in the first calendar quarter of the year. But working down the revenue pieces you see that we had a $1.206 billion of investment banking fees which, while it's down, we feel very good about it because, as I said at the top, the strong rankings we have in investment banking fees - number one, with market share growth versus a year ago as well as the top ranking we had in debt, equity and equity related underwritings for the first time - we feel very good about the momentum we have serving clients in the investment banking space. Moving along to Fixed Income Markets, here you see a substantial decline in Fixed Income Markets revenues to $466 million, and that's really where you see the $2.6 billion worth of markdowns across a variety of asset classes. I'll take you through the details, but it's $1.2 billion across mortgage-related categories and $1.1 billion in leveraged lending and a little bit of the remaining corporate loan positions we have in our warehouses make up the balance there. When you really think about all other areas, though, results included some records in rates and currencies, strong in areas like emerging markets, commodities and credit trading, and pretty much it would throw the rest into the basket of mixed results generally, aside from that. I will just - we've pointed this out before, the gain on the widening of our credit spread as it relates to structured notes issued out of our Fixed Income Markets and Equity Markets businesses of 662 in Fixed Income Markets and 287 in Equities - I will just make the note that, while that's spread widening on the structured note liabilities, we of course do have derivative-related liabilities and payables that also change in value quarter to quarter by changes in credit spreads of ourselves and our counterparties. And across the IB, that was actually several hundred million to the negative as spreads on some of our counterparties widened more than we did, putting a little pressure actually on overall revenue. So just to put the 662 and 287 in proper context. Moving on then to Equity Markets, just shy of $1 billion of revenues; relatively weak trading results, but strong client flows in the Equities business. And then lastly in the P&L for the Investment Bank, credit costs of $618 million, which includes the addition to reserves that we talked about at Investor Day making up the preponderance of that as we moved $4.9 billion of our leveraged loans, which I'll talk about on the next page, into held for investment as it's our intention to at the levels they're at continue to hold onto those. Commenting on the outlook in the Investment Bank P&L, we expect looking ahead continued good market share on the investment banking fee side, but probably a continuation of this lower absolute level of fees versus the levels we were operating at in 2007. And in general, near-term expectations for trading should also be lower just given the difficult conditions we're operating with. But obviously that could change quite quickly if markets open up some. And then credit, the last driver of the P&L, we feel like obviously we have very strong reserves. You see the 255 allowance to - loan losses to average loans. Very strong, but remember losses in investment banking can be pretty idiosyncratic on the credit side. Now moving on to just some of the risk classes in the Investment Bank, on Page 4 you see leveraged lending the same page we've showed you for a couple of quarters now - so here again we took $1.1 billion of write-downs and we have remaining commitments of $22.5 billion. In the second bullet on the page, you can see we just walk forward from where we ended last quarter, $26.4 billion, down to the 22.5. Really $2.3 billion closed or distributed or otherwise reduced during the quarter. We added, and this is worth noting and pointing out, that we are capturing here all new commitments as well. Obviously, new commitments of $3.3 billion done at market terms, i.e., not covenant like, not over leveraged, so capable of being distributed and therefore not related to the markdowns we've taken in the quarter which relate to some of the stuff that got stuck from last summer. And then, of course, we transferred the $4.9 billion to held for investment that I talked about on the prior page. So all in all on average we've got an 11% write-down on the balances there, but that obviously widens out when you really consider that it's - the new commitments that are part of the denominator there don't require a mark against them. So we're more in the mid-80s when you really think about it for the troublesome deals in terms of where we're marked. Still obviously a large risk for us, though, at $22.5 billion of leveraged loans on the balance sheet. Now moving on to Page 5 - the remaining areas that we've talked about before - start with mortgage-related, so you see not a lot of movement here in balances, and let me just comment on it quickly. Prime and Alt-A mortgages in the mortgage trading areas, $13.7 billion the balance is last quarter, down to $12.8 billion this quarter largely due to the $1.1 billion of markdowns we talked about and took in the quarter. Subprime exposures were $2.7 billion gross last quarter down to $1.9 billion gross with markdowns net of hedges of $152 million. Exposure here is hedged with $1.6 billion against the gross positions, so we do continue to feel we're well covered in the subprime space, as we've talked about in prior quarters. And lastly in mortgage, CMBS exposure of $13.5 billion, down from 15.5, and this is one - we had some modest markdowns here, but we're not breaking that out given that we really consider this to be kind of normal trading activity at this stage relative to some of the other areas where we're capturing some more warehouse positions that we're stuck with. Collateralized debt obligations - which, as we talked about before, is not subprime related at all; this is corporate debt largely in these CLO warehouses - $5.5 billion in those warehouses last quarter down to 4.4 and $266 million of marks. So that's the areas away from leveraged loans where we took some significant marks in the quarter. And last comment, a little bit of increase - from 5% to 6% would be my estimate - in terms of Level 3 assets for the firm for the quarter, so not something that gives me any pause. Moving ahead now onto the Retail business, Slide 6, so here as usual we just, before talking about the P&L, just point out some things about the health of the business and the drivers of the P&L overall. So you see $214 billion worth of deposits, up 4% from a year ago, 11.1 million checking accounts, up 9% from a year ago, which then drives all the increased - sales and investments in product and sales force in the branches drive the rest of the stats that you then see related to the branches. Moving to the loan origination side you see, given the tightening of underwriting standards in home equity, a 47% decline from a year ago to $6.7 billion of originations in home equity in the quarter. And then moving on to mortgages, $47.1 billion of originations, up - the bulk of that is in the conforming space. Now moving on to Slide 7, we get to the P&L for Retail, so loss inclusive of all the credit costs and the reserving done of $227 million for the quarter. But again, starting at the top, you've got the $4.7 billion worth of revenues, up 15% from a year ago, which is fundamentally organic. There's no acquisitions added in in this period versus the prior period. And so when you really skip down a little bit and look at the Regional Bank, which earned - in the consumer and business banking portion of it - earned $545 million, the revenue there is up 11% on higher loan balances and higher deposit balances and wider spreads as well as higher levels of deposit-related fees. So, given this, great revenue momentum in the retail banking business for the reasons we talked about on the prior page, as well as revenues up overall with growth in production in Mortgage Banking, as you saw from the prior page. On the credit side, I'll get into it in the next few slides but total P&L impact in credit costs, you see the number circled of $2.5 billion. So that's $800 million worth of charge-offs, $1.7 billion of addition to allowance, with $1.1 billion of increase in reserves in the home equity space as we had talked about at Investor Day, as well as about $400 million in subprime and some in the prime space as well. You see, before we leave this page, overall for Retail related to credit costs, the allowance to loan losses - to loans - improves again to 2.28%. Now moving on to the next slide on home equity, here we took you through a lot of detail on Investor Day, Charlie did, about what really - very much the details, what's driving the trends that we're seeing here - so I won't repeat all that, but I would say we just continue to see those credit trends degrade as we had said at the time, continuing to have bad roll rates in credit as well as high severities. So we're not yet ready to predict where this peaks but, as we had talked about, if you just look at the box in the upper right you see charge-offs up to $447 million. We'd talked about 450 or so for the quarter when we were at Investor Day, and we also said at Investor Day that, given the trends we see, we could reasonably see that number doubling by the time we get to the fourth quarter, so the 450 becoming potentially $900 million for the outer part of the year. It's still hard to exactly predict, but we would continue to say that that's in the realm of the potential outcomes there. So trends continue to be as we talked about here during Investor Day. So moving down to the bottom, you just see that as a result we've increased the loan loss reserves as we suggested we would by $1.1 billion here, taking us to a level of future losses covered, so to speak, by that reserve of amounting to $2.6 billion on an annual basis. Obviously higher than the level that we are currently running at but, in light of what I've said in terms of expectations of higher levels, the reserve needs to go up. And just to comment - and this is true for the way we think about loss forecasts and reserves - I'll just that what we have embedded in there is - certainly affecting our loss forecast - is home price appreciation declines. We're expecting declines nationally for this year, on top of what we've seen already, in the high single digits, which translates to - peak to end-of-year losses. In some of the tougher markets - Arizona, California, Florida - in the mid20s peak to end-of-year. And so that's what's contemplated in terms of home prices. Obviously, as we talked about, we just continue to roll forward, carryforward the bad loss roll rates as the various vintages age. We don't assume improvement in roll rates. We're not relying on FICO scores as we do our work there. And then, again, in terms of the broader economy, we don't contemplate anything getting materially better nor worse from here. So those could be some of the factors that would affect us as we do losses in future quarters. Moving on now to subprime mortgage on the next page, I'll be quicker with these, so you just skip to the upper right. So you see we have certainly higher than we expected roll rates of dollars of balances moving from the late delinquency buckets to charge-off and loss. Beyond what we talked about last quarter, where we saw $71 million of charge-offs, we now jump to 149. And as you recall, we had set up reserves to cover on average $75 million of losses per quarter. So with this degradation, we've added $400-plus million to reserves here which covers for annualized losses to the tune of about $700 million. Obviously tightening underwriting standards across all areas, very much so, and at this stage in subprime the tightening that we've done left us with almost no subprime production in the month of March. And then lastly on the next slide, Slide 10, prime mortgage, you see the upper left, the 30day delinquency trend even moving into the prime space and as a result - which is really just the effect of home price declines bleeding into the prime mortgage portfolio - so you see net charge-offs of $50 million, up from 17 last quarter. So here again, higher losses as well as about $250 million of additions to reserves. And given we hold much of the balances here, as you see in the upper right, in corporate, where we also hold mortgage securities. Now moving on - I finished up with Retail there - let's move on to Card Services on Slide 11. So starting with profits of $609 million, down from a year ago, again driven by the $1.670 billion of credit costs, which is all charge-offs. No changes in reserves here. The charge-off rate you see down at the bottom circled of 437 basis points behaving consistently with - what we said in the second half of last year looking into this year is that we did see and expect to see a normalization, and that the first half was expected to be, in our minds, around a 450 charge-off rate with likelihood but not yet visibility into the second half of the year as we started this year that we could be approaching 5 by the end of the year. So I think at the 437 we're at now, looking ahead we do expect to see us progress towards something in the neighborhood of a 5% charge-off rate as we get to the back end of this year. On the revenue side, $3.9 billion and up 6% from a year ago. And a couple of pieces there - 3% growth in outstandings from a year ago. Charge volume of 5% overall increase, which includes a 10% increase in sales volume. Remember, we've tightened up on balance transfer offers and other promotional offers which deflate the amount of charge volume that we get from balance transfers. And then the last piece there, second bullet from the bottom, the net interest margin continues to widen a little bit to 834, which includes the shift away from low rate intro balances. Outlook, as I've said, 4.5% to 5% full year losses trending higher as we get through the rest of the year. And probably a little bit of an effective slowing card spend, which is what we've seen in the past couple of weeks. Commercial banking - on the next slide, Slide 12 - we see profits of $292 million, down a touch from a year ago. On the revenue side, up 6% from a year ago primarily driven by treasury services and lending growth which are associated with, as you see, the $68 billion and $90 - almost $100 billion of loan balances and deposit balances, respectively, which are up 18% and 22% year-over-year each, just demonstrating the growth in the client franchise there and the growth in the balance sheet and the revenues associated with that. Expenses relatively flat, so nice expansion of operating margin in the business as the team there does quite a good job. Credit costs, you see $101 million. A 48 basis point charge-off rate as we get some normalization here. In particular this quarter you see a good scrubbing of our homebuilder real estate portfolio making up the preponderance of the movement that we see into nonperformers and charge-offs in the quarter. And the outlook here, I would say it's just continued underlying growth as we've seen and credit continuing to normalize though I would say that, if you'll look at the 265 basis points of allowance to loans - to average loans among the tops in the industry. So we feel very good about the reserve levels in the Commercial Bank. Moving on to Treasury Services - next slide - profits of $403 million, up 53% from a year ago with strong pre-tax margins. The customer balances on the Treasury Services side primarily up 21% to $250-plus billion and assets under custody of nearly $16 trillion, up 7% from a year ago gets us to the 25% revenue growth we had from a year ago, which is double-digit growth in both of those businesses. And we'll just point out we do in fact benefit in this business from some of the market volatility, wider spreads on securities lending and some of the product areas helps here. So again outlook here, we would expect to see continued good growth in the business, seeing a nice flight to JPMorgan in some of the balances that our customers bring to us. And, as I said, we continue to - so long as market conditions continue to be challenged, we'll benefit from some of the market volatility on the revenue side. Last of the businesses, Asset Management on Slide 14, you see profits down for - the first time we've seen this picture in awhile - $356 million, so let me spend a minute on the story here. Revenue's down to $1.9 billion. Let me just focus for a second on the quarter-over-quarter explanation. The major component is the fact of seasonality of when we actually bill and recognize performance fees. We have a seasonal spike in the fourth quarter related to some of the hedge fund billing that we do. That, together with the decline in market levels we've seen - which is really the basis for the management fees we collect on the rest of the money management that we do - are the two factors that really bring the revenues down quarter-over-quarter. The story there I guess outlook-wise is at these levels of markets - indices and so forth - we would expect that kind of run rate of revenues is where we should expect to be barring seasonal spikes in performance fees, which we won't see again until the fourth quarter of the year. So I think there's a good level of revenues to be working with as we look ahead. Assets under management, you see $1.2 trillion of assets under management. I will just point out the very strong liquidity flows - $68 billion of liquidity flows into the business - and then other flows in the Private Bank, Private Client space, about $22 billion of flows into our client business in the first quarter, which is tremendous; obviously, much of that in liquidity as well. So while you see assets under management holding up actually up yearoveryear and flattish versus last quarter, given the mix from higher fee to lower fee liquidity products that presents an opportunity over time to move our clients into other products that give us bigger revenues. But for now, it goes back to the comments I made on revenue as we look ahead. But we do as well expect, with the hustle that we've got on the asset inflow side to see asset inflows continue. Lastly, for profits, let's talk about Corporate on Slide 15. So you see the three pieces. We've broken out the Visa gain here, so we've got - I'll start with Private Equity - after-tax profits of $57 million on Private Equity gains of $189 million. The outlook here will certainly continue to be volatile, as we've already said. I would just additionally say that I don't have much of a visible pipeline in terms of the likelihood of very many deals, though there's several that could fall into the remaining quarters of this year. But just not the same kind of visibility we had in a year like 2007, which was obviously very strong for us. But a lot of that is subject to things we don't control and what the markets allow for in terms of exits of investments. So a word of caution in predicting that. Then in Corporate, I'll just start with the Visa gain, so you see $955 million after tax. That's on the $1.5 billion of sale proceeds that come from the sale of the portion of the 50% of our ownership that we sold, net of an amount of shares that were retained by Visa to fund litigation escrow. Then we of course do have another 50% that we still own and hold on our books at cost, which is essentially zero. Corporate excluding Visa, profits of $15 million ex the sale of Visa. Lots of swing items in there. What I will do is just kind of point you to the outlook ahead, where we typically talk about $50 to $100 million negative, and I would just continue to give that as my best estimate of how to think about that on average through time though, again, that's going to be a pretty volatile line item, as you see this quarter. Moving on to Slide 16, you see capital and balance sheet, so again, a Tier 1 ratio of 8.3%, tangible common equity of $74 billion - up by about $2 billion from last quarter - growth in Tier 1 capital, all accommodating a several percentage point increase in risk weighted assets as we serve client needs. I would again say the liquidity and funding position is very strong. I don't need to repeat myself there. And then you see on a summary basis at the bottom here the allowance coverage ratios for each of our businesses which - you can check yourself match up very strongly for total credit reserves of $12.6 billion. So the sum picture there is a very strong balance sheet and funding position for the firm, which we feel good about. Let me just give one last page before I hand it over to Jamie, just some of the technicals on the accounting side and timing related to Bear Stearns. So we do expect the deal to close by a June 30th calendar we're hoping to hit. I'll just say now administratively we do expect that the month of June will be our first close of the books with Bear Stearns in it, so as a result, in looking at the tight calendar we have in July, we're going to be doing our earnings on July 22nd, a Tuesday, versus the usual Wednesday prior that we would normally do it. But too tight to do it on that timeframe, so just a heads up now. In terms of what's going to happen at the time of the close on the accounting front, we do expect I'm just summarizing the S4 that was filed, the merger proxy, so you can go back and then come back with any questions through IR - but to summarize it for those of you who haven't pored through it, we expect at a midpoint range that we put in the S4 to have an increase in our book equity, our capital, of about $5 billion, plus or minus a little bit. All these numbers are still moving and just estimates subject to change. But that's incorporating the results, estimates of results, for Bear through the - now to the close. The cost of the deleveraging that we talked about as well as various purchase accounting adjustments or structuring costs, litigation, et cetera, are all wrapped up in that. The other item you should understand is that that more or less will be the amount that - a similar amount will run through our P&L in the second quarter as an extraordinary gain, so below the line but affecting net income and that's how it gets into the capital account. Once we get beyond the second quarter, we do expect some amount of the overall deal costs, merger costs, to still be borne in the second half of the year. That could - rough numbers - could be in the range of $500 million to $1 billion after tax in the second half of the year. And then lastly, capital ratios, as we've said before, we expect them to remain strong after we do the Bear Stearns deal. And as we've said on that score, we do plan on reducing the Bear balance sheet in an orderly way. That's already under way, and it's part of the objective of the overall deal. As such, we've gotten some regulatory relief for the Bear Stearns assets that we'll be bringing on as we calculate our regulatory ratios for the next several quarters, but I'll go through all that detail when we actually put out our second quarter results in July. So with that, let me hand it over to Jamie.
James Dimon: So hello, everybody. Let me - I'm going to just do two quick things. One is give you a little update on the Bear integration, and then also just an overall comment. So, you know, Bear Stearns, obviously a deal's really never been done exactly like this, but now we're in full merger mode. We have a full merger integration office. It's kind of like a military operation; hundreds, maybe even a thousand people are now involved. We've been through all the major real estate, all the major data centers, the Investment Bank will occupy all of 383 Madison, which we think is a great building. We'll be building two new brandnew trading floors there, which we think will be best in class. They already have five, so there will be seven in total. The management team - and I really should say here, the really heavy lifting - is being done by Steve Black and Bill Winters and the whole management team of JPMorgan Investment Bank, now including several members from Bear Stearns, who really are pretty much working around the clock. The next round of things is to be announcing by business - so for Equities, Fixed Income, et cetera - who the management teams are so we can go about the people selection process. We are treating it as a real merger. We're trying to get the best people to make sure we capture all the things we want to capture. All 14,000 people we hope will be informed about their future some time before the close, which we hope will happen before June 30th. And we think the better we can people - the sooner we can tell people, the better. I do want to point out that we have a talent network office set up. It's to be fully staffed. We have put a freeze on hiring for JPMorgan in New York City, not because we're afraid or anything like that because of recession but because we have a lot of open [recs], a lot of temps, a lot of consultants, and we want to give those jobs first to anyone who's dislocated in this process, whether a Bear Stearns employee or a JPMorgan employee, because some of the pain unfortunately will be also borne at JPMorgan. We'll be contacting a lot of your firms. I'll let you know that we've got some really talented people who would like to continue working, so we're really going to try to do an unbelievable job to place as many of those people as possible in New York City if they can't get something here. We have, on the systems side, we've already pretty much selected most of the major applications so we know what we're doing there. We'll start moving people in short order, in the next month or so. And we've kind of consolidated all the risk positions into one risk format. We are already deeply engaged in making sure we're looking at consolidated risk and understanding it and starting to derisk a little bit the added risk positions that come on from Bear Stearns. If you asked, I'd say it's probably down about 20% or so from the time the transaction was done. So the teams are working well together. We still think that this could be a very good thing for shareholders and that we can capture $1 billion or more of profit as we consolidate Bear Stearns in. And for the Bear Stearns folks, I just want to remind people, a lot of great talent there, a lot of really great talent. And we've been getting to know the folks, and we do nothing but get more excited about the possibilities across virtually all of our businesses. And then overall, we feel pretty good about where we are. I just want to emphasize and I'm a little bit of a contrarian, great underlying numbers, again. The underlying numbers - deposits, loans, growth, bankers, assets under management, custody - are what are going to really drive the future of this company, and we really feel good about what we see. And the Investment Bank - Mike mentioned it; I just want to emphasize it - number one, global debt and equity and [eq-related payables] for the first time ever. So congratulations to the folks who accomplished that. And with that, we will turn it over to you all for questions.
Operator: Thank you, sir. (Operator Instructions) We'll take our first question from Guy Moszkowski with Merrill Lynch.
Guy Moszkowski - Merrill Lynch: Good morning.
James Dimon: Hi, Guy.
Guy Moszkowski - Merrill Lynch: I just wanted to follow up on the Bear Stearns discussion. First of all, just some clarity - you said risk position's down about 20%. Would we be able to apply that number to the $30 billion or so of assets which the Fed was helping you fund?
James Dimon: No. That's a completely separate thing.
Guy Moszkowski - Merrill Lynch: So that 20% would be some kind of a risk adjusted notional number that you're thinking about?
James Dimon: Yeah. I'm using 20% because it's really complicated. [inaudible] like a balance sheet risk, hedging. We're just trying to get a little bit small, a little bit more de-risk as we put it on our balance sheet. So don't use that number too specifically.
Guy Moszkowski - Merrill Lynch: And are you still comfortable with the idea of around $1 billion of earnings run rate there?
James Dimon: Yeah. Yes.
Guy Moszkowski - Merrill Lynch: What would you say have been the biggest surprises and the biggest disappointments, if any, as you've kind of looked through the businesses and the risk management there?
James Dimon: Initially, when we did the transaction, we really worried much more about the downside than the upside. And now we're getting to meet the people and see all the other possibilities there. So there are very few real negatives in addition to the things we worried about before, and the positives are across most of the businesses. Some very good people [inaudible] equities, prime brokers, correspondent commodities, fixed income, mortgages, research we just see a lot of good things there. So we're working hard to try to capture all that as fast as we can.
Guy Moszkowski - Merrill Lynch: Are you going to run prime brokerage as a joint venture between the Investment Bank and TSS?
James Dimon: Right now it's going to stay in investment banking in the Equities business.
Guy Moszkowski - Merrill Lynch: And just switching gears to the CMBS exposure that you talked about, as you mentioned, you didn't highlight any write-downs there. Would that be on a gross basis or because hedges helped you out there? And could you talk about how hedging helped you in that portfolio, in particular during the quarter and maybe how that might have changed since the first of April?
James Dimon: We lost a little bit of money there, and so we're not going to get into too much specifics. There you are able to hedge because there are places you can edge in CMBS et cetera, unlike Alt-A, where it's really hard to hedge AltA. So we feel pretty comfortable with those exposures. And actually - and Mike mentioned April - things started to trade a little bit more in Alt-A [land] and CMBS - in the cash side of CMBS, not just the derivative side.
Guy Moszkowski - Merrill Lynch: Thanks for that. Just a question on whether you're seeing anything that would give you some signs of stabilization of the loss and delinquency rates in the home equity portfolio?
James Dimon: No. It's exactly what we saw - higher - more houses are going negative equity, roll rates are high, home prices we expect to still go down. We have not seen it. Now we'll see it eventually, but we have not seen it yet.
Guy Moszkowski - Merrill Lynch: And just back to the Investment Bank for a moment, is there any change in your compensation structure that you're anticipating for this year, early as it is, in terms of stock, cash mix or anything like that that would have driven a lower percentage accrual than what we usually would see for you guys?
James Dimon: No, the accrual is pretty close to what it's always been, which is for us 42%. And we make a whole bunch of adjustments; it's close to 46% if you compare it to other investment banks. The answer's no. It's really early in the year.
Guy Moszkowski - Merrill Lynch: Okay. And then I'm just going to revisit this issue - this is the last question - revisit this issue of your putting some of these leveraged finance assets into held to maturity or held for investment, as you called it. Obviously you're putting these assets in at a significantly marked down price, and on top of that you reserved at what's pretty close to a 10 percentage point rate. And I guess the question I have is: Is that strictly a matter of accounting mechanics, that you really can't take into account the fact that you're already buying the loan at a discount, essentially buying the loan into that portfolio at a discount to face? It just seems like you're building pretty massive reserves for that portfolio.
James Dimon: Yeah, so two things. One is, the accounting rules are you move it at fair value; you calculate what the reserve would have been. If the reserve is more than the discount, you add it up. You have to add it back in. So obviously, it's conservative. It was bigger than the mark. On the other hand, we like conservative loan loss reserves, so that wasn't a negative to us because we like building loan loss reserves for rainy days.
Guy Moszkowski - Merrill Lynch: Yeah, I know. The economics are what they are, but clearly the net impact is what you just said, that they
James Dimon: Right. If we had not done it, we wouldn't have put up the $500 million as of that date. Those loans would change in value after that date.
Michael J. Cavanagh: Yeah, that's the issue, guys. We took action before some degradation in spreads, and so we would have taken more marks during the quarter. So there's a little bit of difference - a little bit of incremental cost in the quarter related to that move, a couple hundred million dollars.
James Dimon: Yeah.
Guy Moszkowski - Merrill Lynch: That's fair. Okay, thanks very much for all the information. I appreciate it.
James Dimon: No problem.
Operator: We'll go next to Glenn Schorr with UBS.
James Dimon: Hey, Glenn.
Glenn Schorr - UBS: Hey, what's going on? On home equities, just finishing that thought up, have you had any success in reducing the nondraw lines, and can you remind us how big they are right now?
Michael J. Cavanagh: We do what we can do, but Charlie's answer at Investor Day and just talking to it, I wouldn't point you to it being a substantial impact despite what we've all read in newspapers about there being - the rules don't really easily allow for you to preemptively bring lines down. So I wouldn't say that there's been substantial change in risk profile as a result of doing that, though I would say we're as focused as we can be on that. I don't have the open line number off the top of my head.
Glenn Schorr - UBS: No worries. And just off the top of your head, have people been pulling them down or are they just kind of hanging out there?
Michael J. Cavanagh: Well, the losses you see include - tend to be pulled-down lines at the time we're losing money.
Glenn Schorr - UBS: Got it. Got it. [inaudible] A quickie on the outflows in Asset Management, around $21 billion across equities balance and alternatives. Any color there that I might have missed on the prepared remarks?
Michael J. Cavanagh: No, but it is a little bit in Europe, in our retail distribution to third parties in Europe, where - that we and others lost a little ground there. So that's where you've seen some of the preponderance of outflows. And like I was saying earlier, though, significant inflows, though at different revenue per asset levels into liquidity products was very strong, as well as great inflows into the global Private Bank franchise.
Glenn Schorr - UBS: Okay. Last one for both of you all is: Obviously, the Bear transaction's pretty involved and tapping a lot of people's time, but it doesn't really impact the retail banking side of the house. Given your [inaudible] ratios, given that in a weird way this is the environment you've been waiting for and a lot of - it feels like properties are getting cheaper and available, do you have the bandwidth to take on something if something was attractive now?
James Dimon: Yep.
Michael J. Cavanagh: Yep.
Glenn Schorr - UBS: Enough said. All right. Thanks, guys.
Operator: We'll go next to Mike Mayo with Deutsche Bank.
Michael Mayo - Deutsche Bank: Good morning.
James Dimon: Good morning, Mike.
Michael Mayo - Deutsche Bank: Can you elaborate on the commercial and wholesale NPAs, which were up by over half? And I recognize that loans to homebuilders are going bad, but what else is causing the increase in those out there?
James Dimon: I guess it's up by half from a very low level, so a few hundred million dollars of increase in nonperformers on, what, a $60, $70 billion portfolio I would say more in the category of getting a little bit of normalization. But I would say the largest explanation is we've got about $1.5 billion of loans to homebuilders. Todd and Team Maclin have scrubbed that portfolio hard given everything that's going on. As a result, some charge-offs and movement of like half or a little more of the change in nonperformers and a little bit more of the charge-offs relate to just that activity. The rest is just generally spread around.
Michael Mayo - Deutsche Bank: And I guess the bigger question is: Are the problems from homebuilders and homes spreading more to commercial? Is it more than simply normalization?
Michael J. Cavanagh: It's real estate is getting worse, yes.
Michael Mayo - Deutsche Bank: And your bread-and-butter commercial companies?
Michael J. Cavanagh: Not much more than normalization there.
Michael Mayo - Deutsche Bank: Okay. And as it relates to the Bear transaction, what will your pro forma book value or tangible book value be?
James Dimon: That $5 billion that Mike gave will go right directly to the equity account.
Michael Mayo - Deutsche Bank: And you said capital ratios afterwards would be strong. Can you give any [bents] relative to your 8.3% Tier 1 ratio?
Michael J. Cavanagh: Yeah, our intent is to maintain similar strong ratios going forward, so with Bear Stearns, we're getting some equity. We also get some preferred. We get a lot of long-term debt. We're still working on making sure the risk grade assets are coming down a little bit. But when all is said and done, quarter by quarter we will have pretty strong ratios.
Michael Mayo - Deutsche Bank: And then lastly, prime mortgage loan losses went up, too. I mean that's, to some degree, expected, but we heard a lot about subprime and Alt-A and home equity. Can you elaborate on prime mortgages?
James Dimon: They're getting worse, Mike.
Michael J. Cavanagh: It's home prices burning through whatever underlying - whatever lies under the prime mortgage, and then the same dynamics.
Michael Mayo - Deutsche Bank: All right. Thank you.
Operator: We'll go next to Betsy Graseck with Morgan Stanley.
Betsy Graseck - Morgan Stanley : Thanks. A couple questions, one on Bear. The billion dollar run rate that you're expecting there, given the expectation that you're de-risking the portfolio I would think that means that we should assume that the revenue run rate should come down so you're hitting the billion number with the cost saves. Is that a fair way of thinking about it?
Michael J. Cavanagh: Yeah, all in. Yes. That's a fair way to think about it.
Betsy Graseck - Morgan Stanley : Okay.
Michael J. Cavanagh: It may take a little bit of time to get that, but that's what we do expect still.
Betsy Graseck - Morgan Stanley : Yeah, because -
Michael J. Cavanagh: And possibly better, by the way. We're not saying it can't be better because we're still working on all the issues. Like I said, this was not a merger done in an ordinary course.
Betsy Graseck - Morgan Stanley : Right. I mean, it's just the 8-K - the Bear 8-K that was put out last week indicated the degree to which revenues were hit recently. Maybe you could comment a little bit as to what you think the run rate of revenues is relative to what they'd indicated in the 8K?
James Dimon: We really can't because we didn't spend much time reconciling all that.
Betsy Graseck - Morgan Stanley : Yeah, okay.
James Dimon: I'd like to just mention, in terms of - someone asked about the bandwidth of our ability to do a retail deal and Bear Stearns, and one of the reasons we were able to do something like Bear Stearns is because we have the management teams who can actually execute it. And we've spoken before in the past about price has to be right, the ability to execute, and so we also have a management team in Retail that can execute it, people who have already consolidated systems. They're on top of what they've done. We did the Bank of New York transaction. So we actually have the management teams and the systems and the back office who can execute things like this, and that's what makes it possible. I would tell you several years ago, it would not have been possible.
Betsy Graseck - Morgan Stanley : And there was some speculation that you had been involved in looking at the WaMu transaction. Is that something that you can comment on?
Michael J. Cavanagh: We're not going to comment on it, but you should assume we look at everything.
Betsy Graseck - Morgan Stanley : Right. Okay. On just the loan growth and the asset growth generally, I mean, when I look on a consolidated basis, the Q-onQ growth rates are slowing. But when I look at specific - you know, there's obviously some specific pockets of acceleration, like in commercial loans, not only in the Investment Bank but also in the Commercial Bank and then, you know, your trading assets, in particular derivative receivable trading assets - could you comment a little bit as to what's driving the growth rates in those categories and whether that's proactive on your part, the degree to which it is proactive on your part versus customers drawing down lines or utilizing your balance sheet?
James Dimon: I'll comment on the derivative one. Maybe Mike will do the loan one. On the derivative side, remember, that number bounces all over the place because they're marked to market, and what starts with no receivable can become a very large receivable depending on how things move. Remember, a lot of those are fully collateralized, so it isn't like you have that kind of exposure on all of that. So that's always going to bounce around. And obviously as you grow your business, the chance of that volatility - of that asset moving around and growing is higher.
Michael J. Cavanagh: And then on the loan side, I'll just tackle Commercial Bank because I think it's indicative of other places. We think this is a great window of time to be there for our clients, so yeah, there is a degree to which it's existing clients that we're providing capacity to. I would say, just going back to the real estate comments, it's general, commercial and industrial more so than it is commercial real estate there, as a point. Yeah, government not-for-profits for some of the dislocations in the muni space. There's activity going on there. But also this is a great window of time to go after the prospects that we have in middle-market banking, for example, around the country, and that is what our folks are actively doing. And it's true there. It's true in the Private Bank that it's a - we definitely [go in commenting] on it. We want to use this time to build our franchise, so to be there and use our balance sheet in a smart way to build the franchise for the long term and take market share and get new business as well as cement existing relationships I would say is the general nature of the loan growth.
James Dimon: And Mike mentioned it, but I should add that on that slide on leveraged loans, there's $3 billion of new loans. That included one fairly large one, but it also included 10 or so much smaller ones. We're still in business, and we're still willing to do that. We still want to facilitate clients. And so we look at that as a positive sign to indicate leveraged finance was still there. Give us a call.
Betsy Graseck - Morgan Stanley : So when you're thinking about the capital ratios that you want to be holding, and I know you've talked long about having a fortress balance sheet and your changeable equities - definitely highest in the peer group - how do you think about the opportunities to grow, given the size of the balance sheet you've got today, what you've got coming on from Bear, relative to peers? Because you do live in a relative world, and you do have some peers that are increasing capital ratios to deal with deteriorating credit and extending duration on their assets.
Michael J. Cavanagh: I guess, Betsy, I'm not worried about us falling out of the place we hold on a relative through time. But I would say that the important thing is, well, we use this as an opportunity to really make sure we maintain efficiency of the balance sheet. So all of our businesses understand the importance of maintaining strong capital position and how it's benefiting the business broadly, so are actively working hard to use tougher times to make sure we eliminate wasteful use of the balance sheet so we can re-deploy it in normal course without having to see our capital ratios degrade. So that's the general dynamic. Beyond that, the last thing we want to do is close down for ongoing business. It would hurt the franchise, and that's not the point of trying to - it wouldn't be the point to try to maintain strong capital position at the expense of the franchise.
James Dimon: Yeah, and look. We've been adding - I think we started early, but we've been adding jumbo loans to the balance sheet. We're growing the mortgage business. We're growing loans and deposits in the Private Bank. We're growing - I mean, we're not - we haven't scrimped. We want to grow and have the ability to grow intelligently. If you ever do a really big transaction, you can always finance that, too. You don't have to try to do it off your own balance sheet.
Betsy Graseck - Morgan Stanley : Okay. Thanks.
Operator: (Operator Instructions) We'll go to Jeff Harte with Sandler O'Neill.
Jeffrey Harte - Sandler O'Neill & Partners L.P.: Good morning, guys.
James Dimon: Hey, Jeff.
Jeffrey Harte - Sandler O'Neill & Partners L.P.: You talked a little bit about prime mortgage and that it's definitely getting worse, but I look at a 48 basis point charge-off ratio in prime mortgage and say, "Wow, that's pretty bad." I mean, from that as a base, how much worse do you envision it getting or could it get?
Michael J. Cavanagh: First of all, the risk factors in prime mortgage are exactly the same you've seen elsewhere, which is negative home prices, high LTV, things like that. And I think it'll probably get a little bit worse. And we probably owe you a better answer than that - we did not - but it's hard in almost all these mortgage areas to say exactly what's going to happen to behavior, and you and I - you can guess as easily as we can what's going to happen to home prices. We expect they'll go down another 7%, 8%, 9% in '08.
Jeffrey Harte - Sandler O'Neill & Partners L.P.: Okay. And in Asset Management, just doing back-of-the-envelope math, I mean, looking at revenues, annualizing them and looking at the assets under management, I'm getting something like a 48 basis point fee yield. That seems kind of low. I understand there's a lot of stuff going on. Were there any fee reversals of previous incentive fees or anything like that in the quarter, previously recorded incentive fees?
Michael J. Cavanagh: Nope. Nope. Like I said, the timing of all the kind of performance-driven fees is unfortunately not smooth over time. So you obviously have the issue of what is performance, but that wasn't the issue in this case so much as a fourth quarter spike. We come off that at the same time we have asset levels due to markets coming down and bringing so there was - you had a double effect.
Jeffrey Harte - Sandler O'Neill & Partners L.P.: Okay. And in Commercial, commercial lending specifically, as we look forward, I guess looking at a 38% year-over-year loan growth, it makes me a little concerned if we're seeing mass credit deterioration. Some of these loans you're putting on today, you may wish you didn't have them six, eight months from now if credit goes the wrong way. How comfortable are you with overall kind of commercial credit quality and where we're heading?
James Dimon: Well, assuming that we have the exact same concerns you have, we have been very careful. So assume that we think we're getting good credits. And Mike mentioned government not-for-profits, that's a big piece of the recent growth. And we think the people we're doing business with are good credit, so we're being careful. And, as you know, a lot of it is not real estate. That portfolio's gone down.
Jeffrey Harte - Sandler O'Neill & Partners L.P.: Okay. Thank you.
Operator: And we'll go next to Meredith Whitney with Oppenheimer.
Meredith Whitney - Oppenheimer: Hi. Good morning.
James Dimon: Hi, Meredith.
Meredith Whitney - Oppenheimer: My questions are all around consumer. I wanted to get some comments on what you're seeing in auto, why you're growing that portfolio. And then more broadly on your funding strategy with respect to consumer, the higher cost of funding and securitization market - has your strategy for funding any of your consumer buckets changed? And then competitively, as it's changed for your competitors, what do you see the outlook there in terms of market share gains or potential problems because of a slowdown in available credit for consumers at large? If you could comment on that, that'd be great.
Michael J. Cavanagh: I guess in funding consumer, you know, non-card - obviously our name in the card funding space is a strong issuer of securitization on the card funding side. We'll continue to do that as a main source of funding. I think when we look at the other categories of consumer assets, the securitization markets tend to be more expensive than us just raising the natural sources we have coming through the deposit side, particularly of the Retail business itself but the firm more broadly. We don't have that as a - we have a wealth of deposits, so we're not a price leader in terms of ratcheting deposit prices higher, so we do need to be conscious of what we see going on with competitors in the regional markets that we operate in on the deposit side having fewer sources of funding and thus pushing deposit pricing up. So we're mindful of that as the major source that we have for consumer funding. And I guess --
James Dimon: But strategically, we're always better off. We have all the options - our cost of funds are lower, we have multiple sources of funding, so whatever happens, we're still better off than the competitors.
Michael J. Cavanagh: Did that help, Meredith?
Meredith Whitney - Oppenheimer: Well, to the extent that - yeah, you're better off and you benefit on one level because you have more access to funding. On the other side, though, you're hurt in a way because, as the consumers get squeezed and lines are pulled from those who can't access securitization and don't have as ready a deposit base, how do you see that impacting your business, just a broad base? And then not to forget the auto outlook, please
James Dimon: Yeah, the auto outlook - and we're still in the auto business, and we try to do credit right; we're not going to stop making loans because people think things might get worse. So we're growing the auto business carefully. We've tightened up standards there just like we've tightened them up everywhere else. And it may be that we're just we're still in business, which is why the business is growing like that. The other thing about how it affects us because other people are pulling lines, that's more of a question about how bad the recession will get. Obviously, the worse the recession gets, the worse it is for us. But we're not going to sit here and spend a lot of time worrying about what other people are doing. We're going to just build our own business. In a lot of these areas, we've been gaining a little bit of share. We're still open for business in the mortgage side - jumbo, Alt-A, subprime, even though we're doing very little of it - because we're here for business, you know? We're not - we're here for clients, ultimately. These franchises are great franchises that we want to grow for decades, not flip and flop every time the economy sneezes.
Meredith Whitney - Oppenheimer: All right. Thanks.
Operator: Mr. Dimon and Mr. Cavanagh, there are no further questions at this time.
James Dimon: Wow.
Michael J. Cavanagh: Okay, great. Thanks, everyone. Look forward to talking to you next quarter.
James Dimon: Thank you.
Michael J. Cavanagh: Thanks.
Operator: That does conclude today's call. Thank you for your participation. Have a good day. | [
{
"speaker": "Executives",
"text": "Michael J. Cavanagh - Chief Financial Officer James Dimon - Chairman of the Board, President, Chief Executive Officer"
},
{
"speaker": "Analysts",
"text": "Guy Moszkowski - Merrill Lynch Glenn Schorr - UBS Michael Mayo - Deutsche Bank Betsy Graseck - Morgan Stanley Jeffrey Harte - Sandler O'Neill & Partners L.P. Meredith Whitney - Oppenheimer"
},
{
"speaker": "Operator",
"text": "Good morning, ladies and gentlemen. Welcome to the JPMorgan Chase first quarter 2008 earnings call. This call is being recorded. Today's presentation may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements speak only as of the date hereof and reflect management's current beliefs. These statements are by their nature subject to significant risks and uncertainties, and the firm's actual returns could differ materially from those described in the forward-looking statements. Please refer to JPMorgan Chase's filings with the Securities and Exchange Commission, including its most recent Form 10K and Forms 10Q for a description of the risk and factors that could cause the firm's results to differ materially from those described in the forward-looking statements. At the conclusion of the presentation, you'll have an opportunity to ask questions. (Operator Instructions) And at this time, I'd like to turn the call over to JPMorgan Chase's Chairman and Chief Executive Officer Jamie Dimon and Chief Financial Officer Mike Cavanagh. Mr. Cavanagh, please go ahead, sir."
},
{
"speaker": "Michael J. Cavanagh",
"text": "Great. Good morning. Thank you, Operator. Good morning, everyone. You've got Mike here and Jamie as well. As usual, we'll run through a presentation that you can pull off the web to run through. I'll run through the numbers and Jamie will make some comments, and then we'll take Q&A for a bit. So hopefully you have the presentation in front of you. If you go to the first page, Financial Highlights, this is the highlights exactly as - yeah, headlines from our press release - so I'm not going to sit here and read it verbatim for you. But I guess I would just make the general couple of comments that you do see from the diverse earnings sources that we've got, resulting in $2.4 billion of earnings for the quarter inclusive of the $2.6 billion in markdowns in the investment bank that I'll get to, as well as the strengthening of credit reserves by $2.5 billion in the quarter on top of the higher level of actual credit losses in the quarter, net of the benefit of the $1.5 billion, all that washing through given the broader sources of earnings we have to create the positive earnings of $2.4 billion. Which really gets to my next point, which is really that the earnings helped build and strengthen capital, with Tier 1 capital actually increasing again in the quarter to just around $90 billion. It maintains our 8.3% Tier 1 ratio, which we feel very good about. But more broadly in light of - and that's with some growth in the balance sheet - so meeting the franchise needs of our clients as we operate through these tougher times along with the strength and the liquidity [in] place and the $12.6 billion in overall credit reserves, I feel like the balance sheet and capital position is all in good shape and proud of how we managed through the difficult couple of quarters we had in a row and maintain strength there. And then I guess the last point I'd make here is that we are dealing in tough times, but it's been very important to the team here that we maintain our focus on the underlying business momentum. And you really see it across the businesses. You can see a summary of it down here at the bottom, that revenue growth of 15% in Retail, the strong rankings we maintain in investment banking fee side and the market share gains we've taken there, and really in many of our other businesses and the strong profit growth in TSS. So we spend a lot of time focused on it and feel very good about the continued ability to drive underlying growth there. Flipping now to the second slide, not much to add versus the first page but you do see at a high level the firm's kind of GAAP P&L, the $2.4 billion of reported net income and EPS of $0.68, obviously down substantially from the very strong conditions we operated in and the record results of the first quarter last year. You can see on a net basis, revenues and expenses down together, and the substantial story is obviously the big increase to $5.1 billion worth of credit costs which, as I said, is about $2.5 billion of increase in allowance in the quarter along with charge-offs ticking higher through prior year quarter and last quarter into this quarter. So now if we - we'll move to the businesses; I'll start with the Investment Bank on Page 3. So here you see, starting with profits, we had a loss of $87 million in the quarter inclusive of a very tough month of March in the first calendar quarter of the year. But working down the revenue pieces you see that we had a $1.206 billion of investment banking fees which, while it's down, we feel very good about it because, as I said at the top, the strong rankings we have in investment banking fees - number one, with market share growth versus a year ago as well as the top ranking we had in debt, equity and equity related underwritings for the first time - we feel very good about the momentum we have serving clients in the investment banking space. Moving along to Fixed Income Markets, here you see a substantial decline in Fixed Income Markets revenues to $466 million, and that's really where you see the $2.6 billion worth of markdowns across a variety of asset classes. I'll take you through the details, but it's $1.2 billion across mortgage-related categories and $1.1 billion in leveraged lending and a little bit of the remaining corporate loan positions we have in our warehouses make up the balance there. When you really think about all other areas, though, results included some records in rates and currencies, strong in areas like emerging markets, commodities and credit trading, and pretty much it would throw the rest into the basket of mixed results generally, aside from that. I will just - we've pointed this out before, the gain on the widening of our credit spread as it relates to structured notes issued out of our Fixed Income Markets and Equity Markets businesses of 662 in Fixed Income Markets and 287 in Equities - I will just make the note that, while that's spread widening on the structured note liabilities, we of course do have derivative-related liabilities and payables that also change in value quarter to quarter by changes in credit spreads of ourselves and our counterparties. And across the IB, that was actually several hundred million to the negative as spreads on some of our counterparties widened more than we did, putting a little pressure actually on overall revenue. So just to put the 662 and 287 in proper context. Moving on then to Equity Markets, just shy of $1 billion of revenues; relatively weak trading results, but strong client flows in the Equities business. And then lastly in the P&L for the Investment Bank, credit costs of $618 million, which includes the addition to reserves that we talked about at Investor Day making up the preponderance of that as we moved $4.9 billion of our leveraged loans, which I'll talk about on the next page, into held for investment as it's our intention to at the levels they're at continue to hold onto those. Commenting on the outlook in the Investment Bank P&L, we expect looking ahead continued good market share on the investment banking fee side, but probably a continuation of this lower absolute level of fees versus the levels we were operating at in 2007. And in general, near-term expectations for trading should also be lower just given the difficult conditions we're operating with. But obviously that could change quite quickly if markets open up some. And then credit, the last driver of the P&L, we feel like obviously we have very strong reserves. You see the 255 allowance to - loan losses to average loans. Very strong, but remember losses in investment banking can be pretty idiosyncratic on the credit side. Now moving on to just some of the risk classes in the Investment Bank, on Page 4 you see leveraged lending the same page we've showed you for a couple of quarters now - so here again we took $1.1 billion of write-downs and we have remaining commitments of $22.5 billion. In the second bullet on the page, you can see we just walk forward from where we ended last quarter, $26.4 billion, down to the 22.5. Really $2.3 billion closed or distributed or otherwise reduced during the quarter. We added, and this is worth noting and pointing out, that we are capturing here all new commitments as well. Obviously, new commitments of $3.3 billion done at market terms, i.e., not covenant like, not over leveraged, so capable of being distributed and therefore not related to the markdowns we've taken in the quarter which relate to some of the stuff that got stuck from last summer. And then, of course, we transferred the $4.9 billion to held for investment that I talked about on the prior page. So all in all on average we've got an 11% write-down on the balances there, but that obviously widens out when you really consider that it's - the new commitments that are part of the denominator there don't require a mark against them. So we're more in the mid-80s when you really think about it for the troublesome deals in terms of where we're marked. Still obviously a large risk for us, though, at $22.5 billion of leveraged loans on the balance sheet. Now moving on to Page 5 - the remaining areas that we've talked about before - start with mortgage-related, so you see not a lot of movement here in balances, and let me just comment on it quickly. Prime and Alt-A mortgages in the mortgage trading areas, $13.7 billion the balance is last quarter, down to $12.8 billion this quarter largely due to the $1.1 billion of markdowns we talked about and took in the quarter. Subprime exposures were $2.7 billion gross last quarter down to $1.9 billion gross with markdowns net of hedges of $152 million. Exposure here is hedged with $1.6 billion against the gross positions, so we do continue to feel we're well covered in the subprime space, as we've talked about in prior quarters. And lastly in mortgage, CMBS exposure of $13.5 billion, down from 15.5, and this is one - we had some modest markdowns here, but we're not breaking that out given that we really consider this to be kind of normal trading activity at this stage relative to some of the other areas where we're capturing some more warehouse positions that we're stuck with. Collateralized debt obligations - which, as we talked about before, is not subprime related at all; this is corporate debt largely in these CLO warehouses - $5.5 billion in those warehouses last quarter down to 4.4 and $266 million of marks. So that's the areas away from leveraged loans where we took some significant marks in the quarter. And last comment, a little bit of increase - from 5% to 6% would be my estimate - in terms of Level 3 assets for the firm for the quarter, so not something that gives me any pause. Moving ahead now onto the Retail business, Slide 6, so here as usual we just, before talking about the P&L, just point out some things about the health of the business and the drivers of the P&L overall. So you see $214 billion worth of deposits, up 4% from a year ago, 11.1 million checking accounts, up 9% from a year ago, which then drives all the increased - sales and investments in product and sales force in the branches drive the rest of the stats that you then see related to the branches. Moving to the loan origination side you see, given the tightening of underwriting standards in home equity, a 47% decline from a year ago to $6.7 billion of originations in home equity in the quarter. And then moving on to mortgages, $47.1 billion of originations, up - the bulk of that is in the conforming space. Now moving on to Slide 7, we get to the P&L for Retail, so loss inclusive of all the credit costs and the reserving done of $227 million for the quarter. But again, starting at the top, you've got the $4.7 billion worth of revenues, up 15% from a year ago, which is fundamentally organic. There's no acquisitions added in in this period versus the prior period. And so when you really skip down a little bit and look at the Regional Bank, which earned - in the consumer and business banking portion of it - earned $545 million, the revenue there is up 11% on higher loan balances and higher deposit balances and wider spreads as well as higher levels of deposit-related fees. So, given this, great revenue momentum in the retail banking business for the reasons we talked about on the prior page, as well as revenues up overall with growth in production in Mortgage Banking, as you saw from the prior page. On the credit side, I'll get into it in the next few slides but total P&L impact in credit costs, you see the number circled of $2.5 billion. So that's $800 million worth of charge-offs, $1.7 billion of addition to allowance, with $1.1 billion of increase in reserves in the home equity space as we had talked about at Investor Day, as well as about $400 million in subprime and some in the prime space as well. You see, before we leave this page, overall for Retail related to credit costs, the allowance to loan losses - to loans - improves again to 2.28%. Now moving on to the next slide on home equity, here we took you through a lot of detail on Investor Day, Charlie did, about what really - very much the details, what's driving the trends that we're seeing here - so I won't repeat all that, but I would say we just continue to see those credit trends degrade as we had said at the time, continuing to have bad roll rates in credit as well as high severities. So we're not yet ready to predict where this peaks but, as we had talked about, if you just look at the box in the upper right you see charge-offs up to $447 million. We'd talked about 450 or so for the quarter when we were at Investor Day, and we also said at Investor Day that, given the trends we see, we could reasonably see that number doubling by the time we get to the fourth quarter, so the 450 becoming potentially $900 million for the outer part of the year. It's still hard to exactly predict, but we would continue to say that that's in the realm of the potential outcomes there. So trends continue to be as we talked about here during Investor Day. So moving down to the bottom, you just see that as a result we've increased the loan loss reserves as we suggested we would by $1.1 billion here, taking us to a level of future losses covered, so to speak, by that reserve of amounting to $2.6 billion on an annual basis. Obviously higher than the level that we are currently running at but, in light of what I've said in terms of expectations of higher levels, the reserve needs to go up. And just to comment - and this is true for the way we think about loss forecasts and reserves - I'll just that what we have embedded in there is - certainly affecting our loss forecast - is home price appreciation declines. We're expecting declines nationally for this year, on top of what we've seen already, in the high single digits, which translates to - peak to end-of-year losses. In some of the tougher markets - Arizona, California, Florida - in the mid20s peak to end-of-year. And so that's what's contemplated in terms of home prices. Obviously, as we talked about, we just continue to roll forward, carryforward the bad loss roll rates as the various vintages age. We don't assume improvement in roll rates. We're not relying on FICO scores as we do our work there. And then, again, in terms of the broader economy, we don't contemplate anything getting materially better nor worse from here. So those could be some of the factors that would affect us as we do losses in future quarters. Moving on now to subprime mortgage on the next page, I'll be quicker with these, so you just skip to the upper right. So you see we have certainly higher than we expected roll rates of dollars of balances moving from the late delinquency buckets to charge-off and loss. Beyond what we talked about last quarter, where we saw $71 million of charge-offs, we now jump to 149. And as you recall, we had set up reserves to cover on average $75 million of losses per quarter. So with this degradation, we've added $400-plus million to reserves here which covers for annualized losses to the tune of about $700 million. Obviously tightening underwriting standards across all areas, very much so, and at this stage in subprime the tightening that we've done left us with almost no subprime production in the month of March. And then lastly on the next slide, Slide 10, prime mortgage, you see the upper left, the 30day delinquency trend even moving into the prime space and as a result - which is really just the effect of home price declines bleeding into the prime mortgage portfolio - so you see net charge-offs of $50 million, up from 17 last quarter. So here again, higher losses as well as about $250 million of additions to reserves. And given we hold much of the balances here, as you see in the upper right, in corporate, where we also hold mortgage securities. Now moving on - I finished up with Retail there - let's move on to Card Services on Slide 11. So starting with profits of $609 million, down from a year ago, again driven by the $1.670 billion of credit costs, which is all charge-offs. No changes in reserves here. The charge-off rate you see down at the bottom circled of 437 basis points behaving consistently with - what we said in the second half of last year looking into this year is that we did see and expect to see a normalization, and that the first half was expected to be, in our minds, around a 450 charge-off rate with likelihood but not yet visibility into the second half of the year as we started this year that we could be approaching 5 by the end of the year. So I think at the 437 we're at now, looking ahead we do expect to see us progress towards something in the neighborhood of a 5% charge-off rate as we get to the back end of this year. On the revenue side, $3.9 billion and up 6% from a year ago. And a couple of pieces there - 3% growth in outstandings from a year ago. Charge volume of 5% overall increase, which includes a 10% increase in sales volume. Remember, we've tightened up on balance transfer offers and other promotional offers which deflate the amount of charge volume that we get from balance transfers. And then the last piece there, second bullet from the bottom, the net interest margin continues to widen a little bit to 834, which includes the shift away from low rate intro balances. Outlook, as I've said, 4.5% to 5% full year losses trending higher as we get through the rest of the year. And probably a little bit of an effective slowing card spend, which is what we've seen in the past couple of weeks. Commercial banking - on the next slide, Slide 12 - we see profits of $292 million, down a touch from a year ago. On the revenue side, up 6% from a year ago primarily driven by treasury services and lending growth which are associated with, as you see, the $68 billion and $90 - almost $100 billion of loan balances and deposit balances, respectively, which are up 18% and 22% year-over-year each, just demonstrating the growth in the client franchise there and the growth in the balance sheet and the revenues associated with that. Expenses relatively flat, so nice expansion of operating margin in the business as the team there does quite a good job. Credit costs, you see $101 million. A 48 basis point charge-off rate as we get some normalization here. In particular this quarter you see a good scrubbing of our homebuilder real estate portfolio making up the preponderance of the movement that we see into nonperformers and charge-offs in the quarter. And the outlook here, I would say it's just continued underlying growth as we've seen and credit continuing to normalize though I would say that, if you'll look at the 265 basis points of allowance to loans - to average loans among the tops in the industry. So we feel very good about the reserve levels in the Commercial Bank. Moving on to Treasury Services - next slide - profits of $403 million, up 53% from a year ago with strong pre-tax margins. The customer balances on the Treasury Services side primarily up 21% to $250-plus billion and assets under custody of nearly $16 trillion, up 7% from a year ago gets us to the 25% revenue growth we had from a year ago, which is double-digit growth in both of those businesses. And we'll just point out we do in fact benefit in this business from some of the market volatility, wider spreads on securities lending and some of the product areas helps here. So again outlook here, we would expect to see continued good growth in the business, seeing a nice flight to JPMorgan in some of the balances that our customers bring to us. And, as I said, we continue to - so long as market conditions continue to be challenged, we'll benefit from some of the market volatility on the revenue side. Last of the businesses, Asset Management on Slide 14, you see profits down for - the first time we've seen this picture in awhile - $356 million, so let me spend a minute on the story here. Revenue's down to $1.9 billion. Let me just focus for a second on the quarter-over-quarter explanation. The major component is the fact of seasonality of when we actually bill and recognize performance fees. We have a seasonal spike in the fourth quarter related to some of the hedge fund billing that we do. That, together with the decline in market levels we've seen - which is really the basis for the management fees we collect on the rest of the money management that we do - are the two factors that really bring the revenues down quarter-over-quarter. The story there I guess outlook-wise is at these levels of markets - indices and so forth - we would expect that kind of run rate of revenues is where we should expect to be barring seasonal spikes in performance fees, which we won't see again until the fourth quarter of the year. So I think there's a good level of revenues to be working with as we look ahead. Assets under management, you see $1.2 trillion of assets under management. I will just point out the very strong liquidity flows - $68 billion of liquidity flows into the business - and then other flows in the Private Bank, Private Client space, about $22 billion of flows into our client business in the first quarter, which is tremendous; obviously, much of that in liquidity as well. So while you see assets under management holding up actually up yearoveryear and flattish versus last quarter, given the mix from higher fee to lower fee liquidity products that presents an opportunity over time to move our clients into other products that give us bigger revenues. But for now, it goes back to the comments I made on revenue as we look ahead. But we do as well expect, with the hustle that we've got on the asset inflow side to see asset inflows continue. Lastly, for profits, let's talk about Corporate on Slide 15. So you see the three pieces. We've broken out the Visa gain here, so we've got - I'll start with Private Equity - after-tax profits of $57 million on Private Equity gains of $189 million. The outlook here will certainly continue to be volatile, as we've already said. I would just additionally say that I don't have much of a visible pipeline in terms of the likelihood of very many deals, though there's several that could fall into the remaining quarters of this year. But just not the same kind of visibility we had in a year like 2007, which was obviously very strong for us. But a lot of that is subject to things we don't control and what the markets allow for in terms of exits of investments. So a word of caution in predicting that. Then in Corporate, I'll just start with the Visa gain, so you see $955 million after tax. That's on the $1.5 billion of sale proceeds that come from the sale of the portion of the 50% of our ownership that we sold, net of an amount of shares that were retained by Visa to fund litigation escrow. Then we of course do have another 50% that we still own and hold on our books at cost, which is essentially zero. Corporate excluding Visa, profits of $15 million ex the sale of Visa. Lots of swing items in there. What I will do is just kind of point you to the outlook ahead, where we typically talk about $50 to $100 million negative, and I would just continue to give that as my best estimate of how to think about that on average through time though, again, that's going to be a pretty volatile line item, as you see this quarter. Moving on to Slide 16, you see capital and balance sheet, so again, a Tier 1 ratio of 8.3%, tangible common equity of $74 billion - up by about $2 billion from last quarter - growth in Tier 1 capital, all accommodating a several percentage point increase in risk weighted assets as we serve client needs. I would again say the liquidity and funding position is very strong. I don't need to repeat myself there. And then you see on a summary basis at the bottom here the allowance coverage ratios for each of our businesses which - you can check yourself match up very strongly for total credit reserves of $12.6 billion. So the sum picture there is a very strong balance sheet and funding position for the firm, which we feel good about. Let me just give one last page before I hand it over to Jamie, just some of the technicals on the accounting side and timing related to Bear Stearns. So we do expect the deal to close by a June 30th calendar we're hoping to hit. I'll just say now administratively we do expect that the month of June will be our first close of the books with Bear Stearns in it, so as a result, in looking at the tight calendar we have in July, we're going to be doing our earnings on July 22nd, a Tuesday, versus the usual Wednesday prior that we would normally do it. But too tight to do it on that timeframe, so just a heads up now. In terms of what's going to happen at the time of the close on the accounting front, we do expect I'm just summarizing the S4 that was filed, the merger proxy, so you can go back and then come back with any questions through IR - but to summarize it for those of you who haven't pored through it, we expect at a midpoint range that we put in the S4 to have an increase in our book equity, our capital, of about $5 billion, plus or minus a little bit. All these numbers are still moving and just estimates subject to change. But that's incorporating the results, estimates of results, for Bear through the - now to the close. The cost of the deleveraging that we talked about as well as various purchase accounting adjustments or structuring costs, litigation, et cetera, are all wrapped up in that. The other item you should understand is that that more or less will be the amount that - a similar amount will run through our P&L in the second quarter as an extraordinary gain, so below the line but affecting net income and that's how it gets into the capital account. Once we get beyond the second quarter, we do expect some amount of the overall deal costs, merger costs, to still be borne in the second half of the year. That could - rough numbers - could be in the range of $500 million to $1 billion after tax in the second half of the year. And then lastly, capital ratios, as we've said before, we expect them to remain strong after we do the Bear Stearns deal. And as we've said on that score, we do plan on reducing the Bear balance sheet in an orderly way. That's already under way, and it's part of the objective of the overall deal. As such, we've gotten some regulatory relief for the Bear Stearns assets that we'll be bringing on as we calculate our regulatory ratios for the next several quarters, but I'll go through all that detail when we actually put out our second quarter results in July. So with that, let me hand it over to Jamie."
},
{
"speaker": "James Dimon",
"text": "So hello, everybody. Let me - I'm going to just do two quick things. One is give you a little update on the Bear integration, and then also just an overall comment. So, you know, Bear Stearns, obviously a deal's really never been done exactly like this, but now we're in full merger mode. We have a full merger integration office. It's kind of like a military operation; hundreds, maybe even a thousand people are now involved. We've been through all the major real estate, all the major data centers, the Investment Bank will occupy all of 383 Madison, which we think is a great building. We'll be building two new brandnew trading floors there, which we think will be best in class. They already have five, so there will be seven in total. The management team - and I really should say here, the really heavy lifting - is being done by Steve Black and Bill Winters and the whole management team of JPMorgan Investment Bank, now including several members from Bear Stearns, who really are pretty much working around the clock. The next round of things is to be announcing by business - so for Equities, Fixed Income, et cetera - who the management teams are so we can go about the people selection process. We are treating it as a real merger. We're trying to get the best people to make sure we capture all the things we want to capture. All 14,000 people we hope will be informed about their future some time before the close, which we hope will happen before June 30th. And we think the better we can people - the sooner we can tell people, the better. I do want to point out that we have a talent network office set up. It's to be fully staffed. We have put a freeze on hiring for JPMorgan in New York City, not because we're afraid or anything like that because of recession but because we have a lot of open [recs], a lot of temps, a lot of consultants, and we want to give those jobs first to anyone who's dislocated in this process, whether a Bear Stearns employee or a JPMorgan employee, because some of the pain unfortunately will be also borne at JPMorgan. We'll be contacting a lot of your firms. I'll let you know that we've got some really talented people who would like to continue working, so we're really going to try to do an unbelievable job to place as many of those people as possible in New York City if they can't get something here. We have, on the systems side, we've already pretty much selected most of the major applications so we know what we're doing there. We'll start moving people in short order, in the next month or so. And we've kind of consolidated all the risk positions into one risk format. We are already deeply engaged in making sure we're looking at consolidated risk and understanding it and starting to derisk a little bit the added risk positions that come on from Bear Stearns. If you asked, I'd say it's probably down about 20% or so from the time the transaction was done. So the teams are working well together. We still think that this could be a very good thing for shareholders and that we can capture $1 billion or more of profit as we consolidate Bear Stearns in. And for the Bear Stearns folks, I just want to remind people, a lot of great talent there, a lot of really great talent. And we've been getting to know the folks, and we do nothing but get more excited about the possibilities across virtually all of our businesses. And then overall, we feel pretty good about where we are. I just want to emphasize and I'm a little bit of a contrarian, great underlying numbers, again. The underlying numbers - deposits, loans, growth, bankers, assets under management, custody - are what are going to really drive the future of this company, and we really feel good about what we see. And the Investment Bank - Mike mentioned it; I just want to emphasize it - number one, global debt and equity and [eq-related payables] for the first time ever. So congratulations to the folks who accomplished that. And with that, we will turn it over to you all for questions."
},
{
"speaker": "Operator",
"text": "Thank you, sir. (Operator Instructions) We'll take our first question from Guy Moszkowski with Merrill Lynch."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "Good morning."
},
{
"speaker": "James Dimon",
"text": "Hi, Guy."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "I just wanted to follow up on the Bear Stearns discussion. First of all, just some clarity - you said risk position's down about 20%. Would we be able to apply that number to the $30 billion or so of assets which the Fed was helping you fund?"
},
{
"speaker": "James Dimon",
"text": "No. That's a completely separate thing."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "So that 20% would be some kind of a risk adjusted notional number that you're thinking about?"
},
{
"speaker": "James Dimon",
"text": "Yeah. I'm using 20% because it's really complicated. [inaudible] like a balance sheet risk, hedging. We're just trying to get a little bit small, a little bit more de-risk as we put it on our balance sheet. So don't use that number too specifically."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "And are you still comfortable with the idea of around $1 billion of earnings run rate there?"
},
{
"speaker": "James Dimon",
"text": "Yeah. Yes."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "What would you say have been the biggest surprises and the biggest disappointments, if any, as you've kind of looked through the businesses and the risk management there?"
},
{
"speaker": "James Dimon",
"text": "Initially, when we did the transaction, we really worried much more about the downside than the upside. And now we're getting to meet the people and see all the other possibilities there. So there are very few real negatives in addition to the things we worried about before, and the positives are across most of the businesses. Some very good people [inaudible] equities, prime brokers, correspondent commodities, fixed income, mortgages, research we just see a lot of good things there. So we're working hard to try to capture all that as fast as we can."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "Are you going to run prime brokerage as a joint venture between the Investment Bank and TSS?"
},
{
"speaker": "James Dimon",
"text": "Right now it's going to stay in investment banking in the Equities business."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "And just switching gears to the CMBS exposure that you talked about, as you mentioned, you didn't highlight any write-downs there. Would that be on a gross basis or because hedges helped you out there? And could you talk about how hedging helped you in that portfolio, in particular during the quarter and maybe how that might have changed since the first of April?"
},
{
"speaker": "James Dimon",
"text": "We lost a little bit of money there, and so we're not going to get into too much specifics. There you are able to hedge because there are places you can edge in CMBS et cetera, unlike Alt-A, where it's really hard to hedge AltA. So we feel pretty comfortable with those exposures. And actually - and Mike mentioned April - things started to trade a little bit more in Alt-A [land] and CMBS - in the cash side of CMBS, not just the derivative side."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "Thanks for that. Just a question on whether you're seeing anything that would give you some signs of stabilization of the loss and delinquency rates in the home equity portfolio?"
},
{
"speaker": "James Dimon",
"text": "No. It's exactly what we saw - higher - more houses are going negative equity, roll rates are high, home prices we expect to still go down. We have not seen it. Now we'll see it eventually, but we have not seen it yet."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "And just back to the Investment Bank for a moment, is there any change in your compensation structure that you're anticipating for this year, early as it is, in terms of stock, cash mix or anything like that that would have driven a lower percentage accrual than what we usually would see for you guys?"
},
{
"speaker": "James Dimon",
"text": "No, the accrual is pretty close to what it's always been, which is for us 42%. And we make a whole bunch of adjustments; it's close to 46% if you compare it to other investment banks. The answer's no. It's really early in the year."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "Okay. And then I'm just going to revisit this issue - this is the last question - revisit this issue of your putting some of these leveraged finance assets into held to maturity or held for investment, as you called it. Obviously you're putting these assets in at a significantly marked down price, and on top of that you reserved at what's pretty close to a 10 percentage point rate. And I guess the question I have is: Is that strictly a matter of accounting mechanics, that you really can't take into account the fact that you're already buying the loan at a discount, essentially buying the loan into that portfolio at a discount to face? It just seems like you're building pretty massive reserves for that portfolio."
},
{
"speaker": "James Dimon",
"text": "Yeah, so two things. One is, the accounting rules are you move it at fair value; you calculate what the reserve would have been. If the reserve is more than the discount, you add it up. You have to add it back in. So obviously, it's conservative. It was bigger than the mark. On the other hand, we like conservative loan loss reserves, so that wasn't a negative to us because we like building loan loss reserves for rainy days."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "Yeah, I know. The economics are what they are, but clearly the net impact is what you just said, that they"
},
{
"speaker": "James Dimon",
"text": "Right. If we had not done it, we wouldn't have put up the $500 million as of that date. Those loans would change in value after that date."
},
{
"speaker": "Michael J. Cavanagh",
"text": "Yeah, that's the issue, guys. We took action before some degradation in spreads, and so we would have taken more marks during the quarter. So there's a little bit of difference - a little bit of incremental cost in the quarter related to that move, a couple hundred million dollars."
},
{
"speaker": "James Dimon",
"text": "Yeah."
},
{
"speaker": "Guy Moszkowski - Merrill Lynch",
"text": "That's fair. Okay, thanks very much for all the information. I appreciate it."
},
{
"speaker": "James Dimon",
"text": "No problem."
},
{
"speaker": "Operator",
"text": "We'll go next to Glenn Schorr with UBS."
},
{
"speaker": "James Dimon",
"text": "Hey, Glenn."
},
{
"speaker": "Glenn Schorr - UBS",
"text": "Hey, what's going on? On home equities, just finishing that thought up, have you had any success in reducing the nondraw lines, and can you remind us how big they are right now?"
},
{
"speaker": "Michael J. Cavanagh",
"text": "We do what we can do, but Charlie's answer at Investor Day and just talking to it, I wouldn't point you to it being a substantial impact despite what we've all read in newspapers about there being - the rules don't really easily allow for you to preemptively bring lines down. So I wouldn't say that there's been substantial change in risk profile as a result of doing that, though I would say we're as focused as we can be on that. I don't have the open line number off the top of my head."
},
{
"speaker": "Glenn Schorr - UBS",
"text": "No worries. And just off the top of your head, have people been pulling them down or are they just kind of hanging out there?"
},
{
"speaker": "Michael J. Cavanagh",
"text": "Well, the losses you see include - tend to be pulled-down lines at the time we're losing money."
},
{
"speaker": "Glenn Schorr - UBS",
"text": "Got it. Got it. [inaudible] A quickie on the outflows in Asset Management, around $21 billion across equities balance and alternatives. Any color there that I might have missed on the prepared remarks?"
},
{
"speaker": "Michael J. Cavanagh",
"text": "No, but it is a little bit in Europe, in our retail distribution to third parties in Europe, where - that we and others lost a little ground there. So that's where you've seen some of the preponderance of outflows. And like I was saying earlier, though, significant inflows, though at different revenue per asset levels into liquidity products was very strong, as well as great inflows into the global Private Bank franchise."
},
{
"speaker": "Glenn Schorr - UBS",
"text": "Okay. Last one for both of you all is: Obviously, the Bear transaction's pretty involved and tapping a lot of people's time, but it doesn't really impact the retail banking side of the house. Given your [inaudible] ratios, given that in a weird way this is the environment you've been waiting for and a lot of - it feels like properties are getting cheaper and available, do you have the bandwidth to take on something if something was attractive now?"
},
{
"speaker": "James Dimon",
"text": "Yep."
},
{
"speaker": "Michael J. Cavanagh",
"text": "Yep."
},
{
"speaker": "Glenn Schorr - UBS",
"text": "Enough said. All right. Thanks, guys."
},
{
"speaker": "Operator",
"text": "We'll go next to Mike Mayo with Deutsche Bank."
},
{
"speaker": "Michael Mayo - Deutsche Bank",
"text": "Good morning."
},
{
"speaker": "James Dimon",
"text": "Good morning, Mike."
},
{
"speaker": "Michael Mayo - Deutsche Bank",
"text": "Can you elaborate on the commercial and wholesale NPAs, which were up by over half? And I recognize that loans to homebuilders are going bad, but what else is causing the increase in those out there?"
},
{
"speaker": "James Dimon",
"text": "I guess it's up by half from a very low level, so a few hundred million dollars of increase in nonperformers on, what, a $60, $70 billion portfolio I would say more in the category of getting a little bit of normalization. But I would say the largest explanation is we've got about $1.5 billion of loans to homebuilders. Todd and Team Maclin have scrubbed that portfolio hard given everything that's going on. As a result, some charge-offs and movement of like half or a little more of the change in nonperformers and a little bit more of the charge-offs relate to just that activity. The rest is just generally spread around."
},
{
"speaker": "Michael Mayo - Deutsche Bank",
"text": "And I guess the bigger question is: Are the problems from homebuilders and homes spreading more to commercial? Is it more than simply normalization?"
},
{
"speaker": "Michael J. Cavanagh",
"text": "It's real estate is getting worse, yes."
},
{
"speaker": "Michael Mayo - Deutsche Bank",
"text": "And your bread-and-butter commercial companies?"
},
{
"speaker": "Michael J. Cavanagh",
"text": "Not much more than normalization there."
},
{
"speaker": "Michael Mayo - Deutsche Bank",
"text": "Okay. And as it relates to the Bear transaction, what will your pro forma book value or tangible book value be?"
},
{
"speaker": "James Dimon",
"text": "That $5 billion that Mike gave will go right directly to the equity account."
},
{
"speaker": "Michael Mayo - Deutsche Bank",
"text": "And you said capital ratios afterwards would be strong. Can you give any [bents] relative to your 8.3% Tier 1 ratio?"
},
{
"speaker": "Michael J. Cavanagh",
"text": "Yeah, our intent is to maintain similar strong ratios going forward, so with Bear Stearns, we're getting some equity. We also get some preferred. We get a lot of long-term debt. We're still working on making sure the risk grade assets are coming down a little bit. But when all is said and done, quarter by quarter we will have pretty strong ratios."
},
{
"speaker": "Michael Mayo - Deutsche Bank",
"text": "And then lastly, prime mortgage loan losses went up, too. I mean that's, to some degree, expected, but we heard a lot about subprime and Alt-A and home equity. Can you elaborate on prime mortgages?"
},
{
"speaker": "James Dimon",
"text": "They're getting worse, Mike."
},
{
"speaker": "Michael J. Cavanagh",
"text": "It's home prices burning through whatever underlying - whatever lies under the prime mortgage, and then the same dynamics."
},
{
"speaker": "Michael Mayo - Deutsche Bank",
"text": "All right. Thank you."
},
{
"speaker": "Operator",
"text": "We'll go next to Betsy Graseck with Morgan Stanley."
},
{
"speaker": "Betsy Graseck - Morgan Stanley",
"text": "Thanks. A couple questions, one on Bear. The billion dollar run rate that you're expecting there, given the expectation that you're de-risking the portfolio I would think that means that we should assume that the revenue run rate should come down so you're hitting the billion number with the cost saves. Is that a fair way of thinking about it?"
},
{
"speaker": "Michael J. Cavanagh",
"text": "Yeah, all in. Yes. That's a fair way to think about it."
},
{
"speaker": "Betsy Graseck - Morgan Stanley",
"text": "Okay."
},
{
"speaker": "Michael J. Cavanagh",
"text": "It may take a little bit of time to get that, but that's what we do expect still."
},
{
"speaker": "Betsy Graseck - Morgan Stanley",
"text": "Yeah, because -"
},
{
"speaker": "Michael J. Cavanagh",
"text": "And possibly better, by the way. We're not saying it can't be better because we're still working on all the issues. Like I said, this was not a merger done in an ordinary course."
},
{
"speaker": "Betsy Graseck - Morgan Stanley",
"text": "Right. I mean, it's just the 8-K - the Bear 8-K that was put out last week indicated the degree to which revenues were hit recently. Maybe you could comment a little bit as to what you think the run rate of revenues is relative to what they'd indicated in the 8K?"
},
{
"speaker": "James Dimon",
"text": "We really can't because we didn't spend much time reconciling all that."
},
{
"speaker": "Betsy Graseck - Morgan Stanley",
"text": "Yeah, okay."
},
{
"speaker": "James Dimon",
"text": "I'd like to just mention, in terms of - someone asked about the bandwidth of our ability to do a retail deal and Bear Stearns, and one of the reasons we were able to do something like Bear Stearns is because we have the management teams who can actually execute it. And we've spoken before in the past about price has to be right, the ability to execute, and so we also have a management team in Retail that can execute it, people who have already consolidated systems. They're on top of what they've done. We did the Bank of New York transaction. So we actually have the management teams and the systems and the back office who can execute things like this, and that's what makes it possible. I would tell you several years ago, it would not have been possible."
},
{
"speaker": "Betsy Graseck - Morgan Stanley",
"text": "And there was some speculation that you had been involved in looking at the WaMu transaction. Is that something that you can comment on?"
},
{
"speaker": "Michael J. Cavanagh",
"text": "We're not going to comment on it, but you should assume we look at everything."
},
{
"speaker": "Betsy Graseck - Morgan Stanley",
"text": "Right. Okay. On just the loan growth and the asset growth generally, I mean, when I look on a consolidated basis, the Q-onQ growth rates are slowing. But when I look at specific - you know, there's obviously some specific pockets of acceleration, like in commercial loans, not only in the Investment Bank but also in the Commercial Bank and then, you know, your trading assets, in particular derivative receivable trading assets - could you comment a little bit as to what's driving the growth rates in those categories and whether that's proactive on your part, the degree to which it is proactive on your part versus customers drawing down lines or utilizing your balance sheet?"
},
{
"speaker": "James Dimon",
"text": "I'll comment on the derivative one. Maybe Mike will do the loan one. On the derivative side, remember, that number bounces all over the place because they're marked to market, and what starts with no receivable can become a very large receivable depending on how things move. Remember, a lot of those are fully collateralized, so it isn't like you have that kind of exposure on all of that. So that's always going to bounce around. And obviously as you grow your business, the chance of that volatility - of that asset moving around and growing is higher."
},
{
"speaker": "Michael J. Cavanagh",
"text": "And then on the loan side, I'll just tackle Commercial Bank because I think it's indicative of other places. We think this is a great window of time to be there for our clients, so yeah, there is a degree to which it's existing clients that we're providing capacity to. I would say, just going back to the real estate comments, it's general, commercial and industrial more so than it is commercial real estate there, as a point. Yeah, government not-for-profits for some of the dislocations in the muni space. There's activity going on there. But also this is a great window of time to go after the prospects that we have in middle-market banking, for example, around the country, and that is what our folks are actively doing. And it's true there. It's true in the Private Bank that it's a - we definitely [go in commenting] on it. We want to use this time to build our franchise, so to be there and use our balance sheet in a smart way to build the franchise for the long term and take market share and get new business as well as cement existing relationships I would say is the general nature of the loan growth."
},
{
"speaker": "James Dimon",
"text": "And Mike mentioned it, but I should add that on that slide on leveraged loans, there's $3 billion of new loans. That included one fairly large one, but it also included 10 or so much smaller ones. We're still in business, and we're still willing to do that. We still want to facilitate clients. And so we look at that as a positive sign to indicate leveraged finance was still there. Give us a call."
},
{
"speaker": "Betsy Graseck - Morgan Stanley",
"text": "So when you're thinking about the capital ratios that you want to be holding, and I know you've talked long about having a fortress balance sheet and your changeable equities - definitely highest in the peer group - how do you think about the opportunities to grow, given the size of the balance sheet you've got today, what you've got coming on from Bear, relative to peers? Because you do live in a relative world, and you do have some peers that are increasing capital ratios to deal with deteriorating credit and extending duration on their assets."
},
{
"speaker": "Michael J. Cavanagh",
"text": "I guess, Betsy, I'm not worried about us falling out of the place we hold on a relative through time. But I would say that the important thing is, well, we use this as an opportunity to really make sure we maintain efficiency of the balance sheet. So all of our businesses understand the importance of maintaining strong capital position and how it's benefiting the business broadly, so are actively working hard to use tougher times to make sure we eliminate wasteful use of the balance sheet so we can re-deploy it in normal course without having to see our capital ratios degrade. So that's the general dynamic. Beyond that, the last thing we want to do is close down for ongoing business. It would hurt the franchise, and that's not the point of trying to - it wouldn't be the point to try to maintain strong capital position at the expense of the franchise."
},
{
"speaker": "James Dimon",
"text": "Yeah, and look. We've been adding - I think we started early, but we've been adding jumbo loans to the balance sheet. We're growing the mortgage business. We're growing loans and deposits in the Private Bank. We're growing - I mean, we're not - we haven't scrimped. We want to grow and have the ability to grow intelligently. If you ever do a really big transaction, you can always finance that, too. You don't have to try to do it off your own balance sheet."
},
{
"speaker": "Betsy Graseck - Morgan Stanley",
"text": "Okay. Thanks."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) We'll go to Jeff Harte with Sandler O'Neill."
},
{
"speaker": "Jeffrey Harte - Sandler O'Neill & Partners L.P.",
"text": "Good morning, guys."
},
{
"speaker": "James Dimon",
"text": "Hey, Jeff."
},
{
"speaker": "Jeffrey Harte - Sandler O'Neill & Partners L.P.",
"text": "You talked a little bit about prime mortgage and that it's definitely getting worse, but I look at a 48 basis point charge-off ratio in prime mortgage and say, \"Wow, that's pretty bad.\" I mean, from that as a base, how much worse do you envision it getting or could it get?"
},
{
"speaker": "Michael J. Cavanagh",
"text": "First of all, the risk factors in prime mortgage are exactly the same you've seen elsewhere, which is negative home prices, high LTV, things like that. And I think it'll probably get a little bit worse. And we probably owe you a better answer than that - we did not - but it's hard in almost all these mortgage areas to say exactly what's going to happen to behavior, and you and I - you can guess as easily as we can what's going to happen to home prices. We expect they'll go down another 7%, 8%, 9% in '08."
},
{
"speaker": "Jeffrey Harte - Sandler O'Neill & Partners L.P.",
"text": "Okay. And in Asset Management, just doing back-of-the-envelope math, I mean, looking at revenues, annualizing them and looking at the assets under management, I'm getting something like a 48 basis point fee yield. That seems kind of low. I understand there's a lot of stuff going on. Were there any fee reversals of previous incentive fees or anything like that in the quarter, previously recorded incentive fees?"
},
{
"speaker": "Michael J. Cavanagh",
"text": "Nope. Nope. Like I said, the timing of all the kind of performance-driven fees is unfortunately not smooth over time. So you obviously have the issue of what is performance, but that wasn't the issue in this case so much as a fourth quarter spike. We come off that at the same time we have asset levels due to markets coming down and bringing so there was - you had a double effect."
},
{
"speaker": "Jeffrey Harte - Sandler O'Neill & Partners L.P.",
"text": "Okay. And in Commercial, commercial lending specifically, as we look forward, I guess looking at a 38% year-over-year loan growth, it makes me a little concerned if we're seeing mass credit deterioration. Some of these loans you're putting on today, you may wish you didn't have them six, eight months from now if credit goes the wrong way. How comfortable are you with overall kind of commercial credit quality and where we're heading?"
},
{
"speaker": "James Dimon",
"text": "Well, assuming that we have the exact same concerns you have, we have been very careful. So assume that we think we're getting good credits. And Mike mentioned government not-for-profits, that's a big piece of the recent growth. And we think the people we're doing business with are good credit, so we're being careful. And, as you know, a lot of it is not real estate. That portfolio's gone down."
},
{
"speaker": "Jeffrey Harte - Sandler O'Neill & Partners L.P.",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "And we'll go next to Meredith Whitney with Oppenheimer."
},
{
"speaker": "Meredith Whitney - Oppenheimer",
"text": "Hi. Good morning."
},
{
"speaker": "James Dimon",
"text": "Hi, Meredith."
},
{
"speaker": "Meredith Whitney - Oppenheimer",
"text": "My questions are all around consumer. I wanted to get some comments on what you're seeing in auto, why you're growing that portfolio. And then more broadly on your funding strategy with respect to consumer, the higher cost of funding and securitization market - has your strategy for funding any of your consumer buckets changed? And then competitively, as it's changed for your competitors, what do you see the outlook there in terms of market share gains or potential problems because of a slowdown in available credit for consumers at large? If you could comment on that, that'd be great."
},
{
"speaker": "Michael J. Cavanagh",
"text": "I guess in funding consumer, you know, non-card - obviously our name in the card funding space is a strong issuer of securitization on the card funding side. We'll continue to do that as a main source of funding. I think when we look at the other categories of consumer assets, the securitization markets tend to be more expensive than us just raising the natural sources we have coming through the deposit side, particularly of the Retail business itself but the firm more broadly. We don't have that as a - we have a wealth of deposits, so we're not a price leader in terms of ratcheting deposit prices higher, so we do need to be conscious of what we see going on with competitors in the regional markets that we operate in on the deposit side having fewer sources of funding and thus pushing deposit pricing up. So we're mindful of that as the major source that we have for consumer funding. And I guess --"
},
{
"speaker": "James Dimon",
"text": "But strategically, we're always better off. We have all the options - our cost of funds are lower, we have multiple sources of funding, so whatever happens, we're still better off than the competitors."
},
{
"speaker": "Michael J. Cavanagh",
"text": "Did that help, Meredith?"
},
{
"speaker": "Meredith Whitney - Oppenheimer",
"text": "Well, to the extent that - yeah, you're better off and you benefit on one level because you have more access to funding. On the other side, though, you're hurt in a way because, as the consumers get squeezed and lines are pulled from those who can't access securitization and don't have as ready a deposit base, how do you see that impacting your business, just a broad base? And then not to forget the auto outlook, please"
},
{
"speaker": "James Dimon",
"text": "Yeah, the auto outlook - and we're still in the auto business, and we try to do credit right; we're not going to stop making loans because people think things might get worse. So we're growing the auto business carefully. We've tightened up standards there just like we've tightened them up everywhere else. And it may be that we're just we're still in business, which is why the business is growing like that. The other thing about how it affects us because other people are pulling lines, that's more of a question about how bad the recession will get. Obviously, the worse the recession gets, the worse it is for us. But we're not going to sit here and spend a lot of time worrying about what other people are doing. We're going to just build our own business. In a lot of these areas, we've been gaining a little bit of share. We're still open for business in the mortgage side - jumbo, Alt-A, subprime, even though we're doing very little of it - because we're here for business, you know? We're not - we're here for clients, ultimately. These franchises are great franchises that we want to grow for decades, not flip and flop every time the economy sneezes."
},
{
"speaker": "Meredith Whitney - Oppenheimer",
"text": "All right. Thanks."
},
{
"speaker": "Operator",
"text": "Mr. Dimon and Mr. Cavanagh, there are no further questions at this time."
},
{
"speaker": "James Dimon",
"text": "Wow."
},
{
"speaker": "Michael J. Cavanagh",
"text": "Okay, great. Thanks, everyone. Look forward to talking to you next quarter."
},
{
"speaker": "James Dimon",
"text": "Thank you."
},
{
"speaker": "Michael J. Cavanagh",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "That does conclude today's call. Thank you for your participation. Have a good day."
}
] | null | null |
KO | 4 | 2,008 | 2009-02-12 09:30:00 | Executives: Jackson Kelly - Vice President and Director of Investor Relations Muhtar Kent - President and Chief Executive Officer Gary P. Fayard - Chief Financial Officer
Analysts: Judy Hong - Goldman Sachs & Company, Inc. Marc Greenberg - Deutsche Bank Securities John Faucher - J.P. Morgan Kaumil Gajrawala - UBS Christine Farkas – BAS-ML Lauren Torres - HSBC Mark Swartzberg - Stifel Nicolaus & Company, Inc. Carlos Laboy - Credit Suisse Celso Sanchez – Citigroup
Operator: Welcome everyone to The Coca-Cola Company fourth quarter 2008 earnings results conference call. (Operator Instructions) I would now like to introduce Jackson Kelly, Vice President and Director of Investor Relations.
Jackson Kelly: Good morning and thank you for being with us today. I'm joined by Muhtar Kent, our President and Chief Executive Officer, and Gary Fayard, our Chief Financial Officer. Following prepared remarks this morning by Muhtar and Gary we will turn the call over for your questions. Before we get started I'd like to remind you that this conference call may contain forward-looking statements, including statements concerning long-term earnings objectives, and should be considered in conjunction with cautionary statements contained in our earnings release and in the company's most recent periodic SEC report. In addition, I would also like to note that we have posted schedules on our company’s website at www.thecoca-colacompany.com under the Financial Information tab in the Investor section which reconciles certain non-GAAP financial measures that may be referred to by our senior executives in our discussion this morning and from time to time in discussing our financial performance as reported under generally accepted accounting principles. Please look on our website for this information. Now let me turn the call over to Muhtar.
Muhtar Kent: I am pleased to report that we have delivered another quarter and year of strong financial performance. This marks our ninth consecutive quarter of double-digit comparable EPS growth and the third straight year of meeting or exceeding our long-term growth targets. Our results reflect the hard work and dedication of our global system through this incredibly challenging economic environment. Together with our bottling partners we are assertive and flexible in terms of managing our business, focusing strategies, accelerating actions, redirecting investments, and being prudent with our capital and other expenditures, while maintaining a disciplined long-term approach to our operations. Our performance for the quarter and full year underscore our firm belief that there is no better business to be in than non-alcoholic commercial beverages. In a challenging environment we added another billion incremental unit cases in volume, essentially another Japan, our fifth largest volume market. We firmly believe our industry will continue to experience growth across all categories and geographies as macro population and person expenditure trends still highly favor the simple moments of pleasure we bring to our consumers over 1.5 billion times a day, a cent at a time. Strong, decisive execution based on focused strategies enabled us to deliver continued global volume and value share gains across key geographies as well as categories. As we all manage through these globally challenging times, volume and value share gains will continue to be critical benchmarks for our performance progress. We remain on track to deliver $0.5 billion in annualized savings from productivity initiatives by 2011. The continued acceleration of these efforts are going to enable our cash to be re-deployed to drive investments for sustainable growth. And there is no question that this year will pose unique macroeconomic challenges for all businesses. That said, we are not content to just ride out the storm, rather we will leverage this as an opportunity to further build the equity of our brands and drive value for our system and customers. Our highly skilled management team has navigated through a very difficult operating conditions around the world before and is well equipped to run our operations in these challenging times. I’m confident that our solid brands, as well as our business fundamentals, coupled with a sound balance sheet, robust cash generating model, and strong bottling partners spread across all five continents, provide a sound foundation for our management team to continue delivering against our long-term targets this year and position our company and our system to become even stronger over the long term. Looking at this past quarter and year, we delivered 4% unit case growth for the past quarter and 5% unit case growth for the full year of 2008. Our international operations again led the way with 6% volume growth for the quarter and the full year. In close, close collaboration with our bottling partners, we are building from a strong competitive position with share that is three times that of our nearest competitor to drive continued, solid international growth. This growth was well balanced across the entire globe as each of our five geographic operating groups outpaced the industry for the year, resulting in consistent top- and bottom-line performance. By any measure, we continue to believe these are strong results. We credit our performance to a consistent set of strategic initiatives. Now I would like to take you through some of the progress we have made against those strategic initiatives. First, drive growth in sparkling and still beverages. Sparkling beverages are the very oxygen of our business, as I’ve said many times. Unit case volume for sparkling beverages grew 2% for the full year with our international performance up 4%, representing incremental growth of 0.5 billion unit cases last year. Full year global performance was driven by Coca-Cola, up 2%; Coca-Cola Zero up 35% with nearly 600.0 million unit cases sold; Sprite, which became our third trademark to reach 2.0 billion unit cases in annual volume, was up 6%, led by countries like China and India; and Fanta, driven by innovation, was up 3%. Coca-Cola continues to be the brand that consumers love most around the world with a three-to-one favorite brand preference versus our global competitor. Our Olympic sponsorship is a great, great example of how incremental investments have an exponential impact on building the global equity of our powerful brands. During the most successful Olympic activation in our history, we connected with more than 0.5 billion consumers in China and were cited by many as the most recognized and effective sponsor of the Beijing games. Also, we are continuing to build on the heritage as well as the incredible global appeal of our flagship brand with the recent launch of our new worldwide Open Happiness campaign. This exciting new integrated marketing campaign is the next generation of the Coke Side of Life and stays true to Coca-Cola’s 123-year heritage, while opening new doors to connect with consumers around the world in a relevant and timely manner. Again, this year our ads rated highly during Super Bowl, and importantly, Open Happiness will be leveraged globally with launched in most of key markets by mid-2009. Importantly, we gained sparkling beverage share globally for the quarter and the year across most of our key global markets. Our still beverage unit case volume increased 13% for the year, driven by strong growth in existing brands and several strategic brand acquisitions. Internationally still beverages were up 17%. Still beverage growth across each of our operating groups drove category volume and value share gains globally. Leading the way were gains by Vitaminwater and our global juice, tea, coffee, as well as energy brands. Our strategy to build on the world’s strongest juice business continues to succeed. Minute Maid Pulpy, already a huge success in China, is being expanded to several other key international markets. Here in North America our multitude juice strategy continues to outperform the category and drive share gains. The Simply trademark is quickly approaching billion-dollar brand status. Our Latin American acquisitions are providing growth and scale to drive efficiencies for our bottling partners. In 2008 we continued to innovate with new brand launches such as the successful Original Leaf Tea in China. We are also leveraging our partnership with Illy and launched this ready-to-drink coffee in ten markets in close collaboration with our bottling partner Coca-Cola Illy. Glaceau, led by Vitaminwater, remains well on track to become a $2.0 billion trademark through continued volume and value share gains and we have several new product innovations in store for this year. we grew Glaceau double digits in the quarter as well as full year in the U.S. while expanding this great brand to five international markets in 2008. And finally, better marketing focus drove performance for our critically important Georgia coffee brand in Japan. Unit case volume for Georgia grew 2% for the year in 2008, driven by 9% growth in key core Georgia flavors. Before I move on to a summary of our geographies, let me briefly touch on two innovations that many of you will get to experience at the upcoming Cagney Conference next week in Florida, one in ingredients and the other in equipment. In 2008 we announced two significant advances. First, the introduction of products sweetened with Truvia, an all natural non-nutritive sweetener. We have already launched several products, two new Aguila flavors along with Sprite Green, the first sparkling beverage enhanced with this break-through sweetener. Also we are announcing the launch of Vitaminwater Ten, the perfect combination of ten naturally-sweetened calories and great taste. Second, last September we unveiled our breakthrough fountain dispensing technology that empowers consumers to select from over 100 branded beverages in the same footprint as our current six-valve fountain. Through unique design and micro-dosing technology this is surely something you will want to try first-hand at the Cagney Conference next week. These are just two examples of how the Coca-Cola Company is applying new thinking and new ways of quickly leveraging our R&D investments across our global operations. We continue to leverage our geographic footprint in over 200 countries where our three-fold strategy is focused on: first, leveraging our share leadership position for profit in developed markets; second, driving value as we achieve scale in developing markets; and investing for volume growth in the emerging markets. Let me share a few highlights from some key markets. In Japan we delivered our largest unit case volume year on record, successfully cycling 3% growth in the prior year, resulting in non-alcoholic commercial beverage share gains. We continue to invest in our three-cola strategy and this investment paid off with the 5% growth of sparkling beverages during the year, led by trademark Coca-Cola. Europe grew 3% for the year, cycling 5%, continuing our successful efforts to gain share in both sparkling and still categories. Continued expansion of Coke Zero was strong in European marketing platforms such as our 007-Bond activation and the Christmas activation on Coca-Cola drove our sparkling beverage growth. And in Latin America, which is a great example of how we achieved scale in a developing market very rapidly. We delivered solid balanced growth with all Latin America business units delivering mid- to high-single-digit unit case volume growth and share gains for the year. Coca-Cola increased 4% and still beverages increased 40% as we continued to leverage the regionally important [Kuka Staballa]. In Russia, unit case volume increased slightly for the year, primarily the impact from unseasonable weather during the summer and economic pressures at year end. Despite the slowdown of volume growth in Russia, we gained volume and value share in non-alcoholic registered drink beverages in the quarter and full year. The fundamentals of our business in this key market remain very strong. In Turkey, one of our leading emerging markets, we increased unit case volume 11% in the quarter and 15% for the full year as we benefitted from the strength of our brand portfolio and solid execution by Coca-Cola Bishkek, our bottling partner. Importantly, in our 120 countries with per caps less than 150, our volume growth was 9% for the year, cycling 11% in the prior year. We continue to believe we are early in the game in key emerging markets. To that end, this past year we grew volume 19% in China and 14% in India, the two fastest growth economies in the world. While China is clearly expecting slower GDP growth this year, we are confident in our plans to ensure our brands as affordable consumers’ favorites continue to offer real value to Chinese consumers during these difficult times. During 2009 each of our operating groups will continue to execute against our strategies and focus on delivering consistent results. We will continue working closely with our bottling partners in these challenging times to adapt to conditions on the ground and better meet the needs of our consumers, as well as customers. In North America, we along with so many other industries, are facing some of the most challenging economic conditions in the world. However, we made real progress last year. In what is arguably the world’s most competitive beverage market, I am pleased that our brand portfolio is getting stronger, our customer relationships are improving dramatically, and we have a more aligned and capable bottling system. The continued success and enduring investment in this progress is enabled by a relentless ongoing focus on cost management and productivity. The fundamental measurement of our results is brand health and share gains. Clearly, the volatile economic environment and bottler price increase impacted our results, however, it is important to recognize we outperformed the industry. When measuring across all channels, we gained volume and value share in the quarter and the full year. In fact, the Coca-Cola Company owned five of the top ten fastest growing trademarks in incremental retail sales in North America for 2008 with Coca-Cola Zero, Glacéau, Simply, Nos, and FUZE. And our system also handled half the volume of the Monster trademark, given us access to a sixth brand. Real and tangible progress is being made in strengthening our aligned with our bottlers, as illustrated by strong customer teamwork across our system. We have a rigorous portfolio effectiveness and efficiency initiatives with our bottlers as we move forward. These actions are ongoing and we expect will drive incremental gains and long-term profitability for our system in North America. Our marketing and innovation calendar for North America is robust with numerous activities across the portfolio. As the economic environment strengthens, we believe our continued investment in our brands, customer and franchise relationships, will enable us to return our sparkling brands to growth and accelerate continued growth in our still brands. Before I turn the call over to Gary, let’s just step back and review what makes the Coca-Cola Company’s model so special. First, we have some of the best brands in the world and the cash flow to keep investing in them to build long-term equity with our consumers and customers. Second, our invested capital generates high returns. Simply said, we were built for times like these. The Coca-Cola system generates up to $50.0 million of cash per day. Our fundamentally sound balance sheet allows us to pursue growth and we have demonstrated the ability to deliver a reliable dividend which has increased each of the last 46 years. We enter 2009 with the same mindset as one year ago: deliver on a consistent set of strategies and initiatives that provide us a disciplined road map to operate in the best consumer business in the world, a business with significant long-term opportunities. We have a tradition of delivering growth over the long term and it is our intention to continue to drive long-term balance to sustainable growth for the benefit of our shareholders. Our picture of success this year is clear. First, maintain simplicity by focusing on a critical set of measurable deliverables. Second, increase the speed and efficiency of execution to capitalize on opportunities while mitigating risk. And third, remain constructively discontent in all that we do in order to deliver against our long-term growth targets and enhance our long-term brand and system health. With that, let me now turn the call over to Gary.
Gary P. Fayard: As Muhtar indicated, we once again delivered strong financial results in the quarter, resulting in our ninth consecutive quarter of double-digit comparable EPS growth and our third consecutive year of delivering against our long-term growth targets. We continued with our disciplined approach to financial management using our many business levers, consistent volume, solid price mix, improving operating expense leverage, and disciplined capital allocation to deliver value customers, consumers, and share owners, even in this difficult operating environment. Our management’s effort to diligently execute our strategies and work with our bottlers to adapt to the marketplace is a testament to the resilience of our business model and the talents of our employees. We reported earnings per share of $0.43 per quarter on a diluted basis in the quarter, however, this included a net charge of $0.21 per share. $0.15 of the net charge was related primarily to our proportionate share of the non-cash impairment charge recorded by Coca-Cola Enterprises. The remaining $0.06 of the net charge was primarily related to asset impairments, restructuring charges, and costs related to our global productivity initiatives. Therefore comparable earnings per share was $0.64 per share, an increase of 10%. For the year, recorded EPS was $2.49. Comparable EPS was up 17% to $3.15. The net charge of $0.66 per share primarily related to non-cash impairment charges recorded at Coca-Cola Enterprises in the second and fourth quarters as well as asset impairments, restructuring charges, and costs related to our productivity initiatives. For the year unit case volume growth was 5%, essentially in line with concentrate sales. Revenue growth was 11% as we balanced the volume and value equation by delivering a 4% increase in concentrate sales, a 3% favorable impact from price and mix, and a 4% currency benefit for the year. Full year comparable operating income was up 17% as our productivity efforts have begun to pay off and includes a 6% benefit from currency. Again, ahead of our long-term targets. Importantly, our advantageous geographic diversity played a key role with each of our international operating groups contributing to our profit growth for the year. In terms of margins, our core business remains healthy, expanding margins for the full year as we drove top-line growth and delivered operating expense leverage. Bottling investments continues to improve margins as well. In the fourth quarter you will have noticed that we delivered significant operating expense leverage. We do not expect to achieve that Q4 leverage in 2009. Rather we would expect the run rate for 2009 operating expense leverage to be more in line with our 2008 full year results. Our productivity initiatives remain on track to deliver $500.0 million in annual savings by year end 2011 and we are accelerating efforts to rewire the organization to support our next era of growth. Cash flow from operations for the year increased 6% to $7.6 billion on strong underlying business performance. But you may have noticed that working capital was a $700.0 million year-over-year use of cash. The working capital change was primarily one-time international tax payments which will reverse in 2009 and cash payments related to restructuring charges and our costs incurred for productivity initiatives. Excluding these items, cash from operations increased 13%. As part of our ongoing productivity initiatives we will continue to focus on managing our working capital in 2009. We repurchased approximately $1.1 billion of our stock for the full year in line with our prior guidance. Additionally, the company paid $3.5 billion in dividends to shareholders in 2008. Our balance sheet remains fundamentally strong with solid interest coverage ratios and a conservatively invested cash position of $4.7 billion. Now let me address some of the factors that we see impacting 2009. First, let me reiterate Muhtar’s sentiment, there is no question that the coming year will pose macroeconomic challenges for all businesses but we will not be content to just ride out the storm. We will leverage this as an opportunity to drive our business for the long-term and build on our track record of success. We have continued to evolve and improve our operational and fiscal discipline while building on our solid foundation with consistent strategic priorities. Our seasoned management team is poised to continue to do so in 2009. As you know, our long-term currency-neutral growth targets are 6% to 8% operating income growth and high single-digit ongoing earnings per share growth. Our picture of success for 2009 is to achieve those targets as well as enhancing brand health and gaining share despite the difficult operating environment. Additionally, we will track share gain across all of the key markets and categories. On concentrate pricing we will continue to work in alignment with our bottlers to adjust our occasion, brand, price, pack, and channel architecture to bring value to both our customers and consumers. As always, our intention is to take pricing in line with our bottlers net retail pricing over the long term. As in the fourth quarter, our revenues will continue to be impacted due to structural changes primarily related to disposal of bottlers. We would expect a similar drag during a portion of 2009 as we cycle the sale of the re-milled bottler in Brazil at the end of Q2 and the Pakistan bottler investment at the end of Q3. We expect to deliver operating expense leverage on both the core business and bottling businesses in 2009. We will continue to invest behind our brands and innovation initiatives. Additionally, selling and service expenses will increase as we invest for growth in our bottling operations as well as investments behind our band acquisitions, particularly in North America. G&A expenses were tightly controlled in 2008 and we will continue with our disciplined approach in 2009, including further progress on our productivity initiatives. As for our pension plan, we remain on fairly solid ground, however, we were impacted by declines in the value of plan assets and a lower discount rate. As a result we would expect pension expense to increase $0.03 to $0.04 per share in 2009 as compared to 2008. From a capital expenditure standpoint, we purchased approximately $1.8 billion in net property plant equipment during 2008. For 2009 we would expect the total company net capital expenditures to be approximately $1.8 billion to $2.0 billion as we continue to make investments in our business as well as recently acquired bottling operations. For share repurchase, we do not plan to repurchase additional shares in 2009 due to the pending acquisition of Huiyuan Juice Company in China. Now let me move to currency. As expected, currency has proved to be a headwind in the fourth quarter, impacting comparable operating income by a negative 9%. As for our 2009 currency outlook, it is obviously a very volatile environment and there are no clear trends for the U.S. dollar. As we are all observing, the market’s risk perspectives continue to evolve and may move to mute the attractiveness of the dollar as the year progresses. However, there are many different scenarios that could play out and we are managing against this backdrop. We are effectively 100% hedged on key hard currencies like the Euro and the yen for all of 2009, but emerging market currencies continue to be particularly volatile and provide the highest risk and opportunity for our currency expectations for this year. Base on our current hedge position, we are expecting an estimated 10% to 12% headwind from currencies in the first quarter and will provide further updates as we progress through the year. It is important to note that we manage our business in local currency to ensure we make the right decisions for the long-term business health. For 2009 our best estimate is that the full year underlying effective tax rate will be approximately 23% to 24%, up from the rate of 2008 largely due to the impact of currency. Finally, let me say a few words about quarterly phasing. As many of you know, we report quarterly unit case volume growth on an average daily sales basis to eliminate comparability issues due to calendar variations. For 2009 we will have one fewer day, since 2008 was a leap year. first quarter of 2009 will have five more days than Q1 2008 and the fourth quarter of 2009 will have six fewer days versus Q4 2008. This will not impact our unit case sales reporting but will impact our concentrate sales and therefore revenues. Additionally, both Easter and the impact of July 4th U.S. holiday will shift into Q2 this year. We expect 2009 will be a challenging but successful year. We continue to be a consistent generator of operating cash flow providing attractive, long-term returns to our shareholders. Well, that’s it with what I wanted to cover this morning. We are ready for questions.
Operator: (Operator Instructions) Your first question comes from Judy Hong - Goldman Sachs & Company, Inc.
Judy Hong - Goldman Sachs & Company, Inc.: Muhtar, can you speak to the volume strength that we saw in fourth quarter in a lot of the international markets? And if you can go through whether this is really driven by the category being very resilient in the face of the economic downturn or you’re just maybe gaining more share in those markets. And then, as we look out at 2009, you talked about the picture of success in 2009, meeting your long-term targets, does that apply to the volume targets of 3% to 5% as well?
Muhtar Kent: The answer to the first part of your question is both, the resilience of the category. As I said many, many times, we are selling moments of pleasure billions of times a day. More than 1.5 billion times a day, a cent at a time, and our bottling partners have been continuing to invest very heavily on the ground in equipment, with the customers in the past two or three years, and I think that’s paying off. We had a balance growth. Our developed markets like Europe grew as well as our emerging markets and Latin America grew. Eurasia and Africa grew very well. The brick markets, particularly India and China, had a very strong quarter in the last quarter of last year. So I think overall we have had a very strong quarter. As far as going forward, we recognize the challenges, our picture of success still remains to meet our long-term growth targets, but we have said we will have bumps along the road. And we may not achieve our targets in one or two quarters, that is possible. But our picture of success remains to continue to drive investments, to ensure that we are investing in the health of our brands, and to ensure that we gain market share as we have done this past year—this past quarter and this past year—and to come out of this tunnel with stronger portfolios, strong brands. And one thing you will not see us doing is that we will not cut our communication with our consumers. We will continue to invest with our bottling partners. Our bottling partners’ appetite for investment remains very strong around the world and that is a very good litmus test of what’s happening in the marketplace with our system.
Judy Hong - Goldman Sachs & Company, Inc.: In relations to that, we have seen media rates coming down pretty substantially. Is there an opportunity to kind of look at the marketing expense line and get more leverage and maybe flow some the more productivity savings to the bottom line in this environment where the media spending is trending down?
Muhtar Kent: Well, even when media costs were not trending down, we were achieving significant efficiencies in our marketing. We have much fewer agencies that we are working with. We have consolidated our agencies. The Coke Side of Life campaign was leveraged all across the globe as will be the Open Happiness campaign. The new Open Happiness campaign agency numbers have gone down by more than half and I think we have driven a lot of efficiencies in our market research costs, in our marketing, over the past 12 months. That will continue and we will evaluate the cost of media but ensure that our GRPs remain very healthy in the way that we communicate with our consumers across the world. And I have personally seen, in Russia, where I have live through these crises in the past in the 1990s and in Turkey, Argentina. It’s always paid off to ensure that you keep communicating with your consumers in macroeconomic conditions as the ones that we’re living through right now.
Judy Hong - Goldman Sachs & Company, Inc.: Gary, is there any transactional impact that we should be aware of beyond that 10% to 12% impact in the first quarter you talked about. And if the reason you’re not giving the full year currency guidance is just volatility in the emerging markets currency and really the full year depends on where these currencies go from here through the end of the year?
Gary P. Fayard: That’s exactly right. 10% to 12% impact on the first quarter at operating income is kind of what we see today for the quarter. But you’ve seen the volatility as well as we have and I think to try to give guidance on what currencies could do for the full year is impossible. Because of these swings. I think long term there is no doubt in my mind that the dollar is going to weaken. For many reasons. But right now obviously it is a safe haven, it’s why the feds is looking at adding four new primary dealers for Treasuries right now because of everybody going to safe havens. But at some point it’s going to turn. We just don’t know when it’s going to turn.
Operator: Your next question comes from Marc Greenberg - Deutsche Bank Securities.
Marc Greenberg - Deutsche Bank Securities: Muhtar, I was hoping you could elaborate on something. Expense management in the quarter was terrific. Can you talk about longer term how you can increase investing to drive brand growth and at the same time get expense leverage? Beyond some of the comments to Judy. I guess I’m thinking about the sustainability of lower SG&A into 2009.
Muhtar Kent: Firstly, I think what we want to say is that over this year and 2009 you should be guided by our full year expense leverage from last year. So 4% to 5% opex leverage is what you should be looking at for 2009 and that is going to be achieved through our continuing successful transformation process. As you know, we started that process way ahead of the current macroeconomic downturn. It’s been going on now for more than 12 months. We have already captured significant effectiveness and efficiency and productivity and we will continue to drive our target of $0.5 billion by 2011, recurring. And I think that is a combination of effectiveness and efficiency in our process and our systems and how we approach our business and also it is being driven by the whole new architecture that we have in our organization that we put into place at the end of 2006 in our international markets and North America continues to drive also a lot of effectiveness and efficiency inside their own transformation process. And this is all outside of the supply chain efficiencies and effectiveness that we are also beginning to tap into.
Gary P. Fayard: I would just add a little color on that and I am going to give you a little granularity because as we are going through rewiring our company for significantly enhanced effectiveness, what we’re getting is a lot of efficiency as well. And let me just give you a really granular example. In finance itself, global finance within our company, we have been going through and starting to rationalize the companies we own and the legal entities. So when we do a consolidation each month or each quarter, we consolidate about 1,200 entities. We have gone through and last week have found 112 of those that we can eliminate, another 200 that we can probably eliminate, and if you just think about, there are people spending many, many hours doing work on legal entities that actually don’t need to exist, that have just been around for years, that there was a reason for in the beginning. It goes to how do we do inter-company accounting. We are in granular detail of how we wire and rewire the company to be significantly more effective and we will be a lot more efficient at the same time. So we are very confident that we’re going the right way and doing the right things for long term and getting short-term benefits while we’re doing it.
Muhtar Kent: One other point I want to add is that we always talk about the money side of it. I think the piece I would like you to really focus on also is the organization now that we have in place, as a result of the work that we have done, is executing with much greater speed and effectiveness and mitigating risks as it goes along. And I think that’s the piece that is also very important. We are much closer to the marketplace today, much fewer meetings, much more time in the marketplace with our bottling partners, with our customers, and that’s really also a significant advantage of the transformation process, in addition to the actual monetary side of the effectiveness.
Operator: Your next question comes from John Faucher - J.P. Morgan.
John Faucher - J.P. Morgan: Gary, the capex has risen and you talked about investing in companies and company-owned bottlers. It’s a little bit of a change from how we have historically thought of capex at the Coca-Cola Company. So how long do you see this higher capex trend continuing and as you begin to divest more bottlers does it have less of an incremental impact year-over-year?
Gary P. Fayard: If you look at, like I said, about capex last year and in 2009, $1.8 billion to $2.0 billion for 2009, about half of it or so is actually related to the bottling investments group or the bottlers that we own. My expectation, as you saw, in 2008 is over time we will be net sellers and as we actually sell bottlers, the capex will come down fairly significantly. The capex is really being driven right now because as we continue to invest in China and the Philippines and Germany and those bottlers, and really invest in India, investing in cold drink equipment, those kinds of things, to drive volume, value, across the long term, we think we’re doing the right things for the long term in those, but capex will start coming down significantly over the next five years, if you will, as we are disposing of some of those bottlers.
Operator: Your next question comes from Kaumil Gajrawala – UBS.
Kaumil Gajrawala - UBS: As you consider this economic slowdown in emerging markets and the fact that a good percentage of your portfolio is the premium ready-to-drink offering, to what extent are you considering affordability in these markets and what would you do to address it?
Muhtar Kent: I think we are always ensuring that our products are affordable, we have the right price pack architecture and we are doing a lot more work on ensuring that we have the right price points in this current environment, adding more packages that will bring the price point down, both in the at-home market as well as in the immediate consumption market. And we’re not doing that only in emerging markets. We are doing it across the world, in North America, right here, with really good initial results in terms of the new price pack channel architecture. With 16-ounce and some other smaller packages. And so as well as places like Mexico, to ensure that we are much more a part of the new location and we increase pantry. And so what we have seen in this environment is that it is really working well in terms of driving the pantry at home, creating more occasions in this environment, and whether it’s in China or whether it’s in Great Britain. In China we just launched a new 355 ml PT that’s doing, initial results are very good, just to give you one example. So I think across the entire geography, across all continents, we have done a lot of work in the past four or five months in that area.
Kaumil Gajrawala - UBS: With media deflation, are you maintaining the budget and increasing impressions or maintaining the number of impressions and just enjoying some efficiency?
Muhtar Kent: I think we are doing all of the above and it’s too early to say where it’s going to pan out. One thing you can be sure of is we are not going to reduce our weight and we will capitalize on the current market trends.
Operator: Your next question comes from Christine Farkas – BAS-ML.
Christine Farkas – BAS-ML: I’m looking at a couple of your mature markets, North America and Europe and you talked about unusually high leverage in the quarter and maybe you can speak to this on a more normalized basis, but the margins were quite strong. Are some savings coming through from the $500.0 million program already? Was this about market allocation timing of where you put your dollars in the quarter? And then within those regions, speak to the strong food service trends and what countries worked or didn’t work in Western Europe.
Muhtar Kent: Basically I think as far as Europe is concerned, I think we have had a lot of initiatives for Pan European programs over the last 12 months and I think they have really started working well for us in this environment. So we have got a lot of efficiencies, and they are sustainable efficiencies. Across the whole company and across our headquarter’s functions, we have started to reap some of the benefits already of the transformation process. We have got a lot more coming. And again, in terms of, there is a tremendous focus on G&A across the whole company, and particularly opex. And what we’ve said is this is the time to be choiceful about how we spend our money and anything that basically does not drive value does not have a place. So we have certainly also launched a lot of products with better margins in Europe. New teas, new smoothies, that has brought some efficiencies effectiveness on the P&L line, in our European business. In North America, a lot of work is going on in effectiveness and efficiency. Part of the transformation process but also the work that is ongoing with our bottling partners in the supply chain and then some other areas in order to drive again some leverage on our P&L. In terms of food service, we are cycling (3%) from Q4 of 2008 which was the beginning of the economic downturn. And I think that, again, we have launched some new products in our food service in Q4, some new teas, some new coffees and smoothies. And I think basically all the investments that we’re doing with all our customers are paying dividends.
Christine Farkas – BAS-ML: Was Germany positive in the quarter?
Muhtar Kent: Basically we would prefer not to comment on individual countries but I would just basically say to you that overall, key markets like Great Britain, France, were positive and I think all the programs that we have in Germany are paying dividends. And 2009 is going to be the first full year of consolidation in Germany when we will get really, the results of all the good work that’s being done. We’re gaining traction in Germany.
Gary P. Fayard: Let me add one thing to your Europe question, and I don’t know if this is where you were coming from but I know I picked up a few comments earlier this morning about Europe and I think a lot of people perhaps thought currency was a really significant tailwind in Europe in the fourth quarter. We had some hedge coverage in place, so let me just kind of give you a little bit on that. Currency for Europe was a negative 8, so if you look at that versus what you are expecting it to be, you may find that there is a little bit of difference as well because of our hedge coverage.
Operator: Your next question comes from Lauren Torres – HSBC.
Lauren Torres - HSBC: Yesterday Coke Enterprises spoke about their strengthening relationship with you and the formation of Coca-Cola Supply. I was hoping you could just give us a little bit of your thoughts behind this organization, what are your expectations. How should we gauge and monitor the progress that’s developing in this new relationship.
Muhtar Kent: I think basically we are very serious about our efforts in Coca-Cola Supply and I think we have got a very good program in place in terms of the new integrated supply chain initiative that will consolidate the common supply chain initiatives. It will optimize product flow and create over $150.0 million of annual incremental operating income by 2011 for CC and the Coca-Cola Company. I think all our other bottling partners are going to benefit from that. It is a very serious initiative.
Lauren Torres - HSBC: Is there anything we’re going to see or should expect to see over the course of this year? I know we’re talking about the savings through the next couple of years but as far as the immediate impact, just something somewhat more material that we will be seeing coming through?
Muhtar Kent: I think you can look at it similar to the transformation initiative that we announced over 12 months ago in our company. Basically you can expect that the 2009 plan will deliver an aligned outcome for both companies, the Coca-Cola Company as well as our bottling partners and certainly a more progressive agreement for the future. I think that we will wrap up everything as best as we can and we have a very good plan forward.
Operator: Your next question comes from Mark Swartzberg - Stifel Nicolaus & Company, Inc.
Mark Swartzberg - Stifel Nicolaus & Company, Inc.: When you look, particularly at your emerging market businesses, and even to an extent your developed market businesses, can you talk a little about some of the assumptions you are making about key macro trends unfolding? Obviously they are getting worse but I’m particularly interest about how you’re thinking about inflation and other key variables affecting the broader environment you are operating in.
Muhtar Kent: Well, what you have to do is absolutely remain flexible because it’s changing so fast. We don’t right now, I think immediate there is no threat of inflation but over a period of time there is no question with all the amount of money that’s being printed around the world, no question that we need to make some planning ahead. We may be facing an inflationary environment but we certainly don’t know when that will when, if that will happen, and where it will start or how it will evolve. All I can tell you is that we have lived through those inflationary environment in the past and our businesses really, we have great operating talent across the whole world that have operated in that environment, whether it be Latin America, in Eurasian countries and we will certainly be looking at what’s evolving and we will remain very flexible as well as ready for anything that comes in that area.
Gary P. Fayard: I would add one thing about inflation. If you go back and look at history, any time we really enter into an inflationary environment our company actually benefits. We do extremely well in that type of environment.
Mark Swartzberg - Stifel Nicolaus & Company, Inc.: Some interesting comments out of Diagio this morning describing at least parts of their emerging markets business as having not only the better growth but perhaps the most enduring growth. When you look at your own business and think about volatility and risk of slowdown and magnitude of slowdown outside of the U.S., what do you consider your markets that are most vulnerable to slowdown, just from a macro perspective? Hearing what you all can do to defend against that is I think pretty persuasive, but what do you kind of put at the top of the list as your most vulnerable market? If you have to put something up there.
Muhtar Kent: Certainly we talked about Russia. Russian has been hit in a different way and earlier than some of the other markets and we have certainly seen the results of that slowdown on our business, too. Our volume growth has slowed down. Philippines was one of the other markets that’s been hit significantly earlier than the rest, in terms of the macroeconomic situation and in terms of the remittances that were driving a lot of the consumption in that economy came down. And we have seen the impact of that. And no question that there are some Latin American markets that are beginning to feel the United States more, like Mexico. We know that the GNP in India and China is not going to be the same as it was in the past 12 months, it’s going to be slower but there will be growth. The Chinese prime minister reiterated the objectives of his government to ensure that they grow at 7% to 8% last week and announced more details of their stimulus package, which is very real. And I think all governments, across the world, are launching, in their own way, different stimulus packages whether it’s tax cuts, investment incentives, supporting small and medium size enterprises. So across the world there is a tremendous effort that we are seeing by a lot of governments, by central banks, to ensure that the macroeconomic downturn in their markets is not as deep as in some of the other markets that have already been hit. And we shall see how all of that evolves. Then we have others that are still resilient that are still growing, countries in Latin America, Indonesia, Turkey, and I have mentioned earlier, we have got a lot of small countries that make up a fairly large portion of our volume. Over 100 countries that we have, with per caps of less than 150, where last year we have grown almost double digits, 8% to 9% in these countries. So all the investments that we’re doing on the ground, in distribution, in customer connectivity, in cold drink equipment, in packaging, in new product, are paying off in a lot of those markets.
Operator: Your next question comes from Carlos Laboy - Credit Suisse.
Carlos Laboy - Credit Suisse: On Japan, the co-op of the bottlers there was being restructured and you were looking at the structure of Japan, I was hoping you could offer some thoughts on how you see that system evolving and whether you see yourself having to buy any bottlers there. And on the issue of China, how detached do you feel that your business trends might be from these macro pressures given how low you are in the evolutionary development of these markets for you?
Muhtar Kent: Let me just talk first, shed some light on the supply chain. The supply chain was set up for speed, flexibility, as well as scale, in Japan and none of that is being lost as we restructure it. The key is now it is much more aligned with local bottlers and how they ensure that their needs are met on a more timely basis. So it’s a restructuring but ensuring that the scale and the flexibility and the speed is still there. That is point number one on Japan. In terms of detachment, in markets like India and China that you referenced, our per capitas area still very, very low. 24 in China, less than 24 in India and again, we know that there is a pressure on migrant workers, for example. I will give you one example in China, that are returning back to the rural areas. Well, we have 30+ bottling plants in China, scattered across the whole country. We are selling to those rural customers and we were selling to them before they migrated to the cities and we are selling to them now. And we are, again, re-architecturing, creating new price points, ensuring that we are available and we are available in more formats with different price points to ensure that the affordability of our brands is still in place for Chinese and Indian consumers as well as consumers across all of the emerging markets can still afford and buy our products. Trademark Coke in China was up 18% in Q4, Minute Main Pulpy, a great product, that was up almost more than 50% in Q4 and is now a couple of hundred million case business on its own in China. And we’ve doubled our volume in tea last year in China. Growth more than 90%. So again, a lot of our organic growth has been very successful in China. And I repeat, organic growth.
Carlos Laboy - Credit Suisse: Just to clarify on the Japan issue, do you see yourselves having to inject yourselves into Japan maybe more aggressively in terms of M&A? There was a transaction that hit the tape on Japanese bottling.
Muhtar Kent: I think the thing about Japan is, think about it, we have had success with our cluster in west Japan. It has produced good results, achieving great market results now, with that cluster that has been formed where we injected ourselves in a minority position but ensured that we played a critical role in creating West Japan. And again, after the investment that we had in Coca-Cola Bottlers Tokyo, we are continuing to work to create the next cluster in Japan, around [Kynto] and if there is a need for us to inject ourselves in a small way, to ensure that we can play a role of catalyst there, we will do so.
Operator: Your final question comes from Celso Sanchez – Citigroup
Celso Sanchez – Citigroup: Could you talk a little bit about the fountain business in North America, specifically the U.S.? The innovations with the mega-choice dispenser that you will be displaying next week certainly encouraging. But if you could speak more to the organizational changes that may be occurring in terms of how you approach the business and how you approach it in conjunction with your bottlers? I would love to see your roles evolving, both bottler and brand owner, over the next 12 months or so.
Muhtar Kent: First, the fountain of the future is something we’re very excited about. We have been working on this as part of our innovation pipeline over the past couple of years and certainly what we have seen so far is very encouraging in that the consumer gets excited with the choice and with the flavors and certainly compared to a much more limited choice, we see great consumer excitement in the marketplace and how the consumer interacts. So we’re excited with what that will bring to us in a key channel of our business in North America and other parts of the world as we roll it out. So our efforts are really focused on the deployment of beverage offerings that this will create a lot of excitement at the point of sale with all of our customers as we start to roll that out. And I hope that you can see it for yourself at Cagney next week. In terms of the organizational change, an approach to business with our bottler and price pack architecture, don’t think about it as an organizational change. Think about it as a tremendously aligned approach. We have dual customer calling in about 20% of CC’s territory. We have begun to move to a single call model in the market to improve value to the customer and the system and it’s in early stages of its development and it’s all about being more effective in the marketplace and it’s all about being flexible and fast in the marketplace.
Celso Sanchez – Citigroup: That sounds like a procedural change but I was wondering more along the lines of the alignment you spoke of in the markets where there is not dual calling. Is there room for improvement, do you think, for the alignment of price pack between found and bottle can?
Muhtar Kent: I think there is and that’s one of the work streams that we have with CCE and our other bottling partners, what we call fountain harmony, which offers the opportunity to implement the occasions brands package pricing as well as channel architecture across on-premise channels in a manner that will ensure that we meet evolving consumer desires. And also the incremental volume opportunities.
Operator: There are no further questions in the queue.
Muhtar Kent: Thank you. Our focus in this challenging and dynamic environment is to proactively drive our strategic agenda. We see tremendous opportunity to extend the reach potential and profitability of our business around the world despite the prevailing macro conditions and we are confident we have the right strategies as well as the right leadership team to do just that. We also remain committed to always ensuring open and ongoing transparent communication with you, our investors.
Operator: This concludes today’s conference call. | [
{
"speaker": "Executives",
"text": "Jackson Kelly - Vice President and Director of Investor Relations Muhtar Kent - President and Chief Executive Officer Gary P. Fayard - Chief Financial Officer"
},
{
"speaker": "Analysts",
"text": "Judy Hong - Goldman Sachs & Company, Inc. Marc Greenberg - Deutsche Bank Securities John Faucher - J.P. Morgan Kaumil Gajrawala - UBS Christine Farkas – BAS-ML Lauren Torres - HSBC Mark Swartzberg - Stifel Nicolaus & Company, Inc. Carlos Laboy - Credit Suisse Celso Sanchez – Citigroup"
},
{
"speaker": "Operator",
"text": "Welcome everyone to The Coca-Cola Company fourth quarter 2008 earnings results conference call. (Operator Instructions) I would now like to introduce Jackson Kelly, Vice President and Director of Investor Relations."
},
{
"speaker": "Jackson Kelly",
"text": "Good morning and thank you for being with us today. I'm joined by Muhtar Kent, our President and Chief Executive Officer, and Gary Fayard, our Chief Financial Officer. Following prepared remarks this morning by Muhtar and Gary we will turn the call over for your questions. Before we get started I'd like to remind you that this conference call may contain forward-looking statements, including statements concerning long-term earnings objectives, and should be considered in conjunction with cautionary statements contained in our earnings release and in the company's most recent periodic SEC report. In addition, I would also like to note that we have posted schedules on our company’s website at www.thecoca-colacompany.com under the Financial Information tab in the Investor section which reconciles certain non-GAAP financial measures that may be referred to by our senior executives in our discussion this morning and from time to time in discussing our financial performance as reported under generally accepted accounting principles. Please look on our website for this information. Now let me turn the call over to Muhtar."
},
{
"speaker": "Muhtar Kent",
"text": "I am pleased to report that we have delivered another quarter and year of strong financial performance. This marks our ninth consecutive quarter of double-digit comparable EPS growth and the third straight year of meeting or exceeding our long-term growth targets. Our results reflect the hard work and dedication of our global system through this incredibly challenging economic environment. Together with our bottling partners we are assertive and flexible in terms of managing our business, focusing strategies, accelerating actions, redirecting investments, and being prudent with our capital and other expenditures, while maintaining a disciplined long-term approach to our operations. Our performance for the quarter and full year underscore our firm belief that there is no better business to be in than non-alcoholic commercial beverages. In a challenging environment we added another billion incremental unit cases in volume, essentially another Japan, our fifth largest volume market. We firmly believe our industry will continue to experience growth across all categories and geographies as macro population and person expenditure trends still highly favor the simple moments of pleasure we bring to our consumers over 1.5 billion times a day, a cent at a time. Strong, decisive execution based on focused strategies enabled us to deliver continued global volume and value share gains across key geographies as well as categories. As we all manage through these globally challenging times, volume and value share gains will continue to be critical benchmarks for our performance progress. We remain on track to deliver $0.5 billion in annualized savings from productivity initiatives by 2011. The continued acceleration of these efforts are going to enable our cash to be re-deployed to drive investments for sustainable growth. And there is no question that this year will pose unique macroeconomic challenges for all businesses. That said, we are not content to just ride out the storm, rather we will leverage this as an opportunity to further build the equity of our brands and drive value for our system and customers. Our highly skilled management team has navigated through a very difficult operating conditions around the world before and is well equipped to run our operations in these challenging times. I’m confident that our solid brands, as well as our business fundamentals, coupled with a sound balance sheet, robust cash generating model, and strong bottling partners spread across all five continents, provide a sound foundation for our management team to continue delivering against our long-term targets this year and position our company and our system to become even stronger over the long term. Looking at this past quarter and year, we delivered 4% unit case growth for the past quarter and 5% unit case growth for the full year of 2008. Our international operations again led the way with 6% volume growth for the quarter and the full year. In close, close collaboration with our bottling partners, we are building from a strong competitive position with share that is three times that of our nearest competitor to drive continued, solid international growth. This growth was well balanced across the entire globe as each of our five geographic operating groups outpaced the industry for the year, resulting in consistent top- and bottom-line performance. By any measure, we continue to believe these are strong results. We credit our performance to a consistent set of strategic initiatives. Now I would like to take you through some of the progress we have made against those strategic initiatives. First, drive growth in sparkling and still beverages. Sparkling beverages are the very oxygen of our business, as I’ve said many times. Unit case volume for sparkling beverages grew 2% for the full year with our international performance up 4%, representing incremental growth of 0.5 billion unit cases last year. Full year global performance was driven by Coca-Cola, up 2%; Coca-Cola Zero up 35% with nearly 600.0 million unit cases sold; Sprite, which became our third trademark to reach 2.0 billion unit cases in annual volume, was up 6%, led by countries like China and India; and Fanta, driven by innovation, was up 3%. Coca-Cola continues to be the brand that consumers love most around the world with a three-to-one favorite brand preference versus our global competitor. Our Olympic sponsorship is a great, great example of how incremental investments have an exponential impact on building the global equity of our powerful brands. During the most successful Olympic activation in our history, we connected with more than 0.5 billion consumers in China and were cited by many as the most recognized and effective sponsor of the Beijing games. Also, we are continuing to build on the heritage as well as the incredible global appeal of our flagship brand with the recent launch of our new worldwide Open Happiness campaign. This exciting new integrated marketing campaign is the next generation of the Coke Side of Life and stays true to Coca-Cola’s 123-year heritage, while opening new doors to connect with consumers around the world in a relevant and timely manner. Again, this year our ads rated highly during Super Bowl, and importantly, Open Happiness will be leveraged globally with launched in most of key markets by mid-2009. Importantly, we gained sparkling beverage share globally for the quarter and the year across most of our key global markets. Our still beverage unit case volume increased 13% for the year, driven by strong growth in existing brands and several strategic brand acquisitions. Internationally still beverages were up 17%. Still beverage growth across each of our operating groups drove category volume and value share gains globally. Leading the way were gains by Vitaminwater and our global juice, tea, coffee, as well as energy brands. Our strategy to build on the world’s strongest juice business continues to succeed. Minute Maid Pulpy, already a huge success in China, is being expanded to several other key international markets. Here in North America our multitude juice strategy continues to outperform the category and drive share gains. The Simply trademark is quickly approaching billion-dollar brand status. Our Latin American acquisitions are providing growth and scale to drive efficiencies for our bottling partners. In 2008 we continued to innovate with new brand launches such as the successful Original Leaf Tea in China. We are also leveraging our partnership with Illy and launched this ready-to-drink coffee in ten markets in close collaboration with our bottling partner Coca-Cola Illy. Glaceau, led by Vitaminwater, remains well on track to become a $2.0 billion trademark through continued volume and value share gains and we have several new product innovations in store for this year. we grew Glaceau double digits in the quarter as well as full year in the U.S. while expanding this great brand to five international markets in 2008. And finally, better marketing focus drove performance for our critically important Georgia coffee brand in Japan. Unit case volume for Georgia grew 2% for the year in 2008, driven by 9% growth in key core Georgia flavors. Before I move on to a summary of our geographies, let me briefly touch on two innovations that many of you will get to experience at the upcoming Cagney Conference next week in Florida, one in ingredients and the other in equipment. In 2008 we announced two significant advances. First, the introduction of products sweetened with Truvia, an all natural non-nutritive sweetener. We have already launched several products, two new Aguila flavors along with Sprite Green, the first sparkling beverage enhanced with this break-through sweetener. Also we are announcing the launch of Vitaminwater Ten, the perfect combination of ten naturally-sweetened calories and great taste. Second, last September we unveiled our breakthrough fountain dispensing technology that empowers consumers to select from over 100 branded beverages in the same footprint as our current six-valve fountain. Through unique design and micro-dosing technology this is surely something you will want to try first-hand at the Cagney Conference next week. These are just two examples of how the Coca-Cola Company is applying new thinking and new ways of quickly leveraging our R&D investments across our global operations. We continue to leverage our geographic footprint in over 200 countries where our three-fold strategy is focused on: first, leveraging our share leadership position for profit in developed markets; second, driving value as we achieve scale in developing markets; and investing for volume growth in the emerging markets. Let me share a few highlights from some key markets. In Japan we delivered our largest unit case volume year on record, successfully cycling 3% growth in the prior year, resulting in non-alcoholic commercial beverage share gains. We continue to invest in our three-cola strategy and this investment paid off with the 5% growth of sparkling beverages during the year, led by trademark Coca-Cola. Europe grew 3% for the year, cycling 5%, continuing our successful efforts to gain share in both sparkling and still categories. Continued expansion of Coke Zero was strong in European marketing platforms such as our 007-Bond activation and the Christmas activation on Coca-Cola drove our sparkling beverage growth. And in Latin America, which is a great example of how we achieved scale in a developing market very rapidly. We delivered solid balanced growth with all Latin America business units delivering mid- to high-single-digit unit case volume growth and share gains for the year. Coca-Cola increased 4% and still beverages increased 40% as we continued to leverage the regionally important [Kuka Staballa]. In Russia, unit case volume increased slightly for the year, primarily the impact from unseasonable weather during the summer and economic pressures at year end. Despite the slowdown of volume growth in Russia, we gained volume and value share in non-alcoholic registered drink beverages in the quarter and full year. The fundamentals of our business in this key market remain very strong. In Turkey, one of our leading emerging markets, we increased unit case volume 11% in the quarter and 15% for the full year as we benefitted from the strength of our brand portfolio and solid execution by Coca-Cola Bishkek, our bottling partner. Importantly, in our 120 countries with per caps less than 150, our volume growth was 9% for the year, cycling 11% in the prior year. We continue to believe we are early in the game in key emerging markets. To that end, this past year we grew volume 19% in China and 14% in India, the two fastest growth economies in the world. While China is clearly expecting slower GDP growth this year, we are confident in our plans to ensure our brands as affordable consumers’ favorites continue to offer real value to Chinese consumers during these difficult times. During 2009 each of our operating groups will continue to execute against our strategies and focus on delivering consistent results. We will continue working closely with our bottling partners in these challenging times to adapt to conditions on the ground and better meet the needs of our consumers, as well as customers. In North America, we along with so many other industries, are facing some of the most challenging economic conditions in the world. However, we made real progress last year. In what is arguably the world’s most competitive beverage market, I am pleased that our brand portfolio is getting stronger, our customer relationships are improving dramatically, and we have a more aligned and capable bottling system. The continued success and enduring investment in this progress is enabled by a relentless ongoing focus on cost management and productivity. The fundamental measurement of our results is brand health and share gains. Clearly, the volatile economic environment and bottler price increase impacted our results, however, it is important to recognize we outperformed the industry. When measuring across all channels, we gained volume and value share in the quarter and the full year. In fact, the Coca-Cola Company owned five of the top ten fastest growing trademarks in incremental retail sales in North America for 2008 with Coca-Cola Zero, Glacéau, Simply, Nos, and FUZE. And our system also handled half the volume of the Monster trademark, given us access to a sixth brand. Real and tangible progress is being made in strengthening our aligned with our bottlers, as illustrated by strong customer teamwork across our system. We have a rigorous portfolio effectiveness and efficiency initiatives with our bottlers as we move forward. These actions are ongoing and we expect will drive incremental gains and long-term profitability for our system in North America. Our marketing and innovation calendar for North America is robust with numerous activities across the portfolio. As the economic environment strengthens, we believe our continued investment in our brands, customer and franchise relationships, will enable us to return our sparkling brands to growth and accelerate continued growth in our still brands. Before I turn the call over to Gary, let’s just step back and review what makes the Coca-Cola Company’s model so special. First, we have some of the best brands in the world and the cash flow to keep investing in them to build long-term equity with our consumers and customers. Second, our invested capital generates high returns. Simply said, we were built for times like these. The Coca-Cola system generates up to $50.0 million of cash per day. Our fundamentally sound balance sheet allows us to pursue growth and we have demonstrated the ability to deliver a reliable dividend which has increased each of the last 46 years. We enter 2009 with the same mindset as one year ago: deliver on a consistent set of strategies and initiatives that provide us a disciplined road map to operate in the best consumer business in the world, a business with significant long-term opportunities. We have a tradition of delivering growth over the long term and it is our intention to continue to drive long-term balance to sustainable growth for the benefit of our shareholders. Our picture of success this year is clear. First, maintain simplicity by focusing on a critical set of measurable deliverables. Second, increase the speed and efficiency of execution to capitalize on opportunities while mitigating risk. And third, remain constructively discontent in all that we do in order to deliver against our long-term growth targets and enhance our long-term brand and system health. With that, let me now turn the call over to Gary."
},
{
"speaker": "Gary P. Fayard",
"text": "As Muhtar indicated, we once again delivered strong financial results in the quarter, resulting in our ninth consecutive quarter of double-digit comparable EPS growth and our third consecutive year of delivering against our long-term growth targets. We continued with our disciplined approach to financial management using our many business levers, consistent volume, solid price mix, improving operating expense leverage, and disciplined capital allocation to deliver value customers, consumers, and share owners, even in this difficult operating environment. Our management’s effort to diligently execute our strategies and work with our bottlers to adapt to the marketplace is a testament to the resilience of our business model and the talents of our employees. We reported earnings per share of $0.43 per quarter on a diluted basis in the quarter, however, this included a net charge of $0.21 per share. $0.15 of the net charge was related primarily to our proportionate share of the non-cash impairment charge recorded by Coca-Cola Enterprises. The remaining $0.06 of the net charge was primarily related to asset impairments, restructuring charges, and costs related to our global productivity initiatives. Therefore comparable earnings per share was $0.64 per share, an increase of 10%. For the year, recorded EPS was $2.49. Comparable EPS was up 17% to $3.15. The net charge of $0.66 per share primarily related to non-cash impairment charges recorded at Coca-Cola Enterprises in the second and fourth quarters as well as asset impairments, restructuring charges, and costs related to our productivity initiatives. For the year unit case volume growth was 5%, essentially in line with concentrate sales. Revenue growth was 11% as we balanced the volume and value equation by delivering a 4% increase in concentrate sales, a 3% favorable impact from price and mix, and a 4% currency benefit for the year. Full year comparable operating income was up 17% as our productivity efforts have begun to pay off and includes a 6% benefit from currency. Again, ahead of our long-term targets. Importantly, our advantageous geographic diversity played a key role with each of our international operating groups contributing to our profit growth for the year. In terms of margins, our core business remains healthy, expanding margins for the full year as we drove top-line growth and delivered operating expense leverage. Bottling investments continues to improve margins as well. In the fourth quarter you will have noticed that we delivered significant operating expense leverage. We do not expect to achieve that Q4 leverage in 2009. Rather we would expect the run rate for 2009 operating expense leverage to be more in line with our 2008 full year results. Our productivity initiatives remain on track to deliver $500.0 million in annual savings by year end 2011 and we are accelerating efforts to rewire the organization to support our next era of growth. Cash flow from operations for the year increased 6% to $7.6 billion on strong underlying business performance. But you may have noticed that working capital was a $700.0 million year-over-year use of cash. The working capital change was primarily one-time international tax payments which will reverse in 2009 and cash payments related to restructuring charges and our costs incurred for productivity initiatives. Excluding these items, cash from operations increased 13%. As part of our ongoing productivity initiatives we will continue to focus on managing our working capital in 2009. We repurchased approximately $1.1 billion of our stock for the full year in line with our prior guidance. Additionally, the company paid $3.5 billion in dividends to shareholders in 2008. Our balance sheet remains fundamentally strong with solid interest coverage ratios and a conservatively invested cash position of $4.7 billion. Now let me address some of the factors that we see impacting 2009. First, let me reiterate Muhtar’s sentiment, there is no question that the coming year will pose macroeconomic challenges for all businesses but we will not be content to just ride out the storm. We will leverage this as an opportunity to drive our business for the long-term and build on our track record of success. We have continued to evolve and improve our operational and fiscal discipline while building on our solid foundation with consistent strategic priorities. Our seasoned management team is poised to continue to do so in 2009. As you know, our long-term currency-neutral growth targets are 6% to 8% operating income growth and high single-digit ongoing earnings per share growth. Our picture of success for 2009 is to achieve those targets as well as enhancing brand health and gaining share despite the difficult operating environment. Additionally, we will track share gain across all of the key markets and categories. On concentrate pricing we will continue to work in alignment with our bottlers to adjust our occasion, brand, price, pack, and channel architecture to bring value to both our customers and consumers. As always, our intention is to take pricing in line with our bottlers net retail pricing over the long term. As in the fourth quarter, our revenues will continue to be impacted due to structural changes primarily related to disposal of bottlers. We would expect a similar drag during a portion of 2009 as we cycle the sale of the re-milled bottler in Brazil at the end of Q2 and the Pakistan bottler investment at the end of Q3. We expect to deliver operating expense leverage on both the core business and bottling businesses in 2009. We will continue to invest behind our brands and innovation initiatives. Additionally, selling and service expenses will increase as we invest for growth in our bottling operations as well as investments behind our band acquisitions, particularly in North America. G&A expenses were tightly controlled in 2008 and we will continue with our disciplined approach in 2009, including further progress on our productivity initiatives. As for our pension plan, we remain on fairly solid ground, however, we were impacted by declines in the value of plan assets and a lower discount rate. As a result we would expect pension expense to increase $0.03 to $0.04 per share in 2009 as compared to 2008. From a capital expenditure standpoint, we purchased approximately $1.8 billion in net property plant equipment during 2008. For 2009 we would expect the total company net capital expenditures to be approximately $1.8 billion to $2.0 billion as we continue to make investments in our business as well as recently acquired bottling operations. For share repurchase, we do not plan to repurchase additional shares in 2009 due to the pending acquisition of Huiyuan Juice Company in China. Now let me move to currency. As expected, currency has proved to be a headwind in the fourth quarter, impacting comparable operating income by a negative 9%. As for our 2009 currency outlook, it is obviously a very volatile environment and there are no clear trends for the U.S. dollar. As we are all observing, the market’s risk perspectives continue to evolve and may move to mute the attractiveness of the dollar as the year progresses. However, there are many different scenarios that could play out and we are managing against this backdrop. We are effectively 100% hedged on key hard currencies like the Euro and the yen for all of 2009, but emerging market currencies continue to be particularly volatile and provide the highest risk and opportunity for our currency expectations for this year. Base on our current hedge position, we are expecting an estimated 10% to 12% headwind from currencies in the first quarter and will provide further updates as we progress through the year. It is important to note that we manage our business in local currency to ensure we make the right decisions for the long-term business health. For 2009 our best estimate is that the full year underlying effective tax rate will be approximately 23% to 24%, up from the rate of 2008 largely due to the impact of currency. Finally, let me say a few words about quarterly phasing. As many of you know, we report quarterly unit case volume growth on an average daily sales basis to eliminate comparability issues due to calendar variations. For 2009 we will have one fewer day, since 2008 was a leap year. first quarter of 2009 will have five more days than Q1 2008 and the fourth quarter of 2009 will have six fewer days versus Q4 2008. This will not impact our unit case sales reporting but will impact our concentrate sales and therefore revenues. Additionally, both Easter and the impact of July 4th U.S. holiday will shift into Q2 this year. We expect 2009 will be a challenging but successful year. We continue to be a consistent generator of operating cash flow providing attractive, long-term returns to our shareholders. Well, that’s it with what I wanted to cover this morning. We are ready for questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from Judy Hong - Goldman Sachs & Company, Inc."
},
{
"speaker": "Judy Hong - Goldman Sachs & Company, Inc.",
"text": "Muhtar, can you speak to the volume strength that we saw in fourth quarter in a lot of the international markets? And if you can go through whether this is really driven by the category being very resilient in the face of the economic downturn or you’re just maybe gaining more share in those markets. And then, as we look out at 2009, you talked about the picture of success in 2009, meeting your long-term targets, does that apply to the volume targets of 3% to 5% as well?"
},
{
"speaker": "Muhtar Kent",
"text": "The answer to the first part of your question is both, the resilience of the category. As I said many, many times, we are selling moments of pleasure billions of times a day. More than 1.5 billion times a day, a cent at a time, and our bottling partners have been continuing to invest very heavily on the ground in equipment, with the customers in the past two or three years, and I think that’s paying off. We had a balance growth. Our developed markets like Europe grew as well as our emerging markets and Latin America grew. Eurasia and Africa grew very well. The brick markets, particularly India and China, had a very strong quarter in the last quarter of last year. So I think overall we have had a very strong quarter. As far as going forward, we recognize the challenges, our picture of success still remains to meet our long-term growth targets, but we have said we will have bumps along the road. And we may not achieve our targets in one or two quarters, that is possible. But our picture of success remains to continue to drive investments, to ensure that we are investing in the health of our brands, and to ensure that we gain market share as we have done this past year—this past quarter and this past year—and to come out of this tunnel with stronger portfolios, strong brands. And one thing you will not see us doing is that we will not cut our communication with our consumers. We will continue to invest with our bottling partners. Our bottling partners’ appetite for investment remains very strong around the world and that is a very good litmus test of what’s happening in the marketplace with our system."
},
{
"speaker": "Judy Hong - Goldman Sachs & Company, Inc.",
"text": "In relations to that, we have seen media rates coming down pretty substantially. Is there an opportunity to kind of look at the marketing expense line and get more leverage and maybe flow some the more productivity savings to the bottom line in this environment where the media spending is trending down?"
},
{
"speaker": "Muhtar Kent",
"text": "Well, even when media costs were not trending down, we were achieving significant efficiencies in our marketing. We have much fewer agencies that we are working with. We have consolidated our agencies. The Coke Side of Life campaign was leveraged all across the globe as will be the Open Happiness campaign. The new Open Happiness campaign agency numbers have gone down by more than half and I think we have driven a lot of efficiencies in our market research costs, in our marketing, over the past 12 months. That will continue and we will evaluate the cost of media but ensure that our GRPs remain very healthy in the way that we communicate with our consumers across the world. And I have personally seen, in Russia, where I have live through these crises in the past in the 1990s and in Turkey, Argentina. It’s always paid off to ensure that you keep communicating with your consumers in macroeconomic conditions as the ones that we’re living through right now."
},
{
"speaker": "Judy Hong - Goldman Sachs & Company, Inc.",
"text": "Gary, is there any transactional impact that we should be aware of beyond that 10% to 12% impact in the first quarter you talked about. And if the reason you’re not giving the full year currency guidance is just volatility in the emerging markets currency and really the full year depends on where these currencies go from here through the end of the year?"
},
{
"speaker": "Gary P. Fayard",
"text": "That’s exactly right. 10% to 12% impact on the first quarter at operating income is kind of what we see today for the quarter. But you’ve seen the volatility as well as we have and I think to try to give guidance on what currencies could do for the full year is impossible. Because of these swings. I think long term there is no doubt in my mind that the dollar is going to weaken. For many reasons. But right now obviously it is a safe haven, it’s why the feds is looking at adding four new primary dealers for Treasuries right now because of everybody going to safe havens. But at some point it’s going to turn. We just don’t know when it’s going to turn."
},
{
"speaker": "Operator",
"text": "Your next question comes from Marc Greenberg - Deutsche Bank Securities."
},
{
"speaker": "Marc Greenberg - Deutsche Bank Securities",
"text": "Muhtar, I was hoping you could elaborate on something. Expense management in the quarter was terrific. Can you talk about longer term how you can increase investing to drive brand growth and at the same time get expense leverage? Beyond some of the comments to Judy. I guess I’m thinking about the sustainability of lower SG&A into 2009."
},
{
"speaker": "Muhtar Kent",
"text": "Firstly, I think what we want to say is that over this year and 2009 you should be guided by our full year expense leverage from last year. So 4% to 5% opex leverage is what you should be looking at for 2009 and that is going to be achieved through our continuing successful transformation process. As you know, we started that process way ahead of the current macroeconomic downturn. It’s been going on now for more than 12 months. We have already captured significant effectiveness and efficiency and productivity and we will continue to drive our target of $0.5 billion by 2011, recurring. And I think that is a combination of effectiveness and efficiency in our process and our systems and how we approach our business and also it is being driven by the whole new architecture that we have in our organization that we put into place at the end of 2006 in our international markets and North America continues to drive also a lot of effectiveness and efficiency inside their own transformation process. And this is all outside of the supply chain efficiencies and effectiveness that we are also beginning to tap into."
},
{
"speaker": "Gary P. Fayard",
"text": "I would just add a little color on that and I am going to give you a little granularity because as we are going through rewiring our company for significantly enhanced effectiveness, what we’re getting is a lot of efficiency as well. And let me just give you a really granular example. In finance itself, global finance within our company, we have been going through and starting to rationalize the companies we own and the legal entities. So when we do a consolidation each month or each quarter, we consolidate about 1,200 entities. We have gone through and last week have found 112 of those that we can eliminate, another 200 that we can probably eliminate, and if you just think about, there are people spending many, many hours doing work on legal entities that actually don’t need to exist, that have just been around for years, that there was a reason for in the beginning. It goes to how do we do inter-company accounting. We are in granular detail of how we wire and rewire the company to be significantly more effective and we will be a lot more efficient at the same time. So we are very confident that we’re going the right way and doing the right things for long term and getting short-term benefits while we’re doing it."
},
{
"speaker": "Muhtar Kent",
"text": "One other point I want to add is that we always talk about the money side of it. I think the piece I would like you to really focus on also is the organization now that we have in place, as a result of the work that we have done, is executing with much greater speed and effectiveness and mitigating risks as it goes along. And I think that’s the piece that is also very important. We are much closer to the marketplace today, much fewer meetings, much more time in the marketplace with our bottling partners, with our customers, and that’s really also a significant advantage of the transformation process, in addition to the actual monetary side of the effectiveness."
},
{
"speaker": "Operator",
"text": "Your next question comes from John Faucher - J.P. Morgan."
},
{
"speaker": "John Faucher - J.P. Morgan",
"text": "Gary, the capex has risen and you talked about investing in companies and company-owned bottlers. It’s a little bit of a change from how we have historically thought of capex at the Coca-Cola Company. So how long do you see this higher capex trend continuing and as you begin to divest more bottlers does it have less of an incremental impact year-over-year?"
},
{
"speaker": "Gary P. Fayard",
"text": "If you look at, like I said, about capex last year and in 2009, $1.8 billion to $2.0 billion for 2009, about half of it or so is actually related to the bottling investments group or the bottlers that we own. My expectation, as you saw, in 2008 is over time we will be net sellers and as we actually sell bottlers, the capex will come down fairly significantly. The capex is really being driven right now because as we continue to invest in China and the Philippines and Germany and those bottlers, and really invest in India, investing in cold drink equipment, those kinds of things, to drive volume, value, across the long term, we think we’re doing the right things for the long term in those, but capex will start coming down significantly over the next five years, if you will, as we are disposing of some of those bottlers."
},
{
"speaker": "Operator",
"text": "Your next question comes from Kaumil Gajrawala – UBS."
},
{
"speaker": "Kaumil Gajrawala - UBS",
"text": "As you consider this economic slowdown in emerging markets and the fact that a good percentage of your portfolio is the premium ready-to-drink offering, to what extent are you considering affordability in these markets and what would you do to address it?"
},
{
"speaker": "Muhtar Kent",
"text": "I think we are always ensuring that our products are affordable, we have the right price pack architecture and we are doing a lot more work on ensuring that we have the right price points in this current environment, adding more packages that will bring the price point down, both in the at-home market as well as in the immediate consumption market. And we’re not doing that only in emerging markets. We are doing it across the world, in North America, right here, with really good initial results in terms of the new price pack channel architecture. With 16-ounce and some other smaller packages. And so as well as places like Mexico, to ensure that we are much more a part of the new location and we increase pantry. And so what we have seen in this environment is that it is really working well in terms of driving the pantry at home, creating more occasions in this environment, and whether it’s in China or whether it’s in Great Britain. In China we just launched a new 355 ml PT that’s doing, initial results are very good, just to give you one example. So I think across the entire geography, across all continents, we have done a lot of work in the past four or five months in that area."
},
{
"speaker": "Kaumil Gajrawala - UBS",
"text": "With media deflation, are you maintaining the budget and increasing impressions or maintaining the number of impressions and just enjoying some efficiency?"
},
{
"speaker": "Muhtar Kent",
"text": "I think we are doing all of the above and it’s too early to say where it’s going to pan out. One thing you can be sure of is we are not going to reduce our weight and we will capitalize on the current market trends."
},
{
"speaker": "Operator",
"text": "Your next question comes from Christine Farkas – BAS-ML."
},
{
"speaker": "Christine Farkas – BAS-ML",
"text": "I’m looking at a couple of your mature markets, North America and Europe and you talked about unusually high leverage in the quarter and maybe you can speak to this on a more normalized basis, but the margins were quite strong. Are some savings coming through from the $500.0 million program already? Was this about market allocation timing of where you put your dollars in the quarter? And then within those regions, speak to the strong food service trends and what countries worked or didn’t work in Western Europe."
},
{
"speaker": "Muhtar Kent",
"text": "Basically I think as far as Europe is concerned, I think we have had a lot of initiatives for Pan European programs over the last 12 months and I think they have really started working well for us in this environment. So we have got a lot of efficiencies, and they are sustainable efficiencies. Across the whole company and across our headquarter’s functions, we have started to reap some of the benefits already of the transformation process. We have got a lot more coming. And again, in terms of, there is a tremendous focus on G&A across the whole company, and particularly opex. And what we’ve said is this is the time to be choiceful about how we spend our money and anything that basically does not drive value does not have a place. So we have certainly also launched a lot of products with better margins in Europe. New teas, new smoothies, that has brought some efficiencies effectiveness on the P&L line, in our European business. In North America, a lot of work is going on in effectiveness and efficiency. Part of the transformation process but also the work that is ongoing with our bottling partners in the supply chain and then some other areas in order to drive again some leverage on our P&L. In terms of food service, we are cycling (3%) from Q4 of 2008 which was the beginning of the economic downturn. And I think that, again, we have launched some new products in our food service in Q4, some new teas, some new coffees and smoothies. And I think basically all the investments that we’re doing with all our customers are paying dividends."
},
{
"speaker": "Christine Farkas – BAS-ML",
"text": "Was Germany positive in the quarter?"
},
{
"speaker": "Muhtar Kent",
"text": "Basically we would prefer not to comment on individual countries but I would just basically say to you that overall, key markets like Great Britain, France, were positive and I think all the programs that we have in Germany are paying dividends. And 2009 is going to be the first full year of consolidation in Germany when we will get really, the results of all the good work that’s being done. We’re gaining traction in Germany."
},
{
"speaker": "Gary P. Fayard",
"text": "Let me add one thing to your Europe question, and I don’t know if this is where you were coming from but I know I picked up a few comments earlier this morning about Europe and I think a lot of people perhaps thought currency was a really significant tailwind in Europe in the fourth quarter. We had some hedge coverage in place, so let me just kind of give you a little bit on that. Currency for Europe was a negative 8, so if you look at that versus what you are expecting it to be, you may find that there is a little bit of difference as well because of our hedge coverage."
},
{
"speaker": "Operator",
"text": "Your next question comes from Lauren Torres – HSBC."
},
{
"speaker": "Lauren Torres - HSBC",
"text": "Yesterday Coke Enterprises spoke about their strengthening relationship with you and the formation of Coca-Cola Supply. I was hoping you could just give us a little bit of your thoughts behind this organization, what are your expectations. How should we gauge and monitor the progress that’s developing in this new relationship."
},
{
"speaker": "Muhtar Kent",
"text": "I think basically we are very serious about our efforts in Coca-Cola Supply and I think we have got a very good program in place in terms of the new integrated supply chain initiative that will consolidate the common supply chain initiatives. It will optimize product flow and create over $150.0 million of annual incremental operating income by 2011 for CC and the Coca-Cola Company. I think all our other bottling partners are going to benefit from that. It is a very serious initiative."
},
{
"speaker": "Lauren Torres - HSBC",
"text": "Is there anything we’re going to see or should expect to see over the course of this year? I know we’re talking about the savings through the next couple of years but as far as the immediate impact, just something somewhat more material that we will be seeing coming through?"
},
{
"speaker": "Muhtar Kent",
"text": "I think you can look at it similar to the transformation initiative that we announced over 12 months ago in our company. Basically you can expect that the 2009 plan will deliver an aligned outcome for both companies, the Coca-Cola Company as well as our bottling partners and certainly a more progressive agreement for the future. I think that we will wrap up everything as best as we can and we have a very good plan forward."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mark Swartzberg - Stifel Nicolaus & Company, Inc."
},
{
"speaker": "Mark Swartzberg - Stifel Nicolaus & Company, Inc.",
"text": "When you look, particularly at your emerging market businesses, and even to an extent your developed market businesses, can you talk a little about some of the assumptions you are making about key macro trends unfolding? Obviously they are getting worse but I’m particularly interest about how you’re thinking about inflation and other key variables affecting the broader environment you are operating in."
},
{
"speaker": "Muhtar Kent",
"text": "Well, what you have to do is absolutely remain flexible because it’s changing so fast. We don’t right now, I think immediate there is no threat of inflation but over a period of time there is no question with all the amount of money that’s being printed around the world, no question that we need to make some planning ahead. We may be facing an inflationary environment but we certainly don’t know when that will when, if that will happen, and where it will start or how it will evolve. All I can tell you is that we have lived through those inflationary environment in the past and our businesses really, we have great operating talent across the whole world that have operated in that environment, whether it be Latin America, in Eurasian countries and we will certainly be looking at what’s evolving and we will remain very flexible as well as ready for anything that comes in that area."
},
{
"speaker": "Gary P. Fayard",
"text": "I would add one thing about inflation. If you go back and look at history, any time we really enter into an inflationary environment our company actually benefits. We do extremely well in that type of environment."
},
{
"speaker": "Mark Swartzberg - Stifel Nicolaus & Company, Inc.",
"text": "Some interesting comments out of Diagio this morning describing at least parts of their emerging markets business as having not only the better growth but perhaps the most enduring growth. When you look at your own business and think about volatility and risk of slowdown and magnitude of slowdown outside of the U.S., what do you consider your markets that are most vulnerable to slowdown, just from a macro perspective? Hearing what you all can do to defend against that is I think pretty persuasive, but what do you kind of put at the top of the list as your most vulnerable market? If you have to put something up there."
},
{
"speaker": "Muhtar Kent",
"text": "Certainly we talked about Russia. Russian has been hit in a different way and earlier than some of the other markets and we have certainly seen the results of that slowdown on our business, too. Our volume growth has slowed down. Philippines was one of the other markets that’s been hit significantly earlier than the rest, in terms of the macroeconomic situation and in terms of the remittances that were driving a lot of the consumption in that economy came down. And we have seen the impact of that. And no question that there are some Latin American markets that are beginning to feel the United States more, like Mexico. We know that the GNP in India and China is not going to be the same as it was in the past 12 months, it’s going to be slower but there will be growth. The Chinese prime minister reiterated the objectives of his government to ensure that they grow at 7% to 8% last week and announced more details of their stimulus package, which is very real. And I think all governments, across the world, are launching, in their own way, different stimulus packages whether it’s tax cuts, investment incentives, supporting small and medium size enterprises. So across the world there is a tremendous effort that we are seeing by a lot of governments, by central banks, to ensure that the macroeconomic downturn in their markets is not as deep as in some of the other markets that have already been hit. And we shall see how all of that evolves. Then we have others that are still resilient that are still growing, countries in Latin America, Indonesia, Turkey, and I have mentioned earlier, we have got a lot of small countries that make up a fairly large portion of our volume. Over 100 countries that we have, with per caps of less than 150, where last year we have grown almost double digits, 8% to 9% in these countries. So all the investments that we’re doing on the ground, in distribution, in customer connectivity, in cold drink equipment, in packaging, in new product, are paying off in a lot of those markets."
},
{
"speaker": "Operator",
"text": "Your next question comes from Carlos Laboy - Credit Suisse."
},
{
"speaker": "Carlos Laboy - Credit Suisse",
"text": "On Japan, the co-op of the bottlers there was being restructured and you were looking at the structure of Japan, I was hoping you could offer some thoughts on how you see that system evolving and whether you see yourself having to buy any bottlers there. And on the issue of China, how detached do you feel that your business trends might be from these macro pressures given how low you are in the evolutionary development of these markets for you?"
},
{
"speaker": "Muhtar Kent",
"text": "Let me just talk first, shed some light on the supply chain. The supply chain was set up for speed, flexibility, as well as scale, in Japan and none of that is being lost as we restructure it. The key is now it is much more aligned with local bottlers and how they ensure that their needs are met on a more timely basis. So it’s a restructuring but ensuring that the scale and the flexibility and the speed is still there. That is point number one on Japan. In terms of detachment, in markets like India and China that you referenced, our per capitas area still very, very low. 24 in China, less than 24 in India and again, we know that there is a pressure on migrant workers, for example. I will give you one example in China, that are returning back to the rural areas. Well, we have 30+ bottling plants in China, scattered across the whole country. We are selling to those rural customers and we were selling to them before they migrated to the cities and we are selling to them now. And we are, again, re-architecturing, creating new price points, ensuring that we are available and we are available in more formats with different price points to ensure that the affordability of our brands is still in place for Chinese and Indian consumers as well as consumers across all of the emerging markets can still afford and buy our products. Trademark Coke in China was up 18% in Q4, Minute Main Pulpy, a great product, that was up almost more than 50% in Q4 and is now a couple of hundred million case business on its own in China. And we’ve doubled our volume in tea last year in China. Growth more than 90%. So again, a lot of our organic growth has been very successful in China. And I repeat, organic growth."
},
{
"speaker": "Carlos Laboy - Credit Suisse",
"text": "Just to clarify on the Japan issue, do you see yourselves having to inject yourselves into Japan maybe more aggressively in terms of M&A? There was a transaction that hit the tape on Japanese bottling."
},
{
"speaker": "Muhtar Kent",
"text": "I think the thing about Japan is, think about it, we have had success with our cluster in west Japan. It has produced good results, achieving great market results now, with that cluster that has been formed where we injected ourselves in a minority position but ensured that we played a critical role in creating West Japan. And again, after the investment that we had in Coca-Cola Bottlers Tokyo, we are continuing to work to create the next cluster in Japan, around [Kynto] and if there is a need for us to inject ourselves in a small way, to ensure that we can play a role of catalyst there, we will do so."
},
{
"speaker": "Operator",
"text": "Your final question comes from Celso Sanchez – Citigroup"
},
{
"speaker": "Celso Sanchez – Citigroup",
"text": "Could you talk a little bit about the fountain business in North America, specifically the U.S.? The innovations with the mega-choice dispenser that you will be displaying next week certainly encouraging. But if you could speak more to the organizational changes that may be occurring in terms of how you approach the business and how you approach it in conjunction with your bottlers? I would love to see your roles evolving, both bottler and brand owner, over the next 12 months or so."
},
{
"speaker": "Muhtar Kent",
"text": "First, the fountain of the future is something we’re very excited about. We have been working on this as part of our innovation pipeline over the past couple of years and certainly what we have seen so far is very encouraging in that the consumer gets excited with the choice and with the flavors and certainly compared to a much more limited choice, we see great consumer excitement in the marketplace and how the consumer interacts. So we’re excited with what that will bring to us in a key channel of our business in North America and other parts of the world as we roll it out. So our efforts are really focused on the deployment of beverage offerings that this will create a lot of excitement at the point of sale with all of our customers as we start to roll that out. And I hope that you can see it for yourself at Cagney next week. In terms of the organizational change, an approach to business with our bottler and price pack architecture, don’t think about it as an organizational change. Think about it as a tremendously aligned approach. We have dual customer calling in about 20% of CC’s territory. We have begun to move to a single call model in the market to improve value to the customer and the system and it’s in early stages of its development and it’s all about being more effective in the marketplace and it’s all about being flexible and fast in the marketplace."
},
{
"speaker": "Celso Sanchez – Citigroup",
"text": "That sounds like a procedural change but I was wondering more along the lines of the alignment you spoke of in the markets where there is not dual calling. Is there room for improvement, do you think, for the alignment of price pack between found and bottle can?"
},
{
"speaker": "Muhtar Kent",
"text": "I think there is and that’s one of the work streams that we have with CCE and our other bottling partners, what we call fountain harmony, which offers the opportunity to implement the occasions brands package pricing as well as channel architecture across on-premise channels in a manner that will ensure that we meet evolving consumer desires. And also the incremental volume opportunities."
},
{
"speaker": "Operator",
"text": "There are no further questions in the queue."
},
{
"speaker": "Muhtar Kent",
"text": "Thank you. Our focus in this challenging and dynamic environment is to proactively drive our strategic agenda. We see tremendous opportunity to extend the reach potential and profitability of our business around the world despite the prevailing macro conditions and we are confident we have the right strategies as well as the right leadership team to do just that. We also remain committed to always ensuring open and ongoing transparent communication with you, our investors."
},
{
"speaker": "Operator",
"text": "This concludes today’s conference call."
}
] | null | null |
KO | 3 | 2,008 | 2008-10-15 08:30:00 | Executives: Ann Taylor - Vice President and Director of Investor Relations Muhtar Kent - President and Chief Executive Officer Gary P. Fayard - Chief Financial Officer Sandy Douglas - President, North America Group
Analysts: Bill Pecoriello - Morgan Stanley Judy Hong - Goldman Sachs & Company, Inc. Kaumil Gajrawala - UBS Christine Farkas - Merrill Lynch Bryan Spillane - Banc of America Securities Lauren Torres - HSBC Mark Swartzberg - Stifel Nicolaus & Company, Inc. John Faucher - J.P. Morgan Marc Greenberg - Deutsche Bank Securities Carlos Laboy - Credit Suisse
Operator: Welcome everyone to The Coca-Cola Company third quarter 2008 earnings conference call. (Operator Instructions) I would now like to introduce Ann Taylor, Vice President and Director of Investor Relations.
Ann Taylor: I'm joined by Muhtar Kent, our President and Chief Executive Officer, Gary Fayard, our Chief Financial Officer, and Sandy Douglas, our North America Group President. Following prepared remarks this morning by Muhtar and Gary we will turn the call over for your questions. Before we get started I'd like to remind you that this conference call may contain forward-looking statements, including statements concerning long-term earnings objectives, and should be considered in conjunction with cautionary statements contained in our earnings release and in the company's most recent SEC report. In addition, I would also like to note that we have posted schedules on our company website at www.TheCoca-ColaCompany.com under the Financial Information tab in the Investor section which reconciles certain non-GAAP financial measures that may be referred to by our senior executives in our discussion this morning and from time to time in discussing our financial performance as reported under generally accepted accounting principals. Please look on our website for this information. Now let me turn the call over to Muhtar.
Muhtar Kent: I'm happy to report that our financial performance continues to be strong and I'm pleased with our results for the quarter. Our ability to proactively address the rapidly changing economic environment exemplifies the strength of the Coca-Cola system. The fundamentals of our business are strong and we continue to work closely with our bottling partners to take action to drive sustainability growth. We are clearly in uncharted territory in these global markets, and we continue to calibrate and recalibrate the actions we need to take to continue delivering strong results. Given our performance this quarter and our proven ability to deliver strong and sustainable long-term results for our shareowners, we remain confident in our ability to navigate in these challenging times. However, the current global macroeconomic environment continues to be volatile. This is particularly true in North America, and we expect this to continue through 2009 with economic growth moderating around the globe. Nevertheless, I remain confident that we operate in a very resilient industry and that we have the management and strategies to help us operate successfully during these difficult times. Our performance during the third quarter demonstrates this resilience. During the third quarter we achieved double-digit comparable earnings per share growth of 17%, marking our eighth consecutive quarter of double-digit EPS growth, which means we are well ahead of our long-term earnings growth model in 2008. Our unit case volume increased 5% in the quarter and, as expected, accelerated versus the second quarter, which was impacted by several one-time events. Revenue growth increased 9%. This growth was negatively impacted by 2 percentage points due primarily to the sale of bottlers. So, excluding the sale of bottlers, revenue increased by a very solid 11%. Once again, we successfully balanced the value and volume equation to deliver consistent top line performance. Ongoing operating income increased 17%, reflecting the solid revenue growth, continued brand investment and disciplined management of operating expenses. Year-to-date, cash generation remains strong, with over $5.5 billion from operations. By any measure, a strong set of results. Our volume performance during the quarter was again led by our international markets, including solid growth across most emerging markets. Unit case volume in international markets increased 7%, cycling 8% growth in the prior year quarter. The international performance was driven by 5% growth in sparkling beverages, including Coca-Cola, up by 4%, Coca-Cola Zero up by 22%, and strong growth in both Sprite as well as Fanta. Coca-Cola Zero, now in over 100 markets worldwide, is on plan to exceed half a billion unit cases for 2008. Most key emerging markets delivered solid growth, with China up 17%, India up 18%, and Brazil and Mexico both up 7%. In addition, we saw strong performances in Argentina, Turkey, Eastern Europe, Southern Eurasia, Pakistan, North and West Africa, Nigeria, Korea, and across most of Southeast Asia, including Thailand. As you can see, our quality performance spans most of the globe. In countries with per capitas of less than 150, our volume growth was 9% in the quarter, cycling 12% from prior year. Importantly, we continued to gain volume and value share in most of our key markets and in core sparkling and still beverages. This illustrates how the strength of our brands and the strength of our system enable us to successfully operate in tough environments. History has proven by continuing to invest in our business, even during difficult economic times, we can further strengthen our bonds with consumers, thus garnering a stronger share position for the long term. Simply said, we are winning in the marketplace. Let me turn now to the results in our geographies. Latin America once again achieved very solid results. Unit case volume increased 8%, cycling 9% growth in prior year. The growth was balanced across geographies as well as the beverage portfolio, with all business units delivering high single-digit unit case volume growth. Coca-Cola increased 4% and still beverages increased 38% in the quarter as we continued to leverage the Jugos del Valle acquisition. The group also continued to achieve share gains in all key countries. In Eurasia and Africa we achieved unit case volume growth of 9%, cycling 13% growth in the prior year. The performance was led by double-digit growth in key markets, including India, Nigeria, Turkey, Southern Eurasia, and high single-digit growth in the Middle East and Northwest Africa. Growth was solid across sparking and still beverages, with sparkling beverages growing 6% and still beverages growing 21%. In Russia unit case volume declined 3%, primarily reflecting the impact from unseasonable weather and economic and inflationary pressures. Despite the slowdown of volume growth in Russia, we gained volume and value share in nonalcoholic ready to drink beverages in the quarter and the fundamentals of our business in this key market remain strong. The Pacific group grew unit case volume 7% in the quarter, cycling 11% growth in the prior year. China and Japan delivered strong results, solid results offsetting weaknesses in the Philippines due to continuing weather and inflationary pressures, both of which impacted consumer spending. China once again delivered solid double-digit growth, which accelerated versus the second quarter. Sparkling beverages grew 13% and still increased 27%, led by the continued success of Minute Maid Pulpy and the expansion of our Original Leaf Tea, which, as you will recall, we launched earlier this year. Perhaps the most significant achievement for the company in the quarter was our successful activation of the Beijing Olympic games sponsorship. Our sponsorship attracted widespread positive media and consumer attention for the company in China and around the world. During the 16 days of the games, over half a billion Chinese consumers connected with our brands through sampling programs, Olympic torch relay activities, and downloads of the Coca-Cola Olympics song, which was downloaded over 260 million times and reached number one on the pop music charts in the country. All of these activities, as well as numerous other events and promotions, resulted in Coca-Cola being cited as the most recognized and effective sponsor of the Beijing games, as reported by Neilson. Also in the quarter we announced our offer to acquire China Huiyuan Juice Group Ltd. The acquisition provides a unique opportunity to complement our existing leadership in China in sparkling beverages and expand our presence in still beverages, particularly in the dynamic and fast-growing juice category. Huiyuan brands are highly complementary to our Minute Maid business and Huiyuan's existing manufacturing footprint will provide additional scale to our China operations. In terms of the process, we've filed for Chinese Ministry of Commerce approval and are fully cooperating with their review of the transaction. In Japan volume increased 1%, successfully cycling 4% growth in the prior year, resulting in nonalcoholic ready to drink retail share gain. We continued to invest in our three cola strategy, and the success of this was evident in the growth of sparkling beverages during the quarter, which was led by trademark Coca-Cola. Additionally, we've continued with successful innovation behind the Fanta trademark. Georgia Coffee grew 4%, marking its fourth consecutive quarter of growth and core Georgia flavors increased 10%. The strength of the marketing activity behind the Georgia brand led the continued category share gain. In Japan, we've continued to execute against our strategies and focus on delivering consistent sustainable results. The Europe group overcame a slowing Western European economy and unseasonable weather in Northwest Europe to increase volume 3%. Despite the challenges, we are outperforming the marketplace and gaining overall nonalcoholic beverage share. We continue to strike a balance between tactically addressing the current economic environment and investing for long-term growth by supporting our core sparkling brands and driving innovation across the portfolio. Driving sparkling performance in Europe is the development of the Zero range, including Coca-Cola Zero, which grew double digits in the quarter, the launch of the Pan-European Pemberton program, which highlights the heritage of Coca-Cola, and the German launch of the Spirit of Georgia, our first adult-targeted lightly sparkling lemonade beverage containing fermented juices. We continue to expand our still beverage offerings to generate more balanced growth, including continued support of Illy ready to drink coffee, which is now in 9 markets, as well as Vitamin Water in Great Britain. We are consistently making solid strategic investments behind our brands for the balance of 2008 in Europe, and we will activate the recently announced Zero Zero 7 campaign supporting the latest James Bond film as well as our traditional holiday campaign. In North America results were clearly impacted by the volatile economic environment, however it is important to recognize volume declines of 2% outperformed the industry in the quarter. This resulted in total measured and unmeasured nonalcoholic ready to drink volume and value share gains in the quarter. Sparkling beverages declined 2% in the quarter, an improvement from the year-to-date trend, and resulted in core sparkling volume and value share gains. This reflects the successful activation and execution of our Olympic marketing program during July and August. Our red, black and silver portfolio - Coca-Cola Classic, Coca-Cola Zero and Diet Coca-Cola - continued to gain volume and value share as well. Coca-Cola Zero delivered strong results, growing 30% in the quarter, cycling double-digit growth from the prior year. However, there was continued softness in our Food Service business and other on-premise channels, both of which are being impacted by the current economic reality. Additionally, bottler pricing post-Labor Day has impacted volume performance. As a consequence, we are aggressively moving to address these challenges by allocating resources to consumer and customer-facing programs. Our still beverages portfolio continued to outperform the industry, resulting in volume and value share gains. Our multi-tiered juice strategy, led by double-digit growth in Minute Maid Enhanced and Simply trademarks resulted in continued superior category performance and share gain. Glaceau performance remains solid, increasing double digits in the quarter, with strong performance in the immediate consumption and non-measured channels, driving increased volume and value share leadership. Glaceau remains on target to becoming a $2 billion trademark in early 2009. Glaceau, along with trademark Simply, Coca-Cola Zero, [Nos] and Fuse are five of the top 10 fastest growing trademarks in incremental retail sales for North America. Last week we also announced a distribution agreement for Hansen's Monster Energy Drinks. We believe the Monster brand will complement our existing portfolio of energy drinks and provide our bottlers with further opportunity to drive profitable growth. While we have a strong marketing calendar with our bottling system and customers across sparkling and still brands for the remainder of the year, we expect fourth quarter volume to trail the year-to-date trend due to the continued impacts of the economic slowdown and bottler pricing action. We continue to focus on productivity and expense management initiatives to target investments in consumer and customer-facing programs for future growth in North America. We remain committed to our strategies and to winning in North America. Now let me update you on our company wide productivity initiative, which has been up and running since last quarter. We are leveraging our efforts to redirect investments to drive top line growth and long-term sustainable value creation. Our systemwide focus on productivity remains a priority for 2008 and beyond. As you know from our last call, we moved early to take aggressive steps in this area. Through this work we are rewiring our business and reallocating our resources to be more directly focused on the marketplace as well against our highest growth opportunities. Building strong brands with world class marketing is the key to our sustainable top line growth. As previously indicated, our target is to generate annualized operating savings in the range of $400 to $500 million by the end of 2011. These are savings accruing directly to the The Coca-Cola Company. We will also continue to work towards improving the system supply chain. We also previously indicated that there will be nonrecurring costs of approximately $400 to $500 million associated with implementing these initiatives and that both the benefits and the costs would be spread fairly equally annually through 2011. A team led by seasoned operators has ensured that we are on track to deliver against these targets, and we have already begun to benefit meaningfully from this initiative in 2008. Once again, I am pleased with our results for the quarter. We are winning in the market as evidenced by our share gains in key categories and markets. Our increased focus on effectiveness and efficiency is providing the additional flexibility needed to consistently deliver long-term growth and create value for our share owners. During periods of economic stress, the merits of The Coca-Cola Company truly come to the fore, as we have seen again in this most recent quarter. Our brands and our business were built for times like these. We have a seasoned management team with great experience honed through many tough cycles in markets across the globe. Our business is balanced across nearly every market, our product portfolio spans most major nonalcoholic beverage categories, and our brands are available in more channels and outlets than any other consumer company. This quarter's performance reflects that reality. Backed by a solid balance sheet, The Coca-Cola Company continues to deliver attractive earnings growth, strong free cash flow, as well as a reliable dividend that we have included for 46 straight years in both good and challenging times. It is incumbent upon us to ensure that we not only meet these challenges but that we use them to our advantage. We continue to define our picture of success as exceeding our long-term growth model. We are also realistic about the operating environment for 2009. We're in the process of reviewing and finalizing our plans for 2009 and will provide more color on our expectations for next year during our fourth quarter call in February. However, you can expect us to continue to invest to fuel brand growth while aggressively managing costs. I remain confident we're building a stronger Coca-Cola system for the future. With that, let me turn the call over to Gary.
Gary P. Fayard: As Muhtar indicated, we've just again delivered strong financial results in the quarter. We reported earnings per share of $0.81 per share on a diluted basis in the quarter; however, this included a net charge of $0.02 per share for restructuring charges and costs related to global productivity initiatives, partially offset by the gain on the sale of a portion of our investment in our Pakistan bottler. Therefore, comparable earnings per share was $0.83 per share, an increase of 17% after considering factors impacting comparability in both the current and prior year quarters, our eighth consecutive quarter of double-digit comparable EPS growth. Net revenue in the quarter increased 9% and increased 11% excluding the impact from structural changes primarily related to the sale of bottlers. Growth was driven by 2% favorable impact from price and mix, a 3% increase in concentrate sales, and a 6% increase from currency. In the quarter, unit case volume increased 5%, cycling 6% growth in the prior year quarter, and year-to-date concentrate sales and unit case growth rates are essentially in line. We grew operating income by 20% on a reported basis. After considering items impacting comparability and the current and prior year quarters, operating income increased 17%, which includes a 9% benefit from currencies. Year-to-date, our currency neutral operating income of 9% remains ahead of our 6% to 8% long-term target. Total selling, general and administrative expenses on an ongoing basis increased 8% in the quarter. This translated into 5 points of operating expense leverage. We continued to invest in our brands and build market execution capabilities. Marketing expenses increased at approximately the same rate as gross profit growth, and sales and service increased solidly to support our bottling operations. Our focus on expense management and productivity initiatives is reflected in a mid single-digit decrease in general and administrative expenses. Additionally, we continue to see year-to-date margin improvement in both our core business and in our Bottling Investments group. For the remainder of the year we would expect to continue to achieve expense leverage, but at a more moderate rate as we start to cycle some of the programs put in place late last year. Our net interest expense decreased in the quarter, reflecting the benefit of interest income earned internationally at higher rates. And with regard to taxes, we ended up the quarter with an underlying effective tax rate of 22%, and we expect to remain at the underlying effective rate for the remainder of the year. As we've previously announced during the quarter, we have curtailed our share repurchase program for the remainder of the year as we pursue the acquisition of the Huiyuan juice business in China. We repurchased a slight number of additional shares at the beginning of the quarter and now have bought approximately $1.1 billion of our stock year-to-date. Now let me address some of the factors that we see impacting the remainder of 2008. We remain confident in our ability to achieve long-term sustainable growth and our picture of success remains to exceed our long-term growth model. We will continue to portfolio manage globally as we expect solid performance in most of our markets. While we expect economic growth in some emerging markets to moderate, we believe that key emerging markets like China, India, Eurasia and Latin America should continue, with solid business growth. It is our belief that among other consumer goods companies, our business will better navigate the current economic environment as we reach the consumer through a broader array of channels and packages with preferred brands. Improvement in our market share will continue to be a benchmark of our success. Globally, we are working closely with our bottling partners. The fundamentals of our business remain strong, and as a system we continue to take appropriate actions to navigate the near-term volatility while strategically investing behind our brands in the marketplace for long-term growth. Last quarter we revised our net capital expenditure forecast to approximately $1.8 to $1.9 billion, and we'll likely come out close to $1.9 billion for the full year. Lastly, as you saw in the quarter, structural changes primarily related to disposal of bottlers, caused a drag on net revenue growth. We sold all of the Remil bottler in Brazil to Coca-Cola FEMSA at the end of the second quarter. We sold a portion of our investment in the Pakistan bottler to our Turkish bottler at the end of the third quarter such that we now own just under 50% and will no longer consolidate the Pakistan bottler, but include it in equity income. Additionally, we will not have the offsetting impacts of the Norsa bottler in Brazil and PCAG, our German bottler acquisitions, as we cycle these in the third quarter, so we would expect a larger impact from structural change on net revenues in the fourth quarter and into 2009. Moving now to two key topics - liquidity and currency. Given the recent market volatility, I know liquidity may be top of mind for some of you. Our liquidity remains strong and our commercial paper program continues to function each day as broadly authorized by investors and is [praised] strongly. We have been able to continue to access 60 to 90-day terms and have not had a material change to our spreads to benchmark rates. We also have $2.2 billion of committed unused credit facilities from our network of relationship banks and our almost $8 billion in cash is available and in liquid, high-quality investments. Most of the cash is offshore, but we have reviewed our contingency plans and would be able to access the cash on short notice. Year-to-date we have generated over $5.5 billion in cash from operations and, in short, liquidity is not a concern as we're able to fund our operations from internal cash generation and commercial paper. With regard to currency, as I mentioned, we saw a positive impact from currencies in the quarter on operating income of 9% and 10% year-to-date. We are maintaining our full year 2008 forecast of at least a mid single-digit currency benefit. We realized a stronger than expected benefit in the third quarter which we expect to be offset by a slightly weaker forecast in the fourth quarter, therefore no change for the full year. As for our 2009 currency outlook, it is obviously a very volatile environment. We're already 100% covered on key hard currencies like the Euro and the yen. Emerging market currencies are particularly volatile, as we've seen over the last few weeks; therefore, it would be impractical to give a view on currencies for 2009 at this time. However, it is important to note that we manage our business in local currency to ensure that we make the right decisions for the long term. As Muhtar indicated, we're in the process of finalizing our 2009 business plans, so we'll provide our outlook for 2009 on our year end call in February. So that's the topics I wanted to cover this morning. We're ready for questions.
Operator: (Operator Instructions) Your first question comes from Bill Pecoriello - Morgan Stanley.
Bill Pecoriello - Morgan Stanley: You mentioned the system's ability to adapt to the rapidly changing economic environment as a key competitive advantage. Can you give us some examples, some of the tactics the system is using to adapt, especially as immediate consumption begins to slow in several regions of the world, maybe a shift in channel or package focus to adapt to that?
Muhtar Kent: First I think what you need to see is that we keep focus with our strategies of growing sparkling and expanding still beverages, balanced growth, increasing our pace of innovation and growing capability. But within that, as I said, we've continued to calibrate and recalibrate to ensure that our system remains very flexible, leveraging new packaging innovations, new price points, and also ensuring that there's an absolute good balance between above the line and below the line activities; a much closer relationship with our customers, value offers. And in this environment more and more people, particularly in the West, are going to spend more time at home and we have programs to address that with future consumption, bringing back refillables in many countries in emerging markets. So all of that taken as a whole, I think - affordability focus, new price points, package innovation, and continued bottler investment ensure that we keep focus. There is no other business in the world that visits 20 million customers on a weekly basis and no other business that is as close to the marketplace as our business, so we've continued to leverage that and stay connected with all local markets and I think we're seeing the benefit of that.
Bill Pecoriello - Morgan Stanley: Any implications for system margins as you see more of the future consumption focus or are you going to pull various levers so the system can maintain margins as you get that shift?
Muhtar Kent: I think we will balance the margins with share gains. And we want to be absolutely sure that we do the right thing for the long term. You know, I've been through this movie in smaller versions a number of times in the past - in 1998 in Russia, 2001 in Turkey, and in Latin America - and I can tell you that the key here is to make sure that you keep connected to the consumer, maintain the health of your brands, and that's what you're going to be seeing us do. But also we are going to be making sure that any kind of costs that are not necessary are going to be - we will continue to eliminate them out of our system religiously and refocus our resources to market-facing and customer-facing activity.
Operator: Your next question comes from Judy Hong - Goldman Sachs & Company, Inc.
Judy Hong - Goldman Sachs & Company, Inc.: Muhtar, can you speak to the resiliency of or even sequential improvement of some of your key international markets in terms of volume trends in Q3 versus Q2? And then, as you look out to 2009, as you kind of deal with the economic conditions - and I understand you're not giving specific guidance - but if you can give us some perspective as to how you think about '09 relative to your long-term growth targets, both from a volume and EPS perspective.
Muhtar Kent: I think what you see, Judy, is first, you see the balanced portfolio working in our favor. We had some countries that even again in the third quarter did not perform up to our expectations, like Philippines, like Russia, like U.S. Food Service. Germany was flat. But despite that we came in with a very strong quarter. You saw that every single one of our international operating groups increased their growth trend versus the second quarter of '08 - Europe from zero to 3%, Latin America from 7% to 8%, Eurasia and Africa from 6% to 9%, and the Pacific group going from 4% to 7%. And we had indicated to you that there was a lot of one-off items in the second quarter that were impacting our business, and I think that you saw us coming through in what was still a very difficult quarter. And the balance and our actions, the flexibility in the marketplace, our bottlers' ability to continue and an appetite to continue to invest in the marketplace, you saw us coming through. I think that there are going to be areas of the world next year that will be growing less. There will be growth for sure in the emerging markets. It may not be to the same extent as we saw this year, but I think that despite the volatility we are in the best consumer business there is. Tremendous resilience, providing we take the right actions, and you will see us taking the right actions.
Judy Hong - Goldman Sachs & Company, Inc.: And your comment about the fourth quarter volume trending a bit below the year-to-date volume, is that more a function of North America potentially showing another leg down or is that also related to international markets?
Muhtar Kent: No, no, that was purely - that comment was purely related to North America, and I made sure that I stated it that way. It was purely related to North America and related to those issues that I discussed with you because of the continuing pressure on immediate consumption and attitudes of the U.S. consumer as well as pricing to shore up the margins by our bottling partners at the end of the quarter.
Judy Hong - Goldman Sachs & Company, Inc.: And then just a quick question for you, Gary. If you look at your expense leverage, clearly a big driver is the corporate expenses coming down. And if we look at the run rate in the last two quarters, it looks like around 3% of net sales. Is that sort of a good run rate to use going forward?
Gary P. Fayard: Yes, Judy, I would expect that the run rate will be about that or slightly less. We actually started having some of that leverage coming through in the fourth quarter of last year, so it'll actually go down a little bit because of what we're cycling.
Operator: Your next question comes from Kaumil Gajrawala - UBS.
Kaumil Gajrawala - UBS: A couple questions on the regions that you mentioned with the per caps under 150. First, just quickly, how much of your volume comes from those regions? And then second, given the economic environment, should we be assuming a lower run rate, maybe these regions in aggregate going forward? And then are some of these regions big enough that we should start seeing margins grow at a much faster rate than we're seeing sales grow?
Muhtar Kent: I think roughly it's fair to say about a third of our volume globally will come from those kind of markets, per capitas of around 150. And I think that what you've seen in many of the markets that were there and now are at higher per capitas - Latin American markets, South Africa, Turkey and so forth, that have passed that level - you're seeing margins for the system improving fairly radically. And I think that as we see per capitas growing, we certainly will make sure that the same trend is also valid for margin improvement and enhancement. And I think that we are seeing from many African markets and many other smaller Latin American markets, Asian markets, Middle Eastern markets, Eurasian markets, that, as they approach the sort of 100 to 150 per capita range the scale of our business is beginning to power ahead and that we're seeing really good growth levels and also margin enhancement in these countries.
Kaumil Gajrawala - UBS: And then on a volume run rate?
Muhtar Kent: I think that basically I am cautiously optimistic that we will have growth coming through in all those markets, as we've seen this year.
Operator: Your next question comes from Christine Farkas - Merrill Lynch.
Christine Farkas - Merrill Lynch: There were some reversals, as you indicated, in the third quarter versus the second quarter. I'm wondering if you can talk about early fourth quarter trends, specifically in Russia given their macro environment, China post the Olympics and how those trends are, and then Mexico on the back of the U.S. economy. I mean, your volumes there have been pretty strong. Can you talk about perhaps the competitive environment?
Muhtar Kent: Firstly, I wouldn't call it reversals. I would call it improvements. But I think I can't give you basically guidance for quarter four at the moment, but I can tell you that our business is very, very strong in markets in Latin America, including but not limited to Mexico, as well as China. And I think that we certainly are going to be looking at ensuring that we can move forward with our plans for Q4 and '09 so that our picture of success remains valid, that we can meet or exceed our long-term growth targets.
Christine Farkas - Merrill Lynch: And then a follow-up for Gary. I think if I heard you correctly you mentioned equity income may have been boosted by the impact of the sale of the Pakistan bottler. Can you tell us how much was reflected in that line item?
Gary P. Fayard: Yes, Christine. What I said was it would now be reported in equity income. We actually closed the transaction at the very end of the third quarter, so starting in the fourth quarter, but it's really not going to be a significant change. The biggest change you'll see is just it'll be a drag on top line revenue, but relative to income it's not going to make a big difference at all.
Christine Farkas - Merrill Lynch: So the equity income line was actually just the regular equity income drawing from your anchor bottlers, etc.
Gary P. Fayard: Correct. Correct.
Operator: Your next question comes from Bryan Spillane - Banc of America Securities.
Bryan Spillane - Banc of America Securities: Gary, a question for you on liquidity. Just two areas of interest; one is what's the potential that there may be a tax holiday to allow you to repatriate some of that cash back to the U.S. without taking the tax penalty? And then second, just related to both bottlers and trade customers, are you seeing anything different in terms of the tighter credit markets, whether it's retailers carrying less inventory, maybe a destocking situation, or bottlers that may not have otherwise been under stress that may be stressed by the liquidity or the credit market?
Gary P. Fayard: Number one, potential for a tax holiday, you know, coming up to the election and everything else, I really don't know. If it happened we would look at it and we'd make the right decision for the long term, but that one I really can't speculate on. I don't know at this point. What I do know is we've got the cash. We can access it if needed, but whether we repatriate or not, I really can't comment on that. Relative to bottlers and trade customers, I'd say two things. Let me address both; first, receivables, as we've really been working on our working capital. And, in fact, if you look at our cash flow, in fact, I'll point out one item within our cash flow statement that does not - it makes it look like we did not improve working capital as much as we did. There's about a $350 million tax item on a settlement of an issue with - a foreign tax issue where we paid the cash in the quarter, and we'll actually recoup it, we'll get it back, but it'll be - we'll get it back in the fourth quarter or early first quarter of next year. So if you look, then, if you take that out, we actually bettered our use of working capital significantly, I mean, like $700 million or so year-to-date Q3 versus year-to-date Q2. The other is our days in receivables are exactly in line with where they were at the end of third quarter last year, so we've not seen any issues there. We've also not seen a lot of destocking because for us obviously it's primarily with the bottlers, and we actually work with the bottlers every year as we put our plans together on optimizing what their inventory should be. And so it's something we work on routinely every year to ensure that they're in exactly the right place because we don't want them holding too much inventory and having a lot of working capital tied up, either. So I think we're in a pretty good place right now.
Operator: Your next question comes from Lauren Torres - HSBC.
Lauren Torres - HSBC: [inaudible] has been rather vocal, I'd say, over the course of this year with regard to challenges in several of their markets. You've been somewhat more positive on emerging market growth, but I was hoping you could address specific markets, expectations for Russia, maybe parts of Eastern Europe. I know there's some macro challenges or there are macro challenges, but I was just curious about your thoughts looking out over the next year or so about a return to some more normalized growth there.
Muhtar Kent: Yes, Lauren. First, the current conditions in Eastern Europe, Russia, the markets of Eurasia are still - the macroeconomic conditions are still such that they are generating growth. And the sentiment is a lot better than it is, say, in the United States or Western Europe. Now, I don't think they'll get as bad as the United States or Western Europe. I don't think they will stay as good as they were in the past 12 months. Russia is certainly experiencing issues and problems in their financial markets. But I think that if you look at our business, the fundamentals of our business are strong in all these markets. We're a business, you know, you've got to keep in mind that we're a business that generates with our bottlers as a system $15 billion plus of cash a year. We visit multiple, multiple customers, millions of customers in these markets, and in many of these markets that you've referenced, the trade is very fragmented, very, very fragmented, and that I think is a big advantage going forward for us in working closely with all these smaller customers. My experience in this kind of environment is that Coca-Cola and our brands become a bigger part of the revenue of these smaller customers in these circumstances. We mean more to these customers as we service them. No one services them like our system services them, and I think that is a huge advantage that we will continue to leverage in this environment.
Lauren Torres - HSBC: So with that said, even though we may see some volume weakness, you're still seeing share gains, be it volume or value share gains?
Muhtar Kent: Yes. And I do still believe that there will be growth in these markets for our business.
Operator: Your next question comes from Mark Swartzberg - Stifel Nicolaus & Company, Inc.
Mark Swartzberg - Stifel Nicolaus & Company, Inc.: Muhtar, acquisitions. I was hoping you could talk a little bit more here about you appetite for additional multi-billion dollar acquisitions generally? And then, with share repo being on hold because of Huiyuan, if the right thing were to present itself, is there any issue with your credit rating given, you know, you backed up your bottlers, that would prevent you over the near term from doing additional major acquisitions?
Muhtar Kent: Right. Mark, I'd just say the following: First, I said it and I'll repeat it again. Organic growth is key to our success. Sparkling growth is key to our success. It's the oxygen. We've got to balance sparkling growth with still growth, and we've got to have organic growth. And any opportunities for acquisitions will come on top of that. That remains absolutely valid. Huiyuan, I think, is a great opportunity, and we continue to work with the Chinese government. We are the first company to apply to the Minister of Commerce under the new law, and we believe that we will prevail in China with that great opportunity. If there are any other opportunities that present themselves, our strategy remains bolt-on acquisitions are still part of the strategy. And we will make sure that, if we see a great opportunity for the future of our business, complementing our existing business in a country, we will not let it go by.
Operator: Your next question comes from John Faucher - J.P. Morgan.
John Faucher - J.P. Morgan: In looking at the performance of your publicly traded anchor bottlers year-to-date, obviously some pretty tough times in that regard, so I guess a couple of questions. You've talked about selling off bottling assets. We've begun to see that a little bit. Has the change in the public market valuations drifted into the private markets? And then, flipping that around, given the fact that the private market valuations are so low, does that change your interest in maybe bringing more bottlers into the hospital ward or is that something you say, look, we're going to worry about the market. We'll let the market deal with that, and we're just focused on operating where we need to operate.
Muhtar Kent: I'll reflect on that and maybe Gary can also comment on it. Firstly, I was with - we had a big bottlers meeting three weeks ago with about 50 of our top bottlers around the world, the first meeting of its kind for some time, and I can only tell you that I think everyone comes away with tremendous passion, realistic optimism as well as determination to continue driving our business, to continue investing, and to continue to do the right things for our business whether they're public or private bottlers. And I think that nothing really has changed from our strategy in terms of looking at homes for bottlers that - weaker currently - are running when it makes sense, the right homes, and also if there's a need, we will not hesitate to bring another bottler into our sphere. However, I don't see anything near on the horizon for us to do that right now, and I think that I came away, as well as our bottling partners came away, from that meeting really charged up and really feeling good about the future of our business.
Gary P. Fayard: And John, I would add relative to values of the bottlers that we have, that we own, I'd say a couple of things. Number one, we've always taken a long-term view basically that we would only sell a bottler if the purchaser had the financial and the management resources to really grow that market for the long term, and that when selling we would sell at a fair value. And so I would say that's still where we are. If we were looking to sell a bottler today, we would be looking for fair value and then that would be just subject to negotiation on how you define that number. But our strategy really has not changed at all.
John Faucher - J.P. Morgan: And then if I could ask one follow up on that, which would be you guys have been managing Philly Coke for awhile now. Any insight into how the rest of your North American bottling system should deal with its recent struggles given the fact that you guys have a little bit more hands on experience right now?
Muhtar Kent: Well, I think, John, we're learning from many experiments in North America. It's not just Philly. I think Philly is doing many things to prop up their on-premise business very successfully. In fact, they've been proving to everyone that sparkling beverages can grow again in North America if you do the right things. But then with many of our other bottlers, including [CC], we have a number of initiatives going, whether it be packaging initiatives, whether it be sparkling growth initiatives, whether it be still growth initiative, on-premise initiatives as well as in the Food Service business of ours, where we're looking at commercializing a number of innovations in the coming months. So I think it's not just limited to Philly, and the entire system - the entire system - is really learning from all the - not experiments but lead market tests that we're doing, not just experiments. And I think that you will see us rolling out a number of those very, very shortly. And Sandy Douglas is here, President of our North American business, and I'll ask him to also shed some light on that.
Sandy Douglas: Muhtar, I think you said it well. We've been working with the entire system on remerchandising the sparkling packaging mix with a number of lead markets, all bottlers involved. We're working closely with the system to create new processes and approaches for managing large customers, and we're continuing to work on integrating our supply chain to drive out waste and to be able to have more money to invest in the consumer and the customer. And we couldn't be happier about bottler involvement and participation, and those lead markets, as you say, are presenting a road map for us to go forward that will put us in a stronger position in the years ahead.
Operator: Your next question comes from Marc Greenberg - Deutsche Bank Securities.
Marc Greenberg - Deutsche Bank Securities: First, just a follow up on John's question. In light of Pepsi's comments yesterday about taking a restructuring and investing significant new monies behind North America, Sandy or Muhtar, do you feel that the absolute level of investment behind the U.S. business is sufficient right now? Is it going to be a step change kind of a year in 2009?
Muhtar Kent: Yes, Marc, I think you need to understand that we have been on a path indicating and saying and wholly believing that sparkling beverages can grow in North America since late 2004. And we have pushed this agenda forward, and you've seen the successes of Coca-Cola Zero and many other initiatives. Fanta brand also doing really well in our business in North America. Don't forget that we also took out $400 million in '05 and invested it in marketing across the world, and a lot of that was honed in here in the United States. So our marketing base had already grown. We will continue with our bottling partners to ensure that we have the right level of investments in North America, to make sure that we can leverage all of the opportunities that we talked about in the answer to the previous question, to make sure that we can replicate great experiments, great examples, great lead market stories in both innovations in packaging, new price points, and much more inspiration at the point of sale, much more focus on gaining availability in the universe of accounts that we have. And learn from all the lead markets in the United States and make sure that we have the right level of investment, customer-facing and consumer-facing investments.
Marc Greenberg - Deutsche Bank Securities: Gary, just a quick housekeeping item. The 7% volume growth in Mexico, I'm wondering if there's any kind of a timing or acquisition bump in there. Based on comments and guidance from some of the larger Mexican bottlers, our sense was that it wasn't going to be that big a number in the quarter, and obviously expectations for the fourth quarter may be coming down a little bit. Can you talk to that?
Gary P. Fayard: Yes, Marc. In Mexico specifically, acquisitions contributed low single digits to that growth rate or 5 points to that growth rate and our organic was low single digits.
Operator: Your last question comes from Carlos Laboy - Credit Suisse.
Carlos Laboy - Credit Suisse: Muhtar, you've mentioned this, I think, in some form, but market downturns sometimes - they open up opportunities to radically change a market. Argentina a few years ago, for example, comes to mind. Can you expand on the company owned bottler performance expectation through this macro slowdown and whether it's Germany or the Philippines, what kind of opportunities do you see in this downturn to gain competitive ground?
Muhtar Kent: Well, Carlos, I see opportunities in their environment not just for our company owned bottling operations, for our entire bottling system. I want to stress that. And I think that the consolidation in Germany is complete. We are gaining share in the German market. We are doing some great things under one of our great operators in our bottling business in Germany, and we're gaining great traction with discounters in Germany. And I see the business fundamentals getting stronger every day. In the Philippines, I think we're again doing exactly the right things for the long term. We had a disappointing quarter in the Philippines - it was 9% down - but you will see that trend improving going forward. And I think that the Philippines has had more than its fair share of this economic volatility in the third quarter, with food pricing really affecting consumer spending and sentiment. But going forward I believe that trends in the Philippines are going to improve. And I think in China, again, we're doing exactly the right things to have a great, great business. I always say China is another Coca-Cola company, and I firmly believe that.
Operator: I'll now turn the call over to Mr. Kent for closing remarks.
Muhtar Kent: Thank you, Gary and Ann. Before we close the call I'd like to thank Ann Taylor for serving as Director of Investor Relations for the last four years. She and her team have done a tremendous job helping craft and deliver our strategic and financial message as the company has evolved during both Neville's and now my tenure as CEO. Ann will be moving within our organization to a role overseeing the company's transformation efforts, one of our most critical growth enablers. I want to thank Ann for her contributions, and I know she will continue to play a very meaningful role going forward. I'm pleased to announce that [Jackson Kelly] has been appointed our new Director of Investor Relations. Jackson has spent the last two years working directly with me on global strategic initiatives, and Jackson's 17 years with the company, his background as a CPA as well as his experience in marketing, strategy and finance, will add an important new dimension to how we interact with each of you. Thanks for joining us this morning, and have a great day. | [
{
"speaker": "Executives",
"text": "Ann Taylor - Vice President and Director of Investor Relations Muhtar Kent - President and Chief Executive Officer Gary P. Fayard - Chief Financial Officer Sandy Douglas - President, North America Group"
},
{
"speaker": "Analysts",
"text": "Bill Pecoriello - Morgan Stanley Judy Hong - Goldman Sachs & Company, Inc. Kaumil Gajrawala - UBS Christine Farkas - Merrill Lynch Bryan Spillane - Banc of America Securities Lauren Torres - HSBC Mark Swartzberg - Stifel Nicolaus & Company, Inc. John Faucher - J.P. Morgan Marc Greenberg - Deutsche Bank Securities Carlos Laboy - Credit Suisse"
},
{
"speaker": "Operator",
"text": "Welcome everyone to The Coca-Cola Company third quarter 2008 earnings conference call. (Operator Instructions) I would now like to introduce Ann Taylor, Vice President and Director of Investor Relations."
},
{
"speaker": "Ann Taylor",
"text": "I'm joined by Muhtar Kent, our President and Chief Executive Officer, Gary Fayard, our Chief Financial Officer, and Sandy Douglas, our North America Group President. Following prepared remarks this morning by Muhtar and Gary we will turn the call over for your questions. Before we get started I'd like to remind you that this conference call may contain forward-looking statements, including statements concerning long-term earnings objectives, and should be considered in conjunction with cautionary statements contained in our earnings release and in the company's most recent SEC report. In addition, I would also like to note that we have posted schedules on our company website at www.TheCoca-ColaCompany.com under the Financial Information tab in the Investor section which reconciles certain non-GAAP financial measures that may be referred to by our senior executives in our discussion this morning and from time to time in discussing our financial performance as reported under generally accepted accounting principals. Please look on our website for this information. Now let me turn the call over to Muhtar."
},
{
"speaker": "Muhtar Kent",
"text": "I'm happy to report that our financial performance continues to be strong and I'm pleased with our results for the quarter. Our ability to proactively address the rapidly changing economic environment exemplifies the strength of the Coca-Cola system. The fundamentals of our business are strong and we continue to work closely with our bottling partners to take action to drive sustainability growth. We are clearly in uncharted territory in these global markets, and we continue to calibrate and recalibrate the actions we need to take to continue delivering strong results. Given our performance this quarter and our proven ability to deliver strong and sustainable long-term results for our shareowners, we remain confident in our ability to navigate in these challenging times. However, the current global macroeconomic environment continues to be volatile. This is particularly true in North America, and we expect this to continue through 2009 with economic growth moderating around the globe. Nevertheless, I remain confident that we operate in a very resilient industry and that we have the management and strategies to help us operate successfully during these difficult times. Our performance during the third quarter demonstrates this resilience. During the third quarter we achieved double-digit comparable earnings per share growth of 17%, marking our eighth consecutive quarter of double-digit EPS growth, which means we are well ahead of our long-term earnings growth model in 2008. Our unit case volume increased 5% in the quarter and, as expected, accelerated versus the second quarter, which was impacted by several one-time events. Revenue growth increased 9%. This growth was negatively impacted by 2 percentage points due primarily to the sale of bottlers. So, excluding the sale of bottlers, revenue increased by a very solid 11%. Once again, we successfully balanced the value and volume equation to deliver consistent top line performance. Ongoing operating income increased 17%, reflecting the solid revenue growth, continued brand investment and disciplined management of operating expenses. Year-to-date, cash generation remains strong, with over $5.5 billion from operations. By any measure, a strong set of results. Our volume performance during the quarter was again led by our international markets, including solid growth across most emerging markets. Unit case volume in international markets increased 7%, cycling 8% growth in the prior year quarter. The international performance was driven by 5% growth in sparkling beverages, including Coca-Cola, up by 4%, Coca-Cola Zero up by 22%, and strong growth in both Sprite as well as Fanta. Coca-Cola Zero, now in over 100 markets worldwide, is on plan to exceed half a billion unit cases for 2008. Most key emerging markets delivered solid growth, with China up 17%, India up 18%, and Brazil and Mexico both up 7%. In addition, we saw strong performances in Argentina, Turkey, Eastern Europe, Southern Eurasia, Pakistan, North and West Africa, Nigeria, Korea, and across most of Southeast Asia, including Thailand. As you can see, our quality performance spans most of the globe. In countries with per capitas of less than 150, our volume growth was 9% in the quarter, cycling 12% from prior year. Importantly, we continued to gain volume and value share in most of our key markets and in core sparkling and still beverages. This illustrates how the strength of our brands and the strength of our system enable us to successfully operate in tough environments. History has proven by continuing to invest in our business, even during difficult economic times, we can further strengthen our bonds with consumers, thus garnering a stronger share position for the long term. Simply said, we are winning in the marketplace. Let me turn now to the results in our geographies. Latin America once again achieved very solid results. Unit case volume increased 8%, cycling 9% growth in prior year. The growth was balanced across geographies as well as the beverage portfolio, with all business units delivering high single-digit unit case volume growth. Coca-Cola increased 4% and still beverages increased 38% in the quarter as we continued to leverage the Jugos del Valle acquisition. The group also continued to achieve share gains in all key countries. In Eurasia and Africa we achieved unit case volume growth of 9%, cycling 13% growth in the prior year. The performance was led by double-digit growth in key markets, including India, Nigeria, Turkey, Southern Eurasia, and high single-digit growth in the Middle East and Northwest Africa. Growth was solid across sparking and still beverages, with sparkling beverages growing 6% and still beverages growing 21%. In Russia unit case volume declined 3%, primarily reflecting the impact from unseasonable weather and economic and inflationary pressures. Despite the slowdown of volume growth in Russia, we gained volume and value share in nonalcoholic ready to drink beverages in the quarter and the fundamentals of our business in this key market remain strong. The Pacific group grew unit case volume 7% in the quarter, cycling 11% growth in the prior year. China and Japan delivered strong results, solid results offsetting weaknesses in the Philippines due to continuing weather and inflationary pressures, both of which impacted consumer spending. China once again delivered solid double-digit growth, which accelerated versus the second quarter. Sparkling beverages grew 13% and still increased 27%, led by the continued success of Minute Maid Pulpy and the expansion of our Original Leaf Tea, which, as you will recall, we launched earlier this year. Perhaps the most significant achievement for the company in the quarter was our successful activation of the Beijing Olympic games sponsorship. Our sponsorship attracted widespread positive media and consumer attention for the company in China and around the world. During the 16 days of the games, over half a billion Chinese consumers connected with our brands through sampling programs, Olympic torch relay activities, and downloads of the Coca-Cola Olympics song, which was downloaded over 260 million times and reached number one on the pop music charts in the country. All of these activities, as well as numerous other events and promotions, resulted in Coca-Cola being cited as the most recognized and effective sponsor of the Beijing games, as reported by Neilson. Also in the quarter we announced our offer to acquire China Huiyuan Juice Group Ltd. The acquisition provides a unique opportunity to complement our existing leadership in China in sparkling beverages and expand our presence in still beverages, particularly in the dynamic and fast-growing juice category. Huiyuan brands are highly complementary to our Minute Maid business and Huiyuan's existing manufacturing footprint will provide additional scale to our China operations. In terms of the process, we've filed for Chinese Ministry of Commerce approval and are fully cooperating with their review of the transaction. In Japan volume increased 1%, successfully cycling 4% growth in the prior year, resulting in nonalcoholic ready to drink retail share gain. We continued to invest in our three cola strategy, and the success of this was evident in the growth of sparkling beverages during the quarter, which was led by trademark Coca-Cola. Additionally, we've continued with successful innovation behind the Fanta trademark. Georgia Coffee grew 4%, marking its fourth consecutive quarter of growth and core Georgia flavors increased 10%. The strength of the marketing activity behind the Georgia brand led the continued category share gain. In Japan, we've continued to execute against our strategies and focus on delivering consistent sustainable results. The Europe group overcame a slowing Western European economy and unseasonable weather in Northwest Europe to increase volume 3%. Despite the challenges, we are outperforming the marketplace and gaining overall nonalcoholic beverage share. We continue to strike a balance between tactically addressing the current economic environment and investing for long-term growth by supporting our core sparkling brands and driving innovation across the portfolio. Driving sparkling performance in Europe is the development of the Zero range, including Coca-Cola Zero, which grew double digits in the quarter, the launch of the Pan-European Pemberton program, which highlights the heritage of Coca-Cola, and the German launch of the Spirit of Georgia, our first adult-targeted lightly sparkling lemonade beverage containing fermented juices. We continue to expand our still beverage offerings to generate more balanced growth, including continued support of Illy ready to drink coffee, which is now in 9 markets, as well as Vitamin Water in Great Britain. We are consistently making solid strategic investments behind our brands for the balance of 2008 in Europe, and we will activate the recently announced Zero Zero 7 campaign supporting the latest James Bond film as well as our traditional holiday campaign. In North America results were clearly impacted by the volatile economic environment, however it is important to recognize volume declines of 2% outperformed the industry in the quarter. This resulted in total measured and unmeasured nonalcoholic ready to drink volume and value share gains in the quarter. Sparkling beverages declined 2% in the quarter, an improvement from the year-to-date trend, and resulted in core sparkling volume and value share gains. This reflects the successful activation and execution of our Olympic marketing program during July and August. Our red, black and silver portfolio - Coca-Cola Classic, Coca-Cola Zero and Diet Coca-Cola - continued to gain volume and value share as well. Coca-Cola Zero delivered strong results, growing 30% in the quarter, cycling double-digit growth from the prior year. However, there was continued softness in our Food Service business and other on-premise channels, both of which are being impacted by the current economic reality. Additionally, bottler pricing post-Labor Day has impacted volume performance. As a consequence, we are aggressively moving to address these challenges by allocating resources to consumer and customer-facing programs. Our still beverages portfolio continued to outperform the industry, resulting in volume and value share gains. Our multi-tiered juice strategy, led by double-digit growth in Minute Maid Enhanced and Simply trademarks resulted in continued superior category performance and share gain. Glaceau performance remains solid, increasing double digits in the quarter, with strong performance in the immediate consumption and non-measured channels, driving increased volume and value share leadership. Glaceau remains on target to becoming a $2 billion trademark in early 2009. Glaceau, along with trademark Simply, Coca-Cola Zero, [Nos] and Fuse are five of the top 10 fastest growing trademarks in incremental retail sales for North America. Last week we also announced a distribution agreement for Hansen's Monster Energy Drinks. We believe the Monster brand will complement our existing portfolio of energy drinks and provide our bottlers with further opportunity to drive profitable growth. While we have a strong marketing calendar with our bottling system and customers across sparkling and still brands for the remainder of the year, we expect fourth quarter volume to trail the year-to-date trend due to the continued impacts of the economic slowdown and bottler pricing action. We continue to focus on productivity and expense management initiatives to target investments in consumer and customer-facing programs for future growth in North America. We remain committed to our strategies and to winning in North America. Now let me update you on our company wide productivity initiative, which has been up and running since last quarter. We are leveraging our efforts to redirect investments to drive top line growth and long-term sustainable value creation. Our systemwide focus on productivity remains a priority for 2008 and beyond. As you know from our last call, we moved early to take aggressive steps in this area. Through this work we are rewiring our business and reallocating our resources to be more directly focused on the marketplace as well against our highest growth opportunities. Building strong brands with world class marketing is the key to our sustainable top line growth. As previously indicated, our target is to generate annualized operating savings in the range of $400 to $500 million by the end of 2011. These are savings accruing directly to the The Coca-Cola Company. We will also continue to work towards improving the system supply chain. We also previously indicated that there will be nonrecurring costs of approximately $400 to $500 million associated with implementing these initiatives and that both the benefits and the costs would be spread fairly equally annually through 2011. A team led by seasoned operators has ensured that we are on track to deliver against these targets, and we have already begun to benefit meaningfully from this initiative in 2008. Once again, I am pleased with our results for the quarter. We are winning in the market as evidenced by our share gains in key categories and markets. Our increased focus on effectiveness and efficiency is providing the additional flexibility needed to consistently deliver long-term growth and create value for our share owners. During periods of economic stress, the merits of The Coca-Cola Company truly come to the fore, as we have seen again in this most recent quarter. Our brands and our business were built for times like these. We have a seasoned management team with great experience honed through many tough cycles in markets across the globe. Our business is balanced across nearly every market, our product portfolio spans most major nonalcoholic beverage categories, and our brands are available in more channels and outlets than any other consumer company. This quarter's performance reflects that reality. Backed by a solid balance sheet, The Coca-Cola Company continues to deliver attractive earnings growth, strong free cash flow, as well as a reliable dividend that we have included for 46 straight years in both good and challenging times. It is incumbent upon us to ensure that we not only meet these challenges but that we use them to our advantage. We continue to define our picture of success as exceeding our long-term growth model. We are also realistic about the operating environment for 2009. We're in the process of reviewing and finalizing our plans for 2009 and will provide more color on our expectations for next year during our fourth quarter call in February. However, you can expect us to continue to invest to fuel brand growth while aggressively managing costs. I remain confident we're building a stronger Coca-Cola system for the future. With that, let me turn the call over to Gary."
},
{
"speaker": "Gary P. Fayard",
"text": "As Muhtar indicated, we've just again delivered strong financial results in the quarter. We reported earnings per share of $0.81 per share on a diluted basis in the quarter; however, this included a net charge of $0.02 per share for restructuring charges and costs related to global productivity initiatives, partially offset by the gain on the sale of a portion of our investment in our Pakistan bottler. Therefore, comparable earnings per share was $0.83 per share, an increase of 17% after considering factors impacting comparability in both the current and prior year quarters, our eighth consecutive quarter of double-digit comparable EPS growth. Net revenue in the quarter increased 9% and increased 11% excluding the impact from structural changes primarily related to the sale of bottlers. Growth was driven by 2% favorable impact from price and mix, a 3% increase in concentrate sales, and a 6% increase from currency. In the quarter, unit case volume increased 5%, cycling 6% growth in the prior year quarter, and year-to-date concentrate sales and unit case growth rates are essentially in line. We grew operating income by 20% on a reported basis. After considering items impacting comparability and the current and prior year quarters, operating income increased 17%, which includes a 9% benefit from currencies. Year-to-date, our currency neutral operating income of 9% remains ahead of our 6% to 8% long-term target. Total selling, general and administrative expenses on an ongoing basis increased 8% in the quarter. This translated into 5 points of operating expense leverage. We continued to invest in our brands and build market execution capabilities. Marketing expenses increased at approximately the same rate as gross profit growth, and sales and service increased solidly to support our bottling operations. Our focus on expense management and productivity initiatives is reflected in a mid single-digit decrease in general and administrative expenses. Additionally, we continue to see year-to-date margin improvement in both our core business and in our Bottling Investments group. For the remainder of the year we would expect to continue to achieve expense leverage, but at a more moderate rate as we start to cycle some of the programs put in place late last year. Our net interest expense decreased in the quarter, reflecting the benefit of interest income earned internationally at higher rates. And with regard to taxes, we ended up the quarter with an underlying effective tax rate of 22%, and we expect to remain at the underlying effective rate for the remainder of the year. As we've previously announced during the quarter, we have curtailed our share repurchase program for the remainder of the year as we pursue the acquisition of the Huiyuan juice business in China. We repurchased a slight number of additional shares at the beginning of the quarter and now have bought approximately $1.1 billion of our stock year-to-date. Now let me address some of the factors that we see impacting the remainder of 2008. We remain confident in our ability to achieve long-term sustainable growth and our picture of success remains to exceed our long-term growth model. We will continue to portfolio manage globally as we expect solid performance in most of our markets. While we expect economic growth in some emerging markets to moderate, we believe that key emerging markets like China, India, Eurasia and Latin America should continue, with solid business growth. It is our belief that among other consumer goods companies, our business will better navigate the current economic environment as we reach the consumer through a broader array of channels and packages with preferred brands. Improvement in our market share will continue to be a benchmark of our success. Globally, we are working closely with our bottling partners. The fundamentals of our business remain strong, and as a system we continue to take appropriate actions to navigate the near-term volatility while strategically investing behind our brands in the marketplace for long-term growth. Last quarter we revised our net capital expenditure forecast to approximately $1.8 to $1.9 billion, and we'll likely come out close to $1.9 billion for the full year. Lastly, as you saw in the quarter, structural changes primarily related to disposal of bottlers, caused a drag on net revenue growth. We sold all of the Remil bottler in Brazil to Coca-Cola FEMSA at the end of the second quarter. We sold a portion of our investment in the Pakistan bottler to our Turkish bottler at the end of the third quarter such that we now own just under 50% and will no longer consolidate the Pakistan bottler, but include it in equity income. Additionally, we will not have the offsetting impacts of the Norsa bottler in Brazil and PCAG, our German bottler acquisitions, as we cycle these in the third quarter, so we would expect a larger impact from structural change on net revenues in the fourth quarter and into 2009. Moving now to two key topics - liquidity and currency. Given the recent market volatility, I know liquidity may be top of mind for some of you. Our liquidity remains strong and our commercial paper program continues to function each day as broadly authorized by investors and is [praised] strongly. We have been able to continue to access 60 to 90-day terms and have not had a material change to our spreads to benchmark rates. We also have $2.2 billion of committed unused credit facilities from our network of relationship banks and our almost $8 billion in cash is available and in liquid, high-quality investments. Most of the cash is offshore, but we have reviewed our contingency plans and would be able to access the cash on short notice. Year-to-date we have generated over $5.5 billion in cash from operations and, in short, liquidity is not a concern as we're able to fund our operations from internal cash generation and commercial paper. With regard to currency, as I mentioned, we saw a positive impact from currencies in the quarter on operating income of 9% and 10% year-to-date. We are maintaining our full year 2008 forecast of at least a mid single-digit currency benefit. We realized a stronger than expected benefit in the third quarter which we expect to be offset by a slightly weaker forecast in the fourth quarter, therefore no change for the full year. As for our 2009 currency outlook, it is obviously a very volatile environment. We're already 100% covered on key hard currencies like the Euro and the yen. Emerging market currencies are particularly volatile, as we've seen over the last few weeks; therefore, it would be impractical to give a view on currencies for 2009 at this time. However, it is important to note that we manage our business in local currency to ensure that we make the right decisions for the long term. As Muhtar indicated, we're in the process of finalizing our 2009 business plans, so we'll provide our outlook for 2009 on our year end call in February. So that's the topics I wanted to cover this morning. We're ready for questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from Bill Pecoriello - Morgan Stanley."
},
{
"speaker": "Bill Pecoriello - Morgan Stanley",
"text": "You mentioned the system's ability to adapt to the rapidly changing economic environment as a key competitive advantage. Can you give us some examples, some of the tactics the system is using to adapt, especially as immediate consumption begins to slow in several regions of the world, maybe a shift in channel or package focus to adapt to that?"
},
{
"speaker": "Muhtar Kent",
"text": "First I think what you need to see is that we keep focus with our strategies of growing sparkling and expanding still beverages, balanced growth, increasing our pace of innovation and growing capability. But within that, as I said, we've continued to calibrate and recalibrate to ensure that our system remains very flexible, leveraging new packaging innovations, new price points, and also ensuring that there's an absolute good balance between above the line and below the line activities; a much closer relationship with our customers, value offers. And in this environment more and more people, particularly in the West, are going to spend more time at home and we have programs to address that with future consumption, bringing back refillables in many countries in emerging markets. So all of that taken as a whole, I think - affordability focus, new price points, package innovation, and continued bottler investment ensure that we keep focus. There is no other business in the world that visits 20 million customers on a weekly basis and no other business that is as close to the marketplace as our business, so we've continued to leverage that and stay connected with all local markets and I think we're seeing the benefit of that."
},
{
"speaker": "Bill Pecoriello - Morgan Stanley",
"text": "Any implications for system margins as you see more of the future consumption focus or are you going to pull various levers so the system can maintain margins as you get that shift?"
},
{
"speaker": "Muhtar Kent",
"text": "I think we will balance the margins with share gains. And we want to be absolutely sure that we do the right thing for the long term. You know, I've been through this movie in smaller versions a number of times in the past - in 1998 in Russia, 2001 in Turkey, and in Latin America - and I can tell you that the key here is to make sure that you keep connected to the consumer, maintain the health of your brands, and that's what you're going to be seeing us do. But also we are going to be making sure that any kind of costs that are not necessary are going to be - we will continue to eliminate them out of our system religiously and refocus our resources to market-facing and customer-facing activity."
},
{
"speaker": "Operator",
"text": "Your next question comes from Judy Hong - Goldman Sachs & Company, Inc."
},
{
"speaker": "Judy Hong - Goldman Sachs & Company, Inc.",
"text": "Muhtar, can you speak to the resiliency of or even sequential improvement of some of your key international markets in terms of volume trends in Q3 versus Q2? And then, as you look out to 2009, as you kind of deal with the economic conditions - and I understand you're not giving specific guidance - but if you can give us some perspective as to how you think about '09 relative to your long-term growth targets, both from a volume and EPS perspective."
},
{
"speaker": "Muhtar Kent",
"text": "I think what you see, Judy, is first, you see the balanced portfolio working in our favor. We had some countries that even again in the third quarter did not perform up to our expectations, like Philippines, like Russia, like U.S. Food Service. Germany was flat. But despite that we came in with a very strong quarter. You saw that every single one of our international operating groups increased their growth trend versus the second quarter of '08 - Europe from zero to 3%, Latin America from 7% to 8%, Eurasia and Africa from 6% to 9%, and the Pacific group going from 4% to 7%. And we had indicated to you that there was a lot of one-off items in the second quarter that were impacting our business, and I think that you saw us coming through in what was still a very difficult quarter. And the balance and our actions, the flexibility in the marketplace, our bottlers' ability to continue and an appetite to continue to invest in the marketplace, you saw us coming through. I think that there are going to be areas of the world next year that will be growing less. There will be growth for sure in the emerging markets. It may not be to the same extent as we saw this year, but I think that despite the volatility we are in the best consumer business there is. Tremendous resilience, providing we take the right actions, and you will see us taking the right actions."
},
{
"speaker": "Judy Hong - Goldman Sachs & Company, Inc.",
"text": "And your comment about the fourth quarter volume trending a bit below the year-to-date volume, is that more a function of North America potentially showing another leg down or is that also related to international markets?"
},
{
"speaker": "Muhtar Kent",
"text": "No, no, that was purely - that comment was purely related to North America, and I made sure that I stated it that way. It was purely related to North America and related to those issues that I discussed with you because of the continuing pressure on immediate consumption and attitudes of the U.S. consumer as well as pricing to shore up the margins by our bottling partners at the end of the quarter."
},
{
"speaker": "Judy Hong - Goldman Sachs & Company, Inc.",
"text": "And then just a quick question for you, Gary. If you look at your expense leverage, clearly a big driver is the corporate expenses coming down. And if we look at the run rate in the last two quarters, it looks like around 3% of net sales. Is that sort of a good run rate to use going forward?"
},
{
"speaker": "Gary P. Fayard",
"text": "Yes, Judy, I would expect that the run rate will be about that or slightly less. We actually started having some of that leverage coming through in the fourth quarter of last year, so it'll actually go down a little bit because of what we're cycling."
},
{
"speaker": "Operator",
"text": "Your next question comes from Kaumil Gajrawala - UBS."
},
{
"speaker": "Kaumil Gajrawala - UBS",
"text": "A couple questions on the regions that you mentioned with the per caps under 150. First, just quickly, how much of your volume comes from those regions? And then second, given the economic environment, should we be assuming a lower run rate, maybe these regions in aggregate going forward? And then are some of these regions big enough that we should start seeing margins grow at a much faster rate than we're seeing sales grow?"
},
{
"speaker": "Muhtar Kent",
"text": "I think roughly it's fair to say about a third of our volume globally will come from those kind of markets, per capitas of around 150. And I think that what you've seen in many of the markets that were there and now are at higher per capitas - Latin American markets, South Africa, Turkey and so forth, that have passed that level - you're seeing margins for the system improving fairly radically. And I think that as we see per capitas growing, we certainly will make sure that the same trend is also valid for margin improvement and enhancement. And I think that we are seeing from many African markets and many other smaller Latin American markets, Asian markets, Middle Eastern markets, Eurasian markets, that, as they approach the sort of 100 to 150 per capita range the scale of our business is beginning to power ahead and that we're seeing really good growth levels and also margin enhancement in these countries."
},
{
"speaker": "Kaumil Gajrawala - UBS",
"text": "And then on a volume run rate?"
},
{
"speaker": "Muhtar Kent",
"text": "I think that basically I am cautiously optimistic that we will have growth coming through in all those markets, as we've seen this year."
},
{
"speaker": "Operator",
"text": "Your next question comes from Christine Farkas - Merrill Lynch."
},
{
"speaker": "Christine Farkas - Merrill Lynch",
"text": "There were some reversals, as you indicated, in the third quarter versus the second quarter. I'm wondering if you can talk about early fourth quarter trends, specifically in Russia given their macro environment, China post the Olympics and how those trends are, and then Mexico on the back of the U.S. economy. I mean, your volumes there have been pretty strong. Can you talk about perhaps the competitive environment?"
},
{
"speaker": "Muhtar Kent",
"text": "Firstly, I wouldn't call it reversals. I would call it improvements. But I think I can't give you basically guidance for quarter four at the moment, but I can tell you that our business is very, very strong in markets in Latin America, including but not limited to Mexico, as well as China. And I think that we certainly are going to be looking at ensuring that we can move forward with our plans for Q4 and '09 so that our picture of success remains valid, that we can meet or exceed our long-term growth targets."
},
{
"speaker": "Christine Farkas - Merrill Lynch",
"text": "And then a follow-up for Gary. I think if I heard you correctly you mentioned equity income may have been boosted by the impact of the sale of the Pakistan bottler. Can you tell us how much was reflected in that line item?"
},
{
"speaker": "Gary P. Fayard",
"text": "Yes, Christine. What I said was it would now be reported in equity income. We actually closed the transaction at the very end of the third quarter, so starting in the fourth quarter, but it's really not going to be a significant change. The biggest change you'll see is just it'll be a drag on top line revenue, but relative to income it's not going to make a big difference at all."
},
{
"speaker": "Christine Farkas - Merrill Lynch",
"text": "So the equity income line was actually just the regular equity income drawing from your anchor bottlers, etc."
},
{
"speaker": "Gary P. Fayard",
"text": "Correct. Correct."
},
{
"speaker": "Operator",
"text": "Your next question comes from Bryan Spillane - Banc of America Securities."
},
{
"speaker": "Bryan Spillane - Banc of America Securities",
"text": "Gary, a question for you on liquidity. Just two areas of interest; one is what's the potential that there may be a tax holiday to allow you to repatriate some of that cash back to the U.S. without taking the tax penalty? And then second, just related to both bottlers and trade customers, are you seeing anything different in terms of the tighter credit markets, whether it's retailers carrying less inventory, maybe a destocking situation, or bottlers that may not have otherwise been under stress that may be stressed by the liquidity or the credit market?"
},
{
"speaker": "Gary P. Fayard",
"text": "Number one, potential for a tax holiday, you know, coming up to the election and everything else, I really don't know. If it happened we would look at it and we'd make the right decision for the long term, but that one I really can't speculate on. I don't know at this point. What I do know is we've got the cash. We can access it if needed, but whether we repatriate or not, I really can't comment on that. Relative to bottlers and trade customers, I'd say two things. Let me address both; first, receivables, as we've really been working on our working capital. And, in fact, if you look at our cash flow, in fact, I'll point out one item within our cash flow statement that does not - it makes it look like we did not improve working capital as much as we did. There's about a $350 million tax item on a settlement of an issue with - a foreign tax issue where we paid the cash in the quarter, and we'll actually recoup it, we'll get it back, but it'll be - we'll get it back in the fourth quarter or early first quarter of next year. So if you look, then, if you take that out, we actually bettered our use of working capital significantly, I mean, like $700 million or so year-to-date Q3 versus year-to-date Q2. The other is our days in receivables are exactly in line with where they were at the end of third quarter last year, so we've not seen any issues there. We've also not seen a lot of destocking because for us obviously it's primarily with the bottlers, and we actually work with the bottlers every year as we put our plans together on optimizing what their inventory should be. And so it's something we work on routinely every year to ensure that they're in exactly the right place because we don't want them holding too much inventory and having a lot of working capital tied up, either. So I think we're in a pretty good place right now."
},
{
"speaker": "Operator",
"text": "Your next question comes from Lauren Torres - HSBC."
},
{
"speaker": "Lauren Torres - HSBC",
"text": "[inaudible] has been rather vocal, I'd say, over the course of this year with regard to challenges in several of their markets. You've been somewhat more positive on emerging market growth, but I was hoping you could address specific markets, expectations for Russia, maybe parts of Eastern Europe. I know there's some macro challenges or there are macro challenges, but I was just curious about your thoughts looking out over the next year or so about a return to some more normalized growth there."
},
{
"speaker": "Muhtar Kent",
"text": "Yes, Lauren. First, the current conditions in Eastern Europe, Russia, the markets of Eurasia are still - the macroeconomic conditions are still such that they are generating growth. And the sentiment is a lot better than it is, say, in the United States or Western Europe. Now, I don't think they'll get as bad as the United States or Western Europe. I don't think they will stay as good as they were in the past 12 months. Russia is certainly experiencing issues and problems in their financial markets. But I think that if you look at our business, the fundamentals of our business are strong in all these markets. We're a business, you know, you've got to keep in mind that we're a business that generates with our bottlers as a system $15 billion plus of cash a year. We visit multiple, multiple customers, millions of customers in these markets, and in many of these markets that you've referenced, the trade is very fragmented, very, very fragmented, and that I think is a big advantage going forward for us in working closely with all these smaller customers. My experience in this kind of environment is that Coca-Cola and our brands become a bigger part of the revenue of these smaller customers in these circumstances. We mean more to these customers as we service them. No one services them like our system services them, and I think that is a huge advantage that we will continue to leverage in this environment."
},
{
"speaker": "Lauren Torres - HSBC",
"text": "So with that said, even though we may see some volume weakness, you're still seeing share gains, be it volume or value share gains?"
},
{
"speaker": "Muhtar Kent",
"text": "Yes. And I do still believe that there will be growth in these markets for our business."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mark Swartzberg - Stifel Nicolaus & Company, Inc."
},
{
"speaker": "Mark Swartzberg - Stifel Nicolaus & Company, Inc.",
"text": "Muhtar, acquisitions. I was hoping you could talk a little bit more here about you appetite for additional multi-billion dollar acquisitions generally? And then, with share repo being on hold because of Huiyuan, if the right thing were to present itself, is there any issue with your credit rating given, you know, you backed up your bottlers, that would prevent you over the near term from doing additional major acquisitions?"
},
{
"speaker": "Muhtar Kent",
"text": "Right. Mark, I'd just say the following: First, I said it and I'll repeat it again. Organic growth is key to our success. Sparkling growth is key to our success. It's the oxygen. We've got to balance sparkling growth with still growth, and we've got to have organic growth. And any opportunities for acquisitions will come on top of that. That remains absolutely valid. Huiyuan, I think, is a great opportunity, and we continue to work with the Chinese government. We are the first company to apply to the Minister of Commerce under the new law, and we believe that we will prevail in China with that great opportunity. If there are any other opportunities that present themselves, our strategy remains bolt-on acquisitions are still part of the strategy. And we will make sure that, if we see a great opportunity for the future of our business, complementing our existing business in a country, we will not let it go by."
},
{
"speaker": "Operator",
"text": "Your next question comes from John Faucher - J.P. Morgan."
},
{
"speaker": "John Faucher - J.P. Morgan",
"text": "In looking at the performance of your publicly traded anchor bottlers year-to-date, obviously some pretty tough times in that regard, so I guess a couple of questions. You've talked about selling off bottling assets. We've begun to see that a little bit. Has the change in the public market valuations drifted into the private markets? And then, flipping that around, given the fact that the private market valuations are so low, does that change your interest in maybe bringing more bottlers into the hospital ward or is that something you say, look, we're going to worry about the market. We'll let the market deal with that, and we're just focused on operating where we need to operate."
},
{
"speaker": "Muhtar Kent",
"text": "I'll reflect on that and maybe Gary can also comment on it. Firstly, I was with - we had a big bottlers meeting three weeks ago with about 50 of our top bottlers around the world, the first meeting of its kind for some time, and I can only tell you that I think everyone comes away with tremendous passion, realistic optimism as well as determination to continue driving our business, to continue investing, and to continue to do the right things for our business whether they're public or private bottlers. And I think that nothing really has changed from our strategy in terms of looking at homes for bottlers that - weaker currently - are running when it makes sense, the right homes, and also if there's a need, we will not hesitate to bring another bottler into our sphere. However, I don't see anything near on the horizon for us to do that right now, and I think that I came away, as well as our bottling partners came away, from that meeting really charged up and really feeling good about the future of our business."
},
{
"speaker": "Gary P. Fayard",
"text": "And John, I would add relative to values of the bottlers that we have, that we own, I'd say a couple of things. Number one, we've always taken a long-term view basically that we would only sell a bottler if the purchaser had the financial and the management resources to really grow that market for the long term, and that when selling we would sell at a fair value. And so I would say that's still where we are. If we were looking to sell a bottler today, we would be looking for fair value and then that would be just subject to negotiation on how you define that number. But our strategy really has not changed at all."
},
{
"speaker": "John Faucher - J.P. Morgan",
"text": "And then if I could ask one follow up on that, which would be you guys have been managing Philly Coke for awhile now. Any insight into how the rest of your North American bottling system should deal with its recent struggles given the fact that you guys have a little bit more hands on experience right now?"
},
{
"speaker": "Muhtar Kent",
"text": "Well, I think, John, we're learning from many experiments in North America. It's not just Philly. I think Philly is doing many things to prop up their on-premise business very successfully. In fact, they've been proving to everyone that sparkling beverages can grow again in North America if you do the right things. But then with many of our other bottlers, including [CC], we have a number of initiatives going, whether it be packaging initiatives, whether it be sparkling growth initiatives, whether it be still growth initiative, on-premise initiatives as well as in the Food Service business of ours, where we're looking at commercializing a number of innovations in the coming months. So I think it's not just limited to Philly, and the entire system - the entire system - is really learning from all the - not experiments but lead market tests that we're doing, not just experiments. And I think that you will see us rolling out a number of those very, very shortly. And Sandy Douglas is here, President of our North American business, and I'll ask him to also shed some light on that."
},
{
"speaker": "Sandy Douglas",
"text": "Muhtar, I think you said it well. We've been working with the entire system on remerchandising the sparkling packaging mix with a number of lead markets, all bottlers involved. We're working closely with the system to create new processes and approaches for managing large customers, and we're continuing to work on integrating our supply chain to drive out waste and to be able to have more money to invest in the consumer and the customer. And we couldn't be happier about bottler involvement and participation, and those lead markets, as you say, are presenting a road map for us to go forward that will put us in a stronger position in the years ahead."
},
{
"speaker": "Operator",
"text": "Your next question comes from Marc Greenberg - Deutsche Bank Securities."
},
{
"speaker": "Marc Greenberg - Deutsche Bank Securities",
"text": "First, just a follow up on John's question. In light of Pepsi's comments yesterday about taking a restructuring and investing significant new monies behind North America, Sandy or Muhtar, do you feel that the absolute level of investment behind the U.S. business is sufficient right now? Is it going to be a step change kind of a year in 2009?"
},
{
"speaker": "Muhtar Kent",
"text": "Yes, Marc, I think you need to understand that we have been on a path indicating and saying and wholly believing that sparkling beverages can grow in North America since late 2004. And we have pushed this agenda forward, and you've seen the successes of Coca-Cola Zero and many other initiatives. Fanta brand also doing really well in our business in North America. Don't forget that we also took out $400 million in '05 and invested it in marketing across the world, and a lot of that was honed in here in the United States. So our marketing base had already grown. We will continue with our bottling partners to ensure that we have the right level of investments in North America, to make sure that we can leverage all of the opportunities that we talked about in the answer to the previous question, to make sure that we can replicate great experiments, great examples, great lead market stories in both innovations in packaging, new price points, and much more inspiration at the point of sale, much more focus on gaining availability in the universe of accounts that we have. And learn from all the lead markets in the United States and make sure that we have the right level of investment, customer-facing and consumer-facing investments."
},
{
"speaker": "Marc Greenberg - Deutsche Bank Securities",
"text": "Gary, just a quick housekeeping item. The 7% volume growth in Mexico, I'm wondering if there's any kind of a timing or acquisition bump in there. Based on comments and guidance from some of the larger Mexican bottlers, our sense was that it wasn't going to be that big a number in the quarter, and obviously expectations for the fourth quarter may be coming down a little bit. Can you talk to that?"
},
{
"speaker": "Gary P. Fayard",
"text": "Yes, Marc. In Mexico specifically, acquisitions contributed low single digits to that growth rate or 5 points to that growth rate and our organic was low single digits."
},
{
"speaker": "Operator",
"text": "Your last question comes from Carlos Laboy - Credit Suisse."
},
{
"speaker": "Carlos Laboy - Credit Suisse",
"text": "Muhtar, you've mentioned this, I think, in some form, but market downturns sometimes - they open up opportunities to radically change a market. Argentina a few years ago, for example, comes to mind. Can you expand on the company owned bottler performance expectation through this macro slowdown and whether it's Germany or the Philippines, what kind of opportunities do you see in this downturn to gain competitive ground?"
},
{
"speaker": "Muhtar Kent",
"text": "Well, Carlos, I see opportunities in their environment not just for our company owned bottling operations, for our entire bottling system. I want to stress that. And I think that the consolidation in Germany is complete. We are gaining share in the German market. We are doing some great things under one of our great operators in our bottling business in Germany, and we're gaining great traction with discounters in Germany. And I see the business fundamentals getting stronger every day. In the Philippines, I think we're again doing exactly the right things for the long term. We had a disappointing quarter in the Philippines - it was 9% down - but you will see that trend improving going forward. And I think that the Philippines has had more than its fair share of this economic volatility in the third quarter, with food pricing really affecting consumer spending and sentiment. But going forward I believe that trends in the Philippines are going to improve. And I think in China, again, we're doing exactly the right things to have a great, great business. I always say China is another Coca-Cola company, and I firmly believe that."
},
{
"speaker": "Operator",
"text": "I'll now turn the call over to Mr. Kent for closing remarks."
},
{
"speaker": "Muhtar Kent",
"text": "Thank you, Gary and Ann. Before we close the call I'd like to thank Ann Taylor for serving as Director of Investor Relations for the last four years. She and her team have done a tremendous job helping craft and deliver our strategic and financial message as the company has evolved during both Neville's and now my tenure as CEO. Ann will be moving within our organization to a role overseeing the company's transformation efforts, one of our most critical growth enablers. I want to thank Ann for her contributions, and I know she will continue to play a very meaningful role going forward. I'm pleased to announce that [Jackson Kelly] has been appointed our new Director of Investor Relations. Jackson has spent the last two years working directly with me on global strategic initiatives, and Jackson's 17 years with the company, his background as a CPA as well as his experience in marketing, strategy and finance, will add an important new dimension to how we interact with each of you. Thanks for joining us this morning, and have a great day."
}
] | null | null |
KO | 2 | 2,008 | 2008-07-17 08:30:00 | Executives: Ann Taylor - Vice President and Director of Investor Relations Neville Isdell - Chairman of the Board, Chief Executive Officer Muhtar Kent - President, Chief Operating Officer Gary P. Fayard - Chief Financial Officer, Executive Vice President Sandy Douglas - North America Group President
Analysts: Judy Hong - Goldman Sachs Bill Pecoriello - Morgan Stanley Marc Greenberg - Deutsche Bank John Faucher - J.P. Morgan Christine Farkas - Merrill Lynch Bryan Spillane - Bank of America Kaumil Gajrawala - UBS Mark Swartzberg - Stifel Nicolaus Lauren Torres - HSBC Carlos Laboy - Credit Suisse Todd Divek - Banc of America Karen Lamarc - Federated Investors
Operator: Good morning. My name is Dennis and I will be your conference facilitator. At this time, I would like to welcome everyone to The Coca-Cola Company’s second quarter 2008 earnings results conference call. (Operator Instructions) I would like to now introduce Ann Taylor, Vice President and Director of Investor Relations.
Ann Taylor: Good morning and thank you for being with us today. I am joined by Neville Isdell, our Chairman; Muhtar Kent, our President and Chief Executive Officer; Gary Fayard, our Chief Financial Officer; and Sandy Douglas, our North America Group President. Following prepared remarks this morning by Neville, Muhtar, and Gary, we will turn the call over for your questions. Before we get started, I would like to remind you that this conference call may contain forward-looking statements, including statements concerning long-term earnings objectives and should be considered in conjunction with cautionary statements contained in our earnings release and in the company’s most recent SEC report. In addition, I would also like to note that we have posted schedules on our company website at www.thecocacolacompany.com under the financial information tab in the investors section, which reconcile certain non-GAAP financial measures that may be referred to by our senior executives in our discussion this morning and from time to time in discussing our financial performance to our results as reported under generally accepted accounting principles. Please look on our website for this information. Now let me turn the call over to Neville.
Neville Isdell: Thank you, Ann and good morning, everyone. As you all know, this has been my final quarter as CEO of this outstanding company and before I turn the call over to Muhtar, who will provide context around the results of the second quarter and the outlook going forward, and to Gary who will give you an overview of the financials and some additional perspective on 2008, I want to make a few opening comments. The Coca-Cola Company has made significant progress since our turnaround began in 2004. We have revitalized the sparkling beverage category globally and continue to grow trademark Coca-Cola. We’ve addressed key issue markets and taken decisive actions. We have reconnected with our customers and consumers through effective marketing and innovation strategies, and we have reengaged our associates, who are absolutely key to our winning in the marketplace. And importantly, we have successfully implemented a seamless CEO transition plan for the next leg of our journey. Clearly our strategies are working as we continue to expand our volume and value share leadership position in the non-alcoholic ready-to-drink beverage industry, as well as in sparkling and key still beverage categories. And our financial performance continues to be strong, as we deliver our seventh consecutive quarter of double-digit comparable earnings per share growth. As I depart as CEO, I am pleased with our accomplishments and solid performance. We have put in place a strong foundation and I remain confident in our outlook for 2008 as we continue to invest and build share. Our balanced geographic mix and broad portfolio, along with the talent and experience of our people across the system, positions us well to continue to be successful, delivering growth and value for our shareowners for the long-term. And now, I’d like to turn the call over to our new CEO, my good friend, Muhtar. Muhtar Kent, please.
Muhtar Kent: Thank you, Neville and good morning, everyone. First, I’d like to take this opportunity to thank Neville for his extraordinary leadership and the support that he has provided to me for the past two decades. I am truly honored by the confidence both he and our board of directors have shown in my ability to lead this great company. Before I get into the specifics of our operating performance, I’d like to reiterate that our business is a true great business to be in. The non-alcoholic beverage industry is the fastest growing segment of the consumer products industry and we have leading positions in almost all categories we compete in. The Coca-Cola Company offers an affordable luxury, connecting with our consumers 1.5 billion times every day. But I know what is top of mind for all of you; the current macroeconomic environment and its impact on our results. Based on our volume performance of 3% in the quarter, it is clear we were faced with some challenges around the globe. Our results in the quarter were impacted primarily by a number of one-time events, including strikes in Europe and natural disasters in Asia, as well as unfavorable weather in a number of our markets. Moreover, we are certainly operating in a more challenging environment, particularly as rising food and energy costs way on consumer confidence. Internationally, GDP forecasts are coming down; however, growth is still expected to remain at healthy levels, and it is no surprise that we continue to face challenges also in North America due to the U.S. economy. We continue to invest aggressively in our portfolio with new products, marketing platforms, and a consistent strategy in very close coordination with our bottling partners to offer our customers the best beverage choices for consumers. Our second quarter performance demonstrates our ability to leverage the strengths of our system to achieve balanced growth. Our results were once again led by our international operations, which delivered 5% unit case volume growth, cycling 9% growth in the prior year, despite some one-off events and a more challenging macroeconomic environment. For the past few years, we have been rebuilding our foundation and solidifying our position as the leading global non-alcoholic ready-to-drink beverage company. We believe that our broad and balanced geographic mix positions us very well to navigate through any headwind as we continue to focus on operating efficiencies and execution strategies. Our actions are allowing us to win in the market. Globally, we accelerated our volume and value share gains in total non-alcoholic beverages. Importantly, we gained share in most of our key markets as well as key categories, and this illustrates the strength of our brand and the strength of our system to operate successfully in tough environments. By continuing to invest in difficult economic times, our system is seeking to build a stronger bond with consumers and a stronger share position for the long-term. We clearly recognize that there are short-term challenges in the marketplace related to economic trends and we will maintain our disciplined approach of analyzing and understanding the impact of these challenges to our business and adjust our plans accordingly. Now let me turn to our operating performance for the quarter. We increased our unit case volume by 3% in the quarter and 4% year-to-date, successfully cycling 6% growth in the prior year quarter and year-to-date period. While the growth was not where we would have liked it to be, it is not unexpected given the headwinds we faced from natural disasters, including earthquakes and floods, as well as unseasonably cold weather -- cold and wet weather in certain markets. Additionally, we were challenged, as I said, with strikes in key European markets and continued softness in consumer trends in North America. In the quarter, our financial results remained strong. We achieved double-digit comparable earnings per share growth of 19%, now our seventh consecutive quarter of double-digit EPS growth. Revenue growth was solid, increasing 17% with the acquisition of bottlers contributing two points of growth. This performance illustrates that our strategies to drive top line growth are working. Ongoing operating income increased 20% with currency contributing 11 points of growth, so our currency neutral operating income was 9% even as we have continued to make solid, strategic investments for long-term sustainable growth. Moving now onto our geographies, Latin America continues to be a bright spot for our system, once again achieving solid results. Unit case volume increased 7% with all business units delivering growth and the group also continued to achieve share gains in key countries. Additionally, the successful integration Jugos del Valle into our system is contributing to still beverage growth and share gains. In Mexico, unit case volume increased 10%, led by the continued strong performance of brand Coca-Cola, up 3% and the benefit of Jugos del Valle also contributing three points to growth, all leading to volume and value share gains in sparkling as well as still beverages. Brazil increased 1% in the quarter, reflecting the slowdown in industry growth, particularly in April as consumer spending shifted to durable goods as a result of continued credit expansion. Despite challenges in the marketplace, Brazil gained volume and value share in total non-alcoholic ready-to-drink beverages, also as well as with sparkling and still beverages. In Africa, we achieved unit case volume growth of 5%. South Africa’s unit case volume was even with last year, cycling 12% growth in the prior year quarter and reflecting the continued effects of CO2 shortages. We expect to have the CO2 shortages in our business resolved during the second half of this year. Eurasia delivered unit case volume growth of 7%, led by solid results in India, Turkey, Eastern Europe, Southern Eurasia, and the Middle East. Growth was solid across sparkling and still beverages, with sparkling beverages growing 3% and still beverages, led by the expansion of Minute Maid in India and [Molten] Juice in Russia growing 24%. In Russia, unit case volume growth was 2%, primarily reflecting the impact from poor weather conditions, particularly in the second half of the quarter. Despite the slowdown of volume growth in Russia, our volume and value share in non-alcoholic beverages in the quarter reached an all-time high. The Pacific group grew unit case volume 4% in the quarter, led by China, which continued to delivered double-digit growth despite being negatively impacted by significant flooding and earthquakes in certain regions of the country. We continue to drive growth by leveraging our Olympic activation programs centered around brand Coca-Cola, expanding Minute Maid Pulpy and successfully launching our new original Leaf Tea brand. In Japan, volume declined 1% in the quarter; however, we achieved share gains in non-alcoholic ready-to-drink beverages. Sparkling beverages continued to grow, led by trademark Coca-Cola as we continue to invest behind our three cola strategy and the introduction of a new Fanta product, [Fofuru], a unique innovative sparkling jelly fusion shaker. Additionally, Georgia Coffee grew 4%, the highest growth rate for Georgia in more than five years. Core Georgia flavors contributed to more than 50% of the growth, proving our strategies to innovate the brand through marketing initiatives, new packaging, and new flavors are working well. Georgia is now in its third consecutive quarter of growth and gaining category share. Adverse weather conditions resulted in volume declines for Sokenbicha and Aquarius. Together with our bottling partners, our outlook for Japan remains positive with an expectation of low-single-digit unit case volume growth over time. In Japan, we have a clear formula for success and we’ll continue executing against our strategies. In the Philippines, results were impacted by severe typhoons in the early part of the quarter. Additionally, we saw a slowdown in overall consumer spending in all staple goods, including beverages, due to inflationary pressures. Unit case volume grew 3%, cycling 11% growth from prior years. We continued to gain sparkling and total volume and value share during the quarter. We remain committed to investing in the marketplace, focused on affordability and availability initiatives to drive future growth. In the European Union group, our volume declined 1%, cycling 5% growth from the prior year. Our operations were impacted by strikes in several of our key markets and the shift of the Easter holiday into the first quarter. Volume declined in April but returned to growth in May and June. Despite these challenges, we are winning in the marketplace, gaining overall volume share and value share across the group, as well as share gains in sparkling and still beverage categories. Coca-Cola Zero remains strong with presence in 26 countries now in the group and growing double-digits in the quarter. We continue to expand our still beverage offerings to generate more balanced growth and launched Vitamin Water in Great Britain with early signs showing good progress. We are consistently making solid strategic investments behind our brands with marketing initiatives around Euro 2008 and the Olympics, focusing on revitalizing the sparkling category with the expansion of our Zero range portfolio and broadening our footprint in still beverages. In Europe, we have a solid foundation in place and remain committed to executing against our strategies. In North America, results were clearly impacted by the worsening economic environment, which as we know may continue for some time. The economic environment is reflected in the non-alcoholic beverage industry declining 2% in the quarter. However, we remain confident we have the right strategies in place to deliver long-term sustainable growth, working alongside closely with our bottling partners and customers. Our unit case volume growth was even in the quarter, despite the challenging environment. Importantly, we’ve continued to gain total beverage volume and value share. Sparkling beverages declined 4% in the quarter, reflecting the continued weakness in our food service business and other on-premise channels. However, our red, black, and silver portfolio -- Coca-Cola Classic, Coca-Cola Zero, and Diet Coke -- continued to gain volume and value share. Coca-Cola Zero delivered strong results, growing more than 40% in the quarter, cycling double-digit growth. Our still beverages portfolio performed strongly as unit case volume increased 9% in the quarter. Warehouse juices grew double-digits, led by trademark Simply Juices, and continued to gain volume and value share. Importantly for Glaceau, performance remained solid, up strong double-digits with strong performance in immediate consumption and non-measured channels. Additionally, Fuse continues to perform very well and for the still beverage category, we continued to gain total volume and value share. In this difficult economic environment looking forward, we have a strong marketing calendar and our bottling system and customers across sparkling and still brands, but we expect the back half of 2008 to remain challenging in North America. We are accelerating productivity initiatives to focus investment in consumer and customer-facing programs and remain committed to winning in this important market. Now let me cover productivity; driving effectiveness and efficiency across our entire system continues to be a key lever in our ability to consistently deliver long-term sustainable results. Recognizing the challenges we are facing, in my first two weeks as CEO I have accelerated several initiatives which were already underway focusing the system on three primary areas. First, supply chain optimization, where we are working within our own supply chain and with our bottling partners to improve operating efficiencies to drive margin-enhancing opportunities. Second, marketing and innovation effectiveness -- we are aggressively reviewing marketing spend to reduce non-consumer facing programs through greater use of global campaigns, leveraging best practices on creative designs and execution as well as optimizing our use of agencies and other third-party providers. As an example, we recently negotiated a global marketing research agreement that will generate savings versus the numerous local agreements in place, as well as provide additional services. These are just a few of the many steps we are taking to optimize investments behind our brands and leverage global best practices. Our objective is to reinvest marketing efficiencies we realize into -- marketing efficiencies that we realize into additional brand-building activities to drive the long-term health of our business. And third, operating effectiveness and efficiency, which will provide us with ongoing flexibility to invest in additional initiatives to drive top line growth and also to support the foundation for future performance as well as drive more streamlined decision-making. I’ve talked to you about these opportunities before. We are now ready to share with you a range of expected monetary benefits. Our target is to generate annualized operating savings in the range of $400 million to $500 million by the end of 2011. We have already begun to implement several initiatives to realize these savings, including first by aggressively managing operating expense budgets and concentrate supply chain operations to eliminate inefficiency and waste supported by lean techniques across our operations; second, by redesigning processes to drive standardization and effectiveness; and third, by identifying opportunities to leverage our size and scale, including shared service operations. And also, last but not least, driving savings in our indirect spend areas through the implementation of a new procure-to-pay purchasing program first in North America and Europe, which is really going to cover approximately 80% of our total indirect spend globally. So overall, while our volume growth in the quarter was weaker than we would like, I am pleased that we successfully managed the numerous one-off factors, as well as the more challenging economic environment by delivering solid financial results and winning in the market, as evidenced by our share gains globally in key categories and also across all our markets. Our system has proven that it is taking the right actions to be successful in the market and we will continue to do that. Going forward, we will remain relentless in becoming more efficient, leaner, and more adaptive to the changing market conditions while continuing to invest behind our brands, building a strong position for the future. Both the fundamentals of our business and the strength of our brands continue to be solid. Through our focus on superior system execution and driving productivity, I remain confident we are building a stronger Coca-Cola system for the future. With that, let me turn the call over to Gary.
Gary P. Fayard: Thanks, Muhtar and good morning, everyone. As Neville and Muhtar have indicated, we once again delivered strong financial results. As you saw in the release, we reported earnings per share of $0.61 per share on a diluted basis in the quarter. However, this included a net charge of $0.40 per share; $0.38 of the net charge was related to our proportionate share of the non-cash impairment charge recorded by Coca-Cola Enterprises. The remaining $0.02 of the net charge was related to restructuring charges and some tax matters, partially offset by gains from the sale of assets, primarily the sale of our [Ramill] bottler in Brazil to Coca-Cola FEMSA. Therefore, our adjusted earnings per share was $1.01 per share, an increase of 19% after considering items impacting comparability in both the current and prior year quarter, as Muhtar side, our seventh consecutive quarter of double-digit comparable earnings per share growth. Net revenue in the quarter increased 17%, which included a 2% benefit from structural changes primarily related to our acquisitions of certain bottlers. The growth was driven by a 3% increase in concentrate sales, a 9% increase from currency, and a 3% favorable impact from price and mix. In the quarter, unit case volume increased 3%, cycling 6% growth in the prior year quarter. Additionally, unit cases and concentrate sales are in line for the quarter and year-to-date. We grew operating income by 18% on a reported basis. After considering items impacting comparability in the current and prior year quarters, operating income increased 20%, which includes an 11% benefit from currency. Total SG&A on an ongoing basis increased 16% in the quarter. About 14 points of the increase was due to bottler and brand acquisitions, increased sales and service expenses, as we invested for growth in our bottling operations and because of currency. The remaining two points reflected continued investment behind our brands at a rate approximating gross profit growth while tightly controlling general and administrative expenses as we focus on expense management and productivity initiatives. We are maintaining a disciplined approach to marketing our brands, particularly in the current environment. As Muhtar mentioned earlier, we are continuing to support our brands, building a stronger share position for the future. We’re achieving this through a slight step-up in our total direct marketing spend versus our original plans, while at the same time reinvesting marketing productivity savings. We’re also strategically reallocating resources against geographies and initiatives to drive sustained growth. Additionally, we continue to see margins improve in both our core business and in our bottling investment group. Our continued focus on driving efficiencies and effectiveness throughout our organization generated four points of expense leverage on our core business in the quarter. For the remainder of the year, we would expect to continue to achieve expense leverage but at a more moderate rate as we start to cycle some of the programs put in place late last year. Our interest expense decreased in the quarter, reflecting the impact of a $17 million gain from terminating interest rate locks put into place in anticipation of a long-term debt issuance later this year, which is now being deferred given the current market environment, as well as lower interest rates. We repurchased approximately $1 billion of our stock year-to-date and we continue to expect to repurchase between $1.75 billion and $2 billion for the full year 2008. Now let me address some of the factors that we see impacting us in the remainder of this year. We remain confident in our ability to achieve long-term sustainable growth, despite a more challenging short-term environment, given our balanced geographic mix and brand portfolio. We will continue to portfolio manage globally as we expect solid performance in most of our markets, with softness in North America, as our business in North America will continue to be impacted by the difficult economic environment in the near-term. Globally, we have strong plans in place with our bottling partners and customers for the remainder of the year, which reflects the realities of each market’s economic conditions. From a commodity cost perspective, given the continued rise in oil prices and the impact on PET, we would expect a slight increase for the company for this year. From a capital expenditure standpoint, we purchased $850 million in net property, plant, and equipment year-to-date. For 2008, the full year, we expect total company net capital expenditures will be approximately $1.8 billion to $1.9 billion. That’s versus our prior estimate of 1.6 to 1.7. About half of the increase is due to currency movements since the time we set our budgets and the remainder is to support the growth in our bottling investments group. With regard to taxes, we ended up the quarter with an underlying effective tax rate of 22% and we expect to remain at that underlying effective tax rate for the remainder of the year. Moving now to currency, as I mentioned we saw a positive impact from currency in the quarter on operating income of 11%. We are effectively covered for the full year on the YEN and the Euro, and based on current market rate expectations for the remainder of the year and benefits of coverage in place, we would expect currency benefits on operating income for the full year to be at least mid-single-digits, with most of the benefit occurring in the first three quarters of this year. And finally, let me turn to productivity; as you saw from our release and as Muhtar mentioned, we expect to achieve $400 million to $500 million of annualized operating savings from our productivity initiatives by the end of 2011. In realizing the savings, the company expects to incur total non-recurring costs by 2011 approximately equal to the annualized savings. Starting in 2008, we expect the phasing of the savings and cost to be approximately 25% per year through 2011. That’s it for the topics I wanted to cover, so Operator, now for the questions.
Operator: (Operator Instructions) Your first question will come from the line of Judy Hong with Goldman Sachs.
Judy Hong - Goldman Sachs: Good morning, everyone. Muhtar, I was just wondering, if we looked at your volume growth of 3% in the quarter, I’m wondering if there’s a way to quantify how much of that was really one-off factors, like the labor strike, et cetera, versus the more challenging macro conditions that you’ve cited. And related to that issue, if you look at markets around the world, can you compare and contrast markets where you are seeing more negative impact from challenging macroeconomic conditions versus markets where you are not? And whether going forward, you are looking for a broader slowdown in markets where you haven’t really seen the weakness in some of these markets at this point.
Muhtar Kent: Good morning, Judy. I think as I said, I talked about the one-off events; again, just to reiterate them, China certainly experienced earthquakes, flooding, also unseasonable weather -- that certainly had an impact early in the quarter. Philippines experienced typhoons, Europe experienced unseasonable weather, very unseasonable weather in April and also we experienced labor strikes in both France, Greece, and Spain, and Japan and Russia were again impacted very significantly in terms of the unseasonable weather. Now, it is again very difficult to quantify. We do know that these had an impact on our business, no question. And then you see countries like the Philippines where the food inflation is having an impact on consumer sentiment and we are going to see that continuing. But I think overall, we know that had these one-off events not had taken place that our volume growth would have been higher in certain markets like Russia, certainly in markets like China and also for sure in Europe, where we have a very solid foundation of our business. So I think you can isolate some of those things into the quarter and then Brazil, where the economy is very, very robust, we saw again a significant expansion of credit endurables that had an impact on our business early in the quarter but again, that was also a one-off because that, we don’t see that continuing going into the balance of the year. So those are sort of the comments that I would give you. I think we see that although at a slightly slower rate, the macro economies in the BRIC countries are going to continue to grow and the emerging markets are going to continue to grow. The difference between what you see today in the economic environment versus what you saw perhaps a decade ago in the crisis is that the current macroeconomic -- the current economies of the emerging countries are much better positioned from a fiscal discipline, monetary discipline point of view to weather some of these current challenges and again, we will all see it and live through but I want to reiterate that certainly the business that we are in is the business that -- where we sell essentially a very affordable luxury, billions of times every day, is one where we are very confident that we can continue to grow going forward.
Judy Hong - Goldman Sachs: Okay, and just a clarification on this year’s outlook, because I think Gary mentioned that you guys are confident in achieving the long-term growth targets this year. Does that mean -- are you backing off on your comment before about the picture of success this year exceeding those long-term targets?
Muhtar Kent: We have reiterated that our long-term targets of 3% to 4% volume growth, 6% to 8% operating income growth and high-single-digit earnings growth and the picture of success for us is to exceed those and I think we currently will be disappointed if that is not the case.
Judy Hong - Goldman Sachs: That’s still the case this year?
Muhtar Kent: We would be disappointed if that would be not the case.
Judy Hong - Goldman Sachs: Okay, yeah, thank you.
Operator: Your next question will come from the line of Bill Pecoriello with Morgan Stanley.
Bill Pecoriello - Morgan Stanley: Good morning, everybody. A question on -- as the bottlers are beginning to raise price further in the second half of ’08 due to commodity increases, maybe as high as mid- to high-single-digit in the U.S., I think [Helenica] talked about mid-single-digit, will you be raising concentrate prices more than historically to offset any of the volume impact that you might suffer? Would you wait for January to raise the concentrate again? And are you trying to evaluate more incident-based pricing type models in these developed markets due to the inflationary outlook versus past practice? Thanks.
Muhtar Kent: I don’t think I want to go into the details of our concentrate arrangements with our bottlers but you can rest assured that -- I think firstly, please -- you know, it’s important to understand that our bottlers’ financial architecture today is much stronger than it used to be three, four years ago in terms of their ROICs, in terms of their cash positions, in terms of their willingness and appetite to invest in the marketplace, and again the commodity increases are impacting our bottlers in very different ways in different geographies, so it’s wrong to assume that it’s all going to be looking like the U.S. picture across the world in terms of its relationship to the revenue that the bottlers are generating out of the cases that they are selling. But we have very good equitable arrangements in place with our bottlers to ensure that we remain very disciplined in the way we continue to invest in the marketplace, to continue to ensure that our brands are healthy, and continue to ensure that we gain volume and value share as we move forward in this environment.
Bill Pecoriello - Morgan Stanley: But in certain regions where the bottlers might have to take higher pricing, if you look at what we are seeing with the Procter & Gambles and other companies that are all raising prices, in your case as the bottlers would be raising, you might take more of the impact in your P&L but you obviously have levers, whether it be market support in concentrate, but you would be working with the bottlers on adjusting those levers, so you didn’t suffer any harder impact from those increases.
Muhtar Kent: Absolutely. The key word is to optimize volume and value and also the key word is equitable.
Bill Pecoriello - Morgan Stanley: Thank you.
Operator: Your next question will come from the line of Marc Greenberg with Deutsche Bank.
Marc Greenberg - Deutsche Bank: Thanks. Good morning, Muhtar. Today’s results at CCE, weak volumes, $5 billion impairment, indication of another comprehensive business review, bear all the markings of a bottler that belongs in the hospital ward. Does Coke still believe the best go-to-market approach in the U.S. is with an independent bottler? And what might cause your point of view to change there?
Muhtar Kent: Well firstly, I think we are continuing to work with CCE and all our bottlers to optimize our value and price to the consumer and customer in this challenging -- it is a challenging cost environment and that going forward, to grow value in a sustainable way to balance volume and share, as well as operating income. And we are relying on many aspects. Of course, I want to just reiterate that we are working very closely with CCE and all our bottlers. There is no question that we feel that this market has tremendous potential and that we will realize that potential. We have a much stronger portfolio. We have a very close working relationship and we have -- you know, I want to just reiterate, if your question is going that, that we have no plans in place to -- I’ve said it before, any intention in acquiring the bottler that you talked about.
Operator: Your next question will come from the line of John Faucher with J.P. Morgan.
John Faucher - J.P. Morgan: Good morning. Thank you. You know, as you talked about all these one-time items, I guess the question would be as you’ve cycled through some of them, it seems as though those should dissipate. And can you give us a clue -- have you seen any acceleration as we sort of cycled some of these? Again, talk as you went through the second quarter but also give us an idea, I realize it’s only a couple of weeks into the third quarter, would you say the run-rate is improving as you move past some of these factors?
Muhtar Kent: Well, John, first we don’t provide mid-quarter updates, but I just want to say that we remain confident in the long-term prospects of the business, recognize that we are facing uncertain economic conditions but remain fully committed to delivering on our commitments. We do closely monitor the economic environment, market by market and I can tell you that we had very flexible plans in place to adjust our plans where appropriate in terms of packaging, price points, and as I reiterate, our picture of success continues to meet or exceed our long-term targets. And in terms of -- I believe in statistics and probability and I do believe that the one-offs should not continue going forward. We may have other one-offs but I don’t think that all of those will come together all in one quarter in that intensity. Gary, you want to add to that?
Gary P. Fayard: John, let me see if I can add a little bit of context to it, in two different ways; one is you really have to talk about different countries, because there’s a lot of volatility in the macroeconomic environment today. But let me give you a couple of examples -- Brazil, if I told you about Brazil for a minute and focus on it, it was 1% growth in the quarter. But it was a really bad April but actually returned to nice growth in May and June. If I look at in Europe at Germany or Great Britain, very bad April, return to growth in May and June. But I can give you some examples that go the other way. It really depends on the country, so we think a lot of it is telling us it’s kind of these one-off items but sure there’s some macroeconomic environmental factors as well. But to try to quantify any of those would be kind of speculation on our part, so that’s why we feel comfortable. I guess the other point I would make though is we have a management team that’s seen this before. We’ve been through this before. In the late ‘90s, if you’ll remember when it was much worse and the emerging markets were so tied to the U.S., and thank God they’re not any longer. We’ve been through this before and we know what to do and I think that’s why we feel very confident with where we are and why we’re gaining share. And we would expect in this kind of environment with our system and with our brands, we plan to come out of this much stronger, actually, than other companies in the industry.
John Faucher - J.P. Morgan: Thanks.
Operator: Your next question will come from the line of Christine Farkas with Merrill Lynch.
Christine Farkas - Merrill Lynch: Thank you very much. Good morning. Muhtar and Gary, I have just a housekeeping question; I’m wondering if you can tell us how much Glaceau added to your North American volumes and were there any other ongoing or lingering issues with your large format water? And then I want to understand with your SG&A growth in the quarter, you’ve talked about the bottler and brand acquisitions impacting that a lot. As we are cycling through this, if your acquisitions of bottlers slow, what kind of leverage could we hope to see there, or would you continue to expect the same kind of leverage once we cycle that impact?
Muhtar Kent: I’ll ask Gary to comment on the second piece of the question but in terms of Glaceau, it added two percentage points in the quarter for our North American business going forward, so that’s the number that I think you were looking for. And then Gary, do you want to just take the piece on the SG&A?
Gary P. Fayard: On SG&A, what you would -- basically for the quarter, let me go through that again first, SG&A was up 16%. About eight points of that was currency, four points of it was structural, and about two points for brand acquisitions. So if you strip all that stuff out, apples-to-apples, OpEx was up about 2%; within that, marketing up in line, pretty much in line with gross profit, so you are seeing some pretty good leverage coming from tight control on G&A spend within that. Now related to that, we put some of those programs into place late last year, so we’ll start cycling those. We’ll continue to see leverage but it will be less than what we’ve seen in the first half of this year, which was about four points of leverage in the quarter.
Christine Farkas - Merrill Lynch: Okay, great. And then on your currency, Gary, have you indicated what you plan to spend that back on, or is that embedded into your plans of what you’ve discussed?
Gary P. Fayard: It’s embedded in the plans. We actually are aggressively managing, portfolio managing, and we have increased spend in some areas but at the same time, we’re being very disciplined on spending back, that it needs to have a long-term return for us and so we’re very disciplined in what we are spending. So that’s why you see a lot of the currency benefit coming through, dropping right to the bottom line because we are continuing to spend in line with our plans. We’ve increased that somewhat as we portfolio manage as well, but you know our plans already have significant marketing spend behind the Olympics and Euro 2008, so I think we are very well-positioned in marketing. When we see opportunities, we’ll jump on it but at the same time, if it’s not a good financial -- long-term financial decision, we’ll be very disciplined and it will flow through, as it did this quarter.
Christine Farkas - Merrill Lynch: Thank you.
Operator: Your next question will come from the line of Bryan Spillane with Bank of America Securities.
Bryan Spillane - Bank of America: Good morning. Gary, a question on the restructuring charges and savings, a couple of questions; first, just all the spending will be all cash? Were there any write-downs or is the amount you are going to spend to generate the charges going to be all cash?
Gary P. Fayard: Bryan, I would say that most of it will be cash. There will be some write-downs on facilities, et cetera, that we closed. The example -- the current example would be that we just closed one of our concentrate plants in Ireland. We announced that last fall. It actually closed in June, so last month, and in that you had cash restructuring charges as well as a write-down of the plant itself, all within that restructuring. So you will have some of both but I would say probably tend more toward the cash side, both on the savings and on the restructuring charges to achieve those savings.
Bryan Spillane - Bank of America: Okay, and then will there be any capitalized spending associated with this as well?
Gary P. Fayard: Not really anything of any significance, no.
Bryan Spillane - Bank of America: Okay, and then in terms of just how we flow what you’re spending versus the savings, is the 25% per year the way we should think about the spending, or are you going to spend more up-front and the savings come through more gradually?
Gary P. Fayard: You know, we’re going to do this one the way you would really like it to be done. It’s almost we’re trying to achieve a kind of 25% per year on both sides, so it’s going to be fairly well matched.
Bryan Spillane - Bank of America: Okay, great. Thank you.
Operator: Your next question will come from the line of Kaumil Gajrawala with UBS.
Kaumil Gajrawala - UBS: Good morning, everyone. First, if we could talk about marketing a bit, can you comment if, given what’s happening to the economy, if you are shifting some of your marketing strategies potentially maybe from advertising over to promotions in areas like the United States? And then also, as it relates to the economy, as we think about Western and Eastern Europe where private label is a little stronger, can you talk about if you are seeing any trading down?
Muhtar Kent: I think not just in the United States or Europe, but everywhere we remain very flexible and in fact, you see us shifting some of our emphasis in our marketing programs but not just in marketing programs but also in the area of packaging, ensuring that we remain affordable and ensure that we can continue to capture all beverage opportunities around the world. And I think that what you see us doing is to make sure that we remain relevant to the consumer and also that our key partnerships with all our key customers, small or large, continue around the world. I think that we will do whatever is necessary to ensure that we can keep maximizing our growth and also gaining volume and value share in all our markets. In Europe, specific to your question about discounters, what you see us actually is that we are gaining availability in discounters quarter by quarter in Europe, including not just in legal but all key discounters. So you see us being more relevant now with our different formats across east as well as across Western Europe. What we see is that in these times, consumers find it easier to make decisions to buy affordable luxuries, like our products. And I think that our strategies are working because we are gaining market share across all our key markets. In 17 of our top markets, we’ve gained both volume and value share and I think that you will see that continuing as we move into the balance of the year.
Kaumil Gajrawala - UBS: Great. Thank you.
Operator: Your next question will come from the line of Mark Swartzberg with Stifel Nicolaus.
Mark Swartzberg - Stifel Nicolaus: Good morning, thanks. Gary, just a clarification; I didn’t understand your comment about the productivity savings in the Q&A with Bryan. When you said on both sides matching, were you saying you plan to spend back those savings pretty much at a 125 per annum, or 100 per annum depending on the total number between now and 2011?
Gary P. Fayard: Yes, Mark. Basically as the savings com through, the costs will come through at about the same amount, so --
Mark Swartzberg - Stifel Nicolaus: Oh, that was a reference to the charge, but what about where those savings actually -- you know, to the extent to which they hit the bottom line?
Muhtar Kent: Let me just reflect on that. I mean, what you will see us doing is -- you know, because we’re realizing some of those savings as we speak and what you see us doing is ensuring that we spend some of it against our brands to keep our brands healthy and relevant, and then some of it will go into leverage on our P&L. So you will see us spending some of it and then using to ensure that we continue our leverage on our P&L. But what Gary was explaining was the costs to realize those savings as opposed to how we were going to spend the money.
Mark Swartzberg - Stifel Nicolaus: Thank you, guys.
Operator: Your next question will come from the line of Lauren Torres with HSBC.
Lauren Torres - HSBC: Good morning. You updated us on your commodity cost guidance for the Coca-Cola Company for this year. I was just wondering if you wanted to make some comments just with respect to the Coke system. Obviously costs are getting that much tougher. What’s your expectation for the system? And just also if you could be a bit more specific about what you are doing with your bottlers really just to manage these cost pressures? Thanks.
Muhtar Kent: I think there’s a -- we see a fairly big difference between how the outlook looks in the United States and how the outlook looks around the world. I think I made a brief comment on that earlier when I was answering an earlier question, but what you see is that in the United States, clearly we see a much higher number than we’ve experienced in the past, maybe around 5%, 6%, this year and then double-digits next year. But certainly in terms of the international environment, I think you see a very different -- huge differences in different countries but certainly a much smaller amount in terms of how we see it in 2008 and also how we see it going forward. Both what you see in Eastern Europe or Western Europe, it is much, much lower than the numbers in the United States. So as a system, what we see is low-single-digits in 2008 and it is still difficult to assess exactly where it’s going to land in 2009.
Lauren Torres - HSBC: But with that in mind, thinking about your relationship and how you are working with your U.S. bottlers this year, what initiatives would support -- you know, how do we think about your relationship and support with respect to these cost increases and how you can help offset that in partnership with your bottlers?
Muhtar Kent: As I said, we are continuing to work very, very closely with CCE and our bottlers to optimize value and price to the consumer and customer. It is a challenging environment and I think we are basically aligned in how we go forward on the importance of immediate consumption to build our brands, on the importance of investments in packaging differentiation and capabilities, and on the continued investment in customer capabilities. So you see us having a significant number of initiatives, also on supply chain optimization. And I’d like to turn to Sandy to give you a little more detail on that.
Sandy Douglas: Good morning, everyone. The principal focus of our plan this year with our bottlers has continued to move aggressively on productivity initiatives and to bring support forward to support both packaging and marketing programs to drive growth. We expect the system to look for pricing improvement in the balance of the year in a balanced way to try to begin to recover margins while at the same time protecting consumer and customer value, and all of our investment is focused on helping the system achieve that in a balance way while at the same time growing the health of the brands.
Muhtar Kent: I just want to reiterate, in the United States we have a much richer portfolio, a much better architecture in our portfolio and brands in our stable in the still beverage category. Our three cola strategy is gaining traction and I think that we certainly will continue to build on our rich still beverage portfolio, growing -- the fastest growing still beverage -- to remain the fastest growing still beverage portfolio, led by Glaceau and Fuse and Simply Juices but also to ensure that we continue to drive relevance to our consumer base with our three cola strategy in the sparkling category.
Lauren Torres - HSBC: Thank you.
Operator: Your next question will come from the line of Carlos Laboy with Credit Suisse.
Carlos Laboy - Credit Suisse: Good morning, everyone. Muhtar, I was hoping you could give us a more detailed update on your company-owned bottlers. Who’s the best performing bottler of these this past quarter, what’s working there, and similarly, who is still in deep trouble? And for Gary, is this macro environment risk putting those company-owned bottling earnings advances back into reverse, or for those growth rates to stall out on us here?
Muhtar Kent: I think that all our actual company bottling operations are gaining traction. They are enhancing margin, they are growing, they are gaining market share in their territories and both China, Philippines, improving distribution, gaining market share in both those environments, as well as in Germany, I think we are gaining very good traction and leveraging the current architecture as a single bottling system, working much closer with customers. Germany is an area where we’ve gained tremendous traction with all retailers, including discounters, where we are very successful with our different packaging and formats and portfolio. You know, across Latin America, the CBO is doing very well. Scandinavia again, we’re gaining traction and doing very well. And across the financial performance continues to improve and our volumes are very much in line or better than the general market in all the territories.
Gary P. Fayard: And relative to those, let me just echo basically what Muhtar just said as well, Carlos. The volume within the bottling investments group, in fact, organic volume was up 6%, so they are performing really well in this environment. Income is up significant and ongoing operating income margins increased 120 basis points, kind of ongoing, so these bottlers, while they were in the hospital ward, I think the BIG group is doing a very good job of managing them across the world, and in fact we’re seeing improving results pretty much everywhere. So I don’t anticipate any big issues there.
Carlos Laboy - Credit Suisse: Thank you.
Operator: Your next question will come from the line of Todd Divek with Banc of America Securities.
Todd Divek - Banc of America: Good morning. Gary, I guess this question is primarily for you; the financial markets have been very difficult and some of the financial firms have had to raise additional capital and Suntrust has been one of those that’s been speculated. Given that they own a significant number of shares, can you just refresh our memory in terms of what the policy is towards buying back shares directly from Suntrust? Is there an agreement in place?
Gary P. Fayard: Thanks, Todd, for the question. Suntrust does own directly about 44 million shares of the company stock, going back to the original IPO of the company. They have announced plans during this quarter that they are looking at ways to enhance their capital position, and one of the ways to do that could involve either the sale of or some kind of other type transaction involving the Coke shares that they directly own. They have not announced what if anything they’ve done at this point. I believe their earnings release and quarterly call is on I think Tuesday of next week, so I would expect -- I think they have said that they expected to have something in place by the end of this quarter, so I would expect all of us to learn on Tuesday exactly where they are.
Todd Divek - Banc of America: Okay, that’s helpful, and just a follow-up; with respect to your comments in the prepared remarks about deferring long-term debt issuance that you had planned for this fall, is that primarily to pre-finance some long-term debt that matures next spring? Or are you planning to term out additional debt that is currently in short-term debt?
Gary P. Fayard: We were actually looking at terming out some of the acquisition debt from the Glaceau transaction. It’s just we have a commercial paper program in place that we’re in the market basically every day. We have not had a single issue at all in our commercial paper program. We probably are paying lower than almost anybody else in the world. I mean, we’ve got a great program there. As we look at, as interest rates have come down but as we look at the spreads on longer term debt, we just have concluded that it’s really just not worth paying those kinds of spreads and we are going to stay short, as we have for the last year or so. And because of that, we have put this interest rate lock in in anticipation of probably issuing some debt. This summer, we’re not going to do that. As I said, we’ll defer that as we continue to watch the spreads over treasuries, and we made $17 million on the deal.
Todd Divek - Banc of America: Okay, fair enough. Thank you very much.
Ann Taylor: Operator, we have time for one last question.
Operator: Thank you. This morning’s final question will come from the line of Karen [Lamarc] with Federated Investors.
Karen Lamarc - Federated Investors: Good morning. I wonder if you can give us a little bit more color on the step-up in the non-currency related CapEx, as maybe what changed or what made you realize that you wanted to step up the investment [side]? Thanks.
Gary P. Fayard: Thanks, Karen. Of the about $200 million step-up, as I said about half of that -- about $100 million of that is really just due to currency. The other 100 is really about the timing around our bottling investment group. If you think about it, they are growing nicely, as I said a few minutes ago when I was talking to Carlos, they are growing nicely, we continue to invest in the bottling investments group. Because of the planning cycle, we are going ahead and spending some money now in orders so that we’ve got equipment, lines, et cetera in place for the summer selling season next year. So we’re just accelerating some plans really from placing orders in January to now. And additionally, we are starting to build a new concentrate type facility as well, and that’s going to add a little bit of cost in this fall.
Karen Lamarc - Federated Investors: Great, thanks very much.
Muhtar Kent: Thank you, Neville, Gary, and Sandy, and thanks to each of you for joining us this morning. I’m excited to lead this great company and I am confident our strategies are working. The fundamentals of our business and the strength of our brands remain strong. We are focused on the initiatives that will drive our results, execution in the marketplace, and outward focus on our customers and consumers, and diligence with capital and expense allocation. I am very excited about the next phase of our journey to create a true, sustainable growth company. Thank you very much.
Operator: Ladies and gentlemen, this concludes the Coca-Cola Company’s second quarter 2008 earnings results conference call. You may now disconnect. | [
{
"speaker": "Executives",
"text": "Ann Taylor - Vice President and Director of Investor Relations Neville Isdell - Chairman of the Board, Chief Executive Officer Muhtar Kent - President, Chief Operating Officer Gary P. Fayard - Chief Financial Officer, Executive Vice President Sandy Douglas - North America Group President"
},
{
"speaker": "Analysts",
"text": "Judy Hong - Goldman Sachs Bill Pecoriello - Morgan Stanley Marc Greenberg - Deutsche Bank John Faucher - J.P. Morgan Christine Farkas - Merrill Lynch Bryan Spillane - Bank of America Kaumil Gajrawala - UBS Mark Swartzberg - Stifel Nicolaus Lauren Torres - HSBC Carlos Laboy - Credit Suisse Todd Divek - Banc of America Karen Lamarc - Federated Investors"
},
{
"speaker": "Operator",
"text": "Good morning. My name is Dennis and I will be your conference facilitator. At this time, I would like to welcome everyone to The Coca-Cola Company’s second quarter 2008 earnings results conference call. (Operator Instructions) I would like to now introduce Ann Taylor, Vice President and Director of Investor Relations."
},
{
"speaker": "Ann Taylor",
"text": "Good morning and thank you for being with us today. I am joined by Neville Isdell, our Chairman; Muhtar Kent, our President and Chief Executive Officer; Gary Fayard, our Chief Financial Officer; and Sandy Douglas, our North America Group President. Following prepared remarks this morning by Neville, Muhtar, and Gary, we will turn the call over for your questions. Before we get started, I would like to remind you that this conference call may contain forward-looking statements, including statements concerning long-term earnings objectives and should be considered in conjunction with cautionary statements contained in our earnings release and in the company’s most recent SEC report. In addition, I would also like to note that we have posted schedules on our company website at www.thecocacolacompany.com under the financial information tab in the investors section, which reconcile certain non-GAAP financial measures that may be referred to by our senior executives in our discussion this morning and from time to time in discussing our financial performance to our results as reported under generally accepted accounting principles. Please look on our website for this information. Now let me turn the call over to Neville."
},
{
"speaker": "Neville Isdell",
"text": "Thank you, Ann and good morning, everyone. As you all know, this has been my final quarter as CEO of this outstanding company and before I turn the call over to Muhtar, who will provide context around the results of the second quarter and the outlook going forward, and to Gary who will give you an overview of the financials and some additional perspective on 2008, I want to make a few opening comments. The Coca-Cola Company has made significant progress since our turnaround began in 2004. We have revitalized the sparkling beverage category globally and continue to grow trademark Coca-Cola. We’ve addressed key issue markets and taken decisive actions. We have reconnected with our customers and consumers through effective marketing and innovation strategies, and we have reengaged our associates, who are absolutely key to our winning in the marketplace. And importantly, we have successfully implemented a seamless CEO transition plan for the next leg of our journey. Clearly our strategies are working as we continue to expand our volume and value share leadership position in the non-alcoholic ready-to-drink beverage industry, as well as in sparkling and key still beverage categories. And our financial performance continues to be strong, as we deliver our seventh consecutive quarter of double-digit comparable earnings per share growth. As I depart as CEO, I am pleased with our accomplishments and solid performance. We have put in place a strong foundation and I remain confident in our outlook for 2008 as we continue to invest and build share. Our balanced geographic mix and broad portfolio, along with the talent and experience of our people across the system, positions us well to continue to be successful, delivering growth and value for our shareowners for the long-term. And now, I’d like to turn the call over to our new CEO, my good friend, Muhtar. Muhtar Kent, please."
},
{
"speaker": "Muhtar Kent",
"text": "Thank you, Neville and good morning, everyone. First, I’d like to take this opportunity to thank Neville for his extraordinary leadership and the support that he has provided to me for the past two decades. I am truly honored by the confidence both he and our board of directors have shown in my ability to lead this great company. Before I get into the specifics of our operating performance, I’d like to reiterate that our business is a true great business to be in. The non-alcoholic beverage industry is the fastest growing segment of the consumer products industry and we have leading positions in almost all categories we compete in. The Coca-Cola Company offers an affordable luxury, connecting with our consumers 1.5 billion times every day. But I know what is top of mind for all of you; the current macroeconomic environment and its impact on our results. Based on our volume performance of 3% in the quarter, it is clear we were faced with some challenges around the globe. Our results in the quarter were impacted primarily by a number of one-time events, including strikes in Europe and natural disasters in Asia, as well as unfavorable weather in a number of our markets. Moreover, we are certainly operating in a more challenging environment, particularly as rising food and energy costs way on consumer confidence. Internationally, GDP forecasts are coming down; however, growth is still expected to remain at healthy levels, and it is no surprise that we continue to face challenges also in North America due to the U.S. economy. We continue to invest aggressively in our portfolio with new products, marketing platforms, and a consistent strategy in very close coordination with our bottling partners to offer our customers the best beverage choices for consumers. Our second quarter performance demonstrates our ability to leverage the strengths of our system to achieve balanced growth. Our results were once again led by our international operations, which delivered 5% unit case volume growth, cycling 9% growth in the prior year, despite some one-off events and a more challenging macroeconomic environment. For the past few years, we have been rebuilding our foundation and solidifying our position as the leading global non-alcoholic ready-to-drink beverage company. We believe that our broad and balanced geographic mix positions us very well to navigate through any headwind as we continue to focus on operating efficiencies and execution strategies. Our actions are allowing us to win in the market. Globally, we accelerated our volume and value share gains in total non-alcoholic beverages. Importantly, we gained share in most of our key markets as well as key categories, and this illustrates the strength of our brand and the strength of our system to operate successfully in tough environments. By continuing to invest in difficult economic times, our system is seeking to build a stronger bond with consumers and a stronger share position for the long-term. We clearly recognize that there are short-term challenges in the marketplace related to economic trends and we will maintain our disciplined approach of analyzing and understanding the impact of these challenges to our business and adjust our plans accordingly. Now let me turn to our operating performance for the quarter. We increased our unit case volume by 3% in the quarter and 4% year-to-date, successfully cycling 6% growth in the prior year quarter and year-to-date period. While the growth was not where we would have liked it to be, it is not unexpected given the headwinds we faced from natural disasters, including earthquakes and floods, as well as unseasonably cold weather -- cold and wet weather in certain markets. Additionally, we were challenged, as I said, with strikes in key European markets and continued softness in consumer trends in North America. In the quarter, our financial results remained strong. We achieved double-digit comparable earnings per share growth of 19%, now our seventh consecutive quarter of double-digit EPS growth. Revenue growth was solid, increasing 17% with the acquisition of bottlers contributing two points of growth. This performance illustrates that our strategies to drive top line growth are working. Ongoing operating income increased 20% with currency contributing 11 points of growth, so our currency neutral operating income was 9% even as we have continued to make solid, strategic investments for long-term sustainable growth. Moving now onto our geographies, Latin America continues to be a bright spot for our system, once again achieving solid results. Unit case volume increased 7% with all business units delivering growth and the group also continued to achieve share gains in key countries. Additionally, the successful integration Jugos del Valle into our system is contributing to still beverage growth and share gains. In Mexico, unit case volume increased 10%, led by the continued strong performance of brand Coca-Cola, up 3% and the benefit of Jugos del Valle also contributing three points to growth, all leading to volume and value share gains in sparkling as well as still beverages. Brazil increased 1% in the quarter, reflecting the slowdown in industry growth, particularly in April as consumer spending shifted to durable goods as a result of continued credit expansion. Despite challenges in the marketplace, Brazil gained volume and value share in total non-alcoholic ready-to-drink beverages, also as well as with sparkling and still beverages. In Africa, we achieved unit case volume growth of 5%. South Africa’s unit case volume was even with last year, cycling 12% growth in the prior year quarter and reflecting the continued effects of CO2 shortages. We expect to have the CO2 shortages in our business resolved during the second half of this year. Eurasia delivered unit case volume growth of 7%, led by solid results in India, Turkey, Eastern Europe, Southern Eurasia, and the Middle East. Growth was solid across sparkling and still beverages, with sparkling beverages growing 3% and still beverages, led by the expansion of Minute Maid in India and [Molten] Juice in Russia growing 24%. In Russia, unit case volume growth was 2%, primarily reflecting the impact from poor weather conditions, particularly in the second half of the quarter. Despite the slowdown of volume growth in Russia, our volume and value share in non-alcoholic beverages in the quarter reached an all-time high. The Pacific group grew unit case volume 4% in the quarter, led by China, which continued to delivered double-digit growth despite being negatively impacted by significant flooding and earthquakes in certain regions of the country. We continue to drive growth by leveraging our Olympic activation programs centered around brand Coca-Cola, expanding Minute Maid Pulpy and successfully launching our new original Leaf Tea brand. In Japan, volume declined 1% in the quarter; however, we achieved share gains in non-alcoholic ready-to-drink beverages. Sparkling beverages continued to grow, led by trademark Coca-Cola as we continue to invest behind our three cola strategy and the introduction of a new Fanta product, [Fofuru], a unique innovative sparkling jelly fusion shaker. Additionally, Georgia Coffee grew 4%, the highest growth rate for Georgia in more than five years. Core Georgia flavors contributed to more than 50% of the growth, proving our strategies to innovate the brand through marketing initiatives, new packaging, and new flavors are working well. Georgia is now in its third consecutive quarter of growth and gaining category share. Adverse weather conditions resulted in volume declines for Sokenbicha and Aquarius. Together with our bottling partners, our outlook for Japan remains positive with an expectation of low-single-digit unit case volume growth over time. In Japan, we have a clear formula for success and we’ll continue executing against our strategies. In the Philippines, results were impacted by severe typhoons in the early part of the quarter. Additionally, we saw a slowdown in overall consumer spending in all staple goods, including beverages, due to inflationary pressures. Unit case volume grew 3%, cycling 11% growth from prior years. We continued to gain sparkling and total volume and value share during the quarter. We remain committed to investing in the marketplace, focused on affordability and availability initiatives to drive future growth. In the European Union group, our volume declined 1%, cycling 5% growth from the prior year. Our operations were impacted by strikes in several of our key markets and the shift of the Easter holiday into the first quarter. Volume declined in April but returned to growth in May and June. Despite these challenges, we are winning in the marketplace, gaining overall volume share and value share across the group, as well as share gains in sparkling and still beverage categories. Coca-Cola Zero remains strong with presence in 26 countries now in the group and growing double-digits in the quarter. We continue to expand our still beverage offerings to generate more balanced growth and launched Vitamin Water in Great Britain with early signs showing good progress. We are consistently making solid strategic investments behind our brands with marketing initiatives around Euro 2008 and the Olympics, focusing on revitalizing the sparkling category with the expansion of our Zero range portfolio and broadening our footprint in still beverages. In Europe, we have a solid foundation in place and remain committed to executing against our strategies. In North America, results were clearly impacted by the worsening economic environment, which as we know may continue for some time. The economic environment is reflected in the non-alcoholic beverage industry declining 2% in the quarter. However, we remain confident we have the right strategies in place to deliver long-term sustainable growth, working alongside closely with our bottling partners and customers. Our unit case volume growth was even in the quarter, despite the challenging environment. Importantly, we’ve continued to gain total beverage volume and value share. Sparkling beverages declined 4% in the quarter, reflecting the continued weakness in our food service business and other on-premise channels. However, our red, black, and silver portfolio -- Coca-Cola Classic, Coca-Cola Zero, and Diet Coke -- continued to gain volume and value share. Coca-Cola Zero delivered strong results, growing more than 40% in the quarter, cycling double-digit growth. Our still beverages portfolio performed strongly as unit case volume increased 9% in the quarter. Warehouse juices grew double-digits, led by trademark Simply Juices, and continued to gain volume and value share. Importantly for Glaceau, performance remained solid, up strong double-digits with strong performance in immediate consumption and non-measured channels. Additionally, Fuse continues to perform very well and for the still beverage category, we continued to gain total volume and value share. In this difficult economic environment looking forward, we have a strong marketing calendar and our bottling system and customers across sparkling and still brands, but we expect the back half of 2008 to remain challenging in North America. We are accelerating productivity initiatives to focus investment in consumer and customer-facing programs and remain committed to winning in this important market. Now let me cover productivity; driving effectiveness and efficiency across our entire system continues to be a key lever in our ability to consistently deliver long-term sustainable results. Recognizing the challenges we are facing, in my first two weeks as CEO I have accelerated several initiatives which were already underway focusing the system on three primary areas. First, supply chain optimization, where we are working within our own supply chain and with our bottling partners to improve operating efficiencies to drive margin-enhancing opportunities. Second, marketing and innovation effectiveness -- we are aggressively reviewing marketing spend to reduce non-consumer facing programs through greater use of global campaigns, leveraging best practices on creative designs and execution as well as optimizing our use of agencies and other third-party providers. As an example, we recently negotiated a global marketing research agreement that will generate savings versus the numerous local agreements in place, as well as provide additional services. These are just a few of the many steps we are taking to optimize investments behind our brands and leverage global best practices. Our objective is to reinvest marketing efficiencies we realize into -- marketing efficiencies that we realize into additional brand-building activities to drive the long-term health of our business. And third, operating effectiveness and efficiency, which will provide us with ongoing flexibility to invest in additional initiatives to drive top line growth and also to support the foundation for future performance as well as drive more streamlined decision-making. I’ve talked to you about these opportunities before. We are now ready to share with you a range of expected monetary benefits. Our target is to generate annualized operating savings in the range of $400 million to $500 million by the end of 2011. We have already begun to implement several initiatives to realize these savings, including first by aggressively managing operating expense budgets and concentrate supply chain operations to eliminate inefficiency and waste supported by lean techniques across our operations; second, by redesigning processes to drive standardization and effectiveness; and third, by identifying opportunities to leverage our size and scale, including shared service operations. And also, last but not least, driving savings in our indirect spend areas through the implementation of a new procure-to-pay purchasing program first in North America and Europe, which is really going to cover approximately 80% of our total indirect spend globally. So overall, while our volume growth in the quarter was weaker than we would like, I am pleased that we successfully managed the numerous one-off factors, as well as the more challenging economic environment by delivering solid financial results and winning in the market, as evidenced by our share gains globally in key categories and also across all our markets. Our system has proven that it is taking the right actions to be successful in the market and we will continue to do that. Going forward, we will remain relentless in becoming more efficient, leaner, and more adaptive to the changing market conditions while continuing to invest behind our brands, building a strong position for the future. Both the fundamentals of our business and the strength of our brands continue to be solid. Through our focus on superior system execution and driving productivity, I remain confident we are building a stronger Coca-Cola system for the future. With that, let me turn the call over to Gary."
},
{
"speaker": "Gary P. Fayard",
"text": "Thanks, Muhtar and good morning, everyone. As Neville and Muhtar have indicated, we once again delivered strong financial results. As you saw in the release, we reported earnings per share of $0.61 per share on a diluted basis in the quarter. However, this included a net charge of $0.40 per share; $0.38 of the net charge was related to our proportionate share of the non-cash impairment charge recorded by Coca-Cola Enterprises. The remaining $0.02 of the net charge was related to restructuring charges and some tax matters, partially offset by gains from the sale of assets, primarily the sale of our [Ramill] bottler in Brazil to Coca-Cola FEMSA. Therefore, our adjusted earnings per share was $1.01 per share, an increase of 19% after considering items impacting comparability in both the current and prior year quarter, as Muhtar side, our seventh consecutive quarter of double-digit comparable earnings per share growth. Net revenue in the quarter increased 17%, which included a 2% benefit from structural changes primarily related to our acquisitions of certain bottlers. The growth was driven by a 3% increase in concentrate sales, a 9% increase from currency, and a 3% favorable impact from price and mix. In the quarter, unit case volume increased 3%, cycling 6% growth in the prior year quarter. Additionally, unit cases and concentrate sales are in line for the quarter and year-to-date. We grew operating income by 18% on a reported basis. After considering items impacting comparability in the current and prior year quarters, operating income increased 20%, which includes an 11% benefit from currency. Total SG&A on an ongoing basis increased 16% in the quarter. About 14 points of the increase was due to bottler and brand acquisitions, increased sales and service expenses, as we invested for growth in our bottling operations and because of currency. The remaining two points reflected continued investment behind our brands at a rate approximating gross profit growth while tightly controlling general and administrative expenses as we focus on expense management and productivity initiatives. We are maintaining a disciplined approach to marketing our brands, particularly in the current environment. As Muhtar mentioned earlier, we are continuing to support our brands, building a stronger share position for the future. We’re achieving this through a slight step-up in our total direct marketing spend versus our original plans, while at the same time reinvesting marketing productivity savings. We’re also strategically reallocating resources against geographies and initiatives to drive sustained growth. Additionally, we continue to see margins improve in both our core business and in our bottling investment group. Our continued focus on driving efficiencies and effectiveness throughout our organization generated four points of expense leverage on our core business in the quarter. For the remainder of the year, we would expect to continue to achieve expense leverage but at a more moderate rate as we start to cycle some of the programs put in place late last year. Our interest expense decreased in the quarter, reflecting the impact of a $17 million gain from terminating interest rate locks put into place in anticipation of a long-term debt issuance later this year, which is now being deferred given the current market environment, as well as lower interest rates. We repurchased approximately $1 billion of our stock year-to-date and we continue to expect to repurchase between $1.75 billion and $2 billion for the full year 2008. Now let me address some of the factors that we see impacting us in the remainder of this year. We remain confident in our ability to achieve long-term sustainable growth, despite a more challenging short-term environment, given our balanced geographic mix and brand portfolio. We will continue to portfolio manage globally as we expect solid performance in most of our markets, with softness in North America, as our business in North America will continue to be impacted by the difficult economic environment in the near-term. Globally, we have strong plans in place with our bottling partners and customers for the remainder of the year, which reflects the realities of each market’s economic conditions. From a commodity cost perspective, given the continued rise in oil prices and the impact on PET, we would expect a slight increase for the company for this year. From a capital expenditure standpoint, we purchased $850 million in net property, plant, and equipment year-to-date. For 2008, the full year, we expect total company net capital expenditures will be approximately $1.8 billion to $1.9 billion. That’s versus our prior estimate of 1.6 to 1.7. About half of the increase is due to currency movements since the time we set our budgets and the remainder is to support the growth in our bottling investments group. With regard to taxes, we ended up the quarter with an underlying effective tax rate of 22% and we expect to remain at that underlying effective tax rate for the remainder of the year. Moving now to currency, as I mentioned we saw a positive impact from currency in the quarter on operating income of 11%. We are effectively covered for the full year on the YEN and the Euro, and based on current market rate expectations for the remainder of the year and benefits of coverage in place, we would expect currency benefits on operating income for the full year to be at least mid-single-digits, with most of the benefit occurring in the first three quarters of this year. And finally, let me turn to productivity; as you saw from our release and as Muhtar mentioned, we expect to achieve $400 million to $500 million of annualized operating savings from our productivity initiatives by the end of 2011. In realizing the savings, the company expects to incur total non-recurring costs by 2011 approximately equal to the annualized savings. Starting in 2008, we expect the phasing of the savings and cost to be approximately 25% per year through 2011. That’s it for the topics I wanted to cover, so Operator, now for the questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question will come from the line of Judy Hong with Goldman Sachs."
},
{
"speaker": "Judy Hong - Goldman Sachs",
"text": "Good morning, everyone. Muhtar, I was just wondering, if we looked at your volume growth of 3% in the quarter, I’m wondering if there’s a way to quantify how much of that was really one-off factors, like the labor strike, et cetera, versus the more challenging macro conditions that you’ve cited. And related to that issue, if you look at markets around the world, can you compare and contrast markets where you are seeing more negative impact from challenging macroeconomic conditions versus markets where you are not? And whether going forward, you are looking for a broader slowdown in markets where you haven’t really seen the weakness in some of these markets at this point."
},
{
"speaker": "Muhtar Kent",
"text": "Good morning, Judy. I think as I said, I talked about the one-off events; again, just to reiterate them, China certainly experienced earthquakes, flooding, also unseasonable weather -- that certainly had an impact early in the quarter. Philippines experienced typhoons, Europe experienced unseasonable weather, very unseasonable weather in April and also we experienced labor strikes in both France, Greece, and Spain, and Japan and Russia were again impacted very significantly in terms of the unseasonable weather. Now, it is again very difficult to quantify. We do know that these had an impact on our business, no question. And then you see countries like the Philippines where the food inflation is having an impact on consumer sentiment and we are going to see that continuing. But I think overall, we know that had these one-off events not had taken place that our volume growth would have been higher in certain markets like Russia, certainly in markets like China and also for sure in Europe, where we have a very solid foundation of our business. So I think you can isolate some of those things into the quarter and then Brazil, where the economy is very, very robust, we saw again a significant expansion of credit endurables that had an impact on our business early in the quarter but again, that was also a one-off because that, we don’t see that continuing going into the balance of the year. So those are sort of the comments that I would give you. I think we see that although at a slightly slower rate, the macro economies in the BRIC countries are going to continue to grow and the emerging markets are going to continue to grow. The difference between what you see today in the economic environment versus what you saw perhaps a decade ago in the crisis is that the current macroeconomic -- the current economies of the emerging countries are much better positioned from a fiscal discipline, monetary discipline point of view to weather some of these current challenges and again, we will all see it and live through but I want to reiterate that certainly the business that we are in is the business that -- where we sell essentially a very affordable luxury, billions of times every day, is one where we are very confident that we can continue to grow going forward."
},
{
"speaker": "Judy Hong - Goldman Sachs",
"text": "Okay, and just a clarification on this year’s outlook, because I think Gary mentioned that you guys are confident in achieving the long-term growth targets this year. Does that mean -- are you backing off on your comment before about the picture of success this year exceeding those long-term targets?"
},
{
"speaker": "Muhtar Kent",
"text": "We have reiterated that our long-term targets of 3% to 4% volume growth, 6% to 8% operating income growth and high-single-digit earnings growth and the picture of success for us is to exceed those and I think we currently will be disappointed if that is not the case."
},
{
"speaker": "Judy Hong - Goldman Sachs",
"text": "That’s still the case this year?"
},
{
"speaker": "Muhtar Kent",
"text": "We would be disappointed if that would be not the case."
},
{
"speaker": "Judy Hong - Goldman Sachs",
"text": "Okay, yeah, thank you."
},
{
"speaker": "Operator",
"text": "Your next question will come from the line of Bill Pecoriello with Morgan Stanley."
},
{
"speaker": "Bill Pecoriello - Morgan Stanley",
"text": "Good morning, everybody. A question on -- as the bottlers are beginning to raise price further in the second half of ’08 due to commodity increases, maybe as high as mid- to high-single-digit in the U.S., I think [Helenica] talked about mid-single-digit, will you be raising concentrate prices more than historically to offset any of the volume impact that you might suffer? Would you wait for January to raise the concentrate again? And are you trying to evaluate more incident-based pricing type models in these developed markets due to the inflationary outlook versus past practice? Thanks."
},
{
"speaker": "Muhtar Kent",
"text": "I don’t think I want to go into the details of our concentrate arrangements with our bottlers but you can rest assured that -- I think firstly, please -- you know, it’s important to understand that our bottlers’ financial architecture today is much stronger than it used to be three, four years ago in terms of their ROICs, in terms of their cash positions, in terms of their willingness and appetite to invest in the marketplace, and again the commodity increases are impacting our bottlers in very different ways in different geographies, so it’s wrong to assume that it’s all going to be looking like the U.S. picture across the world in terms of its relationship to the revenue that the bottlers are generating out of the cases that they are selling. But we have very good equitable arrangements in place with our bottlers to ensure that we remain very disciplined in the way we continue to invest in the marketplace, to continue to ensure that our brands are healthy, and continue to ensure that we gain volume and value share as we move forward in this environment."
},
{
"speaker": "Bill Pecoriello - Morgan Stanley",
"text": "But in certain regions where the bottlers might have to take higher pricing, if you look at what we are seeing with the Procter & Gambles and other companies that are all raising prices, in your case as the bottlers would be raising, you might take more of the impact in your P&L but you obviously have levers, whether it be market support in concentrate, but you would be working with the bottlers on adjusting those levers, so you didn’t suffer any harder impact from those increases."
},
{
"speaker": "Muhtar Kent",
"text": "Absolutely. The key word is to optimize volume and value and also the key word is equitable."
},
{
"speaker": "Bill Pecoriello - Morgan Stanley",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question will come from the line of Marc Greenberg with Deutsche Bank."
},
{
"speaker": "Marc Greenberg - Deutsche Bank",
"text": "Thanks. Good morning, Muhtar. Today’s results at CCE, weak volumes, $5 billion impairment, indication of another comprehensive business review, bear all the markings of a bottler that belongs in the hospital ward. Does Coke still believe the best go-to-market approach in the U.S. is with an independent bottler? And what might cause your point of view to change there?"
},
{
"speaker": "Muhtar Kent",
"text": "Well firstly, I think we are continuing to work with CCE and all our bottlers to optimize our value and price to the consumer and customer in this challenging -- it is a challenging cost environment and that going forward, to grow value in a sustainable way to balance volume and share, as well as operating income. And we are relying on many aspects. Of course, I want to just reiterate that we are working very closely with CCE and all our bottlers. There is no question that we feel that this market has tremendous potential and that we will realize that potential. We have a much stronger portfolio. We have a very close working relationship and we have -- you know, I want to just reiterate, if your question is going that, that we have no plans in place to -- I’ve said it before, any intention in acquiring the bottler that you talked about."
},
{
"speaker": "Operator",
"text": "Your next question will come from the line of John Faucher with J.P. Morgan."
},
{
"speaker": "John Faucher - J.P. Morgan",
"text": "Good morning. Thank you. You know, as you talked about all these one-time items, I guess the question would be as you’ve cycled through some of them, it seems as though those should dissipate. And can you give us a clue -- have you seen any acceleration as we sort of cycled some of these? Again, talk as you went through the second quarter but also give us an idea, I realize it’s only a couple of weeks into the third quarter, would you say the run-rate is improving as you move past some of these factors?"
},
{
"speaker": "Muhtar Kent",
"text": "Well, John, first we don’t provide mid-quarter updates, but I just want to say that we remain confident in the long-term prospects of the business, recognize that we are facing uncertain economic conditions but remain fully committed to delivering on our commitments. We do closely monitor the economic environment, market by market and I can tell you that we had very flexible plans in place to adjust our plans where appropriate in terms of packaging, price points, and as I reiterate, our picture of success continues to meet or exceed our long-term targets. And in terms of -- I believe in statistics and probability and I do believe that the one-offs should not continue going forward. We may have other one-offs but I don’t think that all of those will come together all in one quarter in that intensity. Gary, you want to add to that?"
},
{
"speaker": "Gary P. Fayard",
"text": "John, let me see if I can add a little bit of context to it, in two different ways; one is you really have to talk about different countries, because there’s a lot of volatility in the macroeconomic environment today. But let me give you a couple of examples -- Brazil, if I told you about Brazil for a minute and focus on it, it was 1% growth in the quarter. But it was a really bad April but actually returned to nice growth in May and June. If I look at in Europe at Germany or Great Britain, very bad April, return to growth in May and June. But I can give you some examples that go the other way. It really depends on the country, so we think a lot of it is telling us it’s kind of these one-off items but sure there’s some macroeconomic environmental factors as well. But to try to quantify any of those would be kind of speculation on our part, so that’s why we feel comfortable. I guess the other point I would make though is we have a management team that’s seen this before. We’ve been through this before. In the late ‘90s, if you’ll remember when it was much worse and the emerging markets were so tied to the U.S., and thank God they’re not any longer. We’ve been through this before and we know what to do and I think that’s why we feel very confident with where we are and why we’re gaining share. And we would expect in this kind of environment with our system and with our brands, we plan to come out of this much stronger, actually, than other companies in the industry."
},
{
"speaker": "John Faucher - J.P. Morgan",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Your next question will come from the line of Christine Farkas with Merrill Lynch."
},
{
"speaker": "Christine Farkas - Merrill Lynch",
"text": "Thank you very much. Good morning. Muhtar and Gary, I have just a housekeeping question; I’m wondering if you can tell us how much Glaceau added to your North American volumes and were there any other ongoing or lingering issues with your large format water? And then I want to understand with your SG&A growth in the quarter, you’ve talked about the bottler and brand acquisitions impacting that a lot. As we are cycling through this, if your acquisitions of bottlers slow, what kind of leverage could we hope to see there, or would you continue to expect the same kind of leverage once we cycle that impact?"
},
{
"speaker": "Muhtar Kent",
"text": "I’ll ask Gary to comment on the second piece of the question but in terms of Glaceau, it added two percentage points in the quarter for our North American business going forward, so that’s the number that I think you were looking for. And then Gary, do you want to just take the piece on the SG&A?"
},
{
"speaker": "Gary P. Fayard",
"text": "On SG&A, what you would -- basically for the quarter, let me go through that again first, SG&A was up 16%. About eight points of that was currency, four points of it was structural, and about two points for brand acquisitions. So if you strip all that stuff out, apples-to-apples, OpEx was up about 2%; within that, marketing up in line, pretty much in line with gross profit, so you are seeing some pretty good leverage coming from tight control on G&A spend within that. Now related to that, we put some of those programs into place late last year, so we’ll start cycling those. We’ll continue to see leverage but it will be less than what we’ve seen in the first half of this year, which was about four points of leverage in the quarter."
},
{
"speaker": "Christine Farkas - Merrill Lynch",
"text": "Okay, great. And then on your currency, Gary, have you indicated what you plan to spend that back on, or is that embedded into your plans of what you’ve discussed?"
},
{
"speaker": "Gary P. Fayard",
"text": "It’s embedded in the plans. We actually are aggressively managing, portfolio managing, and we have increased spend in some areas but at the same time, we’re being very disciplined on spending back, that it needs to have a long-term return for us and so we’re very disciplined in what we are spending. So that’s why you see a lot of the currency benefit coming through, dropping right to the bottom line because we are continuing to spend in line with our plans. We’ve increased that somewhat as we portfolio manage as well, but you know our plans already have significant marketing spend behind the Olympics and Euro 2008, so I think we are very well-positioned in marketing. When we see opportunities, we’ll jump on it but at the same time, if it’s not a good financial -- long-term financial decision, we’ll be very disciplined and it will flow through, as it did this quarter."
},
{
"speaker": "Christine Farkas - Merrill Lynch",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question will come from the line of Bryan Spillane with Bank of America Securities."
},
{
"speaker": "Bryan Spillane - Bank of America",
"text": "Good morning. Gary, a question on the restructuring charges and savings, a couple of questions; first, just all the spending will be all cash? Were there any write-downs or is the amount you are going to spend to generate the charges going to be all cash?"
},
{
"speaker": "Gary P. Fayard",
"text": "Bryan, I would say that most of it will be cash. There will be some write-downs on facilities, et cetera, that we closed. The example -- the current example would be that we just closed one of our concentrate plants in Ireland. We announced that last fall. It actually closed in June, so last month, and in that you had cash restructuring charges as well as a write-down of the plant itself, all within that restructuring. So you will have some of both but I would say probably tend more toward the cash side, both on the savings and on the restructuring charges to achieve those savings."
},
{
"speaker": "Bryan Spillane - Bank of America",
"text": "Okay, and then will there be any capitalized spending associated with this as well?"
},
{
"speaker": "Gary P. Fayard",
"text": "Not really anything of any significance, no."
},
{
"speaker": "Bryan Spillane - Bank of America",
"text": "Okay, and then in terms of just how we flow what you’re spending versus the savings, is the 25% per year the way we should think about the spending, or are you going to spend more up-front and the savings come through more gradually?"
},
{
"speaker": "Gary P. Fayard",
"text": "You know, we’re going to do this one the way you would really like it to be done. It’s almost we’re trying to achieve a kind of 25% per year on both sides, so it’s going to be fairly well matched."
},
{
"speaker": "Bryan Spillane - Bank of America",
"text": "Okay, great. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question will come from the line of Kaumil Gajrawala with UBS."
},
{
"speaker": "Kaumil Gajrawala - UBS",
"text": "Good morning, everyone. First, if we could talk about marketing a bit, can you comment if, given what’s happening to the economy, if you are shifting some of your marketing strategies potentially maybe from advertising over to promotions in areas like the United States? And then also, as it relates to the economy, as we think about Western and Eastern Europe where private label is a little stronger, can you talk about if you are seeing any trading down?"
},
{
"speaker": "Muhtar Kent",
"text": "I think not just in the United States or Europe, but everywhere we remain very flexible and in fact, you see us shifting some of our emphasis in our marketing programs but not just in marketing programs but also in the area of packaging, ensuring that we remain affordable and ensure that we can continue to capture all beverage opportunities around the world. And I think that what you see us doing is to make sure that we remain relevant to the consumer and also that our key partnerships with all our key customers, small or large, continue around the world. I think that we will do whatever is necessary to ensure that we can keep maximizing our growth and also gaining volume and value share in all our markets. In Europe, specific to your question about discounters, what you see us actually is that we are gaining availability in discounters quarter by quarter in Europe, including not just in legal but all key discounters. So you see us being more relevant now with our different formats across east as well as across Western Europe. What we see is that in these times, consumers find it easier to make decisions to buy affordable luxuries, like our products. And I think that our strategies are working because we are gaining market share across all our key markets. In 17 of our top markets, we’ve gained both volume and value share and I think that you will see that continuing as we move into the balance of the year."
},
{
"speaker": "Kaumil Gajrawala - UBS",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question will come from the line of Mark Swartzberg with Stifel Nicolaus."
},
{
"speaker": "Mark Swartzberg - Stifel Nicolaus",
"text": "Good morning, thanks. Gary, just a clarification; I didn’t understand your comment about the productivity savings in the Q&A with Bryan. When you said on both sides matching, were you saying you plan to spend back those savings pretty much at a 125 per annum, or 100 per annum depending on the total number between now and 2011?"
},
{
"speaker": "Gary P. Fayard",
"text": "Yes, Mark. Basically as the savings com through, the costs will come through at about the same amount, so --"
},
{
"speaker": "Mark Swartzberg - Stifel Nicolaus",
"text": "Oh, that was a reference to the charge, but what about where those savings actually -- you know, to the extent to which they hit the bottom line?"
},
{
"speaker": "Muhtar Kent",
"text": "Let me just reflect on that. I mean, what you will see us doing is -- you know, because we’re realizing some of those savings as we speak and what you see us doing is ensuring that we spend some of it against our brands to keep our brands healthy and relevant, and then some of it will go into leverage on our P&L. So you will see us spending some of it and then using to ensure that we continue our leverage on our P&L. But what Gary was explaining was the costs to realize those savings as opposed to how we were going to spend the money."
},
{
"speaker": "Mark Swartzberg - Stifel Nicolaus",
"text": "Thank you, guys."
},
{
"speaker": "Operator",
"text": "Your next question will come from the line of Lauren Torres with HSBC."
},
{
"speaker": "Lauren Torres - HSBC",
"text": "Good morning. You updated us on your commodity cost guidance for the Coca-Cola Company for this year. I was just wondering if you wanted to make some comments just with respect to the Coke system. Obviously costs are getting that much tougher. What’s your expectation for the system? And just also if you could be a bit more specific about what you are doing with your bottlers really just to manage these cost pressures? Thanks."
},
{
"speaker": "Muhtar Kent",
"text": "I think there’s a -- we see a fairly big difference between how the outlook looks in the United States and how the outlook looks around the world. I think I made a brief comment on that earlier when I was answering an earlier question, but what you see is that in the United States, clearly we see a much higher number than we’ve experienced in the past, maybe around 5%, 6%, this year and then double-digits next year. But certainly in terms of the international environment, I think you see a very different -- huge differences in different countries but certainly a much smaller amount in terms of how we see it in 2008 and also how we see it going forward. Both what you see in Eastern Europe or Western Europe, it is much, much lower than the numbers in the United States. So as a system, what we see is low-single-digits in 2008 and it is still difficult to assess exactly where it’s going to land in 2009."
},
{
"speaker": "Lauren Torres - HSBC",
"text": "But with that in mind, thinking about your relationship and how you are working with your U.S. bottlers this year, what initiatives would support -- you know, how do we think about your relationship and support with respect to these cost increases and how you can help offset that in partnership with your bottlers?"
},
{
"speaker": "Muhtar Kent",
"text": "As I said, we are continuing to work very, very closely with CCE and our bottlers to optimize value and price to the consumer and customer. It is a challenging environment and I think we are basically aligned in how we go forward on the importance of immediate consumption to build our brands, on the importance of investments in packaging differentiation and capabilities, and on the continued investment in customer capabilities. So you see us having a significant number of initiatives, also on supply chain optimization. And I’d like to turn to Sandy to give you a little more detail on that."
},
{
"speaker": "Sandy Douglas",
"text": "Good morning, everyone. The principal focus of our plan this year with our bottlers has continued to move aggressively on productivity initiatives and to bring support forward to support both packaging and marketing programs to drive growth. We expect the system to look for pricing improvement in the balance of the year in a balanced way to try to begin to recover margins while at the same time protecting consumer and customer value, and all of our investment is focused on helping the system achieve that in a balance way while at the same time growing the health of the brands."
},
{
"speaker": "Muhtar Kent",
"text": "I just want to reiterate, in the United States we have a much richer portfolio, a much better architecture in our portfolio and brands in our stable in the still beverage category. Our three cola strategy is gaining traction and I think that we certainly will continue to build on our rich still beverage portfolio, growing -- the fastest growing still beverage -- to remain the fastest growing still beverage portfolio, led by Glaceau and Fuse and Simply Juices but also to ensure that we continue to drive relevance to our consumer base with our three cola strategy in the sparkling category."
},
{
"speaker": "Lauren Torres - HSBC",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question will come from the line of Carlos Laboy with Credit Suisse."
},
{
"speaker": "Carlos Laboy - Credit Suisse",
"text": "Good morning, everyone. Muhtar, I was hoping you could give us a more detailed update on your company-owned bottlers. Who’s the best performing bottler of these this past quarter, what’s working there, and similarly, who is still in deep trouble? And for Gary, is this macro environment risk putting those company-owned bottling earnings advances back into reverse, or for those growth rates to stall out on us here?"
},
{
"speaker": "Muhtar Kent",
"text": "I think that all our actual company bottling operations are gaining traction. They are enhancing margin, they are growing, they are gaining market share in their territories and both China, Philippines, improving distribution, gaining market share in both those environments, as well as in Germany, I think we are gaining very good traction and leveraging the current architecture as a single bottling system, working much closer with customers. Germany is an area where we’ve gained tremendous traction with all retailers, including discounters, where we are very successful with our different packaging and formats and portfolio. You know, across Latin America, the CBO is doing very well. Scandinavia again, we’re gaining traction and doing very well. And across the financial performance continues to improve and our volumes are very much in line or better than the general market in all the territories."
},
{
"speaker": "Gary P. Fayard",
"text": "And relative to those, let me just echo basically what Muhtar just said as well, Carlos. The volume within the bottling investments group, in fact, organic volume was up 6%, so they are performing really well in this environment. Income is up significant and ongoing operating income margins increased 120 basis points, kind of ongoing, so these bottlers, while they were in the hospital ward, I think the BIG group is doing a very good job of managing them across the world, and in fact we’re seeing improving results pretty much everywhere. So I don’t anticipate any big issues there."
},
{
"speaker": "Carlos Laboy - Credit Suisse",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question will come from the line of Todd Divek with Banc of America Securities."
},
{
"speaker": "Todd Divek - Banc of America",
"text": "Good morning. Gary, I guess this question is primarily for you; the financial markets have been very difficult and some of the financial firms have had to raise additional capital and Suntrust has been one of those that’s been speculated. Given that they own a significant number of shares, can you just refresh our memory in terms of what the policy is towards buying back shares directly from Suntrust? Is there an agreement in place?"
},
{
"speaker": "Gary P. Fayard",
"text": "Thanks, Todd, for the question. Suntrust does own directly about 44 million shares of the company stock, going back to the original IPO of the company. They have announced plans during this quarter that they are looking at ways to enhance their capital position, and one of the ways to do that could involve either the sale of or some kind of other type transaction involving the Coke shares that they directly own. They have not announced what if anything they’ve done at this point. I believe their earnings release and quarterly call is on I think Tuesday of next week, so I would expect -- I think they have said that they expected to have something in place by the end of this quarter, so I would expect all of us to learn on Tuesday exactly where they are."
},
{
"speaker": "Todd Divek - Banc of America",
"text": "Okay, that’s helpful, and just a follow-up; with respect to your comments in the prepared remarks about deferring long-term debt issuance that you had planned for this fall, is that primarily to pre-finance some long-term debt that matures next spring? Or are you planning to term out additional debt that is currently in short-term debt?"
},
{
"speaker": "Gary P. Fayard",
"text": "We were actually looking at terming out some of the acquisition debt from the Glaceau transaction. It’s just we have a commercial paper program in place that we’re in the market basically every day. We have not had a single issue at all in our commercial paper program. We probably are paying lower than almost anybody else in the world. I mean, we’ve got a great program there. As we look at, as interest rates have come down but as we look at the spreads on longer term debt, we just have concluded that it’s really just not worth paying those kinds of spreads and we are going to stay short, as we have for the last year or so. And because of that, we have put this interest rate lock in in anticipation of probably issuing some debt. This summer, we’re not going to do that. As I said, we’ll defer that as we continue to watch the spreads over treasuries, and we made $17 million on the deal."
},
{
"speaker": "Todd Divek - Banc of America",
"text": "Okay, fair enough. Thank you very much."
},
{
"speaker": "Ann Taylor",
"text": "Operator, we have time for one last question."
},
{
"speaker": "Operator",
"text": "Thank you. This morning’s final question will come from the line of Karen [Lamarc] with Federated Investors."
},
{
"speaker": "Karen Lamarc - Federated Investors",
"text": "Good morning. I wonder if you can give us a little bit more color on the step-up in the non-currency related CapEx, as maybe what changed or what made you realize that you wanted to step up the investment [side]? Thanks."
},
{
"speaker": "Gary P. Fayard",
"text": "Thanks, Karen. Of the about $200 million step-up, as I said about half of that -- about $100 million of that is really just due to currency. The other 100 is really about the timing around our bottling investment group. If you think about it, they are growing nicely, as I said a few minutes ago when I was talking to Carlos, they are growing nicely, we continue to invest in the bottling investments group. Because of the planning cycle, we are going ahead and spending some money now in orders so that we’ve got equipment, lines, et cetera in place for the summer selling season next year. So we’re just accelerating some plans really from placing orders in January to now. And additionally, we are starting to build a new concentrate type facility as well, and that’s going to add a little bit of cost in this fall."
},
{
"speaker": "Karen Lamarc - Federated Investors",
"text": "Great, thanks very much."
},
{
"speaker": "Muhtar Kent",
"text": "Thank you, Neville, Gary, and Sandy, and thanks to each of you for joining us this morning. I’m excited to lead this great company and I am confident our strategies are working. The fundamentals of our business and the strength of our brands remain strong. We are focused on the initiatives that will drive our results, execution in the marketplace, and outward focus on our customers and consumers, and diligence with capital and expense allocation. I am very excited about the next phase of our journey to create a true, sustainable growth company. Thank you very much."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes the Coca-Cola Company’s second quarter 2008 earnings results conference call. You may now disconnect."
}
] | null | null |
KO | 1 | 2,008 | 2008-04-16 08:30:00 | Executives: Ann Taylor - Vice President and Director of Investor Relations Neville Isdell - Chairman of the Board, Chief Executive Officer Muhtar Kent - President, Chief Operating Officer Gary P. Fayard - Chief Financial Officer, Executive Vice President
Analysts: Christine Farkas - Merrill Lynch Bill Pecoriello - Morgan Stanley Lauren Torres - HSBC John Faucher - J.P. Morgan Judy Hong - Goldman Sachs Mark Swartzberg - Stifel Nicolaus Bryan Spillane - Bank of America Ann Gurkin - Davenport & Co. Of Virginia Anthony Vocallo - Credit Suisse Marion Montagne
Operator: Good morning. My name is Dennis and I will be your conference facilitator. At this time, I would like to welcome everyone to The Coca-Cola Company’s first quarter 2008 earnings results conference call. (Operator Instructions) I would like to now introduce Ann Taylor, Vice President and Director of Investor Relations.
Ann Taylor: Good morning and thank you for being with us today. I am joined by Neville Isdell, our Chairman and Chief Executive Officer; Muhtar Kent, our President and Chief Operating Officer; and Gary Fayard, our Chief Financial Officer. Following prepared remarks this morning, we will turn the call over for your questions. Before we get started, I would like to remind you that this conference call may contain forward-looking statements, including statements concerning long-term earnings objectives and should be considered in conjunction with cautionary statements contained in our earnings release and in the company’s most recent SEC report. In addition, I would also like to note that we have posted schedules on our company website at www.thecocacolacompany.com under the financial information tab in the investors section, which reconcile certain non-GAAP financial measures that may be referred to by our senior executives in our discussion this morning and from time to time in discussing our financial performance to our results as reported under generally accepted accounting principles. Please look on our website for this information. Now let me turn the call over to Neville.
Neville Isdell: Thank you, Ann and good morning, everyone. I am going to start this morning with just a few brief observations about our first quarter results and Muhtar will then provide details on the operational performance and the strategies we are employing, and that will be followed by Gary’s overview of financials and some additional perspective on 2008. Well, we are off to a good start for 2008 further building on our success in 2007. The strength of our brand portfolio, the breadth of our global system, and the winning culture that thrives throughout the system continue to drive our business forward. I am particularly pleased with our performance in the first quarter given the very strong comparables from the prior year and the challenging U.S. economic environment. We once again proved our ability to successfully manage our portfolio of brands and geographies and through that over time to deliver balanced growth. We continue to see the benefit of successfully executing our system strategies together with our bottling partners and thus driving strong top and bottom line results. We achieved volume growth of 6% in the quarter, successfully cycling 6% growth in the prior year. This is now the 12th consecutive quarter that we’ve achieved volume results of 4% or greater. Revenue growth was robust at 21%. The acquisition of bottlers contributed 5% to this growth, such that even excluding this impact revenues grew a very strong 16%. Ongoing operating income increased 19%, with currency contributing 11%. So our currency neutral operating income increased 8% while as before, we are continuing to make strategic long-term investments behind our brands. And notably, this is our sixth consecutive quarter of double-digit comparable EPS growth. Now once again our international operations drove our results, delivering unit case volume growth of 7%, even while successfully cycling 9% growth in the prior year. Importantly, the growth continues to be sourced from developed and emerging markets. All operating groups delivered growth with the exception of Africa, which had a challenging cycle of 17% growth last year but also significant power shortages in South Africa which impacted the results. Even in North America, we achieved slight growth despite the difficult macroeconomic environment. The current strength of our portfolio also enabled us to deliver balanced growth. Sparkling beverages unit case volume increased 3% in the quarter with our international operations delivery 5% growth on top of 8% in the prior year. This growth was led by trademark Coca-Cola and the continued expansion and strong performance of Coca-Cola Zero, which is now in 81 markets. This is particularly noteworthy given that we are now cycling the successful launches that took place in 2006 and 2007. Additionally, trademarks Fanta and Sprite delivered 2% and 6% growth respectively. Still beverage unit case volume increased 17%, driven by robust growth across our portfolio of juice, tea, and water brands. Clearly our strategies are working and we are expanding our volume and value share relationship position in the non-alcoholic ready-to-drink beverage industry, as well as in sparkling beverages and key still beverage categories. As I enter my final quarter as CEO, I am pleased with our accomplishments and our solid performance. We have put in place a strong foundation and I remain confident in our outlook for 2008. Our well-balanced geographic mix and broad portfolio gives us a unique position from which to manage through current headwinds. So with that, let me now turn the call over to Muhtar to provide the details on our operations. Muhtar.
Muhtar Kent: Thank you, Neville and good morning, everyone. Overall, this was another solid quarter for the Coca-Cola Company, again characterized by balanced growth across countries and across brands. As Neville indicated, our performance in the quarter was once again led by our international operations, where we continue to reap the benefits of our scale, our world-class franchise leadership, and the successful execution of our clearly defined strategies to drive growth and address key issue markets. We continue to make significant investments for the long-term in our BRIC markets. In the emerging markets, we focus on realizing profitable growth and continue to expand our leadership positions in our developed markets with value growth. Our performance in 2007 and thus far in 2008 underscores this approach and we believe enables us to appropriately manage our portfolio for balanced and sustained growth as we track emerging macroeconomic trends. The international business growth in our emerging markets remained strong. For the quarter we achieved double-digit growth in key emerging markets including China, India, Russia, Brazil, Turkey, the Philippines, as well as Eastern Europe. Double-digit unit case volume growth in trademark Coca-Cola drove the results in most of these markets, whilst we continue to rapidly expand our still portfolio with the continued success of Minute Maid Pulpy, the strong growth of our sparkling and still portfolio in Russia, and the launch of the new mainstream tea Original Leaf in China. Additionally, China continues to leverage the Olympic Games to drive positive performance. In our Eurasia and Pacific groups, we delivered strong growth of 13% and 10% respectively, primarily driven by the solid performance of these emerging markets. In Eurasia, we are improving our share trend and are delivering balanced healthy growth across all key countries. And in the Pacific group, we are continuing to invest for future growth and achieving non-alcoholic ready-to-drink volume and value share gains. Japan’s performance reflects our efforts to successfully stabilize our business. Japan achieved slight unit case volume growth in the quarter, cycling 3% from the previous year. This is now the sixth consecutive quarter of growth in Japan. Sparkling beverage volume growth was led by trademark Coca-Cola, which increased double-digits, benefiting from the successful execution of our three cola strategy. Georgia Coffee for the second consecutive quarter also delivered growth. We launched a new marketing campaign which is connecting well with consumers. We are continuing to innovate around the brand with new flavors, new packaging, as well as marketing initiatives to drive further growth. The European group demonstrated it has established a solid foundation from which to deliver balanced broad-based geographic and brand growth. Europe achieved 3% unit case volume growth in the quarter, successfully cycling 11% from the prior year. Importantly, key countries delivered solid growth in the quarter -- Germany growing unit case volume at 2%, successfully cycling 11% as we continue to expand our availability in the fast-growing discounted channel. We continue to be encouraged by our progress in Great Britain, which increased unit case volume mid-single-digits and delivered its second consecutive quarter of growth. Europe also achieved balanced portfolio growth with sparkling beverages growing 2% and still beverages increasing 14%. Sparkling beverage growth was led by the continued success of Coke Zero and our three cola strategy which jointly drove category share gains in the quarter. Coca-Cola Zero has now been launched in 26 countries in Europe and continues to recruit drinkers back into the category. We also continue to create innovation in the category with the launch of Coca-Cola Light Plus in France, a product offering vitamins and minerals and now in six international markets. The expansion in still beverages was driven by double-digit organic growth in Nestea, Aquarius, Powerade, and Burn. The brand performance led to volume and value share gains in still beverages for the entire group. Additionally, I am pleased that our global joint venture with illycaffè, a premium brand of ready-to-drink coffee is now launching in 10 European countries. European consumers will now be able to enjoy three premium espresso based offerings, and this is a great example of an idea moving from conception to the marketplace in less than a year. We believe this partnership is going to enhance our global leadership in the fast-growing, high value, ready-to-drink coffee category. Latin America delivered strong results in the first quarter and continues to be a dynamic story for our company. Unit case volume increased 9% with all business units delivering solid growth. In Mexico, unit case volume increased 11%. Continued solid organic growth was led by a mid-single-digit unit case volume increase in trademark Coca-Cola. Key marketing initiatives around Coke and [Mills] and the Happiness Factory 2 campaigns led to volume and value share gains. We are successfully integrating also Jugos del Valle into our system and while it’s early days, it is performing ahead of our expectations. In Africa, unit case volume in the quarter declined 1%, cycling strong growth of 17% in the prior quarter. South Africa in particular had a challenging 29% prior year growth rate to cycle, which reflected the replenishment of trade inventories due to CO2 shortages at the end of ’06. Additionally, CO2 shortages in the current quarter also contributed to the 9% volume decline in South Africa. Our system is currently investing in manufacturing capability that would allow us to produce our own supply of CO2 and therefore minimizes the impact on us in the -- which will minimize the impact on us in the future. Now I would like to move to North America. As you are well aware, we faced a challenging macroeconomic environment in the first quarter which not only affected our North America business but also negatively impacted the U.S. beverage industry as a whole. Specifically, our food service and other on-premise businesses were hit the hardest. However, our consistent focus on executing our strategies and our commitment to winning enabled us to deliver slight unit case volume growth in the quarter. While our performance in North America is not where we want it to be, I am encouraged by the steadfastness of our teams. Despite the overall U.S. industry volume declining in the first quarter, we actually gained volume and value share. I am confident that we have the right strategies in place to deliver against our goals. We will continue to invest behind our brands as well as customer relationships while improving our in-market execution. We continue to execute our three cola strategy. In the quarter, our U.S. business achieved share gains in core sparkling beverages led by Coca-Cola Classic, Diet Coca-Cola, and Coca-Cola Zero each gaining share. Coca-Cola Zero continued to drive strong growth, achieving more than 40% volume growth, two-and-a-half years after launch, cycling in fact 27% growth from prior year. On the marketing side, we are investing in brand building activities and connecting to the passion points of our consumers through our Super Bowl advertising, sponsorship of American Idol, the NCAA Final Four, as well as Daytona 500 activation. Importantly, our still beverage portfolio continues to outperform the industry, driven by the strong performance from Glaceau, Fuse, and our warehouse Chill Juice business. Glaceau and Fuse continue to perform ahead of expectations, reflecting increased availability as well as velocity through our hybrid distribution model. These acquisitions remain a key catalyst for our overall business in North America, creating greater alignment between us and our bottling partners, as well as providing resources to continue to invest behind our total portfolio. In the first quarter, we began the international expansion of Glaceau first in Australia. We will continue to strategically look at other markets to expand the brand throughout 2008. As Neville and I have been saying for the past several quarters, we are committed to restoring growth to North America and have taken important steps to put us on the right track. Despite the challenging environment, in 2008 we will continue to invest along with our bottling partners for growth. We are aligned with our bottling system and our customers behind a strong marketing calendar for the remainder of the year. Overall, I am pleased with our performance in the first quarter. However, we continue to recognize there is still much more work to be done, particularly in North America. Globally, our performance going forward will be underpinned by the successful execution of our five strategic priorities, which I have previously laid out. I am committed to continuing improvement in the execution of our strategies. Even in the face of a challenging economic environment, I am confident that by leveraging the scale and power of our brands, our consumer base, customer network, and franchise system to capture the greatest share of opportunity while carefully managing our expenses, we will achieve another successful year of growth for the Coca-Cola Company and create value for our shareowners. Now let me turn the call over to Gary.
Gary P. Fayard: Thanks, Muhtar and good morning, everyone. As Neville and Muhtar indicated, we are starting the year with solid financial results. As you saw in the release, we reported earnings per share of $0.64 per share on a diluted basis for the first quarter, an increase of 19%. This included a net charge primarily related to restructuring charges and asset write-downs of $0.03 per share. Therefore our adjusted EPS was $0.67 per share, an increase of 20% after considering items impacting comparability in both the current and prior year. This is now our sixth consecutive quarter of double-digit comparable EPS growth. Net revenue in the quarter increased 21%, which included a 5% benefit from structural changes primarily related to our acquisition of bottlers. The growth was driven by 5% increase in concentrate sales, a 9% increase from currency, and a 2% favorable impact from price mix. In the quarter, unit case volume increased 6%, which we report on an average daily sales basis. There was one less day this quarter than in the prior year quarter. Therefore on a reported basis, unit cases and concentrate sales are in line for the quarter. In the quarter, the impact of one less day was offset by the shift of Easter into the first quarter, so really no net P&L impact. The second quarter will be impacted by the shift of the Easter holiday into the first quarter but also note that in the fourth quarter of this year, we will have two additional days. We grew operating income by 15% on a reported basis. After considering items impacting comparability in the current and prior year quarter, operating income increased 19%, which includes an 11% benefit from currencies. So on an ongoing currency neutral basis, we grew operating income 8%. SG&A on an ongoing basis increased 21% in the quarter. About 17 points of that increase was due to bottler and brand acquisition, increased sales and service expenses as we invested for growth in our bottling operations and from currency. The remaining four points were from our continued investment behind our brands, while controlling G&A expenses as we focus on productivity and expense management. Additionally, we continue to see margins improve in both our core business as well as in our bottling investment group. Our continued focus on driving efficiency and effectiveness throughout our organization generated three points of operating expense leverage on our core business. Cash from operations for the quarter increased 18% to $1.1 billion on the strong underlying business performance. In the quarter, we repurchased approximately $309 million of our stock. We still anticipate that our range for share repurchase for the full year will be between $1.5 billion and $2 billion. Now let me address some of the factors we see impacting the remainder of 2008. We remain confident in our ability to achieve long-term sustainable growth despite the slowdown in the U.S. economy, given our balanced geographic mix and brand portfolio. As you have seen from our results, our international markets, particularly our emerging markets, have maintained their strong performance even against a difficult economic environment in the U.S. Globally, we have strong aligned plans in place with our bottling partners for the remainder of the year which reflect the realities of the local economic conditions. We will continue to portfolio manage globally as we expect solid performance in most of our markets with softness in North America, as our business in North America will continue to be impacted by the difficult economic environment in the near-term. From a commodity cost perspective, our assumptions are unchanged. We would expect a slight increase for the system and essentially flat for the company. From a capital expenditure standpoint, we purchased approximately $372 million in net property, plant, and equipment during the quarter. For 2008, we continue to expect total company net capital expenditures to be approximately $1.6 billion to $1.7 billion, as we make investments primarily in our acquired bottling operations. With regard to taxes, we ended up the quarter with an underlying effective tax rate of 22% and we expect to remain at that underlying rate for the remainder of the year. Finally, let me move to currency -- as I mentioned, we saw a positive impact from currency for the quarter on operating income of 11%. This was clearly ahead of our previous expectations, given the change in market rates late in the quarter. We are effectively covered for the full year on the YEN and the Euro and I would remind everyone that in our hedging strategy, we use an option strategy so we maintain all of the upside in currencies. Based on current market rate expectations for the remainder of the year and benefits of coverage in place, we would expect currency benefits on ongoing operating income for the full year to be in the mid single digit range. Given the greater than expected currency benefit, the company is evaluating whether there might be opportunities to reinvest a portion of the currency benefit in marketing programs and productivity initiatives to drive long-term sustainable growth. That’s what I wanted to cover this morning. Operator, if we can now turn it over for questions.
Operator: (Operator Instructions) Your first question will come from the line of Christine Farkas with Merrill Lynch.
Christine Farkas - Merrill Lynch: Thank you very much. There’s a lot that’s growing here but I want to focus on the segment that isn’t and that’s North America. I’m wondering, Muhtar, in looking at your margins for the quarter, which were down substantially year over year, we know that Glaceau is probably a lower margin business while your fountain business is also a lower margin business and that was down. Can you just kind of go through perhaps those factors or other factors and how they might have impacted structurally the margin structure in North America?
Muhtar Kent: I’ll just reflect on first the margins. Firstly, I think what you see is that Glaceau is adding of course revenue at a higher rate than it’s adding obviously income in terms of how it comes into the business and how it is reflected in the P&L, so you do see a greater, a higher benefit from revenues versus income when you add Glaceau numbers to our total numbers. Secondly, certainly in terms of the food service, both cost of goods sold are impacted by freight, by HFCS, and we are continuing to invest in our marketing programs. But overall, I think that we have also a lot of supply chain initiatives that we are working on in our North American business and not all of them have been coming and bearing fruit in Q1.
Gary P. Fayard: If I could add one thing to that, remember on Glaceau that while on a percentage margin basis, it would not be -- the margins are not as high. On a pennies, profit per case basis it is actually higher. So Glaceau is very positive for us from an absolute P&L point of view. So really what you are seeing is some cost of goods and some mix with food service and sparkling down for the quarter.
Christine Farkas - Merrill Lynch: As well as some investment itself. Thank you.
Gary P. Fayard: Correct and we are continuing to invest behind the brands in fact globally in every market.
Christine Farkas - Merrill Lynch: Thanks a lot, gentlemen.
Operator: Your next question will come from the line of Bill Pecoriello with Morgan Stanley.
Bill Pecoriello - Morgan Stanley: Good morning, everybody. Congratulations on a strong quarter. I also had a question on North America. Aside from the weak food service business, the retail business was also flattish if you exclude acquisitions and I wanted to try and understand some of the other factors that could be playing a role there. Do you see -- you mentioned that you think the Coke system gained volume share. We saw Pepsi very promotional over Easter in some channels. Was that a factor? On the bottler execution, any distraction as the Glaceau, which is exceeding your expectations, is being integrated, is that having any impact? And then as you look at the balance of the year and trying to grow the business, would the U.S. be a prime candidate for getting any disproportionate reinvestment on the foreign currency upsides that you were referring to? Thanks.
Muhtar Kent: Firstly, as I indicated overall industry declined in the U.S. but we have gained total beverage volume and value share in terms of the quarter, so I want to highlight that and our still beverage portfolio also continues to outperform the industry and Glaceau and Fuse continue to perform ahead of our expectations. And therefore, looking into the second half of the year, we remain confident that we do have the right strategies in place. It’s a difficult environment and in terms of what is being impacted in the bottle and can side of the business is also the immediate consumption side of the business that is impacted more because of the way -- how the consumer sentiment is currently reflecting into the total industry. So I want to just highlight that the retail performed -- our retail business performed better than the industry and there’s a move from on-premise to more home consumption and we are reflecting our marketing programs to -- realigning our marketing programs all the time on a flexible basis to ensure that we can capture whatever opportunities are out there. But there’s no question that the food side of the business is more challenging at the moment, the food service side.
Neville Isdell: Just to add on the -- your comment about the end of March and our competitor, that does happen at the end of a quarter sometimes from a competitor. We have got a very balanced plan for the full year and we don’t react as it were week by week, and you know we’ve had a very strong quarter. So that -- from a share standpoint and that’s because of the integrity of our programs and the way that we work in conjunction with our bottlers.
Bill Pecoriello - Morgan Stanley: Thank you.
Operator: Your next question will come from the line of Lauren Torres with HSBC.
Lauren Torres - HSBC: Good morning. Latin America was once again a strong market for you in this quarter. I was just hoping you could talk more about how the weakness in the U.S. has or may carry over to potential weakness in Latin America, particularly in Mexico. Have you seen evidence of this or are you at least concerned about a slow down in these markets?
Muhtar Kent: Lauren, we have not yet seen any evidence of any slow down in Latin America at the moment. There’s -- we also -- we all read about the remittances from the United States having gone down significantly to Mexico at the moment but right now from -- in terms of the market sentiment, in terms of the consumer sentiment, we have not yet seen any impact not just in Mexico but across all of Latin America. We haven’t yet seen any but certainly that could be a risk going forward but we have certainly not seen anything at the moment.
Lauren Torres - HSBC: But so far with respect to volume and pricing, it’s been well accepted and you’ve seen some good momentum there?
Muhtar Kent: Absolutely, yes.
Lauren Torres - HSBC: Okay. Thank you.
Neville Isdell: Lauren, just to add, I was actually in two of the smaller markets, Chile and Peru, a few weeks ago and there’s a vibrancy in Latin America that I don’t think we’ve seen in decades and reflect in those some other markets, which are actually going to be -- they are not obviously of the size of the ones that we normally focus on but from an incremental standpoint are going to be important as we go forward. So I think this is also true globally. We look at the BRICs as we should and we will continue to but again around them are some other markets, the Vietnams, et cetera, Philippines, where there is significant incremental growth for us as we go forward.
Operator: Your next question will come from the line of John Faucher with J.P. Morgan.
John Faucher - J.P. Morgan: Good morning, everyone. I was wondering if you could update us in terms of any further thoughts on spinning off some of the company owned bottlers. The margin improvement there has been very impressive. It seems like you’ve got great plans there. How is the spin-off of sort of the better functioning, the ones you’ve made better going to impact your margin targets and your growth targets in terms of looking at the bottling operations? Thanks.
Neville Isdell: John, let me give you a headline comment and then pass it over to Muhtar. We’ve consistently said that, as you know, it will be our plan to divest. However, we really need to get these large bottlers, some of which we have only recently acquired, if you take China, if you take the Philippines, into really good shape before we move them on. So for the larger ones, nothing immediate whatsoever and I’ll let Muhtar pick it up from there on some of the others.
Muhtar Kent: The key for us is that first we need to assure ourselves that we’ve got it right and working where we want it to be in terms of the conditions that we’ve brought -- improved inside the operational side of the bottlers that we own. That’s point number one and you’ve seen us talk about -- you know, [Ramill] has now found itself the right home and you’ll see us doing more of that as we move forward. We’re working on this investment of a portion of our equity in our Pakistan CBOs at the moment and again, that’s because we feel the timing is right and we will move forward with that. And as we move into the future, you will see us employing different strategies. It’s not just going out and selling but structural also strategies to make sure that we have the right structures in place for the right markets as we move forward into our bigger bottling investments, whether it be Germany or whether it be Philippines or whether it be China or whether it be India.
Gary P. Fayard: I guess I would add one other thing as well -- as we look to dispose of bottlers, and you’ll see some of those as Muhtar said this year and in fact, this second quarter. The other thing we look for is ensuring that the bottling partner that we are going to sell to has the capability not only financially because we want a long-term sustainable successful bottler when we sell, but also has the management capability, the operational capability to maintain the momentum once we’ve corrected these bottlers and continue for the long-term success of the system. So we are being very careful in who we sell to and what we do and we are selling for fair prices as well. We are not trying to maximize big gains. We’re trying to maximize long-term sustainable results as we go forward.
Muhtar Kent: Just one add-on, John, and don’t -- take what we are doing also in the face of ensuring that we may now own a bottler but we may have a -- we may employ a structural difference that will benefit our system as we move forward. Example is Korea where now we have a local partner, very effective. We are working -- we have totally aligned and we’ve actually generated growth in the quarter in Korea for the first time in many quarters and we are confident about the future there. So the main purpose is to ensure that we have the right structure in place for the future benefit of creating sustainable value and growth in that market.
John Faucher - J.P. Morgan: Okay and then Gary, to your point on the second quarter, I mean, I’m assuming you are going to sell off the smaller bottlers, so I’m assuming there’s not going to be much of a P&L dilution impact there but any advice in terms of how we model it or is it just too much of a rounding error to say there is really not going to be any noticeable dilution?
Gary P. Fayard: There’s not going to be noticeable dilution and in fact on [Ramill], and for those that don’t know [Ramill], it’s one of the bottlers that we own in Brazil that we’ve announced that we are selling to Femsa, we actually had planned to sell it. It was in our plan so everything we’ve said about 2008 off the year-end call today, we’ve had it in our plans the whole time so it’s not that significant.
John Faucher - J.P. Morgan: Thanks.
Operator: Your next question will come from the line of Judy Hong with Goldman Sachs.
Judy Hong - Goldman Sachs: Good morning, everyone. I wanted to go back to North America and I appreciate the comment that you guys are gaining market share here but just looking at the broader industry and looking at the significant slowdown that we’ve seen in some of the higher growth segments in the still segment, like ready-to-drink teas, sports drinks, energy drinks, et cetera, I’m just wondering if you can talk about what are really the drivers of the weakness. Is it purely just a consumer weakness? Is there any concern that these segments are now becoming a bit more mature and that the growth rate is slowing down in some of these segments? Because it looks like the total LRB segment has seen a slowdown and it really seems to be coming from the slowdown from some of these higher growth segments.
Muhtar Kent: Good morning. Firstly, just reiterating that our strategic focus is to ensure that we are the fastest growing still beverage company in North America and our still beverage portfolio is outperforming the industry. Total still beverages for us grew 10%, double-digits, in the quarter. Warehouse chill juices, led by simply trademark and Minute Maid enhanced juices grew and gained share. Glaceau and Fuse are continuing to perform ahead of our expectations and we do still see growth ahead in those categories, in the still categories and the challenges around North America, as I said before, are about the food service side and about the immediate consumption side and those are -- we are addressing those as I said with refocus programs.
Gary P. Fayard: Judy, I would add a couple of things. We have always said that our food service business is a leading indicator of the U.S. economy and that’s what we’re seeing now. It by the way as a leading indicator will be one of the things that tell us actually that we are coming out of the economic issues that we are currently seeing in the U.S., so you are seeing a lot of channel driven issues, food service, and it’s just traffic is down. And you are also seeing the impact of the price of gasoline and people are staying at home, more future consumption versus immediate consumption, and that is truly just the economic conditions that we are seeing.
Judy Hong - Goldman Sachs: Okay, and then Gary, if I could just get a clarification on your comment about the outlook for the remainder of the year, I think you said that you are confident that you can achieve the long-term growth targets. I think in the beginning of the year, you’ve talked about your picture of success this year being -- exceeding those long-term growth targets and I’m just trying to see if there is any change in the thinking there.
Gary P. Fayard: No, in fact -- thank you for asking that. We were, in all candor, debating before the call whether we put it in the script and told you or waited for you to ask the question, so I’m glad you asked the question. Our picture of success is that we should exceed our long-term growth targets and I’ll go further and tell you, without telling you exactly what they are, the metrics in our incentive plans for our compensation are in excess of our long-term growth targets.
Judy Hong - Goldman Sachs: Okay, and then just final question, Gary, on your corporate expense line, it was down significantly year over year. Is that basically driven by some of the cost-savings initiatives bearing fruit and is that a pretty good run-rate to use going forward?
Gary P. Fayard: It’s a good run-rate for this year and it is definitely part of our productivity initiatives. A lot of that is coming through in some health costs that we’ve taken some real initiatives around that to control some of those benefit costs. We’ve been doing -- and we are doing that in all areas of the business, so you’ll see us continuing with a real focus on controlling G&A expenses as we go forward.
Muhtar Kent: Judy, just to add on to that, what we strive for always in all the productivity initiatives is that they result in some leverage on our P&L and if you look at the core business, you see that we have achieved leverage on our P&L quite substantially also in the quarter, so that’s how -- that’s the measure of success, in a way.
Gary P. Fayard: And I would add -- let me just add one thing to that -- as we continued to drive productivity in G&A, we continued very solid investment in the brands globally everywhere, so we are continuing with very solid investment on the brands and marketing.
Neville Isdell: Let me just add to that as well in that when there are times of economic difficulty, it’s the weaker competitors that tend to suffer more. That’s why we are continuing with the investment. And just as we’ve outlined that food service often is an indicator of what’s happening in the broader economy, one of the early indicators of our ability to grow share is economic difficulty because other companies will pull back on their investment in marketing. The noise level broadly in the marketplace, not just with regard to non-alcoholic ready-to-drink, goes down and therefore the impact of our investments is greater. And we’ve seen that over many cycles and we would anticipate that to be the case as we go ahead, so that is the mitigating factor for us as we meet the same headwinds that everyone else does and that is why we are maintaining that confidence behind our marketing programs and investing behind them.
Operator: Your next question will come from the line of Mark Swartzberg with Stifel Nicolaus.
Mark Swartzberg - Stifel Nicolaus: Thanks. Good morning, everyone. Muhtar, trademark Coke, it’s your largest trademark. If I have my facts right, it slowed appreciably in the quarter to up 2% after accelerating to up 4 in ’07. I guess first, do I have the facts right and if I do, to what extent do you think that’s purely a function of North America and to what extent are there other factors at work here?
Muhtar Kent: No, I think actually we’re pleased with the growth of our sparkling beverages overall, as well as trademark Coca-Cola. I think what you have to take into consideration is that now we are cycling an international that’s up 4% and we are cycling now Coca-Cola Zero and in fact, despite cycling Coca-Cola Zero, we are still growing trademark Coca-Cola, which is really the litmus test for success for us. And you’ve got two factors that happen in the quarter. One is that North America is down but also Africa, for specific reasons related to South Africa, which is a big trademark Coca-Cola market, was down as a result of the specific shortages for CO2 resulting from energy shortages in the country and we are taking mitigating action to correct that. So we feel good about the results overall, both internationally and overall as a total global basis.
Mark Swartzberg - Stifel Nicolaus: And the interaction between Coke Zero and the other trademark Coke names continues to be as favorable as you have seen it in the past?
Muhtar Kent: Positive and the same kind of dynamics in terms of incremental growth.
Mark Swartzberg - Stifel Nicolaus: Great. Thank you.
Operator: Your next question will come from the line of Bryan Spillane with Bank of America.
Bryan Spillane - Bank of America: Good morning. I just wanted to follow-up to John Faucher’s question about the bottling assets. In India, Neville, when you first came back to the company there was a lot of work that had to be done to fix that business and it seems like it is on the right track, at least volumetrically. So if you could talk a little bit about the profitability of the bottling operations in India now relative to where they were. And then also, I understand you made a management change there during the first quarter, so if you could talk a little bit about the thinking behind that management change and what happens going forward there.
Neville Isdell: Well, the Indian bottling operations were profitable in 2007. We see that profitability expanding in 2008. I’ve just spend 12 days in India, actually, and I was out in a number of markets. Some of them are CBO markets and the quality of execution against what we had four years ago is actually chalk and cheese, which is what we are trying to do around the world. We are still not there yet in India. There is still a great deal to be done. I think that’s true of all of the CBOs. Again, I think that comes back to the question that we answered earlier on CBOs. We’ve made an awful lot of progress. Generally profitability is improving. It is masked somewhat by the new acquisitions and the drag that they bring to it. You don’t see it within that but if you look at the ones that we’ve been working on for some time, every single one is reacting positively to the new management that we’ve brought in four years ago in terms of Irial and the people that he’s brought in. So we have a really strong professional team now that’s doing an excellent job. On the management change, Muhtar can comment on it as well but that essentially was just a normal cycling. We sent John [Ustavson] there on a specific period of time to really put an expert in to change many, many things in a short period of time. John’s a very experienced executive. But that was the agreement with John. We have an Indian executive who’s been trailing him who has now taken over, so we have local management. And what happens with a turnaround, the first real big difficult piece is the first tranche. You need a really strong individual to do that. Then once it’s in place, you can bring someone who sees the strategies are all there and can continue to do that, and I’ve spent some time with him actually in India and we are confident we’ve got very good Indian management leading that business. Muhtar, I don’t know if you want to add to that.
Muhtar Kent: The only add-on would be that I am also very pleased to see in India that it’s not just the CBOs, that the company-owned bottling operations that are performing but it’s the franchise bottlers and their increasing appetite to continue to invest in the marketplace is driving results in every part of the country in all markets, so it’s not just the CBOs that are performing but also the franchise business is performing very well and all the -- we have a much stronger brand portfolio in India. We’ve launched organically some still beverages that we believe will do very well in the area of juice and juice containing beverages. We have a very good trademark in juice in Maaza as well as Minute Maid, so we think that India is on track but as Neville said, a long way to go before we can be pleased about -- it’s still very low per capita when you think about it. So we’ve got a long road ahead of us in terms of sustainable growth.
Neville Isdell: I just want to build off Muhtar’s comment because there is a very important piece here, and that is the new level of respect that the bottlers have for our ability to run bottlers and what that actually does in terms of the overall system. And I will give you some anecdotal stories but let me go back to India; four years ago, I met a very, very unhappy group of franchise bottlers. I was with all the franchise bottlers, as I say, a couple of weeks ago. I have never seen them more bullish. Muhtar has given you some facts around that. We were with the Mexican bottlers a few weeks ago. I can tell you four years ago I had a very difficult meeting with the Mexican bottlers. We had a very good meeting with the Mexican bottlers and that -- I can tell you stories of those sort of pictures around the world, so -- it’s A, what we are doing with the portfolio, what we are doing with the marketing, what we are doing on the franchise leadership side but also the confidence that we actually know what to do with regard to our bottling investments as well. I think there really is a positive synergy that comes out of this.
Bryan Spillane - Bank of America: Thank you.
Operator: Your next question will come from the line of Ann Gurkin with Davenport.
Ann Gurkin - Davenport & Co. Of Virginia: Good morning. As you look at many of your faster growing international markets, is there any reason right now to change your economic outlook for those markets? Any reason to suggest a slowdown? And then, is there any likelihood you’ll use greater cash flow to buy back more than expected shares?
Muhtar Kent: Let me take the first part, Ann, and then I’ll hand it over to Gary on the share purchase. As far as -- we had again a very, very good quarter in terms of how we grew both in the BRIC markets with China leading the way, but also in Brazil, also in Russia, very good results in Russia, both in the sparkling category, trademark Coca-Cola and also in the still beverage category in Russia, in India, as we just talked about. But also in key emerging markets, such as Ukraine and such as Turkey and such as some other Asian markets. I mentioned Korea also, that we had some growth for the first time in many quarters. So in general, we are very, very happy with the results and with the market conditions, with the investments, with the portfolio, with the alignment with our bottling partners and with the programs that we have in place for the balance of the year and going into the future. In terms of economic contagion and what happens, we haven’t seen any results right now. What will happen in terms of the impact of the food prices around the world, we’ll have to wait and see. You know as well as I do that there’s a lot of current dislocation in terms of the staple goods, wheat and rice and corn, and we’ll see how all of that plays out.
Gary P. Fayard: Ann, as we go through that and because -- well, we are seeing obviously, IMF last Friday I believe revised downwards some GDP growth estimates in a lot of the markets. Our expectation is you will see some slowdown in GDP around the world but I think those countries we continue to believe will still remain healthy and continue to grow maybe a little slower. But recognizing that fact, that’s why we said at the beginning of the year that our share repurchase would actually be in the $1.5 billion to $2 billion range, because it is kind of uncertain economic times. So each quarter we’ll revise that number based on what we see. We’re still at the 1.5 to 2, but obviously cash flow is coming in significantly ahead of what we would have expected even six weeks ago, just from the currency upside that we’ve seen and we’ll be revising that as we go through the year.
Muhtar Kent: And just one last comment on the macroeconomic situation; based on my experience from past previous macroeconomic headwinds, what we do have a difference of this time is that across the world in terms of BRIC countries, in terms of the macroeconomic indicators of the emerging markets, the fiscal discipline and the monetary dynamics and ratios of all the economies have never been better. In other words, all the emerging market economies are going into this economic environment with actually better fiscal discipline in terms of budget deficits, inflation, et cetera, than they’ve ever, ever faced such a situation in past years. So there is that piece to consider also.
Ann Gurkin - Davenport & Co. Of Virginia: Great. Thank you.
Operator: Your next question will come from the line of Anthony [Vocallo] with Credit Suisse.
Anthony Vocallo - Credit Suisse: Good morning, everyone. On the expected currency benefit reinvestment, you touched on that in your press release and I think Gary touched on that in his comments. Are those plans in place? Are they being created now? And if so, how and where could we expect those to materialize for your company and for your --
Neville Isdell: Well, the headline is they are not in place yet. We are still working on them. Let me make -- let Muhtar make some additional comment.
Muhtar Kent: I think the important thing is where we see opportunities, we will proactively make decisions to ensure that we continue to reinvest behind our brands for sustainable growth. That’s the real bottom line that I’d like to underline. We don’t have plans in place but we see this as an opportunity and therefore you will see us taking those opportunities where we see they will deliver long-term, continue to deliver long-term sustainable growth. Gary.
Gary P. Fayard: That’s exactly what I would say. On every opportunity that we see, we are being very rigorous as we go through, looking at long-term returns, the things you would expect us to look at. We do have an opportunity but we are going to be very prudent and review everything -- is it a valid investment that we think we should make?
Neville Isdell: I just want to keep emphasizing the word long-term that you hear because I’m sure the fear might be that we take short-term actions because of the currency gains that we have, by just pricing actions, which are non-replicable as we go forward, and I just want to point out that that is what we are not going to do. You heard the words -- we’ll only do it if it is expenditure that is going to benefit the long-term.
Anthony Vocallo - Credit Suisse: So there’s no specific broken bone that you are going to treat this year?
Muhtar Kent: No, I mean, we’ve addressed our issue markets rapidly in past periods and you won’t see us doing that. I think the two areas that you will see us focusing on opportunities will be investing in certain programs that will give us sustainable growth, long-term sustainable growth and secondly also some productivity initiatives, behind some productivity initiatives that may require some investment up front.
Anthony Vocallo - Credit Suisse: Great. Thank you very much.
Operator: Your next question will come from the line of Marion [Montagne] with [inaudible].
Marion Montagne: At the European Union, you seem to have some pretty good numbers versus year-ago, at least on the volume side. And as I look further down, I’m wondering if that’s an area where you’ve started to put it more into marketing. Could you give us a little more color around that area?
Muhtar Kent: Yeah, what I’d like to say is that as I mentioned, we’ve cycled a very strong quarter from previous year and the good news is that all our major countries -- Great Britain and also France and Italy and Germany, Spain, they all grew in volume and we also gained both volume and value share across the categories in Europe. I think that the key word here is that we have the foundation in place to continue to generate long-term growth. We are cycling many programs, particularly Coca-Cola Zero, very successful launches from previous year, and we’ve got great programs ahead with the European Football Championship happening in two key locations in Central Europe this year, with most of the summer, particularly early summer will be soccer fever. And we’ve got good programs across the Olympics and we feel that we can continue to generate long-term growth in this very key geography.
Marion Montagne: Okay, since you threw out the word Olympics, can I ask is the marketing going to directed towards the -- what was it, a universal table kind of theme and then local theme? Is that how you are going to approach this?
Muhtar Kent: It’s going to be local from market to market, with customer -- specific customer related programs as well as brand related programs mainly across trademark Coca-Cola.
Marion Montagne: Okay. Thank you.
Ann Taylor: We have time for one last question.
Operator: The last question will come from the line of Mark Swartzberg with Stifel Nicolaus.
Mark Swartzberg - Stifel Nicolaus: Muhtar, on vitamin water, clearly as you’ve noted here, it’s outperforming your expectations. I was hoping we could get a little bit more update on where the -- from a North America perspective, where the ACV in convenience for vitamin water and smart water is versus the 50 and 15 you had at the start of the year. And then also when you look at same-store sales growth for that particular brand or family of brands, in some of the older markets like New York and L.A., what are you seeing there versus some of the newer markets?
Muhtar Kent: I think that we, as I said, we see some very robust consumer reaction to vitamin water. We’ve got basically ACV up to now 98% in the supermarkets, up from about 90% in pre-acquisition. Both vitamin water and smart water increases in velocity. The hybrid distribution system is really working well and you’ve seen us in the quarter almost doubling the business versus prior year and again, sourcing volume from across the board and generally creating a very good category platform for active lifestyle beverages, sourcing volume from the sports category, from energy and very, very powerful again in particularly the convenience channel, as well as the supermarket channel and also with some customer-specific distribution in some food service, selected food service customers as well as airlines, as well as almost now 40 extra campuses around the country, et cetera.
Mark Swartzberg - Stifel Nicolaus: And when you look at the more -- I wouldn’t call them developed but some of the older markets like New York and L.A., how are they performing on a same-store sales basis?
Muhtar Kent: Very good vertical growth continuing, organic vertical growth.
Mark Swartzberg - Stifel Nicolaus: Excellent. Okay, thank you, Muhtar.
Neville Isdell: Well, that being the last question, I just want to say thanks to Muhtar and Gary and also to each of you for joining us this morning. As you hear from our tonality and I guess even the tonality of your questions, we are off to a very good start in 2008. I know what you are focused on is is this going to continue through 2008 and we are actually confident that our strategies are working and as I mentioned earlier, that we expect 2008 to be another successful year for the Coca-Cola Company. Just as a headline, we’re going to just continue to leverage our leading brands, our global footprint, and also our strategic acquisitions to continue to drive growth and, most importantly, long-term value for our shareowners. Thank you very much indeed.
Operator: Ladies and gentlemen, this does conclude the Coca-Cola Company’s first quarter 2008 earnings results conference call. You may now disconnect. | [
{
"speaker": "Executives",
"text": "Ann Taylor - Vice President and Director of Investor Relations Neville Isdell - Chairman of the Board, Chief Executive Officer Muhtar Kent - President, Chief Operating Officer Gary P. Fayard - Chief Financial Officer, Executive Vice President"
},
{
"speaker": "Analysts",
"text": "Christine Farkas - Merrill Lynch Bill Pecoriello - Morgan Stanley Lauren Torres - HSBC John Faucher - J.P. Morgan Judy Hong - Goldman Sachs Mark Swartzberg - Stifel Nicolaus Bryan Spillane - Bank of America Ann Gurkin - Davenport & Co. Of Virginia Anthony Vocallo - Credit Suisse Marion Montagne"
},
{
"speaker": "Operator",
"text": "Good morning. My name is Dennis and I will be your conference facilitator. At this time, I would like to welcome everyone to The Coca-Cola Company’s first quarter 2008 earnings results conference call. (Operator Instructions) I would like to now introduce Ann Taylor, Vice President and Director of Investor Relations."
},
{
"speaker": "Ann Taylor",
"text": "Good morning and thank you for being with us today. I am joined by Neville Isdell, our Chairman and Chief Executive Officer; Muhtar Kent, our President and Chief Operating Officer; and Gary Fayard, our Chief Financial Officer. Following prepared remarks this morning, we will turn the call over for your questions. Before we get started, I would like to remind you that this conference call may contain forward-looking statements, including statements concerning long-term earnings objectives and should be considered in conjunction with cautionary statements contained in our earnings release and in the company’s most recent SEC report. In addition, I would also like to note that we have posted schedules on our company website at www.thecocacolacompany.com under the financial information tab in the investors section, which reconcile certain non-GAAP financial measures that may be referred to by our senior executives in our discussion this morning and from time to time in discussing our financial performance to our results as reported under generally accepted accounting principles. Please look on our website for this information. Now let me turn the call over to Neville."
},
{
"speaker": "Neville Isdell",
"text": "Thank you, Ann and good morning, everyone. I am going to start this morning with just a few brief observations about our first quarter results and Muhtar will then provide details on the operational performance and the strategies we are employing, and that will be followed by Gary’s overview of financials and some additional perspective on 2008. Well, we are off to a good start for 2008 further building on our success in 2007. The strength of our brand portfolio, the breadth of our global system, and the winning culture that thrives throughout the system continue to drive our business forward. I am particularly pleased with our performance in the first quarter given the very strong comparables from the prior year and the challenging U.S. economic environment. We once again proved our ability to successfully manage our portfolio of brands and geographies and through that over time to deliver balanced growth. We continue to see the benefit of successfully executing our system strategies together with our bottling partners and thus driving strong top and bottom line results. We achieved volume growth of 6% in the quarter, successfully cycling 6% growth in the prior year. This is now the 12th consecutive quarter that we’ve achieved volume results of 4% or greater. Revenue growth was robust at 21%. The acquisition of bottlers contributed 5% to this growth, such that even excluding this impact revenues grew a very strong 16%. Ongoing operating income increased 19%, with currency contributing 11%. So our currency neutral operating income increased 8% while as before, we are continuing to make strategic long-term investments behind our brands. And notably, this is our sixth consecutive quarter of double-digit comparable EPS growth. Now once again our international operations drove our results, delivering unit case volume growth of 7%, even while successfully cycling 9% growth in the prior year. Importantly, the growth continues to be sourced from developed and emerging markets. All operating groups delivered growth with the exception of Africa, which had a challenging cycle of 17% growth last year but also significant power shortages in South Africa which impacted the results. Even in North America, we achieved slight growth despite the difficult macroeconomic environment. The current strength of our portfolio also enabled us to deliver balanced growth. Sparkling beverages unit case volume increased 3% in the quarter with our international operations delivery 5% growth on top of 8% in the prior year. This growth was led by trademark Coca-Cola and the continued expansion and strong performance of Coca-Cola Zero, which is now in 81 markets. This is particularly noteworthy given that we are now cycling the successful launches that took place in 2006 and 2007. Additionally, trademarks Fanta and Sprite delivered 2% and 6% growth respectively. Still beverage unit case volume increased 17%, driven by robust growth across our portfolio of juice, tea, and water brands. Clearly our strategies are working and we are expanding our volume and value share relationship position in the non-alcoholic ready-to-drink beverage industry, as well as in sparkling beverages and key still beverage categories. As I enter my final quarter as CEO, I am pleased with our accomplishments and our solid performance. We have put in place a strong foundation and I remain confident in our outlook for 2008. Our well-balanced geographic mix and broad portfolio gives us a unique position from which to manage through current headwinds. So with that, let me now turn the call over to Muhtar to provide the details on our operations. Muhtar."
},
{
"speaker": "Muhtar Kent",
"text": "Thank you, Neville and good morning, everyone. Overall, this was another solid quarter for the Coca-Cola Company, again characterized by balanced growth across countries and across brands. As Neville indicated, our performance in the quarter was once again led by our international operations, where we continue to reap the benefits of our scale, our world-class franchise leadership, and the successful execution of our clearly defined strategies to drive growth and address key issue markets. We continue to make significant investments for the long-term in our BRIC markets. In the emerging markets, we focus on realizing profitable growth and continue to expand our leadership positions in our developed markets with value growth. Our performance in 2007 and thus far in 2008 underscores this approach and we believe enables us to appropriately manage our portfolio for balanced and sustained growth as we track emerging macroeconomic trends. The international business growth in our emerging markets remained strong. For the quarter we achieved double-digit growth in key emerging markets including China, India, Russia, Brazil, Turkey, the Philippines, as well as Eastern Europe. Double-digit unit case volume growth in trademark Coca-Cola drove the results in most of these markets, whilst we continue to rapidly expand our still portfolio with the continued success of Minute Maid Pulpy, the strong growth of our sparkling and still portfolio in Russia, and the launch of the new mainstream tea Original Leaf in China. Additionally, China continues to leverage the Olympic Games to drive positive performance. In our Eurasia and Pacific groups, we delivered strong growth of 13% and 10% respectively, primarily driven by the solid performance of these emerging markets. In Eurasia, we are improving our share trend and are delivering balanced healthy growth across all key countries. And in the Pacific group, we are continuing to invest for future growth and achieving non-alcoholic ready-to-drink volume and value share gains. Japan’s performance reflects our efforts to successfully stabilize our business. Japan achieved slight unit case volume growth in the quarter, cycling 3% from the previous year. This is now the sixth consecutive quarter of growth in Japan. Sparkling beverage volume growth was led by trademark Coca-Cola, which increased double-digits, benefiting from the successful execution of our three cola strategy. Georgia Coffee for the second consecutive quarter also delivered growth. We launched a new marketing campaign which is connecting well with consumers. We are continuing to innovate around the brand with new flavors, new packaging, as well as marketing initiatives to drive further growth. The European group demonstrated it has established a solid foundation from which to deliver balanced broad-based geographic and brand growth. Europe achieved 3% unit case volume growth in the quarter, successfully cycling 11% from the prior year. Importantly, key countries delivered solid growth in the quarter -- Germany growing unit case volume at 2%, successfully cycling 11% as we continue to expand our availability in the fast-growing discounted channel. We continue to be encouraged by our progress in Great Britain, which increased unit case volume mid-single-digits and delivered its second consecutive quarter of growth. Europe also achieved balanced portfolio growth with sparkling beverages growing 2% and still beverages increasing 14%. Sparkling beverage growth was led by the continued success of Coke Zero and our three cola strategy which jointly drove category share gains in the quarter. Coca-Cola Zero has now been launched in 26 countries in Europe and continues to recruit drinkers back into the category. We also continue to create innovation in the category with the launch of Coca-Cola Light Plus in France, a product offering vitamins and minerals and now in six international markets. The expansion in still beverages was driven by double-digit organic growth in Nestea, Aquarius, Powerade, and Burn. The brand performance led to volume and value share gains in still beverages for the entire group. Additionally, I am pleased that our global joint venture with illycaffè, a premium brand of ready-to-drink coffee is now launching in 10 European countries. European consumers will now be able to enjoy three premium espresso based offerings, and this is a great example of an idea moving from conception to the marketplace in less than a year. We believe this partnership is going to enhance our global leadership in the fast-growing, high value, ready-to-drink coffee category. Latin America delivered strong results in the first quarter and continues to be a dynamic story for our company. Unit case volume increased 9% with all business units delivering solid growth. In Mexico, unit case volume increased 11%. Continued solid organic growth was led by a mid-single-digit unit case volume increase in trademark Coca-Cola. Key marketing initiatives around Coke and [Mills] and the Happiness Factory 2 campaigns led to volume and value share gains. We are successfully integrating also Jugos del Valle into our system and while it’s early days, it is performing ahead of our expectations. In Africa, unit case volume in the quarter declined 1%, cycling strong growth of 17% in the prior quarter. South Africa in particular had a challenging 29% prior year growth rate to cycle, which reflected the replenishment of trade inventories due to CO2 shortages at the end of ’06. Additionally, CO2 shortages in the current quarter also contributed to the 9% volume decline in South Africa. Our system is currently investing in manufacturing capability that would allow us to produce our own supply of CO2 and therefore minimizes the impact on us in the -- which will minimize the impact on us in the future. Now I would like to move to North America. As you are well aware, we faced a challenging macroeconomic environment in the first quarter which not only affected our North America business but also negatively impacted the U.S. beverage industry as a whole. Specifically, our food service and other on-premise businesses were hit the hardest. However, our consistent focus on executing our strategies and our commitment to winning enabled us to deliver slight unit case volume growth in the quarter. While our performance in North America is not where we want it to be, I am encouraged by the steadfastness of our teams. Despite the overall U.S. industry volume declining in the first quarter, we actually gained volume and value share. I am confident that we have the right strategies in place to deliver against our goals. We will continue to invest behind our brands as well as customer relationships while improving our in-market execution. We continue to execute our three cola strategy. In the quarter, our U.S. business achieved share gains in core sparkling beverages led by Coca-Cola Classic, Diet Coca-Cola, and Coca-Cola Zero each gaining share. Coca-Cola Zero continued to drive strong growth, achieving more than 40% volume growth, two-and-a-half years after launch, cycling in fact 27% growth from prior year. On the marketing side, we are investing in brand building activities and connecting to the passion points of our consumers through our Super Bowl advertising, sponsorship of American Idol, the NCAA Final Four, as well as Daytona 500 activation. Importantly, our still beverage portfolio continues to outperform the industry, driven by the strong performance from Glaceau, Fuse, and our warehouse Chill Juice business. Glaceau and Fuse continue to perform ahead of expectations, reflecting increased availability as well as velocity through our hybrid distribution model. These acquisitions remain a key catalyst for our overall business in North America, creating greater alignment between us and our bottling partners, as well as providing resources to continue to invest behind our total portfolio. In the first quarter, we began the international expansion of Glaceau first in Australia. We will continue to strategically look at other markets to expand the brand throughout 2008. As Neville and I have been saying for the past several quarters, we are committed to restoring growth to North America and have taken important steps to put us on the right track. Despite the challenging environment, in 2008 we will continue to invest along with our bottling partners for growth. We are aligned with our bottling system and our customers behind a strong marketing calendar for the remainder of the year. Overall, I am pleased with our performance in the first quarter. However, we continue to recognize there is still much more work to be done, particularly in North America. Globally, our performance going forward will be underpinned by the successful execution of our five strategic priorities, which I have previously laid out. I am committed to continuing improvement in the execution of our strategies. Even in the face of a challenging economic environment, I am confident that by leveraging the scale and power of our brands, our consumer base, customer network, and franchise system to capture the greatest share of opportunity while carefully managing our expenses, we will achieve another successful year of growth for the Coca-Cola Company and create value for our shareowners. Now let me turn the call over to Gary."
},
{
"speaker": "Gary P. Fayard",
"text": "Thanks, Muhtar and good morning, everyone. As Neville and Muhtar indicated, we are starting the year with solid financial results. As you saw in the release, we reported earnings per share of $0.64 per share on a diluted basis for the first quarter, an increase of 19%. This included a net charge primarily related to restructuring charges and asset write-downs of $0.03 per share. Therefore our adjusted EPS was $0.67 per share, an increase of 20% after considering items impacting comparability in both the current and prior year. This is now our sixth consecutive quarter of double-digit comparable EPS growth. Net revenue in the quarter increased 21%, which included a 5% benefit from structural changes primarily related to our acquisition of bottlers. The growth was driven by 5% increase in concentrate sales, a 9% increase from currency, and a 2% favorable impact from price mix. In the quarter, unit case volume increased 6%, which we report on an average daily sales basis. There was one less day this quarter than in the prior year quarter. Therefore on a reported basis, unit cases and concentrate sales are in line for the quarter. In the quarter, the impact of one less day was offset by the shift of Easter into the first quarter, so really no net P&L impact. The second quarter will be impacted by the shift of the Easter holiday into the first quarter but also note that in the fourth quarter of this year, we will have two additional days. We grew operating income by 15% on a reported basis. After considering items impacting comparability in the current and prior year quarter, operating income increased 19%, which includes an 11% benefit from currencies. So on an ongoing currency neutral basis, we grew operating income 8%. SG&A on an ongoing basis increased 21% in the quarter. About 17 points of that increase was due to bottler and brand acquisition, increased sales and service expenses as we invested for growth in our bottling operations and from currency. The remaining four points were from our continued investment behind our brands, while controlling G&A expenses as we focus on productivity and expense management. Additionally, we continue to see margins improve in both our core business as well as in our bottling investment group. Our continued focus on driving efficiency and effectiveness throughout our organization generated three points of operating expense leverage on our core business. Cash from operations for the quarter increased 18% to $1.1 billion on the strong underlying business performance. In the quarter, we repurchased approximately $309 million of our stock. We still anticipate that our range for share repurchase for the full year will be between $1.5 billion and $2 billion. Now let me address some of the factors we see impacting the remainder of 2008. We remain confident in our ability to achieve long-term sustainable growth despite the slowdown in the U.S. economy, given our balanced geographic mix and brand portfolio. As you have seen from our results, our international markets, particularly our emerging markets, have maintained their strong performance even against a difficult economic environment in the U.S. Globally, we have strong aligned plans in place with our bottling partners for the remainder of the year which reflect the realities of the local economic conditions. We will continue to portfolio manage globally as we expect solid performance in most of our markets with softness in North America, as our business in North America will continue to be impacted by the difficult economic environment in the near-term. From a commodity cost perspective, our assumptions are unchanged. We would expect a slight increase for the system and essentially flat for the company. From a capital expenditure standpoint, we purchased approximately $372 million in net property, plant, and equipment during the quarter. For 2008, we continue to expect total company net capital expenditures to be approximately $1.6 billion to $1.7 billion, as we make investments primarily in our acquired bottling operations. With regard to taxes, we ended up the quarter with an underlying effective tax rate of 22% and we expect to remain at that underlying rate for the remainder of the year. Finally, let me move to currency -- as I mentioned, we saw a positive impact from currency for the quarter on operating income of 11%. This was clearly ahead of our previous expectations, given the change in market rates late in the quarter. We are effectively covered for the full year on the YEN and the Euro and I would remind everyone that in our hedging strategy, we use an option strategy so we maintain all of the upside in currencies. Based on current market rate expectations for the remainder of the year and benefits of coverage in place, we would expect currency benefits on ongoing operating income for the full year to be in the mid single digit range. Given the greater than expected currency benefit, the company is evaluating whether there might be opportunities to reinvest a portion of the currency benefit in marketing programs and productivity initiatives to drive long-term sustainable growth. That’s what I wanted to cover this morning. Operator, if we can now turn it over for questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question will come from the line of Christine Farkas with Merrill Lynch."
},
{
"speaker": "Christine Farkas - Merrill Lynch",
"text": "Thank you very much. There’s a lot that’s growing here but I want to focus on the segment that isn’t and that’s North America. I’m wondering, Muhtar, in looking at your margins for the quarter, which were down substantially year over year, we know that Glaceau is probably a lower margin business while your fountain business is also a lower margin business and that was down. Can you just kind of go through perhaps those factors or other factors and how they might have impacted structurally the margin structure in North America?"
},
{
"speaker": "Muhtar Kent",
"text": "I’ll just reflect on first the margins. Firstly, I think what you see is that Glaceau is adding of course revenue at a higher rate than it’s adding obviously income in terms of how it comes into the business and how it is reflected in the P&L, so you do see a greater, a higher benefit from revenues versus income when you add Glaceau numbers to our total numbers. Secondly, certainly in terms of the food service, both cost of goods sold are impacted by freight, by HFCS, and we are continuing to invest in our marketing programs. But overall, I think that we have also a lot of supply chain initiatives that we are working on in our North American business and not all of them have been coming and bearing fruit in Q1."
},
{
"speaker": "Gary P. Fayard",
"text": "If I could add one thing to that, remember on Glaceau that while on a percentage margin basis, it would not be -- the margins are not as high. On a pennies, profit per case basis it is actually higher. So Glaceau is very positive for us from an absolute P&L point of view. So really what you are seeing is some cost of goods and some mix with food service and sparkling down for the quarter."
},
{
"speaker": "Christine Farkas - Merrill Lynch",
"text": "As well as some investment itself. Thank you."
},
{
"speaker": "Gary P. Fayard",
"text": "Correct and we are continuing to invest behind the brands in fact globally in every market."
},
{
"speaker": "Christine Farkas - Merrill Lynch",
"text": "Thanks a lot, gentlemen."
},
{
"speaker": "Operator",
"text": "Your next question will come from the line of Bill Pecoriello with Morgan Stanley."
},
{
"speaker": "Bill Pecoriello - Morgan Stanley",
"text": "Good morning, everybody. Congratulations on a strong quarter. I also had a question on North America. Aside from the weak food service business, the retail business was also flattish if you exclude acquisitions and I wanted to try and understand some of the other factors that could be playing a role there. Do you see -- you mentioned that you think the Coke system gained volume share. We saw Pepsi very promotional over Easter in some channels. Was that a factor? On the bottler execution, any distraction as the Glaceau, which is exceeding your expectations, is being integrated, is that having any impact? And then as you look at the balance of the year and trying to grow the business, would the U.S. be a prime candidate for getting any disproportionate reinvestment on the foreign currency upsides that you were referring to? Thanks."
},
{
"speaker": "Muhtar Kent",
"text": "Firstly, as I indicated overall industry declined in the U.S. but we have gained total beverage volume and value share in terms of the quarter, so I want to highlight that and our still beverage portfolio also continues to outperform the industry and Glaceau and Fuse continue to perform ahead of our expectations. And therefore, looking into the second half of the year, we remain confident that we do have the right strategies in place. It’s a difficult environment and in terms of what is being impacted in the bottle and can side of the business is also the immediate consumption side of the business that is impacted more because of the way -- how the consumer sentiment is currently reflecting into the total industry. So I want to just highlight that the retail performed -- our retail business performed better than the industry and there’s a move from on-premise to more home consumption and we are reflecting our marketing programs to -- realigning our marketing programs all the time on a flexible basis to ensure that we can capture whatever opportunities are out there. But there’s no question that the food side of the business is more challenging at the moment, the food service side."
},
{
"speaker": "Neville Isdell",
"text": "Just to add on the -- your comment about the end of March and our competitor, that does happen at the end of a quarter sometimes from a competitor. We have got a very balanced plan for the full year and we don’t react as it were week by week, and you know we’ve had a very strong quarter. So that -- from a share standpoint and that’s because of the integrity of our programs and the way that we work in conjunction with our bottlers."
},
{
"speaker": "Bill Pecoriello - Morgan Stanley",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question will come from the line of Lauren Torres with HSBC."
},
{
"speaker": "Lauren Torres - HSBC",
"text": "Good morning. Latin America was once again a strong market for you in this quarter. I was just hoping you could talk more about how the weakness in the U.S. has or may carry over to potential weakness in Latin America, particularly in Mexico. Have you seen evidence of this or are you at least concerned about a slow down in these markets?"
},
{
"speaker": "Muhtar Kent",
"text": "Lauren, we have not yet seen any evidence of any slow down in Latin America at the moment. There’s -- we also -- we all read about the remittances from the United States having gone down significantly to Mexico at the moment but right now from -- in terms of the market sentiment, in terms of the consumer sentiment, we have not yet seen any impact not just in Mexico but across all of Latin America. We haven’t yet seen any but certainly that could be a risk going forward but we have certainly not seen anything at the moment."
},
{
"speaker": "Lauren Torres - HSBC",
"text": "But so far with respect to volume and pricing, it’s been well accepted and you’ve seen some good momentum there?"
},
{
"speaker": "Muhtar Kent",
"text": "Absolutely, yes."
},
{
"speaker": "Lauren Torres - HSBC",
"text": "Okay. Thank you."
},
{
"speaker": "Neville Isdell",
"text": "Lauren, just to add, I was actually in two of the smaller markets, Chile and Peru, a few weeks ago and there’s a vibrancy in Latin America that I don’t think we’ve seen in decades and reflect in those some other markets, which are actually going to be -- they are not obviously of the size of the ones that we normally focus on but from an incremental standpoint are going to be important as we go forward. So I think this is also true globally. We look at the BRICs as we should and we will continue to but again around them are some other markets, the Vietnams, et cetera, Philippines, where there is significant incremental growth for us as we go forward."
},
{
"speaker": "Operator",
"text": "Your next question will come from the line of John Faucher with J.P. Morgan."
},
{
"speaker": "John Faucher - J.P. Morgan",
"text": "Good morning, everyone. I was wondering if you could update us in terms of any further thoughts on spinning off some of the company owned bottlers. The margin improvement there has been very impressive. It seems like you’ve got great plans there. How is the spin-off of sort of the better functioning, the ones you’ve made better going to impact your margin targets and your growth targets in terms of looking at the bottling operations? Thanks."
},
{
"speaker": "Neville Isdell",
"text": "John, let me give you a headline comment and then pass it over to Muhtar. We’ve consistently said that, as you know, it will be our plan to divest. However, we really need to get these large bottlers, some of which we have only recently acquired, if you take China, if you take the Philippines, into really good shape before we move them on. So for the larger ones, nothing immediate whatsoever and I’ll let Muhtar pick it up from there on some of the others."
},
{
"speaker": "Muhtar Kent",
"text": "The key for us is that first we need to assure ourselves that we’ve got it right and working where we want it to be in terms of the conditions that we’ve brought -- improved inside the operational side of the bottlers that we own. That’s point number one and you’ve seen us talk about -- you know, [Ramill] has now found itself the right home and you’ll see us doing more of that as we move forward. We’re working on this investment of a portion of our equity in our Pakistan CBOs at the moment and again, that’s because we feel the timing is right and we will move forward with that. And as we move into the future, you will see us employing different strategies. It’s not just going out and selling but structural also strategies to make sure that we have the right structures in place for the right markets as we move forward into our bigger bottling investments, whether it be Germany or whether it be Philippines or whether it be China or whether it be India."
},
{
"speaker": "Gary P. Fayard",
"text": "I guess I would add one other thing as well -- as we look to dispose of bottlers, and you’ll see some of those as Muhtar said this year and in fact, this second quarter. The other thing we look for is ensuring that the bottling partner that we are going to sell to has the capability not only financially because we want a long-term sustainable successful bottler when we sell, but also has the management capability, the operational capability to maintain the momentum once we’ve corrected these bottlers and continue for the long-term success of the system. So we are being very careful in who we sell to and what we do and we are selling for fair prices as well. We are not trying to maximize big gains. We’re trying to maximize long-term sustainable results as we go forward."
},
{
"speaker": "Muhtar Kent",
"text": "Just one add-on, John, and don’t -- take what we are doing also in the face of ensuring that we may now own a bottler but we may have a -- we may employ a structural difference that will benefit our system as we move forward. Example is Korea where now we have a local partner, very effective. We are working -- we have totally aligned and we’ve actually generated growth in the quarter in Korea for the first time in many quarters and we are confident about the future there. So the main purpose is to ensure that we have the right structure in place for the future benefit of creating sustainable value and growth in that market."
},
{
"speaker": "John Faucher - J.P. Morgan",
"text": "Okay and then Gary, to your point on the second quarter, I mean, I’m assuming you are going to sell off the smaller bottlers, so I’m assuming there’s not going to be much of a P&L dilution impact there but any advice in terms of how we model it or is it just too much of a rounding error to say there is really not going to be any noticeable dilution?"
},
{
"speaker": "Gary P. Fayard",
"text": "There’s not going to be noticeable dilution and in fact on [Ramill], and for those that don’t know [Ramill], it’s one of the bottlers that we own in Brazil that we’ve announced that we are selling to Femsa, we actually had planned to sell it. It was in our plan so everything we’ve said about 2008 off the year-end call today, we’ve had it in our plans the whole time so it’s not that significant."
},
{
"speaker": "John Faucher - J.P. Morgan",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Your next question will come from the line of Judy Hong with Goldman Sachs."
},
{
"speaker": "Judy Hong - Goldman Sachs",
"text": "Good morning, everyone. I wanted to go back to North America and I appreciate the comment that you guys are gaining market share here but just looking at the broader industry and looking at the significant slowdown that we’ve seen in some of the higher growth segments in the still segment, like ready-to-drink teas, sports drinks, energy drinks, et cetera, I’m just wondering if you can talk about what are really the drivers of the weakness. Is it purely just a consumer weakness? Is there any concern that these segments are now becoming a bit more mature and that the growth rate is slowing down in some of these segments? Because it looks like the total LRB segment has seen a slowdown and it really seems to be coming from the slowdown from some of these higher growth segments."
},
{
"speaker": "Muhtar Kent",
"text": "Good morning. Firstly, just reiterating that our strategic focus is to ensure that we are the fastest growing still beverage company in North America and our still beverage portfolio is outperforming the industry. Total still beverages for us grew 10%, double-digits, in the quarter. Warehouse chill juices, led by simply trademark and Minute Maid enhanced juices grew and gained share. Glaceau and Fuse are continuing to perform ahead of our expectations and we do still see growth ahead in those categories, in the still categories and the challenges around North America, as I said before, are about the food service side and about the immediate consumption side and those are -- we are addressing those as I said with refocus programs."
},
{
"speaker": "Gary P. Fayard",
"text": "Judy, I would add a couple of things. We have always said that our food service business is a leading indicator of the U.S. economy and that’s what we’re seeing now. It by the way as a leading indicator will be one of the things that tell us actually that we are coming out of the economic issues that we are currently seeing in the U.S., so you are seeing a lot of channel driven issues, food service, and it’s just traffic is down. And you are also seeing the impact of the price of gasoline and people are staying at home, more future consumption versus immediate consumption, and that is truly just the economic conditions that we are seeing."
},
{
"speaker": "Judy Hong - Goldman Sachs",
"text": "Okay, and then Gary, if I could just get a clarification on your comment about the outlook for the remainder of the year, I think you said that you are confident that you can achieve the long-term growth targets. I think in the beginning of the year, you’ve talked about your picture of success this year being -- exceeding those long-term growth targets and I’m just trying to see if there is any change in the thinking there."
},
{
"speaker": "Gary P. Fayard",
"text": "No, in fact -- thank you for asking that. We were, in all candor, debating before the call whether we put it in the script and told you or waited for you to ask the question, so I’m glad you asked the question. Our picture of success is that we should exceed our long-term growth targets and I’ll go further and tell you, without telling you exactly what they are, the metrics in our incentive plans for our compensation are in excess of our long-term growth targets."
},
{
"speaker": "Judy Hong - Goldman Sachs",
"text": "Okay, and then just final question, Gary, on your corporate expense line, it was down significantly year over year. Is that basically driven by some of the cost-savings initiatives bearing fruit and is that a pretty good run-rate to use going forward?"
},
{
"speaker": "Gary P. Fayard",
"text": "It’s a good run-rate for this year and it is definitely part of our productivity initiatives. A lot of that is coming through in some health costs that we’ve taken some real initiatives around that to control some of those benefit costs. We’ve been doing -- and we are doing that in all areas of the business, so you’ll see us continuing with a real focus on controlling G&A expenses as we go forward."
},
{
"speaker": "Muhtar Kent",
"text": "Judy, just to add on to that, what we strive for always in all the productivity initiatives is that they result in some leverage on our P&L and if you look at the core business, you see that we have achieved leverage on our P&L quite substantially also in the quarter, so that’s how -- that’s the measure of success, in a way."
},
{
"speaker": "Gary P. Fayard",
"text": "And I would add -- let me just add one thing to that -- as we continued to drive productivity in G&A, we continued very solid investment in the brands globally everywhere, so we are continuing with very solid investment on the brands and marketing."
},
{
"speaker": "Neville Isdell",
"text": "Let me just add to that as well in that when there are times of economic difficulty, it’s the weaker competitors that tend to suffer more. That’s why we are continuing with the investment. And just as we’ve outlined that food service often is an indicator of what’s happening in the broader economy, one of the early indicators of our ability to grow share is economic difficulty because other companies will pull back on their investment in marketing. The noise level broadly in the marketplace, not just with regard to non-alcoholic ready-to-drink, goes down and therefore the impact of our investments is greater. And we’ve seen that over many cycles and we would anticipate that to be the case as we go ahead, so that is the mitigating factor for us as we meet the same headwinds that everyone else does and that is why we are maintaining that confidence behind our marketing programs and investing behind them."
},
{
"speaker": "Operator",
"text": "Your next question will come from the line of Mark Swartzberg with Stifel Nicolaus."
},
{
"speaker": "Mark Swartzberg - Stifel Nicolaus",
"text": "Thanks. Good morning, everyone. Muhtar, trademark Coke, it’s your largest trademark. If I have my facts right, it slowed appreciably in the quarter to up 2% after accelerating to up 4 in ’07. I guess first, do I have the facts right and if I do, to what extent do you think that’s purely a function of North America and to what extent are there other factors at work here?"
},
{
"speaker": "Muhtar Kent",
"text": "No, I think actually we’re pleased with the growth of our sparkling beverages overall, as well as trademark Coca-Cola. I think what you have to take into consideration is that now we are cycling an international that’s up 4% and we are cycling now Coca-Cola Zero and in fact, despite cycling Coca-Cola Zero, we are still growing trademark Coca-Cola, which is really the litmus test for success for us. And you’ve got two factors that happen in the quarter. One is that North America is down but also Africa, for specific reasons related to South Africa, which is a big trademark Coca-Cola market, was down as a result of the specific shortages for CO2 resulting from energy shortages in the country and we are taking mitigating action to correct that. So we feel good about the results overall, both internationally and overall as a total global basis."
},
{
"speaker": "Mark Swartzberg - Stifel Nicolaus",
"text": "And the interaction between Coke Zero and the other trademark Coke names continues to be as favorable as you have seen it in the past?"
},
{
"speaker": "Muhtar Kent",
"text": "Positive and the same kind of dynamics in terms of incremental growth."
},
{
"speaker": "Mark Swartzberg - Stifel Nicolaus",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question will come from the line of Bryan Spillane with Bank of America."
},
{
"speaker": "Bryan Spillane - Bank of America",
"text": "Good morning. I just wanted to follow-up to John Faucher’s question about the bottling assets. In India, Neville, when you first came back to the company there was a lot of work that had to be done to fix that business and it seems like it is on the right track, at least volumetrically. So if you could talk a little bit about the profitability of the bottling operations in India now relative to where they were. And then also, I understand you made a management change there during the first quarter, so if you could talk a little bit about the thinking behind that management change and what happens going forward there."
},
{
"speaker": "Neville Isdell",
"text": "Well, the Indian bottling operations were profitable in 2007. We see that profitability expanding in 2008. I’ve just spend 12 days in India, actually, and I was out in a number of markets. Some of them are CBO markets and the quality of execution against what we had four years ago is actually chalk and cheese, which is what we are trying to do around the world. We are still not there yet in India. There is still a great deal to be done. I think that’s true of all of the CBOs. Again, I think that comes back to the question that we answered earlier on CBOs. We’ve made an awful lot of progress. Generally profitability is improving. It is masked somewhat by the new acquisitions and the drag that they bring to it. You don’t see it within that but if you look at the ones that we’ve been working on for some time, every single one is reacting positively to the new management that we’ve brought in four years ago in terms of Irial and the people that he’s brought in. So we have a really strong professional team now that’s doing an excellent job. On the management change, Muhtar can comment on it as well but that essentially was just a normal cycling. We sent John [Ustavson] there on a specific period of time to really put an expert in to change many, many things in a short period of time. John’s a very experienced executive. But that was the agreement with John. We have an Indian executive who’s been trailing him who has now taken over, so we have local management. And what happens with a turnaround, the first real big difficult piece is the first tranche. You need a really strong individual to do that. Then once it’s in place, you can bring someone who sees the strategies are all there and can continue to do that, and I’ve spent some time with him actually in India and we are confident we’ve got very good Indian management leading that business. Muhtar, I don’t know if you want to add to that."
},
{
"speaker": "Muhtar Kent",
"text": "The only add-on would be that I am also very pleased to see in India that it’s not just the CBOs, that the company-owned bottling operations that are performing but it’s the franchise bottlers and their increasing appetite to continue to invest in the marketplace is driving results in every part of the country in all markets, so it’s not just the CBOs that are performing but also the franchise business is performing very well and all the -- we have a much stronger brand portfolio in India. We’ve launched organically some still beverages that we believe will do very well in the area of juice and juice containing beverages. We have a very good trademark in juice in Maaza as well as Minute Maid, so we think that India is on track but as Neville said, a long way to go before we can be pleased about -- it’s still very low per capita when you think about it. So we’ve got a long road ahead of us in terms of sustainable growth."
},
{
"speaker": "Neville Isdell",
"text": "I just want to build off Muhtar’s comment because there is a very important piece here, and that is the new level of respect that the bottlers have for our ability to run bottlers and what that actually does in terms of the overall system. And I will give you some anecdotal stories but let me go back to India; four years ago, I met a very, very unhappy group of franchise bottlers. I was with all the franchise bottlers, as I say, a couple of weeks ago. I have never seen them more bullish. Muhtar has given you some facts around that. We were with the Mexican bottlers a few weeks ago. I can tell you four years ago I had a very difficult meeting with the Mexican bottlers. We had a very good meeting with the Mexican bottlers and that -- I can tell you stories of those sort of pictures around the world, so -- it’s A, what we are doing with the portfolio, what we are doing with the marketing, what we are doing on the franchise leadership side but also the confidence that we actually know what to do with regard to our bottling investments as well. I think there really is a positive synergy that comes out of this."
},
{
"speaker": "Bryan Spillane - Bank of America",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question will come from the line of Ann Gurkin with Davenport."
},
{
"speaker": "Ann Gurkin - Davenport & Co. Of Virginia",
"text": "Good morning. As you look at many of your faster growing international markets, is there any reason right now to change your economic outlook for those markets? Any reason to suggest a slowdown? And then, is there any likelihood you’ll use greater cash flow to buy back more than expected shares?"
},
{
"speaker": "Muhtar Kent",
"text": "Let me take the first part, Ann, and then I’ll hand it over to Gary on the share purchase. As far as -- we had again a very, very good quarter in terms of how we grew both in the BRIC markets with China leading the way, but also in Brazil, also in Russia, very good results in Russia, both in the sparkling category, trademark Coca-Cola and also in the still beverage category in Russia, in India, as we just talked about. But also in key emerging markets, such as Ukraine and such as Turkey and such as some other Asian markets. I mentioned Korea also, that we had some growth for the first time in many quarters. So in general, we are very, very happy with the results and with the market conditions, with the investments, with the portfolio, with the alignment with our bottling partners and with the programs that we have in place for the balance of the year and going into the future. In terms of economic contagion and what happens, we haven’t seen any results right now. What will happen in terms of the impact of the food prices around the world, we’ll have to wait and see. You know as well as I do that there’s a lot of current dislocation in terms of the staple goods, wheat and rice and corn, and we’ll see how all of that plays out."
},
{
"speaker": "Gary P. Fayard",
"text": "Ann, as we go through that and because -- well, we are seeing obviously, IMF last Friday I believe revised downwards some GDP growth estimates in a lot of the markets. Our expectation is you will see some slowdown in GDP around the world but I think those countries we continue to believe will still remain healthy and continue to grow maybe a little slower. But recognizing that fact, that’s why we said at the beginning of the year that our share repurchase would actually be in the $1.5 billion to $2 billion range, because it is kind of uncertain economic times. So each quarter we’ll revise that number based on what we see. We’re still at the 1.5 to 2, but obviously cash flow is coming in significantly ahead of what we would have expected even six weeks ago, just from the currency upside that we’ve seen and we’ll be revising that as we go through the year."
},
{
"speaker": "Muhtar Kent",
"text": "And just one last comment on the macroeconomic situation; based on my experience from past previous macroeconomic headwinds, what we do have a difference of this time is that across the world in terms of BRIC countries, in terms of the macroeconomic indicators of the emerging markets, the fiscal discipline and the monetary dynamics and ratios of all the economies have never been better. In other words, all the emerging market economies are going into this economic environment with actually better fiscal discipline in terms of budget deficits, inflation, et cetera, than they’ve ever, ever faced such a situation in past years. So there is that piece to consider also."
},
{
"speaker": "Ann Gurkin - Davenport & Co. Of Virginia",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question will come from the line of Anthony [Vocallo] with Credit Suisse."
},
{
"speaker": "Anthony Vocallo - Credit Suisse",
"text": "Good morning, everyone. On the expected currency benefit reinvestment, you touched on that in your press release and I think Gary touched on that in his comments. Are those plans in place? Are they being created now? And if so, how and where could we expect those to materialize for your company and for your --"
},
{
"speaker": "Neville Isdell",
"text": "Well, the headline is they are not in place yet. We are still working on them. Let me make -- let Muhtar make some additional comment."
},
{
"speaker": "Muhtar Kent",
"text": "I think the important thing is where we see opportunities, we will proactively make decisions to ensure that we continue to reinvest behind our brands for sustainable growth. That’s the real bottom line that I’d like to underline. We don’t have plans in place but we see this as an opportunity and therefore you will see us taking those opportunities where we see they will deliver long-term, continue to deliver long-term sustainable growth. Gary."
},
{
"speaker": "Gary P. Fayard",
"text": "That’s exactly what I would say. On every opportunity that we see, we are being very rigorous as we go through, looking at long-term returns, the things you would expect us to look at. We do have an opportunity but we are going to be very prudent and review everything -- is it a valid investment that we think we should make?"
},
{
"speaker": "Neville Isdell",
"text": "I just want to keep emphasizing the word long-term that you hear because I’m sure the fear might be that we take short-term actions because of the currency gains that we have, by just pricing actions, which are non-replicable as we go forward, and I just want to point out that that is what we are not going to do. You heard the words -- we’ll only do it if it is expenditure that is going to benefit the long-term."
},
{
"speaker": "Anthony Vocallo - Credit Suisse",
"text": "So there’s no specific broken bone that you are going to treat this year?"
},
{
"speaker": "Muhtar Kent",
"text": "No, I mean, we’ve addressed our issue markets rapidly in past periods and you won’t see us doing that. I think the two areas that you will see us focusing on opportunities will be investing in certain programs that will give us sustainable growth, long-term sustainable growth and secondly also some productivity initiatives, behind some productivity initiatives that may require some investment up front."
},
{
"speaker": "Anthony Vocallo - Credit Suisse",
"text": "Great. Thank you very much."
},
{
"speaker": "Operator",
"text": "Your next question will come from the line of Marion [Montagne] with [inaudible]."
},
{
"speaker": "Marion Montagne",
"text": "At the European Union, you seem to have some pretty good numbers versus year-ago, at least on the volume side. And as I look further down, I’m wondering if that’s an area where you’ve started to put it more into marketing. Could you give us a little more color around that area?"
},
{
"speaker": "Muhtar Kent",
"text": "Yeah, what I’d like to say is that as I mentioned, we’ve cycled a very strong quarter from previous year and the good news is that all our major countries -- Great Britain and also France and Italy and Germany, Spain, they all grew in volume and we also gained both volume and value share across the categories in Europe. I think that the key word here is that we have the foundation in place to continue to generate long-term growth. We are cycling many programs, particularly Coca-Cola Zero, very successful launches from previous year, and we’ve got great programs ahead with the European Football Championship happening in two key locations in Central Europe this year, with most of the summer, particularly early summer will be soccer fever. And we’ve got good programs across the Olympics and we feel that we can continue to generate long-term growth in this very key geography."
},
{
"speaker": "Marion Montagne",
"text": "Okay, since you threw out the word Olympics, can I ask is the marketing going to directed towards the -- what was it, a universal table kind of theme and then local theme? Is that how you are going to approach this?"
},
{
"speaker": "Muhtar Kent",
"text": "It’s going to be local from market to market, with customer -- specific customer related programs as well as brand related programs mainly across trademark Coca-Cola."
},
{
"speaker": "Marion Montagne",
"text": "Okay. Thank you."
},
{
"speaker": "Ann Taylor",
"text": "We have time for one last question."
},
{
"speaker": "Operator",
"text": "The last question will come from the line of Mark Swartzberg with Stifel Nicolaus."
},
{
"speaker": "Mark Swartzberg - Stifel Nicolaus",
"text": "Muhtar, on vitamin water, clearly as you’ve noted here, it’s outperforming your expectations. I was hoping we could get a little bit more update on where the -- from a North America perspective, where the ACV in convenience for vitamin water and smart water is versus the 50 and 15 you had at the start of the year. And then also when you look at same-store sales growth for that particular brand or family of brands, in some of the older markets like New York and L.A., what are you seeing there versus some of the newer markets?"
},
{
"speaker": "Muhtar Kent",
"text": "I think that we, as I said, we see some very robust consumer reaction to vitamin water. We’ve got basically ACV up to now 98% in the supermarkets, up from about 90% in pre-acquisition. Both vitamin water and smart water increases in velocity. The hybrid distribution system is really working well and you’ve seen us in the quarter almost doubling the business versus prior year and again, sourcing volume from across the board and generally creating a very good category platform for active lifestyle beverages, sourcing volume from the sports category, from energy and very, very powerful again in particularly the convenience channel, as well as the supermarket channel and also with some customer-specific distribution in some food service, selected food service customers as well as airlines, as well as almost now 40 extra campuses around the country, et cetera."
},
{
"speaker": "Mark Swartzberg - Stifel Nicolaus",
"text": "And when you look at the more -- I wouldn’t call them developed but some of the older markets like New York and L.A., how are they performing on a same-store sales basis?"
},
{
"speaker": "Muhtar Kent",
"text": "Very good vertical growth continuing, organic vertical growth."
},
{
"speaker": "Mark Swartzberg - Stifel Nicolaus",
"text": "Excellent. Okay, thank you, Muhtar."
},
{
"speaker": "Neville Isdell",
"text": "Well, that being the last question, I just want to say thanks to Muhtar and Gary and also to each of you for joining us this morning. As you hear from our tonality and I guess even the tonality of your questions, we are off to a very good start in 2008. I know what you are focused on is is this going to continue through 2008 and we are actually confident that our strategies are working and as I mentioned earlier, that we expect 2008 to be another successful year for the Coca-Cola Company. Just as a headline, we’re going to just continue to leverage our leading brands, our global footprint, and also our strategic acquisitions to continue to drive growth and, most importantly, long-term value for our shareowners. Thank you very much indeed."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this does conclude the Coca-Cola Company’s first quarter 2008 earnings results conference call. You may now disconnect."
}
] | null | null |
KO | 4 | 2,007 | 2008-02-13 08:30:00 | Executives: Ann Taylor - Vice President and Director of Investor Relations Neville Isdell - Chairman of the Board, Chief Executive Officer Muhtar Kent - President, Chief Operating Officer Gary P. Fayard - Chief Financial Officer, Executive Vice President
Analysts: Judy Hong - Goldman Sachs Bill Pecoriello - Morgan Stanley Bryan Spillane - Bank of America Mark Swartzberg - Stifel Nicolaus John Faucher - J.P. Morgan Carlos Laboy - Credit Suisse Christine Farkas - Merrill Lynch Justin Hott - Bear Stearns
Operator: Good morning. My name is Jennifer and I will be your conference facilitator. At this time, I would like to welcome everyone to The Coca-Cola Company’s fourth quarter 2007 earnings results conference call. (Operator Instructions) I would now like to introduce Ann Taylor, Vice President and Director of Investor Relations.
Ann Taylor: Good morning and thank you for being with us today. I am joined by Neville Isdell, our Chairman and Chief Executive Officer; Muhtar Kent, our President and Chief Operating Officer; and Gary Fayard, our Chief Financial Officer. Following prepared remarks this morning, we will turn the call over for your questions. Before we get started, I would like to remind you that this conference call may contain forward-looking statements, including statements concerning long-term earnings objectives and should be considered in conjunction with cautionary statements contained in our earnings release and in the company’s most recent SEC report. In addition, I would also like to note that we have posted schedules on our company website at thecocacolacompany.com under the financial information tab in the investors section, which reconcile our results as reported under generally accepted accounting principles to certain non-GAAP measures which may be referred to by our senior executives in our discussions this morning and from time to time in discussing our financial performance. Please look on our website for this information. Now let me turn the call over to Neville.
Neville Isdell: Thank you, Ann and good morning, everyone. I’m going to start this morning with a few brief observations about the results and also highlight some of our accomplishments for 2007. Muhtar will then provide details on operational performance and our priorities for the current year, followed by Gary’s overview of the financials and some additional perspective on 2008. Today we reported a very positive finish to 2007, with another solid quarter of business results, a strong 5% unit case volume growth and 12% ongoing EPS growth capped an excellent year for The Coca-Cola Company. In the fourth quarter, all operating units reported volume growth despite tough comparisons in some key markets. We benefited from the diversity of our geographic reach and our breadth and also the breadth of our product portfolio. We delivered consistent financial performance and achieved results ahead of our long-term growth model in each quarter of 2007. By successfully executing our clearly defined strategies, we achieved the following full year results: 6% unit case volume growth, led by our international operations up 8% and robust 4% sparkling and 12% still beverage growth; 20% net revenue growth -- even when you exclude the acquisition of bottlers, net revenue grew 12%; ongoing operating income growth of 14%; comparable earnings per share of 14%; and cash flow from operations up 20%. Notably, this is our 11th consecutive quarter of delivering at least 4% volume growth. The strong top line performance is translating to bottom line results as we delivered our fifth consecutive quarter of double-digit comparable EPS. In 2007, we sold over 1.2 billion incremental unit cases, 1 billion being organic, not acquisition related. What this actually means is that our consumers refresh themselves 1.5 billion times each day with one of our beverages. We’re a company moving successfully by executing against a clear strategic growth agenda. Across the company and throughout the system, talented people are driving growth and developing a culture of innovation and also improving efficiency. We realize the journey is long and we are by no means declaring victory but we can confidently say that we have a solid foundation upon which to deliver long-term sustainable growth and value for our shareholders. In 2007, we put our manifesto for growth into action. In fact, we now call it the manifesto in action. We made commitments to strengthen our sparkling portfolio, to enhance our position in still beverages, to improve our capabilities in consumer marketing, customer leadership, and franchise leadership, and ensure that our business is sustainable. I am pleased to report that we delivered against each one of these commitments and are well-positioned to do so again in 2008 and beyond. Specifically, we strengthened our position in sparkling beverages with trademarks Coca-Cola, Sprite, and Fanta, all delivering solid unit case growth. In fact, overall we captured 72% of the global sparkling beverage industry growth for the year. Trademark Coca-Cola continued to be the key driver, with Coca-Cola Zero driving expansion of the category and gaining share. Coca-Cola Zero is now in 55 countries and it has become our 12th billion-dollar brand. Moreover, we’re executing against our three cola strategy with passionate and award-winning global marketing campaigns. This strategy has delivered the highest growth in trademark Coca-Cola since 1998. As I’ve discussed in the past, sparkling beverages are going to continue to be the backbone of our global growth in both developed and emerging markets. Through integrated marketing and connection of our brands to consumer passion points like the Olympics in 2008, American Idol, and Super Bowl, we are uniquely positioned to capture the highly profitable sparkling beverage opportunity. We also enhanced and expanded our still beverage business through organic growth and targeted bolt-on acquisitions. The biggest headline was our acquisition of Glaceau and its vitamin water brand. The fast-growing premier active lifestyle beverage has now become our 13th billion-dollar brand. The acquisition has changed the game in North America beverages and helped align the Coca-Cola system to invest behind a winning portfolio of brands. Beyond that one headline is continued global success across categories. Trademark Minute Maid increased unit cases 5%, driven by the expansion of Minute Maid Pulpy in China and other emerging markets. We’ve built a strong global juice position in all of the BRIC countries -- Brazil with Jugos del Valle and Suco Mais, Russia with the Multon brands, India with Maaza and now Minute Maid, and of course China, where Minute Maid Pulpy is the number one brand in key metro markets. In sports drinks and water, we continue to look for the highest value opportunities and drive innovation through functional enhancements. Additionally, we are starting to make progress in the ready-to-drink tea and coffee categories. While we are number one globally in both categories, we are continuing to innovate in-house as well as work with our global partners Nestle and [Nilli] to capture the opportunity in these fast-growing categories. This solid performance across the portfolio resulted in our company growing faster than the industry and capturing close to a quarter of the 5.5 billion incremental non-alcoholic ready-to-drink unit cases sold in 2007. We gained non-alcoholic ready-to-drink volume and value share globally, driven by share increases in both sparkling and still beverages. Our progress in consumer marketing and consumer leadership sparked new interest in our expanding portfolio among shoppers, retail customers, and our bottling partners. The Coke side of life, happiness factory the movie, and other award-winning marketing programs have reignited the energy and the optimism right at the core of our brands, and our bottling partners are investing behind the business and they are driving inspirational markets themselves at the point of sale. The combined efforts across the system are working and driving our winning performance every day in the marketplace. Next, a commitment that’s become a true passion for me. We recognize that we cannot have a sustainable business unless the communities that we serve are themselves sustainable. Our commitments center around four key touch stones: water, where we announced our new global partnership with the World Wildlife Fund to conserve seven of the world’s most important watersheds and to become water neutral in all our beverage production processes. Packaging, where we see opportunities to turn today’s waste products into valuable resources for the future. We announced a significant expansion of our U.S. recycling efforts by investing $60 million, including the building of the world’s largest PET bottle to bottle recycling plant in South Carolina and just last night, we announced the long-term target to recycle or reuse 100% of our aluminum beverage cans which we sell in the U.S., which builds on our previously announced goal to recycle or reuse 100% of our PET plastic bottles. Climate -- we’re intensifying our efforts to reduce carbon emissions. For example, at the 2008 Summer Olympic Games, we’ll buy more than 5,000 climate friendly coolers and vending machines. And finally, well-being -- we need all consumers to understand the equation of calories in and calories out. We provide a range of beverage choices for our consumers and believe they thrive at the nexus of refreshment and nutrition. They all play a role in a balance diet for all age groups. Overall, I am pleased with our accomplishments and strong performance in the quarter and the year. We have put in place a strong foundation and remain confident in our outlook for 2008. While we continue to monitor the weakness in the U.S. economy, we remain optimistic about the resiliency of our portfolio, particularly in the developing and emerging markets. Of course, our eyes are wide open and we’ll continue to analyze and respond appropriately to both opportunities and challenges. We believe that we will continue to progress off this strong base. Before I turn the call over to Muhtar, I’d like to make a few comments about our announcement in December. As you know, we announced plans to begin a seamless transition of the CEO responsibilities to Muhtar effective July 1, 2008. This is something that I’ve been engaged with the board on since my return in 2004. I’ve always believed that effective succession must be planned early in the game and also must be one of the core imperatives of how you manage the company. Having worked closely with Muhtar for nearly 20 years, I am confident that his combination of industry knowledge, operational excellence, strategic vision, and commitment to our people, which he has already demonstrated as President in 2008, will continue to take our company forward. With that then, let me now turn the call over to Muhtar to provide the details on our operations.
Muhtar Kent: Thank you, Neville and good morning to everyone. The strong results we’ve achieved in the quarter completed what was a successful year for the company strategically, operationally, and financially. The consistent execution of our strategic agenda and the renewed vigor and confidence across the organization enabled us to deliver balanced geographic and portfolio growth throughout the year. The fourth quarter was no different, as all of our operating units once again delivered positive volume growth. Clearly the systems investments behind this brand, its people and its capabilities are paying off and we have built a strong foundation for sustainable long-term performance. In the first quarter of last year, I outlined my key priorities for 2007 and I am proud to say that due to the dedication of our people around the world, we have made significant progress against each of those initiatives. First, our international operations continued to be the primary driver of growth for the company. Volume performance exceeded our long-term growth target in every quarter of 2007. This success reflects the disciplined execution and local approach of our bottling partners every day in the marketplace and the connection of our brands with consumers around the world. Second, in North America we took a number of aggressive actions which addressed some of our challenges and enabled us to deliver on our commitment of sequential improvement in the second half of 2007. We remain committed to restoring consistent growth in our home market while becoming the preferred beverage partner for our customers. Third, our system-wide efforts resulted in improved efficiency for faster decision making and operating expense savings. These savings created operating expense leverage and were partially reinvested to drive top line growth. And finally, we continue to push the envelope with innovation in product, packaging, delivery, as well as customer service. The global success of Coca-Cola Zero, our most successful launch in the past 25 years, is a perfect example of this. Today I’d like to share with you details on our progress and add some perspective on our priorities for 2008. Our international operations continued their strong performance and increased full year unit case volume by 8%. The performance was broad-based, as evidenced by 19 of our key 22 markets delivering positive growth. Unit case volume growth in our international operations was led by the emerging markets. For the year, we achieved double-digit unit case volume growth in such markets as China, India, Brazil, Russia, Turkey, Eastern Europe, and Southern Eurasia. In the Philippines, since we acquired control of the bottling operations we also have delivered double-digit growth. Africa also produced solid balanced growth across key markets, including a 13% growth in South Africa. Whilst it is clear that we are maintaining our focus and winning internationally, there are a few key markets that I would like to highlight where aligned system execution is delivering progress and results. Latin America continued the success with all business units delivering solid growth. Latin America is now our largest operating group in volume terms, selling over 6 billion unit cases. It is also our second most profitable operating unit with $1.75 billion in operating income. Mexico increased unit case volume 6% while Argentina increased 9% and Brazil delivered double-digit growth. The strong performance reflects the success of our strategies to drive growth in sparkling beverages led by trademark Coca-Cola and expand our footprint in still beverages both organically as well as through acquisitions, such as Jugos del Valle. The strong performance in Mexico is particularly noteworthy as it validates our ability to transfer best practices to drive balanced growth in high per capita markets all around the world. In Mexico, our highest per capita market in the world, we added another 25 servings per person in 2007. The growth across the portfolio led to share gains in both sparkling as well as still beverages for the group. The European Union group has established a solid foundation for sustainable growth, evidenced in the balanced geographic and category performance. Our marketing programs and strong execution of our bottling partners provided the platform to overcome a difficult summer weather comparison from 2006. For the year, unit case volume increased 3%, successfully cycling 6% growth in the prior year, as we achieved solid growth in most key markets. We are encouraged by our progress in Great Britain, which returned to growth in the fourth quarter. Full year volume results in Germany were positive, although volume was slightly down in the quarter as we cycled strong growth in the prior year quarter. We continue to make progress in this market as demonstrated by our move to a one bottler system and remain confident that we are building a foundation for consistent sustainable performance in Germany over time. Europe delivered solid growth with sparkling beverages up 2% and still beverages up 15% for the year. Sparkling growth was driven by 3% growth in trademark Coca-Cola, including the continued success of Coca-Cola Zero, now in 21 countries in the E.U. The strong performance of still beverages was the result of solid organic growth in Minute Maid, along with Nestea, Aquarius, Powerade, and Burn, as well as targeted bolt-on acquisitions. The brand performance led to volume and value share gains in both sparkling and still beverages for the quarter and the full year. It is clear we have the right strategies in place and the E.U. leadership team is effectively managing our business with the goal of delivering consistent, sustainable growth. In 2007, we also validated our track record of rapidly addressing problem markets and delivering on our commitments to restore growth to those markets. Let me give you some examples. Japan delivered its fifth consecutive quarter of unit case volume growth, cycling 2% growth in the prior year quarter. Importantly, all four key trademarks delivered growth. A double-digit volume increase in trademark Coca-Cola drove sparkling beverage growth. Execution of the three cola strategy led to trademark Coca-Cola achieving its highest volume growth rate in 30 years. Georgia grew 1% in the quarter, its first growth in eight quarters. The performance was driven by growth of the 190-milliliter can in the vending channels. The results reflect progress against our previously shared plans to stabilize Georgia’s performance. Aquarius and tea brands Sokenbicha, Karada Meguri-Cha, and [Iyethica] also continued to perform strongly with innovation and solid integrated marketing execution, leading to all four brands gaining share for the year. We have gained significant traction in Japan during 2007. With our management team in place and the health of our brand portfolio improving, we will continue to build upon a stabilized business in 2008. Now let me turn to the Philippines. After acquiring the bottling franchise in March of 2007, we committed to quickly stabilize this key market and demonstrate sequential improvement throughout 2007. Our team’s effort to seamlessly integrate and improve execution through improved availability and focus on rapid execution resulted in performance ahead of our original expectations and volume growth for the full year. We continue to invest in market capabilities and cold drink equipment while driving supply chain efficiencies. We remain confident that our management team will continue to drive growth in 2008 in the Philippines. Overall, I am very pleased with the performance of our international operations. We have a talented and experienced team of operators across the system and our bottling partners are aligned to deliver high quality, broad-based growth while investing to solidify the foundation for sustainable growth in the future. Let me now discuss the progress we are making in North America. In the fourth quarter, we achieved 1% unit case volume growth, the second consecutive quarter of growth, and we delivered on our commitment of sequential improvement in the second half of 2007. We continue to focus on revitalizing the sparkling beverage category with our three cola strategy, Red, Black and Silver. For the year, all three brands gained category share. Coca-Cola Zero continued to deliver strong double-digit unit case volume growth even after two years in the market place. Our key priorities for Coca-Cola Zero are continuing to build trial, increase awareness, and furthering channel penetration. For the second year in a row, the Coke side of life ads that were featured during the Super Bowl telecast were amongst the favorites of both media critics and viewers. It’s Mine, where the nice guy finishes first in a tussle for a Coke over the streets of Manhattan, made the top 10 list in U.S.A. Today’s ad meter and also was the most popular non-alcoholic beverage commercial out of nine beverage ads that aired during the Super Bowl event. The Glaceau acquisition continues to perform beyond our expectations as the trademark achieved triple-digit unit case volume growth in the quarter, driven by both sales velocity and increased availability. Additionally, we successfully moved distribution to a hybrid model to take advantage of the strength of our system while leveraging Glaceau’s unique [route] to market strategy. I am pleased to report that the transition to our bottlers has been successful. This acquisition has aligned our North America system and we continue to expect the acquisition to act as a catalyst for growth across our entire North American business. While we have made significant strides with our portfolio and organization in 2007, we still have much to accomplish. Overall, however, I am confident that our North America system is executing against the right priorities and we remain relentlessly committed to our goal of returning our whole market to sustainable growth. Our successes with Coca-Cola Zero, Glaceau, Powerade, Fuse, Full Throttle, Minute Maid, Simply Juices, Dasani, and our recent investment in Honest Tea, provides the business a much stronger base from which to build in 2008. Our bottling partners are aligned and the system is in an improved position to serve our customers and compete in the marketplace, even with an uncertain U.S. macroeconomic environment. Finally, I’d like to share the progress we’ve made in driving efficiency and effectiveness. As I’ve said, the results of productivity ultimately is leverage in the income statement. In 2007, we successfully achieved this in the core business, as well as in our bottling investments group. We flattened our organizations of 80 fully functional offices to 37 business units across the world. This allows us to improve the speed of decision-making and it improves our effectiveness. We executed lean productivity initiatives at our concentrate manufacturing facilities and were able to increase capacity as well as operational efficiencies. This resulted in the elimination of costs associated with the concentrate plant in Ireland. Within bottling investments, we reallocated expenses from manufacturing and production supply chain and invested in market facing roles to further drive execution in the trade. For The Coca-Cola Company, productivity remains a critical growth enabler to ensure the sustainability of our results over time. Looking forward, we see three main areas of opportunity. First, supply chain optimization, which will allow our system to maintain or enhance our gross margins and increase affordability of our product. Second, marketing and innovation effectiveness, where we optimize investments behind our brands and leverage global best practices. And third, operating efficiencies, which we use to fuel growth and build a foundation for future performance. This includes the ability to fund investments behind the highest impact innovations in products, packaging, ingredients, as well as equipment. As I look forward into 2008, part of the reason I remain confident is the result of the robust planning process we completed with our bottling partners. We have the plans in place to drive towards our ultimate goal of sustainable growth. We are focused on five strategic priorities. First, continue to drive growth from our leadership position in sparkling beverages. Sparkling beverages provides the oxygen to our business. We know there is tremendous opportunity to grow all of our sparkling products in both developed as well as emerging markets. Second, drive faster growth in our still beverage portfolio by adding new functional benefits, developing affordable formulations, pursuing strategic bolt-on acquisitions, and seeking margin enhancements. Third, continue to generate and leverage the balanced growth that we have achieved across our geographic footprint. Growth in our emerging and BRIC markets remain robust, even as headwinds are developing in the U.S. economy. In North America, our business is stronger, our bottlers continue to invest, and we are better positioned from a portfolio and operating structure basis. Fourth, accelerate the commercialization of our innovation pipeline through aggressive investments in product, ingredients, packaging, and equipment. Fifth, further strengthen our system capabilities. Consumer marketing, commercial leadership, and franchise leadership remain our core capabilities. We will continue to drive productivity across our system so that we can expedite decision making and rapidly respond to the changing marketplace. Savings extracted from these initiatives will enhance our ability to achieve consistent and sustained growth. And last but not least, leadership development is a top priority across our system, fostering even more collaboration, accountability, clarity, and calculated risk taking than ever before. Supporting all of this is our staunch belief in the health of our business, supported by the sustainability of the communities we serve. We understand that by acting as an engaged positive corporate citizen, we helped create communities of favorably disposed consumers and as those communities grow, our business continues to flourish. I am pleased with the results we achieved and the progress we made against our strategic agenda. As we enter 2008, we’ll be watching carefully with the volatility in the macroeconomic environment. From the strengthened foundation which I referred to earlier, we are better prepared to weather any potential challenges. I look forward to 2008 being another successful year for The Coca-Cola Company. Now let me turn the call over to Gary. Thank you.
Gary P. Fayard: Thanks, Muhtar. Good morning. As Neville and Muhtar indicated, the fourth quarter was a solid finish to the year, where we achieved strong consistent performance in all quarters. As you saw in the release, reported earnings per share was $0.52 on a diluted basis for the fourth quarter, an increase of 79%. This included a net charge of $0.06 per share, primarily related to restructuring charges and some asset write-downs. Therefore, after considering items impacting comparability in both the current and prior year, adjusted earnings per share for the quarter was $0.58 versus $0.52 in the prior year, an increase of 12%. This is our fifth consecutive quarter of double-digit EPS growth and it’s important to note that we successfully cycled our toughest quarterly comparison, cycling double-digit growth in both ongoing operating income and earnings per share in Q4 2006, again with double-digit growth in Q4 2007. I am sure you’ve also noticed that our volume growth rate for the quarter was 5% versus our full year growth of 6%. We believe this is a very solid result. Sparkling beverages grew 4% for the quarter and for the full year. Still beverages increased 11% versus full year 12%. This quarter was impacted by a strategic decision to de-emphasize low value water in several countries, such as China, which caused volume to round down to 5% in the quarter. For the year, reported earnings per share increased 19% to $2.57. This included a net charge of $0.13 per share, primarily related to restructuring charges. After considering items impacting comparability in both years, earnings per share was $2.70 versus $2.37 in the prior year, a 14% increase. For the year, unit case volume growth was 6%, in line with concentrate sales. Revenue growth was 20% and 12% excluding structural changes related to bottler acquisitions. The increase was driven by a 6% increase in concentrate, a 4% currency benefit, and a 2% favorable impact from price and mix. After considering factors impacting comparability, operating income growth was 14% and 10% on a currency neutral basis. In terms of margins, our core business remains healthy and expanded margins for the full year as we drove top line growth and delivered operating expense leverage. Bottling investments continues to improve margins as well. Cash from operations for the year increased 20% to $7.1 billion on strong underlying business performance and a decrease in working capital. We repurchased approximately $1.75 billion of our stock for the full year, in line with our prior guidance. Additionally, the company paid $3.1 billion in dividends to shareowners in 2007. For 2007, this contributed to a 30% total return to our shareowners. Now let me address some of the factors that we see impacting the company in 2008. As you know, our long-term growth targets are 3% to 4% volume growth, 6% to 8% ongoing currency neutral operating income growth, and high-single-digit ongoing earnings per share growth. We successfully exceeded these targets in 2007. Our picture of success will be to continue to exceed these targets. We recognize that there is some uncertainty, particularly as it relates to the U.S. economy. However, as Muhtar said, we remain committed to restoring growth in our home market and believe our business is well-positioned to navigate headwinds that might develop. Emerging and BRIC markets have maintained their robust growth, even against the backdrop of uncertainty in the U.S. market, and we remain positive on the global macroeconomic outlook, especially in many of these emerging markets. As Muhtar detailed, we will continue to focus on driving efficiency and effectiveness across our organization and will utilize the realized benefits to further improve our ability to deliver consistent and sustained performance. On commodity cost, 2007 was certainly a difficult year with cost pressures from several of our key system inputs, particularly in North America. Commodity cost volatility remains a risk. However, as we said on the third quarter call, for 2008 we continue to expect to see a moderation in commodity cost pressures. Currently our assumptions on commodity cost pressures. Currently our assumptions on commodity costs versus 2007 are a slight increase for the system and essentially flat for the company. We expect to deliver operating expense leverage on both the core and bottling business in 2008 and we will continue to invest behind our brands and innovation initiatives. Additionally, selling and service expenses will increase as we invest for growth in our bottling operations as well as investments behind our brand acquisitions, particularly in North America. General and administrative expenses were tightly controlled in 2007 and we will continue our disciplined approach in 2008. We would expect net interest costs to increase for 2008 as we carry a full year of higher debt associated with our 2007 acquisitions. For 2008, our best estimate is that the full year underlying effective tax rate will be between 22% and 22.5%. From a capital expenditure standpoint, we purchased approximately $1.4 billion in net PP&E during 2007. For 2008, we expect the total company net capital expenditures will be approximately $1.6 billion to $1.7 billion as we make investments in recently acquired bottling operations. And we anticipate that our range of share repurchase on a gross basis will be $1.5 billion to $2 billion this year. Now let me move to currency. We’re effectively covered for the full year on the YEN and for the first three quarters of 2008 on the other key hard currencies. Based on anticipated benefits of current hedging coverage in place, the company expects currencies to have a minimal impact on operating income in 2008. Finally, let me say a few words about quarterly phasing. As many of you know, we report unit case volume on an average daily sales basis, kind of like same-store sales, to eliminate comparability issues due to calendar variations. For 2008, we will have one extra day, since it is a leap year. The first quarter will have one fewer day than Q107 and the fourth quarter will have two more days versus Q407. This will not impact our unit case sales reporting but will impact our concentrate sales and therefore revenues. Additionally, also remember that Easter will shift from Q2 last year into Q1 this year. Those are the topics that I wanted to cover and now we can turn it over to your questions. Operator.
Operator: (Operator Instructions) Judy Hong, Goldman Sachs.
Judy Hong - Goldman Sachs: Good morning, everyone. Just looking at the fourth quarter volume trends globally, you’ve talked about a bit of a slowdown sequentially. I’m just wondering how much of the decision to de-emphasize the water brand really impacted the global volume number.
Muhtar Kent: Basically we had sparkling growth was both the same number for the full year as well as for the fourth quarter, and we still achieved 6% growth in sparkling in the international business. So we are very pleased with that trend. What you see is a slight slowing down of the still beverages, mainly water and that because we’ve had growth in juice, good growth in juice comparable to the full year, same as in -- also in sports, also for tea and coffee. Essentially, it’s been a de-emphasizing of the water business in big large markets, particularly in Asia, like China, as well as in Indonesia and therefore -- and mainly as a result of that category being low value for us. So it’s been a specific action on our part and we feel very confident about our business in all the categories.
Judy Hong - Goldman Sachs: And just kind of following up on that in terms of just looking at just over the next 12 to 24 months and thinking about the macro outlook and you sounded still pretty positive about the macro, but just in terms of whether there are any regions or markets that may be a bit more concerning if the U.S. starts to show a bigger slowdown?
Neville Isdell: Well, Judy -- by the way, just one other on the water, just to give you a data point -- full year growth was 13%. If we take out vitamin water here, the quarter was 8%, so that gives you the metric in terms of what happened with regard to water in the fourth quarter. We don’t see there being a major impact on the emerging economies or the developing economies. There will be one or two economies in the developed world there will be housing bubbles, where we think there will be some pull-back. But balanced with that, we think the momentum that we have behind our existing brands and the new brands, the better execution, all the things that we talked about on our call are such that we are going to be able to manage what may be a half-a-percent decline at the worst in terms of overall global growth. And I think we already addressed the U.S. issue. So let me put it to you this way -- we feel we’ve really got a strong tailwind behind our business and that that is going to carry us through 2008 even as we see some areas where there will be some economic dislocation.
Judy Hong - Goldman Sachs: Thanks.
Operator: Your next question comes from Bill Pecoriello with Morgan Stanley.
Bill Pecoriello - Morgan Stanley: I was hoping to get a little bit more color on the Pacific division, which decelerated sequentially. Aside from the China water strategy, some of the other markets that you didn’t discuss in the release -- Indonesia, Korea -- if there were some reasons there for the sequential deceleration versus the prior quarters and what efforts you are doing in those markets to improve the growth. Thanks.
Muhtar Kent: Essentially, Indonesia was specifically related again to a slowdown of the water, just like we mentioned for China. As far as Korea is concerned, as you know we’ve had a transition of our evolving partnership there and we are very confident that our new partnership and alignment with our new bottling partner there will take us into a modality of growth in Korea for the years to come and we are very confident about that. And there’s been a slight slowing down in the Australian economy but we feel generally confident that our business will perform in terms of its past historical trends in 2008 quarter by quarter in the Pacific.
Neville Isdell: Just to pick up on Korea, I think there is a real pattern here that you’ve seen with us in terms of acquisitions. In some instances, we were able to turn it around very quickly like the Philippines. In others, there have been more in-depth reforms required. Germany would be one example of that. And we take the pain along the way and that’s really Korea. That’s the story of Korea and we are confident that we’ll see that one turning around. I think we’ve got a good track record on that and we can deliver against it.
Bill Pecoriello - Morgan Stanley: And then on the bottled water, we should expect that across the four quarters as you made that decision and that would impact the following three quarters as well?
Muhtar Kent: No, I don’t believe that that will. I think that we now are in a situation where we are going into 2008 pretty clean in terms of where we want to be in the water category.
Bill Pecoriello - Morgan Stanley: Thanks.
Operator: Your next question comes from Bryan Spillane with Bank of America.
Bryan Spillane - Bank of America: A question on operating leverage; if you look at the 10% organic or currency neutral operating profit growth for the year, if you could give us a breakdown of how much of that growth was acquisitions, how much was cost savings, and then how much was underlying organic growth. And then, as we look into ’08, you’ve taken -- the company has taken over $400 million of charges over the last two years and what’s the pay-back on some of the restructuring actions? And as we look at ’08, what should we be thinking about in terms of productivity as a contributor to profit growth?
Gary P. Fayard: Okay, Bryan. We hesitated on you for a minute because as we take these questions, we’re just trying to make sure that in fact you are who you say you are.
Bryan Spillane - Bank of America: I am the real deal.
Gary P. Fayard: As has been experienced by a few companies over the last couple of weeks. As we look at it, let me take you through a couple of different ways. Basically if you look at currency neutral operating income, we’ve gotten about -- of the 10% growth, about 8% of that is out of the core concentrate business, about a point is out of the bottling investments group, and about a point out of acquisitions, so that’s how it comes to your 10% operating income growth currency neutral.
Bryan Spillane - Bank of America: Okay.
Gary P. Fayard: Relative to the charges, we in fact had within OpEx, and let me just talk about the quarter and the year, kind of the same. What we did this year, we had significant increase actually in marketing because we continue to invest behind the brands and we in fact accelerated some of that in the fourth quarter because we’ve had a really good year and we recognize that we have the flexibility to do that, to continue to drive the growth that we are seeing across all of our markets. Within sales and service it’s been up but primarily it’s been up because of the acquisitions, primarily the bottlers but you’ll see some continue to increase from that not only there but also the brands. Within G&A -- in fact, G&A in the fourth quarter on a -- if you kind of make it apples-to-apples, G&A in the fourth quarter was up 3% and 100% of that was due to incentive plans that we’ve accrued for long-term plans because we’ve actually exceeded and it’s where we want to be. Relative to restructuring charges, the biggest restructuring charges this year was really around closing a concentrate in Ireland, which will be completely closed by mid-year 2008. It was a result, as we said, from applying lean manufacturing techniques to that and we’ve been able to in fact shut down a whole plant without any increases anywhere else. We are taking though -- some of that is going to the bottom line but a lot of that we are reinvesting actually behind the brand and into innovation to really drive the sustainability of this business over the long-term.
Bryan Spillane - Bank of America: So is it fair to say that the pool of productivity is going to be bigger in ’08 than it was in ’07? It’s just a matter of how much you spend back and how much you flex to the bottom line?
Muhtar Kent: I’d just like to make one comment just to build on what Gary said. You will see us relentlessly focusing across the entire organization on the effectiveness and the efficiency measures and also the programs. And we -- as we said, we’ll take some of that to create more expense leverage on the P&L and we will continue to invest for the health of our brands long-term.
Neville Isdell: Bryan, just on the fourth quarter marketing spend, when I came back, I discovered that we had major markets in the fourth quarter that weren’t spending a penny. The numbers weren’t that good but they still weren’t spending a penny. We are back up at a level now where we’ve got 12 months good, solid support right behind our brands and that’s part of what you saw in the fourth quarter. So we are in good shape now going into ’08.
Bryan Spillane - Bank of America: Okay, great. See you guys next week in Florida.
Operator: (Operator Instructions) Your next question comes from Mark Swartzberg with Stifel Nicolaus.
Mark Swartzberg - Stifel Nicolaus: Thanks. Good morning, everyone. Muhtar, I was hoping on your priorities, specifically the one about accelerating still beverage growth, you could peel the onion a bit more for us there, talk a little bit about the role of existing brands in that acceleration and the role of new brands and give us some idea, if you can, about regions where you see the opportunity being bigger than other regions.
Muhtar Kent: I think that, as I said, the key is organic growth, as I said in my remarks. Organic growth is the oxygen of our business and you will see us continue to drive innovation in organic growth in still beverages. I think the Minute Maid brand and the success of it in markets like China and Vietnam, Korea is a great example of that. I think you will see us -- we’ve just launched that also in India and it’s doing very, very well. You will see us focused on Glaceau internationally. You will see us certainly adding much more functionality and benefits to our still portfolio through innovation and I’d like to just highlight one thing that Neville said. We are now the leaders in juice in all four BRIC markets. That’s an incredible footprint. When you look at Brazil, when you look at Russia with our Dobriy brand. When you look at Brazil with Jugos del Valle and Suco Mais and when you look at China with the Minute Maid Pulpy across all metro markets, number one. In India with Mazaa, both in the mango category of juice as well as in the leading mango category as well as in the citrus now with our new launch, and many other emerging markets. So you will see us focus much more on organic growth. We’ve got a great portfolio and we have a great innovation pipeline that we will drive through that portfolio.
Mark Swartzberg - Stifel Nicolaus: And I know it’s early but your comment on Glaceau internationally, we’ve heard your willingness to look at that since the day you announced the deal, but you’ve had maybe six, seven, eight months to test the water from a consumer buy-in or potential for buy-in in markets other than the U.S., other than North America. Have you found anything of interest there in terms of the opportunity for that brand on the other side of the world, if you will?
Muhtar Kent: You will certainly see Glaceau in international markets in the very near future. And CCE yesterday said that they will launch it in Canada in quarter two. I think you will see us in different international markets with that brand.
Mark Swartzberg - Stifel Nicolaus: Okay, and the linkage between that and Powerade here in North America is notable. Is that a fair linkage to make, at least in some cases on the other side of the Atlantic and Pacific?
Muhtar Kent: Well, we have said always that Glaceau is a wonderful brand that transgresses categories and sources volume from different categories, whether it’s sports or enhanced waters or the entire active lifestyle category. So it’s a category really on its own and we believe that it will also hit the same buttons with consumers in international markets as we progress that trademark, vitamin water, into international markets.
Mark Swartzberg - Stifel Nicolaus: Very good. Thank you, Muhtar.
Operator: Your next question comes from John Faucher with J.P. Morgan.
John Faucher - J.P. Morgan: Good morning, everyone. A quick question on Japan; it looks as though the fourth quarter of this year was only about the second positive volume number on a positive comp in the past couple of years, the last being last year’s Q4. So can you talk a little bit about the ability to sustain that? What level of operating profit you’ve been delivering in Japan on a currency neutral basis over the past year or so and can you keep the volume positive while maybe needing to accelerate the operating profit growth there over the next couple of years? Thanks.
Muhtar Kent: I have said that clearly our target was to stabilize Japan and we have done that in 2008 and we have consecutively -- in 2007 and we have consecutively delivered quarter after quarter growth. We are now in a much more normalized position in Japan, so you will see us delivering between 1% and 3% growth over the years. That’s our target. That’s basically how we see the picture of success. We expect modest profit growth in Japan. Importantly also, as we have stabilized Japan in 2007 and from the end of 2006 and into 2007, what we see now also is that our bottlers, our bottling partners are in a much more strengthened position. Their willingness to invest in the marketplace is much more and I think that you are seeing one of the key categories in Japan -- one of the also important things in Japan in 2007 was that we had growth in two of the key channels, both in the vending channel as well as in the supermarket channel and the vending channel, of course, as you know, is a very highly profitable important channel and our bottler’s willingness to continue to invest will drive further growth in that channel is our belief.
John Faucher - J.P. Morgan: Okay, so what it sounds as though your levels of incremental investment over the past couple of years, it sounds like you kind of -- you feel like you’ve normalized the margins maybe there and we should see a more normalized growth rate going forward. Is that the right way to look at it?
Muhtar Kent: As I said, we’ve stabilized the business and we are looking for a more normalized growth rate in Japan going forward and we believe also that we’ve strengthened our brands in all the categories. Sparkling notably in 2007 was a key category that has grown, particularly the trademark Coca-Cola, very pleased double-digit growth, the highest in 30 years. The tea category is also growing and very healthy in terms of our brand, as well as Aquarius and as I mentioned in the call, we’ve also had a growth in Georgia Coffee in the fourth quarter of 2007.
John Faucher - J.P. Morgan: Thanks.
Operator: Your next question comes from Carlos Laboy with Credit Suisse.
Carlos Laboy - Credit Suisse : My question relates to some of these bottling JVs. You now have a growing collection of these non-carb JVs building around the world. Do you see more of these in the future and could you speak to some of the benefits and challenges of these arrangements and how they might affect your bottling relationships?
Muhtar Kent: First, let me just say that we are very pleased at where our bottling relationships are, in terms of how we are aligned, how we are planning together in joint force and how we see the future and the picture of success jointly together. It’s a very simple reason why we have these JVs, because we believe that the categories that we have these JVs in are much better suited to be operated through these JVs, like we have now formed in Latin America for our juice acquisition and like the ones that we have in Europe and it basically creates the focus, it creates the scale, and it creates the economics that deal properly with the categories and allows the bottling partners and us to focus on how we build that business together.
Carlos Laboy - Credit Suisse : Thank you.
Operator: Your next question comes from Christine Farkas with Merrill Lynch.
Christine Farkas - Merrill Lynch: Thank you very much. Good morning. Gary, I have a question for you regarding your buy-back plans for 2008. You’ve indicated similar levels in ’08 to 2007, which was under my impression pulled back based on your acquisition of Glaceau. Can you help us understand, given that your cash flows can allow a larger buy-back, what’s going into that consideration? I understand CCE’s plans for buy-back. Perhaps there are other considerations there. Can you help us understand why that level is where it is for ’08?
Gary P. Fayard: Sure, or at least I’ll try. Let me go through that. First, as we look at it, as you look at the credit markets and the volatility there and with some modest increase of debt levels, we think it’s prudent at this point to be somewhat conservative in some of our financial policies and therefore with what we are looking at, as well as maintaining credit ratings for the system, we think the $1.5 billion to $2 billion is a pretty good place to start the year. I think it’s important as we go through the year, we’ll update you on that. The share repurchase that was announced by CCE yesterday is also very modest. Really dealing with kind of trying to keep their share count kind of flat, so a pretty modest share repurchase program. So I would say -- I would sum it up probably as we’ll be a little cautious just because of volatility in the markets but stay tuned and we’ll update you as we go through the year, and because the credit ratings are pretty important to us as well.
Christine Farkas - Merrill Lynch: Well, the CCE program is modest. Would you anticipate participating in that to maintain your stake?
Gary P. Fayard: No, I think -- I mean, that will just be arms length where they are just going into the market, I would think.
Christine Farkas - Merrill Lynch: Okay, great, and just on the back of acquisitions, can you tell us how much Glaceau contributed to your North American volumes in the quarter?
Gary P. Fayard: About two points.
Christine Farkas - Merrill Lynch: Great. Thanks, Gary.
Ann Taylor: Operator, we have time for one more question.
Operator: Your last question comes from Justin Hott with Bear Stearns.
Justin Hott - Bear Stearns: Thanks. On Glaceau, CCE yesterday mentioned that they might have been a little bit slower in promotional activity in the fourth quarter due to I guess the transition there. Would it be fair to say that CCE is ramping up that Glaceau can even accelerate its great growth? And also, if you could just give us, since it’s the last question, some comments on CoBos and where you stand with some of them around the world, your plans there. Thanks.
Muhtar Kent: Was the last question on CoBos? Okay, just let me give you the answer on Glaceau. It’s absolutely it was related to the transition and it’s back on a normalized sequence now in terms of our promotional calendar. And what you’ve seen is that we’ve had very good progressive increases as we’ve transitioned the distribution, bottler distribution into our bottlers, an increase in supermarkets for distribution as well as in convenience stores for both vitamin water, smart water, as well as vitamin energy. So all of the components are working very well for us as we’ve moved into a normalized fashion. And as far as the CoBos are concerned, as we’ve said to you before, we will continue to look at opportunities in our ownerships and where we see some opportunities for divestiture, we will. And you’ve heard Neville mention our BIG as a hospital ward and we’re very happy with the performance of our BIG group but over time, you will see us taking some more on board and divesting some.
Justin Hott - Bear Stearns: Thanks.
Neville Isdell: Thank you, Muhtar and Gary. Just to wrap up, and also thanks to each one of you for joining us this morning. So now we’re in 2008 and it’s the next step on our journey. I am confident that we’ve laid a solid foundation on which to build in 2008 and we remain I assure you resolute about delivering against our strategic agenda this year as we did in ‘07. We’ll continue to leverage our leading brands, our global footprint, and our strategic acquisitions. You’re going to see us building also on our innovation pipeline, which we didn’t talk a lot about today, and all the while driving efficiency to deliver sustainable growth and shareowner value. Thank you very much indeed.
Operator: Ladies and gentlemen, this concludes The Coca-Cola Company’s fourth quarter 2007 earnings results conference call. Thank you for your participation. You may now disconnect. | [
{
"speaker": "Executives",
"text": "Ann Taylor - Vice President and Director of Investor Relations Neville Isdell - Chairman of the Board, Chief Executive Officer Muhtar Kent - President, Chief Operating Officer Gary P. Fayard - Chief Financial Officer, Executive Vice President"
},
{
"speaker": "Analysts",
"text": "Judy Hong - Goldman Sachs Bill Pecoriello - Morgan Stanley Bryan Spillane - Bank of America Mark Swartzberg - Stifel Nicolaus John Faucher - J.P. Morgan Carlos Laboy - Credit Suisse Christine Farkas - Merrill Lynch Justin Hott - Bear Stearns"
},
{
"speaker": "Operator",
"text": "Good morning. My name is Jennifer and I will be your conference facilitator. At this time, I would like to welcome everyone to The Coca-Cola Company’s fourth quarter 2007 earnings results conference call. (Operator Instructions) I would now like to introduce Ann Taylor, Vice President and Director of Investor Relations."
},
{
"speaker": "Ann Taylor",
"text": "Good morning and thank you for being with us today. I am joined by Neville Isdell, our Chairman and Chief Executive Officer; Muhtar Kent, our President and Chief Operating Officer; and Gary Fayard, our Chief Financial Officer. Following prepared remarks this morning, we will turn the call over for your questions. Before we get started, I would like to remind you that this conference call may contain forward-looking statements, including statements concerning long-term earnings objectives and should be considered in conjunction with cautionary statements contained in our earnings release and in the company’s most recent SEC report. In addition, I would also like to note that we have posted schedules on our company website at thecocacolacompany.com under the financial information tab in the investors section, which reconcile our results as reported under generally accepted accounting principles to certain non-GAAP measures which may be referred to by our senior executives in our discussions this morning and from time to time in discussing our financial performance. Please look on our website for this information. Now let me turn the call over to Neville."
},
{
"speaker": "Neville Isdell",
"text": "Thank you, Ann and good morning, everyone. I’m going to start this morning with a few brief observations about the results and also highlight some of our accomplishments for 2007. Muhtar will then provide details on operational performance and our priorities for the current year, followed by Gary’s overview of the financials and some additional perspective on 2008. Today we reported a very positive finish to 2007, with another solid quarter of business results, a strong 5% unit case volume growth and 12% ongoing EPS growth capped an excellent year for The Coca-Cola Company. In the fourth quarter, all operating units reported volume growth despite tough comparisons in some key markets. We benefited from the diversity of our geographic reach and our breadth and also the breadth of our product portfolio. We delivered consistent financial performance and achieved results ahead of our long-term growth model in each quarter of 2007. By successfully executing our clearly defined strategies, we achieved the following full year results: 6% unit case volume growth, led by our international operations up 8% and robust 4% sparkling and 12% still beverage growth; 20% net revenue growth -- even when you exclude the acquisition of bottlers, net revenue grew 12%; ongoing operating income growth of 14%; comparable earnings per share of 14%; and cash flow from operations up 20%. Notably, this is our 11th consecutive quarter of delivering at least 4% volume growth. The strong top line performance is translating to bottom line results as we delivered our fifth consecutive quarter of double-digit comparable EPS. In 2007, we sold over 1.2 billion incremental unit cases, 1 billion being organic, not acquisition related. What this actually means is that our consumers refresh themselves 1.5 billion times each day with one of our beverages. We’re a company moving successfully by executing against a clear strategic growth agenda. Across the company and throughout the system, talented people are driving growth and developing a culture of innovation and also improving efficiency. We realize the journey is long and we are by no means declaring victory but we can confidently say that we have a solid foundation upon which to deliver long-term sustainable growth and value for our shareholders. In 2007, we put our manifesto for growth into action. In fact, we now call it the manifesto in action. We made commitments to strengthen our sparkling portfolio, to enhance our position in still beverages, to improve our capabilities in consumer marketing, customer leadership, and franchise leadership, and ensure that our business is sustainable. I am pleased to report that we delivered against each one of these commitments and are well-positioned to do so again in 2008 and beyond. Specifically, we strengthened our position in sparkling beverages with trademarks Coca-Cola, Sprite, and Fanta, all delivering solid unit case growth. In fact, overall we captured 72% of the global sparkling beverage industry growth for the year. Trademark Coca-Cola continued to be the key driver, with Coca-Cola Zero driving expansion of the category and gaining share. Coca-Cola Zero is now in 55 countries and it has become our 12th billion-dollar brand. Moreover, we’re executing against our three cola strategy with passionate and award-winning global marketing campaigns. This strategy has delivered the highest growth in trademark Coca-Cola since 1998. As I’ve discussed in the past, sparkling beverages are going to continue to be the backbone of our global growth in both developed and emerging markets. Through integrated marketing and connection of our brands to consumer passion points like the Olympics in 2008, American Idol, and Super Bowl, we are uniquely positioned to capture the highly profitable sparkling beverage opportunity. We also enhanced and expanded our still beverage business through organic growth and targeted bolt-on acquisitions. The biggest headline was our acquisition of Glaceau and its vitamin water brand. The fast-growing premier active lifestyle beverage has now become our 13th billion-dollar brand. The acquisition has changed the game in North America beverages and helped align the Coca-Cola system to invest behind a winning portfolio of brands. Beyond that one headline is continued global success across categories. Trademark Minute Maid increased unit cases 5%, driven by the expansion of Minute Maid Pulpy in China and other emerging markets. We’ve built a strong global juice position in all of the BRIC countries -- Brazil with Jugos del Valle and Suco Mais, Russia with the Multon brands, India with Maaza and now Minute Maid, and of course China, where Minute Maid Pulpy is the number one brand in key metro markets. In sports drinks and water, we continue to look for the highest value opportunities and drive innovation through functional enhancements. Additionally, we are starting to make progress in the ready-to-drink tea and coffee categories. While we are number one globally in both categories, we are continuing to innovate in-house as well as work with our global partners Nestle and [Nilli] to capture the opportunity in these fast-growing categories. This solid performance across the portfolio resulted in our company growing faster than the industry and capturing close to a quarter of the 5.5 billion incremental non-alcoholic ready-to-drink unit cases sold in 2007. We gained non-alcoholic ready-to-drink volume and value share globally, driven by share increases in both sparkling and still beverages. Our progress in consumer marketing and consumer leadership sparked new interest in our expanding portfolio among shoppers, retail customers, and our bottling partners. The Coke side of life, happiness factory the movie, and other award-winning marketing programs have reignited the energy and the optimism right at the core of our brands, and our bottling partners are investing behind the business and they are driving inspirational markets themselves at the point of sale. The combined efforts across the system are working and driving our winning performance every day in the marketplace. Next, a commitment that’s become a true passion for me. We recognize that we cannot have a sustainable business unless the communities that we serve are themselves sustainable. Our commitments center around four key touch stones: water, where we announced our new global partnership with the World Wildlife Fund to conserve seven of the world’s most important watersheds and to become water neutral in all our beverage production processes. Packaging, where we see opportunities to turn today’s waste products into valuable resources for the future. We announced a significant expansion of our U.S. recycling efforts by investing $60 million, including the building of the world’s largest PET bottle to bottle recycling plant in South Carolina and just last night, we announced the long-term target to recycle or reuse 100% of our aluminum beverage cans which we sell in the U.S., which builds on our previously announced goal to recycle or reuse 100% of our PET plastic bottles. Climate -- we’re intensifying our efforts to reduce carbon emissions. For example, at the 2008 Summer Olympic Games, we’ll buy more than 5,000 climate friendly coolers and vending machines. And finally, well-being -- we need all consumers to understand the equation of calories in and calories out. We provide a range of beverage choices for our consumers and believe they thrive at the nexus of refreshment and nutrition. They all play a role in a balance diet for all age groups. Overall, I am pleased with our accomplishments and strong performance in the quarter and the year. We have put in place a strong foundation and remain confident in our outlook for 2008. While we continue to monitor the weakness in the U.S. economy, we remain optimistic about the resiliency of our portfolio, particularly in the developing and emerging markets. Of course, our eyes are wide open and we’ll continue to analyze and respond appropriately to both opportunities and challenges. We believe that we will continue to progress off this strong base. Before I turn the call over to Muhtar, I’d like to make a few comments about our announcement in December. As you know, we announced plans to begin a seamless transition of the CEO responsibilities to Muhtar effective July 1, 2008. This is something that I’ve been engaged with the board on since my return in 2004. I’ve always believed that effective succession must be planned early in the game and also must be one of the core imperatives of how you manage the company. Having worked closely with Muhtar for nearly 20 years, I am confident that his combination of industry knowledge, operational excellence, strategic vision, and commitment to our people, which he has already demonstrated as President in 2008, will continue to take our company forward. With that then, let me now turn the call over to Muhtar to provide the details on our operations."
},
{
"speaker": "Muhtar Kent",
"text": "Thank you, Neville and good morning to everyone. The strong results we’ve achieved in the quarter completed what was a successful year for the company strategically, operationally, and financially. The consistent execution of our strategic agenda and the renewed vigor and confidence across the organization enabled us to deliver balanced geographic and portfolio growth throughout the year. The fourth quarter was no different, as all of our operating units once again delivered positive volume growth. Clearly the systems investments behind this brand, its people and its capabilities are paying off and we have built a strong foundation for sustainable long-term performance. In the first quarter of last year, I outlined my key priorities for 2007 and I am proud to say that due to the dedication of our people around the world, we have made significant progress against each of those initiatives. First, our international operations continued to be the primary driver of growth for the company. Volume performance exceeded our long-term growth target in every quarter of 2007. This success reflects the disciplined execution and local approach of our bottling partners every day in the marketplace and the connection of our brands with consumers around the world. Second, in North America we took a number of aggressive actions which addressed some of our challenges and enabled us to deliver on our commitment of sequential improvement in the second half of 2007. We remain committed to restoring consistent growth in our home market while becoming the preferred beverage partner for our customers. Third, our system-wide efforts resulted in improved efficiency for faster decision making and operating expense savings. These savings created operating expense leverage and were partially reinvested to drive top line growth. And finally, we continue to push the envelope with innovation in product, packaging, delivery, as well as customer service. The global success of Coca-Cola Zero, our most successful launch in the past 25 years, is a perfect example of this. Today I’d like to share with you details on our progress and add some perspective on our priorities for 2008. Our international operations continued their strong performance and increased full year unit case volume by 8%. The performance was broad-based, as evidenced by 19 of our key 22 markets delivering positive growth. Unit case volume growth in our international operations was led by the emerging markets. For the year, we achieved double-digit unit case volume growth in such markets as China, India, Brazil, Russia, Turkey, Eastern Europe, and Southern Eurasia. In the Philippines, since we acquired control of the bottling operations we also have delivered double-digit growth. Africa also produced solid balanced growth across key markets, including a 13% growth in South Africa. Whilst it is clear that we are maintaining our focus and winning internationally, there are a few key markets that I would like to highlight where aligned system execution is delivering progress and results. Latin America continued the success with all business units delivering solid growth. Latin America is now our largest operating group in volume terms, selling over 6 billion unit cases. It is also our second most profitable operating unit with $1.75 billion in operating income. Mexico increased unit case volume 6% while Argentina increased 9% and Brazil delivered double-digit growth. The strong performance reflects the success of our strategies to drive growth in sparkling beverages led by trademark Coca-Cola and expand our footprint in still beverages both organically as well as through acquisitions, such as Jugos del Valle. The strong performance in Mexico is particularly noteworthy as it validates our ability to transfer best practices to drive balanced growth in high per capita markets all around the world. In Mexico, our highest per capita market in the world, we added another 25 servings per person in 2007. The growth across the portfolio led to share gains in both sparkling as well as still beverages for the group. The European Union group has established a solid foundation for sustainable growth, evidenced in the balanced geographic and category performance. Our marketing programs and strong execution of our bottling partners provided the platform to overcome a difficult summer weather comparison from 2006. For the year, unit case volume increased 3%, successfully cycling 6% growth in the prior year, as we achieved solid growth in most key markets. We are encouraged by our progress in Great Britain, which returned to growth in the fourth quarter. Full year volume results in Germany were positive, although volume was slightly down in the quarter as we cycled strong growth in the prior year quarter. We continue to make progress in this market as demonstrated by our move to a one bottler system and remain confident that we are building a foundation for consistent sustainable performance in Germany over time. Europe delivered solid growth with sparkling beverages up 2% and still beverages up 15% for the year. Sparkling growth was driven by 3% growth in trademark Coca-Cola, including the continued success of Coca-Cola Zero, now in 21 countries in the E.U. The strong performance of still beverages was the result of solid organic growth in Minute Maid, along with Nestea, Aquarius, Powerade, and Burn, as well as targeted bolt-on acquisitions. The brand performance led to volume and value share gains in both sparkling and still beverages for the quarter and the full year. It is clear we have the right strategies in place and the E.U. leadership team is effectively managing our business with the goal of delivering consistent, sustainable growth. In 2007, we also validated our track record of rapidly addressing problem markets and delivering on our commitments to restore growth to those markets. Let me give you some examples. Japan delivered its fifth consecutive quarter of unit case volume growth, cycling 2% growth in the prior year quarter. Importantly, all four key trademarks delivered growth. A double-digit volume increase in trademark Coca-Cola drove sparkling beverage growth. Execution of the three cola strategy led to trademark Coca-Cola achieving its highest volume growth rate in 30 years. Georgia grew 1% in the quarter, its first growth in eight quarters. The performance was driven by growth of the 190-milliliter can in the vending channels. The results reflect progress against our previously shared plans to stabilize Georgia’s performance. Aquarius and tea brands Sokenbicha, Karada Meguri-Cha, and [Iyethica] also continued to perform strongly with innovation and solid integrated marketing execution, leading to all four brands gaining share for the year. We have gained significant traction in Japan during 2007. With our management team in place and the health of our brand portfolio improving, we will continue to build upon a stabilized business in 2008. Now let me turn to the Philippines. After acquiring the bottling franchise in March of 2007, we committed to quickly stabilize this key market and demonstrate sequential improvement throughout 2007. Our team’s effort to seamlessly integrate and improve execution through improved availability and focus on rapid execution resulted in performance ahead of our original expectations and volume growth for the full year. We continue to invest in market capabilities and cold drink equipment while driving supply chain efficiencies. We remain confident that our management team will continue to drive growth in 2008 in the Philippines. Overall, I am very pleased with the performance of our international operations. We have a talented and experienced team of operators across the system and our bottling partners are aligned to deliver high quality, broad-based growth while investing to solidify the foundation for sustainable growth in the future. Let me now discuss the progress we are making in North America. In the fourth quarter, we achieved 1% unit case volume growth, the second consecutive quarter of growth, and we delivered on our commitment of sequential improvement in the second half of 2007. We continue to focus on revitalizing the sparkling beverage category with our three cola strategy, Red, Black and Silver. For the year, all three brands gained category share. Coca-Cola Zero continued to deliver strong double-digit unit case volume growth even after two years in the market place. Our key priorities for Coca-Cola Zero are continuing to build trial, increase awareness, and furthering channel penetration. For the second year in a row, the Coke side of life ads that were featured during the Super Bowl telecast were amongst the favorites of both media critics and viewers. It’s Mine, where the nice guy finishes first in a tussle for a Coke over the streets of Manhattan, made the top 10 list in U.S.A. Today’s ad meter and also was the most popular non-alcoholic beverage commercial out of nine beverage ads that aired during the Super Bowl event. The Glaceau acquisition continues to perform beyond our expectations as the trademark achieved triple-digit unit case volume growth in the quarter, driven by both sales velocity and increased availability. Additionally, we successfully moved distribution to a hybrid model to take advantage of the strength of our system while leveraging Glaceau’s unique [route] to market strategy. I am pleased to report that the transition to our bottlers has been successful. This acquisition has aligned our North America system and we continue to expect the acquisition to act as a catalyst for growth across our entire North American business. While we have made significant strides with our portfolio and organization in 2007, we still have much to accomplish. Overall, however, I am confident that our North America system is executing against the right priorities and we remain relentlessly committed to our goal of returning our whole market to sustainable growth. Our successes with Coca-Cola Zero, Glaceau, Powerade, Fuse, Full Throttle, Minute Maid, Simply Juices, Dasani, and our recent investment in Honest Tea, provides the business a much stronger base from which to build in 2008. Our bottling partners are aligned and the system is in an improved position to serve our customers and compete in the marketplace, even with an uncertain U.S. macroeconomic environment. Finally, I’d like to share the progress we’ve made in driving efficiency and effectiveness. As I’ve said, the results of productivity ultimately is leverage in the income statement. In 2007, we successfully achieved this in the core business, as well as in our bottling investments group. We flattened our organizations of 80 fully functional offices to 37 business units across the world. This allows us to improve the speed of decision-making and it improves our effectiveness. We executed lean productivity initiatives at our concentrate manufacturing facilities and were able to increase capacity as well as operational efficiencies. This resulted in the elimination of costs associated with the concentrate plant in Ireland. Within bottling investments, we reallocated expenses from manufacturing and production supply chain and invested in market facing roles to further drive execution in the trade. For The Coca-Cola Company, productivity remains a critical growth enabler to ensure the sustainability of our results over time. Looking forward, we see three main areas of opportunity. First, supply chain optimization, which will allow our system to maintain or enhance our gross margins and increase affordability of our product. Second, marketing and innovation effectiveness, where we optimize investments behind our brands and leverage global best practices. And third, operating efficiencies, which we use to fuel growth and build a foundation for future performance. This includes the ability to fund investments behind the highest impact innovations in products, packaging, ingredients, as well as equipment. As I look forward into 2008, part of the reason I remain confident is the result of the robust planning process we completed with our bottling partners. We have the plans in place to drive towards our ultimate goal of sustainable growth. We are focused on five strategic priorities. First, continue to drive growth from our leadership position in sparkling beverages. Sparkling beverages provides the oxygen to our business. We know there is tremendous opportunity to grow all of our sparkling products in both developed as well as emerging markets. Second, drive faster growth in our still beverage portfolio by adding new functional benefits, developing affordable formulations, pursuing strategic bolt-on acquisitions, and seeking margin enhancements. Third, continue to generate and leverage the balanced growth that we have achieved across our geographic footprint. Growth in our emerging and BRIC markets remain robust, even as headwinds are developing in the U.S. economy. In North America, our business is stronger, our bottlers continue to invest, and we are better positioned from a portfolio and operating structure basis. Fourth, accelerate the commercialization of our innovation pipeline through aggressive investments in product, ingredients, packaging, and equipment. Fifth, further strengthen our system capabilities. Consumer marketing, commercial leadership, and franchise leadership remain our core capabilities. We will continue to drive productivity across our system so that we can expedite decision making and rapidly respond to the changing marketplace. Savings extracted from these initiatives will enhance our ability to achieve consistent and sustained growth. And last but not least, leadership development is a top priority across our system, fostering even more collaboration, accountability, clarity, and calculated risk taking than ever before. Supporting all of this is our staunch belief in the health of our business, supported by the sustainability of the communities we serve. We understand that by acting as an engaged positive corporate citizen, we helped create communities of favorably disposed consumers and as those communities grow, our business continues to flourish. I am pleased with the results we achieved and the progress we made against our strategic agenda. As we enter 2008, we’ll be watching carefully with the volatility in the macroeconomic environment. From the strengthened foundation which I referred to earlier, we are better prepared to weather any potential challenges. I look forward to 2008 being another successful year for The Coca-Cola Company. Now let me turn the call over to Gary. Thank you."
},
{
"speaker": "Gary P. Fayard",
"text": "Thanks, Muhtar. Good morning. As Neville and Muhtar indicated, the fourth quarter was a solid finish to the year, where we achieved strong consistent performance in all quarters. As you saw in the release, reported earnings per share was $0.52 on a diluted basis for the fourth quarter, an increase of 79%. This included a net charge of $0.06 per share, primarily related to restructuring charges and some asset write-downs. Therefore, after considering items impacting comparability in both the current and prior year, adjusted earnings per share for the quarter was $0.58 versus $0.52 in the prior year, an increase of 12%. This is our fifth consecutive quarter of double-digit EPS growth and it’s important to note that we successfully cycled our toughest quarterly comparison, cycling double-digit growth in both ongoing operating income and earnings per share in Q4 2006, again with double-digit growth in Q4 2007. I am sure you’ve also noticed that our volume growth rate for the quarter was 5% versus our full year growth of 6%. We believe this is a very solid result. Sparkling beverages grew 4% for the quarter and for the full year. Still beverages increased 11% versus full year 12%. This quarter was impacted by a strategic decision to de-emphasize low value water in several countries, such as China, which caused volume to round down to 5% in the quarter. For the year, reported earnings per share increased 19% to $2.57. This included a net charge of $0.13 per share, primarily related to restructuring charges. After considering items impacting comparability in both years, earnings per share was $2.70 versus $2.37 in the prior year, a 14% increase. For the year, unit case volume growth was 6%, in line with concentrate sales. Revenue growth was 20% and 12% excluding structural changes related to bottler acquisitions. The increase was driven by a 6% increase in concentrate, a 4% currency benefit, and a 2% favorable impact from price and mix. After considering factors impacting comparability, operating income growth was 14% and 10% on a currency neutral basis. In terms of margins, our core business remains healthy and expanded margins for the full year as we drove top line growth and delivered operating expense leverage. Bottling investments continues to improve margins as well. Cash from operations for the year increased 20% to $7.1 billion on strong underlying business performance and a decrease in working capital. We repurchased approximately $1.75 billion of our stock for the full year, in line with our prior guidance. Additionally, the company paid $3.1 billion in dividends to shareowners in 2007. For 2007, this contributed to a 30% total return to our shareowners. Now let me address some of the factors that we see impacting the company in 2008. As you know, our long-term growth targets are 3% to 4% volume growth, 6% to 8% ongoing currency neutral operating income growth, and high-single-digit ongoing earnings per share growth. We successfully exceeded these targets in 2007. Our picture of success will be to continue to exceed these targets. We recognize that there is some uncertainty, particularly as it relates to the U.S. economy. However, as Muhtar said, we remain committed to restoring growth in our home market and believe our business is well-positioned to navigate headwinds that might develop. Emerging and BRIC markets have maintained their robust growth, even against the backdrop of uncertainty in the U.S. market, and we remain positive on the global macroeconomic outlook, especially in many of these emerging markets. As Muhtar detailed, we will continue to focus on driving efficiency and effectiveness across our organization and will utilize the realized benefits to further improve our ability to deliver consistent and sustained performance. On commodity cost, 2007 was certainly a difficult year with cost pressures from several of our key system inputs, particularly in North America. Commodity cost volatility remains a risk. However, as we said on the third quarter call, for 2008 we continue to expect to see a moderation in commodity cost pressures. Currently our assumptions on commodity cost pressures. Currently our assumptions on commodity costs versus 2007 are a slight increase for the system and essentially flat for the company. We expect to deliver operating expense leverage on both the core and bottling business in 2008 and we will continue to invest behind our brands and innovation initiatives. Additionally, selling and service expenses will increase as we invest for growth in our bottling operations as well as investments behind our brand acquisitions, particularly in North America. General and administrative expenses were tightly controlled in 2007 and we will continue our disciplined approach in 2008. We would expect net interest costs to increase for 2008 as we carry a full year of higher debt associated with our 2007 acquisitions. For 2008, our best estimate is that the full year underlying effective tax rate will be between 22% and 22.5%. From a capital expenditure standpoint, we purchased approximately $1.4 billion in net PP&E during 2007. For 2008, we expect the total company net capital expenditures will be approximately $1.6 billion to $1.7 billion as we make investments in recently acquired bottling operations. And we anticipate that our range of share repurchase on a gross basis will be $1.5 billion to $2 billion this year. Now let me move to currency. We’re effectively covered for the full year on the YEN and for the first three quarters of 2008 on the other key hard currencies. Based on anticipated benefits of current hedging coverage in place, the company expects currencies to have a minimal impact on operating income in 2008. Finally, let me say a few words about quarterly phasing. As many of you know, we report unit case volume on an average daily sales basis, kind of like same-store sales, to eliminate comparability issues due to calendar variations. For 2008, we will have one extra day, since it is a leap year. The first quarter will have one fewer day than Q107 and the fourth quarter will have two more days versus Q407. This will not impact our unit case sales reporting but will impact our concentrate sales and therefore revenues. Additionally, also remember that Easter will shift from Q2 last year into Q1 this year. Those are the topics that I wanted to cover and now we can turn it over to your questions. Operator."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Judy Hong, Goldman Sachs."
},
{
"speaker": "Judy Hong - Goldman Sachs",
"text": "Good morning, everyone. Just looking at the fourth quarter volume trends globally, you’ve talked about a bit of a slowdown sequentially. I’m just wondering how much of the decision to de-emphasize the water brand really impacted the global volume number."
},
{
"speaker": "Muhtar Kent",
"text": "Basically we had sparkling growth was both the same number for the full year as well as for the fourth quarter, and we still achieved 6% growth in sparkling in the international business. So we are very pleased with that trend. What you see is a slight slowing down of the still beverages, mainly water and that because we’ve had growth in juice, good growth in juice comparable to the full year, same as in -- also in sports, also for tea and coffee. Essentially, it’s been a de-emphasizing of the water business in big large markets, particularly in Asia, like China, as well as in Indonesia and therefore -- and mainly as a result of that category being low value for us. So it’s been a specific action on our part and we feel very confident about our business in all the categories."
},
{
"speaker": "Judy Hong - Goldman Sachs",
"text": "And just kind of following up on that in terms of just looking at just over the next 12 to 24 months and thinking about the macro outlook and you sounded still pretty positive about the macro, but just in terms of whether there are any regions or markets that may be a bit more concerning if the U.S. starts to show a bigger slowdown?"
},
{
"speaker": "Neville Isdell",
"text": "Well, Judy -- by the way, just one other on the water, just to give you a data point -- full year growth was 13%. If we take out vitamin water here, the quarter was 8%, so that gives you the metric in terms of what happened with regard to water in the fourth quarter. We don’t see there being a major impact on the emerging economies or the developing economies. There will be one or two economies in the developed world there will be housing bubbles, where we think there will be some pull-back. But balanced with that, we think the momentum that we have behind our existing brands and the new brands, the better execution, all the things that we talked about on our call are such that we are going to be able to manage what may be a half-a-percent decline at the worst in terms of overall global growth. And I think we already addressed the U.S. issue. So let me put it to you this way -- we feel we’ve really got a strong tailwind behind our business and that that is going to carry us through 2008 even as we see some areas where there will be some economic dislocation."
},
{
"speaker": "Judy Hong - Goldman Sachs",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Your next question comes from Bill Pecoriello with Morgan Stanley."
},
{
"speaker": "Bill Pecoriello - Morgan Stanley",
"text": "I was hoping to get a little bit more color on the Pacific division, which decelerated sequentially. Aside from the China water strategy, some of the other markets that you didn’t discuss in the release -- Indonesia, Korea -- if there were some reasons there for the sequential deceleration versus the prior quarters and what efforts you are doing in those markets to improve the growth. Thanks."
},
{
"speaker": "Muhtar Kent",
"text": "Essentially, Indonesia was specifically related again to a slowdown of the water, just like we mentioned for China. As far as Korea is concerned, as you know we’ve had a transition of our evolving partnership there and we are very confident that our new partnership and alignment with our new bottling partner there will take us into a modality of growth in Korea for the years to come and we are very confident about that. And there’s been a slight slowing down in the Australian economy but we feel generally confident that our business will perform in terms of its past historical trends in 2008 quarter by quarter in the Pacific."
},
{
"speaker": "Neville Isdell",
"text": "Just to pick up on Korea, I think there is a real pattern here that you’ve seen with us in terms of acquisitions. In some instances, we were able to turn it around very quickly like the Philippines. In others, there have been more in-depth reforms required. Germany would be one example of that. And we take the pain along the way and that’s really Korea. That’s the story of Korea and we are confident that we’ll see that one turning around. I think we’ve got a good track record on that and we can deliver against it."
},
{
"speaker": "Bill Pecoriello - Morgan Stanley",
"text": "And then on the bottled water, we should expect that across the four quarters as you made that decision and that would impact the following three quarters as well?"
},
{
"speaker": "Muhtar Kent",
"text": "No, I don’t believe that that will. I think that we now are in a situation where we are going into 2008 pretty clean in terms of where we want to be in the water category."
},
{
"speaker": "Bill Pecoriello - Morgan Stanley",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Your next question comes from Bryan Spillane with Bank of America."
},
{
"speaker": "Bryan Spillane - Bank of America",
"text": "A question on operating leverage; if you look at the 10% organic or currency neutral operating profit growth for the year, if you could give us a breakdown of how much of that growth was acquisitions, how much was cost savings, and then how much was underlying organic growth. And then, as we look into ’08, you’ve taken -- the company has taken over $400 million of charges over the last two years and what’s the pay-back on some of the restructuring actions? And as we look at ’08, what should we be thinking about in terms of productivity as a contributor to profit growth?"
},
{
"speaker": "Gary P. Fayard",
"text": "Okay, Bryan. We hesitated on you for a minute because as we take these questions, we’re just trying to make sure that in fact you are who you say you are."
},
{
"speaker": "Bryan Spillane - Bank of America",
"text": "I am the real deal."
},
{
"speaker": "Gary P. Fayard",
"text": "As has been experienced by a few companies over the last couple of weeks. As we look at it, let me take you through a couple of different ways. Basically if you look at currency neutral operating income, we’ve gotten about -- of the 10% growth, about 8% of that is out of the core concentrate business, about a point is out of the bottling investments group, and about a point out of acquisitions, so that’s how it comes to your 10% operating income growth currency neutral."
},
{
"speaker": "Bryan Spillane - Bank of America",
"text": "Okay."
},
{
"speaker": "Gary P. Fayard",
"text": "Relative to the charges, we in fact had within OpEx, and let me just talk about the quarter and the year, kind of the same. What we did this year, we had significant increase actually in marketing because we continue to invest behind the brands and we in fact accelerated some of that in the fourth quarter because we’ve had a really good year and we recognize that we have the flexibility to do that, to continue to drive the growth that we are seeing across all of our markets. Within sales and service it’s been up but primarily it’s been up because of the acquisitions, primarily the bottlers but you’ll see some continue to increase from that not only there but also the brands. Within G&A -- in fact, G&A in the fourth quarter on a -- if you kind of make it apples-to-apples, G&A in the fourth quarter was up 3% and 100% of that was due to incentive plans that we’ve accrued for long-term plans because we’ve actually exceeded and it’s where we want to be. Relative to restructuring charges, the biggest restructuring charges this year was really around closing a concentrate in Ireland, which will be completely closed by mid-year 2008. It was a result, as we said, from applying lean manufacturing techniques to that and we’ve been able to in fact shut down a whole plant without any increases anywhere else. We are taking though -- some of that is going to the bottom line but a lot of that we are reinvesting actually behind the brand and into innovation to really drive the sustainability of this business over the long-term."
},
{
"speaker": "Bryan Spillane - Bank of America",
"text": "So is it fair to say that the pool of productivity is going to be bigger in ’08 than it was in ’07? It’s just a matter of how much you spend back and how much you flex to the bottom line?"
},
{
"speaker": "Muhtar Kent",
"text": "I’d just like to make one comment just to build on what Gary said. You will see us relentlessly focusing across the entire organization on the effectiveness and the efficiency measures and also the programs. And we -- as we said, we’ll take some of that to create more expense leverage on the P&L and we will continue to invest for the health of our brands long-term."
},
{
"speaker": "Neville Isdell",
"text": "Bryan, just on the fourth quarter marketing spend, when I came back, I discovered that we had major markets in the fourth quarter that weren’t spending a penny. The numbers weren’t that good but they still weren’t spending a penny. We are back up at a level now where we’ve got 12 months good, solid support right behind our brands and that’s part of what you saw in the fourth quarter. So we are in good shape now going into ’08."
},
{
"speaker": "Bryan Spillane - Bank of America",
"text": "Okay, great. See you guys next week in Florida."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your next question comes from Mark Swartzberg with Stifel Nicolaus."
},
{
"speaker": "Mark Swartzberg - Stifel Nicolaus",
"text": "Thanks. Good morning, everyone. Muhtar, I was hoping on your priorities, specifically the one about accelerating still beverage growth, you could peel the onion a bit more for us there, talk a little bit about the role of existing brands in that acceleration and the role of new brands and give us some idea, if you can, about regions where you see the opportunity being bigger than other regions."
},
{
"speaker": "Muhtar Kent",
"text": "I think that, as I said, the key is organic growth, as I said in my remarks. Organic growth is the oxygen of our business and you will see us continue to drive innovation in organic growth in still beverages. I think the Minute Maid brand and the success of it in markets like China and Vietnam, Korea is a great example of that. I think you will see us -- we’ve just launched that also in India and it’s doing very, very well. You will see us focused on Glaceau internationally. You will see us certainly adding much more functionality and benefits to our still portfolio through innovation and I’d like to just highlight one thing that Neville said. We are now the leaders in juice in all four BRIC markets. That’s an incredible footprint. When you look at Brazil, when you look at Russia with our Dobriy brand. When you look at Brazil with Jugos del Valle and Suco Mais and when you look at China with the Minute Maid Pulpy across all metro markets, number one. In India with Mazaa, both in the mango category of juice as well as in the leading mango category as well as in the citrus now with our new launch, and many other emerging markets. So you will see us focus much more on organic growth. We’ve got a great portfolio and we have a great innovation pipeline that we will drive through that portfolio."
},
{
"speaker": "Mark Swartzberg - Stifel Nicolaus",
"text": "And I know it’s early but your comment on Glaceau internationally, we’ve heard your willingness to look at that since the day you announced the deal, but you’ve had maybe six, seven, eight months to test the water from a consumer buy-in or potential for buy-in in markets other than the U.S., other than North America. Have you found anything of interest there in terms of the opportunity for that brand on the other side of the world, if you will?"
},
{
"speaker": "Muhtar Kent",
"text": "You will certainly see Glaceau in international markets in the very near future. And CCE yesterday said that they will launch it in Canada in quarter two. I think you will see us in different international markets with that brand."
},
{
"speaker": "Mark Swartzberg - Stifel Nicolaus",
"text": "Okay, and the linkage between that and Powerade here in North America is notable. Is that a fair linkage to make, at least in some cases on the other side of the Atlantic and Pacific?"
},
{
"speaker": "Muhtar Kent",
"text": "Well, we have said always that Glaceau is a wonderful brand that transgresses categories and sources volume from different categories, whether it’s sports or enhanced waters or the entire active lifestyle category. So it’s a category really on its own and we believe that it will also hit the same buttons with consumers in international markets as we progress that trademark, vitamin water, into international markets."
},
{
"speaker": "Mark Swartzberg - Stifel Nicolaus",
"text": "Very good. Thank you, Muhtar."
},
{
"speaker": "Operator",
"text": "Your next question comes from John Faucher with J.P. Morgan."
},
{
"speaker": "John Faucher - J.P. Morgan",
"text": "Good morning, everyone. A quick question on Japan; it looks as though the fourth quarter of this year was only about the second positive volume number on a positive comp in the past couple of years, the last being last year’s Q4. So can you talk a little bit about the ability to sustain that? What level of operating profit you’ve been delivering in Japan on a currency neutral basis over the past year or so and can you keep the volume positive while maybe needing to accelerate the operating profit growth there over the next couple of years? Thanks."
},
{
"speaker": "Muhtar Kent",
"text": "I have said that clearly our target was to stabilize Japan and we have done that in 2008 and we have consecutively -- in 2007 and we have consecutively delivered quarter after quarter growth. We are now in a much more normalized position in Japan, so you will see us delivering between 1% and 3% growth over the years. That’s our target. That’s basically how we see the picture of success. We expect modest profit growth in Japan. Importantly also, as we have stabilized Japan in 2007 and from the end of 2006 and into 2007, what we see now also is that our bottlers, our bottling partners are in a much more strengthened position. Their willingness to invest in the marketplace is much more and I think that you are seeing one of the key categories in Japan -- one of the also important things in Japan in 2007 was that we had growth in two of the key channels, both in the vending channel as well as in the supermarket channel and the vending channel, of course, as you know, is a very highly profitable important channel and our bottler’s willingness to continue to invest will drive further growth in that channel is our belief."
},
{
"speaker": "John Faucher - J.P. Morgan",
"text": "Okay, so what it sounds as though your levels of incremental investment over the past couple of years, it sounds like you kind of -- you feel like you’ve normalized the margins maybe there and we should see a more normalized growth rate going forward. Is that the right way to look at it?"
},
{
"speaker": "Muhtar Kent",
"text": "As I said, we’ve stabilized the business and we are looking for a more normalized growth rate in Japan going forward and we believe also that we’ve strengthened our brands in all the categories. Sparkling notably in 2007 was a key category that has grown, particularly the trademark Coca-Cola, very pleased double-digit growth, the highest in 30 years. The tea category is also growing and very healthy in terms of our brand, as well as Aquarius and as I mentioned in the call, we’ve also had a growth in Georgia Coffee in the fourth quarter of 2007."
},
{
"speaker": "John Faucher - J.P. Morgan",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Your next question comes from Carlos Laboy with Credit Suisse."
},
{
"speaker": "Carlos Laboy - Credit Suisse",
"text": "My question relates to some of these bottling JVs. You now have a growing collection of these non-carb JVs building around the world. Do you see more of these in the future and could you speak to some of the benefits and challenges of these arrangements and how they might affect your bottling relationships?"
},
{
"speaker": "Muhtar Kent",
"text": "First, let me just say that we are very pleased at where our bottling relationships are, in terms of how we are aligned, how we are planning together in joint force and how we see the future and the picture of success jointly together. It’s a very simple reason why we have these JVs, because we believe that the categories that we have these JVs in are much better suited to be operated through these JVs, like we have now formed in Latin America for our juice acquisition and like the ones that we have in Europe and it basically creates the focus, it creates the scale, and it creates the economics that deal properly with the categories and allows the bottling partners and us to focus on how we build that business together."
},
{
"speaker": "Carlos Laboy - Credit Suisse",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Christine Farkas with Merrill Lynch."
},
{
"speaker": "Christine Farkas - Merrill Lynch",
"text": "Thank you very much. Good morning. Gary, I have a question for you regarding your buy-back plans for 2008. You’ve indicated similar levels in ’08 to 2007, which was under my impression pulled back based on your acquisition of Glaceau. Can you help us understand, given that your cash flows can allow a larger buy-back, what’s going into that consideration? I understand CCE’s plans for buy-back. Perhaps there are other considerations there. Can you help us understand why that level is where it is for ’08?"
},
{
"speaker": "Gary P. Fayard",
"text": "Sure, or at least I’ll try. Let me go through that. First, as we look at it, as you look at the credit markets and the volatility there and with some modest increase of debt levels, we think it’s prudent at this point to be somewhat conservative in some of our financial policies and therefore with what we are looking at, as well as maintaining credit ratings for the system, we think the $1.5 billion to $2 billion is a pretty good place to start the year. I think it’s important as we go through the year, we’ll update you on that. The share repurchase that was announced by CCE yesterday is also very modest. Really dealing with kind of trying to keep their share count kind of flat, so a pretty modest share repurchase program. So I would say -- I would sum it up probably as we’ll be a little cautious just because of volatility in the markets but stay tuned and we’ll update you as we go through the year, and because the credit ratings are pretty important to us as well."
},
{
"speaker": "Christine Farkas - Merrill Lynch",
"text": "Well, the CCE program is modest. Would you anticipate participating in that to maintain your stake?"
},
{
"speaker": "Gary P. Fayard",
"text": "No, I think -- I mean, that will just be arms length where they are just going into the market, I would think."
},
{
"speaker": "Christine Farkas - Merrill Lynch",
"text": "Okay, great, and just on the back of acquisitions, can you tell us how much Glaceau contributed to your North American volumes in the quarter?"
},
{
"speaker": "Gary P. Fayard",
"text": "About two points."
},
{
"speaker": "Christine Farkas - Merrill Lynch",
"text": "Great. Thanks, Gary."
},
{
"speaker": "Ann Taylor",
"text": "Operator, we have time for one more question."
},
{
"speaker": "Operator",
"text": "Your last question comes from Justin Hott with Bear Stearns."
},
{
"speaker": "Justin Hott - Bear Stearns",
"text": "Thanks. On Glaceau, CCE yesterday mentioned that they might have been a little bit slower in promotional activity in the fourth quarter due to I guess the transition there. Would it be fair to say that CCE is ramping up that Glaceau can even accelerate its great growth? And also, if you could just give us, since it’s the last question, some comments on CoBos and where you stand with some of them around the world, your plans there. Thanks."
},
{
"speaker": "Muhtar Kent",
"text": "Was the last question on CoBos? Okay, just let me give you the answer on Glaceau. It’s absolutely it was related to the transition and it’s back on a normalized sequence now in terms of our promotional calendar. And what you’ve seen is that we’ve had very good progressive increases as we’ve transitioned the distribution, bottler distribution into our bottlers, an increase in supermarkets for distribution as well as in convenience stores for both vitamin water, smart water, as well as vitamin energy. So all of the components are working very well for us as we’ve moved into a normalized fashion. And as far as the CoBos are concerned, as we’ve said to you before, we will continue to look at opportunities in our ownerships and where we see some opportunities for divestiture, we will. And you’ve heard Neville mention our BIG as a hospital ward and we’re very happy with the performance of our BIG group but over time, you will see us taking some more on board and divesting some."
},
{
"speaker": "Justin Hott - Bear Stearns",
"text": "Thanks."
},
{
"speaker": "Neville Isdell",
"text": "Thank you, Muhtar and Gary. Just to wrap up, and also thanks to each one of you for joining us this morning. So now we’re in 2008 and it’s the next step on our journey. I am confident that we’ve laid a solid foundation on which to build in 2008 and we remain I assure you resolute about delivering against our strategic agenda this year as we did in ‘07. We’ll continue to leverage our leading brands, our global footprint, and our strategic acquisitions. You’re going to see us building also on our innovation pipeline, which we didn’t talk a lot about today, and all the while driving efficiency to deliver sustainable growth and shareowner value. Thank you very much indeed."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes The Coca-Cola Company’s fourth quarter 2007 earnings results conference call. Thank you for your participation. You may now disconnect."
}
] | null | null |
KO | 3 | 2,007 | 2007-10-17 08:30:00 | Executives: Ann Taylor - IR Neville Isdell – Chairman, CEO Muhtar Kent –President, COO Gary Fayard - CFO
Analysts: Christine Farkas - Merrill Lynch Kaumil Gajrawala - UBS John Faucher – JP Morgan Bonnie Herzog - Citigroup Bill Pecoriello - Morgan Stanley Mark Swartzberg - Stifel Nicolaus Lauren Torres - HSBC Bryan Spillane - Banc of AmericaSecurities
Operator: I would like to welcome everyone to the Coca-Cola Company'sthird quarter 2007 earnings results conference call. (Operator Instructions) Iwould like to now introduce Ann Taylor, Vice President and Director of InvestorRelations.
Ann Taylor: Good morning, and thank you for being with us today. I amjoined by Neville Isdell, our Chairman and Chief Executive Officer; MuhtarKent, our President and Chief Operating Officer; and Gary Fayard, our ChiefFinancial Officer. Following prepared remarksthis morning, we will turn the call over for your questions. Before we get started, I would like to remind you that thisconference call may contain forward-looking statements, including statementsconcerning long-term earnings objectives and should be considered inconjunction with cautionary statements contained in our earnings release and inthe company's most recent SEC report. In addition, I would also like to note that we have postedschedules on our company website at theCocaColaCompany.com under the financialinformation tab in the investor section, which reconciles our results asreported under Generally Accepted Accounting Principals to certain non-GAAPmeasures which may be referred to by our senior executives in our discussionthis morning, and from time to time in discussing our financial performance.Please look on our website for this information. Now let me turn the call over to Neville.
Neville Isdell: Thank you, Ann and good morning, everyone. I will start thismorning with just a few brief observations about the third quarter results, andthen Muhtar will provide details on operational performance and Garywill follow with an overview of the financials. Today we report another quarter of solid business results.The strength of our brand portfolio, the breadth of our global system and theculture of winning increasingly exhibited by our talented people right acrossthe company and the system continue to drive our business forward. Theinvestments that we have made in our brands, our early and continued focus onrevitalizing the culture through our manifesto for growth, and our commitmenttogether with our bottling partners to re-energize our marketing and improveoperational execution are all working. They are driving high quality, balancedgrowth in volume, revenues, profits and cash flow. This is the third consecutive quarter in which we haveachieved 6% global unit case growth. Notably, this is our tenth consecutivequarter of delivering at least 4% volume growth, and top line growth continuesto be robust, reflecting our ability to capture the highest value opportunitiesacross the whole non-alcoholic, ready to drink industry. Revenues increased 19% in the quarter. Now the acquisitionof bottlers contributed about 8 points of this growth, so even excluding thisimpact, revenues grew a very strong 11%, demonstrating the success of thecontinued system-wide focus on revenue growth management and segmentedexecution strategies. We delivered our fourth consecutive quarter of double-digitcomparable EPS growth, up 15% versus the prior year. Ongoing operating incomefor the quarter increased 12%, and year-to-date increased 13%. Cash fromoperations for the quarter increased 18% on solid underlying businessperformance. Importantly, our focus on productivity is resulting inoperating expense leverage for our core business. Our effective management ofcommodity cost pressures is also reflected in the results. Our international operations again led the way, posting unitcase volume growth of 8%, and once again driving strong top line performance. Thegrowth continues to be sourced from both developed and emerging markets. Allinternational operating groups, with the exception of the European Union --which as anticipated had a challenging prior year quarter this cycle --delivered strong growth. We're also on track with our plans for North America, which recorded sequential volume improvement. In North America, I would like to highlight the continued execution of ourthree cola strategy; in particular, Coca-Cola Zero, and also our ability todrive our still portfolio, which now of course includes Glacau. In terms of our global portfolio performance, we achievedcontinued volume growth in sparkling beverages, while expanding our footprintand enhancing our offerings in still beverages. Today we're reporting anincrease of 4% in sparkling beverages. Within sparkling, continued emphasis onour three cola strategy resulted in 4% global growth in trademark Coca-Cola. Coke Zero, now launched in 51 countries, continues to drivethe expansion of the sparkling category and gain share. Given the strong repeatrates for Coca-Cola Zero, we're focused on driving trial via sampling programsto continue to recruit new consumers and retain core Coca-Cola drinkers withreal Coca-Cola taste and zero sugar and calories. In still beverages, globally strong performance from ourwater portfolio, but also from POWERade and Minute Maid led to a 14% increase.This solid growth across the portfolio resulted in our gaining non-alcoholic readyto drink volume and value share globally, driven by share increases insparkling and still beverages, both internationally and importantly in NorthAmerica. I would note that value share is growing faster than volume share, aswe focused on the highest value opportunities. Overall therefore I am very pleased with the strongperformance in the quarter and year-to-date. As we enter the final quarter ofthe year, we will continue to leverage our leading brands, our globalfootprint, and our strategic acquisitions. We'll build our innovation pipelineand all the while driving productivity to continue to deliver sustainablegrowth and shareholder value. Now let me turn the call over to Muhtar to provide thedetails.
Muhtar Kent: Thank you, Neville, and good morning, everyone. Overall,this was another strong quarter for the Coca-Cola Company, both financially andstrategically. Importantly, we continued to deliver on our commitment. Weachieved balanced geographic and portfolio growth, further solidifying ourfoundation for sustainable, long-term performance. Our international operations continue to drive results forthe company through the strength of our bottling system and the power of ourbrands around the world. The aggressive actions we continue to take to restoregrowth in North America are starting to bear fruit. Oursystem-wide productivity efforts are allowing us to focus on driving top linegrowth and creating operating expense leverage. Finally, we continue to pushthe envelope with innovation in product, packaging, delivery and customerservice. Today I would like to share with you details on our progressthis quarter, and add some perspective for the remainder of the year. Even witha very strong third quarter of 2006 to cycle in Europe,our international operations increased unit volume by 8% for the quarter,following our 9% growth in the first half of the year. Broad-based growthacross each of our international operating groups has enabled year-to-date volumegrowth of 6%. This speaks to the power of our global reach and the executioncapabilities of our bottling partners. Volume growth in our international operations was once againled by the emerging markets. We achieved double-digit growth in such markets asChina, Russia,India, Brazil,Turkey, the Philippines,Pakistan, Eastern Europe and Southern Eurasia. Africaalso experienced solid growth across all business units. Additionally, weexperienced robust growth across Latin America. Mexicodelivered 7% growth in the quarter, a particularly strong performancereflecting the success of our strategies to drive growth in sparkling beveragesled by Trademark Coca-Cola. While it is clear that we're maintaining our focus andwinning internationally, there are a few key markets that I would like tohighlight where best practice sharing is leading to world class execution. In China,we once again achieved double-digit growth this quarter. We are aggressivelyand strategically investing in our infrastructure and our route to marketinitiatives to continuously adopt to a rapidly changing marketplace.Year-to-date we have activated over 120,000 outlets, placed approximately175,000 new coolers and we surpassed the 1 billion cases sold benchmark earlierthan any other year in our history. Sprite in Chinacontinues to perform exceptionally well, growing nearly 30% in the quarter andyear-to-date. As we start the one year countdown to the Beijingsummer Olympics, our focus will be on leveraging our leading brands to become astaple in the local communities and ensuring our full portfolio is readilyavailable in every outlet. Let me turn now to the Philippines,where our efforts have led to improved execution and seamless integration.After two quarters of managing the bottling operations, our double-digit volumegrowth is ahead of our expectations. We have a first-class management team inplace that has a deep commitment to, and understanding of, the marketplace. Weare investing in the market there, adding 2,000 additional front end salesforceassociates, while driving supply chain efficiency. Next in India,strong double-digit volume growth reflects the benefits of the initiatives weput in place in 2006 to rebuild the fundamentals of the franchise. Our marketinginitiatives continue to gain traction, supported by improvements andinvestments made in the bottling operations, including a specific focus on theright route to market, supply chain and people capability. As a result, werecorded share gains in the quarter for both sparkling beverages led byTrademark Coca-Cola, as well as still beverages led by our juice brands. Russiais another example of how we're working with our bottling partner to invest ina market with tremendous opportunity and growth potential. The Multon juicebusiness, including the leading Dobriy brand, continues to provide a solidplatform for growth in our still beverages. Also during the quarter, ourbottler demonstrated a commitment to this market by expanding capacity with theacquisition of a brand new plant. Japandelivered another solid performance in the quarter. The team there iseffectively executing our strategy of leveraging our core brands, particularlyTrademark Coca-Cola, to drive progress. Overall in the quarter, we gained sharein non-alcoholic ready to drink beverages, a validation that our strategy isworking. In the quarter, we delivered more than 4% increase in unitcase volume, our fourth consecutive quarter of growth, with August andSeptember achieving record breaking sales levels; performance driven by trademarkCoca-Cola with year-to-date volume growth at its highest growth rate in 30years. From a marketing perspective the Coke Side of Life campaignand promotion behind Coke Zero are having measurable success. Year-to-date, wehave attracted nearly 5 million new drinkers to the trademark versus the prioryear. We also leveraged our successful work that we have underwayin Europe linking Coke and iTunes by launching a similarprogram in Japanthat utilizes all brands and packages. Our still beverage portfolio in Japangrew in the quarter as well. Sokenbicha Tea, Aquarius sports drink and both ofour water brands drove the results with each gaining share. While the favorable warm weather benefited most areas of ourbusiness, it did have an adverse effect on the coffee category. Results from GeorgiaCoffee in the quarter were disappointing, as gains in the recently introducedVintage label did not fully offset declines in other flavors. We remain focusedon driving growth in the coffee category through innovation, new promotions andcontinued marketing investments behind the brand. We have gained significant traction in Japanand it is reflected in the year-to-date results. But we do recognize we stillhave more work to do. As expected, the European Union faced difficult 2006comparables that had benefited from World Cup activation and acquisition. Inthe current quarter, solid unit case volume growth in Central and Southern Europe was offset by a volume decline in Western Europe,resulting from unfavorable summer weather across Western Europeand the difficult cycling. I am satisfied that we have the right strategies inplace and the initiatives taken by the EU leadership team over the last twoyears have built a solid foundation for balanced, sustainable, long-term growthin Europe. Year-to-date, volumes in the EU have increased 4%. For thethird quarter, after removing the impact of acquisitions, the two-year compoundorganic growth rate is 2%. The performance of both our sparkling beverages andthe ongoing expansion of our still footprint are two strong indicators of theimprovements we have made. Additionally, as a result of our successful programs, we'veoutperformed the industry in the quarter and year-to-date across the EU. Wehave made broad improvements in sparkling beverages through innovation andtargeted execution led by the implementation of our three cola strategy and thesuccess of Coke Zero. The roll-out strategy has delivered year-to-date trademarkCoca-Cola growth of 3% and Coke Zero, which is now available in Europein 20 countries, has become approximately a 3 share brand across the EU, andhas achieved as high as an 8 share in markets like Denmarkand Greece.That is a direct result of the close alignments we have with our bottlingpartners as we execute this key strategy. Additionally, we are driving expansion of our still platformacross Europe, both organically and throughacquisitions. Minute Maid, along with Nestea, Aquarius, POWERade and Burn, allachieved growth year-to-date driving still category share gain. In Germany,we had a particularly challenging quarter this cycle as we achieved volumegrowth of 15% in the third quarter of 2006. While volume was down in Germanyfor the quarter, during the year we've been able to stabilize share performanceand we continue to make progress in executing our plans for long-term growth. We also continue to improve channel penetration as webroaden our offerings to discounters, enhancing our position in a growingchannel where we have historically been under-represented. Also during thequarter, we finalized an agreement to consolidate the German bottlers. Ourfocus has now turned to improving our speed and flexibility with our customers andover time, driving supply chain efficiency. Overall, I am very pleased with the performance of ourinternational operations and our operators continue to deliver high quality,broad-based growth while maintaining investments to solidify the foundation forsustainable growth in the future. Let me now discuss the progress we're making in North America. In the quarter, we achieved 1% unit case volume growth,the first quarter of growth in five quarters. While this reflects the benefitof acquisitions and an improved trend in sparkling beverages, we are notsatisfied with our performance. However, I am confident that our North America system is executing against the right priorities and isfully committed to restoring sustainable growth in our home market. We continueto focus on revitalizing the sparkling beverage strategy with our three colastrategy: Red, Black and Silver. Coca-Cola Zero, which achieved a 1.3 share in the quarter,delivered strong double-digit unit case volume growth and along with Diet Coke,drove sparkling category share gains in the quarter. We believe there is stillsignificant opportunity for increased awareness and penetration for Coke Zero. Building on our success in Asia and Latin America, we introduced the new contour grip bottle in the U.S.for all three cola brands. While only launched in early September, we havealready achieved approximately 75% availability. The new bottle not only allowsus to further leverage our iconic image, but the package also contains 5% lessweight than the prior 20-ounce bottle, reducing our carbon footprint andmanufacturing cost. This is just the first of many exciting package innovationsthat we'll be pilot testing in different North America markets over the comingmonths. The Glacau acquisition continues to perform ahead of ourexpectations as we have been able to leverage the strength of the system whilemaintaining the culture and innovation capabilities of the Glacau team. In thequarter, brand growth continued to accelerate, driven by both sales velocityand increased availability. We expect Glacau to continue to be a catalyst fordriving growth across the entire North America business. Last quarter, I mentioned that we were working with ourbottlers and distribution partners to develop a hybrid operating model thatwould take advantage of the strength of the system and leverage existing routesto market. As we announced during the quarter, I am pleased to report that wehave finalized an agreement with nearly 100% of our U.S.bottlers on this front. This is real progress and speaks to the effectivealignment with our North America bottling partners. Webelieve the new operating model will benefit our system, will bring value toour customers and will deliver attractive returns to our share owners. Duringthe fourth quarter, we will be working to ensure seamless transition to thisnew operating model. Additionally, as part of the agreement, we gained brandalignment for the next three years and agreed on our 2008 business planpriority. Overall, we remain relentlessly committed to our goal ofre-energizing our business in North America and becomingthe preferred beverage partner for our customers. In the fourth quarter, wewill continue to expect sequential improvement and further evidence of ourprogress as we execute against our key priorities. Finally, I would like to discuss some of the initialprogress we have made in driving productivity to improve margin performance.Our objective is simple: improve our speed of execution and drive operatingexpense leverage. When we organize around our three pillars, namely consumermarketing, customer leadership and franchise leadership, not only do we driveour top line growth, but we improve efficiencies as well. After successfully delayering our international operationsduring the first half of the year, we transitioned the process to North America. Central to the new operating framework in North America is the creation of three business units: sparklingbeverages, still beverages and emerging brands, along with Glacau. To support our consumer leadership pillar, the new modeldefines roles in the organization and allows for greater clarity andaccountability for our priorities. As a result, we will be better equipped as atotal organization and as individual managers to win the marketplace and toclaim leadership with consumers, customers and bottlers. In terms of the supply chain, we have made several initialsteps across the organization. As I mentioned earlier, as part of ourrestructuring in the Philippinesbottling operations, we're investing to grow our front end sales force by morethan 2,000 people as we take cost out of our supply chain to fund additionalcustomer-facing roles. Additionally, we announced initiatives to driveproductivity in our Irish concentrate operations, resulting in our plan toclose one of our concentrate plants. By executing lean productivityinitiatives, we were able to increase the capacity of our remaining twoconcentrate plants and remove the cost associated with the third plant. Efforts are underway to drive cost savings throughingredient and packaging harmonization, along with projects to optimizeprocesses for the most efficient production of our product. Ultimately, we are building a productivity-based culturewhere employees feel engaged in the process. We are changing behavior acrossthe system and making productivity a core part of the way we approach ourbusiness every single day. As we reinvigorate the organization and realize theproductivity gains, we will selectively reinvest behind our three pillars todrive further top line growth. In summary, I am very pleased with these results whichvalidate the progress we are making against our strategic agenda. Theconsistent, balanced results we are achieving are a culmination of the entiresystem working together seamlessly, which has been a key focus for us and isessential to our long-term success. The foundation for sustainable growth isbuilt and I'm confident that we will continue to deliver on our promises andcreate long-term value for our share owners. Now let me turn the call over to Gary.
Gary Fayard: Thanks, Muhtar andgood morning, everyone. As Neville and Muhtar indicated, we delivered anotherquarter of strong financial results. As you saw in the release, we reportedearnings per share of $0.71 on a diluted basis for the third quarter, anincrease of 15%. This included a net charge of $0.03 per share, primarilyrelated to restructuring charges, which was offset by a $0.03 per share gain,primarily related to the sale of a portion of our investment in Coca-ColaAmatil. Therefore, after considering items impacting comparabilityin both the current and prior year, adjusted EPS for the quarter andyear-to-date increased 15%. In addition, we lowered our expected underlying effectivetax rate on operations for 2007 to 22% from the previous estimate of 22.5% tobring the effective tax rate for the year in line with the current estimate, werecorded income tax expense at a rate of approximately 21.7% in the thirdquarter, which resulted in a tax benefit of $0.01 for the quarter. For 2008, weexpect the underlying effective tax rate to be between 22% and 22.5%. Net revenue in the quarter increased 19%, which included an8% benefit from structural changes related to our acquisition of bottlers.Excluding the impact of these bottler acquisitions, revenue growth was 11%,driven by 6% increase in concentrate sales, a 1% benefit from price mix and a4% increase from currency. Price mix benefit on the core concentrate business waspositive in the low single-digits. However, this was partially offset bybottling investments, primarily due to the volume decline in Germany. We grew operating income by 10% on a reported basis. Afterconsidering factors impacting comparability in the current and prior years,operating income increased 12%, which includes a 3% benefit from currency. Soon an ongoing currency neutral basis, we grew operating income 9%. SG&A increased 16% in the quarter, so let me take aminute to walk you through the increase. About 12 points of the increase weredue to currency bottler acquisitions and increased selling and service expensesin our consolidated bottling operations, and behind acquired brands as weinvested for growth. The remaining 4 points reflect continued solid investmentbehind our brands, and similar to our year-to-date results, G&A expensesincreased low single-digits, reflecting the early results of our productivityinitiatives and disciplined expense management. So while the quarter's reported operating margins are 23.8%,this includes a significant impact due to the lower margin bottling operations,including the recent bottler acquisitions. Underlying margins on the corebusiness remain healthy as we drive top line growth and deliver operatingexpense leverage. We repurchased $1.6 billion of our stock year-to-date and westill expect to repurchase a total of $1.75 billion to $2 billion for the fullyear 2007. Cash from operations year-to-date increased 18% on strongunderlying business performance and a decrease in working capital, primarily asa result of cycling the higher net taxes paid in 2006 related to therepatriation of foreign earnings from 2005. Now let me address some of the factors that we see impactingthe remainder of 2007. We recognize that there is some uncertainty as itrelates to the U.S.economy. However, as Muhtar said, we remain committed to restoring growth inour home market. We continue to expect sequential improvement in our North America performance as we finish out 2007. We also remain positive on the global macroeconomic outlook,especially in many of our emerging markets. We will continue to manage ourcountry portfolio as we expect solid performance in most of our markets. We feelconfident in our progress and have built a solid foundation strategically,operationally and financially as we finish out the year. Given the recent focus on commodity cost, I would like toprovide you with some insight into our point of view. In 2007 we have seenheadwinds across several key input costs. Globally, we have seen significantincreases in orange juice cost which we have effectively managed. The resulthas been year-to-date, mid single-digit unit case volume growth in our juiceand juice drink brands, while driving volume and value share globally. The other significant commodity cost increases in 2007 havebeen in corn sweetener and aluminum, which was primarily impacting the North America bottling system and has been reflected in retail pricing.However, we are starting to see a moderation in commodity cost impactingbeverage companies, both globally and in North America,and we believe the worst is behind us. While commodity cost volatility remainsa risk, our current assumption is that commodity costs overall for the systemin 2008 will be essentially flat with 2007. For the company, we expectcommodity cost to be flat to down slightly versus 2007. From a capital expenditure standpoint, as we stated lastquarter, we expect total company net capital expenditures for this year to bein the range of $1.5 billion to $1.6 billion as we make investments in recentlyacquired bottling operations. Now let me move to currency. As I mentioned, we saw apositive impact from currencies for the quarter on operating income of 3%.Benefits from the euro, Brazilreal and sterling are being partially offset by weakness in the yen. We areeffectively covered for the full year on the yen and the euro. Based on currentspot rates and the expected impact of the coverage in place, we expect a midsingle-digit favorable impact of currency on the fourth quarter results. We're in the process of finalizing our 2008 business plan,so we'll provide our outlook for 2008 on our year end call in February. That'sit for the topics I wanted to cover this morning, so we can now turn it overfor your questions.
Operator: Your first question comes from Christine Farkas - MerrillLynch.
Christine Farkas - Merrill Lynch: Can you quantify at all how much Glacau Infused added interms of basis points to your growth? In the past, water had been a drag interms of the larger volumes. Is that now cycling itself and no longer a factor?Thank you.
Muhtar Kent: Certainly we have had a very, very good solid performancewith Glacau. It added about 2 points overall. In terms of the bottom line, actually, we are very pleasedwith the North America performance, even without Glacau, it still had adouble-digit growth in the quarter. So that's basically how I would phrasethat.
Christine Farkas - Merrill Lynch: And in terms of thewater?
Muhtar Kent: Water, I think we're pretty much through the cycling.There's still a little bit of impact but nothing like in the first twoquarters.
Operator: Your next question comes from Kaumil Gajrawala - UBS.
Kaumil Gajrawala - UBS: Can you talk a little bit about productivity, and if any ofthat will fall to the bottom-line?
Neville Isdell: Well, it clearly already is, because we had 1 point ofoperating leverage if you go down to the core business this quarter. Muhtarfocused on the really consistent drive that we have with regard to creating amuch more effective, a much more efficient system. You are going to see thatcontinuing, and it will evidence itself obviously in operating leverage, but itwill also allow us, where we selectively choose to do it, to invest behind thebrands and invest in terms of top line growth. You see that virtuous cycle actually in this quarter, wherewe've got the operating leverage, we have reinvested behind the brands and thatcontinuing investment behind the brands drives the top line growth. That's thebalance that we'll continue to strike and we certainly see that continuinggoing forward.
Operator: Your next question comes from John Faucher – JP Morgan.
John Faucher - JP Morgan: You talked about the flattish commodity cost as we head into2008. The question is, how does that impact your feeling on concentratepricing, given the fact that particularly with CC you took less net concentratepricing in 2007 because of the commodity environment?
Neville Isdell: John, we're still obviously in our budget cycle and wehaven't finalized that at this point in time, so it's premature to speculate onthat. However, I would go back to the broader statements that I've made in thepast and that is that we will be increasing concentrate around about inflation,or slightly less. And also reflecting on the fact that as you look at thehealth of the overall bottling system and the recalibration that we have had todo really over the last seven or eight years, that we now have a very healthysystem so a more normal situation will prevail into the future. But it is tooearly for me to give you any real guidance on that for '08.
Operator: Your next question comes from Bonnie Herzog - Citigroup.
Bonnie Herzog - Citigroup: Unit case volume growth that you've reported this quarter,since your total worldwide volume growth you mentioned was up 6% and that wascertainly led by the international unit case volume growth which was up 8%, Ibelieve you mentioned North America was up 1%. I am quite frankly just simply trying to dothe math and understand how that works or where do I exclude the acquisition?
Muhtar Kent: We may have missed justthe beginning of your question, Bonnie, because there was interruption in the line. Tell me ifI haven't answered it properly. Internationally, as you said, we've grown 8%and in terms of both international as well as U.S.volume we're increasing still beverages double digits in both international aswell as in our North American operations. Overall, international we've grown 8%and in the U.S.we've grown overall 1%; that generates the average of 6% globally in thequarter.
Bonnie Herzog - Citigroup: I think you may haveanswered it. You're right, I just was trying to make sure I understood the mathcorrectly, Muhtar, because what you just stated, worldwide is up 6%,international is up 8% and North America is up 1%.
Muhtar Kent: That's right. And in both operations we've increased stillbeverages double-digit growth in both international and North America.
Neville Isdell: Bonnie, just to the other part of your question is how muchof that is acquisition? It's actually 1% on a global basis and 2% for North America. So the underlying North America is1, which is what you're looking for, I think, the plus 1%. Global is plus 6%and plus 5% if you exclude acquisitions.
Operator: Your next questionwill come from the line of Bill Pecoriello - Morgan Stanley.
Bill Pecoriello - Morgan Stanley: Good morning, everybody. On North Americaas you're looking out to '08, do you see most of the focus on the integrationand continuing the momentum behind Glacau, which is going to be a bigundertaking for the system, or do you also see a strong innovation pipeline andefforts to improve the core sparkling business? You had had mentioned in thepast leveraging Glacau benefits to re-energize the core and you brieflymentioned some package innovation in your prepared comments.
Muhtar Kent: Certainly Glacau is going to be a very important catalystfor sustainable growth in North America, and really,this new agreement is really a milestone with our bottling partners. Almostunanimous agreement with our bottling partners going forward, which iscompletely in line with our three key goals, which is leading growth insparkling beverages led by Trademark Coca-Cola, delivering our fastest volumegrowth in the still portfolio for North America; and being the preferred partnerfor our customers. What this agreement has done is aligned our 2008 businessplan agreement and it's given us agreement on brand alignment, veryimportantly, for the next three years and it's also had very important impacton capability assessments going forward for reinvestment into our totalbusiness in the United States. Now having said that, our key focus is still to stabilizeand regenerate growth in sparkling beverages and you'll see us innovating bothfrom a package point of view and our three cola strategy is really workingwell, driving growth in the diet category and sparkling beverages and we willcontinue to focus on that. We will also certainly be coming out with a lot ofinnovation in packaging in also sales equipment as we move forward. A key focuson the point of sale going forward in the United States with our bottling partners wherewe're fully aligned for Q4 onwards.
Gary Fayard: One other thing Iwould add, Bill, that I think gives us a lot of confidence in our statementsaround sequential improvement and winning in our home market is we have talkedabout in the past that we've been doing some tests around segmented executionand really ramping up those capabilities. One of those is in Philadelphia.We've seen the results of that coming through this year and in fact in thequarter Philadelphia was positivein volume terms in sparkling. We know what we can do and have great confidencethat the entire bottler system can now execute behind what we're seeing andreally continue to improve our North America business.
Bill Pecoriello - Morgan Stanley: Great. So on that,you plan to take the learnings from Philadelphiaand extrapolate that out to the balance of the system?
Neville Isdell: Yes, we certainly do. We have many plans around leveragingthe best practice out of markets like Philadelphia,as well as some other markets and drive that through across the system with akey focus, as I said, on execution at the point of sale and driving packaginginnovation at the point of sale. Just to give you the example of the grip bottle, which hasbeen a really important addition to our packing portfolio in the United States, it's already in 50 internationalmarkets and it's driving results across trademark Coca-Cola in all the markets thatit's been introduced and it's achieved about 75% availability already.
Operator: Your next question comes from Mark Swartzberg - StifelNicolaus.
Mark Swartzberg - Stifel Nicolaus: If you step back and look at the volume that this companyhas been producing, compared to what it might produce over the next year or so,if you take a mathematical view you could just say the compares are gettingtougher. If you take a qualitative view, you could say the momentum is reallypicking up here. What in your mind, if you had to rank the key drivers of nomaterial slowdown and unit volume growth where we assuming you're managing themix as well as you have been, what in your mind ranks at the top here?
Neville Isdell: Mark, I wouldactually say consistency, execution and partnership with the global bottlers. Fromday one I have talked about executing for the long term and that that thenbuilds a momentum of its own. I also have said that don't judge us quarter byquarter, judge us over a period of time, because we will certainly havedifficult quarters. That happens. Now, cycling the summer of '06 in Europe, wemanaged to be able to do that because of the strength of the rest of ourportfolio. You may recall that didn't occur when there was a very bad summer inEurope in '04, cycling a very strong summer in '03. So Ithink that underscores the fact that we have momentum and that momentum isgoing to continue. It is broad-based. It is based on sparkling and the completereinvigoration that we have of the sparkling category. Muhtar has outlinedwhere we are with regard to that in North America andhow he feels that there will certainly be a recovery and we will have anabsence of the headwinds with regard to the cost pressures that we experiencedin '07 and '08 as well. So I would really use the words consistency and continuingexecution, execution, execution. In a way, it's steady as she goes. There isnothing new we are going to say about a new initiative, it's all of the keydrivers of growth that we're going to continue to execute much better as we goforward and I think you see that happening with this management team as it hascome together very successfully.
Mark Swartzberg - Stifel Nicolaus: Coke Zero, you've got a level of detail globally we don'thave. The same question, obviously it's been an important contributor to growthbut there's real buy-in at the consumer level there. How do you think aboutthat brand as either a risk in terms of lapping or really continuing to act asa driver of growth?
Neville Isdell: I'll give you aheadline and let Muhtar give you some granularity. Every piece of evidence wehave is that that growth continues as we lap very successful launches.
Muhtar Kent: We are now in more than 50 countries. By the end of the yearit will be close to 60 interms of launches. Everywhere, whether broad-based Asia,Latin America, Eurasia, Europeand North America, everywhere the brand is performingtremendously well, high double-digits. But I'll give you one piece of statisticthat may help you. If you take the total global Diet Coca-Cola and Coca-ColaZero volume, we have a double-digit growth versus prior year. The importantthing is that in most, in almost all markets Coca-Cola Zero drives a substantialamount of incremental volume. Of course, there is some cannibalization. But if you takethe two in terms of Coca-Cola Zero as well as Diet Coca-Cola and add the twotogether versus prior year, right now we have double-digits and very highrepeat and high velocity in all markets. So we expect this momentum to continuegoing forward and you can see that from our business where we're lapping,there's still tremendous velocity in the brand and horizontal expansion takingplace. That also is true for North America. We seetremendous potential right here in North America forfurther expansion of the brand.
Mark Swartzberg - Stifel Nicolaus: So it sounds likeeven the oldest market you're seeing that double-digit relationship?
Muhtar Kent: Yes.
Operator: Your next question will come from the line of Lauren Torres -HSBC.
Lauren Torres - HSBC: Solid results this quarter from some of your previouslytroubled markets. I guess that would be Japan,India and the Philippines.Outside of just cycling easier comps, can you talk about what's fundamentallychanged in each of these markets? I know, Muhtar, you talked about it in yourprepared remarks. Why should we expect some of this positive momentum tocontinue?
Muhtar Kent: Well first as afocus, the important thing is that we have now out of our top 22 markets, 19 ofthem are growing and growing with an increased momentum. That's the key. Wecertainly have had, as you put, issues around four large markets last year.Those were Japan,India,certainly Philippines,Nigeria and allof those are showing positive growth right now. Now as I said, out of the top 22 markets 19, there's stillthree of them that are not performing. There will always be some in ourportfolio across 200 markets that need fixing. I can assure you that we focuson those religiously and with intensity and we fix them. You see all those fourmarkets today that were not performing that I mentioned to you now growing. All of them had different issues. We had indicated a plan torestore, to stabilize Japan.I think we have stabilized Japannow. From here on we will continue to execute in Japanand it is a very high per capita market and we will return to traditionalgrowth rates in Japan. In the case of Philippines,in the case of India,in the case of Nigeria,they're emerging markets and we'll continue to drive our volume and gain sharein those markets.
Neville Isdell: Let me just add oneother thing which I think is important, because it comes from the wholestrategy of the formation of the bottler investment group. We now have veryskilled bottling professionals within the company and you see that in theresults in Indiaand the Philippines,where we are able to go into those sort of markets and very aggressively,particularly with the Philippines,turn around in a very short period of time. Now, we have bottlers who are able to do that with marketsas well. But the strategic point is that what that does is it means that wetake a systemic view. We are able to think about the whole value chain, we'redoing that of course obviously when it comes to productivity as well. But we'vegot executives who now not only think about the concentrate side at theexclusion of the bottling side or vice versa, we now have a total systemicview. When you're able to do that and link that togethereffectively, that's when you get the execution and that's when you get theresults. So that move has given us the intellectual capital within the businessto be able to execute the way we are doing and to be able to execute rapidly.
Operator: Your next question comes from Bryan Spillane - Banc ofAmerica Securities.
Bryan Spillane - Banc of America Securities: I just wanted to ask a question about productivity and Iguess the potential to start thinking about increasing the co-mingling of beerand soft drink distribution in some markets. If my memory is correct, this hasbeen a platform that's been in and out of favor at Coke over the years. But itappears like there's a few markets where that is effective right now and Iwould like to get an update on your current thinking, if it's changed at all asto whether or not that's a viable option in terms of creating some leverage insome markets around the world.
Muhtar Kent: Bryan, let me just firstly just say that our strategy and effortsaround productivity are to ensure that we have a realigned organization thatcan make decisions with speed, that we can drive value in key spend areasacross our organization on our system, build the foundation for sustainablegrowth going forward in key processes and then of course the culture piece. In some exceptional situations, there may be distributionand there may be synergies in the back office. But clearly, we are focused toensure that we have exclusive management of the market development at the pointof sale across the world and this is critical for us. Developing outlet byoutlet, impulse creation across the world and that requires an exclusive focus. So our thinking is very clear. Where there may be someopportunities on an exceptional basis, I think the bottling system finds those.It's not a strategy that we look to develop across the world from here andcertainly our strategy on productivity are those that I've outlined to you.
Operator: Your final question comes from Mark Swartzberg - StifelNicolaus.
Mark Swartzberg - Stifel Nicolaus: Muhtar, a quick question on Glacau North America. Anydifference in the contract, the distribution contracts you have with CCE versusother Coke bottlers?
Muhtar Kent: No. Essentially we have, as I said, an agreement, really Iwould call it a historical agreement, almost unanimous participation by all ourbottlers that essentially focuses on the areas that I've already outlinedbefore. It is the same with distributors.
Mark Swartzberg - Stifel Nicolaus: It's the same across distributors?
Muhtar Kent: Yes.
Neville Isdell: Thank you very much, indeed, everyone. Thanks Muhtar andGary. Just to conclude, it's good to be with you again this morning. I justwant to reflect on the fact that for decades the Coca-Cola Company, we've stoodfor positivity, we've stood for happiness. One of the things I feel as I walkaround the corridors, the halls in Atlantaand also in our field locations, because we all spend a lot of time out therearound the globe, is that our employees are engaged and just as importantly,they're having fun again. So I'm confident that our strategies are working. We remainresolute about delivering against our strategic agenda in order to continue tocreate sustainable growth and value for our shareholders. Thank you very much indeed. | [
{
"speaker": "Executives",
"text": "Ann Taylor - IR Neville Isdell – Chairman, CEO Muhtar Kent –President, COO Gary Fayard - CFO"
},
{
"speaker": "Analysts",
"text": "Christine Farkas - Merrill Lynch Kaumil Gajrawala - UBS John Faucher – JP Morgan Bonnie Herzog - Citigroup Bill Pecoriello - Morgan Stanley Mark Swartzberg - Stifel Nicolaus Lauren Torres - HSBC Bryan Spillane - Banc of AmericaSecurities"
},
{
"speaker": "Operator",
"text": "I would like to welcome everyone to the Coca-Cola Company'sthird quarter 2007 earnings results conference call. (Operator Instructions) Iwould like to now introduce Ann Taylor, Vice President and Director of InvestorRelations."
},
{
"speaker": "Ann Taylor",
"text": "Good morning, and thank you for being with us today. I amjoined by Neville Isdell, our Chairman and Chief Executive Officer; MuhtarKent, our President and Chief Operating Officer; and Gary Fayard, our ChiefFinancial Officer. Following prepared remarksthis morning, we will turn the call over for your questions. Before we get started, I would like to remind you that thisconference call may contain forward-looking statements, including statementsconcerning long-term earnings objectives and should be considered inconjunction with cautionary statements contained in our earnings release and inthe company's most recent SEC report. In addition, I would also like to note that we have postedschedules on our company website at theCocaColaCompany.com under the financialinformation tab in the investor section, which reconciles our results asreported under Generally Accepted Accounting Principals to certain non-GAAPmeasures which may be referred to by our senior executives in our discussionthis morning, and from time to time in discussing our financial performance.Please look on our website for this information. Now let me turn the call over to Neville."
},
{
"speaker": "Neville Isdell",
"text": "Thank you, Ann and good morning, everyone. I will start thismorning with just a few brief observations about the third quarter results, andthen Muhtar will provide details on operational performance and Garywill follow with an overview of the financials. Today we report another quarter of solid business results.The strength of our brand portfolio, the breadth of our global system and theculture of winning increasingly exhibited by our talented people right acrossthe company and the system continue to drive our business forward. Theinvestments that we have made in our brands, our early and continued focus onrevitalizing the culture through our manifesto for growth, and our commitmenttogether with our bottling partners to re-energize our marketing and improveoperational execution are all working. They are driving high quality, balancedgrowth in volume, revenues, profits and cash flow. This is the third consecutive quarter in which we haveachieved 6% global unit case growth. Notably, this is our tenth consecutivequarter of delivering at least 4% volume growth, and top line growth continuesto be robust, reflecting our ability to capture the highest value opportunitiesacross the whole non-alcoholic, ready to drink industry. Revenues increased 19% in the quarter. Now the acquisitionof bottlers contributed about 8 points of this growth, so even excluding thisimpact, revenues grew a very strong 11%, demonstrating the success of thecontinued system-wide focus on revenue growth management and segmentedexecution strategies. We delivered our fourth consecutive quarter of double-digitcomparable EPS growth, up 15% versus the prior year. Ongoing operating incomefor the quarter increased 12%, and year-to-date increased 13%. Cash fromoperations for the quarter increased 18% on solid underlying businessperformance. Importantly, our focus on productivity is resulting inoperating expense leverage for our core business. Our effective management ofcommodity cost pressures is also reflected in the results. Our international operations again led the way, posting unitcase volume growth of 8%, and once again driving strong top line performance. Thegrowth continues to be sourced from both developed and emerging markets. Allinternational operating groups, with the exception of the European Union --which as anticipated had a challenging prior year quarter this cycle --delivered strong growth. We're also on track with our plans for North America, which recorded sequential volume improvement. In North America, I would like to highlight the continued execution of ourthree cola strategy; in particular, Coca-Cola Zero, and also our ability todrive our still portfolio, which now of course includes Glacau. In terms of our global portfolio performance, we achievedcontinued volume growth in sparkling beverages, while expanding our footprintand enhancing our offerings in still beverages. Today we're reporting anincrease of 4% in sparkling beverages. Within sparkling, continued emphasis onour three cola strategy resulted in 4% global growth in trademark Coca-Cola. Coke Zero, now launched in 51 countries, continues to drivethe expansion of the sparkling category and gain share. Given the strong repeatrates for Coca-Cola Zero, we're focused on driving trial via sampling programsto continue to recruit new consumers and retain core Coca-Cola drinkers withreal Coca-Cola taste and zero sugar and calories. In still beverages, globally strong performance from ourwater portfolio, but also from POWERade and Minute Maid led to a 14% increase.This solid growth across the portfolio resulted in our gaining non-alcoholic readyto drink volume and value share globally, driven by share increases insparkling and still beverages, both internationally and importantly in NorthAmerica. I would note that value share is growing faster than volume share, aswe focused on the highest value opportunities. Overall therefore I am very pleased with the strongperformance in the quarter and year-to-date. As we enter the final quarter ofthe year, we will continue to leverage our leading brands, our globalfootprint, and our strategic acquisitions. We'll build our innovation pipelineand all the while driving productivity to continue to deliver sustainablegrowth and shareholder value. Now let me turn the call over to Muhtar to provide thedetails."
},
{
"speaker": "Muhtar Kent",
"text": "Thank you, Neville, and good morning, everyone. Overall,this was another strong quarter for the Coca-Cola Company, both financially andstrategically. Importantly, we continued to deliver on our commitment. Weachieved balanced geographic and portfolio growth, further solidifying ourfoundation for sustainable, long-term performance. Our international operations continue to drive results forthe company through the strength of our bottling system and the power of ourbrands around the world. The aggressive actions we continue to take to restoregrowth in North America are starting to bear fruit. Oursystem-wide productivity efforts are allowing us to focus on driving top linegrowth and creating operating expense leverage. Finally, we continue to pushthe envelope with innovation in product, packaging, delivery and customerservice. Today I would like to share with you details on our progressthis quarter, and add some perspective for the remainder of the year. Even witha very strong third quarter of 2006 to cycle in Europe,our international operations increased unit volume by 8% for the quarter,following our 9% growth in the first half of the year. Broad-based growthacross each of our international operating groups has enabled year-to-date volumegrowth of 6%. This speaks to the power of our global reach and the executioncapabilities of our bottling partners. Volume growth in our international operations was once againled by the emerging markets. We achieved double-digit growth in such markets asChina, Russia,India, Brazil,Turkey, the Philippines,Pakistan, Eastern Europe and Southern Eurasia. Africaalso experienced solid growth across all business units. Additionally, weexperienced robust growth across Latin America. Mexicodelivered 7% growth in the quarter, a particularly strong performancereflecting the success of our strategies to drive growth in sparkling beveragesled by Trademark Coca-Cola. While it is clear that we're maintaining our focus andwinning internationally, there are a few key markets that I would like tohighlight where best practice sharing is leading to world class execution. In China,we once again achieved double-digit growth this quarter. We are aggressivelyand strategically investing in our infrastructure and our route to marketinitiatives to continuously adopt to a rapidly changing marketplace.Year-to-date we have activated over 120,000 outlets, placed approximately175,000 new coolers and we surpassed the 1 billion cases sold benchmark earlierthan any other year in our history. Sprite in Chinacontinues to perform exceptionally well, growing nearly 30% in the quarter andyear-to-date. As we start the one year countdown to the Beijingsummer Olympics, our focus will be on leveraging our leading brands to become astaple in the local communities and ensuring our full portfolio is readilyavailable in every outlet. Let me turn now to the Philippines,where our efforts have led to improved execution and seamless integration.After two quarters of managing the bottling operations, our double-digit volumegrowth is ahead of our expectations. We have a first-class management team inplace that has a deep commitment to, and understanding of, the marketplace. Weare investing in the market there, adding 2,000 additional front end salesforceassociates, while driving supply chain efficiency. Next in India,strong double-digit volume growth reflects the benefits of the initiatives weput in place in 2006 to rebuild the fundamentals of the franchise. Our marketinginitiatives continue to gain traction, supported by improvements andinvestments made in the bottling operations, including a specific focus on theright route to market, supply chain and people capability. As a result, werecorded share gains in the quarter for both sparkling beverages led byTrademark Coca-Cola, as well as still beverages led by our juice brands. Russiais another example of how we're working with our bottling partner to invest ina market with tremendous opportunity and growth potential. The Multon juicebusiness, including the leading Dobriy brand, continues to provide a solidplatform for growth in our still beverages. Also during the quarter, ourbottler demonstrated a commitment to this market by expanding capacity with theacquisition of a brand new plant. Japandelivered another solid performance in the quarter. The team there iseffectively executing our strategy of leveraging our core brands, particularlyTrademark Coca-Cola, to drive progress. Overall in the quarter, we gained sharein non-alcoholic ready to drink beverages, a validation that our strategy isworking. In the quarter, we delivered more than 4% increase in unitcase volume, our fourth consecutive quarter of growth, with August andSeptember achieving record breaking sales levels; performance driven by trademarkCoca-Cola with year-to-date volume growth at its highest growth rate in 30years. From a marketing perspective the Coke Side of Life campaignand promotion behind Coke Zero are having measurable success. Year-to-date, wehave attracted nearly 5 million new drinkers to the trademark versus the prioryear. We also leveraged our successful work that we have underwayin Europe linking Coke and iTunes by launching a similarprogram in Japanthat utilizes all brands and packages. Our still beverage portfolio in Japangrew in the quarter as well. Sokenbicha Tea, Aquarius sports drink and both ofour water brands drove the results with each gaining share. While the favorable warm weather benefited most areas of ourbusiness, it did have an adverse effect on the coffee category. Results from GeorgiaCoffee in the quarter were disappointing, as gains in the recently introducedVintage label did not fully offset declines in other flavors. We remain focusedon driving growth in the coffee category through innovation, new promotions andcontinued marketing investments behind the brand. We have gained significant traction in Japanand it is reflected in the year-to-date results. But we do recognize we stillhave more work to do. As expected, the European Union faced difficult 2006comparables that had benefited from World Cup activation and acquisition. Inthe current quarter, solid unit case volume growth in Central and Southern Europe was offset by a volume decline in Western Europe,resulting from unfavorable summer weather across Western Europeand the difficult cycling. I am satisfied that we have the right strategies inplace and the initiatives taken by the EU leadership team over the last twoyears have built a solid foundation for balanced, sustainable, long-term growthin Europe. Year-to-date, volumes in the EU have increased 4%. For thethird quarter, after removing the impact of acquisitions, the two-year compoundorganic growth rate is 2%. The performance of both our sparkling beverages andthe ongoing expansion of our still footprint are two strong indicators of theimprovements we have made. Additionally, as a result of our successful programs, we'veoutperformed the industry in the quarter and year-to-date across the EU. Wehave made broad improvements in sparkling beverages through innovation andtargeted execution led by the implementation of our three cola strategy and thesuccess of Coke Zero. The roll-out strategy has delivered year-to-date trademarkCoca-Cola growth of 3% and Coke Zero, which is now available in Europein 20 countries, has become approximately a 3 share brand across the EU, andhas achieved as high as an 8 share in markets like Denmarkand Greece.That is a direct result of the close alignments we have with our bottlingpartners as we execute this key strategy. Additionally, we are driving expansion of our still platformacross Europe, both organically and throughacquisitions. Minute Maid, along with Nestea, Aquarius, POWERade and Burn, allachieved growth year-to-date driving still category share gain. In Germany,we had a particularly challenging quarter this cycle as we achieved volumegrowth of 15% in the third quarter of 2006. While volume was down in Germanyfor the quarter, during the year we've been able to stabilize share performanceand we continue to make progress in executing our plans for long-term growth. We also continue to improve channel penetration as webroaden our offerings to discounters, enhancing our position in a growingchannel where we have historically been under-represented. Also during thequarter, we finalized an agreement to consolidate the German bottlers. Ourfocus has now turned to improving our speed and flexibility with our customers andover time, driving supply chain efficiency. Overall, I am very pleased with the performance of ourinternational operations and our operators continue to deliver high quality,broad-based growth while maintaining investments to solidify the foundation forsustainable growth in the future. Let me now discuss the progress we're making in North America. In the quarter, we achieved 1% unit case volume growth,the first quarter of growth in five quarters. While this reflects the benefitof acquisitions and an improved trend in sparkling beverages, we are notsatisfied with our performance. However, I am confident that our North America system is executing against the right priorities and isfully committed to restoring sustainable growth in our home market. We continueto focus on revitalizing the sparkling beverage strategy with our three colastrategy: Red, Black and Silver. Coca-Cola Zero, which achieved a 1.3 share in the quarter,delivered strong double-digit unit case volume growth and along with Diet Coke,drove sparkling category share gains in the quarter. We believe there is stillsignificant opportunity for increased awareness and penetration for Coke Zero. Building on our success in Asia and Latin America, we introduced the new contour grip bottle in the U.S.for all three cola brands. While only launched in early September, we havealready achieved approximately 75% availability. The new bottle not only allowsus to further leverage our iconic image, but the package also contains 5% lessweight than the prior 20-ounce bottle, reducing our carbon footprint andmanufacturing cost. This is just the first of many exciting package innovationsthat we'll be pilot testing in different North America markets over the comingmonths. The Glacau acquisition continues to perform ahead of ourexpectations as we have been able to leverage the strength of the system whilemaintaining the culture and innovation capabilities of the Glacau team. In thequarter, brand growth continued to accelerate, driven by both sales velocityand increased availability. We expect Glacau to continue to be a catalyst fordriving growth across the entire North America business. Last quarter, I mentioned that we were working with ourbottlers and distribution partners to develop a hybrid operating model thatwould take advantage of the strength of the system and leverage existing routesto market. As we announced during the quarter, I am pleased to report that wehave finalized an agreement with nearly 100% of our U.S.bottlers on this front. This is real progress and speaks to the effectivealignment with our North America bottling partners. Webelieve the new operating model will benefit our system, will bring value toour customers and will deliver attractive returns to our share owners. Duringthe fourth quarter, we will be working to ensure seamless transition to thisnew operating model. Additionally, as part of the agreement, we gained brandalignment for the next three years and agreed on our 2008 business planpriority. Overall, we remain relentlessly committed to our goal ofre-energizing our business in North America and becomingthe preferred beverage partner for our customers. In the fourth quarter, wewill continue to expect sequential improvement and further evidence of ourprogress as we execute against our key priorities. Finally, I would like to discuss some of the initialprogress we have made in driving productivity to improve margin performance.Our objective is simple: improve our speed of execution and drive operatingexpense leverage. When we organize around our three pillars, namely consumermarketing, customer leadership and franchise leadership, not only do we driveour top line growth, but we improve efficiencies as well. After successfully delayering our international operationsduring the first half of the year, we transitioned the process to North America. Central to the new operating framework in North America is the creation of three business units: sparklingbeverages, still beverages and emerging brands, along with Glacau. To support our consumer leadership pillar, the new modeldefines roles in the organization and allows for greater clarity andaccountability for our priorities. As a result, we will be better equipped as atotal organization and as individual managers to win the marketplace and toclaim leadership with consumers, customers and bottlers. In terms of the supply chain, we have made several initialsteps across the organization. As I mentioned earlier, as part of ourrestructuring in the Philippinesbottling operations, we're investing to grow our front end sales force by morethan 2,000 people as we take cost out of our supply chain to fund additionalcustomer-facing roles. Additionally, we announced initiatives to driveproductivity in our Irish concentrate operations, resulting in our plan toclose one of our concentrate plants. By executing lean productivityinitiatives, we were able to increase the capacity of our remaining twoconcentrate plants and remove the cost associated with the third plant. Efforts are underway to drive cost savings throughingredient and packaging harmonization, along with projects to optimizeprocesses for the most efficient production of our product. Ultimately, we are building a productivity-based culturewhere employees feel engaged in the process. We are changing behavior acrossthe system and making productivity a core part of the way we approach ourbusiness every single day. As we reinvigorate the organization and realize theproductivity gains, we will selectively reinvest behind our three pillars todrive further top line growth. In summary, I am very pleased with these results whichvalidate the progress we are making against our strategic agenda. Theconsistent, balanced results we are achieving are a culmination of the entiresystem working together seamlessly, which has been a key focus for us and isessential to our long-term success. The foundation for sustainable growth isbuilt and I'm confident that we will continue to deliver on our promises andcreate long-term value for our share owners. Now let me turn the call over to Gary."
},
{
"speaker": "Gary Fayard",
"text": "Thanks, Muhtar andgood morning, everyone. As Neville and Muhtar indicated, we delivered anotherquarter of strong financial results. As you saw in the release, we reportedearnings per share of $0.71 on a diluted basis for the third quarter, anincrease of 15%. This included a net charge of $0.03 per share, primarilyrelated to restructuring charges, which was offset by a $0.03 per share gain,primarily related to the sale of a portion of our investment in Coca-ColaAmatil. Therefore, after considering items impacting comparabilityin both the current and prior year, adjusted EPS for the quarter andyear-to-date increased 15%. In addition, we lowered our expected underlying effectivetax rate on operations for 2007 to 22% from the previous estimate of 22.5% tobring the effective tax rate for the year in line with the current estimate, werecorded income tax expense at a rate of approximately 21.7% in the thirdquarter, which resulted in a tax benefit of $0.01 for the quarter. For 2008, weexpect the underlying effective tax rate to be between 22% and 22.5%. Net revenue in the quarter increased 19%, which included an8% benefit from structural changes related to our acquisition of bottlers.Excluding the impact of these bottler acquisitions, revenue growth was 11%,driven by 6% increase in concentrate sales, a 1% benefit from price mix and a4% increase from currency. Price mix benefit on the core concentrate business waspositive in the low single-digits. However, this was partially offset bybottling investments, primarily due to the volume decline in Germany. We grew operating income by 10% on a reported basis. Afterconsidering factors impacting comparability in the current and prior years,operating income increased 12%, which includes a 3% benefit from currency. Soon an ongoing currency neutral basis, we grew operating income 9%. SG&A increased 16% in the quarter, so let me take aminute to walk you through the increase. About 12 points of the increase weredue to currency bottler acquisitions and increased selling and service expensesin our consolidated bottling operations, and behind acquired brands as weinvested for growth. The remaining 4 points reflect continued solid investmentbehind our brands, and similar to our year-to-date results, G&A expensesincreased low single-digits, reflecting the early results of our productivityinitiatives and disciplined expense management. So while the quarter's reported operating margins are 23.8%,this includes a significant impact due to the lower margin bottling operations,including the recent bottler acquisitions. Underlying margins on the corebusiness remain healthy as we drive top line growth and deliver operatingexpense leverage. We repurchased $1.6 billion of our stock year-to-date and westill expect to repurchase a total of $1.75 billion to $2 billion for the fullyear 2007. Cash from operations year-to-date increased 18% on strongunderlying business performance and a decrease in working capital, primarily asa result of cycling the higher net taxes paid in 2006 related to therepatriation of foreign earnings from 2005. Now let me address some of the factors that we see impactingthe remainder of 2007. We recognize that there is some uncertainty as itrelates to the U.S.economy. However, as Muhtar said, we remain committed to restoring growth inour home market. We continue to expect sequential improvement in our North America performance as we finish out 2007. We also remain positive on the global macroeconomic outlook,especially in many of our emerging markets. We will continue to manage ourcountry portfolio as we expect solid performance in most of our markets. We feelconfident in our progress and have built a solid foundation strategically,operationally and financially as we finish out the year. Given the recent focus on commodity cost, I would like toprovide you with some insight into our point of view. In 2007 we have seenheadwinds across several key input costs. Globally, we have seen significantincreases in orange juice cost which we have effectively managed. The resulthas been year-to-date, mid single-digit unit case volume growth in our juiceand juice drink brands, while driving volume and value share globally. The other significant commodity cost increases in 2007 havebeen in corn sweetener and aluminum, which was primarily impacting the North America bottling system and has been reflected in retail pricing.However, we are starting to see a moderation in commodity cost impactingbeverage companies, both globally and in North America,and we believe the worst is behind us. While commodity cost volatility remainsa risk, our current assumption is that commodity costs overall for the systemin 2008 will be essentially flat with 2007. For the company, we expectcommodity cost to be flat to down slightly versus 2007. From a capital expenditure standpoint, as we stated lastquarter, we expect total company net capital expenditures for this year to bein the range of $1.5 billion to $1.6 billion as we make investments in recentlyacquired bottling operations. Now let me move to currency. As I mentioned, we saw apositive impact from currencies for the quarter on operating income of 3%.Benefits from the euro, Brazilreal and sterling are being partially offset by weakness in the yen. We areeffectively covered for the full year on the yen and the euro. Based on currentspot rates and the expected impact of the coverage in place, we expect a midsingle-digit favorable impact of currency on the fourth quarter results. We're in the process of finalizing our 2008 business plan,so we'll provide our outlook for 2008 on our year end call in February. That'sit for the topics I wanted to cover this morning, so we can now turn it overfor your questions."
},
{
"speaker": "Operator",
"text": "Your first question comes from Christine Farkas - MerrillLynch."
},
{
"speaker": "Christine Farkas - Merrill Lynch",
"text": "Can you quantify at all how much Glacau Infused added interms of basis points to your growth? In the past, water had been a drag interms of the larger volumes. Is that now cycling itself and no longer a factor?Thank you."
},
{
"speaker": "Muhtar Kent",
"text": "Certainly we have had a very, very good solid performancewith Glacau. It added about 2 points overall. In terms of the bottom line, actually, we are very pleasedwith the North America performance, even without Glacau, it still had adouble-digit growth in the quarter. So that's basically how I would phrasethat."
},
{
"speaker": "Christine Farkas - Merrill Lynch",
"text": "And in terms of thewater?"
},
{
"speaker": "Muhtar Kent",
"text": "Water, I think we're pretty much through the cycling.There's still a little bit of impact but nothing like in the first twoquarters."
},
{
"speaker": "Operator",
"text": "Your next question comes from Kaumil Gajrawala - UBS."
},
{
"speaker": "Kaumil Gajrawala - UBS",
"text": "Can you talk a little bit about productivity, and if any ofthat will fall to the bottom-line?"
},
{
"speaker": "Neville Isdell",
"text": "Well, it clearly already is, because we had 1 point ofoperating leverage if you go down to the core business this quarter. Muhtarfocused on the really consistent drive that we have with regard to creating amuch more effective, a much more efficient system. You are going to see thatcontinuing, and it will evidence itself obviously in operating leverage, but itwill also allow us, where we selectively choose to do it, to invest behind thebrands and invest in terms of top line growth. You see that virtuous cycle actually in this quarter, wherewe've got the operating leverage, we have reinvested behind the brands and thatcontinuing investment behind the brands drives the top line growth. That's thebalance that we'll continue to strike and we certainly see that continuinggoing forward."
},
{
"speaker": "Operator",
"text": "Your next question comes from John Faucher – JP Morgan."
},
{
"speaker": "John Faucher - JP Morgan",
"text": "You talked about the flattish commodity cost as we head into2008. The question is, how does that impact your feeling on concentratepricing, given the fact that particularly with CC you took less net concentratepricing in 2007 because of the commodity environment?"
},
{
"speaker": "Neville Isdell",
"text": "John, we're still obviously in our budget cycle and wehaven't finalized that at this point in time, so it's premature to speculate onthat. However, I would go back to the broader statements that I've made in thepast and that is that we will be increasing concentrate around about inflation,or slightly less. And also reflecting on the fact that as you look at thehealth of the overall bottling system and the recalibration that we have had todo really over the last seven or eight years, that we now have a very healthysystem so a more normal situation will prevail into the future. But it is tooearly for me to give you any real guidance on that for '08."
},
{
"speaker": "Operator",
"text": "Your next question comes from Bonnie Herzog - Citigroup."
},
{
"speaker": "Bonnie Herzog - Citigroup",
"text": "Unit case volume growth that you've reported this quarter,since your total worldwide volume growth you mentioned was up 6% and that wascertainly led by the international unit case volume growth which was up 8%, Ibelieve you mentioned North America was up 1%. I am quite frankly just simply trying to dothe math and understand how that works or where do I exclude the acquisition?"
},
{
"speaker": "Muhtar Kent",
"text": "We may have missed justthe beginning of your question, Bonnie, because there was interruption in the line. Tell me ifI haven't answered it properly. Internationally, as you said, we've grown 8%and in terms of both international as well as U.S.volume we're increasing still beverages double digits in both international aswell as in our North American operations. Overall, international we've grown 8%and in the U.S.we've grown overall 1%; that generates the average of 6% globally in thequarter."
},
{
"speaker": "Bonnie Herzog - Citigroup",
"text": "I think you may haveanswered it. You're right, I just was trying to make sure I understood the mathcorrectly, Muhtar, because what you just stated, worldwide is up 6%,international is up 8% and North America is up 1%."
},
{
"speaker": "Muhtar Kent",
"text": "That's right. And in both operations we've increased stillbeverages double-digit growth in both international and North America."
},
{
"speaker": "Neville Isdell",
"text": "Bonnie, just to the other part of your question is how muchof that is acquisition? It's actually 1% on a global basis and 2% for North America. So the underlying North America is1, which is what you're looking for, I think, the plus 1%. Global is plus 6%and plus 5% if you exclude acquisitions."
},
{
"speaker": "Operator",
"text": "Your next questionwill come from the line of Bill Pecoriello - Morgan Stanley."
},
{
"speaker": "Bill Pecoriello - Morgan Stanley",
"text": "Good morning, everybody. On North Americaas you're looking out to '08, do you see most of the focus on the integrationand continuing the momentum behind Glacau, which is going to be a bigundertaking for the system, or do you also see a strong innovation pipeline andefforts to improve the core sparkling business? You had had mentioned in thepast leveraging Glacau benefits to re-energize the core and you brieflymentioned some package innovation in your prepared comments."
},
{
"speaker": "Muhtar Kent",
"text": "Certainly Glacau is going to be a very important catalystfor sustainable growth in North America, and really,this new agreement is really a milestone with our bottling partners. Almostunanimous agreement with our bottling partners going forward, which iscompletely in line with our three key goals, which is leading growth insparkling beverages led by Trademark Coca-Cola, delivering our fastest volumegrowth in the still portfolio for North America; and being the preferred partnerfor our customers. What this agreement has done is aligned our 2008 businessplan agreement and it's given us agreement on brand alignment, veryimportantly, for the next three years and it's also had very important impacton capability assessments going forward for reinvestment into our totalbusiness in the United States. Now having said that, our key focus is still to stabilizeand regenerate growth in sparkling beverages and you'll see us innovating bothfrom a package point of view and our three cola strategy is really workingwell, driving growth in the diet category and sparkling beverages and we willcontinue to focus on that. We will also certainly be coming out with a lot ofinnovation in packaging in also sales equipment as we move forward. A key focuson the point of sale going forward in the United States with our bottling partners wherewe're fully aligned for Q4 onwards."
},
{
"speaker": "Gary Fayard",
"text": "One other thing Iwould add, Bill, that I think gives us a lot of confidence in our statementsaround sequential improvement and winning in our home market is we have talkedabout in the past that we've been doing some tests around segmented executionand really ramping up those capabilities. One of those is in Philadelphia.We've seen the results of that coming through this year and in fact in thequarter Philadelphia was positivein volume terms in sparkling. We know what we can do and have great confidencethat the entire bottler system can now execute behind what we're seeing andreally continue to improve our North America business."
},
{
"speaker": "Bill Pecoriello - Morgan Stanley",
"text": "Great. So on that,you plan to take the learnings from Philadelphiaand extrapolate that out to the balance of the system?"
},
{
"speaker": "Neville Isdell",
"text": "Yes, we certainly do. We have many plans around leveragingthe best practice out of markets like Philadelphia,as well as some other markets and drive that through across the system with akey focus, as I said, on execution at the point of sale and driving packaginginnovation at the point of sale. Just to give you the example of the grip bottle, which hasbeen a really important addition to our packing portfolio in the United States, it's already in 50 internationalmarkets and it's driving results across trademark Coca-Cola in all the markets thatit's been introduced and it's achieved about 75% availability already."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mark Swartzberg - StifelNicolaus."
},
{
"speaker": "Mark Swartzberg - Stifel Nicolaus",
"text": "If you step back and look at the volume that this companyhas been producing, compared to what it might produce over the next year or so,if you take a mathematical view you could just say the compares are gettingtougher. If you take a qualitative view, you could say the momentum is reallypicking up here. What in your mind, if you had to rank the key drivers of nomaterial slowdown and unit volume growth where we assuming you're managing themix as well as you have been, what in your mind ranks at the top here?"
},
{
"speaker": "Neville Isdell",
"text": "Mark, I wouldactually say consistency, execution and partnership with the global bottlers. Fromday one I have talked about executing for the long term and that that thenbuilds a momentum of its own. I also have said that don't judge us quarter byquarter, judge us over a period of time, because we will certainly havedifficult quarters. That happens. Now, cycling the summer of '06 in Europe, wemanaged to be able to do that because of the strength of the rest of ourportfolio. You may recall that didn't occur when there was a very bad summer inEurope in '04, cycling a very strong summer in '03. So Ithink that underscores the fact that we have momentum and that momentum isgoing to continue. It is broad-based. It is based on sparkling and the completereinvigoration that we have of the sparkling category. Muhtar has outlinedwhere we are with regard to that in North America andhow he feels that there will certainly be a recovery and we will have anabsence of the headwinds with regard to the cost pressures that we experiencedin '07 and '08 as well. So I would really use the words consistency and continuingexecution, execution, execution. In a way, it's steady as she goes. There isnothing new we are going to say about a new initiative, it's all of the keydrivers of growth that we're going to continue to execute much better as we goforward and I think you see that happening with this management team as it hascome together very successfully."
},
{
"speaker": "Mark Swartzberg - Stifel Nicolaus",
"text": "Coke Zero, you've got a level of detail globally we don'thave. The same question, obviously it's been an important contributor to growthbut there's real buy-in at the consumer level there. How do you think aboutthat brand as either a risk in terms of lapping or really continuing to act asa driver of growth?"
},
{
"speaker": "Neville Isdell",
"text": "I'll give you aheadline and let Muhtar give you some granularity. Every piece of evidence wehave is that that growth continues as we lap very successful launches."
},
{
"speaker": "Muhtar Kent",
"text": "We are now in more than 50 countries. By the end of the yearit will be close to 60 interms of launches. Everywhere, whether broad-based Asia,Latin America, Eurasia, Europeand North America, everywhere the brand is performingtremendously well, high double-digits. But I'll give you one piece of statisticthat may help you. If you take the total global Diet Coca-Cola and Coca-ColaZero volume, we have a double-digit growth versus prior year. The importantthing is that in most, in almost all markets Coca-Cola Zero drives a substantialamount of incremental volume. Of course, there is some cannibalization. But if you takethe two in terms of Coca-Cola Zero as well as Diet Coca-Cola and add the twotogether versus prior year, right now we have double-digits and very highrepeat and high velocity in all markets. So we expect this momentum to continuegoing forward and you can see that from our business where we're lapping,there's still tremendous velocity in the brand and horizontal expansion takingplace. That also is true for North America. We seetremendous potential right here in North America forfurther expansion of the brand."
},
{
"speaker": "Mark Swartzberg - Stifel Nicolaus",
"text": "So it sounds likeeven the oldest market you're seeing that double-digit relationship?"
},
{
"speaker": "Muhtar Kent",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "Your next question will come from the line of Lauren Torres -HSBC."
},
{
"speaker": "Lauren Torres - HSBC",
"text": "Solid results this quarter from some of your previouslytroubled markets. I guess that would be Japan,India and the Philippines.Outside of just cycling easier comps, can you talk about what's fundamentallychanged in each of these markets? I know, Muhtar, you talked about it in yourprepared remarks. Why should we expect some of this positive momentum tocontinue?"
},
{
"speaker": "Muhtar Kent",
"text": "Well first as afocus, the important thing is that we have now out of our top 22 markets, 19 ofthem are growing and growing with an increased momentum. That's the key. Wecertainly have had, as you put, issues around four large markets last year.Those were Japan,India,certainly Philippines,Nigeria and allof those are showing positive growth right now. Now as I said, out of the top 22 markets 19, there's stillthree of them that are not performing. There will always be some in ourportfolio across 200 markets that need fixing. I can assure you that we focuson those religiously and with intensity and we fix them. You see all those fourmarkets today that were not performing that I mentioned to you now growing. All of them had different issues. We had indicated a plan torestore, to stabilize Japan.I think we have stabilized Japannow. From here on we will continue to execute in Japanand it is a very high per capita market and we will return to traditionalgrowth rates in Japan. In the case of Philippines,in the case of India,in the case of Nigeria,they're emerging markets and we'll continue to drive our volume and gain sharein those markets."
},
{
"speaker": "Neville Isdell",
"text": "Let me just add oneother thing which I think is important, because it comes from the wholestrategy of the formation of the bottler investment group. We now have veryskilled bottling professionals within the company and you see that in theresults in Indiaand the Philippines,where we are able to go into those sort of markets and very aggressively,particularly with the Philippines,turn around in a very short period of time. Now, we have bottlers who are able to do that with marketsas well. But the strategic point is that what that does is it means that wetake a systemic view. We are able to think about the whole value chain, we'redoing that of course obviously when it comes to productivity as well. But we'vegot executives who now not only think about the concentrate side at theexclusion of the bottling side or vice versa, we now have a total systemicview. When you're able to do that and link that togethereffectively, that's when you get the execution and that's when you get theresults. So that move has given us the intellectual capital within the businessto be able to execute the way we are doing and to be able to execute rapidly."
},
{
"speaker": "Operator",
"text": "Your next question comes from Bryan Spillane - Banc ofAmerica Securities."
},
{
"speaker": "Bryan Spillane - Banc of America Securities",
"text": "I just wanted to ask a question about productivity and Iguess the potential to start thinking about increasing the co-mingling of beerand soft drink distribution in some markets. If my memory is correct, this hasbeen a platform that's been in and out of favor at Coke over the years. But itappears like there's a few markets where that is effective right now and Iwould like to get an update on your current thinking, if it's changed at all asto whether or not that's a viable option in terms of creating some leverage insome markets around the world."
},
{
"speaker": "Muhtar Kent",
"text": "Bryan, let me just firstly just say that our strategy and effortsaround productivity are to ensure that we have a realigned organization thatcan make decisions with speed, that we can drive value in key spend areasacross our organization on our system, build the foundation for sustainablegrowth going forward in key processes and then of course the culture piece. In some exceptional situations, there may be distributionand there may be synergies in the back office. But clearly, we are focused toensure that we have exclusive management of the market development at the pointof sale across the world and this is critical for us. Developing outlet byoutlet, impulse creation across the world and that requires an exclusive focus. So our thinking is very clear. Where there may be someopportunities on an exceptional basis, I think the bottling system finds those.It's not a strategy that we look to develop across the world from here andcertainly our strategy on productivity are those that I've outlined to you."
},
{
"speaker": "Operator",
"text": "Your final question comes from Mark Swartzberg - StifelNicolaus."
},
{
"speaker": "Mark Swartzberg - Stifel Nicolaus",
"text": "Muhtar, a quick question on Glacau North America. Anydifference in the contract, the distribution contracts you have with CCE versusother Coke bottlers?"
},
{
"speaker": "Muhtar Kent",
"text": "No. Essentially we have, as I said, an agreement, really Iwould call it a historical agreement, almost unanimous participation by all ourbottlers that essentially focuses on the areas that I've already outlinedbefore. It is the same with distributors."
},
{
"speaker": "Mark Swartzberg - Stifel Nicolaus",
"text": "It's the same across distributors?"
},
{
"speaker": "Muhtar Kent",
"text": "Yes."
},
{
"speaker": "Neville Isdell",
"text": "Thank you very much, indeed, everyone. Thanks Muhtar andGary. Just to conclude, it's good to be with you again this morning. I justwant to reflect on the fact that for decades the Coca-Cola Company, we've stoodfor positivity, we've stood for happiness. One of the things I feel as I walkaround the corridors, the halls in Atlantaand also in our field locations, because we all spend a lot of time out therearound the globe, is that our employees are engaged and just as importantly,they're having fun again. So I'm confident that our strategies are working. We remainresolute about delivering against our strategic agenda in order to continue tocreate sustainable growth and value for our shareholders. Thank you very much indeed."
}
] | null | null |
KO | 2 | 2,007 | 2007-07-17 08:30:00 |
Executives | [] | null | null |
KO | 1 | 2,007 | 2007-04-17 08:00:00 | TRANSCRIPT SPONSOR :
Executives: Ann Taylor - VP, Director, IR Neville Isdell - Chairman, CEO Gary Fayard - EVP, CFO Muhtar Kent - President, COO
Analysts: John Faucher – JP Morgan Bill Pecoriello - Morgan Stanley Robert van Brugge - Sanford Bernstein Bryan Spillane - Banc of America Securities Mark Swartzberg - Stifel Nicolaus Judy Hong - Goldman Sachs Christine Farkas - Merrill Lynch Bonnie Herzog - Citigroup Kaumil Gajrawala - UBS Lauren Torres - HSBC Matthew Riley - Morningstar Ann Gurkin - Davenport
Operator: At this time I would like to welcome everyone to the Coca-Cola Company's first quarter 2007 earnings results conference call. (Operator Instructions) I would now like to introduce Ann Taylor, Vice President and Director of Investor Relations.
Ann Taylor: Good morning, and thank you for being with us today. I am pleased to be joined by Neville Isdell, our Chairman and Chief Executive Officer; Muhtar Kent, our Chief Operating Officer; and Gary Fayard, our Chief Financial Officer. Following prepared remarks this morning we will turn the call over for your questions. Before we get started, I'd like to remind you that this conference call may contain forward-looking statements, including statements concerning long-term earnings objectives and should be considered in conjunction with cautionary statements contained in our earnings release and in the company's most recent SEC report. In addition, I would also like to call your attention to the fact that we have posted schedules on our company website at thecocacolacompany.com in the investor section which reconcile our results as reported under generally accepted accounting principles, to certain non-GAAP measures which may be referred to by our senior executives in our discussion this morning, and from time to time in discussing our financial performance. Please look on our website for this information. Now let me turn the call over to Neville.
TRANSCRIPT SPONSOR :
What if there was a way to promote your company to a perfectly targeted group of potential customers, partners, acquirers and investors? What if you could tailor your pitch to them at the moment of maximum interest? And what if you could do this for a no-brainer price? :
Company sponsors its own earnings call transcript:
Company sponsors partner's transcript:
Company sponsors competitor's transcript:
Issuer-sponsored research firm sponsors client's transcript:
Investment newsletter sponsors transcripts of successful stock picks:
IR firm sponsors transcript of micro-cap company:
Consulting company sponsors company's transcript in sector of interest: Your company's name and promotion could have been on this transcript! Learn more, or email Zack Miller for details.
Neville Isdell: Thank you, Ann and good morning, everyone. I am going to start this morning with a few brief observations about the quarterly results, and Muhtar will then provide details on operational achievements, and Gary will follow with an overview of the financials and he’s going to give you some additional perspective on the Philippines as well. What you see today is a very strong quarter, delivered by a company and a system that has found its footing, regained its focus and come a long way in retooling its operations. While there is much more that we can and will do, the Coca-Cola Company is today proving that we can meet the commitments that we make. We said that we would drive growth and profitable brands in packs and channels, and today we are reporting revenue growth of 17% on worldwide unit case volume growth of 6%, our highest quarterly volume growth rate since 2002, while cycling 5% volume growth for the first quarter of last year. We also said that we would maximize our local brand footprint to leverage our sweet spot in the industry. Today we are reporting international growth of 9%, which is our highest quarterly international growth rate since 2000. We also said that we would grow our core sparkling beverages whilst expanding the footprint of our still portfolio. Today, we are reporting an increase of 5% in sparkling beverages, led by 4% growth in trademark Coca-Cola. That growth includes the rollout of Coca-Cola Zero to 20 additional markets including Mexico, Brazil, Argentina, and France amongst others. Still beverages increased 9%. The solid growth resulted in share being gained or maintained in key nonalcoholic ready to drink categories, including sparkling, bottled water, juice and juice drinks, sports drinks, and ready to drink tea. So, for the quarter, we've delivered on our commitments. Now I'd like to give you a new commitment. We will win again in our home market. It will not come quickly and we continue to expect 2007 to be weak, but we do expect to begin seeing sequential improvement in the second half of the year as we execute against our key goals. Muhtar will address this topic in more detail in a moment, but I want to underscore my absolute focus on North America. We delivered strong financial results this quarter, even with this decline in North America. Strong top line growth resulted in ongoing currency neutral operating income growth of 11%, which is ahead of our long-term growth targets. The geographic sources of profit growth were, in fact, more balanced as well. Additionally, we delivered solid operating expense leverage, even as we continued to invest to support our brands and build capabilities within our own company-owned bottling operations. Certainly a strong performance to start the year. So now, let me turn the call over to our Chief Operating Officer, Muhtar Kent, who will provide you with more details.
Muhtar Kent: Thank you, Neville and good morning, everyone. It has been just over 120 days since I assumed my new role. What I would like to cover this morning are my key priorities for 2007 and relate those to our performance in the quarter, as well as expectations for the remainder of this year. These priorities are designed around a simple strategy: continue to innovate, take smart risks, and work closely with our bottlers to drive growth in sparkling and still beverages. The first priority is to sustain and drive progress in our international business. Second, address the issues in North America, where I've been spending a great deal of time these past four months. Third, increase productivity across the organization and drive leverage on the P&L. Fourth and last, compress and accelerate the commercialization rate of innovation and best practice sharing. Let's start with the first one, sustaining and driving progress in our international business. Our quarterly results clearly display the strength of our global portfolio and our ability to execute across the entire system, with most of our key markets delivering solid performance. We will continue to build on these results by growing our core sparkling beverages, expanding our still offerings, and executing with precision. Unit case volume growth was again led by our key emerging markets including China, Russia, Eastern Europe, Southern Eurasia, South Africa and across Latin America. Also, some of our emerging market weak spots from last year continued to rebound as India and Nigeria both delivered solid results for the quarter. In addition -- and equally encouraging -- is the strength of some of our more developed markets. One of our most consistent performers, Mexico, increased unit case volume 2%, cycling 8% in the prior year on the strength of trademark Coca-Cola driving total sparkling beverage share gain. This is the third consecutive quarter of improvement in Japan, with unit case volume up 3%. Although cycling a 2% decline from prior quarter, the performance across brand portfolios is particularly encouraging and demonstrates the changes we put in place last year. The strategy we are now pursuing there is really paying off. Solid growth in trademarks Coca-Cola, Fanta, Sprite, Enviga Green Tea and Aquarius drove the results, with each gaining share. The European Union increased unit case volume 11%, as all operating divisions delivered mid single-digit or better growth. I am encouraged by the growth particularly in Europe in Germany and Western Europe, which continued to show progress. As expected, our business in the Philippines continued to face challenges and experienced declines in the quarter. However, we are taking a number of critical actions to address these issues. At the end of February, we completed the acquisition of the bottling operations in the Philippines previously held by San Miguel Corporation. The bottler will now have full access to the expertise of our management, as well as be fully integrated with our company's overall objectives. With a robust business plan being implemented and an experienced management team in place under Irial Finan’s leadership, the leading share position and strong brand metrics, we believe we are well positioned to return the Philippines market to its former standing as one of our top performers. During 2007, as our program gains traction, we expect to see sequential improvement in unit case volume and return to growth in 2008. Gary will provide more details on the financial impact on 2007 in a moment. The success in our international operations in the first quarter directly reflects our ability to build on the progress we made in 2006. We've delivered 8% organic growth in sparkling beverages, led by 7% growth in trademark Coca-Cola. This is the highest growth in trademark Coke in international operations since 1998. In fact, sparkling beverages have averaged 6% growth over the past five quarters, confirming our belief that sparkling beverages have not matured, but rather still have great potential. Coke Zero and our new grip bottle, properly directed marketing initiatives such as the integrated activation of the Coke Side of Life at Coca-Cola.com, and efforts to win at the point of sale are prime examples of how we will use innovation and our close partnership with our bottlers to develop marketing campaigns that drive growth. In addition, we continue to expand our still beverage footprint around the world. Internationally, our still brands increased 16% in the first quarter by leveraging our existing trademarks and successfully integrating our recent acquisitions to improve our offerings to customers and ultimately to consumers. For the E.U. group, still beverages increased 36% and even excluding acquisitions, still increased solid high teens. Our juice and water platforms continue to gain strength with the expansion products such as Minute Maid into India, the pending acquisition of Jugos del Valle in Latin America, and the acquisition of Apollinaris in Europe. Success requires a robust and rational portfolio. We continue to evaluate all of our options and when necessary, we will selectively make acquisitions for additional speed, scale, as well as capability. A large competitive advantage for us, of course, is our relationship with our bottlers and the strength of our distribution channels. We've seen solid progress in our company-owned bottling operations, which in terms of volume is now the second-largest bottler in the world. The back to basics approach, an improved in-market execution can clearly be seen in our results in Germany as well as in India, amongst many other places. Now let me focus on my second priority, which is to reestablish consistent growth in our home market, North America. The first quarter results were weak, as expected, and we are clearly not satisfied with the 3% decline in volumes. We’ve got a lot of work to do, but certainly there are signs of improvement. In the first quarter we demonstrated our commitment to driving growth in trademark Coca-Cola as we activated solid campaigns for Coca-Cola Classic, Diet Coke, and Coke Zero. Integrated campaigns for all three brands included events television advertising linked to retail activation. We returned to the Super Bowl with the Coke Side of Life, to the Oscars with Diet Coke, and most recently built our presence with the NCAA basketball tournament featuring Coke Zero, and of course, our sponsorship of American idol continues to feature all three brands. Our campaigns are creating consumer awareness. Coke Zero continues to gain share, reaching a 1.2 share during the quarter. Diet Coke showed positive growth in the quarter and gained share while Coca-Cola Classic also gained share. The next round of innovation you will see in the second quarter is the introduction of Diet Coke Plus, our first venture under the Coca-Cola trademark for a sparkling, calorie-free beverage with vitamins and minerals. In still beverages for North America, we continue to make progress in our areas of focus. Trademarks Disani, Minute Maid, Simply, Oswalda and Power-Aid each gained category share. In teas, while volumes increased by double-digits, there is significant opportunity to improve and we have begun to reset our business. Our recent agreement with Nestle to refocus the DPW joint venture increases our flexibilities in the tea and coffee categories in North America, which we are pursuing vigorously. We're very excited about our recently announced acquisition of Fuse, which includes a variety of tea, juice, and other enhanced beverages and further rounds out our expanding still portfolio. Overall, we remain totally committed to winning in North America and have an active plan to address the business issues. We are focused on building our system execution capability by developing working relationships with our bottlers based on cooperation and collaboration. We anticipate continued weakness in 2007, though, the first half of the year. In the second half of 2007, we expect to see sequential improvement and evidence of progress as we execute against our key goals, which are leading growth in sparkling beverages driven by trademark Coca-Cola, delivering the fastest value growth in still beverages, and being the preferred beverage partner for our customers. Now let me turn to productivity. A very important component to our success in North America as well as around the globe is ensuring we increase productivity. We are delayering and simplifying our structure so we can improve our speed of execution and improve leverage. This will enable us to better align the architecture of the organization to the three pillars that are the core drivers of our top line growth: consumer marketing, commercial leadership and franchise leadership. This is a targeted effort to enable the organization to be more effective, efficient and to remove bureaucracy. All of our efforts center around avoiding waste and removing distractions that cause us to lose focus on the three pillars mentioned above. These initiatives will result in some cost savings, but importantly will improve clarity on decision-making which will allow for more time to be focused on revenue-generating activities. Other efforts are longer term and involve driving system efficiencies. There are projects around the global supply chain and common IT platforms. The bottlers have already been doing an excellent job in many respects and it can be seen in the improvement of their returns. We've already experienced success in global procurement of key commodity inputs as well as in Japan with the supply chain management company, where we are using those lessons to build similar models in China and Mexico, particularly as we gain scale in the still beverages. But there is still significant room for improvement across our entire system. As we reintegrate the organization and realize the productivity gains, we'll selectively reinvest behind our three pillars to drive further top line growth. My fourth priority is compressing the innovation pipeline. This really gets at our speed to market. Our organization has never lacked for innovative ideas. What we've lacked is a discipline to commercialize expeditiously. We are focused on doing fewer things and doing them better. A clear example has been the global success of Coke Zero, which will reach 40 markets representing 75% of total trademark Coca-Cola volume by the end of 2007. But we are taking a broader view of innovation. It's not just simply product formulations, it also includes such things as the new Coca-Cola grip bottle, which will be available to over 50% of the world's population by the end of 2007; the Coke Side of Life campaign, which will be in over 200 markets; we're using M&A to augment scale and capabilities, for example with Fuse here in North America. It's also brand, price, packaging and channel optimization that we are jointly developing with our bottling partners. And, it is the way we're working with our bottlers to agree on long-term plans for profitable system growth and equitable value share. While I've identified four distinct priorities, my goal for the year is to deliver on our business plan by driving sustainable top line growth and leverage in the P&L. In summary, both Neville and I are pleased with the solid start to 2007, but we are not satisfied. While we're moving in the right direction, we still have a lot of work to do. Neville said it best at CAGNY: the opportunity for Coca-Cola as the only truly global beverage company in a growing beverage industry remains significant. Having sustained solid growth in sparkling beverages internationally, we have proven that there is still opportunity in sparkling beverages and our global still portfolio is just beginning to develop. We have a focused and effective strategic agenda, supporting a renewed confidence in delivering against our long-term growth targets. We know there will be bumps, but with a new culture of innovation, improving speed to market, and maintaining an outward focus, I am certain our work will create long-term sustainable growth and value for our shareholders. Now, let me turn the call over to Gary Fayard.
Gary Fayard: Thanks, Muhtar and good morning, everyone. As Neville and Muhtar indicated, we are starting the year with a strong financial performance. As you saw in the release, we reported EPS at $0.54 for the first quarter, an increase of 15%. This included a net charge primarily related to an asset write-off in the Philippines from the Philippines bottler, partially offset by gains from the sale of an ownership interest in one of our Brazilian bottlers and from real estate in Spain. Therefore, our adjusted EPS was $0.56 per share, an increase of 14% after considering items impacting comparability in both 2007 and in 2006. We attribute about a penny of the EPS to timing of concentrate shipments, as concentrate sales growth was slightly ahead of reported unit case growth in the quarter, primarily due to Easter being a little earlier this year. Net revenue in the quarter increased 17%, that included a 5 point benefit from structural change related to our acquisitions of some bottlers. The growth was also driven by a 6 point increase in concentrate sales, 3 points from currency and 3 points from price and mix benefits. We grew operating income by 17% on a reported basis, after considering items impacting comparability in the current and prior year quarter, operating income increase 14%, which includes a 3 point benefit from currency. So on an ongoing currency neutral basis, we grew operating income at 11%. SG&A increased 13% in the quarter, so let me take a moment and walk you through that increase. About 8 points of that 13 point increase were due to the bottler acquisitions, and that is from increased selling and service expenses as we invested for growth in bottling operations, and due to currency. The remaining 5 points we continued to invest solidly behind our brands, and control G&A expenses as we continue to focus on productivity and expense management. In the quarter, we repurchased approximately $676 million of our stock; as a result, our average shares outstanding in the first quarter of 2007 were approximately 45 million shares lower than the average in 2006. We still anticipate that a range of share repurchase in 2007 will be between $2.5 billion and $3 billion. In terms of dividends, the board raised the quarterly dividend for the 45th consecutive year by 10% to $0.34 per common share, which is an equivalent $1.36 per share on an annual basis. Now let me address some of the factors that we see impacting the remainder of 2007. We remain relatively positive on the macroeconomic outlook for the remainder of the year, especially in many of our emerging markets. We will continue to portfolio manage globally, as we expect solid performance in most of our markets with weak performance in North America, particularly in the second quarter as we cycle stronger volume and profit results. As with the first quarter, we would again expect our consolidated bottling operations to be a positive contributor, as we continue to build world-class operations. As for the acquisition of the Philippines bottler, you should think about it really in two buckets. First, we took a charge this quarter for the write-off of bottles and cases in the Philippines bottler. Second, we expect full year EPS results to be reduced by $0.02 as we invest to return the Philippines bottler operations to growth. Most of this impact will be reflected in the bottling investments group. Capital expenditure requirements will be slightly less than $100 million and will take the total company capital expenditures for 2007 up to about $1.6 billion. For 2008, we do not expect the Philippines to have any impact on consolidated results. In 2009, the operations should start contributing to growth. That and the impact on 2008 would include covering the interest cost from the acquisition. As for items below operating income in the P&L, I'd like to remind everyone that we still expect net interest costs to increase primarily due to lower cash balances and higher debt balances due to share repurchase, acquisitions such as the Philippines bottler, dividends, and capital spending. Also keep in mind that equity income will be negatively impacted by our reduced ownership position in Coca-Cola Fimsa and our Turkish bottler as well as selling our equity interest in one of our Brazilian bottlers this quarter. With regard to taxes, we ended the quarter with an underlying effective tax rate of 23%, and we would expect to remain at that underlying effective rate for the remainder of the year. Let me move to currency. As I mentioned, we saw a positive impact from currencies for the quarter on operating income of 3%. That was in line with our expectations. We continue to put coverage in place and are now effectively covered for the full year on both the yen and the euro. Based on current spot rates and the expected impact of coverage in place, we expect a small positive impact from currencies on full year 2007 results. Before I close, I wanted to remind everyone about the 8-K we filed with SEC 2 weeks ago containing the additional segment detail for the two new operating groups, Eurasia and Pacific. Please go to our website and pull the information down to assist in your modeling. Those are the topics I wanted to cover this morning, now we can turn the call over to your questions.
Operator: (Operator Instructions) Our first question will come from the line of John Faucher – JP Morgan.
John Faucher - JP Morgan: Good morning, everyone. I wanted to follow-up a little bit on the price mix line, which came in very nice this quarter. Can you give us a little guidance in terms of with the change in concentrate pricing from what we can see from a CCE standpoint in terms of looking at plus 4 and then net it down to zero, can you talk a little bit about how that's going to work out financially and what goals you have in place for CCE in that regard? Can you also give us an idea on the mix side in terms of how we're seeing some of the bottler case mix, is that a positive which is offsetting some of the negative country mix? How should we map that out over the balance of the year? Thanks.
Gary Fayard: Thanks for the question. Let me take price mix first. What you're seeing is 3 points of price mix. About 2 points of that is coming from the core, and 1 point is an impact from bottling operations. That price mix is really from I'd say the quality of our growth with very strong sparkling beverage growth as well as very balanced growth across the world, particularly EU, Latin America, Japan. You're seeing positive mix come through, country mix come through even with an offset from North America, as well as the quality of that growth with a strong sparkling beverage growth.
Muhtar Kent: Yes, essentially in those numbers, the U.S. concentrate price is already included embedded in those numbers and, essentially we've also had very good benefits in Latin America from pricing as we drive revenue growth management across all of the markets, as well as in the EU.
John Faucher - JP Morgan: CCE had talked about meeting certain goals to get the concentrate pricing netted down to zero. Is that showing up in the price mix line, or is that showing up in the SG&A line if you are in fact netting the concentrate pricing down?
Gary Fayard: John, it's showing up in the price mix line.
John Faucher - JP Morgan: Even with that, assuming that CCE's meeting their targets, even with that you're still putting up high quality growth there on the price mix line?
Gary Fayard: That's correct.
Operator: Your next question comes from Bill Pecoriello - Morgan Stanley.
Bill Pecoriello - Morgan Stanley: Good morning, everybody. Muhtar, you had mentioned some productivity benefits as one of your goals. You mentioned delayering, indirect procurement, supply chain. Can you quantify any of this or talk about the timing in terms of what kind of funds would be available for reinvestment? Also with the recent meeting you had with the bottlers in China, I guess supply chain was one of the topics. Can you help us all understand what was discussed with the bottlers at that meeting?
Muhtar Kent: You need to think of this activity this ongoing activity, Bill, in various buckets. The first is the architecture of our organization, with the primary purpose of that being really delayering and ensuring that we have speed, better focus, less bureaucracy, much more improved time in terms of our execution. That, of course, will yield some savings. We're in the process of analyzing what we do with those savings and how we reinvest, how much we reinvest, and how much we actually put to our bottom line in terms of leverage. I can't quantify any further. The international piece of that work is completed. We're completing some further work on that in North America. The second bucket is some of the other productivity work that is going on at the moment in the Company that is related to our indirect cost inside the total Coca-Cola Company. Gary and his team are leading that work stream. The third piece is the whole area of longer term supply chain initiatives for the entire system, which is a much bigger number and there's different buckets of work going on across the world in that area. If you look at it in three groups, that's as much as I'd like to say on that right now.
Neville Isdell: If I could just build on that, you'll see that there is operating leverage coming through in this quarter. We believe you'll continue to see that. If you go back to when we did not appear to have operating leverage, really it was the 2005 $400 million reinvestment back into marketing. If you look at our top line growth, you can see that clearly has worked, adding the fuel to the brands. So, just echoing what Muhtar has said, you can create operating leverage in two different ways: you can keep your expenses flat where they are and push the top line by reinvesting some savings; that's one way we're looking at it. But you've got to be sure that you've got effective programs. We think we've got those effective programs in the works right now. Also, of course, there will be some that will actually just naturally flow down to the bottom line, as well. You'll see that evolve in the quarters ahead.
Bill Pecoriello - Morgan Stanley: The recent meetings in China with the bottlers, how would you characterize them?
Neville Isdell: First of all, the headlines very positive. Muhtar was talking about improved bottler relations in his earlier comments. Obviously their numbers -- if you look at the international bottlers -- are improving. They have a strong belief in how we're moving forward. We spent quite a lot of time sharing some of the innovations for the future. I think we're bringing the bottling system in line with us. Obviously, we are focusing on execution, which is their side of the bargain and something that clearly they agreed they have to improve upon. The other piece of the other bucket that Muhtar talked about -- we spent a lot of time on that -- which is what we can do systemically in order to improve the overall health of the system as a whole.
Operator: Your next question comes from the line of Robert van Brugge - Sanford Bernstein.
Robert van Brugge - Sanford Bernstein: In connection with your increased incidence rate in Mexico, you had agreed with your bottlers increased marketing spending this year. So far in the first quarter, the margin trends are still pretty much consistent with last year. Are we starting to see this increased marketing spending in the P&L at this point?
Gary Fayard: Yes, and you're right. When we increased the incidence rate in Mexico, we also agreed that we would increase or spend back some of that incidence increase in marketing as well as the creation and exploitation, if you will, of the still portfolio in Mexico. You are seeing us do that; that is happening. The marketing, remember, is on a sales curve. So it's curved over the full year, but there is an increase in marketing in Latin America. That includes the impact from the increased incidence.
Operator: Your next question comes from the line of Bryan Spillane - Banc of America Securities.
Bryan Spillane - Banc of America Securities: Muhtar, a couple of questions relative to North America. Going into this year, pretty high expectations in terms of retail pricing. I'm just curious to know your assessment so far in terms of price elasticity. Has volume responded more or less in line with where you thought it would be? Looking forward, what are your expectations on how you'll monitor that and whether or not there's going to be a need to maybe act in terms of moderating price increases?
Muhtar Kent: Although we have not been happy at all with the results for the first quarter for our North American operations, essentially they are actually slightly better than our expectations and what we had in our budget. What we see is generally, of course -- and particularly the sparkling category overall as well as in segments like orange juice and juice-containing beverages – are very large price increases, but we see also in the retail environment the actual elasticity and actual demand elasticity for our products based on individual packages has been generally in line with expectations; what we've expected based on those price increases.
Operator: Your next question comes from the line of Mark Swartzberg - Stifel Nicolaus.
Mark Swartzberg - Stifel Nicolaus: Muhtar, a question for you regarding Japan, nice to see another quarter of positive volumes there. Georgia seems, relatively speaking, a little better positioned than it was a year ago. Nonetheless, it looks like margins are going down in that market for you. You're spending more there. Is that a fair assessment? How would you characterize the competitive environment and the retail environment across your portfolio, not only for the ready-to-drink coffee, but your total portfolio?
Muhtar Kent: Well, I think what I'd like to say is on Japan, six of our core brands grew double-digits in Q1, and we've strengthened the core by refocusing our commitment. Sokenbicha tea remains a strong brand, delivered good volume growth; and trademark Coca-Cola has shown stabilization and has actually grown now with The Coke Side of Life campaign, and more to come in that area. In general, I think we're happy with where we are with our stabilization and return to growth in Japan. As far as coffee is concerned, the core brands of coffee grew. What is also very encouraging in Japan is that in the entire quarter our vending machines and our entire vending segment has grew, which is also very important for our margins. Essentially we are focused, we are spending in the market, and we believe that our sequential improvement in Japan is going to continue.
Mark Swartzberg - Stifel Nicolaus: Great, that's helpful. Just to close that thought on the spending side. When you think about the level of spend today, perhaps on a per case basis versus a year ago, 18 months ago versus looking forward, how do you feel about that number? There's been a step up investment. Do you see it stepping up further?
Muhtar Kent: I don't see any significant changes compared to 12 or 18 months ago, overall. There may be some timing in there, but I don't see anything materially changing there. And I think we're at the reasonable rate right now. I don't see it going up any further. I think the critical thing is that our entire bottling system is in a much different place, it's energized and everything else we're doing for productivity in the market is working; and the growth, of course, is the key to everything.
Operator: Your next question comes from the line of Judy Hong - Goldman Sachs.
Judy Hong - Goldman Sachs: Good morning. I'm wondering if you can update us further on your tea strategy going forward, both in U.S. and outside the U.S. given the changes to the BPW joint venture? Particularly North America, if you look at your tea portfolio, whether this is a category where you may need to be more aggressive on the acquisition front?
Muhtar Kent: First, just two sentences on the BPW. As you know the BPW arrangement has been recast and now essentially it's for all teas across the world with the exception of Japan and now North America; and also coffee, both sides are free to do what they want in the area of coffee. Now, let me focus on tea. BPW arrangement with the Nestea brand has been successful in many, many markets and will continue to be successful in many, many markets around the world. USA was one market where we believed we were not winning in tea, we needed more flexibility, and we are intent on winning in tea in the U.S. market. The results so far in the last two years have not been acceptable, are not acceptable and we are going to win in tea. We cannot afford not to win share in tea and we cannot afford not to grow ahead of the market in a very big category that is growing in the United States. That's the objective of all of the exercise that we've gone through. You will see us refocusing what we have in our portfolio with Nestea, with Gold Peak, with Enviga, with other brands as well as looking at new opportunities in the market in rapid fashion.
Operator: Your next question comes from the line of Christine Farkas - Merrill Lynch.
Christine Farkas - Merrill Lynch: Thank you very much. Good morning. Muhtar, you talked about brand, pack and price architecture internationally and how that's successful. In looking at North America, can you point to what the real efforts are here in North America? Is it squarely focused on go to market strategy? Or is the brand pack price architecture something that has to be aligned more quickly? Thank you.
Muhtar Kent: Both. Go to market strategy is critical as well as the BPPC architecture is critical as we move forward in order to ensure that we have revenue growth activities, management in the marketplace, and that we align consumer needs and the consumer better to our brand price pack and channel architecture in the United States. There's going to be a lot of activity in that area, including simple things like redesigning some of our labels to look more attractive. Looking at the entire merchandising sets by channel from convenience stores all the way into retail and different parts of retail and how we can generate further impulse in the marketplace, which has all worked and continues to work very favorably for us in Latin America, across Eurasia, and across parts of the EU. The test in Denver that we've had, we're doing some tests in Denver with CC and successive tests are actually showing that it's a simple architecture, but it works. It works very effectively.
Christine Farkas - Merrill Lynch: Your corporate expenses, is there any investment in that line for overall system productivity at this stage, or is that a good run rate in terms of year-over-year growth?
Gary Fayard: Within the Corporate expense line, there's slight investment in productivity, investments for system initiatives, but it's primarily just kind of year-on-year growth. Underlying the G&A expenses, underlying in corporate, in fact, we're below our budgeted rate so we're really focused on holding those expenses.
Operator: Your next question comes from the line of Bonnie Herzog - Citigroup.
Bonnie Herzog - Citigroup: Good morning, everyone. My question is for Muhtar and Neville. It's quite clear you're not satisfied with the business in North America. I'm curious, when you look out over the next several years, is there some concern that this could be a leading indicator in any way, shape or form? Either the consumer here in North America, the way you go to market, the products? If so, because I know we're different all around the world, how do you try to prevent that? Or is it the reverse? Are you really trying to, again, incorporate the best practices that you mentioned, Muhtar, in trying to fix North America?
Neville Isdell: Let the non-American here start first. I don't think there's any fundamental difference. After all, it's what happened in America that built the business around the world. There are a number of issues facing us at the moment. The headwinds of the pricing are clearly the major headwind that we have with regard to sparkling beverages. There's also this whole issue of commitment and belief. And you heard me say, you heard me at CAGNY about around the world people looking at me when I came back, when I said we'll get sparkling beverages growing again, with a level of disbelief. Obviously the pricing headwinds have held back North America. But I and Muhtar were with a number of bottlers over the last week. They have a belief that what we have coming along the pipeline, Diet Coke Plus now, what's happening with Coke Zero, et cetera that we now have the tools to actually replicate what we've done in the rest of the world in North America, whilst building out our still beverage portfolio. So I don't think there's anything exceptional about the United States. Remembering that you'll see the same sort of sticker shock in the Hispanic community, a lot of them who were immigrants who were consuming the product in other parts of the world. So the headline for us is that there is sticker shock here, but number two, that we have the consumer marketing which is working. We also have the bottler commitment in terms of franchise leadership. I think if you talked to the bottlers you'll feel a whole new level of confidence and a commitment in terms of the operational side of what is needed. John Brock has said that one of the things that he's picked up is there are lessons from around the world that we need to pick up in North America and I think that's a very good sign. Muhtar, do you want to build off that?
Muhtar Kent: Yes, just to refocus again on the consumer, connecting with our core consumers and industry with well received creative and highly rated messaging. You saw examples of that in the Super Bowl, NCAA, Oscars, improving the performance of Coke Zero and Diet Coke which are actually significantly, significantly outperforming the sparkling category. My Coke Rewards program, now over 4 million members. Again, connecting with our chief consumer target base. On the commercial leadership, we are aligned. I repeat, we are aligned with CCE on segmented merchandising, which is part of the BPPC architecture and a rollout of that. It's going to cover about a fourth to maybe even a third of our large source supermarkets by the end of this year. Agreement also with CCE to build total beverage account team, again a very important, significant area in commercial leadership. Then also on franchise leadership, the third pillar, again, aligned beverage growth agenda with all of our top to top bottlers. So again, with specifics on product innovation, we've mentioned Diet Coke Plus, but there are many others in the area of packaging, in the area of how we create impulse at the point of sale. Then we've reorganized our United States business along the lines of our international business to focus on the three core pillars, focusing on sparkling, focusing on stills, and focusing on new and emerging markets; we have put very experienced people against all those three areas. The other important thing is you walk around the U.S. market, Bonnie, you walk around the U.S. market and we've lost the drive to create impulse. That's what we're bringing back. No signage. The whole signage program for the world started right here in the United States 30, 40 years ago. Now you walk around Latin America, you walk around Europe, you walk around Asia, you walk around Africa everywhere you have signs that say ice cold Coca-Cola served here, not in the United States. That's creating the impulse, again back to basics and we know we can do it. So it's both. Bringing best practices from outside and then leveraging the power of the category, which is bigger than anywhere else in the world here in the United States. Doing both at the same time.
Bonnie Herzog - Citigroup: That was very helpful. So in terms of timing, you're thinking by the end of this year, will it take you maybe until early next year to do a lot of what you said? Because it all sounds great.
Muhtar Kent: I don't want to comment any more on the timing. I think you see our sense of urgency.
Operator: Your next question comes from the line of Kaumil Gajrawala - UBS.
Kaumil Gajrawala - UBS: Good morning, everyone. To the extent that you beat your top line growth algorithms, what impact could this have on your future CapEx? Potentially does it limit any increase in your cash return to shareholders? Also can you talk about the macro economic backdrop in some of the developed markets like Western Europe and Japan and how this may have helped results?
Gary Fayard: Relative to CapEx, it should not have any real impact on CapEx, actually, because most of our CapEx is in some of the finished products businesses in North America, some of the bottling and bottling investments, which are really kind of not permanent investments for us. No change in business model. I don't see much change in CapEx. Relative to dividends, we've been very consistent and have been increasing dividends at a pretty good clip over the last few years. So we would expect to continue to see dividend increases. Again, an annual decision that we'd be looking at the end of this year, but have a dividend policy in place for this year. Relative to macro economic trends, Muhtar, do you want to comment on that one or Neville?
Neville Isdell: I'll pick that up. There is a broad optimism you've seen what the OECD is saying, what the World Bank is saying. I think that global growth is going to continue at the rate that we've seen over the past couple of years for '07 and through into '08. That's really reflected in our plans. The one that you still would query, I suppose, would be Japan. I think we're cautiously optimistic about that country coming out of stagnation and given the importance of Japan, together with the actions that we're taking in the Japanese business which are becoming apparent in terms of being successful, we are becoming more bullish but cautiously optimistic, I would put it, about Japan.
Operator: Your next question comes from the line of Lauren Torres - HSBC.
Lauren Torres - HSBC: I was hoping you could talk a bit more about product build outs, maybe even more importantly the potential for acquisitions in North America. Obviously we heard about your acquisition of Fuse. I was just thinking about if we should expect similar deals in the works. Basically, how are you thinking about internally developing brands in the U.S. versus acquiring brands?
Neville Isdell: Developing brands let me pass that to Muhtar in a second, but we really don't comment on acquisitions. I still stay with what we've said all along that we're going to do both. That would be largely bolt-on. But opportunities come up, and we evaluate every opportunity and look to see whether that is the right way to build our portfolio. Muhtar made the comments in his remarks that that's what we would do. Buying is sometimes the right way. What we have is an innovation pipeline coming along where we are building and building at a rate that we have not been building in the past. Even if you look at patents that we're getting registered in terms of new benefits that we could add to our own beverages, you'll see that in the innovation pipeline. Muhtar, would you like to talk about just about what's coming down to the pipe from the build side for North America?
Muhtar Kent: There's no question, we have some clear winners. We've mentioned Coke Zero, the Simply trademark is really a great winner. We're excited about Vault, the recent launch of Vault Red Blitz, with a huge immediate consumption focus. Energy continues to gain share in this competitive category against our principal competitor as well as against the market, the flavored waters. You'll see us doing a lot of critical extensions. You'll see us being more active in the area of ready to drink coffee. As we said, we launched Coca-Cola Cherry Zero in the quarter. You'll see more extensions around Coke Zero, the success of Coke Zero leveraged to more extensions. Diet Coke Plus and what the implications that has for some of the other products. You'll see us again developing and leveraging Fuse. We feel it's a huge opportunity. So those are just some of the ideas that I want to share with you in terms of how we feel about building internally. Enviga is another one. You'll see us again being active in the area of tea, Gold Peak. Those are just some of the things that I can highlight to you what we feel in terms of both what's in our innovation pipeline and how we intend to quickly commercialize and build internally as well as strategically add on any bolt-on acquisitions.
Lauren Torres - HSBC: I guess it would be fair to say that your bottlers are encouraged by the pipeline coming through?
Muhtar Kent: If you talked to them, I believe that's what they would say.
Operator: Your next question comes from the line of Matthew Riley - Morningstar.
Matthew Riley - Morningstar: I was hoping you could address the labor issues the Coke system seems to be facing in North America. Whether this could lead to trouble executing the turnaround you anticipate in the North American market?
Neville Isdell: Well, the issue is one that is with CCE. We don't want to comment on what our bottlers are doing in terms of a potential labor dispute. I think the evidence that you've seen in the past is that we have a very capable bottler that is certainly able to handle these type of issues very effectively with their unions. Clearly there is some discussion around issues at the moment as they restructure. I would anticipate that sensible people will be able to come to sensible solutions.
Operator: Your final question will come from the line of Ann Gurkin -Davenport.
Ann Gurkin - Davenport : Good morning. Two things. One, can you talk about the strategy for Powerade in the U.S. in terms of pricing and marketing? Secondly, I believe at CAGNY you talked about pushing into or developing volumes in emerging markets and your strategies in terms of using existing bottlers, acquiring bottlers, or using JVs in terms of distribution?
Muhtar Kent: Yes, let me take the one on Powerade. Essentially, we've gained volume as well as value in Powerade and we continue to be cautiously optimistic in terms of the category and also the competitive position of Powerade. You will see us accelerating Powerade in retail channels this year. The Powerade option expansion is an example of that, the NCAA commercials and so forth. So certainly we feel that there's runway ahead of Powerade and that it will gain, continue to gain traction as well as competitive advantage. As far as the question you asked about international. Basically, I've said it before. As we expand our portfolio across the world, whether it's Latin America, Europe, Asia, the traditional models that we have worked with for the last 100 years, 120 years may not always be best uses for developing fast, quickly our business in these noncarbonated and particularly juice and juice-containing beverage categories. And in those areas where we are trying out some new models with our bottling partners that are more close to what we call JV models and based on sharing of the opportunities and sharing of the investments as well as equitably sharing the value created rapidly in those segments. That's basically what I'd like to say. Does that sufficiently answer your question?
Ann Gurkin - Davenport : Yes. Are you raising prices on Powerade in the U.S.?
Muhtar Kent: I don't really want to comment on that right now. But if you looked at the Nielsen numbers, you won't see that happening.
Neville Isdell: Thank you, everyone. Thanks Muhtar and Gary. I want to just emphasize to all of you who joined us this morning, that this one quarter is a strong start to the year. We are continuing to build off the successes that we saw in 2006. So we do have consistency, we do have momentum. I am confident that our strategies are working. As I've mentioned in every quarter since my return, execution and maintaining an outward focus on our customers and consumers are critical for our success. That consistency you're going to see continuing. We continue to remain focused on the long-term health of the business. Again, I've said that since day one, everything we're doing is looking at building this business for long term, sustainable growth and therefore building value for our share owners. Thank you very much, everyone. Good-bye.
TRANSCRIPT SPONSOR :
Company sponsors its own earnings call transcript:
Company sponsors partner's transcript:
Company sponsors competitor's transcript:
Issuer-sponsored research firm sponsors client's transcript:
Investment newsletter sponsors transcripts of successful stock picks:
IR firm sponsors transcript of micro-cap company:
Consulting company sponsors company's transcript in sector of interest: Your company's name and promotion could have been on this transcript! Learn more, or email Zack Miller for details. | [
{
"speaker": "TRANSCRIPT SPONSOR",
"text": ""
},
{
"speaker": "Executives",
"text": "Ann Taylor - VP, Director, IR Neville Isdell - Chairman, CEO Gary Fayard - EVP, CFO Muhtar Kent - President, COO"
},
{
"speaker": "Analysts",
"text": "John Faucher – JP Morgan Bill Pecoriello - Morgan Stanley Robert van Brugge - Sanford Bernstein Bryan Spillane - Banc of America Securities Mark Swartzberg - Stifel Nicolaus Judy Hong - Goldman Sachs Christine Farkas - Merrill Lynch Bonnie Herzog - Citigroup Kaumil Gajrawala - UBS Lauren Torres - HSBC Matthew Riley - Morningstar Ann Gurkin - Davenport"
},
{
"speaker": "Operator",
"text": "At this time I would like to welcome everyone to the Coca-Cola Company's first quarter 2007 earnings results conference call. (Operator Instructions) I would now like to introduce Ann Taylor, Vice President and Director of Investor Relations."
},
{
"speaker": "Ann Taylor",
"text": "Good morning, and thank you for being with us today. I am pleased to be joined by Neville Isdell, our Chairman and Chief Executive Officer; Muhtar Kent, our Chief Operating Officer; and Gary Fayard, our Chief Financial Officer. Following prepared remarks this morning we will turn the call over for your questions. Before we get started, I'd like to remind you that this conference call may contain forward-looking statements, including statements concerning long-term earnings objectives and should be considered in conjunction with cautionary statements contained in our earnings release and in the company's most recent SEC report. In addition, I would also like to call your attention to the fact that we have posted schedules on our company website at thecocacolacompany.com in the investor section which reconcile our results as reported under generally accepted accounting principles, to certain non-GAAP measures which may be referred to by our senior executives in our discussion this morning, and from time to time in discussing our financial performance. Please look on our website for this information. Now let me turn the call over to Neville."
},
{
"speaker": "TRANSCRIPT SPONSOR",
"text": ""
},
{
"speaker": "What if there was a way to promote your company to a perfectly targeted group of potential customers, partners, acquirers and investors? What if you could tailor your pitch to them at the moment of maximum interest? And what if you could do this for a no-brainer price?",
"text": ""
},
{
"speaker": "Company sponsors its own earnings call transcript",
"text": ""
},
{
"speaker": "Company sponsors partner's transcript",
"text": ""
},
{
"speaker": "Company sponsors competitor's transcript",
"text": ""
},
{
"speaker": "Issuer-sponsored research firm sponsors client's transcript",
"text": ""
},
{
"speaker": "Investment newsletter sponsors transcripts of successful stock picks",
"text": ""
},
{
"speaker": "IR firm sponsors transcript of micro-cap company",
"text": ""
},
{
"speaker": "Consulting company sponsors company's transcript in sector of interest",
"text": "Your company's name and promotion could have been on this transcript! Learn more, or email Zack Miller for details."
},
{
"speaker": "Neville Isdell",
"text": "Thank you, Ann and good morning, everyone. I am going to start this morning with a few brief observations about the quarterly results, and Muhtar will then provide details on operational achievements, and Gary will follow with an overview of the financials and he’s going to give you some additional perspective on the Philippines as well. What you see today is a very strong quarter, delivered by a company and a system that has found its footing, regained its focus and come a long way in retooling its operations. While there is much more that we can and will do, the Coca-Cola Company is today proving that we can meet the commitments that we make. We said that we would drive growth and profitable brands in packs and channels, and today we are reporting revenue growth of 17% on worldwide unit case volume growth of 6%, our highest quarterly volume growth rate since 2002, while cycling 5% volume growth for the first quarter of last year. We also said that we would maximize our local brand footprint to leverage our sweet spot in the industry. Today we are reporting international growth of 9%, which is our highest quarterly international growth rate since 2000. We also said that we would grow our core sparkling beverages whilst expanding the footprint of our still portfolio. Today, we are reporting an increase of 5% in sparkling beverages, led by 4% growth in trademark Coca-Cola. That growth includes the rollout of Coca-Cola Zero to 20 additional markets including Mexico, Brazil, Argentina, and France amongst others. Still beverages increased 9%. The solid growth resulted in share being gained or maintained in key nonalcoholic ready to drink categories, including sparkling, bottled water, juice and juice drinks, sports drinks, and ready to drink tea. So, for the quarter, we've delivered on our commitments. Now I'd like to give you a new commitment. We will win again in our home market. It will not come quickly and we continue to expect 2007 to be weak, but we do expect to begin seeing sequential improvement in the second half of the year as we execute against our key goals. Muhtar will address this topic in more detail in a moment, but I want to underscore my absolute focus on North America. We delivered strong financial results this quarter, even with this decline in North America. Strong top line growth resulted in ongoing currency neutral operating income growth of 11%, which is ahead of our long-term growth targets. The geographic sources of profit growth were, in fact, more balanced as well. Additionally, we delivered solid operating expense leverage, even as we continued to invest to support our brands and build capabilities within our own company-owned bottling operations. Certainly a strong performance to start the year. So now, let me turn the call over to our Chief Operating Officer, Muhtar Kent, who will provide you with more details."
},
{
"speaker": "Muhtar Kent",
"text": "Thank you, Neville and good morning, everyone. It has been just over 120 days since I assumed my new role. What I would like to cover this morning are my key priorities for 2007 and relate those to our performance in the quarter, as well as expectations for the remainder of this year. These priorities are designed around a simple strategy: continue to innovate, take smart risks, and work closely with our bottlers to drive growth in sparkling and still beverages. The first priority is to sustain and drive progress in our international business. Second, address the issues in North America, where I've been spending a great deal of time these past four months. Third, increase productivity across the organization and drive leverage on the P&L. Fourth and last, compress and accelerate the commercialization rate of innovation and best practice sharing. Let's start with the first one, sustaining and driving progress in our international business. Our quarterly results clearly display the strength of our global portfolio and our ability to execute across the entire system, with most of our key markets delivering solid performance. We will continue to build on these results by growing our core sparkling beverages, expanding our still offerings, and executing with precision. Unit case volume growth was again led by our key emerging markets including China, Russia, Eastern Europe, Southern Eurasia, South Africa and across Latin America. Also, some of our emerging market weak spots from last year continued to rebound as India and Nigeria both delivered solid results for the quarter. In addition -- and equally encouraging -- is the strength of some of our more developed markets. One of our most consistent performers, Mexico, increased unit case volume 2%, cycling 8% in the prior year on the strength of trademark Coca-Cola driving total sparkling beverage share gain. This is the third consecutive quarter of improvement in Japan, with unit case volume up 3%. Although cycling a 2% decline from prior quarter, the performance across brand portfolios is particularly encouraging and demonstrates the changes we put in place last year. The strategy we are now pursuing there is really paying off. Solid growth in trademarks Coca-Cola, Fanta, Sprite, Enviga Green Tea and Aquarius drove the results, with each gaining share. The European Union increased unit case volume 11%, as all operating divisions delivered mid single-digit or better growth. I am encouraged by the growth particularly in Europe in Germany and Western Europe, which continued to show progress. As expected, our business in the Philippines continued to face challenges and experienced declines in the quarter. However, we are taking a number of critical actions to address these issues. At the end of February, we completed the acquisition of the bottling operations in the Philippines previously held by San Miguel Corporation. The bottler will now have full access to the expertise of our management, as well as be fully integrated with our company's overall objectives. With a robust business plan being implemented and an experienced management team in place under Irial Finan’s leadership, the leading share position and strong brand metrics, we believe we are well positioned to return the Philippines market to its former standing as one of our top performers. During 2007, as our program gains traction, we expect to see sequential improvement in unit case volume and return to growth in 2008. Gary will provide more details on the financial impact on 2007 in a moment. The success in our international operations in the first quarter directly reflects our ability to build on the progress we made in 2006. We've delivered 8% organic growth in sparkling beverages, led by 7% growth in trademark Coca-Cola. This is the highest growth in trademark Coke in international operations since 1998. In fact, sparkling beverages have averaged 6% growth over the past five quarters, confirming our belief that sparkling beverages have not matured, but rather still have great potential. Coke Zero and our new grip bottle, properly directed marketing initiatives such as the integrated activation of the Coke Side of Life at Coca-Cola.com, and efforts to win at the point of sale are prime examples of how we will use innovation and our close partnership with our bottlers to develop marketing campaigns that drive growth. In addition, we continue to expand our still beverage footprint around the world. Internationally, our still brands increased 16% in the first quarter by leveraging our existing trademarks and successfully integrating our recent acquisitions to improve our offerings to customers and ultimately to consumers. For the E.U. group, still beverages increased 36% and even excluding acquisitions, still increased solid high teens. Our juice and water platforms continue to gain strength with the expansion products such as Minute Maid into India, the pending acquisition of Jugos del Valle in Latin America, and the acquisition of Apollinaris in Europe. Success requires a robust and rational portfolio. We continue to evaluate all of our options and when necessary, we will selectively make acquisitions for additional speed, scale, as well as capability. A large competitive advantage for us, of course, is our relationship with our bottlers and the strength of our distribution channels. We've seen solid progress in our company-owned bottling operations, which in terms of volume is now the second-largest bottler in the world. The back to basics approach, an improved in-market execution can clearly be seen in our results in Germany as well as in India, amongst many other places. Now let me focus on my second priority, which is to reestablish consistent growth in our home market, North America. The first quarter results were weak, as expected, and we are clearly not satisfied with the 3% decline in volumes. We’ve got a lot of work to do, but certainly there are signs of improvement. In the first quarter we demonstrated our commitment to driving growth in trademark Coca-Cola as we activated solid campaigns for Coca-Cola Classic, Diet Coke, and Coke Zero. Integrated campaigns for all three brands included events television advertising linked to retail activation. We returned to the Super Bowl with the Coke Side of Life, to the Oscars with Diet Coke, and most recently built our presence with the NCAA basketball tournament featuring Coke Zero, and of course, our sponsorship of American idol continues to feature all three brands. Our campaigns are creating consumer awareness. Coke Zero continues to gain share, reaching a 1.2 share during the quarter. Diet Coke showed positive growth in the quarter and gained share while Coca-Cola Classic also gained share. The next round of innovation you will see in the second quarter is the introduction of Diet Coke Plus, our first venture under the Coca-Cola trademark for a sparkling, calorie-free beverage with vitamins and minerals. In still beverages for North America, we continue to make progress in our areas of focus. Trademarks Disani, Minute Maid, Simply, Oswalda and Power-Aid each gained category share. In teas, while volumes increased by double-digits, there is significant opportunity to improve and we have begun to reset our business. Our recent agreement with Nestle to refocus the DPW joint venture increases our flexibilities in the tea and coffee categories in North America, which we are pursuing vigorously. We're very excited about our recently announced acquisition of Fuse, which includes a variety of tea, juice, and other enhanced beverages and further rounds out our expanding still portfolio. Overall, we remain totally committed to winning in North America and have an active plan to address the business issues. We are focused on building our system execution capability by developing working relationships with our bottlers based on cooperation and collaboration. We anticipate continued weakness in 2007, though, the first half of the year. In the second half of 2007, we expect to see sequential improvement and evidence of progress as we execute against our key goals, which are leading growth in sparkling beverages driven by trademark Coca-Cola, delivering the fastest value growth in still beverages, and being the preferred beverage partner for our customers. Now let me turn to productivity. A very important component to our success in North America as well as around the globe is ensuring we increase productivity. We are delayering and simplifying our structure so we can improve our speed of execution and improve leverage. This will enable us to better align the architecture of the organization to the three pillars that are the core drivers of our top line growth: consumer marketing, commercial leadership and franchise leadership. This is a targeted effort to enable the organization to be more effective, efficient and to remove bureaucracy. All of our efforts center around avoiding waste and removing distractions that cause us to lose focus on the three pillars mentioned above. These initiatives will result in some cost savings, but importantly will improve clarity on decision-making which will allow for more time to be focused on revenue-generating activities. Other efforts are longer term and involve driving system efficiencies. There are projects around the global supply chain and common IT platforms. The bottlers have already been doing an excellent job in many respects and it can be seen in the improvement of their returns. We've already experienced success in global procurement of key commodity inputs as well as in Japan with the supply chain management company, where we are using those lessons to build similar models in China and Mexico, particularly as we gain scale in the still beverages. But there is still significant room for improvement across our entire system. As we reintegrate the organization and realize the productivity gains, we'll selectively reinvest behind our three pillars to drive further top line growth. My fourth priority is compressing the innovation pipeline. This really gets at our speed to market. Our organization has never lacked for innovative ideas. What we've lacked is a discipline to commercialize expeditiously. We are focused on doing fewer things and doing them better. A clear example has been the global success of Coke Zero, which will reach 40 markets representing 75% of total trademark Coca-Cola volume by the end of 2007. But we are taking a broader view of innovation. It's not just simply product formulations, it also includes such things as the new Coca-Cola grip bottle, which will be available to over 50% of the world's population by the end of 2007; the Coke Side of Life campaign, which will be in over 200 markets; we're using M&A to augment scale and capabilities, for example with Fuse here in North America. It's also brand, price, packaging and channel optimization that we are jointly developing with our bottling partners. And, it is the way we're working with our bottlers to agree on long-term plans for profitable system growth and equitable value share. While I've identified four distinct priorities, my goal for the year is to deliver on our business plan by driving sustainable top line growth and leverage in the P&L. In summary, both Neville and I are pleased with the solid start to 2007, but we are not satisfied. While we're moving in the right direction, we still have a lot of work to do. Neville said it best at CAGNY: the opportunity for Coca-Cola as the only truly global beverage company in a growing beverage industry remains significant. Having sustained solid growth in sparkling beverages internationally, we have proven that there is still opportunity in sparkling beverages and our global still portfolio is just beginning to develop. We have a focused and effective strategic agenda, supporting a renewed confidence in delivering against our long-term growth targets. We know there will be bumps, but with a new culture of innovation, improving speed to market, and maintaining an outward focus, I am certain our work will create long-term sustainable growth and value for our shareholders. Now, let me turn the call over to Gary Fayard."
},
{
"speaker": "Gary Fayard",
"text": "Thanks, Muhtar and good morning, everyone. As Neville and Muhtar indicated, we are starting the year with a strong financial performance. As you saw in the release, we reported EPS at $0.54 for the first quarter, an increase of 15%. This included a net charge primarily related to an asset write-off in the Philippines from the Philippines bottler, partially offset by gains from the sale of an ownership interest in one of our Brazilian bottlers and from real estate in Spain. Therefore, our adjusted EPS was $0.56 per share, an increase of 14% after considering items impacting comparability in both 2007 and in 2006. We attribute about a penny of the EPS to timing of concentrate shipments, as concentrate sales growth was slightly ahead of reported unit case growth in the quarter, primarily due to Easter being a little earlier this year. Net revenue in the quarter increased 17%, that included a 5 point benefit from structural change related to our acquisitions of some bottlers. The growth was also driven by a 6 point increase in concentrate sales, 3 points from currency and 3 points from price and mix benefits. We grew operating income by 17% on a reported basis, after considering items impacting comparability in the current and prior year quarter, operating income increase 14%, which includes a 3 point benefit from currency. So on an ongoing currency neutral basis, we grew operating income at 11%. SG&A increased 13% in the quarter, so let me take a moment and walk you through that increase. About 8 points of that 13 point increase were due to the bottler acquisitions, and that is from increased selling and service expenses as we invested for growth in bottling operations, and due to currency. The remaining 5 points we continued to invest solidly behind our brands, and control G&A expenses as we continue to focus on productivity and expense management. In the quarter, we repurchased approximately $676 million of our stock; as a result, our average shares outstanding in the first quarter of 2007 were approximately 45 million shares lower than the average in 2006. We still anticipate that a range of share repurchase in 2007 will be between $2.5 billion and $3 billion. In terms of dividends, the board raised the quarterly dividend for the 45th consecutive year by 10% to $0.34 per common share, which is an equivalent $1.36 per share on an annual basis. Now let me address some of the factors that we see impacting the remainder of 2007. We remain relatively positive on the macroeconomic outlook for the remainder of the year, especially in many of our emerging markets. We will continue to portfolio manage globally, as we expect solid performance in most of our markets with weak performance in North America, particularly in the second quarter as we cycle stronger volume and profit results. As with the first quarter, we would again expect our consolidated bottling operations to be a positive contributor, as we continue to build world-class operations. As for the acquisition of the Philippines bottler, you should think about it really in two buckets. First, we took a charge this quarter for the write-off of bottles and cases in the Philippines bottler. Second, we expect full year EPS results to be reduced by $0.02 as we invest to return the Philippines bottler operations to growth. Most of this impact will be reflected in the bottling investments group. Capital expenditure requirements will be slightly less than $100 million and will take the total company capital expenditures for 2007 up to about $1.6 billion. For 2008, we do not expect the Philippines to have any impact on consolidated results. In 2009, the operations should start contributing to growth. That and the impact on 2008 would include covering the interest cost from the acquisition. As for items below operating income in the P&L, I'd like to remind everyone that we still expect net interest costs to increase primarily due to lower cash balances and higher debt balances due to share repurchase, acquisitions such as the Philippines bottler, dividends, and capital spending. Also keep in mind that equity income will be negatively impacted by our reduced ownership position in Coca-Cola Fimsa and our Turkish bottler as well as selling our equity interest in one of our Brazilian bottlers this quarter. With regard to taxes, we ended the quarter with an underlying effective tax rate of 23%, and we would expect to remain at that underlying effective rate for the remainder of the year. Let me move to currency. As I mentioned, we saw a positive impact from currencies for the quarter on operating income of 3%. That was in line with our expectations. We continue to put coverage in place and are now effectively covered for the full year on both the yen and the euro. Based on current spot rates and the expected impact of coverage in place, we expect a small positive impact from currencies on full year 2007 results. Before I close, I wanted to remind everyone about the 8-K we filed with SEC 2 weeks ago containing the additional segment detail for the two new operating groups, Eurasia and Pacific. Please go to our website and pull the information down to assist in your modeling. Those are the topics I wanted to cover this morning, now we can turn the call over to your questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Our first question will come from the line of John Faucher – JP Morgan."
},
{
"speaker": "John Faucher - JP Morgan",
"text": "Good morning, everyone. I wanted to follow-up a little bit on the price mix line, which came in very nice this quarter. Can you give us a little guidance in terms of with the change in concentrate pricing from what we can see from a CCE standpoint in terms of looking at plus 4 and then net it down to zero, can you talk a little bit about how that's going to work out financially and what goals you have in place for CCE in that regard? Can you also give us an idea on the mix side in terms of how we're seeing some of the bottler case mix, is that a positive which is offsetting some of the negative country mix? How should we map that out over the balance of the year? Thanks."
},
{
"speaker": "Gary Fayard",
"text": "Thanks for the question. Let me take price mix first. What you're seeing is 3 points of price mix. About 2 points of that is coming from the core, and 1 point is an impact from bottling operations. That price mix is really from I'd say the quality of our growth with very strong sparkling beverage growth as well as very balanced growth across the world, particularly EU, Latin America, Japan. You're seeing positive mix come through, country mix come through even with an offset from North America, as well as the quality of that growth with a strong sparkling beverage growth."
},
{
"speaker": "Muhtar Kent",
"text": "Yes, essentially in those numbers, the U.S. concentrate price is already included embedded in those numbers and, essentially we've also had very good benefits in Latin America from pricing as we drive revenue growth management across all of the markets, as well as in the EU."
},
{
"speaker": "John Faucher - JP Morgan",
"text": "CCE had talked about meeting certain goals to get the concentrate pricing netted down to zero. Is that showing up in the price mix line, or is that showing up in the SG&A line if you are in fact netting the concentrate pricing down?"
},
{
"speaker": "Gary Fayard",
"text": "John, it's showing up in the price mix line."
},
{
"speaker": "John Faucher - JP Morgan",
"text": "Even with that, assuming that CCE's meeting their targets, even with that you're still putting up high quality growth there on the price mix line?"
},
{
"speaker": "Gary Fayard",
"text": "That's correct."
},
{
"speaker": "Operator",
"text": "Your next question comes from Bill Pecoriello - Morgan Stanley."
},
{
"speaker": "Bill Pecoriello - Morgan Stanley",
"text": "Good morning, everybody. Muhtar, you had mentioned some productivity benefits as one of your goals. You mentioned delayering, indirect procurement, supply chain. Can you quantify any of this or talk about the timing in terms of what kind of funds would be available for reinvestment? Also with the recent meeting you had with the bottlers in China, I guess supply chain was one of the topics. Can you help us all understand what was discussed with the bottlers at that meeting?"
},
{
"speaker": "Muhtar Kent",
"text": "You need to think of this activity this ongoing activity, Bill, in various buckets. The first is the architecture of our organization, with the primary purpose of that being really delayering and ensuring that we have speed, better focus, less bureaucracy, much more improved time in terms of our execution. That, of course, will yield some savings. We're in the process of analyzing what we do with those savings and how we reinvest, how much we reinvest, and how much we actually put to our bottom line in terms of leverage. I can't quantify any further. The international piece of that work is completed. We're completing some further work on that in North America. The second bucket is some of the other productivity work that is going on at the moment in the Company that is related to our indirect cost inside the total Coca-Cola Company. Gary and his team are leading that work stream. The third piece is the whole area of longer term supply chain initiatives for the entire system, which is a much bigger number and there's different buckets of work going on across the world in that area. If you look at it in three groups, that's as much as I'd like to say on that right now."
},
{
"speaker": "Neville Isdell",
"text": "If I could just build on that, you'll see that there is operating leverage coming through in this quarter. We believe you'll continue to see that. If you go back to when we did not appear to have operating leverage, really it was the 2005 $400 million reinvestment back into marketing. If you look at our top line growth, you can see that clearly has worked, adding the fuel to the brands. So, just echoing what Muhtar has said, you can create operating leverage in two different ways: you can keep your expenses flat where they are and push the top line by reinvesting some savings; that's one way we're looking at it. But you've got to be sure that you've got effective programs. We think we've got those effective programs in the works right now. Also, of course, there will be some that will actually just naturally flow down to the bottom line, as well. You'll see that evolve in the quarters ahead."
},
{
"speaker": "Bill Pecoriello - Morgan Stanley",
"text": "The recent meetings in China with the bottlers, how would you characterize them?"
},
{
"speaker": "Neville Isdell",
"text": "First of all, the headlines very positive. Muhtar was talking about improved bottler relations in his earlier comments. Obviously their numbers -- if you look at the international bottlers -- are improving. They have a strong belief in how we're moving forward. We spent quite a lot of time sharing some of the innovations for the future. I think we're bringing the bottling system in line with us. Obviously, we are focusing on execution, which is their side of the bargain and something that clearly they agreed they have to improve upon. The other piece of the other bucket that Muhtar talked about -- we spent a lot of time on that -- which is what we can do systemically in order to improve the overall health of the system as a whole."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Robert van Brugge - Sanford Bernstein."
},
{
"speaker": "Robert van Brugge - Sanford Bernstein",
"text": "In connection with your increased incidence rate in Mexico, you had agreed with your bottlers increased marketing spending this year. So far in the first quarter, the margin trends are still pretty much consistent with last year. Are we starting to see this increased marketing spending in the P&L at this point?"
},
{
"speaker": "Gary Fayard",
"text": "Yes, and you're right. When we increased the incidence rate in Mexico, we also agreed that we would increase or spend back some of that incidence increase in marketing as well as the creation and exploitation, if you will, of the still portfolio in Mexico. You are seeing us do that; that is happening. The marketing, remember, is on a sales curve. So it's curved over the full year, but there is an increase in marketing in Latin America. That includes the impact from the increased incidence."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Bryan Spillane - Banc of America Securities."
},
{
"speaker": "Bryan Spillane - Banc of America Securities",
"text": "Muhtar, a couple of questions relative to North America. Going into this year, pretty high expectations in terms of retail pricing. I'm just curious to know your assessment so far in terms of price elasticity. Has volume responded more or less in line with where you thought it would be? Looking forward, what are your expectations on how you'll monitor that and whether or not there's going to be a need to maybe act in terms of moderating price increases?"
},
{
"speaker": "Muhtar Kent",
"text": "Although we have not been happy at all with the results for the first quarter for our North American operations, essentially they are actually slightly better than our expectations and what we had in our budget. What we see is generally, of course -- and particularly the sparkling category overall as well as in segments like orange juice and juice-containing beverages – are very large price increases, but we see also in the retail environment the actual elasticity and actual demand elasticity for our products based on individual packages has been generally in line with expectations; what we've expected based on those price increases."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Mark Swartzberg - Stifel Nicolaus."
},
{
"speaker": "Mark Swartzberg - Stifel Nicolaus",
"text": "Muhtar, a question for you regarding Japan, nice to see another quarter of positive volumes there. Georgia seems, relatively speaking, a little better positioned than it was a year ago. Nonetheless, it looks like margins are going down in that market for you. You're spending more there. Is that a fair assessment? How would you characterize the competitive environment and the retail environment across your portfolio, not only for the ready-to-drink coffee, but your total portfolio?"
},
{
"speaker": "Muhtar Kent",
"text": "Well, I think what I'd like to say is on Japan, six of our core brands grew double-digits in Q1, and we've strengthened the core by refocusing our commitment. Sokenbicha tea remains a strong brand, delivered good volume growth; and trademark Coca-Cola has shown stabilization and has actually grown now with The Coke Side of Life campaign, and more to come in that area. In general, I think we're happy with where we are with our stabilization and return to growth in Japan. As far as coffee is concerned, the core brands of coffee grew. What is also very encouraging in Japan is that in the entire quarter our vending machines and our entire vending segment has grew, which is also very important for our margins. Essentially we are focused, we are spending in the market, and we believe that our sequential improvement in Japan is going to continue."
},
{
"speaker": "Mark Swartzberg - Stifel Nicolaus",
"text": "Great, that's helpful. Just to close that thought on the spending side. When you think about the level of spend today, perhaps on a per case basis versus a year ago, 18 months ago versus looking forward, how do you feel about that number? There's been a step up investment. Do you see it stepping up further?"
},
{
"speaker": "Muhtar Kent",
"text": "I don't see any significant changes compared to 12 or 18 months ago, overall. There may be some timing in there, but I don't see anything materially changing there. And I think we're at the reasonable rate right now. I don't see it going up any further. I think the critical thing is that our entire bottling system is in a much different place, it's energized and everything else we're doing for productivity in the market is working; and the growth, of course, is the key to everything."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Judy Hong - Goldman Sachs."
},
{
"speaker": "Judy Hong - Goldman Sachs",
"text": "Good morning. I'm wondering if you can update us further on your tea strategy going forward, both in U.S. and outside the U.S. given the changes to the BPW joint venture? Particularly North America, if you look at your tea portfolio, whether this is a category where you may need to be more aggressive on the acquisition front?"
},
{
"speaker": "Muhtar Kent",
"text": "First, just two sentences on the BPW. As you know the BPW arrangement has been recast and now essentially it's for all teas across the world with the exception of Japan and now North America; and also coffee, both sides are free to do what they want in the area of coffee. Now, let me focus on tea. BPW arrangement with the Nestea brand has been successful in many, many markets and will continue to be successful in many, many markets around the world. USA was one market where we believed we were not winning in tea, we needed more flexibility, and we are intent on winning in tea in the U.S. market. The results so far in the last two years have not been acceptable, are not acceptable and we are going to win in tea. We cannot afford not to win share in tea and we cannot afford not to grow ahead of the market in a very big category that is growing in the United States. That's the objective of all of the exercise that we've gone through. You will see us refocusing what we have in our portfolio with Nestea, with Gold Peak, with Enviga, with other brands as well as looking at new opportunities in the market in rapid fashion."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Christine Farkas - Merrill Lynch."
},
{
"speaker": "Christine Farkas - Merrill Lynch",
"text": "Thank you very much. Good morning. Muhtar, you talked about brand, pack and price architecture internationally and how that's successful. In looking at North America, can you point to what the real efforts are here in North America? Is it squarely focused on go to market strategy? Or is the brand pack price architecture something that has to be aligned more quickly? Thank you."
},
{
"speaker": "Muhtar Kent",
"text": "Both. Go to market strategy is critical as well as the BPPC architecture is critical as we move forward in order to ensure that we have revenue growth activities, management in the marketplace, and that we align consumer needs and the consumer better to our brand price pack and channel architecture in the United States. There's going to be a lot of activity in that area, including simple things like redesigning some of our labels to look more attractive. Looking at the entire merchandising sets by channel from convenience stores all the way into retail and different parts of retail and how we can generate further impulse in the marketplace, which has all worked and continues to work very favorably for us in Latin America, across Eurasia, and across parts of the EU. The test in Denver that we've had, we're doing some tests in Denver with CC and successive tests are actually showing that it's a simple architecture, but it works. It works very effectively."
},
{
"speaker": "Christine Farkas - Merrill Lynch",
"text": "Your corporate expenses, is there any investment in that line for overall system productivity at this stage, or is that a good run rate in terms of year-over-year growth?"
},
{
"speaker": "Gary Fayard",
"text": "Within the Corporate expense line, there's slight investment in productivity, investments for system initiatives, but it's primarily just kind of year-on-year growth. Underlying the G&A expenses, underlying in corporate, in fact, we're below our budgeted rate so we're really focused on holding those expenses."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Bonnie Herzog - Citigroup."
},
{
"speaker": "Bonnie Herzog - Citigroup",
"text": "Good morning, everyone. My question is for Muhtar and Neville. It's quite clear you're not satisfied with the business in North America. I'm curious, when you look out over the next several years, is there some concern that this could be a leading indicator in any way, shape or form? Either the consumer here in North America, the way you go to market, the products? If so, because I know we're different all around the world, how do you try to prevent that? Or is it the reverse? Are you really trying to, again, incorporate the best practices that you mentioned, Muhtar, in trying to fix North America?"
},
{
"speaker": "Neville Isdell",
"text": "Let the non-American here start first. I don't think there's any fundamental difference. After all, it's what happened in America that built the business around the world. There are a number of issues facing us at the moment. The headwinds of the pricing are clearly the major headwind that we have with regard to sparkling beverages. There's also this whole issue of commitment and belief. And you heard me say, you heard me at CAGNY about around the world people looking at me when I came back, when I said we'll get sparkling beverages growing again, with a level of disbelief. Obviously the pricing headwinds have held back North America. But I and Muhtar were with a number of bottlers over the last week. They have a belief that what we have coming along the pipeline, Diet Coke Plus now, what's happening with Coke Zero, et cetera that we now have the tools to actually replicate what we've done in the rest of the world in North America, whilst building out our still beverage portfolio. So I don't think there's anything exceptional about the United States. Remembering that you'll see the same sort of sticker shock in the Hispanic community, a lot of them who were immigrants who were consuming the product in other parts of the world. So the headline for us is that there is sticker shock here, but number two, that we have the consumer marketing which is working. We also have the bottler commitment in terms of franchise leadership. I think if you talked to the bottlers you'll feel a whole new level of confidence and a commitment in terms of the operational side of what is needed. John Brock has said that one of the things that he's picked up is there are lessons from around the world that we need to pick up in North America and I think that's a very good sign. Muhtar, do you want to build off that?"
},
{
"speaker": "Muhtar Kent",
"text": "Yes, just to refocus again on the consumer, connecting with our core consumers and industry with well received creative and highly rated messaging. You saw examples of that in the Super Bowl, NCAA, Oscars, improving the performance of Coke Zero and Diet Coke which are actually significantly, significantly outperforming the sparkling category. My Coke Rewards program, now over 4 million members. Again, connecting with our chief consumer target base. On the commercial leadership, we are aligned. I repeat, we are aligned with CCE on segmented merchandising, which is part of the BPPC architecture and a rollout of that. It's going to cover about a fourth to maybe even a third of our large source supermarkets by the end of this year. Agreement also with CCE to build total beverage account team, again a very important, significant area in commercial leadership. Then also on franchise leadership, the third pillar, again, aligned beverage growth agenda with all of our top to top bottlers. So again, with specifics on product innovation, we've mentioned Diet Coke Plus, but there are many others in the area of packaging, in the area of how we create impulse at the point of sale. Then we've reorganized our United States business along the lines of our international business to focus on the three core pillars, focusing on sparkling, focusing on stills, and focusing on new and emerging markets; we have put very experienced people against all those three areas. The other important thing is you walk around the U.S. market, Bonnie, you walk around the U.S. market and we've lost the drive to create impulse. That's what we're bringing back. No signage. The whole signage program for the world started right here in the United States 30, 40 years ago. Now you walk around Latin America, you walk around Europe, you walk around Asia, you walk around Africa everywhere you have signs that say ice cold Coca-Cola served here, not in the United States. That's creating the impulse, again back to basics and we know we can do it. So it's both. Bringing best practices from outside and then leveraging the power of the category, which is bigger than anywhere else in the world here in the United States. Doing both at the same time."
},
{
"speaker": "Bonnie Herzog - Citigroup",
"text": "That was very helpful. So in terms of timing, you're thinking by the end of this year, will it take you maybe until early next year to do a lot of what you said? Because it all sounds great."
},
{
"speaker": "Muhtar Kent",
"text": "I don't want to comment any more on the timing. I think you see our sense of urgency."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Kaumil Gajrawala - UBS."
},
{
"speaker": "Kaumil Gajrawala - UBS",
"text": "Good morning, everyone. To the extent that you beat your top line growth algorithms, what impact could this have on your future CapEx? Potentially does it limit any increase in your cash return to shareholders? Also can you talk about the macro economic backdrop in some of the developed markets like Western Europe and Japan and how this may have helped results?"
},
{
"speaker": "Gary Fayard",
"text": "Relative to CapEx, it should not have any real impact on CapEx, actually, because most of our CapEx is in some of the finished products businesses in North America, some of the bottling and bottling investments, which are really kind of not permanent investments for us. No change in business model. I don't see much change in CapEx. Relative to dividends, we've been very consistent and have been increasing dividends at a pretty good clip over the last few years. So we would expect to continue to see dividend increases. Again, an annual decision that we'd be looking at the end of this year, but have a dividend policy in place for this year. Relative to macro economic trends, Muhtar, do you want to comment on that one or Neville?"
},
{
"speaker": "Neville Isdell",
"text": "I'll pick that up. There is a broad optimism you've seen what the OECD is saying, what the World Bank is saying. I think that global growth is going to continue at the rate that we've seen over the past couple of years for '07 and through into '08. That's really reflected in our plans. The one that you still would query, I suppose, would be Japan. I think we're cautiously optimistic about that country coming out of stagnation and given the importance of Japan, together with the actions that we're taking in the Japanese business which are becoming apparent in terms of being successful, we are becoming more bullish but cautiously optimistic, I would put it, about Japan."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Lauren Torres - HSBC."
},
{
"speaker": "Lauren Torres - HSBC",
"text": "I was hoping you could talk a bit more about product build outs, maybe even more importantly the potential for acquisitions in North America. Obviously we heard about your acquisition of Fuse. I was just thinking about if we should expect similar deals in the works. Basically, how are you thinking about internally developing brands in the U.S. versus acquiring brands?"
},
{
"speaker": "Neville Isdell",
"text": "Developing brands let me pass that to Muhtar in a second, but we really don't comment on acquisitions. I still stay with what we've said all along that we're going to do both. That would be largely bolt-on. But opportunities come up, and we evaluate every opportunity and look to see whether that is the right way to build our portfolio. Muhtar made the comments in his remarks that that's what we would do. Buying is sometimes the right way. What we have is an innovation pipeline coming along where we are building and building at a rate that we have not been building in the past. Even if you look at patents that we're getting registered in terms of new benefits that we could add to our own beverages, you'll see that in the innovation pipeline. Muhtar, would you like to talk about just about what's coming down to the pipe from the build side for North America?"
},
{
"speaker": "Muhtar Kent",
"text": "There's no question, we have some clear winners. We've mentioned Coke Zero, the Simply trademark is really a great winner. We're excited about Vault, the recent launch of Vault Red Blitz, with a huge immediate consumption focus. Energy continues to gain share in this competitive category against our principal competitor as well as against the market, the flavored waters. You'll see us doing a lot of critical extensions. You'll see us being more active in the area of ready to drink coffee. As we said, we launched Coca-Cola Cherry Zero in the quarter. You'll see more extensions around Coke Zero, the success of Coke Zero leveraged to more extensions. Diet Coke Plus and what the implications that has for some of the other products. You'll see us again developing and leveraging Fuse. We feel it's a huge opportunity. So those are just some of the ideas that I want to share with you in terms of how we feel about building internally. Enviga is another one. You'll see us again being active in the area of tea, Gold Peak. Those are just some of the things that I can highlight to you what we feel in terms of both what's in our innovation pipeline and how we intend to quickly commercialize and build internally as well as strategically add on any bolt-on acquisitions."
},
{
"speaker": "Lauren Torres - HSBC",
"text": "I guess it would be fair to say that your bottlers are encouraged by the pipeline coming through?"
},
{
"speaker": "Muhtar Kent",
"text": "If you talked to them, I believe that's what they would say."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Matthew Riley - Morningstar."
},
{
"speaker": "Matthew Riley - Morningstar",
"text": "I was hoping you could address the labor issues the Coke system seems to be facing in North America. Whether this could lead to trouble executing the turnaround you anticipate in the North American market?"
},
{
"speaker": "Neville Isdell",
"text": "Well, the issue is one that is with CCE. We don't want to comment on what our bottlers are doing in terms of a potential labor dispute. I think the evidence that you've seen in the past is that we have a very capable bottler that is certainly able to handle these type of issues very effectively with their unions. Clearly there is some discussion around issues at the moment as they restructure. I would anticipate that sensible people will be able to come to sensible solutions."
},
{
"speaker": "Operator",
"text": "Your final question will come from the line of Ann Gurkin -Davenport."
},
{
"speaker": "Ann Gurkin - Davenport",
"text": "Good morning. Two things. One, can you talk about the strategy for Powerade in the U.S. in terms of pricing and marketing? Secondly, I believe at CAGNY you talked about pushing into or developing volumes in emerging markets and your strategies in terms of using existing bottlers, acquiring bottlers, or using JVs in terms of distribution?"
},
{
"speaker": "Muhtar Kent",
"text": "Yes, let me take the one on Powerade. Essentially, we've gained volume as well as value in Powerade and we continue to be cautiously optimistic in terms of the category and also the competitive position of Powerade. You will see us accelerating Powerade in retail channels this year. The Powerade option expansion is an example of that, the NCAA commercials and so forth. So certainly we feel that there's runway ahead of Powerade and that it will gain, continue to gain traction as well as competitive advantage. As far as the question you asked about international. Basically, I've said it before. As we expand our portfolio across the world, whether it's Latin America, Europe, Asia, the traditional models that we have worked with for the last 100 years, 120 years may not always be best uses for developing fast, quickly our business in these noncarbonated and particularly juice and juice-containing beverage categories. And in those areas where we are trying out some new models with our bottling partners that are more close to what we call JV models and based on sharing of the opportunities and sharing of the investments as well as equitably sharing the value created rapidly in those segments. That's basically what I'd like to say. Does that sufficiently answer your question?"
},
{
"speaker": "Ann Gurkin - Davenport",
"text": "Yes. Are you raising prices on Powerade in the U.S.?"
},
{
"speaker": "Muhtar Kent",
"text": "I don't really want to comment on that right now. But if you looked at the Nielsen numbers, you won't see that happening."
},
{
"speaker": "Neville Isdell",
"text": "Thank you, everyone. Thanks Muhtar and Gary. I want to just emphasize to all of you who joined us this morning, that this one quarter is a strong start to the year. We are continuing to build off the successes that we saw in 2006. So we do have consistency, we do have momentum. I am confident that our strategies are working. As I've mentioned in every quarter since my return, execution and maintaining an outward focus on our customers and consumers are critical for our success. That consistency you're going to see continuing. We continue to remain focused on the long-term health of the business. Again, I've said that since day one, everything we're doing is looking at building this business for long term, sustainable growth and therefore building value for our share owners. Thank you very much, everyone. Good-bye."
},
{
"speaker": "TRANSCRIPT SPONSOR",
"text": ""
},
{
"speaker": "Company sponsors its own earnings call transcript",
"text": ""
},
{
"speaker": "Company sponsors partner's transcript",
"text": ""
},
{
"speaker": "Company sponsors competitor's transcript",
"text": ""
},
{
"speaker": "Issuer-sponsored research firm sponsors client's transcript",
"text": ""
},
{
"speaker": "Investment newsletter sponsors transcripts of successful stock picks",
"text": ""
},
{
"speaker": "IR firm sponsors transcript of micro-cap company",
"text": ""
},
{
"speaker": "Consulting company sponsors company's transcript in sector of interest",
"text": "Your company's name and promotion could have been on this transcript! Learn more, or email Zack Miller for details."
}
] | null | null |
MA | 4 | 2,008 | 2009-02-05 09:00:00 | Executives: Barbara Gasper – Investor Relations Robert W. Selander – President & Chief Executive Officer Martina Hund-Mejean – Chief Financial Officer Tara Maguire – Corporate Controller
Analysts: Julio C. Quinteros – Gold Sachs & Co. Tien-Tsin Huang – JP Morgan Andrew Jeffrey – SunTrust Robinson Humphrey Craig Maurer – Calyon Securities David [Cox] – Buckingham Research Jason Kupferberg - UBS Chris Brendler – Stifel Nicolaus & Co. Analyst for Wayne Johnson – Raymond James Chris Mammone – Deutsche Bank Securities
Operator: Welcome to the Q4 2008 MasterCard earnings conference call. At this time all participants are in a listen only mode. (Operator Instructions) I would now like to turn the call over to Barbara Gasper, Group Executive, Investor Relations. Please proceed Ma’am.
Barbara Gasper: Good morning to everyone. Thank you for joining us today either by phone or web cast for a discussion about our fourth quarter and full year 2008 financial results. With me on the call this morning are Bob Selander, our Chief Executive Officer; Martina Hund-Mejean, our Chief Financial Officer and Tara Maguire, our Corporate Controller. Following comments from Bob and Martina highlighting some key points about the business environment and our fourth quarter and full year results we will open up the call for your questions. This morning’s earnings release and the slide deck that will be referenced on this call can be found in the Investor Relations section of our website www.MasterCard.com. The earnings release and slide decks have also been attached to an 8K that we filed with the SEC earlier this morning. A replay of this call will be posted on our website for one week until February 12th. Finally as set forth in more detail in today’s earnings release I need to remind everyone that today’s call may include some forward-looking statements about MasterCard's future performance. Actual performance could differ materially from what is suggested by our comments today. Information about the factors that could affect future performance are summarized at the end of our press release as well as contained in our recent SEC filings. With that I will now to turn the call over to Bob Selander.
Robert Selander: Good morning everybody. I would like to start out by saying I am pleased we have been able to deliver another strong quarter of earnings results. We saw net revenue growth of over 14% despite the headwinds from the strengthening U.S. dollar and improved our operating margin by approximately 22 percentage points versus the year-ago quarter. We have seen the economic downturn hit consumers and businesses alike but our business model and global diversity provides a good degree of resilience in this environment. I would like to take a few moments to discuss our view of the global economy, our fourth quarter results which Martina will take you through in more detail and then offer some comments about our capital structure. I am on slide two in the material. Turning first to the economy, as a result of the current economic turbulence the world is facing significant challenges which can only be addressed with time. The U.S. recession continues with low consumer confidence due to a difficult housing market impacting net worth and rising unemployment now putting more stress on household incomes. The economic issues are not limited to the United States. We are seeing government bailouts and economic stimulus packages from the U.K. to China to the Netherlands. We are seeing banks in several countries being, or close to being nationalized. We expect the climate to remain challenging in 2009 and we are not counting on any improvements this year. Although precise timing is something no one can predict we continue to expect that things will begin to improve in 2010 depending on the stabilization in the housing markets, the specifics and timing of any stimulus packages and the resulting impact on consumer confidence and employment. While we are not immune from the global economic problems we are fortunate to be part of an industry that offers opportunities for growth due to the continued secular trend of people moving away from cash and checks to electronic forms of payment. Of course certain countries are particularly hard hit but we still see tremendous growth opportunities in many other countries around the world. In the fourth quarter we saw the following: In the U.S. gross dollar volumes and transactions for credit declined while debit still grew in the mid single digits. We continued to experience volume and transaction growth in Europe in the mid to high single digit range and none of the major countries in that region have yet dipped into a decline. While Latin America’s growth was in the low double digit area overall due to declines in Mexico and Venezuela, Brazil continues to be a bright spot with solid double digit growth. In addition, our South Asia, Middle East, Africa region is also still experiencing significant growth. Consistent with the October data we shared with you in our last earnings call, cross border growth continued to decelerate in November and December and grew at only 7.5% for the quarter compared to 27% for the year-ago quarter. It is also down sequentially from 18% in the third quarter of 2008. U.S. cross border volume saw declines in the low teens while the rest of the world experienced growth. When evaluating MasterCard process volumes and transactions through the first four weeks of January we saw the following: Worldwide processed volume in January was essentially flat. Cross border growth continued to decelerate in January but was still positive despite further declines in the United States. It is important to note that worldwide processed transactions were up slightly driven by a pick up in the United States relative to what we saw in the fourth quarter. While we cannot control some of the issues that are pressing on the economies around the world we are focused on the things we can control such as effective management and prudent investment of our resources and we continue to remain committed to controlling our overall cost base. As you have seen in our fourth quarter numbers we were able to deliver a 1.4% decrease in G&A expense primarily through initiatives that resulted in travel and entertainment expenses that were down 50% year-over-year and professional fees that were down almost 20%. Similar to 2007, we had some severance charges in the fourth quarter of 2008. In these most challenging of economic times we continue to better align our capabilities to meet our customers’ needs as well as ensure that we continue to innovate and deliver in ways that position us for the future. Based on internal and external feedback that we have received we have made recent organizational changes to ensure that we are delivering in a more efficient and cost effective manner to our customers. We are focusing in particular on the United States and Western Europe while still continuing our investments in the emerging markets and innovative products and services offerings. As a result, you can expect to see additional severance charges in the first quarter and perhaps in the second quarter of 2009 but we are not yet in a position to size that expense. Electronic payments remain vital for commerce around the world. Consumers and businesses will still spend. While the current economic climate will likely continue to put pressure on volume growth in many countries around the world the secular shift from cash and checks to electronic payments will continue given the push for greater efficiency and effectiveness. Our business model, geographic diversity, the work we are doing with our customers and merchants around the world and the continued secular trends should enable us to better navigate these challenging times. Just a few words about our thoughts on capital structure. We continue to believe that at this point a strong balance sheet with a good cash position and positive operating cash flow is the right place to be. It creates a level of comfort in these tough economic times and provides flexibility should we see attractive investment opportunities such as our recent Orbiscom acquisition. As you know our Board continuously evaluates our capital structure and supports maintaining our strong position. Earlier this week our Board approved a regular quarterly dividend as well as a conversion program for 2009 of up to 11 million class B shares which would if fully subscribed bring the class B ownership to just above 15% of total shares outstanding. With that I will now turn the call over to Martina for a detailed update on our financial results. Martina?
Martina Hund-Mejean: Thanks Bob and good morning everyone. As Bob mentioned we are very pleased to cap off 2008 with strong fourth quarter financial results. Turning to page three of the slide deck in the fourth quarter we delivered net revenue of $1.2 billion, up 14.2% over the comparable period last year. This was driven by growth in process transactions, moderated rebates and incentives as well as fees for other services. Additionally, pricing changes contributed approximately 8 percentage points to revenue growth. Currency fluctuations of the Euro and the Brazilian Real relative to the U.S. dollar tempered our revenue growth by 3.5 percentage points. On a constant foreign exchange basis net revenue growth was 17.6%. Excluding a special item of $6 million related to the settlement of a Consumer Protection case in California that was an offshoot of our U.S. merchant litigation, our operating income was $468 million. This resulted in a strong operating margin of 38.2% which is a 22.2 percentage point improvement over last year. The combination of our strong revenue growth and effective cost management has enabled us to leverage our operating margin. As you know, our operating margin is typically the lowest in the fourth quarter due to seasonal factors. [End of quarter] effective tax rate was just over 46% in the fourth quarter of 2008 versus 34.9% in the comparable period in 2007. The increase was primarily due to early measurement of deferred tax assets as increased FIN48 tax reserves. In the fourth quarter we delivered net income of $243 million or $1.87 per diluted share excluding the special items. Turning to page four, during the fourth quarter the global diversification of our business has helped us weather the cyclical downturn in the U.S. Our ability to generate significant volume, transactions and revenue from economies outside of the United States has cushioned our business from the decline that we experienced in the U.S. Worldwide gross dollar volume (GDV) grew 3.4% on a local currency basis in the fourth quarter but declined 4.7% on a U.S. dollar converted basis to $605 billion. The lower GDV growth rates are due to the strength of the U.S. dollar against most other currencies during the fourth quarter. The deceleration in the overall local currency growth rate can be attributed to the U.S. The GDV growth declined 5.2% due to negative credit growth. Worldwide debit GDV however grew 10.7% for the quarter. U.S. debit GDV grew 5.8% which was a slower pace of growth than the 15.9% from the same quarter in 2007. Elsewhere GDV continued to grow at healthy rates for every other region on a local currency basis although at a much slower pace than what we had seen either on a year-over-year basis or on a sequential basis. Although not shown on page four, on a local currency basis worldwide purchase volume was up 3.1%. Similar to the GDV trend, U.S. purchase volume growth rate declined 4.6% for the quarter driven by a decline in credit volume. Fourth quarter volume grew at 7.5% for the quarter versus 27% in the fourth quarter of last year. We experienced exceptionally strong cross border growth during the fourth quarter of 2007 making this a very difficult comp to beat. Therefore, the results are more positive than the absolute number implies given the current global economic turmoil. While travel patterns remained largely the same on a year-over-year basis the only significant changes we saw were fewer Latin Americans traveling to the U.S. and an increase in intra-regional cross border travel within Latin America. With cross border growth decline low double digits during the quarter was more than offset by growth in other regions principally in Europe and in SEMEA. European cross border volume growth remained strong and remember that a majority of the European cross border volume is generated on an intra-Europe basis and consumer cross border volume growth moderated somewhat but we still saw strong double digit growth in our commercial cross border volumes. Turning to processed transactions, processed transactions increased 6% compared to the year-ago quarter to $5.5 billion. Even in the U.S. processed transactions grew at low single digit rates. Therefore we are still seeing the secular trend of people moving away from cash and checks to electronic forms of payment. Let’s turn to page five. Here you see that net operation fees increased 16.5% to $966 million in the fourth quarter. Gross operation fees increased 13.2% to about $1 billion. This growth was driven by two factors. First, banking changes implemented in January 2008 on cross border acquiring volumes and some European pricing initiatives implemented this past October. Second, the growth in processed transactions and fees for other services partially offset by volume declines that translated into U.S. dollars. In the fourth quarter net operation fees were 92.4% of gross operation fees, slightly higher than the same quarter in 2007. This was due to a decline in rebates as a result of lower volume and adjustments for previous estimates. Since we won’t be filing our 10K until later in February we have included the quarterly operation fees detail for your reference in Appendix B to the slide deck. On page six we show that net assessments increased 6.1% to $259 million versus the fourth quarter of 2007. Gross assessments increased 6.3% to $604 million primarily due to pricing and increased revenues as a result of growth in debit cards worldwide. The overall growth was partially offset by lower volumes when translated into U.S. dollars. Assessments as a percentage of gross assessment was essentially flat compared to the same quarter 2007. The normal seasonal up tick in fourth quarter rebates and incentives as offset this year because of lower volumes and adjustments for previous estimates. Now we will turn to page seven for some detail on expenses. We have continued implementing a number of expense management measures as part of our commitment to a flat expense structure going forward. During the fourth quarter excluding special items total operating expenses decreased 16%. Currency fluctuations of two percentage points contributed to the decline. Therefore, total operating expense decreased 14% on a constant FX basis. The decrease was mainly driven by the following: General and administrative expenses decreased 3.4% with currency fluctuations contributing approximately two percentage points. On a constant FX basis general and administrative expenses decreased 1.4%. The decrease was due to the following: Lower personnel costs accounted for 3.3 percentage points of the G&A decrease and were about flat on a constant FX basis. Travel expenses decreased approximately 50% as a result of cost reduction initiatives implemented during the fourth quarter. Professional fees also declined by approximately 20% during the quarter due to a reduction in legal costs and consulting expenses. Advertising and marketing spend decreased by 32.8% versus the year-ago period with approximately 1.9 percentage points related to the impact of foreign currency fluctuations. On a constant FX basis, therefore, A&M decreased 30.9% for the quarter. We have included the quarterly general and administrative expense details for your reference in Appendix B. Turning to page eight, let’s take a quick look at our full-year performance which was once again impressive. We delivered net income of $1.2 billion or $9.45 per share on a diluted basis and excluding special items. This includes $0.42 per share from gains on the sale of the remaining portion of our investment in Redecard. We achieved full year net revenue of $5 billion representing growth of 22.7%. Excluding the 2.5 percentage point effect of FX, net revenue growth was 20.2%. Pricing adjustments contributed approximately six percentage points to the growth. Net revenue growth was also driven by strong growth in gross dollar volume and processed transactions including cross border volumes which grew for the whole year at 16.6%. Finally, we saw our full year operating margin improve 11.7 percentage points to 39% from 27.3% excluding the special items in both 2008 and 2007 respectively. Moving to the cash flow statement and balance sheet highlights on page nine, after litigation payments of more than $1 billion we still generated $413 million in cash from operations and ended the year with cash, cash equivalents and current investments of $2.1 billion. The impact of 2008 litigation settlements resulted in decreased stockholder equity as well as increased litigation liabilities and deferred tax assets. Additionally, the impact of the Orbiscom acquisition is reflected in our year-end 2008 balance sheet and cash flow statement. I will now hand it back to Bob to discuss our outlook for the year and share some recent business highlights. Bob?
Robert Selander: There is no reason to assume that the economic slow down across the world will improve for the balance of this year. The global financial markets are undergoing unprecedented change that certainly impacts our industry and we are positioning ourselves for these changes as detailed on slide number 10. When looking at 2009 we continue to expect the following: Net revenue growth will likely fall below the average annual range of 12-15% that is in our longer term objectives. While we intend to invest wisely for long-term growth we have demonstrated our commitment to manage expenses more tightly. Our total operating expenses are expected to be essentially flat versus 2008. We will use the levers that we have in G&A and advertising and marketing prudently and appropriately depending on the economic environment and our customers’ needs. As I said on our last earnings call we expect to meet our longer term objectives of annual margin expansion of 3-5 percentage points and average annual net income growth of 20-30% this year as long as we see high single digit revenue growth. If revenue growth falls below this level we would need to evaluate whether to make further adjustments to our expense structure also keeping in mind our intention to continue making appropriate investments for future growth. Remember, all of our objectives are on a constant FX basis so our as reported numbers will include any impact of foreign exchange. Given the relative strength of the U.S. dollar we expect that foreign exchange will present a headwind for the revenue and net income lines this year and a tailwind on the expense line. Our longer term performance objectives also assume an effective tax rate of 35%. We remain vigilant about the economic developments that affect both our customers’ businesses and consumer spending patterns and we will continue to evaluate our objectives as we move through 2009 and adjust them as appropriate. Finally, while our business model may not experience the growth trajectory we have seen over the last few years we feel both fortunate and optimistic with the business prospects ahead of us. We believe this will continue to deliver attractive results for our shareholders. Before moving to the Q&A session, I would like to share with you some of our recent business successes from around the world. In addition to achieving strong fourth quarter operating results we remained focused on delivering best-in-class products and services to our customers. We made solid strides in opening up new growth opportunities that leverage our unique processing capabilities and solutions, enhanced our strong position in pre-pay and despite the challenges that they face we continue to be recognized by our customers for the value and partnership we provide as we were awarded with new opportunities and agreements for continued growth. We recently announced a new partnership with global retail leader Carrefour in France launching the first MasterCard exclusive branded cards incorporating Pay Pass technology and combining debit and credit payment applications on a single card. This agreement includes our full suite of domestic processing capabilities. Likewise, MasterCard integrated processing solutions (IPS) the debit and prepaid processing platform we introduced in 2008 continues to build momentum with the signing of another customers. Swiss Bankers became the first financial institution to take advantage of the global prepaid transaction processing capabilities of IPS and we hope to have more news to share with you on the IPS front in the near future. Together with MasterCard the Italian Postal System launched the first National Government Benefits Disbursement Program in Italy using MasterCard branded prepaid cards. With the addition of Poste Italiane our leadership in the prepaid public sector continues to grow. We continue to expand our efforts to provide global remittance services that leverage our global network to extend financial services opportunities among banked and un-banked customer segments. In November we launched MasterCard Money Send in association with the Development Bank of Singapore. The cross border remittance service enables consumers in Singapore to send money via the Internet to friends and family in Indonesia, India, Malaysia, the Philippines and Thailand. With MasterCard Money Send we are enabling our issuing banks to access new customer segments and offer payment products as well as other banking and financial services in developing markets. In India Citi Bank launched the first MasterCard Premium Debit program in South Asia targeting high net worth individuals and senior executives in large corporations. In summary, as evidenced through our accomplishments in the fourth quarter we are committed to leveraging the strength of our global network, processing capabilities, strong relationships and our product development platform in order to drive results for our issuers, acquirers and other partners around the world. I will now turn the call back over to Barbara so we can begin taking your questions.
Barbara Gasper: Thank you Bob. We are now ready to begin the question-and-answer period. In order to get to as many people as possible in our allotted one-hour timeframe we ask that you limit yourself to a single question with one follow-up and then queue back in with additional questions. Operator?
:
Operator: (Operator Instructions) The first question comes from the line of Julio C. Quinteros – Gold Sachs & Co.
Julio C. Quinteros – Gold Sachs & Co.: I wanted to just sort of hit one quick thing on the cross border commentary. If you could just rehash what you said there about the volumes there coming out of January so I can make sure I got that right. Also, related to that how to think about some of the cross border pricing benefits as you think about 2009. When should those anniversary and just any other color you could provide on the cross border side would be helpful.
Robert Selander: Let me go back to the cross border. I am trying to recall specifically what you are referring to. The January volumes and transactions that I mentioned which were through the first four weeks in the month of January we saw worldwide process volume that was essentially flat for the same period the prior year. Remember, this is what we see that is processed. It does not include the gross dollar transactions and volumes that we do not process. We think it is a pretty good indicator. Cross border growth continued to decelerate in the month of January although it was still positive. We have seen the U.S. continue to decline. What that means is individuals who have cards from U.S. financial institutions are not traveling and I think you probably have seen that in some of the airline statistics and data that is released through other sources in the U.S. marketplace. I think it is important to note and I believe I also mentioned this that worldwide processed transactions were up and that was driven by a slight pick up in the U.S. relative to what we have seen in the fourth quarter in terms of processed transactions.
Julio C. Quinteros – Gold Sachs & Co.: Lastly, all of your guidance is constant currency just to confirm that, right?
Robert Selander: That is correct.
Operator: The next question comes from Tien-Tsin Huang – JP Morgan.
Tien-Tsin Huang – JP Morgan: I was hoping to get a clarification and I also have a question. It sounds like you still expect 3-5 point of margin expansion of 20-30% as long as high single digit revenue growth is there for this year but just to confirm there wasn’t any point guidance on revenue growth for 2009?
Robert Selander: That is correct.
Tien-Tsin Huang – JP Morgan: Assuming current trends persist, I am actually not going to ask about volumes and revenue but I guess really on rebates that was sort of a little bit a delta from what we expected. It was better than we expected. Can you give us some guidance on how that might trend assuming current volume trends persist and also how does FX impact this rebate line?
Martina Hund-Mejean : Let me take that. First of all in the fourth quarter as you already said we saw some moderating in the rebates and incentives line and some of that was due to lower volume growth that we had in the fourth quarter. However, we also had some adjustments to prior estimates so you also have something in there that is maybe more of a one-time nature. In terms of 2009, if volumes continue to be the way they were in Q4 I think you should see a little bit of moderating on rebates and incentives although not to the extent you saw in Q4. I don’t think this is a linear trend. It is going to be just a little bit of an impact. In terms of foreign exchange we are not really talking about the rebates and the incentive line separately from a foreign exchange point of view. I think I laid out at the last earnings call kind of a rule of thumb that you might be able to use particularly as it relates to our Euro exposure. I am referring back to for every $0.01 move in the Euro our net revenues are impacted by about $8-9 million. Our operating expenses are impacted about $4-5 million so we have a net $3-4 million on the operating income line. When you translate all this, maybe I can be a little bit helpful for you to think about 2009 the Euro is now at $1.33 or $1.35 range versus the U.S. dollar. If you translate all these rules we probably are going to expect a headwind assuming that the dollar stays where it is of around four percentage points for the year.
Operator: The next question comes from Andrew Jeffrey – SunTrust Robinson Humphrey.
Andrew Jeffrey – SunTrust Robinson Humphrey: Could you comment a little bit Bob on pricing environment particularly in the U.S. with respect to what is happening at the issuer level and the pressure that your big issuers are facing? Also as a follow-up could you comment on what your view would be of the risk to your business associated with potential nationalization of a big issuer?
Robert Selander: A couple of thoughts on pricing, I believe we have indicated to you that in order for us to realize year-over-year improvements in pricing we need to deliver improved value to our customers and that equation hasn’t changed. From the perspective of what is going on within the U.S. clearly all of our customers are feeling stress. If you take a look particularly on the credit card side of the business we have seen significant increases in delinquency and charge offs occurring. We do not expect that trend is going to abate so we think our customers are going to continue to have an all-hands on deck approach where they try to maximize what they get in their current customers and work very hard on the credit and collections side of the equation. We think that is going to persist throughout the year. As a result we have been sort of reshaping our thoughts as far as how we serve those customers and we do not expect that we are going to see a buoyant acquisition program or some of the things that we may have seen in past years return in the course of 2009. Our competitors, in addition to the customer expectations, continue to make pricing challenging in the U.S. marketplace. The second part of your question was speculation of what happens if there is a nationalization of large U.S. issuer. I don’t know that there is any model that anybody can look at. I think it has been pretty clearly stated by a lot of people on Congress and others in the administration that they are not looking to nationalize banks. They are looking to support banks to help them restore the U.S. economy. So that is not something we currently are thinking about other than in the context of what we have seen when banks have run into difficulties. For banks it is a pretty straight forward regime in terms of what happens if a bank runs into challenges. We have seen that with the FDIC and other agencies in terms of the relatively smooth, I would describe it, handling of the ongoing obligations of those institutions and the continuation of those programs on which consumers and businesses are dependent. We would much rather have all of our customers thriving so we are going to just have to tough it through and help them tough it through these next challenged quarters.
Operator: The next question comes from Craig Maurer – Calyon Securities.
Craig Maurer – Calyon Securities: The first question I had for you is could you comment on the average ticket you saw or the impact you saw in the fourth quarter on your average ticket size and if you can quantify the impact the cash pricing had or characterize it a little bit?
Martina Hund-Mejean : Average ticket prices in the U.S. as well as for the rest of the world have decreased slightly though we did definitely see an impact while we saw the consumer transacting more as you can see from a transaction growth point of view, average ticket price in particular has gone down. It has gone down some slightly. What was your second question related to?
Robert Selander: In terms of what happened with gasoline as you know in the U.S. gas prices are down dramatically from where they were a year ago. Gasoline represented about 6.5% of our U.S. volume and about 15% of transactions during the fourth quarter. If you were to make adjustments for year-over-year change in gas price, gasoline would have increased slightly as a percentage of volume. On the other hand those prices were down dramatically.
Martina Hund-Mejean : Just to build a little bit on Bob’s comment on gas, when you see our purchase volume in the U.S. being down by 4.6% probably around, not probably but definitely around 25% of that decline was due to lower gas prices.
Craig Maurer – Calyon Securities: One follow-up, it was something that Visa said last night that I thought maybe you could also characterize for us, in terms of the comment that percentage of volume driven by debit or pay in full type customers that aren’t revolving it was a question around what would the impact be from dramatically lower option to buy credit lines in the U.S.?
Robert Selander: I’m not sure I fully understood that.
Craig Maurer – Calyon Securities: The question is around what would the impact be if open credit lines were cut dramatically in the states. It was characterized in the answer by the percentage of volume that is driven by customers that pay in full and don’t revolve or debit driven convenience usage type customers.
Robert Selander: I think that is a reasonable thing. If a consumer who would have otherwise been spending has their line capped that is obviously going to affect that cohort of customers. What we have seen is the decline in credit purchases has been in bigger ticket items; furniture, higher priced over $1,000 types of things, electronic goods, etc. We saw that right through the holiday shopping season and those year-over-year declines have persisted. I would argue that consumers are also being more disciplined. They either are experiencing challenging times and are foregoing things that they might liked to have had, i.e. a brand new big screen TV or whatever it might be and they are paying for basics. I think there are a lot of factors that converge there but I think one you mentioned could be and probably is one of those contributing factors.
Operator: The next question comes from David [Cox] – Buckingham Research.
David [Cox] – Buckingham Research: Could you give us a little more color for the outlook for price increase benefit over the next year? Should we continue to expect sort of 6% year-over-year benefit?
Martina Hund-Mejean : As we have said in the past, we are really only making pricing adjustments if it will deliver particular value propositions to our customers. If you can appreciate in this kind of environment where our customers are having very challenging times we are going to be extremely careful and it has to be completely directly tied to what kind of product and service we will give to them. We have laid out there in the past the terms of what we think our normal, annual pricing adjustment which is in the 200 basis points range and at this point in time that is still where we are. This is a very challenging time and we are going to have to deliver in order to be able to do something like that.
David [Cox] – Buckingham Research: Another way to ask it is just how much of what we saw this quarter will continue or anniversary in October or later in the year? Sooner in the year?
Martina Hund-Mejean : As you know the majority of our price increases were in January of 2008 so all of that has anniversaried at this point in time and we made some pricing adjustments in Europe in October and obviously that would be then anniversarying next October.
David [Cox] – Buckingham Research: Could you give us some color on the change in spending growth on world cards versus basic cards? Much of a noticeable change in consumer behavior?
Martina Hund-Mejean : We have really not seen any big differential on that other than what Bob has mentioned in terms of where people are spending on high ticket items. We really don’t see a lot of spending on that. It is really on items below $1,000. It seems to be that $1,000 threshold is still significant. The other thing we have seen an impact obviously on travel. You can see that travel volume is pretty much down. You see that on our network too. Interestingly enough transactions are up because when you go and travel on an airline these days you get charged for all sorts of wonderful extra things such as checking in, checking bags, actually getting a bottle of water on the airplane, etc. so we are seeing those kinds of trends going on.
David [Cox] – Buckingham Research: So it is really just for pricing too? The airline ticket price is down and that is driving volumes?
Robert Selander: No I think the observation is, regarding your specific question, we are seeing an across the board change in consumer spending patterns. If you were to take a look at the so called luxury end retailers they have had even more significant declines, 15-20% types of year-over-year sales declines as compared with the more day-to-day operators, supermarkets and so forth. That is occurring across all sorts of cards. If you look at consumer travel, airline and hotel are down also in the order of magnitude 10% year-over-year in terms of dollars spent. That cuts across obviously consumers as well as the commercial corporate card products. I think Martina’s observation was related to the fact that even though the dollars being spent on airlines are down, transactions continue to be strong relative to other categories and relative to what we would have otherwise expected given the dollar volumes and that is because there are more transactions occurring around a flight. So individual buys a ticket for $500 winds up also buying a bag check for $20 on their card. So suddenly you have two transactions where we only had one before.
David [Cox] – Buckingham Research: I guess I was just still getting at the fact that prices may be down more than 10% as well on that ticket so you are getting more transactions and still being affected.
Robert Selander: It is increasingly difficult for us to parse the data given the incidents now at least in the airline category of these smaller ticket transactions coming through. We used to be able to make a very good call on how much was price versus volume. It is getting more challenging now because we have to sort out certain transactions that aren’t actually ticket related.
Operator: The next question comes from Jason Kupferberg – UBS.
Jason Kupferberg - UBS: Just a quick clarification before my question. The EPS headwinds from the higher tax rate it seems like you would have gotten another, if I’m right, $0.20 to $0.30 of EPS upside not for the abnormal tax rate. Is that accurate?
Martina Hund-Mejean: Yes. Presume you used the calculation versus a rate of 35% and yes as you can appreciate we had a number of significant items that not only came through in the quarter but for the whole year. We needed to make the adjustment and that is why Bob had mentioned in his remarks that for next year you should really be thinking of a tax rate around 35% again.
Jason Kupferberg - UBS: Understanding you don’t give point guidance for 2009 specifically maybe we can just talk about scenarios. If the January volume trends that you observed stay essentially unchanged for the balance of this year how should we then think about what the implications would be for top and bottom line growth?
Robert Selander: I’m sitting here musing about that. I guess I observe based on what we saw in January it will be a challenge to get to the high single digit top line growth that we mentioned would be necessary for us before taking other actions to achieve both the operating margin and net income growth rates that we have suggested we would like to be achieving over time. That means we are working hard on creating flexibility and options as it relates to where and how we spend the money should that situation either persist or worsen over the course of the year.
Unknown Speaker: I think Adam has a follow up.
Adam [No last name given]: A quick question on the cost side, a really good job in the fourth quarter. If you needed to go more than just being flat with 2008 could you do so? The second part of that is when things do come back on the top line and reaccelerate and the trends are better are the costs you have cut out do they disappear or do some of them get added back once the volumes start to pick up again?
Robert Selander: There are two parts to that question. Let me take the first one in terms of could we be better than flat. Again, let’s stay with constant FX because obviously we get benefits on the expense line as the dollar strengthens whereas it is a headwind for us on both revenue and net income. From my perspective we are trying to build, if you will, an array of scenarios. While we have one, that is the one we are currently managing against, we recognize it could get better or it could get worse and to the answer I gave to the previous question we are trying to find ways to create more flexibility. So think of that as yes we are trying to find ways that we could be better than flat. One of the trade offs that we are constantly making is how much are we potentially foregoing or penalizing the future. Obviously if there is a dollar that is being spent that doesn’t need to be spent or a Euro that doesn’t need to be spent regardless then that goes. But the one that we think has a good business case around it as we look through the challenged 2009 we see things not only stabilizing but improving in 2010 those are the kinds of things we are constantly running into as we go through this process. At the end of the day, we do not want to penalize our future by mindlessly whacking away at those things we think are valuable for improving performance both for our customers and shareholders in the future.
Martina Hund-Mejean : With respect to the second part of your question we are not looking at the deferral of costs. We are really looking at things we would be taking out in a sustainable way for the efficiency of the company and the things you have been seeing in terms of what we are doing on travel and entertainment expenses and we are doing on professional fees we actually are doing in the procurement area, for instance a meter of media rates on the market side, etc. those are all contributing factors to what we might be able to achieve. Before we move on to the next question I would like to just clarify a comment I made a little earlier today related to the question on foreign exchange. I put out there a number in terms of what kind of headwind we might be expecting in 2009 if the U.S. dollar versus the Euro exchange rates were to be staying at about today’s levels and the number I put out there was 4% of net revenue headwind. I just want to be clear that everybody understands that.
Operator: The next question comes from Chris Brendler – Stifel Nicolaus & Co.
Chris Brendler – Stifel Nicolaus & Co. : Can you talk at all about the mix of spending between discretionary and non-discretionary and what happened in the fourth quarter and do you possibly get some of that back in the first quarter with less holiday spending? Also, on a related topic did you see any evidence of consumers switching away from your products to go back to cash to help their holiday budgeting and potentially that impact may go away as you get less holiday spending in the first quarter? If you could address a couple of those trends if you could please.
Robert Selander: On the discretionary/non-discretionary I think that trend has persisted in terms of consumers managing their finances in a way that they are buying the things they need to feed their families, get themselves to and from work and so forth and they are clearly cutting back on things they might like to have but at this point in time don’t feel comfortable spending on. We have already mentioned the slow down year-over-year in the larger ticket items and I think you also see that to some extent in the decline in credit and charge based spending in the U.S. as compared to the continued growth in debit. If you look at the volume reduction in credit the reduction on cash is much more significant and you can see that in the attachment to the press release where year-over-year cash growth fell quite considerably in the U.S. on credit and charge programs. That relates to things like balance transfers. Obviously ATM and other activity would also get lumped into that number. It is principally because of the slow down in the account acquisition programs we are seeing in the U.S. credit markets. The second thing was is there some counter-secular movement back to cash. I don’t believe there is any evidence shown of that given our continued growth in transactions and as I mentioned the January data in the U.S. showed year-over-year transactional growth persisting. We are just about to start going through our spending pulse which covers all categories for January but I believe we will confirm that as it continues to move toward card electronic based transactions.
Operator: The next question comes from Analyst for Wayne Johnson – Raymond James.
Analyst for Wayne Johnson – Raymond James: The acquisitions of Washington Mutual and Wachovia what percentage of revenues or transactions did they compose and have those acquisitions had any impact or will they on your domestic portfolio?
Martina Hund-Mejean : First of all we really don’t give any customer related information on our revenue detail. From that perspective I can’t really help you.
Robert Selander: I think the way you should think about it is both of these firms are still going concerns and I expect that JP Morgan Chase with WaMu is going to try and keep as many of those customers as they can while seeing the benefits of consolidation on the expense side. The same game will be played out by Wells Fargo. Clearly the Wachovia branch network is very complementary as it is more of an East Coast branch network than the existing Wells footprint. We look forward to working with both of these players. Washington Mutual, as you know, is an extremely important debit customer of ours. JP Morgan Chase is an extremely important credit and debit customer of ours. So what we now have is a bigger and even more important customer in both of these transactions.
Operator: The next question comes from Chris Mammone – Deutsche Bank Securities.
Chris Mammone – Deutsche Bank Securities: I guess we won’t get the K until later in the month. Any update on the interchange litigation? Any change in some of the key milestones on class certification or I guess discovery at this stage? Anything to call out there?
Robert Selander: In terms of the timeline on the U.S. interchange case, fact discovery was essentially completed during the month of November. That was pretty much wrapped up. There have been briefings taking place on class certification during the month of January. The court has not scheduled any oral argument to my recollection with regard to the class motion. We expect this is going to play out over the course of the next several months and we believe that expert reports will be coming in the month of May from the plaintiffs and our expert reports will come in the course of the late second or early third quarter. At this point in time there is no trial date that has been set. So we expect this case is going to be persisting through this year and well into 2010.
Chris Mammone – Deutsche Bank Securities: Could you just remind us what percentage of profit or volume doesn’t involve U.S. consumers?
Martina Hund-Mejean : I think we have, I’m not sure we actually put out numbers there. What we have said is more than half of the cross border volume we have comes from Europe. That is about the specificity we provide.
Chris Mammone – Deutsche Bank Securities: That is just intra-Europe?
Martina Hund-Mejean : Both intra-Europe and outside of Europe but obviously a significant portion of it is intra-Europe.
Operator: This concludes the question-and-answer portion of today’s call. I would now like to turn the call back over to management for any closing remarks.
Robert Selander: I’d like to just say thank you all for joining us again today. We think we had a very strong fourth quarter. We also recognize that there are major challenges that our customers and consumers are facing around the world so we have a heightened emphasis on creating flexibility for the company as we look forward and in doing so we hope that will not only give us better performance as we move into future years but also perhaps identify some special opportunities for the company. We appreciate your joining us. Now we are all going to get back to work. Thank you.
Operator: Thank you for your participation in today’s conference call. This concludes the presentation. You may now disconnect.
and are :
Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.:
THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S : If you have any additional questions about our online transcripts, please contact us at: [email protected]. Thank you! | [
{
"speaker": "Executives",
"text": "Barbara Gasper – Investor Relations Robert W. Selander – President & Chief Executive Officer Martina Hund-Mejean – Chief Financial Officer Tara Maguire – Corporate Controller"
},
{
"speaker": "Analysts",
"text": "Julio C. Quinteros – Gold Sachs & Co. Tien-Tsin Huang – JP Morgan Andrew Jeffrey – SunTrust Robinson Humphrey Craig Maurer – Calyon Securities David [Cox] – Buckingham Research Jason Kupferberg - UBS Chris Brendler – Stifel Nicolaus & Co. Analyst for Wayne Johnson – Raymond James Chris Mammone – Deutsche Bank Securities"
},
{
"speaker": "Operator",
"text": "Welcome to the Q4 2008 MasterCard earnings conference call. At this time all participants are in a listen only mode. (Operator Instructions) I would now like to turn the call over to Barbara Gasper, Group Executive, Investor Relations. Please proceed Ma’am."
},
{
"speaker": "Barbara Gasper",
"text": "Good morning to everyone. Thank you for joining us today either by phone or web cast for a discussion about our fourth quarter and full year 2008 financial results. With me on the call this morning are Bob Selander, our Chief Executive Officer; Martina Hund-Mejean, our Chief Financial Officer and Tara Maguire, our Corporate Controller. Following comments from Bob and Martina highlighting some key points about the business environment and our fourth quarter and full year results we will open up the call for your questions. This morning’s earnings release and the slide deck that will be referenced on this call can be found in the Investor Relations section of our website www.MasterCard.com. The earnings release and slide decks have also been attached to an 8K that we filed with the SEC earlier this morning. A replay of this call will be posted on our website for one week until February 12th. Finally as set forth in more detail in today’s earnings release I need to remind everyone that today’s call may include some forward-looking statements about MasterCard's future performance. Actual performance could differ materially from what is suggested by our comments today. Information about the factors that could affect future performance are summarized at the end of our press release as well as contained in our recent SEC filings. With that I will now to turn the call over to Bob Selander."
},
{
"speaker": "Robert Selander",
"text": "Good morning everybody. I would like to start out by saying I am pleased we have been able to deliver another strong quarter of earnings results. We saw net revenue growth of over 14% despite the headwinds from the strengthening U.S. dollar and improved our operating margin by approximately 22 percentage points versus the year-ago quarter. We have seen the economic downturn hit consumers and businesses alike but our business model and global diversity provides a good degree of resilience in this environment. I would like to take a few moments to discuss our view of the global economy, our fourth quarter results which Martina will take you through in more detail and then offer some comments about our capital structure. I am on slide two in the material. Turning first to the economy, as a result of the current economic turbulence the world is facing significant challenges which can only be addressed with time. The U.S. recession continues with low consumer confidence due to a difficult housing market impacting net worth and rising unemployment now putting more stress on household incomes. The economic issues are not limited to the United States. We are seeing government bailouts and economic stimulus packages from the U.K. to China to the Netherlands. We are seeing banks in several countries being, or close to being nationalized. We expect the climate to remain challenging in 2009 and we are not counting on any improvements this year. Although precise timing is something no one can predict we continue to expect that things will begin to improve in 2010 depending on the stabilization in the housing markets, the specifics and timing of any stimulus packages and the resulting impact on consumer confidence and employment. While we are not immune from the global economic problems we are fortunate to be part of an industry that offers opportunities for growth due to the continued secular trend of people moving away from cash and checks to electronic forms of payment. Of course certain countries are particularly hard hit but we still see tremendous growth opportunities in many other countries around the world. In the fourth quarter we saw the following: In the U.S. gross dollar volumes and transactions for credit declined while debit still grew in the mid single digits. We continued to experience volume and transaction growth in Europe in the mid to high single digit range and none of the major countries in that region have yet dipped into a decline. While Latin America’s growth was in the low double digit area overall due to declines in Mexico and Venezuela, Brazil continues to be a bright spot with solid double digit growth. In addition, our South Asia, Middle East, Africa region is also still experiencing significant growth. Consistent with the October data we shared with you in our last earnings call, cross border growth continued to decelerate in November and December and grew at only 7.5% for the quarter compared to 27% for the year-ago quarter. It is also down sequentially from 18% in the third quarter of 2008. U.S. cross border volume saw declines in the low teens while the rest of the world experienced growth. When evaluating MasterCard process volumes and transactions through the first four weeks of January we saw the following: Worldwide processed volume in January was essentially flat. Cross border growth continued to decelerate in January but was still positive despite further declines in the United States. It is important to note that worldwide processed transactions were up slightly driven by a pick up in the United States relative to what we saw in the fourth quarter. While we cannot control some of the issues that are pressing on the economies around the world we are focused on the things we can control such as effective management and prudent investment of our resources and we continue to remain committed to controlling our overall cost base. As you have seen in our fourth quarter numbers we were able to deliver a 1.4% decrease in G&A expense primarily through initiatives that resulted in travel and entertainment expenses that were down 50% year-over-year and professional fees that were down almost 20%. Similar to 2007, we had some severance charges in the fourth quarter of 2008. In these most challenging of economic times we continue to better align our capabilities to meet our customers’ needs as well as ensure that we continue to innovate and deliver in ways that position us for the future. Based on internal and external feedback that we have received we have made recent organizational changes to ensure that we are delivering in a more efficient and cost effective manner to our customers. We are focusing in particular on the United States and Western Europe while still continuing our investments in the emerging markets and innovative products and services offerings. As a result, you can expect to see additional severance charges in the first quarter and perhaps in the second quarter of 2009 but we are not yet in a position to size that expense. Electronic payments remain vital for commerce around the world. Consumers and businesses will still spend. While the current economic climate will likely continue to put pressure on volume growth in many countries around the world the secular shift from cash and checks to electronic payments will continue given the push for greater efficiency and effectiveness. Our business model, geographic diversity, the work we are doing with our customers and merchants around the world and the continued secular trends should enable us to better navigate these challenging times. Just a few words about our thoughts on capital structure. We continue to believe that at this point a strong balance sheet with a good cash position and positive operating cash flow is the right place to be. It creates a level of comfort in these tough economic times and provides flexibility should we see attractive investment opportunities such as our recent Orbiscom acquisition. As you know our Board continuously evaluates our capital structure and supports maintaining our strong position. Earlier this week our Board approved a regular quarterly dividend as well as a conversion program for 2009 of up to 11 million class B shares which would if fully subscribed bring the class B ownership to just above 15% of total shares outstanding. With that I will now turn the call over to Martina for a detailed update on our financial results. Martina?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "Thanks Bob and good morning everyone. As Bob mentioned we are very pleased to cap off 2008 with strong fourth quarter financial results. Turning to page three of the slide deck in the fourth quarter we delivered net revenue of $1.2 billion, up 14.2% over the comparable period last year. This was driven by growth in process transactions, moderated rebates and incentives as well as fees for other services. Additionally, pricing changes contributed approximately 8 percentage points to revenue growth. Currency fluctuations of the Euro and the Brazilian Real relative to the U.S. dollar tempered our revenue growth by 3.5 percentage points. On a constant foreign exchange basis net revenue growth was 17.6%. Excluding a special item of $6 million related to the settlement of a Consumer Protection case in California that was an offshoot of our U.S. merchant litigation, our operating income was $468 million. This resulted in a strong operating margin of 38.2% which is a 22.2 percentage point improvement over last year. The combination of our strong revenue growth and effective cost management has enabled us to leverage our operating margin. As you know, our operating margin is typically the lowest in the fourth quarter due to seasonal factors. [End of quarter] effective tax rate was just over 46% in the fourth quarter of 2008 versus 34.9% in the comparable period in 2007. The increase was primarily due to early measurement of deferred tax assets as increased FIN48 tax reserves. In the fourth quarter we delivered net income of $243 million or $1.87 per diluted share excluding the special items. Turning to page four, during the fourth quarter the global diversification of our business has helped us weather the cyclical downturn in the U.S. Our ability to generate significant volume, transactions and revenue from economies outside of the United States has cushioned our business from the decline that we experienced in the U.S. Worldwide gross dollar volume (GDV) grew 3.4% on a local currency basis in the fourth quarter but declined 4.7% on a U.S. dollar converted basis to $605 billion. The lower GDV growth rates are due to the strength of the U.S. dollar against most other currencies during the fourth quarter. The deceleration in the overall local currency growth rate can be attributed to the U.S. The GDV growth declined 5.2% due to negative credit growth. Worldwide debit GDV however grew 10.7% for the quarter. U.S. debit GDV grew 5.8% which was a slower pace of growth than the 15.9% from the same quarter in 2007. Elsewhere GDV continued to grow at healthy rates for every other region on a local currency basis although at a much slower pace than what we had seen either on a year-over-year basis or on a sequential basis. Although not shown on page four, on a local currency basis worldwide purchase volume was up 3.1%. Similar to the GDV trend, U.S. purchase volume growth rate declined 4.6% for the quarter driven by a decline in credit volume. Fourth quarter volume grew at 7.5% for the quarter versus 27% in the fourth quarter of last year. We experienced exceptionally strong cross border growth during the fourth quarter of 2007 making this a very difficult comp to beat. Therefore, the results are more positive than the absolute number implies given the current global economic turmoil. While travel patterns remained largely the same on a year-over-year basis the only significant changes we saw were fewer Latin Americans traveling to the U.S. and an increase in intra-regional cross border travel within Latin America. With cross border growth decline low double digits during the quarter was more than offset by growth in other regions principally in Europe and in SEMEA. European cross border volume growth remained strong and remember that a majority of the European cross border volume is generated on an intra-Europe basis and consumer cross border volume growth moderated somewhat but we still saw strong double digit growth in our commercial cross border volumes. Turning to processed transactions, processed transactions increased 6% compared to the year-ago quarter to $5.5 billion. Even in the U.S. processed transactions grew at low single digit rates. Therefore we are still seeing the secular trend of people moving away from cash and checks to electronic forms of payment. Let’s turn to page five. Here you see that net operation fees increased 16.5% to $966 million in the fourth quarter. Gross operation fees increased 13.2% to about $1 billion. This growth was driven by two factors. First, banking changes implemented in January 2008 on cross border acquiring volumes and some European pricing initiatives implemented this past October. Second, the growth in processed transactions and fees for other services partially offset by volume declines that translated into U.S. dollars. In the fourth quarter net operation fees were 92.4% of gross operation fees, slightly higher than the same quarter in 2007. This was due to a decline in rebates as a result of lower volume and adjustments for previous estimates. Since we won’t be filing our 10K until later in February we have included the quarterly operation fees detail for your reference in Appendix B to the slide deck. On page six we show that net assessments increased 6.1% to $259 million versus the fourth quarter of 2007. Gross assessments increased 6.3% to $604 million primarily due to pricing and increased revenues as a result of growth in debit cards worldwide. The overall growth was partially offset by lower volumes when translated into U.S. dollars. Assessments as a percentage of gross assessment was essentially flat compared to the same quarter 2007. The normal seasonal up tick in fourth quarter rebates and incentives as offset this year because of lower volumes and adjustments for previous estimates. Now we will turn to page seven for some detail on expenses. We have continued implementing a number of expense management measures as part of our commitment to a flat expense structure going forward. During the fourth quarter excluding special items total operating expenses decreased 16%. Currency fluctuations of two percentage points contributed to the decline. Therefore, total operating expense decreased 14% on a constant FX basis. The decrease was mainly driven by the following: General and administrative expenses decreased 3.4% with currency fluctuations contributing approximately two percentage points. On a constant FX basis general and administrative expenses decreased 1.4%. The decrease was due to the following: Lower personnel costs accounted for 3.3 percentage points of the G&A decrease and were about flat on a constant FX basis. Travel expenses decreased approximately 50% as a result of cost reduction initiatives implemented during the fourth quarter. Professional fees also declined by approximately 20% during the quarter due to a reduction in legal costs and consulting expenses. Advertising and marketing spend decreased by 32.8% versus the year-ago period with approximately 1.9 percentage points related to the impact of foreign currency fluctuations. On a constant FX basis, therefore, A&M decreased 30.9% for the quarter. We have included the quarterly general and administrative expense details for your reference in Appendix B. Turning to page eight, let’s take a quick look at our full-year performance which was once again impressive. We delivered net income of $1.2 billion or $9.45 per share on a diluted basis and excluding special items. This includes $0.42 per share from gains on the sale of the remaining portion of our investment in Redecard. We achieved full year net revenue of $5 billion representing growth of 22.7%. Excluding the 2.5 percentage point effect of FX, net revenue growth was 20.2%. Pricing adjustments contributed approximately six percentage points to the growth. Net revenue growth was also driven by strong growth in gross dollar volume and processed transactions including cross border volumes which grew for the whole year at 16.6%. Finally, we saw our full year operating margin improve 11.7 percentage points to 39% from 27.3% excluding the special items in both 2008 and 2007 respectively. Moving to the cash flow statement and balance sheet highlights on page nine, after litigation payments of more than $1 billion we still generated $413 million in cash from operations and ended the year with cash, cash equivalents and current investments of $2.1 billion. The impact of 2008 litigation settlements resulted in decreased stockholder equity as well as increased litigation liabilities and deferred tax assets. Additionally, the impact of the Orbiscom acquisition is reflected in our year-end 2008 balance sheet and cash flow statement. I will now hand it back to Bob to discuss our outlook for the year and share some recent business highlights. Bob?"
},
{
"speaker": "Robert Selander",
"text": "There is no reason to assume that the economic slow down across the world will improve for the balance of this year. The global financial markets are undergoing unprecedented change that certainly impacts our industry and we are positioning ourselves for these changes as detailed on slide number 10. When looking at 2009 we continue to expect the following: Net revenue growth will likely fall below the average annual range of 12-15% that is in our longer term objectives. While we intend to invest wisely for long-term growth we have demonstrated our commitment to manage expenses more tightly. Our total operating expenses are expected to be essentially flat versus 2008. We will use the levers that we have in G&A and advertising and marketing prudently and appropriately depending on the economic environment and our customers’ needs. As I said on our last earnings call we expect to meet our longer term objectives of annual margin expansion of 3-5 percentage points and average annual net income growth of 20-30% this year as long as we see high single digit revenue growth. If revenue growth falls below this level we would need to evaluate whether to make further adjustments to our expense structure also keeping in mind our intention to continue making appropriate investments for future growth. Remember, all of our objectives are on a constant FX basis so our as reported numbers will include any impact of foreign exchange. Given the relative strength of the U.S. dollar we expect that foreign exchange will present a headwind for the revenue and net income lines this year and a tailwind on the expense line. Our longer term performance objectives also assume an effective tax rate of 35%. We remain vigilant about the economic developments that affect both our customers’ businesses and consumer spending patterns and we will continue to evaluate our objectives as we move through 2009 and adjust them as appropriate. Finally, while our business model may not experience the growth trajectory we have seen over the last few years we feel both fortunate and optimistic with the business prospects ahead of us. We believe this will continue to deliver attractive results for our shareholders. Before moving to the Q&A session, I would like to share with you some of our recent business successes from around the world. In addition to achieving strong fourth quarter operating results we remained focused on delivering best-in-class products and services to our customers. We made solid strides in opening up new growth opportunities that leverage our unique processing capabilities and solutions, enhanced our strong position in pre-pay and despite the challenges that they face we continue to be recognized by our customers for the value and partnership we provide as we were awarded with new opportunities and agreements for continued growth. We recently announced a new partnership with global retail leader Carrefour in France launching the first MasterCard exclusive branded cards incorporating Pay Pass technology and combining debit and credit payment applications on a single card. This agreement includes our full suite of domestic processing capabilities. Likewise, MasterCard integrated processing solutions (IPS) the debit and prepaid processing platform we introduced in 2008 continues to build momentum with the signing of another customers. Swiss Bankers became the first financial institution to take advantage of the global prepaid transaction processing capabilities of IPS and we hope to have more news to share with you on the IPS front in the near future. Together with MasterCard the Italian Postal System launched the first National Government Benefits Disbursement Program in Italy using MasterCard branded prepaid cards. With the addition of Poste Italiane our leadership in the prepaid public sector continues to grow. We continue to expand our efforts to provide global remittance services that leverage our global network to extend financial services opportunities among banked and un-banked customer segments. In November we launched MasterCard Money Send in association with the Development Bank of Singapore. The cross border remittance service enables consumers in Singapore to send money via the Internet to friends and family in Indonesia, India, Malaysia, the Philippines and Thailand. With MasterCard Money Send we are enabling our issuing banks to access new customer segments and offer payment products as well as other banking and financial services in developing markets. In India Citi Bank launched the first MasterCard Premium Debit program in South Asia targeting high net worth individuals and senior executives in large corporations. In summary, as evidenced through our accomplishments in the fourth quarter we are committed to leveraging the strength of our global network, processing capabilities, strong relationships and our product development platform in order to drive results for our issuers, acquirers and other partners around the world. I will now turn the call back over to Barbara so we can begin taking your questions."
},
{
"speaker": "Barbara Gasper",
"text": "Thank you Bob. We are now ready to begin the question-and-answer period. In order to get to as many people as possible in our allotted one-hour timeframe we ask that you limit yourself to a single question with one follow-up and then queue back in with additional questions. Operator?"
},
{
"speaker": "",
"text": ""
},
{
"speaker": "Operator",
"text": "(Operator Instructions) The first question comes from the line of Julio C. Quinteros – Gold Sachs & Co."
},
{
"speaker": "Julio C. Quinteros – Gold Sachs & Co.",
"text": "I wanted to just sort of hit one quick thing on the cross border commentary. If you could just rehash what you said there about the volumes there coming out of January so I can make sure I got that right. Also, related to that how to think about some of the cross border pricing benefits as you think about 2009. When should those anniversary and just any other color you could provide on the cross border side would be helpful."
},
{
"speaker": "Robert Selander",
"text": "Let me go back to the cross border. I am trying to recall specifically what you are referring to. The January volumes and transactions that I mentioned which were through the first four weeks in the month of January we saw worldwide process volume that was essentially flat for the same period the prior year. Remember, this is what we see that is processed. It does not include the gross dollar transactions and volumes that we do not process. We think it is a pretty good indicator. Cross border growth continued to decelerate in the month of January although it was still positive. We have seen the U.S. continue to decline. What that means is individuals who have cards from U.S. financial institutions are not traveling and I think you probably have seen that in some of the airline statistics and data that is released through other sources in the U.S. marketplace. I think it is important to note and I believe I also mentioned this that worldwide processed transactions were up and that was driven by a slight pick up in the U.S. relative to what we have seen in the fourth quarter in terms of processed transactions."
},
{
"speaker": "Julio C. Quinteros – Gold Sachs & Co.",
"text": "Lastly, all of your guidance is constant currency just to confirm that, right?"
},
{
"speaker": "Robert Selander",
"text": "That is correct."
},
{
"speaker": "Operator",
"text": "The next question comes from Tien-Tsin Huang – JP Morgan."
},
{
"speaker": "Tien-Tsin Huang – JP Morgan",
"text": "I was hoping to get a clarification and I also have a question. It sounds like you still expect 3-5 point of margin expansion of 20-30% as long as high single digit revenue growth is there for this year but just to confirm there wasn’t any point guidance on revenue growth for 2009?"
},
{
"speaker": "Robert Selander",
"text": "That is correct."
},
{
"speaker": "Tien-Tsin Huang – JP Morgan",
"text": "Assuming current trends persist, I am actually not going to ask about volumes and revenue but I guess really on rebates that was sort of a little bit a delta from what we expected. It was better than we expected. Can you give us some guidance on how that might trend assuming current volume trends persist and also how does FX impact this rebate line?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "Let me take that. First of all in the fourth quarter as you already said we saw some moderating in the rebates and incentives line and some of that was due to lower volume growth that we had in the fourth quarter. However, we also had some adjustments to prior estimates so you also have something in there that is maybe more of a one-time nature. In terms of 2009, if volumes continue to be the way they were in Q4 I think you should see a little bit of moderating on rebates and incentives although not to the extent you saw in Q4. I don’t think this is a linear trend. It is going to be just a little bit of an impact. In terms of foreign exchange we are not really talking about the rebates and the incentive line separately from a foreign exchange point of view. I think I laid out at the last earnings call kind of a rule of thumb that you might be able to use particularly as it relates to our Euro exposure. I am referring back to for every $0.01 move in the Euro our net revenues are impacted by about $8-9 million. Our operating expenses are impacted about $4-5 million so we have a net $3-4 million on the operating income line. When you translate all this, maybe I can be a little bit helpful for you to think about 2009 the Euro is now at $1.33 or $1.35 range versus the U.S. dollar. If you translate all these rules we probably are going to expect a headwind assuming that the dollar stays where it is of around four percentage points for the year."
},
{
"speaker": "Operator",
"text": "The next question comes from Andrew Jeffrey – SunTrust Robinson Humphrey."
},
{
"speaker": "Andrew Jeffrey – SunTrust Robinson Humphrey",
"text": "Could you comment a little bit Bob on pricing environment particularly in the U.S. with respect to what is happening at the issuer level and the pressure that your big issuers are facing? Also as a follow-up could you comment on what your view would be of the risk to your business associated with potential nationalization of a big issuer?"
},
{
"speaker": "Robert Selander",
"text": "A couple of thoughts on pricing, I believe we have indicated to you that in order for us to realize year-over-year improvements in pricing we need to deliver improved value to our customers and that equation hasn’t changed. From the perspective of what is going on within the U.S. clearly all of our customers are feeling stress. If you take a look particularly on the credit card side of the business we have seen significant increases in delinquency and charge offs occurring. We do not expect that trend is going to abate so we think our customers are going to continue to have an all-hands on deck approach where they try to maximize what they get in their current customers and work very hard on the credit and collections side of the equation. We think that is going to persist throughout the year. As a result we have been sort of reshaping our thoughts as far as how we serve those customers and we do not expect that we are going to see a buoyant acquisition program or some of the things that we may have seen in past years return in the course of 2009. Our competitors, in addition to the customer expectations, continue to make pricing challenging in the U.S. marketplace. The second part of your question was speculation of what happens if there is a nationalization of large U.S. issuer. I don’t know that there is any model that anybody can look at. I think it has been pretty clearly stated by a lot of people on Congress and others in the administration that they are not looking to nationalize banks. They are looking to support banks to help them restore the U.S. economy. So that is not something we currently are thinking about other than in the context of what we have seen when banks have run into difficulties. For banks it is a pretty straight forward regime in terms of what happens if a bank runs into challenges. We have seen that with the FDIC and other agencies in terms of the relatively smooth, I would describe it, handling of the ongoing obligations of those institutions and the continuation of those programs on which consumers and businesses are dependent. We would much rather have all of our customers thriving so we are going to just have to tough it through and help them tough it through these next challenged quarters."
},
{
"speaker": "Operator",
"text": "The next question comes from Craig Maurer – Calyon Securities."
},
{
"speaker": "Craig Maurer – Calyon Securities",
"text": "The first question I had for you is could you comment on the average ticket you saw or the impact you saw in the fourth quarter on your average ticket size and if you can quantify the impact the cash pricing had or characterize it a little bit?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "Average ticket prices in the U.S. as well as for the rest of the world have decreased slightly though we did definitely see an impact while we saw the consumer transacting more as you can see from a transaction growth point of view, average ticket price in particular has gone down. It has gone down some slightly. What was your second question related to?"
},
{
"speaker": "Robert Selander",
"text": "In terms of what happened with gasoline as you know in the U.S. gas prices are down dramatically from where they were a year ago. Gasoline represented about 6.5% of our U.S. volume and about 15% of transactions during the fourth quarter. If you were to make adjustments for year-over-year change in gas price, gasoline would have increased slightly as a percentage of volume. On the other hand those prices were down dramatically."
},
{
"speaker": "Martina Hund-Mejean",
"text": "Just to build a little bit on Bob’s comment on gas, when you see our purchase volume in the U.S. being down by 4.6% probably around, not probably but definitely around 25% of that decline was due to lower gas prices."
},
{
"speaker": "Craig Maurer – Calyon Securities",
"text": "One follow-up, it was something that Visa said last night that I thought maybe you could also characterize for us, in terms of the comment that percentage of volume driven by debit or pay in full type customers that aren’t revolving it was a question around what would the impact be from dramatically lower option to buy credit lines in the U.S.?"
},
{
"speaker": "Robert Selander",
"text": "I’m not sure I fully understood that."
},
{
"speaker": "Craig Maurer – Calyon Securities",
"text": "The question is around what would the impact be if open credit lines were cut dramatically in the states. It was characterized in the answer by the percentage of volume that is driven by customers that pay in full and don’t revolve or debit driven convenience usage type customers."
},
{
"speaker": "Robert Selander",
"text": "I think that is a reasonable thing. If a consumer who would have otherwise been spending has their line capped that is obviously going to affect that cohort of customers. What we have seen is the decline in credit purchases has been in bigger ticket items; furniture, higher priced over $1,000 types of things, electronic goods, etc. We saw that right through the holiday shopping season and those year-over-year declines have persisted. I would argue that consumers are also being more disciplined. They either are experiencing challenging times and are foregoing things that they might liked to have had, i.e. a brand new big screen TV or whatever it might be and they are paying for basics. I think there are a lot of factors that converge there but I think one you mentioned could be and probably is one of those contributing factors."
},
{
"speaker": "Operator",
"text": "The next question comes from David [Cox] – Buckingham Research."
},
{
"speaker": "David [Cox] – Buckingham Research",
"text": "Could you give us a little more color for the outlook for price increase benefit over the next year? Should we continue to expect sort of 6% year-over-year benefit?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "As we have said in the past, we are really only making pricing adjustments if it will deliver particular value propositions to our customers. If you can appreciate in this kind of environment where our customers are having very challenging times we are going to be extremely careful and it has to be completely directly tied to what kind of product and service we will give to them. We have laid out there in the past the terms of what we think our normal, annual pricing adjustment which is in the 200 basis points range and at this point in time that is still where we are. This is a very challenging time and we are going to have to deliver in order to be able to do something like that."
},
{
"speaker": "David [Cox] – Buckingham Research",
"text": "Another way to ask it is just how much of what we saw this quarter will continue or anniversary in October or later in the year? Sooner in the year?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "As you know the majority of our price increases were in January of 2008 so all of that has anniversaried at this point in time and we made some pricing adjustments in Europe in October and obviously that would be then anniversarying next October."
},
{
"speaker": "David [Cox] – Buckingham Research",
"text": "Could you give us some color on the change in spending growth on world cards versus basic cards? Much of a noticeable change in consumer behavior?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "We have really not seen any big differential on that other than what Bob has mentioned in terms of where people are spending on high ticket items. We really don’t see a lot of spending on that. It is really on items below $1,000. It seems to be that $1,000 threshold is still significant. The other thing we have seen an impact obviously on travel. You can see that travel volume is pretty much down. You see that on our network too. Interestingly enough transactions are up because when you go and travel on an airline these days you get charged for all sorts of wonderful extra things such as checking in, checking bags, actually getting a bottle of water on the airplane, etc. so we are seeing those kinds of trends going on."
},
{
"speaker": "David [Cox] – Buckingham Research",
"text": "So it is really just for pricing too? The airline ticket price is down and that is driving volumes?"
},
{
"speaker": "Robert Selander",
"text": "No I think the observation is, regarding your specific question, we are seeing an across the board change in consumer spending patterns. If you were to take a look at the so called luxury end retailers they have had even more significant declines, 15-20% types of year-over-year sales declines as compared with the more day-to-day operators, supermarkets and so forth. That is occurring across all sorts of cards. If you look at consumer travel, airline and hotel are down also in the order of magnitude 10% year-over-year in terms of dollars spent. That cuts across obviously consumers as well as the commercial corporate card products. I think Martina’s observation was related to the fact that even though the dollars being spent on airlines are down, transactions continue to be strong relative to other categories and relative to what we would have otherwise expected given the dollar volumes and that is because there are more transactions occurring around a flight. So individual buys a ticket for $500 winds up also buying a bag check for $20 on their card. So suddenly you have two transactions where we only had one before."
},
{
"speaker": "David [Cox] – Buckingham Research",
"text": "I guess I was just still getting at the fact that prices may be down more than 10% as well on that ticket so you are getting more transactions and still being affected."
},
{
"speaker": "Robert Selander",
"text": "It is increasingly difficult for us to parse the data given the incidents now at least in the airline category of these smaller ticket transactions coming through. We used to be able to make a very good call on how much was price versus volume. It is getting more challenging now because we have to sort out certain transactions that aren’t actually ticket related."
},
{
"speaker": "Operator",
"text": "The next question comes from Jason Kupferberg – UBS."
},
{
"speaker": "Jason Kupferberg - UBS",
"text": "Just a quick clarification before my question. The EPS headwinds from the higher tax rate it seems like you would have gotten another, if I’m right, $0.20 to $0.30 of EPS upside not for the abnormal tax rate. Is that accurate?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "Yes. Presume you used the calculation versus a rate of 35% and yes as you can appreciate we had a number of significant items that not only came through in the quarter but for the whole year. We needed to make the adjustment and that is why Bob had mentioned in his remarks that for next year you should really be thinking of a tax rate around 35% again."
},
{
"speaker": "Jason Kupferberg - UBS",
"text": "Understanding you don’t give point guidance for 2009 specifically maybe we can just talk about scenarios. If the January volume trends that you observed stay essentially unchanged for the balance of this year how should we then think about what the implications would be for top and bottom line growth?"
},
{
"speaker": "Robert Selander",
"text": "I’m sitting here musing about that. I guess I observe based on what we saw in January it will be a challenge to get to the high single digit top line growth that we mentioned would be necessary for us before taking other actions to achieve both the operating margin and net income growth rates that we have suggested we would like to be achieving over time. That means we are working hard on creating flexibility and options as it relates to where and how we spend the money should that situation either persist or worsen over the course of the year."
},
{
"speaker": "Unknown Speaker",
"text": "I think Adam has a follow up."
},
{
"speaker": "Adam [No last name given]",
"text": "A quick question on the cost side, a really good job in the fourth quarter. If you needed to go more than just being flat with 2008 could you do so? The second part of that is when things do come back on the top line and reaccelerate and the trends are better are the costs you have cut out do they disappear or do some of them get added back once the volumes start to pick up again?"
},
{
"speaker": "Robert Selander",
"text": "There are two parts to that question. Let me take the first one in terms of could we be better than flat. Again, let’s stay with constant FX because obviously we get benefits on the expense line as the dollar strengthens whereas it is a headwind for us on both revenue and net income. From my perspective we are trying to build, if you will, an array of scenarios. While we have one, that is the one we are currently managing against, we recognize it could get better or it could get worse and to the answer I gave to the previous question we are trying to find ways to create more flexibility. So think of that as yes we are trying to find ways that we could be better than flat. One of the trade offs that we are constantly making is how much are we potentially foregoing or penalizing the future. Obviously if there is a dollar that is being spent that doesn’t need to be spent or a Euro that doesn’t need to be spent regardless then that goes. But the one that we think has a good business case around it as we look through the challenged 2009 we see things not only stabilizing but improving in 2010 those are the kinds of things we are constantly running into as we go through this process. At the end of the day, we do not want to penalize our future by mindlessly whacking away at those things we think are valuable for improving performance both for our customers and shareholders in the future."
},
{
"speaker": "Martina Hund-Mejean",
"text": "With respect to the second part of your question we are not looking at the deferral of costs. We are really looking at things we would be taking out in a sustainable way for the efficiency of the company and the things you have been seeing in terms of what we are doing on travel and entertainment expenses and we are doing on professional fees we actually are doing in the procurement area, for instance a meter of media rates on the market side, etc. those are all contributing factors to what we might be able to achieve. Before we move on to the next question I would like to just clarify a comment I made a little earlier today related to the question on foreign exchange. I put out there a number in terms of what kind of headwind we might be expecting in 2009 if the U.S. dollar versus the Euro exchange rates were to be staying at about today’s levels and the number I put out there was 4% of net revenue headwind. I just want to be clear that everybody understands that."
},
{
"speaker": "Operator",
"text": "The next question comes from Chris Brendler – Stifel Nicolaus & Co."
},
{
"speaker": "Chris Brendler – Stifel Nicolaus & Co.",
"text": "Can you talk at all about the mix of spending between discretionary and non-discretionary and what happened in the fourth quarter and do you possibly get some of that back in the first quarter with less holiday spending? Also, on a related topic did you see any evidence of consumers switching away from your products to go back to cash to help their holiday budgeting and potentially that impact may go away as you get less holiday spending in the first quarter? If you could address a couple of those trends if you could please."
},
{
"speaker": "Robert Selander",
"text": "On the discretionary/non-discretionary I think that trend has persisted in terms of consumers managing their finances in a way that they are buying the things they need to feed their families, get themselves to and from work and so forth and they are clearly cutting back on things they might like to have but at this point in time don’t feel comfortable spending on. We have already mentioned the slow down year-over-year in the larger ticket items and I think you also see that to some extent in the decline in credit and charge based spending in the U.S. as compared to the continued growth in debit. If you look at the volume reduction in credit the reduction on cash is much more significant and you can see that in the attachment to the press release where year-over-year cash growth fell quite considerably in the U.S. on credit and charge programs. That relates to things like balance transfers. Obviously ATM and other activity would also get lumped into that number. It is principally because of the slow down in the account acquisition programs we are seeing in the U.S. credit markets. The second thing was is there some counter-secular movement back to cash. I don’t believe there is any evidence shown of that given our continued growth in transactions and as I mentioned the January data in the U.S. showed year-over-year transactional growth persisting. We are just about to start going through our spending pulse which covers all categories for January but I believe we will confirm that as it continues to move toward card electronic based transactions."
},
{
"speaker": "Operator",
"text": "The next question comes from Analyst for Wayne Johnson – Raymond James."
},
{
"speaker": "Analyst for Wayne Johnson – Raymond James",
"text": "The acquisitions of Washington Mutual and Wachovia what percentage of revenues or transactions did they compose and have those acquisitions had any impact or will they on your domestic portfolio?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "First of all we really don’t give any customer related information on our revenue detail. From that perspective I can’t really help you."
},
{
"speaker": "Robert Selander",
"text": "I think the way you should think about it is both of these firms are still going concerns and I expect that JP Morgan Chase with WaMu is going to try and keep as many of those customers as they can while seeing the benefits of consolidation on the expense side. The same game will be played out by Wells Fargo. Clearly the Wachovia branch network is very complementary as it is more of an East Coast branch network than the existing Wells footprint. We look forward to working with both of these players. Washington Mutual, as you know, is an extremely important debit customer of ours. JP Morgan Chase is an extremely important credit and debit customer of ours. So what we now have is a bigger and even more important customer in both of these transactions."
},
{
"speaker": "Operator",
"text": "The next question comes from Chris Mammone – Deutsche Bank Securities."
},
{
"speaker": "Chris Mammone – Deutsche Bank Securities",
"text": "I guess we won’t get the K until later in the month. Any update on the interchange litigation? Any change in some of the key milestones on class certification or I guess discovery at this stage? Anything to call out there?"
},
{
"speaker": "Robert Selander",
"text": "In terms of the timeline on the U.S. interchange case, fact discovery was essentially completed during the month of November. That was pretty much wrapped up. There have been briefings taking place on class certification during the month of January. The court has not scheduled any oral argument to my recollection with regard to the class motion. We expect this is going to play out over the course of the next several months and we believe that expert reports will be coming in the month of May from the plaintiffs and our expert reports will come in the course of the late second or early third quarter. At this point in time there is no trial date that has been set. So we expect this case is going to be persisting through this year and well into 2010."
},
{
"speaker": "Chris Mammone – Deutsche Bank Securities",
"text": "Could you just remind us what percentage of profit or volume doesn’t involve U.S. consumers?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "I think we have, I’m not sure we actually put out numbers there. What we have said is more than half of the cross border volume we have comes from Europe. That is about the specificity we provide."
},
{
"speaker": "Chris Mammone – Deutsche Bank Securities",
"text": "That is just intra-Europe?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "Both intra-Europe and outside of Europe but obviously a significant portion of it is intra-Europe."
},
{
"speaker": "Operator",
"text": "This concludes the question-and-answer portion of today’s call. I would now like to turn the call back over to management for any closing remarks."
},
{
"speaker": "Robert Selander",
"text": "I’d like to just say thank you all for joining us again today. We think we had a very strong fourth quarter. We also recognize that there are major challenges that our customers and consumers are facing around the world so we have a heightened emphasis on creating flexibility for the company as we look forward and in doing so we hope that will not only give us better performance as we move into future years but also perhaps identify some special opportunities for the company. We appreciate your joining us. Now we are all going to get back to work. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you for your participation in today’s conference call. This concludes the presentation. You may now disconnect."
},
{
"speaker": "and are",
"text": ""
},
{
"speaker": "Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.",
"text": ""
},
{
"speaker": "THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S",
"text": "If you have any additional questions about our online transcripts, please contact us at: [email protected]. Thank you!"
}
] | null | null |
MA | 3 | 2,008 | 2008-11-04 17:00:00 | Executives: Barbara Gasper – Investor Relations Robert W. Selander – President & Chief Executive Officer Martina Hund-Mejean – Chief Financial Officer Tara Maguire – Corporate Controller
Analysts: Julio C. Quinteros – Gold Sachs & Co. Charles Murphy – Morgan Stanley Adam Frisch – UBS Gregory Smith – Merrill Lynch Moshe Katri – Cowen & Co. Anurag Rana – Keybanc Capital Markets Craig Maurer – Calyon Securities Tien-Tsin Huang – JP Morgan Christopher Brendler – Stifel Nicolaus & Company, Inc. Sanjay Sakhrani – Keefe, Bruyette & Woods Patrick M. Burton – Citigroup
Operator: Welcome to the third quarter 2008 MasterCard earnings conference call. At this time all participants are in a listen only mode. We will be facilitating a question-and-answer session towards the end of this conference. (Operator Instructions) As a reminder this conference is being recorded for replay purposes. I would now like to turn the presentation over to your host for today’s call, Miss Barbara Gasper, head of Investor Relations.
Barbara Gasper: Thank you for joining us today either by phone or webcast for a discussion about our third quarter 2008 financial results. With me on the call today are Bob Selander, our Chief Executive Officer; Martina Hund-Mejean, our Chief Financial Officer; and Tara Maguire, our Corporate Controller. Following comments by Bob and Martina highlighting some key points about the business environment and our third quarter results we will open up the call for your questions. Today’s earnings release and the slide deck that will be referenced on this call can be found in the Investor Relations section of our website www.MasterCard.com. These materials have also been attached to an 8-K that we filed with the SEC earlier today. A replay of this call will be posted on our website for one week until November the 10th. Finally as set forth in more detail in today’s earnings release I need to remind everyone that today’s call may include some forward-looking statements about MasterCard's future performance. Actual performance could differ materially from what is suggested by our comments today. Information about the factors that could affect future performance are summarized at the end of our press release as well as contained in our recent SEC filings. With that I will now to turn the call over to Bo Selander.
Robert W. Selander: I’d like to start out by saying how proud we are that in the current economic situation we have been able to deliver another strong quarter of earnings results. We saw net revenue growth of over 23% and I’m particularly pleased that we were able to post a 41% operating margin for the quarter an 8.4 percentage point increase over last year excluding our litigation settlement. However it is the economic situation that everyone is interested in. I’m going to leave the discussion of our third quarter results to Martina and begin by focusing on what we’re seeing in our business. The current economic crisis is like no other that we’ve seen. When we faced the last economic downturn in the United States we saw employment begin to rise, housing was driving the recovery, the financial institutions were in good shape, the financial markets were functioning and there was very limited commodity inflation. In some ways this time around there are fewer economic and financial levers to be pulled and over the last month we have seen unprecedented coordinated and structured responses from governments and central banks around the world resulting in a large scale intervention into the financial markets and institutions. As credit markets have tightened and fears of recession spread the last several weeks have been challenging for everyone, our customers, you as investors and for us. The concerns about a global economic slow down have had an impact on spending around the world primarily by the consumer. We recently saw that US Conference Boards Index of Consumer Confidence fell to an all time low since the measurement began 40 years ago. US GDV fell by .3% in the third quarter and consumer spending fell by the same .3% in the month of September. Housing prices continue to fall in the US, UK and Spain and all of this has led to sharply declining equity markets. We’ve also seen unbelievable banking industry consolidation and the nationalization of others and we’re seeing trends in our US business that until now we have not seen. You have heard us say in previous public forums that our business was holding at levels roughly equal to our second quarter gross volume dollar growth through July and August. This continued through early September but turned downward in mid-September following announcements such as Lehman’s bankruptcy, Merrill Lynch’s buyout and several bank mergers or bailouts both here in the United States and abroad. For the third quarter our total global gross dollar volume grew 12.3%. During the month of September worldwide processed volume growth our intra-quarter proxy for gross dollar volume was high single digits on a local currency basis. US growth was in the low single digit range. In the month of October we have seen a pronounced weakness in the US where are our process volumes were slightly negative versus last year. On a global basis our processed volume growth was in the mid single digits on a local currency basis. Cross border volume growth has also been slowing globally. For the third quarter we saw growth of 18%. Through the first four weeks of October cross border growth was in the high single digits. The decline has been primarily driven by a marked slow down in cross border volumes from US cardholders as Americans are cutting back on travel and cautiously spending if they do travel. From our perspective we’re seeing thoughtful and significantly reduced spending among our financial institution customers. They’re shifting their focus away from marketing, account acquisition and system enhancements towards retention and credit loss management activities. We’re supporting their efficiency and optimization efforts. We’re leveraging the strengths of our brands, technology, product innovations, people while emphasizing the balance of intelligence and insights, risk management and cost management best practices. For example customers are particularly interested in our data analytics and benchmarking capabilities. We anticipate these challenges continuing for the remainder of 2008 and into 2009. While we are fortunate to be part of an industry that offers tremendous opportunities for growth with the secular trends away from cash and checks we are not immune from the world’s economic problems, our customers’ challenges and the increased competition we face. As are most companies we continue looking for ways to control expenses as we navigate through these difficult economic times. We are using resources in a more thoughtful and efficient manner while trying to ensure that we remain well positioned for future growth. We have significantly ratcheted up our focus on our cost structure while making the investments necessary for future growth. For instance we have established a hiring cap essentially eliminating all open positions. We are also tightening up on contractor expenses, reducing travel expenses and spending with suppliers and consultants. I’d like to stress that our global structure, the diversification of our business and our solid business model are resilient. We are not directly exposed to consumer debt so we don’t have the risk of consumer credit write offs. Also it’s important to consider that we do business in 210 countries and territories and over 50% of our revenue is generated outside of the United States. As we move forward we continue to focus on supporting our customers as they address the needs of their businesses while we develop our pipeline of new business opportunities. We were already on the ground in emerging markets with the local capabilities to deliver our global product and service propositions. Payment trends are working in our favor, people all over the world continue to migrate toward electronic payments. The biggest opportunity still lies in cash and checks. On the legal front we recently reported that we reached a settlement in the Discover litigation. I’m pleased that this settlement has closed another chapter with respect to our legacy litigation cases. Under the terms of the settlement we will pay Discover a total of $862.5 million later this month. In the third quarter we recorded a pre-tax charge of $827.5 million. This includes receiving a payment of $35 million from Morgan Stanley and the total after-tax charge was $515.5 million. Before turning the call over to Martina I’d like to provide you with some initial thoughts about our outlook for 2009 which are summarized on Slide 3. We are still completing the work on our 2009 budget. However, when thinking about next year there are two items I’d like to highlight for you now. First, we expect that our net revenue growth will fall below the average annual range of 12% to 15% that is in our longer term objectives. Second, we are planning to hold operating expenses essentially flat over 2008 levels. We still need to invest wisely for long term growth while managing our expenses aggressively. I already mentioned some of the cost containment and reduction initiatives. In summary for 2009 we would expect that high single digit growth would be necessary in order to meet our margin expansion objective of three to five percentage points per year and average annual net income growth of 20% to 30%. Based on the recent strengthening of the US dollar we expect that foreign exchange will be a headwind for us on the revenue and net income lines keeping in mind that the same phenomenon results in a tailwind for us on the expense line. This is the reverse of what we’ve seen over the past several years. We are holding to our longer term performance objectives. Currently visibility beyond 2009 is difficult but we will continue to work towards those objectives over the longer term and we are pulling all the levers we can as we drive the organization to achieve them. Remember that our longer term objectives are based on constant foreign exchange rates. Also while we feel very fortunate and comfortable with the growth prospects of our business model the changes that are taking place in the financial markets globally are unprecedented and have certainly not been expected by anyone. As we gain more clarity about these forces we will continue to evaluate our objectives and adjust them if appropriate. With that I’ll now turn the call over to Martina for a detailed update on our third quarter financial results.
Martina Hund-Mejean: As Bob mentioned we are pleased with our overall third quarter results. Turing to Page 4 of the slide deck in the third quarter we delivered net revenue of $1.3 billion up 23.6% over the comparable period last year. This was driven primarily by strong growth in worldwide gross dollar volume and processed transactions as well as cross border volume, currency fluctuations of the Euro and the Brazilian Reais relative to the US dollar contributed 3.5 percentage points of the net revenue increase resulting in underlying business growth of 20.1%. Pricing changes contributed approximately five percentage points of the revenue growth in the quarter. As Bob discussed we have taken a one time tax effective charge of $515.5 million for the Discover litigation settlement in the third quarter which we are treating as a special item. Because the settlement will be paid as a lump sum later this month there is no interest accretion that needs to be considered for modeling purposes. With respect to the American Express settlement that was reached in the prior quarter we have already told you about the $23 million in interest accretions which is not considered a special item. This represents about $0.11 per diluted share in the third quarter. Excluding the Discover settlement total operating expenses grew at 8.3% or $60 million to $790 million. We continue to demonstrate the leveragability of our business model by delivering operating income of $548 million excluding the litigation settlements. In 2008 we have consistently and significantly our operating margin delivering 41% in the third quarter an 8.4 percentage point improvement on a year-over-year basis. While strong revenue growth has enabled us to leverage our operating margin combined with some efficiencies related to an accelerated company wide cost containment and reduction program. We delivered net income of $322 million or $2.47 per diluted share excluding the special item in the third quarter. Including the litigation settlement we recorded a net loss of $194 million or a loss of $1.49 per diluted share. Turning to Page 5 we continue to benefit from the global diversification of our business with our ability to generate significant volume transactions and revenue from economies outside of the US. Worldwide gross dollar volumes grew 12.3% on a local currency basis in the third quarter and 14.8% on a US dollar converted basis to $662 billion. While the local currency growth rate is very similar to the GDV growth rate in the same quarter a year ago the US experienced slower growth offset in Asia-Pacific, Canada and Europe. Although not shown on Page 4 on a local currency basis worldwide purchase volume was up 13.3%, also slightly lower than the growth rate in the comparative quarter last year. Cash volume growth was 9.5%. Total US gross dollar volume growth was 4.7% and US purchase volume was higher at 6.6%. US debit for GDV continues to grow at a healthy 15.3% versus third quarter growth last year of 12.1%. Total US credit GDV growth declined by 1.3% but credit purchase volume grew at 1.5% for the quarter. Therefore the decline in overall US credit GDV was driven by negative cash volume growth as US issuers significantly reduced balance transfer acquisition campaigns. This is the second consecutive quarter of negative cash volume growth due to reduced convenience check usage and balance transfer activities which do not generate significant revenue for us. Cross border volume which is generated from cardholders who travel outside of the country where their card was issued was up 18% over the comparable quarter last year. This rate of growth was slightly lower than the growth rate of 19.2% for the third quarter last year. On the whole travel patterns remained fairly consistent on a year-over-year basis and we saw no significant change with the exception that there was less US travel to Europe but US cardholders increased their travel to other markets. Overall strong European cross border volume growth did offset lower growth in the US and a majority of the Europe cross border volume was generated on an intra-Europe basis. This pattern is consistent with the same quarter last year as Europeans traveled closer to home during the summer. While we’re still seeing healthy double digit growth rates for both consumer cross border volume grew at a somewhat slower pace than a year ago and commercial cross border growth accelerated. Processed transactions or the transactions processed across MasterCard’s network increased 13% to $5.4 billion in the third quarter compared with the year ago quarter. Net revenue yield which was 20.2 basis points in the quarter versus 18.8 basis points in the third quarter of 2007 was driven primarily by pricing. On a sequential basis the increase was primarily due to higher revenue for authorization settlement and switch revenue and cross border revenue. Let’s turn to Page 6, here you can see that net operation fees increased 25.8% or $204 million to $996 million in the third quarter. Gross operations fees increased 24.8% to about $1.1 billion. This growth was driven by two factors, first the growth in processed transactions, gross dollar volume and cross border volumes that I’ve previously described on Page 4. Second, new pricing changes implemented in January of this year on cross border acquiring volumes and on retail purchases in the US by non-US cardholders. In the third quarter net operation fees were 90.8% of gross operation fees slightly higher than the same quarter in 2007 due to the slower growth in rebates than gross revenue growth as a result of customer performance. On Page 7 we show that net assessments increased 17.5% to $342 million versus the third quarter of 2007. Gross assessment increased 15% to $604 million due to strong GDV growth of 14.8% on a US dollar basis. Net assessments as a percentage of gross assessments improved slightly to 56.6% due to timing and terms of non-gross dollar volume based incentives. Finally when looking at full year 2008 total net revenue growth we expect to exceed the 15% upper limit of our longer term revenue growth target assuming minimal changes in current exchange rates. Please turn to Page 8 for some detail on expenses. During the third quarter excluding the special item total operating expenses increased 8.3% of which 2.4 percentage points were related to currency fluctuations. This increase was mainly driven by the following, general and administrative expenses increased 14.1% of which two percentage points were related to currency fluctuations. The increase was the following, higher personnel costs accounted for eight percentage points of the G&A growth and was primarily driven the hiring of new personnel over the last 12 months and increased contractor costs. Three percentage points of the G&A increase was due to foreign currency transaction losses mostly due to the strengthening of the US dollar and higher professional fees primarily consisted of legal costs to defend outstanding litigations accounted for a further percentage point of the G&A increase. For the full year 2008 we expect G&A growth to approximate the third quarter year-to-date growth rate of 13.6%. As Bob mentioned earlier we are making significant changes in order to maintain an essentially flat expense structure going forward. In response to the current economic climate we have continued implementing a number of expense management measures such as eliminating open job reqs, reducing contractor spend and reducing travel and consulting expenses. In fact we saw a 20% saving in T&E expenses over the third quarter last year. While we had a slight increase in advertising and marketing expenses of 1.1% approximately three percentage points of this increase was due to foreign exchange. So excluding the impact of foreign exchange advertising and marketing expenses declined on a year-over-year basis. For the full year of 2008 we expect that our total advertising and marketing spend will be down versus what we spent in 2007. Previously we said that we expected 2008 spend to be flat relative to last year. Moving to the cash flow statement and balance sheet highlights on Page 9 we generated $388 million in cash flow from operations during the quarter and $931 million during the nine months through September 30, 2008. Even after our first payment of $150 million to American Express in the third quarter we ended the quarter with $2.8 billion in cash, cash equivalents and current available for sale securities. We have a number of balance sheet accounts that are impacted by the settlement with Discover such as our accounts receivable for the $35 million payment from Morgan Stanley and an increase in tax receivables and prepaid expenses. The lease on our St. Louis facility and related off balance sheet arrangements will change in 2009 by MasterCard repaying $149 million in debt. This item has been re-classed from long term to short term in the quarter. In conjunction with this payment during the first quarter of 2009 we will record the building as an asset on our books. I will now hand back to Bob to discuss some recent business highlights.
Robert W. Selander: Before moving to the Q&A session I would like to share with you some of our recent business successes from around the world. In addition to our strong top line performance we remain focused on delivering best in class products and services to our customers. We continue global expansion of our credit and debit products and our acceptance channels including mobile phones and public transportation systems. We are happy to announce a new partnership with Barclaycard launching the first Barclaycard MasterCard commercial proposition targeted at UK small businesses. We are very pleased to continue building our relationship with Barclaycard. Likewise we continue to expand our relationship with Chase in the United States with the recent launch of the Chicago Bears Debit MasterCard. All new and existing Chase personal checking customers in Illinois are now eligible for this program. We continue our tradition of innovation with mobile payments which goes back five years when we first piloted the use of contactless payments on mobile phones. Earlier this year we announced our Mobile Money Send capability delivering person-to-person mobile payment service to MasterCard cardholders. Just last week we announced another competitive first, our over-the-air provisioning service. This service allows over-the-air personalization of cardholders’ mobile devices in an easy, one step process. This will enable mobile devices to perform payment transactions at merchant location with PayPass enabled terminals. In Italy we announced a strategic partnership with Telecom Italia to develop PayPass enabled mobile phones. We signed a deal with HSBC for a co-branding partnership with Woolworth’s Australia’s leading supermarket retailer to provide PayPass enabled cards to the retailer’s customers. In Europe we continue to see slow but steady progress on the SEPA front. Over the past two years we have concluded business agreement with approximately 30 banks across the Sapa area for their debit card business adding to our already strong European debit position. As a result the majority of European debit cards are now branded with either Maestro or MasterCard. With banks taking a more gradual approach towards Sapa by maintaining local schemes longer than the end of 2010 co-branded cards will be in the market longer than originally foreseen. We are making progress in unlocking the domestic debit business with acquirers and merchants now able to route domestic transactions across our network. We continue to see an increase in domestic processing of Maestro transactions. For example earlier this year I told you that we were processing roughly 14% of all domestic transactions in Italy. That figure is now approaching 17%. While other countries are less mature in processing domestic transactions we are beginning to see domestic Maestro volumes over our network in Belgium, The Netherlands, Luxembourg, France, Portugal, Germany and Ireland where before we only saw cross border transactions. In summary I’d just like to reiterate how pleased we are with being able to deliver a great third quarter with over 23% revenue growth and a 41% operating margin. We are seeing slow downs that are affecting our customers and we expect some challenges over the next few quarters as we work through this unprecedented economic environment. However we are still confident in our business model and will continue to make the necessary investments to fund future initiatives while being mindful of making our cost structure even more efficient. It is this combination that will position the company to continue to deliver growth over the longer term. I’ll now turn the call back over to Barbara so we can begin taking your questions.
Barbara Gasper: We’re now ready to begin the question-and-answer period and in order to get to as many people as possible in our allotted timeframe we ask that you limit yourself to a single question with one follow up and then queue back in for additional questions.
Operator: (Operator Instructions) Our first question comes from Julio C. Quinteros – Gold Sachs & Co.
Julio C. Quinteros – Gold Sachs & Co.: Real quickly two things, both on pricing opportunities and headwinds as you guys think about the longer term trajectory. Can you just sort of spell those out in terms of what you are expecting on both fronts, pricing on the one side and then fx on the other?
Martina Hund-Mejean : Let me take that, in terms of the pricing opportunities, as you know this year we were fortunate enough to have about 5 percentage points impact on our top line from additional pricing that we were able to take in the market due to the kind of value propositions that we are actually delivering to customers. We did say in the past that we believe that pricing opportunities exist in the future albeit it is completely connected to what kind of value we are delivering to customers and as you can appreciate in this kind of economic environment we’re certainly going to be very carefully evaluating what kind of pricing actions we will take. However, from what we said in the past, our view on pricing remains to be the same. So, at this point in time we are really not having a change in thought on that. From a foreign exchange point of view, foreign exchange is obviously a moving parameter. You can see that in terms of our top line growth we are always calling out what kind of foreign exchange impact we had. For this quarter it was 3.5%. Maybe it’s helpful if I can give everybody a guideline in terms of how to look at our foreign exchange impact. Maybe what I do is I really hinge it towards the Euro dollar relationship. So, let me lay this out for you, for every $0.01 of move in the US dollar to Euro relationship so for instance if, and these are always number but for instance the US dollar instead of taking $1.50 to purchase a Euro, it’s only $1.49 to purchase a Euro so every $0.01 the impact on our top line for the whole year would roughly be $8 million to $9 million. With that you have about 80% of our foreign exchange exposure captured. We are also exposed to the Brazilian Real and a number of other currency but we pretty much have 80%. Now, in addition to that I would like to add to the guideline that obviously we also have an impact on our operating expenses and that would be an offsetting impact. So, with the appreciating dollar you have headwinds on the revenue line but you would have tailwinds on the operating expenses and for that the guideline I would say is about $4 million to $5 million so in operating income you roughly can see for that $0.01 change for the whole year would be able $3 million to $4 million. With that hopefully you can make your assumptions where you think foreign exchange rates will go.
Julio C. Quinteros – Gold Sachs & Co.: Just to clarify, the mid single digit growth for 2009 to get to the 20%, that is just what it would require to get to that 20%, that wasn’t the actual number that you guys were targeting to for 2009, is that correct?
Martina Hund-Mejean : In fact, what we said is that we needed high single digit growth for 2009 in order to continue to have our operating margin performance objective of 3 to 5 percentage points as well as producing net income growth of 20% to 30%.
Operator: Our next question comes from Charles Murphy – Morgan Stanley.
Charles Murphy – Morgan Stanley: I wanted to return to pricing, for ’09 do you consider the amount of revenue growth you’ve gotten from pricing this year to be an anomaly? Do you expect to get a similar type of revenue growth from pricing or how should we think about that over the next year?
Martina Hund-Mejean : Charlie, the comments that we are going to make are going to be very consistent with what we had said before. We actually did say, I think, on every earnings call we had this year that the 500 basis points that you’re seeing in every one of the quarters is actually quite extraordinary. It’s predominately fueled by what we’re seeing on cross boarder volume. I think what we laid out is that at any point in time we feel comfortable that we might be able to do pricing according to the kind of value proposition that we delivered to our customers of a minimum of 200 basis points per year and we are not stepping back from that kind of view.
Charles Murphy – Morgan Stanley: As a quick follow up, can you help us understand what a legitimate downside case is for local currency cross boarder GDV growth?
Robert W. Selander : Charlie, I don’t know that there is anyone who could possibly give you a downside on that. If you go back and explore some of the things that happened in Asia Pacific during the SARS crisis in 2003, as I recall they closed the Hong Kong airport for about six weeks so cross boarder completely went away for all intense and purposes in that part of the world. If you can give me the exact amount of plane embarkation and some of the other things, I’ll give you a shot at what the impact will be in cross border. Now, what I did share with you was some of the things we track other than the gross dollar volume which we report out to you quarterly and I did mention that we’ve seen cross border transactions during the month of October fall relative to the 18% growth that we had in the third quarter. We had continued growth but it was high single digit growth rates during the month of October so we’re already seeing a slowdown in that growth rate, I just can’t tell you how low it may go or how long it might last.
Operator: Our next question comes from the line of Adam Frisch – UBS.
Adam Frisch – UBS: Just a quick point of clarification before my question, are you saying that you think ’09 revs will be in the high single digits and you are therefore not changing your margin or EPS growth objectives for ’09?
Robert W. Selander : What we’ve said is we don’t think we’re going to be able to reach the 12% to 15% longer term performance objectives we’ve established and that at this point in time we’re looking at needing high single digits in terms of top line growth in order to make the 3% to 5% on our operating margin and the 20% to 30% on net income growth. Again, excluding the adverse or positive impacts that foreign exchange might have in comparing it with prior years.
Adam Frisch – UBS: It’s a point of technicality but I know I’m going to get asked about it and I think it is the key item here for ’09. Does that mean you do think you will be able to hit your margin and EPS growth targets in ’09?
Robert W. Selander : Well, we’re still working our way through the budget process and at this point in time I believe we can still achieve those objectives. I do not know where we are going to come out and I certainly can’t tell you how the global economy is going to fair, I can only give you a set of assumptions that are the ranges we’re dealing with.
Adam Frisch – UBS: My question is, is the quality of your credit card user base, can you quantify for us just in terms of accessing their quality, what percentage would qualify as challenged from a credit perspective and I don’t know if you want to use metrics like FICO scores or percentages of revolvers or percentages of credit lines being used or anything like that but is there anything you can help us kind of qualify what your credit card user base is like?
Martina Hund-Mejean : Let me try and help you with that. First of all given that we are not an issuer of cards, as you know we would not be seeing individual card holders FICO scores. However, what we do from time-to-time is we actually do an independent third party survey of MasterCard and its major competitors, major payment card competitors and from this data we can absolutely not see any appreciable difference in the terms of percentages of card holders in each category and the categories are obviously subprime, prime and super prime with the exception of one company and that would be American Express which certainly has a lower percentage in the subprime category which is understandable given their business model.
Adam Frisch – UBS: If I could just ask one follow up, if revenue growth is lower than the high single digits is there more room to cut costs? Could we actually see operating costs go negative if you need to in order to preserve the margins or some sort of margins and EPS growth?
Robert W. Selander : Adam there’s a point in time where you decide you’re not going to chase something which will short change our investments in the future. So, we’re trying to position ourselves with as much flexibility as possible as we did last year, as we complete our budget with a set of sort of fixed assumptions, we’ll go back and build contingency plans in the event we’re wrong. I’d like to be able to assure you that regardless of circumstances we can do something but I can’t assure you of that. I can only say that we’re quite focused on flexibility and to the degree revenues come along less rapidly we’ll be doing things in terms of working those expenses levers to try and ensure we produce better results than might have otherwise been anticipated.
Operator: Our next question comes from Gregory Smith – Merrill Lynch.
Gregory Smith – Merrill Lynch: I just wanted to go back to the 20% to 30% sort of net income guidance. I think that is at constant currency so if we do think currency is going to be a headwind which looks pretty obvious at this point could you then fall below that on a reported basis which obviously what the numbers in first call reflect? I just want to be sure I understand that?
Martina Hund-Mejean : Absolutely. If we are going to get these kinds of currency headwinds and I gave you a little bit of a guideline in terms of where we would be coming in from an operating income for how foreign exchange would impacting operating income than you have to take the tax effect but on a reported basis it could fall below that 20% to 30%. That is why we made it so absolutely sure that everybody heard when we put out the long term objectives back in May, at the end of May that is on a constant fx basis because we cannot call foreign exchange.
Barbara Gasper : We’ve had a lot of questions about what constant fx means and one of the things we did is we put together a illustrative example which we’re going to be posting on our website under where you go to get the third quarter call information with the press release and the slide deck and the supplemental operations table. There will be an additional table there that we’ve worked through with an example. So, if people pull that off and you need help walking through that, Jason [Lane] and I would be happy to spend time with anybody who wants to talk about this further.
Gregory Smith – Merrill Lynch: Then just one last question, you’ve obviously gotten a couple big lawsuits behind you which is great but we still have this merchant interchange lawsuit lingering out there. Any update on timing of that lawsuit at this point?
Robert W. Selander : I’m trying to reflect on the timing of that one, to your point we had three sets of legacy litigation, the foreign exchange cases which are substantially behind us, the competitor cases, AMEX and Discover which we’ve obviously taken settlement on and also the merchant case. At this point in time that merchant case is going to play out over the next couple of years. We’re in the midst of completing the discovery process as we speak and there are some dates I think are relevant. Let me see if I can pull those up for you, I mentioned discovery should be completed in November, in the next few weeks. The class certification is currently scheduled for January of next year, expert reports are midyear next year, the June timeframe, there will be further briefing and other motions that we expect would only be filed sometime very late in the year, assume December of 2009. So there is no formal date set for trial yet but I think we’re imaging this thing is going to take a couple of more years to play out.
Operator: Our next question comes from Moshe Katri – Cowen & Co.
Moshe Katri – Cowen & Co.: Going back to cross border transactions, is there a way to break down the mix here by maybe US to non-US destinations, destinations within Europe and then anything that has to do with Latin America travel? Then, can you help us understand the relations between cross border transactions and revenue growth?
Robert W. Selander : We have shared with you that we have seen 18% growth in the third quarter and that it slowed in October to high single digits. I can’t give you more texture than that in terms of the geography. We did mention that US travelers in the third quarter were less active than European travelers and the European travelers tended to be traveling with Europe. I really can’t get any more granular than that.
Martina Hund-Mejean : In terms of cross border volume growth and the impact on net revenues Moshe, first of all when you look at our net revenue growth of 23.6% how I look at it is take out the 3.5 percentage points of foreign exchange here to business growth down to 20% and then you take the 5% pricing out so you’re down to 15%. Well, you look at our GDV growth of 12.3%, our purchase volume growth of 13.3%, transaction growth of 13% and that doesn’t get you quite there to the 15% so it’s really the 18% in terms of cross border volume growth that bridges the gap.
Operator: Our next question comes from Anurag Rana – Keybanc Capital Markets.
Anurag Rana – Keybanc Capital Markets: It’s nice that you guys gave some guidance about operating expenses growth in ’09, I think that was in our view one of the most important features of today’s results but could you also give us a little more color about volume growth in Europe especially given that seems Europe lagging US in terms of just the general economy?
Robert W. Selander : If you take a look at the detailed attachments to the earnings press release you’ll see some breakdowns in terms of third quarter growth rates within the various regions of the world. We continued to have strong gross dollar volume, in this case I guess it would be gross Euro and Sterling volume growth in Europe. For the quarter on a local currency basis we grew 16.8% in Europe and purchase volume grew 17.1%. So, it was quite strong growth in the third quarter. Given the amount of processed transactions we have in Europe, interim reporting in terms of our own monthly data is a little less meaningful in Europe than it is when we look at it on a global basis but I can just say that we’re seeing generally a slowdown versus what we’ve seen in the third quarter around the world and that was the basis on which I shared that data point that suggested in the total GDV on a local currency basis we’re seeing in the month of October mid single digit growth globally.
Operator: Our next question comes from Craig Maurer – Calyon Securities.
Craig Maurer – Calyon Securities: I was hoping to get some clarification on your comments with SEPA and in terms of local banks holding on to their networks a bit longer. One, I was wondering is that being driven by the current economic situation and two, in our discussions with local banks it seems the point of consternation with those large banks that haven’t moved over is the franchise fees currently being paid to MasterCard for local debit transactions to carry the bug that MasterCard isn’t processing and that’s a big point of contention. I was wondering if you could comment if there’s any give and take in that subject that might accelerate conversion to local processing?
Robert W. Selander : From my perspective what we have going on in the single European payments area are a couple of things. First of all, the reality of the economic environment that we’re in, most of our financial institution customers in Europe, in western Europe have gotten their faire share or more of the issues that we’ve seen working their way through US financial institutions. Just take a look at the landscape in terms of what’s going on with the partial nationalization of several banks with the mergers of several banks in the UK, with the [Fordyce] situation. So, the economic impact there is very real, very serious. Consumer was already in recession, I’m sorry there was already negative growth in GDP in the second quarter in Europe. So, Europe is a very trying environment for our customers and the investments that they’re willing to make in order to get things done on multiyear periods not surprisingly are being cut back in favor of restoring their balance sheets, their capital counts and other shorter term priorities that they may have that they think will give them more immediate impacts. So, I think that’s the first thing that is going on, just the reality of the economic environment. The second thing has to do with the business pace and what I will call some regulatory uncertainty and as you know we had a decision from the European Commission a year ago December which resulted in our suspension of our intra European cross border interchange fee. As banks are looking at the business case for various things related to a single European payments area clearly their models are in state of flux as they look at the realities of what that might imply if that decision stands despite our having appealed it and taking it to the Court of First Instance or to the degree it might domino in to the domestic market places. I think all those variables are at work here.
Operator: Our next question comes from Tien-Tsin Huang – JP Morgan.
Tien-Tsin Huang – JP Morgan: I jumped on a little bit late, I just want to confirm with Bob the process volume growth information that you gave for October. Is that inclusive of cash transactions?
Robert W. Selander : Yes, it will be anything we process so if we happen to process a cash transaction we would. Those tend to be more cross border as you would imagine because there are some domestic cash transactions, in fact the vast majority are done on us ATMs so we would not necessarily see those or process those.
Tien-Tsin Huang – JP Morgan: I was just curious if there was a way to get a better sense of what the purchased volume growth looked like?
Robert W. Selander : I think you should just take them at face value which is the best we can share with you at this point in time and that’s where we had a third quarter total gross volume dollar growth of 12.3% globally and local currency. We’re looking at mid single digits in the month of October and cross border which was 18%, we’re looking at high single digits during the month of October. So, quite dramatic reductions relative to what we were seeing for the average of the third quarter.
Tien-Tsin Huang – JP Morgan: So I guess my question is this, what are you seeing in terms of process transaction growth ignoring volume here? I’m just trying to get better sense of how much of the slowdown is really weaker average tickets versus fewer swipes? Do you have a view on that?
Robert W. Selander : We’re going to be releasing spend polls data in the next few days and one of the few things that we’ve seen over the last several months has been a reduction in ticket size, i.e. dollar volume is growing less than the transactions. If you think about it, if you filled your car with gas in the last few weeks, gas prices have fallen about 33% over the last several week but you still wind up going in and buying just about as much gas assuming your driving is the same. So, you keep the transactions but you lose the dollar volume in that environment. We’ve seen that across several categories in prior months. We’ve seen that in airlines and hotels where we’ve seen if you will inflation driven related price increases but slowing transactions.
Tien-Tsin Huang – JP Morgan: Then this is the last follow up, can you remind us how much of your total revenue is really based on a per swipe or just the transaction or click fee versus spread based or average ticket based?
Martina Hund-Mejean : We don’t really give any percentages out but in terms of how we charge a lot of our revenue is volume based and a smaller part is transaction based.
Operator: Our next question comes from Christopher Brendler – Stifel Nicolaus & Company, Inc.
Christopher Brendler – Stifel Nicolaus & Company, Inc.: On the litigation settlements with AMEX and Discover now behind you and the merchant case a couple of years away, any updated thoughts on uses of excess capital? A buyback or anything else?
Robert W. Selander : Just a couple of observations, obviously we will be reviewing our capital position regularly with our board as we’ve indicated in the past and I think it’s even more true today than perhaps it was over the past several quarters, we want to maintain flexibility and at this point in time we believe there’s an extra premium to be placed on the flexibility and having a strong balance sheet given the nature of the credit markets and the environments we’re in. Having said that, assuming we feel comfortable that we have more than enough flexibility than we would look at buy backs if we don’t have other opportunities or deals that would require us to use that capital.
Christopher Brendler – Stifel Nicolaus & Company, Inc.: Then in Europe you reported that you loss a couple of major [inaudible] in UK. Is that impacting your guidance at all? Is it material change to lose HBC and RBS and what are you planning on doing about your [Maestro] strategy?
Robert W. Selander : Those transactions or those deals were already reflected upon when we came out and gave you our longer term performance objectives back in May. So, from that perspective they’ve been built in to our thinking.
Christopher Brendler – Stifel Nicolaus & Company, Inc.: One quick follow up, I think you said on the last quarter’s call that you’d expect process transactions to outpace GDV as average ticket goes down. Are you seeing that in October?
Martina Hund-Mejean : Chris we don’t have the data for transactions for October, we really only have process volume.
Operator: Our next question comes from Sanjay Sakhrani – Keefe, Bruyette & Woods.
Sanjay Sakhrani – Keefe, Bruyette & Woods: Most of my questions have been asked but I was just wondering if I could just drill down on cross border a little bit more and I’ve asked this question before, and I appreciate the commentary on kind of the consumerist line and the commercial kind of accelerating a bit but, have you guys ever drove down on what kind of cross border volume growth has come from kind of cyclical impacts versus secular impacts? My assumption is that both are kind of slowing but cyclical more so but your analysis would seem to indicate the opposite?
Robert W. Selander : I don’t have any real insights to share with you. I don’t know if Martina if you have anything?
Martina Hund-Mejean : That is a very hard thing to divvy apart.
Sanjay Sakhrani – Keefe, Bruyette & Woods: Then maybe one follow up, obviously we saw a lot of consolidation occur across the financial space, have you guys had any discussions with some of the consolidatees or consolidators in your customer base to discuss the opportunity or their appetites for dual issuance on debit?
Robert W. Selander : Well obviously we’re talking with our customers, whichever side of the table they may be sitting on as consolidators or consolidatees, generally it’s at the end of the day consolidators who are making the decisions so that is where our focus is. With regard to debt, in the United States we’ve already seen banks sign up for debt duality and I gave you the example today of Chase’s, and they were already dual and debit but Chase’s Chicago Bears card that they’ve launched. Obviously we have also previously referred to the various NFL and I guess major league baseball debit programs that the Bank of America is involved with. So, we continue to work with our customers to try and find ways to give them obviously more attractive products for their card holders and merchants alike.
Operator: Our last question comes from Patrick M. Burton – Citigroup.
Patrick M. Burton – Citigroup: I’d like to follow up Bob on your earlier comments on how far is too far to potentially cut back. On the advertising side how far could you trim that back without getting let’s say significant push back from clients?
Robert W. Selander : I don’t know if we can give you a definitive point on that. I think the process is one where we pay attention to several variables, first of all our customers and the degree to which they count on our brand and the related marketing support, that’s a result of our budgeting process where we sit with customers and we’re obviously in the midst of that right now and look at what they want to get done and that will vary from one customer and one market to another. Secondly, we believe that we should be investing in our brand and that helps us drive utilization of our products so that’s a second dimension. Obviously, the health of the domestic economy and what’s going on with consumers it has impacted our customers’ plans will then work its way in to our thinking with regard to our marketing activities to drive the usage. I think probably the third dimension on that is what are competitors doing? Do we keep ourselves at a level of awareness, of advertising recognition and likability and some of those other measures that we use in other parts of the world to ensure a vibrant, vital healthy brand? So, all of those things would go in. If everybody in the world stops advertising and marketing and all of our customers say, “We don’t need any.” Then the combination of the competitors and customers telling us that, if we haven’t already gotten the message with what’s going on with the consumer in the marketplace than that would clearly cause us to pull that lever and ratchet back further than we would have otherwise done.
Barbara Gasper : Bob, I think you have a few closing comments you’d like to make before we say goodnight?
Robert W. Selander : I want to thank you all for joining us today. These are clearly challenging times and despite the economic environment, we are very excited with our results in the third quarter. We believe our business fundamentals continue to provide a solid foundation and we remain committed to growing our business while we aggressively manage costs in order to drive shareholder value. Once again, thanks for joining us today.
Operator: Thank you for your participation in today’s conference. This does conclude your presentation. You may now disconnect and have a great day. | [
{
"speaker": "Executives",
"text": "Barbara Gasper – Investor Relations Robert W. Selander – President & Chief Executive Officer Martina Hund-Mejean – Chief Financial Officer Tara Maguire – Corporate Controller"
},
{
"speaker": "Analysts",
"text": "Julio C. Quinteros – Gold Sachs & Co. Charles Murphy – Morgan Stanley Adam Frisch – UBS Gregory Smith – Merrill Lynch Moshe Katri – Cowen & Co. Anurag Rana – Keybanc Capital Markets Craig Maurer – Calyon Securities Tien-Tsin Huang – JP Morgan Christopher Brendler – Stifel Nicolaus & Company, Inc. Sanjay Sakhrani – Keefe, Bruyette & Woods Patrick M. Burton – Citigroup"
},
{
"speaker": "Operator",
"text": "Welcome to the third quarter 2008 MasterCard earnings conference call. At this time all participants are in a listen only mode. We will be facilitating a question-and-answer session towards the end of this conference. (Operator Instructions) As a reminder this conference is being recorded for replay purposes. I would now like to turn the presentation over to your host for today’s call, Miss Barbara Gasper, head of Investor Relations."
},
{
"speaker": "Barbara Gasper",
"text": "Thank you for joining us today either by phone or webcast for a discussion about our third quarter 2008 financial results. With me on the call today are Bob Selander, our Chief Executive Officer; Martina Hund-Mejean, our Chief Financial Officer; and Tara Maguire, our Corporate Controller. Following comments by Bob and Martina highlighting some key points about the business environment and our third quarter results we will open up the call for your questions. Today’s earnings release and the slide deck that will be referenced on this call can be found in the Investor Relations section of our website www.MasterCard.com. These materials have also been attached to an 8-K that we filed with the SEC earlier today. A replay of this call will be posted on our website for one week until November the 10th. Finally as set forth in more detail in today’s earnings release I need to remind everyone that today’s call may include some forward-looking statements about MasterCard's future performance. Actual performance could differ materially from what is suggested by our comments today. Information about the factors that could affect future performance are summarized at the end of our press release as well as contained in our recent SEC filings. With that I will now to turn the call over to Bo Selander."
},
{
"speaker": "Robert W. Selander",
"text": "I’d like to start out by saying how proud we are that in the current economic situation we have been able to deliver another strong quarter of earnings results. We saw net revenue growth of over 23% and I’m particularly pleased that we were able to post a 41% operating margin for the quarter an 8.4 percentage point increase over last year excluding our litigation settlement. However it is the economic situation that everyone is interested in. I’m going to leave the discussion of our third quarter results to Martina and begin by focusing on what we’re seeing in our business. The current economic crisis is like no other that we’ve seen. When we faced the last economic downturn in the United States we saw employment begin to rise, housing was driving the recovery, the financial institutions were in good shape, the financial markets were functioning and there was very limited commodity inflation. In some ways this time around there are fewer economic and financial levers to be pulled and over the last month we have seen unprecedented coordinated and structured responses from governments and central banks around the world resulting in a large scale intervention into the financial markets and institutions. As credit markets have tightened and fears of recession spread the last several weeks have been challenging for everyone, our customers, you as investors and for us. The concerns about a global economic slow down have had an impact on spending around the world primarily by the consumer. We recently saw that US Conference Boards Index of Consumer Confidence fell to an all time low since the measurement began 40 years ago. US GDV fell by .3% in the third quarter and consumer spending fell by the same .3% in the month of September. Housing prices continue to fall in the US, UK and Spain and all of this has led to sharply declining equity markets. We’ve also seen unbelievable banking industry consolidation and the nationalization of others and we’re seeing trends in our US business that until now we have not seen. You have heard us say in previous public forums that our business was holding at levels roughly equal to our second quarter gross volume dollar growth through July and August. This continued through early September but turned downward in mid-September following announcements such as Lehman’s bankruptcy, Merrill Lynch’s buyout and several bank mergers or bailouts both here in the United States and abroad. For the third quarter our total global gross dollar volume grew 12.3%. During the month of September worldwide processed volume growth our intra-quarter proxy for gross dollar volume was high single digits on a local currency basis. US growth was in the low single digit range. In the month of October we have seen a pronounced weakness in the US where are our process volumes were slightly negative versus last year. On a global basis our processed volume growth was in the mid single digits on a local currency basis. Cross border volume growth has also been slowing globally. For the third quarter we saw growth of 18%. Through the first four weeks of October cross border growth was in the high single digits. The decline has been primarily driven by a marked slow down in cross border volumes from US cardholders as Americans are cutting back on travel and cautiously spending if they do travel. From our perspective we’re seeing thoughtful and significantly reduced spending among our financial institution customers. They’re shifting their focus away from marketing, account acquisition and system enhancements towards retention and credit loss management activities. We’re supporting their efficiency and optimization efforts. We’re leveraging the strengths of our brands, technology, product innovations, people while emphasizing the balance of intelligence and insights, risk management and cost management best practices. For example customers are particularly interested in our data analytics and benchmarking capabilities. We anticipate these challenges continuing for the remainder of 2008 and into 2009. While we are fortunate to be part of an industry that offers tremendous opportunities for growth with the secular trends away from cash and checks we are not immune from the world’s economic problems, our customers’ challenges and the increased competition we face. As are most companies we continue looking for ways to control expenses as we navigate through these difficult economic times. We are using resources in a more thoughtful and efficient manner while trying to ensure that we remain well positioned for future growth. We have significantly ratcheted up our focus on our cost structure while making the investments necessary for future growth. For instance we have established a hiring cap essentially eliminating all open positions. We are also tightening up on contractor expenses, reducing travel expenses and spending with suppliers and consultants. I’d like to stress that our global structure, the diversification of our business and our solid business model are resilient. We are not directly exposed to consumer debt so we don’t have the risk of consumer credit write offs. Also it’s important to consider that we do business in 210 countries and territories and over 50% of our revenue is generated outside of the United States. As we move forward we continue to focus on supporting our customers as they address the needs of their businesses while we develop our pipeline of new business opportunities. We were already on the ground in emerging markets with the local capabilities to deliver our global product and service propositions. Payment trends are working in our favor, people all over the world continue to migrate toward electronic payments. The biggest opportunity still lies in cash and checks. On the legal front we recently reported that we reached a settlement in the Discover litigation. I’m pleased that this settlement has closed another chapter with respect to our legacy litigation cases. Under the terms of the settlement we will pay Discover a total of $862.5 million later this month. In the third quarter we recorded a pre-tax charge of $827.5 million. This includes receiving a payment of $35 million from Morgan Stanley and the total after-tax charge was $515.5 million. Before turning the call over to Martina I’d like to provide you with some initial thoughts about our outlook for 2009 which are summarized on Slide 3. We are still completing the work on our 2009 budget. However, when thinking about next year there are two items I’d like to highlight for you now. First, we expect that our net revenue growth will fall below the average annual range of 12% to 15% that is in our longer term objectives. Second, we are planning to hold operating expenses essentially flat over 2008 levels. We still need to invest wisely for long term growth while managing our expenses aggressively. I already mentioned some of the cost containment and reduction initiatives. In summary for 2009 we would expect that high single digit growth would be necessary in order to meet our margin expansion objective of three to five percentage points per year and average annual net income growth of 20% to 30%. Based on the recent strengthening of the US dollar we expect that foreign exchange will be a headwind for us on the revenue and net income lines keeping in mind that the same phenomenon results in a tailwind for us on the expense line. This is the reverse of what we’ve seen over the past several years. We are holding to our longer term performance objectives. Currently visibility beyond 2009 is difficult but we will continue to work towards those objectives over the longer term and we are pulling all the levers we can as we drive the organization to achieve them. Remember that our longer term objectives are based on constant foreign exchange rates. Also while we feel very fortunate and comfortable with the growth prospects of our business model the changes that are taking place in the financial markets globally are unprecedented and have certainly not been expected by anyone. As we gain more clarity about these forces we will continue to evaluate our objectives and adjust them if appropriate. With that I’ll now turn the call over to Martina for a detailed update on our third quarter financial results."
},
{
"speaker": "Martina Hund-Mejean",
"text": "As Bob mentioned we are pleased with our overall third quarter results. Turing to Page 4 of the slide deck in the third quarter we delivered net revenue of $1.3 billion up 23.6% over the comparable period last year. This was driven primarily by strong growth in worldwide gross dollar volume and processed transactions as well as cross border volume, currency fluctuations of the Euro and the Brazilian Reais relative to the US dollar contributed 3.5 percentage points of the net revenue increase resulting in underlying business growth of 20.1%. Pricing changes contributed approximately five percentage points of the revenue growth in the quarter. As Bob discussed we have taken a one time tax effective charge of $515.5 million for the Discover litigation settlement in the third quarter which we are treating as a special item. Because the settlement will be paid as a lump sum later this month there is no interest accretion that needs to be considered for modeling purposes. With respect to the American Express settlement that was reached in the prior quarter we have already told you about the $23 million in interest accretions which is not considered a special item. This represents about $0.11 per diluted share in the third quarter. Excluding the Discover settlement total operating expenses grew at 8.3% or $60 million to $790 million. We continue to demonstrate the leveragability of our business model by delivering operating income of $548 million excluding the litigation settlements. In 2008 we have consistently and significantly our operating margin delivering 41% in the third quarter an 8.4 percentage point improvement on a year-over-year basis. While strong revenue growth has enabled us to leverage our operating margin combined with some efficiencies related to an accelerated company wide cost containment and reduction program. We delivered net income of $322 million or $2.47 per diluted share excluding the special item in the third quarter. Including the litigation settlement we recorded a net loss of $194 million or a loss of $1.49 per diluted share. Turning to Page 5 we continue to benefit from the global diversification of our business with our ability to generate significant volume transactions and revenue from economies outside of the US. Worldwide gross dollar volumes grew 12.3% on a local currency basis in the third quarter and 14.8% on a US dollar converted basis to $662 billion. While the local currency growth rate is very similar to the GDV growth rate in the same quarter a year ago the US experienced slower growth offset in Asia-Pacific, Canada and Europe. Although not shown on Page 4 on a local currency basis worldwide purchase volume was up 13.3%, also slightly lower than the growth rate in the comparative quarter last year. Cash volume growth was 9.5%. Total US gross dollar volume growth was 4.7% and US purchase volume was higher at 6.6%. US debit for GDV continues to grow at a healthy 15.3% versus third quarter growth last year of 12.1%. Total US credit GDV growth declined by 1.3% but credit purchase volume grew at 1.5% for the quarter. Therefore the decline in overall US credit GDV was driven by negative cash volume growth as US issuers significantly reduced balance transfer acquisition campaigns. This is the second consecutive quarter of negative cash volume growth due to reduced convenience check usage and balance transfer activities which do not generate significant revenue for us. Cross border volume which is generated from cardholders who travel outside of the country where their card was issued was up 18% over the comparable quarter last year. This rate of growth was slightly lower than the growth rate of 19.2% for the third quarter last year. On the whole travel patterns remained fairly consistent on a year-over-year basis and we saw no significant change with the exception that there was less US travel to Europe but US cardholders increased their travel to other markets. Overall strong European cross border volume growth did offset lower growth in the US and a majority of the Europe cross border volume was generated on an intra-Europe basis. This pattern is consistent with the same quarter last year as Europeans traveled closer to home during the summer. While we’re still seeing healthy double digit growth rates for both consumer cross border volume grew at a somewhat slower pace than a year ago and commercial cross border growth accelerated. Processed transactions or the transactions processed across MasterCard’s network increased 13% to $5.4 billion in the third quarter compared with the year ago quarter. Net revenue yield which was 20.2 basis points in the quarter versus 18.8 basis points in the third quarter of 2007 was driven primarily by pricing. On a sequential basis the increase was primarily due to higher revenue for authorization settlement and switch revenue and cross border revenue. Let’s turn to Page 6, here you can see that net operation fees increased 25.8% or $204 million to $996 million in the third quarter. Gross operations fees increased 24.8% to about $1.1 billion. This growth was driven by two factors, first the growth in processed transactions, gross dollar volume and cross border volumes that I’ve previously described on Page 4. Second, new pricing changes implemented in January of this year on cross border acquiring volumes and on retail purchases in the US by non-US cardholders. In the third quarter net operation fees were 90.8% of gross operation fees slightly higher than the same quarter in 2007 due to the slower growth in rebates than gross revenue growth as a result of customer performance. On Page 7 we show that net assessments increased 17.5% to $342 million versus the third quarter of 2007. Gross assessment increased 15% to $604 million due to strong GDV growth of 14.8% on a US dollar basis. Net assessments as a percentage of gross assessments improved slightly to 56.6% due to timing and terms of non-gross dollar volume based incentives. Finally when looking at full year 2008 total net revenue growth we expect to exceed the 15% upper limit of our longer term revenue growth target assuming minimal changes in current exchange rates. Please turn to Page 8 for some detail on expenses. During the third quarter excluding the special item total operating expenses increased 8.3% of which 2.4 percentage points were related to currency fluctuations. This increase was mainly driven by the following, general and administrative expenses increased 14.1% of which two percentage points were related to currency fluctuations. The increase was the following, higher personnel costs accounted for eight percentage points of the G&A growth and was primarily driven the hiring of new personnel over the last 12 months and increased contractor costs. Three percentage points of the G&A increase was due to foreign currency transaction losses mostly due to the strengthening of the US dollar and higher professional fees primarily consisted of legal costs to defend outstanding litigations accounted for a further percentage point of the G&A increase. For the full year 2008 we expect G&A growth to approximate the third quarter year-to-date growth rate of 13.6%. As Bob mentioned earlier we are making significant changes in order to maintain an essentially flat expense structure going forward. In response to the current economic climate we have continued implementing a number of expense management measures such as eliminating open job reqs, reducing contractor spend and reducing travel and consulting expenses. In fact we saw a 20% saving in T&E expenses over the third quarter last year. While we had a slight increase in advertising and marketing expenses of 1.1% approximately three percentage points of this increase was due to foreign exchange. So excluding the impact of foreign exchange advertising and marketing expenses declined on a year-over-year basis. For the full year of 2008 we expect that our total advertising and marketing spend will be down versus what we spent in 2007. Previously we said that we expected 2008 spend to be flat relative to last year. Moving to the cash flow statement and balance sheet highlights on Page 9 we generated $388 million in cash flow from operations during the quarter and $931 million during the nine months through September 30, 2008. Even after our first payment of $150 million to American Express in the third quarter we ended the quarter with $2.8 billion in cash, cash equivalents and current available for sale securities. We have a number of balance sheet accounts that are impacted by the settlement with Discover such as our accounts receivable for the $35 million payment from Morgan Stanley and an increase in tax receivables and prepaid expenses. The lease on our St. Louis facility and related off balance sheet arrangements will change in 2009 by MasterCard repaying $149 million in debt. This item has been re-classed from long term to short term in the quarter. In conjunction with this payment during the first quarter of 2009 we will record the building as an asset on our books. I will now hand back to Bob to discuss some recent business highlights."
},
{
"speaker": "Robert W. Selander",
"text": "Before moving to the Q&A session I would like to share with you some of our recent business successes from around the world. In addition to our strong top line performance we remain focused on delivering best in class products and services to our customers. We continue global expansion of our credit and debit products and our acceptance channels including mobile phones and public transportation systems. We are happy to announce a new partnership with Barclaycard launching the first Barclaycard MasterCard commercial proposition targeted at UK small businesses. We are very pleased to continue building our relationship with Barclaycard. Likewise we continue to expand our relationship with Chase in the United States with the recent launch of the Chicago Bears Debit MasterCard. All new and existing Chase personal checking customers in Illinois are now eligible for this program. We continue our tradition of innovation with mobile payments which goes back five years when we first piloted the use of contactless payments on mobile phones. Earlier this year we announced our Mobile Money Send capability delivering person-to-person mobile payment service to MasterCard cardholders. Just last week we announced another competitive first, our over-the-air provisioning service. This service allows over-the-air personalization of cardholders’ mobile devices in an easy, one step process. This will enable mobile devices to perform payment transactions at merchant location with PayPass enabled terminals. In Italy we announced a strategic partnership with Telecom Italia to develop PayPass enabled mobile phones. We signed a deal with HSBC for a co-branding partnership with Woolworth’s Australia’s leading supermarket retailer to provide PayPass enabled cards to the retailer’s customers. In Europe we continue to see slow but steady progress on the SEPA front. Over the past two years we have concluded business agreement with approximately 30 banks across the Sapa area for their debit card business adding to our already strong European debit position. As a result the majority of European debit cards are now branded with either Maestro or MasterCard. With banks taking a more gradual approach towards Sapa by maintaining local schemes longer than the end of 2010 co-branded cards will be in the market longer than originally foreseen. We are making progress in unlocking the domestic debit business with acquirers and merchants now able to route domestic transactions across our network. We continue to see an increase in domestic processing of Maestro transactions. For example earlier this year I told you that we were processing roughly 14% of all domestic transactions in Italy. That figure is now approaching 17%. While other countries are less mature in processing domestic transactions we are beginning to see domestic Maestro volumes over our network in Belgium, The Netherlands, Luxembourg, France, Portugal, Germany and Ireland where before we only saw cross border transactions. In summary I’d just like to reiterate how pleased we are with being able to deliver a great third quarter with over 23% revenue growth and a 41% operating margin. We are seeing slow downs that are affecting our customers and we expect some challenges over the next few quarters as we work through this unprecedented economic environment. However we are still confident in our business model and will continue to make the necessary investments to fund future initiatives while being mindful of making our cost structure even more efficient. It is this combination that will position the company to continue to deliver growth over the longer term. I’ll now turn the call back over to Barbara so we can begin taking your questions."
},
{
"speaker": "Barbara Gasper",
"text": "We’re now ready to begin the question-and-answer period and in order to get to as many people as possible in our allotted timeframe we ask that you limit yourself to a single question with one follow up and then queue back in for additional questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Our first question comes from Julio C. Quinteros – Gold Sachs & Co."
},
{
"speaker": "Julio C. Quinteros – Gold Sachs & Co.",
"text": "Real quickly two things, both on pricing opportunities and headwinds as you guys think about the longer term trajectory. Can you just sort of spell those out in terms of what you are expecting on both fronts, pricing on the one side and then fx on the other?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "Let me take that, in terms of the pricing opportunities, as you know this year we were fortunate enough to have about 5 percentage points impact on our top line from additional pricing that we were able to take in the market due to the kind of value propositions that we are actually delivering to customers. We did say in the past that we believe that pricing opportunities exist in the future albeit it is completely connected to what kind of value we are delivering to customers and as you can appreciate in this kind of economic environment we’re certainly going to be very carefully evaluating what kind of pricing actions we will take. However, from what we said in the past, our view on pricing remains to be the same. So, at this point in time we are really not having a change in thought on that. From a foreign exchange point of view, foreign exchange is obviously a moving parameter. You can see that in terms of our top line growth we are always calling out what kind of foreign exchange impact we had. For this quarter it was 3.5%. Maybe it’s helpful if I can give everybody a guideline in terms of how to look at our foreign exchange impact. Maybe what I do is I really hinge it towards the Euro dollar relationship. So, let me lay this out for you, for every $0.01 of move in the US dollar to Euro relationship so for instance if, and these are always number but for instance the US dollar instead of taking $1.50 to purchase a Euro, it’s only $1.49 to purchase a Euro so every $0.01 the impact on our top line for the whole year would roughly be $8 million to $9 million. With that you have about 80% of our foreign exchange exposure captured. We are also exposed to the Brazilian Real and a number of other currency but we pretty much have 80%. Now, in addition to that I would like to add to the guideline that obviously we also have an impact on our operating expenses and that would be an offsetting impact. So, with the appreciating dollar you have headwinds on the revenue line but you would have tailwinds on the operating expenses and for that the guideline I would say is about $4 million to $5 million so in operating income you roughly can see for that $0.01 change for the whole year would be able $3 million to $4 million. With that hopefully you can make your assumptions where you think foreign exchange rates will go."
},
{
"speaker": "Julio C. Quinteros – Gold Sachs & Co.",
"text": "Just to clarify, the mid single digit growth for 2009 to get to the 20%, that is just what it would require to get to that 20%, that wasn’t the actual number that you guys were targeting to for 2009, is that correct?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "In fact, what we said is that we needed high single digit growth for 2009 in order to continue to have our operating margin performance objective of 3 to 5 percentage points as well as producing net income growth of 20% to 30%."
},
{
"speaker": "Operator",
"text": "Our next question comes from Charles Murphy – Morgan Stanley."
},
{
"speaker": "Charles Murphy – Morgan Stanley",
"text": "I wanted to return to pricing, for ’09 do you consider the amount of revenue growth you’ve gotten from pricing this year to be an anomaly? Do you expect to get a similar type of revenue growth from pricing or how should we think about that over the next year?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "Charlie, the comments that we are going to make are going to be very consistent with what we had said before. We actually did say, I think, on every earnings call we had this year that the 500 basis points that you’re seeing in every one of the quarters is actually quite extraordinary. It’s predominately fueled by what we’re seeing on cross boarder volume. I think what we laid out is that at any point in time we feel comfortable that we might be able to do pricing according to the kind of value proposition that we delivered to our customers of a minimum of 200 basis points per year and we are not stepping back from that kind of view."
},
{
"speaker": "Charles Murphy – Morgan Stanley",
"text": "As a quick follow up, can you help us understand what a legitimate downside case is for local currency cross boarder GDV growth?"
},
{
"speaker": "Robert W. Selander",
"text": "Charlie, I don’t know that there is anyone who could possibly give you a downside on that. If you go back and explore some of the things that happened in Asia Pacific during the SARS crisis in 2003, as I recall they closed the Hong Kong airport for about six weeks so cross boarder completely went away for all intense and purposes in that part of the world. If you can give me the exact amount of plane embarkation and some of the other things, I’ll give you a shot at what the impact will be in cross border. Now, what I did share with you was some of the things we track other than the gross dollar volume which we report out to you quarterly and I did mention that we’ve seen cross border transactions during the month of October fall relative to the 18% growth that we had in the third quarter. We had continued growth but it was high single digit growth rates during the month of October so we’re already seeing a slowdown in that growth rate, I just can’t tell you how low it may go or how long it might last."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Adam Frisch – UBS."
},
{
"speaker": "Adam Frisch – UBS",
"text": "Just a quick point of clarification before my question, are you saying that you think ’09 revs will be in the high single digits and you are therefore not changing your margin or EPS growth objectives for ’09?"
},
{
"speaker": "Robert W. Selander",
"text": "What we’ve said is we don’t think we’re going to be able to reach the 12% to 15% longer term performance objectives we’ve established and that at this point in time we’re looking at needing high single digits in terms of top line growth in order to make the 3% to 5% on our operating margin and the 20% to 30% on net income growth. Again, excluding the adverse or positive impacts that foreign exchange might have in comparing it with prior years."
},
{
"speaker": "Adam Frisch – UBS",
"text": "It’s a point of technicality but I know I’m going to get asked about it and I think it is the key item here for ’09. Does that mean you do think you will be able to hit your margin and EPS growth targets in ’09?"
},
{
"speaker": "Robert W. Selander",
"text": "Well, we’re still working our way through the budget process and at this point in time I believe we can still achieve those objectives. I do not know where we are going to come out and I certainly can’t tell you how the global economy is going to fair, I can only give you a set of assumptions that are the ranges we’re dealing with."
},
{
"speaker": "Adam Frisch – UBS",
"text": "My question is, is the quality of your credit card user base, can you quantify for us just in terms of accessing their quality, what percentage would qualify as challenged from a credit perspective and I don’t know if you want to use metrics like FICO scores or percentages of revolvers or percentages of credit lines being used or anything like that but is there anything you can help us kind of qualify what your credit card user base is like?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "Let me try and help you with that. First of all given that we are not an issuer of cards, as you know we would not be seeing individual card holders FICO scores. However, what we do from time-to-time is we actually do an independent third party survey of MasterCard and its major competitors, major payment card competitors and from this data we can absolutely not see any appreciable difference in the terms of percentages of card holders in each category and the categories are obviously subprime, prime and super prime with the exception of one company and that would be American Express which certainly has a lower percentage in the subprime category which is understandable given their business model."
},
{
"speaker": "Adam Frisch – UBS",
"text": "If I could just ask one follow up, if revenue growth is lower than the high single digits is there more room to cut costs? Could we actually see operating costs go negative if you need to in order to preserve the margins or some sort of margins and EPS growth?"
},
{
"speaker": "Robert W. Selander",
"text": "Adam there’s a point in time where you decide you’re not going to chase something which will short change our investments in the future. So, we’re trying to position ourselves with as much flexibility as possible as we did last year, as we complete our budget with a set of sort of fixed assumptions, we’ll go back and build contingency plans in the event we’re wrong. I’d like to be able to assure you that regardless of circumstances we can do something but I can’t assure you of that. I can only say that we’re quite focused on flexibility and to the degree revenues come along less rapidly we’ll be doing things in terms of working those expenses levers to try and ensure we produce better results than might have otherwise been anticipated."
},
{
"speaker": "Operator",
"text": "Our next question comes from Gregory Smith – Merrill Lynch."
},
{
"speaker": "Gregory Smith – Merrill Lynch",
"text": "I just wanted to go back to the 20% to 30% sort of net income guidance. I think that is at constant currency so if we do think currency is going to be a headwind which looks pretty obvious at this point could you then fall below that on a reported basis which obviously what the numbers in first call reflect? I just want to be sure I understand that?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "Absolutely. If we are going to get these kinds of currency headwinds and I gave you a little bit of a guideline in terms of where we would be coming in from an operating income for how foreign exchange would impacting operating income than you have to take the tax effect but on a reported basis it could fall below that 20% to 30%. That is why we made it so absolutely sure that everybody heard when we put out the long term objectives back in May, at the end of May that is on a constant fx basis because we cannot call foreign exchange."
},
{
"speaker": "Barbara Gasper",
"text": "We’ve had a lot of questions about what constant fx means and one of the things we did is we put together a illustrative example which we’re going to be posting on our website under where you go to get the third quarter call information with the press release and the slide deck and the supplemental operations table. There will be an additional table there that we’ve worked through with an example. So, if people pull that off and you need help walking through that, Jason [Lane] and I would be happy to spend time with anybody who wants to talk about this further."
},
{
"speaker": "Gregory Smith – Merrill Lynch",
"text": "Then just one last question, you’ve obviously gotten a couple big lawsuits behind you which is great but we still have this merchant interchange lawsuit lingering out there. Any update on timing of that lawsuit at this point?"
},
{
"speaker": "Robert W. Selander",
"text": "I’m trying to reflect on the timing of that one, to your point we had three sets of legacy litigation, the foreign exchange cases which are substantially behind us, the competitor cases, AMEX and Discover which we’ve obviously taken settlement on and also the merchant case. At this point in time that merchant case is going to play out over the next couple of years. We’re in the midst of completing the discovery process as we speak and there are some dates I think are relevant. Let me see if I can pull those up for you, I mentioned discovery should be completed in November, in the next few weeks. The class certification is currently scheduled for January of next year, expert reports are midyear next year, the June timeframe, there will be further briefing and other motions that we expect would only be filed sometime very late in the year, assume December of 2009. So there is no formal date set for trial yet but I think we’re imaging this thing is going to take a couple of more years to play out."
},
{
"speaker": "Operator",
"text": "Our next question comes from Moshe Katri – Cowen & Co."
},
{
"speaker": "Moshe Katri – Cowen & Co.",
"text": "Going back to cross border transactions, is there a way to break down the mix here by maybe US to non-US destinations, destinations within Europe and then anything that has to do with Latin America travel? Then, can you help us understand the relations between cross border transactions and revenue growth?"
},
{
"speaker": "Robert W. Selander",
"text": "We have shared with you that we have seen 18% growth in the third quarter and that it slowed in October to high single digits. I can’t give you more texture than that in terms of the geography. We did mention that US travelers in the third quarter were less active than European travelers and the European travelers tended to be traveling with Europe. I really can’t get any more granular than that."
},
{
"speaker": "Martina Hund-Mejean",
"text": "In terms of cross border volume growth and the impact on net revenues Moshe, first of all when you look at our net revenue growth of 23.6% how I look at it is take out the 3.5 percentage points of foreign exchange here to business growth down to 20% and then you take the 5% pricing out so you’re down to 15%. Well, you look at our GDV growth of 12.3%, our purchase volume growth of 13.3%, transaction growth of 13% and that doesn’t get you quite there to the 15% so it’s really the 18% in terms of cross border volume growth that bridges the gap."
},
{
"speaker": "Operator",
"text": "Our next question comes from Anurag Rana – Keybanc Capital Markets."
},
{
"speaker": "Anurag Rana – Keybanc Capital Markets",
"text": "It’s nice that you guys gave some guidance about operating expenses growth in ’09, I think that was in our view one of the most important features of today’s results but could you also give us a little more color about volume growth in Europe especially given that seems Europe lagging US in terms of just the general economy?"
},
{
"speaker": "Robert W. Selander",
"text": "If you take a look at the detailed attachments to the earnings press release you’ll see some breakdowns in terms of third quarter growth rates within the various regions of the world. We continued to have strong gross dollar volume, in this case I guess it would be gross Euro and Sterling volume growth in Europe. For the quarter on a local currency basis we grew 16.8% in Europe and purchase volume grew 17.1%. So, it was quite strong growth in the third quarter. Given the amount of processed transactions we have in Europe, interim reporting in terms of our own monthly data is a little less meaningful in Europe than it is when we look at it on a global basis but I can just say that we’re seeing generally a slowdown versus what we’ve seen in the third quarter around the world and that was the basis on which I shared that data point that suggested in the total GDV on a local currency basis we’re seeing in the month of October mid single digit growth globally."
},
{
"speaker": "Operator",
"text": "Our next question comes from Craig Maurer – Calyon Securities."
},
{
"speaker": "Craig Maurer – Calyon Securities",
"text": "I was hoping to get some clarification on your comments with SEPA and in terms of local banks holding on to their networks a bit longer. One, I was wondering is that being driven by the current economic situation and two, in our discussions with local banks it seems the point of consternation with those large banks that haven’t moved over is the franchise fees currently being paid to MasterCard for local debit transactions to carry the bug that MasterCard isn’t processing and that’s a big point of contention. I was wondering if you could comment if there’s any give and take in that subject that might accelerate conversion to local processing?"
},
{
"speaker": "Robert W. Selander",
"text": "From my perspective what we have going on in the single European payments area are a couple of things. First of all, the reality of the economic environment that we’re in, most of our financial institution customers in Europe, in western Europe have gotten their faire share or more of the issues that we’ve seen working their way through US financial institutions. Just take a look at the landscape in terms of what’s going on with the partial nationalization of several banks with the mergers of several banks in the UK, with the [Fordyce] situation. So, the economic impact there is very real, very serious. Consumer was already in recession, I’m sorry there was already negative growth in GDP in the second quarter in Europe. So, Europe is a very trying environment for our customers and the investments that they’re willing to make in order to get things done on multiyear periods not surprisingly are being cut back in favor of restoring their balance sheets, their capital counts and other shorter term priorities that they may have that they think will give them more immediate impacts. So, I think that’s the first thing that is going on, just the reality of the economic environment. The second thing has to do with the business pace and what I will call some regulatory uncertainty and as you know we had a decision from the European Commission a year ago December which resulted in our suspension of our intra European cross border interchange fee. As banks are looking at the business case for various things related to a single European payments area clearly their models are in state of flux as they look at the realities of what that might imply if that decision stands despite our having appealed it and taking it to the Court of First Instance or to the degree it might domino in to the domestic market places. I think all those variables are at work here."
},
{
"speaker": "Operator",
"text": "Our next question comes from Tien-Tsin Huang – JP Morgan."
},
{
"speaker": "Tien-Tsin Huang – JP Morgan",
"text": "I jumped on a little bit late, I just want to confirm with Bob the process volume growth information that you gave for October. Is that inclusive of cash transactions?"
},
{
"speaker": "Robert W. Selander",
"text": "Yes, it will be anything we process so if we happen to process a cash transaction we would. Those tend to be more cross border as you would imagine because there are some domestic cash transactions, in fact the vast majority are done on us ATMs so we would not necessarily see those or process those."
},
{
"speaker": "Tien-Tsin Huang – JP Morgan",
"text": "I was just curious if there was a way to get a better sense of what the purchased volume growth looked like?"
},
{
"speaker": "Robert W. Selander",
"text": "I think you should just take them at face value which is the best we can share with you at this point in time and that’s where we had a third quarter total gross volume dollar growth of 12.3% globally and local currency. We’re looking at mid single digits in the month of October and cross border which was 18%, we’re looking at high single digits during the month of October. So, quite dramatic reductions relative to what we were seeing for the average of the third quarter."
},
{
"speaker": "Tien-Tsin Huang – JP Morgan",
"text": "So I guess my question is this, what are you seeing in terms of process transaction growth ignoring volume here? I’m just trying to get better sense of how much of the slowdown is really weaker average tickets versus fewer swipes? Do you have a view on that?"
},
{
"speaker": "Robert W. Selander",
"text": "We’re going to be releasing spend polls data in the next few days and one of the few things that we’ve seen over the last several months has been a reduction in ticket size, i.e. dollar volume is growing less than the transactions. If you think about it, if you filled your car with gas in the last few weeks, gas prices have fallen about 33% over the last several week but you still wind up going in and buying just about as much gas assuming your driving is the same. So, you keep the transactions but you lose the dollar volume in that environment. We’ve seen that across several categories in prior months. We’ve seen that in airlines and hotels where we’ve seen if you will inflation driven related price increases but slowing transactions."
},
{
"speaker": "Tien-Tsin Huang – JP Morgan",
"text": "Then this is the last follow up, can you remind us how much of your total revenue is really based on a per swipe or just the transaction or click fee versus spread based or average ticket based?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "We don’t really give any percentages out but in terms of how we charge a lot of our revenue is volume based and a smaller part is transaction based."
},
{
"speaker": "Operator",
"text": "Our next question comes from Christopher Brendler – Stifel Nicolaus & Company, Inc."
},
{
"speaker": "Christopher Brendler – Stifel Nicolaus & Company, Inc.",
"text": "On the litigation settlements with AMEX and Discover now behind you and the merchant case a couple of years away, any updated thoughts on uses of excess capital? A buyback or anything else?"
},
{
"speaker": "Robert W. Selander",
"text": "Just a couple of observations, obviously we will be reviewing our capital position regularly with our board as we’ve indicated in the past and I think it’s even more true today than perhaps it was over the past several quarters, we want to maintain flexibility and at this point in time we believe there’s an extra premium to be placed on the flexibility and having a strong balance sheet given the nature of the credit markets and the environments we’re in. Having said that, assuming we feel comfortable that we have more than enough flexibility than we would look at buy backs if we don’t have other opportunities or deals that would require us to use that capital."
},
{
"speaker": "Christopher Brendler – Stifel Nicolaus & Company, Inc.",
"text": "Then in Europe you reported that you loss a couple of major [inaudible] in UK. Is that impacting your guidance at all? Is it material change to lose HBC and RBS and what are you planning on doing about your [Maestro] strategy?"
},
{
"speaker": "Robert W. Selander",
"text": "Those transactions or those deals were already reflected upon when we came out and gave you our longer term performance objectives back in May. So, from that perspective they’ve been built in to our thinking."
},
{
"speaker": "Christopher Brendler – Stifel Nicolaus & Company, Inc.",
"text": "One quick follow up, I think you said on the last quarter’s call that you’d expect process transactions to outpace GDV as average ticket goes down. Are you seeing that in October?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "Chris we don’t have the data for transactions for October, we really only have process volume."
},
{
"speaker": "Operator",
"text": "Our next question comes from Sanjay Sakhrani – Keefe, Bruyette & Woods."
},
{
"speaker": "Sanjay Sakhrani – Keefe, Bruyette & Woods",
"text": "Most of my questions have been asked but I was just wondering if I could just drill down on cross border a little bit more and I’ve asked this question before, and I appreciate the commentary on kind of the consumerist line and the commercial kind of accelerating a bit but, have you guys ever drove down on what kind of cross border volume growth has come from kind of cyclical impacts versus secular impacts? My assumption is that both are kind of slowing but cyclical more so but your analysis would seem to indicate the opposite?"
},
{
"speaker": "Robert W. Selander",
"text": "I don’t have any real insights to share with you. I don’t know if Martina if you have anything?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "That is a very hard thing to divvy apart."
},
{
"speaker": "Sanjay Sakhrani – Keefe, Bruyette & Woods",
"text": "Then maybe one follow up, obviously we saw a lot of consolidation occur across the financial space, have you guys had any discussions with some of the consolidatees or consolidators in your customer base to discuss the opportunity or their appetites for dual issuance on debit?"
},
{
"speaker": "Robert W. Selander",
"text": "Well obviously we’re talking with our customers, whichever side of the table they may be sitting on as consolidators or consolidatees, generally it’s at the end of the day consolidators who are making the decisions so that is where our focus is. With regard to debt, in the United States we’ve already seen banks sign up for debt duality and I gave you the example today of Chase’s, and they were already dual and debit but Chase’s Chicago Bears card that they’ve launched. Obviously we have also previously referred to the various NFL and I guess major league baseball debit programs that the Bank of America is involved with. So, we continue to work with our customers to try and find ways to give them obviously more attractive products for their card holders and merchants alike."
},
{
"speaker": "Operator",
"text": "Our last question comes from Patrick M. Burton – Citigroup."
},
{
"speaker": "Patrick M. Burton – Citigroup",
"text": "I’d like to follow up Bob on your earlier comments on how far is too far to potentially cut back. On the advertising side how far could you trim that back without getting let’s say significant push back from clients?"
},
{
"speaker": "Robert W. Selander",
"text": "I don’t know if we can give you a definitive point on that. I think the process is one where we pay attention to several variables, first of all our customers and the degree to which they count on our brand and the related marketing support, that’s a result of our budgeting process where we sit with customers and we’re obviously in the midst of that right now and look at what they want to get done and that will vary from one customer and one market to another. Secondly, we believe that we should be investing in our brand and that helps us drive utilization of our products so that’s a second dimension. Obviously, the health of the domestic economy and what’s going on with consumers it has impacted our customers’ plans will then work its way in to our thinking with regard to our marketing activities to drive the usage. I think probably the third dimension on that is what are competitors doing? Do we keep ourselves at a level of awareness, of advertising recognition and likability and some of those other measures that we use in other parts of the world to ensure a vibrant, vital healthy brand? So, all of those things would go in. If everybody in the world stops advertising and marketing and all of our customers say, “We don’t need any.” Then the combination of the competitors and customers telling us that, if we haven’t already gotten the message with what’s going on with the consumer in the marketplace than that would clearly cause us to pull that lever and ratchet back further than we would have otherwise done."
},
{
"speaker": "Barbara Gasper",
"text": "Bob, I think you have a few closing comments you’d like to make before we say goodnight?"
},
{
"speaker": "Robert W. Selander",
"text": "I want to thank you all for joining us today. These are clearly challenging times and despite the economic environment, we are very excited with our results in the third quarter. We believe our business fundamentals continue to provide a solid foundation and we remain committed to growing our business while we aggressively manage costs in order to drive shareholder value. Once again, thanks for joining us today."
},
{
"speaker": "Operator",
"text": "Thank you for your participation in today’s conference. This does conclude your presentation. You may now disconnect and have a great day."
}
] | null | null |
MA | 2 | 2,008 | 2008-07-31 09:00:00 | Executives: Barbara Gasper - Investor Relations Martina Hund-Mejean - Chief Financial Officer
Analysts: Tien-Tsin Huang - J.P. Morgan Patrick M. Burton - Citigroup Adam Frisch - UBS Christopher Mammone - Deutsche Bank - North America Elizabeth W. Grausam - Goldman Sachs Christopher Brendler - Stifel Nicolaus Craig Maurer - Calyon Securities (USA) Inc. Sanjay Sakhrani - Keefe Bruyette & Woods Tim Willi - Avondale Partners Charles Murphy - Morgan Stanley
Operator: Welcome to the second quarter 2008 MasterCard Incorporated earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call, Barbara Gasper, Head of Investor Relations.
Barbara Gasper: Thank you for joining us today, either by phone or webcast, for a discussion about our second quarter 2008 financial results. With me on the call this morning are Martina Hund-Mejean, our Chief Financial Officer; and Tara Maguire, our Corporate Controller. Following comments by Martina highlighting some key points about the quarter, we will open up the call for your questions. In total, the call will last up to one hour. This morning’s earnings release and the slide deck that will be referenced on this call can be found in the Investor Relations section of our website, www.mastercard.com. The earnings release and slide deck have also been attached to an 8-K that we filed with the SEC this morning. A replay of this call will be posted on our website for one week until August 7th. Finally, as set forth in more detail in today’s earnings release, I need to remind everyone that today’s call may include some forward-looking statements about MasterCard's future performance. Actual performance could differ materially from what is suggested by our comments today. Information about the factors that could affect future performance are summarized at the end of our press release as well as contained in our recent SEC filings. With that, I would now like to turn the call over to Martina Hund-Mejean.
Martina Hund-Mejean: We are pleased with our overall second quarter results and while we remain mindful of the current economic environment, our business fundamentals continue to provide a solid foundation for us to meet our business objectives for 2008. Turning to Page 2 of the slide pack, in the second quarter we delivered net income of $276.0 million, or $2.11 per diluted share, excluding a special item related to the settlement of our anti-trust litigation with American Express. Under the terms of the settlement, we will pay American Express up to a total of $1.8 billion. We recorded in the quarter the pre-tax net present value of this liability of $1.65 billion. On an after-tax basis the charge was just over $1.0 billion. While our results have been impacted by the settlement, we are pleased to have brought this issue to closure. Including the special item, we recorded at net loss of $(747.0) million, or a loss of $(5.74) per diluted share. Net revenue totaled $1.2 billion, up 25% over the comparable period last year. This was driven primarily by strong growth and worldwide GDV and processed transactions, as well as cross-border volumes, which grew 18.9%. Additionally, pricing changes contributed approximately 5% of the revenue growth in the quarter. Currency fluctuations also represented 5.4% of this growth. Finally, demonstrating the continued leveraged ability of our business model, we saw our operating margin improve 6.1% to 33.4%, from 27.3% in the second quarter of 2007, excluding special items. Before getting into the detailed financial results, let me just step back a minute and talk about what we are seeing across our business and the economic environment, both here in the United States and abroad. Please turn to Page 3. The slow down in the U.S. economy has had an effect on our growth in the United States. Over the last few quarters we have seen a steady decrease in U.S. GDV growth from 10.6% in Q4 of 2007 to 8.9% in Q1 2008 and now the GDV growth for the second quarter was 6.2%. During the second quarter credit volume growth was only 0.7% but debit grew at 15.8%. U.S. purchase volume was slightly higher than GDV growth, while cash volume growth was down. Processed transaction growth is still ahead of volume growth at 7.8%. As I shared with you on our last earnings call and at our annual investor meeting, in the U.S. we are still seeing consumer spending patterns shifting to more non-discretionary purchases. Our processed transaction data, as well as MasterCard Advisors Spending Cost Analysis, continues to show an increase in sales of necessary goods such as gasoline, food, and health care, largely due to increasing prices. The impact of higher inflation and lower housing prices are compounded by the fact that consumers are finding it increasingly difficult to obtain credit as financial institutions tighten their criteria for loans and credit extensions. However, we continue to see double-digit growth in markets outside the U.S., which contributed a little more than half of our revenues in the quarter. While there are economic downturns in the U.K., Spain, and a few other European countries, in general European markets continue to represent strong growth for us. Furthermore, we still see healthy cross-border volume growth. While down slightly from the 20+% growth levels we have seen over the past two quarters, the second quarter growth rate of 18.9% is higher compared with the same quarter last year. As in recent quarters, this growth continues to be primarily driven by Europeans traveling in Europe and overseas and we have not seen any significant change in travel patterns on a year-over-year basis for any of the regions. Last, as we have discussed before, much of our growth is being driven by the secular shifts of electronic payments, which we believe is somewhat independent of the cyclicality of current market conditions. We continue to collaborate with our customers to help maximize the value of the payments businesses, recognizing that they are experiencing extraordinarily challenging conditions in the current economic environment. We are partnering with them as they refocus their efforts from account acquisition and marketing towards the maintenance of the existing business and areas such as broad-loss prevention. We are not insulated from the pain that our customers are feeling and we are actively working our expense structure to deal with the changing demands of our customers. In a few minutes I will reference a couple of examples of actions that we have undertaken. Switching now to some business highlights: On our last call we discussed our announcement of our debit process platform, Integrated Processing Solutions, OIPS. I am very pleased to report that we are now in light production with our first customer, Security Service Federal Credit Union, having successfully completed the critical first stage of a multi-stage conversion and implementation program. With respect to our U.S. litigations, I have mentioned that we have entered into a settlement agreement with American Express in June. We will pay Amex up to $150.0 million for 12 quarters beginning this September and the payments will not exceed a total of $1.8 billion. There are two recent developments related to the Discover case. First, this week we entered into a judgment-sharing agreement with Visa that the portions costs and liabilities both companies may incur in the event of either an adverse judgment or settlement of the case. This agreement provides that Visa would be responsible for the substantial majority of any judgment or settlement, based primarily on relevant volumes. Second, the district court recently indicated that it expects to issue decisions on summary judgment motions no later than August 18, 2008, and has rescheduled the trial to begin on October 14, 2008. In mid-June we announced that we would comply with the European Commission’s ruling by temporarily repealing our default intra-EEA cross-border consumer card interchange fees effective June 21, 2008. We continue to hold discussions with the Commission to see what interchange fee-setting methodology we might employ in order to be compliant with their decisions. In any event, we will take appropriate action to ensure that we remain competitive in Europe. With respect to our repurchase program, in the second quarter we repurchased approximately 1.3 million shares of Class A common stock for a total of $355.0 million. We have now completed the approved $1.25 billion repurchase program. We regularly review our capital structure with the Board and will continue to evaluate additional share repurchase programs in the future. Further, this past February, our Board authorized the conversion of up to 13.1 million shares of Class B stock into Class A stock during 2008. In the second quarter we implemented and completed the conversion program with all of the 2008 authorized shares of Class B common stock converted into an equal number of Class A common stock, which was then subsequently sold for transfer to public investors. Class A shares now represent approximately 76% of total shares outstanding. Let’s turn to Page 4 of the slide deck. Net revenue for the quarter exceeded $1.2 billion, an increase of 25% versus the year-ago quarter. Current fluctuations of the Euro and the Brazilian real relative to the U.S. dollar constituted 5.4% of the net revenue increase resulting in underlying business growth of 19.6%. Approximately 5% of this was due to pricing changes. Excluding the several items related to the litigation settlement, our operating income of $416.0 million resulted in an operating margin of 33.4% for the quarter, a 6.1% improvement over the second quarter last year. As we have mentioned in the past, our strong revenue growth enabled us to leverage our operating margins. The contribution from foreign exchange was less than 1% of this increase. Net income we $276.0 million, or $2.11 per diluted share, excluding the special items. Turning to Page 5, gross dollar volume grew 12.8% on a local-currency basis in the second quarter, and 18.2% on a U.S. dollar-converted basis, to $655.0 billion. This quarter was the 17th consecutive quarter of double-digit worldwide GDV growth on a local-currency basis. Growth in the U.S. was 6.2% and purchase volume growth in the U.S. was higher, at 8% versus the second quarter in 2007. Although not shown on Page 5, on a local currency-basis, worldwide purchase volume was up 14% and cash volume growth of 9.3% was slightly lower than the comparative quarter last year. Additionally, cross-border volume, or the volume that is generated from cardholders who travel outside of the country where their card is issued, was up 18.9% over the comparable quarter last year. I would like to point out that beginning in the second quarter we refined our methodology of calculating our cross-border volume to use the merchant country rather than the acquirer country. The effect of this change only relates to volume growth rates, which is very small and has no impact on our reported revenues. Prior reporting periods have been re-stated and can be found within the Supplemental Operational Performance data on our Investor Relations website. Processed transactions, or transactions processed across MasterCard’s network, increased 13.6%, or $5.2 billion in the second quarter. We continue to benefit from the global diversification of our business with our ability to generate significant volumes, transactions, and revenues from economies outside of the U.S. Net revenue yield was 19 basis points in the quarter, versus 18 basis points in the second quarter of 2007. Pricing changes were the primary driver of this improvement. Let’s turn to Page 6. Here you can see the net operations fee increased 28.7%, or $209.0 million, to $938.0 million in the second quarter. Gross operation fees increased 27.5%, or $225.0 million to a little more than $1.0 billion. This growth was driven by several factors. First, growth in processed transactions, cross-border volumes, and gross dollar volumes that were previously described on Page 5. Second, new pricing changes implemented in January of this year on cross-border acquiring volumes and on retail purchases in the U.S. by non-U.S. cardholders. And third, revenue for other payment-related services such as new accounts enhancement program launched late in the second quarter of 2007 in global cardholder services. In the second quarter net operation fees, as a percentage of gross operation fees, improved slightly due to a continuation of lower rebates to customers who did not achieve contractual performance criteria. On Page 7 we show that net assessments increased 14.9%, or $40.0 million, versus the second quarter of 2007. Gross assessments increased 15.9% versus U.S. dollar GDV growth of 18.2%, or $80.0 million, to $583.0 million due to strong GDV growth slightly offset by mix. Net assessments as a percentage of gross assessments declined somewhat compared to the second quarter of 2007. Please turn to Page 8 for some detail on expenses. In the second quarter, excluding the special items, total operating expenses increased 14.6%, of which 4.5% were related to currency fluctuations. The increase was mainly driven by two factors. First, a 15.7% increase in general administration expenses, of which 3.3% were related to currency fluctuation. The growth in G&A was driven by higher personnel costs, excluding the impact of FX, personnel costs increased 18.1%, primarily driven by the hiring of new personnel as well as higher severance costs as we continue to align our business needs against our existing talent pool. Second, we recorded a 13% increase in advertising and marketing expense. Currency fluctuations represented 6.6% of this increase. A&M growth was primarily due to the timing of expenses, mostly for sponsorship activities related to the UEFA and European Championship soccer events, as well as ongoing investments in high-growth markets. Moving to the cash flow statement and balance sheet highlights on Page 9, we generated $319.0 million in cash flow from operations during the quarter. We ended the quarter with $2.7 billion in cash, cash equivalents, and available-for-sale securities. This includes the repayment of $80.0 million of subordinated debt. Available-for-sale securities decreased $84.0 million in the quarter, mostly due to the sale of short-term bond funds. The American Express litigation had an impact on primarily two areas of our balance sheet. First, litigation liability increased by $1.65 billion. Second, our deferred income tax assets increased by $530.0 million. Both of these totals were broken down into their short- and long-term components that booked to the balance sheet. In April this year we formally integrated the operating structures of our operations in France with Europay France forming a new entity, MasterCard France. This resulted in a 70% equity interest for MasterCard accounting for this transaction as 100% acquisition and we recorded a liability for the present value of the fixed purchase price of EU $15.0 million which will be paid by MasterCard in three years. At that point we will own 100% of the entity. As of quarter end we have finalized the repurchase of approximately 1.3 million Class A shares in the open market for $355.0 million. Before moving to the Q&A, I would like to spend a few minutes on Slide 10, highlighting a couple of items for your consideration as you refine and update your models for the remainder of 2008. In light of what we currently see for our business, the longer-term performance objectives, what we talked about on May 29, remain unchanged. However, we have refined our outlook for full-year 2008. We continue to expect slower net revenue growth than the 22.3% growth we experienced in 2007 but still at double-digit rates and assuming constant FX. Mid-year our revenue growth has been [inaudible] excluding FX. Lower U.S. growth [inaudible] net revenue growth for the rest of the year [inaudible] effect of performance criteria and customer agreements in our continued strong [inaudible]. Our outlook for G&A expenses, excluding special items, remains unchanged. It should grow at a rate that is both slower than 2008 net revenue growth and below the 2008 G&A growth rate of 16.8%. Similar to revenue growth, our 2008 outlook assumes constant FX. On a year-to-date basis G&A growth has been 10.3%, excluding FX. With respect to A&M we now anticipate to spend roughly the same amount as in 2007 based on current FX rates as we adjust our efforts in line with our custom activities. We don’t anticipate as much marketing expense in the second half of this year, particularly in Q4. Previously we had been expecting to see a modest increase in total A&M spend for full year 2008 assuming constant FX. These thoughts continue to assume no global recession and no event which significantly disrupts cross-border travel. Finally, while we do not plan to break out the interest accretion impact associated with the American Express settlement as a special item, we do expect it will increase interest expense by $44.0 million for the second half of 2008. We have included in our schedule in the appendix to this presentation which models the increased quarterly interest expense amount over the settlement pay-out period over the next 12 quarters. We are very pleased with our second quarter results but are mindful of the economic conditions that we are operating in. We are managing our business plans in light of a tougher market and are taking the necessary expense management actions as we see our customers realigning their plans. We remain committed to growing our business by managing costs and investments in order to drive shareholder value.
Barbara Gasper - Investor Relations: We are now ready to begin the question and answer period. In order to get to as many people as possible in our allotted time frame, we ask that you limit yourself to a single question with one follow-up and then queue back in for additional questions.
Operator: (Operator Instructions) Your first question comes from Tien-Tsin Huang with J.P. Morgan.
Tien-Tsin Huang - J.P. Morgan: First, on U.S. credit growth, last quarter you mentioned a contract termination. Did that occur in the quarter, and if so, what was the impact?
Martina Hund-Mejean: I think we talked about that in the last quarter already. That was where a customer of ours sold their business to somebody else, and the impact in the quarter was actually relatively small, very small.
Tien-Tsin Huang - J.P. Morgan: I think you commented 0.7% growth in credit. Is that where it would have hit? I’m just curious what the growth would have been excluding that change.
Martina Hund-Mejean: It would not have significantly been different.
Tien-Tsin Huang - J.P. Morgan: Can you comment on monthly trends in general on U.S. purchase volume growth in the second quarter?
Martina Hund-Mejean: We saw during the quarter it came down a little bit in June. It wasn’t a cabalistic decline. But I can tell you that what we are seeing here, on average, for the second quarter, we are seeing as a trend, also, for July.
Tien-Tsin Huang - J.P. Morgan: And on G&A, did you quantify the higher severance costs and what kind of savings you expect to get out it?
Martina Hund-Mejean: We can certainly do that. If you just looked at the G&A expenses overall, you saw a 15.7% increase of which 3.3% were related to currency fluctuations, and then in terms of the severance, I can guide you that that was about 3% of that.
Tien-Tsin Huang - J.P. Morgan: And the savings you expect out of that, going forward?
Martina Hund-Mejean: I think you know pretty much our run rate in terms of what we spend on average per employee, so we do obviously expect some savings, otherwise we wouldn’t have done that. But it’s really realigning our work forces with the kind of business needs we’re seeing forward. Again, as you know, we are still investing in the business but we are also seeking to expand our operating margin.
Operator: Your next question comes from Pat Burton with Citi.
Patrick M. Burton - Citigroup: My question is about cross border travel. As you approach the year-ago numbers where you had some pretty hefty growth, how much do you think that 18% number will decelerate? Are we talking like 5% sequentially, something like that?
Martina Hund-Mejean: That is a very difficult question. What we have seen is that cross product growth has actually accelerated over the last year. In particular when you looked at the fourth quarter of last year and it had kind of continued into the first quarter of this year. We are talking relatively still extremely healthy growth rates of almost 19%. What I can tell you is we really have not seen any change in travel patterns. The travel patterns are really still pretty much the same from what we saw before. We saw the Latin Americans maybe traveling a little bit more in Latin America versus coming to the United States. We really saw no discernable difference between what the Europeans do and what people in Asia/Pacific do. So we still believe that cross border volume going forward will be healthy. But I think it will be really hard for us to guide you to any particular number for the future.
Operator: Your next question comes from Adam Frisch with UBS.
Adam Frisch - UBS: Martina, as you see the top line potentially enduring some more headwinds, whether it be from year-over-year comps being tougher in the second half, or a slower consumer, obviously your growth has held up really well so far. But I think expenses are going to become a bigger part of the margin equation going forward. Good to see that A&M is staying steady year-over-year but what can we expect from G&A going forward? Because that’s really the expectation, I think, of a lot of your investors with where there is operating leverage in the model, to achieve higher operating margins going forward.
Martina Hund-Mejean: We are very mindful between the top line growth and what we have to do on the G&A perspective. I mean, we pretty much reiterated our thoughts for 2008, we are very mindful of what happened to the United States and how it could possibly impact our growth rates. Despite that, as you know, we have some pretty good leverage to moderate any kind of impact, be it what happens in terms of a tiering perspective from our customer agreements, be it that more than half of our revenue growth is actually generated out of the United States and from a G&A perspective, again, we are pretty much reiterating what we had said before. And when you put the numbers together, you should see some pretty healthy margin expansion. But you already saw for the first six months as well as the remaining six months of the year.
Adam Frisch - UBS: On the credit portfolio, Tien-Tsin brought up a customer loss, you said it was small. Is there anything else going on in your credit portfolio that would explain the growth there?
Martina Hund-Mejean: No. From everything that we can really see, this is what is happening in the market in the United States. In my opening remarks I told you the economic environment is pretty tough. We obviously still the moves of non-discretionary purchases to discretionary purchases, but we also do believe that the housing crisis and the restrictions in credit for consumers have an impact on the consumers utilizing their cards.
Adam Frisch - UBS: On debit, obviously you’re making a bigger push into that market. IPS, you have your first customer close to up and running. What are your other plans for debit growth going forward? Do you plan on doing it organically or potentially via M&A?
Martina Hund-Mejean: I think we really have all options open. IPS is obviously a significant investment that we did over last year and the first part of this year. So that is our primary focus, to make sure that we get Security Service Federal Credit Union up and running and then focus the next customers in the pipeline. But depending on what kind of things will come in the market, we have an open mind.
Operator: Your next question comes from Chris Mammone with Deutsche Bank.
Christopher Mammone - Deutsche Bank - North America: Last quarter you guys talked about one customer falling short of volume thresholds that caused you guys [inaudible]. I’m just wondering what kind of multiplier effect might have happened in the second quarter, how many customers might have been affected by falling short of volume goals?
Martina Hund-Mejean: As you said, in the first quarter we had actually a significant impact from one particular customer. That’s really why we pointed that out. In this quarter there is no really particular customer, any particular customer who impacted this. But you see how the volume growth in the United States, in particular on the credit side, was lower than in prior quarters and in a year ago, and that is where our customer agreements are actually working from a rebate and inventive point of view. And the kind of performance our customers have to achieve in order to get into the next tier. So we have a little bit of an offsetting lever. But there is no particular customer in this quarter that we would be pointing to. I think it’s a general part of the environment.
Christopher Mammone - Deutsche Bank - North America: And then, any metrical lift from the government stimulus checks? I know about $100.0 billion had reached consumers’ hands by the end of June.
Martina Hund-Mejean: We really looked at our data to see whether we could see any discernable difference, especially where we’re hearing that people are spending those kind of checks. And we really cannot find from our network data any appreciable difference.
Operator: Your next question comes from Liz Grausam with Goldman Sachs.
Elizabeth W. Grausam - Goldman Sachs : I wanted to ask a question on SEPA and looking into the next two years as you reach some of the critical hurdles in that regulatory framework. How should we think about that as possibly some offset in your processed transaction growth, where we could see some decoupling between your GDV and your processed transaction growth trends as you’re gaining share in the processing landscape out there?
Martina Hund-Mejean: That is a good question. As we have talked about it before, SEPA is really a guideline, it’s not a law. The banks in Europe are supposed to comply with the guideline, I believe by the end of 2010. However, this is a relatively slow process. I think at our investor meeting Javier did a really nice job in terms of pointing out where we’re actually going with SEPA and the kind of wins that we already had. And just to remind you, we’re not just working with banks in the market, but we’re also working with merchants in the market because at this point in time, merchants can actually re-point wherever they would like to have the acquiring activity to go through. And obviously given our network and the cost-effectiveness of our network, we found ourselves to be the first choice in a number of those engagements. These kinds of things are going on. There’s nothing in particular that we want to disclose at this point in time, but these efforts that have the analysts talking about have continued in Q2 and we are believing that it definitely will continue for the rest of the year and the next couple of years. But given that it is so early still in this evolution, and given that a lot of the European banks really have to grabble with what are they going to do with their own processing facility, it’s really hard for us to give you a particular guidance in terms of how this might impact our GDV, or processed transactions.
Elizabeth W. Grausam - Goldman Sachs : Another question on the cross-border trends that you’re seeing. Visa reported last night that they saw a little bit of softening, as well, in cross-border trends, but mostly pegged it on the U.S. consumer not going overseas and that’s where the softness is coming with really no major change in trend in the foreign consumer traveling. Is that somewhat of what you’re seeing and have fuel prices affected the ability for Europeans yet to pursue cross-border travel and how are you thinking about that going forward?
Martina Hund-Mejean: At this point in time, as I pretty said, we are not seeing significant changes for region-over-region. I mean, we see a little bit of a variation in the growth rate in this region versus that region, but it’s nothing significantly different than what we saw over the last, I would say, three quarters or so. Even in Europe, where people are often traveling by car and obviously with these high gas prices have to spend a lot more money in order to get from, whatever, Germany to France, we are really not seeing any appreciable difference than what we’ve seen before. So from a trend perspective, again, as I said, it’s really hard to say where this is going to go. But at this point in time, 18.9% is still a pretty significant growth rate.
Operator: Your next question comes from Chris Brendler with Stifel Nicolaus.
Christopher Brendler - Stifel Nicolaus : One of the issues you talked about last quarter and result in a slow down was you may see transaction growth slow less than volume growth, with lower average ticket. And looking at the numbers for this quarter, in my calculations, in the U.S. credit program particularly, the average ticket actually went up a little bit, so that did not happen. Any insights on what exactly is happening in U.S. credit? People have been pulling back so I would think you would see a ticket slow down. Do you think it’s more issuer related and do see any evidence of consumers just moving away from credit cards, given their more limited budgets and trying to stick more to a budget on a debit card product?
Martina Hund-Mejean: I think it’s a mixture of things. Obviously what’s happening with the issuer environment and they way that they have to manage their portfolio in order to make sure that their existing accounts continue to be very profitable for them and the work around it that they have to do on the credit side, that does have some impact and we already said that. We do see some step up of the average tickets but mostly related to, I would say, to what people pump at the gas stations, as well as little bit related to food. The one noticeable difference that we are seeing is related to fuel in this country. So this is a U.S. comment. Actually from a transaction point of view, now I think it’s the second quarter in a row, that we actually have debit transactions being equal to credit transactions. Before you had the number of credit transactions bigger than debit transactions. So that’s the only real discernable difference, but I do believe that inflation do drive some of the things that you’re seeing on the average ticket.
Christopher Brendler - Stifel Nicolaus : There’s this big drop-off in cash transactions, particularly in the U.S. credit program. Does that have an impact on your revenue slide or is that cash transactions are a lower margin?
Martina Hund-Mejean: That really comes at a lower margin. That really does not have a significant impact whatsoever on our revenues. And I think when you see the growth in the U.S. credit and the follow-up on the cash volume, that does explain, that fits together.
Christopher Brendler - Stifel Nicolaus : Have you had any color from your issuing customers, do you think that we’ve seen the worst of them pulling back or do you think that there’s more to come in the second half as we get into this tougher economic environment?
Martina Hund-Mejean: I think this is really hard to tell. Obviously quite a number of our customers have made sure that they are really surrounding their debit card and credit card portfolios with the right kind of discipline that they need to have in order to keep those portfolios profitable. These portfolios are still very profitable for each of the banks. So I really think it depends on which customer you’re talking about. Some of our customers are feeling actually that they could take advantage of this environment at this point in time and are more aggressive in terms of the account credit acquisition side and marketing. And some customers just don’t feel that way. So I think it’s a mixed bag but in general I would say that people are probably more cautious, still at this point in time, because we don’t know what more is going to come or how long this kind of slow down is really going to last.
Operator: Your next question comes from Craig Maurer with Calyon.
Craig Maurer - Calyon Securities (USA) Inc. : First, regarding pricing, just an update on your thoughts regarding where you are in the competitive market place with Visa, both on the acquirer and issuing side.
Martina Hund-Mejean: First of all, on pricing, I think we had, in the first quarter, right about 6% and in this quarter about 5% and I think for the rest of the year we see pretty much a similar impact. We did disclose some of what kind of pricing we did, which is a significant part is related, obviously, to cross-border volume as well as a number of other services and products that we felt like we really needed to adjust the prices in line with the value proposition that we have for our customers. It’s obviously good that we were able to move forward with these kinds of things. In terms of comments of us versus our competition, we are really not seeing, on the pricing unto itself, two different things than what we already said at the investor day. We believe that we are doing, obviously, the right thing from a pricing point of view, given how we work with our customers and our competition has to think about what they have to do.
Craig Maurer - Calyon Securities (USA) Inc. : In comparison, do you feel you’re at relative parity on a global level or has one moved ahead of the other?
Martina Hund-Mejean: First of all, it’s really region-by-region specific, and then you really are going to have to think about what is the pricing environment on the issuing side versus the acquiring side. And on the issuing side, as you know, it’s not just list prices in terms of what you actually charge to issuers, but it really is dependent on what kind of customer business agreement we strike, which have often rebates and incentives attached to performance, total incentives. So you have to take all of this into account. And we do believe that when you take all of this into account, that we are very competitive in the market.
Craig Maurer - Calyon Securities (USA) Inc. : Regarding the Visa agreement that you just entered into regarding sharing of liability, why now on this agreement? What changed all of a sudden that prompted this agreement?
Martina Hund-Mejean: I don’t think I really can talk about the timing and why now, but obviously you’ve heard what Discover said publicly in the market in terms of damages and Visa and ourselves feel very similar in terms of we feel very strongly about our proposition. We are very aligned in terms of how we look at that case and it happened to be at the right time for us to be entering into this kind of agreement. You might recall that there was actually court-mandated mediation prior to June 30, which was Visa and us together with Discover, and that court-mandated mediation, which we did enter into, did not really lead to any results.
Craig Maurer - Calyon Securities (USA) Inc. : You had commented on a shifting of resources. Where are you focusing your new hiring these days as opposed to where it might have been a year ago? Or two years ago?
Martina Hund-Mejean: The one big area that is of difference is our Integrated Processing Solutions platform. Obviously a year ago, a little bit more than a year ago, so really I’m taking you back to the beginning of 2007, we did not have a lot of people related to development of that platform, as well as implementation for customers. That has ramped up significantly over the last 18 months and that is going to continue to ramp up as we’re having more customer implementation. So I would say in terms of one area, that’s a big area. Another area that is important for us, from a numbers point of view, not quite as what I just talked about for the IPS platform, but it’s high-growth markets. High-growth markets are important for us, we are making significant investments in there. And we will continue to do so because we do believe that’s where we see the future.
Craig Maurer - Calyon Securities (USA) Inc. : And where is it shrinking?
Martina Hund-Mejean: The areas I would say we are really massaging our head count and putting it into the right kind of business propositions we want to see, is one, in the U.S., of course, given that not only the majority of all revenues come from overseas. We have to make sure that our work force is very much aligned between what we want to see in the United States versus overseas. And then a number of other areas related to our products. We just do some alignments in order to be appropriately focused on the kind of things we want to put out in the market here in the future.
Operator: Your next question comes from Sanjay Sakhrani with KBW.
Sanjay Sakhrani - Keefe Bruyette & Woods: I just had a question on the assessment rebates and incentives line. I mean, with the deceleration on the U.S. volume side I would have thought we would have seen a little bit lower accrual, or that come down a little bit more than it actually has. Is there any color you could provide on that line?
Martina Hund-Mejean: That’s pretty hard to do because I think we said in the past, you have to be very careful not to torture rebates and incentives on a quarterly basis because it all depends not only on what’s happening in the volume in the quarter, but it also depends on what kind of new agreements we actually signed in the quarter, and we happened to have signed new agreements in the quarter, and some of that actually can drive the timing in terms of when we book the rebates and the incentives. So I don’t think there’s really anything particular that you should read out of that, but I would encourage you to really look at it over time rather than on a quarter-by-quarter basis.
Sanjay Sakhrani - Keefe Bruyette & Woods: Is there a quick rule of thumb on how much of that line is U.S. versus international?
Martina Hund-Mejean: We don’t really give that out.
Sanjay Sakhrani - Keefe Bruyette & Woods: I want to drill down on the volume growth in Europe. As you mentioned, it’s become kind of a hot topic recently. How much of that growth in Europe is organic growth versus new customer additions? Because the growth still remains relatively strong.
Martina Hund-Mejean: I would say it’s a mixture. But I just want to give you a couple of examples. This is really coinciding with the secular trends we see from paper payments to electronic payments. But when you compare the U.S. to, let’s say, France, a Frenchman uses their credit card maybe five times a month, a German uses their credit card maybe one time a month, so the things that have yet on their team to, in terms of really encouraging higher use of credit and debit cards, in terms of the categories that they are actually opening up from a merchant acceptance point of view, and I think we speak to the number of those positive examples, you know, the Lufthansa deal, the co-op deal in Switzerland, etc.. I think that really does influence how we work with our banks. It really does influence the end customer in terms of where they find the utilization of a card much easier than utilizing cash or a check. But that is an evolutionary trend. So there is a big impact from that. Customer agreement, as we have said before, we are very encouraged by all the different activities that we see there on the agreements that we actually sign across Europe. So, that does have an impact. It’s really hard for me to tell you, how much is driven organically versus acquisition, but those factors are important in driving that growth.
Sanjay Sakhrani - Keefe Bruyette & Woods: On the cash balance, post Amex settlement, should we expect the carrying amount to come down a bit and that factor into capital management strategy?
Martina Hund-Mejean: For sure it needs to factor into the capital management. As I said, we are reviewing with the Board constantly, how our capital structure should be taken though. We do have the Discover case out there with a trial date. We are probably taking that into account in some fashion. But you’re absolutely right. We have moved through one major issue with the Amex litigation issue and you will be hearing from us in the future.
Operator: Your next question comes from Tim Willi with Avondale Partners.
Tim Willi - Avondale Partners: The question around international, one was were there any trends in what you would describe as maybe your more established international markets as you went through the quarter. It may not have looked like the U.S., maybe it looked light a lighter version of the U.S., in terms of slowing growth as the quarter progressed. And a follow-up is can you just give us some qualitative thoughts around margin profiles of the various regions of the world? Does their operating contribution approximate what the revenue contribution, or some of the larger more mature established markets, much higher, much lower margins, versus the corporate average?
Martina Hund-Mejean: Let me take your first question. On the international front, let me just take region by region. On Europe we do have a mixture. And I already quoted the U.K. as well as Spain. There are a couple of other countries that seem to be feeling the heat from an economic point of view, like Italy, Portugal, France, and Ireland. That does not really show up that significantly in our volume growth. Again, I truly believe, in terms of what Sanjay and I just talked about, the secular trend, opening up the merchant categories, making end consumers more comfortable using their cards, does definitely have an impact on this, so despite the economic environment, we feel very comfortable on the growth over there. In Asia/Pacific, again, you can see that the growth is still very healthy. But when you look at China and India and a couple of the other markets, they are impacted by the higher commodity prices that we see across the world. We’re watching that very carefully, but given the significant potential for moving people from cash to an electronic-based payment, I think you will see a really good balance there. So I think we feel good about it. Latin America, I think that’s like a two-headed story. Mexico does feel the credit crunch more and we do see that a bit more in our data, versus Brazil. Brazil is just going gang-busters and we are feeling very healthy there. So I think you have a bit of a mix. There’s not a one-size-fits-all. You really have to take it market by market. But what’s really happening in the U.S. and how deep the U.S. went down from an economic down turn point of view, the U.K. is maybe closest to that but we’re not quite yet seeing the other countries being there. And there are other things in the market that would offset that. In terms of your second question, the margin profile question, as you know, we really don’t disclose this kind of data from a regional point of view. The only pointers that I can kind of give you is where we not only see the volume where we charge the assessment fee, where we also process different factions, where we also get a transaction fee. Those are obviously very good markets for us and I think as you know from our filings, there are really five markets in the world where we do process most of the volume. And that particular focus is really important. That’s where we want to expand, too.
Tim Willi - Avondale Partners: Is it inappropriate to think that in some of the more emerging economies, while they might be smaller now and are experiencing extremely strong growth, that just the investments you’re making in brand and resources, would have those obviously being a lower margin region for you with a lot of margin up side over time?
Martina Hund-Mejean: It depends. It depends totally on what the infrastructure in the market is, it depends on how the acquiring actually gets done in the market. So for some markets you’re absolutely right, we’re making investments, we’re encouraging the right kind of behavior in order to get to electronic payments and that way you might see some lower margin. But there are actually some other emerging markets where the infrastructure is in such a way where we don’t have to do that.
Barbara Gasper - Investor Relations: We have time for one more question, please.
Operator: Your last question comes from Charles Murphy with Morgan Stanley.
Charles Murphy - Morgan Stanley: Martina, I was wondering if you could update us on what you’ve seen in July for cross-border GDV and for processed transaction growth.
Martina Hund-Mejean: I really cannot. The only thing that we see on a weekly basis is process volume. At this point in time we also see processed transactions. And I think from what I said before in response to one of the other questions, is that we really see in July the same kinds of things continuing as we saw it in the second quarter.
Charles Murphy - Morgan Stanley: As a quick follow-up, could you clarify the outlook for A&M spend. Should third quarter be lower than second and then fourth be lower than third?
Martina Hund-Mejean: I think you’ve got it.
Operator: I would now like to turn the call back over to Barbara Gasper for closing remarks.
Martina Hund-Mejean: I would like to say thank you for joining us this morning. Obviously we talked about the difficult economic environment in the U.S. but I just want to say how pleased we are with our results for the second quarter. We really believe that our business fundamentals continue to provide a solid foundation for us to meet our business objectives, not only in 2008, but also for the longer term. We definitely remain committed to grow our business and we will manage our costs in order to drive shareholder value. So thank you for your time today.
Barbara Gasper - Investor Relations: If anyone has any further questions, please feel free to contact Investor Relations. Thank you for your time. | [
{
"speaker": "Executives",
"text": "Barbara Gasper - Investor Relations Martina Hund-Mejean - Chief Financial Officer"
},
{
"speaker": "Analysts",
"text": "Tien-Tsin Huang - J.P. Morgan Patrick M. Burton - Citigroup Adam Frisch - UBS Christopher Mammone - Deutsche Bank - North America Elizabeth W. Grausam - Goldman Sachs Christopher Brendler - Stifel Nicolaus Craig Maurer - Calyon Securities (USA) Inc. Sanjay Sakhrani - Keefe Bruyette & Woods Tim Willi - Avondale Partners Charles Murphy - Morgan Stanley"
},
{
"speaker": "Operator",
"text": "Welcome to the second quarter 2008 MasterCard Incorporated earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call, Barbara Gasper, Head of Investor Relations."
},
{
"speaker": "Barbara Gasper",
"text": "Thank you for joining us today, either by phone or webcast, for a discussion about our second quarter 2008 financial results. With me on the call this morning are Martina Hund-Mejean, our Chief Financial Officer; and Tara Maguire, our Corporate Controller. Following comments by Martina highlighting some key points about the quarter, we will open up the call for your questions. In total, the call will last up to one hour. This morning’s earnings release and the slide deck that will be referenced on this call can be found in the Investor Relations section of our website, www.mastercard.com. The earnings release and slide deck have also been attached to an 8-K that we filed with the SEC this morning. A replay of this call will be posted on our website for one week until August 7th. Finally, as set forth in more detail in today’s earnings release, I need to remind everyone that today’s call may include some forward-looking statements about MasterCard's future performance. Actual performance could differ materially from what is suggested by our comments today. Information about the factors that could affect future performance are summarized at the end of our press release as well as contained in our recent SEC filings. With that, I would now like to turn the call over to Martina Hund-Mejean."
},
{
"speaker": "Martina Hund-Mejean",
"text": "We are pleased with our overall second quarter results and while we remain mindful of the current economic environment, our business fundamentals continue to provide a solid foundation for us to meet our business objectives for 2008. Turning to Page 2 of the slide pack, in the second quarter we delivered net income of $276.0 million, or $2.11 per diluted share, excluding a special item related to the settlement of our anti-trust litigation with American Express. Under the terms of the settlement, we will pay American Express up to a total of $1.8 billion. We recorded in the quarter the pre-tax net present value of this liability of $1.65 billion. On an after-tax basis the charge was just over $1.0 billion. While our results have been impacted by the settlement, we are pleased to have brought this issue to closure. Including the special item, we recorded at net loss of $(747.0) million, or a loss of $(5.74) per diluted share. Net revenue totaled $1.2 billion, up 25% over the comparable period last year. This was driven primarily by strong growth and worldwide GDV and processed transactions, as well as cross-border volumes, which grew 18.9%. Additionally, pricing changes contributed approximately 5% of the revenue growth in the quarter. Currency fluctuations also represented 5.4% of this growth. Finally, demonstrating the continued leveraged ability of our business model, we saw our operating margin improve 6.1% to 33.4%, from 27.3% in the second quarter of 2007, excluding special items. Before getting into the detailed financial results, let me just step back a minute and talk about what we are seeing across our business and the economic environment, both here in the United States and abroad. Please turn to Page 3. The slow down in the U.S. economy has had an effect on our growth in the United States. Over the last few quarters we have seen a steady decrease in U.S. GDV growth from 10.6% in Q4 of 2007 to 8.9% in Q1 2008 and now the GDV growth for the second quarter was 6.2%. During the second quarter credit volume growth was only 0.7% but debit grew at 15.8%. U.S. purchase volume was slightly higher than GDV growth, while cash volume growth was down. Processed transaction growth is still ahead of volume growth at 7.8%. As I shared with you on our last earnings call and at our annual investor meeting, in the U.S. we are still seeing consumer spending patterns shifting to more non-discretionary purchases. Our processed transaction data, as well as MasterCard Advisors Spending Cost Analysis, continues to show an increase in sales of necessary goods such as gasoline, food, and health care, largely due to increasing prices. The impact of higher inflation and lower housing prices are compounded by the fact that consumers are finding it increasingly difficult to obtain credit as financial institutions tighten their criteria for loans and credit extensions. However, we continue to see double-digit growth in markets outside the U.S., which contributed a little more than half of our revenues in the quarter. While there are economic downturns in the U.K., Spain, and a few other European countries, in general European markets continue to represent strong growth for us. Furthermore, we still see healthy cross-border volume growth. While down slightly from the 20+% growth levels we have seen over the past two quarters, the second quarter growth rate of 18.9% is higher compared with the same quarter last year. As in recent quarters, this growth continues to be primarily driven by Europeans traveling in Europe and overseas and we have not seen any significant change in travel patterns on a year-over-year basis for any of the regions. Last, as we have discussed before, much of our growth is being driven by the secular shifts of electronic payments, which we believe is somewhat independent of the cyclicality of current market conditions. We continue to collaborate with our customers to help maximize the value of the payments businesses, recognizing that they are experiencing extraordinarily challenging conditions in the current economic environment. We are partnering with them as they refocus their efforts from account acquisition and marketing towards the maintenance of the existing business and areas such as broad-loss prevention. We are not insulated from the pain that our customers are feeling and we are actively working our expense structure to deal with the changing demands of our customers. In a few minutes I will reference a couple of examples of actions that we have undertaken. Switching now to some business highlights: On our last call we discussed our announcement of our debit process platform, Integrated Processing Solutions, OIPS. I am very pleased to report that we are now in light production with our first customer, Security Service Federal Credit Union, having successfully completed the critical first stage of a multi-stage conversion and implementation program. With respect to our U.S. litigations, I have mentioned that we have entered into a settlement agreement with American Express in June. We will pay Amex up to $150.0 million for 12 quarters beginning this September and the payments will not exceed a total of $1.8 billion. There are two recent developments related to the Discover case. First, this week we entered into a judgment-sharing agreement with Visa that the portions costs and liabilities both companies may incur in the event of either an adverse judgment or settlement of the case. This agreement provides that Visa would be responsible for the substantial majority of any judgment or settlement, based primarily on relevant volumes. Second, the district court recently indicated that it expects to issue decisions on summary judgment motions no later than August 18, 2008, and has rescheduled the trial to begin on October 14, 2008. In mid-June we announced that we would comply with the European Commission’s ruling by temporarily repealing our default intra-EEA cross-border consumer card interchange fees effective June 21, 2008. We continue to hold discussions with the Commission to see what interchange fee-setting methodology we might employ in order to be compliant with their decisions. In any event, we will take appropriate action to ensure that we remain competitive in Europe. With respect to our repurchase program, in the second quarter we repurchased approximately 1.3 million shares of Class A common stock for a total of $355.0 million. We have now completed the approved $1.25 billion repurchase program. We regularly review our capital structure with the Board and will continue to evaluate additional share repurchase programs in the future. Further, this past February, our Board authorized the conversion of up to 13.1 million shares of Class B stock into Class A stock during 2008. In the second quarter we implemented and completed the conversion program with all of the 2008 authorized shares of Class B common stock converted into an equal number of Class A common stock, which was then subsequently sold for transfer to public investors. Class A shares now represent approximately 76% of total shares outstanding. Let’s turn to Page 4 of the slide deck. Net revenue for the quarter exceeded $1.2 billion, an increase of 25% versus the year-ago quarter. Current fluctuations of the Euro and the Brazilian real relative to the U.S. dollar constituted 5.4% of the net revenue increase resulting in underlying business growth of 19.6%. Approximately 5% of this was due to pricing changes. Excluding the several items related to the litigation settlement, our operating income of $416.0 million resulted in an operating margin of 33.4% for the quarter, a 6.1% improvement over the second quarter last year. As we have mentioned in the past, our strong revenue growth enabled us to leverage our operating margins. The contribution from foreign exchange was less than 1% of this increase. Net income we $276.0 million, or $2.11 per diluted share, excluding the special items. Turning to Page 5, gross dollar volume grew 12.8% on a local-currency basis in the second quarter, and 18.2% on a U.S. dollar-converted basis, to $655.0 billion. This quarter was the 17th consecutive quarter of double-digit worldwide GDV growth on a local-currency basis. Growth in the U.S. was 6.2% and purchase volume growth in the U.S. was higher, at 8% versus the second quarter in 2007. Although not shown on Page 5, on a local currency-basis, worldwide purchase volume was up 14% and cash volume growth of 9.3% was slightly lower than the comparative quarter last year. Additionally, cross-border volume, or the volume that is generated from cardholders who travel outside of the country where their card is issued, was up 18.9% over the comparable quarter last year. I would like to point out that beginning in the second quarter we refined our methodology of calculating our cross-border volume to use the merchant country rather than the acquirer country. The effect of this change only relates to volume growth rates, which is very small and has no impact on our reported revenues. Prior reporting periods have been re-stated and can be found within the Supplemental Operational Performance data on our Investor Relations website. Processed transactions, or transactions processed across MasterCard’s network, increased 13.6%, or $5.2 billion in the second quarter. We continue to benefit from the global diversification of our business with our ability to generate significant volumes, transactions, and revenues from economies outside of the U.S. Net revenue yield was 19 basis points in the quarter, versus 18 basis points in the second quarter of 2007. Pricing changes were the primary driver of this improvement. Let’s turn to Page 6. Here you can see the net operations fee increased 28.7%, or $209.0 million, to $938.0 million in the second quarter. Gross operation fees increased 27.5%, or $225.0 million to a little more than $1.0 billion. This growth was driven by several factors. First, growth in processed transactions, cross-border volumes, and gross dollar volumes that were previously described on Page 5. Second, new pricing changes implemented in January of this year on cross-border acquiring volumes and on retail purchases in the U.S. by non-U.S. cardholders. And third, revenue for other payment-related services such as new accounts enhancement program launched late in the second quarter of 2007 in global cardholder services. In the second quarter net operation fees, as a percentage of gross operation fees, improved slightly due to a continuation of lower rebates to customers who did not achieve contractual performance criteria. On Page 7 we show that net assessments increased 14.9%, or $40.0 million, versus the second quarter of 2007. Gross assessments increased 15.9% versus U.S. dollar GDV growth of 18.2%, or $80.0 million, to $583.0 million due to strong GDV growth slightly offset by mix. Net assessments as a percentage of gross assessments declined somewhat compared to the second quarter of 2007. Please turn to Page 8 for some detail on expenses. In the second quarter, excluding the special items, total operating expenses increased 14.6%, of which 4.5% were related to currency fluctuations. The increase was mainly driven by two factors. First, a 15.7% increase in general administration expenses, of which 3.3% were related to currency fluctuation. The growth in G&A was driven by higher personnel costs, excluding the impact of FX, personnel costs increased 18.1%, primarily driven by the hiring of new personnel as well as higher severance costs as we continue to align our business needs against our existing talent pool. Second, we recorded a 13% increase in advertising and marketing expense. Currency fluctuations represented 6.6% of this increase. A&M growth was primarily due to the timing of expenses, mostly for sponsorship activities related to the UEFA and European Championship soccer events, as well as ongoing investments in high-growth markets. Moving to the cash flow statement and balance sheet highlights on Page 9, we generated $319.0 million in cash flow from operations during the quarter. We ended the quarter with $2.7 billion in cash, cash equivalents, and available-for-sale securities. This includes the repayment of $80.0 million of subordinated debt. Available-for-sale securities decreased $84.0 million in the quarter, mostly due to the sale of short-term bond funds. The American Express litigation had an impact on primarily two areas of our balance sheet. First, litigation liability increased by $1.65 billion. Second, our deferred income tax assets increased by $530.0 million. Both of these totals were broken down into their short- and long-term components that booked to the balance sheet. In April this year we formally integrated the operating structures of our operations in France with Europay France forming a new entity, MasterCard France. This resulted in a 70% equity interest for MasterCard accounting for this transaction as 100% acquisition and we recorded a liability for the present value of the fixed purchase price of EU $15.0 million which will be paid by MasterCard in three years. At that point we will own 100% of the entity. As of quarter end we have finalized the repurchase of approximately 1.3 million Class A shares in the open market for $355.0 million. Before moving to the Q&A, I would like to spend a few minutes on Slide 10, highlighting a couple of items for your consideration as you refine and update your models for the remainder of 2008. In light of what we currently see for our business, the longer-term performance objectives, what we talked about on May 29, remain unchanged. However, we have refined our outlook for full-year 2008. We continue to expect slower net revenue growth than the 22.3% growth we experienced in 2007 but still at double-digit rates and assuming constant FX. Mid-year our revenue growth has been [inaudible] excluding FX. Lower U.S. growth [inaudible] net revenue growth for the rest of the year [inaudible] effect of performance criteria and customer agreements in our continued strong [inaudible]. Our outlook for G&A expenses, excluding special items, remains unchanged. It should grow at a rate that is both slower than 2008 net revenue growth and below the 2008 G&A growth rate of 16.8%. Similar to revenue growth, our 2008 outlook assumes constant FX. On a year-to-date basis G&A growth has been 10.3%, excluding FX. With respect to A&M we now anticipate to spend roughly the same amount as in 2007 based on current FX rates as we adjust our efforts in line with our custom activities. We don’t anticipate as much marketing expense in the second half of this year, particularly in Q4. Previously we had been expecting to see a modest increase in total A&M spend for full year 2008 assuming constant FX. These thoughts continue to assume no global recession and no event which significantly disrupts cross-border travel. Finally, while we do not plan to break out the interest accretion impact associated with the American Express settlement as a special item, we do expect it will increase interest expense by $44.0 million for the second half of 2008. We have included in our schedule in the appendix to this presentation which models the increased quarterly interest expense amount over the settlement pay-out period over the next 12 quarters. We are very pleased with our second quarter results but are mindful of the economic conditions that we are operating in. We are managing our business plans in light of a tougher market and are taking the necessary expense management actions as we see our customers realigning their plans. We remain committed to growing our business by managing costs and investments in order to drive shareholder value."
},
{
"speaker": "Barbara Gasper - Investor Relations",
"text": "We are now ready to begin the question and answer period. In order to get to as many people as possible in our allotted time frame, we ask that you limit yourself to a single question with one follow-up and then queue back in for additional questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from Tien-Tsin Huang with J.P. Morgan."
},
{
"speaker": "Tien-Tsin Huang - J.P. Morgan",
"text": "First, on U.S. credit growth, last quarter you mentioned a contract termination. Did that occur in the quarter, and if so, what was the impact?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "I think we talked about that in the last quarter already. That was where a customer of ours sold their business to somebody else, and the impact in the quarter was actually relatively small, very small."
},
{
"speaker": "Tien-Tsin Huang - J.P. Morgan",
"text": "I think you commented 0.7% growth in credit. Is that where it would have hit? I’m just curious what the growth would have been excluding that change."
},
{
"speaker": "Martina Hund-Mejean",
"text": "It would not have significantly been different."
},
{
"speaker": "Tien-Tsin Huang - J.P. Morgan",
"text": "Can you comment on monthly trends in general on U.S. purchase volume growth in the second quarter?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "We saw during the quarter it came down a little bit in June. It wasn’t a cabalistic decline. But I can tell you that what we are seeing here, on average, for the second quarter, we are seeing as a trend, also, for July."
},
{
"speaker": "Tien-Tsin Huang - J.P. Morgan",
"text": "And on G&A, did you quantify the higher severance costs and what kind of savings you expect to get out it?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "We can certainly do that. If you just looked at the G&A expenses overall, you saw a 15.7% increase of which 3.3% were related to currency fluctuations, and then in terms of the severance, I can guide you that that was about 3% of that."
},
{
"speaker": "Tien-Tsin Huang - J.P. Morgan",
"text": "And the savings you expect out of that, going forward?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "I think you know pretty much our run rate in terms of what we spend on average per employee, so we do obviously expect some savings, otherwise we wouldn’t have done that. But it’s really realigning our work forces with the kind of business needs we’re seeing forward. Again, as you know, we are still investing in the business but we are also seeking to expand our operating margin."
},
{
"speaker": "Operator",
"text": "Your next question comes from Pat Burton with Citi."
},
{
"speaker": "Patrick M. Burton - Citigroup",
"text": "My question is about cross border travel. As you approach the year-ago numbers where you had some pretty hefty growth, how much do you think that 18% number will decelerate? Are we talking like 5% sequentially, something like that?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "That is a very difficult question. What we have seen is that cross product growth has actually accelerated over the last year. In particular when you looked at the fourth quarter of last year and it had kind of continued into the first quarter of this year. We are talking relatively still extremely healthy growth rates of almost 19%. What I can tell you is we really have not seen any change in travel patterns. The travel patterns are really still pretty much the same from what we saw before. We saw the Latin Americans maybe traveling a little bit more in Latin America versus coming to the United States. We really saw no discernable difference between what the Europeans do and what people in Asia/Pacific do. So we still believe that cross border volume going forward will be healthy. But I think it will be really hard for us to guide you to any particular number for the future."
},
{
"speaker": "Operator",
"text": "Your next question comes from Adam Frisch with UBS."
},
{
"speaker": "Adam Frisch - UBS",
"text": "Martina, as you see the top line potentially enduring some more headwinds, whether it be from year-over-year comps being tougher in the second half, or a slower consumer, obviously your growth has held up really well so far. But I think expenses are going to become a bigger part of the margin equation going forward. Good to see that A&M is staying steady year-over-year but what can we expect from G&A going forward? Because that’s really the expectation, I think, of a lot of your investors with where there is operating leverage in the model, to achieve higher operating margins going forward."
},
{
"speaker": "Martina Hund-Mejean",
"text": "We are very mindful between the top line growth and what we have to do on the G&A perspective. I mean, we pretty much reiterated our thoughts for 2008, we are very mindful of what happened to the United States and how it could possibly impact our growth rates. Despite that, as you know, we have some pretty good leverage to moderate any kind of impact, be it what happens in terms of a tiering perspective from our customer agreements, be it that more than half of our revenue growth is actually generated out of the United States and from a G&A perspective, again, we are pretty much reiterating what we had said before. And when you put the numbers together, you should see some pretty healthy margin expansion. But you already saw for the first six months as well as the remaining six months of the year."
},
{
"speaker": "Adam Frisch - UBS",
"text": "On the credit portfolio, Tien-Tsin brought up a customer loss, you said it was small. Is there anything else going on in your credit portfolio that would explain the growth there?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "No. From everything that we can really see, this is what is happening in the market in the United States. In my opening remarks I told you the economic environment is pretty tough. We obviously still the moves of non-discretionary purchases to discretionary purchases, but we also do believe that the housing crisis and the restrictions in credit for consumers have an impact on the consumers utilizing their cards."
},
{
"speaker": "Adam Frisch - UBS",
"text": "On debit, obviously you’re making a bigger push into that market. IPS, you have your first customer close to up and running. What are your other plans for debit growth going forward? Do you plan on doing it organically or potentially via M&A?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "I think we really have all options open. IPS is obviously a significant investment that we did over last year and the first part of this year. So that is our primary focus, to make sure that we get Security Service Federal Credit Union up and running and then focus the next customers in the pipeline. But depending on what kind of things will come in the market, we have an open mind."
},
{
"speaker": "Operator",
"text": "Your next question comes from Chris Mammone with Deutsche Bank."
},
{
"speaker": "Christopher Mammone - Deutsche Bank - North America",
"text": "Last quarter you guys talked about one customer falling short of volume thresholds that caused you guys [inaudible]. I’m just wondering what kind of multiplier effect might have happened in the second quarter, how many customers might have been affected by falling short of volume goals?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "As you said, in the first quarter we had actually a significant impact from one particular customer. That’s really why we pointed that out. In this quarter there is no really particular customer, any particular customer who impacted this. But you see how the volume growth in the United States, in particular on the credit side, was lower than in prior quarters and in a year ago, and that is where our customer agreements are actually working from a rebate and inventive point of view. And the kind of performance our customers have to achieve in order to get into the next tier. So we have a little bit of an offsetting lever. But there is no particular customer in this quarter that we would be pointing to. I think it’s a general part of the environment."
},
{
"speaker": "Christopher Mammone - Deutsche Bank - North America",
"text": "And then, any metrical lift from the government stimulus checks? I know about $100.0 billion had reached consumers’ hands by the end of June."
},
{
"speaker": "Martina Hund-Mejean",
"text": "We really looked at our data to see whether we could see any discernable difference, especially where we’re hearing that people are spending those kind of checks. And we really cannot find from our network data any appreciable difference."
},
{
"speaker": "Operator",
"text": "Your next question comes from Liz Grausam with Goldman Sachs."
},
{
"speaker": "Elizabeth W. Grausam - Goldman Sachs",
"text": "I wanted to ask a question on SEPA and looking into the next two years as you reach some of the critical hurdles in that regulatory framework. How should we think about that as possibly some offset in your processed transaction growth, where we could see some decoupling between your GDV and your processed transaction growth trends as you’re gaining share in the processing landscape out there?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "That is a good question. As we have talked about it before, SEPA is really a guideline, it’s not a law. The banks in Europe are supposed to comply with the guideline, I believe by the end of 2010. However, this is a relatively slow process. I think at our investor meeting Javier did a really nice job in terms of pointing out where we’re actually going with SEPA and the kind of wins that we already had. And just to remind you, we’re not just working with banks in the market, but we’re also working with merchants in the market because at this point in time, merchants can actually re-point wherever they would like to have the acquiring activity to go through. And obviously given our network and the cost-effectiveness of our network, we found ourselves to be the first choice in a number of those engagements. These kinds of things are going on. There’s nothing in particular that we want to disclose at this point in time, but these efforts that have the analysts talking about have continued in Q2 and we are believing that it definitely will continue for the rest of the year and the next couple of years. But given that it is so early still in this evolution, and given that a lot of the European banks really have to grabble with what are they going to do with their own processing facility, it’s really hard for us to give you a particular guidance in terms of how this might impact our GDV, or processed transactions."
},
{
"speaker": "Elizabeth W. Grausam - Goldman Sachs",
"text": "Another question on the cross-border trends that you’re seeing. Visa reported last night that they saw a little bit of softening, as well, in cross-border trends, but mostly pegged it on the U.S. consumer not going overseas and that’s where the softness is coming with really no major change in trend in the foreign consumer traveling. Is that somewhat of what you’re seeing and have fuel prices affected the ability for Europeans yet to pursue cross-border travel and how are you thinking about that going forward?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "At this point in time, as I pretty said, we are not seeing significant changes for region-over-region. I mean, we see a little bit of a variation in the growth rate in this region versus that region, but it’s nothing significantly different than what we saw over the last, I would say, three quarters or so. Even in Europe, where people are often traveling by car and obviously with these high gas prices have to spend a lot more money in order to get from, whatever, Germany to France, we are really not seeing any appreciable difference than what we’ve seen before. So from a trend perspective, again, as I said, it’s really hard to say where this is going to go. But at this point in time, 18.9% is still a pretty significant growth rate."
},
{
"speaker": "Operator",
"text": "Your next question comes from Chris Brendler with Stifel Nicolaus."
},
{
"speaker": "Christopher Brendler - Stifel Nicolaus",
"text": "One of the issues you talked about last quarter and result in a slow down was you may see transaction growth slow less than volume growth, with lower average ticket. And looking at the numbers for this quarter, in my calculations, in the U.S. credit program particularly, the average ticket actually went up a little bit, so that did not happen. Any insights on what exactly is happening in U.S. credit? People have been pulling back so I would think you would see a ticket slow down. Do you think it’s more issuer related and do see any evidence of consumers just moving away from credit cards, given their more limited budgets and trying to stick more to a budget on a debit card product?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "I think it’s a mixture of things. Obviously what’s happening with the issuer environment and they way that they have to manage their portfolio in order to make sure that their existing accounts continue to be very profitable for them and the work around it that they have to do on the credit side, that does have some impact and we already said that. We do see some step up of the average tickets but mostly related to, I would say, to what people pump at the gas stations, as well as little bit related to food. The one noticeable difference that we are seeing is related to fuel in this country. So this is a U.S. comment. Actually from a transaction point of view, now I think it’s the second quarter in a row, that we actually have debit transactions being equal to credit transactions. Before you had the number of credit transactions bigger than debit transactions. So that’s the only real discernable difference, but I do believe that inflation do drive some of the things that you’re seeing on the average ticket."
},
{
"speaker": "Christopher Brendler - Stifel Nicolaus",
"text": "There’s this big drop-off in cash transactions, particularly in the U.S. credit program. Does that have an impact on your revenue slide or is that cash transactions are a lower margin?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "That really comes at a lower margin. That really does not have a significant impact whatsoever on our revenues. And I think when you see the growth in the U.S. credit and the follow-up on the cash volume, that does explain, that fits together."
},
{
"speaker": "Christopher Brendler - Stifel Nicolaus",
"text": "Have you had any color from your issuing customers, do you think that we’ve seen the worst of them pulling back or do you think that there’s more to come in the second half as we get into this tougher economic environment?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "I think this is really hard to tell. Obviously quite a number of our customers have made sure that they are really surrounding their debit card and credit card portfolios with the right kind of discipline that they need to have in order to keep those portfolios profitable. These portfolios are still very profitable for each of the banks. So I really think it depends on which customer you’re talking about. Some of our customers are feeling actually that they could take advantage of this environment at this point in time and are more aggressive in terms of the account credit acquisition side and marketing. And some customers just don’t feel that way. So I think it’s a mixed bag but in general I would say that people are probably more cautious, still at this point in time, because we don’t know what more is going to come or how long this kind of slow down is really going to last."
},
{
"speaker": "Operator",
"text": "Your next question comes from Craig Maurer with Calyon."
},
{
"speaker": "Craig Maurer - Calyon Securities (USA) Inc.",
"text": "First, regarding pricing, just an update on your thoughts regarding where you are in the competitive market place with Visa, both on the acquirer and issuing side."
},
{
"speaker": "Martina Hund-Mejean",
"text": "First of all, on pricing, I think we had, in the first quarter, right about 6% and in this quarter about 5% and I think for the rest of the year we see pretty much a similar impact. We did disclose some of what kind of pricing we did, which is a significant part is related, obviously, to cross-border volume as well as a number of other services and products that we felt like we really needed to adjust the prices in line with the value proposition that we have for our customers. It’s obviously good that we were able to move forward with these kinds of things. In terms of comments of us versus our competition, we are really not seeing, on the pricing unto itself, two different things than what we already said at the investor day. We believe that we are doing, obviously, the right thing from a pricing point of view, given how we work with our customers and our competition has to think about what they have to do."
},
{
"speaker": "Craig Maurer - Calyon Securities (USA) Inc.",
"text": "In comparison, do you feel you’re at relative parity on a global level or has one moved ahead of the other?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "First of all, it’s really region-by-region specific, and then you really are going to have to think about what is the pricing environment on the issuing side versus the acquiring side. And on the issuing side, as you know, it’s not just list prices in terms of what you actually charge to issuers, but it really is dependent on what kind of customer business agreement we strike, which have often rebates and incentives attached to performance, total incentives. So you have to take all of this into account. And we do believe that when you take all of this into account, that we are very competitive in the market."
},
{
"speaker": "Craig Maurer - Calyon Securities (USA) Inc.",
"text": "Regarding the Visa agreement that you just entered into regarding sharing of liability, why now on this agreement? What changed all of a sudden that prompted this agreement?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "I don’t think I really can talk about the timing and why now, but obviously you’ve heard what Discover said publicly in the market in terms of damages and Visa and ourselves feel very similar in terms of we feel very strongly about our proposition. We are very aligned in terms of how we look at that case and it happened to be at the right time for us to be entering into this kind of agreement. You might recall that there was actually court-mandated mediation prior to June 30, which was Visa and us together with Discover, and that court-mandated mediation, which we did enter into, did not really lead to any results."
},
{
"speaker": "Craig Maurer - Calyon Securities (USA) Inc.",
"text": "You had commented on a shifting of resources. Where are you focusing your new hiring these days as opposed to where it might have been a year ago? Or two years ago?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "The one big area that is of difference is our Integrated Processing Solutions platform. Obviously a year ago, a little bit more than a year ago, so really I’m taking you back to the beginning of 2007, we did not have a lot of people related to development of that platform, as well as implementation for customers. That has ramped up significantly over the last 18 months and that is going to continue to ramp up as we’re having more customer implementation. So I would say in terms of one area, that’s a big area. Another area that is important for us, from a numbers point of view, not quite as what I just talked about for the IPS platform, but it’s high-growth markets. High-growth markets are important for us, we are making significant investments in there. And we will continue to do so because we do believe that’s where we see the future."
},
{
"speaker": "Craig Maurer - Calyon Securities (USA) Inc.",
"text": "And where is it shrinking?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "The areas I would say we are really massaging our head count and putting it into the right kind of business propositions we want to see, is one, in the U.S., of course, given that not only the majority of all revenues come from overseas. We have to make sure that our work force is very much aligned between what we want to see in the United States versus overseas. And then a number of other areas related to our products. We just do some alignments in order to be appropriately focused on the kind of things we want to put out in the market here in the future."
},
{
"speaker": "Operator",
"text": "Your next question comes from Sanjay Sakhrani with KBW."
},
{
"speaker": "Sanjay Sakhrani - Keefe Bruyette & Woods",
"text": "I just had a question on the assessment rebates and incentives line. I mean, with the deceleration on the U.S. volume side I would have thought we would have seen a little bit lower accrual, or that come down a little bit more than it actually has. Is there any color you could provide on that line?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "That’s pretty hard to do because I think we said in the past, you have to be very careful not to torture rebates and incentives on a quarterly basis because it all depends not only on what’s happening in the volume in the quarter, but it also depends on what kind of new agreements we actually signed in the quarter, and we happened to have signed new agreements in the quarter, and some of that actually can drive the timing in terms of when we book the rebates and the incentives. So I don’t think there’s really anything particular that you should read out of that, but I would encourage you to really look at it over time rather than on a quarter-by-quarter basis."
},
{
"speaker": "Sanjay Sakhrani - Keefe Bruyette & Woods",
"text": "Is there a quick rule of thumb on how much of that line is U.S. versus international?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "We don’t really give that out."
},
{
"speaker": "Sanjay Sakhrani - Keefe Bruyette & Woods",
"text": "I want to drill down on the volume growth in Europe. As you mentioned, it’s become kind of a hot topic recently. How much of that growth in Europe is organic growth versus new customer additions? Because the growth still remains relatively strong."
},
{
"speaker": "Martina Hund-Mejean",
"text": "I would say it’s a mixture. But I just want to give you a couple of examples. This is really coinciding with the secular trends we see from paper payments to electronic payments. But when you compare the U.S. to, let’s say, France, a Frenchman uses their credit card maybe five times a month, a German uses their credit card maybe one time a month, so the things that have yet on their team to, in terms of really encouraging higher use of credit and debit cards, in terms of the categories that they are actually opening up from a merchant acceptance point of view, and I think we speak to the number of those positive examples, you know, the Lufthansa deal, the co-op deal in Switzerland, etc.. I think that really does influence how we work with our banks. It really does influence the end customer in terms of where they find the utilization of a card much easier than utilizing cash or a check. But that is an evolutionary trend. So there is a big impact from that. Customer agreement, as we have said before, we are very encouraged by all the different activities that we see there on the agreements that we actually sign across Europe. So, that does have an impact. It’s really hard for me to tell you, how much is driven organically versus acquisition, but those factors are important in driving that growth."
},
{
"speaker": "Sanjay Sakhrani - Keefe Bruyette & Woods",
"text": "On the cash balance, post Amex settlement, should we expect the carrying amount to come down a bit and that factor into capital management strategy?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "For sure it needs to factor into the capital management. As I said, we are reviewing with the Board constantly, how our capital structure should be taken though. We do have the Discover case out there with a trial date. We are probably taking that into account in some fashion. But you’re absolutely right. We have moved through one major issue with the Amex litigation issue and you will be hearing from us in the future."
},
{
"speaker": "Operator",
"text": "Your next question comes from Tim Willi with Avondale Partners."
},
{
"speaker": "Tim Willi - Avondale Partners",
"text": "The question around international, one was were there any trends in what you would describe as maybe your more established international markets as you went through the quarter. It may not have looked like the U.S., maybe it looked light a lighter version of the U.S., in terms of slowing growth as the quarter progressed. And a follow-up is can you just give us some qualitative thoughts around margin profiles of the various regions of the world? Does their operating contribution approximate what the revenue contribution, or some of the larger more mature established markets, much higher, much lower margins, versus the corporate average?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "Let me take your first question. On the international front, let me just take region by region. On Europe we do have a mixture. And I already quoted the U.K. as well as Spain. There are a couple of other countries that seem to be feeling the heat from an economic point of view, like Italy, Portugal, France, and Ireland. That does not really show up that significantly in our volume growth. Again, I truly believe, in terms of what Sanjay and I just talked about, the secular trend, opening up the merchant categories, making end consumers more comfortable using their cards, does definitely have an impact on this, so despite the economic environment, we feel very comfortable on the growth over there. In Asia/Pacific, again, you can see that the growth is still very healthy. But when you look at China and India and a couple of the other markets, they are impacted by the higher commodity prices that we see across the world. We’re watching that very carefully, but given the significant potential for moving people from cash to an electronic-based payment, I think you will see a really good balance there. So I think we feel good about it. Latin America, I think that’s like a two-headed story. Mexico does feel the credit crunch more and we do see that a bit more in our data, versus Brazil. Brazil is just going gang-busters and we are feeling very healthy there. So I think you have a bit of a mix. There’s not a one-size-fits-all. You really have to take it market by market. But what’s really happening in the U.S. and how deep the U.S. went down from an economic down turn point of view, the U.K. is maybe closest to that but we’re not quite yet seeing the other countries being there. And there are other things in the market that would offset that. In terms of your second question, the margin profile question, as you know, we really don’t disclose this kind of data from a regional point of view. The only pointers that I can kind of give you is where we not only see the volume where we charge the assessment fee, where we also process different factions, where we also get a transaction fee. Those are obviously very good markets for us and I think as you know from our filings, there are really five markets in the world where we do process most of the volume. And that particular focus is really important. That’s where we want to expand, too."
},
{
"speaker": "Tim Willi - Avondale Partners",
"text": "Is it inappropriate to think that in some of the more emerging economies, while they might be smaller now and are experiencing extremely strong growth, that just the investments you’re making in brand and resources, would have those obviously being a lower margin region for you with a lot of margin up side over time?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "It depends. It depends totally on what the infrastructure in the market is, it depends on how the acquiring actually gets done in the market. So for some markets you’re absolutely right, we’re making investments, we’re encouraging the right kind of behavior in order to get to electronic payments and that way you might see some lower margin. But there are actually some other emerging markets where the infrastructure is in such a way where we don’t have to do that."
},
{
"speaker": "Barbara Gasper - Investor Relations",
"text": "We have time for one more question, please."
},
{
"speaker": "Operator",
"text": "Your last question comes from Charles Murphy with Morgan Stanley."
},
{
"speaker": "Charles Murphy - Morgan Stanley",
"text": "Martina, I was wondering if you could update us on what you’ve seen in July for cross-border GDV and for processed transaction growth."
},
{
"speaker": "Martina Hund-Mejean",
"text": "I really cannot. The only thing that we see on a weekly basis is process volume. At this point in time we also see processed transactions. And I think from what I said before in response to one of the other questions, is that we really see in July the same kinds of things continuing as we saw it in the second quarter."
},
{
"speaker": "Charles Murphy - Morgan Stanley",
"text": "As a quick follow-up, could you clarify the outlook for A&M spend. Should third quarter be lower than second and then fourth be lower than third?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "I think you’ve got it."
},
{
"speaker": "Operator",
"text": "I would now like to turn the call back over to Barbara Gasper for closing remarks."
},
{
"speaker": "Martina Hund-Mejean",
"text": "I would like to say thank you for joining us this morning. Obviously we talked about the difficult economic environment in the U.S. but I just want to say how pleased we are with our results for the second quarter. We really believe that our business fundamentals continue to provide a solid foundation for us to meet our business objectives, not only in 2008, but also for the longer term. We definitely remain committed to grow our business and we will manage our costs in order to drive shareholder value. So thank you for your time today."
},
{
"speaker": "Barbara Gasper - Investor Relations",
"text": "If anyone has any further questions, please feel free to contact Investor Relations. Thank you for your time."
}
] | null | null |
MA | 1 | 2,008 | 2008-04-29 09:00:00 | Executives: Barbara Gasper - Investor Relations Robert W. Selander - President, Chief Executive Officer, Director Martina Hund-Mejean - Chief Financial Officer
Analysts: Patrick M. Burton - Citigroup Moshe Katri - Cowen & Co. Adam Frisch - UBS Elizabeth W. Grausam - Goldman Sachs David Hochstim - Bear Stearns Tien-Tsin Huang - J.P. Morgan Craig Maurer - Calyon Securities Anurag Rana - Keybanc Capital Markets Christopher Brendler - Stifel Nicolaus Sanjay Sakhrani - Keefe Bruyette & Woods Charles Murphy - Morgan Stanley Bruce W. Harting - Lehman Brothers
Operator: Good day, ladies and gentlemen, and welcome to the first quarter 2008 MasterCard Incorporated earnings conference call. My name is Francis and I will be your coordinator for today. (Operator Instructions) I would now like to turn the presentation over to your host for today, Barbara Gasper, Head of Investor Relations. Please proceed.
Barbara Gasper: Thank you, Francis. Good morning and thanks to everyone for joining us today, either by phone or webcast, for a discussion about our first quarter 2008 financial results. With me on the call this morning are Bob Selander, President and Chief Executive Officer; Martina Hund-Mejean, our Chief Financial Officer; and Tara Maguire, our Corporate Controller. Following comments by Bob and Martina highlighting some key points about the quarter, we will open up the call for your questions and in total, the call will last up to one hour. This morning’s earnings release and the slide deck that will be referenced on this call can be found in the investor relations section of our website, mastercard.com. The earnings release and slide deck have also been attached to an 8-K that we filed with the SEC earlier this morning. A replay of this call will be posted on our website for one week until May 6th. Finally, as set forth in more detail in today’s earnings release, I need to remind everyone that today’s call may include some forward-looking statements about MasterCard's future performance. Actual performance could differ materially from what is suggested by our comments today. Information about the factors that could affect future performance are summarized at the end of our press release as well as contained in our recent SEC filings. With that, I would now like to turn the call over to Bob Selander. Bob.
Robert W. Selander: Thanks, Barbara and good morning, everyone. We are very pleased that we have started the year with a strong financial and operating performance in the first quarter. We continue to be encourage by the transaction growth and cross-border trends we are experiencing in the midst of a challenging economic environment in the United States. The fundamentals of the business are still very strong and our first quarter results provide a solid foundation for us to deliver on our business objectives for 2008. Turning to page two of the slide deck, in the first quarter we delivered net income of $398 million, or $3.01 per share on a diluted basis, excluding a special item. The item was a $49 million after-tax gain from the termination of a customer business agreement, which represents $0.37 per share. Net income also includes after-tax gains of $56 million, or $0.42 per share, from sales of our investment in Redecard. We have now sold all of our Redecard shares. We recorded quarterly net revenue of $1.2 billion, up over 29% from the first quarter of 2007. This was driven primarily by a strong growth in gross dollar volume and process transactions, including cross border volumes, which grew 23.6%. Additionally, pricing changes contributed approximately 6 percentage points of the revenue growth in the quarter. Finally, we saw our operating margin improve 9.3 percentage points to 43.6% from 34.3% in the first quarter of 2007, demonstrating the continued leveragability of our business model. Before turn the call over to Martina, there are a few economic and business developments on page three that I would like to highlight. The slowdown in the U.S. economy has had some effect on our U.S. growth. However, the trends that we saw over the past few quarters have continued and have led to strong global growth for MasterCard. These trends include first, in the U.S. a consumer shift away from discretionary purchases, such as luxury retail and home furnishings, to non-discretionary purchases, including food and gasoline, which have also been infected by commodities price increases. Second, we continue to see double-digit growth in markets outside the United States, where we generate about half of our revenue. Third, cross-border volume trends are still quite healthy and last, the secular shift from paper to electronic payments. All this said, we recognize that our customers are experiencing extraordinarily challenging conditions and we are working with them to help maximize the value of their payments businesses. Switching now to our business updates, earlier this month we announced the launch of our integrated processing solutions, or IPS debit processing platform. IPS provides banks with a suite of branded debit network and card issuer processing services, including PIN, signature, ATM driving, and expanded rewards capabilities. Security Service Federal Credit Union will be the first customer to implement IPS. We believe this new platform will offer a compelling solution for banks that are currently struggling with disparate legacy platforms and seek an integrated solution for PIN, signature, point of sale, and ATM debit processing. With respect to our U.S. litigation, we have no new significant updates to report at this time. In the case of the European Commission ruling, we continue to communicate with the commission regarding specifics related to our compliance with their order. We asked for and were denied an extension beyond the June 21st compliance deadline. In any event, we will take steps that we believe will comply with the commission’s order and we expect to have more specifics in the near future. As we’ve said before, we are prepared to take action to ensure that our payments products remain competitive in Europe. As I just mentioned on page two, during the quarter we sold our remaining share of Redecard and realized pretax gains of approximately $86 million during the period. These gains have been recorded as investment income on our income statement. During the quarter, we repurchased approximately 1.5 million shares of class A common stock for an aggregate of $294 million, or approximately $196 per share. Through April 29th, the company repurchased approximately $557,000 additional shares of its class A common stock at a cost of $129 million. In total, $1.02 billion of the approved $1.25 billion repurchase program has been completed. Additionally, this past February our board of directors authorized the conversion of up to 13.1 million shares of class B stock into class A stock during 2008. Although no conversions have taken place thus far this year, the first 2008 conversion program, for up to 13.1 million shares, is expected to begin on May 17th and may continue through June 13th. With that, I will now turn the call over to Martina for a more detailed update on the financial results.
Martina Hund-Mejean: Thanks, Bob and good morning to everyone. Let me begin on page four of the slide deck. As Bob mentioned, net revenue for the quarter was almost $1.2 billion, an increase of 29.2% versus the year-ago quarter. Currency fluctuations of the Euro and the Brazilian Real relative to the U.S. dollar contributed 5.1 percentage points of the net revenue increase, resulting in underlying business growth of 24.1%. Approximately 6 percentage points of this was due to pricing changes. Our operating income of $516 million resulted in an operating margin of 43.6% for the quarter, a 9.3 percentage point improvement over the first quarter last year. As we’ve mentioned in the past, our strong revenue growth enabled us to leverage our operating margin. The margin contribution from revenue growth was three times as much as the offsetting impact from expense growth. The contribution from foreign exchange was about 1 percentage point. Net income was $398 million, or $3.01 per share on a diluted basis, excluding the special items. Additionally, without the impact of gains from the sale of our remaining investment in Redecard, first quarter EPS was $2.59 per share on a diluted basis. Turning to page five, you see our first quarter gross dollar volume, or GDV numbers, which are reported for the same period as our revenues. GDV grew 14.1% on a local currency basis and 20% on a U.S. dollar converted basis to $611 billion. The first quarter was the 16th consecutive quarter of double-digit worldwide GDV gross on a local currency basis. And despite the economic downturn in the U.S., our U.S. GDV growth was 8.9%, and U.S. purchase volume growth was even stronger at 10.3%. Although not shown on page five, worldwide purchase volume was up 15% and cash volume was up 11.6%, both on a local currency basis. Additionally, cross-border volume, or the volume that is generated from cardholders who travel outside of the country where the card is issued, was up 23.6%. Processed transactions, or the transactions processed across MasterCard's network, increased 15.7% to 4.9 billion in the first quarter. We continue to benefit from the global diversification of our business and our ability to generate significant volume, transactions, and revenue from economies outside of the U.S. where economic conditions are generally more favorable than in the U.S. Net revenue yield was 19.4 basis points in the quarter versus 18 basis points in the first quarter of 2007. The improvement in revenue yield can be primarily attributed to pricing changes and underlying business growth. Let’s turn to page six. Here you can see that net operations fees increased 31.4%, or $205 million, to $858 million in the first quarter. Gross operations fees increased 30.2%, or $219 million, to $944 million. This growth was driven by several factors. First, growth in process transactions, cross-border volumes, and gross dollar volume that I previously described on page five. Second, the continued impact of pricing changes in new programs implemented in the second quarter 2007, including changes related to stand in authorization pricing, pricing for acceptance development fees, and a new fee associated with rewards programs. Additionally, we implemented a new account enhancement service that allows our customers to move cardholders to different programs without a change in account numbers. Third, new pricing changes in January of 2008 on cross-border acquiring volumes and on retail purchases in the U.S. by non-U.S. cardholders. In the first quarter, net operations fees as a percentage of growth operations fees improved slightly. Our operations fees rebate were tempered by an adjustment due to a customer who did not achieve performance hurdles included in their business agreement. On page eight, we show that net assessments increased 23.7%, or $62 million to $324 million versus the first quarter of 2007. Gross assessment increased 20.4%, or $94 million to $554 million due to strong GDV growth. Net assessments as a percentage of gross assessments improved slightly compared to the first quarter of 2007. MasterCard's performance-based pricing continues to moderate the impact of relatively lower U.S. volumes on our revenue. Additionally, as was the case with the operations fees we did this quarter, assessment fee rebates were tempered by the same adjustment related to a customer who did not achieve performance hurdlers included in their business agreement. Please turn to page eight for some detail on expenses. During the first quarter, total operating expenses increased 10.9%, of which 3.3 percentage points were related to currency fluctuations. This increase was mainly driven by two factors. First, a 10.9% increase in general and administrative expense, of which 2.9 percentage points were related to currency fluctuations. The growth in G&A was driven by higher personnel costs, partially offset by foreign exchange settlement gains. Excluding the impact of FX, the personnel costs increased 16.1%, primarily associated with the hiring of additional staff and contractors over the past year, mainly in technology, customer-facing, and product positions. Second, an 11.6% increase in advertising and marketing expenses. Currency fluctuations represented 4.4 percentage points of this increase. A&M growth was primarily due to the timing of expenses for European sponsorship activities, as well as investment in high growth markets. Moving to the cash flow statement and balance sheet highlights on page nine, we generated $224 million in cash flow from operations during the quarter. We ended the quarter with $2.9 billion in cash, cash equivalents, and available for sale securities. Both short- and long-term available for sale securities decreased by $281 million, primarily due to the sale of the remaining shares of our Redecard investment, the sale of short-term bond funds and auction rate securities, and investment losses. We also reclassified $237 million of auction rate securities to non-current assets due to the current lack of liquidity on those securities given market conditions. As of quarter end, we had repurchased approximately 1.5 million class A shares in the open market for $294 million. Stock repurchases results in a $0.02 per share increase to basic EPS for the quarter. I will now turn the call back over to Bob for some comments on 2008.
Robert W. Selander: Before moving to the Q&A, join me on page 10 and I would like to highlight a few items for your consideration, as you refine and update your models for the second quarter of 2008. First, there were two special items in the second quarter of 2007 -- a $3 million litigation settlement and other income of $90 million related to the World Cup settlement agreement. Second, our outlook for full year 2008 remains unchanged from January. We expect slower net revenue growth than 2007 but still at double-digit rates. G&A expenses should grow at a rate that is both slower than net revenue growth and below the 2007 G&A growth rate. With respect to advertising and marketing expenditures, we expect continued modest growth, particularly to support our efforts in international markets. These guidelines assume current FX rates, no global recession, and no event which significantly disrupts cross-border travel. Finally, as I mentioned last quarter, we are currently evaluating whether it is appropriate to update our existing three to five-year long-term performance objectives and we expect to address these at our annual investment community meeting in May. To wrap up, we are very happy with our first quarter results. We remain committed to growing our business while managing costs and investments to add value to our customers, merchants, and shareholder.
Barbara Gasper: We are now ready to begin the question-and-answer period. In order to get to as many people as possible in our allotted timeframe, we ask that you limit yourself to a single question with one follow-up and then queue back in for additional questions. Operator.
Operator: (Operator Instructions) Your first question comes from the line of Patrick Burton with Citigroup. Please proceed.
Patrick M. Burton - Citigroup: Congratulations on the fantastic numbers. My question deals with the settlement gains in G&A. Where does that number show up on the income statement? Thanks.
Martina Hund-Mejean: That shows really up on other G&A.
Patrick M. Burton - Citigroup: Okay, and as a follow-up, is that a hedge then on your foreign denominated G&A expenses?
Martina Hund-Mejean: Exactly. We do expect [inaudible] hedging to really only transactional hedging activities and any gains or losses that could happen as a result of hedging those underlying exposures are reflected in that line item.
Patrick M. Burton - Citigroup: Thank you and congratulations again on the numbers.
Operator: Your next question comes from the line of Moshe Katri with Cowen & Co. Please proceed.
Moshe Katri - Cowen & Co.: Thanks. Congratulations again on a very strong quarter. Can you quantify the portion of your revenues that are considered non-discretionary in terms of -- we’re talking about consumer spending. And then on top of that, can you also talk a bit about the U.S. business, if there is anything unusual that took place during the March quarter on a month-by-month basis that will get you a bit more cautious looking at the June quarter, maybe September quarters as well? Thanks.
Robert W. Selander: With regard to the first one, we really don’t break out across the world discretionary versus non-discretionary volumes. As you know, we do have our spending pulse information that we put out monthly, both in the U.S. and the U.K., which tracks retail sales and that’s the broad retail sales and figures, not just the MasterCard figures. So we capture competing payments products in that. And the trends that we talked about in previous quarters seem to continue in the U.S. with regard to the growth rate of retail sales versus the same period prior year is continuing on a down trend. If you look at the specifics for March, you had a -- I guess it was ex auto -- let me try and remember this data, I think it was a 5.3% increase in retail sales. But if you take out gasoline as well, the retail sales were only up 3.6%. If you were to go back to the first quarter of 2007, you’d have seen growth rates that were well above that, and so the comment I made about the mix change occurring has continued and the rate of growth relative to prior years seems to be continuing to slow in the U.S. March has some anomalies around it because of a relatively early Easter, which occurred at the end of March and we’ll see how those anomalies work out as the April data comes together.
Moshe Katri - Cowen & Co.: Thanks.
Operator: Your next question comes from the line of Adam Frisch with UBS. Please proceed.
Adam Frisch - UBS: Thanks and another quarter of phenomenal results. Going into a specific quarter, how much of your expense base is fixed and how much can be determined during the quarter as you see how your top line is progressing?
Robert W. Selander: I think probably Martina and I will both take a crack at that but generally at the beginning of a quarter, pretty much everything is fixed for that quarter. If you take a look at those items that you would think about being discretionary over the course of the next year or so, marketing expenses are one of the first things that come to mind but a large proportion of our advertising and marketing involve multi-year, in many cases, sponsorship commitments. Clearly when you put together a program, those commitments are made months if not quarters in advance in terms of media buys and other activities. With regard to the G&A, there is some discretion obviously in terms of the short-term pace of bringing on contractors for certain of the projects that we might need, for example, development resources for our systems area but generally there is not a lot that we can do one month to the next within a given quarter. I don’t know if you wanted to add any highlights to that.
Martina Hund-Mejean: Just on G&A, as you know our personnel cost is roughly 70%, 75% of the G&A. That’s not just only full-time employees but also contractors in there and it depends on what kind of customer implementations we actually do in a particular quarter or in the future. We obviously have -- you know, we can throttle the number up and down from a contractor point of view. We have a number of other line items in G&A, such as professional fees, which could be throttled up and down from time to time, G&A. However, you have to note that a lot of those costs are dedicated to really investments that we are doing for future growth, so I do agree with Bob that while we have probably on the margins some room to throttle up and down, as we are going into the year and every quarter, there’s probably more of a fixed component than a variable component.
Adam Frisch - UBS: Okay, thanks for that color. And then just one point of clarification -- the customer termination agreement, the gain of $0.37. Was that the World Cup or was that something different?
Robert W. Selander: That was something different that occurred this year. The settlement we had last year in the second quarter for $90 million went through our income in 2007 --
Adam Frisch - UBS: Right, 2007, so what was the customer termination agreement this quarter?
Robert W. Selander: This was with relationship to a customer who terminated their agreement and as a result of our not having the benefit of that agreement, we received a one-time settlement which worked its way through our income statement this quarter.
Adam Frisch - UBS: Did that have any material effect on volumes or transactions at all?
Robert W. Selander: Well, for the quarter it did not, no.
Adam Frisch - UBS: Will it in the future quarters?
Robert W. Selander: Well, to the extent we don’t retain this business as the customer has sold the business, it could, yes.
Adam Frisch - UBS: Okay. Thank you.
Operator: Your next question comes from the line of Elizabeth Grausam with Goldman Sachs. Please proceed.
Elizabeth W. Grausam - Goldman Sachs: I’d just like to touch a little bit more on the pricing environment as the price, the growth you achieved from pricing changes this quarter certainly outperformed our expectations. Could you give us some outlook as to how much you expect pricing changes to contribute to your full-year outlook, and also other opportunities you may see in your portfolio of businesses to affect pricing changes over the course of the year?
Martina Hund-Mejean: First of all, it’s fair to say that the pricing impact on the quarter was extraordinary and I think we were really benefited by a couple of things. One, in the line items where we did have some price increases and as you know, we always wrap value propositions around that that really have to have a value to the customer. But in those line items, we actually enjoyed a particular nice growth, which obviously contributed to the percentage point increase on the pricing. Secondly, we have been more effective, I believe, in implementing the pricing changes in January of 2008. When you look at the number, that 6 percentage point increase, you do have a lapping effect in the form of the price increases that we did in the second quarter of 2007, so certainly those -- that impact will not continue as we are going into the second quarter. It will basically fall off so I would expect that you are going to see some lower number in the future quarters.
Elizabeth W. Grausam - Goldman Sachs: Great, and just kind of a discussion of where you think in your business you have the most pricing leverage. It certainly seems that the cross-border market, cross-border volume growth is supporting increased pricing changes in that particular line item of your business, yet that also seems to be a fairly volatile portion of the business, depending on travel. Can you help us understand where you see in your business mix the most pricing leverage going forward and where you bring competitive advantage to effect those pricing changes?
Robert W. Selander: One of the things that we’ve been working on is broadening our offerings to our customers, so if we enhance an existing service and that provides more value, than we may have a pricing opportunity there. But to the extent we can bring new services where we now are competing for money they are spending elsewhere, that gives us the most flexibility and that’s a significant portion of our focus. You probably will recall earlier in this month we announced, and I mentioned this morning, our IPS system which will give us an opportunity to provide additional debt related services, processing services, fraud services, et cetera, to our U.S. customers initially. So that’s where I think we see the greatest opportunity.
Elizabeth W. Grausam - Goldman Sachs: Great. Thank you.
Operator: Your next question comes from the line of David Hochstim with Bear Stearns. Please proceed.
David Hochstim - Bear Stearns: I’m wondering, can you just talk about the rebate adjustment and how significant of an affect that had on rebate and incentives and the net revenue yield? I mean, is the net revenue yield sustainable at these levels then?
Martina Hund-Mejean: David, let me take that. It’s not a significant impact on either of the numbers. It has a slight impact but when you really look at the rebate line for [inaudible], it is still around right about 10% of growth and when you look at the rebates and incentive line on the assessments side, you are not really seeing a big change. As we said before, you really have to be careful to look at this on a quarter by quarter basis. You really need to look at it on a year-over-year basis but all we wanted to call out, because you saw some slight improvement in the net, that really is coming down to a flat development when you pull out this particular item.
David Hochstim - Bear Stearns: Okay, so the net revenue yield could continue at about this level?
Martina Hund-Mejean: No, let me just talk a little bit about net revenue yield. The 19.4 basis points that you see for this quarter contrast to about 18 basis points in the year-ago quarter and really of that 1.4 basis points difference, 0.9 is about due to the pricing changes and 0.5 is about due to the business, underlying business growth. So in terms of looking at it in the future, and I think we are going to probably have a more robust discussion at our May investor meeting, but one thing you need to take into account on the 0.9 movement for the pricing, again as I said before we have the lapping effect there from the second quarter of 2007 that will obviously not continue in the next few quarters, and therefore you at least are going to have to take that one out. But we are still holding firm with our view that you are going to see a gently downward trend and then we are going to have a more robust discussion about it at our investor meeting in May.
David Hochstim - Bear Stearns: Okay, and then just to clarify on the termination of the contract, how should we think about the payment relative to the net revenues that were generated by that contract, or could you give us some sense of what that relationship was?
Robert W. Selander: Just an observation, the volume related with this particular deal was less than 1% of our global MasterCard volume --
David Hochstim - Bear Stearns: That’s GDV or --
Robert W. Selander: -- for the past year, so that puts a framework on it.
David Hochstim - Bear Stearns: Less than 1% of GDV?
Robert W. Selander: Yeah, purchase volume.
David Hochstim - Bear Stearns: Okay, thanks.
Operator: Your next question comes from the line of Tien-Tsin Huang with J.P. Morgan. Please proceed.
Tien-Tsin Huang - J.P. Morgan: Thanks. Good morning. I had a question about the cross-border fee increase, which was higher than we expected and the volumes are still looking strong there. Can you give us some high level details on the mix of cars that are driving the volume growth? How much is from the U.S. versus Latin America, Asia-Pac, et cetera?
Martina Hund-Mejean: Really from when we looked at and we did study that as you know in Q4 very much in detail because we wanted to be sure that we do understand the trends in terms of how many foreigners are coming to the United States versus Americans traveling overseas, and really the effect that we talked about in Q4 have really not changed much in Q1. And what we came down to is it is really Europeans traveling outside of Europe, not just into the United States but also in other regions in the world. It is really Latin Americans traveling for a significant extent outside of their country, some of them obviously also come to the United States. And then we have some movement -- I think that was a smaller part of it, of residents in any countries in the Asia-Pacific region traveling again outside of their country. So we really have not seen a change in pattern from what we saw in Q4.
Tien-Tsin Huang - J.P. Morgan: Got it. So the contribution from U.S. traveling outside of their own borders is not -- it sounds like that trend has not changed.
Martina Hund-Mejean: It has not really changed.
Tien-Tsin Huang - J.P. Morgan: Okay. And then just in terms of the outlook on the portfolio conversions going forward -- any others that we should be aware of here as we go through the balance of the year? And I noticed that there was a sequential decline -- it’s small -- in debit cards in the U.S. Anything to read into there and does that link to the contract termination fee?
Martina Hund-Mejean: We have -- no, that’s really not linked to that but when you look at our -- just in the United States, when you look at the GDV, when you look at the purchase volume, when you look at the transaction volume, and in particular when you look at the debit line, you have to recognize that in the first quarter of ’07, we still had the effect of a large debit conversion of one customer in there which, you know, once you do that you just kind of [inaudible] for two years, so you still had it and you had the effect in Q108 versus Q107. So when you pull that out, in fact our growth rates are slightly higher than what you saw in Q107.
Tien-Tsin Huang - J.P. Morgan: Did you say which region the lost contract came from? Was it in the U.S. or outside the U.S.?
Martina Hund-Mejean: Lost contract?
Tien-Tsin Huang - J.P. Morgan: I’m sorry, the contract termination, the portfolio of cards that you lost -- did you give us the details on the region that was sourced from?
Martina Hund-Mejean: We did not.
Tien-Tsin Huang - J.P. Morgan: Got it. If I can just sneak in a last quick question just for Bob, just maybe your high level thoughts on what is going on in the hill regarding a change in the Credit Card Fee Act, et cetera -- what are the implications there for MasterCard? Thanks.
Robert W. Selander: Well, there’s two sets of activities, as you know. There have been some hearings taking place frankly focused on issuer practices and various customers of ours have been involved in conversations or testimony around those practices. Clearly those issuers have been paying attention and where there were practices that needed an adjustment or amendment, I think they’ve been stepping up to that. So I think the industry has been quite responsive in that regard. As you probably also know, Congressman Connors put through a proposal on interchange legislation. We believe that a free market approach towards how that rate gets set and determined is much more appropriate than having congress come in and legislate how that gets done. And so we will continue to work with others in the industry to ensure that the interested merchants and cardholders are looked out for and not legislated by our congress.
Barbara Gasper: Operator, next question.
Operator: Your next question comes from the line of Craig Maurer with Calyon. Please proceed.
Craig Maurer - Calyon Securities: Good morning. Thanks for taking my call. First question is around the rebates outlook, you discussed clearly a weakening U.S. economy. What’s your thoughts currently now on getting some of that rebate effect back to your benefit later in the year?
Martina Hund-Mejean: Let me just start with that. We have already given our thoughts for 2008 in terms of what we believe from a net revenue growth point of view, meaning that we do believe it is lower than 2007 but we will still be double-digit and I think that does comprehend what we are thinking about rebates and incentives. If we have anything else to add to that, I think the appropriate time would be for us to do that at the end of May at the investor meeting.
Craig Maurer - Calyon Securities: Okay. And when looking at my model, I am trying to put the trends around the marketing line. Should we assume that you might have an increase around the Olympics, so perhaps a little more marketing would be weighted to the third quarter of this year? Thanks.
Robert W. Selander: I think it is probably more appropriate to look at the second quarter as a place that will get more weighting this year. We have significant football events -- that’s soccer -- in the case of the European Champions League, as well as the quadrennial European Championship that will be played in the course of the second quarter. The finals, of course, for the European Championship will be I guess in Vienna at the end of June. So this will be a year that is more analogous to the one that we had in 2006 where we had a similar second quarter, at that time World Cup event, which resulted in significant promotional and marketing support.
Craig Maurer - Calyon Securities: Okay, and if I could just get some clarification on something Martina had said, regarding the revenue yield and the 0.9 points of increase versus last year due to pricing changes, how much of that is related to the recent pricing changes that we’ll see repeat and how much of that are you growing over? Thanks.
Martina Hund-Mejean: Craig, I would say that the lesser amount is related to 2007 and a larger amount is related to 2008 but I would like to leave it at that.
Craig Maurer - Calyon Securities: Thank you.
Operator: Your next question comes from the line of Anurag Rana with Keybanc Capital Markets. Please proceed.
Anurag Rana - Keybanc Capital Markets: Good morning, everyone. Congratulations on a good quarter. If you look back, GDV growth in Europe was averaging around 14% in local currency from 2004 to 2006, and we saw this growth rate increase to 18.4% in the fourth quarter and again above 17% in the current quarter. Could you please help us understand the key reasons for the increase in these growth rates? And then I have a follow-up.
Robert W. Selander: The only thing I can observe on that is we’ve obviously had rapid growth in our business over there. As you will have noted, we’ve seen an increase in the number of MasterCard cards there consistently over the last several years. We had a couple of significant deals which began converting last year and we’ve seen continued converting, which we’ve shared with your previously with regard to -- for example, Lloyds TSB as well as HBOS, the Halifax Bank of Scotland in the U.K. So while I can’t point to a specific card base or market, it’s those type of events coupled with relatively healthy economies, although they are showing in both the U.K. and a couple of the continental European markets a bit of a slowdown. Those economies are generally remaining quite healthy for us.
Anurag Rana - Keybanc Capital Markets: Thanks, and are you seeing any trends regarding the greater use of debt in the U.S. at this point, as compared to historical trends?
Robert W. Selander: Well, I think that we continue to see debit as a major opportunity not just in the United States but globally. And if you do look at the growth rates that we reported specifically for the U.S., you can see that charge and credit growth was, in terms of purchase volume, was about 6% first quarter, whereas debit growth was something over 18%. So what we see is increased acceptance by consumers of not just using their debit cards to get cash at ATMs but also going to the point of sale, coupled with a broadening of the issuance of those products in the United States.
Anurag Rana - Keybanc Capital Markets: Thank you.
Operator: Your next question comes from the line of Christopher Brendler with Stifel Nicolaus. Please proceed.
Christopher Brendler - Stifel Nicolaus: Thanks. Good morning. I wondered if you could talk a little bit more -- not to bit a dead horse a little bit here but the price increase, the new one that’s January ’08, my understanding from the conversation this morning is it’s a cross-border related fee for non-U.S. customers traveling to the U.S. Is that correct?
Martina Hund-Mejean: There are a number of components in the pricing adjustments that we did. We typically don’t put out any specific component. I think we talked generally about it, the ones that are more significantly impact our financial statements and there were two things that we really talked about -- one, the new pricing changes on cross-border acquiring volumes. That’s one change, and the other change is for any retail purchases that are done in the U.S. by non-U.S. cardholders, there was a pricing change. So those the most significant ones that we can point to but let me tell you, there were a number of changes that we had in the menu.
Christopher Brendler - Stifel Nicolaus: Okay, that’s helpful. I guess what I was going to hope to do as a follow-up is if you could address some of those pricing changes in any level of detail relative to the comment that you are sensitive to your customers and the fact that they are struggling financially, or many of them are struggling financially, given what’s going on in the world economy, and especially here in the U.S. And also, this discussion of the cross-border interchange ruling in Europe -- do any of these things have any impact in terms of being sensitive to your customers and also the cross border regulatory ruling? Does that have any impact on your ability or what you’ve decided to do in January in the price increases or are those kind of -- you have value-added services that you are adding, you feel like you are pricing appropriately for, so I think you are remaining sensitive to those issues and it’s not a concern going forward?
Robert W. Selander: I think you summarized it very well just then. When we produce additional value, we feel we can price for that and it’s a win-win situation and obviously to the extent we offer a new service that may bring let’s say scale to a customer where they don’t have scale, that saves them money and it gives us new revenues that we would not otherwise have had. We are working with our customers in all parts of the world and these are challenging times for many of them. Clearly the customers in the U.S. with where we are going in terms of the credit cycle and so forth, are feeling pressures in their payments business if they have not felt pressures in some other part of their company, due to mortgage or other issues. So we do work with them on things like portfolio optimization. We work to improve their marketing effectiveness. We will work with them on how they broaden and expand the usage of existing products, so we have efforts underway, for example, to get into the utilities and rental categories, which are other non-discretionary spend areas to see if we can help our customers capture those on our products. And then we are also working on helping them to explore and grow into other areas, such as healthcare. Specifically with regard to the cross-border interchange issue in Europe, as you know we are not direct economic participants in interchange. That’s a flow from the acquirer, financial institution, that goes back to the issuing institution. And what we are trying to do is ensure that we do not have a situation where MasterCard is not viewed as a good product to be issued by issuers, or for that matter a product that wouldn’t be appropriate to continue to be acquired by acquirers. So while it doesn’t impact us directly, we are working to find a way both to comply from our perspective about the order but to also maintain a competitiveness and attractiveness of our products. Over time, if there is an undermining of the capabilities of issuers or acquirers because of regulatory intervention, to have acceptable business cases they are going to slow down their investments in their payments business and clearly that will have an impact on us because there will be less robust growth, less support for the activities we are involved with. So that’s the longer term implications if we don’t manage through this in the short-term in a positive way.
Christopher Brendler - Stifel Nicolaus: Absolutely. Just one quick follow-up, if I could; the fee for the non-U.S. customers traveling to the U.S., is that primarily passed on to the consumer?
Martina Hund-Mejean: It’s an acquiring fee, so it’s paid by the acquirer at that point in time. That’s all I can say.
Christopher Brendler - Stifel Nicolaus: Thank you very much.
Operator: Your next question comes from the line of Sanjay Sakhrani with KBW. Please proceed.
Sanjay Sakhrani - Keefe Bruyette & Woods: Thank you. I appreciate that regional color on the cross-border volume but I was just wondering -- in your analysis, have you guys attempted to sort of decipher how much is driven by a fundamental change in the way customers or consumers are traveling versus what is being cyclically driven? And then I have one follow-up. Thank you.
Robert W. Selander: The answer is we haven’t been able to sort it the way that or parse it the way you’ve described. Clearly we have fairly robust data on how transaction patterns occur and that’s something that we work with our customers to better position ourselves and them to both support their cardholders, to capitalize on promotions and other things that we might do with merchants. But we haven’t got that kind of data to share with you today.
Sanjay Sakhrani - Keefe Bruyette & Woods: Okay, great. And then just on the M&A environment, I was wondering if you had any thoughts on it or any color to offer? Thanks.
Robert W. Selander: Well, I guess two observations -- the first is that we’ve indicated that any time we would look at, and we do look at various opportunities, we go through a criteria that includes does this align with our strategy, will it make financial sense for the company and shareholders over time, can we integrate this and if we are not capable from an experienced management standpoint within MasterCard, are we going to be getting talent as a result of the deal? The only transaction I would point to that closed -- I guessed it closed on April 1st, was our deal with Europay France. That is a business that we’ve now -- I won’t say we’ve fully integrated it but we certainly have made it part of the MasterCard family in Europe and that will enable us to provide additional services to banks in France, and over time we hope to take advantage of some of the things they were doing there possibly in other parts of Europe.
Sanjay Sakhrani - Keefe Bruyette & Woods: I know pricing was a big issue. Have you seen any noticeable shift in terms of pricing?
Martina Hund-Mejean: No, not really. I mean, all that we have to say we already said.
Sanjay Sakhrani - Keefe Bruyette & Woods: Okay, great. Thank you.
Operator: Your next question comes from the line of Charles Murphy with Morgan Stanley. Please proceed.
Charles Murphy - Morgan Stanley: I thought it was interesting how strong purchase GDV growth in Europe was. Is it possible to isolate how much of European purchased GDV comes from cross-border GDV?
Robert W. Selander: I’m sure somewhere we have that data. I don’t have it handy and it is not something that I believe we’ve shared at this point in time. Obviously within Europe we have about 50 countries in our Europe region, so it is much more than the EU. It goes right through what would be considered Eastern Europe and includes Russia, Turkey. So we do have, as you know, a situation where it is pretty easy to jump in your are and driver across two or three borders in the course of a couple of hours in much of Europe, so there is a reasonably strong mix of cross-border activity that takes place in that market.
Charles Murphy - Morgan Stanley: Okay, and as a quick follow-up, I think you’ve hinted in the past that most process transactions come from the U.S., U.K., Canada, Brazil, and Australia. Could you describe the key hurdle to winning new process transaction business in Asia-Pacific and in Latin America?
Robert W. Selander: Well, the hurdles are pretty much the same everywhere in the world. Generally you have banks or bank-owned consortiums operating in many of these markets and as the banks look at whether or not those are economically attractive things for them to continue to do, or in some cases when they decide they want to heighten the competition so that as an individual financial institution, they can differentiate themselves either with the merchants when it comes to dealing with the merchants on the acquiring side or with the cardholders on the issuing side. You tend to see an evolution where they begin to think okay, I want to take on my own issuing or my own acquiring and these shared companies that they’ve established are either sold or in some other way -- I’m hesitant to say disposed of but take the case of the acquiring business in Brazil. You saw a group of banks there spin off Redecard or a portion of Redecard through an IPO. We were a participant in that, as you know, and have completed the sale of our Redecard shares. We see analogous situations in many of the other markets around Latin America and Asia. That’s playing out the way the U.S. -- or we think it will play out similarly to the way the U.S. is playing out and the way the game is afoot in Europe today.
Charles Murphy - Morgan Stanley: Thanks very much.
Barbara Gasper: Operator, I think we have time for one more question, please.
Operator: Your next question will come from the line of Bruce Harting with Lehman Brothers. Please proceed.
Bruce W. Harting - Lehman Brothers: Thanks. Just following up on the last question, it does look like your purchase volume in Europe, if I go back three years or so, continues to pick up and if I’m reading this correctly, it was your strongest quarter in quite a while. It seems like you and Javier have said that SEPA is not going to be like a big bang where you just go from one quarter to the next and announce you’ve made some big wins in processing and other things. So how much of the steady growth are we seeing as Europe creeps up and contributes a larger portion of your overall GDV and revenue if SEPA wins, or sort of the Lufthansa win or the Carte Bancaires win? And will this be just a very subtle but very promising trend that we see develop each quarter? And your economies of scale just continue to amaze, and Asia continues to creep up quietly as well as a percent of GDV. I’m wondering if -- I know you don’t break out your expense or marketing by region, but is that getting a disproportionate amount of that spend? Thanks.
Robert W. Selander: Let me try and take a crack at that. I guess there were a couple of questions embedded there. With regard to Europe and the points that Javier and other of my colleagues have made, I would agree that we don’t see this as one day all of a sudden our business is going to double or whatever. Rather, it is through blocking and tackling as domestic players look at whether or not they are going to continue to run their domestic processors or maintain their domestic brands. And we are very well-positioned with Maestro on over 300 million cards in Europe to offer -- in fact, we’ve built it with the banks in Europe over the last 15 years, really the leading cross-border debit alternative in Europe. And that migration from national use only brands to Maestro has begun. I believe we referred to this -- I’m not sure we did it in the last quarter’s call but we have about 20 million cards in Germany, Italy, Ireland, Portugal and The Netherlands where there are agreements and we are beginning to see those cards as they are reissued as Maestro cards begin to function and operate as Maestro cards. If you look across Europe, we are now in a position where we can process a larger number because of the connectivity of transactions that might otherwise have gone through as domestic transactions. So for example in Italy, over 14% of all debit card transactions are processed by MasterCard under our Maestro brand and we see that continuing to grow, both the number of transactions as well as the penetration of that. So we are very optimistic about what that means in Europe. With regard to your sort of embedded second question, we are very optimistic about our growth in many markets around the world. Asia-Pacific has demonstrated very strong growth this quarter as compared with some of their past quarters, and so that is in part a reflection of the healthy economies out there but also in the degree to which there is a lot of cross-border activity taking place within that region as well. And of course, we process all the cross-border transactions.
Martina Hund-Mejean: Let me just add to Bob’s remarks a little bit based on what he said before -- you know, for the deals that we have struck in Europe, we do see some increased volume and we basically attribute that to two factors; one, obviously the value proposition that we have with our platform in Europe, but two, also the increased secular, or let’s say continuing secular trends from paper to electronic payments in Europe, which we believe is a very promising trend going forward.
Bruce W. Harting - Lehman Brothers: Thank you.
Operator: At this time, we would like to turn the call over to Mr. Bob Selander, Chief Executive Officer, for closing remarks.
Robert W. Selander: I really don’t have a lot to add. I appreciate all of you joining us today. We are very pleased with our results for the first quarter and we look forward to speaking with all of you again when we talk about the second quarter. Thanks very much.
Operator: Thank you all for your participation in today’s conference. This concludes the presentation. You may now disconnect and have a great day. | [
{
"speaker": "Executives",
"text": "Barbara Gasper - Investor Relations Robert W. Selander - President, Chief Executive Officer, Director Martina Hund-Mejean - Chief Financial Officer"
},
{
"speaker": "Analysts",
"text": "Patrick M. Burton - Citigroup Moshe Katri - Cowen & Co. Adam Frisch - UBS Elizabeth W. Grausam - Goldman Sachs David Hochstim - Bear Stearns Tien-Tsin Huang - J.P. Morgan Craig Maurer - Calyon Securities Anurag Rana - Keybanc Capital Markets Christopher Brendler - Stifel Nicolaus Sanjay Sakhrani - Keefe Bruyette & Woods Charles Murphy - Morgan Stanley Bruce W. Harting - Lehman Brothers"
},
{
"speaker": "Operator",
"text": "Good day, ladies and gentlemen, and welcome to the first quarter 2008 MasterCard Incorporated earnings conference call. My name is Francis and I will be your coordinator for today. (Operator Instructions) I would now like to turn the presentation over to your host for today, Barbara Gasper, Head of Investor Relations. Please proceed."
},
{
"speaker": "Barbara Gasper",
"text": "Thank you, Francis. Good morning and thanks to everyone for joining us today, either by phone or webcast, for a discussion about our first quarter 2008 financial results. With me on the call this morning are Bob Selander, President and Chief Executive Officer; Martina Hund-Mejean, our Chief Financial Officer; and Tara Maguire, our Corporate Controller. Following comments by Bob and Martina highlighting some key points about the quarter, we will open up the call for your questions and in total, the call will last up to one hour. This morning’s earnings release and the slide deck that will be referenced on this call can be found in the investor relations section of our website, mastercard.com. The earnings release and slide deck have also been attached to an 8-K that we filed with the SEC earlier this morning. A replay of this call will be posted on our website for one week until May 6th. Finally, as set forth in more detail in today’s earnings release, I need to remind everyone that today’s call may include some forward-looking statements about MasterCard's future performance. Actual performance could differ materially from what is suggested by our comments today. Information about the factors that could affect future performance are summarized at the end of our press release as well as contained in our recent SEC filings. With that, I would now like to turn the call over to Bob Selander. Bob."
},
{
"speaker": "Robert W. Selander",
"text": "Thanks, Barbara and good morning, everyone. We are very pleased that we have started the year with a strong financial and operating performance in the first quarter. We continue to be encourage by the transaction growth and cross-border trends we are experiencing in the midst of a challenging economic environment in the United States. The fundamentals of the business are still very strong and our first quarter results provide a solid foundation for us to deliver on our business objectives for 2008. Turning to page two of the slide deck, in the first quarter we delivered net income of $398 million, or $3.01 per share on a diluted basis, excluding a special item. The item was a $49 million after-tax gain from the termination of a customer business agreement, which represents $0.37 per share. Net income also includes after-tax gains of $56 million, or $0.42 per share, from sales of our investment in Redecard. We have now sold all of our Redecard shares. We recorded quarterly net revenue of $1.2 billion, up over 29% from the first quarter of 2007. This was driven primarily by a strong growth in gross dollar volume and process transactions, including cross border volumes, which grew 23.6%. Additionally, pricing changes contributed approximately 6 percentage points of the revenue growth in the quarter. Finally, we saw our operating margin improve 9.3 percentage points to 43.6% from 34.3% in the first quarter of 2007, demonstrating the continued leveragability of our business model. Before turn the call over to Martina, there are a few economic and business developments on page three that I would like to highlight. The slowdown in the U.S. economy has had some effect on our U.S. growth. However, the trends that we saw over the past few quarters have continued and have led to strong global growth for MasterCard. These trends include first, in the U.S. a consumer shift away from discretionary purchases, such as luxury retail and home furnishings, to non-discretionary purchases, including food and gasoline, which have also been infected by commodities price increases. Second, we continue to see double-digit growth in markets outside the United States, where we generate about half of our revenue. Third, cross-border volume trends are still quite healthy and last, the secular shift from paper to electronic payments. All this said, we recognize that our customers are experiencing extraordinarily challenging conditions and we are working with them to help maximize the value of their payments businesses. Switching now to our business updates, earlier this month we announced the launch of our integrated processing solutions, or IPS debit processing platform. IPS provides banks with a suite of branded debit network and card issuer processing services, including PIN, signature, ATM driving, and expanded rewards capabilities. Security Service Federal Credit Union will be the first customer to implement IPS. We believe this new platform will offer a compelling solution for banks that are currently struggling with disparate legacy platforms and seek an integrated solution for PIN, signature, point of sale, and ATM debit processing. With respect to our U.S. litigation, we have no new significant updates to report at this time. In the case of the European Commission ruling, we continue to communicate with the commission regarding specifics related to our compliance with their order. We asked for and were denied an extension beyond the June 21st compliance deadline. In any event, we will take steps that we believe will comply with the commission’s order and we expect to have more specifics in the near future. As we’ve said before, we are prepared to take action to ensure that our payments products remain competitive in Europe. As I just mentioned on page two, during the quarter we sold our remaining share of Redecard and realized pretax gains of approximately $86 million during the period. These gains have been recorded as investment income on our income statement. During the quarter, we repurchased approximately 1.5 million shares of class A common stock for an aggregate of $294 million, or approximately $196 per share. Through April 29th, the company repurchased approximately $557,000 additional shares of its class A common stock at a cost of $129 million. In total, $1.02 billion of the approved $1.25 billion repurchase program has been completed. Additionally, this past February our board of directors authorized the conversion of up to 13.1 million shares of class B stock into class A stock during 2008. Although no conversions have taken place thus far this year, the first 2008 conversion program, for up to 13.1 million shares, is expected to begin on May 17th and may continue through June 13th. With that, I will now turn the call over to Martina for a more detailed update on the financial results."
},
{
"speaker": "Martina Hund-Mejean",
"text": "Thanks, Bob and good morning to everyone. Let me begin on page four of the slide deck. As Bob mentioned, net revenue for the quarter was almost $1.2 billion, an increase of 29.2% versus the year-ago quarter. Currency fluctuations of the Euro and the Brazilian Real relative to the U.S. dollar contributed 5.1 percentage points of the net revenue increase, resulting in underlying business growth of 24.1%. Approximately 6 percentage points of this was due to pricing changes. Our operating income of $516 million resulted in an operating margin of 43.6% for the quarter, a 9.3 percentage point improvement over the first quarter last year. As we’ve mentioned in the past, our strong revenue growth enabled us to leverage our operating margin. The margin contribution from revenue growth was three times as much as the offsetting impact from expense growth. The contribution from foreign exchange was about 1 percentage point. Net income was $398 million, or $3.01 per share on a diluted basis, excluding the special items. Additionally, without the impact of gains from the sale of our remaining investment in Redecard, first quarter EPS was $2.59 per share on a diluted basis. Turning to page five, you see our first quarter gross dollar volume, or GDV numbers, which are reported for the same period as our revenues. GDV grew 14.1% on a local currency basis and 20% on a U.S. dollar converted basis to $611 billion. The first quarter was the 16th consecutive quarter of double-digit worldwide GDV gross on a local currency basis. And despite the economic downturn in the U.S., our U.S. GDV growth was 8.9%, and U.S. purchase volume growth was even stronger at 10.3%. Although not shown on page five, worldwide purchase volume was up 15% and cash volume was up 11.6%, both on a local currency basis. Additionally, cross-border volume, or the volume that is generated from cardholders who travel outside of the country where the card is issued, was up 23.6%. Processed transactions, or the transactions processed across MasterCard's network, increased 15.7% to 4.9 billion in the first quarter. We continue to benefit from the global diversification of our business and our ability to generate significant volume, transactions, and revenue from economies outside of the U.S. where economic conditions are generally more favorable than in the U.S. Net revenue yield was 19.4 basis points in the quarter versus 18 basis points in the first quarter of 2007. The improvement in revenue yield can be primarily attributed to pricing changes and underlying business growth. Let’s turn to page six. Here you can see that net operations fees increased 31.4%, or $205 million, to $858 million in the first quarter. Gross operations fees increased 30.2%, or $219 million, to $944 million. This growth was driven by several factors. First, growth in process transactions, cross-border volumes, and gross dollar volume that I previously described on page five. Second, the continued impact of pricing changes in new programs implemented in the second quarter 2007, including changes related to stand in authorization pricing, pricing for acceptance development fees, and a new fee associated with rewards programs. Additionally, we implemented a new account enhancement service that allows our customers to move cardholders to different programs without a change in account numbers. Third, new pricing changes in January of 2008 on cross-border acquiring volumes and on retail purchases in the U.S. by non-U.S. cardholders. In the first quarter, net operations fees as a percentage of growth operations fees improved slightly. Our operations fees rebate were tempered by an adjustment due to a customer who did not achieve performance hurdles included in their business agreement. On page eight, we show that net assessments increased 23.7%, or $62 million to $324 million versus the first quarter of 2007. Gross assessment increased 20.4%, or $94 million to $554 million due to strong GDV growth. Net assessments as a percentage of gross assessments improved slightly compared to the first quarter of 2007. MasterCard's performance-based pricing continues to moderate the impact of relatively lower U.S. volumes on our revenue. Additionally, as was the case with the operations fees we did this quarter, assessment fee rebates were tempered by the same adjustment related to a customer who did not achieve performance hurdlers included in their business agreement. Please turn to page eight for some detail on expenses. During the first quarter, total operating expenses increased 10.9%, of which 3.3 percentage points were related to currency fluctuations. This increase was mainly driven by two factors. First, a 10.9% increase in general and administrative expense, of which 2.9 percentage points were related to currency fluctuations. The growth in G&A was driven by higher personnel costs, partially offset by foreign exchange settlement gains. Excluding the impact of FX, the personnel costs increased 16.1%, primarily associated with the hiring of additional staff and contractors over the past year, mainly in technology, customer-facing, and product positions. Second, an 11.6% increase in advertising and marketing expenses. Currency fluctuations represented 4.4 percentage points of this increase. A&M growth was primarily due to the timing of expenses for European sponsorship activities, as well as investment in high growth markets. Moving to the cash flow statement and balance sheet highlights on page nine, we generated $224 million in cash flow from operations during the quarter. We ended the quarter with $2.9 billion in cash, cash equivalents, and available for sale securities. Both short- and long-term available for sale securities decreased by $281 million, primarily due to the sale of the remaining shares of our Redecard investment, the sale of short-term bond funds and auction rate securities, and investment losses. We also reclassified $237 million of auction rate securities to non-current assets due to the current lack of liquidity on those securities given market conditions. As of quarter end, we had repurchased approximately 1.5 million class A shares in the open market for $294 million. Stock repurchases results in a $0.02 per share increase to basic EPS for the quarter. I will now turn the call back over to Bob for some comments on 2008."
},
{
"speaker": "Robert W. Selander",
"text": "Before moving to the Q&A, join me on page 10 and I would like to highlight a few items for your consideration, as you refine and update your models for the second quarter of 2008. First, there were two special items in the second quarter of 2007 -- a $3 million litigation settlement and other income of $90 million related to the World Cup settlement agreement. Second, our outlook for full year 2008 remains unchanged from January. We expect slower net revenue growth than 2007 but still at double-digit rates. G&A expenses should grow at a rate that is both slower than net revenue growth and below the 2007 G&A growth rate. With respect to advertising and marketing expenditures, we expect continued modest growth, particularly to support our efforts in international markets. These guidelines assume current FX rates, no global recession, and no event which significantly disrupts cross-border travel. Finally, as I mentioned last quarter, we are currently evaluating whether it is appropriate to update our existing three to five-year long-term performance objectives and we expect to address these at our annual investment community meeting in May. To wrap up, we are very happy with our first quarter results. We remain committed to growing our business while managing costs and investments to add value to our customers, merchants, and shareholder."
},
{
"speaker": "Barbara Gasper",
"text": "We are now ready to begin the question-and-answer period. In order to get to as many people as possible in our allotted timeframe, we ask that you limit yourself to a single question with one follow-up and then queue back in for additional questions. Operator."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from the line of Patrick Burton with Citigroup. Please proceed."
},
{
"speaker": "Patrick M. Burton - Citigroup",
"text": "Congratulations on the fantastic numbers. My question deals with the settlement gains in G&A. Where does that number show up on the income statement? Thanks."
},
{
"speaker": "Martina Hund-Mejean",
"text": "That shows really up on other G&A."
},
{
"speaker": "Patrick M. Burton - Citigroup",
"text": "Okay, and as a follow-up, is that a hedge then on your foreign denominated G&A expenses?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "Exactly. We do expect [inaudible] hedging to really only transactional hedging activities and any gains or losses that could happen as a result of hedging those underlying exposures are reflected in that line item."
},
{
"speaker": "Patrick M. Burton - Citigroup",
"text": "Thank you and congratulations again on the numbers."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Moshe Katri with Cowen & Co. Please proceed."
},
{
"speaker": "Moshe Katri - Cowen & Co.",
"text": "Thanks. Congratulations again on a very strong quarter. Can you quantify the portion of your revenues that are considered non-discretionary in terms of -- we’re talking about consumer spending. And then on top of that, can you also talk a bit about the U.S. business, if there is anything unusual that took place during the March quarter on a month-by-month basis that will get you a bit more cautious looking at the June quarter, maybe September quarters as well? Thanks."
},
{
"speaker": "Robert W. Selander",
"text": "With regard to the first one, we really don’t break out across the world discretionary versus non-discretionary volumes. As you know, we do have our spending pulse information that we put out monthly, both in the U.S. and the U.K., which tracks retail sales and that’s the broad retail sales and figures, not just the MasterCard figures. So we capture competing payments products in that. And the trends that we talked about in previous quarters seem to continue in the U.S. with regard to the growth rate of retail sales versus the same period prior year is continuing on a down trend. If you look at the specifics for March, you had a -- I guess it was ex auto -- let me try and remember this data, I think it was a 5.3% increase in retail sales. But if you take out gasoline as well, the retail sales were only up 3.6%. If you were to go back to the first quarter of 2007, you’d have seen growth rates that were well above that, and so the comment I made about the mix change occurring has continued and the rate of growth relative to prior years seems to be continuing to slow in the U.S. March has some anomalies around it because of a relatively early Easter, which occurred at the end of March and we’ll see how those anomalies work out as the April data comes together."
},
{
"speaker": "Moshe Katri - Cowen & Co.",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Adam Frisch with UBS. Please proceed."
},
{
"speaker": "Adam Frisch - UBS",
"text": "Thanks and another quarter of phenomenal results. Going into a specific quarter, how much of your expense base is fixed and how much can be determined during the quarter as you see how your top line is progressing?"
},
{
"speaker": "Robert W. Selander",
"text": "I think probably Martina and I will both take a crack at that but generally at the beginning of a quarter, pretty much everything is fixed for that quarter. If you take a look at those items that you would think about being discretionary over the course of the next year or so, marketing expenses are one of the first things that come to mind but a large proportion of our advertising and marketing involve multi-year, in many cases, sponsorship commitments. Clearly when you put together a program, those commitments are made months if not quarters in advance in terms of media buys and other activities. With regard to the G&A, there is some discretion obviously in terms of the short-term pace of bringing on contractors for certain of the projects that we might need, for example, development resources for our systems area but generally there is not a lot that we can do one month to the next within a given quarter. I don’t know if you wanted to add any highlights to that."
},
{
"speaker": "Martina Hund-Mejean",
"text": "Just on G&A, as you know our personnel cost is roughly 70%, 75% of the G&A. That’s not just only full-time employees but also contractors in there and it depends on what kind of customer implementations we actually do in a particular quarter or in the future. We obviously have -- you know, we can throttle the number up and down from a contractor point of view. We have a number of other line items in G&A, such as professional fees, which could be throttled up and down from time to time, G&A. However, you have to note that a lot of those costs are dedicated to really investments that we are doing for future growth, so I do agree with Bob that while we have probably on the margins some room to throttle up and down, as we are going into the year and every quarter, there’s probably more of a fixed component than a variable component."
},
{
"speaker": "Adam Frisch - UBS",
"text": "Okay, thanks for that color. And then just one point of clarification -- the customer termination agreement, the gain of $0.37. Was that the World Cup or was that something different?"
},
{
"speaker": "Robert W. Selander",
"text": "That was something different that occurred this year. The settlement we had last year in the second quarter for $90 million went through our income in 2007 --"
},
{
"speaker": "Adam Frisch - UBS",
"text": "Right, 2007, so what was the customer termination agreement this quarter?"
},
{
"speaker": "Robert W. Selander",
"text": "This was with relationship to a customer who terminated their agreement and as a result of our not having the benefit of that agreement, we received a one-time settlement which worked its way through our income statement this quarter."
},
{
"speaker": "Adam Frisch - UBS",
"text": "Did that have any material effect on volumes or transactions at all?"
},
{
"speaker": "Robert W. Selander",
"text": "Well, for the quarter it did not, no."
},
{
"speaker": "Adam Frisch - UBS",
"text": "Will it in the future quarters?"
},
{
"speaker": "Robert W. Selander",
"text": "Well, to the extent we don’t retain this business as the customer has sold the business, it could, yes."
},
{
"speaker": "Adam Frisch - UBS",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Elizabeth Grausam with Goldman Sachs. Please proceed."
},
{
"speaker": "Elizabeth W. Grausam - Goldman Sachs",
"text": "I’d just like to touch a little bit more on the pricing environment as the price, the growth you achieved from pricing changes this quarter certainly outperformed our expectations. Could you give us some outlook as to how much you expect pricing changes to contribute to your full-year outlook, and also other opportunities you may see in your portfolio of businesses to affect pricing changes over the course of the year?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "First of all, it’s fair to say that the pricing impact on the quarter was extraordinary and I think we were really benefited by a couple of things. One, in the line items where we did have some price increases and as you know, we always wrap value propositions around that that really have to have a value to the customer. But in those line items, we actually enjoyed a particular nice growth, which obviously contributed to the percentage point increase on the pricing. Secondly, we have been more effective, I believe, in implementing the pricing changes in January of 2008. When you look at the number, that 6 percentage point increase, you do have a lapping effect in the form of the price increases that we did in the second quarter of 2007, so certainly those -- that impact will not continue as we are going into the second quarter. It will basically fall off so I would expect that you are going to see some lower number in the future quarters."
},
{
"speaker": "Elizabeth W. Grausam - Goldman Sachs",
"text": "Great, and just kind of a discussion of where you think in your business you have the most pricing leverage. It certainly seems that the cross-border market, cross-border volume growth is supporting increased pricing changes in that particular line item of your business, yet that also seems to be a fairly volatile portion of the business, depending on travel. Can you help us understand where you see in your business mix the most pricing leverage going forward and where you bring competitive advantage to effect those pricing changes?"
},
{
"speaker": "Robert W. Selander",
"text": "One of the things that we’ve been working on is broadening our offerings to our customers, so if we enhance an existing service and that provides more value, than we may have a pricing opportunity there. But to the extent we can bring new services where we now are competing for money they are spending elsewhere, that gives us the most flexibility and that’s a significant portion of our focus. You probably will recall earlier in this month we announced, and I mentioned this morning, our IPS system which will give us an opportunity to provide additional debt related services, processing services, fraud services, et cetera, to our U.S. customers initially. So that’s where I think we see the greatest opportunity."
},
{
"speaker": "Elizabeth W. Grausam - Goldman Sachs",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of David Hochstim with Bear Stearns. Please proceed."
},
{
"speaker": "David Hochstim - Bear Stearns",
"text": "I’m wondering, can you just talk about the rebate adjustment and how significant of an affect that had on rebate and incentives and the net revenue yield? I mean, is the net revenue yield sustainable at these levels then?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "David, let me take that. It’s not a significant impact on either of the numbers. It has a slight impact but when you really look at the rebate line for [inaudible], it is still around right about 10% of growth and when you look at the rebates and incentive line on the assessments side, you are not really seeing a big change. As we said before, you really have to be careful to look at this on a quarter by quarter basis. You really need to look at it on a year-over-year basis but all we wanted to call out, because you saw some slight improvement in the net, that really is coming down to a flat development when you pull out this particular item."
},
{
"speaker": "David Hochstim - Bear Stearns",
"text": "Okay, so the net revenue yield could continue at about this level?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "No, let me just talk a little bit about net revenue yield. The 19.4 basis points that you see for this quarter contrast to about 18 basis points in the year-ago quarter and really of that 1.4 basis points difference, 0.9 is about due to the pricing changes and 0.5 is about due to the business, underlying business growth. So in terms of looking at it in the future, and I think we are going to probably have a more robust discussion at our May investor meeting, but one thing you need to take into account on the 0.9 movement for the pricing, again as I said before we have the lapping effect there from the second quarter of 2007 that will obviously not continue in the next few quarters, and therefore you at least are going to have to take that one out. But we are still holding firm with our view that you are going to see a gently downward trend and then we are going to have a more robust discussion about it at our investor meeting in May."
},
{
"speaker": "David Hochstim - Bear Stearns",
"text": "Okay, and then just to clarify on the termination of the contract, how should we think about the payment relative to the net revenues that were generated by that contract, or could you give us some sense of what that relationship was?"
},
{
"speaker": "Robert W. Selander",
"text": "Just an observation, the volume related with this particular deal was less than 1% of our global MasterCard volume --"
},
{
"speaker": "David Hochstim - Bear Stearns",
"text": "That’s GDV or --"
},
{
"speaker": "Robert W. Selander",
"text": "-- for the past year, so that puts a framework on it."
},
{
"speaker": "David Hochstim - Bear Stearns",
"text": "Less than 1% of GDV?"
},
{
"speaker": "Robert W. Selander",
"text": "Yeah, purchase volume."
},
{
"speaker": "David Hochstim - Bear Stearns",
"text": "Okay, thanks."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Tien-Tsin Huang with J.P. Morgan. Please proceed."
},
{
"speaker": "Tien-Tsin Huang - J.P. Morgan",
"text": "Thanks. Good morning. I had a question about the cross-border fee increase, which was higher than we expected and the volumes are still looking strong there. Can you give us some high level details on the mix of cars that are driving the volume growth? How much is from the U.S. versus Latin America, Asia-Pac, et cetera?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "Really from when we looked at and we did study that as you know in Q4 very much in detail because we wanted to be sure that we do understand the trends in terms of how many foreigners are coming to the United States versus Americans traveling overseas, and really the effect that we talked about in Q4 have really not changed much in Q1. And what we came down to is it is really Europeans traveling outside of Europe, not just into the United States but also in other regions in the world. It is really Latin Americans traveling for a significant extent outside of their country, some of them obviously also come to the United States. And then we have some movement -- I think that was a smaller part of it, of residents in any countries in the Asia-Pacific region traveling again outside of their country. So we really have not seen a change in pattern from what we saw in Q4."
},
{
"speaker": "Tien-Tsin Huang - J.P. Morgan",
"text": "Got it. So the contribution from U.S. traveling outside of their own borders is not -- it sounds like that trend has not changed."
},
{
"speaker": "Martina Hund-Mejean",
"text": "It has not really changed."
},
{
"speaker": "Tien-Tsin Huang - J.P. Morgan",
"text": "Okay. And then just in terms of the outlook on the portfolio conversions going forward -- any others that we should be aware of here as we go through the balance of the year? And I noticed that there was a sequential decline -- it’s small -- in debit cards in the U.S. Anything to read into there and does that link to the contract termination fee?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "We have -- no, that’s really not linked to that but when you look at our -- just in the United States, when you look at the GDV, when you look at the purchase volume, when you look at the transaction volume, and in particular when you look at the debit line, you have to recognize that in the first quarter of ’07, we still had the effect of a large debit conversion of one customer in there which, you know, once you do that you just kind of [inaudible] for two years, so you still had it and you had the effect in Q108 versus Q107. So when you pull that out, in fact our growth rates are slightly higher than what you saw in Q107."
},
{
"speaker": "Tien-Tsin Huang - J.P. Morgan",
"text": "Did you say which region the lost contract came from? Was it in the U.S. or outside the U.S.?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "Lost contract?"
},
{
"speaker": "Tien-Tsin Huang - J.P. Morgan",
"text": "I’m sorry, the contract termination, the portfolio of cards that you lost -- did you give us the details on the region that was sourced from?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "We did not."
},
{
"speaker": "Tien-Tsin Huang - J.P. Morgan",
"text": "Got it. If I can just sneak in a last quick question just for Bob, just maybe your high level thoughts on what is going on in the hill regarding a change in the Credit Card Fee Act, et cetera -- what are the implications there for MasterCard? Thanks."
},
{
"speaker": "Robert W. Selander",
"text": "Well, there’s two sets of activities, as you know. There have been some hearings taking place frankly focused on issuer practices and various customers of ours have been involved in conversations or testimony around those practices. Clearly those issuers have been paying attention and where there were practices that needed an adjustment or amendment, I think they’ve been stepping up to that. So I think the industry has been quite responsive in that regard. As you probably also know, Congressman Connors put through a proposal on interchange legislation. We believe that a free market approach towards how that rate gets set and determined is much more appropriate than having congress come in and legislate how that gets done. And so we will continue to work with others in the industry to ensure that the interested merchants and cardholders are looked out for and not legislated by our congress."
},
{
"speaker": "Barbara Gasper",
"text": "Operator, next question."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Craig Maurer with Calyon. Please proceed."
},
{
"speaker": "Craig Maurer - Calyon Securities",
"text": "Good morning. Thanks for taking my call. First question is around the rebates outlook, you discussed clearly a weakening U.S. economy. What’s your thoughts currently now on getting some of that rebate effect back to your benefit later in the year?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "Let me just start with that. We have already given our thoughts for 2008 in terms of what we believe from a net revenue growth point of view, meaning that we do believe it is lower than 2007 but we will still be double-digit and I think that does comprehend what we are thinking about rebates and incentives. If we have anything else to add to that, I think the appropriate time would be for us to do that at the end of May at the investor meeting."
},
{
"speaker": "Craig Maurer - Calyon Securities",
"text": "Okay. And when looking at my model, I am trying to put the trends around the marketing line. Should we assume that you might have an increase around the Olympics, so perhaps a little more marketing would be weighted to the third quarter of this year? Thanks."
},
{
"speaker": "Robert W. Selander",
"text": "I think it is probably more appropriate to look at the second quarter as a place that will get more weighting this year. We have significant football events -- that’s soccer -- in the case of the European Champions League, as well as the quadrennial European Championship that will be played in the course of the second quarter. The finals, of course, for the European Championship will be I guess in Vienna at the end of June. So this will be a year that is more analogous to the one that we had in 2006 where we had a similar second quarter, at that time World Cup event, which resulted in significant promotional and marketing support."
},
{
"speaker": "Craig Maurer - Calyon Securities",
"text": "Okay, and if I could just get some clarification on something Martina had said, regarding the revenue yield and the 0.9 points of increase versus last year due to pricing changes, how much of that is related to the recent pricing changes that we’ll see repeat and how much of that are you growing over? Thanks."
},
{
"speaker": "Martina Hund-Mejean",
"text": "Craig, I would say that the lesser amount is related to 2007 and a larger amount is related to 2008 but I would like to leave it at that."
},
{
"speaker": "Craig Maurer - Calyon Securities",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Anurag Rana with Keybanc Capital Markets. Please proceed."
},
{
"speaker": "Anurag Rana - Keybanc Capital Markets",
"text": "Good morning, everyone. Congratulations on a good quarter. If you look back, GDV growth in Europe was averaging around 14% in local currency from 2004 to 2006, and we saw this growth rate increase to 18.4% in the fourth quarter and again above 17% in the current quarter. Could you please help us understand the key reasons for the increase in these growth rates? And then I have a follow-up."
},
{
"speaker": "Robert W. Selander",
"text": "The only thing I can observe on that is we’ve obviously had rapid growth in our business over there. As you will have noted, we’ve seen an increase in the number of MasterCard cards there consistently over the last several years. We had a couple of significant deals which began converting last year and we’ve seen continued converting, which we’ve shared with your previously with regard to -- for example, Lloyds TSB as well as HBOS, the Halifax Bank of Scotland in the U.K. So while I can’t point to a specific card base or market, it’s those type of events coupled with relatively healthy economies, although they are showing in both the U.K. and a couple of the continental European markets a bit of a slowdown. Those economies are generally remaining quite healthy for us."
},
{
"speaker": "Anurag Rana - Keybanc Capital Markets",
"text": "Thanks, and are you seeing any trends regarding the greater use of debt in the U.S. at this point, as compared to historical trends?"
},
{
"speaker": "Robert W. Selander",
"text": "Well, I think that we continue to see debit as a major opportunity not just in the United States but globally. And if you do look at the growth rates that we reported specifically for the U.S., you can see that charge and credit growth was, in terms of purchase volume, was about 6% first quarter, whereas debit growth was something over 18%. So what we see is increased acceptance by consumers of not just using their debit cards to get cash at ATMs but also going to the point of sale, coupled with a broadening of the issuance of those products in the United States."
},
{
"speaker": "Anurag Rana - Keybanc Capital Markets",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Christopher Brendler with Stifel Nicolaus. Please proceed."
},
{
"speaker": "Christopher Brendler - Stifel Nicolaus",
"text": "Thanks. Good morning. I wondered if you could talk a little bit more -- not to bit a dead horse a little bit here but the price increase, the new one that’s January ’08, my understanding from the conversation this morning is it’s a cross-border related fee for non-U.S. customers traveling to the U.S. Is that correct?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "There are a number of components in the pricing adjustments that we did. We typically don’t put out any specific component. I think we talked generally about it, the ones that are more significantly impact our financial statements and there were two things that we really talked about -- one, the new pricing changes on cross-border acquiring volumes. That’s one change, and the other change is for any retail purchases that are done in the U.S. by non-U.S. cardholders, there was a pricing change. So those the most significant ones that we can point to but let me tell you, there were a number of changes that we had in the menu."
},
{
"speaker": "Christopher Brendler - Stifel Nicolaus",
"text": "Okay, that’s helpful. I guess what I was going to hope to do as a follow-up is if you could address some of those pricing changes in any level of detail relative to the comment that you are sensitive to your customers and the fact that they are struggling financially, or many of them are struggling financially, given what’s going on in the world economy, and especially here in the U.S. And also, this discussion of the cross-border interchange ruling in Europe -- do any of these things have any impact in terms of being sensitive to your customers and also the cross border regulatory ruling? Does that have any impact on your ability or what you’ve decided to do in January in the price increases or are those kind of -- you have value-added services that you are adding, you feel like you are pricing appropriately for, so I think you are remaining sensitive to those issues and it’s not a concern going forward?"
},
{
"speaker": "Robert W. Selander",
"text": "I think you summarized it very well just then. When we produce additional value, we feel we can price for that and it’s a win-win situation and obviously to the extent we offer a new service that may bring let’s say scale to a customer where they don’t have scale, that saves them money and it gives us new revenues that we would not otherwise have had. We are working with our customers in all parts of the world and these are challenging times for many of them. Clearly the customers in the U.S. with where we are going in terms of the credit cycle and so forth, are feeling pressures in their payments business if they have not felt pressures in some other part of their company, due to mortgage or other issues. So we do work with them on things like portfolio optimization. We work to improve their marketing effectiveness. We will work with them on how they broaden and expand the usage of existing products, so we have efforts underway, for example, to get into the utilities and rental categories, which are other non-discretionary spend areas to see if we can help our customers capture those on our products. And then we are also working on helping them to explore and grow into other areas, such as healthcare. Specifically with regard to the cross-border interchange issue in Europe, as you know we are not direct economic participants in interchange. That’s a flow from the acquirer, financial institution, that goes back to the issuing institution. And what we are trying to do is ensure that we do not have a situation where MasterCard is not viewed as a good product to be issued by issuers, or for that matter a product that wouldn’t be appropriate to continue to be acquired by acquirers. So while it doesn’t impact us directly, we are working to find a way both to comply from our perspective about the order but to also maintain a competitiveness and attractiveness of our products. Over time, if there is an undermining of the capabilities of issuers or acquirers because of regulatory intervention, to have acceptable business cases they are going to slow down their investments in their payments business and clearly that will have an impact on us because there will be less robust growth, less support for the activities we are involved with. So that’s the longer term implications if we don’t manage through this in the short-term in a positive way."
},
{
"speaker": "Christopher Brendler - Stifel Nicolaus",
"text": "Absolutely. Just one quick follow-up, if I could; the fee for the non-U.S. customers traveling to the U.S., is that primarily passed on to the consumer?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "It’s an acquiring fee, so it’s paid by the acquirer at that point in time. That’s all I can say."
},
{
"speaker": "Christopher Brendler - Stifel Nicolaus",
"text": "Thank you very much."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Sanjay Sakhrani with KBW. Please proceed."
},
{
"speaker": "Sanjay Sakhrani - Keefe Bruyette & Woods",
"text": "Thank you. I appreciate that regional color on the cross-border volume but I was just wondering -- in your analysis, have you guys attempted to sort of decipher how much is driven by a fundamental change in the way customers or consumers are traveling versus what is being cyclically driven? And then I have one follow-up. Thank you."
},
{
"speaker": "Robert W. Selander",
"text": "The answer is we haven’t been able to sort it the way that or parse it the way you’ve described. Clearly we have fairly robust data on how transaction patterns occur and that’s something that we work with our customers to better position ourselves and them to both support their cardholders, to capitalize on promotions and other things that we might do with merchants. But we haven’t got that kind of data to share with you today."
},
{
"speaker": "Sanjay Sakhrani - Keefe Bruyette & Woods",
"text": "Okay, great. And then just on the M&A environment, I was wondering if you had any thoughts on it or any color to offer? Thanks."
},
{
"speaker": "Robert W. Selander",
"text": "Well, I guess two observations -- the first is that we’ve indicated that any time we would look at, and we do look at various opportunities, we go through a criteria that includes does this align with our strategy, will it make financial sense for the company and shareholders over time, can we integrate this and if we are not capable from an experienced management standpoint within MasterCard, are we going to be getting talent as a result of the deal? The only transaction I would point to that closed -- I guessed it closed on April 1st, was our deal with Europay France. That is a business that we’ve now -- I won’t say we’ve fully integrated it but we certainly have made it part of the MasterCard family in Europe and that will enable us to provide additional services to banks in France, and over time we hope to take advantage of some of the things they were doing there possibly in other parts of Europe."
},
{
"speaker": "Sanjay Sakhrani - Keefe Bruyette & Woods",
"text": "I know pricing was a big issue. Have you seen any noticeable shift in terms of pricing?"
},
{
"speaker": "Martina Hund-Mejean",
"text": "No, not really. I mean, all that we have to say we already said."
},
{
"speaker": "Sanjay Sakhrani - Keefe Bruyette & Woods",
"text": "Okay, great. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Charles Murphy with Morgan Stanley. Please proceed."
},
{
"speaker": "Charles Murphy - Morgan Stanley",
"text": "I thought it was interesting how strong purchase GDV growth in Europe was. Is it possible to isolate how much of European purchased GDV comes from cross-border GDV?"
},
{
"speaker": "Robert W. Selander",
"text": "I’m sure somewhere we have that data. I don’t have it handy and it is not something that I believe we’ve shared at this point in time. Obviously within Europe we have about 50 countries in our Europe region, so it is much more than the EU. It goes right through what would be considered Eastern Europe and includes Russia, Turkey. So we do have, as you know, a situation where it is pretty easy to jump in your are and driver across two or three borders in the course of a couple of hours in much of Europe, so there is a reasonably strong mix of cross-border activity that takes place in that market."
},
{
"speaker": "Charles Murphy - Morgan Stanley",
"text": "Okay, and as a quick follow-up, I think you’ve hinted in the past that most process transactions come from the U.S., U.K., Canada, Brazil, and Australia. Could you describe the key hurdle to winning new process transaction business in Asia-Pacific and in Latin America?"
},
{
"speaker": "Robert W. Selander",
"text": "Well, the hurdles are pretty much the same everywhere in the world. Generally you have banks or bank-owned consortiums operating in many of these markets and as the banks look at whether or not those are economically attractive things for them to continue to do, or in some cases when they decide they want to heighten the competition so that as an individual financial institution, they can differentiate themselves either with the merchants when it comes to dealing with the merchants on the acquiring side or with the cardholders on the issuing side. You tend to see an evolution where they begin to think okay, I want to take on my own issuing or my own acquiring and these shared companies that they’ve established are either sold or in some other way -- I’m hesitant to say disposed of but take the case of the acquiring business in Brazil. You saw a group of banks there spin off Redecard or a portion of Redecard through an IPO. We were a participant in that, as you know, and have completed the sale of our Redecard shares. We see analogous situations in many of the other markets around Latin America and Asia. That’s playing out the way the U.S. -- or we think it will play out similarly to the way the U.S. is playing out and the way the game is afoot in Europe today."
},
{
"speaker": "Charles Murphy - Morgan Stanley",
"text": "Thanks very much."
},
{
"speaker": "Barbara Gasper",
"text": "Operator, I think we have time for one more question, please."
},
{
"speaker": "Operator",
"text": "Your next question will come from the line of Bruce Harting with Lehman Brothers. Please proceed."
},
{
"speaker": "Bruce W. Harting - Lehman Brothers",
"text": "Thanks. Just following up on the last question, it does look like your purchase volume in Europe, if I go back three years or so, continues to pick up and if I’m reading this correctly, it was your strongest quarter in quite a while. It seems like you and Javier have said that SEPA is not going to be like a big bang where you just go from one quarter to the next and announce you’ve made some big wins in processing and other things. So how much of the steady growth are we seeing as Europe creeps up and contributes a larger portion of your overall GDV and revenue if SEPA wins, or sort of the Lufthansa win or the Carte Bancaires win? And will this be just a very subtle but very promising trend that we see develop each quarter? And your economies of scale just continue to amaze, and Asia continues to creep up quietly as well as a percent of GDV. I’m wondering if -- I know you don’t break out your expense or marketing by region, but is that getting a disproportionate amount of that spend? Thanks."
},
{
"speaker": "Robert W. Selander",
"text": "Let me try and take a crack at that. I guess there were a couple of questions embedded there. With regard to Europe and the points that Javier and other of my colleagues have made, I would agree that we don’t see this as one day all of a sudden our business is going to double or whatever. Rather, it is through blocking and tackling as domestic players look at whether or not they are going to continue to run their domestic processors or maintain their domestic brands. And we are very well-positioned with Maestro on over 300 million cards in Europe to offer -- in fact, we’ve built it with the banks in Europe over the last 15 years, really the leading cross-border debit alternative in Europe. And that migration from national use only brands to Maestro has begun. I believe we referred to this -- I’m not sure we did it in the last quarter’s call but we have about 20 million cards in Germany, Italy, Ireland, Portugal and The Netherlands where there are agreements and we are beginning to see those cards as they are reissued as Maestro cards begin to function and operate as Maestro cards. If you look across Europe, we are now in a position where we can process a larger number because of the connectivity of transactions that might otherwise have gone through as domestic transactions. So for example in Italy, over 14% of all debit card transactions are processed by MasterCard under our Maestro brand and we see that continuing to grow, both the number of transactions as well as the penetration of that. So we are very optimistic about what that means in Europe. With regard to your sort of embedded second question, we are very optimistic about our growth in many markets around the world. Asia-Pacific has demonstrated very strong growth this quarter as compared with some of their past quarters, and so that is in part a reflection of the healthy economies out there but also in the degree to which there is a lot of cross-border activity taking place within that region as well. And of course, we process all the cross-border transactions."
},
{
"speaker": "Martina Hund-Mejean",
"text": "Let me just add to Bob’s remarks a little bit based on what he said before -- you know, for the deals that we have struck in Europe, we do see some increased volume and we basically attribute that to two factors; one, obviously the value proposition that we have with our platform in Europe, but two, also the increased secular, or let’s say continuing secular trends from paper to electronic payments in Europe, which we believe is a very promising trend going forward."
},
{
"speaker": "Bruce W. Harting - Lehman Brothers",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "At this time, we would like to turn the call over to Mr. Bob Selander, Chief Executive Officer, for closing remarks."
},
{
"speaker": "Robert W. Selander",
"text": "I really don’t have a lot to add. I appreciate all of you joining us today. We are very pleased with our results for the first quarter and we look forward to speaking with all of you again when we talk about the second quarter. Thanks very much."
},
{
"speaker": "Operator",
"text": "Thank you all for your participation in today’s conference. This concludes the presentation. You may now disconnect and have a great day."
}
] | null | null |
MRK | 4 | 2,008 | 2009-02-03 17:00:00 | Eva Boratto: Thank you, Taylor and good morning. Welcome to our call to review our business performance for the fourth quarter of 2008. Joining me on the call today is our Chairman, President, and CEO, Dick Clark; Ken Frazier, our Executive Vice President and President of Global Human Health; and Peter Kellogg, our Executive Vice President and Chief Financial Officer. Before we get into the details, I'd like to go over some logistics. On this call, we will review the results contained in the release we issued at 7:30 this morning. You can access this through the Investor Relations section on merck.com, and I would remind you that this conference call is being webcast live and recorded. The replay of this event will be available later today via phone, webcast, and podcast. As we begin our review, let me remind you that some of the statements made during this call may discuss certain subjects that may contain forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. These statements are based on management's current expectations and involve risks and uncertainties, which may cause results to differ materially from those set forth in these statements. The forward-looking statements may include statements regarding product development, product potential, or financial performance. No forward-looking statement can be guaranteed, and actual results may differ materially from those projected. Merck undertakes no obligation to publicly update any forward-looking statement, whether as a result of new information, future events, or otherwise. Forward-looking statements in this press release should be evaluated together with the many uncertainties that affect Merck's business, particularly those mentioned in the Risk Factors and Cautionary Statements in Item 1A of Merck's Form 10-K for the year ended December 31, 2007 and in any Risk Factors or Cautionary Statements contained in the company's periodic reports on Form 10-Q, or current reports on Form 8-K, which the company incorporates by reference. We will begin the call with brief remarks from our senior management, and then open the call for your question, and expect the total call to last approximately an hour. With that, I'll turn the call over and we will begin with remarks from our Chairman, President, and CEO, Mr. Clark.
Richard T. Clark: Thank you, Eva and good morning everyone. Earlier this morning, we announced results for the fourth quarter and full year 2008. The solid financial results we reported today reflect both the challenges we faced in 2008 and the benefit of our broad product portfolio. In 2008, we improved efficiencies, managed through a dramatically changing industry environment and took actions designed to better position Merck for success. And we did so during a very difficult and unsettling time for the U.S. and global economies. In terms of top line for the full year 2008, we recorded revenue of $23.9 billion, 1% lower than 2007. Excluding the impact of the loss of marketing exclusivity for FOSAMAX in 2008, revenue increased by 5% for the full year. Our full year 2008 non-GAAP earnings per share were $3.42, which excludes certain items. While our full year GAAP EPS were $3.64, reflecting the excellent progress we've made in improving our cost structure and strong growth in key products; JANUVIA, JANUMET, ISENTRESS and ROTATEQ. Today, we also confirmed our top and bottom line expectations for the full year 2009. Non-GAAP EPS, we expect to be in the range of $3.15 to $3.30 excluding anticipated restructuring charges, and for 2009 GAAP EPS, in the range of $2.95 to $3.17. For full year revenue, we continue to expect to be in the range of $23.7 billion to $24.2 billion. So based on what we see at this early point in the year, we think revenues are likely to be in the lower half of that range. Peter will be walking you through some additional details on 2009 guidance and 2008 results a bit later on today's call. Also in a few moments, Ken will review the performance of our key products as well as our expectations for them. He'll talk about GARDASIL and the impact on revenue and the delay in the FDA approval of the adult women indication. Now, let me make a few observations about 2008. We were pleased with the standout performance of initiative Merck medicines like JANUVIA, JANUMET, ISENTRESS and ROTATEQ in 2008. We have designed our franchise operating models to manage the entire lifecycle of our products, and they have enabled us to maximize the value of more established products such as COZAAR, HYZAAR and FOSAMAX. Though results for SINGULAIR and GARDASIL were not where we would have liked them to be, Ken will discuss their performance and improvement actions we have underway. Next, I'd like to share a few thoughts on the progress we've made in transforming Merck during 2008. We continue to move away from outdated commercial and business models to a new more effective and efficient of operating. We've moved forward with our new approach to customers through our commercial models and with re-engineering our basic research global operations and our new clinical development model. Those efforts are helping to make us leaner, more agile and better positioned for the long term. By focusing on our core strengths, the new Merck we are building will maximize the value of our current product portfolio and our pipeline. That will enable us to pursue growth through initiatives such as Merck BioVentures in emerging markets, as well as take advantage of the right strategic opportunities. In 2009, we are building on the progress we've made and taking our supply chain management to the next level using Lean Six Sigma. We are on track in the United States to implement an SAP information technology system that is the key step in fundamentally changing how we run this company. Merck's overall financial strength, especially during these difficult economic times, is an advantage that enables us to pursue the important work of transforming our company. Let me move next to our global restructuring efforts. More than just reducing Merck's cost structure, our restructuring initiatives are creating a leaner and more flexible company that is appropriately sized and scaled for the new pharmaceutical operating environment. In 2008, we completed our 2005 restructuring program and we're on track to realize total cumulative savings of approximately 4.5 to $5 billion by 2010. Our 2008 restructuring plan is well underway, and we continue to expect the capital yield of cumulative pre-tax savings of $3.8 billion to $4.2 billion from 2008 to 2013. As a result of our restructuring programs, Merck had approximately 55,200 employees at the end of the year 2008, a 10% reduction compared with the 61,500 we had at the end of 2005. We exceeded this reduction while at the same time continuing to hire employees with the new skills and expertise we need to achieve our long-term strategic goals. We have made significant progress streamlining all management layers across the company, since we announced the effort last October. At that time we outlined plans to reduce our total number of senior and mid level executives by approximately 25%. Those plans are on track. Let me also emphasize that lowering our costs does not come at the expense of supporting our key products in the marketplace. We are fully supportive of our key brands and are continuing to invest in our pipeline. During 2009, we expect to file NDAs for three promising candidates in Phase 3 that address patient needs in the treatment of migraine, acute heart failure and lipid management. In fact, Merck's pipeline includes nine Phase 3 programs continuing in 2009 and nine new Phase 3 programs anticipated to start this year. Finally, I want to comment on vaccine manufacturing. As I mentioned in December, one of our top priority is addressing supply issue for our vaccines. Merck is responsible for providing many of pediatric, adolescent and adult recommended vaccination in the United States. And we take this job very seriously. Our vaccine manufacturing is inherently complex; we are prioritizing our vaccine production based on the public health needs. We regularly communicate with customers, public health agencies, professional societies about the status of our vaccines. We make sure they know when we are returning to normal shipment times as well as when we are experiencing shortages or delays. In addition, we routinely update our customer website to communicate comprehensive information on a timely basis. Finally, I want to note that we are investing nearly $1 billion to help ensure we have consistent, robust manufacturing practices and processes that meet existing demands for our vaccines, as well as expand our capacity to meet demand for the next generation of vaccines under development. While we are focused on building a company that will be a tough competitor in the environment that is very different than one we have known, we are being very careful to protect the values that have long distinguished Merck. Meanwhile, as these harsh economic times continue in the U.S. and around the world, our customers including patients, payers and healthcare providers are likely to feel the effects in one way or another. Just about all economic forecast data, the United States is in a prolonged period of unemployment, and high unemployment means a rise in the number of people without health insurance. That's why we are already engaged with the new administration and Congress to support reform of this country's healthcare system. And now part of the United States where most people still lack adequate access to medicine, vaccines and healthcare, we continue to work independently and in partnerships to improve access to our products. In closing, I want to emphasize that as we move ahead in 2009, the level of determination and the energy throughout our organization remains high. Our employees are the most talented, dedicated people in this industry. They clearly understand the new era for pharmaceutical companies is here today. We strongly believe Merck has what it takes to succeed in a world that places great value on the scientific innovation that continues to be the hallmark of this company. Now, I'd like to turn the call over to Ken and then Peter, who'll summarize our financial results. After their brief remarks, we will take your questions. Ken?
Kenneth C. Frazier: Thanks, Dick and good morning, everyone. As we move into 2009, we must overcome the lingering effects of last year's business challenges to some of our key products; capitalize our new opportunity all the while continuing to implement our new commercial model. As we announced today, overall revenue was down 3% in the fourth quarter of 2008 and 1% for the full year. Excluding the impact of the loss of marketing exclusivity for FOSAMAX in 2008 however, revenue increased 5% in the fourth quarter and the full year. The increase in revenue in the fourth quarter excluding the impact of FOSAMAX was driven by strong growth for a number of our recently launched products including JANUVIA, JANUMET and ISENTRESS. And we also achieved strong growth for ZOSTAVAX as we cleared the majority of the backorders. Outside the United States, our reported revenue grew 5% with strong volume increases of 10%, thanks to continued launches of new product and strong performance from many of our inline brand. As we saw in the first three quarters of the year, our revenue growth internationally was offset by continued challenges to driving demand for SINGULAIR and GARDASIL in the U.S. Our overall U.S. business along with that of others in our industry may have been affected by general slowdown in prescriptions for newer medicine. In addition, the price shortfall of some of our vaccines during 2008 and the year-over-year effects of clearing VARIVAX backorders in the fourth quarter of 2007, also contributed to the sales decline. Before I get into the details of the performance of some of our key products, I'd like to comment briefly on the current global economy as it relates to our business. At this point, it is difficult to determine whether into what extent the economy could have impacted our 2008 performance. However, many patients, providers and payers around the world are facing difficult choices about spending, which could affect healthcare utilization at the macro economic level and could also affect individual brands as well. We will continue to monitor these trends closely and factor them into our activity and our guidance. Now, moving to performance of our key brands; beginning with GARDASIL, our HPV vaccine. Sales as reported by the Merck in the fourth quarter were $286 million, a 16% decline when compared to the fourth quarter of last year. In the U.S., sales declined 19% and ex-U.S. sales declined 2%. The ex-U.S. sales decrease was attributable to a decline in Australia because a significant portion of the female population was vaccinated in previous years as part of the publicly funded vaccination program. In addition, sales of GARDASIL in our SP-MSD joint venture in Europe decreased by 26% versus fourth quarter '07 to 171 million. This is due to a slowdown in demand in large early adopting markets like Germany. Other later adopting markets will continue to grow and we will compete for new government tenders in 2009. The fourth quarter decline for GARDASIL in the U.S. was affected by three factors. First, as expected, because of the broad use of GARDASIL since launch, the total number of 11 to 18 year olds who have already been vaccinated have increased. As a result, despite continued vaccination in this age group, the overall number of first dose vaccination of 11 to 18-year old has declined. Second, also as one would expect, there were fewer second and third dose vaccinations in the fourth quarter because there were fewer first and second dose vaccine as administered during the previous two quarters of 2008 when compared to the same period in 2007. Third, because of continuing challenges to vaccinating the 19 to 26-year old age group, we observed a decline in total vaccinations, during the past quarter compared to the fourth quarter of 2007. I'll remind you that 2007 was the first full year of launch and vaccination rates included the impact of early adopters who are not deterred by some of the barriers to vaccination for this segment. As I mentioned in December, we learnt that OB/GYNs believed that they have vaccinated a significantly larger percentage of their patients than their actual vaccination rates indicate. As a result, we are implementing program to make OB/GYNs aware of the actual vaccination rates in their practices. Our customers appreciate this initiative as they continue to believe in the importance of this vaccine. Here are some other examples of some of the programs we have underway. Approximately 6,500 OB/GYNs and primary care officers have enrolled in the dose replacement program which we launched in 2Q 2008 to address their reimbursement concerns. In the first two to four months since enrollment, we've observed an 8 to 10% lift in sales at these locations versus other locations. Our in-office patient outreach program for physicians and unvaccinated women and parented eligible female has enrolled more than 8000 offices and is distributing 2.5 million patient mailers. This program rolled out in September of 2008. Last week, more than 4 million enrollees in managed care plan have been informed about coverage of GARDASIL. We've learnt much more about the practice-relating and financial challenges affecting vaccination rates, especially for 19 to 26 year olds. The opportunity is still there. Our research indicates that most of these women maybe receptive to vaccination, in fact less than 10% have decided not to be vaccinated. While early indications suggest that our programs are beginning to have an effect, the issues they are designed to address are complex and vary from practice to practice. We believe that is why we've not yet seen an impact on vaccination rates overall. In the 11 to 18-year old group, where high vaccination rates have already been achieved, we continue to work with pediatricians and family practitioners to reach patients -- parents excuse me, whose daughters have not yet been vaccinated. As you all are aware, in January, we received the second complete response letter from the FDA to our application for the use of GARDASIL in women aged 27 to 45. And based on that letter, we now anticipate responding to the agency in the fourth quarter of 2009. As a result of delay of the approval and the declining vaccination rates among 19 to 26-year olds towards the end of 2008, we are reducing our 2009 guidance to 1.1 to 1.3 billion. This guidance takes into account both the high level of vaccination already achieved in the adolescent population as well as the challenges of substantially increasing vaccination rates among the 19 to 26-year old population, where the proportion not yet vaccinated is greatest. These challenges, not withstanding opportunity remains for GARDASIL, the millions of women not yet vaccinated in the 19 to 26-year old population as well as the millions of males and adult women we expect to become eligible for vaccination with GARDASIL over the next two years. I should note here that the FDA has accepted our application for use in males. We continue to believe in GARDASIL's potential to drive revenue growth. We are fully investing in these programs, and we'll invest in additional innovative programs to drive demand for this product. Also, let me be clear that our overall cost reduction have not been and will not be at the expense of fully funding the programs needed to help GARDASIL realize its full potential. Now, I'd like to take a moment to discuss ZOSTAVAX. Total fourth quarter sales as reported by Merck were $162 million, as we cleared the majority of backorders in December 2008. We are working with our customers to drive appropriate utilization for this novel vaccine. For example, we've implemented a patient notification service and pharmacy-based outreach initiatives. Demand for ZOSTAVAX continues to be strong, and we currently believe we will clear all existing backorders in the first quarter of 2009, and that we will have normal shipping time sometime within the second quarter. Once the backorders are resolved, we expect to have adequate supply to meet anticipated U.S. customer demand for the rest of 2009. We remain excited about the potential of ZOSTAVAX and we look forward to supplying this important vaccine to our customers. Turning to SINGULAIR, sales in the fourth quarter were 1.1 billion, down 3% versus the prior year. Performance in the fourth quarter reflects the decline in the U.S. business of 11%, which was partially offset by strong 15% growth outside the U.S. SINGULAIR continues to do well in Japan, for example, thanks to the successful launch of the allergic rhinitis indication and the introduction of the oral granular formulation for pre-school aged children. For the full year, the U.S. performance for SINGULAIR was affected by the availability of ZYRTEC OTC, a smaller allergic rhinitis season in both the spring and the fall and the FDA early communication in March 2008. Merck is pleased that the FDA has now issued its follow-up to its early communication on SINGULAIR. Our sales force is prepared to provide appropriate information to healthcare practitioners about the FDA communication. Merck stands by the proven efficacy and safety of SINGULAIR, a medicine that has been prescribed to tens of millions of patients with asthma and allergic rhinitis for more than 10 years. We are devoting significant resources to programs designed to improve performance and drive growth of SINGULAIR in the U.S. Our sales force had new materials for use for physicians and SINGULAIR remains the key priority as we roll out our new commercial model in the U.S. early this year. We continue to utilize multiple channels for SINGULAIR, including new trial and coupon kit for new patients, educational materials, print, TV and online DTC, in-office branded marketing programs, pharmacy programs, and adherence initiative. We have the resolve as well as the resource plans and materials to ensure SINGULAIR remains the number one respiratory product in the U.S. We are very pleased with the performance of ISENTRESS since its global launch in the fourth quarter of '07. Sales in the fourth quarter were 130 million, up 21% sequentially versus the third quarter. In the U.S., fourth quarter sales were 71 million and continue to exceed the last five launches in TRX market share through December. On January 30, the U.S. Food and Drug Administration granted conditional approval to ISENTRESS following review of the 48-week data from the BENCHMARK-1 and 2 clinical study. ISENTRESS was originally approved under the FDA's accelerated approval process in 2007 with 24-week data. ISENTRESS is currently approved in 70 countries on six continents including all top 10 HIV markets. Overall, uptake has been strong and we look forward to continued success in 2009. Global revenue for JANUVIA and JANUMET grew in the fourth quarter to reach 532 million, up 11% sequentially versus the third quarter. In U.S., JANUVIA continues to be the second leading branded oral antidiabetic agent in terms of new prescription share. Despite the slowdown in the overall U.S. diabetes market last year, the JANUVIA/JANUMET franchise continues to grow in both volume and share, and is the fastest growing family of products in the oral segment of that market. JANUVIA delivers strong once-daily efficacy in a single pill without compromising the weight gain and hypoglycemia associated with other oral diabetes therapy. JANUMET combines JANUVIA with metformin for powerful ultra fast efficacy. We have invested in new patient educational tools administered by diabetes educators around the U.S. and we have an integrated adherence program to help patients remain on JANUVIA and JANUMET therapy. In addition, we are extremely pleased with the international performance of JANUVIA/JANUMET in the fourth quarter. In the EU, these medicines are the fastest growing family of products in the oral diabetes market. JANUVIA is the only marketed DPP-4 inhibitor that is once-daily for all indications. It is widely reimbursed and JANUMET is gaining equally strong reimbursement status. In all markets where more than one DPP-4 exist, sitagliptin is the market leader. Finally, India, Brazil and other emerging markets have enjoyed strong growth since launch. Globally, more than 10 million prescriptions that are written to-date and as these products are major growth drivers for Merck in the short-term as well as the long-term, we are investing in them to ensure that we realize their full potential. As we mentioned at the annual business briefing, we have one new fixed-dose combination product in Phase 3 development with pioglitazone and we anticipate starting two new Phase 3 development programs this year, an extended release for JANUMET as well as a sitagliptin simvastatin fixed-dose combination. Now, I would like to take a moment to provide an update on the performance of our cholesterol JV. Let me start by saying, we are pleased that the FDA has completed its review of the ENHANCE study, and that their tradition (ph) remains that elevated LDL-C cholesterol is an important risk factor for cardiovascular disease. The agency goes on to say that based on currently available data, patients should not stop taking VYTORIN or other cholesterol lowering medication and should talk to their doctor if they have any questions about VYTORIN, ZETIA or the ENHANCE trial. Our sale forces are prepared to provide appropriate information to healthcare practitioners regarding the FDA communication. Moving to performance, worldwide sales of ZETIA and VYTORIN as reported by the Merck/Schering-Plough joint venture were 525 million and 549 million respectively in the fourth quarter. Sales of ZETIA were down 23% and sales of VYTORIN were down 29% versus the prior year. Market share for ZETIA and VYTORIN in the U.S. appears to be stabilizing. Outside the U.S., sales of the fourth quarter were flat relative to 2007, but were up 13% after adjusting ForEx change. We continue to anticipate growth outside the U.S. in 2009, excluding the effect of foreign exchange. We will remain steadfast in our support for ZETIA and VYTORIN, which continue to be valuable treatment options for physicians by helping to get more patients to their LDL goal. Before I close and turn over the call to my colleague, Peter Kellogg, I just want to mention that we are continuing to progress in our global rollout of new commercial model, which are designed to respond directly to our individual customers needs around the world. In the EU, many of our new models are already established; and in the U.S., we expect to complete a national rollout in early 2009 after strong pilot results achieved last year. We fully expect this model will help us drive revenue growth for key franchises and markets while improving efficiency and customer value associated with all of our customer interactions. I look forward to updating you closer about our progress in this important initiative in future calls. In closing, I assure you that the entire Global Human Health Organization is focused upon restoring growth in 2009 by continuing to address challenges with some of our key products and by capitalizing on opportunities with our customers. Notwithstanding the overall slowdown in branded prescription growth for primary care brands in the U.S., Merck has a portfolio of medicine and vaccine that offers unique value to our customers. And we continue to believe that tremendous commercial opportunities exists to grow our established and our newer brand in markets around the world. We are confident that our continued focus on efficiencies on the marketing and administrative lines demonstrated through 2008 will help drive overall margin improvement, and that the plans we have in place to fundamentally change our business model will enable us to better meet the needs of our varied customer base and to drive the top line for our medicines and vaccines. So with that, I will turn the call over to Peter Kellogg.
Peter N. Kellogg: Thank you Ken, and good morning. I will provide an update on the following; our fourth quarter and 2008 results and our 2009 guidance. Now for guidance, I will only highlight those elements of our guidance that have changed as we provide a breakdown of all the elements of our guidance in our other financial disclosure schedule attached to the press release issued earlier today. Merck reported fourth quarter non-GAAP earnings per share of $0.87, representing growth of 9% over the fourth quarter of 2007. On a GAAP basis, EPS for the fourth quarter was $0.78. As Dick and Ken discussed, fourth quarter results reflect the blend of revenue performance, strong expense management, and a favorable tax benefit. For the full year 2008, non-GAAP earnings per share was $3.42, representing a growth of 7% over 2007. On a GAAP basis, EPS for the full year 2008 was $3.64. Turning to revenue, total revenues in the quarter, as reported by Merck, was $6 billion. Total revenue for the year was 23.9 billion. Now Ken already walked you through product performance, so I'll quickly just cover the guidance. As Ken shared with you, we are reducing our 2009 guidance for GARDASIL by $300 million to a new range of 1.1 billion to $1.3 billion. Moving in the other direction, we are increasing our guidance for supply sales to AstraZeneca by $100 million to a new range of 1.3 billion to 1.5 billion, reflecting current market trend. We continue to expect 2009 revenue in the range of 23.7 billion to 24.2 billion. However, based on current information, it is likely that revenues would be in the lower half of that range. Our fourth quarter materials and production costs were 1.5 billion, which includes 33 million for costs associated with the global restructuring program primarily related to accelerated depreciation. Excluding restructuring costs in 2008 and 2007, material and production increased 1% in the quarter. Reported PGM was 75.6%. Excluding the restructuring costs, PGM was 76.2%. Just as in previous periods, these results reflect our final product mix, particularly driven by the patent expiry related decline from the Q4 U.S. COZAAR/TRUSOPT expiry and the Q1 U.S. FOSAMAX expiry. Marketing and administrative expenses were 1.9 billion in the fourth quarter, an increase of 8% versus the fourth quarter of 2007. But let me provide you some additional perspective on that. Included in the fourth quarter of 2008 marketing and administrative expenses is an increase of $62 million to the VIOXX legal defense reserve. Included in Q4, 2007 was a gain of $455 million from insurance proceeds. Excluding these items in both 2007 and 2008, M&A expenses decreased 17% in the fourth quarter. The lower spending for the quarter and the year is attributable to savings from our new commercial model that Ken discussed and corporate G&A efficiency programs. We are benefiting from U.S. sales force reductions completed in July and similar European sales force reductions during the year. We are also continuing to realize reductions in our administrative expenses, as Dick mentioned earlier, particularly in some of the support functions. We have maintained a healthy amount of support behind our core and successful newer franchises. I would also note that 2008 spending was reasonably steady throughout the quarters, highlighting consistent and steady investments. Full year M&A was 7.4 billion, down 6% versus 2007 excluding legal defense reserves in 2007 and 2008 and the $455 million insurance arbitration gain recorded in 2007. Turning to research and development, expenses in the fourth quarter were $1.4 billion, essentially flat versus the fourth quarter 2007. When you adjust for the restructuring cost in the fourth quarter of 2008, Q4 R&D spending is down 7%. The fourth quarter year-over-year comparison is affected by the timing of research activities with third-party collaborations. Now we continue to invest in late-stage clinical trials and in the fourth quarter, there was increased spending to support development programs for our promising new drug candidates, among which are rolofylline, odanacatib, 5-LO, anacetrapib as well as JANUVIA. For the full year, R&D expenses were $4.8 billion. When you address the restructuring charges recorded in 2008 and the $325 million acquired research charge associated with the purchase of NovaCardia in the third quarter of 2007, R&D expenses grew 3%. We remain committed to fully funding core internal and external R&D, ensuring the continued progress of compounds in all phases of development. Now let's turn to equity income. In the fourth quarter, Merck reported $720 million of equity income. There were two major impacts in this result. First, the equity income contribution from the Merck/Schering-Plough joint venture was down 30% or $160 million as results of ZETIA and VYTORIN market share losses in the U.S. Outside the U.S., sales in the fourth quarter were flat relative to the 2007. However, if we adjusted international Q4 results for exchange, MSP sales increased 13%. Second, the AstraZeneca joint venture equity income was $267 million, which is $55 million higher in the fourth quarter compared to the prior year. This increase in equity contribution is attributable to the inherent timing variability of payments from AstraZeneca. Moving to other income and expense, that line for the fourth quarter was $3 million of expense. This compares to $567 million of expense in the fourth quarter of 2007, which included a $671 million charge related to the resolution of certain civil government investigations. Excluding that charge, other income expense was $107 million lower than the fourth quarter of 2007. The largest contributors to the year-over-year change is our balance sheet foreign exchange translational loss and lower net income, our interest income result as a result of the lower interest rate that we're all becoming accustomed to. Now moving to the tax line, Merck's fourth quarter GAAP effective tax rate was 14.7%. Excluding the impact of restructuring charges, the non-GAAP effective tax rate was 14.5%. These rates reflect, first, the benefit of approximately 5 percentage points related to the favorable tax impact of foreign exchange rate changes during the quarter, particularly the strengthening of the Japanese yen. And secondly, a benefit of approximately 3 percentage points related to the U.S. research and development credit, which was enacted as part of the Emergency Economic Stabilization Act on October 3rd. The resulting full year benefit is recorded in the fourth quarter. Now, let's turn to some other financial matters, and I'd like to take a minute to speak about Merck's overall financial strength. As you know, Merck maintains a strong balance sheet and a conservative investment policy. As of December 31st, our current cash and investment portfolio totals approximately $18 billion, which includes $6 billion pledged as collateral for bank guarantees related to certain items, including the VIOXX product liability settlement from last year. I also want to continue to emphasize that we have the financial strength to support our dividend, and we remain fully committed to maintaining it at the current level, while at the same time continuing to fund our important investment priorities. So to summarize, in 2008, despite the loss of patent exclusivity for FOSAMAX and continued challenges in our VYTORIN, ZETIA, SINGULAIR, and GARDASIL U.S. franchises, we achieved solid EPS performance. We delivered non-GAAP EPS of $3.42 for the year through aggressive expense management and strong growth in key products as Ken discussed, JANUVIA, JANUMET, and ISENTRESS. However, it is clear that we did benefit from foreign exchange on a full year basis and various discrete tax items. As we look ahead to 2009, we reaffirm our non-GAAP EPS guidance of $3.15 to $3.30 and this corresponding GAAP EPS guidance of $2.95 to $3.17. Please keep in mind as we think about the quarterly patterns, the company continues to expect GAAP and non-GAAP EPS in the first quarter to be less than one-fourth of the full year EPS. In addition, the company anticipates marketing and administrative expense and R&D expenses to be relatively equally distributed across the four quarters. We are reiterating our longer term guidance. We continue to expect revenues will have a compound annual growth rate of 2 to 4% from 2005 to 2010, including 50% of the revenues from the joint ventures. Merck's GAAP reported sales, which exclude the 50% of revenues from our joint ventures, is expected to have a compound annual growth rate of 1 to 3% from 2005 to 2010. Looking at non-GAAP EPS compound annual growth rate, we continue to expect it to be in the mid to high single-digit range over the same time period, excluding certain items with GAAP EPS compound annual growth of double-digits. Thank you very much. And I would like to turn the call back to Eva. Eva?
Eva Boratto: Thank you, Peter. We will now open the call to take your questions. We will take your questions in the order they are received and try to get through as many as possible. Joining us for the Q&A session is Bruce Kuhlik, our Executive Vice President and General Counsel. At this point, I will turn the call over to Taylor, who will communicate the instructions for our Q&A format and introduce the first question. Operator: Thank you. (Operator Instructions). Your first question comes from the line of Tim Anderson of Sanford Bernstein.
Tim Anderson: Thank you. I have a couple of questions. Just to be clear, on the revenue guidance for 2009, I am wondering if you can rank order the elements of why that maybe at the lower end of the range you gave just about two months ago. And then, foreign exchange impact on total sales in fourth quarter was only a negative 1%, which I think was the lowest of all the drug companies reporting thus far. And I'm wondering why that might be the case. Last question on ZOSTAVAX; can you give us the demand driven sales in fourth quarter ignoring the filling of backorders?
Peter Kellogg: Okay. Tim, it's Peter. Let me take the first two, and let me think about the ZOSTAVAX calculation here for a second. So, our comment related to the range for total revenue for the year really reflects the revision to guidance that we provided for GARDASIL, offset slightly by the AstraZeneca and then just some other trends that we are observing. And we are just kind of highlighting that as we rolled in two changes to the individual line items in revenue, we didn't change the full revenue guidance range, because we think it's actually it's very early in the year and there is a lot of... is quite a healthy range of outcome that could occur in a lot of different products. Certainly we've gotten some good letters back from the FDA, and we've certainly gotten some instinct developments in the lifecycle management as Ken talked about. So, but we primarily indicated the lower end because of the most recent trends in some business; but most importantly, it's the GARDASIL guidance revision. On foreign exchange, you are right. As you'll note in the attachment to the press release that our ForEx impact in the fourth quarter top line revenue was negative 1%. Now that, I really haven't actually checked all the other companies. But as you do know, we have a revenue hedging program at Merck that we roll in the hedges over time. And obviously, as we saw the foreign exchange rates peaking, I'd say in the first half of last year, we really wrapped up a lot of fairly good hedge positions. That certainly helped us. I'd say that we have... that's not something that I would characterize as unusual or unique. We have an ongoing hedging program that we roll in the hedges over three years. It's based against the major currencies. And so perhaps that was the driver of why the foreign exchange rate impact for us as it may appear little bit less than other companies. I really can't comment on the other companies. Finally for ZOSTAVAX, let me turn it over to Ken.
Kenneth Frazier: Thank you, Peter. As I mentioned, we are very pleased that we cleared the majority of backorders in 4Q '08 representing orders received in both 3Q '08 and 4Q '08. While we cannot estimate the amount of inventory at the provider level, we expect the volume of shipments in December will impact first quarter '09 purchases as provided resume normal order patterns. Prescriptions, which represent a portion of the business for ZOSTAVAX showed 4Q, '08 volume at levels comparable to 4Q, '07. And while it is difficult to estimate the total demand following the extended backorder period in second half of 2008, we consider this could be a positive sign of the demand for ZOSTAVAX. Thank you.
Eva Boratto: Next question, please.
Operator: Your next question comes from the line of Roopesh Patel of UBS.
Roopesh Patel: Thank you. I've got three questions. First on the tax rate, the 500 basis points benefit this quarter due to FX, Peter, I was just wondering if you could kindly elaborate on that and clarify if this is just a one-time benefit or if there is a spillover in 2009? Secondly, GARDASIL international sales down sequentially around 45% versus the prior quarter. Could you please elaborate on what explains this big deceleration? And lastly, on VARIVAX, if you could also just provide some color around its performance in the fourth quarter and what we should expect in 2009? Thanks.
Peter Kellogg: Hi, Roop; this is Peter. Let me take the first one on the tax, the five points of impact from the yen strengthening. So, just summarize very quickly, I would view that, I would anticipate that to be a one-time event. We do see sometimes foreign exchange impacting our net monetary assets on our balance sheet. And sometimes when certain movements occur, they can create a gain or loss; and some times that loss on a tax basis does create a deduction on our cash return. So it generally tends to be only in periods when the currencies such as yen, a big currency like the yen, moves back significantly in a short period time and create a noteworthy gain or loss. In this case, it's a loss that is on a tax basis is deductible. For the performance of GARDASIL versus prior quarter, it was down 45%. So Ken, I want to turn that over to you.
Kenneth Frazier: So I think there are a couple of things. As we mentioned, it was the fulfillment of the Australian program and the product impairs; that's one issue. The Canada program was implemented in the third quarter of '08. But I think the real issue here that we are pleased about is that we see continued strong uptake in markets across Europe as well as reasonably good uptake as it relates to the comparison of market share. And I will remind you that in those countries, where both vaccines are reimbursed by the government and physicians have a choice, GARDASIL has a share of 90% or greater in those markets. So we continue to be pleased with that. With respect to VARIVAX, in the fourth quarter '07 significant amount of backorders for VARIVAX, about $35 million were cleared. And when you adjust for those backorders, sales in the 4Q, 2008 were actually up 56%.
Eva Boratto: Next question, please.
Operator: Your next question comes from the line of David Risinger of Bank of America.
David Risinger: Thanks very much. I have operating, financial and R&D questions. First on the operations; can you discuss the SAP systems implementations? For many, many companies, they are often quite problematic. And can you explain your assumptions for being able to operate seamlessly despite the implementation? Second, in terms of your sequential quarterly outlook for the first quarter of '09, is there anything that you'd like to call out versus what you just booked in the fourth quarter of '08 that we should be sensitive to? And then third, with respect to ISENTRESS once daily, can you talk about the registrational trial timeline including when you'll disclose the interim look? Thank you.
Richard Clark: I'll take the SAP question. We are really confident in what we are accomplishing with SAP, probably for several reasons. One is that we have spent a great deal of time in making sure that the planning takes place, that we have line executives involved in it, that we really do our homework in making sure that we are putting the right systems in. And then quite frankly, we put a rule in place that we will do no customization, and any customization that takes place with our SAP system has to be approved by me. And a lot of the systems that haven't worked as well in the past have had a lot of customization, where it is very difficult to implement, but it is also very difficult to get the kind of savings we're talking about. So probably most importantly, what we've been able to do so far is that we have run a significant pilot, our first pilot in Mexico, and that went extremely well. We learnt a lot from that pilot. We made improvements as we go to our next market. And we just completed at the end of last year, a major pilot in Puerto Rico, which included manufacturing and finance in our Global Human Health from Puerto Rico. So it was a much larger project in pilot than just Mexico. And that was just spectacular. In fact, the feedback we are getting is that may have been one of the best pilots ever in SAP to go live. And Ken and I and Peter have spent a great deal of time in Puerto Rico celebrating with our team. So I think we have enough confidence that we have done two major pilots that worked well. We've made improvements. And the fact that we have line people involved and a significant amount of line people involved to go live in the United States gives us the confidence that we need.
Peter Kellogg: So David, let me take the second question, which was your -- I think was your financial sequential quarter question. And you said -- I think you asked basically where there are any items I'd like to call out going from Q4 to Q1. As I think about it, actually we have probably quite a few. So let me bounce you a few that I would think about. First of all, obviously last year, FOSAMAX went off-patent in February in the U.S. So we did have some sales in the beginning of Q1 last year with pre-patent expiry sales volumes and levels. Likewise, COSOPT/TRUSOPT went off our patent in October of this year. So you should look at the impact of that in the fourth quarter and think about that for the first quarter of this year. Now that, obviously some of that was in the fourth quarter already, and I think the same could be true about FOSAMAX because if you look year-over-year that will be important to think about. I mentioned several times that we are anticipating to see our expenses both in R&D and sales and marketing or SG&A. We also think it would be flat as we go quarter-to-quarter and through the year. In the past, we've seen some spikes in the fourth quarter and we don't anticipate seeing those, we didn't see them in 2008. We won't expect to see that again next year. I would highlight that if you look over time, clearly, there has been seasonality in our revenue. We tend to see January as our weakest revenue quarter. So I would highlight that that would be something to factor in your thinking, although I'm sure your models already have that. We did indicate also that we are working through the PGM trends right now. PGM is little softer in the fourth quarter. In fact, it was softer in the second half, but on a full year basis next year, we expect it to return. That may not proper our place (ph) in the first quarter, but these are all things to think about. Then I think equally importantly, we did see tax benefits in the first half of this year as well from the fourth quarter that I just discussed. And we would expect to return to the normal tax range that we would guide to our full year basis in the first quarter. So, those are things that come to mind, I would -- I can't go through and give you specific guides, but those are things to think, factors to think about.
Kenneth Frazier: As it relates to ISENTRESS in once-daily setting the trends away, as you know it started in the fourth quarter of 2008. I can't say when we will be able to provide any data as it relates to that, at the completion on look. But we do anticipate filing in 2011.
Eva Boratto: Next question please.
Operator: Your next question comes from the line of John Boris of Citi.
John Boris: Thanks for taking the questions. Dick, I think you mentioned that you would like to take advantage of the right strategic opportunity going forward. Can you just give some commentary or your thoughts on your appetite for large transformative deal versus smaller strategic type tuck-in acquisitions and what you mean by right strategic opportunity? And then, your commitment based on the amount of cash flow that you are throwing off, your commitment to the dividend going forward? And then on SINGULAIR, when do you anticipate that the FDA is going to come back to you on the review of your clinical data? And then on the litigation side on SINGULAIR, I think you will be entering the courts, litigating the patent on SINGULAIR with Teva. How confident are you that the judge will issue an opinion before the 30 months they expires? Thanks.
Richard Clark: Well John, in talking about strategic opportunities, as I mentioned over the previous few weeks, we are still very focused on strategic opportunities. Obviously, they will have to have shareholder value as we move forward, so it's not an event just from an event standpoint. Concerning large scale transactions, as I said before, I wouldn't rule anything out. I don't think in today's world, any CEO can categorically rule out any type of transaction. There are opportunities across the whole spectrum that we look at, and it could -- a point again is, the transaction has the financial and deliver value to our shareholders. So I think we're looking at the entire spectrum and quite frankly, an important part of how we look at thing is the importance of the dividend and to make sure that we continue to support a strong dividend, which has been part of Merck's reputation.
Kenneth Frazier: On SINGULAIR, as you know, we're pleased with the FDA statements to date relating to suicidality in the absence of any real evidence of a connection based on clinical data between SINGULAIR and suicide or suicidal behavior. We can't say or speculate on when the FDA will come forward with additional analysis of the data. That's underway with respect to the entire class.
Bruce Kuhlik: So... and this is Bruce Kuhlik. With respect to the patent trial, we still are scheduled to go to trial on February 23rd. And both parties have asked for a decision from the court before the stay expires on August 20. Based on the judge's history of decisions, we've got every expectation that we'll issue a decision before then, and obviously we would not expect that would delay beyond 30-month stay. And we have contingency plans in place in case if it does.
Eva Boratto: Okay. Given the time limit, there is time for about one or two more questions. Next question, please.
Operator: Your next question comes from the line of Chris Schott of JPMorgan.
Chris Schott: Great, thank you. Just a question on GARDASIL. Sequentially, should we expect a step up in U.S. GARDASIL sales relative to 4Q? So I am thinking it's relative to the patients getting their first and second doses over the summer returning for a third shot? Second question on GARDASIL, by your estimates, roughly what percent of 11 to 18 year old to this point have received at least one dose of GARDASIL at this point? And maybe just a final question with regards to larger... within a large M&A transaction as for the space. Just two points on that: first, do you see further opportunity on the cost side as we see what appears to be an accelerating trend towards cuts across the industry? I know you've done a lot, but is there more opportunity? And then when you say large transactions, you are looking on everything. Would that include another major pharma company? Thanks.
Kenneth Frazier: Starting with GARDASIL, at the current point in time, I don't think we are in a position to give specific guidance on the quarter-to-quarter patterns that we expect to see. As it relates to the 11 to 18 year olds, without getting specific, it is significantly higher in that population than it is, for example, in the older population. We've gotten much quicker penetration in the adolescent population with pediatricians and general practitioners than we have of the 19 to 26 year olds.
Richard Clark: From an M&A standpoint, as I said before, anything we do must make sense from a shareholder standpoint. And as you've heard me say before, I think there is overcapacity in the industry. And I think the important thing that Merck is doing is that we are recreating a new business model. And so we are not only taking costs out of the system, we are really completely looking at a different way of running the company and research and manufacturing and how we support our customers. And so, there is certainly, in my opinion, if you do that the right way, there is a lot of cost that still need to come out of this system.
Eva Boratto: Okay. We will take one more question.
Operator: Your final question comes from the line of Steve Scala of Cowen
Steve Scala: Thank you. Two questions on the cholesterol franchise. Merck said on its third quarter call that about two-thirds of patients would have access on the second tier in 2009, and that was down from 75% in 2008. That was prior to certain formulary changes and also a positive study from a competitive product late in the year. So has there been any change in that two-thirds figure that you were looking at for 2009? And secondly, Schering said on its conference call earlier today that it was investing for future growth in this franchise. Do you think growth in the U.S. and in 2009 is likely? Thank you.
Kenneth Frazier: So, let me start by saying that the two-third figure that we anticipated continues to be what we see for VYTORIN and ZETIA. That is as you reimburse without restrictions on second tier for about two-thirds of patients in commercial and Medicare Part B plan. As it relates to future growth, let me start by just saying that prior to last year, these were products that had been well received in the marketplace. As the result of those controversies, we have seen a slight change in how... significant change in how these products are actually used. We continue to believe in these products. The FDA's recent statement underscores the importance of LDL, lowering the guideline that exist in the U.S. and that are online in Europe underscore those. And so I can say without predicting when the growth will resume, we fully expect that as people begin to reflect upon the importance of getting large numbers of patients to their cholesterol lowering goal, they will realize that ZETIA and VYTORIN are important ways of achieving that objective. And we continue to invest competitively behind these brands with the hope and the expectation that overtime they will be restored to grow in the U.S.
Eva Boratto: That last question concludes today's conference call. The information from today's call, both the transcript and the replay, will be available at our website for the next several months. And Carol Ferguson and I will be available to take your calls and any incremental questions. Taylor?
Operator: Thank you. This concludes today's Merck's fourth quarter 2008 earnings conference call. You may now disconnect. | [
{
"speaker": "Eva Boratto",
"text": "Thank you, Taylor and good morning. Welcome to our call to review our business performance for the fourth quarter of 2008. Joining me on the call today is our Chairman, President, and CEO, Dick Clark; Ken Frazier, our Executive Vice President and President of Global Human Health; and Peter Kellogg, our Executive Vice President and Chief Financial Officer. Before we get into the details, I'd like to go over some logistics. On this call, we will review the results contained in the release we issued at 7:30 this morning. You can access this through the Investor Relations section on merck.com, and I would remind you that this conference call is being webcast live and recorded. The replay of this event will be available later today via phone, webcast, and podcast. As we begin our review, let me remind you that some of the statements made during this call may discuss certain subjects that may contain forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. These statements are based on management's current expectations and involve risks and uncertainties, which may cause results to differ materially from those set forth in these statements. The forward-looking statements may include statements regarding product development, product potential, or financial performance. No forward-looking statement can be guaranteed, and actual results may differ materially from those projected. Merck undertakes no obligation to publicly update any forward-looking statement, whether as a result of new information, future events, or otherwise. Forward-looking statements in this press release should be evaluated together with the many uncertainties that affect Merck's business, particularly those mentioned in the Risk Factors and Cautionary Statements in Item 1A of Merck's Form 10-K for the year ended December 31, 2007 and in any Risk Factors or Cautionary Statements contained in the company's periodic reports on Form 10-Q, or current reports on Form 8-K, which the company incorporates by reference. We will begin the call with brief remarks from our senior management, and then open the call for your question, and expect the total call to last approximately an hour. With that, I'll turn the call over and we will begin with remarks from our Chairman, President, and CEO, Mr. Clark."
},
{
"speaker": "Richard T. Clark",
"text": "Thank you, Eva and good morning everyone. Earlier this morning, we announced results for the fourth quarter and full year 2008. The solid financial results we reported today reflect both the challenges we faced in 2008 and the benefit of our broad product portfolio. In 2008, we improved efficiencies, managed through a dramatically changing industry environment and took actions designed to better position Merck for success. And we did so during a very difficult and unsettling time for the U.S. and global economies. In terms of top line for the full year 2008, we recorded revenue of $23.9 billion, 1% lower than 2007. Excluding the impact of the loss of marketing exclusivity for FOSAMAX in 2008, revenue increased by 5% for the full year. Our full year 2008 non-GAAP earnings per share were $3.42, which excludes certain items. While our full year GAAP EPS were $3.64, reflecting the excellent progress we've made in improving our cost structure and strong growth in key products; JANUVIA, JANUMET, ISENTRESS and ROTATEQ. Today, we also confirmed our top and bottom line expectations for the full year 2009. Non-GAAP EPS, we expect to be in the range of $3.15 to $3.30 excluding anticipated restructuring charges, and for 2009 GAAP EPS, in the range of $2.95 to $3.17. For full year revenue, we continue to expect to be in the range of $23.7 billion to $24.2 billion. So based on what we see at this early point in the year, we think revenues are likely to be in the lower half of that range. Peter will be walking you through some additional details on 2009 guidance and 2008 results a bit later on today's call. Also in a few moments, Ken will review the performance of our key products as well as our expectations for them. He'll talk about GARDASIL and the impact on revenue and the delay in the FDA approval of the adult women indication. Now, let me make a few observations about 2008. We were pleased with the standout performance of initiative Merck medicines like JANUVIA, JANUMET, ISENTRESS and ROTATEQ in 2008. We have designed our franchise operating models to manage the entire lifecycle of our products, and they have enabled us to maximize the value of more established products such as COZAAR, HYZAAR and FOSAMAX. Though results for SINGULAIR and GARDASIL were not where we would have liked them to be, Ken will discuss their performance and improvement actions we have underway. Next, I'd like to share a few thoughts on the progress we've made in transforming Merck during 2008. We continue to move away from outdated commercial and business models to a new more effective and efficient of operating. We've moved forward with our new approach to customers through our commercial models and with re-engineering our basic research global operations and our new clinical development model. Those efforts are helping to make us leaner, more agile and better positioned for the long term. By focusing on our core strengths, the new Merck we are building will maximize the value of our current product portfolio and our pipeline. That will enable us to pursue growth through initiatives such as Merck BioVentures in emerging markets, as well as take advantage of the right strategic opportunities. In 2009, we are building on the progress we've made and taking our supply chain management to the next level using Lean Six Sigma. We are on track in the United States to implement an SAP information technology system that is the key step in fundamentally changing how we run this company. Merck's overall financial strength, especially during these difficult economic times, is an advantage that enables us to pursue the important work of transforming our company. Let me move next to our global restructuring efforts. More than just reducing Merck's cost structure, our restructuring initiatives are creating a leaner and more flexible company that is appropriately sized and scaled for the new pharmaceutical operating environment. In 2008, we completed our 2005 restructuring program and we're on track to realize total cumulative savings of approximately 4.5 to $5 billion by 2010. Our 2008 restructuring plan is well underway, and we continue to expect the capital yield of cumulative pre-tax savings of $3.8 billion to $4.2 billion from 2008 to 2013. As a result of our restructuring programs, Merck had approximately 55,200 employees at the end of the year 2008, a 10% reduction compared with the 61,500 we had at the end of 2005. We exceeded this reduction while at the same time continuing to hire employees with the new skills and expertise we need to achieve our long-term strategic goals. We have made significant progress streamlining all management layers across the company, since we announced the effort last October. At that time we outlined plans to reduce our total number of senior and mid level executives by approximately 25%. Those plans are on track. Let me also emphasize that lowering our costs does not come at the expense of supporting our key products in the marketplace. We are fully supportive of our key brands and are continuing to invest in our pipeline. During 2009, we expect to file NDAs for three promising candidates in Phase 3 that address patient needs in the treatment of migraine, acute heart failure and lipid management. In fact, Merck's pipeline includes nine Phase 3 programs continuing in 2009 and nine new Phase 3 programs anticipated to start this year. Finally, I want to comment on vaccine manufacturing. As I mentioned in December, one of our top priority is addressing supply issue for our vaccines. Merck is responsible for providing many of pediatric, adolescent and adult recommended vaccination in the United States. And we take this job very seriously. Our vaccine manufacturing is inherently complex; we are prioritizing our vaccine production based on the public health needs. We regularly communicate with customers, public health agencies, professional societies about the status of our vaccines. We make sure they know when we are returning to normal shipment times as well as when we are experiencing shortages or delays. In addition, we routinely update our customer website to communicate comprehensive information on a timely basis. Finally, I want to note that we are investing nearly $1 billion to help ensure we have consistent, robust manufacturing practices and processes that meet existing demands for our vaccines, as well as expand our capacity to meet demand for the next generation of vaccines under development. While we are focused on building a company that will be a tough competitor in the environment that is very different than one we have known, we are being very careful to protect the values that have long distinguished Merck. Meanwhile, as these harsh economic times continue in the U.S. and around the world, our customers including patients, payers and healthcare providers are likely to feel the effects in one way or another. Just about all economic forecast data, the United States is in a prolonged period of unemployment, and high unemployment means a rise in the number of people without health insurance. That's why we are already engaged with the new administration and Congress to support reform of this country's healthcare system. And now part of the United States where most people still lack adequate access to medicine, vaccines and healthcare, we continue to work independently and in partnerships to improve access to our products. In closing, I want to emphasize that as we move ahead in 2009, the level of determination and the energy throughout our organization remains high. Our employees are the most talented, dedicated people in this industry. They clearly understand the new era for pharmaceutical companies is here today. We strongly believe Merck has what it takes to succeed in a world that places great value on the scientific innovation that continues to be the hallmark of this company. Now, I'd like to turn the call over to Ken and then Peter, who'll summarize our financial results. After their brief remarks, we will take your questions. Ken?"
},
{
"speaker": "Kenneth C. Frazier",
"text": "Thanks, Dick and good morning, everyone. As we move into 2009, we must overcome the lingering effects of last year's business challenges to some of our key products; capitalize our new opportunity all the while continuing to implement our new commercial model. As we announced today, overall revenue was down 3% in the fourth quarter of 2008 and 1% for the full year. Excluding the impact of the loss of marketing exclusivity for FOSAMAX in 2008 however, revenue increased 5% in the fourth quarter and the full year. The increase in revenue in the fourth quarter excluding the impact of FOSAMAX was driven by strong growth for a number of our recently launched products including JANUVIA, JANUMET and ISENTRESS. And we also achieved strong growth for ZOSTAVAX as we cleared the majority of the backorders. Outside the United States, our reported revenue grew 5% with strong volume increases of 10%, thanks to continued launches of new product and strong performance from many of our inline brand. As we saw in the first three quarters of the year, our revenue growth internationally was offset by continued challenges to driving demand for SINGULAIR and GARDASIL in the U.S. Our overall U.S. business along with that of others in our industry may have been affected by general slowdown in prescriptions for newer medicine. In addition, the price shortfall of some of our vaccines during 2008 and the year-over-year effects of clearing VARIVAX backorders in the fourth quarter of 2007, also contributed to the sales decline. Before I get into the details of the performance of some of our key products, I'd like to comment briefly on the current global economy as it relates to our business. At this point, it is difficult to determine whether into what extent the economy could have impacted our 2008 performance. However, many patients, providers and payers around the world are facing difficult choices about spending, which could affect healthcare utilization at the macro economic level and could also affect individual brands as well. We will continue to monitor these trends closely and factor them into our activity and our guidance. Now, moving to performance of our key brands; beginning with GARDASIL, our HPV vaccine. Sales as reported by the Merck in the fourth quarter were $286 million, a 16% decline when compared to the fourth quarter of last year. In the U.S., sales declined 19% and ex-U.S. sales declined 2%. The ex-U.S. sales decrease was attributable to a decline in Australia because a significant portion of the female population was vaccinated in previous years as part of the publicly funded vaccination program. In addition, sales of GARDASIL in our SP-MSD joint venture in Europe decreased by 26% versus fourth quarter '07 to 171 million. This is due to a slowdown in demand in large early adopting markets like Germany. Other later adopting markets will continue to grow and we will compete for new government tenders in 2009. The fourth quarter decline for GARDASIL in the U.S. was affected by three factors. First, as expected, because of the broad use of GARDASIL since launch, the total number of 11 to 18 year olds who have already been vaccinated have increased. As a result, despite continued vaccination in this age group, the overall number of first dose vaccination of 11 to 18-year old has declined. Second, also as one would expect, there were fewer second and third dose vaccinations in the fourth quarter because there were fewer first and second dose vaccine as administered during the previous two quarters of 2008 when compared to the same period in 2007. Third, because of continuing challenges to vaccinating the 19 to 26-year old age group, we observed a decline in total vaccinations, during the past quarter compared to the fourth quarter of 2007. I'll remind you that 2007 was the first full year of launch and vaccination rates included the impact of early adopters who are not deterred by some of the barriers to vaccination for this segment. As I mentioned in December, we learnt that OB/GYNs believed that they have vaccinated a significantly larger percentage of their patients than their actual vaccination rates indicate. As a result, we are implementing program to make OB/GYNs aware of the actual vaccination rates in their practices. Our customers appreciate this initiative as they continue to believe in the importance of this vaccine. Here are some other examples of some of the programs we have underway. Approximately 6,500 OB/GYNs and primary care officers have enrolled in the dose replacement program which we launched in 2Q 2008 to address their reimbursement concerns. In the first two to four months since enrollment, we've observed an 8 to 10% lift in sales at these locations versus other locations. Our in-office patient outreach program for physicians and unvaccinated women and parented eligible female has enrolled more than 8000 offices and is distributing 2.5 million patient mailers. This program rolled out in September of 2008. Last week, more than 4 million enrollees in managed care plan have been informed about coverage of GARDASIL. We've learnt much more about the practice-relating and financial challenges affecting vaccination rates, especially for 19 to 26 year olds. The opportunity is still there. Our research indicates that most of these women maybe receptive to vaccination, in fact less than 10% have decided not to be vaccinated. While early indications suggest that our programs are beginning to have an effect, the issues they are designed to address are complex and vary from practice to practice. We believe that is why we've not yet seen an impact on vaccination rates overall. In the 11 to 18-year old group, where high vaccination rates have already been achieved, we continue to work with pediatricians and family practitioners to reach patients -- parents excuse me, whose daughters have not yet been vaccinated. As you all are aware, in January, we received the second complete response letter from the FDA to our application for the use of GARDASIL in women aged 27 to 45. And based on that letter, we now anticipate responding to the agency in the fourth quarter of 2009. As a result of delay of the approval and the declining vaccination rates among 19 to 26-year olds towards the end of 2008, we are reducing our 2009 guidance to 1.1 to 1.3 billion. This guidance takes into account both the high level of vaccination already achieved in the adolescent population as well as the challenges of substantially increasing vaccination rates among the 19 to 26-year old population, where the proportion not yet vaccinated is greatest. These challenges, not withstanding opportunity remains for GARDASIL, the millions of women not yet vaccinated in the 19 to 26-year old population as well as the millions of males and adult women we expect to become eligible for vaccination with GARDASIL over the next two years. I should note here that the FDA has accepted our application for use in males. We continue to believe in GARDASIL's potential to drive revenue growth. We are fully investing in these programs, and we'll invest in additional innovative programs to drive demand for this product. Also, let me be clear that our overall cost reduction have not been and will not be at the expense of fully funding the programs needed to help GARDASIL realize its full potential. Now, I'd like to take a moment to discuss ZOSTAVAX. Total fourth quarter sales as reported by Merck were $162 million, as we cleared the majority of backorders in December 2008. We are working with our customers to drive appropriate utilization for this novel vaccine. For example, we've implemented a patient notification service and pharmacy-based outreach initiatives. Demand for ZOSTAVAX continues to be strong, and we currently believe we will clear all existing backorders in the first quarter of 2009, and that we will have normal shipping time sometime within the second quarter. Once the backorders are resolved, we expect to have adequate supply to meet anticipated U.S. customer demand for the rest of 2009. We remain excited about the potential of ZOSTAVAX and we look forward to supplying this important vaccine to our customers. Turning to SINGULAIR, sales in the fourth quarter were 1.1 billion, down 3% versus the prior year. Performance in the fourth quarter reflects the decline in the U.S. business of 11%, which was partially offset by strong 15% growth outside the U.S. SINGULAIR continues to do well in Japan, for example, thanks to the successful launch of the allergic rhinitis indication and the introduction of the oral granular formulation for pre-school aged children. For the full year, the U.S. performance for SINGULAIR was affected by the availability of ZYRTEC OTC, a smaller allergic rhinitis season in both the spring and the fall and the FDA early communication in March 2008. Merck is pleased that the FDA has now issued its follow-up to its early communication on SINGULAIR. Our sales force is prepared to provide appropriate information to healthcare practitioners about the FDA communication. Merck stands by the proven efficacy and safety of SINGULAIR, a medicine that has been prescribed to tens of millions of patients with asthma and allergic rhinitis for more than 10 years. We are devoting significant resources to programs designed to improve performance and drive growth of SINGULAIR in the U.S. Our sales force had new materials for use for physicians and SINGULAIR remains the key priority as we roll out our new commercial model in the U.S. early this year. We continue to utilize multiple channels for SINGULAIR, including new trial and coupon kit for new patients, educational materials, print, TV and online DTC, in-office branded marketing programs, pharmacy programs, and adherence initiative. We have the resolve as well as the resource plans and materials to ensure SINGULAIR remains the number one respiratory product in the U.S. We are very pleased with the performance of ISENTRESS since its global launch in the fourth quarter of '07. Sales in the fourth quarter were 130 million, up 21% sequentially versus the third quarter. In the U.S., fourth quarter sales were 71 million and continue to exceed the last five launches in TRX market share through December. On January 30, the U.S. Food and Drug Administration granted conditional approval to ISENTRESS following review of the 48-week data from the BENCHMARK-1 and 2 clinical study. ISENTRESS was originally approved under the FDA's accelerated approval process in 2007 with 24-week data. ISENTRESS is currently approved in 70 countries on six continents including all top 10 HIV markets. Overall, uptake has been strong and we look forward to continued success in 2009. Global revenue for JANUVIA and JANUMET grew in the fourth quarter to reach 532 million, up 11% sequentially versus the third quarter. In U.S., JANUVIA continues to be the second leading branded oral antidiabetic agent in terms of new prescription share. Despite the slowdown in the overall U.S. diabetes market last year, the JANUVIA/JANUMET franchise continues to grow in both volume and share, and is the fastest growing family of products in the oral segment of that market. JANUVIA delivers strong once-daily efficacy in a single pill without compromising the weight gain and hypoglycemia associated with other oral diabetes therapy. JANUMET combines JANUVIA with metformin for powerful ultra fast efficacy. We have invested in new patient educational tools administered by diabetes educators around the U.S. and we have an integrated adherence program to help patients remain on JANUVIA and JANUMET therapy. In addition, we are extremely pleased with the international performance of JANUVIA/JANUMET in the fourth quarter. In the EU, these medicines are the fastest growing family of products in the oral diabetes market. JANUVIA is the only marketed DPP-4 inhibitor that is once-daily for all indications. It is widely reimbursed and JANUMET is gaining equally strong reimbursement status. In all markets where more than one DPP-4 exist, sitagliptin is the market leader. Finally, India, Brazil and other emerging markets have enjoyed strong growth since launch. Globally, more than 10 million prescriptions that are written to-date and as these products are major growth drivers for Merck in the short-term as well as the long-term, we are investing in them to ensure that we realize their full potential. As we mentioned at the annual business briefing, we have one new fixed-dose combination product in Phase 3 development with pioglitazone and we anticipate starting two new Phase 3 development programs this year, an extended release for JANUMET as well as a sitagliptin simvastatin fixed-dose combination. Now, I would like to take a moment to provide an update on the performance of our cholesterol JV. Let me start by saying, we are pleased that the FDA has completed its review of the ENHANCE study, and that their tradition (ph) remains that elevated LDL-C cholesterol is an important risk factor for cardiovascular disease. The agency goes on to say that based on currently available data, patients should not stop taking VYTORIN or other cholesterol lowering medication and should talk to their doctor if they have any questions about VYTORIN, ZETIA or the ENHANCE trial. Our sale forces are prepared to provide appropriate information to healthcare practitioners regarding the FDA communication. Moving to performance, worldwide sales of ZETIA and VYTORIN as reported by the Merck/Schering-Plough joint venture were 525 million and 549 million respectively in the fourth quarter. Sales of ZETIA were down 23% and sales of VYTORIN were down 29% versus the prior year. Market share for ZETIA and VYTORIN in the U.S. appears to be stabilizing. Outside the U.S., sales of the fourth quarter were flat relative to 2007, but were up 13% after adjusting ForEx change. We continue to anticipate growth outside the U.S. in 2009, excluding the effect of foreign exchange. We will remain steadfast in our support for ZETIA and VYTORIN, which continue to be valuable treatment options for physicians by helping to get more patients to their LDL goal. Before I close and turn over the call to my colleague, Peter Kellogg, I just want to mention that we are continuing to progress in our global rollout of new commercial model, which are designed to respond directly to our individual customers needs around the world. In the EU, many of our new models are already established; and in the U.S., we expect to complete a national rollout in early 2009 after strong pilot results achieved last year. We fully expect this model will help us drive revenue growth for key franchises and markets while improving efficiency and customer value associated with all of our customer interactions. I look forward to updating you closer about our progress in this important initiative in future calls. In closing, I assure you that the entire Global Human Health Organization is focused upon restoring growth in 2009 by continuing to address challenges with some of our key products and by capitalizing on opportunities with our customers. Notwithstanding the overall slowdown in branded prescription growth for primary care brands in the U.S., Merck has a portfolio of medicine and vaccine that offers unique value to our customers. And we continue to believe that tremendous commercial opportunities exists to grow our established and our newer brand in markets around the world. We are confident that our continued focus on efficiencies on the marketing and administrative lines demonstrated through 2008 will help drive overall margin improvement, and that the plans we have in place to fundamentally change our business model will enable us to better meet the needs of our varied customer base and to drive the top line for our medicines and vaccines. So with that, I will turn the call over to Peter Kellogg."
},
{
"speaker": "Peter N. Kellogg",
"text": "Thank you Ken, and good morning. I will provide an update on the following; our fourth quarter and 2008 results and our 2009 guidance. Now for guidance, I will only highlight those elements of our guidance that have changed as we provide a breakdown of all the elements of our guidance in our other financial disclosure schedule attached to the press release issued earlier today. Merck reported fourth quarter non-GAAP earnings per share of $0.87, representing growth of 9% over the fourth quarter of 2007. On a GAAP basis, EPS for the fourth quarter was $0.78. As Dick and Ken discussed, fourth quarter results reflect the blend of revenue performance, strong expense management, and a favorable tax benefit. For the full year 2008, non-GAAP earnings per share was $3.42, representing a growth of 7% over 2007. On a GAAP basis, EPS for the full year 2008 was $3.64. Turning to revenue, total revenues in the quarter, as reported by Merck, was $6 billion. Total revenue for the year was 23.9 billion. Now Ken already walked you through product performance, so I'll quickly just cover the guidance. As Ken shared with you, we are reducing our 2009 guidance for GARDASIL by $300 million to a new range of 1.1 billion to $1.3 billion. Moving in the other direction, we are increasing our guidance for supply sales to AstraZeneca by $100 million to a new range of 1.3 billion to 1.5 billion, reflecting current market trend. We continue to expect 2009 revenue in the range of 23.7 billion to 24.2 billion. However, based on current information, it is likely that revenues would be in the lower half of that range. Our fourth quarter materials and production costs were 1.5 billion, which includes 33 million for costs associated with the global restructuring program primarily related to accelerated depreciation. Excluding restructuring costs in 2008 and 2007, material and production increased 1% in the quarter. Reported PGM was 75.6%. Excluding the restructuring costs, PGM was 76.2%. Just as in previous periods, these results reflect our final product mix, particularly driven by the patent expiry related decline from the Q4 U.S. COZAAR/TRUSOPT expiry and the Q1 U.S. FOSAMAX expiry. Marketing and administrative expenses were 1.9 billion in the fourth quarter, an increase of 8% versus the fourth quarter of 2007. But let me provide you some additional perspective on that. Included in the fourth quarter of 2008 marketing and administrative expenses is an increase of $62 million to the VIOXX legal defense reserve. Included in Q4, 2007 was a gain of $455 million from insurance proceeds. Excluding these items in both 2007 and 2008, M&A expenses decreased 17% in the fourth quarter. The lower spending for the quarter and the year is attributable to savings from our new commercial model that Ken discussed and corporate G&A efficiency programs. We are benefiting from U.S. sales force reductions completed in July and similar European sales force reductions during the year. We are also continuing to realize reductions in our administrative expenses, as Dick mentioned earlier, particularly in some of the support functions. We have maintained a healthy amount of support behind our core and successful newer franchises. I would also note that 2008 spending was reasonably steady throughout the quarters, highlighting consistent and steady investments. Full year M&A was 7.4 billion, down 6% versus 2007 excluding legal defense reserves in 2007 and 2008 and the $455 million insurance arbitration gain recorded in 2007. Turning to research and development, expenses in the fourth quarter were $1.4 billion, essentially flat versus the fourth quarter 2007. When you adjust for the restructuring cost in the fourth quarter of 2008, Q4 R&D spending is down 7%. The fourth quarter year-over-year comparison is affected by the timing of research activities with third-party collaborations. Now we continue to invest in late-stage clinical trials and in the fourth quarter, there was increased spending to support development programs for our promising new drug candidates, among which are rolofylline, odanacatib, 5-LO, anacetrapib as well as JANUVIA. For the full year, R&D expenses were $4.8 billion. When you address the restructuring charges recorded in 2008 and the $325 million acquired research charge associated with the purchase of NovaCardia in the third quarter of 2007, R&D expenses grew 3%. We remain committed to fully funding core internal and external R&D, ensuring the continued progress of compounds in all phases of development. Now let's turn to equity income. In the fourth quarter, Merck reported $720 million of equity income. There were two major impacts in this result. First, the equity income contribution from the Merck/Schering-Plough joint venture was down 30% or $160 million as results of ZETIA and VYTORIN market share losses in the U.S. Outside the U.S., sales in the fourth quarter were flat relative to the 2007. However, if we adjusted international Q4 results for exchange, MSP sales increased 13%. Second, the AstraZeneca joint venture equity income was $267 million, which is $55 million higher in the fourth quarter compared to the prior year. This increase in equity contribution is attributable to the inherent timing variability of payments from AstraZeneca. Moving to other income and expense, that line for the fourth quarter was $3 million of expense. This compares to $567 million of expense in the fourth quarter of 2007, which included a $671 million charge related to the resolution of certain civil government investigations. Excluding that charge, other income expense was $107 million lower than the fourth quarter of 2007. The largest contributors to the year-over-year change is our balance sheet foreign exchange translational loss and lower net income, our interest income result as a result of the lower interest rate that we're all becoming accustomed to. Now moving to the tax line, Merck's fourth quarter GAAP effective tax rate was 14.7%. Excluding the impact of restructuring charges, the non-GAAP effective tax rate was 14.5%. These rates reflect, first, the benefit of approximately 5 percentage points related to the favorable tax impact of foreign exchange rate changes during the quarter, particularly the strengthening of the Japanese yen. And secondly, a benefit of approximately 3 percentage points related to the U.S. research and development credit, which was enacted as part of the Emergency Economic Stabilization Act on October 3rd. The resulting full year benefit is recorded in the fourth quarter. Now, let's turn to some other financial matters, and I'd like to take a minute to speak about Merck's overall financial strength. As you know, Merck maintains a strong balance sheet and a conservative investment policy. As of December 31st, our current cash and investment portfolio totals approximately $18 billion, which includes $6 billion pledged as collateral for bank guarantees related to certain items, including the VIOXX product liability settlement from last year. I also want to continue to emphasize that we have the financial strength to support our dividend, and we remain fully committed to maintaining it at the current level, while at the same time continuing to fund our important investment priorities. So to summarize, in 2008, despite the loss of patent exclusivity for FOSAMAX and continued challenges in our VYTORIN, ZETIA, SINGULAIR, and GARDASIL U.S. franchises, we achieved solid EPS performance. We delivered non-GAAP EPS of $3.42 for the year through aggressive expense management and strong growth in key products as Ken discussed, JANUVIA, JANUMET, and ISENTRESS. However, it is clear that we did benefit from foreign exchange on a full year basis and various discrete tax items. As we look ahead to 2009, we reaffirm our non-GAAP EPS guidance of $3.15 to $3.30 and this corresponding GAAP EPS guidance of $2.95 to $3.17. Please keep in mind as we think about the quarterly patterns, the company continues to expect GAAP and non-GAAP EPS in the first quarter to be less than one-fourth of the full year EPS. In addition, the company anticipates marketing and administrative expense and R&D expenses to be relatively equally distributed across the four quarters. We are reiterating our longer term guidance. We continue to expect revenues will have a compound annual growth rate of 2 to 4% from 2005 to 2010, including 50% of the revenues from the joint ventures. Merck's GAAP reported sales, which exclude the 50% of revenues from our joint ventures, is expected to have a compound annual growth rate of 1 to 3% from 2005 to 2010. Looking at non-GAAP EPS compound annual growth rate, we continue to expect it to be in the mid to high single-digit range over the same time period, excluding certain items with GAAP EPS compound annual growth of double-digits. Thank you very much. And I would like to turn the call back to Eva. Eva?"
},
{
"speaker": "Eva Boratto",
"text": "Thank you, Peter. We will now open the call to take your questions. We will take your questions in the order they are received and try to get through as many as possible. Joining us for the Q&A session is Bruce Kuhlik, our Executive Vice President and General Counsel. At this point, I will turn the call over to Taylor, who will communicate the instructions for our Q&A format and introduce the first question. Operator: Thank you. (Operator Instructions). Your first question comes from the line of Tim Anderson of Sanford Bernstein."
},
{
"speaker": "Tim Anderson",
"text": "Thank you. I have a couple of questions. Just to be clear, on the revenue guidance for 2009, I am wondering if you can rank order the elements of why that maybe at the lower end of the range you gave just about two months ago. And then, foreign exchange impact on total sales in fourth quarter was only a negative 1%, which I think was the lowest of all the drug companies reporting thus far. And I'm wondering why that might be the case. Last question on ZOSTAVAX; can you give us the demand driven sales in fourth quarter ignoring the filling of backorders?"
},
{
"speaker": "Peter Kellogg",
"text": "Okay. Tim, it's Peter. Let me take the first two, and let me think about the ZOSTAVAX calculation here for a second. So, our comment related to the range for total revenue for the year really reflects the revision to guidance that we provided for GARDASIL, offset slightly by the AstraZeneca and then just some other trends that we are observing. And we are just kind of highlighting that as we rolled in two changes to the individual line items in revenue, we didn't change the full revenue guidance range, because we think it's actually it's very early in the year and there is a lot of... is quite a healthy range of outcome that could occur in a lot of different products. Certainly we've gotten some good letters back from the FDA, and we've certainly gotten some instinct developments in the lifecycle management as Ken talked about. So, but we primarily indicated the lower end because of the most recent trends in some business; but most importantly, it's the GARDASIL guidance revision. On foreign exchange, you are right. As you'll note in the attachment to the press release that our ForEx impact in the fourth quarter top line revenue was negative 1%. Now that, I really haven't actually checked all the other companies. But as you do know, we have a revenue hedging program at Merck that we roll in the hedges over time. And obviously, as we saw the foreign exchange rates peaking, I'd say in the first half of last year, we really wrapped up a lot of fairly good hedge positions. That certainly helped us. I'd say that we have... that's not something that I would characterize as unusual or unique. We have an ongoing hedging program that we roll in the hedges over three years. It's based against the major currencies. And so perhaps that was the driver of why the foreign exchange rate impact for us as it may appear little bit less than other companies. I really can't comment on the other companies. Finally for ZOSTAVAX, let me turn it over to Ken."
},
{
"speaker": "Kenneth Frazier",
"text": "Thank you, Peter. As I mentioned, we are very pleased that we cleared the majority of backorders in 4Q '08 representing orders received in both 3Q '08 and 4Q '08. While we cannot estimate the amount of inventory at the provider level, we expect the volume of shipments in December will impact first quarter '09 purchases as provided resume normal order patterns. Prescriptions, which represent a portion of the business for ZOSTAVAX showed 4Q, '08 volume at levels comparable to 4Q, '07. And while it is difficult to estimate the total demand following the extended backorder period in second half of 2008, we consider this could be a positive sign of the demand for ZOSTAVAX. Thank you."
},
{
"speaker": "Eva Boratto",
"text": "Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Roopesh Patel of UBS."
},
{
"speaker": "Roopesh Patel",
"text": "Thank you. I've got three questions. First on the tax rate, the 500 basis points benefit this quarter due to FX, Peter, I was just wondering if you could kindly elaborate on that and clarify if this is just a one-time benefit or if there is a spillover in 2009? Secondly, GARDASIL international sales down sequentially around 45% versus the prior quarter. Could you please elaborate on what explains this big deceleration? And lastly, on VARIVAX, if you could also just provide some color around its performance in the fourth quarter and what we should expect in 2009? Thanks."
},
{
"speaker": "Peter Kellogg",
"text": "Hi, Roop; this is Peter. Let me take the first one on the tax, the five points of impact from the yen strengthening. So, just summarize very quickly, I would view that, I would anticipate that to be a one-time event. We do see sometimes foreign exchange impacting our net monetary assets on our balance sheet. And sometimes when certain movements occur, they can create a gain or loss; and some times that loss on a tax basis does create a deduction on our cash return. So it generally tends to be only in periods when the currencies such as yen, a big currency like the yen, moves back significantly in a short period time and create a noteworthy gain or loss. In this case, it's a loss that is on a tax basis is deductible. For the performance of GARDASIL versus prior quarter, it was down 45%. So Ken, I want to turn that over to you."
},
{
"speaker": "Kenneth Frazier",
"text": "So I think there are a couple of things. As we mentioned, it was the fulfillment of the Australian program and the product impairs; that's one issue. The Canada program was implemented in the third quarter of '08. But I think the real issue here that we are pleased about is that we see continued strong uptake in markets across Europe as well as reasonably good uptake as it relates to the comparison of market share. And I will remind you that in those countries, where both vaccines are reimbursed by the government and physicians have a choice, GARDASIL has a share of 90% or greater in those markets. So we continue to be pleased with that. With respect to VARIVAX, in the fourth quarter '07 significant amount of backorders for VARIVAX, about $35 million were cleared. And when you adjust for those backorders, sales in the 4Q, 2008 were actually up 56%."
},
{
"speaker": "Eva Boratto",
"text": "Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of David Risinger of Bank of America."
},
{
"speaker": "David Risinger",
"text": "Thanks very much. I have operating, financial and R&D questions. First on the operations; can you discuss the SAP systems implementations? For many, many companies, they are often quite problematic. And can you explain your assumptions for being able to operate seamlessly despite the implementation? Second, in terms of your sequential quarterly outlook for the first quarter of '09, is there anything that you'd like to call out versus what you just booked in the fourth quarter of '08 that we should be sensitive to? And then third, with respect to ISENTRESS once daily, can you talk about the registrational trial timeline including when you'll disclose the interim look? Thank you."
},
{
"speaker": "Richard Clark",
"text": "I'll take the SAP question. We are really confident in what we are accomplishing with SAP, probably for several reasons. One is that we have spent a great deal of time in making sure that the planning takes place, that we have line executives involved in it, that we really do our homework in making sure that we are putting the right systems in. And then quite frankly, we put a rule in place that we will do no customization, and any customization that takes place with our SAP system has to be approved by me. And a lot of the systems that haven't worked as well in the past have had a lot of customization, where it is very difficult to implement, but it is also very difficult to get the kind of savings we're talking about. So probably most importantly, what we've been able to do so far is that we have run a significant pilot, our first pilot in Mexico, and that went extremely well. We learnt a lot from that pilot. We made improvements as we go to our next market. And we just completed at the end of last year, a major pilot in Puerto Rico, which included manufacturing and finance in our Global Human Health from Puerto Rico. So it was a much larger project in pilot than just Mexico. And that was just spectacular. In fact, the feedback we are getting is that may have been one of the best pilots ever in SAP to go live. And Ken and I and Peter have spent a great deal of time in Puerto Rico celebrating with our team. So I think we have enough confidence that we have done two major pilots that worked well. We've made improvements. And the fact that we have line people involved and a significant amount of line people involved to go live in the United States gives us the confidence that we need."
},
{
"speaker": "Peter Kellogg",
"text": "So David, let me take the second question, which was your -- I think was your financial sequential quarter question. And you said -- I think you asked basically where there are any items I'd like to call out going from Q4 to Q1. As I think about it, actually we have probably quite a few. So let me bounce you a few that I would think about. First of all, obviously last year, FOSAMAX went off-patent in February in the U.S. So we did have some sales in the beginning of Q1 last year with pre-patent expiry sales volumes and levels. Likewise, COSOPT/TRUSOPT went off our patent in October of this year. So you should look at the impact of that in the fourth quarter and think about that for the first quarter of this year. Now that, obviously some of that was in the fourth quarter already, and I think the same could be true about FOSAMAX because if you look year-over-year that will be important to think about. I mentioned several times that we are anticipating to see our expenses both in R&D and sales and marketing or SG&A. We also think it would be flat as we go quarter-to-quarter and through the year. In the past, we've seen some spikes in the fourth quarter and we don't anticipate seeing those, we didn't see them in 2008. We won't expect to see that again next year. I would highlight that if you look over time, clearly, there has been seasonality in our revenue. We tend to see January as our weakest revenue quarter. So I would highlight that that would be something to factor in your thinking, although I'm sure your models already have that. We did indicate also that we are working through the PGM trends right now. PGM is little softer in the fourth quarter. In fact, it was softer in the second half, but on a full year basis next year, we expect it to return. That may not proper our place (ph) in the first quarter, but these are all things to think about. Then I think equally importantly, we did see tax benefits in the first half of this year as well from the fourth quarter that I just discussed. And we would expect to return to the normal tax range that we would guide to our full year basis in the first quarter. So, those are things that come to mind, I would -- I can't go through and give you specific guides, but those are things to think, factors to think about."
},
{
"speaker": "Kenneth Frazier",
"text": "As it relates to ISENTRESS in once-daily setting the trends away, as you know it started in the fourth quarter of 2008. I can't say when we will be able to provide any data as it relates to that, at the completion on look. But we do anticipate filing in 2011."
},
{
"speaker": "Eva Boratto",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of John Boris of Citi."
},
{
"speaker": "John Boris",
"text": "Thanks for taking the questions. Dick, I think you mentioned that you would like to take advantage of the right strategic opportunity going forward. Can you just give some commentary or your thoughts on your appetite for large transformative deal versus smaller strategic type tuck-in acquisitions and what you mean by right strategic opportunity? And then, your commitment based on the amount of cash flow that you are throwing off, your commitment to the dividend going forward? And then on SINGULAIR, when do you anticipate that the FDA is going to come back to you on the review of your clinical data? And then on the litigation side on SINGULAIR, I think you will be entering the courts, litigating the patent on SINGULAIR with Teva. How confident are you that the judge will issue an opinion before the 30 months they expires? Thanks."
},
{
"speaker": "Richard Clark",
"text": "Well John, in talking about strategic opportunities, as I mentioned over the previous few weeks, we are still very focused on strategic opportunities. Obviously, they will have to have shareholder value as we move forward, so it's not an event just from an event standpoint. Concerning large scale transactions, as I said before, I wouldn't rule anything out. I don't think in today's world, any CEO can categorically rule out any type of transaction. There are opportunities across the whole spectrum that we look at, and it could -- a point again is, the transaction has the financial and deliver value to our shareholders. So I think we're looking at the entire spectrum and quite frankly, an important part of how we look at thing is the importance of the dividend and to make sure that we continue to support a strong dividend, which has been part of Merck's reputation."
},
{
"speaker": "Kenneth Frazier",
"text": "On SINGULAIR, as you know, we're pleased with the FDA statements to date relating to suicidality in the absence of any real evidence of a connection based on clinical data between SINGULAIR and suicide or suicidal behavior. We can't say or speculate on when the FDA will come forward with additional analysis of the data. That's underway with respect to the entire class."
},
{
"speaker": "Bruce Kuhlik",
"text": "So... and this is Bruce Kuhlik. With respect to the patent trial, we still are scheduled to go to trial on February 23rd. And both parties have asked for a decision from the court before the stay expires on August 20. Based on the judge's history of decisions, we've got every expectation that we'll issue a decision before then, and obviously we would not expect that would delay beyond 30-month stay. And we have contingency plans in place in case if it does."
},
{
"speaker": "Eva Boratto",
"text": "Okay. Given the time limit, there is time for about one or two more questions. Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Chris Schott of JPMorgan."
},
{
"speaker": "Chris Schott",
"text": "Great, thank you. Just a question on GARDASIL. Sequentially, should we expect a step up in U.S. GARDASIL sales relative to 4Q? So I am thinking it's relative to the patients getting their first and second doses over the summer returning for a third shot? Second question on GARDASIL, by your estimates, roughly what percent of 11 to 18 year old to this point have received at least one dose of GARDASIL at this point? And maybe just a final question with regards to larger... within a large M&A transaction as for the space. Just two points on that: first, do you see further opportunity on the cost side as we see what appears to be an accelerating trend towards cuts across the industry? I know you've done a lot, but is there more opportunity? And then when you say large transactions, you are looking on everything. Would that include another major pharma company? Thanks."
},
{
"speaker": "Kenneth Frazier",
"text": "Starting with GARDASIL, at the current point in time, I don't think we are in a position to give specific guidance on the quarter-to-quarter patterns that we expect to see. As it relates to the 11 to 18 year olds, without getting specific, it is significantly higher in that population than it is, for example, in the older population. We've gotten much quicker penetration in the adolescent population with pediatricians and general practitioners than we have of the 19 to 26 year olds."
},
{
"speaker": "Richard Clark",
"text": "From an M&A standpoint, as I said before, anything we do must make sense from a shareholder standpoint. And as you've heard me say before, I think there is overcapacity in the industry. And I think the important thing that Merck is doing is that we are recreating a new business model. And so we are not only taking costs out of the system, we are really completely looking at a different way of running the company and research and manufacturing and how we support our customers. And so, there is certainly, in my opinion, if you do that the right way, there is a lot of cost that still need to come out of this system."
},
{
"speaker": "Eva Boratto",
"text": "Okay. We will take one more question."
},
{
"speaker": "Operator",
"text": "Your final question comes from the line of Steve Scala of Cowen"
},
{
"speaker": "Steve Scala",
"text": "Thank you. Two questions on the cholesterol franchise. Merck said on its third quarter call that about two-thirds of patients would have access on the second tier in 2009, and that was down from 75% in 2008. That was prior to certain formulary changes and also a positive study from a competitive product late in the year. So has there been any change in that two-thirds figure that you were looking at for 2009? And secondly, Schering said on its conference call earlier today that it was investing for future growth in this franchise. Do you think growth in the U.S. and in 2009 is likely? Thank you."
},
{
"speaker": "Kenneth Frazier",
"text": "So, let me start by saying that the two-third figure that we anticipated continues to be what we see for VYTORIN and ZETIA. That is as you reimburse without restrictions on second tier for about two-thirds of patients in commercial and Medicare Part B plan. As it relates to future growth, let me start by just saying that prior to last year, these were products that had been well received in the marketplace. As the result of those controversies, we have seen a slight change in how... significant change in how these products are actually used. We continue to believe in these products. The FDA's recent statement underscores the importance of LDL, lowering the guideline that exist in the U.S. and that are online in Europe underscore those. And so I can say without predicting when the growth will resume, we fully expect that as people begin to reflect upon the importance of getting large numbers of patients to their cholesterol lowering goal, they will realize that ZETIA and VYTORIN are important ways of achieving that objective. And we continue to invest competitively behind these brands with the hope and the expectation that overtime they will be restored to grow in the U.S."
},
{
"speaker": "Eva Boratto",
"text": "That last question concludes today's conference call. The information from today's call, both the transcript and the replay, will be available at our website for the next several months. And Carol Ferguson and I will be available to take your calls and any incremental questions. Taylor?"
},
{
"speaker": "Operator",
"text": "Thank you. This concludes today's Merck's fourth quarter 2008 earnings conference call. You may now disconnect."
}
] | null | null |
MRK | 3 | 2,008 | 2008-10-22 17:00:00 | Operator: Good day, everyone and welcome to Merck's Third Quarter 2008 Earnings Conference Call. Today's call is being recorded. At this time, I'd like to turn the call over to Ms. Eva Boratto, Vice President of Investor Relations. Please go ahead.
Eva Boratto: Thank you Tella, and good morning. Welcome to our call to review our business performance for the third quarter of 2008. Joining me on the call today as always is our Chairman, President and CEO, Rick Clark; Ken Frazier, our Executive Vice President and President of Global Human Health, And Peter Kellogg, our Executive Vice President and Chief Financial Officer. Before we get into the details, I'd like to go over some logistics. On this call, we will review the results contained in the release we issued at 7:30, this morning. You can access this through the Investor Relations section on merck.com and I would remind you that this conference call is being webcast live and recorded. The replay of this event will be available later today via phone, webcast and broadcast. As we begin our review, let me remind you that some of the statements made during this call may discuss certain subjects that may contain forward-looking statements as that term is defined in Private Securities Litigation Reform Act of 1995. These statements are based on management's current expectations and involve risks and uncertainties, which may cause results to differ materially from those set forth in the statement. The forward-looking statements may include statements regarding product development, product potential or financial performance. No forward-looking statements can be guaranteed and actual results may differ materially from those projected. Merck undertakes no obligation to publicly update any forward-looking statements whether as a result of new information, future events or otherwise. Forward-looking statements in this press release should be evaluated together with the many uncertainties that affect Merck's business. Particularly, those mentioned in the risk factors and cautionary statements in Item 1A of Merck's Form 10-K for the year ended December 31, 2007 and in any risk factors or cautionary statements contained in the company's periodic reports on Form 10-Q or current reports on Form 8-K, which the company incorporates by reference. We will begin the call with brief remarks from our senior management, and then open the call for all your questions. And, we expect the total call to last about an hour. Given there are other earnings call today, we will be mindful of our time and will finish up by 10 AM. With that I'll turn the call over, and we will begin with remarks from our Chairman and President, CEO, Mr. Clark.
Richard T. Clark: Thank you, Eva, and good evening everyone. Earlier this morning, we announced Merck's third quarter results and updated our 2008 and 2010 long-term guidance. For this mornings call, we can provide more detail about our most recent performance and our near term outlook and answer your questions. Today, we reported another solid set of quarterly results, including growing non-GAAP EPS and revenue from key products. We delivered those results even in a phase of a slow down in sales. Our Merck/Schering-Plough joint venture, and the continued impact with the loss of market exclusivity for FOSAMAX in United States. Since 2005, Merck has anticipated and aggressively prepared for the changing industrial environment. And restructuring our business and transforming the way in which we discover, manufacture and market our products. All of this was part of the plan to win strategy that I introduced shortly after becoming CEO. For three years, Merck has clearly seen our shares of positive and negative as the industry has overall. In terms of growth and new product introductions, in 2006 and 2007 were outstanding years for Merck. This year thus far has been a more complicated story. We have faced an unusual set of challenges some of them expected and others unexpected, some of them unique to Merck and others affecting many in the pharmaceutical industry. And, of course, global economic conditions are very dynamic at this time and could potentially continue to disrupt many industries for many times to come. We have made good progress on many fronts since 2005. However, our most recent sales trends for key products compounded by known industry and emerging economic factors have led us to reassess the environment in which we expect to be operating between now and 2010. And by the least considerations we have decided to lower our financial guidance over this period. As we look at our business today, we expect adjusted full year 2008 EPS to come in at the lower end but still within our previously disclosed range, the 2008 non-GAAP EPS of $3.28 to $3.32 excluding certain items. We now anticipate reported GAAP full year 2008 EPS of $3.45 to $3.55. And for the longer term, we expect revenues will have a compound annual growth rate, of plus 2% to plus 4% from 2005 to 2010, including 50% of the revenue from our joint ventures. Looking at non-GAAP EPS compound annual growth we now expect it to be at the mid to high single digit range over the same period excluding certain items. I take to deliver you on our commitments to you very seriously and I'm proud of Merck's track record in that regard. That's why I'm disappointed about the changes we needed to make today in our short and long term guidance. We've always been straightforward and realistic when speaking to investors about Merck's business and intend to continue to communicate openly and candidly about where we stand and what we plan to do to accomplish moving forward. The experiences and events of 2008 have been instructive to me and the leadership team. We will be proactive in addressing all challenges facing our business. One of the factors that has led us to moderate our outlook is the manufacturing challenges that have attracted availability of certain of our vaccines. Let me provide some context on this critical aspect our business. As accretive for the results and guidance discussions we will have later on this call. As we have previously discussed vaccine manufacturing is inherently complex. The process is complicated so it can take many months to manufacture vaccines from start to finish. And it can also take several months to complete the necessary testing before the vaccine is ready for the distribution to customers. From time-to-time issues arise, where there is a need to make a change in the manufacturing process. Due to the complexity involved, each issue has its own unique circumstances and can affect vaccine availability. We have recently encountered some of these issues and as a result, availability of certain vaccines will be delayed from the dates previously communicated. We now anticipate having enough supply of the Zostavax to clear the current back quarters by the end of this year. And ongoing supply to enable return the full promotion of Zostavax in United States, launching ProQuad and ZOSTAVAX outside the U.S. beyond 2009, and re-launching our HIV containing vaccine in mid 2009. While these delays are frustrating, we are making encouraging progress. We have resolved the issues regarding our varicella bulk production. Also, we have recently added an additional varicella bulk manufacturing facility, which has been approved by FDA. To support of long-term plans and to ensure we have consistent robust processes and practices that meet increasing demand, both of our existing vaccines and for the next generation of vaccines in development. Merck is investing approximately $1 billion to expand our capacity, and to make improvements to existing processes and infrastructures. That includes two new plans one in Durham, North Carolina, which we dedicated last week and then another in Carlow, Ireland, where we have just began construction. Despite the business challenges we face, I continued to believe that Merck had the right strategy focused on the core pharmaceutical business. We have a broad portfolio, the products that include many of first investment class products with marketing exclusivity that extends well into the next decade; Januvia, Isentress, GARDASIL, Zostavax, and Rotateq. We have a best in class research and development capability, not early in late stage pipeline, and from investigational candidates that address critical unmet medical needs. In addition, our industry leading R&D capability helps strength Merck to partner of choice with new external scientific collaborators to discover, develop, and distribute important therapies. Lastly, we are moving forward on several immediate and long-term steps designed to accelerate our revenue growth including significant investment in expanding our presence in emerging markets, brightening our business development focus to improve de-leveraging of opportunities in regions and countries outside the United States and accelerating development programs for novel mechanisms and fixtures combinations in some of our key therapeutic areas. In addition, we are leveraging our acquisition of GlycoFi to pursue follow-on biologics actively in multi-therapeutic areas, with a goal becoming a leading player. All of these moves has significant incremental revenue potential. We expect to provide greater details concerning these key growth levers at our December Analyst Meeting. In the mean time it is vital that we continue to ensure that we are operating our business in most lean and flexible way. As we move thorough the process we must gain and make significant but necessary changes in our business. Earlier this year, I explained how we would accelerate efforts in 2008 to further optimize our cost base, transform our business model and maximize performance across all of our products. Today, we are moving ahead to the next step in our restructuring efforts. Like its predecessor, this program is focused on continuing to transform our business model, lower our fixed cost, eliminate redundancy and increase the speed at which we make decisions, especially when it comes to taking advantage of growth opportunities. So, for example, Merck is accelerating the roll-out for more customer-centric selling model that we believe will yield a meaningful competitive advantage to Merck, will help physicians, patients and payers improve patient outcomes. Merck's research laboratory is deploying a new operating strategy for basic research which will improve the company's ability to manage increases research program, complexity, expand its access to worldwide external research and relocate resources to translate... to late stage clinical success. Merck's manufacturing division will further focus its capabilities on core products and outsourcing non-core manufacturing needs. And Merck will make greater use of outside technology resources, centralize sales and marketing activities and consolidate and streamline its operations. We expect the 2008 restructuring program to yield cumulative pre-tax savings of $3.8 billion to $4.2 billion from 2008 to 2013. These cost savings are an addition to the cumulative $4.5 billion to $5 billion which the company announced in 2005 and remains on track to achieve the 2010 target. As part of the 2008 restructuring plan, we expect to eliminate approximate 7200 physicians worldwide across all areas of company by the end 2011. Streamlining Merck to meet the demands of ever changing business environment, includes the painful reality of losing employees, whose contribution that helped our company accomplish so much throughout the years. But no matter how difficult the decisions are today, we know our long-term strategy is right. We took a leadership position in the industry and began reshaping our company ahead of our competitors, I am confident that we can overcome our short-term challenges and continue to position this company for success in the future. I recognize the change to guidance is not what our investors expect, nor what we wanted to deliver. That is why we remain committed to doing everything we can to improve this outlook. We are determined to deliver to our investors and we believe our 2008 restructuring program announced today, will help us do so. In closing, let me acknowledge that we are in the midst of an extraordinary time for the business world in the world economy, uncertainties involved in all areas of the market bound. However, I have full confidence in the fundamentals of Merck's business, our strong balance sheet and cash flow. Our product portfolio, our deep strength in research and development, our great people in an excellent management team across the globe. Now, I will turn to Ken, who provides an overview the performance of our product portfolio during the quarter Ken?
Kenneth C. Frazier: Thank you, Dick. And good morning everyone. Merck's revenue performance in the third quarter reflects continued strong growth of a number of recently launched new products including Januvia, Janumet and Isentress. This growth was offset by as discussed, supply shortfalls of some of our vaccines and continued challenges to driving demand for SINGULAIR and GARDASIL. Overall revenue was down 2% in the third quarter, excluding the impact of the loss of marketing exclusively for FOSAMAX revenue in the third quarter increased by 5%. Our international business showed strong growth with an increase of 13%. This was driven by volume increases of 6% as a result of the continued rollout of our new products as well as the prevailing exchange rates. Let me provide you with some perspectives on our top line results this quarter focusing on our key brands. Beginning with our HPV vaccine GARDASIL. Reported Merck failed in the third quarter were $401 million, a 4% decrease when compared to the third quarter of last year. In the U.S., sales declined 16% while Ex-U.S. sales increased 37%. Ex-U.S. sales were aided by the adoption of school based programs in all Canadian provinces, which resulted in a $34 million increase in sales in Canada compared to the base period. We are very pleased that the provinces have adopted this approach for an annual back-to-school based vaccine routine. The U.S. third quarter performance for GARDASIL was driven by three factors. First, we observed the consistent monthly vaccination rate among 19 to 26 year old women over the past year. While we've implemented many programs to increase vaccination in this age group, it will take time to address the barriers and significantly change behaviors of physicians and consumers. I will provide update on the status of some of our key efforts in a moment. Second, while the annual vaccination rate of the remaining 30 to 18 year old increased, the overall number of first dose vaccinations declined because of the early success in vaccine in this age group following launch. Considering the strong cumulative utilization among to 13 to 18 year old since launch continued growth requires substantially higher rates among the remaining eligible population. The vaccination rates for GARDASIL among adolescence remained higher than the average vaccination rates from Menactra and Pedec and comparable points in lifecycle. And third, utilization during back-to-school season was tampered somewhat by negative media coverage over the summer on slightly misperceptions which dampen consumer acceptance. As mentioned on the second quarter call, we have implemented a number of programs aimed at driving utilization among 19 to 26 year old women. I'll share a few early results. More than 5000 OBGYN and primary care locations have enrolled in the dose replacement program that we launched and first discussed last quarter, to address reimbursement concerns. We've already observed the approximate 8% to 10% lift in sales at these locations versus other locations, in the first two to four months since enrollment. Our in-office patient outreach program, which helps physicians reach out to unvaccinated females and mothers, rolled out during September. In this first few weeks of enrollment, more than 1000 locations enrolled and more than 200,000 patient mailers were ordered in those locations. Our outreach through managed care organizations to inform eligible patients about coverage of GARDASIL has reached more than 2 million enrollees in those plans. And finally, just this month we launched two programs to reach young adult females, a multi-channel consumer disease awareness campaign, and a patient program for OBGYN offices. While we are encouraged by the initial progress of these programs, we recognize that it will take time to have a significant impact on the overall vaccination rates of this important 19 to 26 year old group. I'd like to take a moment now to discuss the performance of our two other recently launched vaccines; Zostavax and Rotateq. First, despite significant demand, Zostavax performance in the quarter was hindered by the lack of bulk bearer seller supply. Looking forward, we expect to have enough supply to clear the current back orders for Zostavax by the end of the year. As new orders are received, we will fill in as quickly as possible but it is possible that depending on demand levels, some new orders will be back ordered and filled in early 2009. Throughout this period of constrained supply, we have focused our marketing efforts on reducing many of the logistical and reimbursement barriers to vaccination with Zostavax. We remained extremely excited about the potential of Zostavax, and we look forward to ensuring adequate supply of this important vaccine for our customers. Next, underlying demand for Rotateq continues to be strong. More than 75% of U.S. at risk can now been vaccinated with Rotateq, which was the only rotavirus vaccine available in the U.S. into the middle of this year. When you adjust for the $50 million stock pile purchased by CDC in third quarter 2007, sales in third quarter of '08 were up 11%. As you model the future performance, you should keep in mind that our fourth quarter '07 results included a CDC stockpile purchase of $26 million. Rotateq continues to perform well in the U.S. market, and we have not seen a significant impact to date from the recent introduction of competition. Turning to SINGULAIR, sales in the third quarter were up 1% versus the prior year. SINGULAIR performance in 3Q08 was driven by strong growth in Europe, Middle East and Africa and Asia. And offset by the decline in the U.S. business. Ex-U.S. sales of SINGULAIR grew 12 % as a result of continued growth in EMEA and Asia. U.S. prescriptions for SINGULAIR, that is total prescriptions, were down approximately 8% in the third quarter versus third quarter '07. Similar to the decline in the overall respiratory market. The combined allergy and asthma market without Zyrtec, which was down approximately 6%. As I have mentioned in previous quarters, the U.S. performance for SINGULAIR continued to be effected by the switch of Zyrtec OTC, the weak spring allergy season, and the FDA early communication, this spring. We are determined to improve the performance of SINGULAIR in the U.S. in the fourth quarter and we have significant resources and plans underway to grow SINGULAIR during the fall allergy season and the end of year asthma season. Our sales force has new material to use with physicians including very specific patient profiles, leveraging on efficacy and safety, new trial and coupon kits for new patients, and educational materials for patients. We are using a multi-channel approach with consumers which includes press, television and online DTC including digital banners and e-coupons and office branded marketing programs, pharmacy programs and adherent initiative and an updated website. Looking outside the U.S. SINGULAIR continues to show strong performance for the year so far. SINGULAIR grew 20% outside the U.S. and Europe and other markets such as Japan which illustrates the strong positive perceptions about SINGULAIR held by provisions around the world. Moving to two of our newest growth drivers, global revenue for Januvia and Janumet reached $479 million in the third quarter up 18% sequentially versus second quarter '08. In the U.S. JANUVIA continues to be the second leading branded oral anti-diabetic agent in terms of new prescription share. Despite the slowdown in the overall U.S. diabetes market the Januvia, Janumet franchise continues to grow in both volume and market share. In addition, we are extremely pleased with the Ex-U.S. performance of Januvia, Janumet in the third quarter. In the EU, Januvia is the only DPP for inhibitor approved for dual and triple therapy with the sulfonylurea or sulfonylurea plus metformin remains the only marketed DPP for that is once daily. Worldwide more than 8 million prescriptions have been written today, and we just stood these two benefits to be major growth drivers for Merck in the short-term and in the long-term. And we are investing significantly in them to ensure that we realize their full potential. Now, I would like to take a moment to provide an update on the performance of our cholesterol JV. Worldwide sales of Zetia and Vytorin as reported by the Merck/Schering-Plough joint venture for $534 million and $567 million respectively in the third quarter. Sales of Zetia were down 12% and sale of Vytorin were down 18% versus the prior year. Sales declines in the U.S. were partially offset by continued strong growth outside the United States. Market share for Zetia and Vytorin in the U.S. appears to be stabilized and post ESC. Although we've seen an additional 8% decline in new prescriptions since the initial release of the SEAS results, the rate of volume and share declines for the JV has slowed throughout the year. However the overall cholesterol market growth has been slower than expected. And while we expected the JV brands will remain competitive in terms of managed care, provisioning in 2009. We anticipate a reduction in formulary coverage from 2008 levels. We remain stepped back in our support for Zetia and Vytorin continue to be valuable treatment options for physicians by helping to get more of their patients to their LDL goals. Before turning the call over to my colleague Peter Kellogg, I would like to take a moment to update you on the progress we are making on our efforts to evolve our commercial models and to optimize our cost base to better position Merck to grow the top line. With Merck's portfolio both, inline in new parasitic vaccines, and with the number of people around the world who can still benefit from our products, we have ample opportunities for future growth. The challenge to us is to create a process that can go after these opportunities in an effective and efficient way. We've already changed our headquarters and sales leadership structure, to prepare for the full implementation of the new commercial model in the U.S. in March of next year. The results from our year long palate give us confidence that the new customer centric model provides the right level of support for our new products and can drive revenue and margin improvements. As Dick, mentioned, we have continued the effort that we started back in 2005, to optimize our cost base and improve Merck's effectiveness and efficiency. In Q3, we started to realize the saving of the U.S. sales force actions we announced in May of this year. Overall, for the quarter, marketing and administrative expense excluding the legal defense reserve in the base period, was down 8% versus the third quarter of 2007. But I should note, that promotional spending was up, which is the reflection of the support that we continue to put behind our growth brand and our growth market. We are also realizing savings outside the U.S. as we begin implementing our new commercial models and streamline our sales and marketing operations. What we are doing with these actions, is reducing our fixed cost base. So that we have the flexibility to invest in growth brand and growth markets around the world. And I believe we have laid a great deal of progress here. Turning to our long-term revenue guidance. As, Dick, mentioned, we have reduced our 2010 compound annual revenue guidance including 50% of our joint ventures, to 2% to 4%. As we work through our bottoms up planning process, we needed to assess our underlying product trends as well as project future challenges and opportunities, in a rapidly changing external environment. Based on our assessment, the key drivers for the reduction in revenue guidance since July are as follows. First, since we last gave guidance in July, there has been a 10% to 15% reduction in the euro to dollar exchange rate. Because 40% of our sales are from outside the U.S., the decline in exchange significantly dampens our outlook. Second, supply shortfalls for some of our back hands will affect our ability to meet market demand, and as you know, we are investing heavily in our manufacturing capacity for our vaccines to address this key issue. As Dick, said, we remain confident both, in the alternate revolution of our supply issues, and important benefits provided by these unique vaccine products to our customers. However, the supply issues will affect our future performance. Third, we continue to anticipate that we will have challenges to drive an increased demand trends for our joint venture cholesterol management's GARDASIL and SINGULAIR. While we have comprehensive plans in place to address these challenges, and return these products to higher growth trends, our overall expectations for performance over this period, are now lower. In closing, while we are disappointed in the reductions to our long-term revenue guidance, I assure you that the entire Merck Organization is focused on improving that picture for the top line as well as the bottom line. We continue to believe that tremendous commercial opportunities exist for our established franchises along with our new first in class vaccines and medicines such as GARDASIL, Rotateq, Januvia, Janumet, Zostavax and Isentress. We are confident that our continued focus on efficiencies on the marketing and the administrative line, demonstrated throughout 2008 will help drive overall margin improvement and that the plans we have in place fundamentally to change our business model will enable us to drive the top line for our medicines and vaccines for years to come. So with that I will turn the call over to my colleague Peter Kellogg.
Peter N. Kellogg: Thank you Ken. And good morning everybody. Before we start to Q&A potion of the call I just want to touch on three items very quickly. First discuss the other key elements of our Q2 results that haven't been previously discussed. Secondly, providing the overview of our 2008 and 2010 guidance. And then finally provide an overview of some other financial matters. Let's get started. Merck reported third quarter of non-GAAP earnings per share of $0.80 per share which represented a growth of 7% over the third quarter of 2007 on a GAAP basis EPS for the third quarter was $0.51 per share. Both the GAAP and non-GAAP third quarter results include the impact of $88 million of recognized loses in the company's investment portfolio. Now Ken, just walk you through the key elements of revenue performance for the quarter. So I'd like to now cover the other elements of the P&L beginning with product gross margin or PGM. Our third quarter PGM was 76.1% excluding restructuring the decrease of 1.1 percentage points versus the prior quarter. The sequential reduction in PGM is primarily driven and secondarily discard. In the third quarter sales of SINGULAIR and FOSAMAX both high margin products were lower than in Q2 of 2008 while sales GARDASIL a lower margin product were higher than prior year. In addition PGM was negatively affected by discard associated with vaccine. Moving to research and development. R&D expense for the third quarter was $1.1 billion when you adjust for the $325 million as required research which is a charge associated with the purchase of NovaCardia in the third quarter of last year and the 2008 restructuring cost R&D expenses were up 2%. Turning to restructuring, our 2005 restructuring program is nearing completion at year-end. But we continue to transform Merck into a lean and flexible company appropriately sized and scaled for the future pharmaceutical operating environment. Accordingly the company announced a new 2008 restructuring program. Included in our Q3 results were total restructuring charges of $847 million. Now that's made up of $720 million for the new 2008 program and $127 million for the 2005 program as winding down. In the aggregate the cost of the 2008 program is expected to be $1.6 billion to $2 billion. As expected to very substantially complete by the end of 2011. Now as Dick, has already mentioned this effort is expected to yield cumulative pre-tax savings of $3.8 billion to $4.2 billion from 2008 to 2013. This is a critical next step in our journey to establish a more a variable cost structure. Next in the third quarter we continue to face pressure on the equity income line as a result of 2 factors. First, the equity income contribution for the Merck/Schering-Plough joint venture was down 17% or $81 million. As a result of Zetia and Vytorin market share losses in the U.S. The lower revenue in the U.S. was partially offset by strong growth outside the U.S. Secondly, the equity income contribution from the AVN joint venture was $42 million lower in the third quarter compared to the prior year. The decrease in the equity contribution from the AstraZeneca partnership is attributable to the previously disclosed events surrounding the JV restructuring that incurred to at the end of first quarter this year and we discussed that previously. As well as always we had some inherent variability in the timing of payments from AstraZeneca. As a reminder Merck's prior year returning was decreased to $55 million for quarter from $75 million and Merck no longer received the 10% royalty payments from the Astra USA products. Moving to the other income and expense line, net for the third quarter were $62 million in expense, which declined to $243 million versus Q3 2007. The year-over-year decline is attributable to first, recognize losses of $88 million in our investment portfolio as I mentioned earlier, and that's a result of Merck's exposure primarily to Lehman Brothers and AIG in Q3 2008. Secondly, there were balance sheet translation losses of $52 million in Q3 2008 due to foreign exchange movement and how they impact our balance sheet. And thirdly, income of approximately $100 million occurred last year from the one time net gain that resulted from the settlement of certain patent disputes that we discussed last year. Now moving to our 2008 guidance. Our 2008 non-GAAP EPS guidance is for $3.28 to $3.32 as Dick covered earlier. This guidance is at the low end of the previous range. Our corresponding 2008 GAAP guidance is now $3.45 to $3.55. Now as always, to assist your modeling, we provide a breakdown of the product revenue guidance in our other financial disclosures schedule attached to the press release that we issued earlier today. But let me briefly walk you through the changes that occurred there. On the revenue line SINGULAIR has the full year range lowered by $100 million, for the range now stands at $4.3 billion to $4.5 billion. Other vaccines, also had their full year range lowered by $100 million. So that means now its $2.6 billion to $2.8 billion. And as Ken and Dick mentioned, that's largely attributable to delays and supply. Finally, the Astra component, was increased on a full year basis by $200 million. So that now stands at $1.5 billion to $1.7 billion and that's due to the strong net in performance that we have seen year-to-date. Now regarding, marketing and administrative expense. We are reducing our guidance by $100 million to $7.4 billion to $7.6 billion. This reduction is possible because of our ongoing, companywide, aggressive expense management that Ken covered a few minutes ago. And during the restructuring as a result of the charges associated with additional restructuring program that we announced today, restructuring guidance for 2008 is increased to $1.3 billion to $1.5 billion. Now turning to the 2010 guidance. As Dick, and Ken, mentioned, a number of factors that led to the revised 2005 to 2010 guidance, that we issued this morning. Since we last provided guidance long term guidance in July, foreign exchange rates have clearly moved against us, and that coupled with the manufacturing and supply issues, and product specific changes, has led to the change in outlook. As an organization, we are committed to maintaining focus on cost control and the restructuring program announced this morning will help us move toward a variable cost structure. We have a clear plan in place to enable us to achieve the long term guidance we provided this morning. Now moving to the shares repurchases. Merck, has been actively repurchasing shares. During the third quarter, the company continued its stock buyback program, and purchased approximately $1 billion of treasury stock. And during the first nine month of 2008, we have now purchased $2.5 billion of treasury stock. This program will continue in Q4. The company considers a variety of factors in share repurchase decisions, including our strategy, the long term capital structure, market condition, the impact of actual and anticipated employee stock option exercises, and EPS implications of repurchases. As of September 30th the company has $2.6 billion remaining under the July 2002, treasury stock purchase authorization. Now let's turns to some other financial matters. And I'd like to take a minute to speak about Merck's overall financial strength. As you know, Merck has always had a strong balance sheet, and a conservative investment philosophy. As of September 30th our current cash and investment portfolio totals $19 billion, including $6 billion pledged as collateral for bank guarantees related to certain items, including Vioxx product liability settlement. The portfolio contains a diversified mix of high quality, short term, less than 90 days, and medium term, less than five years. Fixed income, government, agency, corporate, asset backed, agency guaranteed mortgage back, and the municipal securities. Our investment philosophy had served shareholders very well. Since 2001, our benchmark investment portfolios have earned 1.4% per annum more than a Treasury bill portfolio, providing company with incremental interest income in excess of $1.2 billion over this period. Merck's strong financial profile, as indicated by our AA minus credit rating, provides Merck with a distinct advantage in accessing funding during difficult markets. In the current market environment, we continue to have more than sufficient access to the commercial paper markets at attractive pricing, and across all maturity spectrums. We have financial strength and remain fully committed to maintaining our dividend at the current level. At the same time, we continue to fully invest in our key strategic priorities and our pipeline. So in summary, Q3 was a solid quarter. Januvia, Janumet and Isentress continued to perform very well globally. We also continue aggressively manage our overall cost structure, as demonstrated by the reduction in marketing and administrative guidance. And, we believe that our 2008 restructuring program will enable Merck to continue to drive toward a more lean and flexible model. Thank you and now I'll like to turn the call back to Eva. Eva?
Eva Boratto: Thank you, Peter. We will now open the call to take your questions. We will take your questions in the order they are received and try to get through as many as possible. Joining us for the Q&A session is Bruce Kuhlik, our Executive Vice President and General Counsel. At this point, I'll turn the call over to Tella, who will communicate instructions for our Q&A format and then introduce the first question, Tella? Question And Answer
Operator: [Operator Instructions] Your first question comes from the line of Tim Anderson of Bernstein.
Tim Anderson: Hi. Thank you. A couple of questions. Dick, I am hoping you can talk about the notion of having a so called established products group, like one of your competitors who is recently have been talking whereby a higher level of marketing resources are dedicated off patent drugs. I am wondering if this makes sense and if Merck has a similar effort underway and if not, does Merck plan on doing anything differently? And then Ken, when you say you expect Vytorin and Zetia to continue to have competitive formulary positioning going into 2009, how do you define competitive because it sure looks like Vytorin and Zetia will be at disadvantage relative to other products much more often than not based on the date that CMS has on their website?
Richard T. Clark: Okay. So, let me start with the second question which is where we believe would the case for our managed care access. As you know, right now we believe that we remain competitive in 2008 as it relates to our managed care placement, especially as it relates to unrestricted access to second tier and major plans. As we move forward into next year in 2009, we will believe that we'll continue to be competitive but we actually believe that will have somewhat less access, than we have during this year. So, next year we believe that Vytorin and Zetia will be reimbursed without restriction for about for two thirds of patients in commercial and Medicare Part D. I don't know exactly if that's what you are referring to but some of those most recent decisions made in Medicare Part D have been not as positive for Vytorin and Zetia but its also important to keep in mind that they represent only 20% of the book of business. So today we reimburse without restriction or about 75%, next year we believe it will be about two thirds. The other question, relates to how we are thinking about an established products group. We are booking overall at our entire business including how we should apportion funds, scarce funds between all of our products. We have a number of very strong growth drivers that are early in their lifecycle. And our primary focus is ensuring that those products get up to a very fast growth curve. On the other hand, we have plans that are in place which we'll talk about in greater detail in December, for our emerging market strategy, and in those markets as you know, somewhat more established products including product that don't enjoy patent protection, continue to be valuable contributors to portfolios in that part of the world. And we are certainly looking at our entire portfolio, including established products, across various geographic markets and looking at, how to actually maximize the return of the entire portfolio to Merck shareholders.
Eva Boratto: Next question please.
Operator: Your next question comes from the line of Chris Schott of J.P. Morgan.
Chris Schott: Great, thank you. If we look at the cost savings outlined in to the new restructuring program, can you give us more color of this segmentation between our cogs, SG&A and R&D on that one, and may be just a little bit more clarity on the timing of some of these headcount reductions that are way out with these plan? And then may be a final question on GARDASIL, with dose replacement program at the end during the quarter, just quantify how many doses have been provided to physicians at that program? Thank you.
Peter N. Kellogg: Hi Chris it's Peter Kellogg. So let me quickly recap some of the dimensions of this restructuring program. Then I'll pass the GARDASIL question over to my colleagues but. First of all in terms of where the cost will occur. Because good portion of this restructuring is related to real cash items and they are primarily headcount related. Probably that 65% of the cost that you'll see while go though the restructuring line. And then rest of cost will be split between cost of goods and R&D. In terms of where the benefit will flow, we haven't broken that in great detail. But in general, probably about 70% or so of the benefits will come to what we call the M&A line, the SG&A area. And because the largely the impacts are primarily head count related the benefits of this program are fairly evenly spread over time. And so our expectations will probably get about the third of the benefits from this program through 2010 and downs after that. So I can hope that I give you some dimensions of the restructuring and then I guess for Ken for GARDASIL?
Kenneth C. Frazier: So I think it's important to recognize that we're still very early in the dose replacement programs like. It's been in place for about two to four months. As I mentioned we are pleased that there has been a reasonably strong uptake in terms of participation by all the guys and primary care providers. We see in the early days an approximate 8% to 10% lift. So those are all things that all go well particular approach to that barrier around reimbursement. We don't however provide the actual number of doses that we've provided in those locations. But again we're pleased that we are seeing where there is participation in impact on GARDASIL use.
Eva Boratto: Next question please.
Operator: Your next question comes from the line of Roopesh Patel of UBS
Roopesh Patel: Thanks for taking my question. Just a couple of questions first on the cholesterol franchise. Just given the pushes and pulls U.S. versus international. Could you please clarify if you expect the overall global Vytorin and Zetia revenues to grow or decline in 2009. And then secondly on the vaccines business if you could kindly elaborate on the progress of resolving manufacturing issues for the Hepatitis vaccines backed [indiscernible] also for ProQuad thank you?
Kenneth C. Frazier: Okay. So I will start with the first question. As I said we are seeing very strong growth outside the U.S. for Zetia and Vytorin. We are experiencing difficulties in the U.S. as you know we saw 8% decline in NRX we're seeing an issue with respect to the overall market growth of the cholesterol franchise but of those out at this point in time I am not in a position to say whether the franchise will grow globally next year. All I can say is that we continue to provide investments behind Zetia and Vytorin in the U.S. where we've seen the grades decline and we continue to believe that the products will have the right kind of support going forward. As it relates to the other vaccine that you describe feedbacks and comebacks should be available again in mid 2009 and as it relates to vector based on the latest information we expects the ADA formulation would be here on Q1 2009 and pediatric in the fourth quarter of 2008.
Eva Boratto: Next question please.
Operator: Your next question comes from the line of John Boris of Citigroup.
John Boris: Thanks, for taking the questions Dick just a question on investment and R&D you obviously had trend out delayed while back you had to discontinue relatively expensive program on taranabant the obesity compound. Then you announced recently the Hepatitis B vaccine obviously also has issues. Can you just talk about what is going on with at least you believe that the FDA currently from a safety stand point view. You obviously have eight other assets in Phase III clinical development. How can we be assured that you have adequately designed those to meet a much more rigorous FDA from a safety stand point and second question on licensing and business development Dick and Peter. Over the last couple of years the velocity of your licensing and business development activities has been extremely robust. Can you just highlight what that activity has been year-to-date in '08 and how that contrasts with '07 and '06 thanks.
Richard T. Clark: Well thanks for the questions. So we are considering some of the challenges we had with our late stage pipeline I always put it in perspective that this same agency that we are discussing was able to approve non-products over the past two years or so. And these have been first in class differentiated products unmet medical needs. And truly it's going to be the foundation for the company from the revenue standpoint moving forward throughout the world and while products had that we are getting fair and reasonable pricing globally as we speak. I think that's the good news. I have a lot of confidence in our scientific capabilities within Merck I think it is our strong points as a company and I think we have the ability to interact and communicate with the agency to make sure we understand if there are any changes or signals that we received that were able to make sure that we proactively answer those questions. And I think we've been able to do that I think the reasons is Januvia is on the market as we proactively started the questions that they are going to ask and we are able to accomplish those and the fact that GARDASIL on market allows us to do. So there is no doubt that we have to continue to look at clinical development and make sure that we communicate and we listen to what any potential signals or standard changes could exist but I think all effects to do that we've done in the past regard our outstanding scientific leadership. And I think that puts us in a quite competitive position in relationship to I call it in the industry.
Peter N. Kellogg: Just let me take the question. I can on the business development front. The question is specifically I think John, ask was is there pace in '08 comparable what we did in '07, '06 and obviously year is not going yet. But at this point actually we have been very active in the business development front. As you're well aware we did neighborhood of roughly 50 or more deals in each of last prior years. We've done a good number this year. We've announced quite a few we already heard. And we remain very active as we speak today. And our focus is to look at all ways to doing deals whether be in licensing or collaboration and also a truly innovative and novel mechanism that could really add to our portfolio. We tend to look at biotech companies that also bring different kinds of mechanisms into the play and we obviously think about it from the franchise standpoint. So our business development activity is very well integrated with the R&D organization and their franchise team. So increasingly you'll see a stuffing of that activity. I think you'll also see us broadening perhaps some of the scope of what we've done in the past not only to do the classic pipeline and licensing deals but also include as we discussed in the last earnings call more activity on the business development front with commercial products and global companies that may have only regional presence. But we're I think can hand our international portfolio. So I think this will be another robust year. We have full expectations it is one of our corporate goals and certainly one of our finance and R&D goals to have a very strong and licensing activity and I think increasingly we will see more of Ken's organization really diving in as well. So I think it is a big opportunity for us.
Eva Boratto: Next question please
Operator: Your next question comes from line of Dave Risinger of Merrill Lynch.
David Risinger: Thanks very much I have three questions. First regarding Vytorin and Zetia how do you define unrestricted? Do you mean Tier II or are you talking about Tier II and Tier III? The second question is I will just read from your press release the second bullet that I don't understand so I am hoping that you can explain it. It says cumulative savings of $3.8 billion to $4.2 billion expected from 2008 to 2013 and pre tax cost of $1.6 billion to $2.0 billion thorough 2011. Can you just reconcile those two? And then finally and I may have missed this, but where does GARDASIL for 27 to 45 year old females stand? Thank you.
Peter N. Kellogg: So, Dave... this is Peter. If I can start off with your specific question on the bullet point. So we look at restructuring what we trying these exact vernacular is place in the timeframes that we used in the past. And so our cost that will go through the P&L as restructuring charges, we expect to be in the range of $1.6 billion to $2 billion cumulatively between now and 2011. And obviously we'll be incurring those costs as we go along as different activities are taken. As I mentioned earlier, more than half of those costs will be head count related and so those will be severance program charges and so forth. And the rest will be probably either accelerated depreciation for facilities that are being closed or other related cost that are between different investment areas or whatever. So that's the cost side, that's the $1.6 billion to $2 billion. From these restructuring moves, we will then realize savings in the operations of our P&L and what we look for is in the range of $3.8 billion to $4.2 billion of operating savings that'll flow through the P&L on a cumulative basis over the next five years and that's the '08 to 2013 timeframe. And as I mentioned on an earlier question, we expect those savings to come true on a fairly steady basis as we go along because of the size of the program changes we are making right away. So, as I mentioned we would expect about a third of those savings to come in, in the 2009 and 2010 timeframe. Let me hand over to Ken next?
Kenneth C. Frazier: Yes.First of all I apologize for any lack of clarity in my previous response. When I was talking about our access to managed care formularies, I was referring to Tier 2. So, when I said that we have 75% access with no restrictions, this year I was referring to Tier 2 and when I made my comment about two thirds next year, they also related to Tier 2 access without restrictions. With respect to your other question, as you know, we have responded to the FDA complete response letter in July. The agency has informed us that the response was a class two response though typically those responses take about six months to work through.
Eva Boratto: Next question please.
Operator: Your next question comes from the line of Barbara Ryan from Deutsche Bank.
Barbara Ryan: Good morning and thanks for taking my question. Most of them were asked but may be Dick, I wonder if in the targeted cost cutting that you have and specifically that 12% head count reduction through 2013, if within that you have assumed any kind of what I'll call fundamental changes in the marketing model of the company? I mean its probably not the right form to go in to all of those things but just in a generic sense?
Richard T. Clark: Yes, I'll let Ken answer that and then to Barbara but I think one of the important distinctions I want to make that Merck is doing with their restructuring program that we put together today. This is not a reaction to having challenges in 2008 or a reaction to 2010. What this is, is taking a look at our basic strategy and saying, we need a new fundamental business model and globally we've been help in marketing and sales. We need to take a look at our manufacture and supply strategy. We need to take a look at what we can do better in basic research and clinical development. And based on that, the new models what putting in place, what is the outcome of those? So it's much more strategic in nature, its much more process in nature versus just a reaction that we have had a concern in 2008, therefore we have to reduce cost by $2 billion. That's not the way we run Merck and that doesn't put us on the path of regaining our leadership. This is very strategic. It's driven from a business model change that we know have to be responsible from an innovation standpoint in the new business models because if we don't change its business models we are not going to survive as an industry let alone a company. So it's much more than a reaction and I think we are doing it differently than other companies are and I will let Ken make a comment about the marketing part of it.
Kenneth C. Frazier: So I will just join what Dick just said, we are able to accelerate our U.S. in the commercial model because we have learned a lot from the pilot that we had in place and what we learned is giving us a lot encouragement. That we can do that in the U.S. in Europe and other mature markets. At the same time we will be adding head count in some of the emerging markets because we see the growth opportunity is there and just freeze up resources to invest behind our key growth drivers for example, SINGULAIR at the fourth quarter we are able to put even more money behind our DGC campaign.
Eva Boratto: And we have time for one more question please.
Operator: Your final question comes from the lines of Tony Butler of Barclays Capital.
Tony Butler: Good morning and thank you very much. Two brief questions, number one and apologies going back to Vytorin and Zetia but Ken as you look at the equity income from affiliate of 23 to 25 the guidance, it is not necessarily changed from that, that I... only marginally at the top end from that, given back in Q1. And I guess as we look out and I realize we are a few weeks into the fourth quarter at American Hearts there will be a presentation at AstraZeneca will make around the trial called Jupiter with and I am curious, do have an view and clearly because the trial stopped, it must have had some positive benefits. But I m curious of the view, you may have on its effect for not only the overall cholesterol market. But more importantly how that might effect Vytorin and Zetia and if you prepared, for how your message should, change should it need to change post that meeting. And the second question, a little more mundane and forgive me, if it was stated before. But what exactly is the issue with the manufacturing hang ups for in Europe? Thanks very much.
Richard T. Clark: Okay. So very briefly with respect Jupiter we are aware of the fact that trial was stopped early, there is going to be a presentation at AHA, I can only tell you that we continue to believe that by Vytorin and Zetia will be important to physicians. We are looking at that particular trial and developing competitive responses to that trial and I can't go into further detail about those right at the moment. As it relates to the adaptive delay in Europe. All I can say that we haven't countered a delay in the availability of trudaptive to support our pending launches in Europe and other markets due to a manufacturing related issue. We will continue to work quickly to fix that issue by continuing... and analyzing commercial product the commercial product supply and the last thing is, I want to underscore it's business not a safety related issue. It's a manufacturing issue, that we hope to resolve quickly.
Eva Boratto: That last question concludes today's conference call. The information from today's call, both the transcript and the replay will be available at our website for the next several months and my colleague and I will be available to take your calls and any incremental questions.
Operator: Thank you. This concludes today's third quarter 2008 earnings conference call. You may now disconnect. . | [
{
"speaker": "Operator",
"text": "Good day, everyone and welcome to Merck's Third Quarter 2008 Earnings Conference Call. Today's call is being recorded. At this time, I'd like to turn the call over to Ms. Eva Boratto, Vice President of Investor Relations. Please go ahead."
},
{
"speaker": "Eva Boratto",
"text": "Thank you Tella, and good morning. Welcome to our call to review our business performance for the third quarter of 2008. Joining me on the call today as always is our Chairman, President and CEO, Rick Clark; Ken Frazier, our Executive Vice President and President of Global Human Health, And Peter Kellogg, our Executive Vice President and Chief Financial Officer. Before we get into the details, I'd like to go over some logistics. On this call, we will review the results contained in the release we issued at 7:30, this morning. You can access this through the Investor Relations section on merck.com and I would remind you that this conference call is being webcast live and recorded. The replay of this event will be available later today via phone, webcast and broadcast. As we begin our review, let me remind you that some of the statements made during this call may discuss certain subjects that may contain forward-looking statements as that term is defined in Private Securities Litigation Reform Act of 1995. These statements are based on management's current expectations and involve risks and uncertainties, which may cause results to differ materially from those set forth in the statement. The forward-looking statements may include statements regarding product development, product potential or financial performance. No forward-looking statements can be guaranteed and actual results may differ materially from those projected. Merck undertakes no obligation to publicly update any forward-looking statements whether as a result of new information, future events or otherwise. Forward-looking statements in this press release should be evaluated together with the many uncertainties that affect Merck's business. Particularly, those mentioned in the risk factors and cautionary statements in Item 1A of Merck's Form 10-K for the year ended December 31, 2007 and in any risk factors or cautionary statements contained in the company's periodic reports on Form 10-Q or current reports on Form 8-K, which the company incorporates by reference. We will begin the call with brief remarks from our senior management, and then open the call for all your questions. And, we expect the total call to last about an hour. Given there are other earnings call today, we will be mindful of our time and will finish up by 10 AM. With that I'll turn the call over, and we will begin with remarks from our Chairman and President, CEO, Mr. Clark."
},
{
"speaker": "Richard T. Clark",
"text": "Thank you, Eva, and good evening everyone. Earlier this morning, we announced Merck's third quarter results and updated our 2008 and 2010 long-term guidance. For this mornings call, we can provide more detail about our most recent performance and our near term outlook and answer your questions. Today, we reported another solid set of quarterly results, including growing non-GAAP EPS and revenue from key products. We delivered those results even in a phase of a slow down in sales. Our Merck/Schering-Plough joint venture, and the continued impact with the loss of market exclusivity for FOSAMAX in United States. Since 2005, Merck has anticipated and aggressively prepared for the changing industrial environment. And restructuring our business and transforming the way in which we discover, manufacture and market our products. All of this was part of the plan to win strategy that I introduced shortly after becoming CEO. For three years, Merck has clearly seen our shares of positive and negative as the industry has overall. In terms of growth and new product introductions, in 2006 and 2007 were outstanding years for Merck. This year thus far has been a more complicated story. We have faced an unusual set of challenges some of them expected and others unexpected, some of them unique to Merck and others affecting many in the pharmaceutical industry. And, of course, global economic conditions are very dynamic at this time and could potentially continue to disrupt many industries for many times to come. We have made good progress on many fronts since 2005. However, our most recent sales trends for key products compounded by known industry and emerging economic factors have led us to reassess the environment in which we expect to be operating between now and 2010. And by the least considerations we have decided to lower our financial guidance over this period. As we look at our business today, we expect adjusted full year 2008 EPS to come in at the lower end but still within our previously disclosed range, the 2008 non-GAAP EPS of $3.28 to $3.32 excluding certain items. We now anticipate reported GAAP full year 2008 EPS of $3.45 to $3.55. And for the longer term, we expect revenues will have a compound annual growth rate, of plus 2% to plus 4% from 2005 to 2010, including 50% of the revenue from our joint ventures. Looking at non-GAAP EPS compound annual growth we now expect it to be at the mid to high single digit range over the same period excluding certain items. I take to deliver you on our commitments to you very seriously and I'm proud of Merck's track record in that regard. That's why I'm disappointed about the changes we needed to make today in our short and long term guidance. We've always been straightforward and realistic when speaking to investors about Merck's business and intend to continue to communicate openly and candidly about where we stand and what we plan to do to accomplish moving forward. The experiences and events of 2008 have been instructive to me and the leadership team. We will be proactive in addressing all challenges facing our business. One of the factors that has led us to moderate our outlook is the manufacturing challenges that have attracted availability of certain of our vaccines. Let me provide some context on this critical aspect our business. As accretive for the results and guidance discussions we will have later on this call. As we have previously discussed vaccine manufacturing is inherently complex. The process is complicated so it can take many months to manufacture vaccines from start to finish. And it can also take several months to complete the necessary testing before the vaccine is ready for the distribution to customers. From time-to-time issues arise, where there is a need to make a change in the manufacturing process. Due to the complexity involved, each issue has its own unique circumstances and can affect vaccine availability. We have recently encountered some of these issues and as a result, availability of certain vaccines will be delayed from the dates previously communicated. We now anticipate having enough supply of the Zostavax to clear the current back quarters by the end of this year. And ongoing supply to enable return the full promotion of Zostavax in United States, launching ProQuad and ZOSTAVAX outside the U.S. beyond 2009, and re-launching our HIV containing vaccine in mid 2009. While these delays are frustrating, we are making encouraging progress. We have resolved the issues regarding our varicella bulk production. Also, we have recently added an additional varicella bulk manufacturing facility, which has been approved by FDA. To support of long-term plans and to ensure we have consistent robust processes and practices that meet increasing demand, both of our existing vaccines and for the next generation of vaccines in development. Merck is investing approximately $1 billion to expand our capacity, and to make improvements to existing processes and infrastructures. That includes two new plans one in Durham, North Carolina, which we dedicated last week and then another in Carlow, Ireland, where we have just began construction. Despite the business challenges we face, I continued to believe that Merck had the right strategy focused on the core pharmaceutical business. We have a broad portfolio, the products that include many of first investment class products with marketing exclusivity that extends well into the next decade; Januvia, Isentress, GARDASIL, Zostavax, and Rotateq. We have a best in class research and development capability, not early in late stage pipeline, and from investigational candidates that address critical unmet medical needs. In addition, our industry leading R&D capability helps strength Merck to partner of choice with new external scientific collaborators to discover, develop, and distribute important therapies. Lastly, we are moving forward on several immediate and long-term steps designed to accelerate our revenue growth including significant investment in expanding our presence in emerging markets, brightening our business development focus to improve de-leveraging of opportunities in regions and countries outside the United States and accelerating development programs for novel mechanisms and fixtures combinations in some of our key therapeutic areas. In addition, we are leveraging our acquisition of GlycoFi to pursue follow-on biologics actively in multi-therapeutic areas, with a goal becoming a leading player. All of these moves has significant incremental revenue potential. We expect to provide greater details concerning these key growth levers at our December Analyst Meeting. In the mean time it is vital that we continue to ensure that we are operating our business in most lean and flexible way. As we move thorough the process we must gain and make significant but necessary changes in our business. Earlier this year, I explained how we would accelerate efforts in 2008 to further optimize our cost base, transform our business model and maximize performance across all of our products. Today, we are moving ahead to the next step in our restructuring efforts. Like its predecessor, this program is focused on continuing to transform our business model, lower our fixed cost, eliminate redundancy and increase the speed at which we make decisions, especially when it comes to taking advantage of growth opportunities. So, for example, Merck is accelerating the roll-out for more customer-centric selling model that we believe will yield a meaningful competitive advantage to Merck, will help physicians, patients and payers improve patient outcomes. Merck's research laboratory is deploying a new operating strategy for basic research which will improve the company's ability to manage increases research program, complexity, expand its access to worldwide external research and relocate resources to translate... to late stage clinical success. Merck's manufacturing division will further focus its capabilities on core products and outsourcing non-core manufacturing needs. And Merck will make greater use of outside technology resources, centralize sales and marketing activities and consolidate and streamline its operations. We expect the 2008 restructuring program to yield cumulative pre-tax savings of $3.8 billion to $4.2 billion from 2008 to 2013. These cost savings are an addition to the cumulative $4.5 billion to $5 billion which the company announced in 2005 and remains on track to achieve the 2010 target. As part of the 2008 restructuring plan, we expect to eliminate approximate 7200 physicians worldwide across all areas of company by the end 2011. Streamlining Merck to meet the demands of ever changing business environment, includes the painful reality of losing employees, whose contribution that helped our company accomplish so much throughout the years. But no matter how difficult the decisions are today, we know our long-term strategy is right. We took a leadership position in the industry and began reshaping our company ahead of our competitors, I am confident that we can overcome our short-term challenges and continue to position this company for success in the future. I recognize the change to guidance is not what our investors expect, nor what we wanted to deliver. That is why we remain committed to doing everything we can to improve this outlook. We are determined to deliver to our investors and we believe our 2008 restructuring program announced today, will help us do so. In closing, let me acknowledge that we are in the midst of an extraordinary time for the business world in the world economy, uncertainties involved in all areas of the market bound. However, I have full confidence in the fundamentals of Merck's business, our strong balance sheet and cash flow. Our product portfolio, our deep strength in research and development, our great people in an excellent management team across the globe. Now, I will turn to Ken, who provides an overview the performance of our product portfolio during the quarter Ken?"
},
{
"speaker": "Kenneth C. Frazier",
"text": "Thank you, Dick. And good morning everyone. Merck's revenue performance in the third quarter reflects continued strong growth of a number of recently launched new products including Januvia, Janumet and Isentress. This growth was offset by as discussed, supply shortfalls of some of our vaccines and continued challenges to driving demand for SINGULAIR and GARDASIL. Overall revenue was down 2% in the third quarter, excluding the impact of the loss of marketing exclusively for FOSAMAX revenue in the third quarter increased by 5%. Our international business showed strong growth with an increase of 13%. This was driven by volume increases of 6% as a result of the continued rollout of our new products as well as the prevailing exchange rates. Let me provide you with some perspectives on our top line results this quarter focusing on our key brands. Beginning with our HPV vaccine GARDASIL. Reported Merck failed in the third quarter were $401 million, a 4% decrease when compared to the third quarter of last year. In the U.S., sales declined 16% while Ex-U.S. sales increased 37%. Ex-U.S. sales were aided by the adoption of school based programs in all Canadian provinces, which resulted in a $34 million increase in sales in Canada compared to the base period. We are very pleased that the provinces have adopted this approach for an annual back-to-school based vaccine routine. The U.S. third quarter performance for GARDASIL was driven by three factors. First, we observed the consistent monthly vaccination rate among 19 to 26 year old women over the past year. While we've implemented many programs to increase vaccination in this age group, it will take time to address the barriers and significantly change behaviors of physicians and consumers. I will provide update on the status of some of our key efforts in a moment. Second, while the annual vaccination rate of the remaining 30 to 18 year old increased, the overall number of first dose vaccinations declined because of the early success in vaccine in this age group following launch. Considering the strong cumulative utilization among to 13 to 18 year old since launch continued growth requires substantially higher rates among the remaining eligible population. The vaccination rates for GARDASIL among adolescence remained higher than the average vaccination rates from Menactra and Pedec and comparable points in lifecycle. And third, utilization during back-to-school season was tampered somewhat by negative media coverage over the summer on slightly misperceptions which dampen consumer acceptance. As mentioned on the second quarter call, we have implemented a number of programs aimed at driving utilization among 19 to 26 year old women. I'll share a few early results. More than 5000 OBGYN and primary care locations have enrolled in the dose replacement program that we launched and first discussed last quarter, to address reimbursement concerns. We've already observed the approximate 8% to 10% lift in sales at these locations versus other locations, in the first two to four months since enrollment. Our in-office patient outreach program, which helps physicians reach out to unvaccinated females and mothers, rolled out during September. In this first few weeks of enrollment, more than 1000 locations enrolled and more than 200,000 patient mailers were ordered in those locations. Our outreach through managed care organizations to inform eligible patients about coverage of GARDASIL has reached more than 2 million enrollees in those plans. And finally, just this month we launched two programs to reach young adult females, a multi-channel consumer disease awareness campaign, and a patient program for OBGYN offices. While we are encouraged by the initial progress of these programs, we recognize that it will take time to have a significant impact on the overall vaccination rates of this important 19 to 26 year old group. I'd like to take a moment now to discuss the performance of our two other recently launched vaccines; Zostavax and Rotateq. First, despite significant demand, Zostavax performance in the quarter was hindered by the lack of bulk bearer seller supply. Looking forward, we expect to have enough supply to clear the current back orders for Zostavax by the end of the year. As new orders are received, we will fill in as quickly as possible but it is possible that depending on demand levels, some new orders will be back ordered and filled in early 2009. Throughout this period of constrained supply, we have focused our marketing efforts on reducing many of the logistical and reimbursement barriers to vaccination with Zostavax. We remained extremely excited about the potential of Zostavax, and we look forward to ensuring adequate supply of this important vaccine for our customers. Next, underlying demand for Rotateq continues to be strong. More than 75% of U.S. at risk can now been vaccinated with Rotateq, which was the only rotavirus vaccine available in the U.S. into the middle of this year. When you adjust for the $50 million stock pile purchased by CDC in third quarter 2007, sales in third quarter of '08 were up 11%. As you model the future performance, you should keep in mind that our fourth quarter '07 results included a CDC stockpile purchase of $26 million. Rotateq continues to perform well in the U.S. market, and we have not seen a significant impact to date from the recent introduction of competition. Turning to SINGULAIR, sales in the third quarter were up 1% versus the prior year. SINGULAIR performance in 3Q08 was driven by strong growth in Europe, Middle East and Africa and Asia. And offset by the decline in the U.S. business. Ex-U.S. sales of SINGULAIR grew 12 % as a result of continued growth in EMEA and Asia. U.S. prescriptions for SINGULAIR, that is total prescriptions, were down approximately 8% in the third quarter versus third quarter '07. Similar to the decline in the overall respiratory market. The combined allergy and asthma market without Zyrtec, which was down approximately 6%. As I have mentioned in previous quarters, the U.S. performance for SINGULAIR continued to be effected by the switch of Zyrtec OTC, the weak spring allergy season, and the FDA early communication, this spring. We are determined to improve the performance of SINGULAIR in the U.S. in the fourth quarter and we have significant resources and plans underway to grow SINGULAIR during the fall allergy season and the end of year asthma season. Our sales force has new material to use with physicians including very specific patient profiles, leveraging on efficacy and safety, new trial and coupon kits for new patients, and educational materials for patients. We are using a multi-channel approach with consumers which includes press, television and online DTC including digital banners and e-coupons and office branded marketing programs, pharmacy programs and adherent initiative and an updated website. Looking outside the U.S. SINGULAIR continues to show strong performance for the year so far. SINGULAIR grew 20% outside the U.S. and Europe and other markets such as Japan which illustrates the strong positive perceptions about SINGULAIR held by provisions around the world. Moving to two of our newest growth drivers, global revenue for Januvia and Janumet reached $479 million in the third quarter up 18% sequentially versus second quarter '08. In the U.S. JANUVIA continues to be the second leading branded oral anti-diabetic agent in terms of new prescription share. Despite the slowdown in the overall U.S. diabetes market the Januvia, Janumet franchise continues to grow in both volume and market share. In addition, we are extremely pleased with the Ex-U.S. performance of Januvia, Janumet in the third quarter. In the EU, Januvia is the only DPP for inhibitor approved for dual and triple therapy with the sulfonylurea or sulfonylurea plus metformin remains the only marketed DPP for that is once daily. Worldwide more than 8 million prescriptions have been written today, and we just stood these two benefits to be major growth drivers for Merck in the short-term and in the long-term. And we are investing significantly in them to ensure that we realize their full potential. Now, I would like to take a moment to provide an update on the performance of our cholesterol JV. Worldwide sales of Zetia and Vytorin as reported by the Merck/Schering-Plough joint venture for $534 million and $567 million respectively in the third quarter. Sales of Zetia were down 12% and sale of Vytorin were down 18% versus the prior year. Sales declines in the U.S. were partially offset by continued strong growth outside the United States. Market share for Zetia and Vytorin in the U.S. appears to be stabilized and post ESC. Although we've seen an additional 8% decline in new prescriptions since the initial release of the SEAS results, the rate of volume and share declines for the JV has slowed throughout the year. However the overall cholesterol market growth has been slower than expected. And while we expected the JV brands will remain competitive in terms of managed care, provisioning in 2009. We anticipate a reduction in formulary coverage from 2008 levels. We remain stepped back in our support for Zetia and Vytorin continue to be valuable treatment options for physicians by helping to get more of their patients to their LDL goals. Before turning the call over to my colleague Peter Kellogg, I would like to take a moment to update you on the progress we are making on our efforts to evolve our commercial models and to optimize our cost base to better position Merck to grow the top line. With Merck's portfolio both, inline in new parasitic vaccines, and with the number of people around the world who can still benefit from our products, we have ample opportunities for future growth. The challenge to us is to create a process that can go after these opportunities in an effective and efficient way. We've already changed our headquarters and sales leadership structure, to prepare for the full implementation of the new commercial model in the U.S. in March of next year. The results from our year long palate give us confidence that the new customer centric model provides the right level of support for our new products and can drive revenue and margin improvements. As Dick, mentioned, we have continued the effort that we started back in 2005, to optimize our cost base and improve Merck's effectiveness and efficiency. In Q3, we started to realize the saving of the U.S. sales force actions we announced in May of this year. Overall, for the quarter, marketing and administrative expense excluding the legal defense reserve in the base period, was down 8% versus the third quarter of 2007. But I should note, that promotional spending was up, which is the reflection of the support that we continue to put behind our growth brand and our growth market. We are also realizing savings outside the U.S. as we begin implementing our new commercial models and streamline our sales and marketing operations. What we are doing with these actions, is reducing our fixed cost base. So that we have the flexibility to invest in growth brand and growth markets around the world. And I believe we have laid a great deal of progress here. Turning to our long-term revenue guidance. As, Dick, mentioned, we have reduced our 2010 compound annual revenue guidance including 50% of our joint ventures, to 2% to 4%. As we work through our bottoms up planning process, we needed to assess our underlying product trends as well as project future challenges and opportunities, in a rapidly changing external environment. Based on our assessment, the key drivers for the reduction in revenue guidance since July are as follows. First, since we last gave guidance in July, there has been a 10% to 15% reduction in the euro to dollar exchange rate. Because 40% of our sales are from outside the U.S., the decline in exchange significantly dampens our outlook. Second, supply shortfalls for some of our back hands will affect our ability to meet market demand, and as you know, we are investing heavily in our manufacturing capacity for our vaccines to address this key issue. As Dick, said, we remain confident both, in the alternate revolution of our supply issues, and important benefits provided by these unique vaccine products to our customers. However, the supply issues will affect our future performance. Third, we continue to anticipate that we will have challenges to drive an increased demand trends for our joint venture cholesterol management's GARDASIL and SINGULAIR. While we have comprehensive plans in place to address these challenges, and return these products to higher growth trends, our overall expectations for performance over this period, are now lower. In closing, while we are disappointed in the reductions to our long-term revenue guidance, I assure you that the entire Merck Organization is focused on improving that picture for the top line as well as the bottom line. We continue to believe that tremendous commercial opportunities exist for our established franchises along with our new first in class vaccines and medicines such as GARDASIL, Rotateq, Januvia, Janumet, Zostavax and Isentress. We are confident that our continued focus on efficiencies on the marketing and the administrative line, demonstrated throughout 2008 will help drive overall margin improvement and that the plans we have in place fundamentally to change our business model will enable us to drive the top line for our medicines and vaccines for years to come. So with that I will turn the call over to my colleague Peter Kellogg."
},
{
"speaker": "Peter N. Kellogg",
"text": "Thank you Ken. And good morning everybody. Before we start to Q&A potion of the call I just want to touch on three items very quickly. First discuss the other key elements of our Q2 results that haven't been previously discussed. Secondly, providing the overview of our 2008 and 2010 guidance. And then finally provide an overview of some other financial matters. Let's get started. Merck reported third quarter of non-GAAP earnings per share of $0.80 per share which represented a growth of 7% over the third quarter of 2007 on a GAAP basis EPS for the third quarter was $0.51 per share. Both the GAAP and non-GAAP third quarter results include the impact of $88 million of recognized loses in the company's investment portfolio. Now Ken, just walk you through the key elements of revenue performance for the quarter. So I'd like to now cover the other elements of the P&L beginning with product gross margin or PGM. Our third quarter PGM was 76.1% excluding restructuring the decrease of 1.1 percentage points versus the prior quarter. The sequential reduction in PGM is primarily driven and secondarily discard. In the third quarter sales of SINGULAIR and FOSAMAX both high margin products were lower than in Q2 of 2008 while sales GARDASIL a lower margin product were higher than prior year. In addition PGM was negatively affected by discard associated with vaccine. Moving to research and development. R&D expense for the third quarter was $1.1 billion when you adjust for the $325 million as required research which is a charge associated with the purchase of NovaCardia in the third quarter of last year and the 2008 restructuring cost R&D expenses were up 2%. Turning to restructuring, our 2005 restructuring program is nearing completion at year-end. But we continue to transform Merck into a lean and flexible company appropriately sized and scaled for the future pharmaceutical operating environment. Accordingly the company announced a new 2008 restructuring program. Included in our Q3 results were total restructuring charges of $847 million. Now that's made up of $720 million for the new 2008 program and $127 million for the 2005 program as winding down. In the aggregate the cost of the 2008 program is expected to be $1.6 billion to $2 billion. As expected to very substantially complete by the end of 2011. Now as Dick, has already mentioned this effort is expected to yield cumulative pre-tax savings of $3.8 billion to $4.2 billion from 2008 to 2013. This is a critical next step in our journey to establish a more a variable cost structure. Next in the third quarter we continue to face pressure on the equity income line as a result of 2 factors. First, the equity income contribution for the Merck/Schering-Plough joint venture was down 17% or $81 million. As a result of Zetia and Vytorin market share losses in the U.S. The lower revenue in the U.S. was partially offset by strong growth outside the U.S. Secondly, the equity income contribution from the AVN joint venture was $42 million lower in the third quarter compared to the prior year. The decrease in the equity contribution from the AstraZeneca partnership is attributable to the previously disclosed events surrounding the JV restructuring that incurred to at the end of first quarter this year and we discussed that previously. As well as always we had some inherent variability in the timing of payments from AstraZeneca. As a reminder Merck's prior year returning was decreased to $55 million for quarter from $75 million and Merck no longer received the 10% royalty payments from the Astra USA products. Moving to the other income and expense line, net for the third quarter were $62 million in expense, which declined to $243 million versus Q3 2007. The year-over-year decline is attributable to first, recognize losses of $88 million in our investment portfolio as I mentioned earlier, and that's a result of Merck's exposure primarily to Lehman Brothers and AIG in Q3 2008. Secondly, there were balance sheet translation losses of $52 million in Q3 2008 due to foreign exchange movement and how they impact our balance sheet. And thirdly, income of approximately $100 million occurred last year from the one time net gain that resulted from the settlement of certain patent disputes that we discussed last year. Now moving to our 2008 guidance. Our 2008 non-GAAP EPS guidance is for $3.28 to $3.32 as Dick covered earlier. This guidance is at the low end of the previous range. Our corresponding 2008 GAAP guidance is now $3.45 to $3.55. Now as always, to assist your modeling, we provide a breakdown of the product revenue guidance in our other financial disclosures schedule attached to the press release that we issued earlier today. But let me briefly walk you through the changes that occurred there. On the revenue line SINGULAIR has the full year range lowered by $100 million, for the range now stands at $4.3 billion to $4.5 billion. Other vaccines, also had their full year range lowered by $100 million. So that means now its $2.6 billion to $2.8 billion. And as Ken and Dick mentioned, that's largely attributable to delays and supply. Finally, the Astra component, was increased on a full year basis by $200 million. So that now stands at $1.5 billion to $1.7 billion and that's due to the strong net in performance that we have seen year-to-date. Now regarding, marketing and administrative expense. We are reducing our guidance by $100 million to $7.4 billion to $7.6 billion. This reduction is possible because of our ongoing, companywide, aggressive expense management that Ken covered a few minutes ago. And during the restructuring as a result of the charges associated with additional restructuring program that we announced today, restructuring guidance for 2008 is increased to $1.3 billion to $1.5 billion. Now turning to the 2010 guidance. As Dick, and Ken, mentioned, a number of factors that led to the revised 2005 to 2010 guidance, that we issued this morning. Since we last provided guidance long term guidance in July, foreign exchange rates have clearly moved against us, and that coupled with the manufacturing and supply issues, and product specific changes, has led to the change in outlook. As an organization, we are committed to maintaining focus on cost control and the restructuring program announced this morning will help us move toward a variable cost structure. We have a clear plan in place to enable us to achieve the long term guidance we provided this morning. Now moving to the shares repurchases. Merck, has been actively repurchasing shares. During the third quarter, the company continued its stock buyback program, and purchased approximately $1 billion of treasury stock. And during the first nine month of 2008, we have now purchased $2.5 billion of treasury stock. This program will continue in Q4. The company considers a variety of factors in share repurchase decisions, including our strategy, the long term capital structure, market condition, the impact of actual and anticipated employee stock option exercises, and EPS implications of repurchases. As of September 30th the company has $2.6 billion remaining under the July 2002, treasury stock purchase authorization. Now let's turns to some other financial matters. And I'd like to take a minute to speak about Merck's overall financial strength. As you know, Merck has always had a strong balance sheet, and a conservative investment philosophy. As of September 30th our current cash and investment portfolio totals $19 billion, including $6 billion pledged as collateral for bank guarantees related to certain items, including Vioxx product liability settlement. The portfolio contains a diversified mix of high quality, short term, less than 90 days, and medium term, less than five years. Fixed income, government, agency, corporate, asset backed, agency guaranteed mortgage back, and the municipal securities. Our investment philosophy had served shareholders very well. Since 2001, our benchmark investment portfolios have earned 1.4% per annum more than a Treasury bill portfolio, providing company with incremental interest income in excess of $1.2 billion over this period. Merck's strong financial profile, as indicated by our AA minus credit rating, provides Merck with a distinct advantage in accessing funding during difficult markets. In the current market environment, we continue to have more than sufficient access to the commercial paper markets at attractive pricing, and across all maturity spectrums. We have financial strength and remain fully committed to maintaining our dividend at the current level. At the same time, we continue to fully invest in our key strategic priorities and our pipeline. So in summary, Q3 was a solid quarter. Januvia, Janumet and Isentress continued to perform very well globally. We also continue aggressively manage our overall cost structure, as demonstrated by the reduction in marketing and administrative guidance. And, we believe that our 2008 restructuring program will enable Merck to continue to drive toward a more lean and flexible model. Thank you and now I'll like to turn the call back to Eva. Eva?"
},
{
"speaker": "Eva Boratto",
"text": "Thank you, Peter. We will now open the call to take your questions. We will take your questions in the order they are received and try to get through as many as possible. Joining us for the Q&A session is Bruce Kuhlik, our Executive Vice President and General Counsel. At this point, I'll turn the call over to Tella, who will communicate instructions for our Q&A format and then introduce the first question, Tella? Question And Answer"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Your first question comes from the line of Tim Anderson of Bernstein."
},
{
"speaker": "Tim Anderson",
"text": "Hi. Thank you. A couple of questions. Dick, I am hoping you can talk about the notion of having a so called established products group, like one of your competitors who is recently have been talking whereby a higher level of marketing resources are dedicated off patent drugs. I am wondering if this makes sense and if Merck has a similar effort underway and if not, does Merck plan on doing anything differently? And then Ken, when you say you expect Vytorin and Zetia to continue to have competitive formulary positioning going into 2009, how do you define competitive because it sure looks like Vytorin and Zetia will be at disadvantage relative to other products much more often than not based on the date that CMS has on their website?"
},
{
"speaker": "Richard T. Clark",
"text": "Okay. So, let me start with the second question which is where we believe would the case for our managed care access. As you know, right now we believe that we remain competitive in 2008 as it relates to our managed care placement, especially as it relates to unrestricted access to second tier and major plans. As we move forward into next year in 2009, we will believe that we'll continue to be competitive but we actually believe that will have somewhat less access, than we have during this year. So, next year we believe that Vytorin and Zetia will be reimbursed without restriction for about for two thirds of patients in commercial and Medicare Part D. I don't know exactly if that's what you are referring to but some of those most recent decisions made in Medicare Part D have been not as positive for Vytorin and Zetia but its also important to keep in mind that they represent only 20% of the book of business. So today we reimburse without restriction or about 75%, next year we believe it will be about two thirds. The other question, relates to how we are thinking about an established products group. We are booking overall at our entire business including how we should apportion funds, scarce funds between all of our products. We have a number of very strong growth drivers that are early in their lifecycle. And our primary focus is ensuring that those products get up to a very fast growth curve. On the other hand, we have plans that are in place which we'll talk about in greater detail in December, for our emerging market strategy, and in those markets as you know, somewhat more established products including product that don't enjoy patent protection, continue to be valuable contributors to portfolios in that part of the world. And we are certainly looking at our entire portfolio, including established products, across various geographic markets and looking at, how to actually maximize the return of the entire portfolio to Merck shareholders."
},
{
"speaker": "Eva Boratto",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Chris Schott of J.P. Morgan."
},
{
"speaker": "Chris Schott",
"text": "Great, thank you. If we look at the cost savings outlined in to the new restructuring program, can you give us more color of this segmentation between our cogs, SG&A and R&D on that one, and may be just a little bit more clarity on the timing of some of these headcount reductions that are way out with these plan? And then may be a final question on GARDASIL, with dose replacement program at the end during the quarter, just quantify how many doses have been provided to physicians at that program? Thank you."
},
{
"speaker": "Peter N. Kellogg",
"text": "Hi Chris it's Peter Kellogg. So let me quickly recap some of the dimensions of this restructuring program. Then I'll pass the GARDASIL question over to my colleagues but. First of all in terms of where the cost will occur. Because good portion of this restructuring is related to real cash items and they are primarily headcount related. Probably that 65% of the cost that you'll see while go though the restructuring line. And then rest of cost will be split between cost of goods and R&D. In terms of where the benefit will flow, we haven't broken that in great detail. But in general, probably about 70% or so of the benefits will come to what we call the M&A line, the SG&A area. And because the largely the impacts are primarily head count related the benefits of this program are fairly evenly spread over time. And so our expectations will probably get about the third of the benefits from this program through 2010 and downs after that. So I can hope that I give you some dimensions of the restructuring and then I guess for Ken for GARDASIL?"
},
{
"speaker": "Kenneth C. Frazier",
"text": "So I think it's important to recognize that we're still very early in the dose replacement programs like. It's been in place for about two to four months. As I mentioned we are pleased that there has been a reasonably strong uptake in terms of participation by all the guys and primary care providers. We see in the early days an approximate 8% to 10% lift. So those are all things that all go well particular approach to that barrier around reimbursement. We don't however provide the actual number of doses that we've provided in those locations. But again we're pleased that we are seeing where there is participation in impact on GARDASIL use."
},
{
"speaker": "Eva Boratto",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Roopesh Patel of UBS"
},
{
"speaker": "Roopesh Patel",
"text": "Thanks for taking my question. Just a couple of questions first on the cholesterol franchise. Just given the pushes and pulls U.S. versus international. Could you please clarify if you expect the overall global Vytorin and Zetia revenues to grow or decline in 2009. And then secondly on the vaccines business if you could kindly elaborate on the progress of resolving manufacturing issues for the Hepatitis vaccines backed [indiscernible] also for ProQuad thank you?"
},
{
"speaker": "Kenneth C. Frazier",
"text": "Okay. So I will start with the first question. As I said we are seeing very strong growth outside the U.S. for Zetia and Vytorin. We are experiencing difficulties in the U.S. as you know we saw 8% decline in NRX we're seeing an issue with respect to the overall market growth of the cholesterol franchise but of those out at this point in time I am not in a position to say whether the franchise will grow globally next year. All I can say is that we continue to provide investments behind Zetia and Vytorin in the U.S. where we've seen the grades decline and we continue to believe that the products will have the right kind of support going forward. As it relates to the other vaccine that you describe feedbacks and comebacks should be available again in mid 2009 and as it relates to vector based on the latest information we expects the ADA formulation would be here on Q1 2009 and pediatric in the fourth quarter of 2008."
},
{
"speaker": "Eva Boratto",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of John Boris of Citigroup."
},
{
"speaker": "John Boris",
"text": "Thanks, for taking the questions Dick just a question on investment and R&D you obviously had trend out delayed while back you had to discontinue relatively expensive program on taranabant the obesity compound. Then you announced recently the Hepatitis B vaccine obviously also has issues. Can you just talk about what is going on with at least you believe that the FDA currently from a safety stand point view. You obviously have eight other assets in Phase III clinical development. How can we be assured that you have adequately designed those to meet a much more rigorous FDA from a safety stand point and second question on licensing and business development Dick and Peter. Over the last couple of years the velocity of your licensing and business development activities has been extremely robust. Can you just highlight what that activity has been year-to-date in '08 and how that contrasts with '07 and '06 thanks."
},
{
"speaker": "Richard T. Clark",
"text": "Well thanks for the questions. So we are considering some of the challenges we had with our late stage pipeline I always put it in perspective that this same agency that we are discussing was able to approve non-products over the past two years or so. And these have been first in class differentiated products unmet medical needs. And truly it's going to be the foundation for the company from the revenue standpoint moving forward throughout the world and while products had that we are getting fair and reasonable pricing globally as we speak. I think that's the good news. I have a lot of confidence in our scientific capabilities within Merck I think it is our strong points as a company and I think we have the ability to interact and communicate with the agency to make sure we understand if there are any changes or signals that we received that were able to make sure that we proactively answer those questions. And I think we've been able to do that I think the reasons is Januvia is on the market as we proactively started the questions that they are going to ask and we are able to accomplish those and the fact that GARDASIL on market allows us to do. So there is no doubt that we have to continue to look at clinical development and make sure that we communicate and we listen to what any potential signals or standard changes could exist but I think all effects to do that we've done in the past regard our outstanding scientific leadership. And I think that puts us in a quite competitive position in relationship to I call it in the industry."
},
{
"speaker": "Peter N. Kellogg",
"text": "Just let me take the question. I can on the business development front. The question is specifically I think John, ask was is there pace in '08 comparable what we did in '07, '06 and obviously year is not going yet. But at this point actually we have been very active in the business development front. As you're well aware we did neighborhood of roughly 50 or more deals in each of last prior years. We've done a good number this year. We've announced quite a few we already heard. And we remain very active as we speak today. And our focus is to look at all ways to doing deals whether be in licensing or collaboration and also a truly innovative and novel mechanism that could really add to our portfolio. We tend to look at biotech companies that also bring different kinds of mechanisms into the play and we obviously think about it from the franchise standpoint. So our business development activity is very well integrated with the R&D organization and their franchise team. So increasingly you'll see a stuffing of that activity. I think you'll also see us broadening perhaps some of the scope of what we've done in the past not only to do the classic pipeline and licensing deals but also include as we discussed in the last earnings call more activity on the business development front with commercial products and global companies that may have only regional presence. But we're I think can hand our international portfolio. So I think this will be another robust year. We have full expectations it is one of our corporate goals and certainly one of our finance and R&D goals to have a very strong and licensing activity and I think increasingly we will see more of Ken's organization really diving in as well. So I think it is a big opportunity for us."
},
{
"speaker": "Eva Boratto",
"text": "Next question please"
},
{
"speaker": "Operator",
"text": "Your next question comes from line of Dave Risinger of Merrill Lynch."
},
{
"speaker": "David Risinger",
"text": "Thanks very much I have three questions. First regarding Vytorin and Zetia how do you define unrestricted? Do you mean Tier II or are you talking about Tier II and Tier III? The second question is I will just read from your press release the second bullet that I don't understand so I am hoping that you can explain it. It says cumulative savings of $3.8 billion to $4.2 billion expected from 2008 to 2013 and pre tax cost of $1.6 billion to $2.0 billion thorough 2011. Can you just reconcile those two? And then finally and I may have missed this, but where does GARDASIL for 27 to 45 year old females stand? Thank you."
},
{
"speaker": "Peter N. Kellogg",
"text": "So, Dave... this is Peter. If I can start off with your specific question on the bullet point. So we look at restructuring what we trying these exact vernacular is place in the timeframes that we used in the past. And so our cost that will go through the P&L as restructuring charges, we expect to be in the range of $1.6 billion to $2 billion cumulatively between now and 2011. And obviously we'll be incurring those costs as we go along as different activities are taken. As I mentioned earlier, more than half of those costs will be head count related and so those will be severance program charges and so forth. And the rest will be probably either accelerated depreciation for facilities that are being closed or other related cost that are between different investment areas or whatever. So that's the cost side, that's the $1.6 billion to $2 billion. From these restructuring moves, we will then realize savings in the operations of our P&L and what we look for is in the range of $3.8 billion to $4.2 billion of operating savings that'll flow through the P&L on a cumulative basis over the next five years and that's the '08 to 2013 timeframe. And as I mentioned on an earlier question, we expect those savings to come true on a fairly steady basis as we go along because of the size of the program changes we are making right away. So, as I mentioned we would expect about a third of those savings to come in, in the 2009 and 2010 timeframe. Let me hand over to Ken next?"
},
{
"speaker": "Kenneth C. Frazier",
"text": "Yes.First of all I apologize for any lack of clarity in my previous response. When I was talking about our access to managed care formularies, I was referring to Tier 2. So, when I said that we have 75% access with no restrictions, this year I was referring to Tier 2 and when I made my comment about two thirds next year, they also related to Tier 2 access without restrictions. With respect to your other question, as you know, we have responded to the FDA complete response letter in July. The agency has informed us that the response was a class two response though typically those responses take about six months to work through."
},
{
"speaker": "Eva Boratto",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Barbara Ryan from Deutsche Bank."
},
{
"speaker": "Barbara Ryan",
"text": "Good morning and thanks for taking my question. Most of them were asked but may be Dick, I wonder if in the targeted cost cutting that you have and specifically that 12% head count reduction through 2013, if within that you have assumed any kind of what I'll call fundamental changes in the marketing model of the company? I mean its probably not the right form to go in to all of those things but just in a generic sense?"
},
{
"speaker": "Richard T. Clark",
"text": "Yes, I'll let Ken answer that and then to Barbara but I think one of the important distinctions I want to make that Merck is doing with their restructuring program that we put together today. This is not a reaction to having challenges in 2008 or a reaction to 2010. What this is, is taking a look at our basic strategy and saying, we need a new fundamental business model and globally we've been help in marketing and sales. We need to take a look at our manufacture and supply strategy. We need to take a look at what we can do better in basic research and clinical development. And based on that, the new models what putting in place, what is the outcome of those? So it's much more strategic in nature, its much more process in nature versus just a reaction that we have had a concern in 2008, therefore we have to reduce cost by $2 billion. That's not the way we run Merck and that doesn't put us on the path of regaining our leadership. This is very strategic. It's driven from a business model change that we know have to be responsible from an innovation standpoint in the new business models because if we don't change its business models we are not going to survive as an industry let alone a company. So it's much more than a reaction and I think we are doing it differently than other companies are and I will let Ken make a comment about the marketing part of it."
},
{
"speaker": "Kenneth C. Frazier",
"text": "So I will just join what Dick just said, we are able to accelerate our U.S. in the commercial model because we have learned a lot from the pilot that we had in place and what we learned is giving us a lot encouragement. That we can do that in the U.S. in Europe and other mature markets. At the same time we will be adding head count in some of the emerging markets because we see the growth opportunity is there and just freeze up resources to invest behind our key growth drivers for example, SINGULAIR at the fourth quarter we are able to put even more money behind our DGC campaign."
},
{
"speaker": "Eva Boratto",
"text": "And we have time for one more question please."
},
{
"speaker": "Operator",
"text": "Your final question comes from the lines of Tony Butler of Barclays Capital."
},
{
"speaker": "Tony Butler",
"text": "Good morning and thank you very much. Two brief questions, number one and apologies going back to Vytorin and Zetia but Ken as you look at the equity income from affiliate of 23 to 25 the guidance, it is not necessarily changed from that, that I... only marginally at the top end from that, given back in Q1. And I guess as we look out and I realize we are a few weeks into the fourth quarter at American Hearts there will be a presentation at AstraZeneca will make around the trial called Jupiter with and I am curious, do have an view and clearly because the trial stopped, it must have had some positive benefits. But I m curious of the view, you may have on its effect for not only the overall cholesterol market. But more importantly how that might effect Vytorin and Zetia and if you prepared, for how your message should, change should it need to change post that meeting. And the second question, a little more mundane and forgive me, if it was stated before. But what exactly is the issue with the manufacturing hang ups for in Europe? Thanks very much."
},
{
"speaker": "Richard T. Clark",
"text": "Okay. So very briefly with respect Jupiter we are aware of the fact that trial was stopped early, there is going to be a presentation at AHA, I can only tell you that we continue to believe that by Vytorin and Zetia will be important to physicians. We are looking at that particular trial and developing competitive responses to that trial and I can't go into further detail about those right at the moment. As it relates to the adaptive delay in Europe. All I can say that we haven't countered a delay in the availability of trudaptive to support our pending launches in Europe and other markets due to a manufacturing related issue. We will continue to work quickly to fix that issue by continuing... and analyzing commercial product the commercial product supply and the last thing is, I want to underscore it's business not a safety related issue. It's a manufacturing issue, that we hope to resolve quickly."
},
{
"speaker": "Eva Boratto",
"text": "That last question concludes today's conference call. The information from today's call, both the transcript and the replay will be available at our website for the next several months and my colleague and I will be available to take your calls and any incremental questions."
},
{
"speaker": "Operator",
"text": "Thank you. This concludes today's third quarter 2008 earnings conference call. You may now disconnect. ."
}
] | null | null |
Subsets and Splits
No community queries yet
The top public SQL queries from the community will appear here once available.